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FTC Commissioner Josh Wright is on a roll. A couple of days before his excellent Ardagh/Saint Gobain dissent addressing merger efficiencies, Wright delivered a terrific speech on minimum resale price maintenance (RPM). The speech, delivered in London to the British Institute of International and Comparative Law, signaled that Wright will seek to correct the FTC’s early post-Leegin mistakes on RPM and will push for the sort of structured rule of reason that is most likely to benefit consumers.

Wright began by acknowledging that minimum RPM is, from a competitive standpoint, a mixed bag. Under certain (rarely existent) circumstances, RPM may occasion anticompetitive harm by facilitating dealer or manufacturer collusion or by acting as an exclusionary device for a dominant manufacturer or retailer. Under more commonly existing sets of circumstances, however, RPM may enhance interbrand competition by reducing dealer free-riding, facilitating the entry of new brands, or encouraging optimal production of output-enhancing dealer services that are not susceptible to free-riding.

Because instances of minimum RPM may be good or bad, liability rules may err in two directions. Overly lenient rules may fail to condemn output-reducing instances of RPM, but overly strict rules will prevent uses of RPM that would benefit consumers by enhancing distributional efficiency. Efforts to tailor a liability rule so that it makes fewer errors (i.e., produces fewer false acquittals or false convictions) will create complexity that makes the rule more difficult for business planners and courts to apply. An optimal liability rule, then, should minimize the sum of “error costs” (social losses from expected false acquittals and false convictions) and “decision costs” (costs of applying the rule).

Crafting such a rule requires judgments about (1) whether RPM is more likely to occasion harmful or beneficial effects, and (2) the magnitude of expected harms or benefits. If most instances of RPM are likely to be harmful, the harm resulting from an instance of RPM is likely to be great, and the foregone efficiencies from false convictions are likely to be minor, then the liability rule should tend toward condemnation – i.e., should be “plaintiff-friendly.” On the other hand, if most instances of RPM are likely to be beneficial, the magnitude of expected benefit is significant, and the social losses from false acquittals are likely small, then a “defendant-friendly” rule is more likely to minimize error costs.

As Commissioner Wright observed, economic theory and empirical evidence about minimum RPM’s competitive effects, as well as intuitions about the magnitude of those various effects, suggest that minimum RPM ought to be subject to a defendant-friendly liability rule that puts the burden on plaintiffs to establish actual or likely competitive harm. With respect to economic theory, procompetitive benefit from RPM is more likely because the necessary conditions for RPM’s anticompetitive effects are rarely satisfied, while the prerequisites to procompetitive benefit often exist. Not surprisingly, then, most studies of minimum RPM have concluded that it is more frequently used to enhance rather than reduce market output. (As I have elsewhere observed and Commissioner Wright acknowledged, the one recent outlier study is methodologically flawed.) In terms of the magnitude of harms from wrongly condemning or wrongly approving instances of RPM, there are good reasons to believe greater harm will result from the former sort of error. The social harm from a false acquittal – enhanced market power – is self-correcting; market power invites entry. A false condemnation, by contrast, can be corrected only by a subsequent judicial, regulatory, or legislative overruling.  Moreover, an improper conviction thwarts not just the challenged instance of RPM but also instances contemplated by business planners who would seek to avoid antitrust liability. Taken together, these considerations about the probability and magnitude of various competitive effects argue in favor of a fairly lenient liability rule for minimum RPM – certainly not per se illegality or a “quick look” approach that deems RPM to be inherently suspect and places the burden on the defendant to rebut a presumption of anticompetitive harm.

Commissioner Wright’s call for a more probing rule of reason for minimum RPM represents a substantial improvement on the approach the FTC took in the wake of the U.S. Supreme Court’s 2007 Leegin decision. Shortly after Leegin abrogated the rule of per se illegality for minimum RPM, women’s shoe manufacturer Nine West petitioned the Commission to modify a pre-Leegin consent decree constraining Nine West’s use of RPM arrangements. In agreeing to modify (but not eliminate) the restrictions, the Commission endorsed a liability rule that would deem RPM to be inherently suspect (and thus presumptively illegal) unless the defendant could establish an absence of the so-called “Leegin factors” – i.e., that there was no dealer or manufacturer market power, that RPM was not widely used in the relevant market, and that the RPM at issue was not dealer-initiated.

The FTC’s fairly pro-plaintiff approach was deficient in that it simply lifted a few words from Leegin without paying close attention to the economics of RPM. As Commissioner Wright explained,

[C]ritical to any decision to structure the rule of reason for minimum RPM is that the relevant analytical factors correctly match the economic evidence. For instance, some of the factors identified by the Leegin Court as relevant for identifying whether a particular minimum RPM agreement might be anticompetitive actually shed little light on competitive effects. For example, the Leegin Court noted that “the source of the constraint might also be an important consideration” and observed that retailer-initiated restraints are more likely to be anticompetitive than manufacturer-initiated restraints. But economic evidence recognizes that because retailers in effect sell promotional services to manufacturers and benefit from such contracts, it is equally as possible that retailers will initiate minimum RPM agreements as manufacturers. Imposing a structured rule of reason standard that treats retailer-initiated minimum RPM more restrictively would thus undermine the benefits of the rule of reason.

Commissioner Wright’s remarks give me hope that the FTC will eventually embrace an economically sensible liability rule for RPM. Now, if we could only get those pesky state policy makers to modernize their outdated RPM thinking.  As Commissioner Wright recently observed, policy advocacy “is a weapon the FTC has wielded effectively and consistently over time.” Perhaps the Commission, spurred by Wright, will exercise its policy advocacy prowess on the backward states that continue to demonize minimum RPM arrangements.

FTC Commissioner Josh Wright pens an incredibly important dissent in the FTC’s recent Ardagh/Saint-Gobain merger review.

At issue is how pro-competitive efficiencies should be considered by the agency under the Merger Guidelines.

As Josh notes, the core problem is the burden of proof:

Merger analysis is by its nature a predictive enterprise. Thinking rigorously about probabilistic assessment of competitive harms is an appropriate approach from an economic perspective. However, there is some reason for concern that the approach applied to efficiencies is deterministic in practice. In other words, there is a potentially dangerous asymmetry from a consumer welfare perspective of an approach that embraces probabilistic prediction, estimation, presumption, and simulation of anticompetitive effects on the one hand but requires efficiencies to be proven on the other.

In the summer of 1995, I spent a few weeks at the FTC. It was the end of the summer and nearly the entire office was on vacation, so I was left dealing with the most arduous tasks. In addition to fielding calls from Joe Sims prodding the agency to finish the Turner/Time Warner merger consent, I also worked on early drafting of the efficiencies defense, which was eventually incorporated into the 1997 Merger Guidelines revision.

