1. Chapter 13: Vertical Restraints1 Vertical Restraints

2. Chapter 13: Vertical Restraints2 Introduction Many contractual arrangements between manufacturers –Some restrict rights of retailer Can’t carry alternative brands Expected to provide services or to deliver product in a specific amount of time –Some restrict rights of manufacturer Can’t supply other dealers Must buy back unsold goods –Some involve restrictions/guidelines on pricing

3. Chapter 13: Vertical Restraints3 Resale Price Maintenance Resale Price Maintenance is the most important type of vertical price restriction. Under RPM agreement –Retailer agrees to sell at manufactured specified price –RPM agreements have a long and checkered history In US, Dr. Miles case of 1911established per se illegality for any and all such agreements However, Colgate case of 1919 allowed some “wiggle room” Miller-Tydings (1937) and McGuire (1952) Acts even more supportive in allowing states to enforce RPM contracts –Repeal of Miller-Tydings and McGuire Acts reverted legal status back to (mostly) per se illegal –State Oil v. Khan decision in 1997 allowed rule of reason in RPM agreements setting maximum price –Leegin case applies rule of reason to minimum price

4. Chapter 13: Vertical Restraints4 RPM Agreements & Double Marginalization Recall the Double Marginalization Problem –Downstream Demand is P = A – BQ and Retailer has no cost other than wholesale purchase price Downstream Marginal Revenue = MR D = A – 2BQ MR D =Upstream Demand Upstream Marginal Revenue = MR U = A – 4BQ –With Manufacturer’s marginal cost c, profit- maximizing output and upstream price are: – Downstream price is: and

5. Chapter 13: Vertical Restraints5 RPM & Double Marginalization 2 With a vertical chain of a monopoly manufacturer and a monopoly retailer, the downstream price is far too high –There is a pricing externality The manufacturer profit is the wholesale price r – cost c times the volume of output Q [= (r – c)Q] Once r is set, manufacturer’s profit rises with Q In setting a markup over the wholesale price, the retailer limits Q and cuts into manufacturer profit But retailer ignores this external effect –Retail (and wholesale) price maximizing joint profit < Independent retailer’s price

6. Chapter 13: Vertical Restraints6 RPM & Double Marginalization 3 An RPM restriction that prohibits the retailer from selling at any price higher than P* would permit the manufacturer to achieve the maximum profit –There is though an alternative to the RPM, namely a Two-Part Tariff of the type discussed in Chapter 5 Set wholesale price at marginal cost c Retailer will then choose P D = P* = (A + c)/2 and earn profit = (A – c) 2 /4B Charge franchise fee of T = (A – c) 2 /4B

7. Chapter 13: Vertical Restraints7 RPM & Price Discrimination An RPM to prevent double marginalization suggests problem is that the retail price is too high Historical record suggests that perceived problem is often that retail price is too low –Need to find reason(s) for RPM agreements aimed at keeping retail prices high –Retail Price Discrimination may present case where RPM specifying minimum price can help manufacturer

8. Chapter 13: Vertical Restraints8 RPM & Price Discrimination (cont.) Suppose retailer operates in two markets –One has less elastic demand (monopolized) –One has elastic demand (due to potential entrant)—retail price P cannot rise above wholesale price r Manufacturer must use same contract for each –Maximum profit in each market = (A – c) 2 /4B achieved at P* = (A + c)/2 –No single price or single two-part tariff can maximize profit from both markets –Unless r = (A + c)/2 in elastic demand market, P* cannot be achieved since in that market P = r –But there is only one contract, so this implies r = (A + c)/2 in inelastic (monopolized) market and so to double marginalization Solution: write common contract that sets r = c, and imposes RPM minimum price of P=(A+c)/2

9. Chapter 13: Vertical Restraints9 RPM and Retail Services So far the retailer has been a totally passive intermediary between manufacturer and consumer Retailers actually provide additional services: marketing, customer assistance, information, repairs. –These services increase sales –This benefits manufacturers But offering these services is costly, and also –both services and costs are hard for manufacturer to measure –Retailers interested in her profit not manufacturer’s How does the manufacturer provide incentives for retailer to offer services?

