Archives For bundled discounts

The Federal Trade Commission’s (FTC) June 23 Workshop on Conditional Pricing Practices featured a broad airing of views on loyalty discounts and bundled pricing, popular vertical business practices that recently have caused much ink to be spilled by the antitrust commentariat.  In addition to predictable academic analyses featuring alternative theoretical anticompetitive effects stories, the Workshop commendably included presentations by Benjamin Klein that featured procompetitive efficiency explanations for loyalty programs and by Daniel Crane that stressed the importance of (1) treating discounts hospitably and (2) requiring proof of harmful foreclosure.  On balance, however, the Workshop provided additional fuel for enforcers who are enthused about applying new anticompetitive effects models to bring “problematic” discounting and bundling to heel.

Before U.S. antitrust enforcement agencies launch a new crusade against novel vertical discounting and bundling contracts, however, they may wish to ponder a few salient factors not emphasized in the Workshop.

First, the United States has the most efficient marketing and distribution system in the world, and it has been growing more efficient in recent decades (this is the one part of the American economy that has been a bright spot).  Consumers have benefited from more shopping convenience and higher quality/lower priced offerings due to the advent of  “big box” superstores, Internet sales engines (and e-commerce in general), and other improvements in both on-line and “bricks and mortar” sales methods.

Second, and relatedly, the Supreme Court’s recognition of vertical contractual efficiencies in GTE-Sylvania (1977) ushered in a period of greatly reduced potential liability for vertical restraints, undoubtedly encouraging economically beneficial marketing improvements.  A new government emphasis on investigating and litigating the merits of novel vertical practices (particularly practices that emphasize discounting, which presumptively benefits consumers) could inject costly new uncertainty into the marketing side of business planning, spawn risk aversion, and deter marketing innovations that reduce costs, thereby harming welfare.  These harms would mushroom to the extent courts mistakenly “bought into” new theories and incorrectly struck down efficient practices.

Third, in applying new theories of competitive harm, the antitrust enforcers should be mindful of Ronald Coase’s admonition that “if an economist finds something—a business practice of one sort or other—that he does not understand, he looks for a monopoly explanation.  And as in this field we are very ignorant, the number of ununderstandable practices tends to be rather large, and the reliance on a monopoly explanation, frequent.”  Competition is a discovery procedure.  Entrepreneurial businesses constantly seek improvements not just in productive efficiency, but in distribution and marketing efficiencies, in order to eclipse their rivals.  As such, entrepreneurs may experiment with new contractual forms (such as bundling and loyalty discounts) in an effort to expand their market shares and grow their firms.  Business persons may not know ex ante which particular forms will work.  They may try out alternatives, sticking with those that succeed and discarding those that fail, without necessarily being able to articulate precisely the reasons for success or failure.  Real results in the market, rather than arcane economic theorems, may be expected to drive their decision-making.   Distribution and marketing methods that are successful will be emulated by others and spread.  Seen in this light (and relatedly, in light of transaction cost economics explanations for “non-standard” contracts), widespread adoption of new vertical contractual devices most likely indicates that they are efficient (they improve distribution, and imitation is the sincerest form of flattery), not that they represent some new competitive threat.  Since an economic model almost always can be ginned up to explain why some new practice may reduce consumer welfare in theory, enforcers should instead focus on hard empirical evidence that output and quality have been reduced due to a restraint before acting.  Unfortunately, the mere threat of costly misbegotten investigations may chill businesses’ interest in experimenting with new and potentially beneficial vertical contractual arrangements, reducing innovation and slowing welfare enhancement (consistent with point two, above).

Fourth, decision theoretic considerations should make enforcers particularly wary of pursuing conditional pricing contracts cases.  Consistent with decision theory, optimal antitrust enforcement should adopt an error cost framework that seeks to minimize the sum of the costs attributable to false positives, false negatives, antitrust administrative costs, and disincentive costs imposed on third parties (the latter may also be viewed as a subset of false positives).  Given the significant potential efficiencies flowing from vertical restraints, and the lack of empirical showing that they are harmful, antitrust enforcers should exercise extreme caution in entertaining proposals to challenge new vertical arrangements, such as conditional pricing mechanisms.  In particular, they should carefully assess the cumulative weight of the high risk of false positives in this area, the significant administrative costs that attend investigations and prosecutions, and the disincentives toward efficient business arrangements (see points two and three above).  Taken together, these factors strongly suggest that the aggressive pursuit of conditional pricing practice investigations would flunk a reasonable cost-benefit calculus.

