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Chapter 9:
Vertical Relations
Industrial Organization: Contemporary Theory & Practice
Introduction
• In any market, consumers have to decide
– what brand to buy
• lots of intrabrand competition
– Mattel vs. Hasbro, Clarins vs. Estee Lauder
– where to buy
• retailers specialize in carrying certain brands
– toys; perfume; electronic goods
• For some goods there appear to be restrictions on what is sold where
– Gas; Chevron retailer sells only Chevron gasoline
– new cars; dealers sell only a few brands
• For others there are not
– Many newspapers/magazines sold at same newstand
– Department/discount stores carry many brands
• What explains these differences?
Industrial Organization: Contemporary Theory & Practice
Upstream-downstream relations
• The relationship between manufacturers and retailers is complex
• Affects competition in the market-place
– exclusive dealing restricts competition
• consumers have to travel to different outlets to compare brands
– non-restrictive supply increases competition
• different manufacturers have to compete for retail space
• retailers in much more direct competition
• So the chain from manufacturer to retailer is important
– manufacturers typically not in direct contact with consumers
• exceptions: Dell and its imitators
• How the manufacturer connects with the consumer—whether
through a retailer or not—is important
Industrial Organization: Contemporary Theory & Practice
Manufacturer/retailer relations
• Relations between manufacturers and retailers take many forms
– Profit sharing
– Two-part tarrifs
– manufacturer may want to have an input into
• marketing
• required level of support services
• Pricing, e.g., recommended retail price or resale price
maintenance (RPM)
– Pricing agreements between firms cannot help but
look a bit like collusion
» per se violation of anti-trust laws in the US
» but recommended maximum prices might not be
Industrial Organization: Contemporary Theory & Practice
Vertical restraints
• The complexity of manufacturer/retailer relations inevitably leads to
formal contracts to sort out the rights and responsibilities of each party
• Just as inevitably, such contracts impose some restraints on each side.
• While these restraints may look like restrictions on competition, they
may in fact be beneficial. They may improve efficiency
– in pricing
– In service provision
– In preventing excessive duplication and proliferation of retail
outlets
• The issue then becomes whether such potential efficiency gains will
be realized and if so, whether they will be large enough to overcome
any creation of monopoly power
Industrial Organization: Contemporary Theory & Practice
Vertical restraints and pricing
 Double
Marginalization Issues: Monopoly
manufacturer and monopoly retailer
 Manufacturer
makes suits that are sold through
the retailer
Consumer demand for suits: P = 500 - Q/100
Suits cost $20 each to make
Retailer incurs additional cost of $40 per suit sold:
space, labor etc.
The manufacturer sells the suits to the retailer at a
price of r each

Industrial Organization: Contemporary Theory & Practice
This is the
manufacturer’s
Price (P)
derived
The retailer’s
demand
 marginal revenue for the
retailer
500
profit
is
$1.21m
Demand
is MR = 500 - Q/50
390
 marginal cost is r + 40
280
 MC = MR gives r = 460 - Q/50
 The manufacturer’s marginal
MC
r+40
revenue is MR = 460 - Q/25
MR
Quantity  Marginal cost is $20
11,000
25,000 50,000
Price (r)
 MC = MR gives Q = 11,000
460
 The suits are wholesaled at $240
The manufacturer’s
 The retailer’s MC is $280
Manufacturer’s
profit
is
$2.42m
240
demand
 He sells 11,000 suits
 and prices them at $390 each
The example
20
11,000
MR
MC
Quantity
23,000Industrial Organization: Contemporary Theory & Practice
Vertical restraints
 We know from Chapter 8 that a merger of manufacturer
and retailer improves on the foregoing outcome

