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INDUSTRIAL ECONOMICS II
Prof. Davide Vannoni
Handout 7: Vertical Restraints
Content of lecture and objectives
 Introduction
 Vertical Integration – the gains & possible anticompetitive effects
 Defining vertical restraints – classification and examples
 The efficiency justification
 Anti-competitive consequences
 Some real world examples where the effects are contested
Suggested reading
Tirole, chapter 4, but also chapter 1 (especially sections 1.3 & 1.4)
Cabral ch.11
Church and Ware ch.22
Martin S (1993), Advanced Industrial Economics, B Blackwell, ch. 12
Competition Commission (2000) Report on Supermarkets (Food
Retailing)
Dobson P and Waterson M (1996) “Vertical restraints and competition
policy”, OFT Research Paper No. 12
Waterson M (1991), “Vertical Integration and Vertical Restraints”,
Oxford Review of Economic Policy, vol. 9 no.2
Clarke, Davies and Driffield (1998), ch 8 for an extensive annotated
listing of UK cases (see Table 8.1 p.123 for summary.)
Slade M (1998), “Beer and the tie: did divestiture of brewer owned
public houses lead to higher beer prices?” Economic Journal, 108:
565-602
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1. Introduction
In most real world markets, the producer does not sell direct to final
consumers – they may produce only intermediate products, and/or may
sell via a retailer. We can think of most products or services as the
result of a vertical chain, e.g. a restaurant meal
Full vertical integration occurs whenever successive stages of this chain
are brought under single ownership, e.g. a clothing manufacturer with its
own retail shops, a car manufacturer with its own steel factories
Vertical restraints are a milder form, in which a firm at one stage
imposes restraints on its customers or suppliers in adjacent stages.
Below, I will tend to concentrate on the relationship between
manufacturers and retailers: a clothing manufacturer might own its own
retail shops (vertical integration), or it might impose restraints on the
retailers concerning how its clothing is sold in their shops. Equally, it
might impose restrictions on it textile suppliers
The big question: are vertical restraints (and vertical integration)
justified because they improve efficiency, or are they harmful to
competition and consumer welfare because they allow the firms to
achieve and abuse market power? This is highly contested territory.
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2. Full Vertical Integration
There are two standard textbooks explanations of why firms choose to
be vertically integrated, each of which suggests that vertical integration
is a ‘good thing’ from society’s point of view.
2.1
Minimises transactions costs
This is the standard Coase/Williamson explanation of why firms choose
to internalise exchanges within the firm, rather than use market
transactions between firms.
The problems of transacting (i.e. contracting) between firms1:
 unforeseen contingencies
 so many future possibilities that writing them all into the contract
would be too costly
 monitoring the contract may be costly
 enforcement costs (litigation) will be high
Given that contracts are, necessarily, incomplete, there is always the
possibility of opportunistic behaviour (especially with specific assets.)
Where such costs of using the market are high, it is best for the firm (and
society) if the activities are combined within a single firm.
See Tirole sections 1.3 and 1.4 for more discussion.)
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2.2
Avoidance of double marginalisation (successive monopoly
mark-ups)
This is the standard defence of vertical integration in the IO literature.
The problem: where one monopolist is selling to another monopolist,
there is the possibility that each party adds its own mark-up – price is
higher than needed for joint maximisation & the consumer loses out.
(This is covered, slightly differently from the following, in Tirole in
section 4.2.2.)
A simple model
Assume:
 Upstream monopolist supplier of A supplies a downstream
monopolist producer of B
 one unit of A is required for each unit of B
 The upstream monopolist incurs a constant marginal cost MCA =
CA. The downstream monopolist incurs no marginal cost, other
than the A input. Thus MCB = PA
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Say, between one firm undertaking R&D and another, manufacturing, in some very high-tech market. In principle,
they could be separate firms, in practice, both activities are undertaken within the same firm.
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What price will A charge B?
 Before we can answer, we need to know the demand curve for A
from B. To derive this we first note that B will maximise his
profits by setting
MRB = MCB = PA
 So whatever price is set by A, this becomes B’s marginal cost, and
this will be equated to B’s marginal revenue. In other words, firm
B’s MR curve becomes A’s derived demand curve, (see figure (a).)
 Now turn to figure (b) to see what this implies for A’s optimal
price. He will set his own MRA = MCA, and this implies quantity
QA* and price PA*.
What is B’s final price?
 B sets his own marginal cost (PA) equal to his MRB, implying a
price to final consumers of PB*. Thus, there is a double mark-up.
If A and B are integrated (i.e. a single firm.)
 In this case, it sets MRB = CA, with output QI* and price PI*
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Numerical example
Linear demand curve:
PB= 10 - QB
A’s constant MC are 2:
MCA = 2
TRB = 10QB – QB2, and so
MRB = 10 - 2QB
So MRB=MCB means
10 - 2QB = PA
And, since QA=QB, the derived demand curve for A is:
PA = 10 - 2 QA
In figure (b), firm A sets MRA = MCA, i.e.
10 - 4QA = 2
Thus QA = 2, PA = 6,
A = (PA – CA).QA = 8
and PB = 10 – 2 = 8,
B = (PB – CB).QA = 4
But in the integrated case,
MR = MC, i.e.
10 – 2Q = 2
Therefore Q = 4. P = 6,
 = (P – 2).Q = 16
Under vertical integration price is lower, quantity is higher and both
consumer’s surplus and producer’s surplus are higher w.r.t separation
Extensions:
a) What happens if there is more than one firm at the downstream
stage where competition is on prices?
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b) What happens if there is more than one firm at the downstream
stage where competition is on quantities?
c) Is vertical integration the only strategy to avoid double
marginalisation? No, other strategies sort the same effect.
