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[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.

This post is authored by Tim Brennan, (Professor, Economics & Public Policy, University of Maryland; former FCC; former FTC).]

Observers on TOTM and elsewhere have pointed out the importance of preserving patent rights as pharmaceutical and biotechnology companies pursue development of treatments for, and better vaccines against,  Covid-19. As the benefits of these treatments could reach into the trillions of dollars (see here for a casual estimate and here for a more serious one), it is hard to imagine a level of reward for successful innovations that is too high.

On the other hand, as these and other commentaries suggest if only implicitly, the high social value of a coronavirus treatment or vaccine may well lead to calls to limit the ability to profit from a patent. It is easy to imagine that a developer of a vaccine will not be able to charge the patent-protected price (note avoidance of the term “monopoly”). It almost certainly will not be able to do so if it cannot use price discrimination in order to allow those lacking the means to pay a uniform higher price to get the vaccine.

However, there is an alternative to patents that have not received much attention in the policy discussion—having the government (Treasury, NIH, CDC) offer a prize in exchange for open access to a successful vaccine or treatment. Prizes are not new; they go back at least to the early 18th century, when Britain offered a prize for improvements in clock accuracy to facilitate ocean-going navigation. Many prizes have been offered by the private sector, both for their own use—Netflix offering a prize for improvements to its movie recommendation algorithm—and to altruistically promote innovation. Charles Lindbergh’s 1927 first solo transatlantic flight, and previous attempts by others, were motivated at least in part by a $25,000 prize offered by a New York hotel owner. 

In light of the net benefits of an improved vaccine, indicated perhaps by the level of spending in enacted and proposed stimulus and rescue programs, a prize of, oh, $25 billion is practically chump change. But would a prize make sense here?

I and two former colleagues at Resources for the Future, Molly Macauley and Kate Whitefoot, analyzed the use of prizes in comparison to patents and other methods to solicit and procure innovation.  This work was inspired by Molly’s interest in NASA’s use of prizes to induce innovations in space exploration equipment. On the theory side, we were interested because models of patents typically treat patents as prizes—the successful innovator gets $X in expected profit—and thus were unable to explain why one might want to choose prizes rather than patents and vice versa

When is a prize a “prize”?

The answer to this question requires being clear on what I mean by a prize. A familiar type of prize is the “best” of something, from first prize in the middle school science fair to the Academy Award for Best Picture. This is not the kind of prize I’m talking about with regard to coming up with a treatment for or vaccine against Covid-19. (George Mason’s Mercatus Center is offering prizes of this sort for things like $50,000 for “best coronavirus policy writing” to $500,000 for “best effort to find a treatment rapidly”; h/t to Geoff Manne.) Rather, it is a prize for being first to achieve a specific outcome, for example, a solo flight across the Atlantic Ocean. 

A necessary component of such prizes is a winning condition, specified in advance. For example, the $10 million Ansari X Prize to promote commercial space travel was not awarded just for some general demonstration of feasibility that pleased a set of judges. Rather, it specifically went to the first team that could “carry three people 100 kilometers above the earth’s surface twice within two weeks.”  Contestants knew what they had to do, and there was no dispute when the winner met the criterion for getting the prize.

Prizes or patents?

The need for a winning condition highlights one of the two main criteria affecting the choice of patents or prizes: advance knowledge of the specific goal. Economy-wide, the advantage of patents over prizes is that entrepreneurial innovators are rewarded for coming up with sufficiently novel products or processes of value. Knowledge regarding what is worth innovative effort is decentralized and often tacit. On the other hand, if a funder, including the government, knows what it wants sufficiently well that it can specify a winning condition, a prize can be sensible as a way to focus innovative effort toward that desired objective.

The second criterion for choosing between patents and prizes is more subtle. Someone undertaking research effort to come up with a patent bears two risks. The first is the risk that the effort will not be successful, not just overall but in being the first to be able to file for a patent. That risk is essentially shared by those pursuing a prize, where being first involves not filing for a patent but meeting the winning condition. However, patent seekers bear another risk, which is how much the patent will be worth if they win it. Prize seekers do not bear that risk, as the prize is specified in advance. (Economic models of patent activity tend to ignore this variation.) Thus, a prize may induce more risk-averse innovators to compete for the prize.

