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FREE-RIDING PROBLEMS AND EXTERNALITIES IN DISTRIBUTION SYSTEMS POSSIBLE SOLUTIONS TO THE FREE-RIDING PROBLEM AND A COMPARATIVE LOOK AT HOW THEY ARE TREATED UNDER THE ANTITRUST LAWS MAX ROHRIG APRIL 11, 2005 -一- EXECUTIVE SUMMARY This paper examines the problems and false incentives created by the risk of free-riding in distribution systems. It concludes that potential retailers take this risk of free-riding into account when deciding whether to enter a market, and that they may consequently invest too little in the creation of new markets for a product and in advertising and presales advice; inter-brand competition and social welfare will suffer as a result. The paper then turns to possible solutions to this problem. It concludes that there are only two effective ways of cutting down on the free-riding problem. One solution is to grant specific retailers territorial exclusivity (possibly coupled with a maximum price restraint), the other is the imposition of minimum resale prices which would effectively guarantee distributors a certain minimum profit margin. Both of these steps would tend to benefit inter-brand competition, at the cost of restricting intra-brand competition to a greater or lesser degree. The paper next looks at the legal treatment of the two solutions mentioned above. It finds that both the EU and the U.S. treat exclusive territoriality under the rule of reason (the EU even has a presumption of legality under certain circumstances), whereas both legal systems impose per se illegality on resale price maintenance (with the U.S. rule being based on a 1911 case, which itself is partly based on a fundamentally flawed economic argument). The paper ends by concluding that this distinction in legal treatment is unjustifiable. Both solutions usually have the same objectives, both solutions tend to increase inter-brand competition and often have significant overall pro-competitive effects, and both solutions have few arguments speaking against them. Additionally, RPM prices are imposed by manufacturers who share customers’ desire to maintain cheap retail prices and to keep retailers’ margins low. And finally, RPM schemes actually have less anti-competitive effect than territorial exclusivity, since they still allow for some intra-brand competition to take place. As a result, RPM schemes do not deserve to be treated any worse than EDAs, and should also take the benefit of the rule of reason. Subsidiary suggestions are that a positive presumption of legality should be introduced to EDAs in situations where the manufacturer has a fairly small market share and any intrabrand market power would be tempered by the existence of inter-brand competition1, and that maximum-price restraints should be per se legal as they are incapable of hurting consumers (except when they are predatory, and then they are caught under the rules banning predatory pricing anyway). None of these topics is treated in quite as much detail as it would ideally command, but space constraints unfortunately did not permit a more detailed analysis. 1 This is mainly a matter of semantics, as it will be fairly hard to make out a case under the per-se rule in such circumstances anyway. -i- TABLE OF CONTENTS 1. Introduction ............................................................................................................... 1 2. The issue: free-riding and moral hazard in distribution systems ........................ 1 Introducing products to new markets ...................................................................... 1 Advertising .............................................................................................................. 6 Pre-sales services .................................................................................................... 8 After-sales care ....................................................................................................... 9 The common theme............................................................................................... 10 3. Potential Solutions .................................................................................................. 10 3.1. Territorial exclusivity and maximum price restraints .................................... 12 3.1.1. Economic analysis ................................................................................... 12 Territorial restraints .............................................................................................. 12 Maximum price restraints ..................................................................................... 15 3.1.2. The law in the U.S. ................................................................................... 17 Maximum price restraints ..................................................................................... 17 Territorial restraints .............................................................................................. 18 3.1.3. The law in the E.U. .................................................................................. 19 Maximum price restraints ..................................................................................... 19 Territorial restraints .............................................................................................. 21 3.1.4. Conclusions .............................................................................................. 22 3.2. Minimum price restraints / resale price maintenance .................................... 23 3.2.1. Economic analysis .................................................................................... 23 3.2.2. The law in the U.S. .................................................................................... 28 3.2.3. The law in the E.U. ................................................................................... 28 3.2.4. Conclusions ............................................................................................... 29 4. Recapitulation and overall conclusion .................................................................. 30 - ii - 1. Introduction This paper will have a brief look at the incentives created for actual and potential distributors by the risk of free-riding in distribution systems. Part two explains what exactly those risks are and why they are detrimental to social welfare. Part three explores potential measures that manufacturers can take in order to minimize the risk of free riding, and also looks at how those measures are currently treated under antitrust law, both in the EU and the U.S. It turns out that the two roughly equivalent options available are subject to quite different legal treatment, and the paper concludes by commenting on this fact. Due to space constraints, most issues will be addressed only briefly. 2. The issue: free-riding and moral hazard in distribution systems Introducing products to new markets When a new product is introduced for the first time, or an existing product is introduced into a new market, it is often necessary to spend a substantial amount of money on advertising and creating a brand: demand for the new product must be generated, and the public needs to be informed that the product may in fact be substitutable for existing and more established products. It may also be necessary to make certain investments required in order to gain local regulatory approval. Quite often the distributors will have more local knowledge and better local contacts than the product’s manufacturer and will be in a better position to undertake these tasks. It is also often true that distributors tend to have more experience with marketing etc. than do manufacturers; after all, one of the main reasons why manufacturers tend to avoid integrating vertically into retailing is that they are aware that their particular strengths are not best suited to that part of the supply chain. -1- If the product and its sale in the market in question seem commercially viable, both the manufacturer and the retailer have an obvious interest in going through with the deal: the manufacturer gains entrance to a new market and will be able to sell more units, and the distributor calculates that it will make a profit on resale; the public will also benefit as