Archives For Minimum efficient scale

Why the Federal Government’s Antitrust Case Against Google Should—and Likely Will—Fail

Thom Lambert —  18 December 2020

[TOTM: The following is part of a digital symposium by TOTM guests and authors on the law, economics, and policy of the antitrust lawsuits against Google. The entire series of posts is available here.]

On October 20, 2020, the U.S. Department of Justice (DOJ) and eleven states with Republican attorneys general sued Google for monopolizing and attempting to monopolize the markets for general internet search services, search advertising, and “general search text” advertising (i.e., ads that resemble search results).  Last week, California joined the lawsuit, making it a bipartisan affair.

DOJ and the states (collectively, “the government”) allege that Google has used contractual arrangements to expand and cement its dominance in the relevant markets.  In particular, the government complains that Google has agreed to share search ad revenues in exchange for making Google Search the default search engine on various “search access points.” 

Google has entered such agreements with Apple (for search on iPhones and iPads), manufacturers of Android devices and the mobile service carriers that support them, and producers of web browsers.  Google is also pursuing default status on new internet-enabled consumer products, such as voice assistants and “smart” TVs, appliances, and wearables.  In the government’s telling, this all amounts to Google’s sharing of monopoly profits with firms that can ensure its continued monopoly by imposing search defaults that users are unlikely to alter.

There are several obvious weaknesses with the government’s case.  One is that preset internet defaults are super easy to change and, in other contexts, are regularly altered.  For example, while 88% of desktop and laptop computers use the Windows operating system, which defaults to a Microsoft browser (Internet Explorer or Edge), Google’s Chrome browser commands a 69% market share on desktops and laptops, compared to around 13% for Internet Explorer and Edge combined.  Changing a default search engine is as easy as changing a browser default—three simple steps on an iPhone!—and it seems consumers will change defaults they don’t actually prefer.

A second obvious weakness, related to the first, is that the government has alleged no facts suggesting that Google’s search rivals—primarily Bing, Yahoo, and DuckDuckGo—would have enjoyed more success but for Google’s purportedly exclusionary agreements.  Even absent default status, people likely would have selected Google Search because it’s the better search engine.  It doesn’t seem the challenged arrangements caused Google’s search dominance.

Admittedly, the standard of causation in monopolization cases (at least those seeking only injunctive relief) is low.  The D.C. Circuit’s Microsoft decision described it as “edentulous” or, less pretentiously, toothless.  Nevertheless, the government is unlikely to prevail in its action against Google—and that’s a good thing.  Below, I highlight the central deficiency in the government’s Google case and point out problems with the government’s challenges to each of Google’s purportedly exclusionary arrangements.   

The Lawsuit’s Overarching Deficiency

We’ve all had the experience of typing a query only to have Google, within a few key strokes, accurately predict what we were going to ask and provide us with exactly the answer we were looking for.  It’s both eerie and awesome, and it keeps us returning to Google time and again.

But it’s not magic.  Nor has Google hacked our brains.  Google is so good at predicting our questions and providing responsive search results because its top-notch algorithms process gazillions of searches and can “learn” from users’ engagement.  Scale is thus essential to Google’s quality. 

The government’s complaint concedes as much.  It acknowledges that “[g]reater scale improves the quality of a general search engine’s algorithms” (¶35) and that “[t]he additional data from scale allows improved automated learning for algorithms to deliver more relevant results, particularly on ‘fresh’ queries (queries seeking recent information), location-based queries (queries asking about something in the searcher’s vicinity), and ‘long-tail’ queries (queries used infrequently)” (¶36). The complaint also asserts that “[t]he most effective way to achieve scale is for the general search engine to be the preset default on mobile devices, computers, and other devices…” (¶38).

Oddly, though, the government chides Google for pursuing “[t]he most effective way” of securing the scale that concededly “improves the quality of a general search engine’s algorithms.”  Google’s efforts to ensure and enhance its own product quality are improper, the government says, because “they deny rivals scale to compete effectively” (¶8).  In the government’s view, Google is legally obligated to forego opportunities to make its own product better so as to give its rivals a chance to improve their own offerings.

This is inconsistent with U.S. antitrust law.  Just as firms are not required to hold their prices high to create a price umbrella for their less efficient rivals, they need not refrain from efforts to improve the quality of their own offerings so as to give their rivals a foothold. 

Antitrust does forbid anticompetitive foreclosure of rivals—i.e., business-usurping arrangements that are not the result of efforts to compete on the merits by reducing cost or enhancing quality.  But firms are, and should be, free to make their products better, even if doing so makes things more difficult for their rivals.  Antitrust, after all, protects competition, not competitors.    

The central deficiency in the government’s case is that it concedes that scale is crucial to search engine quality, but it does not assert that there is a “minimum efficient scale”—i.e., a point at which scale economies are exhausted.  If a firm takes actions to enhance its own scale beyond minimum efficient scale, and if its efforts may hold its rivals below such scale, then it may have engaged in anticompetitive foreclosure.  But a firm that pursues scale that makes its products better is simply competing on the merits.

The government likely did not allege that there is a minimum efficient scale in general internet search services because returns to scale go on indefinitely, or at least for a very long time.  But the absence of such an allegation damns the government’s case against Google, for it implies that Google’s efforts to secure the distribution, and thus the greater use, of its services make those services better.

In this regard, the Microsoft case, which the government points to as a model for its action against Google (¶10), is inapposite.  Inthat case, the government alleged that Microsoft had entered license agreements that foreclosed Netscape, a potential rival, from the best avenues of browser distribution: original equipment manufacturers (OEMs) and internet access providers.  The government here similarly alleges that Google has foreclosed rival search engines from the best avenues of search distribution: default settings on mobile devices and web browsers.  But a key difference (in addition to the fact that search defaults are quite easy to change) is that Microsoft’s license restrictions foreclosed Netscape without enhancing the quality of Microsoft’s offerings.  Indeed, the court emphasized that the challenged Microsoft agreements were anticompetitive because they “reduced rival browsers’ usage share not by improving [Microsoft’s] own product but, rather, by preventing OEMs from taking actions that could increase rivals’ share of usage” (emphasis added).  Here, any foreclosure of Google’s search rivals is incidental to Google’s efforts to improve its product by enhancing its scale.

Now, the government might contend that the anticompetitive harms from raising rivals’ distribution costs exceed the procompetitive benefits of enhancing the quality of Google’s search services.  Courts, though, have generally been skeptical of claims that exclusion-causing product enhancements are anticompetitive because they do more harm than good.  There’s a sound reason for this: courts are ill-equipped to weigh the benefits of product enhancements against the costs of competition reductions resulting from product-enhancement efforts.  For that reason, they should—and likely will—stick with the rule that this sort of product-enhancing conduct is competition on the merits, even if it has the incidental effect of raising rivals’ costs.  And if they do so, the government will lose this case.     

Problems with the Government’s Specific Challenges

Agreements with Android OEMs and Wireless Carriers

The government alleges that Google has foreclosed its search rivals from distribution opportunities on the Android platform.  It has done so, the government says, by entering into exclusion-causing agreements with OEMs that produce Android products (Samsung, Motorola, etc.) and with carriers that provide wireless service for Android devices (AT&T, Verizon, etc.).

Android is an open source operating system that is owned by Google and licensed, for free, to producers of mobile internet devices.  Under the terms of the challenged agreements, Google’s counterparties promise not to produce Android “forks”—operating systems that are Android-based but significantly alter or “fragment” the basic platform—in order to get access to proprietary Google apps that Android users typically desire and to certain application protocol interfaces (APIs) that enable various functionalities.  In addition to these “anti-forking agreements,” counterparties enter various “pre-installation agreements” obligating them to install a suite of Google apps that use Google Search as a default.  Installing that suite is a condition for obtaining the right to pre-install Google’s app store (Google Play) and other must-have apps.  Finally, OEMs and carriers enter “revenue sharing agreements” that require the use of Google Search as the sole preset default on a number of search access points in exchange for a percentage of search ad revenue derived from covered devices.  Taken together, the government says, these anti-forking, pre-installation, and revenue-sharing agreements preclude the emergence of Android rivals (from forks) and ensure the continued dominance of Google Search on Android devices.

Eliminating these agreements, though, would likely harm consumers by reducing competition in the market for mobile operating systems.  Within that market, there are two dominant players: Apple’s iOS and Google’s Android.  Apple earns money off iOS by selling hardware—iPhones and iPads that are pre-installed with iOS.  Google licenses Android to OEMs for free but then earns advertising revenue off users’ searches (which provide an avenue for search ads) and other activities (which generate user data for better targeted display ads).  Apple and Google thus compete on revenue models.  As Randy Picker has explained, Microsoft tried a third revenue model—licensing a Windows mobile operating system to OEMs for a fee—but it failed.  The continued competition between Apple and Google, though, allows for satisfaction of heterogenous consumer preferences: Apple products are more expensive but more secure (due to Apple’s tight control over software and hardware); Android devices are cheaper (as the operating system is ad-supported) and offer more innovations (as OEMs have more flexibility), but tend to be less secure.  Such variety—a result of business model competition—is good for consumers. 

If the government were to prevail and force Google to end the agreements described above, thereby reducing the advertising revenue Google derives from Android, Google would have to either copy Apple’s vertically integrated model so as to recoup its Android investments through hardware sales, charge OEMs for Android (a la Microsoft), or cut back on its investments in Android.  In each case, consumers would suffer.  The first option would take away an offering preferred by many consumers—indeed most globally, as Android dominates iOS on a worldwide basis.  The second option would replace Google’s business model with one that failed, suggesting that consumers value it less.  The third option would reduce product quality in the market for mobile operating systems. 

In the end, then, the government’s challenge to Google’s Android agreements is myopic and misguided.  Competition among business models, like competition along any dimension, inures to the benefit of consumers.  Precluding it as the government is demanding would be silly.       

Agreements with Browser Producers

Web browsers like Apple’s Safari and Mozilla’s Firefox are a primary distribution channel for search engines.  The government claims that Google has illicitly foreclosed rival search engines from this avenue of distribution by entering revenue-sharing agreements with the major non-Microsoft browsers (i.e., all but Microsoft’s Edge and Internet Explorer).  Under those agreements, Google shares up to 40% of ad revenues generated from a browser in exchange for being the preset default on both computer and mobile versions of the browser.

Surely there is no problem, though, with search engines paying royalties to web browsers.  That’s how independent browsers like Opera and Firefox make money!  Indeed, 95% of Firefox’s revenue comes from search royalties.  If browsers were precluded from sharing in search engines’ ad revenues, they would have to find an alternative source of financing.  Producers of independent browsers would likely charge license fees, which consumers would probably avoid.  That means the only available browsers would be those affiliated with an operating system (Microsoft’s Edge, Apple’s Safari) or a search engine (Google’s Chrome).  It seems doubtful that reducing the number of viable browsers would benefit consumers.  The law should therefore allow payment of search royalties to browsers.  And if such payments are permitted, a browser will naturally set its default search engine so as to maximize its payout.  

Google’s search rivals can easily compete for default status on a browser by offering a better deal to the browser producer.  In 2014, for example, search engine Yahoo managed to wrest default status on Mozilla’s Firefox away from Google.  The arrangement was to last five years, but in 2017, Mozilla terminated the agreement and returned Google to default status because so many Firefox users were changing the browser’s default search engine from Yahoo to Google.  This historical example undermines the government’s challenges to Google’s browser agreements by showing (1) that other search engines can attain default status by competing, and (2) that defaults aren’t as “sticky” as the government claims—at least, not when the default is set to a search engine other than the one most people prefer.

In short, there’s nothing anticompetitive about Google’s browser agreements, and enjoining such deals would likely injure consumers by reducing competition among browsers.

Agreements with Apple

That brings us to the allegations that have gotten the most attention in the popular press: those concerning Google’s arrangements with Apple.  The complaint alleges that Google pays Apple $8-12 billion a year—a whopping 15-20% of Apple’s net income—for granting Google default search status on iOS devices.  In the government’s telling, Google is agreeing to share a significant portion of its monopoly profits with Apple in exchange for Apple’s assistance in maintaining Google’s search monopoly.

An alternative view, of course, is that Google is just responding to Apple’s power: Apple has assembled a giant installed base of loyal customers and can demand huge payments to favor one search engine over another on its popular mobile devices.  In that telling, Google may be paying Apple to prevent it from making Bing or another search engine the default on Apple’s search access points.

If that’s the case, what Google is doing is both procompetitive and a boon to consumers.  Microsoft could easily outbid Google to have Bing set as the default search engine on Apple’s devices. Microsoft’s market capitalization exceeds that of Google parent Alphabet by about $420 billion ($1.62 trillion versus $1.2 trillion), which is roughly the value of Walmart.  Despite its ability to outbid Google for default status, Microsoft hasn’t done so, perhaps because it realizes that defaults aren’t that sticky when the default service isn’t the one most people prefer.  Microsoft knows that from its experience with Internet Explorer and Edge (which collectively command only around 13% of the desktop browser market even though they’re the defaults on Windows, which has a 88% market share on desktops and laptops), and from its experience with Bing (where “Google” is the number one search term).  Nevertheless, the possibility remains that Microsoft could outbid Google for default status, improve its quality to prevent users from changing the default (or perhaps pay users for sticking with Bing), and thereby take valuable scale from Google, impairing the quality of Google Search.  To prevent that from happening, Google shares with Apple a generous portion of its search ad revenues, which, given the intense competition for mobile device sales, Apple likely passes along to consumers in the form of lower phone and tablet prices.

