Efficiency Rationales For Vertical Restraints Economics Essay

INTRODUCTION

Competition law history shows that since the early 70’s, many economists have developed a more thorough theoretical and empirical knowledge into the workings of vertical restraints.

“The new theories are often rooted in principal-agent theory, where the supplier is the principal and the distributor is the agent, and vertical contracts are used to align incentives to resolve information asymmetries between the two.” (Niels, G, Jenkins, H and Kavanagh, J, 2011).

VERTICAL RESTRAINTS

In nearly all markets across the world, products are made in different stages and manufacturers do not sell their products directly to the final consumer but via intermediaries, distributors, wholesalers, retailers etc….

The treatment of vertical agreements under competition law is different when compared to horizontal agreements.

“When goods and services are complements, price cuts cause an opposite effect”. [1] “Price cuts by one company will tend to stimulate demand for complementary products. This effect is again an external effect, and the price-cutting company will normally not take it into account. Thus, each firm has an interest in seeing price cuts by suppliers of complementary products. A joint profit-maximizing agreement between complementary firms will then seek to internalize the price externalities and lead to price reduction. This is exactly in the interest of the consumers. As a result, an agreement entered into by providers of complementary products is unlikely to be bad for welfare.” [2] 

According to M.Motta (2004) some of the most common examples of vertical restraints are:

Non-linear pricing.

Quantity discounts

Resale Price Maintenance (RPM)

Quantity fixing.

Exclusivity clauses

EFFICIENCY RATIONALES FOR VERTICAL RESTRAINTS

It is recognized that vertical restraints promote non-price competition and improved quality of services. When a firm has no or limited market power it will try to increase its gains by optimizing its processes. According to the EU Commission Notice: Guidelines on Vertical Restraints (2000/ C 291/01) “In a number of situations vertical restraints may be helpful in this respect since the usual arm’s length dealings between supplier and buyer, determining only price and quantity of a certain transaction, can lead to a sub-optimal level of investments and sales.”

In a business environment producers would usually benefit from strong competition among the retailers. Therefore any restrictions imposed must have as a rationale- efficiency motives. The most common pro-competitive explanations are:

Elimination of double marginalization: If a product has to go through many intermediaries before reaching the final consumer, the mark-ups imposed by each on top of the costs may result in excessive pricing. Double marginalization problem can be overcome by vertical integration or through vertical agreements (a looser form) as well as by means of some clauses, such as RPM or two-part tariffs.

Another important justification revolves around the free – rider problem which is of two-types- rival suppliers and rival distributors. Retailers might have low incentive to invest in services, as these are difficult to fully appropriate. Others may free ride on a full-service retailer’s effort to increase demand. As a result, without restrictive clauses, there will be under-provision of services, to the detriment of consumers. Secondly, in order to increase the demand, producers may be willing to invest in the retailer’s services such as training etc…. However, this incentive would be removed by the possibility that other producers enjoy the positive spillover from this investment. Exclusive dealing can counteract this concern.

“The “hold-up problem”. When there are client-specific investments to be made by either the supplier or the buyer, such as in special equipment or training. The investor may not commit the necessary investments before particular supply arrangements are fixed”. European Commission. Commission Notice: Guidelines on Vertical Restraints. Brussels. SEC (2010) 411.

Alleviation of commitment problem: when a manufacturer holds market power and can sell a specific input to more retailers, it cannot credibly commit not to renegotiate the contract once it has already been signed. Due to this, the manufacturer cannot fully enjoy the market power unless some contractual clauses make the commitment credible.

Finally, other efficiency motives of vertical restraints exist such as economies of scale in distribution, reduction in transaction costs, capital market imperfections, increasing brand image, uniformity and quality standardization.

In essence, the economically sound presumption is that vertical restraints are efficiency-enhancing, may enhance inter-brand competition or foster the relationship-specific investments and help the development of new markets. In addition, vertical restraints may thus result in a reduction in prices, increase in demand and higher consumer welfare effects.

INTERBRAND VERSUS INTRABRAND COMPETITION

Generally, when there is substantial market power at the level of the supplier or the buyer even if at both levels, vertical agreements will likely to raise competition concern. It is important at this juncture to make explicit the distinction between interbrand and intrabrand competition.

Interbrand competition is between suppliers selling different brands of goods of similar kind. This means interbrand competition takes place within the relevant market. On the other hand, intrabrand competition (including price competition) is between retailers selling the same brand of a product.

Interbrand competition, rather than intrabrand competition, is the primary focus of antitrust law [3] and the correlation between intrabrand and interbrand competition forms the basis for decisions in respect of the lessening of both. The protection of interbrand and intrabrand becomes vital when there is inadequate interbrand competition.

In the Research Handbook on International Competition Law 2012, pg 431, (Dobson, Paul W. & Waterson, Michael, 2007) stated that “in cases where the interbrand competition in the market is not as strong, intrabrand competition might become more important because intrabrand competition can reintroduce the loss of competitive pressure from other brands.”

