ECONOMICS 3200M Lecture 15 March 15, 2005

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ECONOMICS 3200MLecture 15March 15, 2005
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Networks

• Strategic use of tie-in sales and product design
• Product compatibility reduces price competition
• Tipping point for networks if one network
  overtakes another in terms of size, the other may
  become insignificant
• VHS and Beta formats for video recording
• Apple and DOS operating systems
• Plasma vs. LCD for flat screen TVs
• Sony (Play Station), Microsoft (X-box), Nintendo
• Use standard setting process to gain advantage
  for one technology/network
• Announcements of future product availabilities
  (software) compatible with a technology
• Switching costs incentive to develop new
  products/services which appeal to new customers
  because existing customers locked in
• Upgrades software

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Pricing

• Market power short-term, longer-term
• Product characteristics commodity vs.
  differentiated network
• Basis for competition
• Cooperative behavior
• Market segments ability to price discriminate
• Uncertainty re. demand curve (position, shape)
  competitors responses costs
• Complementary goods vertical integration
• Consumer information re. quality, reliability
  (lemons model)
• Economies of scale, scope experience curves
• Signaling effects of price
• Competition law

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Vertical Controls

• Vertical controls vertical integration and
  vertical restrictions
• Relationships between upstream and downstream
  firms
• Vertical integration firm participates in more
  than one successive stage of value chain
  (production/distribution chain)
• Advantages of vertical integration
• Internalization
• Lower transactions costs avoid opportunistic
  behavior
• Quality control
• Coordination feeder networks in transportation,
  JIT delivery
• Uncertainty re. prices, availability
• Assure steady supply of key input
• Avoid government restrictions, regulations, taxes
• Regulated utilities and unregulated service
  companies
• Transfer pricing and allocation of profits

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Vertical Controls

• Vertical integration
• Eliminate externalities
• Quantity demanded depends upon P and other
  services provided
• Distribution free riding among distributors
  sub-optimal provision of services (information,
  sales staff and waiting times, promotional
  activities, after sales service (credit, free
  delivery), shelf space
• Maintain reputation for quality by controlling
  distribution
• Downstream retailer provides services
• Q D(P, S)
• S level of services
• Costs to retailer ?(S) per unit of output
• Total service costs Q?(S)
• Vertically integrated solution Max ? P C -
  ?(S) D(P, S)
• Optimal price and service level

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Vertical Controls

• Vertical integration
• Double monopoly
• M has unit costs of C and sells product to R at
  P PM (C) gt C
• R incurs no other costs and sells at PM (P) gt PM
  (C)
• QPM (P) lt QPM (C), so aggregate profits of R
  and M lower than if single monopoly
• If R operates in competitive environment, no
  negative externality for M since PC PM (C)

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P
PM (P)
P
C
D
MR
Q
Q2
Q1
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Vertical Controls

• Vertical integration
• Increase market power foreclose entry, price
  discrimination
• Increase profits when selling product which is
  combined with another input (supplied by
  competitive industry) to produce a final product
  (also sold by competitive industry) variable
  proportions production function problem does not
  arise with fixed proportions P.F
• Without vertical integration, competitive
  industry substitutes other input for input
  supplied by monopolist
• Higher costs for downstream firm because input
  sold by monopolist at P gt MC
• Close distribution channels, lock up key
  suppliers
• Interbrand competition set up own distribution
  network to increase costs of entry
• Fords attempt to buy back dealers in order to
  offset bargaining advantages of large,
  independent dealers

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Vertical Controls

• Vertical restrictions
• Contracts instead of integration transactions
  costs lower than costs of internalization
• Contractual restraints (prices, forms of
  behavior) to approximate outcomes form vertical
  integration at lower costs
• Upstream firm is monopolist selling to downstream
  firm(s) has bargaining advantage

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Vertical Controls

• Vertical restrictions
• Types of contracts
• Franchise fee upstream firm charges downstream
  firm a fixed charge plus a per unit price
• Resale price maintenance upstream firms
  dictates selling price for downstream firm (price
  ceilings, price floors)
• Quantity fixing upstream firm dictates amount
  to be bought by downstream firm (quantity forcing
  if quantity greater than free contracting
  quantity quantity rationing if quantity lower)
• Exclusive territories
• Tie-in sales
• Royalty

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Vertical Controls

• Vertical restrictions
• Chicago School observed vertical restraints
  meant only to improve efficiency of real-world
  vertical relations and not exercise monopoly
  power
• Address externality and free rider problems
• Store with reputation for stocking high quality
  products provides signal to consumers and thus
  helps overcome lemons/moral hazard problems
• If certain of these products available at
  discount store, reputation suffers and store no
  longer as valuable a signal of quality
• Consider case of WalMart
• Cost advantages of vertical integration

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Vertical Controls

• Vertical restrictions
• Consider case of double monopoly
• M charges R a per unit price of C and charges a
  franchise/license fee of ?M PM (C)
• P PM (C) and total profits ?M PM (C)
• Quantity forcing M requires R to buy Q1 units at
  P PM (C)
• Resale price maintenance (RPM) M requires R to
  set a maximum price equal to PM (C)
• If demand at retail level depends upon services
  provided, R may provide sub-optimal level of
  services

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Vertical Controls

• Vertical restrictions
• Case of services provided by downstream
  retailer(s)
• Too high a price and sub-optimal level of
  services
• Franchise fee single monopoly profit
• Quantity forcing sufficient to encourage R to
  charge correct price and provide optimal level of
  services

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Vertical Controls

• Vertical restrictions
• Multiple inputs case M sells product which is
  combined with another input (produced by
  competitive industry) to produce final product
  sold by monopolist
• Franchise fee and unit price set at Ms MC(C)
  no distortion in input use
• Tie-in with RPM M sells both inputs to
  downstream firms, sets prices of both inputs so
  as to not distort relative prices and extract
  monopoly profits
• Royalty on number of units sold with input sold
  at MC
• If final product sold by competitive industry
  franchise fee no longer works because profits 0
  for each of the downstream firms

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P
P2
P1
MC(PM, C)
MC(C, C)
D
MR
Q
Q1
Q2