Economics of Industry

Howard Smith
University of Oxford

Lecture 15: Vertical Relations

Introduction
Vertically related industries are endemic: many (if not most) rms do not sell
directly to consumers but rather to other rms.
Example: Wood pulp producer ! paper producer ! stationary wholesaler !
stationary retailer ! consumers.
The dierent production processes in the vertical chain may take place in different rms (vertical separation) or within the same rm (vertical integration).
Under vertical separation, one rm may impose vertical restraints (nonlinear
pricing, retail price maintenance, exclusive dealing, etc.) on another rm in the
vertical chain.

Questions:

1. Do rms have an incentive to vertically integrate? What are the potential

anti-competitive eects of vertical merger?

2. Do rms have an incentive to impose vertical restraints? What are the

potential anti-competitive eects of such business practices?

The Basic Vertical Externality

Consider a vertically related industry with an upstream monopolist, U , and
a downstream monopolist, D.

The upstream rm produces the intermediate input a constant marginal

cost cU .

The downstream rm transform unit of the intermediate input into one

unit of the nal good at constant marginal cost cD .

The downstream rm sells the nal good to consumers at price p.

marginal cost c U

marginal cost c D

Vertically
integrated
structure

p
Consumers
Qp

 Market demand for the nal good is Q(p).

Vertical Integration
Suppose U and D are vertically integrated.
Hence, the marginal cost of producing the nal good is cU + cD .
The vertically integrated rm sets the monopoly price pM (cU + cD ), where
pM (c) arg max[p c]Q(p)
p

is the monopoly price of a rm with marginal cost c. The vertically integrated rms resulting prot is
M (c

+ cD ) =

pM (c

+ cD ) ( c U + c D )

Q pM (cU

+ cD ) :

U
Vertically
separated
structure

marginal cost c U

p
Consumers
Qp

marginal cost c D

Vertical Separation: Linear Pricing

Suppose now that U and D are vertically separated.

Consider the following sequence of moves:

1. The upstream rm U sets the wholesale price w for the input.

2. The downstream rm D sets the retail price p for the nal good.

Solve for the subgame-perfect equilibrium by backward induction.

 The downstream rms problem is:

max[p w cD ]Q(p);
p

and so the prot-maximizing retail price is pM (w + cD ).

The upstream rms problem is:

max[w cU ]Q pM (w
w

+ cD ) :

b satises w
b > cU .
The equilibrium wholesale price w
b > cU , and since the monopoly (retail) price is increasing in the
Since w
marginal cost that the (retail) monopolist faces, the equilibrium (retail)
price for the nal good, pb, satises pb > pM (cU + cD ).

 Remarks:

Vertical separation induces a higher price of the nal good (and therefore a lower output).
When rms are vertically separated, there is double marginalization
(Spengler, Journal of Political Economy, 1950): under imperfect competition, each rm adds its own prot margin at each stage of production. (What is worse than a monopoly? A chain of monopolies.)
Under vertical separation, there is an inherent vertical externality: each
rm does not take into account that an increase in its (wholesale or
retail) price reduces the prot of the other rm. This externality is
internalized under vertical integration.

Discussion

This result seems to suggest that vertical integration is both protable

and welfare-enhancing: under vertical integration, aggregate prots and
consumer surplus are higher than under vertical separation.

But this result relies heavily on the assumption of linear wholesale prices:
it would disappear if the upstream rm could use a two-part tari. In
that case, U would charge (w; F ) = (cU ; M (cU + cD )). The wholesale
price w = cU would induce D to set the monopoly price under vertical
integration pM (cU + cD ), and the xed (or franchise) fee F = M (cU +
cD ) would allow U to extract the entire rent of the vertically integrated
structure. Essentially, by oering the optimal two-part tari, U sells the
vertical structure to D who thereby becomes the residual claimant.

 A two-part tari is not the only vertical restraint that would solve the
vertical externality. Alternatively, the upstream rm could impose retailprice maintenance (RPM) with p = pM (cU + cD ) and charge a linear
wholesale price w = pM (cU +cD )cD . The downstream rm would make
zero prot and the vertical structures joint prot would be M (cU + cD ),
as under vertical integration.

