When retailers must commit to shipment quantities prior to resolution of demand uncertainty, manufacturer stipulation of a minimum retail price is likely to be profitable for the manufacturer, and not damaging to the retailers. The reason is simple: If demand turns out to be low, the unfettered market-clearing price can lie below the price that maximizes total sales revenue. A minimum retail price that is binding in the low demand state can thus increase total revenue even though it saddles retailers with unsold merchandise. This "new" insight of Deneckere, Marvel, and Peck is actually a straightforward generalization of the model of full manufacturer reimbursement for returns developed in Flath and Nariu (1989). The ubiquity of full reimbursement for returns in Japan even though it is in theory merely a second-best way of achieving minimum retail price stipulations, reveals important aspects of manufacturer maintenance of retail prices having to do with enforcement problems, the allocation of risk-bearing and economic incentives. These aspects of resale price maintenance are relevant to the normative evaluation of the special exemptions for RPM that Japan's Fair Trade Commission has long maintained but is now phasing out

Flath, David

Nariu, Tatsuhiko

Columbia University Academic Commons

                                                                                                                          October 1998Demand Uncertainty and Price MaintenanceDavid Flath and Tatsuhiko Nariu**Flath: Department of Economics, NCSU, Raleigh, NC 27695-7506, USA.Email:david_flath@ncsu.edu; and Nariu: Faculty of Economics, Kyoto University, Kyoto, Japan. Abstract     When retailers must commit to shipment quantities prior to resolution of demand uncertainty,manufacturer stipulation of a minimum retail price is likely to be profitable for the manufacturer, andnot damaging to the retailers.  The reason is simple: If demand turns out to be  low, the unfetteredmarket-clearing price can lie below the price that maximizes total sales revenue.  A minimum retailprice that is binding in the low demand state can thus increase total revenue even though it saddlesretailers with unsold merchandise.  This “new” insight of  Deneckere, Marvel, and Peck is actuallya straightforward generalization of the model of full manufacturer reimbursement for returnsdeveloped in Flath and Nariu (1989).  The ubiquity of full reimbursement for returns in Japan eventhough it is in theory merely a second-best way of achieving minimum retail price stipulations, revealsimportant aspects of manufacturer maintenance of retail prices having to do with enforcementproblems, the allocation of risk-bearing and economic incentives.  These aspects of resale pricemaintenance are relevant to the normative evaluation of the special exemptions for RPM that Japan’sFair Trade Commission has long maintained but is now phasing out.1More on Demand Uncertainty and Price Maintenance     In a recent paper Raymond Deneckere, Howard P. Marvel, and James Peck (1997) argue thatwhen retailers must commit to shipment quantities prior to resolution of demand uncertainty,manufacturer stipulation of a minimum retail price is likely to be profitable for the manufacturer, andnot damaging to the retailers.  The reason is simple: If demand turns out to be  low, the unfetteredmarket-clearing price can lie below the price that maximizes total sales revenue.  A minimum retailprice that is binding in the low demand state can thus increase total revenue even though it saddlesretailers with unsold merchandise.  In the following paragraphs, we first develop a simple algebraicexample that, among other things, exposes the close correspondence between this argument andanalysis of the peak-load pricing problem.  We then discuss some considerations bearing upon themanufacturer’s choice among the different ways of curbing price discounting by independent retailers.Finally, we offer some specific empirical examples from Japan in which the argument may apply.     We start with the algebraic example that ties the Deneckere, Marvel and Peck argument to thephenomenon k own as peak-load pricing, and that is also the basis for some other points.  Let thelinear demand curve for some good have vertical intercept Y,  and let the demand curve have slope-bH with probability 2, and slope -bL with probability 1-2, where bL>bH:                      pH=Y-bHxH, with probability = 2price =                       9   pL=Y-bLxL, with probability = (1-2)Suppose that a risk-neutral and vertically-integrated manufacturer must produce before realizationof the stochastic demand just described.  Suppose further that the unit cost equals c.  Themanufacturer solves the problem:   max   expected profit=2(Y-bHxH)xH + (1-2)(Y-bLxL)xL - cQ,       s.t. xH#Q, and xL#Q.     Q                                                            The manufacturer will not allow the price to fall below the revenue maximizi g level Y/2 even if itresults in some output remaining unsold.  But the self-imposed price floor of Y/2 is only binding forsome combinations of the parameters c/Y, 2, bL and bH.  Specifically, if  (bL- H)/bL $ c/(Y2), then thefirm maximizes its expected profit by producing (Y-c/2)/2bH, but only selling the smaller amountY/2bL at the price Y/2 in the low demand state, while selling all at the price (Y+c/2)/2in the highdemand state.  If, on the other hand, (bL-bH)/bL < c/(Y2), then the firm produces (Y-c)/(2[bL(1-2)+bH2]), and sells all at the corresponding state-dependent market-clearing prices.To state it formally, the solution to the manufacturer’s problem is:2                  (Y-c/2) 2bH  = xH* $ xL*=Y/2bL,               if  (bL- H)/bL $ c/(Y2)Q*   =                   9   (Y-c)/(2[bL(1-2)+bH2]) = xH*=xL* ,             if (bL- H)/bL < c/(Y2)Analytically, this is exactly the same as the familiar peak-load pricing problem, in which a firm thatcan adjust its prices in conjunction with time-varying demands must decide upon how muchproductive capacity to install.  