A Bilateral Monopoly Model of Profit Sharing along Vertical Production Structure

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.