RPM is usually illegal but downstream competition is an alternative "restraint" for the upstream rm: if U sets w = pM (cU + cD ) cD then
sells to several Bertrand competitors, this results in p = pM (cU + cD ) .

 Uncertainty Rey and Tirole (1986) compare the alternatives franchise fees
and RPM in the two cases where U is uncertain about (i) demand Q()
and (ii) downstream cost cD . D learns about these in time to set prices
but after the vertical contract is agreed.

Franchise fee: Since U is uncertain of M (cU + cD ), nonlinear wholesale prices that make D a residual claimant impose risk on D. If D is
risk neutral ith will accept xed
i fee equal to expected monopoly prot
i.e. F = E M (cU + cD ) If D is risk averse it will only accept a
lower F , which is costly to U:
The advantage of a xed fee (relative to RPM) is that prices are set
by the informed party (D) but the disadvantage is that reducing F is
costly to U:

 The advantage of RPM under demand uncertainty is that risk can be

eliminated for the retailer. However, this advantage does not apply for
cost uncertainty.
RPM v Franchise fee Under demand uncertainty RT(1986) show that
RPM is be better for U and for welfare than a franchise fee. However
under cost uncertainty a franchise fee is better (for both) than RP M .

 Two other instances of vertical externalities (both which could be solved

through vertical integration or nonlinear wholesale prices):

1. Downstream moral hazard. (D has to choose promotional services, the

level of which cannot be veried contractually.)
2. Input substitution. (D requires another input that is competitively supplied and the two types of inputs are imperfect substitutes/complements.)

Downstream pre-sale service free-riding may also result when pre-sale advice may be obtained from one seller but the good purchased from another.

Exclusionary Vertical Contracts

Antitrust and Vertical Agreements in the U.S.

For much of the 20th century, U.S. courts were hostile towards vertical
mergers and vertical restraints such as RPM (per se illegal), exclusive
dealing contracts (rule of reason), and tied sales.

From the 1950s, the Chicago School (Director, Posner, Bork, etc.) attacked legal practice:

1. Anticompetitive practices are not protable for rms.

2. Vertical agreements are eciency-enhancing.

 Chicago School had profound impact on antitrust law/economics. In contrast to their opponents, the proponents of the Chicago School used formal
models (albeit simple models of monopoly and perfect competition).

Exclusive Contracts

An exclusive contract stipulates that, for a given set of transactions, one

party to the contract deals only with the other party.

 Standard Fashion Company vs. Magrane-Houston Company. (1922)

Standard was a leading manufacturer of dress patterns.

Magrane-Houston was a large retailer in Boston.
Exclusive dealing contract demanded that Magrane-Houston does not
sell the patterns of any other manufacturer.
Contract was struck down by court:
The restriction of each merchant to one pattern manufacturer in hundreds, perhaps
in thousands, of small communities amount to giving such single pattern manufacturer
a monopoly of the business in such community. Even in larger cities, to limit to a
single pattern maker the pattern business of dealers most resorted to by customers
whose purchases tend to give fashions their vogue, may tend to facilitate further
combinations; so that plainti [...] will shortly have almost, if not quite, all of the
pattern business.

 Chicago School (Bork, 1978):

Standard can extract in the prices that it charges all that its line is worth. It cannot
charge the retailer that full amount in money and then charge it again in exclusivity
that the retailer does not wish to grant. To suppose that it can is to commit the
error of double counting. [...] Exclusivity has necessarily been purchased from it,
which means that the store has balanced the inducement oered by Standard [...]
against the disadvantage of handling only Standards patterns. [...] The stores decision, made entirely in its own interest, necessarily reects the balance of competing
considerations that determine consumer welfare. [...] If Standard nds it worthwhile
to purchase exclusivity [...], the reason is not the barring of entry, but some more
sensible goal, such as obtaining the special selling eort of the outlet.

A Model of the Chicago View on Exclusive Contracts

Suppose there are three agents:

1. a downstream buyer (D);

2. an incumbent upstream seller (U );
3. a potential upstream entrant (E ).

Initially, E is not in the market, and so D can contract only with U .

The downstream buyers demand is Q(p).

