Economics of distribution and franchising

This chapter surveys the economic principles underlying distribution
arrangements between upstream firms (manufacturers) and downstream
firms (such as wholesalers, dealers, or retailers). The focus is on the
potential procompetitive and anticompetitive effects from vertical
restraints, such as exclusive dealing and tying arrangements. The
discussion applies generally to franchisor-franchisee relationships as well.
This chapter also reviews the empirical economic evidence on the use and
effects of distribution and franchise arrangements. All of the effects
identified by economic theory have implications for how the antitrust laws
will treat the distribution or franchise arrangements, particularly given
most of these arrangements are analyzed under a rule of reason.
A. Economic Analysis of Distribution
1. Introduction
In a stylized world without “vertical restraints,” manufacturers simply
would sell their products to dealers with no conditions imposed by or on
either party, and dealers would resell the products when, where, and for
whatever price they wanted. Vertical restraints include a range of
contractual terms between manufacturers and their dealers that impose
conditions on one or both parties. These restraints may include, among
other things, exclusive dealing, exclusive territories, and tying
requirements.1This chapter broadly articulates the economics of such
vertical restraints, leaving detailed discussions of the specific effect of
various restraints to later chapters.
To understand the relevance of vertical restraints, it is useful to
consider a hypothetical world in which manufacturers produce goods of
known and unalterable quality and sell their products to dealers operating
1. Vertical restraints also include market share discounts and bundled
discounts (which are partial exclusive dealing arrangements), most favored
nation clauses, and vertical price restraints, such as resale price maintenance
and restrictions on price advertising.
10 Antitrust Law and Economics of Product Distribution
in perfectly competitive markets. Dealers would be acting as mere
intermediaries between consumers and manufacturers. For a given level of
production costs, manufacturers would benefit by distributing their
products through the most extensive and efficient dealer networks
available. Dealers in this hypothetical world would earn returns consistent
with a very high degree of retail competition. Manufacturers using such a
dealer network would ensure that their products were widely available to
consumers at the lowest possible retail prices. To increase sales and
maximize profits, each manufacturer would compete aggressively against
other manufacturers for consumers’ demand, and thus would have strong
incentives both to reduce its wholesale prices to retailers and advertise its
products to consumers.
In reality, many products do not fit this paradigm. Retailers and
dealers often operate in less than perfectly competitive markets with
heterogeneous products and, accordingly, have some ability to influence
product demand by such actions as altering shelf space, engaging in
temporary promotional activities, and selective pricing decisions.
Moreover, retailers may also influence product quality directly through the
inputs they employ, such as storage and display equipment. Where the
demand for a manufacturer’s products depends upon the behavior of its
retailers, the manufacturer will want to encourage retailers to act in ways
that maximize profits throughout the supply chain.
This desire to align manufacturer and retailer interests is the main
procompetitive justification for vertical restraints. However, where the
manufacturer (or retailer) is a dominant firm with substantial market
power, vertical restraints potentially can have anticompetitive effects by
foreclosing or limiting competition. As this chapter will discuss, the
relationships among manufacturers and dealers are a key factor in the
analysis of the potential competitive effects of vertical restraints.
Relationships between manufacturers and independent dealers are
characterized by “principal-agent problems,” in which dealers are
“agents” who often have interests and incentives that differ from those of
the manufacturers (the “principals”) whose products they sell. For
example, a manufacturer might prefer that its dealers charge lower retail
prices to increase consumers’ demand for its products, while each dealer
instead might have a unilateral incentive to raise price and earn a higher
retail margin. This chapter will discuss other examples of principal-agent
problems in the section on the economic characteristics of franchise
Principal-agent problems may be particularly acute when the
manufacturer desires that its dealers undertake certain promotional
Economic Analysis of Distribution and Franchising 11
services that increase the demand for its products. Many of the demand-
enhancing services that manufacturers want retailers to provide are
qualitative in nature. They may be designed to match a marketing image
or meet assumed psychological needs of a consumer. As such, they may
be difficult to articulate in a contract. Because of their subjective nature,
these services often are not susceptible to measurement and verification
by a third party (such as a court). For example, a manufacturer may want
retailers to demonstrate the qualities of its product to prospective buyers,
but in many cases it may be very difficult for the manufacturer to specify
in advance in a contract all the details of the task at hand. How much time
should each potential customer receive? What sort of training should each
salesperson receive? How many products should be on hand for the
purpose of demonstration? These and many other details may be needed
to describe the task.2 As reflected in the current treatment of distribution
restraints in U.S. antitrust law,3 most economists recognize it is difficult to
articulate all of the services that may benefit competition in a contract, and
it is more efficient (and therefore more logical) to have contracts that align
the distributor’s and the manufacturer’s economic interests (with certain
limitations, as discussed below). If such interests are not aligned and there
is no contract articulating the required services, dealers tend to provide
fewer such services than the manufacturer desires.4
This problem can be exacerbated by the fact that a dealer generally
cannot prevent consumers from purchasing the same product from a
retailer that does not provide such promotional services. As a result,
retailers of the same product or brand almost always have incentives to
2. See, e.g., R. Pitofsky, Why Dr. Miles Was Right, 8 REG. 27, 29 (1984)
(asserting that these attributes of dealer service can be articulated in a
contract; the very essence of a business format franchise is the distillation
of a certain type of “service” into a very detailed set of contractual
3. Cases since Continental T.V. v. GTE Sylvania, Inc., 433U.S. 36 (1977),
have accepted the rationale that distribution restraints may benefit
interbrand competition, and thereby benefit consumers.
4. See Benjamin Klein, Transaction Cost Determinants of “Unfair”
Contractual Arrangements, 70 AM. ECON. REV. 356, 358-59 (1980)
(discussing incomplete contracts and the use of implicit mechanisms to
enforce them). See generally OLIVER WILLIAMSON, MAR KETS AND
Telser, Why Should Manufacturers Want Free Trade, 3 J.L. & ECON. 86

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