The efficiencies defense was added to the Guidelines specifically to correct a defect of the pre-1997 Guidelines era in which

It is unlikely that efficiencies were recognized as an antitrust defense…. Even if efficiencies were thought to have a significant impact on the outcome of the case, the 1984 Guidelines stated that the defense should be based on “clear and convincing” evidence. Appeals Court Judge and former Assistant Attorney General for Antitrust Ginsburg has recently called reaching this standard “well-nigh impossible.” Further, even if defendants can meet this level of proof, only efficiencies in the relevant anticompetitive market may count.

The clear intention was to ensure better outcomes by ensuring that net pro-competitive mergers wouldn’t be thwarted. But even under the 1997 (and still under the 2010) Guidelines,

the merging firms must substantiate efficiency claims so that the Agency can verify by reasonable means the likelihood and magnitude of each asserted efficiency, how and when each would be achieved (and any costs of doing so), how each would enhance the merged firm’s ability and incentive to compete, and why each would be merger-specific. Efficiency claims will not be considered if they are vague or speculative or otherwise cannot be verified by reasonable means.

The 2006 Guidelines Commentary further supports the notion that the parties bear a substantial burden of demonstrating efficiencies.

As Josh notes, however:

Efficiencies, like anticompetitive effects, cannot and should not be presumed into existence. However, symmetrical treatment in both theory and practice of evidence proffered to discharge the respective burdens of proof facing the agencies and merging parties is necessary for consumer‐welfare based merger policy

There is no economic basis for demanding more proof of claimed efficiencies than of claimed anticompetitive harms. And the Guidelines since 1997 were (ostensibly) drafted in part precisely to ensure that efficiencies were appropriately considered by the agencies (and the courts) in their enforcement decisions.

But as Josh notes, this has not really been the case, much to the detriment of consumer-welfare-enhancing merger review:

To the extent the Merger Guidelines are interpreted or applied to impose asymmetric burdens upon the agencies and parties to establish anticompetitive effects and efficiencies, respectively, such interpretations do not make economic sense and are inconsistent with a merger policy designed to promote consumer welfare. Application of a more symmetric standard is unlikely to allow, as the Commission alludes to, the efficiencies defense to “swallow the whole of Section 7 of the Clayton Act.” A cursory read of the cases is sufficient to put to rest any concerns that the efficiencies defense is a mortal threat to agency activity under the Clayton Act. The much more pressing concern at present is whether application of asymmetric burdens of proof in merger review will swallow the efficiencies defense.

It benefits consumers to permit mergers that offer efficiencies that offset presumed anticompetitive effects. To the extent that the agencies, as in the Ardagh/Saint-Gobain merger, discount efficiencies evidence relative to their treatment of anticompetitive effects evidence, consumers will be harmed and the agencies will fail to fulfill their mandate.

This is an enormously significant issue, and Josh should be widely commended for raising it in this case. With luck it will spur a broader discussion and, someday, a more appropriate treatment in the Guidelines and by the agencies of merger efficiencies.

 

Commissioner Wright makes a powerful and important case in dissenting from the FTC’s 2-1 (Commissioner Ohlhausen was recused from the matter) decision imposing conditions on Nielsen’s acquisition of Arbitron.

Essential to Josh’s dissent is the absence of any actual existing market supporting the Commission’s challenge:

Nielsen and Arbitron do not currently compete in the sale of national syndicated cross-platform audience measurement services. In fact, there is no commercially available national syndicated cross-platform audience measurement service today. The Commission thus challenges the proposed transaction based upon what must be acknowledged as a novel theory—that is, that the merger will substantially lessen competition in a market that does not today exist.

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[W]e…do not know how the market will evolve, what other potential competitors might exist, and whether and to what extent these competitors might impose competitive constraints upon the parties.

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To be clear, I do not base my disagreement with the Commission today on the possibility that the potential efficiencies arising from the transaction would offset any anticompetitive effect. As discussed above, I find no reason to believe the transaction is likely to substantially lessen competition because the evidence does not support the conclusion that it is likely to generate anticompetitive effects in the alleged relevant market.

This is the kind of theory that seriously threatens innovation. Regulators in Washington are singularly ill-positioned to predict the course of technological evolution — that’s why they’re regulators and not billionaire innovators. To impose antitrust-based constraints on economic activity that hasn’t even yet occurred is the height of folly. As Virginia Postrel discusses in The Future and Its Enemies, this is the technocratic mindset, in all its stasist glory:

Technocrats are “for the future,” but only if someone is in charge of making it turn out according to plan. They greet every new idea with a “yes, but,” followed by legislation, regulation, and litigation.

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By design, technocrats pick winners, establish standards, and impose a single set of values on the future.

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For technocrats, a kaleidoscope of trial-and-error innovation is not enough; decentralized experiments lack coherence. “Today, we have an opportunity to shape technology,” wrote [Newt] Gingrich in classic technocratic style. His message was that computer technology is too important to be left to hackers, hobbyists, entrepreneurs, venture capitalists, and computer buyers. “We” must shape it into a “coherent picture.” That is the technocratic notion of progress: Decide on the one best way, make a plan, and stick to it.

It should go without saying that this is the antithesis of the environment most conducive to economic advance. Whatever antitrust’s role in regulating technology markets, it must be evidence-based, grounded in economics and aware of its own limitations.

As Josh notes:

A future market case, such as the one alleged by the Commission today, presents a number of unique challenges not confronted in a typical merger review or even in “actual potential competition” cases. For instance, it is inherently more difficult in future market cases to define properly the relevant product market, to identify likely buyers and sellers, to estimate cross-elasticities of demand or understand on a more qualitative level potential product substitutability, and to ascertain the set of potential entrants and their likely incentives. Although all merger review necessarily is forward looking, it is an exceedingly difficult task to predict the competitive effects of a transaction where there is insufficient evidence to reliably answer these basic questions upon which proper merger analysis is based.

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When the Commission’s antitrust analysis comes unmoored from such fact-based inquiry, tethered tightly to robust economic theory, there is a more significant risk that non-economic considerations, intuition, and policy preferences influence the outcome of cases.

Josh’s dissent also contains an important, related criticism of the FTC’s problematic reliance on consent agreements. It’s so good, in fact, I will quote it almost in its entirety:

Whether parties to a transaction are willing to enter into a consent agreement will often have little to do with whether the agreed upon remedy actually promotes consumer welfare. The Commission’s ability to obtain concessions instead reflects the weighing by the parties of the private costs and private benefits of delaying the transaction and potentially litigating the merger against the private costs and private benefits of acquiescing to the proposed terms. Indeed, one can imagine that where, as here, the alleged relevant product market is small relative to the overall deal size, the parties would be happy to agree to concessions that cost very little and finally permit the deal to close. Put simply, where there is no reason to believe a transaction violates the antitrust laws, a sincerely held view that a consent decree will improve upon the post-merger competitive outcome or have other beneficial effects does not justify imposing those conditions. Instead, entering into such agreements subtly, and in my view harmfully, shifts the Commission’s mission from that of antitrust enforcer to a much broader mandate of “fixing” a variety of perceived economic welfare-reducing arrangements.

