Integration Vertical and Vertical Restrictions
Econ 425, Summer I 2008
Intro
Some firms choose to vertically integrate and perform all production and distribution activities themselves. Other firms prefer to write complex contracts that restrict the actions of those with whom they deal (establish vertical restrictions or restraints). A final group of firms simply rely on the market. Why do firms vertically integrate? Why do firms sometimes use vertical restrictions? What about franchise systems? What should public policy be toward these practices?
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When will a firm vertically integrate?
Whether a firm performs a task itself or relies on the market basically depends on relative costs.
- firms can avoid integration by outsourcing. e.g. retail and commercial banks in U.S. (67%); high-tech firms; governments.
Costs of vertical integration:
- High costs of supplying own factors or of distributing product; - Larger firms have to deal with higher management and monitor costs; - Legal costs of merger.
What about the advantages to integrating?
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Advantages to integrating
1. Lower transaction costs. Specialized assets: give rise to opportunistic behavior.
- specific physical capital; specific human capital; site-specific capital.
Uncertainty. 2. Assure supply. Avoid rationing of important inputs; minimize inventory costs while ensure timely delivery (Toyota and Dell). 3. Eliminate externalities. Maintain high uniform standards (positive reputation externality).
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Advantages to integrating (2)
4. Avoid Government regulation. Avoid price controls; shift profits because of different tax rates. 5. Increase monopoly profits. A monopoly supplier of an input can increase its profits by vertically integrating to monopolize producing industry.
How? - production function, Q=f(E,L), with CRS; - inputs produced at constant marginal cost (w,m); - monopoly upstream (supply of energy), competition downstream; - costs of vertically integrating.
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Advantages to integrating (3)
If downstream production process uses fixed proportions, upstream monopoly does not have an incentive to vertically integrate.
- it makes same profits whether it integrates or not!
If downstream production process uses variable proportions, upstream monopoly has an incentive to vertically integrate.
- downstream firms can substitute between inputs so upstream monopoly does not have complete control over them.
6. Eliminate market power. A firm may find it profitable to vertically integrate backward and buy the 6 upstream monopoly that sells an essential input.
Vertical restrictions
When distribution is costly, a manufacturer would prefer to rely on independent firms to distribute their products. However, certain principal-agent problems may arise in the relationship between manufacturer and distributor.
- Double monopoly markup; - Free riding among distributors; - Free riding by manufacturers; - Externalities due to lack of coordination among distributors.
So manufacturer may place vertical restrictions on distributors actions to deal with these problems (e.g. minimum units sold, location).
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Vertical restrictions (2)
1. Double monopoly markup. If manufacturer and distributor are both monopolies, either firms will have incentive to vertically integrate or use vertical restrictions. Why? If vertical integration is not practical, use vertical restrictions. - The idea is to drive retail price (p1) to wholesale price (p2). e.g. maximum retail price (but illegal since 1976!); sales quota; two-part pricing scheme (p2 = m plus franchise fee). Blockbuster: pay $8 per tape plus share 40-60% revenue with distributors. - Mortimer (2002): profits increased 3-6% compared to previous contracting scheme.
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Vertical restrictions (3)
2. Free riding among distributors. Some distributors may benefit from promotional activities or highly trained staff of others without paying for them. Solutions? Establish exclusive territories or limit number of distributors (auto dealers); set a minimum retail price (illegal since 1976!); advertising by manufacturer. 3. Free riding by manufacturers. Competing manufacturers, that share the same distributor, can free ride off the advertising efforts of each other. Solution? Exclusive dealing. 4. Externalities due to lack of coordination distributors. among Manufacturers objectives may differ from independent distributors objectives.
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Effects of vertical restrictions
It follows the vertical restrictions used by manufacturers may limit the amount of competition in a market, but encourage at the same time additional efforts to sell product. So, are vertical restraints desirable or undesirable?
