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Chapter 9: Vertical Relations

Chapter 9: Vertical Relations. 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

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Chapter 9: Vertical Relations

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  1. Chapter 9: Vertical Relations Industrial Organization: Contemporary Theory & Practice

  2. 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

  3. 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

  4. 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

  5. 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

  6. 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

  7. This is the manufacturer’s derived demand The example Price (P) The retailer’s profit is $1.21m  marginal revenue for the retailer is MR = 500 - Q/50 500 Demand 390  marginal cost is r + 40 280  MC = MR gives r = 460 - Q/50  The manufacturer’s marginal revenue is MR = 460 - Q/25 MC r+40 MR  Marginal cost is $20 Quantity 11,000 25,000 50,000 Price (r)  MC = MR gives Q = 11,000 460  The suits are wholesaled at $240 The manufacturer’s profit is $2.42m  The retailer’s MC is $280 Manufacturer’s demand 240  He sells 11,000 suits  and prices them at $390 each 20 MC MR Quantity 23,000 11,000 Industrial Organization: Contemporary Theory & Practice

  8. Vertical restraints • We know from Chapter 8 that a merger of manufacturer and retailer improves on the foregoing outcome  marginal revenue for the merged firm is MR = 500 - Q/50 But is such a merger necessary to achieve these gains? Price 500  marginal cost is MC = $60  So MC = MR gives suit sales of 22,000 Demand 280  The suits are priced at $280 each  Profit of the merged firm is $4.84 million 60 MC Quantity 25,000 50,000 22,000 Industrial Organization: Contemporary Theory & Practice

  9. 3000 1 - a 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 This is less than 22,000 for all positive values of , i.e., for any scheme under which the manufacturer earns a profit. Q* = 25,000 - Industrial Organization: Contemporary Theory & Practice

  10. 2000 1 - a 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 33.33% this will equal 22,000 • Solving for Q yields : Q* = 25,000 - A royalty rate of 33.33% of total revenues gives the vertically integrated total output, product price and aggregate profit . . . BUT Industrial Organization: Contemporary Theory & Practice

  11. 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

  12. 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- now affects both revenues and costs: So marginal revenue is (1-)(500Q – 2Q/100) and marginal cost is (1-)(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

  13. 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

  14. 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 • The retailer’s profit is: 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 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

  15. Two-part pricing (cont.) • Consider how the fixed charge T might be negotiated Profit with linear pricing Profit with linear pricing • If negotiations break down it is reasonable to suppose that the manufacturer and retailer revert to simple linear pricing Profit with a zero 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

  16. Two-Part Pricing (cont) • How common is a two-part pricing type of scheme? • When seen as a franchise agreementfairly 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

  17. 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  set a maximum price of $280 per suit  the retailer will set this price 500 Demand  sales of suits increase to 22,000 390  aggregate profit is $4.84m 280 RPM  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 60 Quantity 11,000 25,000 50,000 22,000 Industrial Organization: Contemporary Theory & Practice

  18. 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

  19. Retail services (cont.) Price Demand with retail services s1 Demand with retail services s2 > s1 The provision of retail services increases demand But the provision of retail services is costly for the retailer: f(s) per unit sold D(s2) D(s1) Quantity (Q) Suppose the wholesale price is r $ The retailer’s marginal cost is r+f(s) f(s) What level of services will be provided by the retailer? Services (s) Industrial Organization: Contemporary Theory & Practice

  20. Retail services (cont.) • Efficiency is most likely if the retailer and manufacturer are vertically integrated  suppose that consumer demand is Q = 100s(500 - P) Price Demand with retail services s = 1  Note: higher s (more service) raises demand Demand with retail services s = 2 500  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) 50 100 Industrial Organization: Contemporary Theory & Practice

  21. Retail services (cont.) • Profit of the integrated firm: pI = (P- cm - cr - f(s))100s(500 - P) Cancel the 100s terms • The integrated firm sets P and s to maximize profits Cancel the 100(500 - P) terms pI/P = 100s(500 - P) - 100s(P - cm - cr - f(s)) = 0  500 - 2P + cm + cr + f(s) = 0  P* = (500 + cm + cr + f(s))/2 This equation gives the efficient level of retail services pI/s = 100s(500 - P)(P - cm - cr - f(s)) - 100s(500 - P)f’(s) = 0  (P - cm - cr - f(s)) = sf’(s) • 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

  22. ŝ Retail services (cont.) The right hand side is increasing in s Initial manufacturing and retail costs  (500 - cm - cr)/2 = f(s)/2 + sf’(s) Suppose that there is an increase in marginal costs, apart from services, at either the manufacturing or retail level $ f(s)/2 + sf’(s) Let c’m and c’r be new marginal costs (500-cm-cr)/2 The rise in cost leads to a fall in the optimal choice of sfrom s*to ŝ (500-c’m-c’r)/2 s s* Industrial Organization: Contemporary Theory & Practice

  23. 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  P* = $320 And Q = 100s(500 - P)  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

  24. Retail services (cont.) • Suppose that retailer and manufacturer are independent • The manufacturer sells its suits to the retailer at r per suit Cancel the 100(500 - P) terms • The retailer then sets retail price and service level to maximize profits • Profit of the retailer is: pR = (P- r- cr - f(s))100s(500 - P) • The retailer sets P and s to maximize profits pR/P = 100s(500 - P) - 100s(P - r - cr - f(s)) = 0 Cancel the 100s terms  500 - 2P + r + cr + f(s) = 0  PR = (500 + r + cr + f(s))/2 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

