Distribution and Franchising Committee: ABA Section of Antitrust Law

Resale Price Maintenance and Dual Distribution by Reuben Arnold, Neill Norman, and Daniel Schmierer 1 Several recent antitrust cases brought by both direct and indirect purchasers have challenged minimum resale price maintenance (“RPM”) policies imposed by manufacturers engaged in dual distribution or multi-channel distribution.2 These cases are frequently dismissed because plaintiffs fail to establish a relevant market or fail to demonstrate that the defendant has market power in that market.3 While these are appropriate threshold tests, dismissal on these grounds means that the court does not reach the central economic issue in the case, namely whether the procompetitive benefits of an RPM policy that supports dual distribution outweigh any harm to competition. In this article, we discuss the positive impact of dual distribution and multi-channel distribution on interbrand competition, review the economic analysis of RPM, and demonstrate that RPM plays a key role in facilitating the competitive benefits that can arise from dual distribution and multi-channel distribution. “Dual distribution” describes the distribution strategy of a manufacturer that sells to customers both directly and through third-party distributors or retailers. “Multichannel distribution” describes a distribution strategy in which a manufacturer sells through multiple types of retailers, such as online vs. bricks-and-mortar stores, or big box stores vs. specialist stores, etc. In this article we

focus on RPM as it applies dual distribution although the analysis applies to multi-channel distribution as well, except where noted. Dual distribution and multi-channel distribution are common practices across many industries, including information technology, consumer electronics, cosmetics, apparel, and home furnishings, among many others. As one Harvard Business School case study puts it, “[i] practice, most producers and resellers are usually members of multiple—often, competing—channels systems. Producers often sell through a number of intermediaries, while resellers often carry the products of competing manufacturers as well as the lines of many other suppliers in different product categories.”4 For example, Levi Strauss, a manufacturer of blue jeans and other clothing, sells a variety of product lines through different channels targeting different segments of the market, including its own retail stores, high-end stores like Neiman Marcus, department stores like Macy’s and Sears, and discount retailers like Wal-Mart.5 Coach, a manufacturer of luxury handbags and accessories, markets products to its consumers through a variety of channels, such as retail stores, factory outlets, concession counters within larger stores (shop-in-shops), online channels, and specialty stores.6

1

Reuben Arnold is a senior analyst, Neill Norman is a principal, and Daniel Schmierer is a manager at Cornerstone Research. The opinions expressed are those of the authors, who are responsible for the content, and do not necessarily reflect the views of the Cornerstone Research.

2

See, e.g., Complaint, Costco Wholesale Corp. v. Johnson & Johnson Vision Care, Inc., 3:15-cv-00941 (N.D. Cal. Mar. 2, 2015); Corrected Consolidated Class Complaint, In re: Disposable Contact Lens Antitrust Litig. 1:15-md-2626-HES (M.D. Fla. Nov. 23, 2015); People of the State of New York v. Tempur-Pedic Int’l, Inc., 916 N.Y.S.2d 900 (N.Y. Sup. Ct. 2011); Jacobs v. Tempur-Pedic Int’l, Inc.,No. 4:07-cv-02-RLV (N.D. Ga. Dec. 11, 2007); and House of Brides, Inc. v. Alfred Angelo, Inc., No. 11 C 07834 (N.D. Ill. Dec. 4, 2014).

3 In House of Brides, Inc. v. Alfred Angelo, Inc., the plaintiff failed to allege facts that plausibly suggested that a single wedding dress brand constituted a cognizable product market. In People of the State of New York v. Tempur-Pedic Int’l Inc; the state court ruled that RPM provisions are unenforceable but not unlawful under New York state law. In Jacobs v. TempurPedic International, Inc., the federal court concluded that plaintiffs had not identified a relevant market as required under the rule of reason standard that had to be applied after Leegin Creative Leather Prods., Inc. v. PSKS, 551 U.S. 877 (2007). Costco Wholesale Corporation v. Johnson & Johnson Vision Care Inc., and In Re: Disposable Contact Lens Antitrust Litigation are ongoing. 4

Frank V. Cespedes, Channel Management, Harvard Business School Case Study No. 9-590-045, 3–6, 8 (rev. Nov. 2006).

