High-profile cases like those of Michael Brown in Ferguson, Missouri, and Breonna Taylor in Louisville, Kentucky, have garnered attention from the media and the academy alike about decisions by grand juries not to charge police officers with homicide.
While much of this focus centers on alleged racial bias on the part of police officers and the criminal justice system writ large, it’s also important to examine the perverse incentives faced by local district attorneys tasked with prosecuting police.
District attorneys rely on close professional relationships with police officers and law enforcement departments to prosecute criminal cases. Professional incentives require district attorneys to win cases. They can’t do that without cooperation from the police who investigate and bring criminal complaints. Moreover, police unions have disproportionate influence on district attorney elections.
Applying a law & economics lens to criminal justice offers a way forward that could better align incentives to prosecute police officers who break the law.
Aligning incentives in the legal profession
The legal profession is regulated largely by the rules of professional conduct developed by bar associations in each jurisdiction. The stated goal of these rules is to promote legal ethics among attorneys admitted to the bar. But these rules can also be understood economically. The organized bar can use legal ethics rules to increase its members’ profits in two main ways: by restricting entry to the practice of law and by adopting efficient rules that reduce the costs of contracting between lawyers and clients.
The bar’s rules can restrict competition in the market by requiring prospective lawyers to have graduated from an accredited law school and passed a bar exam, or to have substantial experience in another jurisdiction before they are allowed to waive in. The ability to practice law in a given jurisdiction without having taken the necessary steps to become a member of the bar is limited to pro hac vice rules that require working with a member of the bar. The result of the limitations allows lawyers to raise prices higher than they would without the restrictions on competition.
But the rules also can promote economically efficient outcomes. For instance, conflict-of-interest rules prevent lawyers from representing clients who have interests directly adverse to other clients, or where there would be significant risk that representation would be materially limited by responsibilities to other clients or former clients. (See, for example, Rule 1.7 of theAmerican Bar Association’s Model Rules of Professional Conduct.) Many of these conflicts are waivable, but some are not.
It is worth considering why these rules make sense economically. In a world devoid of transaction costs and strategic behavior, lawyers and clients could negotiate complete contracts for each representation, which would include compensation for those who would possibly be hurt by conflicts. But that’s not the real world. Conflict-of-interest rules are designed to overcome the principal-agent problems that arise from representing clients with adverse interests, including the potential use of information from representations to the detriment of those clients. Thus, conflict-of-interest rules supply efficient defaults that generally limit potentially harmful representation.
Incentives in prosecuting police
Imagine the following scenario: a local district attorney works with a municipal police officer on a number of cases over the years, relying upon that officer’s evidence and testimony to prosecute criminal defendants. A video of the officer is later posted on YouTube showing him beating a non-resisting handcuffed citizen with his baton. The district attorney must now make the decision of whether to charge the officer with potential crimes.
The bar’s usual conflict-of-interest rules, as described above, do not apply the same way to prosecutors. The prosecutor’s client is presumed to be the public, rather than the police officers with whom they work on a daily basis. Thus, the district attorney is not deemed to face an ethical problem in prosecuting the officer, despite their long-standing professional institutional relationship. The rules of professional conduct don’t require a district attorney to recuse herself from the case.
Following the incentives, it is no surprise that prosecutors often give benefit of the doubt to police officers in allegations of criminal conduct. One of a prosecutor’s primary jobs is to ensure judges and juries believe the testimony of police officers. Future relationships with officers may be impaired by police prosecutions that are perceived by law enforcement to be unfair.
Elections are ineffective checks on prosecutorial power
While in theory (and sometimes in fact), public elections could serve as a check on district attorneys who fail to live up to their duty to prosecute unlawful behavior by police officers, there are reasons to be skeptical that they successfully do so consistently. Public choice economics helps explain why.
The public as a whole is dispersed and unorganized, especially when it comes to its interest as potential victims of the criminal justice system. On the other hand, police unions and associations are organized to forward the interest of law enforcement officers. Indeed, among the benefits police unions commonly provide to members are lawyers to defend against civil rights lawsuits and criminal prosecutions. Police unions and associations also can exert significant influence on who is chosen to be district attorney in the first place. Such organized interests often are among the leaders in spending and campaigning for or against district attorney candidates. By contrast, the voting public tends to have far less information about and interest in those elections.
Getting the incentives right
In pursuing institutional reform, it is important both to get the incentives right and to remain cognizant of trade-offs. The goal should be to align incentives so that there is no disincentive for prosecuting police officers criminally if the facts call for it. Some popular proposed reforms, however, could be both legally deficient or suffer from similar incentive problems.
For instance, a number of California district attorneys and candidates have called for an amendment to the state’s rules of professional conduct to define it as a conflict of interest for a district attorney candidate to receive campaign contributions from a police union. While this calls out the same problem identified here, the proposal would be subject to challenge on First Amendment grounds for targeting political speech, and on equal protection grounds for preferencing other groups over police unions.
Other possibilities, such as escalating police prosecutions to the state attorney general’s office, face the same public choice and conflict-of-interest problems identified for local district attorneys.
The incentives faced by district attorneys contribute to the problem of insufficient prosecution of police officers who engage in criminal behavior. Prosecutors who generally rely upon close professional relationships with police officers have a conflict of interest when it comes to cases where police officers are the defendants. A new path is needed to get the incentives right.
This post is authored by Shane Greenstein (Professor of Business Administration, Harvard Business School).]
In his book, Nicolas Petit approaches antitrust issues by analyzing their economic foundations, and he aspires to bridge gaps between those foundations and the common points of view. In light of the divisiveness of today’s debates, I appreciate Petit’s calm and deliberate view of antitrust, and I respect his clear and engaging prose.
I spent a lot of time with this topic when writing a book (How the Internet Became Commercial, 2015, Princeton Press). If I have something unique to add to a review of Petit’s book, it comes from the role Microsoft played in the events in my book.
Many commentators have speculated on what precise charges could be brought against Facebook, Google/Alphabet, Apple, and Amazon. For the sake of simplicity, let’s call these the “big four.” While I have no special insight to bring to such speculation, for this post I can do something different, and look forward by looking back. For the time being, Microsoft has been spared scrutiny by contemporary political actors. (It seems safe to presume Microsoft’s managers prefer to be left out.) While it is tempting to focus on why this has happened, let’s focus on a related issue: What shadow did Microsoft’s trials cast on the antitrust issues facing the big four?
Two types of lessons emerged from Microsoft’s trials, and both tend to be less appreciated by economists. One set of lessons emerged from the media flood of the flotsam and jetsam of sensationalistic factoids and sound bites, drawn from Congressional and courtroom testimony. That yielded lessons about managing sound and fury – i.e., mostly about reducing the cringe-worthy quotes from CEOs and trial witnesses.
Another set of lessons pertained to the role and limits of economic reasoning. Many decision makers reasoned by analogy and metaphor. That is especially so for lawyers and executives. These metaphors do not make economic reasoning wrong, but they do tend to shape how an antitrust question takes center stage with a judge, as well as in the court of public opinion. These metaphors also influence the stories a CEO tells to employees.
If you asked me to forecast how things will go for the big four, based on what I learned from studying Microsoft’s trials, I forecast that the outcome depends on which metaphor and analogy gets the upper hand.
In that sense, I want to argue that Microsoft’s experience depended on “the fox and shepherd problem.” When is a platform leader better thought of as a shepherd, helping partners achieve a healthy outcome, or as a fox in charge of a henhouse, ready to sacrifice a partner for self-serving purposes? I forecast the same metaphors will shape experience of the big four.
Gaps and analysis
The fox-shepherd problem never shows up when a platform leader is young and its platform is small. As the platform reaches bigger scale, however, the problem becomes more salient. Conflicts of interests emerge and focus attention on platform leadership.
Petit frames these issues within a Schumpeterian vision. In this view, firms compete for dominant positions over time, potentially with one dominant firm replacing another. Potential competition has a salutary effect if established firms perceive a threat from the future shadow of such competitors, motivating innovation. In this view, antitrust’s role might be characterized as “keeping markets open so there is pressure on the dominant firm from potential competition.”
In the Microsoft trial economists framed the Schumpeterian tradeoff in the vocabulary of economics. Firms who supply complements at one point could become suppliers of substitutes at a later point if they are allowed to. In other words, platform leaders today support complements that enhance the value of the platform, while also having the motive and ability to discourage those same business partners from developing services that substitute for the platform’s services, which could reduce the platform’s value. Seen through this lens, platform leaders inherently face a conflict of interest, and antitrust law should intervene if platform leaders could place excessive limitations on existing business partners.
This economic framing is not wrong. Rather, it is necessary, but not sufficient. If I take a sober view of events in the Microsoft trial, I am not convinced the economics alone persuaded the judge in Microsoft’s case, or, for that matter, the public.
As judges sort through the endless detail of contracting provisions, they need a broad perspective, one that sharpens their focus on a key question. One central question in particular inhabits a lot of a judge’s mindshare: how did the platform leader use its discretion, and for what purposes? In case it is not obvious, shepherds deserve a lot of discretion, while only a fool gives a fox much license.
Before the trial, when it initially faced this question from reporters and Congress, Microsoft tried to dismiss the discussion altogether. Their representatives argued that high technology differs from every other market in its speed and productivity, and, therefore, ought to be thought of as incomparable to other antitrust examples. This reflected the high tech elite’s view of their own exceptionalism.
Reporters dutifully restated this argument, and, long story short, it did not get far with the public once the sensationalism started making headlines, and it especially did not get far with the trial judge. To be fair, if you watched recent congressional testimony, it appears as if the lawyers for the big four instructed their CEOs not to try it this approach this time around.
Origins
Well before lawyers and advocates exaggerate claims, the perspective of both sides usually have some merit, and usually the twain do not meet. Most executives tend to remember every detail behind growth, and know the risks confronted and overcome, and usually are reluctant to give up something that works for their interests, and sometimes these interests can be narrowly defined. In contrast, many partners will know examples of a rule that hindered them, and point to complaints that executives ignored, and aspire to have rules changed, and, again, their interests tend to be narrow.
Consider the quality-control process today for iPhone apps as an example. The merits and absurdity of some of Apples conduct get a lot of attention in online forums, especially the 30% take for Apple. Apple can reasonably claim the present set of rules work well overall, and only emerged after considerable experimentation, and today they seek to protect all who benefit from the entire system, like a shepherd. It is no surprise however, that some partners accuse Apple of tweaking rules to their own benefit, and using the process to further Apple’s ambitions at the expense of the partner’s, like a fox in a henhouse. So it goes.
More generally, based on publically available information, all of the big four already face this debate. Self-serving behavior shows up in different guise in different parts of the big four’s business, but it is always there. As noted, Apple’s apps compete with the apps of others, so it has incentives to shape distribution of other apps. Amazon’s products compete with some products coming from its third—party sellers, and it too faces mixed incentives. Google’s services compete with online services who also advertise on their search engine, and they too face issues over their charges for listing on the Play store. Facebook faces an additional issues, because it has bought firms that were trying to grow their own platforms to compete with Facebook.
Look, those four each contain rather different businesses in their details, which merits some caution in making a sweeping characterization. My only point: the question about self-serving behavior arises in each instance. That frames a fox-shepherd problem for prosecutors in each case.
Lessons from prior experience
Circling back to lessons of the past for antitrust today, the Shepherd-Fox problem was one of the deeper sources of miscommunication leading up to the Microsoft trial. In the late 1990s Microsoft could reasonably claim to be a shepherd for all its platform’s partners, and it could reasonably claim to have improved the platform in ways that benefited partners. Moreover, for years some of the industry gossip about their behavior stressed misinformed nonsense. Accordingly, Microsoft’s executives had learned to trust their own judgment and to mistrust the complaints of outsiders. Right in line with that mistrust, many employees and executives took umbrage to being characterized as a fox in a henhouse, dismissing the accusations out of hand.
Those habits-of-mind poorly positioned the firm for a court case. As any observer of the trial knowns, When prosecutors came looking, they found lots of examples that looked like fox-like behavior. Onerous contract restrictions and cumbersome processes for business partners produced plenty of bad optics in court, and fueled the prosecution’s case that the platform had become too self-serving at the expense of competitive processes. Prosecutors had plenty to work with when it came time to prove motive, intent, and ability to misuse discretion.
What is the lesson for the big four? Ask an executive in technology today, and sometimes you will hear the following: As long as a platform’s actions can be construed as friendly to customers, the platform leader will be off the hook. That is not wrong lessons, but it is an incomplete one. Looking with hindsight and foresight, that perspective seems too sanguine about the prospects for the big four. Microsoft had done plenty for its customers, but so what? There was plenty of evidence of acting like a fox in a hen-house. The bigger lesson is this: all it took were a few bad examples to paint a picture of a pattern, and every firm has such examples.
