Minimum Prices

By: Jeff Grabmeier

Published on December 24, 1997

MINIMUM PRICES FOR PRODUCTS CAN SOMETIMES BENEFIT CONSUMERS

COLUMBUS, Ohio -- Contrary to popular belief, new research suggests consumers may sometimes benefit if manufacturers are allowed to set minimum retail prices for their products.

Consumer groups and federal regulators have argued that setting minimum prices -- a practice known as resale price maintenance (RPM) -- is anti-competitive and means consumers will pay more for goods. But that’s not always the case, according to a study published in a recent issue of The American Economic Review.

Under RPM, consumers may actually pay less for some goods that are in high demand -- like popular holiday toys, said James Peck, co-author of the study and professor of economics at Ohio State University. That’s because retailers are willing to order larger inventories of a product if they are assured of a minimum resale price.

“It’s not surprising that manufacturers would like resale price maintenance,” Peck said “But it’s more surprising that we found consumers may sometimes prefer it as well.”

Peck conducted the study with Howard Marvel, professor of economics and law at Ohio State, and Raymond Deneckere, professor of economics at the University of Wisconsin.

The researchers said RPM can benefit consumers in situations where retailers have to order a product months in advance of selling it, before they know how popular the product will be. One example would be holiday toys, such as video game systems.

When making order decisions, retailers have to balance the possibility that the product will be a flop versus the possibility that it will be a huge hit, Peck said. Retailers know they can charge a higher price if demand is high, but also realize they will have to sell the product very cheaply if demand is low. The result is that retailers order an intermediate amount of the product, to balance the hit and flop possibilities.

However, under RPM, retailers worry less about what will happen if demand for the product is low because they know prices can’t go below the price floor. This encourages retailers to order more units of the product, Peck said. The result is that if the product is a hit, more units are available for sale -- and prices for consumers are lower than they might otherwise be.

“From the consumer’s standpoint, there is a tradeoff,” Peck said. “When demand for the product is low, there’s a price floor and consumers can’t get the product as cheaply as they otherwise would. But if demand is high, the product is more readily available and retailers won’t charge as much.”

In the American Economic Review paper, the researchers prove their theory about the benefits of RPM using mathematical models. But they also cite the experience of video-game player and cartridges manufacturers as a real-world illustration of their theory.

In the early 1980s, video games were a phenomenal success with sales rising from $200 million in 1978 to $3 billion in 1982. But excessive inventories resulted in massive price-cutting soon after, so that in 1983 sales fell to $100 million and the leading manufacturer of games and game players, Atari, collapsed. The decline in revenues was entirely due to price cutting: unit sales actually increased.

When Nintendo entered the market, it tried to prevent the same catastrophe by cutting off dealers that undercut suggested prices. That strategy was successful until the holiday season of 1990, when, under investigation by federal and state officials, Nintendo agreed not to maintain resale prices of its products. This also coincided with a period of low demand for video game products. The result was sharp declines in the prices of some of Nintendo’s most popular titles.

“The experiences of Atari and Nintendo are consistent with our model of RPM,” Peck said.

As of now, the legal status of RPM is clouded. It is illegal for manufacturers to conspire with retailers to set minimum prices that must be charged for products. But many manufacturers have set up inducements for their retailers to persuade sellers to maintain minimum prices. It is unclear when those inducements become illegal, he said.

While it is understandable why consumer groups and federal regulators are opposed to resale price maintenance, Peck said the results of the study suggest RPM not be dismissed as always anti-consumer.

“There are situations where RPM works in the consumers’ favor,” he said.

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Contact: James Peck, (614) 292-0182; Peck.33@osu.edu Written by Jeff Grabmeier, (614) 292-8457; Grabmeier.1@osu.edu


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