The Commission Wins an Exclusive Dealing Case

Josh Wright —  3 March 2010

Today, the Commission announced a consent decree with Transitions Optical in an exclusionary conduct case.  Here’s the FTC description:

Transitions Optical, Inc., the nation’s leading manufacturer of photochromic treatments that darken corrective lenses used in eyeglasses, has agreed to stop using allegedly anticompetitive practices to maintain its monopoly and increase prices, under a settlement with the Federal Trade Commission announced today. Photochromic treatments are applied to eyeglass lenses to protect the eyes from harmful ultraviolet (UV) light. Treated lenses darken when exposed to UV light and fade back to clear when the UV light diminishes….

The FTC charges that the company illegally maintained its monopoly by engaging in exclusive dealing at nearly every level of the photochromic lens distribution chain. First, Transitions refused to deal with manufacturers of corrective lenses, known as “lens casters,” if they sold a competing photochromic lens. Further down the supply chain, Transitions used exclusive and other agreements with optical retail chains and wholesale optical labs that restricted their ability to sell competing lenses.  According to the FTC’s complaint, Transitions’ exclusionary tactics locked out rivals from approximately 85 percent of the lens caster market, and partially or completely locked out rivals from up to 40 percent or more of the retailer and wholesale lab market.

In settling the agency’s charges, Transitions has agreed to a range of restrictions, including an agreement to stop all exclusive dealing practices that pose a threat to competition. These provisions will end its allegedly anticompetitive conduct and make it easier for competitors to enter the market.

The Complaint is here.   And the analysis to aid public comment is available here.  A few quick observations and reactions, with the obvious caveat that these comments have only the benefit of the public information linked above and not more.

1. In light of a certain high-profile loyalty / market-share discount case that the Commission has on its plate, the analysis here is interesting not only on its own merits, but to the extent it might inform about how the Commission would pursue other cases involving similar conduct, i.e. exclusive dealing and discounts conditioned on full or partial exclusivity or threshold purchase requirements.   I note, for example, that the order prohibits Transitions from both exclusive dealing and partial exclusives/ loyalty discounts.  It will be interesting to see if the Commission adopts a similar approach of bearing the burden of demonstrating substantial foreclosure as a necessary but not sufficient condition in other cases involving allegedly exclusionary contracts aimed at depriving rivals of access to distribution sufficient to achieve minimum efficient scale.

2. The alleged foreclosure percentages are very high, over 85 percent with lens casters and “as much as 40 percent or more” with retailers and wholesale labs.  Under a straight Section 2 analysis, which the Commission discusses in the aid to public comment, and assuming the accuracy of these calculations, these foreclosure levels are likely to raise significant concerns where monopoly power is present and the contracts are difficult to terminate (both are alleged).

3. I found one passage in the aid to public comment troublesome, and in my view, incorrect.  With respect to pro-competitive efficiencies flowing from the arrangement, the Commission appears to be taking an overly narrow stance about cognizable justifications. Here’s what the FTC says about efficiencies from exclusives:

No procompetitive efficiencies justify Transitions’ exclusionary and anticompetitive conduct. Transitions cannot show that the exclusive arrangements were reasonably necessary to achieve a procompetitive benefit, such as protecting Transitions’ intellectual property or technical know-how, or preventing interbrand free-riding.5 Transitions does not transfer substantial intellectual property or technical know-how to its customers, and even if it did, any such transfer would likely be protected by existing confidentiality agreements. A concern about interbrand free-riding also does not justify the substantial anticompetitive effects found here. The vast majority of Transitions’ promotional efforts are brand specific, reducing the significance of any free-riding concern.6 While Transitions’ marketing efforts may generate some consumer interest in the product category as a whole – and not just in Transitions’ own products – this is a part of the natural competitive process. This type of consumer response does not raise a free-riding concern sufficient to justify the substantial anticompetitive effects found here.

As a conceptual matter, the Commission at least appears to reject the idea of distributional / promotional efficiencies in the absence of inter-retailer free-riding.  Footnote 6 of the analysis seems to support that conclusion.   As readers of this blog will know, I’ve done some work in this area arguing that this interbrand free-riding conception is too narrow and does not reflect the benefits of vertical restraints in resolving pervasive incentive conflicts between manufacturers and retailers even in the absence of free-riding.

Thom has a great post on this summarizing Ben Klein’s work on RPM which is in a similar vein.  But the fundamental economic facts are that under a set of conditions frequently satisfied in conventional differentiated products markets (manufacturer margins > retailer margins; manufacturer-specific retailer promotional efforts lack significant inter-retailer effects), manufacturers will have to compensate retailers for promotional effort.  These payments can take a lot of different forms: discounts, RPM, slotting contracts, etc.  The promotional sales generated are output increasing and so, from an antitrust perspective, vertical restraints resolving these incentive conflicts provide an important efficiency justification for restraints such as RPM, as I note here, and as the majority in Leegin recognizes.  Or see Ben Klein’s latest on RPM for an excellent explanation of the economics at work here, extending the analysis in Klein and Murphy (1988).

The next key step, and the one relevant for exclusive dealing, is that the very fact that dealers are compensated by manufacturers for supplying promotion on the basis of all their sales also opens the door to a type of free-riding that might undermine these promotional efforts that does not involve switching sales to a rival.  The manufacturer and dealer can be thought of as having an implicit contact to supply the contracted-for level of promotional services, with the manufacturer paying a premium for this performance and monitoring its retailers, terminating for non-performance where necessary.   However, dealers can free-ride by taking the compensation but reducing costly promotional effort.  Even if inter-brand free-riding is not possible, the vertical chain faces this incentive conflict.  Exclusive dealing and reduce the incentive to free-ride and facilitate performance by increasing the incentives for the retailer to perform.

Klein and Lerner (2007) present this analysis is significant detail and readers are referred there.  The fundamental point is that, as the authors write:

In particular, the presence of free-rideable manufacturer investments and dealer switching, the conditions focused upon by the court in Dentsply, are not necessary conditions for determining whether a prevention of free-riding justification for exclusive dealing makes economic sense. All that is required for exclusive dealing to be used to prevent dealer free-riding is that dealers have a significant economic role in the promotion of the manufacturer’s product, that manufacturers are compensating dealers for the supply of additional promotion and that exclusive dealing encourages such extra dealer promotion by facilitating manufacturer enforcement of its implicit contract for dealer promotion.

Note that I am not arguing that these potential efficiencies were present in Transitions as a factual matter.  Rather, I am just saying that to the extent that the passage endorses the position that exclusive dealing cannot prevent free-riding in the absence of free-rideable investments by the manufacturer, it is overly restrictive.  I should also note that my view is not only consistent with much of the case law recognizing a “dealer loyalty” explanation for exclusive dealing, it is also the case that Commission itself has discussed this type of efficiency in the past!  See, for example, this advocacy filing (signed by BC, BE and OPP) concerning potential legislation restricting vertical restaints in the wine industry.  The filing (and there are others), signed ecognizes that in addition to preventing inter-brand free-riding (and citing Klein) “exclusive dealing can be used to assure that suppliers receive the sales-generating effort that they have bargained for from distributors (e.g., through direct payment or through increased revenue that comes with exclusive territories), rather than distributors focusing their efforts on competing brands.”

Because the Commission makes reference only to the inter-brand free-riding, and does not discuss other free-riding justifications, this seemed worth comment.  Of course, even if such a pro-competitive justification fit the facts, it also does not mean it would outweigh any potential anticompetitive effects, but I do find the omission at least mildly troublesome.

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