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Are we naively restrained? : A critique on former US Solicitor General, Robert Bork’s view that vertical restraints are always in the best interest of consumers

In this article, Mashal Aamir (4th year LL.B), critically discusses the pro and anti-competitive effects of vertical restraints and the extent to which EU Competition law is in line with, or diverges from, Bork’s statement that vertical restraints should be lawful in the consumer interest
 

 

Are we naively restrained? : A critique on former US Solicitor General, Robert Bork’s view that vertical restraints are always in the best interest of consumers

 

Introduction

 

Vertical agreements are made between undertakings which operate on different levels of the production process, such as a supplier and retailer. The contractual restrictions employed in vertical agreements are called vertical restraints and are adopted, inter alia, for facilitating the distribution of goods and services.[1] Efficient distribution is a crucial part of business success, which in turn facilitates the economy. This is why the legal framework surrounding distribution arrangements are important and, in the past, the Commission’s treatment of vertical agreements have been criticized for being inefficient. In response to this the newest regulation is the Vertical Agreements Block Exemption Regulation 2010.[2]

 

With one of the goals of the single market being to increase competition, there is great debate over whether vertical restraints help facilitate that goal. Judge Bork has a strong stance that they do and always benefit consumers but I shall assess his conclusion after an overview of the effects and legality of vertical restraints and then the limits competition law place upon them.

 

What Bork fails to mention is that many of the positive and negative effects of vertical restraints is contingent on the context they are imposed in, it can vary in different scenarios but the main effects to consider are resale price maintenance (RPM), territorial restriction, the free rider problem and restriction of intra-brand competition. Territorial restriction remains an objectionable effect of vertical restraints particularly because it jars with the overriding EU goal of market integration and the role of competition law within the internal market. An effort is made to balance limitations on cross-border trade for distribution agreements and the procompetitive effects of imposing these agreements.

 

  1. Critique of Bork’s View

 

Bork believed vertical restraints should be lawful, as they were imposed to create efficiencies.[3] He is challenged for not making reference to different consumers, new or existing, as well as new or existing products. Vertical restraints are considered to assist the introduction of new products and provide net benefits, yet overall most contend Bork and feel a hostile approach should be taken.[4]

 

In comparison to horizontal restraints, vertical restraints are generally more favoured by the Commission, being regarded as less harmful. Bork was correct in saying vertical restraints have pro-competitive effects. Vertical restraints can be used to reduce transaction costs as well as other objectives, such as achieving efficiencies between firms at different levels of the production and distribution chain.[5] In its guidelines, the Commission highlights the vast range of efficiencies that are achieved due to vertical restraints.[6] Furthermore, a benefit based on vertical restraints is a potential solution for the free-rider-problem.[7]

 

Bork believed manufacturers impose vertical restraints as it encourages distributors to then supply certain customer services. He feels restraints are only imposed by manufacturers when the resulting factor is an increase of sales which in turn means higher profits.[8] In relation to how this benefits the consumers, they purchase more of the manufacturer’s product when the value of the supplementary services is greater than the addition cost the distributor adds on in order to cover their expenses.[9] Under Bork’s view, there is a corresponding interest with consumers and manufacturers, as vertical restraints encourage higher profits for the manufacturers, but only when consumers themselves received more marginal value from the increase of services. This is an ideal situation and under this assumption it is easy to say that all vertical restraints should be lawful, however not every scenario is clear cut and we shall look into areas where the interests of the consumer and the manufacturer do not align.

 

  1. Do Vertical Restraints Always Benefit Consumers?

 

A wide variety of choice is always desirable for a consumer, therefore they prefer strong intra-brand competition.[10] When distributors compete over the same product, they will reduce their profit margins and perhaps compete in a non-price way, all of which benefits consumers. Vertical restraints can detrimentally reduce intra-brand competition and create obstacles that prevent market integration, which is harmful to consumer interests.[11]

 

Bork can be criticized for using an overly simple test; that restrictions on output are anti-competitive, whilst increases in output are pro-competitive. Consequently, when a manufacturer imposes restraints these must be efficiency-enhancing as well as procompetitive, “otherwise, the manufacturer would not employ the restraint”.[12]

 

Comnor also notes Bork’s over-simplification, as “the efficiency of vertical restraints is far less certain” than Bork posits.[13] Bork acknowledged this but continued to argue that the manufacturer would still only use vertical restraints when the value added to the service for consumers increases the cost it entails.[14] Bork stood by his view that an increase in profits was the criteria for efficiency. We can criticize this for holding up only on the basis that consumer and manufacturer interests both coincide with each other, yet this is seldom the case, as both actors have different motives and aligning their interests involves some give and take, which Bork presumes in his analysis. However, Bork’s theory has gained popular acceptance due to the argument that vertical restraints would not be imposed by manufacturers - if consumers themselves did not find the new value of services is worth more than their cost. If this was not the case a rival could offer the same product without the additional services. Bork still fails to consider the fundamental economic rule that consumers are irrational, there will be differences between them over preferences for services and due to these differences their interests might not necessarily align with manufacturers interests.

