Documents
Resources
Learning Center
Upload
Plans & pricing Sign in
Sign Out
Your Federal Quarterly Tax Payments are due April 15th Get Help Now >>

Retailer Franchise Agreement

VIEWS: 24 PAGES: 50

Retailer Franchise Agreement document sample

More Info
									     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

								
To top