Archives For slotting contracts

[TOTM: The following is part of a digital symposium by TOTM guests and authors on the law, economics, and policy of the antitrust lawsuits against Google. The entire series of posts is available here.]

As one of the few economic theorists in this symposium, I believe my comparative advantage is in that: economic theory. In this post, I want to remind people of the basic economic theories that we have at our disposal, “off the shelf,” to make sense of the U.S. Department of Justice’s lawsuit against Google. I do not mean this to be a proclamation of “what economics has to say about X,” but merely just to help us frame the issue.

In particular, I’m going to focus on the economic concerns of Google paying phone manufacturers (Apple, in particular) to be the default search engine installed on phones. While there is not a large literature on the economic effects of default contracts, there is a large literature on something that I will argue is similar: trade promotions, such as slotting contracts, where a manufacturer pays a retailer for shelf space. Despite all the bells and whistles of the Google case, I will argue that, from an economic point of view, the contracts that Google signed are just trade promotions. No more, no less. And trade promotions are well-established as part of a competitive process that ultimately helps consumers. 

However, it is theoretically possible that such trade promotions hurt customers, so it is theoretically possible that Google’s contracts hurt consumers. Ultimately, the theoretical possibility of anticompetitive behavior that harms consumers does not seem plausible to me in this case.

Default Status

There are two reasons that Google paying Apple to be its default search engine is similar to a trade promotion. First, the deal brings awareness to the product, which nudges certain consumers/users to choose the product when they would not otherwise do so. Second, the deal does not prevent consumers from choosing the other product.

In the case of retail trade promotions, a promotional space given to Coca-Cola makes it marginally easier for consumers to pick Coke, and therefore some consumers will switch from Pepsi to Coke. But it does not reduce any consumer’s choice. The store will still have both items.

This is the same for a default search engine. The marginal searchers, who do not have a strong preference for either search engine, will stick with the default. But anyone can still install a new search engine, install a new browser, etc. It takes a few clicks, just as it takes a few steps to walk down the aisle to get the Pepsi; it is still an available choice.

If we were to stop the analysis there, we could conclude that consumers are worse off (if just a tiny bit). Some customers will have to change the default app. We also need to remember that this contract is part of a more general competitive process. The retail stores are also competing with one another, as are smartphone manufacturers.

Despite popular claims to the contrary, Apple cannot charge anything it wants for its phone. It is competing with Samsung, etc. Therefore, Apple has to pass through some of Google’s payments to customers in order to compete with Samsung. Prices are lower because of this payment. As I phrased it elsewhere, Google is effectively subsidizing the iPhone. This cross-subsidization is a part of the competitive process that ultimately benefits consumers through lower prices.

These contracts lower consumer prices, even if we assume that Apple has market power. Those who recall your Econ 101 know that a monopolist chooses a quantity where the marginal revenue equals marginal cost. With a payment from Google, the marginal cost of producing a phone is lower, therefore Apple will increase the quantity and lower price. This is shown below:

One of the surprising things about markets is that buyers’ and sellers’ incentives can be aligned, even though it seems like they must be adversarial. Companies can indirectly bargain for their consumers. Commenting on Standard Fashion Co. v. Magrane-Houston Co., where a retail store contracted to only carry Standard’s products, Robert Bork (1978, pp. 306–7) summarized this idea as follows:

The store’s decision, made entirely in its own interest, necessarily reflects the balance of competing considerations that determine consumer welfare. Put the matter another way. If no manufacturer used exclusive dealing contracts, and if a local retail monopolist decided unilaterally to carry only Standard’s patterns because the loss in product variety was more than made up in the cost saving, we would recognize that decision was in the consumer interest. We do not want a variety that costs more than it is worth … If Standard finds it worthwhile to purchase exclusivity … the reason is not the barring of entry, but some more sensible goal, such as obtaining the special selling effort of the outlet.

How trade promotions could harm customers

Since Bork’s writing, many theoretical papers have shown exceptions to Bork’s logic. There are times that the retailers’ incentives are not aligned with the customers. And we need to take those possibilities seriously.

The most common way to show the harm of these deals (or more commonly exclusivity deals) is to assume:

  1. There are large, fixed costs so that a firm must acquire a sufficient number of customers in order to enter the market; and
  2. An incumbent can lock in enough customers to prevent the entrant from reaching an efficient size.

