Ignorance Is Us: Toys, Music, and Antitrust Regulations

On Point No. 70



Decades ago, the Federal Trade Commission (FTC) had a reputation for using the antitrust laws to defend mom-and-pop stores against the retailing revolution brought about by supermarkets and discount stores.  The effect was to deprive consumers of the benefits of the efficiencies made possible by these new institutions. 

This history taught the commission the wrong lesson.  Instead of learning to keep its thumb off the scales and let markets work, it has now jumped to the opposite extreme, intervening on the side of the big discount houses against smaller specialty stores.  It has already acted on the toy and CD industries, and who knows what new mischief is afoot.  The only constant theme is that, once again, consumers will be injured, not helped.

Toys and CDs.  On August 1, 2000, the 7th Circuit Court of Appeals upheld the Federal Trade Commission’s decision that Toys ‘R’ Us (TRU) violated the Sherman Act by making deals with 10 toy manufacturers concerning the latter’s dealings with warehouse clubs.1  In May 2000, the FTC moved against the CD industry, extracting settlements from the five largest distributors on charges that their systems for paying cooperative advertising money to retailers violated the Sherman Act.  As usual in FTC consent agreements, the companies admitted no wrongdoing but promised not to do it any more.  They also carefully avoided any admission that they had acted in concert.2  In early August, 28 state attorneys general announced a law suit against the same CD distributors over the practices covered by the FTC consent order.  The state suit explicitly charges that the distributors conspired, and adds three CD retail chains as defendants.

All these actions were accompanied by the usual self-congratulations by regulators about the evils of the practices under attack and the size of the consumer benefits of their actions.  The FTC put a value of $480 million over three years on the supposed consumer losses from the CD-industry practices that it was halting. 

Institutional Innovation.  In reality, the actions prove (for the nth time) some points made by CEI’s Fred Smith in a recent article.3  Antitrust regulators do not understand either business or markets very well, especially when things are in flux.  Their instincts when they see an institutional innovation, particularly anything involving even a whiff of cooperation among competitors, are to suppress.  And they do this by applying antitrust doctrine that is based on faith rather than reason, and that is seriously in need of radical re-evaluation, and, for the most part, repeal.  The usual result is damage to everyone in sight—both producers and consumers. 

The instinct to suppress innovation also promises future ill, because the revolution in computers and communications is increasing the potential benefits from cooperative arrangements among companies, and continuing ignorance and reflexive opposition by the antitrust regulators will deprive consumers of new, efficiency-enhancing institutional arrangements.  An ominous recent example was hidden under a cheery headline, “FTC Clears Covisint, Big Three’s Auto Parts Site.”4 The FTC took three months to investigate a proposed online exchange for automobile parts—during which the enterprise was unable to hire staff or commence operations—only to conclude that the agency did not know enough to have an opinion on possible antitrust problems.  The investigation was closed, but the Commission reserved the right to start it up again in the future. 

High-risk Industries.  The toy and CD industries have several things in common.  Each depends on a stream of new products.  Each is high risk, in that most new products fail.  In the music business, for example, the major labels release about 7,000 CDs per year, of which 10 percent make a profit.  Other distributors release another 20,000, of which even fewer do well.  The players, at all levels, rely on the hits to help pay for the overall distribution system.  But no one can tell in advance which products will be hits, so they must play a numbers game, pushing lots of things out there and seeing what catches on. 

The drawing power of hits helps in ways besides simply paying for the system’s overhead.  Hits get customers into the stores where they will see, and hopefully buy, other items, which is important to both manufacturers and retailers.  Each industry also needs sales of old stand-bys and non-hits because even the products that do not make a profit for tax purposes can make more than the short-term marginal costs of production, and thus contribute to paying the overheads of the industry participants.  Given these complex needs, discounters create a problem.  They can cherry pick, ordering the hits once popularity is established.  This means the discounter bears none of the risks of the failures or the costs of the so-so products, which means, of course, that it does not have to charge enough to cover the costs of supporting these non-hits.  Nor does it incur the cost of carrying a backlog of older releases.

Siphoned to Groceries?  In consequence, when hit toys or CDs are sold by discounters the manufacturers do not get any extra benefits.  The customers who come to the discounter for the bargain hits are siphoned over to groceries or tires or electronic equipment, not to other toys or CDs.

So, in each industry, the manufacturers are ambivalent about discounters.  They like the increased volume that comes from selling selected hit merchandise at a low markup, but this also undermines a complex distribution system designed to meet the whole spectrum of a manufacturer’s needs.  Also, the conventional retailers, who are the backbone of any broad distribution system, scream loudly.  The manufacturers must pay attention because they could not sell a broad product line through a system that contained only cherry-picking discounters.

Prisoner’s Dilemma.  This combination of pressures presents the manufacturers in each of these industries with a prisoner’s dilemma.5  For any individual manufacturer, the best outcome would be for it to sell to the discounters while none of its competitors do so.  It would then get the benefits of the increased sales created by the discounted price; at the same time, it would free-ride on the in-depth distribution system financed by sales of its competitors’ products.  But each manufacturer understands this, so none will be able to take advantage of it.  Each, knowing that its competitors will sell to discounters, will do the same, even if the end result is the destruction of their joint distribution system, and even if all are left worse off as a result.

This outcome would not benefit consumers, who would lose the variety produced by the current system.  They might also lose the hit products, because, remember, hits are hard to predict and without variety there will be fewer of them.  In the TRU and CD cases, each set of manufacturers responded to this prisoner’s dilemma in a rational way, and each got slapped down by the FTC. 

