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Review of Industrial Organization

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09-07-2019

Input Price Discrimination and Upstream R&D Investments

Author: Ioannis N. Pinopoulos

Published in: Review of Industrial Organization | Issue 1/2020

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Abstract

We study the welfare effects of input price discrimination when an upstream firm that supplies two cost-asymmetric downstream firms undertakes R&D investments. With observable two-part tariffs, banning discrimination always decreases R&D levels and long-run welfare. Under unobservable two-part tariffs, banning discrimination may increase or decrease R&D levels—depending on the degree of downstream cost-asymmetry; but it always decreases long-run welfare. Thus, with unobservable two-part tariffs, a ban on input price discrimination is detrimental to welfare even when its effect on upstream R&D investments is positive.

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See Schwartz (1986) and Geradin and Petit (2006) for extensive discussions of input price discrimination issues from the point of view of competition law analysis.

We will briefly review the existing literature on input price discrimination in the next section.

See Herweg and Müller (2012, 2016), as well as Chen (2017), for brief but informative reviews of this literature.

For empirical evidence on the use of non-linear contracts, see: Slade (1998), Berto Villa-Boas (2007), Bonnet and Dubois (2010), and Ferrari and Verboven (2012) among others.

However, banning input price discrimination can be socially desirable when downstream firms possess private information about their costs and the demand they face (Herweg and Müller 2014) and/or the more cost-efficient downstream firm has significantly higher fixed cost than its less efficient rival (Herweg and Müller 2016).

The situation where the supplier is tempted to offer better terms to a downstream firm after having signed with another firm is referred to in the existing literature as either the supplier’s commitment or opportunism problem. In the present paper, we use the first term.

The logic of the results that are described in this paragraph will be further explained in Sect. 4. We note here that—as was pointed out first by O’Brien and Shaffer (1994)—the upstream supplier can be better off under uniform pricing as long as the degree of downstream cost-asymmetry is sufficiently low. In that case, it can self-impose uniform pricing by enforcing ‘non-discrimination’ clauses. Nevertheless, irrespective of whether a ban on discrimination can be self-imposed by the supplier or it is imposed by antitrust agencies, the main point is that it is detrimental for welfare. As was mentioned above, we will address this issue further in Sect. 4.

However, a ban on input price discrimination can be welfare-improving when the supplier is constrained by the presence of a competitive fringe (Caprice 2006).

Nevertheless, we briefly discuss the case of linear contracts in Sect. 5.

For instance, medical equipment suppliers and pharmaceutical companies have long been under great pressure by the US government to disclose information about their costs at the wholesale level (Arya and Mittendorf 2011; Lai et al. 2012). In the UK, the National Health Service Act 2006, as amended by the Health Service Medical Supplies (Costs) Act 2017, enables the Secretary of State to make regulations requiring the provision of information about costs in connection with the manufacturing, distribution or supply of health service products. In the EU, article 24(4) of the Markets in Financial Instruments Directive II (MiFID II) requires the effective communication of costs across the distribution chain.

Despite the fact that we allow for product differentiation, we restrict the paper’s focus on downstream Cournot competition; the case of downstream Bertrand competition is not analyzed for reasons that will be explained in the Conclusion.

As noted by Inderst and Shaffer (2009), the fact that \( M \) offers a single two-part tariff to both downstream firms implies that the latter will pay the same marginal input price and thus compete on the same ‘level playing field’ as is required by the Robinson-Patman Act under US law and the Article 102(c) TFEU under EU law.

The fact that the upstream supplier sets marginal input prices above marginal cost under observable two-part tariff contracts was first shown by Mathewson and Winter (1984) for the case of downstream cost-symmetry.

This is the so-called ‘waterbed effect’: As one downstream firm becomes relatively more cost-efficient, the upstream supplier increases the other downstream firm’s input price.

As pointed out by Rey and Tirole (2007, p. 2156):

“There is […] a strong analogy with Coase’s durable good analysis. […] a durable-good monopolist in general does not make the full monopoly profit because it ‘creates its own competition’: By selling more of the durable good at some date, it depreciates the value of units sold at earlier dates; the prospect of further sales in turn makes early buyers wary of expropriation and makes them reluctant to purchase”.

From the perspective of \( M \), when contracts are unobservable and downstream competition is in quantities, the two downstream firms form two separate markets. Thus, a passive-beliefs equilibrium survives both unilateral and multilateral deviations (for more details, see: Rey and Vergé (2004), Rey and Tirole (2007)).

As can be seen from (18), the two contracts affect the upstream supplier’s profits in a separable way.

Alternatively, we could have assumed that contracts are still unobservable, but downstream firms now hold symmetric beliefs: Following any out-of-equilibrium contract offer, a downstream firm believes that its rival receives the same deviation contract. As is well-known, with symmetric beliefs, the upstream supplier can achieve the same equilibrium outcomes as if contracts were observable.

They are also known as ‘most favored nation’ (MFN) clauses. This latter usage draws on the parallel with international trade agreements, which often have a similar restriction on a country’s ability to discriminate in the setting of different tariffs for imports of the same good from different countries.

The critical value of \( c_{R} \) below (above) which the supplier’s profits increase (decrease) as a result of the ban is too complex to be presented here but is in the Appendix 1.

It should be noted that the main issue with such clauses is their credibility: How can they be implemented when downstream firms can never observe price discounts that are offered to rivals? Since the commitment problem arises precisely in situations where contracts are unobservable, it seems reasonable that the same circumstances will also make it difficult to apply MFC clauses, unless competition-policy authorities come to their rescue: by introducing a “transparent pricing” rule (sellers cannot offer secret discounts to buyers) with heavy penalties for its violation. See Motta (2004, pp. 342–343) for a discussion on this issue.

On the other hand, denying self-enforceability to MFC clauses rests on the assumption that contracts are never observable. It is an intriguing question whether allowing rival contracts to be observed with a positive probability less than one may enable M to find ways credibly to self-impose MFC clauses (I am grateful to the Editor for raising this point). This issue cannot be answered without further research that lies beyond the scope of this paper.

Therefore, we focus on the case where the supplier does not face a commitment problem. Kim and Sim (2015)—contrary to the rest of the existing literature—assume that the upstream supplier contracts sequentially instead of simultaneously with downstream firms, in which case a commitment problem does exist. However, sequential contracting alters the mode of downstream competition from Cournot to Stackelberg and introduces additional effects that are beyond the scope of the present paper.

The formal analysis is relegated to Appendix 2.

Nevertheless, input price discrimination can be welfare improving when: (i) it prevents inefficient backward integration into the supply of the input (Katz 1987; O’Brien 2014); (ii) it fosters entry in the downstream market (Herweg and Müller 2012; Dertwinkel-Kalt et al. 2016); (iii) downstream firms have an alternative source of supply (Inderst and Valletti 2009; O’Brien 2014); and (iv) the upstream supplier contracts sequentially, instead of simultaneously, with downstream firms (Kim and Sim 2015).

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Title: Input Price Discrimination and Upstream R&D Investments
Author: Ioannis N. Pinopoulos
Publication date: 09-07-2019
Publisher: Springer US
Published in: Review of Industrial Organization / Issue 1/2020
Print ISSN: 0889-938X
Electronic ISSN: 1573-7160
DOI: https://doi.org/10.1007/s11151-019-09713-6

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