A Further Reply to Steve Salop

Dan Crane —  13 June 2013

Dan’s next installment, responding to Steve’s latest post responding to Dan’s latest post on the appropriate liability rule for loyalty discounts. Other posts in the series: SteveDan, and Thom.

I’m happy to keep going back in forth with Steve until we wear out our welcome at TOTM, or simply wear out. [Keep ‘em coming! – ed.]

(1) There’s neither input foreclose nor output foreclosure if a rival can neutralize a loyalty discount without pricing unprofitably.  The rival who can profitably compete despite the loyalty discount structure will remain in the market; there is no input exclusion.  As I understand him, Steve posits that an RRC effect would arise if the guilty firm tried to use loyalty rebates to raise the effective price the rival had to pay for “distribution services” with the effect of raising general market prices.  But that theory doesn’t work.  First, why would a firm that can profitably match a loyalty discount have to increase its price in order to “pay for” the loyalty discount?  Second, the theory requires the victimized rival to simultaneously increase its “payments” to distributors in the form of discounts even while it is increasing its prices to those same distributors in equal amount in order to offset the payments.   A rival who feels “pressured” to make a $100 loyalty payment to distributors and consequently raises his price to the distributors by $100 to offset has done . . . nothing.

(2) Steve posits “that economic analysis is the same” for loyalty discounts and contractual commitments not to buy from rivals.  Really?  I suppose at a high level of generality one would say that in both cases the question is whether the price or contract forecloses competitors, but it can’t possibly be that an exclusive dealing contract that prohibits purchases from a rival has the same effect as a 0.0001% rebate if the customer purchases exclusively from the seller.  Once an exclusive dealing contract is in place, the rival can’t compete without inducing breach of contract.  With a pure loyalty discount, the rival can always compete so long as it can profitably neutralize the loyalty discount with its own pricing terms.  You see this in the real world—customers operate in environments where multiple sellers are offering loyalty discounts.  The customers freely switch between suppliers (sometimes showing loyalty and obtaining the discounts; sometimes deciding to forgo the discounts and prefer variety).  This is not true of a market locked up with exclusive dealing agreements.

(3) Steve presents four examples of how an auction for contractual exclusivity results in a single firm obtaining contractual exclusivity with anticompetitive effects due to asymmetry of incentives, all of which begs the question of how loyalty discounts without contractual exclusivity achieve the same effect.  Moreover, all Steve shows is that if you applied unmodified predatory pricing analysis to the exclusivity auction, the contracts wouldn’t be illegal since the winning bidder could show that its revenues exceeded its costs.  He doesn’t show how, in the absence of contractual exclusivity, the winning bidder would satisfy the attribution test we’ve been assuming.  For example, in Scenario (a), if there isn’t contractual exclusivity but merely a discount structure that would require the entrant to pay rebates of $71 even while earning revenues of $70, then the rebate system would fail the price-cost screen and we could proceed to all of the foreclosure/RRC analysis that Steve has so magnificently pioneered and illustrated.  The same is true in each of Steve’s examples.  None of his examples shows a circumstance where the new entrant could obtain retailer distribution services without inducing breach of contract and without pricing below its cost and yet there would be an anticompetitive effect from a loyalty discount scheme.

(4) In his first post, Steve said that “the price-cost test is premised on the erroneous idea that only equally efficient competitors are worth protecting.”  My last post disputed that claim.  Steve now says that “the price-cost test is better framed as a measure of ‘profit-sacrifice,’ and EEC is simply a misleading way to express the test.”  So I think we’re now in agreement that one could accept a version of the price-cost screen even while believing that antitrust law should not necessarily be bounded by an EEC component.  As to profit sacrifice, more in a moment.

(5) I don’t want to get pulled into defending an EEC component in this discussion, since I think we’re now in agreement that it’s not necessary to support some version of the price-cost screen.  In any event, when I said that the test has “merit,” I wasn’t saying that it should be applied categorically to all types of exclusion claims.  For example, (and I’m not committing to this), institutional context might matter to whether an EEC test should apply.  One might reasonably believe that it’s dangerous to allow less efficient rivals to seek treble damages for their exclusion from the market for all kinds of incentives and decisional reasons but that the government should be free to mount exclusion theories that do not depend on a showing that EECs were excluded.  Again, I’m not arguing that this should be the case, only explaining the non-committal nature of my “merit” comment.

(6) (I’ll collapse my response to Steve’s points 6-8 into one).  The discount penalty theory is premised on the assumption that the monopolist increases its list price above the profit-maximizing monopoly level and then offers a concession back down to the monopoly level, combined with an onerous term restricting the customer’s freedom of choice among suppliers.  I take it that Steve accepts the point from my last post that a price of x plus loyalty restriction is effectively higher than a price of x without a loyalty restriction.  Steve says that a monopolist might choose to exceed the profit-maximizing price and thereby forego profits as a predatory investment.  In that case, the loyalty discount program must be of short duration and the monopolist has to be highly confident of recoupment, just as in conventional predation cases.  Observe that the profit sacrifice is not merely the charging of the $105 “penalty” price but also the charging of the $100 plus loyalty restriction price.  Thus, the monopolist is not saved from profit sacrifice, as Steve posits, merely by threatening a price of $105 that it never has to charge.  Also, observe that the strategy is much more risky and expensive to the monopolist than to the customer.  By definition, the monopoly price the customer is paying is one where the customer will be willing to substitute to other products at just a slightly higher price, whereas the monopolist stands to lose highly profitable sales by exceeding its monopoly profit-maximizing price.  Finally, let me underline as I did in my last post that I’m not claiming that “penalty pricing” is economically impossible.  Rather, I’m making the point that “penalty pricing” is an expensive and risky strategy for monopolists, that we should therefore not assume that it will be routinely deployed, and that the starting presumption should be that most loyalty discounts are true reductions from the but-for price.

3 responses to A Further Reply to Steve Salop

  1. 
    Laura Bennett Peterson 13 June 2013 at 11:10 pm

    This is a very engaging and high-quality set of posts on single-product loyalty discounts. Dan Crane and Thom Lambert ask whether an equally efficient rival or, less stringently (as Dan offers in his latest post), even a less efficient rival, could profitably respond to the loyalty discounts. Steve Salop argues that this test is too narrow since it fails to take into account the improper foreclosure or exclusion that may arise from raising rivals’ costs. Commissioner Josh Wright also rejects the position that pricing above costs should yield a safe harbor for the loyalty discounts.

    I believe on balance that Dan Crane and Thom Lambert have the better argument. Their test offers greater certainty as to conduct that conforms with the law, easier administrability, and less danger of deterring what antitrust should encourage: lower but non-predatory prices.

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