TOPIC 14: VERTICAL RESTRAINTS

Topic 14| Part 2 21 November 2013Date

ANTITRUST ECONOMICS 2013David S. EvansUniversity of Chicago, Global Economics Group

Elisa MariscalCIDE, Global Economics Group

2Overview

Part 1

Vertical Restraints Overview

Single-Monopoly Profit Theorem

Procompetitive Tying Theories

Anticompetitive Tying Theories

Part 2

Vertical Restraints and Efficiency

Using Vertical Restraints to Foreclosure Competition

Multi-Sided Platforms

3 Vertical Restraints and Efficiency

4Resolving Conflicts Among Firms

Firms have “vertical relationships” with each other on a “supply chain” with one being “upstream” and the other “downstream”.

In general what is best for one firm in this relationship may not be best for the other.

Kelloggs would like to sell Cornflakes to Tescos for a price close to the price it is sold in the shops (keeps most price for itself).

Tescos would like to buy Cornflakes from Kelloggs for a price close to its manufacturing cost (keeps most price for itself).

Vertical restraints help resolve these conflicts and thereby reduce “transactions costs”.

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Vertical Restraints Help Resolve ConflictsOverview of Vertical Restraints

Vertical restraints are contracts and agreements that place restrictions on the actions of buyers and sellers in a vertical chain.

One firm may try to influence (restrain) the other through contract terms.

E.g. Kelloggs’ tells Tesco that it can’t charge more than £3.75 for Cornflakes (vertical maximum price fixing).

E.g. Tesco tells Kelloggs that it can’t sell Cornflakes to any other retailer at a lower price.

6Purpose of Vertical Restraints

Overview of Vertical Restraints

Making the profit pie as big as possible by aligning incentives between participants in vertical chain.

Splitting the pie up among members of the vertical chain each of whom would like more of the profits.

As with other business relationships how the pie is split depends on bargaining power, market position, and so forth.

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Major Contract Instruments for Maximizing and Splitting the Pie

Direct methods for determining price—e.g. two-part tariffs.

Indirect methods for determining price—e.g. exclusive territories.

Service and marketing requirements—e.g. aisle placement, displays, exclusivity.

8Direct Pricing Methods

Overview of Vertical Restraints

• Example: 3M give volume discounts for selling many of of its office-supply products.

• (what’s the difference between package sales?).

Non-linear prices (volume discounts, bundled prices).

• Example: McDonald’s sells the right to supply McDonald’s products for a “franchise fee” (partly fixed), and also supplies the inputs (variable).

Two part tariffs (fixed fee+variable price):

9Indirect Pricing Mechanisms

Overview of Vertical Restraints

• Example: British Airlines can only serve Coke. FaceBook only has Microsoft ads

Exclusivity (dealings, territories): The contract specifies exclusivity agreements between the retailer and the producer. It might take different forms as exclusive territory, selective distribution.

• Example: Retailers must sell book for list price.

Resale Price Maintenance (Floor prevents discounts, or ceiling prevents price gouging).

• The contract specifies a fixed quantity the retailer has to buy from the manufacturer; also quantity rationing (the retailer cannot exceed a determined quantity) and minimum quantity requirement (retailer must pay for minimum).

Quantity forcing (quotas):

• The contract requires taking multiple products or to carry a “full line” of manufacturers products.

Bundling or full-line forcing.

10Efficiency Reasons for Vertical Restraints

Pro-Efficiency Reasons for Vertical Restraints

Note: In all these cases firms in a vertical chain could obtain the efficiency through vertical integration; vertical restraints solve market coordination problem through contractual mechanisms that fall short of full integration. Why do firms choose vertical restraints rather than full integration?

Double marginalisation

Sales Effort

Retail Free Riding

Externalities

Risk Sharing

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Pro-Efficiency Reasons for Vertical Restraints

Vertical Restraint and Double Marginalisation

• Two Part Tariff.

• Resale Price Maintenance.

• Quantity forcing.

Vertical restraints might be able to replicate results of vertical merger or encouraging downstream competition, through:

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Pro-Efficiency Reasons for Vertical Restraints

Sell product at manufacturing cost so that the downstream firm sets the “single monopoly” profit-maximizing price.

Recover the full monopoly profit by charging a fee (assumes you can predict optimal output).

Example: Franchise Fee. A company grants the right to sell its product for a fixed fee (equal to monopoly price). Then the product is sold at a price equal to marginal cost.

Two Part Tariff

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Resale price maintenancePro-Efficiency Reasons for Vertical Restraints

Retail Price Maintenance (ceiling).

