Efficiencies without economists: the early years of resale price maintenance.

• Author: Kleit, Andrew N.

4. See, for example, Seligman and Love |29, 143-61~. In Canada, the desire to avoid loss-leading is an exception to the per se rule against RPM. See Restrictive Trade Practises Commission |26~ and R. v. H.D. Lee, 57 C.P.R. 60 (1981).

5. Using this analysis, Klein and Murphy |19~ argue that by reducing vertical externalities RPM can promote various forms of sales efforts, which are generally thought of as horizontal externalities. Discerning whether the provision of sales efforts is deterred by horizontal or vertical externalities is a debate this author does not wish to enter. Arbitrarily, for I. Introduction

   Resale price maintenance (RPM) continues to be a contentious topic, both in economics and in antitrust. During the 1980s economists derived new efficiency motivations for RPM while the Supreme Court reaffirmed the decades-old per se ban on its use and Congress threatened to extend that ban. In the 1990s, after several years of federal inactivity during the Reagan Administration, the Federal Trade Commission (FTC) has once again begun bringing RPM cases.(1)

   While economists have proposed a number of different efficiency explanations for RPM, such theorizing has been performed largely without the help of businesses that actually use RPM. With little practical evidence, such hypotheses have been subject to substantial criticism. Of course, since RPM has been per se illegal, businesses may be reluctant to admit that they are engaged in the practice, which would appear to be a necessary condition for generating an efficiency defense. This article seeks to find out why businesses may believe that they benefit from RPM. It does so by examining which efficiency rationales were advanced by firms during a critical time for RPM in the United States, 1915 to 1917. These rationales, drawn largely from previously unexplored materials, are then examined in the light of current economic theory. There are two basic sources for these rationales. The first is three hearings on RPM held in 1915, 1916, and 1917 in the U.S. House of Representatives on a bill to legalize certain forms of RPM. The second is the transcript of seven days of hearings the FTC held in 1917 to discuss efficiency motivations for RPM.

   Section II explains several economic theories that have been posited for RPM and briefly discusses the critiques of these theories that have arisen in the legal and economic communities. Section III examines federal RPM case law prior to 1918 and posits efficiency rationales from section II to match the products involved in the case law. Section III also discusses the uncertainty in the case law during the period 1908 to 1917 and the concepts behind the various judicial decisions. Section IV presents the efficiency arguments made during this period of legal uncertainty for RPM. Section IV also shows that RPM had support from diverse sources, including Thomas Edison, Louis Brandeis, and apparently Henry Ford, as well as the president of the National Housewives League and the Consulting Home Editor of the Ladies' Home Journal.

   The hearings, despite being held over 70 years ago, disclose the same motivations for RPM that scholars use today. These motivations were presented largely without the assistance of economists. Yet in many circumstances the efficiency arguments were presented, while not with technical rigor, accurately and in a manner consistent with the current economic learning.

   2. The Efficiency Theories for RPM--and Their Critics

      Several efficiency rationales for RPM and other vertical restraints have emerged in the last thirty years in the economic literature. They compose a wide variety of efficiencies for a large number of goods.(2)

      Horizontal Externalities: Special Services, Shelf Space and Information

      The oldest efficiency story in the economic literature, presented by Tesler |32~ may be put in the following way. A manufacturer places a new product, like a videocassette recorder (VCR), on the market. Before many or most sales take place, consumers have to be educated in how to use this product. If retailers incur costs teaching consumers how to work the VCR, the retailer must be compensated for its expenses by higher margins on its sales. Unfortunately for both manufacturers and full-service retailers, a customer may be able to take that training and go across the street and buy the VCR from a discount dealer who does not offer these services and thus does not incur the relevant costs, eliminating the retailer's incentive to provide such information. Without the protection of RPM or another similar instrument, manufacturers cannot prevent the existence of a "horizontal externality", with one retailer gaining benefit from the actions of another. Retailers will thus be reluctant to invest in educating customers, and therefore insufficient product information will be supplied to consumers.

