Strategic Implications of Leegin Price Floor Ruling

In a landmark case, the US Supreme Court removed a barrier to vertical price floors in a 5-4 ruling on Leegin v. PSKS on June 28th.

While the court’s decision leaves room for future anti-competitive lawsuits and therefore ensures that case law will determine the legal framework for future decisions, it also opens the possibility for manufacturers to mandate and enforce minimum retail prices without automatically incurring anti-trust enforcement.

The court’s decision is bound to result in changes in the pricing, promotion, and distribution practices of many manufacturers.  In this article, we examine the potential effect of the new manufacturer latitude in decision making created by Leegin v. PSKS on consumers, distributors, and manufacturers.

Distributor Value

Distributors create value through four principle means:

1. Reduce Search Costs. Distributors make it easier for customers to identify, evaluate, and select between competing products.  They also make it easier for manufactures to reach customers with their products.  As such, they reduce search costs for consumers and marketing costs for manufacturers.  (Example:  shopping malls, online superstores, etc.)
2. Break Bulk. For reasons of economies of scale and focus, manufacturers find it easier to make products in large batches.  Consumers, however, rarely desire to purchase items in the same quantities as manufactures can profitably produce.  By receiving large lots from manufacturers and distributing small lots to consumers, distributors add value.  (Example:  grocers, big-box stores, etc.)
3. Complementary Assortment. Often, customers must use complementary goods to gain a complete solution to their problem.  Manufacturers, for reasons of economies of scale, focus, or experience, often find that the cost to producing all associated goods is prohibitive.  In these cases, distributors add value by providing complementary goods in a single location.  (Example:  CD players and music CDs, iron skillets and spatulas, etc.)
4. Hold Inventory. Consumers’ demand for an item may vary with time or seasonality, but for reasons of economies of scale and focus manufactures may find it necessary to continuously produce.  Distributors add value by holding inventory until demand is exhibited.  (Example:  convenience stores, Christmas stores, etc.)

Channel Conflict

Channel conflict arises when a distributor incurs the cost of creating value through one or more of their principle value creating functions, but fails to be economically rewarded for their efforts because customers circumvent their position in the value chain and purchasing through a lower-cost distribution channel.

A common cause of channel conflict arises from tasking some, but not all, distributors with the function of educating customers on the relative benefits of competing goods.  (Educating the market can be categorized as one way by which distributors reduce search costs.)  Those distributors that educate customers on the relative benefits will have incurred greater costs and will seek greater economic rewards in the form of higher margins than those which did not perform that function.  However, after a consumer has learned which product is most likely to suit their needs, that consumer can then “shop around” for a better offer.  When they do so, they may find a distributor that eschews the cost of educating consumers in exchange for offering the same product at a lower price.  The result is that consumers are educated and make their choice through the high-cost channel, but purchase from the low-cost channel.

When consumers gain by learning from high-cost distributors and purchasing from low-cost distributors, high-value distributors exit the channel.  This leaves the manufacturer with only low-cost, low-service distribution.  While low prices may appear appealing, it is in fact unappealing for manufacturers whose products benefit from distributors educating customers.  Rewards and costs need to be aligned for all channel partners.

Customer Learning

Products, whose differentiating factors are difficult to self-learn and thereby difficult to properly value, benefit from distributors educating customers on the points of differentiation. Here, it is important that distributors communicate where the product lies on the value equivalence line in a price to value comparison.

The types of products that benefit from distributors educating customers are usually high-value branded goods that fall into one of the following categories:

• Complex products whose features and benefits cannot be summed up in a one-line promotional statement.
• Products whose benefits are hard to predict prior to use.
• Products whose benefits are not obvious during use, thus making consumer learning slow and difficult.
• Products with a long cycle between repeat purchases, thus suffer from a low rate at which consumers can experience competing offers and select that which benefits them the most.
• High-priced products where the total costs born by the customer of a bad decision are high.

The education process can occur through personalized selling, customized displays, product demonstrations, or other interactive learning experiences.  Examples include listening rooms for sound systems, changing rooms for garments, showrooms for cars, dedicated spaces for demonstrating floor models of refrigerators, etc.  Each of these activities tends to be distributor intensive activities.

Pre-Leegin vs. Post-Leegin

Prior to the recent Leegin decision, channel conflict was managed by an array of coercion techniques including (1) restricting distribution to authorized dealers who pledge to perform the education process, (2) restricting distribution intensity so as to reduce inter-distributor competition and ensure economic rewards for performing the education process (3) the Minimum Advertised Price cooperative advertising funds where all promotional campaigns by distributors are partially funded by manufacturers as long as any advertised price is above a minimal level, (4) staffing distributors with manufacturer trained sales representatives, and many other unique arrangements.  These arrangements came under acute strain in the late 90’s through the invention of a new distribution channel:  the internet and ecommerce.

With the Leegin decision, manufacturers are free to explore a different arrangement.  Branded goods manufacturers can increase the intensity of distribution, and continue to encourage distributors to educate customers, yet mandate a minimum resale price.

For customers, distributors, and manufacturers, the value of executing such a strategy for customers, distributors, and manufacturers is twofold.  (1) It would alter the dimension of distributor competition from lowering price and reducing service, towards maintaining price integrity and competing on providing good customer service.  (2) It can increase distribution of the product, thus enabling customers to get the value they seek, when they seek it, and where they seek it, while maintaining price integrity.

Price Effect

Will companies automatically set a price floor, thus effectively increase consumer prices?  It depends.

Consumers are likely to see a price increase on some high-value branded goods, infrequently purchased goods, and hard to evaluate goods.  Higher prices aren’t necessarily bad for the consumer.  If the new arrangement improves the health of the distribution channel and enables consumers to make better purchase decision, the Leegin decision will have improved the welfare of the consumer by helping them get what they want.

On most consumer goods, the Leegin decision will have little to zero effect.  Manufacturers have no incentive to mandate a price floor for products that do not require distributors to educate consumers.  Frequently purchased, obvious benefit, low-cost, and easily definable products should be free of any effects of the Leegin decision.

The Leegin decision’s real result will be a shift in power between distributors and manufacturers and among distributors.  Because the manufacturer can better define distributor relationships, the manufacturer will be better positioned to manage distributor performance and pricing requirements.   And, because some distributors will have reduced incentive to reduce service and price, the tide of eroding market share from high-service channels to low-service channels may reverse.

Another real effect of the Leegin decision:  the marketing and strategy textbooks must be updated.

Notes

1. Gary McWilliams, Joseph B. White, and Jess Bravin, “Price-Floor Ruling May Have Small Effect”, The Wall Street Journal, June 29, 2007, p. A2.
2. “Supreme Courte Abandons Ban on Price Floors”, MSNBC, AP Press 2007, http://www.msnbc.msn.com/id/19482358/
3. “The Price is Right (but only if I say so)”  Stranova Blog, July 2, 2007, http://blog.stranova.com/?p=122
4. Thomas T. Nagle and Reed K Holden, The Strategy and Tactics of Pricing, 3rd ed. (Upper Saddle River, NJ: Pearson Education, Inc., 2002) pp 278 – 304.
5. Vertical price floors are minimum prices set by manufactures and managed through the vertical distribution chain.  Horizontal price floors, where distributors collaborate and set a minimum price, remain fully illegal according to US law.