On March 31, I and several other law and economics scholars filed an amicus brief in Epic Games v. Apple, which is on appeal to the U.S. Court of Appeals for Ninth Circuit. In this post, I summarize the central arguments of the brief, which was joined by Alden Abbott, Henry Butler, Alan Meese, Aurelien Portuese, and John Yun and prepared with the assistance of Don Falk of Schaerr Jaffe LLP.
First, some background for readers who haven’t followed the case.
Epic, maker of the popular Fortnite video game, brought antitrust challenges against two policies Apple enforces against developers of third-party apps that run on iOS, the mobile operating system for Apple’s popular iPhones and iPads. One policy requires that all iOS apps be distributed through Apple’s own App Store. The other requires that any purchases of digital goods made while using an iOS app utilize Apple’s In App Purchase system (IAP). Apple collects a share of the revenue from sales made through its App Store and using IAP, so these two policies provide a way for it to monetize its innovative app platform.
Epic maintains that Apple’s app policies violate the federal antitrust laws. Following a trial, the district court disagreed, though it condemned another of Apple’s policies under California state law. Epic has appealed the antitrust rulings against it.
My fellow amici and I submitted our brief in support of Apple to draw the Ninth Circuit’s attention to a distinction that is crucial to ensuring that antitrust promotes long-term consumer welfare: the distinction between the mere extraction of surplus through the exercise of market power and the enhancement of market power via the weakening of competitive constraints.
The central claim of our brief is that Epic’s antitrust challenges to Apple’s app store policies should fail because Epic has not shown that the policies enhance Apple’s market power in any market. Moreover, condemnation of the practices would likely induce Apple to use its legitimately obtained market power to extract surplus in a different way that would leave consumers worse off than they are under the status quo.
Mere Surplus Extraction vs. Market Power Extension
As the Supreme Court has observed, “Congress designed the Sherman Act as a ‘consumer welfare prescription.’” The Act endeavors to protect consumers from harm resulting from “market power,” which is the ability of a firm lacking competitive constraints to enhance its profits by reducing its output—either quantitively or qualitatively—from the level that would persist if the firm faced vigorous competition. A monopolist, for example, might cut back on the quantity it produces (to drive up market price) or it might skimp on quality (to enhance its per-unit profit margin). A firm facing vigorous competition, by contrast, couldn’t raise market price simply by reducing its own production, and it would lose significant sales to rivals if it raised its own price or unilaterally cut back on product quality. Market power thus stems from deficient competition.
As Dennis Carlton and Ken Heyer have observed, two different types of market power-related business behavior may injure consumers and are thus candidates for antitrust prohibition. One is an exercise of market power: an action whereby a firm lacking competitive constraints increases its returns by constricting its output so as to raise price or otherwise earn higher profit margins. When a firm engages in this sort of conduct, it extracts a greater proportion of the wealth, or “surplus,” generated by its transactions with its customers.
Every voluntary transaction between a buyer and seller creates surplus, which is the difference between the subjective value the consumer attaches to an item produced and the cost of producing and distributing it. Price and other contract terms determine how that surplus is allocated between the buyer and the seller. When a firm lacking competitive constraints exercises its market power by, say, raising price, it extracts for itself a greater proportion of the surplus generated by its sale.
The other sort of market power-related business behavior involves an effort by a firm to enhance its market power by weakening competitive constraints. For example, when a firm engages in unreasonably exclusionary conduct that drives its rivals from the market or increases their costs so as to render them less formidable competitors, its market power grows.
U.S. antitrust law treats these two types of market power-related conduct differently. It forbids behavior that enhances market power and injures consumers, but it permits actions that merely exercise legitimately obtained market power without somehow enhancing it. For example, while charging a monopoly price creates immediate consumer harm by extracting for the monopolist a greater share of the surplus created by the transaction, the Supreme Court observed in Trinko that “[t]he mere possession of monopoly power, and the concomitant charging of monopoly prices, is not . . . unlawful.” (See also linkLine: “Simply possessing monopoly power and charging monopoly prices does not violate [Sherman Act] § 2….”)
Courts have similarly refused to condemn mere exercises of market power in cases involving surplus-extractive arrangements more complicated than simple monopoly pricing. For example, in its Independent Ink decision, the U.S. Supreme Court expressly declined to adopt a rule that would have effectively banned “metering” tie-ins.
