In the Name of God Sharif University of Technology

Graduate School of Management and Economics

Industrial Organization 44772 (1392-93 1st term) Dr. S. Farshad Fatemi

Vertical Relationships 

 Vertical relationships: questions How do input suppliers / manufacturers / retailers affect one another? Do incentives of manufacturers and retailers diverge? How are prices determined? Wholesale prices Retail prices Why do vertically-related firms sign complex agreements? What are the economic effects of these mechanisms? Policy towards vertical restraints and vertical merger Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Vertical relationships So far we have thought of firms as single entities which make products and sell them to final consumers But most industries involve a chain of production, with a number of stages which must take place in sequence, e.g. Raw inputs: energy, raw materials, components Manufacturing of finished product Distribution / retailing

Vertical integration: All stages are undertaken by a single firm Vertical separation: Stages are undertaken by separate firms Transfers and transactions take place between the firms Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Examples of vertically-related industries Gas production, transportation and supply Gas production in North Sea by oil companies (BP, Shell, Exxon Mobil) Transportation within UK by National Grid Transco (NGT) Supply by Centrica(British Gas), electricity suppliers, Sainsburys

Petrol: oil extraction/refining and service stations Oil companies produce oil and refine into petrol Service stations: some controlled by oil companies; supermarkets

Car manufacturing and distribution Manufacturers: Ford, BMW, Fiat Distribution: independent chains and individual dealerships Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Vertical restraints In reality, there is not a clear-cut distinction between vertical integration and separation Separate but vertically-related firms often use contractual clauses and practices to restrict one another’s behaviour These are called vertical restraints. E.g. Resale price maintenance (RPM) Quantity forcing Exclusive distribution/territories and selective distribution Exclusive dealing Franchising agreements Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Types of vertical restraints Resale price maintenance (RPM) Manufacturer imposes conditions on the price at which the retailer sells the good to final consumers Pure RPM: manufacturer specifies a single retail price Maximum RPM: retailer agrees not to sell above a specified retail price Minimum RPM: retailer agrees not to sell below a specified retail price

Quantity forcing Similar to maximum RPM, but achieved by specifying a minimum quantity to be sold rather than a maximum price May be achieved through bulk discounts or bonus payments

Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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Exclusive distribution / territories Manufacturer appoints a single, exclusive distributor within a particular geographic territory E.g. car manufacturer appoints a single distributor in each area Typically a contract guarantees the distributor this exclusivity

Selective distribution Manufacturer only allows its product to be sold by retailers whosatisfy certain minimum quality or service standards Tends to restrict number of retailers (due to higher costs): akin to exclusive distribution Manufacturer also refuses to supply non-selective outlets

Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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Exclusive dealing Distributor agrees not to stock rival products E.g. VW distributor agrees not to sell cars of other makes Franchising agreements (e.g. McDonalds) Often involve a number of vertical restrictions May charge a franchise fee or royalty to extract profits

Forms of bundling Full-line forcing: retailer must take the whole product line in orderto obtain any one product Tie-in sales: cannot buy product X without also buying Y, in fixed proportions

Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Vertical and horizontal relationships Horizontal Products are substitutes Each firm would like others to raise price

Vertical Products are complements: this reverses many interrelationships Each would like others to reduce price e.g. manufacturer would like distributor to charge a low retail price, for a given wholesale price, as this increases demand for the manufacturer’s product without lowering its profit margin Thus, agreement between the firms may be a good thing Other actions of distributor may also affect manufacturer e.g. investment, advertising, services provided to customers Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Issues arising in vertical relationships Various externalities exist between vertically-related firms Pricing externality: results in double marginalisation Other externalities, e.g. service provision and quality These imply that vertical integration or restraints may be beneficial, both privately and socially

Other efficiency motives for vertical integration Foreclosure A firm with monopoly power at one stage of production may use vertical integration or restraints to foreclose a related market Reduce competition, exclude rivals and/or prevent entry This is the main focus of policy concerns over vertical relationships Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Pricing externality Problem arises when imperfect competition at both stages Simple framework: one manufacturer and one retailer Manufacturer M sells its product to the retailer R, charging a uniform wholesale price w (i.e. no two-part tariffs or bulk discounts) Retailer R sells to final consumers, setting the retail price P

Integrated firm: set P such that gain from a further increase in price is exactly offset by the resulting fall in demand Separation: R takes account of loss of its own profit margin but ignores impact on M Retail price will be too high: it will exceed the monopoly price

This problem is known as double marginalisation Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Model of double marginalization

M sells product to R who sells to final consumers Final consumers have demand function Q = 1 –P M sets wholesale price w; R sets final price P M has marginal cost c; R has no mc other than w Assuming profit-maximization by M and R, we can derive expressions for P under vertical separation P under vertical integration and show that P falls when vertical integration takes place Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Overcoming double marginalization Both firms and consumers would be better served if the retail price were lower Possible remedies Perfect competition downstream Vertical integration Resale price maintenance: maximum RPM But this might be illegal Recommended retail price (RRP): can have similar effect Quantity forcing Two-part tariff: set w = c and charge (lump sum) franchise fee to extract profit Problems if demand is uncertain or R has asymmetric information Industrial Organization

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 Service externalities Demand may depend on services that are provided with the product (as well as its price) Advertising and promotional activities Pleasant surroundings (e.g. pubs) Information provided by sales staff; customer trials Delivery speed and area covered After-sales services and warranties

Key features of these services are that They are provided and (generally) paid for by the retailer Higher provision tends to increase sales When both parties have positive profit margins, this benefits the manufacturer as well as the retailer Industrial Organization