Fifth, a new U.S. antitrust enforcement crusade against conditional pricing could be used by foreign competition agencies to justify further attacks on efficient vertical practices.  This could add to the harm suffered by companies (including, of course, U.S.-based multinationals) which would be deterred from maintaining and creating new welfare-beneficial distribution methods.  Foreign consumers, of course, would suffer as well.

My caveats should not be read to suggest that the FTC should refrain from pursuing new economic learning on loyalty discounting and bundled pricing, nor on other novel business practices.  Nor should it necessarily eschew all enforcement in the vertical restraints area – although that might not be such a bad idea, given error cost and resource constraint issues.  (Vertical restraints that are part of a cartel enforcement scheme should be treated as cartel conduct, and, as such, should be fair game, of course.)  In order optimally to allocate scarce resources, however, the FTC might benefit by devoting relatively greater attention to the most welfare-inimical competitive abuses – namely, anticompetitive arrangements instigated, shielded, or maintained by government authority.  (Hard core private cartel activity is best left to the Justice Department, which can deploy powerful criminal law tools against such schemes.)

Yale Law Journal has published my article on “The Antitrust/ Consumer Protection Paradox: Two Policies At War With One Another.”  The hat tip to Robert Bork’s classic “Antitrust Paradox” in the title will be apparent to many readers.  The primary purpose of the article is to identify an emerging and serious conflict between antitrust and consumer protection law arising out of a sharp divergence in the economic approaches embedded within antitrust law with its deep attachment to rational choice economics on the one hand, and the new behavioral economics approach of the Consumer Financial Protection Bureau.  This intellectual rift brings with it serious – and detrimental – consumer welfare consequences.  After identifying the causes and consequences of that emerging rift, I explore the economic, legal, and political forces supporting the rift.

Here is the abstract:

The potential complementarities between antitrust and consumer protection law— collectively, “consumer law”—are well known. The rise of the newly established Consumer Financial Protection Bureau (CFPB) portends a deep rift in the intellectual infrastructure of consumer law that threatens the consumer-welfare oriented development of both bodies of law. This Feature describes the emerging paradox that rift has created: a body of consumer law at war with itself. The CFPB’s behavioral approach to consumer protection rejects revealed preference— the core economic link between consumer choice and economic welfare and the fundamental building block of the rational choice approach underlying antitrust law. This Feature analyzes the economic, legal, and political institutions underlying the potential rise of an incoherent consumer law and concludes that, unfortunately, there are several reasons to believe the intellectual rift shaping the development of antitrust and consumer protection will continue for some time.

Go read the whole thing.

The American Antitrust Institute has announced plans to draft a comprehensive set of jury instructions for antitrust trials.  According to AAI president Bert Foer:

In Sherman Act Section 1 and Section 2 civil cases, judges tend to gravitate towards the ABA Model Instructions as the gold standard for impartial instructions. … The AAI believes the ABA model instructions are, in some situations, confusing, out of date, or do not adequately effectuate the goals of the antitrust laws. To provide an alternative, the AAI will develop a set of jury instructions that can be widely disseminated to lawyers and judges.

Foer is certainly right about existing jury instructions.  They’re often confusing and frequently provide so little guidance that jurors are effectively invited simply to “pick a winner.”  Crafting clearer, more concrete jury instructions would benefit the antitrust enterprise and further AAI’s stated mission “to increase the role of competition [and] assure that competition works in the interests of consumers.”

But clarity alone is not enough.  Any new jury instructions should set forth (in clear terms) liability standards whose substance enhances the effectiveness of the antitrust.  Here’s where I worry about the AAI project.

