Understanding Vertical Market Restrictions and Antitrust Laws in Private Markets

1. Public Policy in Private Markets Vertical Market Restrictions

2. Announcements • 4/12: • Debate # 3 • Homework 6 (posted) • 4/18: • Review session (6pm-8pm, Holdsworth 203) • Practice exam • will be posted on 4/17 • due @ review session • Answer key will be posted on 4/18 (after review)

3. Overview of Antitrust Laws • √ • √ • √

4. Pros - cons • Pros: • Better trained salesman / brand reputation • More effective training • Increased profit margin (eliminating middleman) • Differentiation strategy (Apple effect) • Efficient shipping/inventory • More effective advertising (economies of scope)

5. Pros - cons • Cons: • High operation costs (learning curve) • LG is not as popular as Apple • People who are in the retail business might be more effective/knowledgeable about local market conditions (promotion)

6. Vertical Market Restrictions • 4 types of VR: • Tying (aka bundling) • Exclusive Dealing • Exclusive Territories • Resale price maintenance All important in franchising

7. Vertical Market Restrictions • 4 types of VR: • Tying (aka bundling) • Exclusive Dealing • Exclusive Territories • Resale price maintenance All important in franchising

8. Tying: Burden of Proof • Reasonableness: • In some cases, firm can argue that without tie in, business is unfeasible • Example: Jerrold Electronics (1960) • Tied in equipment, layout and service for community antenna systems (equivalent of cable systems today) • Argued systems were delicate • Court agreed tie in was ok

9. Tying: Burden of Proof • Reasonableness: • Chicken Delight (1971) • Forcing franchisees to buy chicken, mixes and equipment • Franchisor: to protect quality • Q: what are the tied and tying products? • Court: • Sufficient economic power in tying product market • Substantial commerce in tied product market • UNREASONABLE: same quality could have been achieved under less restrictive means • Reasonableness can not always be claimed.

10. Vertical Market Restrictions • 4 types of VR: • Tying (aka bundling) • Exclusive Dealing • Exclusive Territories • Resale price maintenance All important in franchising

11. Exclusive Dealing Manufacturer A Manufacturer B Retailer 1 Sells: A + B Retailer 2 Sells: A+B

12. Exclusive Dealing Manufacturer A Manufacturer B Retailer 1 Sells: A Retailer 2 Sells: A+B

13. Exclusive Dealing • Seller forces buyer not to distribute products from seller’s competitors • Examples: fast food franchises, Apple store • Business motives: • Distributors devote sole attention to 1 manufacturer (avoids free riding by distributor/retailer) • Manufacturer will invest more on distributor • Better coordination and sales effort • Economies of scale in shipping

14. Exclusive Dealing • Why are antitrust laws concerned? • Exclusivity: other manufacturers looking for an outlet may not find one, as they are scarce • Clayton Act: • Exclusive dealing is illegal when used “to substantially lessen competition or create a monopoly” • Rule of reason approach.

15. Exclusive Dealing Manufacturer A Manufacturer B Retailer 1 Sells: A Retailer 2 Sells: A+B

16. Vertical Market Restrictions • 4 types of VR: • Tying (aka bundling) • Exclusive Dealing • Exclusive Territories • Resale price maintenance All important in franchising

17. Exclusive Territories • Arrangement between upstream firm (e.g. manufacturer) and downstream firm (e.g. retailer) Coke Bottler Distributor B Distributor A Franklin County Hampshire County

18. Exclusive Territories • Either a geographic area or set of customers • Examples: distribution, franchises McDonald’s Franchisee 1 Franchisee 2 Northampton Hadley

19. Exclusive Territories • Upstream Motives: • Incentive to downstream firm to increase investment, advertising, quality of service that upstream firm wants • Can guarantee an appropriate return to downstream firm • Downstream motive: • Reduces competition (less intrabrand competition)

