RPM and the NIE

Thom Lambert —  12 June 2008

I’ve just spent a couple of great days in spectacular Boulder, Colorado at a conference on the New Institutional Economics (NIE). (Not sure why the “the” is required, but it always seems to be used.) The conference, organized by Colorado Law’s Phil Weiser and hosted by the Silicon Flatirons Center for Law, Technology, and Entrepreneurship, was designed to provide law professors with an overview of what the NIE is about and how it can inform legal scholarship. Geoff also attended and would probably agree that the conference was great fun.

Based on what I learned at the conference (and from the assigned readings, which were terrific), a mantra of the NIE might be something akin to Mies van der Rohe’s famous aphorism, “God is in the details.” Institutions — the formal and informal norms, rules, and structures that constrain our choices (e.g., the firm, government agencies, property regimes, contractual structures, social norms) — very much affect economic performance and ought to be closely examined. We should not, as neoclassical economics has sometimes done, treat them as black boxes. Instead, we must examine them very closely to see what exactly they’re doing.

The father of this thinking, of course, is Ronald Coase, who first sought to sketch out what exactly it is that a firm does. Coase concluded that firms — which inevitably involve resource allocation via managerial fiat, a type of allocation that cannot take advantage of the information produced by the prices that result from decentralized allocation — chiefly economize on the costs of using the market, a.k.a. transaction costs. (I talked a bit about that insight here.) Subsequent scholars — Demsetz, Williamson, North, etc. — have similarly taken hard looks at the inner workings of other institutions that constrain economic behavior. Their theories and empirical findings have greatly assisted us in discovering what’s really going on in the economic world.

Given its focus on the reasons for and functions of various institutions and restraints, the NIE offers substantial promise to antitrust scholars. Antitrust, of course, regulates business practices that appear to reduce competition. Throughout its history, antitrust has often failed to live up to its promise, for it has too quickly condemned business practices that seem on first glance to be anti-competitive (in that they make life harder for the defendant’s competitors) but in reality facilitate competition by permitting the defendant to achieve some output-enhancing objective. By focusing closely on the reason for and effect of a business practice, the NIE can help answer antitrust’s $64,000 question: “Is this practice, in this context, competition-reducing or output-enhancing?”

Take, for example, resale price maintenance (RPM). As Coase, Williamson, et al. have taught us, producers always confront a “make” or “buy” decision for each input — i.e., should I buy that particular ingredient or make it myself (vertically integrate)? As noted, Coase theorized that the relative cost of these two options, costs which change with technological development, will determine the contours of the firm. Distribution to consumers is, of course, an input every producer needs. Thus, a manufacturer must decide whether to (1) “buy” the input by selling at a discount to retail specialists, who will then re-sell at a mark-up to consumers (the “price” the manufacturer pays for this service is the difference between the price he charges the reseller and the higher price ultimately charged to consumers) or (2) “make” distribution by expanding his operations to include retail sales to end-user consumers. From the manufacturer’s perspective, the upside of a “buy” approach is that the retailer can specialize in sales to consumers and can thus achieve some productive efficiencies; the downside is that the retailer may shirk — i.e., he may not adequately promote the manufacturer’s product. As for the “make” decision, the upside is that the manufacturer can much better control how much effort is put into promoting his products; the downside is that the manufacturer, who doesn’t specialize in retailing, is likely less efficient at selling to end-users.

RPM permits the manufacturer to get the best of both worlds. If the manufacturer sets the resale price so that the retailer is guaranteed a nice mark-up, then the retailer will have an incentive not to shirk on promoting the manufacturer’s products. (This reduces the manufacturer’s monitoring costs.) At the same time, the manufacturer can take advantage of the retailer’s superior product-promotion skills. Thus, RPM provides sort of a “middle ground” between purchasing distribution services on the market and vertically integrating. Voila! Output is enhanced.

Obviously, there’s lots to say about potential pros and cons of RPM. The insights provided by the NIE, though, are invaluable in helping us see what’s really going on with this sort of practice. Perhaps our FTC Commissioners should attend the NIE conference next year. That might help us avoid this sort of nonsense.

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.

4 responses to RPM and the NIE

  1. 

    Late to the game, but definitely concurring with Josh’s comment. Coase’s focus in the 1960 papers was not on how neighbors should or do actually behave, but on how the assignment of property rights (via the judicial system as an illustration) does in fact affect economic outcomes, due to positive transaction costs. The entire discussion of nuisance law cases is used to illustrate that (even) judges seemed to understand (better than most economists) the implications of institutions (i.e., precedent in a common law system) for (future) economic behavior.

    It is this interface between the legal system and the economic system that was always Coase’s interest and concern. In fact, I think it easy to conclude that Coase’s brand of law and economics is much more relevant to antitrust law than is much of the more typical law and economics literature, in which scholars use economic theory to examine the lint of the legal system’s navel.

  2. 

    “He built his whole reputation on a paper on the behavior of neighbors without, it seems, ever troubling for a moment how neighbors really behave.”

    Wow. I’m not sure that I could disagree more with the first commenter. First, Coase (1960) was not about the behavior of neighbors any more than Leibowitz & Margolos’ seminal work on network effects and path dependence was “about” a theory of typing or Cheung (1973) is “about” the behavior of bees. The economic lessons are much more important and fundamental. Second, The Nature of the Firm 23 years earlier must have been at least a little bit responsible for Coase’s reputation? Third, most industrial organization economists or antitrust scholars I know would be surprised to hear that Coase was not interested in actual market behavior and instead hypothetical behavior. To the contrary, one of the primary lessons of Coase’s work in these areas was institutions and facts matter.

  3. 

    Thanks for the comment. Thanks particularly for mentioning Ellickson, who is, of course, hugely important.

    Remember that all Coase said in “The Problem of Social Cost” (not the sole source of Coase’s reputation, by the way) was that bargaining would lead to the efficient allocation of a property right IF TRANSACTION COSTS WERE ZERO. Of course, they’re usually significant, so the main value of the paper is to draw attention to the importance of transaction costs, which standard economic theory had largely ignored. As Coase himself explained in his Nobel Prize lecture:

    “I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion: let us study the world of positive transaction costs.”

    As for Ellickson, I agree with you that his work is quite significant. By drawing attention to the role of social norms (rather than formal law) in constraining behavior, he made a valuable contribution to the NIE. Just as Coase might be deemed the father of transaction costs economics, Ellickson might be considered the father of social norms research (at least among law and economics scholars).

  4. 

    I’d say that Coase is about the last guy who deserves credit for inventing the new institutional economics. He built his whole reputation on a paper on the behavior of neighbors without, it seems, ever troubling for a moment how neighbors really behave. The beauty part is that when Bob Ellickson came along and proved that real behavior bears not the remotest relationship to hypothetical behavior, the profession said “woo, cute,” and went charging forward as if nothing had happened.