Archives For Nobel prize

Politics Has No Place in Antitrust Enforcement, Left or Right

Sam Bowman —  18 May 2020

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

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

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

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

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

The letter argues that:

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

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

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

The full letter is here.

In Antitrust & Competition, COVID-19, Economic Theory, Google, Justice Department, Law & Economics, Monopolization, Platforms, Truth on the Market, Twitter, Tying, Vertical Restraints , , , , , , , , , , ,
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Kolasky: The DOJ and FTC Should Revise Their Proposed Vertical Merger Guidelines to Emulate the EU’s

William J. Kolasky —  6 February 2020

[TOTM: The following is part of a symposium by TOTM guests and authors on the 2020 Vertical Merger Guidelines. The entire series of posts is available here.

This post is authored by William J. Kolasky (Partner, Hughes Hubbard & Reed; former Deputy Assistant Attorney General, DOJ Antitrust Division), and Philip A. Giordano (Partner, Hughes Hubbard & Reed LLP).] 

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

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

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

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

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

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

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

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

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

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

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

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

2. Safe harbors

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

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

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

By contrast, the EU guidelines state that,

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The ability to raise rivals’ costs: 

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

The incentive to foreclose access to inputs: 

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

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

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

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

Overall likely impact on effective competition: 

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

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

* * * * *

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

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

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

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

[4] Id. at § 12.

[5] Id.

[6] Id. at § 13.

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

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

[9] EU guidelines, at § 4.24.

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

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

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

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

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

[15] EU guidelines, at § 25.

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

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

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

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

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

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

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

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

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

In Antitrust & Competition, Antitrust Division, Barriers to Entry, Draft Joint Vertical Merger Guidelines: What’s in, what’s out — and do we need them anyway?, European Union, Exclusionary Conduct, Exclusive Dealing, Exemptions, Federal Trade Commission, International, Justice Department, Law & Economics, Market Definition, Merger Guidelines, Truth on the Market, Tying, Vertical Restraints , , , , , , , , , , , , ,
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This Too Shall Pass: Unassailable Monopolies That Were, in Hindsight, Eminently Assailable

Geoffrey Manne & Alec Stapp —  1 April 2019
Source: Benedict Evans

[N]ew combinations are, as a rule, embodied, as it were, in new firms which generally do not arise out of the old ones but start producing beside them; … in general it is not the owner of stagecoaches who builds railways. – Joseph Schumpeter, January 1934

Elizabeth Warren wants to break up the tech giants — Facebook, Google, Amazon, and Apple — claiming they have too much power and represent a danger to our democracy. As part of our response to her proposal, we shared a couple of headlines from 2007 claiming that MySpace had an unassailable monopoly in the social media market.

Tommaso Valletti, the chief economist of the Directorate-General for Competition (DG COMP) of the European Commission, said, in what we assume was a reference to our posts, “they go on and on with that single example to claim that [Facebook] and [Google] are not a problem 15 years later … That’s not what I would call an empirical regularity.”

We appreciate the invitation to show that prematurely dubbing companies “unassailable monopolies” is indeed an empirical regularity.

It’s Tough to Make Predictions, Especially About the Future of Competition in Tech

No one is immune to this phenomenon. Antitrust regulators often take a static view of competition, failing to anticipate dynamic technological forces that will upend market structure and competition.

Scientists and academics make a different kind of error. They are driven by the need to satisfy their curiosity rather than shareholders. Upon inventing a new technology or discovering a new scientific truth, academics often fail to see the commercial implications of their findings.

Maybe the titans of industry don’t make these kinds of mistakes because they have skin in the game? The profit and loss statement is certainly a merciless master. But it does not give CEOs the power of premonition. Corporate executives hailed as visionaries in one era often become blinded by their success, failing to see impending threats to their company’s core value propositions.

Furthermore, it’s often hard as outside observers to tell after the fact whether business leaders just didn’t see a tidal wave of disruption coming or, worse, they did see it coming and were unable to steer their bureaucratic, slow-moving ships to safety. Either way, the outcome is the same.

Here’s the pattern we observe over and over: extreme success in one context makes it difficult to predict how and when the next paradigm shift will occur in the market. Incumbents become less innovative as they get lulled into stagnation by high profit margins in established lines of business. (This is essentially the thesis of Clay Christensen’s The Innovator’s Dilemma).

Even if the anti-tech populists are powerless to make predictions, history does offer us some guidance about the future. We have seen time and again that apparently unassailable monopolists are quite effectively assailed by technological forces beyond their control.

PCs

Source: Horace Dediu

Jan 1977: Commodore PET released

Jun 1977: Apple II released

Aug 1977: TRS-80 released

Feb 1978: “I.B.M. Says F.T.C. Has Ended Its Typewriter Monopoly Study” (NYT)

Mobile

Source: Comscore

Mar 2000: Palm Pilot IPO’s at $53 billion

Sep 2006: “Everyone’s always asking me when Apple will come out with a cellphone. My answer is, ‘Probably never.’” – David Pogue (NYT)

Apr 2007: “There’s no chance that the iPhone is going to get any significant market share.” Ballmer (USA TODAY)

Jun 2007: iPhone released

Nov 2007: “Nokia: One Billion Customers—Can Anyone Catch the Cell Phone King?” (Forbes)

Sep 2013: “Microsoft CEO Ballmer Bids Emotional Farewell to Wall Street” (Reuters)

If there’s one thing I regret, there was a period in the early 2000s when we were so focused on what we had to do around Windows that we weren’t able to redeploy talent to the new device form factor called the phone.

Search

Source: Distilled

Mar 1998: “How Yahoo! Won the Search Wars” (Fortune)

Once upon a time, Yahoo! was an Internet search site with mediocre technology. Now it has a market cap of $2.8 billion. Some people say it’s the next America Online.

Sep 1998: Google founded

Instant Messaging

Sep 2000: “AOL Quietly Linking AIM, ICQ” (ZDNet)

AOL’s dominance of instant messaging technology, the kind of real-time e-mail that also lets users know when others are online, has emerged as a major concern of regulators scrutinizing the company’s planned merger with Time Warner Inc. (twx). Competitors to Instant Messenger, such as Microsoft Corp. (msft) and Yahoo! Inc. (yhoo), have been pressing the Federal Communications Commission to force AOL to make its services compatible with competitors’.

Dec 2000: “AOL’s Instant Messaging Monopoly?” (Wired)

Dec 2015: Report for the European Parliament

There have been isolated examples, as in the case of obligations of the merged AOL / Time Warner to make AOL Instant Messenger interoperable with competing messaging services. These obligations on AOL are widely viewed as having been a dismal failure.

Oct 2017: AOL shuts down AIM

Jan 2019: “Zuckerberg Plans to Integrate WhatsApp, Instagram and Facebook Messenger” (NYT)

Retail

Source: Seeking Alpha

May 1997: Amazon IPO

Mar 1998: American Booksellers Association files antitrust suit against Borders, B&N

Feb 2005: Amazon Prime launches

Jul 2006: “Breaking the Chain: The Antitrust Case Against Wal-Mart” (Harper’s)

Feb 2011: “Borders Files for Bankruptcy” (NYT)

Social

Feb 2004: Facebook founded

Jan 2007: “MySpace Is a Natural Monopoly” (TechNewsWorld)

Seventy percent of Yahoo 360 users, for example, also use other social networking sites — MySpace in particular. Ditto for Facebook, Windows Live Spaces and Friendster … This presents an obvious, long-term business challenge to the competitors. If they cannot build up a large base of unique users, they will always be on MySpace’s periphery.

Feb 2007: “Will Myspace Ever Lose Its Monopoly?” (Guardian)

Jun 2011: “Myspace Sold for $35m in Spectacular Fall from $12bn Heyday” (Guardian)

Music

Source: RIAA

Dec 2003: “The subscription model of buying music is bankrupt. I think you could make available the Second Coming in a subscription model, and it might not be successful.” – Steve Jobs (Rolling Stone)

Apr 2006: Spotify founded

Jul 2009: “Apple’s iPhone and iPod Monopolies Must Go” (PC World)

Jun 2015: Apple Music announced

Video

Source: OnlineMBAPrograms

Apr 2003: Netflix reaches one million subscribers for its DVD-by-mail service

Mar 2005: FTC blocks Blockbuster/Hollywood Video merger

Sep 2006: Amazon launches Prime Video

Jan 2007: Netflix streaming launches

Oct 2007: Hulu launches

May 2010: Hollywood Video’s parent company files for bankruptcy

Sep 2010: Blockbuster files for bankruptcy

The Only Winning Move Is Not to Play

Predicting the future of competition in the tech industry is such a fraught endeavor that even articles about how hard it is to make predictions include incorrect predictions. The authors just cannot help themselves. A March 2012 BBC article “The Future of Technology… Who Knows?” derided the naysayers who predicted doom for Apple’s retail store strategy. Its kicker?

And that is why when you read that the Blackberry is doomed, or that Microsoft will never make an impression on mobile phones, or that Apple will soon dominate the connected TV market, you need to take it all with a pinch of salt.

But Blackberry was doomed and Microsoft never made an impression on mobile phones. (Half credit for Apple TV, which currently has a 15% market share).

