Archives For resale price maintenance

On September 15, Tesla won a big victory in Massachusetts. As we have previously chronicled at length on TOTM ( see, e.g., here, here, herehere, here and here), the car dealers are waging a state-by-state ground war to prevent Tesla from bypassing them and distributing directly to consumers. The dealers invoke 1950s-era franchise protection laws that are obsolete given the radical changes in automotive market in the intervening years and, in any event, have nothing to do with a company like Tesla that doesn’t use dealers at all. In Massachusetts State Automobile Dealers Ass’n, Inc. v. Tesla Motors MA, Inc., -2014 WL 4494167, the Supreme Judicial Court held that the dealers lacked standing to challenge Tesla’s direct distribution since the Massachusetts statute was intended to protect dealers from oppression by franchising manufacturers, not from competition by manufacturers who didn’t franchise at all. As we have previously detailed, there is no legitimate pro-consumer reason for prohibiting direct distribution.

What I found most telling about the Court’s decision was its quotation of a passage from the dealers’ brief. As readers may recall, the dealers have previously asserted that prohibiting direct distribution is necessary to break up the manufacturer’s “retail monopoly,” create price competition, and ensure that consumers get lower prices — arguments that are facially ludicrous as a matter of economics. But now listen to what the dealers have to say in Massachusetts:

Unless the defendants are enjoined, they will be allowed to compete unfairly with the dealers as their model of manufacturer owned dealerships with remote service centers will allow Tesla and Tesla MA financial savings which would not be available to Massachusetts dealers who must spend considerably to conform to Massachusetts law. This could cause inequitable pricing which also [could] cause consumer confusion and the inability to fairly consider the various automobiles offered.

Translation: Direct distribution leads to cost savings that are reflected in lower (“inequitable!”) prices to consumers.

Surely right, since a Justice Department study found that direct distribution could save over $2,200 per vehicle. But coming from the car dealers?  Who would have thunk it?

Earlier this week the New Jersey Assembly unanimously passed a bill to allow direct sales of Tesla cars in New Jersey. (H/T Marina Lao). The bill

Allows a manufacturer (“franchisor,” as defined in P.L.1985, c.361 (C.56:10-26 et seq.)) to directly buy from or sell to consumers a zero emission vehicle (ZEV) at a maximum of four locations in New Jersey.  In addition, the bill requires a manufacturer to own or operate at least one retail facility in New Jersey for the servicing of its vehicles. The manufacturer’s direct sale locations are not required to also serve as a retail service facility.

The bill amends current law to allow any ZEV manufacturer to directly or indirectly buy from and directly sell, offer to sell, or deal to a consumer a ZEV if the manufacturer was licensed by the New Jersey Motor Vehicle Commission (MVC) on or prior to January 1, 2014.  This bill provides that ZEVs may be directly sold by certain manufacturers, like Tesla Motors, and preempts any rule or regulation that restricts sales exclusively to franchised dealerships.  The provisions of the bill would not prevent a licensed franchisor from operating under an existing license issued by the MVC.

At first cut, it seems good that the legislature is responding to the lunacy of the Christie administration’s previous decision to enforce a rule prohibiting direct sales of automobiles in New Jersey. We have previously discussed that decision at length in previous posts here, here, here and here. And Thom and Mike have taken on a similar rule in their home state of Missouri here and here.

In response to New Jersey’s decision to prohibit direct sales, the International Center for Law & Economics organized an open letter to Governor Christie based in large part on Dan Crane’s writings on the topic here at TOTM and discussing the faulty economics of such a ban. The letter was signed by more than 70 law professors and economists.

But it turns out that the legislative response is nearly as bad as the underlying ban itself.

First, a quick recap.

In our letter we noted that

The Motor Vehicle Commission’s regulation was aimed specifically at stopping one company, Tesla Motors, from directly distributing its electric cars. But the regulation would apply equally to any other innovative manufacturer trying to bring a new automobile to market, as well. There is no justification on any rational economic or public policy grounds for such a restraint of commerce. Rather, the upshot of the regulation is to reduce competition in New Jersey’s automobile market for the benefit of its auto dealers and to the detriment of its consumers. It is protectionism for auto dealers, pure and simple.

While enforcement of the New Jersey ban was clearly aimed directly at Tesla, it has broader effects. And, of course, its underlying logic is simply indefensible, regardless of which particular manufacturer it affects. The letter explains at length the economics of retail distribution and the misguided, anti-consumer logic of the regulation, and concludes by noting that

In sum, we have not heard a single argument for a direct distribution ban that makes any sense. To the contrary, these arguments simply bolster our belief that the regulations in question are motivated by economic protectionism that favors dealers at the expense of consumers and innovative technologies. It is discouraging to see this ban being used to block a company that is bringing dynamic and environmentally friendly products to market. We strongly encourage you to repeal it, by new legislation if necessary.

Thus it seems heartening that the legislature did, indeed, take up our challenge to repeal the ban.

Except that, in doing so, the legislature managed to write a bill that reflects no understanding whatever of the underlying economic issues at stake. Instead, the legislative response appears largely to be the product of rent seeking,pure and simple, offering only a limited response to Tesla’s squeaky wheel (no pun intended) and leaving the core defects of the ban completely undisturbed.

Instead of acknowledging the underlying absurdity of the limit on direct sales, the bill keeps the ban in place and simply offers a limited exception for Tesla (or other zero emission cars). While the innovative and beneficial nature of Tesla’s cars was an additional reason to oppose banning their direct sale, the specific characteristics of the cars is a minor and ancillary reason to oppose the ban. But the New Jersey legislative response is all about the cars’ emissions characteristics, and in no way does it reflect an appreciation for the fundamental economic defects of the underlying rule.

Moreover, the bill permits direct sales at only four locations (why four? No good reason whatever — presumably it was a political compromise, never the stuff of economic reason) and requires Tesla to operate a service center for its cars in the state. In other words, the regulators are still arbitrarily dictating aspects of car manufacturers’ business organization from on high.

Even worse, however, the bill is constructed to be nothing more than a payoff for a specific firm’s lobbying efforts, thus ensuring that the next (non-zero-emission) Tesla to come along will have to undertake the same efforts to pander to the state.

Far from addressing the serious concerns with the direct sales ban, the bill just perpetuates the culture of political rent seeking such regulations create.

Perhaps it’s better than nothing. Certainly it’s better than nothing for Tesla. But overall, I’d say it’s about the worst possible sort of response, short of nothing.

The American Bar Association’s (ABA) “Antitrust in Asia:  China” Conference, held in Beijing May 21-23 (with Chinese Government and academic support), cast a spotlight on the growing economic importance of China’s six-year old Anti-Monopoly Law (AML).  The Conference brought together 250 antitrust practitioners and government officials to discuss AML enforcement policy.  These included the leaders (Directors General) of the three Chinese competition agencies (those agencies are units within the State Administration for Industry and Commerce (SAIC), the Ministry of Foreign Commerce (MOFCOM), and the National Development and Reform Commission (NDRC)), plus senior competition officials from Europe, Asia, and the United States.  This was noteworthy in itself, in that the three Chinese antitrust enforcers seldom appear jointly, let alone with potential foreign critics.  The Chinese agencies conceded that Chinese competition law enforcement is not problem free and that substantial improvements in the implementation of the AML are warranted.