Taking into account intrabrand and interbrand competition is important to determine the impact of vertical restraints on competition. In certain scenario, introducing vertical restraints can be a means to dilute competition upstream between manufacturers that do not compete directly face to face but through their retailers.

Furthermore, as interbrand and intrabrand rivalry intensifies, all prices (regardless of supply arrangements) fall towards marginal costs.

POTENTIAL HARM TO COMPETITION

Whish, R and Bailey, D (2012) outlines four possible negative effects arising from vertical restraints under EU law:

“Anti-competitive foreclosure of other suppliers or buyers by raising barriers to entry.”

“Softening of competition between the supplier and its competitors and/or facilitation of both explicit and tacit collusion, often referred to as a reduction of interbrand competition.”

“Softening of competition between the buyer and its competitors and/or facilitation of collusion, commonly referred to as a reduction of intra-brand competition between distributors of the same brand”.

“The creation of obstacles to market integration.”

The above negative effects may result from various vertical restraints.

The negative effects on competition will be analyzed mainly concentrating on two groups for the purpose of this assignment.

‘Single branding’ are those agreements which have as their core the inducement of the buyer to concentrate orders for a particular type of product with one supplier. The four main negative effects on competition and interbrand competition are “(1) other suppliers in that market cannot sell to the particular buyers and this may lead to foreclosure of the market or, in the case of tying, to foreclosure of the market for the tied product, (2) it makes market shares more rigid and this may help collusion when applied by several suppliers, (3) as far as the distribution of final goods is concerned, the particular retailers will only sell one brand and there will therefore be no interbrand competition on their shops (no in-store competition) (4) in the case of tying ,the buyer may pay a higher price for the tied product.” EU Commission Notice: Guidelines on Vertical Restraints (2000/ C 291/01)

‘Limited distribution’ is those agreements which have as their core that the manufacturer sells to one or a limited number of buyers. There are three main negative effects on competition: “(1) certain buyers within that market can no longer buy from that particular supplier, and this may lead in particular in the case of exclusive supply, to foreclosure of the purchase market, (2) when most or all of the competing suppliers limit the number of retailers, this may facilitate collusion, either at the distributor’s level or at the supplier’s level, and (3) since fewer distributors will offer the product it will also lead to a reduction of intra-brand competition. In the case instance of wide exclusive territories or exclusive customer allocation the result may be total elimination of intra-brand competition. This reduction of intra-brand competition can in turn lead to a weakening of interbrand competition.” EU Commission Notice: Guidelines on Vertical Restraints (2000/ C 291/01)

Entry deterrence: one of the most obvious concerns is represented by the possibility that vertical restrictions are strategically used to deter entry in either level of the chain, by foreclosing access to inputs or to customers and in the long run they can be used to raise significant barriers to entry if competition is not already substantial.

Under Bertrand competition, downstream manufacturers can strategically use some vertical clauses to encourage retailers to behave in a less aggressive way and reap a higher profit.

Exclusive arrangements are generally worse for competition than non-exclusive arrangements.

In essence, the potential for anticompetitive outcomes depends upon factors such as the market power of the firms involved, the presence of a minimum scale to cover fixed costs, the share of downstream market covered by the restraints and the nature of competition downstream.

CONCLUSION

The fact that vertical agreements are agreements concluded between companies in a vertical relationship suggests that they can often be regarded as positive. However, economic literatures on vertical restraints have shown both pro and anti-competitive effects.

Both price and non-price may either increase or decrease economic welfare: the crucial importance is not the restraints used but the context in which it is used and the goal that it is supposed to achieve.

The EU Commission has observed that market structure plays an important role in determining the impact of vertical restraints: ‘The fiercer is interbrand competition, the more likely are the pro-competitive and efficiency effects to outweigh any anti-competitive effects of vertical restraints. Anti-competitive effects are only likely where interbrand competition is weak and there are barriers to entry at either producer or distributor level. In addition it is recognised that contracts in the distribution chain reduce transaction costs, and allow the potential efficiencies in distribution to be realised. In contrast, there are cases where vertical restraints raise barriers to entry or further dampen horizontal competition in oligopolistic markets.’ [4] 

In addition, EU Regulation 2790/1999 recognized the importance of market power in establishing whether or not vertical restraints can have important anti-competitive effects.

As per the OECD: Joint Group on Trade and Competition Paper, the efficiency enhancing effect and benefit to consumers from vertical restraints is likely to dominate with the exception of vertical restraints being used to facilitate collusion, it is highly improbable that such restraints will have net anti-competitive effects unless there is either:

market power on at least one level in the market or

the restraint, either on its own or in concert with other vertical restraints, has the power to exclude or disadvantage a significant number of competitors

anti-competitive effects are only likely where interbrand competition is weak and there are barriers to entry,

(d) causing foreclosure of competitors.

Accordingly, the approach taken by many competition authorities on vertical restraints is a careful case by case analysis.

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