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In mid-November, the 50 state attorneys general (AGs) investigating Google’s advertising practices expanded their antitrust probe to include the company’s search and Android businesses. Texas Attorney General Ken Paxton, the lead on the case, was supportive of the development, but made clear that other states would manage the investigations of search and Android separately. While attorneys might see the benefit in splitting up search and advertising investigations, platforms like Google need to be understood as a coherent whole. If the state AGs case is truly concerned with the overall impact on the welfare of consumers, it will need to be firmly grounded in the unique economics of this platform.

Back in September, 50 state AGs, including those in Washington, DC and Puerto Rico, announced an investigation into Google. In opening the case, Paxton said that, “There is nothing wrong with a business becoming the biggest game in town if it does so through free market competition, but we have seen evidence that Google’s business practices may have undermined consumer choice, stifled innovation, violated users’ privacy, and put Google in control of the flow and dissemination of online information.” While the original document demands focused on Google’s “overarching control of online advertising markets and search traffic,” reports since then suggest that the primary investigation centers on online advertising.

Defining the market

Since the market definition is the first and arguably the most important step in an antitrust case, Paxton has tipped his hand and shown that the investigation is converging on the online ad market. Yet, he faltered when he wrote in The Wall Street Journal that, “Each year more than 90% of Google’s $117 billion in revenue comes from online advertising. For reference, the entire market for online advertising is around $130 billion annually.” As Patrick Hedger of the Competitive Enterprise Institute was quick to note, Paxton cited global revenue numbers and domestic advertising statistics. In reality, Google’s share of the online advertising market in the United States is 37 percent and is widely expected to fall.

When Google faced scrutiny by the Federal Trade Commission in 2013, the leaked staff report explained that “the Commission and the Department of Justice have previously found online ‘search advertising’ to be a distinct product market.” This finding, which dates from 2007, simply wouldn’t stand today. Facebook’s ad platform was launched in 2007 and has grown to become a major competitor to Google. Even more recently, Amazon has jumped into the space and independent platforms like Telaria, Rubicon Project, and The Trade Desk have all made inroads. In contrast to the late 2000s, advertisers now use about four different online ad platforms.

Moreover, the relationship between ad prices and industry concentration is complicated. In traditional economic analysis, fewer suppliers of a product generally translates into higher prices. In the online ad market, however, fewer advertisers means that ad buyers can efficiently target people through keywords. Because advertisers have access to superior information, research finds that more concentration tends to lead to lower search engine revenues. 

The addition of new fronts in the state AGs’ investigation could spell disaster for consumers. While search and advertising are distinct markets, it is the act of tying the two together that makes platforms like Google valuable to users and advertisers alike. Demand is tightly integrated between the two sides of the platform. Changes in user and advertiser preferences have far outsized effects on the overall platform value because each side responds to the other. If users experience an increase in price or a reduction in quality, then they will use the platform less or just log off completely. Advertisers see this change in users and react by reducing their demand for ad placements as well. When advertisers drop out, the total amount of content also recedes and users react once again. Economists call these relationships demand interdependencies. The demand on one side of the market is interdependent with demand on the other. Research on magazines, newspapers, and social media sites all support the existence of demand interdependencies. 

Economists David Evans and Richard Schmalensee, who were cited extensively in the Supreme Court case Ohio v. American Express, explained the importance of their integration into competition analysis, “The key point is that it is wrong as a matter of economics to ignore significant demand interdependencies among the multiple platform sides” when defining markets. If they are ignored, then the typical analytical tools will yield incorrect assessments. Understanding these relationships makes the investigation all that more difficult.

The limits of remedies

Most likely, this current investigation will follow the trajectory of Microsoft in the 1990s when states did the legwork for a larger case brought by the Department of Justice (DoJ). The DoJ already has its own investigation into Google and will probably pull together all of the parties for one large suit. Google is also subject to a probe by the House of Representatives Judiciary Committee as well. What is certain is that Google will be saddled with years of regulatory scrutiny, but what remains unclear is what kind of changes the AGs are after.

The investigation might aim to secure behavioral changes, but these often come with a cost in platform industries. The European Commission, for example, got Google to change its practices with its Android operating system for mobile phones. Much like search and advertising, the Android ecosystem is a platform with cross subsidization and demand interdependencies between the various sides of the market. Because the company was ordered to stop tying the Android operating system to apps, manufacturers of phones and tablets now have to pay a licensing fee in Europe if they want Google’s apps and the Play Store. Remedies meant to change one side of the platform resulted in those relationships being unbundled. When regulators force cross subsidization to become explicit prices, consumers are the one who pay.

The absolute worst case scenario would be a break up of Google, which has been a centerpiece of Senator Elizabeth Warren’s presidential platform. As I explained last year, that would be a death warrant for the company:

[T]he value of both Facebook and Google comes in creating the platform, which combines users with advertisers. Before the integration of ad networks, the search engine industry was struggling and it was simply not a major player in the Internet ecosystem. In short, the search engines, while convenient, had no economic value. As Michael Moritz, a major investor of Google, said of those early years, “We really couldn’t figure out the business model. There was a period where things were looking pretty bleak.” But Google didn’t pave the way. Rather, Bill Gross at GoTo.com succeeded in showing everyone how advertising could work to build a business. Google founders Larry Page and Sergey Brin merely adopted the model in 2002 and by the end of the year, the company was profitable for the first time. Marrying the two sides of the platform created value. Tearing them apart will also destroy value.

The state AGs need to resist making this investigation into a political showcase. As Pew noted in documenting the rise of North Carolina Attorney General Josh Stein to national prominence, “What used to be a relatively high-profile position within a state’s boundaries has become a springboard for publicity across the country.” While some might cheer the opening of this investigation, consumer welfare needs to be front and center. To properly understand how consumer welfare might be impacted by an investigation, the state AGs need to take seriously the path already laid out by platform economics. For the sake of consumers, let’s hope they are up to the task. 

An oft-repeated claim of conferences, media, and left-wing think tanks is that lax antitrust enforcement has led to a substantial increase in concentration in the US economy of late, strangling the economy, harming workers, and saddling consumers with greater markups in the process. But what if rising concentration (and the current level of antitrust enforcement) were an indication of more competition, not less?

By now the concentration-as-antitrust-bogeyman story is virtually conventional wisdom, echoed, of course, by political candidates such as Elizabeth Warren trying to cash in on the need for a government response to such dire circumstances:

In industry after industry — airlines, banking, health care, agriculture, tech — a handful of corporate giants control more and more. The big guys are locking out smaller, newer competitors. They are crushing innovation. Even if you don’t see the gears turning, this massive concentration means prices go up and quality goes down for everything from air travel to internet service.  

But the claim that lax antitrust enforcement has led to increased concentration in the US and that it has caused economic harm has been debunked several times (for some of our own debunking, see Eric Fruits’ posts here, here, and here). Or, more charitably to those who tirelessly repeat the claim as if it is “settled science,” it has been significantly called into question

Most recently, several working papers looking at the data on concentration in detail and attempting to identify the likely cause for the observed data, show precisely the opposite relationship. The reason for increased concentration appears to be technological, not anticompetitive. And, as might be expected from that cause, its effects are beneficial. Indeed, the story is both intuitive and positive.

What’s more, while national concentration does appear to be increasing in some sectors of the economy, it’s not actually so clear that the same is true for local concentration — which is often the relevant antitrust market.

The most recent — and, I believe, most significant — corrective to the conventional story comes from economists Chang-Tai Hsieh of the University of Chicago and Esteban Rossi-Hansberg of Princeton University. As they write in a recent paper titled, “The Industrial Revolution in Services”: 

We show that new technologies have enabled firms that adopt them to scale production over a large number of establishments dispersed across space. Firms that adopt this technology grow by increasing the number of local markets that they serve, but on average are smaller in the markets that they do serve. Unlike Henry Ford’s revolution in manufacturing more than a hundred years ago when manufacturing firms grew by concentrating production in a given location, the new industrial revolution in non-traded sectors takes the form of horizontal expansion across more locations. At the same time, multi-product firms are forced to exit industries where their productivity is low or where the new technology has had no effect. Empirically we see that top firms in the overall economy are more focused and have larger market shares in their chosen sectors, but their size as a share of employment in the overall economy has not changed. (pp. 42-43) (emphasis added).

This makes perfect sense. And it has the benefit of not second-guessing structural changes made in response to technological change. Rather, it points to technological change as doing what it regularly does: improving productivity.

The implementation of new technology seems to be conferring benefits — it’s just that these benefits are not evenly distributed across all firms and industries. But the assumption that larger firms are causing harm (or even that there is any harm in the first place, whatever the cause) is unmerited. 

What the authors find is that the apparent rise in national concentration doesn’t tell the relevant story, and the data certainly aren’t consistent with assumptions that anticompetitive conduct is either a cause or a result of structural changes in the economy.

Hsieh and Rossi-Hansberg point out that increased concentration is not happening everywhere, but is being driven by just three industries:

First, we show that the phenomena of rising concentration . . . is only seen in three broad sectors – services, wholesale, and retail. . . . [T]op firms have become more efficient over time, but our evidence indicates that this is only true for top firms in these three sectors. In manufacturing, for example, concentration has fallen.

