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As ICLE argued in its amicus brief, the Second Circuit’s ruling in United States v. Apple Inc. is in direct conflict with the Supreme Court’s 2007 Leegin decision, and creates a circuit split with the Third Circuit based on that court’s Toledo Mack ruling. Moreover, the negative consequences of the court’s ruling will be particularly acute for modern, high-technology sectors of the economy, where entrepreneurs planning to deploy new business models will now face exactly the sort of artificial deterrents that the Court condemned in Trinko:

Mistaken inferences and the resulting false condemnations are especially costly, because they chill the very conduct the antitrust laws are designed to protect.

Absent review by the Supreme Court to correct the Second Circuit’s error, the result will be less-vigorous competition and a reduction in consumer welfare. The Court should grant certiorari.

The Second Circuit committed a number of important errors in its ruling.

First, as the Supreme Court held in Leegin, condemnation under the per se rule is appropriate

only for conduct that would always or almost always tend to restrict competition… [and] only after courts have had considerable experience with the type of restraint at issue.

Neither is true in this case. The use of MFNs in Apple’s contracts with the publishers and its adoption of the so-called “agency model” for e-book pricing have never been reviewed by the courts in a setting like this one, let alone found to “always or almost always tend to restrict competition.” There is no support in the case law or economic literature for the proposition that agency models or MFNs used to facilitate entry by new competitors in platform markets like this one are anticompetitive.

Second, the court of appeals emphasized that in some cases e-book prices increased after Apple’s entry, and it viewed that fact as strong support for application of the per se rule. But the Court in Leegin made clear that the per se rule is inappropriate where, as here, “prices can be increased in the course of promoting procompetitive effects.”  

What the Second Circuit missed is that competition occurs on many planes other than price; higher prices do not necessarily suggest decreased competition or anticompetitive effects. As Josh Wright points out:

[T]the multi-dimensional nature of competition implies that antitrust analysis seeking to maximize consumer or total welfare must inevitably calculate welfare tradeoffs when innovation and price effects run in opposite directions.

Higher prices may accompany welfare-enhancing “competition on the merits,” resulting in greater investment in product quality, reputation, innovation, or distribution mechanisms.

While the court acknowledged that “[n]o court can presume to know the proper price of an ebook,” its analysis nevertheless rested on the presumption that Amazon’s prices before Apple’s entry were competitive. The record, however, offered no support for that presumption, and thus no support for the inference that post-entry price increases were anticompetitive.

In fact, as Alan Meese has pointed out, a restraint might increase prices precisely because it overcomes a market failure:

[P]roof that a restraint alters price or output when compared to the status quo ante is at least equally consistent with an alternative explanation, namely, that the agreement under scrutiny corrects a market failure and does not involve the exercise or creation of market power. Because such failures can result in prices that are below the optimum, or output that is above it, contracts that correct or attenuate market failure will often increase prices or reduce output when compared to the status quo ante. As a result, proof that such a restraint alters price or other terms of trade is at least equally consistent with a procompetitive explanation, and thus cannot give rise to a prima facie case under settled antitrust doctrine.

Before Apple’s entry, Amazon controlled 90% of the e-books market, and the publishers had for years been unable to muster sufficient bargaining power to renegotiate the terms of their contracts with Amazon. At the same time, Amazon’s pricing strategies as a nascent platform developer in a burgeoning market (that it was, in practical effect, trying to create) likely did not always produce prices that would be optimal under evolving market conditions as the market matured. The fact that prices may have increased following the alleged anticompetitive conduct cannot support an inference that the conduct was anticompetitive.

Third, the Second Circuit also made a mistake in dismissing Apple’s defenses. The court asserted that

this defense — that higher prices enable more competitors to enter a market — is no justification for a horizontal price‐fixing conspiracy.

But the court is incorrect. As Bill Kolasky points out in his post, it is well-accepted that otherwise-illegal agreements that are ancillary to a procompetitive transaction should be evaluated under the rule of reason.

It was not that Apple couldn’t enter unless Amazon’s prices (and its own) were increased. Rather, the contention made by Apple was that it could not enter unless it was able to attract a critical mass of publishers to its platform – a task which required some sharing of information among the publishers – and unless it was able to ensure that Amazon would not artificially lower its prices to such an extent that it would prevent Apple from attracting a critical mass of readers to its platform. The MFN and the agency model were thus ancillary restraints that facilitated the transactions between Apple and the publishers and between Apple and iPad purchasers. In this regard they are appropriately judged under the rule of reason and, under the rule of reason, offer a valid procompetitive justification for the restraints.

And it was the fact of Apple’s entry, not the use of vertical restraints in its contracts, that enabled the publishers to wield the bargaining power sufficient to move Amazon to the agency model. The court itself noted that the introduction of the iPad and iBookstore “gave publishers more leverage to negotiate for alternative sales models or different pricing.” And as Ben Klein noted at trial,

Apple’s entry probably gave the publishers an increased ability to threaten [Amazon sufficiently that it accepted the agency model]…. The MFN [made] a trivial change in the publishers’ incentives…. The big change that occurs is the change on the other side of the bargaining situation after Apple comes in where Amazon now cannot just tell them no.

Fourth, the purpose of applying the per se rule is to root out activities that always or almost always harm competition. Although it’s possible that a horizontal agreement that facilitates entry and increases competition could be subject to the per se rule, in this case its application was inappropriate. The novelty of Apple’s arrangement with the publishers, coupled with the weakness of proof of any sort of actual price fixing fails to meet even a minimal threshold that would require application of the per se rule.

Not all horizontal arrangements are per se illegal. If an arrangement is relatively novel, facilitates entry, and is patently different from naked price fixing, it should be reviewed under the rule of reason. See BMI. All of those conditions are met here.

The conduct of the publishers – distinct from their agreements with Apple – to find some manner of changing their contracts with Amazon is not itself price fixing, either. The prices themselves would be set only subsequent to whatever new contracts were adopted. At worst, the conduct of the publishers in working toward new contracts with Amazon can be characterized as a facilitating practice.

But even then, the precedent of the Court counsels against applying the per se rule to facilitating practices such as the mere dissemination of price information or, as in this case, information regarding the parties’ preferred, bilateral, contractual relationships. As the Second Circuit itself once held, following the Supreme Court,  

[the] exchange of information is not illegal per se, but can be found unlawful under a rule of reason analysis.

In other words, even the behavior of the publishers should be analyzed under a rule of reason – and Apple’s conduct in facilitating that behavior cannot be imbued with complicity in a price-fixing scheme that may not have existed at all.

Fifth, in order for conduct to “eliminate price competition,” there must be price competition to begin with. But as the district court itself noted, the publishers do not compete on price. This point is oft-overlooked in discussions of the case. It is perhaps possible to say that the contract terms at issue and the publishers’ pressure on Amazon affected price competition between Apple and Amazon – but even then it cannot be said to have reduced competition, because, absent Apple’s entry, there was no competition at all between Apple and Amazon.

It’s true that, if all Apple’s entry did was to transfer identical e-book sales from Amazon to Apple, at higher prices and therefore lower output, it might be difficult to argue that Apple’s entry was procompetitive. But the myopic focus on e-book titles without consideration of product differentiation is mistaken, as well.

The relevant competition here is between Apple and Amazon at the platform level. As explained above, it is misleading to look solely at prices in evaluating the market’s competitiveness. Provided that switching costs are low enough and information about the platforms is available to consumers, consumer welfare may have been enhanced by competition between the platforms on a range of non-price dimensions, including, for example: the Apple iBookstore’s distinctive design, Apple’s proprietary file format, features on Apple’s iPad that were unavailable on Kindle Readers, Apple’s use of a range of marketing incentives unavailable to Amazon, and Apple’s algorithmic matching between its data and consumers’ e-book purchases.

While it’s difficult to disentangle Apple’s entry from other determinants of consumers’ demand for e-books, and even harder to establish with certainty the “but-for” world, it is nonetheless telling that the e-book market has expanded significantly since Apple’s entry, and that purchases of both iPads and Kindles have increased, as well.

There is, in other words, no clear evidence that consumers viewed the two products as perfect substitutes, and thus there is no evidence that Apple’s entry merely caused a non-welfare-enhancing substitution from Amazon to Apple. At minimum, there is no basis for treating the contract terms that facilitated Apple’s entry under a per se standard.

***

The point, in sum, is that there is in fact substantial evidence that Apple’ entry was pro-competitive, that there was no price-fixing scheme of which Apple was a part, and absolutely no evidence that the vertical restraints at issue in the case were the sort that should presumptively give rise to liability. Not only was application of the per se rule inappropriate, but, to answer Richard Epstein, there is strong evidence that Apple should win under a rule of reason analysis, as well.

By Chris Sagers

United States v. Apple has fascinated me continually ever since the instantly-sensational complaint was made public, more than three years ago. Just one small, recent manifestation of the larger theme that makes it so interesting is the improbable range of folks who apparently consider certiorari rather likely—not least some commenters here, and even SCOTUSblog, which listed the case on their “Petitions We’re Watching.” It seems improbable, I say, not because reasonable people couldn’t differ on the policy issues. In this day and age somebody pops up to doubt every antitrust case brought against anybody no matter what. Rather, on the traditional criteria, the case just seems really ill-suited for cert.[*]

But it is in keeping with the larger story that people might expect the Court to take this basically hum-drum fact case in which there’s no circuit split. People have been savaging this case since its beginnings, despite the fact that to almost all antitrust lawyers it was such a legal slam dunk that so long as the government could prove its facts, it couldn’t lose.

And so I’m left with questions I’ve been asking since the case came out. Why, given the straightforward facts, nicely fitting a per se standard generally thought to be well-settled, involving conduct that on the elaborate trial record had no plausible effect except a substantial price increase,[**] do so many people hate this case? Why, more specifically, do so many people think there is something special about it, such that it shouldn’t be subject to the same rules that would apply to anybody else who did what these defendants did?

To be clear, I think the case is interesting. Big time. But what is interesting is not its facts or the underlying conduct or anything about book publishing or technological change or any of that. In other words, I don’t think the case is special. Like Jonathan Jacobson, I think it is simple.  What is remarkable is the reactions it has generated, across the political spectrum.

In the years of its pendency, on any number of panels and teleconferences and brown-bags and so on we’ve heard BigLaw corporate defense lawyers talking about the case like they’re Louis Brandeis. The problem, you see, is not a naked horizontal producer cartel coordinated by a retail entrant with a strong incentive to discipline its retail rival. No, no, no. The problem was actually Amazon, and the problem with Amazon was that it is big. Moreover, this case is about entry, they say, and entry is what antitrust is all about. Entry must be good, because numerosity in and of itself is competition. Consider too the number of BigLaw antitrust partners who’ve publicly argued that Amazon is in fact a monopolist, and that it engaged in predatory pricing, of all things.

When has anyone ever heard this group of people talk like that?

For another example, consider how nearly identical have been the views of left-wing critics like the New America Foundation’s Barry Lynn to those of the Second Circuit dissenter in Apple, the genteel, conservative Bush appointee, Judge Dennis Jacobs. They both claim, as essentially their only argument, that Amazon is a powerful firm, which can be tamed only if publishers can set their own retail prices (even if they do so collusively).

And there are so many other examples. The government’s case was condemned by no less than a Democrat and normally pro-enforcement member of the Senate antitrust committee, as it was by two papers as otherwise divergent as the Wall Street Journal and the New York Times. Meanwhile, the damnedest thing about the case, as I’ll show in a second, is that it frequently causes me to talk like Robert Bork.

So what the hell is going on?

I have a theory.  We in America have almost as our defining character, almost uniquely among developed nations, a commitment to markets, competition, and individual enterprise. But we tend to forget until a case like Apple reminds us that markets, when they work as they are supposed to, are machines for producing pain. Firms fail, people lose jobs, valuable institutions—like, perhaps, the paper book—are sometimes lost. And it can be hard to believe that such a free, decentralized mess will somehow magically optimize organization, distribution, and innovation. I think the reason people find a case like Apple hard to support is that, because we find all that loss and anarchy so hard to swallow, we as a people do not actually believe in competition at all.

I think it helps in making this point to work through the individual arguments that the Apple defendants and their supporters have made, in court and out. For my money, what we find is not only that most of the arguments are not really that strong, but that they are the same arguments that all defendants make, all the time. As it turns out, there has never been an antitrust defendant that didn’t think its market was special.