Consumers can be locked-in because there is some fixed cost of changing suppliers or because of some coordination problems. If that’s true, customers can be made worse off, on net, because the Google contracts reduce consumer choice.

To understand the logic, let’s simplify the model to just search engines and searchers. Suppose there are two search engines (Google and Bing) and 10 searchers. However, to operate profitably, each search engine needs at least three searchers. If Google can entice eight searchers to use its product, Bing cannot operate profitably, even if Bing provides a better product. This holds even if everyone knows Bing would be a better product. The consumers are stuck in a coordination failure.

We should be skeptical of coordination failure models of inefficient outcomes. The problem with any story of coordination failures is that it is highly sensitive to the exact timing of the model. If Bing can preempt Google and offer customers an even better deal (the new entrant is better by assumption), then the coordination failure does not occur.

To argue that Bing could not execute a similar contract, the most common appeal is that the new entrant does not have the capital to pay upfront for these contracts, since it will only make money from its higher-quality search engine down the road. That makes sense until you remember that we are talking about Microsoft. I’m skeptical that capital is the real constraint. It seems much more likely that Google just has a more popular search engine.

The other problem with coordination failure arguments is that they are almost non-falsifiable. There is no way to tell, in the model, whether Google is used because of a coordination failure or whether it is used because it is a better product. If Google is a better product, then the outcome is efficient. The two outcomes are “observationally equivalent.” Compare this to the standard theory of monopoly, where we can (in principle) establish an inefficiency if the price is greater than marginal cost. While it is difficult to measure marginal cost, it can be done.

There is a general economic idea in these models that we need to pay attention to. If Google takes an action that prevents Bing from reaching efficient size, that may be an externality, sometimes called a network effect, and so that action may hurt consumer welfare.

I’m not sure how seriously to take these network effects. If more searchers allow Bing to make a better product, then literally any action (competitive or not) by Google is an externality. Making a better product that takes away consumers from Bing lowers Bing’s quality. That is, strictly speaking, an externality. Surely, that is not worthy of antitrust scrutiny simply because we find an externality.

And Bing also “takes away” searchers from Google, thus lowering Google’s possible quality. With network effects, bigger is better and it may be efficient to have only one firm. Surely, that’s not an argument we want to put forward as a serious antitrust analysis.

Put more generally, it is not enough to scream “NETWORK EFFECT!” and then have the antitrust authority come in, lawsuits-a-blazing. Well, it shouldn’t be enough.

For me to take the network effect argument seriously from an economic point of view, compared to a legal perspective, I would need to see a real restriction on consumer choice, not just an externality. One needs to argue that:

  1. No competitor can cover their fixed costs to make a reasonable search engine; and
  2. These contracts are what prevent the competing search engines from reaching size.

That’s the challenge I would like to put forward to supporters of the lawsuit. I’m skeptical.

Search Bias and Antitrust

Josh Wright —  24 March 2011

There is an antitrust debate brewing concerning Google and “search bias,” a term used to describe search engine results that preference the content of the search provider.  For example, Google might list Google Maps prominently if one searches “maps” or Microsoft’s Bing might prominently place Microsoft affiliated content or products.

Apparently both antitrust investigations and Congressional hearings are in the works; regulators and commentators appear poised to attempt to impose “search neutrality” through antitrust or other regulatory means to limit or prohibit the ability of search engines (or perhaps just Google) to favor their own content.  At least one proposal goes so far as to advocate a new government agency to regulate search.  Of course, when I read proposals like this, I wonder where Google’s share of the “search market” will be by the time the new agency is built.

As with the net neutrality debate, I understand some of the push for search neutrality involves an intense push to discard traditional economically-grounded antitrust framework.  The logic for this push is simple.  The economic literature on vertical restraints and vertical integration provides no support for ex ante regulation arising out of the concern that a vertically integrating firm will harm competition through favoring its own content and discriminating against rivals.  Economic theory suggests that such arrangements may be anticompetitive in some instances, but also provides a plethora of pro-competitive explanations.  Lafontaine & Slade explain the state of the evidence in their recent survey paper in the Journal of Economic Literature:

We are therefore somewhat surprised at what the weight of the evidence is telling us. It says that, under most circumstances, profit-maximizing vertical-integration decisions are efficient, not just from the firms’ but also from the consumers’ points of view. Although there are isolated studies that contradict this claim, the vast majority support it. Moreover, even in industries that are highly concentrated so that horizontal considerations assume substantial importance, the net effect of vertical integration appears to be positive in many instances. We therefore conclude that, faced with a vertical arrangement, the burden of evidence should be placed on competition authorities to demonstrate that that arrangement is harmful before the practice is attacked. Furthermore, we have found clear evidence that restrictions on vertical integration that are imposed, often by local authorities, on owners of retail networks are usually detrimental to consumers. Given the weight of the evidence, it behooves government agencies to reconsider the validity of such restrictions.

