Search Results For RPM

From a pure antitrust perspective, the real story behind the DOJ’s Apple e-book investigation is the Division’s deep commitment to the view that Most-Favored-Nation (MFN) clauses are anticompetitive (see also here), no doubt spurred on at least in part by Chief Economist Fiona Scott-Morton’s interesting work on the topic.

Of course, there are other important stories here (see Matt Yglesias’ excellent post), like “how much should a digital book cost?” And as Yglesias writes, whether “the Justice Department’s notion that we should fear a book publishers’ cartel is borderline absurd, on par with worrying about price-fixing in the horse-and-buggy market.”

I can’t help but notice another angle here.  For those not familiar, the current dispute over e-books emerges over a shift in business models from a traditional one in which publishers sold at wholesale prices to bookstores who would, in turn, set the prices they desired — sometimes below the book’s cover price — and sell to consumers at retail.  Much of the dispute arises out of the incentive conflict between publishers and retailers with respect to the profit-maximizing price.  The WSJ describes the recent iteration of the conflict:

To build its early lead in e-books, Amazon Inc. AMZN +0.19% sold many new best sellers at $9.99 to encourage consumers to buy its Kindle electronic readers. But publishers deeply disliked the strategy, fearing consumers would grow accustomed to inexpensive e-books and limit publishers’ ability to sell pricier titles.

Apple’s proposed solution was a move to what is described as an “agency model,” in which Apple takes a 30% share of the revenues and the publisher sets the price — readers may recognize that this essentially amounts to resale price maintenance — an oft-discussed topic at TOTM.  The move to the agency-RPM model also entailed the introduction of an MFN clause stipulating that publishers could not sell to rivals at a lower price.

Whether Apple facilitated a collusive agreement among publishers or whether this industry-wide move to the agency-model is an efficient and consumer-welfare enhancing method of solving the incentive conflict between publishers and retailers remains to be seen.  What is somewhat new in this dispute about book distribution is the technology involved; but the underlying economics of vertical incentive conflict between publishers and retailers is not!

Many economists are aware Alfred Marshall’s Principles of Economics textbook was apparently the first commodity sold in the United States under an RPM agreement!  (HT: William Breit)  The practice apparently has deeper roots in Germany.  The RPM experiment was thought up by (later to become Sir) Frederick Macmillan.  Perhaps this will sound familiar:

In 1890 Frederick Macmillan of the Macmillan Company was casting about for a book with which to conduct an experiment in resale price maintenance.  For years it had been the practice in Great Britain for the bookselllers to give their customers discounts off the list prices; i.e. price cutting had become the general practice.  In March, 1890, Mr. Macmilan had written to The Bookseller suggesting a change from the current discount system and had inserted a form to be filled out by the dealers.

Experimentation with business models to align the incentives of publishers and sellers is nothing new; it is only wonderful coincidence that the examples involve a seminal economics text published as the Sherman Act was enacted.  Nonetheless, an interesting historical parallel and one that suggests caution in interpreting the relevant facts without understanding the pervasive nature of incentive conflicts within this particular product line between publishers and sellers.  One does not want to discourage experimentation with business models aimed at solving those incentive conflicts.  What remains to be seen is whether and why the move to the new arrangement was executed through express coordination rather than unilateral action.

Did Apple conspire with e-book publishers to raise e-book prices?  That’s what DOJ argues in a lawsuit filed yesterday. But does that violate the antitrust laws?  Not necessarily—and even if it does, perhaps it shouldn’t.

Antitrust’s sole goal is maximizing consumer welfare.  While that generally means antitrust regulators should focus on lower prices, the situation is more complicated when we’re talking about markets for new products, where technologies for distribution and consumption are evolving rapidly along with business models.  In short, the so-called Agency pricing model Apple and publishers adopted may mean (and may not mean) higher e-book prices in the short run, but it also means more variability in pricing, and it might well have facilitated Apple’s entry into the market, increasing e-book retail competition and promoting innovation among e-book readers, while increasing funding for e-book content creators.