Taking the arguments I’ve heard, roughly in increasing order of plausibility:

  • Should it matter that discipline of Amazon’s aggressive pricing might help keep the publisher defendants in business? Hardly. While the lamentations of the publishers seem overblown—they may be forced to adapt, and it may not be painless, but that is much more likely at the moment than their insolvency—if they are forced out because they cannot compete on a price basis, then that is exactly what is supposed to happen. Econ 101.
  • Was Apple’s entry automatically good just because it was entry? Emphatically no. There is no rule in antitrust that entry is inherently good, and a number of strong rules to the contrary (consider, for example, the very foundation of the Brook Group predation standard, which is that we should provide no legal protection to less efficient competitors, including entrants). That is for a simple reason: entry is good when causes quality-adjusted price to go down. The opposite occurred in Apple[***]
  • Is Amazon the real villain, so obviously that we should allow its suppliers to regulate its power through horizontal cartel? I rather think not. While I have no doubt that Amazon is a dangerous entity, that probably will merit scrutiny on any number of grounds now or in the future, it seems implausible that it priced e-books predatorily, surely not on the legal standard that currently prevails in the United States. In fact, an illuminating theme in The Everything Store, Brad Stone’s comprehensive study of the company, was the ubiquity of supplier allegations of Amazon’s predation in all kinds of products, complaints that have gone on throughout the company’s two-decade existence. I don’t believe Amazon is any hero or that it poses no threats, but what it’s done in these cases is just charge lower prices. It’s been able to do so in a sustained manner mainly through innovation in distribution. And in any case, whether Amazon is big and bad or whatever, the right tool to constrain it is not a price fixing cartel. No regulator cares less about the public interest.
  • Does it make the case special in some way that a technological change drove the defendants to their conspiracy? No. The technological change afoot was in effect just a change in costs. It is much cheaper to deliver content electronically than in hard copy, not least because as things have unfolded, consumers have actually paid for and own most of the infrastructure. To that extent there’s nothing different about Apple than any case in which an innovation in production or distribution has given one player a cost advantage. In fact, the publishers’ primary need to defend against pricing of e-books at some measure of their actual cost is that the publishers’ whole structure is devoted to an expensive intermediating function that becomes largely irrelevant with digital distribution.
  • Is there reason to believe that a horizontal cartel orchestrated by a powerful distributor will achieve better quality-adjusted prices, which I take to be Geoff Manne’s overall theme? I mean, come on. This is essentially a species of destructive competition argument, that otherwise healthy markets can be so little trusted efficiently to supply products that customers want that we’ll put the government to a full rule of reason challenge to attack a horizontal cartel? Do we believe in competition at all?
  • Should it matter that valuable cultural institutions may be at risk, including the viability of paper books, independent bookstores, and perhaps the livelihoods of writers or even literature itself? This seems more troubling than the other points, but hardly is unique to the case or a particularly good argument for self-help by cartel. Consider, if you will, another, much older case. The sailing ship industry was thousands of years old and of great cultural and human significance when it met its demise in the 1870s at the hands of the emerging steamship industry. Ships that must await the fickle winds cannot compete with those that can offer the reliable, regular departures that shipper customers desire. There followed a period of desperate price war following which the sail industry was destroyed. That was sad, because tall-masted sailing ships are very swashbuckling and fun, and were entwined in our literature and culture. But should we have allowed the two industries to fix their prices, to preserve sailing ships as a living technology?

There are other arguments, and we could keep working through them one by one, but the end result is the same. The arguments mostly are weak, and even those with a bit more heft do nothing more than pose the problem inherent in that very last point. Healthy markets sometimes produce pain, with genuinely regrettable consequences.  But that just forces us to ask: do we believe in competition or don’t we?

___________

[*] Except possibly for one narrow issue, Apple is at this point emphatically a fact case, and the facts were resolved on an extensive record by an esteemed trial judge, in a long and elaborate opinion, and left undisturbed on appeal (even in the strongly worded dissent). The one narrow issue that is actually a legal one, and that Apple mainly stresses in its petition—whether in the wake of Leegin the hub in a hub-and-spoke arrangement can face per se liability—is one on which I guess people could plausibly disagree. But even when that is the case this Court virtually never grants cert. in the absence of a significant circuit split, and here there isn’t one.

Apple points only to one other Circuit decision, the Third Circuit’s Toledo Mack. It is true as Apple argues that a passage in Toledo Mack seemed to read language from Leegin fairly broadly, and to apply even when there is horizontal conspiracy at the retail level. But Toledo Mack was not a hub-and-spoke case. While plaintiff alleged a horizontal conspiracy among retailers of heavy trucks, and Mack Trucks later acquiescence in it, Mack played no role in coordinating the conspiracy. Separately, whether Toledo Mack really conflicts with Apple or not, the law supporting the old per se rule against hub-and-spoke conspiracies is pretty strong (take a look, for example, at pp. 17-18 of the Justice Department’s opposition brief.

So, I suppose one might think there is no distinction between a hub-and-spoke and a case like Toledo Mack, in which a manufacturer merely agreed after the fact to assist an existing retail conspiracy, and that there is therefore a circuit split, but that would be rather in contrast to a lot of Supreme Court authority. On the other hand, if there is some legal difference between a hub-and-spoke and the facts of Toledo Mack, then Toledo Mack is relevant only if it is understood to have read Leegin to apply to all “vertical” conduct, including true hub-and-spoke agreements. But that would be a broad reading indeed of both Leegin and Toledo Mack. It would require believing that Leegin reversed sub silentio a number of important decisions on an issue that was not before the Court in Leegin. It would also make a circuit split out of a point that would be only dicta in Toledo Mack. And yes, yes, yes, I know, Judge Jacobs in dissent below himself said that his panel’s decision created a circuit split with Toledo Mack. But I mean, come on. A circuit split means that two holdings are in conflict, not that one bit of dicta commented on some other bit of dicta.

A whole different reason cert. seems improbable is that the issue presented is whether per se treatment was appropriate. But the trial court specifically found the restraint to have been unreasonable under a rule of reason standard. Of course that wouldn’t preclude the Court from reversing the trial court’s holding that the per se rule applies, but it would render a reversal almost certainly academic in the case actually before the Court.

Don’t get me wrong. Nothing the courts do really surprises me anymore, and there are still four members of the Court, even in the wake of Justice Scalia’s passing, who harbor open animosity for antitrust and a strong fondness for Leegin. It is also plausible that those four will see the case Apple’s way, and favor reversing Interstate Circuit (though that seems unlikely to me; read a case like Ticor or North Carolina Dental Examiners if you want to know how Anthony Kennedy feels about naked cartel conduct). But the ideological affinities of the Justices, in and of themselves, just don’t usually turn an otherwise ordinary case into a cert-worthy one.

[**] Yes, yes, yes, Grasshopper, I know, Apple argued that in fact its entry increased quality and consumer choice, and also put on an argument that the output of e-books actually expanded during the period of the publishers’ conspiracy. But, a couple of things. First, as the government observed in some juicy briefing in the case, and Judge Cote found in specific findings, each of Apple’s purported quality enhancements turned out to involve either other firms’ innovations or technological enhancements that appeared in the iPad before Apple ever communicated with the publishers. As for the expanded output argument, it was fairly demolished by the government’s experts, a finding not disturbed even in Judge Jacobs’ dissent.

In any case, any benefit Apple did manage to supply came at the cost of a price increase of fifty freaking percent, across thousands of titles, that were sustained for the entire two years that the conspiracy survived.

[***] There have also been the usual squabbles over factual details that are said to be very important, but these points are especially uninteresting. E.g., the case involved “MFNs” and “agency contracts,” and there is supposed to be some magic in either their vertical nature or the great uncertainty of their consequences that count against per se treatment. There isn’t. Neither the government’s complaint, the district court, nor the Second Circuit attacked the bilateral agreements in and of themselves; on the contrary, both courts emphatically stressed that they only found illegal the horizontal price fixing conspiracy and Apple’s role in coordinating it.

Likewise, some stress that the publisher defendants in fact earned slightly less per price-fixed book under their agency agreements than they had with Apple. Why would they do that, if there weren’t some pro-competitive reason? Simple. The real money in trade publishing was not then or now in the puny e-book sector, but in hard-cover, new-release best sellers, which publishers have long sold at very significant mark-ups over cost. Those margins were threatened by Amazon’s very low e-book prices, and the loss on agency sales was worth it to preserve the real money makers.

For a few months I have thought that the Apple eBooks case would find an easy fit within the Supreme Court’s antitrust decisions. The case that seems closest to me is Business Electronics v. Sharp Electronics, an unfortunately under-appreciated piece of antitrust precedent. One sign of its under-appreciation is its absence in some recent editions of antitrust casebooks.

In Business Electronics, the Court looked at a vertical relationship in which a manufacturer agreed with one of its retailers to terminate another retailer for failing to comply with the manufacturer’s suggested minimum prices. The Court held that such an agreement could not be ruled per se illegal unless the plaintiff could prove that the non-terminated retailer had agreed with the manufacturer to set its resale price at some level. The Court was reluctant to apply the per se test to this sort of case because of the potential efficiencies that might justify the manufacturer’s minimum retail prices. To allow some leeway for these efficiencies to be realized, the Court erected a high burden of proof under the per se test. Now, of course, the Court no longer applies the per se test to vertical arrangements like that in Business Electronics because of its decision in Leegin to adopt rule of reason analysis for vertical restraints.

The Apple eBooks case falls under Business Electronics. Apple offered the book publishers a contract that left Amazon with a choice of complying with a pricing system closer to the publisher’s preferences or terminating its relationship with the publishers. In other words, the Apple contract, with its famous most-favored-nations clause, effectively presented Amazon with an ultimatum similar to the one observed in Business Electronics. The ultimatum worked: Amazon was forced to comply with the pricing scheme preferred by the publishers and Apple. It follows from Business Electronics, and from Leegin, that the burden of proof in this case should be set high – a bit higher than the trial court set it in this case. Further, Leegin suggests that rule of reason analysis should apply because the relationship at issue is vertical.

Justice Scalia’s passing may have affected the Apple eBooks case already. Scalia was the author of Business Electronics, and presumably the Supreme Court Justice most likely to have noticed the similarity between Business Electronics and Apple eBooks.

As Judge (and Professor) Frank Easterbrook famously explained over three decades ago (in his seminal article The Limits of Antitrust), antitrust is an inherently limited body of law. In crafting and enforcing liability rules to combat market power and encourage competition, courts and regulators may err in two directions: they may wrongly forbid output-enhancing behavior or wrongly fail to condemn output-reducing conduct. The social losses from false convictions and false acquittals, taken together, comprise antitrust’s “error costs.” While it may be possible to reduce error costs by making liability rules more nuanced, added complexity raises the “decision costs” incurred by business planners (ex ante) and adjudicators (ex post). In light of all these costs, Easterbrook advocated an approach that would optimize antitrust’s effectiveness: interpret and enforce the antitrust laws so as to minimize the sum of error and decision costs.

Judge Easterbrook’s approach is consistent with the widely accepted proposition that antitrust enforcement should be viewed as an exercise in consumer welfare maximization. In order to maximize welfare, enforcers must have an understanding of – and seek to maximize the difference between – the aggregate costs and benefits that are likely to flow from their policies.  Specifically, antitrust enforcers first should ensure that the rules they propagate create net welfare benefits. Next, they should (to the extent possible) seek to calibrate those rules so as to maximize net welfare. This is achieved by employing an error cost (decision theoretic) framework, which seeks to minimize the sum of the costs attributable to false positives, false negatives, antitrust administrative costs, and disincentive costs imposed on third parties (the latter may also be viewed as a subset of false positives).

Perhaps the most glaring flaw of the Second Circuit’s 2015 decision in United States v. Apple Inc., is the failure to pay heed to error costs and the limits of antitrust as an administrative system.

In condemning Apple’s vertical contracts as illegal per se, because they allegedly were used to facilitate a horizontal price-fixing conspiracy among publishers, the Second Circuit ignored the vast literature on the efficiencies associated with vertical restraints. (They also failed to heed Supreme Court precedent, see here). Moreover, the vertical restraints employed by Apple in this case, such as most-favored nation (MFN) clauses, clearly had substantial efficiency potential – they were particularly well-suited to facilitate Apple’s competition with Amazon’s established e-book platform and thereby enhance competition in the emerging e-book market. (This theme is explained and developed here). Accordingly, the Second Circuit’s failure to examine the restraints in detail under the antitrust rule of reason created a strong potential for wrongly condemning procompetitive behavior (false positives). In contrast, the likelihood of wrongly failing to condemn anticompetitive practices (false negatives) under a rule of reason assessment in this case (involving a substantial record, an emerging dynamic market, and the use of typically efficient vertical contracts by a new entrant) would have been comparatively small. Furthermore, the Second Circuit’s per se condemnation of vertical restraints in Apple creates substantial disincentive costs, by discouraging other businesses from developing innovative distribution models employing vertical restraints in emerging markets.

In sum, the Second Circuit’s approach is plainly at odds with a welfare-enhancing, decision theoretic approach to antitrust. It also runs counter to the general thrust of the Supreme Court’s recent antitrust jurisprudence, which implicitly has adopted an error cost framework (see the article by Thom Lambert and me, here) with a focus on false positives. As the late Justice Scalia pithily explained, “[m]istaken inferences and the resulting false condemnations are ‘especially costly, because they chill the very conduct the antitrust laws are designed to protect.’” Verizon v. Trinko (citing Matsushita Elec. Indus. Co. v. Zenith Radio Corp.). It would be fitting tribute to the great Justice for the Supreme Court to heed this teaching and grant certiorari in the Apple case.

by Jonathan Jacobson

Try as one may, it is hard to find an easier antitrust case than United States v. Apple.

Consider: The six leading publishers all wanted to prevent Amazon and others from offering best seller e-books at $9.99 (or other similar low prices). The problem, however, was that they had no mechanism for accomplishing that result. Then came Apple. Apple figured out that the “Amazon problem” could be fixed if the publishers changed their customer relationships from sale/resale to “agency,” all subject to an MFN with Apple that would prohibit any of the publishers – and, through the MFN, Amazon – from underselling the (higher) prices on Apple’s iBookstore. Loving this “aikido move” (in Steve Jobs’ words), all the publishers but Random House happily agreed. Prices for best seller e-books increased 30% almost overnight.

So what is this? The fact of a horizontal conspiracy among the five publishers is largely undisputed. Is it any less per se illegal because Apple was involved? Hardly; especially on these facts, where the participation by the “vertical” player was essential to make the whole scheme work. Apple’s role in no way made the conspiracy benign. It made it worse – and it couldn’t have been achieved without Apple’s active role.

Truly, all one needs to know about the case is in the attached video clip from the iPad launch event. Asked by the Wall Street Journal why anyone would pay $14.99 for a book from the iBookstore when it could be had for $9.99 on Amazon, Steve Jobs said: “Well, that won’t be the case.” Asked to explain, he added: “The prices will be the same.”

So we have a horizontal conspiracy to fix and raise e-book prices, made operational only through Apple’s aggressive involvement, that immediately raised prices by 30%. If that’s not an antitrust violation, we’re all in trouble.

In its June 30 decision in United States v. Apple Inc., a three-judge Second Circuit panel departed from sound antitrust reasoning in holding that Apple’s e-book distribution agreement with various publishers was illegal per se. Judge Dennis Jacobs’ thoughtful dissent, which substantially informs the following discussion of this case, is worth a close read.