Do not get me wrong. I am not saying a fox and hen-house analogy is fair or unfair to platform leaders. Rather, I am saying that economists like to think the economic trade-off between the interests of platform leaders, platform partners, and platform customers emerge from some grand policy compromise. That is not how prosecutors think, nor how judges decide. In the Microsoft case there was no such grand consideration. The economic framing of the case only went so far. As it was, the decision was vulnerable to metaphor, shrewdly applied and convincingly argued. Done persuasively, with enough examples of selfish behavior, excuses about “helping customers” came across as empty.
Policy
Some advocates argue, somewhat philosophically, that platforms deserve discretion, and governments are bound to err once they intervene. I have sympathy with that point of view, but only up to a point. Below are two examples from outside antitrust where government routinely do not give the big four a blank check.
First, when it started selling ads, Google banned ads for cigarettes, porn and alcohol, and it downgraded in its quality score for websites that used deceptive means to attract users. That helped the service foster trust with new users, enabling it to grow. After it became bigger should Google have continued to have unqualified discretion to shepherd the entire ad system? Nobody thinks so. A while ago the Federal Trade Commission decided to investigate deceptive online advertising, just as it investigates deceptive advertising in other media. It is not a big philosophical step to next ask whether Google should have unfettered discretion to structure the ad business, search process, and related e-commerce to its own benefit.
Here is another example, this one about Facebook. Over the years Facebook cycled through a number of rules for sharing information with business partners, generally taking a “relaxed” attitude enforcing those policies. Few observers cared when Facebook was small, but many governments started to care after Facebook grew to billions of users. Facebook’s lax monitoring did not line up with the preferences of many governments. It should not come as a surprise now that many governments want to regulate Facebook’s handling of data. Like it or not, this question lies squarely within the domain of government privacy policy. Again, the next step is small. Why should other parts of its business remain solely in Facebook’s discretion, like its ability to buy other businesses?
This gets us to the other legacy of the Microsoft case: As we think about future policy dilemmas, are there a general set of criteria for the antitrust issues facing all four firms? Veterans of court cases will point out that every court case is its own circus. Just because Microsoft failed to be persuasive in its day does not imply any of the big four will be unpersuasive.
Looking back on the Microsoft trial, it did not articulate a general set of principles about acceptable or excusable self-serving behavior from a platform leader. It did not settle what criteria best determine when a court should consider a platform leader’s behavior closer to that of a shepherd or a fox. The appropriate general criteria remains unclear.
One of the great scholars of law & economics turns 90 years old today. In his long and distinguished career, Thomas Sowell has written over 40 books and countless opinion columns. He has been a professor of economics and a long-time Senior Fellow at the Hoover Institution. He received a National Humanities Medal in 2002 for a lifetime of scholarship, which has only continued since then. His ability to look at issues with an international perspective, using the analytical tools of economics to better understand institutions, is an inspiration to us at the International Center for Law & Economics.
Here, almost as a blog post festschrift as a long-time reader of his works, I want to briefly write about how Sowell’s voluminous writings on visions, law, race, and economics could be the basis for a positive agenda to achieve a greater measure of racial justice in the United States.
The Importance of Visions
One of the most important aspects of Sowell’s work is his ability to distill wide-ranging issues into debates involving different mental models, or a “Conflict of Visions.” He calls one vision the “tragic” or “constrained” vision, which sees all humans as inherently limited in knowledge, wisdom, and virtue, and fundamentally self-interested even at their best. The other vision is the “utopian” or “unconstrained” vision, which sees human limitations as artifacts of social arrangements and cultures, and that there are some capable by virtue of superior knowledge and morality that can redesign society to create a better world.
An implication of the constrained vision is that the difference in knowledge and virtue between the best and the worst in society is actually quite small. As a result, no one person or group of people can be trusted with redesigning institutions which have spontaneously evolved. The best we can hope for is institutions that reasonably deter bad conduct and allow people the freedom to solve their own problems.
An important implication of the unconstrained vision, on the other hand, is that there are some who because of superior enlightenment, which Sowell calls the “Vision of the Anointed,” can redesign institutions to fundamentally change human nature, which is seen as malleable. Institutions are far more often seen as the result of deliberate human design and choice, and that failures to change them to be more just or equal is a result of immorality or lack of will.
The importance of visions to how we view things like justice and institutions makes all the difference. In the constrained view, institutions like language, culture, and even much of the law result from the “spontaneous ordering” that is the result of human action but not of human design. Limited government, markets, and tradition are all important in helping individuals coordinate action. Markets work because self-interested individuals benefit when they serve others. There are no solutions to difficult societal problems, including racism, only trade-offs.
But in the unconstrained view, limits on government power are seen as impediments to public-spirited experts creating a better society. Markets, traditions, and cultures are to be redesigned from the top down by those who are forward-looking, relying on their articulated reason. There is a belief that solutions could be imposed if only there is sufficient political will and the right people in charge. When it comes to an issue like racism, those who are sufficiently “woke” should be in charge of redesigning institutions to provide for a solution to things like systemic racism.
For Sowell, what he calls “traditional justice” is achieved by processes that hold people accountable for harms to others. Its focus is on flesh-and-blood human beings, not abstractions like all men or blacks versus whites. Differences in outcomes are not just or unjust, by this point of view, what is important is that the processes are just. These processes should focus on institutional incentives of participants. Reforms should be careful not to upset important incentive structures which have evolved over time as the best way for limited human beings to coordinate behavior.
The “Quest for Cosmic Justice,” on the other hand, flows from the unconstrained vision. Cosmic justice sees disparities between abstract groups, like whites and blacks, as unjust and in need of correction. If results from impartial processes like markets or law result in disparities, those with an unconstrained vision often see those processes as themselves racist. The conclusion is that the law should intervene to create better outcomes. This presumes considerable knowledge and morality on behalf of those who are in charge of the interventions.
For Sowell, a large part of his research project has been showing that those with the unconstrained vision often harm those they are proclaiming the intention to help in their quest for cosmic justice.
A Constrained Vision of Racial Justice
Sowell has written quite a lot on race, culture, intellectuals, economics, and public policy. One of the main thrusts of his argument about race is that attempts at cosmic justice often harm living flesh-and-blood individuals in the name of intertemporal abstractions like “social justice” for black Americans. Sowell nowhere denies that racism is an important component of understanding the history of black Americans. But his constant challenge is that racism can’t be the only variable which explains disparities. Sowell points to the importance of culture and education in building human capital to be successful in market economies. Without taking those other variables into account, there is no way to determine the extent that racism is the cause of disparities.
This has important implications for achieving racial justice today. When it comes to policies pursued in the name of racial justice, Sowell has argued that many programs often harm not only members of disfavored groups, but the members of the favored groups.
For instance, Sowell has argued that affirmative action actually harms not only flesh-and-blood white and Asian-Americans who are passed over, but also harms those African-Americans who are “mismatched” in their educational endeavors and end up failing or dropping out of schools when they could have been much better served by attending schools where they would have been very successful. Another example Sowell often points to is minimum wage legislation, which is often justified in the name of helping the downtrodden, but has the effect of harming low-skilled workers by increasing unemployment, most especially young African-American males.
Any attempts at achieving racial justice, in terms of correcting historical injustices, must take into account how changes in processes could actually end up hurting flesh-and-blood human beings, especially when those harmed are black Americans.
A Positive Agenda for Policy Reform
In Sowell’s constrained vision, a large part of the equation for African-American improvement is going to be cultural change. However, white Americans should not think that this means they have no responsibility in working towards racial justice. A positive agenda must take into consideration real harms experienced by African-Americans due to government action (and inaction). Thus, traditional justice demands institutional reforms, and in some cases, recompense.
The policy part of this equation outlined below is motivated by traditional justice concerns that hold people accountable under the rule of law for violations of constitutional rights and promotes institutional reforms to more properly align incentives.
What follows below are policy proposals aimed at achieving a greater degree of racial justice for black Americans, but fundamentally informed by the constrained vision and traditional justice concerns outlined by Sowell. Most of these proposals are not on issues Sowell has written a lot on. In fact, some proposals may actually not be something he would support, but are—in my opinion—consistent with the constrained vision and traditional justice.
Reparations for Historical Rights Violations
Sowell once wrote this in regards to reparations for black Americans:
Nevertheless, it remains painfully clear that those people who were torn from their homes in Africa in centuries past and forcibly brought across the Atlantic in chains suffered not only horribly, but unjustly. Were they and their captors still alive, the reparations and retribution owed would be staggering. Time and death, however, cheat us of such opportunities for justice, however galling that may be. We can, of course, create new injustices among our flesh-and-blood contemporaries for the sake of symbolic expiation, so that the son or daughter of a black doctor or executive can get into an elite college ahead of the son or daughter of a white factory worker or farmer, but only believers in the vision of cosmic justice are likely to take moral solace from that. We can only make our choices among alternatives actually available, and rectifying the past is not one of those options.
In other words, if the victims and perpetrators of injustice are no longer alive, it is not just to hold entire members of respective races accountable for crimes which they did not commit. However, this would presumably leave open the possibility of applying traditional justice concepts in those cases where death has not cheated us.
For instance, there are still black Americans alive who suffered from Jim Crow, as well as children and family members of those lynched. While it is too little, too late, it seems consistent with traditional justice to still seek out and prosecute criminally perpetrators who committed heinous acts but a few generations ago against still living victims. This is not unprecedented. Old Nazis are still prosecuted for crimes against Jews. A similar thing could be done in the United States.
Similarly, civil rights lawsuits for the damages caused by Jim Crow could be another way to recompense those who were harmed. Alternatively, it could be done by legislation. The Civil Liberties Act of 1988 was passed under President Reagan and gave living Japanese Americans who were interned during World War II some limited reparations. A similar system could be set up for living victims of Jim Crow.
Statutes of limitations may need to be changed to facilitate these criminal prosecutions and civil rights lawsuits, but it is quite clearly consistent with the idea of holding flesh-and-blood persons accountable for their unlawful actions.
Holding flesh-and-blood perpetrators accountable for rights violations should not be confused with the cosmic justice idea—that Sowell consistently decries—that says intertemporal abstractions can be held accountable for crimes. In other words, this is not holding “whites” accountable for all historical injustices to “blacks.” This is specifically giving redress to victims and deterring future bad conduct.
End Qualified Immunity
Another way to promote racial justice consistent with the constrained vision is to end one of the Warren Court’s egregious examples of judicial activism: qualified immunity. Qualified immunity is nowhere mentioned in the statute for civil rights, 42 USC § 1983. As Sowell argues in his writings, judges in the constrained vision are supposed to declare what the law is, not what they believe it should be, unlike those in the unconstrained vision who—according to Sowell— believe they have the right to amend the laws through judicial edict. The introduction of qualified immunity into the law by the activist Warren Court should be overturned.
In a civil rights lawsuit, the goal is to make the victim (or their families) of a rights violation whole by monetary damages. From a legal perspective, this is necessary to give the victim justice. From an economic perspective this is necessary to deter future bad conduct and properly align ex ante incentives going forward. Under a well-functioning system, juries would, after hearing all the evidence, make a decision about whether constitutional rights were violated and the extent of damages. A functioning system of settlements would result as a common law develops determining what counts as reasonable or unreasonable uses of force. This doesn’t mean plaintiffs always win, either. Officers may be determined to be acting reasonably under the circumstances once all the evidence is presented to a jury.
However, one of the greatest obstacles to holding police officers accountable in misconduct cases is the doctrine of qualified immunity… courts have widely expanded its scope to the point that qualified immunity is now protecting officers even when their conduct violates the law, as long as the officers weren’t on clear notice from specific judicial precedent that what they did was illegal when they did it… This standard has predictably led to a situation where officer misconduct which judges and juries would likely find egregious never makes it to court. The Cato Institute’s website Unlawful Shield details many cases where federal courts found an officer’s conduct was illegal yet nonetheless protected by qualified immunity.
Immunity of this nature has profound consequences on the incentive structure facing police officers. Police officers, as well as the departments that employ them, are insufficiently accountable when gross misconduct does not get past a motion to dismiss for qualified immunity… The result is to encourage police officers to take insufficient care when making the choice about the level of force to use.
Those with a constrained vision focus on processes and incentives. In this case, it is police officers who have insufficient incentives to take reasonable care when they receive qualified immunity for their conduct.