Nobel Prize-winning economist Paul Krugman wrote a piece for Red Herring magazine (seriously) in June 1998 with the title “Why most economists’ predictions are wrong.” Headline-be-damned, near the end of the article he made the following prediction:

The growth of the Internet will slow drastically, as the flaw in “Metcalfe’s law”—which states that the number of potential connections in a network is proportional to the square of the number of participants—becomes apparent: most people have nothing to say to each other! By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.

Robert Metcalfe himself predicted in a 1995 column that the Internet would “go spectacularly supernova and in 1996 catastrophically collapse.” After pledging to “eat his words” if the prediction did not come true, “in front of an audience, he put that particular column into a blender, poured in some water, and proceeded to eat the resulting frappe with a spoon.”

A Change Is Gonna Come

Benedict Evans, a venture capitalist at Andreessen Horowitz, has the best summary of why competition in tech is especially difficult to predict:

IBM, Microsoft and Nokia were not beaten by companies doing what they did, but better. They were beaten by companies that moved the playing field and made their core competitive assets irrelevant. The same will apply to Facebook (and Google, Amazon and Apple).

Elsewhere, Evans tried to reassure his audience that we will not be stuck with the current crop of tech giants forever:

With each cycle in tech, companies find ways to build a moat and make a monopoly. Then people look at the moat and think it’s invulnerable. They’re generally right. IBM still dominates mainframes and Microsoft still dominates PC operating systems and productivity software. But… It’s not that someone works out how to cross the moat. It’s that the castle becomes irrelevant. IBM didn’t lose mainframes and Microsoft didn’t lose PC operating systems. Instead, those stopped being ways to dominate tech. PCs made IBM just another big tech company. Mobile and the web made Microsoft just another big tech company. This will happen to Google or Amazon as well. Unless you think tech progress is over and there’ll be no more cycles … It is deeply counter-intuitive to say ‘something we cannot predict is certain to happen’. But this is nonetheless what’s happened to overturn pretty much every tech monopoly so far.

If this time is different — or if there are more false negatives than false positives in the monopoly prediction game — then the advocates for breaking up Big Tech should try to make that argument instead of falling back on “big is bad” rhetoric. As for us, we’ll bet that we have not yet reached the end of history — tech progress is far from over.

 

In Amazon, Antitrust & Competition, Antitrust Division, Apple, Corporate & Securities Law, European Union, Facebook, Federal Communications Commission, Federal Trade Commission, Google, International, Monopolization, Platforms, Telecommunications, Truth on the Market, Twitter , , , , , , , , , , , , , , , , , , , ,
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The European Commission’s Google Android decision takes a mistaken, ahistorical view of the smartphone market

Julian Morris —  23 July 2018

What to make of Wednesday’s decision by the European Commission alleging that Google has engaged in anticompetitive behavior? In this post, I contrast the European Commission’s (EC) approach to competition policy with US antitrust, briefly explore the history of smartphones and then discuss the ruling.

Asked about the EC’s decision the day it was announced, FTC Chairman Joseph Simons noted that, while the market is concentrated, Apple and Google “compete pretty heavily against each other” with their mobile operating systems, in stark contrast to the way the EC defined the market. Simons also stressed that for the FTC what matters is not the structure of the market per se but whether or not there is harm to the consumer. This again contrasts with the European Commission’s approach, which does not require harm to consumers. As Simons put it:

Once they [the European Commission] find that a company is dominant… that imposes upon the company kind of like a fairness obligation irrespective of what the effect is on the consumer. Our regulatory… our antitrust regime requires that there be a harm to consumer welfare — so the consumer has to be injured — so the two tests are a little bit different.

Indeed, and as the history below shows, the popularity of Apple’s iOS and Google’s Android operating systems arose because they were superior products — not because of anticompetitive conduct on the part of either Apple or Google. On the face of it, the conduct of both Apple and Google has led to consumer benefits, not harms. So, from the perspective of U.S. antitrust authorities, there is no reason to take action.

Moreover, there is a danger that by taking action as the EU has done, competition and innovation will be undermined — which would be a perverse outcome indeed. These concerns were reflected in a statement by Senator Mike Lee (R-UT):

Today’s decision by the European Commission to fine Google over $5 billion and require significant changes to its business model to satisfy EC bureaucrats has the potential to undermine competition and innovation in the United States,” Sen. Lee said. “Moreover, the decision further demonstrates the different approaches to competition policy between U.S. and EC antitrust enforcers. As discussed at the hearing held last December before the Senate’s Subcommittee on Antitrust, Competition Policy & Consumer Rights, U.S. antitrust agencies analyze business practices based on the consumer welfare standard. This analytical framework seeks to protect consumers rather than competitors. A competitive marketplace requires strong antitrust enforcement. However, appropriate competition policy should serve the interests of consumers and not be used as a vehicle by competitors to punish their successful rivals.

Ironically, the fundamental basis for the Commission’s decision is an analytical framework developed by economists at Harvard in the 1950s, which presumes that the structure of a market determines the conduct of the participants, which in turn presumptively affects outcomes for consumers. This “structure-conduct-performance” paradigm has been challenged both theoretically and empirically (and by “challenged,” I mean “demolished”).

Maintaining, as EC Commissioner Vestager has, that “What would serve competition is to have more players,” is to adopt a presumption regarding competition rooted in the structure of the market, without sufficient attention to the facts on the ground. As French economist Jean Tirole noted in his Nobel Prize lecture:

Economists accordingly have advocated a case-by-case or “rule of reason” approach to antitrust, away from rigid “per se” rules (which mechanically either allow or prohibit certain behaviors, ranging from price-fixing agreements to resale price maintenance). The economists’ pragmatic message however comes with a double social responsibility. First, economists must offer a rigorous analysis of how markets work, taking into account both the specificities of particular industries and what regulators do and do not know….

Second, economists must participate in the policy debate…. But of course, the responsibility here goes both ways. Policymakers and the media must also be willing to listen to economists.

In good Tirolean fashion, we begin with an analysis of how the market for smartphones developed. What quickly emerges is that the structure of the market is a function of intense competition, not its absence. And, by extension, mandating a different structure will likely impede competition, or, at the very least, will not likely contribute to it.

A brief history of smartphone competition

In 2006, Nokia’s N70 became the first smartphone to sell more than a million units. It was a beautiful device, with a simple touch screen interface and real push buttons for numbers. The following year, Apple released its first iPhone. It sold 7 million units — about the same as Nokia’s N95 and slightly less than LG’s Shine. Not bad, but paltry compared to the sales of Nokia’s 1200 series phones, which had combined sales of over 250 million that year — about twice the total of all smartphone sales in 2007.

By 2017, smartphones had come to dominate the market, with total sales of over 1.5 billion. At the same time, the structure of the market has changed dramatically. In the first quarter of 2018, Apple’s iPhone X and iPhone 8 were the two best-selling smartphones in the world. In total, Apple shipped just over 52 million phones, accounting for 14.5% of the global market. Samsung, which has a wider range of devices, sold even more: 78 million phones, or 21.7% of the market. At third and fourth place were Huawei (11%) and Xiaomi (7.5%). Nokia and LG didn’t even make it into the top 10, with market shares of only 3% and 1% respectively.

Several factors have driven this highly dynamic market. Dramatic improvements in cellular data networks have played a role. But arguably of greater importance has been the development of software that offers consumers an intuitive and rewarding experience.

Apple’s iOS and Google’s Android operating systems have proven to be enormously popular among both users and app developers. This has generated synergies — or what economists call network externalities — as more apps have been developed, so more people are attracted to the ecosystem and vice versa, leading to a virtuous circle that benefits both users and app developers.

By contrast, Nokia’s early smartphones, including the N70 and N95, ran Symbian, the operating system developed for Psion’s handheld devices, which had a clunkier user interface and was more difficult to code — so it was less attractive to both users and developers. In addition, Symbian lacked an effective means of solving the problem of fragmentation of the operating system across different devices, which made it difficult for developers to create apps that ran across the ecosystem — something both Apple (through its closed system) and Google (through agreements with carriers) were able to address. Meanwhile, Java’s MIDP used in LG’s Shine, and its successor J2ME imposed restrictions on developers (such as prohibiting access to files, hardware, and network connections) that seem to have made it less attractive than Android.

The relative superiority of their operating systems enabled Apple and the manufacturers of Android-based phones to steal a march on the early leaders in the smartphone revolution.

The fact that Google allows smartphone manufacturers to install Android for free, distributes Google Play and other apps in a free bundle, and pays such manufacturers for preferential treatment for Google Search, has also kept the cost of Android-based smartphones down. As a result, Android phones are the cheapest on the market, providing a powerful experience for as little as $50. It is reasonable to conclude from this that innovation, driven by fierce competition, has led to devices, operating systems, and apps that provide enormous benefits to consumers.

The Commission decision would harm device manufacturers, app developers and consumers

The EC’s decision seems to disregard the history of smartphone innovation and competition and their ongoing consequences. As Dirk Auer explains, the Open Handset Alliance (OHA) was created specifically to offer an effective alternative to Apple’s iPhone — and it worked. Indeed, it worked so spectacularly that Android is installed on about 80% of all new phones. This success was the result of several factors that the Commission now seeks to undermine:

First, in order to maintain order within the Android universe, and thereby ensure that apps developed for Android would function on the vast majority of Android devices, Google and the OHA sought to limit the extent to which Android “forks” could be created. (Apple didn’t face this problem because its source code is proprietary, so cannot be modified by third-party developers.) One way Google does this is by imposing restrictions on the licensing of its proprietary apps, such as the Google Play store (a repository of apps, similar to Apple’s App Store).