With the proliferation of international business arrangements subject to AML jurisdiction, multinational companies have a growing stake in the development of economically sound Chinese antitrust enforcement practices.  Achieving such a result is no mean feat, in light of the AML’s (Article 27) explicit inclusion of industrial policy factors, significant institutional constraints on the independence of the Chinese judiciary, and remaining concerns about transparency of enforcement policy, despite some progress.  Nevertheless, Chinese competition officials and academics at the Conference repeatedly emphasized the growing importance of competition and the need to improve Chinese antitrust administration, given the general pro-market tilt of the 18th Communist Party Congress.  (The references to Party guidance illustrate, of course, the continuing dependence of Chinese antitrust enforcement patterns on political forces that are beyond the scope of standard legal and policy analysis.)

While the Conference covered the AML’s application to the standard antitrust enforcement topics (mergers, joint conduct, cartels, unilateral conduct, and private litigation), the treatment of price-related “abuses” and intellectual property (IP) merit particular note.

In a panel dealing with the investigation of price-related conduct by the NDRC (the agency responsible for AML non-merger pricing violations), NDRC Director General Xu Kunlin revealed that the agency is deemphasizing much-criticized large-scale price regulation and price supervision directed at numerous firms, and is focusing more on abuses of dominance, such as allegedly exploitative “excessive” pricing by such firms as InterDigital and Qualcomm.  (Resale price maintenance also remains a source of some interest.)  On May 22, 2014, the second day of the Conference, the NDRC announced that it had suspended its investigation of InterDigital, given that company’s commitment not to charge Chinese companies “discriminatory” high-priced patent licensing fees, not to bundle licenses for non-standard essential patents and “standard essential patents” (see below), and not to litigate to make Chinese companies accept “unreasonable” patent license conditions.  The NDRC also continues to investigate Qualcomm for allegedly charging discriminatorily high patent licensing rates to Chinese customers.  Having the world’s largest consumer market, and fast growing manufacturers who license overseas patents, China possesses enormous leverage over these and other foreign patent licensors, who may find it necessary to sacrifice substantial licensing revenues in order to continue operating in China.

The theme of ratcheting down on patent holders’ profits was reiterated in a presentation by SAIC Director General Ren Airong (responsible for AML non-merger enforcement not directly involving price) on a panel discussing abuse of dominance and the antitrust-IP interface.  She revealed that key patents (and, in particular, patents that “read on” and are necessary to practice a standard, or “standard essential patents”) may well be deemed “necessary” or “essential” facilities under the final version of the proposed SAIC IP-Antitrust Guidelines.  In effect, implementation of this requirement would mean that foreign patent holders would have to grant licenses to third parties under unfavorable government-set terms – a recipe for disincentivizing future R&D investments and technological improvements.  Emphasizing this negative effect, co-panelists FTC Commissioner Ohlhausen and I pointed out that the “essential facilities” doctrine has been largely discredited by leading American antitrust scholars.  (In a separate speech, FTC Chairwoman Ramirez also argued against treating patents as essential facilities.)  I added that IP does not possess the “natural monopoly” characteristics of certain physical capital facilities such as an electric grid (declining average variable cost and uneconomic to replicate), and that competitors’ incentives to develop alternative and better technology solutions would be blunted if they were given automatic cheap access to “important” patents.  In short, the benefits of dynamic competition would be undermined by treating patents as essential facilities.  I also noted that, consistent with decision theory, wise competition enforcers should be very cautious before condemning single firm behavior, so as not to chill efficiency-enhancing unilateral conduct.  Director General Ren did not respond to these comments.

If China is to achieve its goal of economic growth driven by innovation, it should seek to avoid legally handicapping technology market transactions by mandating access to, or otherwise restricting returns to, patents.  As recognized in the U.S. Justice Department-Federal Trade Commission 1995 IP-Antitrust Guidelines and 2007 IP-Antitrust Report, allowing the IP holder to seek maximum returns within the scope of its property right advances innovative welfare-enhancing economic growth.  As China’s rapidly growing stock of IP matures and gains in value, it hopefully will gain greater appreciation for that insight, and steer its competition policy away from the essential facilities doctrine and other retrograde limitations on IP rights holders that are inimical to long term innovation and welfare.

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.

Earlier this month New Jersey became the most recent (but likely not the last) state to ban direct sales of automobiles. Although the rule nominally applies more broadly, it is directly aimed at keeping Tesla Motors (or at least its business model) out of New Jersey. Automobile dealers have offered several arguments why the rule is in the public interest, but a little basic economics reveals that these arguments are meritless.

Today the International Center for Law & Economics sent an open letter to New Jersey Governor Chris Christie, urging reconsideration of the regulation and explaining why the rule is unjustified — except as rent-seeking protectionism by independent auto dealers.

The letter, which was principally written by University of Michigan law professor, Dan Crane, and based in large part on his blog posts here at Truth on the Market (see here and here), was signed by more than 70 economists and law professors.

As the letter notes:

The Motor Vehicle Commission’s regulation was aimed specifically at stopping one company, Tesla Motors, from directly distributing its electric cars. But the regulation would apply equally to any other innovative manufacturer trying to bring a new automobile to market, as well. There is no justification on any rational economic or public policy grounds for such a restraint of commerce. Rather, the upshot of the regulation is to reduce competition in New Jersey’s automobile market for the benefit of its auto dealers and to the detriment of its consumers. It is protectionism for auto dealers, pure and simple.

The letter explains at length the economics of retail distribution and the misguided, anti-consumer logic of the regulation.

The letter concludes:

In sum, we have not heard a single argument for a direct distribution ban that makes any sense. To the contrary, these arguments simply bolster our belief that the regulations in question are motivated by economic protectionism that favors dealers at the expense of consumers and innovative technologies. It is discouraging to see this ban being used to block a company that is bringing dynamic and environmentally friendly products to market. We strongly encourage you to repeal it, by new legislation if necessary.

Among the letter’s signatories are some of the country’s most prominent legal scholars and economists from across the political spectrum.

Read the letter here:

Open Letter to New Jersey Governor Chris Christie on the Direct Automobile Distribution Ban

Last summer I blogged here at TOTM about the protectionist statutes designed to preempt direct distribution of Tesla cars that are proliferating around the country. This week, New Jersey’s Motor Vehicle Commission voted to add New Jersey to the list of states bowing to the politically powerful car dealers’ lobby.

Yesterday, I was on Bloomberg’s Market Makers show with Jim Appleton, the president of the New Jersey Coalition of Automotive Retailers. (The clip is here). Mr. Appleton advanced several “very interesting” arguments against direct distribution of cars, including that we already regulate everything else from securities sales to dogs and cats, so why not regulate car sales as well. The more we regulate, the more we should regulate. Good point. I’m stumped. But moving on, Mr. Appleton also argued that this particular regulation is necessary for actual reasons, and he gave two.