Of course, this does not bless all instances of vertical contracts or integration as pro-competitive.  The antitrust approach appropriately eschews ex ante regulation in favor of a fact-specific rule of reason analysis that requires plaintiffs to demonstrate competitive harm in a particular instance. Again, given the strength of the empirical evidence, it is no surprise that advocates of search neutrality, as net neutrality before it, either do not rely on consumer welfare arguments or are willing to sacrifice consumer welfare for other objectives.

I wish to focus on the antitrust arguments for a moment.  In an interview with the San Francisco Gate, Harvard’s Ben Edelman sketches out an antitrust claim against Google based upon search bias; and to his credit, Edelman provides some evidence in support of his claim.

I’m not convinced.  Edelman’s interpretation of evidence of search bias is detached from antitrust economics.  The evidence is all about identifying whether or not there is bias.  That, however, is not the relevant antitrust inquiry; instead, the question is whether such vertical arrangements, including preferential treatment of one’s own downstream products, are generally procompetitive or anticompetitive.  Examples from other contexts illustrate this point.

Continue Reading…

Tyler Cowen has posted the reading list for his 2010 Industrial Organization class in the George Mason economics department.  He asks for recommendations.  Below the fold are my suggestions to supplement Section I or II of Cowen’s reading list. The first order of business is getting Coase, Klein, Crawford Alchian (1978), Alchian and Demsetz (1972) and Williamson (1971, 1975) added to the theory of the firm reading.

Continue Reading…

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.

The soda industry is trending toward vertical integration, which Coke and Pepsi acquiring their largest bottlers.  From the WSJ:

Coke and PepsiCo sell concentrate to bottlers, which then bottle and distribute the soft drinks in their territories. Many of these smaller bottlers are small businesses that have been run by family members for decades and have perpetual contracts to distribute the sodas.   One concern for some smaller bottlers is that the big cola makers might now push for more price promotions in the regions they control, a move that could also drive down prices and profit margins at smaller bottlers. There are also questions about how both companies will handle distribution of any new drinks they launch.

For Coke and PepsiCo, managing the often delicate relations with their remaining independent bottlers will be key to driving sales and efficiency in their distribution systems.  PepsiCo said it is committed to nurturing “constructive” and “mutually profitable” relationships with its independent bottlers. PepsiCo says it has no plans to acquire the remaining portion of its bottling system, but instead it intends to focus on teaming up with its bottlers.  Coke declined to comment.

Most industry watchers say that independent bottlers will continue to have a strong presence and that both companies will likely strive to keep relations cordial with these distributors. Small bottlers will also benefit as the overall beverage system gets more efficient. Nonetheless, the big bottler deals are set to bring major changes to the industry, which is fighting a slump in sales of traditional sodas….

The recent deals will allow Coke and PepsiCo to cut costs sharply and allow them to be more flexible on pricing and in offering retailers better deals, moves that could indirectly push smaller bottlers to do the same.  “The pressure would be that they might lower prices to major customers on some products, where the independent bottlers may not have thought it necessary in the past,” Mr. Glover said.

This trend back toward vertical integration is pretty interesting.  The article suggests that integration will result in greater pricing flexibility and lower overall prices, suggesting that perhaps integration is solving a double marginalization problem.  But has bottler market power increased in the last decade or so?  Why now?

A second possible explanation is that the costs of ameliorating promotional incentive conflicts by contract has increased over the relevant time frame. 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.    The basic economic forces under these conditions suggest that the downstream “promotional service provider” such as a franchisee or retailer does not have adequate incentives to promote the product or supply the efficient level of marketing activity. This is because the franchisee does not take into account the franchisor’s (large) profit margin on additional sales induced by provision of promotional services. This is most likely to be the case when products are differentiated, e.g. soda!