In 2009, Apple sought to enter the retail market for e-books, as it prepared to launch its first iPad tablet. Apple, however, confronted an e-book monopolist, Amazon (possessor of a 90 percent e-book market share), that was effectively excluding new entrants by offering bestsellers at a loss through its popular Kindle device ($9.99, a price below what Amazon was paying publishers for the e-book book rights). In order to effectively enter the market without incurring a loss itself (by meeting Amazon’s price) or impairing its brand (by charging more than Amazon), Apple approached publishers that dealt with Amazon and offered itself as a competing e-book buyer, subject to the publishers agreeing to a new distribution model that would lower barriers to entry into retail e-book sales. The new publishing model was implemented by three sets of contract terms Apple asked the publishers to accept – agency pricing, tiered price caps, and a most-favored-nation (MFN) clause. (I refer the reader to the full panel majority opinion for a detailed discussion of these clauses.) None of those terms, standing alone, is illegal. Although the publishers were unhappy about Amazon’s below-cost pricing for e-books, no one publisher alone could counter Amazon. Five of the six largest U.S. publishers (Hachette, HarperCollins, Macmillan, Penguin, and Simon & Schuster) agreed to Apple’s terms and jointly convinced Amazon to adopt agency pricing. Apple also encouraged other publishers to implement agency pricing in their contracts with other retailers. The barrier to entry thus removed, Apple entered the retail market as a formidable competitor. Amazon’s retail e-book market share fell, and today stands at 60 percent.

The U.S. Department of Justice (DOJ) and 31 states sued Apple and the five publishers for conspiring in unreasonable restraint of trade under Sherman Act § 1. The publishers settled (signing consent decrees which prohibited them for a period from restricting e-book retailers’ ability to set prices), but Apple proceeded to a bench trial. A federal district court held that Apple’s conduct as a vertical enabler of a horizontal price conspiracy among the publishers was a per se violation of § 1, and that (in any event) Apple’s conduct would also violate § 1 under the antitrust rule of reason.   A majority of the Second Circuit panel affirmed on the ground of per se liability, without having to reach the rule of reason question.

Judge Jacobs’ dissent argued that Apple’s conduct was not per se illegal and also passed muster under the rule of reason. He pointed to three major errors in the majority’s opinion. First, the holding that the vertical enabler of a horizontal price fixing is in per se violation of the antitrust laws conflicts with the Supreme Court’s teaching (in overturning the per se prohibition on resale price maintenance) that a vertical agreement designed to facilitate a horizontal cartel “would need to be held unlawful under the rule of reason.” Leegin Creative Leather Prods, Inc. v. PSKS, Inc. 551 U.S. 877, 893 (2007) (emphasis added).   Second, the district court failed to recognize that Apple’s role as a vertical player differentiated it from the publishers – it should have considered Apple as a competitor on the distinct horizontal plane of retailers, where Apple competed with Amazon (and with smaller player such as Barnes & Noble). Third, assessed under the rule of reason, Apple’s conduct was “overwhelmingly” procompetitive; Apple was a major potential competitor in a market dominated by a 90 percent monopoly, and was “justifiably unwilling” to enter a market on terms that would assure a loss on sales or exact a toll on its reputation.

Judge Jacobs’ analysis is on point. The Supreme Court’s wise reluctance to condemn any purely vertical contractual restraint under the per se rule reflects a sound understanding that vertical restraints have almost always been found to be procompetitive or competitively neutral. Indeed, vertical agreements that are designed to facilitate entry into an important market dominated by one firm, such as the ones at issue in the Apple case, are especially bad candidates for summary condemnation. Thus, the majority’s decision to apply the per se rule to Apple’s contracts appears particularly out of touch with both scholarship and marketplace realities.

More generally, as Professor Herbert Hovenkamp (the author of the leading antitrust treatise) and other scholars have emphasized, well-grounded antitrust analysis involves a certain amount of preliminary evaluation of a restraint seen in its relevant factual context, before a “per se” or “rule of reason” label is applied. (In the case of truly “naked” secret hard core cartels, which DOJ prosecutes under criminal law, the per se label may be applied immediately.) The Apple panel majority panel botched this analytic step, in failing to even consider that Apple’s restraints could enhance retail competition with Amazon.

The panel majority also appeared overly fixated on the fact that some near-term e-book retail prices rose above Amazon’s previous below cost levels in the wake of Apple’s contracts, without noting the longer term positive implications for the competitive process of new e-book entry. Below-cost prices are not a feature of durable efficient competition, and in this case may well have been a temporary measure aimed at discouraging entry. In any event, what counts in measuring consumer welfare is not short term price, but whether expanded output is being promoted by a business arrangement – a key factor that the majority notably failed to address. (It appears highly probable that the fall in Amazon’s e-book retail market share, and the invigoration of e-book competition, have generated output and welfare levels higher than those that would have prevailed had Amazon maintained its monopoly. This is bolstered by Apple’s showing, which the majority does not deny, that in the two years following the “conspiracy” among Apple and the publishers, prices across the e-book market as a whole fell slightly and total output increased.)

Finally, Judge Jacobs’ dissent provides strong arguments in favor of upholding Apple’s conduct under the rule of reason. As the dissent stresses, removal of barriers to entry that shield a monopolist, as in this case, is in line with the procompetitive goals of antitrust law. Another procompetitive effect is the encouragement of innovation (manifested by the enablement of e-book reading with the cutting-edge functions of the iPad), a hallmark and benefit of competition. Another benefit was that the elimination of below-cost pricing helped raise authors’ royalties. Furthermore, in the words of the dissent, any welfare reductions due to Apple’s vertical restrictions are “no more than a slight offset to the competitive benefits that now pervade the relevant market.” (Admittedly that comment is a speculative observation, but in my view very likely a well-founded one.) Finally, as the dissent points out, the district court’s findings demonstrate that Apple could not have entered and competed effectively using other strategies, such as wholesale contracts involving below-cost pricing (like Amazon’s) or higher prices. Summing things up, the dissent explains that “Apple took steps to compete with a monopolist and open the market to more entrants, generating only minor competitive restraints in the process. Its conduct was eminently reasonable; no one has suggested a viable alternative.” In closing, even if one believes a more fulsome application of the rule of reason is called for before reaching the dissent’s conclusion, the dissent does a good job in highlighting the key considerations at play here – considerations that the majority utterly failed to address.

In sum, the Second Circuit panel majority wore jurisprudential blinders in its Apple decision. Like the mesmerized audience at a magic show, it focused in blinkered fashion on a magician’s sleight of hand (the one-dimensional characterization of certain uniform contractual terms), while not paying attention to what was really going on (the impressive welfare-enhancing invigoration of competition in e-book retailing). In other words, the majority decision showed a naïve preference for quick and superficial characterizations of conduct at the expense of a nuanced assessment of the broader competitive context. Perhaps the Second Circuit en banc will have the opportunity to correct the panel’s erroneous understanding of per se and rule of reason analysis. Even better, the Supreme Court may wish to step in to ensure that its thoughtful development of antitrust doctrine in recent years – focused on actual effects and economic efficiency, not on superficial condemnatory labels that ignore marketplace benefits – not be undermined.

Ours is not an age of nuance.  It’s an age of tribalism, of teams—“Yer either fer us or agin’ us!”  Perhaps I should have been less surprised, then, when I read the unfavorable review of my book How to Regulate in, of all places, the Federalist Society Review.

I had expected some positive feedback from reviewer J. Kennerly Davis, a contributor to the Federalist Society’s Regulatory Transparency Project.  The “About” section of the Project’s website states:

In the ultra-complex and interconnected digital age in which we live, government must issue and enforce regulations to protect public health and safety.  However, despite the best of intentions, government regulation can fail, stifle innovation, foreclose opportunity, and harm the most vulnerable among us.  It is for precisely these reasons that we must be diligent in reviewing how our policies either succeed or fail us, and think about how we might improve them.

I might not have expressed these sentiments in such pro-regulation terms.  For example, I don’t think government should regulate, even “to protect public health and safety,” absent (1) a market failure and (2) confidence that systematic governmental failures won’t cause the cure to be worse than the disease.  I agree, though, that regulation is sometimes appropriate, that government interventions often fail (in systematic ways), and that regulatory policies should regularly be reviewed with an eye toward reducing the combined costs of market and government failures.

Those are, in fact, the central themes of How to Regulate.  The book sets forth an overarching goal for regulation (minimize the sum of error and decision costs) and then catalogues, for six oft-cited bases for regulating, what regulatory tools are available to policymakers and how each may misfire.  For every possible intervention, the book considers the potential for failure from two sources—the knowledge problem identified by F.A. Hayek and public choice concerns (rent-seeking, regulatory capture, etc.).  It ends up arguing:

  • for property rights-based approaches to environmental protection (versus the command-and-control status quo);
  • for increased reliance on the private sector to produce public goods;
  • that recognizing property rights, rather than allocating usage, is the best way to address the tragedy of the commons;
  • that market-based mechanisms, not shareholder suits and mandatory structural rules like those imposed by Sarbanes-Oxley and Dodd-Frank, are the best way to constrain agency costs in the corporate context;
  • that insider trading restrictions should be left to corporations themselves;
  • that antitrust law should continue to evolve in the consumer welfare-focused direction Robert Bork recommended;
  • against the FCC’s recently abrogated net neutrality rules;
  • that occupational licensure is primarily about rent-seeking and should be avoided;
  • that incentives for voluntary disclosure will usually obviate the need for mandatory disclosure to correct information asymmetry;
  • that the claims of behavioral economics do not justify paternalistic policies to protect people from themselves; and
  • that “libertarian-paternalism” is largely a ruse that tends to morph into hard paternalism.

Given the congruence of my book’s prescriptions with the purported aims of the Regulatory Transparency Project—not to mention the laundry list of specific market-oriented policies the book advocates—I had expected a generally positive review from Mr. Davis (whom I sincerely thank for reading and reviewing the book; book reviews are a ton of work).

I didn’t get what I’d expected.  Instead, Mr. Davis denounced my book for perpetuating “progressive assumptions about state and society” (“wrongheaded” assumptions, the editor’s introduction notes).  He responded to my proposed methodology with a “meh,” noting that it “is not clearly better than the status quo.”  His one compliment, which I’ll gladly accept, was that my discussion of economic theory was “generally accessible.”

Following are a few thoughts on Mr. Davis’s critiques.

Are My Assumptions Progressive?

According to Mr. Davis, my book endorses three progressive concepts:

(i) the idea that market based arrangements among private parties routinely misallocate resources, (ii) the idea that government policymakers are capable of formulating executive directives that can correct private ordering market failures and optimize the allocation of resources, and (iii) the idea that the welfare of society is actually something that exists separate and apart from the individual welfare of each of the members of society.

I agree with Mr. Davis that these are progressive ideas.  If my book embraced them, it might be fair to label it “progressive.”  But it doesn’t.  Not one of them.

  1. Market Failure

Nothing in my book suggests that “market based arrangements among private parties routinely misallocate resources.”  I do say that “markets sometimes fail to work well,” and I explain how, in narrow sets of circumstances, market failures may emerge.  Understanding exactly what may happen in those narrow sets of circumstances helps to identify the least restrictive option for addressing problems and would thus would seem a pre-requisite to effective policymaking for a conservative or libertarian.  My mere invocation of the term “market failure,” however, was enough for Mr. Davis to kick me off the team.

Mr. Davis ignored altogether the many points where I explain how private ordering fixes situations that could lead to poor market performance.  At the end of the information asymmetry chapter, for example, I write,

This chapter has described information asymmetry as a problem, and indeed it is one.  But it can also present an opportunity for profit.  Entrepreneurs have long sought to make money—and create social value—by developing ways to correct informational imbalances and thereby facilitate transactions that wouldn’t otherwise occur.

I then describe the advent of companies like Carfax, AirBnb, and Uber, all of which offer privately ordered solutions to instances of information asymmetry that might otherwise create lemons problems.  I conclude:

These businesses thrive precisely because of information asymmetry.  By offering privately ordered solutions to the problem, they allow previously under-utilized assets to generate heretofore unrealized value.  And they enrich the people who created and financed them.  It’s a marvelous thing.

That theme—that potential market failures invite privately ordered solutions that often obviate the need for any governmental fix—permeates the book.  In the public goods chapter, I spend a great deal of time explaining how privately ordered devices like assurance contracts facilitate the production of amenities that are non-rivalrous and non-excludable.  In discussing the tragedy of the commons, I highlight Elinor Ostrom’s work showing how “groups of individuals have displayed a remarkable ability to manage commons goods effectively without either privatizing them or relying on government intervention.”  In the chapter on externalities, I spend a full seven pages explaining why Coasean bargains are more likely than most people think to prevent inefficiencies from negative externalities.  In the chapter on agency costs, I explain why privately ordered solutions like the market for corporate control would, if not precluded by some ill-conceived regulations, constrain agency costs better than structural rules from the government.

Disregarding all this, Mr. Davis chides me for assuming that “markets routinely fail.”  And, for good measure, he explains that government interventions are often a bigger source of failure, a point I repeatedly acknowledge, as it is a—perhaps the—central theme of the book.

  1. Trust in Experts

In what may be the strangest (and certainly the most misleading) part of his review, Mr. Davis criticizes me for placing too much confidence in experts by giving short shrift to the Hayekian knowledge problem and the insights of public choice.

          a.  The Knowledge Problem

According to Mr. Davis, the approach I advocate “is centered around fully functioning experts.”  He continues:

This progressive trust in experts is misplaced.  It is simply false to suppose that government policymakers are capable of formulating executive directives that effectively improve upon private arrangements and optimize the allocation of resources.  Friedrich Hayek and other classical liberals have persuasively argued, and everyday experience has repeatedly confirmed, that the information needed to allocate resources efficiently is voluminous and complex and widely dispersed.  So much so that government experts acting through top down directives can never hope to match the efficiency of resource allocation made through countless voluntary market transactions among private parties who actually possess the information needed to allocate the resources most efficiently.