- Desirable effects: when they benefit both consumers & firms (e.g. eliminate double markup); - Ambiguous effects: training staff may rise prices, so beginners benefit but experienced users are worse off; - Undesirable effects: when used for anticompetitive purposes (e.g. cartelize an industry, prevent entry or harm rivals).
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Banning vertical restrictions: The case of Toys R US (TRU)
TRU is worlds largest toy retailer. - purchases >30% of output of largest toy companies (Mattel, Fisher Price). In mid 90s, FTC filed a complaint against TRU arguing that through a range of vertical agreements, TRU persuaded 10 leading toy manufacturers to restrict the range of products sold to warehouse clubs (Costco, Sams, Price Club). -e.g. Costcos sales increased by 51% between 91-93; after 1993, decreased by 1.5%! FTC also accused TRU of orchestrating a horizontal agreement between manufacturers. TRU argued that discount retailers (warehouses) were free-riding TRU valuable promotional activities and point-of-sale service that created and added demand for toys. But What finally happened?
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Franchising
When franchisor sells a proven method of doing business (business format) or right to carry franchisors brand to individual franchisee. - By 2002, franchise outlets accounted for 40% of all retail sales in U.S.
Fasted-Growing Franchises in U.S. in 2003 Franchisor Subway Curves 7-Eleven McDonalds Jani-King # Franchises 15,257 4,671 3,761 11,465 7,843 Company-owned 1 0 2,547 8,094 33 Franchise fee $12,500 $24,900 varies $45,000 $8,600-16,300 Royalty fee on sales 8% $395/month varies 12.5% + 10%
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Franchising (2)
Why franchises have expanded so fast? Franchising combines the benefit of vertical integration (specific investments made or provided by franchisor) with benefits of vertical separation (franchisees retain most of profits). By sharing profits (or sales), both franchisor and franchisee have incentives to work harder. Some franchisors prefer to have company-owned outlets. - LaFontaine (1995): prices at company-owned franchises are 2% lower.
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Exercise 1
A monopolistic producer uses a dealer network, in which it limits the number of dealers and restricts them to exclusive territories, to sell its product in another country. But some importers also buy its product in the U.S. to sell it in this other country. Such imported products are said to be sold on the gray market. It follows that if the manufacturer becomes aware of this, he should prevent such gray market sales.
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Exercise 2
Total demand in the competitive market for tulips is Q = 100,000 1,000p, where p is in cents. To produce a single tulip requires one minute of labor, L, and two tulip bulbs (on average only one in two bulbs yields a marketable tulip). The wage rate is constant at 20 cents per minute. Suppose all tulip bulbs are produced by a monopolist at a constant marginal cost of 10 cents per bulb. a. What price, m, does the monopoly charge for the bulbs and what is its resulting profit? b. What price would it charge for tulips if it vertically integrated into the tulip market, and what would its profit be?
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End of Chapter
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Fixed-proportions production function
$
Integrated firm
$
Monopoly supplying competitive industry
p* p(Q)
w MCQ
p* e* p(Q)
*
m+w MRQ Q* E* = L* = Q* * = [p* (m + w)]Q*
*
m+w m MRE MRQ Q* =E*
e(E) MCQ MCE
Q
Q,E
e = p - w or e(E) = p(E) w Max = [e(E) m]E = [(p(E) w) m]E * = (e* m)E* = [(p* w) m]E*
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1 unit of E & 1 unit of L to produce 1 unit of Q.
Monopolies in both manufacturing and distributing
$
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Integrated manufacturer-distributor
$
10 p1=6
Successive monopolies
p*=6
1=4
D1
*=16 m=2
p2=p*=6
D1
2=8
MC MR1
Q*=4
m=2
MC MR2 MR1 = D2
Q
Q1=2 = Q2 Q*=4 Distributor faces D1 and MR1 Manufacturer faces D2 = MR1 and MR2 Consumers & firms are worse off!
Q
Distribution costs are zero. Demand: p = 10 Q; MC = 2
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