The procompetitive story goes something like the following.  (As always with antitrust, the question isn’t so much which model is better, but that no one really knows what the right model is—least of all antitrust regulators—and that, the more unclear the consumer welfare effects of a practice are, as in rapidly evolving markets, the more we should err on the side of restraint).

Apple versus Amazon

Apple–decidedly a hardware company–entered the e-book market as a device maker eager to attract consumers to its expensive iPad tablets by offering appealing media content.  In this it is the very opposite of Amazon, a general retailer that naturally moved into retailing digital content, and began selling hardware (Kindle readers) only as a way of getting consumers to embrace e-books.

The Kindle is essentially a one-trick pony (the latest Kindle notwithstanding), and its focus is on e-books.  By contrast, Apple’s platform (the iPad and, to a lesser degree, the iPhone) is a multi-use platform, offering Internet browsing, word processing, music, apps, and other products, of which books probably accounted–and still account–for a relatively small percentage of revenue.  Importantly, unlike Amazon, Apple has many options for promoting adoption of its platform—not least, the “sex appeal” of its famously glam products.  Without denigrating Amazon’s offerings, Amazon, by contrast, competes largely on the basis of its content, and its devices sell only as long as the content is attractive and attractively priced.

In essence, Apple’s iPad is a platform; Amazon’s Kindle is a book merchant wrapped up in a cool device.

What this means is that Apple, unlike Amazon, is far less interested in controlling content prices for books and other content; it hardly needs to control that lever to effectively market its platform, and it can easily rely on content providers’ self interest to ensure that enough content flows through its devices.

In other words, Apple is content to act as a typical platform would, acting as a conduit for others’ content, which the content owner controls.  Amazon surely has “platform” status in its sights, but reliant as it is on e-books, and nascent as that market is, it is not quite ready to act like a “pure” platform.  (For more on this, see my blog post from 2010).

The Agency Model

As it happens, publishers seem to prefer the Agency Model, as well, preferring to keep control over their content in this medium rather than selling it (as in the brick-and-mortar model) to a retailer like Amazon to price, market, promote and re-sell at will.  For the publishers, the Agency Model is essentially a form of resale price maintenance — ensuring that retailers who sell their products do not inefficiently discount prices.  (For a clear exposition of the procompetitive merits of RPM, see this article by Benjamin Klein).

(As a side note, I suspect that they may well be wrong to feel this way.  The inclination seems to stem from a fear of e-books’ threat to their traditional business model — a fear of technological evolution that can have catastrophic consequences (cf. Kodak, about which I wrote a few weeks ago).  But then content providers moving into digital media have been consistently woeful at understanding digital markets).

So the publishers strike a deal with Apple that gives the publishers control over pricing and Apple a cut (30%) of the profits.  Contrary to the DOJ’s claim in its complaint, this model happens to look exactly like Apple’s arrangement for apps and music, as well, right down to the same percentage Apple takes from sales.  This makes things easier for Apple, gives publishers more control over pricing, and offers Apple content and a good return sufficient to induce it to market and sell its platform.

It is worth noting here that there is no reason to think that the wholesale model wouldn’t also have generated enough content and enough return for Apple, so I don’t think the ultimate motivation here for Apple was higher prices (which could well have actually led to lower total return given fewer sales), but rather that it wasn’t interested in paying for control.  So in exchange for a (possibly) larger slice of the pie, as well as consistency with its existing content provider back-end and the avoidance of having to monitor and make pricing decisions,  Apple happily relinquished decision-making over pricing and other aspects of sales.

The Most Favored Nation Clauses

Having given up this price control, Apple has one remaining problem: no guarantee of being able to offer attractive content at an attractive price if it is forced to try to sell e-books at a high price while its competitors can undercut it.  And so, as is common in this sort of distribution agreement, Apple obtains “Most Favored Nation” (MFN) clauses from publishers to ensure that if they are permitting other platforms to sell their books at a lower price, Apple will at least be able to do so, as well.  The contracts at issue in the case specify maximum resale prices for content and ensure Apple that if a publisher permits, say, Amazon to sell the same content at a lower price, it will likewise offer the content via Apple’s iBooks store for the same price.

