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Vertical Integration
Lecture 11


Vertical Integration

1. Firm expands and reduces transaction costs

  • Increases efficiency

  • Boosts welfare

  • Example

    • Supply chain for a clothing store

    • Upstream - the wholesaler

    • Downstream - the retailer

    • Assume zero transaction costs

2. Four cases for supply chain

  1. Both wholesaler and retailer are competitive firms

    • Wholesaler is W while retailer is R

    • Retail for one shirt, PR = MCR

    • Wholesale for one shirt, PW = MCW

    • Note: The MCR = PW because the retailer buys one more shirt from the wholesaler for a price of PW

    • Thus, PR = MCR = PW = MCW

    • Hence, vertical integration has no impact on social welfare

  2. Wholesaler is competitive while the retailer is a monopolist

    • For the competitive wholesaler, PW = MCW

    • For the monopolist retailer, MRR = MCR = PW = MCW

    • The monopolist pays PW for one shirt, which is marginal revenue (MRR)

    • The monopolist receives a greater price from the consumers by reducing the amount it sells

    • Retailer earns profit equal to the green rectangle

    • Thus, no change in social welfare for vertical integration

Competitive wholesaler and monopolist retailer

  1. Wholesaler is a monopolist while retailer is competitive

    • The demand function represent both the retailer and wholesaler

    • Retailer sells to the consumers

    • Wholesaler can reduce its sales to the retailer to boost profits and prices

    • This affects consumers' behavior

    • Retailer charges PR = MCR

    • Retailer pays PW for every shirt, so PW = PR = MCR

    • Marginal revenue is for the wholesaler, and he earns profit equal to the green rectangle

    • No change in social welfare for vertical integration

Monopolist wholesaler and competitive retailer

  1. Both wholesaler and retailer are monopolists

    • The retailer has a marginal revenue function

    • The wholesaler sees the retailer's marginal revenue function as its demand function

      • Wholesaler also has a marginal revenue function

    • Double marginalization - both monopolists have a marginal revenue function and they both restrict outputs

    • Graph

      • Wholesaler sets production where MCW intersects MRW, and the output is QR

      • The wholesaler's price become PW which is the retailer's marginal costs

      • Retailer sets its PR where PW = MCR = MRR

Monopolist wholesaler and monopolist retailer

  • Social welfare increases for vertical integration if both firms merge into one

    • The marginal costs become MCW

    • Profit is the purple plus pink areas

    • Output rises to QV

    • The market price falls to PW and consumers' surplus rises

Vertical Relationships

1. What determines a firm's boundaries?

  • Example: Walmart owns all stores

  • A firm produces at MES, so that

A firm's average cost function

  • Then a firm replicates this factory until one firm controls an industry

2. Vertically integrated – firms may control all stages in one industry and pieces in another industry

A vertically integrated firm

  • Coase (1988) – vertical integration exists because it is efficient

    • Cost of organizing transactions within a firm < cost of buying from another firm

    • Example: Alcoa produced 90% of aluminum in the U.S.

    • Alcoa controlled all stages


  • One firm may not want to mine bauxite, because it would have only one customer, Alcoa

  • Alcoa used vertical integration to create a price squeeze

    • Price squeeze - a vertical integrated firm raises the input costs and reduces the prices for finished products

    • Competitors have more difficulty entering the market

3. Holdup Problem

  • Example 1

    • Alcoa could have market power

    • Bauxite firm could have market power

    • One of these firms tries to holdup the other firm to extract profits from it

  • Example 2

    • Samsung makes the computer chips for Apple's tables and Iphones

    • Samsung and Apple compete for consumers with similar products

    • Apple is searching for a supplier for its chips because it worries about the holdup problem

4. Foreclosure - vertical integration may pose problems for new firms

  • Retailers may have trouble obtaining products from a wholesaler or manufacturer

  • Wholesaler or manufacturer has trouble marketing its products to a retailer

5. Techniques wholesalers use to extract profits from retailers

  • Benefits

    • Techniques could improve social welfare if relationship between wholesaler and retailer gets rid of double marginalization

    • Wholesaler and retailer can act as one monopoly and split the profits.

  • Problems

    • Similar to price discrimination techniques

    • Effective in increasing monopoly power and profits

    • Could be legal or illegal depending on courts, facts, etc.

      • Courts looked at market shares

      • Power and control exerted by wholesaler

    • Raises barriers to entry and could prevent competition

  • Tying products - wholesaler forces retailers to take several products

    • Example 1

      • A film studio forces cinemas to take its good and bad movies

    • Example 2

      • American Can and Continental Can

      • They forced food companies to lease can closing equipment from them for five years

      • They refused to sell their machines to other companies

      • They forced the food companies to buy their cans

  • Franchise - a company buys the right to use a trademark, copyright, etc from the holder

    • Company pays an annual royalty and a percentage of sales or profits to franchise holder

    • Company must buy from approved suppliers and distributors

    • Company must adhere to rules, conditions, etc.