Price
500
Demand
280
60
25,000
marginal revenue for the merged
firm is MR = 500 - Q/50
But is such a merger
 marginal cost is MC = $60
necessary to achieve
these gains?  So MC = MR gives suit sales of
22,000
 The suits are priced at $280 each
 Profit of the merged firm is
$4.84 million
MC
50,000
Quantity
22,000
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes
 Royalty schemes may seem a better way to link the
interests of the manufacturer and the retailer. But these too
have problems.
 Under one possible royalty contract the manufacturer
sells at cost c = $20 to the dealer and then receives a
fraction a of the retailer’s revenues
The retailer’s marginal revenue is: = (1 - a)(500Q -2 Q/100)
 Equating marginal revenue with the marginal cost of 20 + 40 = 60
yields the retailer’s profit maximizing output of
3000 This is less than 22,000 for all positive
Q* = 25,000 1 - a values of a, i.e., for any scheme under
which the manufacturer earns a profit.
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes (cont.)
 As we have just seen, a royalty scheme based on the
manufacturer’s selling at cost and then claiming some of the
downstream revenues cannot replicate the integrated outcome
 There are other possible royalty contracts, though. One
is to give the suits at no charge to the dealer and then again
claim some of the downstream revenue
Now the retailer equates marginal revenue with a marginal
cost of 40: = (1 - a)(500Q - 2Q/100) = 40
At a = 1/3 or
2000 33.33% this will
 Solving for Q yields : Q* = 25,000 1-a
equal 22,000
A royalty rate of 33.33% of total revenues gives the vertically integrated
total output,
product
price Contemporary
and aggregate
. . . BUT
Industrial
Organization:
Theoryprofit
& Practice
Royalty Schemes (cont)
 With output = 22,000, the retail price is again $280 so the
retailer’s revenue is
$280 x 22,000 = $6.16 million
 The manufacturer gets 1/3 of this so her royalty
income is $2.053 million
the manufacturer’s costs are $20 x 22,000 = $0.440 million
 so her net profit from the royalty is $1.61 million.
. This is less than the $2.42 million it earned under the non-
integrated case. The manufacturer’s royalty scheme has
duplicated the integrated outcome but at the cost of giving away
even more profit to the retailer.
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes (cont.)
 As a final scheme we consider the case in which the
manufacturer sells at cost and then sets a royalty that is
simply a fraction of a of the retailer’s net profits
the retailer’s profit now is: pR = (1 - a)(500 - Q/100 - 20 - 40)Q
Notice that the factor 1-a now affects both revenues and costs:
So marginal revenue is (1-a)(500Q – 2Q/100) and marginal
cost is (1-a)(20+40).
Equating MR and MC yields the integrated output of Q = 22,000
This type of royalty scheme always works. The royalty rate is set by
negotiation to distribute aggregate profits of $4.84 million
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes (cont.)
• Why are royalty schemes based on profits not more
widespread?
– profits are easy to disguise
• misrepresent costs
• incur additional discretionary costs: travel costs,
entertainment …..
• suppose that retailing incurs fixed costs of F:
marketing, space costs ...
• then the retailer can exaggerate F to negotiate a lower
royalty rate
– revenues are more easily observable
• Are there other mechanisms that work?
Industrial Organization: Contemporary Theory & Practice
Two-Part Pricing
 Manufacturer sells Q suits at a total charge of C(Q) = T + rQ
 Set r equal to the manufacturer’s marginal cost of $20 per suit
pR = (500 - Q/100 - 20 - 40)Q - T
The retailer’s marginal revenue is: MR = 500 – 2Q/100
The retailer’s marginal cost is: MC = 20 + 40 = 60
 The retailer’s profit is:
Equating MR and MC yields Q* = 22,000
Because the fixed charge does not affect marginal calculations, the retailer
chooses the vertically integrated output and sells at the vertically integrated price
 Total profit is the vertically integrated profit of $4.84 million
 The manufacturer uses the fixed charge T to claim this profit
Industrial Organization: Contemporary Theory & Practice
Two-part pricing (cont.)
 Consider how the fixed charge TProfit
might
negotiated
withbelinear
pricing
Profit
 If negotiations break down it is reasonable to suppose
thatwith
thelinear
pricing
Profit with a zero
manufacturer
and retailer revert to simple linear pricing
fixed charge
the maximum the retailer will pay is $4.84m- $1.21m = $3.63m
the minimum the manufacturer will accept is
$2.42m
There is scope for mutually beneficial negotiation over the fixed charge
Industrial Organization: Contemporary Theory & Practice
Two-Part Pricing (cont)
• How common is a two-part pricing type of scheme?
• When seen as a franchise agreement fairly
common
– fixed charge represents a franchise fee giving the
retailer the right to sell the manufacturer’s
product
– generates up-front profit for the manufacturer
– so the manufacturer is willing to set a price per
unit near to (at) marginal cost
Industrial Organization: Contemporary Theory & Practice
Resale Price Maintenance
• Double marginalization means that the retailer sets too high
a retail price for the suits
– what if the manufacturer imposes a price on the retailer?