 

Michael Spence argues that when manufacturers decide the amount of product to produce they only consider marginal consumers, those who are sensitive to a change in product.[15] He further analyses that not all consumers are marginal consumers- a distinction which Bork fails to make. Some consumers have inelastic demand preferences and therefore the change in price will not affect their demand for it, Spence argues it is only the preference of marginal consumers that determine if a change in the product will increase sales and consequentially manufacturer’s profit. Spence may over-emphasize the role of marginal consumers for it is the aggregate demand of all consumers that reflect any loss or gain for the manufacturers. However, what we can derive from him is the coinciding interests of manufacturers and consumers is not as clear cut as Bork basis his entire assumption on. This is why Spence says vertical restraints being imposed may not lead to an efficient result for the interests of infra-marginal consumers. It follows that if they make up the greater portion of customers that pay for unwanted services, this can exceed the benefit which marginal consumers derive. In conclusion simply because the manufacturer profits from services does not mean that consumers benefit from the supply of these, these services could even be oversupplied much beyond the optimum level for consumers.[16]

 

  1. The Detrimental Effects of Vertical Restraints

 

Previously a formalistic approach was adopted due to a wide interpretation of Article 101(1) TFEU and then under Regulation 17 many vertical agreements required exemption under Article 101(3). This was a slow process for it was just the Commission which had sole power to grant exemptions while a formalistic approached hindered efficiency in distribution. VABER[17] gave a more general solution under Article 101(3) while the Commission notes in its Guidelines on Vertical Restraints that the focus under Article 101(1) will be based on the economic effects of vertical agreements as well as agreements involving market power or foreclosing access to markets.

 

Though the commission has shifted from a formal approach to a more economics based approach, economic theory on its own is not sufficient in predicting whether imposing vertical restrains will benefit consumers. Consumer benefit is contingent on whether the gains to marginal consumers outweigh the losses to infra marginal consumers.[18] As a sect of consumers who are infra-marginal can lose out, especially when vertical restraints are applied to established products, then there is a portion of consumers that can be harmed by them.

 

As mentioned, vertical restraints can be detrimental when infra-marginal consumers do not place as much value on the extra services as marginal consumers do. This can be due to different reasons, firstly vertical restraints often support services being provided such as advertising due to the fact that the free-rider problem is prevalent in this aspect. When a new product enters a market vertical restrains can increase consumer welfare because there will be a demand for information about these products, under these conditions vertical agreements are more favourable and beneficial. Without vertical restrictions for new products the distributor might not distribute the product at all, which is why it has been recognized that certain distributions agreements need territorial protection, as seen in Societe La Technique when Article 101(1) is not breached if the term is essential for the distributor to market the product.[19] Therefore limited territorial exclusivity is permissible but it is not lawful to completely obstruct parallel imports. Consten and Grundig established the ban on absolute territorial protection.[20] We can see a strict approach here is necessary, for these restrictions can hinder the market by isolating national markets. It is important to have some sort of parallel trade from outside territory.

 

However, most consumers who regularly purchase the product as less likely to value the additional services due to their prior knowledge of the product. This highlights the complexity of consumer preference which Bork fails to consider. Producers may therefore be supplying services in excess of demand. The way these consumers are divided into infra marginal and marginal consumers is relevant to the response in additional services and whether vertical restraints are overall effective or detrimental.  In this scenario it is better off not to have vertical restraints and we can argue they should be unlawful.

 

A key reason vertical restraints are imposed is to combat the free rider problem amongst distributors of the same product. Telser felt manufacturers benefit from RPM as the quantity sold depends on the final price paid by consumers so the manufacturer gains from competition between dealers to decrease distribution margins.[21] If rival products are fairly similar, not only does this increase competition but the free rider problem could still prevail even with vertical restraints. Say a manufacturer were to impose the restraints and provide services alongside their product, consumers can benefit from these services but then seek out a rival manufacturer’s similar product which is sold at a lower price. This renders the vertical restraint ineffective and the free rider problem prevails. It reflects that the products amongst rivals should be sufficiently different or unique enough for the imposition of a vertical restraint to be effective.