there will be increased competition between the new product and existing comparable products and since consumer choice is increased. However, since the deal requires up-front investment of capital in order to facilitate the market entry of the new product, there is a risk that the first distributor to enter the market will incur externalities and become subject to free-riding. This may result in the transaction not taking place in the first place, or if it goes ahead in the early demise of the initial distributor. The problem here is as follows: once the first distributor (‘X’) has made the initial investment in getting the product approved and in establishing a demand base for the product, there is nothing to stop a second distributor (‘Y’) from coming along and starting to resell the same product. Since Y did not incur (and therefore does not have to recoup) the initial investment in promoting the product, Y will be able to profitably sell the product at a lower price2 and will have a competitive advantage vis-à-vis X. If we now assume that the market for the distribution of the product is competitive (either because further retailers enter the market and start selling the new product 3, or because the new product is highly substitutable for another product and vice versa 4), standard economic wisdom dictates that economic profits will tend towards zero: when people 2 We assume that all else is equal, i.e. that both resellers are able to source the product from the manufacturer at the same cost, and that there are no other factors (such as economies of scale or differences in cost base) that affect the distributors’ ability to make a profit on reselling the product. 3 ‘Intra-brand competition’ 4 ‘Inter-brand competition’ -2- see that a certain activity offers above-normal returns (especially when that activity or market, like retailing, has relatively low barriers to entry) they will tend to enter that market, thereby increasing competition and driving prices down until a competitive price equilibrium has been reached. This is where things get problematic for X: everybody else can sell the product for a price that allows them to recover (1) their cost of buying the product from the manufacturer, (2) the cost of day-to-day operation of the distribution business, and (3) a reasonable profit or return. X himself, however, has a fourth cost factor to recoup: he made the up-front investment in establishing the product in the market and has to amortize that investment, usually by spreading the cost across all units of the product sold over the next few years5. As a result, the price that allows X to sell the good for a reasonable profit (economic profit = zero) will be higher than the price that allows other retailers to do so. Still assuming a competitive market, it would also be a reasonable assumption that X only has a relatively small market share and that the prevailing market price will be dictated by the other resellers, who operate on the lower cost base and are able to charge lower prices. If X insists on charging supra-competitive prices in order to recoup his initial investment, he will lose substantially all sales to Y and the other new market entrants and will eventually go out of business. Conversely, if X reacts by lowering his prices to the competitive level charged by Y, he will be selling at a price that leaves him unable to recoup his initial investment in establishing the product on the market, and he will lose out on that front. 5 Assuming that there is at least some differentiation between the product and its other-brand competitors, the retailer should, in the absence of intra-brand competition, not have too much of a problem charging a small premium in order to do so. -3- Assuming further that most potential distributors are smart people with a rudimentary understanding of economics, it seems likely that X (and other potential distributors) will be aware of the problem described above. Given the risk that the first distributor to enter the market will be unable to make even an economic profit of zero, no distributor will want to be the first to enter the market (and the one to incur the initial investment) unless they are given some reassurance that they will be able to recoup that investment. In the absence of adequate protective measures, we are left with perverse incentives for distributors: there is a perfectly viable market to be developed here, but all potential retailers are aware that whoever takes the first step will suffer a negative return on their investment6. As a result, neither of the retailers will take any steps at all, the product will never be introduced, and the market in question will not come into existence. Assuming for simplicity’s sake that (1) there are only two potential distributors, (2) we model only two points in time at which a potential distributor can enter the market7, and (3) the two potential distributors cannot cooperate to share costs, and hence cannot enter the market at the same time, this problem can also be looked at in gametheoretical terms. Since both parties’ incentives are symmetric, we will only look at Y. Let us look first at the second point in time, t=1. If X entered the market at t=0, Y will now have an incentive to enter: X already incurred all the costs and there is a positive return to be had. However, if X did not enter at t=0, Y will not enter at t=1: it is impossible for both parties to enter at the same time, and if only Y enters now it will be the 6 They will either have to charge competitive prices and be unable to recoup their sunk costs, or they will be priced out of the market. 7 Distributors can also enter the market at t=2, t=3, etc., but the incentives at t=2 depend on the other party’s presence in the market at t=1 in precisely the same way as the incentives at t=1 depend on the other party’s presence in the market at t=0, so there is no need to look at t > 1 in any detail. -4- first in the market and can be fairly sure that X will enter once it has made the investment, i.e. at t=2. Looking now at t=0, both parties will be able to predict how the other party will react to each action they take: if they enter the market at t=0, the other party will enter at t=1 and will render them unable to recoup the investment, but if they do not enter at t=0 the other party will not enter at t=1 either. Assuming now that both parties are rational profit-maximizers and do not wish to make an investment with an expected economic return below zero, both potential retailers will have a strong incentive to not enter the market. Returning now to t=1, we will know that neither party entered the market at t=0. As a result, the incentives at t=2 will be the ones we originally had at t=1 and the incentives at t=1 are now the same as those we originally had at t=0. In other words, neither party will want to enter the market at this point either. Assuming that the need for upfront investment by the first market entrant remains the same, the same result will apply for any subsequent point in time, and neither of the retailers will ever enter the market. So, in game-theoretical terms, the dominant strategy is clearly not to be the first distributor to enter the market. Since each potential market entrant shares that strategy and is aware that they do, the only point at which anybody would have an incentive to enter the market (when there is already somebody else in it) will never be reached. As a result, the dominant strategy becomes not entering the market at all. As explained above, in the absence of sufficient protection, no distributor will be willing to make the investment necessary to introduce the product into the new market. This will prevent the new market from being created and will have a number of negative -5- effects: consumer choice is not increased, inter-brand competition8 (which would lower prices) is not increased, resellers will not be selling the products and will not be making a profit by doing so, and the manufacturer will not be making increased profits by selling his product into the new market as well. In other words, this outcome is unilaterally detrimental to social welfare, when compared with a world where the new market is in fact created. Advertising Another example of free-riding issues