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28.3 Vertical Restraints of Trade

Learning Objectives

  1. Distinguish vertical restraints of trade from horizontal restraints of trade.
  2. Describe exclusive dealing, and explain why exclusive dealing is anticompetitive in any way.
  3. Explain how tying one product’s sale to that of another could be anticompetitive.

We have been exploring the Sherman Act as it applies to horizontal restraints of trade, restraints that are created between competitors. We now turn to vertical restraints—those that result from agreements between different levels of the chain of distribution, such as manufacturer and wholesaler or wholesaler and retailer.

Resale Price Maintenance

Is it permissible for manufacturers to require distributors or retailers to sell products at a set price? Generally, the answer is no, but the strict per se rule against any kind of resale price maintenanceAn agreement between a manufacturer and a retailer in which the manufacturer specifies what the retail prices of its products must be. has been somewhat relaxed.

But why would a manufacturer want to fix the price at which the retailer sells its goods? There are several possibilities. For instance, sustained, long-term sales of many branded appliances and other goods depend on reliable servicing by the retailer. Unless the retailer can get a fair price, it will not provide good service. Anything less than good service will ultimately hurt the brand name and lead to fewer sales. Another possible argument for resale price maintenance is that unless all retailers must abide by a certain price, some goods will not be stocked at all. For instance, the argument runs, bookstores will not stock slow-selling books if they cannot be guaranteed a good price on best sellers. Stores free to discount best sellers will not have the profit margin to stock other types of books. To guarantee sales of best sellers to bookstores carrying many lines of books, it is necessary to put a floor under the price of books. Still another argument is that brand-name goods are inviting targets for loss-leader sales; if one merchant drastically discounts Extremis Widgets, other merchants may not want to carry the line, and the manufacturer may experience unwanted fluctuations in sales.

None of these reasons has completely appeased the critics of price-fixing, including the most important critics—the US federal judges. As long ago as 1910, in Dr. Miles Medical Co. v. John D. Park & Sons Co., the Supreme Court declared vertical price-fixing (what has come to be called resale price maintenance) unlawful under the Sherman Act. Dr. Miles Medical Company required wholesalers that bought its proprietary medicines to sign an agreement in which they agreed not to sell below a certain price and not to sell to retailers who did not have a “retail agency contract” with Dr. Miles. The retail agency contract similarly contained a price floor. Dr. Miles argued that since it was free to make or not make the medicines, it should be free to dictate the prices at which purchasers could sell them. The Court said that Dr. Miles’s arrangement with more than four hundred jobbers (wholesale distributors) and twenty-five thousand retailers was no different than if the wholesalers or retailers agreed among themselves to fix the price. Dr. Miles “having sold its product at prices satisfactory to itself, the public is entitled to whatever advantage may be derived from a competition in the subsequent traffic.”Dr. Miles Medical Co. v. John D. Park & Sons Co., 220 U.S. 373 (1910).

In Dr. Miles, the company’s restrictions impermissibly limited the freedom of choice of other drug distributors and retailers. Society was therefore deprived of various benefits it would have received from unrestricted distribution of the drugs. But academics and some judges argue that most vertical price restraints do not limit competition among competitors, and manufacturers retain the power to restrict output, and the power to raise prices. Arguably, vertical price restraints help to ensure economic efficiencies and maximize consumer welfare. Some of the same arguments noted in this section—such as the need to ensure good service for retail items—continue to be made in support of a rule of reason.

The Supreme Court has not accepted these arguments with regard to minimum prices but has increased the plaintiff’s burden of proof by requiring evidence of an agreement on specific price levels. Where a discounter is terminated by a manufacturer, it will probably not be told exactly why, and very few manufacturers would be leaving evidence in writing that insists on dealers agreeing to minimum prices.

Moreover, in State Oil Company v. Khan, the Supreme Court held that “vertical maximum price fixing, like the majority of commercial arrangements subject to the antitrust laws, should be evaluated under the rule of reason.”State Oil Company v. Khan, 522 U.S. 3 (1997). Vertical maximum price-fixing is not legal per se but should be analyzed under a rule of reason “to identify the situations in which it amounts to anti-competitive conduct.” The Khan case is at the end of this chapter, in Section 28.8.2 "Vertical Maximum Price Fixing and the Rule of Reason".