The DOJ is fighting a war against MFNs, which is a story for another day, and it seems clear from the terms of the settlement with the three setting publishers that indeed MFNs are a big part of the target here.  But there is nothing inherently problematic about MFNs, and there is plenty of scholarship explaining why they are beneficial.  Here, and important among these, they facilitate entry by offering some protection for an entrant’s up-front investment in challenging an incumbent, and prevent subsequent entrants from undercutting this price.  In this sense MFNs are essentially an important way of inducing retailers like Apple to sign on to an RPM (no control) model by offering some protection against publishers striking a deal with a competitor that leaves Apple forced to price its e-books out of the market.

There is nothing, that I know of, in the MFNs or elsewhere in the agreements that requires the publishers to impose higher resale prices elsewhere, or prevents the publishers from selling throughApple at a lower price, if necessary.  That said, it may well have been everyone’s hope that, as the DOJ alleges, the MFNs would operate like price floors instead of price ceilings, ensuring higher prices for publishers.  But hoping for higher prices is not an antitrust offense, and, as I’ve discussed, it’s not even clear that, viewed more broadly in terms of the evolution of the e-book and e-reader markets, higher prices in the short run would be bad for consumers.

The Legal Standard

To the extent that book publishers don’t necessarily know what’s really in their best interest, the DOJ is even more constrained in judging the benefits (or costs) for consumers at large from this scheme.  As I’ve suggested, there is a pretty clear procompetitive story here, and a court may indeed agree that this should not be judged under a per se liability standard (as would apply in the case of naked price-fixing).

Most important, here there is no allegation that the publishers and Apple (or the publishers among themselves) agreed on price.  Rather, the allegation is that they agreed to adopt a particular business model (one that, I would point out, probably resulted in greater variation in price, rather than less, compared to Amazon’s traditional $9.99-for-all pricing scheme).  If the DOJ can convince a court that this nevertheless amounts to a naked price-fixing agreement among publishers, with Apple operating as the hub, then they are probably sunk.  But while antitrust law is suspicious of collective action among rivals in coordinating on prices, this change in business model does not alone coordinate on prices.  Each individual publisher can set its own price, and it’s not clear that the DOJ’s evidence points to any agreement with respect to actual pricing level.

It does seem pretty clear that there is coordination here on the shift in business models.  But sometimes antitrust law condones such collective action to take account of various efficiencies (think standard setting or joint ventures or collective rights groups like BMI).  Here, there is a more than plausible case that coordinated action to move to a plausibly-more-efficient business model was necessary and pro-competitive.  If Apple can convince a court of that, then the DOJ has a rule of reason case on its hands and is facing a very uphill battle.

There is a nice example in the WSJ concerning the economics of vertical contractual arrangements.  I’ve noted previously the apparent trend in the soda industry toward vertical integration and the link to the economics of promotional shelf space.  In particular, incentive conflicts between manufacturers and retailers of differentiated products over the use of promotional shelf space are pervasive.

Like most vertical contracts, the key here is to understand how the incentives of the prospective transacting parties do not coincide and therefore must be controlled contractually rather than left to unrestrained competition and self-interest.  A common incentive incompatibility, identified by Klein & Murphy (1988) and later analyzed by Klein (1995), occurs when: (1) manufacturers sell a product at a significant markup over marginal cost, (2) the retailer provides some input like marketing activity or promotion that has a significant impact on demand for the product, and (3) consumers have heterogeneous demand for these promotional services, i.e. different value placed on placement of the product on eye-level shelf space, product demonstrations, etc.

Under these conditions, the retailer does not have adequate incentive to supply the efficient level of promotion or marketing activity because the retailer does not take into account the manufacturer’s (relatively large) profit margin on additional sales induced by provision of promotional services. These conditions are most likely to hold for differentiated products where manufacturer incremental profit margins are large relative to retailer profit margins.

