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`426
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`Chapter 12 Vertical Integration and Vertical Restrictions
`
`custom-made components often own the specialized dies needed to make them. Mon-
`teverde and Teece (1982) found that the more specialized the die, the more likely an
`automobile company is to own it.4
`A firm may need workers, such as engineers, who are specially trained in how the firm
`operates (specific human capital ) to produce a particular product. If it uses outside con-
`tractors as opposed to its own employees, opportunistic behavior is possible. For exam-
`ple, a contractor who knows that a firm is facing a deadline may demand more money.
`Vertical integration in the form of an employment relationship can avoid such problems.
`If successive stages of a production process must be located adjacent to each other
`(that is, they involve site-specific capital ), vertical integration is likely. The reason is
`that if a manufacturing firm stops demanding the input of a supplying firm, that sup-
`plying firm must relocate, which can be extremely costly. Opportunistic behavior can
`be avoided by integrating. The empirical section at the end of this chapter discusses
`three studies of the importance of specific physical assets and site-specific capital in the
`automobile and airplane manufacturing industries and in manufacturing as a whole.
`When a firm relies heavily on one supplier for specialized products, not only is it at
`risk from opportunistic behavior by the supplier, but also a rival may try to interfere
`strategically with its supply. For example, in 1990, Conner Peripherals Inc., a disk-
`drive manufacturer, sued Seagate Technology Inc., a rival disk-drive manufacturer with
`half the market, charging that Seagate had blocked Conner’s supplies of a critical com-
`ponent. Conner had bought thin film heads from Imprimis Technology Inc., the dom-
`inant supplier of the three thin film head vendors. After Seagate acquired Imprimis, it
`cut off Conner as a customer, according to Conner’s complaint.5
`
`Uncertainty. As an example of the second transaction-cost reason for vertical inte-
`gration, uncertainty, suppose that a buyer cannot determine how long a durable ma-
`chine will last. The best way to predict quality (life expectancy) may be to observe the
`method by which the machine is constructed. If an outside firm cannot monitor qual-
`ity controls on construction, it may vertically integrate where quality is crucial.
`
`Transactions Involving Information. The third transaction-cost reason for verti-
`cal integration concerns transactions involving information. It may be difficult to
`structure a contract that gives the supplying firm the appropriate incentives to de-
`velop the information. For example, if one firm pays another firm a fixed fee to ob-
`tain information on newly developing markets, the hired firm does not have an in-
`centive to work hard at the margin to uncover all the information, and the buyer has
`
`4See also Masten (1984), who shows that asset specificity influences asset ownership in the aircraft
`industry, Anderson and Schmittlein (1984), who examine asset specificity and the decision of a firm
`to have its own sales force, and Crocker and Reynolds (1993), who study how asset specificity influ-
`ences procurement procedures of the Air Force.
`5Ken Siegmann, “Conner Sues Seagate over Component Cut-Off,” San Francisco Chronicle,April 19,
`1990:C1. Roxanna Li Nakamura, “Conner Sues Seagate for Contract Reneging,” InfoWorld,April 30,
`1990.
`
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`The Reasons for and Against Vertical Integration
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`427
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`no way of determining whether the supplier did a good job. Disputes on payments
`may well arise and be difficult to resolve. Such problems can be avoided by vertical
`integration.
`
`Extensive Coordination. The fourth transaction-cost reason to vertically integrate
`is to facilitate extensive coordination, as in industries with networks such as airlines
`and railroads. A railroad depends heavily on developing feeder traffic for its through-
`routes. Although it might be possible to devise a price system for feeder traffic on each
`link in the network, such a system would be very complicated. As a result, there is an
`incentive for railroads to merge to deal with these coordination problems (Carlton and
`Klamer 1983).
`Technological conditions alone do not explain the vertical integration of a firm. For ex-
`ample, a common case of vertical integration is a steel mill that produces its own pig
`iron. The molten pig iron is run directly into the steel furnace. Although it is ineffi-
`cient to allow the pig iron to cool down and then ship it to a steel furnace where it
`must be heated again, it is not necessary that one firm produce both pig iron and steel:
`Two firms can locate side by side. However, because pig iron production and steel pro-
`duction are so interrelated, there is a potential for opportunistic behavior if two sepa-
`rate firms are involved. Therefore, vertical integration often arises when production
`interrelated. (See www.aw-bc.com/
`processes at different stages are closely
`carlton_perloff “Biotech Firms.”)
