Wholesale Price Determination Under the Threat of Demand-Side Substitution

Inderst, Roman and Shaffer, Greg (2011): Wholesale Price Determination Under the Threat of Demand-Side Substitution.

Abstract

An upstream supplier that is constrained both by downstream competition and the threat of demand-side substitution faces a tradeoff between maximizing joint-profit and extracting surplus. Although joint-profit maximization calls for relatively high marginal wholesale prices in order to dampen intra-brand competition, surplus extraction will be higher when the supplier instead charges relatively low marginal wholesale prices. The reason is that by inducing more intra-brand competition through lower wholesale prices, the supplier makes it less attractive for downstream firms to switch to alternative sources of supply. We show how this can make it optimal for the supplier to disadvantage more efficient and thus ultimately larger buyers, thereby smoothing out differences in their market shares. We further show that despite the use of non-linear supply contracts, marginal wholesale prices and thus final goods’ prices will decrease when either downstream competition intensifies or the supplier becomes more constrained by the threat of demand-side substitution.

• Item Type: MPRA Paper
• Language: English
• Keywords: Keywords: Vertical control; Input markets; Price discrimination; Buyer power
• Subjects: L - Industrial Organization > L1 - Market Structure, Firm Strategy, and Market Performance > L11 - Production, Pricing, and Market Structure ; Size Distribution of Firms

References

Athey, S. and Schmutzler, A. (2001), Investment and Market Dominance, Rand Journal of Economics, 32: 1-26.

DeGraba, P. (1990), Input Market Price Discrimination and the Choice of Technology, American Economic Review, 80: 1246-53.

Hart, O. and Tirole, J. (1990), Vertical Integration and Market Foreclosure, Brookings Papers on Economic Activity, Microeconomics, 205-285.

Inderst, R. and Shaffer, G. (2009), Market Power, Price Discrimination, and Allocative Efficiency in Intermediate-Goods Markets, Rand Journal of Economics, 40: 658-672.

Inderst, R. and Valletti. T. (2009a), Price Discrimination in Input Markets, Rand Journal of Economics, 40: 1-19.

Inderst, R. and Valletti, T. (2009b), Third-Degree Price Discrimination with Buyer Power, B.E. Journal of Economic Analysis & Policy, 9: Iss. 1 (Contributions), Article 6.

Katz, M. (1987), The Welfare Effects of Third Degree Price Discrimination in Interme- diate Good Markets, American Economic Review, 77: 154-67.

McAfee, R.P. and Schwartz, M. (1994), Opportunism inMultilateral Vertical Contracting: Nondiscrimination, Exclusivity, and Uniformity, American Economic Review, 84: 210-230.

O’Brien, D.P. (1989), Bargaining, Commitment, and Third-Degree Price Discrimination, mimeo.

O’Brien, D.P. (2011), The Welfare Effects of Third-Degree Price Discrimination in Inter- mediate Goods Markets: The Case of Bargaining, forthcoming in Rand Journal of Economics.

O’Brien, D.P. and Shaffer, G. (1992), Vertical Control with Bilateral Contracts, Rand Journal of Economics, 23: 299-308.

Raskovich, A. (2003), Pivotal Buyers and Bargaining Position, Journal of Industrial Economics, 51: 405-426.

Rey, P. and Verge, T. (2004). Bilateral Control with Vertical Contracts, Rand Journal of Economics, 35:728-746.

Shubik, M., and Levitan, R., (1980), Market Structure and Behavior, Harvard University Press.

Yoshida, Y. (2000), Third-Degree Price Discrimination in Input Markets: Output and Welfare, American Economic Review, 90: 240-46.