WHAT ARE VERTICAL RESTRAINTS?

In most markets, producers do not sell their goods directly, but reach final customers through intermediaries, wholesalers and retailers. Further, the final good is often produced in several stages, from raw material, to intermediate good, to final product. Very often, firms at different stages of the vertical process do not simply rely on spot market transactions, but sign contracts of various types in order to reduce transaction costs, guarantee stability of supplies, and better co-ordinate actions. These agreements and contractual provisions between vertically related firms are called vertical restraints. This chapter analyses the welfare effects of vertical restraints as well as of vertical mergers, that is mergers between vertically related firms.

To gain some initial insight on the topic, consider the classical example of the vertical relationship between a manufacturer and a retailer which distributes its products. In general, both the manufacturer and the retailer decide on different actions, and what is an optimal action for one is not necessarily optimal for the other. As a result, a party can try to use contracts and clauses so as to restrain the choice of the other and induce an outcome which is more favourable to itself. (To put it another way, each party's actions create an externality on the other. Vertical contracts might be used to try to control for these externalities.)

For instance, the manufacturer would like the retailer to make a lot of effort in marketing its products (such as advertise its products, put them in evidence on shelves, employ specialised personnel who assist potential customers, offer post-sale assistance and so on), but the latter might have a lower incentive to do so, as effort and services are costly to provide. The manufacturer might then decide to use contractual provisions (that is, vertical restraints) in order to induce higher marketing effort from its retailer.