Search Results For loyalty discounts

In Collins Inkjet Corp. v. Eastman Kodak Co. (2015) (subsequently settled, leading to a withdrawal of Kodak’s petition for certiorari), the Sixth Circuit elected to apply the Cascade Health Solutions v. PeaceHealth “bundled discount attribution price-cost” methodology in upholding a preliminary injunction against Kodak’s policy of discounting the price of refurbished Kodak printheads to customers who purchased ink from Kodak, rather than from Collins.  This case illustrates the incoherence and economic irrationality of current tying doctrine, and the need for Supreme Court guidance – hopefully sooner rather than later.

The key factual and legal findings in this case, set forth by the Sixth Circuit, were as follows:

Collins is Kodak’s competitor for selling ink for Versamark printers manufactured by Kodak. Users of Versamark printers must periodically replace a printer component called a printhead; Kodak is the only provider of replacement “refurbished printheads” for such printers. In July 2013, Kodak adopted a pricing policy that raised the cost of replacing Versamark printheads, but only for customers not purchasing Kodak ink. Collins filed suit, arguing that this amounts to a tying arrangement prohibited under § 1 of the Sherman Act, 15 U.S.C. § 1, because it is designed to monopolize the Versamark ink market. Collins sought a preliminary injunction barring Kodak from charging Collins’ customers a higher price for refurbished printheads. The district court issued the preliminary injunction, finding a strong likelihood that Kodak’s pricing policy was a non-explicit tie that coerced Versamark owners into buying Kodak ink and that Kodak possessed sufficient market power in the market for refurbished printheads to make the tie effective.

On appeal, Kodak challenges both the legal standard the district court applied to find whether customers were coerced into using Kodak ink and the district court’s preliminary factual findings. In evaluating the likelihood of success on the merits, the district court applied a standard that unduly favored Collins to determine whether customers were coerced into buying Kodak ink. The court examined whether the policy made it likely that all or almost all customers would switch to Kodak ink, but did not examine whether this would be the result of unreasonable conduct on Kodak’s part. A tying arrangement enforced entirely through differential pricing of the tying product contravenes the Sherman Act only if the pricing policy is economically equivalent to selling the tied product below cost. The record makes it difficult to determine conclusively Kodak’s ink production costs, but the available evidence suggests that Kodak was worse off when customers bought both products, meaning that it was in effect selling ink at a loss. Thus, Collins was likely to succeed on the merits even under the correct standard.  Furthermore, the district court was correct in its consideration of the other factors for a preliminary injunction. Accordingly, the preliminary injunction was not an abuse of discretion.

The Sixth Circuit’s Collins Inkjet opinion nicely illustrates the current unsatisfactory state of tying law from an economic perspective.  Unlike in various other areas of antitrust law, such as vertical restraints, exclusionary conduct, and enforcement, the Supreme Court has failed to apply a law and economics standard to tying.  It came close on two occasions, with four Justices supporting a rule of reason standard for tying in Jefferson Parish, and with a Supreme Court majority acknowledging that “[m]any tying arrangements . . . are fully consistent with a free, competitive market” in Independent Ink (which held that it should not be presumed that a patented tying product conveyed market power).  Nevertheless, despite the broad scholarly recognition that tying may generate major economic efficiencies (even when the tying product conveys substantial market power), tying still remains subject to a peculiar rule of limited per se illegality, which is triggered when:  (1) two separate products or services are involved; (2) the sale or agreement to sell one is conditioned on the purchase of the other; (3) the seller has sufficient economic power in the market for the tying product to enable it to restrain trade in the market for the tied product; and (4) a “not insubstantial amount” of interstate commerce in the tied product is affected.  Unfortunately, it is quite possible for plaintiffs to shoehorn much welfare-enhancing conduct into this multipart test, creating a welfare-inimical disincentive for efficiency-seeking businesses to engage in such conduct.  (The U.S. Court of Appeals for the D.C. Circuit refused to apply the per se rule to platform software in United States v. Microsoft, but other appellate courts have not been similarly inclined to flout Supreme Court precedent.)

Courts that are concerned with the efficient application of antitrust may nonetheless evade the confines of the per se rule in appropriate instances, by applying economic reasoning to the factual context presented and finding particular test conditions not met.  The Sixth Circuit’s Collins Inkjet opinion, unfortunately, failed to do so.  It is seriously problematic, in at least four respects.

First, the Sixth Circuit’s opinion agreed with the district court that “coercive” behavior created an “implicit tie,” despite the absence of formal contractual provisions that explicitly tied Kodak’s ink to sale of its refurbished printheads.

Second, it ignored potential vigorous and beneficial ex ante competition among competing producers of printers to acquire customers, which would have negated a finding of significant economic power in the printer market and thereby precluded per se condemnation.

Third, it incorrectly applied the PeaceHealth standard to the facts at hand due to faulty economic reasoning.  For a finding of anticompetitive (“exclusionary”) bundled discounting, PeaceHealth requires that, after all discounts are applied to the “competitive” product, “the resulting price of the competitive product or products is below the defendant’s incremental cost to produce them”.  In Collins Inkjet, all that was known was that Kodak “stood to make more money if customers bought ink from Collins and paid Kodak’s unmatched printhead refurbishment price than if they bought Kodak ink and paid the matched printhead refurbishment price.”  Absent additional information, however, this merely supported a finding that Kodak’s tied ink was priced below its average total cost, not below its (far lower) incremental cost.  (Applying PeaceHealth, the Collins Inkjet court attributed the printhead discount entirely to Kodak’s ink, the tied product.)  In short, absent this error in reasoning (ironically, the court justified its flawed cost analysis “as a matter of formal logic”), the Sixth Circuit could not have based a finding of anticompetitive conduct on the PeaceHealth precedent.

Fourth, and more generally, the Sixth Circuit’s opinion, in its blinkered search for a “modern” (PeaceHealth) finely-calibrated test to apply in this instance, lost sight of the Supreme Court’s broad teaching in Reiter v. Sonotone Corp. that antitrust law was designed to be “a consumer welfare prescription.”  Kodak’s pricing policy that offered discounts to buyers of its printheads and ink yielded lower prices to consumers.  There was no showing that Collins Inkjet would likely be driven out of business, or, even if it were, that consumers would eventually be harmed.  Absent any showing of likely anticompetitive effects, vertical contractual provisions, including tying, should not be subject to antitrust challenge.  Indeed, as Professor (and former Federal Trade Commissioner) Joshua Wright and I have pointed out:

[T]he potential efficiencies associated with . . . tying . . . and the fact that [tying is] prevalent in markets without significant antitrust market power, lead most commentators to believe that [it is] . . . generally procompetitive and should be analyzed under some form of rule of reason analysis. . . .  [T]he adoption of a rule of reason for tying and presumptions of legality for [tying] . . . under certain circumstances may be long overdue.  

In sum, it is high time for the Supreme Court to take an appropriate case and clarify that tying arrangements (whether explicit or “coerced”) are subject to the rule of reason, with full recognition of tying’s efficiencies.  Such a holding would enable businesses to engage in a wider variety of efficient contracts, thereby promoting consumer welfare.

Finally, while it is at it, the Court should also consider taking a loyalty discount case, to reduce harmful uncertainty in this important area (caused by such economically irrational precedents as LePage’s, Inc. v. 3M) and establish a clear standard to guide the business community.  If it takes a loyalty discount case, the Court could beneficially draw upon Wright’s observation that “economic theory and evidence suggest[s] that instances of anticompetitive loyalty discounts will be relatively rare,” and his recommendation that “an exclusive dealing framework . . . be applied in such cases.”

Guest post by Steve Salop responding to Dan’s latest post on the appropriate liability rule for loyalty discounts. Other posts in the series: SteveDan, and Thom.

(1) Dan says that price-cost test should apply to “customer foreclosure” allegations.   One of my key points was that many loyalty discount claims involve “input foreclosure” or “raising rivals’ costs” effects, not plain-vanilla customer foreclosure.   In addition, loyalty agreements with distributors often involve input foreclosure because “distribution services” are an input and a rebate might be characterized as a reward payment for the (near-) exclusivity.    From his silence on the issue, I am inclined to presume that Dan would agree that the price-cost test should not be applied to such allegations.      Dan, what do you intend?

(2) Dan says that he agrees that the price-cost test should not be required for “partial exclusivity contracts” that involve contractual commitments to limit purchases from rivals.  He says that the price-cost test should apply only where the “claimed exclusionary mechanism is the price term.”  This distinction is peculiar because the economic analysis is the same in both situations.  In addition, even such voluntary exclusivity flowing from a price term can be anticompetitive, and even if the price-cost test is passed.  There are numerous reasons for this, as I explained in my original post. (I also discuss these issues in my contribution to Robert Pitofsky’s volume, “How the Chicago School Overshot the Mark.”  See also articles by Eric Rasmussen et. al., Michael Whinston and others.)

(3) Consider the following numerical examples that concretely illustrate the economic forces at work when there is competition for distribution, even in the absence of contractual commitments.