10. Chapter 13: Vertical Restraints10 RPM and Retail Services 2 Think of retail services s and shifting out demand curve similar to the way that quality increases shifted out the demand curve in Chapter 6 $/unit Quantity Demand with retail services s = 1 Demand with retail services s = 1 Demand with retail services s = 2 Demand with retail services s = 2 But cost of providing retail services  (s) rises as more services are provided $/unit Service Level s (s)(s)

11. Chapter 13: Vertical Restraints11 RPM and Retail Services 3 As a benchmark, see what happens if manufacturing and retailing are integrated in one firm –suppose that consumer demand is Q = 100s(500 - P) –Note how s shifts out demand –assume that marginal costs are c m for manufacturing and for the c r for retailing –the cost of providing retail services is an increasing function of the level of services,  (s) –the integrated firm’s profit  I is: –  I = [P-c m -c r -  (s)]100s(500 - P)

12. Chapter 13: Vertical Restraints12 RPM and Retail Services 4 The integrated firm has two choices to make: –What price P to charge (what Q to produce); and –The level of retail services s to provide To maximize profit, take derivatives of integrated firm’s profit function both with respect to Q and with respect to s and set each equal to zero Cancel the 100s terms Cancel the 100s terms  I /  P = 100s(500 - P) - 100s(P - c m - c r -  (s)) = 0  500 - 2P + c m + c r +  (s) = 0  P* = (500 + c m + c r +  (s))/2

13. Chapter 13: Vertical Restraints13 RPM and Retail Services 5 Now take the derivative with respect to services s and set it equal to  (P - c m - c r -  (s)) = s  ’(s)  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 Solving we obtain: Substituting the price equation into the service equation then yields:  (500 - c m - c r )/2 =  (s)/2 + s  ’(s) The s that satisfies the above equation gives the efficient (profit-maximizing) level of services

14. Chapter 13: Vertical Restraints14 RPM and Retail Services 6 We can use this equation to show how changes in the production and retailing marginal cost (c m and c r ) affect the optimal level of services $/unit Service Level s  (500 - c m - c r )/2 =  (s)/2 + s  ’(s)  (s)/2 + s  ’(s) (500-c m -c r )/2 s*s* (500-c’ m -c’ r )/2 s** The right hand side is increasing in s The right hand side is increasing in s The left hand side is decreasing in c m and c r The left hand side is decreasing in c m and c r Let c m and c r be initial marginal costs Suppose now that there is an increase in marginal costs, apart from services, at either the manufacturing or retail level Let c’ m and c’ r be new marginal costs The rise in cost leads to a fall in the optimal choice of s from s * to s **

15. Chapter 13: Vertical Restraints15 RPM and Retail Services 7 For example let c m = $20, c r = $30 and  (s) = 90s 2 (P - c m - c r -  (s)) = 180s 2 = 180  P= $320 225 = 45s 2 + s180s ; OR 225 = 225s 2  s = 1 Then, solving for P we obtain: Implying an output level of: Q = 100s(500 - P) = 18,000 The integrated firm earns profit  I = $3.24 million. Then (500 - c m - c r )/2 =  (s)/2 + s  (s) implies It chooses the socially efficient level of retail services but sets price above marginal cost. This is our benchmark case.

16. Chapter 13: Vertical Restraints16 RPM and Retail Services 8 Now let manufacturer sell to monopoly dealer If we assume two-part pricing is not possible, then the only way that the manufacturer can earn profit is by charging a wholesale price r above cost c m – The profit of the retailer is now:   R = (P- r - c r -  (s))100s(500 - P) = (P- r - 30-  s 2 )100s(500 - P) – Retailer sets P and s to maximize retail profit  R /  P = 100s(500 - P) - 100s(P - r - 30 – 90s 2 ) = 0 Cancel the 100s terms Cancel the 100s terms  R /  s = 100(500 - P)(P - r - 30 –  s 2 ) - 100s(500 - P)180s = 0 Cancel the 100(500 - P) terms Cancel the 100(500 - P) terms – P = (530 + r + 90s 2 )/2 – P – r – 30 = 270s 2

17. Chapter 13: Vertical Restraints17 RPM and Retail Services 9 Put the two profit-maximizing conditions together – It is clear that unless r = c m = 20, s will be less than 1, i.e., less than the optimal level of services – Yet absent an alternative pricing arrangement, the manufacturer only earns a positive profit if r > 20. – From the retailer’s perspective, a value of r > 20 is equivalent to a rise in c m and as we saw previously, this reduces the retailer’s optimal service level (500 – r – c r )/2 =  (s)/2 + s  ’(s) OR 225s 2 = 235 – r/2