Device manufacturers that don’t conform to these restrictions may still build devices with their forked version of Android — but without those Google apps. Indeed, Amazon chooses to develop a non-conforming version of Android and built its own app repository for its Fire devices (though it is still possible to add the Google Play Store). That strategy seems to be working for Amazon in the tablet market; in 2017 it rose past Samsung to become the second biggest manufacturer of tablets worldwide, after Apple.

Second, in order to be able to offer Android for free to smartphone manufacturers, Google sought to develop unique revenue streams (because, although the software is offered for free, it turns out that software developers generally don’t work for free). The main way Google did this was by requiring manufacturers that choose to install Google Play also to install its browser (Chrome) and search tools, which generate revenue from advertising. At the same time, Google kept its platform open by permitting preloads of rivals’ apps and creating a marketplace where rivals can also reach scale. Mozilla’s Firefox browser, for example, has been downloaded over 100 million times on Android.

The importance of these factors to the success of Android is acknowledged by the EC. But instead of treating them as legitimate business practices that enabled the development of high-quality, low-cost smartphones and a universe of apps that benefits billions of people, the Commission simply asserts that they are harmful, anticompetitive practices.

For example, the Commission asserts that

In order to be able to pre-install on their devices Google’s proprietary apps, including the Play Store and Google Search, manufacturers had to commit not to develop or sell even a single device running on an Android fork. The Commission found that this conduct was abusive as of 2011, which is the date Google became dominant in the market for app stores for the Android mobile operating system.

This is simply absurd, to say nothing of ahistorical. As noted, the restrictions on Android forks plays an important role in maintaining the coherency of the Android ecosystem. If device manufacturers were able to freely install Google apps (and other apps via the Play Store) on devices running problematic Android forks that were unable to run the apps properly, consumers — and app developers — would be frustrated, Google’s brand would suffer, and the value of the ecosystem would be diminished. Extending this restriction to all devices produced by a specific manufacturer, regardless of whether they come with Google apps preinstalled, reinforces the importance of the prohibition to maintaining the coherency of the ecosystem.

It is ridiculous to say that something (efforts to rein in Android forking) that made perfect sense until 2011 and that was central to the eventual success of Android suddenly becomes “abusive” precisely because of that success — particularly when the pre-2011 efforts were often viewed as insufficient and unsuccessful (a January 2012 Guardian Technology Blog post, “How Google has lost control of Android,” sums it up nicely).

Meanwhile, if Google is unable to tie pre-installation of its search and browser apps to the installation of its app store, then it will have less financial incentive to continue to maintain the Android ecosystem. Or, more likely, it will have to find other ways to generate revenue from the sale of devices in the EU — such as charging device manufacturers for Android or Google Play. The result is that consumers will be harmed, either because the ecosystem will be degraded, or because smartphones will become more expensive.

The troubling absence of Apple from the Commission’s decision

In addition, the EC’s decision is troublesome in other ways. First, for its definition of the market. The ruling asserts that “Through its control over Android, Google is dominant in the worldwide market (excluding China) for licensable smart mobile operating systems, with a market share of more than 95%.” But “licensable smart mobile operating systems” is a very narrow definition, as it necessarily precludes operating systems that are not licensable — such as Apple’s iOS and RIM’s Blackberry OS. Since Apple has nearly 25% of the market share of smartphones in Europe, the European Commission has — through its definition of the market — presumed away the primary source of effective competition. As Pinar Akman has noted:

How can Apple compete with Google in the market as defined by the Commission when Apple allows only itself to use its operating system only on devices that Apple itself manufactures?

The EU then invents a series of claims regarding the lack of competition with Apple:

  • end user purchasing decisions are influenced by a variety of factors (such as hardware features or device brand), which are independent from the mobile operating system;

It is not obvious that this is evidence of a lack of competition. A better explanation is that the EU’s narrow definition of the market is defective. In fact, one could easily draw the opposite conclusion of that drawn by the Commission: the fact that purchasing decisions are driven by various factors suggests that there is substantial competition, with phone manufacturers seeking to design phones that offer a range of features, on a number of dimensions, to best capture diverse consumer preferences. They are able to do this in large part precisely because consumers are able to rely upon a generally similar operating system and continued access to the apps that they have downloaded. As Tim Cook likes to remind his investors, Apple is quite successful at targeting “Android switchers” to switch to iOS.

 

  • Apple devices are typically priced higher than Android devices and may therefore not be accessible to a large part of the Android device user base;

 

And yet, in the first quarter of 2018, Apple phones accounted for five of the top ten selling smartphones worldwide. Meanwhile, several competing phones, including the fifth and sixth best-sellers, Samsung’s Galaxy S9 and S9+, sell for similar prices to the most expensive iPhones. And a refurbished iPhone 6 can be had for less than $150.

 

  • Android device users face switching costs when switching to Apple devices, such as losing their apps, data and contacts, and having to learn how to use a new operating system;

 

This is, of course, true for any system switch. And yet the growing market share of Apple phones suggests that some users are willing to part with those sunk costs. Moreover, the increasing predominance of cloud-based and cross-platform apps, as well as Apple’s own “Move to iOS” Android app (which facilitates the transfer of users’ data from Android to iOS), means that the costs of switching border on trivial. As mentioned above, Tim Cook certainly believes in “Android switchers.”

 

  • even if end users were to switch from Android to Apple devices, this would have limited impact on Google’s core business. That’s because Google Search is set as the default search engine on Apple devices and Apple users are therefore likely to continue using Google Search for their queries.

 

This is perhaps the most bizarre objection of them all. The fact that Apple chooses to install Google search as the default demonstrates that consumers prefer that system over others. Indeed, this highlights a fundamental problem with the Commission’s own rationale, As Akman notes:

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

Conclusion

As the foregoing demonstrates, the EC’s decision is based on a fundamental misunderstanding of the nature and evolution of the market for smartphones and associated applications. The statement by Commissioner Vestager quoted above — that “What would serve competition is to have more players” — belies this misunderstanding and highlights the erroneous assumptions underpinning the Commission’s analysis, which is wedded to a theory of market competition that was long ago thrown out by economists.

And, thankfully, it appears that the FTC Chairman is aware of at least some of the flaws in the EC’s conclusions.

Google will undoubtedly appeal the Commission’s decision. For the sakes of the millions of European consumers who rely on Android-based phones and the millions of software developers who provide Android apps, let’s hope that they succeed.

In Amazon, Antitrust & Competition, Apple, China, Economic Theory, European Union, Google, International, Platforms, Resale Price Maintenance, Truth on the Market, Tying , , , , , , , , , , , , , ,
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Some Good News (Maybe?) from DOJ’s Antitrust Division

Thom Lambert —  17 November 2017

I remain deeply skeptical of any antitrust challenge to the AT&T/Time Warner merger.  Vertical mergers like this one between a content producer and a distributor are usually efficiency-enhancing.  The theories of anticompetitive harm here rely on a number of implausible assumptions — e.g., that the combined company would raise content prices (currently set at profit-maximizing levels so that any price increase would reduce profits on content) in order to impair rivals in the distribution market and enhance profits there.  So I’m troubled that DOJ seems poised to challenge the merger.

I am, however, heartened — I think — by a speech Assistant Attorney General Makan Delrahim recently delivered at the ABA’s Antitrust Fall Forum. The crux of the speech, which is worth reading in its entirety, was that behavioral remedies — effectively having the government regulate a merged company’s day-to-day business decisions — are almost always inappropriate in merger challenges.

That used to be DOJ’s official position.  The Antitrust Division’s 2004 Remedies Guide proclaimed that “[s]tructural remedies are preferred to conduct remedies in merger cases because they are relatively clean and certain, and generally avoid costly government entanglement in the market.”

During the Obama administration, DOJ changed its tune.  Its 2011 Remedies Guide removed the statement quoted above as well as an assertion that behavioral remedies would be appropriate only in limited circumstances.  The 2011 Guide instead remained neutral on the choice between structural and conduct remedies, explaining that “[i]n certain factual circumstances, structural relief may be the best choice to preserve competition.  In a different set of circumstances, behavioral relief may be the best choice.”  The 2011 Guide also deleted the older Guide’s discussion of the limitations of conduct remedies.

Not surprisingly in light of the altered guidance, several of the Obama DOJ’s merger challenges—Ticketmaster/Live Nation, Comcast/NBC Universal, and Google/ITA Software, for example—resulted in settlements involving detailed and significant regulation of the combined firm’s conduct.  The settlements included mandatory licensing requirements, price regulation, compulsory arbitration of pricing disputes with recipients of mandated licenses, obligations to continue to develop and support certain products, the establishment of informational firewalls between divisions of the merged companies, prohibitions on price and service discrimination among customers, and various reporting requirements.

