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The strategic impact of voluntary vs. mandated vertical restraints and termination restrictions on exclusion of rivals

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Abstract

It has been shown that manufacturers can employ vertical practices and restraints to prevent entry in markets where upstream entrants require downstream accommodation. I show that if downstream product investment is important and encouraged by the restraint, foreclosing entry this way may not be credible. Additionally, publicly mandated vertical restraints and termination restrictions could prevent foreclosure, but if these restrictions reduce downstream product investment, they could have the opposite effect and decrease entry.

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Notes

  1. Aghion and Bolton (1987) is a classic example. See Rey and Tirole (2007) and Rey and Verge (2008) for summaries of this literature.

  2. I adopt the distinction between mandated versus voluntary use of vertical restraints made in a summary of the empirical literature regarding vertical restraints in Lafontaine and Slade (2008).

  3. Dr. Miles Medical Co. v. John D. Park and Sons, 220 US 373 (1911).

  4. Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 US 877 (2007).

  5. While US antitrust authorities have taken a more lenient stance over time regarding vertical restraints, European antitrust authorities tend to be stricter than the US (Cooper et al. 2005b).

  6. In an online Appendix, Asker and Bar-Isaac (2014) consider alternative post-entry equilibria, including the possibility of post-entry collusion.

  7. Note that in stage (iii) the entrant can offer different transfers to different targeted retailers. If the entrant were required to offer the same transfer to each retailer, this would make it more difficult to enter.

  8. Asker and Bar-Isaac (2014) show this can be applied to vertical practices such as resale price maintenance and exclusive territories.

  9. They use as an illustrating example how Coors brewery assigned exclusive territories and used resale price maintenance for their beer wholesalers. If multiple wholesalers sold to the same retailers, wholesalers would have an incentive to not take costly product investments, such as cold storage, promotional activity, etc. as consumers do not observe which wholesaler their beer was distributed by. By assigning exclusive territories and enforcing resale price maintenance, any underinvestment would have consequences only for Coors and that wholesaler, rather than being spread across multiple wholesalers. This removed the incentive to free ride and increased investment.

  10. This is also in line with the logic of Butz and Kleit (2001) who present a model where downstream firms’ effort impacts upstream profits.

  11. If investment is costly, and if, as with franchise laws, termination is restricted, this gives retailers an incentive to shirk. Indeed, Klein (1995) characterizes franchise laws by stating, “[t]he effect of these provisions is to increase the franchisee’s ability to not perform without being terminated,” and other mandates could be used similarly.

  12. The incumbent may be receiving \(I^H\) prior to entry in this equilibrium or not: this is unimportant as we only need to consider credible post-entry equilibrium behavior from the incumbent here. We can characterize the case where . In this case, any use of vertical restraints to facilitate transfers is solely to prevent entry.

  13. See, for example, https://indianexpress.com/article/cities/pune/newlaw-in-making-to-punish-vendors-charging-overmrp/.

  14. For one such example, see Virginia’s Beer Franchise Act, §4.1-505. Cancellation, which reads, “Notwithstanding the terms, provisions or conditions of any agreement, no brewery shall unilaterally amend, cancel, terminate or refuse to continue to renew any agreement,... unless ... good cause exists for amendment, termination, cancellation, nonrenewal, noncontinuation or causing a resignation”. (Emphasis added).

  15. Even if we relax the assumption that the investment downstream is non-contractible, such laws may still have the effect of restricting even some justifiable terminations, if the downstream firm is likely to sue upon termination, or due because of imperfections or frictions in enforcement.

  16. The trust sold a homogeneous good with little use for product investment (Zerbe 1969).

  17. In an extreme case, the Michigan based Bell’s Brewery exited the entire Illinois market due to concerns that a Chicago wholesaler would not invest enough in Bell’s brands. See “Bell’s Brings Beer Back to Area.” Chicago Tribune, August 1, 2008, http://articles.chicagotribune.com/2008-08-01/business/0807310746_1_brewers-association-new-distributors-craft-brewer.

  18. Many states require the use of independent beer wholesalers, which is similar to requirements of independent dealers in the auto industry. The latter prevents Tesla from their preferred method of “direct selling” in several states. See, e.g. http://www.autonews.com/article/20150403/RETAIL07/150409912/tesla-blocked-in-w.va.-as-governor-signs-bill.

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Authors and Affiliations

  1. Department of Economics, College of Business, Suite 144, University of Louisville, Louisville, KY, 40292, USA

    Jacob Burgdorf

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Correspondence to Jacob Burgdorf.

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I thank Tim Bersak, Charles Thomas, and numerous seminar participants for helpful comments and suggestions.

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Burgdorf, J. The strategic impact of voluntary vs. mandated vertical restraints and termination restrictions on exclusion of rivals. J Regul Econ 59, 94–107 (2021). https://doi.org/10.1007/s11149-020-09419-8

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