Vertical Restraints

Vertical Restraints and the Rule of Reason

John M. GaleEconomists Incorporated

Vertical Restraint: Definition

• Any resale requirement placed on a counter-party as part of a sale– Can place requirements on either the upstream or

downstream firm (e.g. exclusivity can go either way)

• Includes price and non-price restraints– Exclusive territories Snap-on tools– Exclusive dealing and Franchising Cell phones– Performance requirements Acura cars– Tying 3M

Rule of Reason

• Economic theory finds that vertical restraints can be anti- or pro-competitive

• Different economic models find that the same restraint can be good or bad for consumers (actually can be good and bad simultaneously)

• Should some restraints have an enforcement presumption?

• Facts matter– Is there market power?

Effects in Two Markets

• Restraint may make upstream market (manufacturers) more or less competitive– Number of upstream and downstream firms– Higher or lower upstream prices

• Competitive effect of restraint (good or bad) is measured by consumer impact, not effects in the upstream market– Restraint will create winners and losers among

wholesale and retail competitors– Competitor complaints are not dispositive

Example: Effects of RPM

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Demand

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Good RPM

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Example: Effects of RPM• When a manufacturer implements “good” RPM:– Consumers have available products with high retail

service features– High-service retailers can win while discount retailers

may lose– Competing manufacturers can win or lose

• When a manufacturer implements “bad” RPM:– Consumers face higher price without additional value– Entrenched retailers can win while discount retailers

lose– Competing manufacturers can win or lose

Models of Anti-competitive RPM

• Facilitating Retailer collusion to limit retail competition

• Facilitating Manufacturer collusion on wholesale price which subsequently raises retail prices

Models of Pro-competitive RPM

• Induces non-price competition among retailers

• Maintains wholesale margins• Improves quality, variety, and availability• Can facilitate manufacturer entry

Competitive Effects are Measured in the Long Run

• Short run — RPM will always restrict retailer price competition and increase price

• Long run – anti-competitive RPM– Protects retailer market power (one or group of retailers)– Protects manufacturer market power

• Long run – pro-competitive RPM– Non-price competition can improve quality, variety, and

availability– Can protect Manufacturer wholesale margin in long run– Can facilitate Manufacturer entry

Leegin: Facts• Leegin is a manufacturer of fine leather goods• Products sold in small specialty stores and high-

end department stores• Leegin had a published policy of not continuing to

sell to retailers that discounted prices– Exceptions for products not reordered

• Leegin discontinued sales to a retailer that if found to be discounting price

• Retailer sued claiming anticompetitive effects of Leegin policy which was an agreement with retailers

Leegin: Economic Issues

• Supreme Court removed per-se illegality of RPM and mandated a rule-of-reason analysis– DOJ and FTC supported decision

• Does a rule-of-reason analysis find that the Leegin RPM policy good or bad for consumers?

Plaintiff Arguments

• Leegin entered into a price fixing conspiracy with retailers– Leegin was itself the largest retailer

• Leegin has market power in– Retail market for Brighton’s women’s accessories– Sale of branded women’s accessories to

independent retailers• Consumers harmed by higher prices due to

lack of retail competition

Leegin Arguments

• Maintaining retail margins necessary for carriage in preferred retailers– High-end retailers have higher average costs

• Maintaining product image requires limiting price discounting

• Long-run output higher with RPM• No Leegin market power in “women’s

accessories” market• No retailer market power

How to Tell if RPM is Good or Bad

• Output test– If RMP increases output then it is good for

Manufacturers and Consumers– If RPM decreases output then it is bad for Consumers

• Market Power test– If Retailers have market power, RPM may be

protecting Retailers and harming Consumers– If Manufacturers have market power, RPM may be

protecting Manufacturers and harming Consumers– If no one has market power, then there cannot be

anticompetitive effects

Output Test• If Manufacturer output is higher with RPM, then

restriction is good for consumers– Increased output associated with prevention of free

riding and resulting increase in consumer demand– Decreased output associated with retailer or

manufacturer collusion• Analysis must separate short-run and long-run

impact on output– There are always short-run output decreases

• Analysis must value non-price benefits to Consumers and Manufacturers

Market Power Test• Anticompetitive effects rely on retailers having market

power in a relevant retail market– If manufacturers have viable alternatives to reach

consumers, they will not submit to retailer demands• Manufacturers imposing RPM must also have some

market power in a relevant consumer product market– If Retailers have access to good substitute products, then

limiting price competition on a product will have no market impact

• Market power in two separate markets is a necessary condition – Showing market power in both markets is still not

sufficient to prove anticompetitive effects

Leegin Tests

• Leegin claimed that sales were higher due to improved retailer services and improved brand perception

• Court found that single brand cannot be a market – therefore no market power

• Court found that “women’s accessories” was not properly defined or proven – therefore no market power

Conclusion: Rule of Reason• Each instance of a vertical restraint must be individually

examined• Consumer impact is not either-or, a single instance of RPM

may have some pro-competitive and anti-competitive effects– With RPM, one consumer can purchase at a high-service retailer

while simultaneously another consumer if foreclosed from a lower price at a discount retailer

• For an Economist, source of RPM is not dispositive• Properly measured Manufacturer profits may be dispositive

– Must examine possibility of manufacturer collusion– Must examine long run profitability