Consents can and do play an important and productive role in the Commission’s competition enforcement mission. Consents can efficiently address competitive concerns arising from a merger by allowing the Commission to reach a resolution more quickly and at less expense than would be possible through litigation. However, consents potentially also can have a detrimental impact upon consumers. The Commission’s consents serve as important guidance and inform practitioners and the business community about how the agency is likely to view and remedy certain mergers. Where the Commission has endorsed by way of consent a willingness to challenge transactions where it might not be able to meet its burden of proving harm to competition, and which therefore at best are competitively innocuous, the Commission’s actions may alter private parties’ behavior in a manner that does not enhance consumer welfare. Because there is no judicial approval of Commission settlements, it is especially important that the Commission take care to ensure its consents are in the public interest.

This issue of the significance of the FTC’s tendency to, effectively, legislate by consent decree is of great importance, particularly in its Section 5 practice (as we discuss in our amicus brief in the Wyndham case).

As the FTC begins its 100th year next week, we need more voices like those of Commissioners Wright and Ohlhausen challenging the FTC’s harmful, technocratic mindset.

The Federalist Society has started a new program, The Executive Branch Review, which focuses on the myriad fields in which the Executive Branch acts outside of the constitutional and legal limits imposed on it, either by Executive Orders or by the plethora of semi-independent administrative agencies’ regulatory actions.

I recently posted on the Federal Trade Commission’s (FTC) ongoing investigations into the patent licensing business model and the actions (“consent decrees”) taken by the FTC against Bosch and Google.  These “consent decrees” constrain Bosch’s and Google’s rights in enforce patents they have committed to standard setting organizations (these patents are called “standard essential patents”). Here’s a brief taste:

One of the most prominent participants at the FTC-DOJ workshop back in December, former DOJ antitrust official and UC-Berkeley economics professor Carl Shapiro, explained in his opening speech that there was still insufficient data on patent licensing companies and their effects on the market.  This is true; for instance, a prominent study cited by Google et al. in support of their request to the FTC to investigate patent licensing companies has been described as being fundamentally flawed on both substantive and methodological grounds. Even more important, Professor Shapiro expressed skepticism at the workshop that, even if there was properly acquired, valid data, the FTC lacked the legal authority to sanction patent licensing firms for being allegedly anti-competitive.

Commentators have long noted that courts and agencies have a lousy historical track record when it comes to assessing the merits of new innovation, whether in new products or new business models. They maintain that the FTC should not continue such mistakes by letting its decision-making today be driven by rhetoric or by the widespread animus against certain commercial firms. Restraint and fact-gathering, institutional virtues reflected in a government animated by the rule of law and respect for individual rights, are key to preventing regulatory overreach and harm to future innovation.

Go read the whole thing, and, while you’re at it, check out Commissioner Joshua Wright’s similar comments on the FTC’s investigations of patent licensing companies, which the FTC calls “patent assertion entities.”

Co-authored with Berin Szoka

FTC Commissioner Wright issued today his Policy Statement on enforcement of Section 5 of the FTC Act against Unfair Methods of Competition (UMC)—the one he promised in April. Wright introduced the Statement in an important policy speech this morning before the Executive Committee Meeting of the New York State Bar Association’s Antitrust Section. Both the Statement and the speech are essential reading, and, collectively, they present a compelling and comprehensive vision for Section 5 UMC reform at the Commission.

As we’ve been saying for some time, and as Wright notes at the outset of his Statement:

In order for enforcement of its unfair methods of competition authority to promote consistently the Commission’s mission of protecting competition, the Commission must articulate a clear framework for its application.

Significantly, in addition to offering important certainty to guide business actions, Wright bases his proposed Policy Statement on the error cost framework:

The Commission must formulate a standard that distinguishes between acceptable business practices and business practices that constitute an unfair method of competition in order to provide firms with adequate guidance as to what conduct may be unlawful.  Articulating a clear and predictable standard for what constitutes an unfair method of competition is important because the Commission’s authority to condemn unfair methods of competition allows it to break new ground and challenge conduct based upon theories not previously enshrined in Sherman Act or Clayton Act jurisprudence.

As far as we know, this Statement is the most significant effort yet to cabin FTC enforcement decisions within a coherent error-cost framework, and it is especially welcome.

Ironically, this is former Chairman Jon Leibowitz’s true legacy: His efforts to expand Section 5 to challenge conduct under novel theories, devoid of economic grounding and without proof of anticompetitive harm (in cases like Intel, N-Data and Google, among others) brought into stark relief the potential risks of an unfettered, active Section 5. Commissioner Wright’s Statement can be seen as the unintended culmination of—and backlash against—Leibowitz’s Section 5 campaign.

Particularly given the novelty of circumstances that might come within Section 5’s ambit, the error-cost minimizing structure of Commissioner Wright’s proposed Statement is enormously important. As one of us (Manne) notes in the paper, Innovation and the Limits of Antitrust (co-authored with then-Professor Wright),

Both product and business innovations involve novel practices, and such practices generally result in monopoly explanations from the economics profession followed by hostility from the courts (though sometimes in reverse order) and then a subsequent, more nuanced economic understanding of the business practice usually recognizing its procompetitive virtues.

And as Wright’s Statement notes,

This is particularly true if business conduct is novel or takes place within an emerging or rapidly changing industry, and thus where there is little empirical evidence about the conduct’s potential competitive effects.

The high cost and substantial risk of over-enforcement arising from unbounded Section 5 authority counsel strongly in favor of Wright’s Statement restricting Section 5 to minimize these error costs.

Thus, while the specifics matter, of course, the real import of Commissioner Wright’s Statement is in some ways structural: If adopted, it would both bring much needed, basic guidance to the scope of the FTC’s Section 5 authority; just as important, it would constrain (an important aspect of) the FTC’s enforcement discretion within the error cost framework, bringing the sound economic grounding of antitrust law and economics to Section 5, benefiting consumers as well as commerce generally:

This Policy Statement benefits both consumers and the business community by relying on modern economics and antitrust jurisprudence to strengthen the agency’s ability to target anticompetitive conduct and provide clear guidance about the contours of the Commission’s Section 5 authority.

For Wright, this is about saving Section 5 from its ill-defined and improperly deployed history. As he noted in his speech this morning,

In undertaking this task, I think it is important to recall why the Commission’s use of Section 5 has failed to date. In my view, this failure is principally because the Commission has sought to do too much with Section 5, and in so doing, called into serious question whether it has any limits whatsoever. In order to save Section 5, and to fulfill the vision Congress had for this important statute, the Commission must recast its unfair methods of competition authority with an eye toward regulatory humility in order to effectively target plainly anticompetitive conduct….. I believe that doing anything less would betray our obligation as responsible stewards of the Commission and its competition mission, and may ultimately result in the Commission having its Section 5 authority defined for it by the courts, or worse, having that authority completely revoked by Congress.

