R E P O R T A N D R E C O M M E N D A T I O N S 31 Chapter I.A Antitrust Law and the “New Economy” 1 . I N T R O D U C T I O N The term “new economy” can describe a diverse array of markets in which new information, communication, and other technologies have produced significant changes in recent decades. For purposes of this Report, the key question is whether antitrust analysis can properly account for the economic characteristics of these markets. Those economic char- acteristics include innovation, intellectual property, and technological change. As refer- enced in this Report,the new economy includes those industries in which innovation,intel- lectual property,and technological change are central features. To assess how well antitrust law addresses competitive issues in such industries first requires an understanding of the major changes in antitrust analysis in recent decades. During this period a quiet transformation has strengthened the economic foundations of antitrust and increased its flexibility. These changes have improved the likelihood of an accu- rate assessment of competitive effects. In particular,the flexibility to account properly for the efficiencies associated with business conduct means that antitrust analysis has become less likely to condemn improperly business conduct that in fact benefits consumer welfare. The Commission sought comment on and testimony about the application of antitrust analysis in industries in which innovation,intellectual property,and technological change are central features. Among other things,the Commission asked whether antitrust law encour- aged a static analysis of dynamic industries or whether particular features of new econo- my industries posed distinctive problems for antitrust analysis. The Commission also asked whether antitrust law should use different benchmarks for market definition or market power assessments in new economy industries because innovation-driven firms may need to set prices above marginal costs to earn reasonable returns on their investments in inno- vation. Commenters and witnesses largely agree that antitrust analysis has sufficient grounding in sound economic analysis, openness to new economic learning, and flexibility to enable the courts and the antitrust agencies properly to assess competitive issues in new econo- my industries. Most importantly, commenters noted, the economic principles on which antitrust is based do not require revision for application to those industries. As one econ- omist noted, basic economic principles do not become “outdated” simply because indus- tries become highly dynamic.1 32 A N T I T R U S T M O D E R N I Z A T I O N C O M M I S S I O N The Commission agrees and makes the following recommendations. 1. There is no need to revise the antitrust laws to apply different rules to industries in which innovation,intellectual property,and technological change are central features. 2. In industries in which innovation,intellectual property,and technological change are central features,just as in other industries,antitrust enforcers should carefully consider market dynamics in assessing competitive effects and should ensure proper attention to economic and other characteristics of particular industries that may,depending on the facts at issue,have an important bearing on a valid antitrust analysis. The economic principles that guide antitrust law remain relevant to and appropriate for the antitrust analysis of industries in which innovation, intellectual property, and techno- logical change are central features. Antitrust analysis, as refined to incorporate new eco- nomic learning, is sufficiently flexible to provide a sound competitive assessment in such industries. This has improved the potential for a sound competitive assessment in all industries, including those characterized by innovation, intellectual property, and techno- logical change. To be sure,not all agree with the results in particular cases. That antitrust has the prop- er tools for an economically sound analysis of competitive effects does not mean that every- one agrees on how to use those tools in particular cases or interpret the results of their use. Nonetheless,the Commission concluded that current antitrust analysis is up to the task of properly assessing the competitive effects of business conduct in new economy indus- tries. Just as in other industries,of course,antitrust enforcers evaluating business conduct in new economy industries must ensure proper attention to particular market dynamics and economic characteristics that may play a role in determining likely competitive effects. Certain characteristics may arise more frequently in markets in which innovation, intellec- tual property, and technological change are key factors than in some other industries. These characteristics can include: ● very high rates of rapid innovation; ● falling average costs (on a product,not a firm-wide,basis) over a broad range of out- put; ● relatively modest capital requirements; ● quick and frequent entry and exit; ● demand-side economies of scale; R E P O R T A N D R E C O M M E N D A T I O N S 33 ● switching costs; and ● first-mover advantages. That one or more of these characteristics may be important in the context of a new econ- omy industry, however, does not suggest that such characteristics never appear in other industries or that all of the listed characteristics always appear in new economy industries. Rather,the point is simply that proper antitrust analysis in allindustries requires careful con- sideration of economic characteristics of the industry,and the listed characteristics are ones that may play important roles in industries in which innovation,intellectual property,and tech- nological change are central features. 