Advanced Industrial Organization IILecture 9: Empirical Analysis of Vertical

Restraints

Måns Söderbom�

28 April 2009

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1 Plan

Two main activities today:

� Student presentation, followed by general discussion, of the following pa-per:

Hortacsu, Ali and Chad Syverson (2006). �Cementing Relationships: Verti-cal integration, Foreclosure, Productivity, and Prices,� NBER Working Paper12894-

�Department of Economics, University of Gothenburg. O¢ ce: E526. E-mail:mans.soderbom@economics.gu.se

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� Empirical analysis of vertical restraints. This discussion will be based onthe following paper, which is added to your reading list:

Lafontaine, F. and M. Slade (2005). "Exclusive contracts and vertical re-straints: Empirical evidence and public policy". Mimeo; subsequently publishedin Handbook of Antitrust Economics, Paolo Buccirossi (ed.) Cambridge: MITPress, 2008, pp. 391-414.

I have updated my reading list to re�ect this addition and the paper discussedyesterday by Hastings and Gilbert - see web page for AIO2.

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2 Empirical analysis of vertical integration

We�ve just had a presentation of the Hortacsu-Syverson paper. Questions:

� What�s the main research question?

� Data: Why is this an excellent sample for analysis of the e¤ects of verticalintegration?

� How are the regression models speci�ed, and why?

� How do the authors distinguish between the e¤ects of vertical integrationon e¢ ciency and market power?

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� What do the empirical results indicate? Is vertical integration a sourceof e¢ ciency gains - or does e¢ ciency lead to vertical integration (self-selection? It seems it�s the latter: e¢ ciency! desire to expand! verticalintegration ! logistical coordination gains (lower costs)

[Key results on prices are shown in Table 6]

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Table 6. Vertical Integration and Ready-Mixed Concrete Prices: Market-Level Results A. Benchmark Specifications

[1] [2] [3] [4] [5] [6] [7] [8] [9] [10] N 1870 1870 1870 1550 1550 1870 1870 1870 1550 1550 R2 0.087 0.433 0.434 0.573 0.573 0.087 0.432 0.432 0.573 0.573

Mkt share of VI firms -0.125* (0.028)

-0.090* (0.041)

-0.086* (0.041)

-0.043 (0.039)

-0.043 (0.039)

Mkt share of MU firms -0.015 (0.022) 0.001

(0.024)

Number of VI firms -0.028* (0.007)

-0.015 (0.011)

-0.013 (0.011)

-0.009 (0.009)

-0.007 (0.009)

Number of MU firms -0.003 (0.004) -0.004

(0.004)

Quantity-wt avg TFP -0.293* (0.054)

-0.293* (0.054) -0.294*

(0.054) -0.294* (0.054)

Market fixed effects? No Yes Yes Yes Yes No Yes Yes Yes Yes Notes: The panel shows the coefficients obtained by regressing quantity-weighted average concrete prices in a market on either the market share or number of vertically integrated firms operating in the market. The market share or number of multi-unit firms and the quantity-weighted average TFP in the market are also included in some specifications. All regressions control for the HHI and density of demand in the market as well as year effects (coefficients not reported). Standard errors clustered by market. An asterisk denotes significance at the five percent level.

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3 Empirical Analysis of Vertical Restraints

Reference: Lafontaine, F. and M. Slade (2005).

3.1 Background

� Competition policy towards restraints between upstream �rms and theirdownstream retailers is controversial and has been inconsistent over timeand across jurisdictions.

� This is mirrored in economic theory. Some theoretical models imply thatvertical agreements are welfare enhancing, while others support the oppo-site conclusion.

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� I argued last time, when discussing vertical mergers, that if the theoreticalpredictions are ambiguous then there is a strong case for empirical research.

� The purpose of Lafontaine and Slade is to shed light on the empiricsof vertical restraints. This is primarily a methodological paper, o¤eringan overview of methods that can be used to assess the consequences ofvertical restraints. Most of the empirical literature has addressed the e¤ectsof restraints in the context of exclusive retail relationships, includingfranchise distribution. Such contracts will be the focus of the discussion.

