Martin K. Perry

Vertical integration: Determinants and effects

Publisher Summary The theory of vertical integration is situated at the intersection of the theory of the firm, the theory of contracts, and the theory of markets. A firm can be described as vertically integrated if it encompasses two single-output production processes in which either (1) the entire output of the upstream process is employed as part or all of the quantity of one intermediate input into the downstream process or (2) the entire quantity of one intermediate input into the downstream process is obtained from part or all of the output of the upstream process. This includes the more restrictive criterion that the entire output of the upstream subsidiary be employed as all of the quantity of one intermediate input into the downstream process. There are three broad determinants of vertical integration: technological economies, transactional economies, and market imperfections. Vertical integration may arise from technological economies of integration. In particular, less of the other intermediate inputs may be required to obtain the same output in the downstream process when the firm has integrated one of the upstream processes.

Equilibrium Incentives for Exclusive Dealing in a Differentiated Products Oligopoly

We consider the incentives for oligopolistic manufacturers to adopt exclusive dealing. Manufacturers producing differentiated brands can choose to distribute through exclusive retail dealerships or nonexclusive dealerships. With nonexclusive dealing, manufacturers face an interbrand externality because brand-enhancing investments made by one manufacturer may benefit the brands of other manufacturers. Although exclusive dealing eliminates this externality, oligopolistic manufacturers may not choose exclusive dealing. Exclusive dealing enhances the incentive to invest, but the promotional investments are a form of competition between manufacturers. Thus, manufacturers might earn higher profits with nonexclusive dealing making lower promotional investments. We find cases in which nonexclusive dealing is a dominant strategy. We also find cases in which some, but not all, manufacturers adopt exclusive dealing. Moreover, even if adoption of exclusive dealing by all manufacturers is the equilibrium, it can arise from a prisoners dilemma in that each manufacturer would prefer nonexclusive dealing.

Resale Price Maintenance and Forward Integration into a Monopolistically Competitive Industry

In this paper we adopt the CES model of product differentiation for the downstream stage of the industry. With an upstream monopolist we first show that resale price maintenance is equivalent to forward integration and that both increase profits. Then we demonstrate that forward integration by an upstream monopolist will reduce welfare for the industry. Prices fall with forward integration, but the integrating firm contracts the number of downstream subsidiaries so drastically that the reduced diversity more than offsets the gains from lower prices.

Exclusive dealing in a spatial model of retail competition

Abstract This paper analyzes exclusive dealing in a model with brand differentiation by manufacturers and spatial differentiation by retailers. Exclusive dealing is shown to generate higher profits for manufacturers, who thus have an incentive to insist on exclusive dealing. Exclusive dealing also results in higher prices and higher transportation costs for consumers. However, exclusive dealing may still increase total surplus because it reduces the fixed costs of retailing. If so, the comparison with non-exclusive dealing becomes difficult because these lower fixed costs induce entry of additional retailers, reducing the retail margin and consumers transportation costs. Numerical analysis suggests that total surplus is likely to increase with exclusive dealing when there are substantial reductions in the fixed costs of retailing.

Can resale price maintenance and franchise fees correct sub-optimal levels of retail service?☆

Abstract This paper examines resale price maintenance by a monopoly manufacturer who sells its product through monopolistically competitive retailers. The retailers also provide service, but there is an externality in its provision. If the manufacturer sets only a wholesale price, the externality results in too little service, and the addition of RPM will not correct this. Maximum RPM is used only to correct the successive monopoly problem with no effect on service. However, if the manufacturer can also set a franchise fee, too little service arises when the externality is large. Minimum RPM will correct this, increasing both profits and consumer surplus. This partially confirms the Telser (1960) argument for RPM. When the externality is small, retailers provide too much service, and the ‘vertical externality’ argument is invalid. These results suggest that the insights from simple vertical models may not generalize to models which allow other dimensions of non-price competition among retailers.

Price Discrimination and Forward Integration

An input monopolist could price discriminate among all downstream industries by integrating into all but the one with the most inelastic derived demand. We demonstrate that a dominant firm will have a similar incentive to integrate into industries with more elastic derived demands. However, the extent of the fringe of competitive input suppliers will determine the number of such industries into which integration can profitability be maintained.

Resale Price Maintenance and Manufacturer Competition for Exclusive Dealerships

Two manufacturers distribute their brands through exclusive retail dealers and must compete for consumers indirectly by inducing retailers to carry their brands. The authors compare equilibrium outcomes with and without resale price maintenance. Maximum resale price maintenance lowers the retail price if manufacturers cannot employ franchise fees. Minimum retail price maintenance raises the retail price if manufacturers cannot set a wholesale price above marginal cost and must employ only a franchise fee. However, these traditional insights are reversed if manufacturers can set both a wholesale price and a franchise fee in the equilibrium without retail price maintenance. Copyright 1991 by Blackwell Publishing Ltd.

Forward Integration by Alcoa: 1888-1930

Alcoa initially entered fabricating [aluminum forms such as sheet] primarily because of the lack of interest in aluminum by existing metal fabricators. In end-products [such as furniture], however, Alcoa followed a general policy of persuading existing end-product manufacturers to produce new aluminum products, and only after indifferent or no success did Alcoa produce end-products, and then only temporarily and on a small scale.

Auctions for Split-Award Contracts

The buyer of a homogeneous input employs split-award contracting to divide his input requirements into two contracts that are awarded to different suppliers. The buyer uses a sequential second-price auction to award a larger primary contract and a smaller secondary contract. With a fixed number of suppliers participating in the auctions, we find that the buyer pays a higher expected price than with a sole-source auction. The premium paid to the winner of the secondary contract must also be paid to the winner of the primary contract as an opportunity cost of not winning the secondary contract. With fixed costs of participating in the auction, we identify the conditions under which a secondary contract can increase the number of suppliers and lower the expected price paid by the buyer. An optimal secondary contract can internalize the cost reductions from the new industry capacity and extract the rents of the suppliers. An optimal secondary contract can be particularly beneficial when the number of suppliers is limited by high fixed costs.

Vertical Integration by Competitive Firms: Uncertainty and Diversification

In this paper, we distinguish the circumstances under which uncertainty and risk aversion create incentives or disincentives for vertical integration by competitive firms in adjacent stages of an industry. The uncertainty is allowed to impinge upon the industry via the supply of a factor, the external demand for the intermediate product, or the demand for the final product. The decision on vertical integration is prior to the revelation of the uncertain parameters. However, firms choose production levels and all markets clear after these parameters are observed. Since the uncertain parameters influence the rents earned by the firms in the two stages, vertical integration can alter the distribution of these earnings. For each type of uncertainty we examine the conditions under which vertical integration will or will not result in diversification of the risks on rental earnings. Previous analyses of vertical integration by competitive firms under uncertainty have exhibited incentives to integrate which result from differential information or the inability of markets to clear. In Arrow [1], upstream firms possess some information about the total input supply while downstream firms possess no information. Since downstream firms must make ex ante choices of technology, there is an information incentive to integrate backward. In Green [3], the price in the intermediate market is fixed so that fluctuations in the external demand for the intermediate product result in rationing of either upstream or downstream firms. Balanced integration allows the combined firms to avoid rationing. Finally, in Carlton [2], some consumers are unable to obtain the final product while some downstream firms are burdened with an excess supply. Furthermore, some downstream firms which wish to produce more of the final product are unable to do so while some producers of the intermediate product are burdened by overproduction. As a result, there is an incentive for downstream firms to integrate into production of the intermediate product so as to insure a supply sufficient to produce that portion of their demand which is highly probable.