Settlements of such sort move antitrust a long way from the state of affairs described by then-professor Stephen Breyer, who wrote in his classic book Regulation and Its Reform:

[I]n principle the antitrust laws differ from classical regulation both in their aims and in their methods.  The antitrust laws seek to create or maintain the conditions of a competitive marketplace rather than replicate the results of competition or correct for the defects of competitive markets.  In doing so, they act negatively, through a few highly general provisions prohibiting certain forms of private conduct.  They do not affirmatively order firms to behave in specified ways; for the most part, they tell private firms what not to do . . . .  Only rarely do the antitrust enforcement agencies create the detailed web of affirmative legal obligations that characterizes classical regulation.

I am pleased to see Delrahim signaling a move away from behavioral remedies.  As Alden Abbott and I explained in our article, Recognizing the Limits of Antitrust: The Roberts Court Versus the Enforcement Agencies,

[C]onduct remedies present at least four difficulties from a limits of antitrust perspective.  First, they may thwart procompetitive conduct by the regulated firm.  When it comes to regulating how a firm interacts with its customers and rivals, it is extremely difficult to craft rules that will ban the bad without also precluding the good.  For example, requiring a merged firm to charge all customers the same price, a commonly imposed conduct remedy, may make it hard for the firm to serve clients who impose higher costs and may thwart price discrimination that actually enhances overall market output.  Second, conduct remedies entail significant direct implementation costs.  They divert enforcers’ attention away from ferreting out anticompetitive conduct elsewhere in the economy and require managers of regulated firms to focus on appeasing regulators rather than on meeting their customers’ desires.  Third, conduct remedies tend to grow stale.  Because competitive conditions are constantly changing, a conduct remedy that seems sensible when initially crafted may soon turn out to preclude beneficial business behavior.  Finally, by transforming antitrust enforcers into regulatory agencies, conduct remedies invite wasteful lobbying and, ultimately, destructive agency capture.

The first three of these difficulties are really aspects of F.A. Hayek’s famous knowledge problem.  I was thus particularly heartened by this part of Delrahim’s speech:

The economic liberty approach to industrial organization is also good economic policy.  F. A. Hayek won the 1974 Nobel Prize in economics for his work on the problems of central planning and the benefits of a decentralized free market system.  The price system of the free market, he explained, operates as a mechanism for communicating disaggregated information.  “[T]he ultimate decisions must be left to the people who are familiar with the[] circumstances.”  Regulation, I humbly submit in contrast, involves an arbiter unfamiliar with the circumstances that cannot possibly account for the wealth of information and dynamism that the free market incorporates.

So why the reservation in my enthusiasm?  Because eschewing conduct remedies may result in barring procompetitive mergers that might have been allowed with behavioral restraints.  If antitrust enforcers are going to avoid conduct remedies on Hayekian and Public Choice grounds, then they should challenge a merger only if they are pretty darn sure it presents a substantial threat to competition.

Delrahim appears to understand the high stakes of a “no behavioral remedies” approach to merger review:  “To be crystal clear, [having a strong presumption against conduct remedies] cuts both ways—if a merger is illegal, we should only accept a clean and complete solution, but if the merger is legal we should not impose behavioral conditions just because we can do so to expand our power and because the merging parties are willing to agree to get their merger through.”

The big question is whether the Trump DOJ will refrain from challenging mergers that do not pose a clear and significant threat to competition and consumer welfare.  On that matter, the jury is out.

In Antitrust & Competition, Antitrust Division, Google, Justice Department, Merger Guidelines, Platforms, Price Discrimination, Vertical Restraints , , , ,
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The Apple tax case: Plain vanilla competition policy?

Nicolas Petit —  29 March 2017

Since Brussels has ordered Ireland to recover 13€ billion from Apple, much ink has been spilled on the European Commission’s (EC) alleged misuse of power and breach of the “rule of law.” In the Irish Times, Professor Liza Lovdahl-Gormsen wrote that the EC has been “bending” competition law to pursue a corporate taxation agenda in disguise. Former European Commissioner Neelie Kroes went so far as to suggest that the EC was attempting to rewrite international tax rules.

Conspiracy stories sell well, all the more so when the EC administration is on display. Yet, the claim that the Apple case is not a genuine competition case is a trick often used to deride enforcement — one that papers over an old lesson of mainstream economics: that monopolists are particularly good at “acquiring” public interest legislation. Nobel Prize winner George Stigler once wrote that “the most obvious contribution that a group may seek of the government is a direct subsidy of money.”  

While this basic economic teaching is not the narrative behind the EC decision against Ireland, there are clear signs that Apple is a textbook monopolist, and that rent-seeking theory could thus assist the EC in the forthcoming appeal. Let us look closer. Year after year, Apple sits atop the rankings as the most successful company of the 21st century. It has been the world’s largest company by market capitalization for some time. It is also the most profitable company in the history of the modern economy. Its flagship product, the iPhone, is the most expensive mass-market smartphone ever sold. On each device, Apple’s earns a 69% gross margin. Last year, industry analysts were taken aback when Apple outsold Samsung.

Granted, high prices and large profits do not a monopolist make. So let us consider other metrics: among tech’s frightful five, Apple is the slacker when it comes to investing in innovation: It spent about 3.5% of its revenue on research and development in 2016. By way of comparison, Alphabet (Google) spent 16%, Microsoft spent 14%, and Facebook spent a whopping 27%. Apple didn’t even feature in the EU ranking of the top 50 highest R&D-intensive companies, trailing behind a host of less-glitzy manufacturers of telecoms infrastructure equipment like Nokia and Ericsson and even “mundane” suppliers of cars, chemicals, and agricultural products. At such low levels of R&D investment, it is even questionable that Apple can be called a “high tech” company (the minimum to be part of that league is 5-7.5%). 

Apple also features as the world champ payer of dividends and purchaser of its own shares in financial analysts’ recommendations. Instead of retaining earnings to devote to internal R&D projects as a patient capitalist, Apple returns comparatively more profits to shareholders than any of its peers. It also sits atop a mountain of unproductive capital.

Beyond financial numbers, Apple’s body language also denotes behavioural signs of monopoly power. In his best seller, “Zero to One,” Peter Thiel writes that “monopolists lie to protect themselves.” Apple is a grandmaster at this game. In a bid to reduce the prices it pays for certain inputs, Apple has routinely claimed to be an antitrust victim in proceedings in the US, the EU, and Asia, accusing upstream component suppliers and innovators such as Qualcomm and Nokia, but also rivals such as Samsung, of unlawful monopolization. To assist it, Apple enlisted the help of a former European Commission official who spent over ten years spearheading the EU’s assaults on Intel, Microsoft, Google and other high-tech firms. To the trained observer, this should come as no surprise. For monopolists, the ends justify the means – including efforts to instrumentalise the regulatory process. 

With such facts in mind, it is now much less obvious that the EC Apple tax case is not plain vanilla competition policy, and much more clear that Apple behaved as a textbook rent-seeking monopolist when it secured 13€ billion from the Irish Government. 

That monopolists expend vast resources in rent-seeking, unproductive activities aimed at capturing rents from governments is a fundamental teaching of modern economic theory.  Like theft, corruption or bribery, those resources – and those invested by governments to counter rent-seeking strategies – are pure waste; they generate no socially valuable production. The EC would be well advised to keep this narrative in mind when defending its case against allegations of unlawful tax harmonization before the EU courts. As I often tell my students, forget the legalese; go for the big picture.

In Antitrust & Competition, Apple, Economic Theory, European Union, Facebook, Google, Intellectual Property, International, Monopolization, Patent, Platforms, Telecommunications , , , ,
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Significant Impediment To Industry Innovation: A novel theory of harm in EU merger policy?

Nicolas Petit —  21 March 2017

Thanks to Truth on the Market for the opportunity to guest blog, and to ICLE for inviting me to join as a Senior Scholar! I’m honoured to be involved with both of these august organizations.

In Brussels, the talk of the town is that the European Commission (“Commission”) is casting a new eye on the old antitrust conjecture that prophesizes a negative relationship between industry concentration and innovation. This issue arises in the context of the review of several mega-mergers in the pharmaceutical and AgTech (i.e., seed genomics, biochemicals, “precision farming,” etc.) industries.

The antitrust press reports that the Commission has shown signs of interest for the introduction of a new theory of harm: the Significant Impediment to Industry Innovation (“SIII”) theory, which would entitle the remediation of mergers on the sole ground that a transaction significantly impedes innovation incentives at the industry level. In a recent ICLE White Paper, I discuss the desirability and feasibility of the introduction of this doctrine for the assessment of mergers in R&D-driven industries.

The introduction of SIII analysis in EU merger policy would no doubt be a sea change, as compared to past decisional practice. In previous cases, the Commission has paid heed to the effects of a merger on incentives to innovate, but the assessment has been limited to the effect on the innovation incentives of the merging parties in relation to specific current or future products. The application of the SIII theory, however, would entail an assessment of a possible reduction of innovation in (i) a given industry as a whole; and (ii) not in relation to specific product applications.

The SIII theory would also be distinct from the “innovation markets” framework occasionally applied in past US merger policy and now marginalized. This framework considers the effect of a merger on separate upstream “innovation markets,” i.e., on the R&D process itself, not directly linked to a downstream current or future product market. Like SIII, innovation markets analysis is interesting in that the identification of separate upstream innovation markets implicitly recognises that the players active in those markets are not necessarily the same as those that compete with the merging parties in downstream product markets.