This means circumscribing the FTC’s Section 5 authority to limit enforcement to cases where the Commission shows both actual harm to competition and the absence of cognizable efficiencies.

The Status Quo

Both together and separately, we’ve discussed the problems with the Section 5 status quo in numerous places, including:

To summarize: The problem is that Section 5 enforcement standards in the unfairness context are non-existent. Former Chairman Jon Leibowitz and former Commissioner Tom Rosch, in particular, have, in several places, argued for expanded use of Section 5, both as a way around judicial limits on the scope of Sherman Act enforcement, as well as as an affirmative tool to enforce the FTC’s mandate. As the Commission’s statement in the N-Data case concluded:

We recognize that some may criticize the Commission for broadly (but appropriately) applying our unfairness authority to stop the conduct alleged in this Complaint. But the cost of ignoring this particularly pernicious problem is too high. Using our statutory authority to its fullest extent is not only consistent with the Commission’s obligations, but also essential to preserving a free and dynamic marketplace.

The problem is that neither the Commission, the courts nor Congress has defined what, exactly, the “fullest extent” of the FTC’s statutory authority is. As Commissioner Wright noted in this morning’s speech,

In practice, however, the scope of the Commission’s Section 5 authority today is as broad or as narrow as a majority of the commissioners believes that it is.

The Commission’s claim that it applied its authority “broadly (but appropriately)” in N-Data is unsupported and unsupportable. As Commissioner Ohlhausen put it in her dissent in In re Bosch,

I simply do not see any meaningful limiting principles in the enforcement policy laid out in these cases. The Commission statement emphasizes the context here (i.e. standard setting); however, it is not clear why the type of conduct that is targeted here (i.e. a breach of an allegedly implied contract term with no allegation of deception) would not be targeted by the Commission in any other context where the Commission believes consumer harm may result. If the Commission continues on the path begun in N-Data and extended here, we will be policing garden variety breach-of-contract and other business disputes between private parties….

It is important that government strive for transparency and predictability. Before invoking Section 5 to address business conduct not already covered by the antitrust laws (other than perhaps invitations to collude), the Commission should fully articulate its views about what constitutes an unfair method of competition, including the general parameters of unfair conduct and where Section 5 overlaps and does not overlap with the antitrust laws, and how the Commission will exercise its enforcement discretion under Section 5. Otherwise, the Commission runs a serious risk of failure in the courts and a possible hostile legislative reaction, both of which have accompanied previous FTC attempts to use Section 5 more expansively.

This consent does nothing either to legitimize the creative, yet questionable application of Section 5 to these types of cases or to provide guidance to standard-setting participants or the business community at large as to what does and does not constitute a Section 5 violation. Rather, it raises more questions about what limits the majority of the Commission would place on its expansive use of Section 5 authority.

Commissioner Wright’s proposed Policy Statement attempts to remedy these defects, and, in the process, explains why the Commission’s previous, broad applications of the statute are not, in fact, appropriate.

Requirement #1: Harm to Competition

It should go without saying that anticompetitive harm is a basic prerequisite of the FTC’s UMC enforcement. Sadly, however, this has not been the case. As the FTC has, in recent years, undertaken enforcement actions intended to expand its antitrust authority, it has interpreted far too expansively the Supreme Court’s statement in FTC v. Indiana Federation of Dentists that Section 5 contemplates

not only practices that violate the Sherman Act and the other antitrust laws, but also practices that the Commission determines are against public policy for other reasons.

But “against public policy for other reasons” does not mean “without economic basis,” and there is no indication that Congress intended to give the FTC unfettered authority unbounded by economically sensible limits on what constitutes a cognizable harm. As one of us (Manne) has written,

Following Sherman Act jurisprudence, traditionally the FTC has understood (and courts have demanded) that antitrust enforcement . . . requires demonstrable consumer harm to apply. But this latest effort reveals an agency pursuing an interpretation of Section 5 that would give it unprecedented and largely-unchecked authority. In particular, the definition of “unfair” competition wouldn’t be confined to the traditional antitrust measures — reduction in output or an output-reducing increase in price — but could expand to, well, just about whatever the agency deems improper.

Commissioner Wright’s Statement and its reasoning are consistent with Congressional intent on the limits of the “public policy” rationale in Section 5’s “other” unfairness authority, now enshrined in Section 45(n) of the FTC Act:

The Commission shall have no authority under this section or section 57a of this title to declare unlawful an act or practice on the grounds that such act or practice is unfair unless the act or practice causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition.

While not entirely foreclosing the possibility of other indicia of harm to competition, Wright provides a clear statement of what would constitute Section 5 UMC harm under his standard:

Conduct that results in harm to competition, and in turn, in harm to consumer welfare, typically does so through increased prices, reduced output, diminished quality, or weakened incentives to innovate.

This means is that, among other things, “reduction in consumer choice” is not, by itself, a cognizable harm under Section 5, just as it is not under the antitrust laws. As one of us (Manne) has discussed previously:

Most problematically, Commissioner Rosch has suggested that Section Five could address conduct that has the effect of “reducing consumer choice” without requiring any evidence that conduct actually reduces consumer welfare…. Troublingly, “reducing consumer choice” seems to be a euphemism for “harm to competitors, not competition,” where the reduction in choice is the reduction of choice of competitors who may be put out of business by a competitor’s conduct.

The clear limit on “consumer choice” claims contemplated by Wright’s Statement is another of its important benefits.

But Wright emphatically rejects proposals to limit Section 5 to mean only what the antitrust laws themselves mean. Section 5 does extend beyond the limits of the antitrust laws in encompassing conduct that is likely to result in harm to competition, although it hasn’t yet.

Because prospective enforcement of Section 5 against allegedly anticompetitive practices that may turn out not to be harmful imposes significant costs, Wright very nicely here also incorporates an error cost approach, requiring a showing of greater harm where the risk of harm is lower:

When the act or practice has not yet harmed competition, the Commission’s assessment must include both the magnitude and probability of competitive harm.  Where the probability of competitive harm is smaller, the Commission will not find an unfair method of competition without reason to believe the act or practice poses a risk of substantial harm.

In this category are the uncontroversial “invitation to collude” cases long agreed by just about everyone to be within the ambit of Section 5. But Commissioner Wright also suggests Section 5 is appropriate to prevent

the use by a firm of unfair methods of competition to acquire market power that does not yet rise to the level of monopoly power necessary for a violation of the Sherman Act.

This is somewhat more controversial as it contemplates (as the Statement’s illustrative examples make clear) deception that results in the acquisition of market power.

But most important to note is that, while deception was the basis for the Commission’s enforcement action in Rambus (later reversed by the D.C. Circuit), Commissioner Wright’s Statement would codify the important limitation (partly developed in Wright’s own work) on such cases that the deception must be the cause of an acquisition of market power.

