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On balance the Second Circuit was right to apply the antitrust laws to Apple.

Right now the Supreme Court has before it a petition for Certiorari, brought by Apple, Inc., which asks the Court to reverse the decision of the Second Circuit. That decision found per se illegality under the Sherman Act, for Apple’s efforts to promote cooperation among a group of six major publishers, who desperately sought to break Amazon’s dominant position in the ebook market. At that time, Amazon employed a wholesale model for ebooks under which it bought them for a fixed price, but could sell them for whatever price it wanted, including sales at below cost of popular books treated as loss leaders. These sales particularly frustrated publishers because of the extra pressure they placed on the sale of hard cover and paper back books. That problem disappeared under the agency relationship model that Apple pioneered. Now the publishers would set the prices for the sale of their own volumes, and then pay Apple a fixed commission for its services in selling the ebooks.

This agency model gives the publishers a price freedom, but it would fall apart at the seams if Amazon could continue to sell ebooks under the wholesale model at prices below those that were set by publishers for ebook sales by Apple. To deal with this complication, Apple insisted that all publishers that sold to it through the agency model require Amazon to purchase the ebooks on the same terms. Apple also insisted that it receive a most-favored-nation clause so that it would not find itself undercut either by Amazon or by a new entrant that also used the agency model.

There is little question that Apple would be in fine shape if it had proposed this model to each of the publishers separately, for then its action would be a form of ordinary competition of the sort permitted to every new entrant. Competition often takes place in terms of price, where the terms of the contracts are standard between competitors. That common state of affairs makes it easier for customers to compare prices with each other, and—sigh—for competitors to collude with each other. But without some evidence of collusion, the price parallelism should be regarded as per se legal, as it is routinely today. The decision to adopt a new form of pricing makes cross-product comparisons more difficult, but, by the same token, it offers a wider range of choice to customers. Again there is nothing in the antitrust laws that does, or should, prevent nonprice competition, including a radical shift in business model.

As it happened, once Apple imposed its model, the older wholesale model gave way, because it could not survive anywhere once the agency model was introduced. In the short run, this tectonic market shift has resulted in an increase in the price of ebooks and a corresponding decline in revenue, which is just what one would expect when prices are raised. It is therefore difficult to defend the case on the ground that it produces, in either the long or the short run, lower prices that benefit consumers. But it is difficult in the abstract to find that higher prices themselves are the hallmark of an antitrust violation.

At root the main considerations should be structural. What makes the ebooks case so hard is that it arises at the cross-currents of two different antitrust approaches. The general view is that horizontal arrangements are per se illegal, which means that it is necessary to show some very specific justifications to defeat a charge under Section 1 of the Sherman Act. No such arguments — like the need to share information in order to operate in a network industry — present themselves here. Yet by the same token, the general view on vertical arrangements is that they offer efficiencies by reducing the bottlenecks that could be created if players at different levels of the distribution system seek to hold out for a larger share of the gain, thereby creating a serious double marginalization problem. In these cases, the modern view is that vertical arrangements are in general governed by rule of reason considerations. The question now is what happens where there is an inevitable confluence of the vertical and horizontal arrangements.

In preparing for this short column, I read the petition for certiorari by Apple, and the two separate briefs prepared in support of Apple by a set of law professors and economists respectively. Both urge that this case be evaluated under a rule of reason, not the per se rule that applies to horizontal price-fixing. Both these briefs are excellently done. But I confess that my current view is that they miss the central difficulty in this case. Any argument for a rule of reason has to be able to identify in advance the gains and losses that justify some kind of balancing act. That standard can be met in merger cases, where under the standard Williamson model one is asked to compare the social gains from lower costs with the social losses from increased competition. These are not decisions that can be made well within the judicial context, so a separate administrative procedure is set up under the premerger notification program established under the 1976 Hart-Scott-Rodino Act. The administrative setting makes it possible to collect the needed information, and to decide whether to allow the merger to go through, and if so, subject to what conditions on matters such as partial divestiture to avoid excessive concentration in relevant submarkets. The task is always messy, but the rule-of-thumb that five-to-four is generally fine and three-to-two is not, shows that it is possible to hone in on an answer in most cases, but not all.