� The empirical approaches can be grouped into three broad classes.

1. Actual consequences of changes in the legal environment. Analyses ofcross sectional, time series, or panel data on �rms or regions, some

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of which employ a vertical restraint and some of which do not. Stud-ies range from mainly descriptive to rigorous econometric analyses.Changes in the legal environment are often viewed as natural exper-iments that allow applied researchers to assess the consequences oflaws and regulations by examining di¤erential responses of two groupsof �rms - a treatment group that is a¤ected by the change and a con-trol group that is not. We discussed this last time, in the context ofhorizontal mergers in the US airline industry.

2. Event studies to assess market forecasts of the consequences of verticalrestraints, e.g. share-price information can be used to infer implicationsof changes in the law.

3. Structural models. Derive theoretical model and estimate the parame-ters of this model. The main advantage of this approach is that, unlikethe �rst two classes of empirical approaches, it can used to forecast

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the e¤ects of changes that have not yet occurred - i.e. it can be usedfor counterfactual simulations of policy changes.

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3.2 Why vertical restraints? A brief summary of principal

paradigms

� Vertical relationship: �rms operating at di¤erent but complementary levelsof the production/distribution chain. Thus, upstream/downstream andinput/output relationships are vertical.

� Any restriction that is imposed by one member of a vertical relationshipon the other member of that relationship is a vertical restraint.

� Price vertical restraints - e.g. manufacturer sets the price that retailerscan charge.

� Non-price vertical restraints - e.g. exclusive dealing, exclusive territo-ries, quantity forcing, tying.

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� Most of the empirical evidence focuses on the situation where the upstream�rm imposes restraints on the downstream �rm, who is a retailer.

� Most exclusive retailing arrangements occur within franchise relation-ships. Two forms:

� Traditional franchising: upstream manufacturer and a downstream re-tailer (e.g. gasoline retailing, car dealerships).

� Business�format franchising, production takes place mainly at the retailoutlet, e.g. fast food.

� What are the economic rationale behind vertical restraints that are vol-untarily undertaken? These include e¢ ciency as well as anticompetitivemotives.

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3.2.1 E¢ ciency reasons for vertical restraints

Chain of monopolies

� Double marginalization - key outcome: consumer price too high, Largewelfare loss.

� In the context of traditional franchising: franchisor sells an input that isresold by franchisees under a �xed�proportion technology (i.e. no substi-tution between factors of production, which would mitigate the e¤ects ofdouble marginalization).

� Simple solution: Franchisor imposes �xed fee on the franchisee, andsells the product at marginal cost. The fee means the franchisor ex-tracts some of the downstream surplus.

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� In the context of business-format franchising: franchisors sell only smallamounts of inputs to franchisees; still a form of double marginalizationoccurs due to the reliance on revenue-based royalty payments in franchisecontracts. This is like a tax on output that results in a downward rotationof the demand curve faced by the franchisee.

� Double marginalization hurts the upstream �rm (franchisor). To overcomethis problem, and reduce retail prices, franchisors might want to use someform of vertical restraint, e.g.

� �x resale prices.

� use a minimum quantity requirement

� replace royalties on sales by higher franchise fees (independent of sales).

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� control the number of stores that sell the product so as to promotecompetition at the downstream level.

� Clearly, such restraints, designed to combat double marginalization, arelikely welfare enhancing.

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Dealer services and free-riding issues.

� A general problem is that the incentives of the franchisor do not fully matchthose of the franchisee.

� Dealers might free ride on investments made by the franchisor (e.g.training). Exclusive dealing resolves this problem, making it impossi-ble for the dealer to propose, say, an alternative brand to his customers.Thus exclusive dealing is a mechanism that enables manufacturers toprotect their investments against potential dealer opportunism.

� Franchisees do not fully internalize the bene�t that is associated withtheir own decisions, as some of their customers with positive experi-ences will patronize other units of the same chain rather than returningto their unit in the future. However, franchisees bear the full cost of

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quality enhancing policies, and as a result they will tend to provide toopoor quality.