Exclusive Dealing and Tying

We move now to a nonprice vertical form of restraint. Suppose you went to the grocery store intent on purchasing a bag of potato chips to satisfy a late-night craving. Imagine your surprise—and indignation—if the store manager waved a paper in your face and said, “I’ll sell you this bag only on the condition that you sign this agreement to buy all of your potato chips in the next five years from me.” Or if he said, “I’ll sell only if you promise never to buy potato chips from my rival across the street.” This is an exclusive dealing agreementA contract—as between buyer and seller—where the parties agree only to deal with each other., and if the effect may be to lessen competition substantially, it is unlawful under Section 3 of the Clayton Act. It also may be unlawful under Section 1 of the Sherman Act and Section 5 of the Federal Trade Commission (FTC) Act. Another form of exclusive dealing, known as a tying contractA form of exclusive dealing, prohibited under Section 3 of the Clayton Act, forcing you to take an additional product in order to get the product you really want., is also prohibited under Section 3 of the Clayton Act and under the other statutes. A tying contract results when you are forced to take a certain product in order to get the product you are really after: “I’ll sell you the potato chips you crave, but only if you purchase five pounds of my Grade B liver.”

Section 3 of the Clayton Act declares it unlawful for any person engaged in commerce

to lease or make a sale or contract for sale of goods, wares, merchandise, machinery, supplies or other commodities, whether patented or unpatented, for use, consumption or resale…or fix a price charged therefore, or discount from or rebate upon, such price, on the condition…that the lessee or purchaser…shall not use or deal in the goods, wares, merchandise, machinery, supplies, or other commodities of a competitor or competitors of the lessor or seller, where the effect of such lease, sale, or contract for sale or such condition…may be to substantially lessen competition or tend to erect a monopoly in any line of commerce. (emphasis added)

Under Section 3, the potato chip example is not unlawful, for you would not have much of an effect on competition nor tend to create a monopoly if you signed with your corner grocery. But the Clayton Act has serious ramifications for a producer who might wish to require a dealer to sell only its products—such as a fast-food franchisee that can carry cooking ingredients bought only from the franchisor (Chapter 29 "Unfair Trade Practices and the Federal Trade Commission"), an appliance store that can carry only one national brand of refrigerators, or an ice-cream parlor that must buy ice-cream supplies from the supplier of its machinery.

A situation like the one in the ice-cream example came under review in International Salt Co. v. United States.International Salt Co. v. United States, 332 U.S. 392 (1947). International Salt was the largest US producer of salt for industrial uses. It held patents on two machines necessary for using salt products; one injected salt into foodstuffs during canning. It leased most of these machines to canners, and the lease required the lessees to purchase from International Salt all salt to be used in the machines. The case was decided on summary judgment; the company did not have the chance to prove the reasonableness of its conduct. The Court held that it was not entitled to. International Salt’s valid patent on the machines did not confer on it the right to restrain trade in unpatented salt. Justice Tom Clark said that doing so was a violation of both Section 1 of the Sherman Act and Section 3 of the Clayton Act:

Not only is price-fixing unreasonable, per se, but also it is unreasonable, per se, to foreclose competitors from any substantial market. The volume of business affected by these contracts cannot be said to be insignificant or insubstantial, and the tendency of the arrangement to accomplishment of monopoly seems obvious. Under the law, agreements are forbidden which “tend to create a monopoly,” and it is immaterial that the tendency is a creeping one rather than one that proceeds at full gallop; nor does the law await arrival at the goal before condemning the direction of the movement.

