Preliminary considerations
‘For most vertical restraints, competition concerns can only arise if there is insufficient competition at one or more levels of trade, i.e. if there is some degree of market power at the level of the supplier or the buyer or at both levels’[1]. This competition policy statement is consistent with the economic reasoning that vertical restraints (”VRs”) can be anti-competitive when they reduce horizontal competition and ‘involve firms endowed with significant market power’[2].
The incentives of the firms to reduce the horizontal competition must also be explained, so that to answer the critique that questions the incentives of either firm for accepting VRs that would eventually leave it worse off, while a better outcome might be obtained by signing a deal with other more efficient firm.
VRs can reduce horizontal competition by reducing inter-brand (at the supplier level) or intra-brand competition (at the buyer level). The inter-brand competition is more important than the intra-brand competition[3]. VRs that harm intra-brand competition may harm competition when inter-brand competition is already weak. Authors show[4] that divergence of interest might exist between the firms seeking a better coordination in the choice of effort and price within a vertical structure, on one hand, and the consumers on the other hand. In this case, VRs used to achieve the coordination within the respective vertical structure (which might also reduce intra-brand competition) may negatively affect consumer surplus. Nevertheless, if strong inter-brand competition exists, increasing retail efforts and prices through VRs will not reduce welfare since most of the affected consumers could switch to alternative offers.
The remainder of this paper is dedicated to:
- the economics around the ways in which VRs can reduce horizontal competition;
- discussing whether the concept of a hardcore vertical restraint makes economic sense.
A.How can VRs reduce horizontal competition?
- By market foreclosure
An incumbent supplier holding market power might use VRs in order to block new entry, thus decreasing inter-brand competition. For example, in a market with few efficient distributors or good retail locations, the incumbent supplier can raise entry barriers for potential rivals by concluding long-term exclusive dealing contracts with the best distributors or locations[5]. Forcing potential new suppliers to set-up their own distribution systems, the incumbent would raise its rivals’ entry costs[6] whenever there are significant economies of scope or scale in distribution. Equally, exclusive distribution with at least the best suppliers might be used by a distributor to deter entry for new distributors[7], and thus reducing intra-brand competition. MFN might cause a similar entry deterrence at downstream level, by removing the ability of the entrant to undercut the incumbent distributor.
The market might also be foreclosed at downstream level, via VRs, when an upstream monopolist, wishing to preserve his market power and extract monopoly profits, must solve a commitment problem first, i.e. to convince his distributor that he could not profitably offer subsequent distributors a lower price. To solve this problem, the monopolist has incentives to reduce intra-brand competition downstream via various VRs such as exclusive distribution with just one distributor, exclusive territories, MFN or by building a reputation that he will not supply other distributors[8].
- By competition-dampening
VRs used within a certain vertical structure can affect its strategic interactions with rival vertical structures, thus affecting the horizontal competition at either upstream or downstream levels or both. Rey and Stiglitz[9] show that VRs such as exclusive territories, which eliminate intra-brand competition within a given vertical structure, can also help to reduce inter-brand competition. In this scenario manufacturers use exclusive territories offered to their retailers in order to commit themselves not to compete aggressively against each other. This is achieved through the delegation of retail price decision to the retailers that might adopt a monopolistic behavior in the exclusive territories. Thus, the retail price for a certain brand might rise, which will be followed by a similar response by the retailer of a rival brand.
A similar effect might have an exclusive dealing combined with a two-part tariff. By setting a high variable fee as a profit maximizing strategy, the manufacturers will determine a chain reaction by inducing the retailers to raise the retail prices in order to keep their margins. The level of the fixed fee will determine then how the profits within the each vertical structure are distributed. A manufacturer holding bargaining power can extract most or all the profits though the fixed fee.
A key point for the results of the above examples to hold is that the retailers must compete in prices (i.e. Bertrand competition) and a rather high level of market power of the manufacturers should also exist. In Cournot settings the opposite effects occur, as an increase in price by one retailer means a reduction in its sales that would determine a rival retailer to increase its sales (i.e. to reduce price).
- By facilitating collusion
Among the conditions for a cartel or tacit collusion to be sustainable is that the deviations from the collusive behavior should be detected easily by the other cartelists. RPM can facilitate collusion by making visible the deviations from the cartel price. For example, in case that a number of major manufacturers use RPM, thus allowing them to set the retail prices, it makes collusion at the upstream level more likely because the retail price variations will be eliminated.
However, considering the incentives issue, as shown by Jullien and Rey[10], while RPM facilitates the detection of a deviation, it reduces the profitability of the collusive outcome. Consumers prefer price stability whereas firms prefer to let them react to demand conditions. Thus, colluding firms will impose RPM only when the increase in the collusive price is high enough to compensate them from the negative impact on profits.
Another example of VRs that might facilitate tacit collusion is when manufacturers would impose on the retailers that the retail prices of their products are directly linked to the retail prices of the rival products (price parity agreements). Because of this process, price parity agreements increase the incentives of the manufacturers to raise their wholesale price and decrease as well the incentives to reduce the wholesale price. Nevertheless, the incentives of both manufacturers and retailers in agreeing price parity conditions should be also clear. Unless the profits made by the manufacturers are big enough so that the retailers are compensated accordingly, there is no reason for the retailers to accept price conditions that lead not only to higher wholesale but also to higher retail prices.
