**PROCOMPETITIVE JUSTIFICATIONS FOR EXCLUSIVE DEALING:**

**PREVENTING FREE-RIDING AND CREATING**

**UNDIVIDED DEALER LOYALTY**

Benjamin Klein

and

Andres V. Lerner[^1]

**TABLE OF CONTENTS**

Page

[I. Introduction 1](#introduction)

[II. The Standard Free-Riding Theory: Exclusive Dealing Prevents Dealer
Free-Riding on Manufacturer-Supplied Investments
7](#the-standard-free-riding-theory-exclusive-dealing-prevents-dealer-free-riding-on-manufacturer-supplied-investments)

[III. Dealer Free-Riding In the Absence of Manufacturer Promotional
Investments
14](#dealer-free-riding-in-the-absence-of-manufacturer-promotional-investments)

[A. Manufacturers Desire Increased Dealer Promotion
14](#manufacturers-desire-increased-dealer-promotion)

[B. Manufacturer Contracts For Increased Dealer Promotion
19](#manufacturer-contracts-for-increased-dealer-promotion)

[C. Dealer Free-Riding By Using Manufacturer Paid-for Promotion to Sell
Rival Products
26](#dealer-free-riding-by-using-manufacturer-paid-for-promotion-to-sell-rival-products)

[D. Exclusive Dealing Prevents Free-Riding By Preventing Dealer
Switching
29](#exclusive-dealing-prevents-free-riding-by-preventing-dealer-switching)

[IV. Dealer Free-Riding In the Absence of Switching
31](#dealer-free-riding-in-the-absence-of-switching)

[A. Dealer Free-Riding By Failing to Supply the Promotion Paid-for By
the Manufacturer
31](#dealer-free-riding-by-failing-to-supply-the-promotion-paid-for-by-the-manufacturer)

[B. Does "Undivided Dealer Loyalty" Make Economic Sense?
34](#does-undivided-dealer-loyalty-make-economic-sense)

[C. Exclusive Dealing Prevents Free-Riding By Increasing Dealer
Incentives to Perform
39](#exclusive-dealing-prevents-free-riding-by-increasing-dealer-incentives-to-perform)

[V. Conclusion 47](#conclusion)

# Introduction

Recent exclusive dealing antitrust case law has magnified the importance
of procompetitive justifications. While the minimum market share for
antitrust liability under Section 1 has increased substantially over
time, making it increasingly difficult for plaintiffs to successfully
challenge exclusive dealing contracts on Section 1 grounds,[^2] there
has been a simultaneous recent movement making it easier for plaintiffs
to successfully challenge exclusive dealing contracts on Section 2
monopolization grounds when a procompetitive rationale cannot be
provided for exclusivity. In these circumstances Section 2 antitrust
liability may be found even when plaintiffs have not established that
distribution has been effectively blocked to rivals by the exclusive
dealing arrangements.

These two disparate trends in Section 1 and Section 2 exclusive dealing
law are perhaps most recognizable in *Microsoft*.[^3] The Justice
Department lost on its exclusive dealing Section 1 claims at the
district court, with the court holding that Microsoft's exclusive
distribution contracts with Internet access providers and personal
computer manufacturers did not foreclose Netscape from distributing its
browser.[^4] However, Justice prevailed on its Section 2 exclusive
dealing monopolization claims, which the Appeals Court affirmed.
Microsoft was condemned not because its exclusive browser distribution
contracts effectively foreclosed the market to its rivals, but because
the contracts, which controlled the "most efficient" means of browser
distribution, were held to be pretextual.[^5] Microsoft's exclusive
contracts, therefore, unnecessarily placed rivals at a competitive
disadvantage.[^6] Because there was no reasonable procompetitive
rationale for Microsoft's exclusivity restrictions, the court concluded
that the contracts did not involve "competition on the merits."[^7]

More recently, a similar result occurred in *Dentsply*.[^8] Dentsply, a
manufacturer of artificial teeth with a 75 to 80 percent market
share,[^9] entered exclusive dealing contracts with its dealers, who
sold Dentsply teeth along with other supplies to dental labs.[^10] The
Department of Justice challenged the contracts on Section 1 and
Section 2 grounds, maintaining that exclusivity had the effect of
foreclosing rival artificial teeth manufacturers from the primary
channel of distribution with no procompetitive rationale. The district
court rejected Dentsply's attempt to provide procompetitive
justifications for its exclusive dealing contracts as pretextual, but
did not condemn the arrangements because it held that sufficient
alternative distribution channels were available for rival
manufacturers. Specifically, "because direct distribution is viable,
non-Dentsply dealers are available, and Dentsply dealers may be
converted at any time," the court concluded that Dentsply's exclusive
contracts did not have an anticompetitive effect.[^11]

Once again, the Department of Justice did not challenge its Section 1
loss, and only appealed the court's Section 2 ruling. The Appeals Court
reversed the district court's rejection of Section 2 antitrust liability
because it concluded that Dentsply effectively foreclosed the "preferred
distribution channels ‑- in effect the 'gateways' \-- to the artificial
teeth market" without a valid procompetitive rationale.[^12] Dentsply's
exclusive contracts, therefore, placed its rivals at a competitive
disadvantage without any procompetitive benefit to balance against this
anticompetitive effect. While the court in *Dentsply* does not use the
*Microsoft* terminology, that Dentsply's use of exclusive dealing did
not involve "competition on the merits", the reasoning suggests that a
firm with market power must have a non-pretextual procompetitive
rationale for using an exclusive dealing contract that imposes an extra
burden on competitors. Without a valid procompetitive justification for
exclusivity, the balancing of procompetitive justifications and
anticompetitive effects is easily tipped towards antitrust liability.

In addition to reinforcing the increasing legal importance placed on
procompetitive justifications for exclusive dealing contracts,
*Dentsply* illustrates the extremely narrow economic foundation upon
which procompetitive justifications currently rest. The two
procompetitive justifications for exclusive dealing offered by Dentsply,
that exclusive dealing prevented dealer free-riding on
manufacturer-supplied investments and created dedicated dealers that
more actively promoted Dentsply products, were firmly rejected by the
district court as making no economic sense, and this conclusion was
fully accepted by the Appeals Court. The court emphasized that the
prevention of dealer free-riding on Dentsply's investments, a widely
accepted rationale for exclusive dealing presented by Howard Marvel in
his now classic article and reiterated in his testimony as the economic
expert retained by Dentsply, did not fit the facts of the case.[^13] In
particular, the court held that (a) Dentsply did not provide investments
to its dealers that could be used to sell rival manufacturer's products,
(b) there was no evidence of dealers switching customers (dental labs)
to rival brands, and (c) contrary to the economic theory of free-riding,
where exclusive dealing has the beneficial effect of increasing the
manufacturer's incentive to make promotional investments, Dentsply
executives testified that absent exclusive dealing Dentsply would have
increased its promotional investments.[^14]

The only other procompetitive justification offered by Dentsply was the
claim that exclusive dealing created dedicated distributors that devoted
their efforts to promoting Dentsply products.[^15] While "undivided
dealer loyalty" has been accepted by a number of courts as a
procompetitive motivation for exclusive dealing,[^16] the *Dentsply*
court maintained that this rationale lacks an economic basis because
inter-dealer competition generally provides dealers with the incentive
to supply dealer services.[^17] In fact, the court noted that this
rationale for exclusive dealing was explicitly rejected by Marvel in his
article as making no economic sense and the court fully accepted
Marvel's economic analysis in rejecting Dentsply's undivided dealer
loyalty rationale.[^18]

The economic analysis underlying the court's rejection of Dentsply's
procompetitive rationales for exclusive dealing is an example of the
common error of trying to determine if the facts of a case fit a
preconceived economic model instead of developing an appropriate
economic model that best explains the facts. In particular, Dentsply's
procompetitive rationales were rejected because they failed to
correspond with a particular, fairly narrow economic theory of how
exclusive dealing prevents dealer free-riding and the economic
assumption that competition between dealers necessarily leads to the
desired level of dealer promotional effort.

The major purpose of this paper is to expand the economic framework
under which we conduct our analysis of exclusive dealing contracts. We
provide an economic basis for the fundamental business reality that
manufacturers often want their dealers to supply more promotion than the
dealers would independently decide to supply. This leads manufacturers
to contract with (and compensate) their dealers for providing increased
promotion. Using examples taken from important exclusive dealing cases
we show that dealers have an incentive to violate these contractual
arrangements in three distinct ways that can usefully be described as
free-riding and demonstrate how exclusive dealing may be used to
mitigate all three forms of free-riding. Within this more realistic
economic framework exclusive dealing is shown to prevent free-riding in
cases where a manufacturer does not provide any promotional assets to
its dealers (but merely compensates dealers for their increased
promotional efforts), and where dealers do not switch their sales
efforts to the promotion of rival brands (but merely fail to supply the
promotion the manufacturer has contracted and paid for). Consequently,
the use of exclusive dealing to avoid free-riding and to create
dedicated dealers are justifications that have much broader
applicability than previously recognized.[^19]

# The Standard Free-Riding Theory: Exclusive Dealing Prevents Dealer Free-Riding on Manufacturer-Supplied Investments

The standard avoidance of dealer free-riding theory of exclusive dealing
refers to cases where a manufacturer makes investments in promotional
assets that it provides to its dealers free of charge.[^20] These
investments often include, for example, dealer display fixtures or
salesperson training. The manufacturer then expects its dealers to use
these assets to promote its products, and not the products of rival
manufacturers. In *Beltone*, for example, these manufacturer-supplied
promotional investments consisted of sales leads.[^21] Beltone, a
hearing aid manufacturer, advertised its products in magazines where
prospective customers filled out cards requesting additional
information. Beltone, which sold its products through exclusive dealers
that were granted exclusive sales territories,[^22] supplied these sales
leads to the dealer located nearest the prospective customer.[^23]

Since Beltone directly provided its dealers with significant promotional
assets in the form of sales leads, it is obvious that Beltone would want
its dealers to use these investments to sell its products. However, when
a manufacturer directly supplies a dealer with investments that
potentially can be used to sell other manufacturers' products, a
potential dealer free-riding problem is created. Specifically, dealers
will have an incentive to use the manufacturer's investments to sell a
rival manufacturer's brand if they can earn a higher profit margin on
the rival brand.

The dealer's profit margin is very likely to be higher on an
alternative, low brand name product because the dealer generally can
purchase such alternative products at lower wholesale prices. Low brand
name products have lower wholesale prices because the manufacturers of
these products do not bear the costs of supplying promotional
investments to dealers. In addition, dealers demanding a low brand name
product usually will have a choice of several highly substitutable
alternative suppliers, each of whom faces a highly elastic demand by
dealers. The wholesale price of the alternative, low brand name product,
therefore, will be much closer to marginal manufacturer production cost
than the branded product.

It may appear that the alternative, low brand name manufacturer is
free-riding on the brand name manufacturer that has made the promotional
investment, in effect using the brand name manufacturer's investment as
its own. However, it is the dealer that is ultimately engaging in
free-riding by violating its implicit contract with the manufacturer
when using the manufacturer-supplied assets to sell a rival
manufacturer's product. In addition, it is primarily the dealer that is
benefiting from the switching because competition between low brand name
rival manufacturers in supplying the substitute product will mean that
rival manufacturers are unlikely to significantly profit from the
free-riding.

