Vertical Restraints

1
Vertical Restraints
2
Vertical Relationships

• vertical relationships are those among sellers of
  goods and services that are complements to each
  other in demand
• horizontal relationships are those among sellers
  of substitutes in demand.

3
Vertical Relationships

• The most familiar vertical relationships are
  between manufacturers and input suppliers.
• designation of one level as upstream and the
  other as downstream is conceptually convenient
• but arbitrary - for example, retailers could be
  thought of as upstream to manufacturers since
  they sell a key input retailing services to
  manufacturers

4
Vertical Restraints on Competition include

• Resale price maintenance
• Territorial restraints
• Exclusive territories
• Location clauses
• Exclusive dealing
• Partial Integration
• Tying Agreements

5
Vertical Restraints

• Resale price maintenance or RPM means that the
  supplier requires the dealer to resell its
  product at some set price.
• Can be either minimum or maximum
• minimum RPM if Nintendo requires its dealers to
  sell its video games at no less than 40
• Maximum RPM if the NY Times required its home
  delivery distributors to sell the paper for no
  more than 10 per week

6
Vertical Restraints on Competition

• Market allocation
• territorial restraint is an agreement between the
  supplier and the dealer that the supplier will
  not allow any other dealer to locate within a
  certain territory thereby preserving an
  exclusive marketing territory to that dealer.
• Practice is widespread in the automobile industry
• Customer allocation is an agreement that
  establishes the classes of customers to whom a
  dealer may sell to.
• Location Clauses Retailers can only sell from a
  specified retail location

7
Vertical Restraints on Competition

• Exclusive dealership agreements retailers can
  only carry the products of one manufacturer
• Illustrated by an agreement between an oil
  company and an independent service station that
  the service station would buy all of its oil and
  gasoline from the oil company

8
Vertical Restraints on Competition

• Partial Integration The manufacturer owns key
  inputs of the retailers (e.g., land and
  buildings)
• Example McDonalds

9
Vertical Restraints on Competition

• Tying refers to the practice of a supplier
  agreeing to sell its customer one product (the
  tying good) only if the customer agrees to
  purchase all of its requirements for another
  product (the tied product) from the supplier
• Example is IBMs practice of leasing its
  tabulating machines on the condition that the
  customer purchase all of its needs for tabulating
  cards from IBM

10
Legal Treatment of Vertical Restraints

• Practices are generally judged under Section I of
  the Sherman Act or Section 3 of the Clayton Act
• RPM has been held to be illegal per se under the
  Sherman Act. It is viewed by the courts as
  simply a vertical form of price fixing.
• Section 3 of the Clayton Act specifically
  mentions both exclusive dealing and tying and
  holds them to be illegal where the effect may be
  to substantially lessen competition or tend to
  create a monopoly.

11
Anticompetitive Effect of Vertical Price Fixing
(RPM)

• The essential antitrust argument supporting
  illegality of RPM is that such agreements produce
  the same effects as horizontal price fixing among
  dealers
• What might account for this behavior?

12
Anticompetitive Effect of Vertical Price Fixing
(RPM)

• One possible explanation is when there is a
  cartel among manufacturers that cannot observe
  each others prices but can observe retail prices.
  They may fear that price wars among retailers
  will tempt manufacturers to cut their prices
  thereby undermining the cartel.
• Facilitating practice for a dealer cartel

13
Possible Justifications

• The answer to the policy question of how should
  resale price maintenance agreements be treated
  depends on the weight you attach to the following
  contentions
• Manufacturers have differing incentives
• the retail price a manufacturer would sell is
  almost assuredly different from the price a
  retail cartel would set. WHY?
• Some argue that the manufacturer can be depended
  upon to set the minimum retail price at
  reasonable or efficient levels

14
Possible Justifications

• Maximum resale prices the ability of the
  supplier to limit the dealers price will increase
  its own profitability
• How does this reduce consumer welfare?

15
Possible Justifications

• Attracting Dealers
• May assure margins and thereby induce dealers to
  stock and promote the brand
• Inducing Desired Services
• Computer stores with technically competent
  personnel vs Internet purchases
• Is this argument persuasive? Do higher markups
  ensure dealers will undertake outlays on nonprice
  competition? Why cant the market be depended on
  to solve this problem?