VRs can also facilitate collusion via ‘hub and spoke’ relationships, where a common retailer works as a wholesale price information exchange hub by the manufacturers. In this case also, the issue of incentives should be given with proper consideration.
B. Does the concept of a hardcore VR make economic sense?
The concept of a hardcore VR is not consistent with economic reasoning[11]. From an economic perspective, the effects of vertical restraints must be assessed on the facts of the particular case under investigation.
For example, Salinger and Elbittar[12] explain that minimum RPM can facilitate collusion but also prevents free-riding, particularly on pre-sales service, and that in the latter case there should be even a presumption that minimum RPM is legal. Also, when the pre-sales service argument does not seem important, antitrust authorities should check whether other elements conducive to collusion are present. For example minimum RPM is unlikely to facilitate collusion if firms accounting for only a small share of a non-concentrated market use it.
Besides RPM (which targets the inter-brand competition also), the rest of hardcore VRs (i.e. territorial or customer resale restrictions) relate to intra-brand competition, which may not harm competition if inter-brand competition is strong. Actually, the stance of EC competition policy towards these VRs is driven rather by a market integration concern than a competition one (and mainly inter-brand competition concern)[13].
Moreover, the concept of ‘hardcore restraints’ is also linked to the burden of proof in antitrust investigations: the anti-competitive effects of these restraints are presumed to exist unless they are unlikely to have appreciable effects on competition, or if they may harm competition the procompetitive effects outweigh the anticompetitive effects. Thus, while one may argue that a per se approach is easier and less expensive to administer and enforce than a rule of reason, as Salinger and Elbittar (2013) state, ”per se illegality does, however, reflect a greater tolerance for false convictions than would some variant of a rule of reason”.
Conclusions:
- Vertical agreements may be anti-competitive when they contain restraints that involve an exercise of horizontal market power which reduces horizontal competition. Horizontal competition may be reduced by reducing inter-brand or intra-brand competition.
- For the competition policy, the inter-brand competition is more important than the intra-brand competition. Vertical agreements containing restraints that harm inter-brand competition may harm competition. If inter-brand competition is strong then the vertical agreements containing restraints that harm intra-brand competition will not harm competition. If inter-brand competition is weak then the vertical agreements containing restraints that harm intra-brand competition may harm competition.
- Inter-brand competition may be harmed via foreclosure (e.g. long-term exclusive dealing contracts and raising rivals’ entry costs, exclusive distribution, MFN, various VRs to solve the monopolist’s commitment problem, such as exclusive distribution with just one distributor, exclusive territories, or by building a reputation that he will not supply other distributors), via softening of competition (e.g. exclusive territories or exclusive dealing combined with a two-part tariff) or via facilitating collusion (e.g. RPM, price parity agreements or ”hub and spoke” relationships). Proper consideration should be given to the incentives of the parties for entering into vertical restraints.
- The concept of a hardcore VR is not consistent with economic reasoning. Considering that VRs can have both procompetitive effects and anticompetitive effects, the VRs should be assessed on the facts of the particular case under investigation.
[1] Commission Notice (2010) – Guidelines on Vertical Restraints (”Guidelines (2010)”), para. (6).
[2] Motta, M. (2004), Competition Policy: Theory and Practice, Cambridge University Press (”Motta (2004)”).
[3] Guidelines (2010), para. (102).
[4] Motta (2004) and Rey, Patrick (2012), Vertical restraints – an economic perspective (Revised draft report), http://www.fne.gob.cl/wp-content/uploads/2013/11/Patrick-Rey.-Vertical-Restraints.pdf
[5] Rey (2012).
[6] To respond to the Chicago School critique, foreclosing exclusive deals can be supported by using clauses such as “penalties for breach” or “options to buy” as a rent-extraction devices by the incumbent supplier in order to extract some of the entrants’ advantages, or in situations where entry must happen for example in 2 markets in order to cover fixed costs, and the incumbent compensates one retailer in one market by offering him the monopoly profits of the 2 markets (see Rey (2012)).
[7] Bishop, S. and Walker, M. (2010), The Economics of EC Competition Law: Concepts, Application and Measurement, Third Edition, Sweet and Maxwell.
[8] Bishop and Walker (2010).
[9] Rey, Patrick and Stiglitz, Joseph (1995), The role of exclusive territories in producers’ competition, RAND Journal of Economics, Vol. 26, No. 3, Autumn 1995 pp. 431-451
[10] Jullien, Bruno and Rey, Patrick (2000) – Resale Price Maintenance and Collusion, https://ideas.repec.org/p/ide/wpaper/681.html
[11] Bishop and Walker (2010); Niels, G., Jenkins, H. and Kavanagh, J. (2011), Economics for Competition Lawyers, Oxford University Press; Motta (2004)
[12] Salinger, Michael A. and Elbittar, Alexander (2013), White paper on Vertical Restraints, https://www.competitionpolicyinternational.com/the-regional-competition-center-for-latin-america-presents-white-paper-on-vertical-restraints
[13] Bishop and Walker (2010)
