2. Industrial Organization: Contemporary Theory & Practice Chapter 9: Vertical Relations

3. 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?

4. 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

5. 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

6. 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

7. 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

8. Industrial Organization: Contemporary Theory & Practice The example Price (P) Quantity 500 50,000 Demand  marginal revenue for the retailer is MR = 500 - Q/50 MR 25,000  marginal cost is r + 40 MC r+40  MC = MR gives r = 460 - Q/50 This is the manufacturer’s derived demand This is the manufacturer’s derived demand Price (r) Quantity Manufacturer’s demand 460 23,000  The manufacturer’s marginal revenue is MR = 460 - Q/25 MR  Marginal cost is $20 20MC  MC = MR gives Q = 11,000 11,000  The suits are wholesaled at $240 240  The retailer’s MC is $280 280  He sells 11,000 suits 11,000  and prices them at $390 each 390 The manufacturer’s profit is $2.42m The manufacturer’s profit is $2.42m The retailer’s profit is $1.21m The retailer’s profit is $1.21m

9. Industrial Organization: Contemporary Theory & Practice Vertical restraints  We know from Chapter 8 that a merger of manufacturer and retailer improves on the foregoing outcome Price Quantity 500 50,000  marginal revenue for the merged firm is MR = 500 - Q/50 Demand 25,000  marginal cost is MC = $60 MC 60  So MC = MR gives suit sales of 22,000 22,000  The suits are priced at $280 each 280  Profit of the merged firm is $4.84 million But is such a merger necessary to achieve these gains?

10. 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  of the retailer’s revenues The retailer’s marginal revenue is: = (1 -  )(500Q -2 Q/100)  Equating marginal revenue with the marginal cost of 20 + 40 = 60 yields the retailer’s profit maximizing output of Q* = 25,000 - 3000 1 -  This is less than 22,000 for all positive values of , i.e., for any scheme under which the manufacturer earns a profit.

11. 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 -  )(500Q - 2Q/100) = 40  Solving for Q yields :Q* = 25,000 - 2000 1 -  At  = 1/3 or 33.33% this will equal 22,000 A royalty rate of 33.33% of total revenues gives the vertically integrated total output, product price and aggregate profit... BUT A royalty rate of 33.33% of total revenues gives the vertically integrated total output, product price and aggregate profit... BUT

12. Industrial Organization: Contemporary Theory & Practice 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 . 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.  so her net profit from the royalty is $1.61 million.

13. 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  of the retailer’s net profits the retailer’s profit now is:  R = (1 -  )(500 - Q/100 - 20 - 40)Q Notice that the factor 1-  now affects both revenues and costs: So marginal revenue is (1-  )(500Q – 2Q/100) and marginal cost is (1-  )(20+40). This type of royalty scheme always works. The royalty rate is set by negotiation to distribute aggregate profits of $4.84 million This type of royalty scheme always works. The royalty rate is set by negotiation to distribute aggregate profits of $4.84 million Equating MR and MC yields the integrated output of Q = 22,000

14. 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?

15. 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:  R = (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

16. Industrial Organization: Contemporary Theory & Practice Two-part pricing (cont.) the maximum the retailer will pay is$4.84m- $1.21m  Consider how the fixed charge T might be negotiated  If negotiations break down it is reasonable to suppose that the manufacturer and retailer revert to simple linear pricing Profit with a zero fixed charge Profit with a zero fixed charge Profit with linear pricing Profit with linear pricing = $3.63m the minimum the manufacturer will accept is$2.42m Profit with linear pricing Profit with linear pricing There is scope for mutually beneficial negotiation over the fixed charge

17. 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

18. 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 Quantity 500 50,000 Demand 25,000 RPM 280 11,000 390  set a maximum price of $280 per suit  the retailer will set this price  sales of suits increase to 22,000 22,000 60  aggregate profit is $4.84m  what wholesale price should the manufacturer set for the suits?  must negotiate to redistribute the profits, e.g., a wholesale price of $240 will give all the profit to the manufacturer

19. 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?

20. Industrial Organization: Contemporary Theory & Practice Retail services (cont.)  The provision of retail services increases demand Price Quantity (Q) D(s 1 ) D(s 2 ) Demand with retail services s 1 Demand with retail services s 1 Demand with retail services s 2 > s 1 Demand with retail services s 2 > s 1  But the provision of retail services is costly for the retailer:  (s) per unit sold $ Services (s)  (s)  What level of services will be provided by the retailer?  The retailer’s marginal cost is r+  (s)  Suppose the wholesale price is r

21. Industrial Organization: Contemporary Theory & Practice Retail services (cont.)  Efficiency is most likely if the retailer and manufacturer are vertically integrated  suppose that consumer demand is Q = 100s(500 - P) Price Quantity (‘000) 500 50 Demand with retail services s = 1 Demand with retail services s = 1 100 Demand with retail services s = 2 Demand with retail services s = 2  assume that marginal costs for manufacture are c m and for the retailer are c r  the integrated firm’s profits are  I = (P-c m -c r -  (s))100s(500 - P)  Note: higher s (more service) raises demand