2 . B A C K G R O U N D Antitrust law has gone through many changes. From the 1950s through the early 1970s, antitrust law was expansively interpreted and broadly enforced. Plaintiffs frequently won,and a wide variety of business practices were presumed to be illegal.2The bases for such expan- sive interpretations was sometimes questionable, however. Courts, for example, in some cases seemed more concerned about protecting competitors than consumers. Business practices might be quickly condemned, seemingly on the basis of courts’ skepticism that businesses would try to maximize profits by becoming more efficient,rather than by obtain- ing greater market power. These expansive interpretations of antitrust law precipitated a sea change,led by critics who questioned the basic premises of antitrust law as it was then enforced. “In the 1960s through the 1980s,[antitrust scholars generally associated with the University of Chicago] explained how many market structures and practices that antitrust treated with hostility could be beneficial.”3Around the same time,antitrust scholars generally associated with Harvard advanced the concept that,in developing antitrust rules,courts and enforcers should keep in mind institutional limits,so that “antitrust rules [do] not outrun the capabilities of imple- menting institutions.”4 In the 1980s, developments in economics continued to influence antitrust thinking, with “‘post-Chicago’ economic literature argu[ing] that certain market structures and types of collaborative activity are more likely to be anticompetitive than Chicago School antitrust writers imagined.”5 All of these schools of thought “emphasize[] reliance on economic theory in the formu- lation of antitrust rules.”6The reassessment of antitrust doctrine based on economic learn- ing has resulted in significant improvements to antitrust law over the past thirty years. This Section briefly reviews a few of the most important developments below. First,antitrust case law integrated the related principles that antitrust protects competition,not competitors,and it does so in order to ensure consumer welfare. Second, as new economic learning sug- gested possible procompetitive explanations for conduct previously assumed to be anti- competitive,the courts moved away from per se rules of automatic illegality toward a more 34 A N T I T R U S T M O D E R N I Z A T I O N C O M M I S S I O N flexible rule of reason analysis that would allow consideration of procompetitive explanations of challenged business conduct. Finally,antitrust enforcers have recognized the importance of intellectual property as a spur to innovation and have adopted policies that reflect a greater sensitivity to the need to protect incentives to innovate. A. Antitrust Protects Competition, Not Competitors, and Should Ensure Consumer Welfare During the 1960s and early 1970s antitrust decisions from the Supreme Court sometimes seemed more directed to protecting small businesses than to protecting competition that would benefit consumers through lower prices, improved quality, or innovation.7 Indeed, in some instances the Court “condemned conduct precisely because it reduced costs or gen- erated more desirable products [for consumers].”8 For example,in FTC v.Procter & Gamble the Court affirmed that a merger was illegal because it created efficiencies its rivals could not match.9 Decisions such as this were criticized as likely to deprive consumers of lower prices or other benefits from the increased competition that a more efficient merged firm could provide.10 Such decisions also were criticized for the absence of a coherent rule of law that could explain them.11 On what basis should courts decide to disallow cost-saving,pro-consumer transactions so that smaller,less efficient firms could be kept afloat? The Court’s premise seemed to be that all markets should be made up of many small firms, staying as close as possible to the economic ideal of “perfect competition.”12 “The Warren Court defined ‘competitive’ as a market containing many firms,the small ones having a ‘right’ to compete with the bigger ones.”13The underlying economic assumption was that a “certain [industry] structure made certain types of conduct inevitable,so antitrust should be directed mainly toward anticompetitive industry structures.”14 Developments in economic learning seriously undermined these premises and sent antitrust law in a new direction. Economic research found procompetitive reasons to explain highly concentrated markets—that is, that the most efficient firms were winning the com- petitive struggle and thereby achieving high market shares.15Some economists and lawyers further contended that effective competition did not require dozens of little firms, but instead could occur with relatively few firms in a market.16If effective competition could occur without many small firms in a market,then courts did not need to interpret antitrust law to protect small businesses at the expense of consumers. In response to this and other advances in economic understanding,the Supreme Court in 1977 stated without caveat that the “antitrust laws . . . were enacted for ‘the protection of competition, not competitors.’”17 The adoption of this principle represented a marked change in the direction of antitrust law. There is now a better understanding that trade-offs exist between the goals of consumer welfare and protecting small firms. To protect small firms can mean a less efficient economy in which consumers must pay higher prices. R E P O R T A N D R E C O M M E N D A T I O N S 35 Conversely,to allow firms to achieve economies of scale may harm small firms. “For exam- ple, large scale production and distribution may reduce costs but also eliminate competi- tive opportunities for small firms.”18 In 1979 the Supreme Court once again chose to interpret the antitrust law to protect con- sumers, not small businesses, describing the Sherman Act as a “consumer welfare pre- scription.”19Other courts have adopted similar views.20For the last few decades courts,agen- cies, and antitrust practitioners