Updated Jan 3, 2023 Competition law prohibits many controversial business practices. Although most economists agree that price-fixing among competitors should be illegal, other practices have less obvious effects. In this article, we are going to look at three of those controversial business strategies from an economic perspective. The three practices we’ll analyze are resale price maintenance, predatory pricing, and tying. Resale price maintenance describes a business practice where producers require retailers to sell their products at a certain minimum price or higher. That means they sell their products to different stores and set up contracts that require those retailers to charge customers a fixed minimum price. This is sometimes also called fair trade (although it has absolutely nothing to do with fairtrade). To give an example, think of an imaginary mobile phone producer called Pear Inc. Now assume that Pear sells its smart mobile phones to retailers for USD 500. However, to get the phones, the retailers have to sign a contract that requires them to charge customers at least USD 600 per phone. As a result, the retailers cannot compete on price, because they all have to respect the same price floor. The fact that resale price maintenance can reduce competition among retailers has led many governments to ban it altogether. However, some economists argue that prohibiting resale price maintenance may, in fact, be undesirable for society. There are two reasons for that. First, producers actually have no reason to discourage competition among their resellers. If retailers worked like a cartel, they would end up selling fewer products (because of their monopoly power), which is the contrary of what producers want. Second, according to its advocates, resale price maintenance may actually reduce the inherent free-rider problem associated with good customer service. That is, it helps to prevent customers from taking advantage of one retailer’s service and then buying the good at a discount from another store. Predatory pricing refers to a business practice where firms sell their products below cost to drive competitors out of the market. That means they cut their prices to a point where selling the product becomes unprofitable because costs exceed revenues. This pushes existing competitors out of business and prevents new firms from entering the market. To illustrate this, let’s revisit our Pear Inc. example from above. We know that the company sells its phones to retailers for USD 500 apiece (this time without minimum price requirements). In addition to that, we’ll assume that only two retailers sell Pear phones, Largemart and Smallmart. As the name suggests, Largemart is significantly larger than Smallmart and currently controls 80% of the market. Starting from there, Largemart decides to sell the phones for USD 450, while taking a loss. They do that because they know that Smallmart cannot afford to beat that price in the long run. As a result, Smallmart eventually decides to stop selling Pear phones altogether, and Largemart becomes a monopoly. Predatory pricing is often considered a violation of competition law. However, many economists have raised concerns that it is, in fact, hardly ever a profitable business strategy. After all, cutting prices below cost hurts both the predator and its prey. In fact, it may even hurt the predator more. According to the law of supply and demand, a lower price attracts more customers, so the predator has to sell more products at a loss. Meanwhile, the prey can reduce their output in response to the price cuts. In that case, the predator has to carry a larger share of the losses. Furthermore, even if the competition is eventually forced out of business, it is often difficult to raise prices to profitable levels afterward. Tying describes a business practice where firms sell multiple products together, rather than separately, to expand their market power. That means they bundle two or more of their goods together and force buyers to buy the package, rather than the individual products. This gives them the possibility to boost sales of less popular products by combining them with more popular goods or services. For example, assume that Pear Inc. has a second product line in addition to its phones that consists of microwaves. These microwaves aren’t nearly as popular as the phones, and Pear Inc.’s market share is low. Therefore the company decides to tie the two products together and only sell phones to retailers if they also buy a certain number of microwaves. As a result, the company’s market share in the microwave business increases because many retailers buy Pear microwaves to get access to the highly requested mobile phones. Although some economists argue that tying should be banned by competition law, others suggest that it is not a threat and cannot be used to increase market power. The idea behind this is that bundling is merely a form of price discrimination. That is, it doesn’t increase the willingness to pay for worthless products; it only allows producers to collect a larger share of the buyers’ total willingness to pay. After all, retailers can still refuse to take the package deal if they feel like it’s not worth their money. Competition law prohibits many controversial business practices. While most economists agree that practices such as price-fixing among competitors hurt the economy, other practices have less obvious effects. Three of those methods include resale price maintenance, predatory pricing, and tying. Resale price maintenance describes a business practice where producers require retailers to sell their products at a certain minimum price or higher. Predatory pricing refers to a strategy where firms sell their products below cost to drive competitors out of the market. And last but not least, tying describes a business practice where firms sell multiple products together, rather than separately to expand their market power.1. Resale Price Maintenance
2. Predatory Pricing
3. Tying
Summary
Sources
(2nd ed., revised ed.) Andover: Cengage Learning. 374-376.
Microeconomics