Intensive and exclusive distribution

Chapter 2
Review of Related Literature and Studies
Foreign Studies
According to the report made by Dr. Cristina Caffarra and Prof. Kai-Uwe Kühn, University of Michigan from CRA International, vertical restraints have traditionally raised concerns in antitrust enforcement because they tend to limit the degree of competition between retailers distributing products of the same manufacturer (so-called “intra-brand” competition). However, from an economic point of view it is puzzling that a manufacturer would ever restrict competition between retailers: any such restriction of competition would increase the retailers’ (downstream) margins at the expense of the manufacturer’s own (upstream) margin. Everything else equal, manufacturers would like very intense competition between their retailers in order to extract maximal profits from their products. This basic insight has not only undermined the traditional view of vertical restraints, but also posed a challenge to economic theory. Why would manufacturers impose competition-reducing constraints (such as exclusive dealing, territorial exclusivity, selective distribution, etc.) on retailers if these increase the profits of retailers at the expense of manufacturers?

The economic literature has studied this question extensively, and identified several efficiency reasons why manufacturers may want to guarantee downstream margins in order to induce retailer behavior that increases demand overall. In this section they discuss the many facets of this efficiency argument, and contrast it with anticompetitive theories of vertical restraints. They conclude that it is much more likely that a manufacturer would reduce competition between its retailers when it is motivated by efficiency concerns. The available empirical research confirms that vertical restraints reduce intra-brand competition but at the same time also tend to increase sales. The empirical literature thus largely supports the efficiency explanations of vertical restraints. In the relationship between a manufacturer and a retailer, the retailer will normally take actions aimed at maximising its own profits. However, on any unit sold by the retailer the manufacturer will typically make some margin. The actions of the retailer will therefore have some impact on the upstream manufacturer’s profits by affecting the quantity sold. But normally a retailer will not take this effect on the manufacturer’s profits into account. For this reason, the retailer generally takes decisions that do not maximise the joint profits of the vertical structure (manufacturer and retailers). Decision making in the vertical structure will then be inefficient. The impact of retailers’ actions on the manufacturer’s profits is called a “vertical externality” in the economic literature on vertical relationships. In most of this literature, vertical restraints are explained as contractual agreements that help align the incentives of the retailers with those of the manufacturer, thus eliminating the vertical externality.

In other words, vertical restraints help replicate the incentives a manufacturer would face if it were vertically integrated into retailing. Vertical restraints can therefore be viewed as contractual restrictions that allow the replication of vertical integration without the manufacturer taking ownership. Any deviation of behaviour from that of an integrated structure arises because the margin of an independent retailer is lower than the margin of an integrated structure. This can come about either because the marginal wholesale price exceeds the marginal cost of manufacturing, or because competition between retailers reduces the margin for any wholesale price. The first problem arises because, typically, the manufacturer needs to raise the (marginal) wholesale price above the marginal cost of manufacturing in order optimally to extract profits from his sales. This creates an “upstream margin”. The marginal cost faced by the retailer is then the marginal retailing cost plus the wholesale price, which is higher than the total. There are some very limited assumptions under which two-part pricing can fully resolve the problem. However, these are almost never relevant in real industries. The difference between the retailer margin and the industry margin is a property of almost all vertical structures. There are in fact a number of reasons why vertical restraints can be more efficient than outright vertical integration. A leading issue is that for many products there are large economies of scope in retailing that prevent vertical integration for most manufacturers.

Another reason is that vertical integration will typically induce a separation of ownership and control for the downstream retailers, which can lead to important agency problems that might be even more severe than those that arise under simple contracting marginal cost of a vertically integrated entity. Hence, the downstream margin is lower for the independent retailer than for a vertically integrated unit at any retail price. The second effect is present when there is downstream competition. Suppose that competition is perfect at the downstream level, and as a result the downstream price-cost margin is zero. If there are demand-enhancing activities (e.g. sales effort) that the retailer can undertake, then there is no return on such activities and the retailer would not undertake them. But since the marginal wholesale price exceeds the marginal manufacturing costs this is inefficient: there would be a return to demand-enhancing activities from the point of view of a vertically integrated structure. Both effects therefore lead retailers to make decisions based on a price-cost margin that is “too low” from the industry perspective. This leads to a number of well-known inefficiencies in the absence of vertical restraints: The “double marginalisation” problem. According to them, an independent retailer will set the final price based on the wholesale price he faces from the manufacturer, which includes a margin on the manufacturing cost. Because it includes this margin, the “marginal cost” which the independent retailer faces is higher than the marginal cost that an integrated manufacturer/retailer would face. As a result the final price is too high relative to the one that would maximise the joint profits of the vertical chain.

Both the firms and the consumers would benefit from elimination of this “double marginalisation”. Double marginalisation problem arises because the retailer generally has some market power. If retailers were perfectly competitive, they would not be able to extract a margin, and the manufacturer could set his wholesale price (and effectively the final goods price) just at the level that maximises joint profits. This means that in the absence of demand enhancing activities by the retailer, the manufacturer would like to induce as much competition among his retailers as possible. However, this conclusion is altered when the manufacturer has to give the retailer incentives for demand-enhancing activities (besides the setting of the retail price). This creates a conflict between the extraction of rents – for which competition between retailers helps – and giving incentives for demand enhancing activities – which requires a retailer margin. This is a general problem in markets where producers of complementary products set prices independently. This was first observed by Cournot in his book Recherches sur les principes mathématiques de la théorie des richesses (Researches into the Mathematical Principles of the Theory of
Wealth), 1838 (1897, Engl. trans. by N.T. Bacon). Retailer advertising (either persuasive or informative) will increase the number of buyers who purchase the product of the manufacturer. Since the margin of the retailer is smaller than that of an integrated firm, advertising will be too low compared to an integrated firm. To the extent that advertising increases the number of buyers who know about the availability of the product, there is again the possibility of a Pareto improvement when advertising is increased.

Note that in contrast to the double marginalisation problem this vertical externality cannot be resolved through more competition at the retail level. Competition at the retail level erodes downstream margins, thus reducing the incentive to provide retailer advertising. Efficient solutions will therefore necessarily require restricting competition between retailers. Retailer effort might not consist of advertising as we normally know it but might instead amount to giving advice to the customer as to the product they should choose. Buyers may not be completely informed about all characteristics of a product and value an improved “match” with the most suitable product. The retailer will achieve a better match between buyer and product, and therefore achieve higher value for the buyer, the greater the retailer effort. Again, a retailer will not capture the full value of increasing the likelihood of a sale, leading to too little effort in matching the customer with the right product. Achieving a better match can improve both the joint profits of manufacturers and retailers as well as increasing consumer benefits from a purchase. Conflicts between upstream and downstream incentives can also arise concerning the decision to carry a specific product. Typically, there is some fixed retailing cost associated with carrying a product. This may consist of the shadow value of the shelf or retailing space dedicated to the product at the retail outlet. A product with low market share will tend to “sit” on the shelf for longer, and the retailer may need to be guaranteed a larger margin to carry it. In such a case, competition between retailers may make it much more difficult to resolve such conflicts. As an example, consider a retailer with a large amount of retailing space and a retailer with little retailing space.