`
`Integration to Assure Supply
`A common reason for vertical integration is to assure the supply of important inputs.
`Timely delivery of an item is of concern to businesspeople, yet standard models of
`market behavior ignore this topic. Assurance of supply is important in markets
`where price is not the sole device used to allocate goods (see Chapter 17). Nonprice
`allocation occurs in a wide range of common situations. For example, a bakery fre-
`quently runs out of bread by the end of the day and yet does not raise its price. In-
`stead,
`late-arriving customers cannot buy the bread. Similarly, grocery stores
`frequently run out of produce without raising prices. In many producer-good indus-
`tries, good customers often get the product during “tight” times, and other cus-
`tomers must wait. It is the marketing department, not customer responses to
`short-run price movements, that allocates goods. Such rationing has occurred in
`many industries, including paper, chemicals, and metals. Toyota and Dell Comput-
`ers stress the use of just-in-time deliveries of inputs to minimize inventory costs while
`ensuring timely delivery.
`When rationing is a possibility, there is an incentive to vertically integrate in order
`to raise the probability of obtaining the product. A firm has an incentive to produce its
`own supplies to meet its predictable level of demand and to rely on other firms for
`supplies to meet its less stable demand. Outside suppliers respond to this risky envi-
`ronment by raising prices. This arrangement, in which outside suppliers bear the risky
`demand, may not be the most efficient system for reliably providing the product, but
`may provide a strong incentive for a firm to vertically integrate (Carlton 1979b).
`
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`The Reasons for and Against Vertical Integration
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`429
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`transaction costs to buying steel companies, and if owners of steel mills are entitled
`to steel in proportion to their ownership, then price controls on steel are completely
`ineffective because all users vertically integrate by acquiring ownership interests in
`steel mills.
`Similarly, taxes encourage vertical integration. Depending on where firms are lo-
`cated, they may be subject to different taxes. For example, tax rates differ by state as
`well as by country. A vertically integrated firm may be able to shift profits from one lo-
`cation to another simply by changing the transfer price at which it sells its internally
`(See www.aw-bc.com/
`produced materials
`from one division
`to another.
`carlton_perloff “Oil Depletion Allowance,” for an example.) By shifting profits from
`a high tax jurisdiction to a low tax jurisdiction, a firm can increase its profits. The In-
`ternal Revenue Service is, of course, aware of such shifting and insists that firms use in-
`ternal transfer prices that reflect prices in the marketplace (see Chapter 18).
`Government regulations create incentives for a firm to vertically (or horizontally) inte-
`grate when the profits of only one division of a firm are regulated. For example, the prof-
`its that local telephone companies earn on local services are regulated, but their profits on
`other services, such as selling telephones in competition with other suppliers, are not reg-
`ulated. If a telephone company can shift profit from its regulated division to its unregu-
`lated division, it can effectively avoid the regulation of its local telephone service.
`For example, suppose that such a firm is able, through accounting conventions, to
`transfer costs from its unregulated division to its regulated division, thus lowering its
`reported profits in the regulated line of business and raising them in the unregulated
`line. At the next rate hearing, the telephone company may argue that it is entitled to
`increase its rates to raise its profits in its regulated business. By shifting profits from the
`regulated to the unregulated division, the telephone company can thus increase its
`overall profits. The fear that profits would be transferred from a regulated business to
`an unregulated business, and the difficulty of detecting such transfers, motivated the
`U.S. government to control the entry of local telephone companies into unregulated
`businesses after it dismantled the phone monopoly.6
`
`Integration to Increase Monopoly Profits
`God helps them that help themselves.
`
`—Benjamin Franklin
`
`A firm may be able to increase its monopoly profits in two ways by vertically integrat-
`ing.7 First, a firm that is a monopoly supplier of a key input in a production process
`used by a competitive industry may be able to vertically integrate forward, monopolize
`the production industry, and increase its profits. Or a firm that is a buyer may benefit
`from acquiring its sole supplier. Second, a vertically integrated monopoly supplier may
`be able to price discriminate.
