Credible Commitments: Schwinn

Although issues posed in Schwinn are not precisely the same as the franchise matters discussed above, they are nevertheless closely related. Inasmuch as this case displays pretransaction cost type reasoning, it is instructive to consider the government’s arguments against the franchise restrictions employed by Schwinn and then to consider an alternative construction.

1. The Objections 

Arnold, Schwinn & Co. is a longtime producer of quality bicycles. It decided to impose restrictions on its franchisers in 1951, at which time its U.S. market share was 22 percent. Authorized dealers, who had previously been required to provide minimum services (advertising, assembly, maintaining a stock of bicycles and replacement parts, providing qualified repair personnel, and the like),-were now prohibited from reselling Schwinn bicycles to nonauthorized dealers. The restriction was designed to deny access of Schwinn product to discount houses. Although its market share thereafter fell steadily (to 13 percent in 1961 ), Schwinn enforced that restriction over the next decade. The government brought suit, claiming that the restriction was anticompetitive. Its jurisdictional statement advanced the following theory of the case:

In industries in which products are highly differentiated, a particular brand—like Schwinn bicycles—often has a market of its own, within which [intrabrand] competition is highly important to the consumer and should be preserved. . . . Schwinn s strenuous efforts to exclude unauthorized retailers from selling its  bicycles suggest that, absent these restraints, there would be a broader retail distribution of these goods with the resulting public benefits (including lower price) of retail competition.

Similar views were repeated in the government’s brief:

The premise of the Schwinn franchising program is that Schwinn is a distinctive brand which commands a premium price—that it enjoys, in other words, a margin of protection from the competition of other brands. To the extent that this premise is sound, it is clear that the only fully effective control upon the retail price of Schwinn bicycles is that imposed by competition among Schwinn dealers and distributors.

The government also disclosed the animosity with which it regarded product differentiation:

Either the Schwinn bicycle is in fact a superior product for which the consumer would willingly pay more, in which event it should be unnecessary to create a quality image by the artificial device of discouraging competition in the price of distributing the product; or it is not of premium quality, and the consumer is being deceived into believing that it is by its high and uniform retail price. In neither event would the manufacturer’s private interest in maintaining a high- price image justify the serious impairment on competition that results.

And the government expressed its view about the merits of vertical integration as compared with vertical restraints:

Even if the threat to integrate were not wholly lacking in credibility in the circumstances of this case, we would urge that it was not a proper defense to the restraint of trade charge. In the first place, a rule that treats manufacturers who assume the distribution function themselves more leniently than those who impose restraints on independent distributors merely reflects the fact that, although integration in distribution may sometimes benefit the economy by leading to cost savings, agreements to maintain resale prices or to impose territorial restrictions of unlimited duration or outlet limitations of the type involved here have never been shown to produce comparable economies.

The government’s views on product differentiation and franchise restraints thus can be reduced to the following three propositions: (1) Differentiated products can be classed as those for which a price premium is warranted and those for which such a premium is not; (2) whether differentiation is real or contrived, intrabrand price competition is essential to the protection of consumer interests; and (3) although vertical integration sometimes yields economies, the same cannot be said for vertical restraints.

2. An Alternative Interpretation 

The possibility that Schwinn had identified a viable niche in a competitive industry and that the restraints it had introduced were needed to préserve the viability of the niche went completely unnoticed by the government. Instead, the government turned all its powers of advocacy to the description of an imagined anticompetitive offense. It ignored possible differences among customers and their marketing ramifications. Such a simplistic formulation is not satisfactory.

The buyers that will be most attracted by Schwinn will presumably be those for whom the opportunity cost of time is great or who are relatively inept at self-assembly and service. Thus, high-priced lawyers and other consultants who bill clients on an hourly basis will pay several times the going rate for a haircut, by patronizing barber shops that cut hair by appointment, rather than joining the queue at a wait-your-tum establishment (Becker, 1965, p. 493). The argument generalizes to the procurement of consumer durables. Time is economized if the customer does not have to search for a brand possessing the requisite properties and is easily able to locate and visit an outlet where the brand is stocked. And additional time is saved if the item comes preassembled, is reasonably trouble- free, and is reliably serviced at convenient outlets.

Such a brand of bicycle will also be attractive to customers who, though their unit opportunity cost of time may be below average, are particularly inept at self-assembly and repairs. In such a situation, despite low unit costs, the total opportunity cost is great, being the product of unit cost and time expended. Thus, two fiasses of customers will respond positively to the Schwinn image: Those who are mechanically inept and those who, although capable, have a high per-unit opportunity cost of time.                                                                                                            .

All that merely establishes, however, that franchised sales of Schwinn bicycles will appeal to some customers. It does not reach the question whether Schwinn should sell to all comers, allowing dealers to determine whether or not to offer the set of services that would qualify them as franchisees. Were Schwinn to do so, customers who have the above-described attributes would presumably go to the franchised outlet; those who do not could go elsewhere. Because in a world of unbounded rationality more degrees of freedom—in this instance, more methods of merchandising—are necessarily better than less, the natural policy inclination would be to let customers decide the question for themselves.