In order to convince the smaller retailer to carry the product the manufacturer has to guarantee the smaller retailer a larger margin than the larger retailer. This will often only be possible if competition between retailers is limited because the wholesale price cannot be reduced sufficiently for the product to be carried. However, it may be better for the manufacturer (and for consumers) if more retailers carry the product – despite the difference in relative retailing costs. This is an especially important consideration for manufacturers who are market entrants. A related idea is discussed in Marvel and McCafferty (1984), who emphasise the role of quality certification of products by reputable retailers. Marvel, Howard and Stephen McCafferty, “Resale Price Maintenance and Quality Certification”, Rand Journal of Economics, 15 (1984): 346 A retailer may have less of an incentive to carry a product of the manufacturer or make a strong effort to win sales for the manufacturer through retailing effort because the retailer also carries the competing products of other manufacturers. Additional effort to sell the product of one manufacturer partly redistributes some of the sales from one manufacturer to the other, which is of no great advantage to the retailer. This effect may reduce overall sales effort below what manufacturers would choose were they to sell directly. Similarly, these incentives may limit the range of products that a manufacturer supplies. Economic theory predicts that a retailer has an incentive to carry a narrower product line than the upstream manufacturer would like it to. Both effects can limit competition between manufacturers, as they reduce the ability to provide a greater variety of choice to customers. Without vertical restrictions to offset this incentive, the retailer would have inefficiently low variety in its brand portfolio. However, selective distribution systems are very different because they deny potential retailers the opportunity to carry the product. Such vertical restraints then increase the profits a rival can make in a deviation.

These theories are therefore not applicable to selective distribution systems. Moreover, if antitrust enforcement against collusion is rigorous it seems inappropriate to prohibit vertical restraints on this basis. Because vertical restraints have great potential for efficiency enhancement, it appears unreasonable to prohibit them in the absence of clear evidence of collusion. But if such evidence exists, enforcement against collusion should be sufficient to prevent collusive conduct. Furthermore, there is no evidence that points to the empirical relevance of these effects. Essentially, this concern would come down to a plausible possibility of one manufacturer denying access for another manufacturer to sufficient retail outlets.

This concern appears implausible in industries where the retail function is relatively fragmented, so that a manufacturer could not realistically deprive a competitor of customers, by foreclosing access to retail outlets. For this to be an issue at all, very strong market power and very exceptional circumstances would have to be in place. In the absence of such exceptional features, there can be no realistic exclusionary concern. Such concerns are particularly out of place for the selective distribution networks in the luxury goods industry. Selective distribution does not establish an outlet as an exclusive retailer for a manufacturer. Indeed, it simply limits the number of retailing outlets that a manufacturer sells. This means that selective distribution networks cannot possibly have exclusionary effects on other manufacturers.

The incentive effects arise powerfully in the luxury goods industry. As a result, a set of vertical restraints appears to be necessary to enhance the efficiency of distribution. This has long been recognised by competition authorities. “Luxury” products appeal to large sections of consumers because of their lifestyle associations. Market research (and the marketing literature) consistently find that consumers value the luxury “feel” of their experience with the product (from packaging to texture to colour to scent) and buy luxury goods with the intent of enhancing their image – both in their self perception, and in their desire to present an appealing image to others. This is a common feature of fashion-related products. This means the value of a specific purchase will often be related to how others view the product, and a deterioration of image even in the assessment of people who are not consumers of the product can reduce the value of the product to the customer. The “image” of a brand is therefore an integral part of the product, and determines the willingness to pay of consumers. Manufacturers of luxury goods invest heavily in preserving (For instance in the YSL perfume case in 1991 (16th December, 1991, IV/33.242 – Yves Saint Laurent Parfums), the Commission recognized: “Since the maintenance of a prestige brand image is, on the luxury cosmetic products market, an essential factor in competition, no producer can maintain its position on the market without constant promotion activities.

Clearly, such promotion activities would be thwarted if, at the retail stage, Yves Saint Laurent products were marketed in a manner that was liable to affect the way consumers perceived them. Thus, the criteria governing the location and aesthetic and functional qualities of the retail outlet constitute legitimate requirements by the producer, since they are aimed at providing the consumer with a setting that is in line with the luxurious and exclusive nature of the products and a presentation which reflects the Yves Saint Laurent brand image. In addition, the criterion relating to the shop-name is designed to ensure that the name of the perfumery or shop or area within the perfumery counter or perfumery is situated is compatible with the principles governing the distribution of the products in question and thus to exclude any name whose image would be associated with an absence of or restriction in customer service and in standing and with a lack of attention to decoration. It should e stressed in this respect that the down-market nature of a retail outlet or of its name cannot be deduced from the retailer’s habitual policy on prices.” And further, in analysing YSL’s so-called “closed network” clause: “…….. the requirement incumbent on Yves Saint Laurent Parfums or, where appropriate, its exclusive agents to market the products bearing the Yves Saint Laurent brand name only in retail outlets that meet the conditions specified in the selective distribution contract is complementary to the specialization requirement imposed on authorized retailers and makes it possible to ensure uniform conditions of competition between resellers of the brand.

Otherwise, competition would be distorted if Yves Saint Laurent Parfums supplied traders which, not being subject to the same obligations, had to bear financial charges that were appreciably smaller than those borne by the members of the selective distribution network. In such a situation, it would no longer be possible to require authorized Yves Saint Laurent retailers to continue to carry out their own obligations, with the result that the selective distribution system could no longer be maintained.”) the image of the brand through advertising, promotions and endorsements, and in making sure each product reflects and supports the brand image. They do so because customers positively value the image that is associated with the brand and the product, for they perceive that image in part attaches to them when they choose and wear (or otherwise use) the product. Consumers also attach value to the experience of buying the good because it affects their assessment of brand image. It is important that the presentation and the environment in which the good can be bought reflects the type of luxury experience that consumers aim to obtain through the purchase of the good. Finally, the choice of a specific product is highly personal, as it reflects an image that a buyer has of herself, as well as the image the buyer wants to project to others. It is therefore important to provide the buyer with an opportunity to find the most suitable match between the whole range of products on offer and her own specific needs.

In particular, the assessment of the image that is projected to others can be better assessed when the customer is provided with some feedback by a sales representative. Because many luxury goods are “experience goods” (e.g. we do not know how good a lipstick looks or a perfume smells on us until we’ve actually worn it), a “bad experience” with an unsuitable product may make consumers switch away from the brand altogether – even though a better “match” for the individual’s preferences might in fact be available in the brand portfolio. A “bad match” in the short run (e.g. through poor advice at the point of sale) has a cost both for the manufacturer, as it may lead the customer to switch brand altogether (long-run substitution to another brand), and potentially for the customer herself (if by switching brand she ends up with a suboptimal choice). A first concern for the manufacturer is to ensure that the product is sold only in outlets whose “image” (location, type of outlet, outlet name, quality of fixtures and fittings, other brands sold) is consistent with the image the manufacturer is seeking to achieve for the product. Surroundings that do not conform to the luxury image of the product in one location will tend to diminish the value of the product to the consumer also at another – better – location. Ensuring consistency in the “image” of the product across points of sale may therefore be very important to the overall valuation of the product by consumers in this industry. The presentation of the product (e.g. the product display) within the retail outlet is equally important. Such presentation involves a greater investment for luxury products than for many other products, and is therefore subject to the vertical externalities discussed in the theory section of this paper. Without any vertical restraints, retailers would have a tendency to invest too little to ensure a quality “presentation” of the product. It may also be difficult to project a coherent image for the product in the first place.

Contractual restrictions can be used in a relatively straightforward way to deal with presentation issues, since shop characteristics and retailer investment in the presentation of the product are in principle observable by the manufacturer (and can be verified by an outside court). Instead of providing indirect incentives for effort, the manufacturer can directly specify the required standards the retailer needs to adhere to in the contract. This is precisely what happens in practice in many cases: contracts with retailers list a set of “qualitative criteria” the retailer agrees to meet and maintain. CHANEL pointed out besides the image of the product, the manufacturer wants to achieve the optimal “match” between customer and product. One aspect of this problem is that the manufacturer will want to ensure that the retailer carries the widest variety of the manufacturer’s products. This generates the greatest likelihood that a customer will find a good match within the product portfolio. As we have discussed, a retailer serving multiple manufacturers will have too small an incentive to carry the full product line. To ensure that retailers do not only carry a small number of best selling products but a wider product range, the contract can stipulate requirements of the range of products that has to be offered. Again this is an easily enforced restriction that takes care of a serious vertical externality problem.