`
`6Even if some avoidance of regulation does occur, there may be offsetting efficiencies to society from
`allowing the telephone company to enter new businesses. See Chapter 20 on regulation and
`www.aw-bc.com/carlton_perloff “The Breakup of AT&T.”
`7As discussed in Chapter 11, another reason for vertical integration is strategic. A firm that controls
`scarce inputs could put its rival at a disadvantage.
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`The Reasons for and Against Vertical Integration
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`431
`
`4. Competition downstream: The downstream industry is competitive. We relax
`this assumption later.
`5. Costs of vertically integrating: Certain costs are associated with vertically
`integrating, such as negotiation and legal fees. Thus, unless there are benefits
`from vertically integrating, the firm does not integrate.
`
`Under what additional conditions does it pay for the monopoly supplier of E to
`vertically integrate forward and take over the downstream production? The answer de-
`pends on whether the industry has a fixed-proportions production or a variable-pro-
`portions production function. In a fixed-proportions production function, the inputs
`are always used in the same proportions, so the proportions used are independent of
`relative factor prices. In a variable-proportions production function, one factor can be
`substituted for another to some degree, so the ratio of factors used is sensitive to rela-
`tive factor prices.
`Given the four assumptions, there are two key results:
`1. If the downstream production process uses fixed proportions, the upstream mo-
`nopoly does not have an incentive to vertically integrate. It makes the same
`profit whether it integrates or not.
`2. If, alternatively, the downstream production process uses variable proportions,
`the monopoly has an incentive to vertically integrate. It integrates if its increase
`in profits exceeds the cost of integration.
`
`The following sections examine fixed proportions and variable proportions in turn
`and then present a numerical example to illustrate how the two cases differ.
`
`Fixed-Proportions Production Function. In a fixed-proportions production pro-
`cess it is impossible to substitute one input for another. Producing firms buy card-
`board boxes from one input market and cakes from another input market. The pro-
`duction industry takes one box and one cake and produces a “cake in a box,” which it
`sells. If the cost of a cake doubles while the cost of a box remains unchanged, the pro-
`duction firm still uses the same proportions of cakes and boxes (one of each), because
`it cannot substitute boxes for cakes.
`Graphically, such a production process has an isoquant (a curve that shows the vari-
`ous combinations of the inputs that produce a given output level) in the shape of an L,
`as Figure 12.2 shows. The isoquant illustrates the various combinations of cakes and
`boxes that can be used to make one cake in a box. If the firm has two boxes and one
`cake or one box and two cakes, it can make only one cake in a box.
`The figure also shows an isocost line (the various combinations of the inputs that
`cost a given amount) where the prices for cakes and boxes are equal (1 to 1), and an-
`other isocost line where a cake costs three times as much as a box (3 to 1). Regardless
`of the relative price of the two inputs, the cost-minimizing combination of inputs is to
`use one unit of each to make one cake in a box: Both isocost curves hit the isoquant at
`the point (1, 1) in Figure 12.2.
`Now we can compare the profits that the energy monopoly makes if it vertically in-
`tegrates and if it does not. For simplicity, suppose that it takes 1 unit of E and 1 unit of
`L to make 1 unit of Q.
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`434
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`Chapter 12 Vertical Integration and Vertical Restrictions
`
`Thus, because the upstream firm earns the same profit whether it integrates or not,
`if there is any cost to integration, it chooses not to integrate. What is the intuition be-
`hind this result? When the nonintegrated monopoly raises its price for a unit of E by
`m ⫹ w
`$1, the marginal cost of the downstream firm (
`) rises by $1, so the price to con-
`sumers also goes up by $1. That is, the energy monopoly can perfectly control the final
`price consumers pay without vertically integrating. Not only can it raise the price, but
`also it captures all the resulting profits. None go to the competitive industry, which
`merely passes on higher energy costs to consumers. The reason that the nonintegrated
`monopoly can control the downstream price perfectly is that the downstream firms
`cannot substitute away from the input produced by the monopoly.