Second, rising concentration in these sectors is entirely driven by an increase [in] the number of local markets served by the top firms. (p. 4) (emphasis added).

These findings are a gloss on a (then) working paper — The Fall of the Labor Share and the Rise of Superstar Firms — by David Autor, David Dorn, Lawrence F. Katz, Christina Patterson, and John Van Reenan (now forthcoming in the QJE). Autor et al. (2019) finds that concentration is rising, and that it is the result of increased productivity:

If globalization or technological changes push sales towards the most productive firms in each industry, product market concentration will rise as industries become increasingly dominated by superstar firms, which have high markups and a low labor share of value-added.

We empirically assess seven predictions of this hypothesis: (i) industry sales will increasingly concentrate in a small number of firms; (ii) industries where concentration rises most will have the largest declines in the labor share; (iii) the fall in the labor share will be driven largely by reallocation rather than a fall in the unweighted mean labor share across all firms; (iv) the between-firm reallocation component of the fall in the labor share will be greatest in the sectors with the largest increases in market concentration; (v) the industries that are becoming more concentrated will exhibit faster growth of productivity; (vi) the aggregate markup will rise more than the typical firm’s markup; and (vii) these patterns should be observed not only in U.S. firms, but also internationally. We find support for all of these predictions. (emphasis added).

This is alone is quite important (and seemingly often overlooked). Autor et al. (2019) finds that rising concentration is a result of increased productivity that weeds out less-efficient producers. This is a good thing. 

But Hsieh & Rossi-Hansberg drill down into the data to find something perhaps even more significant: the rise in concentration itself is limited to just a few sectors, and, where it is observed, it is predominantly a function of more efficient firms competing in more — and more localized — markets. This means that competition is increasing, not decreasing, whether it is accompanied by an increase in concentration or not. 

No matter how may times and under how many monikers the antitrust populists try to revive it, the Structure-Conduct-Performance paradigm remains as moribund as ever. Indeed, on this point, as one of the new antitrust agonists’ own, Fiona Scott Morton, has written (along with co-authors Martin Gaynor and Steven Berry):

In short, there is no well-defined “causal effect of concentration on price,” but rather a set of hypotheses that can explain observed correlations of the joint outcomes of price, measured markups, market share, and concentration. As Bresnahan (1989) argued three decades ago, no clear interpretation of the impact of concentration is possible without a clear focus on equilibrium oligopoly demand and “supply,” where supply includes the list of the marginal cost functions of the firms and the nature of oligopoly competition. 

Some of the recent literature on concentration, profits, and markups has simply reasserted the relevance of the old-style structure-conduct-performance correlations. For economists trained in subfields outside industrial organization, such correlations can be attractive. 

Our own view, based on the well-established mainstream wisdom in the field of industrial organization for several decades, is that regressions of market outcomes on measures of industry structure like the Herfindahl-Hirschman Index should be given little weight in policy debates. Such correlations will not produce information about the causal estimates that policy demands. It is these causal relationships that will help us understand what, if anything, may be causing markups to rise. (emphasis added).

Indeed! And one reason for the enduring irrelevance of market concentration measures is well laid out in Hsieh and Rossi-Hansberg’s paper:

This evidence is consistent with our view that increasing concentration is driven by new ICT-enabled technologies that ultimately raise aggregate industry TFP. It is not consistent with the view that concentration is due to declining competition or entry barriers . . . , as these forces will result in a decline in industry employment. (pp. 4-5) (emphasis added)

The net effect is that there is essentially no change in concentration by the top firms in the economy as a whole. The “super-star” firms of today’s economy are larger in their chosen sectors and have unleashed productivity growth in these sectors, but they are not any larger as a share of the aggregate economy. (p. 5) (emphasis added)

Thus, to begin with, the claim that increased concentration leads to monopsony in labor markets (and thus unemployment) appears to be false. Hsieh and Rossi-Hansberg again:

[W]e find that total employment rises substantially in industries with rising concentration. This is true even when we look at total employment of the smaller firms in these industries. (p. 4)

[S]ectors with more top firm concentration are the ones where total industry employment (as a share of aggregate employment) has also grown. The employment share of industries with increased top firm concentration grew from 70% in 1977 to 85% in 2013. (p. 9)

Firms throughout the size distribution increase employment in sectors with increasing concentration, not only the top 10% firms in the industry, although by definition the increase is larger among the top firms. (p. 10) (emphasis added)

Again, what actually appears to be happening is that national-level growth in concentration is actually being driven by increased competition in certain industries at the local level:

93% of the growth in concentration comes from growth in the number of cities served by top firms, and only 7% comes from increased employment per city. . . . [A]verage employment per county and per establishment of top firms falls. So necessarily more than 100% of concentration growth has to come from the increase in the number of counties and establishments served by the top firms. (p.13)

The net effect is a decrease in the power of top firms relative to the economy as a whole, as the largest firms specialize more, and are dominant in fewer industries:

Top firms produce in more industries than the average firm, but less so in 2013 compared to 1977. The number of industries of a top 0.001% firm (relative to the average firm) fell from 35 in 1977 to 17 in 2013. The corresponding number for a top 0.01% firm is 21 industries in 1977 and 9 industries in 2013. (p. 17)

Thus, summing up, technology has led to increased productivity as well as greater specialization by large firms, especially in relatively concentrated industries (exactly the opposite of the pessimistic stories):  

[T]op firms are now more specialized, are larger in the chosen industries, and these are precisely the industries that have experienced concentration growth. (p. 18)

Unsurprisingly (except to some…), the increase in concentration in certain industries does not translate into an increase in concentration in the economy as a whole. In other words, workers can shift jobs between industries, and there is enough geographic and firm mobility to prevent monopsony. (Despite rampant assumptions that increased concentration is constraining labor competition everywhere…).

Although the employment share of top firms in an average industry has increased substantially, the employment share of the top firms in the aggregate economy has not. (p. 15)

It is also simply not clearly the case that concentration is causing prices to rise or otherwise causing any harm. As Hsieh and Rossi-Hansberg note:

[T]he magnitude of the overall trend in markups is still controversial . . . and . . . the geographic expansion of top firms leads to declines in local concentration . . . that could enhance competition. (p. 37)

Indeed, recent papers such as Traina (2018), Gutiérrez and Philippon (2017), and the IMF (2019) have found increasing markups over the last few decades but at much more moderate rates than the famous De Loecker and Eeckhout (2017) study. Other parts of the anticompetitive narrative have been challenged as well. Karabarbounis and Neiman (2018) finds that profits have increased, but are still within their historical range. Rinz (2018) shows decreased wages in concentrated markets but also points out that local concentration has been decreasing over the relevant time period.

None of this should be so surprising. Has antitrust enforcement gotten more lax, leading to greater concentration? According to Vita and Osinski (2018), not so much. And how about the stagnant rate of new firms? Are incumbent monopolists killing off new startups? The more likely — albeit mundane — explanation, according to Hopenhayn et al. (2018), is that increased average firm age is due to an aging labor force. Lastly, the paper from Hsieh and Rossi-Hansberg discussed above is only the latest in a series of papers, including Bessen (2017), Van Reenen (2018), and Autor et al. (2019), that shows a rise in fixed costs due to investments in proprietary information technology, which correlates with increased concentration. 

So what is the upshot of all this?

  • First, as noted, employment has not decreased because of increased concentration; quite the opposite. Employment has increased in the industries that have experienced the most concentration at the national level.
  • Second, this result suggests that the rise in concentrated industries has not led to increased market power over labor.
  • Third, concentration itself needs to be understood more precisely. It is not explained by a simple narrative that the economy as a whole has experienced a great deal of concentration and this has been detrimental for consumers and workers. Specific industries have experienced national level concentration, but simultaneously those same industries have become more specialized and expanded competition into local markets. 

Surprisingly (because their paper has been around for a while and yet this conclusion is rarely recited by advocates for more intervention — although they happily use the paper to support claims of rising concentration), Autor et al. (2019) finds the same thing:

Our formal model, detailed below, generates superstar effects from increases in the toughness of product market competition that raise the market share of the most productive firms in each sector at the expense of less productive competitors. . . . An alternative perspective on the rise of superstar firms is that they reflect a diminution of competition, due to a weakening of U.S. antitrust enforcement (Dottling, Gutierrez and Philippon, 2018). Our findings on the similarity of trends in the U.S. and Europe, where antitrust authorities have acted more aggressively on large firms (Gutierrez and Philippon, 2018), combined with the fact that the concentrating sectors appear to be growing more productive and innovative, suggests that this is unlikely to be the primary explanation, although it may important in some specific industries (see Cooper et al, 2019, on healthcare for example). (emphasis added).

The popular narrative among Neo-Brandeisian antitrust scholars that lax antitrust enforcement has led to concentration detrimental to society is at base an empirical one. The findings of these empirical papers severely undermine the persuasiveness of that story.

A recently published book, “Kochland – The Secret History of Koch Industries and Corporate Power in America” by Christopher Leonard, presents a gripping account of relentless innovation and the power of the entrepreneur to overcome adversity in pursuit of delivering superior goods and services to the market while also reaping impressive profits. It’s truly an inspirational American story.