Requirement #2: Absence of Cognizable Efficiencies

The real work in Wright’s Statement is done by the limitation on UMC enforcement in cases where the complained-of practice produces cognizable efficiencies. This is not a balancing test or a rule of reason. It is a safe harbor for cases where conduct is efficient, regardless of its effect on competition otherwise:

The Commission therefore creates a clear safe harbor that provides firms with certainty that their conduct can be challenged as an unfair method of competition only in the absence of efficiencies.

As noted at the outset, this is the most important and ambitious effort we know of to incorporate the error cost framework into FTC antitrust enforcement policy. This aspect of the Statement takes seriously the harm that can arise from the agency’s discretion, uncertainty over competitive effects (especially in “likely to cause” cases) and the imbalance of power and costs inherent in the FTC’s Part III adjudication to tip the scale back toward avoidance of erroneous over-enforcement.

Importantly, Commissioner Wright called out the last of these in his speech this morning, describing the fundamental imbalance that his Statement seeks to address:

The uncertainty surrounding the scope of Section 5 is exacerbated by the administrative procedures available to the Commission for litigating unfair methods claims. This combination gives the Commission the ability to, in some cases, take advantage of the uncertainty surrounding Section 5 by challenging conduct as an unfair method of competition and eliciting a settlement even though the conduct in question very likely would not violate the traditional federal antitrust laws. This is because firms typically will prefer to settle a Section 5 claim rather than going through lengthy and costly administrative litigation in which they are both shooting at a moving target and have the chips stacked against them. Such settlements only perpetuate the uncertainty that exists as a result of ambiguity associated with the Commission’s Section 5 authority by encouraging a process by which the contours of the Commission’s unfair methods of competition authority are drawn without any meaningful adversarial proceeding or substantive analysis of the Commission’s authority.

In essence, by removing the threat of Section 5 enforcement where efficiencies are cognizable, Wright’s Statement avoids the risk of Type I error, prioritizing the possible realization of efficiencies over possible anticompetitive harm with a bright line rule that avoids attempting to balance the one against the other:

The Commission employs an efficiencies screen to establish a test with clear and predictable results that prevents arbitrary enforcement of the agency’s unfair methods of competition authority, to focus the agency’s resources on conduct most likely to harm consumers, and to avoid deterring consumer welfare-enhancing business practices.

Moreover, the FTC bears the burden of demonstrating that its enforcement meets the efficiencies test, ensuring that the screen doesn’t become simply a rule of reason balancing:

The Commission bears the ultimate burden in establishing that the act or practice lacks cognizable efficiencies. Once a firm has offered initial evidence to substantiate its efficiency claims, the Commission must demonstrate why the efficiencies are not cognizable.

Fundamentally, as Commissioner Wright explained in his speech,

Anticompetitive conduct that lacks cognizable efficiencies is the most likely to harm consumers because it is without any redeeming consumer benefits. The efficiency screen also works to ensure that welfare-enhancing conduct is not inadvertently deterred…. The Supreme Court has long recognized that erroneous condemnation of procompetitive conduct significantly reduces consumer welfare by deterring investment in efficiency-enhancing business practices. To avoid deterring consumer welfare-enhancing conduct, my proposed Policy Statement limits the use of Section 5 to conduct that lacks cognizable efficiencies.

The Big Picture

Wright’s proposed Policy Statement is well thought out and much needed. It offers clear guidance for companies navigating the FTC’s murky Section 5 waters, and it offers clear, economically grounded limits on the FTC’s UMC enforcement authority. While preserving a scope of enforcement authority for Section 5 beyond the antitrust statutes (including against deceptive conduct that harms competition without any corresponding efficiency justification), it nevertheless reins in the most troubling abuses of that authority by clearly prohibiting the agency’s unprincipled enforcement actions in cases like N-Data, Google and Rambus, all of which failed to establish a connection between the complained-of conduct and harm to competition or else ignored clear efficiencies (particularly Google).

No doubt some agency watchers will criticize the Statement, labeling it reflexively deregulatory. But remember this isn’t being proposed in a vacuum. Commissioner Wright’s Statement defines only what should be a fairly narrow set of cases beyond the antitrust statutes’ reach. The Sherman Act doesn’t disappear because Section 5 is circumscribed, and the most recent controversial Section 5 cases could all theoretically have been plead solely as Section 2 cases (although they may well have failed).

What does change is the possibility of recourse to Section 5 as a means of avoiding the standards established by the courts in enforcing and interpreting the Sherman Act.

The Statement does not represent a restriction of antitrust enforcement authority unless you take as your starting point the agency’s recent unsupported and expansive interpretation of Section 5—a version of Section 5 that was never intended to, and doesn’t, exist. Wright’s Statement is, rather, a bulwark against unprincipled regulatory expansion: a sensible grounding of a statute with a checkered past and a penchant for mischief.

Chairman Leibowitz and Commissioner Rosch, in defending the use and expansion of Section 5, argued in Intel that it was necessary to circumvent judicial limitations on the enforcement of Section 2 aimed only at private plaintiffs (like, you know, demonstration of anticompetitive harm, basic pleading standards…)—basically the FTC’s “get out of Trinko free” card. According to Leibowitz, the Court’s economically rigorous, error-cost jurisprudence in cases like linkline, Trinko, Leegin, Twombly, and Brook Group were aimed at private plaintiffs, not agency actions:

But I also believe that the result, at least in the aggregate, is that some anticompetitive behavior is not being stopped—in part because the FTC and DOJ are saddled with court-based restrictions that are designed to circumscribe private litigation. Simply put, consumers can still suffer plenty of harm for reasons not encompassed by the Sherman Act as it is currently enforced in the federal courts.

The claim is meritless (as one of us (Manne) discussed here, for example). But it helps to make clear what the problem with current Section 5 standards are: There are no standards, only post hoc rationalizations to justify pursuing Section 2 cases without the cumbersome baggage of its jurisprudential limits.

The recent Supreme Court cases mentioned above are only the most recent examples of a decades-long jurisprudential trend incorporating modern economic thinking into antitrust law and recognizing the error-cost tradeoff. These cases have served to remove certain conduct (at least without appropriate evidence and analysis) from the reach of Section 2 in a measured, accretive fashion over the last 40 years or so. They have by no means made antitrust irrelevant, and the agencies and private plaintiffs alike bring and win cases all the time—and this doesn’t even measure the conduct that is deterred by the threat of enforcement.  The limits on Section 5 suggested by Commissioner Wright’s Statement are marginal limits on the scope of antitrust beyond the Sherman Act, Clayton Act and other statutes. There is nothing in the legislative history or plain language of Section 5 to suggest adopting a more expansive approach, in effect using it to undo what the courts have methodically done.

It is also worth noting that not only the antitrust laws, but also the the Unfair and Deceptive Acts and Practices (UDAP) prong of Section 5 exerts a regulatory constraint on business conduct, proscribing deception, for example, as a consumer protection matter—without having to prove the existence of market power or its abuse. This also forms a piece of the institutional backdrop against which Wright’s proposed Policy Statement must be adjudged.