  25. Retail services (cont.) The manufacturer will set the suit price at greater than marginal cost: r > cm  (500 - r - cr)/2 = f(s)/2 + sf(s) $ f(s)/2 + sf(s) (500-cm-cr)/2 This is the retailer’s choice of s at wholesale price r The retailer provides too low a level of support services (500- r - cr)/2 The efficient choice of s s sr s* Industrial Organization: Contemporary Theory & Practice

  26. 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

  27. 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

  28. 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

  29. 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

  30. Competitive retail services (cont.) • Demand is Q = 100s(500 - P)  suppose the service level for each firm is s1 Gain in consumer surplus  competition gives P1 = r+cr+f(s1) Price  consumer surplus is shaded area Loss of consumer surplus 500  Now increase service level to s2 Demand with retail services s1 Demand with retail services s2  price rises to P2 = r+cr+f(s2) r+cr+f(s2)  there is both a gain and a loss in consumer surplus r+cr+f(s1)  these have to be balanced in the choice of s Quantity (‘000) 50s1 50s2 Industrial Organization: Contemporary Theory & Practice

  31. Multiplied by half the base of the triangle Competitive retail services (cont.) Height of the triangle • Demand is Q = 100s(500 - P) and P = r + f(s) Cancel the common term 50(500 - r - cr - f(s)) • Consumer surplus is CS = (500 - P) x Q/2 = 50s(500 - P)2 = 50s(500- r-cr-f(s))2 Price • To maximize CS with respect to s: CS/s = 50(500-r-cr-f(s))2 500 -100s(500-r-cr-f(s))f(s) = 0 so 500 - r - cr - f(s) = 2sf(s) P = r+cr+f(s) (500 - r - cr)/2 = f(s)/2 + sf(s) This equation gives the competitive level of retail services Quantity (‘000) Q 50s1 Industrial Organization: Contemporary Theory & Practice

  32. Competitive retail services (cont.) (500 - r - cr)/2 = f(s)/2 + sf(s) For the manufacturer to make a profit requires r > cm $ f(s)/2 + sf(s) (500 - cm - cr)/2 Retail competition gives too low a level of support services This is the competitive choice of s given a wholesale cost r This is the efficient choice of s (500 - r - cr)/2 s sC s* Industrial Organization: Contemporary Theory & Practice

  33. 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

  34. 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

  35. 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

  36. 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

  37. 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

  38. 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

  39. 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 stage 1: how much to produce DH stage 2: knowing demand - how much to sell since costs are sunk: maximize revenue DL c MC Quantity Industrial Organization: Contemporary Theory & Practice

  40. RPM and variable demand illustrated  an integrated firm will not produce more than QUpper Price  and will not produce less than QLower  the integrated firm will produce Q* DH How is Q* determined MC = MR with low demand MC = MR with high demand DL c MC MRL MRH Quantity QLower Q* QUpper Industrial Organization: Contemporary Theory & Practice

  41. RPM and variable demand illustrated  if demand is high the firm sells Q* at price PMax: MR = MR*H  if demand is low selling Q* is excessive Price  the firm maximizes revenue by selling Q*L at price PMin: MR = 0 Revenue with high demand  expected marginal revenue is: MR*H/2 + 0 = MR*H/2 DH Revenue with low demand  Q* is such that expected MR = MC so MR*H/2 = c PMax PMin DL  Expected profit is pI = PMaxQ*/2 + PMinQ*L/2 - cQ* MR*H c MC MRL MRH Quantity Q*L Q* Industrial Organization: Contemporary Theory & Practice

  42. RPM and variable demand illustrated Suppose that retailing is competitive  Will competitive retailers stock the optimal amount Q*? What will happen if they do? Price  if demand is high the retail firms sell Q* at price PMax: MR = MR*H Revenue with high demand  if demand is low each firm will sell more so long as price is positive DH  so, if demand is low competitive retailers keep selling until they sell the total quantity QL at which price is zero PMax DL  revenue is therefore zero in low demand periods if competitive firms stock Q* c MC MRL MRH Quantity QL Q* Industrial Organization: Contemporary Theory & Practice

  43. 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

  44. RPM and variable demand illustrated  the integrated firm never sells at a price below PMin  so set a minimum RPM of PMin Price  In high demand periods Q* is sold at price PMax  In low demand periods the RPM agreement ensures that only Q*L is sold DH PMax  Expected revenue to the retailers is PMaxQ*/2 + PMinQ*L/2 PMin DL MR*H c MC MRL MRH Quantity Q*L Q* Industrial Organization: Contemporary Theory & Practice

  45. 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

  46. 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

  47. Exclusive dealing and competition Suppose there are 2 suppliers of competing products What if the suppliers offer an exclusive territory? Supplier 1 Supplier 2 Price competition by the retailers drives price to marginal cost Price competition by the suppliers drives price to marginal cost Suppose that there are several retailers Retailers Consumers Industrial Organization: Contemporary Theory & Practice

  48. Exclusive dealing and competition Suppose the suppliers divide retail into two regions And suppose the suppliers give exclusive territories to the same retailers Supplier 1 Supplier 2 Retailers Each lucky retailer is now a local monopolist Consumers 2 Consumers 1 Industrial Organization: Contemporary Theory & Practice

  49. 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

  50. 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 one-fifth 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

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