First, he argued that Tesla has a monopoly and that the direct distribution prohibition would create price competition. But, of course, Tesla does not have anything like a monopoly. A point that Mr. Appleton repeated three times over the course of our five minutes yesterday was that Tesla’s market share in New Jersey is 0.1%. Sorry, not a monopoly.

Mr. Appleton then insisted that the relevant “monopoly” is over the Tesla brand. This argument misunderstands basic economics. Every seller has a “monopoly” in its own brand to the same extent as Mr. Appleton has a “monopoly” in the tie he wore yesterday. No one but Tesla controls the Tesla brand, and no one but Mr. Appleton controls his tie. But, as economists have understood for a very long time, it would be absurd to equate monopoly power in an economic sense with the exclusive legal right to control something. Otherwise, every man, woman, child, dog, and cat is a monopolist over a whole bunch of things. The word monopoly can only make sense as capturing the absence of rivalry between sellers of different brands. A seller can have monopoly power in its brand, but only if there are not other brands that are reasonable substitutes. And, of course, there are many reasonable substitutes for Teslas.

Nor will forcing Tesla to sell through dealers create “price competition” for Teslas to the benefit of consumers. As I explained in my post last summer, Tesla maximizes its profits by minimizing its cost of distribution. If dealers can perform that function more efficiently than Tesla, Tesla has every incentive to distribute through dealers. The one thing Tesla cannot do is increase its profits by charging more for the retail distribution function than dealers would charge. Whatever the explanation for Tesla’s decision to distribute directly may be, it has nothing to do with charging consumers a monopoly price for the distribution of Teslas.

Mr. Appleton’s second argument was that the dealer protection laws are necessary for consumer safety. He then pointed to the news that GM might have prevented accidents taking 12 lives if it had recalled some of its vehicles earlier than it eventually did. But of course all of this occurred while GM was distributing through franchised dealers. To take Mr. Appleton’s logic, I should have been arguing that distribution through franchised dealers kills people.

Mr. Appleton then offered a concrete argument on car safety. He said that, to manufacturers, product recalls are a cost whereas, to dealers, they are an opportunity to earn income. But that argument is also facially absurd. Dealers don’t make the decision to issue safety recalls. Those decisions come from the manufacturer and the National Highway Traffic Safety Administration. Dealers benefit only incidentally.

The direct distribution laws have nothing to do with enhancing price competition or car safety. They are protectionism for dealers, pure and simple. At a time when Chris Christie is trying to regain credibility with New Jersey voters in general, and New Jersey motorists in particular, this development is a real shame.

Mike Sykuta and I recently co-authored a short article discussing the latest evidence on, and proper legal treatment of, minimum resale price maintenance (RPM). Following is a bit about the article (which is available here).

Despite the U.S. Supreme Court’s Leegin decision holding that minimum RPM must be evaluated under antitrust’s Rule of Reason, the battle over the proper legal treatment of the practice continues to rage at both the federal and state levels.

At the federal level, courts, commentators, and regulators have split over what sort of Rule of Reason should apply.  Some, like yours truly, have argued that because RPM is usually pro- rather than anticompetitive, challengers should bear the burden of proving likely anticompetitive effect (at a minimum, the structural prerequisites to such an effect) under a full-blown Rule of Reason.  Others contend that RPM should be assessed using some version of “quick look” Rule of Reason, under which a challenged instance of RPM is presumed anticompetitive if the plaintiff makes some fairly narrow showing (e.g., that consumer prices have risen, or that the RPM was dealer-initiated, or that the RPM is imposed on homogeneous products that are not sold with dealer services that are susceptible to free-riding).

At the state level, a number of states have simply decided not to follow Leegin and to retain, under state antitrust law, the per se rule of Dr. Miles (the 1911 decision overruled by Leegin).  At least nine states have taken this tack.

We advocates of a full-blown Rule of Reason for minimum RPM have generally emphasized two things.  First, we have observed that while the structural prerequisites to RPM’s potentially anticompetitive harms (facilitation of dealer-level or manufacturer-level cartels, or exclusion by a dominant dealer or manufacturer) are rarely satisfied, the necessary conditions for RPM’s procompetitive benefits (avoidance of free-riding, facilitating entry, encouraging non-free-rideable dealer services) are frequently met.  Second, we have shown that the pre-Leegin empirical evidence on RPM’s effects generally confirmed what theory would predict: Most instances of RPM that have been examined closely have proven output-enhancing.

In recent months, advocates of stricter RPM rules have pointed to an ambitious new study that they say supports their position.  The study authors, University of Chicago economics PhD candidates Alexander MacKay and David Aron Smith, purported to conduct “a natural experiment to estimate the effects of Leegin on product prices and quantity.”  In particular, MacKay & Smith compared post-Leegin changes in price and output levels in states retaining a rule of per se illegality with those in states likely to assess RPM under the Rule of Reason.  Utilizing Nielsen consumer product data for 1,083 “product modules” (i.e., narrowly defined product categories such as “vegetables-broccoli-frozen”), the authors assessed price and output changes between the six month period immediately preceding Leegin (January-June 2007) and the last six months of 2009.

With respect to price changes, MacKay & Smith found that 15% of the product modules exhibited price increases that were higher, by a statistically significant margin, in Rule of Reason states than in per se states.  In only 6.9% of modules were price increases higher, to a statistically significant degree, in per se states than in Rule of Reason states.  With respect to quantity changes, 14.7% of modules saw a statistically significant decrease in quantity in Rule of Reason states versus per se states, whereas only 3% of modules exhibited a statistically significant quantity increase in Rule of Reason states over per se states.  MacKay & Smith thus conclude that greater leniency on minimum RPM is associated with higher prices and lower output levels, a conclusion that, they say, supports the view that RPM is more frequently anticompetitive than procompetitive.

Mike and I contend that the MacKay & Smith study is flawed and does not justify restrictive RPM policies.  First, the study provides very little support for the view that RPM has caused anticompetitive harm within the group of product markets examined.  As an initial matter (and as the authors admit), the study does not demonstrate that actual RPM agreements have caused anticompetitive harm in the post-Leegin era.  To make such a showing, one would have to demonstrate that (1) minimum RPM was actually imposed on a product after the Leegin decision, (2) the RPM policy raised the price of that product from what it otherwise would have been, and (3) the quantity of the product sold fell from what it otherwise would have been.  The authors present no evidence that RPM policies were actually implemented on any of the product categories for which they identified statistically significant price increases and quantity decreases.  As they concede, their study could show only that legal environments treating RPM leniently (not RPM agreements themselves) are conducive to anticompetitive outcomes.

But the authors’ data provide little support for even that claim.  To prove anticompetitive harm stemming from an “RPM-permissive” legal environment, one would have to show that the transition from per se illegality to rule of reason treatment occasioned, for a substantial number of products, both a statistically significant price increase and a statistically significant output reduction on the same product.  An output reduction not accompanied by an increase in price suggests that something besides minimum RPM (or even a “permissive attitude” toward RPM) caused output to fall.  A price increase without a reduction in output is consistent with the view that RPM induced demand-enhancing dealer activities that mitigated the effect of the price increase, albeit by not as much as the producer may have hoped.  (A price increase without an output decrease could also indicate that demand for the product at issue was inelastic, but MacKay & Smith presented no evidence suggesting that demand for any of the product categories exhibiting price increases but not quantity decreases was particularly inelastic.)