This is an economically reasonable and efficiency-enhancing restriction in contracting environments in which the matching issue between product and customer is an important element of the retailing activity. A second aspect of “matching” consumer and product is harder to enforce: the “feedback and advice” that is offered to the customer about the image the customer projects as a result of choosing a particular product. The problem the manufacturer faces here is that when there is competition in the retail market, there are strong incentives for each retailer to minimise expenditure on trained staff, and free ride on the matching services of other retailers. A customer could thus visit one retailer, get all the advice she needs and then buy the product from another outlet that does not offer these services but offers the product at a lower price. Of course the advice will be better, and the cost of offering the advice lower, if the sales staff are better trained at advising customers. Making training available and requiring retailers to send staff to the training provides a direct way for the manufacturer to address part of this incentive problem.

Furthermore, to the extent that quality can be assured by staffing levels, these can be directly written into the contract and monitored. How is the analysis we have just outlined affected by the availability of the internet as a distribution channel? Recent lobbying efforts are seeking to overturn the acceptability of established contractual restrictions as far as internet retailing is concerned. This is based on the claim that the internet fundamentally revolutionises retailing, and that the use of vertical restraints eliminates the benefits the internet can generate. Based on this argument, eBay is lobbying for a change in the vertical restraints guidelines that would effectively establish a presumption of unlawfulness for any restrictions on internet retailing. In this section we explain that there is no economic justification for such a policy. First, the arguments for the efficiency of selective distribution systems are not fundamentally changed when considering the internet as a distribution channel. Second, most of the real benefits from the internet can still be achieved in the presence of restrictions on distribution. In a general sense, an internet store is an outlet like any other. The basic motivation for the introduction of vertical restraints applies in exactly the same way as for bricks-and-mortar stores. First, the concerns about controlling the brand image are legitimate independent of the retail channel. Second, the possibility of an internet outlet free-riding on the image and services provided by bricks-and-mortar stores is just as legitimate as concerns about some bricks-and-mortar stores free-riding on others.

The analysis of the efficiencies of selective distribution systems applies independently of the specific retail channel. In this section we show that the specific technology of internet retailing even aggravates the efficiency issue and makes appropriate vertical restraints more important. Indeed, the restrictions that are currently in place for internet distribution in contracts such as those of CHANEL appear well motivated by an effort to address these incentive problems. The distinctive feature of the internet as a retailing technology is that it allows the basic transaction activity to take place at relatively low cost. Internet retailing is also unconstrained by shelf space in the retail outlet, so that concerns about ensuring that the retailer carries the full product line will not necessarily arise to the same extent (unless the internet retailer has a business model in which it needs to carry inventory of the products offered). At the same time, the implications of internet distribution for the image that luxury goods would like to project are unclear. If internet distribution were perceived as similar to an upscale department store, there may be little dilution of brand image. But the luxury image could be seriously undermined if internet distribution were perceived as similar to a discount store.

This uncertainty alone may create legitimate reasons for manufacturers to abstain from the internet as a distribution channel. As discussed, in the case of bricks-and-mortar stores “image” issues can be relatively easily taken care of by directly imposing specific conditions on the sales environment in a retailing contract. While in principle this solution is also available for internet retailing, in practice it is much more difficult for brand owners to control systematically the “image” projected by internet outlets. Design requirements cannot always be easily accommodated by the website design of an internet retailer (indeed it is as a response to this problem that CHANEL has developed an “internet sales module” software that internet retailers could plug directly into their website. In addition, in internet retailing there are large economies of scale associated with selling many different goods based on the same type of interface. For many goods the optimal presentation would rank offerings by price. For luxury goods such a presentation may well have a diluting effect on the band image. However, imposing an appropriate sales environment through a different screen presentation would increase the costs of internet retailing. Internet retailing is also a very poor technology for providing sales-related services such as personalised advice (the “product matching” role of the bricks-and-mortar retailer). As we have argued, this function of the distribution channel is very important to ensure an efficient sales structure for luxury goods. An internet store cannot provide the “matching” services (between the customer and the product) that can be provided in a bricks-and-mortar store. In a conventional outlet the customer can try out the product in real light, compare the match with his/her image and have a specialist in-store advisor provide feedback.

Physical proximity to the product and the sales person providing the feedback is essential for providing the service. None of this is possible in the case of internet purchases, as the store website can at best contain a photo and a description of the product but does not allow trying out the product and getting direct feedback. In this respect the luxury goods industry is quite different from other industries in which retailing has shifted more dramatically to the internet. Take for example the case of domestic appliances or computer equipment. Subjective assessments of aesthetic value (real light, atmosphere, trying out a fit etc.) are relatively unimportant for these products. What is crucial for the customer is objective information about characteristics and performance. This information can be very efficiently provided over the internet. It is therefore not surprising that manufacturers have found it beneficial to move a large proportion of sales for these products to the internet. In fact, today it is very hard to get any good sales advice at a bricks-and mortar retailer about a computer purchase. The difference in the characteristics of computers (or domestic appliances) and luxury goods very much explain the different importance of the internet as a sales channel On the other hand one could argue that it is no easier to select fresh produce over the internet than to buy personal luxury goods items, and yet fresh groceries are purchased in significant quantities over the internet. While that may be true, this is irrelevant for the assessment of vertical restraints.

With fresh produce it is not possible to make the selection of an especially nice apple and then buy that same apple on the internet at a lower price. Hence, an internet retailer has no opportunity to free ride on the costs a bricks-and-mortar grocery store incurs by providing a consumer with the ability to inspect the product. In this case there is no reason for a manufacturer to limit distribution over the internet and, in fact, manufacturers do not impose such limitations. This analysis does not imply that the internet cannot play any role as a sales outlet for luxury goods. Customers who already know their ideal match for a product and simply wish to reorder (i.e. repeat purchasers) may very well prefer the convenience of an internet-based order over a visit to the store. Hence individuals who have been “matched” in the past, or care little about the “match”, may well benefit from the existence of internet sales. To the extent that this is true there will be an incentive for manufacturers to have an internet presence. For the efficient design of a distribution network, a luxury goods manufacturer may thus want to reap the benefits of an internet sales channel (in terms of convenience for consumers), while ensuring at the same time that this does not negatively impact the part of the business that relies on personalised “matching services” and that such a presence does not detract from the projection of a luxury image to customers.

When luxury goods producers want to use both the bricks-and-mortar sales channel and the internet channel the difference in the two sales technologies leads to a significant problem. By its technology the internet distribution channel cannot provide the matching services of the bricks-and-mortar store. The internet retailer will therefore have lower costs, and so the internet distribution channel generates the same problem as a bricks-and-mortar retailer who does not exert sales effort. Internet retailing can therefore generate strong incentives for customers to obtain matching services in a bricks-and-mortar store, and then make the purchase from an internet-only store at a lower price. The problem of internet retailing free riding on bricks-and-mortar “matching” services would never arise if the retailer could charge for the service separately. Then the customer would pay for the service whether it takes place in the bricks-and-mortar outlet or not. Competition between bricks-and-mortar outlets and internet retailers would equalise the price of the product but incentives for effort would not be reduced because effort would be compensated directly.