SIII is way more intrusive, however, because R&D incentives are considered in the abstract, without further obligation on the agency to identify structured R&D channels, pipeline products, and research trajectories.

With this, any case for an expansion of the Commission’s power to intervene against mergers in certain R&D-driven industries should rely on sound theoretical and empirical infrastructure. Yet, despite efforts by the most celebrated Nobel-prize economists of the past decades, the economics that underpin the relation between industry concentration and innovation incentives remains an unfathomable mystery. As Geoffrey Manne and Joshua Wright have summarized in detail, the existing literature is indeterminate, at best. As they note, quoting Rich Gilbert,

[a] careful examination of the empirical record concludes that the existing body of theoretical and empirical literature on the relationship between competition and innovation “fails to provide general support for the Schumpeterian hypothesis that monopoly promotes either investment in research and development or the output of innovation” and that “the theoretical and empirical evidence also does not support a strong conclusion that competition is uniformly a stimulus to innovation.”

Available theoretical research also fails to establish a directional relationship between mergers and innovation incentives. True, soundbites from antitrust conferences suggest that the Commission’s Chief Economist Team has developed a deterministic model that could be brought to bear on novel merger policy initiatives. Yet, given the height of the intellectual Everest under discussion, we remain dubious (yet curious).

And, as noted, the available empirical data appear inconclusive. Consider a relatively concentrated industry like the seed and agrochemical sector. Between 2009 and 2016, all big six agrochemical firms increased their total R&D expenditure and their R&D intensity either increased or remained stable. Note that this has taken place in spite of (i) a significant increase in concentration among the largest firms in the industry; (ii) dramatic drop in global agricultural commodity prices (which has adversely affected several agrochemical businesses); and (iii) the presence of strong appropriability devices, namely patent rights.

This brief industry example (that I discuss more thoroughly in the paper) calls our attention to a more general policy point: prior to poking and prodding with novel theories of harm, one would expect an impartial antitrust examiner to undertake empirical groundwork, and screen initial intuitions of adverse effects of mergers on innovation through the lenses of observable industry characteristics.

At a more operational level, SIII also illustrates the difficulties of using indirect proxies of innovation incentives such as R&D figures and patent statistics as a preliminary screening tool for the assessment of the effects of the merger. In my paper, I show how R&D intensity can increase or decrease for a variety of reasons that do not necessarily correlate with an increase or decrease in the intensity of innovation. Similarly, I discuss why patent counts and patent citations are very crude indicators of innovation incentives. Over-reliance on patent counts and citations can paint a misleading picture of the parties’ strength as innovators in terms of market impact: not all patents are translated into products that are commercialised or are equal in terms of commercial value.

As a result (and unlike the SIII or innovation markets approaches), the use of these proxies as a measure of innovative strength should be limited to instances where the patent clearly has an actual or potential commercial application in those markets that are being assessed. Such an approach would ensure that patents with little or no impact on innovation competition in a market are excluded from consideration. Moreover, and on pain of stating the obvious, patents are temporal rights. Incentives to innovate may be stronger as a protected technological application approaches patent expiry. Patent counts and citations, however, do not discount the maturity of patents and, in particular, do not say much about whether the patent is far from or close to its expiry date.

In order to overcome the limitations of crude quantitative proxies, it is in my view imperative to complement an empirical analysis with industry-specific qualitative research. Central to the assessment of the qualitative dimension of innovation competition is an understanding of the key drivers of innovation in the investigated industry. In the agrochemical industry, industry structure and market competition may only be one amongst many other factors that promote innovation. Economic models built upon Arrow’s replacement effect theory – namely that a pre-invention monopoly acts as a strong disincentive to further innovation – fail to capture that successful agrochemical products create new technology frontiers.

Thus, for example, progress in crop protection products – and, in particular, in pest- and insect-resistant crops – had fuelled research investments in pollinator protection technology. Moreover, the impact of wider industry and regulatory developments on incentives to innovate and market structure should not be ignored (for example, falling crop commodity prices or regulatory restrictions on the use of certain products). Last, antitrust agencies are well placed to understand that beyond R&D and patent statistics, there is also a degree of qualitative competition in the innovation strategies that are pursued by agrochemical players.

My paper closes with a word of caution. No compelling case has been advanced to support a departure from established merger control practice with the introduction of SIII in pharmaceutical and agrochemical mergers. The current EU merger control framework, which enables the Commission to conduct a prospective analysis of the parties’ R&D incentives in current or future product markets, seems to provide an appropriate safeguard against anticompetitive transactions.

In his 1974 Nobel Prize Lecture, Hayek criticized the “scientific error” of much economic research, which assumes that intangible, correlational laws govern observable and measurable phenomena. Hayek warned that economics is like biology: both fields focus on “structures of essential complexity” which are recalcitrant to stylized modeling. Interestingly, competition was one of the examples expressly mentioned by Hayek in his lecture:

[T]he social sciences, like much of biology but unlike most fields of the physical sciences, have to deal with structures of essential complexity, i.e. with structures whose characteristic properties can be exhibited only by models made up of relatively large numbers of variables. Competition, for instance, is a process which will produce certain results only if it proceeds among a fairly large number of acting persons.

What remains from this lecture is a vibrant call for humility in policy making, at a time where some constituencies within antitrust agencies show signs of interest in revisiting the relationship between concentration and innovation. And if Hayek’s convoluted writing style is not the most accessible of all, the title captures it all: “The Pretense of Knowledge.”

In Antitrust & Competition, European Union, Health Care, Intellectual Property, International, Law & Economics, Market Definition, Mergers & Acquisitions, Patent, Pharmaceuticals, Platforms, Twitter, Vertical Restraints , , , , , , , , , , ,
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George Mason University School of Law to be Renamed “Antonin Scalia School of Law at George Mason University”

Adam Mossoff —  31 March 2016

I am sharing the press release below:

George Mason University receives $30 million in gifts, renames School of Law after Justice Antonin Scalia

Largest combined gift in university’s history will support new scholarship programs

Arlington, VA— George Mason University today announces pledges totaling $30 million to the George Mason University Foundation to support the School of Law.  The gifts, combined, are the largest in university history. The gifts will help establish three new scholarship programs that will potentially benefit hundreds of students seeking to study law at Mason.

In recognition of this historic gift, the Board of Visitors has approved the renaming of the school to The Antonin Scalia School of Law at George Mason University.

“This is a milestone moment for the university,” said George Mason University President Ángel Cabrera. “These gifts will create opportunities to attract and retain the best and brightest students, deliver on our mission of inclusive excellence, and continue our goal to make Mason one of the preeminent law schools in the country.”

Mason has grown rapidly over the last four decades to become the largest public research university in Virginia. The School of Law was established in 1979 and has been continually ranked among the top 50 law programs in the nation by U.S. News and World Report.

Justice Scalia, who served 30 years on the U.S. Supreme Court, spoke at the dedication of the law school building in 1999 and was a guest lecturer at the university.  He was a resident of nearby McLean, Virginia.

Justice Ruth Bader Ginsburg, his esteemed colleague on the Supreme Court for more than two decades, said Scalia’s opinions challenged her thinking and that naming the law school after him was a fine tribute.

“Justice Scalia was a law teacher, public servant, legal commentator, and jurist nonpareil. As a colleague who held him in highest esteem and great affection, I miss his bright company and the stimulus he provided, his opinions ever challenging me to meet his best efforts with my own. It is a tribute altogether fitting that George Mason University’s law school will bear his name. May the funds for scholarships, faculty growth, and curricular development aid the Antonin Scalia School of Law to achieve the excellence characteristic of Justice Scalia, grand master in life and law,” added Ginsburg.

“Justice Scalia’s name evokes the very strengths of our school: civil liberties, law and economics, and constitutional law,” said Law School Dean Henry N. Butler. “His career embodies our law school’s motto of learn, challenge, lead. As a professor and jurist, he challenged those around him to be rigorous, intellectually honest, and consistent in their arguments.”

The combined gift will allow the university to establish three new scholarship programs to be awarded exclusively and independently by the university:

Antonin Scalia Scholarship – Awarded to students with excellent academic credentials.

A. Linwood Holton, Jr. Leadership Scholarship – Named in honor of the former governor of the Commonwealth of Virginia, this scholarship will be awarded to students who have overcome barriers to academic success, demonstrated outstanding leadership qualities, or have helped others overcome discrimination in any facet of life.

F.A. Hayek Law, Legislation, and Liberty Scholarship – Named in honor of the 1974 Nobel Prize winner in economics, this scholarship will be awarded to students who have a demonstrated interest in studying the application of economic principles to the law.

“The growth of George Mason University’s law school, both in size and influence, is a tribute to the hard work of its leaders and faculty members,” said Governor Terry McAuliffe. “I am particularly pleased that new scholarship awards for students who face steep barriers in their academic pursuits will be named in honor of former Virginia Governor Linwood Holton, an enduring and appropriate legacy for a man who championed access to education for all Virginians.”

The scholarships will help Mason continue to be one of the most diverse universities in America.

“When we speak about diversity, that includes diversity of thought and exposing ourselves to a range of ideas and points of view,” said Cabrera. “Justice Scalia was an advocate of vigorous debate and enjoyed thoughtful conversations with those he disagreed with, as shown by his longtime friendship with Justice Ginsburg. That ability to listen and engage with others, despite having contrasting opinions or perspectives, is what higher education is all about.”