have recognized consumer welfare as the unifying goal of antitrust law.21 “Few people dispute that antitrust’s core mission is protecting consumers’ right to the low prices,innovation,and diverse production that competition promises.”22 B. Procompetitive Explanations May Exist for Much Business Conduct, So Antitrust Law Should Avoid Per Se Rules of Automatic Illegality Over time,new economic learning has brought to the fore procompetitive explanations for certain business practices previously condemned outright.23 Some have argued that many practices reflect aggressive competition or innovation and “that nearly all vertical practices [e.g.,arrangements between manufacturers and distributors],price discrimination and most strategic pricing, many patent practices, and business torts were rarely or never anticom- petitive.”24New anticompetitive theories have also emerged.25Given the potential for either procompetitive or anticompetitive explanations for business conduct, antitrust analysis needed to move away from per se rules of automatic illegality. In 1977 in Continental T.V.,Inc.v.GTE Sylvania Inc.,the Supreme Court relied on economic reasoning to hold that territorial restraints on franchisees should be evaluated under the rule of reason,rather than viewed as per se illegal.26 Territorial restraints forbid franchisee retailers from selling the manufacturer’s products outside their agreed-upon locations, which typically do not overlap with those of other franchisees. Although such restrictions could reduce competition among franchisees of the same manufacturer (“intrabrand com- petition”), the Court explained that they also could increase competition among different manufacturers’ franchisees (“interbrand competition”).27 “Economists have identified a number of ways in which manufacturers can use such restrictions to compete more effectively against other manufacturers,” the Court stated.28 For example,such restrictions may be used to provide franchisees with sufficient incentives to engage in promotional activities or to provide service and repair facilities for the manu- facturer’s products. Franchisees might be reluctant to make such investments without ter- ritorial restraints because they would worry that other franchisees of the same manufacturer would “free ride” on their efforts to promote the manufacturer’s brand, the Court pointed out.29 In light of these potentially “redeeming virtues,” the rule of reason,not a per se rule of automatic illegality, should be applied.30 Moreover, the Court directed, “departure from 36 A N T I T R U S T M O D E R N I Z A T I O N C O M M I S S I O N the rule of reason standard must be based upon demonstrable economic effect rather than . . . upon formalistic line drawing.”31 The Court’s decision in Sylvania marked a major turning point in antitrust law. After this decision,“the Court systematically went about the task of dismantling many of the per se rules it had created in the prior fifty years,and increasingly turned to modern economic the- ory to inform its interpretation and application of the Sherman Act.”32Indeed,only two years later, in Broadcast Music, Inc. v. Columbia Broadcasting System, Inc., the Court refused to apply a per se rule to circumstances in which alleged price-fixing among competitors pro- vided substantial efficiencies that could not be obtained through other means.33Defendants were the American Society of Composers, Authors and Publishers (ASCAP) and Broadcast Music,Inc. (BMI),both of which had thousands of composers as members. The composers granted nonexclusive licenses to their compositions to ASCAP or BMI, which then created blanket licenses authorizing the playing of millions of copyrighted musical compositions at agreed-upon fees. Plaintiff CBS objected that the blanket licenses issued to television net- works were per se illegal price-fixing. The Court described the critical question as “whether the practice facially appears to be one that would always or almost always tend to restrict competition and decrease output,and in what portion of the market,or instead one designed to ‘increase economic efficiency and render markets more,rather than less,competitive.’”34 For several reasons,including a substantial lowering of costs through eliminating thousands of individual transactions, the Court held the blanket licenses should be “subjected to a more discriminating examination under the rule of reason.”35 Since Sylvania and BMI, the Supreme Court and lower courts have often looked to eco- nomic learning to understand why firms may use particular business practices. Rule of rea- son analysis allows this examination of potential efficiency rationales for challenged con- duct. Although there are exceptions, of course,36 the use of per se rules of automatic illegality is now substantially reduced,replaced by a more discriminating analysis under the rule of reason. C. Antitrust Analysis Has Incorporated a More Sophisticated Understanding of How Intellectual Property Can Benefit Competition and Consumer Welfare During much of the twentieth century, the courts, antitrust enforcers, and antitrust practi- tioners viewed intellectual property with deep skepticism.37Most assumed that a patent or other intellectual property automatically created a monopoly,38and Supreme Court cases fos- tered that presumption.39 Antitrust enforcers attempted to restrict the use of intellectual property so that competition would be protected.40 Over-zealous antitrust rules for the use of patents reached a pinnacle when, in 1972, the Antitrust Division of the Department of Justice (DOJ) issued the so-called “Nine No-Nos,” a list of nine patent licensing practices the DOJ generally viewed as per se illegal.41 R E P O R T A N D R E C O M M E N D A T I O N S 37 The influence of economic learning about the competitive benefits of intellectual property and the potential efficiencies of intellectual property licensing