18. Chapter 13: Vertical Restraints18 RPM and Retail Services 10 Two contracts that might solve the problem are: –A royalty contract written on the retailer’s profit; –A two-part tariff Under a profit-royalty contract, the manufacturer sells at cost c m to the retailer but claims a percentage x of the retailer’s profit –This works because there is no difference between maximizing total retail profit or maximizing (1 – x) of total retail profit – Given that the wholesale cost is c m, the profit-maximizing condition: 235 = 225s 2 + r/2 leads to s = 1, the efficient level of services

19. Chapter 13: Vertical Restraints19 RPM and Retail Services 11 Similarly, a two-part tariff could solve the problem: –Again, sell at wholesale price c m = $20; –As before, this leads to the efficient level of services, namely, s = 1. –Now manufacturer can claim downstream profit (or some part of it) by use of an upfront franchise fee However, both royalty and two-part tariff requires that manufacturer know the retailer’s true profit level. This can be difficult if retailer has inside information on the nature of: –Retailing cost, c r –Retail consumer demand

20. Chapter 13: Vertical Restraints20 RPM and Retail Services 12 Can an RPM solve the problem? –It has the advantage that it is easily monitored –It also addresses the double-marginalization problem –However, it cannot solve the service problem in the present context Without a royalty or up-front franchise fee, manufacturer can only earn profit if r > c m. As we have seen, this in itself leads to a service reduction Imposing a maximum price via an RPM agreement intensifies this fall in service because it reduces the retailer’s margin, P – r, and it is that margin that funds the provision of services

21. Chapter 13: Vertical Restraints21 RPM and Retail Services 13 However, use of an RPM becomes considerably more attractive if retail sector is competitive –large number of identical retailers –each buys 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 –chooses the service level to maximize consumer surplus

22. Chapter 13: Vertical Restraints22 RPM and Retail Services 14 With competition there is no retail markup and no retail profit –P = r + c r +  (s) –Profit royalty and two-part tariff will not work because there is no profit to share or take up front –Given wholesale price r, retailers compete by offering level of services s that maximizes consumer surplus Recall: Demand is: Q = 100s(500 - P) P = r + c r +  (s) Consumer Surplus is therefore: CS = (500 – P)xQ/2 = 50s(500 – P) 2 CS = 50s[500 – r – c r –  (s)] 2

23. Chapter 13: Vertical Restraints23 RPM and Retail Services 15 By way of a diagram, we have: $/unit Quantity (000’s) 500 50s P=r+cr+(s)P=r+cr+(s) Q Triangle = Consumer Surplus. Given r, c r, and  (s), competitive retailers will compete by offering services that maximize this triangle

24. Chapter 13: Vertical Restraints24 RPM and Retail Services 16 We can determine the competitive service outcome for any value of r by maximizing CS = 50s[500 – r – c r –  (s)] 2 with respect to s. This yields   CS/  s = 50(500-r-c r -  (s)) 2 -100s(500-r-c r -  (s))  (s) = 0 Cancel the common term 50(500 - r - c r -  (s)) Cancel the common term 50(500 - r - c r -  (s)) 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 when the manufacturer simply chooses r and lets retailers choose P and s

25. Chapter 13: Vertical Restraints25 RPM and Retail Services 17 Recall: the integrated firm wants to set a price=P* = $320. RPM lets manufacturer impose this price on retailers. With retail price = P* = $320, competitive retailers offer services until they just break even, i.e., until:  (s) = P* – c r – r = 90s 2 = 320 – 30 – r By choosing, r = $200, the competitive service level satisfies: 90s 2 = 90  s = 1 with P = $320 This is the optimal service level and price. The RPM has led to duplication of the integrated outcome

26. Chapter 13: Vertical Restraints26 RPM and Retail Services 18 Consideration of customer services with competitive retailing also gives another reason that RPM agreements may be useful—the free-riding problem. Many services are informational –Features of high-tech equipment –Quality, e.g., wine Providing these services are costly –But no obligation of consumer to buy from retailer –Discount stores can free-ride on retailer’s services –Retailers cut back on services –Manufacturers and consumers lose out RPM agreements prevent free-riding discounters

27. Chapter 13: Vertical Restraints27 RPM and Variable Demand RPM agreements may also be helpful in dealing with variable retail demand Retailer facing uncertain demand has to balance –how to meet demand if demand is strong –how to avoid unwanted inventory if demand is weak monopoly retailer acts differently from competitive –monopolist throws away inventory when demand is weak to avoid excessive price fall –competitive retailer will sell it because he believes that he is small enough not to affect the price Intense retail competition if demand is weak –reduces the profit of the manufacturer –makes firms reluctant to hold inventory