If the government succeeds in enjoining Google’s payments to Apple for default status, other search engines will presumably be precluded from such arrangements as well.  After all, the “foreclosure” effect of paying for default search status on Apple products is the same regardless of which search engine does the paying, and U.S. antitrust law does not “punish” successful firms by forbidding them from engaging in competitive activities that are open to their rivals. 

Ironically, then, the government’s success in its challenge to Google’s Apple payments would benefit Google at the expense of consumers:  Google would almost certainly remain the default search engine on Apple products, as it is most preferred by consumers and no rival could pay to dislodge it; Google would not have to pay a penny to retain its default status; and Apple would lose revenues that it likely passes along to consumers in the form of lower prices.  The courts are unlikely to countenance this perverse result by ruling that Google’s arrangements with Apple violate the antitrust laws.

Arrangements with Producers of Internet-Enabled “Smart” Devices

The final part of the government’s case against Google starkly highlights a problem that is endemic to the entire lawsuit.  The government claims that Google, having locked up all the traditional avenues of search distribution with the arrangements described above, is now seeking to foreclose search distribution in the new avenues being created by internet-enabled consumer products like wearables (e.g., smart watches), voice assistants, smart TVs, etc.  The alleged monopolistic strategy is similar to those described above: Google will share some of its monopoly profits in exchange for search default status on these smart devices, thereby preventing rival search engines from attaining valuable scale.

It’s easy to see in this context, though, why Google’s arrangements are likely procompetitive.  Unlike web browsers, mobile phones, and tablets, internet-enabled smart devices are novel.  Innovators are just now discovering new ways to embed internet functionality into everyday devices. 

Putting oneself in the position of these innovators helps illuminate a key beneficial aspect of Google’s arrangements:  They create an incentive to develop new and attractive means of distributing search.  Innovators currently at work on internet-enabled devices are no doubt spurred on by the possibility of landing a lucrative distribution agreement with Google or another search engine.  Banning these sorts of arrangements—the consequence of governmental success in this lawsuit—would diminish the incentive to innovate.

But that can be said of every single one of the arrangements the government is challenging. Because of Google’s revenue-sharing with search distributors, each of them has an added incentive to make their distribution channels desirable to consumers.  Android OEMs and Apple will work harder to produce mobile devices that people will want to use for internet searches; browser producers will endeavor to improve their offerings.  By paying producers of search access points a portion of the search ad revenues generated on their platforms, Google motivates them to generate more searches, which they can best do by making their products as attractive as possible. 

At the end of the day, then, the government’s action against Google seeks to condemn conduct that benefits consumers.  Because of the challenged arrangements, Google makes its own search services better, is able to license Android for free, ensures the continued existence of independent web browsers like Firefox and Opera, helps lower the price of iPhones and iPads, and spurs innovators to develop new “Internet of Things” devices that can harness the power of the web. 

The Biden administration would do well to recognize this lawsuit for what it is: a poorly conceived effort to appear to be “doing something” about a Big Tech company that has drawn the ire (for different reasons) of both progressives and conservatives.  DOJ and its state co-plaintiffs should seek dismissal of this action.  

In Apple, Google, Justice Department, Platforms, Symposia, Symposium on the Future of American Antitrust: The Google Lawsuits, Telecommunications, Truth on the Market, Wireless , , , , , , , , , ,
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Global Antitrust Institute Points the Way Toward Sounder Japanese Antitrust Guidelines

Alden Abbott —  4 May 2017

The indefatigable (and highly talented) scriveners at the Scalia Law School’s Global Antitrust Institute (GAI) once again have offered a trenchant law and economics assessment that, if followed, would greatly improve a foreign jurisdiction’s competition law guidance. This latest assessment, which is compelling and highly persuasive, is embodied in a May 4 GAI Commentary on the Japan Fair Trade Commission’s (JFTC’s) consultation on its Draft Guidelines Concerning Distribution Systems and Business Practices Under the Antimonopoly Act (Draft Guidelines). In particular, the Commentary highlights four major concerns with the Draft Guidelines’ antitrust analysis dealing with conduct involving multi-sided platforms, resale price maintenance (RPM), refusals to deal, tying, and other vertical restraints. It also offers guidance on the appropriate analysis of network effects in multi-sided platforms. After summarizing these five key points, I offer some concluding observations on the potential benefit for competition policy worldwide offered by the GAI’s commentaries on foreign jurisdictions’ antitrust guidance.

  1. Resale price maintenance. Though the Draft Guidelines appear to apply a “rule of reason” or effects-based approach to most vertical restraints, Part I.3 and Part I, Chapter 1 carve out resale price maintenance (RPM) practices on the ground that they “usually have significant anticompetitive effects and, as a general rule, they tend to impede fair competition.” Given the economic theory and empirical evidence showing that vertical restraints, including RPM, rarely harm competition and often benefit consumers, the Commentary urges the JFTC to reconsider its approach and instead apply a rule of reason or effects-based analysis to all vertical restraints, including RPM, under which restraints are condemned only if any anticompetitive harm they cause outweighs any procompetitive benefits they create.
  2. Effects of vertical restraints. The Draft Guidelines identify two types of effects of vertical non-price restraints, “foreclosures effects” and “price maintenance effects.” The Commentary urges the JFTC to require proof of actual anticompetitive effects for both competition and unfair trade practice violations, just as it requires proof of procompetitive effects. It also recommends that the agency take cognizance only of substantial foreclosure effects, that is, “foreclosure of a sufficient share of distribution so that a manufacturer’s rivals are forced to operate at a significant cost disadvantage for a significant period of time.” The Commentary explains that a “consensus has emerged that a necessary condition for anticompetitive harm arising from allegedly exclusionary agreements is that the contracts foreclose rivals from a share of distribution sufficient to achieve minimum efficient scale.” The Commentary notes that “the critical market share foreclosure rate should depend upon the minimum efficient scale of production. Unless there are very large economies of scale in manufacturing, the minimum foreclosure of distribution necessary for an anticompetitive effect in most cases would be substantially greater than 40 percent. Therefore, 40 percent should be thought of as a useful screening device or ‘safe harbor,’ not an indication that anticompetitive effects are likely to exist above this level.”

The Commentary also strongly urges the JFTC to include an analysis of the counterfactual world, i.e., to identify “the difference between the percentage share of distribution foreclosed by the allegedly exclusionary agreements or conduct and the share of distribution in the absence of such an agreement.” It explains that such an approach to assessing foreclosure isolates any true competitive effect of the allegedly exclusionary agreement from other factors.

The Commentary also recommends that the JFTC explicitly recognize that evidence of new or expanded entry during the period of the alleged abuse can be a strong indication that the restraint at issue did not foreclose competition or have an anticompetitive effect. It stresses that, with respect to price increases, it is important to recognize and consider other factors (including changes in the product and changes in demand) that may explain higher prices.

  1. Unilateral refusals to deal and forced sharing. Part II, Chapter 3 of the Draft Guidelines would impose unfair trade practice liability for unilateral refusals to deal that “tend to make it difficult for the refused competitor to carry on normal business activities.” The Commentary strongly urges the JFTC to reconsider this vague and unclear approach and instead recognize the numerous significant concerns with forced sharing.

For example, while a firm’s competitors may want to use a particular good or technology in their own products, there are few situations, if any, in which access to a particular good is necessary to compete in a market. Indeed, one of the main reasons not to impose liability for unilateral, unconditional refusals to deal is “pragmatic in nature and concerns the limited abilities of competition authorities and courts to decide whether a facility is truly non-replicable or merely a competitive advantage.” For one thing, there are “no reliable economic or evidential techniques for testing whether a facility can be duplicated,” and it is often “difficult to distinguish situations in which customers simply have a strong preference for one facility from situations in which objective considerations render their choice unavoidable.”

Furthermore, the Commentary notes that forced competition based on several firms using the same inputs may actually preserve monopolies by removing the requesting party’s incentive to develop its own inputs. Consumer welfare is not enhanced only by price competition; it may be significantly improved by the development of new products for which there is an unsatisfied demand. If all competitors share the same facilities this will occur much less quickly if at all. In addition, if competitors can anticipate that they will be allowed to share the same facilities and technologies, the incentives to develop new products is diminished. Also, sharing of a monopoly among several competitors does not in itself increase competition unless it leads to improvements in price and output, i.e., nothing is achieved in terms of enhancing consumer welfare. Competition would be improved only if the terms upon which access is offered allow the requesting party to effectively compete with the dominant firm on the relevant downstream market. This raises the issue of whether the dominant firm is entitled to charge a monopoly rate or whether, in addition to granting access, there is a duty to offer terms that allow efficient rivals to make a profit.

  1. Fair and free competition. The Draft JFTC Guidelines refer throughout to the goal of promoting “fair and free competition.” Part I.3 in particular provides that “[i]f a vertical restraint tends to impede fair competition, such restraint is prohibited as an unfair trade practice.” The Commentary urges the JFTC to adopt an effects-based approach similar to that adopted by the U.S. Federal Trade Commission in its 2015 Policy Statement on Unfair Methods of Competition. Tying unfairness to antitrust principles ensures the alignment of unfairness with the economic principles underlying competition laws. Enforcement of unfair methods of competition statutes should focus on harm to competition, while taking into account possible efficiencies and business justifications. In short, while unfairness can be a useful tool in reaching conduct that harms competition but is not within the scope of the antitrust laws, it is imperative that unfairness be linked to the fundamental goals of the antitrust laws.
  2. Network effects in multi-sided platforms. With respect to multi-sided platforms in particular, the Commentary urges that the JFTC avoid any presumption that network effects create either market power or barriers to entry. In lieu of such a presumption, the Commentary recommends a fact-specific case-by-case analysis with empirical backing on the presence and effect of any network effects. Network effects occur when the value of a good or service increases as the number of people who use it grows. Network effects are generally beneficial. While there is some dispute over whether and under what conditions they might also raise exclusionary concerns, the Commentary notes that “transactions involving complementary products (indirect network effects) fully internalize the benefits of consuming complementary goods and do not present an exclusionary concern.” The Commentary explains that, “[a]s in all analysis of network effects, the standard assumption that quantity alone determines the strength of the effect is likely mistaken.” Rather, to the extent that advertisers, for example, care about end users, they care about many of their characteristics. An increase in the number of users who are looking only for information and never to purchase goods may be of little value to advertisers. “Assessing network or scale effects is extremely difficult in search engine advertising [for example], and scale may not even correlate with increased value over some ranges of size.”
  3. Concluding thoughts. Implicit in the overall approach of this latest GAI Commentary, and in many other GAI assessments of foreign jurisdictions’ proposed antitrust guidance, is the need for regulatory humility, sound empiricism, and a focus on consumer welfare. Antitrust enforcement policies that blandly accept esoteric theories of anticompetitive behavior and ignore actual economic effects are welfare reducing, not welfare enhancing. The very good analytical work carried out by GAI helps competition authorities keep this reality in mind, and merits close attention.
In Antitrust & Competition, Barriers to Entry, Economic Theory, Federal Trade Commission, International, Platforms, Resale Price Maintenance, Truth on the Market, Tying, Vertical Restraints , , ,
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Antitrust Law and Economics Scholars Urge Reversal in McWane

Thom Lambert —  12 July 2014

Last Monday, a group of nineteen scholars of antitrust law and economics, including yours truly, urged the U.S. Court of Appeals for the Eleventh Circuit to reverse the Federal Trade Commission’s recent McWane ruling.

McWane, the largest seller of domestically produced iron pipe fittings (DIPF), would sell its products only to distributors that “fully supported” its fittings by carrying them exclusively.  There were two exceptions: where McWane products were not readily available, and where the distributor purchased a McWane rival’s pipe along with its fittings.  A majority of the FTC ruled that McWane’s policy constituted illegal exclusive dealing.

Commissioner Josh Wright agreed that the policy amounted to exclusive dealing, but he concluded that complaint counsel had failed to prove that the exclusive dealing constituted unreasonably exclusionary conduct in violation of Sherman Act Section 2.  Commissioner Wright emphasized that complaint counsel had produced no direct evidence of anticompetitive harm (i.e., an actual increase in prices or decrease in output), even though McWane’s conduct had already run its course.  Indeed, the direct evidence suggested an absence of anticompetitive effect, as McWane’s chief rival, Star, grew in market share at exactly the same rate during and after the time of McWane’s exclusive dealing.

Instead of focusing on direct evidence of competitive effect, complaint counsel pointed to a theoretical anticompetitive harm: that McWane’s exclusive dealing may have usurped so many sales from Star that Star could not achieve minimum efficient scale.  The only evidence as to what constitutes minimum efficient scale in the industry, though, was Star’s self-serving statement that it would have had lower average costs had it operated at a scale sufficient to warrant ownership of its own foundry.  As Commissioner Wright observed, evidence in the record showed that other pipe fitting producers had successfully entered the market and grown market share substantially without owning their own foundry.  Thus, actual market experience seemed to undermine Star’s self-serving testimony.