� Franchisor may adopt vertical restraints which leads to higher qualityat the retailer stage. For example, give retailers exclusive territoriessubject to certain quality standards being ful�lled; if the retailer doesnot deliver the required level of quality, then the franchisor can termi-nate the contract, which is costly for the franchisee given that exclusiverights create rents. There are other examples too - see Lafontaine &Slade for a brief discussion.

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Dealer ex-ante investment incentives

� Suppose the manufacturer wants the dealer to invest ex ante in speci�cfacilities or human capital in order for him to provide better service toconsumers. Unless the dealer can be assured that his investments are fullyprotected, however, he will choose to underinvest or not invest at all.

� A vertical restraint such as an exclusive territory can provide the guaranteethat the dealer needs.

Price discrimination

� Vertical restraints can be used to enforce price discrimination schemes.Ambiguous welfare implications.

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3.2.2 Anticompetitive reasons for vertical restraints

Now let�s consider two commonly discussed reasons why vertical restraints maybe anticompetitive and thus harm welfare.

Dealer cartels and monopolization

� Vertical restraints can facilitate cartels or monopoly power. For example,large exclusive territories protects retailers from competition by eliminatingnearby competitors as well as preventing entry.

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Foreclosure and raising rival�s costs

� This is perhaps the main worry of antitrust authorities in the U.S. and theEU: vertical restraints may foreclose entry by upstream and/or downstreamcompetitors

� For instance, if a manufacturer establishes an exclusive retail network (i.e.,exclusive dealing) that involves most retailers, this may prevent the man-ufacturer�s competitors from gaining access to customers.

� How detect anticompetitive vertical restraints empirically? If vertical re-straints are anticompetitive through foreclosing or disadvantaging rivals,prices to consumers should be higher and quantities sold smaller thanthey would be in the absence of such restraints.

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3.3 Empirical evaluation of vertical restraints

Economic theorists and policy makers do not agree amongst themselves on themost important consequences of vertical contracts. Fortunately, we can learnabout this from empirical research.

The focus of the following discussion will be on the consequences of verticalrestraints. In particular, we discuss methods for assessing the e¤ects of verticalrestraints on:

� price

� consumption (and other measures of consumer welfare),

� pro�ts (and other measures of �rm value).

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3.3.1 Methods for assessing the e¤ects of vertical restraints

� Persuasive descriptive statistics. For example, compare retail prices inregions where a restrictive agreement is banned to prices in regions wherethe agreement is allowed.

� A good descriptive analysis shows that there is an empirical regularity thatshould be explained. The obvious problem, however, is that there can bemany explanations for the regularity.

� The most common empirical approach, therefore, is to combine descriptivestatistics with econometric analysis.

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Econometrics: Cross-Section, Time-Series, and Panel Estimation

� Simple example:

price = �+ � �RESTRAINT + controls+ residual;estimated based on a cross section of �rms or retailers. The vector ofcontrols includes other variables impacting on price, e.g. supply, demand,and policy variables. Important to include such variables in order to reducethe risk of omitted variables bias.

� Still, there is a problem with approach as the use of a restraint may beendogenous to the relationship. It seems reasonable to assume that theupstream �rm will choose restraints that maximize its pro�t, and there aremany unobservable characteristics of the franchisor and franchisee thatcan a¤ect both retail price and the choice of restraints.

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� The relationships uncovered are therefore correlations, not causalities.

� To identify the causal e¤ect of vertical restraints in this setting, we mightbe able to use instrumental variables. However informative and validinstruments are not easy to �nd in general.

� Another way of identifying the causal e¤ect of restraints is to base theanalysis on a natural experiment - e.g. cross sections of regions that banand do not ban particular restraints.

� Is the ban guaranteed to be exogenous? No. Even though the ban comesfrom outside the vertical relationship, it may be that prices are higherin regions where vertical restraints are allowed because such policies areimplemented in order to eliminate double marginalization.

