The European Commission’s e-commerce inquiry and various investigations by national competition authorities have brought vertical restraints under the spotlight. It is widely acknowledged that, while these practices can have anti-competitive effects, they can also bring consumer benefits. A recent Oxera report, commissioned by the UK Competition and Markets Authority, presents primary evidence on the business rationale for such practices.

Vertical restraints refer to agreements or contract terms between firms that are in different layers of the supply chain—for example, an agreement between a manufacturer and a retailer or distributor. These can include restrictions on the overall number or type of retailers selling a particular product; on the geographic area where each retailer can sell; whether they can sell competitor products; and/or the price at which retailers may sell the products.

As such, the debate about when certain vertical restraints have anticompetitive effects, and when they might be beneficial for the consumer, is not new. There is a large and well-established body of economics literature highlighting the mechanisms by which vertical restraints may have anti- and/or pro-competitive effects. However, the growth of the Internet and, with it, e-commerce, has revived this debate among competition authorities, practitioners and academics.

For example, the European Commission, as part of its Digital Single Market strategy, has launched an inquiry into e-commerce, which will focus on ‘potential barriers erected by companies to cross-border online trade in goods and services’.(1) It is also investigating a number of businesses (such as Amazon, Sky UK and six major Hollywood film studios) in relation to specific vertical restraints.(2)  National competition authorities have also been active in investigating vertical restraints in many markets. The most salient example is the online hotel booking market, which has been investigated by the UK Competition and Markets Authority (CMA), the German Bundeskartellamt, and at least eight other competition authorities. There have also been inquiries into online retailing of running shoes in Germany (for example, into ASICS’s practice of banning the use of online marketplaces), mobility scooters in the UK (where the concern was also about online sales bans), and consumer electronics across Europe.

In this context, the Oxera report, prepared in collaboration with market research firm, Accent, presents primary evidence on why businesses use vertical restraints (including any anti- and pro-competitive reasons). It also looks at the impact on market players and consumers, and how this has been influenced by e-commerce, in order to inform the assessment of when potential benefits from these restraints may outweigh the potential consumer harm.(3) Before discussing these survey results in more detail, it is worth exploring what the economic literature says on the impact of vertical restraints.

What are the insights from the economic literature?

There is a large body of literature exploring the harmful and beneficial effects of vertical restraints, including studies that assess how the Internet and e-commerce may affect the balance between anti- and pro-competitive effects.

On the anticompetitive front, economists note that vertical restraints can: (4)

• soften intra-brand competition—for example, by reducing the number of retailers that stock a given brand;
• soften inter-brand competition—for example, by restricting a retailer from stocking a competing brand;
• facilitate collusion—for example, through price agreements, such as RPM, that can aid collusion by facilitating monitoring and enforcement.

Pro-competitive reasons discussed in the literature include the following.

• Addressing vertical and horizontal externalities—in particular, manufacturers may use restraints such as selective or exclusive distribution (i.e. limiting the number of retailers) to ensure that retailers earn sufficient margins and therefore have the appropriate incentives to stock the product, and provide pre- and/or after-sales service to consumers on behalf of the manufacturer. Such restraints can also prevent other retailers from ‘free-riding’ on one retailer’s efforts to provide customer service (such as product information) and to remove double marginalisation.(5)
• Reducing transaction costs—for example, quantity forcing may reduce the number of trading partners and the costs incurred for associated negotiations; or RRPs may help manufacturers to convey information about market conditions, such as demand trends, to uninformed retailers.(6)
• Signalling the high quality of a product—this might include a direct signal through the level of the RRP and/or an indirect signal by restricting the distribution network to retailers with a reputation for quality, such that the fact that the retailer is stocking a product signals pre-selection of high-quality products for consumers.(7)
• Signalling a status good—branded-goods manufacturers may use selective distribution to limit usage and maintain a high price when they want to target a group of high-income consumers who derive a higher benefit from the ‘social status’ of using an expensive and/or exclusive product.(8)

Evidence on business rationale

So, why do businesses use vertical restraints? To explore this the Oxera and Accent study undertook telephone interviews with 33 small and medium-sized businesses (SMEs). Consistent with the economic literature, the most common reasons stated by participants in the survey were to prevent free-riding and thereby maintain pre- and after-sales service quality, and to protect brand image.

Other stated reasons (for example, for using quantity forcing or single branding) included increasing brand presence in stores, cementing the viability of the business relationship, and ensuring that the retailer had the necessary expertise. However, some responses also suggested that manufacturers and retailers use these practices only to secure a good commercial deal, without a clear link to any (actual or perceived) benefit to consumers.

Many of the participants using selective or exclusive distribution, and specifying RRPs, highlighted that the main rationale was to prevent free-riding and ensure quality of service.

