NBER WORKING PAPER SERIES ANTITRUST Louis Kaplow Carl Shapiro Working Paper 12867 http://www.nber.org/papers/w12867 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 January 2007 We are grateful to Jonathan Baker for extensive and very valuable comments, Stephanie Gabor, Jeffrey Harris, Christopher Lanese, Bradley Love, Stephen Mohr, Andrew Oldham, Peter Peremiczki, Michael Sabin, and Kevin Terrazas for research assistance, and the John M. Olin Center for Law, Economics, and Business at Harvard University for financial support. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. © 2007 by Louis Kaplow and Carl Shapiro. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Antitrust Louis Kaplow and Carl Shapiro NBER Working Paper No. 12867 January 2007 JEL No. K21,L12,L13,L40,L41,L42 ABSTRACT This is a survey of the economic principles that underlie antitrust law and how those principles relate to competition policy. We address four core subject areas: market power, collusion, mergers between competitors, and monopolization. In each area, we select the most relevant portions of current economic knowledge and use that knowledge to critically assess central features of antitrust policy. Our objective is to foster the improvement of legal regimes and also to identify topics where further analytical and empirical exploration would be useful. Louis Kaplow Harvard University Hauser 322 Cambridge, MA 02138 and NBER [email protected] Carl Shapiro UC, Berkeley Haas School of Business Berkeley, CA 94720-1900 [email protected] Table of Contents I. Introduction..................................................................................................1 II. Market Power...............................................................................................2 A. Definition of Market Power ......................................................................3 B. Single-Firm Pricing Model Accounting for Rivals...................................4 C. Multiple-Firm Models...............................................................................7 1. Cournot Model with Homogeneous Products.........................................................7 2. Bertrand Model with Differentiated Products.........................................................9 3. Other Game-Theoretic Models and Collusion......................................................11 D. Means of Inferring Market Power...........................................................11 1. Price-Cost Margin.................................................................................................12 2. Firm’s Elasticity of Demand.................................................................................14 3. Conduct.................................................................................................................18 E. Market Power in Antitrust Law...............................................................20 III. Collusion.....................................................................................................22 A. Economic and Legal Approaches: An Introduction................................23 1. Economic Approach..............................................................................................23 2. Legal Approach.....................................................................................................24 B. Oligopoly Theory....................................................................................26 1. Elements of Successful Collusion.........................................................................26 2. Repeated Oligopoly Games and the Folk Theorem..............................................27 3. Role of Communications......................................................................................29 C. Industry Conditions Bearing on the Likelihood of Collusive Outcomes31 1. Limited Growth for Defecting Firm.....................................................................31 2. Imperfect Detection..............................................................................................32 3. Credibility of Punishment.....................................................................................33 4. Market Structure...................................................................................................35 5. Product Differentiation.........................................................................................39 6. Capacity Constraints, Excess Capacity, and Investment in Capacity...................40 7. Market Dynamics..................................................................................................42 D. Agreements under Antitrust Law............................................................44 1. On the Meaning of Agreement.............................................................................44 2. Agreement, Economics of Collusion, and Communications................................47 E. Other Horizontal Arrangements..............................................................51 1. Facilitating Practices.............................................................................................52 2. Rule of Reason......................................................................................................54 F. Antitrust Enforcement.............................................................................58 1. Impact of Antitrust Enforcement on Oligopolistic Behavior................................58 2. Determinants of the Effectiveness of Antitrust Enforcement...............................59 IV. Horizontal Mergers...................................................................................59 A. Oligopoly Theory and Unilateral Competitive Effects...........................61 1. Cournot Model with Homogeneous Products.......................................................61 2. Bertrand Model with Differentiated Products.......................................................65 3. Bidding Models.....................................................................................................70 B. Oligopoly Theory and Coordinated Effects............................................71 C. Empirical Evidence on the Effects of Horizontal Mergers.....................74 1. Stock Market Prices..............................................................................................75 