The Oxford Handbook of International Antitrust Economics

T H E O X F O R D HA N D B O O K O F
I N T E R NAT IONA L
A N T I T RU ST
E C ON OM IC S
Volume 2
CONSULTING EDITORS
Michael Szenberg
Lubin School of Business, Pace University
Lall Ramrattan
University of California, Berkeley Extension
THE OXFORD HANDBOOK OF
INTERNATIONAL
ANTITRUST
ECONOMICS
Volume 2
Edited by
ROGER D. BLAIR
and
D. DANIEL SOKOL
1
3
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Contents
List of Contributors ix
Introduction xiii
PA RT I M ON OP OL I Z AT ION : C ON DU C T
1. A Framework for the Economic Analysis of Exclusionary Conduct 3
B. Douglas Bernheim and Randal Heeb
2. Predatory Pricing 40
Kenneth G. Elzinga and David E. Mills
3. Raising Rivals’ Costs 62
David T. Scheffman and Richard S. Higgins
4. Predatory Buying 72
John E. Lopatka
5. Competitive Discounts and Antitrust Policy 89
Kevin M. Murphy, Edward A. Snyder, and Robert H. Topel
6. Squeeze Claims: Refusals to Deal, Essentials Facilities, and
Price Squeezes 120
Barak Orbach and Raphael Avraham
7. Innovation and Antitrust Policy 132
Thomas F. Cotter
8. Continental Drift in the Treatment of Dominant Firms: Article 102
TFEU in Contrast to Section 2 Sherman Act 153
Pierre Larouche and Maarten Pieter Schinkel
9. Treatments of Monopolization in Japan and China 188
Ping Lin and Hiroshi Ohashi
vi Contents
10. Monopolization in Developing Countries 234

Alberto Heimler and Kirtikumar Mehta
11. Business Strategy and Antitrust Policy 253
Michael J. Mazzeo and Ryan C. McDevitt
PA RT I I V E RT IC A L I N T E G R AT ION A N D
C ON T R AC T UA L E Q U I VA L E N T S
12. Resale Price Maintenance of Online Retailing 277
Benjamin Klein
13. Exclusive Dealing 304
Howard Marvel
14. Tying Arrangements 329
Erik Hovenkamp and Herbert Hovenkamp
15. Vertical Restraints across Jurisdictions 351
Edward M. Iacobucci and Ralph A. Winter
16. Franchising and Exclusive Distribution: Adaptation and Antitrust 387
Francine Lafontaine and Margaret E. Slade
PA RT I I I C OL LU SION A M ON G O S T E N SI B L E
C OM P E T I TOR S
17. Cartels and Collusion: Economic Theory and
Experimental Economics 415
Jay Pil Choi and Heiko Gerlach
18. Cartels and Collusion: Empirical Evidence 442
Margaret C. Levenstein and Valerie Y. Suslow
19. Tacit Collusion in Oligopoly 464
Edward J. Green, Robert C. Marshall, and Leslie M. Marx
20. Auctions and Bid Rigging 498
Ken Hendricks, R. Preston McAfee, and Michael A. Williams
Contents vii
21. Screening for Collusion as a Problem of Inference 523

Michael J. Doane, Luke M. Froeb, David S. Sibley, and
Brijesh P. Pinto
22. Competition Policy for Industry Standards 554
Richard Gilbert
23. Antitrust Corporate Governance and Compliance 586
Rosa M. Abrantes-Metz and D. Daniel Sokol
Index 619
List of Contributors
Rosa M. Abrantes-Metz, Adjunct Associate Professor, Stern School of Business,

New York University and Principal, Global Economics Group
Raphael Avraham, Associate, Snell & Wilmer
B. Douglas Bernheim, Edward Ames Edmunds Professor of Economics, Stanford
University and Partner, Bates White Economic Consulting
Roger D. Blair, Walter J. Matherly Professor and Chair, Department of Economics,
Warrington College of Business, University of Florida
Jay Pil Choi, Scientia Professor, School of Economics, Australian School of Business,
University of New South Wales and Professor of Economics, Yonsei University
Thomas F. Cotter, Briggs and Morgan Professor of Law, University of Minnesota Law
School
Michael J. Doane, Director, Competition Economics LLC
Kenneth G. Elzinga, Robert C. Taylor Professor of Economics, University of Virginia
Luke M. Froeb, William C. Oehmig Chair of Free Enterprise and Entrepreneurship,
Owen Graduate School of Management, Vanderbilt University
Heiko Gerlach, Associate Professor, School of Economics, University of Queensland
Richard Gilbert, Emeritus Professor of Economics and Professor in the Graduate School,
University of California, Berkeley
Edward J. Green, Professor of Economics, Penn State University
Randal Heeb, Partner, Bates White Economic Consulting
Alberto Heimler, Professor of Economics, Italian School of Public Administration
Ken Hendricks, Professor of Economics, University of Wisconsin
Richard S. Higgins, Director, Berkeley Research Group
Erik Hovenkamp, JD/PhD Candidate, Graduate School, Economics, Northwestern
University
Herbert Hovenkamp, Ben V. & Dorothy Willie Professor of Law, University of Iowa
x List of Contributors
Edward M. Iacobucci, Professor of Law, Osler Chair in Business Law, and Associate
Dean of Research, University of Toronto Law School
Benjamin Klein, Professor Emeritus of Economics, University of California, Los Angeles
Francine Lafontaine, William Davidson Professor of Business Economics and Public
Policy, Professor of Economics, Ross School of Business, University of Michigan
Pierre Larouche, Professor of Competition Law, Tilburg Law and Economics Center
(TILEC), Tilburg Law School, Tilburg University
Margaret C. Levenstein, Executive Director, Michigan Census Research Data Center;
Research Scientist, Survey Research Center, Institute for Social Research; Adjunct
Professor of Business Economics and Public Policy, Ross School of Business, the
University of Michigan
Ping Lin, Professor, Department of Economics, Lingnan University of Hong Kong
John E. Lopatka, A. Robert Noll Distinguished Professor of Law, Dickinson School of
Law, the Pennsylvania State University
Robert C. Marshall, Department Head, Professor, Department of Economics,
Pennsylvania State University
Howard Marvel, Professor Emeritus of Economics, The Ohio State University
Leslie M. Marx, Robert A. Bandeen Professor of Economics, The Fuqua School of
Business, Duke University
Michael J. Mazzeo, Associate Professor, Department of Management and Strategy and
Faculty Associate, Institute for Policy Research, Northwestern University
R. Preston McAfee, Research Leader, Google
Ryan C. McDevitt, Assistant Professor of Economics, The Fuqua School of Business,
Duke University
Kirtikumar Mehta, former Cartels Director, Directorate General for Competition,
European Commission
David E. Mills, Professor, Department of Economics, University of Virginia
Kevin M. Murphy, George J. Stigler Distinguished Service Professor of Economics,
University of Chicago Booth School of Business
Hiroshi Ohashi, Professor of Economics, University of Tokyo
Barak Orbach, Professor of Law and the Director of the Business Law Program,
University of Arizona College of Law
Brijesh P. Pinto, Senior Consultant, Competition Economics LLC
David T. Scheffman, Director, Berkeley Research Group
List Of Contributors xi
Maarten Pieter Schinkel, Professor of Economics, Amsterdam Center for Law &
Economics (ACLE), University of Amsterdam
David S. Sibley, Professor, Department of Economics, University of Texas at Austin
Margaret E. Slade, Professor Emeritus, Vancouver School of Economics, The University
of British Columbia
Edward A. Snyder, Dean & William S. Beinecke Professor of Economics and
Management, Yale School of Management
D. Daniel Sokol, Professor, Levin College of Law, University of Florida and Senior
Research Fellow, George Washington University Law School Competition Law Center
Valerie Y. Suslow, Associate Dean of Graduate Programs, Professor of Business
Economics and Public Policy, Louis and Myrtle Moskowitz Research Professor of
Business and Law, Ross School of Business, University of Michigan
Robert H. Topel, Isidore Brown and Gladys J. Brown Distinguished Service Professor in
Urban and Labor Economics, The University of Chicago Booth School of Business
Michael A. Williams, Director, Competition Economics LLC
Ralph A. Winter, Canada Research Chair, Business Economics and Policy and Professor,
Strategy and Business Economics Division, Sauder School of Business, University of
British Columbia
Introduction
RO GER D. BLAIR AND D. DANIEL SOKOL
Antitrust economics is a subset of industrial organization economics. What makes

antitrust economics rather unique is the centrality of economic analysis to the develop-
ment of antitrust law and policy. In the United States antitrust economics guides all anti-
trust analysis by government enforcers (at the federal level the Department of Justice
Antitrust Division and the Federal Trade Commission) and courts. In other systems,
the centrality of antitrust economics to antitrust law (typically called competition law)
and policy has not been established. Instead, cutting edge antitrust economic analysis
competes with non-antitrust economics goals. Nevertheless, across the major non-US
jurisdictions, antitrust economics is far more utilized now than previously. With global
mergers and various types of conduct, increased coordination across agencies, practi-
tioner lawyers and economists around the world trained in the latest theories of anti-
trust economics, and a rise of economic analysis in decision-making by adjudicators,
the increasing role of international antitrust economics seems somewhat inevitable.
The desire to provide scholars and policy-makers across jurisdictions a reference
tool to understand the most important developments in antitrust economics motivates
this handbook. We have assembled many of the most important scholars in the field to
provide overviews and analysis of the core issuers in antitrust economics. Although no
handbook can be exhaustive, we have attempted to cover all of what we believe to be
the major topics in the field. The developments in economic analysis across these areas
that the handbook covers will shape policy and legal issues in the field for some time.
We hope that the handbook will provide inspiration for new avenues of theoretical and
empirical research in the field.
Many people deserve thanks for this book. The project took a number of years to com-
plete. Our editors at Oxford University Press deserve our gratitude for their patience
and excellent editing. Coordinating production across so many chapters was not always
easy. We particularly thank those authors who turned in their work in a timely manner.
T H E O X F O R D HA N D B O O K O F
I N T E R NAT IONA L
A N T I T RU ST
E C ON OM IC S
Volume 2
PA R T I
M ON OP OL I Z AT ION :
C ON DU C T
CHAPTER 1
A F R A M E WO R K F OR T H E
E C O N OM IC A NA LYSI S OF
E XC LU SIO NA RY C ON DU C T
B. D OUGLAS BERNHEIM AND RANDAL HEEB
1.1. Introduction
“Exclusionary conduct” is a phrase commonly used to describe practices that a firm

might undertake to deny a rival access to a market, or some portion thereof. The appro-
priate antitrust treatment of such conduct is a matter of spirited debate among both
economists and legal scholars. The courts have likewise struggled to articulate consistent
standards governing the legal status of various practices potentially deemed exclusion-
ary, and some commentators go so far as to pronounce a circuit split between the appli-
cable precedential cases, especially noting the apparently conflicting legal and economic
principles articulated in 3M v. LePage’s in the Third Circuit and Cascade Health Solutions
v. PeaceHealth in the Ninth Circuit (see, e.g., Jaeckel 2010; Markus 2008; Hungar and
Koopmans 2009). The lack of any clear consensus on principles heightens the risk that
courts will inadvertently establish economically counterproductive precedents.1 Legal
practitioners complain that the resulting ambiguity precludes them from counseling cli-
ents effectively, leaving companies uncertain as to whether any given mode of conduct is
1
This lack of consensus and the resulting prescriptive confusion was perhaps most visibly on display
following the DOJ’s issuance of the Single Firm Conduct report in September 2008. The report emerged
from lengthy joint hearings held by the DOJ and FTC, but was issued independently by the DOJ and
instantly disavowed by four commissioners of the FTC (http://www.ftc.gov/opa/2008/09/section2.
shtm). The DOJ subsequently withdrew the report in May 2009.
4 B. Douglas Bernheim and Randal Heeb
permissible or proscribed, and hence reluctant to pursue business strategies that might
be procompetitive.
Devising clear and broadly applicable principles for analyzing allegedly anticompeti-
tive exclusionary conduct is challenging in large part because that heading subsumes a
wide range of diverse practices, including exclusive dealing and other agreements that
limit a customer’s or supplier’s ability to do business with a rival, predatory pricing,
bundled pricing, tying, and loyalty discounts. While these practices are unquestionably
related, each differs from the others in potentially substantive ways. Those differences
contribute to the multiplicity of models and theories pertaining to exclusionary conduct
found in the scholarly literature, as well as to the disparate conduct-specific legal prec-
edents. As a result, the topic of exclusionary conduct is widely perceived as complex,
confusing, and unsettled.
Despite the manifest confusion surrounding these issues, we maintain that it is pos-
sible to distill from the extant body of scholarly thought a single, consistent, and trac-
table economic framework for analyzing the antitrust implications of a wide variety of
exclusionary practices. Analytic unification is possible because all of the exclusionary
practices listed above share an ability to activate a single economic mechanism. Briefly,
the mechanism has the feature that exclusion from a market or some portion thereof
weakens a rival, and thereby impairs its ability to compete for other business.2 Our pref-
erence for a single, unified framework—rather than a conceptually distinct approach
for each pertinent practice—reflects our belief that this mechanism overwhelmingly
provides the most commonly and persuasively alleged pathway through which exclu-
sionary practices potentially harm consumers. From that premise, it follows that the
core objective of any inquiry into the potential anticompetitive effects of exclusionary
conduct should be to detect and evaluate the mechanism’s operation, a task that natu-
rally calls for a unified approach. While we acknowledge that the scholarly literature has
explored other economic mechanisms by which exclusion might achieve anticompeti-
tive ends, we view these as considerably less important in practice, and better handled
as special cases and/or exceptions to general principles (much as the Horizontal Merger
Guidelines handle failing firms).3
With this perspective in mind, we describe a framework for systematically imple-
menting a rule-of-reason inquiry into the competitive effects of exclusionary practices.
In the first of three stages, one asks whether the conduct is in fact exclusionary. (To be
absolutely clear from the outset, an affirmative answer to this first question does not
signify that the conduct is necessarily anticompetitive.) For that purpose, we divide
2 The “other business” often involves future sales for which exclusion will render the rival less
competitive, but it may also consist of contemporaneous sales to other customers, for instance in other
geographic regions.
3 For example, a pattern of patent abuse that prevents an established rival from entering a market can
potentially achieve anticompetitive ends through exclusion without impairing a rival’s ability to compete
for other sales. Similarly, a network of vertical arrangements with a supplier might be used to coordinate
and discipline collusive horizontal agreements among downstream firms, or to deter entry that might
diminish overall industry profits. See Asker and Bar-Isaac (2014).
A Framework for the Economic Analysis of Exclusionary Conduct 5
conduct into two broad classes: practices that involve “exclusionary conditions” and
those that do not. We define an exclusionary condition as any practice that renders
aspects of transactions between a company and any one of its customers or suppliers
effectively contingent upon that party’s dealings with the company’s rival(s).4 Practices
involving exclusionary conditions include exclusive dealing (both total and partial
exclusivity), loyalty discounts (with discounts tied to purchase shares),5 and myriad
restrictions on customers’ dealings with rivals. Potentially exclusionary practices that
do not involve exclusionary conditions include predatory pricing, simple bundling,
volume discounts, and conventional tying.6 For the latter practices, the principle lever
over the customer’s behavior is price, which the excluding firm links to the volume
and/or composition of its own sales to the customer without conditioning on the cus-
tomer’s purchases from rivals.7
For conduct involving exclusionary conditions, some degree of exclusion is gener-
ally explicit, in the sense that those conditions preclude or discourage incremental pur-
chases from (or sales to) rivals, even if there is no change in purchases from (or sales to)
the excluding firm. Consequently, establishing that such conduct is exclusionary (but
not necessarily anticompetitive), as required in the first stage of the analysis, involves
little more than documenting the conditionality.
In contrast, when exclusionary conditions are not employed, determining whether
a particular practice serves exclusionary and nonexclusionary objectives is more chal-
lenging, and practical compromises are unavoidable. For example, a firm may reduce
prices either to weaken a rival by depriving it of sales or simply to win more business.
In that case, because the conduct at issue closely resembles the most common form of
procompetitive behavior, subjecting it to close scrutiny creates a substantial risk of chill-
ing beneficial rivalry. Consequently, it is appropriate to set a high bar for establishing
that low prices are exclusionary (but not necessarily anticompetitive), as required in
the first stage of the analysis; applying a price-cost test represents a reasonable com-
promise between the conflicting public policy objectives. A more nuanced standard is
4
Fiona Scott Morton (2012) coined the term “contracts referencing rivals” to describe agreements
containing such terms, implicitly or explicitly.
5 We use the term “loyalty discounts” here to mean discounts that are conditional on the share of
the customer’s business given to the discounting firm and, consequently, the share of business given
to rivals, as opposed to volume discounts, which are conditional only on the volume but not the
share purchased from the discounting firm. Some authors call this practice “fidelity discounts” or
“market-share discounts.” A more descriptive term might be “purchase-share discounts” or “partial
exclusivity discounts.” These terms are not used consistently by all commentators. Note that while
nondiscriminatory volume discounts do not entail exclusionary conditions, they can achieve the same
ends as loyalty discounts if they are tailored to the customer’s size or market potential.
6 Conventional tying (a “tie-in”) involves offering two or more products together when at least some
of those products are not offered separately; it does not require exclusionary conditions. Negative tying
(a “tie-out”) involves forbidding a customer from buying a particular product from a rival as a condition
of sale for another product; it does involve exclusionary conditions. However, for reasons discussed later,
that distinction turns out to be of relatively little practical significance within our framework.
7 A similar statement pertains to practices involving relationships with suppliers rather than with
customers.
appropriate when the conduct resembles modes of nonexclusionary competition that

have ambiguous implications for consumer welfare to begin with, such as price discrim-
ination, or that are relatively uncommon, so that the downside consequences of chilling
legitimate rivalry through scrutiny are modest.
In the second stage of the inquiry, one examines whether the exclusionary con-
duct has anticompetitive effects. Such an investigation is naturally structured around
empirical manifestations of the main anticompetitive mechanism. Specifically, one asks
whether, by virtue of exclusion, a rival’s ability to compete for other business is impaired,
so that market power is enhanced and consumers are harmed. One must also conduct a
factual investigation of the industry to determine whether the types of market failures
that are prerequisites for anticompetitive exclusion are present.
Upon reaching a determination that exclusionary conduct has anticompetitive
effects, the inquiry proceeds to the third stage, in which one then asks whether the con-
duct has offsetting procompetitive effects. To demonstrate the presence of such effects,
one must identify the market imperfections and contracting failures for which exclusion
provides a potential remedy. The task of weighing anticompetitive and procompetitive
effects against each other also requires one to document consumers’ gains from the use
of exclusionary measures, rather than the next best nonexclusionary remedy, to address
the contracting failures.
The unified analytic framework set forth herein incorporates familiar principles
and approaches and is at least arguably consistent with the legal precedents estab-
lished in the guiding cases pertaining to exclusion. Importantly, the framework har-
monizes the apparently disparate treatment of bundled pricing practices in LePage’s,
Ortho, and PeaceHealth. The recent decision by the Third Circuit in ZF Meritor explic-
itly addresses the distinction between price-related conduct governed by preda-
tory pricing case law, including PeaceHealth, and exclusionary conduct governed by
LePage’s, in a way that fits nicely into the framework. As we explain, our approach
is also compatible with the court’s treatment of foreclosure and exclusive dealing in
Dentsply and Microsoft, as well as in predatory pricing cases such as Brooke Group and
Concord Boat.8
This chapter 1 is organized as follows: Section 1.2 describes the anticompetitive mech-
anism of primary concern and explains how the various aforementioned practices can
activate it. Section 1.3 details the three stages of an inquiry into the competitive effects of
exclusionary practices and provides brief examples. Section 1.4 discusses how to iden-
tify procompetitive effects and to balance these against anticompetitive effects. Section
1.5 concludes.
8
Even though each of these cases is typically cited as establishing precedent for one particular type
of conduct, most if not all of them involve allegations of multiple exclusionary practices, or they at least
discuss economic principles that are applicable to multiple practices. For a summary of the various
elements present in key cases before 2005, see Kobayashi (2005).
1.2. Why Is Exclusionary Conduct

Potentially Anticompetitive?
Antitrust policy is primarily concerned with the possibility that exclusionary con-
duct may lessen competition to the detriment of consumers. To determine whether
conduct has that effect in any given instance, we must first understand how the effect
might arise. Looking to the scholarly literature for guidance, one can become some-
what discouraged by the multiplicity of models and theories pertaining to exclu-
sionary conduct, and by the absence of a clear focus on any single channel through
which exclusion might affect market outcomes.9 However, the fact that scholars have
explored a variety of issues pertaining to exclusion (and that journals favor studies
that present novel perspectives) does not mean that it is impossible to distill useful
general principles.
In this section, we identify the economic mechanism that we take to be the most
important reason for concern about exclusionary conduct in practice, and we iden-
tify the modes of conduct that potentially implicate that mechanism. In section 1.3, we
describe a framework for analysis that is designed to detect the operation of that mecha-
nism and gauge its effectiveness. We do not mean to suggest that other mechanisms are
never important, but they appear insufficiently common to serve as the central focus for
a practical analytic framework.10
Throughout the following discussion, we focus on examples in which conduct
excludes an upstream firm from a portion of the downstream market (e.g., a buyer
agrees to make purchases from only one seller). Similar principles apply to cases in
which conduct excludes a downstream firm from a portion of the upstream market (e.g.,
a seller agrees to make sales to only one buyer).
9 For instance, Aghion and Bolton (1987) show how exclusive arrangements can reduce the likelihood
of entry by specifying a damage fee that the entrant must pay in order to make sales to the customers;
Rasmusen, Ramseyer, and Wiley (1991) and Segal and Whinston (2000) highlight how exclusive
arrangements can thwart entry when the incumbent monopolist can exploit the externalities between
buyers; Bernheim and Whinston (1998) explain how exclusive dealing in one market can weaken the
rival in another market. Salop and Scheffman (1983) explore mechanisms that achieve exclusionary
outcomes by raising rivals’ costs. Asker and Bar-Isaac (2014) show how a monopolist can support
exclusion by sharing a portion of its monopoly rents with downstream firms and facilitating collusion
among them so that they can avoid competing away those rents.
10 A branch of the literature suggests that exclusive dealing may provide a solution to what is known
as the “hold-up problem,” thereby allowing firms with market power to exercise that power more
efficiently (Hart and Tirole 1988). We do not see that consideration as the central concern for antitrust
policy (though it may play a role in particular contexts).
1.2.1. The Mechanism

The mechanism of concern is most easily illustrated in a market with the following fea-
tures. A well-established firm (the “market leader”) competes with a smaller and less
established rival (possibly a recent entrant) by selling a product to a group of customers.
Entry barriers are high, so the market leader is not concerned about potential competi-
tion. The degree to which the rival will pose a future competitive threat to the market
leader depends on the rival’s current success in the marketplace. (We discuss possible
reasons for that dependence in section 1.3.) The market leader understands that depen-
dence and exploits it to weaken the rival in the future. Specifically, through one or more
of the exclusionary devices discussed in section 1.2.2, the market leader effectively
“buys” a substantial chunk of the downstream demand so that customers will not pur-
chase the product from the rival. While customers may benefit from improved terms in
the short run, the future harm to competition leaves them worse off overall.11
For the purpose of our analysis, the central feature of this example is that one custom-
er’s decision to enter into an exclusionary arrangement with the market leader reduces
the benefits that other customers can expect to derive from vendor competition. In the
language of economists, this effect is an example of a “negative contracting externality”
(which we will abbreviate as NCE)—that is, an adverse effect that one party experiences
due to the nature of a contract between other parties. Here, the NCE results from the
conjunction of three conditions: first, an exclusionary arrangement between the mar-
ket leader and a customer impairs the rival’s ability to compete for future sales; second,
entry is difficult (which typically implies that the market leader has market power), so
that a reduction in the rival’s competitive efficacy leads to an overall decline in compe-
tition among vendors; and third, vendors have many potential customers, so that the
burden of reduced competition resulting from the exclusionary arrangement is borne,
at least in part, by customers who were not part of that arrangement.
In the absence of NCEs, vertical agreements that exclude rivals are generally procom-
petitive. To understand why that is the case, observe that any negotiation involving a
vendor and a customer consists of two separable components, one encompassing all
considerations that determine the size of the pie they expect to split and the other being
the division of that pie. With respect to the second component, the vendor’s and cus-
tomer’s interests are diametrically opposed; however, with respect to the first compo-
nent, they are perfectly aligned, in the sense that both parties benefit from maximizing
the pie’s size.12 Consequently, when a vendor and a customer enter into an exclusionary
11
For analyses that share the essential features of this example, see Bernheim and Whinston (1998,
section IV); Rasmusen, Ramseyer, and Wiley (1991); and Segal and Whinston (2000).
12 If an agreement between a vendor and a customer did not maximize the sum of their economic
benefits, then one could propose an alternative that would make both better off, and the other would
accept. This principle presupposes that vendors and customers can freely divide up the benefits they
expect to derive from an agreement without otherwise altering the substance of the agreement—a
condition that rarely fails to hold.
arrangement, one can infer that exclusion maximizes the sum of their economic
benefits.
What about the economic benefits enjoyed by the customer? There is no reason to
think that the mere possibility of agreeing to an exclusionary contract would improve
the vendor’s negotiating position with respect to the customer and thereby allow it to
extract a larger share of the pie. Consequently, if exclusion maximizes the sum of the
economic benefits enjoyed by the vendor and the customer, then it will also typically
maximize the customer’s benefits. This principle applies even when the seller allegedly
possesses the power to “compel” the buyer. Unless exclusion increases the sum of the
economic benefits received by the vendor and the customer, any bargaining power that
is used to compel the customer’s participation in an exclusionary arrangement could
be deployed more profitably to obtain greater financial consideration without that
arrangement.13 Robert Bork (1978) correctly recognized this point when commenting
on Standard Fashion: “Standard can extract in the price that it charges all that its line is
worth. It cannot charge the retailer that full amount in money and then charge it again in
exclusivity that the retailer does not wish to grant.”
From the principles in the two preceding paragraphs, it follows that, in the absence
of NCEs, exclusionary agreements will emerge only if they are both socially beneficial,
in the sense that they maximize total economic benefits to all members of society, and
beneficial to customers. That is why (as noted above), unless NCEs are present, one can
reasonably infer that such agreements are procompetitive whenever they are used. An
alternative way to state this principle is that, in the absence of NCEs, a market leader
cannot profitably engage in anticompetitive exclusion. Assuming that the exclusion of a
rival has no procompetitive effects, it generally reduces the total economic value shared
by the market leader and the customer.14 In that case, although a market leader could
induce the customer to accept an exclusionary arrangement and thereby impair a rival,
the terms required to secure the consent of a customer who anticipates the full impact
of the rival’s exclusion would leave the market leader with lower profits than it could
achieve by negotiating a nonexclusive relationship. While there are exceptions to this
principle,15 it applies in a wide range of circumstances.
13 This observation presupposes that the buyer and seller can write contracts that include
volume-insensitive payments (e.g., a fixed fee that is imposed on top of per-unit charges). If one assumes
instead that the buyer can only charge a fixed per-unit price, then Bork’s argument (as well as the more
general one given in the text) breaks down, and there is greater scope for anticompetitive exclusionary
conduct (Matthewson and Winter 1987). As a practical matter, however, we believe that this alternative
assumption is typically (though not always) incorrect. See O’Brien and Shaffer (1992) for criticisms of
that assumption.
14 For example, if the established firm and the rival offer differentiated products, then the weakening
of the rival deprives the buyer of value that the established firm cannot fully replace.
15 For example, as noted by Whinston (1990), commitments to certain types of exclusionary practices
can alter strategic incentives in ways that favor the established firm, even with only one (current and
future) buyer. Also, in some instances, customers may not fully anticipate the effects of exclusive
arrangements with the vendor on future competition.
In contrast, when NCEs are present, the chain of reasoning that rules out the possibil-
ity of anticompetitive exclusion can break down. Specifically, an exclusionary arrange-
ment can maximize the sum of the economic benefits enjoyed by the market leader
and a given customer precisely because the resulting impairment of the rival allows
the market leader to extract greater economic value from other customers.16 The seller
can then secure each customer’s consent to an exclusive arrangement for consideration
that is potentially of much smaller value than the harm to all customers collectively.17
Accordingly, the market leader may well find anticompetitive exclusionary conduct
profitable, even though it is highly inefficient.18
A simple numerical version of our example helps to illustrate this point. Suppose there
are ten customers. When the market leader and any one customer enter into an exclusion-
ary agreement, each customer loses $10 due to reduced future competition (given that the
rival is incrementally weakened), while the market leader gains $80. Because all customers
are adversely affected, NCEs are present. We have chosen these numbers so that exclusion
is inefficient: the total loss to all customers ($100) exceeds the gains to the market leader
($80). Now suppose the market leader offers one of the customers $11 to enter into an exclu-
sive relationship. That customer will accept the deal because it comes out $1 ahead. After
paying for exclusion, the market leader comes out $69 ahead. But every other customer
comes out $10 behind, and customers as a whole come out $89 behind. From a collective
perspective, the problem here is that each customer’s willingness to enter into an exclusion-
ary relationship reflects the balance of competing considerations that determine its own
economic costs and benefits, rather than the costs and benefits for all customers. By signing
up all customers to exclusive relationships for $11 each, the market leader can achieve a total
profit of $690, leaving each buyer worse off by $89, or $890 in total. Thus, due to the pres-
ence of contracting externalities, the market leader profits from anticompetitive exclusion.
Our example shows that exclusionary agreements can be anticompetitive when they
generate NCEs that are borne by the market leader’s other customers. What if those exter-
nalities are instead borne by other parties? The fact that another party suffers from an NCE
does not by itself provide an incentive to engage in anticompetitive exclusion.19 For such
16
Farrell (2005) provides an intuitive discussion of this mechanism.
17
In fact, when negative contracting externalities are strong, the consideration may be extremely
small (Segal and Whinston 2000). For a more general discussion of negative contracting externalities,
see Segal (1999).
18 See Bernheim and Whinston (1998, section IV). This was essentially the government’s theory of
harm in Regional Health (http://www.justice.gov/atr/cases/unitedregional.html).

19 For example, an exclusionary agreement between a vendor and a customer will typically impose
an NCE on the vendor’s rival. Such an effect would not necessarily implicate the antitrust laws, which
are designed to protect competition rather than competitors. Leaving legal issues aside, in standard
economic models an NCE borne by a rival does not reflect more effective expropriation of economic
benefits from the rival by the market leader, the customer, or both. On the contrary, it reflects a reduction
in aggregate economic benefits, as a result of which the market leader and customer also jointly suffer
(e.g., because the incremental benefits of the rival’s differentiated product are lost). Therefore, such NCEs
cannot provide a motivation to engage in exclusion. In addition, the relationship between the rival and
customer may effectively internalize any contracting externality experienced by the rival; see Bernheim
and Whinston (1998).
an incentive to arise, the market leader and the customer must jointly benefit from that
NCE; in other words, the NCE must exist because either the market leader, the customer,
or both more effectively expropriate economic benefits from another party (just as in our
example). For that to occur, the parties bearing the NCEs usually must lie downstream
from the market leader—that is, they must either be the market leader’s customers, final
consumers downstream from the market leader’s customers, or (in industries with long
supply chains) companies situated between the two.20
When vendors engaging in exclusionary practices sell intermediate goods, it is indeed
the case that parties downstream from the market leader’s customers, such as final
consumers, often suffer from NCEs. For example, such NCEs will be present if exclu-
sion allows the market leader to charge higher prices in the future by weakening the
rival, and if customers pass some portion of the price increase downstream.21 As long
as an exclusionary arrangement between the market leader and a customer imposes
NCEs borne by (or passed through) the market leader’s other customers, NCEs borne
by downstream parties as a consequence of pass-through can magnify the incentive to
engage in exclusion for anticompetitive purposes.22
To illustrate this point, we will modify the last numerical example as follows.
Suppose that when any one customer enters an exclusive deal with the market leader,
all customers lose $5 in future benefits due to reduced competition (given that the
rival is incrementally weakened), and downstream consumers lose $50, while the
market leader again gains $80. The total loss to all customers and downstream con-
sumers combined is $100, just as before, but now that loss is not absorbed entirely
by the market leader’s customers. In this case, the market leader can lure a customer
into an exclusive deal by offering only $6 rather than $11—the consenting customer
ignores the benefits of an unimpaired rival not only to the market leader’s other cus-
tomers but also to downstream consumers. After paying for exclusion, the market
20 One can imagine exceptions. Suppose, for example, that the market leader and the rival purchase
a critical input from an upstream supplier with market power. By weakening the rival, the market leader
may be able to create offsetting monopsony power, and thereby obtain the input at lower cost. While
the NCE suffered by the upstream supplier would provide an incentive for the market leader and the
customer to enter into an exclusionary agreement, the agreement might well benefit consumers, and
consequently might not qualify as an antitrust violation.
21 Pass-through is not a foregone conclusion. The market leader may have an incentive to exploit its
market power by charging lump-sum fees, which the customer would tend to absorb.
22 See Abito and Wright (2008) and Simpson and Wickelgren (2007), which conclude that exclusion
is more likely when buyers are downstream firms that compete with one another. A different conclusion
(i.e., that exclusion is less likely when buyers are downstream competitors instead of final consumers)
is reached by Fumagalli and Motta (2006), though their result depends crucially on some of their
simplifying assumptions. For example, as discussed by Wright (2009), they assume that the downstream
firms sell a homogenous good and have to pay a fixed cost to stay in business. As a consequence, a
downstream firm that secures the input from the rival at a lower price can serve the entire downstream
market without competitive constraint. The prospect of the resulting profit makes rejecting the dominant
firm’s exclusive offer attractive; as a result, exclusion does not occur in equilibrium. However, with
differentiated products and small fixed costs, the downstream firms that have entered into exclusive deals
will remain in the market and continue to exert a competitive constraint on the deviating firm, making
deviations less profitable.
leader comes out $74 ahead. But every other customer comes out $5 behind, or $45 in
total, while downstream consumers come out $50 behind. The market leader could
induce all of them to sign the same exclusive deal, thereby profiting $740 in total,
while leaving the customers all worse off to the tune of $44 individually, or $440
in total, and leaving downstream consumers worse off by $500. Because the NCEs
borne by downstream consumers reduce the price of exclusion (from $11 in the pre-
vious numerical example to $6 in this one), anticompetitive exclusive dealing pres-
ents the market leader with an even greater profit opportunity in this example ($74
per customer, or $740 in total) than in the previous one ($69 per customer, or $690
in total).
Downstream consumers may suffer from NCEs due to pass-through even in the
absence of NCEs borne by (or passed through) other customers. However, in that
case, firms do not generally have incentives to engage in exclusion to achieve purely
anticompetitive ends. Consider the simplest case, in which the market leader and
rival sell to a single customer, who in turn supplies a product to final consumers.
Because exclusion of the rival does not increase the customer’s market power over
the final consumers, there is no reason to think that it allows the customer to expro-
priate greater economic benefits from them. Indeed, the effect can be precisely the
opposite: if, by weakening the rival, exclusion subsequently allows the market leader
to charge the customer a higher price, then expropriation of economic benefits from
final consumers may become less efficient (e.g., due to double marginalization).23 In
that case, the NCE suffered by final consumers will be associated with a reduction
in the joint benefits enjoyed by the market leader and the customer, rather than an
increase, which attenuates the incentive to exclude. Thus, an exclusionary agreement
between a market leader and a customer does not usually raise anticompetitive con-
cerns unless it imposes NCEs borne by (or passed through) the market leader’s other
customers, and unless those NCEs reflect greater expropriation of economic benefits
by the market leader.24
It is worth emphasizing that, in the preceding examples (and more generally),
exclusionary conditions are anticompetitive even though each customer voluntarily
agrees to exclude the rival. Considered in isolation, each deal between the market
leader and a customer is necessarily mutually beneficial, even accounting for its sub-
sequent impact on competition. However, every such deal harms other parties (other
customers and possibly their downstream consumers) who are not part of the deal.
23
Spengler (1950) is credited with first articulating the inefficiencies of double marginalization.
24
Notably, when NCEs are borne by (or passed through) the market leader’s other customers,
exclusion can lead to greater expropriation of economic benefits from final consumers. In that case,
the rival’s exclusion can mitigate the extent to which downstream competition limits the extraction of
economic benefits from consumers: with a weakened rival, the market leader can raise the input price,
thereby causing customers to increase the prices of their downstream offerings. Because competition
would otherwise keep those prices below profit-maximizing levels, the sum of the economic benefits
received by the market leader and the customer who enter into the exclusionary arrangement can rise,
thereby making exclusion attractive for anticompetitive reasons.
Consequently, every customer would be better off if no deals were consummated;

still, each customer has a strong individual incentive to consummate its own deal.
It follows that coercion is not necessary to achieve exclusion. Indeed, recognizing
the potential for mutual benefit, individual customers may actively seek exclusive
arrangements with the market leader, but that possibility renders the arrangements
no less anticompetitive.
Certain features of our examples play critical roles in generating anticompeti-
tive effects, while others do not. Distinguishing between those two sets of features
is important, because a well-designed antitrust inquiry should focus on the first
set and not the second. In tracing anticompetitive exclusion to particular types of
NCEs, we have emphasized the importance of entry barriers (and thus the market
leader’s market power), the rival’s vulnerability, and the presence of multiple custom-
ers. Many other features of our examples are either inessential or less critical. For
instance, similar conclusions follow regardless of whether there is one rival or many
and irrespective of whether the rival is active or merely a potential entrant. In the
remainder of this section, we elaborate on the roles played by several other features
of our examples.
While our examples assume that exclusion impairs the rival’s future competitive effi-
cacy, the same anticompetitive mechanism can operate when exclusion only limits the
rival’s current ability to compete, for example through the lost economies of scale (see
Rasmusen, Ramseyer, and Wiley 1991 and Segal and Whinston 2000). In the latter case,
however, the mechanism may be more fragile. For example, it may operate less reliably
when contract negotiations with customers are synchronized than when they are stag-
gered (see Segal and Whinston 2000). Alternatively, if the source of the scale economies
is a one-time entry cost, and if contract duration is short, then a new rival may well
find it profitable to incur that cost even if the market leader has locked up a large frac-
tion of the market in short-term exclusive arrangements; once the entry cost is sunk, the
rival can operate efficiently at small scale, so that the exclusionary mechanism is subse-
quently disabled.
There is a sense in which the mechanism highlighted in this section always involves
both profit sacrifice and recoupment. Any provisions in an agreement between the mar-
ket leader and a customer that restrict the customer’s freedom to do business with other
vendors leaves the customer worse off, ceteris paribus. The customer will not enter into
such an agreement voluntarily unless the market leader compensates it for that loss,
thereby sacrificing profits. Similarly, the market leader will find the agreement unat-
tractive unless it expects to recoup the compensation. It achieves recoupment by exer-
cising greater market power over other parties. Thus, recoupment is the source of the
NCEs at the heart of the mechanism.
Courts have long recognized that profit sacrifice and recoupment are essential fea-
tures of predatory pricing, and require proof of both in that context (see Concord Boat;
Brooke Group). Some subsequent commentators have advocated the application of this
principle to exclusionary practices more generally, and have in particular proposed
that courts use evidence of profit sacrifice as a criterion for distinguishing between
anticompetitive and procompetitive exclusionary conduct (see Melamed 2005; Werden

2006). Others have argued that exclusionary conduct does not necessarily require profit
sacrifice, that the sacrifice may not be readily observable, and that it may not be closely
associated with the underlying anticompetitive harm (see Nalebuff 2005a and 2005b;
Salop 2006).
Though forms of sacrifice and recoupment are always elements of the anticompeti-
tive mechanism highlighted above, a broad requirement that plaintiffs provide direct
evidence of sacrifice and/or recoupment is inadvisable. Predatory pricing is a rather
special case, in that there is a clear temporal separation between the periods during
which the market leader sacrifices profit on the one hand and receives recoupment
on the other. For many other forms of exclusionary conduct, there is no such separa-
tion. For example, when exclusionary contracts with multiple customers impair the
rival’s current competitive efficacy, each contract implicitly involves both profit sacri-
fice to secure that customer’s assent, and (partial) recoupment of the profits sacrificed
to secure the assent of other customers. One cannot, however, measure those com-
ponents individually; the terms of the contract reflect only their combined effects.
Even when the sacrifice and recoupment associated with an exclusionary agreement
are temporally separated (as in our examples), exclusionary conduct may be ongoing,
in which case the current profit sacrifice may be obscured by recoupment associated
with past conduct.
Of course, for the market leader to engage willingly in anticompetitive exclusion, the
anticipated recoupment must exceed the profit sacrifice, in which case the firm earns
supracompetitive profits. To test that implication of the theory, one would not need to
distinguish between sacrifice and recoupment. However, the use of such a test is also
often inadvisable, given the difficulty of measuring economic profits, let alone ex ante
profit expectations. Measurement problems aside, the firm may have other sources of
supracompetitive profits or, alternatively, economic losses that offset the gains from
anticompetitive exclusion. Thus, it is usually better to investigate whether economic
conditions favor the operation of the anticompetitive mechanism. For example, supra-
competitive profit (i.e., net recoupment) is possible only if the rival is weakened. This
principle has been articulated most clearly in the context of predatory pricing: the pred-
ator cannot profitably exclude rivals by selling output at prices below cost unless, as a
result, rivals collectively pose a reduced competitive threat in the future.25 Of course,
focusing only on the weakening of a rival would not distinguish the effects of anticom-
petitive conduct from the natural demise of a less efficient competitor. Thus, this ele-
ment is necessary but not sufficient for the conduct in question to be anticompetitive via
the highlighted mechanism.
25 See Elzinga and Miles (1994). Matsushita v. Zenith Radio is the guiding case on the requirement for
recoupment.
1.2.2. Modes of Conduct That Potentially Implicate the

Mechanism
So far, we have been intentionally vague concerning the nature of the conduct through
which a company excludes a rival from all or part of the market. Modes of exclusionary
conduct fall into two main categories: practices that rely on the use of exclusionary con-
ditions (defined in the next section), and those that do not. The latter category includes
various pricing strategies, including predatory pricing, bundling, volume discounts,
and conventional tying. There are, of course, important substantive differences between
the modes of conduct that fall within these categories, and the case law treats them dif-
ferently.26 However, despite their differences, they have critical commonalities, chief
among which is their ability to activate the anticompetitive mechanism described in the
previous section. Accordingly, an analytic framework designed to detect the operation
of that mechanism can be applied in a unified way to all modes of conduct within the
two categories.
1.2.3. Practices That Involve Exclusionary Conditions

We use the phrase exclusionary conditions to denote practices that render aspects of
transactions between a seller and one of its customers effectively contingent upon the
customer’s dealings with the seller’s rival(s).27 Often, an exclusionary condition takes
the form of a restriction, which the customer accepts in exchange for a fixed payment or
some other additional consideration (such as a discounted price for goods or services).
Alternatively, a company may reward or penalize a customer based on the volume that it
purchases from a rival.
The simplest and most readily recognizable type of exclusionary condition is a “100%
exclusive deal,” in which the seller either pays the customer an agreed sum of money
or offers a commensurate price reduction, to refrain from doing business with the
rival. Alternatively, instead of 100% exclusivity, the seller may place some other explicit
or implied limit on the customer’s dealings with the rival. For example, the seller may
require the customer to restrict sales of its rival’s products to no more than a specified
(usually small) percentage of total sales.28 Alternatively, it might require the customer to
26 For predatory pricing, see Concord Boat and Brooke Group; for tying, see Jefferson Parish, Microsoft,
and Eastman Kodak Co.; for exclusive dealing, see Microsoft and Dentsply.
27 See Fiona Scott Morton (2012) for a characterization of such conditions.
28 Applicable case law includes Tampa Electric (exclusive dealing arrangements violate antitrust
law if it is probable that they “will foreclose competition in a substantial share of the line of commerce
affected”); LePage’s (exclusive dealing contracts with large customers); Microsoft (arrangements that
closed to rivals “a substantial percentage” of distribution opportunities); SmithKline (conditioning
rebates on market-share thresholds).
limit sales of rivals’ products to secondary channels, forbid active marketing of rivals’
products, or insist upon inferior placement of rivals’ products in advertisements, store
displays, or on customers’ websites.29 Provided that the scope of the resulting exclusion
is sufficient to meaningfully handicap the rival and thereby impair its ability to serve
other customers, such arrangements can activate the anticompetitive mechanism
described in the preceding section.
Significantly, exclusionary conditions involve more than merely winning all of a cus-
tomer’s business through aggressive competition on the merits. Instead of focusing on
the business that the customer transacts with the seller, these conditions place limits on
the business that the customer can transact with the rival. This distinction is substan-
tive. For instance, a requirement of exclusivity precludes the rival from selling additional
units to the same customer beyond those the seller supplies, whereas merely winning a
bid to sell the customer some number of units does not.
The fundamental character of arrangements involving exclusionary conditions does
not depend on the form of consideration received by the customer in exchange for
accepting the exclusionary condition. In the simplest case, the quid pro quo consists
of a monetary payment. Alternatively, it could take the form of a large rebate or addi-
tional marketing funds (see, e.g., LePage’s; Microsoft; SmithKline). It may also involve an
in-kind payment, such as technological information, engineering support, preferential
supply consideration, or other advantages.30 Any good or service received as an in-kind
payment has an equivalent monetary value—either the price for which the good or ser-
vice sells in the open market or the price at which the seller would provide it to the buyer
separate from the broader agreement. Transferring the good or service is economically
equivalent to transferring its monetary value, although it may be very difficult to deter-
mine precisely what that value is.
When the seller’s customers compete with each other downstream, the compensation
that a customer receives in exchange for exclusivity may entail a promise to supply the
customer at terms that are more favorable than those given to other customers. Such a
promise effectively amounts to a payment for exclusivity: the seller forgoes revenue by
supplying the customer at preferential terms; the customer receives an opportunity to
earn greater profits in competition with other downstream firms. Significantly, the quid
pro quo for accepting an exclusionary condition may also take the form of a threat unex-
ecuted. For example, the seller can “reward” the customer’s cooperation by refraining
29
Applicable case law includes Grinnell; LePage’s; Conwood; General Industries.
30
See, e.g., Microsoft; in its complaint against Intel, the Federal Trade Commission charged that “[o]‌n
one hand, Intel threatened to and did increase prices, terminate product and technology collaborations,
shut off supply, and reduce marketing support to OEMs that purchased too many products from Intel’s
competitors. On the other hand, some OEMs that purchased 100% or nearly 100% of their requirements
from Intel were favored with guarantees of supply during shortages, indemnification from intellectual
property litigation, or extra monies to be used in bidding situations against OEMs offering a non-Intel
product” (United States of America before the Federal Trade Commission, Complaint in the Matter of
Intel (2009)).
from withholding products that are essential to the customer’s business and/or from
supplying the customer’s competitors at favorable terms.31
An exclusionary condition need not be memorialized in a formal written contract.
A shared understanding of the relationship between the extent of the customer’s deal-
ings with the rival and the consideration received from the seller will suffice.32 Indeed,
ambiguity in the terms of the relationship can be useful to the supplier, as it permits the
supplier to interpret the exclusionary requirement broadly and flexibly in light of new
developments.
1.2.4. Practices That Do Not Involve Exclusionary Conditions

Anticompetitive exclusion does not require the use of exclusionary conditions. Instead,
a company that seeks to limit a customer’s purchases from a rival can simply “buy” the
customer’s business by offering sufficiently attractive terms for its own products. The
most straightforward approach, predatory pricing, is to charge a price so low that the
rival is unable or at least unwilling to compete. Of course, that practice closely resem-
bles the type of competitive conduct that the antitrust laws are designed to protect.
Conceptually, the considerations that distinguish predatory pricing from ordinary com-
petitive pricing are motives and their associated effects. When a company sets its prices
to maximize profits without regard to the effect that sales will have on the future viability
of rivals, it is acting competitively, even if the rival suffers as a result. However, when
a company sets a lower price than it would otherwise have charged because it recog-
nizes that limiting a rival’s sales will weaken the rival as a future competitor, it is acting
anticompetitively.33 Thus, anticompetitive pricing can be defined as prices below those
that would prevail if the firm ignored any resulting impairment of rivals. Significantly,
costs do not enter into that definition. However, because motives and counterfactual
profit maximizing prices are difficult to establish in practice, predatory pricing is usually
31
See, e.g., LePage’s (“[T]‌he evidence in this case shows that Scotch brand tape is indispensable to any
retailer in the transparent tape market”). If the conduct succeeds in inducing the buyer’s cooperation,
then such a threat need never be carried out. Whether or not such threats can sustain an exclusionary
equilibrium in a theoretical model or compel cooperation in the real world depends upon parties’
beliefs. See for example Nalebuff (2005b). Thus, evidence illuminating both the beliefs of the parties and
observable efforts to influence those beliefs may be informative about whether or not (anticompetitive)
exclusion is possible.
32 The Dentsply court noted that although the arrangements between monopolist and dealer were
“technically only a series of independent sales” rather than “agreements,” “the economic elements
involved . . . realistically make the arrangements here as effective as those in written contracts.” See also
Tampa Electric (“[E]‌ven though a contract does not contain specific agreements not to use the [goods] of
a competitor, if the practical effect . . . is to prevent such use, it comes within the condition of the section
as to exclusivity” (internal quotation omitted)).
33 Ordover and Willig (1981) have proposed a definition of predatory pricing that is based on this
distinction.
defined as pricing below some cost-based threshold. We will return to its practical defi-
nition in section 1.3.1.
Companies can accomplish the same end through more complicated pricing
arrangements. One strategy, bundled pricing (or simply “bundling”), is to charge
lower prices when goods are purchased in specified combinations than when they
are bought separately. Antitrust concerns related to bundling tend to arise most often
in practice when a seller offers a discount on a good over which it has monopoly
power,34 conditional upon the customer purchasing a sufficient volume of a product
for which rivals provide close substitutes. As in the case of predatory pricing, the
seller limits a customer’s purchases from rivals by “buying” the customer’s contested
business; in this case, it compensates the buyer through the contingent discount on
the monopolized good rather than through an unconditional discount on the con-
tested good.35
For the purpose of the mechanism described in section 1.2.1, it is not actually neces-
sary for the seller to have significant market power over the good that bears the contin-
gent discount,36 inasmuch as this discount is simply a vehicle for packaging a payment
to the buyer. From the perspective of a company seeking to exclude a rival, attaching
the discount to a monopolized good is cosmetically advantageous; in that case, the dis-
counted price may be well above cost and, hence, less likely to raise suspicion of anti-
competitive predatory pricing. As we explain in section 1.3.1, any given contingent
discount is more likely to be anticompetitive if the seller monopolizes the good that
bears the discount, than if that good is provided competitively.
A seller can also use single-product pricing schemes (as opposed to the
multiple-product pricing schemes employed in bundling arrangements) to reward
buyers with lower prices and/or rebates when the volume purchased exceeds speci-
fied thresholds. As with predatory pricing and bundling, the seller limits a customer’s
purchases from rivals by “buying” the customer’s contested business, but in this case, it
compensates the buyer through a conditional discount on the contested good (e.g., with
a volume discount or “loyalty” discount), rather than through either an unconditional
discount or a conditional discount on some other good.37
34 Throughout, we use the phrase “monopoly power” to denote a high degree of market power, rather
than that held by a textbook monopolist.

35 When the seller links the discount on the monopolized good to the buyer’s purchases of the
contested good from a rival, the conduct also involves exclusionary conditions, because it renders
aspects of transactions between a company and one of its customers or suppliers effectively contingent
upon that party’s dealings with the company’s rival(s).
36 In contrast, for other mechanisms through which bundled pricing may have anticompetitive
effects, a high degree of market power over the product that bears the contingent discount is essential
(Whinston 1990).
37 Brooke Group addressed discriminatory volume discounts and market share “loyalty” discounts as
predatory pricing and examined them under a price-cost test; see Kobayashi (2005) for a discussion; see
also Greenlee and Reitman (2006); ZF Meritor addressed contracts with high share requirements and
other conditions restricting dealing with rivals without requiring a price-cost test.
Sellers can also exclude rivals through tying. Tying occurs when a company links a
monopolized product to another potentially competitive product and either sells the
products only as a package (conventional tying, or a “tie-in”) or requires that purchas-
ers of the monopolized product refrain from purchasing the competitive products of
rival firms (negative tying, or a “tie-out”). Negative tying involves an exclusionary con-
dition, but conventional tying does not. Nevertheless, a seller can still exclude rivals
through a conventional tie. Indeed, one can think of this practice as an extreme form
of bundling, where the seller sets the prices of the products at prohibitive levels if they
are purchased separately (so that the contingent discounts are extremely large). Even
so, courts have treated the two practices differently. Any tie between a monopolized
product and a competitive product is a per se antitrust violation, while a rule of reason
is applied in cases that involve bundling.38 Although a rule-of-reason analysis is bet-
ter suited conceptually for correctly sorting out the exclusionary implications of tying
than a per se standard, there is indeed a good reason to treat both forms of tying more
skeptically than practices involving less rigid links between goods, such as bundled
pricing; see section 1.3.1. In addition, tying may implicate some special anticompeti-
tive mechanisms that bundled pricing is less likely to activate (see, e.g., Carlton and
Waldman 2002).
1.3. Evaluating Exclusionary Conduct
Having elaborated on the primary economic mechanism through which exclusionary

conduct may achieve anticompetitive ends, we turn to the question of how one properly
evaluates suspect conduct. It is helpful to divide the inquiry into three stages, each of
which addresses a distinct question. First, we ask whether the conduct is, in fact, exclu-
sionary. If we find that it is, we then move to the second stage and ask whether it has anti-
competitive effects. To be clear, a finding that conduct is exclusionary does not by itself
answer the second question; it merely establishes that further inquiry is warranted. If we
find that anticompetitive effects are indeed present, we then move to the third stage, ask-
ing whether the conduct also has procompetitive effects and, if so, whether the company
could achieve those benefits through less restrictive practices. If such effects are also
present, we then weigh them against the harms to competition.
38 Jefferson Parish establishes that tying is a per se violation if the firm has sufficient market power
to compel customers of the tying good to purchase a “second, unwanted product.” Whether this
precondition, which would make the tie a per se violation, is met in practice would appear to require
a rule-of-reason analysis; the court further limited the assumption of market power based on patent
rights in Independent Ink, observing that “many tying arrangements, even those involving patents and
requirements ties, are fully consistent with a free and competitive market”; some commentators predict
that the Supreme Court is on the verge of revoking the per se status of tying arrangement entirely. See,
e.g., Werden (2009).
1.3.1. Determining Whether Conduct Is Exclusionary

Antitrust policy seeks to limit anticompetitive conduct without chilling legitimate com-
petitive activity. Where exclusion is concerned, the similarities between procompeti-
tive and anticompetitive conduct render that objective especially challenging. In some
sense, all competitive conduct involves exclusion: the losing party is excluded from
making the sales won by the prevailing party. Because exclusion of that form can moti-
vate firms to better serve consumers’ interests by lowering prices and improving quality,
it is essential to define the scope of suspect conduct much more narrowly.
The type of exclusion that occurs with plain-vanilla competition has two features
that render it innocuous. First, from the perspective of the prevailing firm, depriving
the rival of sales is an incidental consequence of winning business; it does not provide
additional motivation for prevailing over the rival beyond the benefits of making the
sales. Second, the rival is free to make additional sales to the customer over and above
those made by the prevailing firm. It is therefore appropriate to treat conduct as exclu-
sionary (in the suspect sense) only when at least one of these features is absent; that
is, either when there are good reasons to conclude that the excluding firm views the
reduction in the rival’s sales as an added benefit over and above the increase in its own
sales or when the conduct precludes or impedes the rival from making incremental
sales to the customer.
Based on these criteria, conduct involving exclusionary conditions is easily distin-
guished from plain-vanilla competition. If the objective is simply to win business, then,
conditional on doing so, there is no reason in addition to require exclusion of the rival
or otherwise seek to limit the rival’s dealings with the customer. The inclusion of such
provisions, which are secured only at a cost to the excluding firm, necessarily implies
that it views the reduction in the rival’s sales as an extra benefit. Exclusionary conditions
also go beyond the units at stake in any given negotiation—they prevent the buyer from
obtaining additional units from the rival, even when the excluding firm would not itself
meet that incremental demand (e.g., because either it has limited inventories or the rival
offers a differentiated product).
To be clear, exclusionary conditions are not necessarily anticompetitive. In some
settings, they may help firms resolve incentive problems and thereby establish more
productive business relationships, in which case their effects are at least partially pro-
competitive. However, they do not routinely arise in the course of competition on the
merits. The potentially chilling effects of subjecting exclusionary conditions to scrutiny
under the antitrust laws is therefore narrowly circumscribed and can be minimized pro-
vided that the courts carefully examine the conduct’s causes and effects, recognizing the
potential procompetitive uses of such conditions in particular circumstances. Certainly,
there is no risk of chilling straightforward price and quality competition, which are the
main engines of the competitive marketplace. Accordingly, evidence of exclusionary
conditions adequately answers the threshold question—whether the conduct is exclu-
sionary—and calls for a thorough investigation of competitive impact.
Unfortunately, if the challenged conduct does not involve exclusionary conditions,

then matters are not so clear-cut. The distinction between exclusionary and nonexclu-
sionary conduct is necessarily more subtle when the instrument of exclusion is the price
of the good in question. Conceptually, the most challenging case involves predatory
pricing. Some economists have proposed classifying a price as anticompetitive if it falls
below the level that would prevail if the seller maximized short-term profits, ignoring
effects on a rival’s future competitiveness or on the number of rivals (Ordover and Willig
1981). While such definitions are conceptually appealing from the perspective of eco-
nomic principles, they would potentially expose all forms of price cutting to routine
challenge and would preclude procompetitive, dynamic rationales for such low prices,
such as accelerated learning or penetration pricing. Such challenges could severely chill
legitimate price competition to the detriment of consumers, contrary to the intent of the
antitrust laws.
To reduce the risk of broadly chilling price competition, exclusionary pricing can be
defined more narrowly, ideally with reference to characteristics that, like exclusionary
conditions, are more distinctively anticompetitive. One widely discussed possibility is
to focus on prices that are below costs (Areeda and Hovenkamp 2008). The law and
most commentators treat such prices as presumptively exclusionary (because they pre-
vent equally efficient rivals from winning business profitably) (see Brooke Group and
Advo), and they arise in the course of legitimate competition only in relatively limited
and identifiable circumstances.39 Indeed, economic principles teach us that compe-
tition is desirable not because it drives prices downward, but rather because it pushes
them toward costs (Bernheim and Whinston 2008). From the perspective of achieving a
desirable allocation of society’s resources, prices that are too low can be just as problem-
atic as prices that are too high, even if they benefit consumers in the short term. To be
clear, evidence of below-cost pricing does not by itself establish that a seller’s conduct is
anticompetitive, but it is another cause for potential concern and, like exclusionary con-
ditions, calls for a thorough investigation of competitive impact. Consistent with this
reasoning, the Supreme Court has ruled that below-cost pricing is a necessary (but not
sufficient) condition for a finding of predation (see Brooke Group).
It is critical to emphasize, however, that as a matter of economic theory, prices above
costs can be exclusionary and anticompetitive (Ordover and Willig 1981). To illustrate,
suppose a monopolist in a differentiated product market faces competition from an
emerging rival but realizes that the rival will be weakened in subsequent rounds of com-
petition if it is denied opportunities to benefit from learning-by-doing, to raise capital at
attractive terms based on evidence of market success, and to build valuable relationships
with customers. Taking these effects into account, the monopolist would set a lower
price than it would have otherwise chosen. Its conduct is exclusionary (because its objec-
tive is not merely to win sales but also to deprive the rival of sales) and anticompetitive
39 E.g., prices below costs may be used procompetitively by a firm to promote product introductions,
to gain positions of leadership in emerging industries, to benefit from learning-by-doing, or to generate

positive externalities that increase the value of a firm’s offerings in a two-sided market.
(because it reduces subsequent competition). And yet, there is no particular reason to

think that the price it sets will be below cost.
Thus, the Supreme Court’s requirement of a price-cost test in the context of predation
is appropriate not because economic theory tells us that below-cost pricing is neces-
sary for exclusion (which it is not), but rather because extreme caution is warranted to
avoid chilling legitimate competition when price is the only instrument of exclusion.
In principle, one could apply price-cost tests to exclusive deals (and other exclusion-
ary conditions), by asking whether prices are below costs when adjusted to reflect an
(appropriately attributed) share of the payment received in exchange for exclusivity.40
However, the courts have pointedly not required such a test for exclusive dealing or
exclusionary conditions (see, e.g., Dentsply; Microsoft). The absence of such a require-
ment is appropriate. The extreme level of caution exercised in the context of predatory
pricing is excessive in the context of conduct involving exclusionary conditions because,
unlike low prices, such conduct is (1) clearly differentiated from plain-vanilla price com-
petition, and (2) a relatively uncommon consequence of routine competition, so that the
adverse effects of chilling competition by subjecting those conditions to scrutiny is rela-
tively small. In addition, when the monopolist supplies an intermediate good, exclusive
dealing or exclusionary conditions (again, unlike a low price) can harm downstream
customers immediately by blocking current sales of the rival’s products, including those
that are significantly differentiated from the monopolist’s offerings.
For bundled pricing, an analysis of exclusion is neither as clear-cut as for exclusionary
conditions, nor as challenging as for predatory pricing. A systematic pattern of link-
ing discounts on monopolized products to competitive offerings in response to a rival’s
marketing efforts is certainly more suspicious than simply charging a low price. As with
exclusionary conditions, if the object is simply to win the business, then the monopo-
list could incorporate the discount into the price of the good facing competition; there
is no obvious need to provide it in a more convoluted way through bundled pricing.
Moreover, because bundled pricing is used far less often than straightforward price
competition, subjecting it to scrutiny under the antitrust laws does not carry nearly the
same risk of chilling important forms of competition as scrutinizing low prices, par-
ticularly inasmuch as some of its other uses (e.g., facilitating price discrimination) may
also be contrary to consumers’ interests (Nalebuff 2005a). Even so, unlike exclusionary
conditions, bundled pricing can arise when exclusion is not the objective; hence, the
practice is not intrinsically exclusionary. Consequently, some additional consideration
may be required to determine whether or not bundled pricing is exclusionary within the
context of a particular factual setting.
Courts considering particular cases involving different factual circumstances have
reached different conclusions as to the showing required to establish exclusion for
40
Other commentators in this volume and elsewhere have discussed appropriate attribution of
discounts in the context of bundled pricing. Mechanically, the same principles could be employed to
compute attribution in the context of a payment for exclusivity. However, as we explain in the text, that
calculation does not provide an appropriate basis for evaluating exclusionary conditions.
bundled pricing. Most notably, within a context where bundled pricing was inter-
mingled with a broader pattern of exclusionary conduct by a monopolist (including
exclusive dealing and other exclusionary conditions), the Third Circuit in LePage’s
determined such pricing to be exclusionary, without need for a showing that effective
prices were below cost.41 In Ortho and PeaceHealth, two other courts examined bun-
dled pricing in contexts in which it constituted the principal basis for alleged exclusion.
Both courts recognized the potential for exclusion but endorsed the use of a price-cost
test to determine whether bundled pricing actually had that effect, given the facts of
those cases.
The apparently disparate precedents mentioned in the preceding paragraph are
potentially reconcilable within our framework. It is far less likely that the objective of
bundled pricing is nonexclusionary when a monopolist’s intent to exclude is appar-
ent from other intrinsically exclusive practices, as in LePage’s, than when it is not, as in
Ortho and PeaceHealth. Recalling that the argument for protecting bundled pricing is
less compelling than that for protecting plain-vanilla price-cutting, one could reason-
ably conclude that the price-cost test is excessively demanding in the circumstances of
LePage’s, but not necessarily in those of Ortho and PeaceHealth.
In section 1.2.4, we noted that bundled pricing can in principle activate an anticom-
petitive mechanism even when the good that bears the discount is not monopolized.
However, whether or not that good is monopolized affects the proper implementation
of a price-cost test. The reason is that a properly performed price-cost test attributes
contingent discounts to contested sales.42 Consider the following example: a company
produces good A at a cost of $5 per unit and good B at a cost of $10 per unit, selling good
A at a price of $10 per unit and good B at a price of $15 per unit. A customer purchases
1,000 units of good A and none of good B. Seeking to boost sales of good B, the company
offers a discount of $1 per unit on all units of good A if the customer purchases at least
100 units of good B. Under this bundled pricing scheme, the customer buys the first
100 units of good B at a net cost of $500,43 or $5 per unit, which is below cost. If good
A is monopolized, then the bundled pricing scheme fails the price-cost test: an equally
efficient rival for good B cannot win business without losing money. In contrast, if good
A is also contested, then the same scheme passes an appropriately formulated price-cost
41 See LePage’s (“3M raises various objections to the trial court’s decision but essentially its position is
a legal one: it contends that a plaintiff cannot succeed in a § 2 monopolization case unless it shows that
the conceded monopolist sold its product below cost. Because we conclude that exclusionary conduct,
such as the exclusive dealing and bundled rebates proven here, can sustain a verdict under § 2 against a
monopolist and because we find no other reversible error, we will affirm”).
42 See United Regional (“To accurately determine whether United Regional’s discounted prices are
above cost, however, the entire discount should be attributed not to the entire volume of the ‘competitive
product[s]‌,’ as suggested by the court in PeaceHealth, id. at 909, but rather to the patients that United
Regional would actually be at risk of losing if an insurer were to choose non-exclusivity (the ‘contestable
volume’)”), http://www.justice.gov/atr/cases/f267600/267653.pdf.
43 If the customer can buy 1,000 units of good A for $10,000 or 1,000 units of good A and 100 units
of good B for $10,500 (i.e., $9,000 for 1,000 units of good A and $1,500 for 100 units of good B), the net
difference is $500.
test: an equally efficient rival can match and even beat the bundled price for 1,000 units
of good A and 100 units of good B ($10,500) while still earning a profit (because the total
cost of the bundle is $6,000). Indeed, if both goods are contested, then a bundled pricing
scheme cannot fail an appropriate price-cost test unless the discounted price of at least
one of the goods is below its cost, which typically is not the case.
When the good that bears the discount is not only monopolized but also generates
large amounts of revenue, the attributed discount for the contested good can be very
large, even when the nominal discount on the monopolized good is small (as in our
example). Hence, under those conditions, there is legitimate reason for heightened con-
cern that bundled pricing schemes are exclusionary.
Single-product volume discounts are widespread, likely for legitimate procompetitive
reasons. Subjecting such discounts to scrutiny under the antitrust laws therefore runs a
risk of chilling an important and largely beneficial form of competition. For that reason,
the standard for evaluating exclusion should reflect a high level of caution, just as with
aggressive price-cutting. Once again, a price-cost test emerges as a reasonable and prac-
tical compromise.44
Some legal scholars have expressed the view that pricing schemes involving either
a single product or multiple products belonging to the same market do not raise any
antitrust concerns apart from the possibility of predatory pricing (see, e.g., Areeda and
Hovenkamp 2008). Their argument asserts that if only one product is involved, a rival
can then defeat any putative exclusionary effects of the pricing scheme by competing
to sell all of the volume (in other words, by offering a package to meet all of the buyer’s
needs). That conclusion is warranted in some circumstances, but not in others, because
it depends on critical and unstated assumptions: that the buyer is willing to purchase all
units of the single product from the rival, and that the rival is able to provide all of the
units that the buyer requires. These assumptions may be untenable. The first assump-
tion is violated, for example, when the buyer uses the single product in two or more dis-
tinct applications and the perceived suitability of the rival’s offering is low for at least one
important application.45 The second assumption is violated, for example, when the rival
is capacity constrained. In such cases, because the rival cannot offer a competing pack-
age to meet all of the buyer’s needs, single-product bundled pricing schemes, includ-
ing certain types of volume discounts, can raise the same concerns about exclusion as
bundled pricing involving multiple products.
For volume discounts, exactly as for bundled pricing, all contingent discounts are
appropriately attributed to the contested units. To illustrate, let’s suppose that a com-
pany sells its product for $10 per unit, and that a customer buys 800 units. Seeking
44
See notes 10, 21, 27 above.
45
For example, with respect to allegations that Intel excluded AMD from portions of the market for
microprocessors, the European Commission found that computer purchasers fell into two classes: those
who insisted upon purchasing Intel-based computers, and those who were open to purchasing
AMD-based alternatives; moreover, in order to remain viable, computer makers needed to carry
Intel-based computers for the first group. Decision of the European Commission (Non-confidential
version), (COMP/C-3 /37.990—Intel) at 870–71.
to boost sales, the company offers a discount of $2 per unit on the first 1,000 units if
the consumer purchases at least 1,000 units; the customer responds by purchasing
1,000 units (paying $8,000 in total). If all units sold to the customer are contestable,
an equally efficient rival could then conceivably secure the customer’s business by
charging a total of $8,000 for 1,000 units, for an average of $8 per unit. Applying the
same standard as for predatory pricing, the volume discount fails the price-cost test
if the unit cost of production is greater than $8 and passes it if the unit cost is less
than $8.
Now let’s assume that the first 600 units of the product sold to the customer are not
actually contestable. (Possibly the customer has downstream clients for whom the brand
of the input is essentially nonnegotiable.) In that case, the rival can only contest the last
400 units. Under the volume discount scheme, the customer pays $6,000 for the first
600 units and $8,000 for 1,000; therefore, incrementally, the customer pays $2,000,
or $5 per unit, when buying the last 400 units from the volume discounter. If the cost
of production is, say, $7 per unit, then this pricing arrangement fails the appropriate
price-cost test (because it precludes an equally efficient rival from winning the 400 con-
testable sales without losing money), even though it would pass the corresponding test
when evaluated as conventional predatory pricing.
One can think of conventional tying as an extreme form of bundling, where the seller
sets the prices of the products at prohibitive levels if they are purchased separately (so
that the contingent discounts are extremely large). Consequently, to determine whether
it is exclusionary, we apply the same test as for bundling.
To illustrate, suppose a seller ties two products, good A and good B, so that custom-
ers must buy an equal number of each. Our objective is to determine whether the tie
excludes a rival producer of good B. For the customer, the incremental price of obtaining
good B from the tying firm, conditional on purchasing good A, is zero, which is always
below cost. Therefore, if the tying firm monopolizes good A, then the tie automatically
fails the pertinent price-cost test. It follows that a tie between a monopolized good and a
contested good is intrinsically exclusionary. To determine whether the exclusion is anti-
competitive, one would proceed directly to the second stage of the analysis; however,
because other uses of tying are not necessarily in consumers’ interests, a per se standard
may well be justified.
Thus, even though conventional tie-ins between contestable and monopolized goods
need not involve exclusionary conditions, our framework effectively treats them as if
they do: because such tying fails the pertinent price-cost test automatically, one moves
immediately to the second stage of the analysis, just as if exclusionary conditions were
present. In practice, that same treatment is also sometimes warranted because the tie is
associated with implicit exclusionary conditions that make it costly or infeasible for the
customer to deal with a rival.
In contrast, if the tying firm does not have market power over good A, then a rival
could contest the entire bundle. In that case, we simply treat the bundle as a single prod-
uct: the inquiry into anticompetitive exclusion ends unless the bundle’s cost exceeds its
price. The fact that there is a tie raises no additional issues.
1.3.2. Determining If Exclusionary Conduct Has

Anticompetitive Effects
Exclusionary conduct is not necessarily anticompetitive; indeed, it sometimes has pro-
competitive effects. Consequently, even when conduct has been deemed exclusionary,
further investigation is required to determine whether it is in fact problematic from an
antitrust perspective.
To determine whether exclusionary conduct generates anticompetitive effects
through the mechanism discussed in section 1.2.1, one can apply a test consisting of the
following four elements:
lement 1: Diminished ability to compete

E
Element 2: Enhanced market power
Element 3: Harm to consumers
Element 4: Negative contracting externalities
We will elaborate on each of these elements in turn.
1.3.2.1. Element 1 (Diminished Ability to Compete)

Exclusion from the portion of the market targeted by the excluding firm’s conduct
must significantly impair the rival’s ability and/or incentive to compete effectively
for business other than that which the excluding firm captures directly. In other words,
the impact on the rival of the exclusionary conduct must extend beyond the loss of
the sales covered by the agreement. It is not enough that the conduct simply deprives
the rival of the sales that are captured by virtue of the conduct; after all, the customer
forgoes the opportunity to purchase those units from the rival voluntarily and can-
not be worse off as a consequence.46 However, if the rival’s ability to compete for other
sales—for example, sales at later points in time or to other customers—is substantially
impaired by conduct that precludes the rival from doing business with a customer, then
that conduct is potentially anticompetitive. Notice that this first element of the test
automatically protects firms that adopt exclusionary practices in contexts where there
is no serious risk of meaningfully weakening rivals; see section 1.4.1 for an example
involving a soft drink duopoly.
Why might exclusion substantially impair a rival’s ability and/or incentive to compete
effectively at later points in time? There are many possibilities. One effect of exclusion is
that it reduces the rival’s cash flow by limiting its ability to make profitable sales. When a
company cannot access external capital markets on attractive terms (which is often the
case for the types of firms that are the victims of exclusionary practices), limited cash
46 Even if the customer is coerced by the threat of retaliation for purchasing from a rival, the choice to
accede to the condition must be in the customer’s interest, given the threat, and the customer is no worse
off than if the seller had chosen to exercise the same negotiating power in some other way.
can constrain its investments in research and development, as well as in plant and equip-
ment, thereby undermining its ability to offer competitive products in the future. Cash
constraints can slow a company’s growth and prevent it from achieving an economically
efficient scale.47 They can prevent the company from enjoying a “cushion” against hard
times, bad luck, or even bad decisions of the sort that the monopolist, not similarly con-
strained, can weather.
Often, a company with good prospects can turn to external investors to overcome
its liquidity constraints. In practice, a greater need for external financing can increase
a rival’s cost of capital (Myers 2003). External financing can be particularly expen-
sive when insiders have much better information about the company’s prospects than
outside investors, which is often the case for newly emerging rivals (see Jensen and
Meckling 1976; Myers and Majluf 1984). The problem of asymmetric information may
be so severe that that a company’s ability to raise capital essentially vanishes (Stiglitz
and Weiss 1981). Significantly, when outside investors are unaware that the rival’s fail-
ure to generate profits results from anticompetitive exclusion (or are simply uncertain
about the existence, continuation, and/or impact of anticompetitive conduct), they
may conclude incorrectly that the company itself is at fault, that its business plan is
ill-conceived, and that its prospects are therefore poor, even if it is, in fact, positioned
to compete successfully on the merits.48 Accordingly, anticompetitive exclusion can
leave a company cash-starved, dependent on costly sources of finance, and with limited
ability to raise funds.
A second effect of exclusion is that it can prevent the rival’s product from earning
the degree of customer acceptance required to compete effectively. In some contexts,
customer interest and acceptance depend on whether the product is widely used, for
example because positive evaluations spread by word of mouth, because extensive
use establishes reliability, or because adoption by certain market leaders, or in certain
applications, confers validation. Limiting usage through exclusion (particularly selec-
tive exclusion from opinion leaders) deprives the rival of the opportunity to acquire
those competitive advantages. In other circumstances, successful product development
depends upon iterative feedback from customers, so hindering access to initial custom-
ers can inhibit future product innovation.
A third effect of exclusion is that it can prevent the rival from achieving the scale
and scope necessary to compete effectively. For example, in industries where firms
47 A leading treatise explains, “A set of strategically planned exclusive dealing contracts may slow the
rival’s expansion by requiring it to develop alternative outlets for its products or rely at least temporarily
on inferior or more expensive outlets. Consumer injury results from the delay that the dominant firm
imposes on the smaller rival’s growth.” (Dentsply at 191, quoting Hovenkamp 2002). The Dentsply court
found that the monopolist’s exclusionary conditions “help[ed] keep sales of competing teeth below the
critical level necessary for any rival to pose a real threat to Dentsply’s market share,” making them “a solid
pillar of harm to competition.”
48 In this way, anticompetitive exclusion can create a “signal jamming” problem. See Fudenberg and
Tirole (1986); see also Dentsply (recognizing that the monopolist’s conduct could create the impression
that the rivals were ineffective: “The apparent lack of aggressiveness by competitors is not a matter of
apathy, but a reflection of the effectiveness of [the monopolist’s] exclusionary policy”).
achieve significant cost reductions and/or insights into product development through
learning-by-doing, exclusion can significantly reduce the future competitive threat
posed by a rival.
A few clarifying remarks are in order concerning the extent of foreclosure required
to satisfy the first element of the test. As the courts have recognized, exclusion may be
problematic from an antitrust perspective even if the rival is not foreclosed from the
entire market.49 The pertinent question is whether the overall scope of exclusion is mate-
rial, in the sense that it is sufficiently widespread to meaningfully weaken the rival or
otherwise prevent the rival from effectively competing for other business. In assessing
materiality, the following considerations come into play.
First, the scope of exclusion may be material even if the conduct does not entirely
prevent the rival from selling to any particular buyer. All else equal, a condition that
explicitly or effectively excludes a rival from all of the business served by a customer who
purchases 90 units may have the same impact on the rival, and, hence, on competition
and consumers, as an exclusionary agreement covering 90% of the business served by a
customer who purchases 100 units, or one covering half of the business served by a cus-
tomer who purchases 180 units. Complete exclusion from any particular buyer may not
be needed to reduce the rival’s ability to compete (see, e.g., Dentsply; LePage’s; Microsoft).
Second, one must judge the materiality of a company’s exclusionary conduct as a
whole, not episode by episode.50 Neither is it sufficient to judge the effect of all episodes
of a particular type of conduct or exclusionary condition without taking into account all
of the other forms of exclusionary conduct. In the extreme, individual episodes or col-
lections of episodes may each inflict only a little damage on the rival, and yet the overall
pattern of conduct may have a substantial effect on the rival’s ability to compete. Any
analysis that attempts to evaluate component parts of the conduct independently, rather
than assess the totality of the effect, is inevitably biased against a finding of anticompeti-
tive impact, which necessarily depends upon all facets of an exclusionary agenda.
Third, a restriction on the channels through which a rival’s product is distributed, includ-
ing exclusion from important or uniquely positioned downstream firms, can be material in
and of itself, even if other routes to the customer remain, and even if the scope of that exclu-
sion is somewhat limited relative to the entire market. For example, the adoption and pro-
motion of a product by an influential set of downstream firms may validate a rival’s product
in the minds of consumers; consequently, exclusion from one or more of those firms can
materially weaken the rival by depriving its products of validation. As the Third Circuit
49
“The test is not total foreclosure, but whether the challenged practices bar a substantial number of
rivals or severely restrict the market’s ambit” (Dentsply).
50 See, e.g., Continental Ore (“The character and effect of a conspiracy are not to be judged by
dismembering it and viewing its separate parts, but only by looking at it as a whole; and in a case like
the one before us, the duty of the jury was to look at the whole picture and not merely at the individual
figures in it” (internal citations and quotation omitted)); LePage’s (“The relevant inquiry is the
anticompetitive effect of [the defendant’s] exclusionary practices considered together”); Anaheim (“[I]‌t
would not be proper to focus on specific individual acts of an accused monopolist while refusing to
consider their overall combined effect”).
concluded in Dentsply, the “realities of the marketplace” may make the foreclosed channel
much more valuable and significant than those channels that remain available.51
Fourth, one must also judge the materiality of a company’s exclusionary conduct relative
to the portion of the market that is, in principle, open to the rival at a given point in time,
absent artificial barriers. For example, customers may differ in their willingness to purchase
products that are less familiar to them or less familiar to those on whom they rely for advice.
To earn potential acceptance with such customers, an upstart rival might first have to make
significant inroads among those who are less wedded to established products. Artificial
exclusion from 20% of the total market might not be sufficiently material to meaningfully
weaken the rival if it implies that the rival can legitimately compete for the other 80% of a suf-
ficiently large market. However, the same foreclosure looms much larger if the rival’s product
is not yet sufficiently well established to gain acceptance with a large portion of the market.
Suppose, for example, that 50% of consumers in the overall market are committed to pur-
chasing the more familiar brand and will remain so until the rival is much better established.
In that case, the same exclusion from 20% of the total market limits the rival to competing
for a residual 30% slice of the market, rather than 80%, in which case the exclusion may
well be material. To put the matter another way, in this example, exclusion from 20% of the
market leaves the rival effectively excluded from 70% of total sales. If those customers from
whom the rival is excluded are particularly influential in winning over other customers (e.g.,
because they are opinion leaders), then the effect of the exclusion can be compounded.
Fifth, the duration of the exclusionary conduct also bears on materiality. If the conduct
is brief, then the effect on the rival will presumably be small. However, in evaluating dura-
tion, it is important to avoid confusing the duration of the conduct with the contractual
duration of any particular exclusionary agreement. As we noted in section 1.2.1, the latter
consideration does not necessarily play an essential role in what we take to be the anticom-
petitive mechanism of greatest practical concern.52 As long as negative contracting exter-
nalities exist at short durations (Element 4, discussed later), the same analysis potentially
applies, and exclusion over long time periods can be achieved by stringing together suc-
cessive short-term agreements. Consistent with this economic logic, agreements imposing
exclusivity can be anticompetitive even if the contracts are terminable at will.53
51 The Dentsply court rejected the argument that vendors of artificial teeth had a “viable” method of
distribution in the form of direct sales when they were foreclosed from the dealer network.
52 The contractual duration of exclusionary agreements may, however, be relevant in other settings,
where other anticompetitive mechanisms are implicated. E.g., some theories of exclusive dealing
require that exclusion directly limits the achievable future sales the rival can make as a result of current
investments. Either the agreements must span a period of time that starts before the investment and
includes the resulting sales, or exclusive contracts with different customers must cover overlapping time
periods that collectively bridge the same time period. See, e.g., Rasmusen, Ramseyer, and Wiley (1991);
Segal and Whinston (2000).
53 See Dentsply (“Although the parties to the sales transactions consider the exclusionary
arrangements to be agreements, they are technically only a series of independent sales. Dentsply sells
teeth to the dealers on an individual transaction basis and essentially the arrangement is ‘at-will.’
Nevertheless, the economic elements involved—the large share of the market held by Dentsply and its
conduct excluding competing manufacturers—realistically make the arrangements here as effective as
those in written contracts”).
1.3.2.2. Element 2 (Enhanced Market Power)

The conduct must increase, extend, or maintain market power. The excluding firm
must start out with market power and, once the rival is weakened, have greater mar-
ket power than it would otherwise possess. The purpose of this element of the test
is to distinguish harm to competition from mere harm to the rival. Antitrust laws
protect competition, not competitors. If, for example, a rival harmed by exclusionary
conduct is simply replaced by yet another equally capable competitor, then competi-
tion is not diminished. The existence of significant entry barriers is, therefore, gen-
erally a necessary but not sufficient condition for enhanced market power. Notably,
this element automatically and appropriately protects conduct by firms that neither
have nor verge upon monopoly power.54 Even among those firms with substantial
market power, only conduct that demonstrably increases or maintains that power
raises concerns.
1.3.2.3. Element 3 (Harm to Consumers)

The conduct must cause harm to consumers, whom the antitrust laws are designed to
protect. When the conduct enhances the excluding firm’s market power (as Element 2
of the test requires), harm to consumers is usually ensured: consumers will pay higher
prices and potentially forgo other benefits of competition, such as improved variety and
innovation. However, because it is often necessary to weigh the anticompetitive effects
of exclusionary conduct against procompetitive effects, it is not enough simply to estab-
lish the existence of harm; it is also important to assess its magnitude.
Measuring the degree to which exclusionary practices impair a rival, reduce competi-
tion, and raise prices can prove challenging. An alternative approach is to evaluate the
magnitude of gains that consumers have derived from a rival’s past competitive activi-
ties. Estimates of those gains provide indicators of the economic benefits that the con-
duct places at risk.
When measuring harm to consumers, it is also important to recall that some forms of
exclusionary conduct (specifically, exclusionary conditions) are designed to suppress
sales beyond those that the excluding firm captures. That outcome is particularly likely
in industries with differentiated products. When weighing anticompetitive and pro-
competitive effects, one should include the lost economic value associated with those
suppressed sales. Measuring those losses can be more straightforward than quantifying
the lost consumer benefits associated with reductions in future competition.
As long as the first three elements are present, exclusion of the rival from a portion
of the market during one period of time reduces competition and allows the excluding
firm to extract greater rents from buyers in other markets or at future points in time.
However, unless a fourth condition is also present, the exclusion is not necessarily
anticompetitive.
54 Thus, it is appropriate to treat the absence of market power as a “safe harbor” for the use of vertical
practices with potentially exclusionary effects. That said, it is also important to bear in mind that firms
may collectively wield significant market power through explicit or tacit collusion.
1.3.2.4. Element 4 (Negative Contracting Externalities)

By diminishing the rival’s ability to compete, the exclusionary conduct must give rise to
negative contracting externalities, reflecting more effective expropriation of economic
benefits from other parties, from which the parties to an exclusive arrangement can
jointly benefit. As we explained in section 1.2.1, such externalities are typically present
when the rival potentially serves many customers, either in the same market or differ-
ent markets,55 especially when a portion of the benefits of competition would be passed
along to downstream parties, such as final customers. Thus, evaluating this fourth ele-
ment of the test is usually straightforward. However, as we emphasized in section 1.2.1,
the issue involves some subtleties. For example, negative contracting externalities borne
only by the rival, or by downstream consumers served by a single customer, typically do
not sustain anticompetitive exclusionary conduct, because they usually do not reflect
more effective expropriation of economic benefits by the parties to the exclusionary
agreement.
It is worth emphasizing that, in the presence of negative contracting externalities,
evidence that certain customers eagerly agreed to or even sought out an exclusion-
ary relationship with the seller sheds no light on the question of whether the conduct
is anticompetitive. Considered in isolation, each deal between the seller and a buyer
is necessarily mutually beneficial, even accounting for its subsequent impact on com-
petition. However, such deals may harm other parties (especially other buyers and/or
downstream consumers) who are not part of the deal. Consequently, every buyer might
be better off if no deals were consummated; nevertheless, recognizing the potential for
mutual bilateral benefit, each buyer has a strong individual incentive to enter an exclu-
sionary arrangement, and even to seek it out.
This four-part test is generally consistent with the approach to predatory pricing
adopted by the US Supreme Court. Specifically, a competitor may be held liable under
the antitrust laws for setting prices below costs if there is a sufficient probability of
recouping, through subsequent monopoly profits, more than the losses sustained (see
Brooke Group; Matsushita). Elements 1–3 ensure that the seller benefits from greater
monopoly profits as a consequence of exclusion. Those benefits will exceed the cost of
securing the participation of customers only if Element 4 is also present.
While it is possible that exclusionary conduct could be anticompetitive without meet-
ing this four-part test through some other mechanism, when considering such possibili-
ties, it is important to avoid common fallacies. For example, it is sometimes alleged that
loyalty discounts permit a dominant firm facing limited competition to earn monopoly
profits instantly by denying rivals access to customers.56 The following simple example
illustrates the idea. A single customer buys five units of a good from a monopolist at a
price of $200 per unit. A new entrant arrives on the scene, possessing an ability (in the
55 Anticompetitive effects can arise if the excluding firm and the rival compete in “noncoincident
markets.” See Bernheim and Whinston (1999).

56 See, e.g., Jacobsen (2010), who quotes testimony to this effect by Einer Elhauge.
near term) to supply one unit. Both produce the good at a cost of $100 per unit. To defeat
the entrant’s threat, the monopolist increases its price to $250 per unit but offers a dis-
count of $50 per unit if the customer buys five. Faced with a choice between buying four
units from the monopolist at a total cost of $1,000 or four units from the monopolist at a
total cost of $1,000 plus a fifth unit from the rival at any positive price, the customer will
clearly buy all five units from the monopolist. According to the argument, the entrant is
foreclosed, and the dominant firm continues to charge the monopoly price for all five
units.
There is, however, a fly in the ointment, because the argument ignores an important
possibility: facing these terms, the customer might choose to buy one unit from the rival
and nothing from the dominant firm. Implicitly, the example assumes that the custom-
er’s marginal benefit from consuming the good is $200 per unit for the first five units,
and less thereafter.57 Let’s suppose that the rival sets the price of a single unit equal to its
cost. Then the consumer’s net benefit from buying five units under the loyalty discount
program is zero, while his net benefit from buying a single unit from the rival is $100.
The second option is clearly better than the first. Because the dominant firm must leave
the customer with a net benefit of at least $100 (lest the customer decide to deal only
with the rival), it cannot improve on the profits it receives when offering the first four
units at a price of $200 and a fifth unit at a price of $100, matching (rather than exclud-
ing) the rival.
1.4. Determining If Exclusionary

Conditions Are Procompetitive
If conduct is found to be both exclusionary in the first stage of the inquiry and to have
anticompetitive effects in the second, we then move to the third stage: determin-
ing whether the conduct also has procompetitive effects, and weighing those effects
against the costs of reduced competition. The scholarly literature identifies a number
of potential procompetitive rationales for exclusionary practices (see, e.g., Marvel 1982;
Bernheim and Whinston 1998, section V). Generally, these rationales proceed from
the premise that, because written contracts are imperfect, the conflicting interests of
any given buyer and seller can cause their relationship to operate inefficiently. In some
57
Because the example involves loyalty discounts, it plainly assumes that the monopolist can employ
nonlinear price schedules. If the consumer’s marginal benefit differed over the first five units, then a
monopolist would generally earn higher profits by using a nonlinear price schedule, rather than by
setting a fixed price. See Oi (1971); Maskin and Riley (1984). Thus, the premise that the monopolist
charges a fixed price of $200 in the rival’s absence implies that the consumer’s marginal benefit is the
same over the first five units. That benefit cannot be less than $200 per unit or the consumer would buy
nothing; it cannot be greater than $200 per unit or the monopolist would raise its price.
circumstances, those inefficiencies may be reduced when the relationship excludes

other sellers, other buyers, or both.
As an example, suppose that a manufacturer’s sales depend heavily on its reputation
with customers, and that the point of contact with customers is a sales-and-service orga-
nization (which we will call the “rep” for short). If the relationship between the manu-
facturer and the rep is nonexclusive, the rep can then potentially expropriate some of
the benefits generated by the manufacturer’s investments in product promotion and/
or quality. First, the rep can divert customers at the point of sale to other products
from which it receives greater profits, even if the customers come to the rep seeking the
manufacturer’s product because of the latter’s investments. Second, if the manufacturer
invests in quality improvements, customers may then misattribute part of the incremen-
tal value they receive to the quality of service and repairs provided by the rep, which
again allows the rep to benefit by selling competing products. Anticipating these out-
comes, the manufacturer may underinvest or choose not to make any investments in the
first place. Designing a nonexclusive contract that overcomes these problems can prove
difficult. For example, as a matter of principle, one potential solution is to shift responsi-
bility for the pertinent investments to the rep. But in practice, an agreement cannot call
upon the rep to make investments in product quality on the behalf of a manufacturer,
and in any event, conflicting incentivization by multiple manufacturers can produce
inefficient outcomes (see Bernheim and Whinston 1998, section V). Thus, exclusivity
can emerge as a more efficient solution. Automobile dealerships and prestige goods
retailers are often cited as exemplifying this motive for exclusivity.
The procompetitive and anticompetitive rationales for exclusion share a common
characteristic: they all presuppose the existence of market imperfections that prevent
collections of parties from achieving mutually efficient outcomes through contracts. In
a Coasian world with perfectly efficient contracts, there would be no contracting exter-
nalities. Any exclusionary relationship that inefficiently reduced a market’s total contri-
bution to economic value by increasing some party’s market power would be avoided;
the parties would instead collectively opt for a more efficient alternative, along with a
distribution of benefits that would leave all of them better off. Consequently, anticom-
petitive exclusion would not occur. Similarly, the agreements reached by buyers and sell-
ers would be sufficiently comprehensive to preclude opportunism. Because there would
be no incentive problems to remedy, procompetitive exclusion would not be necessary.
Significantly, procompetitive and anticompetitive exclusion reflect different types of
contracting failures. Procompetitive exclusion occurs when contracting imperfections
afflict the relationship between a buyer and a seller; in that case, exclusion provides a
partial solution to the contracting problem. In contrast, anticompetitive exclusion
occurs when contracting imperfections afflict the relationships between multiple parties
on the same side of the exclusionary relationship (e.g., several buyers, and potentially
customers who are downstream from those buyers). In that case, a party on the oppo-
site side of the relationship (e.g., a seller) takes advantage of the afflicted parties’ lack of
coordination and conjures its business relationships to extract a larger share of the total
pie. Thus, determining whether exclusionary conduct is pro- or anticompetitive always
requires an examination of the types of market imperfections and associated contract-

ing failures that lead to exclusion.
When evaluating procompetitive explanations for exclusionary conduct, it is impor-
tant to be wary of ex post rationalizations. The mere fact that an economist can concoct
a logically coherent rationalization consistent with the details of a case does not mean
that the rationalization is correct. Unlike a company seeking anticompetitive ends, one
engaging in procompetitive exclusion has no reason to disguise its objectives. Thus, when
the objective is procompetitive, one expects to find contemporaneous documents that
describe the problem and characterize the conduct as an attractive solution.58 Exchanges
between the buyer and seller may be particularly informative concerning the nature of
the contracting problem (if any).59 However, it is also important to keep in mind that a
strategically savvy company can defensively conjure a helpful paper trail. Therefore,
courts should not automatically lend credence to such evidence when it is uncovered.
When conduct yields both anticompetitive and procompetitive effects, one must
weigh one against the other. In the previous subsection, we emphasized the impor-
tance of quantifying the harm borne by consumers; the need to quantify procom-
petitive benefits is no less important, and the same standard of proof should apply.
Consistent with the antitrust laws, the focus should once again be on benefits to con-
sumers. Furthermore, it is generally not appropriate to measure those benefits by com-
paring market outcomes with and without the conduct. Rather, the proper approach
is to compare the market outcome with the conduct to the outcome with the most effi-
cient nonexclusionary alternative solution to the contracting problem that the conduct
addresses. Consider the following simple example: without the conduct, consumers
would gain $100 million in value from increased competition but lose $150 million in
value due to the consequences of worsened incentive problems between buyers and
sellers; however, were buyers and sellers to adopt a less efficient, nonexclusive solution
for the incentive problems, the losses would be $50 million rather than $150 million.
In that case, it is appropriate to compare the $100 million gain with the $50 mil-
lion loss, not the $150 million loss, and to conclude that the conduct is, on balance,
anticompetitive.
1.4.1. Some Illustrative Examples

To illustrate the application of our framework, we will briefly describe two contrast-
ing examples. In the first, a dominant supplier of false teeth demands (and receives)
exclusive deals with most of its large distributors. The resulting exclusion prevents a
58 That said, if the genesis of the conduct predates the available records, then the absence of more
recent documents that continue to reference the problem may or may not be surprising, depending on
the facts of the case.
59 The absence of such discussion does not imply that the restrictions are anticompetitive, as their
necessity may be obvious to both parties, or at least to the party proposing the contract.
smaller rival from gaining access to a substantial and important portion of the market.
As a result, the rival loses not only the immediate sales denied to it by the exclusion-
ary conduct but also future sales that it would gain from customers who, but for the
exclusivity, might have made introductory or exploratory purchases leading to larger
future contracts. The rival is denied both the opportunity to establish its reputation
with those end customers and also the scale that would support a more extensive and
effective marketing and distribution operation. As a consequence, the rival is weaker
in the future, and the dominant firm gains not only from its current sales but also from
reduced competition for future sales. There is no contracting failure that calls for exclu-
sivity between the distributor and supplier. The harms resulting from reduced future
competition are divided among distributors (both those that entered into exclusive
deals and those that did not), as well as consumers, who cannot efficiently coordinate
their actions to forestall the dominant firm’s opportunism. Here, the conduct is plainly
anticompetitive.
In the second example, the owner of a sports stadium or a fast-food franchise has
a limited degree of monopsony power with respect to soft drinks that it resells on its
premises.60 Practical considerations, such as space constraints at food-vending sta-
tions, rule out offering highly similar products (i.e., both Coke and Pepsi, both Sprite
and 7UP, and so forth). The establishment owner therefore requires the Coca-Cola
Company and PepsiCo to compete for the right to be the establishment’s exclusive sup-
plier of soft drinks. It is difficult to imagine that the Coca-Cola Company would notice-
ably impair the future competitiveness of PepsiCo by entering into such an agreement
with the establishment owner or that PepsiCo would noticeably impair the Coca-Cola
Company.61 Each enters into exclusive arrangements with similar types of establish-
ments, and both distribute their products through a wide array of unaffected channels,
such as grocery stores, convenience stores, and vending machines. Accordingly, in this
example, the conduct is procompetitive.
1.5. Concluding Remarks
The framework for analyzing the competitive effects of exclusionary conduct pro-
posed in this chapter does not aspire to an unachievable ideal. Rather, it reflects a
60
While this hypothetical example involves exclusivity at the venue or chain, another case, PepsiCo,
Inc. v. Coca-Cola Co., addressed a similar question involving soft drink exclusivity at the distribution
level. There, too, the court found no evidence of an anticompetitive effect.
61 Some customers might have sufficiently strong preferences to go without a soft drink entirely rather
than purchase the exclusively provided alternative, but in the present example, this would not result in a
material reduction in the rival’s ability to compete for other sales. Competition in the soft drink market
remains robust, even under exclusivity. More generally, however, such arrangements could adversely
affect competition, depending on the fact pattern. E.g., if exclusive arrangements are sufficiently
widespread, then they could adversely affect the viability of an upstart soft drink manufacturer.
combination of both sound economic principles and reasonable, practical compro-

mises. We have made those compromises, where possible, to favor simplicity, clarity
(in terms of what is and is not permitted), and predictability (with respect to the out-
come of an informed inquiry).
It is also worth emphasizing that the framework is reasonably conservative. For exam-
ple, the requirements for establishing the presence of anticompetitive effects in stage 2
of the inquiry resemble those that are currently applied in cases of predatory pricing
(once below-cost pricing is established); to our knowledge, relatively few commentators
have claimed that the standards for establishing predation are too lax. A conservative
approach is, in our view, preferable to one that favors a wider range of challenges and,
thereby, risks chilling beneficial competition.
Contrary to our objective of achieving clarity, we have intentionally left portions of
the analytic framework somewhat vague—for example, the appropriate measure of cost
to apply when evaluating whether bundled pricing is exclusionary, given any particular
fact pattern. In such instances, the appropriate details depend on subjective judgments
concerning social costs and benefits, and consequently are more appropriately left to
policymakers and the courts; our framework usefully clarifies the pertinent tradeoffs.
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CHAPTER 2
P R E DATO RY P R IC I N G
KENNETH G. ELZINGA AND DAVID E. MILLS
Given the enormous stake that antitrust has in low prices, and our extraor-
dinary difficulties assessing predation claims, the best course is to develop
predation rules that are both simple and somewhat underdeterrent.
Herbert Hovenkamp (2005, p. 161)
2.1. Introduction
Predatory pricing occurs when a dominant firm, motivated by the prospect of charg-
ing high prices in the future, uses temporary, low prices to drive its competitors out of
business. Economists have long recognized that “underselling for predatory purposes”
can harm competition and reduce consumer welfare (Giddings, 1887, p. 77). Indeed anti-
trust enforcement in the United States cut its teeth on claims that predatory pricing vio-
lated the Sherman Act.1 It was not until McGee (1958) mounted a serious challenge to
the canonical predatory pricing story that economists and legal scholars began to exam-
ine this pricing phenomenon carefully.
McGee disputed whether a profit-seeking dominant firm would ever launch a preda-
tory pricing campaign against a rival. His challenge provoked two important reactions.
The first was judicial skepticism about the plausibility of predatory pricing claims that
earlier courts did not have. This development spawned a debate about the proper test or
criterion to apply in predatory pricing cases, a debate that is not yet resolved to every-
body’s satisfaction. The second reaction was a flood of activity on the part of economic
theorists who were skeptical about McGee’s hypothesis that predatory pricing would
1 The US Supreme Court’s landmark opinions are Standard Oil and American Tobacco. Allegations of
predatory pricing actually precede the US antitrust laws. Mogul Steamship is an English tort law case that
involved claims of below-cost pricing to destroy ocean-shipping competition.
Predatory Pricing 41
rarely be a successful monopolizing strategy. This research program used game theory
to identify conditions that would circumvent McGee’s objections and proposed inter-
nally consistent economic theories of predatory pricing.
The search for a compelling antitrust test to evaluate predatory pricing claims is an
exercise in balancing false positive against false negative judicial outcomes. How this
balance is made depends in large part on whether one thinks aggressive low-price epi-
sodes typically are about ejecting rivals or generally reflect vigorous competition among
rivals.2 These priors are shaped and informed (an economist hopes) by what economic
theory has to say about the plausibility of predatory pricing.
This chapter summarizes both of these post-McGee endeavors: the search for cred-
ible economic theories of predatory pricing that can identify those pricing episodes that
warrant antitrust sanction, and the search for an optimal predatory pricing rule for use
in antitrust enforcement.
In its 1993 decision in Brooke Group, the US Supreme Court developed standards
for establishing liability in predatory pricing cases. The Antitrust Modernization
Commission commended these standards for being “clear and predictable in applica-
tion and administrable” (2007, p. 89). While Brooke Group has proved too cautious for
some economists and antitrust scholars who favor more judicial intervention, the cau-
tion built into the Brooke Group standards reflects the Court’s concern with false posi-
tives and shows the Court’s determination not to let antitrust get in the way of aggressive
price competition.3 This chapter shares the Court’s caution and concurs with its embrace
of the Brooke Group standards for conventional predatory pricing claims.
2.2. The Economics of Predatory

Pricing
The practice of predatory pricing traditionally is identified with pricing below cost. In
her influential history of the Standard Oil Company, Tarbell wrote that a firm threatens
“predatory competition” when it sets out ruthlessly and persistently “to sell at cost or
less, until the rival is worn out” (1904, p. 60). Not long after, Clark declared that “preda-
tory competition differ[ed] from ordinary competition in that producers who have the
. . . most influence on the market . . . do not stop lowering prices at a point which covers
all costs, . . . but go below this level” (1926, p. 131).
The presumed intention of predatory pricing is to eliminate rivals, whether by forc-
ing them out of the market or by acquiring them on advantageous terms, and thereby to
2
A false positive concludes that predation has occurred when it did not. A false negative concludes
that there is no predatory pricing when in fact there is.
3 The foundation for this caution was laid earlier in the Court’s opinion in Matsushita: “predatory
pricing schemes are rarely tried, and even more rarely successful” (p. 589).
42 Kenneth G. Elzinga and David E. Mills
establish or maintain monopoly power that will yield supracompetitive profits for the
predator. Ordover and Willig (1981) defined a predatory practice as one that is profitable
only because it induces the exit of a competitor.
While the elimination of rivals was the first recognized consequence of predatory
behavior, economists have since classified pricing strategies with other goals such as
deterring entry or disciplining rivals to be predatory as well.4 Strategies that deter entry
or discipline rivals have adverse effects on consumer welfare, of course, and are the
proper concern of antitrust policy. But the focus in this chapter is on pricing behavior
that reduces consumer welfare because it induces exit as a monopolizing strategy. In the
most common scenario, a predator charges prices below cost and willingly sacrifices
profits so it can inflict an unsustainable loss on a competitor, often a new entrant. The
predator supposedly is able to withstand the losses that accompany below-cost pricing
better than its target because it is much larger and has a “long purse.”5 Once the competi-
tor exits the market, the predator raises its prices and recovers the lost profits.
The general notion that a dominant firm might establish or strengthen a monopoly
position by waging a price war against a smaller competitor was widely accepted at the
time the US antitrust laws were enacted. It was not until McGee (1958) revisited Standard
Oil, and raised objections to the prevailing interpretation of that important case, that the
strategy of predatory pricing was submitted to careful economic analysis.
McGee concluded that Standard Oil did not use predatory pricing to drive out its
competitors, as was widely assumed, and in the course of his argument offered several
reasons for doubting the plausibility of predatory pricing in general.6 He argued that,
as compared to a small competitor, a predator with a large market share would suffer a
disproportionate loss from below-cost prices—a loss that the small competitor would be
able to amplify by curtailing its own unremunerative sales. Realizing this, the competi-
tor would remain in the market and wait for the predator to capitulate. Anticipating this
futile sequence of events, the dominant firm would never resort to predatory pricing.
McGee also questioned whether a “long purse” (or what is sometimes called a “deep
pocket”) would confer an advantage to a prospective predator. He reasoned that a small
firm with limited financial resources would have access to creditors willing to sustain
the firm through a siege of low prices because the creditors would understand that this
access would convince a predator to abandon the siege. Even if a predator succeeded in
driving a small competitor out of the market, the availability of durable equipment and
4 For instance, Joskow and Klevorick write that “[p]‌redatory pricing behavior involves a reduction
of price in the short run so as to drive competing firms out of the market or to discourage entry of new
firms in an effort to gain larger profits via higher prices in the long run” (1979, pp. 219–20). Milgrom
and Roberts define predatory pricing as “the temporary charging of particularly low prices in order to
improve long-run profitability by inducing exit, deterring entry, or ‘disciplining’ rivals into accepting
relatively small market shares” (1990, p. 112).
5 When a large firm “finds itself matching expenditures or losses, dollar for dollar, with a substantially
smaller firm, the length of its purse assures it of victory” (Edwards, 1955, p. 334).
6 While acknowledging the “extraordinary influence” of McGee’s analysis of Standard Oil, Dalton and
Esposito offer an alternative interpretation of events (2011, p. 245).

specialized human capital released by the failed competitor would facilitate subsequent
entry or reentry. Consequently, the predator’s gains from driving the competitor from
the market would be short-lived. This, according to McGee, would make predatory pric-
ing a costly and futile undertaking. Finally, McGee argued it would be more profitable
for a prospective predator to achieve a monopoly position by acquiring its bothersome
competitors instead of waging a costly price war to drive them out of business.7
One consequence of McGee’s spadework in the Standard Oil record was to raise sus-
picion about the merits of other alleged instances of predatory pricing. Elzinga (1970)
examined the record of an early case in which US explosives manufacturers were
accused of using predatory pricing tactics, and found no evidence that they had. Koller
(1971) examined twenty-three cases in which defendants were convicted of predatory
pricing and found little evidence of below-cost pricing and even less evidence that
below-cost pricing tactics were directed at the elimination of a rival. When Adelman
deconstructed the antitrust case against A&P, he found that “[t]‌here is not a single
instance in the record of the sequence: lower prices—fewer competitors—higher prices
again,” notwithstanding the government’s successful prosecution of the once prominent
food retailer (1959, p. 373).8
Another consequence of McGee’s paper was to arouse interest in the economic the-
ory of predatory pricing and stimulate critical commentary on the thesis that successful
predatory pricing would be rare and unlikely. These criticisms have led to qualifications
and refinements of the theory of predatory pricing.9 For instance, McGee’s argument
about the threat of reentry requires that the fixed costs of entry or reentry are small, or if
they are large they must not be sunk. Yamey (1972) countered McGee’s reentry argument
by contending that episodic predatory pricing might enable a predator to discourage
reentry by cultivating a “predatory” reputation, an insight that frequently reappears in
subsequent analyses of predatory pricing.
To counter the fault McGee found with the long-purse story, it was necessary to
explain why a small competitor might not have access to sufficient financial resources to
withstand a siege of below-cost pricing by a predator with substantial financial resources
(Telser, 1966). One such explanation holds that the smaller competitor’s access to capital
markets is limited by asymmetric information prevalent in these markets.
McGee’s claim that predatory pricing is a less profitable monopolization strategy than
acquiring one’s competitors does not mean that a dominant firm bent on eliminating
its competitors would always reject predatory pricing. Acquiring competitors became
7
Two years before McGee’s seminal article, Leeman expressed skepticism that Rockefeller used
predatory pricing as a monopolizing tactic and argued that “localized price cutting” by a large incumbent
was unlikely to thwart new entry (1956, p. 332). He considered whether a dominant firm might use
predatory pricing to “soften up” smaller rivals in order to acquire them at fire-sale prices, but concluded
that price wars are “a very costly method of preserving a dominant position and that probably in most
cases in the long run the costs are prohibitive” (1956, p. 330).
8 Adelman’s extensive analysis of the A&P case actually preceded McGee’s article.
9 Ordover and Saloner (1989) and, more recently, Motta (2004) provide summaries of the
counterarguments.
more difficult in the years after McGee made this claim because federal antimerger
enforcement became more stringent. Also, predatory pricing and horizontal mergers
are not necessarily alternative monopolizing strategies. A dominant firm might use
predatory pricing to discourage a competitor and thereby reduce the firm’s acquisition
price (Telser, 1966; Yamey, 1972). Burns’s (1986) investigation of American Tobacco’s
acquisition of over forty small, geographically separated competitors at the turn of the
20th century found that the terms of sale for these buyouts were depressed by price wars
instigated by American Tobacco.10
Countering McGee’s skepticism about predatory pricing launched a search for
more complete and internally consistent theories of predation, a project that coin-
cided with the ascension of game theory within the economics profession. This search
led away from case study narratives about predation and to the identification of the-
oretical conditions that would uphold predatory pricing as an equilibrium strategy.
A characteristic generally shared by the reformulated theories of predatory pricing is
that incomplete information handicaps firms that are the victims of predatory pric-
ing. A predator exploits this handicap to raise the competitor’s doubts about the ratio-
nale behind the predator’s low prices and hence raise doubts about the competitor’s
prospects for success in the market. The predator raises these doubts to persuade the
victim to withdraw from the market (or persuade potential entrants to refrain from
entering).
Ordover and Saloner (1989) summarized the theories of predatory pric-
ing that emerged in reaction to McGee’s critique, and assigned them to three cat-
egories: multiple-market reputation theories, signaling theories, and reconstituted
long-purse theories. Exploring the theory of predatory pricing attracted a talented
group of economic theorists, and an expansive literature on the subject appeared follow-
ing Selten’s (1978) influential demonstration of the chain store paradox. This is not the
place to give a full account of these theories, but a few prominent examples are indica-
tive of the literature.
McGee argued that the losses a predator would experience in a predatory pricing epi-
sode would be too great to recoup even if the targeted competitor is driven out of the
market. But if the predator operates in multiple markets in which it faces the prospect
of new entry, the payoff from driving a new entrant out of one market with below-cost
prices may come from other markets where new entry is deterred. If new or prospec-
tive entrants have incomplete information about the predator’s costs, they are uncer-
tain whether the predator’s low, postentry prices are below the predator’s own costs (and
hence unsustainable for the predator in the long run) or above the predator’s costs due to
the firm’s efficiency (and hence sustainable over time). Kreps and Wilson (1982) showed
that a multimarket monopolist facing poorly informed potential entrants in a succes-
sion of markets may find it profitable to respond to one or several early entrants with
10 Genesove and Mullin examined the pricing behavior of the American Sugar Refining Company at
roughly the same period and concluded that the firm used below-cost pricing “to lower the acquisition
price of entrants and small incumbents” (2006, p. 67).
below-cost prices to establish a reputation for being more efficient than it really is. The
payoff to the predator then comes from the entry-deterring effect this reputation has on
subsequent prospective entrants. The loss the predator incurs in a “demonstration” mar-
ket becomes an investment that pays off in other markets.
Signaling theories of predatory pricing incorporate a similar informational asym-
metry but can apply to a single market in which an incumbent’s goal is to deter entry
(Milgrom and Roberts, 1982; Fudenberg and Tirole, 1986). To understand this sce-
nario, assume that a potential entrant is uncertain about its own postentry pros-
pects because it is not fully informed about the incumbent firm’s costs, the size
of the market, or other factors that would affect the potential entrant’s profits. The
entrant’s best signal of its own prospects may be the pre-entry prices of the suppos-
edly better-informed incumbent. By charging low prices, the incumbent can manipu-
late this indicator to magnify the entrant’s doubts about whether it would be efficient
enough to survive competing with the incumbent. The low price signal thereby deters
the entrant.
For the long-purse theory to trump McGee’s criticism, there must be a reason why
a new entrant would lack sufficient external funding to remain in the market with
a predatory incumbent gorged with liquidity. One such explanation holds that the
new entrant’s access to the necessary resources is limited by asymmetric informa-
tion of a kind that is prevalent in capital markets (Bolton and Scharfstein, 1990). The
key insight in this theory is that lenders would be reluctant to continue funding an
entrant whose initial financial performance is poor. This reluctance is due to a lender’s
inability to tell whether the entrant’s poor financial performance is due to the incum-
bent’s predatory pricing or the entrant’s inefficiency. As the price war continues, the
entrant exhausts its own financial resources and exits the market. Victory follows for
the predator.
2.3. Predatory Pricing and Antitrust

Enforcement
In the United States, predatory pricing allegations have been brought under both the
Sherman Act and the Clayton Act.11 The US Supreme Court has defined predatory pric-
ing as “pricing below an appropriate measure of cost for the purpose of eliminating
11 Section 2 of the Sherman Act prohibits monopolization. Section 2 of the Clayton Act singles
out price discrimination for special scrutiny, distinguishing primary from secondary line price
discrimination. Primary line price discrimination is when the alleged effect of the discriminatory
pricing is at the level of the discriminating firm. Secondary line price discrimination takes place when
the alleged effect of the discriminatory pricing is at the level of the buyers of the discriminating firm.
Predatory pricing need not involve price discrimination.
competitors in the short run and reducing competition in the long run.”12 In the EU,
predatory pricing allegations are brought as an abuse of a dominant position under
Article 102 of the Treaty on the Functioning of the European Union. The European
Court of Justice held in Tetra Pak II that an abuse of dominance is established when a
dominant firm charges prices below average variable cost (AVC), or when prices are
below average total cost (ATC) if the intention to eliminate a competitor is established.
Detecting predatory pricing is a greater challenge than detecting many other antitrust
offenses because the offense involves charging low prices. Low prices, in themselves,
generally confer benefits on consumers. But low, predatory prices are problematic
because they trigger a sequence of events that leads to high prices. From a consumer’s
vantage point, predatory pricing (at least initially) looks a lot like vigorous competition.
This is why antitrust requires an error-cost framework to evaluate predatory pricing
allegations in order to weigh the likelihood and consequences of false positive outcomes
against false negative outcomes.
In the years before Areeda and Turner (1975) proposed a specific test for distinguish-
ing whether prices were predatory, predatory pricing in the United States was inferred
mainly from ad hoc demonstrations of predatory intent. Demonstrating predatory
intent usually involved an assessment of the defendant’s conduct, and this could range
from a pattern of declining prices to an assessment of the language used by a firm in its
internal strategy documents. If an enthusiastic sales manager gave instructions to “kill
the competition,” this might be construed as predatory intent. There was, to say the least,
no clear standard for identifying predatory intent, and it is not hard to see the difficulty
of distinguishing a subjective state of mind seemingly bent on the destruction of a rival
from a subjective state of mind that is set on winning business and letting the rival’s
chips fall where they may. In Utah Pie the Supreme Court deduced predatory intent
from a “drastically declining price structure” when the defendant cut prices to establish
itself in a new sales territory, and from the firm’s internal documents.
In an effort to bring economic analysis and a measure of predictability to the task of
proving predatory intent, Areeda and Turner proposed a concrete test for determining
whether a defendant’s low prices were predatory. This test asked whether those prices
were below the firm’s reasonably anticipated average variable cost AVC, where AVC was
a proxy for marginal cost (MC).13 Areeda and Turner rationalized that if the defendant’s
prices were below its AVC, the low prices probably revealed predatory intent. There are
two reasons for drawing this inference; both would be familiar to any economics stu-
dent. One reason is that prices this low generally are not remunerative for the defendant
in the short run and hence require an explanation other than short-run profit maximi-
zation. One such explanation is predatory pricing.
The other reason for the inference of predatory intent is that with prices below AVC,
an equally efficient competitor would rather close down its operations than match
12
Cargill, Inc. v. Monfort of Colo., Inc., 479 U.S. 104, 117 (1986).
13
Areeda and Turner believed that MC was the proper benchmark, but that AVC was more easily
measured.
the defendant’s low prices and continue producing. Areeda and Turner proposed this
test to protect otherwise efficient firms from being forced out of the market. But the
Areeda-Turner test does not encumber defendants with an obligation to protect the
viability of an inefficient competitor. Effective competition provides no such protection
for inefficient competitors, so it would be perverse for competition policy to impose this
obligation. Posner (2001) proposes that the equally efficient competitor standard should
be applied for all claims that involve exclusionary practices.
The Areeda-Turner test was designed to assign the burden of proof in predatory
pricing cases. If those prices were above AVC, then they are presumed to be nonpreda-
tory because prices above AVC generally do not signal a departure from short-run
profit maximization. Areeda and Turner proposed that such prices should be a safe
harbor for defendant firms. If a defendant’s prices were below AVC, the defendant
must prove that its prices were not motivated by predatory intent. This might be done,
for instance, by showing the low prices were an introductory offer or a temporary
promotion.
The Areeda-Turner test is perceived as a cautious test and in some corners it is viewed
as being too permissive. Early dissatisfaction arose because the test does nothing to
detect strategic price-cutting behavior that threatens the viability of competitors when,
if ever, the defendant’s prices are above AVC but below ATC. Scherer (1976) disapproved
of evaluating an allegation of predatory pricing by applying a single price-cost test, and
favored a more open ended rule-of-reason analysis as had been customary in the past.
Others proposed rules that placed less reliance on the price-cost relationship than the
Areeda-Turner standard. Every alternative that has been proposed has its own set of dif-
ficulties in its application.14
Recognizing that a predatory incumbent would raise prices once a new entrant is
driven from the market by the incumbent’s low prices, Baumol (1979) proposed a rule
that would require an incumbent who cuts prices by any amount in response to entry to
maintain those low prices for an extended period. The rationale for this approach was to
deter predation by making it more difficult for an incumbent to recoup any losses that
stem from price-cutting. Williamson (1977) proposed a rule that would limit the aggres-
siveness of an incumbent’s response to a new entrant. Williamson’s approach would
prohibit any increase in an incumbent’s output level in response to entry. Edlin (2002)
advocated a rule that would prohibit an incumbent from reducing prices substantially in
response to entry. The goal of Edlin’s “price freeze” proposal, which combined elements
14 Detecting predatory pricing by a state-owned enterprise presents a different set of problems
because the firm’s objectives are various and multidimensional and are not limited to the pursuit of
private profit (Lott, 1990). This does not mean that state-owned enterprises are less likely to acquire
or preserve a dominant position by means of below-cost pricing. For instance, Sappington and Sidak
show “how the diverse goals that a public enterprise faces may lead it to act more aggressively toward its
rivals than a private enterprise” (2003, p. 199). In any case, the non-profit-seeking conduct of a public
enterprise makes a comparison of the firm’s prices and costs a flawed indicator of predatory intent. See
generally Sokol (2009).
of the Baumol and Williamson rules, was to discourage dominant firms from charging
high prices before an entrant appears.
Joskow and Klevorick (1979) favored a two-tier test. The first tier would examine
structural conditions in the market, such as market shares, entry conditions, and profit
histories, to assess whether a defendant has sufficient market power to make it plau-
sible that predatory pricing could be successful. If a defendant in a predatory pricing
case does not have significant market power, there is no need to inquire further. But
if the first-tier examination indicates that the defendant has enough market power to
be a predatory threat, the analysis would proceed to the second tier, in which the firm’s
prices and costs would be compared. For an incumbent firm that satisfies their first-tier
criterion, Joskow and Klevorick proposed that prices below average total costs should
establish a presumption of predation. Motta advocates using a more lenient variation of
Joskow and Klevorick’s second-tier test. He proposes that a price below AVC “should be
presumed unlawful, with the burden of proving the opposite on the defendant”; a price
above AVC but below ATC “should be presumed lawful, with the burden of proving the
opposite on the plaintiff,” and a price above ATC “should definitely be considered law-
ful, without exceptions” (2004, p. 442).
The principal reservation some economists have about relying on the Areeda-Turner
test is that AVC or even MC may not be the “correct price floor: whether some poten-
tially higher price floor would not be more appropriate from the welfare standpoint
given the strategic nature of predatory conduct” (Ordover and Saloner, 1989, p. 582).
This reservation springs from the post-McGee game-theoretic theories of predation
that incorporate incomplete information. In these theories, strategic behavior by a
dominant firm seeking to induce a competitor’s exit often does not involve prices
below cost, regardless of how costs are measured. If these theories are relevant for
antitrust policy, the relationship between a defendant’s prices and its marginal costs is
not a reliable indicator of predatory intent. Charging prices below cost is a feature of
some strategies for eliminating a competitor, but it is not an essential feature of other
strategies.
The Areeda-Turner test does not distinguish whether a defendant’s pricing conduct
conforms to the predictions of any above-cost theory of predatory pricing. But this short-
coming does not matter in the great majority of predatory pricing claims (going all the
way back to Standard Oil) that explicitly allege below-cost pricing. The Areeda-Turner
test provides vital guidance for assigning the burden of proof in these predatory pric-
ing cases. Fisher (2007) disapproves of reliance on any one “bright-line” test for distin-
guishing predatory pricing from competitive pricing. But Fisher acknowledges that the
Areeda-Turner test is a useful diagnostic tool, given the difficulty of drawing the correct
inference about a defendant’s intent from the firm’s conduct, and recognizing that a test
for predatory intent is not the same thing as a definition of predation.
The circumstance that generates the most serious reservation about reliance on the
Areeda-Turner test is when firms have high fixed costs and very low MC or AVC. In
markets with this characteristic, a defendant has more leeway than elsewhere to cut
prices and impose losses on a competitor (vis-à-vis ATC) without running afoul of the
Areeda-Turner test. The most frequently cited examples are airlines and firms with valu-
able intellectual property.15
Notwithstanding the scrutiny and the criticism it has received, the Areeda-Turner
test has altered the way courts evaluate predatory pricing claims. Phlips (1995) proposes
that the reason the Areeda-Turner test became so influential is the test’s conceptual sim-
plicity. One thing is clear: an important consequence of the Areeda-Turner test was to
raise the burden for plaintiffs in predatory pricing cases. The number of such cases fell
sharply in the years that followed (Salop and White, 1988).
2.4. Brooke Group
The most important predatory pricing opinion issued by the Supreme Court since
Areeda and Turner proposed their test is Brooke Group (1993).16 This case involved two
cigarette manufacturers and focused on the aggressive pricing of newly introduced dis-
count cigarettes. In its opinion,17 the Court adopted a two-pronged approach for prov-
ing predatory pricing: “A plaintiff must prove (1) that the prices complained of are below
an appropriate measure of its rival’s costs and (2) that the competitor had a reasonable
prospect of recouping its investment in below cost prices” (p. 210). If a plaintiff demon-
strates both prongs, this establishes a rebuttable presumption of predatory intent.
In the price-below-cost prong, the Court did not specify which measure of the defen-
dant’s costs is appropriate, but Brooke Group is widely read as an endorsement of the
Areeda-Turner test (Baker, 1994). A defendant’s marginal or average variable cost has
been adopted as the appropriate cost measure in the First, Second, Fifth, and Sixth fed-
eral circuits. Prices above that benchmark but below the firm’s average total cost will
not necessarily exonerate a defendant in the Eighth and Ninth circuits, and in the latter,
prices above the defendant’s average total cost may still be considered predatory. The
Seventh Circuit’s benchmark currently is a defendant’s long-run incremental cost. The
Third, Fourth, and Tenth circuits have not specified what they consider an appropriate
measure of costs for the purpose of applying the Brooke Group standard (ABA Section of
Antitrust Law, 2012, pp. 278ff.).
15 In the US Department of Justice’s lawsuit against American Airlines, the airline successfully
defended its practice of dramatically reducing fares on routes served by new entrants. In this case, the
court did not accept the government’s inclusion of the opportunity cost of fixed assets (such as airplanes)
in its AVC calculations with the result that the airline’s fares remained above AVC. However, the court
in a subsequent predatory pricing case against another airline was more receptive to including these
opportunity costs. See Elzinga and Mills (2009).
16 The authors were consultants to the defendant in the course of the litigation. See Elzinga and Mills
(1994).
17 Also, Brooke Group established a single standard for proving predatory pricing under both the
Robinson-Patman Act and Section 2 of the Sherman Act.