(a) Suppose that a monopolist is earning profits of $200.  If there is successful entry by an equally efficient entrant, each of the two firms will earn duopoly profits of $70.  (The duopoly profits are less than monopoly profits because of the price competition.)  Suppose that the entrant needs to obtain just non-exclusive distribution from a particular retailer in order to be viable.  In this case, the entrant would be willing to bid up to $70 per period for the non-exclusive distribution.  (In price terms, this would be a payment that led to the entrant’s costs equaling its price.)  But the monopolist would be willing to bid up to $130 for an exclusive (i.e., the difference between its monopoly and duopoly profits), in order to prevent the entrant from surviving.   Thus, the monopolist would win the bidding, say for a price of $71.   The monopolist would easily pass the price-cost test.   Why is the monopolist systematically able to outbid the entrant? This fundamental asymmetry does not arise because the entrant is less efficient.  Instead, the answer is that the monopolist is bidding to maintain its monopoly power, whereas the entrant can only obtain duopoly price.  The monopolist is “purchasing market power” in addition to distribution, whereas the entrant is only purchasing distribution.

(b) Or, consider this interesting variant with sequential bidding for multiple distributors.   Suppose there are two retailers and the entrant needs to get non-exclusive distribution at both in order to be viable.  Suppose that the negotiations at the two stores are sequential.  In this scenario, the entrant would have no incentive even to try to outbid the monopolist.   This is easy to see.   Suppose that the entrant wins the competition to get into the first store by paying the amount $B1.   In bidding for distribution at the second retailer, the monopolist would be willing to bid up to $130, as above.   At this second store, the entrant would not be willing to pay more than $70 (or $70 – $B1, if it is ignores the fact that the $B1 was an already sunk cost).  So the monopolist will win the exclusive at the second retailer and the entry will fail.   Looking back to the negotiations at the first store, the entrant would have had no incentive to throw away money by paying any positive amount $B1 to get distribution at the first store.   This is because it rationally would anticipate that it is inevitable that it will fail to gain distribution at the second retailer.  Thus, the monopolist will be able to gain the exclusive at both stores for next to nothing.   It clearly will pass the price-cost test even as it maintains its monopoly, merely by instituting the competition for distribution.

(c) If the entrant only needs to gain non-exclusive distribution at either one of the two stores, then the situation can be reversed and the entry can succeed.   The monopolist clearly would not be willing to pay $71 each at both stores (equal to a total payment of $142) in order to deter the entry and protect its “incremental” monopoly profits (equal to only $130 in the example).  Therefore, when the entrant bids for distribution at the first store, the monopolist might as well let the entrant win, which means that the entrant can gain access to both stores for next to nothing.   The entry succeeds, but again, the price-cost test would not be relevant to the analysis.

(d) There also can be elements of a “self-fulfilling equilibrium” because of lack of coordination by the distributors.  Suppose that there are 10 retailers and the entrant only needs to get distribution at 5 of them.   Suppose that the entrant offers to pay a $14 rebate for non-exclusive distribution, and it also will offer $14 again in the next period, if its entry succeeds in the first period.   Suppose the monopolist offers a lower rebate for an exclusive that will continue into the second period.   Suppose that each of the 10 retailers anticipates that the other retailers will accept the monopolist’s lower offer out of fear that the entrant will be unable to get 4 other retailers to accept its offer.  In that situation, the entry will fail.  This is not because the entrant is less efficient.  Instead, it is because the entrant faces a classic coordination problem.  If the retailers behave independently, the retailers’ fear of the entrant’s failure can be a self-fulfilling prophecy.   Again, the monopolist will easily pass the price-cost test.

(4) Dan makes the point that the price-cost test does not require adoption of an EEC antitrust standard (i.e., whereby only harm to EECs is relevant to antitrust).  I certainly agree that the price-cost screen does not necessarily rely on the EEC standard.   The price-cost test is better framed as a measure of “profit-sacrifice,” and EEC is simply a misleading way to express the test.  For example, I expect that Dan agrees that predatory pricing law uses the price-cost test as a measure of “profit-sacrifice,” not an assumption that only EECs matter.

(5) But, I was surprised that Dan also says that the EEC theory “has merit.”  In my view, the EEC standard has no merit in rigorous antitrust analysis. The example in my previous post illustrates why that is the case.  Raising the costs and possibly deterring the entry of a less efficient rival harms consumers and reduces output.

(6) Dan says that the “disloyalty penalty” price theory has problems, “including the empirical one that it doesn’t fit the pattern of almost any of the recent loyalty discount cases.”   The validity of Dan’s empirical claim is not obvious clear to me.  To evaluate whether there is a price penalty, you would need to know more than the path of prices over time.  You also would need to know what the price would be in the “but-for world.”   For example, suppose that in the absence of the loyalty discount, the incumbent would have reduced its price to $90.  This observation has two important implications.  First, this is a reason why it is not clear that loyalty discounts are “presumptively beneficial.”  Second, this is another reason why a price-cost test is not a good “screen” in loyalty discount cases.  Implementing the screen involves evaluating what prices would be absent the conduct.  But, after the competitive effects on consumers are known, what is the value of the screen?

(7) As to the question of whether Josh’s speech on loyalty discounts (and this issue of penalty prices) is inconsistent with their joint article on bundled discounts, I will leave that one for Josh and Dan to sort out, at least for the moment.   I certainly will concede the point that Wright is not always right.

(8) Dan began to suggest that the penalty price theory has a “problem of basic economics” in that the penalty price was not short-run profit-maximizing.   Dan subsequently seemed to withdraw this criticism, noticing that one could characterize the loyalty restriction as not profit-maximizing in the same way.   In any event, it is not a “problem” with the theory.  The reason why the firm is willing to sacrifice profits is because it gains the benefit of deterring entry.  By the way, it also may not even end up sacrificing profits.  The threat of the penalty price for non-exclusivity may be sufficient.  If the distributors succumb to the threat and buy exclusively from the incumbent, it never needs to actually charge them the penalty price.

Guest post by Dan Crane, responding to Steve’s post responding to Dan’s earlier post and Thom’s post on the appropriate liability rule for loyalty discounts.

Something that Thom and I both said in our earlier posts needs to be repeated at the outset:  I don’t know of anyone who disagrees with Steve and Josh that raising rivals’ costs (“RRC”) and economic analysis drawn from exclusive dealing law belong in an analysis of loyalty discounts.  There’s also no claim on the table that a loyalty discount that fails the “contestable share”/discount attribution test that Steve mentions should be treated anything like presumptively illegal.  The current debate is solely about whether there should be a price-cost screen in loyalty discount cases.  We aren’t even talking about what the measure of cost should be or how that screen should work (although, with Steve, I’m happy to assume marginal or average variable cost and the aforementioned contestable share/discount attribution approach for the sake of argument).  Josh and Steve are well justified in pointing out how aspects of RRC theory can apply in loyalty discount cases—but that doesn’t meet the objection that a screen should also apply.

It’s also important to recognize that the argument in favor of a price-cost screen for loyalty rebates does not need to entail a general argument in favor of a “profit sacrifice” theory for all monopolization offenses.  What we’re talking about here is unilaterally determined discounts to customers—something that is presumptively procompetitive, although potentially exclusionary under some circumstances.  Such discounts could be harmful if they resulted in customer foreclosure, but they would not result in customer foreclosure if the rival could profitably match the loyalty discount.  That is the point of the price-cost screen.  You might wonder why a rival would ever complain about a loyalty discount if they could profitably match it.  The reasons are many.  The rival might be losing sales because customers don’t like its product.  It might have failed for reasons completely apart from the accused firm’s loyalty discounts. It might be attempting to use antitrust law to thwart price competition, as a large body of literature suggests.  (See work by Will Baumol and Janusz Ordover, Preston McAfee and Nicholas Vakkur, and Edward Snyder and Tom Kauper, among others).

One thing I didn’t just mention—although it could often be true—is that the complaining rival isn’t an equally efficient competitor (“EEC”).  Steve is wrong to suggest that the price-cost test depends on adopting an EEC theory.  Although there is much merit to the EEC test (heck, even the Europeans have adopted it), one could formulate a version of the price-cost screen that simply requires the rival to show that the discount foreclosed a hypothetically equally efficient competitor or even this particular rival given its actual costs, as some have suggested.  The current argument is not over the formulation of the test, but whether we should dispense with a price-cost screen altogether in loyalty discount cases.

In any event, observe that the entire structure of modern predatory pricing law is premised on an EEC assumption.  If an incumbent firm with marginal costs of $50 and a current price of $100 faces entry by a new rival with marginal costs of $75 and drops its price to $74 in order to exclude the new rival, it enjoys categorical immunity under a long line of Supreme Court cases.  In another forum, Steve suggested that the difference in those cases is that the customer is getting the benefit of a lower price, so the law is hesitant to condemn the price as predatory.  But that exposes something problematic about Steve’s starting premise—he assumes that it’s uncertain whether loyalty discounts generally lower prices.  Prima facie, that seems wrong.  Customers routinely offer to trade loyalty for lower prices precisely because the prices are . . . lower.