22. Industrial Organization: Contemporary Theory & Practice Retail services (cont.)  I = (P- c m - c r -  (s))100s(500 - P)  Profit of the integrated firm:  The integrated firm sets P and s to maximize profits  I /  P = 100s(500 - P) - 100s(P - c m - c r -  (s)) = 0 Cancel the 100s terms Cancel the 100s terms  500 - 2P + c m + c r +  (s) = 0  P* = (500 + c m + c r +  (s))/2  I /  s = 100s(500 - P)(P - c m - c r -  (s)) - 100s(500 - P)  ’(s) = 0 Cancel the 100(500 - P) terms Cancel the 100(500 - P) terms  (P - c m - c r -  (s)) = s  ’(s)  Substitute the first equation into the second and simplify  (500 - c m - c r )/2 -  (s)/2 = s  ’(s)  (500 - c m - c r )/2 =  (s)/2 + s  ’(s) This equation gives the efficient level of retail services This equation gives the efficient level of retail services

23. Industrial Organization: Contemporary Theory & Practice Retail services (cont.)  (500 - c m - c r )/2 =  (s)/2 + s  ’(s) The right hand side is increasing in s The right hand side is increasing in s $ s  (s)/2 + s  ’(s) (500-c m -c r )/2 s* Let c’ m and c’ r be new marginal costs Suppose that there is an increase in marginal costs, apart from services, at either the manufacturing or retail level (500-c’ m -c’ r )/2 ŝ The rise in cost leads to a fall in the optimal choice of s from s* to ŝ Initial manufacturing and retail costs

24. Industrial Organization: Contemporary Theory & Practice Retail services (cont.)  Suppose for example that c m = $20, c r = $30 and  (s) = 90s 2 the equation (500 - c m - c r )/2 =  (s)/2 + s  (s) then gives 225 =45s 2 + s180swhich gives:225 = 225s 2  s* = 1 P* = (500 + c m + c r +  (s))/2 so P* = 275 + 45s 2  P* = $320 And Q = 100s(500 - P)  Q* = 18,000  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  Aggregate profit is (320 - 50 - 90)x18,000   I = $3.24 million

25. 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  R = (P- r - c r -  (s))100s(500 - P)  Profit of the retailer is:  The retailer sets P and s to maximize profits  R /  P = 100s(500 - P) - 100s(P - r - c r -  (s)) = 0 Cancel the 100s terms Cancel the 100s terms  500 - 2P + r + c r +  (s) = 0  P R = (500 + r + c r +  (s))/2  R /  s = 100(500 - P)(P - r - c r -  (s)) - 100s(500 - P)d  (s)/ds = 0 Cancel the 100(500 - P) terms Cancel the 100(500 - P) terms  (P - r - c r -  (s)) = s  (s) which together gives : ( 500 - r - c r )/2 =  (s)/2 + s  (s)

26. Industrial Organization: Contemporary Theory & Practice Retail services (cont.)  (500 - r - c r )/2 =  (s)/2 + s  (s) $ s  (s)/2 + s  (s) (500-c m -c r )/2 s* This is the retailer’s choice of s at wholesale price r This is the retailer’s choice of s at wholesale price r (500- r - c r )/2 The efficient choice of s The efficient choice of s The manufacturer will set the suit price at greater than marginal cost: r > c m srsr The retailer provides too low a level of support services

27. 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

28. 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 = c m  R = (P- c m - c r -  (s))100s(500 - P) - T Profit of the retailer is: 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

29. 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 > c m –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?

30. 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  (s) plus marginal costs c r –competition in retailing drives retail price to P C = r + c r +  (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

31. Industrial Organization: Contemporary Theory & Practice Competitive retail services (cont.)  Demand is Q = 100s(500 - P)  suppose the service level for each firm is s 1 Price Quantity (‘000 ) 500 50s 1 Demand with retail services s 1 Demand with retail services s 1 50s 2 Demand with retail services s 2 Demand with retail services s 2  competition gives P 1 = r+c r +  (s 1 ) r+c r +  (s 1 )  consumer surplus is shaded area  Now increase service level to s 2  price rises to P 2 = r+c r +  (s 2 ) r+c r +  (s 2 )  there is both a gain and a loss in consumer surplus Gain in consumer surplus Gain in consumer surplus Loss of consumer surplus Loss of consumer surplus  these have to be balanced in the choice of s

32. Industrial Organization: Contemporary Theory & Practice Competitive retail services (cont.)  Demand is Q = 100s(500 - P) and P = r +  (s) Price Quantity (‘000) 500 50s 1 P = r+c r +  (s )  Consumer surplus is CS = (500 - P) Height of the triangle Height of the triangle Q x Q/2 Multiplied by half the base of the triangle Multiplied by half the base of the triangle = 50s(500 - P) 2 = 50s(500- r-c r -  (s)) 2  To maximize CS with respect to s:  CS/  s =50(500-r-c r -  (s)) 2 -100s(500-r-c r -  (s))  (s) = 0 so 500 - r - c r -  (s) = 2s  (s)  (500 - r - c r )/2 =  (s)/2 + s  (s) This equation gives the competitive level of retail services This equation gives the competitive level of retail services Cancel the common term 50(500 - r - c r -  (s)) Cancel the common term 50(500 - r - c r -  (s))