The price-below-cost prong is similar to, but more permissive than, a profit-sacrifice
test based on Ordover and Willig’s definition of predation (Salop, 2006). Instead of
establishing predatory intent by showing that a defendant’s prices constitute a short-run
profit sacrifice (i.e., an avoidable reduction in profit), the Brooke Group standard requires
a defendant’s prices to be low enough to create an actual short-run loss. Substituting a
negative profit test for a profit sacrifice test avoids the difficulty of identifying an alleged
predator’s most profitable alternative pricing strategy—an exercise that would bring its
own set of problems (Motta, 2004). Although some ambiguity remains about which cost
measure is appropriate, Brooke Group’s below-cost pricing requirement creates a less
problematic safe harbor for the defendant than a strict profit-sacrifice test.
The more striking feature of the Court’s opinion in Brooke Group is the recoupment
prong: “The plaintiff must demonstrate that there is a likelihood that the scheme alleged
would cause a rise in prices above a competitive level sufficient to compensate for the
amounts expended on the predation” (p. 210). Here the Court recognizes that predatory
pricing has the characteristics of an investment. The recoupment test assesses the likeli-
hood that the defendant could charge monopoly prices for a long enough period after
disposing of the target competitor to recoup its investment in low prices.
The prospect of recoupment is not a consideration that materialized in US law with
Brooke Group. The ability of the defendant to recoup allegedly predatory losses fig-
ured prominently in preceding decisions in Cargill (1986), Matsushita (1986) and A. A.
Poultry Farms (1989). In William Inglis (1982), the Ninth Circuit Court of Appeals
held that “Predation exists when the justification for . . . [low] . . . prices is based . . . on
their tendency to eliminate rivals and create a market structure enabling the seller to
recoup his losses. This is the ultimate standard, and not rigid adherence to a particular
cost-based rule” (p. 1035).
An inquiry about the likelihood of recoupment shifts the focus in predation cases
away from the narrow issue of the defendant’s short-run losses to the larger issue of the
economic rationality of the firm’s alleged predatory scheme in its entirety. An evaluation
of a defendant’s prospects for recoupment involves both the firm’s conduct and struc-
tural conditions in a properly defined relevant market: “The determination requires an
estimate of the alleged predation’s cost and a close analysis of both the scheme alleged
and the relevant market’s structure and conditions” (p. 210). Structural conditions con-
ducive to recoupment are present if the defendant’s market share is large, its rivals are
small and limited in their ability to discipline the defendant’s prices, and if there are sig-
nificant barriers to entry in the market.
This inquiry harkens back to the first-tier market power component of Joskow and
Klevorick’s two-tier approach. A necessary condition for successful recoupment is
a defendant’s possession of, or a reasonable prospect of acquiring, significant market
power. In keeping with the screening role Joskow and Klevorick assigned to the first tier
of their approach, the Antitrust Modernization Commission (2007, p. 89) noted that the
recoupment test “enhances administrability for the courts by allowing summary dispo-
sition of claims where market circumstances—such as easy entry—preclude the possi-
bility of recoupment.”
The recoupment prong of the Court’s approach creates a safeguard or “reality check”
(Katz, 2006, p. 6) for courts against reaching false positive conclusions, especially
because there are legitimate, procompetitive reasons why the price-cost analysis in the
first step should not be dispositive.18 The Court’s concern with false positive outcomes
in predatory pricing cases was a prominent factor in its earlier Matsushita and Cargill
opinions as well as in Brooke Group.19
In European law, an abuse of dominance is an objective notion that stands apart from
the defendant’s subjective intent. Accordingly, in the EU it is not necessary to show that a
defendant had predatory intent in order to prove that the firm’s low prices constituted an
abuse of dominance. The standard for proving an abuse of dominance such as predatory
pricing in the EU does not include a recoupment test. Vickers (2008, p. 419) suggests
that a separate recoupment test is unnecessary in the EU because “dominance—without
which there can be no abuse in European law—implies ability to recoup.”
The two-pronged Brooke Group formula, and for that matter the two prongs them-
selves, are not without their detractors. Depending on one’s priors about how frequently
dominant firms employ exclusionary pricing practices, and about how detectable those
practices are, the Brooke Group formula is susceptible of both false negative and false
positive errors. Because of the infrequency of “positive” findings since Brooke Group,
most of the dissatisfaction with the Brooke Group formula has been expressed by the
commentators who find the formula, and especially its price-below-cost provision, too
permissive. Post-McGee theories of predatory pricing provide a variety of theoretical
scenarios in which a defendant might reduce its prices to impair the profitability and
threaten the survival of a rival without resorting to prices so low that the defendant runs
afoul of a price-below-cost test. In fact some theoretical predatory scenarios do not even
require sacrifice, let alone prices below cost.
The fact that the Brooke Group formula might excuse a hypothetical defendant engaged
in what Edlin (2002) calls “above cost predatory pricing” is a source of concern for econ-
omists and antitrust scholars who are more sanguine than the Court about the ease of
separating procompetitive from anticompetitive pricing. Recognizing that the competi-
tive discipline brought to bear against a dominant firm by even a less-efficient rival may
create consumer benefits,20 these critics of Brooke Group favor the use of more stringent
rules or elaborate rule-of-reason analyses to reduce such firms’ exposure to the aggressive
pricing of a dominant firm. But it would not be a trivial matter to ferret out by means of a
18 Areeda and Turner discuss temporary “promotional pricing” and “meeting competition” as two
examples. Learning effects, whereby costs fall over time with greater experience and cumulative output,
are another circumstance where prices below an otherwise appropriate measure of cost in the short run
would not necessarily be predatory.
19 In Matsushita the Court held that “we must be concerned lest a rule or precedent that authorizes
a search for a particular type of undesirable pricing behavior end up by discouraging legitimate price
competition” (p. 594).
20 For example, a duopoly with two firms—one larger and somewhat more efficient than the other—
will charge consumers a lower price than the large, efficient firm would if it were a monopolist. In this
instance, consumer welfare would be greater if the small, inefficient firm remains in the market. Total
welfare could be greater or less if the inefficient firm remains.
rule-of-reason analysis which vulnerable, inefficient, or disgruntled rivals should be pre-

served without putting spirited head-to-head price competition at risk. Elhauge, while rec-
ognizing the potential for false positive outcomes, takes the position that “efforts to restrict
above-cost reactive price cuts are likely to be futile and harmful” because many such price
cuts are procompetitive and distinguishing the exceptions would be difficult (2003, p. 826).
Other commentators are more optimistic about the ability of the courts to undertake
analyses of a predatory pricing defendant’s prices applying methods that are more elab-
orate and nuanced than the Areeda-Turner test. Salop, for instance, proposes that courts
should deemphasize formulaic price-cost comparisons and apply a “consumer welfare
effect standard” to “evaluate whether the consumer benefits from lower prices achieved
during the predatory period outweigh the likely harm during the recoupment period. . . .
[This] standard could be more or less permissive than . . . Brooke Group . . . depending
upon the exact facts” (2006, p. 337–38). The informational requirements of the kind of
inquiry Salop proposes could be demanding, and the result is unlikely to be as predict-
able as applying the Brooke Group standard.
The Court’s approach in Brooke Group is not a blueprint for detecting every kind of
strategy with exclusionary designs and effects. Identifying exclusionary behavior with-
out jeopardizing a broad spectrum of procompetitive conduct that is unwelcome to
rivals is a formidable undertaking. In its review of antitrust enforcement in the United
States several years ago, the Antitrust Modernization Commission concluded that
evaluating firm conduct under Section 2 of the Sherman Act “poses among the most
difficult questions in antitrust law. Appropriate antitrust enforcement must distin-
guish aggressive competition that benefits consumers, such as most price discounting,
from conduct that tends to destroy competition itself, and thus maintains, or facilitates
acquiring, monopoly power” (2007, p. 81). Given the inherent difficulty of discerning in
an adversarial proceeding the intent that animates a firm’s conduct, and given the cost
of deterring conduct that ultimately is procompetitive in an overly zealous attempt to
protect vulnerable competitors and the status quo, the judicial modesty and restraint of
the Brooke Group formula is warranted. While it is true that positive findings of preda-
tion since Brooke Group are few, a plausible explanation could be that the Court’s estab-
lishing a clear, administrable standard deters predatory pricing in the same way that
radar-enforced speed limits deter speeding.
Bolton, Brodley, and Riordan have another explanation as to why “no predatory pric-
ing plaintiff has prevailed on the merits in the federal courts” since Brooke Group: “ the
judicial belief that predatory pricing is extremely rare, if not economically irrational
conduct” (2000, p. 2241–42). They maintain that this belief is in tension with the “the
consensus view in modern economics that predatory pricing can be a successful and
fully rational business strategy.”21
21 Milgrom and Roberts observed in the early 1980s that “a large fraction of the economics profession
would argue that . . . predation is an irrational strategy for attempting to gain or maintain a monopoly
position and that it is, therefore, unlikely to be adopted in practice” (1982, p. 280). Bolton, Brodley, and
Riordan’s assessment of economists’ views twenty years after Milgrom and Roberts’s reflects the influence
of the predatory pricing theories that appeared during the intervening years.
It is one thing for economists, or even the courts, to acknowledge that preda-
tory pricing is a theoretical possibility in certain circumstances. But until the courts
are confronted with unambiguous evidence in actual cases, there is little reason for
this acknowledgment to reduce judicial skepticism about the likelihood of success-
ful predatory pricing.22 The courts have found multimarket predatory pricing theories
that involve acquiring an intimidating reputation to be particularly unpersuasive: “The
courts have to date rejected efforts to establish recoupment of predatory losses in
one group of markets by demonstrating that the predation will facilitate the exercise
of monopoly power in other markets” (ABA Section of Antitrust Law, 2012, p. 285).
Easterbrook (1981) makes the observation that a strong piece of evidence supporting
the courts’ presumption that predatory pricing is rare is because so few plaintiffs have
prevailed under any theory of predatory pricing. The Brooke Group formula does not
prevent a plaintiff from demonstrating that a defendant’s conduct fits the mold of a
reputation-based predatory pricing theory, or any other theory that involves below-cost
pricing. It is just that the plaintiff must assume the burden of proving such theories if the
defendant passes both prongs of Brooke Group.
Some commentators recognize so many difficulties with the enterprise of detecting
predatory pricing that they pose the impish question: whether the entire enterprise
should be abandoned? Writing in this vein, Milgrom and Roberts question whether
“it may be best simply to give up on attempts to control predation, even if one believes
that it can and does occur” (1982, p. 134). Hovenkamp speculates (without agreeing)
that “the world would very likely be better off with no law of predatory pricing at all”
(2005, p. 160–61). There is nothing impish about Easterbrook’s conclusion: “If there is
any room in antitrust law for rules of per se legality, one should be created to encom-
pass predatory conduct. The antitrust offense of predation should be forgotten” (1981,
p. 337; footnote omitted).
2.5. Implementing Brooke Group
Competing price-cost comparisons have been the focal point of many predatory pric-
ing cases in the years since the Areeda-Turner article appeared. The analysis of prices
and costs in these disputes often is complex and highly contextual. Applications of the
recoupment prong generally are not as complex as price-cost comparisons, but they are
equally fact-specific. Although there are idiosyncratic considerations to applying both
prongs of the Brooke Group standard in any market, there are some principles that apply
generally.
22 Bolton, Brodley, and Riordan (2000, 2001) believe that several prominent predatory pricing
plaintiffs present fact situations that are similar to those of recognized economic theories of predatory
pricing, but see Elzinga and Mills (2001) for a dissenting view.
2.5.1. Price-Cost Comparisons

Implementing the price-cost comparison prong of Brooke Group requires an answer
to two fundamental questions: Which prices (e.g., which sales?) and which costs?
Litigants often dispute the scope of a defendant’s products and customers over which
the firm’s prices and costs should be compared. A plaintiff may argue that the proper
test involves only those sales of the defendant—those specific products and custom-
ers—that the plaintiff actively contested. Under this definition of the proper scope,
a defendant’s prices and costs due to sales of the same product to different custom-
ers, or of similar products to the same or different customers, are irrelevant to the
analysis.
The proper scope of sales for a price-cost test may, in some instances, be narrow,
but narrowing the scope of sales to match the extent of the plaintiff ’s endeavors as a
matter of principle is inappropriate. The reasoning behind this contention verges on
equating predation with the drawing away of a current or prospective customer of the
plaintiff by means of price competition. Where there are as-yet-unexploited prospec-
tive sales of the same or similar products within the reach of a plaintiff—sales that are
not off limits because of formidable barriers—a predator reasonably could not expect
to drive a competitor out of business without extending its below-cost pricing to these
prospective sales. Predatory pricing is not a practice carried out on a transaction-by-
transaction basis.
Courts usually have approved extending the scope of sales to the entire relevant prod-
uct and geographic market that contains the contested sales. This is because predatory
pricing in one part of the relevant market leaves a refuge from low prices in other parts
(Denger and Herfort, 1994, p. 551). If one purpose of a price-cost test is to detect whether
the defendant intends to make it unprofitable for a competitor to remain anywhere in
the market, the test should be applied everywhere in the market. Consequently, com-
paring prices and costs throughout the relevant market is consistent with the goal of
detecting predatory intent. Similarly, if the other purpose of a price-cost test is to detect
whether the defendant intends to loses money on its sales in the relevant market, the test
should be applied market-wide. The procompetitive reasons why a defendant might be
willing to lose money in the short run on sales of a narrow set of products to a narrow set
of customers, such as promotional pricing or meeting competition, are more numerous
and more plausible than reasons why the firm would be willing to lose money on sales
throughout the relevant market.
Calculating an appropriate measure of a defendant’s costs is often the most nuanced
element of a Brooke Group price-cost comparison. In designating their cost benchmark
as AVC, Areeda and Turner drew on the distinction between fixed and variable costs
as described in economics textbooks. While this is a clear and unambiguous distinc-
tion in the textbooks, the distinction is not always easy to operationalize when imple-
menting the Areeda-Turner test in real markets. The circumstances and time frame
in which a cost is variable rather than fixed are different for different costs. The costs
that are “variable” with respect to a very small increment of output (e.g., labor and
materials) are not necessarily the same as the costs that are “variable” with respect to a
larger increment of output (e.g., an additional production line). And the costs that are
incremental with respect to an increase in output are not the same as the costs that are
decremental with respect to a decrease in output (e.g., an advertising campaign when
opening a new sales territory).
Baumol (1996) made the relevant distinction clearer when he substituted the twin
notions of incremental and avoidable costs for variable costs. The relevant costs for
implementing a price-cost test depends on which question the test is meant to answer.
While most commentators interpret such tests to emphasize whether the defendant lost
money because it charged such low prices on the contested sales, Baumol puts more
emphasis on the second question: whether the defendant’s prices were so low that it
would be unremunerative for an equally efficient competitor to match. If the question
is whether the defendant lost money on the contested sales, Baumol argued that the test
should compare the defendant’s average prices on those sales to the average incremental
costs (AIC) the defendant incurs to make those sales. These are the costs that the defen-
dant must incur to increase output when it captures the contested sales. If the question
is whether it would be unremunerative for the plaintiff to match the defendant’s prices,
Baumol argued, the test should examine decremental rather than incremental costs.
Specifically, the relevant test compares the defendant’s average prices to the plaintiff ’s
average avoidable costs (AAC)—those costs the plaintiff could avert by forfeiting the
contested sales.
These two cost measures are not always the same even where the plaintiff and the
defendant are equally efficient (when similarly positioned with respect to the contested
sales). For instance, the costs a plaintiff could avoid by surrendering certain sales that
it made in the past, or would have made but for the defendant’s challenged pricing, are
not necessarily the same as the costs the defendant would incur by increasing its out-
put to take away those sales. Baumol reasons that certain costs incurred by a firm when
it expands output are, like a ratchet, not as quickly and easily averted when the firm
reduces output. This means that AIC usually is greater than AAC. Thus, if a defendant
passes a test that uses its AIC, the firm would almost certainly pass a test based on AAC.
Several economists have stressed that the proper price-cost comparison must calcu-
late costs in ways that are consistent with the opportunity cost principle. When a mul-
timarket defendant cuts prices in one market, allegedly to drive a competitor out of
that market, it may deploy assets whose costs are fixed in character to increase output.
If those assets otherwise would be deployed in different markets, their cost should be
treated as incremental in the relevant market because of the opportunity cost principle.
For instance, an incumbent airline that deploys a plane and crew in one (city-pair) mar-
ket to increase the number of passengers it can carry in conjunction with a steep fare
reduction has alternative uses for the plane and crew in other markets. This means that
the relevant measure of AIC should include these costs.
The time span a plaintiff proposes for comparing a defendant’s prices and costs is
another factor that comes into play in a Brooke Group price-cost comparison. When the
low prices that form the basis of a plaintiff ’s complaint are of short duration, they may
not last long enough to credibly threaten the plaintiff ’s survival. Low prices over a time
span that is too short to put the plaintiff ’s survival in jeopardy are an insufficient basis
for inferring predatory intent. In addition, a short time span, just like a narrow set of
contested sales, increases the number and plausibility of alternative explanations for a
defendant’s low prices.
2.5.2. Recoupment
The Court’s opinion in Brooke Group held that the prospect of recoupment is a necessary
component of a predatory pricing claim: “Evidence of below cost pricing is not alone
sufficient to permit an inference of probable recoupment and injury to competition. The
determination requires an estimate of the alleged predation’s cost and a close analysis
of both the scheme alleged and the relevant market’s structure and conditions” (p. 210).
Consequently, under Brooke Group, a plaintiff ’s claim must pass the recoupment test
even if the price-cost test creates a rebuttable presumption that the defendant’s prices
were predatory. Proof that the defendant, looking forward from the time the firm’s low
pricing began, could expect to recoup lost profits once the competitor expired buttresses
the presumption established by the price-cost test. However, if a plaintiff proves that the
defendant’s prices were below an appropriate measure of costs, but cannot prove that the
scheme alleged held out the prospect of recoupment, the defendant is under no obliga-
tion to explain its low prices.
Although the recoupment requirement in Brooke Group creates an additional hur-
dle for predatory pricing plaintiffs, this burden is warranted by three considerations.
These are the risk of price-cost miscalculations, the potential welfare loss from disrupt-
ing legitimate price competition, and the infrequency of low-price episodes that have
proved, on close examination, to be predatory.
The recoupment test examines whether structural conditions in the market and the
defendant’s market power, once the plaintiff is out of the picture, make recoupment
plausible.23 There are several structural conditions that would be favorable to recoup-
ment. A low price elasticity of demand is favorable because it limits a predator’s losses
when prices are low (e.g., low prices do not elicit a large increase in unprofitable sales),
and enhances the firm’s gains when prices subsequently rise. Indications of growing
demand are favorable, because recoupment is easier in an expanding market, all else
equal. Factors that make the target competitor’s withdrawal more likely or quicker are
favorable to recoupment, as are barriers to entry or reentry. A large postpredation mar-
ket share for the predator and any factors that limit the supply response of the predator’s
remaining competitors when prices rise also are favorable.
Neither the Court’s Brooke Group opinion nor any subsequent opinions have speci-
fied exactly how to assess a defendant’s prospects for recoupment. Hemphill proposed
that the recoupment test should be seen as a filter that would weigh relevant structural
23
See generally Elzinga and Mills (1989).
factors, such as those listed above, but also including factors suggested by post-McGee
theories of predatory pricing: “information asymmetries and linkages across markets
[that] might make recoupment more likely, by allowing a predator to build a reputa-
tion for predation and/or send misleading signals about demand and cost in a market”
(2001, p. 1589). A structural analysis to evaluate a defendant’s prospects for recoupment
is similar to an analysis of the firm’s market power such as was proposed by Joskow and
Klevorick, but there is a difference. When assessing the defendant’s prospect for recoup-
ment, the question is not whether the firm possesses market power in some substantial
degree. The question is whether conditions in the market are such that the firm rea-
sonably could expect to accomplish specifically what plaintiff ’s predatory pricing claim
alleges. In most instances, because such claims are idiosyncratic and fact intensive, this
is not a question amenable to a generic answer.
The goal of the recoupment test in Brooke Group is to gauge whether the defendant
had, at the outset, a “dangerous probability, of recouping its investment in below-cost
prices” (p. 224). This calls for estimates and a comparison of the defendant’s likely dis-
counted gains and losses, viewed prospectively.24 Calculating such gains and losses
would require evaluating the structural factors mentioned above and making some
assumptions about the defendant’s expectations. The proper benchmark for calculat-
ing and comparing gains and losses is the profit stream the defendant would expect if
the firm followed its most profitable alternative course of action. In most instances this
means that the relevant losses are greater, and the gains less, than if the benchmark were
a short-run break-even scenario.
Comparing the defendant’s expected gains and losses can provide answers to ques-
tions that bear directly on the plausibility of recoupment. For example, how quickly
must the defendant expect the competitor to capitulate in order to recoup? Or in order
to recoup, how much time after the competitor capitulates would the defendant require
before entry or reentry is likely? Or, what rate of return would the defendant expect to
earn on its investment in predatory prices? In answering these questions, particular
attention must be given to how sensitive the answers are to the assumptions made about
the defendant’s expectations.
2.6. Conclusion
The Brooke Group standard for proving predatory pricing claims sets the bar high
to avoid false negative conclusions. A further reason for maintaining a high bar is
24
In this connection, Denger and Herfort (1994, p. 543) propose that ex post knowledge that the target
competitor exited the market during the course of the alleged predation should be irrelevant. Motta
(2004, p. 450) proposes that maintaining a prospective point of view precludes a defense based on ex post
evidence that the defendant “did not manage to recoup losses.”
that the market power of dominant firms, left alone, tends to erode. If one thinks
of US firms with high market shares who, in the past, have been prosecuted under
Section 2 of the Sherman Act, it often has been market forces more than antitrust
enforcement that marked their decline in prominence: witness American Tobacco,
U.S. Steel, Alcoa, A&P, DuPont, and Kodak, among other once purportedly domi-
nant firms.
Applying the Brooke Group standard in all predatory pricing cases, rather than adopt-
ing a portfolio of tests or launching an open-ended rule-of-reason inquiry, has other
virtues. Brooke Group provides criteria that are sufficiently predictable that a prudent
incumbent or dominant firm can avoid price cuts that would incur antitrust liability. In
addition, the Brooke Group standard is sufficiently administrable to provide meaningful
guidance for courts that face the task of deciding whether a dominant firm’s low prices
threaten competition—or instead only threaten competitors.
Economic theories of predation are differentiated in so many ways that trying to
embrace the particulars of every theory in a coherent, predictable, and administra-
ble rule is unworkable. In Barry Wright, a well-known predatory pricing opinion he
authored before being elevated to the Supreme Court, Justice Breyer (who once taught
antitrust law at Harvard Law School) expressed his concern with trying to embed every
theory of predation into the enforcement of the antitrust laws in the following man-
ner: “Rules that seek to embody every economic complexity and qualification may well,
through the vagaries of administration, prove counterproductive, undercutting the very
economic ends they seek to serve” (p. 234).
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CHAPTER 3
R A I SI N G R I VA L S’ C O ST S
DAVID T. SCHEFFMAN AND RICHARD S. HIGGINS
3.1. Overview of Theory
The theory of “raising rivals’ costs” (RRC) deals with actions that might be taken by a
firm with market power (“dominant firm”) to harm its rivals even if those actions may
also harm the dominant firm.1 The sorts of actions dealt with in the theory are ones that,
in various ways, raise the costs of rivals and of the dominant firm. Originally, a focus of
the theory was a type of “vertical squeeze” theory, that is, theories in which the dom-
inant firm and its rivals purchased an input, and the dominant firm “overpurchased”
that input in order to raise the price of the input to its rivals (Scheffman and Higgins
2003). By doing so, however, the dominant firm also raised its own costs by purchasing
at higher prices than without the “overpurchasing.”
The fundamental insight of the theory is that increases in rivals’ marginal costs will
lead the rivals to reduce their output relative to an initial equilibrium level. Other things
equal, that will cause their prices to rise, which, alone, is a benefit to the dominant firm.
However, recall that in this theory, the dominant firm also experiences an increase in
its marginal costs, which, other things equal, reduces its profits. The net effect on the
dominant firm’s profits is the combination of lower output / higher prices of rivals and
the higher input costs of the dominant firm.
It is straightforward to derive a condition for which raising rivals’ costs is profit-
able for the dominant firm. Suppose the cost-raising strategy involves raising the price
1 The original unique contribution of the original RRC papers was that they showed that it could pay
for the dominant firm to take actions that raised the costs of its rivals, even though, as a consequence, the
dominant firm raised its own costs.
Raising Rivals’ Costs 63
of an input X that is used by both the rivals and the dominant firm. Denote the price
PX. Suppose further that all competitors produce an identical homogeneous product.
Finally, assume that the rivals act as perfect competitors. The increase in the rivals’ costs
arising from the increase in PX causes them to restrict their output at the original out-
put price, PQ. That results in an increase in PQ, keeping sales of the dominant firm con-
stant (lower total output moves up the industry demand curve and raises the output
price). The actual amount of increase in PQ depends on the amount of increase in PX,
the amount by which the rivals’ marginal costs increase due to the increase in PX, the
resulting amount by which rivals restrict their outputs, and the effect on output price,
PQ, which is determined by the demand.
Recall that in this example, since the rivals are assumed to act as perfect competi-
tors, they take prices as given, and produce where their marginal costs equal the market
price. Suppose, for example, that the rivals’ only cost of production is the use of X, and
they need one unit of X to produce one unit of Q for any level of output. This means that
if we assume that the dominant firm output is kept fixed, the market price will increase
by the amount of the increase in the rivals’ (aggregate) marginal costs. Then the increase
in their marginal costs is equal to the increase in PX, and that is also the amount by which
PQ will increase, keeping the dominant firm’s output constant. If the dominant firm uses
less than one unit of X to produce one unit of Q, the dominant firm’s average cost (and
marginal cost) goes up by less than the change in PX. In this situation the dominant
firm’s profits have gone up—for constant output for the dominant firm, price goes up
more than the dominant firm’s average cost.
Because in this example we have assumed that the fringe’s marginal costs are constant
for different levels of output, the change in the fringe’s marginal cost equals the change
in the market price of Q. That greatly simplifies things.
Consider all the moving pieces in a more complex situation. First, to increase the
price of X, the dominant firm must purchase more X. Therefore, one relevant factor is
the quantitative relationship between purchases of X and the price of X—which deter-
mines how much the dominant firm’s purchases of X must increase to lead to a given
increase in PX for rivals. The second relevant factor is how an increase in PX affects the
marginal costs of the fringe. The final factor is how an increase in the fringe’s marginal
costs affects fringe total sales (or, in the case of differentiated products, their prices)—
and therefore the size of the movement up the demand curve for Q (or, in the case of
differentiated products, their prices). With differentiated products, another factor is the
effects of rivals’ increases in prices on the dominant firm.
The general condition that is sufficient (but not necessary) for the dominant firm to
gain from raising PX is that the resulting increase in price PQ (dominant firm’s output
constant) is larger than the increase in the dominant firm’s average costs (Salop and
Scheffman 1983). This condition holds for quite general models of competition and
actions by which the dominant firm can increase its rivals’ costs, while at the same time
increasing its own costs.
64 David T. Scheffman and Richard S. Higgins
3.1.1. The Theory Is More General Than the Model of

“Overpurchasing” an Input
Although the modeling can be more complex, the raising rivals’ costs theory covers any
situation in which a dominant firm takes actions that increase the costs of rivals. For
example, we would view the basic Microsoft case as one in which Microsoft was alleged
to have taken actions that had the purpose and effect of making it difficult for various
rivals to compete or potentially compete in the future, and that those actions had no
significant precompetitive benefits.
As will be discussed below, one common application of RRC theory is in the context
of vertical mergers.
3.2. Demand Effects and Efficiencies
Care must be taken in assessing the potential net effects of actions that increase costs
to take into account the totality of the costs and benefits of the increase in costs. For
example, if a firm incurs costs to improve its product and in order to compete effec-
tively rivals must also incur costs to improve their products, quality-adjusted output
rises. That, of course, is competition—not anticompetitive cost raising. Similarly, if a
firm takes actions that improve its production processes, resulting in lowering its costs
relative to its rivals, that generally would be competitive.
3.3. Counterstrategies
Another factor that must be taken into account is that rivals my engage in counterstrate-
gies that would thwart otherwise potential anticompetitive cost-increasing strategies.
Suppose, for example, the dominant firm incurs costs to lobby for regulatory changes
that would disproportionately affect its rivals—leading to the rivals raising their prices
to the benefit of the dominant firm. In response, the rivals may instead incur costs for
lobbying to thwart those regulatory changes. Thus, in assessing potential cost-raising
strategies by a dominant firm against its rivals, we must assess the ability of rivals to
thwart those efforts.
3.4. Assessment
It probably cannot be stressed enough that raising rivals’ costs or exclusion is not neces-
sarily anticompetitive. In concentrated markets, competition is necessarily rivalry—that is,
competitors are well aware that their rivals’ actions affect them and vice versa. Particularly
in mature industries, significant increases in sales for one firm generally reduce the sales of
rivals. Price changes by one firm also have effects on rivals. Thus in concentrated markets,
particularly mature ones, competition is “about” taking actions that directly or indirectly
take sales from rivals. This is the case in markets in which no firm has significant market
power. As stated by Krattenmaker and Salop, “A firm that raises its rivals’ costs has not
necessarily gained anything. It may have harmed one or more of its competitors, but has it
harmed competition? Competition is harmed only if the firm purchasing the exclusionary
right can, as a result, raise its price above the competitive level” (1986, 262). In fact, much of
“competition on the merits” in concentrated industries involves strategies and tactics that in
some way disadvantage rivals, but is not anticompetitive (Holt and Scheffman 1989).
3.4.1. Strengths of the RRC Analysis

The RRC framework has a number of virtues. The analysis is pretty straightforward, so
that you do not need to be an economic theorist to grasp the basic logic. In some senses
the results are theoretically powerful. RRC makes clear that cost-raising and exclusionary
strategies are generally, if not always, going to be superior (for an instigating dominant
firm) to predatory pricing or other strategies that require recoupment, since a RRC strat-
egy will often be profitable nearly from the outset. Put differently, the RRC analyses (and
the literature on predatory pricing) make clear that cost-raising and exclusionary strate-
gies should be the predominant antitrust concern about a dominant firm’s behavior.
A further strength, at least as a matter of theory, of some of the RRC literature, partic-
ularly Salop and Scheffman (1987), Salop, Scheffman, and Schwartz (1984), and Ordover
and Saloner (1989), is that empirically “testable” conditions are derived. These condi-
tions are probably too cryptic for most lawyers, but they are conditions amenable, at
least in principle, to application by economists in specific fact situations.
3.4.2. Limitations of the RRC Analysis

Both the original RRC article and the later articles2 make clear that as a matter of eco-
nomic theory, the net welfare effects of cost-raising strategies are ambiguous. That is,
2 Particularly Salop and Scheffman (1987).

that a dominant firm engages in cost-raising strategies, does not, itself prove, as a matter
of economic theory, that such strategies are anticompetitive—that is, harm consumers.
It is important to understand this theoretical ambiguity, particularly in light of the many
papers written since the RRC paper that focus on the potential for vertical mergers to be
anticompetitive (a topic we will discuss in more detail below).
The analyses in the RRC papers largely focus on a situation with a dominant firm
that is assumed to have significant market power, independent of any cost-raising
strategies. Although it appears pretty simple, the model is actually quite complex
in generating general results, as are all general models that involve market power
short of monopoly. Thus, as is pointed out clearly in the Salop and Scheffman (1987)
paper, as a matter of theory, cost-raising strategies by a dominant firm may raise or
lower prices, raise or lower total welfare, and even raise or lower the profits of the
“victims.”
The ambiguity arises from a number of sources. The most straightforward reason
is that in the models, the dominant firm prices according to the elasticity of demand
that it faces. A cost-raising strategy shifts out the demand faced by the dominant firm,
but it is possible that it also makes the demand more elastic—sufficiently more elastic
that the profit maximizing price falls. In addition, by restricting its output and rais-
ing price, a dominant firm increases the incentives for less efficient competitors to
produce more than they otherwise would. Under some circumstances a cost-raising
strategy can increase total welfare by shifting a product to a more efficient dominant
firm. Again, RRC theory lays out, in principle, testable conditions under which in a
specific situation cost-raising strategies are likely, from an economic perspective, to be
anticompetitive.
A more serious limitation of the RRC analysis is that it does not provide simple, prac-
tical guidance on how to distinguish cost-raising strategies from “competition on the
merits,” or procompetitive strategies that shift business from rivals.3 As a matter of sim-
ple theoretical modeling, in principle this could be tackled, in part, in the RRC models
by having the cost-raising strategy also impact market demand and/or the production
costs of the dominant firm (to incorporate the possibility the strategy that increases
rivals’ costs makes the dominant firm more efficient). Needless to say, such changes
greatly increase the ambiguity of the competitive effects of cost-raising strategies. As
a matter of policy, conduct by a dominant firm that clearly increases market demand
should not be challenged absent a showing that clearly “separable and unnecessary”
portions of the conduct were anticompetitive. As we will discuss below, one problem in
some monopolization cases is that what at best is highly ambiguous conduct is labeled
monopolization, and a case with “bad” conduct can sweep in what at best is highly
ambiguous conduct.
3
This is discussed in some detail by Holt and Scheffman (1989).
3.5. Policy Implications of RRC
Many commentators have been very skeptical about the viability of RRC-type cases. For
example, Granitz and Klein (1996, 39) state, “our analysis provides no support for a new
antitrust policy which would condemn a vertical relationship without the presence of a
horizontal conspiracy.” This leaves unclear their view of vertical relationships for which
at least one party has substantial market power and is able to anticompetitively exclude
rivals or entrants. Judge Easterbrook states, “My recommendation is that for the fore-
seeable future we leave raising rivals’ costs to the academy.”4 We are not as skeptical. To
begin, we suspect that both Klein and Easterbrook would support going after anticom-
petitive exclusion through manipulation of governmental or legal process. However, we
advocate enlarging the focus of potential governmental or legal process abuse cases.
In the modern economy, barriers to entry or to effective competition increasingly do
not arise from bricks and mortar, economies of scale, and so on. In the modern econ-
omy, the traditional sources of competitive advantage have often been eroded by glo-
balization and technological advances. Competitive advantage increasingly involves
intangibles such as intellectual property. Such intangibles are often more amenable
to manipulation than are bricks and mortar. Thus, we would argue that the sound
policy basis for potential concern with nonprice predation by a dominant firm has
increased over time. Certainly, manipulating the government and the patent system is
a fruitful area of concern with potentially anticompetitive conduct. Two Federal Trade
Commission cases, Rambus5 and Unocal,6 are examples. More difficult to reach are what
appear to be anticonsumer (but may be more difficult to reach as anticompetitive) activ-
ities of “patent vultures,” and the use of patent thickets, sometimes combined with high
stakes (for the defendant) actions at the International Trade Commission.
Of course, we do not mean that conduct involving patents should be challenged
because patents sometimes “create” market power. Rather, we think it is appropriate to
be aggressive about patent “misuse,” involving patents “inappropriately” obtained, and
misused, for example, in standard-setting contexts. FTC/DOJ hearings on intellectual
property7 highlighted widespread concern with “patent quality,” that is, concern that
patents may too frequently be “inappropriately” granted. Of course the solution to this
problem, if it exists, lies with the Patent and Trademark Office, and perhaps legislation in
intellectual property (IP) law. But in limited circumstances, the antitrust (and perhaps
other) laws can, and should, attack anticompetitive use of patents. In recent years the
FTC has been very active in pursuing matters involving alleged anticompetitive use of
4
Easterbrook (2003: 345). See, also Easterbrook (1986, 972).
5
Available at http://www.ftc.gov/os/caselist/d9302.htm.
6 Available at http://www.ftc.gov/os/caselist/d9305.htm.
7 FTC/DOJ hearings on intellectual property: available at http://www.ftc.gov/opp/intellect/index.
htm.
patents. This includes pharmaceutical cases in involving “Hatch-Waxman” issues, using

patents in connection standard setting, and patent litigation before the International
Trade Commission.8
In any event there is little reason to use many enforcement resources to search for suit-
able and significant potentially anticompetitive RRC cases. The “beauty” of RRC is that
it is likely to leave its fingerprints on a disadvantaged rival, whether or not the conduct is
anticompetitive, and disadvantaged rivals are not shy about suing and/or complaining
to enforcement agencies. The problem is sorting through what are mostly complaints
about competition and competitive advantage to find the relatively few “nuggets” of
harm to competition. More empirical research is needed to develop reliable empirical
analyses that facilitate the evaluation of the nuggets.9
Of course the great weakness in trying to apply RRC is that there are so many false
positives. Competition on the merits often injures rivals and potential rivals. It cannot be
stressed enough that allegations of injury to rivals and potential rivals should not “pass
Go” unless there is a credible concern that the result is anticompetitive. We agree with Tim
Muris that credible anticompetitive effects must be required for any viable RRC-theory
case (Muris 2000). This is another area in which economic research could be helpful.
3.6. Vertical Mergers and RRC
One of the major areas of RRC application is vertical mergers.10 The context is competi-
tor A purchases supplier X that was supplying B, a competitor of A. If A has significant
market power, there is a possibility that the merger will be a vehicle of raising B’s cost,
à la RRC. However, the RRC analysis is considerably more complicated because of the
vertical merger. This is because a vertical merger may entail significant efficiencies. One
such efficiency may be avoiding “double marginalization”—which occurs when X was
selling at a price above its marginal costs. Other efficiencies can arise from more efficient
coordination of various kinds between X and A. Thus, for example, A’s acquisition of X
may lead to increase in X’s price to B, but lower A’s costs sufficiently so that A’s price falls.
The complexity of the analysis of vertical mergers is illustrated here by recounting
DGComp’s analysis of the vertical merger of Tom Tom and TeleAtlas.11
8
See, for example, http://online.wsj.com/article/BT-CO-20120531-712251.html.
9
Easterbrook (2003) stresses the inherent difficulties in evaluating situations that appear to be
procompetitive in the short run but potentially anticompetitive in the longer run. We agree that we are
a long way from having any research that could provide significant general assistance in complex cases
involving product innovation, etc.
10 A fuller treatment can be found in Higgins and Perelman (2013).
11 The US antitrust agencies have also evaluated the competitive effects of several vertical mergers
recently, most notably, the acquisition of Double Click by Google. However, the EU provides more
transparency into its merger investigations and, thus, we have a more informed basis for applying the
theory of RRC to vertical merger in Europe.
The EU Non-Horizontal Merger Guidelines express concern that vertical merger

will lead to foreclosure, in particular, in our example, input foreclosure. At the same
time, the Guidelines recognize the potential efficiencies associated with elimination of
double marginalization. In TomTom/TeleAtlas, the European Commission undertook
an econometric analysis of the up- and downstream markets before permitting the
combination.12
Before the acquisition, TeleAtlas and NavTeq competed as duopolists in the market
for digital maps, which were sold downstream to Tom Tom and to Nokia, two promi-
nent rival manufacturers of portable navigation devices (“PNDs”). Vertical foreclosure
would be of concern if, after merger, TeleAtlas had significant incentives to refuse to
sell digital maps externally. The Commission correctly noted that foreclosure would be
profitable if the upstream loss incurred by TeleAtlas by refusing to deal with nonaffili-
ated PNDs were more than offset by the increased margin Tom Tom realized on the sale
of PNDs. Ultimately, the Commission’s economists estimated that TeleAtlas’s input fore-
closure would have to increase the price of digital maps by as much as 200% to be profit-
able, which price increase would most certainly have elicited competitive entry.13
The analysis proceeded as follows: econometric and quantitative estimates were devel-
oped for downstream own- and cross-price demand elasticities, upstream and down-
stream contribution margins, market shares, and the cost of digital maps as a percentage
of the unit cost of supplying PND services. The hypothetical withdrawal of TeleAtlas’s
merchant market sales would cause the merged entity to lose the margin on these sales
and, at the same time, cause the price of digital maps to rise, since NavTeq would be the
sole remaining merchant market supplier. The magnitude of the merchant market input
price increase depends on the derived demand for the input from Nokia and possibly
others, and its elasticity. Based on this merchant market input price increase, Nokia’s
PND price will rise to an extent that depends on the relative importance of digital maps
as an input into PND services. The higher price of Nokia PNDs will cause an increase in
the demand for Tom Tom PNDs the magnitude of which depends on the diversion ratio
from Nokia PNDs to Tom Tom PNDs—that is, on the cross elasticity of downstream
demand. Finally, Tom Tom’s contribution margin—assuming marginal cost pricing of
digital maps—when multiplied by the estimated increase in unit sales provides a mea-
sure of the expected gains from foreclosure.
The Commission apparently found that the downstream gain to TomTom/TeleAtlas
from RRC would just equal the cost of withdrawing from the merchant input market
only if foreclosure would cause the price of digital maps to increase an extraordinary
amount. The implausibility of a nontransitory price increase of this magnitude appar-
ently convinced the Commission not to object to the proposed merger. According to
12 The description of the antitrust analysis of the TomTom/TeleAtlas acquisition is based on the paper
by Rafael de Coninck (2008).

13 In large part this is because Tom Tom’s closest rival, Garmin, purchased digital maps from NavTeq
subject to a long-term contract that prevented an input price increase for one of the major PND
manufacturers.
Coninck, the critical factor was the relative insignificance of digital maps as an input to
the supply of PND services.14
If foreclosure had been found to be likely, the Commission would have had the addi-
tional task of determining the consumer welfare effects of the vertical merger. As indicated
above in the theory section, enhanced competition may accompany foreclosure, including
complete foreclosure. According to the account in Coninck, the Commission was spared
this burden.15 Were the additional analysis necessary, the first-order effects cited above
could be used to predict the overall output effects of the proposed vertical merger. In light
of the second-order and feedback effects associated with RRC, a full merger simulation
may be necessary to predict accurately the welfare effects of vertical merger.
3.7. Conclusion
RRC is now a widely accepted mode of analysis for addressing allegations of a domi-
nant firm taking actions that may injure, anticompetitively, its rivals. Proper use of RRC
requires demonstration of the alleged dominance (substantial market power within a
properly defined relevant market) and economic RRC analysis based on the relevant facts.
References
Coninck, Rafael de. 2008. Economic Analysis in Vertical Mergers. Competition Policy Newsletter
3: 48–52.
Easterbrook, Frank H. 1986. On Identifying Exclusionary Conduct. Notre Dame Law Review
61: 972–980.
Easterbrook, Frank H. 2003. When Is It Worthwhile to Use the Courts to Search for Exclusionary
Conduct? Columbia Business Law Review 345–358.
Granitz, Elizabeth, and Benjamin Klein. 1996. Monopolization by “Raising Rivals’ Costs”: The
Standard Oil Case. Journal of Law & Economics 39: 1–47.
Higgins, Richard and M. Perelman. 2013. Vertical Merger. In William Shughart and Christopher
Thomas, Oxford Handbook of Managerial Economics. New York: Oxford University Press
424–448.
14
This fact seems unlikely on its face. The Commission’s decision may have had more to do with the
fact that during the course of analyzing the merger of Tom Tom and TeleAtlas, NavTeq and Nokia also
proposed to merge, together with the protection from elevated digital map prices enjoyed by Garmin due
to its long-run supply contract with NavTeq. Whatever the critical factors involved, both vertical mergers
were allowed to proceed without opposition.
15 See Coninck (2008). Apparently, the Commission also considered the likelihood of partial
foreclosure and found no significant cause for concern.

Holt, Charles, and David Scheffman. 1989. Strategic Business Behavior and Antitrust. In R.
Larner and J. Meehan, Economics and Antitrust Policy. New York: Quorum Books, 39–82.
Krattenmaker, Thomas, and Steven Salop. 1986. Anticompetitive Exclusion: Raising Rivals’ Costs
to Achieve Power over Price. Yale Law Journal 96: 215–291.
Muris, Timothy J. 2000. The FTC and the Law of Monopolization. Antitrust Law Journal
67: 693–723.
Ordover, Janusz, and Garth Saloner. 1989. Predation, Monopolization, and Antitrust, in R.
Schmalensee and R. Willig, Handbook of Industrial Organization, vol. 1. New York: North
Holland, 538–592.
Salop, Steven C., and David T. Scheffman. 1983. Raising Rival’s Costs. American Economic
Review 73: 267–271.
Salop, Steven C., and David T. Scheffman. 1987. Cost-Raising Strategies. Journal of Industrial
Salop, Steven C., David T. Scheffman, and W. Schwartz. 1984. A Bidding Analysis of Special
Interest Regulation: Raising Rivals’ Costs in a Rent Seeking Society. In B. Yandle and R.
Rogowsky, The Political Economy of Regulation: Private Interests in the Regulatory Process.
Washington, DC: Federal Trade Commission, 102–127.
Scheffman, David T., and Richard S. Higgins. 2003. 20 Years of Raising Rivals’ Costs. George
Mason Law Review 12: 371–387.
CHAPTER 4
P R E DAT O RY BU Y I N G
JOHN E. LOPATKA
Monopsony is the negative image of monopoly. Narrowly defined, it is the structural

condition in which a well-specified good or service has only one buyer (Blair and
Harrison 2010). In a broader sense, monopsony power is the ability to pay less for a
product by reducing the quantity purchased,1 and it can be possessed by a single firm or
a group of firms acting jointly. Technically, a buyer has monopsony power if it confronts
in its purchasing decisions a positively sloped supply curve; by contrast, a buyer in a
perfectly competitive market faces a horizontal supply curve at the competitive price.
A firm can be a monopsonist, therefore, as the term is commonly used, despite the pres-
ence of a fringe of competing buyers.2
A firm can have monopsony power for competitively legitimate reasons. For instance,
a firm might become the only substantial employer in a region by foresight or natural
attrition. In general, a firm does not violate antitrust law unless it acquires, maintains,
or increases monopsony power through anticompetitive means (Bauer and Page 2002,
p. 329). Predatory buying—the rough counterpart of predatory pricing—is one method
a firm might use to increase its monopsony power, though the term can be understood
more broadly. It can mean the anticompetitive practice of increasing the amount of an
input purchased and hence the price paid for it either to reduce competition in the input
market or to impose costs on competitors in the input market and thereby raise price
in the output market. The idea that overbuying can generate profits either by lessen-
ing competition in the input market alone or by causing an anticompetitive effect in
1 In unusual situations, a monopsonist may be able to reduce the price paid for a good without
reducing the quantity purchased. For instance, if a firm can make a credible threat that it will buy nothing
unless suppliers sell to it at the lower price offered, the firm can force suppliers onto their all-or-none
supply curve, and they will sell to the monopsonist the amount they would have sold in a competitive
market, but at a subcompetitive price (Blair and Harrison 2010).
2 Although a monopsonist could be an ultimate consumer, in most monopsony cases of concern to
competition policy the firm is an intermediary, purchasing the monopsonized good as an input or for
resale. This discussion will assume that a monopsonist is an intermediary.
Predatory Buying 73
the output market too distinguishes it from predatory pricing, which when successful
impairs competition only in one market.
4.1. The Economics of Monopsony
An understanding of predatory buying starts with the economic rudiments of mon-

opsony. If supply of an input is infinitely elastic, no buyer can have monopsony power.
But a buyer facing an upward-sloping supply curve recognizes that by increasing its
purchases of the input, it will ordinarily have to pay the higher price not only for the last
unit purchased but for all other units purchased as well.3 As a result, for every possible
quantity above 1, the marginal factor cost, or marginal outlay, of the buyer exceeds the
price paid. The monopsonist confronts a marginal factor cost curve that lies above and
rises more sharply than the supply curve, which represents the schedule of prices that
must be paid to suppliers for different quantities of the input. The relationship between
the supply curve and the marginal factor cost curve is fundamentally the same as the
relationship between a negatively sloped demand curve and the associated marginal
revenue curve.
In a competitive input market, a single buyer’s demand represents so small a share
of total demand that the buyer cannot affect the price of the input by varying the quan-
tity purchased. The buyer perceives a horizontal supply curve at the competitive price,
and the competitive price is determined by the intersection of the market supply curve
and the aggregate value of the input for all purchasers in the market. The firm buys the
quantity at which market price equals the value of the marginal product. The value of
the marginal product, or marginal revenue product, equals the output price multiplied
by the marginal physical product, which is the additional output attributable to another
unit of input. Because marginal physical product normally declines, the value of the
marginal product declines as output increases. The monopsonist, like the perfect com-
petitor, calculates the value of its marginal product based on the demand for its output.
But unlike a competitive firm, the monopsonist purchases the quantity of input such
that the marginal factor cost equals the value of its marginal product. The price it pays
for that quantity is determined by the supply curve. Therefore the monopsonist pays a
price that is below the value of its marginal product. Monopsony power can be measured
using an adapted form of the Lerner Index (Lerner 1934; Blair and Lopatka 2008). It is
the percentage deviation from the competitive result. Thus, a monopsonist’s power (I)
equals the value of the marginal product (VMP) minus input price (w) divided by input
price I = (VMP − w ) / (w ), all measured at the profit-maximizing price. Equivalently,
this index of monopsony power equals the reciprocal of the elasticity of supply.
3
The exception is a buyer that can price discriminate, a practice that is usually infeasible.
74 John E. Lopatka
Price and Cost
MFC
a S
b
w1
w2
c
VMP
0 Q2 Q1 Quantity
FIGURE 4.1 Competitive and Monopsony Conditions
Figure 4.1 illustrates the position of the monopsonist in the input market. A firm in a
competitive market would purchase the quantity of input supplied where price equals
the value of the marginal product. The firm would purchase Q1 units at a unit price of
w1. A monopsonist would restrict purchases to the amount at which marginal factor
cost equals the value of the marginal product. It would purchase Q2 units at a price of w2.
Monopsony behavior is considered exploitation of input suppliers because the monop-
sonist pays a price for the input that is less than the value of the marginal product to the
monopsonist.
In most cases, an exercise of monopsony power causes a distortion in the input mar-
ket and therefore reduces total welfare relative to the competitive outcome (Blair and
Harrison 2010, p. 44).4 In the short run, the lower price paid by the monopsonist for
the units it purchases results in a wealth transfer from input suppliers to the buyer. But
the input not purchased by the monopsonist results in a deadweight loss. In figure 4.1,
the deadweight loss is depicted as area abc. The input is released for use elsewhere in
the economy, but alternative uses are less valuable than the use the monopsonist would
make of it; both suppliers and the monopsonist lose surplus. Further, in the long run
input suppliers may shift investments to the production of less valuable resources. In
a simple exercise of monopsony power, therefore, input suppliers suffer a loss and the
monopsonist enjoys a gain, for the value of its marginal product exceeds the input price.
4 The exceptions are situations in which the monopsonist engages in perfect price discrimination or
forces input suppliers onto the all-or-none supply curve.

Predatory Buying 75
Price and Cost
mfc
Sr S
w*
Ddf
Df
0 Q*f Q*df Q* Quantity
FIGURE 4.2 Dominant Buyer and Competitive Fringe
When a firm is a dominant buyer competing for the purchase of an input, the analysis
is substantially the same (Blair and Lopatka 2008, p. 427). The collective demand of the
competitive fringe lies below the value of the marginal product of the dominant buyer,
either because the dominant buyer is more efficient than its competitors or because the
dominant buyer sells in a market that places a higher value on its output than the value
different markets place on the output sold by its competitors. The dominant buyer con-
fronts a residual supply curve that equals market supply minus the demand of the com-
petitive fringe at every output. The residual supply curve implies an associated marginal
outlay curve. The dominant buyer maximizes profits by purchasing the quantity sup-
plied at the price where its marginal outlay equals the value of the marginal product. The
competitive fringe collectively purchases the quantity determined by fringe demand at
that price. The total quantity purchased in the market is greater and the price higher than
they would be if a buyer was a pure monopsonist, but quantity and price are lower than
if the buyer was a perfect competitor. The monopsony power of a dominant buyer can
be measured as the reciprocal of the elasticity of supply of the dominant buyer, which
depends on the market elasticity of supply, the elasticity of demand of the fringe, and the
dominant buyer’s market share. The welfare and distributional effects of dominant buy-
ing behavior are comparable though smaller than in the case of pure monopsony.
Figure 4.2 illustrates an input market in which a dominant buyer confronts a fringe
of competitors. The demand curve of the dominant firm (Ddf ), or the value of the mar-
ginal product, lies above the demand curve of the competitive fringe (Df ). The dominant
buyer confronts a residual supply curve (Sr) equal to the market supply (S) minus the
76 John E. Lopatka
demand of the competitive fringe. The dominant buyer purchases the quantity deter-
mined by the intersection of its demand curve and the residual marginal factor cost
(mfc). The firm buys quantity Q*df at a price of w*. At that price, the competitive fringe
purchases quantity Q*f. The total quantity purchased is the sum of Q*df and Q*f, or Q*.
All of the effects described so far occur in the input market. As a firm with mon-
opsony power reduces input purchases, it will almost certainly reduce output.5 The
effects of the output reduction depend upon conditions in the output market (Blair and
Harrison 2010, p. 47). At one extreme, the monopsonist might be a perfect competi-
tor in an output market in which supply is infinitely elastic. In that case, any reduction
in the output of the monopsonist will be completely offset by an increase in produc-
tion by other suppliers. Price and total quantity are unchanged, and consumers suffer
no loss. Nevertheless, the monopsonist earns profits. The monopsonist sells the quantity
at which marginal cost equals market price, just as a competitive firm would do, but the
marginal cost of the monopsonist is higher than that of a competitive firm. And at the
output the monopsonist produces, its average cost is lower than its marginal cost (Blair
and Durrance 2008). Monopsony profits, therefore, are profits earned on the sale of out-
put because of the exercise of market power in the input market.
The perfectly competitive output market from the perspective of an input competi-
tor and a monopsonist is depicted in figure 4.3. The firm can sell any amount it chooses
at a price of p. If the firm is a perfect competitor in the input market, it will operate
along marginal cost curve MC. It will sell q1 units, where price equals marginal cost,
and in equilibrium price will also equal average cost. At the competitive quantity, the
firm’s marginal cost curve and average cost curve (AC) intersect, and the firm’s revenues
equal its costs. The monopsonist’s marginal cost curve (MCm) lies above a perfect input
competitor’s marginal cost curve. The monopsonist equates price and marginal cost and
sells q2 units. The firm earns profits because its average cost at q2 is less than its marginal
cost. The monopsonist’s average cost equals price at the quantity a perfect input compet-
itor would sell, q1. Thus, the monopsonist’s average cost curve (ACm) intersects with the
marginal cost and average cost curves of a perfect input competitor at the competitive
quantity. The monopsonist sacrifices profits if it expands output beyond q2; it does not
suffer a loss unless it expands output beyond q1.
In a more realistic setting, the monopsonist has no monopoly power, but output sup-
ply is not perfectly elastic. A reduction in output by the monopsonist will result in a
reduction in total output. But the proportionate reduction in market output will be min-
ute, and any associated price increase negligible, if even detectable.
At the other extreme, the monopsonist may have monopoly power. In that case, the
firm will set output quantity where its marginal cost equals its marginal revenue. It
will sell less than if it only had monopsony power. An exercise of monopsony power in
these circumstances will cause measurable welfare losses in both the input and output
markets.
5 A monopsonist could substitute other inputs and continue to produce the same quantity of output.
But the input substitution would be inefficient, and the welfare effects would be analogous.
Predatory Buying 77
Price and Cost

ACm
MCm AC
MC
0 q2 q1 Quantity
FIGURE 4.3 Output Market for Input Competitor and Monopsonist
The welfare effects of monopsony are legally important. If competition law is inter-
preted to promote consumer welfare in a narrow sense, then an exercise of pure
monopsony power—an exercise that has no appreciable effect on output price—is
unproblematic, and the acquisition of that power is unobjectionable. If, however, the
law is interpreted to promote total welfare or to recognize a value in the welfare of input
suppliers, an exercise of pure monopsony power is a matter of concern, and the acquisi-
tion of such power by anticompetitive means is objectionable.6 Under any prevailing
interpretation of competition law, the anticompetitive acquisition and exercise of mon-
opsony power that causes a significant reduction in output quantity and a consequent
increase in output price would be condemned.
4.2. Predatory Buying
Judicial decisions addressing claims of predatory buying are rare, either because the
practice is rare or because the practice is rarely challenged. The most notable case is the
6 For a sample of differing views on whether antitrust law should be interpreted to protect input
suppliers when output consumers are not injured, see Werden (2007), Rosch (2007), Salop (2005),
Kirkwood (2005), Zerbe (2005), Grimes (2005), Hylton (2008), and Jones (1989).
78 John E. Lopatka
US Supreme Court’s decision in Weyerhaeuser Co. v. Ross-Simmons Hardwood Lumber

Co. (2007). Nevertheless, the economic logic of increasing purchases in the input mar-
ket as an anticompetitive strategy can be examined, and it depends upon the setting in
which the conduct takes place. A number of settings are possible, three of which will
be addressed here: (1) the monopsonist competes with completely different firms in
the input and output markets, and the monopsonist has no monopoly power; (2) the
monopsonist competes with different firms in the two markets but has monopoly
power; and (3) the monopsonist competes with at least some of the same firms in the
input and output market.
4.2.1. Completely Different Rivals and No Monopoly Power

In the simplest setting for predatory buying, the predator is a dominant firm in the input
market; its input competitors do not compete with it in the output market; and it has no
monopoly power in the output market. These are the conditions the US Supreme Court
assumed prevailed in Weyerhaeuser (2007). In that case, the Court rejected a claim that
a lumber company that purchased about 65% of the alder sawlogs in a market but had
no monopoly power in the hardwood lumber market excluded a competitor by paying
timberland owners and loggers high prices for alder sawlogs; sawlogs accounted for as
much 75% of sawmill’s cost of producing lumber. As a technical matter, the predator
need not have monopsony power before it initiates predation. But as a practical matter,
a buyer without some pre-predation monopsony power is unlikely to succeed in a pred-
atory strategy. That strategy depends upon at least making a credible threat to bid up
the price of an input by increasing the quantity purchased, and increasing purchases by
the necessary amount will be implausible unless the firm has monopsony power. In this
setting, any increase in profits brought about by predatory buying does not depend on
price effects in the output market. Rather, the buyer can increase profits only by increas-
ing its monopsony power, or increasing the gap between its average cost and the market
price of the output.
The conventional theory of predatory buying—which itself is adapted from the con-
ventional theory of predatory pricing—assumes that the predator and its rivals have
perfect information. Predation involves a two-period strategy: during the first, or pred-
atory, period, the predator increases the quantity of input it purchases, forcing the price
up, until rivals exit the market or permanently shrink their capacity; during the second,
or recoupment, period, the predator reduces input purchases below pre-predation lev-
els and pays a correspondingly lower price. The losses sustained during the predatory
period represent an investment that pays off during the recoupment period. Predation
is a rational strategy if the net effect is positive. Notably, the net effect must take into
account the time-use value of money, for the firm sustains losses sooner than it enjoys
gains, and gains therefore must be discounted to present value (Posner 2001, p. 210).
Successful predation will reduce total welfare. The predator is able to exclude competi-
tors because its marginal revenue product is greater than their collective demand. In a
Predatory Buying 79
Price and Cost
MFC
w1
VMP
Df
0 Q1 Quantity
FIGURE 4.4 Predatory Buying with No Allocative Distortion
broad sense, the predator is more efficient than its competitors—its costs are lower or
the value of its output is higher than its competitors’.
Just how high the predator must increase price during the predatory period to exclude
its competitors depends primarily on the relative efficiency of the predator and its rivals.
As the monopsonist increases input purchases, it necessarily sacrifices profits, for the
assumption is that it maximizes profits at a level that permits a competitive fringe to
operate. Putting aside any potential legal liability, the predator will likely convert that
additional input into output in the ordinary production cycle, because once the input
is purchased its use in production of the output is normally its highest valued use; if
the firm stores the extra input for future use, it will do so at a positive cost, reducing
the expected net profits of the strategy. The dominant buyer may be able to exclude its
rivals at an input price equal to the value of its marginal product. That is the input price
that would prevail in a competitive market, and if competitors are excluded at this price,
total welfare necessarily increases during the predatory period. The situation is depicted
in figure 4.4. At an input price of w1, the competitive fringe purchases no input. The
dominant buyer purchases Q1 units of input, and the input price equals the value of the
marginal product to the dominant buyer. If the dominant buyer were instead a perfect
competitor, it would also purchase Q1 units at a price of w1.
The dominant buyer, however, may have to increase price beyond this level to exclude
its competitor, and an input price above the competitive level implies an allocative
distortion. The dominant buyer in figure 4.5 must purchase Q′ units at a price of w′ to
exclude competitors. The deadweight loss is area def. The distortions caused by paying
80 John E. Lopatka
Price
MFC
S
e
w′
w1
d
f
VMP
Df
0 Q1 Q′ Quantity
FIGURE 4.5 Predatory Buying with Allocative Distortion
a supracompetitive price for an input and by paying a monopsony price have opposite
directions, and normally a distortion caused by a buyer paying more than necessary for
a good is not a matter of antitrust concern, for the buyer incurs a market penalty. But if
paying a supracompetitive price is part of an exclusionary strategy, it is not necessarily
self-deterring. If the distortion is greater than the distortion caused by the dominant
firm’s pre-predation monopsony pricing, total welfare declines during the predatory
period. Thus, if area def in figure 4.5 is larger than area abc in figure 4.1, welfare declines
during predation.
In any event, if the predator succeeds in excluding rivals and in recouping its losses
through the exercise of additional monopsony power, the predatory campaign certainly
reduces total welfare. In theory, total welfare can decline as a result of predation even if
the predator excludes competitors at a price no higher than the competitive price: rela-
tive to the pre-predation period, the gain in welfare during the predatory period may
be less than the loss of welfare during the recoupment period. The predator’s ability to
recoup losses depends upon whether monopsony pricing during the recoupment period
attracts new demand, be it in the form of new entry into the input market, reentry of
former competitors driven out of the market, or resurrection of capacity permanently
curtailed during the predatory period. New demand will push input price up, reducing
the predator’s monopsony profits. If new demand is forestalled long enough, the preda-
tor can profit on balance. The condition necessary for successful recoupment is captured
imperfectly in the concept of entry barriers.
A challenge confronting lawmakers is to establish liability standards for predatory
buying as well as predatory pricing that take into account the institutional competence
Predatory Buying 81
of tribunals and the expected costs of error (Blair and Lopatka 2008; Hylton 2008;
Easterbrook 1981). Prices during what might be a predatory period of a predatory pric-
ing campaign will always be low relative to some standard, and low prices are gener-
ally desirable. The threat of liability may chill pricing behavior that lawmakers want to
encourage. Similarly, input prices during a putative predatory bidding campaign will
be high relative to some standard, and though high prices will not necessarily ben-
efit consumers, lawmakers may wish to encourage them in many circumstances. The
legal policy objective is to establish standards that minimize the costs of error—the
costs of both false positives and false negatives—given the inherent limitations in the
decision-making ability of tribunals.
The US Supreme Court has recognized that predatory pricing and predatory bid-
ding are analytically symmetrical (Weyerhaeuser 2007, p. 321). The Court had held in
Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. (1993) that unlawful preda-
tory pricing requires that a firm (1) charge prices below an appropriate measure of its
costs and (2) have a dangerous probability of recouping its investment in below-cost
prices. Analogously, according to the Court, the plaintiff in a predatory bidding case
must prove that (1) “the alleged predatory bidding led to below-cost pricing of the
predator’s outputs” and (2) “the defendant has a dangerous probability of recouping the
losses incurred in bidding up input prices through the exercise of monopsony power”
(Weyerhaeuser 2007, p. 325).7 The logic of the Court’s predatory-pricing analysis is that
prices normally are not “predatory” unless they can exclude an equally or more efficient
competitor, and a price equal to or above the alleged predator’s costs can only exclude
a less efficient competitor. A perfect competitor prices at marginal cost, and therefore
the relevant measure of cost for identifying predation is in theory marginal cost. But
the first prong of the Court’s test for predatory bidding is not directed to the price a per-
fect competitor would pay for an input, but rather the price the alleged predator would
charge for its output. A firm may be able to exclude input competitors by raising price to
no more than the value of its marginal product, which is the price it would pay in a com-
petitive input market. By analogy to predatory pricing, a competitive input price cannot
be predatory. And yet a monopsonist that converts all input into output and pays a com-
petitive input price will charge an output price below marginal cost. The Court might
have held that a monopsonist’s price for an input is predatory if it is above the value of
the monopsonist’s marginal product (Blair and Harrison 2010, p. 73). If the first prong of
the test is based on output price rather than input price, however, the relevant measure
of cost is not marginal cost, but average cost.
A monopsonist may increase input purchases, even in an amount that results in an
output price below average cost, for competitively legitimate or at least nonpredatory
reasons. For instance, demand for the monopsonist’s output may increase or the monop-
sonist may increase its productive efficiency. In either case, the value of the monopso-
nist’s marginal product will increase, and the profit-maximizing quantity of input will
7 The Court’s use of the present tense in describing the prospect of recoupment implies that a
violation can be found before recoupment is complete or even begun.

82 John E. Lopatka
increase. The equilibrium output price will equal average cost. But if the monopsonist
misestimates an increase in demand or an increase in its efficiency, purchasing addi-
tional input the need for which does not materialize, it may pay an input price above
the actual value of its marginal product and charge an output price below average cost.
Similarly, a firm is likely to maintain a reserve of inputs, warehousing them to guard
against unpredictable shortages of supply or surges in output demand. Warehousing
is an aspect of productive efficiency. A monopsonist may conclude that its reserve has
been inefficiently low and increase input purchases accordingly. Or the monopsonist
may anticipate increases in input prices or the demand for its output, and it may increase
its input reserves in response. Again, if its forecast proves mistaken, it may sell its output
at a price below average cost. A firm that errs in predicting the future is apt to suffer a
market penalty. But mistaken increases in input purchases that drive output cost above
some objective benchmark do not imply a predatory intent or effect. The threat of liabil-
ity can dampen competitive zeal.
The leading models of predatory pricing depend upon asymmetric information (see
Kreps and Wilson 1982; Milgrom and Roberts 1982; Ordover and Willig 1981). If a firm
lowers its price, its competitors may not know whether the firm is taking advantage of its
superior efficiency or is engaging in predatory pricing. If the firm has lower costs than its
competitors, it will be able to exclude them and generally avoid legal liability. If the com-
petitors cannot costlessly avoid losses by curtailing production while the firm is pricing
low, they are better off leaving or staying out of the market. Predatory pricing could be
used to acquire a reputation as a low-cost firm, even if the firm in fact is no more effi-
cient than its competitors, and thereby deter entry. Another model assumes that firms
have symmetric information, but the incumbent has lower costs than entrants (see Edlin
2002). The incumbent is able to charge high prices indefinitely because entrants know
that they could be lawfully excluded by prices above the incumbent’s costs and therefore
do not attempt to enter. Consumers never receive the benefit of the incumbent’s lower
costs. The logic of models of strategic predatory pricing applies to predatory bidding.
A buyer might respond to entry by increasing its input purchases to convince competi-
tors that it is more efficient than they are, or it might be able to pay low prices perpetu-
ally because potential entrants realize that they could be lawfully excluded. Theories of
strategic predatory pricing have not significantly affected legal standards, however, at
least partly because lawmakers doubt the ability of tribunals to identify strategic price
predation that does not satisfy administrable objective criteria. Analogous theories of
predatory bidding are not likely to have any greater impact on the law.
4.2.2. Completely Different Rivals and Monopoly Power

A dominant buyer may also be a dominant seller, meaning that it has monopoly power
in the output market while facing a competitive fringe. A dominant seller will calcu-
late a residual demand curve equal to market demand minus the supply of the competi-
tive fringe. The residual demand curve implies a residual marginal revenue curve. The
Predatory Buying 83
dominant seller will set quantity where its marginal cost is equal to its residual marginal
revenue and charge the associated price. At that price, the competitive fringe will supply
part of the market, earning no profits, and the dominant firm will supply the rest, earn-
ing monopoly profits. Total quantity is lower and price higher than they would be in a
perfectly competitive market, but quantity is higher and price lower than they would be
if the dominant firm were a perfect monopolist.
Figure 4.6 depicts a market with a dominant seller and a competitive fringe. The
dominant firm has lower marginal costs (MCdf ) than the collective marginal costs of
its competitor, shown as the supply curve of the competitive fringe (Sf ). The dominant
firm calculates a residual demand curve (d) and an associated residual marginal revenue
curve (mr). It sells the quantity determined by the intersection of MCdf and mr, or Q*df
units. The competitive fringe takes the price as given and sells the quantity dictated by
Sf, or Q*f units. Total quantity is the sum of Q*df and Q*f, or Q*. The dominant firm earns
profits based on the difference between price and its average costs.
If the dominant firm competes against completely different firms in the input and
output markets and engages in predatory buying, it will increase input purchases during
the predatory period and likely convert at least some of the extra input into output. As its
output increases, the welfare loss in the output market will decline. If the firm must raise
input price above the competitive level to exclude input competitors, converts the input
into output, and as a result sells output at a price below its marginal cost, the firm will
cause net welfare losses in both markets. But it would expose itself to predatory pricing
liability.
Price and Cost
Sf
p*
MCdf
D
mr
FIGURE 4.6 Dominant Seller and Competitive Fringe

84 John E. Lopatka
If predatory buying is successful in excluding fringe buyers, the dominant buyer

during the recoupment period will pay a lower price for and buy less input than it did
prior to the beginning of predation. Consequently, it will reduce output, and the dead-
weight loss in the output market will be greater than it was in the pre-predation period.
Successful predatory buying by a dominant buyer with monopoly power will result in
net welfare losses in both the input and output markets. Predatory buying in such a case
poses a greater danger to economic welfare than it does in a pure monopsony case—one
in which the monopsonist has no monopoly power. Moreover, it threatens to impose a
significant loss on consumers, whereas it represents at most a trivial threat to consum-
ers in the pure monopsony situation. If competition law is interpreted to protect only
consumers or to value consumer welfare more highly than the welfare of input suppli-
ers, then predatory buying by a monopolist is a greater concern than predatory buying
by a pure monopsonist. Nevertheless, the legal standards should be the same in the two
contexts, assuming the imposition of a welfare loss in the input market alone is objec-
tionable. In both settings, the mechanism of causing a welfare loss is the same. It relates
solely to the use of price to exclude input competitors.
4.2.3. Same Competitors in Input and Output Markets

A dominant buyer might compete with at least some of the same firms in both the input
and output markets. A common set of competitors is a necessary though not sufficient
condition for the use of overbuying to earn profits in the output market by raising out-
put price. The idea is straightforward: By raising input price through overbuying, the
predator increases the marginal costs of its input competitors, inducing them to reduce
their output or raise output price (Salop 2005; Salop and Scheffman 1983; Salop and
Scheffman 1987). The predator’s own marginal costs are likely to increase, but they may
increase in a lesser amount. The predator functioning as a dominant firm in the output
market faces a competitive fringe with higher costs and calculates residual demand and
residual marginal revenue curves that lie above the comparable curves prior to preda-
tion.8 Market price increases and total quantity decreases, and the predator’s share of the
market increases. Increasing the costs of input competitors can have no effect on output
price if those competitors do not compete with the predator in an output market. The
exclusionary strategy is profitable only if the firm’s costs of predation are less than the
profits it earns from a larger market share and higher output prices.
Figure 4.7 depicts the effects in the output market of successful predatory overbuying
in the input market by a dominant buyer with monopoly power. Overbuying increases
the marginal costs of competitors, resulting in a rotation of the fringe supply curve from
8
A predatory buying strategy may be successful even if the predator does not have the power in the
output market to raise price by restricting its output. All that is necessary is that the demand curve for
the output is negatively sloped and that the competitors’ supply curve is positively sloped (Krattenmaker,
Lande, and Salop 1987).
Predatory Buying 85
Sf ′
Price and Cost
Sf
d′
p*′ MCdf ′
p*
MCdf
mr D
mr ′
Q*f ′ Q*df ′ Q*′
FIGURE 4.7 Dominant Buyer and Seller Facing Common Competitors
Sf to Sf′. The predator’s marginal cost curve rotates from MCdf to MCdf′. The predator
calculates a new residual demand curve (d′) and residual marginal revenue curve (mr′),
and it produces the quantity dictated by the intersection of mr′ and MCdf′, or Q*df′. Price
increases from p* to p*′, the quantity sold by the competitive firm drops to Q*f′, and
market quantity decreases to Q*′.
The rationality of predatory buying as a method of increasing profits in the output
market by reducing the elasticity of supply depends upon two conditions. First, the
higher input cost imposed on competitors must have an appreciable effect on the output
market, which generally implies that the predator’s input rivals account for a significant
share of output. If a large share of the output market is supplied by firms that do not use
the input or acquire the input in markets unaffected by the putative predator’s overbuy-
ing, the overbuying is not likely to affect output price. Similarly, if entry into the out-
put market is easy without use of the affected input, an overbuying predatory strategy is
likely to fail.
Second, the increase in the predator’s profits must exceed the predator’s costs of pre-
dation. For example, if the predator uses the relevant input less extensively than does
its rivals, a strategy of overbuying will increase the price the predator as well as its com-
petitors pays. But because the input represents a smaller proportion of total cost for the
predator than for its competitors, the resulting increase in output price more than off-
sets the predator’s increased costs. A classic example of this situation is a predator that
86 John E. Lopatka
uses labor less intensively than does its competitors and drives up wages by hiring excess
workers.
Both the ability to raise input price by increasing the amount of input purchased
and the profitability of a cost-raising strategy are affected by the predator’s relative
size. A firm is not likely to be able to raise input price appreciably through its purchase
decisions unless it purchases a substantial share of the available input before increas-
ing the amount it purchases. And the smaller the firm is before it launches the strategy,
the greater the proportionate increase in its own costs will be to impose significant cost
increases on rivals, thereby necessitating higher profits in the output market to achieve a
net positive effect. Nevertheless, a firm need not have the level of monopoly power nec-
essary to raise price by restricting its own output.
If the conditions necessary for rational predation by overbuying are not fulfilled,
the implication is that the firm’s increase in input purchases is not part of an anticom-
petitive strategy to increase output price. That conclusion is consistent with the obser-
vation above that a firm may increase the amount of input purchased for legitimate
reasons.
Although the use of predatory buying merely to raise input price on the one hand
and ultimately to raise output price on the other are both anticompetitive strategies,
they have certain different implications that are economically and legally important.
Critically, when predatory buying is used as a method of raising output price, input sup-
pliers benefit, consumers suffer, and the predator profits concurrently. The strategy does
not involve a two-period sequence. By contrast, when predatory buying is used merely
to increase monopsony profits, the predator does not begin to gain until exclusion is
successful. As a result, the profits earned when overbuying causes output price to rise
need not be discounted to present value. Further, because the future is inevitably unpre-
dictable to some extent, the form of predatory buying that depends upon an increase in
output price is to that extent a less risky anticompetitive strategy.
In addition, the law need not be as reticent to condemn predatory buying if the legal
challenge takes place when anticompetitive effects are present than when they are
predicted. If the theory of the claim is that the firm is using predatory buying only to
increase monopsony profits and the claim is made during the predatory period, a tribu-
nal will have to decide at least whether the firm is planning to lower the price it pays for
the input below pre-predation levels during a recoupment period, and depending upon
the standards adopted it may have to decide whether recoupment is objectively prob-
able. A mistake in finding an illicit purpose or likely effect will punish competitively
desirable conduct. Conversely, if the theory is that simultaneously the firm is overbuy-
ing input and output price has increased, a tribunal will not be required to make predic-
tions, though it will be required to determine that the overbuying was illicit and led to
increased output prices. The focus of legal analysis is the output market. The tribunal
will have to determine that the alleged predator’s increase in input purchases caused
output prices to increase, and it will also have to determine that the input purchases
were not made for competitively legitimate reasons, even if based on assumptions or
predictions that later proved erroneous.
Predatory Buying 87
4.3. Conclusion
Predatory buying can be a rational anticompetitive strategy. In one setting, a dominant

buyer can increase its purchases and input price to exclude competing purchasers, then
reduce its purchases and input price to earn monopsony profits while imposing little or
no adverse effect in the output market. In another, a buyer can engage in the same con-
duct while exercising monopoly power as well, reducing output sufficiently to impose
a significant negative impact on output consumers. In a third, a buyer can bid up the
price of an input to raise the costs of input competitors who also compete with it in
the output market, thereby forcing output price up, earning profits immediately in the
output market, and imposing a loss on consumers. In each of these settings, predatory
buying can increase the predator’s profits and is therefore rational. In each, the strategy
is anticompetitive, if competition is understood to be a process that maximizes total
welfare. In the first setting, however, the welfare loss is sustained almost entirely in the
input market, and if competition policy is directed solely at the welfare of consumers,
the strategy is not anticompetitive; in the two other settings, consumers are injured
appreciably.
That predatory buying can be a rational anticompetitive strategy in theory does not
mean that it is prevalent. A number of obstacles can thwart a predatory campaign, and
successful predatory buying may be rare. Moreover, the heart of predatory buying is an
increase in the amount of an input purchased by a large buyer. A buyer may increase
purchases for a number of competitively legitimate reasons. Legal standards that are
ill-conceived in theory, that are imprecise and unpredictable, or that cannot be effec-
tively administered can stifle competitive fervor. They can do more harm than good. The
optimal legal approach to predatory buying is an open question.
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CHAPTER 5
C OM P E T I T I V E D I S C OU N T S A N D
A N T I T RU S T P OL IC Y
KEVIN M. MURPHY, EDWARD A. SNYDER, AND

ROBERT H. TOPEL
5.1. Introduction
This chapter deals with a broad class of quasi-exclusive, vertical agreements in which
a seller conditions price discounts on the specified quantity or share of a product line
that the buyer commits to purchase from the seller. We refer to such agreements as
“quantity commitment discounts” (QCDs), though they are often referred to as “loy-
alty discounts,” as they appear to exchange price concessions for a buyer’s loyalty to
a particular brand. Both economic theory and the law recognize that in some cases
pricing and business practices of sellers may harm or weaken rivals and might also
reduce social welfare. The classic example is predatory pricing, in which a seller tem-
porarily prices below incremental cost with the explicit goal of driving rivals from
the market.1 Common and typically procompetitive business practices designed to
increase sales—including forms of quantity-related discounts, nonlinear pricing, and
various vertical restrictions on distributors—similarly might in certain circumstances
harm competition by harming competitors (see, e.g., Schwartz and Vincent 2008;
Wilson 1993).
Of particular concern to the current US Department of Justice (DOJ) are “contracts
that reference rivals” (CRR) in which the terms of one seller’s procurement contracts
with downstream buyers implicitly or explicitly condition on the terms that apply to
1
For a more detailed discussion, see Kenneth Elzinga and David Mills, “Predatory Pricing,” in this
Handbook.
90 Kevin M. Murphy, Edward A. Snyder, and Robert H. Topel
rivals.2 Exclusive dealing arrangements, where a buyer agrees to purchase all of a par-
ticular product from a single seller, can be viewed as a limiting case of CRRs. More
generally, a seller may condition discounts from list prices on a buyer’s agreement to
promote the seller’s products more prominently than certain competitors’ or to not pro-
mote them at all.3 While such practices are known to have procompetitive benefits, if
widely practiced by a dominant seller the cumulative effect of such practices might be to
weaken competition by impairing rivals’ ability to compete in the market.
The ambiguity and difficulty inherent in attempts to balance pro- and anticompetitive
effects of common pricing practices is, in our view, the great challenge of antitrust enforce-
ment. The bedrock proposition—that harms to rivals does not imply harm to competi-
tion—does not extend to governing this core component of the economic activity. It is
recognized that lax enforcement can harm competition, but so can overly aggressive
enforcement that protects competitors at the expense of vigorous competition. Further,
absent clear standards defining the bounds of illegal conduct the mere threat of antitrust
liability may dampen rivalry among firms, with resulting harm to the competitive pro-
cess and, ultimately, consumers.4 An increasing reliance on economic analysis in antitrust
matters has resulted in a movement towards fewer per se illegality rules; however, per se
illegality rules have not been replaced with broad safe harbors (Kobayahi and Muris 2012).
As our discussion in section 5.2 indicates, law and policy have not evolved to yield
clear standards for judging QCDs and indeed have taken divergent paths. In section
5.3 we cover the basic economics of QCDs, showing that they are a natural outcome of
sales-promoting competition by differentiated sellers and are typically mutually ben-
eficial for participating buyers and sellers. In section 5.4 we evaluate the circumstances
when QCDs may cause harm to competition. We demonstrate that QCD agreements
that would arise absent an ability or intent to exclude rivals might nevertheless do so,
and might also cause ancillary harm to competition. In section 5.5 we then assess the
various means of testing for potential harm. We discuss interpretations of the so-called
attribution test and its flaws as well as other indicators of potential harm.
2
Scott-Morton (2012) concludes that CRRs, such as market share discounts, “have the potential
to harm consumers and competition, particularly—but not always—when they involve firms with
market power. CRRs have thus been, and will continue to be, the subject of antitrust scrutiny, both at the
government [sic] and in private litigation.” See Scott-Morton (2012) p. 3. Salop (1986) p. 265 discusses
conditions under which pricing practices such as most-favored-nation (MFN) and meeting competition
clauses (MCC) may have anticompetitive implications.
3 For example, in J.B.D.L. Corp. et al. v. Wyeth-Ayerst Laboratories, Inc., et al. (6th Cir. 2007), Wyeth’s
contracts with pharmacy benefit managers granted discounts on its Premarin conjugated estrogen
product in exchange for exclusive placement of Premarin in pharmacy benefit managers’ core formulary.
4 The degree of difficulty in evaluating pricing practices is underscored by the fact that private
plaintiffs in the United States can bring claims of anticompetitive exclusion against their rivals under
the Section 4 of the Clayton Act, which provides for treble damages and one-way fee-shifting in favor
of plaintiffs (Clayton Antitrust Act of 1914, Pub. L. 63-212, 38 Stat. 730, codified at 15 U.S.C. §§12-27,
29 U.S.C. §§52-53). If the threshold to survive a motion to dismiss is that economic analysis is needed
to assess the effects of a firm’s pricing practices on its rivals, then firms face the prospect to having to
settle such claims or risk treble damages and the legal costs of both parties. For relevant discussions, see
Easterbrook (1984); Kauper and Snyder (1991).
Competitive Discounts and Antitrust Policy 91
Our concluding remarks in section 5.6 follow most directly from two main points. First,
QCDs virtually always have a clear procompetitive rationale. Second, while economic
theory shows that under certain conditions the intent and effect of commitment discounts
could be to harm competition, these same theories provide little guidance in identifying
situations where harm actually occurs. Further, few if any past cases provide convincing
evidence of competitive harm, and no evidence of outright exclusion to our knowledge. In
our view, the ubiquity of procompetitive or competitively neutral reasons for QCDs, com-
bined with the lack of reliable tests or filters that would identify anticompetitive conduct,
support our overall conclusion that QCDs should be viewed as presumptively legal. Our
views contrast, therefore, with current US policy whereby a broad range of single-firm pric-
ing practices are typically judged under a rule of reason analysis.
5.2. Legal and Policy Context
The number of actual judgments evaluating claims of anticompetitive exclusion have

not converged on a standard. Noteworthy is the Third Circuit’s 2004 decision in Lepage’s,
upholding a jury verdict that 3M’s bundled quantity discounts violated Section 2 based
on the standard that 3M’s actions made it “very difficult or impossible for competitors to
engage in fair competition.”5 The Lepage’s decision has proven controversial because the
court did not provide an objective standard of competitive harm and neglected to show that
plaintiff LePage’s was unable to profitably compete in the sale of its private-label transpar-
ent tape against 3M’s bundled discounts. When arguing that the US Supreme Court should
not grant certiorari in LePage’s, the US solicitor general described the case law as underde-
veloped and pointed out that the lack of systematic assessment of alternative standards by
lower courts failed to establish bases for determining how standards would be applied.6
5 See LePage’s v. 3M, 324 F3d 141 (3d Cir 2003) (en banc), cert. denied 124 S Ct 2932 (2004). LePage’s
claimed that 3M set target quantities for individual LePage’s distributors such that it was impractical
for the distributors to meet the targets and retain LePage’s as a supplier. See Brief for Respondents in
Opposition at 5, 3M v. LePage’s, 2003 WL 22428377, at *1 (2003) (No. 02-1865).
6 The US government stated:
The court of appeals focused exclusively on petitioner’s proposed below-cost sales standard,
Pet. App. 7a–8a, and the meager case law addressing bundled rebates offers little assistance in
determining how alternative standards might work in practice. Because the courts below did
not attempt to apply alternative standards to the facts, their decisions offer little to illuminate
such potentially significant questions as whether an equally efficient supplier of private label tape
could profitably have matched 3M’s discounts and rebates; whether lowered prices resulting from
the bundled discounts would have increased quantities of tape purchased by an amount suffi-
cient to make the lowering of prices profitable, even if LePage’s had matched the discounts; and
whether 3M’s “discounts” and “rebates” actually resulted in reduced prices for 3M’s customers, as
3M contends, or whether the net result was a price increase structured to discourage trade with
LePage’s, as LePage’s apparently claims.
The courts have not been consistent in selecting and applying standards when eval-
uating QCDs. In Concord Boat Corp. v. Brunswick Corp., Brunswick—a producer of
stern-drive boat engines—offered discounts to boat manufacturers who would commit
to purchase at least 60% of their engines from Brunswick, which naturally reduced pur-
chases from rival engine producers among participating buyers.7 In Concord Boat the
court applied a cost-based standard. The court in SmithKline Corp. v. Eli Lilly & Co. held
that Lilly’s loyalty discounts on a bundle of antibiotics would have excluded an “equally
efficient” producer.8 Meanwhile, in Masimo Corp. v. Tyco Health Care Group the court
sustained a jury’s verdict that Tyco’s share-based discounts on a single product—pulse
oximetry sensors purchased by hospitals—violated Section 2 by maintaining Tyco’s
monopoly power.9 In Eli Lilly and in Tyco, as in other cases where liability was not found,
the courts sought to establish whether the defendant’s contracts were exclusionary in
the sense that a hypothetical equally efficient rival could not profitably compete against
them. Intel’s agreements with computer manufacturers such as Dell or Hewlett Packard
were alleged to condition discounts for Intel processors on the share of total processor
purchases that a buyer would commit to purchase from Intel—an implicit reference to
Intel’s sole major rival, AMD.10 Intel’s practices generated challenges by the EU, Korea,
and US Federal Trade Commission,11 as well as a flow of private antitrust suits by alleg-
edly excluded rivals, but no well-defined standard.12 Finally, and most recently, is the
Supreme Court’s refusal in April 2013 to review Eaton v. Meritor. Despite above-cost
pricing of its heavy-duty transmissions, Eaton was found guilty of illegal monopo-
lization by the Third Circuit because of other terms of the long-term contracts Eaton
formed with heavy-duty truck manufacturers.13
Rf. Brief for the United States as Amicus Curiae, 3M Company v. LePage’s Incorporated, No 02-1865, p. 18
(footnote omitted).
7 See Concord Boat Corp. v. Brunswick Corp., 207 F.3d 1039 (8th Cir. 2000). The discounts were 1% for
purchases accounting for 60% of total purchases, 2% for purchases accounting for 70% of total purchases,
and 3% for purchases accounting for 80% of total purchases.
8 SmithKline Corp. v. Eli Lilly & Co., 427 F. Supp. 1089 (E.D. Pa. 1976), affirmed 575 F.2d 1056 (3d Cir.
1978).
9 Masimo Corp. v. Tyco Health Care Group, L.P., No. CV 02-4770 MRP, 2006 WL 1236666, at *13 (C.D.
Cal. Mar. 22, 2006).

10 For discussion and analysis of the antitrust claims relating to Intel’s use of loyalty discounts, see
Wright (2011).
11 See, e.g., “Antitrust: Commission imposes fine of €1.06 bn on Intel for abuse of dominant position;
orders Intel to cease illegal practices,” European Union press release (May 13, 2009), http://europa.eu/
rapid/press-release_IP-09-745_en.htm?locale=en; Statement of Chairman Leibowitz and Commissioner
Rosch In the Matter of Intel Corporation, Docket No., 9341, Federal Trade Commission (December 16,
2009), http://www.ftc.gov/os/adjpro/d9341/091216intelchairstatement.pdf.
12 Other antitrust cases alleging anticompetitive exclusion include Ortho Diagnostics Sys. Inc.,
v. Abbott Lab, Inc., 920 F. Supp. 455 (S.D.N.Y. 1996); Virgin Atlantic Airways Ltd. v. British Airways PLC,
69 F. Supp. 2d 571 (S.D.N.Y. 1999), aff ’d 257 F.3d 256 (2d Cir. 2001); Applied Medical Resources Corp.
v. Ethicon Endo-Surgery (Johnson & Johnson), 03-CV-1329 (C.D. Cal. 2006).
13 See Eaton Corporation v. ZF Meritor LLC and Meritor Transmission Corporation, cert. denied, 133
S. Ct. 2025 (2013).

Given the lack of clear standards for evaluating QCDs and lack of guidance to busi-
nesses, the US Department of Justice (DOJ) in 2008 issued a detailed report clarifying
its positions on liability for single-firm conduct (US Department of Justice 2008). The
DOJ cited a number of potential benefits related to QCDs, including economies of scale
and scope, promotional incentives for retailers, inducing customers to try new prod-
ucts, customer convenience, and price discrimination based on differences in customer
demand elasticities.14 The DOJ report recommended a fairly high liability threshold
for conduct with demonstrated procompetitive benefits and potential anticompeti-
tive harms: for conduct to be actionable, harms would have to be “disproportionate” to
benefits.
The 2008 DOJ report also attempted to provide more detailed guidance based on tests.
For example, though above-cost net prices may in theory exclude, the DOJ report as well
as the 2007 Antitrust Modernization Commission (AMC) recommended that discount-
ing practices that pass the so-called attribution test should be viewed as per se legal with
no further inquiry into possible effects. Thus, in the case of bundled QCDs—like those
featured in LePage’s—where a subset of a discounting seller’s products are contestable by
rivals, all the discounts on noncontestable elements of the bundle are attributed to (sub-
tracted from) the price of contestable units. A “net price” above incremental cost would
be viewed as lawful, which is inconsistent with the recent Eaton decision. By this rule, a
finding that the net price is below incremental cost would suggest that discounts might
be unprofitable to the seller absent some other motive, which might include exclusion.
As we discuss in section 5.5 below, even this safe harbor is fairly narrow, however, as the
attribution test is known to produce “false positives,” and we provide several additional
reasons why this is so. One may further object that even in combination with other
(noisy) signals of competitive effects, reliance on tests risks exposing innocent contract-
ing practices to antitrust scrutiny and possible litigation, and may blunt sellers’ incen-
tives to engage in more aggressive and procompetitive discounting practices.
The 2008 DOJ report’s recommendations, however, were formally withdrawn in
2009. Assistant Attorney General for Antitrust Christine Varney commented as follows:
[T]‌he disproportionality test reflected an excessive concern with the risks of

over-deterrence and a resulting preference for an overly lenient approach to enforce-
ment. The failing of this approach is that it effectively straightjacketed antitrust enforc-
ers and courts from redressing monopolistic abuses, thereby allowing all but the most
bold and predatory conduct to go unpunished and undeterred. (Varney 2009, pp. 8–9).
The withdrawal of the DOJ 2008 policy guidelines, as indicated, underscores the absence
of a standard for determining whether any particular discounting practice merits
14
US Department of Justice (2008). See also similar discussion in Antitrust Modernization
Commission 2007. Some observers argue that the widespread use of QCDs in situations where
anticompetitive intent “makes no economic sense” indicates that some such benefits must exist (e.g.,
efficiencies or lower costs). See Jacobson and Weick (2012).
antitrust scrutiny or liability. Current DOJ policies as reflected in its United Regional
Health Care System move yet further from a common standard, by requiring sellers to
tailor their discounts to the specific capabilities of particular rivals.15
Other efforts following LePage’s have been made to define standards or tests that
would distinguish instances in which QCDs might be anticompetitive.16 Noting that
the possible anticompetitive impact from QCDs almost always relies on the existence
of rivals’ scale economies, some suggest that initial inquiries focus on whether a seller’s
contracts deny the benefits of scale to affected rivals (see, e.g., Carlton and Waldman
2008). Accordingly, demonstration of rivals’ scale economies might be considered
a necessary condition for a successful complaint of exclusion. The challenge herein is
that various economies are difficult to quantify and it is even more difficult to ascer-
tain whether a particular discounting practice prevents their realization. Moreover,
reliance on evidence of rivals’ scale economies requires a discounting seller to calcu-
late the impact of its contracts on rivals’ costs and profits, and to refrain from discounts
that might harm them. Here we agree with Areeda and Hovenkamp (2008) that such
attempts to find a middle approach would make a contracting seller “trustee for another
firm’s economies of scale,” holding “a price umbrella over its rivals” even if rivals’ tech-
nologies were somehow known, with the clear danger of dampening competition
(Areeda and Hovenkamp 2007, par. 749b at 249).
5.3. Basic Economics of Quantity

Commitment Discounts
In this section we explain how quantity commitment contracts and associated dis-
counts from “list” prices are natural outcomes of the competitive process, as sellers
seek to increase sales.17 These increases in sales naturally occur at the expense of rivals.
Key to what follows is that the typical seller does not face perfectly elastic demand for
its product. As a result, almost all sellers in modern wholesale and retail markets have
some control over the prices they charge—they do not simply “take” prices as given
but instead have pricing strategies in which chosen prices exceed incremental costs.
Simple linear pricing (“here’s my price, buy what you want”) leaves unrealized gains
from trade and, therefore, establishes incentives for buyers and sellers to devise ways
to unlock them.
15 Competitive Impact Statement filed by the US Department of Justice, United States of America
and State of Texas v United Regional Health Care System, United States District Court for the Northern
District of Texas, February 25, 2011, http://www.justice.gov/atr/cases/f267600/267653.pdf.
16 These efforts are discussed in US Department of Justice (2008).
17 The discussion that follows is based on Murphy and Topel (2011a, 2011b).
5.3.1. Mutual Gains from Quantity Commitment Discounts

Assume that seller S produces a differentiated product within a category of close sub-
stitutes also produced by rival(s) R. For the situations we have in mind, a buyer (B) will
typically be a downstream business that uses the products of S and R as inputs or resells
them. For example, Intel (S) is a producer of processors purchased by OEMs (B) as com-
ponents for personal computers, but rival AMD makes processors that are close substi-
tutes for at least some of the Intel line. Most large OEMs purchase processors from both
Intel and AMD. Similarly, Johnson & Johnson (J&J) produces a line of endoscopic surgi-
cal tools purchased by hospitals, but rival Tyco also produces a full line of tools, while
smaller, more specialized, manufacturers produce substitutes for various elements of
the J&J and Tyco lines. Most hospitals purchase from multiple vendors. And grocery
stores typically stock beverage lines produced by both Coke and Pepsi, who compete for
scarce shelf space and other promotional advantages.
In each of these examples, within-buyer competition between S and R means that
increased purchases from S reduce purchases from R, and conversely. Stepping back,
we should recognize that even if S had no rivals, it would want to use QCDs to realize
additional gains from trade with buyers. When S does have rivals, the sales gained from
QCDs may be a combination of additional purchases by buyers and buyers shifting pur-
chases from rivals to S. To feature the issue of potential exclusion, we focus on the case
where the seller S has a rival R and assume that incremental purchases from S result in a
one-for-one substitution in purchases from R.18 This assumption is appropriate in some
settings, such as when hospitals procure supplies or HMO pharmacies procure drugs
targeted at particular ailments. The fact that these buyers purchase substitute products
from multiple vendors implies a within-buyer demand for variety. For example, within
a hospital some surgeons may have a strong preference for a particular manufacturer’s
surgical tools while other surgeons are more willing to substitute, and some HMO mem-
bers with a particular ailment may be better served by one type of drug within a class of
therapeutic equivalents. In other cases the assumption of exact one-for-substitution is
less compelling, such as when a retailer resells multiple brands of substitute goods to
final consumers.
Figure 5.1 illustrates the incentive to discount in this environment. We assume for
now that buyers are identical and that demand curve Q(P;PR) represents the quantities
that representative buyer B wishes to purchase from S at various hypothetical prices P,
holding constant the prices charged by the rival seller, PR.19 Equivalently, at any quantity
18 We only require that S and R provide substitutes, though the one-for-one substitution is a good
representation in many important cases. Whether one or the other brand of surgical tool is used does
not materially affect the number of surgeries. Displacement is likely to be less than one-for-one in the
grocery store example of Coke and Pepsi.
19 If R produces a differentiated product, we interpret P as its optimal Bertrand price given P . With
R L
many rivals who are undifferentiated from each other we interpret PR as equal to rivals’ marginal cost.
Price
PL
PD D
IB
IS
K
Q(P,PR )=v(Q,PR )
Quantity
QL QD QE
FIGURE 5.1 The non-contract price and quantity are PL > K and QL. With
a quantity commitment contract buyer and seller may achieve mutual
gains at combinations like D that lie above IS and below IB. The efficient
quantity is QE where v(QE, PR) = K.
Q the same curve represents B’s willingness to pay for an additional unit, v(Q;PR). With
these demand conditions a seller that charges a single “list” price PL for all units will set
price above marginal cost (PL > K) and sell quantity QL = Q(PL,PR).20 The seller earns a
profit of ΠL = [PL − K]QL.
With price above marginal cost it is obvious that seller S would gain if buyer B were to
purchase more than QL at the same price. But B is unwilling to do so: the meaning of the
demand curve is that B wishes to purchase exactly QL units at price PL—each additional
unit beyond QL is worth less than PL to the buyer. Even so, there is a set of prices P < PL
and quantities Q > QL where both B and S would be better off. To find these mutually
advantageous combinations we draw two “indifference curves,” IS (for the seller) and
IB (for the buyer). Curve IS represents the set of all price-quantity pairs that yield to S
the same profit as combination (PL,QL), equal to ΠL = [PL − K]QL.21 By construction,
curve IS touches (is tangent to) B’s demand curve at (PL,QL) but otherwise lies every-
where above the demand curve—S would accept lower prices, but only in exchange for
20 The familiar solution is to set price so that marginal revenue is equal to marginal cost. We do not
show the marginal revenue curve in fi gure 5.1 in order to reduce clutter.