2. Accounting Measures of Firm Performance.........................................................76 3. Case Studies..........................................................................................................76 D. Antitrust Law on Horizontal Mergers.....................................................78 1. Background and Procedure...................................................................................78 2. Anticompetitive Effects........................................................................................81 3. Efficiencies...........................................................................................................83 E. Market Analysis Under the Horizontal Merger Guidelines....................89 1. Market Definition: General Approach and Product Market Definition................90 2. Geographic Market Definition..............................................................................95 3. Rivals’ Supply Response......................................................................................97 F. Predicting the Effects of Mergers............................................................98 1. Direct Evidence From Natural Experiments.........................................................98 2. Merger Simulation................................................................................................99 V. Monopolization ....................................................................................... 100 A. Monopoly Power: Economic Approach............................................... 101 1. Rationale for Monopoly Power Requirement.....................................................101 2. Application to Challenged Practices...................................................................103 B. Legal Approach to Monopolization ..................................................... 106 1. Monopoly Power.................................................................................................106 2. Exclusionary Practices........................................................................................110 C. Predatory Pricing.................................................................................. 113 1. Economic Theory................................................................................................113 2. Empirical Evidence.............................................................................................115 3. Legal Test............................................................................................................116 D. Exclusive Dealing................................................................................. 121 1. Anticompetitive Effects......................................................................................121 2. Efficiencies.........................................................................................................127 3. Legal Test............................................................................................................128 VI. Conclusion............................................................................................... 130 VII. References................................................................................................ 131 I. Introduction In this chapter we survey the economic principles that underlie antitrust law and use these principles to illuminate the central challenges in formulating and applying competition policy. Our twin goals are to inform readers about the current state of knowledge in economics that is most relevant for understanding antitrust law and policy and to critically appraise prevailing legal principles in light of current economic analysis. Since the passage of the Sherman Act in 1890, antitrust law has always revolved around the core economic concepts of competition and market power. For over a century, it has been illegal in the United States for competitors to enter into price-fixing cartels and related schemes and for a monopolist to use its market power to stifle competition. In interpreting the antitrust statutes, which speak in very general terms, U.S. courts have always paid attention to economics. Yet the role of economics in shaping antitrust law has evolved greatly, especially over the past few decades. The growing influence of economics on antitrust law can be traced in part to the Chicago School, which, starting in the 1950s, launched a powerful attack on many antitrust rules and case outcomes that seemed to lack solid economic underpinnings. But the growing influence of economics on antitrust law also has resulted from substantial theoretical and empirical advances in industrial organization economics over the period since then. With a lag, often spanning a couple of decades, economic knowledge shapes antitrust law. It is our hope in this essay both to sharpen economists’ research agendas by identifying open questions and difficulties in applying economics to antitrust law, and also to accelerate the dissemination of economic knowledge into antitrust policy. Antitrust economics is a broad area, overlapping to a great extent with the field of industrial organization. We do not offer a comprehensive examination of the areas within industrial organization economics that are relevant for antitrust law. That task is far too daunting for a single survey and is already accomplished in the form of the three-volume Handbook of Industrial Organization (1989a, 1989b, 2007).1 Instead, we focus our attention on four core economic topics in antitrust: the concept of market power (Section II), the forces that facilitate or impede efforts by competitors to engage in collusion (Section III), the effects of mergers between competitors (Section IV), and some basic forms of single-firm conduct that can constitute illegal monopolization, namely predatory pricing and exclusive dealing (Section V).2 In each case, we attempt to select from the broad base of models and approaches the ones that seem most helpful in formulating a workable competition policy. Furthermore, we use this analysis to scrutinize the corresponding features of antitrust law, in some cases providing a 1 Schmalensee and Willig (1989a, 1989b) and Armstrong and Porter (2007). 