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Chapter 9:
Vertical Relations
Industrial Organization: Contemporary Theory & Practice
Introduction
• In any market, consumers have to decide
– what brand to buy
• lots of intrabrand competition
– Mattel vs. Hasbro, Clarins vs. Estee Lauder
– where to buy
• retailers specialize in carrying certain brands
– toys; perfume; electronic goods
• For some goods there appear to be restrictions on what is sold where
– Gas; Chevron retailer sells only Chevron gasoline
– new cars; dealers sell only a few brands
• For others there are not
– Many newspapers/magazines sold at same newstand
– Department/discount stores carry many brands
• What explains these differences?
Industrial Organization: Contemporary Theory & Practice
Upstream-downstream relations
• The relationship between manufacturers and retailers is complex
• Affects competition in the market-place
– exclusive dealing restricts competition
• consumers have to travel to different outlets to compare brands
– non-restrictive supply increases competition
• different manufacturers have to compete for retail space
• retailers in much more direct competition
• So the chain from manufacturer to retailer is important
– manufacturers typically not in direct contact with consumers
• exceptions: Dell and its imitators
• How the manufacturer connects with the consumer—whether
through a retailer or not—is important
Industrial Organization: Contemporary Theory & Practice
Manufacturer/retailer relations
• Relations between manufacturers and retailers take many forms
– Profit sharing
– Two-part tarrifs
– manufacturer may want to have an input into
• marketing
• required level of support services
• Pricing, e.g., recommended retail price or resale price
maintenance (RPM)
– Pricing agreements between firms cannot help but
look a bit like collusion
» per se violation of anti-trust laws in the US
» but recommended maximum prices might not be
Industrial Organization: Contemporary Theory & Practice
Vertical restraints
• The complexity of manufacturer/retailer relations inevitably leads to
formal contracts to sort out the rights and responsibilities of each party
• Just as inevitably, such contracts impose some restraints on each side.
• While these restraints may look like restrictions on competition, they
may in fact be beneficial. They may improve efficiency
– in pricing
– In service provision
– In preventing excessive duplication and proliferation of retail
outlets
• The issue then becomes whether such potential efficiency gains will
be realized and if so, whether they will be large enough to overcome
any creation of monopoly power
Industrial Organization: Contemporary Theory & Practice
Vertical restraints and pricing
Double Marginalization Issues: Monopoly
manufacturer and monopoly retailer
Manufacturer makes suits that are sold through
the retailer
Consumer demand for suits: P = 500 - Q/100
Suits cost $20 each to make
Retailer incurs additional cost of $40 per suit sold:
space, labor etc.
The manufacturer sells the suits to the retailer at a
price of r each
Industrial Organization: Contemporary Theory & Practice
This is the
Price (P) The example manufacturer‘s
derived
The retailer‘s demand
500 marginal revenue for the retailer
profit
Demand is $1.21m is MR = 500 - Q/50
390
marginal cost is r + 40
280
MC = MR gives r = 460 - Q/50
r+40 MC The manufacturer‘s marginal
revenue is MR = 460 - Q/25
MR
11,000 Quantity Marginal cost is $20
25,000 50,000
Price (r) MC = MR gives Q = 11,000
460 The suits are wholesaled at $240
The manufacturer‘s
Manufacturer‘s The retailer‘s MC is $280
240
profit is $2.42m
demand He sells 11,000 suits
and prices them at $390 each
20 MR MC
Quantity
11,000
23,000
Industrial Organization: Contemporary Theory & Practice
Vertical restraints
We know from Chapter 8 that a merger of manufacturer
and retailer improves on the foregoing outcome
marginal revenue for the merged
Price
firm
But is such a merger is MR = 500 - Q/50
500 marginal cost is MC = $60
necessary to achieve
Demand these gains? So MC = MR gives suit sales of
22,000
280
The suits are priced at $280 each
Profit of the merged firm is
$4.84 million
60 MC
25,000 50,000 Quantity
22,000
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes
Royalty schemes may seem a better way to link the
interests of the manufacturer and the retailer. But these too
have problems.
Under one possible royalty contract the manufacturer
sells at cost c = $20 to the dealer and then receives a
fraction a of the retailer‘s revenues
The retailer‘s marginal revenue is: = (1 - a)(500Q -2 Q/100)
Equating marginal revenue with the marginal cost of 20 + 40 = 60
yields the retailer‘s profit maximizing output of
3000 This is less than 22,000 for all positive
Q* = 25,000 -
1 - a values of a, i.e., for any scheme under
which the manufacturer earns a profit.
