Archives For vertical restraints

The goal of US antitrust law is to ensure that competition continues to produce positive results for consumers and the economy in general. We published a letter co-signed by twenty three of the U.S.’s leading economists, legal scholars and practitioners, including one winner of the Nobel Prize in economics (full list of signatories here), to exactly that effect urging the House Judiciary Committee on the State of Antitrust Law to reject calls for radical upheaval of antitrust law that would, among other things, undermine the independence and neutrality of US antitrust law. 

A critical part of maintaining independence and neutrality in the administration of antitrust is ensuring that it is insulated from politics. Unfortunately, this view is under attack from all sides. The President sees widespread misconduct among US tech firms that he believes are controlled by the “radical left” and is, apparently, happy to use whatever tools are at hand to chasten them. 

Meanwhile, Senator Klobuchar has claimed, without any real evidence, that the mooted Uber/Grubhub merger is simply about monopolisation of the market, and not, for example, related to the huge changes that businesses like this are facing because of the Covid shutdown.

Both of these statements challenge the principle that the rule of law depends on being politically neutral, including in antitrust. 

Our letter, contrary to the claims made by President Trump, Sen. Klobuchar and some of the claims made to the Committee, asserts that the evidence and economic theory is clear: existing antitrust law is doing a good job of promoting competition and consumer welfare in digital markets and the economy more broadly, and concludes that the Committee should focus on reforms that improve antitrust at the margin, not changes that throw out decades of practice and precedent.

The letter argues that:

  1. The American economy—including the digital sector—is competitive, innovative, and serves consumers well, contrary to how it is sometimes portrayed in the public debate. 
  2. Structural changes in the economy have resulted from increased competition, and increases in national concentration have generally happened because competition at the local level has intensified and local concentration has fallen.
  3. Lax antitrust enforcement has not allowed systematic increases in market power, and the evidence simply does not support out the idea that antitrust enforcement has weakened in recent decades.
  4. Existing antitrust law is adequate for protecting competition in the modern economy, and built up through years of careful case-by-case scrutiny. Calls to throw out decades of precedent to achieve an antitrust “Year Zero” would throw away a huge body of learning and deliberation.
  5. History teaches that discarding the modern approach to antitrust would harm consumers, and return to a situation where per se rules prohibited the use of economic analysis and fact-based defences of business practices.
  6. Common sense reforms should be pursued to improve antitrust enforcement, and the reforms proposed in the letter could help to improve competition and consumer outcomes in the United States without overturning the whole system.

The reforms suggested include measures to increase transparency of the DoJ and FTC, greater scope for antitrust challenges against state-sponsored monopolies, stronger penalties for criminal cartel conduct, and more agency resources being made available to protect workers from anti-competitive wage-fixing agreements between businesses. These are suggestions for the House Committee to consider and are not supported by all the letter’s signatories.

Some of the arguments in the letter are set out in greater detail in the ICLE’s own submission to the Committee, which goes into detail about the nature of competition in modern digital markets and in traditional markets that have been changed because of the adoption of digital technologies. 

The full letter is here.

[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 Jonathan M. Jacobson (Partner, Wilson Sonsini Goodrich & Rosati), and Kenneth Edelson (Associate, Wilson Sonsini Goodrich & Rosati).]

So we now have 21st Century Vertical Merger Guidelines, at least in draft. Yay. Do they tell us anything? Yes! Do they tell us much? No. But at least it’s a start.

* * * * *

In November 2018, the FTC held hearings on vertical merger analysis devoted to the questions of whether the agencies should issue new guidelines, and what guidance those guidelines should provide. And, indeed, on January 10, 2020, the DOJ and FTC issued their new Draft Vertical Merger Guidelines (“Draft Guidelines”). That new guidance has finally been issued is a welcome development. The antitrust community has been calling for new vertical merger guidelines for some time. The last vertical merger guidelines were issued in 1984, and there is broad consensus in the antitrust community – despite vigorous debate on correct legal treatment of vertical mergers – that the ’84 Guidelines are outdated and should be withdrawn. Despite disagreement on the best enforcement policy, there is general recognition that the legal rules applicable to vertical mergers need clarification. New guidelines are especially important in light of recent high-visibility merger challenges, including the government’s challenge to the ATT/Time Warner merger, the first vertical merger case litigated since the 1970s. These merger challenges have occurred in an environment in which there is little up-to-date case law to guide courts or agencies and the ’84 Guidelines have been rendered obsolete by subsequent developments in economics. 

The discussion here focuses on what the new Draft Guidelines do say, key issues on which they do not weigh in, and where additional guidance would be desirable

What the Draft Guidelines do say

The Draft Guidelines start with a relevant market requirement – making clear that the agencies will identify at least one relevant market in which a vertical merger may foreclose competition. However, the Draft Guidelines do not require a market definition for the vertically related upstream or downstream market(s) in the merger. Rather, the agencies’ proposed policy is to identify one or more “related products.” The Draft Guidelines define a related product as

a product or service that is supplied by the merged firm, is vertically related to the products and services in the relevant market, and to which access by the merged firm’s rivals affects competition in the relevant market.

The Draft Guidelines’ most significant (and most concrete) proposal is a loose safe harbor based on market share and the percentage of use of the related product in the relevant market of interest. The Draft Guidelines suggest that agencies are not likely to challenge mergers if two conditions are met: (1) the merging company has less than 20% market share in the relevant market, and (2) less than 20% of the relevant market uses the related product identified by the agencies. 

This proposed safe harbor is welcome. Generally, in order for a vertical merger to have anticompetitive effects, both the upstream and downstream markets involved need to be concentrated, and the merging firms’ shares of both markets have to be substantial – although the Draft Guidelines do not contain any such requirements. Mergers in which the merging company has less than a 20% market share of the relevant market, and in which less than 20% of the market uses the vertically related product are unlikely to have serious anticompetitive effects.

However, the proposed safe harbor does not provide much certainty. After describing the safe harbor, the Draft Guidelines offer a caveat: meeting the proposed 20% thresholds will not serve as a “rigid screen” for the agencies to separate out mergers that are unlikely to have anticompetitive effects. Accordingly, the guidelines as currently drafted do not guarantee that vertical mergers in which market share and related product use fall below 20% would be immune from agency scrutiny. So, while the proposed safe harbor is a welcome statement of good policy that may guide agency staff and courts in analyzing market share and share of relevant product use, it is not a true safe harbor. This ambiguity limits the safe harbor’s utility for the purpose of counseling clients on market share issues.

The Draft Guidelines also identify a number of specific unilateral anticompetitive effects that, in the agencies’ view, may result from vertical mergers (the Draft Guidelines note that coordinated effects will be evaluated consistent with the Horizontal Merger Guidelines). Most importantly, the guidelines name raising rivals’ costs, foreclosure, and access to competitively sensitive information as potential unilateral effects of vertical mergers. The Draft Guidelines indicate that the agency may consider the following issues: would foreclosure or raising rivals’ costs (1) cause rivals to lose sales; (2) benefit the post-merger firm’s business in the relevant market; (3) be profitable to the firm; and (4) be beyond a de minimis level, such that it could substantially lessen competition? Mergers where all four conditions are met, the Draft Guidelines say, often warrant competitive scrutiny. While the big picture guidance about what agencies find concerning is helpful, the Draft Guidelines are short on details that would make this a useful statement of enforcement policy, or sufficiently reliable to guide practitioners in counseling clients. Most importantly, the Draft guidelines give no indication of what the agencies will consider a de minimis level of foreclosure.

The Draft Guidelines also articulate a concern with access to competitively sensitive information, as in the recent Staples/Essendant enforcement action. There, the FTC permitted the merger after imposing a firewall that blocked Staples from accessing certain information about its rivals held by Essendant. This contrasts with the current DOJ approach of hostility to behavioral remedies.

What the Draft Guidelines don’t say

The Draft Guidelines also decline to weigh in on a number of important issues in the debates over vertical mergers. Two points are particularly noteworthy.

First, the Draft Guidelines decline to allocate the parties’ proof burdens on key issues. The burden-shifting framework established in U.S. v. Baker Hughes is regularly used in horizontal merger cases, and was recently adopted in AT&T/Time-Warner in a vertical context. The framework has three phases: (1) the plaintiff bears the burden of establishing a prima facie case that the merger will substantially lessen competition in the relevant market; (2) the defendant bears the burden of producing evidence to demonstrate that the merger’s procompetitive effects outweigh the alleged anticompetitive effects; and (3) the plaintiff bears the burden of countering the defendant’s rebuttal, and bears the ultimate burden of persuasion. Virtually everyone agrees that this or some similar structure should be used. However, the Draft Guidelines’ silence on the appropriate burden is consistent with the agencies’ historical practice: The 2010 Horizontal Merger Guidelines allocate no burdens and the 1997 Merger Guidelines explicitly decline to assign the burden of proof or production on any issue.

Second, the Draft Guidelines take an unclear approach to elimination of double marginalization (EDM). The appropriate treatment of EDM has been one of the key topics in the debates on the law and economics of vertical mergers, but the Draft Guidelines take no position on the key issues in the conversation about EDM: whether it should be presumed in a vertical merger, and whether it should be presumed to be merger-specific.

EDM may occur if two vertically related firms merge and the new firm captures the margins of both the upstream and downstream firms. After the merger, the downstream firm gets its input at cost, allowing the merged firm to eliminate one party’s markup. This makes price reduction profitable for the merged firm where it would not have been for either firm before the merger. 

The Draft Guidelines state that the agencies will not challenge vertical mergers where EDM means that the merger is unlikely to be anticompetitive. OK. Duh. However, they also claim that in some situations, EDM may not occur, or its benefits may be offset by other incentives for the merged firm to raise prices. The Draft Guidelines do not weigh in on whether it should be presumed that vertical mergers will result in EDM, or whether it should be presumed that EDM is merger-specific. 

These are the most important questions in the debate over EDM. Some economists take the position that EDM is not guaranteed, and not necessarily merger-specific. Others take the position that EDM is basically inevitable in a vertical merger, and is unlikely to be achieved without a merger. That is: if there is EDM, it should be presumed to be merger-specific. Those who take the former view would put the burden on the merging parties to establish pricing benefits of EDM and its merger-specificity. 

Our own view is that this efficiency is pervasive and significant in vertical mergers. The defense should therefore bear only a burden of producing evidence, and the agencies should bear the burden of disproving the significance of EDM where shown to exist. This would depart from the typical standard in a merger case, under which defendants must prove the reality, magnitude, and merger-specific character of the claimed efficiencies (the Draft Guidelines adopt this standard along with the approach of the 2010 Horizontal Merger Guidelines on efficiencies). However, it would more closely reflect the economic reality of most vertical mergers. 

Conclusion

While the Draft Guidelines are a welcome step forward in the debates around the law and economics of vertical mergers, they do not guide very much. The fact that the Draft Guidelines highlight certain issues is a useful indicator of what the agencies find important, but not a meaningful statement of enforcement policy. 

On a positive note, the Draft Guidelines’ explanations of certain economic concepts important to vertical mergers may serve to illuminate these issues for courts

However, the agencies’ proposals are not specific enough to create predictability for business or the antitrust bar or provide meaningful guidance for enforcers to develop a consistent enforcement policy. This result is not surprising given the lack of consensus on the law and economics of vertical mergers and the best approach to enforcement. But the antitrust community — and all of its participants — would be better served by a more detailed document that commits to positions on key issues in the relevant debates. 

[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 Gregory J. Werden (former Senior Economic Counsel, DOJ Antitrust Division (ret.)) and Luke M. Froeb (William C. Oehmig Chair in Free Enterprise and Entrepreneurship, Owen School of Management, Vanderbilt University; former Chief Economist, DOJ Antitrust Division; former Chief Economist, FTC).]

The proposed Vertical Merger Guidelines provide little practical guidance, especially on the key issue of what would lead one of the Agencies to determine that it will not challenge a vertical merger. Although they list the theories on which the Agencies focus and factors the Agencies “may consider,” the proposed Guidelines do not set out conditions necessary or sufficient for the Agencies to conclude that a merger likely would substantially lessen competition. Nor do the Guidelines communicate generally how the Agencies analyze the nature of a competitive process and how it is apt to change with a proposed merger. 

The proposed Guidelines communicate the Agencies’ enforcement policy in part through silences. For example, the Guidelines do not mention several theories that have appeared in recent commentary and thereby signal that Agencies have decided not to base their analysis on those theories. That silence is constructive, but the Agencies’ silence on the nature of their concern with vertical mergers is not. Since 1982, the Agencies’ merger guidelines have always stated that their concern was market power. Silence on this subject might suggest that the Agencies’ enforcement against vertical mergers is directed to something else. 

The Guidelines’ most conspicuous silence concerns the Agencies’ general attitude toward vertical mergers, and on how vertical and horizontal mergers differ. This silence is deafening: Horizontal mergers combine substitutes, which tends to reduce competition, while vertical mergers combine complements, which tends to enhance efficiency and thus also competition. Unlike horizontal mergers, vertical mergers produce anticompetitive effects only through indirect mechanisms with many moving parts, which makes the prediction of competitive effects from vertical mergers more complex and less certain.

The Guidelines also are unhelpfully silent on the basic economics of vertical integration, and hence of vertical mergers. In assessing a vertical merger, it is essential to appreciate that vertical mergers solve coordination problems that are solved less well, or not at all, by contracts. By solving different coordination problems, a vertical merger can generate merger-specific efficiencies or eliminate double marginalization. But solving a coordination problem need not be a good thing: Competition is the ultimate coordination problem, and a vertical merger can have anticompetitive consequences by helping to solve that coordination problem.   Finally, the Guidelines are unhelpfully silent on the fundamental policy issue presented by vertical merger enforcement: What distinguishes a vertical merger that harms competition from a vertical merger that merely harm competitors? A vertical merger cannot directly eliminate rivalry by increasing market concentration. The Supreme Court has endorsed a foreclosure theory under which the merger directly causes injury to a rival and thus proximately causes diminished rivalry. Vertical mergers also might diminish rivalry in other ways, but the proposed Guidelines do not state that the Agencies view diminished rivalry as the hallmark of a lessening of competition.   

[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 William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division), and Philip A. Giordano (Partner, Hughes Hubbard & Reed LLP).

