Independent Service Organizations and Economic Efficiency

DAVID E. MILLS (*) I. INTRODUCTION Many manufacturers of capital equipment provide maintenance service to their equipment users. Sometimes equipment and service are sold separately and at other times they are bundled (for example, through leases and rental agreements). Numerous recent antitrust cases revolve around allegedly anti-competitive practices used by some manufacturers to deter independent service organizations (ISOs) from servicing the manufacturer's equipment. Indeed the volume of cases brought by ISOs in the past decade exceeds litigation in more conventional antitrust areas like antimerger disputes and cases under the Robinson Patman Act. (1) The controversial practices in these cases include tying sales of equipment and service, tying sales of service and other "aftermerket" products, refusals to sell replacement parts to ISOs, and refusals to license operating or diagnostic software to ISOs. The pivotal issue in these cases is whether practices that deter ISOs injure competition in the service aftermarket. (2) Manufacturers claim their customers shop for equipment and service simultaneously. That is, customers choose a proprietary "system" comprised of equipment, service and other components instead of merely choosing a brand of equipment. This line of reasoning holds that (interbrand) competition for systems disciplines the pricing of every component in tile system and, therefore, is sufficient to protect equipment users' welfare. If one manufacturer's equipment is priced above rivals', the high-priced equipment manufacturer must supply service at a lower price than its rivals to remain competitive on a "total cost of ownership" (TCO) basis. (3) Brand-specific (intrabrand) competition in the service aftermarket is not necessary to maximize equipment users' welfare. Because systems competition is sufficient, manufacturer practices that deter ISOs or discourage intrabrand service competition canno t injure competition. ISOs claim that systems competition does not adequately discipline manufacturers' service pricing. Once customers acquire a piece of durable equipment, they cannot replace it with another brand without incurring switching costs. Thus, as Salop argues, such customers become "locked in" to the manufacturer for maintenance service and are left vulnerable to opportunistic service pricing throughout the useful life of the equipment (1993). The only protection customers enjoy from exploitation by manufacturers in the service aftermarket is the protection afforded by ISOs. In the much cited Kodak decision, (4) the Supreme Court rejected the notion that inter-brand competition in systems (or equipment) is always sufficient to prevent the exercise of monopoly power in the service aftermarket. The Court was influenced by recent economic research that highlights theoretical opportunities for equipment manufacturers to exploit their locked in customers. These theoretical opportunities stem from information costs faced by customers and incomplete contracts between manufacturers and their customers. (5) Carl Shapiro recounted the "available theories of antitrust injury" (1995, 485) that apply to these circumstances. These theories include (i) incomplete information, where customers who are poorly informed about the TCO of competing brands of equipment are exploited by manufacturers once they become locked in; (ii) opportunistic pricing, where manufacturers break trust with their locked-in customers (and sacrifice their reputations) by implementing unanticipated increases in service pricing; (iii) inability to commit, where higher-than-competitive service pricing, and lower-than-competitive equipment pricing, arise because manufacturers cannot provide contractual assurances about future service prices; (6) and (iv) better opportunities for price discrimination afforded by the absence of independent maintenance providers. The price discrimination theory of lock-in exploitation differs from the previous three in that price discrimination often improves rather than impairs market performance. …