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes (cont.)
As we have just seen, a royalty scheme based on the
manufacturer‘s selling at cost and then claiming some of the
downstream revenues cannot replicate the integrated outcome
There are other possible royalty contracts, though. One
is to give the suits at no charge to the dealer and then again
claim some of the downstream revenue
Now the retailer equates marginal revenue with a marginal
cost of 40: = (1 - a)(500Q - 2Q/100) = 40
At a = 1/3 or
2000 33.33% this will
Solving for Q yields : Q* = 25,000 -
1-a equal 22,000
A royalty rate of 33.33% of total revenues gives the vertically integrated
Industrial Organization: and aggregate & Practice
total output, product price Contemporary Theoryprofit . . . BUT
Royalty Schemes (cont)
With output = 22,000, the retail price is again $280 so the
retailer‘s revenue is $280 x 22,000 = $6.16 million
The manufacturer gets 1/3 of this so her royalty
income is $2.053 million
the manufacturer‘s costs are $20 x 22,000 = $0.440 million
so her net profit from the royalty is $1.61 million.
. This is less than the $2.42 million it earned under the non-
integrated case. The manufacturer‘s royalty scheme has
duplicated the integrated outcome but at the cost of giving away
even more profit to the retailer.
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes (cont.)
As a final scheme we consider the case in which the
manufacturer sells at cost and then sets a royalty that is
simply a fraction of a of the retailer‘s net profits
the retailer‘s profit now is: pR = (1 - a)(500 - Q/100 - 20 - 40)Q
Notice that the factor 1-a now affects both revenues and costs:
So marginal revenue is (1-a)(500Q – 2Q/100) and marginal
cost is (1-a)(20+40).
Equating MR and MC yields the integrated output of Q = 22,000
This type of royalty scheme always works. The royalty rate is set by
negotiation to distribute aggregate profits of $4.84 million
Industrial Organization: Contemporary Theory & Practice
Royalty Schemes (cont.)
• Why are royalty schemes based on profits not more
widespread?
– profits are easy to disguise
• misrepresent costs
• incur additional discretionary costs: travel costs,
entertainment …..
• suppose that retailing incurs fixed costs of F:
marketing, space costs ...
• then the retailer can exaggerate F to negotiate a lower
royalty rate
– revenues are more easily observable
• Are there other mechanisms that work?
Industrial Organization: Contemporary Theory & Practice
Two-Part Pricing
Manufacturer sells Q suits at a total charge of C(Q) = T + rQ
Set r equal to the manufacturer‘s marginal cost of $20 per suit
The retailer‘s profit is: pR = (500 - Q/100 - 20 - 40)Q - T
The retailer‘s marginal revenue is: MR = 500 – 2Q/100
The retailer‘s marginal cost is: MC = 20 + 40 = 60
Equating MR and MC yields Q* = 22,000
Because the fixed charge does not affect marginal calculations, the retailer
chooses the vertically integrated output and sells at the vertically integrated price
Total profit is the vertically integrated profit of $4.84 million
The manufacturer uses the fixed charge T to claim this profit
Industrial Organization: Contemporary Theory & Practice
Two-part pricing (cont.)
Consider how the fixed charge T might be negotiated
Profit with linear
pricing Profit with
If negotiations break down it is reasonable to suppose that thelinear
pricing
Profit with a and
manufacturer zero retailer revert to simple linear pricing
fixed charge
the maximum the retailer will pay is $4.84m- $1.21m = $3.63m
the minimum the manufacturer will accept is $2.42m
There is scope for mutually beneficial negotiation over the fixed charge
Industrial Organization: Contemporary Theory & Practice
Two-Part Pricing (cont)
• How common is a two-part pricing type of scheme?
• When seen as a franchise agreement fairly
common
– fixed charge represents a franchise fee giving the
retailer the right to sell the manufacturer‘s
product
– generates up-front profit for the manufacturer
– so the manufacturer is willing to set a price per
unit near to (at) marginal cost
Industrial Organization: Contemporary Theory & Practice
Resale Price Maintenance
• Double marginalization means that the retailer sets too high
a retail price for the suits
– what if the manufacturer imposes a price on the retailer?