- Resale Price Maintenance - RPM (the downstream firm cannot sell
at a price higher than 6)
- Quantity fixing (the downstream firm must buy 4 units or more)
- Franchise fee- downstream firm is charged a two part tariff:
F + 2 q. Profits of the downstream firm are 16- F while profits of the
upstream firm are F: they bargain over F.
2.3
Possible harmful effects of vertical integration
 extension of market power in cases where each stage is unable to
extract full monopoly profit when unintegrated
 foreclosure of rivals (refusal to supply) and/or to increase barriers
to entry
For more detail, see vertical restraints below.
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3. Vertical Restraints: definition and classification scheme
A Vertical Restraint (VR) is anything which restrains the freedom of
resale; invariably contractual, and can be seen as an alternative to full
vertical integration
Being similar to vertical integration, VR can usually be justified on
efficiency terms (incl. avoidance of double marginalisation.)
For anti-competitive consequences, we should look for the possible
impact on collusion, predatory possibilities and entry deterrence
Below, think mainly in terms of the relationship between manufacturers
and retailers. This will focus our minds on a key distinction - between
intrabrand and interbrand competition (T: 172-3).
Upstream
Downstream1
Upstream1 Upstream2
Downstream2
Downstream1
Downstream2
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classification and nomenclature
 minimum sales requirement: the manufacturer requires the
retailer to sell at least a minimum quantity (T:171)
 resale price maintenance the manufacturer insists retailer does
not price below some minimum (T: 177)
 geographic restrictions on location of sales agent; territorial
restrictions: the manufacturer bars the agent (retailer) from selling
outside his designated locality
 selective distribution: the manufacturer limits which retailers can
sell his product
 exclusive dealership: the manufacturer bars the retailer from
selling rival manufacturers’ products
 tie in sales, full line forcing, bundling: the manufacturer requires
the consumer to purchase ‘bundles’ of his products
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Efficiency defences of VR
Note that, in these four cases, VRs will ultimately benefit the consumer
as well as the manufacturer.
I.
Minimises transactions costs
See above. Also, without the vertical link, there is the possibility of:
 ‘hold-up’ this is where one party should make a specific
investment (e.g. specific training, location or display facilities), but
fears that the other will then act opportunistically. If so, there may
be underinvestment.
 lack of coordination: e.g. on advertising and sales promotion
 The solution: long-term contracts, or simultaneous commitment
(exchange of hostages)
 Appropriate VRs: exclusivity and price guarantees; selective
distribution
II.
Avoidance of double marginalisation
 The solution: restrict ability of retailer to charge high price; or
change incentives of retailer to ensure that they don’t want to price
too high.
 Appropriate VRs: maximum retail price; quantity forcing; or two
part pricing scheme, often in the form of a franchise agreement (T:
170-1 and 176-7).
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III. To secure sufficient retailer investment/effort
This is the free rider problem on the retailer side (T: 182-3)
 The problem: applies to cases where retailers need ‘effort’
(advertising, showrooms, training, quality control) to sell the
product properly. The danger is that some retailers (discounters?)
will cut out on these expenditures in order to price low, relying on
other retailers to provide these
 The solution: selective distribution, or force retailers to compete
on quality not price (RPM)
 Appropriate VRs: selective distribution, exclusive territories,
RPM. These encourage intrabrand competition but not interbrand.
IV. Avoidance of free riding by other manufacturers
This is the free rider problem on the manufacturer side
 The problem: applies to cases where one manufacturer provides
advertising, training, or a list of customers, which retailers can also
use to sell products of rival manufacturers. Therefore, danger that
manufacturers underprovide such services.
 The solution: again, look for property rights solutions, but this
time for the manufacturer
 Appropriate VRs: various types of exclusivity, price guarantees,
selective distribution.
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Market power effects of VR
In these four cases, VRs will harm the consumer as well as rivals. They
tend to occur where some degree of market power (but not full
monopoly) already exists
I.
To soften independent price competition
This is where unilateral price competition is too fierce, so firms look for
non-collusive solutions
 The solution: delegate retail price setting to someone with less
incentive to cut price; reduce manufacturer’s own perceived
elasticity
 Appropriate VRs: any which reduce interbrand competition
(exclusivity for manufacturers, different from exclusivity for
retailers)
II.
To sustain collusion
Similar, but has more to do with ways of securing coordinated pricing
 The solution: leadership; making price more transparent; change
incentives away from price cutting
 Appropriate VRs: common selling agency, RPM, exclusive
territories for producers (mutual forbearance); most favoured
customers; meet the competition
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III. Foreclosure and predation
(T: 185-6 and 193-8)
 The solution: reduce profitability of entry
 Appropriate
VRs:
exclusive
purchasing
limits
potential
distribution chain; minimum sales targets; loyalty rebates etc.
make small scale entry difficult as retailers need to sell more of
existing products to get discounts; tie in sales & full line forcing
can exclude competitors who can only offer a restricted range of
products
IV. Price discrimination
in general, price discrimination is only possible if arbitrage (between
retailers) is prevented
 The solution: prevent resale e.g. parallel imports
 Appropriate VRs: any which reduce intrabrand competition, such
as exclusive territories and sales targets
Three case studies from Church & Ware (chapter 22)
case study 22.1 (pp. 695-6)
exclusive supply in petrol
case study 22.2 (pp. 698-702) Microsoft
Kodak case (p. 704)
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DIAGRAMS TO ILLUSTRATE DOUBLE MARGINALISATION
(a) deriving the demand curve for A
$
MRB=DA
DB
Q
(b) double marginalisation with successive monopoly
PB
PA
DB
CA
QA*
MRA
MRB=DA
(c) the integrated firm
PI*
CA
MRB
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QI*