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Vertical Integration and Vertical Restraints

Vertical Integration and Vertical Restraints. By Kevin Hinde. Aims. In this lecture we will explore the competitive effects of vertical integration and vertical restraints.

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Vertical Integration and Vertical Restraints

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  1. Vertical Integration and Vertical Restraints By Kevin Hinde

  2. 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.

  3. 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.

  4. 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.

  5. The positive effects of Vertical Integration

  6. P Pr Pw MCw =Pw Dr MRr 0 Q Q Vertical Integration: Competitive Wholesaler (w), Monopolist Retailer (r) 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

  7. P Pr=Pw MCw Dr=Dw MRw 0 Q Q Vertical Integration: Monopolist Wholesaler (w), Competitive Retailer (r) Dr = Dw because it represents the quantity that retailers are willing to sell at any given wholesale price By maximising profit the wholesaler’s price is retailer’s marginal cost.

  8. P Pr=Pw MCw Dr=Dw MRw 0 Q Q Vertical Integration: Monopolist Wholesaler (w), Competitive Retailer (r) Again, there is no difference between vertical separation and vertical integration. So vertical integration would only maintain market power.

  9. P Pw MCr MCw Dr MRw MRr =Dw 0 Q Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r) Because w knows r will restrict output to its MRr the demand curve of w = MRr. Pr

  10. P Pr Pw MCr MCw Dr MRw MRr =Dw 0 Q Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r) Ws demand is determined by anticipation about downstream demand.

  11. P Pr Pw MCr MCw Dr MRw MRr =Dw 0 Q Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r) The profit maximising w sets MCw = MRw and charges Pw. In effect, w knows what price r will charge and acts accordingly.

  12. P Consumer Surplus Profit for retailer Pr Pw MCr Profit for wholesaler MCw Dr MRw MRr =Dw 0 Q Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r)

  13. P Pr Pw MCr Consumer surplus MCw Abnormal Profit Dr MRw MRr =Dw 0 Q Vertical Integration: Monopolist Wholesaler (w), Monopolist Retailer (r) By vertically integrating the firm would consider the internally evaluated marginal cost of the wholesale product to be MCw not Pw.

  14. The positive effects of Vertical Restraints

  15. Maximum Resale Price maintenance • Many products sold by manufacturers require a pre-sales service to avoid the Free Riding Problem

  16. P Pw =Pr MCw D (P,0) MRw 0 Q Q Insufficient Promotional Services Monopolists Wholesaler’s profits if competitive retailers provide no services Retailers have no incentive provide services - they only earn a normal profit.

  17. P Maximum Price reflects pre-sales services per unit P* MCr + S* Pw MCr = ACr MCw = ACw D (P,S*) MR(P, S*) 0 Q Q Insufficient Promotional Services Wholesaler’s profits if retailers provide the optimal level of services.

  18. A B C The welfare impact of services P With no service combined consumer and producer surplus = A+B+C Pw=Pns Pw = MCr =ACr MCw = ACw D(P, 0) 0 Q Qns

  19. D E F D (P,S*) Q The welfare impact of services Services shift demand. Consumer surplus changes by D - B. Producer surplus increases by F. Net Effect depends on the size of B P A MCr + S* P* B Pw=Pns Pw = MCr C MCw D(P, 0) 0 Q Qns

  20. 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

  21. 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

  22. 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

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