The problem with such a solution is that service (or “matching” effort) cannot be measured except when it leads to a purchase. There are theoretically two ways that a customer can pay for service. First, the customer could pay for a given service time. But then it is difficult to prove that the employee worked hard enough to justify the payment. Alternatively, the employee is paid for a successful match. But then the customer can always claim that he/she did not find a match and still buy on the internet, avoiding payment for the service. Essentially, any sales effort that aims at matching the consumer with the right product cannot be contracted for. As a result, sales effort must be compensated through the purchase price of the product. In the next subsection we discuss how efficient retailing solutions can be obtained through contractual restraints. This report had identified problems, first:

a) Imposing conditions on presentation – because product presentation is directly observable, it should be possible for the manufacturer to impose directly contractual conditions on how the product must be presented for sale on the internet. Since the basic incentive problem is the same as for bricks-and mortar stores, manufacturers should be allowed to impose requirements on how the product is to be showcased – as is the case today for a bricks-and-mortar store.

Of course, the requirements will have to be different because the presentation technology differs. But while such constraints entail costs for retailers, there is no economic basis for a concern that the manufacturer could generate significant anti-competitive benefits to himself by increasing the retailing costs of his distributors. Thus insofar as luxury goods manufacturers are concerned about the implications of internet sales for the “image” of their products, they must retain the ability to write such restrictions into contracts – independently of other vertical restraints. This also means that manufacturers must be able to exclude from their distribution systems internet retailers that do not comply with these criteria.

b) Differential pricing for brick-and- mortar stores and internet retailers – One possible way to generate efficient outcomes with respect to retailing effort would be for the manufacturer to charge different wholesale prices to bricks-and-mortar retailers and (pure) internet retailers. In such a solution the internet retailers would have to pay a higher wholesale price. This could be achieved, for example, by offering bricks-and-mortar retailers a per-unit discount on the wholesale price to guarantee them an additional margin. Such a discount should be interpreted as a compensation for the costs of the sales effort. Competition between internet and bricks-and-mortar outlets would still lead to arbitrage, and possibly to greater retail price convergence between retail channels. But the retailer would still have incentives for sales effort. Allowing a manufacturer to charge systematically different wholesale prices would avoid undermining the purpose of selective distribution, while at the same time allowing customers to benefit from internet offerings. The problem with this solution is that it may be misunderstood as price discrimination and as such not accepted by competition authorities. We note, however, that from an economic perspective differential wholesale pricing does not amount to price discrimination because the difference simply reflects compensation of the retailer’s effort cost by the manufacturer.

These are therefore different transactions that should be allowed to occur at different prices. Conditioning the wholesale price on whether a retailer provides sales services or not is not a form of price discrimination. It should also be noted that differential pricing of this type would not undermine progress towards a “unified European market”, in the sense that this is commonly understood, namely the “convergence” of retail prices between countries/regions. Since an internet retailer will still compete with all bricks-and-mortar outlets in this scenario, price differences may be arbitraged away (or at least reduced). If one views such convergence as one of the potential benefits of the internet, this benefit would be preserved when internet and bricks-and-mortar outlets face different wholesale prices. Of course, differential pricing does not directly solve the problem of ensuring that internet distribution will optimally present a product image. For this purpose one would still need the right of the manufacturer to contractually restrict the internet presentation.

But under a regime of differential pricing the manufacturer would always make optimal decisions about restrictions imposed on internet presentation (and if the internet was in danger of diluting the luxury image of the brand, the manufacturer should be able to optimally decide to exclude this channel). b) Resale price maintenance – An RPM solution would be problematic in Europe as RPM remains per-se illegal here. Nonetheless, in principle RPM would have a similar effect to allowing differential wholesale pricing. The manufacturer could eliminate undercutting by internet outlets through a minimum price floor, which would allow him to guarantee the bricks-and-mortar retailer a margin for effort incentives. Again the internet presence would lead to a tendency for price equalization across different geographic regions. Economically this solution is less efficient than the one of differential pricing since the internet retailer has to be given the same margin as the bricksand-mortar retailer. This leads to inefficiently low sales through the internet channel. c) Vertical Integration into Internet Retailing by the Manufacturer – An alternative approach to escaping the free-riding problem would be for the manufacturer to integrate vertically into internet retailing.

Vertical integration would allow the manufacturer to sell only from its own site and not allow internet retailing by any other firm. Note that a firm that is vertically integrated into retailing has generally no obligation to allow competing retailers to carry the product. There are no economic reasons why a manufacturer should be treated differently if it chose to vertically integrate into internet retailing. Vertical integration into internet retailing would resolve the incentive issue because the manufacturer would fully take into account the incentive effect on retail effort when setting the internet price. On the other hand, a centralised vertically integrated internet site would allow the manufacturer to completely control the image of the luxury product. It would not involve specific investments by a separate retailer to adapt their internet presence to the requirements of manufacturer. Indeed, since any such effort would involve considerable noncontractable investments by the retailer, this may fall into the typical class of cases in which the theoretical literature suggests that vertical integration may be optimal. Hence, whether vertical integration into retailing or a decentralised solution with differential pricing is preferred will depend very much on the specific demand characteristics of the good and the particular product line.

Both solutions would go in the right direction in terms of establishing efficient incentives for sales effort – although they may differ in the degree to which product presentation can be optimally designed. d) Other Restrictions on Internet Retailing – If none of the solutions we have discussed so far are available, the only other solution that can address the incentive problem for bricks-and-mortar sales effort is to limit the scope for internet-only offerings. We tend to observe such restrictions in practice today, presumably because the other solutions we suggest currently are considered problematic for antitrust reasons. Selective distribution agreements for luxury products typically require three restrictions on internet retailing:

(a) Manufacturers typically stipulate that only a retailer with an authorised bricks-and-mortar presence can be active as an internet retailer.

(b) The price charged for internet sales has to be the same as in the bricks-and-mortar store.

(c) There are often quantitative restrictions on internet sales that establish a maximum share of internet sales in total sales for a retailer. These restrictions directly address the problem of internet free-riding that could undermine the incentives for the provision of retailing effort. Joint ownership of bricks-and-mortar and internet operations combined with uniform pricing across the two outlet types may reduce this problem because the retailer internalizes effects across the two outlet types. However, the incentive problem can only be truly solved when a sales restriction is imposed. Otherwise a bricks-and-mortar retailer could qualify as an authorised internet retailer by having a retail outlet that satisfied all qualitative and other requirements set by the manufacturer.

But by taking advantage of its freedom to set the final price (as recognised in the contract), retailer could then set a low price both for the brick-and mortar-store and the internet channel. The retailer would meet the relevant contractual conditions, but it would effectively make most of its business as an internet retailer. As the internet has no geographic boundaries (other than those created by transport cost), customers would have an incentive to seek matching effort at their local bricks-and-mortar store and then buy (and pay) only at the internet store. A retailer that has no restrictions on internet sales can effectively become the equivalent of a internet-only business that runs a small bricks-and-mortar outlet simply to qualify as an internet retailer. Then none of the incentive problems are resolved.It should again be clear that any issues concerning the presentation of product image on the internet outlet are not directly resolved through this solution. As in all other cases they are most efficiently resolved by allowing the manufacturer to directly impose restraints on the internet presentation, just as the manufacturer imposes presentation conditions on bricksand-mortar outlets.

The restrictions that was observed in CHANEL’s contracts are therefore reasonable given the potential for free-rider problems, and the difficulties that can arise with adopting other efficiency-enhancing solutions that we have outlined. While the exact proportion can be debated, a quantitative limitation of this kind is precisely what economic analysis would suggest as a natural and necessary response to the free riding problem in the absence of the instruments of differential pricing, RPM, or vertical integration into internet retailing. The solution of restrictions on internet sales volume is undoubtedly less efficient than the other solutions we have suggested above. It also reduces the scope for internet retailing to lead to the convergence of retail prices across different regions. We believe it is indeed one of the costs of a restrictive policy towards vertical restraints that potentially more efficient retailing structures are not chosen because of concerns about antitrust liabilities. In recent times arguments have been put forward that restrictions of internet distribution should be generally seen as anticompetitive, unless the manufacturers concerned can prove otherwise.