    • McDonald's, Burger King, Subway

    • Ingenious - franchise holder does not deal or has headaches with the day-to-day operation of a business but earns profits from it

    • Franchise holder can be a wholesaler and forces companies to buy all supplies, equipment, etc from it

  • Exclusive Dealings Contracts

    • Retailers sign agreements to deal exclusively with the wholesalers

    • Example

      • Visa and Mastercard force banks to sign exclusive agreements with them

      • Discover and American Express had trouble entering the credit card market

  • Territory and Customer Restrictions

    • This one is not necessarily bad

    • Wholesaler uses authorized dealers who in turn sell to customers

    • Wholesaler limits the number of dealers in a geographical location

    • Dealer may be prohibited to sell to customers outside his geographical area

    • Could reduce transaction costs

      • Dealers only do business with one manufacturer reducing retail costs

      • Wholesalers only deal with one group of customers, the dealers

    • Wholesaler may help the authorized dealer improve quality and maintenance

      • Train sales staff

      • Improve quality of customer service and sales staff

      • Note - consumers could increase their demand for the product

    • Wholesaler may even advertise its products for its dealers

    • Examples - dealerships and stores that sell cars, trucks, and large appliances like refrigerators, freezers, stoves, washing machines, etc.

  • Resale Price Maintenance Agreements

    • Vertical pricing - the wholesaler sets the retail price for the retailers usually the maximum or minimum

    • Wholesaler will police and monitor its retailers to ensure compliance

    • Wholesaler tries to prevent discount retailers

    • Wholesaler sets a minimum price for high-quality products

    • Example - Colgate refused to sell to retailers that did not abided by its pricing agreements

    • Not common anymore except a handful of companies

      • Rise of the large discount retailers

        • Large stores like Walmart have monopsony power

        • Monopsony - the buyer has the market power

        • Walmart forces prices, quality standards, etc. on wholesalers

      • E-commerce and internet sales

      • Mail order products

  • Note

    • Wholesalers can use two or more simultaneously

    • Apple Computers

      • Uses authorized dealers

      • Sets retail prices for its products

      • Sales staff are friendly, knowledgeable, helpful and products are high quality

6. Benefits of Retail Price Maintenance Agreements

  • Form of collusion to keep prices high

    • Wholesaler and retailer are working together

    • Small retailers want price agreements to specialize in products, keep prices high, and compete with large discount retailers

    • Prices exceed marginal cost, and retailer and wholesaler can split profits

    • Wholesalers usually do not vertically integrate with retailers

      • Wholesaler needs capital to buy a network of stores

      • Many headaches involved with the day-to-day management of stores and restaurants

      • Some wholesalers do sell through catalogs and their website

    • Collusion is difficult to maintain in long run

      • Some members will violate and cheat on prices and quotas

  • Prevent retailers from selling products at a discount

    • Consumers think a low price means low quality

    • Example - Levi Strauss

      • Levi Strauss moved away from price agreements

      • Levi Strauss lost market share to designer jeans like Gloria Vanderbilt, Ralph Lauren, and Calvin Klein

  • Retailers can offer better customer service

    • They provide information

    • Help the consumer when they have problems with the product

  • Retail Price Maintenance are difficult to maintain in current society

    • Intense competition

    • Large malls and discount stores

    • Sales through the internet

    • Specialty stores like The Gap and The Limited

    • Free riders - consumers will go to brick-and-mortar stores and ask sales people for information or inspect product

      • Consumers go home and order product from a discount e-store like Amazon

      • Note - manufacturers usually charge more on their website than the stores because they encourage consumers to go to the stores

The Holdup Problem

Holdup Problem – trading firms try to redistribute quasi-rents in their favor

  • Redistribute

    • Strengths

    • Abilities

    • Positions

  • Example: Coca-cola outsources bottling to other firms

  • Bottler’s cost, CB

    • CB = TVB + F

    • Notation

      • Total variable cost for bottling, TVB

      • Fixed cost for machines, F

  • Coca-cola’s profit (i.e. rent), V

    • V = R –TVB – TVP

    • Notation

      • Revenue for selling coke, R

      • Total variable cost of making soda, excluding bottling cost, TVP

      • Bottling company prices its costs competitively, TVB

    • MR = MC excludes fixed cost

    • Note – for two companies to enter into a relationship, bottling company invest F into machines

    • Total rent = V – F

    • Notation

      • V is Coca-cola’s rent

      • F is fixed cost for bottling machines

  • Results

    • Bottling company could try to holdup on Coca-cola to extract rents

    • Coca-cola could try to holdup on the bottling company to extract rents

  • If they terminate the relationship

    • Coca-cola pays T to find another bottler

    • Bottler sells equipment for salvage, S

    • Profits (rent) to terminate

      • Profit = (V – T) + (S – F)

      • Notation

        • V – T is Coca-cola’s rent

        • S – F is rent to the bottling company

  • Take difference between maintain relationship and terminate a relationship

    • Rent to maintain relationship, V

    • Rent to terminate the relationship, (V – T) + (S – F)

    • Total rent (Q) = V – (V – T + S – F) = T – S + F

    • If T = 0 and F = S, there is no benefit to a long-term relationship

    • If T > 0 and F > S, companies become “locked” to each other

      • Firms use contracts to lock relationship


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