Under these conditions, transacting parties will find contractual solutions to these problems (including vertical integration) to induce the supply of the efficient level of promotional services. My analysis with Ben Klein on slotting contracts and solo authored work on category management contracts are examples of the types of contracts one sees put to use in the retail industry to control the transacting parties incentives in favor of non-performance and faciliate self-enforcement of the contract.  But the real question here is whether the incentive conflict has changed in the soda market in recent years such that vertical integration has become a more efficient solution for assuring supply of the desired distribution services than contracting.   I’m not sure what the change could be.  Contractual relationships with bottlers can be governed by franchise termination laws, which render if incredibly difficult and nearly impossible to terminate a bottler for non-performance.  The article notes that many of the bottler contracts are “perpetual.”

Relatedly, Muris, Scheffman & Spiller (1992) provide a similar analysis of the previous shift to vertical integration in the soft drink distribution market following a dramatic increase in the importance of marketing activity in the industry, e.g. supplying retailers with product display, “pushing” product by encouraging retailers to give premium shelf space with “slotting contracts,” and executing local promotions. It is true that one could call this change in optimal contractual form as a response to increasing transactions costs, but that is probably a bit misleading and certainly too vague to really get at the underlying economics.  Most folks assume that this means a response to an increased incentive to engage in hold up over specialized assets. But this incentive to vertically integrate has nothing to do with specialized assets in the conventional Klein, Crawford, and Alchian (1978) or Williamsonian sense.

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.

A TOTM reader sends me the following interesting development on an emerging dispute over shelf space competition in Israeli supermarkets:

Israel’s Super-Sol to Aggressively Pursue Stocking Fees and Perhaps its Private Label Positioning
Tel Aviv…Stocking shelves in an Israeli supermarket will henceforth cost manufacturers and distributors money, it was announced by the mega Super-Sol chain, according to Globes, Israel’s leading business publication. In fact, Supersol’s announcement said that while it plans to take back its power from suppliers—or impose it on them unfairly, depending on how you look at it—by stocking products in its stores itself, it will permit food wholesalers to continue to arrange the shelves using their own workers for six months, as long as they pay Super-Sol for the privilege during the transition period. About six weeks ago Super-Sol sent its suppliers a letter stating that beginning at the end of December the chain will begin to gradually introduce its own stockers. The Manufacturers Association of Israel said it would go to the Antitrust Authority and demand that Super-Sol be declared a monopoly.

The chain has promised to hire a significant number of the stockers now working for its suppliers, who otherwise stand to lose their jobs. Super-Sol has promised to hire 1,275 stockers, some of them from among those who are working for suppliers as well as new employees it will train. Beyond the stocking fees, what is at stake here is a critical component of retail marketing, especially in the food sector: control of product placement, from the height at which items are shelved to the amount of shelf space they take up horizontally, to the battle for the all-important “end caps” at the end of an aisle. Suppliers fear that if Super-Sol takes over shelf stocking it will give priority to its own house brand and they will lose market share.

This is an interesting development.  Israel, in 2004-05, developed a code of ethics governing vertical relationships between grocery product manufacturers and supermarkets which was quite restrictive in terms of slotting contracts, category management, and partial exclusivity requirements.   The concerns were largely to do with supplier market power.  Apparently, the move by Super-Sol has reopened discussion of the code.  It should be interesting to watch.

In April 2008, the UK Competition Commission issued its Final Report culminating from its grocery sector inquiry.  Along with supermarket concentration, the concern that emerges out of that Report is that supermarkets will use their power to negotiate sharp deals with suppliers.  For example:

In emails from store buyers seized during its investigation, the Commission found evidence of foul language towards suppliers together with demands for retrospective discounts and payment for stock lost or damaged after delivery.  Business Secretary Peter Mandelson will decide whether to implement the recommendation, which came in the face of steadfast opposition by the Big Four store chains, Tesco, Asda, Sainsbury’s and Morrisons.  The British Retail Consortium, which represents the chains, accused the watchdog of imposing a £5m a year scheme that was likely to lead to higher costs for shoppers.  Groups representing suppliers, including the National Farmers Union, welcomed the recommendations and called for their swift implementation.