5

S. C. Jain and G. T. Haley, Marketing Planning and Strategy 339 (8th ed. 2009).

6

P. Kotler and K. L. Keller, Marketing Management 495 (15th ed. 2016).

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Distribution and Franchising Committee: ABA Section of Antitrust Law

I. Competitive Benefits from Dual and MultiChannel Distribution Dual distribution and multi-channel distribution can expand a manufacturer’s output, reduce distribution costs, and thereby yield pro-competitive benefits that would not be realized under single-channel distribution. First, multi-channel and dual-channel distribution may allow suppliers to reach a wider array of demand segments within a broad market. In markets for many differentiated consumer goods, preferences for pointof-sale service vary.7 By providing a product through a variety of channels that offer differing levels of service at the point of sale, a manufacturer can cater to a wider range of consumer preferences and penetrate different market segments.8 This expands output, and increases competition between brands. For example, a consumer purchasing a computer may value the ability to use the product on a trial basis buying it and or the transfer of their data and settings from an old computer to the new computer; a small business purchasing the same computer may value the availability of local repair services and procurement advice; and a large corporation with dedicated IT staff purchasing the computer may need none of these services. Different distribution channels tailored to different demand segments allow a manufacturer to efficiently satisfy these varied needs and desires. In many cases, this segmentation would not be possible were a manufacturer to sell entirely through distributors or entirely directly to consumers, or entirely through a single type of reseller.9 Aside from product and service specifications, dual and multi-channel distribution also allow manufacturers to optimize across location and delivery method while minimizing costs.10 For example, it may be most efficient for a company to sell directly to consumers in a dense

urban area and to sell through a distributor in a more thinly-populated rural area.11 Again, this distribution strategy has a pro-competitive impact: a supplier reaches certain market segments at a lower cost than it can attain on its own, and thereby increases the degree of competition between brands in the marketplace. Additionally, the nature of a given product or market segment may require a company to take direct control of a particular channel, while other channels are more efficiently shared with intermediaries.12 For example, if a manufacturer of auto parts sells some proportion of its product to an auto manufacturer that uses the product as an intermediate input, the auto parts manufacturer may wish to control distribution directly to minimize the possibility of supply interruption. In contrast, the parts manufacturer may find it simpler to allow an intermediary to distribute that same part to its auto parts store and auto mechanic customers. Second, and relatedly, multi-channel distribution allows different channels to focus on marketing and selling efforts in which they have a comparative advantage. In many cases, local retailers have an informational advantage that allows them to more effectively engage in local advertising and selling efforts than a national manufacturer. However, a national brand may be able to run large advertising campaigns and target market segments that are difficult for a local retailer to reach. For example, a local HVAC retailer that sells Trane products likely has a better strategy for targeting and selling to local small businesses than Trane does. However, Trane itself can produce and run large advertising campaigns more effectively, and can compete for large corporate procurements. This sort of dynamic exists in many areas; distributors provide many services such as order processing, customer support, and

7

See Frank Mathewson and Ralph Winter, The Law and Economics of Resale7 Price Maintenance,” 13 Rev. Indus. Org. 67 (1998) (“Additional demand factors include: the number of outlets or availability of the product, the convenience of the outlet’s location, the information provided to customers at the point of sale, the sales effort and talent of dealers, the reputation of the product for quality, the prominence of the display of the product and so on.”).

8

Jain, supra note 5 at 338.

9 Id. 10

Kotler, supra note 6 at 494.

11

Jain, supra note 5 at 340.

12

“Channel Management,” Cespedes, supra note 4 at Harvard Business School, Case Study No. 9-590-045, pp. 3–6, 8.

