Competitive Resale Price Maintenance in the Absence of Free-Riding

Thom Lambert —  23 February 2009

I want to second Josh’s commendation of Ben Klein’s submission to the recent FTC Hearings on Resale Price Maintenance. Klein’s paper, which bears the same title as this post, is lucidly written (blissfully free of equations, Greek letters, etc.) and makes a point that, at this juncture in antitrust’s history, is absolutely crucial.

In the pre-Leegin era, commentators who were critical of Dr. Miles‘s per se rule (including yours truly) usually emphasized the so-called free-rider rationale for minimum RPM. According to that rationale, manufacturers frequently set minimum resale prices for their products in order to encourage demand-enhancing point-of-sale services upon which retailers could free-ride. Golf club manufacturer Ping, for example, tried to control its dealers’ resale prices because it wanted dealers to expend great effort helping customers find the perfect set of highly customizable clubs. It worried that the ability to compete on resale price would lead some dealers to cut their own customizing services (and thus their costs), direct their customers to high-service dealers for the necessary customization, and then offer a discount to those customers on the clubs selected by the high service (and thus higher cost) dealers, who couldn’t afford to match the discount. If such free-riding were pervasive, Ping dealers would eventually stop providing the sort of customizing services that enhance demand for Ping clubs.

In the pre-Leegin era, it made sense for critics of Dr. Miles to emphasize the free-rider rationale because (1) it’s easy to explain, and (2) it applies often enough that we can say with confidence that RPM — often motivated by a desire to avoid free-riding on output-enhancing services — is not “always or almost always anticompetitive.” That, of course, is all we Dr. Miles critics needed to establish in order to undermine the per se rule against minimum RPM. (Per se illegality is appropriate only for practices that are always or almost always anticompetitive.)

It’s now a new day in antitrust. Dr. Miles is dead, and the key question for courts, commentators, and the regulatory agencies is how particular instances of RPM should be evaluated to determine their legality. Answering that question requires more than a simple showing that RPM can, under a fairly common set of circumstances, lead to higher output. Indeed, if our rule of reason focuses exclusively on the free-rider rationale for RPM, it may well lead to condemnation of procompetitive instances of RPM in circumstances in which the free-rider rationale does not apply. For example, the highly influential Areeda-Hovenkamp treatise proposes a rule of reason that would automatically condemn RPM arrangements on “homogeneous products,” for which there are unlikely to be any point-of-sale services that are susceptible to free-riding. (See par. 1633c of the Second Edition.) The assumption here is that RPM’s only significant procompetitive effect is the elimination of free-riding.

Fortunately, the Supreme Court’s Leegin decision recognized that RPM may be output enhancing even in the absence of free-riding. The Court explained (page 12):

Resale price maintenance can also increase interbrand competition by encouraging retailer services that would not be provided even absent free riding. It may be difficult and inefficient for a manufacturer to make and enforce a contract with a retailer specifying the different services the retailer must perform. Offering the retailer a guaranteed margin and threatening termination if it does not live up to expectations may be the most efficient way to expand the manufacturer’s market share by inducing the retailer’s performance and allowing it to use its own initiative and experience in providing valuable services.

The idea here — developed fully in Klein & Murphy (1988) — is that RPM, which guarantees retailers a healthy margin on sales of the product at issue, can be used to generate retailer services that are hard to secure contractually. Exhaustively specifying ex ante all the services a retailer should provide would be quite difficult for a manufacturer. In addition, monitoring and enforcing a dealer’s performance obligations along multiple service dimensions would require substantial effort. RPM coupled with a liberal right of termination can provide an alternative means of securing the retailer services(attractive product placement, etc.) that enhance demand for the manufacturer’s products. If the manufacturer generally observes its retailers’ performance, retains an unfettered right to terminate underperformers, and provides an attractive retail margin as an incentive to avoid termination, then the manufacturer can motivate its retailers to provide demand-enhancing point of sale services without specifying them exhauastively.

While the Leegin majority nicely explained how RPM can be used to enhance demand-enhancing retailer services even when those services are not subject to free-riding, it failed to address one crucial question: Why would a manufacturer need to use RPM to encourage these services, since retailers themselves would also benefit from increasing the sales of their manufacturers’ products?

Justice Breyer pounced on this omission in his Leegin dissent. Referring to the majority’s contention that RPM “may be the most efficient way to expand the manufacturer’s market share by inducing the retailer’s performance and allowing it to use its own initiative and experience in providing valuable services,” Justice Breyer stated (pages 14-15):

…I do not understand how, in the absence of free-riding (and assuming competitiveness), an established producer would need resale price maintenance. Why, on these assumptions, would a dealer not “expand” its “market share” as best that dealer sees fit, obtaining appropriate payment from consumers in the process? There may be an answer to this question. But I have not seen it.