2 Since the field of antitrust economics and law is far too large to cover in one chapter, we are forced to omit some topics that are very important in practice and have themselves been subject to extensive study, including joint ventures (touched on briefly in subsection III.E.2), vertical mergers, bundling and tying, vertical intrabrand restraints, the intersection of antitrust law and intellectual property law, and most features of enforcement policy and administration, including international dimensions. Antitrust, Page 1 firmer rationalization for current policy and in others identifying important divergences.3 For reasons of concreteness and of our own expertise, we focus on antitrust law in the United States, but we also emphasize central features that are pertinent to competition policy elsewhere and frequently relate our discussion to the prevailing regime in the European Union.4 II. Market Power The concept of market power is fundamental to antitrust economics and to the law. Except for conduct subject to per se treatment, antitrust violations typically require the government or a private plaintiff to show that the defendant created, enhanced, or extended in time its market power. Although the requisite degree of existing or increased market power varies by context, the nature of the inquiry is, for the most part, qualitatively the same. It is important to emphasize at the outset that the mere possession of market power is not a violation of antitrust law in the United States. Rather, the inquiry into market power is usually a threshold question; if sufficient market power is established, it is then asked whether the conduct in question—say, a horizontal merger or an alleged act of monopolization—constitutes an antitrust violation. If sufficient market power is not demonstrated, the inquiry terminates with a victory for the defendant. Here, we begin our treatment of antitrust law and economics with a discussion of the basic economic concept of market power and its measurement. We first define market power, emphasizing that, as a technical matter, market power is a question of degree. Then we explore the factors that determine the extent of market power, first when exercised by a single firm and then in the case in which multiple firms interact. We also consider various methods of inferring market power in practice and offer some further remarks about the relationship between the concept of market power as understood by economists and as employed in antitrust law.5 Further elaboration appears in Sections IV and V on horizontal mergers and monopolization, respectively. 3 There are a number of books that have overlapping purposes, including Bork (1978), Hylton (2003), Posner (2001), and Whinston (2006), the latter being closest to the present essay in the weight given to formal economics. 4 As implied by the discussion in the text, our references to the law are primarily meant to make concrete the application of economic principles (and secondarily to offer specific illustrations) rather than to provide detailed, definitive treatments. On U.S. law, the interested reader should consult the extensive treatise Antitrust Law by Areeda and Hovenkamp, many volumes of which are cited throughout this essay. On the law in the European Union, see, for example, Bellamy and Child (2001), Dabbath (2004), and Walle de Ghelcke and van Gerven (2004). A wide range of additional information, including formal policy statements and enforcement statistics, are now available on the Internet. Helpful links are: Antitrust Division, Department of Justice: http://www.usdoj.gov/atr/index.html; Bureau of Competition, Federal Trade Commission: http://www.ftc.gov/ftc/antitrust.htm; European Union, DG Competition: http://ec.europa.eu/comm/competition/index_en.html; Antitrust Section of the American Bar Association, http://www.abanet.org/antitrust/home.html. 5 Prior discussions of the general relationship between the economic conception of market power and its use in antitrust law include Areeda, Kaplow, and Edlin (2004, pp. 483-499), Kaplow (1982), and Landes and Posner (1981). For a recent overview, see American Bar Association, Section of Antitrust Law (2005). Antitrust, Page 2 A. Definition of Market Power Microeconomics textbooks distinguish between a price-taking firm and a firm with some power over price, that is, with some market power. This distinction relates to the demand curve facing the firm in question. Introducing our standard notation for a single firm selling a single product, we write P for the price the firm receives for its product, X for the firm’s output, and X(P) for the demand curve the firm perceives that it is facing, with X '(P)≤0.6 When convenient, we will use the inverse demand curve, P(X). A price-taking firm has no control over price: P(X)= P regardless of X, over some relevant range of the firm’s output. In contrast, a firm with power over price can cause price to rise or fall by decreasing or increasing its output: P'(X<) 0 in the relevant range. We say that a firm has “technical market power” if it faces a downward sloping (rather than horizontal) demand curve. In practice almost all firms have some degree of technical market power. Although the notion of a perfectly competitive market is extremely useful as a theoretical construct, most real-world markets depart at least somewhat from this ideal. An important reason for this phenomenon is that marginal cost is often below average cost, most notably for products with high fixed costs and few or no capacity constraints, such as computer software, books, music, and movies. In such cases, price must exceed marginal cost for firms to remain viable in the long run.7 Although in theory society could mandate that all prices equal marginal cost and provide subsidies where appropriate, this degree of regulation is generally regarded to be infeasible, and in most industries any attempts to do so are believed to be inferior to reliance upon decentralized market interactions. Antitrust law, as explained in the introduction, has the more modest but, it is hoped, achievable objective of enforcing competition to the extent feasible. Given the near ubiquity of some degree of technical market power, the impossibility of eliminating it entirely, and the inevitable costs of antitrust intervention, the mere fact that a firm enjoys some technical market power is not very