According to the authors’ list of “modules with significant price or quantity changes” (Appendix A of their study), only 17 of the 1,083 product categories examined—a mere 1.6%—exhibited both a price increase and a quantity decrease.  And those effects were for categories of products (e.g., barbecue sauces as a whole), not necessarily particular brands of a product (e.g., KC Masterpiece or Sweet Baby Ray’s).  It could well be that within the 1.6% of categories exhibiting both an average price increase and an average output decrease, there were no individual brands exhibiting both effects at once.  Indeed, most of the seventeen product categories involve dealer and manufacturer markets that are neither cartelizable (so neither the dealer nor manufacturer collusion theory of anticompetitive harm could apply) nor dominated by a powerful manufacturer or dealer (so neither the dominant manufacturer nor dominant dealer theory could apply).  To the extent MacKay & Smith’s findings provide any evidence that RPM-permissiveness occasions anticompetitive harm in household consumer products markets, that evidence is awfully thin.

Moreover, in limiting their examination to the product categories included in the Nielsen Consumer Panel Data, MacKay & Smith excluded most products for which one of the procompetitive rationales for minimum RPM—the “avoidance of free-riding” rationale—would apply.  As the authors observe, only about “30% of household consumption is accounted for by the categories in the data.”  That 30% is comprised mainly of groceries, other consumable household products, and small appliances.  The study thus excludes data related to purchases of large appliances, complicated electronics projects, and other relatively expensive products that are frequently sold along with “free-rideable” amenities such as product demonstrations, consumer education, and set-up or repair services.  Because the MacKay & Smith study systematically disregards information on transactions likely to reflect a procompetitive use of minimum RPM, it fails to establish the authors’ conclusion that “the harm to consumers resulting from rule-of-reason treatment of minimum RPM seems to outweigh its benefits.”

In the end, then, Mike and I conclude that the new RPM evidence provides no reason to reject the persuasive theory- and evidence-based arguments in favor of lenient, full-blown Rule of Reason treatment of minimum RPM.  Of course, we welcome comments on our article.

On July 10 a federal judge ruled that Apple violated antitrust law by conspiring to raise prices of e-books when it negotiated deals with five major publishers. I’ve written on the case and the issues involved in it several times, including here, here, here and here. The most recent of these was titled, “Why I think the government will have a tough time winning the Apple e-books antitrust case.” I’m hedging my bets with the title this time, but it’s fairly clear to me that the court got this case wrong.

The predominant sentiment among pundits following the decision seems to be approval (among authors, however, the response to the suit has been decidedly different). Supporters believe it will lower e-book prices and instigate a shift in the electronic publishing industry toward some more-preferred business model. This sort of reasoning is dangerous and inconsistent with principled, restrained antitrust. Neither the government nor its supporting commentators should use, or applaud the use, of antitrust to impose the government’s (or anyone else’s) preferred business model on industry. And lower prices in the short run, while often an indication of increased competition, are not, by themselves, sufficient to determine that a business model is efficient in the long run.

For example, in a recent article, Mark Lemley is quoted supporting the outcome, noting that it may spur a shift toward his preferred model of electronic publishing:

It also makes no sense that publishers, not authors, capture most of the revenue from e-books, when they do very little of the work. I understand why publishers are reluctant to give up their old business model, but if they want to survive in the digital world, it’s time to make some changes.

As noted, there is no basis for using antitrust enforcement to coerce an industry to shift to a particular distribution of profits simply because “it’s time to make some changes.” Lemley’s characterization of the market’s dynamics is also seriously lacking in economic grounding (and the Authors Guild response to the suit linked above suggests the same). The economics of entrepreneurship has an impressive intellectual pedigree that began with Frank Knight, was further developed by Joseph Schumpeter, Israel Kirzner and Harold Demsetz, among others, and continues to today with its inclusion as a factor of production. (On the development of this tradition and especially Harold Demsetz’s important contribution to it, see here). The implicit claim that publishers’ and authors’ interests (to say nothing of consumers’ interests) are simply at odds, and that the “right” distribution of profits would favor authors over publishers based on the amount of “work” they do is economically baseless. Although it is a common claim, reflecting either idiosyncratic preferences or ignorance about the role of content publishers and distributors in the e-book marketplace and the role of entrepreneurship more generally, it is nonetheless mistaken and has no place in a consumer-welfare-based assessment of the market or antitrust intervention in it.

It’s also utterly unclear how the antitrust suit would do anything to change the relative distribution of profits between publishers and authors. In fact, the availability of direct publishing (offered by both Amazon and Apple) is the most likely disruptor of that dynamic, and authors could only be helped by an increase in competition among platforms—in other words, by Apple’s successful entry into the market.

Apple entered the e-books market as a relatively small upstart battling a dominant incumbent. That it did so by offering publishers (suppliers) attractive terms to deal with its new iBookstore is no different than a new competitor in any industry offering novel products or loss-leader prices to attract customers and build market share. When new entry then induces an industry-wide shift toward the new entrants’ products, prices or business model it’s usually called “competition,” and lauded as the aim of properly functioning markets. The same should be true here.

Despite the court’s claim that

there is overwhelming evidence that the Publisher Defendants joined with each other in a horizontal price-fixing conspiracy,

that evidence is actually extremely weak. What is unclear is why the publishers would need a conspiracy when they rarely compete against each other directly.

The court states that

To protect their then-existing business model, the Publisher Defendants agreed to raise the prices of e-books by taking control of retail pricing.

But despite the use of the antitrust trigger-words, “agreed to raise prices,” this agreement is not remotely clear, and rests entirely on circumstantial evidence (more on this later). None of the evidence suggests actual agreement over price, and none of the evidence demonstrates conclusively any real incentive for the publishers to reach “agreement” at all. In actuality, publishers rarely compete against each other directly (least of all on price); instead, for each individual publisher (and really for each individual title), the most relevant competition for this case is between the e-book version of a particular title and its physical counterpart. In this situation it should matter little to any particular e-book’s sales whether every other e-book in the world is sold at the same price or even a lower price.

While the opinion asserts that each publisher

could also expect to lose substantial sales if they unilaterally raised the prices of their own e-books and none of their competitors followed suit,

it also states that

there is no evidence that the Publisher Defendants have ever competed with each other on price. To the contrary, several of the Publishers’ CEOs explained that they have not competed with each other on that basis.

These statements are difficult to reconcile, but the evidence supports the latter statement, not the former.

The only explanation offered by the court for the publishers’ alleged need for concerted action is an ambiguous claim that Amazon would capitulate in shifting to the agency model only if every publisher pressured it to do so simultaneously. The court claims that

if the Publisher Defendants were going to take control of e-book pricing and move the price point above $9.99, they needed to act collectively; any other course would leave an individual Publisher vulnerable to retaliation from Amazon.

But it’s not clear why this would be so.

