PROFIT TRANSFER WITHIN A VERTICAL RELATIONSHIP

We consider a vertical relationship between a single upstream firm and a single downstream firm and examine the economic eects of the profit transfer program, where the downstream firm transfers a predetermined share of its profit to the upstream firm. We analyze the eects under two scenarios, according as how the price is determined in the upstream market. One is where the upstream firm sets the price of the intermediate good and the downstream firm takes the price as given. The other is where the downstream firm acts as a monopsonist and sets the price of the intermediate good. In the former scenario, the profit transfer alleviates the problem of ‘double marginalization’ and enhances economic e- ciency. The downstream firm will hire more intermediate good and will produce more output. And the upstream firm will increase the eort level to reduce the production cost. The consumer surplus and the social welfare will rise. On the other hand, in the latter scenario, the profit transfer has opposite eects. It induces the downstream firm to hire less intermediate good. The upstream firm’s eort level to reduce the production cost decreases. As a result, the output of the final good, the consumer surplus, and the social welfare decrease. We will also examine how the profit transfer aects the individual firms’ profits.