Economic theory tells us that firms will use a variety of contractual measures to mitigate these incentive conflicts and exploit gains from trade.  For example, firms enter into slotting contracts, category management arrangements, and sometimes partial or full exclusive dealing contracts to control the transacting parties incentives in favor of non-performance and facilitate self-enforcement of the contract.   The trend towards vertical integration, as reported, appears to suggest that integration has become a more efficient solution for assuring supply of the desired distribution services than contracting.

Today’s WSJ article gives a nice example of how this theory applies in practice:

“Our [retail] customers really want to be able to differentiate themselves from their competitors,” says Mr. Foss. PepsiCo benefits when stores sell its snacks and drinks together, but it was harder to coordinate such promotions before PepsiCo bought its bottlers.

It is interesting to note that while the Pepsi and Coke have acquired bottlers recently, the article also discusses how Pepsi is tightening up its contractual relationships with retailers in order to align incentives with respect to promotions:

Mr. Foss says retailers he has visited have told him they would like to run more promotions that combine PepsiCo products, such as displaying six packs of Pepsi and bags of Doritos tortilla chips side by side, and offering discounts for purchasing them together.

Obviously, the costs of a multi-product retailer such as a gas station, convenience store, or supermarket granting an exclusive to Pepsi or Coke are higher than those of the bottler because of consumer demand for product variety in these settings.  In these settings, Pepsi and Coke rely on the contractual solutions described above to align incentives and induce the supply of efficient promotional services.

As a side note, slotting contracts and RPM are two ways to compensate the retailer for the supply of those services.  From there, one is only a step away from understanding why the Leegin decision was correctly decided, what Justice Breyer doesn’t understand about the economics of RPM, and why the “inherently suspect” approach to RPM is misguided.

is here, over at eCCP, and differs somewhat from Thom’s.

The takeway excerpt is:

Credit Suisse has important implications for antitrust practice. The decision’s effect is to narrow the scope of antitrust law and to invite efforts by regulated industries to narrow it still further. The court’s “clearly incompatible” standard is new and (though it purports not to) seems to water down considerably the old “plain repugnancy” test of Gordon v. New York Stock Exchange, Inc. 422 U.S. 659, 682 (1975). Under the new incompatibility standard, there no longer has to be an actual conflict between antitrust and other federal law for antitrust implicitly not to apply. Even a mere regulatory overlap may now be sufficient to trigger antitrust immunity. (Recall that in Credit Suisse the Court assumed that both antitrust and the SEC disapproved of the tying and other practices in question, and yet the Court still considered the two bodies of law incompatible on account of the regulatory overlap.) ….

Going forward, the Court will need to tighten the rule in Credit Suisse if it wants antitrust to continue to operate as Congress intended it to in conjunction with the compartmentalized maze of federal regulatory law. No one thinks that securities firms should be exempt from the legal obligations that generally flow from non-securities law (antitrust aside). If we expect to hold securities and other regulated firms accountable for torts and breaches of contract, or for crimes and discrimination, then why not also hold them accountable for antitrust violations? If Congress says otherwise, that is one thing. But if Congress is silent on the question, a federal agency should not have have any more power than a state to confer antitrust immunity upon those that it regulates. Of states we require a clearly articulated policy that presents an actual conflict, not merely the possibility of future potential incompatibility. From federal agencies we should not expect any less.

Just yesterday, in its historic decision in Leegin, the Court strongly reaffirmed its confidence in the Rule of Reason’s workability by overturning Dr. Miles and extending the rule’s reach to vertical RPM. That workability should make us equally confident that antitrust can peacefully coexist with the reguatory state.

Professor Bainbridge offers a correction to Keith’s Starbucks analysis by pointing out that Starbucks does not have franchisees. I don’t think the franchise/ franchisee distinction has much to do with Keith’s conclusion that whatever is going on is not an antitrust problem. But the Professor is on to a really cool question about franchising and vertical integration. Professor Bainbridge presents the contrasting franchising decisions by Starbucks and Subway as a transactions cost puzzle and links to a fuller analysis of this problem here:

What bugs me about the Subway v. Starbucks problem is that I can’t see any reason to believe that Subway’s transaction cost schedule is going to differ from that of Starbucks.