16
Possible Justifications

• Product Image and loss Leaders
• It is argued that for some products like wine or
  perfume price cuts might actually reduce sales
  volume
• Preservation of small business
• Pressure by small business community advocating
  resale price maintenance
• Are such attitudes favoring soft competition in
  the public interest?

17
Questions on Vertical Restraints

• Suppose the product is complex or retailing is
  complex
• Retailers require training in business methods
• general training beneficial for any business
• specific training beneficial only for this
  business or product
• Retailers make investments to promote the product
• Advertising or promotion
• Pre-sale information about the product
• Post-sale service for the product
• Manufacturers make investments to promote the
  product

18
Retailer Training

• Retail training is specific to the manufacturers
  product
• Training about how to explain and sell the
  product
• Training how to service and repair the product
• NO problem knowledge is public good, but no
  externality
• Retail training is general to any product
• Training how to manage a retail business
• Training how to sell any product in the industry
• Problem knowledge is a public good, AND positive
  externalities

19
Retailer Training

• Retail training is general to any product
  (continued)
• Problem knowledge is a public good, AND positive
  externalities
• To whom? Free-riders are manufacturers of
  substitute products that could be distributed by
  the same retailers
• Solution Exclusive Dealing
• Retailers cannot use their general training to
  sell the products of other manufacturers

20
Retail Advertising

• Specific Advertising by the Retailer
• Location of the store, products carried
• NO Problem knowledge is a public good, but no
  externality
• General Advertising by the Retailer
• Product advertising
• Problem knowledge is a public good AND positive
  externalities

21
Retail Advertising

• General Advertising by the Retailer
• To whom? Free-riders are other retailers
  carrying the same product in the same area, they
  need only do specific advertising
• Solution Location Clauses or Exclusive
  Territories
• Manufacturers can separate retailers, giving each
  a local monopoly
• Retailers then have an incentive to advertise and
  promote the product in their local area because
  they appropriate all the benefits

22
Retail Services

• Post-Sale Service increases the value of the
  product
• Repair shop, exchange program
• NO problem retailers can exclude consumers who
  purchased from other retailers, and can
  appropriate the value of these services
• Pre-Sale Service increases knowledge about the
  product
• Salesmen who provide information, showroom for
  the product
• Problem Free-riders are consumers who can learn
  about the product, but then purchase it at a
  lower price from a discounter

23
Retail Services

• Solution Location Clauses or Exclusive
  Territories
• Separating retailers make it more costly for
  consumers to shop for price giving each retailer
  a local monopoly
• How can the manufacturer deal with catalog or
  website sales?

24
Franchising

• How does McDonalds generate revenue from its
  franchisees?
• Revenue from sale of supplies? Some yes
• Royalties on the trademark name? Yes some
• Leases on the land and the buildings? Yes the big
  money
• Who decided where to put each store? McDonalds
• Why? Cover the market and minimize consumer
  transportation costs
• Why? Compete with other franchisers not among
  franchisees

25
Franchising

• Why Does McDonalds own the building? Partial
  integration
• Suppose franchisee owns the building and must be
  terminated
• If building is used for another fast food
  business, could create a negative externality on
  McDonalds brand image
• Consumer confusion when McDonalds opens another
  franchise in the same geographic area

26
FTC v. CD Distributors (2000)

• Minimum Advertised Price (MAPS)
• CD distributors provide payments to retailers for
  local advertising
• But in return, the CD distributors require the
  retailers not to advertise prices below a minimum
  level fixed by the distributor
• But, the retailer cannot advertise these lower
  prices

27
FTC v. CD Distributors (2000)

• Minimum Resale Price Maintenance is ILLEGAL per
  se
• Map program does not really set the minimum
  retail price because the retailer can charge
  lower prices for the CDs
• What is the point of setting lower prices if the
  retailer cannot tell consumers that it has lower
  prices?