But what is troublesome in Apple is that, though the briefs are very persuasive in arguing that mixed vertical and horizontal arrangements might fit better into a rule of reason framework, they do not indicate what metric the parties should use to determine, once the case is remanded, how the rule of reason plays out. That is to say, there is no clear theory of what should be traded off against what. To put the point another way, none of these briefs argues that the transaction in question should be regarded as per se legal, so my fear is this: all the relevant information is already made available in the case, so that, on remand, the only task left to be done is to decide whether Apple should be protected because its own conduct disrupts a near-monopoly position that is held by Amazon. But that argument is at least a little dicey given that no one could argue that Amazon has obtained its dominant position by any unlawful means, which undercuts (but does not destroy) the argument that cutting Amazon down to size is necessarily a good thing. It might not be if the willingness to allow a collusive collateral attack orchestrated by Apple would reduce ex ante the gains from innovation that Amazon surely created when it pioneered its own wholesale ebook model. Facilitation is often regarded as criminal and tortious conduct in other areas. So at the moment, and subject to revision, my view is that the Second Circuit got it right. The vertical assist to the horizontal arrangement increased the odds of the horizontal deal that was illegal, and probably shares in that taint.

In making this judgment I think of the decision in Fashion Originators’ Guild of America, Inc. v. FTC (FOGA) which did address the question of whether the defendants could resist a cease and desist order by the FTC, which had attacked as per se illegal a decision of the manufacturers whose comparative advantage was to act as sellers of original and distinctive designs that at the time received neither patent nor copyright protection. The defendants entered into a limited form of collusion whereby they agreed not to sell to any retailer who carried a knock-off of their creations. They did not extend their cooperative activity into any other area. In essence, they sought only to protect what they regarded as their intellectual property. Justice Black held that the case did not fall outside the per se Section 1 prohibition even though it could easily have been argued that these decisions were undertaken to protect the labor that these individuals had placed in their creations. In addition, the opinion concluded with this passage:

even if copying were an acknowledged tort under the law of every state, that situation would not justify petitioners in combining together to regulate and restrain interstate commerce in violation of federal law. And for these same reasons, the principles declared in International News Service v. Associated Press, 248 U.S. 215, [1918], cannot serve to legalize petitioners’ unlawful combination.

I think that the first sentence here is wrong if self-help is cheaper and more reliable in dealing with the threat. But Justice Black flatly rejected the INS decision, which in my view represents a highly sophisticated effort to develop a tort of unfair competition between direct competitors. It reaches the correct result by defining the protected right narrowly—publication for one news cycle only. That move guards against misappropriation when it matters most, but by design prevents the creation of any long-term monopoly on anything like the copyright model. The limited and proportionate response in FOGA, however, did not cut any ice.

In addition, the defendants in FOGA have a respectable case on the merits that some protection of these design elements should be provided under either the patent or copyright laws, precisely because the appropriation is so difficult to guard against by any other means. Probably, the statutory length of such protection should not be as long as that offered by standard patents and copyrights, but that matter could be settled by statute. Accordingly, if antitrust law turns a blind eye to these justifications, is the nonspecific concern raised, but not spelled out, by Apple any stronger?

Finally, what should be the bottom line? It is worth noting that in FOGA the government was seeking only an injunction against the conduct, without asking for any damages. In Apple, the co-plaintiff states are seeking damage awards. Perhaps the simplest solution is to allow the injunction and to deny the damages, in part because of the clear complexity of the underlying legal issues. In this case, King Solomon might be wise to split the baby.

by Richard A. Epstein, Laurence A. Tisch Professor of Law, NYU School of Law

A recent story in the Wall Street Journal described Josh Wright as the “FTC’s most conservative commissioner.” It is a sign of today’s politicized environment that this label is used as a substitute for serious substantive analysis of the particular positions that Wright has taken relative to the other commissioners. The article also noted that he was the Republican commissioner who brokered a deal with the three democratic members to publish a short set of guidelines to deal with the Delphic question of what counts as unlawful methods of competition. Before I had received knowledge that Josh was about to resign, I had posted a piece on Defining Ideas that carried with it the near-oxymoronic title, “When Bureaucrats Do Good.”

I must confess that my initial impression on hearing of the publication of the statement was that it would be more bad news. But I happily I changed course after reading the statement, which is mercifully short, and after having the benefit of the thoughtful dissent of the other Republican Commissioner Maureen Ohlhausen, and of the speech that FTC Chairwoman Edith Ramirez gave in defense of those guidelines at the George Washington Law School.

There are clearly times when short should be regarded as sweet, and this is one of them.  It may well be that there is an iron law that says the longer the document that any government prepares, the worse its content. This short policy statement sets matters in the right direction when it treats unfair methods of competition as a variation on the basic theme of monopoly, and notes that where the antitrust laws do apply, the FTC should be reluctant to exercise its standalone jurisdiction. It is a tribute to Ramirez and Wright that they could come to agree on the statement, so that a set of sound principles has bipartisan support.