21 The formula for the combinations on indifference curve I is P = K+Π /Q.
S L
greater quantity increments than are available along the demand curve.22 It follows that
all price-quantity combinations above the curve IS yield greater profits.
Similarly, indifference curve IB is the set of combinations that yield to B the same con-
sumer surplus as (PL, QL). By construction IB is tangent to the horizontal line PL at the
point where the demand curve crosses PL, but otherwise lies everywhere below PL—if
given the choice of any quantity at price PL the buyer would choose QL, but would be
willing to purchase more if compensated by a sufficiently lower price, and so on. The
buyer prefers all price-quantity pairs below IB to combinations on it as they yield greater
consumer surplus. Since B’s indifference curve is tangent to the horizontal line at PL
and S’s indifference curve is tangent to B’s downward-sloping demand curve, there will
always be mutually beneficial gains to trade available with the property that P < PL and
Q > QL.
The area below IB and above IS is the set of price-quantity pairs that are mutually pre-
ferred to the stand-alone price and quantity. Ignoring income effects, the quantity that
maximizes the joint surplus of B and S for a given rival’s price is QE where the buyer’s
marginal value is equal to the seller’s marginal cost, v(QE, PR) = K, so the “contract curve”
of price-quantity pairs that maximize joint gains is vertical at QE. But full efficiency need
not be achieved for discounting to be mutually beneficial. All pairs like D = (PD, QD) in
the shaded region involve the buyer paying a discounted unit price PD <PL in exchange
for a commitment to purchase sufficiently more units than at the stand-alone price
(QD > QL)—and correspondingly fewer from R. Note that the buyer’s ability to commit
is necessary to achieve this mutually beneficial outcome: At the discounted price PD an
uncommitted buyer would choose to purchase less than QD along the demand curve, at
which S’s profit would be less than ΠL. Therefore, realization of mutual gains requires a
contract, explicit or implicit, between buyer and seller. The contract commits the buyer
to purchase a larger quantity in exchange for the seller’s commitment to an appropri-
ately large discount from the “list” (uncommitted) price PL.23 As we show later, there
are many ways to achieve this commitment including nonlinear pricing, bundling, and
loyalty discounts, all of which fall under our definition of QCDs.
Importantly, the quantity commitment and associated price discount illustrated in
figure 5.1 need not be initiated or designed by the seller. As indicated by figure 5.1, both
parties stand to gain, and it is just as reasonable that the moving party is the buyer, who
offers to purchase more in exchange for a negotiated discount. In practice, with het-
erogeneous buyers the size and location of the “football” area of mutual gain is uncer-
tain and buyer specific—but both parties know it is there and that they would prefer
to be in it. There is a deal to be made. In many cases these gains are the foundation
22
In drawing figure 5.1 we have assumed that all buyers are the same, with identical demand curves.
Then IS must be tangent to D. If buyers are heterogeneous then IS need not be tangent to any particular
buyer’s demand curve, but this does not affect the following analysis.
23 Given this need for a buyer’s commitment to purchase more than it would otherwise (and hence
less from S’s rivals), it is not surprising that some buyers might complain ex post that they are being
“forced” to buy more from S than they would like. In a sense, this forcing is true. Without the contract,
however, they would not get the discount.
for buyer-seller negotiations, be they between Intel and Dell for a favorable deal on
processors, or between a grocery chain and Coke over the placement of beverages on
shelves. In other cases, such as in Concord Boat, a seller may announce a common pric-
ing schedule that offers explicit discounts in exchange for specified quantity or share
commitments.
This analysis has important implications for antitrust policies that target contracted
discounts and quantity commitments. It says that in any situation where the uncommit-
ted price would exceed marginal cost—which for practical purposes means always—
there are mutual gains for a buyer and a seller from an agreement that offers a discount
in exchange for a buyer’s commitment to purchase more. Put differently, absent transac-
tions costs or barriers to contracting, simple linear pricing is not an equilibrium outcome
of the competitive process. As a business practice subject to antitrust scrutiny, there-
fore, QCDs always have a procompetitive justification even if, in some circumstances,
they might also have an exclusionary impact—whether intentional or ancillary—as
explained below.
5.3.2. Competition and the Division of Gains between

Buyers and Sellers
All combinations like D in figure 5.1 increase the joint surplus of S and B, while reducing
purchases from rival(s) R. These gains exist because the stand-alone price exceeds mar-
ginal cost. The division of these gains depends on the relative bargaining powers of the
two parties and the nature of competition from rivals, but without further structure it
is not possible to say more than that linear pricing is not an equilibrium outcome when
contracts are feasible, and that both parties stand to gain from the deal.
If the parties realize the entire potential surplus, then the outcome will be on the
vertical contract curve at the jointly efficient quantity QE. This is not the end of the
story, however, because figure 5.1 is drawn under the assumption that S’s chosen list
price and the competing offers by rivals are unaffected by commitment contracts.
Assume for the moment that rivals are perfectly competitive with constant cost, so
they do not offer competing contracts and PR is fixed. There are two reasons that PL
will not be the same as the price that S would charge in the absence of contracts. First,
so long as some buyers purchase at the list price and others through contracts, the
opportunity to purchase through a commitment contract leads to sorting of buyers.
For example, if there are fixed costs of negotiating and enforcing contracts then large
buyers will be more likely to purchase through contracts. If small, noncontract buyers
are more elastic demanders—they are more willing to substitute R for S—then this
would tend to reduce the list price; and conversely if noncontract buyers are predomi-
nantly inelastic demanders.
Second, with contract and noncontract customers seller S is likely to set a list price
higher than the price that would maximize profits from noncontract buyers alone. To
see this, let P be the price that would maximize S’s profits from noncontract buyers.
Now consider a small increase in the list price above this level. This price increase has
only a second-order (approximately zero) impact on the profits earned from noncon-
tract buyers because (by assumption) P was set to maximize profits in that segment.
But for contract buyers the price increase makes the buyer’s alternative of purchasing
at the list price less attractive—indifference curve IB in figure 5.1 shifts upward as the
list price is increased, allowing S to earn greater profits
_
from contract buyers.24
It follows that the seller would want to set PL > P . The strength of this incentive to
raise the list price clearly depends on the relative numbers of contract and noncontract
buyers because raising the list price by more than a “small” amount reduces profits
among noncontract buyers. If the number of contract buyers is small relative to noncon-
tract buyers, then the incentive to raise the price will also be small, and conversely. Both
contract and noncontract customers of S are worse off than if S did not increase its list
price, and some may be worse off than if commitment contracts were impossible. But
it is difficult to argue that this feature of commitment contracts is anticompetitive—it
is instead an example of first-degree price discrimination that allows S to extract more
of the gains from trade. Nor are rivals harmed by the higher list and contract price—
they sell more than they would otherwise, though possibly less than they would in the
absence of commitment contracts.25
In most real-world cases S faces a differentiated rival, R, whose price PR also exceeds
marginal cost. Because of this wedge, R would also gain by offering a discount to increase
sales at S’s expense. This means that B’s alternatives are improved by “competition for
the contract” among differentiated rivals, S and R. Assuming that S wins this competi-
tion, its contracts with buyers must nevertheless offer as much consumer surplus as R’s
best offers, which must yield at least as much profit to R as simply selling fewer units at
its own list price PR. This competition improves B’s alternative as well as its bargaining
position with S, while the reduction in demand for R will generally reduce R’s list price.
Both of these effects of competition benefit buyers.26
The effect on R’s list price can be very important. For example, in their analysis of
exclusive dealing Klein and Murphy (2008) showed that if S and R initially compete
with linear prices each would often have the unilateral incentive to offer the buyer, on an
all-or-nothing basis, an exclusive contract at a price below the equilibrium linear price,
since that allows them to capture more sales at a lower price. However, once the two
24
When rival R also offers a commitment contract discount, a buyer has two alternatives to S’s
contract: (1) enter a commitment contract with R and pay list for S’s good, or (2) contract with neither
and pay list for both. In either case the alternative is to pay list for S’s good, so raising the list price makes
the rival’s offer less attractive.
25 An extreme example: suppose buyers are identical, all contract with S, and all bargaining power
resides with S. Then S will increase PL to the level that drives quantity demanded in figure 5.1 to zero. The
contract leaves buyers indifferent between purchasing the efficient quantity QE via contract and doing
without S’s good entirely—S’s contract and list price replicate perfect first-degree price discrimination
and capture all the gains from trade. Consumers of S (and rivals) are harmed relative to a world without
contracts, but (as in any case of perfect price discrimination) efficiency is enhanced.
26 Klein and Murphy (2008, 2011) and Zenger (2010) analyze “competition for the contract” in the
case of exclusive dealing and illustrate how such competition benefits consumers.
sellers compete for the exclusive contract, the resulting prices will often be lower and
consumer welfare higher than they would be under linear pricing. Under these condi-
tions B’s outside opportunities are enhanced by the use of QCDs and consumers benefit
more than the static analysis in figure 5.1 would imply.
5.3.3. Loyalty Discounts and Other Forms of

Quantity Commitment
The contract described above has a very particular form: buyer B commits to purchase a
specified quantity and seller S commits to supply those units at a discounted price PD < PL,
where PL is the noncontract or “list” price.
Within this class of agreements, we define a loyalty discount as a contract in which B
receives a discount from the list price in exchange for B’s commitment to devote a given
share (s) of its purchases in category C to the products of S. The resulting nonlinear pric-
ing schedule may have one or several steps that result in larger discounts for greater
shares. Such commitments may be individually negotiated between the seller and a par-
ticular buyer, so that different buyers may have different deals, or they may be outcomes
along a single pricing schedule announced by S in which buyers may choose different
price-share combinations. Or both may occur.27 At the extreme, a share commitment
of 100% by buyer B is a negotiated exclusive supply contract. Note, however, that a 100%
share commitment is less restrictive than oft-analyzed exclusive dealing contracts, which
would specify that S will be the exclusive supplier to B under all circumstances for the
duration of the contract. Here, even a 100% commitment may be abandoned by B at any
time, albeit by paying a higher price.
Why would a buyer and seller prefer to specify a share of purchases instead of a par-
ticular quantity? There are at least two major reasons. The first is heterogeneity among
buyers. In our analysis above, we assumed that a buyer’s increased purchases from S
resulted in a one-for-one reduction in purchases from R, which is a reasonable charac-
terization in many procurement settings. Then any contract specifying a quantity that
B will purchase is a share contract. Specifying contracts in terms of shares is especially
useful when a seller supplies hundreds or even thousands of buyers of different sizes,
and separately negotiated contracts are not cost effective. For example, J&J supplies
endoscopic surgical tools to thousands of hospitals and clinics in the United States. In
figure 5.1 the existence of a mutual gain from contractual discounts does not depend on
the size of the buyer; all can gain from such arrangements. A simple and cost-effective
way of achieving these gains is for J&J to offer discounts from the list price depending on
27
For example, J&J’s pricing schedule for its endoscopic surgical tools offers greater discounts in
exchange for greater share commitments from buyer hospitals. Any small or large hospital can avail
the schedule, but many chains and group purchasing organizations (GPOs) negotiate separate deals,
typically with still larger discounts and share commitments.
a hospital’s committed share of J&J tools. This contract is independent of scale, allowing
small and large hospitals to benefit from the same share-based schedule of discounts.28
The second reason is demand uncertainty. When demand for the final product sold
by the buyer is highly uncertain, it is inefficient to write an enforceable contract that
specifies how much should be purchased in each state of the world. For example, sup-
pose Intel’s contract with Lenovo specified a particular quantity of processors that
Lenovo must purchase to qualify for a discount. If demand for Lenovo’s personal com-
puters turns out to be unexpectedly low, then the quantity threshold to qualify for a dis-
count should be reduced, which means that such contracts must be state contingent and
verifiable. But such a state-contingent contract with an individual buyer would be nearly
identical to a share contract, so long as total purchases within a product category (here,
processors) are a good summary measure of the state of demand for a particular brand.
Then a share contract achieves the goal of exploiting gains from trade, but with lower
negotiation and monitoring costs (see, e.g., Dana and Spier 2001).
In other circumstances a commitment contract specifies neither a particular quantity
nor a share threshold, but rather favorable promotion or placement of a seller’s goods or
other advantages that will increase sales. The challenged conduct in Brand Name Drugs29
was that drug manufacturers entered into agreements with large mail-order pharma-
cies such as Medco and Caremark that granted particular drugs preferred promotional
status within a class of “therapeutic equivalents.” In exchange, the pharmacy received a
discount from the list price of the favored drug.30 For example, Medco might have a con-
tract granting favorable treatment to Glaxo’s antiulcer drug Zantac: if Medco received
a prescription for other drugs within this class—the main rival drug at the time was
Tagamet—Medco pharmacists would ask the prescribing physician to switch the patient
to Zantac. Unusually for lawsuits challenging such practices, plaintiffs in Brand Name
Drugs were not rival manufacturers (who had their own deals with other buyers, and
were defendants) but rather brick-and-mortar drug stores that paid higher wholesale
prices because they were unable to duplicate such promotional advantages.31 Similarly,
food and beverage manufacturers negotiate with grocery stores for favorable placement
28 In the case of hospital procurement, hospitals and clinics typically purchase through “group
purchasing organizations” (GPOs) that contract with manufacturers on behalf of member hospitals. The
GPOs typically negotiate share-based commitment contracts and discounts with manufacturers, which
are natural outcomes that can be applied to large and small members.
29 In re: Brand Name Prescription Drug Antitrust Litigation, Case No. 94 C 897 MDL 997 (U.S. District
Court, Northern District of Illinois, Eastern Division 1996).

30 As mentioned earlier, similarly in J.B.D.L. Corp. v. Wyeth-Ayerst Laboratories, 485 F. 3d 880 (6th Cir.
2007) defendant Wyeth offered discounts (rebates) to PBMs in exchange for placing Wyeth’s conjugated
estrogen product Premarin in the PBM’s “Core Formulary.” Wyeth’s discounts and contract provisions
were found legal.
31 Mail order pharmacies supplied mainly drugs for chronic ailments, used over long periods. So
there was time to contact the prescribing physician between receipt of a new prescription and when it
must be filled. Walk-in pharmacies had less ability and incentive to do this, because a smaller share of
their sales was in switchable categories and because patients were typically waiting.
or amounts of shelf space, in exchange for discounts on wholesale prices (see Klein and
Murphy 2008, 2011).
5.4. Potential Harm to Competition
Much of the economics literature on nonlinear pricing and related vertical restrictions
is concerned with the possibility of anticompetitive effects, mainly as a result of “exclu-
sion” or “foreclosure” of rivals. These analyses implicate a variety of factors such as econ-
omies of scale, capacity constraints, and cost conditions.32 They also account for various
characteristics of the practices in question: (i) whether the seller uses customer-specific
quantity or share thresholds, (ii) whether discounts are on a single product, a product
line, or are based on “bundles” of multiple products, and (iii) whether discounts are
applied to all purchases (“first unit” discounts) or only to marginal purchases above the
relevant threshold.
It is important that any sense of anticompetitive exclusion of rival sellers due to
quantity-commitment contracts must refer to factors that prevent rivals from effectively
competing in the market as opposed to competing for particular buyers (Elhauge and
Wickelgren 2012). Contracts that prevent or restrict a rival’s ability to sell to some buyers
for a period of time, but do not impair the rival’s ability to compete—that is, do not drive
the rival from the market or raise its marginal costs—do not impinge the rival’s ability to
discipline market prices, including the prices paid by buyers who do not purchase from
the rival and the terms that S must offer to buyers in order to induce them to sign a QCD.
The main issues are easily illustrated in the context of the model presented above.
Because the products of a contracting seller and its rivals are demand substitutes within
buyers, it is clear that one seller’s commitment contracts must reduce the demand for
rivals’ goods compared to a world without such contracts. Some rivals may be excluded
and the terms that are offered must be competitive with those offered by the rival. For
example, let rivals be perfectly competitive with rising supply price. Then the reduction in
residual demand caused by S’s contracts will reduce the price rivals receive and the quan-
tity they sell. Rivals’ profits are then lower, and high-cost producers may exit the market.
The exit of some high-cost rivals is not, however, anticompetitive. Indeed, the resulting
fall in the price charged by rivals will tighten the competitive constraint on S even though
S’s market share is increased by the QCD. Nor will economic efficiency be reduced—
absent commitment contracts by S, those sellers would be viable only because S priced
above marginal cost, which distorts buyers’ choices away from S. Commitment contracts
32
In an environment with simultaneous contracting, where buyers face costs of switching sellers and
at least one seller is financially constrained, a ban on below-cost pricing is sufficient to prevent exclusion.
See Ordover and Shaffer 2007. When negotiations between a buyer and sellers are sequential, below-cost
pricing has no effect on consumer welfare. See Marx and Shaffer (2008).
reduce this distortion. The same is true if S faces differentiated rivals, some of which are
more efficient than others. Some sellers may be driven from the market by S’s commitment
contracts because demand for their products is reduced. Others are forced to reduce their
prices (which benefits buyers) and earn lower profits. But this harm to competitors is not
harm to competition. The same effects on rivals would be induced by any action by S that
encourages buyers to purchase more of its product, such as an across-the-board price cut.
Things can be different in the presence of fixed costs or economies of scale caus-
ing declining marginal costs, and some form of scale economy is a common element
of models that generate welfare-reducing exclusion.33 To (again) keep things simple
suppose that S competes with a single differentiated rival, R. Let R’s technology have
constant marginal cost for output above a minimum efficient scale (MES) but infinite
marginal cost for lower rates of output; an economy of scale. Absent commitment con-
tracts, S and R would set Bertrand prices above marginal cost and divide the market,
so long as in the resulting equilibrium R operates above MES. But as above this leaves
unexploited gains from trade. So assume that buyers and S pursue these gains, resulting
in QCD contracts with some buyers and a reduction in the residual demand for R. R will
be driven from the market if its best response to S’s contracts pushes its sales below MES.
Consumers and social welfare will be harmed, while S captures the market and earns
“monopoly” profits. There is harm to competition.
In this example, the welfare-reducing impact of S’s contracts is ancillary to their true
purpose, which is to increase sales and unlock gains from trade. S’s conduct would have
been the same if exclusion of R were impossible—that is, in the complete absence of scale
economies. But change the example just slightly; assume that absent intent to exclude R,
S’s contracts would leave just enough residual demand for R to operate above MES. If S is
aware of R’s tenuous participation, it can exclude R by negotiating slightly higher quantity
commitments and/or slightly more contracts with buyers.34 Then S’s conduct is (slightly)
different than if exclusion were impossible. Its monopoly is gained as a result of intentional
exclusion, not merely a competitive effort to increase sales and unlock gains from trade.
These examples illustrate the central quandary of antitrust policy in dealing with
quantity commitment discounts, including their share-based variant. We have dem-
onstrated that such contracts are part of the competitive process and would be com-
monly used by buyers and sellers even if exclusion of rival sellers were impossible. In
certain circumstances specifically involving rivals’ scale economies, these contracts
could, in theory, harm competition by excluding rivals or raising their costs. Even if
harm to competition could be demonstrated by some test, however, if this harm is ancil-
lary to contract competition it is difficult to argue that a contracting seller should face
33 In the presence of scale economies in production, Segal and Whinston (2000b) show that exclusive
contracts can prevent entry if a sufficient number of buyers agree to exclusive contracts. However, if
buyers can breach the exclusive contracts and pay expectation damages, the contracts cannot prevent
entry (Simpson and Wickelgren (2007)).
34 Similarly, if R would operate just above MES in the absence of contracts, then S might offer
contracts even if they would not be profitable in the absence of an ability to exclude R.
antitrust liability for the outcome, or even that the seller’s contracting practices should
be enjoined ex post. And how does one prove that anticompetitive effects are not ancil-
lary to normal competition? Further, what exactly would be illegal—commitment con-
tracts themselves, so that certain sellers in certain circumstances may not offer them, or
the act of having too many or too aggressive contracts?
It is clear that in some circumstances the intent of QCD contracts could be to harm
competition. But given that QCDs are by definition intended to increase S’s sales and
therefore reduce R’s sales, it is difficult if not impossible to reliably identify intent from
S’s contracting practices. If QCD contracts are to be judged by a rule of reason, then
courts and antitrust authorities must be armed with analytical tools that can distinguish
exclusionary intent from the intent to simply win sales from rivals, and businesses must
be able to reliably predict when their conduct will run afoul of the law or be exposed
to costly antitrust scrutiny.35 One possibility is to infer intent from the data and con-
duct: similar to pricing below cost in the analysis of predation, certain conduct might be
profitable only if its purpose is to exclude rivals and harm competition. Our view is that
such fine distinctions are nearly impossible in practice, as explained below.
5.4.1. Implicit or Explicit Bundling

Consider a simple QCD contract in which a particular buyer commits to maintain its
category purchases of S’s product above some designated quantity, QD, in exchange for
a discounted price PD.36 We aren’t concerned with situations where the discounted price
itself is below marginal cost, so we assume PD > K, as implied by figure 5.1. Since we are
analyzing competition for the business of a single buyer, we can ignore scale economies
for the moment. It is then clear that an equally efficient (identical cost and value) rival
cannot be excluded from competing for the entirety of QD at a price above its marginal
cost. It follows that in order for a contract to prevent a rival from competing for the busi-
ness of a particular buyer there must be some fraction of S’s sales to the buyer that are
(effectively) not “at risk” or are noncontestable—that is, that the rival cannot capture.37
This can occur for two closely related reasons.
First, in the case of “single-product” commitment contracts, the fact that the buyer
purchases a mixture of products from S and from rivals implies within-buyer hetero-
geneity of brand preferences—a demand for variety represented by downward-sloping
35
Further, the economic literature on game-theoretic models of firm behavior has provided little in
the way of guidance for antitrust law. See Kobayashi and Muris (2012).
36 To translate this analysis into a share contract, simply normalize the buyer’s total purchases to unity,
so QD is the share of total purchases that come from S.

37 Some have argued that the necessity of having some units that are not “at risk” means that
single-product discounting practices should be per se legal, because all units are evidently at risk and
anticompetitive impact is impossible. Our analysis in the following paragraphs shows that this argument
is not quite correct, but per se legality is probably a good rule because anticompetitive impact would be
nearly impossible to establish in the case of single-product QCDs.
demand in figure 5.1. As explained above, for all commitment contracts that we know
of, the “buyer” is better described as a purchasing agent or middleman for a group of
final purchasers or users. For example, a hospital that purchases J&J surgical tools acts
as a purchasing agent for staff surgeons who use them. Then a subset of surgeons in a
hospital may have a strong preference for J&J’s brand of tools and be unwilling to switch,
which affects the hospital’s purchasing mix. Similarly, Intel’s processors may be particu-
larly well suited to a subset of an OEM’s product line, so those units are more difficult
for a rival to displace than other marginal units. Then one might argue that a committed
buyer purchases an implicit bundle of “contestable” and “noncontestable” units, even if
all units purchased from S are physically identical.
The second circumstance is actual heterogeneity of the units used to calculate the
threshold quantity or share. For example, J&J’s share contracts for “endoscopic tools”
encompass a variety of instruments used in that type of surgery, and some rivals only
produce substitutes for a subset of the line.38 Then J&J’s contracts are closer to an explicit
bundle of heterogeneous products that are physically and economically distinct on
the supply side, only some of which may be “contestable” by a particular rival. Taking
things one step further, J&J’s customers can avail further discounts on endoscopic tools
by achieving an additional threshold on purchases of J&J’s popular line of sutures—an
entirely different product line that is also discounted—which means that J&J offers an
explicit bundle of commitment contracts.39 Similarly in Lepage’s, 3M’s discounts were
conditioned on quantity thresholds for a range of 3M products, not simply its Scotch
brand of transparent tape, a private-label version of which was sold by plaintiff Lepage’s.
5.5. Potential Tests for Harm to

Competition
5.5.1. The Attribution Test for Exclusion

Some form of bundling—either explicit or implicit—is necessary for S’s commitment
contracts to exclude a hypothetical equally efficient rival from competing for the busi-
ness of a particular buyer, B. To see this, assume that QN of B’s committed purchases
38
Bundles are very common in the procurement of medical supplies, where GPOs negotiate
commitment contracts on behalf of member hospitals that include multiple product categories.
39 Why would a seller offer a bundle of commitment contracts in which discounts on product
X are partially conditioned on purchases of product Y? One answer is a form of selection or price
discrimination in which willingness to substitute in many product categories is a buyer-specific
trait. Then those most willing to substitute receive bigger discounts in exchange for larger quantity
commitments in the bundled categories. Further, if buyers have heterogeneous tastes for elements of the
bundles offered by competing sellers, then bundles are better substitutes than are individual products.
Then competition in bundles may be more aggressive, benefiting buyers.
from S are “noncontestable” in that they cannot be displaced by rival R—either because
some users cannot reasonably be induced to switch or because R does not produce the
products in QN and cannot form an implicit or explicit joint bid with other sellers that
do. On these units a buyer purchasing on the discount contract pays a discount from the
list price, PDN = PLN − d N . We assume that the remaining QC of B’s committed purchases
are “contestable” by R and we denote S’s discounted price for these units byPDC .40 We then
ask: under what conditions would S’s contract exclude an equally efficient rival from
profitably competing for the contestable units, QC?
We assume that “equally efficient rival” means that B values the contestable units of S
and R comparably, and that the sellers have identical marginal cost K of supplying these
units. Interpreting the bundled contract literally for the moment, assume that if B pur-
chases the contestable units from R it loses its discounts and must pay S the list price PLN
for the noncontestable good. With these assumptions, R’s lowest feasible offer to supply
the contestable units is a price equal to marginal cost, which would reduce B’s costs of
purchasing the contestable units by [PDC − K ]Q C . But by purchasing from R the buyer sac-
rifices discounts on the noncontestable goods, so it isn’t enough to simply undercut S’s
price. R’s offer must also offset the buyer’s loss of surplus on those purchases, denoted LN.
So R can profitably compete if [PDC − K ]Q C − LN ≥ 0 , which we write on a per-unit basis as
LN
PDC − ≥K. (5.1)
QC
The left side of inequality (5.1) is the highest price that B will find attractive, which must
exceed R’s marginal cost in order to be feasible. This bound is below S’s contract price
because B must be compensated for sacrificing discounts on noncontestable purchases.
Equation (5.1) is not yet in usable form because we haven’t specified LN, the lost sur-
plus on noncontestable units if the buyer purchases contestable units from R. Figure
5.2 shows this loss of surplus. Absent a contract and discount dN we assume that the
buyer chooses quantity Q N on the demand curve, but the discount may require a quan-
tity commitment that is off the demand curve, Q N > Q N . The buyer’s loss of surplus is
the difference in shaded areas:
LN = L1 + L2 − L3
= d N Q N − (L3 + L4 )
1
= d N Q N − [PLN − v N ][Q N − Q N ],
2
40 This setup is consistent with either explicit or implicit bundling if QN represents units of a separate
product from QC. If the latter, QN represents units of a single product that are noncontestable by R due to
buyer preferences for variety.
where we have assumed that demand is approximately linear over the relevant range. If
the contract sets QN efficiently then vN = KN and condition (5.1) becomes
QN  N 1 N N (5.2)
PDC − d − 2 m η  ≥ K ,
QC  
where mN = PLN − K N is S’s list price markup on noncontestable units and

ηN = [Q N − Q N ]/ Q N is the percentage reduction in B’s purchases when the discount is
removed.
Equation (5.2) is the condition that determines whether an “equally efficient” rival can
profitably compete for the contestable units, given our maintained assumptions that a
noncompliant buyer loses the full amount of the discount dN specified in the contract
and that QC and QN are known. As indicated above, if practiced with many buyers and if
R requires sufficient scale of operations in order to effectively compete, the cumulative
effect of such agreements could be to exclude R from effectively competing in the mar-
ket, not just from selling to an individual buyer or buyers.
But even with these (extreme) assumptions, condition (5.2) is difficult to apply as a
test of exclusion because it is generally unknown how much less a buyer would purchase
Price
P NL
L1 L2 L4
P NL − d N
L3
vN
QN (P,PR )=v(Q,PR )
Quantity
QN QN
N
N
FIGURE 5.2 The list price is PL with associated quantity Q . The QCD contract offers
discount d N with committed quantity Q N. At this quantity the buyer’s marginal value
is v N. A buyer who switches to rival R sacrifices discounts and loses surplus
1
L1 + L2 − L3 = L1 + L2 + L4 − (L3 + L4 ) = d N Q N − (L3 + L4 ) = d N D N − [PLM − νN ][Q N − Q N ].
2
in the counterfactual where discounts are removed, ηN . One possibility is simply to

ignore the buyer’s ability to mitigate the lost discounts by assuming ηN = 0; the buyer
will purchase the same quantity of noncontestable units from S regardless of price. This
yields the so-called attribution test:
QN (5.3)
PDC − d N ≥ K.
QC
The left-hand side of (5.3) is the upper bound on offers from R that would be acceptable
to a buyer that does not mitigate forgone discounts. It is typically interpreted as a “net”
price for the contestable units, having “attributed” discounts granted on the noncon-
testable units to the contestable ones.41 Failure to satisfy (5.3) is interpreted as evidence
that an equally efficient seller of the contestable units cannot profitably compete against
S’s contract. Notwithstanding other flaws that we discuss below, comparison of (5.3) to
(5.2) indicates that the attribution test is too likely to indicate exclusion. By assuming
away mitigation, it overstates the compensation that a rival must provide to offset lost
discounts.
A second interpretation of the attribution test is that it determines whether a con-
tracting seller is pricing the contestable units “below cost” to exclude equally efficient
rivals. This is a form of the common “profit sacrifice” test. This may at first appear to be
the same question addressed by condition (5.2), but it is not. On this interpretation, a
contracting seller is “pricing below cost” if discounts would be unprofitable but for their
ability to exclude, similar to predatory pricing. Discounts will be profitable in the sense
that incremental revenues exceed incremental cost if the discounted price on contest-
able units covers incremental cost and any loss of profit, ∆Π N , from selling the noncon-
testable units at a discount. This yields a condition similar to (5.1):
∆Π N
PDC − ≥ K. (5.4)
QC
In condition (5.1) the discounted price is offset by the reduction in buyer’s surplus when
discounts are removed on noncontestable purchases, LN. This loss is always positive
because the buyer is harmed by a higher price. In contrast, the offset in (5.4) is the sacri-
fice in profit by S from selling noncontestable units at a discounted price. This “sacrifice”
41 Equation (3) can be evaluated under two cases. First, if all units are contestable, then the ratio,
QN/ QC, in the left-hand side approaches zero and the equation reduces to a test of whether price is above
incremental cost. Second, if all the discounts should be applied to the contestable units, then QN/ QC
approaches one and the equation reduces to a test of whether net price, after full attribution, is above
incremental cost.
need not even be positive because the discount increases sales of the noncontestable
good. Indeed, if the list price for noncontract purchases is near a profit maximum this
effect will be about zero, and if discounts on the noncontestable good are profitable, as
in figure 5.1, then the offset is negative. For both of these cases, (5.4) is automatically
satisfied. More generally LN > ∆Π N and some algebra establishes that discounts are
profitable if
QN N
PDC − d − mN ηN  ≥ K . (5.5)
QC 
Condition (5.5) is in the same form as the “exclusion” condition (5.2). But inspection
of (5.2) indicates that the buyer’s mitigation of lost discounts gets smaller weight (1/2)
in condition (5.2) than in condition (5.5) for the reasons just stated. Since mN > 0
and ηN > 0, equation (5.5) implies that discounts that pass the attribution test are
always profitable, but profitable discounts may fail the attribution test. Indeed, profit-
able discounts are likely to fail, especially when list prices are close to the stand-alone
profit-maximizing price where d N − mN ηN ≈ 0. Unlike the usual analyses of preda-
tion—which involve temporary sacrifice of profit by pricing below cost—this analysis
means that QCD contracts that are profitable in the absence of any possibility of “exclu-
sion” may nevertheless exclude an equally efficient rival from competing for a buyer’s
business. Discounts that “exclude” and discounts that sacrifice profits are different
things.42
As above, if we assume that buyers do not mitigate forgone discounts by purchasing
( )
less or switching to alternatives suppliers ηN = 0 , then (5.5) also reduces to the attribu-
tion test (5.3). Only then are discounts that “exclude” an equally efficient rival equivalent
to a seller sacrificing profits by setting a “net price” for contestable units below mar-
ginal cost. Note that in either (5.2) or (5.5) the conditions are satisfied if all units are
( )
contestable Q N = 0 . Hence our point that some form of implicit or explicit bundling
is essential if an equally efficient rival is to be “excluded” from competing for a buyer’s
business.43 We return to this point below in the context of “single-product” QCDs and
the possibility of inferring harm to competition.
42 A related interpretation of (5) and (2) is that exclusion can be “cheap” for a seller with substantive
margins on the noncontestable good, because discounts from the profit-maximizing price are attractive
to buyers and are compensated by greater sales. Further, a seller satisfying (5) may nevertheless be
sacrificing profits if smaller discounts and/or quantity commitments would be profit maximizing, but
somewhat larger discounts and commitments are chosen in order to exclude.
43 We have assumed that all contestable units from S and rivals are perfect substitutes. If they aren’t
then B’s demand for S’s version of the contestable units is downward sloping—a taste for variety—and
some units will be more costly for R to capture, as if more units are noncontestable. We think this strains
the definition of “equally efficient” because it implies that R cannot reproduce some attributes of S’s
product that buyers value.
5.5.2. The Attribution Test and Liability Thresholds

The attribution test is the first leg of the 2007 AMC’s three-part test for identifying dis-
counting practices that may violate Section 2 of the Sherman Act:
Courts should adopt a three-part test to determine whether bundled discounts or

rebates violate Section 2 of the Sherman Act. To prove a violation of Section 2, a
plaintiff should be required to show each one of the following elements (as well as
other elements of a Section 2 claim): (1) after allocating all discounts and rebates
attributable to the entire bundle of products to the competitive product, the defen-
dant sold the competitive product below its incremental cost for the competitive
product; (2) the defendant is likely to recoup these short-term losses; and (3) the
bundled discount or rebate program has had or is likely to have an adverse effect
on competition. (See, e.g., Antitrust Modernization Commission 2007; emphasis
added)
Rather than an “exclusion test” in the sense of (5.1) and (5.2), these requirements are
basically a rule-of-reason test for predatory pricing. Here, a price “below its incremen-
tal cost” is determined by the logic of (5.5) with the additional assumption that ηN = 0,
resulting in the attribution test (5.3) rather than a simple comparison of unit price and
cost. The “each one” requirement means that contracts passing any one of the three tests
would enjoy safe harbor from antitrust liability. Thus the AMC requirements at least
appear to provide clear rules and, hopefully, a filter that might reliably identify anticom-
petitive conduct without itself dampening competition.
The AMC requirements are similar to the position of the DOJ in its 2008 Section
2 guidelines, which would also grant safe harbor to discounts passing the attribution
(“discount-allocation”) test:
The Department believes that, when actual or probable harm to competition is shown,
bundled discounting by a monopolist that falls outside the discount-allocation safe
harbor should be illegal only when (1) it has no procompetitive benefits, or (2) if there
are procompetitive benefits, the discount produces harms substantially disproportion-
ate to those benefits. (US Department of Justice 2008)
We regard condition (1) above as moot because, as we explained in subsection 5.3.1, vir-
tually all QCD practices have a procompetitive benefit. The DOJ threshold for illegality
of discounts failing the attribution test in condition (2) is higher than that of the AMC,
requiring not simply that harm is likely (AMC: “has had or is likely to have an adverse
effect on competition”) but that the harm be both demonstrable (“produces”) and dis-
proportionate to benefits.
5.5.3. Flaws with the Attribution Test, and Its Potential Uses
The attribution test is superficially attractive because it appears to determine whether a
seller’s discounts are unprofitable, which might indicate predation. Further, comparison
of (5.5) and (5.2) indicates that unprofitable discounts would exclude an equally efficient
rival under the assumptions commonly used, that is, no mitigation. But the test suffers
from a number of major flaws, each of which tends to bias the test toward failure, and so
toward the exposure of procompetitive or competitively neutral discounting practices
to antitrust scrutiny and litigation. These flaws derive from the inability of contract and
sales data available in litigation to reliably estimate (i) the relative quantities that are
non-contestable by rivals (QN/QC) and (ii) the “but-for” terms of trade between buyer
and seller that would exist in the absence of the observed contract, particularly the mag-
nitude of discounts on noncontestable units that a buyer would lose by switching its
business to a rival (dN).
As a threshold matter, it is worth emphasizing that the attribution test is meant to
provide evidence that an equally efficient rival would be excluded from competing for
a buyer’s business. The catalyst for this inquiry is typically a complaint by a particular
rival that alleges exclusion, so it is sensible to ask whether there is direct evidence
that the defendant’s contracts actually exclude the plaintiff—that is, that customers
would purchase substantially more of the plaintiff ’s product but for the defendant’s
contracts. For example, among buyers that do not purchase under the defendant’s
contracts, is the plaintiff ’s share materially higher? If not, then it is difficult to argue
that the plaintiff is equally efficient in the sense of producing goods that can replace
the defendant’s sales, or that defendant’s contracts are the cause of the plaintiff ’s poor
performance.
We have already noted the test’s implicit assumption that buyers do not mitigate
N
the impact of loss of discounts (η = 0), or equivalently that the cost of the discounts
to S are not reduced by the enhanced sales of noncontestable units generated by the
discounts. Whether the test is interpreted as an indicator of exclusion as in (5.2) or
below-cost pricing as in (5.5), this omission means that the test will generate false
positives, suggesting anticompetitive impact or conduct when there is none. Put dif-
ferently, if a seller’s contracts pass the attribution test then discounting practices are
almost certainly “above cost” in the sense of (5.5). And while above-cost contracts may
nevertheless exclude, or even be intended to exclude, there is clear danger that litigat-
ing profitable discounting practices would have a chilling effect on competition. The
AMC’s safe harbor for such contracts is therefore warranted, though in our view, too
many contracts would be left exposed. We are also concerned that existence of such
a “guideline” will encourage sellers to satisfy it, avoiding more aggressive discounts
and commitments that would otherwise enhance competition and benefit consumers.
Even with the AMC safe harbor, a useful refinement would be to require evidence that
a seller actually is sacrificing profit on the noncontestable good, that is, that the brack-
eted term in (5.5) is positive. And of course, if a reliable estimate of ηN is available, it
should be used. For example, if there are substantial sales at list price one might pre-
sume that the list price is profit maximizing. Then one can infer that the bracketed term
is nonpositive, at least for small discounts.
Our discussion to this point has assumed that the relative quantities of “noncon-
testable” and “contestable” sales (QN/QC) are known or accurately estimated, but this
is rarely the case. The issue of reliably specifying QN/QC is especially problematic in
the case of single-product QCDs. As explained above, the existence of such contracts
generally implies a buyer-specific taste for variety (downward-sloping demand for a
brand) within a product category. Then some units are more difficult to contest than
others and the contract specifies an implicit bundle. Yet the very notion of “non-
contestable” units in the single-product case strains the definition of an equally effi-
cient rival. “Equally efficient” cannot simply mean “equal marginal cost” regardless
of how users view the rival’s product—to qualify as equally efficient in an economic
sense, the rival must also offer equal value to consumers. If so, then all units should
be viewed as contestable in the single product case, and we have already seen that if
Q N = 0, the attribution test is automatically satisfied so long as total sales are profit-
able. And even if we accept for the sake of argument that some units might not be
easily contested, there is no scientifically reliable method for determining the relative
number of noncontestable units—in Concord Boat, how many engines “must” a buyer
have purchased from Brunswick?44 We conclude that Q N = 0 is the practically correct
assumption for single-product QCDs, in which case (5.3) simply asks if price is above
cost and the usual analysis of predation can follow. We then agree with Areeda and
Hovenkamp (2007) that single-product QCDs should enjoy per se legal status so long
as price exceeds a reasonable measure of incremental cost (Areeda and Hovenkamp
2012, chap. 17).
A particularly vivid example of misapplying the “equally efficient” concept in defin-
ing contestable shares is provided by the DOJ’s recent application of the attribution test
in United Regional Health Care (2011). United Regional is the largest hospital in Wichita
Falls, Texas, and it has entered into QCD contracts with a number of private insurers.
The DOJ calculated that noncontract buyers Blue Cross, Blue Shield and Medicare pur-
chased only 10% of units within contestable categories from rival hospital Kell West,
because “many patients are likely to choose care at United Regional even for services
that competing providers offer.”45 So the DOJ assumed that 90% of products offered
44 The record in Concord Boat indicated that two previously compliant buyers switched all their
purchases to rival sellers, indicating that all units were contestable, at least for those buyers.
45 Competitive Impact Statement filed by the U.S. Department of Justice, United States of America
and State of Texas v United Regional Health Care System, United States District Court for the Northern
District of Texas, February 25, 2011, p. 16. It is noteworthy that “foreclosure” in the government’s view
applies to a rival (Kell West) that has participated in the alleged market since 1999. The DOJ’s brief goes
so far as to calculate how much more profitable Kell West would be if it were to capture some of the
business that currently goes to United.
by both United Regional and Kell West were, in fact, noncontestable because consum-
ers would not purchase them from Kell West regardless of discounts. Then discounts
received on all purchases were subtracted from the 10% that Kell West could allegedly
contest, and it should come as no surprise that United’s discounts were found to “fail”
the attribution test. The clear implication of the DOJ’s analysis is that a seller must tailor
its discounts to accommodate the capabilities of its rivals, including lack of acceptance
of rivals’ products by consumers. There could hardly be a better example of protecting
competitors instead of competition.
Things are only slightly more promising in the case of explicit bundles of physically
distinct products. In many cases, a particular plaintiff who complains of exclusion
may produce only a small portion of the product lines that led to the seller’s discount
policy, so the “QC” for that particular rival actually is small. In suits challenging J&J’s
bundled loyalty discounts on endoscopic tools and sutures, small manufacturers that
did not produce sutures and could replace only a small fraction of the J&J endoscopic
line (mainly tools called trocars) alleged that they could not profitably overcome the
discounts that buyers might lose on all other purchases from J&J. Applied to what a
single rival could displace, condition (5.3) would likely fail. But the QC relevant for
antitrust scrutiny is the number of units open to competition from all rivals, not
simply a one-off test of whether a buyer would be willing to switch a portion of its
purchases to one rival holding constant all other purchases. Narrowly specialized
plaintiffs should not enjoy preferred status in making antitrust claims, just as plaintiffs
that do not meet consumer acceptance should not. In J&J the entire lines of endo-
scopic tools and sutures were subject to competition from another full-line supplier
(Tyco), as well as from combinations of several specialized sellers.46 Then competition
in the presence of QCD contracts is “bundle-to-bundle”—including the possibility
that buyers or their agents may create virtual bundles from combinations of sellers,
including the plaintiff. Then it is proper to think of all or almost all units as contest-
able, so Q N = 0 even if a particular rival can only replace a small portion of a buyer’s
purchases from S. As in the single-product case the question becomes whether the
“price” of the entire bundle exceeds its cost, so the usual predation analysis can be
applied to the bundle as a whole.
These arguments narrow the cases where Q N > 0 down to those where (a) the QCD
contract consists of an explicit bundle of physically distinct products and (b) no rival
or rivals produce reasonable substitutes for some elements of the bundle. Inspection of
(5.3) indicates that failure to pass the test is more likely when relative number of units
that might be contested by a plaintiff is small (QN/QC is large). Hence allegedly excluded
plaintiffs emphasize that a committed buyer wishing to purchase a small amount “QC”
of their products must forgo discounts on all its purchases from the discounting seller.
But applying the test in this way makes no sense, because any discrete discount—say a
46 Tyco and J&J engaged in bundle-to-bundle competition, and each offered loyalty discounts. In
recognition of this, J&J ultimately “carved out” smaller suppliers from share calculations, which were
then based only on purchases from “full-line” suppliers of surgical inputs—J&J and Tyco.
10% discount if S’s share exceeds 80%—will fail the test when the number of contested
units is sufficiently small, as demonstrated by the DOJ’s analysis in United Regional
Health Care. In other words, the QC in equation (5.3) must account for the best offer the
plaintiff might make, which for an “equally efficient” rival is to supply all of the contest-
able units. In addition, if S’s contract specifies a share threshold of (say) 80% to qualify
for discounts, that leaves 20% “headroom” for which any rival may compete without
triggering any loss of discounts. To the extent that those units are also contestable by
the plaintiff but are now supplied by other rivals, the contracting sellers’ discounts are
not binding on the plaintiff ’s ability to sell more. And even if those units are not directly
contestable by the plaintiff—say because they are products the plaintiff doesn’t make—
the buyer could still purchase the full amount of headroom from the plaintiff if the units
now supplied by others are substitutes for products supplied by S.
The general principle should be to judge what sales the rival can profitably compete
for using its most effective strategy (e.g., competing for all the sales in the headroom to
avoid a loss of discounts or competing for all contestable units in order to spread any
loss of discounts over as many units as possible). When the rival can profitably compete
for all contestable sales to a given buyer, even if the rival could not compete for smaller
quantities, we should conclude that the rival is not foreclosed. This principle also applies
to the time dimension of the shift in sales. The question is whether the rival has the abil-
ity to compete for the sales, not whether it would be profitable to win those sales on a
temporary basis. For example, if the rival must win 100 units annually in order to make
matching the loss of discounts profitable, a conclusion that the buyer could switch 80
units in year one, 150 units in year two and 200 units in year three would mean the seller
would not be excluded at any reasonable discount rate, even though the shift in sales
would not be profitable on the basis of year one alone.
A second issue is measuring the loss of discounts that the buyer would suffer, that is,
how much more a buyer would have to pay if it wished to purchase less than its com-
mitted quantity or share from S. In a naive application of (5.3), the discount dN is the
difference between the “list price” of noncontestable units, PLN , and the agreed-upon
commitment price written in a contract—the assumption being that if a buyer wished to
purchase less than the committed amount it would actually pay the list price. But con-
tract prices and quantities are often the result of direct negotiations between seller and
buyer, and contracts often have short durations. Thus Intel’s negotiations with individ-
ual OEMs resulted in buyer-specific agreements and associated percentage discounts
from Intel’s menu of list prices for processors. If innovations or aggressive pricing by
AMD caused an OEM to want more of AMD’s processors, its next round of negotia-
tions with Intel could specify a smaller Intel volume or share and, perhaps, a smaller
discount from the list price benchmark. But the OEM would generally not pay the list
price, which is to say that the “dN” contained in a particular contract is just a convenient
way of specifying the price that will be paid for the indicated quantity or share relative
to a benchmark, and it overstates what would be lost if the OEM wished to purchase less
from Intel. Notwithstanding its other flaws, then, proper application of (5.3) (or other
variants) requires the trier of fact to estimate the outcome of individual negotiations,
and how much “dN” would actually change if a buyer wished to purchase less from the
defendant.47 Some information on this might be available from econometric study of
changes in contracts over time, or by comparing contracts negotiated by different buy-
ers, which will keep the economics experts busy. But these sources are unlikely to rep-
licate the needed conceptual experiment, which is to ask: “what if a particular buyer
wants to purchase less than the amount specified in its current contract?”
While the case of bundling discrete products makes measuring the relative volume of
noncontestable and contestable units, QN/QC, somewhat easier, it exacerbates the prob-
lem of measuring the loss of profits from discounting and/or the buyer’s ability to miti-
gate. In the case of single-product QCD, the noncontestable units are a subset of all units
purchased, so it might be reasonable to assume that the demand for them is inelastic at
the list price because the seller is unable to price them separately. However, when the
uncontestable units are sold as a separate product on a stand-alone basis, the list price
is likely to be closer to the profit-maximizing price for the seller. As we discussed above,
under these conditions, the profit sacrifice from a discount is likely to be small or may
even be negative. Similarly, buyers will be able to mitigate their loss by purchasing less of
the uncontestable product according to equation (5.2).
The attribution test presumes that failure to satisfy (5.3) is evidence that the seller is
forgoing current profits—it is pricing below cost. Putting aside obviously benign exam-
ples of below-cost pricing such as promoting new products, driving future scale econo-
mies, or balancing incentives in two-sided markets, the fact is that a bundled pricing
scheme that fails the attribution test is consistent with both profit maximization and
enhanced efficiency. For example, bundled contracts are often forms of self-sorting
price discrimination in which the list price is paid by relatively inelastic demanders who
are less willing to substitute. In such circumstances providing enhanced discounts to
more price-sensitive customers can increase sales and social surplus. The relevant ques-
tion to ask when assessing whether contracts reflect “below cost” pricing is whether the
seller has sacrificed profit relative to a but-for world without QCDs, in which case the
seller’s price would not, in general, be the list price charged to noncontract buyers. In
most reasonable cases it will be lower, which means the attribution test would be heavily
biased against a defendant seller.48
47 The point remains relevant in cases where a seller offers a pricing schedule that may be availed by
any buyer—which saves on transactions costs. Individual buyers may negotiate separate off-schedule
deals and “carve-outs” for particular purchases. For example, in procurement of medical supplies for
hospitals standard pricing schedules of manufacturers are negotiated through GPOs. In J&J, individual
hospitals negotiated quantity carve-outs for particular surgeons who insisted on using a particular
rival’s product, and large hospitals and chains often negotiated separate contracts with larger discounts
or smaller commitments. Then the generally available pricing schedule is a sort of starting point for
buyer-seller negotiations rather than a constraint.
48 The failure of the attribution test in situations where exclusion is not possible and bundled
discounts are used to price discriminate was noted by AMC commissioners Carlton and Garza, who
stated their concern that the test would subject innocent pricing schemes to undue scrutiny. In these
situations, incremental revenue is not properly calculated in the Commission’s recommendation, which
is the point of our examples. See Antitrust Modernization Commission (2007) p. 99.
These failures of the attribution test are not isolated or contrived examples. If used
as anything but a safe harbor, it is certain that the test would implicate common and
procompetitive pricing and procurement practices and, at least, subject those prac-
tices to further antitrust scrutiny. This type of bias no doubt motivated the AMC’s
(2007) and DOJ’s (2008) recommendation that contracts passing the attribution test
be given unambiguous safe harbor. But even this narrow exemption is evidently too
lenient and specific for the current DOJ, which eschewed such safe harbors in its
withdrawal of the 2008 DOJ report and has provided no other guidance beyond the
notion that “contracts that reference rivals” are of particular concern. As far as we
can tell, these concerns are based on theoretical possibilities rather than compelling
evidence of anticompetitive effects. The DOJ’s failure to endorse the attribution test
as a safe harbor is particularly troubling in light of the fact that it is essentially a
predation test for below-cost pricing that is heavily biased in favor of a positive find-
ing. If pricing that is demonstrably above cost is not immune, the implication is that
QCDs will face scrutiny and litigation in situations where even allegations of pre-
dation would not be deemed credible. Given the clear consumer benefits that flow
from firms competing aggressively for sales, we believe it is a mistake to condemn
discounting practices that are profitable and hence that firms would employ absent
any intent or ability to exclude rivals. In this light, we regard the DOJ’s withdrawal of
safe harbor status for above-cost single-product and bundled discount schemes as a
serious policy error.
5.5.4. Other Indicators of Potential Competitive Harm

Beyond the attribution test, the AMC suggested two other necessary conditions for anti-
trust liability. Condition (2) is that “the defendant is likely to recoup these short-term
losses” and condition (3) is that “the bundled discount or rebate program has had or
is likely to have an adverse effect on competition” (see Antitrust Modernization
Commission 2007). Our analysis above demonstrated that all of these conditions can be
satisfied by nonpredatory and profitable QCDs that would be utilized in the absence of
a possibility to exclude. In considering the efficacy of this and similar policies, the con-
sequent efficiency loss that would be caused by condemning procompetitive discounts
might be acceptable if it could be demonstrated that real-world discounting practices
of the type being challenged have caused material harm to competition. But convincing
examples of such harm are conspicuous by their absence. If we judge potential antitrust
policies themselves by a rule-of-reason balancing of harms and benefits, it is difficult
to make a case that the AMC filter or any other that we know of is useful for inferring
liability. At the same time, the theoretical possibility of harm makes per se legality of
all QCDs an unattractive policy—paraphrasing Potter Stewart’s inability to state a legal
threshold for pornography, “we’ll know it when we see it.” In the end, the DOJ’s (2008)
disproportionality standard may be the best we can do.
5.6. Concluding Remarks
Antitrust policy should put a heavy evidentiary burden on plaintiffs to demonstrate

clear anticompetitive effects that clearly outweigh procompetitive benefits of challenged
contracts. In this sense, our views are close to the DOJ’s 2008 disproportionality stan-
dard, and are perhaps more stringent. For this class of conduct at least, the DOJ’s 2009
decision to abandon the disproportionality standard was a mistake that has muddied
the waters for effective antitrust policy, and likely itself reduced competition.
Acknowledgments
We gratefully acknowledge comments, insights, and assistance offered by Shannon

Seitz, Pierre Cremieux, Marc Van Audenrode, and the editors.
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CHAPTER 6
SQUEEZE CLAIMS
Refusals to Deal, Essentials
Facilities, and Price Squeezes
BARAK ORBACH AND RAPHAEL AVRAHAM
6.1. Introduction
In the marketplace, firms often find themselves helpless and squeezed. Actions taken by
other firms weaken them and sometimes even threaten to drive them out of business.
In the past, such realities heavily influenced antitrust courts. Many old antitrust cases
expressed concerns regarding “[the interests of] small dealers and worthy men,”1 “the
protection of viable, small, locally, owned businesses,”2 and the “helplessness of the indi-
vidual.”3 To date, many judges believe that it is “axiomatic . . . that antitrust law should
prevent unfairness in commercial dealings” (Areeda and Hovenkamp, vol. IIIB, 100).
Fairness perceptions may be powerful. They tend to influence the public, lawmakers,
and courts (Kahneman et al., 1986; Klein, 1980; Macaulay, 1963). Fairness perceptions,
however, are not equivalent to anticompetitive effects that are the focus of antitrust
law. How does antitrust law treat squeezes and squeeze claims that interact with fair-
ness perceptions? This chapter examines this question, focusing on three traditional
squeeze claims—the refusal to deal, essential facility, and price squeeze. Several old anti-
trust doctrines, not all of which are valid today or consistent with modern antitrust,
supposedly offer remedies to these claims. By contrast, the US Supreme Court is largely
1
U.S. v. Trans-Missouri Freight Ass’n, 166 U.S. 290, 323 (1897).
2
Brown Shoe Co. v. United States, 370 U.S. 294, 344 (1962).
3 United States v. Aluminum Co. of America, 148 F.2d 416, 428 (2d Cir. 1945) (“Alcoa”).
Squeeze Claims 121
reluctant to recognize squeezing as an antitrust violation. The chapter intends to clarify

the law and economics of antitrust squeeze claims.
A “squeeze” is an increase in costs that cannot be passed on to consumers. A firm or a
group of firms that dominates and that supplies intermediate inputs—credit, goods, or
services used for the production of other goods and services—has the power to impose
restrictions on their supply, which in turn could squeeze other firms. Squeeze claims
take the position that, by imposing restrictions on the supply of intermediate inputs,
the defendant violated antitrust law. The three traditional squeeze claims embrace this
position.
A refusal to deal is a unilateral or collective unwillingness to trade with a market par-
ticipant. By eliminating access to needed intermediate inputs, a refusal to deal may raise
a firm’s costs and adversely affects its competitiveness. A refusal to deal may be explicit
or implicit, in the form of unfavorable contractual terms that a profitable firm cannot
accept.
An essential facility is an asset that has no practical alternatives and without access to
which a firm is blocked from competing effectively in the market. An essential facility
claim states that a firm is precluded from an essential facility or that its access to such
facility is crippled in another way.
A price squeeze occurs when a vertically integrated firm with market power in one
market gains an advantage over its rivals in an adjacent market through a pricing scheme
that erodes their profit margin.
The legal distinction among the traditional squeeze claims is historical and not
particularly helpful. It is highly artificial as it identifies two simple forms of squeez-
ing—through refusals to deal and price squeezes. In practice, squeezing may be more
nuanced and conducted also through reduced output, degraded quality of service, and
other ways. The distinction follows the classification of old antitrust cases but is incon-
sistent with the legal understanding that “for antitrust purposes, there is no reason to
distinguish between price and nonprice components of a transaction.”4 Indeed, courts
often analyze one type of claim by using cases that refer to other claims. Nonetheless,
because antitrust law builds on precedents, the distinction is still alive.
The practical meaning of determining that squeezing is illegal is that a firm may be
subject to an antitrust duty to deal, since it is not free to squeeze. Thus, it should be
stated clearly that the American legal system is hostile toward duties to act and, specifi-
cally, duty to deal.5 In antitrust, the general principle is that a business has the right to
refuse to deal with other businesses. Articulated a century ago, in Colgate,6 in Linkline
4
Pacific Bell Telephone Co. v. Linkline Communications, Inc., 555 U.S. 438, 450 (2009).
5
See, e.g., National Federation of Independent Business v. Sebelius, 132 S.Ct. 2566 (2012).
6 United States v. Colgate & Co., 250 U.S. 300, 307 (1919):
In the absence of any purpose to create or maintain a monopoly, the [Sherman Act] does not
restrict the long recognized right of [a]‌trader or manufacturer engaged . . . freely to exercise
his own independent discretion as to parties with whom he will deal; and, of course, he may
announce in advance the circumstances under which he will refuse to sell.
122 Barak Orbach and Raphael Avraham
the Supreme Court restated the principle: “As a general rule, businesses are free to
choose the parties with whom they will deal, as well as the prices, terms, and conditions
of that dealing.”7 In its present form, this principle is misleading. Antitrust law and many
other laws impose many restrictions on such freedom. The general rule is (or used to
be) that the freedom to harm is restricted by common-law maxims and modern statutes
(Orbach, 2012a; Orbach, 2012b).
6.2. Unilateral versus Concerted

Squeezing
Antitrust law draws a sharp distinction between unilateral conduct and concerted
action. This distinction is fundamental. Certain actions, such as price setting and mar-
keting decisions, are perfectly legal when they are made by a single firm but could be ille-
gal when made collectively by competitors. Correspondingly the analysis of unilateral
squeezing is very different from that of concerted squeezing. First, under the present
jurisprudence of the US Supreme Court, “a dominant firm may incur antitrust liability
for purely unilateral conduct” only in “rare instances,”8 while collusion is “the supreme
evil of antitrust.”9 The analysis of unilateral and concerted squeezing loosely follows this
philosophy.
Second, the US Supreme Court is generally “very cautions in recognizing” antitrust
duties to deal imposed on single firms.10 In Trinko, the Court declared that it had recog-
nized only one setting in which such duty might apply: where a single firm with market
power unilaterally decides “to cease participation in a cooperative venture . . . [presum-
ably exhibits] a willingness to forsake short-term profits to achieve an anticompetitive
end.”11 This setting is the Court’s interpretation of the so-called Aspen exception to the
general rule that a firm is free to refuse to deal with others.12 By contrast, as discussed
below, concerted squeezing is evaluated under standards that are much less favorable to
defendants.
While the distinction between unilateral conduct and concerted action is very basic,
in the context of antitrust squeeze claims it is sometimes neglected or confused.
To illustrate consider Klor’s.13 In Klor’s, the Supreme Court declared that concerted
refusals to deal are illegal per se. The known facts of Klor’s, however, describe a set of
7
Linkline, 555 U.S. at 448.
8
9 Trinko, 540 U.S. at 411.
10 Id.
11 Id. at 409.
12 See Aspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585 (1985).
13 Klor’s, Inc. v. Broadway-Hale Stores, Inc., 359 U.S. 207 (1959).
Squeeze Claims 123
unilateral actions without collusion. Broadway-Hale (“BH”), an appliances retailer,

operated one of its stores on Mission Street in San Francisco. Many other appliances
stores operated in the area, including Klor’s (“K”) that operated next door to BH’s store
(see fi
gure 6.1). BH was an established retailer in California. It informed eighteen lead-
ing manufacturers and distributors that it would continue dealing with them only if they
stopped dealing with its next-door rival, K. They complied with its demands. Losing
a large number of leading brands, K claimed that BH used its “monopolistic buying
power” to advance a “conspiracy” with the manufacturers and the distributors not to
sell to K or to sell only “at discriminatory prices.” It further argued that this “concerted
refusal to deal . . . [had] seriously handicapped its ability to compete and . . . caused it a
great loss of profits, goodwill, reputation and prestige.”14 The district court concluded
that the controversy was a “purely private quarrel.” The Ninth Circuit affirmed. The
Supreme Court reversed, concluding that BH’s vertical agreements established a “group
boycott.” It explained that the “combination” took from K “its freedom to buy appliances
in an open competitive market and drives it out of business as a dealer in the defendants’
products.”15 Further, the Court stressed that “[i]‌t deprives the manufacturers and dis-
tributors of their freedom to sell to [K] at the same prices and conditions made available
to [BH] and in some instances forbids them from selling to it on any terms whatso-
ever.”16 Put simply, the Klor’s Court found a conspiracy in a set of vertical agreements.
Consider now the Adderall XR Antitrust Litigation.17 The plaintiffs, wholesale dealers
in pharmaceutical products, argued that reversed payment settlement agreements may
give rise to an antitrust duty to deal. Namely, a horizontal agreement could establish a
liability toward downstream firms. The defendant, Shire, held a patent for a widely pre-
scribed drug used in the treatment of attention deficit hyperactivity disorder. It entered
into reversed payment settlement agreements with two manufacturers of generic equiv-
alents. Under the agreements, the generic manufacturers would stay out of the market
for three years, in exchange for licenses to make and sell a generic version of the drug
after those three years. Since the generic manufacturers failed to obtain the required
regulatory approvals for their generic equivalents, after three years they started selling
an unbranded version of Shire’s drug. Shire, however, breached the settlement agree-
ments and only partially filled the orders of the generic manufacturers. The plaintiffs
claimed that by supplying to the generic manufacturers less than their requirements of
the unbranded drug, Shire artificially maintained and raised the price of the branded
drug. The antitrust duty to deal existed, the plaintiffs maintained, because Shire entered
into “a cooperative venture” and its breach was a unilateral decision intending to achieve
an anticompetitive end. The district court rejected the argument, stressing that “not
every sharp-elbowed business practice—though potentially wrongful as a breach of
14
Id. at 209.
15
Id. at 213.
16 Id.
17 In re Adderall XR Antitrust Litig., 13-1232, 2014 WL 2565832 (2d Cir. June 9,
2014) (hereinafter: “Adderall XR”).
FIGURE 6.1 Retailers in the vicinity of Klor’s that sold the branded appliances carried by Broadway-Hale.
Squeeze Claims 125
contract or even fraud—necessarily amounts to an antitrust violation.”18 The Second

Circuit affirmed, holding that the plaintiffs failed to show that the facts resembled
those of the Aspen exception; first and foremost, Shire did not cease dealing with the
generic drug manufacturers.19 In other words, the plaintiffs in the Adderall XR Antitrust
Litigation failed to convince the courts to consider the economic meaning of squeezing.
6.3. Unilateral Squeezing
Unilateral squeeze claims may arise when a firm dominating the supply of intermedi-
ate inputs imposes restrictions on their supply, supposedly to gain economic benefits.
To prove antitrust violation, however, a plaintiff must show harm to competition that
antitrust law intends to prevent. We stress two biases that influence the legal analysis
of unilateral squeezing claims. First, the unfairness appearance of squeezing prompts
redundant litigation. Second, the Supreme Court is largely reluctant to recognize that
squeezing could violate antitrust law.
6.3.1. The Vertically Integrated Firm

The traditional squeeze claims—unilateral refusal to deal, the essential facility doctrine,
and price squeeze claims—refer to squeezing by a vertically integrated firm. The litera-
ture, therefore, has largely focused on situations where the defendant is a vertically inte-
grated firm using restrictions on trade in intermediate inputs in the upstream market
it dominates to establish and extend its power in the downstream market. Studies of
foreclosure (Rey and Tirole, 2007) and price squeezes (Hovenkamp and Hovenkamp,
2009) epitomize this framework. When a firm that dominates the supply of certain
intermediate inputs also operates in an adjacent market in which those intermediate
inputs are essential, the firm could gain certain economic advantages in the adjacent
market through squeezing (Rey and Tirole, 2007).
Undoubtedly, under certain circumstances, when a vertically integrated firm holds
market power in one market, it may have the power to squeeze its rivals in the adjacent
markets. For example, when proprietary rights give a firm market power in the market
for replacement parts for certain machines and that firm also operates in the market for
maintenance services for those machines, it could squeeze independent service provid-
ers.20 This may also be the outcome when a firm operates with no or with very limited
competition a facility, such as a hospital, and also operates in an adjacent market in which
18
Louisiana Wholesale Drug Co., Inc. v. Shire LLC, 929 F. Supp. 2d 256, 262 (S.D.N.Y. 2013).
19
Adderall XR, at *6.
20 See, e.g., Eastman Kodak Co. v. Image Technical Services, Inc., 504 U.S. 451 (1992).
access to that facility is critical.21 In the same spirit, when a firm dominates the supply of
certain products and decides to enter into retail sales, it may have a negative impact on
retailers that compete against it.22 Likewise, when Microsoft decided to enter segments
related to its operating system, it effectively squeezed its rivals.23 The squeezing in such
circumstances and in many others is straightforward: The control of the vertically inte-
grated firm over the supply of intermediate inputs gives it power its rivals do not have.
While perhaps unfair, in itself such squeezing is not illegal. A plaintiff must show that
the vertically integrated firm excluded competition, as opposed to promoted efficiencies
through vertical integration. In this spirit, Philip Areeda famously criticized the so-called
essential facility doctrine, arguing that it undermines efficiencies (Areeda, 1989). In
Trinko, the Supreme Court declared that it had never recognized such the doctrine.24
In Alcoa, Judge Learned Hand analyzed price squeezes. He held that it was unlawful for
a firm with monopoly power “to set the price of [the finished product] so low and hold the
price of the [intermediate input] so high . . . [that it] must be regarded as higher than a ‘fair
price.’ ”25 This is a very rudimentary test for squeezing financed by exclusion of competition.
The test supposedly provides that price squeezing is illegal when a vertically integrated firm
sets the retail price and the wholesale price at unsustainable levels to exclude competition.
In Linkline, the US Supreme Court rejected the Alcoa test ruling that squeezing by a
vertically integrated firm does not violate antitrust laws so long as (1) the Aspen excep-
tion does not apply and (1) the Brooke Group test for predatory pricing is not met.26 As
discussed above, the Aspen exception refers to circumstances where a single firm with
market power unilaterally decides “to cease participation in a cooperative venture . . .
[presumably exhibiting] a willingness to forsake short-term profits to achieve an anti-
competitive end.”27 The Brooke Group for predatory pricing requires proving below-cost
retail pricing and a “dangerous probability” that the defendant will recoup its invest-
ment in below-cost pricing.28
Linkline’s significance deserves emphasis on three points. First, the Linkline Court
analyzed price squeeze claims but declared that “for antitrust purposes, there is no
reason to distinguish between price and nonprice components of a transaction.”29
Specifically, the Court rejected the distinction between “insufficient assistance claims”
and price-squeeze claims.”30 Linkline, therefore, applies to squeeze claims in general.
Second, the Linkline Court did not bother to consider possible anticompetitive effects
21 See, e.g., McKenzie v. Mercy Hosp. of Independence, Kansas, 854 F.2d 365 (10th Cir. 1988) (hospital
as a facility needed by physicians).

22 See, e.g., Eastman Kodak Co. of New York v. Southern Photo Materials Co., 273 U.S. 359 (1927).
23 United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001).
24 Verizon Communications Inc. v. Law Offices of Curtis V. Trinko, LLP, 540 U.S. 398, 411 (2004).
25 Alcoa, 148 F.2d at 437.
26 Linkline, 555 U.S. 438.
27 Trinko, 540 U.S. at 409.
28 Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993).
29 Id. at 450.
30 Id.
Squeeze Claims 127
of squeezing. Rather, the Court focused on the question whether the defendant had an
antitrust duty to deal under Aspen, or engaged in predatory pricing in the meaning of
Brooke Group. Finally, Linkline was the only antitrust decision that Chief Justice John
Roberts wrote during his first decade at the Court. Other than Leegin,31 it was the only
five-to-four antitrust decision the Supreme Court handed down during that decade.
In sum, a vertically integrated firm with market power in one market may profitably
engage in squeezing in adjacent markets, including for the purpose of monopolizing
those markets. Under present law, with very narrow exceptions, squeezing by a verti-
cally integrated firm is generally legal.
6.3.2. The Nonintegrated Firm

We now turn to unilateral squeezing by nonintegrated firms. Nonintegrated firms
may and often do creatively devise unilateral squeezing strategies. For example, a
powerful firm can set a network of exclusive contracts with upstream or downstream
firms to exclude its rivals from the market by leaving them with insufficient access
to intermediate inputs. Krattenmaker and Salop (1986) called this squeezing strategy
“exclusionary rights contracts.” To illustrate the use of this strategy, consider Lorain
Journal. A monopoly newspaper refused to sell newspaper advertising to advertisers
that also used a radio station that attempted to enter the local market.32 The United
States Tobacco Company (“USTC”), which dominated the market for moist snuff
throughout the 20th century, deployed a similar squeezing strategy.33 The company
used slotting allowances to secure its space on racks and points of sales and exclude
competitors.34 These vertical arrangements, which are common and offer efficiencies,
can also be used for exclusion (FTC, 2003).
The facts of Klor’s, discussed in section 6.2, as described by the plaintiff, supposedly
depict a similar squeezing strategy. Leveraging “a monopolistic buying power,” a power-
ful firm allegedly secured a network of agreements with appliances manufacturers and
suppliers to exclude competition. However, the agreements Broadway-Hale secured
were limited in their scope. Klor’s approach to vertical agreements belongs to the anti-
trust tradition of inhospitality (Turner, 1966). We compare Klor’s to Lorain Journal and
USTC to emphasize that the analysis of vertical arrangements is not and should not be
beyond the scope of antitrust. As contractual instruments, vertical arrangements may
be used also for anticompetitive purposes.
In reality, powerful nonintegrated firms devise ways limit the access of their com-
petitors to the market and inputs in many other ways (Baker, 2013). The view that “a
31
Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 U.S. 877 (2007).
32
Lorain Journal Co. v. United States, 342 U.S. 143 (1951).
33 Conwood Co., L.P. v. U.S. Tobacco Co., 290 F.3d 768 (6th Cir. 2002).
34 “Slotting allowances” are payments a supplier makes to a retailer as a condition for the initial
placement of the supplier’s products on the retailer’s store shelves. (FTC, 2003).
dominant firm may incur antitrust liability for purely unilateral conduct” only in “rare
circumstances”35 governs US antitrust law but does not rest on economic analysis.
6.4. Concerted Squeezing
Concerted squeezing is collusion with a feature that enables a squeeze of some sort. The
ordinary collusion intends to squeeze surplus from consumers but does not exclude
competition through restrictions on the supply of intermediate inputs. Concerted
squeezing schemes include an enforcement mechanism that facilitates the squeeze. The
enforcement mechanism may include vertical relationships with upstream or down-
stream firms,36 a control over trade association or industry standards,37 ownership of
technological standards,38 or something else.
To illustrate concerted squeezing, consider the seminal Terminal Railroad case that
established the essential facility doctrine.39 In 1889, railroad tycoon Jay Gould orga-
nized the Terminal Railroad Association of St. Louis (“TRRA”) to consolidate control
over railway transportation entering and leaving St. Louis and, specifically, transpor-
tation across the Mississippi River between St. Louis and Illinois. At the time, St. Louis
was the fourth largest city in the United States, and in it was concentrated a significant
volume of trade. TRRA was a consortium consisting of fourteen of the twenty-four
railroad companies that converged at St. Louis. Its members controlled “about one
third of the railroad mileage of the United States.”40 TRRA established a concerted
squeezing scheme facilitated through vertical integration. It was able to squeeze
other railroads through control over the transportation means across the Mississippi
River: the Eads Bridge, the Merchants’ Bridge, and the Wiggins Ferry Company.
Another example of an effective enforcement mechanism is the ringmaster of
hub-and-spoke cartels. The ringmaster typically has vertical relationships with the
cartel members, setting and enforcing a cartel for them, while squeezing its competi-
tors and possibly also competitors of other cartel members.41 In such hub-and-spoke
cartels, the ringmaster organizes a cartel among inputs sellers and, in exchange for its
35
36
See, e.g., JTC Petroleum Co. v. Piasa Motor Fuels, Inc., 190 F.3d 775 (7th Cir. 1999).
37 See, e.g., Associated Press v. United States, 326 U.S. 1 (1945); American Society of Mechanical
Engineers, Inc. v. Hydrolevel Corp., 456 U.S. 556 (1982); Abraham & Veneklasen Joint Venture
v. American Quarter Horse Association, 2013 WL 2297104 (N.D. Tex. May 24, 2013); Areeda, 1989
(referring to “industry consortia”).
38 See, e.g., Clamp-All Corp. v. Cast Iron Soil Pipe Institute, 851 F.2d 478 (1st Cir. 1988); Fashion
Originators’ Guild of America v. FTC, 312 U.S. 457 (1941).

39 See, e.g., United States v. Terminal Railroad Association of St. Louis, 224 U.S. 383 (1912).
40 Id. at 400.
41 Interstate Circuit v. United States, 306 U.S. 208 (1939); Toys “R” Us, Inc. v. FTC, 221 F.3d 928 (7th Cir.
2000); United States v. Apple Inc., 952 F. Supp. 2d 638 (S.D.N.Y. 2013); Klein, 2012.
Squeeze Claims 129
organizational services (or for its ability to enforce discipline), the sellers do not deal
with its competitors or deal with them in a squeezing manner. For example, in Interstate
Circuit, a first-run theater chain established an agreement among the major distribu-
tors regarding the organization of movie exhibition in the region and the squeezing of
its rivals.42 Similarly, Toys “R” Us, a powerful toy retailer, formed a network of vertical
agreements with individual toy manufacturers, in which each manufacturer commit-
ted to restrict distribution of its products to low-priced club stores on the condition that
other manufacturers do the same.43
The analysis of enforcement mechanisms that facilitate concerted squeezing may be
rather complex. For example, when the mechanism is a vertical arrangement, it may be
presented as a contractual instrument adopted to enhance efficiency. This was Apple’s
argument in defense of the e-book hub-and-spoke cartel.44 Similarly, when the mecha-
nism is control over industry membership, the mechanism is typically presented as a
means necessary to protect quality.45 The legal rule for concerted squeezing, however,
is very crude. Under Klor’s, group boycott is illegal per se. As a result, courts have been
rationalizing deviations from the per se rule to the rule of reason.46 The complexity of
the enforcement mechanisms suggests that per se rules may be inadequate for con-
certed squeezing. This point is consistent with the broad criticism of the law of group
boycott.
6.5. Conclusion
Squeezing is restrictions on the supply of intermediate inputs that a firm with market
power or a cartel can impose on other firms, thereby raising their costs. It is a rather
common strategy. Antitrust squeeze claims are as old as antitrust. Squeezed firms some-
times try to find remedy in antitrust law. The traditional antitrust analysis of squeeze
claims is quite dismissive, among other reasons, because they try to revive noneconomic
doctrines. In this chapter, we argue that the analysis of both unilateral and concerted
squeezing is too crude and could be improved.
Specifically, we argue that the traditional squeeze claims—refusal to deal, essen-
tial facility, and price squeeze—correspond to an outdated case law. They describe
a limited set of restrictions on the supply of intermediate inputs and do not identify
42
Interstate Circuit, 306 U.S. 208.
43
Toys “R” Us, 221 F.3d 928.
44 Apple, 952 F. Supp. 2d 638.
45 See, e.g., FTC. v. Indiana Federation of Dentists, 476 U.S. 447 (1986); FTC v. Superior Court
Trial Lawyers Association, 493 U.S. 411 (1990) (holding that a strike illegal per se); see, e.g., Northwest
Wholesale Stationers, Inc. v. Pacific Stationery & Printing Co., 472 U.S. 284 (1985); Gregory v. Fort
Bridger Rendezvous Ass'n, 448 F.3d 1195 (10th Cir. 2006); Abraham & Veneklasen, 2013 WL 2297104.
46 See, e.g., FTC. v. Indiana Federation of Dentists, 476 U.S. 447 (1986).
anticompetitive effects or practical remedies. It may well be that antitrust should not
address squeeze claims, but probably not for the reasons presently used.
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Law Journal 58: 841–52.
Areeda, Phillip E., and Herbert Hovenkamp. Antitrust Law. New York: Wolters Kluwer.
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Cases Cited
Abraham & Veneklasen Joint Venture v. American Quarter Horse Association, 2013 WL
2297104 (N.D. Tex. May 24, 2013).
America’s Best Cinema Corp. v. Fort Wayne Newspapers, Inc., 347 F. Supp. 328, 333 (N.D. Ind.
1972).
American Society of Mechanical Engineers, Inc. v. Hydrolevel Corp., 456 U.S. 556. (1982).
Aspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585 (1985).
Associated Press v. United States, 326 U.S. 1 (1945).
Brown Shoe Co. v. United States, 370 U.S. 294, 320 (1962).
Brooke Group Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993).
Clamp-All Corp. v. Cast Iron Soil Pipe Institute, 851 F.2d 478 (1st Cir. 1988).
Squeeze Claims 131
Conwood Co., L.P. v. U.S. Tobacco Co., 290 F.3d 768 (6th Cir. 2002).
Eastman Kodak Co. v. Image Technical Services, Inc., 504 U.S. 451 (1992).
Eastman Kodak Co. of New York v. Southern Photo Materials Co., 273 U.S. 359 (1927).
Eatoni Ergonomics, Inc. v. Research in Motion Corp., 486 F. App’x 186 (2d Cir. 2012).
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F.T.C. v. Indiana Federation of Dentists, 476 U.S. 447 (1986).
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Image Technical Services, Inc. v. Eastman Kodak Co., 125 F.3d 1195 (9th Cir. 1997).
In re Independent Service Organizations Antitrust Litigation, 203 F.3d 1322 (Fed. Cir. 2000).
In re Adderall XR Antitrust Litig., 13-1232, 2014 WL 2565832 (2d Cir. June 9, 2014).
Intergraph Corp. v. Intel Corp., 195 F.3d 1346 (Fed. Cir. 1999).
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K & S Associates, Inc. v. American Association of Physicists in Medicine, 2013 WL 2177938
(M.D. Tenn. May 20, 2013).
Klor’s, Inc. v. Broadway-Hale Stores, Inc., 359 U.S. 207 (1959).
Laurel Sand & Gravel, Inc. v. CSX Transp., Inc., 924 F.2d 539 (4th Cir. 1991).
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CHAPTER 7
I N N OVAT IO N A N D A N T I T RU ST P OL IC Y
THOMAS F. COT TER
Most economists would agree that, in the long run, the welfare gains from innovation
likely dwarf the relatively short-term welfare gains—the elimination or reduction of the
deadweight loss attributable to market power—that economic analysis predicts will result
from more competitive market structures.1 Consistent with this premise, nations offer
inventors and creators intellectual property rights (IPRs), on the theory that the possibility
of obtaining a (short-run) monopoly provides a necessary inducement for individuals to
invest in the creation of inventions, works of authorship, and other innovative subject mat-
ter that promise to generate greater long-run social benefits. On this reasoning, an anti-
trust policy that focuses exclusively, or too aggressively, on promoting static (short-run)
competition would appear, at best, myopic and at worst, perverse. Perhaps, then, antitrust
would better serve the public interest if it focused as much or more attention on fostering
long-run, dynamic competition—in penalizing what Bohannan and Hovenkamp refer to
as restraints on innovation—as it traditionally has on promoting static competition.
The problem, of course, lies in the details. As Bohannan and Hovenkamp also note,
the standard tools of economic analysis are much better designed for predicting and
measuring the effects of, say, monopoly or cartel behavior on short-run pricing and out-
put decisions than they are at predicting the effects of such behavior on long-run innova-
tion.2 To illustrate, under a simple decision-theoretical perspective an optimal antitrust
standard is one that minimizes the sum of error (false positive and false negative) costs
and enforcement costs—that is, of p1c1 + (1 − p1c2) + c3, where p1 is the probability of
1
For discussions, see, e.g., Bohannan and Hovenkamp (2012, 8–11, 14, 241–42); Warsh (2006).
2
Bohannan and Hovenkamp (2012, 6–7, 11, 242–56). A word on terminology may be appropriate
here. Patent laws confer protection in inventions, that is, in the intangible inventive principle the
inventor claims to have discovered. That principle itself may be incorporated in a wide variety of tangible
embodiments that are not, strictly speaking, identical to the intangible patented invention (inventive
principle). Relatedly, many scholars also differentiate invention from innovation, where the latter term
refers to the embodiment of an invention in a commercial product or service. As will be noted in the text
above, many patented inventions are never deployed in commercial products and thus do not result in
innovation as such.
Innovation and Antitrust Policy 133
wrongly condemning conduct that is, on balance, welfare-enhancing; 1 − p1 is the

probability of wrongly exonerating conduct that is, on balance, welfare-reducing; c1
is the net social welfare loss from wrongly condemning conduct that is, on balance,
welfare-enhancing; c2 is the net social welfare loss from wrongly exonerating conduct
that is, on balance, welfare-enhancing; and c3 is the cost of adjudication. If we ignore the
potential effect of the conduct at issue on innovation, c1 would be the forgone net effi-
ciency gains—the excess of short-term efficiency gains over deadweight loss, if any—if
the conduct is wrongly condemned. c2 would be the net efficiency loss—the excess dead-
weight loss over short-term efficiency gains, if any—if the conduct is wrongly exoner-
ated. Economic analysis can assist in attaining a (rough) idea of whether the sum of error
and enforcement costs so defined is likely to be higher or lower if the conduct at issue is
evaluated under a per se rule, the rule of reason, or some other intermediate standard.
By contrast, an antitrust policy that factors into the mix a practice’s effects on innova-
tion would define c1 as the excess of efficiency gains (from both short-term efficiency
gains and long-term efficiencies resulting from innovation) over efficiency losses
(from both deadweight loss and any longer-term, countervailing harms to innovation).
The farther out one goes in predicting those long-term consequences resulting from
innovation-related efficiency gains, the less one can envision their magnitude or direc-
tion. Estimating the value of p becomes increasingly difficult as well, since the future
course of innovation is, almost by definition, unpredictable. One can attempt to model
these effects of dynamic innovation by incorporating into c1 and c2 the costs and benefits
of IPRs and other institutions that affect the rate of innovation, but the analysis is often
too abstract to produce concrete policy recommendations—one problem being that any
system designed to encourage future innovation necessarily relies upon past innovation
as an input.3 Innovation’s dual status as both an output and an input of, say, a patent or
copyright system, in other words, means that predictions as to the net effect of a given
policy on innovation are often fraught with substantial uncertainty. Seen in this light, it
is not surprising that antitrust law generally focuses on the more tractable short-term
costs and benefits, notwithstanding their (relative) lack of importance to social welfare.
Be that as it may, whether or not policymakers consciously consider the effects of anti-
trust on innovation, antitrust surely will have some impact on innovation, for good or for
ill; the question then is whether antitrust should at least strive to take those effects into
consideration, or whether those effects are simply too unpredictable to merit any such
conscious effort. I will argue below that, at least in some discrete circumstances, policy-
makers should (and do) take likely impacts on innovation into account in formulating
antitrust standards, and that some modest expansions of such efforts would be welcome.
At the same time, I will argue, it would probably be a mistake to expect antitrust to do
too much. Antitrust’s role in promoting innovation inevitably will be modest in com-
parison with the role of intellectual property (IP) law; and IP law itself is hardly the only
3 The observation that information is both an input and an output can be traced at least as far back
as Arrow (1962, 618). For discussions of the difficulties of fine-tuning a patent system to optimize
innovation over time, see Green and Scotchmer (1995); Scotchmer (1991).
134 Thomas F. Cotter
game in town, but rather only one component of an innovation policy that may include
public or private patronage, self-help and first-mover advantages, and possibly other
tools. Antitrust therefore may be part of the solution to the problem of ensuring effective
dynamic competition, but it should play a dominant role only in limited circumstances.
Section 7.1 provides a brief overview of the role of IPRs in promoting innovation, accord-
ing to standard economic theory. Section 7.2 discusses the relationship between antitrust
and IP law in promoting social welfare. Section 7.3 then highlights three ways in which anti-
trust can play a useful role in innovation policy. Section 7.4 concludes.
7.1. Of Intellectual Property Rights

and Innovation
IPRs are probably the most prominent tool modern governments use to foster inno-
vation, but the debate over whether IPRs are a necessary or even desirable means to
this presumed end is of long standing. With regard to patents, for example—and most
of the discussion that follows will focus on patents for new inventions, with less atten-
tion being paid to trade secrets, copyright in works of authorship, and other forms of IP
that generally play a smaller role in innovation as such—the conventional argument is
that patents solve a free-rider problem that otherwise would threaten to undermine the
incentive to invent: that is, that given a sufficiently high cost of inventing and a suffi-
ciently low cost of copying another’s invention, the dominant strategy of rational actors
often would be to copy rather than to invent. Indeed, the copier often would have a com-
petitive advantage against the inventor, since the copier does not need to make up the
sunk costs of research and development (R & D) in order to meet his long-run costs.
If too many people follow this strategy of copying as opposed to inventing, however,
innovation stands to suffer. Of course, the conditions that give rise to the strategy are not
universally present. Sometimes the cost of inventing is low, or the cost of copying—say,
by reverse engineering the formula for a popular soft drink—may be surprisingly high.
Or the expected gains from inventing may exceed the expected gains from copying, not-
withstanding the copier’s potential cost advantage. Some people may invent or engage
in other creative work for the sheer joy of it—the psychic gain, if you will—though psy-
chic pleasures alone are unlikely to compensate for the sunk costs of, say, developing a
new antiretroviral drug. In other instances, merely being the first on the market with a
new product may provide the inventor with a sufficient opportunity to recoup its R & D
costs, before copiers can enter and compete.4 Alternatively, various self-help measures,
including contractual limitations on use or resale, or any of a variety of measures to keep
the invention secret, may suffice to preserve the incentive to invent even though third
4 For arguments that first-mover advantages alone often would suffice, see Boldrin and Levine (2008,
136–40).
parties who are not bound by any duty of confidentiality might succeed in copying the
invention. Many analysts nevertheless conclude that these alternatives would be insuf-
ficient to stimulate the optimal amount of invention—and that some of these measures,
in particular secrecy, suffer from their own defects as tools of social policy. An invention
that remains secret can be difficult to license efficiently, as Arrow’s Information Paradox
(Arrow 1962; 614–16) teaches; and in any event secrecy interferes with the public’s ability
to learn from, and improve upon, the technology at issue.
Conventional analysis therefore assumes that some form of government intervention
may be desirable in order to solve the aforementioned free-rider problem. One form that
such intervention may take is the granting of exclusive rights in the form of a patent. From
one perspective, this form of intervention may seem odd because the subject matter of a
patent is intangible—an inventive principle (which, however, may be embodied in a vari-
ety of tangible things). Inventions therefore reflect two characteristics often associated
with public goods, namely nonrivalrousness (many people can simultaneously consume
the same inventive principle without depleting it) and nonexcludability (preventing
someone from using an inventive principle once it has been disclosed to him can be
extremely difficult). Public goods generally can give rise to free-rider problems, insofar
as the nonrivalrous and nonexcludable nature of such goods make it difficult to prevent
anyone—including those who do not contribute to the cost of creating or maintaining
them—from enjoying their benefits. Though markets or other informal institutions
sometimes may succeed in overcoming free-rider problems that threaten to undermine
the provision of public goods, quite often governments step in to provide such goods
themselves and finance their provision from taxes assessed from the general public; in
theory, at least, such public financing overcomes the free-rider problem. To some extent,
the provision of the public good of innovation is financed in much the same way, through
the use or private or public institutions that fund research, either directly (for example,
through grants) or indirectly (for example, through the provision of tax deductions for
R & D); or that offer ex ante incentives (prizes) or ex post rewards for inventive success.
One advantage of a system of IPRs, however, is that unlike a system of grants, prizes, and
rewards, the system is decentralized. Rather than having government or private founda-
tions decide what needs to be invented and how much value (either ex post or ex ante) to
place upon such inventions, the government instead offers inventors exclusive rights for
any and all inventions meeting the statutory requirements (novelty, nonobviousness, and
so on). In theory, this decentralized approach capitalizes upon the informational advan-
tage collectively possessed by market actors in deciding what to invent and, if they are
successful in obtaining a patent, how much to ask for the use of it. The market, in other
words, ultimately decides which inventions are valuable and which are not.5
5 Such an approach might not be very helpful, however, when it comes to creating incentives to
develop inventions that may confer great social utility but that possess relatively little commercial value,
such as essential medicines for the treatment of diseases endemic to the developing world. To fund this
type of research, alternatives such as prizes may be optimal. For an overview and critical discussion of
the relevant literature, see Fisher and Syed (forthcoming, ch.7).
According inventors exclusive rights in their inventions therefore may be desirable

if it generates social benefits that would be more costly to generate, or that might not
be generated at all, in the absence of such a system. Whether any given patent system
actually is desirable, however, depends as well on its corresponding social costs. Aside
from administrative costs, the most prominent costs attributable to patents are potential
monopoly and (what I will refer to as) “access” costs. As for the first of these, in collo-
quial usage patents are often referred to as “monopolies,” but the term is a misnomer.
Empirical studies generally show that less than half of all patents are ever commercial-
ized at all, and of these only a subset enable the owner to derive substantial economic
rents.6 That subset, however, can be an important one, including within it (for example)
patents on new drugs for which there are no good market substitutes.7 Of course, con-
sumers may be better off paying a monopoly price for an invention that greatly improves
their lives but that would not have been invented so soon (or at all) absent the patent sys-
tem, than they would be paying a competitive price for a poor substitute (Dam 1994, 251).
Nevertheless, an ideal patent system would work to reduce the social costs of monopoly,
for example by limiting the scope and duration of patent rights to the minimum nec-
essary to enable the owner to recoup its R & D costs. As for access costs, the principal
problem is that patents can raise the cost incurred by future inventors whose work nec-
essarily builds upon (and perhaps improves) that which has gone before. To be sure, in
a world of zero information and transaction costs, patent owners would never demand
a royalty so high as to derail a potentially valuable new application of their technology.
In the real world, however, information and transaction costs can sometimes be quite
high. The payoff to be earned from developing an improvement is itself unpredictable;
it is often difficult to determine whether a given patent actually would read on (cover)
a potential improvement; and sometimes just the sheer number of patents potentially
reading on a given technology can be enormous, thus giving rise to concerns that a “pat-
ent thicket” or “anticommons” of potentially blocking patent rights would be so burden-
some to negotiate that some improvements will simply be abandoned instead.8
Seen in this light, the ideal patent system would be one that maximized the surplus of
social benefits derived from innovation over social costs—the administrative, access,
and occasional monopoly costs that are (to some degree) an inevitable byproduct of any
patent system. The problem is that no one knows where this “sweet spot” lies; resolving
6
For citations to the relevant literature, see Sichelman (2010, 362–63 and n. 121).
7
One might imagine that only those patents that do enable the owner to accrue economic rents
would be the subject of litigation. Because a patented invention for which there are adequate market
substitutes can be easily designed around, an injunction would provide little leverage for extracting
a lucrative licensing agreement, and damages should be minimal. Due to imperfections in the way in
which patents provide public notice of their covered subject matter, however, the cost of designing
around ex post may be much higher than the cost of designing around ex ante, in which case the owner
of a patent that contributes little to the state of the art nevertheless sometimes may be able to negotiate a
favorable settlement that reflects some portion of the infringer’s sunk costs. See Cotter (2009, 1181–82).
8 See Heller and Eisenberg (1998). Cf. Walsh et al. (2005, 2003) (reporting “little empirical basis for
claims that restricted access to IP is currently impeding biomedical research,” though noting that “there
is evidence that access to material research inputs is restricted more often”).
the problem appears thus far to elude empirical analysis. Nevertheless, many standard
patent law doctrines—including the limited term of patent rights, the exclusion from
patentability of abstract ideas and laws of nature, and limiting patent protection only to
novel, useful, and nonobvious subject matter that is adequately disclosed by the inven-
tor—can be viewed as efforts, however imperfect, to attain this optimal point. In prin-
ciple, moreover, policymakers could look to empirical evidence, where available, for
guidance in refining patent doctrine so as to bring it more closely in alignment with
optimum. As discussed below, for example, empirical evidence tends to show that pat-
ent protection is much more important in certain industries (e.g., pharmaceuticals)
than in others (e.g., software). In theory, then, policymakers could adopt a system of
industry-specific patent rights; and there is reason to believe that, in practice, courts
do engage in a bit of “tailoring,” whether consciously or not, in determining, for exam-
ple, the amount of disclosure needed to enable a person of ordinary skill in the art to
practice the claimed invention.9 Explicit tailoring, however, in the sense of (say) afford-
ing pharmaceutical patents a longer term than other patents, appears to be ruled out of
bounds under the TRIPs Agreement, an international treaty that forbids WTO mem-
ber states from discriminating with respect to patent rights on the basis of field of tech-
nology.10 Such explicit tailoring also likely would induce rent-seeking and regulatory
capture. As a result, however, in the absence of such tailoring patent law may confer
stronger rights (e.g., a longer term) than is optimal for some fields of technology and
weaker-than-optimal rights for others.
The uncertainty that surrounds the optimal design of patent rights is further compli-
cated by a number of less obvious effects that patents may have on innovation. Edmund
Kitch’s famous “prospect” theory, for example, argues that patent rights enable inven-
tors to coordinate follow-up investments in improvements upon an early technology.
This coordination can be socially efficient to the extent it reduces the risk of duplica-
tive efforts on the part of multiple would-be improvers (Kitch 1977, 267–71).11 Kitch’s
theory, if correct, suggests that the patent system should accord “pioneering” patents
broad scope, and is therefore at least broadly consistent with Joseph Schumpeter’s thesis
that monopoly acts as a spur to innovation. On this view, an aggressive antimonopoly
9
See, e.g., Burk and Lemley (2009, 59–65, 115–16). Burk and Lemley argue, however, that courts
have sometimes gotten the tailoring wrong by, for example, applying doctrine so as to encourage large
numbers of very narrow patents on DNA sequences. Some biotech patent cases decided since 2009 may
ameliorate these consequences to some extent.
10 TRIPs art. 27(1). Moreover, TRIPs requires a minimum patent term expiring no earlier than
20 years from the date of filing, see id. art. 33, so even if discrimination as to field of technology were
permitted, patents could not be granted for a shorter term. Nations may, however, extend the patent
term to compensate for regulatory delay in approving a product for marketing or for delays in patent
prosecution. The United States does so, and to some extent this often does result in pharmaceutical
patents enjoying a longer term (though not necessarily a longer effective term). Patents also may expire
earlier than 20 years for failure to pay national patent maintenance fees.
11 Some scholars have attempted to modify or extend the theory—for example, to explain why laws
of nature are not patentable, see Grady and Alexander (1992), or to show how patents may assist in
coordinating follow-up investments in innovation, meaning here not invention as such but rather the
commercialization of invention, see Kieff (2001).
policy is misguided, because the gains from innovation, being permanent, outweigh the
relatively transitory losses from monopoly; moreover, no monopolist can maintain its
position forever, but rather will eventually be overtaken by the purveyor of a new gener-
ation of technology in a process of creative destruction (Schumpeter [1942] 2003, 84–85,
100–103). The prospect theory remains controversial, however, with some analysts find-
ing empirical support for the theory lacking (Beck 1983; but see Duffy 2004, 488 n. 141),
and others arguing that competition in the market for follow-up improvements is more
likely to improve social welfare than is according broad control to the owner of the pio-
neering patent (Merges and Nelson 1990, 871–78). Kitch skeptics find support in the the-
oretical work of Kenneth Arrow, who (contra Schumpeter) contended that competition,
not monopoly, is the greater spur to innovation (Arrow 1962, 620–21).
Other theorists have focused on yet other ways in which patents can impact innova-
tion. Clarisa Long (2002), for example, argues that patents provide a signal of a start-up
company’s potential value, and thus assist venture capitalists in deciding which
start-ups to fund. Some empirical evidence supports her thesis that venture capital-
ists place substantial weight on start-ups’ patent portfolios,12 though questions remain
whether or to what extent the signal provided by a large portfolio is an accurate one.
Other theoretical literature has highlighted the possible impact of patents and other
IPRs on the size and structure of firms. For example, the type and scope of IPRs cov-
ering a given technology can impact firms’ and employees’ willingness to share their
ideas with one another and with authorized third parties. IPRs thus can at least indi-
rectly affect the ability of firms to organize at efficient scale (Burk and McDonnell 2007;
Barnett 2011).
Empirical studies on the effects of patents on invention and innovation have tended
to show at most relatively modestly positive incentive effects in most industries other
than pharmaceuticals and chemicals.13 Relatedly, Bessen and Meurer (2008, 141) argue
that, since the late 1990s, the private costs of patenting have outweighed the private
benefits for US public firms other than those in the chemical and pharmaceutical
industries (see Bessen and Meurer 2008). In addition, a study of US patent litigation
in the IT sector by Lemley and Cotropia (2008) shows that only a small percentage
of the cases involve deliberate copying. In most, the alleged infringer independently
invented (but did not itself attempt to patent) the subject matter at issue, suggesting
perhaps that a good deal of innovation in this field occurs independently of the patent
incentive. On the other hand, empirical work thus far has failed to show systematic
12 See Graham et al. (2009, 1270 n. 44, 1280) (“Firms that seek venture-funding appear to be patenting
more actively prior to the funding event (and for the purpose of securing funding), and venture-capital
investors appear much less willing to fund companies that hold no patents”).
13 See Cohen, Nelson, and Walsh (2000) (concluding, based on a “Carnegie Mellon Survey (CMS)
on Industrial R&D in the U.S. manufacturing sector administered in 1994,” that patents “are still not one
of the major mechanisms in most industries when the views of all firms are considered”). The authors
caution, however, that “[w]‌hile patents are still not the dominant mechanism in most industries for
protecting product innovations, it now appears that they can be counted among the major mechanisms
of appropriation in a more sizeable minority of industries.” See also Boldrin and Levine (2008, 192–98)
(discussing other empirical literature on the incentive effects of patents).
negative effects resulting from patent thickets or anticommonses. In fields such as

semiconductors and biotechnology, firms and researchers have tended to reach
accommodations, either of a formal nature (patent pools or other cross-licensing
agreements) or of an informal one (norms counseling against filing suit for experi-
mental purposes).14 Such studies do not prove, however, that thickets and anticom-
monses can never give rise to problems in the real world. Formal legal recognition of
an experimental use defense, available in many countries other than the United States,
might be helpful in fending off such problems in the future. Antitrust as well can (and
generally does) play a positive role by recognizing that the procompetitive benefits of
agreements to cross-license patents often, though not always, dominate their poten-
tial anticompetitive consequences.
7.2. Antitrust and IP: A Complex

Relationship
A view commonly expressed by outsiders to the fields is that antitrust and IP are antago-
nistic bodies of law: antitrust, after all, condemns monopolies, while IP law offers inven-
tors and authors the possibility of obtaining monopoly power as a goad to creating
and disclosing their creations. If this view were correct, courts would have to decide
whether in cases of apparent conflict antitrust or IP law would take precedence; and
early in the history of US antitrust law, courts often did defer to IP owners’ right to
engage in conduct that might otherwise appear contrary to antitrust norms.15 Before
too long, however, the tide turned and courts began applying increasingly aggressive
antitrust scrutiny to transactions involving IPRs. The high-water mark of this approach
was probably in the early 1970s, when a Department of Justice (DOJ) official in a public
14
See, e.g., Hall and Ziedonis (2001, 109) (noting cross-licensing in the semiconductor industry).
15
For example, in Bement v. National Harrow Co., 186 U.S. 70, 92–94 (1902), the US Supreme Court
held that the Patent Act permitted—and the Sherman Act did not forbid—the patentee to license
the right to make and sell a patented invention, subject to an obligation on the part of the licensee/
manufacturer to resell the product at a specified price. The Court reaffirmed this rule in its 1926 decision,
United States v. General Electric Co., 272 U.S. 476, 488 (1926), although it has since hinted the rule may no
longer be valid. See Simpson v. Union Oil Co. of Cal., 377 U.S. 13, 24 (1964) (noting that, although “price
fixing in the marketing of patent articles had been condoned” previously, resale price fixing through a
“coercive type of ‘consignment’ agreement is illegal under the antitrust laws”). Similarly, in Henry v. A.B.
Dick Co., 224 U.S. 1, 48–49 (1912), the Court held that a person who bought a patented machine subject
to the condition that the purchaser would use only (nonpatented) ink made by the patentee engaged
in an infringing use when she used another company’s ink; and the supplier of the ink, who was aware
of the license restriction, was liable for contributory patent infringement. Five years later, however, the
Court held that § 3 of the newly enacted Clayton Act overruled A.B. Dick. See Motion Picture Patents Co.
v. Universal Film Mfg. Co., 243 U.S. 502, 517–18 (1917).
speech identified the “Nine No-Nos,” nine practices involving IPRs that the DOJ viewed
as being of dubious legality.16
By the late 1970s, however, as the Chicago school began to exert increasing influence
among antitrust policymakers in the United States, a more nuanced view of the rela-
tionship between antitrust and IP began to emerge, in recognition of the fact that many
IPRs do not confer meaningful monopoly power after all, and that many IP-related
transactions (such as patent pools) frequently offer substantial procompetitive bene-
fits. Notably as well, even when IPRs do confer monopoly power, the mere possession
of such power does not state a claim for violation of § 2 of the Sherman Act, which
instead requires proof of the willful acquisition or maintenance of such power.17 Thus
in 1995, the US antitrust enforcement authorities published guidelines relating to the
licensing of IP that expressly recognized that “[i]‌ntellectual property is . . . neither par-
ticularly free from scrutiny under the antitrust laws, nor particularly suspect under
them.”18 In a similar vein, in its 2006 decision in Independent Ink, Inc. v. Illinois Tool
Works Inc., the US Supreme Court overruled previous case law holding that posses-
sion of a patent conferred a presumption of market power for purposes of evaluating
the legality of a tying arrangement. Henceforth, antitrust plaintiffs must prove, among
other things, that a defendant patent owner has market power in the market for the
tying patented product.19 On one view, then, antitrust and IP are best viewed as com-
plementary bodies of law, each seeking to improve social welfare albeit through differ-
ent means (Cotter 2008, 745–49).
Any conclusion that antitrust and IP can never be in tension, however, would be
premature. At least under some circumstances, antitrust may have to determine how
much weight to accord a patent owner’s defense that a particular restraint or conduct is
reasonably necessary to preserve the value of the patent (or other IP) incentive system;
or that the restraint or conduct serves the ancillary purpose of facilitating the efficient
use of a technological standard, notwithstanding (some) potential for also reducing
incentives or inhibiting the development of a rival standard. Sometimes the tension is
starkly presented, as in the case of grantback arrangements, where the patentee licenses
its invention on condition that the licensee grant back a license to use improvements
developed by the licensee. Grantback provisions may be procompetitive, to the extent
they induce the licensing of the earlier (“dominant”) invention, but they also could
impede dynamic competition to the extent they stifle would-be improvers’ incentives
16 See Tom and Newberg (1997, 178–79) (discussing the “Nine No-No’s” as described in a 1970 speech
by Deputy Assistant Attorney General Bruce Wilson). The nine practices included “tying of unpatented
supplies; mandatory grantbacks; post-sale restrictions on resale by purchasers of patented products;
tie-outs; licensee veto power over the licenser’s grant of further licenses; mandatory package licensing;
compulsory payment of royalties in amounts not reasonably related to sales of the patented product;
restrictions on sales of unpatented products made by a patented process; and specifying prices a licensee
could charge upon resale of licensed products.”
17 See United States v. Grinnell Corp., 384 U.S. 563, 570–71 (1966).
18 U.S. Department of Justice and Federal Trade Commission (1995; § 2.1).
19 547 U.S. 28, 38–42 (2006).
to create or their own ability to license third parties.20 In such cases, antitrust courts
may be thrust into the uncomfortable role of determining whether the restraint on
balance tends to promote or restrain innovation. Another, perhaps more controver-
sial example, is the determination of the European Court of First Instance in Microsoft
v. Commission that Microsoft had abused its dominant position by refusing to license
interoperability information to potential competitors in the market for work group
server operating systems. In particular, the court held that Microsoft’s “refusal to sup-
ply the relevant information limited technical development to the prejudice of con-
sumers,” and that Microsoft had not demonstrated any impairment of its ability to
innovate.21 Other times a court’s consideration of the effects of a restraint or conduct on
dynamic innovation may be less explicit. In all such instances, however, the question
arises whether courts are according adequate weight to the incentives of both pioneers/
licensors and improvers/licensees; unfortunately, there is often no clear answer to this
question, as discussed below.
7.3. Antitrust’s Role in Promoting

Innovation
In theory, antitrust could play a much more aggressive role in promoting innovation
than it currently does under either US or EU law. One could imagine, for example, a
regime in which it would be an antitrust offense to use a patent or other IPR to extract
rents that are grossly disproportionate to the IP owner’s costs of developing the IP at
issue. Such a regime would work to constrain the deadweight loss attributable to some
IPRs; it also might reduce the risk of patent holdup, and by narrowing the scope of
potential bargaining outcomes it might reduce the cost of licensing negotiations. Access
costs faced by developers of follow-on innovation would be expected to decrease for all
of these reasons, while at the same time the incentives for pioneering inventors would be
adequate as long as the pioneers were assured of recovering at least some rent in excess
of their R & D costs.
Such an approach would be a clear break from standard antitrust policy, which
generally does not focus on whether a lawful monopolist is charging too high a price.
As noted above, for example, Section 2 of the Sherman Act focuses on whether the
monopolist is engaging in the willful acquisition or maintenance of monopoly power
20 See U.S. Department of Justice and Federal Trade Commission (1995; § 5.6) (stating that, in
accordance with Transparent-Wrap Machine Corp. v. Stokes & Smith Co., 329 U.S. 637, 645–48 (1947), the
agencies will evaluate grantbacks under the rule of reason, considering both the procompetitive benefits
of encouraging initial invention and disclosure, on the one hand, and the potential anticompetitive harm
of discouraging licensee-generated innovation, on the other).
21 Case T-201/04, 2007 E.C.R. II-3601, ¶¶ 331–32.
by excluding would-be rivals for reasons that lack a plausible procompetitive justifi-
cation.22 US antitrust law, in other words, generally focuses on the risk of unjustifiable
monopoly extension rather than on an otherwise lawful monopolist’s mere extraction
of monopoly rents (Carlton and Heyer 2008, 287–88). In cases involving allegations of
abuse of dominant position within the EU, the legal standard is a little closer to the theo-
retical one sketched out above, in that courts sometimes consider whether the antitrust
defendant’s conduct is justified by the social interest in providing appropriate incentives
to the developers of pioneering innovations. But even in this context, in cases such as
Microsoft v. Commission, the principal focus is on whether the IP owner’s conduct (e.g.,
a refusal to deal) directly threatens the development of new products or services, and
not on whether the owner is simply charging a disproportionately high price.23
As many analysts have observed, however, an antitrust regime that required courts
to set prices in the manner of a public utility commission would be misguided for sev-
eral reasons, the most obvious of which is judicial competence.24 Courts are not well
positioned to receive evidence and make expert determinations of what an appropriate
(incentive-preserving) rate of return on an investment in R & D would be, and thus a
regime of this nature would be vulnerable not only to substantial administrative costs
but to error costs as well. Errors resulting from courts’ inability accurately to correlate
rewards with incentives in turn threaten to impede dynamic efficiency by undermin-
ing the incentives offered to pioneering innovators. Trying to determine how much of a
reward is appropriate to preserve incentives therefore is probably not a productive ave-
nue for a significant expansion of antitrust liability.
That said, antitrust’s appropriate role in promoting innovation is not negligible,
though it is more modest than the proposal sketched above. In what follows, I will sug-
gest three ways in which antitrust works (or can work) to promote innovation: first, by
playing its traditional role in policing anticompetitive conduct such as horizontal price
fixing and market allocation, notwithstanding the fact that the product the price of
which is being fixed happens to be IP; second, by playing (if anything) a lesser role in
certain instances in which analysis suggests that greater coordination is actually neces-
sary to promote the efficient use or development of technological standards; and third,
by playing a (marginally) more aggressive role in cases in which the risk of harm to
dynamic efficiency in the form of nascent technology, even if small, outweighs the cor-
responding risk of harm to static and dynamic efficiency from limiting the exploitation
of IPRs to some degree. I will briefly explain each in turn.
22
See United States v. Grinnell Corp., 384 U.S. 563, 570–71 (1966).
23
See Case T-201/04, Microsoft v. Commission, 2007 E.C.R. II-3601, ¶ 332 (stating that a refusal
to license IP may constitute an abuse of discretion under exceptional circumstances, namely when
(1) “the refusal relates to a product or service indispensable to the exercise of a particular activity on a
neighbouring market”; (2) “the refusal is of such a kind as to exclude any effective competition on that
neighbouring market”; and (3) “the refusal prevents the appearance of a new product for which there is
potential consumer demand”).
24 See, e.g., Verizon Communications Inc. v. Law Offices of Curtis V. Trinko, LLP, 540 U.S. 398, 408 (2004)
(“Enforced sharing also requires antitrust courts to act as central planners, identifying the proper price,
quantity, and other terms of dealing—a role for which they are ill suited”); Hovenkamp et al. (2010, 13-10).
First, antitrust promotes innovation by playing its traditional role of penalizing prac-
tices such as horizontal price fixing and other anticompetitive practices that offer no
plausible procompetitive justification, even when such practices happen to involve
IPRs. Where two firms agree to pool or package potentially competing patents, for
example, in such a way as to control the price of the end products that embody those
patents, antitrust enforcers rightly are not reluctant to perceive an agreement to fix
prices that derives no justification from the fact that the agreement also involves pat-
ent rights.25 Relatedly, antitrust is replete with examples of purported settlements or
pooling arrangements that in reality have been nothing more than disguised efforts at
industry-wide collusion.26 Condemning such arrangements clearly promotes antitrust’s
traditional static efficiency goals, but it also can be viewed as promoting innovation as
well to the extent that competition spurs market participants to differentiate themselves
by offering newer, more innovative products. Indeed, one might argue that, in practice,
the general rule of not exempting IPRs from antitrust scrutiny is not always applied with
sufficient consistency. Section 211 of the US Patent Act, for example, expressly states that
nothing in the statute “shall be deemed to convey to any person immunity from civil
or criminal liability, or to create any defenses to actions, under any antitrust law,” yet at
the same time another provision of the same statute appears to permit patent owners
to offer licenses under which the patent owner itself agrees to market its product exclu-
sively in one geographic area, while the licensee may market it exclusively in another.27
Outside the IP realm such an agreement normally would be per se illegal. To be sure,
such an arrangement might be reasonably ancillary to the efficient licensing of a patent
in a geographic area the patentee could not serve directly; and in the absence of such
an enforceable arrangement, the patentee might demand a higher licensing fee to com-
pensate for the risk of competition from the licensee within the patentee’s own terri-
tory. Nevertheless, the blanket exemption for such conduct has no counterpart in the
copyright statute and may be overly broad. Similarly, the minimal scrutiny that many
US courts have applied to potentially anticompetitive settlements of pharmaceutical
patent litigation arising under the Hatch-Waxman Act arguably does not take seriously
enough the risk of collusion among potential competitors, particularly in cases in which
the owner of a patent on a brand name drug pays its would-be generic competitor more
than the generic producer could have expected to earn from sales of the generic drug.28
To the extent courts have deviated from conventional antitrust principles in this latter
class of cases, however, the resulting harm would appear to be fall more heavily on static
efficiency (consumers paying more than is necessary to obtain pharmaceutical prod-
ucts) than on dynamic efficiency, which is not one of the expected benefits of generic
competition. Yet another example, this one with potentially more serious consequences
25
See, e.g., In the Matter of Summit Technology, 127 F.T.C. 208 (1999).
26
See, e.g., United States v. New Wrinkle, Inc., 342 U.S. 371 (1952); United States v. United States
Gypsum Co., 333 U.S. 364 (1948).
27 See 35 U.S.C. § 261 (stating that the patentee “may . . . grant and convey an exclusive right under his
. . . patents . . . to the whole or any specified part of the United States”).
28 For an overview and citations to relevant literature, see Cotter (2008, 797–801).
for dynamic efficiency, is the US courts’ arguably overcautious approach to Walker

Process claims, that is, antitrust claims founded on allegations that a patentee acquired
monopoly power by practicing fraud on the patent office.29
Second, however, there may be circumstances in which antitrust can promote innova-
tion by showing greater leniency than one might otherwise expect toward joint conduct
intended to make technology more widely available.30 While this might sometimes take
the form of greater tolerance for, say, joint ventures organized to promote a new technol-
ogy, in other instances it might involve greater tolerance for joint conduct on the part of
IP users. Both examples may arise in connection with standard-setting organizations
(SSOs). Because a certain degree of collaboration is necessary whenever competitors or
potential competitors negotiate the adoption of technological standards, antitrust has
long recognized both the potential benefits and costs of such collaboration—though it
properly takes a skeptical approach to features of any such agreement that (for exam-
ple) appear to serve no purpose other than placing potential rivals at a disadvantage.31
More interesting are features found in, or proposed for use in, some contemporary
standard-setting arrangements under which members agree to various obligations that
can be understood as serving to reduce the risk of patent holdup—for example, require-
ments that members disclose issued or pending patents that might read on a proposed
standard; or that they license any such patents on fair, reasonable, and nondiscriminary
(FRAND) terms; or (more controversial yet) that such licenses may not exceed a certain
rate. The more extensive the obligation is, the greater the risk that it is nothing more than
glorified price fixing; at the same time, some such obligations may be reasonably neces-
sary to ensure that firms are willing to commit to the standard without undue risk of fall-
ing victim to opportunistic conduct on the part of other members. In recent years, many
commentators (including the US Antitrust Modernization Commission) have called for
greater recognition of the potential procompetitive benefits of such agreements.32 My
own work has expressed agreement that in some such instances the best antitrust can
do to promote innovation is to get out of the way—by which I mean not that antitrust
should grant a blanket exemption from liability for any conduct that SSOs may wish
to adopt, but only that a antitrust regime that is sensitive to the social benefits of interop-
erability, on the one hand, and to the (arguably marginal) benefits of strong patent rights
in sectors such as information technology, properly may conclude that SSO conduct that
plausibly and proportionately serves to limit holdup risks is on balance procompetitive. The
same presumption, however, may not apply in less technologically dense industries, or in
29
For critical discussions, see Bohannan and Hovenkamp (2012, 85–90); Leslie (2008).
30
Reflective of the Schumpeterian perspective, one school of thought suggests that antitrust should
take more of a deferential approach to certain types of conduct in “New Economy” industries, by
focusing more on promoting competition for the market than on promoting competition in the market.
See, e.g., Evans and Schmalensee (2002).
31 See, e.g., Allied Tube & Conduit Corp. v. Indian Head, Inc., 486 U.S. 492, 496–98, 509–10 (1988);
Am. Soc’y of Mech. Eng’rs, Inc. v. Hydrolevel Corp., 456 U.S. 556, 577–78 (1982); Radiant Burners, Inc.
v. Peoples Gas Light & Coke Co., 364 U.S. 656, 659–60 (1961) (per curiam).
32 For discussion and citations, see Cotter (2009, 1200–1206); Cotter (2008, 758–69, 786–94).
industries such as pharmaceuticals in which patent owner incentives arguably are substan-
tial; and courts must remain vigilant for evidence of agreements that adopt requirements
that go beyond what is reasonably necessary to avoid holdup, for example requirements
relating to the price at which technology-embodying products will be sold.
Third, it may be the case that antitrust should be more aggressive—less concerned
about false positive risks—in circumstances in which the conduct at issue poses even
an objectively small risk to future innovation, if that risk (should it come to pass)
threatens substantial social harm, and the potential procompetitive benefits of tol-
erating the conduct at issue are only modest. Imagine, for example, a case in which
Firm A and Firm B each own a portfolio of patents relating to a technological standard.
The two firms agree to establish a joint venture that will be authorized to offer other
firms a nonexclusive package license of patents essential to the marketing of products
conforming to the standard. Both firms also agree, however, not to license any of the
patents other than through the joint venture; in addition, Firm B, which owns a pat-
ent (Patent X) claiming a technological solution different from the one that is enabled
by the patents vested in the joint venture, agrees not to license Patent X to anyone. In
theory, those portions of the agreement preventing the licensing of the essential pat-
ents other than through the joint venture and forbidding the licensing of Patent X at
all could be procompetitive to the extent they are reasonably ancillary to the success of
the joint venture itself: in a sense, A and B are both agreeing not to undermine the joint
venture by competing against it. And to the extent the venture enables others to par-
ticipate in the use of the technological standard at issue, its existence is procompetitive
not only in the short-run sense but also, potentially, in the longer run as well, insofar
as firms that license from the venture may be better poised to develop newer and better
products by accessing the standard. At the same time, the risks to innovation should be
apparent too. Firms that might seek to innovate by licensing only a subset of the patents
cannot do so (though whether this puts them at a disadvantage depends on whether
the price for the package exceeds the hypothetical price for a single license). More trou-
bling, perhaps, is the fact that no one can use Patent X to develop a competing tech-
nology that may (or may not) turn out to have farther-reaching applications than the
standard enabled by the package license. Perhaps, in such a case, antitrust should take
a hard line against such a hypothetical agreement even if the alternative technology is
merely “nascent” or even altogether unproven in its capabilities. Even though antitrust
normally might require a stronger of potential anticompetitive consequences before
condemning such an arrangement,33 perhaps in such a case even a small risk of sub-
stantial harm to dynamic innovation should not be tolerated, particularly if there are
less restrictive alternatives that would provide an adequate, albeit not foolproof, assur-
ance that Firm B will not undermine the venture. Perhaps as well, antitrust and patent
law should be open to novel theories of private party standing, application of FTC § 5
33 See Princo Corp. v. Int’l Trade Comm’n, 616 F.3d 1318, 1338–40 (Fed. Cir. 2010) (en banc), cert.
denied, 131 S. Ct. 2480 (2011) (noting that the “suppression of nascent threats can be construed as
actions, or expansions of the patent misuse doctrine to permit a challenge to the hypo-
thetical agreement to come forward.
Readers may recognize in the above hypothetical an adaptation of the facts alleged
by certain patent infringement defendants in Princo v. International Trade Commission,
a case in which the US Court of Appeals for the Federal Circuit decided that an alle-
gation of technology suppression on the part of the joint venturers was insufficient to
render the infringed patent unenforceable under the US doctrine of patent misuse.34 In
other work, I have expressed agreement with the Princo court’s narrow interpretation
of the patent misuse defense, while reserving judgment on whether a stronger antitrust
response to conduct like that alleged by the infringement defendants would be desirable.
For present purposes, I will note only that such a response may be warranted, assum-
ing there were evidence of such an agreement among the two patent owners, even if
the probability that the alternative technology would have been successful is somewhat
speculative. If, as suggested above, the benefits from innovation are in general much
higher than the benefits resulting from improvements in short-run efficiency, the bet-
ter view might be to require the poolants to keep the alternative available for licensing
by others. More generally, one might imagine other circumstances in which a restraint
poses a small but nontrivial risk to future innovation while offering only relatively mod-
est short-term efficiency benefits;35 perhaps some mergers that implicate so-called inno-
vation markets would fall into this category.36 A more difficult situation arises when the
purported justification itself relates to longer-term, dynamic efficiency concerns. The
example above involving an agreement among SSO members to cap the price to be paid
for a given patent would be one in which there may be plausible dynamic efficiency ben-
efits on both sides.
The obvious problem, once we accept the principle that any conduct that threatens
some harm to innovation or creativity (no matter how speculative) properly could
give rise to antitrust liability, is knowing where to stop. To illustrate, under EU law, a
license agreement that forbids the licensee from challenging the validity of a licensed
patent is excluded from the block antitrust exemptions given to certain other features
anticompetitive behavior under certain circumstances,” but concluding that Princo bore the burden of
proving, and had failed to prove, more than just a “speculative possibility” of anticompetitive harm).
34 The Federal Circuit defines misuse as the “impermissibly broaden[ing of] the ‘physical or temporal
scope’ of a patent with anticompetitive effect.” Princo, 616 F.3d at 1328; Windsurfing Int’l, Inc. v. AMF,
Inc., 782 F.2d 995, 1001 (Fed. Cir. 1986) (citing Blonder-Tongue Labs., Inc. v. Univ. of Ill. Found., 402 U.S.
313, 343 (1971)).
35 I develop this line of reasoning mathematically in Cotter (2006, 520–37).
36 See US Department of Justice and Federal Trade Commission (1995; § 3.2.3); Gilbert and Sunshine
(1995); see also Cotter (2006, 525–26 and n. 176) (discussing relevant literature). For analysis of the
role innovation should play in merger analysis, see Carrier (2009, 92–93, 295–322); Katz and Shelanski
(2007). More controversially, Tim Wu (2010, 96–97) has suggested that the Supreme Court’s quondam
practice of subjecting conduct such as, say, block booking of motion pictures, to serious antitrust
scrutiny—an approach that seems quite dated under most contemporary understandings of antitrust
economics—could play a positive role in promoting greater innovation in the production of creative
expression.
of technology and R & D licenses, and thus is subject to challenge under article 81 of the
EC Treaty.37 In theory, this rule could promote both short- and long-run efficiency by
more effectively screening out invalid patents (the enforcement of which, by definition,
is presumed to generate an inadequate or negative surplus of social benefits over costs).
But the rule also forces the patentee to bear the risk of a licensee-initiated challenge, for
which the patentee presumably will demand a higher licensing fee; at the margin, then,
it may decrease the amount of licensing, which seems undesirable. Moreover, given the
ability of other parties to challenge patent validity (in the major European nations in
particular, anyone may do so at any time) and given the fact that most patents do not
actually confer substantial market power, the prohibition on no-challenge clauses seems
unduly broad, indeed potentially counterproductive to an effective innovation policy.
My own view is that courts should apply the more expansive liability standard pro-
posed above only in cases in which one can be highly confident that the potential short-
and long-term benefits of permitting the restraint at issue are minimal. Such cases
should be rare but not an empty set. In particular, it may be possible in some instances to
conclude that the countervailing efficiencies are small, given factors such as the approxi-
mate cost of the R & D needed to generate the IP at issue, the strength of first-mover
advantages or other empirical evidence of the relative importance of patent protection
in a given industry, the presence of network effects that have already generated a supra-
competitive return, and the like. Taking account of these factors does not necessarily
run afoul of my admonition that courts should not try to determine appropriate rates
of return in the manner of a public utility regulator, since courts would not be setting
the amount of remuneration owed to the patent owner. Even so, in recognition of their
institutional limitations, courts should exercise caution in determining that forbidding
a given restraint will not have a negative impact on incentives.
In brief, the approach sketched out above is simply a call for antitrust enforcers to
show appropriate sensitivity both to what can be stated with confidence about the
likely impact of market structure and conduct in specific innovation environments,
and to the limits of their ability to predict and manage that environment far out into
the future. As such, the approach broadly resembles an approach described in a recent
paper in which Carl Shapiro (2012) argues that antitrust enforcers should not overex-
aggerate the difficulties of predicting the consequences of present conduct for future
37
Article 81 of the EC Treaty—now codified as article 101 of the Treaty on the Functioning of the
European Union—generally prohibits, and renders automatically void, agreements “which may affect
trade between Member States and which have as their object or effect the prevention, restriction or
distortion of competition within the common market, and in particular those which . . . limit or control
production, markets, technical development, or investment.” The Technology Transfer and Research
and Development Block Exemption Regulations exempt certain restraints from the scope of Article 81,
but both regulations expressly do not exempt no-challenge clauses. See Commission Regulation (EC)
No. 772/2004 of 27 April 2004 on the application of Article 81(3) of the Treaty to categories of technology
transfer agreements, art. 5(1)(c); Commission Regulation (EC) No. 2659/2000 of 29 November 2000 on
the application of Article 81(3) of the treaty to categories of research and development agreements, art.
5(1)(b). Ulmer-Eilfort and Boulware (2007, 769) assert that “today there are only very narrow borders for
such clauses being effective.”
innovation. Instead, Shapiro proposes, policymakers should work to integrate the

Arrovian and Schumpeterian perspectives into a competition policy based on prin-
ciples of “Contestability” (“The prospect of gaining or protecting profitable sales by
providing greater value to customers spurs innovation”); “Appropriability” (“Increased
appropriability spurs innovation”); and “Synergies” (“Combining complementary assets
enhances innovation capabilities and thus spurs innovation”). In a similar vein, one
might argue that antitrust should make greater use of the empirical literature on the
impact of market structure on innovation—as described by Bohannan and Hovenkamp
(2012, 9), “there is probably more empirical literature on the relation between competi-
tion and innovation than on any topic in the field of industrial organization economics,”
including influential work by Aghion and colleagues (2005)—though the nature of these
studies may be such that they do not properly lend themselves to simple application.38
And by now the pioneering insights of economists in the 1980s on network externalities
(see, e.g., Farrell and Saloner 1985; Katz and Shapiro 1985) are already part of the standard
antitrust toolkit (as reflected most famously in the monumental Microsoft antitrust liti-
gation), thus lending credence to the views of the Antitrust Modernization Commission
(2007, 31) 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 economy industries.”
Nevertheless, to the extent patent and other IP laws are perceived as conferring exces-
sive protection or otherwise as undermining, rather than advancing, their stated pur-
pose of promoting the progress of science and the useful arts, for the most part reform
must come from the IP side, not the antitrust side. There is little if anything that antitrust,
consistent with rule-of-law values, can or should do if legislatures set excessive terms of
protection, confer patents on trivial inventions, or permit inventors to capture the value
of others’ improvements by filing series of continuation applications.39 Antitrust’s role in
promoting innovation is important but nevertheless constrained by the limited reach of
the statute and by courts’ competence to second-guess legislative judgments about the
appropriate scope of IPRs.
7.4. Conclusion
I have argued above that antitrust has a useful, albeit limited, role to play in fostering
innovation. Much of the time antitrust best plays this role simply by doing what it does
best, namely focusing on practices that threaten harms to static efficiency, even when the
conduct at issue happens to involve IP. At other times, for example in cases involving
38
For overviews of the major studies and discussion of some possible limitations, see Gilbert (2006,
187–204); Greenhalgh and Rogers (2010, 140–42); Shapiro (2012, 370–82).
39 On this last point in particular, see Lemley and Moore (2004).
joint conduct on the part of SSO members, courts arguably should play a more deferen-
tial role, to the extent joint conduct is reasonably necessary for the efficient development
or deployment of new technology. In yet other instances, however, US courts in particu-
lar arguably have accorded too much deference to IPRs, for example in connection with
Walker Process and Hatch-Waxman litigation; and in theory a more aggressive antitrust
policy could sometimes improve social welfare, to the extent such a policy can (for exam-
ple) enable greater interoperability with or new uses of pioneering technology without
simultaneously killing off the incentive to create such technology in the first place. Most
of the heavy lifting, though, must come from other bodies of law, most notably the IP laws
themselves. Antitrust tribunals are neither well positioned nor legally competent to make
many of the fundamental decisions concerning the optimal scope and duration of IPRs;
and even within antitrust’s own domain, uncertainties over the effects of market struc-
ture and other variables on long-term innovation counsel in favor of a relatively modest
approach. Put another way, in the competition over competition policy, policymakers
should ensure that antitrust itself does not come to enjoy too large a market share.
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CHAPTER 8
C ON T I N E N TA L D R I F T I N T H E
T R E AT M E N T O F D OM I NA N T F I R M S
Article 102 TFEU in Contrast to Section 2 Sherman Act
PIERRE LAROUCHE AND MAARTEN PIETER SCHINKEL
The policing of significant marker power remains one of the largest areas of debate in
comparative competition law. While the two leading systems, US antitrust law and EU
competition law, both originate in the recognition of a need to control monopoly mar-
ket power, they were set on different tectonic plates that drifted on their own individ-
ual paths. The interpretation and application of both Section 2 of the Sherman Act and
Article 102 of the TFEU have been reviewed over the years. Recently, a number of lead-
ing cases have been issued on both sides of the Atlantic. While in the past decade the two
systems have converged on a focus on exclusionary conduct, a number of fundamental
underlying differences remain. On the fault lines, there is potential for tension, as well as
motion.
The aim of this chapter is to take stock of the debate, at a fundamental level. Our con-
tribution is written from a European perspective, that is, we take US antitrust law as
granted and we seek to explain particular aspects of EU competition law against it. In
that, we are fully aware that US antitrust law is more diverse than presented here. Much
as our representation of EU competition law is based on the most authoritative state-
ments by the European courts and the European Commission, the representation of US
law here given relies on the most authoritative primary sources.
Without going in the detail of the laws, we identify a number of distinctive features of
Article 102, both in wording and interpretation, in section 8.1. We subsequently discuss
three lines of argument to explain these differences. The first one, considered in section
8.2, is traditionally put forward: the interpretation of Article 102 reflects the influence
of the ordoliberal school of thought on EU competition law. We will provide some new
insights from this point of view. The second, more contemporary line of argument derives
from the observation that competition law enforcement is fallible and is primarily insti-
tutional, as explained in section 8.3. The third argument, set out in section 8.4, introduces
154 Pierre Larouche and Maarten Pieter Schinkel
dynamic elements into the analysis, whereby the interpretation of Article 102 would reflect
a specifically European view of innovation policy. In section 8.5, we return to the under-
utilized EU category of exploitative abuses and argue that economic techniques developed
in the context of damages litigation could open it up for future enforcement in a way that
would be in line with ordoliberal principles. We conclude in section 8.6.
8.1. Distinctive Features in the

Wording and Interpretation of
Article 102 TFEU
8.1.1. Limited Differences in Wording
The core parts of the two respective legal texts compare as follows:
Section 2 Sherman Act, 15 U.S.C. § 2

Every person who shall monopolize, or attempt to monopolize, or combine or conspire
with any other person or persons, to monopolize any part of the trade or commerce
among the several States, or with foreign nations, shall be deemed guilty of a felony.
Article 102 TFEU

Any abuse by one or more undertakings of a dominant position within the internal
market or in a substantial part of it shall be prohibited as incompatible with the inter-
nal market in so far as it may affect trade between Member States.
While Section 2 of the Sherman Act was enacted in 1890 as part of criminal law, with
monopolization being classified as a felony, Article 102 TFEU was inspired by European
administrative laws and inserted in the international Treaty of Rome in 1957.1
8.1.1.1. “Monopolization” versus “Abuse”: Convergence on

Exclusionary Behavior
At first glance, “monopolization” and “abuse” seem different concepts. With the term
“monopolization,” Section 2 would focus on how a monopoly position is obtained or
maintained, and not so much on the actions of the monopolist once that position has
been achieved, whereas Article 102 would not pay attention so much to how a dominant
1
As a consequence, violations carry different types of sanctions, with prison sentences being
unavailable at the European level—as opposed to the level of individual member states, some of which
have adopted criminal sanctions for individuals in recent years, albeit first and foremost for cartel
infringements, not abuses of dominance. See Cseres, Schinkel, and Vogelaar (2006).
Continental Drift in the Treatment of Dominant Firms 155
position has arisen, but would instead police particular abusive actions of the dominant
firm (Elhauge and Geradin, 2011).
While this distinction appears to be supported by the respective wording of these pro-
visions, it is nowhere near as sharp as it is made out to be, once case law is taken into
account. Over time, as case law and literature accumulated, these two provisions have
arguably evolved away from what some presented as their original intent, and converged
in their coverage. Section 2 was used in early cases to attack market power directly,2 yet
it was reframed subsequently. Similarly, in the early days of Article 102, part of the com-
mentary argued that the provision was aimed at policing the abusive exploitation of
market power only (Joliet, 1970). However, it suffices to look at two recent administra-
tive statements on these respective provisions—DOJ (2008) and European Commission
(2009)—to see that as they are construed now, both provisions are primarily used to deal
with exclusionary behavior on the part of firms holding significant market power. Their
application requires a showing of both significant market power (monopoly power or
dominance, respectively) and of exclusionary conduct (or abuse, in EU competition law).
Conceptually, under EU law, an undertaking is dominant if it can behave “to an
appreciable extent independently of its competitors, customers and ultimately of its
consumer.”3 The prevailing measure for market power in both systems is market share in
the relevant market. Under EU law, a (combined) market share of 38% can be sufficient
to raise the rebuttable presumption of a dominant position (a 40% threshold is put for-
ward in European Commission, 2009), whereas in the United States interventions based
on Section 2 will usually require a market share of over 50% (DOJ, 2008).
8.1.1.2. An EU Outlier: Exploitative Abuses

While the main focus of both Section 2 and Article 102 has therefore shifted over time to lie
on exclusionary abuses of market power, Article 102 TFEU continues to harbor an outlier,
namely the notion of “exploitative abuses.”4 This is the use of dominance to extract rents
from customers, by way of excessive pricing, for instance. While Section 2 of the Sherman
Act could theoretically extend to excessive pricing, the hurdles are very high, as the Supreme
Court most emphatically reaffirmed in Trinko, and accordingly no excessive pricing cases
have been brought in ages.5 As the Supreme Court conceives it, exploitative behavior is
quite the opposite from monopolization, on the logic that high prices would rather make
customers look for alternatives and attract competitors to the market in question.
In Europe, the prohibition of exploitative abuses under Article 102 has hardly been
enforced, with only a handful of cases in which it was the main finding of an infringe-
ment. It is linked with the specificities of Article 102, as stated above, in ways that will be
explained later in this chapter.6
2
Most famously in Standard Oil v. US 221 U.S. 1 (1911).
3
ECJ, Case C-27/76, United Brands [1978] ECR 207.
4 As evidenced for instance in Article 102(2)a) TFEU: “directly or indirectly imposing unfair purchase
or selling prices or other unfair trading conditions.”

