Vertical Control with Bilateral Contracts

It is widely believed that a supplier who distributes her product through retailers can achieve the vertically integrated outcome with nonlinear contracts, provided the retail price is the only target of control and there is no uncertainty. We show that this result fails when retailers cannot observe their rivals' contracts, as incentives to choose each contract to maximize bilateral profits may yield retail prices well below the vertically integrated level. This provides a new explanation for vertical restraints, and it rationalizes an oft-expressed but never formalized view that resale price maintenance prevents countervailing buyer power from lowering retail prices.