Bye Bye, Dr. Miles.

Thom Lambert —  9 December 2006

So it looks like Dr. Miles is going down. That’s a good thing.

For non-antitrusters, Dr. Miles is a 1911 Supreme Court decision holding that “minimum vertical resale price maintenance” is per se illegal — that is, automatically illegal without inquiry into the practice’s actual effect on competition. Minimum vertical resale price maintenance (or “RPM”) occurs when a manufacturer requires dealers who sell its product to charge no less than a set price for that product. For example, Ford might require its dealers to charge at least $30,000 for an Explorer.

Several theories have been asserted for why RPM is anticompetitive. Some complain that it interferes with dealer freedom. That’s a non-starter. Manufacturers could eliminate dealers altogether and sell their own goods directly, and they’ll be more likely to engage in such “vertical integration” if they can’t exercise meaningful control over how dealers promote and sell their products. It’s therefore in dealers’ interests to permit manufacturers to tailor the dealer relationship — a creature of contract — as they see fit. In any event, dealers would seem to benefit, at least as much as manufacturers, from minimum RPM. Dealers’ compensation is the difference between wholesale price and retail price, so the larger that difference, the greater their compensation. High fixed retail prices might cause total sales to fall, of course, but that would seem to impact manufacturers more adversely than dealers. (Unless they raise wholesale prices as well, manufacturers only suffer lost sales from supracompetitive retail prices; retailers, by contrast, at least make more money on the smaller number of sales that do occur.) In short, theories of dealer harm are unconvincing.

More promising theories of anticompetitive harm have focused on RPM’s potential to facilitate the creation and enforcement of cartels. It might, for example, make it easier to form and enforce dealer-level cartels. Given the strict rules against horizontal price-fixing, it’s tough for competing dealers to agree on a fixed price. If they can get the manufacturer to dictate that price, formation of the cartel is easier. Moreover, the manufacturer could enforce the cartel by punishing dealers who depart from the minimum price. Dealers might therefore pressure manufacturers to mandate minimum resale prices. On the manufacturers’ side, minimum RPM might facilitate a manufacturer-level cartel by decreasing each manufacturer’s incentive to “cheat” by charging its dealers less than the agreed-upon wholesale price. If the dealers are unable (because of RPM) to pass a price cut on to consumers, then manufacturers won’t be able to sell more of their products to end users by lowering their wholesale price from the fixed level. RPM thus reduces their incentive to cheat on a price-fixing agreement in order to expand their output and increase revenues.

For an explanation of why these competitive concerns do not justify a per se rule against minimum RPM, see below the fold.

In a nutshell, the per se rule against RPM is bad because (1) RPM’s anticompetive harms are likely only in narrow circumstances that a court could identify through a more probing analysis (i.e., by using the “rule of reason,” which does not automatically condemn practices but instead inquires into their actual competitive effects); and (2) RPM frequently has procompetitive, output-enhancing effects. Let me explain.

Anticompetitive Harms Only in Narrow Circumstances

For RPM to work as a facilitation device for dealer cartels, dealers would have to “demand” the policy and manufacturers would have to give in to those demands. So when would dealers desire manufacturer-imposed RPM? Well, if the product at issue faces competition from products made by other manufacturers, setting resale prices above competitive levels will likely cause customers to switch to other products. If, for example, Procter & Gamble were to impose a supracompetitive resale price for Crest toothpaste, buyers would likely switch to Colgate or another brand. This wouldn’t benefit Crest retailers. Thus, retailers would seem to demand this sort of scheme only when either (1) the manfacturer has monopoly power over the product at issue (so there aren’t good substitutes, and widespread switching won’t occur in response to higher retail prices), or (2) all the manufacturers of the type of product at issue (e.g., all toothpaste manufacturers) similarly impose minimum resale prices.

How about manufacturers? When would they “give in” to dealer demands for RPM? Because manufacturers make their money on the wholesale price, not the retail price, they generally want the retail mark-up to be low so that sales are maximized. Thus, unless they have some output-enhancing reason for seeking to ensure a certain retail mark-up (more about this below), they’ll oppose higher retail prices. If a dealer insisted on minimum RPM, the manufacturer could either find other dealers or vertically integrate (i.e., engage in its own retail sales). Thus, it seems that manufacturers would be willing to go along with colluding dealers’ scheme only if two conditions were met. First, vertical integration must not be a practicable option. If, for example, the product at issue is not amenable to single-product distribution (a “Crest Toothpaste Store”?!), then a pressured manufacturer could not respond by vertically integrating. Second, the retailers must have some market power, so that the pressured manufacturer couldn’t just seek out substitute retail outlets.

In sum, then, use of RPM to facilitate a dealer cartel is likely only if:

(1) EITHER substitutes for the product at issue are limited, OR all manufacturers of the product at issue similarly impose RPM; AND

(2) vertical integration of retail sales operations is impracticable, AND the retailers seeking RPM have market power.

These conditions will not usually be met, and determining whether they are satisfied in any particular case would seem to require a rather probing inquiry — the sort of inquiry the rule of reason mandates.

With regard to the use of RPM to facilitate a manufacturer-level cartel, such an approach would seem to work only if all the manufacturers of a product had similarly imposed RPM. A reviewing court could easily determine whether that condition was satisfied.