Now, I should note that I don’t believe Mr. Leonard actually intended his book to be quite so complimentary to the Koch brothers and the vast commercial empire they built up over the past several decades. He includes plenty of material detailing, for example, their employees playing fast and loose with environmental protection rules, or their labor lawyers aggressively bargaining with unions, sometimes to the detriment of workers. And all of the stories he presents are supported by sympathetic emotional appeals through personal anecdotes. 

But, even then, many of the negative claims are part of a larger theme of Koch Industries progressively improving its business practices. One prominent example is how Koch Industries learned from its environmentally unfriendly past and implemented vigorous programs to ensure “10,000% compliance” with all federal and state environmental laws. 

What really stands out across most or all of the stories Leonard has to tell, however, is the deep appreciation that Charles Koch and his entrepreneurially-minded employees have for the fundamental nature of the market as an information discovery process. Indeed, Koch Industries has much in common with modern technology firms like Amazon in this respect — but decades before the information technology revolution made the full power of “Big Data” gathering and processing as obvious as it is today.

The impressive information operation of Koch Industries

Much of Kochland is devoted to stories in which Koch Industries’ ability to gather and analyze data from across its various units led to the production of superior results for the economy and consumers. For example,  

Koch… discovered that the National Parks Service published data showing the snow pack in the California mountains, data that Koch could analyze to determine how much water would be flowing in future months to generate power at California’s hydroelectric plants. This helped Koch predict with great accuracy the future supply of electricity and the resulting demand for natural gas.

Koch Industries was able to use this information to anticipate the amount of power (megawatt hours) it needed to deliver to the California power grid (admittedly, in a way that was somewhat controversial because of poorly drafted legislation relating to the new regulatory regime governing power distribution and resale in the state).

And, in 2000, while many firms in the economy were still riding the natural gas boom of the 90s, 

two Koch analysts and a reservoir engineer… accurately predicted a coming disaster that would contribute to blackouts along the West Coast, the bankruptcy of major utilities, and skyrocketing costs for many consumers.

This insight enabled Koch Industries to reap huge profits in derivatives trading, and it also enabled it to enter — and essentially rescue — a market segment crucial for domestic farmers: nitrogen fertilizer.

The market volatility in natural gas from the late 90s through early 00s wreaked havoc on the nitrogen fertilizer industry, for which natural gas is the primary input. Farmland — a struggling fertilizer producer — had progressively mismanaged its business over the preceding two decades by focusing on developing lines of business outside of its core competencies, including blithely exposing itself to the volatile natural gas market in pursuit of short-term profits. By the time it was staring bankruptcy in the face, there were no other companies interested in acquiring it. 

Koch’s analysts, however, noticed that many of Farmland’s key fertilizer plants were located in prime locations for reaching local farmers. Once the market improved, whoever controlled those key locations would be in a superior position for selling into the nitrogen fertilizer market. So, by utilizing the data it derived from its natural gas operations (both operating pipelines and storage facilities, as well as understanding the volatility of gas prices and availability through its derivatives trading operations), Koch Industries was able to infer that it could make substantial profits by rescuing this bankrupt nitrogen fertilizer business. 

Emblematic of Koch’s philosophy of only making long-term investments, 

[o]ver the next ten years, [Koch Industries] spent roughly $500 million to outfit the plants with new technology while streamlining production… Koch installed a team of fertilizer traders in the office… [t]he traders bought and sold supplies around the globe, learning more about fertilizer markets each day. Within a few years, Koch Fertilizer built a global distribution network. Koch founded a new company, called Koch Energy Services, which bought and sold natural gas supplies to keep the fertilizer plants stocked.

Thus, Koch Industries not only rescued midwest farmers from shortages that would have decimated their businesses, it invested heavily to ensure that production would continue to increase to meet future demand. 

As noted, this acquisition was consistent with the ethos of Koch Industries, which stressed thinking about investments as part of long-term strategies, in contrast to their “counterparties in the market [who] were obsessed with the near-term horizon.” This led Koch Industries to look at investments over a period measured in years or decades, an approach that allowed the company to execute very intricate investment strategies: 

If Koch thought there was going to be an oversupply of oil in the Gulf Coast region, for example, it might snap up leases on giant oil barges, knowing that when the oversupply hit, companies would be scrambling for extra storage space and willing to pay a premium for the leases that Koch bought on the cheap. This was a much safer way to execute the trade than simply shorting the price of oil—even if Koch was wrong about the supply glut, the downside was limited because Koch could still sell or use the barge leases and almost certainly break even.

Entrepreneurs, regulators, and the problem of incentives

All of these accounts and more in Kochland brilliantly demonstrate a principal salutary role of entrepreneurs in the market, which is to discover slack or scarce resources in the system and manage them in a way that they will be available for utilization when demand increases. Guaranteeing the presence of oil barges in the face of market turbulence, or making sure that nitrogen fertilizer is available when needed, is precisely the sort of result sound public policy seeks to encourage from firms in the economy. 

Government, by contrast — and despite its best intentions — is institutionally incapable of performing the same sorts of entrepreneurial activities as even very large private organizations like Koch Industries. The stories recounted in Kochland demonstrate this repeatedly. 

For example, in the oil tanker episode, Koch’s analysts relied on “huge amounts of data from outside sources” – including “publicly available data…like the federal reports that tracked the volume of crude oil being stored in the United States.” Yet, because that data was “often stale” owing to a rigid, periodic publication schedule, it lacked the specificity necessary for making precise interventions in markets. 

Koch’s analysts therefore built on that data using additional public sources, such as manifests from the Customs Service which kept track of the oil tanker traffic in US waters. Leveraging all of this publicly available data, Koch analysts were able to develop “a picture of oil shipments and flows that was granular in its specificity.”

Similarly, when trying to predict snowfall in the western US, and how that would affect hydroelectric power production, Koch’s analysts relied on publicly available weather data — but extended it with their own analytical insights to make it more suitable to fine-grained predictions. 

By contrast, despite decades of altering the regulatory scheme around natural gas production, transport and sales, and being highly involved in regulating all aspects of the process, the federal government could not even provide the data necessary to adequately facilitate markets. Koch’s energy analysts would therefore engage in various deals that sometimes would only break even — if it meant they could develop a better overall picture of the relevant markets: 

As was often the case at Koch, the company… was more interested in the real-time window that origination deals could provide into the natural gas markets. Just as in the early days of the crude oil markets, information about prices was both scarce and incredibly valuable. There were not yet electronic exchanges that showed a visible price of natural gas, and government data on sales were irregular and relatively slow to come. Every origination deal provided fresh and precise information about prices, supply, and demand.

In most, if not all, of the deals detailed in Kochland, government regulators had every opportunity to find the same trends in the publicly available data — or see the same deficiencies in the data and correct them. Given their access to the same data, government regulators could, in some imagined world, have developed policies to mitigate the effects of natural gas market collapses, handle upcoming power shortages, or develop a reliable supply of fertilizer to midwest farmers. But they did not. Indeed, because of the different sets of incentives they face (among other factors), in the real world, they cannot do so, despite their best intentions.

The incentive to innovate

This gets to the core problem that Hayek described concerning how best to facilitate efficient use of dispersed knowledge in such a way as to achieve the most efficient allocation and distribution of resources: 

The various ways in which the knowledge on which people base their plans is communicated to them is the crucial problem for any theory explaining the economic process, and the problem of what is the best way of utilizing knowledge initially dispersed among all the people is at least one of the main problems of economic policy—or of designing an efficient economic system.

The question of how best to utilize dispersed knowledge in society can only be answered by considering who is best positioned to gather and deploy that knowledge. There is no fundamental objection to “planning”  per se, as Hayek notes. Indeed, in a complex society filled with transaction costs, there will need to be entities capable of internalizing those costs  — corporations or governments — in order to make use of the latent information in the system. The question is about what set of institutions, and what set of incentives governing those institutions, results in the best use of that latent information (and the optimal allocation and distribution of resources that follows from that). 

Armen Alchian captured the different incentive structures between private firms and government agencies well: 

The extent to which various costs and effects are discerned, measured and heeded depends on the institutional system of incentive-punishment for the deciders. One system of rewards-punishment may increase the extent to which some objectives are heeded, whereas another may make other goals more influential. Thus procedures for making or controlling decisions in one rewards-incentive system are not necessarily the “best” for some other system…

In the competitive, private, open-market economy, the wealth-survival prospects are not as strong for firms (or their employees) who do not heed the market’s test of cost effectiveness as for firms who do… as a result the market’s criterion is more likely to be heeded and anticipated by business people. They have personal wealth incentives to make more thorough cost-effectiveness calculations about the products they could produce …

In the government sector, two things are less effective. (1) The full cost and value consequences of decisions do not have as direct and severe a feedback impact on government employees as on people in the private sector. The costs of actions under their consideration are incomplete simply because the consequences of ignoring parts of the full span of costs are less likely to be imposed on them… (2) The effectiveness, in the sense of benefits, of their decisions has a different reward-inventive or feedback system … it is fallacious to assume that government officials are superhumans, who act solely with the national interest in mind and are never influenced by the consequences to their own personal position.