Amen and hallelujah!  I couldn’t agree more!  Indeed, I said something similar when I came to the first regulatory tool my book examines (and criticizes), command-and-control pollution rules.  I wrote:

The difficulty here is an instance of a problem that afflicts regulation generally.  At the end of the day, regulating involves centralized economic planning:  A regulating “planner” mandates that productive resources be allocated away from some uses and toward others.  That requires the planner to know the relative value of different resource uses.  But such information, in the words of Nobel laureate F.A. Hayek, “is not given to anyone in its totality.”  The personal preferences of thousands or millions of individuals—preferences only they know—determine whether there should be more widgets and fewer gidgets, or vice-versa.  As Hayek observed, voluntary trading among resource owners in a free market generates prices that signal how resources should be allocated (i.e., toward the uses for which resource owners may command the highest prices).  But centralized economic planners—including regulators—don’t allocate resources on the basis of relative prices.  Regulators, in fact, generally assume that prices are wrong due to the market failure the regulators are seeking to address.  Thus, the so-called knowledge problem that afflicts regulation generally is particularly acute for command-and-control approaches that require regulators to make refined judgments on the basis of information about relative costs and benefits.

That was just the first of many times I invoked the knowledge problem to argue against top-down directives and in favor of market-oriented policies that would enable individuals to harness local knowledge to which regulators would not be privy.  The index to the book includes a “knowledge problem” entry with no fewer than nine sub-entries (e.g., “with licensure regimes,” “with Pigouvian taxes,” “with mandatory disclosure regimes”).  There are undoubtedly more mentions of the knowledge problem than those listed in the index, for the book assesses the degree to which the knowledge problem creates difficulties for every regulatory approach it considers.

Mr. Davis does mention one time where I “acknowledge[] the work of Hayek” and “recognize[] that context specific information is vitally important,” but he says I miss the point:

Having conceded these critical points [about the importance of context-specific information], Professor Lambert fails to follow them to the logical conclusion that private ordering arrangements are best for regulating resources efficiently.  Instead, he stops one step short, suggesting that policymakers defer to the regulator most familiar with the regulated party when they need context-specific information for their analysis.  Professor Lambert is mistaken.  The best information for resource allocation is not to be found in the regional office of the regulator.  It resides with the persons who have long been controlled and directed by the progressive regulatory system.  These are the ones to whom policymakers should defer.

I was initially puzzled by Mr. Davis’s description of how my approach would address the knowledge problem.  It’s inconsistent with the way I described the problem (the “regional office of the regulator” wouldn’t know people’s personal preferences, etc.), and I couldn’t remember ever suggesting that regulatory devolution—delegating decisions down toward local regulators—was the solution to the knowledge problem.

When I checked the citation in the sentences just quoted, I realized that Mr. Davis had misunderstood the point I was making in the passage he cited (my own fault, no doubt, not his).  The cited passage was at the very end of the book, where I was summarizing the book’s contributions.  I claimed to have set forth a plan for selecting regulatory approaches that would minimize the sum of error and decision costs.  I wanted to acknowledge, though, the irony of promulgating a generally applicable plan for regulating in a book that, time and again, decries top-down imposition of one-size-fits-all rules.  Thus, I wrote:

A central theme of this book is that Hayek’s knowledge problem—the fact that no central planner can possess and process all the information needed to allocate resources so as to unlock their greatest possible value—applies to regulation, which is ultimately a set of centralized decisions about resource allocation.  The very knowledge problem besetting regulators’ decisions about what others should do similarly afflicts pointy-headed academics’ efforts to set forth ex ante rules about what regulators should do.  Context-specific information to which only the “regulator on the spot” is privy may call for occasional departures from the regulatory plan proposed here.

As should be obvious, my point was not that the knowledge problem can generally be fixed by regulatory devolution.  Rather, I was acknowledging that the general regulatory approach I had set forth—i.e., the rules policymakers should follow in selecting among regulatory approaches—may occasionally misfire and should thus be implemented flexibly.

           b.  Public Choice Concerns

A second problem with my purported trust in experts, Mr. Davis explains, stems from the insights of public choice:

Actual policymakers simply don’t live up to [Woodrow] Wilson’s ideal of the disinterested, objective, apolitical, expert technocrat.  To the contrary, a vast amount of research related to public choice theory has convincingly demonstrated that decisions of regulatory agencies are frequently shaped by politics, institutional self-interest and the influence of the entities the agencies regulate.

Again, huzzah!  Those words could have been lifted straight out of the three full pages of discussion I devoted to public choice concerns with the very first regulatory intervention the book considered.  A snippet from that discussion:

While one might initially expect regulators pursuing the public interest to resist efforts to manipulate regulation for private gain, that assumes that government officials are not themselves rational, self-interest maximizers.  As scholars associated with the “public choice” economic tradition have demonstrated, government officials do not shed their self-interested nature when they step into the public square.  They are often receptive to lobbying in favor of questionable rules, especially since they benefit from regulatory expansions, which tend to enhance their job status and often their incomes.  They also tend to become “captured” by powerful regulatees who may shower them with personal benefits and potentially employ them after their stints in government have ended.

That’s just a slice.  Elsewhere in those three pages, I explain (1) how the dynamic of concentrated benefits and diffuse costs allows inefficient protectionist policies to persist, (2) how firms that benefit from protectionist regulation are often assisted by “pro-social” groups that will make a public interest case for the rules (Bruce Yandle’s Bootleggers and Baptists syndrome), and (3) the “[t]wo types of losses [that] result from the sort of interest-group manipulation public choice predicts.”  And that’s just the book’s initial foray into public choice.  The entry for “public choice concerns” in the book’s index includes eight sub-entries.  As with the knowledge problem, I addressed the public choice issues that could arise from every major regulatory approach the book considered.

For Mr. Davis, though, that was not enough to keep me out of the camp of Wilsonian progressives.  He explains:

Professor Lambert devotes a good deal of attention to the problem of “agency capture” by regulated entities.  However, he fails to acknowledge that a symbiotic relationship between regulators and regulated is not a bug in the regulatory system, but an inherent feature of a system defined by extensive and continuing government involvement in the allocation of resources.

To be honest, I’m not sure what that last sentence means.  Apparently, I didn’t recite some talismanic incantation that would indicate that I really do believe public choice concerns are a big problem for regulation.  I did say this in one of the book’s many discussions of public choice:

A regulator that has both regular contact with its regulatees and significant discretionary authority over them is particularly susceptible to capture.  The regulator’s discretionary authority provides regulatees with a strong motive to win over the regulator, which has the power to hobble the regulatee’s potential rivals and protect its revenue stream.  The regular contact between the regulator and the regulatee provides the regulatee with better access to those in power than that available to parties with opposing interests.  Moreover, the regulatee’s preferred course of action is likely (1) to create concentrated benefits (to the regulatee) and diffuse costs (to consumers generally), and (2) to involve an expansion of the regulator’s authority.  The upshot is that that those who bear the cost of the preferred policy are less likely to organize against it, and regulators, who benefit from turf expansion, are more likely to prefer it.  Rate-of-return regulation thus involves the precise combination that leads to regulatory expansion at consumer expense: broad and discretionary government power, close contact between regulators and regulatees, decisions that generally involve concentrated benefits and diffuse costs, and regular opportunities to expand regulators’ power and prestige.

In light of this combination of features, it should come as no surprise that the history of rate-of-return regulation is littered with instances of agency capture and regulatory expansion.

Even that was not enough to convince Mr. Davis that I reject the Wilsonian assumption of “disinterested, objective, apolitical, expert technocrat[s].”  I don’t know what more I could have said.

  1. Social Welfare

Mr. Davis is right when he says, “Professor Lambert’s ultimate goal for his book is to provide policymakers with a resource that will enable them to make regulatory decisions that produce greater social welfare.”  But nowhere in my book do I suggest, as he says I do, “that the welfare of society is actually something that exists separate and apart from the individual welfare of each of the members of society.”  What I mean by “social welfare” is the aggregate welfare of all the individuals in a society.  And I’m careful to point out that only they know what makes them better off.  (At one point, for example, I write that “[g]overnment planners have no way of knowing how much pleasure regulatees derive from banned activities…or how much displeasure they experience when they must comply with an affirmative command…. [W]ith many paternalistic policies and proposals…government planners are really just guessing about welfare effects.”)

I agree with Mr. Davis that “[t]here is no single generally accepted methodology that anyone can use to determine objectively how and to what extent the welfare of society will be affected by a particular regulatory directive.”  For that reason, nowhere in the book do I suggest any sort of “metes and bounds” measurement of social welfare.  (I certainly do not endorse the use of GDP, which Mr. Davis rightly criticizes; that term appears nowhere in the book.)

Rather than prescribing any sort of precise measurement of social welfare, my book operates at the level of general principles:  We have reasons to believe that inefficiencies may arise when conditions are thus; there is a range of potential government responses to this situation—from doing nothing, to facilitating a privately ordered solution, to mandating various actions; based on our experience with these different interventions, the likely downsides of each (stemming from, for example, the knowledge problem and public choice concerns) are so-and-so; all things considered, the aggregate welfare of the individuals within this group will probably be greatest with policy x.

It is true that the thrust of the book is consequentialist, not deontological.  But it’s a book about policy, not ethics.  And its version of consequentialism is rule, not act, utilitarianism.  Is a consequentialist approach to policymaking enough to render one a progressive?  Should we excise John Stuart Mill’s On Liberty from the classical liberal canon?  I surely hope not.

Is My Proposed Approach an Improvement?

Mr. Davis’s second major criticism of my book—that what it proposes is “just the status quo”—has more bite.  By that, I mean two things.  First, it’s a more painful criticism to receive.  It’s easier for an author to hear “you’re saying something wrong” than “you’re not saying anything new.”

Second, there may be more merit to this criticism.  As Mr. Davis observes, I noted in the book’s introduction that “[a]t times during the drafting, I … wondered whether th[e] book was ‘original’ enough.”  I ultimately concluded that it was because it “br[ought] together insights of legal theorists and economists of various stripes…and systematize[d] their ideas into a unified, practical approach to regulating.”  Mr. Davis thinks I’ve overstated the book’s value, and he may be right.

The current regulatory landscape would suggest, though, that my book’s approach to selecting among potential regulatory policies isn’t “just the status quo.”  The approach I recommend would generate the specific policies catalogued at the outset of this response (in the bullet points).  The fact that those policies haven’t been implemented under the existing regulatory approach suggests that what I’m recommending must be something different than the status quo.

Mr. Davis observes—and I acknowledge—that my recommended approach resembles the review required of major executive agency regulations under Executive Order 12866, President Clinton’s revised version of President Reagan’s Executive Order 12291.  But that order is quite limited in its scope.  It doesn’t cover “minor” executive agency rules (those with expected costs of less than $100 million) or rules from independent agencies or from Congress or from courts or at the state or local level.  Moreover, I understand from talking to a former administrator of the Office of Information and Regulatory Affairs, which is charged with implementing the order, that it has actually generated little serious consideration of less restrictive alternatives, something my approach emphasizes.

What my book proposes is not some sort of governmental procedure; indeed, I emphasize in the conclusion that the book “has not addressed … how existing regulatory institutions should be reformed to encourage the sort of analysis th[e] book recommends.”  Instead, I propose a way to think through specific areas of regulation, one that is informed by a great deal of learning about both market and government failures.  The best audience for the book is probably law students who will someday find themselves influencing public policy as lawyers, legislators, regulators, or judges.  I am thus heartened that the book is being used as a text at several law schools.  My guess is that few law students receive significant exposure to Hayek, public choice, etc.

So, who knows?  Perhaps the book will make a difference at the margin.  Or perhaps it will amount to sound and fury, signifying nothing.  But I don’t think a classical liberal could fairly say that the analysis it counsels “is not clearly better than the status quo.”

A Truly Better Approach to Regulating

Mr. Davis ends his review with a stirring call to revamp the administrative state to bring it “in complete and consistent compliance with the fundamental law of our republic embodied in the Constitution, with its provisions interpreted to faithfully conform to their original public meaning.”  Among other things, he calls for restoring the separation of powers, which has been erased in agencies that combine legislative, executive, and judicial functions, and for eliminating unchecked government power, which results when the legislature delegates broad rulemaking and adjudicatory authority to politically unaccountable bureaucrats.

Once again, I concur.  There are major problems—constitutional and otherwise—with the current state of administrative law and procedure.  I’d be happy to tear down the existing administrative state and begin again on a constitutionally constrained tabula rasa.

But that’s not what my book was about.  I deliberately set out to write a book about the substance of regulation, not the process by which rules should be imposed.  I took that tack for two reasons.  First, there are numerous articles and books, by scholars far more expert than I, on the structure of the administrative state.  I could add little value on administrative process.

Second, the less-addressed substantive question—what, as a substantive matter, should a policy addressing x do?—would exist even if Mr. Davis’s constitutionally constrained regulatory process were implemented.  Suppose that we got rid of independent agencies, curtailed delegations of rulemaking authority to the executive branch, and returned to a system in which Congress wrote all rules, the executive branch enforced them, and the courts resolved any disputes.  Someone would still have to write the rule, and that someone (or group of people) should have some sense of the pros and cons of one approach over another.  That is what my book seeks to provide.

A hard core Hayekian—one who had immersed himself in Law, Legislation, and Liberty—might respond that no one should design regulation (purposive rules that Hayek would call thesis) and that efficient, “purpose-independent” laws (what Hayek called nomos) will just emerge as disputes arise.  But that is not Mr. Davis’s view.  He writes:

A system of governance or regulation based on the rule of law attains its policy objectives by proscribing actions that are inconsistent with those objectives.  For example, this type of regulation would prohibit a regulated party from discharging a pollutant in any amount greater than the limiting amount specified in the regulation.  Under this proscriptive approach to regulation, any and all actions not specifically prohibited are permitted.

Mr. Davis has thus contemplated a purposive rule, crafted by someone.  That someone should know the various policy options and the upsides and downsides of each.  How to Regulate could help.