[Kolasky & Giordano: The authors thank Katherine Taylor, an associate at Hughes Hubbard & Reed, for her help in researching this article.]

On January 10, the Department of Justice (DOJ) withdrew the 1984 DOJ Non-Horizontal Merger Guidelines, and, together with the Federal Trade Commission (FTC), released new draft 2020 Vertical Merger Guidelines (“DOJ/FTC draft guidelines”) on which it seeks public comment by February 26.[1] In announcing these new draft guidelines, Makan Delrahim, the Assistant Attorney General for the Antitrust Division, acknowledged that while many vertical mergers are competitively beneficial or neutral, “some vertical transactions can raise serious concern.” He went on to explain that, “The revised draft guidelines are based on new economic understandings and the agencies’ experience over the past several decades and better reflect the agencies’ actual practice in evaluating proposed vertical mergers.” He added that he hoped these new guidelines, once finalized, “will provide more clarity and transparency on how we review vertical transactions.”[2]

While we agree with the DOJ and FTC that the 1984 Non-Horizontal Merger Guidelines are now badly outdated and that a new set of vertical merger guidelines is needed, we question whether the draft guidelines released on January 10, will provide the desired “clarity and transparency.” In our view, the proposed guidelines give insufficient recognition to the wide range of efficiencies that flow from most, if not all, vertical mergers. In addition, the guidelines fail to provide sufficiently clear standards for challenging vertical mergers, thereby leaving too much discretion in the hands of the agencies as to when they will challenge a vertical merger and too much uncertainty for businesses contemplating a vertical merger. 

What is most troubling is that this did not need to be so. In 2008, the European Commission, as part of its merger process reform initiative, issued an excellent set of non-horizontal merger guidelines that adopt basically the same analytical framework as the new draft guidelines for evaluating vertical mergers.[3] The EU guidelines, however, lay out in much more detail the factors the Commission will consider and the standards it will apply in evaluating vertical transactions. That being so, it is difficult to understand why the DOJ and FTC did not propose a set of vertical merger guidelines that more closely mirror those of the European Commission, rather than try to reinvent the wheel with a much less complete set of guidelines.

Rather than making the same mistake ourselves, we will try to summarize the EU vertical mergers and to explain why we believe they are markedly better than the draft guidelines the DOJ and FTC have proposed. We would urge the DOJ and FTC to consider revising their draft guidelines to make them more consistent with the EU vertical merger guidelines. Doing so would, among other things, promote greater convergence between the two jurisdictions, which is very much in the interest of both businesses and consumers in an increasingly global economy.

The principal differences between the draft joint guidelines and the EU vertical merger guidelines

1. Acknowledgement of the key differences between horizontal and vertical mergers

The EU guidelines begin with an acknowledgement that, “Non-horizontal mergers are generally less likely to significantly impede effective competition than horizontal mergers.” As they explain, this is because of two key differences between vertical and horizontal mergers.

  • First, unlike horizontal mergers, vertical mergers “do not entail the loss of direct competition between the merging firms in the same relevant market.”[4] As a result, “the main source of anti-competitive effect in horizontal mergers is absent from vertical and conglomerate mergers.”[5]
  • Second, vertical mergers are more likely than horizontal mergers to provide substantial, merger-specific efficiencies, without any direct reduction in competition. The EU guidelines explain that these efficiencies stem from two main sources, both of which are intrinsic to vertical mergers. The first is that, “Vertical integration may thus provide an increased incentive to seek to decrease prices and increase output because the integrated firm can capture a larger fraction of the benefits.”[6] The second is that, “Integration may also decrease transaction costs and allow for a better co-ordination in terms of product design, the organization of the production process, and the way in which the products are sold.”[7]

The DOJ/FTC draft guidelines do not acknowledge these fundamental differences between horizontal and vertical mergers. The 1984 DOJ non-horizontal guidelines, by contrast, contained an acknowledgement of these differences very similar to that found in the EU guidelines. First, the 1984 guidelines acknowledge that, “By definition, non-horizontal mergers involve firms that do not operate in the same market. It necessarily follows that such mergers produce no immediate change in the level of concentration in any relevant market as defined in Section 2 of these Guidelines.”[8] Second, the 1984 guidelines acknowledge that, “An extensive pattern of vertical integration may constitute evidence that substantial economies are afforded by vertical integration. Therefore, the Department will give relatively more weight to expected efficiencies in determining whether to challenge a vertical merger than in determining whether to challenge a horizontal merger.”[9] Neither of these acknowledgements can be found in the new draft guidelines.

These key differences have also been acknowledged by the courts of appeals for both the Second and D.C. circuits in the agencies’ two most recent litigated vertical mergers challenges: Fruehauf Corp. v. FTC in 1979[10] and United States v. AT&T in 2019.[11] In both cases, the courts held, as the D.C. Circuit explained in AT&T, that because of these differences, the government “cannot use a short cut to establish a presumption of anticompetitive effect through statistics about the change in market concentration” – as it can in a horizontal merger case – “because vertical mergers produce no immediate change in the relevant market share.”[12] Instead, in challenging a vertical merger, “the government must make a ‘fact-specific’ showing that the proposed merger is ‘likely to be anticompetitive’” before the burden shifts to the defendants “to present evidence that the prima facie case ‘inaccurately predicts the relevant transaction’s probable effect on future competition,’ or to ‘sufficiently discredit’ the evidence underlying the prima facie case.”[13]

While the DOJ/FTC draft guidelines acknowledge that a vertical merger may generate efficiencies, they propose that the parties to the merger bear the burden of identifying and substantiating those efficiencies under the same standards applied by the 2010 Horizontal Merger Guidelines. Meeting those standards in the case of a horizontal merger can be very difficult. For that reason, it is important that the DOJ/FTC draft guidelines be revised to make it clear that before the parties to a vertical merger are required to establish efficiencies meeting the horizontal merger guidelines’ evidentiary standard, the agencies must first show that the merger is likely to substantially lessen competition, based on the type of fact-specific evidence the courts required in both Fruehauf and AT&T.

2. Safe harbors

Although they do not refer to it as a “safe harbor,” the DOJ/FTC draft guidelines state that, 

The Agencies are unlikely to challenge a vertical merger where the parties to the merger have a share in the relevant market of less than 20 percent, and the related product is used in less than 20 percent of the relevant market.[14] 

If we understand this statement correctly, it means that the agencies may challenge a vertical merger in any case where one party has a 20% share in a relevant market and the other party has a 20% or higher share of any “related product,” i.e., any “product or service” that is supplied by the other party to firms in that relevant market. 

By contrast, the EU guidelines state that,

The Commission is unlikely to find concern in non-horizontal mergers . . . where the market share post-merger of the new entity in each of the markets concerned is below 30% . . . and the post-merger HHI is below 2,000.[15] 

Both the EU guidelines and the DOJ/FTC draft guidelines are careful to explain that these statements do not create any “legal presumption” that vertical mergers below these thresholds will not be challenged or that vertical mergers above those thresholds are likely to be challenged.

The EU guidelines are more consistent than the DOJ/FTC draft guidelines both with U.S. case law and with the actual practice of both the DOJ and FTC. It is important to remember that the raising rivals’ costs theory of vertical foreclosure was first developed nearly four decades ago by two young economists, David Scheffman and Steve Salop, as a theory of exclusionary conduct that could be used against dominant firms in place of the more simplistic theories of vertical foreclosure that the courts had previously relied on and which by 1979 had been totally discredited by the Chicago School for the reasons stated by the Second Circuit in Fruehauf.[16] 

As the Second Circuit explained in Fruehauf, it was “unwilling to assume that any vertical foreclosure lessens competition” because 

[a]bsent very high market concentration or some other factor threatening a tangible anticompetitive effect, a vertical merger may simply realign sales patterns, for insofar as the merger forecloses some of the market from the merging firms’ competitors, it may simply free up that much of the market, in which the merging firm’s competitors and the merged firm formerly transacted, for new transactions between the merged firm’s competitors and the merging firm’s competitors.[17] 

Or, as Robert Bork put it more colorfully in The Antitrust Paradox, in criticizing the FTC’s decision in A.G. Spalding & Bros., Inc.,[18]:

We are left to imagine eager suppliers and hungry customers, unable to find each other, forever foreclosed and left languishing. It would appear the commission could have cured this aspect of the situation by throwing an industry social mixer.[19]

Since David Scheffman and Steve Salop first began developing their raising rivals’ cost theory of exclusionary conduct in the early 1980s, gallons of ink have been spilled in legal and economic journals discussing and evaluating that theory.[20] The general consensus of those articles is that while raising rivals’ cost is a plausible theory of exclusionary conduct, proving that a defendant has engaged in such conduct is very difficult in practice. It is even more difficult to predict whether, in evaluating a proposed merger, the merged firm is likely to engage in such conduct at some time in the future. 

Consistent with the Second Circuit’s decision in Fruehauf and with this academic literature, the courts, in deciding cases challenging exclusive dealing arrangements under either a vertical foreclosure theory or a raising rivals’ cost theory, have generally been willing to consider a defendant’s claim that the alleged exclusive dealing arrangements violated section 1 of the Sherman Act only in cases where the defendant had a dominant or near-dominant share of a highly concentrated market — usually meaning a share of 40 percent or more.[21] Likewise, all but one of the vertical mergers challenged by either the FTC or DOJ since 1996 have involved parties that had dominant or near-dominant shares of a highly concentrated market.[22] A majority of these involved mergers that were not purely vertical, but in which there was also a direct horizontal overlap between the two parties.

One of the few exceptions is AT&T/Time Warner, a challenge the DOJ lost in both the district court and the D.C. Circuit.[23] The outcome of that case illustrates the difficulty the agencies face in trying to prove a raising rivals’ cost theory of vertical foreclosure where the merging firms do not have a dominant or near-dominant share in either of the affected markets.

Given these court decisions and the agencies’ historical practice of challenging vertical mergers only between companies with dominant or near-dominant shares in highly concentrated markets, we would urge the DOJ and FTC to consider raising the market share threshold below which it is unlikely to challenge a vertical merger to at least 30 percent, in keeping with the EU guidelines, or to 40 percent in order to make the vertical merger guidelines more consistent with the U.S. case law on exclusive dealing.[24] We would also urge the agencies to consider adding a market concentration HHI threshold of 2,000 or higher, again in keeping with the EU guidelines.

3. Standards for applying a raising rivals’ cost theory of vertical foreclosure

Another way in which the EU guidelines are markedly better than the DOJ/FTC draft guidelines is in explaining the factors taken into consideration in evaluating whether a vertical merger will give the parties both the ability and incentive to raise their rivals’ costs in a way that will enable the merged entity to increase prices to consumers. Most importantly, the EU guidelines distinguish clearly between input foreclosure and customer foreclosure, and devote an entire section to each. For brevity, we will focus only on input foreclosure to show why we believe the more detailed approach the EU guidelines take is preferable to the more cursory discussion in the DOJ/FTC draft guidelines.

In discussing input foreclosure, the EU guidelines correctly distinguish between whether a vertical merger will give the merged firm the ability to raise rivals’ costs in a way that may substantially lessen competition and, if so, whether it will give the merged firm an incentive to do so. These are two quite distinct questions, which the DOJ/FTC draft guidelines unfortunately seem to lump together.

The ability to raise rivals’ costs

The EU guidelines identify four important conditions that must exist for a vertical merger to give the merged firm the ability to raise its rivals’ costs. First, the alleged foreclosure must concern an important input for the downstream product, such as one that represents a significant cost factor relative to the price of the downstream product. Second, the merged entity must have a significant degree of market power in the upstream market. Third, the merged entity must be able, by reducing access to its own upstream products or services, to affect negatively the overall availability of inputs for rivals in the downstream market in terms of price or quality. Fourth, the agency must examine the degree to which the merger may free up capacity of other potential input suppliers. If that capacity becomes available to downstream competitors, the merger may simple realign purchase patterns among competing firms, as the Second Circuit recognized in Fruehauf.

The incentive to foreclose access to inputs: 

The EU guidelines recognize that the incentive to foreclose depends on the degree to which foreclosure would be profitable. In making this determination, the vertically integrated firm will take into account how its supplies of inputs to competitors downstream will affect not only the profits of its upstream division, but also of its downstream division. Essentially, the merged entity faces a trade-off between the profit lost in the upstream market due to a reduction of input sales to (actual or potential) rivals and the profit gained from expanding sales downstream or, as the case may be, raising prices to consumers. This trade-off is likely to depend on the margins the merged entity obtains on upstream and downstream sales. Other things constant, the lower the margins upstream, the lower the loss from restricting input sales. Similarly, the higher the downstream margins, the higher the profit gain from increasing market share downstream at the expense of foreclosed rivals.

The EU guidelines recognize that the incentive for the integrated firm to raise rivals’ costs further depends on the extent to which downstream demand is likely to be diverted away from foreclosed rivals and the share of that diverted demand the downstream division of the integrated firm can capture. This share will normally be higher the less capacity constrained the merged entity will be relative to non-foreclosed downstream rivals and the more the products of the merged entity and foreclosed competitors are close substitutes. The effect on downstream demand will also be higher if the affected input represents a significant proportion of downstream rivals’ costs or if it otherwise represents a critical component of the downstream product.

The EU guidelines recognize that the incentive to foreclose actual or potential rivals may also depend on the extent to which the downstream division of the integrated firm can be expected to benefit from higher price levels downstream as a result of a strategy to raise rivals’ costs. The greater the market shares of the merged entity downstream, the greater the base of sales on which to enjoy increased margins. However, an upstream monopolist that is already able to fully extract all available profits in vertically related markets may not have any incentive to foreclose rivals following a vertical merger. Therefore, the ability to extract available profits from consumers does not follow immediately from a very high market share; to come to that conclusion requires a more thorough analysis of the actual and future constraints under which the monopolist operates.

Finally, the EU guidelines require the Commission to examine not only the incentives to adopt such conduct, but also the factors liable to reduce, or even eliminate, those incentives, including the possibility that the conduct is unlawful. In this regard, the Commission will consider, on the basis of a summary analysis: (i) the likelihood that this conduct would be clearly be unlawful under Community law, (ii) the likelihood that this illegal conduct could be detected, and (iii) the penalties that could be imposed.

