Chapter 13
Ethics and the Law

Understanding the Constraints on Pricing

When making pricing decisions, the successful strategist must consider not only what is profitable, but also what will be perceived as ethical and legal. Unfortunately, good advice on both of these issues is all too often unavailable or misleading. Attorneys who do not specialize in antitrust law tend to be overly conservative—advising against activities that are only sometimes illegal or that could trigger an investigation. In fact, benign changes in questionable pricing policies are often all that is necessary to make them both profitable and defensible. On the other hand, product and sales managers eager to achieve quarterly objectives will sometimes fail to consider these constraints at all, resulting in costly condemnations of their companies in courts of law or public opinion. This chapter is intended to raise awareness of the issues and educate you enough to question the advice you receive.

Ethical Constraints on Pricing

“Perhaps no other area of managerial activity is more difficult to depict accurately, assess fairly, and prescribe realistically in terms of morality than the domain of price.”¹ This oft-quoted assessment reflects the exceptional divergence of ethical opinions with respect to pricing. Even among writers sympathetic to the need for profit, some consider it unethical to charge different prices unless they reflect differences in costs, while others consider pricing unethical unless prices are set “equal or proportional to the benefit received.”² Consequently, there is less written on ethics in pricing than on other marketing issues, and what is written tends to focus on the easy issues, like deception and price-fixing.³ The tougher issues involve strategies and tactics for gaining profit.

EXHIBIT 13-1 When Is a Price Ethical? Ethical Constraints

This book is intended to help managers capture more of the value created by the products and services they sell. In many cultures, and among many who promulgate ethical principles, such a goal is morally reprehensible. Although this opinion was once held by the majority, its popularity has generally declined over the past three centuries due to the success of capitalism and the failure of collectivism to deliver an improvement in material well-being. Still, many people, including many in business practice and education, believe that there are legitimate ethical constraints on maximizing profit through pricing.

It is important to clarify your own and your customers’ understanding of those standards before ambiguous situations arise. The topology of ethical constraints in pricing illustrated in Exhibit 13-1 is a good place to start. Readers should determine where to draw the line concerning ethical constraints— for themselves and their industry—and determine as well how other people (family, neighbors, social groups) might view such decisions.

Most people would reject the idea of zero ethical constraints, in which the seller can dictate the price and terms and force them on an unwilling buyer. Sale of “protection” by organized crime is universally condemned. The practice of forcing employees in a one-company town to buy from the “company store” is subject to only marginally less condemnation. Even when the government itself is the seller that is forcing people to purchase goods and services at a price (tax rate) it sets, people generally condemn the transaction unless they feel empowered to influence the terms. This level of ethical constraint was also used to condemn the “trusts” that, before the antitrust laws, sometimes used reprehensible tactics to drive lower-priced competitors out of business. By denying customers alternative products, trusts arguably forced them to buy theirs.

Ethical level one, embodied in all well-functioning, competitive market economies, requires that all transactions be voluntary. Early capitalist economies, and some of the most dynamic today (for instance, that of Hong Kong), condone any transaction that meets this criterion. The legal principle of caveat emptor, “Let the buyer beware,” characterized nearly all economic transactions in the United States prior to the twentieth century. In such a market, people often make regrettable purchases (for example, expensive brand-name watches that turn out to be cheap substitutes and stocks in overvalued companies). On the other hand, without the high legal costs associated with meeting licensing, branding, and disclosure requirements, new business opportunities abound even for the poor— making unemployment negligible.

Ethical level two imposes a more restrictive standard, condemning even voluntary transactions by those who would profit from unequal information about the exchange. Selling a used car without disclosing a known defect, concealing a known risk of using a product, or misrepresenting the benefits achievable from a product are prime examples of transactions that would be condemned by this ethical criterion. Thus, many would condemn selling land in Florida at inflated prices to unwary out-of-state buyers, or selling lottery tickets to the poor, since the seller could reasonably expect these potential buyers to be ignorant of, or unable to process, information needed to make an informed decision. Since sellers naturally know more about the features and benefits of products than most consumers do, they may have an ethical duty to disclose what they know completely and accurately.⁴

Ethical level three imposes a still more stringent criterion: that sellers earn no more than a “fair” profit from sales of “necessities” for which buyers have only limited alternatives. This principle is often stated as follows: “No one should profit from other people’s adversity.” Thus, even nominally capitalist societies sometimes impose rent controls on housing and price controls on pharmaceutical costs and physicians’ fees. Even when this level of ethical constraint is not codified into law, people who espouse it condemn those who raise the price of ice during a power failure or the price of lumber following a hurricane, when the demand for these products soars.

Ethical level four extends the criteria of ethical level three to all products, even those with many substitutes and not usually thought of as necessities. Profit is morally justifiable only when it is the minimum necessary to induce companies and individuals to make decisions for the good of less-advantaged members of society.⁵ Profit is ethically justifiable only as the price society must pay to induce suppliers of capital and skills to improve the well-being of those less fortunate. Profits from exploiting unique skills, great ideas, or exceptional efficiency (called “economic rents”) are morally suspect in this scenario unless it can be shown that everyone, or at least the most needy, benefits from allowing such profits to be earned, such as when a high-profit company nevertheless offers lower prices and better working conditions than its competitors. Profits from speculation (buying low and selling high) are clearly condemned, as is segmented pricing (charging customers different prices to capture different levels of value), unless those prices actually reflect differences in cost.