Steve suggests that maybe loyalty discounts aren’t really discounts at all.  Maybe the seller, who was previously charging a price of $100, raises the price to $105 and then gives a discount back down to $100 in exchange for customer loyalty.  Steve notes that Thom and I didn’t consider this scenario.  That’s because Josh didn’t raise it in his speech.  It would have been very surprising if Josh had raised it in his speech, since Josh and I co-authored a paper several years ago debunking this same theory in the bundled discount context.  I discuss the “disloyalty penalty” theory at length in a forthcoming article in the Texas Law Review, really just extending the work that Josh and I started several years ago.

There are many problems with this “disloyalty penalty” theory, including the empirical one that it doesn’t fit the pattern of almost any of the recent loyalty discount cases.  But there is also a problem of basic economics.  Unless it is engaging in limit pricing, the accused firm’s $100 price is a monopoly (or market power) profit-maximizing price.  By definition, any price increase will be unprofitable to the seller.  Obviously, the $105 price would be unprofitable.  But it’s also true that a price of $100 coupled with a new obligation to buy a certain percentage of requirements from the seller to achieve that price is unprofitable because it exceeds the profit-maximizing price.  The addition of a contractual term that restricts the buyer’s freedom is economically equivalent to a price increase if the buyer valued the prior freedom from the restriction (if the buyer didn’t value the prior freedom from the restriction there’s no effective price increase but also no anticompetitive effect, since the buyer wouldn’t have bought from the rival anyway).  Hence a price of $100 with loyalty term is effectively higher than a price of $100 without a loyalty term that restricts the buyer’s purchasing freedom.  By adding a loyalty term to obtain the $100 price, the seller exceeds its profit-maximizing monopoly price.

My claim is not that “penalty pricing” for disloyalty is impossible, but that the presumption should be that loyalty discounts are true discounts off the but-for price.  Loyalty discounts belong squarely in the “hospitability” tradition for unilaterally determined pricing structures—all those judicial decisions that talk about how important it is not to chill vigorous price competition.

Steve argues that loyalty discounts may “tie up customers” before competitors arrive on the scene.  I’m not sure what Steve means by “tie up customers.”  Suppose that a monopolist, knowing that rivals are about to enter the market, goes to all of its customers and offers  them a 5% discount if they will agree to purchase 95% of their requirements from the monopolist for the next three years.  At that point we have a partial exclusive dealing contract and the cost-price screen shouldn’t be required.  But, there, the exclusionary mechanism—the thing that keeps rivals from competing—is not the loyalty discount but rather the contractual commitment not to buy any more than 5% of requirements from rivals.  Customers would have to breach their contract in order to consider even the most advantageous offers from rivals.  The point that amici made in our Meritor v. Eaton brief was that when the claimed mechanism of exclusion is a price term and not a contractual restriction on purchasing from rivals, some version of the price-cost screen should apply.

The example I’ve just attributed to Steve (and sorry Steve if this is not what you have in mind) is not what we’re talking about in almost any of the current generation of loyalty discount cases.  In Meritor, for example, the Third Circuit acknowledged that the loyalty provisions at issue did not require customers to buy any of their requirements from Eaton.  It’s just that if the customers didn’t meet the loyalty thresholds, they would lose a possible rebate.  Meritor could compete for that business by offering its own counter-rebates so long as it wouldn’t have had to price unprofitably to do so.

Steve’s point about economies of scale is one that I covered in my post and is fully accounted for by the cost-price screen.  A rival who can profitably match a loyalty discount scheme is not foreclosed from operating at any particular scale.

The same is true of Steve’s point about loyalty discount schemes foreclosing a new seller’s ability to make incremental sales that don’t reduce the accused firm’s own sales.  Again, so long the rival can profitably match the discounts, there is no reason that output should be reduced.

Finally, Steve asserts that loyalty discounts obtained by intermediaries may not be passed onto ultimate consumers.  That’s equally true of conventional single-firm price reductions that are categorically immunized from antitrust liability under a long line of precedent.  One may not like the price-cost test in any context for that reason or others, but there’s nothing special about its application to loyalty discounts. The common denominator of all of these points is that loyalty discounts aren’t exclusionary unless they force rivals to price below cost in order to match the customer’s loss of the loyalty discounts if they fail to meet the loyalty threshold.

Steve thinks the price-cost screen exhibits “formalism”—that dreaded epithet in the post-realist world—but it’s actually just an expression of economic common sense.  Steve and Josh are excellent economists and it’s hard for me to imagine a case in which they would condemn a loyalty discount if there was undisputed evidence that the allegedly excluded rival could have completely neutralized the financial inducement of the loyalty discount by offering a counter-discount of its own without pricing below cost.  If they can offer an example of a circumstance where such a loyalty discount should be condemned, I would be very interested to hear it.  If they can’t, then they have implicitly adopted a version of the price-cost screen and, to repeat a point from my earlier post, all we’re haggling over is the price.

Guest post by Steve Salop, responding to Dan’s post and Thom’s post on the appropriate liability rule for loyalty discounts.

I want to clarify some of the key issues in Commissioner Wright’s analysis of Exclusive Dealing and Loyalty Discounts as part of the raising rivals’ costs (“RRC”) paradigm. I never thought that I would have to defend Wright against Professors Lambert and Crane. But, it appears that rigorous antitrust analysis sometimes makes what some would view as strange bedfellows.

In my view, there should not be a safe harbor price-cost test used for loyalty discounts. Nor should these discounts be treated as conclusively (per se) illegal if the defendant fails the price-cost test. Either way, the test is a formalistic and unreliable screen. To explain these conclusions, and why I think the proponents of the screen are taking too narrow approach to these issues, I want to start with some discussion of the legal and economic frameworks.

In my view, there are two overarching antitrust legal paradigms for exclusionary conduct – predatory pricing and raising rivals’ costs (RRC), and conduct that falls into the RRC paradigm generally raises greater antitrust concerns. (For further details, see my 2006 Antitrust L.J. article, “Exclusionary Conduct, Effect on Consumers, and the Flawed Profit-Sacrifice Standard.”) Commissioner Wright also takes this approach in his speech of identifying and distinguishing the two paradigms.

This raises the question of which framework is better suited for addressing exclusive dealing and loyalty discounts (that is, where the conduct is not pled in the complaint as predatory pricing). Commissioner Wright’s speech articulates the view that theories of harm alleging RRC/foreclosure should be analyzed under exclusive dealing law, which is more consistent with the raising rivals’ costs approach, not under predatory pricing law (i.e., with its safe harbor for prices above cost). (Incidentally, I don’t read his speech as saying that he has abandoned Brooke Group for predatory pricing allegations. For example, it seems clear that he would support a price-cost test in a case alleging that a loyalty discount harmed competition via predatory pricing rather than RRC/foreclosure.)

To understand which legal framework – raising rivals’ costs/exclusive dealing versus predatory pricing/price-cost test – is most relevant for analyzing the relevant competitive issues, I want to begin with a primer on RRC theories of foreclosure. This will also hopefully bring everyone closer on the economics.

Input Foreclosure and Customer Foreclosure

There are two types of foreclosure theories within the RRC paradigm — “input foreclosure” and “customer foreclosure.” Both are relevant for evaluating exclusive dealing and loyalty discounts. The input foreclosure theory says that the ED literally “raises rivals’ costs” by foreclosing a rival’s access to a critical input subject to ED. The customer foreclosure theory says that ED literally “reduces rivals’ revenues” by foreclosing a rival’s access to a sufficient customer base and thereby drives the rival out of business or marginalizes it as a competitor (i.e., where it lacks the ability or incentive to move effectively beyond a niche position or to invest to grow).

Commissioner Wright’s speech tended to merge the two variants. But, it is useful to distinguish between them. (I think that this is one source of Professor Lambert being “baffled” by the speech, and more generally, is a source of confusion among commentators that leads to unnecessary disagreements.)

In the simplest presentation, one might say that customer foreclosure concerns are raised primarily by exclusive dealing with customers, while input foreclosure concerns are raised primarily by exclusive dealing with input suppliers. But, as noted below, both concerns may arise in the same case, and especially so where the “customers” are distributors rather than final consumers, and the “input” is distribution services.

Analysis of exclusive dealing (ED) often invokes the customer foreclosure theory. For example, Lorain Journal may be analyzed as customer foreclosure. However, input foreclosure is also highly relevant for analyzing ED because exclusive dealing often involves inputs. For example, Judge Posner’s famous JTC Petroleum cartel opinion can be interpreted in this way, if there were solely vertical agreements.