End the Drug War
While not something he has written a lot on, Sowell has argued for the decriminalization of drugs, comparing the War on Drugs to the earlier attempts at Prohibition of alcohol. This is consistent with the constrained vision, which cares about the institutional incentives created by law.
Interestingly, work by Michelle Alexander in the second chapter of The New Jim Crow is largely consistent with Sowell’s point of view. There she argued the institutional incentives of police departments were systematically changed when the drug war was ramped up.
Alexander asks a question which is right in line with the constrained vision:
[I]t is fair to wonder why the police would choose to arrest such an astonishing percentage of the American public for minor drug crimes. The fact that police are legally allowed to engage in a wholesale roundup of nonviolent drug offenders does not answer the question why they would choose to do so, particularly when most police departments have far more serious crimes to prevent and solve. Why would police prioritize drug-law enforcement? Drug use and abuse is nothing new; in fact, it was on the decline, not on the rise, when the War on Drugs began.
Alexander locates the impetus for ramping up the drug war in federal subsidies:
In 1988, at the behest of the Reagan administration, Congress revised the program that provides federal aid to law enforcement, renaming it the Edward Byrne Memorial State and Local Law Enforcement Assistance Program after a New York City police officer who was shot to death while guarding the home of a drug-case witness. The Byrne program was designed to encourage every federal grant recipient to help fight the War on Drugs. Millions of dollars in federal aid have been offered to state and local law enforcement agencies willing to wage the war. By the late 1990s, the overwhelming majority of state and local police forces in the country had availed themselves of the newly available resources and added a significant military component to buttress their drug-war operations.
On top of that, police departments were benefited by civil asset forfeiture:
As if the free military equipment, training, and cash grants were not enough, the Reagan administration provided law enforcement with yet another financial incentive to devote extraordinary resources to drug law enforcement, rather than more serious crimes: state and local law enforcement agencies were granted the authority to keep, for their own use, the vast majority of cash and assets they seize when waging the drug war. This dramatic change in policy gave state and local police an enormous stake in the War on Drugs—not in its success, but in its perpetual existence. Suddenly, police departments were capable of increasing the size of their budgets, quite substantially, simply by taking the cash, cars, and homes of people suspected of drug use or sales. Because those who were targeted were typically poor or of moderate means, they often lacked the resources to hire an attorney or pay the considerable court costs. As a result, most people who had their cash or property seized did not challenge the government’s action, especially because the government could retaliate by filing criminal charges—baseless or not.
As Alexander notes, black Americans (and other minorities) were largely targeted in this ramped up War on Drugs, noting the drug war’s effects have been to disproportionately imprison black Americans even though drug usage and sales are relatively similar across races. Police officers have incredible discretion in determining who to investigate and bring charges against. When it comes to the drug war, this discretion is magnified because the activity is largely consensual, meaning officers can’t rely on victims to come to them to start an investigation. Alexander finds the reason the criminal justice system has targeted black Americans is because of implicit bias in police officers, prosecutors, and judges, which mirrors the bias shown in media coverage and in larger white American society.
Anyone inspired by Sowell would need to determine whether this is because of racism or some other variable. It is important to note here that Sowell never denies that racism exists or is a real problem in American society. But he does challenge us to determine whether this alone is the cause of disparities. Here, Alexander makes a strong case that it is implicit racism that causes the disparities in enforcement of the War on Drugs. A race-neutral explanation could be as follows, even though it still suggests ending the War on Drugs: the enforcement costs against those unable to afford to challenge the system are lower. And black Americans are disproportionately represented among the poor in this country. As will be discussed below in the section on reforming indigent criminal defense, most prosecutions are initiated against defendants who can’t afford a lawyer. The result could be racially disparate even without a racist motivation.
Regardless of whether racism is the variable that explains the disparate impact of the War on Drugs, it should be ended. This may be an area where traditional and cosmic justice concerns can be united in an effort to reform the criminal justice system.
Reform Indigent Criminal Defense
A related aspect of how the criminal justice system has created a real barrier for far too many black Americans is the often poor quality of indigent criminal defense. Indigent defense is a large part of criminal defense in this country since a very high number of criminal prosecutions are initiated against those who are often too poor to afford a lawyer (roughly 80%). Since black Americans are disproportionately represented among the indigent and those in the criminal justice system, it should be no surprise that black Americans are disproportionately represented by public defenders in this country.
According to the constrained vision, it is important to look at the institutional incentives of public defenders. Considering the extremely high societal costs of false convictions, it is important to get these incentives right.
David Friedman and Stephen Schulhofer’s seminal article exploring the law & economics of indigent criminal defense highlighted the conflict of interest inherent in government choosing who represents criminal defendants when the government is in charge of prosecuting. They analyzed each of the models used in the United States for indigent defense from an economic point of view and found each wanting. On top of that, there is also a calculation problem inherent in government-run public defender’s offices whereby defendants may be systematically deprived of viable defense strategies because of a lack of price signals.
An interesting alternative proposed by Friedman and Schulhofer is a voucher system. This is similar to the voucher system Sowell has often touted for education. The idea would be that indigent criminal defendants get to pick the lawyer of their choosing that is part of the voucher program. The government would subsidize the provision of indigent defense, in this model, but would not actually pick the lawyer or run the public defender organization. Incentives would be more closely aligned between the defendant and counsel.
Conclusion
While much more could be said consistent with the constrained vision that could help flesh-and-blood black Americans, including abolishing occupational licensing, ending wage controls, promoting school choice, and ending counterproductive welfare policies, this is enough for now. Racial justice demands holding rights violators accountable and making victims whole. Racial justice also means reforming institutions to make sure incentives are right to deter conduct which harms black Americans. However, the growing desire to do something to promote racial justice in this country should not fall into the trap of cosmic justice thinking, which often ends up hurting flesh-and-blood people of all races in the present in the name of intertemporal abstractions.
Happy 90th birthday to one of the greatest law & economics scholars ever, Dr. Thomas Sowell.
This guest post is by Jonathan M. Barnett, Torrey H. Webb Professor of Law at the University of Southern California, Gould School of Law.
State bar associations, with the backing of state judiciaries and legislatures, are typically entrusted with a largely unqualified monopoly over licensing in legal services markets. This poses an unavoidable policy tradeoff. Designating the bar as gatekeeper might protect consumers by ensuring a minimum level of service quality. Yet the gatekeeper is inherently exposed to influence by interests with an economic stake in the existing market. Any licensing requirement that might shield uninformed consumers from unqualified or opportunistic lawyers also necessarily raises an entry barrier that protects existing lawyers against more competition. A proper concern for consumer welfare therefore requires that the gatekeeper impose licensing requirements only when they ensure that the efficiency gains attributable to a minimum quality threshold outweigh the efficiency losses attributable to constraints on entry.
There is increasing reason for concern that state bar associations are falling short of this standard. In particular, under the banner of “legal ethics,” some state bar associations and courts have blocked or impeded entry by innovative “legaltech” services without a compelling consumer protection rationale.
The LegalMatch Case: A misunderstood platform
This trend is illustrated by a recent California appellate court decision interpreting state regulations pertaining to legal referral services. In Jackson v. LegalMatch, decided in late 2019, the court held that LegalMatch, a national online platform that matches lawyers and potential clients, constitutes an illegal referral service, even though it is not a “referral service” under the American Bar Association’s definition of the term, and the California legislature had previously declined to include online services within the statutory definition.
The court’s reasoning: the “marketing” fee paid by subscribing attorneys to participate in the platform purportedly runs afoul of state regulations that proscribe attorneys from paying a fee to referral services that have not been certified by the bar. (The lower court had felt differently, finding that LegalMatch was not a referral service for this purpose, in part because it did not “exercise any judgment” on clients’ legal issues.)
The court’s formalist interpretation of applicable law overlooks compelling policy arguments that strongly favor facilitating, rather than obstructing, legal matching services. In particular, the LegalMatch decision illustrates the anticompetitive outcomes that can ensue when courts and regulators blindly rely on an unqualified view of platforms as an inherent source of competitive harm.
Contrary to this presumption, legal services referral platforms enhance competition by reducing transaction-cost barriers to efficient lawyer-client relationships. These matching services benefit consumers that otherwise lack access to the full range of potential lawyers and smaller or newer law firms that do not have the marketing resources or brand capital to attract the full range of potential clients. Consistent with the well-established economics of platform markets, these services operate under a two-sided model in which the unpriced delivery of attorney information to potential clients is financed by the positively priced delivery of interested clients to subscribing attorneys. Without this two-sided fee structure, the business model collapses and the transaction-cost barriers to matching the credentials of tens of thousands of lawyers with the preferences of millions of potential clients are inefficiently restored. Some legal matching platforms also offer fixed-fee service plans that can potentially reduce legal representation costs relative to the conventional billable hour model that can saddle clients with unexpectedly or inappropriately high legal fees given the difficulty in forecasting the required quantity of legal services ex ante and measuring the quality of legal services ex post.
Blocking entry by these new business models is likely to adversely impact competition and, as observed in a 2018 report by an Illinois bar committee, to injure lower-income consumers in particular. The result is inefficient, regressive, and apparently protectionist.
Indeed, subsequent developments in thislitigation are regrettably consistent with the last possibility. After the California bar prevailed in its legal interpretation of “referral service” at the appellate court, and the Supreme Court of California declined to review the decision, LegalMatch then sought to register as a certified lawyer referral service with the bar. The bar responded by moving to secure a temporary restraining order against the continuing operation of the platform. In May 2020, a lower state court judge both denied the petition and expressed disappointment in the bar’s handling of the litigation.
Bar associations’ puzzling campaign against “LegalTech” innovation
This case of regulatory overdrive is hardly unique to the LegalMatch case. Bar associations have repeatedly acted to impede entry by innovators that deploy digital technologies to enhance legal services, which can drive down prices in a field that is known for meager innovation and rigid pricing. Puzzlingly from a consumer welfare perspective, the bar associations have taken actions that impede or preclude entry by online services that expand opportunities for lawyers, increase the information available to consumers, and, in certain cases, place a cap on maximum legal fees.
In 2017, New Jersey Supreme Court legal ethics committees, following an “inquiry” by the state bar association, prohibited lawyers from partnering with referral services and legal services plans offered by Avvo, LegalZoom, and RocketLawyer. In 2018, Avvo discontinued operations due in part to opposition from multiple state bar associations (often backed up by state courts).
In some cases, bar associations have issued advisory opinions that, given the risk of disciplinary action, can have an in terrorem effect equivalent to an outright prohibition. In 2018, the Indiana Supreme Court Disciplinary Commission issued a “nonbinding advisory” opinion stating that attorneys who pay “marketing fees” to online legal referral services or agree to fixed-fee arrangements with such services “risk violation of several Indiana [legal] ethics rules.”
State bar associations similarly sought to block the entry of LegalZoom, an online provider of standardized legal forms that can be more cost-efficient for “cookie-cutter” legal situations than the traditional legal services model based on bespoke document preparation. These disputes are protracted and costly: it took LegalZoom seven years to reach a settlement with the North Carolina State Bar that allowed it to continue operating in the state. In a case pending before the Florida Supreme Court, the Florida bar is seeking to shut down a smartphone application that enables drivers to contest traffic tickets at a fixed fee, a niche in which the traditional legal services model is likely to be cost-inefficient given the relatively modest amounts that are typically involved.
State bar associations, with supporting action or inaction by state courts and legislatures, have ventured well beyond the consumer protection rationale that is the only potentially publicly-interested justification for the bar’s licensing monopoly. The results sometimes border on absurdity. In 2006, the New Jersey bar issued an opinion precluding attorneys from stating in advertisements that they had appeared in an annual “Super Lawyers” ranking maintained by an independent third-party publication. In 2008, based on a 304-page report prepared by a “special master,” the bar’s ethics committee vacated the opinion but merely recommended further consideration taking into account “legitimate commercial speech activities.” In 2012, the New York legislature even changed the “unlicensed practice of law” from a misdemeanor to a felony, an enhancement proposed by . . . the New York bar (see here and here).
In defending their actions against online referral services, the bar associations argue that these steps are necessary to defend the public’s interest in receiving legal advice free from any possible conflict of interest. This is a presumptively weak argument. The associations’ licensing and other requirements are inherently tainted throughout by a “meta” conflict of interest. Hence it is the bar that rightfully bears the burden in demonstrating that any such requirement imposes no more than a reasonably necessary impediment to competition. This is especially so given that each bar association often operates its own referral service.
The unrealized potential of North Carolina State Board of Dental Examiners v. FTC
Bar associations might nonetheless take the legal position that they have statutory or regulatory discretion to take these actions and therefore any antitrust scrutiny is inapposite. If that argument ever held water, that is clearly no longer the case.
