Price discrimination by big manufacturers: Supporting arguments for its prohibition by European competition law

Fabian Herweg, Daniel Müller 07 April 2015

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Price discrimination by manufacturers is a recurring theme in antitrust cases. For instance, in February 2015, the federal district court in Beaumont, Texas discussed the claim of Games People Play (GPP), a major retailer for golf equipment in the US, against Nike. GPP alleged that Nike had charged the retailer significantly higher prices for its Viktory Red irons than other retailers. Nike’s pricing practice may have harmed competition and thus may have increased prices for final consumers (Games People Play, Inc. v. Nike, Inc.; case number 1:14-CV-321).

Price discrimination by manufacturers is governed by the Robinson-Patman Act in the US and Article 102 TFEU in the EU. According to these legal statutes, a manufacturer who charges different prices to different retailers may be found liable of an infringement of the laws. The economic analysis of the effects of price discrimination on overall welfare and consumer surplus dates back to Robinson (1933). The traditional economic view regarding price discrimination in intermediate-goods markets is that the ‘wrong’ downstream firm receives a discount; i.e. less efficient retailers obtain lower wholesale prices than more efficient retailers. As a result, banning price discrimination improves allocative efficiency and typically also overall welfare (Katz 1987).

Quantity discounts

Early investigations of price discrimination by manufacturers presumed that wholesale contracts specify only a per-unit price for the intermediate good in question. Wholesale contracts – e.g. contracts written between big manufacturers and large retail chains – typically are more complex, often allowing for the average unit price to decline in the overall amount purchased. Such quantity (or ‘bulk’) discounts enhance the efficiency of the vertical chain by reducing the double markup problem — i.e. the manufacturer and the retailer both charging unit prices above their respective marginal cost — which in turn reduces final prices for consumers. Hence, it is not surprising that antitrust authorities regard quantity discounts per se as a justifiable pricing strategy for manufactures. This point of view, however, prevails only as long as quantity discounts are not discriminatory. As early as the European sugar industry decision in 1973, the Commission ruled that, “the granting of a rebate which does not depend on the amount bought [...] is an unjustifiable discrimination […]” (Recital II-E-1 of Commission decision 73/109/EC). Against the background of this legal conduct, more recent contributions to the economic literature analyse the effects of discriminatory quantity discounts. The main finding is that price discrimination strengthens competitive differences (the ‘waterbed effect’), thereby enhancing allocative efficiency and often improving overall welfare and consumer surplus (Inderst and Shaffer 2009).

Asymmetric information

In a recent paper (Herweg and Müller 2014), we present a theoretical study of intermediate-goods market price discrimination with nonlinear wholesale contracts. We show that previous findings may not be robust if retailers possess private information.

Retailers are often better informed about the demand they face and their retailing costs than manufacturers. If this is the case, there is a further rationale for a manufacturer to offer quantity discounts: quantity discounts allow the manufacturer to screen a retailer with regard to its efficiency. Specifically, quantity discounts are more attractive for a highly efficient retailer, which processes high quantities, than for an inefficient one. Appropriately chosen quantity discounts then achieve self-selection of the different retailer types, thereby allowing the manufacturer to distinguish efficient retailers from inefficient ones. By screening retailers, the manufacturer can extract higher rents from them. Screening, however, requires the manufacturer to distort the contract offers made to inefficient retailers in order to make these contracts sufficiently unattractive for efficient retailers, which in turn reduces welfare. This mechanism is present irrespective of whether the manufacturer offers the same quantity discounts to all retailers, or discriminatory quantity discounts. Screening of retailers, however, can be achieved more effective with retailer-specific — i.e. discriminatory — wholesale contracts, which implies that the distortions caused by screening are more severe under price discrimination than under uniform pricing. This harms particularly inefficient retailers who would be better off under non-targeted — i.e. non-discriminatory — quantity discounts. Moreover, we show that permitting price discrimination often reduces the total quantity sold by the manufacturer, which in turn also reduces overall welfare. In light of our findings, we conclude that a reservation regarding price discrimination by big manufacturers may well be warranted even if wholesale contracts comprise bulk discounts

Investments

A ban on price discrimination not only affects welfare and final prices in the short run, but may also have an impact on final prices and qualities offered in the long run: a ban on price discrimination may interfere with investment incentives. Under linear wholesale contracts with only a fixed unit wholesale price, the less efficient firm receives a discount under price discrimination. Thus, permitting price discrimination reduces retailers’ incentives to invest in process innovations (reducing retailing costs) or in demand-enhancing advertising (DeGraba 1990). We obtain a similar finding for our analysis of discriminatory quantity discounts: a ban on price discrimination enhances downstream firms’ investment incentives, which typically improves overall welfare. The reason is that the manufacturer can extract downstream firms’ rents more effectively with discriminatory wholesale contracts. Hence, a larger part of the rent that is generated by a downstream firm’s investment accrues to the manufacturer under price discrimination than under uniform pricing. In consequence, the incentives to undertake the investment in the first place are reduced if price discrimination is permitted.

We conclude that the EU’s current legal practice regarding price discrimination by big manufacturers — i.e. allowing quantity discounts but forbidding discriminatory discounts — is, by and large, beneficial for the economy as a whole and particularly for small retailers. This view is also in line with a recent working paper (Herweg and Müller 2015) in which we analyse the situation of an efficient entrant becoming active in the downstream market only if the wholesale tariff offered allows the entrant to recoup its fixed entry cost.

References

DeGraba, P (1990), “Input Market Price Discrimination and the Choice of Technology”, American Economic Review 80(5), pp. 1246-1253.

Herweg, F and F Müller (2014), “Price Discrimination in Input Markets: Quantity Discounts and Private Information”, Economic Journal 124(577), pp. 776–804.

Herweg, F and D Müller (2015), “Discriminatory Nonlinear Pricing, Entry, and Welfare in Intermediate-Goods Markets”, mimeo, University of Bayreuth.

Inderst, R and G Shaffer (2009), “Market Power, Price Discrimination, and Allocative Efficiency in Intermediate-Goods Markets”, RAND Journal of Economics 40(4), pp. 658–672.

Katz, M L (1987), “The Welfare Effects of Third-Degree Price Discrimination in Intermediate Good Markets”, American Economic Review 77(1), pp. 154-167.

Robinson, J V (1933), The Economics of Imperfect Competition,  London: Macmillan.

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Topics:  Competition policy

Tags:  price discrimination, big manufacturers, quantity discounts

Professor of International Competition Policy, University of Bayreuth

Postdoctoral Researcher, University of Bonn

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