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� Thus causality might run from prices to policies on vertical restraints!

� If the underlying factors that a¤ect both the use of a restraint and the de-pendent variable are time invariant, a panel data approach (�xed e¤ects)could solve the problem:

priceit = �i + � �RESTRAINTit + controlsit + residualitNote that the e¤ect of a restraint is identi�ed solely through time-seriesvariation, which may be a problem if there isn�t much variation in therestraint variable over time (why?).

� In any case, if the unobservable characteristics vary over time, the endo-geneity problem is not solved.

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� With panel data, it is tempting to use lagged endogenous variables as in-struments in the hopes that they are predetermined. This requires absenceof serial correlation in the residual - why? - which may be an unrealisticassumption.

� Alternatively, look at a single time series of prices that includes periodsbefore and after a change in the law (e.g. the banning of a restraint).However, many things change over time, and so readers may not be con-vinced the estimated coe¢ cient on the restraint variable is interpretable asan estimate of the causal e¤ect.

� So what is an applied IO researcher to do?

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Natural experiments

� If you are a scientist working in a laboratory you may be able to carryout a controlled experiment, in which you assign "treatment" randomlyto (say) half of the observations and observed the di¤erence in outcomesbetween treated and nontreated observations. In such a case there is noendogeneity problem.

� Experimental economics involves trying to mimic the laboratory environ-ment in the context of economic questions. For example, to estimate thecausal e¤ect of a training programme, it might be possible to assign train-ing randomly to some individuals and not others, and then measure theoutcome of interest after a suitable period of time.

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� In IO implementing realistic experiments for real companies is di¢ cult(it might be possible to come up with an arti�cial experiment applied tostudents, but the external validity of such a study would appear uncertain).

� Second best might be to rely on a natural experiment - in the contextof vertical restraints this typically involves legal changes, perhaps acrossstates (in the US). We thus need:

� An exogenous policy change

� A group of observations that is a¤ected by the change (the treatmentgroup)

� A group that is not a¤ected (the control group).

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Furthermore, the average di¤erence in the outcome variable of interest (typicallythe price) identi�es the causal e¤ect of a restraint.

� Last time I discussed how the di¤erence in di¤erences (DiD) estimate,under certain assumptions, can be obtained by simply comparing the dif-ference in the growth rates of treated and nontreated observations.

� This extends naturally to a regression framework. Suppose we have datafor two regions, j = 1; 2 and that the law is exogenously changed in region1 and not in 2. Take as the starting point the following regression modelfor price:

pjit = �i + �

j + Djt + �Xit + ujit;

where i denotes brand, t denotes time period (before and after), Dj isa dummy variable equal to 1 in the period after the policy change in the

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treated region and zero otherwise, Xit is a vector of control variables, andujit is an error term assumed u

jit is uncorrelated with treatment status and

the observed characteristics in both periods. The parameter is de�nedas the treatment e¤ect.

� We have:

Ehpji2 � p

ji1jDjt; Xit

i= Djt + ��Xit;

hence,

Ehp1i2 � p1i1jD1t; Xit

i= � 1 + ��Xit

Ehp2i2 � p2i1jD2t; Xit

i= � 0 + ��Xit;

hence the di¤erence-in-di¤erence;:

DiD = Ehp1i2 � p1i1jD1t; Xit

i� E

hp2i2 � p2i1jD2t; Xit

iDiD = :

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� Thus, all we need to do is to run a regression in �rst di¤erences, e.g.

�pjit = Dj + ��Xit +�u

jit;

where the coe¢ cient on the treatment dummy identi�es the treatmente¤ect.

� The validity of this simple procedure hinges on the treatment being exoge-nous. Can you think of an example in which this may not hold?

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Event studies

� We can also learn something about the e¤ect of vertical restraints on pricesand, more generally, �rm performance, by investigating stock market data.(We have already touched upon this when discussing the background tothe study on the e¤ects of mergers on airfares in the US)

� Key assumption: stock markets are e¢ cient and share prices re�ect allcurrently available information.