Commissioner Wright also observed that complaint counsel produced no evidence showing what percentage of McWane’s sales of DIPF might have gone to other sellers absent McWane’s exclusive dealing policy.  Only those “contestable” sales – not all of McWane’s sales to distributors subject to the full support policy – should be deemed foreclosed by McWane’s exclusive dealing.  Complaint counsel also failed to quantify sales made to McWane’s rivals under the generous exceptions to its policy.  These deficiencies prevented complaint counsel from adequately establishing the degree of market foreclosure caused by McWane’s policy – the first (but not last!) step in establishing the alleged anticompetitive harm.

In our amicus brief, we antitrust scholars take Commissioner Wright’s side on these matters.  We also observe that the Commission failed to account for an important procompetitive benefit of McWane’s policy:  it prevented rival DIPF sellers from “cherry-picking” the most popular, highest margin fittings and selling only those at prices that could be lower than McWane’s because the cherry-pickers didn’t bear the costs of producing the full line of fittings.  Such cherry-picking is a form of free-riding because every producer’s fittings are more highly valued if a full line is available.  McWane’s policy prevented the sort of free-riding that would have made its production of a full line uneconomical.

In short, the FTC’s decision made it far too easy to successfully challenge exclusive dealing arrangements, which are usually procompetitive, and calls into question all sorts of procompetitive full-line forcing arrangements.  Hopefully, the Eleventh Circuit will correct the Commission’s mistake.

Other professors signing the brief include:

  • Tom Arthur, Emory Law
  • Roger Blair, Florida Business
  • Don Boudreaux, George Mason Economics (and Café Hayek)
  • Henry Butler, George Mason Law
  • Dan Crane, Michigan Law (and occasional TOTM contributor)
  • Richard Epstein, NYU and Chicago Law
  • Ken Elzinga, Virginia Economics
  • Damien Geradin, George Mason Law
  • Gus Hurwitz, Nebraska Law (and TOTM)
  • Keith Hylton, Boston University Law
  • Geoff Manne, International Center for Law and Economics (and TOTM)
  • Fred McChesney, Miami Law
  • Tom Morgan, George Washington Law
  • Barack Orbach, Arizona Law
  • Bill Page, Florida Law
  • Paul Rubin, Emory Economics (and TOTM)
  • Mike Sykuta, Missouri Economics (and TOTM)
  • Todd Zywicki, George Mason Law (and Volokh Conspiracy)

The brief’s “Summary of Argument” follows the jump. Continue Reading…

In Antitrust & Competition, Exclusionary Conduct, Exclusive Dealing, Federal Trade Commission, International Center for Law & Economics, Law & Economics, Monopolization , , , , ,
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Commissioner Wright’s McWane Dissent Illuminates the Law and Economics of Exclusive Dealing

Thom Lambert —  17 February 2014

Commissioner Josh Wright’s dissenting statement in the Federal Trade Commission’s recent McWane proceeding is a must-read for anyone interested in the law and economics of exclusive dealing. Wright dissented from the Commission’s holding that McWane Inc.’s “full support” policy constituted unlawful monopolization of the market for domestic pipe fittings.

Under the challenged policy, McWane, the dominant producer with a 45-50% share of the market for domestic pipe fittings, would sell its products only to distributors that “fully supported” its fittings by carrying them exclusively.  There were two exceptions: where McWane products were not readily available, and where the distributor purchased a McWane rival’s pipe along with its fittings.  A majority of the Commission ruled that McWane’s policy constituted illegal exclusive dealing.  Commissioner Wright agreed that the policy amounted to exclusive dealing, but he concluded that the complainant had failed to prove that the exclusive dealing constituted unreasonably exclusionary conduct in violation of Sherman Act Section 2.

The first half of Wright’s 52-page dissent is an explanatory tour de force.  Wright first explains how and why the Supreme Court rethought its originally inhospitable rules on “vertical restraints” (i.e., trade-limiting agreements between sellers at different levels of the distribution system, such as manufacturers and distributors).  Recognizing that most such restraints enhance overall market output even if they incidentally injure some market participants, courts now condition liability on harm to competition—that is, to overall market output.  Mere harm to an individual competitor is not enough.

Wright then explains how this “harm to competition” requirement manifests itself in actions challenging exclusive dealing.  Several of the antitrust laws—Sections 1 and 2 of the Sherman Act and Section 3 of the Clayton Act—could condemn arrangements in which a seller will deal only with those who purchase its brand exclusively.  Regardless of the particular statute invoked, though, there can be no antitrust liability absent either direct or indirect evidence of anticompetitive (not just anti-competitor) effect.  Direct evidence entails some showing that the exclusive dealing at issue led to lower market output and/or higher prices than would otherwise have prevailed.  Indirect evidence usually involves showings that (1) the exclusive dealing at issue foreclosed the defendant’s rivals from a substantial share of available marketing opportunities; (2) those rivals were therefore driven (or held) below minimum efficient scale (MES), so that their per-unit production costs were held artificially high; and (3) the defendant thereby obtained the ability to price higher than it would have absent the exclusive dealing.

The McWane complainant, Star Pipe Products, Ltd., sought to discharge its proof burden using indirect evidence. It asserted that its per-unit costs would have been lower if it owned a domestic foundry, but it maintained that its 20% market share did not entail sales sufficient to justify foundry construction.  Thus, Star concluded, McWane’s usurping of rivals’ potential sales opportunities through its exclusive dealing policy held Star below MES, raised Star’s per-unit costs, and enhanced McWane’s ability to raise prices.  Voila!  Anticompetitive harm.

Commissioner Wright was not convinced that Star had properly equated MES with sales sufficient to justify foundry construction.  The only record evidence to that effect—evidence the Commission deemed sufficient—was Star’s self-serving testimony that it couldn’t justify building a foundry at its low level of sales and would be a more formidable competitor if it could do so.  Countering that testimony were a couple of critical bits of actual market evidence.

First, the second-largest domestic seller of pipe fittings, Sigma Corp., somehow managed to enter the domestic fittings market and capture a 30% market share (as opposed to Star’s 20%), without owning any of its own production facilities.  Sigma’s entire business model was built on outsourcing, yet it managed to grow sales more than Star.  This suggests that foundry ownership – and, thus, a level of sales sufficient to support foundry construction – may not be necessary for efficient scale in this industry.

Moreover, Star’s own success in the domestic pipe fittings market undermined its suggestion that MES can be achieved only upon reaching a sales level sufficient to support a domestic foundry.  Star entered the domestic pipe fittings market in 2009, quickly grew to a 20% market share, and was on pace to continue growth when the McWane action commenced.  As Commissioner Wright observed, “for Complaint Counsel’s view of MES to make sense on the facts that exist in the record, Star would have to be operating below MES, becoming less efficient over time as McWane’s Full Support Program further raised the costs of distribution, and yet remaining in the market and growing its business.  Such a position strains credulity.”

Besides failing to establish what constitutes MES in the domestic pipe fittings industry, Commissioner Wright asserted, complainant Star also failed to prove the degree of foreclosure occasioned by McWane’s full support program.

First, both Star and the Commission reasoned that all McWane sales to distributors subject to its full support program had been “foreclosed,” via exclusive dealing, to McWane’s competitors.  That is incorrect.  The sales opportunities foreclosed by McWane’s full support policy were those that would have been made to other sellers but for the policy.  In other words, if a distributor, absent the full support policy, would have purchased 70 units from McWane and five from Star but, because of the full support program, purchased all 75 from McWane, the full support program effectively foreclosed Star from five sales opportunities, not 75.  By failing to focus on “contestable” sales—i.e., sales other than those that would have been made to McWane even absent the full support program—Star and the Commission exaggerated the degree of foreclosure resulting from McWane’s exclusive dealing.

Second, neither Star nor the Commission made any effort to quantify the sales made to McWane’s rivals under the two exceptions to McWane’s full support policy.  Such sales were obviously not foreclosed to McWane’s rivals, but both Star and the Commission essentially ignored them.  So, for example, if a distributor that carried McWane’s products (and was thus subject to the full support policy) purchased 70 domestic fittings from McWane and 30 from other producers pursuant to one of the full support program’s exceptions, Star and the Commission counted 100 foreclosed sales opportunities.  Absent information about the number of distributor purchases under exceptions to the full support program, it is simply impossible to assess the degree of foreclosure occasioned by the policy.

In sum, complainant Star – who bore the burden of establishing an anticompetitive (i.e., market output-reducing) effect of the exclusive dealing at issue – failed to show how much foreclosure McWane’s full support program actually created and to produce credible evidence (other than its own self-serving testimony) that the program raised its costs by holding it below MES.  The most Star showed was harm to a competitor – not harm to competition, a prerequisite to liability based on exclusive dealing.      

In addition, several other pieces of evidence suggested that McWane’s exclusive dealing was not anticompetitive.  First, the full support program did not require a commitment of exclusivity for any period of time. Distributors purchasing from McWane could begin carrying rival brands at any point (though doing so might cause McWane to refuse to sell to them in the future).  Courts have often held that short-duration exclusive dealing arrangements are less troubling than longer-term agreements; indeed, a number of courts presume the legality of exclusive dealing contracts of a year or less.  McWane’s policy was of no, not just short, duration.

Second, entry considerations suggested an absence of anticompetitive harm here.  If entry into a market is easy, there is little need to worry that exclusionary conduct will produce market power.  Once the monopolist begins to exercise its power by reducing output and raising price, new entrants will appear on the scene, driving price and output back to competitive levels.  The recent and successful entry of both Star and Sigma, who collectively gained about half the total market share within a short period of time, suggested that entry into the domestic pipe fittings market is easy.

Finally, evidence of actual market performance indicated that McWane’s exclusive dealing policies did not generate anticompetitive effect.  McWane enforced its full support program for the first year of Star’s participation in the domestic fittings market, but not thereafter.  Star’s growth rate, however, was identical before and after McWane stopped enforcing the program.  According to Commissioner Wright, “Neither Complaint Counsel nor the Commission attempt[ed] to explain how growth that is equal with and without the Full Support Program is consistent with Complaint Counsel’s theory of harm that the Program raised Star’s costs of distribution and impaired competition.  The most plausible inference to draw from these particular facts is that the Full Support Program had almost no impact on Star’s ability to enter and grow its business, which, under the case law, strongly counsels against holding that McWane’s conduct was exclusionary.”

***

Because antitrust exists to protect competition, not competitors, an antitrust complainant cannot base a claim of monopolization on the mere fact that its business was injured by the defendant’s conduct.  By the same token, a party complaining of unreasonably exclusionary conduct also ought not to prevail simply because it made self-serving assertions that it would have had more business but for the defendant’s action and would have had lower per-unit costs if it had more business.  If the antitrust is to remain a consumer-focused body of law, claims like Star’s should fail.  Hopefully, Commissioner Wright’s FTC colleagues will eventually see that point.

In Antitrust & Competition, Exclusionary Conduct, Exclusive Dealing, Federal Trade Commission, Law & Economics, Monopolization, Regulation, Vertical Restraints ,
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My New Paper on Defining Exclusionary Conduct

Thom Lambert —  3 October 2013

In our recent blog symposium on Section 5 of the FTC Act, Latham & Watkins partner Tad Lipsky exposed one of antitrust’s dark little secrets: Nobody really knows what Sherman Act Section 2 forbids.  The provision bans monopolization, attempted monopolization, and conspiracies to monopolize, and courts have articulated formal elements for each claim.  But the element common to the two unilateral offenses—“exclusionary conduct”—remains essentially undefined.  Lipsky writes:

123 years of Section 2 enforcement and the best our Supreme Court can do is the Grinnell standard, defining [exclusionary conduct] as the “willful acquisition or maintenance of [monopoly] power as distinguished from growth or development as a consequence of a superior product, business acumen, or historic accident.”  Is this Grinnell definition that much better than [Section 5’s reference to] “unfair methods of competition”?

No, it’s not.  Nor are any of the other commonly cited judicial definitions of exclusionary conduct, such as “competition not on the merits.”  As Einer Elhauge has observed, such judicial definitions are not just vague but vacuous.

This is problematic because business planners need clarity.  On some specific unilateral practices—straightforward price cuts and aggressive input-bidding, for example—courts have provided clear liability rules and safe harbors.  But in a dynamic economy, business people are constantly coming up with new ideas for sales-enhancing practices that might have the effect of disadvantaging rivals, of “excluding” them from the market.  Absent some general understanding of what constitutes an “unreasonably exclusionary” act, business people are likely to forego novel but efficient sales-enhancing practices, to the detriment of consumers.

In the last decade or so, commentators have proposed four generally applicable definitions of unreasonably exclusionary conduct.  Judge Posner suggested that such conduct be defined as acts that could exclude an “equally efficient rival” from the perpetrator’s market (the “EER” approach).  Post-Chicago theorists would equate unreasonably exclusionary conduct with unjustifiably “raising rivals’ costs” (the “RRC” approach).  The Areeda-Hovenkamp treatise prescribes a balancing of the “consumer welfare effects” resulting from the practice at issue (“CWE-balancing”).  And the U.S. Department of Justice has called for defining unreasonably exclusionary conduct as that which would make “no economic sense” apart from its tendency to enhance market power (the “NES” test, or “NEST”).