Cases where manufacturers have ED arrangements with wholesale or retail distributors might be thought to fall into the customer foreclosure theory because the distributors can be seen as customers of the manufacturer. However, distributors also can be seen as providing an input to the manufacturer, “distribution services.” For example, a supermarket or drug store provides shelf space to a manufacturer. If the manufacturer (say, unilaterally) sets resale prices, then the difference between this resale price and the wholesale price is the effective input price.

One reason why the input foreclosure/customer foreclosure distinction is important involves the proper roles of minimum viable scale (MVS) and minimum efficient scale (MES). The customer foreclosure theory may involve a claim that the rival likely will be driven below MVS and exit Or it may involve a claim that the rival will be driven below MES, where its costs will be so much higher or its demand so much lower that it will be marginalized as a competitor.

By contrast, and this is the key point, input foreclosure does not focus on whether the rival likely will be driven below MVS. Even if the rival remains viable, if its costs are higher, it will be led to raise the prices charged to consumers, which will cause consumer harm. And prices will not be raised only in the future. The recoupment can be simultaneous.

Another reason for the importance of the distinction is the role of the “foreclosure rate,” which often is the focus in customer foreclosure analysis. For input foreclosure, the key foreclosure issue is not the fraction of distribution input suppliers or capacity that is foreclosed, but rather whether the foreclosure will raise the rival’s distribution costs. That can occur even if a single distributor is foreclosed, if the exclusivity changes the market structure in the input market or if that distributor was otherwise critical. (For example, see Krattenmaker and Salop, “Anticompetitive Exclusion.”)

At the same time, it is important to note that the input/customer foreclosure distinction is not a totally bright line difference in many real world cases. A given case can raise both concerns. In addition, customer foreclosure sometimes can raise rivals costs, and input foreclosure sometimes (but not always) can cause exit.
While input foreclosure can succeed even if the rival remains viable in the market, in more extreme scenarios, significantly higher costs inflicted on the rival could drive the rival to fall below minimum viable scale, and thereby cause it to exit. I think that this is one way in which unnecessary disagreements have occurred. Commentators might erroneously focus only this more extreme scenario and overlook the impact of the exclusives or near-exclusives on the rival’s distribution costs.

Note also that customer foreclosure can raise a rival’s costs when there are economies of scale in variable costs. For this reason, even if the rival does not exit or is not marginalized, it nonetheless may become a weaker competitor as a result of the exclusivity or loyalty discount.

These points also help to explain why neither a price-cost test nor the foreclosure rate will provide sufficient reliable evidence for either customer foreclosure or input foreclosure, which I turn to next.

(For further discussion of the distinction between input foreclosure and customer foreclosure, see Riordan and Salop, Evaluating Vertical Mergers: A Post-Chicago Approach, 63 ANTITRUST L.R. 513(1995). See also the note on O’Neill v Coca Cola in Andrew Gavil, William Kovacic and Jonathan Baker, Antitrust Law in Perspective: Cases, Concepts and Problems in Competition Policy (2d ed.) at 868-69. For analysis of Lorain Journal as customer foreclosure, see Gavil et. al at 593-97.)

The Inappropriateness of a Dispositive Price-Cost Test

A price-cost test obviously is not relevant for evaluating input foreclosure concerns, even where the input is distribution services. Even if the foreclosure involves bidding up the price of the input, it can succeed in permitting the firm to achieve or maintain market power, despite the fact that the firm does not bid to the point that its costs exceed its price. (In this regard, Weyerhaeuser was a case of “predatory overbuying,” not “raising rivals’ cost overbuying.” The allegation was that Weyerhaeuser would gain market power in the timber input market, not the lumber output market.)

Nor is a price-cost test the critical focus for assessing customer foreclosure theories of competitive harm. (By the way, I think we all agree that the relevant price-cost test involves a comparison of the incremental revenue and incremental cost of the “contestable volume” at issue for the loyalty discount. So I will not delve into that issue.)

First, and most fundamentally, the price-cost test is premised on the erroneous idea that only equally efficient competitors are worth protecting. In other words, the price-cost requires the premise that the antitrust laws only protect consumers against competitive harm arising from conduct that could have excluded an equally efficient competitor. This premise makes absolutely no economic sense. One simple illustrative example is a monopolist raising the costs of a less efficient potential competitor to destroy its entry into the market. Suppose that monopolist has marginal cost of $50 and a monopoly price of $100. Suppose that there is the potential entrant has costs of $75. If the entry were to occur, the market price would fall. Entry of the less efficient rival imposes a competitive constraint on the monopolist. Thus, the entry clearly would benefit consumers. (And, it clearly often would raise total welfare as well.) It is hard to see why antitrust should permit this type of exclusionary conduct.

It is also unlikely that antitrust law would allow this conduct. For example, Lorain Journal is probably pretty close to this hypothetical. WEOL likely was not equally efficient. The hypothetical probably also fits Microsoft pretty well.

Second, the price-cost test does not make economic sense in the case of the equally efficient rival either. Even if the competitor is equally efficient, bidding for exclusives or near-exclusives through loyalty discounts often does not take place on a level playing field. There are several reasons for this. One reason is that the dominant firm may tie up customers or input providers before the competitors even arrive on the scene or are in a position to counterbid. A second reason is that the exclusive may be worth more to the dominant firm because it will allow it to maintain market power, whereas the entrant would only be able to obtain more competitive profits. In this sense, the dominant firm is “purchasing market power” as well as purchasing distribution. (This point is straightforward to explain with an example. Suppose that the dominant firm is earning monopoly profits of $200, which would be maintained if it deters the entry of the new competitor. Suppose that successful entry by the equally efficient competitor would lead to the dominant firm and the entrant both earning profits of $70. In this example, the entrant would be unwilling to bid more than $70 for the distribution. But, the dominant firm would be willing to bid up to $130, the difference between its monopoly profits of $200 and the duopoly profits of $70.) A third reason is that customers may not be willing to take the risk that the entry will fail, where failure can occur not because the entrant’s product is inferior but simply because other customers take the exclusive deal from the dominant firm. In this case, a fear that the entrant would fail could become a self-fulfilling prophecy because the customers cannot coordinate their responses to the dominant firms’ offer. Lorain Journal may provide an illustrative example of this self-fulfilling prophecy phenomenon. This last point highlights a more general point Commissioner Wright made in his speech — that successful and harmful RRC does not require a below-cost price (net of discounts). When distributors cannot coordinate their responses to the dominant firm’s offer, a relatively small discount might be all that is required to purchase exclusion. Thus, while large discounts might accompany RRC conduct, that need not be the case. These latter reasons also explain why there can be successful foreclosure even when contracts have short duration.

Third, as noted above, customer foreclosure may raise rivals’ costs when there are economies of scale. The higher costs of the foreclosed rivals are not well accounted for by the price-cost test.

Fourth, as stressed by Joe Farrell, the price-cost test ignores the fact that loyalty discounts triggered by market share may deter a customer’s purchases from a rival that do not even come at the expense of the dominant firm. (For example, suppose in light of the discounts, the customer is purchasing 90 units from the dominant firm and 10 from the rival in order to achieve a “reward” that comes from purchasing 90% from the dominant firm. Now suppose that entrant offers a new product that would lead the customer to wish to continue to purchase 90 units from the dominant firm but now purchase 15 units from the rival. The purchase of these additional 5 units from the rival does not come at the expense of the dominant firm. Yet, even if the entrant were to offer the 5 units at cost, these purchases would be deterred because the customer would fall below the 90% trigger for the reward.) In this way, the market share discount can directly reduce output.

Fifth, the price-cost test assumes that the price decreases will be passed on to final consumers. This may be the clear where the exclusives or loyalty discounts are true discounts given to final consumers. But, it may not be the case where the dominant firm is acquiring the loyalty from input suppliers, including distributors who then resell to final consumers. The loyalty discounts often involve lump sum payments, which raises questions about pass-on, at least in the short-run.

Finally, it is important to stress that the price-cost test for loyalty discounts assumes that price actually represents a true discount. I expect that this assumption is the starting point for commentators who give priority to the price-cost test. However, the price may not represent a true discount in fact, or the size of the discount may turn out to be smaller than it appears after the “but-for world” is evaluated. That is, the proponents of a price-cost test have the following type of scenario in mind. The dominant firm is initially charging the monopoly price of $100. In the face of competition, the dominant firm offers a lower price of (say) $95 to customers that will accept exclusivity, and the customers accept the exclusivity in order to obtain the $5 discount. (To illustrate, suppose that absent the exclusive, the customers would purchase 90 units from the dominant firm at $100 for total revenue of $9000. With the exclusive, they purchase 100 units at a price of $95 for total revenue of $9500.
Thus, the dominant firm earns incremental revenue of $500 on the 10 incremental units, or $50 per unit. If the dominant firm’s costs are $50 or less, it will pass the price-cost test.) But, consider next the following alternative scenario. The dominant firm offers the original $100 price to those customers that will accept exclusivity, and sets a higher “penalty” price of $105 to customers that purchase non-exclusively from the competitor. In this latter scenario, the $5 discount similarly may drive customers to accept the exclusive. These prices would lead to a similar outcome of the price-cost test. (To illustrate, suppose that absent the exclusive, the customers would purchase 90 units from the dominant firm at $105 for total revenue of $9450. With the exclusive, they purchase 100 units at a price of $100 for total revenue of $10,000. Thus, the dominant firm earns revenue of $550 on the 10 incremental units, or $55 per unit. Here, the dominant firm will pass the price-cost test, if its costs are $55 or less.) However, in this latter scenario, it is noteworthy that the use of the “penalty” price eliminates any benefits to consumers. This issue seems to be overlooked by Crane and Lambert. (For further details of the role of the penalty price in the context of bundled discounts, see Barry Nalebuff’s articles on Exclusionary Bundling and the articles of Greenlee, Reitman and Sibley.)