In short, incentives matter — and are a function of the institutional arrangement of the system. Given the same set of data about a scarce set of resources, over the long run, the private sector generally has stronger incentives to manage resources efficiently than does government. As Ludwig von Mises showed, moving those decisions into political hands creates a system of political preferences that is inherently inferior in terms of the production and distribution of goods and services.

Koch Industries: A model of entrepreneurial success

The market is not perfect, but no human institution is perfect. Despite its imperfections, the market provides the best system yet devised for fairly and efficiently managing the practically unlimited demands we place on our scarce resources. 

Kochland provides a valuable insight into the virtues of the market and entrepreneurs, made all the stronger by Mr. Leonard’s implied project of “exposing” the dark underbelly of Koch Industries. The book tells the bad tales, which I’m willing to believe are largely true. I would, frankly, be shocked if any large entity — corporation or government — never ran into problems with rogue employees, internal corporate dynamics gone awry, or a failure to properly understand some facet of the market or society that led to bad investments or policy. 

The story of Koch Industries — presented even as it is through the lens of a “secret history”  — is deeply admirable. It’s the story of a firm that not only learns from its own mistakes, as all firms must do if they are to survive, but of a firm that has a drive to learn in its DNA. Koch Industries relentlessly gathers information from the market, sometimes even to the exclusion of short-term profit. It eschews complex bureaucratic structures and processes, which encourages local managers to find opportunities and nimbly respond.

Kochland is a quick read that presents a gripping account of one of America’s corporate success stories. There is, of course, a healthy amount of material in the book covering the Koch brothers’ often controversial political activities. Nonetheless, even those who hate the Koch brothers on account of politics would do well to learn from the model of entrepreneurial success that Kochland cannot help but describe in its pages. 

Last week the Senate Judiciary Committee held a hearing, Intellectual Property and the Price of Prescription Drugs: Balancing Innovation and Competition, that explored whether changes to the pharmaceutical patent process could help lower drug prices.  The committee’s goal was to evaluate various legislative proposals that might facilitate the entry of cheaper generic drugs, while also recognizing that strong patent rights for branded drugs are essential to incentivize drug innovation.  As Committee Chairman Lindsey Graham explained:

One thing you don’t want to do is kill the goose who laid the golden egg, which is pharmaceutical development. But you also don’t want to have a system that extends unnecessarily beyond the ability to get your money back and make a profit, a patent system that drives up costs for the average consumer.

Several proposals that were discussed at the hearing have the potential to encourage competition in the pharmaceutical industry and help rein in drug prices. Below, I discuss these proposals, plus a few additional reforms. I also point out some of the language in the current draft proposals that goes a bit too far and threatens the ability of drug makers to remain innovative.  

1. Prevent brand drug makers from blocking generic companies’ access to drug samples. Some brand drug makers have attempted to delay generic entry by restricting generics’ access to the drug samples necessary to conduct FDA-required bioequivalence studies.  Some brand drug manufacturers have limited the ability of pharmacies or wholesalers to sell samples to generic companies or abused the REMS (Risk Evaluation Mitigation Strategy) program to refuse samples to generics under the auspices of REMS safety requirements.  The Creating and Restoring Equal Access To Equivalent Samples (CREATES) Act of 2019 would allow potential generic competitors to bring an action in federal court for both injunctive relief and damages when brand companies block access to drug samples.  It also gives the FDA discretion to approve alternative REMS safety protocols for generic competitors that have been denied samples under the brand companies’ REMS protocol.  Although the vast majority of brand drug companies do not engage in the delay tactics addressed by CREATES, the Act would prevent the handful that do from thwarting generic competition.  Increased generic competition should, in turn, reduce drug prices.

2. Restrict abuses of FDA Citizen Petitions.  The citizen petition process was created as a way for individuals and community groups to flag legitimate concerns about drugs awaiting FDA approval.  However, critics claim that the process has been misused by some brand drug makers who file petitions about specific generic drugs in the hopes of delaying their approval and market entry.  Although FDA has indicated that citizens petitions rarely delay the approval of generic drugs, there have been a few drug makers, such as Shire ViroPharma, that have clearly abused the process and put unnecessary strain on FDA resources. The Stop The Overuse of Petitions and Get Affordable Medicines to Enter Soon (STOP GAMES) Act is intended to prevent such abuses.  The Act reinforces the FDA and FTC’s ability to crack down on petitions meant to lengthen the approval process of a generic competitor, which should deter abuses of the system that can occasionally delay generic entry.  However, lawmakers should make sure that adopted legislation doesn’t limit the ability of stakeholders (including drug makers that often know more about the safety of drugs than ordinary citizens) to raise serious concerns with the FDA. 

3. Curtail Anticompetitive Pay-for-Delay Settlements.  The Hatch-Waxman Act incentivizes generic companies to challenge brand drug patents by granting the first successful generic challenger a period of marketing exclusivity. Like all litigation, many of these patent challenges result in settlements instead of trials.  The FTC and some courts have concluded that these settlements can be anticompetitive when the brand companies agree to pay the generic challenger in exchange for the generic company agreeing to forestall the launch of their lower-priced drug. Settlements that result in a cash payment are a red flag for anti-competitive behavior, so pay-for-delay settlements have evolved to involve other forms of consideration instead.  As a result, the Preserve Access to Affordable Generics and Biosimilars Act aims to make an exchange of anything of value presumptively anticompetitive if the terms include a delay in research, development, manufacturing, or marketing of a generic drug. Deterring obvious pay-for-delay settlements will prevent delays to generic entry, making cheaper drugs available as quickly as possible to patients. 

However, the Act’s rigid presumption that an exchange of anything of value is presumptively anticompetitive may also prevent legitimate settlements that ultimately benefit consumers.  Brand drug makers should be allowed to compensate generic challengers to eliminate litigation risk and escape litigation expenses, and many settlements result in the generic drug coming to market before the expiration of the brand patent and possibly earlier than if there was prolonged litigation between the generic and brand company.  A rigid presumption of anticompetitive behavior will deter these settlements, thereby increasing expenses for all parties that choose to litigate and possibly dissuading generics from bringing patent challenges in the first place.  Indeed, the U.S. Supreme Court has declined to define these settlements as per se anticompetitive, and the FTC’s most recent agreement involving such settlements exempts several forms of exchanges of value.  Any adopted legislation should follow the FTC’s lead and recognize that some exchanges of value are pro-consumer and pro-competitive.

4. Restore the balance established by Hatch-Waxman between branded drug innovators and generic drug challengers.  I have previously discussed how an unbalanced inter partes review (IPR) process for challenging patents threatens to stifle drug innovation.  Moreover, current law allows generic challengers to file duplicative claims in both federal court and through the IPR process.  And because IPR proceedings do not have a standing requirement, the process has been exploited  by entities that would never be granted standing in traditional patent litigation—hedge funds betting against a company by filing an IPR challenge in hopes of crashing the stock and profiting from the bet. The added expense to drug makers of defending both duplicative claims and claims against challengers that are exploiting the system increases litigation costs, which may be passed on to consumers in the form of higher prices. 

The Hatch-Waxman Integrity Act (HWIA) is designed to return the balance established by Hatch-Waxman between branded drug innovators and generic drug challengers. It requires generic challengers to choose between either Hatch-Waxman litigation (which saves considerable costs by allowing generics to rely on the brand company’s safety and efficacy studies for FDA approval) or an IPR proceeding (which is faster and provides certain pro-challenger provisions). The HWIA would also eliminate the ability of hedge funds and similar entities to file IPR claims while shorting the stock.  By reducing duplicative litigation and the exploitation of the IPR process, the HWIA will reduce costs and strengthen innovation incentives for drug makers.  This will ensure that patent owners achieve clarity on the validity of their patents, which will spur new drug innovation and make sure that consumers continue to have access to life-improving drugs.

5. Curb illegal product hopping and patent thickets.  Two drug maker tactics currently garnering a lot of attention are so-called “product hopping” and “patent thickets.”  At its worst, product hopping involves brand drug makers making minor changes to a drug nearing the end of its patent so that they gets a new patent on the slightly-tweaked drug, and then withdrawing the original drug from the market so that patients shift to the newly patented drug and pharmacists can’t substitute a generic version of the original drug.  Similarly, at their worst, patent thickets involve brand drug makers obtaining a web of patents on a single drug to extend the life of their exclusivity and make it too costly for other drug makers to challenge all of the patents associated with a drug.  The proposed Affordable Prescriptions for Patients Act of 2019 is meant to stop these abuses of the patent system, which would facilitate generic entry and help to lower drug prices.

However, the Act goes too far by also capturing many legitimate activities in its definitions. For example, the bill defines as anticompetitive product-hopping the selling of any improved version of a drug during a window which extends to a year after the launch of the first generic competitor.  Presently, to acquire a patent and FDA approval, the improved version of the drug must be different and innovative enough from the original drug, yet the Act would prevent the drug maker from selling such a product without satisfying a demanding three-pronged test before the FTC or a district court.  Similarly, the Act defines as anticompetitive patent thickets any new patents filed on a drug in the same general family as the original patent, and this presumption can only be rebutted by providing extensive evidence and satisfying demanding standards to the FTC or a district court.  As a result, the Act deters innovation activity that is at all related to an initial patent and, in doing so, ignores the fact that most important drug innovation is incremental innovation based on previous inventions.  Thus, the proposal should be redrafted to capture truly anticompetitive product hopping and patent thicket activity, while exempting behavior this is critical for drug innovation. 

