Resale Price Maintenance Policy with Choice of Vertical Contracts PRELIMINARY – PLEASE DO NOT QUOTE Amelia Fletchera and Liang Lub* Norwich Business Schoola and the Centre for Competition Policya,b, University of East Anglia, Norwich NR4 7TJ, UK June, 2017 Abstract Standard analysis of resale price maintenance (RPM) typically involves comparison between just two possible vertical contacts, one of which involves RPM. This paper adopts the novel approach of allowing firms to make an upfront choice across a wide choice set of vertical contracts, some of which involve RPM. We identify that the the most important factor for firms, in choosing whether to adopt RPM, is not the impact of RPM on end retail prices but its more powerful impact on how total industry profits are divided between the upstream and downstream levels. More relevant factors for end retail prices are the choice of form of transfer charge (unit fee or royalty-sharing) and the choice of single level versus split decision-making. Our analysis of the equilibrium contract choice suggests that the market will naturally avoid the most inefficient contracts. However, a strict policy rule banning all forms of RPM may drive the parties towards choosing a contract that makes consumer worse off. * Amelia Fletcher ([email protected]) and Liang Lu ([email protected]) We thank Bruce Lyons, Subhasish M. Chowdhury, Stephen Davies, Morten Hviid, Kai-Uwe Kuhn and workshop 2016 participants at the CCP for useful comments. Any remaining mistakes are our own. 1 2 1. Introduction Resale price maintenance (RPM) is the practice by which an upstream supplier establishes the retail price of a product sold to consumers, or at least its minimum level1, rather than this being set by the downstream distributor or retailer. In the EU, at least, there is a strong legal presumption under competition law against any form of RPM, as defined on this basis, and in practice, this broadly acts to as a ban. In recent years, however, there has been a debate around whether the same rules should apply to online platforms, such as Amazon Marketplace or Etsy, where upstream suppliers typically set prices, and downstream platforms take a commission fee, typically (but not always) in the form of a share of revenue. In a previous paper, Fletcher and Hviid (2016) highlight that the most harmful anticompetitive effects of RPM emerge when vertical RPM, as defined above, is accompanied by an additional horizontal restriction, which may be implicit or explicit, whereby each supplier is constrained to set its retail prices at an identical level across distributors. By contrast, the effects of purely vertical RPM are far more ambiguous. This is relevant to online platforms, as the RPM observed is typically purely vertical, with additional Most Favoured Nation Clauses (MFNs) sometimes employed to provide for the horizontal restriction. The authors suggest that the law should treat these MFNs harshly, but that there is no strong case for the harsh treatment of purely vertical RPM. In this paper, we analyse further such purely vertical RPM, and consider the impact of a strict policy rule banning RPM on contract choice and market outcomes in a context where contracting parties can choose between different forms of vertical contract structure. Despite the extensive literature on the economic effects of RPM,2 the effect of purely vertical RPM and the possible impact of RPM policy on choice of vertical contract structure does not seem to have been considered in detail before. Instead, existing models of RPM effectively assume a single counterfactual vertical contract structure, which the market will shift to if RPM is not allowed. This paper shows that this assumption is over-simplistic and may be misleading. Once we allow for the endogenous choice of vertical contract structure, it becomes clear that market outcomes for consumers may be harmed by an outright wide ban on RPM, which covers RPM with revenue-sharing commissions, such as we frequently observe on online platforms. 1 In this paper, we focus on fixed RPM. Minimum RPM provides for more upward pricing flexibility but is generally viewed as having similar effects to fixed RPM. By contrast, maximum RPM, which allows for downward pricing flexibility, is generally viewed as positive, and is not generally prohibited by competition policy. 2 The literature suggests that RPM can have both pro and anticompetitive effects. It may be used to improve the efficiency in vertical relations, while it can also be anticompetitive by dampening competition, facilitating collusion and blocking new entrants at upstream or downstream markets. See, Rey and Caballero-Sanz (1996) for a comprehensive survey. 