Vertical Restraints

1. Vertical Restraints Vertical Restraints and the Rule of Reason John M. Gale Economists Incorporated

2. 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

3. 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?

4. 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

5. Example: Effects of RPM P P P Good RPM Minimum Price P1 New Demand Minimum Price Q Q1 Q* Supply P1 P1 Bad RPM Demand Demand Q Q Q1 Q1 Q*

6. 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

7. Models of Anti-competitive RPM • Facilitating Retailer collusion to limit retail competition • Facilitating Manufacturer collusion on wholesale price which subsequently raises retail prices

8. Models of Pro-competitive RPM • Induces non-price competition among retailers • Maintains wholesale margins • Improves quality, variety, and availability • Can facilitate manufacturer entry

9. 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

10. 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

11. 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?

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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