Ethical level five, the most extreme constraint, is inconsistent with markets. In some “primitive” societies, everyone is obliged to share good fortune with those in the tribe who are less fortunate. “From each according to his ability, to each according to his need” is the espoused ethical premise of Marxist societies and even some respected moral philosophers. Those that have actually tried to put it into practice, however, have eventually recoiled at the brutality necessary to force essentially self-interested humans “to give according to their abilities” without reward. Within families and small, self-selected societies, however, this ethical principle can thrive. Within social and religious organizations, members often work together for their common good and share the results. Even within businesses, partnerships are established to share, within defined bounds, each other’s good and bad fortune.

For each level of ethical constraint on economic exchange, one must determine the losses and gains, for both individuals and societies, that will result from the restriction. What effect does each level have on the material and social well-being of those who hold it as a standard? Should the same standards be applied in different contexts? For example, is your standard different for business markets than it is for consumer markets? Would your ethical standards change when selling in a foreign country where local competitors generally hold a higher or lower ethical standard than yours? In assessing the standards that friends, business associates, and political representatives apply, managers must ask themselves if their personal standards are the same for their business as well as for their personal conduct. For example, would they condemn an oil company for earning excess profits as a result of higher crude prices, yet themselves take excess profits on a house that had appreciated substantially in a hot real estate market? If so, are they hypocrites or is there some justification for holding individuals and firms to different standards?

Although we certainly have our own beliefs about which of these ethical levels is practical and desirable in dealing with others, and would apply different standards in different contexts, we feel that neither we nor the people who claim to be experts on business ethics are qualified to make these decisions for someone else. Each individual must make his or her own decisions and live with the personal and social consequences.

Regardless of one’s personal ethical beliefs about pricing, it would be foolish to ignore the legal constraints on pricing. Antitrust law in the United States has developed over the years to reflect both citizens’ moral evaluations of companies’ actions and companies’ attempts to get laws passed that protect them from more efficient or aggressive competitors. As the summary below illustrates, the meaning of these laws changes over time as courts respond to changing social attitudes and the placement of judges with differing political views.

The Legal Framework for Pricing

When making pricing decisions, the strategist must consider not only what is profitable, but also what is lawful. Since the late nineteenth century, the United States has been committed to maintaining price competition through establishing and enforcing antitrust policy. Statutes, regulations, and guidelines, as well as countless judicial decisions, have defined what constitutes anticompetitive pricing behavior and the rules under which the government and private parties may pursue those who engage in it.

For more than 120 years, U.S. antitrust law has responded to a complex and dynamic marketplace by being both of these things, resulting in policies that are always being scrutinized and questioned and sometimes stretched and revised. The overall trend in the United States for the last several decades has been to move away from judging behavior based on economic assumptions toward focusing on demonstrable economic effect, something that has fostered a great deal of contemporary pricing freedom. Of course, a necessary companion to evolving policies, as well as the lag time sometimes necessary for the law to catch up with the marketplace, is ambiguity. In return for some uncertainty, there is more latitude for businesses to cope creatively with both new and old challenges.

This section discusses key aspects of the law of pricing, focusing primarily on that of general applicability in the United States at the federal level.⁶ Due to the long history of U.S. law in the pricing area, it has served as a model for other parts of the world, including the European Union (EU) and Japan. For example, EU antitrust law historically prohibited such things as territorial restrictions on intermediaries that interfered with cross-border trade, but a safe harbor became effective in 2000.⁷ That, much like the change in the U.S. view that occurred more than 20 years earlier, recognizes a supplier’s legitimate interest in controlling how its products are resold under certain circumstances.

In the United States, the antitrust laws are enforced by both government and private parties. The Department of Justice is empowered to bring criminal and civil actions, although the former are reserved primarily for price-fixing and hardcore cartel activity.⁸ At the same time, the Federal Trade Commission (FTC) may bring civil actions,⁹ as can private parties. Often, civil plaintiffs pursue injunctions to stop certain conduct and, in the case of private parties, they may also or alternatively seek three times their actual economic damages (something known as “treble damages”), as well as their legal fees and court costs.¹⁰ While the volume of private antitrust litigation dwarfs that brought by the government, private suits often follow significant government cases.