 

Therefore, when a vertical restraint is adopted in the context of promoting a provision of distribution services the relevant question from a competition law perspective is whether consumers are better off with the higher price and additional services or if they were in fact better off with the lower price and no additional services. As its effectiveness in relation to consumer welfare depends upon the context it is not, as Bork suggests, always beneficial to consumers.

 

There are also challenges such as the hold-up problem, this is when you are making a very specific investment to a transaction or a product in the hope that a manufacturer commits with you to sell these products. It is called a hold-up problem because when the party makes an investment that is very specific to you, they have stronger bargaining power and it restricts other competitor’s products being given the same opportunity.[22] This is another type of economic problem that may prevent markets from running efficiently.

 

We can counteract this argument with that of economies of scale for there may be efficiency of vertical agreements because when a manufacturer can plan with more certainty its production and there is more output it can lead to economies of scale. Economies of scale benefit consumers when the manufacturer’s efficiency gains pass on as lower prices.

 

  1. Balancing Objectives 

 

The court has generally taken a flexible approach to considering when by Art 101(1) there has been a restriction of competition. We should look to territorial restraints which are significant for vertical agreements. On appeal the court in Consten and Grundig stated that unless the object of the agreement is to restrict trade, an analysis of the effects of the agreement is needed.[23] The court stated absolute territorial protection is prohibited under Article 101(1) and emphasized the Commission should have prohibited the creation of absolute territorial protection- but not other clauses in the agreement. Though this was a decisive case where it was show the provision of territorial exclusivity did not infringe Article 101(1), this was balanced against prohibiting absolute territorial protection- the line has since been clouded however in cases (Van Vliet) which reflected a more restrictive approach to exclusive distribution agreements.[24] Even following the implementation of VABER, the approach to territorial restrictions have not prominently changed.

 

There has been recognition that a more flexible approach should be given to vertical restraints and we have seen that in some judgements ancillary restraints may not infringe Article 101(1).[25]

 

The ‘umbrella exception’ approach under Regulation 330/2010 of VABER increases flexibility by having a list of prohibited restraints which permits non-prohibited restraints.[26] One Block exemption regulation covers all vertical agreements which also adds to flexibility. Finally a safe haven is created where the market share of either seller or buyer does not exceed 30%, this is a key element of the regulation while there is a black list of hard core restrictions, including RPM, in Article 4. Indeed, many vertical agreements may not infringe Article 101(1) therefore do not require exemptions under the Regulation for they could satisfy the Delimitis principle.[27]

 

The Commission has set a four-stage approach for analysis in the Guidelines on Vertical Restraints.[28] Firstly, the relevant market should be defined for parties and market share should be understood. Then, if market share is not in excess of 30% the agreement will be covered by the Regulation if there is no hard-core restraints. If there is higher than a 30% share an assessment will be undertook if the agreement is covered by Article 101(1) or further falls into the terms of article 101(3). We see the commissions general concern here is of a lack of inter-brand competition, for this is viewed to be more harmful than a reduction of intra-brand competition.

 

The issues facing competition law is balancing restrictions on intra-brand competition through territorial exclusivity while avoiding trade restrictions which are contrary to the market integration objective.

 

  1. The American Approach

 

In the US, the Supreme Court in Leegin[29] overturned the rule established in Dr Miles Medical Co.[30] The rule was that RPM is illegal per se, and instead this was now to be assessed under their rule of reason. In the EU, RPM remains a “hard-core” restraint under VABER, it is routinely prohibited under Art 101(1).[31] It is often argued that the EU should follow this stance however I feel we should bear in mind that though these two separate stances are often compared, a comparison of EU competition law to USA antitrust law is not always helpful or even useful, mainly because of the distinguished goals and situations we have under EU Law and its objectives of the internal market, the EU would need unique laws to facilitate this objective which is not the case for its America counterpart, while the Rule of Reason can also be criticised for its lack of certainty. There is also a big contrast in the different laws, due to Article 101(3) there is less pressure of Article 101(1) in comparison to The Shearman Act s1, to reduce a restriction of competition. EU law has a distinction, unlike the US law where vertical restraints are separated by those which have the object of restricting competition and are per se prohibited under Article 101(1) and those which require an economic analysis of the agreement’s effects.

 

 

 

Conclusion

 

There are upsides and downsides to vertical restraints and the Chicago School support distribution restraints due to the free-rider problem.[32]  Their argument is that intra-brand protection is necessary to allow distributors to effectively promote their brand and increase inter-brand competition.[33] Therefore, vertical restraints would only be harmful if a broad approach was taken where parties had market power and therefore inter-brand competition was weak.