Reforms that close loopholes in the current patent process should facilitate competition in the pharmaceutical industry and help to lower drug prices.  However, lawmakers need to be sure that they don’t restrict patent rights to the extent that they deter innovation because a significant body of research predicts that patients’ health outcomes will suffer as a result.

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.

(The following is adapted from a recent ICLE Issue Brief on the flawed essential facilities arguments undergirding the EU competition investigations into Amazon’s marketplace that I wrote with Geoffrey Manne.  The full brief is available here. )

Amazon has largely avoided the crosshairs of antitrust enforcers to date. The reasons seem obvious: in the US it handles a mere 5% of all retail sales (with lower shares worldwide), and it consistently provides access to a wide array of affordable goods. Yet, even with Amazon’s obvious lack of dominance in the general retail market, the EU and some of its member states are opening investigations.

Commissioner Margarethe Vestager’s probe into Amazon, which came to light in September, centers on whether Amazon is illegally using its dominant position vis-á-vis third party merchants on its platforms in order to obtain data that it then uses either to promote its own direct sales, or else to develop competing products under its private label brands. More recently, Austria and Germany have launched separate investigations of Amazon rooted in many of the same concerns as those of the European Commission. The German investigation also focuses on whether the contractual relationships that third party sellers enter into with Amazon are unfair because these sellers are “dependent” on the platform.

One of the fundamental, erroneous assumptions upon which these cases are built is the alleged “essentiality” of the underlying platform or input. In truth, these sorts of cases are more often based on stories of firms that chose to build their businesses in a way that relies on a specific platform. In other words, their own decisions — from which they substantially benefited, of course — made their investments highly “asset specific” and thus vulnerable to otherwise avoidable risks. When a platform on which these businesses rely makes a disruptive move, the third parties cry foul, even though the platform was not — nor should have been — under any obligation to preserve the status quo on behalf of third parties.

Essential or not, that is the question

All three investigations are effectively premised on a version of an “essential facilities” theory — the claim that Amazon is essential to these companies’ ability to do business.

There are good reasons that the US has tightly circumscribed the scope of permissible claims invoking the essential facilities doctrine. Such “duty to deal” claims are “at or near the outer boundary” of US antitrust law. And there are good reasons why the EU and its member states should be similarly skeptical.

Characterizing one firm as essential to the operation of other firms is tricky because “[c]ompelling [innovative] firms to share the source of their advantage… may lessen the incentive for the monopolist, the rival, or both to invest in those economically beneficial facilities.” Further, the classification requires “courts to act as central planners, identifying the proper price, quantity, and other terms of dealing—a role for which they are ill-suited.”

The key difficulty is that alleged “essentiality” actually falls on a spectrum. On one end is something like a true monopoly utility that is actually essential to all firms that use its service as a necessary input; on the other is a firm that offers highly convenient services that make it much easier for firms to operate. This latter definition of “essentiality” describes firms like Google and Amazon, but it is not accurate to characterize such highly efficient and effective firms as truly “essential.” Instead, companies that choose to take advantage of the benefits such platforms offer, and to tailor their business models around them, suffer from an asset specificity problem.

Geoffrey Manne noted this problem in the context of the EU’s Google Shopping case:

A content provider that makes itself dependent upon another company for distribution (or vice versa, of course) takes a significant risk. Although it may benefit from greater access to users, it places itself at the mercy of the other — or at least faces great difficulty (and great cost) adapting to unanticipated, crucial changes in distribution over which it has no control.

Third-party sellers that rely upon Amazon without a contingency plan are engaging in a calculated risk that, as business owners, they would typically be expected to manage.  The investigations by European authorities are based on the notion that antitrust law might require Amazon to remove that risk by prohibiting it from undertaking certain conduct that might raise costs for its third-party sellers.

Implications and extensions

In the full issue brief, we consider the tensions in EU law between seeking to promote innovation and protect the competitive process, on the one hand, and the propensity of EU enforcers to rely on essential facilities-style arguments on the other. One of the fundamental errors that leads EU enforcers in this direction is that they confuse the distribution channel of the Internet with an antitrust-relevant market definition.

A claim based on some flavor of Amazon-as-essential-facility should be untenable given today’s market realities because Amazon is, in fact, just one mode of distribution among many. Commerce on the Internet is still just commerce. The only thing preventing a merchant from operating a viable business using any of a number of different mechanisms is the transaction costs it would incur adjusting to a different mode of doing business. Casting Amazon’s marketplace as an essential facility insulates third-party firms from the consequences of their own decisions — from business model selection to marketing and distribution choices. Commerce is nothing new and offline distribution channels and retail outlets — which compete perfectly capably with online — are well developed. Granting retailers access to Amazon’s platform on artificially favorable terms is no more justifiable than granting them access to a supermarket end cap, or a particular unit at a shopping mall. There is, in other words, no business or economic justification for granting retailers in the time-tested and massive retail market an entitlement to use a particular mode of marketing and distribution just because they find it more convenient.

The German Bundeskartellamt’s Facebook decision is unsound from either a competition or privacy policy perspective, and will only make the fraught privacy/antitrust relationship worse.

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Drug makers recently announced their 2019 price increases on over 250 prescription drugs. As examples, AbbVie Inc. increased the price of the world’s top-selling drug Humira by 6.2 percent, and Hikma Pharmaceuticals increased the price of blood-pressure medication Enalaprilat by more than 30 percent. Allergan reported an average increase across its portfolio of drugs of 3.5 percent; although the drug maker is keeping most of its prices the same, it raised the prices on 27 drugs by 9.5 percent and on another 24 drugs by 4.9 percent. Other large drug makers, such as Novartis and Pfizer, will announce increases later this month.

So far, the number of price increases is significantly lower than last year when drug makers increased prices on more than 400 drugs.  Moreover, on the drugs for which prices did increase, the average price increase of 6.3 percent is only about half of the average increase for drugs in 2018. Nevertheless, some commentators have expressed indignation and President Trump this week summoned advisors to the White House to discuss the increases.  However, commentators and the administration should keep in mind what the price increases actually mean and the numerous players that are responsible for increasing drug prices. 

First, it is critical to emphasize the difference between drug list prices and net prices.  The drug makers recently announced increases in the list, or “sticker” prices, for many drugs.  However, the list price is usually very different from the net price that most consumers and/or their health plans actually pay, which depends on negotiated discounts and rebates.  For example, whereas drug list prices increased by an average of 6.9 percent in 2017, net drug prices after discounts and rebates increased by only 1.9 percent. The differential between the growth in list prices and net prices has persisted for years.  In 2016 list prices increased by 9 percent but net prices increased by 3.2 percent; in 2015 list prices increased by 11.9 percent but net prices increased by 2.4 percent, and in 2014 list price increases peaked at 13.5 percent but net prices increased by only 4.3 percent.

For 2019, the list price increases for many drugs will actually translate into very small increases in the net prices that consumers actually pay.  In fact, drug maker Allergan has indicated that, despite its increase in list prices, the net prices that patients actually pay will remain about the same as last year.

One might wonder why drug makers would bother to increase list prices if there’s little to no change in net prices.  First, at least 40 percent of the American prescription drug market is subject to some form of federal price control.  As I’ve previously explained, because these federal price controls generally require percentage rebates off of average drug prices, drug makers have the incentive to set list prices higher in order to offset the mandated discounts that determine what patients pay.

Further, as I discuss in a recent Article, the rebate arrangements between drug makers and pharmacy benefit managers (PBMs) under many commercial health plans create strong incentives for drug makers to increase list prices. PBMs negotiate rebates from drug manufacturers in exchange for giving the manufacturers’ drugs preferred status on a health plan’s formulary.  However, because the rebates paid to PBMs are typically a percentage of a drug’s list price, drug makers are compelled to increase list prices in order to satisfy PBMs’ demands for higher rebates. Drug makers assert that they are pressured to increase drug list prices out of fear that, if they do not, PBMs will retaliate by dropping their drugs from the formularies. The value of rebates paid to PBMs has doubled since 2012, with drug makers now paying $150 billion annually.  These rebates have grown so large that, today, the drug makers that actually invest in drug innovation and bear the risk of drug failures receive only 39 percent of the total spending on drugs, while 42 percent of the spending goes to these pharmaceutical middlemen.

Although a portion of the increasing rebate dollars may eventually find its way to patients in the form of lower co-pays, many patients still suffer from the list prices increases.  The 29 million Americans without drug plan coverage pay more for their medications when list prices increase. Even patients with insurance typically have cost-sharing obligations that require them to pay 30 to 40 percent of list prices.  Moreover, insured patients within the deductible phase of their drug plan pay the entire higher list price until they meet their deductible.  Higher list prices jeopardize patients’ health as well as their finances; as out-of-pocket costs for drugs increase, patients are less likely to adhere to their medication routine and more likely to abandon their drug regimen altogether.