In a metering tie-in, a seller with market power on some unique product that is used with a competitively supplied complement that is consumed in varying amounts—say, a highly unique printer that uses standard ink—reduces the price of its unique product (the printer), requires buyers to also purchase from it their requirements of the complement (the ink), and then charges a supracompetitive price for the latter product. This allows the seller to charge higher effective prices to high-volume users of its unique tying product (buyers who use lots of ink) and lower prices to lower-volume users.
Assuming buyers’ use of the unique product correlates with the value they ascribe to it, a metering tie-in allows the seller to price discriminate, charging higher prices to buyers who value its unique product more. This allows the seller to extract more of the surplus generated by sales of its product, but it in no way extends the seller’s market power.
In refusing to adopt a rule that would have condemned most metering tie-ins, the Independent Ink Court observed that “it is generally recognized that [price discrimination] . . . occurs in fully competitive markets” and that tying arrangements involving requirements ties may be “fully consistent with a free, competitive market.” The Court thus reasoned that mere price discrimination and surplus extraction, even when accomplished through some sort of contractual arrangement like a tie-in, are not by themselves anticompetitive harms warranting antitrust’s condemnation.
The Ninth Circuit has similarly recognized that conduct that exercises market power to extract surplus but does not somehow enhance that power does not create antitrust liability. In Qualcomm, the court refused to condemn the chipmaker’s “no license, no chips” policy, which enabled it to enhance its profits by earning royalties on original equipment manufacturers’ sales of their high-priced products.
In reversing the district court’s judgment in favor of the FTC, the Ninth Circuit conceded that Qualcomm’s policies were novel and that they allowed it to enhance its profits by extracting greater surplus. The court refused to condemn the policies, however, because they did not injure competition by weakening competitive constraints:
This is not to say that Qualcomm’s “no license, no chips” policy is not “unique in the industry” (it is), or that the policy is not designed to maximize Qualcomm’s profits (Qualcomm has admitted as much). But profit-seeking behavior alone is insufficient to establish antitrust liability. As the Supreme Court stated in Trinko, the opportunity to charge monopoly prices “is an important element of the free-market system” and “is what attracts ‘business acumen’ in the first place; it induces risk taking that produces innovation and economic growth.”
The Qualcomm court’s reference to Trinko highlights one reason courts should not condemn exercises of market power that merely extract surplus without enhancing market power: allowing such surplus extraction furthers dynamic efficiency—welfare gain that accrues over time from the development of new and improved products and services.
Dynamic efficiency results from innovation, which entails costs and risks. Firms are more willing to incur those costs and risks if their potential payoff is higher, and an innovative firm’s ability to earn supracompetitive profits off its “better mousetrap” enhances its payoff.
Allowing innovators to extract such profits also helps address the fact most of the benefits of product innovation inure to people other than the innovator. Private actors often engage in suboptimal levels of behaviors that produce such benefit spillovers, or “positive externalities,” because they bear all the costs of those behaviors but capture just a fraction of the benefit produced. By enhancing the benefits innovators capture from their innovative efforts, allowing non-power-enhancing surplus extraction helps generate a closer-to-optimal level of innovative activity.
Not only do supracompetitive profits extracted through the exercise of legitimately obtained market power motivate innovation, they also enable it by helping to fund innovative efforts. Whereas businesses that are forced by competition to charge prices near their incremental cost must secure external funding for significant research and development (R&D) efforts, firms collecting supracompetitive returns can finance R&D internally. Indeed, of the top fifteen global spenders on R&D in 2018, eleven were either technology firms accused of possessing monopoly power (#1 Apple, #2 Alphabet/Google, #5 Intel, #6 Microsoft, #7 Apple, and #14 Facebook) or pharmaceutical companies whose patent protections insulate their products from competition and enable supracompetitive pricing (#8 Roche, #9 Johnson & Johnson, #10 Merck, #12 Novartis, and #15 Pfizer).
In addition to fostering dynamic efficiency by motivating and enabling innovative efforts, a policy acquitting non-power-enhancing exercises of market power allows courts to avoid an intractable question: which instances of mere surplus extraction should be precluded?