This has been advanced especially forcefully in the recent “Call for Action” paper circulated by eBay, which explicitly identifies selective distribution as one of the key “threats” to realising the benefits of the internet. The paper calls for the “EU’s Vertical Restraints Regulation (Regulation 2790/1999) to be amended to ensure that restrictions on dealers’ abilities to use the Internet are prohibited” (p.14). Central to this policy advice is the claim that the economic analysis of vertical restraints with respect to the internet should be viewed as fundamentally different from the established economic analysis because a different sales “threats” are the allegedly “outdated trade mark law”, “divergent consumer protection rules”, and “potentially incorrect implementation and enforcement of the EU Services Directive technology is involved. However, this claim has no basis in economics. The analysis of vertical contracting does not depend on any specific technology. As we have demonstrated above, the analysis remains fundamentally unchanged. Once this is clarified, it becomes clear that the critical view of vertical restraints promoted in the eBay paper is essentially a return to old arguments about vertical restraints, that the economic literature of the least 40 years has shown to be incorrect.

For instance, eBay’s paper argues that manufacturers profit from limiting intra-brand competition, and that limits on vertical restraints therefore limit manufacturer market power The eBay paper also promotes a second argument against restrictions on internet retailing. It claims that the primary purpose of restrictions on distribution channels is price discrimination – i.e. maintaining price differences – across geographic markets, because this allows for greater rent extraction. The paper states that:“… [some manufacturers] have strong interests in defending the status quo and in undermining challenges to entrenched distribution models. (…) Enormous margins are generated through the use of pricing “segmentation strategies”. These divide the market for each product into segments (often geographically), with different prices being charged in different segments. The objective: to control supply and prevent “intra-brand” competition in any one segment, thereby maximizing margins. Seeking to justify these margins, entrenched manufacturers have pointed to the value that their brands bring to the consumer – i.e. that the consumer actually benefits from paying a higher price. In light of the information now available to consumers, these claims are questionable and such strategies seem to serve only the interests of the manufacturers, and not those of the 21st Century consumer”. Essentially, the paper argues that restrictions on internet sales are adopted because manufacturers increase profits through market segmentation. Without restrictions on internet retailing, consumers would be able to arbitrage between different prices in different regions, and this would lead to uniform prices. The eBay paper completely overlooks that precisely this feature of the internet greatly complicates the resolution of the free-riding problem facing luxury goods manufacturers. As we have explained in Section 4, any shopper has the option of comparing prices in their local bricks-and-mortar store with online offers from anywhere.

But that means that having received costly “matching” services in the bricks-and-mortar store, the shopper can go home and purchase online if the online price is lower than the bricks-andmortar price. As the online store has lower marginal cost (it does not have to provide the same services), prices will be competed down to a lower margin. This will make it difficult to maintain the density of bricks-and-mortar outlets, and will therefore reduce the benefits for those consumers who value the “matching” service. The internet’s effectiveness in eliminating price dispersion across different retailers is precisely what undermines the incentive effects of a selective distribution system. Restrictions on internet selling of some sort are therefore needed to avoid the kind of free-riding problem that has motivated the adoption of selective distribution in the first place It is a common misconception, repeated in the eBay paper, that it is in the interest of a manufacturer to limit competition between retailers of his product. This is false because it is costly for the manufacturer to leave a margin to the retailer. The manufacturer benefits from greater competition between retailers, either because, for a given wholesale price, retail prices are lower and sales are greater, or because the same sales can be induced with a higher wholesale price. Indeed, an optimal response to greater retail competition typically involves lower consumer prices, higher sales, and higher wholesale prices.

This is a direct consequence of the double marginalization problem discussed earlier in the paper. This means that the manufacturer can only have an interest in ensuring a margin for the retailer if this provides incentives to the retailer for other sales-enhancing activities that the manufacturer cannot control directly. Indeed, we have seen that the empirical literature consistently finds that sales are expanded when there is private agreement to impose vertical restraints. But sales-enhancing activities benefit the customer – even when prices rise as a result. This observation has a direct policy consequence. Since activities of the manufacturer to guarantee retailer margins are only rational when sales-expanding activities are incentivised, manufacturers should not have to prove that this is the purpose of the restraint. In contrast, eBay’s paper essentially calls on policy makers to disallow vertical restraints on the internet unless an efficiency enhancing effect can be demonstrated. This directly contradicts what economic analysis suggests. The conclusion that a manufacturer should generally be interested in intra-brand competition, unless there is a need to support demand-enhancing efforts, also explains why the economic literature has focused on the importance of inter-brand competition, i.e. competition between manufacturers.

Note that the idea that competition authorities should be concerned about promoting intra-brand competition when inter-brand competition is low is another version of the fallacy that we just discussed. Even when the manufacturer is a monopolist, its preferences about the intensity of downstream competition will be qualitatively aligned with those of a competition regulator in most standard models of vertical contracting. In addition, the theory implies that the imposition of selective distribution agreements should lead to lower overall sales, a result that – as we have mentioned – is contradicted by the existing empirical literature. We do not therefore believe that the literature on secret individualised contracting can justify a presumption that the manufacturer generally benefits from restricting intra-brand competition. The most distinctive feature of an internet retailer is that it is not bound to a geographic location. This means that any internet retailer is in competition with all bricks-and-mortar outlets – independent of their locations. The eBay paper argues that this aspect of internet retailing can bring about fast and effective arbitrage across different geographic regions, leading to the convergence of prices across different regions, and that the internet therefore fosters the integration of markets.

The eBay paper then alleges that the main reason for restrictions on internet distribution imposed by manufacturers is that this supports price discrimination in the final goods price between customers in different countries (or regions), which leads to higher profit extraction of the manufacturers. EBay concludes that it is anticompetitive for manufacturers to adopt restrictions that preserve price discrimination. Indeed, in many circumstances the prohibition of price discrimination leads to higher price levels. Furthermore, disallowing differential pricing between bricks-and-mortar retailers and internet retailers can reduce market efficiency. Indeed, some scope for price discrimination may actually be efficiency enhancing by increasing retail effort where there is the greatest demand for it. According to Katz (1987) who has developed an argument that this established reasoning on price discrimination may break down for price discrimination by input suppliers into oligopolistic downstream markets.32 Superficially his setting is very similar to the one we consider here: one firm is present in many local markets (internet retailer) while other firms are only local. But to obtain his results of a systematic price effect, the internet retailer must have the option to backward integrate into manufacturing of the product.

That is simply not realistic for an internet retailer that makes money by offering a broad product range. This paper is therefore not applicable to evaluating the effect of restraints on internet retailing. Allowing price discrimination can make the market strictly more competitive.The result of Katz (1987) has been recently turned on its head for more realistic settings that model the bargaining behaviour between manufacturers and retailers. If the manufacturer can price discriminate by bargaining out individual market conditions it can be shown this strictly lowers prices. This is shown for example in O’Brien and Shaffer (1994)33. Essentially, the retailer has an incentive to strike a bargain that puts it in a better position relative to the rival retailer. Hence, there is an interest in concluding a contract with low marginal costs and high fixed costs. This ex-ante competition between retailers lowers their effective marginal costs and thus leads to lower prices in the final goods market. It is therefore much more plausible that allowing for price discrimination in wholesale pricing will lead to lower final goods pricing. There may be also regionally systematic differences in preferences over sales services, which mean that at the margin, a customised advice and “matching” service may not be valued uniformly in all regions.