Set a ceiling price of pm and sell at a price that equals this minus the marginal cost of distribution.

Distributor signs the contract because it at least breaks even.

Distributor charges as much as it can—but this is capped at the profit-maximizing price.

How does quantity forcing achieve the same outcome?.

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Encouraging Optimal Sales Effort

p, effort

c

pw

Consumers Q(p,e)

Suppose higher retailer effort increases sales.

Higher effort increases retailer sales and hence also increases manufacturer sales.

The optimal effort that the retailer makes to sell products does not take account of the increased profits to the manufacturer.

Thus effort is lower compared to integrated firm, but integrated effort may not be social optimum if people have different preferences for services.

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Encouraging Optimal Sales Effort

Consumers Q(p,e)

c

pw

RPM no longer sufficient as distributor doesn’t share at the margin in manufacturer’s profit.

Franchise (two part tariff) works; franchise makes money at the margin but franchisor retrieves in franchise fee.

Quota also works (set q = qm) with penalties for not achieving.

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Retail Free RidingPro-Efficiency Reasons for Vertical Restraints

• Retail competition may prevent provision of information.

• Retailers who don’t provide costly information can free-ride on those that do. (i.e. John Lewis versus Argos).

• At the extreme (with Bertrand competition) no information is ever provided.

Pre-sale information helps sell durable goods (I.e. cameras).

• Exclusive Territories – Commit not to sell to Argos. • RPM (price floors) – Manufacturer sets the lowest

possible retail price to ensure information can still be profitably provided (ie prevent cut-throat competition).

Solutions:

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ExternalitiesPro-Efficiency Reasons for Vertical Restraints

Information creates positive externalities.

Positive retailer externalities (i.e. promotions) not taken into account and not enough sold.

Solutions: Two part tariff—charge the distributor marginal cost so that he acts like he’s the monopolist; then take his profit back through a fixed fee.

18Risk Sharing

Manufacturer

Retailer

Consumers Q(p)

c

T=F + cq

p =RPM

Pro-Efficiency Reasons for Vertical Restraints

Uncertainty and risk aversion can be protected against by two part tariffs or RPM.

Retailer is risk averse, and demand fluctuates.

• Franchise (two part tariff) exposes retailer to all the risk of a change in demand.

• RPM gives perfect insurance with demand fluctuations, as final price is independent of level of demand.

Solutions:

• RPM does not work as cost shocks will squeeze the retailer, and all risk is carried by the downstream firm.

• Franchise (two part tariff) insures retailer against changes in cost.

Retailer is risk averse and cost fluctuates.

19 Using Vertical Restraints to Foreclosure Competition

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Essential Facilities and Monopoly LeveragingUsing vertical restraints to foreclosure competition

The “essential facility doctrine” suggests that a firm may use an indispensable asset to leverage its monopoly from that asset to adjacent markets.

Bridge over river (US Terminal Railroad Association—Joint Venture of railroads owned key bridges).

21Chicago Critique of Monopoly Foreclosure

The Single Monopoly Profit Theorem

M

R1

Consumers

R2

Using vertical restraints to foreclosure competition

A monopoly owner of a bottleneck gets highest profit by charging a monopoly price for bottleneck service. Can’t do any better than that.

He’d prefer competition downstream (because of double marginalisation). And he’d prefer most efficient downstream firms.

Same reasoning applies to any adjacent market that produces a complementary good: more competition and more efficient firms is better for the monopolist because it helps him sell more.

Vertical restraints might be adopted for efficiency reasons but not for anti-competitive reasons. The monopoly profits but in doing so consumers are better off (remember consumers should prefer one monopoly in a chain over two.)

22Summary of Post-Chicago Models

Using vertical restraints to foreclosure competition

Chicago critique doesn’t always hold.

• Get additional monopoly profit in downstream market.• Prevent entry into monopoly market (more later on this topic).• Restore monopoly power.

Foreclosure can be used to:

Monopoly leveraging may reduce social welfare.

• Models find foreclosure anti-competitive only under certain assumptions; Pro-competitive or uncertain under different assumptions.

• empirical studies find little support; but those studies themselves may not be robust.

But the devil is in the details:

23Overview of Empirical Findings

Most studies find evidence that vertical restrains/vertical integration are pro-competitive;

This efficiency often is plausibly attributable to the elimination of double-markups or other cost savings;

A number of studies also find evidence consistent with “dealer services” efficiencies;

Instances where vertical controls were.

