#88 - Article 81 Theory - Competition Law

Competition theory notes article 81

Vertical Restraints

Slade and Lafontaine (2005)

Some say there are no reasons for restricting vertical agreements, since they have a self-policing mechanism to keep price down. The lower the unit cost, the more will be sold, and the more units will be ordered by retailer from manufacturer. Any price rises above wholesale price represents a loss to the manufacturer. Thus the manufacturer will aim to keep prices as close to wholesale price as possible.

There are also many precompetitive effects of vertical restraints. Over 1/3 of sales from upstream to downstream firms in the US are subject to some form of exclusive dealing. Vertical restraints can be helpful in many ways:

• Overcoming double marginalisation (DM): DM occurs when there are upstream and downstream dominant undertakings. In order to make a profit, each prices at a monopolistic mark-up over its own costs, resulting in consumers paying a price that is higher, and a quantity that is lower than would be optimal to profit maximise from their joint point of view. They impose externalities on one another, since a high wholesale price raises retailer’s costs, while a high retail price reduces the number of orders the retailer will make from the manufacturer, reducing the latter’s revenue.

  • Resale price maintenance sets a single level of price (and hence outcome) for both

  • Minimum output requirement on downstream e.g. in franchising solves the problem

  • Reducing the dominance of the downstream firm by only supplying to a limited number of downstream suppliers (who will hold market power that restrains the previously dominant downstream retailer) will create downstream intra-brand competition

• Overcoming the free-rider problem: If an upstream firm invests in downstream retailers e.g. training sales staff, renovating the retail outlets, providing technical support etc, there is a risk that these will benefit other brands sold there, discouraging upstream firm from investing. Exclusive dealing avoids this and therefore encourages investment.

• In franchising, there is an incentive on franchisees to free-ride on the brand: They are unlikely to get repeat business from good service (since consumers view all McDonalds/Dunkin Doughnuts as the same). Any benefit of repeat service that is produced by quality service they offer could be used to benefit other franchisees. Thus the incentive is to offer poor quality service. A vertical restraint of wide exclusive territories could overcome this problem, since consumers may not go to other areas, so that any benefits from quality service offered by an individual franchisee is internalised to that same franchisee, as are poor service.

However there are in theory some anticompetitive effects of vertical restraints. The main concern is that vertical restraints will foreclose the market from either upstream or downstream competition. If a manufacturer agrees exclusive dealing with most of the downstream retailers, it may be impossible for a rival manufacturer to compete and force it to leave the market. This argument requires that there be limited downstream competition due to barriers to entry (such as good locations etc). If there were many insignificant retailers then upstream rivals could still compete, unless exclusivity network covered nearly all of them. The consequent reduction on competition will harm consumers as prices will rise. However Slade and Lafontaine look at the results of some empirical studies. Their findings are that

• Consumer welfare, defined by looking at price, quality and service-provision e.g. after-sale service etc is congruent with manufacturer profits (S&L say this is due to self-policing mechanism- it is in manufacturers’ interests to make max number of sales at a price that is as close to its own profit maximising price as possible, minimising retailer profits. Manufacturers tend to have a degree of market power due to their brands and IP, and vertical restraints allow them to use this power to pressure retailers into accepting lower resale prices.)

• Privately agreed vertical restraints overwhelmingly improve consumer welfare

• When PAs force the end of vertical restraints, consumer welfare tens to be reduced in almost all cases.

• NB they do accept that more empirical studies are needed before these positions can be conclusively accepted.

Chicago View

Bork, Posner, Chicagoans etc argued that vertical restraints removed price distortions (e.g. DM), optimised investment levels (see above), and eliminated transaction costs (as neither upstream nor downstream firms need to seek out alternative retailers/suppliers etc). This improves productive and allocative efficiency, improving consumer welfare and therefore shouldn’t be subject to antitrust regulations.

Robert Hahn

Territorial Exclusivity and Single Branding agreements can have different effects on different types of competition:

• Some argue that exclusivity for a retailer over a territory can reduce intra-brand competition, because consumers in that area will not be able to purchase the product from another retailer in that area more cheaply. However, by providing that retailer with exclusivity, the manufacturer gives it an incentive to promote and advertise the product (since all resulting increase in interest will be internalised) and thus promotes inter-brand competition.

• Equally single brand agreements (retailer exclusively sells M’s brand) prevents free riding on any sales training/store improvements paid for by the manufacturer. This in turn creates an incentive to invest in that retailer, again promoting inter-brand competition.

Tying/bundling is extremely common. Car manufacturers/retailers tie the car with air fresheners, radios etc. This can have precompetitive effects on consumer welfare, such as saving the consumer the transaction costs of buying a car radio elsewhere. However it can also have anticompetitive effects, where a monopolist ties an essential good to a complementary one, such as an operating system to an internet explorer. This is because in the long term the monopolist seeks to preserve market dominance (rather than merely pursuing short term profit maximisation) which will allow it to preserve a long term monopoly profit in both markets. I.e. the leveraging theory. This is especially the case in software, where each sale of the complementary good- the software- will lead to future revenue streams from people paying for upgrades. However, due to the problems with the leveraging theory (such as the fact that a monopolist may already charge profit maximising price, and an increase in overall cost to the consumer, as represented by the tie, will cause a drop in quantity demanded below the profit maximising level), the difficulties of distinguishing single products from a main one and a complementary one, and the potential for consumer benefits, such as lowered transaction costs, there should be a high threshold for...