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Distribution and Franchising Committee: ABA Section of Antitrust Law

customer education that a manufacturer may be wellpositioned to deliver to some segments of the market but poorly-positioned to deliver to other segments.13 Indeed, in many cases, manufacturers add channels when they realize there are customers or market segments that they cannot effectively satisfy with existing channels.14 While product distribution through third-party retailers may be the most efficient solution for many manufacturers, others choose to integrate forward into direct sales to consumers for a number of reasons. First, a manufacturer-operated retail store allows the manufacturer to shape its brand image by controlling the shopping experience more closely and providing a broader selection of its goods. Nike and Apple are notable examples of this approach.15 Many large firms and brands have also decided to manage Internet sales of their products for the same reason. Estee Lauder, for example, decided to launch an Internet channel for its Clinique products as an alternative distribution method to traditional sales via department store cosmetics counters.16 Similarly, Apple manages its own online storefront and prohibits its bricks-and-mortar resellers from selling over the Internet.17 Second, a manufacturer that integrates forward into retail may be able to generate higher profit margins and expand output by eliminating double marginalization.18 Finally, direct selling provides closer contact with customers and customer information, improving supply chain efficiency by giving the manufacturer a better picture of market demand.19 Manufacturers that choose a dual distribution strategy are able to realize these benefits while simultaneously enjoying the benefits of third-party distribution in other market segments. This efficient

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combination of distribution methods increases the manufacturer’s competitiveness in the market which, in turn, promotes inter-brand competition and improves consumer welfare.

II. Resale Price Maintenance Can Facilitate Dual - and Multi-Channel Distribution and Enhance Interbrand Competition As part of a dual or multi-channel distribution strategy, manufacturers frequently impose vertical restraints, i.e., policies that limit the conduct of both the manufacturer and its downstream trading partners. These include policies such as resale price maintenance, minimum advertised prices, exclusive territories, and exclusive dealing. Minimum resale price maintenance (RPM)20 in particular can play a key role in facilitating successful dual and multi-channel distribution, as it provides the manufacturer with an instrument with which it can elicit the level of retail promotion services consistent with its objectives for its brand. First, manufacturers may use RPM to correct a wellknown market failure — the free rider problem — that can otherwise frustrate attempts to elicit competition in retail services to promote its products. A free rider is an economic agent who appropriates the benefits of another agent’s (costly) economic endeavors. The classic example involves a complex consumer durable good whose sale requires a knowledgeable salesperson to inform and persuade a consumer of the product’s merits. Suppose that, upon receiving the requisite information from the full-service retailer, the shopper leaves the store without making a purchase, travels to a discount operation that stocks the product the consumer now knows she wants,

A. A. Tsay and N. Agrawal, Modeling Conflict and Coordination in Multi-Channel Distribution Systems: A Review, in Handbook of Quantitative Supply Chain Analysis: Modeling in the E-Business Era 558 (2004).

14

Jain, supra note 5 at 340.

15

Kevin Lane Keller, Brand equity management in a multichannel, multimedia retail environment. 24:2 J. Interactive Marketing 58-70 (2010).

16 Tsay, supra note 13 at 559. 17

Steve Tobak, How to Sell Like Apple, CBS News Moneywatch (May 13, 2010), available at http://www.cbsnews.com/news/how-to-sell-like-apple/.

18

Jean Tirole, The Theory of Industrial Organization, MIT Press (1988), pp. 174-175.

19

Tsay, supra note 13 at 558.

20

A minimum resale price maintenance agreement between a manufacturer and a retailer sets a minimum price that a retailer may charge for the manufacturer’s products. See Dennis W. Carlton and Jeffrey M. Perloff, Modern Industrial Oorganization 423 (4th ed 2004).

