A Bilateral Monopoly Model of Profit Sharing along Vertical Production Structure

42 Pages Posted: 10 Sep 2018 Last revised: 22 Aug 2019

See all articles by Jim Huangnan Shen

Jim Huangnan Shen

University of London, School of Oriental and African Studies (SOAS), Economics; Center for International Development, Harvard Kennedy School, Harvard University

Pasquale Scaramozzino

University of Rome II - Faculty of Economics; University of London - School of Oriental and African Studies (SOAS); University of London - Centre for Financial and Management Studies (CeFIMS)

Date Written: August 28, 2018

Abstract

This paper investigates the firm-level division of the gains in the vertical production structure and provides a new theoretical framework to explain how gains are divided among firms and within the vertical supply chain. It constructs an economic model using a bilateral monopoly market structure to analyse how the average profitability varies with the stages in the chain. By introducing a vertical restraint known as quantity fixing, the double marginalization problem arising as a result of bilateral monopoly can be resolved. It demonstrates joint-profit maximizing contracts emerge under quantity fixing parameters whereby the Assembly and downstream retailer eliminate the incentives for vertical integration. This paper also shows the downstream retailer is more profitable than the upstream Manufacturer if (and only if) both the capability and cost effect of Retailer dominates the two counterpart effects of Manufacturer. For the dominance of capability effect, the retailer must have higher monoposonistic market power in the intermediate inputs market than in the final goods market where it acts as a monopolist. As a result, it could extract more surplus from manufacturer rather than consumers. In terms of cost effect, the factor endowment structure differentials are important to the model. The labour intensive nature of the Manufacturer would lead it to the lower average product of labour, generating a lower level of profitability compared with downstream Retailer which is more capital intensive with higher average labour productivity.

Keywords: vertical production structure, bilateral contracting choices, vertical supply chain, quantity fixing, bilateral monopoly, average profitability, capability effect, cost effect

JEL Classification: F12, F23, F60, L14

Suggested Citation

Shen, Jim Huangnan and Scaramozzino, Pasquale, A Bilateral Monopoly Model of Profit Sharing along Vertical Production Structure (August 28, 2018). Available at SSRN: https://ssrn.com/abstract=3239757 or http://dx.doi.org/10.2139/ssrn.3239757

Jim Huangnan Shen (Contact Author)

University of London, School of Oriental and African Studies (SOAS), Economics ( email )

London, WC1E 7HU
United Kingdom

Center for International Development, Harvard Kennedy School, Harvard University ( email )

One Eliot Street Building
79 JFK Street
Cambridge, MA 02138
United States

Pasquale Scaramozzino

University of Rome II - Faculty of Economics ( email )

Via Columbia n.2
Rome, 00100
Italy

University of London - School of Oriental and African Studies (SOAS) ( email )

Thornhaugh Street
Russell Square: College Buildings 541
London, WC1H 0XG
United Kingdom

University of London - Centre for Financial and Management Studies (CeFIMS)

Thornhaugh Street
London, WC1H 0XG
United Kingdom

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