Overall likely impact on effective competition: 

Finally, the EU guidelines recognize that a vertical merger will raise foreclosure concerns only when it would lead to increased prices in the downstream market. This normally requires that the foreclosed suppliers play a sufficiently important role in the competitive process in the downstream market. In general, the higher the proportion of rivals that would be foreclosed in the downstream market, the more likely the merger can be expected to result in a significant price increase in the downstream market and, therefore, to significantly impede effective competition. 

In making these determinations, the Commission must under the EU guidelines also assess the extent to which a vertical merger may raise barriers to entry, a criterion that is also found in the 1984 DOJ non-horizontal merger guidelines but is strangely missing from the DOJ/FTC draft guidelines. As the 1984 guidelines recognize, a vertical merger can raise entry barriers if the anticipated input foreclosure would create a need to enter at both the downstream and the upstream level in order to compete effectively in either market.

* * * * *

Rather than issue a set of incomplete vertical merger guidelines, we would urge the DOJ and FTC to follow the lead of the European Commission and develop a set of guidelines setting out in more detail the factors the agencies will consider and the standards they will use in evaluating vertical mergers. The EU non-horizontal merger guidelines provide an excellent model for doing so.


[1] U.S. Department of Justice & Federal Trade Commission, Draft Vertical Merger Guidelines, available at https://www.justice.gov/opa/press-release/file/1233741/download (hereinafter cited as “DOJ/FTC draft guidelines”).

[2] U.S. Department of Justice, Office of Public Affairs, “DOJ and FTC Announce Draft Vertical Merger Guidelines for Public Comment,” Jan. 10, 2020, available at https://www.justice.gov/opa/pr/doj-and-ftc-announce-draft-vertical-merger-guidelines-public-comment.

[3] See European Commission, Guidelines on the assessment of non-horizontal mergers under the Council Regulation on the control of concentrations between undertakings (2008) (hereinafter cited as “EU guidelines”), available at https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52008XC1018(03)&from=EN.

[4] Id. at § 12.

[5] Id.

[6] Id. at § 13.

[7] Id. at § 14. The insight that transactions costs are an explanation for both horizontal and vertical integration in firms first occurred to Ronald Coase in 1932, while he was a student at the London School of Economics. See Ronald H. Coase, Essays on Economics and Economists 7 (1994). Coase took five years to flesh out his initial insight, which he then published in 1937 in a now-famous article, The Nature of the Firm. See Ronald H. Coase, The Nature of the Firm, Economica 4 (1937). The implications of transactions costs for antitrust analysis were explained in more detail four decades later by Oliver Williamson in a book he published in 1975. See Oliver E. William, Markets and Hierarchies: Analysis and Antitrust Implications (1975) (explaining how vertical integration, either by ownership or contract, can, for example, protect a firm from free riding and other opportunistic behavior by its suppliers and customers). Both Coase and Williamson later received Nobel Prizes for Economics for their work recognizing the importance of transactions costs, not only in explaining the structure of firms, but in other areas of the economy as well. See, e.g., Ronald H. Coase, The Problem of Social Cost, J. Law & Econ. 3 (1960) (using transactions costs to explain the need for governmental action to force entities to internalize the costs their conduct imposes on others).

[8] U.S. Department of Justice, Antitrust Division, 1984 Merger Guidelines, § 4, available at https://www.justice.gov/archives/atr/1984-merger-guidelines.

[9] EU guidelines, at § 4.24.

[10] Fruehauf Corp. v. FTC, 603 F.2d 345 (2d Cir. 1979).

[11] United States v. AT&T, Inc., 916 F.2d 1029 (D.C. Cir. 2019).

[12] Id. at 1032; accord, Fruehauf, 603 F.2d, at 351 (“A vertical merger, unlike a horizontal one, does not eliminate a competing buyer or seller from the market . . . . It does not, therefore, automatically have an anticompetitive effect.”) (emphasis in original) (internal citations omitted).

[13] AT&T, 419 F.2d, at 1032 (internal citations omitted).

[14] DOJ/FTC draft guidelines, at 3.

[15] EU guidelines, at § 25.

[16] See Steven C. Salop & David T. Scheffman, Raising Rivals’ Costs, 73 AM. ECON. REV. 267 (1983).

[17] Fruehauf, supra note11, 603 F.2d at 353 n.9 (emphasis added).

[18] 56 F.T.C. 1125 (1960).

[19] Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself 232 (1978).

[20] See, e.g., Alan J. Meese, Exclusive Dealing, the Theory of the Firm, and Raising Rivals’ Costs: Toward a New Synthesis, 50 Antitrust Bull., 371 (2005); David T. Scheffman and Richard S. Higgins, Twenty Years of Raising Rivals Costs: History, Assessment, and Future, 12 George Mason L. Rev.371 (2003); David Reiffen & Michael Vita, Comment: Is There New Thinking on Vertical Mergers, 63 Antitrust L.J. 917 (1995); Thomas G. Krattenmaker & Steven Salop, Anticompetitive Exclusion: Raising Rivals’ Costs to Achieve Power Over Price, 96 Yale L. J. 209, 219-25 (1986).

[21] See, e.g., United States v. Microsoft, 87 F. Supp. 2d 30, 50-53 (D.D.C. 1999) (summarizing law on exclusive dealing under section 1 of the Sherman Act); id. at 52 (concluding that modern case law requires finding that exclusive dealing contracts foreclose rivals from 40% of the marketplace); Omega Envtl, Inc. v. Gilbarco, Inc., 127 F.3d 1157, 1162-63 (9th Cir. 1997) (finding 38% foreclosure insufficient to make out prima facie case that exclusive dealing agreement violated the Sherman and Clayton Acts, at least where there appeared to be alternate channels of distribution).

[22] See, e.g., United States, et al. v. Comcast, 1:11-cv-00106 (D.D.C. Jan. 18, 2011) (Comcast had over 50% of MVPD market), available at https://www.justice.gov/atr/case-document/competitive-impact-statement-72; United States v. Premdor, Civil No.: 1-01696 (GK) (D.D.C. Aug. 3, 2002) (Masonite manufactured more than 50% of all doorskins sold in the U.S.; Premdor sold 40% of all molded doors made in the U.S.), available at https://www.justice.gov/atr/case-document/final-judgment-151.

[23] See United States v. AT&T, Inc., 916 F.2d 1029 (D.C. Cir. 2019).

[24] See Brown Shoe Co. v. United States, 370 U.S. 294, (1962) (relying on earlier Supreme Court decisions involving exclusive dealing and tying claims under section 3 of the Clayton Act for guidance as to what share of a market must be foreclosed before a vertical merger can be found unlawful under section 7).

[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 Jonathan E. Nuechterlein (Partner, Sidley Austin LLP; former General Counsel, FTC; former Deputy General Counsel, FCC).

[Nuechterlein: I represented AT&T in United States v. AT&T, Inc. (“AT&T/Time Warner”), and this essay is based in part on comments I prepared on AT&T’s behalf for the FTC’s recent public hearings on Competition and Consumer Protection in the 21st Century. All views expressed here are my own.]

The draft Vertical Merger Guidelines (“Draft Guidelines”) might well leave ordinary readers with the misimpression that U.S. antitrust authorities have suddenly come to view vertical integration with a jaundiced eye. Such readers might infer from the draft that vertical mergers are a minefield of potential competitive harms; that only sometimes do they “have the potential to create cognizable efficiencies”; and that such efficiencies, even when they exist, often are not “of a character and magnitude” to keep the merger from becoming “anticompetitive.” (Draft Guidelines § 8, at 9). But that impression would be impossible to square with the past forty years of U.S. enforcement policy and with exhaustive empirical work confirming the largely beneficial effects of vertical integration. 

The Draft Guidelines should reflect those realities and thus should incorporate genuine limiting principles — rooted in concerns about two-level market power — to cabin their highly speculative theories of harm. Without such limiting principles, the Guidelines will remain more a theoretical exercise in abstract issue-spotting than what they purport to be: a source of genuine guidance for the public

1. The presumptive benefits of vertical integration

Although the U.S. antitrust agencies (the FTC and DOJ) occasionally attach conditions to their approval of vertical mergers, they have litigated only one vertical merger case to judgment over the past forty years: AT&T/Time Warner. The reason for that paucity of cases is neither a lack of prosecutorial zeal nor a failure to understand “raising rivals’ costs” theories of harm. Instead, in the words of the FTC’s outgoing Bureau of Competition chief, Bruce Hoffman, the reason is the “broad consensus in competition policy and economic theory that the majority of vertical mergers are beneficial because they reduce costs and increase the intensity of interbrand competition.” 

Two exhaustive papers confirm that conclusion with hard empirical facts. The first was published in the International Journal of Industrial Organization in 2005 by FTC economists James Cooper, Luke Froeb, Dan O’Brien, and Michael Vita, who surveyed “multiple studies of vertical mergers and restraints” and “found only one example where vertical integration harmed consumers, and multiple examples where vertical integration unambiguously benefited consumers.” The second paper is a 2007 analysis in the Journal of Economic Literature co-authored by University of Michigan Professor Francine LaFontaine (who served from 2014 to 2015 as Director of the FTC’s Bureau of Economics) and Professor Margaret Slade of the University of British Columbia. Professors LaFontaine and Slade “did not have a particular conclusion in mind when [they] began to collect the evidence,” “tried to be fair in presenting the empirical regularities,” and were “therefore somewhat surprised at what the weight of the evidence is telling us.” They found that:

[U]nder most circumstances, profit-maximizing vertical-integration decisions are efficient, not just from the firms’ but also from the consumers’ points of view. Although there are isolated studies that contradict this claim, the vast majority support it. (p. 680) 

Vertical mergers have this procompetitive track record for two basic reasons. First, by definition, they do not eliminate a competitor or increase market concentration in any market, and they pose fewer competitive concerns than horizontal mergers for that reason alone. Second, as Bruce Hoffman noted, “while efficiencies are often important in horizontal mergers, they are much more intrinsic to a vertical transaction” and “come with a more built-in likelihood of improving competition than horizontal mergers.”

It is widely accepted that vertical mergers often impose downward pricing pressure by eliminating double margins. Beyond that, as the Draft Guidelines observe (at § 8), vertical mergers can also play an indispensable role in “eliminate[ing] contracting frictions,” “streamlin[ing] production, inventory management, or distribution,” and “creat[ing] innovative products in ways that would have been hard to achieve through arm’s length contracts.”

2. Harm to competitors, harm to competition, and the need for limiting principles

Vertical mergers do often disadvantage rivals of the merged firm. For example, a distributor might merge with one of its key suppliers, achieve efficiencies through the combination, and pass some of the savings through to consumers in the form of lower prices. The firm’s distribution rivals will lose profits if they match the price cut and will lose market share to the merged firm if they do not. But that outcome obviously counts in favor of supporting, not opposing, the merger because it makes consumers better off and because “[t]he antitrust laws… were enacted for the protection of competition not competitors.” (Brunswick v Pueblo Bowl-O-Mat). 

This distinction between harm to competition and harm to competitors is fundamental to U.S. antitrust law. Yet key passages in the Draft Guidelines seem to blur this distinction

For example, one passage suggests that a vertical merger will be suspect if the merged firm might “chang[e] the terms of … rivals’ access” to an input, “one or more rivals would [then] lose sales,” and “some portion of those lost sales would be diverted to the merged firm.” Draft Guidelines § 5.a, at 4-5. Of course, the Guidelines’ drafters would never concede that they wish to vindicate the interests of competitors qua competitors. They would say that incremental changes in input prices, even if they do not structurally alter the competitive landscape, might nonetheless result in slightly higher overall consumer prices. And they would insist that speculation about such slight price effects should be sufficient to block a vertical merger. 

That was the precise theory of harm that DOJ pursued in AT&T/Time Warner, which involved a purely vertical merger between a video programmer (Time Warner) and a pay-TV distributor (AT&T/DirecTV). DOJ ultimately conceded that Time Warner was unlikely to withhold programming from (“foreclose”) AT&T’s pay-TV rivals. Instead, using a complex economic model, DOJ tried to show that the merger would increase Time Warner’s bargaining power and induce AT&T’s pay-TV rivals to pay somewhat higher rates for Time Warner programming, some portion of which the rivals would theoretically pass through to their own retail customers. At the same time, DOJ conceded that post-merger efficiencies would cause AT&T to lower its retail rates compared to the but-for world without the merger. DOJ nonetheless asserted that the aggregate effect of the pay-TV rivals’ price increases would exceed the aggregate effect of AT&T’s own price decrease. Without deciding whether such an effect would be sufficient to block the merger — a disputed legal issue — the courts ruled for the merging parties because DOJ could not substantiate its factual prediction that the merger would lead to programming price increases in the first place. 

It is unclear why DOJ picked this, of all cases, as its vehicle for litigating its first vertical merger case in decades. In an archetypal raising-rivals’-costs case, familiar from exclusive dealing law, the defendant forecloses its rivals by depriving them of a critical input or distribution channel and so marginalizes them in the process that it can profitably raise its own retail prices (see, e.g., McWane; Microsoft). AT&T/Time Warner could hardly have been further afield from that archetypal case. Again, DOJ conceded both that the merged firm would not foreclose rivals at all and that the merger would induce the firm to lower its retail prices below what it would charge if the merger were blocked. The draft Guidelines appear to double down on this odd strategy and portend more cases predicated on the same attenuated concerns about mere “chang[es in] the terms of … rivals’ access” to inputs, unaccompanied by any alleged structural changes in the competitive landscape

Bringing such cases would be a mistake, both tactically and doctrinally

“Changes in the terms of inputs” are a constant fact of life in nearly every market, with or without mergers, and have almost never aroused antitrust scrutiny. For example, whenever a firm enters into a long-term preferred-provider agreement with a new business partner in lieu of merging with it, the firm will, by definition, deal on less advantageous terms with the partner’s rivals than it otherwise would. That outcome is virtually never viewed as problematic, let alone unlawful, when it is accomplished through such long-term contracts. The government does not hire a team of economists to pore over documents, interview witnesses, and run abstruse models on whether the preferred-provider agreement can be projected, on balance, to produce incrementally higher downstream prices. There is no obvious reason why the government should treat such preferred provider arrangements differently if they arise through a vertical merger rather than a vertical contract — particularly given the draft Guidelines’ own acknowledgement that vertical mergers produce pro-consumer efficiencies that would be “hard to achieve through arm’s length contracts.” (Draft Guidelines § 8, at 9).