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Distribution and Franchising Committee: ABA Section of Antitrust Law

and buys it for a lower price. The lower price is possible because the buyer and ultimate seller can free-ride on (i.e., appropriate the benefits of) the full-service retailer’s costly investment in pre-sale service. In markets in which free-riding is common, sellers may reduce the level of services they provide because they do not receive adequate compensation in the form of a sufficient retail margin. Consumers in turn may reduce their participation in such markets because they do not receive adequate pre- or post-sale services. The upshot is a reduction of output, consumer welfare, and interbrand competition. In the extreme, the market for a desirable good (i.e., a good whose value exceeds its opportunity cost) can simply dissolve because of free-riding. RPM corrects the free-rider problem by requiring retailers of a manufacturer’s products to charge a minimum price that provides a profit margin sufficient to justify investment in pre-sale service, thereby thwarting discounters that seek to free-ride on other retailers.21 The effect of the policy is to enhance intrabrand service competition, limit intrabrand price competition, and increase interbrand competition. The use of RPM is not confined to markets for information-intensive consumer goods vulnerable to free-riding. Manufacturers also implement RPM pricing policies for goods that do not require detailed information or extensive product demonstration at the point of sale, or significant post-sale service commitments. Economics offers two theories to explain this phenomenon. Under the “quality certification” view of RPM, retailers may use protected margins to invest in greater services (e.g., longer hours of operation, nicer store furnishings, additional sales force training) that signal or certify the quality of their merchandise and increase demand for the manufacturer’s product.22 A second view explains RPM as a contract enforcement mechanism that a manufacturer adopts to assure that

retailers supply non-contractible retail service that increases the demand for the manufacturer’s product. Where incomplete information and monitoring costs make writing and enforcing a complete and explicit performance contract with a retailer impractical, manufacturers may instead use RPM to elicit performance by retailers who are eager to retain the protected retail margin it affords.23 The problem of free-riding can be a particular concern in cases where there is dual distribution. The fact that the retailer and the manufacturer have different incentives, business models, and cost structures can increase the likelihood of conflict between the retailer and manufacturer and increase the incentives to free-ride. Therefore, to have an effective dual distribution system, a manufacturer can use RPM to reduce conflicts and eliminate free-riding. A. Manufacturers Selling Directly to Consumers Have Incentives Consistent with Interbrand Competition Manufacturers who sell directly to consumers do not have the same incentive to free-ride as non-affiliated retailers. This is because the manufacturer internalizes the impact of its actions on the brand as a whole. While any individual third-party retailer has an incentive to reduce its provision of service and reduce its price to undercut other retailers of the manufacturer’s products, the manufacturer will not engage in such behavior itself because it recognizes that this behavior is inconsistent with the long-term competitiveness of its brand. This is one reason why some manufacturers, particularly those who are concerned with the provision of service or the consistency of their brand image, may choose to control the online sales of their products: whereas thirdparty Internet retailers have an incentive to free ride on the services provided by bricks-and-mortar stores, the manufacturer does not.

21

Lester G. Tesler, Why should manufacturers want fair trade? 3 J. Law and Econ. 86-105 (1960).

22

See Howard P.Marvel and Stephen McCafferty, Resale price maintenance and quality certification, 15 RAND J. Econ. 346-359 (1984).

23

See Benjamin Klein and Kevin M. Murphy, Vertical restraints as contract enforcement mechanisms, 31 J. Law and Econ. 265-297 (1988); Benjamin Klein, Competitive Resale Price Maintenance in the Absence of Free Riding, 76 Antitrust L.J. 431-481 (2009).

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Distribution and Franchising Committee: ABA Section of Antitrust Law

This distinction between the incentives of the manufacturer (in its role as a direct-to-consumer seller) and third-party retailers is perhaps best illustrated through examples. As the following examples show, RPM policies can be useful to manufacturers with different retail strategies. However, in both examples, an RPM policy allows the manufacturer to implement a dual distribution strategy that increases interbrand competition.

and education. Since the manufacturer is concerned with the long-term profitability and strength of its brand, it prices its online sales at a level that internalizes the impact of online sales on service. In doing so, it may, for example, choose to sell online only at MSRP. By supporting the provision of service and education, this arrangement may strengthen the competitiveness of the cosmetic manufacturer’s brand and thereby enhance inter-brand competition.

