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Vertical and Horizontal Integration. Mergers

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Vertical Integration

•Vertical relationships: relations between firms involved in sequential steps of productionExample:

Upstream firm Wholesaler

Downstream firm Retailer

Intermediate good Subcontractor

Final good General contractor

•Vertical Integration: organization of more than one sequential stages of production within one firm

•Firms integrate or not “make or buy” decision

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Why integrate?• Eliminate Transaction costs 1. Contracting costs

2. Opportunities for “holdup”=opportunism* by one party to a relationship when other party is in a weak bargaining position (e.g. auto manufacturer buys parts from specialized parts supplier. Key: part supplier has invested in “relationship-specific capital”)

*It makes sense in asymmetric info. Otherwise you can write down everything (for every possible contingency in the contract)

• Coordinate production 1. Physical condition issues

2. Avoid inventory costs (“just in time production”)

• Exert markets power in the downstream market

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Vertical restraints

• Restriction by upstream firm on behavior of downstream firms

• Motivation for vertical restraints:1. Vertical externalities

2. Double marginalization problem

3. Vertical service externality (part of the benefit of providing good service goes to manufacturer)

• Horizontal externalities1. Horizontal price externality (usual oligopoly competition)

2. Horizontal service externality (e.g. high street store with trained sales staff, customers come and check out product, but buy online)

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Horizontal mergers

• Mergers of competitors

• Unilateral Effects (as opposed to Coordinate Effects): Concerned with effects of changing market shares on price and welfare

• Antitrust (Competition) Policy in the EU and the US

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Strategic Investment and Non-Price Competition

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Research and Development

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Introduction• Technical progress is the source of rising living

standards over time• Introduces new concept of efficiency

– Static efficiency—traditional allocation of resources to produce existing goods and services so as to maximize surplus and minimize deadweight loss

– Dynamic efficiency—creation of new goods and services to raise potential surplus over time

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Introduction 2

• Schumpeterian hypotheses (conflict between static and dynamic efficiency)– Concentrated industries do more research and

development of new goods and services, i.e., are more dynamically efficient, than competitively structured industries

– Large firms do more research & development than small firms

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A Taxonomy of InnovationsProduct versus Process Innovations • Product Innovations refer to the creation of new goods and

new services, e.g., DVD’s, PDA’s, and cell phones• Process Innovations refer to the development of new

technologies for producing goods or new ways of delivering services, e.g., robotics and CAD/CAM technology

• We mainly focus on process or cost-savings innovations but the lines of distinction are blurred—a new product can be the means of implementing a new process

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A Taxonomy of Innovations 2

Drastic versus Non-Drastic Innovations• Process innovations have two further categories• Drastic innovations have such great cost savings that they

permit the innovator to price as an unconstrained monopolist

• Non-drastic innovations give the innovator a cost advantage but not unconstrained monopoly power

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Drastic versus Non-Drastic Innovations• Suppose that demand is given by: P = 120 – Q and all

firms have constant marginal cost of c = $80• Let one firm have innovation that lowers cost to cM = $20• This is a Drastic innovation. Why?

– Marginal Revenue curve for monopolist is: MR = 120 – 2Q

– If cM = $20, optimal monopoly output is: QM = 70 and PM = $70

– Innovator can charge optimal monopoly price ($70) and still undercut rivals whose unit cost is $80

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Drastic versus Non-Drastic Innovations 2• Now consider the case if cost fell only to $60,

innovation is Non-drastic– Marginal Revenue curve again is: MR = 120 = 2Q– Optimal Monopoly output and price: QM = 30; PM = $90– However, innovator cannot charge $90 because rivals

have unit cost of $80 and could under price it– Innovator cannot act as an unconstrained monopolist– Best innovator can do is to set price of $80 (or just

under) and supply all 40 units demanded.

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Drastic vs. Non-Drastic Innovations 3Innovation is drastic if monopoly output QM at MR = new marginal

c’ exceeds the competitive output QC at old marginal cost c$/unit = p

Quantity

c

QC

c’

QM

Demand

$/unit = p

c

PM

QC QM

Demand

c’

PM

Drastic Innovation: QM > QC so innovator can

charge monopoly price PM without constraint

NonDrastic Innovation: QM < QC so innovator cannot charge monopoly price PM

because rivals can undercut

that price

MR

Quantity

MR

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Innovation and Market Structure• Arrow’s (1962) analysis—

– Innovative activity likely to be too little because innovators consider only monopoly profit that the innovation brings and not the additional consumer surplus

– Monopoly provides less incentive to innovate that competitive industry because of the Replacement Effect

• Assume demand is: P = 120 – Q; MC= $80. Q is initially 40. Innovator lowers cost to $60 and can sell all 40 units at P = $80.

