Competition Policy

Vertical Restraints: Intra-brand

competition

What are vertical restraints?

In many markets producers sell their goods through

intermediaries: wholesalers and retailerssign contracts
to guarantee supply stability and improve coordination
These agreements in the vertical chain are called vertical
restraints
What is optimal for a manufacturer is not necessarily
optimal for the retailer one party can try to use
contracts to restrain choice and induce the best outcome
for itself
Example: the manufacturer wants to improve the
marketing efforts of the retailer1) it may assign an
exclusive area to the retailer so that the latter will fully
appropriate the results of his efforts 2) It may use a
non-linear wholesale price (the retailer gets a discount if
it buys a large quantity of the goods)

Most common vertical

restraints

Non linear pricing

Quantity discounts
Resale price maintenance (makes sense
if the price paid by the consumer is
observable as in the case of consumer
goods)
If the manufacturer finds it difficult to
use contracts then it could resort to
vertical integration merge with (or
take over) the retailervertical merger

Intra-Brand Competition

Welfare effects of vertical restraints when they affect

competition between retailers that sell the same product (or
brand)
A manufacturer (monopolist) may sell through one or more
retailers
If both the M and the R have market power, both charge a
positive mark-up the final price is too highDouble
Marginalizationwith vertical restraints or vertical integration
price would decrease and welfare would increase
If several retailers distributed the same brand they would be
unable to appropriate their marketing effortthey reduce their
efforts Underprovision of sales servicesvertical restraints
give incentives to retailers to improve their effortEX.Give
exclusive territories if consumers value these services
welfare increases

The Commitment Problem

Vertical restraints and vertical mergers may

have an adverse effect on welfare when they
help the manufacturer to keep prices
highwithout them it would not be able to
commit to high prices
EX.a successful brand has not been sold yet in
a region the expected profit from selling it is
several franchisee are ready to sell the
brandIf the manufacturer offered exclusivity
to one franchisee competitive bidding will lead
the winning bidder to offer to the up-stream
firm

The Commitment Problem.

Once it has sold the franchise the up-stream

has an incentive to renege on its exclusivity
promise and offer a second franchise
(promising there will be no more than 2) and
obtain an additional gain /2 (the first
franchisee incurs a loss = /2 )then it can
offer a third franchise
Potential franchisee would anticipate this
behaviour. If the manufacturer is unable to
commit on a single franchise nobody wants the
licence and the monopolist will not get its

The Commitment Problem

Because of this problem a firm cannot

appropriate its potential market power in the
example the franchisee could accept to buy the
licence only at a low price and the producer
gains a low profit.
The same commitment problem arises when a
firm has an input to be sold to more than
one buyer incentive to renegotiate the
contract with some buyers after having
concluded the contract with all of them if
contracts are not observable better terms
can be renegotiated with some buyers

The Commitment Problem:

Renegotiation
Two retailers sell the same good in the
same town
Pay w to the manufacturer M (wholesale
market) sell Q at P. Each make profits
/2
Suppose: The manufacturer can offer a
non linear contract: retailers pay a fixed
fee /2 and a variable fee w (=0 for
each retailer)

The Commitment Problem:

Renegotiation
After the contract is signed the M can renegotiate
with one retailer and offer better terms: wCompetitive advantage the retailer gets all the
market and gains > /2 and be willing to pay up
to
At the expense of the other retailer (still paying /2
) now the M gains an additional profit (- /2 )
The retailers anticipate the temptation of the
Manufacturer and would we unwilling to contract
with M unless they pay a very low fee to him

Vertical Mergers may cause

foreclosure

An obvious solution for the manufacturer to

commit to higher prices is to merge with one of
the downstream firmsit internalizes the profit
made by its affiliate
It has no incentive to offer better terms to
other downstream firms ( as it will reduce the
profit made by its affiliate)
The foreclosure of rival downstream firms
will follow as the upstream unit would not
supply the input to rival retailers
monopoly power is restored! (if there are
no competing suppliers of the input)

Vertical Mergers with alternative

upstream suppliers
With alternative upstream suppliers, prices
will increase due to the vertical merger,
but to a less extent, due to the retailers
threat to switch suppliers
limit to the exercise of market power
vertical restraints may still negatively
affect welfare, but the negative effects
may be limited by the existence of
competing suppliers

Exclusive territories

If it is possible to conclude a legal contract that

grant exclusivity to one supplier in each
area .. the manufacturer committment
problem is solved!
In the region protected by esclusivity
competition among retailers will bring them to
pay up to the monopoly price to be a
monopolist retailer in the area the
manufacturer restores its market power
Exclusive territories then harm welfare
consumers pay the monopoly price rather than
the lower price to be set without the esclusivity
clause

Resale Price Maintenance

The commitment problem is solved, if the monopolist

commit to industry-wide prices (renegotiation expost with some retailers is exluded)
EX.RPM clauses as in the case of books or
pharmaceuticalsthe producer prints the price on the
products that cannot be sold at a discount price (the
retailer can be taken to courts if it did)
There is no incentive for the producer to cut
secretly wholesale prices (secret renegotiation with
some downstream retailer has no effects) a price cut
would not increase final sales but worsen the distribution
of profits between the producer and the retailer that
receives a discount

Conclusions

The magnitude of the damage created by

vertical restraints (or a vertrical merger)
depends on the upstream firm being or not a
monopolist
if there are competing suppliers the damage
is low
competition policies should then monitor
such practices only when undertaken by
firms with enough market power