can be seen by looking at the need for continued advertising by resellers. This essentially covers the same problem as the one that arises during initial market-creation, but deals with a situation where continued spending over time (as opposed to a single up-front investment) is required: in other words, there is no need to ‘translate’ the concept of an initial lump-sum investment into a need to amortize that cost over time, and we can simply look at costs as they arise over time instead. The issue is the same, but due to the fact that we do not need the extra ‘translation’ step, the problem may be easier to grasp in this context. If reseller X spends money on a local advertising campaign extolling the virtues of the product he sells (say, Sony TVs), this is likely to increase the demand for Sony TVs in that area. However, this increased demand benefits all retailers of Sony TVs in 8 For clarification: strong intra-brand competition can drive economic profits on resale to zero, as there is no distinguishing factor that would allow anybody to maintain a higher price. Inter-brand competition also is a strong restraining influence on resale prices, but the product will be somewhat differentiated (hence cross-elasticity of demand will be less than 100%) and inter-brand competition will not generally prevent a reseller from charging the relatively small mark-up necessary to recoup the up-front investment needed to develop the new market. -6- that geographic market and not just X alone; we could say that the advertising campaign gives rise to informational externalities9. X is therefore left bearing the entire cost of the advertising campaign, but reaping only part of the rewards10. Furthermore, the amount spent on advertising will increase X’s costs of operating the business and will increase the price he needs to charge in order to make a reasonable profit. Other retailers in the area will benefit from his advertising, but they will not have to recoup any advertising costs and will therefore be able to make a reasonable profit by charging less. Again, X will be placed at a competitive disadvantage and will either have to cut its profits in order to meet other distributors’ prices or will end up losing market share. The manufacturer (say, Sony) will have an obvious interest in its resellers pursuing advertising campaigns extolling the virtues of their products: such campaigns are likely to increase the demand for Sony TVs and will therefore allow Sony to sell more units and make more profits. Similarly, consumers have an interest in getting as much information as possible and will also be happy about such campaigns. However, the incentives for distributors are more complicated: Sony retailers as a whole have an obvious interest in such campaigns, as they improve the standing of their brand vis-à-vis other-brand TVs 11 and essentially improve the competitive position of Sony retailers as a whole12. However, each individual retailer faces the risk that he ends See also Mathewson and Winter’s externality hypothesis: The Economics of Vertical Restraints in Distribution, in New Developments in the Analysis of Market Structure, 211-36 (Stiglitz & Mathewson, eds. 1986) and Lester G Telser, Why should Manufacturers Want Fair Trade?, 3 J.L. & Econ. 86 (1960). 10 How many of the extra sales resulting from the advertising campaign X manages to capture himself will depend on his market share and a number of other factors. 11 Obviously, such campaigns are eventually subject to diminishing returns and the point will be reached where the marginal benefit of further advertising does not suffice to offset the marginal costs involved; we implicitly assume that this point has not yet been reached. 12 In other words, the campaign improves inter-brand competitive standing. 9 -7- up incurring a cost that confers a benefit on all Sony retailers and is then later underpriced by other retailers who did not incur that cost. This leaves us with a classic prisoners’ dilemma scenario: Sony retailers as a group have an incentive to advertise, but no individual retailer has an incentive to do so. As a result, no advertising will take place, and retailers as a group (as well as consumers and the manufacturer) will end up being worse off. Pre-sales services Many ‘information-intensive’ products (such as consumer electronics) require extensive pre-sales information before customers can be enticed to buy them; this is, after all, the reason why many resellers invest considerable amounts of money in the provision of knowledgeable sales staff and well-stocked showrooms. The provision of these facilities is all about providing product information which customers require before deciding to buy. Again, these facilities create informational externalities and induce free-riding: in the absence of meaningful restrictions, there is nothing to stop a discounter from setting up shop next to a full-service retailer; the discounter is free to tell customers to go to the full-service showroom next door to get all the information they need to decide which model they want; they can then come back to him and buy the same product for 10% less than what the full-service store charges. Since the discounter does not bear any of the cost involved in providing the information, he will easily be able to undercut the full-service retailer on prices. The full-service retailer will either be forced out of business (if he maintains his prices, he will lose most of his market share) or will be forced to reduce the level of service provided in order to be able to compete on price. Either outcome is detrimental for -8- both consumers and the manufacturer: consumers will no longer be able to get adequate pre-sales information (even those that are willing to pay for it), and the manufacturer will lose market share since those customers that are willing to pay for information will change over to competing brands that still have a full-service retailer in the area. Again, the interests of manufacturer and customer are closely aligned, and an individual retailer would also tend to cater to these customer interests if it was not for the pressure put upon him (and his profit margin) by free-riding competitors. After-sales care Similar issues arise with respect to after-sales care: distributors that do not offer any after-sales care or customer support will easily be able to under-price those that do, thereby disadvantaging full-service retailers in terms of price competition. This situation is then aggravated even further by the fact that people who bought their goods at the no-frills retailer will end up going to the full-service retailer for servicing or customer support. If we assume that these after-sales services are provided below cost in order to drive sales in the first place, this will result in the full-service retailer having to bear the costs involved in supporting products on which he did not make a sales profit in the first place. Again, the full-service retailer will be forced to reduce the degree of service it offers or will face being priced out of the market. And again, both customers and the manufacturer suffer as a result: customers no longer have anywhere to turn to for after-sales care, and the manufacturer will lose sales as a result of his brand gaining a reputation for poor customer service. -9- The common theme In all four situations described above, the common theme is that the manufacturer of the product and the ultimate consumer have a shared interest in resellers providing certain services which involve incurring either certain up-front investments or regular costs: customers get the goods and services that they want, and the manufacturer gets to sell more units as a result of his brand’s improved position in inter-brand competition. In general, resellers as a group will have an interest in catering towards these interests, so as to improve the inter-brand position of the products they sell and so as to increase sales. However, as soon as one reseller makes the required investment or provides the required services, there are externalities across the intra-brand market, and there is an incentive for other resellers of the same product to free-ride on the first reseller’s investments. Since the free-riders do not have to bear the costs born by the lead retailer, they are able to undercut him on price. In the absence of restraints on intra-brand competition, such free-riding will eventually force the lead retailer out of business or force him into ceasing to provide the valuable services in order to cut price. Taking an ex ante view, the prospect of this happening will provide individual retailers with an incentive to not provide these services, and no retailer will want to take on the position of being the lead retailer. 