28
FTC v. CD Distributors (2000)

• FTC sues and obtains a settlement to end MAPS
• Section 5 of FTC Act prohibits unfair methods of
  competition
• MAPs can facilitate collusion among the CD
  distributors

29
Dr. Miles Medical Co. v. John D. Park Sons
(1911)

• The plaintiff was a manufacturer of proprietary
  medicines. The drugs were sold under an
  agreement that the drugs would sell at a price
  set by Dr. Miles.
• The defendant was a wholesale drug concern that
  refused to enter into a required RPM contract
• Procured the medicines by inducing those who have
  entered into the contracts to violate resale
  provisions

30

• Dr Miles argued the manufacturer may make and
  sell or not as he chooses, he may affix
  conditions as to the use of the article or as to
  the prices at which the purchasers may dispose of
  it.
• Does it follow that because a manufacturer can
  choose to make or sell that he can also impose
  conditions as to the use of the article or as to
  the prices at which purchasers may dispose of it?

31
Dr. Miles Medical Co. v. John D. Park Sons
(1911)

• The court found the disposal of the goods after
  their sale to dealers, the basic element of RPM
  agreements were invalid under common law
• Established that RPMs were naked restraints and
  were illegal under the standards established in
  Addyston Pipe

32
United States v. Colgate Company (1919)

• Court seemed to open a loophole
• In the absence of any purpose to create or
  maintain a monopoly, the act does not restrict
  the long recognized right of trader or
  manufacturer engaged in an entirely private
  business, freely to exercise his own independent
  discretion as to the parties with whom he will
  deal. And of course he may announce in advance
  the circumstances under which he will refuse to
  sell.
• In Dr. Miles the unlawful combination was
  effected through the contracts which undertook to
  prevent dealers from freely exercising the right
  to sell.

33
Monsanto v. Spray-Rite 1984 (KW Case 15)

• Monsanto is a major manufacturer of chemical
  products which declined to renew its
  distributorship with Spray-Rite
• Spray-Rite Service Corporation is a small Iowa
  Herbicide distributor
• Low-margin, high volume operation selling
  primarily to large seed-corn companies, dealers
  and sprayers.

34
Monsanto v. Spray-Rite 1984 (KW Case 15)

• In 1967 Monsanto decided to change its marketing
  strategy in order to stress dealer education.
• It announced it would appoint dealers for 1 year
  terms and that it would renew based on the
  following criteria.
• Whether the distributors primary activity was
  soliciting sales from dealers
• Whether the distributor employed trained salesmen
• Whether the distributor could be expected to
  exploit fully the market area

35
Monsanto v. Spray-Rite 1984 (KW Case 15)

• In 1968 Monsanto declined to renew Spray-Rites
  distributorship
• Spray-Rite sued alleging that Monsanto and some
  of its distributors conspired to fix the retail
  prices of Monsantos herbicides

36
Monsanto v. Spray-Rite 1984 (KW Case 15)

• The lower Court stated that proof of termination
  following competitor complaints is sufficient to
  support an inference of concerted action.
• Court of Appeals held that a plaintiff can
  survive if it shows that a manufacturer
  terminated a price cutting distributor in
  response to or following complaints by other
  distributors
• Supreme Court In 1968 Monsanto declined to renew
  Spray-Rites distributorship
• Do a manufacturer and its distributors have
  legitimate reasons for exchanging price
  information?
• Need to distinguish independent action from
  concerted action on nonprice restrictions from
  price-fixing agreements

37
Monsanto v. Spray-Rite 1984 (KW Case 15)

• The correct standard is that there must be
  evidence that tends to exclude the possibility of
  independent action by the manufacturer and
  distributor. That is, there must be direct or
  circumstantial evidence that reasonably tends to
  prove that the manufacturer and others had a
  conscious commitment to a common scheme designed
  to achieve an unlawful objective.

38
Business Electronics v. Sharp (1988)

• Involved the cancellation of a price-cutting
  dealer by a manufacturer of consumer electronics
• Burgess states that Sharpe placed the theory of
  efficiency enhancement ahead of the theory of
  restraint as the more plausible explanation for
  RPM behavior