In a case involving the sale of newspaper advertising space (to purchase space in the morning paper, an advertiser would have to take space in the company’s afternoon paper), the government lost because it could not use the narrower standards of Section 3 and could not prove that the defendant had monopoly power over the sale of advertising space. (Another afternoon newspaper carried advertisements, and its sales did not suffer.) In the course of his opinion, Justice Clark set forth the rule for determining legality of tying arrangements under both the Clayton and Sherman Acts:

When the seller enjoys a monopolistic position in the market for the “tying” product [i.e., the product that the buyer wants] or if a substantial volume of commerce in the “tied” product [i.e., the product that the buyer does not want] is restrained, a tying arrangement violates the narrower standards expressed in section 3 of the Clayton Act because from either factor the requisite potential lessening of competition is inferred. And because for even a lawful monopolist it is “unreasonable per se to foreclose competitors from any substantial market” a tying arrangement is banned by section 1 of the Sherman Act wherever both conditions are met.Times-Picayune Publishing Co. v. United States, 345 U.S. 594 (1953).

This rule was broadened in 1958 in a Sherman Act case involving the Northern Pacific Railroad Company, which had received forty million acres of land from Congress in the late nineteenth century in return for building a rail line from the Great Lakes to the Pacific. For decades, Northern Pacific leased or sold the land on condition that the buyer or lessee use Northern Pacific to ship any crops grown on the land or goods manufactured there. To no avail, the railroad argued that unlike International Salt’s machines, the railroad’s “tying product” (its land) was not patented, and that the land users were free to ship on other lines if they could find cheaper rates. Wrote Justice Hugo Black,

[A] tying arrangement may be defined as an agreement by a party to sell one product but only on the condition that the buyer also purchases a different (or tied) product, or at least agrees that he will not purchase that product from any other supplier. Where such conditions are successfully exacted competition on the merits with respect to the tied product is inevitably curbed.…They deny competitors free access to the market for the tied product, not because the party imposing the tying requirements has a better product or a lower price but because of his power or leverage in another market. At the same time buyers are forced to forego their free choice between competing products.…They are unreasonable in and of themselves whenever a party has sufficient economic power with respect to the tying product to appreciably restrain free competition in the market for the tied product and a “not insubstantial” amount of interstate commerce is affected. In this case…the undisputed facts established beyond any genuine question that the defendant possessed substantial economic power by virtue of its extensive landholdings which it used as leverage to induce large numbers of purchasers and lessees to give it preference.Northern Pacific Railway Co. v. United States, 356 U.S. 1 (1958). (emphasis in original)

Taken together, the tying cases suggest that anyone with certain market power over a commodity or other valuable item (such as a trademark) runs a serious risk of violating the Clayton Act or Sherman Act or both if he insists that the buyer must also take some other product as part of the bargain. Microsoft learned about the perils of “tying” in a case brought by the United States, nineteen individual states, and the District of Columbia. The allegation was that Microsoft had tied together various software programs on its operating system, Microsoft Windows. Windows came prepackaged with Microsoft’s Internet Explorer (IE), its Windows Media Player, Outlook Express, and Microsoft Office. The United States claimed that Microsoft had bundled (or “tied”) IE to sales of Windows 98, making IE difficult to remove from Windows 98 by not putting it on the Remove Programs list.

The government alleged that Microsoft had designed Windows 98 to work “unpleasantly” with Netscape Navigator and that this constituted an illegal tying of Windows 98 and IE. Microsoft argued that its web browser and mail reader were just parts of the operating system, included with other personal computer operating systems, and that the integration of the products was technologically justified. The United States Court of Appeals for the District of Columbia Circuit rejected Microsoft’s claim that IE was simply one facet of its operating system, but the court held that the tie between Windows and IE should be analyzed deferentially under the rule of reason. The case settled before reaching final judicial resolution. (See United States v. Microsoft.United States v. Microsoft, 253 F.3d 34 (D.C. Cir. 2001).)

Nonprice Vertical Restraints: Allocating Territory and Customers

With horizontal restraints of trade, we have already seen that it is a per se violation of Section 1 of the Sherman Act for competitors to allocate customers and territory. But a vertical allocation of customers or territory is only illegal if competition to the markets as a whole is adversely affected. The key here is distinguishing intrabrand competition from interbrand competition. Suppose that Samsung electronics has relationships with ten different retailers in Gotham City. If Samsung decides to limit its contractual relationships to only six retailers, the market for consumer electronics in Gotham City is still competitive in terms of interbrand competition. Intrabrand competition, however, is now limited. It could be that consumers will pay slightly higher prices for Samsung electronics with only six different retailers selling those products in Gotham City. That is, intrabrand competition is lowered, but interbrand competition remains strong.