A similar exclusive dealing case, where the manufacturer directly
supplied significant promotional investments valued by its dealers, is
*Ryko*.[^24] Ryko, a manufacturer of automatic car-wash equipment, used
exclusive dealing/exclusive territory contracts with its dealers, who
were responsible for promoting the sales of Ryko equipment to car washes
and gasoline stations in their designated areas.[^25] As part of the
marketing process Ryko made sales presentations to national gasoline
companies, who then would decide whether to recommend the product to
their gasoline station dealers.[^26] Once Ryko convinced the national
gasoline company of the potential value of the product, this information
was supplied to the operators of the gasoline company's stations in
their areas.[^27]

The Ryko dealer was responsible for completing the sale by convincing
individual gas stations to purchase the Ryko system.[^28] However,
without Ryko first devoting resources to obtain approval of its system
from the national gasoline company, it is much less likely that local
Ryko dealers would have been able to make the ultimate sale to the
gasoline stations.[^29] Litigation arose because Eden Services, a local
Ryko distributor, promoted its own water reclaim system at the expense
of the Ryko system when making its presentation to potential gasoline
station buyers in violation of Ryko's exclusive dealing contract.[^30]
Ryko then terminated Eden and Eden sued, challenging the exclusive on
antitrust grounds.[^31]

In general, dealers will have to make an extra effort to switch
consumers to rival brands when consumers visit a dealer, such as a
Beltone hearing aid dealer, with an expectation of purchasing a
particular manufacturer's product. However, dealers will have an
incentive to devote resources to switching sales from the manufacturer's
product to an alternative, low brand name product that the dealer can
sell at a lower price because the dealer earns a greater profit margin
on the alternative product. For consumers that do not have a strong
preference for the manufacturer's product, switching may be accomplished
merely by the dealer asserting that the lower-priced, lower brand name
alternative product is "just as good" as the manufacturer's product the
consumers may have initially asked for.

In contrast, dealers may not always disclose to customers that a
substitution is being made, and therefore can "pass off an inferior
product as the supplier's own..."[^32] In cases where buyers are unaware
that the dealer has switched them to an alternative, possibly inferior
product, the cost to the dealer of switching buyers may be very low or
nonexistent and the investments provided by a manufacturer to its
dealers can be costlessly used by dealers to sell alternative
products.[^33]

It is obvious why a manufacturer that wishes to prevent the type of
potential free-riding illustrated in *Beltone* and *Ryko* may use
exclusive dealing. An exclusive, by prohibiting dealers from selling any
competing hearing aid brand or water reclaim system, prevents Beltone
and Ryko dealers from engaging in free-riding on the manufacturer's
investments by preventing dealer switching of consumers to other brands.
And by permitting the manufacturer to capture the return on its
investments, the exclusive encourages manufacturers to make valuable
investments in generating sales.[^34]

This procompetitive rationale for exclusive dealing was accepted in both
*Beltone* and *Ryko*. In *Beltone* the FTC held that, by protecting
Beltone's promotional investments, the exclusive was justified because
it encouraged Beltone to make promotional investments.[^35] Similarly,
in *Ryko* the court noted that Eden's behavior in promoting its own
water reclaim system at the expense of the Ryko system in violation of
the exclusive dealing contract amounted to free-riding on Ryko's
marketing efforts. The court concluded that the exclusive contract was
procompetitive because it made it more likely that manufacturers would
undertake valuable marketing activities in the first place because they
need not fear that the increased sales created by such activities would
be partially lost to other firms.[^36]

This standard analysis of exclusive dealing as a way to prevent
free-riding on manufacturer promotional investments was rejected by the
court in *Dentsply* because the court found that Dentsply's promotional
investments were "purely brand-specific" and, therefore, dealers could
not free-ride by using such investments to sell rivals' products.[^37]
It is unclear exactly what the court understood "purely brand-specific"
to mean. Any manufacturer investment that gets the customer into the
dealership or otherwise increases a customer's demand for the dealer's
services, including brand-specific advertising, creates the potential
for dealer free-riding by switching customers to rival brands. *Beltone*
and *Ryko* clearly illustrate that a dealer may free-ride upon
manufacturer investments that are brand-specific. Marvel similarly
argued in *Dentsply* that without exclusive dealing it would not have
been economic for Dentsply to undertake the required branded promotion
to introduce new products because of the potential dealer free-riding
that would exist.[^38]

Whether dealers could in principle free-ride on Dentsply's investments
or not is irrelevant because in rejecting Marvel's analysis the court
noted there was an absence of any evidence of dealers switching dental
labs to rival brands.[^39] Furthermore, rather than exclusive dealing
encouraging increased manufacturer investments, the court cited
testimony by Dentsply executives that absent exclusive dealing Dentsply
actually would have increased these brand-specific investments.[^40]
However, dealer free-riding can occur in circumstances where
manufacturers do not make any investments whatsoever (section III) and
where dealers do not switch customers to rival brands (section IV) and,
therefore, where the absence of exclusive dealing may increase
manufacturer promotion as an inefficient substitute for lost dealer
promotion.

# Dealer Free-Riding In the Absence of Manufacturer Promotional Investments

## Manufacturers Desire Increased Dealer Promotion

The court in *Dentsply* concluded that inter-dealer competition provides
dealers with the correct incentive to promote a manufacturer's products
and that, therefore, the supply of dealer services can be left up to
competition among dealers without any contractual interference by the
manufacturer with regards to requiring exclusivity.[^41] However, an
important economic fact about real world business relationships is that
in most markets manufacturers desire more dealer promotion of their
products than dealers would independently provide.[^42] Contrary to the
assumption made by the court in *Dentsply*, uncontrolled dealers will,
in general, supply less than the desired (joint manufacturer and dealer
profit-maximizing) amount of promotional services.

Marvel acknowledges that dealers will sometimes supply less than the
amount of promotional services desired by the manufacturer, but only
when dealers engage in inter-dealer free-riding, where dealers do not
supply customer service, such as product demonstrations, but instead
encourage their customers to first go to a full-service dealer to
receive these services before purchasing the product from them at a
lower price.[^43] Because dealers can free-ride on the services provided
by competing dealers in this way, each dealer will have an incentive to
supply less than the optimal quantity of dealer services. However,
Marvel maintains that, even in these circumstances, "exclusive dealing
is not an efficient means by which to promote increases in dealers
services."[^44] If such inter-dealer free-riding existed, exclusive
dealing would have no effect in mitigating the free-riding and would not
encourage dealers to increase the supply of services since an identical
inter-dealer free-riding incentive continues to exist under
exclusivity.[^45] Consequently, Marvel and the Dentsply court conclude
that "enhancing dealer services cannot be the justification for
exclusive dealing."[^46]

However, even in the absence of such inter-dealer free-riding,
manufacturers cannot leave it entirely up to their dealers to decide how
much promotion to supply in marketing their products because dealers
will not take account of the profit earned by the manufacturer on the
incremental sales produced by the dealer's promotional efforts. The
incremental profit earned by manufacturers on additional sales is often
significant because most manufacturers face a negatively sloped demand
and, hence, set dealer wholesale prices above marginal cost.[^47]
Dealers will not take account of this profit earned by manufacturers on
incremental sales in determining their level of promotion.

In general, a dealer's failure to take account of incremental
manufacturer profitability on additional sales will not lead to any
distortion with regard to insufficient dealer price competition or
supply of services that have significant inter-dealer demand effects.
Although dealers do not take account of the manufacturer's profit when
deciding to, for example, lower price, a lower dealer price produces a
much larger increase in an individual dealer's demand than in the
manufacturer's demand since consumers purchasing the manufacturer's
product at other dealers switch their purchases to the dealer that has
lowered its price. Because the individual dealer response to price
changes will be much larger than the manufacturer response due to these
inter-dealer competitive effects, the dealer's incentive to lower price
will be the same as the manufacturer's incentive to lower price even if
the manufacturer's margin on incremental sales is substantially greater
than the dealer's margin. Inter-dealer competition largely eliminates
any distortion with regards to individual dealer incentives to engage in
price competition.[^48]

Similarly, when dealers supply a service that produces large
inter-dealer effects, such as the supply of free, convenient parking
that shifts sales between dealers, competition between dealers leads
dealers to provide the desired quantity of these services. An individual
dealer that supplies the service experiences a shift out in its demand
resulting in an increase in the price it can charge for its products
and/or the sale of increased quantity. Once again, although the dealer
will not consider the extra manufacturer profit from incremental sales
produced by the provision of free parking, inter-dealer competition will
lead dealers to provide free parking because it attracts customers from
other dealers. Therefore, when dealers make decisions about supplying
such services, the dealer's higher elasticity of demand compared to the
manufacturer's elasticity of demand with respect to provision of the
services will offset the dealer's lower profit margin on incremental
sales compared to the manufacturer since the services can be thought of
as similar to a lower price.

With regard to a dealer's promotion of a manufacturer's product,
however, dealers will not undertake the promotional efforts required to
generate the incremental sales that would be profitable to the
manufacturer because there are unlikely to be any significant
inter-dealer demand effects from a dealer's promotion of a
manufacturer's product, which we refer to as inter-brand promotion.[^49]
In contrast to the provision of non-price services such as free parking,
inter-brand promotion generally will not lead consumers to switch
dealers in response to its provision.[^50] However, the extra sale made
by an individual dealer as a result of its promotion represents an extra
sale to the manufacturer.

Neither can a dealer profit from providing inter-brand promotion by
charging customers for the promotion. This is because a dealer's
inter-brand promotion is aimed at "marginal" consumers who, absent the
promotion, would not otherwise purchase the product. Retailer promotion
increases the reservation values of some of these consumers so that they
become equal to (or greater than) the retail price, and the consumers
decide to purchase the product. The promotion can be thought of as a way
to provide a targeted effective price discount to these particular
"marginal" consumers to induce incremental sales of the manufacturer's
product. To operate, therefore, such promotional services must be
provided to marginal consumers free of charge. The dealer cannot charge
for the promotion or it would defeat its very purpose.[^51]

Consequently, the dealer's failure to take account of incremental
manufacturer profit and inability to charge customers for its
promotional efforts will lead to too small an amount of dealer
inter-brand promotion. Although manufacturers would be willing to pay
the dealer's increased costs of providing additional promotion that
would be more than covered by the manufacturer's additional profit on
the incremental sales generated by the dealer's promotion, dealers will
not independently provide sufficient inter-brand promotion because they
will not cover their increased cost of providing the promotion.

## Manufacturer Contracts For Increased Dealer Promotion

Because manufacturers will want greater dealer promotion provided for
their products than dealers would choose to supply on their own, they
must find a way to get the desired (joint manufacturer and dealer
profit-maximizing) quantity of promotion supplied by dealers. This is
what creates the economic motivation for the manufacturer to supply
promotional assets to its dealers free of charge that underlies the
standard case of dealer free-riding. More generally, because much
promotion is efficiently provided by dealers at the point of sale,
manufacturers will contract with their dealers to supply an increased
level of promotion, with manufacturer supply of free promotional assets
only one possible element in the overall manufacturer-dealer contractual
arrangement.