Bainbridge continues with the conventional account of the economics of franchising, focusing primarily on monitoring costs:

Franchising gives a residual claimant-like status to the local franchisee, while the franchise contract gives the franchisee incentives to ensure that the local employees comply with brand requirements. Franchising thus can be understood as an adaptive response to the problem of monitoring numerous employees in countless locations.

If this analysis is correct, one would expect to see corporate ownership in settings where monitoring via a vertically integrated management structure can be effected at low cost (relative to situations in which franchising dominates). But does Starbucks really face lower monitoring costs than Subway? If not, did Starbucks make an economic error by not going the franchise route?

The comments to Professor Bainbridge’s prior analysis from the folks at Marginal Revolution (and others) following the post hint at cross-store cannibalization as the key to the economic explanation. This is basically right, or at least, on the right track. But I think all this talk about “monitoring” and “transactions costs” is covering up some really interesting economics that shed some light on vertical contracting more generally. Don’t get me wrong, the critical variable that should influence the vertical integration decision here is indeed (as Professor Bainbridge says) the monitoring costs of franchisor owned outlets relative to franchised oulets. But I think these rather vague labels are blurring some important underlying economics.

So what’s going on with Starbucks’ decision to vertically integrate its outlets? I offer some analysis below the fold.

Continue Reading…

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.

In a new article in the June 2008 issue of Antitrust Source, Howard Marvel discusses what the rule of reason could and should look like in the Post-Leegin world as well as the different proposals to a rule of reason approach articulated by the states and the FTC in the recent Nine West consent order modification. For interested readers, Marvel is much more generous to the FTC decision than co-blogger Thom who not to long ago posted a harsh (and in my view, fairly devastating on both legal and economic grounds) critique of the Commission’s approach.

As interesting as the issue of identifying the appropriate post-Leegin rule of reason RPM framework is, I want to focus instead on an interesting historical and analytical point Professor Marvel makes about the intellectual foundations of the Leegin decision and its approach to the law and economics of vertical restraints:

The antitrust treatment of non-price vertical restraints is a much compressed mirror of that of vertical price restraints. In 1963, no broad condemnation of non-price restraints was deemed appropriate because “too little was known about the competitive impact of such vertical limitations to warrant treating them as per se unlawful.” Apparently, however, this perceived lack of knowledge did not extend to those teaching or trained at Harvard. Within four years, the Court faced a similar challenge to exclusive territories in Schwinn and responded with a per se rule against the practice. The arguments for imposition of per se status came from impeccable sources—the Assistant Attorney General for Antitrust, Donald Turner, supported a brief written by a young Harvard-trained lawyer in the Solicitor General’s office, one Richard A. Posner. The Court thus was encouraged to endorse “then prevailing thinking of the economics profession [to bear] on restricted distribution.”

Posner, benefiting from remedial training at the University of Chicago, soon came to see the errors of the Harvard view, flaws well summarized by Oliver Williamson: Alas, what Turner and Posner took to be the then prevailing thinking of the economics profession was deeply confused. . . . [T]he prevailing thinking was self-limiting in three respects: (1) there was little appreciation for the possibility that product differentiation (as opposed to homogeneous product market exchange) might be the source of economic benefits, (2) there was even less appreciation for the possibility that the integrity of a distribution system could be compromised by subgoal pursuit among the parts (in this case, the individual franchisees), and (3) there was a preference for internal organization (hierarchy) over market organization (interfirm contract) if vertical restrictions, for whatever reason, were to be applied.

Marvel’s analysis supports my view that Leegin is perhaps the best example of the Roberts Court adopting a Chicagoan view of antitrust analysis (and not adopting the Harvard School view, contra Professor Elhauge). Along those lines, I’ve recently posted to SSRN a paper forthcoming in the Elgar Companion to Transaction Cost Economics further exploring the link between the The Chicago School, Transaction Cost Economics, and the Roberts Court’s Antitrust Jurisprudence.