20. Exclusive Territories: Competitive Effects • Negative: It reduces intrabrandcompetition • Coke distributor in Hampshire county does not face competition from other Coke distributors • Particularly important if firm has large market share • Positive: • More investment, better services, more quality, more product variety • It may increase interbrandcompetition as dealer makes an effort to beat dealers of other brands • Antitrust policy tries to balance both effects

21. Exclusive Territories • Courts: rule of reason approach • Major precedent case: Continental v. GTE-Sylvania (1977) • Low TV sales: • GTE Sylvania: reduction of retailers + use of exclusive territories • Result: higher sales • Cut-out retailers (Continental) brought a suit against GTE-Sylvania • Court: • Sylvania’s practices ok • Rule of reason approach (no specific guidelines)

22. Exclusive Territories • Soft drink industry: • Has used exclusive territories since early 1900’s • 1971, FTC challenged practice • Territories might not be efficient • 1978: FTC ordered Coke and Pepsi to stop practice • 1980: Coke and Pepsi went directly to Congress • “Soft Drink Interbrand Competition Act” exempted SD industry from antitrust suits over exclusive territories as long as there is significant interbrand competition • FTC dropped the case

23. Exclusive Territories • 1989: Purity Products v. Tropicana • Tropicana dropped Purity products as its dealer in Baltimore-DC area, because it was selling outside its territory • RULE of REASON: court found that Tropicana’s actions were not unreasonable restraint of trade • Bottom line: • Law gives lots of room to exclusive territories

24. Vertical Market Restrictions • 4 types of VR: • Tying (aka bundling) • Exclusive Dealing • Exclusive Territories • Resale price maintenance All important in franchising

25. Resale Price Maintenance • Manufacturer specifies minimum or maximum price that downstream unit can charge • Two types: • Minimum RPM • Maximum RPM • Antitrust concerns: • Minimum RPM: Vertical price fixing that can result in horizontal price fixing • Maximum RPM: Downstream firms’ profits may be squeezed

26. Resale Price Maintenance: Motives • Minimum RPM: • High prices can maintain quality image: “you get what you pay for” • Better coordination across retailers • Ensure adequate margins for retailers, protects them from cut-throat competition • Avoids free riding problem among retailers: retailer across the street can not undercut retailer with high sales effort (e.g. a showroom).

27. Resale Price Maintenance: Motives • Maximum RPM: • Reduction of double marginalization problem (very important) • Not having intermediaries in the supply chain increases efficiency • In practical terms, this allows firm to put a cap on price so that quantity sold is as high as possible. • This usually is accompanied by a compensation scheme to the retailer (e.g. sharing profits)

28. Oil State v. Khan Oil State (distributor) Other Gas Distributors Exclusive Distributor Khan (retailer) Retailer x Retailer y Maximum price: Wholesale price + $3.25 Consumers

29. What is (may be) wrong with RPM? • Historically viewed as (vertical) “price fixing”, per se illegal under Sherman Act (section 1) • Price fixing = high profits detriment of consumers/society, but with maximum RPM: • Market power by retailer may be limited (good for consumers) • Why would State Oil seek a price that is too low? • Too high a price (bad for consumers)=higher incentives for retailer (better service, investment, etc.) • But here is the opposite (i.e. too low a price) • Squeezed margins (anticompetitive): • But market is relatively competitive, retailers can seek other distributors

30. Illegality of RPM District Court: sided with Khan Court of Appeals: illegal price fixing BUT, recommends revisiting Albretch 1968 decision Supreme Court: overturn Albretch and Court of Appeals ruling • Maximum RPM: rule of reason • Minimum RPM: per se illegal (until 2007)

31. The Changing Law on RPM • 1911-1930: Per se illegal under Sherman, Section 1 • Restraint of trade • 1930-1975: largely legal (state laws allowing it) • 1975-2007 : Consumer Goods Pricing Act: • Per se Illegal, for the most part • State Oil Co. v. Khan et al. (case 14), maximum RPM becomes rule of reason • 2007- present: • Rule of reason approach