Precluding all instances of surplus extraction by firms with market power would conflict with precedents like Trinko and linkLine (which say that legitimate monopolists may legally charge monopoly prices) and would be impracticable given the ubiquity of above-cost pricing in niche and brand-differentiated markets.
A rule precluding surplus extraction when accomplished by a practice more complicated that simple monopoly pricing—say, some practice that allows price discrimination against buyers who highly value a product—would be both arbitrary and backward. The rule would be arbitrary because allowing supracompetitive profits from legitimately obtained market power motivates and enables innovation regardless of the means used to extract surplus. The rule would be backward because, while simple monopoly pricing always reduces overall market output (as output-reduction is the very means by which the producer causes price to rise), more complicated methods of extracting surplus, such as metering tie-ins, often enhance market output and overall social welfare.
A third possibility would be to preclude exercising market power to extract more surplus than is necessary to motivate and enable innovation. That position, however, would require courts to determine how much surplus extraction is required to induce innovative efforts. Courts are poorly positioned to perform such a task, and their inevitable mistakes could significantly chill entrepreneurial activity.
Consider, for example, a firm contemplating a $5 million investment that might return up to $50 million. Suppose the managers of the firm weighed expected costs and benefits and decided the risky gamble was just worth taking. If the gamble paid off but a court stepped in and capped the firm’s returns at $20 million—a seemingly generous quadrupling of the firm’s investment—future firms in the same position would not make similar investments. After all, the firm here thought this gamble was just barely worth taking, given the high risk of failure, when available returns were $50 million.
In the end, then, the best policy is to draw the line as both the U.S. Supreme Court and the Ninth Circuit have done: Whereas enhancements of market power are forbidden, merely exercising legitimately obtained market power to extract surplus is permitted.
Apple’s Policies Do Not Enhance Its Market Power
Under the legal approach described above, the two Apple policies Epic has challenged do not give rise to antitrust liability. While the policies may boost Apple’s profits by facilitating its extraction of surplus from app transactions on its mobile devices, they do not enhance Apple’s market power in any conceivable market.
As the creator and custodian of the iOS operating system, Apple has the ability to control which applications will run on its iPhones and iPads. Developers cannot produce operable iOS apps unless Apple grants them access to the Application Programming Interfaces (APIs) required to enable the functionality of the operating system and hardware. In addition, Apple can require developers to obtain digital certificates that will enable their iOS apps to operate. As the district court observed, “no certificate means the code will not run.”
Because Apple controls which apps will work on the operating system it created and maintains, Apple could collect the same proportion of surplus it currently extracts from iOS app sales and in-app purchases on iOS apps even without the policies Epic is challenging. It could simply withhold access to the APIs or digital certificates needed to run iOS apps unless developers promised to pay it 30% of their revenues from app sales and in-app purchases of digital goods.
This means that the challenged policies do not give Apple any power it doesn’t already possess in the putative markets Epic identified: the markets for “iOS app distribution” and “iOS in-app payment processing.”
The district court rejected those market definitions on the ground that Epic had not established cognizable aftermarkets for iOS-specific services. It defined the relevant market instead as “mobile gaming transactions.” But no matter. The challenged policies would not enhance Apple’s market power in that broader market either.
In “mobile gaming transactions” involving non-iOS (e.g., Android) mobile apps, Apple’s policies give it no power at all. Apple doesn’t distribute non-iOS apps or process in-app payments on such apps. Moreover, even if Apple were to being doing so—say, by distributing Android apps in its App Store or allowing producers of Android apps to include IAP as their in-app payment system—it is implausible that Apple’s policies would allow it to gain new market power. There are giant, formidable competitors in non-iOS app distribution (e.g., Google’s Play Store) and in payment processing for non-iOS in-app purchases (e.g., Google Play Billing). It is inconceivable that Apple’s policies would allow it to usurp so much scale from those rivals that Apple could gain market power over non-iOS mobile gaming transactions.
That leaves only the iOS segment of the mobile gaming transactions market. And, as we have just seen, Apple’s policies give it no new power to extract surplus from those transactions; because it controls access to iOS, it could do so using other means.
Nor do the challenged policies enable Apple to maintain its market power in any conceivable market. This is not a situation like Microsoft where a firm in a market adjacent to a monopolist’s could somehow pose a challenge to that monopolist, and the monopolist nips the potential competition in the bud by reducing the potential rival’s scale. There is no evidence in the record to support the (implausible) notion that rival iOS app stores or in-app payment processing systems could ever evolve in a manner that would pose a challenge to Apple’s position in mobile devices, mobile operating systems, or any other market in which it conceivably has market power.