Klein’s submission to the FTC’s RPM hearings provides a straightforward answer to Justice Breyer’s question. RPM may be necessary, Klein contends, because a manufacturer and its dealers often have divergent incentives when it comes to services that expand demand for the manufacturer’s products. Frequently, a manufacturer will stand to gain much more from its dealers’ promotional efforts than the dealers themselves. Thus, “RPM plus a liberal right of termination” may be needed to incentivize dealers to provide the services that will maximize sales of the manufacturer’s products. Klein points to three commonly present economic factors that create the sort of incentive divergence that warrants RPM:

(1) Manufacturers often enjoy a larger per-unit profit margin than do their retailers. Because manufacturers’ products tend to be more highly differentiated than the services retailers provide, and because the ability to charge prices in excess of one’s costs is a function of the uniqueness of whatever one is providing, manufacturers will generally earn higher per-unit profits on their products than will the retailers who resell those products. Accordingly, manufacturers stand to gain more from incremental sales of their products than do their retailers, and they may therefore need a way to give their retailers an extra incentive to promote their products.

(2) Many manufacturer-specific retailer promotional efforts lack significant inter-retailer demand effects. While some retailer promotional efforts, such convenient free parking or extended store hours, would provide competitive benefits for both the manufacturers whose products are carried by the retailer and the retailer itself, other retailer promotional efforts, such as prominent placement of the manufacturer’s product within the “impulse buy” section of the retailer’s store, would really benefit only the manufacturer without enhancing demand for the retailer’s services over those of its competitors. Absent some nudge from the manufacturer, retailers won’t be adequately incentivized to perform these sorts of services. RPM can provide the needed nudge.

(3) Manufacturer-specific retailer promotional efforts may cannibalize a multi-brand retailer’s sales of other brands. Many retailer services that would promote a manufacturer’s brand of a product would merely reduce the retailer’s sales of competing brands of the same product and would thus provide little, if any, net benefit to the retailer. Granting favored shelf space to one brand, for example, may require moving a competing brand to less favorable shelf space, thus reducing the sales of that brand. A manufacturer can induce its retailers to provide it with “cannibalizing” promotional services by employing RPM to guarantee the retailer a higher markup on sales of the manufacturer’s brand.

These sources of divergence between manufacturers’ and retailers’ incentives are discussed in more detail in Josh’s 2007 collaboration with Klein, The Economics of Slotting Contracts, 50 J. L. & Econ. 421 (2007). Taken together, the various sources of divergence make it in the interest of many manufacturers to adopt some sort of RPM policy, even when the product at issue is not one that is sold along with services that are susceptible to free-riding. The RPM policies manufacturers adopt to address incentive divergence enhance the manufacturers’ overall output and should thus be assumed to be procompetitive. Accordingly, liability rules such as that proposed in the Areeda-Hovenkamp treatise, which maintains that “[p]roduct homogeneity is an easily observable fact that is inconsistent with known legitimate uses of RPM” (Par. 1633c, at 334 (2d ed.)), are unsound and should be rejected.

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 Competitive Resale Price Maintenance in the Absence of Free-Riding

  1. 

    I suggest the reader take a look at Ralph Winter’s slides from the FTC hearing (http://www.ftc.gov/opp/workshops/rpm/docs/rwinter0217.pdf), especially starting at slide #12. As Winter points out (and as Josh and Thom have noted), if you really believe that this “inframarginal vs. marginal” consumer argument is a basis for regulating vertical restraints, then you must also accept that the antitrust authorities can efficiently regulate product quality decisions, advertising and marketing decisions, and so forth — generally speaking, ANYTHING which shifts out a firm’s demand curve. Recall that the Spence (1976) article which provides the theoretical basis for the Comanor et al. condemnation of RPM isn’t about RPM, or vertical restraints of any sort. It’s about the decision of a monopolist about how much quality he should provide. Spence’s general point is that a firm with market power will “distort” its decision along (e.g., output, quality, etc.) a variety of dimensions, and there is no assurance that its choice will coincide with the choices that will maxmize total surplus. From a purely theoretical perspective, this was a useful insight, but it really says little about policy, unless you think that antitrusters can play the role of the ominiscient and benevolent social planner who makes regular appearances theoretical treatises.

  2. 

    Michael, let me add a complicating twist that may or may not help. One of the issues at hand is “modesty” in the sense of measuring the net consumer welfare benefits of a price discrimination regime like what one gets with RPM (some consumers benefit from the additional promotional services and others don’t — you can think of this as a selected discount to those that value the services). Its just very costly and difficult to measure who is who under that setting which favors some humility.

    A second point, which the Klein excerpt gets at is that if we accept true consumer surplus as the absolute goal of antitrust, we do get into the micro-management of the economy. That is, we know that firms with very small shares price discriminate in highly competitive markets (think grocery store coupons, movie theater tickets, etc.). This is related to the first point.

