Manne on the Apple e-books case: The Second Circuit’s decision has no support in the law and/or economics

Geoffrey Manne —  15 February 2016

As ICLE argued in its amicus brief, the Second Circuit’s ruling in United States v. Apple Inc. is in direct conflict with the Supreme Court’s 2007 Leegin decision, and creates a circuit split with the Third Circuit based on that court’s Toledo Mack ruling. Moreover, the negative consequences of the court’s ruling will be particularly acute for modern, high-technology sectors of the economy, where entrepreneurs planning to deploy new business models will now face exactly the sort of artificial deterrents that the Court condemned in Trinko:

Mistaken inferences and the resulting false condemnations are especially costly, because they chill the very conduct the antitrust laws are designed to protect.

Absent review by the Supreme Court to correct the Second Circuit’s error, the result will be less-vigorous competition and a reduction in consumer welfare. The Court should grant certiorari.

The Second Circuit committed a number of important errors in its ruling.

First, as the Supreme Court held in Leegin, condemnation under the per se rule is appropriate

only for conduct that would always or almost always tend to restrict competition… [and] only after courts have had considerable experience with the type of restraint at issue.

Neither is true in this case. The use of MFNs in Apple’s contracts with the publishers and its adoption of the so-called “agency model” for e-book pricing have never been reviewed by the courts in a setting like this one, let alone found to “always or almost always tend to restrict competition.” There is no support in the case law or economic literature for the proposition that agency models or MFNs used to facilitate entry by new competitors in platform markets like this one are anticompetitive.

Second, the court of appeals emphasized that in some cases e-book prices increased after Apple’s entry, and it viewed that fact as strong support for application of the per se rule. But the Court in Leegin made clear that the per se rule is inappropriate where, as here, “prices can be increased in the course of promoting procompetitive effects.”  

What the Second Circuit missed is that competition occurs on many planes other than price; higher prices do not necessarily suggest decreased competition or anticompetitive effects. As Josh Wright points out:

[T]the multi-dimensional nature of competition implies that antitrust analysis seeking to maximize consumer or total welfare must inevitably calculate welfare tradeoffs when innovation and price effects run in opposite directions.

Higher prices may accompany welfare-enhancing “competition on the merits,” resulting in greater investment in product quality, reputation, innovation, or distribution mechanisms.

While the court acknowledged that “[n]o court can presume to know the proper price of an ebook,” its analysis nevertheless rested on the presumption that Amazon’s prices before Apple’s entry were competitive. The record, however, offered no support for that presumption, and thus no support for the inference that post-entry price increases were anticompetitive.

In fact, as Alan Meese has pointed out, a restraint might increase prices precisely because it overcomes a market failure:

[P]roof that a restraint alters price or output when compared to the status quo ante is at least equally consistent with an alternative explanation, namely, that the agreement under scrutiny corrects a market failure and does not involve the exercise or creation of market power. Because such failures can result in prices that are below the optimum, or output that is above it, contracts that correct or attenuate market failure will often increase prices or reduce output when compared to the status quo ante. As a result, proof that such a restraint alters price or other terms of trade is at least equally consistent with a procompetitive explanation, and thus cannot give rise to a prima facie case under settled antitrust doctrine.

Before Apple’s entry, Amazon controlled 90% of the e-books market, and the publishers had for years been unable to muster sufficient bargaining power to renegotiate the terms of their contracts with Amazon. At the same time, Amazon’s pricing strategies as a nascent platform developer in a burgeoning market (that it was, in practical effect, trying to create) likely did not always produce prices that would be optimal under evolving market conditions as the market matured. The fact that prices may have increased following the alleged anticompetitive conduct cannot support an inference that the conduct was anticompetitive.

Third, the Second Circuit also made a mistake in dismissing Apple’s defenses. The court asserted that

this defense — that higher prices enable more competitors to enter a market — is no justification for a horizontal price‐fixing conspiracy.

But the court is incorrect. As Bill Kolasky points out in his post, it is well-accepted that otherwise-illegal agreements that are ancillary to a procompetitive transaction should be evaluated under the rule of reason.

It was not that Apple couldn’t enter unless Amazon’s prices (and its own) were increased. Rather, the contention made by Apple was that it could not enter unless it was able to attract a critical mass of publishers to its platform – a task which required some sharing of information among the publishers – and unless it was able to ensure that Amazon would not artificially lower its prices to such an extent that it would prevent Apple from attracting a critical mass of readers to its platform. The MFN and the agency model were thus ancillary restraints that facilitated the transactions between Apple and the publishers and between Apple and iPad purchasers. In this regard they are appropriately judged under the rule of reason and, under the rule of reason, offer a valid procompetitive justification for the restraints.