As also highlighted in the economics literature, this was particularly important for products requiring some form of customer service—either before or after the sale (such as advice on the quality of products or demonstration of use). Examples included high-end machines that require technical advice, a prescription product where personalised advice was necessary, bespoke bicycles that may require after-sales customer service, and special adult shoes that require expertise and training in shoe-fitting:(9)

"If [retailers are] taking the time to fit the [product], to add the value…etc. then it seems only fair that you are long term rewarded for that effort and therefore they come back and buy the products from you. What we don’t want to have is a company whose…you know, they do all the work and then some Internet reseller nicks all the business."

"if the consumer is wishing to invest in a premium product they want to be able to see it…and someone who has got competent knowledge to explain the product to them, so we [retailer] are able to ensure that they make the right decision."

As for the impact of vertical restraints, the responses highlight that, while they necessarily restrict the number of retailers and availability, and potentially increase prices in the short run, in the longer term such restraints help to increase retail service standards, maintain stock in stores, and improve the customer experience. This is particularly relevant in recent years, given the higher scope for free-riding by online businesses. For example, one retailer explained how the pressure from lower prices online may lead smaller stores to no longer stocking the product:

"[The manufacturer] had a bit of an issue with it being sold into both online and retail, you know, sort of bricks and mortar environment, and there was a big issue with retailers like myself not being able to take the product because it was being discounted heavily online."

"then it would mean that potentially you wouldn’t find them on the high street because we [the retailer] wouldn’t be able to support the price."

Concluding Remarks

The insights from the interviews confirm much of the understanding from the economics literature on the costs and benefits to consumers of vertical restraints. Indeed, the strength of any pro-competitive rationale would be expected to vary across markets.

End Notes

1. European Commission (2015), ‘Commission launches e-commerce sector inquiry’, press release, 6 May [http://europa.eu/rapid/press-release_IP-15-4921_en.htm].
2. European Commission (2015), ‘Commission opens formal investigation into Amazon's e-book distribution arrangements’, press release, 11 June [http://europa.eu/rapid/press-release_IP-15-5166_en.htm]. European Commission (2015), ‘Commission sends Statement of Objections on cross-border provision of pay-TV services available in UK and Ireland’, press release, 23 July [http://europa.eu/rapid/press-release_IP-15-5432_en.htm].
3. In addition to potential anticompetitive effects, the potential efficiencies and pro-competitive effects have been considered by authorities in many of the cases assessed in the report. However, very rarely have they been accepted, partly due to a lack of reliable evidence and the challenges of demonstrating that the relevant vertical restraints are indispensable to achieving those efficiencies/benefits. One case where retail price maintenance was allowed is the Tooltechnic case, where Australia’s Competition and Consumer Commission granted conditional authorisation to engage in a minimum retail price for a specific brand of product due to the product’s complexity and low consumer awareness, and consequently a strong need for point-of-sale service by retailers. Australian Competition and Consumer Commission (2014), ‘Determination, authorisation number A91433’, 5 December [http://registers.accc.gov.au/content/index.phtml/itemId/1179445/fromItemId/278039].
4. See, for example, Rey, P. and Stiglitz, J. (1995), ‘The role of exclusive territories in producers’ competition’, RAND Journal of Economics, 26:3, pp. 431–51; and Rey, P. and Vergé, T. (2005), ‘Bilateral control with vertical contracts’, RAND Journal of Economics, 35:4, pp. 728–46.
5. For example, see Winter, R. (1993), ‘Vertical control and price versus non-price competition’, Quarterly Journal of Economics, 108:1, pp. 61–76; Marvel, H. and McCafferty, S. (1985), ‘The welfare effects of resale price maintenance’, Journal of Law and Economics, 28, pp. 363–79; and Mathewson, F. and Winter, R. (1998), ‘The law and economics of resale price maintenance’, Review of Industrial Organisation, 13, pp. 57–84.
6. Verouden, V. (2008), ‘Vertical Agreements: Motivation and Impact’, Issues in Competition Law and Policy, pp. 1813–40; and Buehler, S. and Gärtner, D. (2013), ‘Making Sense of Nonbinding Retail-Price Recommendation’, American Economic Review, 103:1, pp. 335–59.
7. Wolinsky, A. (1983), ‘Prices as signals of product quality’, Review of Economic Studies, 50:4, pp. 647–58; and Marvel, H. and McCafferty, S. (1985), ‘The welfare effects of resale price maintenance’, Journal of Law and Economics, 28, pp. 363–79.
8. For a discussion of this effect, see Veblen, T. (1899), The theory of the leisure class: An economic study of institutions, Unwin Books; and Amaldoss, W. and Jain, S. (2005), ‘Conspicuous Consumption and Sophisticated Thinking’, Management Science, 51:10, pp. 1449–66.
9. All quotes from Oxera/Accent survey. Emphasis added.