Vertical Separation with Private Contracts

We consider a manufacturer’s incentive to sell through an independent retailer, rather than directly to final consumers, when contracts with retailers cannot be observed by competitors. If retailers conjecture that identical competing manufacturers always offer identical contracts (symmetric beliefs), manufacturers choose vertical separation in equilibrium. Even with private contracts, vertically separated manufacturers reduce competition and increase profits by inducing less aggressive behaviour by retailers in the final market. Manufacturers profits may be higher with private than with public contracts. Our results hold both with price and with quantity competition and do not hinge on retailers beliefs being perfectly symmetric. We also discuss various justifications for symmetric beliefs, including incomplete information.