And it was the fact of Apple’s entry, not the use of vertical restraints in its contracts, that enabled the publishers to wield the bargaining power sufficient to move Amazon to the agency model. The court itself noted that the introduction of the iPad and iBookstore “gave publishers more leverage to negotiate for alternative sales models or different pricing.” And as Ben Klein noted at trial,

Apple’s entry probably gave the publishers an increased ability to threaten [Amazon sufficiently that it accepted the agency model]…. The MFN [made] a trivial change in the publishers’ incentives…. The big change that occurs is the change on the other side of the bargaining situation after Apple comes in where Amazon now cannot just tell them no.

Fourth, the purpose of applying the per se rule is to root out activities that always or almost always harm competition. Although it’s possible that a horizontal agreement that facilitates entry and increases competition could be subject to the per se rule, in this case its application was inappropriate. The novelty of Apple’s arrangement with the publishers, coupled with the weakness of proof of any sort of actual price fixing fails to meet even a minimal threshold that would require application of the per se rule.

Not all horizontal arrangements are per se illegal. If an arrangement is relatively novel, facilitates entry, and is patently different from naked price fixing, it should be reviewed under the rule of reason. See BMI. All of those conditions are met here.

The conduct of the publishers – distinct from their agreements with Apple – to find some manner of changing their contracts with Amazon is not itself price fixing, either. The prices themselves would be set only subsequent to whatever new contracts were adopted. At worst, the conduct of the publishers in working toward new contracts with Amazon can be characterized as a facilitating practice.

But even then, the precedent of the Court counsels against applying the per se rule to facilitating practices such as the mere dissemination of price information or, as in this case, information regarding the parties’ preferred, bilateral, contractual relationships. As the Second Circuit itself once held, following the Supreme Court,  

[the] exchange of information is not illegal per se, but can be found unlawful under a rule of reason analysis.

In other words, even the behavior of the publishers should be analyzed under a rule of reason – and Apple’s conduct in facilitating that behavior cannot be imbued with complicity in a price-fixing scheme that may not have existed at all.

Fifth, in order for conduct to “eliminate price competition,” there must be price competition to begin with. But as the district court itself noted, the publishers do not compete on price. This point is oft-overlooked in discussions of the case. It is perhaps possible to say that the contract terms at issue and the publishers’ pressure on Amazon affected price competition between Apple and Amazon – but even then it cannot be said to have reduced competition, because, absent Apple’s entry, there was no competition at all between Apple and Amazon.

It’s true that, if all Apple’s entry did was to transfer identical e-book sales from Amazon to Apple, at higher prices and therefore lower output, it might be difficult to argue that Apple’s entry was procompetitive. But the myopic focus on e-book titles without consideration of product differentiation is mistaken, as well.

The relevant competition here is between Apple and Amazon at the platform level. As explained above, it is misleading to look solely at prices in evaluating the market’s competitiveness. Provided that switching costs are low enough and information about the platforms is available to consumers, consumer welfare may have been enhanced by competition between the platforms on a range of non-price dimensions, including, for example: the Apple iBookstore’s distinctive design, Apple’s proprietary file format, features on Apple’s iPad that were unavailable on Kindle Readers, Apple’s use of a range of marketing incentives unavailable to Amazon, and Apple’s algorithmic matching between its data and consumers’ e-book purchases.

While it’s difficult to disentangle Apple’s entry from other determinants of consumers’ demand for e-books, and even harder to establish with certainty the “but-for” world, it is nonetheless telling that the e-book market has expanded significantly since Apple’s entry, and that purchases of both iPads and Kindles have increased, as well.

There is, in other words, no clear evidence that consumers viewed the two products as perfect substitutes, and thus there is no evidence that Apple’s entry merely caused a non-welfare-enhancing substitution from Amazon to Apple. At minimum, there is no basis for treating the contract terms that facilitated Apple’s entry under a per se standard.

***

The point, in sum, is that there is in fact substantial evidence that Apple’ entry was pro-competitive, that there was no price-fixing scheme of which Apple was a part, and absolutely no evidence that the vertical restraints at issue in the case were the sort that should presumptively give rise to liability. Not only was application of the per se rule inappropriate, but, to answer Richard Epstein, there is strong evidence that Apple should win under a rule of reason analysis, as well.

Geoffrey Manne

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http://laweconcenter.org/

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