Vertical Integration by Contractual Restraints in Spatial Markets

Abstract

Manufacturers of products frequently include conditions in contracts with retailers that restrict the final retail price or volume of sales or the retail territory to be serviced by the retail outlet. While such restrictions have largely been ignored in economic theory, they are a source of contention in antitrust legislation. Why would a manufacturer who has any market power be interested in imposing any restrictions on the retail sector rather than setting the wholesale price and selling to all buyers? If manufacturing and retailing markets satisfy the conventional conditions for perfect competition, these restrictions would not be used. In this case, the competitive price system alone would be sufficient to coordinate the retailers' output and entry decisions with the manufacturer's interests. Therefore, the use of these restrictions signals some further characteristic of markets. In particular, this paper focuses on the spatial feature of retail markets where retail firms incur some fixed setup costs and geographically scattered consumers incur some traveling costs to purchase a product from one of a limited number of retail firms, characteristics of many This paper analyzes the private and social incentives for the use of vertical restraints by a monopolistic manufacturer in transactions with firms in a spatial retail market. Under the conditions of our model, the nonintegrated market equilibrium involves a greater density of outlets and a higher price than an integrated manufacturer would set. At the source of these effects are two potential externalities at the retail level, a vertical externality and a horizontal pecuniary externality. The integrated equilibrium is established and the manufacturer's profits are increased through the use of price ceilings, minimum quantity constraints, or franchise fees. The use of these vertical restraints is Pareto improving for some values of the exogenous parameters in our model and particular conjectures on the part of retail outlets, and socially efficient (in the sense of increasing consumers' surplus plus profits) for all parameter values. Where the source of private incentive for the use of vertical restraints is the spatial nature of retail markets, legal prohibitions against the restraints are inappropriate. * We wish to thank Curtis Eaton, Nancy Gallini, Yehuda Kotowitz, and Michael Peters for helpful comments and suggestions. Winter's research was supported by the Social Sciences and Humanities Research Council of Canada.