3. Towards a more useful safe harbor

Quoting then-Judge Breyer, the Supreme Court once noted that “antitrust rules ‘must be clear enough for lawyers to explain them to clients.’” That observation rings doubly true when applied to a document by enforcement officials purporting to “guide” business decisions. Firms contemplating a vertical merger need more than assurance that their merger will be cleared two years hence if their economists vanquish the government’s economists in litigation about the fine details of Nash bargaining theory. Instead, firms need true limiting principles, which identify the circumstances where any theory of harm would be so attenuated that litigating to block the merger is not worth the candle, particularly given the empirically validated presumption that most vertical mergers are pro-consumer.

The Agencies cannot meet the need for such limiting principles with the proposed “safe harbor” as it is currently phrased in the draft Guidelines: 

The Agencies are unlikely to challenge a vertical merger where the parties to the merger have a share in the relevant market of less than 20 percent, and the related product is used in less than 20 percent of the relevant market.” (Draft Guidelines § 3, at 3). 

This anodyne assurance, with its arbitrarily low 20 percent thresholds phrased in the conjunctive, seems calculated more to preserve the agencies’ discretion than to provide genuine direction to industry. 

Nonetheless, the draft safe harbor does at least point in the right direction because it reflects a basic insight about two-level market power: vertical mergers are unlikely to create competitive concerns unless the merged firm will have, or could readily obtain, market power in both upstream and downstream markets. (See, e.g., Auburn News v. Providence Journal (“Where substantial market power is absent at any one product or distribution level, vertical integration will not have an anticompetitive effect.”)) This point parallels tying doctrine, which, like vertical merger analysis, addresses how vertical arrangements can affect competition across adjacent markets. As Justice O’Connor noted in Jefferson Parish, tying arrangements threaten competition 

primarily in the rare cases where power in the market for the tying product is used to create additional market power in the market for the tied product.… But such extension of market power is unlikely, or poses no threat of economic harm, unless…, [among other conditions, the seller has] power in the tying-product market… [and there is] a substantial threat that the tying seller will acquire market power in the tied-product market.

As this discussion suggests, the “20 percent” safe harbor in the draft Guidelines misses the mark in three respects

First, as a proxy for the absence of market power, 20 percent is too low: courts have generally refused to infer market power when the seller’s market share was below 30% and sometimes require higher shares. Of course, market share can be a highly overinclusive measure of market power, in that many firms with greater than a 30% share will lack market power. But it is nonetheless appropriate to use market share as a screen for further analysis.

Second, the draft’s safe harbor appears illogically in the conjunctive, applying only “where the parties to the merger have a share in the relevant market of less than 20 percent, and the related product is used in less than 20 percent of the relevant market.” That “and” should be an “or” because, again, vertical arrangements can be problematic only if a firm can use existing market power in a “related products” market to create or increase market power in the “relevant market.” 

Third, the phrase “the related product is used in less than 20 percent of the relevant market” is far too ambiguous to serve a useful role. For example, the “related product” sold by a merging upstream firm could be “used by” 100 percent of downstream buyers even though the firm’s sales account for only one percent of downstream purchases of that product if the downstream buyers multi-home — i.e., source their goods from many different sellers of substitutable products. The relevant proxy for “related product” market power is thus not how many customers “use” the merging firm’s product, but what percentage of overall sales of that product (including reasonable substitutes) it makes. 

Of course, this observation suggests that, when push comes to shove in litigation, the government must usually define two markets: not only (1) a “relevant market” in which competitive harm is alleged to occur, but also (2) an adjacent “related product” market in which the merged firm is alleged to have market power. Requiring such dual market definition is entirely appropriate. Ultimately, any raising-rivals’-costs theory relies on a showing that a vertically integrated firm has some degree of market power in a “related products” market when dealing with its rivals in an adjacent “relevant market.” And market definition is normally an inextricable component of a litigated market power analysis.

If these three changes are made, the safe harbor would read: 

The Agencies are unlikely to challenge a vertical merger where the parties to the merger have a share in the relevant market of less than 30 percent, or the related product sold by one of the parties accounts for less than 30 percent of the overall sales of that related product, including reasonable substitutes.

Like all safe harbors, this one would be underinclusive (in that many mergers outside of the safe harbor are unobjectionable) and may occasionally be overinclusive. But this substitute language would be more useful as a genuine safe harbor because it would impose true limiting principles. And it would more accurately reflect the ways in which market power considerations should inform vertical analysis—whether of contractual arrangements or mergers.

The 2020 Draft Joint Vertical Merger Guidelines:

What’s in, what’s out — and do we need them anyway?

February 6 & 7, 2020

Welcome! We’re delighted to kick off our two-day blog symposium on the recently released Draft Joint Vertical Merger Guidelines from the DOJ Antitrust Division and the Federal Trade Commission. 

If adopted by the agencies, the guidelines would mark the first time since 1984 that U.S. federal antitrust enforcers have provided official, public guidance on their approach to the increasingly important issue of vertical merger enforcement. 

As previously noted, the release of the draft guidelines was controversial from the outset: The FTC vote to issue the draft was mixed, with a dissent from Commissioner Slaughter, an abstention from Commissioner Chopra, and a concurring statement from Commissioner Wilson.

As the antitrust community gears up to debate the draft guidelines, we have assembled an outstanding group of antitrust experts to weigh in with their initial thoughts on the guidelines here at Truth on the Market. We hope this symposium will provide important insights and stand as a useful resource for the ongoing discussion.

The scholars and practitioners who will participate in the symposium are:

  • Timothy J. Brennan (Professor, Public Policy and Economics, University of Maryland; former Chief Economist, FCC; former economist, DOJ Antitrust Division)
  • Steven Cernak (Partner, Bona Law PC; former antitrust counsel, GM)
  • Eric Fruits (Chief Economist, ICLE; Professor of Economics, Portland State University)
  • Herbert Hovenkamp (James G. Dinan University Professor of Law, University of Pennsylvania)
  • Jonathan M. Jacobson (Partner, Wilson Sonsini Goodrich & Rosati) and Kenneth Edelson (Associate, Wilson Sonsini Goodrich & Rosati)
  • William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division) and Philip A. Giordano (Partner, Hughes Hubbard & Reed LLP)
  • Geoffrey A. Manne (President & Founder, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics) and Kristian Stout (Associate Director, ICLE)
  • Jonathan E. Nuechterlein (Partner, Sidley Austin LLP; former General Counsel, FTC; former Deputy General Counsel, FCC)
  • Sharis A. Pozen (Partner, Clifford Chance; former Vice President of Global Competition Law and Policy, GE; former Acting Assistant Attorney General, DOJ Antitrust Division), Timothy Cornell (Partner, Clifford Chance), Brian Concklin (Counsel, Clifford Chance), and Michael Van Arsdall (Counsel, Clifford Chance)
  • Jan Rybnicek (Counsel, Freshfields Bruckhaus Deringer; former attorney adviser to Commissioner Joshua D. Wright, FTC)
  • Steven C. Salop (tent.) (Professor of Economics and Law, Georgetown University; former Associate Director, FTC Bureau of Economics)
  • Scott A. Sher (Partner, Wilson Sonsini Goodrich & Rosati) and Matthew McDonald (Associate, Wilson Sonsini Goodrich & Rosati)
  • Margaret Slade (Professor Emeritus, Vancouver School of Economics, University of British Columbia)
  • Gregory Werden (former Senior Economic Counsel, DOJ Antitrust Division) and Luke M. Froeb (William C. Oehmig Chair in Free Enterprise and Entrepreneurship, Vanderbilt University; former Chief Economist, DOJ Antitrust Division; former Chief Economist, FTC)
  • Lawrence J. White (Robert Kavesh Professor of Economics, New York University; former Chief Economist, DOJ Antitrust Division)
  • Joshua D. Wright (University Professor of Law, George Mason University; former Commissioner, FTC), Douglas H. Ginsburg (Senior Circuit Judge, US Court of Appeals for the DC Circuit; Professor of Law, George Mason University; former Assistant Attorney General, DOJ Antitrust Division), Tad Lipsky (Assistant Professor of Law, George Mason University; former Acting Director, FTC Bureau of Competition; former chief antitrust counsel, Coca-Cola; former Deputy Assistant Attorney General, DOJ Antitrust Division), and John M. Yun (Associate Professor of Law, George Mason University; former Acting Deputy Assistant Director, FTC Bureau of Economics)

The first of the participants’ initial posts will appear momentarily, with additional posts appearing throughout the day today and tomorrow. We hope to generate a lively discussion, and expect some of the participants to offer follow up posts and/or comments on their fellow participants’ posts — please be sure to check back throughout the day and be sure to check the comments. We hope our readers will join us in the comments, as well.

Once again, welcome!

Truth on the Market is pleased to announce its next blog symposium:

The 2020 Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?

February 6 & 7, 2020

Symposium background

On January 10, 2020, the DOJ Antitrust Division and the Federal Trade Commission released Draft Joint Vertical Merger Guidelines for public comment. If adopted by the agencies, the guidelines would mark the first time since 1984 that U.S. federal antitrust enforcers have provided official, public guidance on their approach to the increasingly important issue of vertical merger enforcement: 

“Challenging anticompetitive vertical mergers is essential to vigorous enforcement. The agencies’ vertical merger policy has evolved substantially since the issuance of the 1984 Non-Horizontal Merger Guidelines, and our guidelines should reflect the current enforcement approach. Greater transparency about the complex issues surrounding vertical mergers will benefit the business community, practitioners, and the courts,” said FTC Chairman Joseph J. Simons.

As evidenced by FTC Commissioner Slaughter’s dissent and FTC Commissioner Chopra’s abstention from the FTC’s vote to issue the draft guidelines, the topic is a contentious one. Similarly, as FTC Commissioner Wilson noted in her concurring statement, the recent FTC hearing on vertical mergers demonstrated that there is a vigorous dispute over what new guidelines should look like (or even if the 1984 Non-Horizontal Guidelines should be updated at all).

The agencies have announced two upcoming workshops to discuss the draft guidelines and have extended the comment period on the draft until February 26.

In advance of the workshops and the imminent discussions over the draft guidelines, we have asked a number of antitrust experts to weigh in here at Truth on the Market: to preview the coming debate by exploring the economic underpinnings of the draft guidelines and their likely role in the future of merger enforcement at the agencies, as well as what is in the guidelines and — perhaps more important — what is left out.  

Beginning the morning of Thursday, February 6, and continuing during business hours through Friday, February 7, Truth on the Market (TOTM) and the International Center for Law & Economics (ICLE) will host a blog symposium on the draft guidelines. 

Symposium participants

As in the past (see examples of previous TOTM blog symposia here), we’ve lined up an outstanding and diverse group of scholars to discuss these issues, including:

  • Timothy J. Brennan (Professor, Public Policy and Economics, University of Maryland; former Chief Economist, FCC; former economist, DOJ Antitrust Division)
  • Steven Cernak (Partner, Bona Law PC; former antitrust counsel, GM)
  • Luke M. Froeb (William C. Oehmig Chair in Free Enterprise and Entrepreneurship, Vanderbilt University; former Chief Economist, DOJ Antitrust Division; former Chief Economist, FTC)
  • Eric Fruits (Chief Economist, ICLE; Professor of Economics, Portland State University)
  • Douglas H. Ginsburg (Senior Circuit Judge, US Court of Appeals for the DC Circuit; Professor of Law, George Mason University; former Assistant Attorney General, DOJ Antitrust Division)
  • Herbert Hovenkamp (James G. Dinan University Professor of Law, University of Pennsylvania)
  • Jonathan M. Jacobson (Partner, Wilson Sonsini Goodrich & Rosati)
  • William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division)
  • Tad Lipsky (Assistant Professor of Law, George Mason University; former Acting Director, FTC Bureau of Competition; former chief antitrust counsel, Coca-Cola; former Deputy Assistant Attorney General, DOJ Antitrust Division) 
  • Geoffrey A. Manne (President & Founder, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics)
  • Jonathan E. Nuechterlein (Partner, Sidley Austin LLP; former General Counsel, FTC; former Deputy General Counsel, FCC)
  • Sharis A. Pozen (Partner, Clifford Chance; former Vice President of Global Competition Law and Policy, GE; former Acting Assistant Attorney General, DOJ Antitrust Division) 
  • Jan Rybnicek (Counsel, Freshfields Bruckhaus Deringer; former attorney adviser to Commissioner Joshua D. Wright, FTC)
  • Steven C. Salop (tent.) (Professor of Economics and Law, Georgetown University; former Associate Director, FTC Bureau of Economics)
  • Scott A. Sher (Partner, Wilson Sonsini Goodrich & Rosati)
  • Margaret Slade (Professor Emeritus, Vancouver School of Economics, University of British Columbia)
  • Kristian Stout (Associate Director, ICLE)
  • Gregory Werden (former Senior Economic Counsel, DOJ Antitrust Division)
  • Lawrence J. White (Robert Kavesh Professor of Economics, New York University; former Chief Economist, DOJ Antitrust Division)
  • Joshua D. Wright (University Professor of Law, George Mason University; former Commissioner, FTC)
  • John M. Yun (Associate Professor of Law, George Mason University; former Acting Deputy Assistant Director, FTC Bureau of Economics)

We want to thank all of these excellent panelists for agreeing to take time away from their busy schedules to participate in this symposium. We are hopeful that this discussion will provide invaluable insight and perspective on the Draft Joint Vertical Merger Guidelines.

Look for the first posts starting Thursday, February 6!

Jonathan B. Baker, Nancy L. Rose, Steven C. Salop, and Fiona Scott Morton don’t like vertical mergers:

Vertical mergers can harm competition, for example, through input foreclosure or customer foreclosure, or by the creation of two-level entry barriers.  … Competitive harms from foreclosure can occur from the merged firm exercising its increased bargaining leverage to raise rivals’ costs or reduce rivals’ access to the market. Vertical mergers also can facilitate coordination by eliminating a disruptive or “maverick” competitor at one vertical level, or through information exchange. Vertical mergers also can eliminate potential competition between the merging parties. Regulated firms can use vertical integration to evade rate regulation. These competitive harms normally occur when at least one of the markets has an oligopoly structure. They can lead to higher prices, lower output, quality reductions, and reduced investment and innovation.