Notice that it is unlikely that the six remaining retailers will raise their prices substantially, since there is still strong interbrand competition. If the retailer only deals in Samsung electronics, it is unlikely to raise prices that much, given the strength of interbrand competition.

If the retailer carries Samsung and other brands, it will also not want to raise prices too much, for then its inventory of Samsung electronics will pile up, while its inventory of other electronics products will move off the shelves.

Why would Samsung want to limit its retail outlets in Gotham City at all? It may be that Samsung has decided that by firming up its dealer network, it can enhance service, offer a wider range of products at each of the remaining retailers, ensure improved technical and service support, increase a sense of commitment among the remaining retail outlets, or other good business reasons. Where the retailer deals in other electronic consumer brands as well, making sure that well-trained sales and service support is available for Samsung products can promote interbrand competition in Gotham City. Thus vertical allocation of retailers within the territory is not a per se violation of the Sherman Act. It is instead a rule of reason violation, or the law will intervene only if Samsung’s activities have an anticompetitive effect on the market as a whole. Notice here that the only likely objections to the new allocation would come from those dealers who were contractually terminated and who are then effectively restricted from selling Samsung electronics.

There are other potentially legitimate territorial restrictions, and limits on what kind of customer the retailer can sell to will prevent a dealer or distributor from selling outside a certain territory or to a certain class of customers. Samsung may reduce its outlets in Iowa from four to two, and it may also impose limits on those retail outlets from marketing beyond certain areas in and near Iowa.

Suppose that a Monsanto representative selling various kinds of fertilizers and pesticides was permitted to sell only to individual farmers and not to co-ops or retail distributors, or was limited to the state of Iowa. The Supreme Court has held that such vertical territorial or customer searches are not per se violations of Section 1 of the Sherman Act, as the situations often increase “interbrand competition.” Thus the rule of reason will apply to vertical allocation of customers and territory.

Nonprice Vertical Restraints: Exclusive Dealing Agreements

Often, a distributor or retailer agrees with the manufacturer or supplier not to carry the products of any other supplier. This is not in itself (per se) illegal under Section 1 of the Sherman Act or Section 3 of the Clayton Act. Only if these exclusive dealing contracts have an anticompetitive effect will there be an antitrust violation. Ideally, in a competitive market, there are no significant barriers to entry. In the real world, however, various deals are made that can and do restrict entry. Suppose that on his farm in Greeley, Colorado, Richard Tucker keeps goats, and he creates a fine, handcrafted goat cheese for the markets in Denver, Fort Collins, and Boulder, Colorado, and Cheyenne, Wyoming. In these markets, if Safeway, Whole Foods, Albertsons, and King Soopers already have suppliers, and the suppliers have gained exclusive dealing agreements, Tucker will be effectively barred from the market.

Suppose that Billy Goat Cheese is a nationally distributed brand of goat cheese and has created exclusive dealing arrangements with the four food chains in the four cities. Tucker could sue Billy Goat for violating antitrust laws if he finds out about the arrangements. But the courts will not assume a per se violation has taken place. Instead, the courts will look at the number of other distributors available, the portion of the market foreclosed by the exclusive dealing arrangements, the ease with which new distributors could enter the market, the possibility that Tucker could distribute the product himself, and legitimate business reasons that led the distributors to accept exclusive dealing contracts from Billy Goat Cheese.

Key Takeaway

Vertical restraints of trade can be related to price, can be in the form of tying arrangements, and can be in the form of allocating customers and territories. Vertical restraints can also come in the form of exclusive dealing agreements.

Exercises

  1. Explain how a seller with a monopoly in one product and tying the sale of that product to a new product that has no such monopoly is in any way hurting competition. How “free” is the buyer to choose a product different from the seller’s?
  2. If your company wants to maintain its image as a high-end product provider, is it legal to create a floor for your product’s prices? If so, under what circumstances?