Friday, June 29, 2007

Leegin vs. PSKS: Vertical Price Fixing is Good for Some

by Tom Bozzo

Yesterday, the Supreme Court's conservative majority decided that arrangements to fix minimum retail prices ("resale price maintenance," or RPM) between manufacturers and their retailers are not "per se" anticompetitive and must instead be judged by the "rule of reason" on the merits or demerits of particular RPM deals.

As an equity holder in an economic consulting firm, my first reaction was, "Woohoo! The economic consultant's full employment act of 2007!" The second reaction, after seeing Justice Kennedy refer to economic literature (Greg Mankiw, via PGL at Angry Bear, has the story as told in his principles textbook) on potential beneficial effects of RPM arrangments was, "Oh, really?"

Before going further, these RPM agreements are not the same sort of restrictions as are provided by minimum markup laws such as Wisconsin's Unfair Sales Act. Such laws directly affect the terms of interbrand competition — the Shell station is limited in its ability to try to underprice the Mobil station down the street — whereas the RPM agreements (directly) limit intrabrand competition. The former are much likelier to have adverse effects on consumers.

The standard story (again via Mankiw) suggests that RPM agreements may be valuable in that they ensure retailers enjoy sufficient markups to pay for what the manufacturer considers to be valuable ancillary services — retail shop ambiance, demonstrations of complex products, etc. In the absence of such arrangements, it's claimed, there's a free-rider problem as cut-price retailers direct their customers to go to full-service stores for the free services and then to come back to buy the product on the cheap. In the end, the full-service retailers can't provide the services (or underprovides them) and everyone's worse-off.

One thing about this type of arrangement is that it appears, on the face, to be allocatively inefficient. That is, in static resource allocation problems, the "market" puts resources to their best possible uses when prices and marginal costs are equal. RPM agreements increase the gap between prices and marginal cost of the affected retail products in order to subsidize the provision of ancillary services at zero price. Whether and how much consumers benefit depends on how they value the ancillary services; it seems uncontroversial that there are, indeed, some people who don't need the hand-holding and/or don't care about having a "free" skinny chai latte while they shop.

The part of the theoretical story that I buy less is that the subsidy is necessary to solve the free-rider problem. An alternative is not that the provision of the ancillary services collapses, but rather than full-service retailers explicitly charge for them (or at least those with nontrivial costs). This happens quite a bit in some markets. For example, interior decorators can (and do) "unbundle" their design services by charging for design consultation; they can (and will) rebate the design fees for customers who subsequently purchase stuff through the designers. Car dealers in Wisconsin can charge a fee to cover "reasonable" costs related to the sales process. The stickers advertising these fees seem to have become much more prevalent since the advent of Intertube-assisted car buying. We haven't yet had the opportunity to determine whether those fees are negotiable. Clothing stores charge for alterations on sale merchandise. The list, I'm sure, could go on.

PGL also points to a very interesting Wall Street Journal Econoblog face-off on the subject. There, Larry White raises some rhetorical questions that don't obviously have the answer he perhaps implies:
It's the manufacturer's judgment that [the RPM arrangement] is the best way to sell the product. Shouldn't the manufacturer's judgment be controlling? Isn't that what a market economy generally relies on to benefit consumers?
Neither is a clear affirmative. Why shouldn't the retailer's judgment be controlling? They, presumably, have better information about the demand for ancillary point-of-sale services than the manufacturers. And it would seem reasonable to believe that vigorous competition among retailers would help ensure efficient provision of those services.

To the extent that the potential market failure doesn't turn into an actual one, then it's very hard to see how consumers would enjoy significant net benefit from RPM arrangements. The appearance of amici such as the American Petroleum Institute and National Association of Manufacturers — not exactly defenders of the Little Guy — in favor of the legality of RPM heightens my doubt that consumer benefits are what's really at stake in the case. And I'm skeptical that maintaining brand images by keeping up the appearance of high prices has dynamic efficiency benefits to speak of.

That said, the SCOTUS majority's view that, in effect, the costs and benefits should be weighed isn't that controversial. However, the end result may still be consistent with Justice Breyer's expectation, in the dissent, that the main effect will be higher retail prices.

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As someone who runs distribution programs I was interested and read the courts opinion.

In general I agree with the spirit of the opinion. However, it has brought the need to be very knowledgeable about channel programs to the lower courts.

Nevertheless, my key concern is that the Leegin channel program was flawed. When PSKS was removed from the "Heart Store Program" its margin should have been reduced to reflect the lower level in the program. This would have removed the ability to discount 20% below the manufacturers set price. Of course if they wanted to sell at a loss for some market gain over the competition that should be allowed but apparently not now.

Providing margins based on adherence to program requirements are how most programs operate. In the opinion it says that "vertical nonprice restraints" may not be the most efficient way to operate.

Well, this is exactly what one needs to determine to implement a successful distribution strategy. If no value can be gleaned by providing, services, expertise, or availability, then your selling nothing more than a comodity. In this case RPMs do nothing more than inflate price.
I am in support of the Leegin decision. The free rider problem is challenging to solve, and this is simply a more direct way of addressing what others have had to address indirectly in the past.
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