The Competition Commission now has a new recommendation to arbitrate disputes in vertical contractual relationships between manufacturers and retailers, presumably over things like product allocation, pricing and shelf space decisions to alleviate fears of the exercise of buyer power in these relationships (again from the Independent):

var articleheadline = “Grocers face price check: Are supermarkets abusing their immense buying power”;

A key recommendation was to establish an ombudsman to police relations between the big grocers and suppliers, in an effort to stamp out alleged cases of bullying or the supermarkets allegedly abusing their immense buying power. The commission, which does not have the power to introduce an ombudsman itself, sought the agreement of supermarkets for this. But most have vehemently opposed the idea, arguing it would add red tape and costs, which would be passed on to customers.

Yesterday, the commission bared its teeth and formally recommended to Lord Mandelson’s Department for Business, Innovation and Skills (BIS) that it should establish an ombudsman to arbitrate on disputes between grocers and suppliers, under the terms of the new Groceries Supply Code of Practice (GSCOP). The new code will come into effect on 4 February 2010, replacing the hitherto voluntary code that the big four grocers signed up to. The ombudsman and GSCOP applies to the 10 grocers with annual turnover of more than £1bn: Tesco, Asda, Morrisons, Sainsbury’s, Aldi, Lidl, Waitrose, The Co-operative Group, Iceland and Marks & Spencer.

The Ombudsman seems like quite an odd remedy to me for solving so-called “problems” believed to arise from vertical contractual relationships.  Of course, “problems” arise whenever two sides to a negotiation would like a greater share of the pie.  Sometimes negotiations are fierce.  Sometimes the contractual instruments that arise out of these negotations are complex and involve sharing of rents in exchange for promotional activity, monitoring, and self-enforcement mechanisms.  Monitoring and maintenance of these relationships can be fluid, complex, profitable, and good for consumers.

The Final Report recognizes the benefits that arise from the negotiations between suppliers and retailers such as extraction of discounts that are passed on to consumers (though in my view does not sufficiently appreciate the benefits of that retail exclusivity can have in terms of intensifying competition for distribution — nor the economic benefits of promotion more generally) but articulates a concern that these negotations will result in the passing on of “excessive risks” or “excessive costs” to suppliers.  Why an Ombudsman is well situated to determine what is an excessive allocation of risk or costs to suppliers in this setting, which generates complex distribution arrangements such as slotting contracts and category management arrangements, escapes me.  It seems to be the most likely outcome of this portion of the plan is to raise costs to consumers by encouraging both sides of the negotation to lobby the Ombudsman in favor of their respective positions and affect the terms of trade rather than than engage in the sometimes tough (and yes, sometimes even involving foul language!) negotations with collaborators in the supply chain.

RPM Workshop Testimony

Josh Wright —  20 May 2009

I’ll be testifying tomorrow at the Federal Trade Commission hearings on Resale Price Maintenance.   My panel will focus on rule of reason analysis of RPM Post-Leegin.  There is a bit of awkwardness testifying about different modes of rule of reason analysis with legislation that would restore the Dr. Miles per se rule pending, but it strikes me as a valuable exercise nonetheless.  The early afternoon panel looks very interesting and focuses on the legal and business history of RPM.   I do not have a written statement for my prepared remarks, but you can see my slides here.

UPDATE: In response to Thom’s query in the comments, I thought the panel went pretty well.  It was fun, anyway.  The panel split time discussion the merits of the pending legislation that would restore the per se rule and whether some “inherently suspect” truncated liability approach placing the burden on defendants to justify their use of minimum RPM was appropriate.  Five of the eight panelists were in favor of the per se rule with three dissenting for various reasons, including my own view that economic learning in the form of theoretical and empirical knowledge about vertical restraints and RPM more specifically simply did not satisfy the standard that the restraint always or almost always reduces output or harms competition.  Much of the discussion of the underlying economics, in my view, revealed a general suspicion not just of RPM but of the promotional services it is designed to induce.  In other words, a few panelists argued that even if RPM did facilitate the supply of promotional services by resolving incentive conflicts (I’m not sure how well the proponents of the per se rule understand the Klein & Murphy model), we should be skeptical of any sort of promotion that manufacturers have to pay for.  Taken seriously, that view would be fairly dangerous and easily expanded to per se rules for exclusive territories, advertising, slotting contracts, and other forms of promotion.  All in all, it was a fun panel and a lively discussion.  I largely stuck to the same mantra: the theory and evidence does not support application of the per se rule, and to the extent that one believes that we know even less than the literature suggests or does not trust the results in the literature, that is not an argument in favor of per se treatment.

