Resale price maintenance as a private contract enforcement mechanism: the special services case.

• Author: Shaw, Daniel J.

1. Introduction

   Since Telser [9], economists have come to recognize pro-competitive motivations for a manufacturer's decision to impose resale price maintenance (RPM), used as a price floor, on his retail network. Until then, retailer and manufacturer cartel explanations had dominated the profession's understanding of the phenomenon. This is despite the fact that these scholars knew that for the most part the retail sector was and remains subject to free entry conditions, and that retailers also have strong incentives to carry the products of non-colluding manufacturers since the practice has rarely been universal in its product coverage.

   Telser's logic is relatively straightforward. When court-enforceable contracts for retailer provision of costly information, promotion or demonstration of the manufacturer's product to consumers at the point of sale is infeasible; when a separate payment for these "special services," made by either the consumer or the manufacturer, is also impractical; RPM can often be the least costly way to enforce their supply. These services are special because they are idiosyncratically fashioned to consumer preferences, where national or local advertising by mass media would be an ineffective substitute. They are also strictly devoted to the manufacturer's product and cannot be diverted to other retail goods.

   Given that the retail price floor established by RPM affords an attractive margin over the wholesale price, thereby enabling retailers to recoup the costs associated with the added resources required in their undertaking, an optimal amount of the special services will be forthcoming. Recourse to a coercive pricing restraint is predicated on the existence of retailers who do not provide the special services but reap the profits generated from sales made to consumers who were informed by rivals. These purchases would be diverted from the informing retailer to the "free-riding" retailer because of the latter's relatively low price offering, which is made possible only through avoiding the costs of providing the special services.

   Klein and Murphy [6, 266], on the other hand, claim that this free-rider model is not entirely thought through. They suggest that RPM cannot prevent free riding when there are alternative margins on which to compete. Accessory goods and services can be provided at no extra cost to the consumer in place of the special services, thereby bolstering the free rider's offering to consumers while maintaining the required minimum retail price. Additionally, a free-riding retailer may continue to be delinquent in offering these services, but keep the profits assured by RPM. Actually this latter criticism was first recognized by Telser [9, 92].

   Klein and Murphy further believe that it is only free riders who discount the dealer price of the product who incriminate themselves--all other forms of free riding go unnoticed and unpunished. Consequently, they argue a Klein and Leffler-type motivation for RPM [5]. That is, the manufacturer uses RPM to induce an optimal amount of specific demand-enhancing dealer services--special or otherwise--by providing a quasi-rent stream for the conforming dealer. The present value of the profit stream is designed to exceed the short-term gain from non-conformity, and thus alters the dealer's incentives from delinquency to compliance when the manufacturer also enforces the policy by monitoring dealers for violations and terminating their distributorships upon discovery.

   Klein and Murphy offer, among other examples, Monsanto Company v. Spray-Rite Service Corporation (1984) as illustrative of their thesis.(1) In that case, Monsanto claims to have adopted a RPM policy to induce distributor promotion of its agricultural herbicides to retail dealers. Klein and Murphy claim that "the standard form of consumer free riding does not appear to have been practised by Spray-Rite. . . . [Spray-Rite] does not appear to have sold to individuals who first obtained the promotional services from another distributor. Instead, Spray-Rite primarily sold at a discount to knowledgeable, large volume customers who did not require the promotional services [6, 290]." Therefore they conclude that RPM provides distributors a quasi-rent stream for the supply of these promotional services, and that Monsanto's termination of Spray-Rite's distributorship was in consequence of its free riding on the implicit contract so formed.

   The purpose of this paper is twofold. First, I show that RPM is a well-crafted marketing strategy designed to ensure retailer-provided special services to consumers by having the manufacturer delegate the monitoring aspects of the policy's enforcement to retailers. What is being monitored is the entire packaged offering, which includes price, of rival retailers, and not their behavior (i.e., the prices and outputs, not the inputs). Therefore free riding by means of offering complimentary goods and services would be readily apparent to rival retailers who will report it to the manufacturer. Furthermore, a retailer who does not provide the special services but reaps the added profits generated by selling at the RPM price will be directly detectable to the manufacturer through the retailer's poor sales performance. The manufacturer needs only to verify this fact through conducting inspections, and then dismiss and replace the poor performer. In any event, the rents attributable to the provision of the special services remain subject to appropriation by retailers who would discount the price or offer free tie-ins for a period until discovered and sanctions are imposed. The minimum retail price established by RPM thus affords a commensurate risk premium--not a quality-assurance premium--as a reward to special services supply.