5 Verizon Communications v. Trinko, 540 U.S. 398 (2004).
6 Infra, section 8.5.
EU law – Article 102 TFEU US law - § 2 Sherman Act
Exclusionary behavior
Exploitative Attempted
behavior
- Dominance/monopoly power monopolization
- Abuse/exclusionary conduct
FIGURE 8.1 Coverage of Article 102 TFEU and Section 2 Sherman Act
8.1.1.3. A US Outlier: Attempted Monopolization

For Section 2 of the Sherman Act, the outlier is “attempted monopolization,” which
is construed along similar lines as monopolization, yet does not require the violation
to have been successful in realizing its objective (DOJ, 2008). Establishing attempted
monopolization requires proof that the defendant intended to destroy competition
or build monopoly, which resulted in a dangerous probability of achieving monopoly
power (Areeda and Hovenkamp, 2013). However, courts have been reluctant to find
intent, and only few cases were tried, none in recent years (DOJ, 2008).
Together, these similarities and differences can be illustrated in the Venn diagram in
figure 8.1. Note that the outlier categories are smaller even, in terms of cases tried, than
they appear.
Despite convergence to a large overlap between the two provisions in terms of sub-
stantive coverage on exclusionary behavior, their interpretation and application shows a
number of important divergences.
8.1.2. Essential Differences in Interpretation

Both Section 2 and Article 102 are brief and generally formulated, leaving ample room
for interpretation. Famously, Frank Easterbrook (1986b, 1702) wrote:
Back in 1890 Senator Sherman and colleagues protested the Sugar Trust and other
malefactors and told the judiciary to do something about it. They weren’t sure just
what. Their statute does not contain a program; it is instead a blank check.
Only in case law did their interpretation emerge. Likewise have Articles 81 and 82 of the
Treaty of Rome, apart from two renumberings, had to go through a long process of case
law developments to harden in their interpretation. As one of major figures in the devel-
opment of EU competition law, Ernst-Joachim Mestmäcker (2011, 35), stated:
Politicians and legislators love the ambivalence of final purposes, leaving their deter-
mination to the ensuing political or legal process. The EC’s ‘founding fathers’ were
particularly resourceful in this respect. Competition rules prove the point. The
drafters of the Treaty charged the European Court and the EC Commission with the
task of injecting into deliberately general provisions the light of precise purpose and
meaning.
In this subsection, we discuss four distinctive features of EU competition law, arising

from the Commission decision practice and the case law of the European courts.
8.1.2.1. The Special Responsibility of the Dominant Firm

Since the early years of the Sherman Act, US courts have applied Section 2 with a view
to avoiding, to the greatest extent possible, restrictions on the commercial freedom of
firms, even if they hold monopoly power. In 1919 in Colgate the Supreme Court held
that,“[i]‌n the absence of any purpose to create or maintain a monopoly, the act does not
restrict the long recognized right of trader or manufacturer engaged in an entirely pri-
vate business, freely to exercise his own independent discretion as to parties with whom
he will deal.”7
More recently, in Trinko and Linkline, the Supreme Court reaffirmed this stance force-
fully.8 In Linkline, after having cited Colgate, the Court presented the scope of Section 2
in the following terms: “But there are rare instances in which a dominant firm may incur
antitrust liability for purely unilateral conduct.”9
The theory underpinning the US approach is well set out by Easterbrook (1986a,
2003). In a number of circumstances, it is beneficial for the economy and for consum-
ers if firms holding monopoly power compete hard with other firms. In other circum-
stances, the conduct of those firms can be exclusionary. Since it is hard to distinguish
between competitive and exclusionary conduct, it is better to allow firms to compete
hard and put the burden upon authorities, in exceptional circumstances, to show that
the conduct was in fact exclusionary and in breach of Section 2.
In contrast, the European courts and the European Commission, in their inter-
pretation of Article 102 TFEU, do not begin with the assumption that firms hold-
ing a dominant position can compete as any other firm would. Rather, the case law
and decision practice under Article 102 TFEU constantly and consistently refers to
the “special responsibility of the dominant firm not to allow its conduct to impair
genuine undistorted competition on the common market.”10 The special responsibil-
ity of the dominant firm was conspicuously absent from the European Commission
(2005) discussion paper circulated by Directorate-General for Competition (DG
COMP), but it has been given pride of place again in the Guidance Paper (European
Commission, 2009).
7
US v. Colgate, 250 U.S. 300 at 307 (1919).
8
Trinko, supra, note 5 at 407, as quoted infra. See the quote made infra, section 8.4.
9 Pacific Bell Telephone v. Linkline Communications, 129 S.Ct. 1109 at 1118 (2009).
10 This statement was made in one of the early Article 102 TFEU cases: ECJ, Case 322/81, Michelin
v. Commission [1983] ECR 3461 at para. 57 and repeated ever since.

8.1.2.2. Competition on the Merits

Under Section 2 of the Sherman Act, there is a notion that some means of competi-
tion are allowable, and others will breach the act. As the Supreme Court put it in
US v. Grinnell:11 “The offense of monopoly under § 2 of the Sherman Act has two
elements: (1) the possession of monopoly power in the relevant market and (2) the
willful acquisition or maintenance of that power as distinguished from growth or
development as a consequence of a superior product, business acumen, or historic
accident.”
Under EU law, that distinction is drawn more sharply. Dominant firms are allowed to
enter into “competition on the merits,” but they must abstain from other forms of com-
petition, which are presumably “unmeritorious.” Recently, in Post Danmark, the ECJ
summed up the case law as follows:12
It is in no way the purpose of Article [102 TFEU] to prevent an undertaking from

acquiring, on its own merits, the dominant position on a market. . . . Competition
on the merits may, by definition, lead to the departure from the market or the mar-
ginalisation of competitors that are less efficient and so less attractive to consumers
from the point of view of, among other things, price, choice, quality or innovation. . . .
Article [102 TFEU] applies, in particular, to the conduct of a dominant undertaking
that, through recourse to methods different from those governing normal competi-
tion on the basis of the performance of commercial operators, has the effect, to the
detriment of consumers, of hindering the maintenance of the degree of competition
existing in the market or the growth of that competition.
Hence, while both systems thus recognize a category of meritorious competition to

which the prohibition should not apply, there is a contrast between the US and EU posi-
tions. Leading US authorities are reserved with respect to active enforcement, out of
recognition of the practical difficulty in telling anti- from procompetitive conduct. EU
law entertains a firm belief in the distinction between competition on the merits/per-
formance competition and other forms of competition, and this distinction is enforced
unreservedly.
8.1.2.3. Protection of the Competitive Process

In mainstream economics, the majority opinion is that antitrust and competition law
should focus on aggregate welfare, with some authors finding that seeking to maximize
consumer welfare is the best way to maximize total welfare in practice (Farrell and Katz,
2006; Martin, 2007). The case law under Article 102 TFEU follows a different path.
When dominant firms inflict injury on the competitive process as such, this is already
sufficient to trigger the application of Article 102 TFEU, even in the absence of concrete
evidence of consumer harm. As the Court of Justice repeatedly stated, “Article 102 TFEU
11
384 U.S. 563 at 570–71 (1966).
12
ECJ, Case C-209/10, Post Danmark, nyr, at para. 21–24.
must be interpreted as referring not only to practices which may cause damage to con-
sumers directly, but also to those which are detrimental to them through their impact
on competition.”13 In its Guidance Paper, the Commission sought to put more emphasis
on the need to show consumer harm (European Commission, 2009) but on that aspect
the Guidance Paper has not yet been endorsed by the EU courts.
In the eyes of many critics, especially from the United States, EU competition law is
then protecting competitors, not competition. In US law, as the Supreme Court put it,
“It is axiomatic that the antitrust laws were passed for ‘the protection of competition,
not competitors.’ ”14 Instead, as Easterbrook (1986b, 1703) concluded: “However you slice
the legislative history, the dominant theme is the protection of consumers from over-
charges.” Indeed, the US now has—by all accounts—a strong focus on consumer welfare
as the ultimate objective, whereas the EU still protects the competitive process, irrespec-
tive of consumer welfare considerations.
In perceptive analyses Eleanor Fox (2003) and Gal (2004) suggest that, beyond the
rhetoric, the difference between US and EU law relates to the gray zone of conduct that
is not clearly output-limiting but nevertheless would injure the competitive process. US
antitrust law does not thread into that gray zone, for fear of error, which would lead to
prohibiting procompetitive conduct. Under EU competition law, in contrast, authorities
do not hesitate to prosecute conduct falling into that gray zone, despite the error risk.
8.1.2.4. Conclusion
In this section, we have inventoried four distinctive features of EU competition law, as
compared to US law. A first feature appears from the text of Article 102 TFEU itself,
namely the possibility of prosecuting exploitative abuses of dominant position. The
three other features arise from the interpretation of Article 102. Dominant firms are put
under a special responsibility. A strong distinction is drawn between competition on the
merits and impermissible forms of competition in which dominant firms might engage.
The protection of the competitive process is emphasized, even in the absence of concrete
evidence of consumer harm.
Our aim is not to justify or rebut these stated differences, but rather to provide pos-
sible explanations for them, so as to shed some light on the reasons why EU and US law
would differ when it comes to the treatment of dominant firms. We start in section 8.2
by revisiting the traditional explanation for these features, that is, the influence of ordo-
liberal thought on EU competition law. We find that ordoliberalism provides an expla-
nation for the latter three features, albeit not as strong as is often assumed. In section
8.3, we go on to examine the institutional context of EU law enforcement, finding there
13 Ibid. at para. 20, referring to ECJ, Case C-52/09 TeliaSonera Sverige [2011] ECR I-527 at para. 24 and
to earlier cases.
14 Brooke Group v. Browne-Williamson Tobacco, 509 U.S. 209, 224 (1993), referring to a statement
first made in Brown Shoe Co. v. United States, 370 U.S.294, 320 (1962). In his recent remarks on the FTC
decision not to further pursue Google for alleged monopolization through search bias, Jon Leibowitz
was prompt in referring to this quote.
a solid explanation for the special responsibility of dominant firms. In section 8.4, we
try to introduce insights from the literature on innovation into the analysis, leading to a
stronger justification for the protection of the competitive process and the emphasis on
competition on the merits. This leads us to come back to exploitative abuses in section
8.5, where we argue that this is a weak spot in ordoliberalism, which can be remedied
with the help of contemporary advances in economics.
8.2. The Influence of Ordoliberalism

on Article 102 TFEU
A number of scholars have linked distinctive features of EU competition law to the

influence of ordoliberalism (the “Freiburg School”), sometimes in a very critical way
(Hawk, 1995; Ahlborn and Grave, 2006; Ahlborn and Padilla, 2008; Ahlborn and Evans,
2009). Accordingly, a first line of explanation for the differences identified above could
be found in ordoliberal thinking. It is beyond the scope of this contribution to review
ordoliberalism in detail. Nevertheless, since the debate on the legacy of ordoliberal-
ism in EU competition policy (Gerber, 1998; Möschel, 2001) has been revived with the
Guidance Paper (European Commission, 2009; Mestmäcker, 2011; Schweitzer, 2008;
Marsden and Lovdahl Gormsen, 2010; Lovdahl Gormsen, 2007) and since the original
sources are not always accessible,15 it seems appropriate to state our views here, based on
our reading of the original sources.
8.2.1. Ordoliberalism as a General Legal and Economic Theory

As a starting point, it must be noted that ordoliberalism is much broader than competition
policy. It is a school of economic thought that covers most areas of economic and social pol-
icy. Born in the 1930s and becoming influential after the war, ordoliberalism was profoundly
influenced by the repeated failures of German economic policy in the first half of the 20th
century (Eucken, 2004). Ordoliberals16 were convinced that the market economy and cen-
tral planning models were so antithetical that they could not be successfully mixed (Böhm,
15 There is no shortage of ordo-liberal scholarship, but most of it is in German. There is disagreement
in the German-language literature about whether English-language accounts of ordo-liberalism are

accurate: see for instance the remarks of Mestmäcker (2011).
16 For the purposes of this short discussion, the authors generally associated with ordo-liberalism
(including W. Eucken and F. Böhm) will be regrouped under the name “ordo-liberals.” As in any school
of thought, there are differences among the various authors, but we chose not to mention them unless
they are relevant for the purposes of the discussion. We chose to focus on the founding authors, such as
Eucken and Böhm, since they represent ordo-liberal thought in its “purest” form. As will be seen infra,
once competition laws in Germany and Europe came into force, ordo-liberal thought evolved in the light
of legal practice.
1980a). Central planning being unsustainable, ordoliberals preferred a market economy.

Yet the experience with laissez-faire policies of the turn of the 20th century showed that
a market economy left on its own would ultimately produce a concentration of economic
power in private hands, with the ensuing nefarious consequences (Eucken, 2001a).
In order to solve that conundrum, ordoliberals repudiated the methods of the
German historicist school prevailing until then in German economics (Eucken, 2001b).
In his macroeconomic textbook of the 1930s, Eucken (1947) advocated a more scien-
tific and theoretical approach to economics. In that sense, ordoliberals were in step with
the times, and indeed ordoliberal writings are not insular: they frequently refer to and
engage with contemporary Anglo-American authors. Still, the main theorists of ordo-
liberalism wrote from the 1930s to 1950s, at a time where economics was not widely for-
malized. Their work follows a deductive, logical analytic method, which is not unlike
that of legal scholars. It is not surprising then that lawyers and economists worked very
closely within the Freiburg School.
Indeed, at its core, ordoliberalism blends law and economics in a liberal project. A lib-
eral polity is characterized by the freedom and autonomy17 its members enjoy, in a con-
stitutional democracy under the rule of law. Such political freedom must be extended
to the economic sphere as well; that is, economic actors, producers, and suppliers must
enjoy the freedom to make economic choices (Eucken, 2004). This dovetails with an
economic policy centered on free markets and competition. Compared to this striking
and distinctive link between law and economics, ordoliberal welfare analysis, while not
absent, is fairly conventional: competition in a free market economy is best able to effect
the coordination of individual efforts (allocative efficiency), and prices play an essential
role in conveying information as between economic actors (Eucken, 2004).
8.2.2. The Threat from Economic Power, Public or Private

In the eyes of ordoliberals, economic power forms the main threat to this free economic
order based on markets and competition.18 Economic power leads to coercion, which
deprives economic actors of their freedom. The ideal to be pursued by economic policy
is therefore a free market without economic power, that is, a market where the only pos-
sible form of competition is “competition on the merits” (Leistungswettbewerb) (Eucken,
2004). Eucken equates the absence of economic power with “perfect competition” (voll-
ständige Konkurrenz), a very consequential link, as we will see below.19
17
In the sense of self-determination (Selbstbestimmung).
18
In line with the term used in ordo-liberal writings (wirtschaftliche Macht), we use “economic
power.” This term is used by and large with the same meaning as “market power” in contemporary
competition law and economics.
19 It has been argued that vollständige Konkurrenz should not necessarily be translated as “perfect
competition” (see for instance Möschel, 2001). Yet it is clear from Eucken’s work (1947; 2004) that he was
aware of the classical theory of market structure. He renders “perfect competition” (i.e. competition on
both supply and demand) as “vollständige Konkurrenz.”
Economic power can be wielded by the state, in centrally planned economies. As

stated above, ordoliberals reject this model, and accordingly ordoliberal thought—as
one form of liberal thought—assigns a limited role to the State (Eucken, 2004).
However, ordoliberals are equally concerned about coercive economic power exerted
by private actors (Eucken, 2001a). As Böhm (1980b) points out, firms have an incentive
to seek market power, and once they hold it, to use it to distort competition for their
benefit. For ordoliberals, free competitive markets are a fragile good, threatened as they
are by economic power, be it in public or private hands. As Eucken (2004, 175) puts it,
“The problem of economic power has always existed, yet since the Industrial Revolution
it has taken on a new dimension. The Industrial Revolution ushered in the era of prolif-
erating economic power . . . : the power of individual firms, of trusts, of cartels, central
planning offices, or unions.”
For ordoliberals, therefore, protecting the free market economy from economic
power held in private hands is crucial. They are very dismissive of the historical expe-
rience of the early 20th century, when the state sought to intervene via regulatory and
other mechanisms in order to control private economic power: these attempts only
compounded private power with state power, leading towards central planning, with
disastrous consequences (Eucken, 2001a). At the same time, the use of state power is the
only avenue to confront private economic power. Competition law becomes the vehicle
whereby the contradiction is solved, and state power can be wielded against private eco-
nomic power without endangering the free market economy.
8.2.3. Competition Law as a Solution to the Problem of

Economic Power
Competition law is therefore a key element of ordoliberal thought and yet, given the
all-encompassing nature of the basic ordoliberal works, it remains summarily dealt with.
The key propositions advanced by Eucken (2004) and Böhm (1980b) are the following.
1. Cartels—to the extent other elements of economic policy have not already made
them unworkable—must be made illegal as such and harshly prosecuted. The
fight against cartels cannot suffice in and of itself to protect the free market econ-
omy, since economic power can also arise from a single firm.
2. Competition law must attack economic power at the root and dissolve it; a mere
policy of policing abuses of economic power will be ineffective.
3. In some limited cases, monopolies are unavoidable.20 In such cases, monopolies
must be placed under the surveillance of the state. The aim of such supervision
is to bring monopolies to behave “as if ” they were in a perfectly competitive
environment.
20 Eucken (2004) refers to “a small number of cases.” He does not use the term “natural monopolies,”
but he might have had them in mind.

4. In order to avoid a repeat of historical experience, state control over unavoidable

monopolies should be exerted via an independent monopoly supervisory office,
and should be carried out strictly in accordance with the law. The applicable law
should be crisp and clear, so as to leave no discretion to authorities and avoid
capture by private interests (as had occurred in the 1920s and 1930s).
8.2.4. Ordoliberalism and Article 102 TFEU

Seen against that background, Article 102 TFEU cannot be considered a straight-
forward implementation of ordoliberal thought (Akman, 2012). It does not pro-
hibit economic power as such, nor does it empower the Commission to dismantle
firms holding economic power; rather it introduces a system of control on abuses of
dominant position, the very system that was found ineffective by Eucken and Böhm.
Indeed, it seems that Article 102 TFEU was the result of political bargaining between
competing visions (both among and even within member states), including not only
ordoliberalism, but also the traditional approach to competition law in Europe until
then (however limited the experience was), which emphasized the policing of abuses
rather than the direct intervention against cartels and monopoly power (Akman,
2012; Gerber, 1998).
So ordoliberal writers had to adjust to a legal reality where private economic power is
policed rather than outright prohibited. In order to see how ordoliberals can accommo-
date that significant departure from their thought, it is interesting to look at the inaugu-
ral lecture of Ernst-Joachim Mestmäcker (1959), a disciple of Franz Böhm and a leading
figure in the development of EU competition law, both in theory and in practice. This
lecture bears on the then new German Competition Act, and its prohibition on abuses of
dominant position.21 Mestmäcker expresses its sympathy for US antitrust law (as it then
was interpreted), which “gives priority to the dissolution of single monopolistic firms
over any attempt to impose upon them obligations to behave properly.”22 In comparison,
German law (and EU law) refuses to try to prevent the creation of dominant firms, and
instead opts for a prohibition on abuse. As Mestmäcker (1959) notes, compared to the
relative simplicity of the ordoliberal prescription against market power, the prohibition
on abuse of dominance requires first of all a sophisticated definition of dominance, in
order to single out the firms subject to the prohibition, and then a definition of abuse. As
regards the latter, Mestmäcker (1959) notes the difficulty of distinguishing abuse from
permissible conduct. With the help of ordoliberal thought, that distinction can be artic-
ulated along the lines of the distinction between Leistungswettbewerb (performance
21 For the purposes of this chapter, it can be assumed that the arguments made concerning § 22 of the
German Competition Act (Gesetz gegen Wettbewerbsbeschränkungen) would be equally applicable to

Article 102 TFEU.
22 Of course, the interpretation of Section 2 of the Sherman Act has evolved since then; nonetheless,
it is striking to see how the interpretation of Section 2 in force in the 1950s is perceived to be closer to
ordo-liberal thought (!) than the new German law.
competition) and Behinderungswettbewerb (hindrance competition).23 From that point

on, it is only a small step to hold that, since the dominant firm will abuse its position if
it engages in hindrance competition, it is under a duty to refrain from such hindrance
competition, hence the special responsibility of the dominant firm.24 Furthermore, it
is consistent with ordoliberal thought to hold that the mere presence of market power
weakens fragile markets, thereby heightening that special responsibility.25
8.2.5. Conclusion
Accordingly, even if Article 102 TFEU does not embody the model of direct interven-
tion against market power advocated by ordoliberals, the distinctive features identified
above can nonetheless be traced back to ordoliberal thought. Such is certainly the case
for the focus on the protection of the competitive process, the insistence on competition
on the merits, and the special responsibility of the dominant firm.
If anything, the main legacy of ordoliberalism might play out at a deeper level than
even the fundamental features of Article 102 TFEU analysis that we have been examin-
ing in the previous sections. Ordoliberalism underlines the fragility of markets, which
are vulnerable to both public and private economic power. Underneath most of EU
competition law analysis, certainly as far as Article 102 TFEU is concerned, one finds a
similar concern for the resilience of competitive markets, or to put it otherwise, a skepti-
cism towards the robustness of markets, a lack of confidence in their ability to self-heal.
This basic tenet is rarely expressed,26 but it is almost always present.
8.3. Decision Theory and the Special

Responsibility of the Firm
As was seen above, the special responsibility of the dominant firm can be derived from
ordoliberal thought, adapted to fit a model of prohibition on abuse of dominance. In this
section, we suggest that this special responsibility can be explained equally well, if not
23 Indeed, even though Eucken (2004) advocates the removal of market power pure and simple, he
nevertheless discusses at length the various forms that Behinderungswettbewerb can take. Ordo-liberal
authors were aware that the distinction between Leistungswettbewerb and Behinderungswettbewerb was
liable to be unduly influenced by considerations coming from the unfair trade practices law.
24 As introduced by the ECJ in Michelin, supra, note 10 at para. 57.
25 As the ECJ has held since its judgment of 13 February 1979, Case 85/76, Hoffmann–La Roche
v. Commission [1979] ECR 461 at para. 91.

26 Except perhaps in the recurring phrase where the Court states that dominant firms, by their very
presence, already weaken the degree of competition in the market (see for instance TeliaSonera, supra,
note 13 at para. 27). Interestingly enough, that phrase was not included in the reasoning of the Court in
the recent Grand Chamber judgment in Post Danmark, supra, note 12.
better, by looking at the institutional context of enforcement in the light of economic

analysis, in particular decision theory.
8.3.1. Decision Theory in the Context of EU Competition Law

One of the legacies of the Chicago school has been to throw the spotlight on the insti-
tutional dimension of competition policy. The work of Easterbrook (1984), in particu-
lar, started from the simple observation that authorities do not and cannot possess all
the information required to fully understand and analyze the practices at stake in the
cases before them. Acquiring that information, if at all possible, might involve an exces-
sive expense of time and resources, in relation to the expected gain from the applica-
tion of competition law. Easterbrook sought to solve that conundrum by introducing
error-cost analysis: rules should be designed in such a way as to minimize the error costs
and the costs of the enforcement system. Furthermore, to the extent that trade-offs are
made, it is preferable to err on the side of allowing anticompetitive practices (Type II
error) than of prohibiting innocuous ones (Type I error). In the words of Easterbrook
(1984), “Other things equal, we should prefer the error of tolerating questionable con-
duct, which imposes losses over a part of the range of output, to the error of condemning
beneficial conduct, which imposes losses over the whole range of output.”
Easterbrook’s analysis rests on the assumption that market forces are sufficiently
strong to overcome monopoly power, so that Type II mistakes are self-correcting in
the long run.27 It is not unreasonable, however, to hold that monopoly power will not
always be dissipated. As was seen above, EU competition policy is based on the assump-
tion that markets are not always self-correcting, and hence that competition policy can
be needed to address the consequences of monopoly power. In addition, the institutional
context remains different in the EU: for the time being, private enforcement is carried out
on a much smaller scale than in the United States. Furthermore, most of the decisions are
taken by competition authorities acting as investigator, prosecutor, and adjudicator. Hence,
rightly or wrongly, the risk of error is perceived as more manageable in the EU.
If, for the sake of argument, monopoly power is considered not to be self-correcting, then
the cost of Type II errors is likely to be substantial, and the trade-off between Type I and
Type II errors is not so simple to assess (Schinkel and Tuinstra, 2006). The competition
27
The idea being that monopoly profits attract entry (as endorsed by the Supreme Court in Trinko,
supra, note 5). Alternatively, if market forces do not suffice to dissolve monopoly power, intervention can
always take place at a later point in time, when more information is available on the consequences of the
impugned conduct. Easterbrook does not give a temporal dimension to his analysis, and in any event
he is generally adverse to intervention. A dynamized Easterbrook-like error-type analysis underpins
the reasoning of the General Court on the relationship between MCR review and Article 102 TFEU in
Case T-80/02, Tetra Laval [2002] ECR II-4519 (upheld by the ECJ in Case C-13/03P, Tetra Laval [2005]
ECR I-1113, but with the ECJ disagreeing with the General Court on that very point) and Case T-201/01,
General Electric [2005] ECR II-5575.
authority will want to take a more interventionist stance, while still minimizing error costs,
given information deficiencies on its part.
In that context, a possible solution would be to try to shift the burden of enforcement
over to firms. Since firms possess all of the relevant information about their own position
and much of the information about the markets on which they evolve, a dominant firm can
certainly assess the compatibility of its conduct with Article 102 TFEU with more accurate
information than a competition authority.
Self-enforcement of Article 102 TFEU is fraught with risks, however. First, the dominant
firm may have no incentive to self-enforce and refuse to do so. Second, the dominant firm
might itself commit Type I or Type II errors, for it may itself suffer from information defi-
ciency. Third, the dominant firm might entertain an inaccurate view of the ambit of Article
102 TFEU, either interpreting it too narrowly or too broadly, and thereby not reaching the
appropriate conclusion as to the legality of its conduct (assessment error). We will explore
these three risks and how they can be remedied in the following three subsections.
8.3.2. Special Responsibility as a Device to Incentivize

Self-Enforcement
The special responsibility of the dominant firm, as set out above, could help in addressing the
first risk. It would then imply first and foremost that dominant firms are expected to question
their own conduct and contribute in enforcing Article 102 TFEU by refraining from conduct
that would infringe that provision. Furthermore, that special responsibility justifies, to some
extent, the high fines that are then imposed when the law is actually enforced.
When seen in that way, the special responsibility of the dominant firm is fully consistent
with current institutional choices in EU competition policy. With Regulation 1/2003, the
enforcement of Article 101 TFEU has been fundamentally modified to bring it from a sys-
tem of administrative control, via individual and block exemptions under Article 101(3),
towards a self-enforcement system, where Article 101(3) TFEU is directly applicable, with-
out any need for a prior decision. Firms are now largely in charge of assessing their behavior
as against Article 101 TFEU. They must conclude for themselves whether any agreement28
they enter into would breach Article 101 TFEU, and act accordingly. To be sure, competition
authorities are monitoring compliance with Article 101 TFEU29 and enforcing it; yet despite
the decentralization brought about by Regulation 1/2003, it is apparent that public enforce-
ment resources are not sufficient to ensure compliance, certainly not if Article 101 TFEU,
much like Article 102, is to have more than a symbolic value.30 Unless and until private
28
Or any decision of an association or any conduct that could be construed as a concerted practice.
29
Private plaintiffs also play a role, via claims before national courts (in addition to complaints to
competition authorities).
30 If the consensus opinion in the EU were that Article 101 and 102 TFEU were by and large marginal
provisions for a largely self-healing competitive market, enforcement issues would be less urgent.
However, that is not the consensus opinion, which is probably correct in the context of the EU.
enforcement can compensate for the lack of resources of public enforcers,31 compliance
with Article 101 TFEU therefore depends in large part on firms self-policing their conduct.
Under Article 102 TFEU, the ever-recurring reference to special responsibility would
therefore signal to dominant firms that they are expected to contribute to enforcing the
law, along the same lines as under Article 101 TFEU. They would play a part in the model
of administrative control—as opposed to court-centric enforcement, using public or
private plaintiffs—that is now prevalent in the EU for the implementation and applica-
tion of competition policy.
In this respect, the special responsibility of dominant firms under Article 102 TFEU
might find the most meaning when it is explained in institutional terms. Indeed, on sub-
stance, the special responsibility does not usually add much to the analysis. Typically,
whether the conduct of the dominant firm is abusive or not does not depend on the
special responsibility of the firm. Even though the Commission and the Courts almost
never fail to mention it, the special responsibility could usually be removed from the
reasoning without loss of cogency. When seen as a signal to dominant firms that they are
expected to contribute actively to enforcement by self-assessing their conduct, however,
it is sensible to mention that special responsibility time and again, to emphasize that
dominant firms are expected to internalize the substantive analysis set out by the com-
petition authority.
In fact, viewing the special responsibility of the dominant firm in institutional terms
helps to explain two recent cases where such responsibility was more central to the
reasoning, namely Deutsche Telekom (price squeeze) and AstraZeneca.32 In both cases,
the Commission faulted the dominant firm for its conduct in regulatory processes,
invoking its special responsibility under Article 102 TFEU. In Deutsche Telekom, the
German telecommunications regulatory authority had approved a set of wholesale
and retail tariffs for DT, which put its competitors in a price squeeze. The Commission
found that DT could not rely on the regulatory outcome, and that its special respon-
sibility under competition law dictated that it go back to the authority to petition for
new tariffs in order to remove the price squeeze. In AstraZeneca, AZ systematically
took the most favorable interpretation possible33 of medicines regulation, in order to
extend its patents to the maximum. The Commission found, here as well, that AZ’s
special responsibility should have led it to take a more mainstream interpretation, to
avoid excluding potential competitors. While on substance both cases seem to take
the special responsibility of the dominant firm very far, from an institutional perspec-
tive the reference to the special responsibility underscores that these two dominant
firms were bound to continue to self-assess their conduct, even when regulation came
in the picture.
31
Whether it is desirable that private enforcement takes a larger role will not be discussed here.
32
ECJ, Case C-280/08 P, Deutsche Telekom [2010] ECR I-9555 (confirming GC, Case T-271/03,
Deutsche Telekom [2008] ECR II-477) and ECJ, Case C-457/10 P, AstraZeneca (6 December 2012), nyr
(confirming GC, Case T-321/05, AstraZeneca [2010] ECR II-2805.
33 Bordering on bad faith: see AstraZeneca (ECJ), ibid. at para. 74–100.
8.3.3. Other Risks Relating to Self-Enforcement: Information

Deficiencies in the Firm
Nevertheless, as set out above, two other risks associated with self-enforcement by firms
remain: errors due to information deficiencies by the firm itself and assessment errors
when the firm does not correctly understand the applicable law.
The risk of information deficiency concerns chiefly information on other firms.
Indeed while the dominant firm knows more about itself, and about its own conduct,
than the competition authority, it may not possess the same level of information as
regards rival firms, customers, suppliers, and so on. It certainly holds enough informa-
tion about others to be able to make business decisions, but that might not suffice for
the purposes of competition law assessment, for which authorities have a number of
privileges.34 Under Article 102 TFEU, some features contribute to reducing the risk of
information deficiency.
For instance, on pricing matters, the European Commission (2009) has put forward
the As-Efficient-Competitor (AEC) test, whereby the impact of the prices entertained
by a dominant firm is assessed by reference to a competitor with the same cost of pro-
duction as the dominant firm. The AEC has been endorsed by the ECJ, among other
reasons because it noted that in practice it allows the dominant firm to assess its pricing
against its own information.35
Beyond that, in nonpricing cases, the effects test currently advocated by the European
Commission (2009) could also help in alleviating this risk. In earlier years, a mere poten-
tial effect on competition was enough for dominant firm conduct to qualify as abuse. In
practice, this meant that since an effect on competition could always be conceived, the
form of conduct became determinative. The Commission is now committed to carrying
out a real effects analysis, which looks at likely effects. In other words, the Commission
endeavors to put together a cogent theory of harm, whereby it is shown that the dominant
firm has incentives to enter into a course of conduct, which will likely cause anticompetitive
harm, in the view of the likely reactions of other firms.
Yet the Commission has also rejected the idea of incorporating an actual effects analy-
sis into Article 102 TFEU, whereby it would need to show that competition has actually
been harmed, that is, that competitors have actually been foreclosed or excluded, to the
detriment of consumers. Unfortunately, the ECJ has not yet endorsed the introduction
of a likely effects analysis (as opposed to mere potential effects) into Article 102 TFEU.36
On the assumption that the view of the Commission will eventually prevail, it could
34
Certainly if the assessment is to be made up to the legal evidentiary standards of competition law.
35
Deutsche Telekom, supra, note 32 at para. 202, and TeliaSonera, supra, note 13 at para. 44.
Unfortunately, the AEC test can also be misinterpreted as an invitation for the dominant firm, in defense,
to turn its guns against the plaintiff and shift the focus of the competition law inquiry to the efficiency of
the plaintiff, as occurred in Intel [2009] OJ C 227/13. This is not what is meant by the AEC test.
36 See, for instance, ECJ, Case C-202/07 P, France Telecom (Wanadoo) [2009] ECR I-2369 or Deutsche
Telekom, ibid.
paradoxically help to reduce the information deficiency risk in ex ante self-assessments

by dominant firms.37 Indeed, ex ante it is easier for the dominant firm to measure the
likely effects of its conduct, based on the information it has in hand, than to try to ascer-
tain what the actual effect thereof will be. In the end, the information deficiency risk
remains limited to information about third parties, and it is somewhat alleviated by the
AEC test and a likely effects test.
8.3.4. Other Risks Relating to Self-Enforcement: Assessment

Error by the Firm
The crux of the matter with self-enforcement, without doubt, is the risk of assessment
error by the dominant firm, whereby the firm would not correctly understand what com-
petition law entails. Firms could either fail to refrain from conduct that breaches Article
102 TFEU, in which case presumably competition authorities can intervene. What is more
worrisome, however, is the opposite scenario, where a firm refrains from permissible con-
duct—in all likelihood procompetitive—because it incorrectly assesses that such conduct
would breach Article 102 TFEU.38 This fear of dulling the competitive edge of dominant
firms underpins much of the US approach to Section 2 of the Sherman Act, certainly as
far as writers associated with the Chicago school are concerned. Under Section 2 of the
Sherman Act, it is generally admitted that the dividing line between pro- and anticom-
petitive conduct is thin and sometimes blurry.39 One need only think of price wars versus
predatory pricing.
Taken ad absurdum, the only way to reduce the risk of assessment error to zero is to
refrain from enforcing competition law, that is, adopt an interpretation whereby every
course of conduct is deemed permissible. This would not be desirable, certainly not in
the EU. Accordingly, assessment errors are unavoidable, and with them the ensuing loss
of some competitive benefits from the conduct of dominant firms. It is more a matter
of reducing them. In the EU, since reliance on self-assessment by dominant firms tends
to increase the risk of assessment errors, one would expect a counterbalancing effort to
keep competition law as understandable as possible, so as to limit the scope for diver-
gent interpretations.
Unfortunately, current trends in the interpretation of EU competition law, and of
Article 102 TFEU in particular, seem to point in the opposite direction. First of all,
37 Even though on substance dominant firms are probably better served by an actual effects test. Such
a test is, however, hard to reconcile with the enforcement of Article 102 TFEU in practice: in most cases,
it is not desirable to wait until the actual effects of dominant firm conduct have been felt before deciding
on whether there is a breach of Article 102 TFEU (and certainly where injunctive relief is at stake).
38 This is not unlike the standard error-risk analysis set out earlier, but this time the source of error
is not an information asymmetry as between the authority and the dominant firm or between the
dominant firm and other firms, but rather a divergence regarding the interpretation of the law, between
what would be entertained by the competition authority, taking into account review by courts, and what
the dominant firm uses for its self-assessment.
39 Supra, heading 1.2.2.
more economic analysis was introduced in the application of the law. Undoubtedly,
this improves the substantive quality of outcomes. As a result, Article 102 TFEU is now
better articulated, at a general, theoretical level, in European Commission (2009)40
with references, for example, to the need for a theory of harm and the emphasis on con-
sumer welfare. In this respect, it might be easier to understand. At the same time, the
old formalistic categories have been upended, so that predictability might have been
adversely affected overall. Here as well, there is a trade-off between flexibility and cer-
tainty.41 By most accounts, recent reforms had a positive overall effect, but the loss of
predictability remains.
Such loss is compounded, however, by a flight into soft-law instruments (guide-
lines, notices) and informal conclusions (by way of settlements or commitments),
instead of case work. Whereas cases offer competition authorities the opportunity to
battle-test their interpretation of the law, soft-law instruments are more in the nature
of general policy statements, all the more when they are not based on experience with
cases (Schinkel, 2011). They might not provide as much guidance to firms as intended
by the issuing authority. It is crucial, if assessment risks are to be kept under control,
that competition authorities continue to process cases, so as to test and sharpen their
interpretation of the law, to the benefit of dominant firms, when they self-assess their
conduct.
8.3.5. Conclusion
In the end, this second line of analysis of the continental drift in the treatment of domi-
nant firms, which emphasizes the institutional dimension of competition law, provides a
good explanation for the special responsibility of the dominant firm. On the assumption
that markets are not self-correcting and therefore that some measure of enforcement of
Article 102 TFEU is needed, one can justify, in the EU context, an enforcement approach
that emphasizes self-assessment by dominant firms. This matches the new approach to
Article 101 TFEU enforcement. Against that background, the special responsibility of
the dominant firm signals to dominant firms that they are expected to self-assess their
conduct. Nevertheless, self-enforcement also creates error risks on the part of the domi-
nant firm, having to do with information deficiencies or divergences in the interpreta-
tion of the law. While the former risk is alleviated by some features of Article 102 TFEU,
the latter could be better contained.
40 However, with the lone exception of Post Danmark, supra, note 12, the ECJ has not endorsed the
approach set out by the Commission in the Guidance Paper.

41 One should not be misled by comments from practice, which tend to request more flexibility when
the law is formalistic and predictable, and then go on to bemoan the lack of legal certainty when the law
becomes more responsive to individual circumstances. Here as well, taken ad absurdum, the only way to
achieve both flexibility and certainty is to refrain from enforcing the law altogether.
The institutional line of analysis does, however, not provide a good explanation for
other features of Article 102 TFEU, such as the emphasis on competition on the merits
or the protection of the competitive process. Here we need to look further.
8.4. Innovation, Dynamic Efficiencies,

the Competitive Process, and
Competition on the Merits
The relationship between competition and innovation has been a vexed issue in eco-
nomic literature. At a theoretical level, Schumpeter (1947) posited a negative relation-
ship between competition and innovation: as competition increases, the potential
rents accruing to the innovator decrease, and so does the incentive to innovate. At the
opposite end of the debate, one finds Arrow (1962), who maintained that competition
rather pushes firms to innovate, because they stand to gain more from innovation if
they are in a competitive environment than if they already enjoy supracompetitive
profits in a monopoly environment. Some of the most interesting research lately has
come from Aghion and colleagues (2005). On the basis of theoretical and empiri-
cal work, they conclude that competition and innovation are not bound in a linear
relationship, but rather an inverted-U relationship. By and large, the work of Aghion
and colleagues is still being received, and not all authors agree with it (Goettler and
Gordon, 2011). In any event, it seems clear that neither Schumpeter nor Arrow is
entirely right, and that competition policy must be carefully calibrated (Segal and
Whinston, 2007).
In US law, by and large, Chicago scholars have been influenced by the Schumpeterian
vision of innovation as a gale of creative destruction. In essence, their main concern is
that the application of antitrust law must not undermine the ex post rewards to innova-
tors, for fear of undermining the ex ante incentives to innovate (Sidak and Teece, 2009;
Evans and Hylton, 2008; Manne and Wright, 2010; Ginsburg and Wright, 2012). When
combined with the Chicago school’s typical concern for productive efficiency, this could
imply, for instance in a high-tech sector where fixed costs (including R & D) are high
and marginal costs low, that competition on the market could be replaced by competi-
tion for the market.
The US Supreme Court seems to espouse a view of dynamic efficiency that comes
very close to that of Chicago school authors. In this view, innovation is seen as a lin-
ear, stand-alone process (production function): resources are invested, and innova-
tion results as a function thereof, not unlike investment in infrastructure, for instance
(Menell and Scotchmer, 2007; Scotchmer, 2004). Such investment must offer sufficient
ex ante perspectives of reward if it is to be undertaken to start with. Since investment
is a crucial element of dynamic efficiency, the law must be careful not to undermine
these ex ante incentives. In Trinko, for example, Justice Scalia famously wrote for the
Court:42
The mere possession of monopoly power, and the concomitant charging of monop-
oly prices, is not only not unlawful; it is an important element of the free-market
system. The opportunity to charge monopoly prices—at least for a short period—is
what attracts “business acumen” in the first place; it induces risk taking that pro-
duces innovation and economic growth. To safeguard the incentive to innovate, the
possession of monopoly power will not be found unlawful unless it is accompanied
by an element of anticompetitive conduct.
There is no comparable statement in the EU. European competition authorities are still
building up case law and decision practice in matters where innovation plays a central
role, such as the recent Microsoft43 and Intel44 cases. The outcome of these cases already
indicates that EU competition law is unlikely to follow the same approach to innovation
as US antitrust law.
In any event, it could be argued that the US Supreme Court, and the authors who
inspired its vision, have a too limitative view of innovation. Innovation cannot just be
reduced to an investment.45 Instead, there are two separate elements in innovation,
namely the idea or invention and its implementation, that is, its successful introduc-
tion to the market. An idea alone does not make an innovation; it must be brought to
the market. While investment might help on both counts, it is not the only determinant.
This broader view of innovation sits well with the central elements of Article 102 TFEU
protection of the competitive process, and competition on the merits.
8.4.1. Ideas Are Scarce and Unpredictable: Protecting the

Competitive Process
First of all, there is no given relationship between ideas and investment: ideas are often
scarce, and will not necessarily be generated by investment (Scotchmer, 2004). Ideas are
unpredictable; they can, and often do, arise outside of well-planned efforts to produce
them (Govindarajan and Trimble, 2010). Ex post, of course, a linear, stand-alone nar-
rative can always be put forward, but it would be mistaken to draw the conclusion that
this is what must be incentivized ex ante. Otherwise, competition law might be picking
winners, at least indirectly, by being biased in favor of a certain innovation narrative,
42
Trinko, supra, note 5.
43
GC, Case T-201/04, Microsoft [2007] ECR II-3601.
44 Supra, note 35.
45 To some extent, the issues discussed here apply to other forms of investment as well, such as
investment in new infrastructure. That point lies outside the scope of this chapter, however. See Larouche
(2008).
namely that of the large investor. Ex ante, it is more realistic to envision that a number of
firms will be vying for the next innovative step. Since it cannot be predicted which idea
will successfully be brought to market (and increase welfare), all firms need to be incen-
tivized to innovate.46 While firms are certainly incentivized by the prospect of innova-
tion rents if they succeed, they also need to perceive that, among all firms competing to
innovate, they stand a chance of succeeding.
When Article 102 TFEU is seen against that background, it is sensible to use that pro-
vision to try to protect the competitive process as a value in and of itself. If innovation by
its nature cannot be predicted by the authorities, and cannot even reliably be produced
by the most skilled and focused firms, the best that competition policy can realistically
achieve is to maximize the innovation rate by ensuring that potentially innovative firms
deploy their efforts.
In contrast with the ordoliberal approach, which seeks to protect the competitive
process against economic power, however, when the competitive process is protected
for the sake of innovation and dynamic efficiency, it would seem logical to insist that
the participants in the competitive process strive for innovation. While competition
authorities are hardly in a position to rule on the validity or promise of R & D efforts,
there is nonetheless an outer bound: firms that are merely seeking to copy or clone the
products, processes, or business methods of existing firms (“copycat firms”) do not and
cannot innovate. As such, claims by copycat firms are not deserving, from a dynamic
perspective.
This view may explain why, in the law on refusal to deal under Article 102 TFEU, for
instance, the plaintiff must show that it is seeking to bring a new product on the market,
as is exemplified by the Magill,47 IMS,48 and Microsoft49 cases. In contrast to this line of
case law, however, in the Deutsche Telekom price squeeze case, the ECJ has enshrined
a principle of “equality of opportunity” between firms under Article 102 TFEU, which
could be read as a requirement that competitors be able to replicate the business strategy
and methods of the dominant firm.50 The ECJ read that principle beyond the narrow
46
Of course, it is always possible that too many resources would be dedicated to R & D in pursuit of
innovation, but we leave that possibility aside for now.
47 ECJ, Case C-241/91 P, RTE [1995] ECR I-743.
48 ECJ, Case C-418/01, IMS [2004] ECR I-5039.
49 Supra, note 43. Microsoft has been widely criticized for setting too low a threshold for novelty,
when the Commission and the General Court found that a technical improvement on some features of
Windows Server OS qualified as a new product within the meaning of IMS. It can be argued, however,
that this holding is sensible as long as it is agreed that incremental innovation—prevalent in the software
industry—is worthy of protection as well: see Larouche (2009).
50 Supra, note 32 at para. 230 and ff. In that case, DT argued that the margin squeeze test was invalid,
since the Commission compared the wholesale unbundled local loop price with the retail monthly
subscription price, leaving out call charges. Since DT had not yet rebalanced its tariffs, it still entertained
a low price for monthly subscriptions and high call charges. It was open to competitors, of course, to
charge a higher subscription price and lower call charges. Leaving out call charges made the margin
squeeze clear. In essence, the ECJ answered that argument with the principle of “equality of opportunity,”
which must be read as implying that Article 102 TFEU will also protect the ability of the competitors of
the dominant firm to compete with the exact same business model.
confines of previous case law,51 and it is to be hoped that such a principle will not develop
further to allow copycats to invoke Article 102 TFEU in their favor.
8.4.2. Innovation Implies the Ability to Bring the Idea to the

Market: Competition on the Merits
Second, bringing the idea to the market is also not strictly linked to investment. There
are other constraints, besides adverse investment incentives and the ensuing lack of
investment, that can also explain why an idea does not unfold into an innovation. They
include the inability to gain access to the market (on the supply side), which is discussed
below, or rejection by prospective customers (on the demand side).
For competition policy, in order to provide appropriate incentives for compet-
ing firms to innovate, it is crucial that these firms have the ability to put forward new
products and services to potential customers and have customers decide whether these
new products and services meet their preferences. Here as well, this implies that, under
Article 102 TFEU, competition policy focuses on keeping the competitive process open,
including the ability to seek customers.
“Competition on the merits” takes a new dimension when seen from a dynamic per-
spective. Ordoliberals drew a distinction between competition on the merits and other,
presumably less meritorious, means of competing.52 From a dynamic perspective, com-
petition on the merits can be seen as the ability to present new products and services to
customers and have customers decide whether these products and services, as opposed
to what is already on the market or to alternative novelties, find their favor. This is the
essence of dynamic competition; if new products and services cannot find their way to
the market, there is no innovation.
In this context, the merits should include all matters of improvement that are associ-
ated with innovation, regarding not only products and processes, but also marketing or
business methods. Beyond that, to the extent that network effects play a role in customer
decisions, is a firm still competing on the merits when it successfully harnesses network
effects to make its products or services gain preeminence on the market? It takes consid-
erable skill to do so, even if skill alone is usually not sufficient. Once network effects have
propelled an “inferior” product to supremacy—as has already happened many times—
it seems beyond the power of competition authorities to reverse the course of events
and restore a “level playing field” where products or services would “compete on their
merits.”
In the context of Article 102 TFEU, fostering competition on the merits would imply
that the law is applied so as to protect the competitive process and keep markets open for
51
All the cases invoked by the ECJ, ibid., at para. 230 in support of this principle of equality of
opportunity arose where the regulatory framework was at stake, and where the dominant operator was
put at an advantage in the application of national regulation.
52 See supra, heading 1.2.2.
potential innovators. This requires careful balancing. For that purpose, it might be use-
ful to think in terms of “innovation paths,” that is, potential directions in which markets
can go as a result of innovation, whereby there can be a number of potential paths, and
it is impossible at the time of decision to know which one will eventually materialize.
As a starting point, the task of competition policy and competition authorities is not
to close innovation paths, that is, not to pick winners. Conversely, one could also argue
that their task does not extend to opening new innovation paths; this would be more
of a matter for R & D funding or industrial policy. Competition policy is there to keep
existing paths open and ensure that the choice of path is made by those whose welfare is
central to the whole enterprise, namely customers. Arguably, this reasoning underpins
the rejection of Microsoft’s efficiency defense in the media player part of the case, where
the General Court held that
Microsoft is in fact claiming that the integration of Windows Media Player in

Windows and the marketing of Windows in that form alone lead to the de facto
standardisation of the Windows Media Player platform, which has beneficial effects
on the market. Although, generally, standardisation may effectively present certain
advantages, it cannot be allowed to be imposed unilaterally by an undertaking in a
dominant position by means of tying.53
At the same time, if the authority prevents a dominant firm from closing down innova-
tion paths and taking choices away from customers, it is not clear what kind of rem-
edy would be appropriate. In Microsoft, Microsoft was ordered to market a version of
Windows without the media player included, next to the standard-issue Windows with
an integrated media player, for the same price. That remedy, while creative, proved
ineffective. In the subsequent case involving the integration of Internet Explorer into
Windows,54 the Commission required the introduction of a “browser choice” window
into Windows. This might be more effective in ensuring meaningful customer choice,
but at the same time it does fixate the browser/operating system articulation, at the
expense of more integrative solutions.55
More broadly, in cases such as Microsoft (interoperability information) or Intel, the
Commission analysis and remedies aim at bolstering competition and keeping innova-
tion paths open within the current value network of the market in question, to use the
terminology of Christensen (1997). The Commission fosters sustaining innovation. Yet
in practice the issues identified by the Commission were solved not so much through its
competition remedies, but rather by disrupting innovation, which shattered the value
network. For instance, the dominance of Microsoft in PC operating systems was ren-
dered less consequential by the rise of browser-centered computing and cloud comput-
ing, as well as the shift away from PCs towards smartphones and tablets. That latter shift
53
Supra, note 43 at para. 1152.
54
Microsoft (Tying) [2010] OJ C 36/7.
55 In other words, it is not totally neutral as far as innovation paths are concerned.
also dampened the effects of Intel’s dominance for x86 CPUs, since smartphones and
tablets do not usually run on x86 CPUs. Similarly, there are signs that Google’s market
power on the search engine market is being disciplined not so much through innova-
tion in search engines, but rather though innovative methods to circumvent the search
engine when linking users to content, for instance through apps on mobile devices or
social networks such as Facebook or Twitter.
8.4.3. Innovation and Interaction between Firms

Third, and consequently, innovation cannot always be perceived as a stand-alone, lin-
ear process. In many situations, innovation depends on the environment: sometimes
it builds on previous innovations (cumulative innovation: Scotchmer, 2004); at other
times it arises out of complex interactions between a firm and its customers (user-driven
innovation: von Hippel, 2005) or among firms and other entities (open innova-
tion: Chesbrough, 2003). These are the hard cases, where interaction between firms is
part of the innovation process. Unavoidably, firms will disagree with one another in the
course of such interactions, and one firm might try to gain an advantage over the others
by affecting these interactions. In the context of Article 102 TFEU, this led to decisions
such as Magill, IMS and Microsoft, for instance, where a competitor requires access to
some facilities, information, or intellectual property of the dominant firm, alleging that
this is necessary to enable it to innovate. The dominant firm claims that it is equally
intent upon innovating, and that it should not be required to share with, or supply, its
competitor.
Assuming an inverted-U relationship as in Aghion and colleagues (2005), settling this
claim could hinge upon whether the sector under inquiry finds itself in the ascending or
descending part of inverted-U curve. In the former case, presumably increasing com-
petition by imposing access will have a positive effect on innovation (and increase wel-
fare), while in the latter case, it would not. Of course, finding out where a sector is on the
inverted-U curve is no easy feat. In addition, if access to facilities or information is nec-
essary to be able to compete at all, the claimant has in fact no or almost no prospect of
any innovation rent, irrespective of the level of competition on the market. Under these
circumstances, the assumptions underpinning the model of Aghion and colleagues are
not met.
In practice, when faced with this issue in Microsoft, the Commission let it slip in
its decision that “on balance, the possible negative impact of an order to supply on
Microsoft’s incentives to innovate is outweighed by its positive impact on the level of
innovation of the whole industry (including Microsoft).”56 The General Court dis-
avowed this statement,57 and indeed this balancing test is too rough to be accurate. In the
56
Supra, note 43 at para. 783.
57
The General Court noted, however, that the Commission had provided ample other reasons why
Microsoft’s argument on innovation incentives should be rejected: ibid., para. 705–10.
end, by ordering Microsoft to provide access, the Commission in fact reduced the cost
of making a technological jump (even if the jump is also smaller, i.e. more incremental
than breakthrough innovation) for Microsoft’s competitors. Yet there are not so many
competitors. If the effect of the decision is to turn the market for server operating sys-
tems into a neck-and-neck market, with a few competitors being at the same technologi-
cal level, then in theory the market could become “sleepy” unless still more competition
is stimulated; it is not clear how a competition authority could achieve that.
In particular, from the moment that a more interventionist stance is chosen when it
comes to innovation and competition policy,58 competition authorities will find it very
difficult not to affect the course of innovation, by preempting certain paths or even pick-
ing winners. In this respect, the first signals emanating from EU competition policy are
not very encouraging. For instance, in cases such as Microsoft or Intel, the Commission
could not manage to set out cogent reasoning without making a negative judgment on
the quality of the research efforts and the products of the dominant players, Microsoft
and Intel. Similarly, in Microsoft, the Commission decided that the level of royalties for
the disclosed information should not reflect its strategic value, that is, the use to which it
can be put (obtaining or maintaining a presence on the server OS market).59 That prin-
ciple was further developed in the course of implementing the Commission decision, as
explained in a subsequent decision where the Commission fixed the periodic penalty
upon Microsoft for having failed to implement the disclosure remedy on time.60 In the
end, the rate of royalties was set to reflect the “intrinsic” value of the intellectual prop-
erty, which was a function of whether the property was innovative. Innovativeness was
assessed by reference to criteria taken from patent law, that is, novelty and nonobvious-
ness.61 The Commission therefore put itself in the position of a patent office, ruling on
the value of a firm’s efforts, and introduced the notion that intellectual property has an
“intrinsic” value that a competition authority can figure out.62
8.4.4. Conclusion
In short, once innovation and dynamic effects are taken seriously and integrated into
competition analysis, central elements of Article 102 TFEU—the protection of the com-
petitive process as such, competition on the merits—are infused with new meaning and
58 A competition policy that is geared simply to ensure that innovators can look forward to
innovation rents, as in the United States, will typically not result in much intervention.
59 Decision of 24 March 2004 [2007] OJ L 32/23, at para. 1008 (ii). This is to avoid the possibility that
the royalties received as a result of the compulsory disclosure would put Microsoft in the same position
as if it had agreed voluntarily on disclosure.
60 Microsoft (Fixation of Penalty Payments) [2009] OJ C 166/20, confirmed by the General Court, Case
T-167/08, Microsoft (27 June 2012), nyr.

61 Ibid. at para. 138–51.
62 It will be interesting to see if the same approach will be followed to solve the cases concerning the
pricing of Standard-Essential Patents (SEPs) now piling up before the Commission.

significance. Nevertheless, as shown above, many fundamental issues are still open, and
we are still far from a solid approach to innovation under Article 102 TFEU.
8.5. Excessive Pricing Revisited
In the previous sections, we explored alternative explanations for the three distinc-
tive features identified as regards the implementation of Article 102 TFEU: the special
responsibility of the dominant firm, the protection of the competitive process, and the
focus on competition on the merits. The European “outlier” prohibition of exploitative
abuses, in particular in the form of excessive pricing, still remains to be explained. As
mentioned in section 8.1, this category has been little enforced. In this section, we revisit
it and suggest how it could be brought to life by recognizing the contradictions limiting
the usefulness of ordoliberal thought for this category, overcoming practical objections,
and applying more recent economic methods from the calculation of antitrust damages.
8.5.1. Ordoliberal Contradictions and Excessive Pricing

The treatment of exploitative abuses highlights a contradiction in ordoliberal thought.
As was seen under section 8.2, ordoliberals advocated outright intervention against
economic power as such.63 Nevertheless, Eucken and others believed that some
“unavoidable monopolies” might remain. The starting point of the ordoliberals was that
this—presumably very limited—class of monopolists is to be regulated by a monopoly
surveillance authority, with a view to making them behave “as if ” they were evolving in
a competitive setting (Eucken, 2004; Böhm, 1980b). This also implies that price-related
conduct is controlled so that regulated prices approximate those that would mate-
rialize under perfect competition. Therein lies a contradiction that Eucken struggled
with: while the freedom to set prices is a central tenet, “as if ” regulation substitutes regu-
lated prices for freely set prices. Regulated prices can hardly fulfill the signaling function
of market prices. Eucken’s way of minimizing the contradiction was to restrict the “as
if ” regulation to that narrow set of unavoidable monopolies, all other manifestations of
economic power having been uprooted.
Other ordoliberal writers—in particular Leonhard Miksch (1948–49), who invented
the term “as if ”—were less hesitant about regulatory intervention. As a starting point,
Miksch considers that, while perfect competition might be the theoretical ideal, it is
rarely achieved in practice. The task of the state is then to intervene in order to bring
about the state of affairs that would have resulted if perfect competition had prevailed: it
is a matter of “finding a price that, first, does not depend on the will of the [dominant
63
Supra, heading 2.4.
firm]; second, leads to rational production because of its relationship to production

costs, and, third, evolves in parallel to free market prices” (Miksch, 1948–49, 333).
Once a system of abuse control was enshrined in the EEC Treaty in 1957, it was
clear that a much larger number of dominant firms would be present than the origi-
nal ordoliberal ideas would have countenanced.64 Accordingly, the more intervention-
ist approach advocated by Miksch took hold, without necessarily having been proven
superior. Indeed, in essence the range of the “as if ” principle was extended to all domi-
nant firms, irrespective of whether their position is “unavoidable” or not. Article 102
TFEU was applied to dominant firms on the assumption that the behavior of these firms
should be analyzed, and remedies imposed on them, “as if ” they would evolve in a com-
petitive environment. In the realm of pricing abuses, price-cost tests, designed to assess
the pricing of the dominant firm as against cost-based “as if ” prices, became a fixation,
as can be seen to this day in the application of Article 102 TFEU to predatory pricing,
rebates, or price squeezes.65
8.5.2. Practical Objections against Enforcing a Prohibition on

Excessive Pricing
However popular Miksch’s “as if ” approach has proven as regards exclusionary abuses,
the situation is different with exploitative abuses. In principle, under this approach,
competition authorities should seek to bring the dominant firm to a price level corre-
sponding to what it would entertain if it were active on a competitive market. But in
practice, this has proven very difficult.
According to the ECJ, an excessive price within the meaning of Article 102 TFEU
bears “no reasonable relation to the economic value of the product.”66 That value is
established by comparing the price with the production costs (cost-plus test), and then
by determining whether the price is unfair by itself or in comparison with competing
products (comparator test).67 The cost-plus test is directly inherited from ordoliberal
thought; neither test is defined with any greater precision in the ECJ case law.
The Commission has a mixed track record as regards excessive pricing under
Article 102 TFEU, having lost two early cases before the ECJ.68 Subsequently, the
Commission brought few excessive pricing cases. Following a review of the decision
64
Supra, heading 2.4.
65
Even if Post Danmark, supra, note 12 might mark some progress in this respect, towards a general
test applicable to pricing practices, it still remains a price-cost test. The ECJ refused to move the analysis
of predatory pricing away from costs, and towards a focus on recoupment, in Wanadoo, supra, note 36.
Similarly, in Case C-549/10 P, Tomra (19 April 2012), nyr, a judgment issued after Post Danmark, the
ECJ reiterates its classic position on rebates, which are to be assessed by looking at cost savings against
an ideal cost-based list price. Furthermore, in Microsoft, supra, note 60 the General Court approves an
extension of this approach to the pricing of IP royalties, as advocated by the Commission.
66 United Brands, supra, note 3 at para. 250.
67 Ibid. at 251–52.
68 ECJ, Case 26/75, General Motors [1976] ECR 1367 and United Brands, ibid.
practice of the Commission and of the British, Dutch, and German competition
authorities, Geradin (2007) concluded that excessive pricing cases are few and often
unsuccessful. The Commission and national authorities tend not to prioritize these
cases, for a number of reasons: a belief—in line with US law—that excessive prices
are self-correcting through market entry, methodological difficulties in ascertaining
whether prices are excessive, and a reluctance to enter into what is perceived as a price
regulation exercise.69
In recent times, a number of authors have sought to improve upon the United Brands
test (Motta and de Streel, 2006; Evans and Padilla, 2005; Röller, 2008; Paulis, 2008;
Geradin, 2007; Akman and Garrod, 2011). While their proposals differ on some points,
they all insist upon the need to restrict enforcement to markets evidencing high barri-
ers to entry; in that sense, these proposals attempt to limit the application of Article 102
TFEU rather than modify or replace the substantive test for excessive pricing.
8.5.3. Applying Modern Economics to Determine “but for”

Prices in Excessive Pricing Cases
The price-cost test approach that stems from the ordoliberal fixation on natural monop-
olies versus perfect competition is, however, only one of several methods developed
in modern economics to determine so-called “but for” prices, in particular in cartel
damage litigation. Comparator-based methods are much more prominent in this area,
including time-series analysis of the same market before and/or after the infringement
and comparisons to a different but similar geographic market, and to different but simi-
lar products (van Dijk and Verboven, 2008; Davis and Garces, 2009, Korenblit, 2012).
In these methods, the key assumption is that the period or market to which a com-
parison is made can serve as a reasonable model for what competitive conditions in the
market under investigation could have been, absent the anticompetitive behavior. The
before-and-after method involves sophisticated econometrics in estimating, from actu-
ally observed prices and relevant additional explanatory variables, the “but for” price
development that would have occurred between endogenously determined structural
breaks around the beginning and the end of the infringement period.70 Yardstick meth-
ods likewise can include a number of variables to control for any differences that might
be present between the markets compared, besides the antitrust violation. An alterna-
tive approach to damages assessment uses structural industrial organization models for
simulation analysis with calibrated parameters, which can endogenize the determina-
tion of costs.
69 A recent example of a regulation-like intervention is Standard & Poor’s. See European Commission,
Antitrust: Commission Makes Standard & Poor’s Commitments Abolish Fees for Use of US International
Securities Identification Numbers Binding, IP/11/1354, 15/11/2011.
70 A prominent example is B. D. Bernheim, Expert Report in RE: Vitamins Litigation, M.D.L. No. 1285,
United States District Court for the District of Columbia, May 24, 2002.
While primarily developed in applications to cartel cases, these economic methods can,
in principle, be modified rather straightforwardly for use in assessing the effects of abuses
of dominance as well. The European Commission (2011) has so far always maintained that
damages claims were also available against exploitative abuses under Article 102 TFEU.
Recently, the OECD (2011) organized a roundtable about the topic, on the observation that
competition authorities are often hesitant to enforce, while direct exploitative abuses can
cause extensive harm to consumers. In the lengthy background paper by the Secretariat,
only slightly more than one page, Section 6.3, discusses the use of price comparisons to
determine to what extent prices may be excessive. The main author of the OECD paper,
Maier-Rigaud (Maier-Rigaud and Schwalbe, 2013), also briefly mention application to
exploitative abuse cases in a recent survey paper on the quantification of antitrust damages.
These more contemporary methods, while developed primarily to deal with pri-
vate damage claims for breaches of Article 101 TFEU, can very well be modified and
applied to assess whether, and by how much, dominant firm prices are excessive. As the
European Commission (2011) itself notes, damage claims for excessive pricing in breach
of Article 102 TFEU do not differ significantly from damage claims for overcharging in
connection with a cartel, in breach of Article 101 TFEU. Nothing seems to stand in the
way of the Commission itself applying these economic methods in Article 102 cases.
Doing so may well revive public enforcement in this stale European outlier category.
Indeed, as appears from the previous section, much of the unease with excessive pricing
under Article 102 TFEU stems from the practical difficulty of applying what remains
a fairly vague price-cost test, and from the more theoretical unease at the perspective
of having to force the dominant firm to bring its prices down to the “right” cost-based
price, if and once it is identified.
The key to staying within ordoliberal principles is to understand that the “but for”
comparator that authorities are ascertaining in excessive pricing cases is not perfect
competition, but any form of imperfect competition that would have prevailed with-
out the abuse of dominance. In this sense, excessive prices are conceptually the same
as cartel overcharges, with one important complicating factor. Whereas in cartel cases
there typically are periods or geographically different but otherwise comparable mar-
kets, where there was no collusion, so that before-and-after or yardstick-methods can
be applied, this may not always be the case in situations of dominance that are caused
by structural characteristics, such as network effects (OECD, 2012). Yet it is exactly here
that the difference appears between natural monopolies and “garden variety” domi-
nance cases: the latter, being the results of exclusionary practices, would potentially
leave comparable competitive conditions to use as a basis for a “but for” estimation.
In contrast, “natural monopoly” markets typically have structural market characteris-
tics, in particular large fixed costs in relation to the size of the market, such that optimal
prices, even in the absence of information problems, cannot be found with the simple
rule of thumb from perfect competition, that is, price equals marginal costs (Viscusi,
Vernon, and Harrington, 2005). Yet despite these complexities in determining optimal
price regulation of natural monopolies, this is a large and very active area of interference
with actual markets, mostly via sector-specific regulation.
Moving away from a reliance on the hypothetical “right” price under perfect com-
petition would overcome a key weakness in ordoliberal thought. Indeed the starting
normative aim for Eucken, Böhm, and others is the absence of economic power on mar-
kets; that is a negatively formulated aim, which can be achieved by removing economic
power, without encroaching on price mechanisms. The “as if ” approach goes beyond
that negative aim; it rests on a positive norm, namely perfect competition. In the writ-
ings of Eucken (2004) and Böhm (1980b), while the negative aim (absence of market
power) is solidly argued, the link with the positive aim (perfect competition) is less
clearly made. Not all authors agree with Eucken, indeed: later authors such as Möschel
(2001) downplay the link between ordoliberalism and perfect competition.
Furthermore, since these methods would be applied to historical data, with the aim
being to establish to what extent prices have been excessive in comparison to a relevant
comparator, modeling a public enforcement practice in excessive pricing on them would
stay a distance away from regulation. After all, damages claims are aimed at obtaining
compensation for past overcharges, rather than regulating future conduct. In a finding
of an infringement of Article 102 by an exploitative abuse of dominance, assessment of
the “but for” price could, but would not need to, be the base of the fine. It suffices as
a foundation for the finding of an infringement. Private damages cases for the breach
of 102 may follow and, based on the same principal methods, add to the liability of the
infringing undertaking. In either case, the only effect going forward would be through
the internalization of the possibility of future conclusions on excessive prices when a
case might be brought, which will discipline undertakings by way of a deterrence effect,
within the realm of the undertaking’s special responsibility.
The methods outlined above—save for cost-based methods—offer an alternative to
the price-cost test. With these methods, the aim of the inquiry is not to identify the posi-
tively “right” price, but rather to tease out, from available data, the effect of dominance
on prices. This corresponds to the negative normative aim of ordoliberalism, that is, the
absence of economic power. The effects of dominance are isolated, and to the extent that
they constitute excessive pricing, a damage claim will be entertained.
8.6. Conclusions
Despite visible divergences in their wording, Section 2 of the Sherman Act and Article
102 TFEU, like two tectonic plates, drifted away from the interpretation commonly
attributed to them at the outset, in order to converge in substance on the policing of
exclusionary conduct by dominant firms. Yet significant differences remain in their
application in individual cases. These differences must be attributable to basic features
of the analysis carried out under each provision. We have inventoried three such dis-
tinctive features of EU competition law, namely: the special responsibility of the domi-
nant firm; the strong distinction between competition on the merits and impermissible
forms of competition; and the protection of the competitive process even in the absence
of proven consumer harm. A fourth feature appears from the text of Article 102 TFEU
itself, namely the possibility of prosecuting exploitative abuses of dominant position.
In this chapter, we sought to provide explanations for these distinctive features.
A first line of explanation, traditionally put forward, is the influence of ordoliberal
thought (the Freiburg school) on Article 102 TFEU. The focus on the protection of
the competitive process, the insistence on competition on the merits, and the special
responsibility of the dominant firm can all be traced back to ordoliberalism. Yet Article
102 TFEU does not correspond to the model of direct intervention against market power
advocated by ordoliberals. It merely polices abuses, as opposed to market power as such.
Considering that the main works of ordoliberalism date from the mid-20th century,
it should come as no surprise that the approach suffers serious shortcomings. Beyond
the sometimes exaggerated criticism leveled in the literature, it can be argued that, for
instance, ordoliberals were too quick to jump from a negative normative ideal of absence
of market power, to a positive ideal of perfect competition. This implied that there was
a “right” price that dominant firms should charge, and accordingly the application of
Article 102 TFEU became rife with price-cost tests. In the case of exploitative abuses, and
especially of excessive pricing, this led to a marked reluctance on the part of competition
authorities to entertain cases. Yet when re-examined in the context of private enforce-
ment, with the help of newer economic tools to ascertain price overcharges, it no longer
seems so odd that dominant firms would have to pay damages for excessive prices.
In light of these gaps in ordoliberal thought, it is worth looking at alternative lines of
explanation.
A second line of explanation emphasizes the institutional dimension of competition
law, and it provides a good explanation for the special responsibility of the dominant
firm. The special responsibility of the dominant firm signals to dominant firms that they
are expected to self-assess their conduct. This matches the new approach to Article 101
TFEU enforcement. Nevertheless, self-enforcement also creates error risks on the part
of the dominant firm, having to do with information deficiencies or divergences in the
interpretation of the law. While the former risk is alleviated by some recent develop-
ments in the interpretation of Article 102 TFEU, the latter could be better contained.
In order to explain the emphasis on competition on the merits or the protection of the
competitive process, however, a third line of explanation is needed. It requires that inno-
vation considerations be brought into Article 102 TFEU analysis. Innovation must be
seen as more than a simple production function, depending on investment, but rather
as a combination of novel ideas and successful implementation. Against that back-
ground, Article 102 TFEU can be seen as an instrument to ensure that markets remain
open for all potential innovators, hence the need for enforcement to focus on keep-
ing the competitive process open. Similarly, competition on the merits takes on a new
meaning, since it is in the essence of dynamic competition that firms seek to compete on
the strength of innovative products that they bring to the market. Nevertheless, as the
chapter shows, many fundamental issues are still open, and we are still far from a solid
approach to innovation under Article 102 TFEU.
The following table sums up our analysis:
Ordoliberalism Decision theory Innovation

Special responsibility of the dominant firm X X
Competition on the merits X X
Protection of the competitive process X X
Accordingly, the features identified above can be explained otherwise than strictly
through ordoliberal thought. Still, this does not imply that ordoliberalism is superfluous
to the understanding of Article 102 TFEU. At an even deeper level, the interpretation
and enforcement of Article 102 TFEU—and to some of extent EU competition law as a
whole—assumes that markets are fragile, that they are vulnerable to both public and pri-
vate economic power. This is the starting point of ordo-liberal thought, and it stands in
contrast with the more confident attitude displayed throughout US antitrust law nowa-
days. EU competition authorities and courts are skeptical of the robustness of markets
and their ability to self-heal. At this juncture, there is no conclusive evidence to support
or disconfirm either the US or the EU basic assumption, and maybe there never will be.
Acknowledgments
The authors wish to thank (in alphabetical order) Pinar Akman, Roger Blair, Victoria
Daskalova, David Gerber, Imelda Maher, Matteo Negrinotti, Heike Schweitzer and
Daniel Sokol for their useful comments at various stages in the preparation of this chap-
ter, as well as the participants in seminars held in Tilburg (TILEC) and the University of
East Anglia (CCP), and in the Loyola Antitrust Colloquium, for their comments.
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CHAPTER 9
TREATMENTS OF MONOPOLIZATION IN
JAPAN AND CHINA
PING LIN AND HIROSHI OHASHI
9.1. Introduction
Monopolization (or abuse of a market dominant position) is prohibited under both Japan’s
Action of Prohibition of Privation Monopolization and Maintenance of Fair Trade, enacted
in 1947, and China’s Antimonopoly Law, passed sixty years later in 2007 (hereafter AMA and
AML respectively). This chapter describes how monopolization is treated under the compe-
tition laws in the two largest economies in the world behind the United States. In addition to
descriptions of the relevant legal provisions, it also focuses on the economic principles and
reasoning that have been adopted in Japan and China, as reflected in their laws and supple-
menting guidelines and regulations, and court rulings. Lastly the chapter attempts to provide
a comparative perspective to the legal and enforcement structures of these two countries.
9.2. Japan
9.2.1. Overview of Japan’s Antimonopoly Act

The principal antimonopoly act in Japan was drafted under pressure from the occupa-
tion forces and issued on 14 April 1947.1 Upon its enactment three months later on 20
1 Japan’s Anti-monopoly Act is an abbreviated name of “the Act on Prohibition of Private
Monopolization and Maintenance of Fair Trade.” An overview of the AMA is available, for example, in
Inoue (2007) and Wakui (2008).
Treatments of Monopolization in Japan and China 189
July, the AMA established the Japan Fair Trade Commission (hereafter JFTC), as the
primary antimonopoly regulatory body. The Commission’s duty has been to achieve the
purposes set forth in Article 1 of the act, which aims
to promote free and fair competition in markets, to stimulate the creative initiative of
entrepreneurs, to encourage business activities, to heighten the level of employment
and actual national income, and thereby to promote the democratic and wholesome
development of the national economy as well as to assure the interests of general
consumers.2
While Article 1 contains a multitude of purposes, most legal scholars and practitioners
consider the JFTC’s chief duty to be “to promote free and fair competition in markets.”
Looking back over the sixty-five years that have passed since the establishment
of Japan’s AMA and JFTC, we may observe a number of developments in both the
legal status and the enforcement structure associated with the general prohibition of
monopolization in Japan. In particular, the enforcement of monopolization was nota-
bly lax until the late 1990s, since which time it has been heightened considerably. To
understand the past lack of enforcement and the recent changes in the JFTC’s attitudes
towards regulations on monopolization, it is helpful to adopt a historical perspective
when assessing the AMA. Therefore, before proceeding directly to the issues of monop-
olization, this section begins with an overview of the AMA, followed by accounts of the
historical background to Japan’s antimonopoly act (section 9.2.2) and its enforcement
structure (section 9.2.3). Section 9.2.4 details specific regulations concerning monopo-
lization in Japan, with a particular focus on four types of exclusionary monopolization
in section 9.2.5. Section 9.2.6 provides a future perspective on Japan’s AMA and private
monopolization.
Drafted under the strong leadership of the American occupation forces, many provi-
sions of the AMA resemble the US federal antitrust laws, namely, the Sherman Act,3 the
Clayton Act,4 and the Federal Trade Commission Act.5 The AMA includes four major
categories of regulations: the prohibition of private monopolization (the first clause of
Article 3), the prohibition of unfair trade practices (Article 19), the prohibition of unrea-
sonable restraint of trade (the final clause of Article 3), and regulations on mergers and
acquisitions (Chapter 4). We briefly explain the first two categories below, as they are
relevant to the topic of this chapter.
Private monopolization is the legal name for monopolization in Japan. The word “pri-
vate” originally referred to both for-profit and non-profit businesses, as distinct from
public businesses and those with governmental functions. However, such a distinction
is no longer clearly maintained, and the regulations on private monopolization can be
2 An unauthorized English translation of the act is available at www.jftc.go.jp/e-page/legislation/ama/
amended_ama.pdf.
3 Sherman Act 15 USC §§ 1–7 (2000).
4 Clayton Act 15 USC §§ 12–27 (2000).
5 Federal Trade Commission Act 15 USC §§ 41–58 (2000).
190 Ping Lin and Hiroshi Ohashi
applied to state-owned enterprises.6 The regulations prohibit any exclusion or control

of the business activities of other firms resulting in a substantial restraint of trade in a
relevant market, as we will define later in section 9.2.4.
Unfair trade practices refer to certain business activities defined in Article 2.9 of the
act and are designated by the JFTC. They are regarded as a concept unique to the AMA.
Conduct subject to the regulations of unfair trade practices includes activities such
as abuse of superior bargaining position, below-cost pricing, refusal to sell, and nine
other such violations. Indeed, the regulations on unfair trade practices were originally
viewed as a supplemental role in antitrust enforcement, and cover situations not usu-
ally considered to be the domain of competition laws, such as the protection of con-
sumers and small- and medium-size enterprises (SMEs). It is widely believed that it is
easier to establish a violation of unfair trade practices, which requires “a tendency to
impede fair competition,” than it is to establish a violation of the provisions prohibit-
ing private monopolization, which requires “a substantial restraint of trade” (Takigawa,
2009; Negishi and Funada, 2010). The provisions in the act against unfair trade practices
have been criticized by business and academic groups for their unclear standards delin-
eating illegal conduct. This issue is one of the primary reasons why the regulations on
private monopolization were inactive until the late 1990s, as we will discuss further in
the remaining sections.
9.2.2. Historical Background of the Japanese Act

9.2.2.1. The Original AMA: 1947 to 1953
The original AMA7 was drafted by Judge Posey T. Kime of the Antitrust and Cartels
Division of the General Headquarters of the Allied Forces, and passed by the Imperial
Diet on 31 March 1947. This date was the last day before the Diet was abolished by
the order of the Allied Forces. The original AMA contained the same provisions in
its Article 3 (the prohibition of private monopolization and unreasonable restraint
of trade) as those in the current AMA; however, it contained several unique features
not found in the current act that were sometimes considered severer than US anti-
trust laws. These measures mandated (1) the strict control of business combinations
(Articles 9–16), (2) the per se illegality of cartels (Article 4), and (3) the prohibition
6
The cases against state-owned enterprises include the Metropolitan Slaughter House Case (Supreme
Court, 18 November 1989; 43 12 MINSHU 2078), Municipal Bus for Aged Citizens case (Yamaguchi
District Court Shimonoseki Branch, 16 January 2006; 52 SHINKETSUSHU 918), Yamato Transport
v. Japan Post (Tokyo High Court, 28 November 2007; 2006 (Ne) No. 1078), New Year Postcard Case
(Supreme Court, 18 December 2008; 45 SHINKETSUSHU 467), among others.
7 JFTC (1997) is an authoritative reference to the history of the AMA and JFTC. Kisugi (1999)
summarizes the history before 1977, and Kojo (1999) summarizes the period after 1977. As we will
discuss below, the name of the original AMA, The Law Relating to Prohibition of Private Monopoly and
Methods of Preserving Fair Trade, differs from the current one.
of unreasonable differences in terms of economic power among business entities

(Article 8).
There was a view in the office of the Supreme Commander of the Allied Powers (the
so-called SCAP) that the concentration of economic power was primarily responsible
for the sense of national militarism that had carried Japan into the Second World War. In
particular, the SCAP looked critically upon the zaibatsu (at the time principal four were
Mitsui, Mitsubishi, Sumitomo, and Yasuda). Through such conglomerates, often a sin-
gle family alone held the ownership of hundreds of businesses. The zaibatsu were viewed
as controlling not only finance, industry, and commerce, but also major functions of
the government. No doubt the SCAP perceived it essential to dissolve the zaibatsu in
order for Japan to govern itself as a free and democratic nation. Indeed, in the same
year as the original AMA was passed, the SCAP enacted the Law of the Elimination of
Excessive Concentration of Economic Power (hereafter LECP), and designated a total of
325 companies to be dissolved for standing in violation of the law. As shown in figure 9.1,
the JFTC appeared to spend most of its resources in enforcing the aforementioned three
activities along with LECP (under the heading of “others”), and only three violations
were reported under private monopolization during the period.
A few years of experience enforcing the original AMA made apparent that the con-
centration measure was not useful, even sometimes harmful, to the recovery of the
Japanese economy. Indeed, damages incurred from the Second World War were so
devastating8 that a quick economic recovery would not have been possible without
the help of the zaibatsu and other large companies. To rebuild the Japanese economy
and to transform the country into a fully industrialized nation capable of serving
as a wall against communism, it was deemed essential to maintain some economies
of scale in industries. This feeling culminated when Japan signed the San Francisco
Peace Treaty to regain its independence in 1951. Two years later, the original AMA
was amended and the major provisions of the act were relaxed or eliminated with
regard to the three features unique to the original AMA listed above. First, the con-
trol of business combinations was eased so much that banks were allowed to hold
shares—a prime example of the fact that Japanese anticompetition policies became
more tolerable of the zaibatsu. Second, concerted practices were no longer deemed
per se illegal, but instead were judged according to a rule of reason; “[a]‌substantial
restraint of competition in any particular field of trade” was required for concerted
practices to be considered illegal under the regulations pertaining to the unreason-
able restraint of trade, then as today. The change in the treatment of the cartel regula-
tions opened up many types of cartelized activities led by government authorities,
such as MITI, then the Ministry of International Trade and Industry, under the
names of “depression cartels” or “rationalized cartels.” As many as 49 cartel activities
were legally exempted from the AMA in the 1960s.
8 To take an example from the steel industry, more than 70% of blast furnaces were rendered
inoperable by wartime bombardment.

70
Others
Unfair trade practice
Cartels
60
50
40
30
20
10
0
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
FIGURE 9.1 The Number of Administrative Procedures (Cease-and-Desist Orders and Surcharge
Payment Orders)
Third and finally, the prohibition of unreasonable differences in terms of economic

power among business entities was eliminated from the act. However, at that time,
public pressure grew, calling for the protection of small and medium-sized enter-
prises conducting business transactions alongside larger-sized corporations. Thus,
the government introduced two new provisions in the AMA. One banned the abuse of
bargaining position, which has since become known as the abuse of superior bargain-
ing position under the current act.9 The other provision was the Act against Delay in
Payment of Subcontract Proceeds, Etc. to Subcontractors (the so-called Subcontract
Act), which entered into force in 1955. Both of the new provisions have been powerful
tools to protect small and medium-sized enterprises. In particular, in cases where the
9
Note that abuse of bargaining position was not considered an unfair “method” of competition,
but rather regarded as an unfair trade “practice.” This new provision regarding the abuse of bargaining
position presumably led to this new provision.
payment of subcontract proceeds is delayed, the Subcontract Act automatically charges

main subcontracting firms, defined as entities with capital or total contribution exceed-
ing 300 million yen, of abusing their superior position, without considering the subcon-
tracting firms’ situations to the contrary.
9.2.2.2. Competition Policies versus Industrial Policies: 1953–1977

During the late 1950s and the 1960s Japan experienced rapid economic growth. This
coincides with the period when transactions of goods and capital were liberalized, as
Japan became a member of the GATT and IMF. Faced with increasing pressure from
international competition, MITI came to hold the view that it was essential for Japanese
firms to expand in size and achieve the maximum potential from economies of scale.
A set of policies led by MITI that aimed to restructure industries through mergers and
acquisitions, or through depression and rationalized cartels, were known as industrial
policies,10 tensely squaring off against competition policies.
The tension reached new heights with the merger case between the Yawata and Fuji
Iron and Steel companies in the late 1960s. It is interesting to note that the two com-
panies were originally the same company under the name of Nippon Steel, which had
been previously dissolved by the LECP, the stringent competition law mentioned above.
Thus, it would be a symbolic defeat for competition policies and a victory for indus-
trial policies should the new proposed merger pass muster. As a matter of fact, however,
the JFTC had only a minor influence in this merger case. The unification of Yawata and
Fuji took place in 1970, and Nippon Steel was created once again, leading to the second
largest steel producer in the world after U.S. Steel. Competition policies would not be
enforced afterwards in Japan until the next amendment to the AMA in 1977. Indeed, vio-
lations in private monopolization led to merely four cases during the quarter-century
from 1953 to 1977.
9.2.2.3. The Amendment of 1977

Inflation rates as high as 23 percent after the Oil Crisis of 1973 shed new light on the
importance of competition policies. Public outcry against the high inflation rates and
possible price-gouging behavior demanded strict enforcement of the AMA from the
government. To effectively enforce the law to fight against market concentration, an
amendment to the AMA was passed in 1977. Among a number of changes introduced
with this amendment, a primary one worth mentioning concerns the introduction of
surcharges. The JFTC was empowered to order participants in pricing cartels to pay
administrative fines to deprive them of the excess profits reaped by such behavior. The
amount of the surcharges was calculated according to a formula, namely, as a percent-
age (stipulated in the act) of the sales amount for products or services related to the
10
While there has been no clear definition of the term (and this is perhaps the reason why industrial
policies gained extensive support in the first place), from an economics perspective, industrial policies
are defined as those that facilitate a shift in inter- and intraresource allocations among sectors to correct
for possible market failures.
anticompetitive activity involved. The types of anticompetitive activities applicable to

surcharges under the act expanded to private monopolization in 2006. However, the
nature of the surcharge system has essentially remained the same since its introduction.
We discuss the surcharge system in greater detail in section 9.2.3.2.
The introduction of surcharges, however, did not lead to an increase in the num-
ber of JFTC cases involving anticompetitive behavior. As figure 9.1 shows, the num-
ber remained quite low in the period immediately following 1977. While the JFTC for
the first time lodged a criminal complaint against a wholesale gasoline cartel,11 it did
not seek subsequent charges against other firms potentially conducting price-gouging
behavior afterwards. Private action for compensation damages was difficult to seek
given the high standards of proof demanded on the side of plaintiffs.
9.2.2.4. The Japan-US Structural Impediments Initiative in the

1980s and Afterwards
The bilateral relationship between Japan and the United States was put to the test on
several occasions from 1989 through the first half of the 1990s. Against the backdrop of
continued large trade imbalances, pressure for tougher policies towards Japan intensi-
fied in the United States. Individual trade issues, especially involving semiconductors,
raised in connection with the Super 301 provision of the Omnibus Trade Act and how to
deal with the Structural Impediments Initiative (hereafter SSI), all emerged as a source
of diplomatic contention between the countries.
The SSI talks were initiated by President George Bush and Prime Minister Sosuke
Uno in an attempt to resolve the structural problems that stood as impediments to
the adjustment of trade and the trade balance between the two countries. The United
States faulted Japan for one such structural impediment: namely, its exclusion-
ary business practices and accompanying poor enforcement record. Japan’s stance
toward competition proved the subject of intense discussions during the talks and
changed as a direct result of them. For, following the SSI, the JFTC increased the rates
of surcharges in response to US criticisms of the JFTC’s underdeterrence of anticom-
petitive behavior. We further elaborate upon the Japanese surcharge system in sec-
tion 9.2.3.2.
The JFTC also increased the number of staff and other human resource capacities
to improve the enforcement system of the JFTC. The scope of exemptions under the
AMA was also narrowed; the JFTC scaled down the exemption of resale price main-
tenance and wholly abolished the existing depression and rationalization cartels. As a
consequence, the number of JFTC cases increased in the 1990s. It is worthwhile to note,
however, that no cases were reported regarding violation of private monopolization for
24 years in the period from 197212 to 1996.13
11
Supreme Court, 24 February, 1984; KEISYU 38.4.1287.
12
Toyo Seikan, 18 September 1972; SHINKETSUSYU 19.87.
13 Japan Medical Food Association, 8 May 1996; SHINKETSUSYU 43.209.
9.2.3. Structure of Japanese Antitrust Enforcement

The United States delegates antitrust enforcement to two agencies: the Antitrust Division
of the Department of Justice (hereafter DOJ) and the Federal Trade Commission (here-
after, US-FTC). While the AMA did emulate American antitrust laws, antitrust enforce-
ment in Japan bears no resemblance to the practices in the United States. Unlike the
United States, Japan has only one antitrust agency. The JFTC was apparently modeled
after the US-FTC: it is an independent agency under the Prime Minister’s Office. The
JFTC has five commissioners, including one chairperson, who are appointed by the
prime minister with the consent of both houses of the Diet (Article 29). Commissioners
have five-year terms (Article 30), and they are protected against pay cuts (Article 36) or
removals without cause or without their consent (Article 31).
Having only one antitrust agency responsible for enforcing the act has been advanta-
geous in the sense that it has helped promote the development of a uniform national
competition policy. On the other hand, it makes the JFTC maintain a jurisdictional
monopoly in antitrust enforcement. Miwa and Ramseyer (2005) and Harris and Ohashi
(2011) argue that this kotorii-chusinsyugi, or JFTC-centrism, affords the JFTC a degree of
discretion in the application of the law. An illuminating example comes from the rela-
tionship between the private monopolization and the unfair trade practices regulations.
Figure 9.1 indicates that, throughout the period from 1947 to 2011, the JFTC’s enforce-
ment of private monopolization was weak. This is perhaps because the JFTC required
high standards of proof to establish evidence of adverse effects on competition in the
relevant market. Before 2009 only cease-and-desist orders were imposed for the regula-
tion of exclusionary conduct, as was the case for the regulation of unfair trade practices.
Since the unfair trade practice regulations do not require proof of adverse competitive
effect and they essentially cover the regulations on private monopolization, the JFTC
tends to make use of the former regulations, even if the application of private monop-
olization regulations seems appropriate. It was indeed expected that the regulation of
unfair trade practices would elicit less opposition from the private parties involved
because it did not come with surcharges or criminal penalties.
With the aim of improving the act’s effectiveness and deterrence effects, the JFTC
brought in administrative surcharges under the category of private monopolization;
controlling conduct in the 2006 amendments and exclusionary conduct in 2009. The
JFTC also made public the new guidelines against exclusionary conduct. This series of
revisions leaves the clear impression that the JFTC will intensify enforcement activities
against private monopolization, especially in the area of exclusionary conduct.
A troubling issue is that the 2009 amendments to the AMA also extended coverage
of surcharges to include certain types of unfair trade practices, such activities as unjust
low-price sales and abuse of a superior bargaining position, as the result of strong politi-
cal influence. Note that the regulations concerning unfair trade practices are often con-
sidered a precautionary measure to protect consumers and SMEs, on which Japanese
politicians are very keen as a voting bloc. Since private monopolization and unfair trade
practices are now subject to surcharges, some observers believe that the unfair trade
practices regulations should no longer be supplemental to the private monopolization
regulations and that these two sets of regulations should be unified (Murakami, 1997).
9.2.3.1. Procedure for Antitrust Cases

The JFTC formally takes two types of administrative measures—a cease-and-desist
order and a surcharge payment order—if it finds a violation of AMA. Subsequently, the
Decision and Lawsuit Division under the JFTC initiates a formal administrative hearing
(hereafter Shinpan hearing) upon the request of the respondent. The Shinpan hearing
adopts the adversary system, in which independent referees (namely hearing examin-
ers), who are members of the JFTC staff, make a judgment. The structure of the Shinpan
hearing has long been criticized as being rather inquisitorial, because within the JFTC
staff no clear firewall has been erected between Shinpan referees and Shinpan prosecu-
tors (see, e.g., Murakami, 1997).
During the formal hearing, the respondent firm may challenge the JFTC’s fact-finding
and application of the law and may make a remedial proposal. If the JFTC finds that the
remedy proposed by the respondent is appropriate, the JFTC drops the case,14 or orders
the firm to perform the remedy. If the JFTC finds that a violation exists, the JFTC issues
a formal decision at the end of the Shinpan hearing procedure, ordering the firm to per-
form the remedy.
If the parties are dissatisfied with the decision delivered after the Shinpan hearing,
they may enter into litigation at the Tokyo High Court, which has exclusive jurisdic-
tion to revoke the JFTC judgment. In an instance where the judicial review is exercised,
the court is bound by the facts found in the JFTC’s decision if such facts are “supported
by substantial evidence” (Article 80). If the court finds that a reasonable person would
reach the same conclusion as did the JFTC, based on the same facts the court is obliged
to uphold the JFTC’s findings. Thus, under the judicial review system, the plaintiff tends
to argue that the facts upon which the JFTC’s decision was made are not supported by
substantial evidence. The plaintiff may also file an appeal against the judgment of the
Tokyo High Court to the Supreme Court.
9.2.3.2. Sanctions
Along with the formal administrative procedures (namely, a cease-and-desist order and
a surcharge payment order), criminal and civil procedures in court may also be insti-
tuted, and violations of private monopolization are no exception. Civil procedure is dis-
cussed in section 9.3.3. Regarding criminal procedure, the JFTC has the sole authority
to file an accusation with the prosecutor general, but only when the public investiga-
tor commences the investigation. In instances where the prosecutor general decides not
to prosecute a case, the decision must be reported with reasons to the prime minister
(Article 74(3)). No criminal charges have been executed against private monopolization,
and no one has been imprisoned under violations of the AMA.
14
The recent case is JASRAC (2012), as we discuss in section 4.
As discussed in section 9.2.2, the surcharge system was introduced in 1977. The origi-
nal purpose of the surcharge was to disgorge undue profits obtained from anticompeti-
tive activities, and this purpose still remains alive in the current system. Surcharges are
a rigid administrative fine. There are two aspects to the rigidity: first, the JFTC is wholly
obliged to issue a surcharge order if it is applicable. Second, the amount of the surcharge
is calculated according to a formula, namely, as a percentage (stipulated in the act) of the
sales amount for products or services related to the anticompetitive activity involved.15
The surcharge rate differs according to each firm’s capital or total amount of contribu-
tion and according to line(s) of business, not according to the severity of damages or the
amount of excess profit accrued by the alleged anticompetitive behavior.
The surcharge payment system has significantly evolved since 1977, when it was first
introduced into the regulations on cartels. Initially, surcharges were a set rate of 1.5 per-
cent of sales of products related to the alleged anticompetitive activity, and subsequently
increased to a rate of 6 percent in 1991.16 In order to improve the deterrence effects of
the act, activities under the heading of private monopolization were added under the
scope of surcharge payments in the 2006 amendment to the AMA. The surcharge rate
increased still further, from 6 percent to 10 percent, at the same time. Because of the pos-
sibility that, at this higher rate, the surcharge could exceed the amount of undue profits
accrued from the alleged anticompetitive behavior, the JFTC effectively added a new
function to the role of surcharges in that they would serve as deterrence against viola-
tions of the AMA.
In the 2009 amendments, the scope of the surcharge payment order was further
expanded to incorporate exclusionary conduct falling under the private monopoliza-
tion regulations and five designated activities under the unfair trade practices category
(namely concerted refusal to trade, discriminatory consideration, retail price mainte-
nance, abuse of superior bargaining position, and unjust low-price sales). The surcharge
rates were set at 6 percent of sale values for exclusionary conduct and in the range of 1 to
3 percent for the five unfair trade practices specified (see table 9.1 for details).17 Two other
changes to the surcharge system accompanied the 2009 amendments: the introduction
of a leniency program to promote voluntary notification of violations from cartel mem-
bers themselves; and the introduction of greater flexibility in surcharge calculations.
While these changes to the available pecuniary sanctions may enhance the enforce-
ment effectiveness of the AMA, there remains room for improvement. In particu-
lar, note that in calculating the surcharges, the JFTC takes into account only domestic
sales. Thus, it is currently impossible for the agency to collect fines from companies that
15 Note that a reduction or exemption through an application of the leniency program and
coordination with criminal penalties should be considered an exception. We will discuss this point
shortly in this subsection.
16 The rates shown here are applied to the category of a large company mainly in the manufacturing
sector; small and medium-sized companies were charged at lower rates.

17 To be precise, the rate of 3 percent of sale values was set for concerted refusal to trade,
discriminatory consideration, retail price maintenance, and unjust low-price sales; and the rate of
1 percent of transaction values (sales or purchase values) was imposed for the abuse of superior position.
conduct their business abroad, that is, that participate in cartel activities but do not sell
to Japan. This structure of the surcharge system appears particularly troublesome given
that the JFTC must enforce the law in a globalized economy where cross-border trans-
actions are common. For example, in the Marine Hose Case (2008),18 surcharges were
calculated based on sales to consumers located in Japan, and foreign companies that
were identified as taking part in the cartel activity under the cease-and-desist order were
exempted from the surcharge payment. In the Cathode-Ray TV Tube Case (2009),19
surcharges were levied based on the sales ordered by Japanese TV manufacturers; how-
ever, a majority of cathode-ray TV sets under the surcharge payment order were sold
outside of Japan. As multiple jurisdictions have introduced competition laws and begun
to enforce cartelized activities, double or even triple punishments for the same conduct
across nations have emerged as a real possibility.
While it is often argued in Japan that a discretionary administrative fine violates
transparency and predictability concerns from the respondents’ point of view, it may be
worthwhile to reconsider introducing a discretionary surcharge system. Such a system
is more in line with the original purpose of the surcharge, in that it accounts for the dif-
ference in the amount of disgorged undue profit. Of course, calculating the appropriate
Table 9.1 Surcharge Rates

Sector Types
Manufacturing
and others Retail Wholesale
Unreasonable Restraint of Trade 10% 3% 2%

(4%)a (1.2%)a (1%)a
Private Monopolization
Controlling Conduct 10% 3% 2%
Exclusionary Conduct 6% 2% 1%
Unfair Trade Practices
Concerted refusal to trade, 3% 2% 1%
discriminatory consideration, retail
price maintenance, and unjust low
price sales
Abuse of superior bargaining 1%
position
Note:
a: The number inside the paranthesisis the rate applied to small and medium-sized enterprises.
18
JFTC, 20 February 2008; 54 SINKETSUSYU 512. The cease-and-desist order and surcharge
payment order is also available at http://www.jftc.go.jp/en/pressreleases/uploads/2008-Feb-22.pdf.
19 JFTC, 9 October 2009; The cease-and-desist order and surcharge payment order are also available
at http://www.jftc.go.jp/en/pressreleases/uploads/2009-Oct-7.pdf.
amount of a discretionary surcharge requires the discipline of economics, which may be

lacking in current JFTC practices.20
9.2.3.3. Civil Procedure

The lack of effective consumer involvement in enforcement was long a feature of the
AMA. Even though the AMA was strongly influenced by its American counterparts,
as we have previously noted, there was a marked tendency in the law for both criminal
and administrative sanctions to be exercised solely by the JFTC, undermining the role
of private initiatives. In response to criticisms, the civil injunction system was finally
implemented in 2000. Unfortunately, this system currently demands extremely high
standards of proof for the existence of damage from complainants, and therefore no civil
injunctions have successfully been approved as of today.
The no-fault compensation suit is a private lawsuit specifically prescribed under
Article 25 of the AMA. The damage award is not trebled: instead, single damages are
payable. A firm whose interest is seriously injured by unfair trade practices may seek
injunctive relief from the court for the suspension of such conduct (Article 24 of the
act). Both of these private resources have failed to work properly, however. That is pre-
sumably because plaintiffs, under the civil litigation procedures in Japan, do not have
sufficient capacity to collect evidence to prove the existence of violations. As we will
discuss below, these private actions can in principle be a complement to, rather than a
substitute for, JFTC’s enforcement, and they should thus be activated effectively.
9.2.4. The AMA on Monopolization

The regulation of monopolies is defined as the regulation of “private monopolization”
in the AMA. Private monopolization is an important pillar of the AMA. It is therefore
interesting to note, as has already been pointed out in section 9.2.2, that the regulation of
private monopolization was rarely enforced, resulting in only a handful of cases before
the late 1990s (as shown in figure 9.1). This section describes the general rules that gov-
ern private monopolization under the AMA. Section 9.2.5 then takes up certain types of
activities that fall under the category of exclusionary conduct.
9.2.4.1. Private Monopolization under Japanese Law

In the provision contained in Article 2(5), private monopolization is defined as
such business activities, by which any entrepreneurs, individually or by combination

or conspiracy with other entrepreneurs, or by any other manner, excludes or controls
the business activities of other entrepreneurs, thereby causing, contrary to the public
interest, a substantial restraint of competition in any particular field of trade.
20 According to Global Competition Review (2012), the share of economists employed at the JFTC is
5 percent, which is smaller than in other industrial countries.