28. Chapter 13: Vertical Restraints28 RPM and Variable Demand 2 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: demand known- how much to sell since costs are sunk: maximize revenue

29. Chapter 13: Vertical Restraints29 RPM and Variable Demand 3 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*Q* How is Q* determined MR L

30. Chapter 13: Vertical Restraints30 RPM and Variable Demand 4 Price Quantity DHDH c MC  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*Q* P Max Q*LQ*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*

31. Chapter 13: Vertical Restraints31 RPM and Variable Demand 5 Price Quantity DHDH c MC  If demand is high the retail firms sell Q* at price P Max : MR = MR* H MR H Q*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?

32. Chapter 13: Vertical Restraints32 RPM and variable demand 6 If competitive retailers stock Q*, their expected net revenue is thus : P Max Q*/2 + 0 = P Max Q*/2 Competitive firms just break even. So, manufacturer can only charge a wholesale price P W such that: P W Q* = P Max Q*/2 which gives P W = P Max /2 The manufacturer’s profit is then:    = (P Max /2 - c)Q* This is well below the integrated profit. Competitive retailers sell too much in low demand periods An RPM agreement can fix this. How?

33. Chapter 13: Vertical Restraints33 RPM and Variable Demand 7 Price Quantity DHDH cMC  Recall: The integrated firm never sells at a price below P Min MR H Q*Q* P Max Q*LQ*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

34. Chapter 13: Vertical Restraints34 RPM and Variable Demand 8 With RPM, expected net revenues of retailers is P Max Q*/2 + P Min Q* L /2 Manufacturer can now charge 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 – Consumers can gain too because retailers now stock products with variable demand that would otherwise not be stocked.

35. Chapter 13: Vertical Restraints35 Nonprice Vertical Restraints Vertical Price Restraints are not the only kinds of vertical restrictions Other common vertical restrictions include –Exclusive Dealing: Manufacturer restricts retailer’s ability to buy and sell brands that compete with the manufacturer’s brand, e.g., Coca-Cola may restrain restaurants or other vendors from selling Pepsi products (Interbrand competition) –Exclusive Selling: Retailer restricts manufacturer from supplying other dealers, e.g., Lexus dealer obtains promise from Toyota not to authorize other Lexus dealers to sell in nearby locations (Intrabrand competition)

36. Chapter 13: Vertical Restraints36 Exclusive Dealing Exclusive Dealing as a way to deal with Free-Riding Advertising and promotion by a manufacturer spills over to raise demand for similar products –Example: advertising Tylenol may raise demand not just for Tylenol but also for non-aspirin pain relievers in general –Pharmacist may respond to inquiries about pain relievers by substituting lower-cost non-aspirin pain reliever Substitute costs less because it did not pay for advertising Substitute manufacturer free-rides on the advertising of Tylenol No manufacturer advertising and so no information provision could be the result—This is inefficient. Exclusive dealing may solve this problem. No spillovers if dealer sells no substitute products

37. Chapter 13: Vertical Restraints37 Exclusive Dealing 2 But exclusive dealing can compound monopoly problem Assume two manufacturers and two retailers –Retailers (1 and 2) are spatially separated by distance M along a line –Consumers are spatially located around a circle at each retail location of radius r –Manufacturer’s (A and B) products located on circle at Given retail locations — Retailer 1 Retailer 2 – M ABAB

38. Chapter 13: Vertical Restraints38 Exclusive Dealing 3 With No Exclusive Dealing, A and B compete at each location Retailer 1 Retailer 2 A B AB M – Substitutes never more than 2r apart – Interbrand Price competition is tough – Retailer 1’s price for B also constrained by availability of A at Retailer 2 M units away

39. Chapter 13: Vertical Restraints39 Exclusive Dealing 4 Exclusive Dealing, A and B at separate locations Retailer 1 Retailer 2 A B M – Interbrand competition greatly reduced – Retailer 1’s price for A less constrained by availability of B at Retailer 2 because this is now – just M+ 4r units away – Both manufacturers and retailers can gain at expense of consumers