   Secondly, I argue that the special services argument remains the best explanation for Monsanto's use of RPM. And that the elevated standard of proof which requires direct or circumstantial evidence in support of a vertical price-fixing conspiracy rather than the mere evidence of distributor termination upon receiving complaints of price cutting from rival distributors, thus opening the door to manufacturers who would use RPM for efficiency reasons, as was established by the Supreme Court in its decision rendered in Monsanto v. Spray-Rite, is the correct one.

   Together these points contribute to the literature on RPM through their characterization of the role of non-free-riding dealers as active participants in the enforcement of special services provision. Their behavior should be taken, not as evidence of horizontal conspiracy, but as evidence of cooperation with the manufacturer's desire to solicit the patronage of lesser-informed consumers. A manufacturer-dealer negotiated minimum resale price which would allow for profitable joint product-services provision (the latter deliverable upon request by the consumer) combined with dealer-initiated communication of rival non-compliance is an efficient response to the breakdown of separate marginal-cost pricing of the product and these services.

   This paper is divided into five sections. The second presents a spatial retail model of special services supply. In that section, a cooperative special services equilibrium is established as a benchmark; retailer incentives to free ride the special services provided by rivals are introduced; and an equilibrium without special services supply is also presented. The third section establishes the risk premium required to assure retailer-provided special services to consumers under a RPM regime given that the dismissal of a free-riding retailer occurs only after it happens and that losses are incurred in the interim by rival retailers. The welfare impact of RPM-induced special services supply is also analyzed. The fourth section applies this free-rider model to Monsanto v. Spray-Rite. Finally, conclusions are drawn on the appropriateness of the new legal standard.

2. A Spatial Retail Model of "Special Services" Supply

   Demand and Supply Conditions

   Consider a community comprising two types of consumers of product [Chi], [Alpha] and [Beta], who are risk-neutral wealth maximizers. Similar to the standard spatial competition literature, these consumers are assumed to be uniformly distributed with density [Eta] along a circular retail market of length 2[Pi]r, where [Eta] = [[Eta].sub.[Alpha]] + [[Eta].sub.[Beta]] and [[Eta].sub.[Alpha]], [[Eta].sub.[Beta]] [is greater than or equal to] 1. These consumers are assumed to demand product x per period according to their type and as given by

   {1 if [p.sub.d] [is less than or equal to] P]}

   [q.sub.[Alpha]] = {0 if [p.sub.d] [is greater than] p}

   and

   {1 if [p.sub.d] [is less than or equal to] [Rho]*, or [p.sub.d] [is less than or equal to] P and S = s*}

   [q.sub.[Beta]] = {0 otherwise}

   where [p.sub.d] = [p.sub.r] + [c.sub.t] [center dot] t, S [is an element of] {0, s*} and s* [is greater than] 0.(2).

   Both these equations demonstrate that all consumers demand only one unit of the product depending on its delivered price, [p.sub.d], being no greater than their valuations of the product--that being P for [Alpha] and [Rho]* for [Beta]. The delivered price comprises two parts: the retail price, [p.sub.r]; and the consumer's shopping cost, which is simply the product of the constant cost of travel per unit of distance, [c.sub.t], and the distance of travel to the retail outlet patronized, t.(3)

   The second condition of demand is set only by [Beta] and reveals the distinguishing feature of the two consumer types: [Beta] are uninformed about the characteristics of product x, and thus place a lower value on the use of the good, i.e., [Mathematical Expression Omitted] and [Rho]* [is an element of] {[[Rho].sub.1], . . ., [[Rho].sub.n]}. However, if detailed technical information on the product's attributes or a demonstration of its performance characteristics at the point of sale is forthcoming, [Beta] would revalue...