The Vertical Structure

These notes cover a number of topics related to the vertical structure of markets. I will begin by reviewing the problem of double marginalization, which occurs when firms selling to each other along a vertical chain have market power. You were introduced to double marginalization in 15.010; my objective here is to review the concept, and discuss strategies (besides vertical integration) that firms sometimes use to deal with the problem. Next, I turn to the practice of monopsonistic price discrimination. Often, buyers of intermediate inputs have monopsony power. The simplest way of exercising monopsony power is by reducing the quantity purchased. (See Sections 10.5 and 10.6 of Pindyck and Rubinfeld, Microeconomics, for a discussion of monopsony power.) However, sometimes firms can utilize price discrimination as a means of exploiting their monopsony power. We will see how this can be done, focusing in particular on the purchase of timber by paper companies. Then, I will discuss issues that arise when a firm depends on downstream distributers to distribute and sell its products. Examples are bottlers in the case of soft drinks, and dealerships in the case of automobiles. What restrictions, if any, should be imposed on downstream distributers to maximize the benefits to the upstream manufacturers? Lastly, I discuss franchising, a form of vertical structure that has become very common in many service-related industries. As we will see, franchising can be an effective way of dealing with problems of asymmetric information and incentive design.