33. Industrial Organization: Contemporary Theory & Practice Competitive retail services (cont.) (500 - r - c r )/2 =  (s)/2 + s  (s) $ s  (s)/2 + s  (s) (500 - c m - c r )/2 s* This is the efficient choice of s This is the efficient choice of s (500 - r - c r )/2 For the manufacturer to make a profit requires r > c m For the manufacturer to make a profit requires r > c m sCsC This is the competitive choice of s given a wholesale cost r This is the competitive choice of s given a wholesale cost r Retail competition gives too low a level of support services

34. 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 = c m but then competition between retailers destroys their profits so T = 0 and the manufacturer makes no profit

35. 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 - c r equals cost of optimal level of services  (s*) –In our example set RPM = P* = $320 set r so that r = P* - c r -  (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

36. 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

37. 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

38. 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

39. 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

40. Industrial Organization: Contemporary Theory & Practice RPM and variable demand illustrated  Suppose that demand is high, D H with probability 1/2 Price Quantity DHDH  And that demand is low, D L with probability 1/2 DLDL  Marginal costs are assumed constant at c cMC  Integrated firm has to choose in each period stage 1: how much to produce stage 2: knowing demand - how much to sell since costs are sunk: maximize revenue

41. Industrial Organization: Contemporary Theory & Practice RPM and variable demand illustrated Price Quantity DHDH DLDL cMC  an integrated firm will not produce more than Q Upper MR H Q Upper  and will not produce less than Q Lower Q Lower MC = MR with high demand MC = MR with high demand MC = MR with low demand MC = MR with low demand  the integrated firm will produce Q* Q* How is Q* determined MR L

42. Industrial Organization: Contemporary Theory & Practice RPM and variable demand illustrated Price Quantity DHDH cMC  if demand is high the firm sells Q* at price P Max : MR = MR* H MR H  if demand is low selling Q* is excessive  the firm maximizes revenue by selling Q* L at price P Min : MR = 0 Q* P Max Q* L P Min MR* H  expected marginal revenue is: DLDL MR L MR* H /2 + 0 = MR* H /2  Q* is such that expected MR = MC so MR* H /2 = c Revenue with low demand Revenue with low demand Revenue with high demand Revenue with high demand  Expected profit is  I = P Max Q*/2 + P Min Q* L /2 - cQ*

43. Industrial Organization: Contemporary Theory & Practice RPM and variable demand illustrated Price Quantity DHDH cMC  if demand is high the retail firms sell Q* at price P Max : MR = MR* H MR H Q* P Max DLDL MR L Suppose that retailing is competitive Revenue with high demand Revenue with high demand  if demand is low each firm will sell more so long as price is positive  so, if demand is low competitive retailers keep selling until they sell the total quantity Q L at which price is zero QLQL  revenue is therefore zero in low demand periods if competitive firms stock Q*  Will competitive retailers stock the optimal amount Q*? What will happen if they do?

44. Industrial Organization: Contemporary Theory & Practice RPM and variable demand  If competitive retailers stock Q*, their expected net revenue is thus: P Max Q*/2 + 0 = P Max Q*/2  Since competitive firms just break even, this means that the manufacturer can charge a wholesale price P W such that: P W Q* = P Max Q*/2which gives P W = P Max /2  The manufacturer’s profit is then:    = (P Max /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

45. Industrial Organization: Contemporary Theory & Practice RPM and variable demand illustrated Price Quantity DHDH cMC  the integrated firm never sells at a price below P Min MR H Q* P Max Q* L P Min MR* H DLDL MR L  so set a minimum RPM of P Min  In high demand periods Q* is sold at price P Max  In low demand periods the RPM agreement ensures that only Q* L is sold  Expected revenue to the retailers is P Max Q*/2 + P Min Q* L /2

46. Industrial Organization: Contemporary Theory & Practice RPM and variable demand  Expected net revenues of retailers is P Max Q*/2 + P Min Q* L /2  So the manufacturer can charge a wholesale price P W such that: P W Q* = P Max.Q*/2 + P Min Q* L /2 which gives P W = P Max /2 + P Min Q* L /2Q*  The manufacturer’s profit is    = P Max Q*/2 + P Min Q* 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.

47. 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

48. Industrial Organization: Contemporary Theory & Practice Exclusive dealing and competition Supplier 1Supplier 2 Retailers Consumers Suppose that there are several retailers Suppose there are 2 suppliers of competing products Price competition by the suppliers drives price to marginal cost Price competition by the suppliers drives price to marginal cost Price competition by the retailers drives price to marginal cost Price competition by the retailers drives price to marginal cost What if the suppliers offer an exclusive territory?

49. Industrial Organization: Contemporary Theory & Practice Exclusive dealing and competition Supplier 1Supplier 2 Retailers Consumers 1 Suppose the suppliers divide retail into two regions And suppose the suppliers give exclusive territories to the same retailers Each lucky retailer is now a local monopolist Each lucky retailer is now a local monopolist Consumers 2

50. 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

51. 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