Assuming a winning condition for a Covid-19 treatment or vaccine can be specified in advance—I leave that to the medical people—our present public health dilemma could be well suited for a prize. As observed earlier, with both net benefits and already made public spending responses in the trillions of dollars, such a prize could and should be quite large. That may be a difficult to sell politically but, as also observed earlier, the government may not be able to commit credibly to allow a patent winner to exploit the treatment or vaccine’s economic value.

Design issues, TBD

If prizes become an appealing way to encourage Covid-19 mitigation innovations, a few design issues remain on the table.

One is whether to have intermediate prizes, with their own winning conditions, to narrow down the field of contestants to those with more promising approaches. One would need some sort of winning condition for this, of course. A second is whether the innovation will be achieved more quickly by allowing contestants to combine efforts. The virtues of competition may be outweighed by being able to hedge bets rather than risk being stuck going down a blind alley.

A third is whether to go with winner-take-all or have second or third prizes. One advantage of multiple prizes is that it can mitigate some risk to innovators, at a potential cost of reducing the effort to win. However, one could imagine here that someone other than the winner might come up with a treatment or vaccine that does better than the winner but was found after the winner met the condition. This leads to a fourth policy choice—should contestants, the winner or others, retain patents, even if the winning treatment of vaccine is freely licensed, to be made available at marginal cost.

All of these choices, along with the choice of whether to offer a prize and what that prize should be, are matters of medical and pharmaceutical judgment. But economics does highlight the potential advantages of a prize and suggest that it may deserve some attention as other policy judgments are being made. 

[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.

This post is authored by Tim Brennan, (Professor, Economics & Public Policy, University of Maryland; former FCC; former FTC).]

Thinking about how to think about the coronavirus situation I keep coming back to three economic ideas that seem distinct but end up being related. First, a back of the envelope calculation suggests shutting down the economy for a while to reduce the spread of Covid-19. This leads to my second point, that political viability, if not simple fairness, dictates that the winners compensate the losers. The extent of both of these forces my main point, to understand why we can’t just “get the prices right” and let the market take care of it. Insisting that the market works in this situation could undercut the very strong arguments for why we should defer to markets in the vast majority of circumstances.

Is taking action worth it?

The first question is whether shutting down the economy to reduce the spread of Covid-19 is a good bet. Being an economist, I turn to benefit-cost analysis (BCA). All I can offer here is a back-of-the-envelope calculation, which may be an insult to envelopes. (This paper has a more serious calculation with qualitatively similar findings.) With all caveats recognized, the willingness to pay of an average person in the US to social distancing and closure policies, WTP, is

        WTP = X% times Y% times VSL,

where X% is the fraction of the population that might be seriously affected, Y% is the reduction in the likelihood of death for this population from these policies, and VSL is the “value of statistical life” used in BCA calculations, in the ballpark of $9.5M.

For X%, take the percentage of the population over 65 (a demographic including me). This is around 16%. I’m not an epidemiologist, so for Y%, the reduced likelihood of death (either from reduced transmission or reduced hospital overload), I can only speculate. Say it’s 1%, which naively seems pretty small. Even with that, the average willingness to pay would be

        WTP = 16% times 1% times $9.5M = $15,200.

Multiply that by a US population of roughly 330M gives a total national WTP of just over $5 trillion, or about 23% of GDP. Using conventional measures, this looks like a good trade in an aggregate benefit-cost sense, even leaving out willingness to pay to reduce the likelihood of feeling sick and the benefits to those younger than 65. Of course, among the caveats is not just whether to impose distancing and closures, but how long to have them (number of weeks), how severe they should be (gathering size limits, coverage of commercial establishments), and where they should be imposed (closing schools, colleges).  

Actual, not just hypothetical, compensation

The justification for using BCA is that the winners could compensate the losers. In the coronavirus setting, the equity considerations are profound. Especially when I remember that GDP is not a measure of consumer surplus, I ask myself how many months of the disruption (and not just lost wages) from unemployment should low-income waiters, cab drivers, hotel cleaners, and the like bear to reduce my over-65 likelihood of dying. 