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.

I’ve been reading the papers for the FTC RPM Workshops, though I cannot attend.  On the procompetitive side, I especially recommend Ben Klein’s explanation of how RPM facilitates the supply of promotional services in the absence of dealer free-riding.  Critics of RPM, in my view, generally do not understand the fundamental economic point that retailer competition alone is not sufficient to guarantee the supply of promotional services because of incentive conflicts between manufacturers and retailers.  Klein and Wright (JLE, 2007) explains this incentive conflict in great detail, and how fixed per unit time payments (slotting contracts) can be used to solve this common incentive problem and are part of the normal competitive process.  Klein’s newest RPM explains how RPM contracts can be used to achieve the same effect, that is, solving the incentive conflict between manufacturers and retailers to facilitate the supply of efficient promotional services.

The most common argument raised by defenders of the Dr. Miles rule, including Justice Breyer in Leegin, is that Telser’s (1960) classic discount dealer free-riding story for RPM (RPM solves the problem of consumption of promotional services at the full service retailer before buying the product at the discounter — and thus unraveling the supply of services in equilibrium) does not apply to a number of products where we observe RPM used.  This is where Klein & Murphy’s (1988) seminal explanation comes into play, documenting how the incentive conflict is a real economic problem solved by these vertical restraints, and part of the normal competitive process.  The Klein’s RPM Workshop piece builds on and updates that analysis.

One of the other issues that I’ve been keeping my eye on during the hearings is the evaluation of the current empirical evidence.  I’ve written before that in my own evaluation of the evidence, “the evidence overwhelmingly shows (see also here) [that RPM agreements] are highly likely to make consumers better off in practice.”  I also wrote that I hoped the RPM Workshops would take a hands on and rigorous approach to evaluating the state of evidence in order to design appropriate antitrust enforcement approaches to RPM and vertical restraints generally:

In my view, while there is still a lot to learn about precisely how RPM works, when and by whom it is adopted, and to what effect, there is simply no empirical evidence that its effects warrant per se illegality…. Its my sincere hope that the policy debate to be had on RPM with the pending legislation and FTC Workshops upcoming will be fought on this margin rather than on marketing.

In this light, it caught my eye that Patrick Rey’s slides and paper, which offers yet another possibility theorem of how RPM “could” result in anticompetitive outcomes.   The possibility theorem paper is nothing new in the sense that there are a ton of these around.  But the claim of empirical support is.  Indeed, my views on this matter are well known that there is not much empirical support at all for the anticompetitive theories of vertical restraints including RPM (see also the Lafontaine & Slade and Cooper et al literatuer surveys).  So I did some digging.  Here’s the claim from Rey’s paper with Thibaud Verge:

Our analysis supports this claim and shows that RPM can actually eliminate competition, not only among competing fascias, but also among competing brands. This possibility has been validated by recent empirical studies. Using data about retail prices of food products in French retail chains during the period 1994-1999, Biscourp, Boutin and Vergé (2008) find that the correlation between retail prices and the concentration of local retail markets was important before 1997 and no longer significant after that date. This suggests that the price increases that occurred after 1997 were indeed due to the impact of the new legislation on intrabrand competition.

So what does the Biscourp et al. study actually analyze?  You might think from the context that BBV (2008) studies Minimum RPM contracts.  But you would be wrong.  What did they actually study?  Get this: a set of French laws that make it illegal for retailers to sell “below cost.”  The Loi Galland came into force in 1997 and clarified a pre-existing ban on below-cost sales.  In other words, the Loi Galland set mandatory government enforced minimum price floors that apply to all retailers.  Boutin & Guerrero provide some details on the 1996 Loi Galland:

The Loi Galland gave a simple, precise definition of the actual purchase price and hence of the below-cost retail price floor: `The actual purchase price is the unit price stated on the invoice plus taxes on sales, specific taxes applied to the resale, and transportation costs.’  Since 1997, the definition of purchase price has thus been restricted to the price stated on the invoice, with no deductions such as year-end discounts. The Act also tightened official verification and raised fines. Only the margins formally applied at the invoice date and shown on the invoice the “upfront margins” can be passed on to final consumers through reductions in the final selling price. By contrast, all other discounts are described as “hidden margins” and therefore excluded from the below-cost retail price floor. Examples include margins linked to an annual sales volume, to the retailer’s display of the product on a minimum shelf length, to business cooperation, or simply to the respect of mutual commitments over a certain period. Consequently, hidden margins can in no way be passed on to consumers.