Baker et al. go so far as to argue that any vertical merger in which the downstream firm is subject to price regulation should face a presumption that the merger is anticompetitive.

George Stigler’s well-known article on vertical integration identifies several ways in which vertical integration increases welfare by subverting price controls:

The most important of these other forces, I believe, is the failure of the price system (because of monopoly or public regulation) to clear markets at prices within the limits of the marginal cost of the product (to the buyer if he makes it) and its marginal-value product (to the seller if he further fabricates it). This phenomenon was strikingly illustrated by the spate of vertical mergers in the United States during and immediately after World War II, to circumvent public and private price control and allocations. A regulated price of OA was set (Fig. 2), at which an output of OM was produced. This quantity had a marginal value of OB to buyers, who were rationed on a nonprice basis. The gain to buyers  and sellers combined from a free price of NS was the shaded area, RST, and vertical integration was the simple way of obtaining this gain. This was the rationale of the integration of radio manufacturers into cabinet manufacture, of steel firms into fabricated products, etc.

Stigler was on to something:

  • In 1947, Emerson Radio acquired Plastimold, a maker of plastic radio cabinets. The president of Emerson at the time, Benjamin Abrams, stated “Plastimold is an outstanding producer of molded radio cabinets and gives Emerson an assured source of supply of one of the principal components in the production of radio sets.” [emphasis added] 
  • In the same year, the Congressional Record reported, “Admiral Corp. like other large radio manufacturers has reached out to take over a manufacturer of radio cabinets, the Chicago Cabinet Corp.” 
  • In 1948, the Federal Trade Commission ascribed wartime price controls and shortages as reasons for vertical mergers in the textiles industry as well as distillers’ acquisitions of wineries.

While there may have been some public policy rationale for price controls, it’s clear the controls resulted in shortages and a deadweight loss in many markets. As such, it’s likely that vertical integration to avoid the price controls improved consumer welfare (if only slightly, as in the figure above) and reduced the deadweight loss.

Rather than leading to monopolization, Stigler provides examples in which vertical integration was employed to circumvent monopolization by cartel quotas and/or price-fixing: “Almost every raw-material cartel has had trouble with customers who wish to integrate backward, in order to negate the cartel prices.”

In contrast to Stigler’s analysis, Salop and Daniel P. Culley begin from an implied assumption that where price regulation occurs, the controls are good for society. Thus, they argue avoidance of the price controls are harmful or against the public interest:

Example: The classic example is the pre-divestiture behavior of AT&T, which allegedly used its purchases of equipment at inflated prices from its wholly-owned subsidiary, Western Electric, to artificially increase its costs and so justify higher regulated prices.

This claim is supported by the court in U.S. v. AT&T [emphasis added]:

The Operating Companies have taken these actions, it is said, because the existence of rate of return regulation removed from them the burden of such additional expense, for the extra cost could simply be absorbed into the rate base or expenses, allowing extra profits from the higher prices to flow upstream to Western rather than to its non-Bell competition.

Even so, the pass-through of higher costs seems only a minor concern to the court relative to the “three hats” worn by AT&T and its subsidiaries in the (1) setting of standards, (2) counseling of operating companies in their equipment purchases, and (3) production of equipment for sale to the operating companies [emphasis added]:

The government’s evidence has depicted defendants as sole arbiters of what equipment is suitable for use in the Bell System a role that carries with it a power of subjective judgment that can be and has been used to advance the sale of Western Electric’s products at the expense of the general trade. First, AT&T, in conjunction with Bell Labs and Western Electric, sets the technical standards under which the telephone network operates and the compatibility specifications which equipment must meet. Second, Western Electric and Bell Labs … serve as counselors to the Operating Companies in their procurement decisions, ostensibly helping them to purchase equipment that meets network standards. Third, Western also produces equipment for sale to the Operating Companies in competition with general trade manufacturers.

The upshot of this “wearing of three hats” is, according to the government’s evidence, a rather obviously anticompetitive situation. By setting technical or compatibility standards and by either not communicating these standards to the general trade or changing them in mid-stream, AT&T has the capacity to remove, and has in fact removed, general trade products from serious consideration by the Operating Companies on “network integrity” grounds. By either refusing to evaluate general trade products for the Operating Companies or producing biased or speculative evaluations, AT&T has been able to influence the Operating Companies, which lack independent means to evaluate general trade products, to buy Western. And the in-house production and sale of Western equipment provides AT&T with a powerful incentive to exercise its “approval” power to discriminate against Western’s competitors.

It’s important to keep in mind that rate of return regulation was not thrust upon AT&T, it was a quid pro quo in which state and federal regulators acted to eliminate AT&T/Bell competitors in exchange for price regulation. In a floor speech to Congress in 1921, Rep. William J. Graham declared:

It is believed to be better policy to have one telephone system in a community that serves all the people, even though it may be at an advanced rate, property regulated by State boards or commissions, than it is to have two competing telephone systems.

For purposes of Salop and Culley’s integration-to-evade-price-regulation example, it’s important to keep in mind that AT&T acquired Western Electric in 1882, or about two decades before telephone pricing regulation was contemplated and eight years before the Sherman Antitrust Act. While AT&T may have used vertical integration to take advantage of rate-of-return price regulation, it’s simply not true that AT&T acquired Western Electric to evade price controls.

Salop and Culley provide a more recent example:

Example: Potential evasion of regulation concerns were raised in the FTC’s analysis in 2008 of the Fresenius/Daiichi Sankyo exclusive sub-license for a Daiichi Sankyo pharmaceutical used in Fresenius’ dialysis clinics, which potentially could allow evasion of Medicare pricing regulations.

As with the AT&T example, this example is not about evasion of price controls. Rather it raises concerns about taking advantage of Medicare’s pricing formula. 

At the time of the deal, Medicare reimbursed dialysis clinics based on a drug manufacturer’s Average Sales Price (“ASP”) plus six percent, where ASP was calculated by averaging the prices paid by all customers, including any discounts or rebates. 

The FTC argued by setting an artificially high transfer price of the drug to Fresenius, the ASP would increase, thereby increasing the Medicare reimbursement to all clinics providing the same drug (which not only would increase the costs to Medicare but also would increase income to all clinics providing the drug). Although the FTC claims this would be anticompetitive, the agency does not describe in what ways competition would be harmed.

The FTC introduces an interesting wrinkle in noting that a few years after the deal would have been completed, “substantial changes to the Medicare program relating to dialysis services … would eliminate the regulations that give rise to the concerns created by the proposed transaction.” Specifically, payment for dialysis services would shift from fee-for-service to capitation.

This wrinkle highlights a serious problem with a presumption that any purported evasion of price controls is an antitrust violation. Namely, if the controls go away, so does the antitrust violation. 

Conversely–as Salop and Culley seem to argue with their AT&T example–a vertical merger could be retroactively declared anticompetitive if price controls are imposed after the merger is completed (even decades later and even if the price regulations were never anticipated at the time of the merger). 

It’s one thing to argue that avoiding price regulation runs counter to public interest, but it’s another thing to argue that avoiding price regulation is anticompetitive. Indeed, as Stigler argues, if the price controls stifle competition, then avoidance of the controls may enhance competition. Placing such mergers under heightened scrutiny, such as an anticompetitive presumption, is a solution in search of a problem.

FTC v. Qualcomm

Last week the International Center for Law & Economics (ICLE) and twelve noted law and economics scholars filed an amicus brief in the Ninth Circuit in FTC v. Qualcomm, in support of appellant (Qualcomm) and urging reversal of the district court’s decision. The brief was authored by Geoffrey A. Manne, President & founder of ICLE, and Ben Sperry, Associate Director, Legal Research of ICLE. Jarod M. Bona and Aaron R. Gott of Bona Law PC collaborated in drafting the brief and they and their team provided invaluable pro bono legal assistance, for which we are enormously grateful. Signatories on the brief are listed at the end of this post.

We’ve written about the case several times on Truth on the Market, as have a number of guest bloggers, in our ongoing blog series on the case here.   

The ICLE amicus brief focuses on the ways that the district court exceeded the “error cost” guardrails erected by the Supreme Court to minimize the risk and cost of mistaken antitrust decisions, particularly those that wrongly condemn procompetitive behavior. As the brief notes at the outset:

The district court’s decision is disconnected from the underlying economics of the case. It improperly applied antitrust doctrine to the facts, and the result subverts the economic rationale guiding monopolization jurisprudence. The decision—if it stands—will undercut the competitive values antitrust law was designed to protect.  

The antitrust error cost framework was most famously elaborated by Frank Easterbrook in his seminal article, The Limits of Antitrust (1984). It has since been squarely adopted by the Supreme Court—most significantly in Brooke Group (1986), Trinko (2003), and linkLine (2009).  

In essence, the Court’s monopolization case law implements the error cost framework by (among other things) obliging courts to operate under certain decision rules that limit the use of inferences about the consequences of a defendant’s conduct except when the circumstances create what game theorists call a “separating equilibrium.” A separating equilibrium is a 

solution to a game in which players of different types adopt different strategies and thereby allow an uninformed player to draw inferences about an informed player’s type from that player’s actions.

Baird, Gertner & Picker, Game Theory and the Law

The key problem in antitrust is that while the consequence of complained-of conduct for competition (i.e., consumers) is often ambiguous, its deleterious effect on competitors is typically quite evident—whether it is actually anticompetitive or not. The question is whether (and when) it is appropriate to infer anticompetitive effect from discernible harm to competitors. 

Except in the narrowly circumscribed (by Trinko) instance of a unilateral refusal to deal, anticompetitive harm under the rule of reason must be proven. It may not be inferred from harm to competitors, because such an inference is too likely to be mistaken—and “mistaken inferences are especially costly, because they chill the very conduct the antitrust laws are designed to protect.” (Brooke Group (quoting yet another key Supreme Court antitrust error cost case, Matsushita (1986)). 

Yet, as the brief discusses, in finding Qualcomm liable the district court did not demand or find proof of harm to competition. Instead, the court’s opinion relies on impermissible inferences from ambiguous evidence to find that Qualcomm had (and violated) an antitrust duty to deal with rival chip makers and that its conduct resulted in anticompetitive foreclosure of competition. 

We urge you to read the brief (it’s pretty short—maybe the length of three blogs posts) to get the whole argument. Below we draw attention to a few points we make in the brief that are especially significant. 

The district court bases its approach entirely on Microsoft — which it misinterprets in clear contravention of Supreme Court case law

The district court doesn’t stay within the strictures of the Supreme Court’s monopolization case law. In fact, although it obligingly recites some of the error cost language from Trinko, it quickly moves away from Supreme Court precedent and bases its approach entirely on its reading of the D.C. Circuit’s Microsoft (2001) decision. 

Unfortunately, the district court’s reading of Microsoft is mistaken and impermissible under Supreme Court precedent. Indeed, both the Supreme Court and the D.C. Circuit make clear that a finding of illegal monopolization may not rest on an inference of anticompetitive harm.

The district court cites Microsoft for the proposition that

Where a government agency seeks injunctive relief, the Court need only conclude that Qualcomm’s conduct made a “significant contribution” to Qualcomm’s maintenance of monopoly power. The plaintiff is not required to “present direct proof that a defendant’s continued monopoly power is precisely attributable to its anticompetitive conduct.”

It’s true Microsoft held that, in government actions seeking injunctions, “courts [may] infer ‘causation’ from the fact that a defendant has engaged in anticompetitive conduct that ‘reasonably appears capable of making a significant contribution to maintaining monopoly power.’” (Emphasis added). 

But Microsoft never suggested that anticompetitiveness itself may be inferred.

“Causation” and “anticompetitive effect” are not the same thing. Indeed, Microsoft addresses “anticompetitive conduct” and “causation” in separate sections of its decision. And whereas Microsoft allows that courts may infer “causation” in certain government actions, it makes no such allowance with respect to “anticompetitive effect.” In fact, it explicitly rules it out:

[T]he plaintiff… must demonstrate that the monopolist’s conduct indeed has the requisite anticompetitive effect…; no less in a case brought by the Government, it must demonstrate that the monopolist’s conduct harmed competition, not just a competitor.”

The D.C. Circuit subsequently reinforced this clear conclusion of its holding in Microsoft in Rambus

Deceptive conduct—like any other kind—must have an anticompetitive effect in order to form the basis of a monopolization claim…. In Microsoft… [t]he focus of our antitrust scrutiny was properly placed on the resulting harms to competition.

Finding causation entails connecting evidentiary dots, while finding anticompetitive effect requires an economic assessment. Without such analysis it’s impossible to distinguish procompetitive from anticompetitive conduct, and basing liability on such an inference effectively writes “anticompetitive” out of the law.

Thus, the district court is correct when it holds that it “need not conclude that Qualcomm’s conduct is the sole reason for its rivals’ exits or impaired status.” But it is simply wrong to hold—in the same sentence—that it can thus “conclude that Qualcomm’s practices harmed competition and consumers.” The former claim is consistent with Microsoft; the latter is emphatically not.

Under Trinko and Aspen Skiing the district court’s finding of an antitrust duty to deal is impermissible 

Because finding that a company operates under a duty to deal essentially permits a court to infer anticompetitive harm without proof, such a finding “comes dangerously close to being a form of ‘no-fault’ monopolization,” as Herbert Hovenkamp has written. It is also thus seriously disfavored by the Court’s error cost jurisprudence.

In Trinko the Supreme Court interprets its holding in Aspen Skiing to identify essentially a single scenario from which it may plausibly be inferred that a monopolist’s refusal to deal with rivals harms consumers: the existence of a prior, profitable course of dealing, and the termination and replacement of that arrangement with an alternative that not only harms rivals, but also is less profitable for the monopolist.

In an effort to satisfy this standard, the district court states that “because Qualcomm previously licensed its rivals, but voluntarily stopped licensing rivals even though doing so was profitable, Qualcomm terminated a voluntary and profitable course of dealing.”

But it’s not enough merely that the prior arrangement was profitable. Rather, Trinko and Aspen Skiing hold that when a monopolist ends a profitable relationship with a rival, anticompetitive exclusion may be inferred only when it also refuses to engage in an ongoing arrangement that, in the short run, is more profitable than no relationship at all. The key is the relative value to the monopolist of the current options on offer, not the value to the monopolist of the terminated arrangement. In a word, what the Court requires is that the defendant exhibit behavior that, but-for the expectation of future, anticompetitive returns, is irrational.

