As Chinese authorities implement new regulations to crack down on price-fixers, will consumers be better off or lose out in a pricing race to the bottom?

China’s National Development and Reform Commission (NDRC) recently fined Kweichou Moutai and Wuliangye Yibin RMB 449 million (about $72 million) for violating antimonopoly laws. Although this represents only about 1% of the two firms’ combined revenues last year, the decision has attracted attention because of the companies’ fame and because it is one of the earliest decisions of its type under China’s new anti-monopoly laws. Given this, it is worth considering what the firms have done and whether the NDRC made the right decision.

Moutai and Wuliangye, two of China’s top liquor makers and famous for their strong baijiu rice wine, engaged in price-fixing (see foot note). This is only the second price-fixing case decided under China’s anti-monopoly laws. The first involved horizontal price-fixing in which firms at the same level of production, flat-panel screen manufacturers in this case, were found to have explicitly coordinated to raise prices. The liquor firms engaged in vertical price-fixing in which they controlled the prices charged by their downstream distributors of baijiu. They did this by penalizing distributors if they charged lower prices than the manufacturers specified.

This sounds like a bad outcome for consumers–distributors charging higher prices will result in customers paying more at the retail level–so the NDRC unambiguously made the right decision. However, anti-trust economists began thinking seriously about vertical price controls in the 1960s and have come to realize that vertical price controls can be good or bad for consumers depending on the specifics of the situation.

The way in which vertical price controls can be bad for consumers is probably what comes immediately to your mind. They can be used as a collusive device. Moutai and Wuliangye can dictate that their distributors charge a higher price and can then set the price they charge their distributors to ensure the margin they want.

But vertical price controls can also be good for customers in certain circumstances. Imagine that you are in the market for a new car and you can visit either of two dealerships. One dealership offers extensive services such as providing staff to show you the cars and answer questions, keeping an inventory of cars in the showroom for you to examine, and allowing you to test drive the cars. It also invests in advertising to attract potential customers. The other dealership offers the exact same vehicles but provides none of these amenities–not even a showroom. The high-service dealership will need to charge a higher price for its cars than the low-service dealership in order to cover its promotion and service costs.

This creates a problem for the upstream automobile manufacturer. Customers can visit the high-service dealership first and use its services to figure out which car they want to buy. They can then tell the dealer that they need to think about their decision and turn around and buy from the low-service dealership at a lower price. This is what economists call “free-riding”. The problem for the manufacturer is that free-riding may be so pervasive that no dealership wants to invest in service and fewer customers learn about and buy the manufacturer’s cars. This is also bad for consumers who would actually benefit from the services in helping choose a car.

Vertical price controls can solve the free-riding problem. If the manufacturer imposes a vertical price control, the dealerships cannot compete on price. To attract customers they will instead compete on better service. This will induce the dealerships to provide promotion and in-store services as long as the manufacturer leaves them sufficient margin to be profitable.

Because of the possibility of either pro- or anti-competitive results from vertical price controls, US anti-trust authorities apply a “rule of reason” criterion in evaluating them rather than making them per se illegal. Part of the reason why the distilleries case has attracted so much attention is a clue of how the NDRC may approach these types of cases.

Which brings us back to whether the NDRC made the right decision? I think so. In distributing baijiu there is little scope for either promotion or service. Virtually everyone in China is aware of these brands and if advertising is needed, it can be done by the manufacturers at the national level. High levels of service are not required because these are not complex products. You may need to taste them to know whether you like them but it is unclear how a salesperson can assist. Therefore, I see the distilleries’ actions as an attempt to raise prices with no offsetting benefit in greater service or promotion. Although this case does not tell us how the NDRC will decide vertical price-fixing cases in the future I hope this is a signal that it will evaluate the specific circumstances to determine if consumers are helped or harmed.