The law in other words, is similar to sales below costs laws i the US that are designed to anticompetitive raise prices, are binding on all sellers, and enforced by the government with significant fines.  Unsurprisingly, a law designed to prevent price-cutting achieves its intended effect and is found to have an anticompetitive effect.  But I’m frankly lost as to how Rey & Verge claim from this study of government imposed sales below cost laws that there is empirical support for the proposition that voluntary, privately negotiated RPM contracts are likely to be anticompetitive.  Note that Lafontaine & Slade’s leading survey of the literature argues that this distinction is quite important — concluding that mandatory restraints are far more likely to generate anticompetitive outcomes.

There is more.

Rey and Verge also claim that another paper from Bonnet and Dubois (2008) “supports his analysis of RPM.”  Curious, I took a closer look at this paper.  Does this second paper actually study RPM agreements?  Again, the answer is no.  B&D (2008) do something different: (1) they get retail prices and quantities for branded and unbranded bottles of water, (2) estimate a random coefficients logit model for the demand for bottled water (no data on costs or markups except for general input price indices), (3) infer wholesale and retail markups under a variety of assumptions about the nature of wholesale and retail competition which amount to 12 different models, and (4) from these estimated markups, estimate marginal costs (e.g. 12 different cost equations).  From these cost equations, they conduct a series of non-nested hypothesis tests, comparing the 12 different models against each other (table7, p. 34 at link above).  The authors conclude that “the results finally show that the best model appears to be model 10, that is the case where manufacturers use two part tariffs with resale price maintenance.”  From this series of assumptions and steps, the authors conclude that the branded water sellers are actually using RPM and two-part tariffs (“Our empirical analysis allows it to be concluded that manufacturers and retailers use nonlinear pricing
contracts and in particular two part tariff contracts with resale price maintenance.”)!  Further, the authors simulate the effect of moving from model 10 to other models of pricing and find that pricing is lower in other models and therefore conclude that RPM has anticompetitive effects.

There are some problems with this analysis.  First, suffice it to say that it is difficult to make confident policy statements about the effects of RPM contracts without studying actual RPM contracts.  There is no actual evidence that the water sellers are using RPM.  Indeed, RPM is illegal in France.  The inference is generated because the non-nested hypothesis test (which is notoriously weak) implies the model best fits the data.   Second, my understanding of merger simulations at the FTC is that when marginal costs are inferred from equilibrium conditions, attempts are made to verify the validity of the inference by comparing the inferred level to some actual measure (so that the model can be tossed if they don’t correspond to one another).

Evaluating the empirical evidence in favor of the various pro- and anti-competitive theories is an incredibly important step in the process of identifying the appropriate legal test to apply to resale price maintenance (and other vertical restraints). While the Rey & Verge piece offers an interesting theoretical effect of RPM, the key issue identified by Justice Breyer’s Leegin dissent is understanding how RPM contracts work in practice. In my view, Rey & Verge’s claim that there is empirical support for their model is unfounded. To the contrary, neither the BBV or BD papers add any empirical contribution to the debate over the appropriate antitrust treatment of privately and voluntarily adopted RPM contracts.

The new issue of the Journal of Law & Economics is available online. This is an exciting development for me because the issue includes my paper with Ben Klein on The Economics of Slotting Contracts (SSRN version available here), and because it has been a very long wait to see the paper in final form (note the new release is of the August 2007 issue of JLE). The primary contribution of the paper is to explain the incidence of shelf space contracts as a consequence of the normal competitive process and examine the conditions under which those contracts will take the form of a lump sum per-unit time payment rather than a wholesale price or volume discount. We also have provide some empirical evidence that is consistent with the time series and cross-sectional incidence of slotting across product categories (see also here).

Readers with an interest in antitrust might want to also check out the Duso, Neven & Roller event study analysis of EU merger decisions and Taylor’s analysis of NIRA cartel performance. And to be filed under the category of “law of unintended consequences,” Jonathan Klick and Thomas Strattman also have a very interesting empirical piece demonstrating that state mandates requiring coverage of diabetes treatments have resulted in offsetting behavioral changes and higher Body Mass Index after the mandates.

The Klein and Wright abstract is below the fold:

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