Manufacturer contracts with dealers for added promotion may be either
explicitly written documents or, more generally, implicit contracts. An
example of an explicit contract was involved in the landmark Supreme
Court exclusive dealing case, *Standard Fashion*.[^52] Standard Fashion,
a manufacturer of dress patterns, employed exclusive dealing, requiring
the retailers who sold its patterns not to handle any competing
patterns.[^53] Standard also explicitly contracted with its retailers to
actively promote its patterns.[^54] In particular, Standard required its
retailers to provide a pattern department at "a prominent position on
the ground floor in the store,"[^55] a designated "lady attendant" to
give "proper attention to the sale" of patterns,[^56] and a minimum
inventory level.[^57]

The fact that Standard Fashion contracted with its retailers for
promotional inputs is evidence that retailers did not have the correct
incentive to independently supply promotional services. As with most
products that primarily involve intellectual property, Standard Fashion
had a low marginal cost of producing additional copies of its existing
patterns and, because it faced a negatively sloped demand for its
somewhat unique patterns, a profit-maximizing wholesale price that was
substantially above its marginal cost. Consequently, any incremental
sales made by a retailer were highly profitable for Standard Fashion.
Standard Fashion found it necessary to contractually specify particular
retailer promotional inputs because, as described above, its retailers
would not take account of this significant incremental profit earned by
Standard on each additional sale produced by retailer promotional
efforts.

Even when an explicit contract for specific dealer promotion, as in
*Standard Fashion*, does not exist, it is likely that an implicit
contractual arrangement is present between the manufacturer and its
dealers. For example, in both *Beltone* and *Ryko* the manufacturer did
not merely provide its dealers with promotional assets and then, as long
as dealers did not engage in switching the manufacturer's investments to
the sale of rival products, leave it completely up to the dealers to
decide how much promotional effort to supply. In addition to providing
significant promotional investments to its dealers (in the form of
individual customer sales leads in *Beltone* and a national sales effort
to gasoline companies in *Ryko*), Beltone and Ryko both desired their
dealers to supply additional complementary promotional services and
compensated their dealers for supplying such services.[^58]

Whether the manufacturer's contract with its dealers is explicitly
written or only implicitly understood, the manufacturer generally will
self-enforce rather than court-enforce the contractual arrangement. That
is, whether or not the manufacturer explicitly writes what it expects
its dealers to do with regard to the supply of promotion, when a dealer
does not perform as expected, the manufacturer generally will not take
the dealer to court to demand performance but will merely terminate the
relationship.[^59]

In order for the threat of termination to assure dealer performance with
regard to the supply of adequate promotion, dealers must earn more by
supplying the explicitly or implicitly contracted for level of promotion
than they could earn by violating the contract and supplying the level
of promotion that they independently find in their interests to supply.
Therefore, manufacturers must establish a contractual arrangement where
dealers expect to more than cover their increased costs of supplying the
contracted for promotion. If dealers are to be incentivized to supply
the higher, desired level of promotional services, they must earn a
profit premium over and above their increased costs of providing the
contracted for promotion.[^60]

A dealer profit premium is required for the self-enforcement mechanism
to operate because each dealer, in deciding whether to perform according
to the contractual arrangement and supply the desired level of
promotional services or not, will compare the net present value of the
profit from performing as contracted, *П~P~*, with the net present value
of the profit from not performing and violating the contract, *П~N~*.
Since dealers can earn extra profit for a period (before they are
terminated by the manufacturer for non-performance) by deciding not to
supply the promotion they have contracted and been compensated for and
only supply the quantity of promotion it is in its narrow interests to
provide, *П~N~* is positive. The dealer saves the extra net cost of
supplying the higher, contracted for promotion (and may earn an
increased margin on the products it switches consumers to) until the
manufacturer detects non-performance and terminates the dealer.

The dealer will perform as contracted with the manufacturer if and only
if these gains from not performing are less than the gains from
performing.

\(1\) *П~N~ \< П~P~*

Therefore, to assure that the dealer performs as contracted and supplies
the larger, contracted for level of promotional services, the dealer
must earn a profit stream, the present discount value of which, *П~P~*,
is greater than the short-term gain from not performing, *П~N~*.
Consequently, the manufacturer must more than merely compensate dealers
for their higher costs of providing increased promotion. If the
manufacturer merely compensated dealers for their higher costs, *П~P~*
would equal zero and dealers would not perform. Manufacturers must
create a distribution arrangement where each dealer earns a profit
premium above the higher costs of supplying the contracted for level of
promotional services the present discounted value of which, *П~P~*, or
what the dealer will lose upon termination, is greater than the
short-run gain that can be earned by a dealer by not performing as
implicitly contracted, *П~N~*.

Making sure that *П~P~* is greater than *П~N~* is a primary economic
role of granting dealers, such as the Beltone and Ryko dealers,
exclusive territories.[^61] The dealer earns a rent because it is the
sole supplier within an area and is compensated for supplying the
desired level of promotional services. *П~P~* , the present discounted
value of the dealer's profit stream earned from the grant of the
exclusive territory, is the capital value of the dealer's
distributorship and the potential sanction that the dealer will bear if
it is terminated for nonperformance. The manufacturer then monitors
dealer performance (for example, by comparing a dealer's sales to other
dealers' sales or by sending monitors to secretly observe dealer
behavior) and terminates those dealers that do not perform as implicitly
contracted and compensated for by the manufacturer.

When it is efficient to have a large number of dealers selling the
manufacturer's product within an area, a manufacturer will not use an
exclusive territory to generate the desired level of compensation to
assure dealer performance, *П~P~*, as was used in *Beltone* and *Ryko*.
Instead, the manufacturer may lower the wholesale price and use de facto
minimum resale price maintenance to insure that inter-dealer price
competition does not compete away the dealer's compensation.[^62] This
is, in fact, how Standard Fashion compensated its retailers for the
desired, contractually specified level of promotional efforts.[^63] In
particular, Standard Fashion set its wholesale prices at 50 percent of
retail label prices and contractually required its retailers "not to
sell Standard Patterns except at label prices."[^64] Minimum resale
price maintenance created a per unit sales profit stream for Standard
Fashion retailers that would cover the desired retailer-supplied
promotion and prevent the profit stream from being competed away in
lower retail prices by inter-retailer price competition. Standard
Fashion's retailers knew that if they followed the contractual
arrangement and supplied the specified promotional efforts, they could
expect to earn enough to cover their higher costs of supplying the
desired promotion plus an added profit premium to assure performance.

If the costs of providing extra promotional services are largely per
unit time (for example, the rent of a ground floor location, the salary
of attendants and extra inventory), without minimum resale price
maintenance each retailer would have the incentive to lower its price to
capture increased sales from infra-marginal consumers who knew they
wished to purchase the particular product and were price sensitive. If
uncontrolled, this price competition between dealers would eliminate
Standard Fashion's per unit sale compensation to retailers for supplying
the desired extra promotional services.

Whether a manufacturer provides its dealers with significant promotional
investments (the standard free-riding case) and also pays its dealers
for supplying additional complementary promotional services, as in
*Beltone* and *Ryko*, or uses a contractual arrangement where it does
not provide any investments to dealers but solely compensates dealers
for making the additional promotional investments, as in *Standard
Fashion*, the essential nature of the contractual arrangement between a
manufacturer and its dealers is the same. The manufacturer is
contracting with its dealers to supply additional promotion with certain
understandings. In *Beltone* and *Ryko* the understanding is that each
dealer will use the promotional leads provided by the manufacturer in
combination with its own promotional efforts to sell Beltone hearing
aids or Ryko car washing equipment. Beltone and Ryko are paying their
dealers to supply the desired amount of complementary dealer promotion
with a valuable exclusive territory. In *Standard Fashion* the
manufacturer is paying for dealer-supplied promotional inputs with
resale price maintenance with the understanding that adequate
dealer-provided promotional inputs, some of which were contractually
specified, will be used to promote and sell Standard Fashion patterns.

## Dealer Free-Riding By Using Manufacturer Paid-for Promotion to Sell Rival Products

In the cases we have described, *Beltone*, *Ryko* and *Standard
Fashion*, the potential exists for dealers to free-ride by violating the
implicit contract with the manufacturer regarding the supply of
promotion. One form of such potential dealer free-riding involves
dealers using the promotion paid for by the manufacturer to sell rival
products. Similar to the standard type of free-riding where dealers use
promotional investments supplied by the manufacturer to sell rival
products, a short-term profit incentive exists for dealers to use the
extra promotional services purchased by a manufacturer to sell rival
products with higher dealer profit margins.

As in the standard free-riding case described in Section II, the dealer
generally can earn more by convincing consumers to purchase lower-priced
rival manufacturer products because the rival products have lower
wholesale prices. Rival manufacturers do not bear the costs of
purchasing the dealer promotion and face highly elastic dealer demand.
For example, retailers selling Standard Fashion patterns will have a
profit incentive to use the sales staff, floor space, and other inputs
paid for by Standard Fashion to switch consumers to a competing pattern
that the retailer makes more profit on and can describe to consumers as
"just as good." Although the dealer free-riding motivation is identical
to the standard case, it does not appear to fit the standard free-riding
framework because there need not be any manufacturer-supplied
investments that dealers use to sell rival products. Instead, all the
investments are provided by the dealers, but are paid for by the
manufacturer. [^65]

Since manufacturer compensation of dealers for promotion is contingent
on the dealer's sales of the manufacturer's products, a dealer that
switches consumers to a rival's products may not appear to be
free-riding since manufacturer compensation is reduced. As described
above, manufacturer compensation of dealers for promotion often takes
the form of an extra profit margin on the dealer's sales of the
manufacturer's products via the grant of an exclusive territory or the
enforcement of minimum resale price maintenance.[^66] Therefore, a
dealer that switches sales to rivals will be paid less by the
manufacturer.

Dealer switching of sales to rival products, however, is free-riding
because dealers operating under a per unit sales compensation
arrangement generally are paid for their promotional efforts on the
basis of a profit premium they earn on their *total* sales of the
manufacturer's products, not on the difficult to measure incremental
sales produced by their extra promotional efforts. Therefore, the dealer
will have an incentive to use the promotional inputs paid for by the
manufacturer to make incremental sales of more profitable rival
products. The dealer will continue to receive most of the manufacturer's
compensation on infra-marginal sales, yet use its promotional assets to
sell more profitable rival products.[^67]

## Exclusive Dealing Prevents Free-Riding By Preventing Dealer Switching

Our analysis implies that exclusive dealing may be used to prevent
free-riding in cases where the manufacturer has not made significant
investments. Free-riding occurs because dealers use the promotional
resources paid for by the manufacturer to sell rival products; exclusive
dealing prevents this in the same way as exclusive dealing prevents
free-riding in the standard case where dealers use the promotional
assets supplied by the manufacturer to sell rival products, namely by
preventing dealer switching. Whether dealers are prevented from using
the promotional assets supplied by the manufacturer or paid for by the
manufacturer to switch consumers to rival products, the procompetitive
effect of the exclusive dealing is the same. Therefore, contrary to the
court's analysis in *Dentsply*, there need not be manufacturer
investments that dealers may free-ride upon to justify exclusive dealing
in terms of the prevention of free-riding.