If this is so, then the optimal way of providing retailers with incentives to offer the service inevitably generates different margins (and sales prices) in different regions. To the extent that such differences exist, forcing markets with different preferences for bundled sales services towards a uniform margin would lead to under-provision of such services in the region that values the service highly, and to over-provision where it is not valued as highly. The outcome is likely to be inefficient. In conclusion, claims about the anticompetitive effects of price discrimination do not stand up to economic analysis. Modern economic theory has firmly established that either there are no systematic price level effects or there may even be a tendency for enhanced competition when there is upstream price discrimination. EBay’s paper makes the claim that an extension of selective distribution restrictions to internet distribution undermines the ability to achieve the benefits of the internet. This is another false claim. Internet benefits can generally be achieved without restricting manufacturers’ ability to design their contracts with retailers. Even if one accepted (a) that vertical restraints (and especially restrictions on resale between retailers) can help support geographic price discrimination, and (b) that geographic price discrimination is undesirable as a matter of policy, it does not follow that intervention to restrict the use of selective distribution agreements would be an appropriate form of policy intervention.

The market integration effect of internet retailing arises because local bricks-and-mortar retailers are in competition with internet retailers that can sell to customers anywhere. As a result of such competition, prices in different geographic areas will tend to converge. If the manufacturer could extract more profit through geographic price discrimination and shutting down internet retailing it would have an incentive to foreclose internet retailers in order to reestablish the rent extraction possibilities of price discrimination. In practice, European competition rules are perceived to limit the ability of the manufacturers to price discriminate geographically across their retailers. Furthermore, there is no reason to allow any internet retailer to carry the product of a retailer to encourage a ”price convergence” effect. The impact of internet retailing on price convergence is independent of the number of internet retailers that are served. Hence, even limiting internet retailing to a select number (or using vertical integration or using differential pricing as suggested earlier) will lead to the convergence of prices. As long as there are internet retailers that can sell to anyone, price convergence is facilitated (up to differences in transport costs).

There are some caveats to this conclusion. As we have seen earlier it may be necessary to impose limitations on the volume of internet sales relative to bricks-and-mortar sales, in order to maintain appropriate brick-and mortar incentives. This may limit the extent to which price convergence can occur in practice, because it is not possible for all consumers to purchase the lowest posted price. Hence, differences in price can persist because the quantity restriction means consumers cannot fully arbitrage. For example, if manufacturers are allowed to charge higher wholesale prices to internet retailers relative to the bricks-and-mortar channel, arbitrage on the final goods price between bricks-and-mortar retailers and internet retailers would still encourage convergence in the final goods price. This would be the case also if the manufacturer were allowed to vertically integrate into internet distribution. This would not happen, however, if the image of internet retailing were to dilute the luxury image of the product and luxury goods manufacturers decided not to use the internet channel at all. But in such a case the elimination of the internet channel would be efficiency enhancing, and not anti-competitive. A clear benefit of the internet is that it reduces the “cost” of searching for a product. This benefit may be smaller however for luxury products, for which good “matching” information will typically only be available at a bricks-and-mortar store.

In addition, it is unnecessary to force all manufacturers to sell their product through a single multi-product internet website in order to realise most of the search benefits of the internet. Technology allows for internet offerings by different suppliers, on different sites, to be easily searched and compared. Where there are sufficient gains from search (as with airlines) there are even several specialised search engines that facilitate such search. Spotting the product on the internet might in turn provide an incentive for the potential buyer to visit the bricks-and-mortar store. To provide the right incentives to guide the searcher to the right store, there may well be benefits from bricks-and-mortar and internet outlets being jointly owned, i.e. for limiting internet sales to the sites of authorised bricks-and-mortar retailers. The elimination of shelf space constraints is another well-known potential benefit of internet retailing. The internet store can offer all products in a product line, as well as products from many other manufacturers, without the constraint of limited shelf space. (Depending on the specific retailing model, the internet retailer may have to hold inventory.) However, selective distribution systems do not prevent these benefits, if they exist, from being realised. Manufacturers themselves benefit from being able to advertise their whole product line on the internet.

Also, anyone who wants to sell luxury articles through the internet can do so (even as a small entrant) without having space constraints. This does not require all products to be sold on the same website. As long as search is relatively easy (and done through search engines) there is no reason for the lack of shelf space constraints not to be exploited even when some firms decide to use selective distribution (or restrictions on the presentation of their internet offerings). The internet unquestionably generates much easier access to product information. But again, this is the case independently of how firms organise their internet presence. Internet information will often be provided for goods that cannot be bought over the internet. This benefit can therefore be obtained entirely independently of contractual restrictions on retailing. In conclusion, there are many benefits of the internet in terms of reducing search costs, improving price comparisons, facilitating market access to small suppliers, and generating relevant information about products. However, none of these benefits require for their realisation that manufacturers refrain from using selective distribution systems. Indeed, manufacturers have strong incentives to exploit these cost reductions unless they interfere with giving proper incentives in the vertical sales structure. The economic research of the last 40 years has systematically limited the range of circumstances in which vertical restraints can legitimately be suspected to have anticompetitive effects. Empirical research has supported these conclusions in general.

The economic research we have reported on in this paper has demonstrated that there are strong efficiency reasons for vertical restraints. While the literature has identified some anticompetitive effects, these only apply under fairly limited circumstances. Empirical research has demonstrated that voluntary vertical restraints typically lead to output expansions while government intervention against vertical restraints has been demonstrated to lead to significant output reductions and reductions in number of retail outlets. There is therefore a wide consensus in the economics profession that there has to be a strong presumption that vertical restraints are efficiency enhancing unless anticompetitive effects can be demonstrated. The mere fact that a new sales technology is available does not imply that standard economic analysis does not apply, notwithstanding rhetoric about the “new economy” or the “21stCentury economy”. There is a second reason to adopt a position that vertical restraints are generally legal unless anticompetitive effects can be demonstrated. This reason is, in fact, closely related to the changing retailing structures. In a quickly changing economic environment and with the advent of new technologies it is hard to find out what the most efficient contractual structures are. The convergence to such structures will be significantly slowed down if firms have to fear that the default view of a contractual restraint is that it may be anticompetitive.

Particularly in the case of the luxury goods industry, it is highly undesirable for regulators to intervene at a stage in which the actual impact of using the internet as a sales channel is still untested for many players. The luxury goods industry may want to experiment with internet distribution to learn how severe the free-riding problem for bricks-and-mortar services may be, or how large the deterioration of brand image could be. Different types of product may very well have different optimal retailing structures. A good policy should therefore leave room for firms to experiment without creating an obligation to use the channel. Policy should not hinder the adjustment of retailing structures to new ways of doing business in a rapidly changing world. Forcing manufacturers to allow anyone to sell their goods on the internet is bad policy and harks back to times when we did not understand the economics of vertical restraints. Another study made by Thomas Buettner, Andrea Coscelli, Thibaud Verge and Ralph A. Winter (Forthcoming in the European Competition Journal, Vol 5(2), August 2009; Selective Distribution by Luxury Goods Suppliers: A Response to Kinsella et al) pointed out that image is an important component of luxury products in the sense that may consumers reveal a preference for products on which suppliers have invested substantially in image. Both the manufacturer and retail distributors invest to enhance product image.

They took perfume as an example wherein suppliers of perfume such as Dior or Chanel spend much more in creating the image of the product than they do on the chemicals in the physical product itself; chemicals account for only a small fraction of total costs for perfume manufacturers. Investments in image take the form of fancy packaging, direct image advertising – and indirect investment through the manufacturers’ support of high‐markups at up‐market retail outlets. Perfume manufacturers invest resources on product image, rather than simply selling perfume in bulk as chemicals, because this investment enhances the demand for their product. A consumer values both the scent of a perfume and its image, and suppliers accordingly invest resources in both of these dimensions of the product. If the benefits from “brand image” were regarded by a regulator as merely “speculative” and without empirical foundation, as Kinsella et al claim, the optimal regulatory response would be simple: regulate the price of perfume to be a few percentage points higher than the input cost of the product. Fancy disappear. The cost of perfume would drop to a few Euros per liter, especially if the consumer provided her own container. This type of regulation has not been implemented, not because of the difficulties of regulating prices in markets, but because it is recognized that for a product like perfume the image is an extremely important component of the product.