* * *

For all these reasons, treating loyalty discounts as analogous to predatory pricing and thereby placing over-reliance on a price-cost test represents a formalistic and unreliable antitrust approach. (It is ironic that Commissioner Wright was criticized by Professor Lambert for being formalistic, when the facts are the opposite.)

This analysis is not to say that the court should be indifferent to the lower prices, where there is a true discount. To the contrary, lower prices passed-on would represent procompetitive efficiency benefits. But, the potential for lower prices passed-on does not provide a sufficient basis for adopting a price-cost safe harbor test for loyalty discount allegations, even ones that can be confidently characterized as purely plain vanilla customer foreclosure with no effects on rivals’ costs.

Thus, the price-cost test should be one relevant evidentiary factor. But, it should not be the primary factor or a trump for either side. That is, above-cost pricing (measured in terms of incremental revenue less than incremental cost) should not be sufficient by itself for the defendant to escape liability. Nor should below-cost pricing (again, measured in terms of incremental revenue less than incremental cost) should not be a sufficient by itself for a finding of liability.

Such “Creeping Brookism” does not led to either rigorous or accurate antitrust analysis. It is a path to higher error rates, not a lower ones.

Nor should courts rely on simple-minded foreclosure rates. Gilbarco shows how a mechanical approach to measuring foreclosure leads to confusion. Microsoft makes it clear that a “total foreclosure” test also is deficient. Instead, a better approach is to require the plaintiff to prove under the Rule of Reason standard that the conduct harms the rival by reducing its ability to compete and also that it harms consumers.

I should add one other point for completeness. Some (but not Commissioner Wright or Professor Crane) might suggest that the price-cost test has administrability benefits relative to a full rule of reason analysis under the RRC paradigm. While courts are capable are evaluating prices and costs, that comparison may be more difficult than measuring the increase in the rivals’ distribution costs engendered by the conduct. Moreover, the price-cost comparison becomes an order of magnitude more complex in loyalty discount cases, relative to plain vanilla predatory pricing cases. This is because it also is necessary to determine a reasonable measure of the contestable volume to use to compare incremental revenue and incremental cost. For first-dollar discounts, there will always be some small region where incremental revenue is below incremental cost. Even aside from this situation, the two sides often will disagree about the magnitude of the volume that was at issue.

In summary, I think that Professor Wright’s speech forms the basis of moving the discussion forward into analysis of the actual evidence of benefits and harms, rather than continuing to fight the battles over whether the legal analysis used in the 1950s and 1960s failed to satisfy modern standards and thereby needed to be reined in with unreliable safe harbors.

Guest post by Michigan Law’s Dan Crane. (See also Thom’s post taking issue with FTC Commissioner Josh Wright’s recent remarks on the appropriate liability rule for loyalty discounts).

A number of people on both sides of the ideological spectrum were surprised by FTC Commissioner Josh Wright’s recent speech advocating that the FTC reject the use of price-cost tests to assess the legality of loyalty discounts and instead pursue an exclusive dealing framework of analysis.  As the author of a brief (unsuccessfully) urging the Supreme Court to grant certiorari and reverse in Z.F. Meritor v. Eaton, I want respectfully to disagree with some of what Josh had to say.  But, first, two other observations.

First, I’m delighted that Josh is charting a course as Commissioner that defies some people’s expectations (even if they sometimes happen to be my own!).  Josh has long insisted on evidence-based analysis rather than simplistic theorizing or reductionist legal rules and his position on loyalty discounts is consistent with that theme.  Early in his term on the Commission, Josh is making it clear that he will exercise independent judgment, intellectual integrity, and a principled, non-ideological approach to decision-making.  That’s a nice rejoinder to those who believe that antitrust law reduces to simplistic right-left politics.  So kudos to Josh!

Second, Josh and I probably agree on 90% of what’s important about loyalty discounts.  We agree that loyalty discounts are usually competitively benign or procompetitive, but that they can sometimes be anticompetitive when they exclude rivals and create market power.  We also agree that exclusive dealing principles and analysis can be usefully deployed in loyalty discount cases (although I would only do so after a plaintiff satisfied a price-cost screen).  Finally, we also agree that unmodified predatory pricing rules—requiring the plaintiff to show that the defendant’s sales were below average variable cost—could potentially insulate some exclusionary loyalty discounts from antitrust scrutiny.

Where we differ is on the question of whether antitrust law should ever condemn a loyalty discount that the allegedly excluded rival could have met without pricing below cost.  To say that it should not is to say that there should be some sort of price-cost screen in place in loyalty discount cases.  Josh rejects the use of such screens.

One point of clarification:  Josh asserts that one of the central claims in favor of the price-cost test is its ease of administration.  Contrary to Josh’s suggestion, that is not an argument we made in our Meritor amicus brief.  As someone who has counseled clients and litigated these issues, I can attest that the discount attribution test (the variant of the price-cost test I support for loyalty discounts) is anything but easy to apply (which Josh himself recognizes with respect to the “contestable share” idea).  The virtue of the test is not its ease of administration, but that it requires plaintiffs to show that the discount scheme actually foreclosed them from competing.  Our point was about analytical discipline, not ease of administration.

This, I think, is the crucial difference between Josh and me.  Unless a rival would have to price below cost to match a loyalty discount, it is not foreclosed from competing for the business covered by the discount.  Josh wants to apply exclusive dealing analysis that looks at foreclosure without answering a question that, in my view, is necessary to discover whether there is any foreclosure at all—whether the rival could profitably match the discount.  A rival that has a profitable “predatory counterstrategy,” to quote Frank Easterbrook, isn’t foreclosed.

A thought experiment may be helpful.  Suppose that a firm with a 90% market share offered all of its customers a 0.0001% rebate if they purchased at least 80% of their requirements from the dominant firm.  No one could imagine that such a “loyalty discount” could exclude rivals, since even small rivals could easily make up the rebates foregone if customers forewent buying the 80% from the dominant firm.  We can make the rebate 0.001% with the same result.  And we can continue to pose successive iterations of the same question, increasing the discount incrementally, until we hit a point that someone could reasonably say “well now that could be exclusionary.”  Wherever we cross that Rubicon, we cross it because what was true at 0.0001%—that the small rival could laugh it off by shelling out a few dollars in a counter-discount—is no longer true.  To play this game is to conduct a competitive response sensitivity analysis of the very kind demanded by the attribution test. For present purposes, it’s unimportant where we draw the line; it’s the fact of the line-drawing that matters. To paraphrase Winston Churchill, we’ve already established what we are, now we’re just haggling over the price.

Josh is surely right that loyalty discounts can raise rivals’ costs.  That could happen in one of two ways.  First, if a small firm were prevented from reaching efficient scale, or second if a firm were forced to ramp up to an inefficiently large scale in order to meet a competitor’s loyalty discounts.  But neither of those scenarios holds if the rival is able to compete against the loyalty discounts without pricing below cost.  The small firm will not be prevented from reaching minimum efficient scale if it can increase its share by profitably competing against the loyalty discount.  And the second firm will not be rushed into increasing its scale if it can compete profitably at a smaller scale.  In either case, the RRC mechanism is forcing the firms to price below their costs.

At the end of the day, I suspect that Josh—using whatever analytical tools he associates with exclusive dealing analysis—would be highly unlikely to condemn any loyalty discount in a case where the rival could profitably match the discounts.  That gives me assurances as to Josh, but not as to all other players in the legal system, many of whom are eager to jettison the discipline of price-cost screens so that they can get onto the “real meat” of the case—like inflammatory internal e-mails employing metaphors of coercion that Judge Posner has aptly labeled “compelling evidence of predatory intent to the naïve.”  So I remain highly confident that we’re in good hands with Josh, but worry about what others may do with his words.

It’s not often that I disagree with my friend and co-author, FTC Commissioner Josh Wright, on an antitrust matter.  But when it comes to the proper legal treatment of loyalty discounts, the Commish and I just don’t see eye to eye.

In a speech this past Monday evening, Commissioner Wright rejected the view that there should be a safe harbor for single-product loyalty discounts resulting in an above-cost price for the product at issue.  A number of antitrust scholars—including Herb Hovenkamp, Dan Crane, and yours truly—recently urged the Supreme Court to grant cert and overturn a Third Circuit decision refusing to recognize such a safe harbor.  Commissioner Wright thinks we’re wrong.