For toys, the warehouse clubs, such as Costco, have created a new niche by selling selected items at a markup of about 9 percent over cost.  General discounters, such as Wal-Mart, mark up 22 percent, TRU marks up 30 percent, and traditional toy stores and department stores mark up 40 to 50 percent.

TRU Counter-strategy.  TRU is a major player, with 20 percent of US toy sales.  Feeling the heat from the warehouses, it formulated a counter-strategy.  It negotiated with the individual toy manufacturers to cut off sales of new or promoted items to the clubs unless these bought the entire line, and to sell old items to warehouses in special packs so as to avoid direct price comparisons.  Eventually, TRU got agreements to this effect from 10 manufacturers.  However, each said it would go along only if its competitors did, too, which, in the view of the FTC, meant TRU was orchestrating a horizontal boycott.  This was illegal, both per se and under Rule of Reason analysis.

Viewed without the blinders of antitrust theology, the initiative may have come from TRU, but the underlying reality is that the manufacturers were responding to their prisoner’s dilemma.  Each was showing a willingness to give up short-term benefits from discount sales in order to protect long-term interests in the distribution system upon which they all depend.  To do so, they did not need to make contracts with each other.  It was necessary only that each manufacturer recognize it has an interest in not having the distribution system destroyed, and that each express an intention to act to solve the problem as long as the others do the same.

If the FTC had not intervened, the warehouses would still have had many options for obtaining toys, and they might have thought up some other competitive counterstrokes as well.  Customers would have been as well off—it is not in their interest to have a few toys available instead of many—and the manufacturers would even have added to the proliferation by creating specialty items for the warehouses.  The toy manufacturers would have retained their freedom of action to solve a problem, and TRU, which many customers find quite valuable, would have continued to prosper.  (It may yet, having just made a deal with Amazon to run an online toy store.)

The CD distributors solved their prisoner’s dilemma through a different mechanism.  In the CD business, retailers do much of the advertising and distributors pay for it.  This is logical, since the benefits of advertising for CDs are not limited to any one retailer.  If Tower advertises a particular CD in the local paper, its competitors get some of the benefits. 

Minimum Advertised Prices.  Each distributor, responding to screams from retailers about discount stores using popular CDs as loss leaders, started a policy called “Minimum Advertised Price.”  Under it, a distributor would not pay cooperative advertising money to any retailer that charged less than a distributor-set “Minimum Advertised Price” for CDs. 

Co-op advertising payments are large, and very important to the retailers.  Thus, the distributors had a powerful lever.  While a retailer, discounter or not, could advertise and sell at any price, if it sold below the level of the “Minimum Advertised Price” (MAP, which was, by the way, not the list price; it was only about one dollar over the wholesale price) the distributor would pull all co-op advertising money for a couple of months. 

As in the case of toys, the CD distributors did not need to make a contract among themselves.  They had a common problem—protecting the distribution system.  Each showed that it understood this and intended to help solve it, but each also retained total freedom of action to change its policy at any time.  And none was refusing to sell to discounters or doing anything except say publicly that it would not finance the destruction of a distribution system that it regards as valuable.

Politically Appointed Lawyers.  In the end, no one knows what these industries should look like.  The questions are complicated, and the tradeoffs difficult and not at all clear.  The Internet is a huge joker.  The FTC, which never heard of a prisoner’s dilemma, was outraged at the companies’ behavior.  It decided that TRU had orchestrated a massive conspiracy.  It is not clear what the Commission thought about the CD case, since it settled that one quickly without requiring the companies to admit to any agreement.  But why should one think the FTC—comprising five politically-appointed lawyers—is capable of deciding that the toy business should look like a Costco and the CD business like a Circuit City?

In fact, in each case the FTC has managed to leave everyone worse off.  The manufacturers and distributors are at risk of losing breadth in their distribution systems.  The smaller retailers are obviously injured.  Customers are damaged—they may pay less for hit products, but they will pay more for others, they will lose some variety, and, if some retailers close, they will have fewer sources.  The winner-take-all characteristics of these industries will be accentuated.6 

Even the discounters, who look like obvious gainers, may not really be.  In the toy case, for example, if there were a collapse of the system that produces a variety from which they can cherry pick, they would have to go into the toy business for themselves, which would force them to raise prices.  They were probably better off under the TRU-engineered system whereby the manufacturers packaged things specially for discount outlets. 

Few Gainers.  There are a few gainers.  Money may be transferred to state treasuries in penalties in the CD case, and plaintiffs’ lawyers will now extract a toll from both TRU and the CD distributors, which, naturally, will come out of the pockets of consumers.  And the FTC has gained some laudatory press.  That these cases are regarded as major victories just shows the low intellectual candlepower of current antitrust theology.

1 Toys ‘R’ Us, Inc. v. FTC, August 1, 2000, available at www.findlaw.com/casecode/courts/7th.html.


2 See “Record Companies Settle FTC Charges of Restraining Competition in CD Music Market,” at www.ftc.gov/ftc/antitrust.htm.


3 “The Case for Reforming the Antitrust Regulations (If Repeal Is Not an Option),” 23 Harvard Journal of Law & Public Policy 23 (Fall 1999).


4 The Wall Street Journal, September 12, 2000.


5 See William Poundstone, Prisoner’s Dilemma (New York: Doubleday, 1992).


6 Robert H. Frank and Philip J. Cook, The Winner-Take-All Society (New York: Free Press, 1995).