The Effect of Sarbanes-Oxley on Pricing Practices

In direct response to the high-visibility corporate finance scandals involving such companies as Enron and WorldCom, the Sarbanes-Oxley Act—a significant and sweeping piece of securities reform legislation—became law in 2002.¹¹ Because one of the main purposes of the act is to facilitate more accurate public disclosure of financial information and provide accountability measures in reporting and monitoring of corporate conduct, its impact on pricing practices and antitrust compliance in general is to cause more rigor than had been present in many companies before the law was passed. While most of the requirements of Sarbanes-Oxley apply only to an “issuer,” or a publicly-traded or listed company,¹² some commentators have recommended that even private companies should strive to comply with the full demands of this law.¹³

Among other things, Sarbanes-Oxley specifically provides for stricter financial and auditing procedures and reporting. For example, the act requires that an issuer’s chief financial officer (CFO) and chief executive officer (CEO) certify financial reporting documents (such as the company’s quarterly and annual reports) and make the knowing certification of noncompliant financials a criminal offense.¹⁴ The act also outlines disclosure procedures and internal accounting control mechanisms, as well as whistle-blowing provisions, including language that makes retaliation against truthful informants subject to criminal penalties of a fine or up to 10 years’ imprisonment, or both.¹⁵

While Sarbanes-Oxley was not created with the express intent of policing antitrust compliance in pricing matters, the broad scope of the act clearly affects this area. Some of the most obvious examples in the context of pricing policies and related issues include tighter controls on the accounting and disclosure procedures relating to the treatment and use of discounts, allowances and promotional funds in general, regardless of whether a company is giving or getting them. As a result, companies are well advised, among other things, to address in their internal control policies requirements and guidelines for pricing and pricing actions, process documentation for such actions, and a procedure for investigating and responding to employee reports of internal violations.

Price-Fixing or Price Encouragement

In an effort to reduce or avoid market risks, business people have long been interested in setting prices with their competitors or dictating or influencing the prices charged by their downstream intermediaries, such as distributors, dealers, and retailers. Over the years, U.S. law has taken a rather dim view of this behavior. At the same time, it is now clear that there is some flexibility in what competitors—which collectively affect market prices—can do, but the biggest changes are in the area of distribution channels, where price setting is lawful if done properly.

There are two types of price-fixing: horizontal and vertical. In the former, competitors agree on the prices they will charge or key terms of sale affecting price. In the latter, a supplier and a reseller agree on the prices the reseller will charge or the price-related terms of resale for the supplier’s products. However, where an intermediary, such as an independent sales representative, does not take ownership of the supplier’s products and acts only as the supplier’s agent, there cannot be any vertical price-fixing because the law views the sale as taking place directly between the supplier and the end user, with the intermediary serving as a conduit. Consequently, the supplier is only setting its own prices and terms of sale.¹⁶

The primary law in this area is Section 1 of the Sherman Act, an 1890 statute that prohibits “[e]very contract, combination . . . or conspiracy in restraint of trade.”¹⁷ The contract, combination, or conspiracy requirement necessarily means that there must be an agreement between two or more individuals or entities. As a result, the law does not reach unilateral behavior.¹⁸ Moreover, in the horizontal context, the Sherman Act does not ban merely imitating a competitor’s pricing behavior (something called “conscious parallelism”).¹⁹

Sometimes, there are written contracts or other direct evidence of price-fixing conspiracies. Far more often, evidence of agreement must be inferred from the actions of the parties involved. Although conscious parallelism by itself is not enough to establish an agreement, when uniform or similar behavior is coupled with one or more “plus factors,” courts have found concerted activity. Perhaps the most powerful of these factors exists when the conduct in question would be against the self-interest of each party if it acted alone, but consistent with their self-interest if they all behaved the same way, such as the uniform imposition of unpopular restrictions or price increases in the face of surplus.²⁰ Another factor exists when the opportunity to collude (often shown by communications between or among the parties) is followed by identical or similar actions, although the probative effect of such opportunity or communications can be undercut by legitimate business explanations.²¹

Once concerted action has been found, the next step is to evaluate it. Case law has further refined Section 1 of the Sherman Act to require two levels of proof, depending on the nature of the alleged offense. Some offenses are considered to be “per se” illegal, while others are analyzed under the “rule of reason.” Per se offenses require that the presence of the objectionable practice be proven and that there be antitrust injury and damages, while offenses subject to the rule of reason add a third element—that the practice at issue be unreasonably anticompetitive. In general, it is easier to prove a violation under the per se test and more difficult to do so under the rule of reason, because the latter requires detailed economic analysis and a balancing of procompetitive and anticompetitive effects. Of course, the rule of reason also provides defendants with the opportunity to justify their behavior, something denied under the per se rule.

Historically, all arrangements affecting price were presumed to be unreasonably anticompetitive on their face and, therefore, per se illegal. However, during the past 30 years or so, the U.S. Supreme Court has placed more emphasis on showing demonstrable economic effect rather than relying on assumptions, so there has been an erosion of per se application to both horizontal and vertical pricing issues.

Horizontal Price-Fixing

In the horizontal arena, direct price-fixing—competitors in the stereotypical smoke-filled room agreeing to set prices or rig bids—remains per se illegal. The same treatment is accorded to indirect price-fixing, where there is an ambiguous arrangement between competitors that a court has determined constitutes illegal price-fixing after conducting a detailed factual review or market analysis.²²

However, when a restriction on price is merely the incidental effect of a desirable procompetitive activity (sometimes referred to as “incidental price-fixing”), it is now clear that the more forgiving rule of reason applies. This point is illustrated by National Collegiate Athletic Association v. Board of Regents, where the U.S. Supreme Court applied the rule of reason and noted that rules covering athletic equipment and schedules were appropriate, but those that limited the television exposure of member football teams were an unreasonable restriction on output that unlawfully increased prices.²³