It is also welcome that the dissent of Commissioner Ohlhausen does not differ on fundamental orientation but on two questions that I regard as having subordinate importance: do we give public hearings before publishing the statement; and do we provide more illustrations as to how the principle out to be applied. The pressure therefore came from the pro-market side of the political spectrum such that there is now no Commissioner on the FTC who regards Section 5 of the Federal Trade Commission Act as a general warrant to pursue any and all forms of professional mischief.

The contrast of this document with the FCC’s net neutrality principles is too clear to require much comment.

At this point, Josh will return to his position at George Mason University Law School, where he shall resume his distinguished academic career. He regards the publication of this one page statement as the capstone of his career. On that point, I am confident that history will prove him right. Welcome back to the Academy, and thanks for a job well done on the Commission.

Richard A. Epstein is the Laurence A. Tisch Professor of Law, New York University School of Law, The Peter and Kirsten Bedford Senior Fellow, The Hoover Institution, and the James Parker Hall Distinguished Service Professor of Law, The University of Chicago.

Few academic publications have had as much direct public influence on the law as the 2008 article by my NYU colleague Oren Bar-Gill and then Harvard Law Professor Elizabeth Warren.  In “Making Credit Safer,” they seek to combine two strands of academic thought in support of one great cause—more regulation of financial markets.  They start with the central claim of behavioral economics that sophisticated entrepreneurs are able to take advantage of the systematic foibles of ordinary people, by rigging their products in ways that work systematically to their own advantage.  By plying ordinary individuals will carefully packaged payment contracts, firms can undercut the central postulate of rational choice economics that all voluntary transactions produce mutual gains for the parties.  In its stead we get the wreckage of families and fortunes brought about by unscrupulous bankers in search of a buck.  Warren and Bar-Gill repeatedly talk about the importance of empirical evidence.  Her own work, however, is exceptionally shoddy, as Todd Zywicki has recently pointed out in the Wall Street Journal.

The second strand of their argument refers to the law of product liability in which they claim that government actors at all levels have intervened into markets to cure the information deficits in products that in an earlier age used to maim, if not kill, ordinary consumers.  The exploding toaster is their key example of a product that needs government oversight.  In their view, the key insight is that “sellers have no incentive to invest in making a safer product given consumers’ imperfect information.”  That position, moreover, is barely tolerable if consumers know about their own ignorance because they are then in a position to take precautions to offset the lamentable neglect of product providers.  Yet in those cases where consumers fail to perceive the risks, they get the worst of both worlds.  Sellers can afford to be indifferent to product risk, which leads to many bad consequences for consumers in the absence of firm government regulation.

In their model, financial products have similar characteristics.  It is just a short step therefore to argue that the insights of behavioral economics should transform the way in which payment cards should be regulated, to bring the situation into a closer alignment with the system of product liability regulation. However imperfect, Bar-Gill and Warren insist that the current regulation of consumer products outperforms the current of financial products.

At this point, the proper approach is to accept no small ambitions.  Instead their prescient conclusion runs as follows:

[T]he current legal structure, a loose amalgam of common law, statutory prohibitions, and regulatory agency oversight, is structurally incapable of providing effective protection. We propose the creation of a single regulatory body that will be responsible for evaluating the safety of consumer credit products and policing any features that are designed to trick, trap, or otherwise fool the consumers who use them.

Their fondest dreams have been realized.  By recess appointment, Elizabeth Warren is perched inside the United States Treasury as an Assistant to the President and Special Advisor to the Secretary of the Treasury on the Consumer Financial Protection Bureau. (CFPB)  In that capacity, my hope is that she will come to realize the uselessness of the product liability analogies to which she attaches so much weight.  You have to know something first about the body of law to which you which to compare payment markets.  In this instance, neither Bar-Gill nor Warren have the slightest clue about the evolution of product liability law.

Continue Reading…

I have now had a chance to review the excellent posts on the second day, all of which have a common flavor.  They expand the universe of relative considerations that need to be taken into account to decide whether imposing caps on interchange fees enhances or reduces overall social welfare.  The narrow perspective on this issue, which is difficult enough, is to master the dynamics of two-sided markets to figure out where the fixed costs of running the overall system should be allocated.