Each of these approaches, it turns out, is troubling.  The EER approach is underdeterrent in that it fails to condemn practices that cause rivals to be less efficient than the perpetrator.  The RRC, CWE-balancing, and NEST approaches turn out to be difficult to apply—and largely indeterminate—for any exclusion-causing conduct involving “degrees.” For example, a 15% loyalty rebate conditioned upon purchasing 70% of one’s requirements from the defendant requires a certain “degree” of loyalty and provides a certain “degree” of price reduction.  It might well turn out that some degree of required loyalty (e.g., the increment from 60% to 70%) or some degree of discount (e.g., the increment from 10% to 15%) either (1) raised rivals’ costs unjustifiably (RRC) or (2) created greater consumer harm than benefit (CWE-balancing) or (3) made no economic sense but for its ability to enhance market power (NEST).  Because the RRC, CWE-balancing, and NEST approaches appear to require marginal analysis of exclusion-causing conduct, they become fairly inadministrable and indeterminate when applied to conduct involving degrees, a category that includes most of the novel conduct for which a generally applicable exclusionary conduct definition would be useful.  Because they provide little guidance and no reliable safe harbors, the RRC, CWE-balancing, and NEST approaches are likely to overdeter efficient, but novel, business practices.

In light of these and other difficulties with the proposed exclusionary conduct definitions, a number of scholars now advocate abandoning the search for a generally applicable definition and applying different liability standards to different types of behavior.  Eschewal of universal standards, though, is also troubling.  To the extent non-universalists are saying that there is no single definition of unreasonably exclusionary conduct—no common thread that runs through all instances of unreasonable exclusion—their position seems to violate rule of law norms.  After all, the Court has told us that unreasonably exclusionary conduct is an element of monopolization and attempted monopolization.  That means that the exclusionary conduct component of all Section 2 offenses must share something in common; otherwise, the “element” would consist of a non-exhaustive menu of unrelated features and would cease to be an element.

A less extreme “non-universalist” approach would concede that there is a single definition of unreasonably exclusionary conduct—that which reduces overall consumer welfare—but hold that there should be no universal test for identifying when a particular practice runs afoul of the definition.  This more defensible position resembles “rule utilitarianism” in ethical theory.  Rule utilitarians concede that morality is ultimately concerned with utility-maximization, but they would judge the morality of any particular act not on the basis of its actual consequences but instead according to whether it complies with a rule selected to maximize utility.  Similarly, “soft” non-universalists would select liability tests for particular business practices on the basis of whether those tests maximize overall consumer welfare, but they would evaluate particular instances of exclusion-causing behavior on the basis of whether they comply with applicable liability tests, not whether they actually enhance consumer welfare.

Because it reduces to a version of CWE-balancing (though at the rule level rather than the act level), “soft” non-universalism is subject to the same criticisms as CWE-balancing in general: it is difficult to apply and indeterminate.  Indeed, under a soft non-universal approach, a business planner considering a novel but efficient exclusion-causing practice would first have to predict the liability rule a reviewing court would adopt for the practice under consideration and then apply that rule.  Talk about a lack of clarity and reliable safe harbors!

I have recently authored a paper that critiques the proposed definitions of unreasonably exclusionary conduct as well as the non-universalist approaches discussed above and, finding each position deficient, proposes an alternative approach.  My approach would deem conduct to be unreasonably exclusionary if it would likely exclude from the perpetrator’s market a “competitive rival,” defined as a rival that is both as determined as the perpetrator and capable, at minimum efficient scale, of matching the perpetrator’s efficiency.  This “exclusion of a competitive rival” approach, the paper demonstrates, identifies a common thread running through instances of unreasonable exclusion, comports with prevailing intuitions about what constitutes appropriate competition, generates clear guidance and reliable safe harbors, and would minimize the sum of decision and error costs resulting from monopolization doctrine.

A draft of the paper, which is slated to appear as an article in the North Carolina Law Review, is available on SSRN.  Please download, and let me know if you have any comments.

In Antitrust & Competition, Error Costs, Exclusionary Conduct, Federal Trade Commission, Law & Economics, Monopolization, Regulation, Section 5 ,
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Wright is Right and Price-Cost Safe Harbors are Wrong: The Raising Rivals’ Cost Paradigm, Loyalty Discounts and Exclusive Dealing

Steve Salop —  7 June 2013

Guest post by Steve Salop, responding to Dan’s post and Thom’s post on the appropriate liability rule for loyalty discounts.

I want to clarify some of the key issues in Commissioner Wright’s analysis of Exclusive Dealing and Loyalty Discounts as part of the raising rivals’ costs (“RRC”) paradigm. I never thought that I would have to defend Wright against Professors Lambert and Crane. But, it appears that rigorous antitrust analysis sometimes makes what some would view as strange bedfellows.

In my view, there should not be a safe harbor price-cost test used for loyalty discounts. Nor should these discounts be treated as conclusively (per se) illegal if the defendant fails the price-cost test. Either way, the test is a formalistic and unreliable screen. To explain these conclusions, and why I think the proponents of the screen are taking too narrow approach to these issues, I want to start with some discussion of the legal and economic frameworks.

In my view, there are two overarching antitrust legal paradigms for exclusionary conduct – predatory pricing and raising rivals’ costs (RRC), and conduct that falls into the RRC paradigm generally raises greater antitrust concerns. (For further details, see my 2006 Antitrust L.J. article, “Exclusionary Conduct, Effect on Consumers, and the Flawed Profit-Sacrifice Standard.”) Commissioner Wright also takes this approach in his speech of identifying and distinguishing the two paradigms.

This raises the question of which framework is better suited for addressing exclusive dealing and loyalty discounts (that is, where the conduct is not pled in the complaint as predatory pricing). Commissioner Wright’s speech articulates the view that theories of harm alleging RRC/foreclosure should be analyzed under exclusive dealing law, which is more consistent with the raising rivals’ costs approach, not under predatory pricing law (i.e., with its safe harbor for prices above cost). (Incidentally, I don’t read his speech as saying that he has abandoned Brooke Group for predatory pricing allegations. For example, it seems clear that he would support a price-cost test in a case alleging that a loyalty discount harmed competition via predatory pricing rather than RRC/foreclosure.)

To understand which legal framework – raising rivals’ costs/exclusive dealing versus predatory pricing/price-cost test – is most relevant for analyzing the relevant competitive issues, I want to begin with a primer on RRC theories of foreclosure. This will also hopefully bring everyone closer on the economics.

Input Foreclosure and Customer Foreclosure

There are two types of foreclosure theories within the RRC paradigm — “input foreclosure” and “customer foreclosure.” Both are relevant for evaluating exclusive dealing and loyalty discounts. The input foreclosure theory says that the ED literally “raises rivals’ costs” by foreclosing a rival’s access to a critical input subject to ED. The customer foreclosure theory says that ED literally “reduces rivals’ revenues” by foreclosing a rival’s access to a sufficient customer base and thereby drives the rival out of business or marginalizes it as a competitor (i.e., where it lacks the ability or incentive to move effectively beyond a niche position or to invest to grow).

Commissioner Wright’s speech tended to merge the two variants. But, it is useful to distinguish between them. (I think that this is one source of Professor Lambert being “baffled” by the speech, and more generally, is a source of confusion among commentators that leads to unnecessary disagreements.)

In the simplest presentation, one might say that customer foreclosure concerns are raised primarily by exclusive dealing with customers, while input foreclosure concerns are raised primarily by exclusive dealing with input suppliers. But, as noted below, both concerns may arise in the same case, and especially so where the “customers” are distributors rather than final consumers, and the “input” is distribution services.

Analysis of exclusive dealing (ED) often invokes the customer foreclosure theory. For example, Lorain Journal may be analyzed as customer foreclosure. However, input foreclosure is also highly relevant for analyzing ED because exclusive dealing often involves inputs. For example, Judge Posner’s famous JTC Petroleum cartel opinion can be interpreted in this way, if there were solely vertical agreements.

Cases where manufacturers have ED arrangements with wholesale or retail distributors might be thought to fall into the customer foreclosure theory because the distributors can be seen as customers of the manufacturer. However, distributors also can be seen as providing an input to the manufacturer, “distribution services.” For example, a supermarket or drug store provides shelf space to a manufacturer. If the manufacturer (say, unilaterally) sets resale prices, then the difference between this resale price and the wholesale price is the effective input price.

One reason why the input foreclosure/customer foreclosure distinction is important involves the proper roles of minimum viable scale (MVS) and minimum efficient scale (MES). The customer foreclosure theory may involve a claim that the rival likely will be driven below MVS and exit Or it may involve a claim that the rival will be driven below MES, where its costs will be so much higher or its demand so much lower that it will be marginalized as a competitor.

By contrast, and this is the key point, input foreclosure does not focus on whether the rival likely will be driven below MVS. Even if the rival remains viable, if its costs are higher, it will be led to raise the prices charged to consumers, which will cause consumer harm. And prices will not be raised only in the future. The recoupment can be simultaneous.

Another reason for the importance of the distinction is the role of the “foreclosure rate,” which often is the focus in customer foreclosure analysis. For input foreclosure, the key foreclosure issue is not the fraction of distribution input suppliers or capacity that is foreclosed, but rather whether the foreclosure will raise the rival’s distribution costs. That can occur even if a single distributor is foreclosed, if the exclusivity changes the market structure in the input market or if that distributor was otherwise critical. (For example, see Krattenmaker and Salop, “Anticompetitive Exclusion.”)

At the same time, it is important to note that the input/customer foreclosure distinction is not a totally bright line difference in many real world cases. A given case can raise both concerns. In addition, customer foreclosure sometimes can raise rivals costs, and input foreclosure sometimes (but not always) can cause exit.
While input foreclosure can succeed even if the rival remains viable in the market, in more extreme scenarios, significantly higher costs inflicted on the rival could drive the rival to fall below minimum viable scale, and thereby cause it to exit. I think that this is one way in which unnecessary disagreements have occurred. Commentators might erroneously focus only this more extreme scenario and overlook the impact of the exclusives or near-exclusives on the rival’s distribution costs.

Note also that customer foreclosure can raise a rival’s costs when there are economies of scale in variable costs. For this reason, even if the rival does not exit or is not marginalized, it nonetheless may become a weaker competitor as a result of the exclusivity or loyalty discount.

These points also help to explain why neither a price-cost test nor the foreclosure rate will provide sufficient reliable evidence for either customer foreclosure or input foreclosure, which I turn to next.

(For further discussion of the distinction between input foreclosure and customer foreclosure, see Riordan and Salop, Evaluating Vertical Mergers: A Post-Chicago Approach, 63 ANTITRUST L.R. 513(1995). See also the note on O’Neill v Coca Cola in Andrew Gavil, William Kovacic and Jonathan Baker, Antitrust Law in Perspective: Cases, Concepts and Problems in Competition Policy (2d ed.) at 868-69. For analysis of Lorain Journal as customer foreclosure, see Gavil et. al at 593-97.)

The Inappropriateness of a Dispositive Price-Cost Test

A price-cost test obviously is not relevant for evaluating input foreclosure concerns, even where the input is distribution services. Even if the foreclosure involves bidding up the price of the input, it can succeed in permitting the firm to achieve or maintain market power, despite the fact that the firm does not bid to the point that its costs exceed its price. (In this regard, Weyerhaeuser was a case of “predatory overbuying,” not “raising rivals’ cost overbuying.” The allegation was that Weyerhaeuser would gain market power in the timber input market, not the lumber output market.)

Nor is a price-cost test the critical focus for assessing customer foreclosure theories of competitive harm. (By the way, I think we all agree that the relevant price-cost test involves a comparison of the incremental revenue and incremental cost of the “contestable volume” at issue for the loyalty discount. So I will not delve into that issue.)

First, and most fundamentally, the price-cost test is premised on the erroneous idea that only equally efficient competitors are worth protecting. In other words, the price-cost requires the premise that the antitrust laws only protect consumers against competitive harm arising from conduct that could have excluded an equally efficient competitor. This premise makes absolutely no economic sense. One simple illustrative example is a monopolist raising the costs of a less efficient potential competitor to destroy its entry into the market. Suppose that monopolist has marginal cost of $50 and a monopoly price of $100. Suppose that there is the potential entrant has costs of $75. If the entry were to occur, the market price would fall. Entry of the less efficient rival imposes a competitive constraint on the monopolist. Thus, the entry clearly would benefit consumers. (And, it clearly often would raise total welfare as well.) It is hard to see why antitrust should permit this type of exclusionary conduct.

It is also unlikely that antitrust law would allow this conduct. For example, Lorain Journal is probably pretty close to this hypothetical. WEOL likely was not equally efficient. The hypothetical probably also fits Microsoft pretty well.