Price
500
set a maximum price of $280 per suit
 the retailer will set this price
Demand

sales of suits increase to 22,000

aggregate profit is $4.84m
390
280
RPM
60
11,000 25,000
50,000
22,000 Industrial Organization:

what wholesale price should the
manufacturer set for the suits?
 must negotiate to redistribute the profits,
e.g., a wholesale price of $240 will give all
the profit to the manufacturer
Quantity
Contemporary Theory & Practice
Retail Services (Advanced)
• So far the retailer has been totally passive
– merely an intermediary between manufacturer and consumer
• But retailers can do more than this
– provide additional services: marketing, consumer assistance
• These services increase sales
• This benefits manufacturers
• But offering these services is costly
– provision by retailer related to retailer’s profit not manufacturer’s
• And both services and costs are hard for manufacturer to measure
• How does the manufacturer encourage the efficient levels of service
provision by the retailer?
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
Price
Demand
Demand
with with  The provision of retail
retail services
retail services
s1
services increases demand
s2 > s1
 But the provision of retail
services is costly for the
D(s2)
retailer: f(s) per unit sold
D(s )
1
Quantity (Q)
$
f(s)

Suppose the wholesale price is r
 The retailer’s marginal cost
is r+f(s)
What level of services will
be provided by the retailer?

Services (s)
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
 Efficiency is most likely if the retailer and manufacturer
are vertically integrated
Price
500
suppose that consumer
demand is Q = 100s(500 - P)

Demand with
retailDemand
services with
s=1
retail services
s=2
50
100
Note: higher s (more service)
raises demand
 assume that marginal costs
for manufacture are cm and
for the retailer are cr
 the integrated firm’s profits are
pI = (P-cm-cr-f(s))100s(500 - P)