3. Potential Solutions As described above, the free-riding issue arises whenever services provided by one distributor lead to externalities that skew intra-brand competition and can be exploited by other distributors of the same good. - 10 - The obvious solution therefore is to find ways to restrict intra-brand competition in a way that guarantees the lead retailer that he will be able to benefit from his investments. One way of doing this is to guarantee each retailer a minimum margin on each sale (by way of minimum resale price, or retail price maintenance: ‘RPM’): this would restrict price competition in favor of service competition. Another way of achieving the same result is by way of assigning exclusive territories to distributors; depending on the market share of the manufacturer’s brand, this gives the distributor significant market power, and the manufacturer often tempers that market power by simultaneously imposing maximum price restraints (‘MPRs’) on the distributor. The following part of this paper will look at the economic merits of both solutions, and compare their (quite different) legal treatment, both in the U.S. and in the EU. It should be noted that the above two seem to be the only two truly workable solutions to the free-riding problem: raising the wholesale price does not guarantee dealers a margin and still allows for the same undercutting of full-service dealers by discounters, albeit at a higher price level13; price-discrimination between full-service and no-frills resellers would work in theory, but would be very hard to apply in practice and would fall foul of the Robinson-Patman Act; and partial vertical integration is generally not an option because the manufacturer and his staff are good at making the product, but not at selling it. 13 Raising the wholesale price may be helpful where a product has a non-standard demand curve, e.g. where the demand for certain luxury products (such as perfumes) actually increases as the price goes up. Increasing the wholesale price will ensure a high retail price and prevent the brand image from being tarnished. However, it does not help to restrict price competition between competing resellers. - 11 - 3.1. 3.1.1. Territorial exclusivity and maximum price restraints Economic analysis Territorial restraints Territorial exclusivity (or exclusive distribution agreements, ‘EDAs’) essentially involves a manufacturer giving a particular reseller a more or less exclusive right to sell that manufacturer’s products in a specific area. Such an agreement has the obvious drawback of conferring a certain amount of market power on the reseller: he is now the only distributor of that product in that area, and there no longer is any intra-brand competition going on14. So, at first sight, the manufacturer is conferring a local intra-brand monopoly on the retailer and thereby allows the retailer to charge higher prices than he would otherwise be able to charge. However, the manufacturer only makes a set amount of profit per unit: he sells at the same wholesale price, regardless of the reseller’s ultimate price charged to the consumer. As a result, the manufacturer has an interest in selling as many units as possible, which mainly translates (assuming a standard downward-sloping demand curve)15 into a desire to keep the reseller’s profit margin as small as possible. The manufacturer will consider any price increase to be justified only when it results in the provision of additional services to customers and if that additional service creates more new sales than the 14 Depending on the seize of the exclusivity area and depending on the value of the product, customers may, of course, be willing to travel to a reseller in another town who offers the good at lower prices, but this is ignored for simplicity’s sake and we are looking solely at competition in the exclusive market in question. In any event, such willingness to travel will usually not arise unless there are significant price differences and the good is fairly high-value; after all, traveling to the non-local retailer involves travel and time costs and the risk of a return journey when repairs are needed, and such costs have to be justified by the price margin between the two retailers. Additionally, the distributor’s market power will be curtailed by the fact that he is still competing with retailers selling competing goods, i.e. by inter-brand competition. 15 As mentioned before, there are exceptions to the downward-sloping demand curve: with certain essential goods, demand may stay fairly constant regardless of price, and with certain luxury goods (such as perfumes), demand may actually increase as price increases. However, the overwhelming majority of products have a downward-sloping demand curve, i.e. demand decreases as price increases. - 12 - increase in price prevents (marginal profit > marginal cost): whilst an increase in retail price may or may not be good for the distributor (depending on whether the extra profit on the units still sold outweighs the profits lost on the units that are no longer sold at the higher price), it will always be bad for the manufacturer who only receives the wholesale price and generally is only interested in selling as many units as possible at that price16. In other words, the manufacturer has a strong interest in keeping the distributor’s profit margin as small as possible. A more intuitive phrasing of this is that the manufacturer is merely purchasing retail services from the distributor. Since the retail services are an input into the manufacturer’s production and sale of his goods, he will want to keep the cost of the retail services (and therefore the distributor’s margin) as low as possible. Given the above, it seems counter-intuitive that any manufacturer would be willing to grant any amount of market power to retailers by giving them the benefit of an EDA17. However, the fact that such agreements are quite frequent in the real world suggests that there must be some other reason underlying such agreements. That reason is the simple fact that such a restriction on intra-brand competition may still leave manufacturers and consumers better off because of having strong pro-competitive effects in the inter-brand market. A reseller who is secure in the knowledge that he does not face any threat from free-riders will be much more willing to invest time and money in product promotion, customer information, pre-sales advice, and after-sales care. These investments will im- 16 This is assuming a stable wholesale price which is not adapted in return to an increase or decrease in retail price. Where a manufacturer supplies a number of separate regional markets, this will usually be the case. 17 The market power can be, and often is, tempered by the simultaneous imposition of an MRP; this will be covered later on in the paper. - 13 - prove the brand’s standing vis-à-vis competing brands and will further inter-brand competition. Providing resellers with a guaranteed margin also ensures that there is a continuing and sustainable supply of full-service retailing, and that customers will have access to the information and service that they require. The reseller, now freed from intra-brand competition and somewhat cushioned against inter-brand competition (because of product differentiation), is free to adjust the level of service offered and the level of price charged so as to conform to what customers want (thereby maximizing sales and profits), rather than having to cut price and service in order to avoid losing market-share to a discounter. Essentially, the restraint on intra-brand competition maintains the reseller’s incentive to invest in the provision of services which customers want, ensures that the reseller will get a fair return on his