Vertically related markets

Firms that sell products usually require inputs, which are produced by other firms in an upstream industry (which again may require inputs from other firms). This leads to a vertical supply chain that is needed to produce a final product. Up until now, we have analysed various forms of competition at one level of the vertical supply chain. This approach is appropriate if inputs are provided in a perfectly competitive way under constant marginal costs. In this case, the input price is equal to the marginal cost that is incurred upstream and this input price does not vary with input supply. However, inputs are often also provided by firms with market power. We then have to take the whole vertical supply chain into account to understand how markets function. For instance, can upstream firms deny competitors access to their distribution channel, for example, because they have signed an exclusive dealing contract with their retailers? Also, what are the effects of vertical mergers? We start in Section 17.1 with the traditional double-marginalization problem within a monopoly context and explore the consequences of allowing contracts between the upstream and downstream firm that differ from linear pricing. In Section 17.2, we analyse the role of resale-price maintenance and exclusive territories. In Section 17.3, we address the role of exclusive dealing contracts. Finally, in Section 17.4, we analyse a model with an oligopolistic industry upstream and downstream. We examine the effects of vertical mergers in such markets. The double-marginalization problem A pricing inefficiency in vertically related markets stems from the so-called double-marginalization problem. The idea is the following: in a market with firms operating only at one level of a vertical supply chain, retail prices are higher than in a market with vertically integrated firms because a downstream firm applies a margin to the wholesale price which includes the margin of an upstream firm. The inefficiency arises because the retailer does not take into account the externality exerted on the upstream firm by changing the retail price. We first formally develop this insight within a monopoly context. We next examine contractual solutions to this problem. Finally, we consider the impact of double marginalization on the provision of retailing services.