� Under this assumption, when an unexpected change in the law occurs, thecausal e¤ect of this new policy is identi�ed from the associated change inthe share price.

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� Illustration of framework:

Rjt = �i + �iRmt +Xs siDst + uit;

where Rjt is the return on asset j in period t; Rmt is the market returnand Dst is a series of dummy variables equal to 1 if the "event" (e.g.change in the law) happened in period t and zero otherwise.

� The e¤ect of the law change on �rm value can be inferred from the esti-mated si:

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Structural models

� The methods discussed above are based on reduced-form equations. Ba-sically, the researcher writes down an equation where the outcome variableof interest (e.g. price) is assumed to a be a function of some judicious setof explanatory variables.

� An alternative method is to use a structural approach:

� Write down a fully speci�ed theoretical model, in which the �rm�stechnology (e.g. the cost function), environment (e.g. nature of thecompetition; supply constraints) and objectives (e.g. pro�t or valuemaximization) are explicitly formulated.

� Use real data to estimate the model parameters

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� Analyze the e¤ects of policy changes on the outcome variable of inter-est.

� The latter point is the big advantage associated with a structural ap-proach, as it is not possible to use reduced-form equations to forecast theconsequences of changes in policy ex ante. This goes back to the Lucascritique: Problematic to evaluate the e¤ects of a policy change based on anon-structural regression model, since policy likely impacts on the reducedform coe¢ cients in an unknown way.

� So far, a structural approach has not been a common way of assessingvertical issues, although this is now changing.

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� Of course, for the structural approach to be useful we must have (a lotof) faith in the model we�ve written down. If this is based on incorrectassumptions, then our results may not be reliable.

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3.4 Empirical �ndings

� Tables 1-3 in Lafontaine and Slade summarize the results of studies thathave analyzed the e¤ects of vertical restraints on market outcomes.

� General remark: there isn�t much empirical research in this area. There isa large number of theoretical articles on the subject; also we know verticalrestraints are common in the real world. Much more empirical research isneeded here.

� Summarizing the results:

� In most cases, privately imposed vertical restraints bene�t consumers.Voluntarily adopted restraints are associated with lower costs, greater

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consumption, higher stock returns, and better chances of survival. SeeTable 2.

� When restraints are mandated by the government, they reduce con-sumer welfare: higher prices, higher

costs, shorter hours of operation, lower consumption, lower upstreampro�ts. See Table 3.

[Tables 2 and 3 here]

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Voluntary Vertical Restraints

The paper by Tim Sass (2004) is on your reading list and will be presented next time we meet. 

When reading the paper by Sass, think about why exclusivedealing is said to be welfareimproving – even though it is associated with a higher price.

In most cases, voluntaryvertical restraints are found to be welfare enhancing:• Lower cost• Higher consumption• Higher stock returns• Better chance of survival

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Mandated Vertical Restraints

The paper by Tim Sass (2004) is on your reading list and will be presented next time we meet. 

When reading the paper by Sass, think about why exclusivedealing is said to be welfareimproving – even though it is associated with a higher price.

In nearly all cases, mandatedvertical restraints are found to be welfare decreasing:• Higher price• Lower consumption• Lower stock returns

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� Thus, the empirical research seems to indicate that vertical restraints inmanufacturer/retailer settings are publically desirable when privately de-sirable - government intervention is thus not warranted in those situations.

� Mandated restraints tend to be welfare decreasing, and hence govern-ment policies that are aimed at helping dealers and consumers tend to bemisguided, counterproductive, and inconsistent with the goals of competi-tion policy.

� Why is this? An important reason is that upstream �rms face problems inproviding their wholesalers and retailers with appropriate incentives. Im-plementing vertical restraints voluntarily may be one way of circumventingsuch problems.

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� In such a context, it seems likely that the �rms themselves are best informed- i.e. it seems unlikely that the government could come up with moree¢ cient ways of achieving the same objectives.

� Lafontaine and Slade therefore argue that a relaxed antitrust attitude to-wards restraints may be warranted.

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