Depending upon the parameters, some installed capacity may remainidle in the low demand state.  Refer, for example, to Tirole (1988), exercise 1.6, p. 71.     The relevance of all this to manufacturer stipulation of a minimum retail price is immediate.  Inthe case of a manufacturer confronting the same situation as above but selling to an atomistic andrisk-neutral retailing industry whose sole cost consists of purchases from it, the manufacturer attainsthe first-best result just described, either by accepting returns of unsold merchandise at the price Y/2or, equivalently, by stipulating minimum retail price Y/2.  The manufacturer lowers its wholesale pricesufficiently that the retail industry just accepts the full supply Q*.     The condition, (bL-bH)/bL $ c/(Y2), encapsulates the factors contributing to the likelihood that themanufacturer will contrive to leave some output unsold in the low demand state, that is, will curbprice discounting in the low demand state.  The factors contributing to this are low unit costs inrelation to the intercept of the demand curve c/Y<<, low probability of realization of the low demandstate (1-2)<<, and great variation between the low demand and high demand state (bL-bH)/bL>>.      Full manufacturer reimbursement for returns, as analyzed in Flath and Nariu (1989), amounts toa fixed pricing policy: pL= H.  In the present context, it emerges only if unit cost c equals zero, inwhich case pL*=pH*=Y/2.  For c>0, full reimbursement for returns does not achieve themanufacturer’s first-best.  Nevertheless, one can point to several actual examples of fullreimbursement for returns.  A “full returns policy” is the usual practice for newspapers, magazinesand books in many countries including the US, as documented in OECD (1997).  And in Japan, fullreimbursement for returns seems to be common for many other products, too.  Why? Reflectionsupon this question prompt several observations on enforcement problems, the allocation of risk-bearing, and the economic incentives, under alternative vertical arrangements.     Consider the problem of enforcement.  On this topic, Deneckere, Marvel and Peck (1997, f.n. 10,p. 622) state only that, “Returns policies may be prohibitive either because of retailer moral hazardor the costs of administering such systems.”  This warrants a closer look.  Reimbursing for unsoldgoods can rest on the physical return of the goods or pro f of the goods’ destruction (for examplereturn of the covers of paperback books).  But to enforce minimum price stipulations, themanufacturer must monitor the actual details of transactions that the parties involved might wish toconceal.  Perhaps the manufacturer can easily detect advertised price discounting.  But in that casethe authorized retailer can make illicit sales to an unauthorized retailer who actually advertises theretail discount.  Even though the manufacturer will in that case detect violation of the RPMagreement, he will not necessarily know the identity of the violator.  On these grounds, minimumresale price stipulations actually seem more costly than return policies for the manufacturer toadminister and enforce.  There are exceptions, and it must be these that Deneckere et al have in mind.For instance, what if the good in question is a service, rather than a commodity, such as the viewing3of a motion picture, or  lunchtime meals in a franchise restaurant?  For such services, “returns” ofunsold goods are essentially meaningless, but minimum price stipulations can still have the statedmotivation.  Another exception to the usual presumption that returns policies are less costly toadminister than minimum resale price stipulations is the instance in which the manufacturer desiresthat the retailers retain their stocks of unsold goods for resale at a later date, which precludes thephysical return or actual destruction of the unsold goods.      Besides the question of enforcement, full and partial returns, and RPM, also differ in how theydivide risk between manufacturer and retailers, and in how they structure economic incentives.  Undera full returns system the manufacturer bears all the risk and the retailers none.  A minimum resaleprice stipulation places all the risk on the retailers.  And a partial returns system divides the riskbetween the manufacturer and the retailers.  If retailers are best organized as sole proprietorshipswhile manufacturers are organized as joint stock companies, then the full returns system achieves thesuperior allocation of risk.  This can be one reason behind actual examples of full returns systems, butthere is another reason as well: To better exploit the manufacturer’s private information regardingthe demand.   Only the one that bears the risk of unsold merchandise has an economic incentive tocollect private information about demand, and act appropriately.  A manufacturer who fullyreimburses retailers for unsold merchandise must itself determine shipment quantities.  By the sametoken, only if retailers are fully insulated from the risk of unsold merchandise, can they be confidentthat the manufacturer’s shipments to them are based on the manufacturer’s own best estimatesregarding the likely future demand.  If the manufacturer’s information regarding the likely futuredemand is superior to the retailers’ then a full return system is indicated, but if retailers’ informationis superior then minimum retail price stipulations might be indicated even if it entails higher risk-bearing costs than would a full or partial returns system.     The  Nintendo example cited by Deneckere et al illustrates the importance of asymmetricinformation.   Nintendo of America first instituted a full return system, only later, apparentlyinstituting RPM (Sheff (1993), p. 188).  