In an undeservedly underapplied decision, North Carolina State Board of Dental Examiners v. FTC, the Supreme Court held definitively in 2015 that any action by a “non-sovereign” licensing entity is subject to antitrust scrutiny unless that action is “actively supervised” by, and represents a “clearly articulated” policy of, the state. The Court emphasized that the degree of scrutiny is highest for licensing bodies administered by constituencies in the licensed market—precisely the circumstances that characterize state bar associations.
The North Carolina decision is hardly an outlier. It followed a string of earlier cases in which the Court had extended antitrust scrutiny to a variety of “hard” rules and “soft” guidance that bar associations had issued and defended on putatively publicly-interested grounds of consumer protection or legal ethics.
At the Court, the bar’s arguments did not meet with success. The Court rejected any special antitrust exemption for a state bar association’s “advisory” minimum fee schedule (Goldfarb v. Virginia State Bar(1975)) and, in subsequent cases, similarly held that limitations by professional associations on advertising by members—another requirement to “protect” consumers—do not enjoy any special antitrust exemption. The latter set of cases addressed specifically both advertising restrictions on price and quality by a California dental association (California Dental Association v. FTC (1999) ) and blanket restrictions on advertising by a bar association (Bates v. State Bar of Arizona(1977 )). As suggested by the bar associations’ recent actions toward online lawyer referral services, the Court’s consistent antitrust decisions in this area appear to have had relatively limited impact in disciplining potentially protectionist actions by professional associations and licensing bodies, at least in the legal services market.
A neglected question: Is the regulation of legal services anticompetitive?
The current economic situation poses a unique historical opportunity for bar associations to act proactively by enlisting independent legal and economic experts to review each component of the current licensing infrastructure and assess whether it passes the policy tradeoff between protecting consumers and enhancing competition. If not, any such component should be modified or eliminated to elicit competition that can leverage digital technologies and managerial innovations—often by exploiting the efficiencies of multi-sided platform models—that have been deployed in other industries to reduce prices and transaction costs. These modifications would expand access to legal services consistent with the bar’s mission and, unlike existing interventions to achieve this objective through government subsidies, would do so with a cost to the taxpayer of exactly zero dollars.
This reexamination exercise is arguably demanded by the line of precedent anchored in the Goldfarb and Bates decisions in 1975 and 1977, respectively, and culminating in the North Carolina Dental decision in 2015. This line of case law is firmly grounded in antitrust law’s underlying commitment to promote consumer welfare by deterring collective action that unjustifiably constrains the free operation of competitive forces. In May 2020, the California bar took a constructive if tentative step in this direction by reviving consideration of a “regulatory sandbox” to facilitate experimental partnerships between lawyers and non-lawyers in pioneering new legal services models. This follows somewhat more decisive action by the Utah Supreme Court, which in 2019 approved commencing a staged process that may modify regulation of the legal services market, including lifting or relaxing restrictions on referral fees and partnerships between lawyers and non-lawyers.
Neither the legal profession generally nor the antitrust bar in particular has allocated substantial attention to potentially anticompetitive elements in the manner in which the practice of law has long been regulated. Restrictions on legal referral services are only one of several practices that deserve a closer look under the policy principles and legal framework set forth most recently in North Carolina Dental and previously in California Dental. A few examples can illustrate this proposition.
Currently limitations on partnerships between lawyers and non-lawyers constrain the ability to achieve economies of scale and scope in the delivery of legal services and preclude firms from offering efficient bundles of complementary legal and non-legal services. Under a more surgical regulatory regime, legal services could be efficiently bundled with related accounting and consulting services, subject to appropriately targeted precautions against conflicts of interest. Additionally, as other commentators have observed and as “legaltech” innovations demonstrate, software could be more widely deployed to provide “direct-to-consumer” products that deliver legal services at a far lower cost than the traditional one-on-one lawyer-client model, subject to appropriately targeted precautions that reflect informational asymmetries in individual and small-business legal markets.
In another example, the blanket requirement of seven years of undergraduate and legal education raises entry costs that are not clearly justified for all areas of legal practice, some of which could potentially be competently handled by practitioners with intermediate categories of legal training. These are just two out of many possibilities that could be constructively explored under a more antitrust-sensitive approach that takes seriously the lessons of North Carolina Dental and the competitive risks inherent to lawyer self-regulation of legal services markets. (An alternative and complementary policy approach would be to move certain areas of legal services regulation out of the hands of the legal profession entirely.)
Conclusion
The LegalMatch case is indicative of a largely unexploited frontier in the application of antitrust law and principles to the practice of law itself. While commentators have called attention to the antitrust concerns raised by the current regulatory regime in legal services markets, and the evolution of federal case law has increasingly reflected these concerns, there has been little practical action by state bar associations, the state judiciary or state legislatures. This might explain why the delivery of legal services has changed relatively little during the same period in which other industries have been transformed by digital technologies, often with favorable effects for consumers in the form of increased convenience and lower costs. There is strong reason to believe a rigorous and objective examination of current licensing and related limitations imposed by bar associations in legal services markets is likely to find that many purportedly “ethical” requirements, at least when applied broadly and without qualification, do much to inhibit competition and little to protect consumers.
This guest post is by Patrick Todd, an England-qualified solicitor and author on competition law/policy in digital markets.
The above quote is not about Democrat-nominee hopeful Elizabeth Warren’s policy views on sport. It is in fact an analogy to her proposal of splitting Google, Amazon, Facebook and Apple (“GAFA”) apart from their respective ancillary lines of business, a solution to one of the current hot topics in antitrust law, namely the alleged practice of GAFA exploiting the popularity of their platforms to gain competitive advantages in neighboring markets. Can a “referee” favor its own “players” in the digital platform game? Can we blame the “referee” if one “player” knocks out another? Should the “referee” be forced to intervene to protect said “player”? The analogy reflects a growing concern that platform owners’ entry into adjacent markets that are, or theoretically could be, served by independent firms creates an irreconcilable misalignment between the interests of users, independent companies and platform owners. As Margrethe Vestager, European Competition Commissioner and Vice-President of the European Commission (“EC”), has said:
[O]ne of the biggest issues we face is with platform businesses that also compete in other markets, with companies that depend on the platform. That means that the very same business becomes both player and referee, competing with others that rely on the platform, but also setting the rules that govern that competition.
Whether and to what extent successful firms in digital markets can enter and compete in neighboring markets, utilizing their existing expertise, has matured into an existential question that plagues and polarizes the antitrust community. Perhaps the most famous and debated case is the EC’s 2017 decision in Google Shopping, where it concluded that Google’s preferential placement of its comparison shopping results in a special box at the top of its search pages constituted an abuse of a dominant position under Article 102 TFEU. The EC found that such prominent placement, coupled with the denial of access to the box for rival price comparison websites, had the effect of driving traffic to Google’s own shopping site, depriving Google’s rivals of user-traffic. Google is strongly contesting both the facts and theory underpinning this decision in its appeal, the hearing for which took place in February. Meanwhile, complaints in relation to Google’s similar treatment of its other ancillary services, such as vacation rentals, have followed suit. Similar allegations have been made against Apple (see e.g.here), Amazon (see e.g. here) and Facebook (see e.g. here) for the way they design their platforms and organize their search results.[KS1]
What links these
cases, investigations and accusations is the doctrine of leverage, i.e. the
practice of exploiting one’s market power in one market in order to extend that
power to an adjacent market. Importantly, leveraging is not a standalone theory
of harm in antitrust law: it is more appropriately regarded as a category of conduct where competitive
effects are felt in a neighboring market (think tying, refusals to deal, margin
squeeze, etc.). Examples of such conduct in the platform context could include
platform owners: promoting their own adjacent products/services in search
result pages; bundling, tying or pre-installing their adjacent products/services
with platform software code; shutting off access to Application Programming Interfaces
or data to third parties to decrease the relative interoperability of their rivals’
products/services; or generally reducing the compatibility of third-party products/services
with the platform as a means of distribution.
This post examines
various proposals that have been put forward to solve the alleged prevalence of
anticompetitive leveraging in digital platform markets, namely:
blocking
platform owners from also owning adjacent products/services;
prohibiting
“favoring” or “self-preferencing” behavior (i.e.
enforcing a non-discrimination standard); and
reversing
the burden of proof so that dominant platform firms bear the burden of showing
that such conduct does not harm
competition.
Each of these
proposals would abrogate the “consumer welfare standard” baked into antitrust
law, which permits exclusionary behavior as long as it constitutes “competition
on the merits”, i.e. that the conduct
ultimately benefits consumers. As Judge Frank Easterbrook has mercilessly held, “injuries
to rivals are byproducts of vigorous competition, and the antitrust laws are
not balm for rivals’ wounds.” Antitrust law maintains a distinction between
pro- and anti-competitive leveraging because consumers frequently benefit from the
conduct outlined above. Conversely, implementing any of the above proposals
would decrease or negate entirely the ability of platform owners to show that such
conduct benefits consumers.
This post then
examines whether protecting competition in adjacent markets is important enough
to sacrifice the consumer benefits that flow from pro-competitive leveraging. Empirical
criteria that have been present in comparable instances of such intervention,
such as bottleneck power over distribution, evidence of widespread harm to
competition in neighboring markets, static product boundaries, and a lack or
unimportance of integrative efficiencies, are not satisfied in the current
context. Absent some proof that they are, the consumer welfare framework under
antitrust law should prevail without recourse to more intrusive intervention.
Proposals to regulate the activities
of digital platform owners in neighboring markets
1.
Structural separation
Some scholars, such
as Lina Khan, propose to implement “[s]tructural remedies and prophylactic bans [to] limit the ability of
dominant platforms to enter certain distinct lines of business.” Senator
Warren has echoed this proposal, calling for “large
tech platforms to be designated as ‘Platform Utilities’ and broken apart from
any participant on that platform.” Under this proposal, Amazon would be
unable to act both as an online marketplace and a seller on its own
marketplace, Google would be unable to act as both a search engine and a
mapping provider, and Apple and Google would be unable to act as both producers
of mobile operating systems and apps that run on those operating systems.
Meanwhile, Facebook would be unable to operate both its core social media
platform and separate services, such as dating, local buy-and-sell, and other
businesses like Instagram and WhatsApp. Khan posits that such separation is the
primary method of “prevent[ing]
leveraging and eliminat[ing] a core conflict of interest currently embedded in
the business model of dominant platforms.”
A rule that
prohibits entry into neighboring markets will certainly catch all instances of
harmful leveraging, but it will inevitably also condemn all instances of
leveraging that are in fact beneficial to consumers (see below for examples). Moreover,
structural separation would also condemn efficiencies stemming from vertical
integration that do not depend on
leveraging behavior, e.g. elimination of double marginalization. As Bruce Owen sums up, such intervention “is not necessary, and may well reduce welfare by deterring efficient
investments,” in circumstances where “[e]mpirical evidence that vertical
integration or vertical restraints are harmful is weak, compared to evidence
that vertical integration is beneficial.”
2.
Non-discrimination principles
Other scholars seek a prohibition on leveraging, i.e. a “non-discrimination” or “platform
neutrality” standard whereby platform owners cannot treat third-party
products/services differently to how they treat their own. Though framed as a
regulatory regime operating in parallel to antitrust law, such regulation would
have the effect of supplanting antitrust in favor of a standard that blocks all
leveraging behavior, whether pro- or anti-competitive. For example, Apple and
Google could still produce both apps and software platforms, but they would be unable
to bundle them together, even if doing so improves the user experience (or
benefits app developers).
This proposal also disregards
the distinction between pro- and anti-competitive leveraging (albeit in a less
intrusive manner than structural separation). It would, however, appear to
maintain efficiencies stemming solely from vertical integration, as long as
said benefits do not result in preferential treatment of the platform owner’s
products/services.
3.
Reversing the burden of proof
Though not
regulatory in nature, it is also worth including the proposal in the EC’s expert report on “competition in the digital era” of
recalibrating the legal analysis of leveraging conduct by “err[ing] on the side of disallowing potentially anti-competitive
conducts, and impos[ing] on the incumbent the burden of proof for showing the
pro-competitiveness of its conduct.” Under this proposal, once a plaintiff
establishes that leveraging conduct exists (without having to establish that it
satisfies pre-existing legal criteria), the defendant would bear the burden of
showing that its conduct did not have long-run anti-competitive effects or that
the conduct had an overriding efficiency rationale.