Several justifications, however, can be articulated in support of franchise restrictions: First, the Schwinn quality image may be debased without sales restraints; second, even if quality images are not impaired, the viability of franchises may hinge on sales restraints; third, the costs of enforcing the distribution contracts are increased in a mixed distribution system.23 The quality image of Schwinn turns partly on objective considerations: Schwinn bicycles bought from authorized dealers come with an assured set of sales and service attributes. But the image may also be affected by information exchanged by word of mouth. If potential customers are told, “1 bought a Schwinn bike and it was a lemon,” but are not advised that the bicycle was bought from a discount house and misassembled, and that Schwinn’s guarantees were thereby vitiated, customer confidence in Schwinn is easily impaired. Put differently, quality reputation may be preserved only if goods and services are sold under conditions of constraint.24 Note in this connection that the incentive to invest in commercial reputation by surrounding transactions with institutional infrastructure occurs only in a world of bounded rationality.

Even if the quality image of franchise sales is unimpaired by non-franchise selling, the commercial viability of franchisees, which hinges on volume considerations, should be examined. Suppose that it is determined that a franchised dealer needs to sell a minimum number of bicycles in order to break even. Suppose further that Schwinn carefully locates its franchisees cognizant of those breakeven needs.25 Finally, suppose that the system is initially viable but that discount sales subsequently appear. Marginal franchise operators shortly thereafter become nonviable. As a consequence the assurance of convenient Schwinn service outlets is jeopardized. Customer interest declines and other viable franchisees become marginal. The deterioration, taken together with the impaired quality image described above, creates the risk that the franchise mode will become nonviable, and customers for whom such differentiation yields net gains will be able to deal only in the undifferentiated market.

The third justification for franchise restrictions involves policing costs. The argument here is that it is less costly to police simple systems than it is to police more complicated ones. Causality (responsibility) is difficult to trace (attribute) in complex systems. If few “excuses” can be offered, fewer veracity checks have to be made. Although I do not suggest that this was a primary consideration for Schwinn, it could be relevant to the design of other marketing systems. Again, it is a problem only in a world of bounded rationality, because frictionless systems are self-policing.

Consider finally whether Schwinn will integrate forward into retailing if restrictions on sales to nonfranchised outlets are prohibited. If Schwinn’s costs of integrated sales were identical with those of its franchisees, that presumably would occur. There are several reasons, however, to believe the case to be otherwise. First, franchised dealers were not exclusively engaged in the sales and service of Schwinn bicycles; other brands were also handled.26” Also, many franchisees were engaged in nonbicycle sales. Assuming that multiple brand and multiple product sales are necessary for distributors to break even, forward integration would require Schwinn to engage in unwanted and possibly unavailable sales activities. Diversification into other products with which Schwinn had no expertise or familiarity is the unwanted activity. Stocking other brands, moreover, might pose difficulties of availability, as other bicycle manufacturers might suspect, with cause, that their brands would be slighted and demeaned if sold by Schwinn employees.

FIGURE 7-3. Consequences of Prohibiting Franchise Restraints

Furthermore, even if disabilities of those kinds did not exist, the question still remains whether Schwinn could provide incentives for managers of inte- grated sales outlets that promote performance equal to that when franchising is used. Both carrot and stick considerations must be addressed. The incentive disabilities associated with bureaucratic modes of organization stand as a further impediment to forward integration by Schwinn (see Chapter 6).

The upshot is that if the worst consequences obtain (namely, the franchise system collapses, Schwinn is unable to integrate forward economically, and the Schwinn brand image vanishes), prohibiting franchise restraints gives rise to real economic losses of the kind shown in Figure 7-3. The demand curve for Schwinn bicycles is here given by p2 = g(q2\ p1), where p1 is the price at which other bicycles sell (which is taken as given). The curve ACƒ2 is the average cost of sales and service for franchised outlets. As drawn, franchising just breaks even (covers all of its costs, including a fair rate of return) at a price and quantity of p*2, q*2 respectively. Assuming that the costs of supplying nondifferentiated bicycles are not increased by Schwinn franchising, the net welfare gains (losses) realized by offering (withdrawing) the Schwinn brand will be given by the shaded consumer surplus region.

The government’s case, which eschewed transaction cost features in favor of the firm-as-production-function construction, missed a great deal of what was relevant in order to reach an accurate economic assessment of what was at stake. Schwinn illustrates the over-reaching that occurred during the inhospitablity era of antitrust enforcement. There being no place for the nonstandard (or, in Coase’s terms, “ununderstandable” [1972, p. 67]) contracting practices within the applied price theory tradition, the merits of these practices were rejected or dismissed.

Source: Williamson Oliver E. (1998), The Economic Institutions of Capitalism, Free Press; Illustrated edition.

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