Economics has moved on, but the law hasn't

In Britain, manufacturers and suppliers can recommend prices to retailers, but they can't enforce those prices through a contract. Retail price maintenance (RPM) has been banned outright since 1964's Resale Prices Act on the grounds that it's anti-competive and hurts consumers. The problem is economics has moved on, but the law hasn't.

That's not the case in the US where the Supreme Court overturned a near hundred year precedent in 2007 to rule that suppliers that set minimum prices weren't necessarily undermining a competitive marketplace. In the US the practice was banned through the courts based on the best available economic theory and evidence. But when new theory and more importantly new data overturned the economic consensus the courts (eventually) took note.

The Competitions and Markets Authority (the regulator tasked with enforcing the law) states that "RPM agreements are usually unlawful because they prevent you (the retailer) from offering lower prices". It's a bit more complicated in reality: suppliers have little incentive to increase their retailer's markup at the expense of their consumers, especially in the face of competition from other brands. It wouldn't be wise for Coca Cola to set a minimum price that boosts Asda and Tesco's bottom lines when they face competition from Pepsi.

Most economists accept that RPM agreements can potentially undermine competition for two main reasons – exclusion and collusion. They make it easier to police collusive agreements at both the manufacturer's and the retailer's level. It might also enable a dominant but inefficient retailer prevent other more efficient retailers from undercutting them with smaller mark-ups.

If that was the only reason to employ an RPM agreement, then banning them would make sense. In fact since the practice was outlawed economists have discovered additional explanations for why a firm might employ an RPM agreement and why it is in the consumer's interest to let them.

To begin with, a range of products from high-end fashion to digital cameras and phones typically require retailers to invest substantial effort in hiring staff to explain and promote their features to customers. This doesn't come cheap. It means hiring more staff, training them and paying them more. That squeezes margins and pushes up prices in store. But a consumer is under no obligation to buy from the retailer who's put the effort in. No-frills retailers can free-ride off the effort of other retailers in promoting the product and sell it at a discount. The threat of free-riding discourages firms from investing in promoting the product and leads to a worse customer experience with less well-informed customers.

Think of a car dealer offering test drives with well-trained staff offering detailed explanations of the vehicle; the incentive to provide those services falls if the buyer has the option of going to a discount retailer afterwards.

If manufacturers agreed a minimum price with their retailers they could prevent no-frills discount stores from undercutting and free riding off of the ones that invested in promoting the product.

But it's not simply blocking free-riders. It also helps resolve a conflict between the incentives of retailers and manufacturers. Retailers have much less to gain than the supplier from promotional services. Retailers tend to make a greater investment attracting customers to their store over other shops, for instance by extending opening hours. If I ran an electronics shop, I might reward repeat customers to attract more customers from other shops. However, I'd have less of an incentive to invest in promoting Apple Macs by displaying them prominently, offering free installation and bundling in products as a special offer, because while I'll sell more Apple Macs I might sell fewer PCs.

It's true that manufacturers could simply pay retailers for floorspace. As UCLA's Benjamin Klein points out Gucci could simply pay a department for their product to be placed in a prominent place, but that would inefficient for a number of reasons. First, the value of floorspace varies from shop to shop. It'd be inefficient for Gucci to go to a great length at determining the value of floorspace in each different shop to them. Second, retailers tend to know better than manufacturers how to market products. Gucci might struggle to specify the exact promotional services that they want the department store to carry out. It is better for Gucci to solve that knowledge problem by creating a financial incentive for shop to push for further sales. Instead of this inefficient duplication of efforts they can just make sure that retailers have a financial incentive to market their products through a bigger markup.

Whether or not America or Britain's approach to RPM is right depends on how often RPM is used to boost competition and how often it's used to suppress competion. If it's the case that RPM is mostly used to police cartels and for dominant dealers to throw their weight around then the UK's approach is right.

But multiple meta-analyses of prosecuted cases of RPM find few cases of it being used to police cartels. Ippolito (1991) reviewed 203 litigated cases of RPM and found that just 13% of case alleged (not proved) horizontal price-fixing, while many more offered evidence suggesting the agreements led to better customer service. Ippolito's review backed up previous research by Overstreet (1983) which found that RPM agreements tended to appear in markets with little scope for either retailer or manufacturer collusion.

A more recent meta-analysis by LaFontaine and Slade (2005) which reviewed 23 papers came to a similar conclusion. They stated:

"...when manufacturers choose to impose such restraints, not only do they make themselves better off, but they also typically allow consumers to benefit from higher quality products and better service provision.

...

The evidence thus supports the conclusion that in these markets, manufacturer and consumer interests are apt to be aligned, while interference in the market is accomplished at the expense of consumers."

The evidence against banning RPM is overwhelming and on the strength of that evidence the US Supreme Court overturned the outright ban on RPM in 2007 moving to a rule of reason approach which requires firms to prove that RPM was being used for the purposes of undermining competition.

Promoting and preserving competition benefits consumers, but too often regulation rules out innovative solutions to potential market failures. Let's fix that and deregulate RPM.