40. Chapter 13: Vertical Restraints40 Exclusive Selling and Territories Again, there is a free-riding issue –Service and Promotion may benefit other Sellers, especially nearby ones –Each dealer may try to “free ride” on service and promotion of other retailers with result that no services are provided There is also a price externality –Price cuts by one dealer cut into profits of other dealers –Each dealer considers only the effect on her own profit

41. Chapter 13: Vertical Restraints41 Exclusive Selling and Territories 2 Exclusive Selling/Territories may solve these problems –With other dealers far away, each dealer can get the full benefits of her selling and promotional services –No free riding Intrabrand price competition lowers double marginalization problem. Why should manufacturer’s want to reduce such competition? –Intrabrand price competition can intensify interbrand competition –(Assume no two-part tariffs)Retailers can only pay high wholesale price if they can pass it on at retail level –This requires some monopoly power on part of retailers –Movements in wholesale price now only partly reflected in retail price  Wholesale price competition less intense

42. Chapter 13: Vertical Restraints42 Aftermarkets The Kodak case –Kodak makes micrographic equipment for creating and viewing microfilm as well as office copiers. This is the Foremarket. –Kodak also has a network of technicians who maintain these machines pursuant to separate service and repair contracts –Other, independent service and repair companies compete with Kodak but both independent and Kodak service people rely on Kodak parts –The service and repair market is the Aftermarket. –After losing a big service contract to an independent Kodak initiated a new policy of refusing to supply parts to any independent service company, i.e. foreclosing them –Independents sued, but Kodak’s defense was that it could not leverage its power in the foremarket into power in the aftermarket because rational consumes would look ahead and if they foresaw a higher price in the aftermarket would reduce their willingness to pay in the foremarket

43. Chapter 13: Vertical Restraints43 Aftermarkets 2 The Kodak case (continued) –Kodak ultimately lost the case. –But the issue of using vertical restrictions and there ability of a firm to leverage foremarket power into the aftermarket remains The logic of Kodak’s defense is clear. Forward- looking consumers will incorporate the cost of expected repairs into their willingness to pay for a new machine. But this is not quite the same as saying price will equal marginal cost. –As Borenstein, Mackie-Mason, and Netz (2000) showed, there can be a “lock-in” effect that shields the firm from aftermarket competition –This lock-in gives rise to a potential for supra- competitive pricing

44. Chapter 13: Vertical Restraints44 Aftermarkets 3 Lock-in and aftermarket power –Two producers of machines –Marginal Cost of making and repairing a machine = 0 –Machine runs at most two periods –Consumers value machine services at $50 per period –Machine is 100% reliable in 1 st period 50% breakdown chance in 2 nd period After 1 period of use, consumers are locked in to the technology of whatever brand they bought If there is a breakdown in period 2, it is not worth buying a new machine However, repair worthwhile if done at marginal cost –Expected value of a new machine at start of period 1 (before purchase) is $50 + 0.5($50) = $75

45. Chapter 13: Vertical Restraints45 Aftermarkets 4 Repair would sell at marginal cost if repair was competitive But aftermarket foreclosure prevents this –If a firm prevents any rival from repairing its machine, say by foreclosing parts supply then price of repairs can rise to (just under) $50, –For cohort of new customers who have not bought a machine, the machine is still valued at $75 –For those with a broken machine, paying the repair bill of $50 is now worthwhile even though it would not have been worth it ex ante –Of course, $50 is well above marginal cost Such effects can also arise if some (not necessarily all) consumers are myopic

46. Chapter 13: Vertical Restraints46 Public Policy In the main, public policy toward nonprice vertical restrictions has been dominated by a rule of reason approach In both Europe and North America, however, policy since the 1990’s has applied the rule of reason with a strong presumption that the restraint is justified The basic argument is that since the restraint is a voluntary contract between an upstream and downstream firm, it must at least benefit these two parties and may benefit consumers, as well. However, policy-makers are not yet ready for a per se legal approach

47. Chapter 13: Vertical Restraints47 Franchising and Divisionalization Why Are There So Many Franchisees? Why do Firms Operate Many Different Divisions? –Recall the Merger Paradox:  With Cournot or quantity, 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.