 U has constant marginal cost cU . E has constant marginal cost cE < cU

but has to pay xed cost F > 0 to enter the market.

Sequence of moves:

1. U can oer D an exclusive contract along with a payment t in return

for D signing contract.
2. D decides whether to accept contract.
3. E decides whether to enter the market (and incur F ).
4. The active upstream sellers (either only U or else both U and E ) set
prices, and D decides how much to purchase (and from whom).

 Assume that if E were to enter and sell to D, it would charge the price
p = cU as cU pM (cE ).
Assume also that E would enter in the absence of an exclusive contract:
(cU cE )Q(cU ) > F .

The Chicago School argument

p Mc U

cU
cE
q
Qp Mc U

Proposition In equilibrium, no exclusive contract will be signed, and so entry

will occur.
Proof If D signs the exclusive contract, and so E does not enter, U will
subsequently charge the monopoly price pM (cU ). If D does not sign the
exclusive contract, then E will enter and charge the price cU . Hence, D will
sign the exclusive contract with U only if
t

Z pM (c )
U
cU

Q(z )dz:

But
Z pM (c )
U
cU

Q(z )dz > M (cU );

and so U will not nd it protable to oer a suciently high payment that will
induce D to sign the exclusive contract.

Note: The Chicago argument does not rely on the assumption that U can make
a take-it-leave-it oer to D. The result is robust to any ecient bargaining
between U and D.

Partial Exclusion Through Stipulated Damages

Aghion and Bolton (American Economic Review, 1997)
Consider the model above but assume that D has unit demand with valuation v , i.e.,
Q(p) =

0
1

if p > v
if p v

The contract between U and D is now of the form (p; d), where p is
the price that D has to pay to U for one unit of the good and d is the
stipulated damage that D has to pay to U if D buys instead from E .
U has a rst mover advantagesets d before entrant can enter.

 Sequence of moves:

1. U oers D a contract of the form (p; d).

2. D decides whether to accept contract.
3. E decides whether to enter the market (and incur F ).
4. If E enters, it oers price pE and D decides from whom to buy. If E
does not enter, D buys from U (provided p v ).

Begin with the case where there is certainty about cE

Proposition In equilibrium, U will oer a contract (p; d) = (v; v (cE + F )).
D will sign this contract. E will enter and oer the price pE = cE + F . D
will purchase from E and pay the stipulated damage to U .
Proof

Suppose E has decided to enter the market and has oered the good at
price pE . Then D will purchase from E if U s eective price p d is
not smaller than pE .
Eective price is the incremental cost of buying versus not buying from U
allowing for d

 If (p; d) = (v; v cE F ), E can make just zero prot by entering,

incurring the xed cost F , and selling the good to D at price pE = cE + F .
Indeed, at pE = cE + F , D is just willing to purchase from E .
The induced outcome is ecient (it maximizes joint surplus) and all of the
surplus is extracted by the rst-moving U , so U cannot do any better.

Note: In eect, the contract does not exclude E but allows the incumbent U
to extract all of the surplus from the more ecient entrant E .
Suppose now that there is uncertainty about E s marginal cost cE .
For example, suppose that v = 1, cU = 1=2, cE is uniformly distributed
on [0; 1], and F = 0.

 In this case, the ecient solution would be that E enters if and only if
cE < 1=2.

If the entrant enters it must price at (p d); so U and D get a joint

surplus v (p d)
The expected joint surplus of U and D is maximized if the eective price
p d solves

max Pr(cE < )(v ) + Pr(cE )(v 1=2):

(1)

Pr(cE < ) is the probability the entrant can price below and hence
enters

 Since cE is uniformly distributed on [0; 1], Pr(cE < ) = and

Pr(cE ) = 1 .
Thus (1) implies the optimum is = 1=4.
Hence, entry will occur if and only if cE < 1=4. There is partial exclusion:
the entrant sometimes comes in. From a social point of view, this is
inecient because entrant stays out when 1=4 < cE < 1=2.

In a sense, partial exclusion is a side eect of the (optimal) contract between U and D. The objective of the contract is not to exclude but to
extract rents from E in order to maximize maximize the joint prot of U
and D at the expense of E .

 By imposing this negative externality on the entrant, there is too little

entry

The End