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.