A single-product loyalty discount occurs when a seller conditions a price cut (either an ex ante discount or an ex post rebate) on a buyer’s purchasing some quantity of a single product from the seller.  The purchase target is often set as a percentage of the buyer’s requirements, as when a medical device manufacturer offers to pay a 20% rebate on all of a hospital’s purchases of the manufacturer’s device if the hospital buys at least 70% of its requirements of that type of device from the manufacturer.  Because a loyalty discount tends to encourage distributors to carry more of the discounting manufacturer’s brand and less of the brands of the discounter’s rivals, such a discount may tend to “foreclose” those rivals from available distribution outlets.  If the degree of foreclose is so great that rivals have to cut their output below minimum efficient scale (the minimum output level required to achieve all economies of scale), then the discount may “raise rivals’ costs” relative to those of the discounter and thereby harm consumers.

On all these points, Commissioner Wright and I are in agreement.  Where we differ is on the question of whether a loyalty discount resulting in a discounted price that is above the discounter’s own cost should give rise to antitrust liability.  I say no.  I take that position because such an “above-cost loyalty discount” could be matched by any rival that is as efficient a producer as the discounter.  If, for example, a manufacturer normally charges $1.00 for widgets it produces for $.79 each but offers a 20% loyalty discount to retailers that buy 70% of their widget requirements from the manufacturer, any competitor that could produce a widget for $.79 (i.e., any equally efficient rival) could stay in business by lowering its price to the level of its incremental cost.  Thus, any rival that loses sales because of a manufacturer’s above-cost loyalty discount must be either less efficient than the manufacturer (so it can’t match the manufacturer’s discounted price) or unwilling to lower its price to the level of its cost.  In either case, the rival is unworthy of antitrust’s protection, where that protection amounts to prohibiting price cuts that provide consumers with immediate benefits.

Commissioner Wright disputes (I think?) the view that equally efficient rivals could match all above-cost loyalty discounts.  He maintains that loyalty discounts may be structured so that

[a] distributor’s purchase of an additional unit from a rival supplier beyond the threshold level can result in a loss of rebates large enough to render rival suppliers unable to attract a distributor to purchase the marginal unit at prices at or above the marginal cost of producing the good.

While I’m not entirely certain what Commissioner Wright means by this remark, I think he’s making the point that a loyalty discounter’s equally efficient rival might not be able to attract purchases by matching the discounter’s above-cost loyalty rebate if the rival’s “regular” base of sales is substantially smaller than that of the discounter.

If that is indeed what Commissioner Wright is saying, he has a point.  Suppose, for example, that the market for tennis balls consists of two brands, Penn and Wilson, that current market shares, reflective of consumer demand, are 60% for the Penn and 40% for Wilson, and that retailers typically stock the two brands in those proportions. Assume also that it costs each manufacturer $.90 to produce a can of tennis balls, that each sells to retailers for $1 per can, and that minimum efficient scale in this market occurs at a level of production equal to 35% of market demand. Suppose, then, that Penn, the dominant manufacturer, offers retailers a 10% loyalty rebate on all purchases made within a year if they buy 70% of their requirements for the year from Penn. The $.90 per unit discounted price is not below Penn’s cost, so the loyalty discount would come within my safe harbor.

Nevertheless, the loyalty discount could have the effect of driving Wilson from the market.  After implementation of the rebate scheme, a typi­cal retailer that previously purchased sixty cans of Penn for $60 and forty cans of Wilson for $40 could save $7 on its 100-can tennis ball require­ments by spending $63 to obtain seventy Penn cans and $30 to obtain thirty Wilson cans. The retailer and others like it would thus have a strong incen­tive to shift pur­chases from Wilson to Penn. To prevent a loss of mar­ket share that would drive it below minimum efficient scale (35% of market demand), Wilson would need to lower its price to provide retailers with the same total dollar discount, but on a smaller base of sales (40% of a typical retailer’s require­ments rather than 60%). This would require it to lower its price below cost. For example, Wilson could match Penn’s $7 discount to the retailer described above only by reducing its $1 per-unit price by 17.5 cents ($7.00/40 = $.175), which would require it to price below its cost of $.90 per unit.  Viewed statically, then, it seems that even an above-cost loyalty discount could occasion competitive harm by causing rivals to be less efficient, so that they could not match the discounter’s price.

In light of dynamic effects, though, I’m not convinced that examples like this undermine the case for a safe harbor for above-cost loyalty discounts. Had the nondominant rival (Wilson) charged a price equal to its marginal cost prior to Penn’s loyalty rebate, it would have enjoyed a price advantage and likely would have grown its market share to a point at which Penn’s loyalty rebate strat­egy could not drive it below minimum effi­cient scale. Moreover, one strategy that would prevent a nondominant but equally efficient firm from being harmed by a dominant rival’s above-cost loyalty rebate would be for the non-dominant firm to give its own volume discounts from the outset, secur­ing up-front commitments from enough buy­ers (in exchange for discounted prices) to ensure that its production stayed above minimum efficient scale. Such a strategy, which would obvi­ously benefit consumers, would be encouraged by a liability rule that evaluated loy­alty discounts under straight­forward Brooke Group principles (i.e., that included a safe harbor for above-cost discounts) and thereby signaled to manufacturers that they must take steps to protect themselves from above-cost loyalty discounts.

Commissioner Wright maintains that all this discussion of price-cost comparisons is inapposite because the theoretical harm from loyalty discounts stems from market exclusion (and its ability to raise rivals’ costs), not from predation.  He says, for example:

  • “[T]o the extent loyalty discounts raise competition concerns, the concerns are about anticompetitive exclusion and, as a result, the legal framework developed to evaluate exclusive dealing claims ought to be used to evaluate claims relating to loyalty discounts.” [p. 12]
  • “[P]redatory pricing and raising rivals’ costs are distinct paradigms of potentially exclusionary conduct. There simply is not a stable relative relationship between price and cost in raising rivals’ cost models that form the basis of anticompetitive exclusion, and hence it does not follow that below cost pricing is a necessary condition for competitive harm.”  [pp. 19-20]
  • “When plaintiffs allege that loyalty discounts … violate the antitrust laws because they deprive rivals of access to a critical input, raise their costs, and ultimately harm competition, they are articulating a raising rivals’ cost theory of harm rather than price predation.”  [p. 24]
  • “Raising rivals’ costs and predation are two different economic paradigms of exclusionary conduct, and economic models within each paradigm establish the necessary conditions for each practice to harm competition and give rise to antitrust concerns. Loyalty discounts and other forms of partial exclusives … are properly analyzed under the exclusive dealing framework. Price‐cost tests in the predatory pricing tradition … simply do not comport with the underlying economics of exclusive dealing.”  [p. 33]

I must confess that I’m baffled by Commissioner Wright’s oddly formalistic pigeonholing.  Why must a practice be one or the other—either pricing too low or excluding rivals and thereby raising their costs?  That seems like a false dichotomy.  Indeed, it seems to me that a problematic loyalty discount is one in which the discounter excludes its rivals from a substantial portion of the distribution network (and thereby raises their costs) via the mechanism of conditional price cuts. It’s “both-and,” not “either-or.”  And if that’s the case, then surely it makes sense to limit which price cuts may occasion liability—i.e., only those that could not be matched by equally efficient rivals.  [It is important to note here that I don’t advocate a price-cost test as an alternative to a foreclosure-based analysis.  Rather, a plaintiff should have to establish below-cost pricing (to show that the plaintiff was deserving of antitrust’s protection via the highly disfavored prohibition of discounts) and demonstrate that the discounting at issue resulted in substantial foreclosure from distribution outlets (the latter showing is necessary to prove harm to competition rather than simply to a competitor).]

Throughout his speech, Commissioner Wright emphasizes that the primary competitive concern presented by loyalty discounts is the possibility of “anticompetitive exclusion.”  He writes on page 8, for example, that “[t]he key economic point is that the antitrust concerns potentially arising from loyalty discounts involve anticompetitive exclusion rather than predatory pricing….”  On page 12, he reiterates that “to the extent loyalty discounts raise competition concerns, the concerns are about anticompetitive exclusion.”  He then apparently assumes that loyalty discount-induced exclusion is “anticompetitive” if it is sufficiently substantial—i.e., if the discounter’s rivals are foreclosed from so many distribution outlets that they are driven below minimum efficient scale so that their costs are raised relative to those of the discounter.

I would dispute the notion that discount-induced exclusion is anticompetitive simply because it’s substantial.  Rather, I’d say such exclusion is anticompetitive only if it is substantial and could not have been avoided by aggressive pricing.  Omitting the second requirement creates the possibility that antitrust will be used by a laggard rival to prevent a more aggressive rival’s consumer-friendly price competition.  (LePage’s anyone?)

