The economics of

vertical restraints

Patrick Rey (IDEI, Toulouse)

CargeseMay 7, 2004

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OutlineOutline

• Introduction

• Inter-firm agreements– Intrabrand coordination– Interbrand competition

• Market power: foreclosure

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IntroductionIntroduction

• What are vertical restraints?

– Revenue sharing: other than a simple “linear price”• Non linear tariffs (two-part tariffs, rebates, menus of tariffs, … ) • Royalties (on sales, total sales, profit)• Commissions

– Obligations (restrictions on behaviour)• Service specification (upstream/downstream, national/local advertising, …)• Quantity forcing, quotas• Exclusivity: exclusive dealing, exclusive territories (active/passive sales)• Resale price maintenance – RPM (price ceiling/floor, recommended prices, …)• Bundling, mixed bundling, full-line forcing

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IntroductionIntroduction

• Questions

– Positive economics: Motivation?

– Normative economics: Competition policy (allow, encourage, forbid, …)?

• Two aspects

– Inter-firm agreements• Vertical coordination (intrabrand)• Strategic effects (interbrand, « short-term »)

– Abuse of market power: foreclosure (entry/exit, « long-term »)

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Intrabrand vertical coordinationIntrabrand vertical coordination• Prices Spengler (1950)

– double marginalisation

w > c => p > pM

– solutions• RPM (ceiling), sales quotas (min.)

• two-part tariffs

• intrabrand competition

– private and social objectives coincidewhat is good for the firm

is good for consumers

P

R

unit cost c

Consumers

wholesale price w

retail price p

q = D(p)

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Intrabrand vertical coordinationIntrabrand vertical coordination• other dimensions

– risk-sharing Rey-Tirole (1986)• local shocks on retail cost/demand• bias towards ET / retail competition

– retail services • excessive price, insufficient effort• solutions:

– RPM (ceiling) + sales quotas (min.)– two-part tariffs– not intrabrand competition

• Private and social interests may diverge– marginal / infra-marginal consumers

Spence (1975) Comanor (1985), Caillaud-Rey (1987)

– more congruence if free-ridingMathewson-Winter (1984)

P

R

unit cost c

Consumers

wholesale price w

retail price p

retail services e

q = D(p,e)

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Interbrand competitionInterbrand competition• “competition-dampening”

– Exclusive territories: strategic delegationBonanno-Vickers (1988), Rey-Stiglitz (1985, 1988)

• ET reduce intrabrand competition• retail prices respond to increases in

rival wholesale prices• higher wholesale (and retail) prices

→ clear conflict between private/social interests

– More generally: strategic commitmentCaillaud-Jullien-Picard (1990), Caillaud-Rey (1994)

P2P1

R1 R2

Consumers

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• RPM and interlocking relationships Rey-Vergé (2003)

Note: consumer goods

Manufacturer AManufacturer A

RetailerRetailer 1 1 Retailer 2Retailer 2

ConsumersConsumers

A-1A-1 B-1B-1 B-2B-2A-2A-2

Interbrand competitionInterbrand competition

Manufacturer BManufacturer B

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– Competition in two-part tariffs: p < pM

• Manufacturer i recovers retail profits → sensitive to retail margins on rival brand

max (pi – c – γ)Di + (pj – wj – γ)Dj

• w > c to maintain « high » retail prices in spite of retail competition→ i does not take into account the upstream margin on rival brand: p < pM

– Two-part tariffs + RPM: p = pM

• No need for w > c to maintain high retail prices• But if wj = c, manufacturer i becomes sensitive to the full margin on rival brand

→ p < pM

– Note: the Galland bill

Interbrand competitionInterbrand competition

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• Collusion: improving market transparency

Example: RPM Jullien-Rey (2003)allows for more uniform prices in spite of variations in local

conditions of supply and demand

• Facilitates the detection of deviations• But inefficient rigidity

→ can/will be used when enhances collusion substantially→ negative impact on consumers and efficiency

Interbrand competitionInterbrand competition

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• Supposes an “essential facility”

– Essential– Controlled by a dominant firm– No “objective” reason to deny access

• Traditional concern (leveraging market power)

Dominant firm – denies /limits access to some potential users, – to extend its market power from the monopolized segment to the

complementary segment

ForeclosureForeclosure

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• Vertical / horizontal foreclosure

monopoly market A, competitive market B

upstream/downstream complementary

ForeclosureForeclosure

C

M

C M C C

A BA

B

Terminal RR 1912, Commercial Solvents 1973

Infrastructure: stadiums, ports, airports, tunnels, RR,

electricity grid, local loop, Computer reservations syst.

Patents

IBM CPU - peripherals

United shoe, Chicken Delight, Tetrapak

Server OS / PC OS / applications

Aftermarkets (Volvo, Renault, Kodak)

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• Vertical foreclosure– vertical integration +

• refusal to deal • incompatibility • high wholesale prices • tie-ins, ...

– no vertical integration but• exclusive dealing• price discrimination, ...

• Horizontal foreclosure– tying,– access,– incompatibility

PracticesPractices

M C

M

M

C

C

M

C

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• Structural– common ownership of bottleneck (Terminal RR)– break up + line of business restrictions (AT&T)

• Regulation of access price– no discrimination among external clients (CAB 1984, Sabena / Saphir)– no discrimination between external and internal clients:– transparency, accounting separation (“chinese walls”)– price linkage: ECPR

access charge = final price - (marginal cost on competitive segment)example: local loop resale

• Open access (common carrier)

• Regulation of wholesale quantities (Eurotunnel).