Consequently, an important component of this policy to respect equity and quite possibly obtaining public acceptance is that the losers be compensated. In that respect, the justification for packages such as the proposal working (as I write) through Congress is not stimulus—after all, it’s  harder to spend money these days—as much as compensating those who’ve lost jobs as a result of this policy. Stimulus can come when the economy is ready to be jump-started.

Markets don’t always work, perhaps like now 

This brings me to a final point—why is this a public policy matter? My answer to almost any policy question is the glib “just get the prices right and the market will take care of it.” That doesn’t seem all that popular now. Part of that is the politics of fairness: Should the wealthy get the ventilators? Should hoarding of hand sanitizer be rewarded? But much of it may be a useful reminder that markets do not work seamlessly and instantaneously, and may not be the best allocation mechanism in critical times.

That markets are not always best should be a familiar theme to TOTM readers. The cost of using markets is the centerpiece for Ronald Coase’s 1937 Nature of the Firm and 1960 Problem of Social Cost justification for allocation through the courts. Many of us, including me on TOTM, have invoked these arguments to argue against public interventions in the structure of firms, particularly antitrust actions regarding vertical integration. Another common theme is that the common law tends toward efficiency because of the market-like evolutionary processes in property, tort, and contract case law.

This perspective is a useful reminder that the benefits of markets should always be “compared to what?” In one familiar case, the benefits of markets are clear when compared to the snail’s pace, limited information, and political manipulability of administrative price setting. But when one is talking about national emergencies and the inelastic demands, distributional consequences, and the lack of time for the price mechanism to work its wonders, one can understand and justify the use of the plethora of mandates currently imposed or contemplated. 

The common law also appears not to be a good alternative. One can imagine the litigation nightmare if everyone who got the virus attempted to identify and sue some defendant for damages. A similar nightmare awaits if courts were tasked with determning how the risk of a pandemic would have been allocated were contracts ideal.

Much of this may be belaboring the obvious. My concern is that if those of us who appreciate the virtues of markets exaggerate their applicability, those skeptical of markets may use this episode to say that markets inherently fail and more of the economy should be publicly administered. Better to rely on facts rather than ideology, and to regard the current situation as the awful but justifiable exception that proves the general rule.

[TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.]

This post is authored by Timothy J. Brennan (Professor, Public Policy and Economics, University of Maryland; former Chief Economist, FCC; former economist, DOJ Antitrust Division).

The DOJ Antitrust Division and the FTC have issued draft proposed Vertical Merger Guidelines (VMGs). These have been long-desired in some quarters, and long-dreaded in others. The controversy remains, although those who long desired them may dread what they got, and vice versa. 

I’ve accepted Geoff’s invitation to offer some short thoughts on this blessedly short draft. I’ll focus on what one might call “pure” vertical mergers, as opposed to those based on concerns regarding potential entry or expansion by a vertically integrated firm into its upstream or downstream market. After looking at what the draft classifies as unilateral effects, I’ll then turn briefly to coordinated effects, burden of proof, and the whether we want to go there at all

A notable omission

It’s useful to think of pure vertical mergers mergers in a reverse direction; that is, not the harms they would create, but the benefits of blocking the merger even if it were harmful. The usual argument against prosecuting such mergers is that one would be left with separate firms charging above-competitive prices at one end or the other — and if they do it at both ends, creating double marginalization. 

In that regard, the draft has a notable omission: a skeptical eye toward mergers when a firm with market power is unable to charge a consequently high price. The usual justification is price regulation of a monopoly. Concern about the harm of vertical integration as a means to evade such regulation was the basis for the divestiture by AT&T of its then-regulated, then-monopoly local telephone companies, the mirror image of blocking a vertical merger. This concern also formed the basis of Federal Energy Regulatory Commission orders (here and here) separating control of regulated electricity transmission lines from ownership of unregulated generation.

More controversially, one could apply this in contexts where pricing is limited by something other than explicit regulation. TOTM has recently featured a debate between Geoff Manne and Dirk Auer on one side and Mark Lemley, Doug Melamed, and Steve Salop regarding the FTC’s case against Qualcomm’s licensing practices, where the issue (I think) is about whether FRAND licensing requirements limit Qualcomm’s ability to extract the full rental value of its patents. Perhaps even more out there, I’ve suggested that transaction costs keeping Google from charging directly for search could justify concern with discrimination in favor of its offerings in other markets, without having to reject a consumer welfare standard and where “free” search could justify rather than impede an antitrust case. Whether non-regulatory restrictions on price should justify vertical concerns is, to say the least, complicated. You’ll see that word often, and I’ll come back to it at the end

Raising rivals’ costs and foreclosure: Why would the merger matter?

