vertical integration and vertical restraints

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Vertical Integration and Vertical Restraints By Kevin Hinde

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

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Page 1: Vertical Integration and Vertical Restraints

Vertical Integration and Vertical Restraints

By Kevin Hinde

Page 2: Vertical Integration and Vertical Restraints

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.

Page 3: Vertical Integration and Vertical Restraints

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.

Page 4: Vertical Integration and Vertical Restraints

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.

Page 5: Vertical Integration and Vertical Restraints

The positive effects of Vertical Integration

Page 6: Vertical Integration and Vertical Restraints

Vertical Integration: Competitive Wholesaler (w), Monopolist Retailer (r)

Pr

P

Q

Pw

MRrDr

MCw =Pw

0Q

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

Page 7: Vertical Integration and Vertical Restraints

Vertical Integration: Monopolist Wholesaler (w), Competitive Retailer (r)

Pr=Pw

P

Q

MRwDr=Dw

MCw

0Q

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.

Page 8: Vertical Integration and Vertical Restraints

Vertical Integration: Monopolist Wholesaler (w), Competitive Retailer (r)

Pr=Pw

P

Q

MRwDr=Dw

MCw

0Q

Again, there is no difference between vertical separation and vertical integration. So vertical integration would only maintain market power.

Page 9: Vertical Integration and Vertical Restraints

Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r)

Pw

P

Q

MRr =DwDr

MCw

0

MRw

MCr

Pr

Because w knows r will restrict output to its MRr the demand curve of w = MRr.

Page 10: Vertical Integration and Vertical Restraints

Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r)

Ws demand is determined by anticipation about downstream demand.

Pw

P

Q

MRr =DwDr

MCw

0

MRw

MCr

Pr

Page 11: Vertical Integration and Vertical Restraints

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.

Pw

P

Q

MRr =DwDr

MCw

0

MRw

MCr

Pr

Page 12: Vertical Integration and Vertical Restraints

Vertical Separation: Monopolist Wholesaler (w), Monopolist Retailer (r)

Pw

P

Q

MRr =DwDr

MCw

0

MRw

MCr

Pr

Consumer Surplus

Profit for retailer

Profit for wholesaler

Page 13: Vertical Integration and Vertical Restraints

Vertical Integration: Monopolist Wholesaler (w), Monopolist Retailer (r)

Pw

P

Q

MRr =DwDr

MCw

0

MRw

MCr

Pr

By vertically integrating the firm would consider the internally evaluated marginal cost of the wholesale product to be MCw not Pw.

Consumer surplus

Abnormal Profit

Page 14: Vertical Integration and Vertical Restraints

The positive effects of Vertical Restraints

Page 15: Vertical Integration and Vertical Restraints

Maximum Resale Price maintenance

Many products sold by manufacturers require a pre-sales service to avoid the Free Riding Problem

Page 16: Vertical Integration and Vertical Restraints

Insufficient Promotional Services

Pw =Pr

P

Q

MRwD (P,0)

MCw

0Q

Monopolists Wholesaler’s profits if competitive retailers provide no services

Retailers have no incentive provide services - they only earn a normal profit.

Page 17: Vertical Integration and Vertical Restraints

Insufficient Promotional Services

P*

P

Q

MR(P, S*)D (P,S*)

MCw = ACw

0Q

MCr = ACrPw

Wholesaler’s profits if retailers provide the optimal level of services.

Maximum Price reflects pre-sales services per unit

MCr + S*

Page 18: Vertical Integration and Vertical Restraints

The welfare impact of servicesP

Q

D(P, 0)

MCw = ACw

0

Pw = MCr =ACrPw=Pns

Qns

A

C

B

With no service combined consumer and producer surplus = A+B+C

Page 19: Vertical Integration and Vertical Restraints

The welfare impact of services

P*

P

Q

D(P, 0)D (P,S*)

MCw

0Q

Pw = MCrPw=Pns

MCr + S*A

Qns

C

B

F

D

E

Services shift demand. Consumer surplus changes by D - B. Producer surplus increases by F.

Net Effect depends on the size of B

Page 20: Vertical Integration and Vertical Restraints

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

Page 21: Vertical Integration and Vertical Restraints

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

Page 22: Vertical Integration and Vertical Restraints

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