As Dolmans and Pesch
point out, proving that conduct does not have a long-term
impact on competition may be nigh on impossible, as it involves proving a
negative. This proposal would therefore bring non-discrimination in by the back
door and return antitrust law to form-based rules that neglect the actual
effects of conduct on competition or consumers. Moreover, making it unduly
difficult for dominant firms to show that their conduct is in fact
pro-competitive, despite any exclusionary effects, would similarly collapse an
effects-based model for leveraging conduct into blanket non-discrimination. The
report’s authors admit as much, citing for their proposal a report by the French telecoms regulator which
advocates “a principle of ‘net
neutrality’ for smartphones, tablets and voice assistants” (i.e. a non-discrimination standard).
Consumer vs. small-business welfare:
which should prevail in digital markets?
Each of the above
proposals would, to varying degrees, dissolve the distinctions between pro- and
anti-competitive leveraging and (in the case of structural separation) pro- and
anti-competitive vertical integration, significantly curtailing the ability of
firms to legitimately out-compete their rivals in neighboring markets. All leveraging would be presumptively
harmful to competition and, by extension, consumers.
The question then
becomes whether we should ignore the incentive
to innovate and compete in platform markets and turn our societal interests to
competition within platforms. It has long been the case that “the
primary purpose of the antitrust laws is to protect interbrand competition.”
However, in certain circumstances, it can be preferable to shift the focus from
inter- to intra-brand competition (often through legislation). Take, for
example, must-carry provisions imposed on cable operators in the US or net
neutrality regulation (repealed in the US, but prevailing in the EU). In
circumstances such as these, society willingly foregoes benefits of continued
innovation and competition in the inter-brand market because it has concluded,
for one reason or another, that bolstering competition in the intra-brand
market is more important. This can entail tolerating counterfactually higher
prices or reduced quality as a byproduct of protecting interests deemed to be
more important, such as maintaining a pluralistic downstream market. In line
with the above proposals, there is a growing belief that such an inversion of
the goals of competition policy is exactly what is needed in digital markets.
This section examines the empirical criteria that one would expect to be
verified before shifting the focal point of competition policy from inter-platform
competition to intra-platform competition.
1.
Strategic bottleneck power over distribution
In past instances of
“access regulation” or structural separation of vertically integrated firms,
there have been concerns that the targeted firms had strategic “bottleneck”
power over the distribution of some downstream product or service, i.e. the firms sat between a set of
suppliers and consumers and, through the control of some vital input or method
of distribution, controlled access between the two. Strategic bottleneck power was
present in the must-carry provisions imposed on cable operators in the US, the
non-discrimination principles enshrined in § 616 of the US Communications Act,
and net neutrality regulation. The same applies to structural separation: when
the District Court approved the consent decree structurally separating
AT&T’s long-distance arm from its local operating companies, it was motivated
by the fact that “the principal means by
which AT&T has maintained monopoly power in telecommunications has been its
control of the Operating Companies with their strategic bottleneck position.”
Do GAFA possess strategic bottleneck power? Take Google Search, for
example. In the EC’s decision in Google
Shopping, it found that referrals from Google Search accounted for a large
proportion of traffic to rival comparison shopping websites and that traffic
could not be effectively replaced by other sources. However, firms operating in
neighboring markets have many more routes to consumers that flout discovery
through a search engine. As John Temple Lang observes, they can access
consumers through “direct navigation, specialized search services, social
networks such as Facebook and Pinterest, partnerships with PC and mobile device
markets, agreements with other publishers to refer traffic to each other, and
so on.” Apple’s iOS and Google’s Android, on the other hand, compete
against each other and thus neither firm, by definition, can possess
the degree of strategic bottleneck power required to consider abandoning their
respective incentives to innovate. As for Amazon: in 2019 it was estimated that
Amazon accounted for 38% of all
online sales in the US. This may seem like a staggering volume, but it in fact shows
that distributors can – and do – bypass Amazon’s platform to reach consumers,
with great success.
Insofar as GAFA possess strategic bottleneck power over particular
categories of goods (i.e. in particular neighboring markets), this
would not justify shifting the focus to intra-platform competition across all
product categories. The market power element of traditional antitrust analyses
serves to guard competition in these circumstances by carving a remedy around
conduct that illegitimately hampers the ability of competitors in neighboring
markets to compete.
2.
Widespread harm in adjacent markets
To ban platform
owners from leveraging anti- and
pro-competitively, one would expect there to be cogent evidence of harm to
competition across a multitude of adjacent markets that depend on the platforms
for access to consumers. However, as Feng Zhu and Qihong Liu note, there is a dearth of empirical evidence on
the effects of platform owners’ entry into complementary markets. Even studies
that support the proposition that such entry dampens or skews innovation
incentives of firms in adjacent markets conclude that the welfare effects are
ambiguous, and that consumers may actually be better off (see e.g. here and here). Other studies show that third-party
producers can benefit from platform entry into adjacent markets (see e.g. here and here). It is therefore clear that this criterion,
which should also be a prerequisite to imposing blanket regulation to control
the behavior of platform owners, has not been satisfied.
3.
Discernible and static product boundaries
In prior cases of
access regulation, the input that firms in neighboring markets have depended on
to access consumers has been clearly distinguishable from their own products. Although
antitrust literature commonly refers to “platforms” and “applications” as if
these are perceptibly different products, the reality is much different: both
platforms and their complementary applications are composed of individual
components and, as Carl Shapiro notes, “the
boundary between the ‘platform’ and services running on that platform can be
fuzzy and can change over time.” Any attempt to freeze the definitional
boundary of a platform would negate platform owners’ incentive to build upon
and improve their platforms, to the detriment of consumers and (in the case of
software platforms) app developers. If Apple were prevented from vertically
integrating, what would iOS look like? Could it even have a voice-call
function? Alternatively, under non-discrimination regulation, what would a new
iOS device look like? Would it just be a blank screen where the user is then
forced to choose between various alternatives?
The problem with
proposing to separate platforms from adjacent products is that any platform component can theoretically
be modularized and opened to competition from third-parties. Because
integration of complementary components is an essential part of inter-platform
competition, imposing the proposed interventions could destroy the very
ecosystems that the competitors that critics seek to protect depend on, and
prevent the next popular digital platform from emerging.
4.
Lack or unimportance of integrative efficiencies
Critics may counter
that efficiencies stemming from leveraging are unimportant or non-existent, or
do not depend on conduct that has exclusionary effects, and thus nothing is
lost by shifting antitrust’s focus to the protection of competitors in adjacent
markets. However, any iPhone user will testify to the consumer benefits flowing
from technically integrating multiple platform components and features into a
single package (e.g. voice-assistant technology and mapping functionality). In
a similar vein, the UK CMA, in approving Google’s acquisition of mapping software
company Waze, was prompted in part by the fact that “[i]ntegration of a map application into the operating system creates
opportunities for operating system developers to use their own or affiliated
services (for example search engines and social networks) to improve the
experience of users.” Integrating Product A (the platform) and Product B (a
component or the software code of an ancillary product/service) can facilitate
the creation some new functionality or feature in the form of Product C that
users value and, crucially, could not achieve by combining Products A and B
themselves (from one or multiple firms). Another potential consumer benefit
flowing from leveraging is a reduction in consumer search costs i.e. providing users with the
functionality or end results that they seek more quickly and efficiently. Even
though anti-competitive concerns can theoretically arise, it remains the case
that, empirically, integration of software code is predominantly motivated by
efficiency justifications and occurs in both competitive and concentrated
markets.
Conclusion
Much of the impetus
to enact the above proposals stems from the perception that antitrust law in
its current form does not act quickly enough to restore competition in the
market. Indeed, it can take over a decade for the dust to settle in big ticket
antitrust cases, by which time antitrust remedies may be too little too late in
those cases where the authorities get it right. To the extent that authorities
can think of innovative ways to enforce existing standards more quickly and accurately,
this would be met with widespread enthusiasm (but may be idealistic).
However, introducing
more intrusive measures to protect competition in neighboring markets, and undermining the consumer welfare standard that
protects the ability of dominant firms to legitimately enter neighboring
markets and compete on the merits, is not warranted. Intervention should remain
targeted and evidence-based. If a complainant can adduce evidence that a
platform owner is leveraging into a neighboring market and raising the complainant’s
cost of doing business, and if the platform owner cannot show a pro-competitive
justification for the behavior, antitrust law will intervene to restore
competition under existing standards. For this, no regulatory intervention or
other change to existing rules is necessary.
For a
more detailed version of this post, see: Patrick F. Todd, Digital Platforms and
the Leverage Problem, 98 Neb. L. Rev. 486 (2019).
[This post is the seventh in an ongoing symposium on “Should We Break Up Big Tech?” that features analysis and opinion from various perspectives.]
[This post is authored by Alec Stapp, Research Fellow at the International Center for Law & Economics]
Should we break up Microsoft?
In all the talk of breaking up “Big Tech,” no one seems to mention the biggest tech company of them all. Microsoft’s market cap is currently higher than those of Apple, Google, Amazon, and Facebook. If big is bad, then, at the moment, Microsoft is the worst.
Apart from size, antitrust activists also claim that the structure and behavior of the Big Four — Facebook, Google, Apple, and Amazon — is why they deserve to be broken up. But they never include Microsoft, which is curious given that most of their critiques also apply to the largest tech giant:
Microsoft is big (current market cap exceeds $1 trillion)
Microsoft is dominant in narrowly-defined markets (e.g., desktop operating systems)
Microsoft is simultaneously operating and competing on a platform (i.e., the Microsoft Store)
Microsoft is a conglomerate capable of leveraging dominance from one market into another (e.g., Windows, Office 365, Azure)
Microsoft has its own “kill zone” for startups (196 acquisitions since 1994)
Microsoft operates a search engine that preferences its own content over third-party content (i.e., Bing)
Microsoft operates a platform that moderates user-generated content (i.e., LinkedIn)
To be clear, this is not to say that an antitrust case against Microsoft is as strong as the case against the others. Rather, it is to say that the cases against the Big Four on these dimensions are as weak as the case against Microsoft, as I will show below.
Big is bad
Tim Wu published a book last year arguing for more vigorous antitrust enforcement — including against Big Tech — called “The Curse of Bigness.” As you can tell by the title, he argues, in essence, for a return to the bygone era of “big is bad” presumptions. In his book, Wu mentions “Microsoft” 29 times, but only in the context of its 1990s antitrust case. On the other hand, Wu has explicitly called for antitrust investigations of Amazon, Facebook, and Google. It’s unclear why big should be considered bad when it comes to the latter group but not when it comes to Microsoft. Maybe bigness isn’t actually a curse, after all.
As the saying goes in antitrust, “Big is not bad; big behaving badly is bad.” This aphorism arose to counter erroneous reasoning during the era of structure-conduct-performance when big was presumed to mean bad. Thanks to an improved theoretical and empirical understanding of the nature of the competitive process, there is now a consensus that firms can grow large either via superior efficiency or by engaging in anticompetitive behavior. Size alone does not tell us how a firm grew big — so it is not a relevant metric.
Dominance in narrowly-defined markets
Critics of Google say it has a monopoly on search and critics of Facebook say it has a monopoly on social networking. Microsoft is similarly dominant in at least a few narrowly-defined markets, including desktop operating systems (Windows has a 78% market share globally):
Microsoft is also dominant in the “professional networking platform” market after its acquisition of LinkedIn in 2016. And the legacy tech giant is still the clear leader in the “paid productivity software” market. (Microsoft’s Office 365 revenue is roughly 10x Google’s G Suite revenue).
The problem here is obvious. These are overly-narrow market definitions for conducting an antitrust analysis. Is it true that Facebook’s platforms are the only service that can connect you with your friends? Should we really restrict the productivity market to “paid”-only options (as the EU similarly did in its Android decision) when there are so many free options available? These questions are laughable. Proper market definition requires considering whether a hypothetical monopolist could profitably impose a small but significant and non-transitory increase in price (SSNIP). If not (which is likely the case in the narrow markets above), then we should employ a broader market definition in each case.
Simultaneously operating and competing on a platform
Elizabeth Warren likes to say that if you own a platform, then you shouldn’t both be an umpire and have a team in the game. Let’s put aside the problems with that flawed analogy for now. What she means is that you shouldn’t both run the platform and sell products, services, or apps on that platform (because it’s inherently unfair to the other sellers).
Warren’s solution to this “problem” would be to create a regulated class of businesses called “platform utilities” which are “companies with an annual global revenue of $25 billion or more and that offer to the public an online marketplace, an exchange, or a platform for connecting third parties.” Microsoft’s revenue last quarter was $32.5 billion, so it easily meets the first threshold. And Windows obviously qualifies as “a platform for connecting third parties.”