Resale Price-Fixing or Encouragement

Vertical Price-Fixing

Vertical price-fixing by agreement was considered per se illegal in the U.S. until a pair of modern-day Supreme Court cases spaced ten years apart established the current rule that all forms of resale price setting—maximum, minimum, or exact—are judged under federal law by the rule of reason. The 1997 decision in Khan overturned a 29-year old case to declare that the rule of reason applies to maximum price agreements, while the far more controversial Leegin decision in 2007 jettisoned a 96-year old precedent by extending Khan to minimum prices (and the analytically equivalent exact prices).²⁴ Likely because maximum prices have the effect of holding down costs, while minimum or exact prices prop them up, bills have been introduced both in Congress and at the state level to legislatively overturn Leegin by restoring the per se rule to minimum resale price agreements, but, so far, only Maryland’s efforts have been enacted into law.²⁵ While application of the rule of reason in this context is too new to assess its effect and the empirical evidence supporting the consumer welfare arguments in favor of going back to the per se rule is lacking, the emotion is not, increasing the odds that Congress will turn back the clock, other states will join Maryland, or both.²⁶

However, regardless whether Leegin survives, none of the legislative efforts aimed at minimum resale price agreements affect the Supreme Court’s 1919 ruling in Colgate that setting maximum, minimum or exact resale prices without an agreement (that is, unilaterally) is not illegal price-fixing prohibited under the Sherman Act.²⁷ As a result, a supplier may announce a price at which its product must be resold (that is, establish a ceiling, floor, or exact price policy) and refuse to sell to any reseller that does not comply, as long as there is no agreement between the supplier and its reseller on resale price levels. Even when resellers follow the supplier’s resale price policy, there is no unlawful agreement. With this latitude, many manufacturers of desirable branded products have successfully discouraged the discounting of their products in such diverse industries as consumer electronics, furniture, appliances, sporting goods, tires, luggage, handbags, videos, agricultural supplies, electronic test equipment, and automotive accessories and replacement parts.

A frequent justification given for minimum or exact resale price policies is to permit resellers sufficient margin to provide a selling environment that is consistent with the supplier’s objectives for its products, including brand image. For example, the supplier may want knowledgeable salespeople, showrooms, substantial inventory, and superior service. Of course, such policies also may help support higher supplier margins. Sometimes, the imposition of such policies is sought by resellers to insulate them from price competition. As long as there is no agreement on price levels, such requests, even if acted upon by the supplier, are not unlawful.²⁸

Pricing policies may be used broadly or selectively to cover everything from a single product to all of those in a supplier’s line. Similarly, they can be used in certain geographic areas and with specific channels of distribution in which price erosion is a problem, or they can be used throughout the country. In any event, a policy violation typically requires that the supplier stop selling the offending reseller the products involved, although it also is permissible to pull a product line or all of the supplier’s business.²⁹ When and if the supplier wishes to resume selling is the supplier’s unilateral decision, although some cases suggest that warnings, threats, and probation short of termination support the inference that some form of agreement has been reached.

To make such a policy stick, the supplier must generally have brand or market power. Otherwise, resellers simply won’t bother to follow the policy, since there are plenty of substitutes available. Ironically, it is those highly desirable products that are most susceptible to discounting anyway, so the requisite power is typically present. In addition, it is important to note that resale price policies have a vertical reach that is limited to one level down the distribution channel. If all resellers buy directly from the manufacturer, this restriction poses no problem, but if a significant amount of sales are made through multiple levels of distribution, a policy will be too porous to be effective. In other words, a manufacturer can control a direct-buying retailer’s sell price by policy, but it can’t reach that of a retailer that buys from a wholesaler. To address this problem, the manufacturer may “jump over” the wholesaler by making a sale directly to the retailer, or it may convert the wholesaler into an agent for the purpose of such a sale. Alternatively, the policy may be circulated to both direct- and indirect-buying resellers, while wholesalers are permitted to sell to “approved” resellers only. One way to remain on the approved list is to comply with the policy.

Resale price policies are potent, but the rules for managing them within the law are necessarily stringent. Careful implementation keeps otherwise lawful programs from going astray. This means that any form of agreement regarding resale prices must be avoided. There must be no resale pricing contracts, no assurances of compliance, and no probation. Because this area can be a legal minefield, it’s crucial to carefully train supplier personnel. At the same time, many companies have adopted such programs with low risk and considerable success.

Direct Dealing Programs

Another way to control the prices charged to end users is for the supplier to sell them directly or, constructively, by the use of agents. When the supplier agrees with the end user on price, but the latter cannot handle delivery of large quantities or maintain sufficient inventory to justify direct shipments from the supplier, some suppliers look to a reseller to fill the order out of the reseller’s warehouse. This can be done by consignment or by the supplier buying back inventory from the reseller immediately prior to its transfer to the end user, so, in either event, the sale runs directly from the supplier to the end user. The reseller becomes the supplier’s warehousing and delivery agent and is compensated by the supplier for performing only these functions.