On the one hand, if Apple really were the electronic publishing juggernaut implied by this antitrust action, this concern should be minimal: Publishers wouldn’t need Amazon and could simply sell their e-books through Apple’s iBookstore. In this case the threat of even any individual publisher’s “retaliation” against Amazon (decamping to Apple) would suffice to shift relative bargaining power between the publishers and Amazon, and concerted action wouldn’t be necessary. On this theory, the fact that it was only after Apple’s entry that Amazon agreed to shift to the agency model—a fact cited by the court many times to support its conclusions—is utterly unremarkable.

That prices may have shifted as well is equally unremarkable: The agency model puts pricing decisions in publishers’ hands (who, as I’ve previously discussed, have very different incentives than Amazon) where before Amazon had control over prices. Moreover, even when Apple presented evidence that average e-book prices actually fell after its entrance into the market, the court demanded that Apple prove a causal relationship between its entrance and lower overall prices. (Even the DOJ’s own evidence shows, at worst, little change in price, despite its heated claims to the contrary.) But the burden of proof in such cases rests with the government to prove that Apple caused prices to rise, not for Apple to explain why they fell.

On the other hand, if the loss of Amazon as a retail outlet were really so significant for publishers, Apple’s ability to function as the lynchpin of the alleged conspiracy is seriously questionable. While the agency model coupled with the persistence of $9.99 pricing by Amazon would seem to mean reduced revenue for publishers on each book sold through Apple’s store, the relatively trivial number of Apple sales compared with Amazon’s, particularly at the outset, would be of little concern to publishers, and thus to Amazon. In this case it is difficult to believe that publishers would threaten their relationships with Amazon for the sake of preserving the return on their newly negotiated contracts with Apple (and even more difficult to believe that Amazon would capitulate), and the claimed coordinating effects of the MFN provisions is difficult to sustain.

The story with respect to Amazon is questionable for another reason. While the court claims that the publishers’ concern with Amazon’s $9.99 pricing was its effect on physical book sales, it is extremely hard to believe that somehow $12.99 for the electronic version of a $30 (or, often, even more expensive) physical book would be significantly less damaging to physical book sales. Moreover, the evidence put forth by the DOJ and found persuasive by the court all pointed to e-book revenues alone, not physical book sales, as the issue of most concern to publishers (thus, for example, Steve Jobs wrote to HarperCollins’ CEO that it could “[k]eep going with Amazon at $9.99. You will make a bit more money in the short term, but in the medium term Amazon will tell you they will be paying you 70% of $9.99. They have shareholders too.”).

Moreover, as Joshua Gans points out, the agency model that Amazon may have entered into with the publishers would have been particularly unhelpful in ensuring monopoly returns for the publishers (we don’t know the exact terms of their contracts, however, and there are reports from trial that Amazon’s terms were “identical” to Apple’s):

While Apple gave publishers a 70 percent share of book sales and the ability to set their own price, Amazon offered a menu. If you price below $9.99 for a book, Amazon’s share will be 70 percent but if you price above $10, Amazon only returns 35 percent to the publisher. Amazon also charged publishers a delivery fee based on the book’s size (in kb).

Thus publishers could, of course, raise prices to $12.99 in both Apple’s and Amazon’s e-book stores, but, if this effective price cap applied, doing so would result in a significant loss of revenue from Amazon. In other words, the court’s claim—that, having entered into MFNs with Apple, the publishers then had to move Amazon to the agency model to ensure that they didn’t end up being forced by the MFNs to sell books via Apple (on the less-attractive agency terms) at Amazon’s $9.99—is far-fetched. To the extent that raising Amazon’s prices above $10 may have cut royalties almost in half, the MFNs with Apple would be extremely unlikely to have such a powerful effect. But, as noted above, because of the relative sales volumes involved the same dynamic would have applied even under identical terms.

It is true, of course, that Apple cares about price differences between books sold through its iBookstore and the same titles sold through other electronic retailers—and thus it imposed MFN clauses on the publishers. But this is not anticompetitive. In fact, by facilitating Apple’s entry, the MFN clauses plainly increased competition by introducing a new competitor to the industry. What’s more, the terms of Apple’s agreements with the publishers exactly mirrors the terms it uses for apps and music sold through the iTunes store, as well. And as Gordon Crovitz noted:

As this column reported when the case was brought last year, Apple executive Eddy Cue in 2011 turned down my effort to negotiate different terms for apps by news publishers by telling me: “I don’t think you understand. We can’t treat newspapers or magazines any differently than we treat FarmVille.” His point was clear: The 30% revenue-share model is how Apple does business with everyone. It is not, as the government alleges, a scheme Apple concocted to fix prices with book publishers.

Another important error in the case — and, unfortunately, it is one to which Apple’s lawyers acceded—is the treatment of “trade e-books” as the relevant market. For antitrust purposes, there is no generalized e-book (or physical book, for that matter) market. As noted above, the court itself acknowledged that the publishers “have [n]ever competed with each other on price.” The price of Stephen King’s latest novel likely has, at best, a trivial effect on sales of…nearly every other fiction book published, and probably zero effect on sales of non-fiction books.

This is important because the court’s opinion turns on mostly circumstantial evidence of an alleged conspiracy among publishers to raise prices and on the role of concerted action in protecting publishers from being “undercut” by their competitors. But in a world where publishers don’t compete on price (and where the alleged agreement would have reduced the publishers’ revenues in the short run and done little if anything to shore up physical book sales in the long run), it is far-fetched to interpret this evidence as the court does—to infer a conspiracy to raise prices.

Meanwhile, by restricting itself to consideration of competitive effects in the e-book market alone, the court also inappropriately and without commentary dispenses with Apple’s pro-competitive justifications for its conduct. Put simply, Apple contends that its entry into the e-book retail and reader markets was facilitated by its contract terms. But the court ignores these arguments.

On the one hand, it does so because it treats this as a per se case, in which procompetitive effects are irrelevant. But the court’s determination to treat this as a per se case—with its lengthy recitation of relevant legal precedent and only cursory application of precedent to the facts of the case—is suspect. As I have noted before:

What would [justify per se treatment] is if the publishers engaged in concerted action to negotiate these more-favorable terms with other publishers, and what would be problematic for Apple is if its agreement with each publisher facilitated that collusion.

But I don’t see any persuasive evidence that the terms of Apple’s deals with each publisher did any such thing. For MFNs to perform the function alleged by the DOJ it seems to me that the MFNs would have to contribute to the alleged agreement between the publishers, just as the actions of the vertical co-conspirators in Interstate Circuit and Toys-R-Us were alleged to facilitate coordination. But neither the agency agreement itself nor the MFN and price cap terms in the contracts in any way affected the publishers’ incentive to compete with each other. Nor, as noted above, did they require any individual publisher to cause its books to be sold at higher prices through other distributors.