Private monopolization is prohibited per the terms outlined under Article 3. Before
considering Article 3, we first provide an explanation of each component of Article 2(5)
in detail.
Entrepreneurs: The entity referred to Article 2(5) is an individual entrepreneur, or a
multiple number of entrepreneurs.21 According to the article, the J-FTC regulates under
the private monopolization heading any conspiracy among many entrepreneurs that
involves excluding or controlling competitors. In practice, however, the private monop-
olization label is applied to unilateral conduct; coordinated conduct such as conspiracy
is usually considered under the regulation of unreasonable restraint of trade. As dis-
cussed below, since exclusion and control exhibit wrongful behavior on the part of a
monopolizing party, private monopolization is usually considered as inherently “con-
trary to the public interest.” In this chapter, we use the terms “entrepreneur” and “firm”
interchangeably.
Exclusion: The term “exclusion” indicates an act that makes it difficult for other entre-
preneurs to continue their business operations (thus eventually forcing their exit) or an
act that deters the entry of new entrepreneurs into a relevant market. The types of con-
duct that fall into this group include predatory pricing, exclusive dealing, tying, refusal
to supply, and discriminatory treatment. As economists know, it is difficult to draw a
clear line between normal competitive business practices and anticompetitive exclu-
sion, and the JFTC is well aware of the issue. The Guidelines for Exclusionary Private
Monopolization under the Antimonopoly Act, issued for the first time in 2009 (hereaf-
ter, “the Guidelines”), stipulate “in the case that an entrepreneur supplies a low-cost and
high-quality product by its own efforts such as improving efficiency [to which the JFTC
refers as “competition on merit”], and if such conduct would make it difficult for com-
petitors to continue their inefficient business activities, it does not fall under exclusion-
ary conduct because it is a result of fair and free competition, which the Antimonopoly
Act intends to promote.”
To constitute exclusionary conduct, such conduct must cause the “substantial
restraint of competition in any particular field of trade,” and does not have to result in
the actual elimination of competitors from the market. At the same time, if the elimina-
tion of competitors from the market does not lead to substantially hindered competi-
tion, the conduct does not fall under the heading of “exclusion.” The Guidelines also
make it clear that the intent to exclude is in itself not essential for the JFTC to establish
exclusion; however, the intent of entrepreneurs, if identified, would help convince the
JFTC of an important fact that might lead to the presumption that the alleged conduct is
exclusionary.
21 Article 2(1) of the AMA defines an entrepreneur as “a person who operates a commercial,
industrial, financial, or any other business.” Any other business is interpreted as “any entity that engages
in business activities in which economic interest of any nature is provided and performance in return
is repeatedly and continuously received.” A natural person and a legal entity can both be entrepreneurs,
either incorporated or unincorporated.
When the market is correctly defined, an entrepreneur (or entrepreneurs operating

collectively) must have a large market share to exercise exclusionary conduct. The JFTC
prioritizes its investigation on cases in which the entrepreneur owns a market share of
the product in question exceeding 50 percent after the alleged exclusionary conduct
takes place.22 Of course, the JFTC quickly adds the caveat in the Guidelines that how it
prioritizes its investigation resources is subject to the type of activities in question, the
degree of product differentiation, and other features of market structure that we will
discuss in section 9.2.5.4.
One of the unique features of the AMA, compared with EC and US laws, is that, even
when the JFTC finds no exclusionary practice, the alleged conduct can be deemed anti-
competitive under the regulation of unfair trade practices, as discussed in sections 9.2.1
and 9.2.3.
Control: Another form of conduct that is deemed to be monopolization under the
AMA is the act of “controlling” the business activities of other entrepreneurs, causing
a substantial restraint of competition in a particular field of trade. Compared with the
classes of conduct associated with exclusion as discussed above, the concept of control is
not as clearly defined in the JFTC’s practice from the vantage of economics. Only three
cases have been identified by the JFTC as private monopolization control violations,
two of which—the Japanese Medical Foods Case (1996)23 and the Paramount Beds Case
(1998)24—were found to be exclusionary conduct as well. Thus, the only private monop-
olization case involving a control violation occurred more than half a century ago: the
Noda Shoyu Case of 1957.25 Therefore, exclusion has been and will be the primary focus
of private monopolization regulations in Japan.
Particular field of trade: The JFTC judges the applicability of exclusionary private
monopolization according to the degree of impact the alleged conduct has on competi-
tion in “a particular field of trade.” The term “particular field of trade” is mentioned also
in Article 2(6), concerning the unreasonable restraint of trade, and in Article 15 on busi-
ness combinations. As stated in the Guidelines, “a particular field of trade” has two main
dimensions: the scope of the products (namely goods and services) under investigation
and the geographical scope. Both types of scope are determined on the basis of substi-
tutability from the consumers’ perspective. If necessary, the JFTC would also consider
suppliers’ substitutability—how easily and quickly suppliers are able to switch over their
sales and production processes from one product to another.
One primary method of defining a particular field of trade is to rely on the small but
significant nontransitory increase in prices (hereafter SSNIP) test, introduced in the
US Merger Guidelines of 1982. These guidelines have been widely used by competi-
tion authorities to define relevant markets in a variety of contexts. The SSNIP test was
22 The “share of the product” refers to the share of the primary tying product in the case of tying
discussed in section 5.2 and to the share of the upstream market in the case of refusal to supply and
discriminatory treatment described in section 5.3.
23 JFTC, 8 May 1996; 43 SHINKETSUSYU 32.
24 JFTC 31 March 1998; 44 SHINKETSUSYU 362.
25 Tokyo High Court, 25 December 1957; 10 12 KOUSAIMINSYU 743.
brought in 2006 under an amendment to Japan’s Guidelines for the Application of the
Antimonopoly Act Concerning the Review of Business Combination.26 However, it has
not been intensively used in Japan, even in the course of horizontal merger investigations.
Substantial restraint of competition: In the NTT East Case (2011) discussed in the
next section, the Supreme Court held that “substantial restraint of competition in a par-
ticular field of trade” should be interpreted as “establishing, maintaining, or strengthen-
ing the state in which a certain entrepreneur or a certain group of entrepreneurs can
control the market at will by being, to some extent, free to influence price, quality, quan-
tity, and other various conditions after competition itself has lessened.”
Given the Supreme Court’s assessment of substantial restraint of competition, it may
be necessary but not sufficient for the firm to possess a certain level of market share.
The exclusion of a firm that holds merely a percentage of the total market share does
not seem to generally restrain market competition. Indeed, as described in section 9.2,
the JFTC prioritizes investigating cases in which the product in question accounts for
more than half of the relevant market after the alleged conduct takes place. Defining
“a particular field of trade” is a task necessary to calculate this market share, but the
market share threshold provides a mere guideline as to how to allocate the JFTC’s inves-
tigatory resources. As stated in the Guidelines, whether or not the agency challenges
the practice as a violation of private monopolization is assessed on a case-by-case basis.
The JFTC does not apply a specific criterion; according to the Guidelines, it consid-
ers the following four aspects: (1) market structure; (2) potential competitive pressure;
(3) countervailing buying power, and (4) efficiency. We discuss how these four aspects
are interlinked in the JFTC’s assessment of exclusionary practice in the following sec-
tion. It should be noted that, as with horizontal merger investigation, exclusion resulting
in (near) monopoly is usually not considered procompetitive by the JFTC.
9.2.5. Four Types of Exclusionary Conduct

While it is difficult to characterize all possible forms of exclusionary conduct, the JFTC
describes four typical categories of exclusion in the Guidelines. They are below-cost pric-
ing, exclusive dealing, tying, and the refusal to supply and discriminatory treatment. We
describe each of them in turn below, along with a selective set of recent JFTC decisions
and court judgments as available. Note that exclusionary conduct under the regulations of
private monopolization and unfair trade practices in the AMA is not limited to these four
types, and that the JFTC will investigate alleged conduct in the context of individual cases.
9.2.5.1. Below-Cost Pricing

The JFTC acknowledges that price-cutting competition based on entrepreneurs’ own
efforts constitutes the core of competition, and thus that intervention in this process
should be kept at a minimum to promote fair and free competition. The practice of selling
26
http://www.jftc.go.jp/en/legislation_guidelines/ama/pdf/110713.2.pdf.
a product at a very low price—at a level that would not allow an entrepreneur to recover
its average avoidable cost (hereafter, AAC)—would normally be considered lacking in
economic rationality and thereby undermine the competition process. The AAC is
defined as the average of product-specific fixed costs and variable costs that could have
been avoided if the entrepreneur had not produced extra output. The JFTC, on the practi-
cal level, takes the AAC as the cost that would not be generated unless the product was
supplied. Below-cost pricing, setting a price below “the cost that would not be generated
unless the product was supplied” so as to make it difficult for an equally or more efficient
competitor to stay in business, may fall under exclusionary conduct under the AMA.
While they can be defined at the theoretical level, determining that costs are actually
“the cost that would not be generated unless the product was supplied” is critical in the
JFTC’s practical assessment of below-cost pricing. The Guidelines explain that whether
or not the cost will vary with the quantity of the product supplied is an important con-
sideration in the assessment. For example, variable costs in economics, or production
and purchasing costs in corporate accounting terms, are presumed to be “the cost that
would not be generated unless the product was supplied.”
Setting a product price below the average total cost (namely the cost required for sup-
plying the product) but not less than “the cost that would not be generated unless the
product was supplied” is unlikely to be deemed significant enough to drive an equally or
more efficient competitor out of the market. Thus, such price-setting behavior may not
fall under the category of exclusionary conduct, unless there are exceptional circum-
stances in which large quantities of the products were supplied at that price over so long
a period that such conduct would not be considered economically rational even from a
long-term perspective.
A recent case is K.K. Usen Broadband Networks, K.K. Nihon Network Vision.27 Usen
Broadband Networks (hereafter Usen) is the largest cable broadcasting company in
Japan, and engaged in a sales contract with Nihon Network Vision (hereafter NNV).
Usen, jointly with NNV, offered a discounted monthly listening fee only to the custom-
ers of their major competitor, Can System, thereby increasing its market share from
68 percent to 72 percent, while Can System lost 6 percent of its market share in one year.
The JFTC issued a cease-and-desist order in 2004 against Usen, finding that it excluded
the business activities of Can System. While the JFTC did not quantitatively assess
whether the discounted fee offered to the Can System customers was below the “cost”
of either Usen or NNV, it appeared to have found both Usen’s and NNV’s pricing strat-
egy anticompetitive in that they targeted specifically Can System among other rivals.
It remains to be seen how the JFTC will determine below-cost pricing before one can
assign more cases to this category.
9.2.5.2. Exclusive Dealing

Exclusive dealing involves a supplier conditioning its sales to customers on their agree-
ment not to purchase from its rivals. Prohibiting customers from purchasing rivals’
27
13 October 2004, 51 SHINKETSUSYU 518.
products is not of itself considered to be anticompetitive, in that every unit sold by a

supplier would have been sold by its rivals given the market size. However, if such pro-
hibition or restraint of transactions with competitors results in driving rivals out of the
market, such conduct is deemed to be anticompetitive and falls under exclusive dealing
regulations.
Exclusive dealing takes various forms other than prohibiting the customers from
transacting with rivals. For example, one form occurs when an entrepreneur requires
customers to purchase a minimum amount. Another form might occur if an entrepre-
neur should require one or more customers to obtain approval to deal with the entrepre-
neur’s rival. The latter form could be anticompetitive if the given entrepreneur provides
benefits to customers not to make transactions with its rivals.
The JFTC considers various aspects of market structure as a whole in its assessment of
exclusive dealing, including the degree of market concentration, product characteristics
and differentiation, economies of scale in production and distribution, market dynam-
ics, and the difficulty of entry. For example, if the market exhibits strong network effects
and/or reputation, or if competitors are subject to capacity constraints, exclusive dealing
would likely be effective in driving rivals out of the market. The Guidelines also mention
an anticompetitive aspect in the use of stipulated damages in the contract. Aghion and
Bolton (1987) and Whinston (2006) showed that a buyer and seller could use stipulated
damages clauses to extract profits from a potential entrant. In their models, the damage
provision typically creates inefficiency, as it makes the buyers transact with the potential
entrant less frequently than is optimal.
The JFTC expresses its concern in the Guidelines that the rebates could serve as means
of facilitating exclusive dealing, although there are many instances when rebates work
procompetitively through stimulating demand. Especially in cases in which the rebate
amount is tied to the volume of transactions conducted with the entrepreneur who pro-
vides the rebates, and this amount is progressively set in accordance with volume, the
JFTC is careful to monitor possible instances of exclusive dealing. The Intel Case (2005)
below provides insight into what the JFTC considers to be unlawful rebates.
9.2.5.2.1. The Intel Case (2005)

Intel Corporation of the United States has a subsidiary in Japan, which sells central pro-
cessing units (CPUs) to Japanese PC manufacturers with a substantial market share.
Advanced Micro Devices (hereafter AMD) in Japan began selling CPUs at a lower price
than Intel Japan, and improved its market share from 17 percent to 22 percent in the
period from 2000 to 2002. In response to this aggressive pricing by AMD Japan, Intel
Japan offered price rebates to the five major Japanese PC manufacturers and subsidies
related to the “Intel Inside Program” supporting advertisements for PC manufactur-
ers products using Intel’s microprocessors. In order for the leading manufacturers to
be eligible for the rebates and subsidies, however, Intel required the PC manufacturers
to purchase “X” percent of their required microprocessors from Intel, in which Intel set
a different value of X for a different manufacturer, such as Toshiba and Sony. After the
introduction of the rebates and subsidies program, the total market shares of Intel’s rivals
(mainly AMD and Transmeta) plummeted from 24 percent in 2002 to a mere 11 percent
in 2003. The JFTC found that Intel’s exclusivity conditions prevented the business activi-
ties of Intel’s rivals, and thus violated the prohibition of private monopolization.28
In the decision, the JFTC was not very clear as to how it evaluated a substantial
restraint of competition. As Amemiya (2005) clearly pointed out, the JFTC’s recommen-
dation order did not contain discussion of how the alleged harm to these competitors
would have resulted in adverse consequences to the PC manufacturers that purchased
the relevant products, nor did it explain why the competitors were unable to match the
rebates or subsidies offered by Intel to retain the business of these customers.
9.2.5.2.2. The JASRAC Case (2012)

The JFTC found on 27 February 2009 that JASRAC (Japanese Society for Rights of
Authors, Composers and Publishers), a dominant copyright management organization,
excluded other copyright management entities from the market by entering into “com-
prehensive contracts” with broadcasting companies for their musical works.29 Under the
contracts, JASRAC charged a fixed amount of total royalty payment, regardless of how
many licensed musical works were broadcast. JASRAC requested the commencement of
Shinpan procedures in order to challenge the cease-and-desist order levied against it by
the JFTC. During Shinpan procedures that commenced in May 2009, new evidence was
submitted indicating that JASRAC’s competitors were not really excluded from broad-
casting business, contrary to the claim in the cease-and-desist order.
The JFTC delivered a decision requiring that the cease-and-desist order be rescinded,
its reason being that there was no evidence to show that JASRAC’s royalty collection
method had the effect of damaging the business activities of other copyright manage-
ment organizations. The JFTC judged no exclusion be present on the basis of the evi-
dence that no actual elimination of competitors was observed in this case. This decision
is inconsistent with the JFTC’s prior findings including the decision made in the Intel
case (2005) discussed above. An action for the revocation of the JFTC’s decision has
been filed with the Tokyo District Court.
9.2.5.3. Tying
The practice of tying, under which a firm requires customers who are purchasing prod-
uct A also to purchase product B, has received a good deal of attention in economics lit-
erature. Tying itself should not be an anticompetitive practice, as it may create new value
for buyers that would not be realized if the products were to be independently offered
untied. However, tying the sales of a monopolized product to sales of partial substitutes
at an appropriate margin can be considered as leverage of monopoly power, particularly
when the substitutes could be otherwise obtained at competitive prices.
28
JFTC, 13 April 2005, 52 SHINKETSUSYU 341.
29
JFTC 12 June 2012. An English translation of the cease-and-desist order of 27 February 2009 is
available at http://www.jftc.go.jp/en/pressreleases/uploads/2009-Feb-27.pdf.
In practice, the essential matter is how the authority assesses two tied products, A and
B, and how it envisages the two sold separately. Considerable attention is given to iden-
tifying the market structure for the respective products, including the nature of user
demand, the degree of market concentration, and product characteristics, to name
a few. Take the example of a mobile phone set that integrates a digital camera. In the
Guidelines, the JFTC mentions that the features and usability of mobile phone sets are
substantially altered without digital cameras. Since a mobile phone set with a digital
camera can be regarded as a single product with distinct functions, the sales of a mobile
phone set that integrates a digital camera should not be considered a tying practice
under the current views held by the JFTC.
9.2.5.3.1. The Microsoft Case (1998)

The JFTC considered a Microsoft Japan licensing policy whereby Japanese manufac-
turers, including NEC and Toshiba, were offered licenses for the Excel spreadsheet
application, but only on the condition that they also took licenses for Microsoft’s
word-processing application, Word.30 In the process of negotiation, Microsoft rejected
proposals from personal computer manufacturers that requested the separate licensing
of Excel and Word.
At that time in Japan, Ichitaro, produced by Just Systems, was the most popular
word-processing application, followed by Microsoft Word, whereas Lotus 1-2-3 had
the largest share next to Microsoft Excel in the spreadsheet market. In 1998, the JFTC
found that Microsoft Japan’s conduct constituted an unfair trade practice under Item 10
of the General Designation (tie-in sales), and issued a recommendation decision to the
company to take remedial measures. Microsoft Japan accepted the recommendation.
Therefore, the JFTC issued a cease-and-desist order requiring Microsoft Japan to cease
imposing conditions on individual Excel licenses, to accept proposals by PC manufac-
turers to amend existing contracts to allow licenses for one or both of the Excel and
Word applications, and not tie the licenses given to PC manufacturers for any other soft-
ware to licenses for Word or Excel.
9.2.5.3.2. The Toshiba Elevator Case (1997)

Toshiba Elevator, a subsidiary under the Toshiba Group that manufactures elevators,
refused to supply spare parts to independent maintenance service providers. At the
time, there existed six competing manufacturers in the Japanese elevator market, of
which Toshiba Elevator accounted for approximately a 20 percent share. Replacement
parts were made incompatible with elevators made by other manufacturers, and Toshiba
Elevator took almost the entire share of the maintenance and repair market for its own
elevators.
The Osaka High Court held on 30 July 1997 that tying the provision of replacement
parts with the use of its own Toshiba maintenance service violated Article 10 of the
30
JFTC, 14 December 1998; 45 SHINKETSUSHU 153.
general designation (tie-in sales), and ordered Toshiba Elevator to pay damages to inde-
pendent maintenance service providers.31 In the course of the proceedings, Toshiba
Elevator argued that the independent service providers had an insufficient capability to
maintain and repair the elevators manufactured by Toshiba Elevator; however, the court
found otherwise. This case is regarded as being similar in nature to the Kodak case in the
United States.32
9.2.5.4. Refusal to Supply and Discriminatory Treatment

A firm has relative freedom to determine which buyers to supply and on what condi-
tions. However, if a firm, beyond a reasonable degree, imposes quantity restrictions or
other discriminatory conditions on its supply to buyers, so as to place those buyers in
such difficulty that they may struggle to continue doing business, this behavior may be
regarded as exclusionary conduct. According to the Guidelines, the JFTC often con-
siders the refusal to supply and discriminatory treatment to take place in transactions
between firms in upstream and downstream markets. Whether or not the product in
question is considered as a product indispensable for the trading customers to carry out
their business activities is judged primarily on two factors: (1) whether the product is
indispensable for the buyers to carry out their business downstream, such that no alter-
natives are available to them, and (2) whether it is impossible for the buyers to manu-
facture the products in question on their own. Products that satisfy both criteria may
exhibit economies of scale or scope in production, or network effects in distribution.
Alternatively, the right of use may be exclusively assigned to a particular supplier under
regulatory oversight.
Whether or not the refusal to supply or discriminatory treatment goes beyond rea-
sonable degree will depend on the market structure in which the particular transaction
at hand takes place. An example might arise in a scenario in which supply conditions
differ between incumbents and new entrants in such a way that the difference cannot
reasonably be explained by market conditions. Nevertheless, the JFTC explicitly men-
tions that it should respect the decisions made by firms regarding their transactions, and
thus “whether or not refusal to supply and discriminatory treatment by a single entre-
preneur falls under exclusionary conduct should be assessed especially prudently.”
When assessing a potential case of refusal to supply and discriminatory treatment,
the JFTC considers both the upstream and downstream market conditions. The JFTC
examines both markets for information about market shares and product concentra-
tion, product characteristics and degree of product differentiation, economies of scale
in production and distribution, difficulty in entry, and market dynamics. For instance,
in a scenario where the products have strong network externalities in the upstream mar-
ket, the buyers in the downstream market will not easily find an alternative source of
supply, which makes the products more critical for the buyers. However, if the down-
stream buyer owns a large market share, the likelihood of monopolization would not be
31
Osaka High Court, 30 July 1993; 833 HANREITIMES 62.
32
Eastman Kodak Co. v. Image Technical Services Inc. 504 US 451 (1992).
considered substantial. Product prices and the duration of the practice in question also
serve as important pieces of evidence for the JFTC to assess the legality of the conduct.
Before we discuss two recent cases associated with refusal to supply and discriminatory
treatment, let us briefly mention unfair trade practices.
As we discuss in section 9.3, if a firm’s conduct is deemed not to engender adverse
effects on market competition, but to enhance the likelihood of impeding fair competi-
tion, the alleged conduct may fall under unfair trade practices.
9.2.5.4.1. The NTT East Case (2010)

One interesting case concerns a decision made by the Supreme Court of Japan on 17
December 2010.33 Nippon Telegraph and Telephone East Corporation (hereafter NTT
East) is a single company whose shares are owned by NTT under the NTT Law. NTT
East operations accounted for high shares of the market in the supply of optical fiber
telecommunications services to homes (hereafter, a service we will refer to by the acro-
nym FTTH) in eastern Japan. Because of its high market share, NTT East falls under the
regulatory oversight of the Ministry of Internal Affairs and Communications (hereafter
MIC), and is obliged to offer its services to other telecommunications carriers for a set,
authorized connection fee. However, NTT East set its user’s fee for the FTTH service
at 5,800 yen for the first month and then at 4,500 yen per month thereafter, which is
lower than the authorized connection fees. Therefore, in order to be competitive with
NTT East in terms of price, other telecommunications carriers had to set a user fee that
would make a negative margin under the homogeneous-good assumption. Since the
connection provided by the NTT East facility is an input essential for other carriers to
provide the FTTH service, these other carriers have to accept the price authorized by the
MIC, which was higher than the price for the NTT East service itself. Noting that it had
no choice but to offer the FTTH connection service at the authorized price, NTT East
argued before the Supreme Court that consumers must have benefited from the lower
price they offered. Although it was not explicit in the judgment, the Supreme Court
essentially examined the welfare trade-off to conclude that NTT East’s pricing behavior
was exclusionary towards the business activities of other telecommunication carriers
intending to enter the subscriber FTTH market.34
9.2.5.4.2. The Pachinko Patent Pool Case (1997)

Ten leading manufacturers of pachinko (Japanese pinball) machines had formed an
association and pooled a portfolio of their patents essential for the manufacture of
pachinko machines. They manufactured almost all of the pachinko machines sold in
Japan. Through that association (named Nittokuren), the manufacturers adopted a
policy of granting no licenses to any of the pooled patents to any entity that was not
a member of the association. The JFTC found in 1997 that this joint refusal to license
33 Supreme Court, 17 December 2010. HANREITIMES 1339·55. An English translation is available at
the website http://www.courts.go.jp/english/judgments/text/2010.12.17-2009.-Gyo-Hi-.No..348.html.

34 A similar analysis is also made in Arai (2012).
substantially restrained competition in the market for pachinko machines.35 The JFTC
ordered the association members to abolish their no-license policy and to cancel all
decisions taken in accordance with it. This decision is now used as an illustrative exam-
ple in the Intellectual Property Guidelines, Part 3(1)(i)(a).36 The JFTC judged that while
patent pooling that limits the use of licenses has some procompetitive effect, the policy
of granting no licenses to non-pool members would eliminate such effects and substan-
tially hinder market competition.
9.2.6. A Future Agenda for the AMA and Summary

The 2009 amendments to AMA discussed in sections 9.2.2 and 9.2.3 have elements that
could fundamentally alter the way the JFTC will enforce private monopolization in the
future. In this final section, we discuss two primary challenges that the JFTC may have
to tackle.
The first issue is related to the expanding coverage of surcharge payment orders.
Since surcharges now have been introduced for unfair trade practices, the agency
may have to reconsider its enforcement practices pertaining to such violations and
instances of private monopolization. As figure 9.1 shows, the JFTC has enforced the reg-
ulations on unfair trade practices far more frequently than those pertaining to private
monopolization. This is presumably because it has been easier to establish violations of
unfair trade practices (as explained in sections 9.1 and 9.3.1), and at least before the 2009
amendment was enacted, the regulations of unfair trade practices were expected to elicit
less opposition from the parties involved because it did not come with surcharges (nor
criminal penalties).
The latest such example is the DeNA case (2011) on social games, by which more than one
person can play in the game through mobile networks. Social games are a booming market,
whose size has tripled over the year to over 130 trillion JPY, equivalent to 1.33 billion USD.
DeNa Co., Ltd. (hereafter DeNA) kept a group of social game developers from providing
their games through DeNA’s primary competitor, GREE, by disconnecting the website links
of the games the developers provided through DeNA’s platform (called “Mobage-Town”),
if the developers provided the games through GREE. The JFTC did not establish the extent
to which DeNA’s conduct affected market competition. However, since the group of social
game developers, who were forced by DeNA not to provide GREE, accounted for a major
share of the market, the JFTC found that DeNA’s conduct interfered with GREE’s business
activities, in violation of Paragraph 14 of the designation of unfair trade practices. The JFTC
issued a cease-and-desist order without surcharges payment orders (as was stipulated under
the violation of Paragraph 14 of the unfair trade practices), while it could have ordered pay-
ments for exclusionary private monopolization.
35
JFTC, 6 August 1997; 44 SHINKETSUSYU 238.
36
http://www.jftc.go.jp/en/pressreleases/uploads/2007-Sep-28.pdf.
As surcharges have been implemented against some exclusionary conduct of unfair

trade practices, however, the JFTC has to consider how “a tendency to impede fair com-
petition” differs from “a substantial restraint of competition.” There is a view expressed in
both legal and economic circles that unfair trade practices should now require an adverse
effect at a level similar to that indicating a substantial restraint of trade (Negishi and
Funada, 2011). Although some legal scholars argue that the JFTC has already set the same
standard for both private monopolization and unfair trade practices, this is not the case in
injunction relief under Article 24, as discussed in section 9.2.3.2, in that the current AMA
limits injunction relief only to cases involving unfair trade practices. The JFTC will have
to clarify how private monopolization differs from several types of unfair trade practices.
Perhaps it is a good occasion for the JFTC to adopt a single standard under private monop-
olization, rather than the current “double” standards under the two types of regulations.
A second point is in need of more economic and econometric analysis in the enforce-
ment procedure. While economic and econometric evidence has been submitted in some
merger investigations, it plays virtually no role in private monopolization cases. It is, how-
ever, worthwhile to note that the Competition Policy Research Center (CPRC) established
inside the Economic Research Office of the JFTC in 2002 offers a platform for academic
researchers in both economics and legal fields to jointly conduct economic and economet-
ric research on topics not directly linked to actual cases.37 It remains to be seen whether the
CPRC’s research activities lead the JFTC to employ economic analysis more prominently
in its decision to bring cases and in the manner in which the cases are argued.
In the meantime, according to Global Competition Review (2012), the JFTC remains a
largely law-dominated organization; a mere 5 percent of its staff are economists, includ-
ing four economics Ph.D. holders, among 748 competition staff members. To bring
Japan closer to the goal of the AMA cited in the introduction to this section, it appears
to be essential to invite private parties and the courts to be more actively involved in
the enforcement process—essentially to introduce “competition” into the enforcement
procedure. Introducing competition in Japan’s antitrust enforcement would further
improve transparency and accountability, increase the opportunity to introduce rigor-
ous economic analysis by private and academic economic consultants into AMA cases,
and eventually ensure the further penetration of economics to levels hopefully equiva-
lent to those of the United States and Europe.
9.3. China
China’s AML was passed on 30 August 2007 and took effect on 1 August 2008, nearly
14 years after it was first proposed. The AML was enacted to “prevent and prohibit
37 The CPRC publishes working papers on topics such as unjust low bids under public procurement
(CPRC, 2012a), and margin squeezes in network industries (CPRC, 2012b), both of which are available in
Japanese.
monopolistic conduct, protect fair competition, improve efficiency of operation, safe-

guard consumer and public interests, and promote the healthy development of the
socialist market economy” (Article 1). Article 17 of the AML prohibits selling at unfairly
high prices and buying at unfairly low prices and the following business practices with-
out valid reasons: predatory pricing, refusal to deal, exclusive dealing, tying, price
discrimination, and other abusive conduct as might be recognized by the relevant anti-
monopoly enforcement authorities. This section describes how the AML treats the
abuse of a market dominant position (or monopolization).38 It focuses on the economic
reasoning/principles that are adopted or reflected in the AML and its supplementary
guidelines and regulations for determining abuse violations of the law.
9.3.1. Legal Provisions and Enforcement: An Overview

9.3.1.1. Legal Provisions
Article 17 of the AML provides that an undertaking with a dominant market position
shall not abuse its dominant market position to carry out the following acts: (1) sell-
ing commodities at unfairly high prices or buying commodities at unfairly low prices;
(2) selling products at prices below cost without valid reasons; (3) refusing to deal with
a trading party without valid reasons; (4) requiring a trading party to trade exclusively
with itself or trade exclusively with a designated undertaking(s) without valid reasons;
(5) tying products or imposing unreasonable trading conditions at the time of trading
without valid reasons; (6) applying dissimilar prices or other transaction terms to coun-
terparties with equal standing without valid reasons; and (7) other conduct determined
as abuse of a dominant position by the relevant antimonopoly authorities under the
State Council.
The AML applies to all “undertakings,” defined as any natural or legal person, or any
other organization, that produces or deals in goods or provides services. If a conduct
eliminates or restricts competition within the territory of the People’s Republic of China
(Hong Kong, Macau and Taiwan are excluded), it can constitute an infringement of the
AML even if it takes place outside the territory of the People’s Republic of China.
The AML establishes a two-tier enforcement structure under the State Council.
The Anti-Monopoly Commission, set up by the AML, is responsible for promulgat-
ing guidelines and coordinates the work of three antimonopoly enforcement authori-
ties. In particular, the Price Supervision and Anti-Monopoly Bureau of the National
Development and Reform Commission (NDRC) is responsible for enforcement of the
provisions on cartels involving pricing decisions and price-related abuse of a dominant
position; the Anti-Monopoly and Unfair Competition Enforcement Bureau of the State
Administration for Industry and Commerce (SAIC) for enforcement with respect to
non-price-related abuse of a dominant position and monopoly agreements involving
38
For an overview of the AML, see, e.g., Fels (2012).
non-price coordination, and the Anti-Monopoly Bureau of the Ministry of Commerce

(MOFCOM) for enforcement of the merger control provisions. The Anti-Monopoly
Commission reports directly to the State Council.39
In the area of abuse of a dominant position, NDRC and SAIC may carry out investi-
gations by following a complaint, taking a case transferred from another authority, or
acting on their own initiative. They may also delegate enforcement functions to relevant
divisions at the provincial and municipal level where the conduct occurs within a par-
ticular administrative region. Pursuant to Article 53 of the AML, any undertaking that
wishes to challenge a decision by the antimonopoly authorities may choose whether to
launch an administrative appeal or seek judicial redress.40
The general provisions of Article 17 of the AML are supplemented by the Regulation
on Anti-Price Monopoly and the Regulation on Prohibiting the Abuse of a Market
Dominant Position, issued by NDRC and SAIC respectively in December 2010.41 The
two regulations (NDRC APM Regulation and SAIC AMD Regulation respectively) pro-
vide more specific guidance on the provisions of Article 17. The presentation below is
primarily drawn from the AML provisions and the two sets of supplementing regula-
tion, as well as some (albeit very few up till now) rulings by the Chinese courts.
9.3.1.2. Private Action

The Intellectual Property Division of the Chinese courts is responsible for handling
private litigations in the area of antitrust.42 According to data released by the Supreme
People’s Court, courts had accepted 61 civil AML cases as of the end of 2011, most of
which are abuse-of-dominance cases. However, most of these cases were dismissed by
the court on the ground that the plaintiff failed to provide sufficient evidence to show
that the defendants possessed dominance in the relevant market.43
39 The new competition enforcers have rather small staffs, with NDRC having around 20 officials,
SAIC 10 officials, and MOFCOM around 30 staff.

40 According to information disclosed by NDRC and SAIC officials at the Asia Competition
Association 2012 Annual Conference, which was held in Beijing on 21 October 2012, the SAIC had
authorized Jiangsu Province and other provinces and cities to investigate 16 suspected cases so far, one
of which was a suspected abuse of dominance and 15 others were suspected non-price cartel agreements.
NDRC has directly investigated 15 cases involving price-related monopoly conduct (including cartel
cases) since 2011. See The China Competition Bulletin, September–October 2012 (available at http://
www.anzsog.edu.au/research/publications/the-china-competition-bulletin). There were no published
cases by either of these two competition authorities during 2008 and 2009 and one case by NDRC
in 2010 (Norton Rose, 2012). Thus, enforcement efforts by the two competition authorities increased
substantially during 2011, though the number of investigated cases is still very small.
41 The regulations are available (in Chinese) at http://jjs.ndrc.gov.cn/zcfg/t20110104_389399.htm and
http://www.saic.gov.cn/fldyfbzdjz/zcfg/zcfg/201101/t20110107_103379.html, respectively.
42 The Supreme People’s Court of China designated its IP divisions the responsibility because of the
fact that Chinese courts generally have not developed an expertise in complex economic analysis.
43 Press conference of the Supreme People’s Court, 8 May 2012. See http://www.court.gov.cn/xwzx/
xwfbh/twzb/201205/t20120508_176702.htm (in Chinese). For example, in Renren v. Baidu, a widely

publicized case, the defendant submitted estimates of Baidu’s market share in the search engine service
market in China as between 65 percent and 70 percent based on business periodicals. The Court
considered the evidence insufficient, as the underlying data and methodology used to calculated the
According to the Judicial Interpretation on the Application of Laws to Anti-Monopoly

Private Actions (Judicial Interpretation) issued by the Supreme People’s Court of China
on 8 May 2012, parties harmed directed or indirectly by anticompetitive conduct have the
standing to sue. Both stand-alone and follow-on cases are allowed. Regarding the burden
of proof, Article 9 of the Judicial Interpretation provides that the plaintiffs shall be respon-
sible for identifying the relevant market within which the alleged abusive conduct has
taken place, and for proving that the defendant possesses a dominant market position and
that the alleged conduct falls within the categories prohibited by Article 17 of the AML.
However, Article 9 provides that for cases involving public utilities or other undertak-
ings with monopolistic licenses issued by the state, the court may determine that the
defendant has the dominant position in the relevant market, based on specific circum-
stances of the market structure and competition landscape. It is noteworthy that the
Juridical Interpretation (Article 13) provides that the parties may apply to the court to
appoint economic or trade experts to provide explanations on technical issues. These
provisions are considered responses to the fact that the plaintiffs had a rather low success
rate in abuse-of-dominance cases during the first three years of AML private enforce-
ment mainly because of the difficulties of proving that the defendant holds a dominant
market position and has abused such a position.
9.3.1.3. Legal Liability under the AML

The following penalties for abuse of a dominant market position are available under the
AML: (a) fines of up to 10 percent of the total turnover in the preceding year;44 (b) con-
fiscation of illegal income; and (c) the invalidation of agreements concluded in violation
of the law, and cease-and-desist orders in respect of abuse of dominant position. There
are no punitive damages or criminal penalties under the AML.
9.3.1.4. Other Relevant Laws

The Anti-Unfair Competition Law of China enacted in 1993 was China’s first competi-
tion law. While mostly aiming at consumer protection and the prevention of fraudulent
commercial practices (such as infringement of trademarks), part of the law is related
to preventing abusive behavior of dominant firms. It particular, it prohibits exclusive
dealing by public utilities or other enterprises with legal monopoly status (Article 6),
predatory pricing (Article 11), and tie-in sales and bundling (Article 12). For a violation
of Article 6 a fine may be imposed of between RMB 50,000 and RMB 200,000 (approxi-
mately US$79,400 to US$317,500), as well as confiscation of between 100 percent and
300 percent of the illegal revenues (Article 23).
Enforced by the NDRC, the 1997 Price Law was enacted to regulate the pricing behav-
ior of both firms and the government.45 Relevant to conduct that constitutes an abuse
market shares were not provided. See Tong (2010) for a detailed description and analysis of the case by
Judge Tong Shu of the IP Tribunal of the Beijing No. 1 Intermediate People’s Court.
44
It is not clear whether the fine is based on total turnover or turnover in the relevant market.
45
Pricing behavior of the government includes the government-guided prices and the
government-set prices, as explained in Article 3 of the Price Law.
of a dominant market position, Article 14 prohibits any firm from selling products at
a below-cost price in an attempt to hurt competitors, spreading rumors of price hikes,
attracting business through deceptive pricing strategies, and price discrimination. The
Price Law allows for fines up to five times the illegal gains.
9.3.2. Determination of Market Dominance and

Abuse under the AML
9.3.2.1. Definition of Market Dominance
Article 17 of the AML defines a dominant market position as “a market position held
by an undertaking having the capacity to control the price, quantity or other trading
conditions in relevant market, or to hinder or affect any other undertaking to enter the
relevant market.” The language of Article 17 is rather general, particularly about the
meaning of “other trading conditions in the relevant market.” Article of the 2011 SAIC
AMD Regulation clarifies that (1) “other trading conditions” refer to factors other than
price and quantity that can have a substantial impact on market transactions, includ-
ing product quality, payment terms, mode of delivery, and after-sale services. Regarding
the meaning of the ability to hinder or affect market entry, the Regulation states that
it includes the ability to exclude, delay, or make more difficult for other undertakings
to enter or expand into the relevant market within a reasonable period of time. This
includes the ability of the undertaking to raise the cost of entry for its competitors so
that they are unable to compete effectively in the relevant market postentry.
9.3.2.2. Determination of Dominant Market Position

In determining whether an undertaking possesses a dominant market position, the
enforcement authorizes will consider the following factors, as stipulated in Article 18
of the AML: (1) the market share of an undertaking and the competition condition in
the relevant market; (2) the capacity of an undertaking to control the product market
or the raw material procurement market; (3) the financial resources and technical capa-
bilities of the undertaking; (4) the degree of dependence of other undertakings on the
undertaking in transactions; (5) the level of difficulty for other undertakings to enter the
relevant market; and (6) other factors relating to the determination whether the subject
undertaking has a dominant market position.
The 2011 SAIC AMD Regulation provides further guidance on the above factors.
Specifically, the market share of an undertaking is calculated both in value and in vol-
ume, and in reviewing an undertaking’s market share SAIC will also take into account
the state of development of the market, product differentiation, and potential compe-
tition, among other factors. When reviewing the financial and technical resources of
an undertaking, SAIC looks at the undertaking’s assets, its financial position and abil-
ity to raise funds, its R&D capabilities, and any intellectual property rights it may have.
SAIC also consider the scale of transactions between other relevant undertakings and
the dominant operator concerned, the duration of such relationships, and the degree of
difficulty of those undertakings switching to other trading parties. When determining
the degree of difficulty of entry by potential entrants, SAIC considers such factors as
market entry regulations, the essential facility conditions, distribution channels, capi-
tal and technological requirements, and the costs of entry (Article 10). While the above
guidance is rather detailed and broadly in line with international standards, there have
not been any published cases by SAIC up till now concerning abuse of dominance.
9.3.2.3. Presumption of Market Dominance

Article 19 of the AML provides that where an undertaking exhibits any of the following cir-
cumstances, it may be presumed to have a dominant market position: (1) the relevant mar-
ket share of an undertaking accounts for one-half or more in the relevant market; (2) the
joint relevant market share of two undertakings accounts for two-thirds or more; or (3) the
joint relevant market share of three undertakings accounts for three-fourths or more. An
undertaking with a market share of less than one-tenth shall not be presumed as having a
dominant market position even if it falls within the scope of the second or third item. If an
undertaking presumed to have a dominant market position can present evidence showing
otherwise, it shall not be deemed as having a dominant market position.
Market share is not the only presumption available to help establish dominance.
According to the Judicial Interpretation issued by the People’s Supreme Court of China
on 8 May 2012, a defendant may be presumed dominant when it is a public utility com-
pany, or when it is conferred with exclusive license by law or administrative rules, or
when the defendant’s trade counterparts are highly reliant on its supply due to a lack of
effective competition in the relevant market.
9.3.2.4. Joint Dominance

Although not stated explicitly, it appears from Article 19 of the AML that two or more
independent undertakings can be found to hold joint dominant position in the relevant
market, even if they are not actively coordinating their conduct in the market. The con-
cept of joint dominance was apparently used in a recent NDRC investigation of China
Telecom and China Unicom, two state-owned firms in the telecommunications indus-
try, which were alleged to have engaged in abuse of dominance in the broadband access
market. Section 9.3.3 contains more information about this case.
9.3.2.5. Definition of Relevant Market

On 24 May 2009 China’s Anti-Monopoly Commission announced its Guidelines
Concerning the Definition of Relevant Markets.46 The Guidelines recognize that “any
competitive behavior (including any behavior that has resulted or is likely to result in
eliminating or restricting competition) occurs within a particular market scope. The
relevant market definition is to define the market scope within which the business oper-
ators compete with each other. In the work of anti-monopoly law enforcement, such
46 See http://www.gov.cn/zwhd/2009-07/07/content_1355288.htm (in Chinese).

as prohibiting monopoly agreements among business operators, prohibiting the abuse

of dominant market positions and controlling the concentrations of business operators
that has resulted or are likely to result in eliminating and restricting competition,
defining the relevant market may be involved” (Article 2).
The Guidelines further make it clear that defining the relevant market “plays an
important role in key issues such as recognizing competitors and potential competi-
tors, determining the market share of the business operators and the degree of market
concentration, deciding the market position of the business operators, analyzing the
impact of the business operators’ behaviors on market competition, judging whether
such behaviors are illegal or not and determining the legal liabilities they need to bear if
their behaviors are illegal. As a result, defining the relevant market is usually the starting
point of conducting an analysis on competitive behavior and an important step of anti-
monopoly law enforcement” (Article 2).
In line with international standards, the Chinese guidelines define the relevant
product and geographical markets based on demand substitution and supply sub-
stitution factors, and take into account factors giving rise to a temporal market. They
also recognize the effectiveness of the hypothetical monopolist test (the SSNIP test)
in ascertaining the boundaries of the market, with a price increase in the range of
5 percent-10 percent and for normally one year as thresholds for testing.
One difficulty in defining the relevant (geographical) market in abuse-of-
market-dominance cases in China was encountered in the recent case against Tencent
by Qihoo, the details of which is contained in section 9.3.4.6.1. The plaintiff and the
defendant disagree on what constitutes the relevant product market. In particular,
the plaintiff is of the view that Tencent’s instant message software and relevant ser-
vices should be defined as the relevant product market and that the market should be
defined as the domestic market of China because of the unique Chinese language and
cultural background of the instant message services. Tencent on the other hand argues
that because of the openness and interoperability of the Internet, the users of the instant
messaging are not limited to those in the Mainland China. The case is still pending at the
time of this writing. More details of this case are contained in section 9.3.4.6.1.
An interesting question of whether “free” services can constitute a relevant mar-
ket arose in Renren v. Baidu (2009), in which the defendant argued that its Internet
search services are free to the general Internet users and thus are not regulated by the
Antimonopoly Law. The court disagreed and reasoned that free provision of some
products or services is often closed related to its charged provision of some other
products or services. The court ruled that “free” services can constitute a relevant
market in the sense of the AML (see Tong 2010). This ruling is consistent with insight
from the modern economics of networks on cross-subsidization of services under
optimal pricing in two-sided markets (see, e.g., Laffont et al., 2003).
9.3.2.6. Rule-of-Reason Approach

Consistent with international best practice, whether a conduct constitutes an abuse
of market dominance is determined by the rule of reason, rather than the per se rule
under the AML. This approach was made clear by the SAIC in its press conference
following its announcement of its AMD Regulation.47 In fact, the rule of reason had been
also explicitly adopted by the court in the early high-profile private action cases. In Renren
v. Baidu, the court explicitly stated that a dominant market position or economies of scale
per se do not violate the AML. The issue for antitrust scrutiny is abuse of a dominant posi-
tion, or anticompetitive behavior of dominant firms.48 In the ongoing Qihoo v. Tencent,
Judge X. J. Zhang of the Guangdong Province People’s Court summarized the focuses of this
case, which are to determine (1) what constitutes the relevant market; (2) whether Tencent
possesses a dominant position in this market; (3) if it has a dominant position, whether
or not Tencent abused its dominant position; and (4) what would be the proper penalty if
Tencent is found to have violated the abuse provisions of the AML.49
In the next section, we focus on the type of abusive conduct that falls within the scope
of responsibility of NDRC, namely abusive conduct related to pricing behaviors.
9.3.3. Price-Related Abuse of Dominance

Among the types of abusive conduct listed in Article 17 of the AML, three concern price
decisions, namely setting unfairly high selling prices or unfairly low buying prices, and
predatory pricing, without valid reasons.
9.3.3.1. Selling at an “Unfairly High Price” or Buying at an

“Unfairly Low Price”
Similar to the EU competition law, China’s AML prohibits dominant firms from “selling
at unfairly high prices or buying at unfairly low prices” (Article 17). What constitutes
“unfair” is not defined in the AML. Article 11 of NDRC APM Regulation lists a range of
factors that NDRC will consider when determining whether a price is excessively high
or low. These include whether the price is significantly higher or lower than the price at
which other operators buy or sell the same type of goods; whether the increase in selling
price or decrease in purchase price exceeds the normal range when production costs are
generally stable; and when production costs vary, whether the change in price is signifi-
cantly larger than the change in costs. No definition of costs is provided.
One decision of the NDRC may be indicative of what may be considered an “unfairly
large increase in price.” In March 2011, in its informal investigation of the pricing policy
of the industry leader in the instant noodle market, Master Kang, the NDRC found the
planned price increase by Master Kang in mid-March 2011 for its canned instant noodle
“overly high” and “improper.” In reaching this conclusion, NDRC specifically stated that
Master Kang’s market share in canned instant noodles was 73.6 percent in 2010; it thus
had a dominant market position. The NDRC referred to the following figures: The price
increase would raise Master Kang’s net profit margin of this product line to 14.3 percent,
47 See http://www.saic.gov.cn/fldyfbzdjz/gzdt/201101/t20110107_103382.html (in Chinese).
48
See Liu and Qiao (2012) for a more detailed description of the case.
49
See, e.g., the report on China Webmaster: http://www.chinaz.com/news/2012/0418/246478.shtml.
a 4.2 percent jump compared with its January 2011 level and an 1.1 percent jump com-
pared with its average level in 2010.50
9.3.3.2. Predatory Pricing

The AML specifies predatory pricing as one of the six types of conduct that are explicitly
prohibited for dominant firms. In particular, Article 17 (2) AML prohibits an under-
taking in a dominant market position from selling products at prices below cost with-
out valid reasons. Article 12 of NDRC APM Regulation lists some of the legitimate
reasons for pricing below cost: undertakings may sell below cost if they are having a
closing-down sale, selling overstocked or perishable goods, or promoting new products.
As under the EU competition law, the AML states that only firms in a dominant mar-
ket position are prohibited from predatory pricing. However, the predatory pricing pro-
visions in early competition laws of China such as the 1993 Anti-Unfair Competition
Law and the 1998 Price Law do not specifically require an undertaking to be dominant
for its below-cost pricing to be predatory. In Chuanglian v. Huimeng, for example, the
Haidian District Court in Beijing found the defendant—an Internet portal—to have
engaged in illegal below-cost pricing of advertising space, although there was no evi-
dence that it occupied a dominant market position.
The AML does not define the term “cost” in relation to predatory pricing. China’s
Price Law suggests that costs include both production and operation costs, as confirmed
in Article 4 of the Regulation on the Prevention of Below Cost Dumping Conduct
(1999), Order No. 2 by the National Development and Plan Commission.51 It appears
that the cost benchmark set out in the Regulation is total unit cost. The Chinese compe-
tition laws and regulations and any court rulings have not made any particular reference
to the notions of Areeda-Turner’s average variable cost (AVC) test or Baumol’s proposal
of use of “average avoidable cost” (AAC).
Moreover, neither the AML nor NDRC APM Regulation has any specific require-
ments regarding a showing of recoupment, consumer harm, or, in fact, the rival’s exit.
Whether there such requirements are needed in future court and enforcement decisions
remains to be seen.
9.3.3.3. Discriminatory Practices

Article 17 of the AML prohibits discriminatory treatment without valid reasons by a
dominant undertaking of trading counterparties in prices or other trading terms that
constitutes abuse of its dominant position. It covers but is not limited to price dis-
crimination. Article 5 of SAIC AMD Regulation provides the following list of (mostly)
non-price-related discriminatory practices by an undertaking towards trading
50 As released at the NDRC press conference held on 6 May 2011 on its formal investigation of the
Unilever price-hikes case. See 国家发展改革委有关负责人就查处联合利华(中国)有限公司散布

涨价信息扰乱市场秩序的有关问题答记者问; http://www.ndrc.gov.cn/xwfb/t20110506_410543.htm.
Advised by the NDRC, Master Kang did not implement the price increase as planned. (It did, however,
raise its price in August 2011 by about 10 percent.)
51 See http://jjs.ndrc.gov.cn/zcfg/t20070727_150273.htm (in Chinese).
counterparties with equivalent tradition conditions without valid reasons:52 (a) impos-
ing different transaction quantities, types of goods, or quality levels; (b) imposing differ-
ent preferential conditions, such as quantity discounts; (c) imposing different payment
conditions or delivery methods; or (d) imposing different after-sales service conditions,
such as warranty terms and term, repair conditions and times, provision of spare parts
and components, and technical guidance. No mention, however, is made of what might
constitute “valid reasons” for such discriminatory practices.
There have some price discrimination cases since the AML took effect. In the recent
high-profit investigation of China Telecom and China Unicom, NDRC clearly adopted
the theory of price squeeze, though it did not use this term.
9.3.3.3.1. NDRC Investigation of China Telcom and China Unicom (2011)

On 9 November 2011, in a News 30’s Program of China Central Television’s (CCTV),
Ms. Li Qing, deputy director of the Price Supervision and Anti-Monopoly Bureau of
the NDRC, publicly acknowledged that NDRC had been conducting an investigation
into China Telecom and China Unicom since the first half of 2011. Implicitly referring
to Article 19 of the AML, Deputy Director Li released the preliminary findings of that
investigation: with a combined share of more than two-thirds of the “broadband access”
market in China, China Telecom and China Unicom held a dominant position in the
broadband access market. She also disclosed that, by charging higher prices for access to
their broadband network to direct competitors than to noncompetitors, China Telecom
and China Unicom were guilty of price discrimination.53 The investigation is still ongo-
ing at the time of this writing.
Price discrimination in final product markets has also been brought to investiga-
tion in China. In Li Fangping v. China Netcom (Group) Co., Ltd., filed on 1 August 2008,
the very day that the AML took effect, Beijing Netcom, a telecommunications service
provider and China Netcom’s Beijing branch, was accused of charging different rates
to consumers with a Beijing residence permit (known as a “hukou”) and those without.
The case was accepted by the Beijing Chaoyang District People’s Court on 24 September
2008, but later referred to Beijing No. 2 Intermediate People’s Court. The trial court
rejected Li’s requests, and Li appealed to the Beijing High People’s Court. The High
Court upheld the trial court decision.
This case attracted wide attention as the first major judicial antimonopoly case in
China. It has been instrumental in establishing principles concerning rules of evidence
and market definition in antimonopoly litigation. First, Beijing Netcom argued that
its discriminatory pricing was reasonable because under its pricing policy, only those
52
The NDRC APM Regulation also contains an article prohibiting discriminatory treatments in price
by a dominant undertaking of trading parties with the same transaction conditions without valid reasons
(Article 16). However, the NDRC Regulation does not provide additional information; it just covers the
price-related abusive discriminatory treatment as provided in Article 17 (6) of the AML.
53 The NDRC has yet to complete its investigation of the alleged price discrimination case. The
CCTV program exclusive interview with Deputy Director Li can be found in http://v.qq.com/
cover/9/9ux3zxaeki17i7s.html?vid=8Effma9lZ7V (in Chinese).
non-Beijing resident customers who did not have real estate in Beijing were charged a
higher rate. Without such a restriction, it would face “business risks.” The court accepted
this justification by the defendant.54
Second, the principle of allocating the burden of proof in antimonopoly litigation was
for the first time specified by a court decision. The Beijing High People’s Court held that
in civil actions involving the abuse of market dominance, the plaintiff was responsible
for providing evidence concerning the definition of the relevant market, and proving
that the defendant held a dominant position in said market, that it had abused that dom-
inance, and that such abuse had caused actual losses to the plaintiff.
Third, the court made a direct determination on the issue of what was the relevant
market. In the final judgment, the Beijing High People’s Court supported the trial court’s
decision that fixed telephone, Little Smart (xiaolingtong) phones, and mobile phones
were closely substitutable, as were ADSL and wireless access to the Internet. Previously,
such determination was generally made by a competition authority in merger
assessments.55
9.3.3.3.2. Prohibition of Price Discrimination under the Price Law

China’s Price Law, which took effect in 1998 and is still in effect together with the AML,
also prohibits price discrimination. In particular, Article 14 (5) of the Price Law prohib-
its “price discrimination against other undertakings with the same trading conditions.”
In comparison, the AML prohibits undertakings from abusing their dominant market
position by engaging in “discriminatory treatment of trading counterparties with the
same trading conditions in terms of prices and other trading conditions, without justifi-
able reasons” (Article 17 (6)).
There are three important differences between the treatments of price discrimination
under the AML and under the Price Law. Firstly, the Price Law prohibits price discrimi-
nation in the intermediate product markets only, as is clear in the wording of Article
14 (5). On the other hand, “trading counterparties” under the AML include final con-
sumers as well business operators. In fact, the plaintiffs in AML cases of Li Fangping
v. China Netcom and Zhou v. China Mobile were both individual consumers. Second, the
Price Law does not require that the undertakings engaging in price discrimination hold
a dominant market position; any undertakings are banned from price discrimination.
54
See, e.g., http://www.chinalawinsight.com/2010/09/articles/corporate/antitrust-competition/
aeaeaeaaceaecaaaeeaaaeeaea/.
55 In a similar case, Zhou vs. China Mobile, an activist lawyer, Mr. Zhou Ze, filed an antitrust suit
with a Beijing district court, which later transferred the case to Beijing No.2 Intermediate People’s
Court on 4 March 2009, alleging that China Mobile abused its dominant position in China’s mobile
telecommunications market by engaging in unlawful price discrimination, in violation of Article 17(6)
of the AML. Specifically, Zhou alleged that China Mobile discriminatorily charged him a “monthly
rental fee” that was not charged to other customers. He sought damages and an injunction to stop the
discriminatory charges. On 23 October 2009 the Beijing Dongcheng District People’s Court announced a
settlement of the case in which China Mobile allowed Zhou to change his plan to one without a “monthly
rental fee” and to keep his same mobile phone number. As compensation for Zhou’s “input to the pricing
issues,” China Mobile rewarded him RMB 1,000 (about US$146). Zhou withdrew the case.
Third, the Price Law adopts the per se illegal rule toward price discrimination, whereas
the AML uses the rule of reason. The last two differences were confirmed by Xu Kunlin,
director general of the Price Supervision and Anti-Monopoly Bureau of the NDRC in his
interview by the Antitrustsource in 2011.56 A possible explanation for the very different
treatments of price discrimination under the two laws is that China puts more emphasis
on fairness during the early stage of its economic development. In 1998, it was stated in
the Interpretation of the Price Law issued by the State Reform and Planning Committee
(the predecessor of NDRC) that price discrimination against downstream undertakings
leads to unfair competition in the downstream market and is thus prohibited.
9.3.4. Treatment of Non-Price-Related Abuse of Dominance

The SAIC ADM Regulation provides guidance as to what constitutes abuse of domi-
nance in the form of non-price business practices, in relation to Article 17 of the AML.
Specifically, Article 4 of the Regulation lists different types of refusal-to-deal behavior
by dominant firms. Articles 5 to 7 specify in detail the abusive practices of dominant
firms in terms of exclusive dealing; tying or restrictive sales; and discriminatory trad-
ing, respectively. However, for refusal to deal and exclusive dealing, the NDRC APM
Regulation may also be applicable if the abuse is disguised in price contracts of the dom-
inant firm with its suppliers or customers.
9.3.4.1. Refusal to Deal

Article 4 of the SAIC AMD Regulation provides that an undertaking with a dominant
market position shall be prohibited from refusing, without legitimate reason, to transact
with the counterparties to the transaction by means of any of the following: (1) reduc-
ing the volume of an existing transaction with the counterparties to the transaction;
(2) delaying in executing or discontinuing an existing transaction with the counterpar-
ties to the transaction; (3) refusing to engage in a new transaction with the counterpar-
ties to the transaction; (4) imposing restrictive conditions that make it difficult for the
counterparties to the transaction to continue to trade; (5) refusing the use of any essen-
tial facility under reasonable conditions by the counterparties to the transaction in the
course of production and operation activities.
There is also so-called disguised refusal to deal. Article 13 of the NDRC APM
Regulation prohibits undertakings from setting a very high selling price that, in effect,
amounts to a refusal to deal with other trading parties without legitimate reasons.
56
With respect to regulation approaches, Mr. Xu stated that “the Price Law emphasizes more the
examination of whether the conduct itself stays in compliance with provisions of the law; the AML
emphasizes the examination of the impact of such conduct on competition in the market.” See F. H.
Deng, S. Harris Jr., and Y. Zhang (2011), “Interview with Xu Kunlin, Director General of the Department
of Price Supervision Under the National Development and Reform Commission of People’s Republic of
China,” available at http://www.americanbar.org/content/dam/aba/migrated/2011_build/antitrust_law/
feb11_fullsource.authcheckdam.pdf.
According to the NDRC APM Regulation, an excessive high selling price by an under-
taking may be legitimate if its trading party has a extremely poor credit record, or is
in financial distress so that continuous dealing may cause financial risks to the under-
taking, or if the party is able to obtain similar goods at a reasonable price from a third
company.
There have not been any formal cases against refusal to deal by either the NDRC or
the SAIC. However, it is important to note that the SAIC AMD Regulation explicitly
refers to the issue of essential facility.57 This provision may potentially be applied in tech-
nological licensing (or refusal to license) cases. Although there have not been formal
such cases, the fact that the SAIC AMD Regulation contains a detailed paragraph par-
ticularly pertaining to the issue of essential facility may be an indication that the issue of
refusal to deal is of substantial importance.
9.3.4.2. Exclusive Dealing

Article 6 of the SAIC AMD Regulation provides that, without legitimate reasons, an
undertaking with a dominant market position shall not restrict a trading partner by
requiring it to deal with the dominant undertaking or with other designated under-
takings; or requiring it not to deal with its competitors. The SAIC Regulation does not
provide additional information as to what constitutes legitimate reasons for exclusive
dealing.
However, Article 14 of the NDRC APM Regulation clarifies that, without justifiable
reasons, a dominant undertaking shall not use price discounts or other means to require
its trading partners to exclusively deal with it or with the undertaking(s) it designates.
The NDRC APM Regulation provides a list of circumstances where imposing an exclu-
sivity requirement may be justifiable by the dominant undertaking. This would be the
case where the exclusivity is required to (1) protect product quality and safety; or (2) to
maintain brand image or improve services; or (3) to lead to significant cost-reductions
or efficiencies gains, the benefits of which must be partially passed on to consumers.
From the language used in the Regulation, the listed cases where exclusive dealing
can be justified seem consistent with modern industrial economics. For instance, exclu-
sive dealings may enhance efficiency when used to improve and protect product quality,
or as a response to free riding among manufacturers in the upstream market, or to facili-
tate R&D investments by upstream and downstream firms. Whether the above modern
economic reasoning is the rationale behind the Regulation or whether or not it will be
adopted in real exclusive dealing cases remains to be seen.
One thing that is interesting to note is that the NDRC Regulation specifically men-
tions the type of exclusive dealing using price discounts, which is presumably often
57 Article 4 states that when determining whether there exists a refusal to deal in essential facilities,
SAIC shall consider such factors as the feasibility of otherwise investing in and constructing or
otherwise developing and building such facilities, the degree of dependence of the counterparties to the
transaction on such facilities in order effectively to conduct their production and operation activities, the
feasibility of undertaking to provide such facilities and the impact of providing such facilities on its own
production and operation activities, etc.
used by an upstream supplier to induce its downstream buyer(s) not to purchase from
other supplier(s). However, the Regulation does not explicitly mention the exclu-
sive dealing arrangements that might be initiated by a downstream buyer that agrees
to pay a higher price for the good concerned in exchange for the supplier’s agreement
to not supply other downstream rivals, although the wording in the Regulation (“by
the use of price discounts or other means”) should capture such arrangements initi-
ated by downstream firms. What leads to the asymmetric wording with regard to the
above two types of exclusive dealing arrangements in the Regulation is not known. The
downstream-initiated exclusive dealing arrangement is at the core of the recent NDRC
decision against two drug companies in Shandong Province.
On 14 November 2011, the NDRC announced fines of nearly RMB 7 million
(US$1.1 million) against two private pharmaceutical companies in Shandong Province
for various abuses of dominant market position, including an exclusive supply contract
and setting excessively retail prices. According to the public announcement issued on
NDRC website on 14 November, the offending companies were two distributors of the
active ingredients used in the manufacture of Reserpine, an antihypertensive drug that
is commonly used for the control of high blood pressure.58
NDRC investigation found that two companies authorized to manufacture the
active ingredient used in Reserpine in China, promethazine hydrochloride, Donggang
Hongda Pharmaceutical Co., Ltd. (“Donggang Hongda”) and Dandong Yichuang Yaoye
Co., Ltd. (“Dandong Yichuang”), each entered into an exclusive distribution agreement
with Shandong Weifang Shuntong Pharmaceuticals Co., Ltd. (“Shuntong”) and Weifang
Huaxin Pharmaceuticals & Trading Co., Ltd. (“Huaxin”) under identical terms on 9
June 2011. Under the terms of these agreements, the two manufacturers of prometha-
zine hydrochloride on the Chinese market were prohibited from selling the product to
third parties without first obtaining the consent of Shuntong and Huaxin. Although the
NDRC announcement did not contain information about price premiums contained
in such exclusive dealing agreement, it was reported that the two distributors agreed to
raise the price of promethazine hydrochloride from RBM 178 prior to the agreement to
RMB 300.59
Having secured exclusive distribution rights over the active ingredient promethazine
hydrochloride, Shuntong and Huaxin then raised the retail prices to their downstream
manufacturers to increase their own retail price of Reserpine by more than 400 percent.
The proceeds of the required price increases were then to be shared between the man-
ufacturers (Dongang Hongda and Dandong Yichuang) and their exclusive suppliers
(Shuntong and Huaxin).
With more than 10 million patients taking the drug nationwide, Reserpine has been
listed as an “essential” medicine in the National Essential Drugs List. Since the payment
for drug is fully covered by the national social insurance policy, the decision noted that
58 The NDRC’s announcement can be found here: http://jjs.ndrc.gov.cn/fjgld/t20120306_465386.htm
(in Chinese).
59 See, e.g., the report at http://www.fh598.com/article-4856892-1.html (in Chinese).
these increased costs were directly borne by society. With the combined total of the fines
of more than RMB 7 million (approximately US$1.1 million), this case marks the first
occasion on which NDRC has sought to impose significant fines for price-related abuse
of dominance under the AML.
NDRC announcement stated that Shuntong and Huaxin had abused their dominant
position, thereby violating the AML and the Price Law. It appears that the NDRC’s deci-
sion was based on the grounds that Shuntong and Huaxin had controlled the supply of
promethazine hydrochloride via its exclusive dealing agreement with the upstream sup-
pliers and that they had then raised the retail price of the final product Reserpine to an
excessively high level.
9.3.4.3. Tie-in Sales

SAIC AMD Regulation offers more explanations on what might constitute an illegal
tie-ins. According to Article 4, an undertaking with a dominant market position shall be
prohibited from tying the sale of goods or, in the course of a transaction, imposing other
unreasonable transaction conditions: (a) in a manner counter to trading practice, con-
sumer habits, and so on, or ignoring the functions of the goods, forcibly tying different
goods together for sale or selling them as a bundle; (b) imposing unreasonable restric-
tions on the contract term, payment method, method of transportation and delivery of
the goods, or the method of provision of the services, and so on; (c) imposing unreason-
able restrictions on the sales territory or sales counterparties for the goods, after-sales
services, and so on; or (d) imposing transaction conditions that have no connection
with the subject matter of the transaction. (The NDRC Regulation does not provide any
guidance on tying practices.)
As can be seen, SAIC AMD Regulation specifies that both demand-side factors and
supply-side factors (including the technical “functions” of the goods), as well as indus-
try practice, are relevant in determining whether a tie-in practice is illegal, which is in
line with international best practice.60 However, there has been very few tying cases in
China, either public or private, so as to provide more guidance on important issues con-
cerning how tie-in sales will be treated under the law. For example, how are relevant
markets defined in tie-in cases? Specifically, how can one determine the two goods
involved in tie-in sales are in two separate markets or just two components of an inte-
grated product? What are the economic theories about the competition effects of tie-in
sales that the enforcement agencies or the court might have accepted?
Perhaps the only tie-in decision under the AML so far is Wuchang Salt (2010).61
On 12 August 2010, the local price bureau of the National Development and Reform
Commission (NDRC) in Hubei (Hubei Price Bureau) launched an investigation into
the conduct of the Wuchang branch (Wuchang Salt) of the Hubei Salt Industry Group
(Hubei Salt) in response to local media reports that Wuchang Salt had tied the sale
60
For example, see Report on Tying and Bundled Discounting, International Competition Network, 2009.
61
This case occurred before NDRC and SAIC issued their 2011 regulations, which specify that SAIC
would be responsible for handling non-price-related abuse of dominance.
of salt to the sale of a local brand detergent washing powder in the wholesale mar-
ket. (Wuchang Salt had previously tied the sale of nutritious salt with ordinary salt.)
Wholesalers then either supplied the salt and the tied products to retailers separately or
as a bundle. Most retailers, when selling to end users, did not tie the sale of salt to the sale
of washing powder.
The Hubei Price Bureau held that the conduct of Wuchang Salt had violated the AML.
First, Wuchang Salt holds a dominant position in the local wholesale market for salt.
Second, the conduct of Wuchang Salt constitutes a tying (without justifiable reasons)
prohibited by Article 17(5) of the AML. Third, Wuchang Salt, as an undertaking having a
status as a statutory monopoly, infringed Article 7 of the AML, which requires that stat-
utory monopolists should “conduct business in accordance with laws in an honest and
trustworthy manner, impose strict self-discipline, and accept supervision from the pub-
lic . . . [and] should not harm consumer interest by taking advantage of their position.”62
With respect to the economic motivation of the tying, the NDRC’s published decision
stated that Hubei Price Bureau found that Wuchang Salt’s tying conduct was pursuant to
a policy of “developing businesses other than salt.” The decision did not make reference
to any economic theory about tying sales, although the pursuit of business in the salt
market can be explained by the standard “leverage theory” of tying sales, given the fact
that Wuchang Salt was the only salt wholesaler in the Wuhan city and that there were
other independent sellers of washing power in the market.63
Regarding the effects of the typing, the NDRC concluded that “the sales volume,
number of consumers affected and the social impact of the tying were limited.” Hubei
Price Bureau issued a warning to Hubei Salt and Wuchang Salt pursuant to Article 45 of
the AML. No fine was imposed.
9.3.4.4. Abuse of Intellectual Property Rights

Article 55 of China’s AML expressly prohibits abuse of IPRs that restrict or eliminate
competition. To supplement the very brief Article 55, SAIC has been drafting IPR
guidelines since 2009. While the official guidelines have yet to be released, consensus
regarding some fundamental issues seems to have been reached. For example, the most
recent Draft Guidelines for Anti-Monopoly Enforcement in the Field of Intellectual
Property Rights (Draft IPR Guidelines) dated 8 August 2012, contain promising signs
of alignment between the Chinese approach in this field and the current approach in
the United States and the EU. For example, the Draft IPR Guidelines explicitly state
that “IPR laws and antimonopoly laws share the same goals and functions, namely
to promote innovation and competition, increase efficiency, and safeguard consum-
ers interest and the public interest” (Article 2). Thus, the Chinese antimonopoly
62 The NDRC’s published decision is available at http://jjs.ndrc.gov.cn/gzdt/t20101115_380421.htm (in
Chinese).
63 There are media commentaries that point out the fact that the tied product was a local brand of
washing power in Hubei Province and suggested that the provincial government may have had an incentive
to use its monopoly position in salt wholesale as a means to promote its local washing power brand under
the tying strategy. See, e.g., http://www.tech-food.com/news/2010-8-12/n0412110.htm (in Chinese).
authorities will not take the narrower and outdated view that IPR laws, by creating
legal monopolies, are in conflict with competition laws.
The Draft IPR Guidelines also state that IPRs are treated in the same way as other
assets of an undertaking and that an undertaking that possess IPRs will not be automati-
cally deemed to enjoy a dominant position in the relevant market. When IPRs are an
important factor that gives rise to a dominant position, the basic principles and ana-
lytical framework of the AML will be followed in determining whether the undertaking
possesses a dominant position in the relevant antitrust market (Article 9).
In accordance with and parallel to Article 17 of the AMIL, the Draft IPR Guidelines
(Article 16) also lists six types of abuse of IPRs by undertakings with a dominant mar-
ket position: (1) setting unfairly high prices in the IPR licensing contract; (2) refusal to
license IPR without valid reasons; (3) exclusive dealing in the context of IPR licensing
without valid reasons; (4) tying in IPR licensing without valid reasons; (5) discrimina-
tory treatment in setting IPR licensing fees; and (6) other abusive conduct as might rec-
ognized by the relevant antimonopoly enforcement agency. Thus, all six forms of abuse
of market dominance stipulated in Article 17 of the AML can potentially occur in rela-
tion to IPRs.
A particularly important issue in IPR-related antitrust conduct is that of refusal to
license. The Draft IPR Guidelines state that the antimonopoly authorities will not inves-
tigate a unilateral refusal to license that is unconditioned or nondiscriminative, but may
investigate relevant cases of unfair and discriminative refusals to license, or cases where
the IPRs concerned constitute the “essential facilities” for the would-be licensee to be
able to compete effectively in the relevant market. The antimonopoly authority may also
investigate refusals to license that occur without justification or as a means of enforcing
other restrictive terms or tying arrangements.
While not official yet, the Draft IPR Guidelines are quite detailed and broadly in line
with international standards. It is expected that the official guidelines will not differ too
much from the current draft, which has gone through four rounds of revision already.
9.3.4.5. Treatment of SOEs

Article 7 of the AML contains somewhat ambiguous language concerning the law’s
application to state-owned enterprises. Specifically, on the one hand, it states that it “the
state shall protect the lawful activity of undertakings in industries controlled by the
Stated-owned enterprises and relied upon by the national economy and national secu-
rity.” At the same time, Article 7 also provides that undertakings in the above-mentioned
industries “shall not use their controlling position or exclusive operation rights to hurt
consumers.”
Although some commentators have interpreted Article 7 as potentially aiming
at protecting SOEs, especially right after the passage of the AML, the official and the
majority view is that the AML applies equally to all undertakings. Some of the cases
investigated by the government in fact involve SOEs. For example, in Wuchang Salt,
NDRC’s local bureau in Hubei province took action against state-owned companies that
enjoyed exclusive operation rights for abuse of dominance in the form of tying and for
their violation of Article 7. Equal treatment of SOEs and privately owned firms is fur-
ther reflected in the more recent NDRC investigation of state-owned China Telecom
and China Unicom for suspected abuse of dominance in the broadband interconnec-
tion market by way of setting discriminatory prices. In the area of merger control, the
Ministry of Commerce has also imposed conditions on proposed mergers involving
SOEs (e.g., in case General Electric/China Shenhua [2011]).
9.3.4.6. Summary of China’s Treatments of Monopolization

The provisions in China’s 2008 AML prohibiting the abuse of a market-dominant posi-
tion follow very closely those under the EU competition law. NDRC APM Regulation
and SAIC AMD Regulation, which went into effect in February 2011, provide useful
guidance on how conduct of dominant firms might be treated as abusive under the very
general language of the AML.64 Although the Chinese antimonopoly authorities have
yet to demonstrate clearly how the newly issued NDRC and SAIC regulations will be
applied when assessing abusive conduct, overall the economic principles and reasoning
that can be seen from the regulations are broadly in line with international standards.
As a unique feature of China’s AML, the three-pillar enforcement structure has raised
concerns over whether coordination will be effective among the three enforcers, and
between NDRC and SAIC in particular when it comes to abuse-of-dominance cases
(see, e.g., Fels 2012 and Zhang 2011). While NDRC and SAIC seem to have a clear divi-
sion of responsibilities, namely that NDRC is responsible for price-related abusive con-
duct and SAIC for non-price-abusive conduct, whether the two enforcers will follow the
same economic principles when assessing abuse cases that have both price and nonprice
elements (for instance, refusal to deal and exclusive dealing) may present a big challenge
in future enforcement of the AML.
Compared with almost no public enforcement in the area of abuse of market domi-
nance (with the exception the NDRC investigation of price discrimination practices by
China Telecom and China Unicom and the Wuchang Salt [2010] tying case), the limited
number of private cases dealt with by the Chinese courts so far has had a significant
“demonstration effect” in the sense that several important legal and economic issues
have been clarified by the courts. For instance, the court in Renren v. Baidu (2009) ruled
that possession of a dominant market position per se does not constitute a violation
of the AML, thus establishing the rule-of-reason approach. It also made clear that the
burden of showing possession of dominance and its abuse both rest on the shoulders
of the plaintiff.65 The national coverage of the ongoing, high-profile Qihoo v. Tencent
case also has the effect of educating the public how the court will go about assessing
abuse-of-dominance cases. On the economic side, the judge in Renren vs Baidu rejected
64 Prior to this, the Chinese courts had handled several private action cases (e.g., Baidu vs. Renren and
Li vs. China Netcom). In all these cases the courts have ruled in favor of the defendants, on the ground of
lack of evidence to establish possession of position. It has been suggested that the courts were taking a
cautious approach until they receive more guidance from enforcement agencies (Cleary Gottlieb, 2010).
65 The recent Judicial Interpretation by the People’s Supreme Court partly alleviates the proof burden
on the plaintiffs, as presented in section 3.1.2.

the defendant’s claim that “free services” cannot constitute a part of an antitrust-relevant
market, which is perfectly consistent with modern economic understanding of monop-
oly pricing in two-sided markets. These developments will undoubtedly continue to
have a positive influence on future private (and public) enforcement of the AML provi-
sions on abuse of dominance.
The Chinese antimonopoly authorities have yet to demonstrate how they will apply
modern economic reasoning in presenting/analyzing evidence, organizing views, and
assessing competition impacts of alleged abuse-of-dominance conduct under the AML.
They have shown signs, on the other hand, of taking the lead in private action cases, as
in the ongoing Qihoo v. Tencent case. Because it is understood to be the first abuse-of-
dominance case under the AML in which economics experts were engaged, we describe
the case below with the focus on the types of evidence presented and the economic argu-
ments adopted in court (which are quite detailed, relatively speaking) by both parties of
the case.66
9.3.4.6.1. Qihoo v. Tencent (2012)

On 18 April 2012, the case of alleged abuse of market dominance by Tencent Technology
Co. Ltd. and Shenzhen Tencent Computer System Co. Ltd. was heard publicly in the
High People’s Court of Guangdong Province. In this case, the plaintiff, Beijing Qihoo
Technology, accused Tencent of exclusive dealing and tying in the market of instant
message services on the Internet. Both parties in this high-profile case invited in expert
witnesses. The plaintiff engaged scholars from overseas, including a former official of
the Office of Fair Trading of England, who submitted a report covering the relevant
market in the context of the litigation, the extent of competition in the market, and the
defendant’s dominance.
At the court hearing, both parties followed the State Council’s 2009 Guidelines
Concerning the Definition of Relevant Markets in defining relevant markets. While the
details of their arguments are not available, the plaintiff utilized such notions as demand
substitutability, market shares, and indirect evidence obtained from event study price
correlation analysis and so on. The analyses of the plaintiff were conducted, and conclusions
drawn, in the context of the SSNIP framework. The court concluded that the QQ instant
messaging software of Tencent and the associated service market constituted the relevant
product market, because according to its unique pricing and profit mode, it is not easily
replaced by any other messaging service. Furthermore, due to the unique Chinese language
and cultural background in this market, there is no substitution relationship between geo-
graphical areas. Hence, the market was defined as the domestic market of China.
Tencent argued that the plaintiff ’s market definition was incorrect. Specifically, it argued
that in addition to QQ, there are various instant messaging services in the market, such as
66
The presentation below is drawn from a report by Chinese Court Daily (19 April, 2012) available at
the web page of the High People’s Court of Guangdong Province (in Chinese): http://www.gdcourts.gov.
cn/gdcourt/front/front!content.action?lmdm=LM20&gjid=20120419103006504217. Also see Chen and
Schoneveld (2012).
MSN, microblog, emails, and MiTalk. Also, instant messaging service is only one of several
communication services, and traditional communication products such as SMS, mobile
phones and telephones, and e-mails, microblog, SNS, and other social networking services,
all are substitutes. Lastly, Tencent held that, because of the openness and interoperability of
the Internet, the users of instant messaging are not limited to those in Mainland China.
In attempting to establish Tencent’s dominance, Qihoo presented the following evi-
dence. First, the market share of QQ significantly exceeds 50 percent, the threshold
specified in the AML. In fact, Qihoo pointed out that according to the data from iRe-
search, a leading consulting company, the market share of the defendant is as high as
76.2 percent, and that the penetration rate of QQ software is 97 percent according to a
report by the China Internet Network Information Center (CNNIC). Second, accord-
ing to the financial reports of the defendant for 2010, the annual revenues of the defen-
dant were as high as RMB 1.96 billion (approximately $311.11 million) and its profitability
was well above that of similar companies. Third, in terms of technological capability, the
defendants possess more than 80 percent of all the patents in the area of instant messag-
ing in China.
Tencent claimed that it does not have a dominant position (even in the market for
instant messaging). First, Tencent argued that there is significant difference between
iResearch’s definition of market share and the provisions of the AML in terms of time
and sale volumes, so the weight of the evidence is light. Additionally, the CNNIC data
refers to the penetration rate rather than market share. Second, the number of users is
not equivalent to the market share because a user may create multiple QQ accounts.
Moreover, the users are generally sensitive to price. According to a survey conducted
by the famous website eNet, if the QQ software becomes fee-based, 81.71 percent of the
users will be lost. This implies that Tencent possesses no pricing power in the market.
Qihoo accused the defendants of acts of exclusive dealing and tie-in sales. Specifically,
Qihoo pointed out that on 3 November 2010, Tencent issued a letter to QQ users, forc-
ing them to uninstall 360 software, a privacy protector developed by Qihoo that specifi-
cally targets Tencent’s QQ software, and refusing access to QQ spaces to users of the 360
browser. The forced uninstalling accounts impeded normal competition, as 360 soft-
ware competes with Internet security software products of Tencent (QQ Doctor and QQ
Software Housekeeper in particular).67 Furthermore, QQ tied its Software Housekeeper
with its popular QQ messaging software, and forced users to install QQ Doctor in the
name of upgrading instant messaging software, in violation of the AML.
Tencent did not dispute the factual aspect of the alleged conduct but claimed that it
did not constitute an abuse of dominance under the AML. Tencent defended its con-
duct by saying that QQ took incompatibility measures against the 360 products as a
self-defense, because Qihoo used infringed software, namely, the 360 privacy protector,
Koukou Guard, and other software to commercially defame and maliciously harm QQ
products. Meanwhile, the packing of QQ software with the QQ software Housekeeper
67
This can be understood as conduct of exclusive dealing, although not stated explicitly.
does not constitute tie-in sale. Rather, it is a normal practice of software integration.
Both products are installed free of charge and the users may uninstall them conveniently.
As can been seen, both the plaintiff and the defendant utilized economic arguments
in each of the three stages of court hearing, namely market definition, and determina-
tions of a dominant position and abuse, within the framework set by the AML. The court
is yet to make a decision on the outcome of Qihoo v. Tencent at the time of this writing. It
will be interesting to see to what extent the court will employ economic reasoning in its
assessment of the facts and arguments of the plaintiffs and defendant. Since the NDRC
and SAIC Regulations (mentioned earlier) are already in effect, unlike earlier private
cases where the courts had no guidance from the antimonopoly authorities on abuse
cases, it will also be interesting to see how the court interprets these regulations.
Whatever the final outcome of Qihoo v. Tencent, it can be expected that more and
more application of modern economic reasoning will be seen in future private cases in
AML enforcement. While the Chinese judges are new learners in AML enforcement,
the parties in private cases certainly have strong incentives to hire competition econo-
mists, both domestically and from overseas. One may even expect that before long, pri-
vate enforcement may lead public enforcement by either NDRC or SAIC in applying
state-of-art economic analyses in AML cases, given the staff constraints of NDRC and
SAIC, which may make it infeasible for them to hire overseas economists.
9.4. Concluding
Remarks: A Comparison
We in this chapter have described treatments of monopolization under Japan’s 1947

antimonopoly act (AMA) and China’s 2008 Antimonopoly Law (AML). While Japan’s
AMA has its roots in US antitrust law, China’s AML is drafted following the European
model, which leads to some differences in their coverage of monopolization conduct.
For instance, excessively high selling prices set by a dominant firm without valid reasons
constitutes a violation of China’s AML, but not under Japan’s AMA. Moreover, China’s
AML recognizes the notion of joint dominance, whereas Japan’s AMA does not. Third,
China’s AML contains a presumption of market dominance based on market shares.
Another distinctive feature of both Japan’s and China’s competition laws is that prohi-
bitions of certain monopolization conduct are contained in either different sections of
the same law or in different laws, which have led and can lead to systematic inconsisten-
cies. Specifically, while they are subject to regulation of unfair trade practices of Japan’s
AMA (Article 2.9), such exclusive conduct as predatory pricing and refusal to supply
may also fall into the range of exclusive private monopolization under Japan’s AMA
(Article 2.5). However, the competition tests for unfair trade practices and exclusion
as set out in the law differ: finding unfair trade practice requires showing “a tendency
to impede fair competition,” whereas finding violation of monopolization requires a
proof of “a substantial restraint of competition.” Furthermore, unfair trade violations

did not carry administrative surcharges (or criminal sanctions) until 2009, when some
of the violations became subject to surcharges. As a result, the JFTC has pursued fewer
monopolization cases than unfair trade practice cases (as discussed in section 9.2.3.2).
A similar situation exists in China. Predatory pricing and price discrimina-
tion (against other undertakings) are prohibited by both China’s AML and its 1998
Price Law. However, unlike the AML, the Price Law does not require possession of a
market-dominant position as a necessary condition for violation. Moreover, the Price
Law adopts the per se rule rather the rule of reason. In terms of sanction, the Price Law
allows for fines up to five times the illegal gains, where the AML does not permit puni-
tive damages. The enforcement agency (NDRC) can in fact choose which law to apply
towards predatory pricing and price discrimination.
The major reason for the presence of the above-mentioned double coverage in both
Japan’s and China’s antimonopoly laws is historical. In Japan, the provisions concern-
ing unfair trade practice were originally meant to be supplemental to the major goal
of the AMA, and they have often been regarded as precautionary means of protecting
consumers and small and medium-sized enterprises. China’s Price Law was enacted in
1997, ten years before its AML, with the aim being to regulate pricing behavior of both
the firms and the government, as China had just started to transform on a broad scale its
central-planning economy to a market-based one.68 While the JFTC may well intend to
enforce the private monopolization regulations by issuance of the 2009 Guidelines for
Exclusionary Private Monopolization, the introduction of surcharges for unfair trade
practices has made the distinction between private monopolization and unfair trade
practices rather obscure. In the years to come, it will be a sensible task for China and
Japan to harmonize the treatment of certain types of monopolization/abuse of market
dominance under their respective legal regimes.
On enforcement, Japan and China adopt quite distinct enforcement structures in
their competition laws: the JFTC is the sole enforcer of Japan’s AMA, whereas China’s
AML enforcement duties are carried out by three government agencies: NDRC, SAIC,
and MOFCOM. It is interesting to note that, while the jurisdictional monopoly of the
JFTC has been criticized by some scholars (e.g., Miwa and Ramseyer, 2005; and Harris
and Ohashi, 2011) for having given the JFTC a degree of discretion in the application of
the laws, as well illustrated in its treatment of private monopolization and unfair trade
practices as discussed above, China’s three-pillar enforcement system has received wide
criticism for its inherent tendency to lead to inconsistent application of the law (e.g.,
Fels, 2012; Zhang, 2011). Japan and China may benefit from sharing their experiences
and lessons from their respective competition law enforcement.
Enforcement of monopolization cases in Japan was notably lax until the late 1990s.
Specific guidance of how private monopolization should be treated under Japan’s AMA
68
The introduction of an antimonopoly law started in 1994 and was delayed until its final passage
in 2007, due to debates about whether, and at which stage of China’s economic development, a
comprehensive competition law was necessary (see, e.g., Lin, 2005).
was first introduced in the Guidelines for Exclusionary Private Monopolization under
the Antimonopoly Act in 2009. In China, the two sets of regulations issued by China’s
competition authorities, NDRC and SAIC, in 2011 provide guidance on how China treats
monopolization. We are of the view that the principles and economic reasoning set forth
under both Japan’s and China’s competition laws are broadly in line with international
standards, although the competition enforcers and courts in both countries have yet to
demonstrate how their respective guidelines are fully implemented in practice.
In both Japan and China, there is a need for more economic and econometric analysis
in competition law enforcement. In Japan, while economic and econometric evidence
has been submitted in some merger investigations, it has played virtually no role in
private monopolization cases, largely due to the lack of private enforcement and to the
fact that the JFTC remains a largely law-dominated organization (Global Competition
Review, 2012). Likewise, the Chinese antimonopoly authorities, as new members of the
international antitrust community and facing tight staffing constraints, have not yet
utilized much economic reasoning and analysis in abuse cases so far. However, private
enforcement in China has been rather active, and there are signs that private parties
have taken the lead in applying economic analysis in monopolization cases, as dem-
onstrated by the ongoing Qihoo v. Tencent, in which the plaintiff engaged competition
experts from overseas who presented systematic economic analysis in court.
Active private enforcement, as a “competitive force,” seems to have an essential role
to play in competition law enforcement in both Japan and China, as private parties have
a strong incentive to employ advanced economic analyses and techniques available in
today’s globalized world. Interaction of private action and public enforcement will fur-
ther help improve the transparency and accountability of competition law enforcement
in both countries.
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CHAPTER 10
M O N O P O L I Z AT IO N I N DEV E L OP I N G
COUNTRIES
ALBERTO HEIMLER AND KIRTIKUMAR MEHTA
10.1. Introduction
More than 100 jurisdictions in the world have adopted an antitrust law. Most of them
(if not all) have legal provisions regarding abuse of a dominant position. Together with
the prohibition of cartels, these provisions represent a central element of these laws.
However, contrary to cartels, which are always prohibited, aggressive practices by domi-
nant companies may only sometimes be an abuse (and prohibited). Furthermore the
same practices are not prohibited if they are put in place by nondominant firms. These
are the reasons why the sound application of provisions against abuse of dominance
involves significant economic and legal challenges. Abuses can be directed towards
the customers of a dominant firm (exploitative abuses) or towards the competitors of a
dominant firm (exclusionary abuses). In recent years, enforcement agencies have for the
most part applied the legal provisions against abuse of dominance to prevent exclusion-
ary as opposed to exploitative abuses,1 as exemplified by the reports of the “Unilateral
Conduct” working group of the International Competition Network (ICN 2007). The
major reason why exploitative abuses are not even mentioned in these reports is that
proving exploitation requires defining what is an acceptable exercise of market power. In
other words it entails identifying the price above which a dominant firm would abuse its
1
In some jurisdictions, notably the United States, only exclusionary abuses are addressed under the
relevant legal provisions (in this case, Section 2 of the Sherman Act).
Monopolization in Developing Countries 235
position, a very difficult task for an administrative agency or for a judge. Furthermore,
a rational dominant firm would price just below this threshold, possibly reducing the
incentives of competitors to enter (that otherwise would have faced a much more profit-
able opportunity), reducing more than enhancing competition. In fact antitrust inter-
vention against “excessive” prices can have the perverse effect of deterring entry by new
competitors.
However, especially in developing countries where regulatory institutions are not
fully operational, it may be necessary to use competition law provisions as a residual tool
of price regulation, as Ordover and Pittman (1993) argue, often in order to overcome
unequal contract terms. More importantly, however, firms’ strategies that may be disci-
plined by the antitrust provisions against exclusionary abuse of dominance range from
the refusal to provide access to an essential infrastructure, to the most complex cases in
the field of competition law, involving, for example, the identification of the informa-
tion requirements on its own products characteristics a dominant firm may be obliged
to provide in order not to block the entry of competitors, the circumstances according
to which intellectual property rights need to be shared, the exclusionary nature of target
discounts, and so on. While a clear refusal to permit access to a physical, essential facil-
ity may indeed be easy to consider abusive, a target discount scheme (even if it achieves
the same result as a refusal to deal) becomes abusive only insofar as it excludes from the
market efficient competitors. In other words, in the case of indirect exclusions (preda-
tion, discounts, margin squeezes, etc.) only practices that are able to block the entry of
equally efficient competitors should be prohibited, See Vickers (2005), a quite complex
type of analysis to be performed. A further source of complexity is that if a firm is not
dominant, not only is the conduct under consideration legitimate, it may even be pro-
competitive or, in any case, beneficial to consumers.
The enforcement of the provisions against abuse of a dominant position should there-
fore be based on a rigorous evaluation of the actual exclusionary effects of the alleged
abusive conduct. In particular, the more open markets are, even to potential competitors,
the more unstable are the observed dominant positions. In such circumstances, abuse-of-
dominance cases may be without merit, or even achieve the opposite of what they are
meant to. By making sure that dominant companies do not exercise too much market
power, abuse-of-dominance cases may suppress the signals that some markets are profit-
able and as a result may keep new entry low. This is the reason why, many argue, it is better
not to intervene against abuse-of-dominance cases (see, e.g., Posner 1979). Arguably such
an approach may be appropriate in the United States, where dominance mostly originates
from innovation and entrepreneurship and therefore most markets are open to outsid-
ers’ entry. In developing countries, where the most common origin of dominance is pro-
tectionist regulation, abuse-of-dominance cases are often the only discipline these firms
may ever face. It is, however, worth reflecting that even in such situations intervention
by the authority may result in losses in consumer welfare if the remedies imposed are
inappropriate or even perverse in that they reinforce the dominant position. Very often,
regulation, more than antitrust, is the most effective instrument.
236 Alberto Heimler and Kirtikumar Mehta
10.2. Legal Standard
As for the legal standard, the European concept of abuse of a dominant position over-
laps but is not synonymous with that of monopolization in US antitrust law. Whereas a
finding of abuse of dominance requires, as a basic element of a violation, the existence
of a dominant position in a market, monopolization is concerned with the process by
which firms achieve or maintain monopoly power. As a result, at least in principle, US
law has a wider range of applications than European law since the rules against monop-
olization could easily be applied to firms that are not yet dominant, but may become so
thanks to the adopted abusive behavior. In practice, however, at least in recent decades,
as a result of case law developments, in the United States there is a higher threshold
than in Europe for the finding of the required degree of market power and a wide
acceptance of firm strategies that would be considered abusive under European law
(Heimler 2007; Fox 2008).
However, abuse of dominance laws in developing countries often have a wider appli-
cation than in the EU or US models. China’s law, for example, is also rightly concerned
with abuse of administrative power, Russia’s law stresses unequal contracts conditions,
while India’s law takes over the EU idea of “unfair” pricing and often considers leverag-
ing an abuse. Most developing countries take over the UNCTAD model law, which also
focuses on compulsory contract terms that may directly or indirectly limit competitors.
The recognition of an abuse of dominance typically requires three steps. First, it is
necessary to identify the relevant market in which a firm is allegedly dominant. Then
the existence of a dominant position needs to be established. Finally it is necessary to
show that the specific practices under review are harmful to competition and are indeed
abusive.
The content and application of these elements varies between jurisdictions, the major
difference being the role played by market shares in the identification of dominance.
While it is clear that market shares represent only an indication of dominance, the full
analysis of harm requires proof that a given practice is indeed harmful to competition.
As a result, any lack of rigor in the definition of dominance can be more than taken
up by the rigorous analysis of harm. Especially in developing countries, where authori-
ties are small and weak and where vested interests are strong and connected, a market
share threshold above which dominance is presumed may strengthen the power of the
authorities with respect to powerful, dominant firms.
Irrespective of the legal requirements associated with proving a dominant position,
both economic theory and case experience underline the difficulties that are involved in
reaching sound conclusions in abuse cases. The major reason is that firms can achieve a
dominant position in a market through innovation, through superior production or dis-
tribution methods, or simply through greater entrepreneurial efforts. The enforcement
of competition law should not interfere with such developments. However, in develop-
ing countries many dominant firms have achieved their positions via the protection of
regulatory barriers to entry, national champion policies, or legal monopolies, so that the
disincentive of innovation originating from an excessive enforcement activism may be
less relevant. Indeed the provisions against abuse of dominance may in some occasion
be the only instrument available for establishing a level playing field vis-à-vis less pro-
tected competitors.
Nonetheless, the application of legal provisions relating to abuse of dominance in
developing or transition economies entails particular challenges. As Anderson and
Heimler (2007a and 2007b) argue, in analyzing cases in developing economies, account
should be taken of some special characteristics: (1) thinly developed capital markets;
(2) high entry barriers due to inadequate distribution channels and other business infra-
structure; (3) intrusive regulatory and licensing regimes; (4) more extreme asymmetries
of information than normally occur in developed economies, in both product and credit
markets; (5) smaller and poorly staffed institutions (see also Beato and Laffont 2003 and
Anderson and Jenny 2005).
However, such shortcomings do not imply that developing countries are incapable
of applying abuse-of-dominance provisions. To the contrary, as Brusick and Evenett
(2008) argue, there are many abuse cases in developing countries and the most common
types of abuses originate from the state or from privatized monopolies, suggesting that
enforcement is complementary to liberalization and to the promotion of competition.
As for markets unaffected by the liberalization drive, there seems to be no problem in
developing countries with the effect-based approach. However, because authorities are
small and weak, the number of cases remains quite limited.
10.3. Competition Law Enforcement in

Developing Countries
Although most countries of the world have adopted a competition law, the number of
cases has not grown proportionally. Indeed, enforcing antitrust laws is much more dif-
ficult than enacting them. Authorities must be funded, must be staffed with high-quality
personnel (both economists and lawyers) and with salaries high enough so as to keep
them in the job. Also, corruption is a problem developing countries face more often than
developed economies, and it should be taken into account when institutions are set up.
Making sure that the competition authority is of high standing ensures that profes-
sionals apply, that they keep their job, and that the institution maintains its indepen-
dence. According to the 2003 ICN report on capacity building (see ICN 2003), some
authorities, for example those of “Lithuania, Romania, Uzbekistan, the Slovak Republic,
Poland and Hungary—whether they are formally inserted in the executive apparatus or
are independent agencies—appear to be inserted into some of the highest policymak-
ing councils of government.” The report suggests that similar status is enjoyed by the
antitrust authorities of Jamaica, India, Mexico, South Africa, and Zambia. In many of
these countries salaries of the staff of competition authorities are higher than normal
government officials and in some they are in line with those of central bank employees,
usually the most reputable institution of any country. In order to strengthen the role and
reputation of antitrust authorities, an effort should be made in that direction, so that
good people are hired and kept in the job.
As for corruption, it is well known that it is very difficult to eliminate it because even
the existence of the crime is unknown.2 As a result, governments can fight corruption
only indirectly, for example by reducing the relative gain associated with it, paying high
enough salaries, and making it unnecessary for employees’ incomes to be supplemented
by illegal activities. This is why granting the competition authority the same status as
the central bank is so important. Furthermore, especially because in developing coun-
tries vested interests are highly concentrated and well connected, the system of antitrust
enforcement has to be structured so as to promote as much independence of judgment
as possible.
One way to reduce the influence of the pressure of vested interests is to make the
opening of a case more or less mandatory, especially in the area of merger control, since
the best outcome for a well-connected dominant firm is not to have the merger analyzed
at all. With an ex ante notification system (rather than a system of voluntary notifica-
tion) the authority is forced to make a decision in favor of any merger above the thresh-
old. When a case is opened a decision needs to be made, which makes it more difficult
to conclude in writing with a coherent argument that an anticompetitive merger is not
to be prohibited. The same is true for abuse of dominance. If the law introduces a pre-
sumption of dominance above a certain market share, the authority is obliged to take
seriously complaints against firms that are legally presumed to be dominant. Otherwise,
the political pressure not to open a case (on the argument that the firm is not dominant)
may be difficult to resist.
This is the main reason why in many jurisdictions (especially in developing coun-
tries) dominance is identified primarily by an established market share threshold that
may allow for possible situation-specific deviations. For example, in South Africa, a firm
is considered dominant in a market if it has at least 45% of that market, or if it has the
power to control prices, or to exclude competition, or to behave to an appreciable extent
independently of its competitors, customer, or suppliers.
The ICN report on unilateral conduct is critical of jurisdictions that adopt a structural
definition of dominance, praising countries like Latvia and Ukraine that have decided to
move to a behavioral definition of dominance. According to the report, “a key advantage
of the behavioral definition is that it better reflects dominance/SMP assessment being
a multi-facetted analysis that reaches well beyond market shares.” However the report
rightly recognizes that “while the use of behavioral and structural definitions [implies]
different breadth and detail of analysis, the definition used does not appear to necessar-
ily affect the assessment practice of specific jurisdictions directly.” In other words, by
2 Heimler (2012) argues that crimes that are undetected by the victims, in the case of corruption the
taxpayer or the competitors, are the most difficult to eliminate.

adopting an effect-based approach when assessing the abusive behavior under scrutiny,
jurisdictions can more than make up any shortcoming encountered in the definition of
dominance.
In any case, the law should not oblige the authority to formally open a case for every
complaint it receives, but only in those instances when there is a high presumption that
a violation will be found. This means that if the authority is not convinced of the validity
of a complaint, it should ask for additional information from the complainant, opening
a procedure only when the probability of finding a violation is high.
At the same time, in order to avoid corruption and to make sure that parties are treated
fairly, antitrust rules should be accompanied by strict procedural requirements: reason-
able deadlines for concluding cases, requirements that decisions be preceded by state-
ments of objections, access to files, and so on. Also, judicial review is a key component
of a fair antitrust procedure. This means ensuring that judicial review is timely and that
judges to whom antitrust cases are assigned build expertise in antitrust enforcement
so that they are able to exercise effective control over the authority’s decision-making.
Especially in jurisdictions where the number of antitrust cases that arrive to the courts is
limited, it is better to make sure that cases arrive to the same section of the court so that
judges are able to gain experience, whereas creating a specialized tribunal would be a
waste of resources and, paradoxically, could lead to a very understaffed body (no assis-
tance provided to judges since the number of cases is low, but when a case arrives the
judge is left alone and the process of judicial review may as result be very slow).
However, in order to build expertise in overseeing successful cases, it may be better
for new authorities to concentrate first on less complex cases (under a technical perspec-
tive) of exclusion of competitors by compulsory contract terms or on monopolization
of raw material sources. In both instances the remedies are also easier to identify, such
as government removing licenses or revising regulations and dominant firms being
obliged to grant access to newcomers.
Finally it would be good to make sure that the law indicates some defenses that
firms can use. In particular efficiency defenses can make it easier to make sure that an
effect-based approach is actually adopted.
10.4. Abuse-of-Dominance Cases in

Developing Countries: Some Examples
In the past, actual examples of abuse-of-dominance cases (or other types of competi-
tion law cases) from developing countries were relatively rare and not well documented.
Increasingly, however, this is no longer the case. Data on competition law cases in devel-
oping countries is becoming more systematically available (see, e.g., Clarke, Evenett,
and Lucenti 2005; OECD 2005; Evenett and Jenny 2006; and Evenett and Brusik 2011).
Also, the International Competition Network (ICN) has provided some new and
relevant information on abuse-of-dominance cases in developing countries, but not as

much as expected.3 The available evidence shows that in developing countries the legal
provisions against abuse of dominance are seldom enforced: the major reason being
that abuse-of-dominance cases are very demanding in terms of the burden of proof
that the agency has to meet. In particular, legal provisions on abuse of dominance are
mostly enforced against firms that benefited from special and exclusive rights and that
artificially excluded competitors from the market. In other words developing countries’
agencies are quite narrow in the way they enforce the rules: market-based dominance is
rare, and the law is very seldom applied with respect to exploitative abuses.
Jamaica has dealt in the past ten years with many abuse cases and in all of them has
conducted a thorough analysis of whether the company was actually dominant and the
alleged behavior was indeed exclusionary. What is interesting in the Jamaican experi-
ence is that many alleged cases of abuse ended with the finding that the abuse did not
take place. At the same time, in the few cases where the agency concluded that the firm
abused its dominant position, the case is well argued and is in line with international best
practices. For example in the investigation into the conduct of Mossel Jamaica Limited
with respect to the pricing of its fixed to mobile (FTM) voice termination service (Case
no: 6489-09 June.22.2010), the Jamaican competition authority concluded that a margin
squeeze by the dominant telecommunications provider was indeed abusive and that in
order not to be abusive “the price Digicel charges its business fixed-line voice (BFV)
subscribers to call its mobile voice (MV) subscribers [must] be no different from the
price Digicel causes LIME to charge its BFV subscribers to call Digicel’s MV subscribers;
and further this price [must] be no greater than is necessary to cover an appropriately
measured cost of providing the service,” a conclusion very similar to the one taken by
the European Commission in its Deutsche Telekom case.4 Very similar experiences can
be found in other countries of Central America.
In Costa Rica the competition authority (COPROCOM) decided in 2011 that an elec-
tricity company, Empresa de Servicios Publicos de Heredia, ESPH, abused its dominant
position by not allowing a competing telecommunications company to use the electric-
ity poles for laying cables to provide TV services. According to COPROCOM the refusal
was not objectively or technically justified. Similarly in El Salvador the authority pro-
hibited practices of refusal to deal in three cases. In one case, the TRANSAE v. MIDES
case, the only waste-processing plant in the region, once it started to provide collecting
services of infectious waste from hospitals, refused access to the waste-processing plant
to competitors. In the other two cases the dominant electricity distributor did not allow
access to competing generators.
The same pattern, that is, that most cases originate in regulated sectors, emerges in the
cases presented to the OECD Global Forum on Competition Policy in 2005. These were
3
While the ICN started as a forum for all agencies of the world, the active participation of non-OECD
countries is quite limited.
4 European Commission, Decision 2003/707/EC, Case Comp/C-1/37.451, 37.578 Deutsche Telekom
AG, 2003 O.J. (L 263).

nine cases of abuses of a dominant position in developing economies in Asia, Africa,

Latin America, and the Caribbean, briefly summarized in table 10.1. The sectors covered
by the cases comprised telecommunications, insurance, stevedoring services, electrical
energy, pharmaceuticals, travel agencies, and marine ports.
The overwhelming majority of these cases relate to infrastructure markets, includ-
ing telecommunications (three of the cases), port facilities, stevedoring services (also
three cases), and electricity transmission. In such cases, the decisions by competition
authorities are clearly meant to promote the entry of competitors in newly liberalized
markets characterized by large vertically integrated incumbents. In fact, the majority of
these cases involve, in one way or another, the denial of access by competitors to unique
or potentially unique facilities owned or managed by a vertically integrated dominant
firm. Dominant firms employ a variety of methods for denying access to competitors,
including a straightforward refusal to deal (Jamaica and the Russian Federation); denial
of interconnection (Peru); tying arrangements (Chinese Taipei) and “degrading” of the
quality of service provided (Zambia). In any case, clearly, the issue of denial of access is a
key concern for developing and transition economies.
Table 10.1 Summary Characteristics of Nine Abuse-of-Dominance Cases from

Developing/Transition Economies in the Early 2000s
Economy Sector affected Key issue(s)
China Insurance for schools Disposition of management fees received by schools for
monopoly-supplied, compulsory insurance
Jamaica Stevedoring services Denial of access by independent stevedoring companies to
wharves owned by an integrated service provider
Latvia Telecommunications Alleged pricing of a bundle of telecom services by a
historical monopolist so as to exclude competition from a
single-service provider
Peru Telecommunications Refusal to allow a competitor’s customers to “roam” using
the facilities of a dominant mobile telephone service
provider
Russian Electricity Denial of access, by competing generators, to electricity
Federation transmission facilities owned by a dominant generator
Senegal Travel agents Alleged abuse by airlines of “economic dependence” of
local travel agents
South Africa Pharmaceuticals Establishment of a sole distributor for certain
pharmaceuticals, jointly owned by major manufacturers
and importers
Taipei, Chinese Telecommunications Whether rivals must be given access to a new service
provided by a historical monopolist
Zambia Marine ports Exclusion of competitors from access to unique port
facilities managed by a long-term concessionaire
Source: OECD (2005).
The majority of the cases (especially those concerning refusals to deal) appear to be
concerned with exclusionary as opposed to exploitative abuses. Only two jurisdictions,
China and Senegal, reported to the OECD cases concerned with exploitative abuses.
However, for China, the decision in the insurance market is clearly related to overcom-
ing the possibility that the monopoly supplier will exercise significant market power
in the process of fee determination. A legitimate regulatory issue was solved through
antitrust enforcement. As for Senegal, the case, an abuse of “economic dependence” by
major airlines on the part of small travel agents, is meant to protect the income of these
travel agents and is clearly not fully in line with an efficiency-oriented approach to anti-
trust enforcement.
10.5. Abuse Cases in Russia, China,

India, and South Africa
10.5.1. Russia
In Russia the number of abuse-of-dominance cases has been very high and relatively
stable for many years (see table 10.2). Contrary to most other jurisdictions, Russia
enforces the provisions against abuse of dominance mainly with respect to exploitative
abuses by public utility service providers (distance heating, electricity, telecommuni-
cations, etc.) or by monopsony purchasers. In other words, the competition authority
mostly serves as the regulator of behavior for natural monopolies in the infrastructure
and utilities sectors.
Most of the cases are meant to stop public utility services from pricing above the regu-
lated prices with limited effect on competition, while a significant portion of Russia’s
refusal-to-contract cases also have limited effects on competition, being cases of simple
denial of service or a result of a dispute over terms rather than strategic denials of access
to competitors. Indeed most cases are opened on the basis of complaints by final con-
sumers, and cases concerning imposition of burdensome contract provisions, refusal to
conclude a contract, and violations of pricing regulatory rules account for a large share
of the caseload.
This overflow of cases that are mostly aimed at consumer protection influences the
work priorities of the Russian agency (Federal Antimonopoly Service, FAS), which
as a result is not so active in the more severe violation of the antitrust rules, including
cartels and abuse of dominance, where the number of ascertained violations is quite
limited. Some cases on abuse of dominance are reported by the ICN and are, at least
partly, in line with international standards. For example, in a case of refusal to deal, FAS
imposed a fine of more than 10 million rubles on the Sakhalin-based supplier of aviation
fuel TOK, a joint-stock company, for monopoly high pricing of aviation kerosene for
the Youzhno-Sakhalinsk airport and for refusing to allow the Vladivistok Avia Open
Table 10.2 Abuse-of-Dominance Cases by Type in the Russian Federation
2008 2009 2010
All cases Complaint Own All cases Complaint Own All cases Complaint Own
opened based initiative opened based initiative opened based initiative
All abuse-of- 1,639 1,481 158 2,411 2,061 350 2,736 2,419 317
dominance cases
Monopoly high prices 66 46 20 161 91 70 130 100 30
Monopoly low prices 4 3 1 7 4 3 6 6 0
Withdrawal of goods from circulation 2 2 0 6 2 4 9 8 1
Abusive conditions of contract 393 373 20 448 415 33 543 513 30
Groundless reduction of production 217 211 6 317 312 5 296 288 8
Refusal to contract 231 227 4 380 371 9 357 345 12
Unreasonably high prices of financial services 41 25 16 72 43 29 63 37 26
Unreasonably low price financial services 3 2 1 2 2 0 4 3 1
Discriminatory conditions 77 68 9 56 45 11 58 47 11
Creation of entry/exit barriers 53 49 4 88 84 4 98 85 13
Violation of legal rules on pricing 210 153 57 366 233 133 394 265 129
Other violations 342 322 20 508 459 49 778 722 56
joint-stock company to store aviation fuel at the airport (ICN, 2010). Analogously, in
2008 FAS concluded that it was abusive for a monopolist gas supplier to make it manda-
tory for customers to specify the gas quantities needed for a given year and then require
customers to pay for storage in case the target set for the year was not reached.
The reason for the relatively few cases on exclusionary abusive practices, is that the
Russian law is mainly concerned with monopoly pricing and as a result requires domi-
nant companies to be registered so that consumers would know that they should not
overprice. The register, maintained by FAS, lists all enterprises with a share of the market
of more than 35% with thousands of listings.5 A significant bureaucracy is required to
keep the register up to date, so that keeping the register is quite costly. On the other hand,
the benefits of the register are very limited since the public is generally not informed on
which enterprise is still dominant, because many entries are old, sometimes even ten
years old. As for monopoly prices, the Russian law defines what an abusive high price is
(a price that exceeds the cost of production and a normal profit), ignoring the difficul-
ties associated with the proper assessment of these values. Although the number of cases
against monopoly prices is a low percentage of all abuse-of-dominance cases, they are
numerically quite important (130 in 2010) and represent a big and unnecessary burden
on FAS resources.
10.5.2. China
In China the antitrust law entered into force in August 2008. The law follows the EU
approach prohibiting the abuse of a dominant position. Like the European Commission
in the “Guidance on the Commission’s enforcement priorities in applying Article 82
(102) of the EC Treaty to abusive exclusionary conduct by dominant undertakings,”6
the Chinese law identifies a rebuttable presumption of a dominant position, defined
in terms of market shares. Furthermore, in December 2010 the authorities in charge of
nonprice (SAIC) and price (NDRC) abuse issued guidelines7 to clarify for the courts and
for dominant firms the way legal provisions are to be interpreted.
Since 2008 quite a number of abuse-of-dominance cases have been decided by the
courts. All of these cases (at least those reported in English sources) show that Chinese
courts adopt an effect-based approach with respect of the definition of dominance and
the identification of an abuse. Even in the first court ruling in a dominance case (in
2009), Sursen v. Shanda and Xuanting, where Shanda and Xuanting were charged with
abuse of a dominant position in the Chinese online literature market, the court made it
5 The full title of the register is the “Register of Economic Subjects (with the Exception of Financial
Organisations) That Have a Share of the Market for a Specific Product Greater Than Thirty-Five Percent.”
6 European Commission (2009), Communication from the Commission, available at http://eur-lex.
europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2009:045:0007:0020:EN:PDF.
7 In December 2010 SAIC released the Regulation on Prohibiting Abuse of Dominant Market
Positions and NDRC released the Regulation on Anti Price Monopoly.

clear that the evidentiary threshold in supporting a plaintiff ’s claims for dominance was
to be “objective, fair and accurate.” Anecdotal evidence was not considered sufficient,
and the case was dismissed.
In the Renren v. Baidu case, Renren, an operator of a medical information intermedi-
ary website, after reducing its spending on Baidu’s search advertising service, immedi-
ately witnessed a sharp reduction of visits to its website, as a result of the fact that Baidu
had actually blocked its website from searches. The court agreed with the complainant
that the “search engine” was a relevant antitrust market even though the search engine
service was free to Internet users. However, the court accepted Baidu’s defense that it
blocked Renren’s website because it contained too many links to dangerous sites that
could threaten the reliability of the search service.8
Contrary to the court cases, Chinese agencies are often influenced in their
decision-making by the peculiar institutional structure China chose for antitrust
enforcement. NDRC is responsible for price-related infringements, while SAIC for
nonprice ones. As a result, once one of the agencies opens a case, it tends to refrain
from entering into the jurisdiction of the other, leading to a very formal approach in
decision-making. For example, in November 2011 NDRC imposed fines of almost CNY
7 million, confiscated illegal gains, and imposed a cease-and-desist order on two phar-
maceutical companies for monopoly pricing, the first time that the NDRC has imposed
significant penalties for a breach of the antitrust law. The two firms, Shuntong and
Huaxin, had signed exclusive distribution agreements with the only two manufacturers
of an essential input for a drug that reduces blood pressure. As a result of the exclusive
arrangements, the price of the drug increased from CNY 200 per kilogram to as much
as CNY 1,350 per kilogram. The origin of the price increase was the exclusive arrange-
ments, which by the way might have been a facilitating practice for a cartel between
Shuntong and Huaxin. This more complex reasoning might have put into question
NDRC’s jurisdiction on the case, and this was probably the reason why NDRC failed to
argue along these lines.
10.5.3. India
Section 4 of the 2002 Competition Act (amended in 2007) contains a prohibition of
both exploitative and exclusionary abuses by dominant enterprise, singly or collectively.
The content of Section 4 is very much in line with standard formulation of prohibited
conducts following the European approach.9
It is useful nevertheless to note certain specific aspects of the legislation on abuse
under Indian competition law.
8 The case in Chinese is summarized in http://bj1zy.chinacourt.org/public/detail.php?Id=675 and is
discussed by Liu and Qiao (2012).