• Profit Gain is $800–Less than Social Gain$/unit

Quantity

80

60

120

B A

40 60

Initial Surplus is Yellow Triangle--Social Gains from Innovation are Areas A

($800) and B ($200)But Innovator Only Considers Profit

Area A ($800)

120

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Innovation and Market Structure 2• Now consider innovation when market structure is monopoly

– Initially, the monopolist produces where MC = MR = $80 at Q = 20 and P = $100, and earns profit (Area C) of $400

– Innovation allows monopolist to produce where MC = MR = $60 at Q = 30 and P = $90 and earn profit of $900

– But this is a gain of only $500 over initial profit due to Replacement Effect—new profits destroy old profits

$/unit

Quantity

90

60

120

C

20 60 120

A

100

30

80

MRDemand

Monopolist Initially Earns Profit C—With Innovation it Earns Profit A—Net Profit

Gain is Area A – Area C Which is Less than the Gain to a

Competitive Firm

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Innovation and Market Structure 3• Preserving Monopoly Profit--the Efficiency Effect• Previous Result would be different if monopolist had to worry

about entrant using innovation– Assume Cournot competition and that entrant can only enter if it

has lower cost, i.e., if it uses the innovation– If Monopolist uses innovation, entrant cannot enter and

monopolist earns $900 in profit– If Monopolist does not use innovation, entrant can enter as low-

cost firm in a duopoly• Entrant earns profit of $711• Incumbent earns profit of $44

– Gain from innovation now is no longer $900 - $400 = $500 but $900 - $44 = $856

– Monopolist always has more to gain from innovation than does entrant—this is the Efficiency Effect

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Advertising, Competition and Brand Names

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Introduction• Advertising is a weapon in the competition between firms• Creating & securing a brand identity can be helpful to

consumers – Consumers may have a taste for variety; each consumer may like

a different version of a particular product– Advertising can match consumers with the version they most

prefer – But advertising can also be an uninformative and wasteful form

of competition• Evaluation of advertising’s competitive role requires an

understanding or clear model of how advertising works• Consider a simple model where firms can either spend a

little or a lot on advertising• If advertising by one firm largely cancels the advertising

of its rival, then this can result in an “advertising” war with both firms spending excessively on advertising

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Advertising as Wasteful CompetitionExample of a Wasteful Advertising War

Gamma

ZIP

Low Advertising Expenditure

High Advertising Expenditure

$450, $450

Low Advertising Expenditure

High Advertising Expenditure

$375, $500

$500, $375 $400,$400

Nash Equilibrium is for both firms to choose the high level of advertising expenditures. This does not maximize their joint profit. Each firm’s advertising undoes the promotional efforts of its rival. The result is excessive advertising that largely cancels itself out with little gain to consumers and lower profit for firms

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Advertising, Information, & Product Differentiation• Recall the Hotelling Model (Chapter 10)

– N Consumers distributed uniformly along a line – Two firms—one at each end of the line

Firm X Firm Y

– Each consumer is willing to pay V for the basic product

– But consumers incur “transport” cost of t per unit of distance traveled to firm– Equilibrium prices (with the entire market being served):

p1 = p2 = c + t

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Advertising, Information,Product Differentiation 2• Now apply Grossman and Shapiro (1984) approach:

– Each firm chooses advertising expenses aimed at reaching the fraction X or Y of the N consumers

– From perspective of firm X, a fraction X(1 - Y) (indicatedby “x”)of consumers will know of its product only and a fraction X Y (indicated by *) will know of both X and Y

Firm X Firm Y

– Firm X is a monopoly with respect to the uniform but less dense population of X (1 - X) N consumers who know only X

–Assume that equilibrium pX is low enough that all of these buy 1 unit of X

x * x x * x x x **

Firm YFirm X

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Advertising, Information, Product Differentiation 3• Firm X competes with Firm Y for the also less dense but

uniform population of XY who know of both goods

Firm X Firm Y

– So, total demand facing firm X is:

Nt

ptpNQ YX

YXYXX

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•Firm Y faces a similar demand

• Each firm must choose

– how much advertising to do, i.e., how big should be

– What price to charge?