investments, and benefits both the manufacturer and consumers by improving inter-brand competition. Hence, territorial restraints, if properly applied, have a strong potential in welfare maximization and pose relatively few problems. They also embody a remarkable convergence between manufacturers’ and customers’ interest, and the restraints imposed by manufacturers usually tend to benefit the ultimate consumer. The only major argument against such EDAs is that they tend to confer a certain amount of market power on the reseller by preventing intra-brand competition. However, this is much less serious than it sounds for the following reasons: - 14 - (1) Other manufacturers will usually be making products that serve the same purpose and there will usually be a fairly high cross-elasticity of demand. So, even if X is the only Sony dealer (intra-brand monopoly) in the area, he will be unable to charge excessive prices, since people will otherwise simply start buying other brands of TV, say Panasonic. (2) Depending on the size of the exclusive territory, on the value of the product, on the anticipated need for after-sale service, and on the price difference between the exclusive dealer in this area and the exclusive dealer in the next area, people may be willing to drive to the non-local dealer if they think that they get a better deal that way. Hence, supra-regional competition also curtails the prices that a distributor with a local monopoly can charge. (3) The manufacturer can also impose a maximum resale price (‘MRP’) cap on the dealer and may require him to provide minimum levels of service. The former is done quite frequently, the latter is not usually done since it is too difficult and costly to monitor. The MRP cap also serves to prevent the reseller from exercising his market power in order to raise prices. Maximum price restraints Economically speaking, MRPs are also fairly unobjectionable. They serve a valuable purpose in curtailing the market power conferred on distributors as a result of an EDA, and there is little that can be said against them. The only maintainable argument against MPRs is that they allow the manufacturer to exploit the retailers by cutting down on the possible margins that retailers can make. However, this would only pose a problem if the manufacturer has sufficient market pow- - 15 - er in the market for local retail services, i.e. holds a position akin to a monopsonist of such retail services; it is exceptionally unlikely that any one manufacturer will have a sufficient share of the local retail market. In any event, the manufacturer has a strong incentive to avoid mistreating his distributors: retailing involves few ‘specific assets’, and the distributor can fairly easily switch to selling a competing brand of TVs or even an entirely different type of product if he no longer finds it worthwhile to sell Sony TVs. Furthermore, over-zealous use of MPRs would essentially result in the manufacturer cutting off its own access to market and would make little sense. Finally, it is wellnigh impossible to think of any circumstances in which the imposition of MPRs can end up hurting consumers. Further evidence of the unobjectionable nature of MPRs can be found in the fact that the Department of Justice and the Federal Trade Commission jointly filed an amicus brief in State Oil, in which they urged the abolishment of the rule of per-se illegality in respect of MPRs18. 18 See footnote 22 on p.329 of The Antitrust Revolution, J Kwoka & L. White (eds.), 4 th edition, Oxford University Press, 2004. - 16 - 3.1.2. The law in the U.S. Maximum price restraints The law on MPRs got off to a bad start in the U.S. when the Supreme Court handed down its decision in Albrecht v. Harold19. The court here likened maximum price restraints to minimum resale price maintenance and found that the per-se rule against RPMs20 should apply to MPRs also. The argument here was essentially that low MPRs may favor large-scale distributors (with lower costs per unit) and that very low MPRs may, in practice, function as maximum and minimum price simultaneously and may result in price fixing. This error was (partly) corrected in 1997 in State Oil v. Khan21, where the Supreme Court overturned Albrecht and held that MPRs were to be analyzed under the rule of reason. The court here pointed out that MPRs can be used to allow a manufacturer to stop resellers from exploiting their monopoly and that lower prices can only be beneficial for consumers. The Court also took account of academic and economic arguments favoring this outcome, and furthermore recognized that MPRs cannot unduly hurt the reseller, since the reseller is always free to turn to another supplier. However, the Court in State Oil explicitly used rule-of-reason analysis and strongly made the point the MPRs are not to be per se legal. At p. 285 the Court states expressly that “we of course do not hold that all vertical maximum price fixing is per se lawful. Instead, vertical maximum price fixing … should be evaluated under the rule of reason”. 19 390 U.S. 145 (1968) See Dr. Miles Medical Co, 220 U.S. 373 (1911) 21 188 S. Ct. 145(1997) 20 - 17 - Whilst this is a definite improvement over the unjustifiable decision in Albrecht, a number of academics22 argue that it does not go far enough, and that MPRs should be per se legal. Given that MPRs serve a number of useful and procompetitive purposes and do not seem to have any detrimental effects whatsoever on consumers, one is inclined to agree. Territorial restraints U.S. law on territorial restraints also got off to a bad start, with the Supreme Court finding territorial restraints illegal per se in U.S. v. Arnold Schwinn and Co23. The finding here was based on a decision that any restrictions on the on-sale of goods were illegal after the title in those goods had passed to the reseller (since such restrictions would interfere with the retailer’s property rights). Schwinn also created the nonsensical distinction between goods sold to the retailer for on-sale ( territorial restrictions illegal per se) and goods sold on a consignment basis, i.e. where the manufacturer retains title in the goods ( technically governed under the rule of reason, but the ‘rule of reason’ here was not much more than a test to see if there really was an agency relationship; in practice, it was more akin to per se legality24). So, under Schwinn, territorial restraints were either per-se illegal or almost-per-se legal, depending on how the business relationship with the retailer was structured. Clearly, this made no sense. 22 These include Gustavo Bamberger (Revisiting Maximum Resale Price Maintenance: State Oil v. Khan, pp. 334-349 of The Antitrust Revolution, J Kwoka & L. White (eds.), 4 th edition , Oxford University Press, 2004), and Roger Blair and John Lopatka (The Albrecht Rule after Khan: Death Becomes Her, 74 Notre Dame Law Review 123-179). 23 388 U.S. 365 (1967) 24 See Keith N. Hylton, Antitrust Law: Economic Theory & Common Law Evolution, Cambridge University Press, 2003, at pp. 265-6. - 18 - Fortunately, the Supreme Court revisited the issue in Continental T.V. v. GTE Sylvania25. The Court decided to reverse Schwinn, and found that territorial restraints should henceforth be analyzed under the rule of reason – regardless of whether title passed or not. This clearly makes more sense, and also allows for a balancing exercise between the loss of intra-brand competition and the gain in inter-brand competition. Since there is a need to balance a loss in one type of competition against gains in another type of competition, the rule of reason seems quite appropriate and there are no calls for per-se legality. 