U.S. Department
of Justice
Procompetitive Justifications For Exclusive Dealing: Preventing Free-Riding And Creating Undivided Dealer Loyalty
FOR EXCLUSIVE DEALING:
CREATING UNDIVIDED DEALER LOYALTY
Slide 2
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Dentsply illustrates that the current economic foundations for procompetitive justifications for exclusive dealing are extremely narrow.
- The court rejected Dentsply’s claim that exclusive dealing was used to:
- Prevent dealer free-riding on manufacturer-supplied promotional investments.
- Create dealers with “undivided loyalty” that more actively promoted Dentsply products.
Slide 3
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The Dentsply court rejected that exclusive dealing was used to prevent dealer free-riding because:
- Dentsply did not make any investments that dealers could free-ride on by using the investments to sell rival products.
- There was no evidence of Dentsply dealers actually switching buyers to rival products.
- Dentsply executives testified that Dentsply would likely increase its promotional investments if there were no exclusive dealing.
Slide 4
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The Dentsply court rejected that exclusive dealing was used to create dealers with “undivided loyalty” who would more actively promote Dentsply products because:
- “Enhancing dealer services” cannot be the justification for exclusive dealing.
- In general, competition between dealers will lead dealers to supply the desired quantity of promotional services.
- Only when there is an inter-dealer free-riding problem (as described in Sylvania) will competition between dealers not result in sufficient dealer services. But this problem would not be corrected by exclusive dealing.
Slide 5
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The expanded economic framework under which we should conduct economic analysis of exclusive dealing contracts is based on two common sense business propositions.
- Manufacturers often want their dealers to supply more promotion than the dealers would independently decide to provide.
- Exclusive dealing, by creating undivided dealer loyalty, increases dealer incentives to more actively promote the manufacturer’s product.
Slide 6
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Manufacturers often want their dealers to supply more promotion than the dealers would independently decide to provide.
- Dealers do not take account of manufacturer profitability on incremental sales.
- This is not a problem for dealer price and non-price competition that has significant inter-dealer quantity effects.
- However, dealer promotion of a manufacturer’s product has no significant inter-dealer quantity effects.
- Consumers do not pay for promotion because promotion is a way to provide an effective price discount to marginal consumers who would not otherwise buy the product.
Slide 7
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Manufacturers solve this problem of insufficient dealer promotion by contracting with and compensating dealers for providing increased promotion.
- Manufacturers often compensate dealers with a valuable distributorship.
- Contractual arrangements generally will be self-enforced with dealer performance assured by manufacturer monitoring and the threat of termination.
Slide 8
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Because dealers are contracting to supply more promotion than would otherwise be in their independent interests to supply, there is an inherent dealer performance problem.
- Dealers have an incentive to violate the contract and “free-ride” on the manufacturer’s compensation arrangement.
Slide 9
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Dealers may “free-ride” in three distinct ways:
- Free-riding #1: dealers use the manufacturer-supplied promotional assets to sell rival products.
- Free-riding #2: dealers use the manufacturer paid-for promotion to sell rival products.
- Free-riding #3: dealers under-supply manufacturer paid-for promotion.
Slide 10
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Dealer free-riding need not involve manufacturer investments or dealer switching.
- Free-riding #1: dealers use the manufacturer-supplied promotional assets to sell rival products.
- involves manufacturer investments and dealer switching
- Free-riding #2: dealers use the manufacturer paid-for promotion to sell rival products.
- occurs without any manufacturer investments
- Free-riding #3: dealers under-supply manufacturerpaid-for promotion.
- occurs without any manufacturer investments ordealer switching
Slide 11
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Exclusive dealing may be used to mitigate all three forms of free-riding.
- Exclusive dealing prevents free-riding #1 and #2 by preventing dealer switching of sales to rival products.
- Exclusive dealing prevents free-riding #3 by creating “undivided dealer loyalty” and thereby an incentive for dealers to more intensively promote the manufacturer’s product.
Slide 12
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How does exclusive dealing increases the dealer’s incentive to promote?
- Consider the example where a customer leaning towards the purchase of a Honda comes into a Toyota dealership to check out the Toyota.
Slide 13
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A non-exclusive dealer will not make its “best efforts” to sell a Toyota.
- Dealer will choose level of promotional services (S) that maximizes its profitability.
- Since it costs the dealer less to sell the Honda, the dealer can earn a higher net profit margin on selling the Honda.
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By selling the Honda rather than promoting the Toyota the dealer is free-riding.
- The dealer is not switching, i.e., actively promoting the rival Honda brand as an alternative to Toyota for customers that prefer Toyota (as in free-riding #1 and #2).
- Instead, the dealer is violating the implicit dealer contract with Toyota by failing to actively promote Toyota automobiles.
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Promotional Effort Undertaken by Dealers Under Alternative Contractual Arrangements
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- The court’s rejection of Dentsply’s procompetitive rationales is an example of a common error:
- Because there are more likely to be valid procompetitive justifications for exclusive dealing, “no economic sense” is less likely to be a useful test for antitrust liability.