Even if it is true that the publishers participated in a per se illegal horizontal price fixing scheme (and despite the court’s assertion that this is beyond dispute, the evidence is not nearly so clear as the court suggests), Apple’s unique role in that alleged scheme can’t be analyzed in the same fashion. As Leegin notes (and the court in this case quotes), for conduct to merit per se treatment it must “always or almost always tend to restrict competition and decrease output.” But the conduct at issue here—whether somehow coupled with a horizontal price fixing scheme or not—doesn’t meet this standard. The agency model, the MFN terms in the publishers’ contracts with Apple, and the efforts by Apple to secure broad participation by the largest publishers before entering the market are all potentially—if not likely—procompetitive. And output seems to have increased substantially following Apple’s entry into the e-book retail market.

In short, I continue to believe that the facts of this case do not merit per se treatment, and there is a good chance the court’s opinion could be overturned on this ground. For this reason, its rejection of Apple’s procompetitive arguments was inappropriate.

But even in its brief “even under the rule of reason…” analysis, the court improperly rejects Apple’s procompetitive arguments. The court’s consideration of these arguments is basically summed up here:

The pro-competitive effects to which Apple has pointed, including its launch of the iBookstore, the technical novelties of the iPad, and the evolution of digital publishing more generally, are phenomena that are independent of the Agreements and therefore do not demonstrate any pro-competitive effects flowing from the Agreements.

But this is factually inaccurate. Apple has claimed that its entry—and thus at minimum its development and marketing of the iPad as an e-reader and its creation of the iBookstore—were indeed functions of the contract terms and the simultaneous acceptance by the largest publishers of these terms.

The court goes on to assert that, even if the claimed pro-competitive effect was the introduction of competition into the e-book market,

Apple demanded, as a precondition of its entry into the market, that it would not have to compete with Amazon on price. Thus, from the consumer’s perspective — a not unimportant perspective in the field of antitrust — the arrival of the iBookstore brought less price competition and higher prices.

In making this claim the court effectively—and improperly—condemns MFNs to per se illegal status. In doing so the court claims that its opinion’s reach is not so broad:

this Court has not found that any of these [agency agreements, MFN clauses, etc.]…components of Apple’s entry into the market were wrongful, either alone or in combination. What was wrongful was the use of those components to facilitate a conspiracy with the Publisher Defendants”

But the claimed absence of retail price competition that accompanied Apple’s entry is entirely a function of the MFN clauses: Whether at $9.99 or $12.99, the MFN clauses were what ensured that Apple’s and Amazon’s prices would be the same, and disclaimer or not they are swept in to the court’s holding.

This effective condemnation of MFN clauses, while plainly sought by the DOJ, is simply inappropriate as a matter of law. In order to condemn Apple’s conduct under the per se rule, the court relies on the operation of the MFNs in allegedly reducing competition and raising prices to make its case. But that these do not “always or almost always tend to restrict competition and reduce output” is clear. While the DOJ may view such terms otherwise (more on this here and here), courts have not done so, and Leegin’s holding that such vertical restraints are to be assessed under the rule of reason still holds. The court’s use of the per se standard and its refusal to consider Apple’s claimed pro-competitive effects are improper.

Thus I (somewhat more cautiously this time…) suggest that the court’s decision may be overturned on appeal, and I most certainly think it should be. It seems plainly troubling as a matter of economics, and inappropriate as a matter of law.

In Continental T.V. v. GTE Sylvania (1977), Justice Powell observed that antitrust law should go easy on manufacturer restraints on dealer resale because manufacturers could always decide to integrate forward into distribution and bypass dealers altogether.  As anyone who has followed electric car manufacturer Tesla’s recent travails will know, Justice Powell’s observation is not true of the auto industry.  Dealer franchise laws in most states require car manufacturers to sell through independent dealers.  Tesla apparently would like to bypass the traditional dealership model and sell directly to customers, which is landing the company in legal hot waters in many states, including traditionally “free market” states like Texas, Virginia, and North Carolina.

Tesla is the offspring of the South African-American entrepreneur Elon Musk, who also brought us Pay-Pal and SpaceX.  The company’s luxury electric cars have caused a sensation in the auto industry, including a review by Consumer Reports calling Tesla’s Model S the best car it ever tested.  Extraordinarily for a startup, in the first quarter of 2013, Tesla Model S sales exceeded the top line offerings of the established German luxury brands, Mercedes, BMW, and Audi.  Indeed, more Teslas were sold than BMW 7 series and Audi A8s combined.

One would imagine that Tesla’s biggest problem would be economic and technological—creating the infrastructure for battery-pack swap and charging facilities necessary to persuade customers that powering their Teslas will be as seamless as pumping gas at a filling station.  (Telsa’s recently announced 90-second battery pack swap will go a long way in that direction).  Alas, Tesla’s major stumbling block seems to be more legal than technological.  Tesla wants to open its own showrooms and sell directly to customers.  The powerful car dealers’ lobby has been invoking decades-old dealer franchising laws to block Tesla’s progress, insisting that Tesla must sell through independent, franchised dealers like other car companies do.  Tesla has been lobbying for legislative reforms at the state level, thus far with mixed success.

The basic economics of the problem are straightforward.  As Ronald Coase taught us, whether a car manufacturer keeps the distribution function in house or buys distribution services on the market is a question of the agency and transactions costs of those respective forms of distribution.  There are many reasons why manufacturers might prefer to distribute through independent dealers.  This shifts the investment in distribution to someone other than the manufacturer, allowing the manufacturer to focus on its core competence in research and development and manufacturing.  It shifts managerial decisions to managers with local market knowledge.  It may create economies of scale or scope as dealers sell several different brands under a single roof.

But there are also good reasons why a manufacturer might prefer to sell directly to consumers.  The manufacturer may be concerned that the dealers will focus more on short-term sales maximization rather than long-term investment in building the brand.  (This could be particularly concerning to a company like Tesla that is introducing a disruptive new technology that still needs to be proven in the market).  The manufacturer may worry that independent dealers will be insufficiently loyal and push other brands.  It may fret that local dealers will be unsophisticated about new technologies and that training and monitoring will be easier if retail distribution stays in house.

There is no a priori reason to favor one model or the other, and I have no idea whether Tesla is better off distributing through traditional dealer networks.  But I find it hard to fathom any good reason why the law should prohibit a car manufacturer from picking whatever distribution model it thinks best.  As a newcomer to these state dealer laws, I’ve been trying to keep an open mind that they might be supported by some legitimate policy concern and not pure protectionism.  Unfortunately, whenever a dealer-aligned speaker opens his mouth to defend these laws, the case that it’s just protectionism gets stronger.

One argument I’ve seen attributed to the auto dealers—and I sincerely hope that there’s some mistake and this is not actually an argument they’re making—is that creating “competition” in retail distribution of Tesla cars is necessary to prevent Tesla from price gouging customers. The idea that a vertically integrated manufacturer has a “monopoly” over the brand’s retail distribution that needs to be broken up by outsourcing the retail function to independent dealers is farcical.  If Tesla has market power, it will extract the full monopoly profit regardless of whether it sells to dealers or end users.  (It will be fully embedded in either the wholesale or resale price).  Since retail distribution is just a cost of doing business, Tesla will increase its monopoly profits by minimizing the cost of retail distribution since then it will sell more cars.  If anything, as economists have long recognized, outsourcing the retail distribution function to locally dominant automobile dealers could lead to double marginalization and increased prices.