It should be noted, as John Lopatka (here) and Alan Meese (here) (both of whom joined the amicus brief) have written, that even the Supreme Court’s approach is likely insufficient to permit a court to distinguish between procompetitive and anticompetitive conduct. 

But what is certain is that the district court’s approach in no way permits such an inference.

“Evasion of a competitive constraint” is not an antitrust-relevant refusal to deal

In order to infer anticompetitive effect, it’s not enough that a firm may have a “duty” to deal, as that term is colloquially used, based on some obligation other than an antitrust duty, because it can in no way be inferred from the evasion of that obligation that conduct is anticompetitive.

The district court bases its determination that Qualcomm’s conduct is anticompetitive on the fact that it enables the company to avoid patent exhaustion, FRAND commitments, and thus price competition in the chip market. But this conclusion is directly precluded by the Supreme Court’s holding in NYNEX

Indeed, in Rambus, the D.C. Circuit, citing NYNEX, rejected the FTC’s contention that it may infer anticompetitive effect from defendant’s evasion of a constraint on its monopoly power in an analogous SEP-licensing case: “But again, as in NYNEX, an otherwise lawful monopolist’s end-run around price constraints, even when deceptive or fraudulent, does not alone present a harm to competition.”

As Josh Wright has noted:

[T]he objection to the “evasion” of any constraint approach is… that it opens the door to enforcement actions applied to business conduct that is not likely to harm competition and might be welfare increasing.

Thus NYNEX and Rambus (and linkLine) reinforce the Court’s repeated holding that an inference of harm to competition is permissible only where conduct points clearly to anticompetitive effect—and, bad as they may be, evading obligations under other laws or violating norms of “business morality” do not suffice.

The district court’s elaborate theory of harm rests fundamentally on the claim that Qualcomm injures rivals—and the record is devoid of evidence demonstrating actual harm to competition. Instead, the court infers it from what it labels “unreasonably high” royalty rates, enabled by Qualcomm’s evasion of competition from rivals. In turn, the court finds that that evasion of competition can be the source of liability if what Qualcomm evaded was an antitrust duty to deal. And, in impermissibly circular fashion, the court finds that Qualcomm indeed evaded an antitrust duty to deal—because its conduct allowed it to sustain “unreasonably high” prices. 

The Court’s antitrust error cost jurisprudence—from Brooke Group to NYNEX to Trinko & linkLine—stands for the proposition that no such circular inferences are permitted.

The district court’s foreclosure analysis also improperly relies on inferences in lieu of economic evidence

Because the district court doesn’t perform a competitive effects analysis, it fails to demonstrate the requisite “substantial” foreclosure of competition required to sustain a claim of anticompetitive exclusion. Instead the court once again infers anticompetitive harm from harm to competitors. 

The district court makes no effort to establish the quantity of competition foreclosed as required by the Supreme Court. Nor does the court demonstrate that the alleged foreclosure harms competition, as opposed to just rivals. Foreclosure per se is not impermissible and may be perfectly consistent with procompetitive conduct.

Again citing Microsoft, the district court asserts that a quantitative finding is not required. Yet, as the court’s citation to Microsoft should have made clear, in its stead a court must find actual anticompetitive effect; it may not simply assert it. As Microsoft held: 

It is clear that in all cases the plaintiff must… prove the degree of foreclosure. This is a prudential requirement; exclusivity provisions in contracts may serve many useful purposes. 

The court essentially infers substantiality from the fact that Qualcomm entered into exclusive deals with Apple (actually, volume discounts), from which the court concludes that Qualcomm foreclosed rivals’ access to a key customer. But its inference that this led to substantial foreclosure is based on internal business statements—so-called “hot docs”—characterizing the importance of Apple as a customer. Yet, as Geoffrey Manne and Marc Williamson explain, such documentary evidence is unreliable as a guide to economic significance or legal effect: 

Business people will often characterize information from a business perspective, and these characterizations may seem to have economic implications. However, business actors are subject to numerous forces that influence the rhetoric they use and the conclusions they draw….

There are perfectly good reasons to expect to see “bad” documents in business settings when there is no antitrust violation lurking behind them.

Assuming such language has the requisite economic or legal significance is unsupportable—especially when, as here, the requisite standard demands a particular quantitative significance.

Moreover, the court’s “surcharge” theory of exclusionary harm rests on assumptions regarding the mechanism by which the alleged surcharge excludes rivals and harms consumers. But the court incorrectly asserts that only one mechanism operates—and it makes no effort to quantify it. 

The court cites “basic economics” via Mankiw’s Principles of Microeconomics text for its conclusion:

The surcharge affects demand for rivals’ chips because as a matter of basic economics, regardless of whether a surcharge is imposed on OEMs or directly on Qualcomm’s rivals, “the price paid by buyers rises, and the price received by sellers falls.” Thus, the surcharge “places a wedge between the price that buyers pay and the price that sellers receive,” and demand for such transactions decreases. Rivals see lower sales volumes and lower margins, and consumers see less advanced features as competition decreases.

But even assuming the court is correct that Qualcomm’s conduct entails such a surcharge, basic economics does not hold that decreased demand for rivals’ chips is the only possible outcome. 

In actuality, an increase in the cost of an input for OEMs can have three possible effects:

  1. OEMs can pass all or some of the cost increase on to consumers in the form of higher phone prices. Assuming some elasticity of demand, this would mean fewer phone sales and thus less demand by OEMs for chips, as the court asserts. But the extent of that effect would depend on consumers’ demand elasticity and the magnitude of the cost increase as a percentage of the phone price. If demand is highly inelastic at this price (i.e., relatively insensitive to the relevant price change), it may have a tiny effect on the number of phones sold and thus the number of chips purchased—approaching zero as price insensitivity increases.
  2. OEMs can absorb the cost increase and realize lower profits but continue to sell the same number of phones and purchase the same number of chips. This would not directly affect demand for chips or their prices.
  3. OEMs can respond to a price increase by purchasing fewer chips from rivals and more chips from Qualcomm. While this would affect rivals’ chip sales, it would not necessarily affect consumer prices, the total number of phones sold, or OEMs’ margins—that result would depend on whether Qualcomm’s chips cost more or less than its rivals’. If the latter, it would even increase OEMs’ margins and/or lower consumer prices and increase output.

Alternatively, of course, the effect could be some combination of these.

Whether any of these outcomes would substantially exclude rivals is inherently uncertain to begin with. But demonstrating a reduction in rivals’ chip sales is a necessary but not sufficient condition for proving anticompetitive foreclosure. The FTC didn’t even demonstrate that rivals were substantially harmed, let alone that there was any effect on consumers—nor did the district court make such findings. 

Doing so would entail consideration of whether decreased demand for rivals’ chips flows from reduced consumer demand or OEMs’ switching to Qualcomm for supply, how consumer demand elasticity affects rivals’ chip sales, and whether Qualcomm’s chips were actually less or more expensive than rivals’. Yet the court determined none of these. 

Conclusion

Contrary to established Supreme Court precedent, the district court’s decision relies on mere inferences to establish anticompetitive effect. The decision, if it stands, would render a wide range of potentially procompetitive conduct presumptively illegal and thus harm consumer welfare. It should be reversed by the Ninth Circuit.

Joining ICLE on the brief are:

  • Donald J. Boudreaux, Professor of Economics, George Mason University
  • Kenneth G. Elzinga, Robert C. Taylor Professor of Economics, University of Virginia
  • Janice Hauge, Professor of Economics, University of North Texas
  • Justin (Gus) Hurwitz, Associate Professor of Law, University of Nebraska College of Law; Director of Law & Economics Programs, ICLE
  • Thomas A. Lambert, Wall Chair in Corporate Law and Governance, University of Missouri Law School
  • John E. Lopatka, A. Robert Noll Distinguished Professor of Law, Penn State University Law School
  • Daniel Lyons, Professor of Law, Boston College Law School
  • Geoffrey A. Manne, President and Founder, International Center for Law & Economics; Distinguished Fellow, Northwestern University Center on Law, Business & Economics
  • Alan J. Meese, Ball Professor of Law, William & Mary Law School
  • Paul H. Rubin, Samuel Candler Dobbs Professor of Economics Emeritus, Emory University
  • Vernon L. Smith, George L. Argyros Endowed Chair in Finance and Economics, Chapman University School of Business; Nobel Laureate in Economics, 2002
  • Michael Sykuta, Associate Professor of Economics, University of Missouri


It might surprise some readers to learn that we think the Court’s decision today in Apple v. Pepper reaches — superficially — the correct result. But, we hasten to add, the Court’s reasoning (and, for that matter, the dissent’s) is completely wrongheaded. It would be an understatement to say that the Court reached the right result for the wrong reason; in fact, the Court’s analysis wasn’t even in the same universe as the correct reasoning.

Below we lay out our assessment, in a post drawn from an article forthcoming in the Nebraska Law Review.

Did the Court forget that, just last year, it decided Amex, the most significant U.S. antitrust case in ages?

What is most remarkable about the decision (and the dissent) is that neither mentions Ohio v. Amex, nor even the two-sided market context in which the transactions at issue take place.

If the decision in Apple v. Pepper hewed to the precedent established by Ohio v. Amex it would start with the observation that the relevant market analysis for the provision of app services is an integrated one, in which the overall effect of Apple’s conduct on both app users and app developers must be evaluated. A crucial implication of the Amex decision is that participants on both sides of a transactional platform are part of the same relevant market, and the terms of their relationship to the platform are inextricably intertwined.

Under this conception of the market, it’s difficult to maintain that either side does not have standing to sue the platform for the terms of its overall pricing structure, whether the specific terms at issue apply directly to that side or not. Both end users and app developers are “direct” purchasers from Apple — of different products, but in a single, inextricably interrelated market. Both groups should have standing.

More controversially, the logic of Amex also dictates that both groups should be able to establish antitrust injury — harm to competition — by showing harm to either group, as long as it establishes the requisite interrelatedness of the two sides of the market.

We believe that the Court was correct to decide in Amex that effects falling on the “other” side of a tightly integrated, two-sided market from challenged conduct must be addressed by the plaintiff in making its prima facie case. But that outcome entails a market definition that places both sides of such a market in the same relevant market for antitrust analysis.

As a result, the Court’s holding in Amex should also have required a finding in Apple v. Pepper that an app user on one side of the platform who transacts with an app developer on the other side of the market, in a transaction made possible and directly intermediated by Apple’s App Store, should similarly be deemed in the same market for standing purposes.

Relative to a strict construction of the traditional baseline, the former entails imposing an additional burden on two-sided market plaintiffs, while the latter entails a lessening of that burden. Whether the net effect is more or fewer successful cases in two-sided markets is unclear, of course. But from the perspective of aligning evidentiary and substantive doctrine with economic reality such an approach would be a clear improvement.

Critics accuse the Court of making antitrust cases unwinnable against two-sided market platforms thanks to Amex’s requirement that a prima facie showing of anticompetitive effect requires assessment of the effects on both sides of a two-sided market and proof of a net anticompetitive outcome. The critics should have been chastened by a proper decision in Apple v. Pepper. As it is, the holding (although not the reasoning) still may serve to undermine their fears.

But critics should have recognized that a necessary corollary of Amex’s “expanded” market definition is that, relative to previous standing doctrine, a greater number of prospective parties should have standing to sue.

More important, the Court in Apple v. Pepper should have recognized this. Although nominally limited to the indirect purchaser doctrine, the case presented the Court with an opportunity to grapple with this logical implication of its Amex decision. It failed to do so.

On the merits, it looks like Apple should win. But, for much the same reason, the Respondents in Apple v. Pepper should have standing

This does not, of course, mean that either party should win on the merits. Indeed, on the merits of the case, the Petitioner in Apple v. Pepper appears to have the stronger argument, particularly in light of Amex which (assuming the App Store is construed as some species of a two-sided “transaction” market) directs that Respondent has the burden of considering harms and efficiencies across both sides of the market.

At least on the basis of the limited facts as presented in the case thus far, Respondents have not remotely met their burden of proving anticompetitive effects in the relevant market.

The actual question presented in Apple v. Pepper concerns standing, not whether the plaintiffs have made out a viable case on the merits. Thus it may seem premature to consider aspects of the latter in addressing the former. But the structure of the market considered by the court should be consistent throughout its analysis.

Adjustments to standing in the context of two-sided markets must be made in concert with the nature of the substantive rule of reason analysis that will be performed in a case. The two doctrines are connected not only by the just demands for consistency, but by the error-cost framework of the overall analysis, which runs throughout the stages of an antitrust case.

Here, the two-sided markets approach in Amex properly understands that conduct by a platform has relevant effects on both sides of its interrelated two-sided market. But that stems from the actual economics of the platform; it is not merely a function of a judicial construct. It thus holds true at all stages of the analysis.

The implication for standing is that users on both sides of a two-sided platform may suffer similarly direct (or indirect) injury as a result of the platform’s conduct, regardless of the side to which that conduct is nominally addressed.

The consequence, then, of Amex’s understanding of the market is that more potential plaintiffs — specifically, plaintiffs on both sides of a two-sided market — may claim to suffer antitrust injury.

Why the myopic focus of the holding (and dissent) on Illinois Brick is improper: It’s about the market definition, stupid!

Moreover, because of the Amex understanding, the problem of analyzing the pass-through of damages at issue in Illinois Brick (with which the Court entirely occupies itself in Apple v. Pepper) is either mitigated or inevitable.

In other words, either the users on the different sides of a two-sided market suffer direct injury without pass-through under a proper definition of the relevant market, or else their interrelatedness is so strong that, complicated as it may be, the needs of substantive accuracy trump the administrative costs in sorting out the incidence of the costs, and courts cannot avoid them.

Illinois Brick’s indirect purchaser doctrine was designed for an environment in which the relationship between producers and consumers is mediated by a distributor in a direct, linear supply chain; it was not designed for platforms. Although the question presented in Apple v. Pepper is explicitly about whether the Illinois Brick “indirect purchaser” doctrine applies to the Apple App Store, that determination is contingent on the underlying product market definition (whether the product market is in fact well-specified by the parties and the court or not).