Quantity (‘000)
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
 Profit of the integrated firm: pI = (P- cm - cr - f(s))100s(500 - P)
Cancel the
100s terms
pI/P = 100s(500 - P) - 100s(P - cm - cr - f(s)) =Cancel
0
the
100(500 - P)
 500 - 2P + cm + cr + f(s) = 0
terms
 P* = (500 + cm + cr + f(s))/2
This equation gives
pI/s = 100s(500 - P)(P - cm - cr - f(s)) - 100s(500 -the
P)f’(s)
= 0 level
efficient
of retail services
 (P - c - c - f(s)) = sf’(s)
 The integrated firm sets P and s to maximize profits
m
r
 Substitute the first equation into the second and simplify
 (500 - cm - cr)/2 - f(s)/2 = sf’(s)
 (500 - cm - cr)/2 = f(s)/2 + sf’(s)
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
The right hand side is
increasing in s
 (500 - cm - cr)/2 = f(s)/2 + sf’(s)
Initial manufacturing
$
Suppose that there is an
and retail costs
f(s)/2 + sf’(s)
increase in marginal costs,
apart from services, at either
(500-cm-cr)/2
the manufacturing
retail
level
Let c’mor
and
c’r be
new
marginal costs
The rise in cost leads
to a fall in the
(500-c’m-c’r)/2
optimal choice of s
from s* to ŝ
s
ŝ
s*
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
 Suppose for example that cm = $20, cr = $30 and f(s) = 90s2
the equation (500 - cm - cr)/2 = f(s)/2 + sf(s) then gives
225 = 45s2 + s180s which gives: 225 = 225s2
 s* = 1
P* = (500 + cm + cr + f(s))/2
so P* = 275 + 45s2
And Q = 100s(500 - P)
 P* = $320
 Q* = 18,000
 Aggregate profit is (320 - 50 - 90)x18,000  pI = $3.24 million
 It turns out that the integrated firm chooses the socially efficient
level of retail services but sets price above marginal cost
 This provides our benchmark case
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
 Suppose that retailer and manufacturer are independent
 The manufacturer sells its suits to the retailer at r per suit
 The retailer then sets retail price and service level to maximize profits
Cancel the
 Profit of the retailer
= (P- r - cr - f(s))100s(500
- P) - P)
100(500
 The retailer sets P and s to maximize profits
terms
R
p /P = 100s(500 - P) - 100s(P - r - cr - f(s)) = 0Cancel the
 500 - 2P + r + cr + f(s) = 0
100s terms
 PR = (500 + r + cr + f(s))/2
is: pR
pR/s = 100(500 - P)(P - r - cr - f(s)) - 100s(500 - P)df(s)/ds = 0
 (P - r - cr - f(s)) = sf(s)
which together gives:
(500 - r - cr)/2 = f(s)/2 + sf(s)
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
The manufacturer will
 (500 - r - cr)/2 = f(s)/2 + sf(s)
set the suit price at greater
$
f(s)/2 + sf(s) than marginal cost:
r > cm
(500-cm-cr)/2
This is the retailer’s
choice of s at
The retailer provides too
wholesale price r
low
a level of support
The
efficient
choice ofservices
s
(500- r - cr)/2
sr s*
s
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
• The only way that the manufacturer makes profit is by
setting wholesale price greater than cost
• This squeezes the profit margin of the retailer
• The retailer marks up the wholesale price
• but also the retailer cuts back on support services
– takes account only of the impact on his own profits
– ignores the beneficial external effect on the
manufacturer
• Can we get the vertically integrated outcome without
integration?
– royalty
– two-part tariff
– RPM
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
• As before, royalty on retailer’s profit could work
– suits provided at cost so no distortion in service provision
• But problems of monitoring retailer’s profits are now even
more severe
– Retailer can exaggerate cost of service provision
• What about a two-part tariff?
– manufacturer sets a charge C(Q) = T + r.Q with r = cm
Profit of the retailer is: pR = (P- cm - cr - f(s))100s(500 - P) - T
Maximizing with respect to P and s gives the integrated outcome!
The manufacturer and retailer then bargain over the franchise fee
A two-part tariff achieves the efficient level of service provision
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
• What about RPM?
– The manufacturer could impose a retail price of P*
– But to make a profit he must set a unit price of r > cm
– This squeezes the retailer’s profit margin
– So the retailer reduces the service level
• RPM does not work
• What happens if the retail sector is competitive?
Industrial Organization: Contemporary Theory & Practice
A Competitive Retail Sector
• Suppose the retail sector is competitive
– large number of identical retailers
– each buys suits from the manufacturer at r and incurs service
costs per unit of f(s) plus marginal costs cr
– competition in retailing drives retail price to PC = r + cr + f(s)
– competition also drives retailers to provide the level of services
most desired by consumers subject to retailers breaking even
– so each retailer sets price at marginal cost
– and chooses the service level that maximizes consumer surplus
Industrial Organization: Contemporary Theory & Practice
Competitive retail services (cont.)
 Demand is Q = 100s(500 - P)
Price
500
r+cr+f(s2)
r+cr+f(s1)
Gain in
consumer
surplus
suppose the service level for
each firm is s1
 competition gives P1 = r+cr+f(s1)