Policymakers must realize that the current system of government price controls and distortive rebates creates perverse incentives for drug makers to continue increasing drug list prices. Pointing the finger at drug companies alone for increasing prices does not represent the problem at hand.

A recent NBER working paper by Gutiérrez & Philippon has attracted attention from observers who see oligopoly everywhere and activists who want governments to more actively “manage” competition. The analysis in the paper is fundamentally flawed and should not be relied upon by policymakers, regulators, or anyone else.

As noted in my earlier post, Gutiérrez & Philippon attempt to craft a causal linkage between differences in U.S. and EU antitrust enforcement and product market regulation to differences in market concentration and corporate profits. Their paper’s abstract leads with a bold assertion:

Until the 1990’s, US markets were more competitive than European markets. Today, European markets have lower concentration, lower excess profits, and lower regulatory barriers to entry.

This post focuses on Gutiérrez & Philippon’s claim that EU markets have lower “excess profits.” This is perhaps the most outrageous claim in the paper. If anyone bothers to read the full paper, they’ll see that claims that EU firms have lower excess profits is simply not supported by the paper itself. Aside from a passing mention of someone else’s work in a footnote, the only mention of “excess profits” is in the paper’s headline-grabbing abstract.

What’s even more outrageous is the authors don’t define (or even describe) what they mean by excess profits.

These two factors alone should be enough to toss aside the paper’s assertion about “excess” profits. But, there’s more.

Gutiérrez & Philippon define profit to be gross operating surplus and mixed income (known as “GOPS” in the OECD’s STAN Industrial Analysis dataset). GOPS is not the same thing as gross margin or gross profit as used in business and finance (for example GOPS subtracts wages, but gross margin does not). The EU defines GOPS as (emphasis added):

Operating surplus is the surplus (or deficit) on production activities before account has been taken of the interest, rents or charges paid or received for the use of assets. Mixed income is the remuneration for the work carried out by the owner (or by members of his family) of an unincorporated enterprise. This is referred to as ‘mixed income’ since it cannot be distinguished from the entrepreneurial profit of the owner.

Here’s Figure 1 from Gutiérrez & Philippon plotting GOPS as a share of gross output.

Fig1-GutierrezPhilippon

Look at the huge jump in gross operating surplus for U.S. firms!

Now, look at the scale of the y-axis. Not such a big jump after all.

Over 23 years, from 1992 to 2015, the gross operating surplus rate for U.S. firms grew by 2.5 percentage points. In the EU, the rate increased by about one percentage point.

Using the STAN dataset, I plotted the gross operating surplus rate for each EU country (blue dots) and the U.S. (red dots), along with a time trend. Three takeaways:

  1. There’s not much of a difference between the U.S. and the EU average—they both hover around a gross operating surplus rate of about 19.5 percent; and
  2. There’s a huge variation in gross operating surplus rate across EU countries.
  3. Yes, gross operating surplus is trending slightly upward in the U.S. and slightly downward for the EU average, but there doesn’t appear to be a huge difference in the slope of the trendlines. In fact the slopes of the trendlines are not statistically significantly different from zero and are not statistically significantly different from each other.

GOPSprod

The use of gross profits raises some serious questions. For example, the Stigler Center’s James Traina finds that, after accounting for selling, general, and administrative expenses (SG&A), mark-ups for publicly traded firms in the U.S. have not meaningfully increased since 1980.

The figure below plots net operating surplus (NOPS equals GOPS minus consumption of fixed capital)—which is not the same thing as net income for a business.

Same three takeaways:

  1. There’s not much of a difference between the U.S. and the EU average—they both hover around a net operating surplus rate of a little more than seven percent; and
  2. There’s a huge variation in net operating surplus rate across EU countries.
  3. The slope of the trendlines for net operating surplus in the U.S. and EU are not statistically significantly different from zero and are not statistically significantly different from each other.

NOPSprod

It’s very possible that U.S. firms are achieving higher and growing “excess” profits relative to EU firms. It’s also very possible they’re not. Despite the bold assertions of Gutiérrez & Philippon, the information presented in their paper provides no useful information one way or the other.

 

A recent NBER working paper by Gutiérrez & Philippon attempts to link differences in U.S. and EU antitrust enforcement and product market regulation to differences in market concentration and corporate profits. The paper’s abstract begins with a bold assertion:

Until the 1990’s, US markets were more competitive than European markets. Today, European markets have lower concentration, lower excess profits, and lower regulatory barriers to entry.

The authors are not clear what they mean by lower, however its seems they mean lower today relative to the 1990s.

This blog post focuses on the first claim: “Today, European markets have lower concentration …”

At the risk of being pedantic, Gutiérrez & Philippon’s measures of market concentration for which both U.S. and EU data are reported cover the period from 1999 to 2012. Thus, “the 1990s” refers to 1999, and “today” refers to 2012, or six years ago.

The table below is based on Figure 26 in Gutiérrez & Philippon. In 2012, there appears to be no significant difference in market concentration between the U.S. and the EU, using either the 8-firm concentration ratio or HHI. Based on this information, it cannot be concluded broadly that EU sectors have lower concentration than the U.S.

2012U.S.EU
CR826% (+5%)27% (-7%)
HHI640 (+150)600 (-190)

Gutiérrez & Philippon focus on the change in market concentration to draw their conclusions. However, the levels of market concentration measures are strikingly low. In all but one of the industries (telecommunications) in Figure 27 of their paper, the 8-firm concentration ratios for the U.S. and the EU are below 40 percent. Similarly, the HHI measures reported in the paper are at levels that most observers would presume to be competitive. In addition, in 7 of the 12 sectors surveyed, the U.S. 8-firm concentration ratio is lower than in the EU.

The numbers in parentheses in the table above show the change in the measures of concentration since 1999. The changes suggests that U.S. markets have become more concentrated and EU markets have become less concentrated. But, how significant are the changes in concentration?

A simple regression of the relationship between CR8 and a time trend finds that in the EU, CR8 has decreased an average of 0.5 percentage point a year, while the U.S. CR8 increased by less than 0.4 percentage point a year from 1999 to 2012. Tucked in an appendix to Gutiérrez & Philippon, Figure 30 shows that CR8 in the U.S. had decreased by about 2.5 percentage points from 2012 to 2014.

A closer examination of Gutiérrez & Philippon’s 8-firm concentration ratio for the EU shows that much of the decline in EU market concentration occurred over the 1999-2002 period. After that, the change in CR8 for the EU is not statistically significantly different from zero.

A regression of the relationship between HHI and a time trend finds that in the EU, HHI has decreased an average of 12.5 points a year, while the U.S. HHI increased by less than 16.4 points a year from 1999 to 2012.

As with CR8, a closer examination of Gutiérrez & Philippon’s HHI for the EU shows that much of the decline in EU market concentration occurred over the 1999-2002 period. After that, the change in HHI for the EU is not statistically significantly different from zero.

Readers should be cautious in relying on Gutiérrez & Philippon’s data to conclude that the U.S. is “drifting” toward greater market concentration while the EU is “drifting” toward lower market concentration. Indeed, the limited data presented in the paper point toward a convergence in market concentration between the two regions.

 

 

Last week, the DOJ cleared the merger of CVS Health and Aetna (conditional on Aetna’s divesting its Medicare Part D business), a merger that, as I previously noted at a House Judiciary hearing, “presents a creative effort by two of the most well-informed and successful industry participants to try something new to reform a troubled system.” (My full testimony is available here).

Of course it’s always possible that the experiment will fail — that the merger won’t “revolutioniz[e] the consumer health care experience” in the way that CVS and Aetna are hoping. But it’s a low (antitrust) risk effort to address some of the challenges confronting the healthcare industry — and apparently the DOJ agrees.

I discuss the weakness of the antitrust arguments against the merger at length in my testimony. What I particularly want to draw attention to here is how this merger — like many vertical mergers — represents business model innovation by incumbents.

The CVS/Aetna merger is just one part of a growing private-sector movement in the healthcare industry to adopt new (mostly) vertical arrangements that seek to move beyond some of the structural inefficiencies that have plagued healthcare in the United States since World War II. Indeed, ambitious and interesting as it is, the merger arises amidst a veritable wave of innovative, vertical healthcare mergers and other efforts to integrate the healthcare services supply chain in novel ways.

These sorts of efforts (and the current DOJ’s apparent support for them) should be applauded and encouraged. I need not rehash the economic literature on vertical restraints here (see, e.g., Lafontaine & Slade, etc.). But especially where government interventions have already impaired the efficient workings of a market (as they surely have, in spades, in healthcare), it is important not to compound the error by trying to micromanage private efforts to restructure around those constraints.   

Current trends in private-sector-driven healthcare reform

In the past, the most significant healthcare industry mergers have largely been horizontal (i.e., between two insurance providers, or two hospitals) or “traditional” business model mergers for the industry (i.e., vertical mergers aimed at building out managed care organizations). This pattern suggests a sort of fealty to the status quo, with insurers interested primarily in expanding their insurance business or providers interested in expanding their capacity to provide medical services.