The seeming truism of raising rivals’ costs is that to raise someone’s costs, you have to raise the price of an input they use or a complement they need. If a merger (or vertical restraint) extends control over an input or complement, the competitive risk arises because that complement market is being monopolized. Accordingly, enforcers need to ensure they are looking at competition and ease of entry in the market that’s being monopolized, not the market in which the bad guy who benefits might operate. For example, in the case involving Intel’s loyalty rebates to computer makers that allegedly excluded AMD’s processing chips, the relevant market was not chips but computers, and it is necessary to explain why AMD couldn’t get new computer makers to use its chips or vertically integrate itself into computers. 

With a “pure” vertical merger, however, the raising rivals’ cost or foreclosure story depends not on the creation or expansion of market power over an input or complement. It must depend on how vertical integration leads to the exercise of power in that market that was not being exercised before. That requires that vertical integration changes the strategic interactions determining price and quality. 

If this is the story, however, the agencies should make clear that they bear an obligation to explain how vertical integration matters, rather than assume a competitive outcome otherwise. The recent (failed) Justice Department challenge to AT&T’s vertical acquisition of Time Warner programming bears this out. DOJ’s core claim was that post-merger, Time Warner program services (HBO, CNN) would strike tougher deals with other video distributors, leading to higher licensing fees, because they would know that a failed negotiation would increase subscribership to AT&T. However, once a program service licenses to any video distributor, it realizes that if other video distributors don’t take their service, it will increase subscribers and profits from its initial deal. If that change in bargaining position benefits whoever gets the first deal, distributors presumably can cut a deal to be the first, without vertical merger being necessary. 

Might vertical merger still matter? Perhaps, but plaintiffs should have to explain what transaction costs prevent such a nominally anticompetitive deal. Critics of indifference to vertical mergers, and the draft VMGs, point out that double marginalization might be eliminated without vertical integration, through use of contracts that include fixed fees and sales at marginal cost. A similar skepticism regarding the need for vertical integration to achieve anticompetitive ends is similarly appropriate. Establishing that need may be, well, complicated

Coordination and symmetry

I have less to say about coordinated effects. Knowing when firms decide to switch from competing to cooperating is probably a matter of psychology and sociology as much as economics. However, economics does suggest that collusion is more likely the more symmetric are the positions of the potential colluders, to help find a mutually agreeable tactic and reduce the need for side payments and the like. To the extent symmetry is relevant, a pure vertical merger will facilitate collusion only if other market participants were similarly integrated. And absent market-wide collusion to integrate, this integration of the other participants could be reasonably interpreted as evidence of efficiencies of vertical integration. This would make a coordinated effects vertical merger case, well, complicated.

The burden of proof

As part of a widely voiced dissatisfaction with the last few decades of antitrust enforcement, some commentators have suggested that vertical mergers deserve no more of a presumption of being good than horizontal mergers. I would argue that the strength of evidence necessary to block a vertical merger should remain greater than that for horizontal mergers. This is not (just) because mergers between complements are more likely to lead prices to fall — eliminating double marginalization being an example — while horizontal mergers are likely to bring about upward pricing pressure. It is that the behavior that warrants concern with horizontal mergers, joint price setting, is illegal. Thus, the horizontal merger might be the only way to enable that conduct. 

Contracting alternatives to vertical merger abound, as two-part pricing to eliminate double marginalization and sequential per-subscriber pricing in video markets illustrate. Absent regulation, the transaction costs necessary to create and exercise market power but for vertical integration will be lower than those necessary to create and exercise that power but for horizontal merger. This difference in transaction costs means that horizontal merger is more likely to be necessary for harm than vertical merger. Thus, proving that the latter are harmful should be, well, more complicated.

So, are pure vertical mergers worth the trouble to prosecute?

