J&J’s Bundled Discounts Victory

As reported here, Johnson & Johnson scored a major victory last week in a case challenging some of its discounting practices. The jury concluded that J&J had not engaged in monopolization of the market for “trocars,” which are sharp cylindrical devices used in endoscopic surgery. Plaintiff Applied Medical Resources Corp., which sells trocars that compete with J&J’s, had complained that J&J’s discounting practices excluded it from the trocars market. Specifically, Applied complained about J&J’s “bundled discounts,” which provided a discount on J&J’s sutures (surgical stitches) to those hospital purchasers that also bought a certain percentage of their trocars from J&J.

Discounts, of course, are usually not illegal unless (1) they result in below-cost prices and (2) there is a likelihood that the discounter will be able to recoup its losses by charging supracompetitive prices in the future (when other firms have been driven out of the market by its discounting). This lenient rule makes sense. Any single-product discount resulting in an above-cost price could be matched by a firm that was as efficient as the discounter, so any firm excluded by an above-cost discount must be a less efficient rival. Because antitrust law favors lower prices and generally doesn’t (and shouldn’t) seek to protect less efficient rivals, single-product discounts resulting in above-cost prices are OK.

Bundled discounts — package discounts conditioned upon purchasing products from multiple product markets — are a different competitive animal. At least in theory, a bundled discount that results in above-cost pricing (for the bundle) may exclude equally efficient rivals that sell a narrower line of products. Consider, for example, a manufacturer (A) that sells both shampoo and conditioner and competes against another manufacturer (B) that sells only shampoo. B, the more efficient shampoo manufacturer, can produce a bottle of shampoo for $1.25. It costs A $1.50 to produce a bottle of shampoo and $2.50 to produce a bottle of conditioner. If purchased separately, A charges $2.00 for shampoo and $4.00 for conditioner ($6.00 total), but if the consumer purchases both products at once, A will sell the combination for $5.00. That $1.00 bundled discount results in a price that is $1.00 greater than A’s cost for the two products ($4.00). Nonetheless, the above-cost bundled discount could exclude B. B could stay in the market only if it charged no more than $1.00 for shampoo (so that a consumer’s total price of B’s shampoo and A’s conditioner would not exceed $5.00, A’s package price), but B’s marginal cost of producing shampoo is $1.25. Accordingly, A’s bundled discount could eliminate B as a competitor even though B is the more efficient producer and even though A’s discounted price is above its cost of producing the bundle.

[NOTE: This example is admittedly somewhat artificial. I use it because it appears (using slightly different numbers) in one of the leading bundled discounts decisions.]

Applied’s original claim was that it was excluded by J&J’s bundled discount even though that discount resulted in an above-cost price for the sutures/trocars bundle. Because Applied does not make sutures (an item on which J&J enjoys significant market power and, consequently, high profits), it could compete with J&J only by offering the full amount of J&J’s trocars/sutures discount on Applied’s narrower (trocars-only) product line. Doing so would require it to price below cost and would drive it out of business.

Unfortunately for Applied, there were some inconvenient facts. First, J&J’s bundled discounts were requested by the hospitals themselves (acting through buying groups called “Group Purchasing Organizations”) during a competitive bidding process. Second, J&J’s bundled discounts were primarily designed to compete with its chief rival, Tyco Corp. (formerly U.S. Surgical), which sells a complete line of trocars and sutures and was offering its own bundled discounts in competition with J&J’s. This “bundle-to-bundle” competition was fierce and consumer-friendly. Finally, J&J responded to Applied’s complaints about the bundles by “carving out” Applied’s products, so that hospitals could count purchases of Applied trocars — but not Tyco trocars — toward the purchases required to earn the discount on J&J sutures. Without doubt, J&J’s bundled discounts were aimed at competing with its chief rival, Tyco, and resulted in lower prices for hospitals.

While this case seems like a no-brainer, that didn’t stop Applied from jumping on the LePage’s bandwagon and going after $54 million in purported (pre-trebled) damages. Fortunately, this jury was smart enough to recognize that the discounts at issue were ultimately good for consumers. Who knows what will happen next time.

It’s high time for the courts to develop some clear guidelines — including manageable safe harbors — for evaluating bundled discounts. I have suggested an easily administrable, balanced approach that would approve most such discounts but would impose liability for truly exclusionary practices. As Josh has noted, Herbert Hovenkamp’s new book (The Antitrust Enterprise) suggests another workable approach. Dan Crane has proposed another. Hopefully, courts will soon latch on to one of these proposals. The very fact that the Applied Medical v. J&J case got as far as it did suggests that the LePage’s-driven status quo is intolerable.