Antitrust Balancing in a (Near) Coasean World: The Case of Franchise Tying Contracts

Abstract

More than half a century ago, the Supreme Court declared tying contracts imposed by firms with market power “unlawful per se,” reasoning that all such agreements necessarily result from “anticompetitive forcing.” Despite the “per se” label, however, lower courts have recognized an affirmative defense to such liability in cases where franchisors require franchisees to purchase inputs from the franchisor as a condition of operating under the franchisor’s trademark. To invoke this defense, the defendant must establish that the challenged agreement produces significant benefits by inducing franchisees to purchase inputs of a higher quality than they would otherwise select. However, proof that the agreement produces such benefits does not suffice to avoid liability. Instead, a plaintiff-franchisee may still prevail by showing that the franchisor could achieve the same benefits by relying upon a “less restrictive alternative,” in particular, allowing franchisees to purchase from whichever vendor they choose, subject to input quality specifications promulgated by the franchisor.

This article contends that the standards governing this defense are unduly biased against franchise tying contracts that produce significant benefits. Many franchise systems are of a “business format” variety, whereby individual franchisees produce the franchise product, subject to specifications set by the franchisor. As economists have previously shown, reliance on individual franchisees to select the inputs employed to create the franchise product can result in a market failure and suboptimal quality of the franchise product. In particular, individual franchisees may purchase cheap and inferior inputs, while at the same time attracting consumers to their establishment by displaying a franchise trademark enhanced by investments made by other franchisees. Of course, if all franchisees pursue this strategy, the overall quality associated with the franchise system and thus franchise trademark will suffer.

To be sure, current law allows franchisors to assert and show that a tying contract overcomes market failure in this manner. Nonetheless, current law rests upon a misconception about the relationship between market power, one the one hand, and ties that eliminate this market failure, on the other. That is, the current methodology for evaluating this “defense,” including the less restrictive alternative test, implicitly assumes that any benefits produced by such agreements coexist with the sort of anticompetitive harms presumed once a plaintiff establishes the market power necessary for per se liability. This “coexistence assumption” reflects the pre-occupation with monopoly explanations for non-standard contracts decried by Ronald Coase and flows naturally from the partial equilibrium trade-off model applied to mergers that both enhance merging parties’ market power and produce technological efficiencies such as economies of scale.

Franchise tying contracts are not mergers, however, and the partial equilibrium trade-off model is ill-suited for analyzing ties that produce significant benefits. After all, such ties arise in a Coasean setting of low transaction costs in which parties can adopt contractual provisions that counter-act anticipated market failure and thus reduce the cost of relying upon the market to conduct economic activity. Instead of suggesting the coexistence of harms and benefits, proof that a tie creates significant benefits suggests that the challenged agreement is the result of voluntary integration between the parties, whereby franchisees and the franchisor collectively establish and enforce quality standards, undermining the presumption of forcing on which per se liability rests. Thus, even if a franchisor possesses market power, proof that a tying agreement produces such benefits should absolve the defendant of liability, absent additional proof, separate and apart from the mere existence of market power, that the agreement actually results in anticompetitive harm exceeding these benefits.

Keywords: Franchising, Business Format Franchising, Franchise Tying Contract, Antitrust, Less Restrictive Alternative, Trademarks, Ronald Coase, Transaction Cost Economics, Partial Equilibrium Trade-Off Model

JEL Classification: D23, D21, D62, D70, K11, K12, K21, L14, L15, L22, L23, L42, M55