Throughout its history, AAI has shown little regard for the inherent limits of antitrust.  Those limits arise because the antitrust laws (1) embody somewhat vague standards that factfinders must flesh out ex post (e.g., they forbid “unreasonable” restraints of trade and “unreasonably” exclusionary conduct by monopolists) and (2) are privately enforceable in lawsuits giving rise to treble damages.  The former feature ensures that courts, regulators, and business planners face difficulty in evaluating the legality of business practices.  The latter guarantees that they’re regularly called upon to do so.  It also discourages borderline practices that might wrongly be deemed, after the fact, to be anticompetitive.  Antitrust therefore creates significant “decision costs” (in both adjudication and counseling) and “error costs” (in the form of either market power resulting from improper acquittals or foregone efficiencies resulting from improper convictions and the chilling of procompetitive conduct).  Those decision and error costs constitute the limits of antitrust and are inexorable:

  • you can’t decrease decision costs (by simplifying a liability rule) without increasing error costs (incorrect judgments and enhanced chilling effect);
  • you can’t decrease error costs (by making the rule more nuanced in order to better separate pro- from anticompetitive conduct) without increasing decision costs; 
  • you can’t reduce false acquittals (by easing the plaintiff’s proof burden or cutting back on affirmative defenses) without increasing false convictions, and vice-versa.

In light of this unhappy situation, antitrust liability standards should be crafted so as to minimize the sum of decision and error costs.  As I have recently explained, the Roberts Court has taken this tack in its eight major antitrust decisions.

AAI, by contrast, has shown little concern for false positives and seems to equate an effective antitrust regime with one that produces more liability.  Time and again, the Institute has advocated “pro-plaintiff” liability rules that threaten high error costs in the form of false convictions (and the chilling effect that follows).  In all but one of the Roberts Court’s antitrust decisions (which, as noted, are consistent with a “decision-theoretic” framework that would help minimize the sum of decision and error costs), AAI has advocated a pro-plaintiff position that the Supreme Court ultimately rejected.  (See AAI’s positions in Twombly, Leegin, Credit Suisse, Dagher, Weyerhaeuser, LinkLine, and Independent Ink.)  This is a stunningly bad record. 

Moreover, AAI remains out of antitrust’s mainstream (which now acknowledges antitrust’s inherent limits and the need to constrain error costs) on practices involving somewhat unsettled liability rules.  Consider, for example, AAI’s views on: 

  • Resale Price Maintenance (RPM).  Even after Leegin abrogated the per se rule against minimum RPM, AAI urged courts to adopt a rule of reason that would burden a defendant with “justifying” any instance of RPM that results in an increase in consumer prices.  Such an approach is likely to generate excessive liability because all instances of RPM — even those aimed at such procompetitive effects as the elimination of free-riding, the facilitation of new entry, or encouraging “non-free-rideable” demand-enhancing services — involve an increase in consumer prices.  AAI’s preferred rule essentially amounts to a presumption of illegality for RPM.  As I explained in this article, such an approach would involve huge error costs (and certainly wouldn’t minimize the sum of decision and error costs).
     
  • Loyalty Rebates.  Efficiency-minded antitrust scholars have generally concluded that there should be a safe harbor for single-product loyalty rebates resulting in an above-cost discounted price for the product at issue.  The leading case on loyalty rebates, the Eight Circuit’s Concord Boat decision, agrees.  The thinking behind such a safe harbor is that any equally efficient rival could match a defendant’s loyalty rebate that resulted in an above-cost discounted price; permitting liability on the basis of such a rebate would chill discounting and create a price umbrella for relatively inefficient rivals.  AAI, however, has urged courts to reject the safe harbor approved in Concord Boat.
     
  • Bundled Discounts.   Efficiency-minded antitrust scholars have also approved a safe harbor for some sorts of multi-product or “bundled”
     discounts: such a discount should be legal if each product in the bundle is priced above cost when the entire amount of the bundled discount is attributed to that single product.  The Ninth Circuit approved this safe harbor in its PeaceHealth decision.  Again, the rationale behind the safe harbor is that an equally efficient, single-product rival could meet any bundled discount resulting an above-cost pricing under this so-called “discount attribution” test.  And again, AAI has opposed this safe harbor.

These are but a few examples of AAI’s wildly pro-plaintiff view of antitrust—a view that ultimately injures consumers by ignoring the error costs (e.g., thwarted procompetitive business practices) associated with false convictions.  So in the end, I’m a bit worried about AAI’s jury instruction project.  If the Institute can simply provide clarity without pushing substantive liability standards in its preferred, pro-plaintiff (error cost-insensitive) direction, antitrust will be better off because of its efforts.  But I’m not optimistic.

