Resale Price Maintenance: Customer Service Without Free Riding

Highlights

RPM is not always manufacturer-optimal.The optimal RPM strategy can entail a price ceiling or a price floor.The optimal RPM floor may only constrain one retailer.The optimal RPM strategy may increase the profits of the larger retailer.

Abstract

Recent judicial legalizations of resale price maintenance (RPM) allow a manufacturer to establish limits to the prices that its retailers charge: a maximum price (a ceiling) or a minimum price (a floor). A manufacturer can also choose not to apply an RPM constraint. To determine how RPM affects service levels and the distribution of profit between channel members, we derive the optimal RPM strategy for a manufacturer that sells through competing retailers who provide their own optimal level of demand-enhancing customer service. Our analysis yields four key insights into a manufacturer's use of RPM in the absence of free riding.

First, there are conditions for which a manufacturer benefits by applying either an RPM Ceiling or an RPM Floor, but there are also conditions that cause the manufacturer not to intervene in its retailers’ pricing decisions. Second, a manufacturer's use of RPM depends on how effectively its retailers provide service, and their service-effectiveness disparity. Third, intensity of inter-retailer competition affects the manufacturer's optimal application of RPM. Fourth, RPM Floors often enhance a large retailer's profit relative to the absence of RPM – but this does not hold for a small retailer. Our findings generate significant managerial implications, insights into the consequences of laws that allow manufacturers to limit their retailers’ pricing decisions. We also offer suggestions for future research.

Introduction

Resale price maintenance (RPM) refers to manufacturer policies that limit retailers’ pricing flexibility. With maximum RPM (a price ceiling), retailers can choose any price that is no higher than the ceiling (e.g., Blair and Lafontaine 1999). With minimum RPM (a price floor), retailers can charge any price that is no lower than the floor (Harbour and Price 2010). In the United States, a manufacturer can legally impose a ceiling or a floor, provided such restraints are not anticompetitive.

RPM's legality is recent. Ceilings were per se illegal from 1968–1997, as were floors from 1911–2007 (albeit with fair trade exceptions from 1937–1975). RPM Ceilings were subjected to the rule of reason in the US Supreme Court's State Oil decision in 1997; the Court reached the same conclusion on RPM Floors in its Leegin decision in 2007.¹ While the State Oil case generated little controversy, critics of the Leegin case have raised several issues.

First, the split decision in the Leegin case relied on free riding to justify minimum RPM (Gundlach, Cannon, and Manning 2010). In his Leegin dissent, Justice Breyer stated: “the ultimate question is not whether, but how much, ‘free riding’ of this sort takes place” (2007, p. 9). Experts have opined that free riding is rather rare, noting that when RPM floors were illegal, manufacturers tried to impose RPM on products needing little or no service (Ippolito 1991). To illustrate, a former FTC chair wrote that when “state fair trade statutes authorized RPM agreements, minimum resale price maintenance was instituted with respect to … pet food, vitamins, hair shampoo, ammunition, blue jeans, and men's underwear” (Pitofsky 2007, p. 63). The thrust of these comments motivates our first and second research questions:

• Does a manufacturer ever benefit by applying an RPM rule in the absence of free riding?

• If a manufacturer does benefit, under what market conditions does it do so?

  Drawing on Pitofsky's examples, pet food is sold by retailers ranging from supermarkets to pet supply stores; similarly, hair shampoo is available at retailers as diverse as supercenters and upscale hair salons. These examples, which span service levels from near zero to quite high, motivate our third research question:

• Does a manufacturer's use of RPM depend on a disparity in retailers’ service effectiveness?

  The preceding examples also highlight that many products are sold by merchants that may have strong, moderate, or even weak competitors in their own line of trade, as well as competition from other lines of trade in specific product classes. This motivates our fourth research question:

• Does intensity of retailer competition affect the application of RPM by a manufacturer?