Particularly where intermediaries exist precisely to address transaction costs between “producers” and “consumers,” the platform services they provide may be central to the underlying claim in a way that the traditional direct/indirect filters — and their implied relevant markets — miss.

Further, the Illinois Brick doctrine was itself based not on the substantive necessity of cutting off liability evaluations at a particular level of distribution, but on administrability concerns. In particular, the Court was concerned with preventing duplicative recovery when there were many potential groups of plaintiffs, as well as preventing injustices that would occur if unknown groups of plaintiffs inadvertently failed to have their rights adequately adjudicated in absentia. It was also concerned with avoiding needlessly complicated damages calculations.

But, almost by definition, the tightly coupled nature of the two sides of a two-sided platform should mitigate the concerns about duplicative recovery and unknown parties. Moreover, much of the presumed complexity in damages calculations in a platform setting arise from the nature of the platform itself. Assessing and apportioning damages may be complicated, but such is the nature of complex commercial relationships — the same would be true, for example, of damages calculations between vertically integrated companies that transact simultaneously at multiple levels, or between cross-licensing patent holders/implementers. In fact, if anything, the judicial efficiency concerns in Illinois Brick point toward the increased importance of properly assessing the nature of the product or service of the platform in order to ensure that it accurately encompasses the entire relevant transaction.

Put differently, under a proper, more-accurate market definition, the “direct” and “indirect” labels don’t necessarily reflect either business or antitrust realities.

Where the Court in Apple v. Pepper really misses the boat is in its overly formalistic claim that the business model (and thus the product) underlying the complained-of conduct doesn’t matter:

[W]e fail to see why the form of the upstream arrangement between the manufacturer or supplier and the retailer should determine whether a monopolistic retailer can be sued by a downstream consumer who has purchased a good or service directly from the retailer and has paid a higher-than-competitive price because of the retailer’s unlawful monopolistic conduct.

But Amex held virtually the opposite:

Because “[l]egal presumptions that rest on formalistic distinctions rather than actual market realities are generally disfavored in antitrust law,” courts usually cannot properly apply the rule of reason without an accurate definition of the relevant market.

* * *

Price increases on one side of the platform likewise do not suggest anticompetitive effects without some evidence that they have increased the overall cost of the platform’s services. Thus, courts must include both sides of the platform—merchants and cardholders—when defining the credit-card market.

In the face of novel business conduct, novel business models, and novel economic circumstances, the degree of substantive certainty may be eroded, as may the reasonableness of the expectation that typical evidentiary burdens accurately reflect competitive harm. Modern technology — and particularly the platform business model endemic to many modern technology firms — presents a need for courts to adjust their doctrines in the face of such novel issues, even if doing so adds additional complexity to the analysis.

The unlearned market-definition lesson of the Eighth Circuit’s Campos v. Ticketmaster dissent

The Eight Circuit’s Campos v. Ticketmaster case demonstrates the way market definition shapes the application of the indirect purchaser doctrine. Indeed, the dissent in that case looms large in the Ninth Circuit’s decision in Apple v. Pepper. [Full disclosure: One of us (Geoff) worked on the dissent in Campos v. Ticketmaster as a clerk to Eighth Circuit judge Morris S. Arnold]

In Ticketmaster, the plaintiffs alleged that Ticketmaster abused its monopoly in ticket distribution services to force supracompetitve charges on concert venues — a practice that led to anticompetitive prices for concert tickets. Although not prosecuted as a two-sided market, the business model is strikingly similar to the App Store model, with Ticketmaster charging fees to venues and then facilitating ticket purchases between venues and concert goers.

As the dissent noted, however:

The monopoly product at issue in this case is ticket distribution services, not tickets.

Ticketmaster supplies the product directly to concert-goers; it does not supply it first to venue operators who in turn supply it to concert-goers. It is immaterial that Ticketmaster would not be supplying the service but for its antecedent agreement with the venues.

But it is quite relevant that the antecedent agreement was not one in which the venues bought some product from Ticketmaster in order to resell it to concert-goers.

More important, and more telling, is the fact that the entirety of the monopoly overcharge, if any, is borne by concert-goers.

In contrast to the situations described in Illinois Brick and the literature that the court cites, the venues do not pay the alleged monopoly overcharge — in fact, they receive a portion of that overcharge from Ticketmaster. (Emphasis added).

Thus, if there was a monopoly overcharge it was really borne entirely by concert-goers. As a result, apportionment — the complexity of which gives rise to the standard in Illinois Brick — was not a significant issue. And the antecedent transaction that allegedly put concertgoers in an indirect relationship with Ticketmaster is one in which Ticketmaster and concert venues divvied up the alleged monopoly spoils, not one in which the venues absorb their share of the monopoly overcharge.

The analogy to Apple v. Pepper is nearly perfect. Apple sits between developers on one side and consumers on the other, charges a fee to developers for app distribution services, and facilitates app sales between developers and users. It is possible to try to twist the market definition exercise to construe the separate contracts between developers and Apple on one hand, and the developers and consumers on the other, as some sort of complicated version of the classical manufacturing and distribution chains. But, more likely, it is advisable to actually inquire into the relevant factual differences that underpin Apple’s business model and adapt how courts consider market definition for two-sided platforms.

Indeed, Hanover Shoe and Illinois Brick were born out of a particular business reality in which businesses structured themselves in what are now classical production and distribution chains. The Supreme Court adopted the indirect purchaser rule as a prudential limitation on antitrust law in order to optimize the judicial oversight of such cases. It seems strangely nostalgic to reflexively try to fit new business methods into old legal analyses, when prudence and reality dictate otherwise.

The dissent in Ticketmaster was ahead of its time insofar as it recognized that the majority’s formal description of the ticket market was an artifact of viewing what was actually something much more like a ticket-services platform operated by Ticketmaster through the poor lens of the categories established decades earlier.

The Ticketmaster dissent’s observations demonstrate that market definition and antitrust standing are interrelated. It makes no sense to adhere to a restrictive reading of the latter if it connotes an economically improper understanding of the former. Ticketmaster provided an intermediary service — perhaps not quite a two-sided market, but something close — that stands outside a traditional manufacturing supply chain. Had it been offered by the venues themselves and bundled into the price of concert tickets there would be no question of injury and of standing (nor would market definition matter much, as both tickets and distribution services would be offered as a joint product by the same parties, in fixed proportions).

What antitrust standing doctrine should look like after Amex

There are some clear implications for antitrust doctrine that (should) follow from the preceding discussion.

A plaintiff has a choice to allege that a defendant operates either as a two-sided market or in a more traditional, linear chain during the pleading stage. If the plaintiff alleges a two-sided market, then, to demonstrate standing, it need only be shown that injury occurred to some subset of platform users with which the plaintiff is inextricably interrelated. The plaintiff would not need to demonstrate injury to him or herself, nor allege net harm, nor show directness.

In response, a defendant can contest standing by challenging the interrelatedness of the plaintiff and the group of platform users with whom the plaintiff claims interrelatedness. If the defendant does not challenge the allegation that it operates a two-sided market, it could not challenge standing by showing indirectness, that plaintiff had not alleged personal injury, or that plaintiff hasn’t alleged a net harm.

Once past a determination of standing, however, a plaintiff who pleads a two-sided market would not be able to later withdraw this allegation in order to lessen the attendant legal burdens.

If the court accepts that the defendant is operating a two-sided market, both parties would be required to frame their allegations and defenses in accordance with the nature of the two-sided market and thus the holding in Amex. This is critical because, whereas alleging a two-sided market may make it easier for plaintiffs to demonstrate standing, Amex’s requirement that net harm be demonstrated across interrelated sets of users makes it more difficult for plaintiffs to present a viable prima facie case. Further, defendants would not be barred from presenting efficiencies defenses based on benefits that interrelated users enjoy.

Conclusion: The Court in Apple v. Pepper should have acknowledged the implications of its holding in Amex

After Amex, claims against two-sided platforms might require more evidence to establish anticompetitive harm, but that business model also means that firms should open themselves up to a larger pool of potential plaintiffs. The legal principles still apply, but the relative importance of those principles to judicial outcomes shifts (or should shift) in line with the unique economic position of potential plaintiffs and defendants in a platform environment.

Whether a priori the net result is more or fewer cases and more or fewer victories for plaintiffs is not the issue; what matters is matching the legal and economic theory to the relevant facts in play. Moreover, decrying Amex as the end of antitrust was premature: the actual affect on injured parties can’t be known until other changes (like standing for a greater number of plaintiffs) are factored into the analysis. The Court’s holding in Apple v. Pepper sidesteps this issue entirely, and thus fails to properly move antitrust doctrine forward in line with its holding in Amex.

Of course, it’s entirely possible that platforms and courts might be inundated with expensive and difficult to manage lawsuits. There may be reasons of administrability for limiting standing (as Illinois Brick perhaps prematurely did for fear of the costs of courts’ managing suits). But then that should have been the focus of the Court’s decision.

Allowing standing in Apple v. Pepper permits exactly the kind of legal experimentation needed to enable the evolution of antitrust doctrine along with new business realities. But in some ways the Court reached the worst possible outcome. It announced a rule that permits more plaintiffs to establish standing, but it did not direct lower courts to assess standing within the proper analytical frame. Instead, it just expands standing in a manner unmoored from the economic — and, indeed, judicial — context. That’s not a recipe for the successful evolution of antitrust doctrine.

Near the end of her new proposal to break up Facebook, Google, Amazon, and Apple, Senator Warren asks, “So what would the Internet look like after all these reforms?”

It’s a good question, because, as she herself notes, “Twenty-five years ago, Facebook, Google, and Amazon didn’t exist. Now they are among the most valuable and well-known companies in the world.”

To Warren, our most dynamic and innovative companies constitute a problem that needs solving.

She described the details of that solution in a blog post:

First, [my administration would restore competition to the tech sector] by passing legislation that requires large tech platforms to be designated as “Platform Utilities” and broken apart from any participant on that platform.

* * *

For smaller companies…, their platform utilities would be required to meet the same standard of fair, reasonable, and nondiscriminatory dealing with users, but would not be required to structurally separate….

* * *
Second, my administration would appoint regulators committed to reversing illegal and anti-competitive tech mergers….
I will appoint regulators who are committed to… unwind[ing] anti-competitive mergers, including:

– Amazon: Whole Foods; Zappos;
– Facebook: WhatsApp; Instagram;
– Google: Waze; Nest; DoubleClick

Elizabeth Warren’s brave new world

Let’s consider for a moment what this brave new world will look like — not the nirvana imagined by regulators and legislators who believe that decimating a company’s business model will deter only the “bad” aspects of the model while preserving the “good,” as if by magic, but the inevitable reality of antitrust populism.  

Utilities? Are you kidding? For an overview of what the future of tech would look like under Warren’s “Platform Utility” policy, take a look at your water, electricity, and sewage service. Have you noticed any improvement (or reduction in cost) in those services over the past 10 or 15 years? How about the roads? Amtrak? Platform businesses operating under a similar regulatory regime would also similarly stagnate. Enforcing platform “neutrality” necessarily requires meddling in the most minute of business decisions, inevitably creating unintended and costly consequences along the way.

Network companies, like all businesses, differentiate themselves by offering unique bundles of services to customers. By definition, this means vertically integrating with some product markets and not others. Why are digital assistants like Siri bundled into mobile operating systems? Why aren’t the vast majority of third-party apps also bundled into the OS? If you want utilities regulators instead of Google or Apple engineers and designers making these decisions on the margin, then Warren’s “Platform Utility” policy is the way to go.

Grocery Stores. To take one specific case cited by Warren, how much innovation was there in the grocery store industry before Amazon bought Whole Foods? Since the acquisition, large grocery retailers, like Walmart and Kroger, have increased their investment in online services to better compete with the e-commerce champion. Many industry analysts expect grocery stores to use computer vision technology and artificial intelligence to improve the efficiency of check-out in the near future.

Smartphones. Imagine how forced neutrality would play out in the context of iPhones. If Apple can’t sell its own apps, it also can’t pre-install its own apps. A brand new iPhone with no apps — and even more importantly, no App Store — would be, well, just a phone, out of the box. How would users even access a site or app store from which to download independent apps? Would Apple be allowed to pre-install someone else’s apps? That’s discriminatory, too. Maybe it will be forced to offer a menu of all available apps in all categories (like the famously useless browser ballot screen demanded by the European Commission in its Microsoft antitrust case)? It’s hard to see how that benefits consumers — or even app developers.

Source: Free Software Magazine

Internet Search. Or take search. Calls for “search neutrality” have been bandied about for years. But most proponents of search neutrality fail to recognize that all Google’s search results entail bias in favor of its own offerings. As Geoff Manne and Josh Wright noted in 2011 at the height of the search neutrality debate:

[S]earch engines offer up results in the form not only of typical text results, but also maps, travel information, product pages, books, social media and more. To the extent that alleged bias turns on a search engine favoring its own maps, for example, over another firm’s, the allegation fails to appreciate that text results and maps are variants of the same thing, and efforts to restrain a search engine from offering its own maps is no different than preventing it from offering its own search results.

Nevermind that Google with forced non-discrimination likely means Google offering only the antiquated “ten blue links” search results page it started with in 1998 instead of the far more useful “rich” results it offers today; logically it would also mean Google somehow offering the set of links produced by any and all other search engines’ algorithms, in lieu of its own. If you think Google will continue to invest in and maintain the wealth of services it offers today on the strength of the profits derived from those search results, well, Elizabeth Warren is probably already your favorite politician.

Source: Web Design Museum  

And regulatory oversight of algorithmic content won’t just result in an impoverished digital experience; it will inevitably lead to an authoritarian one, as well:

Any agency granted a mandate to undertake such algorithmic oversight, and override or reconfigure the product of online services, thereby controls the content consumers may access…. This sort of control is deeply problematic… [because it saddles users] with a pervasive set of speech controls promulgated by the government. The history of such state censorship is one which has demonstrated strong harms to both social welfare and rule of law, and should not be emulated.