Just as in mobile operating systems, desktop operating systems are compatible with third-party applications. These third-party apps can be free (e.g., iTunes) or paid (e.g., Adobe Photoshop). Of course, Microsoft also makes apps for Windows (e.g., Word, PowerPoint, Excel, etc.). But the more you think about the technical details, the blurrier the line between the operating system and applications becomes. Is the browser an add-on to the OS or a part of it (as Microsoft Edge appears to be)? The most deeply-embedded applications in an OS are simply called “features.”
Even though Warren hasn’t explicitly mentioned that her plan would cover Microsoft, it almost certainly would. Previously, she left Apple out of the Medium post announcing her policy, only to later tell a journalist that the iPhone maker would also be prohibited from producing its own apps. But what Warren fails to include in her announcement that she would break up Apple is that trying to police the line between a first-party platform and third-party applications would be a nightmare for companies and regulators, likely leading to less innovation and higher prices for consumers (as they attempt to rebuild their previous bundles).
Leveraging dominance from one market into another
The core critique in Lina Khan’s “Amazon’s Antitrust Paradox” is that the very structure of Amazon itself is what leads to its anticompetitive behavior. Khan argues (in spite of the data) that Amazon uses profits in some lines of business to subsidize predatory pricing in other lines of businesses. Furthermore, she claims that Amazon uses data from its Amazon Web Services unit to spy on competitors and snuff them out before they become a threat.
Of course, this is similar to the theory of harm in Microsoft’s 1990s antitrust case, that the desktop giant was leveraging its monopoly from the operating system market into the browser market. Why don’t we hear the same concern today about Microsoft? Like both Amazon and Google, you could uncharitably describe Microsoft as extending its tentacles into as many sectors of the economy as possible. Here are some of the markets in which Microsoft competes (and note how the Big Four also compete in many of these same markets):
What these potential antitrust harms leave out are the clear consumer benefits from bundling and vertical integration. Microsoft’s relationships with customers in one market might make it the most efficient vendor in related — but separate — markets. It is unsurprising, for example, that Windows customers would also frequently be Office customers. Furthermore, the zero marginal cost nature of software makes it an ideal product for bundling, which redounds to the benefit of consumers.
The “kill zone” for startups
In a recent article for The New York Times, Tim Wu and Stuart A. Thompson criticize Facebook and Google for the number of acquisitions they have made. They point out that “Google has acquired at least 270 companies over nearly two decades” and “Facebook has acquired at least 92 companies since 2007”, arguing that allowing such a large number of acquisitions to occur is conclusive evidence of regulatory failure.
Microsoft has made 196 acquisitions since 1994, but they receive no mention in the NYT article (or in most of the discussion around supposed “kill zones”). But the acquisitions by Microsoft or Facebook or Google are, in general, not problematic. They provide a crucial channel for liquidity in the venture capital and startup communities (the other channel being IPOs). According to the latest data from Orrick and Crunchbase, between 2010 and 2018, there were 21,844 acquisitions of tech startups for a total deal value of $1.193 trillion.
By comparison, according to data compiled by Jay R. Ritter, a professor at the University of Florida, there were 331 tech IPOs for a total market capitalization of $649.6 billion over the same period. Making it harder for a startup to be acquired would not result in more venture capital investment (and therefore not in more IPOs), according to recent research by Gordon M. Phillips and Alexei Zhdanov. The researchers show that “the passage of a pro-takeover law in a country is associated with more subsequent VC deals in that country, while the enactment of a business combination antitakeover law in the U.S. has a negative effect on subsequent VC investment.”
As investor and serial entrepreneur Leonard Speiser said recently, “If the DOJ starts going after tech companies for making acquisitions, venture investors will be much less likely to invest in new startups, thereby reducing competition in a far more harmful way.”
Search engine bias
Google is often accused of biasing its search results to favor its own products and services. The argument goes that if we broke them up, a thousand search engines would bloom and competition among them would lead to less-biased search results. While it is a very difficult — if not impossible — empirical question to determine what a “neutral” search engine would return, one attempt by Josh Wright found that “own-content bias is actually an infrequent phenomenon, and Google references its own content more favorably than other search engines far less frequently than does Bing.”
The report goes on to note that “Google references own content in its first results position when no other engine does in just 6.7% of queries; Bing does so over twice as often (14.3%).” Arguably, users of a particular search engine might be more interested in seeing content from that company because they have a preexisting relationship. But regardless of how we interpret these results, it’s clear this not a frequent phenomenon.
So why is Microsoft being left out of the antitrust debate now?
One potential reason why Google, Facebook, and Amazon have been singled out for criticism of practices that seem common in the tech industry (and are often pro-consumer) may be due to the prevailing business model in the journalism industry. Google and Facebook are by far the largest competitors in the digital advertising market, and Amazon is expected to be the third-largest player by next year, according to eMarketer. As Ramsi Woodcock pointed out, news publications are also competing for advertising dollars, the type of conflict of interest that usually would warrant disclosure if, say, a journalist held stock in a company they were covering.
Or perhaps Microsoft has successfully avoided receiving the same level of antitrust scrutiny as the Big Four because it is neither primarily consumer-facing like Apple or Amazon nor does it operate a platform with a significant amount of political speech via user-generated content (UGC) like Facebook or Google (YouTube). Yes, Microsoft moderates content on LinkedIn, but the public does not get outraged when deplatforming merely prevents someone from spamming their colleagues with requests “to add you to my professional network.”
Microsoft’s core areas are in the enterprise market, which allows it to sidestep the current debates about the supposed censorship of conservatives or unfair platform competition. To be clear, consumer-facing companies or platforms with user-generated content do not uniquely merit antitrust scrutiny. On the contrary, the benefits to consumers from these platforms are manifest. If this theory about why Microsoft has escaped scrutiny is correct, it means the public discussion thus far about Big Tech and antitrust has been driven by perception, not substance.
The dust has barely settled on the European Commission’s record-breaking €4.3 Billion Google Android fine, but already the European Commission is gearing up for its next high-profile case. Last month, Margrethe Vestager dropped a competition bombshell: the European watchdog is looking into the behavior of Amazon. Should the Commission decide to move further with the investigation, Amazon will likely join other US tech firms such as Microsoft, Intel, Qualcomm and, of course, Google, who have all been on the receiving end of European competition enforcement.
The Commission’s move – though informal at this stage – is not surprising. Over the last couples of years, Amazon has become one of the world’s largest and most controversial companies. The animosity against it is exemplified in a paper by Lina Khan, which uses the example of Amazon to highlight the numerous ills that allegedly plague modern antitrust law. The paper is widely regarded as the starting point of the so-called “hipster antitrust” movement.
But is there anything particularly noxious about Amazon’s behavior, or is it just the latest victim of a European crusade against American tech companies?
Where things stand so far
As is often the case in such matters, publicly available information regarding the Commission’s “probe” (the European watchdog is yet to open a formal investigation) is particularly thin. What we know so far comes from a number of declarations made by Margrethe Vestager (here and here) and a leaked questionnaire that was sent to Amazon’s rivals. Going on this limited information, it appears that the Commission is preoccupied about the manner in which Amazon uses the data that it gathers from its online merchants. In Vestager’s own words:
The question here is about the data, because if you as Amazon get the data from the smaller merchants that you host […] do you then also use this data to do your own calculations? What is the new big thing, what is it that people want, what kind of offers do they like to receive, what makes them buy things.
These concerns relate to the fact that Amazon acts as both a retailer in its own right and a platform for other retailers, which allegedly constitutes a “conflict of interest”. As a retailer, Amazon sells a wide range of goods directly to consumers. Meanwhile, its marketplace platform enables third party merchants to offer their goods in exchange for referral fees when items are sold (these fees typically range from 8% to 15%, depending on the type of good). Merchants can either execute theses orders themselves or opt for fulfilment by Amazon, in which case it handles storage and shipping. In addition to its role as a platform operator, As of 2017, more than 50% of units sold on the Amazon marketplace where fulfilled by third-party sellers, although Amazon derived three times more revenue from its own sales than from those of third parties (note that Amazon Web Services is still by far its largest source of profits).
Mirroring concerns raised by Khan, the Commission worries that Amazon uses the data it gathers from third party retailers on its platform to outcompete them. More specifically, the concern is that Amazon might use this data to identify and enter the most profitable segments of its online platform, excluding other retailers in the process (or deterring them from joining the platform in the first place). Although there is some empirical evidence to support such claims, it is far from clear that this is in any way harmful to competition or consumers. Indeed, the authors of the paper that found evidence in support of the claims note:
Amazon is less likely to enter product spaces that require greater seller efforts to grow, suggesting that complementors’ platform‐specific investments influence platform owners’ entry decisions. While Amazon’s entry discourages affected third‐party sellers from subsequently pursuing growth on the platform, it increases product demand and reduces shipping costs for consumers.
Thou shalt not punish efficient behavior
The question is whether Amazon using data on rivals’ sales to outcompete them should raise competition concerns? After all, this is a standard practice in the brick-and-mortar industry, where most large retailers use house brands to go after successful, high-margin third-party brands. Some, such as Costco, even eliminate some third-party products from their shelves once they have a successful own-brand product. Granted, as Khan observes, Amazon may be doing this more effectively because it has access to vastly superior data. But does that somehow make Amazon’s practice harmful to social social welfare? Absent further evidence, I believe not.
The basic problem is the following. Assume that Amazon does indeed have a monopoly in the market for online retail platforms (or, in other words, that the Amazon marketplace is a bottleneck for online retailers). Why would it move into direct retail competition against its third party sellers if it is less efficient than them? Amazon would either have to sell at a loss or hope that consumers saw something in its products that warrants a higher price. A more profitable alternative would be to stay put and increase its fees. It could thereby capture all the profits of its independent retailers. Not that Amazon would necessarily want to do so, as this could potentially deter other retailers from joining its platform. The upshot is that Amazon has little incentive to exclude more efficient retailers.
Astute readers, will have observed that this is simply a restatement of the Chicago school’s Single Monopoly Theory, which broadly holds that, absent efficiencies, a monopolist in one line of commerce cannot increase its profits by entering the competitive market for a complementary good. Although the theory has drawn some criticism, it remains a crucial starting point with which enforcers must contend before they conclude that a monopolist’s behavior is anticompetitive.
So why does Amazon move into retail segments that are already occupied by its rivals? The most likely explanation is simply that it can source and sell these goods more efficiently than them, and that these efficiencies cannot be achieved through contracts with the said rivals. Once we accept the possibility that Amazon is simply more efficient, the picture changes dramatically. The sooner it overthrows less efficient rivals the better. Doing so creates valuable surplus that can flow to either itself or its consumers. This is true regardless of whether Amazon has a marketplace monopoly or not. Even if it does have a monopoly (which is doubtful given competition from the likes of Zalando, AliExpress, Google Search and eBay), at least some of these efficiencies will likely be passed on to consumers. Such a scenario is also perfectly compatible with increased profits for Amazon. The real test is whether output increases when Amazon enters segments that were previously occupied by rivals.
Of course, the usual critiques voiced against the “Single Monopoly Profit” theory apply here. It is plausible that, by excluding its retail rivals, Amazon is simply seeking to protect its alleged platform monopoly. However, the anecdotal evidence that has been raised thus far does not support this conclusion.
But what about innovation?
Possibly sensing the weakness of the “inefficiency” line of arguments against Amazon, critics will likely put put forward a second theory of harm. The claim is that by capturing the rents of potentially innovative retailers, Amazon may hamper their incentives to innovate and will therefore harm consumer choice. Margrethe Vestager intimated this much in a Bloomberg interview. Though this framing might seem tempting at first, it falters under close inspection.
The effects of Amazon’s behavior could first be framed in terms of appropriability — that is: the extent to which an innovator captures the social benefits of its innovation. The higher its share of those benefits, the larger its incentives to innovate. By forcing out its retail rivals, it is plausible that Amazon is reducing the returns which they earn on their potential innovations.
Another potential framing is that of holdup theory. Applied to this case, one could argue that rival retailers made sunk investments (potentially innovation-related) to join the Amazon platform, and that Amazon is behaving opportunistically by capturing their surplus. With hindsight, merchants might thus have opted to stay out of the Amazon marketplace.
Unfortunately for Amazon’s critics, there are numerous objections to these two framings. For a start, the business implication of both the appropriability and holdup theories is that firms can and should take sensible steps to protect their investments. The recent empirical paper mentioned above stresses that these actions are critical for the sake of Amazon’s retailers.