When the supplier has negotiated the price to the end user, but the reseller has or retains the title, the supplier has another alternative. Under the “reseller’s choice” approach, the reseller may either choose to sell the product to the end user at the price set by the supplier or tell the supplier to find someone else to do so. Even if the reseller agrees to sell at the contracted price, there is no per se illegal price fixing, as this practice is seen as voluntary and, therefore, subject to the rule of reason.³⁰

Resale Price Encouragement

Instead of dictating a resale price by agreement, policy, or direct sale, some suppliers encourage desirable resale pricing behavior by providing financial or other incentives, such as advertising allowances to promote certain prices. Although these practices are judged under the rule of reason because participation is voluntary, the provision of incentives is subject to the prohibitions in the Robinson-Patman Act against price and promotional discrimination.³¹

In the area of price advertising, a common practice is to use a minimum advertised price (MAP) program, although the underlying concept could also be used for maximum or exact prices. Under this approach, the reseller receives an advertising allowance (often in the form of co-op advertising funds) in return for adhering to the appropriate price in advertising, in a catalog, or over the Internet.³² Some companies pay an explicit allowance (such as a percentage rebate on purchases), while others employ an implicit allowance stating that failure to follow program requirements results in the loss of the allowance and an increase in price. The latter is found in consumer electronics.

A variant on MAP programs is group or shared-price advertising, through which a supplier sponsors an ad, but resellers can be listed in it only if they agree to sell at the promoted price during the period indicated. Again, resellers that wish pricing freedom may decline to be in the ad, and, because of the voluntary nature of this approach, there is no per se illegality.

Another alternative is target-price rebates. Here, the supplier rewards the reseller with financial incentives the closer its resale prices are to the target set by the supplier. This practice requires point-of-sale (POS) reporting, typically easier to get in the consumer area due to the widespread use of scanners, but becoming more common in the industrial marketplace.

Price and Promotional Discrimination

Although economists maintain that the ability to charge different prices to different customers promotes efficiency by clearing the market, U.S. law on that issue has focused on maintaining the viability of numerous sellers as a means to preserve competition. Consequently, while price discrimination has been unlawful since 1914, the Robinson-Patman Act amended existing legislation in 1936, so this entire area is commonly referred to by the name of the amendment.³³

This complex, Depression-era legislation was enacted to protect small businesses by outlawing discriminatory price and promotional allowances obtained by large businesses, while exempting sales to government or “charitable” organizations for their own use.³⁴ At the same time, the emergence of contemporary power buyers through internal growth or consolidation (such as Wal-Mart or W. W. Grainger), as well as supplier efforts to make discounts and allowances provided to customers more efficient, have forced or encouraged sellers to provide lawful account-specific pricing and promotions by creatively finding ways through the Robinson-Patman maze. This trend is likely to continue, as further consolidation and evolving distribution channels (brought on by e-commerce, among other things) will demand and reward more sophisticated differentiation.

As is the case with the other antitrust laws, the Department of Justice, the FTC, and private parties may each bring Robinson-Patman cases, although the enforcement agencies have not focused on this area for some time. Indeed, the Justice Department has criminal powers in this area that have gone unused for many years, while the FTC today brings few significant cases in this area after being particularly active through the 1970s. Private suits on behalf of businesses (consumers have no standing to sue under the statute) account for most of the enforcement activity.³⁵ Successful plaintiffs are entitled to the same remedies as those available under the antitrust laws discussed previously (injunctions, treble damages, attorneys’ fees and costs).

Price Discrimination

Keep in mind that discrimination in price is not always unlawful. In order to prove illegal price discrimination under the Robinson-Patman Act and assuming that the supplier sells in interstate commerce, each of five elements must be present:³⁶

1. Discrimination. This standard is met simply by charging different prices to different customers. However, if the reason for the difference is due to a discount or allowance made available to all or almost all customers (like a prompt payment discount), but some customers choose not to take advantage of it, the element of discrimination drops out, ending the inquiry. This is known as the “availability defense.”

2. Sales to Two or More Purchasers. The different prices must be charged on reasonably contemporaneous sales to two or more purchasers—a rule that permits price fluctuations. In other words, it is inappropriate under the statute to compare two widely separated sales in a highly volatile market. Yet, if prices typically change annually or semiannually, a sale made in January may be compared with one made in March.

In addition, offering different prices is not enough. Actual sales or agreements to sell at different prices must exist. For example, if two electrical supply distributors seek special pricing from the manufacturer to bid on a construction job or an integrated supply contract that only one will get, the manufacturer may, if it is careful, give one a better price than the other, because in doing so, it is providing two offers, but making only one sale.³⁷

3. Goods. Robinson-Patman applies to the sale of goods only (“commodities” in the statute), so services—such as telecommunications, banking, and transportation—are not covered.³⁸ When a supplier sells a bundled offering, such as repair services that include parts or computer hardware that includes maintenance services, Robinson-Patman is relevant only if the value of the goods in the bundle predominates. Also, it is possible to turn goods into services if the manufacturer procures raw materials and produces and stores the products on behalf of the customer, with the customer owning the inventory every step of the way and bearing the risk of loss.

