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Article 81 Theory Notes

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Competition theory notes article 81 Vertical Restraints Slade and Lafontaine (2005) Some say there are no reasons for restricting vertical agreements, since they have a selfpolicing mechanism to keep price down. The lower the unit cost, the more will be sold, and the more units will be ordered by retailer from manufacturer. Any price rises above wholesale price represents a loss to the manufacturer. Thus the manufacturer will aim to keep prices as close to wholesale price as possible. There are also many precompetitive effects of vertical restraints. Over 1/3 of sales from upstream to downstream firms in the US are subject to some form of exclusive dealing. Vertical restraints can be helpful in many ways:

Overcoming double marginalisation (DM): DM occurs when there are upstream and downstream dominant undertakings. In order to make a profit, each prices at a monopolistic mark-up over its own costs, resulting in consumers paying a price that is higher, and a quantity that is lower than would be optimal to profit maximise from their joint point of view. They impose externalities on one another, since a high wholesale price raises retailer's costs, while a high retail price reduces the number of orders the retailer will make from the manufacturer, reducing the latter's revenue. o Resale price maintenance sets a single level of price (and hence outcome) for both o Minimum output requirement on downstream e.g. in franchising solves the problem o Reducing the dominance of the downstream firm by only supplying to a limited number of downstream suppliers (who will hold market power that restrains the previously dominant downstream retailer) will create downstream intra-brand competition

Overcoming the free-rider problem: If an upstream firm invests in downstream retailers e.g. training sales staff, renovating the retail outlets, providing technical support etc, there is a risk that these will benefit other brands sold there, discouraging upstream firm from investing. Exclusive dealing avoids this and therefore encourages investment.

In franchising, there is an incentive on franchisees to free-ride on the brand: They are unlikely to get repeat business from good service (since consumers view all McDonalds/Dunkin Doughnuts as the same). Any benefit of repeat service that is produced by quality service they offer could be used to benefit other franchisees. Thus the incentive is to offer poor quality service. A vertical restraint of wide exclusive territories could overcome this problem, since consumers may not go to other areas, so that any benefits from quality service offered by an individual franchisee is internalised to that same franchisee, as are poor service. However there are in theory some anticompetitive effects of vertical restraints. The main concern is that vertical restraints will foreclose the market from either upstream or downstream competition. If a manufacturer agrees exclusive dealing with most of the downstream retailers, it may be impossible for a rival manufacturer to compete and force it to leave the market. This argument requires that there be limited downstream competition due to barriers to entry (such as good locations etc). If there were many insignificant retailers then upstream rivals could still compete, unless exclusivity network covered nearly all of them. The consequent reduction on competition will harm consumers as prices will rise. However Slade and Lafontaine look at the results of some empirical studies. Their findings are that

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