Flying back from a hiking trip to spectacular Glacier National Park (see pics below the fold), I overheard a flight attendant say something that made me think of, what else?, bundled discounts.  “We also fly for Delta,” the United flight attendant told the woman in front of me.  That’s when I realized I was really flying on Skywest, a regional airline that provides service to the major airlines.

Skywest, it seems, flies between major airlines’ hub cities (Salt Lake City for Delta, Denver for United) and smaller destinations like Kalispell, Bozeman, Jackson Hole, etc.  (Full route map here.)  It does so, though, under the auspices of the major airlines, so one never buys a “Skywest” ticket, always a Delta or United ticket.  (This is pretty common.  Columbia, Missouri, where I teach, is serviced by Pinnacle Airlines, which flies back and forth between Columbia and Memphis for Delta.)

So what has this to do with bundled discounts?  Well, first recall why such discounts (price-cuts conditioned on purchasing products from multiple product markets) create anticompetitive concerns.  Courts, regulators, and scholars have worried that a multi-product seller may use bundled discounts to exclude equally or more efficient rivals that sell less extensive lines of products.  In theory, a multi-product seller who has market power over at least one of its products (i.e., the ability to charge an above-cost price for that product) could offer a bundled discount that results in an above-cost (and thus non-predatory) price for the bundle, but would still tend to exclude an equally efficient, but less diversified, rival.

The classic example of this strategy involves a bundled discount offered by a producer of shampoo and conditioner.  Suppose that manufacturer A sells both shampoo and conditioner, is a monopolist in the conditioner market, and competes in the shampoo market against manufacturer B, which sells only shampoo.  B is the more efficient shampoo manufacturer, producing shampoo at a cost of $1.25 a bottle compared to A’s cost of $1.50 per bottle.  A’s cost of producing a bottle of conditioner is $2.50.  If purchased separately, A’s per-bottle prices for shampoo and conditioner are $2.00 and $4.00, respectively.  But A offers customers a $1.00 bundled discount, charging only $5.00 for the shampoo/conditioner package.  While this discounted price is still above A’s cost for the bundle ($4.00), it could tend to exclude B.  Assuming that shampoo buyers must also buy conditioner (in equal proportions), buyers would have to pay A’s unbundled conditioner price of $4.00 if they purchased B’s shampoo and would thus be unwilling to pay more than $1.00 for the B brand of shampoo.  That price, though, is below B’s $1.25 cost.  Thus, A’s bundled discount would tend to exclude B from the market even though (1) the discounted price ($5.00) is above A’s aggregate cost for the bundle ($4.00), and (2) B is the more efficient shampoo producer.

Regional airlines like Skywest and Pinnacle find themselves in the same position as the shampoo-only manufacturer.  A significant impediment to these smaller airlines is the major carriers’ ability to offer a type of bundled discount — a price for a “bundle” of flights going from departure point to hub to destination that is significantly lower than the sum of the prices of two flights, one from departure point to hub and the other from hub to destination.  For example, a Delta flight from Columbia, Missouri to Memphis (a Delta hub) to New York City might cost $400, while purchasing separate flights from Columbia to Memphis and then from Memphis to NYC might cost a total of $500 ($200 for the Columbia to Memphis leg and $300 for the Memphis to NYC leg). This is, in effect, a bundled discount of $100.  If Pinnacle wanted to compete for passengers flying from Columbia to NYC, it would have to absorb the entire amount of the package discount on the single leg it offered (Columbia to Memphis), charging no more than $100 for the flight.  That price, though, may be below its cost.

Despite this impediment, regional airlines like Pinnacle and Skywest have not been driven out of business by the major carriers’ pricing strategies.  Instead, they have remained in business and have often delivered higher profits than their major carrier rivals.  How did they accomplish this feat?  By becoming suppliers to the major air carriers, offering to provide short-haul air service more efficiently than the majors.

So what are the implications for legal restrictions on bundled discounts?  A number of commentators have suggested that a bundled discount should be illegal if it would result in below-cost pricing on the competitive product after the entire amount of the discount is attributed to that product.  They take this position because they assume that such a discount would exclude an equally efficient, single-product rival by forcing it to price below its own cost.