A second argument is that having local dealers is necessary to ensure that customers are adequately served.  For example, Bob Glaser of the North Carolina Automobile Dealer’s Association has asserted that the restrictions are a form of “consumer protection,” since “a dealer who has invested a significant amount of capital in a community is more committed to taking care of that area’s customers.”  The obvious rejoinder is that Tesla has as much or more of an interest as the dealers in seeing that customers get the level of service they’re willing to pay for.   If Tesla gets a bad reputation for quality, it will fail.  I suppose that one might worry if  Tesla were a fly-by-night operation selling customers an expensive durable good at a high price and then fleeing with its profits and leaving customers without support.  But that’s obviously unlikely of a company that’s pouring billions of dollars into the creation of a new product and a recharging and battery swapping infrastructure.  Car manufacturers make considerably larger fixed capital investments than do dealers and I’m sure that the dealer failure and exit rate is considerably higher than that of manufacturers.

A related argument is that dealers play an important role in complying with local laws regarding titling and safety inspection.  But this argument doesn’t work either.  First, observe that at present most states only prohibit manufacturers from opening their own dealerships—they don’t prohibit online sales from outside the state.  (North Carolina recently passed a statute banning online sales as well).  There’s no reason why a manufacturer-owned dealership should be less capable of complying with local laws than an independent dealer.  Second, why should Internet sales involve evasion of state titling and safety inspection laws?  Internet sales can just as easily be subject to the same titling and inspection requirements as dealer-initiated sales.

Another argument I’ve heard is that prohibiting manufacturers from integrating forward into distribution is necessary to prevent them from competing unfairly with their own franchised dealers by undercutting them on price.  The logic of this argument is a little fuzzy. What would a manufacturer set up franchised dealers only to undercut them ruinously?  I suppose it might be some variant of the usual free-rider arguments—the manufacturer would set up independent dealers, free-ride on their local brand promotion, and then cut them out once the brand was established.  (Why the dealers can’t contractually bargain for protections from this isn’t clear).  But all of this is a lark for present purposes.  It clearly doesn’t apply to Tesla, which wants to avoid franchising altogether.  At most, if one were worried about “undercutting,” the rule should be a prohibition on manufacturer retail operations for manufacturers that also franchise, not for those that bypass franchising altogether.

Some people have quite fairly complained that Tesla shouldn’t be given special exemptions when other car companies are bound by the dealer restrictions.  For sure, but that cuts in favor of amending or repealing these laws altogether, not enforcing them against Tesla.  If anything, if it’s true that Tesla would obtain a competitive advantage by bypassing traditional dealer networks, consumers should want this advantage available to all car companies.  To put it other way, this argument is basically an admission that the dealer laws are raising car prices.

The last argument I’ve heard—and it’s a real doozy—is that independent dealers are civic bastions of local communities and therefore deserve to be specially protected.  Never mind the fact that many auto dealerships are owned and operated by large regional chains rather than local Boy Scouts troopmasters.  Why on God’s green earth should we single out automobiles for economic protectionism in order to subsidize local civic participation?  Why stop with automobiles?  Why not household appliances, twinkies, and lingerie?   And who is to say that Tesla will be any less civic minded than franchised auto dealers?  Further, if the model of direct distribution is so superior to franchised distribution that eliminating legal restrictions would put the dealers out of business, there must be something systematically inefficient about franchised distribution.  In that case, both consumers and local communities would be better served if state legislatures just levied a tax on auto sales and distributed them pro rata to local civic organizations.

Since the arguments for dealer laws are so weak, I’m left with the firm impression that this is just special interest rent-seeking of the worst kind.  It’s a real shame that Tesla—seemingly one of the most innovative, successful, and environmentally correct American industrial firms of the last decade—is going to have to spend tens of millions of dollars and may eventually have to cut shady political deals for the right to sell its own products.  I’m ordinarily a fan of federalism and states’ rights, but if the current debacle continues, it may be necessary for Congress to step in with preemptive federal legislation.

Trial begins today in the Southern District of New York in United States v. Apple (the Apple e-books case), which I discussed previously here. Along with co-author Will Rinehart, I also contributed an  essay to a discussion of the case in Concurrences (alongside contributions from Jon Jacobson and Mark Powell, among others).

Much of my writing on the case has essentially addressed it as a rule of reason case, assessing the economic merits of Apple’s contract terms. And as I mention in this Reuters article from yesterday on the case, one of the key issues in this analysis (and one of the government’s key targets in the case) is the use of MFN clauses.

But as Josh pointed out in a blog post last year,

my hunch is that if the case is litigated its legacy will be as an “agreement” case rather than what it contributes to rule of reason analysis.  In other words, if Apple gets to the rule of reason, the DOJ (like most plaintiffs in rule of reason cases) are likely to lose — especially in light of at least preliminary evidence of dramatic increases in output.  The critical question — I suspect — will be about proof of an actual naked price fixing agreement among publishers and Apple, and as a legal matter, what evidence is sufficient to establish that agreement for the purposes of Section 1 of the Sherman Act.

He’s likely correct, of course, that a central question at trial will be whether or not this is a per se or rule of reason case, and that trial will focus in significant part on the sufficiency of the evidence of agreement. But because this determination will turn considerably on the purpose and function of the MFN and price cap terms in Apple’s agreements with the publishers, I don’t think there should (or will) be much difference. Nor do I think the government should (or will) win.

Before the court can apply the per se rule, it must satisfy itself that the conduct at issue “would always or almost always tend to restrict competition and decrease output.” But it is not true as a matter of economics — and certainly not true as a matter of law — that MFNs meet this standard.

After State Oil v. Kahn there can be no question about the rule of reason (if not per se legal) status of price caps. And as the Court noted in Leegin:

Resort to per se rules is confined to restraints, like those mentioned, “that would always or almost always tend to restrict competition and decrease output.” To justify a per se prohibition a restraint must have “manifestly anticompetitive” effects, and “lack any redeeming virtue.

As a consequence, the per se rule is appropriate only after courts have had considerable experience with the type of restraint at issue, and only if courts can predict with confidence that it would be invalidated in all or almost all instances under the rule of reason. It should come as no surprise, then, that “we have expressed reluctance to adopt per se rules with regard to restraints imposed in the context of business relationships where the economic impact of certain practices is not immediately obvious.” And, as we have stated, a “departure from the rule-of-reason standard must be based upon demonstrable economic effect rather than . . . upon formalistic line drawing.”

After Leegin, all vertical non-price restraints, including MFNs, are assessed under the rule of reason.  Courts neither have “considerable experience” with MFNs, nor can they remotely “predict with confidence that they would be invalidated in all or almost all instances under the rule of reason.” As a recent article in Antitrust points out,

The DOJ and FTC have brought approximately ten cases over the last two decades challenging MFNs. Most of these cases involved the health care industry and all were resolved by consent judgments.