Today’s health industry mergers and ventures seem more frequently to be different in character, and they portend an industry-wide experiment in the provision of vertically integrated healthcare that we should enthusiastically welcome.

Drug pricing and distribution innovations

To begin with, the CVS/Aetna deal, along with the also recently approved Cigna-Express Scripts deal, solidifies the vertical integration of pharmacy benefit managers (PBMs) with insurers.

But a number of other recent arrangements and business models center around relationships among drug manufacturers, pharmacies, and PBMs, and these tend to minimize the role of insurers. While not a “vertical” arrangement, per se, Walmart’s generic drug program, for example, offers $4 prescriptions to customers regardless of insurance (the typical generic drug copay for patients covered by employer-provided health insurance is $11), and Walmart does not seek or receive reimbursement from health plans for these drugs. It’s been offering this program since 2006, but in 2016 it entered into a joint buying arrangement with McKesson, a pharmaceutical wholesaler (itself vertically integrated with Rexall pharmacies), to negotiate lower prices. The idea, presumably, is that Walmart will entice consumers to its stores with the lure of low-priced generic prescriptions in the hope that they will buy other items while they’re there. That prospect presumably makes it worthwhile to route around insurers and PBMs, and their reimbursements.

Meanwhile, both Express Scripts and CVS Health (two of the country’s largest PBMs) have made moves toward direct-to-consumer sales themselves, establishing pricing for a small number of drugs independently of health plans and often in partnership with drug makers directly.   

Also apparently focused on disrupting traditional drug distribution arrangements, Amazon has recently purchased online pharmacy PillPack (out from under Walmart, as it happens), and with it received pharmacy licenses in 49 states. The move introduces a significant new integrated distributor/retailer, and puts competitive pressure on other retailers and distributors and potentially insurers and PBMs, as well.

Whatever its role in driving the CVS/Aetna merger (and I believe it is smaller than many reports like to suggest), Amazon’s moves in this area demonstrate the fluid nature of the market, and the opportunities for a wide range of firms to create efficiencies in the market and to lower prices.

At the same time, the differences between Amazon and CVS/Aetna highlight the scope of product and service differentiation that should contribute to the ongoing competitiveness of these markets following mergers like this one.

While Amazon inarguably excels at logistics and the routinizing of “back office” functions, it seems unlikely for the foreseeable future to be able to offer (or to be interested in offering) a patient interface that can rival the service offerings of a brick-and-mortar CVS pharmacy combined with an outpatient clinic and its staff and bolstered by the capabilities of an insurer like Aetna. To be sure, online sales and fulfillment may put price pressure on important, largely mechanical functions, but, like much technology, it is first and foremost a complement to services offered by humans, rather than a substitute. (In this regard it is worth noting that McKesson has long been offering Amazon-like logistics support for both online and brick-and-mortar pharmacies. “‘To some extent, we were Amazon before it was cool to be Amazon,’ McKesson CEO John Hammergren said” on a recent earnings call).

Treatment innovations

Other efforts focus on integrating insurance and treatment functions or on bringing together other, disparate pieces of the healthcare industry in interesting ways — all seemingly aimed at finding innovative, private solutions to solve some of the costly complexities that plague the healthcare market.

Walmart, for example, announced a deal with Quest Diagnostics last year to experiment with offering diagnostic testing services and potentially other basic healthcare services inside of some Walmart stores. While such an arrangement may simply be a means of making doctor-prescribed diagnostic tests more convenient, it may also suggest an effort to expand the availability of direct-to-consumer (patient-initiated) testing (currently offered by Quest in Missouri and Colorado) in states that allow it. A partnership with Walmart to market and oversee such services has the potential to dramatically expand their use.

Capping off (for now) a buying frenzy in recent years that included the purchase of PBM, CatamaranRx, UnitedHealth is seeking approval from the FTC for the proposed merger of its Optum unit with the DaVita Medical Group — a move that would significantly expand UnitedHealth’s ability to offer medical services (including urgent care, outpatient surgeries, and health clinic services), give it a significant group of doctors’ clinics throughout the U.S., and turn UnitedHealth into the largest employer of doctors in the country. But of course this isn’t a traditional managed care merger — it represents a significant bet on the decentralized, ambulatory care model that has been slowly replacing significant parts of the traditional, hospital-centric care model for some time now.

And, perhaps most interestingly, some recent moves are bringing together drug manufacturers and diagnostic and care providers in innovative ways. Swiss pharmaceutical company, Roche, announced recently that “it would buy the rest of U.S. cancer data company Flatiron Health for $1.9 billion to speed development of cancer medicines and support its efforts to price them based on how well they work.” Not only is the deal intended to improve Roche’s drug development process by integrating patient data, it is also aimed at accommodating efforts to shift the pricing of drugs, like the pricing of medical services generally, toward an outcome-based model.

Similarly interesting, and in a related vein, early this year a group of hospital systems including Intermountain Health, Ascension, and Trinity Health announced plans to begin manufacturing generic prescription drugs. This development further reflects the perceived benefits of vertical integration in healthcare markets, and the move toward creative solutions to the unique complexity of coordinating the many interrelated layers of healthcare provision. In this case,

[t]he nascent venture proposes a private solution to ensure contestability in the generic drug market and consequently overcome the failures of contracting [in the supply and distribution of generics]…. The nascent venture, however it solves these challenges and resolves other choices, will have important implications for the prices and availability of generic drugs in the US.

More enforcement decisions like CVS/Aetna and Bayer/Monsanto; fewer like AT&T/Time Warner

In the face of all this disruption, it’s difficult to credit anticompetitive fears like those expressed by the AMA in opposing the CVS-Aetna merger and a recent CEA report on pharmaceutical pricing, both of which are premised on the assumption that drug distribution is unavoidably dominated by a few PBMs in a well-defined, highly concentrated market. Creative arrangements like the CVS-Aetna merger and the initiatives described above (among a host of others) indicate an ease of entry, the fluidity of traditional markets, and a degree of business model innovation that suggest a great deal more competitiveness than static PBM market numbers would suggest.

This kind of incumbent innovation through vertical restructuring is an increasingly important theme in antitrust, and efforts to tar such transactions with purported evidence of static market dominance is simply misguided.

While the current DOJ’s misguided (and, remarkably, continuing) attempt to stop the AT&T/Time Warner merger is an aberrant step in the wrong direction, the leadership at the Antitrust Division generally seems to get it. Indeed, in spite of strident calls for stepped-up enforcement in the always-controversial ag-biotech industry, the DOJ recently approved three vertical ag-biotech mergers in fairly rapid succession.

As I noted in a discussion of those ag-biotech mergers, but equally applicable here, regulatory humility should continue to carry the day when it comes to structural innovation by incumbent firms:

But it is also important to remember that innovation comes from within incumbent firms, as well, and, often, that the overall level of innovation in an industry may be increased by the presence of large firms with economies of scope and scale.

In sum, and to paraphrase Olympia Dukakis’ character in Moonstruck: “what [we] don’t know about [the relationship between innovation and market structure] is a lot.”

What we do know, however, is that superficial, concentration-based approaches to antitrust analysis will likely overweight presumed foreclosure effects and underweight innovation effects.

We shouldn’t fetishize entry, or access, or head-to-head competition over innovation, especially where consumer welfare may be significantly improved by a reduction in the former in order to get more of the latter.

By Pinar Akman, Professor of Law, University of Leeds*

The European Commission’s decision in Google Android cuts a fine line between punishing a company for its success and punishing a company for falling afoul of the rules of the game. Which side of the line it actually falls on cannot be fully understood until the Commission publishes its full decision. Much depends on the intricate facts of the case. As the full decision may take months to come, this post offers merely the author’s initial thoughts on the decision on the basis of the publicly available information.

The eye-watering fine of $5.1 billion — which together with the fine of $2.7 billion in the Google Shopping decision from last year would (according to one estimate) suffice to fund for almost one year the additional yearly public spending necessary to eradicate world hunger by 2030 — will not be further discussed in this post. This is because the fine is assumed to have been duly calculated on the basis of the Commission’s relevant Guidelines, and, from a legal and commercial point of view, the absolute size of the fine is not as important as the infringing conduct and the remedy Google will need to adopt to comply with the decision.

First things first. This post proceeds on the premise that the aim of competition law is to prevent the exclusion of competitors that are (at least) as efficient as the dominant incumbent, whose exclusion would ultimately harm consumers.

Next, it needs to be noted that the Google Android case is a more conventional antitrust case than Google Shopping in the sense that one can at least envisage a potentially robust antitrust theory of harm in the former case. If a dominant undertaking ties its products together to exclude effective competition in some of these markets or if it pays off customers to exclude access by its efficient competitors to consumers, competition law intervention may be justified.

The central question in Google Android is whether on the available facts this appears to have happened.

What we know and market definition

The premise of the case is that Google used its dominance in the Google Play Store (which enables users to download apps onto their Android phones) to “cement Google’s dominant position in general internet search.”