Price set a maximum price of $280 per suit
the retailer will set this price
500 Demand
sales of suits increase to 22,000
390
aggregate profit is $4.84m
280 RPM
what wholesale price should the
manufacturer set for the suits?
must negotiate to redistribute the profits,
60 e.g., a wholesale price of $240 will give all
the profit to the manufacturer
11,000 25,000 50,000 Quantity
22,000 Industrial Organization: Contemporary Theory & Practice
Retail Services (Advanced)
• So far the retailer has been totally passive
– merely an intermediary between manufacturer and consumer
• But retailers can do more than this
– provide additional services: marketing, consumer assistance
• These services increase sales
• This benefits manufacturers
• But offering these services is costly
– provision by retailer related to retailer‘s profit not manufacturer‘s
• And both services and costs are hard for manufacturer to measure
• How does the manufacturer encourage the efficient levels of service
provision by the retailer?
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
Price
Demand
Demand with with The provision of retail
retail s1
retail servicesservices services increases demand
s2 > s 1
But the provision of retail
D(s2) services is costly for the
D(s ) retailer: f(s) per unit sold
1
Quantity (Q)
Suppose the wholesale price is r
$
The retailer‘s marginal cost
f(s)
is r+f(s)
What level of services will
be provided by the retailer?
Services (s)
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
Efficiency is most likely if the retailer and manufacturer
are vertically integrated
suppose that consumer
Price demand is Q = 100s(500 - P)
Demand with
Note: higher s (more service)
retailDemand with
services
500 raises demand
s=1
retail services assume that marginal costs
s=2 for manufacture are cm and
for the retailer are cr
the integrated firm‘s profits are
pI = (P-cm-cr-f(s))100s(500 - P)
Quantity (‗000)
50 100
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
Profit of the integrated firm: pI = (P- cm - cr - f(s))100s(500 - P)
The integrated firm sets P and s to maximize profits
Cancel the
100s terms
pI/P = 100s(500 - P) - 100s(P - cm - cr - f(s)) =Cancel the
0
100(500 - P)
500 - 2P + cm + cr + f(s) = 0
terms
P* = (500 + cm + cr + f(s))/2
This equation gives
pI/s = 100s(500 - P)(P - cm - cr - f(s)) - 100s(500 -the efficient level
P)f‘(s) = 0
(P - c - c - f(s)) = sf‘(s) of retail services
m r
Substitute the first equation into the second and simplify
(500 - cm - cr)/2 - f(s)/2 = sf‘(s)
(500 - cm - cr)/2 = f(s)/2 + sf‘(s)
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.) hand side is
The right
increasing in s
(500 - cm - cr)/2 = f(s)/2 + sf‘(s)
Initial manufacturing
$ Suppose that there is an
f(s)/2 + sf‘(s)
and retail costs
increase in marginal costs,
apart from services, at either
(500-cm-cr)/2
Let c’ and c’r level
the manufacturingmor retail be new
marginal costs
The rise in cost leads
(500-c‘m-c‘r)/2 to a fall in the
optimal choice of s
from s* to ŝ
s
ŝ s*
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
Suppose for example that cm = $20, cr = $30 and f(s) = 90s2
the equation (500 - cm - cr)/2 = f(s)/2 + sf(s) then gives
225 = 45s2 + s180s which gives: 225 = 225s2 s* = 1
P* = (500 + cm + cr + f(s))/2
so P* = 275 + 45s2 P* = $320
And Q = 100s(500 - P) Q* = 18,000
Aggregate profit is (320 - 50 - 90)x18,000 pI = $3.24 million
It turns out that the integrated firm chooses the socially efficient
level of retail services but sets price above marginal cost
This provides our benchmark case
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
Suppose that retailer and manufacturer are independent
The manufacturer sells its suits to the retailer at r per suit
The retailer then sets retail price and service level to maximize profits
Cancel the
Profit of the retailer = (P- r - cr - f(s))100s(500 - P) - P)
is: pR 100(500
The retailer sets P and s to maximize profits terms
p R/P = 100s(500 - P) - 100s(P - r - c - f(s)) = 0
r Cancel the
500 - 2P + r + cr + f(s) = 0 100s terms
PR = (500 + r + cr + f(s))/2
pR/s = 100(500 - P)(P - r - cr - f(s)) - 100s(500 - P)df(s)/ds = 0
(P - r - cr - f(s)) = sf(s)
which together gives: (500 - r - cr)/2 = f(s)/2 + sf(s)
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
The manufacturer will
(500 - r - cr)/2 = f(s)/2 + sf(s) set the suit price at greater
$
f(s)/2 + sf(s) than marginal cost:
r > cm
(500-cm-cr)/2
This is the retailer’s
choice of s at
(500- r - cr)/2 The retailer provides too
wholesale price r
low a level
The efficient of support
services
choice of s
s
sr s*
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
• The only way that the manufacturer makes profit is by
setting wholesale price greater than cost
• This squeezes the profit margin of the retailer
• The retailer marks up the wholesale price
• but also the retailer cuts back on support services
– takes account only of the impact on his own profits
– ignores the beneficial external effect on the
manufacturer
• Can we get the vertically integrated outcome without
integration?