Consumers demand perfume, and enjoy the product, because of both the scent and the image. A proposed regulation that would require perfume being sold for in bulk at low prices, with no image creation, would be regarded as absurd, in spite of the price savings to consumers. Product image has value, and public policy reflects this. Thomas et al’s second point is that internet distribution, while now an essential part of the distribution system of virtually any retail product, potentially compromises the incentives for up‐market, bricks‐and‐mortar stores to invest in enhancing the brand image of a product or even to carry the product. This is because some consumers attracted to the product by the retail environment, the retail store prestige and product promotion at the store will subsequently purchase the product much more cheaply on the internet. The up‐market stores will, as a matter of simple economics, invest less in product promotion if they capture fewer of the consumers. The upstream supplier of a product may well desire some product distribution over the internet, but will often want to limit the distribution over the internet so as to encourage bricks‐and‐mortar outlets to promote or even to carry their products. Restricting distribution represents a cost to the supplier because other things equal low retail margins are good for sales – a basic economic point which Kinsella et al fail to acknowledge.5 But where the product image is compromised, demand for the product will drop. The supplier that bears the cost of restricted distribution does so in order to encourage more investment in image, or distribution through more up‐market stores.

In short, selective distribution is simply a means by which a supplier changes the tradeoff between price and image (or promotion or other retailer‐supplied product attributes) in an unrestrained retail market. For many products, as Kinsella et al point out, the internet is a complement to purchases at bricks‐and‐mortar stores, for example because consumers gather information about a product before shopping at a store. If this positive effect dominates the negative effect of internet on retailer investment incentives, in terms of the overall impact on demand, a manufacturer will not restrict internet sales and a policy issue or legal case regarding selective distribution will not arise. The key piece of evidence in any selective distribution case involving internet restrictions, however, is that the supplier has chosen to adopt the strategy. In any real world case of restricted distribution, the positive effect of the internet on information provision is therefore not the dominant effect. Consumer benefits, not firm profits, are at the heart of European competition law. Some economists might argue that the willingness of a product supplier to bear the cost of higher retail prices in exchange for greater investment in product image through selective distribution signals that the tradeoff is necessarily in the consumers’ interest as well. Kinsella et al attribute to us the proposition that “regulators should trust that supplier‐imposed vertical restraints always and inevitably serve the consumer interest”. Our position is that selective distribution agreements should be interpreted prima facie as instruments used by suppliers to shift the mix of price competition and investment in image or other retailer services at the downstream retail level.

Interestingly, Kinsella et al offer no theory or case examples as to how selective distribution can be used to lessen upstream competition. In a comment that criticizes a simple, mainstream economic explanation of selective distribution as encouraging retail sector investment in image and other product dimensions, it would have been appropriate to offer at least one case example of an alternative hypothesis. With this summary of their main points, it is useful, prior to evaluating the comments of Kinsella et al, to delineate some of the things that we do not say. Their article is about selective distribution. Nowhere in their article do they argue that vertical territorial restraints should be per se legal in Europe as they effectively are in the U.S. Nor do they defend exclusive dealing as presumptively pro‐competitive. Indeed, some of them have written papers discussing the possible anticompetitive consequences of these restraints. Finally, while their analysis of selective distribution has some similarity with potential roles for resale price maintenance, they do not address the full costs and benefits of resale price maintenance and in particular do not deny its potential role as a cartel‐facilitating practice. They have written elsewhere on the historical importance of this role of resale price maintenance.

The focus of this paper is the economic foundations of policy towards selective distribution agreements to limit internet distribution. The counter‐argument that Kinsella et al offer to their perspective on selective distribution is summarized distinctly by these authors on the first page of their comment. After incorrectly characterizing their case in the following terms “Basically, the proposition is that regulators should trust that supplier‐imposed vertical restraints always and inevitably serve the consumer interest” (their first “straw man”, discussed above), the authors respond: “The reality, however, is that vertical restraints can easily be imposed to geographically segment markets, raise barriers to entry for competitors and reduce competition between suppliers upstream, resulting in higher prices and less choice – results to the unambiguous detriment of consumers”. Kinsella et al note that vertical territorial restraints can be used by a monopolist to separate markets and increase profits through price discrimination. “Market segmentation can be achieved by giving out exclusive dealerships, or by instituting regional (national) sub‐markets.” Different prices across different areas within the European Union runs counter to the market integration objective of European Competition policy.

They agree. They disagree with other claims by Kinsella et al about territorial exclusivity such as their assertion that territorial exclusivity is “to the indisputable detriment of consumer welfare”, a statement which also conflicts with the recognition in the European Commission’s Guidelines on Vertical Restraints (“Vertical Guidelines”) that “exclusive distribution may lead to efficiencies, especially where investments by the distributors are required to protect or build up the brand image. In equating selective distribution agreements (which they discuss in the context of limitations on internet distribution) to vertical territorial restrictions and exclusivity arrangements (which are not the focus of the paper) Kinsella et al set up a second straw man. Their use of this straw man is best illustrated with the following example, although the attempt to confound our analysis of internet‐limiting agreements with other vertical restraints is made throughout the comment: “An SDA [selective distribution agreement], which eliminates intra‐brand competition, can only address free‐riding (should such problem exist) if markets can be rigorously segmented. This means that the markets in which exclusive retailers operate are effectively isolated from one another. Investment by one retailer, be it in local advertisement, promotion or in‐store service, must not benefit other retailers [footnote deleted]. Apart from the fact that such an SDA – providing territorial exclusivity to the appointed retailers – goes against the very essence of the European ideal of the single market and violates the Vertical Restraints Regulation, such exclusivity arrangements create five distinct problems: dynamic inefficiency, double marginalization, at‐market pricing (ie discrimination), market foreclosure and collusion between suppliers.” This paragraph makes several errors. First, unlike territorial exclusivity, a selective distribution agreement limiting internet distribution (e.g. by excluding pure internet players from the distribution network) in fact does not eliminate intra‐brand competition.

Bricks‐and‐mortar outlets compete amongst themselves and may distribute on the internet as well to the extent allowed under the agreement. Selective distribution that limits internet distribution does not necessarily eliminate it. Second, selective distribution can mitigate the free‐riding problem even though it has nothing to do with “rigourous segmentation of markets” that would result from territorial exclusivity. Selective distribution limiting internet distribution does not of course completely eliminate free riding, or more precisely eliminate positive externalities among retailers: in a distribution system where retailers contribute to the promotion, image and reputation of the products they offer such positive externalities will always be present. We make no claims to the contrary. But selective distribution is a means for the supplier to reduce (not eliminate) intra‐brand competition for the purpose of enhancing retailers’ incentive to invest in image (although not necessarily at the level that would be first‐best for the supplier). Without the ability to limit internet sales, the incentive for such investments would be severely curtailed. Kinsella et al’s third straw man is to equate selective distribution that limits internet sales to a ban on internet sales. They attribute to us an assertion “that a ban on internet sales can effectively tackle the free‐rider problem,” on the argument that a selective distribution agreement “that prohibits internet distribution must by default result in a foreclosure of free‐riding, since it shuts out – by definition – all non‐investing free riders.”