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Advertising, Information, Product Differentiation 4• Assume that advertising expense TAi for firm i where i

equals either X or Y, depends on the total number of consumers reached as follows:

• Profit maximization at both firms now results in two best response functions, one for prices and one for advertising. Solving these jointly then yields the equilibrium price and advertising expenditures at each

NTA ii

2

2

Then the marginal cost of advertising TAi’ is: NTA ii '

andtcpi 2 t/i

21

2

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Advertising, Information, Product Differentiation 5• Note that must be greater than t/2 in order to maintain

our assumption that i < 1 for each firm, i.e., we must assume that advertising is a bit expensive relative to consumer taste for variety in order to have some consumers uninformed

• In turn, this means that the equilibrium price is now higher than it was in our benchmark Hotelling case that assumed all consumers were perfectly informed

Equilibrium Price Fully Informed Case Imperfectly Informed Case

tcpi 2tcpi Information is costly. The cost of providing it through advertising has to be reflected in the product price.

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Advertising, Information, Product Differentiation 6• Two additional insights also follow

– Advertising as the consumer taste for variety t increases. • Recall equilibrium advertising level is

• Profits rise as advertising becomes more costly (as rises).

t/i

212

• This increases as t increases. • Product differentiation and advertising are positively linked NOT because advertising causes product differentiation but because specialized consumer tastes leads firms to advertise.

• Firm profitability is: 2

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2

t/

Ni

• As rises, firms do less advertising and fewer consumers know about both products softer price competition/more profits.

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Building Brand Value vs Extending Brand Reach• Advertising in the Grossman and Shapiro model is pure

information. This begs the question as to how advertising precisely works

• Becker and Murphy (1993) argue that advertising works as a complement to the product, i.e., it enhances consumer valuation of the good or service

• Two ways complementary advertising can work– Consumers prefer to purchase brands that are well known, i.e.,

advertising builds brand value in that consumers are willing to pay more for a well-known brand. This is close to an “advertising as persuasion” view

– Advertising provides information that enhances product value, e.g., where to go for related services such as hotels advertising nearby tourist sites. Here, advertising is truly informative and works therefore to bring in new customers, that is, to extend the brand’s market reach

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Building Value vs Extending Reach 2

$/unit = p

QuantityQM

D1

$/unit = p

Q2* Q1*

D2

PM

When Advertising Builds Brand Value it Rotates the Demand Curve up along the price axis

from D1 to D2. For a monopolist, the optimal quantity does not

change but the price rises.

When Advertising Extends the Brand’s Market Reach It rotates the demand

curve out along the quantity axis from D1 to D2. For a monopolist, the

optimal price does not change but the number of customers rises.

D2

Quantity

D1

P1*

P2*

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Building Value vs Extending Reach 3• The evaluation of advertising efforts from a social

welfare or efficiency point of view requires that we understand whether advertising predominantly builds value or extends market reach

• This is even more true when we add in some competition. – When there is more than one firm and advertising

extends market reach advertising may well be excessive • Now advertising works by stealing customers from rivals• Much greater possibility that game is like the wasteful

advertising game described at start of chapter– When advertising works to build value, excessive

advertising is less likely because advertising now works to permit charging existing customers a higher price—not by taking customers from rivals.

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Building Value vs Extending Reach 4• Amount of advertising is also likely to depend critically

on nature of price competition and number of firms– When price competition is naturally fierce, firms may

advertise a lot to differentiate their product and soften price competition

– When the number of firms is small, firms may again advertise more because most of the gains of a firm’s advertising flow to that firm itself and not to its rivals

– Note the potential interaction of these two effects. • Since advertising is largely a sunk cost, the need to do a lot of

advertising to soften price competition may limit the equilibrium number of firms

• As number of firms falls, each one advertises more• Advertising/sales ratio may be high in concentrated industries

but again causality is not from advertising to concentration• ReaLemmon Case

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Cooperative Advertising • In contrast to analysis so far, much advertising and

promotion is done by retailer on manufacturer’s behalf • Manufacturer and retailer may therefore wish to act

cooperatively so as to avoid problems of underprovision of services discussed in Chapter 18– Retailer may try to free ride on promotional efforts of

other retailers– Retailer may substitute less-costly brands for

manufacturer’s product• These cooperative arrangements take a variety of

forms such as slotting fees, “pay-to-stay” fees, and failure fees

• However, they all result in the manufacturer paying part of the retailer’s promotional expense

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Cooperative Advertising 2• Because cooperative advertising contracts can

resolve many of the manufacturer/retailer conflicts they have the potential to promote economic welfare.