Exactly how exclusive dealing operates to prevent dealer switching of
manufacturer-supplied or manufacturer-paid for promotion to the sale of
rival products is not as obvious as it may seem. We cannot assume that
because a manufacturer contractually specifies exclusivity that this, by
itself, prevents dealer switching and dealer free-riding. In spite of
exclusive dealing, some dealers may attempt to switch consumers to rival
products if they can get away with it for a sufficiently long period
before the manufacturer detects the contract violation and terminates.
In most of these cases the manufacturer will not attempt to legally
enforce its exclusive dealing contract, that is, take the free-riding
dealer to court to demand exclusivity. Instead, dealers that violate
exclusive dealing provisions will be terminated. This is what occurred,
for example, in *Ryko*, where Eden, the dealer violating the exclusive,
was terminated by the manufacturer, Ryko.[^68] Similarly, in *Beltone*
and *Dentsply*, which did not involve private litigation but government
challenges to exclusive arrangements, there is evidence in the record
that the manufacturer in both these cases also merely terminated
non-performing dealers.[^69]

The role of exclusive dealing in these manufacturer/dealer contractual
arrangements is in facilitating manufacturer self-enforcement of the
dealer performance contract. For example, consider the Beltone dealer
contract. Because an exclusive is included in the contract,
representatives from Beltone that policed dealers could much more easily
detect a non-performing dealer. If a Beltone representative observed a
product from a rival hearing aid company at a Beltone dealer, it could
infer that the dealer was violating the implicit "best efforts"
promotion contract. The manufacturer, therefore, could terminate the
dealer without determining if the dealer actually was switching
customers produced by Beltone-supplied leads to competing brands. The
exclusive serves the economic purpose of defining dealer performance in
a way that decreases the manufacturer's cost of monitoring and detecting
dealer non-performance.[^70]

In terms of the self-enforcement model summarized by equation (1), if
exclusivity makes it easier for the manufacturer to detect dealer
non-performance, this reduces the potential dealer short-run gain from
free-riding, *П~N~*, and, hence, reduces the required premium stream the
manufacturer must promise the dealer in order to assure dealer
performance. Therefore, exclusivity reduces the costs to Beltone of
self-enforcing the contractual arrangement by decreasing the
manufacturer's costs of sharing more of the joint profit with dealers,
for example, by granting larger or otherwise more profitable
dealerships.[^71]

# Dealer Free-Riding In the Absence of Switching

## Dealer Free-Riding By Failing to Supply the Promotion Paid-for By the Manufacturer

The fact that dealers are compensated by manufacturers for supplying
promotion on the basis of all their sales implies that dealers also have
an incentive to engage in a type of free-riding that does not involve
switching sales to a rival manufacturer. In particular, dealers have the
incentive to violate the manufacturer's implicit contract by not
supplying the contracted for level of promotion. Dealers that reduce
their promotional efforts save the cost of supplying the extra,
contracted for promotion but continue to receive the manufacturer's
compensation on the infra-marginal sales that continue to be made
without the dealer's promotion. Dealers lose profit on the incremental
sales that would have been induced by the promotion they fail to supply,
but as described in III.A. it is not in the dealers' independent
interests to bear the costs of undertaking this promotion required to
induce these incremental sales.

This potential free-riding problem, where dealers do not have the
incentive to supply the full amount of promotional effort contracted and
paid for by the manufacturer, exists in all the cases we have discussed
where the manufacturer is paying dealers for added promotion with a
restricted distribution arrangement. Because restricted distribution
arrangements compensate dealers on the basis of all their sales,
including the infra-marginal sales that would be made without the
contracted-for promotional efforts, an incentive exists for the dealer
not to supply the contracted-for promotion. Therefore, if the
manufacturer uses an exclusive territory (*Ryko*, *Beltone*) or resale
price maintenance (*Standard Fashion*) to pay dealers for supplying
extra promotion, the very nature of the promotion compensation
arrangement creates an incentive for dealers to supply less promotion
than contracted for, even when there is no possibility of a dealer
switching its promotion to rival brands.

To illustrate these economic forces consider another important exclusive
dealing case, *Roland Machinery*.[^72] The case dealt with the sale of
construction equipment by Roland Machinery Company, a distributor of
International Harvester's line of construction equipment. Since
construction equipment has relatively high fixed costs and a wholesale
price that is greater than marginal cost, it is likely that Dresser
Industries (which acquired International Harvester's construction
equipment business) desired greater point‑of-sale dealer promotion to
induce profitable incremental sales than dealers would independently
supply on their own. Dresser compensated its dealers for their extra
promotional efforts by limiting the number of dealerships and granting
each dealer a profitable, relatively large exclusive marketing
territory. For example, Roland Machinery was the sole International
Harvester distributor serving the 45 county area of central
Illinois.[^73]

In contrast to the exclusive territories granted in *Beltone* and
*Ryko*, Dresser did not use an explicit exclusive dealing contract with
its distributors. Instead, Dresser unilaterally enforced its distributor
contracts as if exclusivity was expected. In particular, only eight
months after signing its distribution agreement with Dresser, Roland
Machinery applied for a dealership from Komatsu, a Japanese manufacturer
of competitive construction equipment.[^74] Immediately after Roland
Machinery signed its Komatsu distribution agreement, Dresser notified
Roland that it planned to terminate its International Harvester
distributorship under the terms of its distribution agreement where
termination could occur without cause on 90 days' notice. [^75]

Although Dresser was compensating Roland for extra dealer promotion, it
is not obvious that there was an economic incentive for Roland to use
the promotional services paid for by Dresser to promote Komatsu
machines, that is, to engage in switching. In contrast to the standard
free-riding analysis, Komatsu is not a low cost, no brand name product
that Dresser could make more money switching buyers to. Moreover, there
was no evidence presented that Roland had engaged in switching demanders
of International Harvester equipment to Komatsu. Instead of preventing
free-riding, Dresser maintained that it preferred exclusive dealing
because it wished to distribute through dealers that had "undivided
loyalty" and, therefore, an increased incentive to promote its
products.[^76] The court accepted Dresser's "undivided loyalty"
procompetitive rationale for exclusive dealing, concluding that
exclusive dealing "leads dealers to promote each manufacturer's brand
more vigorously than would be the case under nonexclusive dealing."[^77]

## Does "Undivided Dealer Loyalty" Make Economic Sense?

The "undivided loyalty" rationale for exclusive dealing accepted by the
court in *Roland Machinery* has been accepted by a number of courts. For
example, a similar rationale for exclusive dealing arrangements was
accepted in Joyce Beverages v. Royal Crown Cola.[^78] The court
concluded that Royal Crown Cola's requirement that its bottler
distributors not carry any other cola brand in order that distributors
use their "best efforts ... to achieve maximum distribution and
sale"[^79] had the effect of increasing rather than inhibiting
competition because the exclusive "insures that the bottler devotes
undivided loyalty to its particular brand and that it competes
vigorously against all competing brands."[^80] Identical reasoning also
was used to justify the exclusive in Hendricks Music Co. v. Steinway,
where the court held that "\[i\]t is perfectly legitimate and, in fact,
procompetitive, for manufacturers to insist that their dealers devote
undivided loyalty to their products and not to those of their
competitors."[^81]

While this reasoning that exclusive dealing encourages dealer promotion
by creating dealers who have undivided loyalty is intuitively appealing
and is consistent with the academic marketing literature, which
recognizes that manufacturers may use exclusive dealing where they "hope
to obtain more dedicated and knowledgeable selling,"[^82] the reasoning
does not have a rigorous economic basis. In fact, Howard Marvel makes a
cogent argument in his paper that the "undivided loyalty" rationale for
exclusive dealing makes no economic sense. Marvel assumes that the only
reason dealers may not adequately provide services to consumers is if
they are taking advantage of the efforts of other dealers by engaging in
the inter-dealer free-riding that was the focus of *Sylvania*, that is,
if dealers are letting other dealers provide product demonstrations and
other valuable dealer services to consumers before the consumers
purchase the product from dealers who do not provide the services.[^83]
Marvel correctly argues that exclusive dealing would not solve this type
of inter-dealer free-riding problem. Dealers who handle only one brand
still have the incentive not to supply services to consumers and to
free-ride on the promotion provided by other, full-service dealers.[^84]
Marvel further argues that if there is not an inter-dealer free-riding
problem, dealers will have adequate incentives to provide services to
consumers, leading him to conclude that "exclusive dealing is not an
efficient means by which to promote increases in dealer services."[^85]

Because a rigorous economic basis for an "undivided loyalty" rationale
for exclusive dealing did not exist, the *Dentsply* court did not accept
Dentsply's attempt to justify its exclusive contracts with dealers
because of "the need for dealers to focus their efforts in order to
effectively promote the company's teeth and service laboratory
customers."[^86] The *Dentsply* court, very well aware of Howard
Marvel's explicit rejection of the possibility that exclusive dealing
could legitimately be used to encourage increased dealer promotion of a
manufacturer's product, noted that "Prof. Marvel has not endorsed this
particular rationale for exclusive dealing ... To the contrary, he
stated in his 1982 paper that enhancing dealer services cannot be the
justification for exclusive dealing."[^87] The court fully accepted
Marvel's economic reasoning in rejecting an undivided dealer rationale
for exclusive dealing. The court concludes that "\[t\]he 'focus dealer
services' rationale is not a valid justification for using exclusive
dealing in the tooth industry because dealers have every incentive on
their own to make sure that their level of service for any given tooth
brand does not suffer... If a customer is dissatisfied with the service
it receives from one Dentsply dealer, it will simply buy \[Dentsply\]
teeth from another dealer."[^88]

Judge Posner in *Roland Machinery* makes an attempt to provide an
economic explanation for the undivided loyalty rationale for exclusive
dealing in concluding that Dresser had "a plausible argument that an
exclusive dealer would promote its line more effectively than a
nonexclusive dealer, and by doing so would increase competition in the
market for construction equipment."[^89] Posner argues that by granting
Roland Machinery an exclusive territory in central Illinois, Dresser had
put "all of its eggs ... in the Roland basket", and therefore if Roland
did not promote Dresser products vigorously, Dresser would not have
another dealer to "fall back on."[^90] Because Dresser would suffer a
significant decrease in sales if Roland did not promote Dresser products
vigorously, this gives Dresser an economic reason to "want that dealer
to devote his efforts entirely to selling Dresser's brand."[^91]

However, Judge Posner does not tell us why Roland would not have the
correct incentive to promote Dresser's products absent exclusive
dealing. Nor does Judge Posner Judge explain why a manufacturer would
want its dealers to exclusively distribute its products even in the
absence of exclusive territories. Moreover, Judge Posner does not tell
us how exclusive dealing works in this context to incentivize dealers
such as Roland to increase their supply of promotional services, merely
asserting that Roland's acceptance of an exclusive dealing contract
"indicates \[Roland's\] commitment to pushing that brand; he doesn't
have divided loyalties... If the dealer carries several brands, his
stake in the success of each is reduced."[^92] But this does not explain
why an exclusive dealer will find it in its economic interests to
promote a brand more intensively.

While it may seem intuitively appealing that a manufacturer may use
exclusive dealing to create a dedicated distribution arrangement so that
dealers have "undivided loyalties", a rigorous economic explanation of
why manufacturers want dealers to provide more promotional services than
they would otherwise provide and exactly how exclusive dealing induces
dealers to do so is not in the economic literature. In fact, the idea
that exclusive dealing will increase desired dealer promotion is
contrary to generally accepted current economic analysis. Dentsply was
unfortunate enough to have a judge that was highly cognizant of the
state of the economic knowledge on this issue.