  In his Leegin dissent, Justice Breyer also noted that concentration “may enable (and motivate) more retailers, accounting for … a greater percentage of total retail sales volume, to seek resale price maintenance, thereby making it more difficult for price-cutting competitors … to obtain market share” (2007, p. 15). Justice Breyer's observation motivates our fifth research question:

• Does the imposition of RPM benefit large retailers?

To address these questions, we analyze a model of a manufacturer that sells through two competing retailers who control their own service levels. We examine the optimal use of RPM without free riding – unlike the preponderance of the RPM literature that focuses on ameliorating deleterious effects of free riding (e.g., Telser 1960). We show that a manufacturer-optimal RPM strategy reflects the interaction of three market conditions: competitive intensity, the effectiveness of the most proficient retailer's service, and the disparity in retailers’ service effectiveness. We prove that a manufacturer can increase its profit by imposing RPM on its dealers under many – but not all – market conditions. Moreover, a large retailer can often gain from RPM floors – justifying Justice Breyer's concern with retail concentration.

Our model's central tension is the profit tradeoff between raising service by forcing prices higher with a floor versus diminishing service with a ceiling to minimize markups above cost. Excessive markups dissipate profit, but so does insufficient service. When service effectiveness is low, a price ceiling can amplify a manufacturer's ability to extract rent from retailers. When service effectiveness is high, a price floor can increase rent available for extraction by raising service. Resolving the manufacturer's service-provision/rent-extraction tradeoff drives the optimal pricing strategy – which sometimes entails not using RPM.

While the academic literature has largely focused on price floors, price ceilings have drawn less academic attention. An exception is Blair and Lafontaine (1999), who highlight the positive impact of RPM ceilings on consumer surplus. Governments also use ceilings, both to control rents (cf., Cheung 1974) and to prevent price gouging on scarce resources (cf., Davis and Kilian 2011). Recent price floors include maternity and children's clothes, light fixtures, women's shoes, dog food, and toys (Pereira, 2008a, Pereira, 2008c).

From a managerial perspective, there are temporal and geographic variations in customer desires for service, and in the legality of RPM, since (a) customers’ service needs change over a product's life cycle; (b) RPM rules change over time; and, (c) RPM rules differ across nations.² Profit-maximizing managers must adjust their RPM usage in response to changes in product-familiarity that alter the desire for service, and in reactions to temporal and international variations in RPM's legality. Our paper gives insight into RPM's optimal application over a wide range of market conditions, and their consequences for channel members.

We will show that (1) under some – not all – market conditions a manufacturer profits by using RPM; (2) whether a manufacturer is more profitable with an RPM Ceiling, an RPM Floor, or not using RPM depends on how responsive sales are to service as well as customers’ price sensitivity; (3) the floor/ceiling/No-RPM decision is affected by the disparity in retailers’ service effectiveness; (4) the more intense is retailer competition, the greater is the likelihood that a manufacturer will apply RPM – either as a floor or as a ceiling; and, (5) a retailer with service effectiveness that is sufficiently superior to its competitor's effectiveness earns more profit with an RPM Floor than it would in the absence of a floor.

Our analysis shows that when a service-decreasing RPM Ceiling generates more manufacturer profit than would a service-increasing RPM Floor, all retailers are worse off than they would be without a ceiling. Symmetrically, an RPM Floor reduces profit for at least one retailer, and often for both retailers. Moreover, there are market conditions in which a retailer with highly effective service is profit-incented to press for the imposition of an RPM Floor. In sum, the imposition of an RPM rule affects both total channel profit and its distribution among channel members.

We organize the paper as follows. The next Section offers a brief literature review, followed by a Section with our assumptions and demand curve. The ensuing two Sections detail RPM with retailers who are homogeneous, then heterogeneous. The next Section provides answers to the five questions raised above. We then address the robustness of our results; we also list potential research questions by generalizing our demand curve. We end with a discussion and conclusion.