Important Procompetitive Benefits

The preceding discussion argued that anticompetitive harm from minimum RPM is unlikely (or, more precisely, is plausible only in a narrow set of circumstances). It’s also important to consider the procompetitive benefits RPM confers.

Most notably, RPM may be used to encourage dealers to provide output-enhancing point-of-sale services that they otherwise might not offer. Dealers hoping to maximize their sales will normally provide these sorts of services — fancy showrooms, product advertising, customer education, etc. — unless they can free-ride off the efforts of other dealers. For example, the dealer of a certain make of dishwasher will normally try to maximize his sales by providing consumer-friendly displays and a knowledgeable sales staff. But if a nearby dealer provides such services, the first dealer may cut his own, knowing that many consumers will go to his neighbor for information and then head to his more bare-bones operation (which has lower costs and can thus offer lower prices) to make the actual purchase. If dealers know such free-riding is a possibility, they will be less likely to provide the point-of-sale services that maximize sales of the manufacturer’s product. Manufacturers may eliminate the free-riding possibility and consequent reduction of point-of-sale services by forbidding sales without the desired services or by separating retailers’ sales territories so that free-riding is difficult. As an alternative to imposing such “non-price restraints,” manufacturers might dictate the minimum price for which their dealers can sell the product at issue. Such RPM forces dealers to compete with each other on terms other than price, and they are most likely to do so by competing on the sort of point-of-sale services that maximize the manufacturer’s total sales. In short, the logic of non-price vertical restraints (which are afforded rule of reason treatment under the antitrust laws) and RPM (which Dr. Miles declares per se illegal) is exactly the same.

NOTE: If you want an example of this dynamic (and you’re old enough…I barely am), think about what air travel was like when the government regulated airline prices. Unable to compete on price, the airlines competed on service, and the in-flight experience was much better than it is today.

The Upshot

So, we have a business practice that can be anticompetitive, but only in a narrow set of circumstances that are fairly easy to identify. Moreover, that practice generally leads to enhanced output by encouraging vigorous interbrand competition (i.e., dealers, barred from competing on price, compete on point-of-sale services that make their manufacturer’s brand more attractive relative to the brands of other sellers). This is precisely the type of business practice that should not be automatically illegal without inquiry into actual competitive effect. It’s high time for the Supreme Court to abandon the per se rule against minimum RPM.

Good riddance, Dr. Miles.

Thom Lambert

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I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

6 responses to Bye Bye, Dr. Miles.

  1. 

    The logic is that manufacturer and retailer would like to exploit the gains from specialization by vertical separation, but the same separation creates opportunities for the retailer to free-ride or “cheat” by not supplying promotional services in any number of ways (which, by the way, are not limited to the discount dealer situation described by Thom above and most familiar to antitrusters).

    The manufacturer and retailer thus come up w. all sorts of contractual instruments to exploit these gains together while minimizing the incentive to free-ride and creating a self-enforcing arrangement. See, e.g., Klein and Murphy (1988).

    Most of these involve vertical restraints which give something of value to the retailer, i.e. a premium created by RPM scheme, a fixed payment, various franchise agreements, an exclusive territory, etc. Retailer cheating is prevented by the threat of termination of this premium stream.

    It is not irrelevant, in this sense, to talk about simply eliminating dealers. Contracting for retail distribution gives a number of advantages, but comes at a cost. Equally, vertically integrating into retail may solve some of these problems, but perhaps at the cost of the gains from delegating the retail function. Manufacturers and retailers economize on these costs, which vary across different settings, and help to predict contractual form in different settings (including vertical integration).

    Even simply assuming that RPM helps to solve only discount-dealer free-riding problems supports a rule of reason approach. The economic logic, however, is more powerful than this. The case here for the rule of reason then, is overwhelmingly persuasive.

  2. 

    “Several theories have been asserted for why RPM is anticompetitive. Some complain that it interferes with dealer freedom. That’s a non-starter. Manufacturers could eliminate dealers altogether and sell their own goods directly, and they’ll be more likely to engage in such “vertical integration” if they can’t exercise meaningful control over how dealers promote and sell their products. It’s therefore in dealers’ interests to permit manufacturers to tailor the dealer relationship — a creature of contract — as they see fit.”

    1. I don’t follow the logic here. Dealerships exists because the manufacture believes that the local sales force knows more about how to attract sales than a corporate manager. So it irrelevant to talk about the manufacturer simply eliminating dealers.

    2. If the local dealer is free to set minimum prices, then locally the consumers benefit from their aggregate choice. That is what we want a market to do.

  3. 

    I’m gratified that the court seems to be moving toward an economic analysis of regulations on business in this case. Unfortunately, the courts appear to be only looking at first order effects, e.g.: “Is this practice actually ‘anti-competitive’?” or perhaps the far more relevant, “Does this practice actually reduce consumer welfare?”

    It seems to me (an economist, not a lawyer) that they are still not inquiring into the second order effects, i.e., the potential costs to consumer welfare associated with the mere existence of certain administrative rules regarding business practices. If you’re a small company contemplating a “below cost” pricing campaign to build volume, you need a war chest to fight off the “predatory pricing” accusations of your larger competitors. How many products never see the light of day because of the fixed costs of legal support associated with novel products or business processes? Maybe that’s a question for the legislature rather than the court.

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