consumer surplus is shaded area
Loss of
 Now increase service level to s2
consumer
Demand with  price rises to P2 = r+cr+f(s2)
Demand
surplus with
services  there is both a gain and a
retail retail
services
s2
s1
loss in consumer surplus
 these have to be balanced in
the choice of s
50s1
50s2 Quantity (‘000)
Industrial Organization: Contemporary Theory & Practice
Multiplied
by half the
Height
of (cont.)
Competitive retail services
base of the triangle
the triangle
 Demand is Q = 100s(500 - P) and P = r + f(s)
2
 Consumer surplus is CS = (500 - P) x Q/2
=
50s(500
P)
Cancel the common term
2
= 50s(500r-cr-f(s))
50(500
- r - cr - f(s))
Price
 To maximize CS with respect to s:
2
CS/s
=
50(500-r-c
-f(s))
r
500
-100s(500-r-cr-f(s))f(s) = 0
P = r+cr+f(s)
so 500 - r - cr - f(s) = 2sf(s)
(500 - r - cr)/2 = f(s)/2 + sf(s)
This equation gives
Q 50s1
the competitive level
of retail services
Industrial Organization: Contemporary Theory & Practice
Quantity (‘000)
Competitive retail services (cont.)
(500 - r - cr)/2 = f(s)/2 + sf(s)
$
f(s)/2 + sf(s)
(500 - cm - cr)/2
For the manufacturer
to make a profit
requires r > cm
Retail competition gives
This is the competitive
too low a level of support
choice This
of s is
given
a
the efficient
services
wholesalechoice
cost of
r s
(500 - r - cr)/2
sC
s*
s
Industrial Organization: Contemporary Theory & Practice
Competitive retail services (cont.)
• Why the low provision of retail services?
– increased services has three effects
• higher retail demand and increased consumer surplus
• higher retail prices and reduced consumer surplus
• higher wholesale demand and increased profits to the
manufacturer
– the competitive retailers ignore the third effect
• it is an externality that does not affect them directly
• Can the manufacturer correct this?
– two-part tariff C = T + rQ
• for this to be efficient r = cm
• but then competition between retailers destroys their profits
• so T = 0 and the manufacturer makes no profit
Industrial Organization: Contemporary Theory & Practice
Competitive retail services (cont.)
• What about RPM?
• This is a possibility but it is complicated
– require retailers to sell at P = P*
• Sell to the retailers at a wholesale price r such that
• margin over cost P* - r - cr
• equals cost of optimal level of services f(s*)
– In our example
• set RPM = P* = $320
• set r so that r = P* - cr - f(s*) = 320 - 30 - 90 = $200
• competition in retailing results in s* = 1 as required
• But does the manufacturer have the necessary information?
– manufacturer may not know cost of service provision
– cost especially difficult to know since retailers are not identical
Industrial Organization: Contemporary Theory & Practice
Further Aspects of RPM
• Manufacturing and retailing are complementary
– separate operation is inefficient
– contractual arrangements can improve efficiency
– RPM is one such arrangement
• but it is controversial
• generally treated as in violation of anti-trust laws
– should re-examine this view
– RPM may offer benefits
• to prevent free-riding on support services of some
retailers
• to help cope with variable demand
Industrial Organization: Contemporary Theory & Practice
RPM & Customer Service
• Many services are informational
– choice of high-tech equipment
– fashion clothing
– wine
• These services are costly
– no obligation on consumer to buy from particular
retailer
– discount stores can free-ride on retailer’s services
– so retailers cut back on services
– manufacturers lose out
• RPM potentially offers a correction
– freeze price discounting
– gives retailers who provide services an edge
Industrial Organization: Contemporary Theory & Practice
RPM and Variable Demand
• Another justification for RPM has been recently suggested
– to cope with variable demand and competitive retailing
– retailer facing uncertain demand has to balance
• how to meet demand when demand is strong
• how to avoid unwanted inventory when demand is weak
– monopoly retailer behaves differently from competitive
• monopolist throws away inventory when demand is weak to
avoid excessive price fall
• competitive retailer will sell it
– believes that he is small enough not to affect the price
• retailing competition causes sharp price cuts if demand is weak
– reduces the profit of the manufacturer
– makes competitive firms reluctant to hold inventory
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand
• RPM can correct this
– in periods of low demand retailers act just like an
integrated firm
• throw away excess inventory
• do not dump it on the market
• An example
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
 Suppose that demand is high, DH with probability 1/2
 And that demand is low, DL with probability 1/2
 Marginal costs are assumed constant at c
Price
 Integrated firm has to choose in each period
DH
stage 1: how much to produce
stage 2: knowing demand - how much to sell
since costs are sunk: maximize revenue
DL
c
MC
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
 an
integrated firm will not produce
more than QUpper
 and will not produce less than QLower
Price
 the
DH
integrated firm will produce Q*
How is Q*
determined
MC
MC
= MR with
DL = MR with
low demandhigh demand
c
MC
MRL
QLower
MRH
Q* QUpper
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
 if
Price
Revenue with
high demand
DH
Revenue with
low demand
PMax
PMin
DL
MR*H
c
demand is high the firm sells Q* at
price PMax: MR = MR*H
 if demand is low selling Q* is excessive
 the firm maximizes revenue by
selling Q*L at price PMin: MR = 0
 expected marginal revenue is:
MR*H/2 + 0 = MR*H/2
 Q* is such that expected MR = MC
so MR*H/2 = c
 Expected profit is
pI = PMaxQ*/2 + PMinQ*L/2 - cQ*
MC
MRL
Q*L
MRH
Q*
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
Suppose that
retailing is
competitive
Price
Revenue with
high demand
DH
PMax
DL
 Will
competitive retailers stock the optimal
amount Q*? What will happen if they do?
 if
demand is high the retail firms sell
Q* at price PMax: MR = MR*H
 if demand is low each firm will sell more
so long as price is positive
 so, if demand is low competitive retailers
keep selling until they sell the total quantity
QL at which price is zero
 revenue
is therefore zero in low demand
periods if competitive firms stock Q*
MC
c
MRL
QL Q*
MRH
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand
 If competitive retailers stock Q*, their expected net revenue is thus:
PMaxQ*/2 + 0 = PMaxQ*/2
 Since competitive firms just break even, this means that the
manufacturer can charge a wholesale price PW such that:
PWQ* = PMaxQ*/2 which gives PW = PMax/2
 The manufacturer’s profit is then:
pM = (PMax/2 - c)Q*
 This is much less than the integrated profit: the
competitive retailers sell too much in low demand periods
 An RPM agreement can fix this
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
the integrated firm never sells at a
price below PMin

