Exclusive Dealing — Incentives, Economics, and Competition
The practice of “exclusive dealing” is mentioned frequently in recent business and law enforcement news stories, often with respect to technology companies. We write to demystify this practice, drawing on our combined 40 years of antitrust practice and experience at the U.S. Department of Justice’s Antitrust Division. Contrary to the impression left by some stories, exclusive dealing frequently is good for competition. The key to understanding exclusive dealing is this: it is lawful when it puts the incentives of contracting companies in the right place, while at the same time allowing business to be “contestable” — meaning that competition is not harmed because rivals still have the ability, at reasonable intervals or for a reasonable share of business, to compete.
Exclusive dealing, in a distribution context, often occurs where a distributor receives exclusive distribution rights from the seller of a product or service in exchange for the distributor promoting the product or directly assisting the seller. To illustrate the effect on promotion incentives, consider the case of video game distribution. Game publishers commonly launch exclusively (at least for a period of weeks or months) on platforms such as the Apple App Store for mobile devices, or the Sony PlayStation in consoles. Why would publishers do this when they may miss out on users of other distribution platforms? A key reason is investment: if a game distributor has exclusive distribution for a game, it has the incentive to invest heavily in promoting that game to users, both on its own platform and through broad-market promotion, such as general media advertising, because it knows it will receive 100% of that game’s sales. If the distributor did not have an exclusive distributorship, part of its promotional spending — particularly in general media — would be wasted when users see the advertisements but purchase the game on a different platform. This waste is known to economists as “free riding”: in the absence of exclusive distribution, other distributors would benefit from the first distributors’ investment. Since no distributor wishes to pay for ads on behalf of competing distributors, this free riding reduces all distributors’ investment incentives. Game publishers understand this. If they want to encourage a distributor to make a maximum promotional effort, an exclusive distributorship is a smart move. In the end, game consumers also benefit from this increased promotion, and more efficient promotion can mean lower prices for games.
If a seller seeks other types of direct assistance by a distributor, such as training or technology equipment, the incentives are similar. Consider the owner of a physical store, such as a bicycle sales and repair shop, who wants to begin selling and scheduling appointments online, but needs the technology to do so. The bicycle shop might commit to use a particular technology platform for a period of time, exclusively, and in exchange, that platform may provide free or low-cost computer equipment and employee training. The technology platform would not have as much incentive to provide such benefits if it were not receiving 100% of the bicycle shop’s business. Some of the benefit of these investments ultimately flows to the shop’s customers, who get better service and convenience without paying the higher prices that would be expected if the shop had to pay for the equipment itself.
In these examples, exclusive dealing arrangements do not eliminate competition. Instead, competition occurs to obtain the seller’s business in the first instance: several app store platforms (in the case of online games) or several sales and scheduling platforms (in the case of the bicycle shop) compete to offer the greatest promotional and technical support, before the seller chooses one platform for an exclusive relationship. Is it possible for exclusive arrangements of this type to damage competition? Yes, but only in the rare situation where a single platform obtains so much business that rival platforms do not have enough remaining business to be viable and then maintains that dominant position by anticompetitive means. This is the concept of a “contestable share” — antitrust regulators wish to ensure that the terms of the exclusive arrangements allow competition to occur, either for a portion of the business at any one time, or at reasonable intervals over a period of time. For example, if one platform has 80% of bicycle shops but 20% of shops remain uncommitted and that is sufficient for another platform to stay in business, this means that competition is unaffected. Likewise, if the exclusivity time periods are reasonably linked to the time period necessary to recoup the relationship-specific investments, then the exclusivity period would be reasonable. Time limiting is a very common way to make sure that business remains “contestable” at reasonable intervals. The legal and economic analysis of each situation may be fact-dependent, but as a general matter, exclusive dealing arrangements are at least as likely to benefit sellers and, ultimately, consumers as they are to harm competition.
As a broader observation, exclusive dealing arrangements cannot be an indication of monopoly by themselves because they are extremely common, even in industries that everyone would agree are highly competitive. Our example of gaming consoles is a real-world case: a recent study showed that most of the largest console games are released exclusively on one manufacturer’s consoles, yet it is obvious that console gaming is very competitive. In 2021, the Sony PlayStation 4 Pro, Xbox One S, and Nintendo Switch consoles all sell very well, and the sales leader among these consoles often has changed over the last several years. Television shows are also examples of exclusive dealing in an obviously competitive market: new shows often debut exclusively on a single network, then are later offered to others on a syndicated basis. It is clear that the motivation for such exclusivity is rooted only in efficiency — there is no prospect of preventing competition in these industries.
There is now a broad consensus among economists, lawyers, and competition regulators worldwide that these arrangements have many benefits. The economic literature notes that exclusive dealing is common and does not signal a competition law problem; instead, it is often a symptom “of the normal competitive process,” and distribution restrictions are “positively related to manufacturer incremental profit margins.”1
Given the ubiquity and benefits of exclusive dealing, competition regulators should be cautious when reviewing such arrangements. If a regulator were to condemn exclusive dealing arrangements without doing a full analysis of the benefits and considering whether a share of relevant business remains contestable, this could accidentally harm competition, increase free riding, reduce promotion or other incentives, and ultimately harm consumers instead of benefiting them. Fortunately, Brazil’s CADE has a history of conducting detailed analyses in past cases, including Telet/CRT and Nestle/Unilever, and we expect it will continue to do the hard work of judging these cases on the facts and only intervene where there is clear evidence of consumer harm.
This article was originally published (in Portuguese) in JOTA, a leading Brazilian publication, focused on business and legal issues and coverage of Brazil’s government agencies. You can read the original article here.
1 Benjamin Klein & Joshua D. Wright, The Economics of Slotting Contracts, 50 J.L. & Econ. 421 (2007), available at https://doi.org/10.1086/524125.
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.