vertical integration and vertical restraints
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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 PresentationTRANSCRIPT
Vertical Integration and Vertical Restraints
By Kevin Hinde
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.
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.
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.
The positive effects of Vertical Integration
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
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.
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.
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.
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
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
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
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
The positive effects of Vertical Restraints
Maximum Resale Price maintenance
Many products sold by manufacturers require a pre-sales service to avoid the Free Riding Problem
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.
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*
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
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
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
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
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