Conclusion

I’m not sure why Mr. Davis viewed my book as no more than dressed-up progressivism.  Maybe he was triggered by the book’s cover art, which he says “is faithful to the progressive tradition,” resembling “the walls of public buildings from San Francisco to Stalingrad.”  Maybe it was a case of Sunstein Derangement Syndrome.  (Progressive legal scholar Cass Sunstein had nice things to say about the book, despite its criticisms of a number of his ideas.)  Or perhaps it was that I used the term “market failure.”  Many conservatives and libertarians fear, with good reason, that conceding the existence of market failures invites all sorts of government meddling.

At the end of the day, though, I believe we classical liberals should stop pretending that market outcomes are always perfect, that pure private ordering is always and everywhere the best policy.  We should certainly sing markets’ praises; they usually work so well that people don’t even notice them, and we should point that out.  We should continually remind people that government interventions also fail—and in systematic ways (e.g., the knowledge problem and public choice concerns).  We should insist that a market failure is never a sufficient condition for a governmental fix; one must always consider whether the cure will be worse than the disease.  In short, we should take and promote the view that government should operate “under a presumption of error.”

That view, economist Aaron Director famously observed, is the essence of laissez faire.  It’s implicit in the purpose statement of the Federalist Society’s Regulatory Transparency Project.  And it’s the central point of How to Regulate.

So let’s go easy on the friendly fire.

In 2014, Benedict Evans, a venture capitalist at Andreessen Horowitz, wrote “Why Amazon Has No Profits (And Why It Works),” a blog post in which he tried to explain Amazon’s business model. He began with a chart of Amazon’s revenue and net income that has now become (in)famous:

Source: Benedict Evans

A question inevitably followed in antitrust circles: How can a company that makes so little profit on so much revenue be worth so much money? It must be predatory pricing!

Predatory pricing is a rather rare anticompetitive practice because the “predator” runs the risk of bankrupting itself in the process of trying to drive rivals out of business with below-cost pricing. Furthermore, even if a predator successfully clears the field of competition, in developed markets with deep capital markets, keeping out new entrants is extremely unlikely.

Nonetheless, in those rare cases where plaintiffs can demonstrate that a firm actually has a viable scheme to drive competitors from the market with prices that are “too low” and has the ability to recoup its losses once it has cleared the market of those competitors, plaintiffs (including the DOJ) can prevail in court.

In other words, whoa if true.

Khan’s Predatory Pricing Accusation

In 2017, Lina Khan, then a law student at Yale, published “Amazon’s Antitrust Paradox” in a note for the Yale Law Journal and used Evans’ chart as supporting evidence that Amazon was guilty of predatory pricing. In the abstract she says, “Although Amazon has clocked staggering growth, it generates meager profits, choosing to price below-cost and expand widely instead.”

But if Amazon is selling below-cost, where does the money come from to finance those losses?

In her article, Khan hinted at two potential explanations: (1) Amazon is using profits from the cloud computing division (AWS) to cross-subsidize losses in the retail division or (2) Amazon is using money from investors to subsidize short-term losses:

Recently, Amazon has started reporting consistent profits, largely due to the success of Amazon Web Services, its cloud computing business. Its North America retail business runs on much thinner margins, and its international retail business still runs at a loss. But for the vast majority of its twenty years in business, losses—not profits—were the norm. Through 2013, Amazon had generated a positive net income in just over half of its financial reporting quarters. Even in quarters in which it did enter the black, its margins were razor-thin, despite astounding growth.

Just as striking as Amazon’s lack of interest in generating profit has been investors’ willingness to back the company. With the exception of a few quarters in 2014, Amazon’s shareholders have poured money in despite the company’s penchant for losses.

Revising predatory pricing doctrine to reflect the economics of platform markets, where firms can sink money for years given unlimited investor backing, would require abandoning the recoupment requirement in cases of below-cost pricing by dominant platforms.

Below-Cost Pricing Not Subsidized by Investors

But neither explanation withstands scrutiny. First, the money is not from investors. Amazon has not raised equity financing since 2003. Nor is it debt financing: The company’s net debt position has been near-zero or negative for its entire history (excluding the Whole Foods acquisition):

Source: Benedict Evans

Amazon does not require new outside financing because it has had positive operating cash flow since 2002:

Notably for a piece of analysis attempting to explain Amazon’s business practices, the text of Khan’s 93-page law review article does not include the word “cash” even once.

Below-Cost Pricing Not Cross-Subsidized by AWS

Source: The Information

As Priya Anand observed in a recent piece for The Information, since Amazon started breaking out AWS in its financials, operating income for the North America retail business has been significantly positive:

But [Khan] underplays its retail profits in the U.S., where the antitrust debate is focused. As the above chart shows, its North America operation has been profitable for years, and its operating income has been on the rise in recent quarters. While its North America retail operation has thinner margins than AWS, it still generated $2.84 billion in operating income last year, which isn’t exactly a rounding error compared to its $4.33 billion in AWS operating income.

Below-Cost Pricing in Retail Also Known as “Loss Leader” Pricing

Okay, so maybe Amazon isn’t using below-cost pricing in aggregate in its retail division. But it still could be using profits from some retail products to cross-subsidize below-cost pricing for other retail products (e.g., diapers), with the intention of driving competitors out of business to capture monopoly profits. This is essentially what Khan claims happened in the Diapers.com (Quidsi) case. But in the retail industry, diapers are explicitly cited as a loss leader that help retailers to develop a customer relationship with mothers in the hopes of selling them a higher volume of products over time. This is exactly what the founders of Diapers.com told Inc Magazine in a 2012 interview (emphasis added):

We saw brick-and-mortar stores, the Wal-Marts and Targets of the world, using these products to build relationships with mom and the end consumer, bringing them into the store and selling them everything else. So we thought that was an interesting model and maybe we could replicate that online. And so we started with selling the loss leader product to basically build a relationship with mom. And once they had the passion for the brand and they were shopping with us on a weekly or a monthly basis that they’d start to fall in love with that brand. We were losing money on every box of diapers that we sold. We weren’t able to buy direct from the manufacturers.

An anticompetitive scheme could be built into such bundling, but in many if not the overwhelming majority of these cases, consumers are the beneficiaries of lower prices and expanded output produced by these arrangements. It’s hard to definitively say whether any given firm that discounts its products is actually pricing below average variable cost (“AVC”) without far more granular accounting ledgers than are typically  maintained. This is part of the reason why these cases can be so hard to prove.

A successful predatory pricing strategy also requires blocking market entry when the predator eventually raises prices. But the Diapers.com case is an explicit example of repeated entry that would defeat recoupment. In an article for the American Enterprise Institute, Jeffrey Eisenach shares the rest of the story following Amazon’s acquisition of Diapers.com:

Amazon’s conduct did not result in a diaper-retailing monopoly. Far from it. According to Khan, Amazon had about 43 percent of online sales in 2016 — compared with Walmart at 23 percent and Target with 18 percent — and since many people still buy diapers at the grocery store, real shares are far lower.

In the end, Quidsi proved to be a bad investment for Amazon: After spending $545 million to buy the firm and operating it as a stand-alone business for more than six years, it announced in April 2017 it was shutting down all of Quidsi’s operations, Diapers.com included. In the meantime, Quidsi’s founders poured the proceeds of the Amazon sale into a new online retailer — Jet.com — which was purchased by Walmart in 2016 for $3.3 billion. Jet.com cofounder Marc Lore now runs Walmart’s e-commerce operations and has said publicly that his goal is to surpass Amazon as the top online retailer.

Sussman’s Predatory Pricing Accusation

Earlier this year, Shaoul Sussman, a law student at Fordham University, published “Prime Predator: Amazon and the Rationale of Below Average Variable Cost Pricing Strategies Among Negative-Cash Flow Firms” in the Journal of Antitrust Enforcement. The article, which was written up by David Dayen for In These Times, presents a novel two-part argument for how Amazon might be profitably engaging in predatory pricing without raising prices:

  1. Amazon’s “True” Cash Flow Is Negative

Sussman argues that the company has been inflating its free cash flow numbers by excluding “capital leases.” According to Sussman, “If all of those expenses as detailed in its statements are accounted for, Amazon experienced a negative cash outflow of $1.461 billion in 2017.” Even though it’s not dispositive of predatory pricing on its own, Sussman believes that a negative free cash flow implies the company has been selling below-cost to gain market share.

2. Amazon Recoups Losses By Lowering AVC, Not By Raising Prices

Instead of raising prices to recoup losses from pricing below-cost, Sussman argues that Amazon flies under the antitrust radar by keeping consumer prices low and progressively decreasing AVC, ostensibly through using its monopsony power to offload costs on suppliers and partners (although this point is not fully explored in his piece).

But Sussman’s argument contains errors in both legal reasoning as well as its underlying empirical assumptions.

Below-cost pricing?

While there are many different ways to calculate the “cost” of a product or service, generally speaking, “below-cost pricing” means the price is less than marginal cost or AVC. Typically, courts tend to rely on AVC when dealing with predatory pricing cases. And as Herbert Hovenkamp has noted, proving that a price falls below the AVC is exceedingly difficult, particularly when dealing with firms in dynamic markets that sell a number of differentiated but complementary goods or services. Amazon, the focus of Sussman’s article, is a useful example here.

When products are complements, or can otherwise be bundled, firms may also be able to offer discounts that are unprofitable when selling single items. In business this is known as the “razor and blades model” (i.e., sell the razor handle below-cost one time and recoup losses on future sales of blades — although it’s not clear if this ever actually happens). Printer manufacturers are also an oft-cited example here, where printers are often sold below AVC in the expectation that the profits will be realized on the ongoing sale of ink. Amazon’s Kindle functions similarly: Amazon sells the Kindle around its AVC, ostensibly on the belief that it will realize a profit on selling e-books in the Kindle store.

Yet, even ignoring this common and broadly inoffensive practice, Sussman’s argument is odd. In essence, he claims that Amazon is concealing some of its costs in the form of capital leases in an effort to conceal its below-AVC pricing while it works to simultaneously lower its real AVC below the prices it charges consumers. At the end of this process, once its real AVC is actually sufficiently below consumers prices, it will (so the argument goes) be in the position of a monopolist reaping monopoly profits.

The problem with this argument should be immediately apparent. For the moment, let’s ignore the classic recoupment problem where new entrants will be drawn into the market to win some of those monopoly prices based on the new AVC that is possible. The real problem with his logic is that Sussman basically suggests that if Amazon sharply lowers AVC — that is it makes production massively more efficient — and then does not drop prices, they are a “predator.” But by pricing below its AVC in the first place, consumers in essence were given a loan by Amazon — they were able to enjoy what Sussman believes are radically low prices while Amazon works to actually make those prices possible through creating production efficiencies. It seems rather strange to punish a firm for loaning consumers a large measure of wealth. Its doubly odd when you then re-factor the recoupment problem back in: as soon as other firms figure out that a lower AVC is possible, they will enter the market and bid away any monopoly profits from Amazon.

Sussman’s Technical Analysis Is Flawed

While there are issues with Sussman’s general theory of harm, there are also some specific problems with his technical analysis of Amazon’s financial statements.

Capital Leases Are a Fixed Cost

First, capital leases should be not be included in cost calculations for a predatory pricing case because they are fixed — not variable — costs. Again, “below-cost” claims in predatory pricing cases generally use AVC (and sometimes marginal cost) as relevant cost measures.

Capital Leases Are Mostly for Server Farms

Second, the usual story is that Amazon uses its wildly-profitable Amazon Web Services (AWS) division to subsidize predatory pricing in its retail division. But Amazon’s “capital leases” — Sussman’s hidden costs in the free cash flow calculations — are mostly for AWS capital expenditures (i.e., server farms).

According to the most recent annual report: “Property and equipment acquired under capital leases was $5.7 billion, $9.6 billion, and $10.6 billion in 2016, 2017, and 2018, with the increase reflecting investments in support of continued business growth primarily due to investments in technology infrastructure for AWS, which investments we expect to continue over time.”

In other words, any adjustments to the free cash flow numbers for capital leases would make Amazon Web Services appear less profitable, and would not have a large effect on the accounting for Amazon’s retail operation (the only division thus far accused of predatory pricing).

Look at Operating Cash Flow Instead of Free Cash Flow

Again, while cash flow measures cannot prove or disprove the existence of predatory pricing, a positive cash flow measure should make us more skeptical of such accusations. In the retail sector, operating cash flow is the appropriate metric to consider. As shown above, Amazon has had positive (and increasing) operating cash flow since 2002.

Your Theory of Harm Is Also Known as “Investment”

Third, in general, Sussman’s novel predatory pricing theory is indistinguishable from pro-competitive behavior in an industry with high fixed costs. From the abstract (emphasis added):

[N]egative cash flow firm[s] … can achieve greater market share through predatory pricing strategies that involve long-term below average variable cost prices … By charging prices in the present reflecting future lower costs based on prospective technological and scale efficiencies, these firms are able to rationalize their predatory pricing practices to investors and shareholders.

“’Charging prices in the present reflecting future lower costs based on prospective technological and scale efficiencies” is literally what it means to invest in capex and R&D.

Sussman’s paper presents a clever attempt to work around the doctrinal limitations on predatory pricing. But, if courts seriously adopt an approach like this, they will be putting in place a legal apparatus that quite explicitly focuses on discouraging investment. This is one of the last things we should want antitrust law to be doing.

On July 10 a federal judge ruled that Apple violated antitrust law by conspiring to raise prices of e-books when it negotiated deals with five major publishers. I’ve written on the case and the issues involved in it several times, including here, here, here and here. The most recent of these was titled, “Why I think the government will have a tough time winning the Apple e-books antitrust case.” I’m hedging my bets with the title this time, but it’s fairly clear to me that the court got this case wrong.