– royalty
– two-part tariff
– RPM
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
• As before, royalty on retailer‘s profit could work
– suits provided at cost so no distortion in service provision
• But problems of monitoring retailer‘s profits are now even
more severe
– Retailer can exaggerate cost of service provision
• What about a two-part tariff?
– manufacturer sets a charge C(Q) = T + r.Q with r = cm
Profit of the retailer is: pR = (P- cm - cr - f(s))100s(500 - P) - T
Maximizing with respect to P and s gives the integrated outcome!
The manufacturer and retailer then bargain over the franchise fee
A two-part tariff achieves the efficient level of service provision
Industrial Organization: Contemporary Theory & Practice
Retail services (cont.)
• What about RPM?
– The manufacturer could impose a retail price of P*
– But to make a profit he must set a unit price of r > cm
– This squeezes the retailer‘s profit margin
– So the retailer reduces the service level
• RPM does not work
• What happens if the retail sector is competitive?
Industrial Organization: Contemporary Theory & Practice
A Competitive Retail Sector
• Suppose the retail sector is competitive
– large number of identical retailers
– each buys suits from the manufacturer at r and incurs service
costs per unit of f(s) plus marginal costs cr
– competition in retailing drives retail price to PC = r + cr + f(s)
– competition also drives retailers to provide the level of services
most desired by consumers subject to retailers breaking even
– so each retailer sets price at marginal cost
– and chooses the service level that maximizes consumer surplus
Industrial Organization: Contemporary Theory & Practice
Competitive retail services (cont.)
Demand is Q = 100s(500 - P)
suppose the service level for
Gain in each firm is s1
consumer competition gives P1 = r+cr+f(s1)
Price surplus
consumer surplus is shaded area
500 Loss of
Now increase service level to s2
consumer
Demand
Demand with with price rises to P2 = r+cr+f(s2)
surplus
r+cr+f(s2) retail retail services there is both a gain and a
services
r+cr+f(s1) s1 s2 loss in consumer surplus
these have to be balanced in
the choice of s
50s1 50s2 Quantity (‗000)
Industrial Organization: Contemporary Theory & Practice
Multiplied by half the
Height of (cont.)
Competitive retail servicesthe triangle
base of
the triangle
Demand is Q = 100s(500 - P) and P = r + f(s)
Consumer surplus is CS = (500 - P) x Q/2 = 50s(500 - P)2 term
Cancel the common
= 50s(500- r-cr-f(s))2 - f(s))
50(500 - r - cr
Price To maximize CS with respect to s:
500 CS/s = 50(500-r-cr-f(s))2
-100s(500-r-cr-f(s))f(s) = 0
so 500 - r - cr - f(s) = 2sf(s)
P = r+cr+f(s)
(500 - r - cr)/2 = f(s)/2 + sf(s)
Quantity (‗000) This equation gives
Q 50s1 the competitive level
of
Industrial Organization: Contemporary Theory & Practice retail services
Competitive retail services (cont.)
(500 - r - cr)/2 = f(s)/2 + sf(s)
$ For the manufacturer
f(s)/2 + sf(s) to make a profit
requires r > cm
(500 - cm - cr)/2
Retail competition gives
This is the competitive
too low a level of support
of s given a
choice This is the efficient
(500 - r - cr)/2 services
choice r
wholesale cost of s
s
sC s*
Industrial Organization: Contemporary Theory & Practice
Competitive retail services (cont.)
