1. Firm expands and reduces transaction costs
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Increases efficiency
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Boosts welfare
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Example
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Supply chain for a clothing store
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Upstream - the wholesaler
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Downstream - the retailer
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Assume zero transaction costs
2. Four cases for supply chain
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Both wholesaler and retailer are competitive firms
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Wholesaler is W while retailer is R
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Retail for one shirt, P R = MC R
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Wholesale for one shirt, P W = MC W
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Note: The MC R = P W because the retailer buys one more shirt from the wholesaler for a price of P W
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Thus, P R = MC R = P W = MC W
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Hence, vertical integration has no impact on social welfare
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Wholesaler is competitive while the retailer is a monopolist
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For the competitive wholesaler, P W = MC W
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For the monopolist retailer, MR R = MC R = P W = MC W
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The monopolist pays P W for one shirt, which is marginal revenue (MR R)
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The monopolist receives a greater price from the consumers by reducing the amount it sells
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Retailer earns profit equal to the green rectangle
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Thus, no change in social welfare for vertical integration
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Wholesaler is a monopolist while retailer is competitive
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The demand function represent both the retailer and wholesaler
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Retailer sells to the consumers
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Wholesaler can reduce its sales to the retailer to boost profits and prices
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This affects consumers' behavior
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Retailer charges P R = MC R
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Retailer pays P W for every shirt, so P W = P R = MC R
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Marginal revenue is for the wholesaler, and he earns profit equal to the green rectangle
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No change in social welfare for vertical integration
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Both wholesaler and retailer are monopolists
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The retailer has a marginal revenue function
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The wholesaler sees the retailer's marginal revenue function as its demand function
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Double marginalization - both monopolists have a marginal revenue function and they both restrict outputs
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Graph
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Wholesaler sets production where MC W intersects MR W, and the output is Q R
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The wholesaler's price become P W which is the retailer's marginal costs
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Retailer sets its P R where P W = MC R = MR R
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1. What determines a firm's boundaries?
2. Vertically integrated – firms may control all stages in one industry and pieces in another industry
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One firm may not want to mine bauxite, because it would have only one customer, Alcoa
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Alcoa used vertical integration to create a price squeeze
3. Holdup Problem
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Example 1
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Alcoa could have market power
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Bauxite firm could have market power
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One of these firms tries to holdup the other firm to extract profits from it
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Example 2
4. Foreclosure - vertical integration may pose problems for new firms
5. Techniques wholesalers use to extract profits from retailers
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Benefits
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Problems
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Similar to price discrimination techniques
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Effective in increasing monopoly power and profits
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Could be legal or illegal depending on courts, facts, etc.
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Raises barriers to entry and could prevent competition
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Tying products - wholesaler forces retailers to take several products
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Example 1
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Example 2
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American Can and Continental Can
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They forced food companies to lease can closing equipment from them for five years
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They refused to sell their machines to other companies
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They forced the food companies to buy their cans
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Franchise - a company buys the right to use a trademark, copyright, etc from the holder
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Company pays an annual royalty and a percentage of sales or profits to franchise holder
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Company must buy from approved suppliers and distributors
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Company must adhere to rules, conditions, etc.
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McDonald's, Burger King, Subway
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Ingenious - franchise holder does not deal or has headaches with the day-to-day operation of a business but earns profits from it
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Franchise holder can be a wholesaler and forces companies to buy all supplies, equipment, etc from it
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Exclusive Dealings Contracts
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Territory and Customer Restrictions
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This one is not necessarily bad
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Wholesaler uses authorized dealers who in turn sell to customers
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Wholesaler limits the number of dealers in a geographical location
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Dealer may be prohibited to sell to customers outside his geographical area
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Could reduce transaction costs
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Dealers only do business with one manufacturer reducing retail costs
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Wholesalers only deal with one group of customers, the dealers
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Wholesaler may help the authorized dealer improve quality and maintenance
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Wholesaler may even advertise its products for its dealers
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Examples - dealerships and stores that sell cars, trucks, and large appliances like refrigerators, freezers, stoves, washing machines, etc.
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Resale Price Maintenance Agreements
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Vertical pricing - the wholesaler sets the retail price for the retailers usually the maximum or minimum
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Wholesaler will police and monitor its retailers to ensure compliance
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Wholesaler tries to prevent discount retailers
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Wholesaler sets a minimum price for high-quality products
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Example - Colgate refused to sell to retailers that did not abided by its pricing agreements
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Not common anymore except a handful of companies
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Note
6. Benefits of Retail Price Maintenance Agreements
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Form of collusion to keep prices high
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Wholesaler and retailer are working together
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Small retailers want price agreements to specialize in products, keep prices high, and compete with large discount retailers
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Prices exceed marginal cost, and retailer and wholesaler can split profits
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Wholesalers usually do not vertically integrate with retailers
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Wholesaler needs capital to buy a network of stores
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Many headaches involved with the day-to-day management of stores and restaurants
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Some wholesalers do sell through catalogs and their website
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Collusion is difficult to maintain in long run
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Prevent retailers from selling products at a discount
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Retailers can offer better customer service
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Retail Price Maintenance are difficult to maintain in current society
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Intense competition
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Large malls and discount stores
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Sales through the internet
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Specialty stores like The Gap and The Limited
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Free riders - consumers will go to brick-and-mortar stores and ask sales people for information or inspect product
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Holdup Problem – trading firms try to redistribute quasi-rents in their favor
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Redistribute
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Strengths
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Abilities
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Positions
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