      The horizontal free-riding(3) argument, however, is not confined solely to complex goods. For instance, in the model of Marvel and McCafferty |20~, some retailers are assumed to have gained consumers' confidence. Consumers view these retailers as their agents in "certifying" which goods are of high quality. RPM-induced margins are thus the manufacturer's payments to the retailer for the costly quality certification of that retailers' goods. This certification is expected to be especially important for manufacturers who are attempting to create a brand name reputation for their own products, and for goods that have uncertain quality.

      In addition, as Goldberg |12~ and Bittlingmayer |3~ point out, retailers' costly conveyance of information can take other forms. For instance, a manufacturer may want to buy high profile shelf space as a form of advertising. The RPM-induced higher margins through RPM, in effect, buy the more expensive shelf-space. Without RPM, consumers could gain this information at a high-priced store and use it to buy goods at a discount house.

      One issue that has consistently arisen in the RPM debate is the desire of manufacturers to prevent their goods from being used as "loss leaders."(4) The only direct reference to this in the current economic literature, however, is a brief discussion by Marvel and McCafferty |21, 375~. Marvel and McCafferty suggest that the desire to free-ride on shelf space partially explains this phenomena. They further argue that goods will be used as loss leaders when "the value of a well-known product line to a new entrant store is greater than to an established retail firm." In other words, manufacturers will use RPM to deter new entrant retailers from using their products as loss-leaders in order to "free-ride" off the shelf-space of established retailers.

      Vertical Externalities and the Importance of Performance Bonds

      Klein and Murphy |19~, extending the model of Klein and Leffler |18~, present a vertical efficiency rationale for the use of RPM. In the Klein-Leffler model, firms use implicit and explicit contracts to create "performance bonds" for good behavior. For instance, a firm with a good whose quality is difficult to evaluate may invest in advertising to create a branded reputation for itself. This reputation creates for the firm a stream of quasi-rents that it receives as long as it continues to produce high-quality product. If it offers a lower quality product, it will receive short-run profits from selling a low quality at a high quality price. Such "cheating", however, would cause the firm to lose the profits from its future stream of quasi-rents and would therefore be unprofitable. Thus, the performance bond of advertising insures product quality.

      Klein and Murphy apply the Klein-Leffler model to vertical restraints. Retailers invest in the sale of a product. In exchange, the manufacturer gives the retailer a stream of quasi-rents in the form of RPM-induced margins. These margins are only available to the retailer, however, should it offer the manufacturer's product in a manner that the manufacturer desires. If the retailer "misbehaves" the manufacturer cuts off its supply of goods, thus denying the retailer the stream of RPM-induced quasi-rents. Klein and Murphy posit that vertical restraints can have one or more of four goals. First, they allow the manufacturer to induce non-price competition among its retailers, such as the provision of pre-sale information about complex goods. Second, they allow the manufacturer to purchase retailer promotional services. Third, they prevent dealers from being overcompensated for promotional services by manufacturers. Finally, they allow the manufacturer to control the type or number of dealers that sell its product.(5) In all these circumstances, vertical restraints prevent retailers from taking advantage of manufacturers by benefitting from vertical externalities.

      Consider, for example, a franchisee of a nationally recognized fast-food chain. If the franchisee reduces the quality of its product below that desired by the national chain, it, in effect, "vertically free rides" on the national chain's reputation. By using RPM, the chain can punish the retailer for such behavior by cancelling its franchise contract and thus denying it a stream of RPM-induced quasi-rents. More broadly, the Klein and Murphy theory implies that RPM can be used to prevent retailers from using a manufacturer's reputation against the manufacturer's best interests. One of the important differences between Klein and Murphy and Telser is that while Telser's theory implies that RPM will be most useful for new products, Klein-Murphy implies that RPM will be of greatest use in protecting the reputation of established goods.

      In an article that precedes the Klein-Murphy article but uses a similar form of analysis, Springer and Frech |30~ present a variant of the Klein-Leffler theory to explain RPM. They discuss how retailers have incentives to free-ride on brand names and deceive consumers.(6) Brand names are used to draw customers into the store. Once in...