Wright was a leading critic of the agency’s expansive use of Section 5 before he joined the Commission, both at Truth on the Market as well as in longer writing.  He has, correctly, seen it as a serious problem in need of remedying for quite some time. It is gratifying that Wright is continuing this work now that he is on the Commission, where he is no longer relegated merely to critiquing the agency but is in a position to try to transform it himself.

What remains needed is the political will to move this draft Policy Statement to adoption by the full Commission—something Chairman Ramirez is not likely to embrace without considerable pressure from Congress and/or the antitrust community. In the modest service of fulfilling this need, ICLE and TechFreedom intend to host later this year the first of what we hope will be several workshops on Commissioner Wright’s Statement and the broader topic of Section 5 enforcement reform. If the Commission won’t do it, the private sector will have to step in. For a taste of our perspective, check out the amicus brief we recently filed with FTC law scholars (Todd Zywicki, Paul Rubin and Gus Hurwitz) in the case of FTC v. Wyndham, which may be the first case to really test how the FTC uses is unfairness authority in consumer protection cases.

Dan’s final post responding to Steve’s latest postOther posts in the series: DanSteveDanSteveDan, and Thom.

It seems that it’s time to wind down and that a further tit-for-tat might not be productive, so I’ll close with a final comment on the first point that Steve makes—one that may undergird much of our disagreement.  Steve asserts that “the $71 payment would fail a test of comparing the rival’s price and cost, but that it is not the test.  The test compares the monopolist’s price and cost.”  That would only be true if we were applying an unmodified predatory pricing rule to loyalty rebates—a position that I’ve never advocated in these posts are elsewhere.  If we applied the attribution test that Steve and I have been assuming, the question would be whether the rival could profitably remain in the market given the price it would have to charge to neutralize the effect of the monopolist’s rebate operating at the contestable share and scale.  And, since Steve and I have now agreed that using the rival’s rather than the monopolist’s costs is admissible if we don’t insist on an EEC component, then my statement that the $71 could fail the price-cost screen is accurate.  But if the effective price the rival would have to meet were $69 and not $71, there wouldn’t be any foreclosure—which is why the screen makes sense.

Thanks, Steve, for this impromptu exchange.  I hope that both our fair points and grievous errors have been educational to ourselves and to others.

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

My invitation comes with several hopefully final observations.

(1) Dan says, “There’s neither input foreclose nor output foreclosure if a rival can neutralize a loyalty discount without pricing unprofitably.”  My examples showed several reasons why an equally efficient rival may not be able to overcome a loyalty discount to get distribution, even if the monopolist does not violate the price-cost test.  Dan’s response to my #3(a) example is that “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.” That is not a good answer for three reasons.  First, the monopolist’s profits pre-entry absent the rebate are $200, and Dan uses the pre-entry situation as the base.  Second, the $71 payment would fail a test of comparing the rival’s price and cost, but that it is not the test.  The test compares the monopolist’s price and cost.   Third, if Dan now wants to use as the base the “but-for world” where the former-monopolist would earn only $70 because he would have lowered price in response to the entrant absent the loyalty discount, then he is accepting the “penalty price” scenario, which he elsewhere rejected as unlikely.  So, Dan has to make up his mind on this last point.  And the price-cost test is defective either way.

(2) Dan says, “Steve posits ‘that economic analysis is the same’ for loyalty discounts and contractual commitments not to buy from rivals.  Really?”  The short answer is “Yes.”  As Dan observes himself, “at a high level of generality one would say that in both cases the question is whether the price or contract forecloses competitors.”  By the way, a small rebate certainly will not always exclude.  But, see #3(b) in my previous post, which is a pretty general example of why the rival often would just give up rather than get involved in a bidding war for distribution.  Dan never explain what he thinks is wrong with this example.

(3) Dan says, “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.”  I assumed no contract.  Nor is a formal auction required.  The monopolist simply can unilaterally offer a high enough bid that the entrant walks away.  And in the #3(b) example, the unilateral bid does not even need to be very high.

(4) Dan says, “The monopolist is not saved from profit sacrifice, as Steve posits, merely by threatening a price of $105 that it never has to charge.”  Why not?  The monopolist never sells any units at $105 when the threat succeeds.  And, given Dan’s model, it will succeed against an equally efficient competitor.  With adequate information, it is neither expensive nor risky.  If Dan is going to rely on it being “expensive and risky,” then he is changing his story.  More importantly, he also is opining it should be permissible for a well-informed monopolist to exclude with penalty pricing threats because poorly informed monopolists may not follow the same strategy.  That does not make sense.   He also does not provide any evidence about how well informed most monopolists who engage in loyalty discounts typically are.

(5) Dan says, “Finally, let me underline as I did in my last post that I’m not claiming that “penalty pricing” is economically impossible.  Rather, …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.”  I do not have to assume penalties will be “routinely deployed.”   It was only one of my several fatal problems with the price-cost test.  But, in terms of the evidence, what is the evidence that the typical loyalty discount by a monopolist or firm with substantial market power are true reductions from the but-for price.  Reliable presumptions need to be more than simply reflections of one’s ideology.

(6) I want to conclude by observing that modern day courts do not need the defective price-cost test to protect monopolists.  Remember that the rival must prove consumer injury.  That is a high burden to carry and some of the factors Dan mentions might throw light on that bottom line issue.  Neither Josh nor I are claiming that loyalty discounts should be per se illegal.  So, Dan, come on over to the rule of reason.

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.

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

(1) Dan says that price-cost test should apply to “customer foreclosure” allegations.   One of my key points was that many loyalty discount claims involve “input foreclosure” or “raising rivals’ costs” effects, not plain-vanilla customer foreclosure.   In addition, loyalty agreements with distributors often involve input foreclosure because “distribution services” are an input and a rebate might be characterized as a reward payment for the (near-) exclusivity.    From his silence on the issue, I am inclined to presume that Dan would agree that the price-cost test should not be applied to such allegations.      Dan, what do you intend?

(2) Dan says that he agrees that the price-cost test should not be required for “partial exclusivity contracts” that involve contractual commitments to limit purchases from rivals.  He says that the price-cost test should apply only where the “claimed exclusionary mechanism is the price term.”  This distinction is peculiar because the economic analysis is the same in both situations.  In addition, even such voluntary exclusivity flowing from a price term can be anticompetitive, and even if the price-cost test is passed.  There are numerous reasons for this, as I explained in my original post. (I also discuss these issues in my contribution to Robert Pitofsky’s volume, “How the Chicago School Overshot the Mark.”  See also articles by Eric Rasmussen et. al., Michael Whinston and others.)

(3) Consider the following numerical examples that concretely illustrate the economic forces at work when there is competition for distribution, even in the absence of contractual commitments.