The gift includes $20 million that came to George Mason through a donor who approached Leonard A. Leo of the Federalist Society, a personal friend of the late Justice Scalia and his family.  The anonymous donor asked that the university name the law school in honor of the Justice. “The Scalia family is pleased to see George Mason name its law school after the Justice, helping to memorialize his commitment to a legal education that is grounded in academic freedom and a recognition of the practice of law as an honorable and intellectually rigorous craft,” said Leo. 

The gift also includes a $10 million grant from the Charles Koch Foundation, which supports hundreds of colleges and universities across the country that pursue scholarship related to societal well-being and free societies.

“We’re excited to support President Cabrera and Dean Butler’s vision for the Law School as they welcome new students and continue to distinguish Mason as a world-class research university,” said Charles Koch Foundation President Brian Hooks.

The name change is pending approval from the State Council of Higher Education for Virginia.

A formal dedication ceremony will occur in the fall.

About George Mason

George Mason University is Virginia’s largest public research university. Located near Washington, D.C., Mason enrolls more than 33,000 students from 130 countries and all 50 states. Mason has grown rapidly over the past half-century and is recognized for its innovation and entrepreneurship, remarkable diversity, and commitment to accessibility.

About the Mason School of Law

The George Mason University School of Law is defined by three words: Learn. Challenge. Lead. The goal is to have students who will receive an outstanding legal education (Learn), be taught to critically evaluate prevailing orthodoxy and pursue new ideas (Challenge), and, ultimately, be well prepared to distinguish themselves in their chosen fields (Lead).

About Faster Farther—The Campaign for George Mason University

Faster Farther is about securing Mason’s place as the intellectual cornerstone of our region and a global leader in higher education. We have a goal to raise $500 million through 2018.       

 

In Constitutional Law, Supreme Court, Truth on the Market , , , , , , ,
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Douglass C. North (1920-2015)

Michael Sykuta —  24 November 2015

I received word today that Douglass North passed away yesterday at the age of 95 (obit here). Professor North shared the Nobel Prize in Economic with Robert Fogel in 1993 for his work in economic history on the role of institutions in shaping economic development and performance.

Doug was one of my first professors in graduate school at Washington University. Many of us in our first year crammed into Doug’s economic history class for fear that he might retire and we not get the chance to study under him. Little did we expect that he would continue teaching into his DoughNorth_color_300-doc80s. The text for our class was the pre-publication manuscript of his book, Institutions, Institutional Change and Economic Performance. Doug’s course offered an interesting juxtaposition to the traditional neoclassical microeconomics course for first-year PhD students. His work challenged the simplifying assumptions of the neoclassical system and shed a whole new light on understanding economic history, development and performance. I still remember that day in October 1993 when the department was abuzz with the announcement that Doug had received the Nobel Prize. It was affirming and inspiring.

As I started work on my dissertation, I had hoped to incorporate a historical component on the early development of crude oil futures trading in the 1930s so I could get Doug involved on my committee. Unfortunately, there was not enough information still available to provide any analysis (there was one news reference to a new crude futures exchange, but nothing more–and the historical records of the NY Mercantile Exchange had been lost in a fire).and I had to focus solely on the deregulatory period of the late 1970s and early 1980s. I remember joking at one of our economic history workshops that I wasn’t sure if it counted as economic history since it happened during Doug’s lifetime.

Doug was one of the founding conspirators for the International Society for New Institutional Economics (now the Society for Institutional & Organizational Economics) in 1997, along with Ronald Coase and Oliver Williamson. Although the three had strong differences of opinions concerning certain aspects of their respective theoretical approaches, they understood the generally complementary nature of their work and its importance not just for the economic profession, but for understanding how societies and organizations perform and evolve and the role institutions play in that process.

The opportunity to work around these individuals, particularly with North and Coase, strongly shaped and influenced my understanding not only of economics, but of why a broader perspective of economics is so important for understanding the world around us. That experience profoundly affected my own research interests and my teaching of economics. Some of Doug’s papers continue to play an important role in courses I teach on economic policy. Students, especially international students, continue to be inspired by his explanation of the roles of institutions, how they affect markets and societies, and the forces that lead to institutional change.

As we prepare to celebrate Thanksgiving in the States, Doug’s passing is a reminder of how much I have to be thankful for over my career. I’m grateful for having had the opportunity to know and to work with Doug. I’m grateful that we had an opportunity to bring him to Mizzou in 2003 for our CORI Seminar series, at which he spoke on Understanding the Process of Economic Change (the title of his next book at the time). And I’m especially thankful for the influence he had on my understanding of economics and that his ideas will continue to shape economic thinking and economic policy for years to come.

In Facebook, Platforms, Truth on the Market , ,
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In Memoriam: Henry G. Manne (1928-2015)

Geoffrey Manne —  20 January 2015

Henry Manne was a great man, and a great father. He was, for me as for many others, one of the most important intellectual influences in my life. I will miss him dearly.

Following is his official obituary. RIP, dad.

Henry Girard Manne died on January 17, 2015 at the age of 86. A towering figure in legal education, Manne was one of the founders of the Law and Economics movement, the 20th century’s most important and influential legal academic discipline.

Manne is survived by his wife, Bobbie Manne; his children, Emily and Geoffrey Manne; two grandchildren, Annabelle and Lily Manne; and two nephews, Neal and Burton Manne. He was preceded in death by his parents, Geoffrey and Eva Manne, and his brother, Richard Manne.

Henry Manne was born on May 10, 1928, in New Orleans. The son of merchant parents, he was raised in Memphis, Tennessee. He attended Central High School in Memphis, and graduated with a BA in economics from Vanderbilt University in 1950. Manne received a JD from the University of Chicago in 1952, and a doctorate in law (SJD) from Yale University in 1966. He also held honorary degrees from Seattle University, Universidad Francesco Marroquin in Guatemala and George Mason University.

Following law school Manne served in the Air Force JAG Corps, stationed at Chanute Air Force Base in Illinois and McGuire Air Force Base in New Jersey. He practiced law briefly in Chicago before beginning his teaching career at St. Louis University in 1956. In subsequent years he also taught at the University of Wisconsin, George Washington University, the University of Rochester, Stanford University, the University of Miami, Emory University, George Mason University, the University of Chicago, and Northwestern University.

Throughout his career Henry Manne ’s writings originated, developed or anticipated an extraordinary range of ideas and themes that have animated the past forty years of law and economics scholarship. For his work, Manne was named a Life Member of the American Law and Economics Association and, along with Nobel Laureate Ronald Coase, and federal appeals court judges Richard Posner and Guido Calabresi, one of the four Founders of Law and Economics.

In the 1950s and 60s Manne pioneered the application of economic principles to the study of corporations and corporate law, authoring seminal articles that transformed the field. His article, “Mergers and the Market for Corporate Control,” published in 1965, is credited with opening the field of corporate law to economic analysis and with anticipating what has come to be known as the Efficient Market Hypothesis (for which economist Eugene Fama was awarded the Nobel Prize in 2013). Manne’s 1966 book, Insider Trading and the Stock Market was the first scholarly work to challenge the logic of insider trading laws, and remains the most influential book on the subject today.

In 1968 Manne moved to the University of Rochester with the aim of starting a new law school. Manne anticipated many of the current criticisms that have been aimed at legal education in recent years, and proposed a law school that would provide rigorous training in the economic analysis of law as well as specialized training in specific areas of law that would prepare graduates for practice immediately out of law school. Manne’s proposal for a new law school, however, drew the ire of incumbent law schools in upstate New York, which lobbied against accreditation of the new program.

While at Rochester, in 1971, Manne created the “Economics Institute for Law Professors,” in which, for the first time, law professors were offered intensive instruction in microeconomics with the aim of incorporating economics into legal analysis and theory. The Economics Institute was later moved to the University of Miami when Manne founded the Law &Economics Center there in 1974. While at Miami, Manne also began the John M. Olin Fellows Program in Law and Economics, which provided generous scholarships for professional economists to earn a law degree. That program (and its subsequent iterations) has gone on to produce dozens of professors of law and economics, as well as leading lawyers and influential government officials.

The creation of the Law & Economics Center (which subsequently moved to Emory University and then to George Mason Law School, where it continues today), was one of the foundational events in the Law and Economics Movement. Of particular importance to the development of US jurisprudence, its offerings were expanded to include economics courses for federal judges. At its peak a third of the federal bench and four members of the Supreme Court had attended at least one of its programs, and every major law school in the country today counts at least one law and economics scholar among its faculty. Nearly every legal field has been influenced by its scholarship and teaching.

When Manne became Dean of George Mason Law School in Arlington, Virginia, in 1986, he finally had the opportunity to implement the ideas he had originally developed at Rochester. Manne’s move to George Mason united him with economist James Buchanan, who was awarded the Nobel Prize for Economics in 1986 for his path-breaking work in the field of Public Choice economics, and turned George Mason University into a global leader in law and economics. His tenure as dean of George Mason, where he served as dean until 1997 and George Mason University Foundation Professor until 1999, transformed legal education by integrating a rigorous economic curriculum into the law school, and he remade George Mason Law School into one of the most important law schools in the country. The school’s Henry G. Manne Moot Court Competition for Law & Economics and the Henry G. Manne Program in Law and Economics Studies are named for him.