`
`Variable-Proportions Production Function. The preceding intuition suggests
`that the results are different if the competitive downstream industry faces a variable-
`proportions production function, with which the downstream industry substitutes
`away from the input monopoly’s product if the price rises.
`Figure 12.4 shows the isoquant of a variable-proportions production function. Un-
`like the fixed-proportions production function, it is a smooth curve, showing that the
`products are (imperfect) substitutes. As a result, as the relative costs of the inputs
`change, as shown by a shift in the slope of the isocost line, the firm substitutes more of
`the now less expensive input for the more expensive input. With a variable-propor-
`tions production function, if the upstream energy monopoly increases its price to the
`competitive downstream industry, firms in that industry substitute more labor for the
`monopoly’s product. If the monopoly raises its price by a dollar, the price of the final
`good no longer necessarily increases by a dollar, and the amount of E used falls by rel-
`atively more than Q does.
`Consider an extreme case where the two inputs are perfect substitutes in the pro-
`duction process. Here, the isoquant is a straight line. For example, downstream food
`processing firms (manufacturers of crackers and other similar products) view palm oil
`and coconut oil as perfect substitutes, so the isoquant is a straight line with a slope of
`⫺1.
`If a monopoly in palm oil increases its price above that of coconut oil, all the
`downstream firms switch to coconut oil. Thus, an upstream monopoly cannot raise
`the price of palm oil above that of coconut oil.
`In short, if downstream firms have some ability to substitute between inputs (vari-
`able-proportions production process), the upstream monopoly does not have complete
`control over the downstream industry. Every time it raises its price, the downstream
`industry substitutes away from its input and this substitution, though it constrains the
`market power of the monopoly, leads to inefficient production, because efficiency re-
`quires the slope of the isoquant to equal the slope of the isocost line. That slope equals
`the ratios of the inputs’ marginal costs. Downstream firms are using too much L and
`too little E. This inefficiency means that there are less profits for the monopoly to
`seize.
`If the upstream firm integrates forward so that it monopolizes the downstream in-
`dustry, it has complete control and can use the inputs in the most efficient combina-
`tion. Thus, its profits increase. If profits increase by more than the cost of vertical
`integration, the firm vertically integrates. At www.aw-bc.com/carlton_perloff “Fixed
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`The Life Cycle of a Firm
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`437
`
`even if there are increasing returns to scale. A specialized firm may have large setup
`(fixed) costs. If the specialized firm produces large quantities of output, the average
`setup or fixed cost per unit is small. In a small industry, however, the setup costs per
`unit are large, so that, if specialized firms are to earn a profit, the sum of the specialized
`firms’ prices must be higher than the cost of a firm that produces everything for itself.
`As the industry expands, it may become profitable for a firm to specialize, because
`the per-unit transaction costs fall.10 That is, as the industry grows, firms vertically dis-
`integrate. When the industry was small, each firm produced all successive steps of the
`production process, so that all firms were vertically integrated. In the larger industry,
`each firm does not handle every stage of production itself but rather buys services or
`products from specialized firms.
`For example, in the 1860s, Birmingham, England, was the leading production cen-
`ter of the small-arms industry.11 Virtually all of the 5,800 people working in this in-
`dustry were located in a small district near St. Mary’s Church. The firms were
`localized because large numbers of firms specialized in particular processes, so parts
`frequently had to be transported from one workshop to another. The typical master
`gun manufacturer owned a warehouse rather than a factory or workshop. These entre-
`preneurs purchased semifinished parts from “material-makers,” such as barrel makers,
`lock makers, sight stampers, trigger makers, ramrod forgers, gun-furniture makers,
`and bayonet forgers. The gun maker then sent the parts to a succession of “setters-up,”
`or specialized craftsmen, who assembled them into guns. For example, jiggers worked
`on the breech end; stockers dealt with the barrel and lock and shaped the stock; barrel
`strippers prepared the gun for rifling and proofing; and hardeners, polishers, borers
`and riflers, engravers, browners, and finally the lock freers adjusted the working parts.