(a) Suppose that a monopolist is earning profits of $200.  If there is successful entry by an equally efficient entrant, each of the two firms will earn duopoly profits of $70.  (The duopoly profits are less than monopoly profits because of the price competition.)  Suppose that the entrant needs to obtain just non-exclusive distribution from a particular retailer in order to be viable.  In this case, the entrant would be willing to bid up to $70 per period for the non-exclusive distribution.  (In price terms, this would be a payment that led to the entrant’s costs equaling its price.)  But the monopolist would be willing to bid up to $130 for an exclusive (i.e., the difference between its monopoly and duopoly profits), in order to prevent the entrant from surviving.   Thus, the monopolist would win the bidding, say for a price of $71.   The monopolist would easily pass the price-cost test.   Why is the monopolist systematically able to outbid the entrant? This fundamental asymmetry does not arise because the entrant is less efficient.  Instead, the answer is that the monopolist is bidding to maintain its monopoly power, whereas the entrant can only obtain duopoly price.  The monopolist is “purchasing market power” in addition to distribution, whereas the entrant is only purchasing distribution.

(b) Or, consider this interesting variant with sequential bidding for multiple distributors.   Suppose there are two retailers and the entrant needs to get non-exclusive distribution at both in order to be viable.  Suppose that the negotiations at the two stores are sequential.  In this scenario, the entrant would have no incentive even to try to outbid the monopolist.   This is easy to see.   Suppose that the entrant wins the competition to get into the first store by paying the amount $B1.   In bidding for distribution at the second retailer, the monopolist would be willing to bid up to $130, as above.   At this second store, the entrant would not be willing to pay more than $70 (or $70 – $B1, if it is ignores the fact that the $B1 was an already sunk cost).  So the monopolist will win the exclusive at the second retailer and the entry will fail.   Looking back to the negotiations at the first store, the entrant would have had no incentive to throw away money by paying any positive amount $B1 to get distribution at the first store.   This is because it rationally would anticipate that it is inevitable that it will fail to gain distribution at the second retailer.  Thus, the monopolist will be able to gain the exclusive at both stores for next to nothing.   It clearly will pass the price-cost test even as it maintains its monopoly, merely by instituting the competition for distribution.

(c) If the entrant only needs to gain non-exclusive distribution at either one of the two stores, then the situation can be reversed and the entry can succeed.   The monopolist clearly would not be willing to pay $71 each at both stores (equal to a total payment of $142) in order to deter the entry and protect its “incremental” monopoly profits (equal to only $130 in the example).  Therefore, when the entrant bids for distribution at the first store, the monopolist might as well let the entrant win, which means that the entrant can gain access to both stores for next to nothing.   The entry succeeds, but again, the price-cost test would not be relevant to the analysis.

(d) There also can be elements of a “self-fulfilling equilibrium” because of lack of coordination by the distributors.  Suppose that there are 10 retailers and the entrant only needs to get distribution at 5 of them.   Suppose that the entrant offers to pay a $14 rebate for non-exclusive distribution, and it also will offer $14 again in the next period, if its entry succeeds in the first period.   Suppose the monopolist offers a lower rebate for an exclusive that will continue into the second period.   Suppose that each of the 10 retailers anticipates that the other retailers will accept the monopolist’s lower offer out of fear that the entrant will be unable to get 4 other retailers to accept its offer.  In that situation, the entry will fail.  This is not because the entrant is less efficient.  Instead, it is because the entrant faces a classic coordination problem.  If the retailers behave independently, the retailers’ fear of the entrant’s failure can be a self-fulfilling prophecy.   Again, the monopolist will easily pass the price-cost test.

(4) Dan makes the point that the price-cost test does not require adoption of an EEC antitrust standard (i.e., whereby only harm to EECs is relevant to antitrust).  I certainly agree that the price-cost screen does not necessarily rely on the EEC standard.   The price-cost test is better framed as a measure of “profit-sacrifice,” and EEC is simply a misleading way to express the test.  For example, I expect that Dan agrees that predatory pricing law uses the price-cost test as a measure of “profit-sacrifice,” not an assumption that only EECs matter.

(5) But, I was surprised that Dan also says that the EEC theory “has merit.”  In my view, the EEC standard has no merit in rigorous antitrust analysis. The example in my previous post illustrates why that is the case.  Raising the costs and possibly deterring the entry of a less efficient rival harms consumers and reduces output.

(6) Dan says that the “disloyalty penalty” price theory has problems, “including the empirical one that it doesn’t fit the pattern of almost any of the recent loyalty discount cases.”   The validity of Dan’s empirical claim is not obvious clear to me.  To evaluate whether there is a price penalty, you would need to know more than the path of prices over time.  You also would need to know what the price would be in the “but-for world.”   For example, suppose that in the absence of the loyalty discount, the incumbent would have reduced its price to $90.  This observation has two important implications.  First, this is a reason why it is not clear that loyalty discounts are “presumptively beneficial.”  Second, this is another reason why a price-cost test is not a good “screen” in loyalty discount cases.  Implementing the screen involves evaluating what prices would be absent the conduct.  But, after the competitive effects on consumers are known, what is the value of the screen?

(7) As to the question of whether Josh’s speech on loyalty discounts (and this issue of penalty prices) is inconsistent with their joint article on bundled discounts, I will leave that one for Josh and Dan to sort out, at least for the moment.   I certainly will concede the point that Wright is not always right.

(8) Dan began to suggest that the penalty price theory has a “problem of basic economics” in that the penalty price was not short-run profit-maximizing.   Dan subsequently seemed to withdraw this criticism, noticing that one could characterize the loyalty restriction as not profit-maximizing in the same way.   In any event, it is not a “problem” with the theory.  The reason why the firm is willing to sacrifice profits is because it gains the benefit of deterring entry.  By the way, it also may not even end up sacrificing profits.  The threat of the penalty price for non-exclusivity may be sufficient.  If the distributors succumb to the threat and buy exclusively from the incumbent, it never needs to actually charge them the penalty price.

Guest post by Dan Crane, responding to Steve’s post responding to Dan’s earlier post and Thom’s post on the appropriate liability rule for loyalty discounts.

Something that Thom and I both said in our earlier posts needs to be repeated at the outset:  I don’t know of anyone who disagrees with Steve and Josh that raising rivals’ costs (“RRC”) and economic analysis drawn from exclusive dealing law belong in an analysis of loyalty discounts.  There’s also no claim on the table that a loyalty discount that fails the “contestable share”/discount attribution test that Steve mentions should be treated anything like presumptively illegal.  The current debate is solely about whether there should be a price-cost screen in loyalty discount cases.  We aren’t even talking about what the measure of cost should be or how that screen should work (although, with Steve, I’m happy to assume marginal or average variable cost and the aforementioned contestable share/discount attribution approach for the sake of argument).  Josh and Steve are well justified in pointing out how aspects of RRC theory can apply in loyalty discount cases—but that doesn’t meet the objection that a screen should also apply.