• Why the low provision of retail services?
– increased services has three effects
• higher retail demand and increased consumer surplus
• higher retail prices and reduced consumer surplus
• higher wholesale demand and increased profits to the
manufacturer
– the competitive retailers ignore the third effect
• it is an externality that does not affect them directly
• Can the manufacturer correct this?
– two-part tariff C = T + rQ
• for this to be efficient r = cm
• but then competition between retailers destroys their profits
• so T = 0 and the manufacturer makes no profit
Industrial Organization: Contemporary Theory & Practice
Competitive retail services (cont.)
• What about RPM?
• This is a possibility but it is complicated
– require retailers to sell at P = P*
• Sell to the retailers at a wholesale price r such that
• margin over cost P* - r - cr
• equals cost of optimal level of services f(s*)
– In our example
• set RPM = P* = $320
• set r so that r = P* - cr - f(s*) = 320 - 30 - 90 = $200
• competition in retailing results in s* = 1 as required
• But does the manufacturer have the necessary information?
– manufacturer may not know cost of service provision
– cost especially difficult to know since retailers are not identical
Industrial Organization: Contemporary Theory & Practice
Further Aspects of RPM
• Manufacturing and retailing are complementary
– separate operation is inefficient
– contractual arrangements can improve efficiency
– RPM is one such arrangement
• but it is controversial
• generally treated as in violation of anti-trust laws
– should re-examine this view
– RPM may offer benefits
• to prevent free-riding on support services of some
retailers
• to help cope with variable demand
Industrial Organization: Contemporary Theory & Practice
RPM & Customer Service
• Many services are informational
– choice of high-tech equipment
– fashion clothing
– wine
• These services are costly
– no obligation on consumer to buy from particular
retailer
– discount stores can free-ride on retailer‘s services
– so retailers cut back on services
– manufacturers lose out
• RPM potentially offers a correction
– freeze price discounting
– gives retailers who provide services an edge
Industrial Organization: Contemporary Theory & Practice
RPM and Variable Demand
• Another justification for RPM has been recently suggested
– to cope with variable demand and competitive retailing
– retailer facing uncertain demand has to balance
• how to meet demand when demand is strong
• how to avoid unwanted inventory when demand is weak
– monopoly retailer behaves differently from competitive
• monopolist throws away inventory when demand is weak to
avoid excessive price fall
• competitive retailer will sell it
– believes that he is small enough not to affect the price
• retailing competition causes sharp price cuts if demand is weak
– reduces the profit of the manufacturer
– makes competitive firms reluctant to hold inventory
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand
• RPM can correct this
– in periods of low demand retailers act just like an
integrated firm
• throw away excess inventory
• do not dump it on the market
• An example
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
Suppose that demand is high, DH with probability 1/2
And that demand is low, DL with probability 1/2
Marginal costs are assumed constant at c
Price
Integrated firm has to choose in each period
stage 1: how much to produce
DH stage 2: knowing demand - how much to sell
since costs are sunk: maximize revenue
DL
c MC
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
Price anintegrated firm will not produce
more than QUpper
and will not produce less than QLower
the integrated firm will produce Q*
DH
How is Q*
MCdetermined
MC = MR with = MR with
DL
high demand
low demand
c MC
MRL MRH
QLower Q* QUpper
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
if demand is high the firm sells Q* at
price PMax: MR = MR*H
if demand is low selling Q* is excessive
Price the firm maximizes revenue by
selling Q*L at price PMin: MR = 0
Revenue with expected marginal revenue is:
high demand MR*H/2 + 0 = MR*H/2
DH
PMax Revenue with Q* is such that expected MR = MC
low demand so MR*H/2 = c
PMin DL Expected profit is
MR*H pI = PMaxQ*/2 + PMinQ*L/2 - cQ*
c MC
MRL MRH
Q*L Q*
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
Suppose that Will
competitive retailers stock the optimal
retailing is amount Q*? What will happen if they do?