Second, the price-cost test does not make economic sense in the case of the equally efficient rival either. Even if the competitor is equally efficient, bidding for exclusives or near-exclusives through loyalty discounts often does not take place on a level playing field. There are several reasons for this. One reason is that the dominant firm may tie up customers or input providers before the competitors even arrive on the scene or are in a position to counterbid. A second reason is that the exclusive may be worth more to the dominant firm because it will allow it to maintain market power, whereas the entrant would only be able to obtain more competitive profits. In this sense, the dominant firm is “purchasing market power” as well as purchasing distribution. (This point is straightforward to explain with an example. Suppose that the dominant firm is earning monopoly profits of $200, which would be maintained if it deters the entry of the new competitor. Suppose that successful entry by the equally efficient competitor would lead to the dominant firm and the entrant both earning profits of $70. In this example, the entrant would be unwilling to bid more than $70 for the distribution. But, the dominant firm would be willing to bid up to $130, the difference between its monopoly profits of $200 and the duopoly profits of $70.) A third reason is that customers may not be willing to take the risk that the entry will fail, where failure can occur not because the entrant’s product is inferior but simply because other customers take the exclusive deal from the dominant firm. In this case, a fear that the entrant would fail could become a self-fulfilling prophecy because the customers cannot coordinate their responses to the dominant firms’ offer. Lorain Journal may provide an illustrative example of this self-fulfilling prophecy phenomenon. This last point highlights a more general point Commissioner Wright made in his speech — that successful and harmful RRC does not require a below-cost price (net of discounts). When distributors cannot coordinate their responses to the dominant firm’s offer, a relatively small discount might be all that is required to purchase exclusion. Thus, while large discounts might accompany RRC conduct, that need not be the case. These latter reasons also explain why there can be successful foreclosure even when contracts have short duration.

Third, as noted above, customer foreclosure may raise rivals’ costs when there are economies of scale. The higher costs of the foreclosed rivals are not well accounted for by the price-cost test.

Fourth, as stressed by Joe Farrell, the price-cost test ignores the fact that loyalty discounts triggered by market share may deter a customer’s purchases from a rival that do not even come at the expense of the dominant firm. (For example, suppose in light of the discounts, the customer is purchasing 90 units from the dominant firm and 10 from the rival in order to achieve a “reward” that comes from purchasing 90% from the dominant firm. Now suppose that entrant offers a new product that would lead the customer to wish to continue to purchase 90 units from the dominant firm but now purchase 15 units from the rival. The purchase of these additional 5 units from the rival does not come at the expense of the dominant firm. Yet, even if the entrant were to offer the 5 units at cost, these purchases would be deterred because the customer would fall below the 90% trigger for the reward.) In this way, the market share discount can directly reduce output.

Fifth, the price-cost test assumes that the price decreases will be passed on to final consumers. This may be the clear where the exclusives or loyalty discounts are true discounts given to final consumers. But, it may not be the case where the dominant firm is acquiring the loyalty from input suppliers, including distributors who then resell to final consumers. The loyalty discounts often involve lump sum payments, which raises questions about pass-on, at least in the short-run.

Finally, it is important to stress that the price-cost test for loyalty discounts assumes that price actually represents a true discount. I expect that this assumption is the starting point for commentators who give priority to the price-cost test. However, the price may not represent a true discount in fact, or the size of the discount may turn out to be smaller than it appears after the “but-for world” is evaluated. That is, the proponents of a price-cost test have the following type of scenario in mind. The dominant firm is initially charging the monopoly price of $100. In the face of competition, the dominant firm offers a lower price of (say) $95 to customers that will accept exclusivity, and the customers accept the exclusivity in order to obtain the $5 discount. (To illustrate, suppose that absent the exclusive, the customers would purchase 90 units from the dominant firm at $100 for total revenue of $9000. With the exclusive, they purchase 100 units at a price of $95 for total revenue of $9500.
Thus, the dominant firm earns incremental revenue of $500 on the 10 incremental units, or $50 per unit. If the dominant firm’s costs are $50 or less, it will pass the price-cost test.) But, consider next the following alternative scenario. The dominant firm offers the original $100 price to those customers that will accept exclusivity, and sets a higher “penalty” price of $105 to customers that purchase non-exclusively from the competitor. In this latter scenario, the $5 discount similarly may drive customers to accept the exclusive. These prices would lead to a similar outcome of the price-cost test. (To illustrate, suppose that absent the exclusive, the customers would purchase 90 units from the dominant firm at $105 for total revenue of $9450. With the exclusive, they purchase 100 units at a price of $100 for total revenue of $10,000. Thus, the dominant firm earns revenue of $550 on the 10 incremental units, or $55 per unit. Here, the dominant firm will pass the price-cost test, if its costs are $55 or less.) However, in this latter scenario, it is noteworthy that the use of the “penalty” price eliminates any benefits to consumers. This issue seems to be overlooked by Crane and Lambert. (For further details of the role of the penalty price in the context of bundled discounts, see Barry Nalebuff’s articles on Exclusionary Bundling and the articles of Greenlee, Reitman and Sibley.)

* * *

For all these reasons, treating loyalty discounts as analogous to predatory pricing and thereby placing over-reliance on a price-cost test represents a formalistic and unreliable antitrust approach. (It is ironic that Commissioner Wright was criticized by Professor Lambert for being formalistic, when the facts are the opposite.)

This analysis is not to say that the court should be indifferent to the lower prices, where there is a true discount. To the contrary, lower prices passed-on would represent procompetitive efficiency benefits. But, the potential for lower prices passed-on does not provide a sufficient basis for adopting a price-cost safe harbor test for loyalty discount allegations, even ones that can be confidently characterized as purely plain vanilla customer foreclosure with no effects on rivals’ costs.

Thus, the price-cost test should be one relevant evidentiary factor. But, it should not be the primary factor or a trump for either side. That is, above-cost pricing (measured in terms of incremental revenue less than incremental cost) should not be sufficient by itself for the defendant to escape liability. Nor should below-cost pricing (again, measured in terms of incremental revenue less than incremental cost) should not be a sufficient by itself for a finding of liability.

Such “Creeping Brookism” does not led to either rigorous or accurate antitrust analysis. It is a path to higher error rates, not a lower ones.

Nor should courts rely on simple-minded foreclosure rates. Gilbarco shows how a mechanical approach to measuring foreclosure leads to confusion. Microsoft makes it clear that a “total foreclosure” test also is deficient. Instead, a better approach is to require the plaintiff to prove under the Rule of Reason standard that the conduct harms the rival by reducing its ability to compete and also that it harms consumers.

I should add one other point for completeness. Some (but not Commissioner Wright or Professor Crane) might suggest that the price-cost test has administrability benefits relative to a full rule of reason analysis under the RRC paradigm. While courts are capable are evaluating prices and costs, that comparison may be more difficult than measuring the increase in the rivals’ distribution costs engendered by the conduct. Moreover, the price-cost comparison becomes an order of magnitude more complex in loyalty discount cases, relative to plain vanilla predatory pricing cases. This is because it also is necessary to determine a reasonable measure of the contestable volume to use to compare incremental revenue and incremental cost. For first-dollar discounts, there will always be some small region where incremental revenue is below incremental cost. Even aside from this situation, the two sides often will disagree about the magnitude of the volume that was at issue.

In summary, I think that Professor Wright’s speech forms the basis of moving the discussion forward into analysis of the actual evidence of benefits and harms, rather than continuing to fight the battles over whether the legal analysis used in the 1950s and 1960s failed to satisfy modern standards and thereby needed to be reined in with unreliable safe harbors.

In Antitrust & Competition, Exclusionary Conduct, Exclusive Dealing, Federal Trade Commission, Law & Economics, Monopolization , , , , , , ,
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Dan Crane on Commissioner Wright’s Rejection of a Price-Cost Test for Loyalty Discounts

Dan Crane —  6 June 2013

Guest post by Michigan Law’s Dan Crane. (See also Thom’s post taking issue with FTC Commissioner Josh Wright’s recent remarks on the appropriate liability rule for loyalty discounts).

A number of people on both sides of the ideological spectrum were surprised by FTC Commissioner Josh Wright’s recent speech advocating that the FTC reject the use of price-cost tests to assess the legality of loyalty discounts and instead pursue an exclusive dealing framework of analysis.  As the author of a brief (unsuccessfully) urging the Supreme Court to grant certiorari and reverse in Z.F. Meritor v. Eaton, I want respectfully to disagree with some of what Josh had to say.  But, first, two other observations.

First, I’m delighted that Josh is charting a course as Commissioner that defies some people’s expectations (even if they sometimes happen to be my own!).  Josh has long insisted on evidence-based analysis rather than simplistic theorizing or reductionist legal rules and his position on loyalty discounts is consistent with that theme.  Early in his term on the Commission, Josh is making it clear that he will exercise independent judgment, intellectual integrity, and a principled, non-ideological approach to decision-making.  That’s a nice rejoinder to those who believe that antitrust law reduces to simplistic right-left politics.  So kudos to Josh!

Second, Josh and I probably agree on 90% of what’s important about loyalty discounts.  We agree that loyalty discounts are usually competitively benign or procompetitive, but that they can sometimes be anticompetitive when they exclude rivals and create market power.  We also agree that exclusive dealing principles and analysis can be usefully deployed in loyalty discount cases (although I would only do so after a plaintiff satisfied a price-cost screen).  Finally, we also agree that unmodified predatory pricing rules—requiring the plaintiff to show that the defendant’s sales were below average variable cost—could potentially insulate some exclusionary loyalty discounts from antitrust scrutiny.

Where we differ is on the question of whether antitrust law should ever condemn a loyalty discount that the allegedly excluded rival could have met without pricing below cost.  To say that it should not is to say that there should be some sort of price-cost screen in place in loyalty discount cases.  Josh rejects the use of such screens.

One point of clarification:  Josh asserts that one of the central claims in favor of the price-cost test is its ease of administration.  Contrary to Josh’s suggestion, that is not an argument we made in our Meritor amicus brief.  As someone who has counseled clients and litigated these issues, I can attest that the discount attribution test (the variant of the price-cost test I support for loyalty discounts) is anything but easy to apply (which Josh himself recognizes with respect to the “contestable share” idea).  The virtue of the test is not its ease of administration, but that it requires plaintiffs to show that the discount scheme actually foreclosed them from competing.  Our point was about analytical discipline, not ease of administration.

This, I think, is the crucial difference between Josh and me.  Unless a rival would have to price below cost to match a loyalty discount, it is not foreclosed from competing for the business covered by the discount.  Josh wants to apply exclusive dealing analysis that looks at foreclosure without answering a question that, in my view, is necessary to discover whether there is any foreclosure at all—whether the rival could profitably match the discount.  A rival that has a profitable “predatory counterstrategy,” to quote Frank Easterbrook, isn’t foreclosed.

A thought experiment may be helpful.  Suppose that a firm with a 90% market share offered all of its customers a 0.0001% rebate if they purchased at least 80% of their requirements from the dominant firm.  No one could imagine that such a “loyalty discount” could exclude rivals, since even small rivals could easily make up the rebates foregone if customers forewent buying the 80% from the dominant firm.  We can make the rebate 0.001% with the same result.  And we can continue to pose successive iterations of the same question, increasing the discount incrementally, until we hit a point that someone could reasonably say “well now that could be exclusionary.”  Wherever we cross that Rubicon, we cross it because what was true at 0.0001%—that the small rival could laugh it off by shelling out a few dollars in a counter-discount—is no longer true.  To play this game is to conduct a competitive response sensitivity analysis of the very kind demanded by the attribution test. For present purposes, it’s unimportant where we draw the line; it’s the fact of the line-drawing that matters. To paraphrase Winston Churchill, we’ve already established what we are, now we’re just haggling over the price.

Josh is surely right that loyalty discounts can raise rivals’ costs.  That could happen in one of two ways.  First, if a small firm were prevented from reaching efficient scale, or second if a firm were forced to ramp up to an inefficiently large scale in order to meet a competitor’s loyalty discounts.  But neither of those scenarios holds if the rival is able to compete against the loyalty discounts without pricing below cost.  The small firm will not be prevented from reaching minimum efficient scale if it can increase its share by profitably competing against the loyalty discount.  And the second firm will not be rushed into increasing its scale if it can compete profitably at a smaller scale.  In either case, the RRC mechanism is forcing the firms to price below their costs.

At the end of the day, I suspect that Josh—using whatever analytical tools he associates with exclusive dealing analysis—would be highly unlikely to condemn any loyalty discount in a case where the rival could profitably match the discounts.  That gives me assurances as to Josh, but not as to all other players in the legal system, many of whom are eager to jettison the discipline of price-cost screens so that they can get onto the “real meat” of the case—like inflammatory internal e-mails employing metaphors of coercion that Judge Posner has aptly labeled “compelling evidence of predatory intent to the naïve.”  So I remain highly confident that we’re in good hands with Josh, but worry about what others may do with his words.

In Antitrust & Competition, Exclusive Dealing, Federal Trade Commission, Law & Economics, Monopolization, Regulation ,
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Should There Be a Safe Harbor for Above-Cost Loyalty Discounts? Why I Believe Wright’s Wrong.

Thom Lambert —  6 June 2013

It’s not often that I disagree with my friend and co-author, FTC Commissioner Josh Wright, on an antitrust matter.  But when it comes to the proper legal treatment of loyalty discounts, the Commish and I just don’t see eye to eye.

In a speech this past Monday evening, Commissioner Wright rejected the view that there should be a safe harbor for single-product loyalty discounts resulting in an above-cost price for the product at issue.  A number of antitrust scholars—including Herb Hovenkamp, Dan Crane, and yours truly—recently urged the Supreme Court to grant cert and overturn a Third Circuit decision refusing to recognize such a safe harbor.  Commissioner Wright thinks we’re wrong.