The predominant sentiment among pundits following the decision seems to be approval (among authors, however, the response to the suit has been decidedly different). Supporters believe it will lower e-book prices and instigate a shift in the electronic publishing industry toward some more-preferred business model. This sort of reasoning is dangerous and inconsistent with principled, restrained antitrust. Neither the government nor its supporting commentators should use, or applaud the use, of antitrust to impose the government’s (or anyone else’s) preferred business model on industry. And lower prices in the short run, while often an indication of increased competition, are not, by themselves, sufficient to determine that a business model is efficient in the long run.

For example, in a recent article, Mark Lemley is quoted supporting the outcome, noting that it may spur a shift toward his preferred model of electronic publishing:

It also makes no sense that publishers, not authors, capture most of the revenue from e-books, when they do very little of the work. I understand why publishers are reluctant to give up their old business model, but if they want to survive in the digital world, it’s time to make some changes.

As noted, there is no basis for using antitrust enforcement to coerce an industry to shift to a particular distribution of profits simply because “it’s time to make some changes.” Lemley’s characterization of the market’s dynamics is also seriously lacking in economic grounding (and the Authors Guild response to the suit linked above suggests the same). The economics of entrepreneurship has an impressive intellectual pedigree that began with Frank Knight, was further developed by Joseph Schumpeter, Israel Kirzner and Harold Demsetz, among others, and continues to today with its inclusion as a factor of production. (On the development of this tradition and especially Harold Demsetz’s important contribution to it, see here). The implicit claim that publishers’ and authors’ interests (to say nothing of consumers’ interests) are simply at odds, and that the “right” distribution of profits would favor authors over publishers based on the amount of “work” they do is economically baseless. Although it is a common claim, reflecting either idiosyncratic preferences or ignorance about the role of content publishers and distributors in the e-book marketplace and the role of entrepreneurship more generally, it is nonetheless mistaken and has no place in a consumer-welfare-based assessment of the market or antitrust intervention in it.

It’s also utterly unclear how the antitrust suit would do anything to change the relative distribution of profits between publishers and authors. In fact, the availability of direct publishing (offered by both Amazon and Apple) is the most likely disruptor of that dynamic, and authors could only be helped by an increase in competition among platforms—in other words, by Apple’s successful entry into the market.

Apple entered the e-books market as a relatively small upstart battling a dominant incumbent. That it did so by offering publishers (suppliers) attractive terms to deal with its new iBookstore is no different than a new competitor in any industry offering novel products or loss-leader prices to attract customers and build market share. When new entry then induces an industry-wide shift toward the new entrants’ products, prices or business model it’s usually called “competition,” and lauded as the aim of properly functioning markets. The same should be true here.

Despite the court’s claim that

there is overwhelming evidence that the Publisher Defendants joined with each other in a horizontal price-fixing conspiracy,

that evidence is actually extremely weak. What is unclear is why the publishers would need a conspiracy when they rarely compete against each other directly.

The court states that

To protect their then-existing business model, the Publisher Defendants agreed to raise the prices of e-books by taking control of retail pricing.

But despite the use of the antitrust trigger-words, “agreed to raise prices,” this agreement is not remotely clear, and rests entirely on circumstantial evidence (more on this later). None of the evidence suggests actual agreement over price, and none of the evidence demonstrates conclusively any real incentive for the publishers to reach “agreement” at all. In actuality, publishers rarely compete against each other directly (least of all on price); instead, for each individual publisher (and really for each individual title), the most relevant competition for this case is between the e-book version of a particular title and its physical counterpart. In this situation it should matter little to any particular e-book’s sales whether every other e-book in the world is sold at the same price or even a lower price.

While the opinion asserts that each publisher

could also expect to lose substantial sales if they unilaterally raised the prices of their own e-books and none of their competitors followed suit,

it also states that

there is no evidence that the Publisher Defendants have ever competed with each other on price. To the contrary, several of the Publishers’ CEOs explained that they have not competed with each other on that basis.

These statements are difficult to reconcile, but the evidence supports the latter statement, not the former.

The only explanation offered by the court for the publishers’ alleged need for concerted action is an ambiguous claim that Amazon would capitulate in shifting to the agency model only if every publisher pressured it to do so simultaneously. The court claims that

if the Publisher Defendants were going to take control of e-book pricing and move the price point above $9.99, they needed to act collectively; any other course would leave an individual Publisher vulnerable to retaliation from Amazon.

But it’s not clear why this would be so.

On the one hand, if Apple really were the electronic publishing juggernaut implied by this antitrust action, this concern should be minimal: Publishers wouldn’t need Amazon and could simply sell their e-books through Apple’s iBookstore. In this case the threat of even any individual publisher’s “retaliation” against Amazon (decamping to Apple) would suffice to shift relative bargaining power between the publishers and Amazon, and concerted action wouldn’t be necessary. On this theory, the fact that it was only after Apple’s entry that Amazon agreed to shift to the agency model—a fact cited by the court many times to support its conclusions—is utterly unremarkable.

That prices may have shifted as well is equally unremarkable: The agency model puts pricing decisions in publishers’ hands (who, as I’ve previously discussed, have very different incentives than Amazon) where before Amazon had control over prices. Moreover, even when Apple presented evidence that average e-book prices actually fell after its entrance into the market, the court demanded that Apple prove a causal relationship between its entrance and lower overall prices. (Even the DOJ’s own evidence shows, at worst, little change in price, despite its heated claims to the contrary.) But the burden of proof in such cases rests with the government to prove that Apple caused prices to rise, not for Apple to explain why they fell.

On the other hand, if the loss of Amazon as a retail outlet were really so significant for publishers, Apple’s ability to function as the lynchpin of the alleged conspiracy is seriously questionable. While the agency model coupled with the persistence of $9.99 pricing by Amazon would seem to mean reduced revenue for publishers on each book sold through Apple’s store, the relatively trivial number of Apple sales compared with Amazon’s, particularly at the outset, would be of little concern to publishers, and thus to Amazon. In this case it is difficult to believe that publishers would threaten their relationships with Amazon for the sake of preserving the return on their newly negotiated contracts with Apple (and even more difficult to believe that Amazon would capitulate), and the claimed coordinating effects of the MFN provisions is difficult to sustain.

The story with respect to Amazon is questionable for another reason. While the court claims that the publishers’ concern with Amazon’s $9.99 pricing was its effect on physical book sales, it is extremely hard to believe that somehow $12.99 for the electronic version of a $30 (or, often, even more expensive) physical book would be significantly less damaging to physical book sales. Moreover, the evidence put forth by the DOJ and found persuasive by the court all pointed to e-book revenues alone, not physical book sales, as the issue of most concern to publishers (thus, for example, Steve Jobs wrote to HarperCollins’ CEO that it could “[k]eep going with Amazon at $9.99. You will make a bit more money in the short term, but in the medium term Amazon will tell you they will be paying you 70% of $9.99. They have shareholders too.”).

Moreover, as Joshua Gans points out, the agency model that Amazon may have entered into with the publishers would have been particularly unhelpful in ensuring monopoly returns for the publishers (we don’t know the exact terms of their contracts, however, and there are reports from trial that Amazon’s terms were “identical” to Apple’s):

While Apple gave publishers a 70 percent share of book sales and the ability to set their own price, Amazon offered a menu. If you price below $9.99 for a book, Amazon’s share will be 70 percent but if you price above $10, Amazon only returns 35 percent to the publisher. Amazon also charged publishers a delivery fee based on the book’s size (in kb).

Thus publishers could, of course, raise prices to $12.99 in both Apple’s and Amazon’s e-book stores, but, if this effective price cap applied, doing so would result in a significant loss of revenue from Amazon. In other words, the court’s claim—that, having entered into MFNs with Apple, the publishers then had to move Amazon to the agency model to ensure that they didn’t end up being forced by the MFNs to sell books via Apple (on the less-attractive agency terms) at Amazon’s $9.99—is far-fetched. To the extent that raising Amazon’s prices above $10 may have cut royalties almost in half, the MFNs with Apple would be extremely unlikely to have such a powerful effect. But, as noted above, because of the relative sales volumes involved the same dynamic would have applied even under identical terms.

It is true, of course, that Apple cares about price differences between books sold through its iBookstore and the same titles sold through other electronic retailers—and thus it imposed MFN clauses on the publishers. But this is not anticompetitive. In fact, by facilitating Apple’s entry, the MFN clauses plainly increased competition by introducing a new competitor to the industry. What’s more, the terms of Apple’s agreements with the publishers exactly mirrors the terms it uses for apps and music sold through the iTunes store, as well. And as Gordon Crovitz noted:

As this column reported when the case was brought last year, Apple executive Eddy Cue in 2011 turned down my effort to negotiate different terms for apps by news publishers by telling me: “I don’t think you understand. We can’t treat newspapers or magazines any differently than we treat FarmVille.” His point was clear: The 30% revenue-share model is how Apple does business with everyone. It is not, as the government alleges, a scheme Apple concocted to fix prices with book publishers.

Another important error in the case — and, unfortunately, it is one to which Apple’s lawyers acceded—is the treatment of “trade e-books” as the relevant market. For antitrust purposes, there is no generalized e-book (or physical book, for that matter) market. As noted above, the court itself acknowledged that the publishers “have [n]ever competed with each other on price.” The price of Stephen King’s latest novel likely has, at best, a trivial effect on sales of…nearly every other fiction book published, and probably zero effect on sales of non-fiction books.

This is important because the court’s opinion turns on mostly circumstantial evidence of an alleged conspiracy among publishers to raise prices and on the role of concerted action in protecting publishers from being “undercut” by their competitors. But in a world where publishers don’t compete on price (and where the alleged agreement would have reduced the publishers’ revenues in the short run and done little if anything to shore up physical book sales in the long run), it is far-fetched to interpret this evidence as the court does—to infer a conspiracy to raise prices.

Meanwhile, by restricting itself to consideration of competitive effects in the e-book market alone, the court also inappropriately and without commentary dispenses with Apple’s pro-competitive justifications for its conduct. Put simply, Apple contends that its entry into the e-book retail and reader markets was facilitated by its contract terms. But the court ignores these arguments.

On the one hand, it does so because it treats this as a per se case, in which procompetitive effects are irrelevant. But the court’s determination to treat this as a per se case—with its lengthy recitation of relevant legal precedent and only cursory application of precedent to the facts of the case—is suspect. As I have noted before:

What would [justify per se treatment] is if the publishers engaged in concerted action to negotiate these more-favorable terms with other publishers, and what would be problematic for Apple is if its agreement with each publisher facilitated that collusion.

But I don’t see any persuasive evidence that the terms of Apple’s deals with each publisher did any such thing. For MFNs to perform the function alleged by the DOJ it seems to me that the MFNs would have to contribute to the alleged agreement between the publishers, just as the actions of the vertical co-conspirators in Interstate Circuit and Toys-R-Us were alleged to facilitate coordination. But neither the agency agreement itself nor the MFN and price cap terms in the contracts in any way affected the publishers’ incentive to compete with each other. Nor, as noted above, did they require any individual publisher to cause its books to be sold at higher prices through other distributors.

Even if it is true that the publishers participated in a per se illegal horizontal price fixing scheme (and despite the court’s assertion that this is beyond dispute, the evidence is not nearly so clear as the court suggests), Apple’s unique role in that alleged scheme can’t be analyzed in the same fashion. As Leegin notes (and the court in this case quotes), for conduct to merit per se treatment it must “always or almost always tend to restrict competition and decrease output.” But the conduct at issue here—whether somehow coupled with a horizontal price fixing scheme or not—doesn’t meet this standard. The agency model, the MFN terms in the publishers’ contracts with Apple, and the efforts by Apple to secure broad participation by the largest publishers before entering the market are all potentially—if not likely—procompetitive. And output seems to have increased substantially following Apple’s entry into the e-book retail market.

In short, I continue to believe that the facts of this case do not merit per se treatment, and there is a good chance the court’s opinion could be overturned on this ground. For this reason, its rejection of Apple’s procompetitive arguments was inappropriate.

But even in its brief “even under the rule of reason…” analysis, the court improperly rejects Apple’s procompetitive arguments. The court’s consideration of these arguments is basically summed up here:

The pro-competitive effects to which Apple has pointed, including its launch of the iBookstore, the technical novelties of the iPad, and the evolution of digital publishing more generally, are phenomena that are independent of the Agreements and therefore do not demonstrate any pro-competitive effects flowing from the Agreements.

But this is factually inaccurate. Apple has claimed that its entry—and thus at minimum its development and marketing of the iPad as an e-reader and its creation of the iBookstore—were indeed functions of the contract terms and the simultaneous acceptance by the largest publishers of these terms.

The court goes on to assert that, even if the claimed pro-competitive effect was the introduction of competition into the e-book market,

Apple demanded, as a precondition of its entry into the market, that it would not have to compete with Amazon on price. Thus, from the consumer’s perspective — a not unimportant perspective in the field of antitrust — the arrival of the iBookstore brought less price competition and higher prices.

In making this claim the court effectively—and improperly—condemns MFNs to per se illegal status. In doing so the court claims that its opinion’s reach is not so broad:

this Court has not found that any of these [agency agreements, MFN clauses, etc.]…components of Apple’s entry into the market were wrongful, either alone or in combination. What was wrongful was the use of those components to facilitate a conspiracy with the Publisher Defendants”

But the claimed absence of retail price competition that accompanied Apple’s entry is entirely a function of the MFN clauses: Whether at $9.99 or $12.99, the MFN clauses were what ensured that Apple’s and Amazon’s prices would be the same, and disclaimer or not they are swept in to the court’s holding.

This effective condemnation of MFN clauses, while plainly sought by the DOJ, is simply inappropriate as a matter of law. In order to condemn Apple’s conduct under the per se rule, the court relies on the operation of the MFNs in allegedly reducing competition and raising prices to make its case. But that these do not “always or almost always tend to restrict competition and reduce output” is clear. While the DOJ may view such terms otherwise (more on this here and here), courts have not done so, and Leegin’s holding that such vertical restraints are to be assessed under the rule of reason still holds. The court’s use of the per se standard and its refusal to consider Apple’s claimed pro-competitive effects are improper.

