How Loyalty Discounts Can Perversely Discourage Discounting

Loyalty discounts are agreements to sell at a lower price to buyers who buy all or most of their purchases from the seller. This article proves that loyalty discounts can create anticompetitive effects, not only because they can impair rival efficiency, but also because loyalty discounts can perversely discourage discounting even when they have no effect on rival efficiency. The essential reason, missed in prior work, is that firms using loyalty discounts have less incentive to compete for free buyers, because any price reduction to win sales to free buyers will, given the loyalty discount, also lower prices to loyal buyers. This in turn reduces the incentive of rivals to cut prices, because there will exist an above-cost price that rivals can charge to free buyers without being undercut by the firm using loyalty discounts. These anticompetitive effects occur even if buyers can breach or terminate commitments, and even if the loyalty conditions require no buyer commitments and less than 100 percent loyalty. These anticompetitive effects also differ from those created by most-favored-nation or price-matching clauses, neither of which requires the seller to commit to maintain a price difference between loyal and disloyal buyers. Further, I prove that these anticompetitive effects are exacerbated if multiple sellers use loyalty discounts. None of the results depend on switching costs, market differentiation, imperfect competition, or whether the loyalty discount bundles contestable and incontestable demand. Contrary to commonly held views, I prove that these anticompetitive effects exist even (1) when all prices are above seller or rival costs, (2) buyers voluntarily agree to the conditions, and (3) discount and foreclosure levels are low, although such low levels do lower the likelihood that buyers would agree to anticompetitive loyalty discounts. I also derive formulas for calculating the inflated price levels in each situation. However, because loyalty discounts can have efficiencies, rule of reason analysis remains appropriate. JEL: C72; K21; L12; L40; L41; L42 Petrie Professor of Law, Harvard Law School. E-mail: [email protected]. I am grateful for helpful comments from Douglas Ginsburg, Patrick Greenlee, Andrei Goureev, Jonathan Jacobson, Louis Kaplow, Doug Melamed, Richard Posner, Mark Ramseyer, Eric Rasmusen, Ken Reinker, Steve Shavell, David Sibley, Kathy Spier, Abe Wickelgren, Joshua Wright, and participants in the Law & Economics Workshop at Harvard. Journal of Competition Law & Economics, 5(2), 189–231 doi:10.1093/joclec/nhn035 Advance Access publication 17 March 2009 # The Author (2009). Published by Oxford University Press. All rights reserved. For Permissions, please email: [email protected]