A single-product loyalty discount occurs when a seller conditions a price cut (either an ex ante discount or an ex post rebate) on a buyer’s purchasing some quantity of a single product from the seller.  The purchase target is often set as a percentage of the buyer’s requirements, as when a medical device manufacturer offers to pay a 20% rebate on all of a hospital’s purchases of the manufacturer’s device if the hospital buys at least 70% of its requirements of that type of device from the manufacturer.  Because a loyalty discount tends to encourage distributors to carry more of the discounting manufacturer’s brand and less of the brands of the discounter’s rivals, such a discount may tend to “foreclose” those rivals from available distribution outlets.  If the degree of foreclose is so great that rivals have to cut their output below minimum efficient scale (the minimum output level required to achieve all economies of scale), then the discount may “raise rivals’ costs” relative to those of the discounter and thereby harm consumers.

On all these points, Commissioner Wright and I are in agreement.  Where we differ is on the question of whether a loyalty discount resulting in a discounted price that is above the discounter’s own cost should give rise to antitrust liability.  I say no.  I take that position because such an “above-cost loyalty discount” could be matched by any rival that is as efficient a producer as the discounter.  If, for example, a manufacturer normally charges $1.00 for widgets it produces for $.79 each but offers a 20% loyalty discount to retailers that buy 70% of their widget requirements from the manufacturer, any competitor that could produce a widget for $.79 (i.e., any equally efficient rival) could stay in business by lowering its price to the level of its incremental cost.  Thus, any rival that loses sales because of a manufacturer’s above-cost loyalty discount must be either less efficient than the manufacturer (so it can’t match the manufacturer’s discounted price) or unwilling to lower its price to the level of its cost.  In either case, the rival is unworthy of antitrust’s protection, where that protection amounts to prohibiting price cuts that provide consumers with immediate benefits.

Commissioner Wright disputes (I think?) the view that equally efficient rivals could match all above-cost loyalty discounts.  He maintains that loyalty discounts may be structured so that

[a] distributor’s purchase of an additional unit from a rival supplier beyond the threshold level can result in a loss of rebates large enough to render rival suppliers unable to attract a distributor to purchase the marginal unit at prices at or above the marginal cost of producing the good.

While I’m not entirely certain what Commissioner Wright means by this remark, I think he’s making the point that a loyalty discounter’s equally efficient rival might not be able to attract purchases by matching the discounter’s above-cost loyalty rebate if the rival’s “regular” base of sales is substantially smaller than that of the discounter.

If that is indeed what Commissioner Wright is saying, he has a point.  Suppose, for example, that the market for tennis balls consists of two brands, Penn and Wilson, that current market shares, reflective of consumer demand, are 60% for the Penn and 40% for Wilson, and that retailers typically stock the two brands in those proportions. Assume also that it costs each manufacturer $.90 to produce a can of tennis balls, that each sells to retailers for $1 per can, and that minimum efficient scale in this market occurs at a level of production equal to 35% of market demand. Suppose, then, that Penn, the dominant manufacturer, offers retailers a 10% loyalty rebate on all purchases made within a year if they buy 70% of their requirements for the year from Penn. The $.90 per unit discounted price is not below Penn’s cost, so the loyalty discount would come within my safe harbor.

Nevertheless, the loyalty discount could have the effect of driving Wilson from the market.  After implementation of the rebate scheme, a typi­cal retailer that previously purchased sixty cans of Penn for $60 and forty cans of Wilson for $40 could save $7 on its 100-can tennis ball require­ments by spending $63 to obtain seventy Penn cans and $30 to obtain thirty Wilson cans. The retailer and others like it would thus have a strong incen­tive to shift pur­chases from Wilson to Penn. To prevent a loss of mar­ket share that would drive it below minimum efficient scale (35% of market demand), Wilson would need to lower its price to provide retailers with the same total dollar discount, but on a smaller base of sales (40% of a typical retailer’s require­ments rather than 60%). This would require it to lower its price below cost. For example, Wilson could match Penn’s $7 discount to the retailer described above only by reducing its $1 per-unit price by 17.5 cents ($7.00/40 = $.175), which would require it to price below its cost of $.90 per unit.  Viewed statically, then, it seems that even an above-cost loyalty discount could occasion competitive harm by causing rivals to be less efficient, so that they could not match the discounter’s price.

In light of dynamic effects, though, I’m not convinced that examples like this undermine the case for a safe harbor for above-cost loyalty discounts. Had the nondominant rival (Wilson) charged a price equal to its marginal cost prior to Penn’s loyalty rebate, it would have enjoyed a price advantage and likely would have grown its market share to a point at which Penn’s loyalty rebate strat­egy could not drive it below minimum effi­cient scale. Moreover, one strategy that would prevent a nondominant but equally efficient firm from being harmed by a dominant rival’s above-cost loyalty rebate would be for the non-dominant firm to give its own volume discounts from the outset, secur­ing up-front commitments from enough buy­ers (in exchange for discounted prices) to ensure that its production stayed above minimum efficient scale. Such a strategy, which would obvi­ously benefit consumers, would be encouraged by a liability rule that evaluated loy­alty discounts under straight­forward Brooke Group principles (i.e., that included a safe harbor for above-cost discounts) and thereby signaled to manufacturers that they must take steps to protect themselves from above-cost loyalty discounts.

Commissioner Wright maintains that all this discussion of price-cost comparisons is inapposite because the theoretical harm from loyalty discounts stems from market exclusion (and its ability to raise rivals’ costs), not from predation.  He says, for example:

  • “[T]o the extent loyalty discounts raise competition concerns, the concerns are about anticompetitive exclusion and, as a result, the legal framework developed to evaluate exclusive dealing claims ought to be used to evaluate claims relating to loyalty discounts.” [p. 12]
  • “[P]redatory pricing and raising rivals’ costs are distinct paradigms of potentially exclusionary conduct. There simply is not a stable relative relationship between price and cost in raising rivals’ cost models that form the basis of anticompetitive exclusion, and hence it does not follow that below cost pricing is a necessary condition for competitive harm.”  [pp. 19-20]
  • “When plaintiffs allege that loyalty discounts … violate the antitrust laws because they deprive rivals of access to a critical input, raise their costs, and ultimately harm competition, they are articulating a raising rivals’ cost theory of harm rather than price predation.”  [p. 24]
  • “Raising rivals’ costs and predation are two different economic paradigms of exclusionary conduct, and economic models within each paradigm establish the necessary conditions for each practice to harm competition and give rise to antitrust concerns. Loyalty discounts and other forms of partial exclusives … are properly analyzed under the exclusive dealing framework. Price‐cost tests in the predatory pricing tradition … simply do not comport with the underlying economics of exclusive dealing.”  [p. 33]

I must confess that I’m baffled by Commissioner Wright’s oddly formalistic pigeonholing.  Why must a practice be one or the other—either pricing too low or excluding rivals and thereby raising their costs?  That seems like a false dichotomy.  Indeed, it seems to me that a problematic loyalty discount is one in which the discounter excludes its rivals from a substantial portion of the distribution network (and thereby raises their costs) via the mechanism of conditional price cuts. It’s “both-and,” not “either-or.”  And if that’s the case, then surely it makes sense to limit which price cuts may occasion liability—i.e., only those that could not be matched by equally efficient rivals.  [It is important to note here that I don’t advocate a price-cost test as an alternative to a foreclosure-based analysis.  Rather, a plaintiff should have to establish below-cost pricing (to show that the plaintiff was deserving of antitrust’s protection via the highly disfavored prohibition of discounts) and demonstrate that the discounting at issue resulted in substantial foreclosure from distribution outlets (the latter showing is necessary to prove harm to competition rather than simply to a competitor).]

Throughout his speech, Commissioner Wright emphasizes that the primary competitive concern presented by loyalty discounts is the possibility of “anticompetitive exclusion.”  He writes on page 8, for example, that “[t]he key economic point is that the antitrust concerns potentially arising from loyalty discounts involve anticompetitive exclusion rather than predatory pricing….”  On page 12, he reiterates that “to the extent loyalty discounts raise competition concerns, the concerns are about anticompetitive exclusion.”  He then apparently assumes that loyalty discount-induced exclusion is “anticompetitive” if it is sufficiently substantial—i.e., if the discounter’s rivals are foreclosed from so many distribution outlets that they are driven below minimum efficient scale so that their costs are raised relative to those of the discounter.

I would dispute the notion that discount-induced exclusion is anticompetitive simply because it’s substantial.  Rather, I’d say such exclusion is anticompetitive only if it is substantial and could not have been avoided by aggressive pricing.  Omitting the second requirement creates the possibility that antitrust will be used by a laggard rival to prevent a more aggressive rival’s consumer-friendly price competition.  (LePage’s anyone?)

Suppose, for example, that there are two producers of widgets, A and B, which both produce widgets at a marginal cost of $.79 and, given their duopoly, charge $1.00 per widget.  A, whose market share has hovered around 50%, institutes a loyalty rebate of 20% for retailers that purchase 70% of their requirements from A.  If B offers the same deal, or simply cuts its price to $.80, it should lose no market share.  But suppose B doesn’t do so, A captures 70% of the market, and B falls below minimum efficient scale.  Would we say that B’s exclusion is “anticompetitive” because A’s discount scheme resulted in such substantial foreclosure that it raised B’s costs?  Should B be able to collect treble damages for based on its “anticompetitive exclusion”?  Surely not.

Commissioner Wright, from whom I have learned more about “error costs” than anyone else, seems oddly unconcerned about the chilling effect his decidedly pro-plaintiff approach to loyalty discounts will produce.  Wouldn’t a firm considering a loyalty discount—a price cut, don’t forget!—think twice if it knew its rivals could sit on their hands, claim “exclusion” if the discount successfully moved substantial market share toward the discounter, and collect treble damages?  The safe harbor Hovenkamp, Crane, and I have advocated would provide assurance to potential discounters that they will not face liability if they charge above-cost prices, prices that could be matched by equally efficient, aggressive rivals.  Isn’t that approach more likely to minimize error costs?

Two closing points.  First, despite my disagreement with Commissioner Wright on this issue, I share the widely held view that he is one of the most brilliant antitrust thinkers out there.  He’s taught me more about antitrust than anyone (with the possible exception of the uber-prolific Herb Hovenkamp).  His questioning of my views on loyalty discounts really makes me wonder if I’m missing something.

Second, to those who think Commissioner Wright has “drifted” or “turned,” let me assure you that he’s long held his views on loyalty discounts.  As you can see here, here, and here, we’ve been going round and round on this matter for quite some time.

Perhaps one day one of us will persuade the other.

In Antitrust & Competition, Error Costs, Exclusionary Conduct, Exclusive Dealing, Federal Trade Commission, Law & Economics, Monopolization, Regulation , ,
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Have Elhauge and Wickelgren Undermined the Rule of Per Se Legality for Above-Cost Loyalty Discounts?

Thom Lambert —  12 September 2012

Einer Elhauge and Abraham Wickelgren, of Harvard and the University of Texas, respectively, have recently posted to SSRN a pair of provocative papers on loyalty discounts (price cuts conditioned on the buyer’s purchasing some amount, usually a percentage of its requirements, from the seller).  Elhauge and Wickelgren take aim at the assertion by myself and others (e.g., Herb Hovenkamp) that loyalty discounts should be per se legal if they result in a discounted per-unit price that is above the seller’s incremental per-unit cost.  E&W would cast the liability net further.

We advocates of per se legality for above-cost loyalty discounts base our position on the fact that such discounts generally cannot exclude aggressive rivals that are as efficient as the discounter.  Suppose, for example, that widgets are normally sold for a dollar each but that a seller whose marginal cost is $.88/widget offers a 10% loyalty rebate to any buyer who purchases 80% of its widget requirements from the seller.  Because the $.90 discounted price exceeds the discounter’s marginal cost, any equally efficient widget producer could compete with the discount by lowering its own price to a level above its cost.

But what if the loyalty rebate actually causes a rival to be less efficient than the discounter? Some have argued that this may occur, even with above-cost loyalty discounts, when scale economies are significant.  Suppose that the market for tennis balls consists of two brands, Pinn and Willson, that current market shares, reflective of consumer demand, are 60% for the Pinn and 40% for Willson,  and that retailers typically stock the two brands in those proportions. Assume also that it costs each manufacturer $.90 to produce a can of tennis balls, that each sells to retailers for $1 per can, and that minimum efficient scale in this market (the lowest production level at which all available scale economies are exploited) occurs at a level of production equal to 35% of market demand. Suppose that Pinn, the dominant manufacturer, offers retailers a 10% loyalty rebate on all purchases made within a year if they buy 70% of their requirements for the year from Pinn.

While the $.90 per unit discounted price is not below Pinn’s cost, it might have the effect of driving Willson, an equally efficient rival, from the market. Willson could avoid losing market share and thus falling below minimum efficient scale only if it matched the full dollar amount of Pinn’s discount on its smaller base of sales. It wouldn’t be able to do so, though, without pricing below its cost.

Consider, for example, a typical retailer that initially (before the rebate announcement) satisfied its requirements by purchasing sixty cans of Pinn for $60 and forty cans of Willson for $40. After implementation of the rebate plan, the retailer could save $7 on its 100-can tennis ball requirements by spending $63 to obtain seventy Pinn cans and $30 to obtain thirty Willson cans. The retailer and others like it would thus have a strong incentive to shift purchases from Willson to Pinn.  To prevent a loss of market share that would drive it below minimum efficient scale, Willson would need to lower its price to provide retailers with the same total dollar discount, but on a smaller base of sales (40% of a typical retailer’s requirements rather than 60%). This would cause it to lower its price below its cost.  For example, Willson could match Pinn’s $7 discount to the retailer described above only by reducing its $1 per-unit price by 17.5 cents ($7.00/40 = $.175), which would require it to price below its cost of $.90 per unit.