B. Example: Dual Distribution Online and Through Specialty Stores

C. Example: Multi-Channel Distribution through Online and Retail Direct Channels and Multiple Third-Party Retail Channels

As a first example, consider a manufacturer of high-end cosmetics that sells products both through beauticians (specialty bricks-and-mortar stores) and through its own website. This manufacturer sells (offline) only through beauticians because it wants to make sure that customers are provided with the service and education needed to properly use the manufacturer’s products. Suppose the manufacturer sells its products to beautician retailers at prices substantially below the manufacturer’s suggested retail price (MSRP). The gap between the wholesale price and MSRP is meant to cover the costs that retailers will incur in providing service related to the manufacturer’s products. However, in this situation, each individual retailer has an incentive to set up an online storefront and sell the manufacturer’s products at discounted prices below MSRP, because the retailer does not incur the costs of service and education in sales to online customers. To protect against this type of free riding, the manufacturer may put in place an RPM policy to keep retailers from selling online at deep discounts. At first blush, the need to prohibit retailers from selling at deep discounts online (and therefore not providing in-store service) may seem inconsistent with the manufacturer itself selling its products online. But the key difference is that the manufacturer, when it sells online, does not have the same incentive to free ride on the service and education provided by the bricks-andmortar retailers. When pricing its own online sales, the manufacturer weighs the direct profits from online sales against the broader impact of those sales on the ability of the bricks-and-mortar beauticians to provide service March 2016

As a second example, consider a manufacturer of computers and electronics that sells its products to consumers directly both online and in manufactureroperated retail stores, and indirectly through a variety of third-party retailers, including big-box electronics stores and small businesses that focus on repair and sales of the manufacturer’s products. Much like the cosmetics manufacturer described above, this manufacturer chooses to sell through vendors that it believes will adequately convey its brand and educate consumers about its products. As part of its retail strategy, this manufacturer also introduces an RPM policy to eliminate the possibility of discounted online sales by third parties. This policy is meant to prevent third parties from free-riding on the brand-building activity conducted by the manufacturer. Since the manufacturer has a strong incentive to ensure a positive customer experience that will generate repeat purchases, and since it benefits from customer purchases regardless of channel, the manufacturer has chosen to invest substantial capital in the development of its website, with professionally-produced videos explaining its products and beautifully-designed interfaces that generate a premium shopping experience. A third-party online seller does not share the manufacturer’s incentive to create a premium online shopping experience, because it cannot completely internalize the return from that investment. Instead, it has an incentive to minimize its costs associated with the online sale of the manufacturer’s brand and free-ride on the positive

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Distribution and Franchising Committee: ABA Section of Antitrust Law

brand image and national marketing conducted by the manufacturer. By setting a minimum resale price, the manufacturer removes the ability of third party online retailers to free ride on the manufacturer’s brand building activities by undercutting the manufacturer on price. The RPM policy also incentivizes third party online sellers to compete, both with each other and with the manufacturer, on the quality of the online shopping experience, which benefits consumer welfare. The RPM policy therefore helps the manufacturer eliminate online customer experiences that would damage its brand, thus improving its ability to compete in the long term against other consumer electronics manufacturers.

III. Conclusion

differentiated goods and services to different customer segments efficiently and permit them to delegate tasks such as order processing and customer support that may be difficult for them to complete in a cost effective manner. However, retailer free-riding and difficulty in obtaining non-contractible retail services can compromise these benefits and undermine dual and multi-channel distribution. RPM policies can support dual and multi-channel distribution and increase interbrand competition. Thus, when analyzing RPM under the rule of reason, the presence of dual and multi-channel distribution — and its attendant benefits to consumers and competition — should be taken into account.

Dual and multi-channel distribution strategies, when working as intended, allow manufacturers to deliver

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