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How the Chicago School Overshot the Mark
Economic Analysis of Exclusionary Vertical Conduct: Where Chicago Has Overshot the Mark
Competition for Exclusives
It has been argued in a number of recent influential antitrust cases that competition for exclusives can prevent anticompetitive harm. Confidence in the constraining power of competition for exclusives has led a number of U.S. courts to take a very permissive approach to exclusives with a short contractual duration.
However, in my view, the real competitive constraints created by competition for exclusives should not be overestimated when there is a dominant firm or the market is highly concentrated. This process differs from competition in the sale of goods and services in a number of significant ways that can limit its benefits to consumers. To begin with, when a firm pays a supplier, distributor or customer to deal exclusively with it, it is not simply paying to obtain an additional supply source, or channel of distribution, or customer for itself. It also is paying for the right to exclude rivals from that supply source or channel of distribution or customer. In fact, exclusion may be the sole or primary function of the exclusivity.
This is not to say that exclusives are always anticompetitive. Exclusives can eliminate free riding, improve coordination or create other efficiency benefits. However, efficiency benefits are not inherent in exclusives. Exclusives instead might reduce competition by destroying rivals’ efficient access to key inputs, make experimentation more difficult and raise switching costs. Stated most simply, the firm may be purchasing market power as well as a channel of distribution, source of supply or additional customer.
There are a number of other reasons to be skeptical of the consumer protection provided by competition for exclusives. First, in some situations, there may not be real competition for the exclusives. An incumbent firm may obtain long-term exclusives before there is another competitor on the horizon. By the time the entrant is poised to enter, the key input suppliers may be tied up in long-term exclusive contracts. For the reasons discussed later on, one cannot count on the suppliers to make decisions that adequately protect the interests of consumers in these circumstances.
Second, even where competition for exclusives does occur, it may not take place on a level playing field. The exclusives tend to be worth more to a dominant incumbent than undoing the exclusive is worth to an equally efficient entrant. This is because the entrant can earn only the (more competitive) duopoly return, whereas a dominant incumbent may earn the monopoly return if entry is deterred or significantly constrained. For example, suppose that the incumbent could earn $200 if it gets the exclusive and so is able to maintain its monopoly. If the entrant gets distribution and breaks the monopoly, suppose that the entrant and incumbent each would earn $70, for a total of $140. Because competition transfers wealth from producers to consumers, the total profits fall from competition (e.g., from $200 to $140). In this case, the entrant would be willing to bid up only to $70 to obtain distribution, an amount equal to its profits from entry. In contrast, the incumbent would be willing to bid up to $130 for an exclusive that prevents the entry, an amount equal to the reduction in its profits from competition. The incumbent thus would win the bidding against an equally efficient entrant and maintain its monopoly. The monopolist would continue to charge the monopoly price for its output, harming consumers. The only difference is that now the distributors would obtain a share of the monopoly profits.
This result does not depend on unusual conditions. We assumed that the entrant was equally efficient. The monopoly result occurs whenever and because aggregate market profits fall from competition. This is a very general condition when the entrant is equally efficient. This example also shows why competition for exclusives cannot be assumed to reach the efficient outcome.
This is not a “deep pocket” argument about the incumbent having more wealth or better access to the capital market. The incumbent’s bidding advantage comes from the fact that it has already sunk the costs of entry, together with the fact that monopoly profits exceed the profits in the more competitive post-entry market. Entry barriers are raised because the entrant’s need to outbid the incumbent artificially raises its costs of entry. The bidding disadvantage faced by the entrant is “artificial” in the sense that the exclusivity does not have real and direct efficiency benefits in the example, but instead has the sole effect of raising barriers to entry.
Third, exclusives increase switching costs and eliminate the ability of suppliers or consumers to experiment by devoting only a portion of their business to the entrant. This in turn raises their risk of switching. For the entrant, this decreases the likelihood that entry will succeed. This increased difficulty of coordination and the resulting barriers to entry and expansion are reinforced if the exclusive contracts are long-term and have “staggered” expiration dates. These factors extend the period before the entrant can achieve viability. They also reinforce the consumers’ or suppliers’ expectations that the entry will not succeed, which will in turn make them less willing to take the risk of forgoing the exclusive in order to remain available to the entrant. As a result, they will require larger inducements to switch to the entrant, thus raising entry costs still further.
This analysis of experimentation and switching costs suggests another reason why the entrant may face a bidding disadvantage. The retailers may not find the entrant’s product adequate as its only offering, whereas the incumbent’s product may be sufficient. In this situation, the entrant does not desire (nor could it practically obtain) an exclusive. Instead, it wants only to maintain nonexclusivity. In some situations, the distributor might be able to substitute a number of independent brands for the incumbent. But, in a bidding situation, these independent firms would face coordination problems in bidding against the dominant incumbent.
Fourth, even if exclusives are terminable at will or embedded in short-term contracts, they still erect a difficult coordination problem for an entrant. This increases the risk that the entrant will be unable to get enough distributors or enough customers to rapidly achieve minimum viable scale and maintain adequate investment incentives. Bidding still does not take place on a level playing field. It may be difficult for an entrant (or entrants collectively) to convince enough suppliers or consumers to switch at the same time. As a result, the exclusives also can lead retailers to expect entry to fail, raising the fees the entrant must offer.
This is not to say that competition for exclusives has no constraining effects at all. It can constrain the attempt to maintain a monopoly to some extent. This is because the need to purchase exclusives also is costly to the incumbent firm. This cost of buying exclusives can act as somewhat of a deterrent. However, the constraint is limited and does not eliminate competitive concerns. Nor would short duration exclusives legitimately provide the basis for an exemption from antitrust scrutiny. Even with short duration exclusives, the entrant(s) will face certain coordination problems. The more important question is whether the exclusives create real procompetitive efficiency benefits and whether those benefits will be passed on to consumers in a competitive output market. This is only likely when exclusives are divided up among several viable competing firms in the output market.
This last point raises the question of why a retailer or consumers ever would cooperate by agreeing to an exclusive that might allow a dominant firm to achieve market power. However, this result can occur because an individual distributor or consumer ignores the effect of its decision on others. As a result, the dominant firm can compensate the retailer or consumer for its own harm and still earn money from the incremental power gained with respect to others. In addition, if a retailer or consumer believes that the entrant likely will fail because others are granting exclusives, then it would not require significant compensation to grant exclusivity as well. Both these reasons flow from the same point: competition is a public good.
Thus, simply because entrants and smaller competitors have the theoretical potential to outbid a monopolist for distribution or shelf space should not be treated as sufficient defense in an antitrust case. The theoretical ability to compete for exclusives may not be a practical ability, and the competition may not take place on a level playing field or in a way that consumer welfare and efficiency will be protected. Similarly, exclusive dealing should not be per se legal.