## Exclusive Dealing Prevents Free-Riding By Increasing Dealer Incentives to Perform

To understand how exclusive dealing creates an incentive for dealers to
more actively promote the manufacturer's product in a case such as
*Roland Machinery*, consider the analogous example of automobile
manufacturers who wish to have their dealers provide more promotion than
the dealers would independently decide to supply in order for the
manufacturer to take advantage of the significant profit it can earn on
incremental sales. For example, a manufacturer may desire its dealers to
remain open longer hours, hire a larger number of knowledgeable and
persuasive salespeople, and have the dealer's salespeople spend a
greater amount of time demonstrating its products and supplying test
drives to "marginal consumers" than the dealer would otherwise supply.
Automobile manufacturers, therefore, implicitly contract with their
dealers for an increased supply of dealer promotional activity.

The usual contractual arrangement is for the automobile manufacturer to
compensate its dealers for providing this extra promotion by limiting
the number of dealerships and, thereby, granting each dealer a valuable
franchise. Because each dealership serves a particular geographic area,
dealers are, in effect, granted a profitable sales and aftermarket
service business as a way to compensate for the provision of promotional
services.[^93] If the manufacturer does not believe the dealer is
adequately promoting its products, the dealer's allocation of
automobiles will be reduced and, in extreme cases, the dealer could be
terminated.

An automobile dealer that handles multiple brands has an increased
incentive to violate this implicit contract and free-ride on the
manufacturer's compensation arrangement. In contrast to the examples of
free-riding described above, this generally does not occur by dealer
switching, that is, by a dealer using the promotional resources that
have been supplied or paid for by the manufacturer to switch consumers
without strong brand preferences to lower-priced, non-brand name rival
products. More relevantly, dealers can violate the implicit contract by
not undertaking as much promotional effort in selling the manufacturer's
product as the manufacturer has implicitly contracted and paid for.

Consider, for example, a case where a customer who is leaning towards
the purchase of a Honda comes into a Toyota dealership to check out the
Toyota. Toyota desires the salespeople at its dealers to take the time
and make their "best efforts" to extol the advantages of Toyota compared
to Honda. However, if the dealer's salespeople have the ability to sell
Hondas in addition to Toyotas, it will not be in their interests to
undertake this extra promotional effort. It will be more economic for
the salespeople to save the additional costs associated with the extra
time and effort that would have to be expended to sufficiently increase
the possibility of a Toyota sale and, instead, merely sell the Honda by
telling the customer he is right, "Yes, Honda is better." From the
salesperson's and the dealership's point of view, everything else equal,
there is a higher profit margin on the Honda sale because there are
lower selling costs associated with the Honda sale. Although selling the
Honda increases the dealer's profit, failing to actively promote Toyota
products in this circumstance violates the implicit contract between
Toyota and the dealer. Toyota has provided the dealer with a valuable
dealership in return for the dealer's implicit promise to actively
promote Toyota products, which the dealer has failed to do.

Although the salesperson has not engaged in switching, this violation of
the implicit manufacturer contractual arrangement is analytically
similar to the type of free-riding we discussed in sections II and III
where the dealer switches a consumer to an alternative, rival brand. In
the switching type of free-riding the dealer actively promotes an
alternative brand because the profit margin on the alternative brand is
greater. In the type of free-riding we are discussing here, the dealer
decides not to promote the manufacturer's brand because it costs the
dealer less to sell the alternative brand. In switching free-riding the
dealer is pushing consumers to higher margin products that have lower
costs because the manufacturers of the alternative products have not
borne the costs of promotion; in this type of free-riding the dealer is
similarly selling a product that has a higher margin because the dealer
itself can save the costs of promoting the manufacturer's product.

When the dealership is exclusive, the incentive of the dealer to violate
the implicit contract by not supplying the contracted and paid for
promotion is substantially reduced because the Toyota dealer does not
have the ability to sell the Honda initially favored by the customer.
Therefore, if the dealer is to make the sale, it must promote the Toyota
product.[^94] The exclusive dealing contract, therefore, serves the
economic purpose of more closely aligning the incentives of the dealer
with the incentives of the manufacturer by creating undivided dealer
loyalty.

This analysis of undivided dealer loyalty can be presented more
rigorously. Without exclusive dealing, when a customer leaning towards a
Honda comes into the dealership to check out the Toyota, the dealer will
choose the level of Toyota promotion which maximizes its expected net
profit from making the Toyota sale. This can be represented by the
following dealer profit function:

\(2\)
$\underset{S}{\text{max}}\text{  }(M_{T}^{D} - M_{H}^{D}) \cdot p(S) - C(S)$

That is, dealers will choose to supply a level of Toyota promotional
services, *S*, so as to maximize their expected net return, where
$M_{T}^{D}$ is the dealer's profit margin from selling a Toyota,
$M_{H}^{D}$ is the dealer's profit margin from selling a Honda (which we
can assume can be sold with little or no promotion), *p* is the dealer's
probability of making the Toyota sale, which is assumed to be positively
related to the amount of Toyota promotional services supplied by the
dealer, *p'(S) \> 0*, and *C* is the cost of promoting the Toyota, which
is also a positive function of *S*, *C'(S) \> 0*.

The profit maximizing level of Toyota promotion that a non-exclusive
dealer chooses is given by:

\(3\) $C^{'}(S) = p^{'}(S)(M_{T}^{D} - M_{H}^{D})$

Dealers will invest in making Toyota promotional expenditures up to
point where the increased cost associated with providing increased
promotion, *C'(S)*, equals the increase in the expected profitability of
selling a Toyota, or the increased probability of making a Toyota sale
as promotional expenditures are increased, *p'(S)*, multiplied by the
dealer profit difference between a Toyota and Honda sale,
($M_{T}^{D} - M_{H}^{D}$).

Equation (3) implies that if $M_{T}^{D}$ = $M_{H}^{D}$, that is, the
dealer's profitability of selling the Toyota and Honda are the same, it
will never pay the dealer to promote the Toyota when a customer is
leaning towards a Honda. There is no incremental profit associated with
the supply of Toyota promotion. A dealer, and specifically a dealer's
sales staff, would not waste its time and resources if it can make just
as much money with less effort by selling a Honda.

On the other hand, if the dealer is an exclusive Toyota dealer, even
when a customer is leaning towards the purchase of a Honda, the dealer
will spend resources promoting the Toyota up to the point where:

\(4\) $C^{'}(S) = p^{'}(S)M_{T}^{D}$

The dealer will increase its promotional expenditures until the
increased cost of the promotion is equal to the expected profitability
of the promotion, that is, the increased probability of selling a Toyota
multiplied by the profit margin on the incremental Toyota sale.

Therefore, even if the profit margin on selling a Toyota is not greater
than on selling a Honda, the dealer will promote Toyota under an
exclusive because if the dealer does not sell the Toyota, the dealer
does not make any sale. In *Roland Machinery*, for example, the dealer's
motivation to promote is altered under exclusive dealing because if the
dealer does not make an International Harvester sale, it does not sell
anything. Consequently, when a customer comes into an exclusive
dealership, the manufacturer can be assured that the salesperson will
"push" the manufacturer's products more than if the dealership were not
exclusive.

The dealer promotion supplied under an exclusive, given by (4), is still
not the manufacturer-dealer joint-profit maximizing level of promotion,
which occurs at

\(5\) $C^{'}(S) = p^{'}(S)(M_{T}^{D} + M_{T}^{M})$

where $M_{T}^{M}$is the Toyota manufacturer's profit in selling an
additional car. However, exclusive dealing clearly does move dealer
promotion closer to the desired level by better aligning incentives than
a contractual arrangement without an exclusive.

Dealer incentives to promote under alternative contractual arrangements
represented in equations (3) ‑ (5) can be compared by transposing the
equations so that the left hand side of each equation is equal to
$\frac{C^{'}(S)}{p^{'}(S)}$, the marginal cost of additional Toyota
promotion divided by the increased probability of making a Toyota sale
from the additional Toyota promotion. Dealers will choose a level of
Toyota promotion where this ratio will equal the additional
profitability of making a Toyota sale under the alternative conditions.
These economic forces are illustrated in Figure 1, which plots
$\frac{C^{'}(S)}{p^{'}(S)}$ as a function of the quantity of *S*.[^95]

![](media/image1.wmf){width="7.559055118110236e-2in"
height="0.31929133858267716in"}

Figure 1 indicates that without an exclusive dealing contract, the
dealer will provide inter-brand promotional services equal to *S~NE~*.
If $M_{T}^{D}$ = $M_{H}^{D}$, then the dealer will not provide any
additional inter-brand promotional services demanded by the manufacturer
(*S~NE~*=0). More generally, the inter-brand promotional services
independently provided by the dealer will be significantly lower than
the level the manufacturer desires. Exclusive dealing moves the dealer
incentive to supply the inter-brand promotional services desired by the
manufacturer from *S~NE~* to *S~ED~* because the dealer cannot save
promotion costs by engaging in free-riding by making an easy sale of a
competing brand. However, the exclusive, by itself, does not induce
dealers to supply the amount of promotion implicitly contracted for by
the manufacturer that maximizes the joint profit of the manufacturer and
dealer, *S~MAX~*. The manufacturer must still monitor dealer performance
and self-enforce the implicit contract to insure that dealers go the
remainder of the way and provide the joint profit-maximizing level of
promotional services.

Monitoring and enforcing dealer performance may occur, for example, by
comparing a dealer's sales volume with the sales of other dealers, by
using performance measures such as customer surveys to determine sales
and service satisfaction, and by providing dealers with a profit stream
that can be lost by termination or reduced by a decrease in the dealer's
supply of "hot" models. The fact that exclusive dealing moves dealers a
significant portion of the way towards the desired level makes it easier
for the manufacturer to use these self-enforcement mechanisms.
Specifically, because dealers operating under exclusive dealing find it
in their own independent self-interests to supply increased promotion,
the short-run dealer profit incentive to supply less than the desired
level of promotional services, *П~N~*, is reduced. Therefore, the amount
of costly manufacturer policing (which controls *П~N~*) and the required
self-enforcing profit premium the manufacturer must pay dealers, *П~P~*,
is also reduced by exclusive dealing.

# Conclusion

The common assumption made by economists that manufacturers can rely
completely on inter-dealer competition to supply the desired level of
promotional services is not generally valid. Manufacturers, in fact,
often contract with and compensate their dealers to supply more
promotion than the dealers would independently supply. Because dealers
are supplying more promotion than they otherwise would find profitable
to supply absent the manufacturer contract, a dealer short-run profit
incentive exists to violate the contract. We have seen that contractual
violations and dealer non-performance may occur in three distinct ways:
(1) dealer switching of manufacturer-supplied promotional assets to the
sale of rival products, the recognized case of dealer free-riding, as
well as (2) dealer switching of manufacturer paid-for promotion to the
sale of rival products and (3) dealer undersupply of manufacturer
paid-for promotion. In all three cases dealers can be said to be
free-riding on the manufacturer's arrangement for compensating in
receiving manufacturer assets or compensation and then not meeting their
end of the bargain by adequately promoting the manufacturer's products.

