Vertical restraints Exclusive dealing
Vertical restraints
Industrial organization – lecture 6
Vertical restraints Exclusive dealing
Vertical restraints
Firms at different stages of the production chain do not rely on spot
market transactions, but sign contracts to reduce transaction costs and
better coordinate actions.
These agreements are called vertical restraints.
Vertically related firms produce complementary products. Vertical
restraints may internalize this externality.
Vertical restraints are also an issue for competition policy. They might be
beneficial as well as harmful for the consumer.
Vertical restraints Exclusive dealing
Types of vertical restraints
There are several types of vertical restraints. The most common examples
are the following:
• Franchise fee (non-linear pricing). Contract specifies fixed price and
variable component.
• Quantity discounts.
• Resale price maintenance (RPM). The manufacturer sets the
price/recommends retailer’s price, or it might establish minimum or
maximum price.
• Exclusivity clauses. E.g. under exclusive dealing a retailer agrees to
carry only the brand of the particular manufacturer; an exclusive
territory implies that only one retailer can sell the brand within a
certain area.
Vertical restraints Exclusive dealing
Exclusive dealing
We focus on exclusive dealing and different types of rationalization of
these contracts.
Exclusive dealing can stimulate retailer’s effort or reduce free-riding on
manufacturer’s investment. On the other hand, it may lead to foreclosure.
Vertical restraints Exclusive dealing
ED: Free-riding
Pepall et al. (2010, pp. 372–373)
This is a variation of Besanko and Perry (1993).
The producers produce differentiated product. Each can invest e into
activity which reduces retailer’s costs. The investment costs are µe2
2 .
There is a perfect competition among retailers. The cost of each retailer
of selling brand i are c + wi − ei − ej .
The inverse demand function is linear Qi = 1
2 (1 − pi + γ
2 (pj − pi )).
Vertical restraints Exclusive dealing
ED: Free-riding - solution
Pepall et al. (2010, pp. 372–373)
Each retailer charges price equal to marginal costs pi = c + wi − ei − ej .
Substituting the manufacturer’s prices and maximizing with respect to w
and e gives the optimal wholesale price and investment level
w∗
=
4µ(1 − c)
2µ(4 + γ) − 4
, e∗
=
2(1 − c)
2µ(4 + γ) − 4
.
Under the ED agreement
w∗
=
4µ(1 − c)
2µ(4 + γ) − 2 − γ
, e∗
=
2(1 − c)
2µ(4 + γ) − 2 − γ
.
Vertical restraints Exclusive dealing
ED: Free-riding - solution
Pepall et al. (2010, pp. 372–373)
You can check that
1. Investment levels are higher.
2. Wholesale price is higher because distribution cost are lower and it
shifts marginal revenue curve of the producer.
3. Retailer’s price is lower.
4. Welfare is higher.
Vertical restraints Exclusive dealing
ED: Foreclosure
Pepall et al. (2010, p. 375-376)
There can be also anti-competitive effects of ED.
There is monopoly incumbent with costs ci and entrant with cost
ce < ci . There are two retailers that compete in Cournot way.
The timing of the game is as follows
1. Each retailer may sign exclusive contract for price T
2. Entrant decides to enter the market. There are entry costs F.
3. Retailers sign two-part tariff contract with some producer.
4. Retailers compete on the final good market with inverse demand
P = 1 − Q.
Vertical restraints Exclusive dealing
ED: Foreclosure - solution
Pepall et al. (2010, p. 375-376)
If both firms sign ED contract, the incumbent is able to divide monopoly
profit 1−ci
2
2
.
If one firm does not sign ED contract and the entrant enters, it gets
1−ci
2
2
. If the entrant does not enter, it gets zero profit.
If no firm signs ED contract, they both get 1+ce −2ci
3
2
.
Hence, the incumbent is able to foreclose a more efficient entrant.