It’s also important to recognize that the argument in favor of a price-cost screen for loyalty rebates does not need to entail a general argument in favor of a “profit sacrifice” theory for all monopolization offenses.  What we’re talking about here is unilaterally determined discounts to customers—something that is presumptively procompetitive, although potentially exclusionary under some circumstances.  Such discounts could be harmful if they resulted in customer foreclosure, but they would not result in customer foreclosure if the rival could profitably match the loyalty discount.  That is the point of the price-cost screen.  You might wonder why a rival would ever complain about a loyalty discount if they could profitably match it.  The reasons are many.  The rival might be losing sales because customers don’t like its product.  It might have failed for reasons completely apart from the accused firm’s loyalty discounts. It might be attempting to use antitrust law to thwart price competition, as a large body of literature suggests.  (See work by Will Baumol and Janusz Ordover, Preston McAfee and Nicholas Vakkur, and Edward Snyder and Tom Kauper, among others).

One thing I didn’t just mention—although it could often be true—is that the complaining rival isn’t an equally efficient competitor (“EEC”).  Steve is wrong to suggest that the price-cost test depends on adopting an EEC theory.  Although there is much merit to the EEC test (heck, even the Europeans have adopted it), one could formulate a version of the price-cost screen that simply requires the rival to show that the discount foreclosed a hypothetically equally efficient competitor or even this particular rival given its actual costs, as some have suggested.  The current argument is not over the formulation of the test, but whether we should dispense with a price-cost screen altogether in loyalty discount cases.

In any event, observe that the entire structure of modern predatory pricing law is premised on an EEC assumption.  If an incumbent firm with marginal costs of $50 and a current price of $100 faces entry by a new rival with marginal costs of $75 and drops its price to $74 in order to exclude the new rival, it enjoys categorical immunity under a long line of Supreme Court cases.  In another forum, Steve suggested that the difference in those cases is that the customer is getting the benefit of a lower price, so the law is hesitant to condemn the price as predatory.  But that exposes something problematic about Steve’s starting premise—he assumes that it’s uncertain whether loyalty discounts generally lower prices.  Prima facie, that seems wrong.  Customers routinely offer to trade loyalty for lower prices precisely because the prices are . . . lower.

Steve suggests that maybe loyalty discounts aren’t really discounts at all.  Maybe the seller, who was previously charging a price of $100, raises the price to $105 and then gives a discount back down to $100 in exchange for customer loyalty.  Steve notes that Thom and I didn’t consider this scenario.  That’s because Josh didn’t raise it in his speech.  It would have been very surprising if Josh had raised it in his speech, since Josh and I co-authored a paper several years ago debunking this same theory in the bundled discount context.  I discuss the “disloyalty penalty” theory at length in a forthcoming article in the Texas Law Review, really just extending the work that Josh and I started several years ago.

There are many problems with this “disloyalty penalty” theory, including the empirical one that it doesn’t fit the pattern of almost any of the recent loyalty discount cases.  But there is also a problem of basic economics.  Unless it is engaging in limit pricing, the accused firm’s $100 price is a monopoly (or market power) profit-maximizing price.  By definition, any price increase will be unprofitable to the seller.  Obviously, the $105 price would be unprofitable.  But it’s also true that a price of $100 coupled with a new obligation to buy a certain percentage of requirements from the seller to achieve that price is unprofitable because it exceeds the profit-maximizing price.  The addition of a contractual term that restricts the buyer’s freedom is economically equivalent to a price increase if the buyer valued the prior freedom from the restriction (if the buyer didn’t value the prior freedom from the restriction there’s no effective price increase but also no anticompetitive effect, since the buyer wouldn’t have bought from the rival anyway).  Hence a price of $100 with loyalty term is effectively higher than a price of $100 without a loyalty term that restricts the buyer’s purchasing freedom.  By adding a loyalty term to obtain the $100 price, the seller exceeds its profit-maximizing monopoly price.

My claim is not that “penalty pricing” for disloyalty is impossible, but that the presumption should be that loyalty discounts are true discounts off the but-for price.  Loyalty discounts belong squarely in the “hospitability” tradition for unilaterally determined pricing structures—all those judicial decisions that talk about how important it is not to chill vigorous price competition.

Steve argues that loyalty discounts may “tie up customers” before competitors arrive on the scene.  I’m not sure what Steve means by “tie up customers.”  Suppose that a monopolist, knowing that rivals are about to enter the market, goes to all of its customers and offers  them a 5% discount if they will agree to purchase 95% of their requirements from the monopolist for the next three years.  At that point we have a partial exclusive dealing contract and the cost-price screen shouldn’t be required.  But, there, the exclusionary mechanism—the thing that keeps rivals from competing—is not the loyalty discount but rather the contractual commitment not to buy any more than 5% of requirements from rivals.  Customers would have to breach their contract in order to consider even the most advantageous offers from rivals.  The point that amici made in our Meritor v. Eaton brief was that when the claimed mechanism of exclusion is a price term and not a contractual restriction on purchasing from rivals, some version of the price-cost screen should apply.

The example I’ve just attributed to Steve (and sorry Steve if this is not what you have in mind) is not what we’re talking about in almost any of the current generation of loyalty discount cases.  In Meritor, for example, the Third Circuit acknowledged that the loyalty provisions at issue did not require customers to buy any of their requirements from Eaton.  It’s just that if the customers didn’t meet the loyalty thresholds, they would lose a possible rebate.  Meritor could compete for that business by offering its own counter-rebates so long as it wouldn’t have had to price unprofitably to do so.

Steve’s point about economies of scale is one that I covered in my post and is fully accounted for by the cost-price screen.  A rival who can profitably match a loyalty discount scheme is not foreclosed from operating at any particular scale.

The same is true of Steve’s point about loyalty discount schemes foreclosing a new seller’s ability to make incremental sales that don’t reduce the accused firm’s own sales.  Again, so long the rival can profitably match the discounts, there is no reason that output should be reduced.

Finally, Steve asserts that loyalty discounts obtained by intermediaries may not be passed onto ultimate consumers.  That’s equally true of conventional single-firm price reductions that are categorically immunized from antitrust liability under a long line of precedent.  One may not like the price-cost test in any context for that reason or others, but there’s nothing special about its application to loyalty discounts. The common denominator of all of these points is that loyalty discounts aren’t exclusionary unless they force rivals to price below cost in order to match the customer’s loss of the loyalty discounts if they fail to meet the loyalty threshold.

Steve thinks the price-cost screen exhibits “formalism”—that dreaded epithet in the post-realist world—but it’s actually just an expression of economic common sense.  Steve and Josh are excellent economists and it’s hard for me to imagine a case in which they would condemn a loyalty discount if there was undisputed evidence that the allegedly excluded rival could have completely neutralized the financial inducement of the loyalty discount by offering a counter-discount of its own without pricing below cost.  If they can offer an example of a circumstance where such a loyalty discount should be condemned, I would be very interested to hear it.  If they can’t, then they have implicitly adopted a version of the price-cost screen and, to repeat a point from my earlier post, all we’re haggling over is the price.