Multi-Sided Platforms

25Platforms Need Critical Mass to Ignite

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Critical massCritical mass refers to the minimal set of customers on each side that is large enough to attract more customers and result in sustainable positive feedbackCritical mass depends on scale and balance

Probability of customers from two sets getting together and exchanging value increases with the number of customers on each sidePlatforms implode if they can’t reach critical massIf there aren’t enough customers on the other side the probability of advantageous exchange falls and customers don’t join and the early adopters who have eventually leave

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26Critical Mass, Platform Ignition and Growth

Side A

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In this example the critical mass points are between C’ and C”.

C* is the point that would lead to optimal platform launch.

Points to the NW of the vector 0-C’ and to the SW of vector 0-C” would result result in platform implosion.

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Making It Harder for Rivals to Reach Critical Mass

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These are possibilities. Unclear how significant they are in practice given that rivals have counterstrategies.

• By keeping available demand below the minimal level on either side the new platform cannot reach the critical mass frontier.

Lock enough demand on either side

• By locking up enough demand on both sides the new platform cannot reach the critical mass frontier.

Lock up enough demand on both sides

• By locking up customers that account for a disproportionate share of positive feedbacks, are early adopters, or high value users, or by preempting exclusive deals, the new platform could be prevented from reaching the critical mass frontier

Lock up key assets needed for ignition

28Vertical Restraints that Might Deter Entry

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• Locks up demand on one or both sides of the platform.

Exclusive Deals.

• Discourages customers from using rival platform and therefore engaging in multi-homing or single homing with entrant.

Conditional rebates.

• Behavioral restraints (tying, pricing restrictions, various behavioral restraints, etc.) could raise the cost of committing demand to a rival platform.

Other restraints.

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Some Procompetitive Explanations of Vertical Restraints

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• Customers on side B benefit from knowing that when they use the platform they will be get access to particular customers on side A. Reduces their search and transactions costs.

Exclusivity benefits customers.

• By reducing risk that customers on one side will reduce demand and thereby jeopardize value of the value to all sides the platform is able to make greater sunk cost investments including in innovation.

Exclusivity reduces platform risks.

• Platform may have incurred significant risks in entering in developing customer groups to maximize platform value. Exclusivity agreements prevent copycats from freeriding.

Exclusivity prevents free riding.

• Restrictions on side A customers benefit side B customers by preventing opportunism.

Behavioral restrictions benefit customers.

30Balancing and Some Complexities

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• Impediment depends on the “type” of customers excluded as well as and perhaps more so than sheer volume of demand foreclosure. Could prevent entry by foreclosing some demand on both sides.

Degree of impediment to entry

• Can differentiation enable entry despite exclusive deals by incumbent platforms? Can entrant enter into exclusive deals of its own?

Counter strategies

• Incumbent may have exclusive dealing arrangements as part of entry strategy to deal with critical mass

Stage of competition

• Vertical restraints may benefit customers that are not subject to vertical restraints (e.g. the other side of the platform).

Behavioral restrictions

• Entrant could be powerful platform in adjacent business while incumbent could be successful startup. Difficult to assess impact of antitrust restraints on long run social welfare (Microsoft vs. Netscape).

Incumbent vs. entrant

31Vertical Restraints and Platform Governance

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• Might deter entry, but…• Give customers on other side assurance that when they use the

platform they will get the platform’s products.

Anti-steering/exclusive dealing rules

• Might deter entry, but …• Prevents opportunistic behavior and provides customers price

certainty for platform.

No surcharge rules.

• Might prevent alternative platform from accessing users, but …• Punishes customers on one side from harming customers on the

other side through fraud, deception, and other bad behavior.

Platform exclusion penalties and rules.

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Factors to Consider in Evaluating Vertical Restraints for Platforms

• To what extent do restraints preclude strategies necessary for reaching critical mass and are there effective counterstrategies.

Impact of restraints on achieving critical mass.

• Restraints more likely to be residue of procompetitive strategy and still provide efficiencies in earlier stages.

Platform and Industry Stage of Development.

• Benefits and costs should be evaluated by looking at impact on all customer sides.

Impact on all sides.

• Possible efficiencies from managing positive and negative platform externalities should be considered.

Role in managing externalities

• No reason to believe that the result of economic models that do not consider interdependent demand hold for multisided platforms and results of literature so far show that the results do not in fact hold in important cases.

Robustness of standard economic models.

33End of Part 1, Next Class Part 2

Part 1

Vertical Restraints Overview

Single-Monopoly Profit Theorem

Procompetitive Tying

Explanations

Anticompetitive Tying Strategies

Part 2

Double-Marginalization

Procompetitive VR Justifications

Anticompetitive VR Theories