3.1.3. The law in the E.U. Maximum price restraints The starting point for competition analysis under EU law is Art. 81(1) of the E.C. Treaty26, which bans all “agreements” between “undertakings”, which “may affect trade between Member States” and “have as their object or effect the prevention, restriction or distortion of competition within the common market”. Such agreements are normally “automatically void” under Art. 81(2). However, Art. 81(3) then goes on to allow for exceptions to the above prima-facie rule in cases where the agreement has an overall beneficial effect on competition. Such an exception may be an individual exemption granted by the Commission, or may be automatically granted under a Block Exemption. Relevant to our case is the Block Exemption on Vertical Restraints (‘BE’) 27 , which applies to vertical agreements in which the supplier (i.e. the manufacturer) has a market share below 30% in the relevant market (here, presumably, TVs). Art. 3(1) then 25 433 U.S. 36 (1977) http://europa.eu.int/eur-lex/en/treaties/dat/C_2002325EN.003301.html 27 Reg. 2790/1999, http://europa.eu.int/eur-lex/pri/en/oj/dat/1999/l_336/l_33619991229en00210025.pdf 26 - 19 - grants an automatic exemption to agreements which comply with the terms of the block exemption. Art. 4 of the BE specifies certain types of vertical restraints which are excluded from the exemption. This ‘blacklist’ includes minimum price restraints, but Art. 4(a) specifically provides that maximum price restraints do take the benefit of the exemption. Art. 6 of the BE finally allows the Commission to withdraw the benefit of the exemption in individual cases. So, in effect we are dealing with a slightly tweaked version of the rule of reason: if the manufacturer has a market share in excess of 30%, the BE does not apply and there will be straight rule-of-reason analysis (the Commission deciding under Art. 81(3) whether the agreement is overall beneficial for competition); if the manufacturer’s market share is below 30%, the agreement takes the benefit of the block exemption and is presumed to be per-se legal under Art. 3(1) of the BE. Art. 6 allows the Commission to disapply the exemption, so this is not genuine per-se legality, but merely a presumption of legality that may be converted back into rule-of-reason analysis. So, essentially the EU applies a rule-of-reason analysis, but on top of that has a displaceable presumption that MPRs are nothing to worry about where the manufacturer’s market share is below 30%. Whilst this is not per-se legality either, it is closer to per-se legality than the U.S. approach. In practice, most cases should take the benefit of the exemption (since relatively few manufacturers will have market shares in excess of 30%), and it will be unlikely for protection to be withdrawn under Art. 6. - 20 - It should be noted that Art. 4(a) specifically excludes RPMs set so low that the ‘maximum’ price ends up being the price charged by all resellers. Territorial restraints The analysis of territorial restraints under EU law operates the same was as that of MPRs, except that we are now dealing with Art. 4(b) rather than Art. 4(a) of the Block Exemption. Art. 4(b) creates that same presumption of legality where a manufacturer has less than 30% market share and where the territorial restraint only bans active28 sales outside the reseller’s exclusive territory. Notably, stricter territorial restraints (which also ban passive sales into other resellers’ territories) and restraints along national boundaries (especially those supported by an assignment of national trademark rights to the reseller in that country) do not take the benefit of the block exemption and are exceedingly unlikely to get an individual exemption under Art. 81(3) either29. The harsher treatment of cases where markets are sealed hermetically or along national boundaries seems to be intended mainly to further the object of the Common Market, but also has the incidental effect of catching those cases where the reseller would be given too much market power: e.g. banning resellers even from making passive sales into neighboring territories would remove one of the three checks placed on the market power of resellers operating under an EDA. 28 i.e. the reseller is not allowed to make an active effort to make sales to people outside his territory (active sales), but is allowed to sell to people outside his territory if they come to him as a result of their own initiative (passive sales). 29 Cases on point include Consten and Grundig v. Commission [1966] ECR 429, STM v. Maschinenbau Ulm [1966] ECR 337, Nungesser v. Commission [1982] ECR 2015, and BASF Lacke + Farben/Accinauto OJ 1995 No L 272 p. 16. - 21 - The 30% threshold here works particularly well: it gives a presumption of legality to EDAs where the manufacturer has a small market share (and where there will be a lot of inter-brand competition to counter the reseller’s power in the intra-brand market), but insists on a full rule of reason analysis for cases where the manufacturer has a large market share and where it is more questionable whether any gain in inter-brand competition suffices to offset the reduction in intra-brand competition. 3.1.4. Conclusions The U.S. got off to a bad start with finding per-se illegality both in MPRs and in EDAs. However, in both cases the Supreme Court reversed itself and we are now left with the rule of reason applying to both MPRs and EDAs. The rule of reason is perfectly adequate for EDAs, where it may sometimes be necessary to weigh the competitive gains on the inter-brand side of things against the loss of competition on the intra-brand side. However, economic theory fails to disclose any situation where an MPR would hurt consumers, and it seems that this is an area where the law should move to per se legality in the future. EU law provides for rule of reason analysis both of MPRs and EDAs, but in both cases provides for a presumption of legality if the manufacturer has a market share below 30%. With respect to MPRs, the same arguments for per se legality apply, so this is not ideal. However, in practice most MPRs should be able to take the benefit of the presumption of legality under the Block Exemption, and the position in the EU is therefore some- - 22 - what closer to per-se legality than that in the U.S. Whilst further change remains desirable, this rule should be quite adequate for most purposes. With respect to EDAs, the EU rules seem to have struck just the right balance: in cases where the manufacturer has market power, it is necessary to weigh the inter-brand competitive gains against the loss in intra-brand competition, and here the rule of reason is entirely appropriate. Where the manufacturer has less than a 30% market share, interbrand competition can be presumed to be existent and to temper the reseller’s conduct, and here the presumption of legality (which can be set aside in appropriate cases under Art. 6) seems justifiable and convenient. As stated above, some further small changes in the rules would be desirable in both jurisdictions, but at least the current set of rules applying to EDAs and MPRs is acceptable: there is no blatant problem like per-se illegality being imposed on procompetitive provisions. 3.2. Minimum price restraints / resale price maintenance 3.2.1. Economic analysis Another way of precluding free-riding would be the imposition of minimum resale price requirements, or ‘resale price maintenance’ (RPM). This is much easier to implement than the above combination of territorial restraints and MPRs, allows multiple resellers to operate in one area, allows for continued intra-brand competition on factors other than price (and often even limited price competition), and is fairly easy to monitor. If the minimum price is fixed at a level sufficiently high above the wholesale price, it will give resellers a guaranteed minimum margin and reduce price-competition. - 23 - As a result, retailers could no longer compete on the basis of offering no service and super-low prices (since they are unable to discount too far), and competition will now be based on the services provided as well as on price. A relatively high minimum price may completely wipe out price competition in favor or service competition, but a lower minimum price (which manufacturers tend to favor, especially given that they need to keep prices low in order to succeed in inter-brand competition) would lead to a balance between price and service competition. If the RPM price is set at the right level, it will still allow for the co-existence of high-price-high-service stores and cheaper less-service stores. However, the minimum margin will prevent the full-service store from being put out of business, and the price difference between the full-service store and the discounter will now be at a level where most customers will no longer find it worthwhile to