Suppose, for example, that there are two producers of widgets, A and B, which both produce widgets at a marginal cost of $.79 and, given their duopoly, charge $1.00 per widget.  A, whose market share has hovered around 50%, institutes a loyalty rebate of 20% for retailers that purchase 70% of their requirements from A.  If B offers the same deal, or simply cuts its price to $.80, it should lose no market share.  But suppose B doesn’t do so, A captures 70% of the market, and B falls below minimum efficient scale.  Would we say that B’s exclusion is “anticompetitive” because A’s discount scheme resulted in such substantial foreclosure that it raised B’s costs?  Should B be able to collect treble damages for based on its “anticompetitive exclusion”?  Surely not.

Commissioner Wright, from whom I have learned more about “error costs” than anyone else, seems oddly unconcerned about the chilling effect his decidedly pro-plaintiff approach to loyalty discounts will produce.  Wouldn’t a firm considering a loyalty discount—a price cut, don’t forget!—think twice if it knew its rivals could sit on their hands, claim “exclusion” if the discount successfully moved substantial market share toward the discounter, and collect treble damages?  The safe harbor Hovenkamp, Crane, and I have advocated would provide assurance to potential discounters that they will not face liability if they charge above-cost prices, prices that could be matched by equally efficient, aggressive rivals.  Isn’t that approach more likely to minimize error costs?

Two closing points.  First, despite my disagreement with Commissioner Wright on this issue, I share the widely held view that he is one of the most brilliant antitrust thinkers out there.  He’s taught me more about antitrust than anyone (with the possible exception of the uber-prolific Herb Hovenkamp).  His questioning of my views on loyalty discounts really makes me wonder if I’m missing something.

Second, to those who think Commissioner Wright has “drifted” or “turned,” let me assure you that he’s long held his views on loyalty discounts.  As you can see here, here, and here, we’ve been going round and round on this matter for quite some time.

Perhaps one day one of us will persuade the other.

Einer Elhauge and Abraham Wickelgren, of Harvard and the University of Texas, respectively, have recently posted to SSRN a pair of provocative papers on loyalty discounts (price cuts conditioned on the buyer’s purchasing some amount, usually a percentage of its requirements, from the seller).  Elhauge and Wickelgren take aim at the assertion by myself and others (e.g., Herb Hovenkamp) that loyalty discounts should be per se legal if they result in a discounted per-unit price that is above the seller’s incremental per-unit cost.  E&W would cast the liability net further.

We advocates of per se legality for above-cost loyalty discounts base our position on the fact that such discounts generally cannot exclude aggressive rivals that are as efficient as the discounter.  Suppose, for example, that widgets are normally sold for a dollar each but that a seller whose marginal cost is $.88/widget offers a 10% loyalty rebate to any buyer who purchases 80% of its widget requirements from the seller.  Because the $.90 discounted price exceeds the discounter’s marginal cost, any equally efficient widget producer could compete with the discount by lowering its own price to a level above its cost.

But what if the loyalty rebate actually causes a rival to be less efficient than the discounter? Some have argued that this may occur, even with above-cost loyalty discounts, when scale economies are significant.  Suppose that the market for tennis balls consists of two brands, Pinn and Willson, that current market shares, reflective of consumer demand, are 60% for the Pinn and 40% for Willson,  and that retailers typically stock the two brands in those proportions. Assume also that it costs each manufacturer $.90 to produce a can of tennis balls, that each sells to retailers for $1 per can, and that minimum efficient scale in this market (the lowest production level at which all available scale economies are exploited) occurs at a level of production equal to 35% of market demand. Suppose that Pinn, the dominant manufacturer, offers retailers a 10% loyalty rebate on all purchases made within a year if they buy 70% of their requirements for the year from Pinn.

While the $.90 per unit discounted price is not below Pinn’s cost, it might have the effect of driving Willson, an equally efficient rival, from the market. Willson could avoid losing market share and thus falling below minimum efficient scale only if it matched the full dollar amount of Pinn’s discount on its smaller base of sales. It wouldn’t be able to do so, though, without pricing below its cost.

Consider, for example, a typical retailer that initially (before the rebate announcement) satisfied its requirements by purchasing sixty cans of Pinn for $60 and forty cans of Willson for $40. After implementation of the rebate plan, the retailer could save $7 on its 100-can tennis ball requirements by spending $63 to obtain seventy Pinn cans and $30 to obtain thirty Willson cans. The retailer and others like it would thus have a strong incentive to shift purchases from Willson to Pinn.  To prevent a loss of market share that would drive it below minimum efficient scale, Willson would need to lower its price to provide retailers with the same total dollar discount, but on a smaller base of sales (40% of a typical retailer’s requirements rather than 60%). This would cause it to lower its price below its cost.  For example, Willson could match Pinn’s $7 discount to the retailer described above only by reducing its $1 per-unit price by 17.5 cents ($7.00/40 = $.175), which would require it to price below its cost of $.90 per unit.

When one considers dynamic effects, examples like this don’t really undermine the case for a rule of per se legality for above-cost loyalty discounts. Had the nondominant rival (Willson) charged a price equal to its marginal cost prior to implementation of Pinn’s loyalty rebate, it would have enjoyed a price advantage and likely would have grown its market share to a point at which Pinn’s loyalty rebate strategy could not drive it below minimum efficient scale. Moreover, a strategy that would prevent a nondominant but equally efficient firm from being harmed by a dominant rival’s above-cost loyalty rebate would be for the non-dominant firm to give its own volume discounts from the outset, securing up-front commitments from enough buyers (in exchange for discounted prices) to ensure that its production stayed above minimum efficient scale. Such a strategy, which would obviously benefit consumers, would be encouraged by a rule that evaluated loyalty discounts under straightforward Brooke Group principles and thereby signaled to manufacturers that they must take steps to protect themselves from above-cost loyalty discounts. In the end, then, any equally efficient rival that is committed to engaging in vigorous price competition ought not to be excluded by a dominant seller’s above-cost loyalty rebate.

Moreover, even if a loyalty rebate could occasionally drive an aggressive, equally efficient rival from the market, a rule of per se legality for above-cost loyalty discounts would still be desirable on error cost grounds.  An alternative rule subjecting above-cost loyalty discounts to potential treble damages liability would chill all sorts of non-exclusionary discounting practices, so that the social losses from reduced price competition would exceed any social gains from the elimination of those rare discounts that could exclude aggressive, efficient rivals. In short, the social costs resulting from potential false convinctions under a broader liability rule would overwhelm the social costs from false acquittals under the per se legality rule I have advocated.

The two new papers by Elhauge and Wickelgren contend that I and other per se legality advocates are missing a key anticompetitive threat posed by loyalty discounts even in the absence of scale economies: their potential to chill price competition.

The first E&W paper addresses loyalty discounts involving “buyer commitment”—i.e., a promise by buyers receiving the discount that they will purchase some percentage of their requirements from the discounter (not its rivals) in the future.  According to E&W, the discounter who agrees to this sort of arrangement will be less likely to give discounts to uncommitted (“free”) buyers in the future.  This is because, E&W say, the discounter knows that if it cuts prices to such buyers, it will have to reduce its prices to committed buyers by the agreed-upon discount percentage.  The discounter’s rivals, knowing that the discounter won’t cut prices to attract free buyers, will similarly abstain from aggressive price competition.  “The result,” E&W maintain, “is inflated prices to free buyers, which also means inflated prices to committed buyers because they are priced at a loyalty discount from those free buyer prices.”  Despite these adverse consequences, E&W contend, buyers will agree to competition-reducing loyalty discounts because much of their cost is externalized:  “[W]hen one buyer agrees to a loyalty discount, all buyers suffer from the higher prices that result from less aggressive competition,” so “an incumbent supplier need not compensate an individual buyer who agrees to a loyalty discount for the losses that all other buyers suffer.”

The second E&W paper contends that loyalty discounts may soften price competition and injure consumers even when they do not involve buyer commitment to purchase from the discounter in the future.  According to E&W, “[b]ecause the loyalty discount requires the seller to charge loyal buyers less than buyer who are not covered by the loyalty discount, the seller cannot lower prices to uncovered buyers without also lowering prices to loyal buyers.”  Given the increased cost of competing for uncovered buyers  (i.e., any price concession will require further concessions to covered buyers), the seller is likely to cede uncovered buyers to its rival, which will reduce the rival’s incentive to compete aggressively for buyers covered by the loyalty discount.  In short, E&W contend, the loyalty discount will facilitate a market division scheme between the discounter and its rival.

As is typical for an Elhauge paper, there’s some elaborate modeling and math in both of these papers.  The analysis appears to be rigorous.  It seems to me, though, that there’s a significant problem with both papers: Each assumes that loyalty discounts are structured so that the discounter promises to reduce the price from the amount collected in sales to others.  While I’m reluctant to make sweeping claims about how loyalty discounts are typically structured, I don’t think loyalty discounts usually work this way.