Many manufacturer-dealer contractual arrangements are likely to contain
the potential for all three forms of dealer free-riding. For example, in
*Beltone* and *Ryko*, where manufacturer promotional investments were
supplied to dealers, manufacturers also made payments to dealers for
added promotion. Therefore, in addition to the first type of dealer
free-riding discussed in the *Beltone* and *Ryko* decisions, the second
and third types of dealer free-riding was also clearly present.
Exclusive dealing, in addition to preventing dealers from using the
promotional assets supplied by the manufacturer to sell rival products
also prevented dealers from using their own promotional efforts to sell
rival products (free-riding type two) and had the effect of increasing
independent dealer incentives to promote (reducing free-riding type
three). More generally, in all the legal cases we have examined
exclusive dealing can be thought of as assuring manufacturers they will
receive the increased dealer promotion they are paying for by
facilitating self-enforcement of the manufacturer's contractual
arrangement. By constraining the ability of the dealer to switch
promotional efforts to rival products and by aligning dealer and
manufacturer incentives, exclusive dealing has the effect of decreasing
the dealer's short-run profit potential from not performing as
contracted, *П~N~*.

This economic framework expands what one should look for in determining
whether there is a legitimate procompetitive justification for an
exclusive dealing contract. In particular, the presence of free-rideable
manufacturer investments and dealer switching, the conditions focused
upon by the court in *Dentsply*, are not necessary conditions for
determining whether a prevention of free-riding justification for
exclusive dealing makes economic sense. All that is required for
exclusive dealing to be used to prevent dealer free-riding is that
dealers have a significant economic role in the promotion of the
manufacturer's product, that manufacturers are compensating dealers for
the supply of additional promotion and that exclusive dealing encourages
such extra dealer promotion by facilitating manufacturer enforcement of
its implicit contract for dealer promotion.

An undivided dealer loyalty rationale for exclusive dealing, therefore,
may have been consistent with the evidence in *Dentsply*. The Department
of Justice's proposed Findings of Fact unambiguously indicates that
Dentsply relied significantly on dealers to promote the sale of its
products.[^96] The Department of Justice offered these facts regarding
the crucial role of Dentsply's dealers in promoting Dentsply's products
in order to demonstrate that the distribution of artificial teeth
through dealers was economically essential in order for a manufacturer
of artificial teeth to compete effectively. But in demonstrating the
anticompetitive effect of Dentsply's exclusive dealing contracts in
controlling a key channel of distribution, the government also
established the necessary economic conditions for a procompetitive
undivided dealer loyalty justification for Dentsply's exclusive dealing
contracts.

Moreover, the use of exclusive dealing to create dedicated dealers that
would more actively promote Dentsply products is fully consistent with
the testimony by Dentsply executives that absent exclusive dealer
Dentsply would have increased its own promotional investments.[^97]
Because the role of exclusive dealing is to encourage dealer promotion
and not to protect manufacturer investments against dealer switching of
customers to rival brands, we would not expect Dentsply to decrease its
investments absent exclusive dealing. Since there is little or no dealer
switching, Dentsply need not fear that its investments would be
appropriated. Instead, Dentsply would find it economic to increase its
promotional investments as a less efficient substitute for the preferred
promotion that dealers would supply if they operated under exclusive
dealing contracts.

Because exclusive dealing is very likely to increase dealer promotional
efforts by creating dedicated dealers, antitrust analysis of exclusive
dealing contracts becomes more difficult. The relatively easy cases
where nothing is placed on the procompetitive justification side of the
scale will be much rarer. However, recognizing that an exclusive dealing
contract serves a procompetitive purpose does not mean that the contract
cannot be anticompetitive. For example, while the exclusive dealing
contracts used by Dentsply likely had a legitimate procompetitive
purpose in encouraging dealer promotion, the Appeals Court found the
contracts to have anticompetitive effects. But the more likely presence
of procompetitive efficiency reasons for adopting exclusive dealing does
mean that one cannot use the "no economic sense" test as a necessary
condition for finding antitrust liability in exclusive dealing
cases.[^98]

However, before balancing the procompetitive and anticompetitive effects
of exclusive dealing contracts, it is important to remember that
balancing is the final step of the analysis. The first step is for
plaintiffs to establish a significant anticompetitive effect of the
exclusive contract. Recent developments in antitrust case law with
regard to exclusive dealing as illustrated by *Microsoft* and
*Dentsply*, where there was a finding of Section 2 but no Section 1
liability, does not mean that this first step of demonstrating a
significant anticompetitive effect may be skipped.[^99] Since an
exclusive dealing contract may appear to inherently exclude rivals, or
at the very least place rivals at a disadvantage, there is a danger that
the absence of a procompetitive justification will always tip the
competitive balance in favor of liability if we do not require
demonstrating a significant anticompetitive effect. The "no economic
sense" test would then become a de facto sufficient condition for
antitrust liability.

What the analysis in this paper should teach us is that exclusive
dealing contracts are more likely to be used as an element of the
competitive process than previously believed. The fact that the expanded
role of exclusive dealing in facilitating the enforcement of efficient
distribution contracts we present in this paper was unrecognized
suggests that there may very well be as yet undiscovered other
legitimate economic purposes served by exclusive dealing
contracts.[^100] Therefore, before concluding that an exclusive contract
should be condemned because it does not involve "competition not on the
merits", we must unambiguously establish that the contract disturbs the
competitive process by anticompetitively foreclosing a significant share
of distribution.

[^1]: ^\*^ Klein: Professor Emeritus of Economics, UCLA and Director,
    LECG, LLC; Lerner: Principal, LECG, LLC.

[^2]: "The recent decisions uniformly favor defendants where foreclosure
    levels are 40 percent or less." Jonathan M. Jacobson, *Exclusive
    Dealing, "Foreclosure," and Consumer Harm*, 70 Antitrust L. J. 311,
    362 (2002), citing cases at 325, n. 85. Moreover, exclusive dealing
    arrangements covering even greater shares of the market have been
    routinely upheld if the contracts are relatively short-term, with a
    number of courts concluding that exclusive contracts covering one
    year or less are presumptively lawful. *See, e.g.*, Roland Machinery
    v. Dresser Industries, 749 F.2d 380 (7^th^ Cir. 1984); Omega
    Environmental Inc. v. Gilbarco, Inc., 127 F.3d 1157 (9^th^ Cir.
    1997); Concord Boat Corp. v. Brunswick Corp., 207 F.3d 1039 (8^th^
    Cir. 2000).

[^3]: United States v. Microsoft Corp., 87 F. Supp. 2d 30 (D.D.C. 2000),
    253 F.3d 34 (D.C. Cir. 2001) (en banc).

[^4]: *Microsoft*, 87 F. Supp. 2d at 52. The D.C. Circuit signaled its
    disagreement, noting that "The District Court appears to have based
    its holding with respect to §1 upon a 'total exclusion test' rather
    than the 40% standard drawn from the case law." *Microsoft*, 253 F.
    3d at 70. But the D.C. Circuit did not reverse the Section 1 ruling,
    which was not appealed by the plaintiffs.

[^5]: "Microsoft's only explanation for its exclusive dealing is that it
    wants to keep developers focused upon its APIs \[Windows application
    program interfaces\] ‑- which is to say, it wants to preserve its
    power in the operating system market. ... That is not an unlawful
    end, but neither is it a procompetitive justification for the
    specific means here in question, namely exclusive dealing contracts
    with IAPs \[Internet access providers\]." *Microsoft*, 253 F. 3d at
    71.

[^6]: *Id.* at 70‑71.

[^7]: The D.C. Circuit defined "competition on the merits" as
    competition that "involves, for example, greater efficiency or
    enhanced consumer appeal." *Id.* at 59.

[^8]: United States v. Dentsply Int'l, Inc. 277 F. Supp. 2d 387 (D. Del.
    Aug. 6, 2003), 399 F.3d 181 (3d Cir. 2005), *cert. denied*, 126 S.
    Ct. 1023 (2006).

[^9]: *Dentsply,* 277 F. Supp. 2d at 423.

[^10]: For consistency of exposition throughout the paper we refer to
    the supplier of the product in question as "the manufacturer" and,
    in most cases, the purchaser of the manufacturer's product as "the
    dealer."

[^11]: *Id.* at 453.

[^12]: *Dentsply,* 399 F.3d at 193, 196-197. The Appeals Court
    discounted the possibility that rival manufacturers could compete
    effectively by relying on direct sales to dental laboratories. *Id.*
    at 193. Sales by Dentsply's two primary direct-selling competitors
    comprised only 8% of the market. *Id.* at 193. Moreover, the court
    concluded that, although dealers theoretically could terminate their
    relationship with Dentsply "at will" and switch to a competing line
    of artificial teeth, "the dealers have a strong economic incentive
    to continue carrying Dentsply's teeth." *Id.* at 193-194. The
    Appeals Court noted that "\[a\]lthough rivals could theoretically
    convince a dealer to buy their products and drop Dentsply's line,
    that has not occurred." In the more than ten years that Dentsply had
    employed exclusive dealing prior to the DOJ challenge, no dealer had
    dropped Dentsply in favor of rival brands of artificial teeth. *Id.*
    at 193‑94. When a firm produces an essential product that makes
    rival entry difficult, the use of short-term contracts may not be a
    sufficient condition for the absence of an anticompetitive effect.

[^13]: Howard P. Marvel, *Exclusive Dealing*, 25 J. L. & Econ. 1 (1982).

[^14]: *Dentsply,* 277 F. Supp. 2d at 442-446.

[^15]: This rationale was not presented by Marvel, but in Dentsply
    answers to interrogatories (GX 157 at Interrogatory Response No. 13)
    and by a Dentsply executive (D.I. 429 at 1719-20). *Dentsply,* 277
    F. Supp. 2d at 440-441.

[^16]: See *infra* notes Error: Reference source not found, Error:
    Reference source not found and Error: Reference source not found.

[^17]: *Dentsply,* 277 F. Supp. 2d at 441.

[^18]: *Id.*

[^19]: A number of other justifications for exclusive dealing are also
    shown to make economic sense within our more realistic economic
    framework. For example, Jacobson, *supra* note Error: Reference
    source not found, at 357‑360 lists nine economic justifications that
    have at times been accepted by courts for exclusive dealing
    contracts, with the prevention of free-riding and the creation of
    dedicated dealers as his first two justifications. However, a number
    of his other justifications are economic variants of these first two
    rationales. In particular, Jacobson lists quality assurance and the
    prevention of dealers passing off an inferior product in place of
    the manufacturer's product as his third justification for exclusive
    dealing. But the role of exclusive dealing in such cases is to
    prevent dealer free-riding on the manufacturer's brand name
    investment by switching buyers to rival products when the buyer is
    unaware that switching is occurring. (See discussion of this type of
    free-riding at *infra* note Error: Reference source not found.)
    Jacobson also lists reducing the costs of monitoring dealer
    performance as a separate rationale for exclusive dealing, but the
    cause of dealer non-performance in these cases often involves the
    same types of free-riding we discuss, and exclusive dealing serves
    the same economic purpose of reducing the manufacturer's costs of
    detecting dealer nonperformance, discussed *infra* at note Error:
    Reference source not found. In addition, Jacobson lists the role of
    exclusive dealing in decreasing dealer "out‑of-stocks", which
    involves the same dealer-manufacturer incentive incompatibilities
    with regard to dealer supply of promotion and exclusive dealing
    solves this problem in the same way by creating dedicated dealers.