Vertical mergers might be problematic, but cases are necessarily going to be complicated. This raises the question of whether the benefits of prosecuting such mergers are worth the costs, at least outside the regulated industry context. These costs are not just the cost of litigation but the costs to companies of having to hire antitrust counsel and consultants to try to determine whether their merger is likely to be challenged, how much negotiation with the agencies will be entailed, and what the likelihood of loss in court will be. Some aspects of antitrust enforcement, primarily determining who competes with whom and how much, are inevitably complicated. But it is not clear that we are better off expending the resources to see whether something is bad, rather than accepting the cost of error from adopting imperfect rules — even rules that imply strict enforcement. Pure vertical merger may be an example of something that we might just want to leave be.

brennanTim Brennan is a professor of public policy and economics at UMBC and a senior fellow with Resources for the Future (RFF).

When I first started working in antitrust at the Justice Department over thirty years ago—there’s a hard reality to accept—the Antitrust Division was then embroiled in an effort to reform the regulation of oil pipelines. The argument on this now obscure issue was that effective prevention of the exercise of market power by natural monopoly pipelines required both clear pricing standards and effective separation of control of the pipeline capacity from the shippers who often owned the pipeline as well. Among other things, this led the Division to take an active role in the proceeding to set the rates to send oil through the Trans-Alaska Pipeline.

This largely forgotten issue had a much more consequential successor—the AT&T divestiture in 1984, settling an antitrust case filed a decade before. That case took the hard line that to prevent anticompetitive abuses, regulated monopolies and competitive services that rely upon them should rest in completely separate companies. Although the 1996 Telecommunications Act superseded that settlement, the principle of separating control of regulated assets from firms that compete in services that use those assets survives. The prominent example is electricity. Many state regulators ordered local distribution utilities to divest power plants, and federal regulators require that power transmission be supplied by regional organizations independent of the control of the competing generators that use them.

When Assistant Attorney General William Baxter announced the AT&T divestiture in 1982, he also announced that he was dropping, with prejudice, the even older antitrust case against IBM. The distinction was that AT&T operated in both regulated and unregulated sectors, while IBM did not. AT&T had an incentive to evade regulatory price constraints by creating an artificial competitive advantage by impeding its competitive market rivals’ access to its local service monopolies (“discrimination”). Moreover, depending on the form that regulation might take, the ability to shift costs from unregulated to regulated sectors may allow cost shifting enable a regulated firm may to make predatory threats credible (“cross-subsidization”). In the old AT&T case, this was called “pricing without regard to cost”.

Mr. Baxter’s distinction rested on the crucial point that regulation is a complement to antitrust, not a substitute. Absent regulation, refusals to deal are not presumptively harmful, and may be beneficial, while predatory threats are notoriously difficult to validate. This is why Mr. Baxter, no great hero to antitrust activists, famously pledged to litigate U.S. v. AT&T “to the eyeballs.” Continue Reading…

brennanTim Brennan is a professor of public policy and economics at UMBC and a senior fellow with Resources for the Future (RFF).

As evidenced by this on-line symposium, the handling of cases under the rubrics “monopolization,” “single firm conduct”, or “abuse of dominance” continues to be debated by the competition policy community. This debate, as evidenced by the Antitrust Division’s Sept. 2008 single firm conduct report and the FTC responses, is not restricted within the U.S. The European Union has published “Guidance Papers” on standards for exclusionary conduct under Article 82, and the Canadian Competition Bureau recently issued draft guidelines for prosecuting conduct under the abuse of dominance provisions of Sec. 79 of its Competition Act.

Almost any significant antitrust case will engender controversy over the facts, e.g., damages resulting from cartel conduct or market definition for mergers. The controversy over single firm conduct runs deeper. Much of this contention arises because the direct focus of the conduct, harm to rivals, is also the byproduct of vigorous competition. Despite everyone having learned to utter the mantra “protect competition, not competitors,” we find a line drawn between two sides. To caricature the bifurcation only slightly, one side, which I’ll call the skeptics, would set the burden of proof very high, with harms to competitors presumptively competitive. The other, here called the activists finds enforcement lax, is more willing to protect competition by protecting competitors.

I propose to resolve the controversy by positing that both sides are right-but within separate categories of monopolization cases. Continue Reading…