Loyalty discounts could be structured many ways.  The seller could offer a discount from a pre-determined price—e.g., “The price is $1 per widget, but if you purchase at least 80% of your widgets from me, I’ll charge you only $.90/widget.”  Such a discount doesn’t create the incentive effect that underlies E&W’s theories of anticompetitive effect, for there’s no reason for the seller not to reduce others’ widget prices in the future.  Alternatively, the seller could offer a discount off a list price that is subject to change—e.g., “If you purchase 80% of your requirements from me, I’ll charge you 10% less than the posted list price.”  This sort of discount might discourage sellers from lowering list prices, but it shouldn’t dissuade them from also giving others a break from list prices.  Indeed, in many industries hardly anyone pays list price.  The only loyalty discounts that threaten the effects E&W fear are those where the discount is explicitly tied to the price charged to others—e.g., “If you purchase 80% of your requirements from me, I’ll charge you 10% less than the lowest price I’m charging others.”

This last sort of loyalty discount might have the effects E&W predict, but I’ve never seen such a discount.  The loyalty discounts and rebates I encountered as an antitrust lawyer resembled the first two types discussed above: discounts off pre-determined prices or discounts off official list prices (from which price concessions were regularly granted to others).  The loyalty discounts that E&W model really just look like souped-up “Most Favored Nations” clauses, where the seller promises not just to meet, but to beat, the price it offers to other favored buyers.  It may make sense to police such clauses, but wouldn’t we do so using the standards governing MFN clauses rather than the rules and standards governing loyalty discounts?  After all, it’s the seller’s promise to beat its other price concessions, not the buyer’s loyalty, that causes the purported anticompetitive harm.

UPDATE:

I just recalled that this is not the first time we at TOTM have addressed Prof. Elhauge’s models of loyalty discounts containing a Most Favored Nations-like provision. FTC Commissioner-Appointee Josh Wright made a similar point about a paper Elhauge produced before these two.  If you found this post at all interesting, please read Josh’s earlier (and more rigorous) post. Sorry about that, Mr. Commish-to-be.

wrightJosh Wright is a Professor of Law at George Mason Law School, a former FTC Scholar in Residence and a regular contributor to Truth on the Market.

The primary anticompetitive concern with exclusive dealing contracts is that a monopolist might be able to utilize exclusivity to fortify its market position, raise rivals’ costs of distribution, and ultimately harm consumers.  The unifying economic logic of these anticompetitive models of exclusivity is that the potential entrant (or current rival) must attract a sufficient mass of retailers to cover its fixed costs of entry, but that the monopolist’s exclusive contracts with retailers prevent the potential entrant from doing so.   However, the exclusionary equilibrium in these models are relatively fragile, and the models also often generate multiple equilibria in which buyers reject exclusivity. At the exclusive dealing hearings where I testified, a sensible consensus view emerged that a necessary condition for exclusive dealing or de facto exclusive contracts such as market-share discounts or loyalty discounts to cause competitive harm is that they deprive rivals of the opportunity to compete for access to distribution sufficient to achieve minimum efficient scale.  The Report (p. 137) reflects this consensus:

In particular, exclusive dealing may be harmful when it deprives rivals “of the necessary scale to achieve efficiencies, even though, absent the exclusivity,” more than one firm “would . . . be large enough to achieve efficiency.”68 In other words, exclusive dealing can be a way that a firm acquires or maintains monopoly power by impairing the ability of rivals to grow into effective competitors that erode the firm’s position. As one panelist put it, “the exclusive dealing case that you ought to worry about” is where exclusivity deprives rivals of the ability to obtain economies of scale.

The Report also goes on to note the competitive justifications for exclusive dealing, ranging from the variety of ways in which exclusive dealing can prevent free-riding, facilitate relationship-specific investments, and intensify manufacturer competition for scarce retailer shelf space or access to distribution with the benefits of that intensified competition passed on to consumers in the form of lower prices or higher quality.

The situation antitrust enforcers find themselves in with respect to exclusive dealing is not unfamiliar.  On the one hand, there are a set of possibility theorems which indicate that exclusive dealing and de facto exclusives can lead to anticompetitive outcomes under some specified conditions, including substantial economies of scale or scope.  On the other, there are a set of sensible and economically rigorous pro-competitive justifications for the practice.  On top of that is the casual empiricism that we observe exclusive dealing contracts in competitive markets and adopted by firms without significant market power.  As David Evans noted on the first day of our symposium, quite a bit can be learned about the relative probabilities of anticompetitive and pro-competitive uses of certain types of business behavior by understanding the incidence of use by competitive firms.  Exclusive dealing is no different.

Still, we find ourselves between battling theories.  The standard error cost approach to this problem, an approach discussed by many in this symposium as a powerful tool to ensure that our liability rules do not do not needlessly harm consumers by overdeterring pro-competitive conduct or under-deterring anticompetitive conduct, is to turn to the evidence.  What do we know about the incidences of anticompetitive exclusive dealing and de facto exclusive dealing contracts?  The question is not one of the logical validity of any of the competing theories.  It is one of their empirical (and therefore policy) relevance.  A sensible approach to designing antitrust liability rules for exclusive dealing would be to design a conduct-specific standard sensitive to the particular relative risks of Type I and Type II errors informed by the best available existing evidence.  Of course, it should be noted that more evidence is always better and there is certainly a need for more empirical research about single firm conduct.  But the limited nature of the evidence does not mean we have zero information to update our priors on the critical policy question.

So what does the evidence say?  What approach would it lead to?  And how does that approach compare with that endorsed in the Section 2 Report?  I’ll focus on those issues in the remainder of the post. Continue Reading…

I promised that I would write about why I think that Professor Elhauge’s claim in his new working paper, “Loyalty Discounts and Naked Exclusion,” that he has proven that loyalty discounts generally involve anticompetitive effects is mistaken. Let me begin by saying that this is a very provocative claim from a very serious antitrust analyst and deserves careful attention. Loyalty discounts are an important and highly controversial issue in antitrust at the moment and so economic analysis that enlightens us to their effects in the marketplace should be applauded. I should also note, as I made clear in the first post, that I admire Elhauge’s work and have a great deal of respect for him. Obviously, with that many caveats, you know what is coming next. I strongly disagree that Elhauge’s economic analysis lives up to his claims. First, here’s an excerpt from the abstract:

This article proves that loyalty discounts create anticompetitive effects, not only because they can impair rival efficiency, but because loyalty discounts perversely discourage discounting even when they have no effect on rival efficiency. The essential reason, missed in prior work, is that firms using loyalty discounts have less incentive to compete for free buyers, because any price reduction to win sales to free buyers will, given the loyalty discount, also lower prices to loyal buyers. This in turn reduces the incentive of rivals to cut prices, because there will exist an above-cost price that rivals can charge to free buyers without being undercut by the firm using loyalty discounts. These anticompetitive effects occur even if buyers can breach or terminate commitments, and even if the loyalty conditions require no contractual commitments and less than 100% loyalty. Further, I prove that these anticompetitive effects are exacerbated if multiple sellers use loyalty discounts. None of the results depend on switching costs, market differentiation, imperfect competition, or the loyalty discount bundling contestable and incontestable demand. Contrary to commonly held views, I prove these anticompetitive effects exist even when: (1) the price with the loyalty discount is above cost, (2) the rival has higher costs than the firm using loyalty discounts, (3) the rival prices above its own costs, (4) buyers voluntarily agree to the conditions, and (5) the discount and foreclosure levels are low. I derive formulas for calculating the inflated price levels in each situation.

In short, Elhauge claims that he has proven that loyalty discounts always or at least generally have anticompetitive effects. I don’t think he has. In fact, I don’t think the paper is really about loyalty discounts at all. And it certainly isn’t about “naked exclusion” as the title implies. I offer a somewhat lengthy critique of the economic analysis in the paper below the fold.

Continue Reading…

Dan Crane (Antitrust Review, Cardozo) has graciously posted his testimony for Wednesday’s FTC/ DOJ Section 2 Hearings on Loyalty Discounts. Readers familiar with Crane’s scholarship on bundled discounts in the Chicago Law Review and Emory Law Journal will not be surprised that it is thorough, careful, mindful of the role that administrative costs should play in designing antitrust liability rules. At the end of the day, Professor Crane proposes a Brooke Group style-discount reallocation rule for bundled discounts, which he articulates as follows: “that the bundled discounts resulted in at least one product in the package being sold at less than cost, after reallocation of the discounts on the other products in the package to the predatory product.” Interested readers should go read Professor Crane’s testimony.
I am also looking forward to seeing TOTM co-blogger Thom’s remarks (who will also be testifying) on this subject, which has become a relatively hot antitrust issue after LePage’s. The panel lineup looks interesting, and also includes Joseph Kattan, David Sibley, Barry Nalebuff, Janusz Ordover, Willard Tom, and my colleague Tim Muris. I am particularly interested in the bundled discount testimony because it has substantial overlap with many of the issues raised in the exclusive dealing session which I participated in, and the relationship between the economics of exclusive dealing and various types of discount contracts.