4. Like Grade and Quality. The goods involved must be physically or essentially the same. Brand preferences are irrelevant, but functional variations can differentiate products. In a key case, the Supreme Court stated that a branded product and its physically and chemically identical private-label version must be priced the same by the manufacturer.³⁹ While the distinctions drawn in the case law sometimes appear arbitrary, meaningful functional or physical variations can result in different products that legitimize different prices. For example, two air conditioners that have significant differences in cooling capacity are distinct products, even if they otherwise are or appear physically identical.

5. Reasonable Probability of Competitive Injury. The law generally focuses on injury at one of two levels. The first, called “primary line,” permits a supplier to sue a competitor for the latter’s discriminatory pricing. But here the law also requires that the supplier’s discriminatory pricing be below its cost, something designed to drive its rival out of business or otherwise injure competition in the market as a whole (called “predatory intent”), rather than to merely take some incremental market share. Moreover, the structure of the market must be such that the discriminating supplier can raise prices after it disposes of the targeted competitor or that market injury otherwise is threatened through reduced output.⁴⁰ Not surprisingly, there are few contemporary primary-line cases due to this tough standard.

Far more common is “secondary-line” injury, where a supplier’s disfavored reseller or end-user customer may sue the supplier for price discrimination. However, the law is clear that only competing customers must be treated alike. To the extent that customers do not compete due to their locations or the markets they serve, different prices are appropriate under the Robinson-Patman Act. If these customer distinctions do not occur naturally, they may be introduced or formalized by contract or policy through the use of vertical nonprice restrictions.*

Defenses to Price Discrimination

Even if all five price-discrimination elements are present, there are three defenses that may be used to avoid what otherwise is unlawful discrimination.⁴¹

1. Cost Justification. This defense permits a price disparity if it is based on legitimate cost differences. For example, freight is usually less expensive on a per-case basis for a truckload shipment. However, while there is no requirement to pass on any savings, if the supplier does so, the law states that some or all of the actual savings may be passed on to the customer, but not a penny more.

One common problem area is volume discounts, particularly those that are stair-stepped with large differences between levels. Perhaps this structure reflected real cost differences many years ago when it was adopted by the supplier, but unless the underlying cost analysis is regularly updated, the discounts probably do not track today’s costs. Indeed, the dynamic nature of business and the precision required to support this defense make it difficult to apply successfully, although the sophistication of activity-based costing holds a great deal of potential. Some manufacturers keep profit-and-loss statements on their customers and adjust their pricing accordingly.

2. Meeting Competition. Under this defense, discrimination is permissible if it is based on a good-faith belief that a discriminatory price is necessary to meet the price of a competitive supplier to the favored customer or to maintain a traditional price disparity.⁴² Many managers are familiar with the application of this defense on the micro level, that is, when a buyer tells the seller that the seller’s competitor offered a lower price. However, meeting competition may also be used on the macro level to justify things like volume discounts that are so institutionalized in the industry that adjusting them to reflect true cost savings would result in the loss of business.

Of course, it is at the micro level where this defense is most often used. Unfortunately, this means relying on the purchaser for competitive pricing information when the buyer has every incentive to lie.⁴³ Some companies provide their salespeople with detailed meeting-competition forms that require competitive invoices and other documentary evidence. While this sort of evidence is helpful, it is not essential if the seller has a reasonable basis at the time of the decision to believe that the competitive price described by the buyer is legitimate, even if it turns out to be wrong later. Nevertheless, a written or electronic record of why the otherwise discriminatory price was provided is useful.

Because meeting competition is a defense, there is no obligation to provide the special price to anyone other than the customer that asked for it. Of course, smart buyers will attempt to secure “most-favored-nations” clauses in their contracts or purchase orders to automatically get the benefit of a lower price elsewhere, regardless of whether they would otherwise be entitled to it. Such clauses may cause tension between a supplier’s Robinson-Patman responsibilities and those under the law of contract.

3. Changing Conditions. Special prices may be provided to sell perishable, seasonal, obsolete, or distressed merchandise, even though the full price had been charged up to the point of offering the special prices.

Promotional Discrimination

The Robinson-Patman Act also bans promotional discrimination in an effort to deny an alternative means of achieving discriminatory pricing. The distinction between price and promotional discrimination is an important one because different legal standards apply and, while the requirements in certain respects are tougher for promotional discrimination, there is ultimately more flexibility.

Price discrimination covers the sale from the supplier to the reseller or to the direct-buying end user, while promotional discrimination usually relates only to the reseller’s sale of the supplier’s products.⁴⁴ Historically, promotional discrimination was largely the purview of consumer goods marketers, as industrial goods sellers concentrated on such things as volume discounts subject to price discrimination standards. However, the need for creative account-specific marketing and the desire to make supplier incentives work harder have caused many industrial sellers to face the same issues. Both consumer and industrial suppliers are now focusing on how their resellers sell their products (promotional discrimination), rather than only on how they buy them (price discrimination).

As was the case with price discrimination, each of several elements must be present to violate the law:

1. The Provision of Allowances, Services, or Facilities. Here, the supplier grants to the reseller advertising or promotional allowances (like $5 off per case to promote a product) or provides services or facilities (such as demonstrators or free display racks), usually in return for some form of promotional performance.