`As an industry matures further, new products often develop and reduce much of
`the demand for the original product, so that the industry shrinks in size. As a result,
`firms again vertically integrate.
`In 1919, 13 percent of manufacturing companies studied had two or more estab-
`lishments making successive products, where the product of one was the raw material
`of the next (Stigler 1951, 135). In 1937, successive functions were found in 10 per-
`cent. Similarly, in 1919, 34.4 percent of all complex central offices had successive es-
`tablishments (companies with establishments in two or more vertically related
`industries); in 1937, only 27.5 percent did. Studies prior to 1970 found no overall
`trend in vertical integration after 1929 (Adelman 1955, Laffer 1969, Livesay and
`Porter 1969). Tucker and Wilder (1977) also find little variation in their vertical inte-
`gration indices from the mid-1950s to the early 1970s. However, Maddigan (1981)
`concludes that “major” firms became more vertically integrated from 1947 to 1972.
`O’Huallacháin (1996) documents a small decline in vertical integration over the pe-
`riod 1977–1987, although there was significant variation across industries.
`
`10A specialized firm cannot charge for its product a price that is higher than the minimum average
`cost of the product if one of the nonspecialized firms produces it itself.
`11This discussion is based on G. C. Allen, The Industrial Development of Birmingham and the Black
`Country, 1860—1927,(London: 1929), 56–7 and 116–7, cited by Stigler (1951).
`
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`Vertical Restrictions
`
`439
`
`In the following sections we identify a number of problems that arise when vertical
`integration is impossible, and describe the vertical restrictions that are used to deal
`with these problems. We then discuss the pro- and anticompetitive implications of
`these vertical restrictions.
`
`Vertical Restrictions Used to Solve Problems in Distribution
`Four problems commonly arise when distribution is costly and a manufacturer retains
`a distributor to retail its products:
`
`1. There is a double monopoly markup (also called double marginalization) by
`successive monopolies in manufacturing and distribution.
`2. Some distributors may free ride (not do their share in promoting the good) on
`other distributors.12
`3. Some manufacturers may free ride on other manufacturers.
`4. There may be a lack of coordination among distributors that leads to externalities.
`
`We discuss each problem in order, along with the vertical restrictions designed to
`deal with each.
`
`Double Monopoly Markup. If the manufacturer and the distributor are both mo-
`nopolies, each adds a monopoly markup (the difference between its price and its mar-
`ginal cost is positive), so consumers face two markups instead of one. This double
`markup provides an incentive for firms either to vertically integrate or to use vertical
`restrictions to promote efficiency and thereby increase joint profits. We first illustrate
`the losses due to the double monopoly markup and then show how vertical restric-
`tions can be used to prevent these losses where vertical integration is not practical.
`
`An Example of the Loss from a Double Monopoly Markup. To illustrate the ef-
`fect of a double markup, we contrast a market in which a manufacturer is vertically in-
`tegrated into distribution to one with two successive monopolies. Both consumers and
`firms lose from the double markup.13
`Suppose that the vertically integrated, monopolistic manufacturer-distributor faces
`D1,
`the downward-sloping demand curve,
`for its product in Figure 12.5a. The firm
`Q *
`units so as to equate its marginal cost of production, m, and its marginal
`produces
`
`12Most of the existing literature on vertical restraints emphasizes the role of free riding. However,
`Winter (1993) presents a more general way to explain why manufacturers want to use vertical
`restraints.
`13Suppose that a retailer buys a good from the manufacturer and then resells it. The retailer has no
`additional costs other than the price it pays the wholesaler, and faces a constant elasticity of demand
`⑀
`with elasticity
`
`
`
`Because it has monopoly power, the retailer sets its price, p1,
`whereequal to m1p2,
`1.
`1] 7 1
`⫽ 1/[1 ⫹ 1/⑀
`is the manufacturer’s price for the good and
`p2
`is the usual monopoly markup
`m1
`2] 7 1, ⑀
`⫽ 1/[1 ⫹ 1/⑀
`
`(Chapter 4). The manufacturer sets its price, p2,
`is
`
`
`where equal to m2m,
`m2
`2
`⫽ m1m2m
`the demand elasticity facing the manufacturer, and mis its constant marginal cost. Thus, p1
`
`and there is a double monopoly markup over the manufacturing cost of
`which is greater than
`m1m2,
`either
`or
`alone.