48. Chapter 13: Vertical Restraints48 Franchising and Divisionalization 2 This may be the logic behind franchising and divisionalization –By operating many independent divisions or franchises, firms may avoid the logic of 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

49. Chapter 13: Vertical Restraints49 Franchising and Divisionalization 3 Assume demand P = A – BQ and Cournot competition – Firm j has divisions denoted by i, i = 1,2 – Profit of ith division of jth firm given by: – q ij is output of ith division of jth firm; Q -ij is output of all other divisions of all industry firms; and c is marginal cost – Equating marginal revenue and marginal cost yields:

50. Chapter 13: Vertical Restraints50 Franchising and Divisionalization 4 Let n 1 and n 2 be the number of divisions at firms 1 and 2, respectively. Since all divisions are alike the, the optimal output of any division is: Solving for industry output Q and price P, we have: and

51. Chapter 13: Vertical Restraints51 Franchising and Divisionalization 5 Given its optimal output, q ij *, each division at each firm will earn profit Firm 1’s total profit is: n 1  i,1 – Kn 1 where K is the sunk cost of setting up each division. So

52. Chapter 13: Vertical Restraints52 Franchising and Divisionalization 6 Maximizing firm 1’s profit with respect to n 1 and recognizing that by symmetry, each firm must have the same optimal number of divisions then yields: Solving for the optimal number of divisions at any firm we have

53. Chapter 13: Vertical Restraints53 Franchising and Divisionalization 7 The implication is that the greater the potential for monopoly profit (A – c), the greater the incentive for firms to create more divisions. But – More independent divisions brings the industry profit down – Firms engaged in a prisoner’s dilemma gain in which each adds divisions to the detriment of joint industry profit – Depending on the nature of the sunk cost of creating a division, it is even possible that the total surplus may be reduced by excess divisionalization

54. Chapter 13: Vertical Restraints54 Empirical Application: Exclusive Dealing in the Beer Industry US beer market has three tiers –Brewers (Anheuser-Busch, Miller, Molson-Coors) sell to –Distributors who sell to –Retailers It is common for brewers to adopt exclusive contracts and exclusive territories with distributors Reasons for exclusive contracts –Foreclosure of rivals. If this is the motivation, exclusive contracts will become less likely as market grows because there will be room for lots of distributors and tying up one or a few will not keep out rivals –Protect advertising investment against free-riding. If this is the motivation, exclusive contract will become more likely as the national advertising level rises

55. Chapter 13: Vertical Restraints55 Empirical Application: Exclusive Dealing in the Beer Industry 2 Sass (2005) analyzes 381 beer distribution contracts 69 of which have an exclusive dealing arrangement Uses probit estimation to determine how probability of an exclusive contract rises as a function of: –Market size as measured by: Regional population, POP Market share of distributor’s largest supplying brewery, MSD –Advertising as measured by National Advertising of distributor’s main supplier, ADS Presence of a ban on billboard advertising in the state, BAN –Years distributor has been owned by one family, YRS, which may indicate how experienced distributor is. Highly experienced distributors may not want to be restricted by an exclusive contract

56. Chapter 13: Vertical Restraints56 Empirical Application: Exclusive Dealing in the Beer Industry 3 Sass (2005) analyzes 381 beer distribution contracts 69 of which have an exclusive dealing arrangement. The results of his Probit estimation are shown below Explanatory Estimated Variable Coefficient t-statistic POP 0.0001 (1.87) MSD 0.0079 (2.79) ADS -0.0017 (-2.10) BAN -0.0002 (-0.38) YRS -0.0095 (-2.12)

57. Chapter 13: Vertical Restraints57 Empirical Application: Exclusive Dealing in the Beer Industry 4 Interpretation of Sass (2005) results –Foreclosure not a likely motivation for exclusive beer contracts because these become more likely as market size grow –Protection of advertising against free-riding seems to be a more compelling explanation for exclusive contracts. Such contracts more likely as advertising expense rises; and Such contracts less likely if billboard advertising is banned –Experienced distributors with lots of specialized information about the local market like to be free to use that information as they see best and so such distributors are less likely to sign an exclusive contract

58. Chapter 13: Vertical Restraints58 Empirical Application: Exclusive Dealing in the Beer Industry 5 Sass (2005) then examines the effect of the exclusive contracts. He finds that –Exclusive contracts raise the wholesale price by about six percent and the retail price by about three percent –Despite these price increases, exclusive contracts also raise total sales volume for both the brewer’s own brand and its rivals by about 30 percent. This again suggests that the exclusive contracts are being used to enhance the effectiveness of advertising. In so doing, they raise demand and thereby raise both price and output. Profit to brewers, wholesalers, and retailers rises. Given sales increase, consumer surplus likely rises, too.