Chapter 11 - Vertical Relations (Skim 11.1, skip 11.2, read rest)

This chapter is rather hard to read, but pretty important as it deals with some real life examples of how manufacturers and retailers struggle over market power. Probably the best way to deal with these issues is through concrete examples. Fortunately, we have two interesting cases - Microsoft and the grocery industry, which we will be examining in more detail. But a little background before delving into the case studies is helpful.

One of the problems with most economic models is that they tend to assume that producers sell directly to consumers. The fact is that much of economic activity takes place between firms.

This is a more complicated model than the simple maximization subject to demand we are used to. For simplicity's sake, we can split the market into two groups:

manufacturers (upstream firms) (M)

retailers (downstream firms) (R)

What is the relationship between manufacturers and retailers (and all the other intermediary producers in between, for that matter)?

There are two levels of dependency between them.

On the one hand, retailers depend on manufacturers for a reliable flow of goods, at reasonable prices. On the other hand, manufacturers often cannot reach consumers directly, so they rely on retailers to market and sell their products.

Just as economists are concerned about market power issues between consumers and retailers, they are also concerned about market power between retailers and manufacturers.

For instance, a manufacturer with a lot of market power may be able to dictate terms to retailers, extracting most of the profit to be made in a market, and possibly eliminating competition. (Microsoft?)

On the other hand, a retailer with a lot of market power may be able to dictate terms to wholesalers or manufacturers and extract most of the profit at their end. (Garment industry? Grocery industry?)

Thus the concepts of vertical relations as well as vertical mergers (which may lead to increased market power) can be major concerns for policy makers and economists.

Some strategies may be legitimate ways of staying in business and avoiding free rider or other negative economic impacts, while others may be attempts to extract monopoly profits. So once again, there may be a role for the government monitoring these relations to make sure nothing predatory is taking place, but it is sometimes difficult to tell what is acceptable.

An important aspect of vertical relations is pricing.

First, any time you add additional players to an economic model (such as middlemen and women), how will that affect the price? Clearly, if there are more players, there are more people trying to make a profit and thus prices are likely to rise. So from one point of view, vertical integration may look appealing, because it may reduce prices to consumers. But it also means increased market power, which in the long run, can mean price gauging.

In lieu of vertical integration, what strategies do manufacturers with market power use to extract higher profits from retailers?

1. nonlinear price contracts

The manufacturer sells the object at marginal cost to the retailer, but then extracts a franchise fee which is a flat fee.

2. Resale-Price Maintenance (or price minimums)

Are RPM 'kosher?'

A number of possible explanations of RPMs exist:

a. Remember that manufacturers' success is linked to retailers' success, so RPMs may be a strategy to maximimize industry profits.

b. Sales and service may be linked and higher sales benefit both retailers and manufacturers, but there may be a free rider problem in the absence of minimum pricing. Retailers who spend a lot on service might fear being undercut by other retailers who 'free ride.' (What examples of RPMs have you observed in the market? Electronics equipment, clothing, etc.) (How about the internet? How does it fit into the free rider issue? Are internet sellers free riders, or are shops free riding on the internet?)

c.Or perhaps RPMs are merely an attempt at collusion.

3. A final way in which manufacturers attempt to control retailers is through exclusive contracts.

Are exclusive contracts a legitimate or illegitimate way of doing business?

a. On the one hand, fear of free riding may lead to this, if the manufacturer spends resources training personnel, they don't want them to sell other products as well.

b. On the other hand, attempts to grab more market power may be behind exclusive contracts.

What about the problem of retailer market power? How do retailers with market power behave?

1. Slotting allowances (manufacturers may have to pay retailers to get shelf space!)

2. Limiting manufacturers to only deal with one retailer.

Again, these may be legitimate ways of competing, or they may be ways of trying to take advantage of weaker players in the market.

Remember, economists primary concern is whether social welfare is affected by the actions of firms. Do vertical restraints reduce social welfare? Are some firms/consumers made worse off? Is there dead weight loss? Possibly, but it may also lead to greater efficiency, so this is a tough problem. This is an issue we will talk more about when studying the Microsoft case.

Were there any vertical relations issues going on in the de Beers case study?