Vertical integration and exclusivity contracts when consumers have switching costs.

• Author: Valletti, Tommaso M.

1. Introduction

   This article examines the endogenous formation of vertical contractual arrangements between producers and retailers when consumers face switching costs. Previous works on switching costs assume that the product is sold directly by the manufacturer to the public, and no mention is made to upstream/downstream activities as they are pooled together. (1) On the other hand, the distinction between manufacturers and retailers is central to an extensive literature on vertical arrangements that has focused on several issues, including the elimination of successive markups or the attempt to raise rivals' costs. However, no reference is made to the fact that market power may arise from the existence of consumer switching costs. (2) This article would like to draw a line between these two streams in the literature by exploring the implications switching costs have for vertical relationships.

   Consider a framework where two upstream firms can supply two downstream firms, and firms compete after having made their vertical contractual choice. In the presence of consumer switching costs, an integrated firm would face a typical trade-off. If it invests in market share by charging a low price, it attracts customers that will be profitable repeat-purchasers; alternatively, the firm can harvest profits by charging high prices to existing customers. When independent retailers sell the product, new factors enter the picture. Manufacturers may face the paradoxical problem of extracting too much surplus from the retailer. If this happens, then the latter is not interested in building a subscriber base, resulting in foregone future profits. This is a case of "dynamic inconsistency," and it is likely that firms would look for a suitable contractual solution. For instance, the problem could be reduced if retailers have the freedom to resort to alternative sources of input supply. This ensures a reservation payoff to the retailer related to what he could get if he supplied the competing manufacturer's product to his customers. Such a reservation payoff depends also on the contract chosen by the rival pair: for example, if the rival manufacturer has signed an exclusivity deal, then it cannot supply any other retailer. Alternatively, vertical integration is a candidate to emerge, so that the problem is internalized. However, it is not clear if independent pairs of firms are able to coordinate on the most profitable contractual choices. I provide a framework suitable for analyzing equilibrium contracts and their properties, with a particular focus on the incentive to invest in market share when long-term contracts are not available. (3)

   The coexistence of vertical relationships and consumer switching costs can be found in the following business examples:

   (i) Telecoms. In the telecommunications industry, network operators can sell services directly to the final users or via service providers. Consumption in this industry involves consumer switching costs: if they try to switch network, users may face compatibility problems (additional software or hardware needed), transaction costs (absence of number portability), and contractual costs (e.g., in mobile telephony, SIM cards are typically locked so that handsets only work on one network). Customers buy their product directly from the network operator if it has (or is allowed by regulators to have) a retailing division or from independent service providers who do not own their own network but provide services over other operator's networks.

   (ii) Durable goods and aftermarkets. Some goods (e.g., a photocopier) are durable and require use with a "consumable" (e.g., toner cartridges). Cartridges may be supplied directly by the manufacturer of the durable good or by other independent firms. Independent suppliers may be required to carry only one particular cartridge compatible with a particular photocopier. If incompatibility between cartridges is achieved by product design, then the customer is locked with the "upstream" manufacturer and will need spare parts from a "downstream" service organization. A similar situation arises with video games designed for a Sony Play-station that cannot be used with a Nintendo games console.

   (iii) Cars. When replacing an old car with a new car, many customers tend to purchase their car from the same supplier as before. Because in principle it is easy to switch brands, this is seen as an indication of "psychological" switching costs (e.g., attachment to a brand or favorable experience with the previous purchase so that uncertainty costs are minimized by purchasing from the same manufacturer). The car itself is not typically purchased directly from the manufacturer but from a car dealer.

   (iv) Credence goods. These arise in medical services and in areas such as financial advice. Customers are not good judges of the appropriateness of a particular medical advice or treatment or of a mortgage or pension product. Some customers are then locked in with a particular doctor or financial adviser. Medical services need a hospital to be carried out. Financial products are offered by financial institutions. In both cases then, the customer buys advice/treatment from an adviser that may be independent or integrated "upstream." In the United States, treatment providers compete for patients, and under many insurance plans customers have a restricted choice of doctors. Also, doctors can sign exclusivity agreements to work only in a given hospital.

   (v) Fidelity cards. Frequent-flyer programs are perhaps the most cited example of a product involving switching costs. They allow travelers to earn "airmiles" each time they fly and they incorporate a nonlinear element that has the potential to generate switching costs. Airline tickets are often bought via a travel agent that does not necessarily coincide with the airline carder. Supermarkets also often employ loyalty programs. Supermarkets are an example of "downstream" retailers that also need to strike deals in wholesale markets in order to be able to supply final consumers.

   These business cases are all very different, but they exhibit two common features: (i) the product involves some sort of consumer switching costs, and (ii) there is a vertical structure of the manufacturer/retailer type (or primary/secondary markets). (4)

   I propose a three-stage game in order to study what implications switching costs have for vertical relationships in a two-tier industry made of two vertical chains, each consisting of one upstream and one downstream firm. In the first stage (time t = 0), within each vertical chain, the upstream and the downstream firm negotiate over the contract type (e.g., they can integrate or sign an exclusivity deal). After each pair of firms has determined its contract type and has observed the rivals' choice, there is market competition over two periods (t = 1, 2). Two periods of market competition are needed to analyze the basic trade-off in markets with switching costs ("invest" at t = 1, then "reap" at t = 2). Though the contract type is irreversibly set at t=0, contract terms (e.g., the input price) are set at t = 1 for the amounts sold at t = 1 and at t = 2 for the amounts sold at t = 2. Contract terms are chosen allowing for side payments between the negotiating pairs. Through these modeling assumptions, I can get rid of the typical "vertical externality" (e.g., double markups) that arises in models with an upstream-downstream structure. I can then concentrate on the problem of "dynamic inconsistency" for the manufacturer/retailer pair. The only type of commitment that can arise in my model is through the choice of contract type.

   As discussed above, the main contribution of this article is to extend the literature on switching costs by considering what happens when retailers and manufacturers are separate entities. At a more technical level, the contract terms of a vertical chain are chosen through bilateral negotiations, rather than take-it-or-leave-it offers chosen by one of the parties alone as is in most of the literature (typically, it is the manufacturer that has this ability). Hence, the second contribution is to deal with a non-straightforward compound problem that encompasses two synchronous bargaining processes. The final contribution of the article arises from the contrast between "downstream" and "upstream" switching costs, a distinction that has not been made in the literature before. Switching costs are said to be "downstream" when it is the change of retailer that matters for the consumer. This is the case, for instance, with service providers or doctors in the illustrative examples above. In other situations, however, it is the manufacturer's brand that matters, hence switching costs occur "upstream." This is the case with cars or frequent-flyer programs. The distinction as to who "owns" the customer is important, as it improves the bargaining position of the parties and hence affects the distribution of rents that is at the very heart of the problem of dynamic inconsistency analyzed by this study.

   The remainder of the article is organized as follows. Section 2 presents a simple upstreamdownstream model. The model is solved in sections 3 and 4. Section 5 deals with two extensions: the case of "upstream" switching costs and the role played by consumer rational expectations. Section 6 concludes.

2. The Model

   The model is a three-stage upstream--downstream duopoly, in which consumers experience a cost when switching retailers. Prior to trade that takes place in dates 1 and 2, at date 0 a producer matches with one retailer, and each matched pair contracts on the specificity of their vertical relationship (e.g., vertical integration, exclusive dealership, independence, and so forth). The vertical contracts are assumed to establish only the relationship-specificity, but not the transfers from a retailer to its upstream supplier. In date 1, each retailer invests in acquiring...