It is interesting that the case appears to concern a dominant undertaking leveraging its dominance from a market in which it is dominant (Google Play Store) into another market in which it is also dominant (internet search). As far as this author is aware, most (if not all?) cases of tying in the EU to date concerned tying where the dominant undertaking leveraged its dominance in one market to distort or eliminate competition in an otherwise competitive market.

Thus, for example, in Microsoft (Windows Operating System —> media players), Hilti (patented cartridge strips —> nails), and Tetra Pak II (packaging machines —> non-aseptic cartons), the tied market was actually or potentially competitive, and this was why the tying was alleged to have eliminated competition. It will be interesting to see which case the Commission uses as precedent in its decision — more on that later.

Also noteworthy is that the Commission does not appear to have defined a separate mobile search market that would have been competitive but for Google’s alleged leveraging. The market has been defined as the general internet search market. So, according to the Commission, the Google Search App and Google Search engine appear to be one and the same thing, and desktop and mobile devices are equivalent (or substitutable).

Finding mobile and desktop devices to be equivalent to one another may have implications for other cases including the ongoing appeal in Google Shopping where, for example, the Commission found that “[m]obile [apps] are not a viable alternative for replacing generic search traffic from Google’s general search results pages” for comparison shopping services. The argument that mobile apps and mobile traffic are fundamental in Google Android but trivial in Google Shopping may not play out favourably for the Commission before the Court of Justice of the EU.

Another interesting market definition point is that the Commission has found Apple not to be a competitor to Google in the relevant market defined by the Commission: the market for “licensable smart mobile operating systems.” Apple does not fall within that market because Apple does not license its mobile operating system to anyone: Apple’s model eliminates all possibility of competition from the start and is by definition exclusive.

Although there is some internal logic in the Commission’s exclusion of Apple from the upstream market that it has defined, is this not a bit of a definitional stop? How can Apple compete with Google in the market as defined by the Commission when Apple allows only itself to use its operating system only on devices that Apple itself manufactures?

To be fair, the Commission does consider there to be some competition between Apple and Android devices at the level of consumers — just not sufficient to constrain Google at the upstream, manufacturer level.

Nevertheless, the implication of the Commission’s assessment that separates the upstream and downstream in this way is akin to saying that the world’s two largest corn producers that produce the corn used to make corn flakes do not compete with one another in the market for corn flakes because one of them uses its corn exclusively in its own-brand cereal.

Although the Commission cabins the use of supply-side substitutability in market definition, its own guidance on the topic notes that

Supply-side substitutability may also be taken into account when defining markets in those situations in which its effects are equivalent to those of demand substitution in terms of effectiveness and immediacy. This means that suppliers are able to switch production to the relevant products and market them in the short term….

Apple could — presumably — rather immediately and at minimal cost produce and market a version of iOS for use on third-party device makers’ devices. By the Commission’s own definition, it would seem to make sense to include Apple in the relevant market. Nevertheless, it has apparently not done so here.

The message that the Commission sends with the finding is that if Android had not been open source and freely available, and if Google competed with Apple with its own version of a walled-garden built around exclusivity, it is possible that none of its practices would have raised any concerns. Or, should Apple be expecting a Statement of Objections next from the EU Commission?

Is Microsoft really the relevant precedent?

Given that Google Android appears to revolve around the idea of tying and leveraging, the EU Commission’s infringement decision against Microsoft, which found an abusive tie in Microsoft’s tying of Windows Operating System with Windows Media Player, appears to be the most obvious precedent, at least for the tying part of the case.

There are, however, potentially important factual differences between the two cases. To take just a few examples:

  • Microsoft charged for the Windows Operating System, whereas Google does not;
  • Microsoft tied the setting of Windows Media Player as the default to OEMs’ licensing of the operating system (Windows), whereas Google ties the setting of Search as the default to device makers’ use of other Google apps, while allowing them to use the operating system (Android) without any Google apps; and
  • Downloading competing media players was difficult due to download speeds and lack of user familiarity, whereas it is trivial and commonplace for users to download apps that compete with Google’s.

Moreover, there are also some conceptual hurdles in finding the conduct to be that of tying.

First, the difference between “pre-installed,” “default,” and “exclusive” matters a lot in establishing whether effective competition has been foreclosed. The Commission’s Press Release notes that to pre-install Google Play, manufacturers have to also pre-install Google Search App and Google Chrome. It also states that Google Search is the default search engine on Google Chrome. The Press Release does not indicate that Google Search App has to be the exclusive or default search app. (It is worth noting, however, that the Statement of Objections in Google Android did allege that Google violated EU competition rules by requiring Search to be installed as the default. We will have to await the decision itself to see if this was dropped from the case or simply not mentioned in the Press Release).

In fact, the fact that the other infringement found is that of Google’s making payments to manufacturers in return for exclusively pre-installing the Google Search App indirectly suggests that not every manufacturer pre-installs Google Search App as the exclusive, pre-installed search app. This means that any other search app (provider) can also (request to) be pre-installed on these devices. The same goes for the browser app.

Of course, regardless, even if the manufacturer does not pre-install competing apps, the consumer is free to download any other app — for search or browsing — as they wish, and can do so in seconds.

In short, pre-installation on its own does not necessarily foreclose competition, and thus may not constitute an illegal tie under EU competition law. This is particularly so when download speeds are fast (unlike the case at the time of Microsoft) and consumers regularly do download numerous apps.

What may, however, potentially foreclose effective competition is where a dominant undertaking makes payments to stop its customers, as a practical matter, from selling its rivals’ products. Intel, for example, was found to have abused its dominant position through payments to a computer retailer in return for its not selling computers with its competitor AMD’s chips, and to computer manufacturers in return for delaying the launch of computers with AMD chips.

In Google Android, the exclusivity provision that would require manufacturers to pre-install Google Search App exclusively in return for financial incentives may be deemed to be similar to this.

Having said that, unlike in Intel where a given computer can have a CPU from only one given manufacturer, even the exclusive pre-installation of the Google Search App would not have prevented consumers from downloading competing apps. So, again, in theory effective competition from other search apps need not have been foreclosed.

It must also be noted that just because a Google app is pre-installed does not mean that it generates any revenue to Google — consumers have to actually choose to use that app as opposed to another one that they might prefer in order for Google to earn any revenue from it. The Commission seems to place substantial weight on pre-installation which it alleges to create “a status quo bias.”

The concern with this approach is that it is not possible to know whether those consumers who do not download competing apps do so out of a preference for Google’s apps or, instead, for other reasons that might indicate competition not to be working. Indeed, one hurdle as regards conceptualising the infringement as tying is that it would require establishing that a significant number of phone users would actually prefer to use Google Play Store (the tying product) without Google Search App (the tied product).

This is because, according to the Commission’s Guidance Paper, establishing tying starts with identifying two distinct products, and

[t]wo products are distinct if, in the absence of tying or bundling, a substantial number of customers would purchase or would have purchased the tying product without also buying the tied product from the same supplier.

Thus, if a substantial number of customers would not want to use Google Play Store without also preferring to use Google Search App, this would cause a conceptual problem for making out a tying claim.

In fact, the conduct at issue in Google Android may be closer to a refusal to supply type of abuse.

Refusal to supply also seems to make more sense regarding the prevention of the development of Android forks being found to be an abuse. In this context, it will be interesting to see how the Commission overcomes the argument that Android forks can be developed freely and Google may have legitimate business reasons in wanting to associate its own, proprietary apps only with a certain, standardised-quality version of the operating system.

More importantly, the possible underlying theory in this part of the case is that the Google apps — and perhaps even the licensed version of Android — are a “must-have,” which is close to an argument that they are an essential facility in the context of Android phones. But that would indeed require a refusal to supply type of abuse to be established, which does not appear to be the case.

What will happen next?

To answer the question raised in the title of this post — whether the Google Android decision will benefit consumers — one needs to consider what Google may do in order to terminate the infringing conduct as required by the Commission, whilst also still generating revenue from Android.

This is because unbundling Google Play Store, Google Search App and Google Chrome (to allow manufacturers to pre-install Google Play Store without the latter two) will disrupt Google’s main revenue stream (i.e., ad revenue generated through the use of Google Search App or Google Search within the Chrome app) which funds the free operating system. This could lead Google to start charging for the operating system, and limiting to whom it licenses the operating system under the Commission’s required, less-restrictive terms.

As the Commission does not seem to think that Apple constrains Google when it comes to dealings with device manufacturers, in theory, Google should be able to charge up to the monopoly level licensing fee to device manufacturers. If that happens, the price of Android smartphones may go up. It is possible that there is a new competitor lurking in the woods that will grow and constrain that exercise of market power, but how this will all play out for consumers — as well as app developers who may face increasing costs due to the forking of Android — really remains to be seen.

 

* Pinar Akman is Professor of Law, Director of Centre for Business Law and Practice, University of Leeds, UK. This piece has not been commissioned or funded by any entity. The author has not been involved in the Google Android case in any capacity. In the past, the author wrote a piece on the Commission’s Google Shopping case, ‘The Theory of Abuse in Google Search: A Positive and Normative Assessment under EU Competition Law,’ supported by a research grant from Google. The author would like to thank Peter Whelan, Konstantinos Stylianou, and Geoffrey Manne for helpful comments. All errors remain her own. The author can be contacted here.