look at one shop before buying at another. The full-service store will therefore be able to survive, and a good number of customers will prefer to buy there as well rather than driving across town in order to get the now-smaller discount at the no-frills store. Within the limit set by the RPM, the various stores will be able to compete and may address, e.g., different customer groups: one store is aimed at those who are willing to pay for extra service and pleasant surroundings, whilst the other offers the goods slightly cheaper to no-frills customers, but will presumably still offer essential services such as repair and basic customer care. Since the price difference will no longer be high enough to lead many people to get information at X before buying at Y, X will retain its customers and will continue to be frequented by those who prefer paying for better ser- - 24 - vice (whilst those customers who do not care about service and are sufficiently knowledgeable to not require advice can save a small amount by going to the no-frills store). The advantage for the manufacturer is that it will now retain a full-service retailer that provides pre- and after-sale care and that this will make its goods more desirable (and also make them appeal to a wider base of potential consumers). As a result, the manufacturer hopes to shift more units and to make more profit. Customers have the advantage of the continuing existence of X, and will be able to pay for X’s service if they want. This approach avoids free-riding on pre-sale and after-sale services, since customers will no longer have a sufficient economic incentive to ‘shop and swap’: the price difference between both shops will be relatively small, and most customers will not consider it worthwhile to go to the slightly discounted no-frills store after having been advised at the full-service store30. Advertising still includes informational externalities, but at least the full-service retailer is guaranteed a certain margin and will have a more stable market share; it will therefore consider advertising to be more worthwhile, even though it may also further the business of the lower-cost rival. They may also try to reduce the effect of any informational externalities by emphasizing their own supreme customer service, knowledgeable sales staff and especially wide selection of products, whereas the no-frills store would do well to articulate the fact that they are the cheapest outlet in town. Product-establishment costs are still subject to substantial externalities and each retailer would still prefer to be second into the market; RPM does not fully prevent the 30 There is a expenditure of time and effort involved in going to another store, and people also have some moral qualms about getting advice in one store and then buying elsewhere. Sufficient price differences may overcome these obstacles, but smaller price differences may not be enough. - 25 - initial distributor from falling victim to others free-riding on his investment. However, if the RPM price guarantees sufficient margins to all (i.e. the price is set so that every reseller, including the initial market entrant, is guaranteed an economic profit of at least zero) the choice will no longer be solely between entering the market second or not at all (which results in no entry at all), but will also allow a profitable first entry: the second retailer to enter the market still gets to free-ride on the benefit of the investments made by the first and will fare better than the first market entrant, but at least the first retailer to enter is guaranteed minimum profits, which hopefully mean that being the first to enter is now more profitable than not entering at all. Hence, even individual retailers (rather than just retailers as a group) will now have an incentive to enter the market, and there is a much better chance that the market will be developed – to the benefit of manufacturer, retailers, and customers alike. Having looked at the economic reasoning supporting RPM, we will now take a quick look at the three main arguments against RPM. Conveniently, all of them seem to be capable of being easily refuted. The first argument is that RPM imposes a minimum price on retailers and hence leads to an increase in consumer prices. However, it should be borne in mind that the minimum price will be imposed by the manufacturer, and that the manufacturer only earns the wholesale price. The manufacturer therefore still has a motivation to keep the retailers’ margins small and to maximize the number of units sold. Assuming that there is interbrand competition and that the manufacturer can’t raise wholesale prices to supracompetitive levels, the manufacturer’s goal coincides with that of consumers: to keep the cost of sales low and to sell as many TVs as possible by making sure that customers are - 26 - happy with the service and price they get). Hence, RPMs generally do not increase prices any more than is required in order to render the distribution system sustainable and in order to finance the provision of services which customers desire and are willing to pay for. The second argument is that RPMs can be used as a cover for horizontal cartels between resellers. The idea here is that the cartel operates along a hub-and-spoke system31 with the manufacturer acting as the hub. However, the manufacturer has an explicit interest in keeping the margins of resellers low (again, they essentially supply retail services to him), and it would make no sense whatsoever for him to aid them in forming a cartel which would then engage in requiring him to pay over the odds for their distribution services. This argument is clearly without merits. Sadly, it served to mislead the Court in Dr. Miles. The third argument is that RPMs may make a horizontal cartel between manufacturers more easy to monitor: manufacturers will have less incentive to cheat on the cartel by reducing wholesale prices if they are unable to pass the price cuts on to customers and to increase their market share. However, the RPM here is mainly a facilitating mechanism and the cartel itself will already be illegal. Arguably, the fact that the cartel itself is illegal is sufficient deterrence and a sufficient basis for prosecution of such cartels, and it is not necessary to outlaw RPMs solely for this reason – especially given the considerable scope for pro-competitive use that they have. Cf Interstate Circuit v. U.S., 306 U.S. 208 (1939) and the FTC’s investigation of Toys’R’Us 126 FTC 415 31 - 27 - 3.2.2. The law in the U.S. In the U.S., resale price maintenance is still governed under the Supreme Court’s decision in Dr. Miles, which found the imposition of minimum prices to be illegal per se. Shockingly, this decision is to some extent based on the erroneous argument that RPMs may be used in order to support a cartel between the resellers: the court specifically found that “the advantage of established retail prices primarily [accrues to] the dealers. The enlarged profits … go directly to them and not to the [manufacturer]”32, in other words that the RPM scheme will be used to increase distributors’ profit margins. So, in addition to the fact that there is relatively little economic justification for a per se ban on RPMs (more about that in 3.2.4. below), the Court’s decision to ban RPMs is based on the argument that the manufacturer would partake in a cartel specifically designed to further the reseller’s interests at his cost. Even cursory analysis reveals this justification to be extremely dubious and throws some serious doubt on the Court’s decision. 3.2.3. The law in the E.U. Under EU law, resale price maintenance is specifically excluded from the ambit of the Block Exemption under Art. 4(a) thereof. Though RPMs could theoretically still get an individual exemption under Art. 81(3), they are in practice treated as per se illegal: the Green Paper on Vertical Restraints in EC Competition Policy specifically states that RPM measures are treated as “serious violations of the competition rules” and are considered “per se contrary to Art [81(1)]”33. 32 220 U.S. at 407; see also Keith N. Hylton, Antitrust Law: Economic Theory & Common Law Evolution, Cambridge University Press, 2003, at p. 256. 