so set a minimum RPM of PMin
 In high demand periods Q* is sold
at price PMax

Price
In low demand periods the RPM
agreement ensures that only Q*L is
sold
 Expected revenue to the retailers is
PMaxQ*/2 + PMinQ*L/2

DH
PMax
PMin
DL
MR*H
c
MC
MRL
Q*L Q*
MRH
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand
 Expected net revenues of retailers is
PMaxQ*/2 + PMinQ*L/2
 So the manufacturer can charge a wholesale price PW such that:
PWQ* = PMax.Q*/2 + PMinQ*L/2
which gives PW = PMax/2 + PMinQ*L/2Q*
 The manufacturer’s profit is
pM = PMaxQ*/2 + PMinQ*L/2 - cQ*
 This is the same as the integrated profit
 The RPM agreement has given the integrated outcome
 This can benefit consumers by encouraging retailers to stock
products with variable demand that would otherwise not be stocked.
Industrial Organization: Contemporary Theory & Practice
Exclusive Territories
• Gives a retailer the sole right to sell a good in a particular
territory
• Prevents the manufacturer from opening too many outlets
• Encourages retailer to provide support services
– inhibits the ability of discount stores to free ride
• Allows the manufacturer to control entry to a market
• Usually see exclusive territories associated with franchise
fee arrangements
• This kind of arrangement may enhance efficiency: remove
double marginalization
• But it may also reduce efficiency
Industrial Organization: Contemporary Theory & Practice
ExclusiveSuppose
dealing
thereand
are competition
2 suppliers of
What if the suppliers
Suppliercompeting
1
products Supplier 2
Price competition
offer an exclusive
territory? by the retailers
drives price to
marginal cost
Price competition
by the suppliers
drives price to
marginal cost
Suppose that
Retailers
there are several
retailers
Consumers
Industrial Organization: Contemporary Theory & Practice
Exclusive dealing
and
competition
Suppose
And suppose
the suppliers
the
suppliers
divide retail
give exclusive
into
Supplier 1
Supplier 2
territories
two regions
to the
same retailers
Retailers
Each lucky retailer
is now a local
monopolist
Consumers 2
Consumers 1
Industrial Organization: Contemporary Theory & Practice
Exclusive Territories/Dealing
• The potential for inefficiency is that this arrangement can create
local monopolies with the usual distortions
• Exclusive dealing agreements whereby the retailer is constrained
to carry the brand of one manufacturer can are similar
– advertising and promotion have public good qualities and can
lead to free-riding problems
– brand-name manufacturer advertising creates demand not just
for that brand but for all such goods including generic types
– retailer may make higher margins on the generic type and so
“suggest” that this is the one to buy
• Exclusive dealing is intended to prevent this type of free-riding
but, as noted, can reduce price competition much like exclusive
territories
• Exclusive dealing also increases possibility of foreclosure
– Coca-Cola’s arrangements with bottlers
Industrial Organization: Contemporary Theory & Practice
Franchising and Divisionalization
Why Are There So Many Franchisees? Why do Firms Operate
Different Divisions?
Recall the Merger Paradox.
In a Cournot or quantity competition setting, the merger of two firms
makes those firms worse off and remaining firms better off
Why? Because the two merged firms act as one. If there were originally
6 firms and two merge, these two firms are now one of five whereas
they were two of six. That is, the merged firms now constitute just onefifth of the independent decision making units instead of one-third.
This is the intuition behind divisionalization. By operating
different divisions or franchises, a single firm avoids the
problem raised by the merger paradox
But with each firm doing this, the industry becomes populated
with many divisions and franchises—perhaps more than is
consistent with either joint profit maximization or efficiency
Industrial Organization: Contemporary Theory & Practice