and other conduct reversed this trend. In 1981 the Chief of the Intellectual Property Section of the Antitrust Division explained that because patents increase the reward for research and development,inven- tions are produced that otherwise would not have come about (or would not have come about as quickly); in those cases,“the availability of a patent [serves] only to benefit competition— to make additional or less expensive choices available to consumers.”42 In 1981 officials from the DOJ renounced the Nine No-Nos.43The 1995 Antitrust Guidelines for the Licensing of Intellectual Property (DOJ/FTC IP Guidelines), issued jointly by the DOJ and the Federal Trade Commission (FTC),take the view that “intellectual property licensing . . . is general- ly procompetitive”44 and should be examined under the rule of reason.45 As part of this trend, Congress in 1988 amended the Patent Code to eliminate a pre- sumption that a patent confers market power in the context of patent misuse.46The antitrust agencies expanded that concept to include copyrights and trade secrets, stating in the DOJ/FTC IP Guidelines that the antitrust agencies “will not presume that a patent,copyright, or trade secret necessarily confers market power upon its owner.”47 In 2006 the Supreme Court recognized that “Congress,the antitrust enforcement agencies,and most economists have all reached the conclusion that a patent does not necessarily confer market power upon the patentee.”48 In light of this consensus, the Court reversed its prior holdings and held that,in a tying case,“the mere fact that a tying product is patented does not support . . . a presumption [of market power.]”49 Over the course of recent decades,the courts and the antitrust agencies have thus moved away from a presumption that intellectual property automatically creates a monopoly and intellectual property arrangements are likely to harm competition. They now assess whether particular intellectual property in fact confers market power and consider how business arrangements involving intellectual property can benefit consumer welfare. This move has opened antitrust analysis to a more economically sophisticated approach to intellectual prop- erty issues,increasing the likelihood that antitrust will properly value the contribution of intel- lectual property rights to innovation and competition. 38 A N T I T R U S T M O D E R N I Z A T I O N C O M M I S S I O N 3 . R E C O M M E N D AT I O N S A N D F I N D I N G S 1. There is no need to revise the antitrust laws to apply different rules to industries in which innovation,intellectual property,and technological change are central features. Current antitrust analysis has a sufficient grounding in economics and is sufficiently flex- ible to reach appropriate conclusions in matters involving industries in which innovation,intel- lectual property,and technological change are central features. Judge Richard A. Posner,for example, has concluded that “antitrust doctrine is sufficiently supple, and sufficiently informed by economic theory,to cope effectively with the distinctive-seeming antitrust prob- lems that the new economy presents.”50Others agree,finding,for example,that “[w]hile the new economy has a number of distinct characteristics,antitrust enforcement is sufficient- ly flexible to account for the distinguishing features of the new economy and to preserve com- petition when it benefits consumers.”51 The fundamental economic principles that guide antitrust law remain relevant to and appropriate for the antitrust analysis of new economy industries. Over the years, antitrust analysis has been refined to incorporate useful aspects of new economic learning. This has improved the potential for a proper competitive assessment in all industries,including those characterized by innovation,intellectual property,and technological change. Moreover, antitrust analysis, guided by valid economic principles, is sufficiently flexible to provide a sound competitive assessment in such industries. Rule of reason analysis,for example,can accommodate the assessment of a wide variety of factors,including likely pro- competitive effects of challenged conduct. As discussed above, advances in economic learning have persuaded courts to replace many per se rules of automatic illegality with a more flexible analysis under the rule of reason. Increased flexibility and improved economic understanding can be seen in the evaluation of both joint and unilateral conduct under the Sherman Act, where courts have largely turned away from the application of per se rules of automatic illegality and moved toward rule of reason analysis. Likewise,the analysis of mergers has moved away from structural presumptions that increased concentration will necessarily result in anticompetitive conduct, toward a more complex analysis that incorporates predictions of competitive effects using tools of modern economic analysis. Significantly, both rule of reason analysis and current merger analysis require an evaluation of procompetitive efficiencies that may result from firms’ agreements,unilateral conduct,or proposed transactions. This is a significant posi- tive change from the typical antitrust analysis of thirty years ago. In addition,as discussed above,the courts and the antitrust agencies in recent decades have evidenced a greater appreciation of the importance of intellectual property in promoting R E P O R T A N D R E C O M M E N D A T I O N S 39 innovation and, accordingly, the need to incorporate this recognition into a dynamic analy- sis of competitive effects. Witnesses and commenters remarked there is an improved understanding that antitrust law and patent law are complementary, with both seeking to encourage innovation and competition.52 Antitrust analysis can be properly applied in dynamic, innovation-driven industries.53 Rapid technological progress and innovation are not new issues in antitrust law.54 One