Industrial Organization I

1
Industrial Organization I

• Vertical Structures (II)

2
Vertical Structure

• What is different about Vertical Separation?
• Manufacturer does not control all variables
  directly (e.g. promotion, quality, service,
  price)
• Inefficiencies
• If both upstream and downstream firms have some
  market power, solution is inefficient (double
  marginalization)
• Contract costs, monitoring, negotiation,
  opportunistic behavior.
• Retailers objectives may not be aligned with
  manufacturers

3
Vertical Structure

• Inefficiencies double marginalization

A
B
Pr
C
D
PwCr
PwPVI
Dr (Demand)
E
F
G
Cw
Dr
MRrDw
MRw
Q
QVS
QVI
4
Solutions to Double Marginalization

• Franchise fees
• Upstream firm sets pwc
• Downstream sets prpiv
• Upstream firm charges franchise fee
• Resale Price Maintenance (RPM)
• Upstream firm forces downstream firm to charge
  the VI price
• Quantity is set at the VI level

5
Franchise Fee

A
B
PVI
Demand
E
G
PwCwCr
MRwMRr
Q
QVI

• Franchise fee PVIBEG

6
Franchise Fee

• Retail price and quantity correspond to VI
  solution
• Downstream unit generates zero profit
• Total welfare increases
• Examples
• McDonalds, Starbucks

7
Resale Price Maintenance

?r
?w
RPMPVI
Pw
c
Demand
MR
Q
QIV

• Downstream firm sells at PVI
• Upstream firm sets Pw between c and PVI
• Profits are split based on Pw location

8
Agency and Efficiency Problems
Manufacturer (Upstream)
Pw
D1
D2
Demand qf(PR)

• Competition among retailers can result in too
  little service or investment
• Service, promotion, quality, are public goods
• Sharing the market may mean less investment (or
  none at all)

9
Agency and Efficiency Problems

• Opportunistic behavior
• Downstream firm can use upstreams investment in
  other activities (e.g. selling more profitable
  brands)
• Upstream firm under-invests because of free
  riding problem

10
Agency and Efficiency Problems Solutions

• Exclusive Distribution downstream firm can only
  sell upstreams products (not those of the
  competition)
• Exclusive Territories downstream firm is granted
  a monopoly within a predetermined geographic
  region (not allowed to sell anywhere else)
• For retailers guaranteed radius

11
Exclusive Distribution

• Key Downstream unit must make sure demand is big
  enough
• Solves incentive problem
• Upstream firms investments are protected
  equipment, training, etc
• Downstream firm focuses effort on upstream
  firms products only
• Upstream firm increases investments
• This decreases distribution costs (better
  equipment, training, etc.)
• Enhanced consumer demand

12
Exclusive Territories

• Aligned incentives
• Quality of service is no longer a public good
• Demand level is guaranteed this provides larger
  investment incentives for distributor
• May enhance consumer surplus
• Better service quality stimulates demand
• Wider selection of products
• With no exclusive territories there can be
  under-provision of products

13
Example US Brewing Industry
D
D2
14
Anticompetitive Behavior?

• Contracts may be frowned upon by antitrust
  authorities
• RPM related to price fixing in horizontal case
  upstream firm more market power?
• Exclusive territories may increase downstream
  firms market power by reducing intrabrand
  competition
• Exclusive distribution
• May exclude smaller downstream firms
• Force use of less efficient channels

15
Anticompetitive Behavior?

• However positive effects too
• More efficient downstream firms in the presence
  of exclusive dealing (lower costs from higher
  upstream investment)
• More investment in the presence of exclusive
  territories
• RPM eliminates double marginalization
• Enhanced provision of services (increased
  consumer welfare) with both ET and ED

16
Ambiguous Predictions Exclusive Territories
S
S
S1
S
S0
P1
P0
D
D0
D1
Q0
Q1
Q
Q1
Q
QQ0
17
Ambiguous Predictions Exclusive Dealing
S
S0
P
P1
S
P0
P
D0
D1
Q0
Q1
Q
Q
18
Empirical Evidence Beer in the US

• Exclusive territories are mandated in some
  states, restricted in others
• Exclusive distribution is practiced by several
  brewers, primarily Anheuser-Busch, Miller and
  Coors
• How do these restrictions affect equilibrium
  price and quantity?

19
Data

• IRI Database
• Three-dimensional supermarket scanner data set on
  prices and quantities 37 metropolitan areas, 64
  brands (13 brewers), 20 quarters (1988-1992).
• Product characteristics, market structure,
  demographics, advertising
• Exclusive Territories
• Prohibited, 0/1 IN
• Mandated, 0/1 GA, AL, OH, MI, FL, AR, IL, NC,
  VA, KS
• Exclusive Dealing (Natl Beverage Marketing
  Directory)
• sales carried out by exclusive dealers (
  sales of exclusive dealers/total sales of all
  dealers) By brewer

20
IRI markets definitions
21

• Exclusive Distribution

22
Empirical Strategy

• Reduced form
• Simplest form pf(exclusivity), q(exclusivity)
• Problem endogeneity of ET ED
• Unobserved firm, brand or market conditions could
  affect both price/quantity and choice of
  exclusivity or presence of law
• Even when mandated by law, causality may not be
  uncovered
• Example Higher prices when exclusive
  territories are mandated by law.
• But ET might be less of a legal issue in smaller
  markets
• Price is lower in smaller markets

23
Empirical Strategy

• 3-dimensional structure to control for
  endogeneity
• Caveat
• Time-variant unobservables that affect both
  restraint choice and independent variables
• Alternatively instrument for ET and ED

Endogeneity controls
24
(No Transcript)
25
(No Transcript)
26
Main Results

• Exclusive Territories
• Higher price and higher quantity (either
  voluntary or mandated)
• Evidence of a larger demand increase (enhanced
  services) wrt to less competition (supply
  contraction) welfare increases
• In general, larger brewers show larger welfare
  improvements

27
Main Results

• Exclusive Dealing
• Lower price, larger quantity
• Evidence for both efficiency gains (lower costs)
  and enhanced provision of the good (higher
  demand)
• Welfare exclusive dealing appears to be welfare
  enhancing with little anticompetitive effects.

28
Summary

• VI profitable if
• Double marginalization and transaction costs are
  more important than efficiency gains due to
  specialization
• In case of vertical separation
• Incentive problems arise
• Exclusive territories and exclusive dealing can
  improve profits, specially when incentive
  problems are pronounced.
• Anticompetitive concerns are judged under a rule
  of reason approach.