• But, cooperative advertising can also be used to suppress or weaken competition– McCormick Spice may have used slotting fees to buy shelf

space preemptively and foreclose it to rival spice firms– Slotting and promotional fees can be offered on different

terms to retailers (price discrimination)• usually large retailers will get a quantity discount• Large retailers (WalMart, Borders) then gain

competitive advantage over small ones (independent retailers and bookstores)

– Slotting fees may be paid to retailer in return for keeping retail price high (Resale Price Maintenace)

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Empirical Application: Information versus Prestige in Advertising

• Can we devise clear empirical tests that truly identify the precise role of advertising?

• Ackerberg (2001) is an effort to do just that. He looks at the impact of advertising that accompanied the introduction of a new, low-fat yogurt product by Yoplait in 1987-88.

• Specifically, Ackerberg tests whether this advertising was primarily informative or instead worked by appealing to the status consciousness of the consumer

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Empirical Application: Information versus Prestige in Advertising 2

• The Data– In April of 1987, Yoplait made its first entry into the

low-fat, low-calorie yogurt category with Yoplait 150.– This corresponds to the time period in which A. C.

Nielsen collected information on about 2,000 households split between Sioux Falls, South Dakota and Springfield, Missouri

• Monitors were attached to the TV’s in these households; • Scanner data was used to monitor their trips to the

supermarket and what they bought

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Empirical Application: Information versus Prestige in Advertising 3

– The Nielsen data cover 12 months starting three months after the April intro of Yoplait 150

– Thus these data give Ackerberg measures of the exposure of these housholds to Yoplait 150 television commercials as well as records of their Yoplait 150 purchases (if any)

– In particular, Ackerberg can measure whether the consumer is a first-time or previous user of Yoplait 150 and how many ads they have seen

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Empirical Application: Information versus Prestige in Advertising 4

– For each town or market, Ackerberg creates two time series from the data covering specific market days over the 12-month period

• One series is the number of first-time purchases of Yoplait 150 as a fraction of the number of shopping trips that day

• The other is the number of repeat purchases of Yoplait 150 as a fraction of the number of trips that day

• He also has data on the Yoplait 150 price (PRICE)for each day in each market as well as for the number of television advertisements (ADS) for Yoplait 150 to which the buyer had been exposed

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Empirical Application: Information versus Prestige in Advertising 5

• As a preliminary step, Ackerberg (2001) runs two separate OLS regressionsFirst time purchases = a0 + a1PRICE + a2ADS + a3MARKET +ei

Repeat purchases = b0 + b1PRICE + b2ADS + b3MARKET + ui

• Here, MARKET is a dummy variable equal to 1 is the data are from Springfield but 0 if from Sioux Falls

• Ackerberg’s argues that if advertising is mainly information, it will have a much bigger effect on first time buyers than on experienced ones

• In other words, a2 should be larger than b2

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Empirical Application: Information versus Prestige in Advertising 6

Ackerberg’s preliminary results are shown below Dependent Variable Initial Purchases Repeat Purchases Coefficient Std. Error Coefficient Std. ErrorPRICE -0.038 (0.013)* -0.029 (0.014)* ADS 0.030 (0.015)* 0.014 (0.017) MARKET 0.002 (0.001)* 0.006 (0.001)* *Indicates significant at the five percent level.

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Empirical Application: Information versus Prestige in Advertising 7

Ackerberg’s preliminary results thus show:1) Yoplait 150 price increases reduce demand significantly

2) Springfield consumers like Yoplait 150 more than Sioux Fall consumers

3) Advertising only raises demand significantly for first time buyer

The last finding is the important one. It confirms the

view that advertising is mostly informative and, in particular, informative about the product’s existence and its primary characteristics

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Empirical Application: Information versus Prestige in Advertising 8

Since any purchase is a 1,0 decision, Ordinary Least Squares (OLS) is not the best estimation technique. Instead, one needs to use a probit or logit approachAlso, one should in principle allow for other factors such as the price of rival yogurts. Ackerberg (2001) makes all these modifications but still finds his basic result. Advertising has by far its biggest and most statistically significant effect on first-time buyers.

Advertising is primarily information