That model assumes that the credit card business operates in isolation from all other payment systems present and future.  Its effort is to run an efficient allocation of costs in the face of the famous marginal cost controversy that dates back to the 1940s.  Unless there is some outside subsidy all relevant players cannot be allowed to pay only marginal cost.  Yet to put in the subsidy is to create a tax distortion in some unrelated market whose welfare consequences are virtually impossible to track, given the difficulty that arises in discovery of the incidence of the tax as it works its way through the economy.  We are therefore necessarily in the world of second-best even on the simplest possible analysis.

Unfortunately, that simple analysis leaves a lot out of the equation.  One key issue is the competition that credit cards have with noncredit card systems, each of which may have built in distortions of their own.  We know that the United States has to print and police the use of cash. We also know that it can disappear from company coffers into the hands of dishonest employees.  It can be lost.  It can be stolen.  It can get waterlogged.  It can be deposited in the wrong account by accident.  Credit cards reduce these costs, and they do so arguably in a more efficient form than the use of checks, which of course clear at par, which means that the cost of interchange is borne by general tax revenues, with the usual set of static distortions. It also creates dynamic distortions because the want of price signals between the players makes it harder to introduce innovation into that space on such critical matters as error control, even if it would result in higher level of reliability in transactions.

In addition, it is also important to consider the other benefits that can arise with the use of credit card payments, one of which is the ability to key in all relevant data from a transaction at once.  Quite simply it may well be easier to link in inventory control, for example,  with a credit card system than it is with a cash or checking system. And it may speed up the rate of transactions so as to reduce the length of queues that are so important in many retail operations.

The clear upshot is that it is difficult through informed speculation to identify all the collateral consequences of running a credit card system, both positive and negative.  The only sure piece of data that we have is that credit transactions have done far better than cash and checks, even if they are losing ground to the next generation of payment systems that rely on cell phones and other technologies that are untied to the now ubiquitous magnetic strip.  These dynamic changes could easily force down interchange prices without the need for administrative proceedings.

The hard institutional question therefore is why concentrate major reforms on the interchange fees when all these other components must be added into the mix.  On this question, priors really matter. And after reading the assembled posts, my own view is that technological innovation is a far more important driver of improvements than partial fine-tuning of the current system, whatever its flaws.

In one sense, therefore, we, the members of this blog-fest, may well be part of the problem.  By putting one part of a complex payment industry under a microscope we divert resources from cost reduction measures that have unambiguously positive effects.  How large a cost is this?  Frankly, no one knows.  But given the risks of error in implementation, the best response still seems to be, play for the next big breakthrough, and in the short run, leave well enough alone.

There is nothing like the provocative post from Allan Shampine to move this debate up a notch.  First, I did not say that the debate over interchange fees was Onionesque. I reserved that dubious distinction to the on-the-hand-on-the-other-hand title of the GAO report.  Allan is right that the stakes are huge, which is why this debate is so important.  But he is wrong to think that the GAO adds much to the debate when all it can responsibly say is that any regulation of interchange fees has both costs and benefits, when it is unable to quantify or evaluate either.

My own substantive view starts with the legal version of the Hippocratic Oath—first, do no harm.  That generally counsels against the interference with competitive markets.  But it does not, evidently, have quite the same pop in the complex world of interchange agreements where there are sure to be some pockets of monopoly power.  But even if that were the case, the second order concern remains true.  Is the cure proposed likely to be worse than the disease, which I suspect will be the case if there is no clear path from diagnosis to treatment.

On this issue, the excellent posts by Tom Brown & Tim Muris, Robert Stillman, and Todd Zywicki all make the same point.  As Zywicki properly notes, the credit-card system is a closed loop.  The loss of revenues from one part of it has to be offset by the gains in revenues elsewhere.  It becomes therefore very difficult to construct a telling narrative that justifies the use of high administrative costs to switch these flows in a direction that retailers prefer, but which do little good for others.  As Brown & Muris point out, fully corrected for debit cards, there is no run up in interchange costs, so why worry.  As Bob Stillman points out, if the merchants were prepared to make a dollar-for-dollar pass through of fee reductions, they would have no incentive to lobby so hard for a program from which they received no return.  I think that they have better knowledge of their own business than I do, so that the question of who pays if they get a government break still remains.

Allan is surely right to point out that the 1.7 percent interconnection fee is not chump change.  It is larger than the 0.5 percent reduction in sales taxes that is being mooted in Chicago.  A fair comparison would ask about the change in effective rates that regulation could impose.  But even if we put that aside, the structural differences between interchange fees and the sales tax really matters.  The sales tax takes wealth out of the productive cycle of credit (indeed all) sales.  The one unambiguous effect is that Chicago purchasers now have an incentive to shop in the suburbs for their large weekly household purchases, and even for smaller transactions like gasoline.  Governing a long and thin city has important tax consequences because it puts a lot of people close to city lines, and also to Indiana.  Cutting down the fees brings business back.