[^20]: Marvel, *supra* note Error: Reference source not found at 2, 6-8.

[^21]: *In re* Beltone Elec. Corp., 100 F.T.C. 68 (1982).

[^22]: *Id.* at 270. Beltone's exclusive territories were enforced in
    part by refusing to issue warranties submitted by dealers on sales
    to consumers outside their assigned territories. *See* Howard P.
    Marvel, *Vertical Restraints in the Hearing Aids Industry* in Impact
    Evaluations of Federal Trade Commission Vertical Restraint Cases,
    Ronald N. Lafferty, Robert H. Lande and John B. Kirkwood, eds.,
    Federal Trade Commission, Washington, D.C. (1984), 270-384 at 280.

[^23]: *Beltone,* 100 F.T.C. at 47, 201-202. The FTC began an
    investigation in 1970 of these distribution arrangements, used by a
    number of hearing aid manufacturers, that resulted in a series of
    actions brought in 1973 against several of the leading hearing aid
    manufacturers, including Dahlberg Electronics, Maico Hearing
    Instruments, Sonotone Corporation and Radioear Corporation, in
    addition to Beltone Electronics. All the other companies reached
    consent agreements between 1973 and 1976. Beltone, the largest
    manufacturer with approximately a 20 percent market share, chose not
    to enter into a consent agreement and litigated to a successful
    conclusion in 1982.

[^24]: Ryko Mfg. Co. v. Eden Servs., 823 F.2d 1215 (8th Cir. 1987).

[^25]: *Id.* at 1218.

[^26]: *Id.* at 1219-1220.

[^27]: *Id.* at 1219-1220.

[^28]: *Id.* at 1220.

[^29]: *Id.* at 1219.

[^30]: *Id.* at 1221, 1230.

[^31]: *Id.* at 1221.

[^32]: Jacobson, supra note Error: Reference source not found, at 358.

[^33]: In addition to the loss of profit to the manufacturer on any
    sales that are switched, in these circumstances there also is likely
    to be the cost to the manufacturer of a loss to its reputation (and
    reduced future sales) when the customer receives an inferior product
    that it believes is the manufacturer's product.

[^34]: Marvel, *supra* note Error: Reference source not found at 7.

[^35]: *Beltone*, 100 F.T.C. at 285-287, 292. The FTC also found that
    Beltone's exclusive contracts did not foreclose distribution and
    that there was significant inter-brand competition. *Id.* at
    290-291.

[^36]: *Ryko*, 823 F.2d at 1234-1235, n. 17. In addition to finding
    Ryko's exclusive contracts procompetitive, the court found that the
    exclusive did not foreclose competition since there was "no evidence
    suggesting that Ryko's exclusive dealing provisions generally
    prevent Ryko's competitors from finding effective distributors for
    (or other means of promoting and selling) their products." *Id*. at
    1234.

[^37]: *Dentsply,* 277 F. Supp. 2d at 445. The district court cited
    Marvel's article, stating that "\[t\]he term 'purely brand specific'
    is derived from Prof. Marvel's 1982 paper describing his theory,
    where he wrote: 'This argument does not apply if the promotional
    investment is purely brand specific. In such cases, the dealer will
    not be in a position to switch customers from brand to brand.'"
    *Id.*

[^38]: Marvel used the example of Dentsply's promotion of "Portrait" and
    other new premium products. *Dentsply* *,* 277 F. Supp. 2d at 442.

[^39]: *Id*. at 443-445 ("There are 'zero examples' in the record of
    these dealers steering customers from one brand to another").

[^40]: *Id*. at 445-446.

[^41]: *Dentsply,* 277 F. Supp. 2d at 441.

[^42]: The following analysis is taken from Benjamin Klein & Joshua
    Wright, *The Economics of Slotting Contracts*, J. Law & Econ.,
    forthcoming (August 2007), which is an extension of the original
    statement of the inadequate retailer incentive to promote (and an
    analysis of the role of various vertical restraints in solving this
    problem) presented in Benjamin Klein & Kevin M. Murphy, *Vertical
    Restraints as Contract Enforcement Mechanisms*, 31 J. L. & Econ. 265
    (1988).

[^43]: This is the inter-dealer free-riding problem described in Lester
    G. Telser, *Why Should Manufacturers Want Fair Trade?*, 3 J. L. &
    Econ. 86 (1960), the avoidance of which is the focus of the
    rationale for non-price vertical restraints in Continental T.V.,
    Inc. v. GTE Sylvania Inc. 433 U.S. 36 (1977).

[^44]: Marvel, *supra* note Error: Reference source not found, at 4.

[^45]: Marvel, *supra* note Error: Reference source not found at 5.
    ("The free-rider problems facing exclusive and multiline dealers are
    identical.")

[^46]: *Dentsply,* 277 F. Supp. 2d at 441; Marvel, *supra* note Error:
    Reference source not found at 5.

[^47]: This does not imply that these manufacturers possess any
    antitrust market power, in the sense of the ability to affect market
    prices. Almost every firm operating in the economy, except perhaps
    the wheat farmer described in introductory economics textbooks,
    faces a negatively sloped demand because it is producing a somewhat
    unique, differentiated product and, hence, charges a price greater
    than marginal cost. *See* Benjamin Klein, *Market Power in
    Antitrust: Economic Analysis After* Kodak, 3 S. Ct. Econ. Rev. 43
    (1993).

[^48]: See Klein and Wright, *supra* note Error: Reference source not
    found, where it is shown that, in equilibrium, the dealer's quantity
    response to its price reduction multiplied by the dealer's profit
    margin will equal the manufacturer's quantity response to a lower
    price multiplied by the manufacturer's profit margin (Klein and
    Wright, equation (5)). This implies that there will be close to the
    optimal amount of dealer price competition when there is intense
    competition at the dealer level.

[^49]: Although we refer to dealer promotion of a manufacturer's
    products as inter-brand promotion because it primarily has
    inter-brand effects, such dealer promotion may also increase sales
    of a manufacturer without decreasing sales of its competitors
    (*i.e.* may increase total industry sales).

[^50]: A dealer's provision of inter-brand promotion may have some
    inter-dealer effects. For instance, a basic product demonstration
    may be demanded by consumers and could have some inter-dealer
    effects. Consumers may not shop at dealers that do not demonstrate
    the product at all (unless the consumers engage in inter-dealer free
    riding). However, we refer to inter-brand promotional services as
    the increased demonstration time spent by a dealer on a
    manufacturer's product.

[^51]: In fact, the common usage definition of promotion is something
    that is provided free of charge; if the dealer service were
    separately demanded and priced, it generally would not be called
    promotion. If consumers demanded these promotional services and were
    willing to pay for them, full-service dealers could prevent the
    inter-dealer free-riding currently emphasized in the economics and
    law (*supra* note Error: Reference source not found) by charging
    consumers directly for the services, so that consumers would have no
    incentive to visit a full-service dealer and obtain the services
    free of charge before using these services to purchase the product
    at a low-service dealer. This notion seems strange because we do not
    observe such arrangements in the marketplace. However, it is not
    because of the transaction costs associated with separate pricing
    that we do not observe such arrangements, but because consumers
    generally would not pay for the services since they are promotional
    services aimed at marginal consumers.

[^52]: Standard Fashion Co. v. Magrane-Houston Co., 258 U.S. 346 (1922).

[^53]: Standard Fashion had a 40 percent share of sales. *Standard
    Fashion*, 258 U.S. at 357. The case involved the attempt by
    Magrane-Houston (a dry-goods retailer in Boston) to substitute
    Standard Fashion's line of dress patterns for the products of
    another full-line pattern manufacturer, McCall. Standard's exclusive
    contracts were not an economic obstacle to McCall or other rival
    manufacturer competition for distribution since the contracts were
    two years in duration and the particular contract with
    Magrane-Houston had already been running for four years. Standard
    Fashion sued to enforce its exclusive contract solely because
    Magrane-Houston had failed to provide the contractually required
    three-months notice of termination. (*Standard Fashion*, 258 U.S. at
    351‑53.) Magrane-Houston's full compliance with the terms of the
    exclusive clearly would not have prevented its switch from Standard
    Fashion to McCall.

[^54]: *Standard Fashion*, 258 U.S. at 351‑352.

[^55]: *Standard Fashion*, 258 U.S., Pls. Ex. 7, Contract, Nov. 25,
    1914, R. at 131.

[^56]: Butterick Publ'g Co. v. William G. Fisher, 203 Mass. 122, 131
    (1909). Butterick was the owner of Standard Fashion.

[^57]: Magrane-Houston committed to purchase and have on hand at all
    times \$1,000 worth of Standard patterns, measured at net invoice
    prices which were 50 percent of retail prices. This amounted to in
    excess of 10,000 patterns. Standard Fashion credited Magrane-Houston
    at 90 percent of its cost for unsold, returned patterns that were
    exchanged for new stock. *Standard Fashion*, 258 U.S. at 352.

[^58]: For instance, in *Ryko,* the court described that "the
    distributor's promotional efforts can be essential to the completion
    of individual \[National Account Program (NAP)\] sales... \[w\]hile
    an oil company might designate Ryko an approved equipment supplier
    as the result of a national sales presentation, many NAP sales
    cannot be completed until the distributor has convinced the local
    purchaser that installing Ryko car-wash equipment at his location is
    a profitable idea." *Ryko*, 823 F.2d at 1220. In *Beltone,* dealers
    were supposed to follow up on sales leads with "a personal call upon
    the responding customer and to provide him or her with testing and
    information about hearing impairment and hearing aids. The dealer
    also requests that the person come to his shop for more thorough
    fitting of a suitable Beltone hearing aid." *Beltone,* 100 F.T.C.
    at. 202.

[^59]: Stewart Macauley, *Non-Contractual Relations in Business: A
    Preliminary Study*, 28 Amer. Soc. Rev. 55 (1963) documents the
    frequent use of such a self-enforcement (that is, non-court
    enforced) mechanism to assure transactor performance in many
    contractual arrangements.

[^60]: See, for example, Benjamin Klein and Keith B. Leffler, *The Role
    of Market Forces in Assuring Contractual Performance*, 89 J. Pol.
    Econ. 615 (1981).

[^61]: Klein and Murphy, *supra* note Error: Reference source not found.

[^62]: Klein and Murphy, *supra* note Error: Reference source not found.
    This role of resale price maintenance as a way for the manufacturer
    to provide sufficient compensation to dealers for the supply of
    increased promotion explains the use of resale price maintenance in
    the distribution of many products where the inter-dealer free-riding
    explanation described in Telser, *supra* note Error: Reference
    source not found, and accepted by the Court in *Sylvania*, 433 U.S.
    at 55 as a procompetitive rationale for vertical restraints, does
    not appear applicable. See Benjamin Klein, *Distribution
    Restrictions Operate By Creating Dealer Profits: Explaining the Use
    of Maximum Resale Price Maintenance in* State Oil v. Kahn, 7 S. Ct.
    Econ. Rev. 1, 7‑8 (1999).

[^63]: A systematic historical survey of exclusive dealing contracts
    indicates that resale price maintenance frequently has been used in
    conjunction with exclusive dealing. *See* Thomas R. Overstreet, Jr.,
    *Resale Price Maintenance: Economic Theories and Empirical
    Evidence*, Bureau of Economics Staff Report to the Federal Trade
    Commission, 84‑101 (1983).