wit- ness pointed out “innovation has been the driver of American economic growth since at least the passage of the Sherman Act in 1890” and maintained “antitrust doctrine does not focus on static analysis.”55 Yet another stated that “[a]ntitrust law is sufficiently flexible to take innovation concerns into account, and today’s theories, which may be replaced over time, need not be codified into the statute.”56 Indeed,the evolution of antitrust law—both through case law and agency guidelines—has shown that new or improved economic learning can be incorporated into antitrust analysis as appropriate. Allowing the ongoing incorporation of economic learning into antitrust case law and agency guidelines is preferable to attempts at legislative change to specify differ- ent antitrust analyses for industries characterized by innovation,intellectual property,and technological change. Industries that fall into those categories will keep changing over time; attempts to define them would likely be difficult and impermanent at best. Furthermore,eco- nomic learning continues to evolve, and antitrust law needs to be able to incorporate this new learning as appropriate. It is important that antitrust develops through mechanisms, such as case law development in the courts and agency guidelines, that allow ongoing reassessments of existing law and economic principles relevant to antitrust analysis. 2. In industries in which innovation,intellectual property,and technological change are central features,just as in other industries,antitrust enforcers should carefully consider market dynamics in assessing competitive effects and should ensure proper attention to economic and other characteristics of particular industries that may,depending on the facts at issue,have an important bearing on a valid antitrust analysis. Antitrust analysis in all industries requires careful assessments of each industry’s mar- ket dynamics and economic characteristics. To take proper account of market dynamics, antitrust analysis should carefully consider the incentives and obstacles that firms seeking to develop and commercialize new technologies may face.57 Antitrust enforcers should “explicitly recognize that market conditions,business strategies,and industry structure can be highly dynamic.”58 Innovation provides a significant share of the consumer benefits associated with com- petition,particularly in the most dynamic industries.59New and improved products and serv- 40 A N T I T R U S T M O D E R N I Z A T I O N C O M M I S S I O N ices,as well as new business methods and production processes,are created through inno- vation.60 To improve the application of antitrust in new economy industries, antitrust enforcers should give further consideration to efficiencies that lead to more rapid or enhanced innovation.61 The potential benefits to consumer welfare from such efficiencies are great, thus warranting careful assessments of the potential for certain business con- duct to create more rapid or enhanced innovation. “[A] proper market-power inquiry in new economy industries must include a serious analysis of the vigor of dynamic competition” that looks beyond current sales figures.62 To account properly for dynamic effects, antitrust enforcers must recognize that current mar- ket shares may overstate or understate likely future competitive significance. The Supreme Court identified this issue thirty years ago in United States v.General Dynamics, a merger case in which a coal company’s share of uncommitted coal reserves was a better indicator of its likely ability to compete for future supply contracts than its historical market share.63 Analogous examples can be found in new economy industries, in which there may be “sequences of races to develop a new product or . . . to replace an existing product through drastic innovation.”64For example,if a firm has failed recently to introduce new and improved products comparable to rivals’ new offerings,and has no plans to do so,its likely future com- petitive significance may be far less than would be indicated by its historical market share.65 A recent entrant with a promising new product, on the other hand, may have greater likely future competitive significance than its current low market share might suggest.66 Intellectual property may be critical to future innovation in an industry, so it is also important “to examine ownership of and investment in relevant intellectual property— which may involve technologies not currently in commercial use.”67 If,for example,the cur- rent leader “owns all intellectual property necessary for radical innovation, dynamic com- petition will not be effective.”68 If a firm with a low market share holds an intellectual property asset essential for future product development, that firm’s likely future competi- tive significance may be far greater than that of a current market leader that has no prom- ising new products or intellectual property assets in the pipeline.69 Antitrust analysis also must recognize that a price above marginal cost, by itself, does not necessarily suggest that a firm has market power that should be relevant in an antitrust matter or is operating anticompetitively in a relevant antitrust market.70Particularly in inno- vative industries,such as those in which intellectual property assets are key,firms may have large, up-front fixed costs for research and development, and relatively small marginal costs of production.71In pharmaceuticals,for example,a drug that costs millions of dollars to research, develop, and put through clinical testing may cost only a few cents per pill to produce.72Over the long run,the pharmaceutical company must set a competitive price that will cover its up-front fixed costs, including a risk-adjusted cost of capital.73 Firms in inno- vative industries also must cover the costs of innovation failures,such as drug products that fail before or during clinical testing.74