`m1
`m2
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`Vertical Restrictions
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`441
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`
`14 Thus, consumers pay a third more ($8⫽ 8.
`⫽ 6
`p* ⫽ p2
`p1
`cost, m, equal to 2,
`and
`instead of $6) due to the successive monopoly markup than they would pay if the firms
`Q* ⫽ 4.
`⫽ 2
`⫽ Q2
`Q1
`were integrated. They buy half as many units:
`instead of
`The firms’ collective profits are also lower. The profits of the integrated firm are
`p* ⫽ 16.
`p1,
`With the successive monopolies, the retailer’s profits,
`are 4 and the
`plus Area A,
`p*
`p2,
`p2,
`manufacturer’s profits,
`are 8. As Figure 12.5b shows,
`equals
`the profits lost due to reduced sales from the higher price. Total profits drop by Area
`⫽ 8 ⫺ 4 ⫽ 4.
`A ⫺ p1
`That is, the total profits of the successive monopolies are 25
`percent lower than those for the integrated firm.
`
`Vertical Restrictions to Reduce Double Markups. Thus, both consumers and
`firms are worse off with successive monopolies than when there is a single, integrated
`monopoly. These losses provide a strong incentive to integrate.15 It is not always prac-
`tical to do so. For example, where the manufacturer is Japanese and the distributor is
`French, it may be too costly for the Japanese firm to vertically integrate into distribu-
`tion. One alternative is to use vertical restrictions.
`The problem with the successive monopolies is that the distributor has an incentive
`to restrict output and raise price. The manufacturer does not want its distributor to re-
`p1,
`strict output further—or, equivalently, to increase its price,
`above the wholesale
`p2
`price, —because profits from the distributor’s markup go to the distributor, not the
`manufacturer. The manufacturer wants as efficient a distribution system as possible
`(that is, with the smallest distributor’s markup).
`Ideally, the manufacturer wants to induce competition at the distribution level in
`p1
`p2.
`order to drive
`to the wholesale price,
`There are many instances, however, when
`it is not possible to have competition in distribution, so the manufacturer is stuck with
`a monopolistic distributor. Before discussing why competition at the distribution level
`may be impossible, we examine three vertical restrictions that manufacturers can use
`to induce a monopoly distributor to behave more competitively.
`Where it is legal, the manufacturer may be able to impose contractually a maximum
`p,
`retail price,
`that the distributor can charge. By so doing, a manufacturer prevents a
`p2.
`distributor from raising its price much above the wholesale price,
`As a result, the
`p2,
`p,
`distributor sells more units. If
`is set equal to
`the distributor behaves like a com-
`Q*
`petitive firm, sells
`units, and the outcome is the same as with an integrated firm. If
`p
`p1
`p2,
`the distributor does not accept this restriction, and
`is set between
`and
`then a
`
`14In this example,
`MR1⫽ D1(Q1) ⫽ 10 ⫺ Q1,
`
`⫽ 10 ⫺ 2Q1
`⫽ p2
`⫽ D2(Q2) ⫽ 10 ⫺ 2Q2,
`p1
`⫽ 10 ⫺ 4Q2.
`Equating marginal cost and marginal revenue for the upstream firm,
`and
`MR2
`m ⫽ 2 ⫽ 10 ⫺ 4Q2
`⫽ 2,
`⫽ 10 ⫺ (2 ⫻ 2) ⫽ 6.
`⫽ MR2,
`implies that
`
`As a result,
`Q2
`so p2
`⫽ 10 ⫺ 2 ⫽ 8.
`⫽ 10 ⫺ 2Q1, Q1
`⫽ 2,
`⫽ 6 ⫽ 10 ⫺ 2Q2
`⫽ MR1
`and
`p2
`p1
`15If the integrated firm produces as efficiently as the separate firms, then integration makes con-
`sumers and the firm better off. Even if the integrated firm is less efficient, the desirable effect of elimi-
`nating one of the monopoly markups may outweigh this negative effect. It is possible, however, that
`some vertical mergers are privately profitable but not socially desirable, and that some socially desir-
`able mergers are not privately profitable (Ross 1990).