competitive
Price if demand is high the retail firms sell
Q* at price PMax: MR = MR*H
Revenue with if demand is low each firm will sell more
high demand so long as price is positive
DH
so, if demand is low competitive retailers
PMax
keep selling until they sell the total quantity
DL QL at which price is zero
revenue is therefore zero in low demand
periods if competitive firms stock Q*
c MC
MRL MRH
QL Q*
Quantity
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand
If competitive retailers stock Q*, their expected net revenue is thus:
PMaxQ*/2 + 0 = PMaxQ*/2
Since competitive firms just break even, this means that the
manufacturer can charge a wholesale price PW such that:
PWQ* = PMaxQ*/2 which gives PW = PMax/2
The manufacturer‘s profit is then:
pM = (PMax/2 - c)Q*
This is much less than the integrated profit: the
competitive retailers sell too much in low demand periods
An RPM agreement can fix this
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand illustrated
the integrated firm never sells at a
price below PMin
so set a minimum RPM of PMin
Price
In high demand periods Q* is sold
at price PMax
In low demand periods the RPM
DH agreement ensures that only Q*L is
PMax sold
Expected revenue to the retailers is
PMin DL PMaxQ*/2 + PMinQ*L/2
MR*H
c MC
MRL MRH
Quantity
Q*L Q*
Industrial Organization: Contemporary Theory & Practice
RPM and variable demand
Expected net revenues of retailers is
PMaxQ*/2 + PMinQ*L/2
So the manufacturer can charge a wholesale price PW such that:
PWQ* = PMax.Q*/2 + PMinQ*L/2
which gives PW = PMax/2 + PMinQ*L/2Q*
The manufacturer‘s profit is
pM = PMaxQ*/2 + PMinQ*L/2 - cQ*
This is the same as the integrated profit
The RPM agreement has given the integrated outcome
This can benefit consumers by encouraging retailers to stock
products with variable demand that would otherwise not be stocked.
Industrial Organization: Contemporary Theory & Practice
Exclusive Territories
• Gives a retailer the sole right to sell a good in a particular
territory
• Prevents the manufacturer from opening too many outlets
• Encourages retailer to provide support services
– inhibits the ability of discount stores to free ride
• Allows the manufacturer to control entry to a market
• Usually see exclusive territories associated with franchise
fee arrangements
• This kind of arrangement may enhance efficiency: remove
double marginalization
• But it may also reduce efficiency
Industrial Organization: Contemporary Theory & Practice
dealing and
ExclusiveSuppose there are competition
2 suppliers of
1 What if the suppliers
Suppliercompeting products Supplier 2
Price
offer an exclusive competition
territory? by the retailers
drives price to
Price competition marginal cost
by the suppliers
drives price to
marginal cost
Retailers Suppose that
there are several
retailers
Consumers
Industrial Organization: Contemporary Theory & Practice
and
Exclusive dealing supplierscompetition
And the
Suppose suppose the
divide give into
suppliersretail exclusive
Supplier 1 territories to the
two regions Supplier 2
same retailers
Retailers
Each lucky retailer Consumers 2
is now a local
Consumers 1
monopolist
Industrial Organization: Contemporary Theory & Practice
Exclusive Territories/Dealing
• The potential for inefficiency is that this arrangement can create
local monopolies with the usual distortions
• Exclusive dealing agreements whereby the retailer is constrained
to carry the brand of one manufacturer can are similar
– advertising and promotion have public good qualities and can
lead to free-riding problems
– brand-name manufacturer advertising creates demand not just
for that brand but for all such goods including generic types
– retailer may make higher margins on the generic type and so
―suggest‖ that this is the one to buy
• Exclusive dealing is intended to prevent this type of free-riding
but, as noted, can reduce price competition much like exclusive
territories
• Exclusive dealing also increases possibility of foreclosure
– Coca-Cola‘s arrangements with bottlers
Industrial Organization: Contemporary Theory & Practice
Franchising and Divisionalization
Why Are There So Many Franchisees? Why do Firms Operate
Different Divisions?
Recall the Merger Paradox.
In a Cournot or quantity competition setting, the merger of two firms
makes those firms worse off and remaining firms better off
Why? Because the two merged firms act as one. If there were originally
6 firms and two merge, these two firms are now one of five whereas
they were two of six. That is, the merged firms now constitute just one-
fifth of the independent decision making units instead of one-third.
This is the intuition behind divisionalization. By operating
different divisions or franchises, a single firm avoids the
problem raised by the merger paradox
But with each firm doing this, the industry becomes populated
with many divisions and franchises—perhaps more than is
consistent with either joint profit maximization or efficiency
Industrial Organization: Contemporary Theory & Practice
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