When one considers dynamic effects, examples like this don’t really undermine the case for a rule of per se legality for above-cost loyalty discounts. Had the nondominant rival (Willson) charged a price equal to its marginal cost prior to implementation of Pinn’s loyalty rebate, it would have enjoyed a price advantage and likely would have grown its market share to a point at which Pinn’s loyalty rebate strategy could not drive it below minimum efficient scale. Moreover, a strategy that would prevent a nondominant but equally efficient firm from being harmed by a dominant rival’s above-cost loyalty rebate would be for the non-dominant firm to give its own volume discounts from the outset, securing up-front commitments from enough buyers (in exchange for discounted prices) to ensure that its production stayed above minimum efficient scale. Such a strategy, which would obviously benefit consumers, would be encouraged by a rule that evaluated loyalty discounts under straightforward Brooke Group principles and thereby signaled to manufacturers that they must take steps to protect themselves from above-cost loyalty discounts. In the end, then, any equally efficient rival that is committed to engaging in vigorous price competition ought not to be excluded by a dominant seller’s above-cost loyalty rebate.

Moreover, even if a loyalty rebate could occasionally drive an aggressive, equally efficient rival from the market, a rule of per se legality for above-cost loyalty discounts would still be desirable on error cost grounds.  An alternative rule subjecting above-cost loyalty discounts to potential treble damages liability would chill all sorts of non-exclusionary discounting practices, so that the social losses from reduced price competition would exceed any social gains from the elimination of those rare discounts that could exclude aggressive, efficient rivals. In short, the social costs resulting from potential false convinctions under a broader liability rule would overwhelm the social costs from false acquittals under the per se legality rule I have advocated.

The two new papers by Elhauge and Wickelgren contend that I and other per se legality advocates are missing a key anticompetitive threat posed by loyalty discounts even in the absence of scale economies: their potential to chill price competition.

The first E&W paper addresses loyalty discounts involving “buyer commitment”—i.e., a promise by buyers receiving the discount that they will purchase some percentage of their requirements from the discounter (not its rivals) in the future.  According to E&W, the discounter who agrees to this sort of arrangement will be less likely to give discounts to uncommitted (“free”) buyers in the future.  This is because, E&W say, the discounter knows that if it cuts prices to such buyers, it will have to reduce its prices to committed buyers by the agreed-upon discount percentage.  The discounter’s rivals, knowing that the discounter won’t cut prices to attract free buyers, will similarly abstain from aggressive price competition.  “The result,” E&W maintain, “is inflated prices to free buyers, which also means inflated prices to committed buyers because they are priced at a loyalty discount from those free buyer prices.”  Despite these adverse consequences, E&W contend, buyers will agree to competition-reducing loyalty discounts because much of their cost is externalized:  “[W]hen one buyer agrees to a loyalty discount, all buyers suffer from the higher prices that result from less aggressive competition,” so “an incumbent supplier need not compensate an individual buyer who agrees to a loyalty discount for the losses that all other buyers suffer.”

The second E&W paper contends that loyalty discounts may soften price competition and injure consumers even when they do not involve buyer commitment to purchase from the discounter in the future.  According to E&W, “[b]ecause the loyalty discount requires the seller to charge loyal buyers less than buyer who are not covered by the loyalty discount, the seller cannot lower prices to uncovered buyers without also lowering prices to loyal buyers.”  Given the increased cost of competing for uncovered buyers  (i.e., any price concession will require further concessions to covered buyers), the seller is likely to cede uncovered buyers to its rival, which will reduce the rival’s incentive to compete aggressively for buyers covered by the loyalty discount.  In short, E&W contend, the loyalty discount will facilitate a market division scheme between the discounter and its rival.

As is typical for an Elhauge paper, there’s some elaborate modeling and math in both of these papers.  The analysis appears to be rigorous.  It seems to me, though, that there’s a significant problem with both papers: Each assumes that loyalty discounts are structured so that the discounter promises to reduce the price from the amount collected in sales to others.  While I’m reluctant to make sweeping claims about how loyalty discounts are typically structured, I don’t think loyalty discounts usually work this way.

Loyalty discounts could be structured many ways.  The seller could offer a discount from a pre-determined price—e.g., “The price is $1 per widget, but if you purchase at least 80% of your widgets from me, I’ll charge you only $.90/widget.”  Such a discount doesn’t create the incentive effect that underlies E&W’s theories of anticompetitive effect, for there’s no reason for the seller not to reduce others’ widget prices in the future.  Alternatively, the seller could offer a discount off a list price that is subject to change—e.g., “If you purchase 80% of your requirements from me, I’ll charge you 10% less than the posted list price.”  This sort of discount might discourage sellers from lowering list prices, but it shouldn’t dissuade them from also giving others a break from list prices.  Indeed, in many industries hardly anyone pays list price.  The only loyalty discounts that threaten the effects E&W fear are those where the discount is explicitly tied to the price charged to others—e.g., “If you purchase 80% of your requirements from me, I’ll charge you 10% less than the lowest price I’m charging others.”

This last sort of loyalty discount might have the effects E&W predict, but I’ve never seen such a discount.  The loyalty discounts and rebates I encountered as an antitrust lawyer resembled the first two types discussed above: discounts off pre-determined prices or discounts off official list prices (from which price concessions were regularly granted to others).  The loyalty discounts that E&W model really just look like souped-up “Most Favored Nations” clauses, where the seller promises not just to meet, but to beat, the price it offers to other favored buyers.  It may make sense to police such clauses, but wouldn’t we do so using the standards governing MFN clauses rather than the rules and standards governing loyalty discounts?  After all, it’s the seller’s promise to beat its other price concessions, not the buyer’s loyalty, that causes the purported anticompetitive harm.

UPDATE:

I just recalled that this is not the first time we at TOTM have addressed Prof. Elhauge’s models of loyalty discounts containing a Most Favored Nations-like provision. FTC Commissioner-Appointee Josh Wright made a similar point about a paper Elhauge produced before these two.  If you found this post at all interesting, please read Josh’s earlier (and more rigorous) post. Sorry about that, Mr. Commish-to-be.

In Antitrust & Competition, Law & Economics, Regulation ,
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The Commission Wins an Exclusive Dealing Case

Josh Wright —  3 March 2010

Today, the Commission announced a consent decree with Transitions Optical in an exclusionary conduct case.  Here’s the FTC description:

Transitions Optical, Inc., the nation’s leading manufacturer of photochromic treatments that darken corrective lenses used in eyeglasses, has agreed to stop using allegedly anticompetitive practices to maintain its monopoly and increase prices, under a settlement with the Federal Trade Commission announced today. Photochromic treatments are applied to eyeglass lenses to protect the eyes from harmful ultraviolet (UV) light. Treated lenses darken when exposed to UV light and fade back to clear when the UV light diminishes….

The FTC charges that the company illegally maintained its monopoly by engaging in exclusive dealing at nearly every level of the photochromic lens distribution chain. First, Transitions refused to deal with manufacturers of corrective lenses, known as “lens casters,” if they sold a competing photochromic lens. Further down the supply chain, Transitions used exclusive and other agreements with optical retail chains and wholesale optical labs that restricted their ability to sell competing lenses.  According to the FTC’s complaint, Transitions’ exclusionary tactics locked out rivals from approximately 85 percent of the lens caster market, and partially or completely locked out rivals from up to 40 percent or more of the retailer and wholesale lab market.

In settling the agency’s charges, Transitions has agreed to a range of restrictions, including an agreement to stop all exclusive dealing practices that pose a threat to competition. These provisions will end its allegedly anticompetitive conduct and make it easier for competitors to enter the market.

The Complaint is here.   And the analysis to aid public comment is available here.  A few quick observations and reactions, with the obvious caveat that these comments have only the benefit of the public information linked above and not more.

1. In light of a certain high-profile loyalty / market-share discount case that the Commission has on its plate, the analysis here is interesting not only on its own merits, but to the extent it might inform about how the Commission would pursue other cases involving similar conduct, i.e. exclusive dealing and discounts conditioned on full or partial exclusivity or threshold purchase requirements.   I note, for example, that the order prohibits Transitions from both exclusive dealing and partial exclusives/ loyalty discounts.  It will be interesting to see if the Commission adopts a similar approach of bearing the burden of demonstrating substantial foreclosure as a necessary but not sufficient condition in other cases involving allegedly exclusionary contracts aimed at depriving rivals of access to distribution sufficient to achieve minimum efficient scale.

2. The alleged foreclosure percentages are very high, over 85 percent with lens casters and “as much as 40 percent or more” with retailers and wholesale labs.  Under a straight Section 2 analysis, which the Commission discusses in the aid to public comment, and assuming the accuracy of these calculations, these foreclosure levels are likely to raise significant concerns where monopoly power is present and the contracts are difficult to terminate (both are alleged).

3. I found one passage in the aid to public comment troublesome, and in my view, incorrect.  With respect to pro-competitive efficiencies flowing from the arrangement, the Commission appears to be taking an overly narrow stance about cognizable justifications. Here’s what the FTC says about efficiencies from exclusives:

No procompetitive efficiencies justify Transitions’ exclusionary and anticompetitive conduct. Transitions cannot show that the exclusive arrangements were reasonably necessary to achieve a procompetitive benefit, such as protecting Transitions’ intellectual property or technical know-how, or preventing interbrand free-riding.5 Transitions does not transfer substantial intellectual property or technical know-how to its customers, and even if it did, any such transfer would likely be protected by existing confidentiality agreements. A concern about interbrand free-riding also does not justify the substantial anticompetitive effects found here. The vast majority of Transitions’ promotional efforts are brand specific, reducing the significance of any free-riding concern.6 While Transitions’ marketing efforts may generate some consumer interest in the product category as a whole – and not just in Transitions’ own products – this is a part of the natural competitive process. This type of consumer response does not raise a free-riding concern sufficient to justify the substantial anticompetitive effects found here.

As a conceptual matter, the Commission at least appears to reject the idea of distributional / promotional efficiencies in the absence of inter-retailer free-riding.  Footnote 6 of the analysis seems to support that conclusion.   As readers of this blog will know, I’ve done some work in this area arguing that this interbrand free-riding conception is too narrow and does not reflect the benefits of vertical restraints in resolving pervasive incentive conflicts between manufacturers and retailers even in the absence of free-riding.

Thom has a great post on this summarizing Ben Klein’s work on RPM which is in a similar vein.  But the fundamental economic facts are that under a set of conditions frequently satisfied in conventional differentiated products markets (manufacturer margins > retailer margins; manufacturer-specific retailer promotional efforts lack significant inter-retailer effects), manufacturers will have to compensate retailers for promotional effort.  These payments can take a lot of different forms: discounts, RPM, slotting contracts, etc.  The promotional sales generated are output increasing and so, from an antitrust perspective, vertical restraints resolving these incentive conflicts provide an important efficiency justification for restraints such as RPM, as I note here, and as the majority in Leegin recognizes.  Or see Ben Klein’s latest on RPM for an excellent explanation of the economics at work here, extending the analysis in Klein and Murphy (1988).

The next key step, and the one relevant for exclusive dealing, is that the very fact that dealers are compensated by manufacturers for supplying promotion on the basis of all their sales also opens the door to a type of free-riding that might undermine these promotional efforts that does not involve switching sales to a rival.  The manufacturer and dealer can be thought of as having an implicit contact to supply the contracted-for level of promotional services, with the manufacturer paying a premium for this performance and monitoring its retailers, terminating for non-performance where necessary.   However, dealers can free-ride by taking the compensation but reducing costly promotional effort.  Even if inter-brand free-riding is not possible, the vertical chain faces this incentive conflict.  Exclusive dealing and reduce the incentive to free-ride and facilitate performance by increasing the incentives for the retailer to perform.

Klein and Lerner (2007) present this analysis is significant detail and readers are referred there.  The fundamental point is that, as the authors write:

In particular, the presence of free-rideable manufacturer investments and dealer switching, the conditions focused upon by the court in Dentsply, are not necessary conditions for determining whether a prevention of free-riding justification for exclusive dealing makes economic sense. All that is required for exclusive dealing to be used to prevent dealer free-riding is that dealers have a significant economic role in the promotion of the manufacturer’s product, that manufacturers are compensating dealers for the supply of additional promotion and that exclusive dealing encourages such extra dealer promotion by facilitating manufacturer enforcement of its implicit contract for dealer promotion.

Note that I am not arguing that these potential efficiencies were present in Transitions as a factual matter.  Rather, I am just saying that to the extent that the passage endorses the position that exclusive dealing cannot prevent free-riding in the absence of free-rideable investments by the manufacturer, it is overly restrictive.  I should also note that my view is not only consistent with much of the case law recognizing a “dealer loyalty” explanation for exclusive dealing, it is also the case that Commission itself has discussed this type of efficiency in the past!  See, for example, this advocacy filing (signed by BC, BE and OPP) concerning potential legislation restricting vertical restaints in the wine industry.  The filing (and there are others), signed ecognizes that in addition to preventing inter-brand free-riding (and citing Klein) “exclusive dealing can be used to assure that suppliers receive the sales-generating effort that they have bargained for from distributors (e.g., through direct payment or through increased revenue that comes with exclusive territories), rather than distributors focusing their efforts on competing brands.”