Manne was celebrated for his independence of mind and respect for sound reasoning and intellectual rigor, instead of academic pedigree. Soon after he left Rochester to start the Law and Economics Center, he received a call from Yale faculty member Ralph Winter (who later became a celebrated judge on the United States Court of Appeals) offering Manne a faculty position. As he recounted in an interview several years later, Manne told Winter, “Ralph, you’re two weeks and five years too late.” When Winter asked Manne what he meant, Manne responded, “Well, two weeks ago, I agreed that I would start this new center on law and economics.” When Winter asked, “And five years?” Manne responded, “And you’re five years too late for me to give a damn.”

The academic establishment’s slow and skeptical response to the ideas of law and economics eventually persuaded Manne that reform of legal education was unlikely to come from within the established order and that it would be necessary to challenge the established order from without. Upon assuming the helm at George Mason, Dean Manne immediately drew to the school faculty members laboring at less-celebrated law schools whom Manne had identified through his economics training seminars for law professors, including several alumni of his Olin Fellows programs. Today the law school is recognized as one of the world’s leading centers of law and economics.

Throughout his career, Manne was an outspoken champion of free markets and liberty. His intellectual heroes and intellectual peers were classical liberal economists like Friedrich Hayek, Ludwig Mises, Armen Alchian and Harold Demsetz, and these scholars deeply influenced his thinking. As economist Donald Boudreax said of Dean Manne, “I think what Henry saw in Alchian – and what Henry’s own admirers saw in Henry – was the reality that each unfailingly understood that competition in human affairs is an intrepid force…”

In his teaching, his academic writing, his frequent op-eds and essays, and his work with organizations like the Cato Institute, the Liberty Fund, the Institute for Humane Studies, and the Mont Pelerin Society, among others, Manne advocated tirelessly for a clearer understanding of the power of markets and competition and the importance of limited government and economically sensible regulation.

After leaving George Mason in 1999, Manne remained an active scholar and commenter on public affairs as a frequent contributor to the Wall Street Journal. He continued to provide novel insights on corporate law, securities law, and the reform of legal education. Following his retirement Manne became a Distinguished Visiting Professor at Ave Maria Law School in Naples, Florida. The Liberty Fund, of Indianapolis, Indiana, recently published The Collected Works of Henry G. Manne in three volumes.

For some, perhaps more than for all of his intellectual accomplishments Manne will be remembered as a generous bon vivant who reveled in the company of family and friends. He was an avid golfer (who never scheduled a conference far from a top-notch golf course), a curious traveler, a student of culture, a passionate eater (especially of ice cream and Peruvian rotisserie chicken from El Pollo Rico restaurant in Arlington, Virginia), and a gregarious debater (who rarely suffered fools gladly). As economist Peter Klein aptly remarked: “He was a charming companion and correspondent — clever, witty, erudite, and a great social and cultural critic, especially of the strange world of academia, where he plied his trade for five decades but always as a slight outsider.”

Scholar, intellectual leader, champion of individual liberty and free markets, and builder of a great law school—Manne’s influence on law and legal education in the Twentieth Century may be unrivaled. Today, the institutions he built and the intellectual movement he led continue to thrive and to draw sustenance from his intellect and imagination.

There will be a memorial service at George Mason University School of Law in Arlington, Virginia on Friday, February 13, at 4:00 pm. In lieu of flowers the family requests that donations be made in his honor to the Law & Economics Center at George Mason University School of Law, 3301 Fairfax Drive, Arlington, VA 22201 or online at http://www.masonlec.org.

In Law & Economics , , , , , , , , , , , ,
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So What’s Going to Happen to Securities Fraud Class Actions? Some Thoughts on Halliburton

Thom Lambert —  7 March 2014

On Wednesday, the U.S. Supreme Court heard oral argument in Halliburton v. Erica P. John Fund, a case that could drastically alter the securities fraud landscape.  Here are a few thoughts on the issues at stake in the case and a cautious prediction about how the Court will rule.

First, some quick background for the uninitiated.  The broadest anti-fraud provision of the securities laws, Section 10(b) of the 1934 Securities Exchange Act, forbids the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe….”  The Commission’s Rule 10b-5, then, makes it illegal “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”

Although Section 10(b) doesn’t expressly entitle victims of securities fraud to sue for damages, the Supreme Court long ago inferred a private right of action to enforce the provision.  The elements of that judicially created private right of action are: (1) a material misrepresentation or omission by the defendant, (2) scienter (i.e., mental culpability worse than mere negligence) on the part of the defendant, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) the plaintiff’s reliance upon the misrepresentation or omission, (5) economic loss by the plaintiff, and (6) loss causation (i.e., the fraud, followed by revelation of the truth, was the proximate cause of the plaintiff’s investment loss).

For most individual investors, the economic loss resulting from any instance of securities fraud (and, thus, the potential recovery) is not enough to justify the costs of bringing a lawsuit.  Accordingly, 10b-5 suits seem like an appropriate context for class actions.  The elements of the judicially created cause of action, however, make class certification difficult.  That is because most securities fraud class actions would proceed under Federal Rule of Civil Procedure 23(b)(3), which requires that common issues of law or fact in all the plaintiffs’ cases predominate over plaintiff-specific issues.  Because the degree to which any individual investor relied upon a misrepresentation (element 4) requires proof of lots of investor-specific facts (How did you learn of the misrepresentation?, How did it influence your investment decision?, etc.), the reliance element would seem to preclude Rule 10b-5 class actions.

In Basic v. Levinson, a 1988 Supreme Court decision from which three justices were recused, a four-justice majority endorsed a doctrine that has permitted Rule 10b-5 class actions to proceed, despite the reliance element.  The so-called “fraud on the market” doctrine creates a rebuttable presumption that an investor who traded in an efficient stock market following a fraudulent disclosure (but before the truth was revealed) “relied” on that disclosure, even if she didn’t see or hear about it.  The theoretical basis for the fraud on the market doctrine is the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), which posits that securities prices almost instantly incorporate all publicly available information about the underlying company, making it impossible to earn above-normal returns by engaging in “fundamental analysis” (i.e., study of publicly available information about a listed company).  The logic of the fraud on the market doctrine is that publicly available misinformation affects a security’s price, upon which an investor normally relies when she makes her investment decision.  Thus, any investor who makes her investment decision on the basis of the stock’s price “relies” on the “ingredients” of that price, including the misinformation at issue.

In light of this logic, the Basic Court reasoned that a defendant could rebut the presumption of reliance by severing either the link between the misinformation and the stock’s price or the link between the stock’s price and the investor’s decision.  To sever the former link, the defendant would need to show that key market makers were privy to the truth, so that the complained of lie could not have affected the market price of the stock (in other words, there was “truth on the market”…great name for a blog, no?).  To sever the latter link, the defendant would need to show that the plaintiff investor made her investment decision for some reason unrelated to the stock’s price—say, because she needed to divest herself of the stock for political reasons.

Basic thus set up a scheme in which the class plaintiff bears the burden of establishing that the stock at issue traded in an efficient market.  If she does so, her (and similarly situated class members’) reliance on the misinformation at issue is presumed.  The defendant then bears the burden of rebutting the presumption by showing either that the misrepresentation did not give rise to a price distortion (probably because the truth was on the market) or that the individual investor would have traded even if she knew the statement was false (i.e., her decision was not based on the stock’s price).

The Halliburton appeal presents two questions.  First, should the Court overrule Basic and jettison the rebuttable presumption of reliance when the stock at issue is traded in an efficient market.  Second, at the class certification stage, should the defendant be permitted to prevent the reliance presumption from arising by presenting evidence that the alleged misrepresentation failed to distort the market price of the stock at issue.

With respect to the first question, the Court could go three ways.  First, it could maintain the status quo rule that 10b-5 plaintiffs, in order to obtain the reliance presumption, must establish only that the stock at issue was traded in an efficient market.  Second, it could overrule Basic wholesale and hold that a 10b-5 plaintiff must establish actual, individualized reliance (i.e., show that she knew of the misrepresentation and that it influenced her investment decision).  Third, the Court could tweak Basic by holding that plaintiffs may avail themselves of the presumption of reliance only if they establish, at the class certification stage, that the complained of
misrepresentation actually distorted the market price of the stock at issue.

My guess, which I held before oral argument and seems consistent with the justices’ questioning on Wednesday, is that the Court will take the third route.  There are serious problems with the status quo.  First, it rests squarely upon the semi-strong version of the ECMH, which has come under fire in recent years.  While no one doubts that securities prices generally incorporate publicly available information, and very quickly, a number of studies purporting to document the existence of arbitrage opportunities have challenged the empirical claim that every bit of publicly available information is immediately incorporated into the price of every security traded in an efficient market.  Indeed, the winners of this year’s Nobel Prize in Economics split on this very question.   I doubt this Supreme Court will want to be perceived as endorsing a controversial economic theory, especially when doing so isn’t necessary to maintain some sort of reliance presumption (given the third possible holding discussed above).