Kinsella et al then refer to this conclusion as “somewhat nonsensical”. The label “nonsensical” is a surprisingly aggressive reaction by Kinsella et al to an argument that is entirely of their own invention. Nowhere in their article do we call for a ban on internet sales. Nowhere do we claim that an internet ban would completely foreclose all free‐riding, i.e. render retailer incentives perfectly aligned with a manufacturer’s interest. The internet is of course a vital part of the distribution network of virtually every product, and there is “free‐riding” (more precisely positive externalities) in any distribution system where retailers contribute to the promotion, image and reputation of the products they carry. Kinsella et al fall into the straw man fallacy throughout their comment, but this is a particularly extreme example. Kinsella et al introduce another theme: there are less restrictive alternatives to vertical restraints that can address free‐riding. They suggest wholesale price discrimination by the supplier but ignore that to be effective this strategy must eliminate the internet’s key benefit: lower prices. They argue that free‐riding could be overcome by incentive contracts which make the wholesale price dependent on effective sales but fail to explain how this would work in practice or the restraints it would imply. Another alternative they suggest as an example of increased vertical cooperation is franchising, ignoring the fact that franchising agreements can be more restrictive than selective distribution. Assessing in the abstract whether these (or other) hypothetical alternatives are in fact more efficient means for a supplier to achieve a legitimate goal in practice is an extremely difficult exercise for a regulator.

But there should be no presumption that a supplier would choose a policy that is more restrictive than necessary. To the contrary, since retail competition is in the supplier’s interest not just the consumers’ interest, the supplier benefits from choosing the least restrictive policy sufficient to solve whatever incentive problem is faced at the retail level. In this article, they offered two basic explanations for selective distribution agreements to limit internet sales: the classic free‐rider problem, based on the assumption that internet distributors do not on average contribute as much to brand image and promotion as an up‐market store offering the product in an environment of prestige, comfort, the ability to “touch‐and‐feel”, and so on; and a second explanation based on simple consumer heterogeneity. In contrast to the free‐ride problem, the heterogeneity argument does not rely on positive externalities between retailers but is applicable where consumers differ in the value they place on image. The argument is that retailers place some attention on attracting customers away from other retailers, where the manufacturer would prefer the retailers’ focus be on attracting new customers to the product. Consumers attracted away from other retailers tend to respond less to product image than to low prices. Hence the retailers’ bias, from the manufacturer’s point of view, towards intensive price competition and away from competing on other retailer attributes. Kinsella et al make an interesting observation in stating that the heterogeneity theory is really “just a simple variant” of the free‐rider theory.

They refer the reader to their comment for the details of this interpretation, and simply note here that the observation is an important contribution not just to the economic foundations of vertical restraints but also to competition law. By pointing out that the concept of free‐riding extends well beyond the narrow, conventional interpretation involving pre‐sale information, Kinsella et al effectively argue for an expanded interpretation of the free‐rider defense of vertical restraints under the Vertical Guidelines. Limitations on internet distribution as a means of enhancing retailer incentives are then not only supported by economic theory as we have shown but, following the logic of Kinsella et al, are also consistent with European competition law. A cautionary approach to regulatory intervention in selective distribution cases is well‐founded in both economics and the law. Local Studies

Burns et al pointed out that an analytic method for minimizing the cost of distributing freight by truck from a supplier to many customers. It derives formulas for transportation and inventory costs, and determines the optimal trade-off between these costs. The paper analyzes and compares two distribution strategies: direct shipping (i.e., shipping separate loads to each customer) and peddling (i.e., dispatching trucks that deliver items to more than one customer per load). The cost trade-off in each strategy depends on shipment size. Our results indicate that, for direct shipping, the optimal shipment size is given by the economic order quantity (EOQ) model, while for peddling, the optimal shipment size is a full truck. The peddling cost trade-off also depends on the number of customers included on a peddling route. This trade-off is evaluated analytically and graphically. The focus of this paper is on an analytic approach to solving distribution problems. Explicit formulas are obtained in terms of a few easily measurable parameters. These formulas require the spatial density of customers, rather than the precise locations of every customer. This approach simplifies distribution problems substantially while providing sufficient accuracy for practical applications. It allows cost trade-offs to be evaluated quickly using a hand calculator, avoiding the need for computer algorithms and mathematical programming techniques. It also facilitates sensitivity analyses that indicate how parameter value changes affect costs and operating strategies.

According to Patrick Avenell, SYDNEY: Samsung business manager – notebooks, EmmanueleSilanesu, has provided an insight into the Korean supplier’s retail strategy for its new range of notebooks. It’s been four years since Samsung operated in this market, and Silanesu is determined to change tactics compared with the past and with Samsung’s general strategy in other categories. In what is being called a “soft launch”, Samsung is only distributing the new range of notebooks through four retail organisations, each one chosen to target a specific demographic. The first retail group is Bing Lee which, though New South Wales-focused, has strong credentials in the Asian community. Samsung dealt directly with Samsung, rather than go through Narta, as it didn’t have the range or broad retail strategy that would make Narta dealings advantageous. Another Narta member to sell the notebooks will be JB Hi-Fi. Whereas nearly all Bing Lee stores will be selling the Samsung range, only the top 25 JB Hi-Fi stores nationally will have the opportunity. JB Hi-Fi is very appealing to Generation Y, and the stores also operate on a high foot traffic business model, with consumers attracted to the stores’ range of cost-price music CDs. For the everyday mum and dad crowd, Samsung has gone with the Good Guys – 51 of around 90 stores nationally.

These stores are individually owned by franchisees and appeal to working families and the older Generation Xers and Baby Boomers. A very organised and centrally-controlled retail organisation, Samsung is looking to capitalise on the Good Guys’ considerable advertising budget and positive community goodwill. The last retail organisation to have been hand-picked by Samsung is Myer. Only six of the publicly listed retail group’s stores will carry the range, with the CBD stores in the state capitals being chosen. Silanesu said the appeal of Myer was two-fold: it allows Samsung to tap into Myer’s loyal department store consumer base, and it appealed to the more affluent mums and dads. In addition to these four retail groups, Samsung notebooks will also be retailed through 20 individually selected specialist computer resellers. All up, Samsung’s new notebook range will be stocked in around 150 stores nationally. Silanesu said that Samsung wanted to concentrate the retail environment so that he and his team could play an active part in the selling of product. “We want to visit and train up the staff at the stores,” he said. “It’s a ‘soft launch’ from which we’ll expand out.” When asked about this outward expansion, Silenesu said that Samsung actually had no intention to move into any other stores or retail groups in the short-to-medium term. Another study is about Coca Cola who has a bottling company which uses the continuous flow method of manufacturing.

Continuous flow may be defined as the so called process industries which refer to manufacturing goods such as beer, paper, oil, and electricity, where in this case it would be a soft drink company. Here, the products are made in a continuous fashion and tend to be highly standardized and automated with very high volumes of production. The production flow of Coca Cola involves passing sub-assemblies/parts from one stage of production to another in a regular flow. Each stage adds to the products, this is typical among bottling plants. Coke used this method because the products being distributed by the company are in wide variation and is sold in bulk amounts. Products being distributed range from the bottled goods such as Coke, Diet Coke, an assorted amount of different flavored soft drinks, to bottled water. Given that Coca Cola has such a large range of production, continuous flow is the best way to produce products,. The type of customer order which Coca Cola uses to process goods is the Made to Stock method. The MTS type of ordering system works very well with Coca Cola as a manufacturer.

This process can help to provide faster service to customers from available stock and lower costs considering Coke normally has a distribution process of bulk items. Normally when customers order Coca Cola products, it is in a bulk amount when distributing through a B2B operation. When customers are purchasing individual bottles of Coke, it is after the process of the wholesale item being sold to a business, and afterwards the business will distribute each single item to their customers, making profit off of the product since they bought it in bulk from the Coca Cola company. The MTS method of customer order has a process where a standard product line is specified by the producer, not by the customer and therefore products are carried in inventory to immediately fulfill customer demand. Suppose Coke Cola used a Made to Order customer process, they would never distribute their goods in a fast enough fashion due to the high demand of customers that the company possesses. Research Gap

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