Epic might retort that but for the challenged policies, rivals could challenge Apple’s market share in iOS app distribution and in-app purchase processing. Rivals could not, however, challenge Apple’s market power in such markets, as that power stems from its control of iOS. The challenged policies therefore do not enable Apple to shore up any existing market power.
Alternative Means of Extracting Surplus Would Likely Reduce Consumer Welfare
Because the policies Epic has challenged are not the source of Apple’s ability to extract surplus from iOS app transactions, judicial condemnation of the policies would likely induce Apple to extract surplus using different means. Changing how it earns profits off iOS app usage, however, would likely leave consumers worse off than they are under the status quo.
Apple could simply charge third-party app developers a flat fee for access to the APIs needed to produce operable iOS apps but then allow them to distribute their apps and process in-app payments however they choose. Such an approach would allow Apple to monetize its innovative app platform while permitting competition among providers of iOS app distribution and in-app payment processing services. Relative to the status quo, though, such a model would likely reduce consumer welfare by:
- Reducing the number of free and niche apps,as app developers could no longer avoid a fee to Apple by adopting a free (likely ad-supported) business model, and producers of niche apps may not generate enough revenue to justify Apple’s flat fee;
- Raising business risks for app developers, who, if Apple cannot earn incremental revenue off sales and use of their apps, may face a greater likelihood that the functionality of those apps will be incorporated into future versions of iOS;
- Reducing Apple’s incentive to improve iOS and its mobile devices, as eliminating Apple’s incremental revenue from app usage reduces its motivation to make costly enhancements that keep users on their iPhones and iPads;
- Raising the price of iPhones and iPads and generating deadweight loss, as Apple could no longer charge higher effective prices to people who use apps more heavily and would thus likely hike up its device prices, driving marginal consumers from the market; and
- Reducing user privacy and security, as jettisoning a closed app distribution model (App Store only) would impair Apple’s ability to screen iOS apps for features and bugs that create security and privacy risks.
An alternative approach—one that would avoid many of the downsides just stated by allowing Apple to continue earning incremental revenue off iOS app usage—would be for Apple to charge app developers a revenue-based fee for access to the APIs and other amenities needed to produce operable iOS apps. That approach, however, would create other costs that would likely leave consumers worse off than they are under the status quo.
The policies Epic has challenged allow Apple to collect a share of revenues from iOS app transactions immediately at the point of sale. Replacing those policies with a revenue-based API license system would require Apple to incur additional costs of collecting revenues and ensuring that app developers are accurately reporting them. In order to extract the same surplus it currently collects—and to which it is entitled given its legitimately obtained market power—Apple would have to raise its revenue-sharing percentage above its current commission rate to cover its added collection and auditing costs.
The fact that Apple has elected not to adopt this alternative means of collecting the revenues to which it is entitled suggests that the added costs of moving to the alternative approach (extra collection and auditing costs) would exceed any additional consumer benefit such a move would produce. Because Apple can collect the same revenue percentage from app transactions two different ways, it has an incentive to select the approach that maximizes iOS app transaction revenues. That is the approach that creates the greatest value for consumers and also for Apple.
If Apple believed that the benefits to app users of competition in app distribution and in-app payment processing would exceed the extra costs of collection and auditing, it would have every incentive to switch to a revenue-based licensing regime and increase its revenue share enough to cover its added collection and auditing costs. As such an approach would enhance the net value consumers receive when buying apps and making in-app purchases, it would raise overall app revenues, boosting Apple’s bottom line. The fact that Apple has not gone in this direction, then, suggests that it does not believe consumers would receive greater benefit under the alternative system. Apple might be wrong, of course. But it has a strong motivation to make the consumer welfare-enhancing decision here, as doing so maximizes its own profits.
The policies Epic has challenged do not enhance or shore up Apple’s market power, a salutary pre-requisite to antitrust liability. Furthermore, condemning the policies would likely lead Apple to monetize its innovative app platform in a manner that would reduce consumer welfare relative to the status quo. The Ninth Circuit should therefore affirm the district court’s rejection of Epic’s antitrust claims.