Retailer Initiated Vertical Restraints: Toys “R” US Case Author: F.M. Scherer Presented by: Janel Bass Yash Shah Chad Sykes

Players Toy Manufacturers – Ex: Mattel, Nintendo, Sega Toys “R” US (TRU) Warehouse Clubs – Ex: Costco, Sam’s Club, BJ’s Federal Trade Commission

Things to Consider Role of econometric vs. investigatory evidence Interaction between vertical restraint and horizontal collusion: Management of agreement Bertrand competition model with regard to prices and supply of information Structure of Trial: Fair process, Deterrence/Punishment concerns

Evolution in Retailing (1/2) General or “Mom and Pop” Stores Department stores and mail-order houses – Ex: Sears, Roebuck Mass consumption stores – Chain Stores (Walgreens) – Supermarkets – Hypermarket Chains (Walmart, Kmart) – “Category Killer” Chains (Home Depot, Staples) 1. Reductions in percentage retail margin (PRM) 2. Price as strategic variable for consumer

Evolution in Retailing (2/2) Rise of TRU as category killer discount chain – Broad line of toys – 16,000 items by 1990s – Realized PRM below traditional 40-50% range – 1992: 497 US stores, 126 abroad

Warehouse Clubs Ex: Costco, Sam’s Club, BJ’s,etc. Late 1980s: opened to individual customers – By 1992, 576 clubs in US Shopping experience PRM – 9-12%

Pricing in Toy Market Price competition on “hit items” – Low PRM for TRU as sales strategy – Clubs stock 100 to 250 items at low PRM as well – Threat to TRU inverse pricing – TRU response: downward price adjustments, maximum estimate of $55 million per year

New York Toy Fair, February 1992 TRU policy towards manufacturer sales to warehouse clubs – Penalty for violations Effect on Market Share – 1.9% of Toy Sales in 1992, 1.4% by 1995 – By 1993, TRU did not set PRM for “hit items” in response to club competition

Antitrust Clubs threatened legal action, informed FTC, FTC formal complaint in May 1996 – Protecting competition vs. processes of competition – Political dimension of FTC activism Trial in front of FTC Administrative Law Judge, September 1997 Appeal in front of FTC Commission members – Set precedent on Retailer Instigated Restraints

Violations – Vertical Restraint Definition Unilateral vs. Bilateral Agreements – Type of Evidence – Violation of Sherman Act, Section 1: Act that prohibits “agreements, conspiracies, or trusts in restraint of trade”

Violations – Horizontal Collusion Need for cooperation between manufacturers – Product differentiation TRU as a “hub and spoke” – Ensured “level playing field” “Hub and spoke” implies unilateral vertical restraint Limitations of both vertical and horizontal agreements

Market Power (1/2) Inference of illegality Methods – Definitions Intermediate concentration amongst manufacturers – Four suppliers produced 34-45% of toy market – Further concentration in relevant market of nationally advertised toys TRU accounted for 20% of US toy sales – 32% in local market

Market Power (2/2) TRU economists, regression between PRM and significant rivals in local markets – PRM uniform with or without competition – FTC response: “hot” items vs. entire inventory TRU economists, ability to raise prices limited – FTC response: Policy intended to avoid reductions in prices

Free Riding (1/2) “Lemons Problem” in presale services – Bertrand equilibrium in supply of effort – Vertical integration as solution TRU presale services and early stocking decisions Rebuttal – No actual product demonstration – Price of toys did not warrant consumer free-riding – Costs were compensated by manufacturers: retroactive wholesale discounts, advertising allowances (90%) Free-riding, even if it occurred, would not eliminate services.

Free Riding (2/2) – Regressions TRU economist, retailers experienced sales increases as a result of TRU advertising FTC response: unobserved heterogeneity, selection issues in April 2, 1995 catalogue as sample – Re-estimation showed negative impact FTC: no evidence of free-riding defense during Toy Fair deliberations

Trial Outcome Found violation in vertical restraints and horizontal collusion, rejected free-riding defense – Prospects for fair trial – 7 th Circuit Court of Appeals, Chicago. Judges were faculty of University of Chicago Law School. – Finding

Post Trial Additional class action antitrust suits – Settlement Declining market share to warehouse clubs and hypermarkets Acquisitions over concerns for viability

The End