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`Eye Therapies Exhibit 2046, 442 of 849
`Slayback v. Eye Therapies - IPR2022-00142
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`442
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`Chapter 12 Vertical Integration and Vertical Restrictions
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`Q*
`Q1
`is sold. Such restrictions were common in the United
`and
`quantity between
`States before 1976, when a change in the law made it illegal for manufacturers to con-
`trol the retail prices of independent distributors.
`A manufacturer uses quantity forcing if it imposes a sales quota on a distributor;
`that is, the distributor must sell a minimum number of units. With this restriction, a
`manufacturer does not have to restrict a distributor’s price. Sales quotas induce distrib-
`utors to expand their output by lowering their prices. Many automobile dealerships
`and computer retailers have sales quotas.
`Another tactic is for a manufacturer to adopt a more complicated pricing scheme
`p2
`than merely charging a distributor
`per unit of output. A manufacturer can use a
`two-part pricing scheme, as described in Chapter 10. It charges the distributor one
`price for the product and a second price for the right to sell the product. For example,
`the manufacturer sells the franchise rights, or rights to sell the product (often together
`with a brand name) to the distributor, for a franchise fee.
`Why would a manufacturer want to set two prices? Suppose that instead of charg-
`p2
`, which is greater than its marginal cost, m, the
`ing the distributor a price per unit of
`manufacturer charges its marginal cost. Here, the distributor equates marginal revenue
`Q*
`to its marginal cost, m, and sells
`units, which is the same outcome as with a verti-
`⫽ m,
`p2
`cally integrated firm. Thus, by setting
`the manufacturer prevents the second
`monopoly distortion.
`If the manufacturer charges m per unit, however, it earns zero profits, and the
`distributor earns all the monopoly returns. But the manufacturer may make positive
`profits from its franchise fee. Indeed, as long as there are many potential distributors,
`the use of a franchise fee allows the manufacturer to earn the same profits as it
`would earn if it were vertically integrated into distribution. The manufacturer can
`offer for sale the right to be the sole distributor of its product with a contractual
`guarantee that the wholesale price to the distributor is m per unit. The largest fran-
`chise fee a distributor is willing to pay is the value of the monopoly profits,
`as
`p*,
`shown in Figure 12.5a. If a large number of firms want the monopoly franchise
`rights, competitive bidding ensures that the franchise fee equals the present value of
`the monopoly profits. Thus, the manufacturer can achieve the equivalence of verti-
`cal integration by charging a franchise fee and charging the marginal cost for its
`product.
`In summary, if there is only one distributor, the problem of double monopoly
`markups may occur. If vertical integration is not feasible, vertical restraints such as
`maximum retail prices, quotas, or franchise fees may reduce or eliminate the problem.
`See Examples 12.4 and 12.5.
`
`Free Riding Among Distributors. In a typical distribution arrangement, several in-
`dependent firms distribute one manufacturer’s product. Each distributor benefits from
`the promotional activities of other distributors without having to pay for them. The
`following sections identify several situations where free riding by distributors is likely
`to occur and then discuss some vertical restraints that may minimize free riding.
`Where distributors must make substantial expenditures (for advertising, show-
`rooms, training a sales staff, training purchasing agents, maintaining quality) to sell a
`
`Eye Therapies Exhibit 2046, 443 of 849
`Slayback v. Eye Therapies - IPR2022-00142
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`

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`Eye Therapies Exhibit 2046, 444 of 849
`Slayback v. Eye Therapies - IPR2022-00142
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`

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`Eye Therapies Exhibit 2046, 445 of 849
`Slayback v. Eye Therapies - IPR2022-00142
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`

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`Vertical Restrictions
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`445
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`Another example of free riding occurs when a distributor’s sales staff must be well
`trained in order to sell a product. Computer salespeople are a good example. If one
`distributor has highly trained salespeople, customers go to that store and learn a great
`deal abo