Henry Grabowski, Tracy Lewis, Rahul Guha, Zoya Ivanova, Maria Salgado and Sally Woodhouse
The Supreme Court’s landmark 2007 ruling in Leegin Creative Leather
Products, Inc. v. PSKS, Inc. overturned a 96 year old precedent that had
established minimum resale price maintenance (RPM) as per se illegal. By
overturning this precedent the Court acknowledged what has long been
recognized by economists—that in certain situations vertical constraints on
prices can be procompetitive. In particular, RPM may solve free rider
problems that discourage retail competition along any dimension other
than price. For example, a free rider problem exists if consumers are able
to rely on the knowledgeable sales people of one retailer to get advice on
their purchases but can then purchase the product at a lower price at a
discount retailer. In such a situation, retailers cannot sustain high levels of
service to their customers without RPM because other retailers can
undercut their prices while free riding off their service offerings. Retailers’
ability to free ride off the services of others could lead all retailers to
provide low levels of service, resulting in a reduction in consumer welfare
as consumers choose to make fewer or less informed purchase decisions.
When such free rider problems are present, manufacturers may want to set
minimum prices at which their products can be resold in order to
encourage competition among retailers along non-price dimensions such
as service. Doing so can increase consumer welfare and enhance the
manufacturer’s product relative to competing brands — i.e., increase
competition between brands.
In the context described above free riding results in “destructive” or
welfare decreasing competition, a form of competition that has long been
noted as a potentially important defect of market systems. In this article
we focus on free riding in a different context — free riding by generic
manufacturers in the pharmaceutical industry. Such free riding decreases
competition across brands akin to that described above and has
implications for assessing the value of generic competition to consumers.
In particular, free riding by generic manufacturers reduces the incentives
of brand manufacturers to promote their products and to enhance the
quality of their products by seeking approval for additional indications.