Because the Commission makes reference only to the inter-brand free-riding, and does not discuss other free-riding justifications, this seemed worth comment.  Of course, even if such a pro-competitive justification fit the facts, it also does not mean it would outweigh any potential anticompetitive effects, but I do find the omission at least mildly troublesome.

In Antitrust & Competition, Economic Theory, Exclusionary Conduct, Exclusive Dealing, Federal Trade Commission, Intellectual Property, Vertical Restraints , ,
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PeaceHealth and De Facto Exclusive Dealing, Part III

Thom Lambert —  13 November 2009

Josh’s thoughtful response (Bitchslap? Nah.) to my post criticizing the Ninth Circuit’s recent Masimo decision raises a number of important matters. I started to just submit a comment to Josh’s post, but then I figured a reply was post-worthy. (I don’t want the antitrust nerds who read these technical posts — and here’s to you, dweeby friends! — to miss the discussion.)

Here’s a run-down of the discussion so far:

I criticized the Masimo court for reasoning that a plaintiff complaining of a rival’s bundled discounting may proceed on a de facto exclusive dealing theory when (1) there’s no express covenant of exclusivity (so it is merely the defendant’s low prices that are leading buyers to forego rivals) and (2) the defendant’s bundled discount would pass muster under the Ninth Circuit’s PeaceHealth standard. Under that so-called “discount attribution” standard, a bundled discount is immune from liability if each product in the bundle is priced above cost after the entire amount of the bundled discount is attributed to that product alone.

The basis for the PeaceHealth court’s safe harbor was a desire to immunize bundled discounts that cannot exclude any single-product rival that can produce its own product as efficiently as the defendant. After all, any bundled discount that results in above-cost pricing on each bundled product, even after the entire discount amount is attributed to that product, could be matched by, and thus cannot exclude, any equally efficient single-product rival. Because such discounts do not make it impossible for equally efficient rivals to stay in the market, the PeaceHealth court reasoned, they are not unreasonably exclusionary.

In my initial post, I argued that this same analysis should apply even when the bundled discount is so successful that it induces customers to drop rivals’ brands and to purchase only from the discounter. If a discounter doesn’t procure a contractual covenant of exclusivity and instead just offers a really attractive discount, that discount, which provides immediate consumer benefit, should be immune from liability as long as it doesn’t threaten to exclude an equally efficient rival. The discount can’t pose such a threat unless it’s so extreme that an equally efficient single-product rival (who must match the entire dollar amount of the bundled discount on its single product) could not match it, and that will be the case only if the discount results in a below-cost price on some item in the bundle after the entire amount of the discount is attributed to that item. Thus, I argued, an allegation (or even proof) that a bundled discount resulted in de facto exclusive dealing should not alter the PeaceHealth safe harbor.

Now, there are two ways one might interpret my position. I could be saying simply that the optimal liability rule would not condemn de facto exclusive dealing induced solely by bundled discounts that pass muster under PeaceHealth. I could appropriately stake that claim, even if I acknowledged potential anticompetitive harm from such discounts, if I concluded that the likelihood and magnitude of such harm was low and the likelihood and magnitude of harm from “false positives” (i.e., improperly condemned discounts) was high. Alternatively, I could be making a more aggressive economic claim, asserting that de facto exclusive dealing accomplished via bundled discounts that satisfy PeaceHealth cannot be anticompetitive.

In his thoughtful and nuanced post, Josh suggests he might, given more empirical analysis, agree with the former position (about what liability rule is optimal, given error costs). But he rejects the more aggressive economic claim. That claim, he maintains, is deficient because it fails to account for the fact that bundled discounts resulting in de facto exclusive dealing may “raise rivals’ costs” even if the discounts would pass muster under PeaceHealth.

Here’s the intuition (my understanding of it, at least): A bundled discount that’s big enough to usurp lots of business from the discounter’s rivals, but not big enough to run afoul of PeaceHealth, may still preclude those rivals from attaining minimum efficient scale (i.e., the output level at which all scale economies are exhausted). The discount may thus prevent rivals from achieving equivalent efficiency with the discounter. That would be anticompetitive. Thus, it is not true, as I said, that “[w]hen it comes to bundled discounts, … there can be no anticompetitive harm in the form of predation, unreasonable exclusion, or foreclosure if the competitive product is priced above the defendant’s cost once the entire discount is attributed to that product.” Rather, Josh suggests, a bundled discount that results in substantial foreclosure of the discounter’s rivals may raise those rivals’ costs and thus be anticompetitive, even if the discount would pass muster under PeaceHealth and therefore not amount to predation.

So what to make of all this? Continue Reading…

In Antitrust & Competition, Error Costs, Exclusionary Conduct, Exclusive Dealing, Law & Economics, Regulation, Tying , ,
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Should PeaceHealth Apply to De Facto Exclusive Dealing Claims?

Josh Wright —  10 November 2009

Thom answers this question in the affirmative in his excellent post about the Ninth Circuit’s analysis in Masimo and is disappointed that the Ninth Circuit rejected the discount attribution standard as the sole test for Section 2 in favor of a separate inquiry as to whether the bundled discount arrangement resulted in a substantial foreclosure of distribution and competitive harm.  Thom describes this reasoning as “sorely disappointing.”  I’m tentatively not convinced things are as bad as Thom sees them and want to explain why.  Maybe Thom can persuade me that I ought to be more upset about Masimo than I am.

Let me start with two preliminary points.

First, I agree that bundled discounts are generally pro-competitive for all of the reasons Thom states as well as some others.  While there is some empirical evidence that bundled discounting appears in highly competitive markets where anticompetitive theories do not apply, suggesting pro-competitive efficiencies, but little empirical verification of a high likelihood of competitive harms.

Second, despite our agreement about the generally efficiency of bundled discounting, Thom’s claim that a bundled discount distribution arrangement cannot result in anticompetitive effect is overstated as a matter of economic theory.  My basic point is that it is possible, as a matter of economic theory, for distribution arrangements involving bundled discounts that satisfy the PeaceHealth safe harbor to result in anticompetitive effects.  Despite this economic point, I’m not sure that Thom and I disagree on the ultimate appropriate legal treatment of bundled discounting.  I’ll get back to that.

Now, to defend my claim.

Let’s start with Thom’s position that, contra the Ninth Circuit, a bundled discount scheme that satisfies PeaceHealth’s discount attribution test (i.e. prices are still above cost after the discount is fully attributed to the competitive product in the bundle) should be immune from Section 2 liability even if the arrangement results in the “foreclosure” of a sufficient share of distribution to deprive rivals of the opportunity to have access to a critical input (such as shelf space) required to achieve minimum efficient scale.

What is the anticompetitive story in these “bundled discount as de facto exclusive dealing” set of cases?  Put simply, the anticompetitive theories are based on the notion that the monopolist’s distribution arrangement will deprive the rival of the opportunity to reach minimum efficient scale through the foreclosure of access to some critical input do not depend on offering distributors a price that fails the discount attribution standard.  A broad set of “exclusionary distribution” cases allege that various forms of marketing arrangements between manufacturers and retailers result in a situation where the monopolist is purchasing exclusion + distribution rather than just distribution.

The economic literature giving rise to these anticompetitive theories of exclusive dealing as “raising rival’s costs” is about the conditions under which manufacturers will be able to purchase exclusion from downstream firms and the price that they will have to pay to do so.  Manufacturers make payments to distributors for access to shelf space in a lot of ways: lump sum payments such as slotting fees, rebates, loyalty discounts, bundled discounts, RPM, cooperative marketing dollars, trade promotions, and more.  But the key question should not turn on the form of those payments.  It should turn on whether the contracts satisfy the conditions necessary for anticompetitive harm: are rivals foreclosed from a sufficient share of distribution that they cannot achieve minimum efficient scale?

This begs the question: is a price that fails the discount attribution test a necessary condition for the above set of theories to operate?  I don’t think so as a matter of theory.  One can think of the raising rivals’ costs theories of distribution as the manufacturer paying a set of distributors to join the manufacturer’s cartel.  What payment would be sufficient to sustain that agreement without defection (distributors would all have the standard incentive to cheat)?  The answer to that question depends on a lot of things: upstream and downstream entry conditions, switching costs, number of distributors, the existence and magnitude of economies of scale or scope, etc.  But I don’t think that there is any reason to believe that economic theory provides a linkage between passing the discount attribution test and failure to satisfy the necessary conditions for standard raising rivals’ cost-based exclusion theories.  Thus, in theory one suspects that there are distribution arrangements that could logically survive PeaceHealth but also potentially create anticompetitive effects because they satisfy the conditions of the exclusion theories.  Let’s call that set of agreements X.

The existence of X doesn’t necessary mean that I disagree with Thom about the appropriate legal rule.  If X is very small such that it would be more costly to identify these agreements and prosecute them, one could justify Thom’s rule on those grounds.  If enforcement actions against X would lead to substantially greater error costs than Thom’s rule, one could also justify his position on those grounds.  The existing empirical evidence, to my knowledge, is insufficient to make such fine grained determinations.  However, the same evidence also tells us that manufacturer arrangements to pay for distribution and promotion are incredibly common, provide benefits to consumers, and occur in competitive markets.  Indeed, I’ve written a great deal about the set of conditions under which the normal competitive process generates payments for distribution. As such, I agree with Thom that it is incredibly important to establish workable and broad safe harbors in this area that minimize error costs. What I reject is the strong economic claim that appears in Thom’s post:

When it comes to bundled discounts, which generally reflect (or promote) cost-savings and which provide an immediate benefit to consumers, there can be no anticompetitive harm in the form of predation, unreasonable exclusion, or foreclosure if the competitive product is priced above the defendant’s cost once the entire discount is attributed to that product.

If the plaintiff is making a predation claim involving bundled discounts, I think the PeaceHealth standard is workable and useful and we should keep it.  A potential case might even be made, as discussed, to justify PeaceHealth as the universal standard for bundled discount claims even when they alleged exclusionary deprivation of scale because we think X is sufficiently small or unimportant or especially susceptible to Type I error.  But I don’t read Thom as making that case.  Perhaps he is and I hope he’ll clarify.

To repeat: I just don’t think that there is any reason to believe that exclusion in the sense defined here is not theoretically possible as a matter of economics because we observe a price that passes PeaceHealth.  As such, I don’t want to throw out foreclosure analysis as an important and relevant part of the antitrust inquiry.  Let me end with a few words in defense of foreclosure analysis which I think gets a bad rap nowadays.

There are costs to keeping the foreclosure analysis, and having two standards for two different allegations of anticompetitive harm.  Beyond that, of course, foreclosure analysis is full of its own complications, e.g. foreclosure of what? does duration of contract matter? what about staggered expiration dates?  But despite its complications and the potential for abuse, the foreclosure analysis asks the right question in deprivation of scale questions and the one that we know is explicitly linked to an important necessary condition of a very large set of the theories of harm alleged in monopolization cases.  Getting a legal standard reasonably tied to the necessary conditions for anticompetitive harm, as Thom knows from his important work in the RPM area, is not always an easy thing to do in antitrust.

By the way, I think that my objection here survives Thom’s “Hydra critique” that the mode of antitrust analysis should be a function of economic substance rather than form.  I agree that the critical question is whether the conduct is likely to impair the competitive process to the detriment of consumers.   The point here is that the the deprivation of scale claims are or at least can be, as a matter of economic substance, different than pure price predation claims.

The critical economic point is that the set of distribution arrangements must, as the literature says, raise a rival’s cost of operating or impair his ability to exist.  Those arrangements that do not should not trigger antitrust violations.  And of course, those that do not satisfied a necessary but not sufficient condition for competitive harm.  The key point is that in cases involving allegations of deprivation of scale, the economic consensus is that those claims require allegations of exclusion require foreclosure sufficient to deprive rivals the opportunity to compete for minimum efficient scale.  If we are ready to accept that this is the state of economic consensus, then we ought to explicitly include this showing in the part of the plaintiff’s burden.  The antitrust law currently attempts to get at this inquiry through foreclosure analysis, requiring something around 40 percent foreclosure share in de facto exclusionary cases.  That seems sensible to me.

Antitrust can handle different standards.  If the plaintiff is alleging deprivation of scale, lets make substantial foreclosure a necessary (but not sufficient) condition.  If the plaintiff is alleging a price predation argument that does not depend on deprivation of scale, PeaceHealth is a safe harbor.  Would that be so bad?  And one more question for discussion purposes, if Thom is right about PeaceHealth in the context of bundled discounts, doesn’t this also apply to any payment distribution?  For example, I think the logic clearly applies that single product loyalty discounts ought to be analyzed the same way, i.e. we should use discount attribution to apply the discount on so-called non-contestable units to the contestable ones and apply the same filter.  But if that’s true, exclusive dealing with discounts is a loyalty discount where the threshold volume is set to 100% of the distributor purchases.  If that’s right, Thom are you arguing that we should get rid of all exclusive dealing law whenever there is a discount scheme?

In Antitrust & Competition, Economic Theory, Error Costs, Exclusive Dealing , ,
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