There of course no taxes involved in this dispute, just lots of dollars.  But the flip side of the tax issue does arise with subsidies for various payment systems.  Here one of the great achievements of credit cards is that it does not have the public subsidy that is found both for checks, and for cash, when, last I looked, no one had to pay a cent to acquire a shiny new $20 bill.  The government assumes the printing costs, and guards against counterfeit transactions, a rough analogy to credit fraud.  If this industry can continue to expand its share of the market, hands off looks to be the better solution, if only because there are more players who can divide the substantial fixed costs in running this system.

Conclusion: even if you cancel your Onion subscription, don’t buy into the regulation of interchange fees until the GAO can supply a better narrative than it has already done.

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law at the University of Chicago, the Peter and Kirstin Bedford Senior Fellow at the Hoover Institution, and a visiting professor at New York University Law School.

About four years ago, I worked for Visa in opposing the opposed limitations on interchange fees that the Australian government was about to impose on the credit card industry. The situation there, like the situation in the United States, seemed hardly propitious for reform.  The use of credit cards was rapidly expanding, and the rate of interest was being brought down by competition, the number of cards in circulation had increased.  What is there not to like?

The fear of monopoly apparently.  Everyone knows that the credit card industry is highly concentrated.  That point in and of itself is not necessarily a bad thing.  The credit cards only work in what is called two-sided markets.  Consumers are prepared to sign up for credit cards only if they are aware that merchants will be prepared to accept them.  Merchants will be prepared to accept these cards only if consumers are prepared to use them.  The huge number of players on each side of the market cry out for the use of an intermediary to forge the connections.  The fewer the intermediate parties, the easier it is to organize the grid.  That task does not come without cost, and that cost in turn is incurred by the credit card companies that invest in the large infrastructure that keeps the entire system humming.

Breaking up these companies has real efficiency losses, so naturally the thought of the aspiring regulator is to turn to price controls as the next best solution. Someone of course has to pay companies to cover that expense, and to make a profit as well, but who should bear that burden? The great siren of all service users is to insist that they be charged at marginal cost.  After all, once costs are raised above marginal cost, some consumer who could have used the service will be excluded, which counts, after a fashion, as a type of inefficiency.   Needless to say, marginal cost pricing is a game that all users of inputs would like to play.  But it is not a game at which all can succeed.  Let the merchants on the one side, and the cardholders on the other, pay marginal cost, and no one is left to pick up the fixed costs of running the entire system.

Those costs amount to a tidy sum that someone has to pick up if the network is to remain viable. But which side and in which proportions?  The usual response is to see which side is more inelastic in the demand, on the simple (but nasty) ground that it has fewer options to escape the costs in question.  One nice consequence of this strategy is that the network will tend to shrink less on one side, which offers an added inducement to remain on the other side.

But, comes the response, just how much over marginal cost should the credit card companies be able to charge in a two-sided market.  Coming up with a precise answer to that question offers enormous descriptive and normative challenges.  And so the question is whether this game is worth the candle.  The Australian experience is not all that reassuring, as the shifts away from merchants imposed higher costs of card users which tended to thin their ranks, without any clear evidence that the merchants did their part by passing on the reduced interchange fees to their customers.

It is therefore no surprise that the title of the GAO’s report is not exactly a clarion call to action:  “Rising Interchange Fees Have Increased Costs for Merchants, But Options For Reducing Fees Pose Problems.”  My believe is that the title was chosen by the editors of the Onion. The first part of this title is of course a necessary truth, but it tells us nothing as to whether the increased fees help or hurt the  overall operation of the credit card system.  The words after the “but” remind us that there no evidence that two simple risks of price controls won’t go away.  The first of these is that the cuts are too deep so that the system will experience a financial shock from which it cannot recover. Lawyers might think that this could even raise the question of whether the rate reductions are confiscatory.  The second risk is a bit less ominous.  The increases of the costs to customers reduce the number of potential customers while making the service less attractive to those who remain.

Needless to say the GAO report gives no assurance that the interchange fee cure is not worse than the disease.  So why wade into such muddy waters?   With the real estate mortgage market under siege, this is hardly the time to open a second front in the credit card wars.  The administrative costs and political risks of initiative are not worth the candle.