RemediesRemedies

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Vertical foreclosureVertical foreclosure

Chicago school critique

Posner (1976), Bork (1978), Posner-Easterbrook (1981)

“Only one profit”: how can bottleneck owner earn more than one profit?”

• M charges – Wholesale price w

– Franchise fee F

• Downstream competition– Retail price p(w) = pm

– Profits recovered through F

C

M

C

Demand

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• Response to the critiqueResponse to the critique

– Incentive: restore, rather than extend market powerUpstream monopolist cannot exercise monopoly power without excluding

Hart-Tirole (1990), O’Brien-Shaffer (1992), McAfee-Schwartz (1994), Rey-Vergé (2004), ..., Rey-Tirole (2003) « A Primer on foreclosure »

– Analogies• Patent: multiplication of licenses• Franchising: multiplication of franchises.

Vertical foreclosureVertical foreclosure

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• Model

Vertical foreclosureVertical foreclosure

M

C1 C2 Cn

unit cost cu

1 unit of input required

for 1 unit of output

unit cost cd

Consumers

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• Example (“Cournot” downstream competition)

– Framework• M offers wholesale contracts (e.g., two-part tariffs: Ti(qi) = Fi + wiqi)• each competitor Ci orders its quantity qi and pays accordingly Ti(qi) • each competitor Ci set its price pi

→ downstream competition analogous to “Cournot”

Kreps-Scheinkman: pi = P(q1 + … + qn)

– If wholesale tariffs are “public”: monopoly outcome• Monopolistic franchise contract w = cu, F = πm

• Oligopolistic franchise contract w: pC(w+cd) = pm, F = πC(w+cd)

Vertical foreclosureVertical foreclosure

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• Secret contracting: OpportunismHart-Tirole (1990)

When dealing with a competitor C, M has an incentive to free-ride on the sales of the other competitors

πM + πi ~ (P(qi +Σj≠iqj) - cu – cd)qi (+ Σj≠i (Tj - cuqj))

→ it is optimal for each competitor C to order and for M to supply a quantity that is the “best reaction” to the others’ production

levels→ Cournot outcome (quantity competition)→ as number of competitors increases, price goes down to cost

(competitive pricing, no market power)

Vertical foreclosureVertical foreclosure

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• Variant: Bertrand downstream competitionO’Brien-Shaffer (1992)

When dealing with one competitor Ci, M still has an incentive to free-ride on the downstream margins of the other competitors

πM + πi ~ ( pi - cu )Di + Σj≠i(wi – cu)Dj

→ It is optimal for M and each competitor C to agree on a price that is the “best reaction” to the others’ prices

→ Bertrand outcome (price competition)

Issue: which conjecture? Passive, wary beliefs McAfee-Schwartz (1994), Rey-Vergé (2004)

Vertical foreclosureVertical foreclosure

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• Foreclosure: restoring market power– reputation, transparency

reduce scope for opportunism– vertical integration

no incentive to free-ride on its own subsidiary– exclusive contracts

eliminates downstream competition– nondiscrimination laws (!)

eliminates opportunism– RPM, …

• Remarks– Incentive for foreclosure stronger

• the more competitive the downstream industry,• the less competitive the upstream industry

– Some competition upstream generates some access.

Vertical foreclosureVertical foreclosure

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• Comment: who’s “upstream”?

Vertical foreclosureVertical foreclosure

Bottleneck is upstream

M

C1 C2

Clients

C1 C2

M

Clients

Illustration : US gas reform (pipelines)

Bottleneck is downstream

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• Efficiency defenses

– Benefits from vertical integration

– Maintaining upstream reputation

– Cost of increasing capacity

– Investment and innovation• Regulation of access = regulation of rate of return• Where does the market power come from?

– historical reasons / legal monopolies (port, airport, ...)– scale economies (Otter Tail, Hecht, ...)– network externalities (WorldComMCI, Open Network Provision directive, ...)– investment / innovation

Vertical foreclosureVertical foreclosure

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Horizontal foreclosureHorizontal foreclosure

• Chicago school critique

Complement goods

→ competition in the B market • makes A good more attractive

• raises profit for M

→ M has no incentive to

reduce competition in B market

M C

Demand

q = D(pA+pB)

A B

C

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• Response to the critique

Two lines of arguments:

– Non complementsa second source of monopoly power does not devalue M's monopolized product A

– Complementsentry in the adjacent market B may facilitate entry in the monopolized market A

Horizontal foreclosureHorizontal foreclosure

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Independent goods: Whinston (1990)

• Assumption: commitment to sell A and B only as a bundle→ M becomes a very aggressive competitor if C enters B market

• Conclusions– tie-in costly if C enters/stays in market,– tie-in tends to discourage entry (commitment to being aggressive)– tie-in may be profitable if deters entry,– (because of Chicago school reason) does not work if A and B complements.

Horizontal foreclosureHorizontal foreclosure

BA

M M, C

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• Complements: protecting home market– Choi-Stefanadis (2001)

• Initially, M monopolist in both A and B• In each market, C can invest I

– enters with probability ½ – if enters, gets profit π

• Without tying, C enters (in both markets) if ½ π = π/2 ≥ I• With tying, C must succeed in both markets:

→enters only if ¼ π = π/4 ≥ I

– Carlton-Waldman (2002)• Sequential entry in B, then in A• Scale economies

Horizontal foreclosureHorizontal foreclosure

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• Efficiency reasons for tie-ins– Prevention of inefficient input substitution

illustration: durable good maintenance

– Protection of reputationSignal of quality for a durable good (profit made on complementary good)

– Price discrimination / metering of demand• IBM cards, Chicken Delight• aftermarkets

Horizontal foreclosureHorizontal foreclosure