A second problem with the status quo is that it places an unreasonable burden on courts deciding whether to certify a class.  The threshold question for the fraud on the market presumption—is the security traded in an efficient market?—is just too difficult for non-specialist courts.  How does one identify an “efficient market”?  One court said the relevant factors are:  “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.”  Others have supplemented these so-called “Cammer factors” with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation.  No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible?  How large may the bid-ask spread be?).  Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t.  It’s a crapshoot.

The status quo approach of presuming investor reliance if the plaintiff establishes an efficient market for the company’s stock is also troubling because the notion of a “market” for any single company’s stock is theoretically unsound.  An economic market consist of all products that are, from a buyer’s perspective, reasonably interchangeable.  For example, Evian bottled water (spring water from the Alps) is a very close substitute for Fiji water (spring water from the Fiji Islands) and is probably in the same product market.  From an investor’s perspective, there are scores of close substitutes for the stock of any particular company.  Such substitutes would include all other stocks that offer the same package of financial attributes (risk, expected return, etc.).  It makes little sense, then, to speak of a “market” consisting of a single company’s stock, and basing the presumption of reliance on establishment of an “efficient market” in one company’s stock is somewhat nonsensical.

With respect to the second possible route for the Halliburton Court—overturning Basic in its entirety and requiring individualized proof of actual reliance—proponents emphasize that the private right of action to enforce Section 10(b) and Rule 10b-5 is judicially created.  The Supreme Court now disfavors implied rights of action and, to avoid stepping on Congress’s turf, requires that they stick close to the statute at issue.  In particular, the Court has said that determining the elements of a private right of action requires “historical reconstruction.”  With respect to the Rule 10b-5 action, the Court tries “to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision of the 1934 Act,” and to do that, it consults “the express causes of action” in the Act and borrows from the “most analogous” one.  In this case, that provision is Section 18(a), which is the only provision in the Exchange Act authorizing damages actions for misrepresentations affecting secondary, aftermarket trading (i.e., trading after a public offering of the stock at issue).  Section 18(a) requires a plaintiff to establish actual “eyeball” reliance—i.e., that she bought the security with knowledge of the false statement and relied upon it in making her investment decision.  There is thus a powerful legal argument in favor of a full-scale overturning of Basic.

As much as I’d like for the Court to take that route (because I believe Rule 10b-5 class actions create far greater social cost than benefit), I don’t think the Court will go there.  Overruling Basic to require eyeball reliance in Rule 10b-5 actions would be perceived as an activist, “pro-business” decision:  activist because Congress has enacted significant legislation addressing Rule 10b-5 actions and has left the fraud on the market doctrine untouched, and pro-business because it would insulate corporate managers from 10b-5 class actions.

Now, both of those characterizations are wrong.  The chief post-Basic legislation involving Rule 10b-5, the 1995 Private Securities Litigation Reform Act, specifically stated (in Section 203) that “[n]othing in this Act shall be deemed to … ratify any implied private right of action.”  As Justices Alito and Scalia emphasized at oral argument, the PSLRA expressly declined to put a congressional imprimatur on the judicially created Rule 10b-5 cause of action, so a Court decision modifying Rule 10b-5’s elements would hardly be “activist.” Nor would the decision be “pro-business” and “anti-investor.”  The fact is, the vast majority of Rule 10b-5 class actions are settled on terms where the corporation pays the bulk of the settlement, which largely goes to class counsel.  The corporation, of course, is spending investors’ money.  All told, then, investors as a class pay a lot for, and get very little from, Rule 10b-5 class actions.  A ruling eviscerating such actions would better be characterized as pro-investor.

Sadly, our financially illiterate news media cannot be expected to understand all this and would, if Basic were overturned, fill the newsstands and airwaves with familiar stories of how the Roberts Court continues on its activist, pro-business rampage.  And even more sadly, at least one key justice whose vote would be needed for a Basic overruling, has proven himself to be exceedingly concerned with avoiding the appearance of “activism.”  A wholesale overruling of Basic, then, is unlikely.

That leaves the third route, modifying Basic to require that class plaintiffs first establish a price distortion resulting from the complained of misrepresentation.  I have long suspected that this is where the Court will go, and the justices’ questioning on Wednesday suggests this is how many (especially Chief Justice Roberts and Justice Kennedy) are leaning.  From the Court’s perspective, there are several benefits to this approach.

First, it would allow the Court to avoid passing judgment on the semi-strong ECMH.  The status quo approach—prove an efficient market and we’ll presume reliance because of an inevitable price effect—really seems to endorse the semi-strong ECMH.  An approach requiring proof of price distortion, by contrast, doesn’t.  It may implicitly assume that most pieces of public information are instantly incorporated into securities prices, but no one really doubts that.

Second, the third route would substitute a fairly manageable inquiry (Did the misrepresentation occasion a price effect?) for one that is both difficult and theoretically problematic (Is the market for the company’s stock efficient?).

Third, the approach would allow the Court to eliminate a number of the most meritless securities fraud class actions without appearing overly “activist” and “pro-business.”  If class plaintiffs can’t show a price effect from a complained of misrepresentation or omission, then their claim is really frivolous and ought to go away immediately.  The status quo would permit certification of the class, despite the absence of a price effect, as long as class counsel could demonstrate an efficient market using the amorphous and unreliable factors set forth above.  And once the class is certified, the plaintiffs have tons of settlement leverage, even when they don’t have much of a claim.  In short, the price distortion criterion is a far better screen than the market efficiency screen courts currently utilize.  For all these reasons, I suspect the Court will decide not to overrule Basic but to tweak it to require a threshold showing of price distortion.

If it does so, then the second question at issue in Halliburton—may the defendant, at the class certification stage, present evidence of an absence of price distortion?—goes away.  If the plaintiff must establish price distortion to attain class certification, then due process would require that the defendant be allowed to poke holes in the plaintiff’s certification case.

So that’s my prediction on Halliburton.  We shall see.  Whatever the outcome, we’ll have lots to discuss in June.

In Corporate & Securities Law, Economic Theory, Financial Regulation, Regulation, Securities , , ,
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James M. Buchanan — 1919-2013

Thom Lambert —  9 January 2013

Yet another loss of a giant in the world of law and economics.  On December 19, it was Robert Bork.  Today, we lost economist James M. Buchanan, Nobel laureate, George Mason professor, and one of the fathers of Public Choice economics.  Regular readers of TOTM will know that several of us–including yours truly–have been heavily influenced by the insights of Public Choice (see, e.g., here and here).

I was alerted to Buchanan’s passing by my friend and collaborator, Virginia Law’s Charles Goetz, co-author of the Goetz & McChesney (now Goetz, McChesney & Lambert) antitrust casebook.  I asked Charlie if he’d pen a few words in honor of Buchanan, his dissertation director and mentor, and he heartily agreed to do so.  Here they are:

Nobel Laureate James McGill Buchanan has passed away and one less giant now walks the pathways of Economics, pathways that he extended and widened.  Jim was my dissertation director, my mentor, my sometime colleague and coauthor—and my friend. There is an old compliment that denotes a man “a gentleman and a scholar.”  Jim was certainly both, to the quintessential degree.

I often reflect on how fortunate I’ve been with many things, but certainly among the luckiest of things was to be an Economics graduate student at the University of Virginia in the early 1960’s.  It was a golden time when Jim and a handful of others were midwifing the birth of what came to be known as Public Choice economics.  I got to watch and listen as great men did great things.

I remember what an eye-opening experience it was for me to take Buchanan’s year-long course in Public Finance.  He was an incredibly effective teacher.  He was far from a classroom showman, but had the genius of asking such devilishly interesting and revelatory questions.  I have acknowledged publicly on a number of occasions that, if he could charge me for the intellectual value-added that he created in me, he would be owed a very large sum indeed.  But I am profoundly in his debt, even if not in a pecuniary sense.

In the days and weeks to come, others will write many highly complimentary things about James M. Buchanan as a scholar. Deservedly so.  I would have little new to add to that outpouring.  Still, there is a revealing anecdote about Jim as a man that can come only from me, the sole witness and participant.

Buchanan generally had a very formal relationship with students and I understandably regarded him with awe and no little bit of fear.  But, one day, he gave me a great big smile and told me a story that made me appreciate, for the first time, the lurking, devilish sense of humor that went with this proper Tennessee Gentleman.

“Goetz,” he said, “you’re a New Yorker, aren’t you?  But, . . . you’re a pretty good fellow anyway.”

“I often dislike New Yorkers because they act like obnoxious know-it-alls.  There was a New Yorker like that in my class at Navy Officer Candidate school during World War II.  This fellow didn’t have much use for a simple Tennessee boy like me and tried to lord it over us country boys.  But I fixed him.”

“At the end of our OCS course, the Navy gave us a battery of tests that it used in allocating new ensigns to their first duty assignment.  I started a rumor that this NY fellow had come out second in the whole class.  At first, he denied it since, of course, he had no basis to believe it.  Gradually, though, he began to accept congratulations and to puff up more and more about the compliments.”

“Then I started the second rumor, about our further training to battle the Japanese: the first three men in the class were being sent to One-man Submarine School.”

Somehow, I saw Jim with different eyes after that story.  Maybe you will as well.

Requiescat in pace, J. M. Buchanan, the little-known joker and man of honed wit, wit in more ways than the scholarly.  In the midst of our sadness, maybe a chuckle is good medicine.

Well-said, Charlie.

In Law & Economics , , , ,
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