Potential solutions abound. Retailers could in principle enter into long-term exclusivity agreements with their suppliers (which would keep Amazon out of the market if there are no alternative suppliers). Alternatively, they could sign non-compete clauses with Amazon, exchange assets, or even outright merge. In fact, there is at least some evidence of this last possibility occurring, as Amazon has acquired some of its online retailers. The fact that some retailers have not opted for these safety measures (or other methods of appropriability) suggests that they either don’t perceive a threat or are unwilling to make the necessary investments. It might also be due to bad business judgement on their part).
Which brings us to the big question. Should competition law step into the breach in those cases where firms have refused to take even basic steps to protect their investments? The answer is probably no.
For a start, condoning this poor judgement encourages firms to rely on competition enforcement rather than private solutions to solve appropriability and holdup issues. This is best understood with reference to moral hazard. By insuring firms against the capture of their profits, competition authorities disincentivize all forms of risk-mitigation on the part of those firms. This will ultimately raise enforcement costs (as firms become increasingly reliant on the antitrust system for protection).
It is also informationally much more burdensome, as authorities will systematically have to rule on the appropriate share of profits between parties to a case.
Finally, overprotecting these investments would go against the philosophy of the European Court of Justice’s Huaweiruling. Albeit in the specific context of injunctions relating to SEPs, the Court conditioned competition liability on firms showing that they have taken a series of reasonable steps to sort out their disputes privately.
Concluding remarks
This is not to say that competition intervention should categorically be proscribed. But rather that the capture of a retailer’s investments by Amazon is an insufficient condition for enforcement actions. Instead, the Commission should question whether Amazon’s actions are truly detrimental to consumer welfare and output. Absent strong evidence that an excluded retailer offered superior products, or that Amazon’s move was merely a strategic play to prevent entry, competition authorities should let the chips fall where they may.
As things stand, there is simply no evidence to indicate that anything out of the ordinary is occurring on the Amazon marketplace. By shining the spotlight on Amazon, the Commission is putting itself under tremendous political pressure to move forward with a formal investigation (all the more so, given the looming European Parliament elections). This is regrettable, as there are surely more pressing matters for the European regulator to deal with. The Commission would thus do well to recall the words of Shakespeare in the Merchant of Venice: “All that glisters is not gold”. Applied in competition circles this translates to “all that is big is not inefficient”.
After more than a year of complaining about Google and being met with responses from me (see also here, here, here, here, and here, among others) and many others that these complaints have yet to offer up a rigorous theory of antitrust injury — let alone any evidence — FairSearch yesterday offered up its preferred remedies aimed at addressing, in its own words, “the fundamental conflict of interest driving Google’s incentive and ability to engage in anti-competitive conduct. . . . [by putting an] end [to] Google’s preferencing of its own products ahead of natural search results.” Nothing in the post addresses the weakness of the organization’s underlying claims, and its proposed remedies would be damaging to consumers.
FairSearch’s first and core “abuse” is “[d]iscriminatory treatment favoring Google’s own vertical products in a manner that may harm competing vertical products.” To address this it proposes prohibiting Google from preferencing its own content in search results and suggests as additional, “structural remedies” “[r]equiring Google to license data” and “[r]equiring Google to divest its vertical products that have benefited from Google’s abuses.”
Tom Barnett, former AAG for antitrust, counsel to FairSearch member Expedia, and FairSearch’s de facto spokesman should be ashamed to be associated with claims and proposals like these. He better than many others knows that harm to competitors is not the issue under US antitrust laws. Rather, US antitrust law requires a demonstration that consumers — not just rivals — will be harmed by a challenged practice. He also knows (as economists have known for a long time) that favoring one’s own content — i.e., “vertically integrating” to produce both inputs as well as finished products — is generally procompetitive.
Because a Section 2 violation hurts competitors, they are often the focus of section 2 remedial efforts. But competitor well-being, in itself, is not the purpose of our antitrust laws.
Access remedies also raise efficiency and innovation concerns. By forcing a firm to share the benefits of its investments and relieving its rivals of the incentive to develop comparable assets of their own, access remedies can reduce the competitive vitality of an industry.
Not only has FairSearch not actually demonstrated that Google has preferenced its own products, the organization has also not demonstrated either harm to consumers arising from such conduct nor even antitrust-cognizable harm to competitors arising from it.
As an empirical study supported by the International Center for Law and Economics (itself, in turn, supported in part by Google, and of which I am the Executive Director) makes clear, search bias simply almost never occurs. And when it does, it is the non-dominant Bing that more often practices it, not Google. Moreover, and most important, the evidence marshaled in favor of the search bias claim (largely adduced by Harvard Business School professor, Ben Edelman (whose work is supported by Microsoft)) demonstrates that consumers do, indeed, have the ability to detect and counter allegedly biased results.
Recall what search bias means in this context. According to Edelman, looking at the top three search results, Google links to its own content (think Gmail, Google Maps, etc.) in the first search result about twice as often as Yahoo! and Bing link to Google content in this position. While the ICLE paper refutes even this finding, notice what it means: “Biased” search results lead to a reshuffling of results among the top few results offered up; there is no evidence that Google simply drops users’ preferred results. While it is true that the difference in click-through rates between the top and second results can be significant, Edelman’s own findings actually demonstrate that consumers are capable of finding what they want when their preferred (more relevant) results appears in the second or third slot.
Edelman notes that Google ranks Gmail first and Yahoo! Mail second in his study, even though users seem to think Yahoo! Mail is the more relevant result: Gmail receives only 29% of clicks while Yahoo! Mail receives 54%. According to Edelman, this is proof that Google’s conduct forecloses access by competitors and harms consumers under the antitrust laws.
But is it? Note that users click on the second, apparently more-relevant result nearly twice as often as they click on the first. This demonstrates that Yahoo! is not competitively foreclosed from access to users, and that users are perfectly capable of identifying their preferred results, even when they appear lower in the results page. This is simply not foreclosure — in fact, if anything, it demonstrates the opposite.
Among other things, foreclosure — limiting access by a competitor to a necessary input — under the antitrust laws must be substantial enough to prevent a rival from reaching sufficient scale that it can effectively compete. It is no more “foreclosure” for Google to “impair” traffic to Kayak’s site by offering its own Flight Search than it is for Safeway to refuse to allow Kroger to sell Safeway’s house brand. Rather, actionable foreclosure requires that a firm “impair[s] the ability of rivals to grow into effective competitors that erode the firm’s position.” Such quantifiable claims are noticeably absent from critic’s complaints against Google.
And what about those allegedly harmed competitors? How are they faring? As of September 2012, Google ranks 7th in visits among metasearch travel sites, with a paltry 1.4% of such visits. Residing at number one? FairSearch founding member, Kayak, with a whopping 61% (up from 52% six months after Google entered the travel search business). Nextag.com, another vocal Google critic, has complained that Google’s conduct has forced it to shift its strategy from attracting traffic through Google’s organic search results to other sources, including paid ads on Google.com. And how has it fared? It has parlayed its experience with new data sources into a successful new business model, Wize Commerce, showing exactly the sort of “incentive to develop comparable assets of their own” Barnett worries will be destroyed by aggressive antitrust enforcement. And Barnett’s own Expedia.com? Currently, it’s the largest travel company in the world, and it has only grown in recent years.
Meanwhile consumers’ interests have been absent from critics’ complaints since the beginning. And not only do they fail to demonstrate any connection between harm to consumers and the claimed harms to competitors arising from Google’s conduct, but they also ignore the harm to consumers that may result from restricting potentially efficient business conduct — like the integration of Google Maps and other products into its search results. That Google not only produces search results but also owns some of the content that generates those results is not a problem cognizable by modern antitrust.
FairSearch and other Google critics have utterly failed to make a compelling case, and their proposed remedies would serve only to harm, not help, consumers.
Steve Bainbridge invites my opinion of Delaware lawyer Edward McNally’s view that alternative entities “may not protect investors.” By “alternative entities” he is referring to limited liability companies and limited partnerships, despite his own recognition that they “have become the preferred form of entity for new businesses” (so why aren’t corporations “alternative entities”)? He uses as the text for his sermon VC Noble’s recent opinion in Brinckerhoff v. Enbridge Energy Co.involving the interpretation of a broad fiduciary duty waiver.
McNally says that “the lack of a uniform governance structure in these alternative entities may cause problems” when there are outside investors. He argues that broad fiduciary waivers may result in investors not being adequately paid for the risks they’re taking because “it seems doubtful that those risks can ever be adequately anticipated.” By contrast
corporate entities with much more standardized governance norms with greater investor protection have long flourished and raised capital. The corporate governance form benefits from its predictability and presumably raised capital effectively without the added risk of unpredictable governance provisions. Thus, the theoretical justification for letting alternative entities be governed loosely [that investors are paid for the risks they take] may not be valid.
Moreover, he says, the parties may not know for sure whether the waiver is effective. He cites the following example:
Years ago, we had a case where a master limited partnership’s 60-page operating agreement attempted in great detail to spell out how to handle conflict of interest transactions involving its general partner. After consulting a national legal expert on limited partnerships, the general partner bought limited partnership interests following what it thought was the correct process. It was promptly sued, lost and paid millions of dollars in damages. The court held it followed the wrong process, and in doing so had breached its duty to the partnership. Complexity has its own risks.
He concludes that this is why “few alternative entities have been used as a vehicle to issue publicly traded securities, such as limited partnerships or membership interests.”
McNally repeatedly refers to the entity involved in Brinckerhoff as an “LLP.” These are the initials for a “limited liability partnership,” which is a form of general partnership. However, the entity in the case is a limited partnership, or “LP.” He also confuses the “good faith” duty, a fiduciary duty which the agreement in Brinckerhoff added, with the “implied contractual covenant of good faith and fair dealing,” a non-waivable rule of contractual interpretation under Delaware law.
Apart from these technical glitches, I question McNally’s reasoning. As to his claim of unpredictability, as I have discussed at some length, Delaware alternative entities are actually a way to avoid the more serious indeterminacy problem in corporate law. McNally’s illustration of uncorporate unpredictability is unpersuasive. Maybe the general partner’s legal advisor was wrong, or the court erred. Both can also happen in corporate practice. Anyway, he says this happened “years ago.” Delaware uncorporate jurisprudence has developed rapidly in recent years, as the Brinckerhoff case itself illustrates.
Now let’s examine the case. A pipeline partnership found itself mid-project at the nadir of the finaical crisis. Its controller offered to invest. A special committee negotiated a deal and hired legal and financial advisors to evaluate it. They determined that it met the agreement’s “arms length” value standard for deals with affiliates. The court held this was not bad faith. The court noted (n. 39):
Although on some level the [agreement] may appear problematic for the simple reason that the controller of a limited partnership’s general partner is engaging in a transaction with the limited partnership, the LPA anticipates such transactions. Moreover, if the Court were to determine that [plaintiff] could state a claim that Enbridge [the defendant controlling party] acted in bad faith even though Enbridge negotiated the JVA with an independent special committee, then what would Enbridge have to do to be able to dispose of bad faith claims on a motion to dismiss? Would Enbridge be required, in analogy to In re John Q. Hammons Hotels Inc. S’holder Litig., 2009 WL 3165613 (Del. Ch. Oct. 2, 2009), to negotiate a transaction with an independent committee and have the transaction approved by a majority of the public unit holders? Requiring Enbridge to put in place those “robust procedural protections,” in order to be able to dispose of a bad faith claim on a motion to dismiss, would seem to rewrite the LPA when the Delaware General Assembly has explicitly stated that “[i]t is the policy of [Delaware’s Limited Partnership Act] … to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements.” 6 Del. C. § 17–1101(c).
The court interestingly compares the determinacy of the partnership agreement with the indeterminacy the parties avoided by not being a corporation.
As I have discussed elsewhere (e.g., here and here) the parties to uncorporations may quite reasonably trade off exit and managerial incentives for control and fiduciary duties. The courts should enforce these contracts and the Delaware courts do. It follows that McNally’s broader point that uncorporate entities are generally unsuitable for outside investors is flat wrong.
McNally raises the separate question of why there are only a relative few publicly held alternative entities. One reason may be that the exit tradeoff I referred to may not work in publicly held firms. Most such firms need the corporate feature of “capital lock in” which precludes buyout and dissolution provisions.
Bottom line: Lawyers need to understand that “alternative” entities are an important transactional tool for clients. Protestations that uncorporate law is too new or unpredictable, which were common 20 years ago, simply don’t wash today.
