Should PeaceHealth Apply to De Facto Exclusive Dealing Claims?

Josh Wright —  10 November 2009

Thom answers this question in the affirmative in his excellent post about the Ninth Circuit’s analysis in Masimo and is disappointed that the Ninth Circuit rejected the discount attribution standard as the sole test for Section 2 in favor of a separate inquiry as to whether the bundled discount arrangement resulted in a substantial foreclosure of distribution and competitive harm.  Thom describes this reasoning as “sorely disappointing.”  I’m tentatively not convinced things are as bad as Thom sees them and want to explain why.  Maybe Thom can persuade me that I ought to be more upset about Masimo than I am.

Let me start with two preliminary points.

First, I agree that bundled discounts are generally pro-competitive for all of the reasons Thom states as well as some others.  While there is some empirical evidence that bundled discounting appears in highly competitive markets where anticompetitive theories do not apply, suggesting pro-competitive efficiencies, but little empirical verification of a high likelihood of competitive harms.

Second, despite our agreement about the generally efficiency of bundled discounting, Thom’s claim that a bundled discount distribution arrangement cannot result in anticompetitive effect is overstated as a matter of economic theory.  My basic point is that it is possible, as a matter of economic theory, for distribution arrangements involving bundled discounts that satisfy the PeaceHealth safe harbor to result in anticompetitive effects.  Despite this economic point, I’m not sure that Thom and I disagree on the ultimate appropriate legal treatment of bundled discounting.  I’ll get back to that.

Now, to defend my claim.

Let’s start with Thom’s position that, contra the Ninth Circuit, a bundled discount scheme that satisfies PeaceHealth’s discount attribution test (i.e. prices are still above cost after the discount is fully attributed to the competitive product in the bundle) should be immune from Section 2 liability even if the arrangement results in the “foreclosure” of a sufficient share of distribution to deprive rivals of the opportunity to have access to a critical input (such as shelf space) required to achieve minimum efficient scale.

What is the anticompetitive story in these “bundled discount as de facto exclusive dealing” set of cases?  Put simply, the anticompetitive theories are based on the notion that the monopolist’s distribution arrangement will deprive the rival of the opportunity to reach minimum efficient scale through the foreclosure of access to some critical input do not depend on offering distributors a price that fails the discount attribution standard.  A broad set of “exclusionary distribution” cases allege that various forms of marketing arrangements between manufacturers and retailers result in a situation where the monopolist is purchasing exclusion + distribution rather than just distribution.

The economic literature giving rise to these anticompetitive theories of exclusive dealing as “raising rival’s costs” is about the conditions under which manufacturers will be able to purchase exclusion from downstream firms and the price that they will have to pay to do so.  Manufacturers make payments to distributors for access to shelf space in a lot of ways: lump sum payments such as slotting fees, rebates, loyalty discounts, bundled discounts, RPM, cooperative marketing dollars, trade promotions, and more.  But the key question should not turn on the form of those payments.  It should turn on whether the contracts satisfy the conditions necessary for anticompetitive harm: are rivals foreclosed from a sufficient share of distribution that they cannot achieve minimum efficient scale?

This begs the question: is a price that fails the discount attribution test a necessary condition for the above set of theories to operate?  I don’t think so as a matter of theory.  One can think of the raising rivals’ costs theories of distribution as the manufacturer paying a set of distributors to join the manufacturer’s cartel.  What payment would be sufficient to sustain that agreement without defection (distributors would all have the standard incentive to cheat)?  The answer to that question depends on a lot of things: upstream and downstream entry conditions, switching costs, number of distributors, the existence and magnitude of economies of scale or scope, etc.  But I don’t think that there is any reason to believe that economic theory provides a linkage between passing the discount attribution test and failure to satisfy the necessary conditions for standard raising rivals’ cost-based exclusion theories.  Thus, in theory one suspects that there are distribution arrangements that could logically survive PeaceHealth but also potentially create anticompetitive effects because they satisfy the conditions of the exclusion theories.  Let’s call that set of agreements X.