9 For a thorough discussion of Indian abuse-of-dominance cases see Chakravarthy (2010); Aditya
Bhattacharjea (2008) provides a critical assessment of the Indian Competition Law and its development
from the previous legislative framework.
First, while liability for abusive conduct can be attributed to an enterprise or to a group
that consists of a parent and its associated subsidiaries, the law does not cover
abusive conduct by “an association of enterprises,” although provisions on anti-
competitive agreements provide a way to intervene in the case of abusive conduct.
For unfair, discriminatory or predatory prices, Section 4 explicitly recognizes the
“meeting the competition” clause. This attempt to circumscribe instances of unfair,
discriminatory, or predatory prices would have been better achieved by relating to
some measure of cost—for example, the simple existence of differences accord-
ing to customers in the price/cost ratio for the same good or service could be
labeled as discriminatory. As defined, however, an incumbent that is pricing to
“meet competition” across all its customers is unlikely to be found to have abused
its dominant position, while if only applying low pricing to customers of rivals
to “meet competition,” it would be considered to abuse its dominant position by
practicing price discrimination.
A dominant incumbent in one relevant market risks being considered to be abusing
its dominance if it merely “enters” another relevant market, which seems to create
unnecessary entry barriers.
By far the majority of the Competition Commission of India’s orders relate to Section
4 complaints. In comparison there are far fewer cases of cartels being uncovered and
fined. Procedurally, if the complainant does not submit sufficient information to permit
a decision by the Commission that there is prima facie indication of abuse, then the case
is closed without an investigation by the director general of investigations. Where there
is a prima facie indication, a full investigation takes place.10
A number of orders of the CCI outline in some detail the findings of the investigation
and generally a reasoned opinion leading to the final decision. Cases of interest from the
point of view of understanding the decisional practice of the CCI are those where after a
fact-intensive investigation the CCI came to a decision on a finding or lack of finding of
abuse, which we describe in what follows.
In the manufacturing sector, an intensive investigation by the CCI (order 22/2010,
Kapoor Glass Private Limited vs Schott Glass India Private Limited) showed that Schott
Glass was dominant in the supply of borosilicate glass of the specific quality that is
used to manufacture ampoules, vials, and cartridges for use in pharmaceutical indus-
try. Furthermore, it reinforced its dominance through a downstream joint venture with
a major India-based manufacturer of ampoules, vials, and cartridges. The abuse con-
cerned unfair and discriminatory pricing to third-party transformers. The complainant
alleged predation, loyalty discounts, and refusal to supply, but the investigation did not
fully sustain a finding on all these aspects. The decision imposed a fine and also ordered
Schott to cease several exclusive vertical agreements and desist from implementing its
scheme of discriminatory discounts to transformers.
10
See Sharma (2014)
In the real estate sector, the CCI found a major construction landowner and property
developer had abused its dominant position by charging unfair, arbitrary, and unreason-
able terms in allotting apartments in a subnational geographical market near Delhi (order
18, 24, 30, 31, 32, 33, 34, and 35/2010 DLF Park Place Residents v. DLF Limited and DLF
Home Development). The relevant market was defined as the provision of apartments in
the region around Delhi where DLF was found to be dominant. As with a large number
of other real estate or property contractual cases dealt with by CCI, in this particular case
the complaints were all made by individuals purchasers who had been directly affected by
unreasonable and unfair pricing and a pattern of arbitrary terms imposed on them. The
assessment of excessive pricing in the decision is based in particular on arbitrary terms
and retrospective changes to those terms, an approach that is not entirely a structural one
(Simon Roberts 2008) nor one based on excessive departures from long-run costs of an
efficient supplier (Calcagno and Walker 2010). CCI’s approach is adapted to the specifici-
ties of the situation under assessment, where the allocation mechanism for development
of urban land did not follow any robust tender procedures. Under the abuse provisions of
Indian competition law, thus, individuals singly or in groups can file for an intervention
by the CCI rather than use consumer protection law.
An important abuse-of-dominance case in the financial sector (order 13/2009 MCX
Stock Exchange v. National Stock Exchange of India) concerned the alleged predatory and
entry deterring practices of National Stock Exchange (NSE) against the entry of MCX into
the currency derivative market. The investigation confirmed the dominant position of NSE
in “all stock exchange segments” and concluded that the waiving by NSE of transaction fees,
subscription fees, and deposit margin requirements for trading currency derivatives and
limiting access to contemporaneous trading data software amounted to an abuse of a domi-
nant position. In contrast to other cases where CCI has found an abuse, here the question
of harm to competition or to investors was not raised; nor did the investigation recognize
that in regard to stock exchanges the competition is “for the market” rather than “within the
market.” The dissenting opinion by two commissioners is based on a robust market defini-
tion exercise, and they rightly raise the question of harm to competition when the entry of a
new rival leads to significant reductions in charges and fees paid by users.
In applying the abuse-of-dominance provisions of the Indian Competition Law, the
CCI has also dismissed a number of complaints after investigation. Some of the impor-
tant ones are listed below:
(1) Order 01/2010 relating to the complaint of GKB High Tech concerning abusive
conduct of Transition Opticals.
(2) Order 1/28 relating to MRTP Case No. 1/28, M/s Royal Energy Ltd. v. M/s Indian
Oil Corporation Ltd. & Ors.
(3) Order 13/2011 relating to Manappuram Jewellers Pvt. Ltd., Thrissur, Kerala
v. Kerala Gold & Silver Dealers Association, Thrissur, Kerala & Ors.
(4) Order 50/2011 relating to Gujarat Textile Processors Association, Surat, Gujarat
and Government of Gujarat v. Gujarat Gas Company Ltd., Ahmedabad.
(5) Order 11/2009 relating to Jindal Steel & Power Ltd. v. Steel Authority of India Ltd.
In regard to order (1), the investigation on the relevant market found that the complain-
ant party itself had a significant market position on the market for plastic photochromatic
lenses. Similarly for order (3), the investigation did not uncover a dominant position on a rel-
evant market for the alleged entity abusing market dominance. In orders (2) and (4) the issue
was not the market position of the defendant but was essentially that of the state measures
facilitating or underpinning conduct, as the dissenting opinion in order (2) very cogently
illustrates. As regards order (5), the investigation and final order dismissing the complaint
reflects a benchmark example of an “effect”-based analysis of alleged abusive conduct.
Finally it is important to note that unlike in most other jurisdictions, in India there
are very few cases against state-owned regulated monopolies in telecoms or other gov-
ernmentally run utilities.
10.5.4. South Africa

In South Africa in recent years the Competition Commission has prosecuted three impor-
tant cases of abuse of dominance, confirming the capabilities of developing countries to
apply an effect-based approach.11 South African Airways was fined by the Competition
Commission in 2005 for operating loyalty schemes for travel agents that induced travel
agents to divert passengers away from competing airlines (Nationwide Airlines and BA/
Comair). The loyalty schemes granted to travel agents a flat basic commission on amounts
up to a target, and if sales exceeded that target, then agents received a commission on the
whole amount, not just on the amount above the target. In addition, amounts above the
target received a higher commission rate. The Competition Tribunal concurred with the
decision of the Commission. According to Federico (2013), this case represents a best-
practice example of how to apply an effect-based approach to exclusionary discounts.
Two other important recent cases concern the sector of agricultural processing.
Following a complaint from maize traders, the Commission brought a case against
Senwes in 2006, finding that it abused its dominant position. Senwes is a silo owner
that is vertically integrated into grain trading. It is dominant in the storage of grain
(mostly white maize) for farmers close to its silos, which are located mainly in the Free
State. It charged a favorable price to farmers, as opposed to traders, to store their maize
beyond a period of 100 days. The Tribunal dismissed the price discrimination charge
but agreed that Senwes was practicing a margin squeeze. The final court judgment
ruled against the Tribunal since neither the original complaint nor the Commission’s
decision referred to margin squeeze. A second case in agriculture concerned of Pioneer
Foods in the bakery sector. As a dominant incumbent, Pioneer Foods’ subsidiary could
aggressively threaten a price war on those independent bakeries that did not follow
prices set by Pioneer.
South Africa has been very active in enforcing the law against abuses by public utilities
in order to promote competition in liberalized markets. For example, in August 2012,
11
The description of the cases is based on media releases by the South African Competition Commission.
the Competition Tribunal imposed a penalty of R 449,000,000 on Telkom SA Limited

for abusing its dominance in the telecommunications market between 1999 and 2004, a
period in which Telkom was a monopoly provider of telecommunications facilities. The
Tribunal concluded that Telkom leveraged its upstream monopoly in the facilities mar-
ket to advantage its own subsidiary in the competitive value-added network market and
in particular in the market for the provision of Internet services.12
A criticism of the South African system, unfortunately shared by many jurisdictions,
is the long time necessary for a decision to be taken. The Telkom case, decided in 2012,
referred to a practice that had taken place eight years before, substantially reducing the
guiding effect of the decision and the deterring effect of the fine.
10.6. Developing Appropriate Remedies

in Abuse-of-Dominance Cases
Remedies in abuse-of-dominance cases typically comprise one or more of the following

types of measures: (1) behavioral orders prohibiting the continuation of specific actions
or behavior; (2) the levying of fines or financial damages on firms that have engaged
in such conduct; (3) divestiture of specific assets of the firm, including vertical disinte-
gration, for the purpose of re-establishing competition in the market; (4) other “proac-
tive” measures such as mandating access to essential facilities and compulsory licensing.
Probably the most common are the first category of measures—that is, orders prohibit-
ing the continuation of specific actions or behavior. This is particularly the case in devel-
oping countries, where antitrust agencies very often lack effective sanctioning powers
or are unable to impose structural measures. However, by themselves, cease-and-desist
orders may not be sufficient to deter similar abuses by other firms or be able to restore
competition in the markets affected by the anticompetitive conduct. For this reason,
other measures such as fines or structural divestiture may need to be considered. Where
simple orders prohibiting abusive conduct are imposed, it is important that they be suf-
ficiently clear and specific to prevent recurrences. For example, if the core abuse relates
to the use of loyalty rebates to exclude potential competitors, guidance must be provided
as to the circumstances in which such rebates will and will not be considered acceptable.
A mere prohibition of “continued anticompetitive conduct” will not suffice.
Pecuniary sanctions have clear advantages vis-à-vis simple prohibitory orders in
deterring similar conduct by other firms. However, while fines are an appropriate remedy
in many cases, they are not appropriate in the circumstances where the abuse is somehow
new or the firm may not have been aware that it had reached a dominant position.
12 See http://www.compcom.co.za/assets/Uploads/AttachedFiles/MyDocuments/
Tribunal-imposes-R449M-on-Telkom.pdf.
On the other hand, where a clearly dominant firm violates known standards, that is,
those that have been enunciated in relevant guidelines or case decisions, it may well be
appropriate to seek/impose fines or other punitive sanctions. Heimler and Mehta (2012)
provide some indications on the range of fines that may be necessary for achieving
deterrence in abuse cases, somewhere between 3% and 6% of the relevant turnover.
Still another remedy that is often considered in cases involving network industries,
sometimes as an alternative to vertical divestiture, is the mandating of access to facilities
that are deemed to be essential. In the EU, the “essential facilities doctrine” permits the
mandating of access in cases where the following four criteria are met: (1) control of the
essential facility by a monopolist; (2) indispensability of access to the facility by a down-
stream/upstream competitor; (3) denial of the use of the facility to a competitor supply-
ing a new product; and (4) the absence of an objective justification for denial of access
(see Oscar Bronner GmbH & Co. K.G. v. Mediapring Zeitungs und Zeitcshriftenverlag
GmbH & Co. K.G., Case C-7/97, 1998 E.C. R. I-7791, [1999] 4 C.M.L.R. 112).13
A key challenge in such cases is to set an appropriate price for the services to be pro-
vided. Without minimizing the problems inherent in setting such a price, one possi-
ble approach to this issue is given by the so-called Efficient Component Pricing Rule
(ECPR) (see Baumol and Sydak 1994). Under this approach, the incumbent operator’s
price to final consumers is accompanied by an access charge low enough to allow equally
efficient competitors to compete (and equal to the final price minus the cost avoided by
not supplying in the competitive segment of the market).
In practice the remedy should be narrowly tailored to the violation and should not be used
to obtain “more.” In addition, behavioral remedies should not be imposed permanently, so as
not to limit too much the flexibility of the dominant company vis-à-vis its competitors. And
third, structural divestiture remedies should be used only in extraordinary circumstances.
10.7. Conclusions
Three conclusions can be reached from this overview. First, in contrast to mature com-
petition jurisdictions, authorities in young jurisdictions do not hesitate to apply the
provisions on abuse of dominance that exist in their laws. Second, and again compared
to mature jurisdictions, the investigation and decision periods are sometimes relatively
short (with some exceptions); thus there exists a reasonable prospect that remedies are
timely. Third, and perhaps not too surprisingly, the risks for false positives of the for-
malistic approach to abuse of dominance have been well understood. Thus in develop-
ing countries overwhelmingly the approach is based on economic effects and harm to
competitive processes with a significant emphasis on good empirical investigations. The
13
It should be noted that the essential facilities doctrine concerns the availability of a remedy and not
a finding of liability; before access can be granted under this doctrine an underlying antitrust violation
must be shown.
cases to date reveal that the focus is on actual foreclosure in the relevant markets con-
cerned rather than on restrictions of competition that may give grounds for assuming
potential foreclosure, or generally on market situations where there is already discern-
ible empirical evidence of damage to competitive process of a dominant incumbent.
A notable specificity of developing countries is that sometimes consumer protec-
tion issues are addressed by enforcing the abuse-of-dominance provisions instead
of the specific consumer protection legislation often administered by the sectoral
regulator, the reason being that the antitrust rules are often the only ones available
in such jurisdictions or the most immediately effective. As soon as the legislative
and institutional pillars are in place, these countries may switch to the best-practice
approach. Finally, the peculiarity of the Chinese institutional structure, where one
agency is in charge of enforcing the law against nonprice and another one against
price abuses, may lead agencies to stick to the original reconstruction of the sub-
stance of the case, fearing otherwise to lose jurisdiction. The same pattern does not
emerge in court cases.
The focus of enforcement actions in developing countries in the last decade, which
was characterized by a process of restructuring and privatizations in the network indus-
tries, was initially on cases having to do with refusals to provide access to entrants by
former monopolies. Over time the focus has moved to other markets in the industrial
and distributive industries where emerging dominant incumbents, several being joint
ventures between domestic and international partners, have been found to exercise
market power through a wide range of classic exclusionary practices. Sanctions for abu-
sive conducts would still appear to be modest; however, certain cases show that even
competition authorities of developing countries are not reluctant to impose mandatory
cancellations of contracts or structural remedies.
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CHAPTER 11
BU SI N E S S S T R AT E G Y A N D
A N T I T RU S T P OL IC Y
MICHAEL J. MAZZEO AND RYAN C. MCDEVIT T
11.1. Introduction
Business strategy is fundamentally about firm decision-making. Antitrust policy and

enforcement, in turn, evaluate the decisions made by firms and the market outcomes
that result. To the extent that firms’ decisions will be scrutinized ex post, managers must
understand how antitrust concerns might constrain their actions and, thus, suggest
alternative optimal decisions. Owing to this importance, most business strategy courses
broach the subject of antitrust, and managers frequently confer with antitrust attorneys
when making important strategic decisions.
Correspondingly, it is also useful for the antitrust community to understand how firms
use the concepts and frameworks of business strategy to make the decisions that they will
be evaluating. Business strategy maintains a holistic orientation, drawing on traditional
functional areas such as operations, finance, accounting, and marketing to inform the firm’s
overarching direction. Through the effort of academics and management consultants, busi-
ness strategy has grown in prominence and is pervasive at the top levels of most firms.
Over the past several decades, economics has emerged as the guiding discipline for
businesses making strategic decisions. This immediately suggests a potential conflict
between the goals of practitioners in strategy and antitrust. Economics-based strategy
will inevitably aim towards the maximization of producer surplus, while antitrust policy
and enforcement puts more emphasis on protecting consumer welfare. In this chapter,
we will discuss circumstances in which conflicts may arise between these goals; how-
ever, we will also highlight situations in which firms can increase their profits without
shifting consumer surplus to producer surplus. These represent potential opportunities
254 Michael J. Mazzeo and Ryan C. McDevitt
where firms can be successful—even to the point of enjoying market power—without

being sanctioned by antitrust authorities.
Using economics as a framework for understanding business strategy requires that
a firm (or any organization) start with a clearly articulated objective. This objective
typically centers on maximizing shareholder wealth for public firms, though for private
companies and nonprofit organizations modified objectives are common. The objec-
tive provides a structured rubric managers can use to evaluate alternative strategies and
make judgments about the optimal approach. We often use profit-maximization as a
shorthand description for maximizing shareholder wealth, reflecting the fact that the
value of a public companies’ shares is based on its current assets plus the future stream of
profits expected to result from its activities.
Definitions of strategy generally emphasize “big picture” issues for a business and
“long run” rather than “short run” decision-making. Distinguishing between strategy
and “tactics” is useful here, with the latter being more the purview of operations than
strategy. As Besanko and coauthors (2009) state in their leading textbook, “strategy is
revealed in terms of consistent behavior, which in turn implies that strategy, once set, is
not easy to reverse.” This may hold relevance for antitrust insofar as individual behaviors
such as predatory pricing may be thought of as tactics rather than strategy. Nonetheless,
the overarching approach to decision-making that reflects a consistent business strategy
may contain elements that put a firm at risk of scrutiny from antitrust authorities.
The role of economics in providing structure for understanding business strategy is nei-
ther universal nor uncontroversial. However, this discipline has influenced both theory
and practice because economics requires precision regarding the inputs to its models and
the identifying assumptions needed to make conclusions based on empirical evidence. In
her article “Why Economics Has Been Fruitful for Strategy,” Scott Morton (2003) notes
that “economists have powerful tools: formal modeling, the assumption of maximizing
behavior by agents, and the notion of equilibrium. Using these techniques produces crisp,
testable conclusions.” Managers benefit from the structure of formal economic modeling
because the resulting insights suggest prescriptions that depend on the specific economic
environment that firms face. However, economics rarely provides the “answer” in strat-
egy—instead, it demonstrates the trade-offs associated with alternative strategies and can
identify the conditions under which they will be more or less successful.
Business strategy is often analyzed from the perspective of three related audi-
ences: practitioners who actually make the decisions (and the consultants who advise
them), researchers who study management and organizational decision-making, and
business school instructors who teach the concepts and frameworks of business strategy
to students ranging from undergraduates and MBA candidates to participants in execu-
tive education programs. This chapter is largely organized around the last perspective,
as it tends to act as a nexus by incorporating both academic research and real-world
applications. Indeed, many practitioners have received training in business schools,
increasing the relevance of what gets taught in the classroom.
With that in mind, this chapter is organized around three fundamental concepts
taught in business strategy classes. The first is “Value Creation and Capture,” which
Business Strategy and Antitrust Policy 255
establishes the connection between firms’ activities and the notion of economic sur-
plus. In so doing, consumers are brought into consideration explicitly, as consumers’
willingness-to-pay represents a bound on the amount of economic surplus that a firm
can create through its activities. A firm’s interaction with its external environment
determines how the total surplus it generates is divided between consumer surplus and
producer surplus. Profit-maximizing firms will focus inevitably on the latter—other-
wise termed value capture—in their decision-making. However, this construct makes
it clear that a firm can generate more producer surplus either by increasing the share of
total surplus captured (relative to consumers) or by increasing the total value created.
Two influential business strategy frameworks help students and practitioners under-
stand the role of a firm’s external environment in capturing value. Michael Porter’s “Five
Forces” framework for industry analysis provides a comprehensive checklist of eco-
nomic factors that complicate the conversion of created value into captured value. To
the extent that a business strategy is designed to mitigate such factors, this may present
antitrust concerns. A second important framework emphasizes “added value,” which
represents the unique contribution that an individual firm can provide to generate
surplus. Successful firms capture value as a consequence of scarcity in the added value
framework, and this scarcity could result potentially from anticompetitive actions.
The second fundamental concept of business strategy is “competitive advantage,”
which focuses on a firm’s ability to create and capture value better than current or future
competitors. In that sense, competitive advantage concerns intraindustry heteroge-
neity in performance and has less to do with generating profitability through the con-
centration of market power. Competitive advantage is a firm-centered concept and, as
such, has been influenced by the academic literature in management, particularly the
so-called resource-based view of the firm. This topic also considers the sustainability
of competitive advantage—how firms can maintain a superior position over time in the
face of potential imitation.
Finally, business strategy covers the foundational issue of the “scope” of the firm.
A firm’s decisions regarding exactly what activities it will perform (and which ones it
will not) are critical components of its overall strategy. Since firms can undertake merg-
ers and acquisitions to alter the set of activities that they perform, a natural connection
exists between this topic and antitrust. In the last section of this chapter, we will discuss
motivations for firms’ scope strategies using the Value Creation and Capture frame-
work. This approach can help managers and policymakers identify which mergers will
likely pose problems from an antitrust perspective.
11.2. Value Creation and Capture
By emphasizing an economics-based approach for business strategy, we evaluate the

decisions that firms make in the context of optimizing behavior. Based on the goal of
enhancing shareholder wealth, that means profit maximization. Immediately, this

provides a simple, straightforward metric for evaluating firm strategy—policies that
improve profitability, Π, must either generate higher prices, P, reduce average costs, C,
or increase quantity sold, Q.
A fundamental organizing structure for undertaking strategy is the Value Creation
and Capture framework. This framework explicitly incorporates an economic treat-
ment of consumers, whose behavior is of course critical to a firm’s decision-making
process. To insert consumers into the framework, we denote the maximum amount
that a consumer is willing to pay for a product or service as B. From this, we define the
following:
• “Value Created” is equal to B − C , and represents the total societal benefit that the
firm generates with its product or service.
• “Consumer Surplus” is equal to B − P , and represents the share of value created
that flows to consumers. Importantly, consumers will choose among alternatives
by selecting the product with the highest consumer surplus.
• The remainder of the Value Created, P − C , flows to the firms as profits. We call
this portion “Value Captured” or “Producer Surplus.” It is the most relevant con-
cept for formulating strategy, as producer surplus falls directly into the profit
function:
Π = ( P − C ) *Q .

Necessarily, where P falls will be a crucial determinant of firm profitability, conceptual-

ized in the Value Creation and Capture graph in figure 11.1.
The Value Creation and Capture framework suggests two generic approaches
for enhancing profits. Profitability is equal to Value Created times the share of Value
Created that a firm can capture. So, a firm can increase profits by creating more value—
either through cost reductions or by making its product more attractive to consumers.
As long as the share captured does not decrease, profits will be higher. In addition, firms
can also focus on capturing a greater share of the value they create.
11.2.1. Enhancing Value Creation

The process and approach by which a firm achieves a particular combination of B and C
represent a starting point for understanding its strategy. In his influential article “What
Is Strategy?” Porter (1996) uses the term “operational effectiveness” to describe how effi-
ciently firms translate C into B. Firms should strive to generate the largest B for a given
level of C, or conversely, to achieve a particular level of B at the lowest cost possible. In
effect, operational effectiveness is a necessary condition for profit maximization—if a
VALUE CREATION AND CAPTURE
$/unit
Benefit of product to customer; B

willingness-to-pay
Value that goes to customers as

CONSUMER SURPLUS
VALUE CREATED
Price customer pays for product P
in the market
Value that goes to firm as PROFITS
or VALUE CAPTURED
Average (per unit) cost of C

production
units sold
Q
Units sold, or number of customers who
purchase
FIGURE 11.1 Graphical Illustration of the Value Creation and Capture Framework
firm could be more efficient, all else equal, it could provide the same B at a lower C, or a
higher B at the same C. In either case, profits could be higher.
Generating profits through operational effectiveness, however, depends critically
on what other firms in the market can achieve through their own efficiency. If multiple
firms are equally efficient, they may engage in destructive price competition that drives
down profits by shifting value created from producer surplus to consumer surplus. As
a result, a firm must achieve operational effectiveness through a unique value creation
proposition in order to generate robust profitability. If the firm’s strategy is somehow
unique, destructive price competition is much less likely.
Uniqueness can come through either doing a different set of activities than competi-
tors, or doing the same set of activities in a different way (or both). Porter further argues
that selecting a strategy that is both unique and operationally effective should be the
goal of all firms. At the same time, firms must be wary that imitators will copy unique
and operationally effective business strategies. In this context, a strategy will have a
greater chance of resulting in continued profitability in the face of potential imitation if
it includes the following:
• Trade-offs. A strategy that gains part of its operational effectiveness and/or unique-
ness by explicitly excluding specific elements as a part of the strategy is said to
exhibit trade-offs. Trade-offs are particularly effective to the extent that potential
imitators are already established in performing the activities that have been explic-
itly excluded by the profitable firm.
• Complementarities. A complementary exists between two elements of a firm’s strat-
egy ( X and Y ) if the return to doing activity X is higher if the firm also does activ-
ity Y (as compared to if it only did X ), and vice versa. To the extent that a strategy
has complementary elements, a potential competitor must imitate all of these
elements to become an effective imitator. Importantly, achieving this becomes
exponentially more difficult as the number of complementary elements in a firm’s
strategy increases. Porter refers to this concept as “strategic fit” and describes the
set of complementary elements as an “activity system.”
It is worth noting that value-creating strategies are much less likely to generate scru-
tiny from antitrust authorities. Rather, regulators are likely to be more concerned about
the split of value created into consumer surplus and producer surplus. Industrial orga-
nization economics has a lot to say about the conditions under which consumer surplus
will be squeezed to the benefit of firms. Earlier work by Michael Porter helped to bring
these issues to the forefront of strategic thinking.
11.2.2. Shifts to Produce Surplus: Porter’s Five Forces

The competitive conditions that influence the split between consumer and producer
surplus are the focus of Michael Porter’s influential “Five Forces” framework of industry
analysis (Porter 1979). Using microeconomic insights, the framework provides a tem-
plate that a firm can use to perform a comprehensive audit of all the factors that poten-
tially could reduce the share of value created that firms in its industry can capture as
profits. By tying industry profits to economic principles, the Five Forces moves beyond
simple rubrics such as industry concentration to assess issues of direct concern to anti-
trust regulators, such as the competitive effects of mergers.
In order to ensure a comprehensive treatment, Porter divides the possible threats to
value capture into five categories: industry rivals, potential entrants, substitute indus-
tries, buyers, and suppliers. For each of these categories, Porter provides a checklist
of economic conditions that tend to strengthen the threat from that group. An ana-
lyst can then use this checklist to determine the sources of competitive threats and
potentially design strategies around limiting their strength (and thereby increase
profitability).
The Five Forces framework uses the industry as the unit of analysis; therefore, using
the framework to understand a firm’s strategic position requires a clear definition of the
relevant industry and market. The tools of industry definition for strategy will be similar
to those in antitrust, with particular focus on products and geography. However, while
the precise details of market definitions are often critical for antitrust cases, the struc-
ture of the Five Forces framework renders the stakes relatively low for strategy. To the
extent that analysts define the market narrowly, there will be less industry rivalry. But,
the analyst will still account for all the parties that affect the industry’s profits in their
consideration of substitute products.
Rivalry stands at the center of the Five Forces framework, and all the other forces
point towards it. Most forms of rivalry result in price competition that reduces indus-
try profits. The presence of several industry characteristics often coincides with intense
industry rivalry or indicates that one of the market’s participants might have a strong
incentive to cut its prices, potentially initiating a price war. For instance, in a market
characterized by high inventory costs, firms may cut prices to unload products nearing
obsolescence. In a market with high fixed costs, firms may lower prices to increase quan-
tity sold and reduce average costs. For undifferentiated products, firms often compete
on price to distinguish themselves.
To counteract each of these industry characteristics, firms may pursue policies that
run afoul of antitrust regulations. To avoid the destructive nature of obsolescence, firms
may join trade organizations that set standards, however implicit, for product redesigns
and innovation cycles. To combat the incentive to move down the average cost curve,
firms may collude to set quotas. To instill a measure of differentiation, firms may divide
up exclusive territories.
In Porter’s framework, rivalry refers only to the firms operating in the same industry
or market. The other forces describe the competitive strength of less-direct competi-
tors, such as those that sell substitute products. When one of these other forces is strong,
downward pressure on prices may also result. For example, in an industry that does not
have intense rivalry, we might expect more firms to join the market and subsequently
increase industry rivalry (Bresnahan and Reiss 1991). Firms may not suffer from this
competitive threat if other firms cannot easily enter the market—that is, when barri-
ers to entry exist. Using the Value Creation and Capture framework, a strategist would
think of a barrier to entry as any factor that increases the costs of new firms in the mar-
ket relative to established firms, or that increases a consumer’s willingness-to-pay for
an incumbent’s products relative to new entrants’. Features such as economies of scale,
product differentiation, switching costs, and access to distribution channels all affect
a potential entrant’s value creation upon joining a market and, consequently, its abil-
ity to compete with incumbents. Again, antitrust concerns may readily apply in situa-
tions where firms take actions to forestall entrants. For instance, Microsoft’s decision to
bundle Internet Explorer with Windows effectively reduced the relative value created by
Netscape in the market for browsers.
In the event that an industry (1) does not have intense rivalry, (2) has meaningful bar-
riers to entry, and (3) lacks compelling substitute products, two remaining forces still
may dampen profits. First, if consumers (here, “buyers”) are more powerful, they may be
able to negotiate lower prices and capture a larger share of the value created. Some of the
factors related to buyer power directly reflect the competitive conditions outlined under
rivalry. For example, with more or undifferentiated rivals, it is easier for buyers to pit one
industry rival against another for price negotiations. Other factors relate to the ability or
motivation buyers have to negotiate more intensely with firms in the industry. A buyer,
or group of buyers, is typically better able to negotiate lower prices if it purchases a large
volume of the seller’s output, if it has full information about the deal’s specifications and
past transactions, or if it earns lower profits.1 A company can improve its strategic posi-
tion by serving customers that do not possess much negotiating power, a tactic known
as buyer selection. Cartels represent a classic example of attempts to reduce buyer power
that violate antitrust acts.
Analogous conditions will permit powerful suppliers to extract profitability from a
given industry. If suppliers have power, they can force price increases (or quality reduc-
tions) onto firms in the industry, which increases their production costs. Supplier power
is unique among the Five Forces insofar as the effect is on value created and not the share
of value that is captured. Nonetheless, there may be regulatory concerns regarding strat-
egies that aim to limit supplier power, as they transfer value created into one industry
from another. Note that labor must be recognized as a supplier as well, and it may exert
substantial power in many industries. Recently, Apple, Google, Intel, and others faced
antitrust scrutiny for conspiring not to recruit each other’s employees (Helft 2010).
11.2.3. Added Value

In a number of productive ways, strategists have incorporated the principles of game
theory to bolster the Value Creation and Capture framework. A particularly prominent
concept from this evolution is added value, which is defined as the total economic value
created less the counterfactual value that would be created absent a given participant
(Brandenburger and Nalebuff 1998). Added value is greater in circumstances where
more value is created and in situations where an agent’s contribution is scarce—that is,
when no other participant can generate the same value. A participant’s added value then
bounds the amount of value that he can capture; intuitively, a player cannot take away
more than he brings to the table.
This reasoning maps directly to the Five Forces, particularly buyer and supplier power,
and the negotiating ability of firms to transfer surplus. Firm tactics aimed at increasing
added value may straddle the line of antitrust regulations. For instance, restricting the
number of licenses available for a given technology protects its scarcity value, but may
draw the attention of regulators who may view it as anticompetitive.
Strategy frameworks that analyze competition using economic principles provide
analysts with a more comprehensive picture of its industry’s prospects for profitability.
Furthermore, an effective competitive strategy does not just accept the industry assess-
ment, but creates a defendable position against the Five Forces. This is the heart of com-
petitive advantage outlined in the following section. Distinguishing between value
creation and value capture provides a useful construct for thinking about the types of
1 For example, Dafny (2010) finds evidence that firms with positive profit shocks subsequently pay
higher health insurance premiums. The interpretation is that the firm’s relative profitability will motivate
them to fight harder or less hard to get a good deal on health insurance for their employees.
strategies on which antitrust authorities will focus. We will continue with this theme in
the next section as well.
Before leaving the topic of value creation and capture, it is worth noting that, from a
business strategy perspective, decisions are typically based on maximizing long-term
profitability. As a result, a firm may not appear to be maximizing short-run profits in
certain contexts related to pricing, R & D, network effects, and so on (Oster 1999). In
contrast, many antitrust analyses are more explicitly short-run in nature.2 We can see
this most readily in empirical merger evaluations, such as Nevo (2000), where price
effects are simulated assuming a change in ownership for previously competing differ-
entiated products but no change in the merged firm’s product portfolio. Efforts to incor-
porate longer-term product decisions in merger analyses (Draganska, Mazzeo, and
Seim 2009, Fan 2013) represent a way to bridge the antitrust and strategy literatures, and
is an important avenue for future research.
11.3. Competitive Advantage and

Sustainability
The Value Creation and Capture framework provides an analytical link between eco-
nomics and firm strategy. An analysis of competitive advantage takes the next logical
step in developing a structure for evaluating the success of individual firms. This frame-
work helps us understand—and predict—why firms in the same industry that face the
same underlying economic forces may nevertheless have very different profits. Perhaps
more importantly, this framework allows us to diagnose the sources of a firm’s superior
(or inferior) profitability to guide strategic decisions. As such, the competitive advan-
tage framework focuses on the individual firm, not its industry. We will consider how
the firm’s “resources” contribute to its capabilities, and how these capabilities explain its
performance.3
To start, we need a precise definition for competitive advantage: the resources or
capabilities that allow a firm to capture value better than existing or potential com-
petitors. We think of these “resources” in fairly general terms. They are anything that
directly affects the quality, costs, and other attributes of a firm’s product or service.
Examples of resources could include tangible elements like location, physical plant/
equipment, or product offerings, as well as intangibles such as brand identity, people/
culture, relationships, and so on. “Capabilities” represent the activities that a firm’s
resources enable it to do. Some analysts will collectively refer to a firm’s resources and
capabilities as its “assets.”
2 Ghosal (2011) discusses this phenomenon and provides relevant citations.

3 This contrasts with Porter’s Five Forces framework, which considers the conditions that make an
entire industry more or less profitable, on average.

A key assumption here involves heterogeneity among firms’ resources and capabili-
ties. All firms are different—even firms producing goods that are very close substitutes
may produce them in very different ways. We need to build on the notion of heterogene-
ity to consider competitive advantage: a firm must possess some resource that leads to
a unique capability that, in turn, results in superior performance compared to its rivals.
It is important to emphasize that a useful analysis of competitive advantage must at all
times be framed in terms of comparisons between a firm and its rivals. With this per-
spective, firms may confront challenging, and potentially uncomfortable, realities—
even activities that a firm does well may not be superior, as compared to its rivals.4
Firms pursue three broad types of advantages, with the first being a cost-based
advantage. Consider an industry with many firms. Even if they produce the same prod-
uct, the firms may be heterogeneous in terms of the resources they use to produce their
output. A firm with superior resources may produce the good at a lower cost than its
rivals. If there is not enough low-cost capacity to satisfy market demand, the low-cost
firm will be able to earn the difference between its own costs and its rivals’ (which will
determine market prices) as economic profits. A firm with a worse set of resources may
just break even.
A cost-based advantage may arise from a number of sources. A firm may increase
its size or scope: economies of scale, economies of scope, volume purchases, increased
capacity utilization, and specialization all potentially reduce a firm’s costs. Relatedly,
a firm may increase its cumulative experience, which can bring down marginal costs
in a setting characterized by a learning curve. Firms may increase their organizational
efficiency through vertical integration, long-term contracts, or management and con-
trol. Finally, a firm may increase its technological efficiency through automation, pro-
duction processes, coordination, transportation, or communication. To the extent that
cost-based advantages derive from efficiencies, antitrust authorities typically remain
passive. When the advantages come from wielding buyer power or from taking actions
that raise rivals’ costs, however, scrutiny may result.
Firms may also pursue a benefit-based advantage, a natural companion to cost-based
differentiation. Typically, firms have to make trade-offs related to the price-quality pref-
erences of consumers because increasing quality involves increasing costs. Suppose,
however, that a firm possessed the resources and capabilities to produce a higher-quality
product at a lower or similar cost than rivals. Charging the same price would not maxi-
mize the firm’s profits in such a case. The firm could increase its price and not lose cus-
tomers—consumer surplus, B − P , for the firm’s superior product would still exceed
competitors’.
Benefit-based advantages stem from various origins. For instance, a firm may
improve the physical characteristics of its product by improving performance, dura-
bility, quality, features, aesthetics, or ease of use. A firm might also be able to increase
4 The related concept of core competencies puts somewhat less emphasis on comparison across
organizations, but nonetheless has contributed to the development of competitive advantage (Prahalad
and Hamel 1990).
the quality of complementary goods such as postsale service, spare parts, warranties,
maintenance and repair, or characteristics associated with sale or delivery in regards to
timeliness, convenience, and the quality of sales staff. Benefit-based advantages could
also result from factors that influence customers’ perceptions or expectations in terms
of reputation, an installed base of users, and network externalities. Finally, a firm may
improve its subjective image through prestige, status, or association.
A firm’s key challenge when pursuing a benefit-based advantage is to choose which
product characteristics to improve. Consumers must be made better off despite the price
increase, which is necessary to offset the firm’s higher costs. When such price increases
are associated with firms having a large market share following a merger, antitrust
authorities may become concerned. For example, practices such as bundling and tying
may result in higher prices but nonetheless improve consumer welfare. Uncertainty
regarding the treatment of such outcomes may yet exist, as the proper role for con-
sumer welfare in competition policy remains the source of considerable debate (see, e.g.,
Crandall and Winston 2003).
Finally, firms can pursue a niche-based competitive advantage in which the firm pro-
duces a good that some consumers prefer over alternatives at the same price—that is,
customers have heterogeneous preferences in the sense that not everyone would pur-
chase the same product at the same price. In a way, this firm is somewhat like a monop-
olist: it occupies a unique location in “product space.” Once the firm has chosen its
product-space location, the resources and capabilities that allow the firm to occupy it
efficiently generate the niche-based advantage. As in Hotelling (1929), a strategist would
conceptualize product heterogeneity as the distance between the firm’s location in prod-
uct space and its nearest rival’s location.
Because of their heterogenous preferences for different varieties, consumers do not
consider competing products perfect substitutes. As a result, a firm that is differenti-
ated in product space can maintain a price above costs without losing all of its market
share to competitors. Since price exceeds cost, the firm with a niche-based competitive
advantage earns an economic profit, P − C > 0. The size of the subsequent profit margin
depends on the intensity of consumer preferences relative to other available substitutes
in the market.
Note that “positioning” in a market cannot deliver, by itself, a niche-based competi-
tive advantage. The firm’s offering must (1) be unique relative to the competition and
(2) have sufficiently high demand to cover its fixed costs of production. These conditions
require the firm to possess distinct resources and capabilities. There may, in this case,
be an inherent conflict between the goals of strategy and antitrust policy. As demand
grows, what was once a profitable “niche” can potentially be construed as a “market,”
resulting in scrutiny by regulators. The questions of market definition presented in the
previous section become especially relevant in such circumstances.
While the competitive advantage framework is not nearly as formal as Porter’s Five
Forces, the underlying microeconomic foundations remain critical. The key conceptual
touchstone for competitive advantage is consonance. Successful firms have consistency
among the activities they pursue, the resources they possess, and the capabilities that
these resources confer. Firms can achieve greater consonance by undertaking strategic
initiatives that are consistent with the resources and capabilities they possess and by
developing and acquiring resources that fit well (i.e., are co-specialized) with their exist-
ing resources. While consonance may be difficult to measure or quantify, some strate-
gists believe that systems of activities that reflect this internal consistency are crucial for
the success of firm strategies.5
11.4. Sustainability of Competitive

Advantage
To this point, our discussion of competitive advantage has taken mostly a static view.
We have looked at how a firm might generate a competitive advantage, but have not
dwelled on whether or not the firm would achieve only a short-term gain. Clearly, mar-
ket conditions change, and a robust competitive advantage framework must incorpo-
rate a dynamic perspective into firm strategy.
As mentioned previously, successful strategies will attract imitators. From an evo-
lutionary perspective, this increases social welfare: good strategies replicate, bad ones
die out. From the perspective of a firm that currently enjoys a profitable competitive
advantage, however, the threat of imitation looms large. The types of strategies that a
firm employs to protect its competitive advantage over time ultimately will determine
its success. These strategies can also be troubling and problematic from an antitrust
perspective.
The competitive advantage framework outlined above suggests that a firm can sustain
its competitive advantage by protecting the resources and capabilities responsible for
generating it. In that spirit, the following set of conditions represents minimum and nec-
essary conditions for a firm to maintain its competitive advantage in the long run: lim-
its to resource competition, limits to resource acquisition competition, and resource
immobility (See, for example, Peteraf (1993) and Wernerfelt 1984).
Limits to resource competition are key to preserving a competitive advantage.
Subsequent to a firm gaining a superior position and earning profits, a protection must
be in place to limit the competition for those profits. Possessing uniquely valuable
resources drives competitive advantage; therefore, if another firm can obtain the same
resources, the competitive advantage will not persist. Two important aspects further
distinguish the limits to resource competition.
First, isolating mechanisms prevent other firms from copying the resources respon-
sible for a firm’s superior profits. An isolating mechanism prevents firms from imitat-
ing either the production efficiencies or the characteristics of the end product (of the
5
One recent example can be found in Leinwand and Mainardi (2010).
superior firm) that make it uniquely desirable to users. Some examples of isolating
mechanisms are formal, such as property rights, patents, or copyrights. These legal pro-
tections prevent others from using the resource. Indeed, resources such as patents and
copyrights explicitly confer monopoly power—society is willing to grant pricing power
as an incentive for innovation (presumably with a net benefit for consumer welfare).
However, some argue that, especially in industries susceptible to monopolies, firms can
abuse the legal protections of patents to protect themselves from competition.6
Other isolating mechanisms may be less formal but can be equally effective in pro-
tecting resources and competitive advantages. For example, if scale is crucial for achiev-
ing lower costs, an entrant may not be able to achieve the same size as incumbents.
Intangibles such as culture and reputation are particularly difficult to replicate. By defi-
nition, culture and reputation need time to grow and can become stronger over time.
In the strategy field, we often point to Southwest Airlines as the prototypical example,
though many others exist as well (O’Reilly and Pfeffer 1995).
Firms must also guard against resource substitutability: situations where competitors
may possess a different resource that delivers the same advantage. The rival firm is not
copying a resource per se, but it nevertheless achieves the same result. For example, if
another farmer developed a very low-cost fertilizer, a firm that owned more-fertile land
than its rivals would no longer have a competitive advantage (even though his property
right to the fertile land remains intact).
An additional condition necessary for sustaining profits is that other firms do not
foresee the value that the resource will create—that is, the firm has strategic foresight.
Consider the alternative: if all firms recognize a resource’s value, competition for the
resource will drive up its acquisition price to a point that offsets any profits generated
by it. This is why, in general, strategists are skeptical that “exclusive” arrangements from
suppliers will be profitable. Obtaining exclusivity should be costly, assuming compe-
tition. As such, this is the place to look to ensure that markets are sufficiently com-
petitive; indeed exclusive dealing is a very rich area for antitrust theory and practice
(Marvel 1982).
The third necessary condition for a firm to achieve a sustainable competitive advan-
tage is resource immobility. Immobility generally requires that the superior resource
cannot be profitably traded. If the resource would be more productive in the hands of
another firm, then the firm that does control it is not maximizing economic profits. For
instance, co-specialization occurs when a resource must be used in conjunction with
other firm-specific resources in order to create the most economic value. In cases where
resources are not co-specialized, a firm can benefit its shareholders by trading the asset
(even if it is a profitable asset). Presumably, a more co-specialized firm would be willing
to pay a premium to acquire the asset, and the net profit from the trade would contribute
positively to the value of the firm.
6 This argument is laid out nicely in Feldman (2003). It is being tested in the contemporary strategic
and legal battles playing out in the handheld device industry (Catan 2011).
In addition to resource protection, established firms can extend their sustainable

competitive advantage through accumulated market experience. Here, we can again
turn to the Value Creation and Capture framework for conditions under which opera-
tions in the past can either lower C or increase B . Such factors would enhance the firm’s
prospects for maintaining profitability by creating additional value.
A firm’s learning curve describes any situation in which cumulative production expe-
rience reduces a firm’s average variable costs. Note the distinction between the learning
curve and economies of scale—an experienced firm (with learning curve economies)
would have lower costs at any particular scale of production. Firms with a steep learn-
ing curve may attempt to underbid rivals for business or subsidize consumption ini-
tially in order to build up their cumulative experience. Note, however, that just as with
scale economies, a firm might reach a point of diminishing incremental cost savings
at very high levels of cumulative experience. When learning curve economies are par-
ticularly compelling, it may be sensible for firms to engage in predatory pricing behav-
ior. Analysts have noted that these cases are often very difficult to prove (Cabral and
Riordan 1997).
For some products, a consumer’s willingness to pay is partially determined by the
total number of consumers who use the product. Here, there are “network externali-
ties”: a “network”of users creates an “external” benefit to additional consumers.In this
environment, firms can gain an advantage by building up sales in early periods and
developing a large “installed base” of users who have purchased the product in previous
periods and still use it. Studies have shown that if network externalities are strong, there
may be a welfare benefit associated with a monopolist, complicating antitrust analysis
(Katz and Shapiro 1985).
Finally, switching costs can increase the effective price of a new product relative to
an established one, conferring an advantage to a firm that has achieved more sales in
earlier periods. Clearly, a strategy of building switching costs into a product or encour-
aging early adoption can permit firms to extend their competitive advantage over
time. As Farrell and Klemperer (2007) point out, this can lead to competition “for the
market,” and competition policy behaves somewhat differently. Note, in addition, that
forward-looking consumers will take the effects of switching costs into account when
they make their initial purchase. Knowing that a firm will have them “locked in” and
vulnerable to price increases in future periods renders consumers more wary at the ini-
tial point of purchase. This may limit the potential efficacy of such strategies.
11.5. Scope of the Firm
Among the specific topics that we address using the principles of economics in strategy,
none is more fundamental and relevant than issues surrounding the scope of the firm.
The first substantial section of the Besanko and coauthors (2009) strategy textbook, for
example, covers firm boundaries—both the vertical boundaries of the firm, as well as
questions related to diversification. This partly reflects the historical context—among
the earliest influential strategy frameworks from consulting was the BCG “growth/share
matrix” that classified a firm’s business units based on their market share and growth
prospects, identifying some for investment and others for divestiture. In addition, eval-
uating potential mergers and acquisitions is a principal responsibility of the strategy
group within many organizations.
In using economics as the underlying framework for making strategic decisions, we
recall Coase’s definition of a firm’s role as “organizing transactions” for the economy.
Coase (1937) suggests that a firm’s decision about its scope should address the question,
“Why does the entrepreneur not organize one less transaction, or one more?” Of course,
the answer to this question depends on the context considered—a particular firm’s
resources, products, and relevant markets will determine how it should set its boundar-
ies in order to maximize profits. In strategy, we focus on the economic issues that affect
a firm’s decision to conduct certain tasks internally or to “use the market” instead. In so
doing, we embellish the Value Creation and Capture and Competitive Advantage frame-
works to address how a firm should organize its activities to maximize profits and share-
holder wealth.
On the surface, strategic decisions regarding economies of scope can be evaluated
using another simple, straightforward rule: a single firm should perform two activities,
X and Y , if and only if the profits from doing both activities within a single firm exceed
the profits from doing each activity across two distinct firms:
Π ( X + Y ) > Π ( X ) + Π (Y ) .

Otherwise, one firm should perform activity X, and a separate firm should perform
activity Y . We can think of activities X and Y in fairly general terms—they could refer
to the same activity in different geographic markets, differentiated products, rival firms
in the same industry, or completely unrelated activities.
When practitioners use the term “synergy,” they are essentially referring to the idea
behind this comparison of profit functions—there would be a synergy between activi-
ties X and Y if profits increased when those activities were done within the same firm.
In other words, the “synergy” is the explanation for why profits are greater when activi-
ties are combined.7
7 In this spirit, a firm derives no synergy if it vertically integrates simply to “obtain the activity at
cost” (i.e., to avoid paying a supplier’s high markup) or if it horizontally integrates to obtain the buyer’s
or supplier’s profit. The buying and selling of firms occurs in a market—to the extent that “excess
profits” exist, the potential integrator would have to pay for these profits in the acquisition price. While
“bargains” may be found, an acquisition premium typically drives final bids to the second-highest value
among the potential acquirers. Even if it seems like the combined firm is obtaining the activity for itself
“at cost,” this masks opportunity costs, in terms of what the firm would earn by selling the output at the
market price.
By linking synergies directly to the profit function, we can immediately categorize

potential ways in which firms could increase profits by combining activities. The com-
bined activities must result in at least one of the following for the firm—higher prices,
lower costs, or greater demand (quantity)—and must do so without counteracting the
gains with offsetting losses on other dimensions. From the firm’s perspective, identify-
ing what these potential synergies are (and attempting to quantify them) is crucial for
making effective strategic decisions. However, as long as synergies exist and are sub-
stantial, it would not matter from the firm’s perspective where the important synergies
associated with a merger derive.
Of course, from an antitrust perspective, the source of the synergy is crucial for the
regulatory evaluation of a merger. Of particular concern are circumstances in which a
firm may achieve price-based synergies from a potential acquisition that reduces com-
petition in a market. In the United States, the Hart-Scott-Rodino Act stipulates that the
parties involved in substantial mergers and acquisitions must notify the Federal Trade
Commission and the Department of Justice before commencing the proposed trans-
action. In their notification filing, the parties provide information about the industry
and their respective firms that may be used (along with additional data and detailed
analysis) to determine whether the merger will reduce competition and cause harm to
consumers.
These agencies may bring legal action to block potential mergers in such cir-
cumstances, though these cases often settle prior to litigation following mutually
agreed-upon conditions aimed at limiting the potential ex post harm to consumers. For
example, a settlement was reached in 2007 between the Federal Trade Commission and
two merging northeastern US supermarkets, A&P and Pathmark. Of the roughly 450
stores in the combined company, it was agreed that six in specific towns in New York
State would be sold in order to ensure that consumers would not face substantial price
increases after the merger.8
In a similar vein, firms may be able to raise revenues (or reduce costs) by expanding
their portfolio of activities to increase their negotiating power over a common buyer
(or supplier). This strategy may be achievable even if the firms are producing noncom-
peting products—the idea is that in a negotiation, a firm’s threat point is more damag-
ing if the firm constitutes more of the buyer or supplier’s overall business. The merger
between Gillette and Procter & Gamble is an illustrative example; by merging, the firm
could potentially increase its negotiating power with powerful retailers such as Walmart
based on the size of its overall portfolio of products sold there. The regulatory authori-
ties considered a “portfolio effect” along with concentration in particular product cat-
egories where the firm offered competing products premerger. Revenue increases that
come from shifting surplus to the merged firm from another firm rather than from
8 The FTC commented that “Absent the relief provided by the Commission’s consent order,
consumers in these areas likely would face higher prices and lower levels of service when shopping for
their weekly groceries.” Cf. http://www.ftc.gov/opa/2007/11/pathwork.shtm.
consumers may well generate less regulatory scrutiny, particularly (as cited in this case)
where the countervailing power of buyers is also quite high.9
This detailed level of regulatory concern and analysis suggests that firms may not
be able to rely solely on price synergies as justifications for mergers. As a consequence,
cost-based synergies and demand-related benefits become more important for manag-
ers that are evaluating opportunities to add further activities to their firm’s scope.
For demand synergies, we attempt to take account of situations in which the prod-
ucts or services offered by a firm would generate a greater willingness-to-pay for con-
sumers as a consequence of the firm increasing its scope and adding an activity. The
2004 merger between health insurers Anthem and WellPoint illustrates this concept.
Providing health insurance requires making contractual arrangements with local pro-
viders and receiving regulatory approval from individual states. Prior to their merger,
each firm offered such services in a network of states that did not overlap. Thus, the
merger would not eliminate a competitor in any geographic market. However, the
merger did increase the network of states in which the combined firm offered coverage.
An insurer with a broader geographic coverage network is likely more attractive to an
employer with a presence (and employees that need to be covered) in multiple states.
There is a potential for higher prices as a consequence of such a merger, but the price
increases would likely come from having created more value rather than from a change
in the share of the value created that is captured by firms.
In practice, firms rarely rely on these sorts of demand-side synergies to justify merger
decisions. Situations like the Anthem-WellPoint merger are rare, and even if a demand
expansion seems compelling, it may be difficult to quantify. Furthermore, alternatives to
integration such as joint marketing agreements can often be employed when indepen-
dent firms want to take advantage of demand-side complementarities between products
or services that they own. Unless there are incentive or informational issues that would
decrease the efficacy of a contractual arrangement, it is often a better strategy to avoid
merging activities to exploit demand-side synergies.
This leaves cost-side synergies, which are typically the most straightforward for firms
to quantify premerger and the least objectionable from the perspective of the regula-
tory agencies. Synergies on the cost side require some kind of reduction in costs that
comes from the integration of multiple activities within the same firm. In the case of
within-industry horizontal mergers, cost savings would be associated with traditional
economies of scale; the extent of the synergy would depend on premerger capacity utili-
zation and the scalability of the underlying activities. If a firm would have to incur addi-
tional fixed costs as a result of the combination, any potential synergy would be offset to
some degree.
9 In its decision on this merger, the European Commission noted that “The risk of portfolio
effects resulting from the merger is mitigated considerably by the ability and incentive of retailers
to exercise countervailing buyer power. Large retailers can exert pressure on the parties as they
can more credibly threaten to integrate private labels on their shelves of by sponsoring new entry
through active in-store promotion.” Cf. http://ec.europa.eu/competition/mergers/cases/decisions/
m3732_20050715_20212_en.pdf.
In other horizontal combinations, the source of cost-side synergies may be more

subtle. Conceptually, however, the notion of shared production infrastructure remains.
For example, firms in different industries that sell to similar consumers may be able to
share customer lists or generate other marketing efficiencies. Managerial infrastructure
can also potentially be shared, especially in cases where the merged activities have a
similar overall strategy. These factors are illustrated in the long-standing mutually ben-
eficial combination within PepsiCo of a soft-drink division and snack foods division
(Frito Lay). The company historically has not attempted to recognize synergies through
negotiations or joint promotions; in fact, the divisions have operated completely inde-
pendently from each other. Instead, the company cites managerial efficiencies at the
highest levels of the organization that come from overseeing businesses with a com-
mon approach (particularly relying on national and international marketing). Indeed,
PepsiCo executives typically rotate through both divisions at various points in their
careers, gaining experience in their shared endeavors.
While most of the discussion above has focused on horizontal combinations, the same
analysis of value creation and capture applies to vertical combinations. In this sense, the
distinction between horizontal and vertical integration is somewhat arbitrary; however,
subtle issues that affect firms as they extend their vertical scope warrant special consid-
eration in strategy formulation. In particular, considering vertical integration provides
us the opportunity to introduce incentive and organizational issues that are critical to
effective strategy. These issues are relevant even for firms that do not typically consider
mergers and acquisitions an important part of their overall strategy.
Indeed, for most firms, vertical combinations reflect a fundamental strategy consider-
ation, insofar as they must decide whether to perform activities along the vertical chain
themselves or “purchase” services from independent firms in the market, if they even
want to be in the business at all. As such, we pose the vertical integration question in the
context of a “make versus buy” problem. A key consideration, then, is the opportunity
cost of not integrating. For example, if the downstream firm does not produce one of its
inputs, it must purchase that input from an upstream supplier. For the firm to pursue
a vertical integration strategy, the overall profits associated with producing that input
must exceed the overall profits associated with purchasing it from the market instead.
Again, much of the focus in analyzing the make-versus-buy problem is about value
creation. Often, straightforward cost-based reasoning applies. For example, a firm
should outsource activities for which it does not have enough scale when (competitive)
market specialists are larger, whereas vertically integrating may allow firms to avoid the
(often expensive) transaction costs associated with exchange across firms. For example,
the coordination of production flows may be compromised when a firm purchases an
input from the market. There may be additional inventory costs if the inputs arrive too
early, or costly idle time if they arrive too late. Dealing with such problems using tech-
nology or contracting may be more difficult if transactions take place outside the firm.
In addition, monitoring in a vertically integrated organization may prove challeng-
ing. We introduce the concept of agency costs in terms of the potentially misaligned
incentives along the vertical chain. The “cost” to the firm represents the forgone profits
when incentives are not appropriately aligned. For example, franchising relationships
are common in industries like lodging and food service because success (at least in part)
requires intense managerial effort that is difficult to monitor and reward. If technologi-
cal improvements allow greater monitoring (as in the trucking industry), it may be opti-
mal to bring once-outsourced activities in-house (Baker and Hubbard 2003).
Beyond these efficiencies, however, there is scope for vertical integration to increase
a firm’s profits without creating additional value. As an example, such a situation can
occur when an upstream monopolist sells to a competitive industry. By vertically inte-
grating with one of the downstream competitors, the firm could, in effect, extend its
monopoly to another industry by limiting access of its unique input to only its inte-
grated division. Providing downstream rivals with the input, but at less attractive
terms, would accomplish a similar goal by raising the rivals’ (relative) costs. In some
markets, limited access to a key input could generate barriers to entry that help main-
tain the profitability of the downstream firm, though attempts at market foreclosure
often incite regulators.
As with horizontal integrations, we see that applying the business strategy objective of
profit maximization can lead to vertical integrations because of efficiencies and because
of greater opportunities to capture value that could generate antitrust scrutiny. To the
extent that either could increase profits, there would be no need to distinguish between
them conceptually. A manager must, however, confront the reality that the firm’s activi-
ties may be constrained by regulators enforcing competition laws. We believe that the
Value Creation and Capture framework provides a useful first step in distinguishing
benign value-creating explanations for acquisitions from ones that may prove problem-
atic based on reliance on value capture synergies.
11.6. Conclusion
At the core of business strategy lies the Value Creation and Capture framework. Owing
to its central importance, we focused our discussion of strategy’s relevance to antitrust
policy on its principal tenets. From the firm’s perspective, a firm may seek to maximize
profits by creating more value or by capturing the largest possible share of this value. It is
this latter objective that most concerns antitrust authorities. Distinguishing between the
economics of value creation and value capture can help practitioners understand how
antitrust policy might constrain their activities.
The remaining topics of industry analysis, competitive advantage, and firm scope
build on the basic strategic foundation of creating and capturing value. An additional
aim of our chapter was to provide a link between antitrust policy and business strategy,
reframing intuition within the particular lexicon of strategy. While these frameworks
influence strategy academics and practitioners, their terminology may be unfamiliar to
those outside of this community. Understanding the foundations of strategy frameworks
and how they are used by practitioners can potentially help regulators apply and inter-
pret antitrust policies in applied business situations.
Given the limitation of this review chapter, we could not possibly address every rel-
evant topic. Chief among the omitted areas is understanding how firms tactically engage
with antitrust, which remains an open area of research in strategy and economics.
Private firms may file antitrust suits against competitors, and doing so often represents a
strategic choice to gain an advantage. For instance, many have speculated that Microsoft
played an important role in recent antitrust investigations against Google (Gans 2010).
Given the nature of competition between Microsoft and Google across several interre-
lated markets, the decision by Microsoft to act as a complainant represents a deliberate
tactical choice. Thinking through the optimal strategy in this regard will be an active
area of research for the near future.
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PA R T I I
V E RT IC A L
I N T E G R AT ION A N D
C ON T R AC T UA L
E QU I VA L E N T S
CHAPTER 12
R E S A L E P R IC E M A I N T E NA N C E OF
O N L I N E R E TA I L I N G
BENJAMIN KLEIN
The growth of online retailing has magnified the competitive economic forces that are
likely to lead manufacturers to adopt resale price maintenance. Because manufacturers
are, in effect, purchasing retailing services at a cost equal to the retail margin, online
retailer price discounting that reduces the retail margin reduces an implicit manufac-
turer cost of doing business. However, manufacturers do not merely “throw their prod-
ucts on the market” and leave it entirely up to price competition among retailers to
minimize retailing costs. It is an obvious business reality that manufacturers actively
determine what they consider to be the most effective retail distribution for their prod-
ucts, including the number and type of retailers that sell their products and the point-of-
sale services they expect those retailers to provide. These retail distribution decisions,
which often are essential determinants of the ultimate success or failure of a manufac-
turer’s products in the marketplace, are more likely to include the use of resale price
maintenance when there is significant online retailing.
The common procompetitive rationale for manufacturer control of retailer price
discounting, widely accepted in both economics and antitrust law, is the prevention of
free-riding. Free-riding occurs when consumers obtain, for example, salesperson assis-
tance or product demonstrations at full-service retailers before purchasing the product
at a lower price at a discount retailer that does not provide such services. The existence
of such free-riding reduces the incentive for retailers to bear the costs of supplying these
valuable services that expand the demand for a manufacturer’s products. Because online
retailing substantially magnifies the free-riding problem by permitting consumers to
more easily buy products at a lower price online after first obtaining desired services at
a full-service brick-and-mortar retailer, resale price maintenance to prevent free-riding
has broader potential applicability when there is significant online retailing.
However, many resale price maintenance arrangements, including arrangements
designed to control the extent of online retailer price discounting, are not motivated
by the desire to prevent free-riding consumers from purchasing at a discount retailer
278 Benjamin Klein
after shopping at a full-service retailer. Resale price maintenance often is used by manu-
facturers even when there is not a consumer free-riding problem as a way to preserve
effective retail distribution by ensuring a retail margin that encourages retailers to stock
and promote the manufacturer’s products. This non-free-riding procompetitive moti-
vation for controlling retailer price discounting is particularly significant when there
is online retailing. Even when consumers who purchase online at a low price do not
first take advantage of the services provided by brick-and-mortar retailers, uncontrolled
online retailer price discounting has the potential to significantly disrupt a manufac-
turer’s efficient retail distribution network by reducing retailer compensation below the
level required for brick-and-mortar retailers (as well as established online retailers) to
effectively distribute the manufacturer’s products.
In what follows, the standard prevention of free-riding procompetitive explana-
tions for resale price maintenance are contrasted with the procompetitive use of resale
price maintenance as a way to preserve effective retail distribution when there is not a
free-riding problem. The non-free-riding procompetitive rationale for resale price main-
tenance is shown to provide insights into the anticompetitive theories of resale price
maintenance and to have important implications for United States and European Union
antitrust regulation of resale price maintenance, especially resale price maintenance of
online retailing. As a result of the US Supreme Court’s adoption of a rule-of-reason anti-
trust standard for resale price maintenance in Leegin,1 manufacturers in the United States
have gained substantially greater flexibility to use resale price maintenance to control
online retailer price discounting whether or not consumer free-riding is occurring. In
contrast, European Union antitrust law continues to consider resale price maintenance
as a “hardcore restraint,” now rebuttable but with the prevention of free-riding as the pri-
mary possible offsetting procompetitive efficiency justification. Consequently, it is much
more difficult for manufacturers in the European Union to use resale price maintenance
to control online retailer price discounting when resale price maintenance is motivated
by the preservation of efficient retail distribution and not by the prevention of free-riding.
12.1. Resale Price Maintenance

Controls Consumer Free-Riding
12.1.1. Resale Price Maintenance Controls Free-Riding on

Retail Services
The widely accepted economic explanation for resale price maintenance relies on
the prevention of an interretailer externality when discount retailers free-ride on the
1
Leegin Creative Leather Prods., Inc. v. PSKS, Inc., dba Kay’s Kloset, 551 U.S. 877 (2007).
Resale Price Maintenance of Online Retailing 279
services supplied by full-service retailers (Telser 1960). Resale price maintenance

eliminates the incentive of consumers to first obtain free services, such as a prod-
uct demonstration, at full-service retailers before buying the product at low-service
retailers because low-service retailers cannot discount price. As a result, retail-
ers capture a greater return on their retailing efforts and are incentivized to supply
increased amounts of the retailing services that are desired by consumers and the
manufacturer.
The potential for consumers to engage in free-riding, and hence this economic moti-
vation for resale price maintenance, is often particularly important when there is online
retailing. Many consumers may first obtain retail services, such as examining the prod-
uct and obtaining salesperson assistance, at a costly brick-and-mortar retailer before
buying the product at a lower price online. This phenomenon, described as “showroom-
ing,” has become more prevalent with the growth of mobile phone scanner apps that per-
mit consumers to take a photo of the product bar code at a brick-and-mortar store and
instantly see the prices at which the identical item can be purchased at online retailers. In
fact, consumers may actually purchase a product online while at the brick-and-mortar
retailer. Van Baal and Dach (2005, 75, 81–82) find that 26% of online purchasers visited a
brick-and-mortar store before their online purchase and less than 2% purchased online
at the online retail website of the brick-and-mortar store they visited.
Critics of resale price maintenance have responded to this empirical evidence of
online retailers free-riding on brick-and-mortar retailers by noting that there also
is a potential for “reverse” free-riding by brick-and-mortar retailers on the services
supplied by online retailers. This occurs when consumers first search online to deter-
mine what they wish to purchase and then use the valuable information acquired free
of charge to purchase the product at a brick-and-mortar store. A survey of market-
ing studies (Gundlach, Cannon, and Manning 2010) concludes that this second type
of reverse free-riding may occur more frequently than the free-riding by consum-
ers who first shop at brick-and-mortar retailers before purchasing at a lower price
online.
These two forms of free-riding, however, are separate “distortions” that should not
merely be netted out against one another. Manufacturers wish to mitigate the malincen-
tive effects from both types of free-riding, preventing both (1) an insufficient amount of
face-to-face retailing services provided by brick-and-mortar retailers, and (2) an insuf-
ficient amount of information provided for their products on the Internet. Types (1) and
(2) are separate potential problems the manufacturer wishes to avoid. A manufacturer
that uses resale price maintenance to reduce the first potential problem by incentivizing
and protecting brick-and-mortar retailer selling efforts from online retailer free-riding
is unlikely to significantly exacerbate the second problem of less than the desired
amount of product information available to consumers online. Furthermore, in con-
trast to insufficient brick-and-mortar retail services, manufacturers sometimes may be
able to more easily directly mitigate the second problem by supplying online product
information, at their own website, and by contracting for online advertising on other
websites (Carlton and Chevalier 2001).
280 Benjamin Klein
12.1.2. Free-Riding on Brand Image Retail Services

While the economic foundation and empirical relevance of the prevention of
free-riding is widely recognized by economists and accepted in antitrust law as a com-
petitive rationale for resale price maintenance, a great many cases of resale price main-
tenance, including the use of resale price maintenance to control online retailer price
discounting, do not fit the prevention of free-riding paradigm. Robert Pitofsky (1984,
29) has perceptively asked us to “think for a moment about the product areas in which
resale price maintenance has appeared—boxed candy, pet foods, jeans, vitamins, hair
shampoo, knit shirts, men’s underwear. What are the services we are talking about in
these cases?”
Economists have attempted to answer this critique, in the first instance, by expanding
the type of services upon which there may be interretailer externalities from consumer
free-riding. Specifically, it is posited that retailer decisions to stock a manufacturer’s
products provide brand image information to consumers and that a potential interre-
tailer externality exists with regard to the supply of these information services. There are
two variants of this brand image externality analysis. The first variant involves the posi-
tive externality a high-quality retailer (that is, a retailer with an established reputation
for selling high-quality products) is presumed to have on the demand for a manufactur-
er’s products at all other retailers when the high-quality retailer stocks a product because
stocking provides product quality “certification services” (Marvel and McCafferty 1984).
Under this theory, some consumers who decide to buy a manufacturer’s products at a
discount store do so in part because they first see the product stocked at a full-priced
retailer that has a reputation for selling high-quality merchandise. Discount retailers
therefore are free-riding on the “certification services” supplied by the high-quality
retailer. Because high-quality reputable retailers share part of the return on their “certi-
fication services” with other free-riding retailers, high-quality retailers are less likely to
stock and therefore “certify” the manufacturer’s products.
While this free-riding hypothesis makes theoretical sense, the products at issue in
most resale price maintenance cases are established brands that consumers already rec-
ognize as high quality without first seeing the products stocked at a reputable retailer. For
example, consider Rolex watches. Consumers do not have to see the Rolex watch sold at
an authorized high-quality retailer to know that the product is high quality. While man-
ufacturers certainly wish to have their products sold at reputable, high-quality retailers
and such retailers are less likely to carry a manufacturer’s products when they are also
sold at discount retailers, this is not because the discount retailers are free-riding on
quality “certification services” provided for the manufacturer’s products by authorized
retailers. As we shall see in section 12.2.3, high-quality retailers are less likely to stock and
promote a manufacturer’s products when the products are also sold by discount retailers
not primarily because of consumer free-riding on certification services but because of
the more fundamental economic reason that the high-quality retailers earn significantly
less in these circumstances from selling the manufacturer’s products.
The second variant of the retailer brand image services theory involves a negative
interretailer externality. Rather than a high-quality retailer creating a positive “certifi-
cation” externality on a discount retailer’s demand for the manufacturer’s products, a
discount retailer is assumed to impose a negative externality on high-quality retailer
demand through deterioration of the perceived quality or brand image of the manu-
facturer’s products when consumers observe the product sold at the discount retailer.
To avoid this negative perceived quality externality and the associated reduction in the
demand for its products, a manufacturer may wish to have only higher quality retail-
ers sell its products. The manufacturer thereby protects the quality brand image of its
products and avoids the association with lower quality products that are sold at discount
stores (Jacoby and Mazursky 1984).
However, while eliminating this negative externality and protecting a product’s
image by preventing distribution through lower quality retailers often may be a
legitimate economic motivation for manufacturers, this alone is unlikely to explain
manufacturer use of resale price maintenance in such cases. The negative external-
ity theory implies that a manufacturer of high brand name products would want to
prevent distribution of its products through retailers that specialize in lower quality
merchandise even when such lower quality retailers sell the manufacturer’s prod-
ucts at suggested prices. The negative brand image externality analysis provides an
economic rationale for the establishment of a distribution network that avoids lower
quality retailers; it does not by itself provide an economic rationale for resale price
maintenance.
12.2. Resale Price Maintenance

Preserves Effective Retail
Distribution When There Is No
Free-Riding
12.2.1. Retailers Have Discretion over Retail Services That Have

Interbrand but Not Interretailer Demand Effects
The economic rationale for manufacturer use of resale price maintenance in cases where
there is no obvious consumer free-riding (Klein 2009) relies, first of all, on the fact that
retailers often have considerable discretion in deciding which particular manufacturer’s
products they will stock, prominently display, or otherwise promote. Retailer discretion
exists with regard to such product promotional decisions because in many cases these
retailing promotional services have primarily interbrand demand effects with little or
no interretailer demand effects.
282 Benjamin Klein
For example, consider a retailer’s decision to prominently display one particular man-
ufacturer’s products rather than another manufacturer’s products. This will have inter-
brand demand effects, positively influencing consumer purchases of the prominently
displayed manufacturer’s products at the expense of products consumers otherwise
would have purchased if they were prominently displayed. As is well known in the mar-
keting literature, a significant fraction of sales are made by consumers who purchase
a product only because they become aware of it when shopping (Areni, Duhan, and
Kiecker 1999; Underhill 2009).
While some consumers will choose to purchase the brand of product that is promi-
nently displayed, few if any consumers are likely to shift the store at which they com-
monly shop based on this retailer decision. Consumers who prefer an alternative brand
that is stocked but not prominently displayed can still obtain their preferred brand with-
out switching retailers. Given the absence of interretailer demand effects, there is no
consumer pressure in the competitive retail market for retailers to provide prominent
display space in connection with the sale of one or another particular manufacturer’s
products. Therefore, retailers often have significant discretion regarding which prod-
ucts they will prominently display.
Another retailer service that similarly has large interbrand demand effects and little
interretailer demand effects is increased salesperson attention devoted to the sale of a
particular manufacturer’s products. While such selling efforts will influence one man-
ufacturer’s sales relative to another manufacturer’s sales at the retailer, these retail ser-
vices also are not likely to significantly shift where consumers shop. Consumers who
prefer a brand that is not promoted by increased sales efforts will, once again, not shift
the retailer they generally purchase from because they are still able to obtain their pre-
ferred products. Consequently, retailers will not be forced by competitive consumer
pressures to actively promote a particular product with salesperson efforts at the point
of sale.
A retailer’s decision to stock one particular brand rather than another brand also
often has primarily interbrand demand effects and relatively small interretailer demand
effects. While retailer failure to stock a well-known, highly demanded product will cause
some consumers to decide to shop elsewhere, retailers often will have considerable dis-
cretion regarding which of many somewhat lesser known brands in a product category
they decide to stock. And when the retailer is a supermarket or department store that
sells hundreds of different products, this retailer stocking discretion will be significant
because it is unlikely that many consumers will switch the retailer they commonly pur-
chase from solely because of the retailer’s failure to stock a single product.
Although retailing is highly competitive, there are not an infinite number of retail-
ers offering every possible product selection combination. Individual consumers decide
where to shop and develop loyalty to particular retailers based on a retailer’s overall
product selection that best fits their tastes, as well as other retailer characteristics such
as average price, convenience of store location, and the service and amenities provided.
Depending upon the degree of consumer loyalty, all retailers therefore have the ability to
shift sales between brands to some extent by their stocking and promotional decisions,
which often will have small interretailer demand effects relative to much larger inter-
brand demand effects.
The fundamental economic distinction between retailer actions that have primarily
interbrand demand effects in contrast to interretailer demand effects does not coincide
with the distinction between the demand effects associated with retailer nonprice ser-
vices versus retailer price discounts (Winter 1993). Consumers may in fact be highly
sensitive across retailers with regard to the supply of some nonprice retailer services
such as free convenient parking or a pleasant selling environment and other amenities.
Because these services are not brand-specific, we know they have little or no interbrand
demand effects.
On the other hand, price discounts, which generally have large interretailer
demand effects, in some circumstances may have primarily interbrand demand
effects. For example, when a supermarket has a sale on Coke, this may substantially
shift sales at the supermarket to Coke from Pepsi, as marginal consumers who are rel-
atively indifferent between Coke and Pepsi shift their purchases to Coke in response
to the price discount. Because Coke and Pepsi are only one product in the consumer’s
total supermarket purchase basket, the price promotion may not dramatically shift
sales across supermarkets. Bottlers further substantially reduce interretailer demand
effects by running the price promotion simultaneously at all supermarkets in their
geographical area.2
12.2.2. Manufacturers Must Compensate Retailers for

Providing Interbrand Retailing Services
Because retailers have substantial discretion with regard to how they decide to allocate
their retail selling efforts that have primarily interbrand demand effects, such as product
stocking, display space, and sales staff promotion, the products that receive these retail-
ing services will not be determined primarily by retailer competition for consumers.
The marginal consumers who are significantly influenced by these point-of-sale pro-
motional services do not pay for the services; the services are provided free of charge to
lower the effective price (net of the value of the services) and thereby generate incremen-
tal sales that primarily benefit the manufacturer. Therefore, rather than retailer com-
petition for consumers determining which products receive retailer promotional sales
2
Coke and Pepsi bottlers also maximize the interbrand demand effects by contracting with
supermarkets for temporary exclusive price discount promotions. If Coke and Pepsi prices were both
reduced, it would not be worth very much to either bottler in terms of incremental sales; when only
one price is reduced, consumers who are marginal with respect to their preference for the two brands
will shift to the price-discounted brand. The competitive outcome is for Coke and Pepsi to each offer
exclusive price discounts for limited periods because this maximizes the extent of interbrand share
shifting and hence the supermarket’s return, and consequently the ultimate benefit to consumers
through supermarket competition. Coca-Cola Co. v. Harmar Bottling Co., 218 S.W. 3d 671 (Tex. 2006),
discussed in Klein and Murphy 2008.
284 Benjamin Klein
efforts, retailers supply these services in connection with the sale of particular products
in response to the compensation they receive from manufacturers.3
Manufacturers compete with one another for retailer selling efforts because the inter-
brand demand effects from the retailer services means that consumers are induced to
switch from rival brands to the manufacturer’s products and therefore represent clear
additional sales of the manufacturer’s products. This is valuable to manufacturers
because manufacturer wholesale prices are generally greater, frequently significantly
greater, than manufacturer marginal costs. As a result, manufacturers often earn signifi-
cant profit on incremental sales induced by retailer selling efforts.
The profit earned by manufacturers on incremental sales is a consequence of the fact
that manufacturers commonly sell differentiated products and face negatively sloped
demands for their products; it certainly does not imply the existence of any manufac-
turer antitrust market power (Klein 1993). The resulting gap between wholesale price
and marginal cost is what permits competitive manufacturers to cover their marketing,
R & D, and other fixed overhead costs. Given this equilibrium under which most manu-
facturers operate, manufacturers will earn additional profit if they can convince retail-
ers to supply point-of-sale services that induce incremental sales to marginal customers
who would not otherwise purchase their products.
Because an effective retail distribution network where retailer promotional ser-
vices that induce incremental sales are provided in connection with a manufacturer’s
products is valuable, often extremely valuable, manufacturers will bid in competition
with other manufacturers for such retailing services. In general, manufacturers with
the largest profit margin on incremental sales and the largest expected sales gain from
retailer promotional selling efforts will bid the most for the retailer services. Retailers
will choose to stock and promote the products they expect will yield them the greatest
return, taking account of both the short-term and long-term effects of their decisions.
Manufacturers must convince retailers that if they devote their valuable retailing assets
such as their shelf space and sales staff to the promotion of the manufacturer’s products,
the return on their assets will be greater than the return the retailers would earn if their
retailing assets were devoted to the sale of another manufacturer’s products.
Manufacturer bidding for retailer promotional selling efforts takes the form of an
implicit manufacturer promise to retailers of an expected return if they devote their
selling efforts to the manufacturer’s products. This implicit promise is frequently made
by manufacturers by adopting some form of restricted distribution arrangement that
reduces the number of authorized retailers of the manufacturer’s products, sometimes
with the grant to each retailer of an explicit or de facto exclusive sales area. This induces
3
Retailer competition for consumers, however, ultimately drives the competitive process by
determining the investments made by retailers in the construction of attractive, conveniently located
stores, the hiring and training of a sales staff, and the development of a reputation for reasonable prices,
good product selection, and knowledgeable and friendly service that creates the loyal customer base
underlying the retail assets manufacturers are bidding for. Competition and free entry into retailing
benefits consumers and drives the equilibrium return earned by retailers on their tangible and intangible
retailing assets to a normal rate of return.
desired retailer selling efforts because it increases the sales and the profit margin retail-
ers expect to earn on the manufacturer’s products.
Alternatively, when the number of retail outlets that carry a manufacturer’s products
is an especially important determinant of total consumer demand, the manufacturer
may compensate retailers for their selling efforts by increasing each retailer’s expected
margin through a decrease in the wholesale price and the use of resale price mainte-
nance.4 If incremental sales induced by retailer promotional services involve merely a
movement down the demand curve or a percentage shift out of demand at every price,
the profit-maximizing suggested retail price will not change. The manufacturer merely
lowers the wholesale price to increase the price gap between retail and wholesale prices
that is protected with resale price maintenance. In many circumstances where desired
retailer promotional selling efforts are significant, this gap may be very large. For exam-
ple, ready-to-wear clothing normally has a suggested retail price that is 2 to 2.5 times
the wholesale price (Binkley 2012) that is protected with either restricted distribution or
resale price maintenance.
When the desired retail promotional services, such as cooperative advertising or hir-
ing an employee dedicated to the demonstration of a manufacturer’s products, can be
precisely specified and monitored, manufacturers may compensate retailers directly for
the provision of such promotional services with a per service payment (Steiner, 1991).5
Manufacturer compensation for retailer product stocking decisions therefore often may
take the form of a per unit time slotting fee payment (Klein and Wright 2007). However,
efficient retailer compensation mechanisms more commonly incentivize retailer pro-
motional efforts with a payment based on sales, such as occurs with resale price mainte-
nance and exclusive territory arrangements. The increased profit margin on sales that is
created provides the retailer with an increased profit incentive to promote the manufac-
turer’s products.6
A promotional payment that compensates retailers on the basis of incremental sales
relative to some prior sales benchmark may appear to be an even more efficient way
for a manufacturer to purchase retailer promotional services. In contrast to resale price
maintenance, which compensates retailers on all their sales, such a promotional pay-
ment compensates retailers only on incremental sales and thereby appears to provide
4 The US Supreme Court recognized in Business Elecs. Corp. v. Sharp Elecs. Corp. 485 U.S. 717, 728
(1988) that all vertical restraints, exclusive territories as well as resale price maintenance, operate by
inducing retailers to devote their selling efforts to a manufacturer’s products by “reduc[ing] intrabrand
price competition to the point where the dealer’s profit margin permits provision of the desired services.”
5 Contrary to the inventory models developed by Deneckere, Marvel, and Peck (1996) and Butz
(1997), where manufacturers use resale price maintenance to induce retailers to hold increased
inventories of their products, increased inventory is a retailer service that manufacturers also are more
likely to use more direct financial incentives to induce, such as subsidized financing of inventories,
liberal return policies, or wholesale price refunds for unsold products.
6 For this reason, a slotting fee arrangement may sometimes include a lower wholesale price together
with the per unit time slotting fee, which is combined with resale price maintenance if there are large
interretailer demand price effects or with the requirement that a minimum fraction of the wholesale
price reduction be passed on in lower retail prices when there are small interretailer demand effects.
286 Benjamin Klein
retailers with a greater direct marginal incentive to expand sales of the manufacturer’s
products. However, incremental sales are often difficult to measure. Moreover, a promo-
tional payment based on incremental sales absent resale price maintenance would lead
retailers to engage in price discounting that has largely interretailer demand effects, that
is, an increase in sales of the manufacturer’s products at the price discounting retailer
at the expense of sales of the manufacturer’s products at other retailers, and less likely
to involve increased manufacturer sales at the expense of rival products. While this
may result in a short-term increase in total manufacturer sales due to a reduction in
the average retailer margin and resulting movement down the manufacturer’s aggregate
demand curve, the reduction in the retailer profit margin also disrupts efficient retail
distribution by decreasing retailer compensation for interbrand shifting retail services
and hence reduces long-run sales.
12.2.3. Retailer Price Discounting May Damage a

Manufacturer’s Distribution Network When There
Is No Consumer Free-Riding
The potential for retailer price discounting to disrupt a manufacturer’s efficient retail
distribution network designed to induce retailer selling efforts explains why manufac-
turers may use resale price maintenance when there is not a consumer free-riding prob-
lem. A retailer that discounts prices reduces the sales and/or the profit margin earned
by other retailers that are distributing the manufacturer’s products. Because retailers
require a minimum expected return to stock, display, and otherwise promote a manu-
facturer’s products equal to what they could earn by devoting their retailing assets to an
alternative manufacturer’s products, this reduction in compensation caused by retailer
price discounting will lead other retailers to reduce the selling efforts they devote to
the manufacturer’s products. It may even lead some retailers to drop distribution of
the manufacturer’s products entirely. Consequently, even when there is no consumer
free-riding, retailer price discounting may deteriorate a manufacturer’s retail distribu-
tion network, in terms of reducing both the number and quality of retailers that stock
the manufacturer’s products and the point-of-sale promotional services the remaining
retailers provide in connection with the manufacturer’s products.
The effects of retailer price discounting on reducing the return earned by other retail-
ers may sound superficially like the effects of normal price competition among retailers,
which manufacturers generally are in favor of. However, although manufacturers wish,
everything else equal, to have their products sold at the lowest retail margin, to maxi-
mize long-run sales and profits manufacturers also wish to have their products effec-
tively distributed and adequately promoted by an efficient number and type of retailers.
To accomplish this manufacturers must establish a retail distribution network where
retailers are adequately compensated for devoting their retailing efforts to the manufac-
turer’s products.
For example, consider resale price maintenance of boxed candy, the first example
noted above by Pitofsky 1984 as a resale price maintenance arrangement that does not
appear to be explainable by the prevention of consumer free-riding.7 The retailer ser-
vices in that case consist primarily of stocking and displaying the product. It is incred-
ible to believe that without resale price maintenance a significant number of consumers
would free-ride by first going to a “full-service” retailer to obtain these stocking services
before purchasing the candy at a discount retailer.
However, although there is not a consumer free-riding problem on stocking services,
these services are very valuable to the candy manufacturer. Candy is the type of product
where display creates significant incremental sales because substantial sales are made
to consumers when they observe the product displayed while shopping for other prod-
ucts. Consequently, wide retail distribution is valuable because it creates the increased
potential for unplanned or “impulse” consumer purchases. A price-discounting retailer
therefore can disturb the manufacturer’s effective retail distribution by reducing the
number of other retailers that distribute the manufacturer’s products even when the
price-discounting retailer is not free-riding on the services supplied by other retailers.
The use of resale price maintenance by a manufacturer to create and protect an
increased retailer margin and thereby ensure that the retail distribution network for
its products consists of a larger number of retailers than would otherwise exist under
uncontrolled retail competition is similar to the “outlets hypothesis” explanation for
resale price maintenance (Gould and Preston 1965). Gould and Preston assume that the
demand for a manufacturer’s products is related to the number of outlets that are sell-
ing the manufacturer’s products. However, while demand for a product often may be
empirically related to the number of outlets that carry the product, Gould and Preston
do not provide an economic basis for why the number of outlets cannot be left entirely
up to consumers who choose where to shop in an uncontrolled competitive retail envi-
ronment. The economic analysis of resale price maintenance presented here indicates
that manufacturers often may wish to purchase an increased quantity of retail display
space in a greater number of outlets than would otherwise exist because this induces
profitable incremental sales by marginal consumers. Resale price maintenance in these
circumstances is an efficient way for the manufacturer to purchase this retailing service.
Manufacturers similarly do not want to leave the quality of retailers that distrib-
ute their products entirely up to uncontrolled retail competition for the same ana-
lytical reason that high-quality retailers stocking their products induces profitable
incremental sales. Manufacturers wish to have reputable high-quality retailers stock
and promote their products not primarily because of the positive “certification exter-
nality” hypothesized by Marvel and McCafferty 1984 described above, where such
retailers increase the overall demand for the manufacturer’s products at all retailers.
Instead, it is because high-quality retailers have a group of loyal customers and dis-
tribution through these retailers provides the manufacturer with valuable access to
7
Russell Stover Candies, Inc., 100 F.T.C. 16 (1982).
288 Benjamin Klein
this customer base. High-quality retailers, however, will decide to stock and promote
a manufacturer’s products and thereby provide the manufacturer with access to their
customers only if they expect to earn a sufficient return on the sale of the manufac-
turer’s products. When discount retailers sell a manufacturer’s products, the reduced
retail profit creates a situation where it may no longer be worthwhile for high-quality
retailers to devote their valuable shelf space and retailing efforts to the manufacturer’s
products.
For example, consider the retail distribution of Rolex watches discussed above. If
Rolex watches are sold at a substantially lower price at discount retailers, this ultimately
would significantly reduce Rolex sales at full-price authorized retailers. The insuffi-
cient return earned by authorized retailers on their valuable retailing assets would then
lead such retailers to reduce their display and selling efforts devoted to Rolex watches,
and possibly to stop carrying Rolex watches entirely. Although total Rolex sales may
increase in the short run as a result of the lower prices set by discount retailers, Rolex
sales ultimately are likely to decrease when authorized retailers no longer carry or
actively promote Rolex products. This long-run reduction in demand is distinct from
any free-riding by consumers on the services, including certification services, supplied
by authorized Rolex retailers or from the possible negative externality effect on Rolex’s
image from distribution by discount retailers. It is merely due to the fact that Rolex has
lost its authorized retailers and authorized retailer sales efforts because of inadequate
authorized retailer compensation, resulting in less effective retail distribution of Rolex’s
products.
Because the retailing promotional services a manufacturer may purchase from its
authorized retailer network with resale price maintenance are not services that are val-
ued by all consumers, a manufacturer that controls retailer price discounting with resale
price maintenance may appear to imply that consumers who do not value the services
and would purchase at a discount retailer in the absence of resale price maintenance are
worse off. While marginal consumers who respond to the retailing services purchased
by a manufacturer with resale price maintenance may benefit, inframarginal consumers
seem to be paying higher prices without receiving any value from the purchased retail
services. Frederic Scherer (1983) and William Comanor (1985) therefore argue that the
net welfare effect and potential antitrust liability of a resale price maintenance arrange-
ment should depend on the relative number of inframarginal versus marginal consum-
ers of the manufacturer’s products.
This analysis, however, fails to recognize that, as described above, manufacturers who
purchase promotional retailing services with resale price maintenance will do so by low-
ering wholesale prices and setting resale price maintenance at unchanged retail prices.
Therefore, discount retailers that evade resale price maintenance to serve consumers
who do not value the promotional services are merely taking advantage of the manufac-
turer’s low wholesale price used to compensate retailers for the supply of such services.
Consumers who do not value the promotional services are not being forced to pay for
the services. If a manufacturer did not purchase the promotional retailing services with
resale price maintenance, wholesale prices would be higher.
Furthermore, even if we ignore the adjustments that would occur in the wholesale
price, differential effects between consumers are not an appropriate basis for determin-
ing whether a practice is anticompetitive. Competitive retailers provide many services
that are not consumed by all customers, such as free sales assistance. One customer may
get the benefit of trying on two dozen pairs of shoes using an hour of salesperson time
before making a purchase, while another customer purchases the same pair of shoes in
five minutes without trying on any shoes. The fact that retailers provide free sales assis-
tance is reflected in the average retail margin, and we leave it up to competition to deter-
mine what retail services are supplied to consumers on what terms. A manufacturer’s
implicit purchase of promotional retail services with resale price maintenance or with
some other substitute arrangement used to compensate retailers for supplying retail-
ing services valued only by some customers is similarly a normal aspect of competition.
Although the purpose of the antitrust laws is to establish rules that have the ultimate
effect of maximizing consumer welfare, this does not imply that antitrust regulation
should involve empirically estimating whether or not a competitive firm’s particular
marketing practice produces a net overall consumer welfare gain or loss from actions
that are a part of the normal competitive process.
12.2.4. Online Retailing Makes It More Likely a Manufacturer

Will Use Resale Price Maintenance to Protect Its Retail
Distribution Network
The growth of online retailing has increased the importance of resale price maintenance
as a way for manufacturers to protect their retail distribution networks. Most manufac-
turers will include online retailing as part of their efficient retail distribution network
because online retailing increases shopping convenience and permits consumers to
obtain product information cheaply, reducing retail distribution costs. However, manu-
facturers generally will not want to leave the terms of online retailing and the share of
retail distribution that moves online entirely uncontrolled.
A fundamental concern of manufacturers is that uncontrolled online retailing is likely
to result in less than the desired amount and type of brick-and-mortar retail distribu-
tion. Even when there is no free-riding by consumers who first visit a brick-and-mortar
retailer before purchasing at an online retailer, online retailer price discounting is likely
to disrupt a manufacturer’s efficient brick-and-mortar retail distribution network. The
effects are similar to the disruption described above that is created when price discount-
ing by an individual retailer reduces retailer compensation below the level required to
induce other retailers to provide the manufacturer’s desired point-of-sale retail services.
Online retailer price discounting has the potential to greatly magnify the detrimental
effects of retailer price discounting on a manufacturer’s efficient retail distribution net-
work because the interretailer demand effects of online retailer price discounting are
likely to be substantially larger than brick-and-mortar retailer price discounting. The
290 Benjamin Klein
result of uncontrolled online retailer price discounting therefore may be a very substan-
tial reduction in the number and type of brick-and-mortar retailers that stock and pro-
mote the manufacturer’s products.
Interretailer demand effects from online retailer price discounting are likely to be
substantially larger than brick-and-mortar retailer price discounting for two reasons;
one, the uncontrolled online retailer price discount is likely to be substantially larger,
and two, the interretailer demand elasticity is likely to be substantially larger. With
regard to the first effect, the online retailer price discount is likely to be substantially
larger because online retailers can take advantage of their relatively low retailing costs in
addition to the lower wholesale prices set by manufacturers to compensate retailers for
the provision of retailer promotional services. Consequently, the potential decrease in
the retail price by a discounting online retailer will be substantially larger than the retail
price decrease by a discounting brick-and-mortar retailer. With regard to the second
effect, the likely demand response from an individual online retailer price discount is
likely to be substantially greater than an individual brick-and-mortar retailer price dis-
count because of the increased ability of consumers to shop alternative retailers online.
For both these reasons, the potential disruption to a manufacturer’s retailer network
(brick-and-mortar retailers as well as established online retailers with loyal customers)
caused by online retailer price discounting is likely to be substantially greater than when
only brick-and-mortar retailers are discounting price.
Even if consumers do not free-ride by shopping at a brick-and-mortar retailer or an
established online retailer before purchasing at an online discount retailer, discount
online retailers are taking advantage of the fact that manufacturers set relatively low
wholesale prices to compensate retailers for supplying costly retailing promotional
services, including access to a retailer’s loyal customers. Online retailers that discount
price close to this low wholesale price are able to expand their sales and profits solely
because of the way manufacturers pay for the provision of retailer promotional services.
As described above, the use of resale price maintenance to prevent such discount online
retailing does not mean that consumers who would otherwise purchase from the dis-
count retailer are being charged for promotional services they do not value and are not
receiving.
Online retailers operating in an environment where there are primarily
brick-and-mortar retailers also are facing lower wholesale prices than otherwise
because their costs of retailing are lower than brick-and-mortar retailers. (If there were
only online retailing, manufacturer profit-maximizing wholesale prices would be set by
the manufacturer at a substantially higher level because, from the manufacturer’s point
of view, retailing is a complementary input.) Given the lower wholesale prices set by
the manufacturer to compensate brick-and-mortar retailers for their supply of inter-
brand promotional services, as well as their higher retailing costs, totally uncontrolled
online retailer price discounting is likely to result in a great many brick-and-mortar
retailers earning an insufficient return on the retailing assets they devote to the sale of
the manufacturer’s products. This will lead many brick-and-mortar retailers to decrease
their retailing efforts focused on the manufacturer’s products and in some cases to drop
distribution of the manufacturer’s products entirely. The presence of online retailing

therefore makes it even more crucial for manufacturers who wish to continue to pur-
chase brick-and-mortar point-of-sale retailer services that induce profitable incremen-
tal sales to control price discounting in order to ensure that the number and type of
retailers that sell their products remains optimal.
As long as online sales are a relatively small fraction of a manufacturer’s total sales,
uniform resale price maintenance with a relatively low wholesale price across all retail
distribution is likely to be an efficient way for a manufacturer to preserve the desired
amount of brick-and-mortar distribution. However, once the efficient amount of online
retailing grows, manufacturers may find it profitable to set differential price terms that
include small permitted online price discounts combined with higher wholesale prices
for online retailers. However, the potential for retailers to underreport the extent of their
online sales to obtain more favorable wholesale prices or for brick-and-mortar retailers
to transship product purchased at lower wholesale prices to online retailers makes this
solution difficult to implement, and it could face legal challenges.
Some manufacturers may find it economic to move to an alternative retailer compen-
sation arrangement, such as making per unit time payments to brick-and-mortar retail-
ers for desired point-of-sale retailer promotional services. Retailers would not have the
same incentive to provide dedicated sales efforts under such an arrangement because
they would be earning less (or even losing) money on the margin on each incremental
sale. Retailers, for example, may not devote as many salespeople or as much preferred
shelf space to the manufacturer’s products. As a result, per unit time payments would
have to be combined with more direct manufacturer monitoring and enforcement of
purchased retailer point-of-sale promotional efforts than exists with resale price main-
tenance, an increased real resource cost borne by both manufacturers and retailers.
The other alternatives to resale price maintenance available to manufacturers that
wish to preserve their desirable brick-and-mortar retail distribution networks also
have significant economic disadvantages because of the economic pressures created by
the large potential interretailer demand effects from online retailer price discounts. As
noted above, manufacturers may sometimes compensate retailers for increased retailer
services not with resale price maintenance but by reducing the number of authorized
retailers that distribute the manufacturer’s products. Adequate retailer compensation
for the services they devote to the sale of a manufacturer’s products is achieved because
each individual retailer then has some potential pricing power and also expects a higher
level of sales of the manufacturer’s products. However, with uncontrolled online retailer
discounting it becomes extremely difficult for manufacturers to create adequate com-
pensation of brick-and-mortar retailers in this way. While consumers generally travel
only a limited distance from home or work to shop and compare prices, when there is
online retailing the fact that there are relatively few authorized brick-and-mortar retail-
ers will not guarantee that these retailers obtain a significant share of sales.
In addition, online retailing makes it difficult for manufacturers to generate a suffi-
cient retailer return necessary for efficient retail distribution with the use of a “mini-
mum advertised price” (MAP) policy. In contrast to resale price maintenance, which
292 Benjamin Klein
controls all prices, a MAP policy only limits retailer public advertisements of prices
to manufacturer-suggested minimum levels but permits retailers to lower prices
to whatever level they wish within their stores. This often makes economic sense
because within-store price discounts may have primarily interbrand demand effects
that manufacturers wish to encourage, while publicly advertised discount prices are
likely to have large interretailer demand effects that may produce deleterious effects
on overall retailer compensation and therefore the manufacturer’s efficient retailer
network.
The presence of online retailing, however, largely destroys these differential demand
effects upon which a MAP policy is based. Because of the ease with which consum-
ers shop across online stores, within-store online retailer price discounting has much
greater interretailer demand effects than within-store brick-and-mortar retailer price
discounts. Even when a manufacturer utilizing a MAP policy requires online retailers to
show consumers their discounted price only at checkout, comparing actual sales prices
across online retailers by consumers before final purchase is fairly easy. The online
retailer may merely include a statement such as “Add to cart to see price.” Within-store
online retailer price discounts therefore have a much greater potential to disrupt a man-
ufacturer’s retail network than within-store brick-and-mortar retailer price discounts.
As a result, rather than a MAP policy, manufacturers that wish to preserve a sufficient
number of brick-and-mortar retailers as part of their efficient retail distribution net-
work will often find it necessary to control online retailer pricing more directly with
resale price maintenance.
12.3. Anticompetitive Motivations for

Resale Price Maintenance
12.3.1. Manufacturer-Motivated Anticompetitive Resale

Price Maintenance
In addition to the procompetitive motivations discussed above, resale price maintenance

also may be motivated by anticompetitive considerations. The potential for anticompet-
itive effects is generally considered significantly lower when a resale price maintenance
arrangement is initiated by a manufacturer rather than by a retailer. Because manufac-
turers are in effect purchasing retailing services at an implicit price equal to the retail
margin defined by the gap between the retail price paid by consumers and the whole-
sale price manufacturers receive, a manufacturer would not appear to have an economic
interest in instituting resale price maintenance that increased retail margins unless
doing so compensated retailers for supplying services that shifted out the demand for
their products. Even if the manufacturer instituting resale price maintenance were
a dominant firm with significant market power, it would not want to have its retailers
earn a greater profit margin or prevent innovations in retailing that lowered retail mar-
gins unless the greater retail margin was serving some demand-increasing competitive
purpose.
There are two primary exceptions to this general presumption that manufacturer-
initiated resale price maintenance must be procompetitively motivated. One exception
involves the joint adoption of resale price maintenance by a group of manufacturers to
stabilize a collusive manufacturer cartel. Because resale price maintenance prevents
retailers from lowering prices, it substantially reduces the sales gain a manufacturer can
achieve by undercutting the collusively set wholesale price. Resale price maintenance
therefore decreases the incentive of manufacturers to cheat on the cartel.
To establish the likely existence of resale price maintenance as a cartel-facilitating
practice one must have evidence of a collusive horizontal conspiracy among manufac-
turers to fix wholesale prices. The mere fact that a large fraction of firms in an industry
use resale price maintenance is far from sufficient evidence of such a horizontal conspir-
acy. The industry must be conductive to a conspiracy and evidence must exist that indi-
vidual manufacturers are acting contrary to their independent economic self-interests
absent such a conspiracy. Without evidence of a horizontal agreement among manufac-
turers to fix wholesale prices and to jointly adopt resale price maintenance, the wide-
spread use of resale price maintenance in an industry, by itself, is more likely to suggest a
common underlying efficiency reason for manufacturers in the industry to have unilat-
erally adopted resale price maintenance.
The second case where it has been claimed that a manufacturer may anticompetitively
adopt resale price maintenance involves a dominant manufacturer’s use of resale price
maintenance to maintain its market power by placing smaller manufacturing rivals and
potential new manufacturing entrants at a significant disadvantage. Although a domi-
nant manufacturer does not want to overpay for retailing services, this anticompetitive
theory posits that a dominant manufacturer may use resale price maintenance to reduce
the incentive of retailers to carry rival brands by providing retailers with a protected,
higher than normal margin on sales of the dominant manufacturer’s brand. Dominant
manufacturer use of resale price maintenance, it is therefore argued, may have the effect
of driving rival firms out of the market and preventing new firms from entering because
of the inability of rivals to obtain retail distribution.
However, absent the dominant manufacturer’s threat to terminate retailers that carry
rival products, that is, absent a de facto exclusivity agreement between the dominant
manufacturer and its retailers (a claim that should be evaluated for anticompetitive
effects separately from resale price maintenance), there is no reason why retailers would
not also carry competing products. Absent exclusivity, all that is necessary for retailers
to decide to carry rival brands is that retailers expect to earn a sufficient return on the
sale of the rival brands.
This anticompetitive theory of resale price maintenance amounts to a claim of
predatory overpayment for retail distribution. When a retailer’s return on the domi-
nant manufacturer’s established brand is increased with resale price maintenance,
294 Benjamin Klein
competing manufacturers of rival brands must similarly increase what they offer retail-
ers to obtain distribution, possibly also compensating retailers with resale price main-
tenance. Rather than exclusionary predatory competition, however, it is much more
likely that a dominant manufacturer’s use of resale price maintenance in these circum-
stances is just an element of the normal competitive process by which manufacturers
compete for retail distribution. Small new manufacturers, as well as large established
manufacturers, may use resale price maintenance within this competitive framework
as one of the effective ways to compensate retailers for stocking and promoting their
products.
12.3.2. Retailer-Motivated Anticompetitive Resale

Price Maintenance
In contrast to manufacturer-initiated resale price maintenance, retailer-initiated resale
price maintenance may superficially appear to be more troubling. If a demand-increasing
purpose were served by resale price maintenance, it would seem that the manufacturer
would initiate it. If instead it is a retailer that demands manufacturer institution of resale
price maintenance, this may incorrectly suggest that resale price maintenance is being
used anticompetitively to protect the retailer from retail price competition and not to
ensure the supply of desired retailing services.
A key question that must be answered, in terms of both the economics and the legal
standard, is whether coercive demands are being made by the retailer on the manu-
facturer to adopt resale price maintenance. Coercion, rather than mere initiation of
a request for resale price maintenance, indicates both the existence of retailer market
power and the exercise of such power. By acquiescing to coercive retailer demands, the
manufacturer is adopting resale price maintenance contrary to its belief that an alterna-
tive arrangement where sales by lower priced retailers are uncontrolled by resale price
maintenance would be in its economic interests.
Retailer market power sufficient to accomplish such coercion generally requires a
dominant retailer market share. Alternatively, a group of smaller retailers may jointly
coerce a manufacturer to institute resale price maintenance. However, this requires a
collusive agreement among numerous small retailers and an effective cartel enforce-
ment mechanism, an extremely rare condition. In fact, a very small number of resale
price maintenance arrangements are instituted as a result of organized group retailer
pressure of manufacturers consistent with the existence of an anticompetitive retailer
cartel (Overstreet 1983). Multiple retailers may make simultaneous demands on
a manufacturer to stop retailer price discounting and to adopt resale price mainte-
nance, but this should not be interpreted as analogous to a coercive retailer cartel.
Extensive retail price discounting may mean that most retailers are not earning a
competitive return on their retailing assets, and therefore it would be in each indi-
vidual retailer’s economic interests to independently demand that the manufacturer
stop such discounting.
A dominant retailer may initiate the discussion of resale price maintenance with a
manufacturer for a similar reason, that it is earning less than normal profit in selling
the manufacturer’s products. It certainly does not imply that the dominant retailer is
coercing the manufacturer to act contrary to its interests. The retailer may initiate the
discussion because it is more immediately aware of retail market conditions and its own
reduced profitability. Retailer communication of market realities to the manufacturer,
such as the extent and magnitude of price discounting occurring in the marketplace,
the retailer’s estimate of its resulting lost sales, and the communication of its likely
response to these market realities do not mean that the manufacturer is being coerced
by the retailer to adopt resale price maintenance. If the manufacturer had this informa-
tion about current and likely future market conditions, the manufacturer independently
may have decided that the adoption of resale price maintenance was in its economic
interests.
We would expect a retailer to communicate to a manufacturer its requirements
regarding minimally acceptable retail margins and its desire for the manufacturer to
adopt resale price maintenance as a normal part of competitive business activity. As
we have seen, resale price maintenance often is an element of an exchange between a
manufacturer who is buying retail promotional services and its retailers who are sell-
ing retail promotional services, both of whom are benefiting from the transaction. In
these circumstances, who initially suggests resale price maintenance may not have
much economic significance. It certainly would be incorrect to infer that the transactor
that initiates discussion of resale price maintenance is the only one benefiting from the
arrangement and is coercing the other party to adopt the arrangement against its eco-
nomic interests.
For example, consider a case where a manufacturer asks a retailer to stock or inten-
sively promote a new product and the retailer in response asks the manufacturer how
it intends to organize distribution of the product—a clearly relevant business con-
sideration for the retailer. The retailer may ask the manufacturer who else is (or will
be) carrying the manufacturer’s product in the retailer’s area and what the manu-
facturer’s other terms of retail distribution will consist of. No economic significance
should be attached in these business communications that are part of the normal
competitive process to whether (a) the manufacturer says it plans to institute resale
price maintenance and expects the retailer in return to intensively promote the prod-
uct, or (b) the retailer offers to carry and more intensively promote the product and
says in return it expects the manufacturer to maintain reasonable retail margins. The
manufacturer may have already decided to adopt some minimum pricing arrange-
ment or may realize during its conversations with retailers that such an arrange-
ment would be the best way to maximize its sales and effectively compete with other
manufacturers.
Continuous communications between manufacturers and their retailers about mar-
ket conditions are expected as part of the normal, noncoercive competitive process.
As noted by the US Supreme Court in Monsanto, “the fact that a manufacturer and its
distributors are in constant communication about prices and marketing strategy does
296 Benjamin Klein
not alone show that the distributors are not making independent pricing decisions.”8
The Supreme Court concluded that “something more than evidence of complaints is
needed” to infer the existence of an agreement (Monsanto at 764). Furthermore, even if
a retailer warns or threatens a manufacturer that it will drop distribution if resale price
maintenance is not instituted, such communications do not imply the existence of a
coercive agreement. We cannot infer that the retailer has forced the manufacturer to
agree to do something that would be contrary to its interests absent retailer coercion. It
may merely involve clarification of the expected quid pro quo in a voluntary transaction
between a retailer that is providing access to valuable distribution through its outlets in
return for reasonable manufacturer compensation for these retailing services.
Economic evidence of retailer coercion of a manufacturer to act against its economic
interests in establishing resale price maintenance requires, first of all, that the retailer
has the ability to coerce a manufacturer or manufacturers to act contrary to their eco-
nomic interests. That is, there must be evidence that the retailer possesses effective mar-
ket power. This requires, as an initial screen, that the retailer possesses a sufficiently large
market share in the relevant retailing market so that the retailer is essential for effective
distribution by the manufacturer of its products. It further requires that the manufac-
turer is not a dominant supplier of an essential product that the retailer finds necessary.
To establish that a dominant retailer is exercising its market power by coercing a manu-
facturer to act contrary to its economic interests requires, as noted, more than that the dom-
inant retailer has informed the manufacturer that it will drop distribution (or stop active
promotion) of the manufacturer’s products if the manufacturer does not stop retailer price
discounting. If small retailers without any market power whatsoever are independently
similarly complaining to the manufacturer about the adverse effects of retailer price dis-
counting on their business and the likely future actions they expect to take if the price dis-
counting does not stop, this would indicate that the dominant retailer’s communications,
by themselves, are not a coercive exercise of its market power but part of normal business
communications with regard to a voluntary economic transaction. Similar to small retail-
ers, a dominant retailer need not provide its valuable distribution to a manufacturer if it
can earn more distributing another manufacturer’s products. Rather than coercion, both
large and small retailers of the manufacturer’s products are just informing the manufacturer
about the market conditions they face and their likely competitive responses.
A manufacturer’s decision to adopt resale price maintenance in reaction to retailer
complaints about price discounting may merely be a response by the manufacturer to
its genuine concern that retailers otherwise would not find it in their economic inter-
ests to distribute its products, or to distribute its products as effectively. If a manufacturer
learns that extensive retailer price discounting is occurring and recognizes that it would
ultimately lead retailers, including a dominant retailer, to unilaterally conclude that it no
longer pays to devote their shelf space or other retail promotional efforts to the manu-
facturer’s products, it would be in the manufacturer’s independent economic interest to
8
Monsanto Co. v. Spray-Rite Serv. Corp., 465 U.S. 752, 762 (1984).
terminate price discounting retailers. The manufacturer would stop the retailer price dis-
counting even though the manufacturer has not received any warnings from its retailers
because the manufacturer expects retailers to independently decide to stop carrying or
promoting its products once they become aware of retail market conditions.
Manufacturers may recognize that they receive benefits of short-term increased sales
as a result of retailer price discounting, and therefore that they may bear a short-term
cost of reduced sales when they terminate price discounting retailers. However, manu-
facturers also recognize that not terminating price discounting retailers would reduce
the long-run demand for their products because of the resulting inability to obtain or
maintain adequate retail distribution. If a manufacturer’s internal business documents
indicate independent concern about the adverse effects of retailer price discounting on
its retail distribution network through expected unilateral retailer reactions, and further
indicate the necessity to terminate price discounting retailers to preserve their overall
efficient retailer distribution network over the long term, this would be a clear indica-
tion that a dominant retailer’s communications with manufacturers regarding the adop-
tion of resale price maintenance do not involve the exercise of retailer market power to
force manufacturers to act contrary to their interests.
12.4. Antitrust Regulation of Resale

Price Maintenance in the United
States and European Union
12.4.1. The Antitrust Standard of Resale Price Maintenance

Analysis in the United States and European Union
The US Supreme Court in its landmark Leegin decision overturned the per se antitrust
treatment of resale price maintenance in favor of a rule-of-reason analysis. Plaintiffs in
the United States challenging a resale price maintenance arrangement therefore are now
legally required to prove the existence of a likely anticompetitive effect, and defendants
may present procompetitive business rationales. The Court made it clear that the fact
that resale price maintenance may increase an individual product’s retail price in the
short term, or even long term, should not, by itself, be considered evidence of such an
anticompetitive effect (Leegin, at 895–97). Instead, US antitrust law post-Leegin requires
demonstration of an anticompetitive market effect in terms of the particular anticom-
petitive theories of resale price maintenance described above (Klein 2012).
In contrast to the US rule-of-reason standard that focuses on potential antitrust
market effects, resale price maintenance is still categorized in the European Union
under the European Commission Guidelines on Vertical Restraints (2010) as
298 Benjamin Klein
a “hardcore restraint” that is “presumed to fall within Article 101 (1)” as “an agree-
ment that appreciably restricts or distorts competition” and is unlikely to fulfill the
minimum market share and other conditions for block exemption under Article 101
(3) (Guidelines at ¶¶ 47–48). However, similar to the US movement to a less stringent
legal treatment of resale price maintenance, the European Commission now consid-
ers this anticompetitive presumption to be rebuttable if there are sufficient efficien-
cies associated with the resale price maintenance on an individual case basis so that
the procompetitive benefits of the arrangement outweigh its anticompetitive effects
(Guidelines at ¶ 223).
12.4.2. Procompetitive Rationales for Resale Price