33 http://europa.eu.int/en/record/green/gp9701/vrc8en.htm. Note that the paper refers to Art. 85(1). This is the same as the current Art. 81(1), but the paper was written before the recent re-numbering of the Treaty. - 28 - 3.2.4. Conclusions Resale-price maintenance is treated as illegal per se, both in the U.S. and in the EU. This is the case in spite of the fact that (1) RPMs can sensibly be used in order to combat free-riding in distribution systems and can have a significant pro-competitive net effect in that setting; in spite of the fact that (2) territorial restraints (which serve much the same purpose) are treated under the rule of reason; in spite of the fact that (3) using an RPM scheme instead of an EDA scheme would still allow intra-brand competition between retailers and would actually be less anti-competitive; and in spite of the fact that (4) those who will impose the RPM and will set the minimum prices (the manufacturers) share the same objectives as consumers and have a strong desire to keep resale prices and reseller margins as low as possible. The per-se ban on RPMs is clearly anachronistic: it is not supported by economic considerations, and is – at least in the U.S. – partly founded on a pseudo-economic argument that even a cursory glance reveals to be deeply flawed. The rule on RPMs is in serious need of an overhaul and should be assimilated to the treatment of territorial restraints. After all, RPMs will in practice usually serve the same purpose and give rise to the same pro-competitive benefits as territorial restraints, whilst actually having less of an anti-competitive impact than exclusive territoriality does: exclusive territoriality wipes out all intra-brand competition in the area in question, whereas resale price maintenance at most wipes out intra-brand price competition in the area (and, depending on the price level set, often only curtails price competition) and allows numerous dealers to continue competing with each other within the boundaries set by the RPM. Hence, it would make a lot more sense to give RPMs the benefit of the ruleof-reason analysis as well. - 29 - 4. Recapitulation and overall conclusion As described above, informational externalities and fears of free-riding by other resellers can often lead to a situation akin to that described in the famous prisoners’ dilemma: resellers have a collective interest in developing the market in question, but every individual retailer is best served by staying out of the market until somebody else has entered first. Those fears of free-riding can prevent distributors from making the investments necessary to develop or fully exploit commercially valuable markets for a product. As a result, inter-brand competition is reduced, producers and consumers both suffer avoidable losses, and overall social welfare does not reach its full potential. The courts have recognized the need to temper intra-brand competition in order to further inter-brand competition, and have accepted that one solution to this problem is the creation of exclusive territories for each dealer (possibly coupled with a maximum price restraint in order to prevent the distributor from abusing his new market power). As a result, they have changed the previous per-se ban on such arrangements into the more appropriate rule-of-reason treatment. Another solution would be the imposition of resale price maintenance. This solution would be almost as effective34 as territorial exclusivity, would be much easier to implement35, and would also allow some more differentiation between multiple retailers in the area36. 34 It works just as well with respect to continuing costs, such as advertising, pre-sales advice and after-sales care, but does not work quite as well as territorial exclusivity in dealing with one-off investments required to create a market for the good in question. 35 No need to arrange for exclusive retail areas and to select and police individual retailers; everybody is allowed to sell the product as long as they do not charge below the RPM. Anybody charging below the RPM will soon come to the attention of other dealers (e.g. by customers haggling on the basis that ‘Y sells it cheaper’) and would then be brought to the attention of the manufacturer for enforcement purposes. 36 There would still be more than one retailer in the area, and within the limits set by the RPM requirement they would still be able to compete on price and competition – and could e.g. address different customer groups with different preferences. - 30 - The benefits on inter-brand competition are the same as those of an EDA, the costs on intra-brand competition are actually lower, and the commercial self-interest of the manufacturer will militate strongly in favor of keeping the RPM as low as feasible whilst ensuring the sustainability of his distribution and service infrastructure. Furthermore, such an approach would finally liberate us from the current awkward distinction37 between illegal RPM ‘agreements’ and the ‘unilateral refusals to deal’ that take the benefit of the Colgate doctrine38. As stated above, there is a strong argument in favor of the equal legal treatment of EDAs and RPMs. Sadly, neither the EU nor the U.S. has realized this, and both continue to impose per-se illegality on RPMs. This does not make sense, as RPMs have substantial pro-competitive uses and little anti-competitive potential that could not be filtered out by rule-of-reason analysis. It makes even less sense when one considers that the per-se illegality in the U.S. is based on the plainly nonsensical argument that the manufacturer would help to uphold a resellers’ cartel which ends up hurting himself and his customers and if one looks at the sometimes nonsensical distinctions drawn by courts which have to decide whether a particular case should fall under Dr. Miles or Colgate. Per-se illegality for RPMs is not supported by economic analysis in any situation where there is substantial inter-brand competition, and in such a setting RPMs can be seen as largely functionally equivalent to EDAs in combating free-riding and the resulting lack in distributor investments. 37 The boundary between what constitutes an RPM agreement and what constitutes and advertised unilateral refusal to deal with price cutters is far from clear in the first place: P. Areeda and L. Kaplow, Antitrust Analysis: Problems, Text, Cases 683-4 (4th ed. 1986). Additionally, the rule actually punishes reasonable manufacturers who give a warning to retailers and give them a second chance (the court is likely to find an illegal agreement here) whilst rewarding harsh manufacturers who immediately terminate an offending retailer (since that looks more like a legitimate unilateral refusal): United States v. Parke, Davis & Co., 362 U.S. 29 (1960). 38 United States v. Colgate & Co., 250 U.S. 300 (1919) - 31 - As such, the per-se rule against RPMs is overdue for abolition and should, at the very least, be replaced by a rule-of-reason analysis. Even better would be a role similar to that used for EDAs in the E.U. (i.e. a rule of reason subject to a presumption of legality where the manufacturer’s market share is sufficiently small), but that would clearly be too much to hope for anytime soon. - 32 - BIBLIOGRAPHY Areeda, Phillip and Kaplow, Louis: Antitrust Analysis: Problems, Text, Cases (4th ed. 1986), at 683-4 Bamberger, Gustavo: Revisiting Maximum Resale Price Maintenance: State Oil v. Khan, pp. 334-349 of Kwoka and White, below. Blair, Roger and Lopatka, John: The Albrecht Rule after Khan: Death Becomes Her, 74 Notre Dame Law Review 123-179 Chen, Andy M. and Hylton, Keith N.: Procompetitive Theories of Vertical Control, 50 Hastings L.J., 573-634 Hylton, Keith N.: Antitrust Law: Economic Theory & Common Law Evolution, Cambridge University Press, 2003 Kwoka, John E. and White, Lawrence J. (eds.): The Antitrust Revolution, 4th edition, Oxford University Press, 2004 Mathewson, G.F. and Winter, R.A.: The Economics of Vertical Restraints in Distribution, New Developments in the analysis of Market Structure, 211-36 (Stiglitz & Mathewson, eds, 1986) Telser, Lester G.: Why Should Manufacturers Want Fair Trade?, 3 J.L. & Econ., 86 (1960) Unknown, EC Green Paper on Vertical Restraints in EC Competition Policy, http://europa.eu.int/en/record/green/gp9701/vrc8en.htm -i-