3 1.1 Modelling approach We examine a three-stage game in which, at stage zero of the game, Nature determines which level of the market can choose the vertical contract. In reality, we might expect this to depend on which level has the greater negotiation power in the vertical relationship. At stage one of the game, this level chooses from a set of possible vertical contracts. At stage two, the transfer charge is set by the level which has been chosen to set this. At stage three, the retail price is set by the level which has been chosen to set this. We consider first the case of bilateral monopoly, in which any effect of RPM derived is purely vertical, since there is no horizontal competition. We allow for a choice set of eight possible contracts. As shown in Table 1, these contracts differ in terms of i) whether a single vertical level (upstream supplier or downstream retailer) sets both transfer charge and retail price, or the two decisions are separated, ii) where set separately, which of the two vertical levels sets the transfer charge and which the retail price, iii) whether the transfer charge between supplier and retailer is set as a unit fee or as a revenue-sharing (or royalty-based) commission. This choice set includes four vertical contracts which involve single level decision-making, whereby either supplier sets both transfer charges (unit fees or revenue-sharing commissions) and retail prices – full RPM, or retailer sets both – full downstream control (full DC).3 It also includes four vertical contracts which involve split decision-making: unit-fee (UF) (supplier sets unit fees and retailer sets prices); unit-fee RPM (UF RPM) (retailer sets unit fees4 and supplier sets prices); revenue-sharing (RS) (supplier sets revenue-sharing commissions and retailer sets prices); and revenue-sharing RPM (RS RPM) (retailer sets revenue-sharing commissions and supplier sets prices). In the case of bilateral duopoly, we introduce horizontal competition to each level of the market, and consider only the four contracts involving split decision-making. 3 A contract is referred as full RPM (full DC) as long as it involves the supplier (retailer) setting both transfer charges and retail prices, although the nature of transfer charge can be unit-fee or revenue-sharing. This is because the market outcomes would be the same – the level making decisions will set a price to maximise joint profits and reimburse the other level an amount equal to its marginal costs to ensure participation. 4 In this context, unit fees may be interpreted as charges for the supply of a distribution or retail service. 4 Vertical contract Transfer charge Retail price Unit-fee Revenue-sharing Single level decision-making Full RPM 푆 - 푆 - 푆 푆 Full downstream control 푅 - 푅 - 푅 푅 Split decision-making Unit-fee (wholesale) 푆 - 푅 Unit-fee RPM 푅 - 푆 Revenue-sharing - 푆 푅 Revenue-sharing RPM (agency) - 푅 푆 Table 1. A choice set of vertical contracts – bilateral monopoly The contract UF, also commonly known as the wholesale model, has been the most well- considered in the theoretical literature. It is also noteworthy that much of the existing RPM literature – and indeed many antitrust cases in this area – involve the upstream level specifying both wholesale and retail price, i.e. full RPM (See, for example, Marvel and McCafferty, 1996; Asker and Bar-Isaac, 2014). The other forms of vertical contract specified in Table 1, though examined relatively less intensely by the literature, have all been observed in real market situations (with the possible exception of full downstream control). For example, price comparison websites often charge suppliers on a unit-fee basis, akin to UF RPM; RS has been observed in a variety of markets, from movie distribution and video rental to airport parking; RS RPM – regularly referred as agency arrangements – has recently become prevalent for online platforms, such as Amazon Marketplace, and was an important element of the recent e-book case.5 It is important to note that agency arrangements are inherently a form of RPM. For both the bilateral monopoly and bilateral duopoly cases, we examine and compare the market outcomes under each of these vertical contract structures, with a view to concluding on which would be chosen at stage one. We then consider how this choice is affected by a strict policy rule against RPM, in order to assess the likely impact of such a rule. 1.2 Headline results First, we find that, ceteris paribus, the key vertical effect of RPM is on the distribution of the total industry rents between the two levels of the market. Specifically, across all forms of vertical contract 5 U.S. v. Apple Inc., et al. 12 Civ. 2826 (DLC), the State of Texas, et al. v. Penguin Group Inc., et al. 12 Civ. 3394 (DLC) (2013). 5 (whether single level decision-making or split decision-making; unit-fee or revenue-sharing), we find that the level which sets the transfer charge gains the greater share of the pot.