Maintenance under US and EU Antitrust Law
Given the heightened standard by which resale price maintenance is judged in the
European Union compared to the United States, the legally accepted procompetitive
rationales for resale price maintenance are more important under the EC Guidelines
than under US antitrust law. Because antitrust liability requires demonstration of an
anticompetitive market effect under US law, a relatively small single manufacturer’s
adoption of resale price maintenance is unlikely to be illegal even when there is no obvi-
ous efficiency rationale. In contrast, under the EC Guidelines justification of a small
firm’s use of resale price maintenance requires a sufficient efficiency rationale for the
practice not to be considered an antitrust violation.
Furthermore, the legally accepted efficiency rationales for resale price maintenance
are significantly broader under US law than under the EC Guidelines. Specifically, US
antitrust law does not rely entirely on the well-established procompetitive economic
benefits of resale price maintenance in preventing free-riding. The US Supreme Court
recognized in Leegin that resale price maintenance may serve as a way for competi-
tive manufacturers to compensate retailers for retailing services as described in this
chapter even when there is no free-riding (Leegin, 551 U.S. 877, 892 (2007), citing Klein
and Murphy 1988 and Mathewson and Winter 1998). In contrast, the EC Guidelines
and European Union national competition authorities do not recognize this procom-
petitive rationale for resale price maintenance. Instead, the Guidelines emphasize
supplier-driven prevention of interretailer free-riding as the primary, if not sole, pro-
competitive efficiency justification that may possibly rebut the anticompetitive pre-
sumption and avoid antitrust liability of resale price maintenance arrangements.
The focus in the EC Guidelines on the prevention of free-riding as the primary pro-
competitive justification for resale price maintenance is illustrated by statements in
the Guidelines that resale price maintenance may be justified only for particular types
of products, such as “experience or complex products” where it is essential for retail-
ers to provide presale demonstration services (Guidelines at ¶ 225). The Guidelines also
describe the free-riding problem more generally as applying to products that are “rel-
atively new or technically complex or the reputation of the product must be a major
determinant of its demand” (e.g., products that rely on selective distribution to protect a
brand name image such as high-end cosmetics) (Guidelines at ¶ 107).
The emphasis on product characteristics where a potential free-riding problem may
exist as the basis for a justification of resale price maintenance suggests that resale price
maintenance cannot be justified for products that are not technologically “complex”
or do not involve a brand name image that must be protected by selective distribution.
For example, consider brand name products more generally, such as Nike sports shoes,
which may have relatively little potential for free-riding under these criteria. Nike sports
shoes are not technologically complex products that require substantial prepurchase
demonstration services and are not products that require especially high-end retailing
services to protect their image. However, competitive manufacturers of brand name
products such as Nike earn a significant profit margin on their incremental sales and
therefore may find it efficient to use resale price maintenance to compensate retailers for
the display and selling efforts that are important for generating incremental sales.
The EC Guidelines refer to the possibility that resale price maintenance may serve
this procompetitive efficient retailer compensation role unrelated to the prevention of
free-riding with regard to the introduction of new products. It is claimed that resale price
maintenance may be used as a way to induce retailers to promote a new product dur-
ing its introductory period by giving retailers the means to stock and increase their sales
efforts (Guidelines at ¶ 225). But it is unclear why the EC Guidelines limit this efficient
retailer compensation rationale for resale price maintenance solely to new products.
The economic importance of resale price maintenance as a way to support a retail
distribution network that includes a sufficient number and quality of retailers, both
brick-and-mortar and online retailers, that stock and actively promote a manufacturer’s
products also is relevant for manufacturers of established products. Manufacturers of
established products may already have a large, effective retailer distribution network,
where the retailers of their products supply point-of-sale display and other retail ser-
vices that induce incremental manufacturer sales. However, the manufacturer must
ensure its retailers that they will continue to earn a sufficient return on their retailing
efforts, without which the manufacturer’s established distribution network will dete-
riorate. In fact, individual retailer price discounting of well-known products may have
even greater interretailer demand effects and therefore would be more likely than new
products to result in a reduction in the compensation received by retailers for providing
retailing services in connection with the sale of the manufacturer’s products.
12.4.3. Manufacturer Control of Online Retailing under

US and EU Antitrust Law
US antitrust law does not specify the particular conditions under which manufacturers
may use resale price maintenance to control online retailing of their products. It is gen-
erally left up to manufacturers to choose the retail distribution arrangement with regard
to online retailing that best fits their business needs as long as there is no demonstrable
300 Benjamin Klein
anticompetitive market effect from the arrangement. And manufacturers in fairly wide
circumstances have the ability under US antitrust law to use resale price maintenance to
protect their brick-and-mortar retail distribution network.
In contrast, the EC Guidelines adopt a regulatory approach that controls the types of
restrictions a manufacturer may impose on the online retailing of its products. The EC
has an additional stated policy aim, separate from antitrust considerations, of encourag-
ing the expansion of online retailing. The EC believes that the growth of online retail-
ing is a way to reduce intercountry price differences and thereby ensure that consumers
receive the benefits of increased price competition and consumer choice from the single
European Union market (EC 2009).9
The EC Guidelines implicitly acknowledge that there may be legitimate problems
associated with uncontrolled online retailer discounting by recognizing that some forms
of manufacturer control of online retailing to protect a brick-and-mortar retail distri-
bution network are considered legally acceptable (Guidelines, ¶¶ 52–54). In particular,
under the EC Guidelines (at ¶ 52(c)) a manufacturer may require authorized retailers to
sell a certain absolute amount (in value or volume) of its products at brick-and-mortar
retail outlets, thereby giving the manufacturer the ability to prevent online retailing
“pure plays.” Manufacturers, however, cannot restrict the fraction of online sales an
authorized retailer may make. This and other restrictions on manufacturer control of
online retailing in the Guidelines are designed so that manufacturers cannot reduce
retailer incentives on the margin to increase online sales.
Most importantly, under the EC Guidelines a manufacturer is permitted to com-
pensate retailers differentially for their brick-and-mortar sales relative to their online
sales. The Guidelines, however, explicitly prevent a manufacturer from compensating
brick-and-mortar retailers for supplying additional costly retailing services by charg-
ing retailers a lower wholesale price on their brick-and-mortar sales than on their
online sales, or equivalently, by raising the wholesale price on online sales (Guidelines
at ¶ 52(d)). While differential compensation is permitted, the EC Guidelines, once
again, are concerned that the relative marginal costs of online retailing not be increased
and online retailer incentives to discount not be reduced.
Therefore, under the EC Guidelines manufacturers may provide brick-and-mortar
retailers either with fixed per unit time payments to cover the higher costs of
brick-and-mortar retailing or presumably with extra direct services, such as provid-
ing brick-and-mortar retailers with salespeople who are paid employees of the manu-
facturer. As the difficulties of resale price maintenance increase with the growth of
online retailing, as described above, companies in the United States also may find these
brick-and-mortar retailer compensation arrangements economic. But because the EC
Guidelines are concerned that there be no increase in the relative marginal costs of
9
To facilitate the growth of online retailing the EC Guidelines (at ¶¶ 51–53) also classifies most
online retailing transactions as “passive,” that is, initiated by consumers who decide to visit the website
of a retailer outside of the consumer’s area, rather than involving an online retailer actively entering a
retailer’s established territory in violation of selective distribution agreements.
online retailing, the slotting fee payment or free services provided to brick-and-mortar
retailers cannot be related to sales.10
Although the EC Guidelines clearly recognize that competitive manufacturers may
reasonably wish to “purchase” a greater amount of brick-and-mortar retailing than
would exist if retailer competition were uncontrolled, a relevant question is whether
the Guidelines would permit manufacturers to use resale price maintenance to control
online retailing so as to be able to maintain an overall effective retail distribution net-
work when resale price maintenance is the most efficient form of retailer compensation.
Under the EC Guidelines manufacturer payment of brick-and-mortar retailer com-
pensation, in whatever form it takes, must be for brick-and-mortar retail services con-
sidered by the Guidelines to be economically legitimate. Therefore, brick-and-mortar
retailer compensation is likely to be limited in practice to compensation for the
point-of-sale demonstration of complex products or the maintenance of a high-end
product image with expensive store rent and sales staff. These are the much too nar-
row brick-and-mortar retailer services that are considered economically legitimate
based solely on the avoidance of free-riding by online retailers on brick-and-mortar
retailers. The EC Guidelines do not recognize the inherent problem that uncontrolled
online retailer price discounting may disrupt or even destroy a manufacturer’s valuable
retailer network crucial for creating profitable incremental sales even when there is not
a free-riding problem.
12.5. Conclusion
The growth of online retailing has made it economically more important for manufac-
turers to be able to use resale price maintenance to preserve essential elements of their
efficient retail distribution networks, both efficient brick-and-mortar and established
online retailer distribution. In the United States this has been facilitated by the legal
movement to a rule-of-reason standard under Leegin. In contrast, in the European
Union, resale price maintenance remains a hardcore restraint, now rebuttable but with
the recognized procompetitive role served by resale price maintenance largely limited
to the avoidance of free-riding. This ignores the competitive use of resale price main-
tenance when there is not a consumer free-riding problem as a way to efficiently com-
pensate retailers for the provision of interbrand point-of-sale retailing services that
induce incremental manufacturer sales. Manufacturers in the European Union there-
fore are more likely to use other retailer compensation mechanisms, such as per unit
time payments, to preserve efficient elements of their retail distribution networks.
10 The EC Guidelines at ¶¶ 203–6 separately set restrictive conditions on the use of up-front access
payments, but such slotting payments are not considered a hardcore restraint.
302 Benjamin Klein
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Inventories, and Resale Price Maintenance. Quarterly Journal of Economics 111:885–913.
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Staff Working Document, SEC (2009) 283 final.
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32:302–12.
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Resale Price Maintenance: Insights from Marketing Research and Practice. Antitrust Bulletin
55:381–422.
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Risks Outweigh the Potential Benefits? Journal of Retailing 60:105–22.
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Court Economic Review 3:43–92.
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174–200.
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CHAPTER 13
E XC LU SI V E DE A L I N G
HOWARD MARVEL
13.1. Introduction
Exclusive dealing is a vertical restraint that requires distributors of a supplier’s prod-

ucts to purchase most or all of the products or services that they offer for sale within
a product category from that supplier, thereby excluding competing products of rival
suppliers from those distributors. In its strictest form, exclusive dealing requires that
dealers or distributors wishing to distribute a supplier’s products agree not to handle
competing products. But more broadly, exclusive dealing can include arrangements
that simply cause distributors to accord a supplier’s products preferential treatment.
For example, a supplier can purchase enhanced access to a distributor’s customers using
wholesale price discounts applicable at the margin, promotional fees, and payments for
shelf space (slotting allowances) or featured placements, such as end cap displays. Under
such contracts, rivals are not completely excluded, but may find their products placed in
ways that do not generate as many sales as they could have achieved in an unconstrained
distribution environment. Klein and Murphy (2008) have termed such restraints “par-
tial exclusive dealing.” Exclusive dealing can also take the form of requirements con-
tracts in which a distributor or ultimate consumer agrees to buy all of its requirements
for a particular product from a single supplier.
Even if we restrict attention to its simplest form—namely, a supplier requirement that
a dealer or distributor not handle the products of competing suppliers—exclusive deal-
ing is perhaps the most ubiquitous of vertical restraints. A survey of marketing manag-
ers for companies in SIC 35, industrial machinery/equipment, and 36, electronic and
electric equipment, reported by Heide, Dutta, and Bergen (1998), found that exclu-
sive dealing was employed by 46 of 147 respondents. More generally, exclusive deal-
ing is common both for goods sold to consumers and for intermediate inputs as well.
Exclusive Dealing 305
Examples of products subject to exclusive dealing include racing tires,1 sandpaper,2

at-shelf coupon dispensers,3 bladder catheters purchased through a group-purchasing
organization,4 pulse oximetry sensors and monitors,5 artificial teeth,6 condoms,7 photo-
chromic lenses,8 petroleum-dispensing equipment (gas pumps),9 and beer (Sass 2005).
Business format franchise contracts typically require complete exclusive dealing—a
franchisee is required to adhere strictly to the specified format, which precludes offer-
ing additional products at its locations. In addition, such franchise agreements can also
require that inputs be purchased exclusively from the franchisor, or from an approved
supplier. Traditional franchising relationships also typically contain exclusivity clauses.
Automobile dealers, for example, are often asked to agree not to engage in “dualing”—
sharing facilities with multiple automobile makes.10 Similarly, gasoline stations offer
only a single fuel brand.11
Exclusive dealing, by its very nature, excludes,12 at least from the portion of a mar-
ket covered by the exclusive dealing contract. As a consequence of this exclusion, its
treatment constitutes an important part of antitrust policy. An exclusive dealing agree-
ment by which a supplier and its dealer agree to exclude rival products from a “quantita-
tively substantial” portion of the market (that foreclose rivals from access to a significant
portion of the potential customer base) can be held to be a violation of Section 1 of the
Sherman Act. With Section 3 of the Clayton Act, Congress identified exclusive dealing
as a specific contractual provision requiring scrutiny to check whether its effect was sig-
nificantly to lessen competition.13 A dominant supplier whose exclusive dealing require-
ment excludes rivals from access to an economically significant portion of market
1 Race Tires Am., Inc. v. Hoosier Racing Tire Corp., 614 F. 3d 57 (3d Cir. 2010).
2 NicSand, Inc., v. 3M Co., 457 F. 3d 534 (6th Cir. 2006).
3 Menasha Corp. v. News Am. Mktg. In-Store Inc., 354 F. 3d 661 (7th Cir. 2004).
4 St. Francis Med. Ctr. v. C.R. Bard, Inc., 657 F. Supp. 2d 1069 (E.D. MO. 2009).
5 Allied Orthopedic Appliances, Inc. v. Tyco Health Care Group, LP, 592 F. 3d 991 (9th Cir 2010).
6 United States v. Dentsply International, Inc., 399 F. 3d 181 (3rd Cir 2005).
7 Church & Dwight v. Mayer Labs., Inc., U.S. Dist. Lexis 51770 (No. D. Cal., 2012).
8 In the Matter of Transitions Optical, Inc., Federal Trade Commission, Docket No. C-4289, 2010.
9 Omega Envtl. v. Gilbarco, Inc. 127 F. 3d 1157 (9th Cir. 1997).
10 For a recent example of an automobile supplier taking action to prevent “dualing,” see Jaguar Land
Rover North America v. Manhattan Imported Cars, 2012 U.S. App. LEXIS 8260 (4th Cir. 2012). The
controversial nature of automobile suppliers to “de-dual” their dealerships in order to obtain exclusive
dealing is indicated by the existence of legislation (in this case, Maryland Code §15-207(d)) prohibiting
de-dualing of existing franchised dealers.
11 But see Standard Oil Co. v. United States, 337 U.S. 294 (1949) (Standard Stations), holding that
exclusive dealing requirements that covered 6.7% of sales in the seven western states in which the
company sold were sufficiently quantitatively substantial enough to trigger condemnation under Section
3 of the Clayton Act.
12 Exclusion, however, is not equivalent to foreclosure. A manufacturer may be excluded from
particular distributors but may still be able to reach customers through available alternatives. See, e.g.,
Omega Envtl. v. Gilbarco, Inc., 127 F. 3d 1157 (9th Cir. 1997).
13 In its Standard Stations opinion, the Supreme Court held that unlike tying, exclusive dealing was
not a per se violation, but neither was a full rule-of-reason investigation required as long as a substantial
volume of commerce was foreclosed.
306 Howard Marvel
distribution for the product in question can also be found to have engaged in monopoli-
zation and thereby to have violated Section 2 of the Sherman Act.14
Limits on the use of exclusive dealing extend beyond those derived from the Sherman
and Clayton Acts. The Federal Trade Commission (FTC) has recently obtained a con-
sent order against exclusive dealing under its broad authority to control unfair competi-
tion provided in Section 5 of the FTC Act.15 Since it is targeted at the products of rivals
who could otherwise choose to have their products distributed through the channels
that exclusive dealing restricts, the practice almost by definition raises rivals’ costs.16 The
degree to which costs are raised depends on the availability and efficacy of alternative
distribution channels open to rivals. Thus in many circumstances, prior to considering
the costs and benefits of particular exclusive dealing restrictions, a threshold inquiry
into the characteristics of alternative channels is required.
The European Commission has a two-pronged approach to antitrust enforcement as
applied to exclusive dealing that is similar to the US application of Sections 1 and 2 of
the Sherman Act. Article 101 of the TFEU (Treaty on the Functioning of the European
Union) prohibits agreements that restrict competition. The application of this article
to vertical agreements is covered by Commission Regulation 330/2010/EU of April 20,
2010, which provides for a number of safe harbor exemptions that apply when market
shares are low. Exclusive dealing is, however, explicitly excluded from the safe harbor
for vertical restraints.17 Article 102 of the TFEU is supposed to prevent anticompetitive
abuses by dominant firms. The focus of Article 102 enforcement is on whether distribu-
tors find it essential to carry the products of the dominant firm. If so, exclusive dealing
forecloses rival producers. Thus according to the European Commission,
The capacity for exclusive purchasing obligations to result in anti-competitive fore-

closure arises in particular where, without the obligations, an important competitive
constraint is exercised by competitors who either are not yet present in the market at
the time the obligations are concluded, or who are not in a position to compete for the
full supply of the customers. Competitors may not be able to compete for an individ-
ual customer’s entire demand because the dominant undertaking is an unavoidable
trading partner at least for part of the demand on the market, for instance because
its brand is a “must stock item” preferred by many final consumers or because the
capacity constraints on the other suppliers are such that a part of demand can only
14 Thus Microsoft’s exclusive dealing agreements with its distributors were not found to have violated
Section 1 of the Sherman Act since Microsoft’s rival, Netscape, had managed to distribute its browser to a
substantial portion of the market, but Microsoft’s exclusive dealing was illegal under Section 2.
15 For a recent challenge to exclusive dealing brought under Section 5 of the FTC Act, see In the
Matter of Transitions Optical, Federal Trade Commission, Docket No. C-4289, 2010.
16 By attracting customers who might otherwise have purchased from rivals, exclusive dealing shifts
a supplier’s demand schedule out, increasing its power over price. See Krattenmaker and Salop (1986).
But note that as Klein (2003, 119), quoting Judge Frank Easterbrook, points out, “injuries to rivals are
byproducts of vigorous competition.”
17 The exemption does not apply to “any direct or indirect obligation causing the members of a
selective distribution system not to sell the brands of particular competing suppliers.” Article 5, sec. 1(c).
be provided for by the dominant supplier. If competitors can compete on equal terms
for each individual customer’s entire demand, exclusive purchasing obligations are
generally unlikely to hamper effective competition unless the switching of supplier
by customers is rendered difficult due to the duration of the exclusive purchasing
obligation. In general, the longer the duration of the obligation, the greater the likely
foreclosure effect. However, if the dominant undertaking is an unavoidable trading
partner for all or most customers, even an exclusive purchasing obligation of short
duration can lead to anti-competitive foreclosure.18
13.2. Exclusive Dealing as Property

Right Creation
Vertical restraints generally are devices that create property rights to customers. Thus an
exclusive territory creates a property right to benefit from customers who are drawn to
purchase a particular product within a defined area. The right is typically created by the
product’s producer, but assigned to distributors. The reason that the supplier establishes
such a right is to provide an incentive for its distributors to promote its brands, bringing
in those customers. The property right ensures that the distributor who provides promo-
tional efforts receives the benefit of those efforts, and that rival distributors who might
otherwise free ride on a dealer’s promotion are prevented from doing so. Resale price
maintenance is a similar method for property right creation and promotion protection.
So, too, is exclusive dealing, but it differs in an important manner from most other
vertical restraints. A supplier that creates a property right for its dealers does so only
to the extent that the right generates promotion for the supplier’s product that more
than offsets the return that the right provides. That is, the supplier’s role is to structure
its distribution so that distributors receive compensation for their competitive promo-
tional activities, but no more. But with exclusive dealing, a supplier creates a property
right with itself as the beneficiary. The supplier’s incentive to limit the right to match dis-
tributor compensation to the services they are expected to provide is absent, or at least
attenuated.19 The mingling of the roles of creator of a property right and beneficiary of
that right is the reason why exclusive dealing is normally considered more suspect than
other vertical restraints.
18
Communication from the Commission—Guidance on the Commission’s enforcement priorities in
applying Article 82 of the EC Treaty to abusive exclusionary conduct by dominant undertakings, Official
Journal C 045, 24/02/2009 P. 0007-0020, http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELE
X:52009XC0224(01):EN:HTML.
19 The principal limitation on suppliers in promulgating exclusive dealing property rights lies in the
requirement that they provide their dealers with returns sufficient to cover their opportunity costs of
remaining with the brand demanding the exclusive.
308 Howard Marvel
True exclusive dealing simply ensures that the supplier obtains the benefits of its own
promotional activities. A supplier who brings customers to its dealers expects to charge
a premium price reflecting the value of those customers. It could charge for customer
leads directly, but if it did so, it would force onto its dealers a substantial amount of risk.
Thus exclusive dealing is akin to a royalty agreement where the dealer (franchisee) pays
its franchisor for the success of the franchisor’s design and promotion only when those
activities yield sales. In the typical exclusive dealing setting, the royalty equivalent is
a charge rolled into the wholesale price of the product. As with a revenue-based roy-
alty, this charge is tied to actual sales rather than merely to customers who are drawn to
the dealer by the manufacturer’s efforts. Alternatively, the manufacturer could impose
a separate charge for its customer-generating activities, and indeed, incorporating a
charge into completed sales clearly has the potential to distort retailer decisions through,
for example, double marginalization. The advantage of linking promotion costs to sales
is that doing so provides incentives to the supplier to design its product and promo-
tion strategies with considerable care, as returns are contingent on those decisions. The
dealer, too, need not monitor or approve the supplier’s customer generation, but can
simply concentrate on converting those customers to sales.
The problem with this approach is that the dealer can avoid the charge for customers
that its supplier brings to its door by offering a rival’s product to customers, where the
rival’s product does not incorporate a customer charge and accordingly has a lower whole-
sale price. The dealer can thereby execute a bait-and-switch scheme, baiting customers
drawn by a supplier’s promotion but switching them to a product that carries a higher
dealer margin. Both customers and dealers can benefit from this—the rival product may
be functionally identical to that of its promoted competitor and the bait-and-switch will
ordinarily require a discount for the lesser known rival product. Without exclusive deal-
ing, however, the supplier may find its incentive to promote the product greatly attenuated.
The following examples consider both the consequences of free riding and the possibility
that the supplier may not alter its behavior should its exclusive dealing be prevented. The
first provides a clear example of how a ban on exclusive dealing suppressed competition
and harmed market efficiency. Final evaluation of the second example must wait until the
effects of a different ban on exclusive dealing can be assessed.
13.2.1. Hearing Instruments

The above explanation for exclusive dealing appeared first in Marvel (1982) with illus-
trative examples provided by an investigation of insurer/agent relationships in the
property/casualty insurance industry and by an analysis of the market for dress pat-
terns as considering in the Standard Fashion case.20 The analysis was inspired by a dif-
ferent example of exclusive dealing, one that was the centerpiece of an investigation of
the effects of the exclusive dealing clauses that hearing instruments manufacturers had
20
Standard Fashion Co. v. Magrane-Houston Co., 256 U.S. 346 (1922).
demanded from their dealers.21 Hearing instruments were and are sold both through
dealers and through audiologists. The latter channel obtains clients primarily from
physician referrals. Hearing instruments sold through dealers, however, require active
client generation. A supplier who wishes to promote its products to potential custom-
ers faces significant difficulties in identifying hearing-impaired individuals. Radio and
television advertising has obvious drawbacks, and while local newspaper advertising is
sometimes employed, the supplier must pay for messages based on the number of cus-
tomers reached, a far greater number than the set of individuals who might potentially
purchase a hearing aid. During the 1970s, suppliers favored periodicals targeted spe-
cifically at older consumers as advertising vehicles. A supplier would typically prepare
a print advertisement with a mail-in postcard that an interested reader could fill out
and submit in order to receive a hearing test. The supplier, upon receipt of the post-
card, would assign it to a dealer in the relevant territory. The dealer was responsible for
administering the test and, if warranted22 would suggest an appropriate hearing aid.
Most customers would not have been familiar with the brands of hearing instruments
available, so that a dealer dispatched by one supplier would have little difficulty sub-
stituting the product of a rival. Since the wholesale price of a hearing aid provided by a
postcard (lead) supplying manufacturer carried a premium over “bargain” instruments
that came without promotion, the incentive to switch customers was substantial.23
The FTC obtained consent orders against four of the largest five hearing instrument
manufacturers outlawing their use of exclusive dealing. The consequence of this action
was dramatic—within one year, all four of the manufacturers had either abandoned the
dealer channel or had disappeared altogether.24 One remaining manufacturer, Beltone,
refused to enter a consent order and ultimately prevailed at the Commission level.25 The
company remains a successful competitor. But Beltone’s success in selling to dealers
hearing instruments bundled with customer leads was not sufficient to counteract the
adverse effects of the ban on exclusive dealing for the remaining manufacturers. In fact,
the decline in promotion following the consent orders appears to have caused a very
large drop in sales through the dealer channel with no corresponding increase in sales
through the alternative audiologist channel.
The hearing instruments case thus suggest that exclusive dealing can be a crucial ele-
ment of a competitive strategy by which consumers are drawn to dealers of the brand
requiring exclusive dealing. Banning the practice can impair or even terminate firms’
ability to compete and thereby has potentially dramatic consequences for competition.
21
The results of that investigation appear in Marvel (1984). This work was not public at the time of the
publication of Marvel (1982).
22 Or perhaps if not warranted. Investigations by both the FTC and FDA uncovered a number of sales
that appear unlikely to have improved customer hearing.

23 One manufacturer who agreed to drop exclusive dealing stopped providing leads to dealers and
reduced its wholesale price by $10, or roughly 10%.

24 The exit of these manufacturers came in spite of the lower prices at which they offered hearing aids
to dealers.
25 In re Beltone Electronics Corp., 100 F.T.C. 68, 271 (1982).
310 Howard Marvel
13.2.2. Photochromic Lenses

Photochromic lenses darken in the presence of significant sunlight and become clear
indoors or in darkness. They allow prescription eyewear consumers to obtain at least
some of the benefits of sunglasses without the need to purchase a second pair of glasses.
Photochromic coatings are applied to about 20% of all corrective lenses, and the market
leader, Transitions Optical, has a market share in excess of 80% of photochromic lenses.
It is also a heavy promoter of photochromic lenses, so much so that the term “transition”
applied to such lenses verges on generic.26 It should be no surprise, then, that Transitions
implemented exclusive dealing arrangements with downstream distributors of its prod-
ucts inhabiting a number of levels in the distribution process, including lens manufac-
turers (casters), wholesale labs, and retailers. In 2010, the Federal Trade Commission
challenged Transitions’ use of exclusive dealing and negotiated a consent order that bans
its use through 2030 (In the Matter of Transitions Optical, Docket No. C-4289, Decision
and Order, US Federal Trade Commission, 2010, http://www.ftc.gov/os/caselist/091006
2/10042tranopticaldo.pdf).
The circumstances of Transitions Optical seem to closely parallel those of the hearing
instruments cases. Given Transitions’ intensive advertising of the benefits of its photo-
chromic lenses,27 how did the FTC deal with the possibility that other photochromic
coating manufacturers might free ride on the customers pulled to eyewear dispensers by
Transitions’ advertising?
The vast majority of Transitions’ promotional efforts are brand specific, reducing the
significance of any free-riding concern. While Transitions’ marketing efforts may
generate some consumer interest in the product category as a whole—and not just in
Transitions’ own products—this is part of the natural competitive process. This type
of consumer response does not raise a free-riding concern sufficient to justify the
substantial anticompetitive effects found here.28
The FTC thus argued that Transitions had been successful in convincing the tar-
gets of its advertising to “accept no substitutes.” Hence the advertising expen-
ditures redounded to Transitions benefit, with little impact on the sales of rival
26 See, for example, http://science.howstuffworks.com/innovation/science-questions/question412.
htm. Sunglasses or prescription eyeglasses that darken when exposed to the sun were first developed by
Corning in the late 1960s and popularized by Transitions in the 1990s. In fact, because of the extreme
popularity of the Transitions brand, these lenses are usually referred to as transition lenses.
27 An article entitled Increasing Patient Awareness of Photochromic Lenses, appearing in Vision
Care Product News, April 2008, catalogs extensive Transitions Optical advertising campaigns including
cooperative advertising with lens labs. Advertising of Transitions Optical’s competitors is also described,
but appears to be minimal in comparison to the volume of Transitions advertising.
28 Analysis to Aid Public Comment, In the Matter of Transitions Optical, Inc., File No. 091-0062,
March 3, 2010, http://www.ftc.gov/os/caselist/0910062/100303transopticalanal.pdf, at 6 (footnotes

omitted).
photochromic coatings producers. The alternative is, of course, that the Transitions
advertising produced customers for photochromic lenses who would seek out dis-
tributors offering Transitions lenses but would accept recommendations of alternate
brands from those distributors, given that they carry the Transitions product and
therefore the brand’s imprimatur. If so, Transitions can be expected to reduce or at
least reorient the focus of its promotions to deal with the threat of free riding. If the
consent order is successful in opening Transitions’ distribution to competing coat-
ing manufacturers, the market’s experience will provide a useful empirical contrast
between the free rider theory and the FTC’s analysis. If the FTC is correct, the share
of lenses with photochromic coating should continue to increase and the intensity of
Transitions’ advertising will be unaffected. Rivals, given access to broader distribu-
tion will not only gain share at Transition’s expense, but may also compensate for any
reductions in Transitions’ advertising efforts. There will be a clear benefit to impact
evaluation of this case.
13.3. Theories of Exclusive Dealing
13.3.1. The Role of Externalities

Bernheim and Whinston (1998, 75) provide an elegant theoretical treatment of exclusive
dealing that opens with a demonstration that without contractual externalities,
exclusive dealing cannot be used profitably to foreclose a rival from a market. Because
each manufacturer must effectively compensate the retailer to attract it to an exclu-
sive deal, manufacturers internalize the retailer’s cost from the loss in product variety.
Bernheim and Whinston thus validate the argument offered by Bork (1978) that retail-
ers must be compensated for forgone surplus when rival products are dropped. But the
validation of the argument does not end the analysis, for as Bernheim and Whinston
point out, while a ban on exclusive dealing cannot increase welfare in their basic model,
something must be missing. In the basic model, exclusionary contracts are superflu-
ous—even without a contract, rival suppliers will not be able to offer a deal sufficient to
induce the retailer to carry their products in addition to the most efficient supplier.29
29
Zenger (2010) notes that the Bernheim-Whinston model assumes that suppliers employ nonlinear
contracts. In practice, exclusive dealing contracts often involve prices that are linear in output or royalties
conditional on sales. The linear pricing in particular is unlikely to be accompanied by significant fixed
fees. Ironically, Zenger’s point is less relevant in the setting he analyze, partial exclusive dealing. For
example, retailers often receive fixed payments for display space (slotting and promotional fees), and
when suppliers purchase additional customers from distributors, the purchase is often in the form of
bundled discounts.
312 Howard Marvel
The Bork approach of searching for payments from suppliers to retailers that com-
pensate retailers for lost sales due to exclusion also faces a problem for classic exclusive
dealing arrangements: the payments flow from retailer to supplier. As we saw above, the
payments compensate suppliers for their demand-generation activities. The royalties
paid by business format franchisees provide a particularly clear illustration of the pay-
ments that exclusive dealing protects. A franchisee who sold rival products to customers
drawn to the franchisor’s trademark and format would avoid compensating the franchi-
sor for those customers.
The principal benefit of the Bernheim and Whinston analysis comes from its guid-
ance concerning where to look for harmful exclusive dealing. They suggest the search
for anticompetitive effects should focus on “noncoincident” markets, which they define
to be markets other than the ones in which exclusive dealing is practiced. The survey of
potentially harmful effects of exclusive dealing that follows indeed features a number
of such situations. But in a sense, the Bernheim-Whinston approach places too high a
hurdle before arguments asserting harm from exclusive dealing. Given that the use of
exclusive dealing to assert a property right is an indication that fully specified contracts
between suppliers and their dealers are infeasible (for otherwise, customer leads could
be dealt with separately from the particular products to which those leads are attached),
it will not be surprising that some instances of exclusive dealing assert a right to which
distributors would not have agreed in a fully specified up-front contract. For example,
a supplier who has cooperated with rivals to build a market for its products may at
some point determine that it would benefit by asserting a right to the market as a whole,
thereby harming its prior collaborators as well as consumers whose range of options is
thereby reduced.
But given Bernheim and Whinston’s results, it should not be surprising that it is
difficult to develop equilibrium models in which exclusive dealing proves harmful to
competition. Harm is often asserted to arise from exclusive dealing’s ability to raise the
distribution costs of rival firms, but the raising-rivals’-costs analysis is more of a loose
description of a potential problem than a full-fledged theory. Thus it is claimed that “if
there are scale economies or other entry barriers in retailing, exclusive dealing arrange-
ments can raise rivals’ costs of distribution” (Salop and Sheffman 1983, 267). But even if
distributors face no entry barriers, a rival supplier faces higher costs to the extent that
the supplier cannot free ride upon the promotion efforts of the supplier imposing exclu-
sive dealing. Salop and Sheffman (1987) do not consider this possibility, as they treat
market demand for the product in question as given, but exclusive dealing that protects
promotion will, if successful, shift the demand schedule out. The raising-rivals’-cost
theory simply assumes that demand is stable, and thus cannot distinguish the extent to
which anticompetitive exclusive dealing operates in addition to the ubiquitous use of
exclusive dealing to protect demand-increasing investments.
The theory is useful, however, to the extent that it can be taken to provide necessary
conditions for harmful effects of exclusive dealing. The harmful effects of exclusive
dealing to raise rivals’ costs require that rivals find distribution alternatives to exclusive
dealing retailers impracticable. Thus a demonstration of the availability of reasonably
efficient distribution alternatives should suffice to defeat accusations of anticompetitive

exclusive dealing. As will see below, some courts, but not all, have adopted such a test.30
We turn next to additional formal theories of anticompetitive effects of exclusive
dealing.
13.3.2. Naked Exclusion as a Coordination Failure

Under what circumstances can exclusion limited to a single product be expected to yield
anticompetitive outcomes? A series of papers (Rasmusen, Ramseyer, and Wiley 1991,
2000; Segal and Whinston 2000) has considered circumstances under which distribu-
tors can be induced to sign contracts with a monopoly supplier that serve to entrench
that supplier against the threat of entry by rivals requiring access to those same distribu-
tors in order to compete. The feasibility of successful exclusion stems from the presence
of a high minimum efficient scale of production for the product that the monopoly sup-
plier and potential rivals wish to market. That level of production can be denied to rivals
if the incumbent supplier can lock up contractually a sufficient share of the available
distributors. But this outcome can only occur if downstream purchasers are unable to
coordinate. As Rasmusen, Ramseyer, and Wiley (2000) explain,31
Another condition is that the victims—customers or suppliers—must expect that

the exclusionary tactic will succeed, and must be unable to coordinate their actions
to defeat the tactic. An excluding firm in this situation can buy naked exclusion
affordably because it can scare victims into selling cheaply; no single victim can stop
the exclusion by itself, so no single victim has any bargaining power. At a theoretical
limit, the excluding firm can gain the exclusionary rights for free.
There are several problems with this analysis. One is that exclusive dealing commit-
ments may be required in order to permit the initial provision of what becomes the
incumbent’s efficient scale facility. For example, contracts between farmers and eleva-
tor operators often contain provisions to prevent the farmers from defecting to a rival,
should one be built (Frasco 1991). Thus if the marginal cost of adding a customer to a
facility with substantial sunk capacity cost is low, customers who are located near to a
new rival can expect to avoid their share of capacity costs due to competition, leaving
the costs to be borne by those customers who turn out to be less felicitously located. But
if the facility was sized initially based on the willingness of customers to contribute to
capacity charges, and if those charges were not captured up front, the expectation of ex
post opportunism will lead to underinvestment. Enforceable exclusive dealing contracts
30 Note that the converse does not hold. Granting access to an existing distribution channel to a firm
that has no feasible alternative will not increase welfare if the result of this access a substantial cutback in
incumbent supplier actions to increase demand funneled through that channel.
31 See also Innes and Sexton (1994).
314 Howard Marvel
can prevent this. Breach would be permitted under such contracts but only upon pay-
ment of a penalty tied to unrecovered capacity costs. Put differently, the coordination
failure that would result is one that did not force customers into exclusive agreements,
but rather one that caused customers to avoid such agreements, preferring to play off
suppliers against one another.
A more serious problem is that there appear to be few if any examples of the com-
bination of minimum efficient scale and coordination failure that result in anticom-
petitive exclusive dealing—an absence that Rasmusen, Ramseyer, and Wiley (2000)
emphasize.32 One possible example is provided by a recent exclusive dealing case, United
Regional.33 In this case, the Department of Justice (DOJ) argued that while the demand
for hospital services in the relevant market, Wichita Falls, Texas, came from Medicaid/
Medicare, the Blue Cross system insurers, other private third-party payers such as John
Hancock, and uninsured individuals, only the third-party insurers were charged fees
sufficient to contribute to the cost of medical facilities. United Regional, the dominant
hospital, was the sole provider of must-have tertiary care facilities.34 Facing competi-
tion for other services, it offered low prices for those services to insurers that agreed
to designate it their sole network supplier for the Wichita Falls market. This require-
ment was interpreted by the DOJ as tantamount to exclusive dealing, for consumption
of out-of-network services would result in substantially copays for patients. The coordi-
nation problem was that had the insurers been able to cooperate, they could have com-
missioned one of United Regional’s rivals to expand to provide the necessary services.35
The United Regional requirement that insurers grant exclusive network provider sta-
tus to United Regional in return for very substantial discounts on medical services that
were available from other providers in the market was likely to exclude those other pro-
viders from selling their services to customers that paid the highest prices in the Wichita
Falls market. The DOJ argued that the lack of access to such customers would slow
expansion of competing providers, though the net result was much lower prices paid for
the competitive services than without the exclusive dealing requirement. By granting
exclusive network provider status to United Regional, an insurer increased significantly
32 In particular, they remark on “the lack of fit between [their naked exclusion] theory and the cases in
which the U.S. Supreme Court has forged the law most relevant to exclusionary conduct” (310).
33 United States and State of Texas v. United Regional Health Care System, Case No.: 7:11-cv-0003
(N.D. Texas, 2011).

34 Tertiary care facilities provide specialty referral care in high-cost facilities are typically available
only in the most comprehensive hospitals in a market. They are “must-have” facilities for insurers who
wish to provide comprehensive medical care coverage to their insureds.
35 It should be noted, however, that private third-party payer insurers covered patients who
represented only about 8% of United Regional’s patient volume, and the payments that United Regional
received from these insurers accounted for approximately 30%–35% of United Regional’s profits in total.
See “Competitive Impact Statement,” United States and State of Texas v. United Regional Health Care
System, Case No.: 7:11-cv-0003 (N.D. Texas, 2011), http://www.justice.gov/atr/cases/f267600/267653.pdf
(at 11). Note, however, that while third-party payers account for only about a third of United Regional’s
profits, those profits derive primarily from services that competing hospitals doe not provide—the
services that were subject to exclusive dealing requirements thus constituted a far smaller share of
recorded profits.
the probability that a consumer would choose to have the procedure in question done by
United Regional. The exclusive dealing arrangement thus delivered customers in return
for prices that were substantially below those that the rival providers offered. Thus the
exclusive dealing may have been a competitive device by which United Regional offered
lower prices in return for the added customers that those discounts would bring. The
task in this case is to determine whether the low prices were designed to exclude rivals
from the market entirely by denying them the high-margin customers that they needed
to justify facilities construction, or whether instead the low prices were a net benefit of
the ability of United Regional to buy additional customers at low prices. This example
thus focuses on the difficulty of distinguishing anticompetitive exclusive dealing from
exclusive dealing that defines a property right to customers as a part of an effort to com-
pete for those particular customers vigorously.
United Regional’s competitors were in fact in operation, and thus not excluded.
Competition from United Regional denied them customers who absent the exclu-
sion might have generated revenues that would have supported expansion of the
competing facilities. Those customers, however, would have paid more for their ser-
vices than the price offered by United Regional. It is possible that the United Regional
offer included prices for the must-have services that were sham prices inflated in
order to make the discounts for marginal customers appear attractive, and there-
fore that United Regional’s scheme was an essential facilities tying arrangement. That
is, absent the exclusive dealing scheme, the price of the essential facilities sold on
their own would have been much less than the price quoted by United Regional. This
is another case in which impact evaluation of the effects of the DOJ consent order
requiring United Regional to drop its scheme would be very useful. But without such
an assessment, combining this example with the reluctance of Rasmusen, Ramseyer,
and Wiley to identify circumstances in which their anticompetitive explanation of
exclusive dealing could apply suggests that considerable caution is warranted before
concluding that exclusive dealing can be explained as a device to take advantage of
coordination failures.
Before turning to other anticompetitive theories of exclusive dealing, it is useful to
consider experimental evidence for the naked exclusion theory provided by Landeo and
Spier (2009, 2012). The first of these papers starts in an unpromising fashion, suggesting
that exclusive dealing imposed by large brewers had caused craft brewers to “hit a brick
wall” so that “analysts were predicting the demise of many small brewers.”36 The brick
wall apparently crumbled, as craft beer sales rose from less than 1% of domestic sales in
1990 to 3% in 2000 and 5%in 2010.37 By 2011, craft brewing accounted for 5.7% of sales by
volume and 9.1% of sales by dollars.38
36 Landeo and Spier (2009), at 1850, quoting “Amid Probe, Anheuser Conquers Turf,” Wall Street
Journal, March 9, 1998.

37 See 2011 Draft Beer Industry Update, October 2011, www.beerinstitute.org.
38 Brewers Association statistics. See www.brewersassociation.org/bages/business-tools/
craft-brewing-statistics/facts, visited January 22, 2013.

316 Howard Marvel
The explanation for the failure of the “brick wall” of exclusive dealing is illuminating.
Exclusive dealing excludes only if the dealers subject to exclusive dealing requirements
represent the sole viable mechanism for new entrants to reach the market. This requires
not only significant scale economics for the manufacture of the product in question, but
also scale economies in distribution. The explosive growth of the craft beer segment of
the beer market suggests that neither of these conditions was met.
Landeo and Spier provide an experimental design that has a single incumbent seller
facing two buyers. A seller who obtains a deal with just one of the two buyers is able
to deter entry, because the potential entrant cannot obtain sales sufficient achieve
efficient scale. The buyers do not compete with each other. If they did, the buyer who
agreed to purchase from a more efficient potential entrant would capture the market
from the incumbent’s dealer.39 Given the experimental design, Landeo and Spier show
that allowing the supplier to discriminate in offers allows it to follow what they term
a “divide-and-conquer” strategy. Buyer communication enhances the effectiveness of
exclusionary practices when the seller can make discriminatory offers, but when dis-
crimination is not permitted, communication increases both the generosity of the
incumbent’s offers and the probability that the buyers will reject those offers, clearing
the way for entry.
A second paper by Landeo and Spier (2012) uses a similar design, but adds a potential
entrant as a player. Communication with the entrant appears to make it easier for the
buyers to agree on their preferred joint strategy of rejecting exclusive dealing contract
offers from the incumbent seller, who responds with more generous offers to obtain
exclusive contracts.
The Landeo and Spier experimental results buttress the Rasmusen, Ramseyer, and
Wiley theoretical finding that anticompetitive exclusion can happen when scale econo-
mies are very significant both in production and in distribution, but it remains an open
question as to when, or whether, such exclusion occurs in the marketplace.
13.3.3. Credible Commitments to Tax Entrant Surplus

When a monopoly manufacturer distributing through independent dealers confronts
the prospect of a competing, and more efficient entrant, that manufacturer may choose
to offer exclusive dealing contracts that commit dealers to defecting to the rival only
upon payment of a portion of the rents that the new entrant expects to obtain. Suppose
that but for the exclusive dealing, all dealers would immediately defect to the new,
more efficient entrant upon its appearance. The new entrant, succeeding the existing
monopolist, can capture the incumbent monopolist’s rents plus the additional value of
its efficiency advantage. Competitive dealers are no better off as a result of the switch in
39 Note, too, that if the buyers are dealers who then resell to their captive customers, the only welfare
loss possible is due to prevention of a more efficient producer from supplanting the incumbent—there is
no impact on consumers. The issue instead is the split of surplus between the supplier and its dealers.
suppliers, receiving merely a competitive return no matter which supplier is present. Is

there a way that the incumbent manufacturer and its dealers can take advantage of their
incumbency to tax the incremental rents that the new entrant will earn? Aghion and
Bolton (1987) propose exclusive dealing contracts with liquidated damages as a device
to extract such a tax. If dealers have been convinced to sign exclusive contracts with
the incumbent producer, once a new, more efficient entrant appears, the deal it offers
the new dealers must be sufficient to compensate them for the liquidated damages they
must incur should they defect. The formation of contracts together with the payment
of liquidated damages thus can transfer rents to the incumbent (who receives the liq-
uidated damage payments) and the dealers (who must be compensated for signing the
liquidated damages contracts).
Whinston (2006) criticizes this theory because it works only if the new entrant
indeed is able to surmount the contractual barrier. That is, the payoff to the incumbent
for forming such a scheme is triggered when the new entrant actually appears and liq-
uidated damages are paid. Exclusion of a more efficient entrant only occurs when the
damages that an entrant must pay are less than the benefit accruing to the new entrant.
But Whinston’s criticism is not completely compelling, for the exclusive dealing con-
tracts designed to tax new entrants must be signed in anticipation of the appearance of a
more efficient entrant. The greater the efficiency gain of the entrant, the higher the rents
that can be extracted. but the exclusive dealing contracts need to be formed prior to the
observation of the entrant’s efficiency. But since liquidated damages need to be speci-
fied in advance, a potential entrant that appears with small but positive efficiencies will
choose not to enter. Thus exclusive dealing can be harmful, but its efficiency losses will
be small.
Perhaps a more serious objection is that the scheme requires both lock-in and a court
system willing to enforce what is truly a penalty clause.40 Aghion and Bolton cite United
States v. United Shoe Machinery Corporation41 as an example of a monopolist impos-
ing lease terms that charged a penalty to customers wishing to switch show machin-
ery suppliers. But Masten and Snyder (1993) investigate the relevant liquidated damages
clauses and conclude that they were designed instead to protect against opportunism
on the part of machinery customers. In particular, they find that damages declined with
the remaining duration of the lease, where in contrast a scheme to extract rents from
entrants would suggest a consistent penalty.
On balance, it appears that the Aghion and Bolton analysis of exclusive dealing contracts
as potentially anticompetitive does not support strong action against exclusive dealing
contracts as the damages that such contracts cause will be limited in size to circumstances
40
Liquidated damage clauses that bear some relationship to the true damages suffered by a firm in the
event of a breach of contract are enforceable, but penalty clauses are not. The Aghion and Bolton theory
requires enforceable penalty clauses, as the damages must be tied to the efficiency benefits expected
to be achieved by a new entrant, not the damages actually suffered by the incumbent. See Lake River
Corp. v. Carborundum Co., 769 F. 2d 1284 (7th Cir. 1985). Note also that the Landeo and Spier analysis
discussed above shares the assumption that penalties are enforceable.
41 258 U.S. 451 (1922).
318 Howard Marvel
where a new entrant offers only a modest advance in efficiency over the incumbent sup-
plier and that simply refusing to enforce penalty clauses may well prove a more effective
way to prevent anticompetitive harm compared to direct attacks on exclusive dealing.
13.3.4. Ex Post Exclusive Dealing

The role of scale economies is central to both the “naked exclusion” and entrant-tax-by-
contract theories of anticompetitive exclusive dealing. With naked exclusion, the incum-
bent can keep rivals from amassing a market share essential to achieve efficient scale by
tying up a substantial portion of existing distributors with exclusive dealing contracts. It
is, of course, crucial that the distributors in question cannot be cloned readily, for other-
wise new distributors would emerge that could undercut existing dealers. Thus in order
for exclusive dealing to work, existing dealers must constitute an essential distribution
component for both the incumbent and potential entrant suppliers. The Aghion-Bolton
approach is different, in that it assumes that an entrant can offer to purchase existing dis-
tribution, paying distributors to breach their existing distribution contracts. But like the
naked exclusion arguments, the requirement is that the entrant acquire existing distribu-
tors as opposed to relying on new entrant distribution for its product. Note, however,
that while new distributors must find it difficult to enter and expand, existing distribu-
tors must also be sharply constrained. If not, just a few existing distributors who defected
from the incumbent producer could use the low prices available to dealers of an entrant
to grab a very substantial share of the market in question, thereby undoing any anticom-
petitive effects of exclusive dealing (Fumagalli and Motta 2006).42
The economic theories of exclusive dealing discussed thus far have grappled with
Robert Bork’s (1978) claim that distributors must be compensated by their suppliers for
accepting exclusive dealing contracts.43 But there is also a possibility that dealers have
locked themselves into distribution arrangements with an incumbent, and that as a
result, the incumbent can unilaterally demand exclusive dealing as a way of appropriat-
ing customers that distributors would prefer to market to rival manufacturers. This ex
post opportunism has been recognized as an important impetus for exclusive dealing, as
this passage from a leading antitrust law treatise indicates:
[S]‌uppose an established manufacturer has long held a dominant position but is start-
ing to lose market share to an aggressive young rival. A set of strategically planned
42 See, however, Simpson and Winkelgren (2007) for an argument that as long as some product
differentiation is present, tough postentry competition can be avoided if an incumbent monopoly

supplier cuts its dealers in on some of its rents in return for their loyalty. The strategy works only if the
dealers anticipate truly brutal competition in the wake of successful entry.
43 While the Rasmusen, Ramseyer, and Wiley approach can lead to retailers who fear being trapped
without access to a crucial product and thus sign exclusive dealing contracts that need not carry a
premium, a supplier may well wish to offer small price benefits to dealers who sign up before the
incumbent locks in a scale of operation that forecloses potential rivals.
exclusive-dealing contracts may slow the rival’s expansion by requiring it to develop

alternative outlets for its product, or rely at least temporarily on inferior or more
expensive outlets. Consumer injury results from the delay that the dominant firm
imposes on the smaller rival’s growth. (Areeda and Hovenkamp 2002, ¶1802c, at 64)
Forced to choose which brand to deal with, a distributor may well choose to stay with
an incumbent as opposed to defecting to a rival. With a fixed number of distributor
outlets available, an incumbent can thus exploit its position simply by refusing to share
its dealers with rivals. It will be very difficult to separate anticompetitive motivations
for exclusive dealing in such cases from a supplier’s desire to protect the customers its
brand name or promotional activity drives to its dealers, but it is possible that the desire
to cripple rival entrants can be at least a part of the explanation for the imposition of
exclusive dealing. The presence of locked-in dealers makes the use of exclusive dealing
requirements less expensive to an incumbent supplier.
Exclusive dealing can also be a problem when a supplier asserts its right to customers
that it has not, in fact, generated, or, more generally, that the supplier has generated in
cooperation with other firms selling complements. Consider a supplier of a core system
product whose product cooperates with producers of complementary products to make
its system more attractive to consumers. For example, a computer manufacturer will
find its system demand enhanced when producers design complementary applications
for its system. Suppliers will wish to cooperate with producers of complementary prod-
ucts, recognizing that their activities enhance its own sales. But what happens if a rival
appears? If the cooperating manufacturers offer variants of their products designed to
work with the new entrant, the new entrant’s system becomes more capable and demand
for its product increases in consequence. To combat the competitive effect of making
complementary products to rivals, the incumbent may copy the products of the comple-
mentary manufacturers and then insist that its distributors handle only its product. The
benefit that the incumbent obtains will be of limited duration, and the incumbent risks
making the new competitor more and not less attractive (since the new entrant obtains
the products of the complementary suppliers), but it is possible that the incumbent can
extend the life of its system for a time by this sort of exclusive dealing.44 If distributors
are locked into a product, the product’s supplier can assert a property right to custom-
ers who wish to purchase the product even if at least a portion of the demand for the
product ultimately derives from the efforts of cooperating manufacturers. The condi-
tions for such an assertion of a property right to be profitable for a supplier are sub-
stantial. The supplier must have very substantial monopoly power over the system it
44
See, for example, the complaint in RealNetworks v. Microsoft, http://news.cnet.com/pdf/ne/2003/
complaint.pdf. RealNetworks complained that Microsoft’s agreements with its distributors (“PC Makers
and others”) “had the effect of restricting the distribution, installation or promotion of RealNetworks’
or other competitors’ products, unreasonably restrained and substantially lessened competition in the
relevant markets.” Microsoft ultimately agreed to cooperate with RealNetworks and paid $761 million
to settle the suit. See Jonathan Krim, RealNetworks, Microsoft Settle Suit, Washington Post, October 12,
2005, http://www.washingtonpost.com/wp-dyn/content/article/2005/10/11/AR2005101100661.html.
320 Howard Marvel
controls. Distributors must have no significant options to handling the supplier’s prod-
uct and accepting ex post restraints that are not in their long-term interest. Rival suppli-
ers must not have available alternative paths to the market. The monopoly supplier must
be prepared to accept that its actions will discourage future demand-increasing invest-
ments by complementary suppliers who see their own property rights to innovations at
increased risk.
As Areeda and Hovenkamp suggest, this harmful exclusive dealing is most likely to
occur when an incumbent faces changes in its position in the market. A supplier may
have cooperated with its distributors or complementary suppliers to build a following
for its product, but when that supplier’s position is threatened by entrants, as, for exam-
ple, when a patent expires, it may try to prolong its position by unilaterally asserting
a property right to consumers through exclusive dealing. Note the difference between
this situation and the economic models of harmful exclusive dealing discussed above.
The initial development of the supplier’s market may have occurred with the voluntary
cooperation of its dealers and complementary suppliers, but the exertion of exclusive
dealing is anything but voluntary. Thus this ex post opportunistic use of exclusive deal-
ing contrasts sharply with exclusive dealing that protects ongoing investments in gen-
erating customers, and which does not require a monopoly position on the part of the
supplier demanding exclusive dealing. In practice, however, it will be difficult to dis-
tinguish ex post opportunism from contracting to protect a stream of customers that
the supplier demanding exclusive dealing generates by dint of its ongoing promotional
efforts.
13.4. Assessing Harm
We have seen that the economic theories that yield anticompetitive effects of exclusive
dealing are, as best, suggestive of where one might look for welfare reductions flowing
from the practice, and, indeed, that harmful exclusive dealing may occur when a party
has locked itself into an arrangement that puts it at risk of an inappropriate assertion of
a property right by an exclusive dealing supplier. It should not be surprising, then, that
courts have resorted to rough-and-ready rules of thumb to determine whether particu-
lar uses of exclusive dealing are anticompetitive. Consider, for example, this discussion
of the requirements for such a finding:
There is no set formula for evaluating the legality of an exclusive dealing agreement,
but modern antitrust law generally requires a showing of significant market power
by the defendant, substantial foreclosure, contracts of sufficient duration to prevent
meaningful competition by rivals, and an analysis of likely or actual anticompetitive
effects considered in light of any procompetitive effects. Courts will also consider
whether there is evidence that the dominant firm engaged in coercive behavior and
the ability of customers to terminate the agreements. The use of exclusive dealing by
competitors of the defendant is also sometimes considered.45
This approach, while far from precise, does represent an evolution from simply accept-
ing that exclusive dealing is harmful when rivals are denied access to a substantial por-
tion of distribution available in a market:
In decades past, courts analyzed nonprice related exclusionary conduct simply by

inferring competitive harm where a substantial percentage of the market was fore-
closed to rivals. Today, courts take the analysis one step further. Rather than sim-
ply calculating the percentage of the market foreclosed, courts also examine how
the exclusionary conduct affects competition and whether any competitive harm
results from the exercise of market power, rather than from unrelated factors (e.g.,
consumer choice, inefficiency of competitors). Similarly, when market foreclosure
occurs at the distribution level, courts assess whether competitors can simply cir-
cumvent the foreclosed distribution channels and reach end-users through alter-
native means (i.e., whether entry into the distribution of the product is easy). This
trend toward a more probing analysis of competitive effects is not surprising with
the advent of more sophisticated economic analyses. As noted by Jonathan Jacobson,
the focus of the antitrust inquiry has moved from considering whether the conduct
foreclosed competition, to whether “the foreclosure or other aspect of exclusion was
imposed in a way designed to lead to an increase in prices or restriction of output in
the market as a whole. (Jacobson and Sher 2006, 786)
If suppliers compete with one another to drive customers to their dealers, the net effect
of their actions will be to increase output. Clearly in the case of hearing aids distrib-
uted through dealers, the suppliers who employed exclusive dealing did so to protect
the streams of customers that their promotion generated. The hearing aids market was
an easy case, particularly given the collapse of hearing aid manufacturers who dropped
exclusive dealing.
But for other products, it will be difficult to determine whether exclusive dealing pro-
tects ongoing investments in new customers, or whether it instead prevents rival sup-
pliers from accessing a stable pool of customers by offering lower prices. For artificial
teeth, a similar argument for efficiencies associated for exclusive dealing was rejected
emphatically by the district court. Unlike for hearing aids, the market for artificial teeth
was not expanding overall, as improvements in dentistry and fluoridation had resulted
in decreased use of dentures. Competition in the artificial tooth market has instead
focused on driving demand for better looking, longer wearing “premium” teeth. The
district court in Dentsply rejected Dentsply’s argument that its exclusive dealing was
designed to protect its investment in customers generated by its promotion, finding that
45 ZF Meritor, LLC v. Eaton Corp., 2012 U.S. App. LEXIS 20342, 2012-2 Trade Cas. (CCH) P78078 (3d
Cir. Del. 2012) (citations omitted).

322 Howard Marvel
Dentsply, with its market share in excess of 75% for premium teeth, “has not reacted with
lower prices when others have not followed its price increases,” and that its exclusive
dealing “has clearly been anticompetitive.” Dentsply’s business justification for its exclu-
sive dealing was “merely pretextual.”46 Dentsply, by using its sales representatives to pro-
mote premium teeth to its customers, dental laboratories, had clearly driven customers
to the higher end segment of the market. But the rapid growth of the higher end was
not sufficient to convince the judge that Dentsply’s promotional efforts were sufficiently
competitive to overcome the exclusion of premium teeth rivals from its dealers.
Nonetheless, the district court did not condemn Dentsply’s exclusive dealing, as
it was determined that exclusive dealing did not close distribution to rivals, and that
Dentsply’s own distribution was not crucial to those rivals’ success. It is worth consider-
ing the findings in this very significant case in more detail.
Dentsply was by far the largest supplier of artificial teeth to dental laboratories, where
those teeth were fabricated into custom dental appliances such as complete dentures
(replacements of all the teeth in one or both [upper and lower] dental arches), or par-
tial dentures replacing a subset of teeth in an arch. Dentsply distributed its teeth to the
laboratories through a network of dental supply dealers who maintained stocks of teeth
of varying shapes and shades. Because the laboratories often ordered artificial teeth only
when a customer’s existing teeth had been removed and a casting of the gum for the
desired dental appliance had been made, labs placed a substantial premium on being able
to obtain the necessary teeth in the appropriate shape and color very quickly. The tooth
dealers also maintained tooth desks that provided advice on available tooth products.
While Dentsply was the largest manufacturer of artificial teeth, rival tooth manufacturers
also offered their teeth through dealers who were authorized to sell Dentsply teeth.
The situation changed when Dentsply introduced “premium” lines of artificial teeth
distinguished by improved material formations that resulted in more luminous and bet-
ter wearing teeth. Dentsply’s smaller rivals did not follow in its path of introducing more
aesthetic and longer lasting teeth, so that Dentsply’s efforts to promote these teeth were
not threatened by the possibility of dealers recommending substitute products to lab
customers who came to the dealers seeking Dentsply teeth.
There were, however, rival producers of premium teeth, principally two large
European firms, Vita Zahnfabrik and Ivoclar, who possessed both premium tooth prod-
uct lines and sales forces that were in a position to promote those teeth to the dental
laboratories. Their entree to the labs was a consequence of the large crown and bridge
businesses that each possessed. In contrast to artificial teeth that are embedded in
custom acrylic bases fitted to consumer gums, crown and bridge materials are sold to
labs who then fabricate them into permanent fittings that are permanently implanted.
Both European competitors had crown and bridge business that were larger than that
of Dentsply, and accordingly, had substantial relationships with the bulk of the dental
laboratories to whom Dentsply sold its teeth.
46
United States v. Dentsply Int’l, Inc., 277 F. Supp. 2d 387 (D. Del. 2003).
Each of these competitors sought to distribute its products through Dentsply deal-
ers. Dentsply responded by requiring any dealer who wished to stock Dentsply teeth
to forgo the rival premium teeth products, though dealers were allowed to continue to
distribute the lower-end lines that they had handled previously. Dentsply’s contracts did
not lock in dealers, as they were terminable at will by either party. The rival premium
tooth manufacturers complained to the Department of Justice that Dentsply’s exclu-
sive dealing excluded them from the marketplace, and the Department, in turn, sued
Dentsply to stop the practice.
The case combined a very high market share for Dentsply, estimated to be about 80%
for premium teeth, with no long-term dealer commitments. DOJ initially attempted to
argue that the dealers were locked into Dentsply by their existing tooth stocks. But the
one example of a dealer who added Ivoclar teeth did not support the allegation—far
from being locked in, that dealer, cut off by Dentsply, was buying Dentsply teeth from
authorized Dentsply dealers in order to maintain its access to Dentsply customers. This
behavior was consistent with the theory that the dealer wished to convert customers
who came to it for Dentsply teeth to those of the rival, and needed to continue to offer
Dentsply’s teeth until the labs seeking Dentsply teeth could be converted, if ever.
As we have seen, the district court rejected Dentsply’s explanation that it was attempt-
ing to prevent Ivoclar from poaching its customers, but nevertheless found for Dentsply.
Its finding was based on Dentsply’s argument that rival tooth suppliers had efficient dis-
tribution alternatives, principally direct distribution that did not require dealer tooth
stocks. Support for this conclusion was provided by Dentsply’s own distribution—
while continuing to use dealers, it drop-shipped an increasing portion of its tooth sales
directly to laboratories. Accordingly, the number of dealer tooth stocks was dropping
rapidly as falling prices for overnight delivery reduced the importance of local tooth
stocks.
Dentsply lost on appeal, however, as a Third Circuit chose not to accept the district
court’s finding of sufficient alternative distribution. The Third Circuit instead held that
Dentsply possessed a market share so high that it must have been successfully excluding
rivals, and that the exclusion must have been anticompetitive.
That some manufacturers resort to direct sales and are even able to stay in business
by selling directly is insufficient proof that direct selling is an effective means of com-
petition. The proper inquiry is not whether direct sales enable a competitor to “sur-
vive” but rather whether direct selling “poses a real threat” to defendant’s monopoly.
See Microsoft, 253 F.3d at 71. The minuscule 5% and 3% market shares eked out by
direct-selling manufacturers Ivoclar and Vita, Dentsply’s “primary competitors,”
FF26, 36, 239, reveal that direct selling poses little threat to Dentsply. (399 F.3d 181, 193)
Was this finding correct? The Dentsply case illustrates the value of follow-up impact
evaluation of vertical restraints decisions. Ivoclar, given the opportunity to distribute
through Dentsply dealers, chose instead to use the alternative channel that the district
court had found was available to it. Doing so required that Ivoclar promote its teeth
324 Howard Marvel
directly to the dental laboratories. This it managed by modifying its incentives to its
sales representatives to concentrate not only on crown and bridge (its previous strat-
egy), but to sell teeth as well. With its own demand in place, it chose not to employ the
Dentsply dealers open to it. Its strategy has apparently been a success. In contract, Vita
Zahnfabrik did employ dealers, but unsuccessfully. Indeed, while Dentsply dealers
did add Vita’s teeth, no Dentsply dealer has continued to stock those teeth. The reason
appears to be that Vita’s teeth were priced higher to dealers than comparable Dentsply
teeth and so free riding was not feasible.
The experience of Dentsply also suggests care in assessing the alternatives against
which exclusive dealing distribution should be compared. Dentsply dealers handled
much more than teeth, suggesting an economies-of-scale barrier to starting rival deal-
ers was a concern. But in fact, the principal alternative to controlled dealer distribution
turned out to be vertical integration, not tooth dealers.
13.5. Exclusive Dealing and Dealer

Property Rights
We have thus far considered cases in which suppliers impose exclusive dealing to pro-
tect customers generated by a supplier’s own efforts. This need not be the case for all
exclusive dealing arrangements. Instead, exclusive dealing may define customers gen-
erated by distributors, permitting access to such customers to be transferred to a sup-
plier. That is, in return for a payment from a supplier to distributors, those distributors
may agree to suggest to their customers that they purchase the supplier’s products.
The suggestion may take the form of a recommendation or may simply involve featur-
ing the product more prominently in the distributor’s assortment. Exclusive dealing
ensures that the customers are delivered to the best of a distributor’s ability, while par-
tial exclusive dealing transfers a defined portion of the distributor’s customers to the
supplier.47
At one time, advertising, particularly successful advertising, was highly suspect from
the standpoint of antitrust. Firms that were successful in attracting customers for their
products were thought to possess monopoly power over those customers. It is now
more common to interpret advertising as a competitive tool for attracting those cus-
tomers from rivals. But recall that vertical restraints represent methods to coordinate
the actions of firms at different stages of the production/distribution process. Thus
a firm may chose to advertise its products directly to consumers, or, alternatively, it
may farm out the customer acquisition to its distributors. Typically firms do both.
Some customers may be drawn to the brand, and here exclusive dealing can prevent
47 Note that the decision to grant exclusive network provider status is an example of this kind of
exclusive dealing.
dealers from switching those customers to rivals. But suppose that some customers
are drawn to a dealer, and that that dealer can steer those customers to one or the
other manufacturer. A manufacturer may be willing to pay for such customers, but is
most likely to want to pay for only the portion of its customers that the dealer is able
to steer in its direction. The result will be a payment for those customers, but only if
the customers are actually delivered. How can property rights be specified to ensure
that compensation for the customers actually generates the promised customers?
A lump sum payment for a group of customers will handle this. The supplier offers
a lower wholesale price in return for more sales—this is competitive compensation
to the dealers who control those sales. A payment to a dealer or distributor for such
customers thus serves a purpose similar to an advertising expenditure for a message
designed to reach consumers directly.
Payments by suppliers to dealers for customers driven to the supplier’s products
ordinarily will be uncontroversial. But as with traditional exclusive dealing, when
a supplier possesses a large share of a market, the purchase of even more customers
may raise concerns about anticompetitive behavior. For example, some retailers pre-
fer to rely on a supplier to organize the merchandising of a particular class of prod-
ucts. Suppliers, in turn, compete to be named the category manager for the product
class in question. The supplier named category manager thereby obtains enhanced
access to a retailer’s customers. The category manager will need to include rival prod-
ucts in a retailer’s assortment if those products are important to at least some of the
retailer’s customers, but when consumers are indifferent between products of rival
supplier, the category manager can include its own products to the exclusion of rival
products and the retailer does not suffer as a result. Moreover, when rival products
are included in a retail assortment, that assortment can still be arranged in ways that
favor the category manager’s products.
Like advertising, partial exclusive dealing steers customers to particular suppli-
ers. It thereby harms rivals and by making customer acquisition tougher, can raise
the rivals’ costs. But as Klein and Murphy (2008) emphasize, the ability to buy
exclusive access to at least a portion of a distributor’s customers permits competi-
tion among suppliers for the rights to customers that distributors control access to.
Whether the competition results in better options for consumers depends on the
degree to which distributors must compete for the consumers they at least tempo-
rarily control.
Anticompetitive category management would impair the distribution of
the category manager’s rival products, increasing rivals’ costs and reducing the
attractiveness of the category to a retailer’s customers. This was claimed to be the
outcome of category management by U.S. Tobacco for sales of smokeless tobacco.48
Conwood, the second largest producer of smokeless tobacco, did not offer category
management services, but complained that when U.S. Tobacco was appointed cat-
egory manager for a retailer, Conwood’s products suffered as a result. A jury found
48
Conwood Corp, v. United States Tobacco Co., 290 F. 3d 768 (6th Cir. 2002).
326 Howard Marvel
for Conwood, awarding $350 million (before trebling). But the focus on the effects of
category management on Conwood, rather than on whether category management
increased the success of retailer assortments, left unresolved the question of whether
competition for the position of category manager benefited or harmed consumers.49
One firm’s purchase of customers from distributors will almost certainly increase the
costs to rival firms of reaching those same customers; relying on the presence of such an
effect on rivals threatens to commit the error of focusing on the effect of a practice on
competitors, rather than on competition.
A recent case suggests that Conwood’s finding that category management by a sup-
plier with a high share is anticompetitive is not the final word on the issue. Church &
Dwight (C&D) is the leading seller of condoms in the United States, with market share
in excess of 75%, up from 67% in 2001. Its two leading rivals have shares of 14% and 10%,
so that the three leaders account for in excess of 99% of the US market.50 A much smaller
rival, Mayer Laboratories, challenged C&D’s widespread category management and its
unwillingness to include Mayer’s competing products in retail assortments under its
control. The district court ruled that market share losses could not be clearly attributed
to a lessening of competition in the market overall. There was no showing of a reduced
output or raised prices in the market as a whole.51
13.6. Conclusion
Exclusive dealing will likely remain a controversial segment of antitrust policy. There
are clearly strong procompetitive reasons for its use in a wide variety of settings. But
since suppliers can create property rights to customers unilaterally, and, given locked-in
distributors, can enforce those property rights with anticompetitive effects, the bound-
aries of efficient and therefore permissible exclusive dealing will continue to be fought
over for the foreseeable future. Standards, at least in the United States, have become
much more lenient over time, and this evolution may continue. But it is unlikely that any
dominant firm will be able to adopt exclusive dealing without triggering charges that its
actions harm competition.
49
See Wright (2009) for an analysis of the case.
50
See Church & Dwight v. Mayer Laboratories, 2012 U.S. Dist. LEXIS 51770; 2012-1 Trade Cas. (CCH)
P77,863 (N.D. Cal. 2012). On a worldwide basis, the three firms together have a share of 62%, with C&D’s
11% share trailing those of each of its two large rivals. Thus it seems unlikely that the rivals’ existence is
threatened by insufficient scale.
51 Church & Dwight v. Mayer, at 51.
References
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Bernheim, B. Douglas, and Michael D. Whinston. 1998. Exclusive Dealing. Journal of Political
Economy 106: 64–103.
Bork, Robert H. 1978. The Antitrust Paradox. New York: Basic Books.
Frasco, Gregg P. 1991. Exclusive Dealing: A Comprehensive Case Study. Lanham, MD: University
Press of America.
Fumagalli, Chiara, and Massimo Motta. 2006. Exclusive Dealing and Entry: When Buyers
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Heide, Jan B., Shantanu Dutta, and Mark Bergen. 1998. Exclusive Dealing and Business
Efficiency: Evidence from Industry Practice. Journal of Law and Economics 41: 387–407.
Innes, Robert, and Richard J. Sexton. 1994. Strategic Buyers and Exclusionary Contracts.
Jacobson, Jonathan M. 2002. Exclusive Dealing, “Foreclosure,” and Consumer Harm. Antitrust
Law Journal 70: 387–407.
Jacobson, Jonathan M., and Scott A. Sher. 2006. “No Economic Sense” Makes No Sense for
Exclusive Dealing. Antitrust Law Journal 73: 779–801.
Klein, Benjamin. 2003. Exclusive Dealing as Competition for Distribution “On the Merits.”
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Distribution. Antitrust Law Journal 75: 433–66.
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Rivals’ Costs to Achieve Power over Price. Yale Law Journal 96: 209–93.
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Contracts with Externalities. American Economic Review 99: 1850–77.
Landeo, Claudia M., and Kathryn E. Spier. 2012. Exclusive Dealing and Market Foreclosure: Further
Experimental Results. Journal of Institutional and Theoretical Economics 168: 150–70.
Marvel, Howard P. 1982. Exclusive Dealing. Journal of Law and Economics 25: 1–25.
Marvel, Howard P. 1984. Vertical Restraints in the Hearing Aids Industry. In Ronald N. Lafferty,
Robert H. Lande, and John B. Kirkwood, Impact Evaluation of the Federal Trade Commission
Vertical Restraints Cases. Washington, DC: Federal Trade Commission, 270–384.
Maston, Scott E., and Edward A. Snyder. 1993. United States versus United Shoe Machinery: On
the Merits. Journal of Law and Economics 36: 33–70.
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Wright, Joshua D. 2009. Antitrust Analysis of Category Management: Conwood v. United States
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Comment on Klein and Murphy. Antitrust Law Journal 77: 205–11.
CHAPTER 14
T YING ARRANGEMENTS
ERIK HOVENKAMP AND HERBERT HOVENKAMP
14.1. Introduction; Identifying Ties
Tying arrangements, sometimes known as “ties,” “tie-ins,” “tied-in sales,” or “bundles,”

occur when a firm offers two separate products together, refusing to sell one of them
without the other. Identifying when two things are really a single product—such as a
shirt and its buttons or an automobile and its tires—has proven controversial. The
dominant position looks at ordinary business practices in order to determine whether
the products are commonly sold separately. In its Jefferson Parish decision (1984) the
Supreme Court held that the separate product inquiry depends “not on the functional
relation” between two goods, but rather “on the character of the demand for them.”
This query requires the plaintiff to show simply that the two products are commonly
sold separately under ordinary market conditions. As a result the “separate products”
requirement serves mainly as a screening device to weed out frivolous cases involving
goods (such as a right shoe and a left shoe) that are rarely sold separately (e.g., Reisner
case [tying of car to drive train]; Areeda and Hovenkamp 2011, ¶¶1741–51). This defini-
tion is in contrast to a more substantive one that a single product should be found when
there are “rather obvious economies of joint provision” (Jack Walters case).1 That test
would merge a test for efficiency, otherwise a defense, into the definition of separate
products.
Ties can come in one-way and two-way varieties. For example, Baskin-Robbins as
franchisor might insist that its franchisees sell its own Baskin-Robbins brand ice cream;
1 Four justices in Jefferson Parish preferred this view: “When the economic advantages of joint
packaging are substantial the package is not appropriately viewed as two products, and that should be the
end of the tying inquiry.” Jefferson Parish, 466 U.S. at 40–41.
330 Erik Hovenkamp and Herbert Hovenkamp
however, it might willingly sell the ice cream alone to independent retailers or consum-
ers. Two-way ties are sometimes referred to as “bundles.” In a one-way tie we can readily
speak of a “tying product” (e.g., the Baskin-Robbins franchise) and a “tied product” (the
ice cream). In a two-way tie each product serves both functions. Bundling arrangements
often involve more than two products. For example, a patent “package license” may
include several hundred patents (e.g., Automatic Radio case), and the “blanket license”
agreements used in the music broadcasting industry include several thousand composi-
tions (e.g., Broadcast Music case). So-called bundled discounts typically operate in both
directions. For example, the seller may offer A and B individually at given prices, but a
lower price for someone who takes an A + B bundle.
In any event, the tying condition must be something that prevents a customer from
purchasing the goods separately or else that creates a disincentive to do so. The ortho-
dox tying form is the “contractual” tie, in which a contract requires the buyer to take the
two products together. Legally, tying can also be inferred from an observed practice of
refusal to make untied sales (Areeda and Hovenkamp, 2011, ¶¶1755–56). Tying can also
be inferred from a discount that attaches when the buyer takes two or more products
together (see Hovenkamp and Hovenkamp 2008; 2009), or from a technological design
or interoperability requirement that effectively forces the customer to use the two prod-
ucts together even if she is not contractually required to do so. Well-known examples
are Microsoft (2001), which condemned the blending of Internet Explorer code with the
Windows computer operating system code, and Berkey Photo, which refused to con-
demn a camera and film design under which the two would work only with each other
(Berkey Photo, 1979; see Bohannan and Hovenkamp 2012, 321–22; Evans and Salinger,
2005). If a customer is free without significant constraint to purchase two products sep-
arately as well as together, there is no tie.
14.2. Statutory Coverage and

Idiosyncratic “Per Se” Rule
The Sherman Act does not explicitly reach tying arrangements, but rather agreements
that restrain trade or actions by dominant firms that monopolize markets (15 U.S.C. §1
[contractual restraints on trade], §2 [monopolization]). In 1912 the Supreme Court con-
fronted its first tying case in Henry (1912), which upheld the right of a maker of office
mimeograph machines to require purchasers to use the machine exclusively with its
own ink and stencils. The case was not brought by the buyer as an antitrust action, but
rather by the seller as a patent infringement action for sales in violation of the patent
license. The Court held that the tying of patented and unpatented products was not an
unwarranted extension of the patent.
Congress was not happy with the Henry decision. Instead of addressing the legal
merits of the Supreme Court’s holding by modifying the Patent Act, however, Congress
Tying Arrangements 331
placed an antitying provision in the Clayton Act (15 U.S.C. §14), which expanded the
antitrust laws to as to prohibit anticompetitive contractual tying. It changed patent doc-
trine only forty years later.2 Congress’s displeasure with Henry may also be read as its
conclusion that a tie should be unlawful even if it threatened no monopoly in the sec-
ondary market, given that the stencils and ink in Henry were common commodities.
Today the antitrust legality of tying is assessed under four different statutes. Most
explicitly, Section 3 of the Clayton Act makes it unlawful for a firm to sell or lease a good
subject to a condition or discount requiring the buyer not to purchase goods from a
rival, and where the effect “may be to substantially lessen competition or tend to create
a monopoly” (15 U.S.C. §14). The statute applies to both patented or unpatented “goods”
or “commodities” but excludes services or other intangibles. In addition, Section 1 of the
Sherman Act reaches agreements “in restraint of trade,” which includes anticompeti-
tive tying and is not restricted to goods. Section 2 of the Sherman Act condemns tying
when it is shown to be an exclusionary practice by a monopolist, or dominant firm.
Finally, Section 5 of the Federal Trade Commission Act (15 U.S.C. §45(a)(1)) can also be
used against tying, although that provision may be enforced only by the Federal Trade
Commission.
During the period from the Clayton Act’s passage through the 1970s Supreme Court
doctrine was particularly hostile toward tying. The Court’s Standard of California deci-
sion (1949) declared that ties “serve hardly any purpose beyond the suppression of
competition.” The Court developed a “per se” rule against them under Section 1 of the
Sherman Act “whenever a party has sufficient economic power with respect to the tying
product to appreciably restrain free competition in the market for the tied product and
a ‘not insubstantial’ amount of interstate commerce is affected” (Northern Pacif. Rwy,
1958).3 This rule differs from the per se rules applied to such practices as naked price
fixing because it requires a showing of (1) market power in the tying product and (2) at
least minimal impact on competition. Further, it has been interpreted to permit a range
of justifications or defenses that are not ordinarily available in per se antitrust cases. The
result of these requirements is that, notwithstanding the per se label, most ties today
are found to be lawful. In addition, ties can also be condemned under a rule of reason
under either Section 3 of the Clayton Act or Section 1 of the Sherman Act. Further, cer-
tain unilateral monopolistic practices such as technological ties that do not meet the
“agreement” requirements in these statutes can be condemned under the antimonopoly
provision, Section 2 of the Sherman Act, which always requires a showing of actual or
threatened market power and anticompetitive effects.
2 In the 1952 Patent Act Congress provided that the doctrine of contributory patent infringement
could not be applied to the sale of a “staple article or commodity of commerce suitable for substantial
noninfringing use.” Patent Act, ch. 950, 66 Stat. 811 (1952) (codified as amended at 35 U.S.C. § 271(c)). As a
result, Henry’s sale of ink capable of other uses could not be the basis of an infringement action.
3 On the meaning of a “not insubstantial” volume of tied commerce, see Areeda and Hovenkamp,
2011, ¶1721.
14.3. Minimum Conditions for

Competitive Harm; Market Power
Almost everyone agrees that tying is harmless if the markets for the tying and tied prod-
uct are both structurally competitive. If a competitive firm attempts tying that is unde-
sirable to consumers, they will go elsewhere. As a result, any tying that exists in such
markets must make consumers better off. The situation is more complex if a seller has
market power in one or both the tying and tied markets.
While market power in the tying product has generally been stated as a legal
requirement for unlawful tying, the courts have not always taken the requirement
very seriously and have inferred sufficient power from phenomena that indicate very
little power at all. The Supreme Court has permitted sufficient power to be inferred
from the tying product’s “uniqueness” (Loew’s, 1962), from the fact that the defen-
dant was able to impose a “host” of tying arrangements (Northern Pacif. Rwy, 1958),
and from the fact that purchasers may be “locked in” by a previous purchase and thus
required to buy the seller’s aftermarket parts or service (Kodak, 1992). A few lower
courts have even held that a long-term contract can impose the requisite power (e.g.,
Collins, 1997). Most of these rationales arose out of a deep suspicion as well as a poor
economic understanding of ties, which presumed them to be anticompetitive in most
cases and thus warranting per se condemnation. While none of these cases has been
expressly overruled, their approaches to power are largely ignored or else construed
very narrowly.
The Kodak lock-in doctrine applies mainly when the defendant requires previous
purchasers of its durable good to use its aftermarket parts or service. The firm may
be nondominant in the primary market, as Kodak was in that case, but the effect of
the lock-in doctrine is to create a relevant market for the firm’s own brand. The the-
ory, quite simply, is that once a person has purchased a durable good such as a photo-
copier, “switching costs” are so high in relation to aftermarket value that the firm can
be forced to pay monopoly prices for tied specialty products or service. The Supreme
Court rejected the defense that a rational customer would engage in “lifecycle” pricing,
attributing high aftermarket prices to the overall price. But the Court found two pos-
sible exceptions: first, there might be a significant group of “myopic” customers who are
initially beguiled by a low price on the primary good and ignore the high aftermarket
prices. Second, a firm might increase aftermarket prices late in a product’s lifecycle, per-
haps sacrificing some prospective hardware sales but earning more from the “installed
base” of customers who have previously purchased. As the quotation marks suggests,
Kodak has produced its own vocabulary of specialty terms. Nevertheless, the doctrine
has been sharply criticized and the courts generally construe it narrowly. For example,
they do not apply it when the purchasers had adequate knowledge of downstream prices
when they made their initial choice (e.g., Hack, 2001).
Finally, the Supreme Court had previously held that the seller’s ownership of a tying
product covered by a patent (International Salt, 1947) or copyright in the motion pic-
ture “block booking” cases (Loew’s, 1962; Paramount, 1948) created a presumption of
sufficient power, and a few lower courts had extended this presumption to trademarks
(e.g., Siegel, 1971). The Supreme Court overturned this presumption in its 2006 Illinois
Tool Works decision, and today market power in tying products protected by intellectual
property rights must be established through the ordinary tools for showing power.
At this writing the Supreme Court has not overruled its legal conclusion that ties are
unlawful “per se” when tying product power is proven and the tie affects a substantial
volume of commerce. The existence of this per se rule has had one very unfortunate con-
sequence: litigants in tying cases have not been required to make a record documenting
the true effects of tying, given that those effects were simply presumed. A few passages
in Illinois Tool Works suggest that the per se tying rule might be ripe for reconsideration.
Market power is a necessary but hardly a sufficient condition for competitive harm
from tying. Indeed, at least presumptively a tie does not cause any additional welfare
harm beyond that which already exists in the untied monopoly market. Further, two
common economic effects, price discrimination and control of double marginalization,
are more likely to increase than to decrease welfare from the stand-alone monopoly
level. Finally, various benefits of tying, including production or distribution economies
or improvements in product quality, can apply to dominant firms and competitors alike.
14.4. Motives and Effects of Tying
14.4.1. Rise and Fall of the Leverage Theory
The leverage theory, which originated in patent law in the nineteenth century,
expressed a concern that a patent owner could use contracts or conditions to “leverage”
more power than the patent itself granted. The best-known statement of the doctrine
is Justice Brandeis’s conclusion in Carbice that a requirement that those using a firm’s
patented refrigeration container also use its dry ice improperly permitted the seller “to
derive its profit, not from the invention on which the law gives it a monopoly, but from
the unpatented supplies [which are] wholly without the scope of the patent monopoly”
(Carbice, 1931).
The leverage theory has nothing to do with the exclusion of any rival (foreclosure).
Rather, the harm is based on the threat that the tying monopolist will extract higher
prices from consumers. This view was largely exploded by Ward S. Bowman, who
observed that when a purchaser wants a combination of two complementary products,
the profit-maximizing price is computed by reference to the combination. See Bowman
(1957). One can raise the price of the second product only by reducing the price of the
first product. For example, if shoes and laces are complements, a shoe monopolist can
extract all available monopoly profits in the price of shoes, and cannot profitably extract
more by tying otherwise competitive laces and charging a second monopoly price for
them. Consumers attribute value to the combination of shoes plus laces.
The leverage theory is clearly a fallacy in situations where the tying product is monop-
olized and the tied product is competitive. It is also incorrect in cases where both prod-
ucts are subject to the exercise of some market power, because in these situations the
elimination of double marginalization is likely to produce lower rather than higher
prices, as we shall see below.
A type of leveraging may occur when a dominant firm ties sequential rather than
simultaneous monopolies, but this is clearly something different than Justice Brandeis
and other proponents of the leverage theory had in mind. For example, a firm such as
Microsoft, seeing that a rival’s Internet browser with operating system capabilities poses
a future threat to its own operating system, might tie its operating system and its browser
in order to keep that threat from being realized (Microsoft, 2001). Even in this case, how-
ever, the competitive threat resembles foreclosure of rivals more than pure leveraging.
See Bohannan and Hovenkamp (2012, 25–26, 269); Whinston (1990).
14.4.2. Price Discrimination

In a variable proportion tie, consumers purchase one unit of the tying product and
amounts of the tied product that vary with their use of the tying product. For exam-
ple, printer manufacturers will frequently tie their printers to their own ink cartridges.
Consumers who do more printing must purchase more ink cartridges, but most users
buy only one printer. In nearly all litigated cases these tying arrangements involve a
price reduction from the nontied level on the tying product, but a markup on the price
of the tied product. Indeed, often the tying product is priced at below cost or given away.
See Hovenkamp and Hovenkamp (2010). This pricing strategy is frequently referred to
as “metering.” A more technical account is presented in Schmalensee (1981), who finds
that such arrangements may often be welfare increasing.
Price discrimination occurs when the ratio of the average price to marginal cost var-
ies among buyers of the same product. If marginal cost is the same for all customers,
then price discrimination occurs whenever two consumers pay different unit prices for
the same product. When demand for the tied product varies significantly among buy-
ers of the tying product, variable proportion tying may be used to discriminate among
buyers with different intensity levels. By shifting profits to the tied sales, the firm earns
greater profits from higher intensity users. Moreover, by reducing the price of the tying
good the firm can obtain a profit from lower intensity buyers who would not have pur-
chased the product at all under separate provision.
Because all consumers face the same price schedule, metering is an example of
second-degree price discrimination. It is important to note that the object of this price dis-
crimination is the combined use of the two products. Individually, both the tying and the
tied products are sold at the same nominal price to all. For example, in a tie of printers and
ink cartridges it is the price of printing that is discriminatory. Of course, the combined use
of the tying and tied products will always have a price schedule of this form, even under
separate provision. However, in that case no single firm can utilize this property to dis-
criminate, and so the resulting prices differ from the optimal discriminatory prices.
To illustrate suppose that a printer monopolist faces costs of 10 per unit and that the
cost of cartridges is 2. Cartridges are sold competitively. The printer maker could sell the
printer at a stand-alone profit-maximizing price of 14, earning 4 on each sale, for a return
of 40%. It would sell the cartridges at the competitive price. Instead the monopolist sells
the printers at its cost price of 10 and ties cartridges, for which it charges 4. The first thing
that will happen is that more buyers will come into the market for printers. Output will
not rise all the way to the competitive level in this illustration because each customer
needs at least one cartridge, so even the lowest intensity user will end up paying 14 rather
than the competitive price of 12. Returns (right column in the table below) are then as
follows for customers requiring different numbers of cartridge (second column):
Number of Cartridge Total

Printer price/cost cartridges price/cost price/cost Return
10/10 1 4/2 14/12 16%
10/10 2 8/4 18/14 28%
10/10 3 12/6 22/16 37.5%
10/10 4 16/8 26/18 44%
10/10 5 20/10 30/20 50%
10/10 10 40/20 50/30 67%
10/10 20 80/40 90/50 80%
Such differences are robust over all situations in which tying involves a transfer of part
of the available monopoly overcharge from the tying to the tied product. In the above
example, printing costs per page actually decline as usage increases, because the printer
price is amortized over more copies while the cartridge cost is constant. However, the
seller earns higher returns per customer as usage increases.
The welfare effects of variable proportion tying are generally ambiguous. We can
safely assume that total profits—the sum of tying and tied good profits—are higher
under tying. Otherwise the seller would not tie. However, some consumers benefit from
tying, while others are injured by it. As figure 14.1 illustrates, we can divide consumers
into three groups: low, medium, and high intensity. Low-intensity consumers are those
with relatively low demand who are unwilling to pay the higher tying good price that
arises under separate provision. They purchase the goods only under tying and are thus
clearly benefitted by the tie. Medium intensity consumers are those who buy the prod-
ucts under both pricing regimes, but who receive more surplus under tying. Because the
marginal cost of consumption (the tied good price) increases, these buyers consume less
under tying. But the reduction in the tying good’s price is sufficiently large to overcome
Consumer
Surplus
Separate
Provision
Tying
Consumer
Intensity
Low Medium High
FIGURE 14.1 Welfare Effects of Variable Proportion Tie
this decline, and the result is a net increase in consumer surplus. Finally, high-intensity
consumers are those who achieve less surplus under tying. These consumers have rela-
tively high demand, and the price of the tying good makes up a relatively small fraction
of their total consumption expenditure. Unlike medium-intensity buyers, the reduction
in the tying good price is insufficient to overcome the negative impact of an increased
tied good price. The net effect of tying on consumer welfare is the aggregation of the
effects on all consumer types.
Given the varied surplus effects depicted in figure 14.1, the overall effect of tying on
welfare generally depends on the distribution of consumer intensity levels within the
population. However, three additional factors can strongly affect the welfare impact of
variable proportion ties. These are the impact of tying on producer costs of the tying
product, the degree of competition in the tied market, and economies of scale in the
tying or both markets. If the marginal cost of the tying product is relatively high—mean-
ing that it is close to the maximum willingness to pay among potential buyers of the
tying good—they tying is more likely to increase consumer welfare. In this case, tying
permits the seller to price the tying good near or below cost, which results in many more
consumers entering the market. In fact, if this marginal cost is sufficiently high, then
tying may be the only pricing arrangement in which sales of the tying product are prof-
itable. For example, a device such as a smartphone may require a price of $400 if sold
alone, but may be included without charge or at a nominal price when bundled with a
two-year service contract. Returns on the phone will depend on consumer usage.
The level of competition in the tied market also affects the impact of tying. In particu-
lar, consumer welfare under separate provision ordinarily decreases as tied market com-
petition diminishes. Under tying, however, consumer welfare is largely unaffected by
the level of tied market competition. The tying product cannot be used with competing
versions of the tied product in any event, so the tying firm’s pricing decision is indepen-
dent of tied market prices. Thus a lack of tied market competition will tend to ease the
conditions under which tying improves consumer welfare.
The third factor is the extent of scale economies in production of the tying product
and, occasionally, the tied product. Because the price cut in the tying product results
in greater tying product sales, more units of the tying product will be produced. If fixed
costs are substantial, as they often are for manufactured products and particularly for
those with a significant R & D component, then the output increase that results from
tying will likely produce a lower profit-maximizing price quite aside from the pricing
shift to the tied product. The output impact on the tied product is more ambiguous.
On the one hand, high-intensity users consume less of the tied product because they
pay more for it under tying. On the other hand, low-intensity users would not be in the
market at all under separate provision. Any demand that tying creates among them con-
stitutes an output increase. Further, the tie itself switches tied product output away from
rivals and toward the tying firm. If the net result is an output increase, then economies of
scale may reduce the costs of the tied product as well. In sum, while precise calculation
may be impossible, there are good reasons for thinking that price discrimination ties
increase aggregate consumer welfare as a general matter.
14.4.2. Foreclosure
The dominant defense of antitrust tying doctrine today is that ties may unreasonably
foreclose, or exclude, rivals, particularly in the tied product market. For example, once
a major hospital enters an exclusive arrangement with an anesthesiologist, rival anes-
thesiologists will be denied the right to practice at that hospital (e.g., Jefferson Parish,
1984), or once Microsoft bundles its Windows operating system with its Internet
Explorer browser, rival browser makers may find it more difficult to sell their product
(Microsoft, 2001).
Several writers, particularly from the Chicago School, have been highly skeptical of
foreclosure claims. First, tying may require no more than a realignment of purchasing
patterns. For example, once an independent anesthesiologist loses the right to practice
anesthesiology at a particular hospital because of its tie, she will have to practice at a
different hospital, but market competition need not be affected. Second, the critique of
the leverage theory also applies in foreclosure cases: that is, even assuming that tying
forecloses rivals, it still does not change the fact that the profit-maximizing price of the
tying-tied combination is no higher than it was before. See Bork (1978, 231–45).
In all events, foreclosure requires an assessment of the downstream market, some-
thing that cannot be inferred from upstream market share. For example, even if the pat-
ent monopolist of a salt-injecting machine for canned foods has a 90% market share in
such machines, foreclosure in the salt market must be assessed against the full range of
uses for salt (e.g., Int’l Salt, 1947). Use through the salt-injecting machine may represent
only a small proportion. Many ties, particularly in the franchise and aftermarket parts
contexts, have involved relatively common commodities with a wide variety of uses
unrelated to the tying product.
Today the rise of transaction cost economics and greater sensitivity toward the
cost of moving resources has forced relaxation of the strict Chicago School view. See
Hovenkamp (2010). Even if tying does not lead to an immediate increase in prices, it
can serve to deter or delay entry by rivals. Before this can occur, however, actual exclu-
sion must be shown and entry or mobility barriers must be shown to be significant. For
example, the OS/browser tie in Microsoft very likely delayed the development of inde-
pendent browsers with OS capabilities.
These barriers to entry or mobility can emanate from a variety of sources, including
intellectual property rights or other government-created licensing restrictions, dif-
ferential economies of scale in the markets for the tying and tied products, or rea-
sons related to asset specificity and risk that are commonly associated with barriers
to entry. For example, once excluded from practicing his profession by the dominant
hospital’s anesthesiology tie, an independent anesthesiologist may be prevented from
building his own hospital by government-imposed regulatory requirements, differ-
ent scale economies as between hospitals and anesthesiological practice, or else the
simple fact that a hospital is a costly specialized asset that cannot readily be rede-
ployed in the event of failure. Of course, none of these explain why the hospital would
be able to charge higher prices when the independent anesthesiologist had been
excluded from the anesthesiologist market. Even a monopoly hospital would gener-
ally profit by procuring inputs of the highest quality and at the lowest cost, and once
its profit-maximizing price is established it will not be able to extract more profits
simply by tying one of these inputs.
More realistic foreclosure fears arise in changing markets where single-level entry
threatens to turn into two-level competition, thus eroding the dominant firm’s position.
In Microsoft (2001) the D.C. Circuit found this to be such a case. Because the Netscape
browser contained operating system features, Microsoft CEO Bill Gates feared that it
could eventually “commoditize” the operating system market by creating competition
there. The Internet Explorer tie was designed to switch customers away from Netscape
in order to suppress that threat.4 In other situations tying may deprive rivals in the
tied market of output that is necessary for efficient production, with the effect of rais-
ing prices in the secondary market. Finally, the use of dominant firm tying to create a
two-level monopoly can raise entry barriers by requiring entry at two levels rather than
one. This can be particularly burdensome when differential scale levels apply at the two
levels. See Areeda and Hovenkamp (2011, ¶1705).
4 See 84 F.Supp.2d 9, 29 (D.D.C. 1999) (district court findings of fact noting Gates’s email to employees
about Netscape threat “to commoditize the underlying operating system”). See Areeda and Hovenkamp
(2011, ¶¶1704, 1706). The Ninth Circuit has held that tying claims alleged under the rule of reason should
be dismissed in the absence of any allegation of foreclosure. Brantley v. NBC Universal, Inc., 675 F.3d 1192
(9th Cir. 2012).
14.5. Tying of Complements and

Double Marginalization
Horizontal double marginalization occurs when two or more complementary products

are sold by separate firms and each one individually maximizes at prices above marginal
cost. As a result, purchasing under separate provision also entails a separate markup on
each good. Such arrangements frequently result in prices whose sum exceeds the price
that would be set by a single firm who sells the products together. By eliminating such
“double marginalization,” tying can benefit consumers. Further, total profits will tend to
be higher under tying, as a single firm will internalize the (negative) pricing externality
of each good. This provides a clear justification for tying that is independent of any pro-
duction efficiency gains that might result from joint provision. Two firms can achieve
similar results by coordinating their output and pricing, but this arrangement will nec-
essarily involve tying in any event, as coordination will require joint sales.
The elimination of double marginalization is always sufficient to justify tying when
the goods in question are mutually perfect complements, meaning that each good is val-
ueless without the other. For example, an automobile consists of many individual parts
that are essential to the final product, but which are independently useless to most con-
sumers. If consumers purchased these parts from separate firms, then each part would
be marked up independently. The total markup would be considerably higher than the
single markup by a manufacturer who “ties” all of the parts into a finished car. With joint
provision, the firm does not distinguish between the profits earned on separate parts; its
only concern is the total profit earned on the car. The tying of mutually perfect comple-
ments virtually always increases both seller profits and consumer welfare. These results
are formalized in the following simple example.
Consider two mutually perfect complements, A and B. Each good i is produced at
constant marginal cost ci ≥ 0. Market demand for the pair (one unit of each good) is
Q (P ) = α − βP , where P denotes the price of the pair and α, β >0. First consider a single
firm who ties the two goods, but does not achieve any production efficiencies (i.e. the
cost of producing the tie is c A + c B ). The firm sets a tie price PT to maximize profits,
which are given by [PT − c A − c B ]Q (PT ) Solving the firm’s optimization problem yields
an optimal tie price of
α + β (c A + c B )
PT* =
2β
Now consider a situation in which A and B are produced by separate firms. Each firm
i ∈{A, B} sets the price of i, denoted Pi , taking its rival’s price as given. Thus, given PB ,
firm A chooses PA to maximize [PA − c A ]Q (PA + PB ). Solving for the Nash equilibrium
yields prices of
α + β (2c A − c B ) α + β (2c B − c A )
PA* = , PB* =
3β 3β
Comparing the prices of the A − B pair between the two scenarios, we find that
PT* ≤ (PA* + PB* ) if and only if α ≥ β (c A + c B ), which is true if and only if PT* ≥ (c A + c B ).
Thus, whenever a firm would actually choose to tie, it must be the case that tying leads to
a lower price for the pair. This implies that consumer welfare increases. Also, it follows
from the fact that PT* ≠ (PA* + PB* ) in general that total profits are higher under tying. Thus
the tying of mutually perfect complements unambiguously increases total welfare.
If a tie includes an imperfect complement—meaning that at least one good has
value independently of the others—then the elimination of double marginalization
may not be sufficient to infer a welfare improvement. However, this is not because
double marginalization ceases to be inefficient in these cases. It is still true that tying
reduces the price paid for the tied-up package of goods, and that total profits increase,
benefiting both the seller and those purchasers who actually want the entire pack-
age. The difference in this case is that some consumers may wish to buy only the tying
product alone—something that does not happen when the goods are mutually per-
fect complements. Tying may injure these consumers, as they may be forced to buy
unwanted items in order to obtain the products they desire. The extent of this harm
will tend to decrease as the level of complementarity among products increases. For
sellers, situations of this type are more readily addressed by bundled discounts rather
than tying. In a bundled discount those customers who want only one component
pay the maximizing price of that item; but sellers who prefer the bundle can obtain
a price that is lower than the summed prices of sales by two different firms. For this
reason one might expect to see bundled discounts as an alternative to tying in situa-
tions where the bundled goods are often but not invariably used together. The price to
the stand-alone buyers will depend on the demand elasticity the seller faces. In some
cases the buyers who prefer the primary product alone may value it more highly than
the bundle buyers, and in some cases less. As a result competitive harm cannot be
inferred from the fact that the seller increases the price of the primary product when it
introduces a bundled discount.
The above double-marginalization arguments may not apply straightforwardly
to ties involving products used in variable proportions, such as printers and ink car-
tridges. Joint maximization may still occur at a lower price than when sales are made
by separate sellers. As developed previously, in variable proportion situations the seller
is typically engaged in price discrimination by reducing the price for the fixed compo-
nent (e.g., the printer) and increasing the price of the variable component (the ink).
As a result, it is no longer the case that tying benefits all consumers who wish to buy all
of the tie’s components. Rather, tying reduces the total price to consumers who desire
relatively few variable units, while increasing the total price for higher intensity con-
sumers. As a result, the double-marginalization effects of variable proportion ties are
more complex.
14.6. Economies of Joint Provision
14.6.1. Generally
Economies are always relevant to tying law, although how they are used depends on
one’s definition of the “separate products” test. Under one version of the test two goods
will be treated as a single product if tied provision is cheaper than provision by two dif-
ferent firms. In that case the plaintiff would have to show separate products by proving
the absence of economies. Under the dominant test that five justices of the Supreme
Court approved in Jefferson Parish, however, proof of economies does not enter at the
definitional stage but rather operates as a defense to the tie. This means that the burden
of proving economies normally lies with the defendant.
Virtually any type of cost savings can justify a tie, including manufacturing economies,
distribution economies, economies in R & D, and purely transactional economies such
as risk reduction or quality control. An example of the first is the Times-Picayune case
(1953), a government challenge to a newspaper’s requirement that classified advertise-
ments be placed simultaneously in its morning and evening editions. As the record in
that case developed, the advertisements were typeset manually and under the tie could
be set a single time for both newspapers. This cost savings could not be achieved by any
mechanism other than requiring identical morning and evening advertising sections.
Many of the economies produced by ties are economies of scope, or the reduced
costs that attend producing two goods or services together rather than separately. The
phrase “economies of joint provision” is useful, because not all economies of scope jus-
tify tying. For example, significant economies of scope justify producing beef and cow-
hide together, or lumber and sawdust. But once a firm has produced these two goods
together, they can and typically are distributed separately. By contrast, the typesetting
in the Times-Picayune advertising case could not produce the economies in question
unless buyers were required to purchase advertising in both newspapers together.
The joint provision of distinct products will frequently result in efficiency gains
that make tying beneficial for both firms and consumers. These efficiencies typically
involve reduced costs or improved product quality. Production cost reductions occur
when the production of one good allows another to be produced more cheaply, or when
there is a common fixed cost that can be spread across multiple production processes.
Improvements in product quality typically arise when joint production allows for
increased compatibility between the goods, making their combined use easier or more
enjoyable.
14.6.2. Production Cost Efficiencies

When joint production of two or more different goods is less costly than separate pro-
duction of each good, we say that joint production exhibits economies of scope. Formally,
consider two products and A and B , let C(q A , qB ) denote the total cost of jointly
producing q A units of A and qB units of B , where C(∙,∙) is nonnegative-valued and
increasing in both situations. Then joint production of A and B exhibits economies of
scope at quantities (q A , qB ) if C(q A , qB ) < C(q A , 0) + C(0, qB ). This may arise because
enabling production of one good reduces the marginal cost of producing another, or
because total fixed costs are lower under joint production.
Perhaps the most common source of scope economies are joint cost savings, which
arise when there is a shared input or production process that can be “spread” across the
production of different products. Suppose that θ is a costly input used in the produc-
tion of both A and B, and let θ*(qA,qB) be the quantity of θ required to jointly produce
qA units of A and qB units of B. In general, θ may be a fixed or variable input, and it
can be either tangible (e.g., a plant or machine) or intangible (e.g., a patent). Then the
joint production of A and B exhibits joint cost savings at (qA,qB) if θ*(qA,qB) < θ*(qA,0) +
θ*(0,qB). For example, Internet and cable television can be delivered by the same wires,
making the cost of joint provision much lower than if two companies offered the ser-
vices separately and each one supplied its own wires. The classic production assembly
line is another example. Adding components as a good travels down a single line may be
much cheaper than subjecting the good to repeated trips down different lines.
In many of these cases a tie is the only way in which a firm can capitalize on joint
cost savings. That is, the savings achieved by tying could not be achieved by separate
sales even if both goods are produced by a single firm. For example, consider a pharma-
ceutical firm that can produce capsules of a cough suppressant and a decongestant. See
Evans and Salinger (2007). The per-unit cost of each medication is 10 cents; the cost of
buying and filling a capsule is 50 cents. Under a tying arrangement for a multisymptom
capsule the firm fills each capsule with both drugs, for a total cost of 70 cents per unit.
Under separate production of single-symptom capsules, however, each drug is encapsu-
lated separately, and the total cost of the drug combination is $1.20. Thus the production
process exhibits joint cost savings, which occur because encapsulation is a shared cost.
Moreover, these savings would not arise if a single firm sold the drugs separately unless
they could form a production joint venture and make the multisymptom capsules.
14.6.3. Quality Control Efficiencies

Tying frequently produces quality improvements when achieving compatibility
between products is costly and highly sensitive to production specifications. This
occurs when the compatibility between products is (1) complex and subject to con-
siderable variation; and (2) essential to the value of one or more products. In these
situations, the direct effect of joint production is to reduce the costliness of ensuring
compatibility; quality improvements arise indirectly in response to this cost shift. For
example, computer operating systems typically include a number of independent pro-
grams or subroutines that are developed by the same manufacturer. Clearly the value
of each tied program is highly dependent on its compatibility with the user’s operat-
ing system. By jointly producing these programs, the producer can capitalize on its
familiarity with its own operating system. This is particularly important when product
compatibility depends on technological specifications that are not fully observable by a
producer’s rivals.
A great many antitrust challenges to ties have arisen in the franchising industry, par-
ticularly for fast foods. Monopoly in these cases is almost never in prospect in either
market. The tying markets for the franchised brands or systems are nearly always com-
petitive, and the tied products are typically common commodities such as spices, cook-
ies, pizza dough, or general purpose real estate rentals. As a result, anticompetitive
foreclosure is virtually out of the question. The plaintiffs are almost invariably franchi-
sees rather than rivals, and the claims are for overcharges in the tied product.
One robust explanation for these ties is price discrimination, as outlined previously.
In addition, however, franchise ties are important for quality control, as an alternative to
self-distribution. Some franchisors such as Baskin-Robbins make their own ice cream
and have chosen to sell it through independently owned franchisees. Others, such as
McDonalds, produce very little product themselves. In both cases, however, the fran-
chisor has a strong interest in maintaining high quality and uniformity across all of its
stores, while individual franchisees may have incentives to cut costs by buying cheaper
products, free riding on the strength of the franchise as a whole. This is particularly likely
when the franchise as a whole depends on repeat business but individual franchisees
serve transient customers that they are likely to see only once. See Blair and Lafontaine
(2005); Klein and Saft (1985).
The Collins v. Dairy Queen case (1999) involved DQ’s insistence that franchisees use
Nabisco cookies in its “Blizzard” ice cream concoctions rather than cheaper cookies
made by generic bakeries. In Queen City (1997) the Domino’s pizza franchisor required
its franchised stores to use its particular pizza dough. Either price discrimination or
quality control, or perhaps both, are likely explanations for these ties. Monopolies of
either cookies or pizza dough was not in prospect.
14.6.4. Package Licensing and Similar Intellectual

Property Bundles
Package licensing of patents creates significant opportunities for cost savings, particu-
larly if the patents are complements. The transaction costs of negotiating license fees
over groups of patents, of offering standardized packages, or of monitoring to ensure
that licensees are using only technology that they have actually licensed can all be
reduced by package licensing. See Bohannan and Hovenkamp (2012, 345–48). Relatedly,
“blanket” licensing of recorded music can enable radio stations and other broadcasters
to achieve instant indemnified access to performance rights without individual nego-
tiation. The value of such licenses would largely be lost, however, if individual licensees
could willy-nilly designate small portions of them and obtain a pro rata price reduction.
Thus in Broadcast Music (1982) the court rejected a tying challenge to a jukebox blanket
licensing provision by a bar that wanted to play only country and western music at a
reduced license price. The court found that determining which songs were included in
the smaller license and monitoring to ensure that the bar did not cheat would actually
cost more than providing the full blanket license.
14.7. Self-Distribution Alternative to

Vertical Integration; Risk-Sharing
A great many tying claims arise in the context of franchise and dealership networks
when the manufacturer forces a dealer or franchisee to take certain products for
resale. An automobile manufacturer may require dealers to sell slower moving lines.
A fast-food franchisee may require individual retailers to sell specific products supplied
by the franchisor. In these cases the independent dealership or franchise arrangement
is a substitute for the manufacturer’s own vertical integration into retailing. That is,
instead of selling its own vehicles through wholly owned dealerships the manufacturer
enters long-term arrangements with locally owned independent dealers. In these cases
the arrangement plus the tying requirement acts as a substitute for self-distribution.
Such arrangements also operate as a form of risk-sharing, converting the dealer from
an employee to an entrepreneur with a significant investment in the local business. Or
to say this somewhat differently, the contractual dealership arrangement plus the tie is
nothing more than a substitute for a single firm. That observation does not necessarily
end all legal inquiry, because the supplier may still be in a position to impose harmful
consequences on its dealers, just as a harsh employer can impose such consequences on
its employees. It very largely ends the antitrust inquiry, however, because it is difficult to
see how the franchise arrangement can be more harmful to competition than outright
ownership of retail outlets.
Variable proportion tying may benefit businesses or consumers who are uncertain of
the value of a particular good. Specifically, a consumer may worry that she will use the
tying product too infrequently to justify its purchase. If the consumer is risk averse, then
this risk may deter her from purchasing the tying product even if her expected surplus is
positive. By reducing the price of the tying product, tying helps to mitigate this risk by
increasing the surplus she receives in the event that her future demand for the tied prod-
uct is low. Economically speaking, the tie has the effect of reducing the purchaser’s fixed
cost investment (e.g., the durable and costly printer) and increasing variable costs (e.g.,
ink). By contrast, if her future demand turns out to be high, then she may achieve less
surplus under tying. Thus tying serves to reduce the “spread” between the consumer’s
possible surplus realizations. A risk-averse agent may prefer this trade-off.
We can illustrate this effect using figure 14.1. Suppose that a consumer is unsure
about her demand for a product such as a printer that uses ink cartridges. If she buys
the tying product and turns out to be a low-intensity user, then she could receive nega-
tive surplus under separate provision (because of the higher printer price) and posi-
tive surplus under tying. She could have garnered zero surplus by not buying anything,
and thus she regrets buying the tying product under separate provision, but not under
tying. If she turns out to be a high-intensity user, then she receives more surplus under
separate provision, but even her tying surplus is positive. That is, she does not regret
purchasing the tying product in either case. If the agent is risk averse, then avoiding
a regrettable situation is valuable in its own right, and so she may prefer tying even if
her expected surplus is higher under separate provision. This illustrates a way in which
variable proportion tying may improve consumer welfare that is independent of price
discrimination effects.
14.8. Tying in High-Technology

Markets; “Misuse”
Technology-rich markets are particularly prone to tying because networking and

interconnection are frequently major components in such markets. See Bohannan
and Hovenkamp (2012, ch. 2); Liebowitz, Stan, and Margolis (2007). As products
become more complex, quality control issues loom larger. Further, as products are
more specialized, aftermarket goods must be individually tailored as well. At the same
time, however, technology can provide opportunities for ties that are anticompeti-
tive because they limit competitor entry or expansion, or in some cases because they
restrain innovation.
The earliest tying cases in the federal courts were not antitrust challenges. Rather,
they were patent infringement cases brought by sellers in which the defendant
defended by arguing that the tying requirement was not enforceable under the Patent
Act because the tie was an improper attempt to expand the scope of the patent “monop-
oly.” The Supreme Court rejected this defense in the Henry case (1912), but fairly
consistently accepted it in the Motion Picture Patents (1917) and later decisions. The
antitrust law of tying actually evolved out of these patent “misuse” cases, where the
law was entirely judge-made with no clear statutory authorization. See Bohannan and
Hovenkamp (2012, ch. 10). The full-blown modern doctrine of patent misuse did not
emerge until the 1940s, principally in the Morton Salt case (1942). In that case patentee
Suppiger owned a patented machine that injected salt into canned foods. Its license
agreement required users of the machine to purchase their salt from Suppiger. When
Suppiger brought a patent infringement suit against Morton for selling an infringing
machine, Morton raised the tie as a defense. The Supreme Court held that Suppiger
lost the right to enforce its patent as long as it was tying, even though Morton was not
injured by the tie. This loss of enforcement right should persist, the Court held, until
the misuse was “purged”—that is, until Suppiger should stop assessing or enforcing
the tying requirement. The decision did not rest on any finding of market power or
exclusionary effects, but only on the proposition that the tying of unpatented staples
improperly extended the patent’s boundaries. The Fourth Circuit extended this rule to
copyrights in its Lasercomb decision (1990).
As the doctrine of misuse evolved it became narrower than antitrust liability in some
ways but broader in others. It is narrower in the very important sense that it oper-
ates almost exclusively as a defense to a patent or copyright infringement suit (e.g.,
Lasercomb, 1990).5 There is no affirmative cause of action for misuse, and thus no treble
damages or attorneys’ fees such as successful antitrust plaintiffs can recover. Misuse is
also broader, however, in that it has been held to reach substantively to practices that
would not be antitrust violations, does not have a market power requirement except in
the case of patent tying arrangements,6 and can provide the very draconian remedy of
making a misused patent unenforceable against everyone, including people who are not
harmed by the misuse.
The issue of misuse law’s substantive coverage has proven quite problematic, and
several decisions have tried to restrict its reach by limiting it to situations that would
actually violate the antitrust laws (e.g., USM).7 Other decisions have found that mis-
use reaches further, although the modern trend is to apply misuse doctrine restrictively
(e.g., Princo, 2010; see Bohannan and Hovenkamp 2011).
Misuse is entirely a creature of IP policy, not antitrust law. While intellectual prop-
erty law shares with antitrust a concern for maintaining competition, its principal con-
cerns are with innovation and protection of the public domain, or the realm of ideas and
expressions that are not covered by IP laws and for which access by future innovators is
so essential. As a result, a good case can be made that the substantive coverage of misuse
law should include antitrust violations but also unreasonable restraints on innovation
or denials of access to the public domain that antitrust law does not reach. However, the
ordinary remedy should be limited to an injunction against the misuse. See Bohannan
and Hovenkamp (2012, ch. 10).
5 One exception to the rule that misuse is asserted as a defense to an IP infringement claim is Brulotte
(1964), where the patentee brought a state court breach-o- contract action when the purchaser stopped
paying royalties on use of a machine after its patents expired; the Supreme Court permitted a misuse
defense.
6 Since 1988 the Patent Act has provided that a patent tie cannot be misuse unless the patentee has
market power in the tying product. 35 U.S.C. §271(d)(5).