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 Model of service provision The model will be demonstrated in Lecture

Vertical integration results in a higher level of service provision Conclusions Vertical integration tends to raise service provision Customers benefit from this too Integrated firm should also choose the correct balance between service provision and price reduction Both strategies reduce profit and the integrated firm will choose whichever increases demand the most

Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Markets with multiple retailers Multiple retailers of the same manufacturers product May be located in different geographical areas(e.g. retailers of books, electronic equipment, cars)

Price competition between retailers Intra-brand competition Good for manufacturer as reduces retailer margins and increases sales: helps overcome double marginalization

Service provision: spill-overs between firms Services provided by one retailer may benefit other retailers( e.g. test drive car at showroom, then buy over the Internet for a lower price) Positive externality between retailers (as well as to manufacturer) This is bad for the manufacturer (and for customers) Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Overcoming service externalities Service provision will be too low, for two reasons Positive externalities between retailer and manufacturer Positive externalities between retailers Both tend to reduce service provision, lowering manufacturer’s profits and consumer welfare

Possible remedies Integration Between M and R Between different R’s Contractual restraints Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Integration to overcome service externalities Integration between M and R Internalizes pricing externality, reducing P and increasing Q Internalizes service externalities, increasing S Possible disadvantage: retailer is “closer to the market” R has better information about consumer demand Vertical integration may weaken this

Integration between retailers Internalizes service externalities between firms, increasing provision But reduces competition between retailers: competition would reduce retail margins and increase sales Thus, likely to worsen the double marginalization problem Also may not be permitted by competition authorities! Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Vertical restraints and service provision Selective distribution M directly specifies minimum service standards: reduces underprovision; but M may be less well-informed than R about effect of S on demand; Monitoring difficulties

Exclusive distribution M appoints a single, exclusive retailer within a particular area: reduces horizontal spill-overs between retailers But does nothing to reduce vertical externality between R and M

Resale price maintenance M specifies a (minimum) retail price With fixed prices, retailers compete by offering higher quality services But reduces the benefits of price competition between retailers Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Assessing vertical integration & restraints So far we have seen vertical integration and restraints in a generally positive light But we have treated market structure and the degree of competition as given Possible anti-competitive effects: vertical structures can be used to Change market structure Foreclosure to weaken, exclude or evict competition

Reduce competition between firms Facilitate (horizontal) collusive by making price cuts more transparent Implement (geographic) price discrimination Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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 Case study: New Cars distribution (CC 2000) SED system: Selective and Exclusive Distribution Exclusive territories and exclusive dealing Refusal to supply retailers other than franchised dealers Prohibition on reselling by dealers except to final customers and other franchised dealers Showroom and service standards, staffing and training, advertising Requirement to provide after-sales servicing and repairs List prices; quantity-forcing measures (targets and bonuses) Detailed business information provided to manufacturer

EU Block Exemption for car distribution agreements 1999: CC investigation following concerns that UK car prices were high compared to other EU countries Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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New cars: market definition Product market definition: new cars Used cars do not sufficiently constraint new car prices

Geographical market definition CC regarded geographical market as UK UK uses right hand drive (RHD) cars, Continent uses LHD (though can be ordered from dealers elsewhere in EU) Japanese imports limited by voluntary export restraints (VERs) (1975-1999)

Tax regime: under EU VAT rules, a car buyer pays the VAT rate relating to the home country, not country of purchase VAT rates vary considerably (15% –200% for some models) Are pre-or post-tax comparisons appropriate? Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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New cars: market segmentation Large and persistent differences in EU pre-tax prices CC compared UK prices with France, Germany and Italy, 1993-9 Found UK prices higher by 3.5-7.1% over the 6 years Sterling appreciated in 1996-7: in latter half of period UK prices were higher by 10.1-12.6%

May 1999 (most recent) survey, excluding 3 high-tax countries For 58 of 71 models analyzed, UK price was at least 20 per cent higher than in the cheapest country

Sensitive to exchange rates; taxation; differences in discounts, benefits and trade-ins; differences in specifications

Within UK, big discounts for fleet buyers (17-35% compare to 7.5-8%) Retail prices to larger fleet buyers lower than wholesale pricesto dealers (even when dealers purchase similar quantities) Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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SED system deemed against the public interest High prices to private buyers attributed to SED Lack of responsiveness to exchange rates attributed to restrictions on dealers buying cars from other countries Pre-registration blamed for inhibiting market-clearing prices SED also blamed for restricting innovation and choice of type of retailer

But remedies were restricted by the EU Block Exemption CC wanted to abolish SED system, ending refusal to supply (including on service/presentation grounds) and exclusivity (territories and dealing) Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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Remedies not restricted by Block Exemption Dealers to benefit from bulk discounts similar to large fleet buyers Manufacturers’ control over dealers’ advertised prices to be ended; dealers to be permitted to sell below recommended prices Dealers to be permitted to import from other EU countries Agreements to pre-register cars to be prohibited

Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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Since the Competition Commission inquiry New car prices have fallen: by 12.2% in the year to November 2000, and further since Manufacturers may choose between Exclusive territories, but dealers free to sell to non-franchised operators Selective (but not exclusive) distribution, where dealers are required to meet various criteria, and are prevented from selling to non-franchisees Blacklist of “hard core” restrictions that are prohibited

Multi-brand dealerships: manufacturer can only request brandspecific area within showroom Measures to facilitate cross-border sales Dealers may sub-contract repairs Removal of restrictions on authorized repairers and supply of spare parts Minimum 5 year term and restrictions on termination of dealer agreement Industrial Organization

Dr. F. Fatemi Graduate School of Management and Economics – Sharif University of Technology

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