    Finally, a third point is related to the welfare economics of price discrimination. There is a substantial literature that suggests that the welfare effects of price discrimination, when one accounts for both static and dynamic effects (e.g. increased returns to monopolist spur innovation), are less ambiguous and more likely to be positive. In any event, they are part of the normal competitive process in highly competitive markets.

  3. 

    Thank you for the detailed answer to my naive questions. I think I have a much better picture of where the lines are drawn on RPM now.

    It is very curious to someone relatively new to the field to hear that increasing consumer surplus is not at least a distal goal for competition regulatory authorities. Who are we protecting? Perhaps the answer is new entrants, the presence or absence of which might be easier to measure. Regardless of the answer, I’m all for modesty when it comes to the practical value of our theories and measurements of something like consumer surplus.

  4. 

    Thanks for the comment, Michael.

    You’re right that the point of procompetitive instances of RPM is to induce retailers to provide demand-enhancing point of sale services so as to maximize sales of the manufacturer’s product. This might occur by, as you suggest, limiting price competition among retailers so as to induce them to compete on non-price amenities. In addition, service enhancement may occur — regardless of the presence or absence of inter-retailer competition — if the manufacturer is using RPM to guarantee retailers the sort of retail mark-up (profit margin) that will induce them to promote the manufacturer’s product over those of its competitors. Klein seems to be emphasizing this latter function of RPM.

    As for the second point that you raise — i.e., can we be sure that using RPM to enhance point-of-sale services actually enhances consumer surplus? — I think the issue should be irrelevant to the antitrust analysis. A number of theorists, most prominently William Comanor (see Vertical Price-Fixing, Vertical Market Restrictions, and the New Antitrust Policy, 98 Harv. L. Rev. 983 (1985)), have argued that even if RPM enhances total sales it may not enhance total consumer surplus. I summarized their argument in my forthcoming William & Mary Law Review article:

    To the extent RPM increases total sales of a manufacturer’s products, it does so by inducing services that make the product at issue more desirable to the consumers who are “on the fence” as to whether to buy the product or not. If the incremental services resulting from RPM increase those marginal consumers’ willingness to pay for the product at issue more than it raises the product’s price, then RPM will result in a greater number of total sales, despite the higher prices. But the additional services that attract new buyers may not be of value to many consumers who value the product more than marginal consumers and would be willing to pay more than the market clearing price, even without the additional services occasioned by RPM. For those “inframarginal” consumers, RPM results in a higher price that is not offset by additional valuable services. This means that their consumer surplus — their wealth gain from buying the product at issue — is reduced by RPM.

    Thus, it is theoretically possible for demand-enhancing RPM to reduce total consumer surplus.

    It’s really beyond the competence of antitrust to determine whether any particular instance of RPM has enhanced or reduced consumer surplus. (To determine that matter, one would need to know the relative quantities of marginal and inframarginal consumers in a market and the reservation prices of the inframarginal consumers.) Accordingly, I would argue that any output-enhancing instance of RPM should be deemed per se procompetitive and immune from liability.

    Klein seems to agree with this analysis. He writes:

    [T]he essence of the competitive process is that some consumers gain and others may lose. For example, there are many competitively supplied costly retailer services that increase price which are not consumed by all customers, such as free delivery or intensive sales assistance. The fact that one customer tries on twenty different pairs of shoes over an hour-long period while another customer purchases the same pair in five minutes without trying them on does not mean that we should prohibit retailers from supplying free sales assistance, and prohibit manufacturers from compensating retailers for supplying such service. Although there may sometimes be positive welfare effects from such a prohibition because inframarginal consumers who do not use intensive sales assistance may be better off as a result, it does not make the prohibition procompetitive. The provision of free retailer services, such as salesperson service, is part of the normal competitive process undertaken by firms without market power. Therefore, rather than attempting to regulate this competitive process to protect inframarginal consumers, antitrust policy should leave it up to the competitive market to determine which of these free services are supplied by retailers, often with the financial assistance of manufacturers.

  5. 

    If I understand the argument correctly, the point is that retailer competition on price alone is likely to result in lower quality goods and services for consumers because it tends to cause “a race to the bottom” in which only the lowest cost retailers survive. RPM can therefore benefit consumers by constraining retailers to compete in non-price-related dimensions, and thereby offer more narrowly tailored services or customized goods.

    If that’s the argument, then the issue would seem to be whether the consumer surplus captured by the offer of higher-quality services and customized goods is large enough to offset the deadweight loss of consumers priced out by the RPM *and* the longer-term effects that pure price-competition might have on how the retail market evolves (with new retail experiments being more difficult to finance without RPM).

    But how do you measure these kinds of quantities? I’m asking naively. I haven’t seen this issue litigated.

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