An Economic Theory of Vertical Restraints

Abstract

Vertical restraints imposed by manufacturers on the prices, locations, and sales of retail firms represent a puzzling departure from the simple price-mediated exchange of conventional markets. In this article we analyze the theoretical basis for these restraints. In a setting where retailers inform consumers and are imperfectly competitive, and where a manufacturer has some monopoly power, we identify three potential externalities affecting retailers' decisions. These externalities lead to the failure of simple uniform-price contracts to coordinate the incentives of retailers with the objective of maximizing combined manufacturer and retailer profits. We identify the packages of vertical restraints that are minimally sufficient, under various conditions, to neutralize the externalities and to achieve the joint-profit maximum.