Even if the court does take a harder look at whether a per se rule should govern, however, as a practical matter there is not likely to be much difference between a “does this merit per se treatment” analysis and analysis of the facts under the rule of reason. As the Court pointed out in California Dental Association,

The truth is that our categories of analysis of anticompetitive effect are less fixed than terms like “per se,” “quick look,” and “rule of reason” tend to make them appear. We have recognized, for example, that “there is often no bright line separating per se from Rule of Reason analysis,” since “considerable inquiry into market conditions” may be required before the application of any so-called “per se” condemnation is justified. “[W]hether the ultimate finding is the product of a presumption or actual market analysis, the essential inquiry remains the same–whether or not the challenged restraint enhances competition.”

And as my former classmate Tom Nachbar points out in a recent article,

it’s hard to identity much relative simplicity in the per se rule. Indeed, the moniker “per se” has become somewhat misleading, as cases determining whether to apply the per se or rule of reason become as long as ones actually applying the rule of reason itself.

Of course that doesn’t end the analysis, and the government’s filings do all they can to sidestep the direct antitrust treatment of MFNs and instead assert that they (and other evidence alleged) permit the court to infer Apple’s participation as the coordinator of a horizontal price-fixing conspiracy among the publishers.

But as Apple argues in its filings,

The[ relevant] cases mandate an inquiry into the possibility that the challenged contract terms and negotiation approach were in Apple’s independent economic interests. The evidence is overwhelming—not just possible—that Apple acted for its own valid business reasons and not to “raise consumer prices market-wide.”…Plaintiffs ask this Court to infer Apple’s participation in a conspiracy from (1) its MFN and price cap terms and (2) negotiations with publishers.

* * *

What is obvious, however, is that Apple has not fixed prices with its competitors. What is remarkable is that the government seeks to impose grave legal consequences on an inherently pro-competitive act—entry—accomplished via agency, an MFN, and price caps, none of which is per se unlawful.

The government’s strenuous objection to Apple’s interpretation of the controlling Supreme Court authority, Monsanto v. Spray-Rite, notwithstanding, it’s difficult to see the MFN clauses as evidence of Apple’s participation in the publishers’ alleged conspiracy.

An important point supporting Apple’s argument here is that, unlike the “hubs” in the other “hub and spoke” conspiracies on which the DOJ bases its case, Apple has no significant leverage over the alleged co-conspirators, and thus no power to coordinate — let alone enforce — a price-fixing scheme. As Apple argues in its Opposition brief,

The only “power” Apple could wield over the publishers was the attractiveness of a business opportunity—hardly the “make or break” scenarios found in Interstate Circuit and [Toys-R-Us]. Far from capitulating to Apple’s requested core business terms, the publishers fought Apple tooth and nail and negotiated intensely to the very end, and the largest, Random House, declined.

And as Will and I note in our Concurrences article,

MFNs are essentially an important way of…offering some protection against publishers striking a deal with a competitor that leaves Apple forced to price its ebooks out of the market.

There is nothing, that we know of, in the MFNs or elsewhere in the agreements that requires the publishers to impose higher resale prices elsewhere, or prevents the publishers from selling through Apple at a lower price, if necessary. Most important, for Apple’s negotiated prices to dominate in the market it would have to enjoy market power – a condition, currently at least, that is exceedingly unlikely given its 10% share of the ebook market.

The point is that, even if everything the government alleges about the publishers’ price fixing scheme were true, it’s extremely difficult to see Apple as a co-conspirator in such a scheme. The Supreme Court’s holding in Monsanto stands for nothing if not the principle that courts may not infer a vertical party’s participation in a horizontal price-fixing scheme from the existence of otherwise-legal and -defensible interactions between the vertically related parties. Because MFNs have valid purposes outside the realm of price-fixing, they may not be converted into illegal conduct on Apple’s part simply because they might also “sharpen [a publisher's] incentives” to try to raise prices elsewhere.

Remember, we are in a world where the requisite anticompetitive conduct can’t be simply the vertical restraint itself. Rather, we’re evaluating whether the vertical restraint was part of a broader anticompetitive scheme among the publishers. For the MFN clauses to be part of that alleged scheme they must have an identifiable place in the scheme.

First of all, it is unremarkable that Apple might offer terms to any individual publisher (or to all publishers independently) that might be more favorable to the publisher than terms it is getting elsewhere; that’s how a new entrant in Apple’s position attracts suppliers. It is likewise unremarkable that Apple would seek to impose terms (like the MFN) that would preserve its ability to offer a publisher’s books for the same price they are offered elsewhere (which is necessary because the agency agreements negotiated by Apple otherwise remove pricing authority from Apple and confer it on the publishers themselves). And finally it is unremarkable that each publisher would try to negotiate similarly favorable terms with other distributors (or, more accurately, continue to try: bargaining over distribution terms with other distributors hardly started only after the agreements were signed with Apple). What would be notable is if the publishers engaged in concerted action to negotiate these more-favorable terms with other publishers, and what would be problematic for Apple is if its agreement with each publisher facilitated that collusion.

But I don’t see any persuasive evidence that the terms of Apple’s deals with each publisher did any such thing. For MFNs to perform the function alleged by the DOJ it seems to me that the MFNs would have to contribute to the alleged agreement between the publishers, just as the actions of the vertical co-conspirators in Interstate Circuit and Toys-R-Us were alleged to facilitate coordination. But neither the agency agreement itself nor the MFN and price cap terms in the contracts in any way affected the publishers’ incentive to compete with each other. Nor, as noted above, did they require any individual publisher to cause its books to be sold at higher prices through other distributors.

On this latter point, the DOJ alleges that the MFNs “sharpen[ed publishers'] incentives” to raise prices:

If a retailer were allowed to remain on wholesale terms, and that retailer continued to price new release e-books at $9.99, the Publisher Defendant would be forced to lower the iBookstore price to match the $9.99 price

Not only does this say nothing about the incentives of the publishers to compete with each other on price (except that it may have increased that incentive by undermining the prevailing $9.99-for-all-books standard), it seems far-fetched to suggest that fear of having to lower prices for books sold in Apple’s relatively trivial corner of the market would have an apreciable effect on a publisher’s incentives to raise prices elsewhere. For what it’s worth, it also seems far-fetched to suggest that Apple’s motivation was to raise prices given that e-book sales generate only about .0005% of Apple’s total revenues.

Beyond this, the DOJ essentially argues that Apple coordinated agreement among the publishers to accept the terms being offered by Apple, with the intent and effect that this would lead to imposition by the publishers of similar terms (and higher prices) on other distributors. Perhaps, but it’s a stretch. And if it is true, it isn’t because of the MFN clauses. Moreover, it isn’t clear to me (maybe I’m missing some obvious controlling case law?) that agreement over the type of contract used amounts to an illegal horizontal agreement; arguably in this case, at least, it is closer to an ancillary restraint or  justified agreement (as in BMI, e.g.) than, say, a group boycott or bid rigging. In any case, if the DOJ has a case at all turning on this scenario, I think it will have to be based entirely on the alleged evidence of direct coordination (i.e., communications between Apple and publishers during dinners and phone calls) rather than the operation of the contract terms themselves.

In any case, it will be interesting to see how the trial unfolds.