Thus I (somewhat more cautiously this time…) suggest that the court’s decision may be overturned on appeal, and I most certainly think it should be. It seems plainly troubling as a matter of economics, and inappropriate as a matter of law.

Trial begins today in the Southern District of New York in United States v. Apple (the Apple e-books case), which I discussed previously here. Along with co-author Will Rinehart, I also contributed an  essay to a discussion of the case in Concurrences (alongside contributions from Jon Jacobson and Mark Powell, among others).

Much of my writing on the case has essentially addressed it as a rule of reason case, assessing the economic merits of Apple’s contract terms. And as I mention in this Reuters article from yesterday on the case, one of the key issues in this analysis (and one of the government’s key targets in the case) is the use of MFN clauses.

But as Josh pointed out in a blog post last year,

my hunch is that if the case is litigated its legacy will be as an “agreement” case rather than what it contributes to rule of reason analysis.  In other words, if Apple gets to the rule of reason, the DOJ (like most plaintiffs in rule of reason cases) are likely to lose — especially in light of at least preliminary evidence of dramatic increases in output.  The critical question — I suspect — will be about proof of an actual naked price fixing agreement among publishers and Apple, and as a legal matter, what evidence is sufficient to establish that agreement for the purposes of Section 1 of the Sherman Act.

He’s likely correct, of course, that a central question at trial will be whether or not this is a per se or rule of reason case, and that trial will focus in significant part on the sufficiency of the evidence of agreement. But because this determination will turn considerably on the purpose and function of the MFN and price cap terms in Apple’s agreements with the publishers, I don’t think there should (or will) be much difference. Nor do I think the government should (or will) win.

Before the court can apply the per se rule, it must satisfy itself that the conduct at issue “would always or almost always tend to restrict competition and decrease output.” But it is not true as a matter of economics — and certainly not true as a matter of law — that MFNs meet this standard.

After State Oil v. Kahn there can be no question about the rule of reason (if not per se legal) status of price caps. And as the Court noted in Leegin:

Resort to per se rules is confined to restraints, like those mentioned, “that would always or almost always tend to restrict competition and decrease output.” To justify a per se prohibition a restraint must have “manifestly anticompetitive” effects, and “lack any redeeming virtue.

As a consequence, the per se rule is appropriate only after courts have had considerable experience with the type of restraint at issue, and only if courts can predict with confidence that it would be invalidated in all or almost all instances under the rule of reason. It should come as no surprise, then, that “we have expressed reluctance to adopt per se rules with regard to restraints imposed in the context of business relationships where the economic impact of certain practices is not immediately obvious.” And, as we have stated, a “departure from the rule-of-reason standard must be based upon demonstrable economic effect rather than . . . upon formalistic line drawing.”

After Leegin, all vertical non-price restraints, including MFNs, are assessed under the rule of reason.  Courts neither have “considerable experience” with MFNs, nor can they remotely “predict with confidence that they would be invalidated in all or almost all instances under the rule of reason.” As a recent article in Antitrust points out,

The DOJ and FTC have brought approximately ten cases over the last two decades challenging MFNs. Most of these cases involved the health care industry and all were resolved by consent judgments.

Even if the court does take a harder look at whether a per se rule should govern, however, as a practical matter there is not likely to be much difference between a “does this merit per se treatment” analysis and analysis of the facts under the rule of reason. As the Court pointed out in California Dental Association,

The truth is that our categories of analysis of anticompetitive effect are less fixed than terms like “per se,” “quick look,” and “rule of reason” tend to make them appear. We have recognized, for example, that “there is often no bright line separating per se from Rule of Reason analysis,” since “considerable inquiry into market conditions” may be required before the application of any so-called “per se” condemnation is justified. “[W]hether the ultimate finding is the product of a presumption or actual market analysis, the essential inquiry remains the same–whether or not the challenged restraint enhances competition.”

And as my former classmate Tom Nachbar points out in a recent article,

it’s hard to identity much relative simplicity in the per se rule. Indeed, the moniker “per se” has become somewhat misleading, as cases determining whether to apply the per se or rule of reason become as long as ones actually applying the rule of reason itself.

Of course that doesn’t end the analysis, and the government’s filings do all they can to sidestep the direct antitrust treatment of MFNs and instead assert that they (and other evidence alleged) permit the court to infer Apple’s participation as the coordinator of a horizontal price-fixing conspiracy among the publishers.

But as Apple argues in its filings,

The[ relevant] cases mandate an inquiry into the possibility that the challenged contract terms and negotiation approach were in Apple’s independent economic interests. The evidence is overwhelming—not just possible—that Apple acted for its own valid business reasons and not to “raise consumer prices market-wide.”…Plaintiffs ask this Court to infer Apple’s participation in a conspiracy from (1) its MFN and price cap terms and (2) negotiations with publishers.

* * *

What is obvious, however, is that Apple has not fixed prices with its competitors. What is remarkable is that the government seeks to impose grave legal consequences on an inherently pro-competitive act—entry—accomplished via agency, an MFN, and price caps, none of which is per se unlawful.

The government’s strenuous objection to Apple’s interpretation of the controlling Supreme Court authority, Monsanto v. Spray-Rite, notwithstanding, it’s difficult to see the MFN clauses as evidence of Apple’s participation in the publishers’ alleged conspiracy.

An important point supporting Apple’s argument here is that, unlike the “hubs” in the other “hub and spoke” conspiracies on which the DOJ bases its case, Apple has no significant leverage over the alleged co-conspirators, and thus no power to coordinate — let alone enforce — a price-fixing scheme. As Apple argues in its Opposition brief,

The only “power” Apple could wield over the publishers was the attractiveness of a business opportunity—hardly the “make or break” scenarios found in Interstate Circuit and [Toys-R-Us]. Far from capitulating to Apple’s requested core business terms, the publishers fought Apple tooth and nail and negotiated intensely to the very end, and the largest, Random House, declined.

And as Will and I note in our Concurrences article,

MFNs are essentially an important way of…offering some protection against publishers striking a deal with a competitor that leaves Apple forced to price its ebooks out of the market.

There is nothing, that we know of, in the MFNs or elsewhere in the agreements that requires the publishers to impose higher resale prices elsewhere, or prevents the publishers from selling through Apple at a lower price, if necessary. Most important, for Apple’s negotiated prices to dominate in the market it would have to enjoy market power – a condition, currently at least, that is exceedingly unlikely given its 10% share of the ebook market.

The point is that, even if everything the government alleges about the publishers’ price fixing scheme were true, it’s extremely difficult to see Apple as a co-conspirator in such a scheme. The Supreme Court’s holding in Monsanto stands for nothing if not the principle that courts may not infer a vertical party’s participation in a horizontal price-fixing scheme from the existence of otherwise-legal and -defensible interactions between the vertically related parties. Because MFNs have valid purposes outside the realm of price-fixing, they may not be converted into illegal conduct on Apple’s part simply because they might also “sharpen [a publisher’s] incentives” to try to raise prices elsewhere.

Remember, we are in a world where the requisite anticompetitive conduct can’t be simply the vertical restraint itself. Rather, we’re evaluating whether the vertical restraint was part of a broader anticompetitive scheme among the publishers. For the MFN clauses to be part of that alleged scheme they must have an identifiable place in the scheme.

First of all, it is unremarkable that Apple might offer terms to any individual publisher (or to all publishers independently) that might be more favorable to the publisher than terms it is getting elsewhere; that’s how a new entrant in Apple’s position attracts suppliers. It is likewise unremarkable that Apple would seek to impose terms (like the MFN) that would preserve its ability to offer a publisher’s books for the same price they are offered elsewhere (which is necessary because the agency agreements negotiated by Apple otherwise remove pricing authority from Apple and confer it on the publishers themselves). And finally it is unremarkable that each publisher would try to negotiate similarly favorable terms with other distributors (or, more accurately, continue to try: bargaining over distribution terms with other distributors hardly started only after the agreements were signed with Apple). What would be notable is if the publishers engaged in concerted action to negotiate these more-favorable terms with other publishers, and what would be problematic for Apple is if its agreement with each publisher facilitated that collusion.

But I don’t see any persuasive evidence that the terms of Apple’s deals with each publisher did any such thing. For MFNs to perform the function alleged by the DOJ it seems to me that the MFNs would have to contribute to the alleged agreement between the publishers, just as the actions of the vertical co-conspirators in Interstate Circuit and Toys-R-Us were alleged to facilitate coordination. But neither the agency agreement itself nor the MFN and price cap terms in the contracts in any way affected the publishers’ incentive to compete with each other. Nor, as noted above, did they require any individual publisher to cause its books to be sold at higher prices through other distributors.

On this latter point, the DOJ alleges that the MFNs “sharpen[ed publishers’] incentives” to raise prices:

If a retailer were allowed to remain on wholesale terms, and that retailer continued to price new release e-books at $9.99, the Publisher Defendant would be forced to lower the iBookstore price to match the $9.99 price

Not only does this say nothing about the incentives of the publishers to compete with each other on price (except that it may have increased that incentive by undermining the prevailing $9.99-for-all-books standard), it seems far-fetched to suggest that fear of having to lower prices for books sold in Apple’s relatively trivial corner of the market would have an apreciable effect on a publisher’s incentives to raise prices elsewhere. For what it’s worth, it also seems far-fetched to suggest that Apple’s motivation was to raise prices given that e-book sales generate only about .0005% of Apple’s total revenues.

Beyond this, the DOJ essentially argues that Apple coordinated agreement among the publishers to accept the terms being offered by Apple, with the intent and effect that this would lead to imposition by the publishers of similar terms (and higher prices) on other distributors. Perhaps, but it’s a stretch. And if it is true, it isn’t because of the MFN clauses. Moreover, it isn’t clear to me (maybe I’m missing some obvious controlling case law?) that agreement over the type of contract used amounts to an illegal horizontal agreement; arguably in this case, at least, it is closer to an ancillary restraint or  justified agreement (as in BMI, e.g.) than, say, a group boycott or bid rigging. In any case, if the DOJ has a case at all turning on this scenario, I think it will have to be based entirely on the alleged evidence of direct coordination (i.e., communications between Apple and publishers during dinners and phone calls) rather than the operation of the contract terms themselves.

In any case, it will be interesting to see how the trial unfolds.

Apple has filed its response to the DOJ Complaint in the e-books case.  Here is the first paragraph of the Answer:

The Government’s Complaint against Apple is fundamentally flawed as a matter of fact and law. Apple has not “conspired” with anyone, was not aware of any alleged “conspiracy” by others, and never “fixed prices.” Apple individually negotiated bilateral agreements with book publishers that allowed it to enter and compete in a new market segment – eBooks. The iBookstore offered its customers a new outstanding, innovative eBook reading experience, an expansion of categories and titles of eBooks, and competitive prices.

And the last paragraph of the Answer’s introduction:

The Supreme Court has made clear that the antitrust laws are not a vehicle for Government intervention in the economy to impose its view of the “best” competitive outcome, or the “optimal” means of competition, but rather to address anticompetitive conduct. Apple’s entry into eBook distribution is classic procompetitive conduct, and for Apple to be subject to hindsight legal attack for a business strategy well-recognized as perfectly proper sends the wrong message to the market, and will discourage competitive entry and innovation and harm consumers.

A theme that runs throughout the Answer is that the “pre-Apple” world of e-books was characterized by little or no competition and that the agency agreements were necessary for its entry, which in turn has resulted in a dramatic increase in output.  The Answer is available here.  While commentary has focused primarily upon the important question of the competitive effects of the move to the agency model, including Geoff’s post here, my hunch is that if the case is litigated its legacy will be as an “agreement” case rather than what it contributes to rule of reason analysis.  In other words, if Apple gets to the rule of reason, the DOJ (like most plaintiffs in rule of reason cases) are likely to lose — especially in light of at least preliminary evidence of dramatic increases in output.  The critical question — I suspect — will be about proof of an actual naked price fixing agreement among publishers and Apple, and as a legal matter, what evidence is sufficient to establish that agreement for the purposes of Section 1 of the Sherman Act.  The Complaint sets forth the evidence the DOJ purports to have on this score.  But my hunch — and it is no more than that — is that this portion of the case will prove more important than any battle between economic experts on the relevant competitive effects.

Geoffrey A. Manne is the President & Founder at the International Center for Law & Economics. Kristian Stout is the Associate Director of Innovation Policy at the International Center for Law & Economics.

The submissions in this symposium thus far highlight, in different ways, what must be considered the key lesson of the Amazon/Whole Foods merger: It has brought about immense and largely unforeseen (in its particulars, at least) competition — and that competition has been remarkably successful in driving innovations that will likely bring immense benefits to consumers and the economy as a whole.

Both before and after the merger was announced, claims of the coming retail apocalypse — the demise of brick-and-mortar retail at Amazon’s hands — were legion. Grocery stores were just the next notch on Amazon’s belt, and a stepping stone to world domination.

What actually happened in the year following the merger is nearly the opposite: Competition among grocery stores has been more fierce than ever. “Offline” retailers are expanding — and innovating — to meet Amazon’s challenge, and many of them are booming. Disruption is never neat and tidy, but, in addition to saving Whole Foods from potential oblivion, the merger seems to have lit a fire under the rest of the industry.

This result should not be surprising to anyone who understands the nature of the competitive process. But it does highlight an important lesson: competition often comes from unexpected quarters and evolves in unpredictable ways, emerging precisely out of the kinds of adversity opponents of the merger bemoaned. Even when critics were right about some of the potential effects of the merger (lower prices, for example), they were absolutely wrong about the allegedly disastrous consequences they claimed would result.

Of course, one must always be careful drawing lessons from limited data, and a year is not very long in the scheme of things — and certainly not in the grand (and fascinating) history of the grocery store. But the signs thus far are remarkably telling.

