Vertical Separation between Competing Manufacturers and Their Retailers

Abstract

We examine an industry in which manufacturers set their wholesale prices (i.e., they engage in price competition) and retailers select order sizes (i.e., they engage in quantity competition). We consider the simplest example of such price-quantity competition, in which each of two manufacturers of a homogenous product sells through a different retailer, and the two retailers together face a non-linear demand function. We show that under this price-quantity competition, manufacturers vertically separate from their retailers and equilibrium wholesale prices are set below the marginal cost of production. The manufacturers' profi ts are lower than under vertical integration (i.e., a prisoner's dilemma occurs) and economic welfare is greater. Equilibrium wholesale prices decrease with demand expansion. The wholesale prices set by the manufacturers are strategic substitutes.