The existence of X doesn’t necessary mean that I disagree with Thom about the appropriate legal rule.  If X is very small such that it would be more costly to identify these agreements and prosecute them, one could justify Thom’s rule on those grounds.  If enforcement actions against X would lead to substantially greater error costs than Thom’s rule, one could also justify his position on those grounds.  The existing empirical evidence, to my knowledge, is insufficient to make such fine grained determinations.  However, the same evidence also tells us that manufacturer arrangements to pay for distribution and promotion are incredibly common, provide benefits to consumers, and occur in competitive markets.  Indeed, I’ve written a great deal about the set of conditions under which the normal competitive process generates payments for distribution. As such, I agree with Thom that it is incredibly important to establish workable and broad safe harbors in this area that minimize error costs. What I reject is the strong economic claim that appears in Thom’s post:

When it comes to bundled discounts, which generally reflect (or promote) cost-savings and which provide an immediate benefit to consumers, there can be no anticompetitive harm in the form of predation, unreasonable exclusion, or foreclosure if the competitive product is priced above the defendant’s cost once the entire discount is attributed to that product.

If the plaintiff is making a predation claim involving bundled discounts, I think the PeaceHealth standard is workable and useful and we should keep it.  A potential case might even be made, as discussed, to justify PeaceHealth as the universal standard for bundled discount claims even when they alleged exclusionary deprivation of scale because we think X is sufficiently small or unimportant or especially susceptible to Type I error.  But I don’t read Thom as making that case.  Perhaps he is and I hope he’ll clarify.

To repeat: I just don’t think that there is any reason to believe that exclusion in the sense defined here is not theoretically possible as a matter of economics because we observe a price that passes PeaceHealth.  As such, I don’t want to throw out foreclosure analysis as an important and relevant part of the antitrust inquiry.  Let me end with a few words in defense of foreclosure analysis which I think gets a bad rap nowadays.

There are costs to keeping the foreclosure analysis, and having two standards for two different allegations of anticompetitive harm.  Beyond that, of course, foreclosure analysis is full of its own complications, e.g. foreclosure of what? does duration of contract matter? what about staggered expiration dates?  But despite its complications and the potential for abuse, the foreclosure analysis asks the right question in deprivation of scale questions and the one that we know is explicitly linked to an important necessary condition of a very large set of the theories of harm alleged in monopolization cases.  Getting a legal standard reasonably tied to the necessary conditions for anticompetitive harm, as Thom knows from his important work in the RPM area, is not always an easy thing to do in antitrust.

By the way, I think that my objection here survives Thom’s “Hydra critique” that the mode of antitrust analysis should be a function of economic substance rather than form.  I agree that the critical question is whether the conduct is likely to impair the competitive process to the detriment of consumers.   The point here is that the the deprivation of scale claims are or at least can be, as a matter of economic substance, different than pure price predation claims.

The critical economic point is that the set of distribution arrangements must, as the literature says, raise a rival’s cost of operating or impair his ability to exist.  Those arrangements that do not should not trigger antitrust violations.  And of course, those that do not satisfied a necessary but not sufficient condition for competitive harm.  The key point is that in cases involving allegations of deprivation of scale, the economic consensus is that those claims require allegations of exclusion require foreclosure sufficient to deprive rivals the opportunity to compete for minimum efficient scale.  If we are ready to accept that this is the state of economic consensus, then we ought to explicitly include this showing in the part of the plaintiff’s burden.  The antitrust law currently attempts to get at this inquiry through foreclosure analysis, requiring something around 40 percent foreclosure share in de facto exclusionary cases.  That seems sensible to me.

Antitrust can handle different standards.  If the plaintiff is alleging deprivation of scale, lets make substantial foreclosure a necessary (but not sufficient) condition.  If the plaintiff is alleging a price predation argument that does not depend on deprivation of scale, PeaceHealth is a safe harbor.  Would that be so bad?  And one more question for discussion purposes, if Thom is right about PeaceHealth in the context of bundled discounts, doesn’t this also apply to any payment distribution?  For example, I think the logic clearly applies that single product loyalty discounts ought to be analyzed the same way, i.e. we should use discount attribution to apply the discount on so-called non-contestable units to the contestable ones and apply the same filter.  But if that’s true, exclusive dealing with discounts is a loyalty discount where the threshold volume is set to 100% of the distributor purchases.  If that’s right, Thom are you arguing that we should get rid of all exclusive dealing law whenever there is a discount scheme?

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