informative or useful in antitrust law. Nonetheless, the technical, textbook notion of market power has the considerable advantage that it is amenable to precise measurement, which makes it possible to identify practices that enhance a firm’s power to a substantial degree. The standard measure of a firm’s technical market power is based on the difference between the price the firm charges and the firm’s marginal cost. In the standard theory of monopoly pricing, a firm sets the price for its product to maximize profits. Profits are given by π= PX(P)−C(X(P)), where C(X) is the firm’s cost function. Differentiating with respect to price, we get the standard expression governing pricing by a single-product firm, 6 For simplicity, unless we indicate otherwise, we assume throughout this chapter that each firm sells a single product. While this assumption is almost always false, in many cases it amounts to looking at a firm’s operations product-by-product. Obviously, a multi-product firm might have market power with respect to one product but not others. When interactions between the different products sold by a multi-product firm are important, notably, when the firm sells a line of products that are substitutes or complements for each other, the analysis will need to be modified. 7 Edward Chamberlin (1933) and Joan Robinson (1933) are classic references for the idea that firms in markets with low entry barriers but differentiated products have technical market power. Antitrust, Page 3 P−MC 1 = (1) P ε F dX P where MC is the firm’s marginal cost, C'(X), and ε ≡ is the elasticity of demand facing F dP X that firm, the “firm-specific elasticity of demand.”8 The left-hand side of this expression is the Lerner Index, the percentage gap between price and marginal cost, which is a natural measure of a firm’s technical market power: P−MC m≡ . P As noted earlier, some degree of technical market power is necessary for firms to cover their costs in the presence of economies of scale. For example, if costs are given by C(X)= F +CX , then profits are given by π= PX −CX −F and the condition that profits are non-negative can be written as m≥ F /PX , that is, the Lerner Index must be at least as large as the ratio of the fixed costs, F, to the firm’s revenues, R≡ PX . Before proceeding with our analysis, we note that, although anticompetitive harm can come in the form of reduced product quality, retarded innovation, or reduced product variety, our discussion will follow much of the economics literature and most antitrust analysis in focusing on consumer harm that comes in the form of higher prices. This limitation is not as serious as may first appear because higher prices can serve as a loose proxy for other forms of harm to consumers. B. Single-Firm Pricing Model Accounting for Rivals To aid understanding, we present a basic but flexible model showing how underlying supply and demand conditions determine the elasticity of demand facing a given firm. This model allows us to begin identifying the factors that govern the degree of technical market power enjoyed by a firm. We also note that this same model will prove very useful conceptually when we explore below the impact of various practices on price. Studying the effects of various practices on price requires some theory of how firms set their prices. The building block for these various theories is the basic model of price-setting by a single, profit-maximizing firm. In addition, as a matter of logic, one must begin with such a model before moving on to theories that involve strategic interactions among rival firms. The standard model involves a dominant firm facing a competitive fringe.9 A profit-maximizing firm sets its price accounting for the responses it expects from its rivals and customers to the 8 Strictly speaking, the elasticity of demand facing the firm is endogenous, except in the special case of constant elasticity of demand, since it varies with price, an endogenous variable. All the usual formulas refer to the elasticity of demand at the equilibrium (profit-maximizing) price level. 9 For a recent textbook treatment of this model, see Carlton and Perloff (2005, pp. 110-119). Landes and Posner (1981) provide a nice exposition of this model in the antitrust context. Antitrust, Page 4 price it sets.10 This is a decision-theoretic model, not a game-theoretic model, so it does not make endogenous the behavior of the other firms in the market or of potential entrants. This is the primary sense in which the generality of the model is limited. The model also is limited because it assumes that all firms in the market produce the same, homogeneous product and do not engage in any price discrimination, although the core ideas underlying it extend to models of differentiated products. The firm faces one or more rivals that sell the same, homogeneous product. When setting its price, P, the firm recognizes that rivals will likely respond to higher prices by producing more output. The combined output of the firm’s rivals increases with price according to Y(P), with Y'(P)≥0. Total (market) demand declines with price according to Z(P), with Z'(P)≤0. If the firm in question sets the price P, then it will be able to sell an amount given by X(P)≡Z(P)−Y(P). This is the largest quantity that the firm can sell without driving price below the level P that it selected; if the firm wants to sell more, if will have to lower its price. The firm’s so-called “residual demand curve” is therefore given by X(P). If we differentiate the equation defining X(P)with respect to P, and then multiply both sides by −P/ X to convert the left-hand side into elasticity form, we get P dX P dZ P dY − =− + . X dP X dP X dP Next, multiply and divide the dZ /dPterm on the right-hand side by Z and the dY /dP term by Y. This gives P dX P dZ Z P dY Y − =− + . X dP Z dP X Y dP X Define the market share of the firm being studied by S = X /Z . The corresponding market share of the rivals is 1−S =Y /Z . Replacing Z / X by 1/S and Y / X by (1−S)/S in the expression above gives P dX P dZ 1 P dY (1−S) − =− + . X dP Z dP S Y dP S 10 As with the standard theory of pure monopoly pricing as taught in microeconomics textbooks, the results of this model are unchanged if we model the firm as choosing its output level, with price adjusting to clear the market. Antitrust, Page 5