Vertical Limit:

Approaching vertical issues with the care of a

high altitude climber

Vertical vs Horizontal agreements

Section 5 of the Competition Act prohibits vertical agreements if they substantially prevent or lessen competition. Restrictive vertical agreements may be permitted if parties to the agreement can demonstrate that any technological or efficiency gains resulting from that agreement outweigh any anti-competitive effect. However, in the case of resale price maintenance (RPM) no trade-off defence is possible, as the practice is prohibited per se.

If a firm acquires another firm that is related to it in the chain of supply or in the production process, then we have a vertical merger. The Competition Commission must investigate any vertical merger falling within the thresholds for notification. As vertical integration is an extreme form of a vertical restraint the assessment of its impact on competition is similar to that of any vertical agreement.

Horizontal agreements or horizontal mergers between firms with market power may have obvious anti-competitive effects. However, a vertical agreement or merger between an upstream and downstream firm may not be apparently anti-competitive. Very often there are strong efficiencies to be gained from vertical relationships - even when both firms have market power. The reason for this is that whereas firms in a horizontal relationship produce substitute products, firms that are vertically related produce complementary products. To see this consider two "products"; X and Y:

If X and Y are compliments: A fall in the price of X will lead to an increased demand for Y. There is clearly an incentive for firms in a vertical relationship to want to keep the prices of the other firm down.

If X and Y are substitutes: The demand for product X will decline as the price of substitute product Y falls. Therefore, in the case of substitute products each firm would like to see the other (competing) firm raise its prices or at least prevent prices from falling. There is, therefore, an incentive for firms in a horizontal relationship to bring about price increases. Private incentives conflict with social needs. The likelihood of anticompetitive behaviour is great when these firms have market power.

However, firms that are vertically related have an incentive to see the other firm reduce its prices. As firms in a vertical relationship produce complementary products the profits of one firm will increase when the other firm lowers its price. There is an alignment of private and social incentives because both firms and society want the other firm to lower its prices. A vertical restraint imposed by one firm on another may well be pro-competitive.

The important insight is that the firms in a vertical relationship have an incentive to bring about alignments of private and social interests. Because the opposite is true in the case of horizontal relationships, the approach that should be taken when dealing with anti-competitive vertical restraints is to ask how the restraint reduces competition at the horizontal level.

Inter-brand and intra-brand competition in vertical agreements

It is an approach that leads one to consider the extent of intra-brand and inter-brand competition when evaluating the effect on competition of a given vertical restraint. Inter-brand competition refers to competition between different brands, whereas intra-brand competition takes place when competing wholesalers and/or retailers sell the same brand. Now a vertical restraint such as an exclusive distribution agreement will undoubtedly reduce intra-brand competition. However, if the brand in question faces competition from other brands then the imposition of the restraint should intensify this inter-brand competition. But if the brand in question is dominant in its relevant market the reduction in intra-brand competition is not compensated for by an intensification of inter-brand competition, because there is insufficient competition from other brands.

A simple showing of a lessening of intra-brand or inter-brand competition is not enough to condemn a vertical restraint as anti-competitive. Because un-integrated firms make profit-maximising price and output decisions independently of their upstream of downstream counterparts, it is often the case that each firm in the vertical relationship is not charging the optimal price for its vertical counterpart. A famous example of this is the problem of double marginalisation. If the upstream and the downstream firm both have significant market power, each will mark up their price well in excess of marginal cost. Consumers thus face two mark ups instead of one. This double mark up can be thought of as an externality resulting from the fact that the un-integrated upstream firm does not take into account the un-integrated downstream firm's mark up when it sets its own price. The externality arises because the price charged by the downstream firm (incorporating the mark up) affects demand conditions in the downstream market. But the manufacturer does not take this into account when it sets its price.

A vertical restraint or full vertical integration will eliminate this double monopoly mark up. The merged firms joint profits will be higher than the sum of the separate profits of the un-integrated firms, and there will be an increase in output and a reduction in the downstream product's price.

Company behaviour

However, there may be times when vertical restraints and vertical integration involve strategies by dominant firms that are far from benevolent. It is important to note that it is not vertical integration or the vertical restraint in itself that is necessarily anti- competitive, but rather it is the behaviour that it facilitates. Such behaviour would normally constitute an abuse of dominance. For example, exclusionary acts like refusing to give a competitor access to an essential facility, or refusing to supply scarce goods to a competitor, may arise when firms impose vertical restraints with market power at one or more levels in the supply chain. Such behaviour also takes place when vertically integrated firms with market power in the upstream market attempt to gain dominance in the downstream market by foreclosing the upstream market to un-integrated downstream competitors.

Conclusion

The impact on competition of vertical restraints has long been the source of an intense debate between mainstream economists as well as between those on the extremes of economic thought. However, consensus seems to have emerged among mainstream economic thinkers. This is reflected in the Green Paper on Vertical Restraints in EC Competition Policy (1997) where it was noted that:

"Vertical restraints are no longer regarded as per se suspicious or per se pro-competitive. Economists are less willing to make sweeping statements. Rather, they rely more on analysis of the facts of the case in question. However, one element stands out: the impact of market structure in determining the impact of vertical restraints"

Keith Weeks

Enforcement and Exemption