2. In Connection with the Resale of the Supplier’s Goods. As is the case with price discrimination, the law regarding promotional discrimination does not reach service providers. In addition, promotional discrimination generally applies only to resellers. Typically, this does not cover purchasers that use or consume the supplier’s product in making their own. Also, it usually does not cover the incorporation of a product, such as sugar used in baked goods or sound systems installed at the automotive factory. However, these purchasers are resellers for promotional discrimination purposes if they receive allowances or other benefits from the supplier for promoting the fact that the finished goods were made using the supplier’s product or contain it, such as an ice cream producer that advertises the use of a particular brand of chocolate chip or a manufacturer that promotes the use of an axle brand in its heavy-duty trucks.

3. Not Available to All Competing Customers on Proportionally Equal Terms. Once again, not all of the supplier’s customers need to be treated alike, only those that compete. In addition, the services or facilities offered or the performance required to earn the allowances must be “functionally available,” that is, usable or attainable in a practical sense by all competing resellers, something that may require alternatives. In other words, if a reseller could take advantage of a promotional program, but chooses not to do so, the supplier is off the legal hook.⁴⁵ For example, if a warehouse club chain could advertise in newspapers, but it decides not to do so, the supplier is under no legal obligation to offer an alternative to a newspaper-advertising allowance. On the other hand, if the supplier pays for advertising on grocery carts, but some of its retail customers can’t have them due to the size of their stores, the supplier must make available an alternative means of performance, such as a poster or window sign in lieu of cart advertising.

The flexibility available under promotional discrimination standards is based on the fact that competing customers do not have to receive the same level of benefits, something contrary to the implicit mandate to do so under price discrimination rules. Instead, the promotional discrimination requirement is one of “proportional equality,” and there are three ways to proportionalize what is provided: (1) on unit or dollar purchases (buy a case, get a dollar—something that lawfully favors larger resellers that buy more); (2) on the cost to the reseller of the promotional activity (a full-page ad in a national trade magazine costs more than that in a regional newsletter); or (3) on the value of the promotional activity to the supplier (salespeople dedicated exclusively to the supplier’s brand have more value than those who are not).⁴⁶

Competitive Injury, Defenses, and Indirect Purchasers

There also are other, somewhat less attractive differences between price and promotional discrimination. First, no competitive injury is necessary for illegal promotional discrimination, making it more like a per se rule.⁴⁷ Second, meeting competition is the only defense, as cost justification and changing conditions are irrelevant. Third, if the supplier provides promotional allowances to direct-buying resellers, it must also furnish them to competitive resellers that buy the promoted product through intermediaries, something that may be accomplished with ultimate reseller rebates or mandatory pass-throughs.

Using Nonprice Variables to Support Pricing Goals

Vertical Nonprice Restrictions

Under the standards for price and promotional discrimination, the Robinson-Patman Act requires that only competing reseller and direct-buying end-user customers be treated similarly. For this reason, or to be consistent with other price-related or marketing objectives, the supplier may wish to control the degree to which its resellers compete with each other, something known as “intrabrand competition.” In 1977, the Supreme Court’s Sylvania decision provided suppliers with considerable flexibility in this regard, by holding that vertical nonprice restrictions are subject to the rule of reason and that intrabrand competition could be reduced to promote “interbrand competition,” or the rivalry between competing brands.⁴⁸

As a result, suppliers may impose vertical restraints on resellers to help manage distribution channels and to provide considerable leeway in pricing design using the carrot approach (financial incentives), the stick approach (contractual requirements), or some combination of the two.* Historically, industrial sellers have favored the use of vertical restrictions and the more selective distribution that goes with them, while many consumer goods suppliers (except those which sell durables) have been more interested in widespread distribution without the same sort of restrictions. However, the challenges of Internet sales and other factors have focused more attention on limiting how products may be resold.

Broadly speaking, there are three types of vertical nonprice restraints, each subject to the rule of reason:

1. Customer Restrictions. Rather than selling to any customer, the reseller is restricted only to particular customers or is prohibited from selling to certain customers. For example, in the industrial area, the reseller could be required to sell only to plumbing contractors or to stay away from accounts that are reserved to the supplier or another reseller. On the consumer side, the reseller could be limited to customers who order over the Internet or prohibited from selling to such customers at all.

2. Territorial Restrictions. Although generally designed to prevent or discourage selling outside of a geographic area, these can also be thought of as market restrictions. An “exclusive distributorship” is actually a restraint on the supplier, as it agrees that a particular reseller will be the exclusive outlet in the latter’s territory or market (however defined) for some or all of the supplier’s products. When the reseller is required to sell inside only a particular territory or market, it is subject to “absolute confinement.” By combining an exclusive distributorship with absolute confinement, the result is known as an “airtight territory.” In other words, if a supplier promises a dealer that the latter will be the only outlet in Oregon for a particular product, it has granted an exclusive distributorship. If the dealer is limited to selling in that state, there is absolute confinement and, when it is combined with an exclusive distributorship, the reseller has an airtight territory.