In 1985, Nintendo, after successfully marketing its gamesin Japan,  believed that the likely demand for the game in the US would also be great.  But Americanretailers, mindful of the recent failure of Atari video games, did not believe that the demand forNintendo games would be great.  Only a policy of full reimbursement for returns could induceAmerican retailers to accept shipments of Nintendo games.  By 1988, Nintendo games were sellingwell and American retailers requested shipment of 110 million game cartridges but Nintendo suppliedonly 33 million (Sheff (1993), p. 194).  Only after this time did Nintendo switch its policy to one inwhich retailers were obliged to pay for shipments within ninety days of receiving them and, possibly,were required to observe minimum retail prices stipulated by it.  Deneckere et al (1997, pp.635-6)suggest that the minimum price stipulation was, in fact, binding in 1990, a year in which the pricesof the games fell significantly below their levels in prior years (It is unclear whether the pricestipulation pertained to the game cartridges or only to the game system, the unit used to play thecartridges).  In 1991, Nintendo consented to desist from further RPM (114 F.T.C. 702, (1991)).     The Nintendo case is a fairly convincing instance of a manufacturer acting to curb pricediscounting by independent retailers, simply to preserve revenues in low demand states.  One wouldlike to discover other examples.  The instances of officially authorized resale price maintenance under1Although resale price maintenance agreements are in principle a violation of Japan’santimonopoly law (section 19), there have been two special exceptions.  First, resale pricemaintenance is explicitly authorized for copyrighted works (Antimonopoly law of Japan, section 24-2(4)).  Second, the Fair Trade Commission of Japan, the agency delegated with enforcement of theantimonopoly aw, may (under the Antimonopoly Law, section 24-2(1)), at the request of amanufacturer, designate specific branded p oducts as exempt from the usual prohibitions on resaleprice maintenance.   As a matter of policy, the JFTC is phasing out such exemptions.  Furthermore,amendments to the antimonopoly law that would remove the special authorization of RPM forcopyrighted works are also under serious discussion in Japan.  For relevant details on theantimonopoly laws of Japan refer to Flath (1989).4the antimonopoly laws of Japan offer some plausible candidates.1  The products for which RPM wasspecifcally authorized in Japan have included shampoo, hairdye, toothpaste, toilet soap and laundrydetergent (1953-1973), caramel candy (1954-1966), men’s white T-shirts (1959-1966), and non-prescription medicines (1953- ).  Every item on this list can be held in retailers’ inventory for laterresell.  All of them are branded, advertised products, presumably therefore having relatively largeprice-cost margins (low unit costs in relation to the i tercept of the demand curve).  All of this, asjust discussed, fits the Deneckere et al explanation.  And there is more.  Although RPM wasauthorized for specific brands of laundry detergent for two decades, it was apparently only actuallyenforced in the very last two years in which authorized, 1972-1973.  This also fits the Deneckere etal argument, for again, as just discussed, minimum price stipulations that are merely to curb pricediscounting in low demand states, are more likely to be profitable if low demand is less likely.  Inother words, it is natural to expect that a minimum price stipulation would often, or even usually, noteven be binding.  In short, we think the Deneckere et al explanation is the correct one for all thesevarious examples of RPM in Japan.      The Fair Trade Commission of Japan is currently phasing out all special exemptions from the usualprohibitions of RPM.  This might or might not be welfare enhancing.  For instance, if returns policiesare not practical, then the alternative to RPM is the regime in which price adjusts to the market-clearing level (flexible pricing).   Consider a specific instance.  In the algebraic example, if  (bL-bH)/bL$ ½ + c/(Y2), then, under the flexible pricing regime, the monopolist would anticipate price equalto zero in the low demand state, and, in anticipation of this, would produce exactly the same quantityas under the RPM regime.  The flexible pricing regime is, in this particular instance, superior fromthe standpoint of social welfare because it avoids the wasteful discarding of output in the low demandstate.  But the social welfare ranking of the alternative regimes is, in general, ambiguous, for withother parameters (in other words, for (bL-bH)/bL < ½ + c/(Y2)), the monopolist supplies less outputunder the flexible pricing regime than under the RPM regime, and in some such instances, the RPMregime confers higher social welfare.5REFERENCESDeneckere, Raymond; Marvel, Howard P. and Peck, James. “Demand Uncertainty and PriceMaintenance: Markdowns as Destructive Competition. ” American Economic Review,September 1997, 87 (4), pp. 619-641.Flath, David.  “Vertical Restraints in Japan.”  Japan and the World Economy, 1989, 1, pp. 187-203.Flath, David and Nariu, Tatsuhiko. “Returns Policy in the Japanese Marketing System.”  Journal ofthe Japanese and International Economies, 1989, 3, pp. 49-63.OECD, Competition Policy Roundtables: Resale Price Maintenance, Paris, France: OECD, 1997(http://www.oecd.org//daf/ccp).Sheff, David. Game Over: How Nintento Zapped an American Industry, Captured Your Dollars, andEnslaved Your Children, New York, NY: Random House, 1993.Tirole, Jean.  The Theory of Industrial Organization, Cambridge, MA: MIT Press, 1988.

Demand uncertainty and price maintenance

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Demand uncertainty and price maintenance

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