 

Vertical restraints generally have both pro and anti-competitive effects. The same restraint can have very different effects depending on the context, which Bork failed to consider and we see that in certain instances, such as closed territories, illegality is beneficial. Thus no per-se rules are appropriate to handle vertical restraints. An economic expert opinion may facilitate the self-assessment of companies as required by EC competition law. Overall, in absence of significant market power at the manufacturer’s or retailer’s level, it is unlikely that vertical restraints are socially undesirable.[34]

 

 

[1] Rodger and MacCulloch, Competition Law and Policy in the UK and EU, Routledge (2015) p.194

[2] See Commission Guidelines of Vertical Restraints, (2010) OJ C130/1 and Commission Regulation 330/2010/EU on the application of Art 101(3) TFEU to vertical agreements and concerted practices, (2010) OJ L102.1.

[3] Bork, R The Antitrust Paradox, A Policy at War with Itself (1993) Oxford, Chapters 14-15

[4] Comanor, WS, Vertical Price Fixing, Vertical Market Restrictions and the New Antitrust Policy (1984) 98 Harvard Law Review 983.

[5] P.Rey The economics of vertical restraints, IDEI, Speech at Cargese, (2004)

[6] EC Commission, Guidelines Article 101(3), para. 33

[7] D.Boyd, Vertical Restraints and the Retail Free Riding Problem: An Austrian Perspective, (1996) The Review of Austrian Economics, Vol. 9, No. 1 pp. 119-134

[8] Bork, The Rule of Reason and the Per Se Concept; Price Fixing and Market Division (pt.2) Yale L.J 373 (1966)

[9] Bork, A reply to Professor Gould and Yamey, 76 Yale L.J 731 pg. 741-743 (1967)

[10] Competition among distributors or retailers of the same branded product

[11] M.Hughes/C.Foss/K.Ross, The Economic Assessment of Vertical Restraints Under U.K. and E.C: Competition Law, (2001) ECLR p. 427

[12]  Bork note 6 at 403

[13] Comnor note 4 page 989

[14] Bork note 7 at 733-734

[15] Spence, Monopoly, quality and regulation. 6 Bell K. Econ (1975) 417

[16] Comnor note 4 page 992

[17] Vertical Agreements Block Exemption Regulations. See Commission Guidelines on Vertical Restraints (2010) OJ C130/1 and Commission regulation 330/2010/EU on application of Art.101(3) TFEU to vertical agreements. 

[18] Comnor note 4 page 999

[19] Societe La Technique Miniere Case 56/65 (1996) ECR 235

[20] Case 58/64

[21] Tesler Why Should Manufacturers Want Fair Trade? 3.L.J & Econ. 86 (1960)

[22] Van den Bergh Foods Ltd v Commission, Case T-65/98, General Court, [2003] ECR II-4653, [2004] 4 CMLR

[23] Etablissemenet Consten SA and Grundig Verkaufs-GmbH v Commission Case 56 and 58/64 (1966) ECR 299.

[24] Van Vliet Kwasten & Ladderfabrieke v Fratelli Dalle Crode Case 25/75 (1975) ECR 1103

[25] Remia BV and Others v Commission Case 42/85 (1985) ECR 2545 and Pronuptia de Paris GmbH v Pronuptia de Paris Irmgard Schillgalis Case 161/84  (1986) ECR

[26] Commission Regulation 330/2010/EU on application of Art 101(3) TFEU (2010) OJ L102/1

[27] Stergios Delimitis v Henninger Bräu AG. Case C-234/89. European Court Reports 1991 I-00935

[28] SEC (2010) 411 final.

[29] Leegin Creative Leather Products Inc v PSKS Inc 127 SCT 2705 US (2007)

[30] Dr Miles Medical Co v John D Park & Son Co 220 US 373 (1911)

[31] Case 161/84 Pronuptia de Paris GmbH v Pronuptia de Paris Irmgard Schillgalis (1986) ECR 353 and  Louis Erauw-Jacquery v La Hesbignonne Case 27/87 (1988) ECR 1919

[32] Marvel, HP, The resale Pirce Maintenance Controversy; Beyond Conventional Wisdom (1994) 63 Antitrust LJ 59, pg.69-71

[33] Tesler, LG, Why should manufacturers want fair trade? (1960) 3 LJ & Econ 86.

[34] Dr.Hildebrand Economic analyses of vertical agreements: a self-assessment  Kluwer Law International (2005)

 

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