Due to some flip-flopping on the part of the Supreme Court, vertical nonprice restrictions were per se illegal from 1968 until the Sylvania decision in 1977. In response, a number of so-called “lesser restraints” were established that may not be as helpful in pricing as other restrictions, but still can be useful. The first of these is an “area of primary responsibility” that permits sales outside a reseller’s territory, but expects the reseller to focus its efforts on its designated geographic area.⁴⁹ The second is a “profit passover” that allows the reseller to sell anywhere, but, to neutralize the “free-rider effect,” the reseller must split revenue or profit for sales outside its territory with the reseller in the area encroached upon. The third is a “location clause” that restricts the reseller to approved sites only. While this last approach is ineffective if sales are made over the Internet or by phone or fax, it can be useful where a physical presence in the territory is necessary, especially in an environment where resellers are consolidating.

3. Product Restrictions. Suppliers have no legal obligation to sell their reseller or end-user customers any of their products, except in two instances— when the supplier has a contract to do so or in the relatively rare situation when the supplier is a monopolist with excess capacity.⁵⁰ In other words, the supplier may generally determine what products, if any, it sells to its reseller or direct-buying end-user customers, something that can be referred to as designated products. In this way, it may limit intrabrand competition or other conflicts by restricting what can be purchased by whom.

In addition, if the reseller or the end user is not permitted to purchase particular products or services or types of products or services from another supplier, this practice is known as exclusive dealing. Alternatively, it may be discouraged from doing so through financial or other incentives, often called “loyalty programs.” Judged under the rule of reason, the test is whether competing suppliers are unreasonably foreclosed from the market. As long as such suppliers have reasonable access to the market through other resellers or other means, exclusive dealing is permissible.⁵¹

In some respects, tying is the other side of the coin from exclusive dealing, with the same effect.⁵² In its most extreme form, tying requires that in order to purchase a desirable product or service, the customer must also buy another product or service that is less desirable. Although tying is often described as per se illegal, the analysis necessary to prove a violation is more like that required by the rule of reason.⁵³ Bundling is not illegal tying, as long as the products or services are available separately, even at a somewhat higher, but reasonable, cost.

Full-line forcing, judged under the rule of reason, is a variation on tying that requires a reseller to carry the supplier’s entire line or a specified assortment to avoid the customer’s cherry-picking of the more desirable products. Note that tying and full-line forcing can effectively crowd competitive products off the shelf.

Nonprice Incentives

To motivate desired behavior, a supplier may provide a favored reseller or end user with certain nonprice benefits, such as first access to new products or enhanced technical support. Due to their nonprice nature, this type of discriminatory reward is not covered by the Robinson-Patman Act, although the other laws still may apply.⁵⁴ At the same time, anything that the supplier does to assume or subsidize an expense that normally would be incurred by the customer triggers application of the Robinson-Patman Act.

Other Pricing Issues

Predatory Pricing

The practice of setting a price so low that a seller harms its own profitability in an attempt to do greater harm to a competitor is predatory pricing. The purpose of such behavior is either to discipline a competitor for competing too intensely or to drive it from the market and thus reduce or eliminate its competition.

Long-term aggressive pricing that is below marginal cost (or its measurable surrogate, average variable cost) can be attacked as monopolization or attempted monopolization under Section 2 of the Sherman Act and by the FTC under Section 5 of the FTC Act.⁵⁵ However, in 1993, the Supreme Court ruled that a successful prosecution requires proof that the price-cutting seller could likely recoup its losses with higher prices later on.⁵⁶ This heavy burden of proof severely limits claims of predation and favors the presumption that price-cutting is procompetitive.

Price Signaling

The practice of a supplier communicating its future pricing intentions to its competitors is known as price signaling. It is usually done to facilitate price parallelism through such means as supplying advance notice of price changes to customers or the media. In DuPont, the court of appeals overturned an FTC decision that such behavior violates the antitrust laws, ruling that consciously parallel pricing is not unlawful unless it is collusive, predatory, coercive, or exclusionary.⁵⁷ While signaling raises questions about the possibility of collusion, it can have legitimate business purposes as well. According to the court of appeals, signaling serves the lawful purpose of aiding buyers in their financial and purchasing planning.⁵⁸

Summary

The development and implementation of pricing strategies and tactics that do not violate the law is an important aspect of pricing. In addition to the risk of legal actions initiated by the government, a company can be sued by private parties, usually its competitors or its customers. If the Justice Department can prove that the company’s pricing violated the criminal provisions of the antitrust laws, the company is subject to fines and its managers may face both fines and imprisonment. In successful civil cases brought by the Justice Department or the FTC, the company may be enjoined from certain conduct, while in civil actions filed by private parties, defendants that lose may also be enjoined and have to pay treble damages and the attorneys’ fees and court costs of the plaintiff. Even if antitrust claims are successfully defended, their defense is usually disruptive to the business and expensive in terms of monetary and management costs, as well as the effects on reputation.

At the same time, it is obvious that the law is rarely black and white, particularly in the area of pricing. Over the past several decades, U.S. courts have placed more emphasis on showing demonstrable economic effect, rather than relying on assumptions to find antitrust violations. Indeed, once the business objectives are clear, contemporary antitrust law provides considerable flexibility to develop alternative strategies and tactics, which are usually compatible with the degree of legal and trade-relations risk a business wishes to assume. While there often are no easy answers, in most cases the ends are achievable with some modification of the means.