Accounting for Social Costs Associated with Resale Price Maintenance

By Fleshman, Cindi; Willner, Jonathan | Contemporary Economic Policy, July 2005 | Go to article overview
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Accounting for Social Costs Associated with Resale Price Maintenance


Fleshman, Cindi, Willner, Jonathan, Contemporary Economic Policy


I. INTRODUCTION

Resale price maintenance (RPM) agreements may be welfare enhancing, yet are under increasing legal pressure. RPM agreements are one mechanism by which an upstream firm can control downstream prices. In the face of uncertain demand, firms that cannot guarantee repurchase of product in a low demand state will find that retail prices fluctuate with demand, leading to lower profits than might be obtained under less open regimes. An upstream firm might offer to repurchase, at cost, any product in a retailer's inventory that is unsold at the price the upstream firm wishes to set. Obviously an upstream producer must be concerned with how demand fluctuations will affect price when considering the construction of capacity.

Without the possibility of using RPM, firms will choose production and, by extension, capacity based on expected profits, with price changes dictated by fluctuating demand. Firms utilizing RPM will choose capacity to maximize profits by weighing the possibility of high production in high-demand states and restricting sales in low-demand states to ensure a higher price. This low-demand state decision would leave excess production or inventory. A retailer would be disinclined to maintain high prices if forced to pay for unsold product. In order to prevent lower prices in the low-demand state, the firm must buy back excess product or, in some other manner, convince retailers not to lower the price. This creates the question of what to do with the excess--dispose or store. In this article we examine the effect of choosing the disposal process in an RPM-tolerant environment.

The net effect of making RPM illegal, as demonstrated in Flath and Nariu (2000), is likely to be welfare reducing. However, what to do with excess production, occurring in low-demand states and leading to inventory disposal problems, was not considered. Their results indicate gains in both consumer surplus and profits in the high-demand state relative to the flexible price (no RPM allowed) choice. In a flexible price regime, the firm sees low prices in a low-demand state, with the possibility of a price equal to zero and excess production. These gains are mitigated by losses, due to higher prices in the low-demand state, which would have been obtained in the flexible price environment. Flath and Nariu (2000) use a simple linear demand model to demonstrate that if used under the conditions where a firm would prefer to operate with RPM, then it improves social welfare to allow RPM. Their model assumes that repurchased or returned products are disposed of at no cost. While a zero disposal cost may have been consistent with firm conditions up through the 1960s, current law in most developed countries requires firms to dispose of waste and excess inventory in a manner consistent with societal norms and prices.

We build a model, based on Flath and Nariu (2000), that incorporates disposal costs of excess production. We then show how failure to internalize the externality associated with "free" disposal reduces and may eliminate the social gains from RPM. We follow this result by incorporating disposal costs directly into the profit function of the firm and examining welfare effects of RPM. Next we examine the effects of disposal costs in an RPM-tolerant regime using an alternative form of demand uncertainty.

Disposal costs should reflect social costs associated with toxicity, bulk, etc. Disposal costs may reflect either governmental or private market activity. In either case, the marginal cost of disposal should reflect societal costs. Disposing of toxic, long-lived products is likely to cost more than disposal of a product that biodegrades easily. The size of the product or weight may be an important consideration as well. For a space-constrained country, such as Japan, a larger product should, ceteris paribus, have a higher disposal cost per unit than a smaller product.

II. LITERATURE

"Demand Uncertainty, Inventories, and Resale Price Maintenance" by Deneckere et al.

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