[^64]: *Standard Fashion*, 258 U.S. at 352.

[^65]: Marvel, *supra* note Error: Reference source not found, justifies
    exclusivity in *Standard Fashion* as a way to protect Standard
    Fashion's intellectual property investments in the creation of dress
    pattern designs, which can easily be copied by rival manufacturers.
    While exclusive dealing does not prevent copying of a manufacturer's
    successful patterns by other full-line manufacturers, such as
    McCall, or by groups of limited-line manufacturers that together can
    supply retailers with a full-line of patterns, exclusive dealing
    prevents the retailer from switching consumers that have chosen a
    Standard Fashion design from a pattern catalog or pamphlet to the
    copy.

[^66]: This is primarily because of the difficulty of more directly
    measuring and contracting for dealer promotional effort. If dealer
    promotion increases the dealer's sales a particular percentage, the
    usual vertical restraint contractual compensation arrangement
    provides a reasonable dealer compensation measure across dealers and
    over time.

[^67]: Because dealers are compensated on total sales they also have an
    incentive to violate the implicit promotion contract by not
    following resale price maintenance. Dealers that supply the desired
    promotional services but lower price and increase sales to
    infra-marginal consumers who would purchase from other dealers are
    overcompensated for supplying the desired level of promotion.
    Meanwhile, other dealers will be under-compensated for supplying the
    desired promotion, leading them to reduce their promotional efforts.
    This incentive by dealers to engage in price competition exists even
    if all dealers are supplying the contracted for promotion and are
    not engaging in the *Sylvania* type of inter-dealer free-riding
    analyzed. *See supra* note Error: Reference source not found.

[^68]: Eden then challenged the termination by suing Ryko for its
    exclusive contract on Section 1 grounds. *Supra* note Error:
    Reference source not found.

[^69]: *Beltone,* 100 F.T.C. at 59; *Dentsply,* 277 F. Supp. 2d at
    414-415, 420. Similar enforcement of exclusive dealing occurred in
    *Roland Machinery*, discussed *infra* note Error: Reference source
    not found, where the manufacturer terminated its dealer, Roland
    Machinery, after it moved to non-exclusive dealing. *Standard
    Fashion* did not involve manufacturer termination of a dealer, but
    dealer termination of the manufacturer, *supra* note Error:
    Reference source not found.

[^70]: *See* Benjamin Klein & Lester Saft, *The Law and Economics of
    Franchise Tying Contracts*, 28 J. L. & Econ. 345 (1985) for a
    discussion of this reduced monitoring cost rationale for exclusive
    input requirements contracts in franchise arrangements.

[^71]: The manufacturer cannot collect the higher profit premium that
    would have to be paid to dealers in the absence of exclusive dealing
    with an initial lump sum payment from the dealer because this would
    make it legally difficult for the manufacturer to terminate dealers
    for nonperformance (without returning the initial fee, which would
    eliminate the dealer sanction implied by termination). See Benjamin
    Klein, *The Economics of Franchise Contracts*, 2 J. Corp. Fin. 9
    (1995) at 28‑30.

[^72]: Roland Machinery Co. v. Dresser Industries, 749 F.2d 380 (7^th^
    Cir. 1984).

[^73]: *Id.* at 381.

[^74]: *Id.* at 381-382.

[^75]: The Appeals Court in *Roland Machinery* held that there was no
    evidence of an exclusive dealing agreement between Dresser and
    Roland (or any other distributor). Although there was a clear desire
    by Dresser for distributor exclusivity, the fact that Roland openly
    obtained a Komatsu dealership indicated to the Court that Roland did
    not believe it had made a commitment to exclusivity. While Dresser
    preferred exclusivity and, in fact, was extremely hostile to
    non-exclusive arrangements as evidenced by its termination of
    Roland, the Court held that there was no "meeting of minds" and,
    therefore, no agreement. (*Roland Machinery*, 749 F.2d at 392‑3). In
    addition to denying the existence of an exclusive contract, the
    court concluded that, even if such a contract existed, it would not
    have been anticompetitive. Dresser Industries manufactured only 16
    or 17 percent of the construction equipment sold in Roland's
    territory of central Illinois. *Id.* at 382. The court also
    concluded that because Dresser's contracts were short-term and could
    not foreclose Komatsu, the second largest manufacturer of
    construction equipment in the world, from obtaining distribution. In
    fact, Komatsu had already become a major factor in the U.S. market.
    *Id.* at 393-395.

[^76]: *Roland Machinery*, 749 F.2d at 395.

[^77]: *Id.*

[^78]: Joyce Beverages v. Royal Crown Cola Co., 555 F. Supp. 271
    (S.D.N.Y. 1983).

[^79]: *Id.* at 273‑74.

[^80]: *Id.* at 278. Royal Crown Cola bottlers were paid for extra
    promotional efforts, in part, with the grant of a valuable exclusive
    territory (*id.*) that would be lost if Royal Crown terminated a
    bottler for its insufficient efforts to "compete for shelf space,
    display racks, promotional rotations and the placement of feature
    advertising." *Id.* at 275. The exclusive dealing contract
    requirement clearly had nothing to do with anticompetitive
    foreclosure because Royal Crown Cola had only a 5 percent share of
    U.S. cola sales. *Id.* at 273.

[^81]: Hendricks Music Co. v. Steinway, Inc., 689 F. Supp. 1501 (N.D.
    Ill. 1988) at 1514, 1545‑48.

[^82]: Phillip Kotler, Marketing Management, 11^th^ ed., 2003, at 513.

[^83]: Marvel, *supra* note Error: Reference source not found, at 3‑5.
    See *supra* note Error: Reference source not found.

[^84]: "The free-rider problems facing exclusive and multiline dealers
    are identical." Marvel, *supra* note Error: Reference source not
    found at 5.

[^85]: Marvel, *supra* note Error: Reference source not found, at 4. An
    indication of the impact of Marvel's analysis can be obtained by
    examining economics textbooks. An undivided loyalty rationale for
    exclusive dealing was included in some economics textbooks before
    Marvel's article. For instance, F.M. Scherer, Industrial Market
    Structure and Economic Performance (1980) at 586 states that
    "\[f\]or manufacturers, exclusive dealing arrangements are often
    appealing, because they ensure that their products will be
    merchandised with maximum energy and enthusiasm." This rationale for
    exclusive dealing was removed from later editions of the same
    textbook. *See* F.M. Scherer and David Ross, Industrial Market
    Structure and Economic Performance, Third Edition (1990).

[^86]: *See* *Dentsply,* 277 F. Supp. 2d, GX. 157 at Interrogatory
    Response No. 13 (p. 12), cited in DOJ Proposed Findings of Fact at
    332 ("In Dentsply's experience, the greater the number of competing
    tooth lines carried, the less likely that a dealer will be able to
    sustain all of the desired services and promotional elements at a
    high competitive level. In short, service and promotional support
    for a particular line is likely to suffer the greater the number of
    lines carried").

[^87]: *Dentsply,* 277 F. Supp. 2d at 441.

[^88]: *Id*.

[^89]: *Roland Machinery*, 749 F.2d at 395.

[^90]: *Id.*.

[^91]: *Id.*

[^92]: *Roland Machinery*, 749 F.2d at 395, citing Sulmeyer v. Coca-Cola
    Co., 515 F.2d 835, 840 n.2 (5^th^ Cir. 1975).

[^93]: While many consumers may find it economic to shop multiple
    dealers before purchasing because of the significant size of the
    purchase, profitable after sale service (including warranty work)
    will often be supplied by the most conveniently located dealer.
    Therefore, the grant of a limited exclusive territory will be a
    profitable asset.

[^94]: This is why instances where an automobile manufacturer permits a
    dual dealership (for example, in small towns), the manufacturer
    prefers that the two brands be in different segments of the market,
    so as not to be in direct competition with one another, and that the
    different brands have distinct sales staffs.

[^95]: The shape of this curve is likely to be convex, which will be the
    case if, for example, there is declining effectiveness of
    promotional expenditures, *p"(S) \< 0*, and the marginal cost of *S*
    is linear, so that *C"(S) = 0*.

[^96]: "Dealers are an important conduit for supplier's promotional
    message." *Dentsply,* 277 F. Supp. 2d, United States' Brief in
    Support of its Proposed Findings of Fact and Conclusions of Law at
    85 "Tooth dealers promote suppliers' products." *Id.* at 24. Because
    dealers assist laboratories in choosing teeth, they have significant
    ability to steer laboratories to a particular brand of artificial
    teeth. *Id.* Dealers can "assist suppliers in generating incremental
    business by promoting the manufacturer's product and providing these
    other services." *Id.* at 90. These conclusions were accepted by the
    Appeals Court. *Dentsply,* 277 F. Supp. 2d at 28.

[^97]: *Dentsply,* 277 F. Supp. 2d at 445-446.

[^98]: A "no economic sense" test is advocated by Gregory J. Werden,
    *Identifying Exclusionary Conduct Under Section 2: The "No Economic
    Sense" Test*, 73 Antitrust L. J. 413 (2006) and A. Douglas Melamed,
    *Exclusive Dealing Agreements and Other Exclusionary Conduct ‑ Are
    There Unifying Principles?*, 73 Antitrust L. J. 375 (2006). Jonathan
    M. Jacobson & Scott A. Sher, *"No Economic Sense" Makes No Sense For
    Exclusive Dealing*, 73 Antitrust L. J. 779 (2006) draw the same
    implication about the inappropriateness of the "no economic sense"
    test for exclusive dealing contracts. However, Jacobson and Sher
    assume that Dentsply's claimed undivided dealer loyalty
    justification makes economic sense, a proposition that we have
    demonstrated is correct but which the *Dentsply* court rejected for
    what appeared to be good economic reasons that Jacobson and Sher do
    not analyze.

[^99]: It is fairly obvious from both Appeals Court decisions that the
    Section 1 district court rulings would have been overturned if
    appealed by the DOJ, which perhaps failed to appeal because it did
    not want to risk further weakening of Section 1 exclusive dealing
    case law.

[^100]: Additional, commonly unrecognized justifications for exclusive
    dealing include the prevention of buyer holdups of a seller that has
    made specific investments, as illustrated by Tampa Electric Co. v.
    Nashville Coal Co., 365 U.S. 320 (1961). See Benjamin Klein, *The
    Economic Lessons of Fisher Body-General Motors*, unpublished ms.,
    2006. (Jacobson, *supra* note Error: Reference source not found,
    claims that the exclusive in *Tampa Electric* was used to provide
    assured supply to a buyer. However, an exclusive is a constraint on
    the buyer, not the seller. If it was the buyer, Tampa, that required
    assurances of supply rather than the seller, Nashville, that
    required assurances of demand, all that would have been needed would
    have been a requirements contract committing Nashville to supply,
    with perhaps some minimum purchase commitment by Tampa.) In
    addition, Benjamin Klein and Kevin M. Murphy, *Exclusive Dealing
    Intensifies Competitive Bidding for Distribution*, unpublished
    working paper (2006), show that exclusive dealing may be used to
    increase competition by manufacturers for distribution when dealers
    effectively act as bargaining agents for ultimate consumers and
    lower price by efficiently internalizing each consumer's independent
    buying decision.