| Manufacturers frequently desire their retailers to provide pre-sale demand-enhancing services. Because these services are rarely priced separately, they are subject to free riding. For the manufacturer to encourage service provision, he must provide some mechanism to protect his dealer's investments in the services.;Two partial remedies are minimum resale price maintenance (RPM) and dealer exclusive territories. Each is shown to have its own shortcomings. By granting monopoly pricing power downstream, exclusive territories suffer from an elevated retail price. RPM, while ameliorating the free rider problem, does not always eliminate it entirely. When residual free riding remains, dealers provide suboptimal levels of service.;The choice of distribution system is analyzed with a model of a retail marketplace comprised of dealers of two types: low service, discounting retailers who compete via retail prices and high service retailers who compete in services. The model yields solutions for wholesale and retail prices, service levels, and manufacturer profitability measures under vertical integration, free trade, exclusive territories, and RPM. Comparisons of manufacturer profits suggest which of the vertical structures is optimal for various combinations of the model's parameters.;The model suggests conditions under which manufacturers select one type of vertical restraint over the other and therefore provides an empirical link between a product's characteristics and the manner in which that product is likely to be distributed. Products with long life spans are most prone to residual free riding on services, and are thereby more likely to be distributed using exclusive territories. Products which change often relative to frequency of consumer purchase quickly render information provided through dealer services obsolete. These types of products are apt to be distributed using RPM. These hypotheses are tested using information contained in vertical restraint litigation from 1976 to 1982. The data strongly support the model's predictions. |
