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Vertical Restraints - Coggle Diagram
Examples of vertical restraints include : selective distribution, exclusive distribution, resale price maintenance, Full-line forcing, quantity forcing, price ceiling, exclusive dealing
How does EU Competition Law treat vertical restraints?
Horizontal and vertical agreements are covered under Article 101 : All agreements between undertakings which may affect trade between member states and which have as their object or effect the prevention, restriction or distortion of competition within the common market, those which: directly or indirectly fix the selling price, limit or control production, share markets or sources of supply.
The Commission guidelines state that for most vertical restraints, competition concerns arise only if there is insufficient competition at one or more levels, i.e., if they have market power at one or both the levels. The guidelines provide an exemption for vertical agreements where neither of the parties has a market share > 30%. The exemption can be removed if there are a number of vertical agreements put in place or if collectively market share is >50%
There are some black listed practices for which the exemption does not apply: resale price maintenance and some territorial restrictions
Intra-brand competition and inter brand competition, i.e., competition within the brand and competition between rival brands
Why are vertical restraints pro competitive? (a) Double Marginalisation
- Double marginalisation - when both the upstream manufacturer and the downstream retailer have set their prices over their production costs, there are double margins and hence vertical integration could help in reducing the retail price.
- When suppliers increase their prices, the wholesale input cost increases, and the price set at the supplier's MR curve where it cuts the MC curve results in a much higher price and a reduced output.
- Resale Price Maintenance could be a way to solve this issue, or putting a quantity forcing restraint in place, non-linear pricing where variable fee w = c + fixed fee could be charged, where w is equal to the firm's own marginal costs, this is almost the same as when the firm is under vertical integration.
- Downstream firms could additionally sponsor new entry in the downstream market
Why are vertical restraints pro-competitive? (b) Horizontal externalities between retailers -
- there maybe situations where customers value pre-purchase services, and so retailers may free ride on other retailers that offer this service and the same product. In this way, the retailer who provides the services is not able to recoup its investments and therefore this eliminates the incentive to invest or leads to under invest.
- there could be free riding between manufacturers as well.
- There are two ways, using vertical restraints this problem can be solved - selective distribution , exclusive dealing
Motta (2004) provides a model wherein there is a monopolistic upstream producer selling through a set of oligopolistic retailers that are perceived by consumers as differentiated. The model takes into account different externalities - double marginalisation, spill over as a result of free riding.Motta's model shows that prices are set at a high level. Furthermore, producers tend to under-sell the supply of pre-sale services - consumer surplus is higher under vertical integration. He proposes:
- No spill over - two-part tariff or quantity forcing would be helpful to solve the double marginalisation problem.
- RPM and a two-part tariff could be used
Other efficiency reasons for vertical integration:
- Economies of Scale and Scope
Where there are economies of scale in distribution, a manufacturer would want to sell to retailers that only operate at minimum efficient scale. In this case, quantity forcing could be an option.
- Hold up problems arising from specific investments
There are situations arising where firms are operating at difference levels of the supply chain and there are hold up problems. When an investment is specific and and long-lasting, such a hold up problem can lead to undermining of investments. For a hold up problem to arise, investment is related to a particular vertical partner and that it leads to sunk costs. This can happen with manufacturers as well as retailers.
Very similar to free-riding, in some sectors retailers provide customers with quality certification service. As providing this quality certification might be expensive, other sellers might sell the goods whose value has been increased by the luxury image of it.
Vertical restraints can be used to solve hold up problems in such cases :
- Agree a long term contract with price exceeding average cost
- Grant exclusive distribution rights or an exclusive territory to the downstream retailer
When are vertical restraints anti-competitive They are mainly anticompetitive when they reduce horizontal competition:
- Exclusive dealerships: Limits competition between different brands in a store, i.e., limits horizontal competition
- Selective distribution : Limits the number of stores where different brands are sold
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How can vertical restraints be anticompetitive:
- Foreclosing competition: manufacturers and retailers signing exclusive dealing with each other results in excluding other entrants, if there was a possibility at all.
- Softening of competition : two manufacturers hire managers to adhere to high retail prices because if they promise, it wouldn't be credible.
- Suppose for instance, each manufacturer retails through an exclusive dealer, and a non linear price such as a tariff is used then it would be profit maximising to set a high variable fee. Distributor would then raise the retail price.
- Similar results if exclusive territories are used.
This applies only for bertrand competition, when firms compete on price.
When firms compete in a cournot type of model, reduction in sales by one retailer would lead to other retailer increasing sales, lower prices, higher quantities and consumer welfare. These models suggest different welfare outcomes for bertrand and cournot. In the case of bertrand, the more the number of upstream manufacturers, the less the anticompetitive effect becomes important. With n vertically integrated manufacturers, the increase in mark up using vertical restraints falls with n increasing.
Commitment Problem: This is one of the best known anticompetitive effect of using a vertical restraint. Suppose an upstream manufacturer is producing a new product and it offers the retailer for profits P, the manufacturer is able to offer it at a lower price subsequently to other retailers. The retailer will only accept this price if it was not profitable for the manufacturer to offer the contract at a lower price to other retailers. Retailers will not enter into an exclusive agreement if he doesn't prove his commitment. Vertical restraints that can be used to solve this problem:
- Vertical integration
- Exclusive Territories
- Reputation
- MFN
Vertical Restraints can cause collusion to occur:
- deviations from collusion agreement must be easy to detect and transparency of prices
- RPM can cause collusion to sustain given the transparency of prices
- Hub and spoke cartels use retailers as the central point to all information flows
Most Favoured Nation Clause
- This refers to a best price promise, that is to say that if a manufacturer offers one retailer a lower price, then it should offer the main retailer the lower price too. There are two main theories of harm associated with this:
- By agreeing with a retailer to a MFN clause, the manufacturer eliminates its desire to offer other retailers lower prices, allowing it to exercise completely, its monopoly power.
- The other theory of harm is that MFN can be used to restrict the entry of downstream firms. Upstream manufacturers set the price and pay retailers a commission. Retailers compete with each other to sell for lower commission rates. If lower commission rates are offered, lower retail prices may be set. If an MFN is in place, under which the manufacturer does not offer lower commission rates, existing retailers will have lower incentive to offer lower commissions as retail prices will not reduce accordingly, and the MFN will also discourage new entrants.
There are two types of MFNs : Wide MFNs and Narrow MFNs
From a competition perspective, wide MFNs are more harmful than narrow MFNs since it restricts sales on many more channels than just the downstream firm's website.
Example: hotel booking case
Price Parity Agreements:
If a retailer has to increase prices of rival brands when the main brand price increases. This is not desirable as the condition will increase prices overall and eliminate any incentive to offer reduced prices.
Three important issues while assessing vertical restraints:
- Chicago critique : it is not profitable from vertical restraints as retailers cannot switch to potentially more efficient competitors. Post chicago models talk about a penalty imposed for retailers
- Efficiency defence - Article 101 (3) provides 4 conditions under which an agreement that restricts competition can be allowed - improves efficiency, a fair share goes to consumers, competition is not eliminated.
- Market partitioning - market partitioning in general is looked down upon as the commission does not support it.
Post Chicago Models:
- incumbent monopolist is also able to increase profits in another (separate) market.
- penalty on the retailer makes both the manufacturer and retailer better off - when cost of entry is substantial, incumbent may make money off the penalty but when its not, penalty can discourage entry.
- two monopolists > two retailers > two markets that must be served to cover fixed costs. Entrant can observe retailer's decision.
key point of the chicago theory is that the monopolist profits are not enough to compensate one retailer by offering him the profits, however, if this is for the two markets, entry can be prevented