Transcript No Slide Title

Vertical Integration and Vertical
Restraints
By Kevin Hinde
Aims
 In
this lecture we will explore the
competitive effects of vertical integration
and vertical restraints.
 We will see that, in general, there are
positive effects but that where vertical
relationships lead to market foreclosure or
collusion public policy should be brought to
bear.
Learning Outcomes
 By
the end of this lecture you will be able to
 identify the theoretical welfare outcomes
associated with vertical relationships.
 comment upon the ambiguities associated
with public policy decisions in this field
using case studies.
Introduction
 Most
vertical integration and vertical
relationships reduces transaction costs.
 They may solve economic problems such as
double marginalisation, insufficient pre-sale
service and inefficient input substitution.
 It may lead to improved quality of retail
services.
 It may also lead to higher barriers to entry,
collusion and market foreclosure.
The positive effects of Vertical
Integration
Vertical Integration: Competitive Wholesaler
(w), Monopolist Retailer (r)
P
Note that Pr is the joint profit
maximising price so a profit
maximising vertically
integrated firm would also
charge Pr. So it matters not
whether VI takes place or not
Pr
Pw
MCw =Pw
MRr
0
Q
Dr
Q
Vertical Integration: Monopolist Wholesaler
(w), Competitive Retailer (r)
P
Dr = Dw because it represents the
quantity that retailers are willing to
sell at any given wholesale price
Pr=Pw
By maximising profit the
wholesaler’s price is retailer’s
marginal cost.
MCw
MRw
0
Q
Dr=Dw
Q
Vertical Integration: Monopolist Wholesaler
(w), Competitive Retailer (r)
P
Again, there is no difference
between vertical separation
and vertical integration. So
vertical integration would
only maintain market
power.
Pr=Pw
MCw
MRw
0
Q
Dr=Dw
Q
Vertical Separation: Monopolist Wholesaler
(w), Monopolist Retailer (r)
P
Because w knows r
will restrict output to
its MRr the demand
curve of w = MRr.
Pr
Pw
MCr
MCw
MRw
0
MRr =Dw
Dr
Q
Vertical Separation: Monopolist Wholesaler
(w), Monopolist Retailer (r)
P
Ws demand is
determined by
anticipation about
downstream demand.
Pr
Pw
MCr
MCw
MRw
0
MRr =Dw
Dr
Q
Vertical Separation: Monopolist Wholesaler
(w), Monopolist Retailer (r)
P
The profit maximising w sets
MCw = MRw and charges Pw.
In effect, w knows what price r
will charge and acts accordingly.
Pr
Pw
MCr
MCw
MRw
0
MRr =Dw
Dr
Q
Vertical Separation: Monopolist Wholesaler
(w), Monopolist Retailer (r)
P
Consumer Surplus
Profit for retailer
Pr
Pw
MCr
Profit for wholesaler
MCw
MRw
0
MRr =Dw
Dr
Q
Vertical Integration: Monopolist Wholesaler
(w), Monopolist Retailer (r)
P
Pr
By vertically integrating the firm would
consider the internally evaluated marginal cost
of the wholesale product to be MCw not Pw.
Pw
MCr
Consumer
surplus
MCw
Abnormal
Profit
MRw
0
MRr =Dw
Dr
Q
The positive effects of Vertical
Restraints
Maximum Resale Price
maintenance
 Many
products sold by manufacturers
require a pre-sales service to avoid the Free
Riding Problem
Insufficient Promotional Services
P
Monopolists Wholesaler’s profits if
competitive retailers provide no services
Retailers have no
incentive provide
services - they only
earn a normal profit.
Pw =Pr
MCw
MRw
0
Q
D (P,0)
Q
Insufficient Promotional Services
P
Maximum Price
reflects pre-sales
services per unit
P*
Pw
Wholesaler’s profits if
retailers provide the
optimal level of
services.
MCr + S*
MCr = ACr
MCw = ACw
MR(P, S*)
0
Q
D (P,S*)
Q
The welfare impact of services
P
With no service combined consumer
and producer surplus = A+B+C
A
B
Pw=Pns
Pw = MCr =ACr
C
MCw = ACw
D(P, 0)
0
Qns
Q
The welfare impact of services
Services shift demand. Consumer
surplus changes by D - B. Producer
surplus increases by F.
P
D
P* AB
Pw=Pns
E
Net Effect depends on the size of B
MCr + S*
Pw = MCr
C
F
MCw
D(P, 0)
0
Qns Q
D (P,S*)
Q
Possible Detrimental welfare
effects of Vertical Relationships
 Studies
show minimum RPM leads to
higher retail prices and lower sales to the
manufacturer
– Case Study of ‘Over the Counter’
Pharmaceuticals
 Strategic
Use of Vertical Restraints and
Integration
– Exclusive Dealing Relationships
– Price Squeezes
Possible Detrimental welfare
effects of Vertical Relationships
 Raising
the Capital barrier to entry
 Collusion
 Foreclosure
 Case Studies of
– Beer, Petrol, Carbonated Drinks, New motor
Vehicles and ice Cream
And finally….
 A summary.
 Have
you covered the learning outcomes?
 Any questions?

Additional On-Line References
Peeperkorn L (1998), The Economics of Verticals, Competition Policy
Newsletter, European Commission,no. 2, June
http://europa.int.eu/com/competition/publications/cpn
Waterson M and Dobb P (1996), Vertical Restraints and Competition
Policy, OFT Research Report 177, December, HMSO London
http://www.oft.gov.uk/html/rsearch/reports/oft177.pdf