Change is the rule in the retail grocery industry (as in every other competitive market)

The ultimate consequences of the Amazon/Whole Foods merger won’t be known for quite some time. Nor will it follow the exact same patterns as previous retail disruptions. Yet there will undoubtedly be some commonality, as there has been in the past. Among other things, the history of the grocery business is intimately tied up with the history of A&P, as William Ruhlman recounts in his fascinating book, Grocery, and as Tim Muris and Jon Nuechterlein discuss, focusing on the antitrust angle, in their article, Antitrust in the Internet Era: The Legacy of United States v. A&P. The main takeaway from that saga is, as Muris & Nuechterlein write, that:

Increasingly integrated and efficient retailers — first A&P, then “big box” brick-and-mortar stores, and now online retailers — have challenged traditional retail models by offering consumers lower prices and greater convenience. For decades, critics on the right and left have reacted to such disruption by urging Congress, the courts, and the enforcement agencies to stop these American success stories by revising antitrust doctrine to protect small businesses rather than the interests of consumers. Using antitrust law to punish pro-competitive behavior makes no more sense today than it did when the government attacked A&P for cutting consumers too good a deal on groceries.

Just as Amazon is feared today, and Walmart was reviled in the 90s and 2000s, A&P was loathed in the first half of the twentieth century for its role in decimating small business. A&P grew to the size it did — at one point the largest retailer in the world — by driving down both costs and prices. That is to say, just as Walmart and Amazon do, A&P discovered the waste in the distribution and retailing system and found ways to better deliver goods and services to consumers on their own terms.

For all the hand wringing (and, of course, antitrust action) surrounding grocery stores in the past (including the misguided FTC action challenging the Whole Foods/Wild Oats merger in 2007), history has demonstrated that the grocery industry is constantly evolving toward better methods of distribution that meet customers’ idiosyncratic — and likewise evolving — preferences. Frequently, this has led to well-established methods of retailing being abandoned, as when the model of having separate vendors for meat, baked goods, dry goods, etc., gave way to the first centralized supermarkets.

What we are witnessing now — and what Amazon/Whole Foods is really emblematic of — is yet another growth spurt in the industry, one where consumer demand for both a high degree of convenience (e.g., same-day delivery) is coupled with the ability to provision fresh, unique goods (e.g., organic, locally-sourced, etc).

But… is this time different — because, you know, Amazon?

Notwithstanding some advocates’ preference for treating digital and analog retailing as distinct “markets,” what’s really happening in the brick-and-mortar world is that retailers understand that, in terms of reaching customers, there is only one “retail” market.

Traditionally offline retailers, like Walmart and Target, as well as supermarkets like Kroger and Giant, were among the landrush to integrate tech-startup, on-demand technologies following the close of the merger. At the same time, online stalwarts have emerged as surprise players in the once staid grocery market. Google, most important among them, has been establishing partnerships with offline retailers in order to provide the digital interfaces to facilitate the online marketing and on-demand delivery needs of the traditionally offline companies.

All of this activity may have been spurred on by the merger, but it is part and parcel of the age-old competitive process — efforts by industry to try to anticipate how consumers, competitors, and… everyone else will behave going forward, and to capture more of the market when they do.

Moreover, it is exemplary of the nature of the grocery industry’s particular evolution, and, although, again, the merger may have served as a proximate trigger for the flurry of activity, the integration of offline and online retailing was basically an inevitability given the development of commerce and technology over the last two decades.

Whatever the very long-term consequences of the merger (and Steve Horwitz, among others, has suggested one plausible consequence: the “hollowing out” of the traditional supermarket, leaving fresh and prepared foods behind in stores and moving dry goods and housewares online), the short-term consequences seem extremely telling.

In short, the death of brick-and-mortar retail is, as Dirk Auer put it (beating us to the punch), greatly exaggerated.

For all the talk of retail dying, the stores that are actually dying are the ones that fail to cater to their customers, not the ones that happen to be offline. In fact, as one article puts it:

Right now, there are at least a dozen new companies in the midst of opening hundreds of new retail stores. And why are they doing this? Because the stores they currently have are making money hand over fist.

You’ve probably heard some of the names: Allbirds, Casper, Birchbox, Boll & Branch. According to real-estate data company CoStar Group, these online-first stores have increased their retail space tenfold over the last five years. Warby Parker is averaging $3,000 per square foot of retail space, which is almost as good as Tiffany’s (!). (Emphasis added)

For every failing Sears store (the chain closed some 250 Sears and Kmart stores in 2017), there are several other retail outlets opening: Last year some 4,000 more retail stores opened than closed.

The same thing is happening in grocery, as well. It’s not that all brick-and-mortar groceries are shuttering; it’s that the un-dynamic, unsuccessful ones are. That’s not a cause for concern; it’s a cause for celebration. As the author of a February 2018 industry analysis notes:

“Retailers die but retail does not,” Cook said about the ongoing evolution in the grocery space. “There’s just churn as retailers are either disrupted by new business models, or they go out of fashion.”

* * *

The most successful grocers today have well-known private labels, fresh food at affordable prices and digital platforms that allow for shopping online, Cook said.

“We’ve got two types of classes in grocery right now: One is about offering the best goods at the lowest prices — it’s a price play that’s targeted at the families in America shopping on a budget, so someone like Aldi is a part of that,” he said. “Another avenue of success is offering a great shopping experience to shoppers who aren’t as price sensitive — those leaders are Whole Foods and Wegmans.” (Emphasis added)

Competition through innovation — and not just online, and not just by Amazon

To be sure, the rise of e-commerce has put pressure on offline retail’s old business models, and it has required it to stake out its comparative advantage, offering services and “experiences” that online retailers can’t easily match.

But the fundamental market reality brought on by the Internet, the emergence of e-commerce, and the blossoming of Amazon in particular is expanded competition. Lackluster retail outlets, particularly in small or remote towns — the ones that some neo-Brandeisians want to preserve at all costs — could, at one time, coast on the protection afforded by geographic isolation (a protection that has, of course, long been under assault by Walmart). But e-commerce can reach everywhere a delivery service can reach, which is to say everywhere — and you don’t even have to drive the 20 miles to Walmart.

Not only that, e-commerce promises not just the local food market’s few thousand products, or even Walmart’s hundreds of thousands, but virtually every product sold virtually anywhere in the world. Amazon — which directly sells only about 30% of the products sold through its platform, and, as a platform, accounts for less than half of e-commerce — has about 500 million products listed.

The point is this: Amazon’s biggest effect on retail isn’t that it’s overpowering its closest brick-and-mortar rivals, decimating the last vestiges of competition, and moving all sales online (after all, e-commerce is still only some 10% of retail sales); it’s that the company is bringing competition to places that haven’t seen very much of it, and picking off the weak and complacent competitors — much to everyone’s benefit.

Those retailers that do survive the alleged “retail apocalypse” will be those that figure out how to offer something better or different than Amazon, with or without Whole Foods:

The truth is that the bigger Amazon gets, the more opportunity it creates for fresh, local alternatives. The more Amazon pushes robot-powered efficiency, the more space there is for warm and individualized service. The more that people interact with Amazon through its AI-based assistant Alexa, the more they will crave the insight and personal connection of fellow humans.

“The idea that everybody needs to be terrified of Amazon is completely wrong,” says Brian Spaly, who co-founded two e-commerce-centric startups, Bonobos (menswear) and Trunk Club (a wardrobe-in-a-box service), which sold to Walmart and Nordstrom, respectively, for nine-figure sums. “Everybody needs to figure out what makes them special and use those weapons to compete.” (Emphasis added)

To put it into an antitrust context, “post-merger product repositioning,” although perpetually (and wrongfully) disregarded by proponents of stronger merger enforcement, is the nature of the beast. Competition need not — indeed, rarely does — replicate the status quo; it evolves beyond it. Amazon combined with Whole Foods isn’t offering exactly what the companies separately offered pre-merger — and their competitors aren’t doing so, either. That’s a good thing, and it creates new opportunities and new mechanisms for fulfilling consumer preferences.

Some of that means further shifting the mix of retail sales that take place in physical stores and online — and even blurring the lines between them, such that online purchases may be picked up at a physical store, or product samples may be browsed, handled, and sized in a retail store and then ordered online and shipped.

But whatever the extent of the slow transition to online services, where grocery retailers think they can still compete offline (which is to say, everywhere), their investments have increased — substantially — since the merger. Take Aldi, for example:

Discounters like Aldi, known for its no-frills stores and highly coveted private label, have put pressure on traditional grocers, which are also trying to prepare for an e-commerce future likely to be remade by Amazon and its acquisition of Whole Foods.

* * *

Aldi, with currently some 1,600 U.S. stores, has said it will invest $3.4 billion in order to up its U.S. store count to 2,500 by 2022. The additional stores would make Aldi the third-biggest seller of food in the U.S. behind Walmart and Kroger. (Emphasis added)

The country’s biggest grocery chains, Walmart and Kroger — each of them substantially larger than even Amazon and Whole Foods combined — are likewise expanding, not contracting, in the face of the new competition the merger has brought. And this is happening not just online, but in physical stores, as well. Take Walmart, for example:

Walmart is making headway in its pitched battle against Amazon, with online sales soaring in the most recent quarter.

Those sales leaped 40 percent in the U.S., a sign that Walmart’s aggressive moves to bolster its e-commerce business by ramping up fashion, adding thousands of new choices, and scooping up other, niche sites, is paying off.

Physical stores held their own as well during the company’s latest quarter, which spanned May through July. Sales at locations open at least a year rose 4.5 percent, the biggest uptick in more than a decade, as shoppers flocked to their local Walmart to pick up groceries, clothing and seasonal items.

Not only did more customers head to their stores, increasing foot traffic 2.2 percent, they spent more money while they were there. (Emphasis added)

These stores aren’t just maintaining the status quo despite the merger; they are also improving their services to reflect the actual and expected increase in competition.

And this positive effect is reflected in the retail labor landscape as well. Despite the bold, Chicken-Little assertions by some critics, Amazon’s effect on retail labor — and the effect of the Whole Foods merger on grocery store labor in particular — hasn’t been to decimate the market. Instead, employment has expanded significantly in 2018, “largely due to a resurgence in two categories that had been contracting, retail and manufacturing. [In fact,] retailers added an average of 12,000 [workers] each month this year.”

But really. Are we just missing an unstoppable monopoly in its incipiency?

All of the foregoing good news notwithstanding, it could be the case that we are complacently snoozing while an unstoppable future monopoly is in its incipiency. Perhaps Amazon is using its already incredible online power to build a path to success that none will be able to rival. Lina Khan, for one, would have you believe that.

But the evidence we have does not suggest that this is at all a realistic concern.

In the first place, in the one area where you could conceivably cite to Amazon’s supremacy — online retail — it doesn’t even remotely behave like a monopolist. Aside from the obvious fact that it has consistently worked to deliver more output and lower prices (which the Fed Chairman has speculated may be contributing to low inflation), Amazon has (to outward appearances, at the very least) worked very hard to deliver a superior customer experience. It vets and monitors merchants in order to prevent fraud, and when it happens Amazon eats the cost of fraud-related losses. And Amazon is well known for its generous return policy. These are not the practices of a complacent monopolist selling to customers with no, or even few, other purchasing alternatives.

But more importantly, there is nothing that Amazon can do that competitors cannot also do, despite the bare assertions of critics.

Last year, for example, Marshall Steinbaum asserted that, with respect to the Whole Foods merger, and the potential for Instacart and Wegman’s to compete with Amazon for grocery delivery,  

Instacart has nowhere near the existing infrastructure or access to capital to make that viable… There’s increasingly no plausible way around Amazon. Wegmans is not going to front an all-out assault on Amazon in e-commerce. Walmart is only now doing it, and only just. Amazon is already dominant and already anticompetitive. There’s also, dare I say it, the threat of antitrust… I think it’s fair to say the agencies have been favorable to Amazon in the past and would-be competitors might assume they will be going forward.

This account is hard to take seriously, particularly since it’s predicated on the idea that there are monopoly profits to be earned in the grocery delivery space. Why exactly wouldn’t Wegman’s (or someone else) partner with Instacart in order to realize some portion of those profits — to innovate to offer enhanced services (over and above its already uniquely pleasant grocery-shopping experience)?

And just one year later, it appears that Amazon’s competitors do indeed intend an “all-out assault on Amazon” in precisely this fashion.

German discount giant Aldi has stepped up to bolster Instacart’s deal with Wegman’s and is using the company’s services to help it succeed in its massive push into the US market.

And meanwhile, on the direct investment front, Instacart has managed to raise $200M in new funding to help it expand its operations, boosting its valuation to a whopping $4.2 billion. This is a “vote of confidence from the venture capital community” and “a far cry from the uncertainty swirling around the grocery startup after the Amazon-Whole Foods deal last year.”

Thus just a single year’s worth of investment and expanded activity — especially coming as it has in the immediate aftermath of the Amazon/Whole Foods merger — fully rebuts Steinbaum’s absurd claim (echoed by others) that “[t]here’s increasingly no plausible way around Amazon.”

And the reason for Instacart’s success is (or should be, to anyone paying attention) entirely predictable, and tied to the reason that the Amazon/Whole Foods merger should continue to be welcomed rather than reviled: competition. Instacart’s success is tied to that of Kroger and Aldi and every other grocer and retailer threatened by competition from Amazon. For now, at least, these stores see same-day delivery of fresh produce and other perishables as key to their ability to take on and even best the combined Amazon/Whole Foods. And it’s been working:

The first and most obvious impact was the pressure that supermarkets like Kroger felt when Amazon began lowering prices at Whole Foods. However, after having its shares rattled by Amazon, Kroger was able to regain investor confidence by partnering with Instacart and several other grocery delivery services, allowing it to outpace Amazon over the past three months. (Emphasis added)

Where exactly the next challenge from Amazon will arise, and from whence exactly the competitive response will emerge, is uncertain. But what we’ve seen thus far should reassure us that both the challenge and the response will happen. Before we pronounce the death of retail, the end of living wages, and the destruction of democracy at Amazon’s hands — and seek out the antitrust laws to thwart every social ill critics can conjure — we should review the tape every so often. And, so far, it seems to suggest that the alarms are dramatically premature.