Although it has the zing of a slogan that I myself have often used, the call to ‘deregulate’ the legal profession is misleading. Yes, most of us who argue that the legal profession is excessively closed to competition—in a way that hampers both access and innovation, as I have argued in recent papers—think that the entry barriers are too high. But the legal profession is not only over-regulated, it is also under-regulated. The regulatory regime lawyers and judges have put in place is overly protective of lawyers’ interests and insufficiently protective of the public’s interest in an accessible, innovative, and efficient legal system. So the goal should not be ‘deregulation’ but ‘right-regulation.’
Right-regulation of the legal profession would not only remove the barriers to the corporate practice of law and limits on the capacity for legal services to be provided by a much wider array of entities and individuals. It would also expose suppliers of legal services to the consumer protection, professional negligence, antitrust, and other law that regulates ordinary markets. Currently, many of these areas of law that support efficient markets are disabled or hobbled when it comes to the legal profession. Bar disciplinary efforts are weak; legal negligence is much harder to prove than other forms of professional negligence. The bar asserts immunity from antitrust laws under the state action doctrine. Even the potential regulatory role of legislatures—both state and federal—is undercut in legal markets: lawyers and judges claim an exclusive authority to regulate. (More about this in my next post)
The major flaw in the regulatory structure governing legal markets is that it is in the hands of lawyers and judges. This raises problems, of course, of a conflict of interest. But even if we think that lawyers and judges are sincere in their belief that the regulatory efforts of the bar and judiciary are necessary to protect the public interest, there’s no reason to think that lawyers and judges make good policymakers in this regard. This leads to a lot of ‘wrong-regulation’ because the policymaking is poorly informed and poorly executed. Lawyers and judges are not policy experts; they don’t have staffs devoted to collecting and analyzing data or exploring alternative regulatory models or consulting experts and market participants—all of which are the things that it usually takes to develop good policy. This is how regulation in most areas of the economy is developed. Bar associations and courts—operating in their administrative capacity—are poorly equipped to understand the impact of, for example, restrictions on outside capital or multi-disciplinary practice on innovation in business legal services or price in legal markets; or the impact of unauthorized practice of law rules on the cost, quality and availability of legal help to ordinary people. Learning how to “think like a lawyer” is not a great way to learn how to structure a major piece of economic infrastructure. But in large and important respects that’s what our legal system is: economic infrastructure. The costs of leaving the regulatory reins of this critical infrastructure in the hands of lawyers and judges are mounting rapidly in the face of global economic change.
It’s been over four years since the heyday of the last boom when I first discussed what I called “privlic equity” in an article about Blackstone’s proposed IPO.
Apollo Global Management LLC became a public company in late March. Last year, KKR & Co. began trading on the New York Stock Exchange. * * * There is more to come. Oaktree Capital Group LLC is planning to sell $100 million of shares, while private-equity powerhouse Carlyle Group LLC is expected to come public in the next six months or so. Meanwhile, hedge-fund investor William Ackman is expected to sell public shares of a new hedge fund.
For those who were skeptical about this business form back in 2007, it’s worth noting that “skeptics acknowledge there is little evidence that being public crimps returns. Blackstone recently raised a $15 billion new fund despite the rough economic period.”
Some may wonder why “private equity” wants to go public. The WSJ story points to the “irony. . . that many private-equity firms tell potential acquisition targets that becoming private through a sale to these firms will allow their businesses to prosper.” The article ineptly responds by parroting the privlic equity hype that “operating privately works best for companies undergoing change, but their investment businesses already are strong and can thrive as public companies.” Yeah, whatever.
I have a more cogent explanation, which I’ve discussed in several places, including the University of Chicago Law Review and my book, Rise of the Uncorporation. I argue that the important feature of what I call “uncorporations,” including private equity firms like the ones noted in the WSJ article, is not whether they’re public or private but their form of governance. In a nutshell, uncorporations substitute partnership-type incentives for corporate-type monitoring. The elements of partnership-type governance include making managers true owners and giving the owners greater access to the cash. This can make sense for both publicly and privately held firms.
Here, for example, is my description of Blackstone in the Chicago article (304-05, footnotes omitted):
[T]he owners of the managing general partner of the publicly traded Blackstone Group own equity shares in the funds and will continue to receive directly a share of the carry. The Group, in turn, owns controlling general partnership interests in the funds. As in other publicly traded partnerships, taxing earnings, whether or not distributed, to the owners should make them more averse than corporate shareholders to earnings retention. Managers who retain earnings on which the unitholders are taxed are likely to be judged harshly in the capital markets and thus face constraints on future capital-raising.
As a tradeoff for partnership discipline and incentives, “privlic” equity firms eliminate the monitoring mechanisms that characterize the corporate form. The Blackstone Group prospectus thus correctly calls itself “a different kind of public company.” Blackstone Group unitholders get almost no formal control rights. The LLC that manages the Group is controlled by a board elected by the LLC members, not by the Group or its unitholders. The prospectus makes clear that the unitholders “will have only limited voting rights on matters affecting our business and . . . will have little ability to remove our general partner.”
Privlic equity firms also sharply restrict managers’ fiduciary duties. For example, The Blackstone Group limited partnership agreement provides that the general partner may make decisions in its “sole discretion” considering any interests it desires, including its own. The general partner may resolve any conflict of interest between the Group and the general partner as long as its decision is “fair and reasonable.” A unitholder challenging the decision has the burden of proof on this issue, and a decision approved by independent directors is conclusively deemed to be fair and reasonable and not a breach of duty. In addition, since the Group is a Delaware limited partnership, courts are likely to enforce these limitations on fiduciary duties.
This uncorporate structure is not for all firms. As discussed in Rise of the Uncorporation, the form makes a lot of sense for the standard publicly traded partnership, which manages “natural resources, real estate, and other properties as these firms can commit to making distributions without compromising long-term business plans.” It may make less sense for more entrepreneurial firms that have a lot of business opportunities and need to give their managers control of the cash. Private equity is somewhere in between.
My discussion of privlic equity in this early-2010 book ended on a bleak note appropriate to the times, noting that “privlic equity shares have melted down with the rest of the market” and “the possibility that the firms will repurchase their newly cheap shares and become private again. It is not clear whether the privlic model ultimately will be seen as a short-lived fad of the financial boom, will make a comeback when the market does, or be seen as a transitional structure that will give rise to the publicly held uncorporation of the future.”
I also suggested that privlic equity might be the harbinger of a “convergence of corporate and uncorporate forms or some sort of reconfiguration of the divisions among large firms.”
It’s not clear from the WSJ article exactly what is happening in this resurgence of privlic equity. Among other things, I don’t know whether the new IPOs will use Blackstone-type techniques to avoid restrictions on partnership taxation of publicly traded partnerships, or will be tax corporations. If the former, it would seem the firms will face pressures to make distributions, since the owners will be taxed on the income whether distributed or not. Yet the WSJ article suggest the firms will have corporate-type “capital lock-in” (to use Margaret Blair’s term): “Mr. Ackman’s IPO would give him capital for investments that can’t be yanked by investors if they sour on him or the market.”
The WSJ article indicates there’s still confusion about what’s going on with these firms. But since going privlic may be here to stay, it’s time to try to understand their financial significance. I suggested in the conclusion of Rise of the Uncorporation that this could be the harbinger of a new type of hybrid firm:
For example, regulators may insist that firms adopt uncorporate discipline before they can waive such important corporate features as shareholder voting and fiduciary duties. Also, publicly traded uncorporations arguably have the same need for inflexible rules as publicly held corporations. Regulators therefore might mandate features such as limited terms or regular distributions for firms that seek to opt out of standard corporate features. In short, the publicly traded partnership could become a distinct type of firm that straddles the corporate-uncorporate boundary.
In other words, we might finally have to face the failure of standard corporate-type governance and the need to replace it with something that works better than shareholder democracy and the business judgment rule.
In a recent Dealbook post, Steven M. Davidoff complains that Delaware’s business judgment rule is too lenient. Davidoff contends that “[a] Delaware court is not going to find [directors] liable no matter how stupid their decisions are. Instead, a Delaware court will find them liable only if they intentionally acted wrongfully or were so oblivious that it was essentially the same thing.” He then asserts that a commonly heard justification for this lenient approach — that it is required in order to induce qualified individuals to serve as directors — is “laughable.”
Prof. Davidoff’s pithy summary of the Delaware business judgment rule seems accurate, and I share his skepticism toward the argument that the rule is justified as a means of inducing highly qualified directors to serve. I disagree, though, with his insinuation that the Delaware approach is unjustified. The rule makes a great deal of sense as a means of aligning the incentives of directors (and officers) with those of shareholders.
Under Delaware’s business judgment rule, courts will abstain from second-guessing the merits of a business decision — even one that appears, in retrospect, to have been substantively unreasonable — as long as the directors acted honestly, in good faith, without any conflict of interest, and on a reasonably informed basis (i.e., they weren’t “grossly negligent” in informing themselves prior to making the decision at issue). Courts treat the rule as quasi-jurisdictional, insisting that they simply will not hear complaints about the substantive reasonableness of a decision as long as the prerequisites to BJR protection are satisfied.
One frequently hears two justifications for this deferential approach. First, courts sometimes seek to justify it on grounds that they are not business experts. Second, as Prof. Davidoff observes, directors and officers often defend it on grounds that it’s needed to prevent qualified directors from being scared off by the prospect of huge liability for good faith business decisions that turn out poorly.
Neither justification works very well. Courts routinely second-guess the substance of decisions in areas where they lack expertise and might, by imposing liability, dissuade qualified individuals from offering their services. Consider, for example, medical malpractice. Courts aren’t medical experts, yet they routinely second-guess the substance of good faith, reasonably informed treatment decisions. And they do this with full knowledge that malpractice judgments dissuade qualified doctors from providing their services. (Remember President Bush’s concern that malpractice verdicts were dissuading gynecologists from “practic[ing] their love with women all across this country”?) There must be something more to the story.
Indeed, there is. By insulating directors from liability for good faith, informed business decisions that turn out poorly, the business judgment rule encourages directors to take greater business risks. This is a good thing, because directors and officers tend to be more risk averse than their principals, the shareholders. I previously explained that point in criticizing Mark Cuban’s claim that shareholders and CEOs “have completely different agendas: Most chief executives want to hit a ‘home run’ — taking big risks for potentially big payoffs — while most mom-and-pop shareholders simply hope not to ‘strike out’ and lose their nest egg.” I wrote:
… Stockholders would normally prefer corporate managers to take more, not less, business risk.
When it comes to managerial decision-making, rational stockholders prefer greater risk-taking (which is associated with higher potential rewards) for a number of reasons. First, stockholders have limited liability, which means that if a business venture totally tanks and creates liabilities in excess of the corporation’s assets, the stockholders are off the hook for the excess. Since stockholders are able to externalize some of the downside of business risks, they’ll tend to be risk-preferring. Moreover, stockholders are the “residual claimants” of a corporation — they don’t get paid until obligations to all other corporate constituents (creditors, employees, preferred stockholders, etc.) have been satisfied. In other words, they get nothing if the corporation breaks even, and they therefore would prefer that managers pursue business ventures likely to do more than break even. Finally, stockholders are able to eliminate firm-specific, “unsystematic” risk from their investment portfolios by owning a diversified collection of stocks. They therefore do not care about such risk (although they do demand compensation for bearing non-diversifiable, “systematic” risk). …
Compared to equity investors, corporate managers (including CEOs) tend to be relatively risk-averse. Unlike shareholders, they get paid even if the corporation breaks even, so high-risk/high-reward ventures are less attractive to them. In addition, they cannot diversify their labor “investment” so as to eliminate firm-specific risk (one can generally work only one job, after all). Managers therefore tend to prefer “safer” business ventures.
The need to reconcile risk preferences among corporate managers (directors and officers) and their principals (the shareholders) provides a compelling justification for Delaware’s business judgment rule. Chancellor Allen clearly articulated this point in footnote 18 of the 1996 Caremark opinion:
Where review of board functioning is involved, courts leave behind as a relevant point of reference the decisions of the hypothetical “reasonable person”, who typically supplies the test for negligence liability. It is doubtful that we want business men and women to be encouraged to make decisions as hypothetical persons of ordinary judgment and prudence might. The corporate form gets its utility in large part from its ability to allow diversified investors to accept greater investment risk. If those in charge of the corporation are to be adjudged personally liable for losses on the basis of a substantive judgment based upon what persons of ordinary or average judgment and average risk assessment talent regard as “prudent” “sensible” or even “rational”, such persons will have a strong incentive at the margin to authorize less risky investment projects.
As Geoff has often reminded us, the optimal level of business risk is not zero.
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