Digital Assistants. Consider also the veritable cage match among the tech giants to offer “digital assistants” and “smart home” devices with ever-more features at ever-lower prices. Today the allegedly non-existent competition among these companies is played out most visibly in this multi-featured market, comprising advanced devices tightly integrated with artificial intelligence, voice recognition, advanced algorithms, and a host of services. Under Warren’s nondiscrimination principle this market disappears. Each device can offer only a connectivity platform (if such a service is even permitted to be bundled with a physical device…) — and nothing more.

But such a world entails not only the end of an entire, promising avenue of consumer-benefiting innovation, it also entails the end of a promising avenue of consumer-benefiting competition. It beggars belief that anyone thinks consumers would benefit by forcing technology companies into their own silos, ensuring that the most powerful sources of competition for each other are confined to their own fiefdoms by order of law.

Breaking business models

Beyond the product-feature dimension, Sen. Warren’s proposal would be devastating for innovative business models. Why is Amazon Prime Video bundled with free shipping? Because the marginal cost of distribution for video is close to zero and bundling it with Amazon Prime increases the value proposition for customers. Why is almost every Google service free to users? Because Google’s business model is supported by ads, not monthly subscription fees. Each of the tech giants has carefully constructed an ecosystem in which every component reinforces the others. Sen. Warren’s plan would not only break up the companies, it would prohibit their business models — the ones that both created and continue to sustain these products. Such an outcome would manifestly harm consumers.

Both of Warren’s policy “solutions” are misguided and will lead to higher prices and less innovation. Her cause for alarm is built on a multitude of mistaken assumptions, but let’s address just a few (Warren in bold):

  • “Nearly half of all e-commerce goes through Amazon.” Yes, but it has only 5% of total retail in the United States. As my colleague Kristian Stout says, “the Internet is not a market; it’s a distribution channel.”
  • “Amazon has used its immense market power to force smaller competitors like Diapers.com to sell at a discounted rate.” The real story, as the founders of Diapers.com freely admitted, is that they sold diapers as what they hoped would be a loss leader, intending to build out sales of other products once they had a base of loyal customers:

And so we started with selling the loss leader product to basically build a relationship with mom. And once they had the passion for the brand and they were shopping with us on a weekly or a monthly basis that they’d start to fall in love with that brand. We were losing money on every box of diapers that we sold. We weren’t able to buy direct from the manufacturers.

Like all entrepreneurs, Diapers.com’s founders took a calculated risk that didn’t pay off as hoped. Amazon subsequently acquired the company (after it had declined a similar buyout offer from Walmart). (Antitrust laws protect consumers, not inefficient competitors). And no, this was not a case of predatory pricing. After many years of trying to make the business profitable as a subsidiary, Amazon shut it down in 2017.

  • “In the 1990s, Microsoft — the tech giant of its time — was trying to parlay its dominance in computer operating systems into dominance in the new area of web browsing. The federal government sued Microsoft for violating anti-monopoly laws and eventually reached a settlement. The government’s antitrust case against Microsoft helped clear a path for Internet companies like Google and Facebook to emerge.” The government’s settlement with Microsoft is not the reason Google and Facebook were able to emerge. Neither company entered the browser market at launch. Instead, they leapfrogged the browser entirely and created new platforms for the web (only later did Google create Chrome).

    Furthermore, if the Microsoft case is responsible for “clearing a path” for Google is it not also responsible for clearing a path for Google’s alleged depredations? If the answer is that antitrust enforcement should be consistently more aggressive in order to rein in Google, too, when it gets out of line, then how can we be sure that that same more-aggressive enforcement standard wouldn’t have curtailed the extent of the Microsoft ecosystem in which it was profitable for Google to become Google? Warren implicitly assumes that only the enforcement decision in Microsoft was relevant to Google’s rise. But Microsoft doesn’t exist in a vacuum. If Microsoft cleared a path for Google, so did every decision not to intervene, which, all combined, created the legal, business, and economic environment in which Google operates.

Warren characterizes Big Tech as a weight on the American economy. In fact, nothing could be further from the truth. These superstar companies are the drivers of productivity growth, all ranking at or near the top for most spending on research and development. And while data may not be the new oil, extracting value from it may require similar levels of capital expenditure. Last year, Big Tech spent as much or more on capex as the world’s largest oil companies:

Source: WSJ

Warren also faults Big Tech for a decline in startups, saying,

The number of tech startups has slumped, there are fewer high-growth young firms typical of the tech industry, and first financing rounds for tech startups have declined 22% since 2012.

But this trend predates the existence of the companies she criticizes, as this chart from Quartz shows:

The exact causes of the decline in business dynamism are still uncertain, but recent research points to a much more mundane explanation: demographics. Labor force growth has been declining, which has led to an increase in average firm age, nudging fewer workers to start their own businesses.

Furthermore, it’s not at all clear whether this is actually a decline in business dynamism, or merely a change in business model. We would expect to see the same pattern, for example, if would-be startup founders were designing their software for acquisition and further development within larger, better-funded enterprises.

Will Rinehart recently looked at the literature to determine whether there is indeed a “kill zone” for startups around Big Tech incumbents. One paper finds that “an increase in fixed costs explains most of the decline in the aggregate entrepreneurship rate.” Another shows an inverse correlation across 50 countries between GDP and entrepreneurship rates. Robert Lucas predicted these trends back in 1978, pointing out that productivity increases would lead to wage increases, pushing marginal entrepreneurs out of startups and into big companies.

It’s notable that many in the venture capital community would rather not have Sen. Warren’s “help”:

Arguably, it is also simply getting harder to innovate. As economists Nick Bloom, Chad Jones, John Van Reenen and Michael Webb argue,

just to sustain constant growth in GDP per person, the U.S. must double the amount of research effort searching for new ideas every 13 years to offset the increased difficulty of finding new ideas.

If this assessment is correct, it may well be that coming up with productive and profitable innovations is simply becoming more expensive, and thus, at the margin, each dollar of venture capital can fund less of it. Ironically, this also implies that larger firms, which can better afford the additional resources required to sustain exponential growth, are a crucial part of the solution, not the problem.

Warren believes that Big Tech is the cause of our social ills. But Americans have more trust in Amazon, Facebook, and Google than in the political institutions that would break them up. It would be wise for her to reflect on why that might be the case. By punishing our most valuable companies for past successes, Warren would chill competition and decrease returns to innovation.

Finally, in what can only be described as tragic irony, the most prominent political figure who shares Warren’s feelings on Big Tech is President Trump. Confirming the horseshoe theory of politics, far-left populism and far-right populism seem less distinguishable by the day. As our colleague Gus Hurwitz put it, with this proposal Warren is explicitly endorsing the unitary executive theory and implicitly endorsing Trump’s authority to direct his DOJ to “investigate specific cases and reach specific outcomes.” Which cases will he want to have investigated and what outcomes will he be seeking? More good questions that Senator Warren should be asking. The notion that competition, consumer welfare, and growth are likely to increase in such an environment is farcical.

[TOTM: The following is the second in a series of posts by TOTM guests and authors on the FTC v. Qualcomm case, currently awaiting decision by Judge Lucy Koh in the Northern District of California. The entire series of posts is available here.

This post is authored by Luke Froeb (William C. Oehmig Chair in Free Enterprise and Entrepreneurship at the Owen Graduate School of Management at Vanderbilt University; former chief economist at the Antitrust Division of the US Department of Justice and the Federal Trade Commission), Michael Doane (Competition Economics, LLC) & Mikhael Shor (Associate Professor of Economics, University of Connecticut).]

[Froeb, Doane & Shor: This post does not attempt to answer the question of what the court should decide in FTC v. Qualcomm because we do not have access to the information that would allow us to make such a determination. Rather, we focus on economic issues confronting the court by drawing heavily from our writings in this area: Gregory Werden & Luke Froeb, Why Patent Hold-Up Does Not Violate Antitrust Law; Luke Froeb & Mikhael Shor, Innovators, Implementors and Two-sided Hold-up; Bernard Ganglmair, Luke Froeb & Gregory Werden, Patent Hold Up and Antitrust: How a Well-Intentioned Rule Could Retard Innovation.]

Not everything is “hold-up”

It is not uncommon—in fact it is expected—that parties to a negotiation would have different opinions about the reasonableness of any deal. Every buyer asks for a price as low as possible, and sellers naturally request prices at which buyers (feign to) balk. A recent movement among some lawyers and economists has been to label such disagreements in the context of standard-essential patents not as a natural part of bargaining, but as dispositive proof of “hold-up,” or the innovator’s purported abuse of newly gained market power to extort implementers. We have four primary issues with this hold-up fad.

First, such claims of “hold-up” are trotted out whenever an innovator’s royalty request offends the commentator’s sensibilities, and usually with reference to a theoretical hold-up possibility rather than any matter-specific evidence that hold-up is actually present. Second, as we have argued elsewhere, such arguments usually ignore the fact that implementers of innovations often possess significant countervailing power to “hold-out as well. This is especially true as implementers have successfully pushed to curtail injunctive relief in standard-essential patent cases. Third, as Greg Werden and Froeb have recently argued, it is not clear why patent holdup—even where it might exist—need implicate antitrust law rather than be adequately handled as a contractual dispute. Lastly, it is certainly not the case that every disagreement over the value of an innovation is an exercise in hold-up, as even economists and lawyers have not reached anything resembling a consensus on the correct interpretation of a “fair” royalty.

At the heart of this case (and many recent cases) is (1) an indictment of Qualcomm’s desire to charge royalties to the maker of consumer devices based on the value of its technology and (2) a lack (to the best of our knowledge from public documents) of well vetted theoretical models that can provide the underpinning for the theory of the case. We discuss these in turn.

The smallest component “principle”

In arguing that “Qualcomm’s royalties are disproportionately high relative to the value contributed by its patented inventions,” (Complaint, ¶ 77) a key issue is whether Qualcomm can calculate royalties as a percentage of the price of a device, rather than a small percentage of the price of a chip. (Complaint, ¶¶ 61-76).

So what is wrong with basing a royalty on the price of the final product? A fixed portion of the price is not a perfect proxy for the value of embedded intellectual property, but it is a reasonable first approximation, much like retailers use fixed markups for products rather than optimizing the price of each SKU if the cost of individual determinations negate any benefits to doing so. The FTC’s main issue appears to be that the price of a smartphone reflects “many features in addition to the cellular connectivity and associated voice and text capabilities provided by early feature phones.” (Complaint, ¶ 26). This completely misses the point. What would the value of an iPhone be if it contained all of those “many features” but without the phone’s communication abilities? We have some idea, as Apple has for years marketed its iPod Touch for a quarter of the price of its iPhone line. Yet, “[f]or most users, the choice between an iPhone 5s and an iPod touch will be a no-brainer: Being always connected is one of the key reasons anyone owns a smartphone.”

What the FTC and proponents of the smallest component principle miss is that some of the value of all components of a smartphone are derived directly from the phone’s communication ability. Smartphones didn’t initially replace small portable cameras because they were better at photography (in fact, smartphone cameras were and often continue to be much worse than devoted cameras). The value of a smartphone camera is that it combines picture taking with immediate sharing over text or through social media. Thus, unlike the FTC’s claim that most of the value of a smartphone comes from features that are not communication, many features on a smartphone derive much of their value from the communication powers of the phone.

In the alternative, what the FTC wants is for the royalty not to reflect the value of the intellectual property but instead to be a small portion of the cost of some chipset—akin to an author of a paperback negotiating royalties based on the cost of plain white paper. As a matter of economics, a single chipset royalty cannot allow an innovator to capture the value of its innovation. This, in turn, implies that innovators underinvest in future technologies. As we have previously written:

For example, imagine that the same component (incorporating the same essential patent) is used to help stabilize flight of both commercial airplanes and toy airplanes. Clearly, these industries are likely to have different values for the patent. By negotiating over a single royalty rate based on the component price, the innovator would either fail to realize the added value of its patent to commercial airlines, or (in the case that the component is targeted primary to the commercial airlines) would not realize the incremental market potential from the patent’s use in toy airplanes. In either case, the innovator will not be negotiating over the entirety of the value it creates, leading to too little innovation.

The role of economics

Modern antitrust practice is to use economic models to explain how one gets from the evidence presented in a case to an anticompetitive conclusion. As Froeb, et al. have discussed, by laying out a mapping from the evidence to the effects, the legal argument is made clear, and gains credibility because it becomes falsifiable. The FTC complaint hypothesizes that “Qualcomm has excluded competitors and harmed competition through a set of interrelated policies and practices.” (Complaint, ¶ 3). Although Qualcomm explains how each of these policies and practices, by themselves, have clear business justifications, the FTC claims that combining them leads to an anticompetitive outcome.

Without providing a formal mapping from the evidence to an effect, it becomes much more difficult for a court to determine whether the theory of harm is correct or how to weigh the evidence that feeds the conclusion. Without a model telling it “what matters, why it matters, and how much it matters,” it is much more difficult for a tribunal to evaluate the “interrelated policies and practices.” In previous work, we have modeled the bilateral bargaining between patentees and licensees and have shown that when bilateral patent contracts are subject to review by an antitrust court, bargaining in the shadow of such a court can reduce the incentive to invest and thereby reduce welfare.

Concluding policy thoughts

What the FTC makes sound nefarious seems like a simple policy: requiring companies to seek licenses to Qualcomm’s intellectual property independent of any hardware that those companies purchase, and basing the royalty of that intellectual property on (an admittedly crude measure of) the value the IP contributes to that product. High prices alone do not constitute harm to competition. The FTC must clearly explain why their complaint is not simply about the “fairness” of the outcome or its desire that Qualcomm employ different bargaining paradigms, but rather how Qualcomm’s behavior harms the process of competition.

In the late 1950s, Nobel Laureate Robert Solow attributed about seven-eighths of the growth in U.S. GDP to technical progress. As Solow later commented: “Adding a couple of tenths of a percentage point to the growth rate is an achievement that eventually dwarfs in welfare significance any of the standard goals of economic policy.” While he did not have antitrust in mind, the import of his comment is clear: whatever static gains antitrust litigation may achieve, they are likely dwarfed by the dynamic gains represented by innovation.

Patent law is designed to maintain a careful balance between the costs of short-term static losses and the benefits of long-term gains that result from new technology. The FTC should present a sound theoretical or empirical basis for believing that the proposed relief sufficiently rewards inventors and allows them to capture a reasonable share of the whole value their innovations bring to consumers, lest such antitrust intervention deter investments in innovation.