The continued existence of Pinnacle, Sky West, and the other regional airlines, though, undermines this assumption.  Equally or more efficient single-product rivals confronted with the sort of bundled discount discussed above have a way to stay in business:  they can become suppliers to the bundled discounter.  If they are, in fact, more efficient than the discounter, it should jump on the opportunity to outsource production to them.  Thus, I would argue, a plaintiff complaining of exclusion by a bundled discount that does not run afoul of standard predatory pricing rules should have to show, among other things, that it could not stay in business by becoming a supplier to its discounting rival.  (It should also have to show that it could not replicate the bundle by collaborating with other product suppliers.)

For greater discussion of the appropriate liability rule for bundled discounts, see Part III of this article and Part IV of this article.  For some Glacier photos, see below the fold.  Continue Reading…

In recent years, antitrust scholars have largely agreed on a couple of propositions involving tying and bundled discounting. With respect to tying (selling one’s monopoly “tying” product only on the condition that buyers also purchase another “tied” product), scholars from both the Chicago and Harvard Schools of antitrust analysis have generally concluded that there should be no antitrust liability unless the tie-in results in substantial foreclosure of marketing opportunities in the tied product market. Absent such foreclosure, scholars have reasoned, truly anticompetitive harm is unlikely to occur. The prevailing liability rule, however, condemns tie-ins without regard to whether they occasion substantial tied market foreclosure.

With respect to bundled discounting (selling a package of products for less than the aggregate price of the products if purchased separately), scholars have generally concluded that there should be no antitrust liability if the discount at issue could be matched by an equally efficient single-product rival of the discounter. That will be the case if each product in the bundle is priced above cost after the entire bundled discount is attributed to that product. Antitrust scholars have therefore generally endorsed a safe harbor for bundled discounts that are “above cost” under a “discount attribution test.”

In an article appearing in the December 2009 Harvard Law Review, Harvard law professor Einer Elhauge challenged each of these near-consensus propositions. According to Elhauge, the conclusion that significant tied market foreclosure should be a prerequisite to tying liability stems from scholars’ naïve acceptance of the Chicago School’s “single monopoly profit” theory. Elhauge insists that the theory is infirm and that instances of tying may occasion anticompetitive “power” (i.e., price discrimination) effects even if they do not involve substantial tied market foreclosure. He maintains that the Supreme Court has deemed such effects to be anticompetitive and that it was right to do so.

With respect to bundled discounting, Elhauge calls for courts to forego price-cost comparisons in favor of a rule that asks whether the defendant seller has “coerced” consumers into buying the bundle by first raising its unbundled monopoly (“linking”) product price above the “but-for” level that would prevail absent the bundled discounting scheme and then offering a discount from that inflated level.

I have just posted to SSRN an article criticizing Elhauge’s conclusions on both tying and bundled discounting. On tying, the article argues, Elhauge makes both descriptive and normative mistakes. As a descriptive matter, Supreme Court precedent does not deem the so-called power effects (each of which was well-known to Chicago School scholars) to be anticompetitive. As a normative matter, such effects should not be regulated because they tend to enhance total social welfare, especially when one accounts for dynamic efficiency effects. Because tying can create truly anticompetitive effect only when it involves substantial tied market foreclosure, such foreclosure should be a prerequisite to liability.

On bundled discounting, I argue, Elhauge’s proposed rule would be a disaster. The rule fails to account for the fact that bundled discounts may create immediate consumer benefit even if the seller has increased unbundled linking prices above but-for levels. It is utterly inadministrable and would chill procompetitive instances of bundled discounting. It is motivated by a desire to prevent “power” effects that are not anticompetitive under governing Supreme Court precedent (and should not be deemed so). Accordingly, courts should reject Elhauge’s proposed rule in favor of an approach that first focuses on the genuine prerequisite to discount-induced anticompetitive harm—“linked” market foreclosure—and then asks whether any such foreclosure is anticompetitive in that it could not be avoided by a determined competitive rival. To implement such a rule, courts would need to apply the discount attribution test.

The paper is a work-in-progress. Herbert Hovenkamp has already given me a number of helpful comments, which I plan to incorporate shortly. In the meantime, I’d love to hear what TOTM readers think.