7 But see Assessment Techs., 2003 (Judge Posner, suggesting that copyright misuse might reach beyond
antitrust).
14.9. Remedies, Mainly Damages
Both the government and private plaintiffs are entitled to obtain an injunction against
a tie that has been found unlawful. The more interesting question concerns antitrust
treble damages, which are required by Section 4 of the Clayton Act to be based on the
injury that the plaintiff sustained. Some tying plaintiffs are rivals in the tied product
market who have been foreclosed by the tie. This was true, for example, in the Jefferson
Parish case. In those cases damages for successful plaintiffs are based on lost profits
or loss of business value, as in most antitrust cases with competitor plaintiffs (e.g.,
Moore, 1982).
When the plaintiffs are consumers the damages inquiry is particularly complicated
by the fact that many consumer ties are brought as class actions, and the analysis above
makes clear that a tying arrangement can affect consumers in very different ways. For
example, some purchasers of a variable proportion tie in the franchise or aftermarket
product setting may be injured by the tie while others are benefited.
Historically consumer damages for tying were based on overcharges on the tied
product alone (e.g., Siegel, 1971).8 That number is clearly excessive, because ties almost
always involve an increase in the tied product price accompanied by a reduction in
the tying product price, sometimes all the way to zero. As figure 14.1 illustrates, lower
intensity customers in such cases are benefited from the tie, sometimes a very great
deal. As a result several courts have adopted an alternative suggested in Areeda and
Hovenkamp (2007, ¶340c) that damages be based on the net overcharge (e.g., Kypta,
1982). For example, if tying results in a $3 price cut in the tying product and a $5 price
increase in the volume of tied product that is purchased, the correct measure of dam-
ages should be $2, not $5.
Tying may increase a buyer’s surplus, however, even if the cost of her original bundle
(the bundle she purchases under separate provision) increases. We can see this in figure
14.2, which shows the effect of a tie that increases the tied product’s price from P to P + a.
The quantities Q(P) and Q(P + a) denote the agent’s demand for tied units under sep-
arate provision and tying, respectively. Assuming tying reduces the price of the tying
product by some amount b > 0, tying increases the cost of the agent’s original bundle by
A + B + C − b (this will be negative for some consumers). However, the agent’s surplus
falls by only A + B − b, because region C was not achieved as surplus under separate
provision. This implies that the agent’s surplus falls by less than the increase in the cost of
her original bundle. For example, if the cost of the agent’s optimal bundle is unchanged
by tying, then she receives more surplus under tying. Similarly, it is possible that the cost
of her original bundle increases slightly, and yet she achieves more surplus under tying.
As such, the change in the cost of an agent’s original bundle is not a strong indication of
8 The court directed, however, that an offset should be provided for the cost of a reasonable franchise
fee.
Marginal
Utility
P+a
C
A
B
P
Q(P+a) Q(P) Q
FIGURE 14.2 Relation Between Bundled Price and Consumer Harm
how her surplus is affected by tying. Damages measured by the net overcharge on the
tying and tied product are therefore likely to be excessive as well.
The plaintiff who claims that it was injured, not by an overcharge, but rather by the
requirement that it purchase a product that it did not want at all, has not suffered anti-
trust harm. Although such a buyer’s welfare may be lower, that injury does not result
from a reduction of competition unless an alternative product was actually foreclosed
from the market.
14.10. Conclusion
In the vast majority of cases tying arrangements increase welfare, whether measured
under a general welfare or a consumer welfare test. Competitive harm is a threat in
a very few situations involving actual market foreclosure or the use of ties to enable
dominant firms to retain their market position as one technology rolls into the
next. As a result, the so-called per se rule for tying is wrongheaded, and ties should
be addressed under the rule of reason, with fairly substantial proof requirements on
challengers.
References
Areeda, Phillip E., and Herbert Hovenkamp. 2007. Antitrust Law. New York: Aspen Publishers.
Areeda, Phillip E., and Herbert Hovenkamp. 2011. Antitrust Law. 4th ed. New York: Aspen
Publishers.
Blair, Roger D., and Francine Lafontaine. 2005. The Economics of Franchising.
Bohannan, Christina, and Herbert Hovenkamp. 2011. Concerted Refusals to License Intellectual
Property Rights. Harvard Business Law Review Online 1:21–24. Available at http://papers.
ssrn.com/sol3/papers.cfm?abstract_id=1710531.
Bohannan, Christina, and Herbert Hovenkamp. 2012. Creation without Restraint: Promoting
Liberty and Rivalry in Innovation. New York: Oxford University Press.
Bork, Robert H. 1978. The Antitrust Paradox: A Policy at War with Itself. New York: Basic Books.
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Evidence. Cambridge, MA: MIT Press.
Hovenkamp, Erik, and Herbert Hovenkamp. 2008. Exclusionary Bundled Discounts and the
Antitrust Modernization Commission. Antitrust Bulletin 53:517–53.
Hovenkamp, Erik, and Herbert Hovenkamp. 2009. Complex Bundled Discounts and Antitrust
Policy. Buffalo Law Review 57:1227–66.
Hovenkamp, Herbert. 2010. Harvard, Chicago and Transaction Cost Economics in Antitrust
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Hovenkamp, Herbert. 2011. Federal Antitrust Policy: The Law of Competition and Its Practices.
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80:837–59.
Cases
Assessment Techs., LLC v. WIREdata, Inc., 350 F.3d 640, 647 (7th Cir. 2003).
Automatic Radio Mfg. Co. v. Hazeltine Research, Inc., 339 U.S. 827 (1950).
Berkey Photo, Inc. v. Eastman Kodak Co., 603 F.2d 263 (2d Cir. 1979).
Brantley v. NBC Universal, Inc., 675 F.3d 1192 (9th Cir. 2012).
Broadcast Music, Inc. v. Moor-Law, Inc., 527 F.Supp. 758 (D.Del. 1981), aff ’d mem., 691 F.2d 490
(3d Cir. 1982).
Brulotte v. Thys Co., 379 U.S. 29 (1964).
Carbice Corp. v. Am. Patents Dev. Corp., 283 U.S. 27, 27–30 (1931).
Collins v. International Dairy Queen, Inc., 980 F. Supp. 1252 (M.D. Ga. 1997); 59 F.Supp.2d 1312
(M.D.Ga. 1999).
Eastman Kodak Co. v. Image Technical Servs., 504 U.S. 451, 460–62 (1992).
Hack v. President and Fellows of Yale College, 237 F.3d 81 (2d Cir. 2000), cert. denied, 534 U.S.
588 (2001).
Henry v. A.B.Dick Co., 224 U.S. 1 (1912).
Illinois Tool Works, Inc. v. Independent Ink, Inc., 547 U.S. 28, 42 (2006).
International Salt Co. v. United States, 332 U.S. 392 (1947).
Jack Walters & Sons Corp. v. Morton Bldg., Inc., 737 F.2d 698, 703 (7th Cir.1984).
Jefferson Parish Hosp. Dist. No. 2 v. Hyde, 466 U.S. 2, 19 (1984).
Kypta v. McDonald’s Corp., 671 F.2d 1282, 1285 (11th Cir.), cert. denied, 459 U.S. 857 (1982).
Lasercomb Am., Inc. v. Reynolds, 911 F.2d 970, 973 (4th Cir. 1990).
Moore v. James H. Matthews, Inc., 682 F.2d 830, 836–37 (9th Cir.1982).
Morton Salt Co. v. G.S. Suppiger Co., 314 U.S. 488, 62 S.Ct. 402 (1942).
Motion Picture Patents Co. v. Universal Film Mfg. Co., 243 U.S. 502 (1917).
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CHAPTER 15
V E RT IC A L R E S T R A I N T S AC R O S S
J U R I SD IC T ION S
EDWARD M. IACOBUCCI AND RALPH A. WINTER
15.1. Introduction
In a very simple economy, sellers would set prices and buyers would chooses quantities.
A manufacturer would sell to any distributor or retailer wanting to purchase its product.
No restrictions would be placed on distributor pricing, territories, the other products
that could be offered by distributors, or on customers to whom the distributor could sell.
The entire property rights to a product would be transferred with the exchange of units
of a product and it would be up to the distributor of the product to decide on how and
where to resell the product.
In reality, contracts struck by firms along a supply chain, from the providers of raw
materials down to retailers selling to consumers, are more complex. Prices remain
the principal means by which incentives are aligned along a supply chain, but we also
observe more complex contract terms. The following types of payment terms are among
those adopted in real-world contracts:
• General nonlinear pricing schedules, including quantity discounts, block pricing,

two-part pricing, minimum quantity contracts, and take-or-pay contracts
• Royalty contracts, in which payment depends on quantity of a product resold by
a downstream retailer, not the quantity purchased by the retailer
• Loyalty contracts, in which (in one form) the buyer’s payment for an input
depends on the proportion of the buyer’s needs that are met by the input
352 Edward M. Iacobucci and Ralph A. Winter
• Slotting allowances, which are a fixed payment by a manufacturer for the right
to be represented in a retail outlet and which may include the rights to a specified
amount of shelf space or floor space
• Buyback options under which the retailer can return unsold inventory
• Consignment selling arrangements
We also see contracts that impose restraints on buyers’ actions:
• Price floors or ceilings imposed on retailers of a product (resale price maintenance)

• Territorial restrictions on where a dealer may sell, where a dealer may actively sell,
or where a dealer may locate. Territorial restrictions may also be placed on the
upstream firm, such as a franchisor, in the location of future outlets
• Exclusivity clauses, either constraining the downstream buyer not to purchase
from other suppliers or constraining the supplier not to deal with other outlets
• Tying restrictions, either in the form of bundling products for which separate
markets could be or are established, or requirements tying, which stipulates that
the buyer must purchase all of its requirements of an input B from the seller if the
buyer is to purchase input A from the seller
In this chapter, we offer an overview of the law and economics of the most impor-
tant restraints—resale price maintenance, territorial restrictions, exclusivity clauses,
and tying—within a unified framework. Our approach is applicable more broadly to the
entire range of contracts.
Vertical restraints are subject to considerably divergent antitrust policy across juris-
dictions. Differences in antitrust policy toward vertical restraints have become even
sharper recently, especially between the United States and the EU. These differences
reflect in some measure a variation in the influence of economics on antitrust law. The
US policy towards vertical restraints is now among the most liberal among developed
nations, largely through the influence of the “Chicago school” of antitrust economics.
Chicago scholars have emphasized that vertical restraints imposed by a manufacturer
on prices, sales territories, and exclusivity and other decisions can often be explained
as means of efficiently responding to the failure of simple price contracts alone to coor-
dinate decisions along a supply chain. In other situations, vertical restraints, including
restraints on final buyers, are means of price discrimination. Neither case yields a pre-
sumption of benefits from antitrust restrictions on the set of vertical contractual strate-
gies available to a firm. Anticompetitive incentives cannot simply be assumed to explain
vertical restraints even where, as is typical, these contracts suppress competition among
dealers or distributors of a product or products sold by a manufacturer.
While US antitrust policy towards vertical restraints has been influenced most by
economic thinking, it would be a mistake to regard economists as having one voice
in this area. Some economists emphasize the efficiency theories of vertical restraints,
others the possibility that vertical restraints can dampen price competition or deter
entry. Even among US policymakers there is a divergence in views. In September
Vertical Restraints across Jurisdictions 353
2008, the US Department of Justice released a 200-page report on single-firm con-

duct (U.S. Department of Justice 2008), largely dealing with vertical restraints. Three
of the four sitting commissioners at the Federal Trade Commission objected to the
report on the grounds that it offered insufficient protection to consumers against
abuse of market dominance.1 President Obama’s new antitrust appointee then with-
drew the report.
Our focus in analyzing competition policy towards vertical restraints is on US and
European law, not just because these are the two most important jurisdictions in the
size of economic activity affected but because the differences in the law between the two
areas provide us with points of strongest contrast for analyzing the law against the foun-
dation of the underlying economics.
In the next section of this chapter we provide a synthesis of the economic theories of
vertical restraints, both efficiency theories and anticompetitive theories, and the types
of evidence that have been brought to support the theories. Section 3 outlines the law
on vertical restraints in the United States and the EU. In section 4 we discuss the gaps
between the legal restrictions on vertical restraints and economics foundations underly-
ing optimal policy.
15.2. The Economics of Vertical

Restraints
As an empirical matter, vertical restraints are common, and arise in many settings
where concerns about market power are minimal. Evidence on the frequency of vertical
restraints is available primarily for resale price maintenance, the most popular restraint
during the times when it has been legal. Vertical price floors have been imposed on
retailers of a wide cross-section of products: clothing, skis, and other sports equipment,
watches, jewelry, luxury goods of all kinds, candy, beer, bread, floor wax, furniture pol-
ish, milk, toilet paper, cereal, canned soup, books, shoes, mattresses, large appliances,
and automobiles, to name a few (Overstreet 1983; Ippolito 1988; Ippolito and Overstreet
1996). Products in virtually every category have been subject to resale price maintenance
at one time or another, and estimates of the proportion of retail sales that have been sub-
ject to resale price maintenance range as high as 25% in the UK and 4% to 10% in the
United States (Scherer and Ross 1990, 549). In Canada, before the law prohibiting resale
price maintenance was enacted in 1951, an estimated 20% of goods sold through grocery
stores and 60% sold through drugstores were “fair-traded” (Overstreet 1983, 153, 155).
1
Three of the four sitting Federal Trade commissioners called the report a “blueprint for radically
weakened enforcement of section 2 of the Sherman Act” (FTC Press Release, September 8, 2008).
Originally the report had been planned as a joint publication, and historically the Department of Justice
and FTC have worked closely together in developing guidelines.
Information is also available on the extent of exclusivity. Of retail sales through inde-
pendent retailers, more than one-third were found to be subject to some form of exclu-
sive dealing in a recent study (Lafontaine and Slade 2005, citing a US Department of
Commerce Study from 1988). Some exclusivity restraints are clearly efficient and would
attract no attention from antitrust law. A McDonalds franchisee must sell exclusively
McDonalds’ hamburgers as opposed to Wendy’s or Burger King’s products. Any luxury
jewelry retailer is restrained against placing cheap watches for sale in its store. Finally,
tying, defined broadly, is ubiquitous. Shoelaces are sold with shoes. Gloves and shows
are sold in pairs. Cars are sold with tires. Tying presents potential anticompetitive con-
cerns in only a very small percentage of cases where it is observed.
The task for competition policy in this area is to distinguish anticompetitive uses of
vertical restraints from efficient or benign uses of vertical restraints. We offer below a
general perspective on the economics of vertical restraints, then turn to specific theories
of why the restraints are adopted.
15.2.1. General Perspective on the Economics of

Vertical Restraints
The traditional theory of vertical restraints, or what could be termed the pre-economics
theory, is that vertical restraints are imposed on downstream firms by a manufacturer
with market power.2 Contractual restraints are not a reflection of joint wealth maximi-
zation under this theory and are instead explained by the power of the party to impose
the restrictions on innocent downstream distributors.3
From an economist’s perspective, the traditional view is wrong. Aside from price dis-
crimination motives, any contract is struck to align the incentives of individual parties
to the contract with the collective interest of the parties to the contract. Under simple
assumptions (symmetric information and transferable wealth), a contract must maxi-
mize the sum of wealth or expected wealth of the contract parties: if another contract
were available with greater total profit, the parties could move to the new contract
and share the gain in profits. A vertical restraint is not imposed in order to achieve an
increase in profits for one party to the contract at the expense of the other party and total
2 See the discussion of the market power requirement in Jefferson Parish Hospital District No. 2
v. Hyde, 466 U.S. 2 (1984), for example.

3 The traditional, or pre-economic, view of vertical restraints is that the restraints are often imposed
by manufacturers on retailers against the retailers’ interest. An expert witness in a Canadian antitrust
case articulated the traditional view very clearly: “The dangers from contracting arise when one side
of the market has the power to impose contract terms on the other. . . . If one contracting party is a
monopolist . . . it can preserve its market power by insisting that its customers (or suppliers) sign
long-term contracts,” and “buyers gain nothing from the . . . provisions in the contract [at issue in
the case]. Hence, the very fact that nearly all buyers sign such contracts is evidence that Laidlaw has
and exercises market power” (Government Expert Report in Director of Investigation and Research
v. Laidlaw Waste Systems Ltd. ((1992), 20 C.P.R. (3d) 289 (Comp. Trib.), paras. 21 and 42).
profits. Rather, it must maximize the combined profit of the contracting parties. In other
words, contracts must be Pareto efficient across the contracting parties.
This does not mean that all contracts are socially efficient. Information may not be
symmetric, and wealth transfers may not be possible. Moreover, parties outside the con-
tract may be harmed. An agreement to establish a cartel or to adopt vertical restraints to
facilitate cartel pricing, for example, is Pareto improving for the members of the agree-
ment but not for consumers, who are outside the agreement. A firm that signs exclusive
contracts with all upstream suppliers of an essential input can monopolize a market to
the detriment of downstream buyers. Inefficiencies, including anticompetitive effects,
are the result of externalities on parties outside the contract.
An assessment of the competitive impact of any vertical restraints contract must be
based on the application of economic theory to the specific facts of the case at hand.
As Cooper and coauthors (2005a, 2005b) have emphasized, however, decisions in a
case must also be informed by one’s prior probability that a restraint is likely to be anti-
competitive, this prior being based on evidence and general principles regarding the
impact of vertical restraints. The single most important economic principle underly-
ing contracts, general agreements, and mergers in competition policy is the following.
Agreements between producers of substitute products (competitors) tend to be det-
rimental to social welfare; contracts between producers of complementary products
tend to be welfare-enhancing. O’Brien (2008) refers to this proposition, dating back to
Cournot ([1838 [1971), as “the fundamental theorem of antitrust.”4 The core example of
an agreement between substitutes is a cartel agreement to raise prices. The most impor-
tant example of complementary products is inputs in the same supply chain. Thus, at
a broad level, economists’ prior is that agreements among suppliers of complementary
inputs or products are efficient. A merger between producers of complementary prod-
ucts, each with market power, results in lower prices, because the positive externality
that each firm had imposed on the other in any decision to lower price is internalized.
Buyers, who are parties outside the merger, benefit from the lower price. Given that there
are complementarities between suppliers at different stages of the distribution chain,
contracts incorporating vertical restraints we can think of a partial merger or coordina-
tion of actions, and the same principle should apply. Thus, a purely vertical agreement
on prices, for example, lowers prices by eliminating the double-marginalization effect
that Spengler (1950) discussed.5
Efficiencies arise from agreements among firms with complementary assets for a set
of reasons beyond those identified by Cournot or Spengler. Vertical agreements allow
4 O’Brien expresses the proposition as “Combining substitutes is bad, and combining complements is
good, unless demonstrated otherwise” (emphasis in the original). William Baxter, the former assistant
attorney general in charge of antitrust enforcement in the United States was a strong proponent of this
principle.
5 If an upstream firm has market power, it will sell at a markup to a downstream firm; if the
downstream firm has market power, it too will sell at a markup to buyers. This “double marginalization”
results in higher prices, and greater distortions, than would be the case if there were only a single firm in
the vertical distribution chain.
closer coordination of investment and production plans, alignment of incentives, and

so on. When a pure monopolist seeks to extend a monopoly market structure into other
market levels, such an expansion is generally procompetitive, because there is typically
no reason for a monopolist to expand into an upstream or downstream market unless
it is more efficient than competitors. In summary, the economists’ prior—although one
that has exceptions and can therefore be defeated by evidence in a case—is that agree-
ments among firms operating in a supply chain are not anticompetitive.
The exceptions to the principle that vertical restraints are likely to be benign arise
where these restraints have horizontal impacts. Consider the following example.
A dominant firm in a market faces a new threat of entry. Either product must be distrib-
uted through a limited set of distributors (e.g., prominent retailers in a city). In response
to the new threat of entry the incumbent firm offers the main distributors a payment not
to accept the entrant’s product, that is, to sell the dominant firm’s product exclusively.
The firm can share some of its profits earned from its dominant position with the limited
number of distribution outlets in order to sustain the position. The set of exclusive con-
tracts profitably excludes the entrant. The contracts are all vertical, between producers
of complementary products, yet the impact is anticompetitive.
The example motivates the following more specific principle for guiding competition
policy in this area. The principle follows from the basic theorem of antitrust, which we
suggest fits the mainstream economic thinking: Antitrust scrutiny of vertical restraints
should be limited to a focus on adverse effects on competition across supply chains. A firm
should have the right to extract as much surplus as it can from its own supply chain, in
the absence of horizontal effects across supply chains. In the absence of strategies that
diminish competition, a manufacturer’s market power is determined by the extent to
which its good is superior to other products, and the profit earned from this level of
market power encourages innovation and development of new products.
We do not assume in stating this generally accepted normative principle that each
and every vertical restraint with a role of coordinating incentives along a supply chain,
or with a role of extracting surplus from downstream firms, necessarily raises total sur-
plus. Vertical restraints can be used to adjust the mix of price and nonprice competi-
tion (competition in the dimensions of service quality, promotion, sales effort, and so
on), as we shall discuss. It is entirely possible, as a matter of economic theory, that the
use of vertical restraints to raise service quality or retail promotion at the expense of
higher prices, for example, results in lower consumer surplus and total surplus in a mar-
ket. The argument for laissez-faire is not based on an assertion that market allocations
are always optimal. It is based on the recognition that it is impossible or impractical to
identify empirically the full set of circumstances under which a decision by a firm to
increase quality or promotion reduces total surplus. We do not as a matter of public pol-
icy constrain firms’ mix of promotion and advertising decisions when these decisions
are implemented directly; nor should we when the mix of price and nonprice decisions
is implemented via vertical restraints.
This is an extension of a principle applied to price discrimination that is generally
accepted by policy economists: price discrimination in and of itself is not a basis for
intervention. Economic theory does not provide a workable guide to determine when
price discrimination does or does not harm total welfare. Firms’ strategies for surplus
extraction can be placed along a spectrum from uniform pricing (no discrimination at
all) at one end to perfect price discrimination at the other end. Firms in reality attempt
to find strategies to move along the spectrum. We know that on average total surplus
increases along this spectrum, since under perfect price discrimination total surplus
is maximized. Examples tell us that the increase in total surplus along this spectrum
is not necessarily monotonic—and therefore it is possible that a particular strategy
decreases welfare. But theory offers us little practical guidance as to when this might
be the case. Similarly, contracts more complex than uniform pricing are intended, for
a profit-maximizing firm in the absence of horizontal anticompetitive effects on prices
or exclusion, to either increase total surplus along the supply chain, including final
consumers, or to increase the share of the surplus captured by the firm. The former is
directly welfare increasing; the latter tends to be surplus increasing “on average.” This
simple perspective is not enough to prove that vertical restraints are efficient, but it does
present us with a prior expectation in approaching any case. In the absence of clear evi-
dence, contracts cannot be assumed to decrease welfare.
In summary, economics supports a laissez-faire policy towards vertical restraints
unless there is evidence that the restraint is supporting horizontal anticompetitive
effects in the form of higher prices between manufacturers or an exclusionary effect in
the case of a dominant firm. The suppression of price competition may be at the retail
level in the case of a vertical restraint with the sole purpose of supporting cartel pricing
among retailers, to the detriment of the upstream manufacturer.
An immediate implication of the principle is the rejection of two common approaches
to thinking about vertical restraints policy. First, it is common to suggest a policy that
attempts to assess a vertical restraint on the basis of a trade-off between negative effects
on intrabrand competition and positive effects on interbrand competition is misguided.
Consider the adoption of vertical restraints by a pure monopolist, facing no competitors
or even the threat of competitors. A monopolist benefits from greater price competi-
tion and lower prices at the retail level, all else equal, because lower prices mean greater
demand if demand curves are downward sloping. The observation that a monopolist is
adopting vertical restraints therefore means that the vertical restraint must be increas-
ing some nonprice retail activity that enhances demand, helps the monopolist extract
surplus, or simply encourages outlets to carry the monopolist’s product. Retailers
engage in many demand-enhancing activities, as we discuss below. The observation of a
vertical restraint on competition means that the nonprice benefits to the monopolist of
greater nonprice activity more than offset any negative impact on profits of higher prices
on demand.
No basis exists for presuming that the benefits to consumers of the encouraged activ-
ity do not offset any detrimental impact of higher prices. The vertical restraint should
therefore be allowed in the case of a pure monopolist. Yet the approach of balancing
increases in intrabrand competition against a decrease in interbrand competition would
lead to the conclusion that the restraint should be prohibited in this case: there is no
interbrand competition to promote, so the test of balancing of the positive impact of

restraints in promoting interbrand competition against the decrease in intrabrand com-
petition would suggest prohibiting the restraint. This is a conclusion without an eco-
nomic basis. For this reason, we would reject the approach of the EU Guidelines on
Vertical Restraints, which describe the reduction of intrabrand competition as a gener-
ally harmful competitive effect that may result from vertical restraints.6 This approach
leads the Guidelines astray in a number of specific respects, perhaps most prominently
in restricting resale price maintenance (RPM) because the direct impact of the practice
is to raise price. This may be an impact of RPM in a particular case, but this says nothing
about the effect of RPM on horizontal competition.
The EU Guidelines’ principle that a reduction in intrabrand competition is harmful
appears to be based on the idea that, other things held constant, an increase in price
reduces welfare. This idea itself is well founded. The application of it is not. When a pure
monopolist adopts a price floor, for example, other things are not held constant. If price
were the only demand-influencing variable affected by the restraint, then profits would
fall with the use of the vertical restraint. The monopolist would not adopt the restraint.
A second approach to thinking about vertical restraints policy can also be rejected
at this point, even before we have discussed specific theories of vertical restraints. The
approach reflected in the European Guidelines, and commonly argued even among
economists, is that the key piece of evidence in understanding whether a vertical
restraint is efficient or anticompetitive is the degree of market power of the manufac-
turer. In a market with a competitive structure upstream and downstream, it is (cor-
rectly) argued that vertical restraints are presumptively procompetitive. But sometimes
policymakers go a step further in arguing that a competitive structure is not only suf-
ficient for a presumption of benign or procompetitive use of restraints, it is necessary as
well. In other words, the use of restraints by a dominant firm should be presumptively
anticompetitive, or at a minimum the firm should have the burden of proof of in demon-
strating a procompetitive role for a restraint. The case of a pure, unthreatened monop-
olist shows this to be wrong; there is no presumption that the monopolist’s choice of
vertical restraints to enhance a nonprice activity at the cost of higher prices is against
the social interest. (Policy generally does not restrict a firm from raising its prices and
spending the additional revenue per unit on product promotion; nor should it regu-
late the same trade-off when the trade-off is implemented indirectly through restraints.)
The extent to which vertical restraints (or business practices in general) should attract
antitrust scrutiny is nonmonotonic as a function of the market power of the firm adopt-
ing the practices. With a competitive market structure, restraints are presumptively
efficient, and at the other extreme the use of vertical restraints by a pure, unthreatened
monopolist cannot be presumed anticompetitive. Only when market concentration is
high but not at the monopoly level can there be a significant chance a vertical restraint
will have potentially anticompetitive consequences.
6
European Commission, Guidelines on Vertical Restraints, 2010/C 103/01 at para. 100.
Against the general background offered above, we turn next to analyzing the incen-
tives for vertical restraint by a single firm.
15.2.2. Efficiency Theories: The Incentive for Vertical Restraints

on the Part of a Single Firm, Including Price Restraints
Our overview of the economic theories of vertical restraints starts with a simple obser-
vation. Retailers do more than post prices. Retailers offer convenience, specifically a low
time-cost of purchasing by providing staff, well-organized inventory, clear information,
and even short cashier lines. Retailers invest in enthusiastic staff and sales effort in provid-
ing accurate and complete point-of-sale information. Retailers choose the level of postsales
service of items that may need repair as well as the return policies, not just the specific writ-
ten return policies but the general sense of either willingness or reluctance that they exhibit
in accepting returns. Retail activity is multidimensional, with prices being only one compo-
nent of the set of decisions. Consumers purchasing a specific product end up with the same
physical product wherever they shop, but the surplus gained from purchasing depends
upon their entire retail purchase experience. This is especially true for luxury or fashion
items where the consumer value is particularly sensitive to product image. Expensive per-
fume purchased from Walmart or Carrefour is simply not the same product as an identi-
cal bottle of chemicals purchased from a luxurious perfume counter in an upmarket outlet
with classical music playing in the background. Retailers add value to the final product pur-
chased by consumers, whether by saving consumers’ time on the purchase of a routine item
or by investing in enhancement of their customers’ shopping experience.
We add another observation. The additional dimensions of retailer input, beyond
price, are costly or even impossible to monitor in a contractual relationship with a man-
ufacturer. The enthusiasm with which a retailer sells a pair of skis, the effort that the
retailer puts into learning the intricacies of new electronic products, the expense that
a retailer puts into maintaining well-organized inventory and displays, and the gen-
eral investment that the retailer undertakes in improving the purchasing experience
cannot be contractually specified—at least not precisely. The manufacturer’s contract
with a retailer cannot dictate that the retailer express a level of enthusiasm of 8.43 on
a scale of 10. Instead, retailers undertake their decisions with incentives provided by
two sources: the contracts with manufacturers on dimensions that can be specified, and
competition with other retailers.
The efficiency theory of vertical restraints rests on two propositions. First, a simple
price contract may leave retailers with inadequate incentives to provide sales effort in
its various dimensions. Second, contracts with vertical restraints can restore or at least
enhance these incentives.
We begin by developing the first proposition, that is, explaining why the price system
alone may fail to coordinate incentives along a supply chain by leaving retailers with
inadequate incentives to exert the level of sales effort that would be specified in a hypo-
thetical, ideal, complete contract that restricted all of the actions of the retailers. This
is the issue of market failure in the Williamsonian (1975) sense. The failure of the price
system to coordinate incentives, that is, to maximize the combined wealth of firms along
the supply chain, opens up the potential for more complex contracts.
We restrict the discussion for the moment to one dimension of sales effort, that
is, demand-enhancing activity, and measure investment in this activity in dollars.7
Consider a manufacturer selling through a set of retailers that, for simplicity, adopt the
same price and effort decisions in a symmetric retail equilibrium whatever the whole-
sale price set by the manufacturer. We denote the price and sales effort by p and e, respec-
tively, and the wholesale price by w. The demand in the market, at a symmetric retail
market equilibrium is denoted by Q(p, e). Finally, we denote the elasticity of demand
with respect to price by εp and the demand elasticity with respect to sales effort by εe.
The price and sales effort that would be set in an ideal, complete contract are at the
levels, denoted by (p*, e*), that would maximize the combined profit of all parties to the
contract, that is, the manufacturer and the retailers.8 In the setting in which a manu-
facturer has a fixed fee to collect profits from retailers, the wholesale price is freed from
its role in collecting profits and is available to use as an instrument to elicit optimal
decisions on the part of retailers, as in Mathewson and Winter (1984). The question is
whether the single instrument, w, is enough to elicit the decisions (p*, e*). That is, as
w is raised from marginal cost to the level w* that elicits p*, will the retailers offer the
optimal sales effort, e*, or some effort level below or above e*? And if the optimum is
not achieved, that is, there is a Williamsonian market failure, what are the sources of
this market failure? As w is raised, p goes up, but (under normal assumptions) the retail
margin, (p − w) will fall. The retail margin represents the marginal benefit that a retailer
obtains from attracting one more unit of demand through sales effort, so the incentive
to provide effort drops as w is raised.
In addressing the market failure question, a very useful result is the Dorfman-Steiner
theorem (Dorfman and Steiner 1954). Dorfman and Steiner considered a firm, facing
demand Q(p, e) that depends on price and sales effort (effort being advertising or prod-
uct quality, in their discussion). They showed that the firm will optimally devote a pro-
portion of revenue to sales effort that is given by the ratio of the two elasticities of demand:

(Dorfman-Steiner ) e / pQ = ε e / ε p

(15.1)
7
The discussion in this section is based on Mathewson and Winter (1984) and Winter (1993).
8
In stating that a wholesale contract will maximize combined profits of the parties to the contract,
we are assuming that the manufacturer has the ability to set a fixed fee in contracts with retailers. More
generally, even if a simple fixed fee is impossible (e.g., because of limited wealth on the part of retail
agents), manufacturers benefit from profits at the retail level in a number of ways. Higher retail profits
encourage more outlets to carry a product, to the manufacturer’s benefit, and also provide incentives to
encourage higher retail quality if this quality is being monitored by the manufacturer (Klein and Murphy
1988). The assumption that a wholesale contract maximizes the combined profit of the contract parties is
surely a reasonable approximation.
In our context, the theorem describes the efficient (collective profit-maximizing) effort
decision as determined in the hypothetical complete contract. But we can also use (15.1)
to characterize the choice of effort and price by a single retailer, within a simple wholesale
price contract, in exactly the same way—substituting the retailer’s elasticities for the mar-
ket elasticities in the right-hand side of (15.1). Thus the market-failure question reduces to
the following: why would the ratio of advertising to price elasticity differ for an individual
retailer than for the market as a whole?9 The right-hand side of (15.1) is equal to the mar-
ginal rate of substitution between effort and price for the firm making the decision; the
market failure question is, then, why the marginal rate of substitution between prices and
sales effort differs between an individual retailer and the market as a whole.
Our second proposition is that vertical restraint contracts can resolve the market fail-
ure or incentive distortions in retailers’ decisions on prices and other demand-enhancing
activities. This proposition can also be posed within the Dorfman-Steiner framework
before we proceed to addressing the questions. When the ratio εe / εp is smaller for the
individual retailer than it is for the market as a whole (evaluated at the first-best p and e),
then retailers are “biased” at the margin towards prices that are too low and effort levels
that are too low. Retailers rely excessively (from the perspective of private efficiency) on
attracting customers through low prices rather than high sales effort. In this case, to start
with the most important vertical restraint, two different roles for vertical price floors
arise. If the manufacturer maintains a price floor at p* and lowers the wholesale price
w, it is increasing the incentive to provide effort (since the marginal benefit of attract-
ing demand, the retail margin, is expanding). It can do so until e* is achieved. The price
floor influences directly the incentives to exert sales effort under this mechanism. A sec-
ond role for price floors arises when the manufacturer can implicitly contract for effort
(e.g., maintaining a sufficiently high level of freshness of the product, or adequate ser-
vicing) but only at the cost of periodic monitoring of the level of effort. A price floor can
act to protect retail profits against erosion from intensive price competition. Under this
indirect mechanism, incentives for providing effort are improved because a retailer has
more to lose in the event that it is caught shirking on effort (Klein and Murphy 1988).10
9 In a simple model of a symmetric retailer duopoly downstream, one can show that the individual
firm elasticity of demand is equal to the sum of the market elasticity of demand and the cross-elasticity of
demand. One can therefore pose the question as the following: why would the ratio of cross-elasticities
between retailers differ from the ratio of own-elasticities?
10 Both the direct and the indirect mechanism work in the same direction: increasing sales effort at
the expense of higher prices. If we extend the setting to one in which effort takes on multiple important
dimensions, the single instrument of a price floor will not achieve first-best profits (unless the key
elasticity ratio condition holds for all effort dimensions simultaneously). If one effort dimension is
perfectly substitutable for price, in buyer preferences, then the price floor may be limited in its usefulness
altogether. For example, when American Airlines tried to constrain travel agents against undercutting
their price schedule, agents simply offered exceptionally low prices on hotel and car rental packages with
the tickets (see discussion by Judge Frank Easterbrook in Illinois Corporate Travel v. American Airlines
Inc. (CCH Trade Regulation Reports, P. 61,921)). Both the direct and indirect mechanisms break down
when an increase in a noncontractable dimension of effort is a perfect substitute for a lower prices. There
is also the question of whether price floors, as opposed to some other reward, are necessary to protect
downstream incentives to provide effort.
The economic explanation of why a manufacturer would benefit from imposing

resale price maintenance in the form of a vertical price floor thus reduces to asking why
retailer demand is relatively more sensitive to price, relative to sales effort, than market
demand as a whole. We express this condition for the profitability of resale price main-
tenance below:
ε e / ε p ( for retailer ) < ε e / ε p ( for market ) (15.2)

We can now return to the question of why retailer incentives deviate from market incen-
tives, and apply the framework to explaining observed contracts. We offer within the
framework five theories of the incentive for resale price maintenance, although many
other theories are available. The first is a correlation argument. Suppose that consumers
most willing to shop among retail outlets for their preferred combination of price and
sales effort are also those consumers for whom price matters relatively more than sales
effort. This is a natural assumption because sales effort often reduces the time cost of
purchasing; consumers end up with the same physical product wherever they purchase
but at lower time cost when greater sales effort takes the form of shorter cashier lines
and more highly trained sales staff and so on. Consumers willing to travel to shop at
different stores are those with low costs of time, and these consumers are also willing
to tolerate long cashier lines in favor of lower prices. This structure yields individual
retailer demand that is relatively price elastic, with the inequality (15.2) being met. In
other words, the consumers whom a retailer attracts away from other retailers are rela-
tively more influenced by low prices than by high sales effort. Retailers set their sale
strategy to attract consumers not just into the market, but also away from other retailers.
Attracting consumers away from other retails involves setting low prices, since this is
what attracts shoppers, but is a pure waste from the prospective of total market demand.
The demand attracted away from other retailers does not increase demand for the prod-
uct at all. Retailers are therefore biased in their strategies towards low prices and inad-
equate service. Resale price maintenance counters this inefficiency, altering incentives
towards higher sales effort and constraining prices against falling (Winter 1993).
A second theory is that retailer effort towards product promotion and greater product
awareness may influence demand upwards in other outlets. Even prominent displays
of a product on the store floor or in shop windows raises consumers awareness of the
product and makes them more likely to purchase the product not just from the out-
let undertaking the sales effort but from other outlets as well (if the consumer happens
to find another outlet most convenient when the need for the product arises). This is
particularly true if a retailer’s decision to display (or simply carry) a product conveys
information about the quality of the product (Marvel and McCafferty 1984). If even only
some potential consumers of other outlets are affected this way, the market demand for
the product is relatively more sensitive to sales effort as opposed to price than the indi-
vidual retailer demand, that is (15.2) is met. Resale price maintenance again counters the
distortion in incentives.
The third theory is similar. The quality of a product such as a photocopier machine, an
appliance, or an automobile may depend not only on the quality decisions of the manu-
facturer but also on the quality of postsales service or installation by the dealer. If the con-
sumer cannot perfectly distinguish between a failure of quality as between the dealer and
the product itself, then greater efforts by the dealer towards quality enhance the reputation
not just of the dealer but of the product itself. Again, the market demand will be relatively
more sensitive to the effort expended by the dealer (relative to price) than the dealer’s own
demand is. The condition (15.2) for the profitability of resale price maintenance is met.
A fourth theory is the classic “free-riding” story (Telser 1960). Suppose that stereo
equipment requires detailed information and a listening room experience in order for
a consumer to decide which model of amplifier or speakers best fits her needs. Outlets
provide this information. A new stereo store could open up selling equipment in boxes,
with very low prices but no information provided at the point of sale. Consumers could
avail themselves of the information provided by the informing stores, which charge
higher prices to cover the cost of the information provided, then make their purchases
at the low-priced store. Demand for the product as a whole will suffer from this type
of free-riding. Resale price maintenance restores demand by preventing this kind of
free-riding. Without the ability to attract consumers on the basis of low prices alone,
outlets must provide the entire package of information and competitive prices.11
The free-riding story is far stronger than is necessary to explain resale price main-
tenance, as Klein (2009), Winter (2004), and a number of other authors have argued.
Our framework makes this very clear. The free-riding story involves a positive impact
of service by one retailer (the informing retailer) on the demand faced by another (the
free-riding retailer). This is a positive cross-elasticity. This is sufficient for (15.2), but all
that is necessary for the condition for resale price maintenance to be profitable is that
demand cross-elasticity be relatively less sensitive for sales than it is for price. To gener-
ate an incentive for resale price maintenance by an individual manufacturer, it is not neces-
sary that the sales cross-elasticity be positive (as it is in the classic free-riding story: greater
information by the informing store increases demand at the free-riding store). That is, it is
not necessary that some stores (noninforming stores) benefit from the sales effort supplied
by other stores. If the sales cross-elasticity is negative but relatively low, resale price mainte-
nance is profitable.
11 As an example, in Applewood Stoves v. Vermont Castings, Inc. USC.A 7th CC No. 86-2818, Judge
Richard Posner writes:

As a new company, selling a somewhat complex product [wood-burning stoves], Vermont
Castings . . . needs dealers who understand the product, can explain it to consumers and can per-
suade them to buy it in preference to substitute products. . . . These selling efforts, which benefit
consumers as well as the supplier, cost money—money that a dealer can’t recoup if another dealer
“free-rides” on the first dealer’s efforts by offering a discount to consumers who have shopped at
the first dealer. . . . As one of Vermont Casting’s dealers explained in a letter to it, “The worst dis-
appointment is spending a great deal of time with a customer only to lose him to Applewood
because of price. This letter was precipitated by the loss of 3 sales of V.C. stoves today [to] people
whom we educated and spent long hours with.” (CCH, Trade Regulation Reports, 1I58,344, p. 12)
In addition to the set of theories under which a manufacturer may want to alter the mix
of price and nonprice competition among its distributors, we would mention an addi-
tional explanation of resale price maintenance. The restraint may be necessary to encour-
age adequate inventory holdings by downstream distributors. As Deneckere, Marvel, and
Peck (1996, 1997) have shown, the price system alone fails to convey adequate incentives for
inventory investment by competitive retailers. Krishnan and Winter (2007) reach the same
conclusion for retailers with market power, based on a framework similar to the one that
we have adopted above. The evidence for the role of resale price maintenance in enhancing
inventory incentives is strong. When resale price maintenance contracts were struck down
as illegal in the early 1970s, manufacturers were suddenly constrained in their design of dis-
tribution systems. Retailer inventories collapsed for some products and the distribution of
the products suffered.12
15.2.3. Territorial Restraints

The general framework that we have offered for the efficiency of price restraints is imme-
diately applicable to territorial restrictions. Let us revisit the market failure question: why
would a manufacturer not adopt a simple wholesale contract with only prices? When dis-
tributors are geographically differentiated, for example, they sell in different countries, the
failures of the simple, nonexclusive price contract to align distributor incentives with sup-
ply chain efficiency are clear. Suppose that a manufacturer assigns each country to a par-
ticular national distributor, but that there are parallel imports into each country. The sales
effort that a distributor in one country undertakes to establish a valuable brand name for
the product in its home country benefits any foreign distributor that exports into that coun-
try. Higher quality of retail service, product promotion or any activity that adds to brand
name capital or simply to demand will have spillover benefits to the foreign distributor.
These positive spillovers lead to a positive cross-elasticity with respect to sales effort across
national distributors; an increase in promotion in one country adds to the total sales of the
foreign distributor.13 It is easy to show that a positive cross-elasticity is sufficient for condi-
tion (15.2) on the market failure of the simple price contract. Furthermore, in the context
of geographical differentiated distributors, any efforts that a distributor undertakes spe-
cifically to attract demand away from a rival distributor, such as investing in a network to
export to the rival’s territory, are a pure waste. Investments that merely transfer demand
12
Corning Glass Works used this restraint from 1937 until it was prevented from doing so in a case
brought by the Federal Trade Commission in 1975. In interviews ten years after the case, Corning
executives indicated that one of the most important effects of the case was the loss of many of its smaller
outlets. In another example, after legislation had ended an earlier era of resale price maintenance, the
number of dealers selling Schick shavers fell from 35,000 to 7,000 in one year (Andrews and Friday
1960).
13 The one potential theoretical source of negative cross-elasticity is the attraction of foreign buyers by
the increase in domestic promotion. But it is unlikely that many customers will travel to another country
to take advantage of better service or promotion.
from one distributor to another add nothing to total product demand.14 The price system
alone fails to coordinate incentives. It is natural for a manufacturer to impose territorial
restraints in order to eliminate the wasteful activity.
Territorial restraints, in short, eliminate the wasteful effort to divert demand away
from rival distributors. In fact, territorial restraints are a more powerful resolution
of incentive distortions than vertical price restraints in two respects. When effort
(any nonprice determinant of demand) is multidimensional, “first-best” resolution
of incentive distortions with price restraints requires that the demand elasticity with
respect to effort be identical across all dimensions. (Recall our discussion that if one
dimension of sales effort is perfectly substitutable with price decreases, resale price
maintenance is useless.) This is not true of territorial restraints. Under the simplest
set of assumptions, for example, territorial restraints are accompanied by variable
prices equal to marginal cost so that the downstream distributor becomes a residual
claimant on profits earned from its territory. As such, it takes privately efficient deci-
sions in all dimensions. In addition, resale price maintenance involves an upstream
manufacturer imposing the same price floor across all retailers, instead of allowing
the price to vary across retailer locations (and over time) in response to information
about demand that may be available only at the retail level. Territorial restraints, by
supporting residual claimancy contracts, avoid distortions that result from this rigid-
ity of prices.
15.2.4. Exclusivity Restraints and Tying

Exclusivity contracts extend beyond territorial exclusivity. Exclusivity restraints may
be imposed on buyers or retail intermediaries (“exclusive dealing”), prohibiting them
from purchasing from other sellers. Or these restraints may be imposed on sellers. The
economics of exclusivity are reviewed in the chapter by Douglas Bernheim and Randall
Heeb and the chapter by Howard Marvel in this volume. Here we outline two of the most
important efficiency explanations of the contracts. Marvel (1982) has explained exclu-
sive dealing as a remedy to potential free-riding not on retailer investments (like the
free-riding explanation of resale price maintenance) but on manufacturer investments.
Manufacturers generate customers for their products through advertising and invest-
ment in their brands. A manufacturer is essentially providing to a retailer a tied prod-
uct—the physical product itself plus investment in generating demand for the product.
If the dealer carries a low-priced, nonadvertised product, then the dealer can sell the
lower priced product to customers attracted to the dealer by the promotion expenditure
on the part of the manufacturer. The dealer can gain a reputation for offering similar
products at lower prices. The problem with this situation is that the manufacturer then
14 This argument assumes that the impact of investment in exporting channels is mainly diversion of
demand away from the distributor located in the destination country, rather than bringing more demand
to the market.
has the incentive to cut back on productive, brand-enhancing investment. Exclusive

dealing is efficient when used to prevent free-riding.
Exclusivity in contracts can be used to prevent holdup. Suppose that a franchisor
sells to a franchisee the right to open an outlet in a small town. Once the franchisee
has built up the market for the product by maintaining a high level of quality and
through promotion, the franchisor can sell a share of the market to a new franchisee—
unless the first franchise has territorial exclusivity rights. In any contract, exclusivity
can serve to protect against inefficient investment. Contracts are inevitably incom-
plete in that they do not specify the rights and obligations to parties for all time; some
negotiations are necessary even after a contract has been signed. In a contract without
exclusivity, a party may have the incentive to invest in options to leave the contract
and transact with other parties—not with the intention necessarily of exercising the
option but rather for the purpose of enhancing its threat point in bargaining with the
contractual partner. The investment in these options would be inefficient, since it has
the impact of simply implementing a transfer between contractual parties (Segal and
Whinston 2000). Exclusivity may be reciprocal, with the buyer and seller each con-
strained to deal with the other, in an arrangement that is sometimes referred to as
quasi-vertical integration.
Tying, another kind of exclusivity, may also have an efficiency explanation. The most
common efficiency explanation of tying is that there are economies in jointly provid-
ing two “products.” For example, the vast majority of consumers prefer to buy a pair of
shoes and not just one. Selling shoes in pairs reduces the cost of provision. The law in the
EU and the United States appropriately accounts for this efficiency explanation provid-
ing that a tying restriction must involve two separate products, which is not true unless
there is significant independent demand for each possible product.
But even if there are two clearly independent products, tying may be efficient. For
example, when a consumer cannot distinguish failures in service quality from failure of
the product itself, then increased efforts by service providers exert a positive externality
between the service providers and the product manufacturer. Because of this external-
ity, an independent supplier of service may have weak incentives to provide quality ser-
vice: the service provider does not internalize the reputational benefits of high quality.
A tying arrangement may require buyers to buy high-quality service from the manufac-
turer and thus efficiently protect the manufacturer’s reputation for quality.15
Tying may also be imposed as a price discrimination mechanism, which, as we dis-
cussed above, may increase surplus. For example, tying aftermarket products to original
equipment may allow the manufacturer to meter demand for its product. Buyers with
relatively high demand for original equipment, such as a printer, may have relatively
high demand for aftermarket products, such as ink. Tying the aftermarket product to
15 Iacobucci (2004) shows that, if buyers anticipate the externality between independent service
providers and manufacturers, there may or may not be a need to tie to protect a reputation for quality.
The incentives for tying depend on the technological relationship between service and product quality.
the original equipment, and imposing a price-cost markup on the tied good, allows the
seller to extract more surplus from high-demand buyers than it would otherwise.
15.2.5. Restrictions on Internet Distribution

Because the European Guidelines adopt a number of restrictions against limiting online
sales, it is useful to consider the possible efficiency roles of vertical restraints on online
sales. The Guidelines’ rules are complex, but include the limits on the proportion of
overall sales made by a distributor on the Internet. Why would a manufacturer want to
limit the proportion of sales done over the Internet?
Consider the case of luxury good sales, which is one of the most important sectors
affected by the European Commission’s restrictions on Internet sales (Buettner et al.
2009a and 2009b). Image is a vital component of luxury products, in the sense that
many consumers reveal a preference for products on which suppliers have invested
substantially in image. Suppliers of perfume, for example, spend much more on cre-
ating the image of the product than on the chemicals in the physical product itself.
A supplier of perfume that simply sold its product in bulk, with no advertisement or
other investment in image (perhaps at a discount to a consumer who provided her
own container) would not succeed in this market. The product itself is not just the
liquid perfume. Consumers value not just the scent but the image of the product.
Manufacturers of perfume are not restricted—nor should they be—in their expendi-
tures on image.
Investment in image is undertaken not just by manufacturers but by
bricks-and-mortar retailers. Consumers are attracted to expensive luxury goods by
the retail environment, the retail store prestige and by promotion at the retail outlet.
Outlets like Tiffany or Saks Fifth Avenue come to mind, but any upmarket retailer can
both add directly to the demand for a product as well as to its image through invest-
ment in prestige and an attractive shopping experience. This experience can include
point-of-sale information such as product sampling in the case of perfume, but retail
investment in these dimensions is much more general. When outlets are allowed to sell
unlimited amounts through the Internet, however, then these outlets benefit from the
investment in images by bricks-and-mortar outlets without contributing anything to
the investment themselves. This free-riding reduces the incentives for outlets to invest
in the product image or to carry the product at all, and this reduces demand for the
product. A manufacturer limits sales through the Internet to protect the incentives of
bricks-and-mortar retailers to offer investment in image. Manufacturers may benefit to
some degree from Internet sales through expansion of its market or from the low prices
that result. A manufacturer that constrains the percentage of sales through the Internet
is simply adjusting the mix of its price and nonprice demand variables (image invest-
ment, for example) just as if it were adjusting these variables directly. Restrictions to
limit sales through the Internet are not part of a scheme to limit competition among
manufacturers and should not be regulated.
15.3. Anticompetitive Uses of

Vertical Restraints
Vertical restraints have a host of efficiency explanations. There are, however, anticom-
petitive explanations as well. We next turn to these anticompetitive explanations.
15.3.1. Resale Price Maintenance
Resale price maintenance can serve to facilitate an upstream cartel among manufac-
turers. Coordinating wholesale prices would be difficult for members of an upstream
cartel because these prices are not posted and may be part of more complicated con-
tracts. Coordinating an upstream cartel via the monitoring of retail prices without verti-
cal restraints would also be difficult because of the variation or “noise” that enters the
relationship between a wholesale price and the set of retail prices charged in different
locations. Retail price floors allow upstream cartel members to agree on prices and to
monitor prices. Telser (1960) used this theory to explain the adoption of resale price
maintenance by GE and Westinghouse in the market for large lamps. Jullien and Rey
(2007) formalize this argument.
RPM can also be used to support a downstream retail cartel. When retailers sell multi-
ple products and require collectively that all manufacturers in a product market engage
in RPM, then the retailer cartel can effectively implement cartel pricing across products.
This explanation is of some historical importance in explaining, for example, the success
of traditional drugstores in delaying the development of discount drugstores in North
America (Overstreet 1983, 143).
The US Supreme Court in Leegin discussed a third potential anticompetitive theory of
resale price maintenance: that the practice results in exclusion at the retail level. A man-
ufacturer can use resale price maintenance to protect rents at the retail level, as in the
Klein-Murphy theory, but the retailer “performance” that is contingent upon continued
receipt of the rents is not provision of adequate service but rather agreeing to refrain
from carrying the products of a new entrant. A dominant firm or small set of collectively
dominant firms can thus protect their dominant position against entry by sharing the
rents from the dominance with retailers. Retailers know that once entry is allowed, rents
will be much reduced in the market and, as agents who share in these rents, retailers will
suffer. John Asker and Heski Bar-Isaac (2011) offer a thorough analysis of this theory
(see also Paldor 2008). The theory of resale price maintenance as exclusionary requires
that there be a small number of distributors, as in the case of the American Sugar
Refining Company, discussed by Asker and Bar-Isaac (see also Zerbe 1969 and Marvel
and McCafferty 1985). With many retailers, it is unlikely that a new entrant could not
gain toehold entry by sharing profits from entry with one or a small number of retailers.
15.3.2. Territorial Restraints

It is possible as a matter of theory that territorial restraints dampen interbrand com-
petition. Rey and Stiglitz (1988) show that territorial restraints can have the impact of
dampening competition between manufacturers. Recall that in the simplest theory
of territorial restraints, a manufacturer sets variable price equal to marginal cost and
charges downstream retailers a fixed fee in exchange for their right to sell exclusively in
an area. Under a territorial restraint, with variable wholesale prices set above marginal
cost, a manufacturer acts as a less aggressive competitor.16 The Rey-Stiglitz theory has,
however, not been applied to specific cases of which we are aware and would be difficult
to distinguish from industry-wide use of the restraints for efficiency purposes.17
Exclusive territories may support price discrimination by allowing the upstream
seller to partition buyers downstream into different classes, each facing different prices.
Such a scheme might arise where buyers in different territories have different elasticities
of demand for a product. While it is conceivable that price discrimination would lower
welfare, price discrimination may also increase welfare. Indeed, as noted above, moving
from a single price set by a monopolist along the spectrum of increasing surplus extrac-
tion to the limit of perfect price discrimination will, on average, increase total welfare.
Given that there are no practical means for determining whether price discrimination
in any given case would lower welfare, we join the consensus of economists that would
not legally forbid price discrimination. We therefore also would reject the establishment
of limits on exclusive territories out of concerns about price discrimination.
15.3.3. Exclusivity Restraints and Tied Sales

It had, until recently, been argued that an exclusivity restriction would not be accepted
by a distributor unless the distributor were offered some offsetting benefit to the restric-
tion distributor under the restraint (Bork 1978). Contracts maximize the sum of ben-
efits to the contractual parties, and if an exclusivity restriction is added it must be
surplus-increasing. Aghion-Bolton (1987) showed this to be false. If a contract imposes
externalities on parties outside the contract, then the contract may be anticompetitive
as it benefits parties to the contract. The most important formulation of this theory
16
More precisely, when manufacturers compete in prices, vertical restraints combined with
above-marginal-cost wholesale prices have the effect of shifting reaction curves upwards.
17 An additional theory of territorial restraints as anticompetitive would build on the Asker and Bar
Isaac (2011) theory of resale price maintenance as facilitating an exclusionary equilibrium. Suppose that
the only feasible means of entry into an industry by an entrant is to choose a particular location, then
build up gradually from there. If territorial exclusivity is used by the incumbent, then a distributor that is
the first to accommodate the entrant would quickly find its profit eroded by the competition upstream.
The condition for profitably refusing an entrant would be weaker (more general) than in the Asker–Bar
Isaac model.
involves an entrant with fixed costs that can be covered only if the entrant secures
enough buyers (Rasmusen, Ramseyer, and Wiley 1991, Segal and Whinston 2000). If
the incumbent offers each buyer a small price reduction in exchange for an exclusive
contract, then acceptance by all buyers is a Nash equilibrium because each buyer knows
that refusing the offer of an exclusivity contract (given that other buyers are accepting
the contract) will not be enough to induce entry.18 Even a more efficient entrant can be
inefficiently deterred from the market by exclusive contracts.
A parallel theory applies to the possibility that tied sales can be anticompetitive
(Whinston 1990). The following example of Whinston’s theory is offered by Carlton and
Heyer (2008, p. 14) (and attributed to Rob Gertner):
Consider the case of a hypothetical island on which there is a monopoly hotel serv-
ing many tourists. Natives live on the island. The hotel operates a restaurant, which
competes for diners, both tourists and natives, in competition with local restaurants.
By tying meals to lodging, the hotel can so diminish the number of tourists dining
at local restaurants that, in the extreme, lack of scale prevents any local restaurants
from surviving. The hotel thus acquires a monopoly over natives in the provision of
restaurant services.
Whinston’s theory shows that market power in one market can be profitably extended to
market power in two markets provided that (1) not all consumers in the second market
use the product in the two markets jointly; (2) in the absence of tying, there is some mar-
ket power, for example a duopoly, in the second market; and (3) a rival or rivals incur
some fixed costs, such as costs of product development or continual product updating,
in the second market. Whinston notes, however, that even in the simple models that he
develops, which set aside various efficiency explanations of tying in order to focus on
exclusion, the welfare implications are unclear.
In summary, contracts with exclusivity constraints or tying restrictions can be anti-
competitive but there are many theories available under which these restrictions serve
efficiency or price discrimination roles. The application of theories to a particular case,
to understand whether the evidence in the case supports an efficiency explanation or
suppression of competition either in the form of higher prices or exclusion, is a chal-
lenging exercise because even theories supporting exclusion can yield ambiguous wel-
fare implications of a practice. It would appear that the vast majority of contracts with
these restrictions are efficient, since such restrictions are seen across such a wide variety
of markets, including markets with competitive structures. We turn next to a systematic
review of empirical evidence on vertical restraints.
18
Note that with small bribes, buyers would be each be better off in another Nash equilibrium: only
(n − 1) accept, where n is the minimum number of free buyers that will induce entry. Segal and Whinston
adopt a refinement of Nash equilibrium that rules out the dominated equilibrium and find that the
essential argument remains valid.
15.3.4. Empirical Evidence on Vertical Restraints

Our review of empirical evidence on vertical restraints is in the form of a summary of sum-
maries. Cooper and coauthors (2005a and 2005b) reviewed 24 empirical papers published
between 1984 and 2004 on the effects of vertical integration, RPM, and exclusive territo-
ries. LaFontaine and Slade (2005) reviewed 23 empirical papers on vertical restraints and
vertical integration. The samples of papers reviewed in the two studies overlapped.
The Lafontaine and Slade sample include 15 papers on RPM, exclusive territories, and
vertical integration. Of these papers, 13 conclude that the restraints under study either
benefitted consumers or did not harm them. Two papers found evidence of higher prices
under exclusive territories, but the higher prices may simply be a trade-off accepted for
higher sales effort, as Lafontaine and Slade point out. Lafontaine and Slade conclude in
summarizing their evidence that when manufacturers’ choose contracts with vertical
restraints “not only do they make themselves better off, but they also typically allow con-
sumers to benefit from higher quality products and better service provision.” Similarly,
Cooper and coauthors reach the conclusion that the literature offers little support for the
proposition that vertical restraints or integration are likely to harm consumers. Some
papers reviewed find evidence consistent with both anticompetitive and procompeti-
tive incentives, but none finds that the hypothesis of procompetitive incentives can be
rejected in favor of the alternative. O’Brien (2011) reviews an additional set of recent
papers in the area that are again consistent with the overall conclusion.
The empirical evidence reviewed is not, of course, a random sample of contracts
from markets across the economy. Some industries such as beer distribution and gaso-
line distribution are overrepresented. And the overall thrust of the evidence, that verti-
cal restraints tend to be procompetitive, does not rule out the possibility of valid cases
against particular uses of vertical restraints. By analogy, less than 2% of mergers raise
competitive concerns, yet merger policy is an active and well-founded area of competi-
tion policy. But the evidence supports our conclusion that competition policy towards
vertical restraints in any case must be approached with a prior expectation that the
restraints are very likely to be efficient. There is no place in competition policy for plac-
ing the burden of proof on defendants to show that restraints are efficient. With this
perspective in mind, we review the law of vertical restraints in the EU and United States
in the next section, and offer a critique in the final section.
15.4. The Law of Vertical Restraints in

the United States and the EU
The differences between the US and EU approaches to competition law on vertical restraints
are interesting as a purely academic matter, and critical as a practical matter in light of the
potentially severe financial consequences that follow from a finding of a legal violation in
either jurisdiction. Significant financial penalties can follow violations of vertical restraints
law in either jurisdiction. In the United States, those adjudged to have improperly lessened
competition through the use of vertical restraints face the threat of publicly imposed fines,
or treble damages as a consequence of private actions. The EU does not, at present, allow
private actions against anticompetitive behavior of any kind, including improper vertical
restraints, but has imposed very large public fines for anticompetitive conduct. In 2007, for
example, the European Commission imposed a fine of 497 million euros on Microsoft for
tying Windows Media Player to Windows Operating System.19
In what follows, we review the key principles of law in each jurisdiction on RPM,
exclusive territories, tying, and exclusive dealing. We focus in each case only on the “fed-
eral” law, examining EU and US law and setting to the side potentially important devia-
tions from the pan-jurisdictional approach at the state, or member state, level.
As an introductory matter, note that the central sources of law in both jurisdictions
are statutes that are phrased in broad, general terms. The US Sherman Act has a provi-
sion on anticompetitive agreements, Section 1, as well as Section 2 on monopolization.
Other relevant statutes include the Clayton Act, Section 3 of which prohibits anticom-
petitive tying and exclusive dealing. In Europe, the Treaty on the Functioning of the
European Union (“TFEU”) also has a provision on anticompetitive agreements and
concerted practices, Article 101, and one on abuse of dominance, Article 102. These pro-
visions set out standards, not rules, and judicial and administrative interpretations are
consequentially very important in the application of the law. Such an approach contrasts
with other jurisdictions, such as Canada, where the relevant competition statute is codi-
fied to a much greater extent, with, for example, practices such as RPM dealt with in spe-
cific sections.20 One cannot examine the statutes in order to understand the prevailing
approach to a particular vertical restraint, but rather must go to the case law and admin-
istrative pronouncements, the latter being particularly important in this area in the EU.

US antitrust law historically banned minimum RPM. The leading case for decades was
Dr. Miles Medical Co. v. John D. Park & Sons Co.21 In this case, the Supreme Court held
that a manufacturer of medicines could not impose minimum price restrictions on
downstream resellers. Just as horizontal agreements between sellers of a product are per
se illegal, which is to say that they violate antitrust law regardless of their competitive
effects in any given case, so too were agreements between sellers and buyers of a prod-
uct. Equating horizontal and vertical agreements for antitrust analysis makes little eco-
nomic sense, but such thinking has been influential in the United States.
19
Microsoft Corp. v. Commission of the European Communities (2007) CFI.
20
See e.g., Canadian Competition Act, Section 76.
21 220 U.S. 373 (1911).
Judicial decisions retreated somewhat from the harshness of the per se illegality stan-
dard by creating exceptions, such as an exception for a seller that stipulates resale prices
and unilaterally refuses to deal with downstream firms that do not adhere to these prices;
in such case, there is no agreement, and hence no per se illegal agreement.22 Moreover,
statutory exemptions to federal antitrust laws were passed, such as the Miller-Tydings
Act in 1937 and the McGuire Act in 1952, that allowed state fair trading laws, which per-
mitted RPM, to apply in states that had adopted such statutes. The McGuire Act and the
Miller-Tydings Act were repealed by the Consumer Goods Pricing Act of 1975.
Two recent cases altered the RPM legal landscape significantly. First, State Oil
v. Khan23 changed the law with respect to maximum resale prices. Recognizing that
there is little reason to conclude that a price cap would hurt competition or consumers,
the Supreme Court rejected per se illegality for maximum RPM and instead adopted a
rule of reason approach: a plaintiff would be required to show a harm to competition
from RPM to succeed.
Despite the venerable status of the Dr. Miles precedent, the Supreme Court aban-
doned per se illegality in Leegin Creative Leather Products, Inc. v. PSKS Inc.24 In a deci-
sion replete with reference to economic thinking on the matter, the Supreme Court
rejected per se illegality for RPM, holding that it should be considered under the rule
of reason instead. The Court suggested that RPM may be more suspect where there is
evident market power on the part of sellers or buyers, and where RPM may be used
in a manner that is harmful to horizontal competition, by supporting a cartel, or by
inducing downstream firms to exclude the upstream firm’s rivals. The notion that an
upstream firm and downstream firm are fixing prices with necessarily harmful effects
when agreeing to RPM is no longer accepted in US federal antitrust law.25 But it would
be wrong to say that the law on RPM is approaching per se legality. The onus of proof to
demonstrate various factors that support the legality of RPM rests with the defendant.26
In practice, as of mid-2012 lawyers were still designing “Colgate programs” for their
clients to ensure that the clients’ distribution practices fall within the Colgate exception
to Dr. Miles.27
22
U.S. v. Colgate & Co. 250 U.S. 300 (1919).
23
522 U.S. 3 (1997).
24 551 U.S. 877 (2007).
25 State laws on RPM vary, with some states effectively banning RPM under their own antitrust laws.
26 Following Leegin, the law on RPM, as interpreted by the FTC in granting a petition to Nine-West
in 2008 to modify an earlier FTC order, is that a manufacturer bears the burden of proving that the use
of RPM is procompetitive unless it can prove the absence of all of the so-called Leegin factors: (1) that
dealers, not the manufacturer, were the impetus for RPM; (2) that the use of RPM was ubiquitous in the
industry; (3) that there is a dominant manufacturer or dealer.
27 Several attempts have been made in Congress to reimpose the per se ban on RPM after Leegin by
drafting statutes to repeal Leegin. Senators Herb Kohl, Joseph Biden, and Hillary Clinton introduced the
Discount Pricing Consumer Protection Act immediately following the decision. This bill proposed to
revise Section 1 of the Sherman Act to make RPM per se illegal. Although this bill never made it out of
committee, similar bills in the House and the Senate are in process as of the writing of this chapter but
have not been passed.
The EU, on the other hand, continues to disapprove of minimum or fixed RPM. In
2010, the EU adopted Regulation 330/2010, which exempts a range of vertical agreements
from the TFEU Article 101 ban on anticompetitive arrangements, and offers guidance
on its approach to remaining restraints. The Regulation will be in place until 2022. The
Regulation creates safe harbors that automatically protect certain “non-hardcore” verti-
cal agreements from antitrust sanctions (though failing to fall within a safe harbor does
not create a presumption of illegality for non-hard-core restrictions). The general struc-
ture is to exempt all vertical non-hard-core restrictions where the market share of seller
and buyer28 in each of their respective markets is below 30%. Hard core restrictions, on
the other hand, are subject to a presumption of illegality. Minimum or fixed RPM is a
hard core restriction under the Regulation. Maximum RPM, on the other hand, is not a
hard core restriction under the Regulation, and thus can qualify under the safe harbor.
The Regulation cites a number of reasons for the treatment of RPM as a hard core
restriction.29 Some are similar to the concerns about horizontal competition that the US
Supreme Court pointed out in Leegin: RPM may facilitate collusion at the upstream or
downstream distributor levels; or may be used to induce retailers not to carry a rival’s
brand. Other reasons are more cryptic. For example, the Regulation suggests that even
absent collusion, RPM may “soften” competition between manufacturers and/or retail-
ers. Others parts seem to stress the importance of protecting intrabrand competition.
For example, the Regulation notes that minimum or fixed RPM prohibits price-cutting,
and thus the direct effect of RPM is a price increase.
The classification of a practice as a hard core restriction means that there is a pre-
sumption that the practice is contrary to Article 101 of the TFEU, and that safe harbors
are unavailable. Minimum or fixed RPM is not illegal per se, however, as firms may be
able to invoke the efficiencies defense under Article 101(3), which allows practices even
if they are anticompetitive as long as they generate efficiencies and these efficiencies are
passed on to the consumer. The Regulation acknowledges that RPM may be efficient, as
where, for example, a seller introduces a new product and seeks to expand its distribu-
tion network. But with a presumption of illegality, the onus will be on the firms to prove
the efficiency effects to justify RPM.
15.4.2. Exclusive Territories

Just as the law on RPM has changed considerably over time in the United States, so too
has the approach to exclusive territories. But while change in the law on RPM took many
decades, the Supreme Court’s precedent on exclusive territories oscillated dramati-
cally in a period of only fifteen years. The first Supreme Court case on the matter was
White Motor Co. v. U.S.30 In this case, a truck manufacturer sought to impose territorial
28
Previously, only the seller’s market share was relevant.
29
See discussion in Regulation 330/2010 at 63.
30 373 U.S. 253 (1963).
restrictions on its distributors. The district court accepted the government’s argument
that such restrictions were analogous to horizontal market division, and to RPM, and
thus should be treated as illegal per se. The district court granted summary judgment
to the government. The Supreme Court, however, overturned, holding that summary
judgment was inappropriate. The majority of the Court did not reach a conclusion on
the proper treatment of territorial restrictions, holding that a full trial, with consider-
ation of all the economic evidence, was warranted.
Four years later, the question of the appropriate treatment of exclusive territories
was before the Court again in two cases, U.S. v. Sealy Inc.,31 and U.S. v. Arnold, Schwinn
& Co.32 The Court was decisively against the practice in these cases. Sealy involved a
number of licensees of the Sealy brand that manufactured mattresses. Conditions to
license the brand included a number of vertical restraints, including RPM and territo-
rial exclusivity. The Court held that the exclusive territorial restraints were tainted by the
aggregate nature of the nature of the restraints in the case, which involved other legally
suspect practices including RPM, and illegal. Schwinn did not involve such an aggrega-
tion of restraints, but again the Court expressed disapproval. In particular, making ref-
erence to doctrines against restraints on alienation, a majority of the Court condemned
as unreasonable the imposition by a manufacturer of restrictions on the downstream
sales of products after title to the products had passed to a downstream distributor.
Schwinn met with considerable hostility and did not survive long. Continental TV
Inc. v. GTE Sylvania Inc.33 involved a manufacturer of televisions agreeing with its fran-
chised dealers that they would not be permitted to sell Sylvania products if they were to
relocate without Sylvania’s approval. While not strictly speaking an agreement to estab-
lish exclusive territories, the arrangement had a similar effect. Stressing the importance
of economic analysis in applying antitrust law, and the role of territorial restrictions
in potentially stimulating interbrand competition, a majority of the Supreme Court
rejected the per se approach to exclusive territories, concluding that they should be con-
sidered instead under the rule of reason. Since then, as with most practices governed by
the rule of reason, territorial restrictions have rarely been challenged successfully.
Exclusive territories law in the EU raises interesting trade-offs. On the one hand, the
case law has long recognized the potential economic benefits of such restraints; on the
other hand, in addition to concerns about intrabrand competition, exclusive territories
raise concerns about the greater integration of the EU itself.34 The trade-off has mani-
fested in the case law and Commission guidelines over the years, most recently in the
EU 2010 Guidelines that contain a general disapproval of exclusive distribution, but
with fairly broad exceptions.
Under the Guidelines, strict exclusive territories are classified as a “hardcore” restric-
tion on competition, which as set out above not only removes them from the possibility
31
388 U.S. 350 (1967).
32
388 U.S. 365 (1967).
33 433 U.S. 36 (1977).
34 See, e.g., Consten and Grundig.
of falling within a safe harbor, but moreover establishes a presumption of illegality.35

There are, however, important exceptions to this treatment. For example, block exemp-
tions are available for restrictions on the buyer’s place of establishment as long as they do
not also contractually confine sales to a particular territory. Perhaps the most significant
exception concerns the distinction between “active” and “passive” sales. Active sales are
sales that result from action by the downstream firm, while passive sales are unsolic-
ited. Reflecting trade-offs between economic and integration concerns, the Guidelines
allow upstream firms to impose restrictions on active sales by downstream firms out-
side of designated territories, but disallow a restriction that prevents downstream firms
from making passive sales. This is typical of the compromises that EU law on exclusive
territories has incorporated over the years, but there was an important addition in the
2010 Guidelines. The Guidelines treat Internet sales as passive sales and, thus, territorial
restrictions cannot prevent sales outside a designated territory on the Internet. Other
exceptions to hardcore treatment of territorial restrictions include restrictions that pre-
vent wholesalers from selling to end users, from selling to unauthorized distributors,
and from selling components to competitors of the upstream firm.
In summary, the EU is again stricter than the United States: exclusive territories are
subject only to rule-of-reason review in the United States, but may be presumptively
problematic under EU law.
15.4.3. Tying
The treatment of tying in the United States is simple to state, but much more complex to
apply. The basic rule is that tying is per se illegal. But there are preconditions for tying
to be per se illegal that undermine significantly the importance of the per se label. First,
there must be two separate and distinct products that the seller ties together. The second
requirement is that the seller must have market power.
The requirement of two products is in some respects a logical prerequisite for a tying
agreement, but is not straightforward to apply. Products have multiple features, and dis-
tinguishing two features of a single product from two distinct products may be diffi-
cult in practice. Cars come with tires; are these elements of a single product, or is this
a tie (bundle)? Shoes come with laces; a single package may contain several oranges; a
cable television package may have several channels—are these tying arrangements? The
Supreme Court offered some guidance on the question in the leading case of Jefferson
Parish Hospital District No. 2 v. Hyde.36 In this case a hospital entered into an agreement
with a designated professional corporation that it would rely only on its anesthesiolo-
gists in providing services to patients. Dr. Hyde, an anesthesiologist who was prevented
by the arrangement from providing services to the hospital’s patients, challenged the
arrangement as an unlawful Section 1 agreement, and the case found its way to the
35
See Guidelines, supra at para. 50.
36
466 U.S. 2 (1984).
Supreme Court. A majority of the Court upheld the per se illegality of tying, but ulti-
mately held that the arrangement at issue was not per se illegal. In so finding, the Court
found the existence of two separate products, setting out a test that asked not whether
it was feasible for the seller to sell the items separately, but rather whether there existed
sufficient demand for each item independently such that they could be considered sepa-
rate products for the purposes of tying law. Here there was sufficient evidence of distinct
demand for anesthetic services independently from hospital services that there were
two products, and thus there was a tying arrangement.
The market power requirement is also far from straightforward, with courts taking
more hawkish and more dovish views at different points in time. The leading case is
again Jefferson Parish, which, in holding that the tying arrangement in question was not
per se illegal, stressed the importance of the market power requirement. Some indica-
tion of market imperfections that might lead to some degree of market power on the
part of the seller, such as the presence of insurance in the health services market and
thus price-insensitive buyers, is not sufficient; rather, the majority stated that the seller
must use its market power to force the buyer into buying a product that the buyer did
not want at all, or that the buyer might have preferred to buy from a different seller. Such
market power was not present in Jefferson Parish, and the tie was not per se illegal.
Given the significant degree of market power required under Jefferson Parish, the later
case of Eastman Kodak Co. v. Image Technical Services, Inc. took many by surprise. In this
case Kodak ceased to supply parts to independent service operators (ISOs) that worked
on its photocopy equipment. ISOs launched an antitrust complaint under Sections 1 and
2 of the Sherman Act, contending, among other things, that Kodak tied the sale of ser-
vice parts to the sale of its parts. Kodak responded by arguing, among other things, that
it did not have market power in the original equipment market, and thus could not have
market power in “aftermarkets” for service and parts even if its market share were 100%.
The Supreme Court held that summary judgment in Kodak’s favor was not appropriate.
Information problems on the part of buyers who may not anticipate high prices in after-
markets, or problems resulting from buyers being “locked in” to Kodak aftermarkets
given past investments in Kodak equipment, could result in the necessary market power
that would support a per se tying claim. The “post–Chicago School” approach to market
power in Kodak suggests greater scope for successful per se tying claims than Jefferson
Parish might imply.
In Europe, tying is not treated as a hard core restriction, and thus is eligible to fall within
the safe harbor if both seller and buyer have market shares below 30% in both the tying and
the tied product markets. Outside the safe harbor, tying arrangements will be assessed on
the merits and not subject to any kind of presumption of illegality. The 2010 Guidelines
outline the key considerations in a review of the tying arrangement. As in the United
States, the determination of whether there are two distinct products, a logical prerequisite
for a tie, depends on demand-side considerations.37 If there is sufficient demand for the
37
Guidelines, supra at para. 215.
sale of the items independently of each other, then there are two products. Laces are not
independent from shoes, for example, and thus selling laces with shoes is not tying.
The analysis of harms to competition from tying turns importantly on the presence of
market power. If the seller faces effective competition, the Guidelines conclude that “no
anti-competitive effects can be expected . . . unless other suppliers are applying similar
tying.”38 Interestingly, however, in reviewing the potential for tying to increase prices,
the Guidelines observe that customers may not always be able to calculate the conse-
quences of tying where aftermarkets are involved.39 This would seem to cast doubt on
the importance of market power in original equipment markets, as in Kodak.
While the requirements of two products and market power are similar to the US
approach to tying, the EU diverges from the US approach by requiring an analysis of
competitive effects before condemning a tying arrangement. Foreclosure is a central
concern, with the Guidelines calling for an examination of the percentage of sales that
are covered by the tying arrangement. The Guidelines observe that a tying arrange-
ment may foreclose entry by forcing entrants to provide both tying and tied goods, or by
denying scale to independent sellers of tied goods. The Guidelines also express concern
about higher prices in aftermarkets, as noted above, and the use of tying as price dis-
crimination: the tied good may meter demand for the tying good, allowing the seller to
extract greater surplus from buyers. The focus on high prices, and concern about price
discrimination, suggest that tying may be problematic even without competitive effects
if the practice helps a seller exploit its market power.
The leading case on tying in recent years in the EU is the Microsoft case.40 In this case,
Microsoft was found by the Commission to have unlawfully tied Windows Media Player
to Windows Operating System. The Court of First Instance found that these were two
separate products, and that Microsoft had market power in operating systems. The
Court also found that there was the risk of foreclosure associated with the tie; thus there
were the requisite competitive effects to make an order against the practice, as well as a fine
of 497 million euros. The analysis of foreclosure did not engage in a far-ranging analysis of
what the economic benefits to Microsoft would be from extending a monopoly in operat-
ing systems to media players, but rather emphasized that the tie prevented competition in
media players given Windows’ share of operating systems, and thus was unlawful.
To summarize, the United States has a per se rule against tying, but requires that
there be two products and that there be market power in the tying market. The EU also
requires two products and market power, and indeed establishes a safe harbor for tying
arrangements involving less than 30% of the tying and tied product markets up- and
downstream. To show that tying is unlawful, the Commission must show negative com-
petitive effects from the practice, though the Guidelines (with their contemplation of
price discrimination as a problematic motivation, for example) and the case law (most
prominently, Microsoft) do not impose a high hurdle for such a finding.
38
Ibid. at para. 220.
39
Ibid. at para 217.
40 Supra.
15.4.4. Exclusive Dealing

As with other practices, the law on exclusive dealing in the United States has undergone
a number of twists and turns with the adoption of different tests over time. The earli-
est leading case is Standard Fashion Co. v. Magrane-Houston Co.41 In this case, a sup-
plier of paper patterns for women’s and children’s clothing entered into exclusive dealing
arrangements with a large number of retail outlets. As a result of a contractual dispute,
Magrane-Houston, one of the retailers, accused Standard Fashion of violating Section 3
of the Clayton Act by foreclosing a large number of potential outlets for dress patterns.
The Supreme Court observed that Section 3 condemned arrangements that “tended”
to create a monopoly, but held that this required that an arrangement probably lessens
competition or creates an actual tendency to monopoly. The threshold for such a finding
was not high, however. The Court concluded that Standard Fashion’s large market share,
and the fact that 40% of potential outlets had agreed to exclusivity, would foreclose com-
petition, and consequently there was a violation of Section 3.
The strict posture toward exclusive dealing became even more aggressive in Standard
Oil of California v. U.S.42 Standard Oil contractually required independent service sta-
tions that collectively had 6.7% of the market to buy gasoline exclusively from it. The
government contended that the exclusive dealing agreements violated the Sherman and
Clayton Acts. The Supreme Court in this case observed that exclusive dealing should
be treated more leniently than tying, stating, “Tying arrangements serve hardly any
purpose beyond the suppression of competition,” while exclusive dealing may be eco-
nomically advantageous to both sellers and buyers.43 At the same time, however, Justice
Frankfurter expressed skepticism that courts would be able to engage in the economic
analysis necessary to apply a full rule-of-reason approach. In the result, the Court con-
cluded that exclusive dealing was unlawful where a substantial share of the line of com-
merce that was involved. It thus failed to overturn the finding of the district court that
foreclosing 7% of retail outlets with exclusive dealing contracts was illegal per se.
The Supreme Court took the economic merits of exclusive dealing more seriously in
Tampa Electric Co. v. Nashville Coal Co.44 The Court rejected lower court findings that
an agreement between a coal supplier and an electric company that the latter would buy
coal only from the former violated Section 3 of the Clayton Act. The lower courts exam-
ined the volume of commerce affected by the contract, a very large volume in absolute
terms, and concluded that exclusivity must lessen competition by foreclosing access to
the electric company by other coal suppliers. The Supreme Court redefined the relevant
geographic area that was covered by the arrangement to a much larger area than that
considered by the lower courts. As a consequence of this redefinition, the foreclosed
commerce was less than 1% of the relevant market. This was sufficient to find for the
41
258 U.S. 346 (1922).
42
337 U.S. 293 (1949).
43 Ibid. at 305–6.
44 365 U.S. 320 (1961).
defendant, but the Court went on to set out a test for substantial foreclosure that invited
lower courts to follow a rule-of-reason, and not a per se, approach in the future:
To determine substantiality in a given case, it is necessary to weigh the probable effect

of the contract on the relevant area of effective competition, taking into account the
relative strength of the parties, the proportionate volume of commerce involved in
relation to the total volume of commerce in the relevant market area, and the prob-
able and immediate effects which pre-emption of that share of the market might have
on effective competition therein.45
As Hovenkamp points out, following Tampa Electric, lower courts have generally fol-
lowed the rule of reason in assessing exclusive dealing (Hovenkamp).
In the EU, exclusive dealing, or “single branding,” is judged on what is effectively the
rule of reason: the arrangement must lessen competition to be unlawful. Single branding
is not a hard core restriction and thus is eligible for a safe harbor under the Guidelines.
For this practice, there is both a market share and a temporal requirement for the safe
harbor: if seller and buyer have less than 30% of their respective markets and the exclu-
sive arrangement is less than five years long, then the practice will not be challenged.
Arrangements that fall outside the safe harbor are not presumed wrongful, but rather
will be subject to a competition test. The Guidelines recognize that if there is compe-
tition for the entirety of each customer’s business, then exclusive dealing raises little
competitive concern. The test turns on foreclosure. The greater the seller’s market share,
and the longer the duration of the agreement, the stronger the probable impact of the
arrangement on foreclosure. The Guidelines also stress the importance of entry barriers,
indicating that if entry is easy, single branding is unlikely to pose a problem.
The Guidelines contemplate the potentially cumulative anticompetitive effects of sin-
gle branding arrangements, holding that even if each supplier is covered by the block
exemption (safe harbor), withdrawal of the exemption may be appropriate where there
are such cumulative effects. The Guidelines state that where the largest market share of
a supplier is below 30% and the market share of the five largest suppliers is below 50%,
there is unlikely to be a single or cumulative anticompetitive situation. The Guidelines
do not, however, indicate any market share threshold for concluding that such a cumu-
lative anticompetitive effect is probable.
To summarize, both the United States and EU consider exclusive dealing under the
rule of reason. A complainant must establish that there are negative competitive effects
from the practice.
One of the prominent forms of legal restrictions on distribution contracts in the EU
Guidelines is on vertical restraints over Internet distribution. The set of regulations
is complex, distinguishing “passive sales,” which are transactions in which consum-
ers’ search effort plays an important role, from “active sales,” which are transactions in
which a distributor expends effort to reach consumers in a specific territory or a specific
45
Ibid. at 329.
customer group. A distributor website is an example of passive sales, and territory-based

banners on third-party websites are a form of active sales in the territory in which the
banners are shown. With some exceptions, vertical restraints on passive online sales by a
distributor are a hard core restriction, illegal without a market-share-based safe harbor.
Active sales by a distributor in support of a (legal) distribution system with exclusive ter-
ritories or customers is allowed.
15.5. Conclusion: Where the Law and

Economics Diverge
In the absence of evidence that vertical restraints are being used to aid collusion or to aid
in the exclusion of firms from a market, the restraints should be legal. A manufacturer
adopting vertical restraints on intrabrand competition must be doing so for a reason: the
restraint on price competition is a cost to the manufacturer since higher retail prices
reduce demand, and this cost would not be incurred without a benefit. Many theories
are available as to why retailers would not provide enough sales effort (defined broadly)
under simple price contracts—and why vertical restraints can resolve the incentive
problems. We showed that vertical restraints can be explained by a difference between
the marginal rates of substitution over price versus nonprice demand-enhancing activi-
ties. Many different specific sources of incentives for vertical restraints fall within this
general framework.
The welfare effect of vertical restraints is sometimes discussed in terms of a trade-off
between reduced intrabrand competition and greater interbrand competition—or as
an instrument by which an upstream firm can better compete.46 Certainly in European
law dominance on the part of a manufacturer creates suspicion about vertical restraints,
and such dominance appears to be a requirement in the US approach to per se illegal
tying, but many academic contributions also point to the trade-off, or the importance
of upstream competition, in assessing vertical restraints. We disagree. Even in the case
of a pure monopolist upstream, without even the threat of competition, there is no pre-
sumption that trading off higher prices in exchange for demand-enhancing activities is
harmful to welfare. For this reason, we would reject the approach of the EU Guidelines
that describes the reduction of intrabrand competition as a generally harmful competi-
tive effect that may result from vertical restraints.47 This approach leads the Guidelines
astray in a number of specific respects, perhaps most prominently in restricting RPM
46 Rey and Vergé (2008) write, “Even when vertical restraints eliminate intra-brand competition, if
there is sufficient competition from other structures [supply chains] this will not decrease economic
welfare since the structure will be unable to exercise market power.”
47 Guidelines, supra at para. 100.
because the direct impact of the practice is to raise price. This may be an impact of RPM
in a case, but this says nothing about the effect of RPM on horizontal competition.
The law currently places too much emphasis on free-riding as an explanation of verti-
cal restraints. For example, in his dissent in the important Leegin case, Justice Breyer of
the US Supreme Court writes:
Petitioner and some amici have also presented us with newer studies that show that
resale price maintenance sometimes brings consumer benefits. Overstreet 119–129
(describing numerous case studies). But the proponents of a per se rule have always
conceded as much. What is remarkable about the majority’s arguments is that nothing
in this respect is new. . . . The one arguable exception consists of the majority’s claim
that, even absent free riding, resale price maintenance may be the most efficient way
to expand the manufacturer’s market share by inducing the retailer’s performance and
allowing it to use its own initiative and experience in providing valuable services . . .
Ante, at 12. I cannot count this as an exception, however, because I do not understand
how, in the absence of free-riding (and assuming competitiveness), an established pro-
ducer would need resale price maintenance. Why, on these assumptions, would a dealer
not expand its market share as best that dealer sees fit, obtaining appropriate payment
from consumers in the process? There may be an answer to this question. But I have
not seen it. (551 U.S. 15 (2007) Breyer, J., dissenting [emphasis added])
The European Commission Guidelines on Vertical Restraints also place undue empha-
sis on free-riding as an evidentiary requirement for the proposition that resale price
maintenance is efficient for established firms.48 In explaining why the practice may be
used to induce retailers to provide additional presales service, the Guidelines describe
the traditional free-riding argument (involving consumers’ obtaining services at one
outlet and then purchasing from a low price outlet), and then state (at paragraph 225):
The parties will have to convincingly demonstrate that the RPM agreement can be
expected to not only provide the means but also the incentive to overcome possible
free riding between retailers on these services and that the pre-sales services over-
all benefit consumers as part of the demonstration that all the conditions of Article
101(3) are fulfilled.
Like Justice Breyer’s opinion in Leegin, the apparent theory is that the efficiency role
of resale price maintenance is limited to the free-riding argument. Our position is that
manufacturers use vertical restraints to readjust the mix of price and nonprice compe-
tition among retail distributors of their products for a host of reasons. The traditional
free-riding theory is only one, narrow explanation. For example, retail distributors
design their strategies to attract consumers not just away from other products, but also
48 The Guidelines also recognize limited roles for resale price maintenance for new products and for
short-term price promotions.

away from other retailers. Designing strategies for the latter purpose is wasteful for the
supply chain as a whole, and is likely to involve low prices and less sales effort. A manu-
facturer can correct the distortion (in terms of achieving maximum profits) with verti-
cal restraints.
Our view that competition policy should examine only horizontal effects on competi-
tion across supply chains is not based on the assumption that the adjustment of price
and nonprice competition such as service quality or promotion by a manufacturer will
necessarily increase consumer surplus or total surplus. Our position is that it may; that
isolating the evidentiary requirements for identifying whether it does or not is impracti-
cal or impossible; and that the burden of proof in antitrust restrictions contracts should
lie on the side of intervention. We do not regulate a manufacturers’ mix of prices or pro-
motion when these decisions are made directly, for example, in a vertically integrated
firm. Nor should we regulate these decisions when they are implemented indirectly
through vertical restraints.49
Turning to specific restraints, in the United States, following Leegin, resale price main-
tenance is no longer per se illegal, but the burden of proof on the firm adopting the prac-
tice to establish various conditions is misguided. A fortiori, the continuing approach of
the EU to treat price maintenance as a hard core vertical restriction that is subject to a
presumption of illegality is also a mistake.
While both the United States and EU are relatively permissive of exclusive territories,
the EU’s insistence that passive extraterritorial sales, including Internet sales, be permit-
ted creates the kind of externalities that motivate exclusivity in the first place. This will be
especially true as Internet sales grow in importance over time. It is not fair to judge the
European approach to exclusive territories based only on economics given the political
motive that influences the law in this area: the EU is concerned about economic integra-
tion as a political matter, and may sacrifice economic gains in order to promote it. But the
EU approach does sacrifice efficiency. That said, the incentive problems that exclusive
territories address are most worrisome for upstream suppliers where one downstream
distributor actively pursues another distributor’s customers. Restrictions on active,
out-of-territory sales are permitted in Europe, so European law does permit an especially
beneficial version of exclusive territories. This is not a justification for Europe’s insistence
on passive sales across territories, but is at least a positive feature of the Guidelines.
Vertical restraints on online passive sales by a distributor, including restraints on the
proportion of sales online, are prohibited under the EU Guidelines. This is another clear
case where competition law in Europe is at odds with economics. Vertical restraints
against excessive online sales are not part of a scheme to lessen horizontal competition
among manufacturers, but can instead be simply explained as a mechanism to correct
distortions in distribution systems in which online sellers can free ride on the invest-
ments in product image and other point-of-sale demand enhancement such as informa-
tion or sampling.
49 This is not to say that resale price maintenance is always efficient. It may be used to suppress
horizontal competition, as we discuss below.

The areas of exclusive contracts and tying present a more difficult challenge. While
these restraints will ordinarily benign, they will on occasion allow dominant firms to
exclude rivals. Both the EU and United States appropriately require dominance before
challenging these practices, but dominance is merely necessary and far from sufficient
to conclude that the restraints are likely to lessen competition. While it is qualified in
important respects, we do not believe that even a nominally per se approach to tying in
the United States is appropriate. Rather, each case should be examined on its merits, and
only in clear cases should such a restraint be regarded as anticompetitive.
Because of the difficulty in determining the economic impact of exclusivity and tying,
we are also concerned about the relatively expansive approach of the EU to foreclosure. In
the Microsoft media player case, for example, the EU was seemingly content to observe
that tying a media player to a dominant operating system would give Microsoft a clear
advantage in the media player market. What the EU did not clearly analyze, however, was
how Microsoft would gain economically from doing so: if Microsoft was a monopolist in
operating systems, why was it not content to reap its profits in that market? How did tying
the media player increase Microsoft’s profits? How did tying the media player hurt con-
sumers? In our view questions like these should be at the forefront of investigations into
exclusivity and tying arrangements, with the burden on those objecting to the restraints.
Yet under the modified per se approach to tying in the United States, and the expansive
approach to foreclosure in the EU, these questions are relegated to a minor role.
The EU and United States provide a useful contrast for the exposition of different
approaches to vertical restraints. They are also the most important jurisdictions in prac-
tice, with many multinational distribution chains likely to be affected by American and/
or European law. But of course many distribution chains will be narrower in scope and
confined to a single jurisdiction governed by a different approach to vertical restraints.
Given the absence of international consensus on optimal policy, even on such mat-
ters as hard core price-fixing cartels (for example, should they be criminalized?), it is
not surprising that there is considerable worldwide variation in the approach to verti-
cal restraints. Canada, for example, is a jurisdiction that has tended to move in recent
years in the direction of the American, more permissive approach to vertical restraints.
Its statute, which provides a much more complete code of antitrust rules on particular
practices than that in either the EU or United States, was amended in 2009 to move the
law from treating RPM as a per se illegal criminal offence to requiring that the prac-
tice have an “adverse effect on competition” to be subject to civil remedies, not crimi-
nal. Tying, exclusive territories, and exclusive dealing are also subject to a competition
test. In each case, the practice must substantially lessen competition to be subject to an
order. But this liberalizing trend is not true across different matters and different juris-
dictions. For example, many significant jurisdictions, such as Germany and Australia,
continue to treat RPM as per se illegal. Given that rules such as the per se illegality of
RPM fail to account for the broad range of efficiency motivations that exist for many
vertical restraints, and moreover are often based on an ill-conceived concern for intra-
brand competition, the law on vertical restraints in many jurisdictions is due for reform.
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CHAPTER 16
F R A N C H I SI N G A N D E XC LU SI V E
D I S T R I BU T ION
Adaptation and Antitrust
FRANCINE LAFONTAINE AND MARGARET E. SLADE
16.1. Introduction
Vertical restraints are contract clauses that one link in a vertical chain imposes on
another. Most often vertical restraints arise in the context of distribution and in retail
settings, with the upstream firm or manufacturer restricting its downstream distribu-
tors or retailers’ choices. For example, a manufacturer might limit its retailer’s product
line or geographic market, or set the retail price.
In this chapter, we examine vertical restraints in franchising and distribution agree-
ments. First, we give a brief outline of the history of franchising and present some data
on franchising in the United States as of 2007, the year of the most recent economic cen-
sus. We then discuss the extent to which franchise relationships rely on specific types of
vertical restraints and the evidence regarding their efficiency or lack thereof. Next, we
describe how changes in the antitrust treatment of some practices are affecting franchise
contracts and franchise relationships today. Although we pay particular attention to the
United States, we also discuss the evolution of antitrust rules as they apply to franchise
contracts in the European Union.1 Finally, we conclude with some comments on the
contractual nature of distribution and franchise relationships, and the need to reach a
1 For an international comparison of the legal treatment of franchising and the interface with
antitrust more generally, see WIPO (2011). For a general treatment of vertical restraints and antitrust, see
Iacobucci and Winter, c hapter 15 in this volume.
388 Francine Lafontaine and Margaret E. Slade
consensus concerning the role of, and harmonize the treatment of, restrictive contract
clauses in distribution and retailing.
16.2. Franchising: History and Extent

in the United States Today
Franchising is a form of business organization in which an upstream firm, the franchi-

sor, enters into contractual relationships with downstream firms, the franchisees, who
operate under the franchisor’s trade name and usually with the franchisor’s guidance. In
some sense, franchising is as old as commerce itself. However, some attribute the origin
of modern franchising to early nineteenth-century German brewers, who granted pubs
and taverns the right to sell their products and use their name.
According to Dicke (1992), franchising in the United States can be traced back to the
mid-1800s when the McCormick Harvesting and Singer Sewing Machine Companies
granted exclusive territories to sales agents in exchange for a franchise fee.2 Initially, like
other firms using agents at the time, these two companies imposed few restrictions on,
and required limited qualifications from, their agents. Over time, however, both found
that they needed more control if they were to protect their reputations and brands. The
McCormick Harvesting Machine Company proceeded to establish company-owned
branch houses throughout the United States and Canada, branch houses that were
given oversight responsibilities for the sales agents in their territories. This allowed
McCormick to systematize procedures and communications with its agents, thereby
transforming them into what we would now call “dealers.” The Singer Sewing Company
addressed the need for control by converting many of the independent agencies into
company outlets. It also devised a series of recommendations for the remaining agents
as to how the offices should be run and, for the first time, required detailed financial
reporting from them. The contracts and methods of control that Singer developed at the
time are often described as the forerunners of the modern franchise agreement.
Coca-Cola began developing its franchise bottling system in 1899, and car manu-
facturers and oil companies followed suit soon after.3 The specific form of organization
used by these firms, whereby the franchisor is a manufacturer that sells finished or semi-
finished products to its dealers/franchisees, has since come to be known as “traditional”
2 See Dicke (1992) for more on the history of franchising in the United States, including a detailed
account of its evolution at these two companies. See also Marx (1985) on the development of franchising
in automobile retailing in the United States.
3 Starting with the arrangements between German brewers and retailers, franchising has always been
a common method of selling beer in Europe. For a discussion of exclusivity in UK beer sales, see Slade
(1998 and 2011). This arrangement, however, is illegal in most states in the United States. Nonetheless,
contractual relationships between beer producers and their distributors are often exclusive and have
several of the characteristics of franchise agreements.
Franchising and Exclusive Distribution 389
franchising. The franchisees in these systems sell their franchisor’s products to consum-
ers or to other firms in the distribution chain. The franchisor’s profit from its dealer
network flows from the markups that it earns on the products sold to franchisees. In
contrast to business-format franchising, as described below, traditional franchisees do
not pay running royalties.
Martha Matilda Harper is said to have created the first true business-format franchise
(Plitt 2000). And indeed, this entrepreneur grew her network of Harper Beauty Shops
from the early 1890s onward using a business model that included all the components of
a business format as described by the US Department of Commerce today. To be sure,
her network of hair salons was developed around the distribution of a product, which
she manufactured in Rochester, New York, similar to traditional franchising. But sales
of the tonic were only a small component of the business concept. To operate a Harper
salon, a woman—all Harper franchisees were women—had to go through rigorous
training and agree to abide by a set of rules that guaranteed customers the same quality
of service at any Harper salon. Although there were more than 500 Harper salons in the
United States, Canada, and Europe by the mid-1920s, Matilda Harper’s business did not
survive her, and ultimately did not leave a visible mark.4
Many business-format franchisors, such as A&W and Howard Johnson restaurants,
established their franchise networks in the 1920s and 1930s. However, it was not until
the 1950s, with the advent of chains such as Burger King and McDonald’s and the eco-
nomic boom of the postwar era, that business-format franchising blossomed in the
United States and Canada and, gradually, throughout much of the rest of the world.
Business-format franchising today encompasses a large number of firms that provide a
wide array of goods and services. In exchange for the business format, or trademark and
way of doing business, franchisees typically pay a relatively small lump-sum fee at the
beginning of the contract period as well as running royalties that are usually a fixed per-
centage of the franchisee’s revenues. They also often contribute an additional fraction of
their revenues to a separate advertising fund. Presumably, the advertising carried out
with these funds benefits all franchisees as well as the franchisor.
Although often made, the distinction between traditional and business-format
franchising is somewhat arbitrary. Dnes (1992) and Klein (1995), for example, argue
that there is little economic difference between the two in terms of the type of agree-
ments that franchisors rely on, the type of support that they provide, and the control
that they exert. Moreover, when constructing theoretical models, researchers often
make no distinction between the two types of franchising, and their models apply
equally well to both. On the other hand, from a descriptive standpoint the distinction
can be important because many countries outside the United States do not include
traditional franchising in their data on franchising activities. The distinction also can
be relevant from an antitrust perspective, particularly in relation to tying, as discussed
below.
4
However, one can still find the building that housed the Harper Laboratory in Rochester, New York.
Table 16.1 Traditional versus Business-Format Franchising

Establishments of
Franchising firms, Traditional Business-format
total franchising firms % franchising firms %
No. of Establishments 453,326 66,223 15 387,103 85

Sales ($000) 1,288,171 867,559 67 420,612 33
Employment 7,881,975 1,480,265 19 6,401,710 81
Payroll ($000) 153,680 56,144 37 97,535 63
Employment per establishment 17.39 22.35 16.54
Sales per establishment 2,842 13,100 1,087
Payroll per establishment 339.00 847.80 251.96
Source: 2007 Economic Census, Core Business Statistics Series: Summary Statistics by Franchise

Status for the United States and authors’ calculations.
Historically, the US government did not collect data on franchise activities in its eco-
nomic censuses. In 1971, the US Department of Commerce began publishing reports,
“Franchising in the Economy,” that provided data on franchising, which were obtained
via franchisor questionnaires. Unfortunately, this initiative was terminated in 1986.
With the 2007 Economic Census, the Census Bureau began a new effort to collect data
on franchising, resulting in information on the franchising status of more than 4.3 mil-
lion establishments across 295 six-digit NAICS industries.
The results of this effort, which were released in the fall of 2010, include data on sales,
employment, payroll, and the number of establishments of franchised chains. As most
franchised chains rely on dual distribution, operating both company-owned and fran-
chised establishments, the census data also quantify the level of activities of franchised
and company-owned establishments separately within each sector.
We summarize some of the information generated by this effort in tables 16.1 and
16.2.5 In table 16.1, we give an overview of the extent of franchising by showing the num-
ber of employer establishments, and total sales, total employment, and total payroll of
the establishments of franchised firms. We also present information about the size of
establishments, in terms of average sales, employment, and payroll per establishment.
The data are presented separately for traditional and business-format franchising.
To give a better sense of the sectors where franchising occurs, and of the extent of dual
distribution, table 16.2 shows the number of employer establishments across detailed
six-digit NAICS industries for those industries that rely on franchising the most (per
these data). The top panel of the table pertains to traditional franchising, whereas the
lower panel is for business-format franchising. The data in this table are further broken
down between establishments that are owned by franchisees and those that are owned
by franchisors.
5
For more on this, see Kosová and Lafontaine (2011).
Table 16.2 US Establishments by Franchise Status and Industry, Six-Digit NAICS

Franchisee-owned Franchisor-owned
Establishments establishments establishments
# in % in % of % of
Sector franchised franchised sector sector
NAICS Sector total chains chains Number total Number total
312111 Soft-drink 472 87 18.43 76 16.10 11 2.33

manufacturers
441110 Automobile dealers, 24,888 24,888 100 24,888 100 0 0
new
447110 Gasoline stations with 97,508 33,991 34.86 17,194 17.63 16,797 17.23
convenience stores
447190 Gasoline stations, no 21,248 7,257 34.15 4,811 22.64 2,446 11.51
convenience store
Total traditional 195,297 91,893 47.05 72,357 37.05 19,536 10.00
franchising sectors
722211 Fast-food restaurants 211,313 124,898 59.11 97,262 46.03 27,636 13.08
722110 Full service restaurants 220,089 30,130 13.69 20,643 9.38 9,487 4.31
721110 Hotels and motels 48,108 22,585 46.95 20,655 42.94 1,930 4.01
(except casinos)
531210 Offices of real estate 109,472 22,009 20.10 19,667 17.97 2,342 2.14
agents and brokers
722213 Snack and 50,491 16,721 33.12 15,413 30.53 1,308 2.59
nonalcoholic beverage
bar
713940 Fitness and 31,919 9,082 28.45 8,593 26.92 489 1.53
recreational sports
centers
561720 Janitorial services 53,814 6,569 12.21 5,833 10.84 736 1.37
812112 Beauty salons 81,632 6,502 7.97 6,179 7.57 323 0.40
445120 Convenience stores 25,510 5,896 23.11 3,249 12.74 2,647 10.38
446130 Optical goods stores 13,149 5,776 43.93 375 2.85 5,401 41.08
Other business-format 3,295,252 111,265 3.38 80,721 2.45 30,544 0.93
sectors
Total business-format 4,140,749 361,433 8.73 278,590 6.73 82,843 2.00
franchising sectors
Total franchising 4,336,046 453,326 10.45 350,947 77.42 102,379 22.58
Source: 2007 Economic Census, Core Business Statistics Series: Summary Statistics by Franchise Status
for the United States and authors calculations.
These tables establish a number of important facts about franchising. First, table 16.1
shows that, in 2007, franchising firms operated more than 450,000 employer estab-
lishments, or about 10.45% of all employer establishments in these sectors. Also, sales
through these amounted to almost 1.3 trillion dollars, or 9.2% of GDP of 14.061 trillion
dollars. These firms, moreover, accounted for 7.9 million jobs in the US economy. By
comparison, it should be noted that US manufacturing accounts for a total of 13.4 mil-
lion jobs. In other words, franchising accounts for more than half as many jobs as does
all manufacturing activity in the United States. Clearly, the results of the 2007 census
confirm that franchising plays a vital role in the US economy.6 As basically all fran-
chising involves operations under exclusive trademarks, that is, exclusive dealing, and
much of it entails the use of other vertical restraints as well, and since such restraints
are not limited to this context, as discussed further below, these figures also confirm
that much business activity is carried out under some form of vertical restraint in the
US economy.
Table 16.2 shows that about 23% (or 102,379) of the 453,326 employer establishments
of franchised companies are operated directly by franchisors. Put differently, while
establishments of US franchisors represent about 10.5% of total employer establish-
ments in the economy, 77% of these are owned by franchisees, while the other 23% are
owned and operated directly by franchisors. Except for new automobile sales, where
state laws prevent car manufacturers from owning dealerships (Lafontaine and Scott
Morton 2010), all of the sectors listed are characterized by dual distribution—both
up- and downstream ownership. This is not the result of aggregation across firms that
use and do not use franchising—though not shown in this table, most individual fran-
chisors operate both types of establishments. This fact has led a number of authors to
explore factors that can explain the variation in the proportion of franchised outlets
across franchised firms.7 For our purposes here, however, the important point is that
under upstream ownership, there are no vertical restraints: instead, the firm controls its
distribution via vertical integration. When considering the legal treatment of vertical
restraints, this implies that the alternative of vertical integration is a very viable option
for most franchisors. Thus changes in the legal status of vertical restraints almost surely
will result in changes in the extent to which these firms rely on vertical integration. In
other words, an important concern in considering the rules that govern the use of ver-
tical restraints is that the imposition of strict rules may lead to a reduction in the extent
to which firms rely on franchising, and hence in the set of opportunities available to
potential franchisees.
6 Like most data in the economic censuses, these data ignore nonemployer establishments. This
is an important omission in the context of franchising, and so all these estimates should be viewed as
conservative.
7 See Blair and Lafontaine (2005) for data at the individual franchisor level, and Lafontaine and
Slade (2007) for a survey of the empirical work on the propensity to franchise. Note that Lafontaine and
Shaw (2005) use panel data approaches to show that mature franchisors operate a stable proportion of
their outlets corporately, and that those with higher valued brands operate a greater proportion of such
outlets. They argue that this is consistent with the franchisor’s desire to protect its investment in the
value of the brand from franchisee free riding. They also find, as prior empirical analyses found, that
more geographically dispersed chains rely on franchising more, a result consistent with agency-theoretic
arguments for franchising.
16.3. Antitrust and Its Role in

Franchising and Distribution
From an antitrust perspective, the main concern with both traditional and
business-format franchising is that they rely extensively on vertical restraints of vari-
ous forms. The vertical restraints that have received the most attention in the literature
include the following:8
• Exclusive dealing—where a manufacturer requires that a retailer sell only her

products—is perhaps the most common form of restraint. Indeed, basically all
franchising involves some form of exclusive-dealing arrangement. For studies of
exclusive dealing in, for example, beer distribution, see Asker (2004), Sass (2005),
and Slade (2011).
• Exclusive territories—where a manufacturer assures a downstream firm that it will
be the exclusive reseller of its brand in a geographic region—often accompany
exclusive dealing. This restraint is common in franchising, and also in beer dis-
tribution in the United States (see Jordan and Jaffe 1987, Culbertson and Bradford
1991, and Sass and Saurman 1993).
• Tying occurs when a manufacturer requires that its customers purchase product B
(the tied product) as a condition for obtaining what they really want, namely prod-
uct A (the tying product). Tying was common, for example, in movie distribution
(see Hanssen 2000).
• Resale price maintenance (RPM)—where the upstream firm exerts control over
the price that the downstream firm can charge—can take the form of setting a
specific price or a price floor or ceiling. Franchisors have been known to impose
mostly downward pressure on franchisee prices, that is, maximum RPM (see Blair
and Lafontaine 2005).
Antitrust authorities have been concerned with all of these restraints as applied to
franchising and distribution: exclusive dealing because of its potential to foreclose and
exclude, exclusive territories due to their potential to create local monopoly power, tying
because of the possibility of extending monopoly power from one sector to another, and
RPM due to its similarity with horizontal price fixing.
Although the intent of antitrust law is to protect competition, a perhaps unintended
consequence of that law is that it gives franchisees some incentives to make antitrust
claims against their franchisors—where they can request treble damages—even when
the fundamental dispute is, in essence, contractual (see, e.g., Joseph 2011, 3).
Unfortunately, from a policy point of view, the theoretical welfare effects of vertical
restraints are almost always ambiguous. In the remainder of this section, we discuss
8
See chapters 12 to 15 in this volume for more on these restraints.
some evidence regarding the use of each of these restraints in franchising and distribu-
tion, and what is known about the effects of that use. In the next section, we explore the
extent to which changes in the legal treatment of vertical restraints have affected fran-
chise and distribution contracts.
16.3.1. Exclusive Dealing

Historically, antitrust authorities have treated exclusive dealing more leniently than
other forms of vertical restraints.9 Were that not the case, franchising could not have
grown so rapidly and would not have assumed such an important position in modern
economies. The tendency to treat exclusive dealing leniently is perhaps surprising.
Indeed, with respect to vertical restraints, one of the major concerns of regulators has
been their potential to foreclose competitors and to raise rivals’ costs, and exclusive deal-
ing clauses have greater potential than other vertical restraints to have such effects. In
spite of this concern, exclusive dealing has a long history in franchising. For example, in
the early 1920s, Sinclair already required its licensed dealers to sell only Sinclair gasoline
from pumps bearing its trademark.10 Exclusive dealing is also used in other contexts,
including movie and beer distribution. Heide, Dutta, and Bergen (1998), moreover, doc-
ument that 46 of the 147 manufacturers they surveyed—all of them in the industrial
machinery and equipment or electronic and electric equipment sectors—used exclusive
dealing clauses in their contracts with distributors.
Given its prevalence, it is not surprising that the reasons for employing exclusivity clauses
have been assessed empirically. Heide, Dutta, and Bergen (1998), for example, examined
this question via survey data collected from manufacturers. They found that manufactur-
ers who were more concerned that their promotional efforts, training, or general support
of distributors might benefit their competitors were more likely to adopt such exclusivity.
On the other hand, when it was costly for manufacturers to assess whether their dealers
sold other manufacturers’ products (i.e., when monitoring the behavior of dealers was dif-
ficult ex post), or when manufacturers perceived that their customers had a preference for
multiproduct distribution, they were less likely to rely on exclusive dealing. These results are
consistent with the type of efficiency or principal-agent arguments that are proposed in the
organization economics literature to explain the use of exclusivity restraints.
A number of other empirical studies have attempted to understand the reasons for
exclusive dealing by examining the consequences of its usage. Those studies again find
considerable support for efficiency-enhancing effects. For example, in the US beer mar-
ket, Asker (2005) finds that brewers that employ exclusive dealing arrangements have
lower cost distributors than their competitors. Similarly, Sass (2005) finds that exclusive
distribution is associated with greater brand and market sales, and Chen (2012) finds that
exclusive distribution is probably adopted to prevent the erosion of efforts to promote
9
For a more complete discussion of exclusive dealing, see Marvel, c hapter 13 in this volume.
10
Federal Trade Commission v. Sinclair Refining Co., 261 U.S. 463 (1923).
individual brands that can occur when distributors handle large numbers of brands. In other
words, empirical studies in the United States have uncovered little evidence of anticompeti-
tive harm due to exclusive dealing (see Cooper et al. 2005 and Lafontaine and Slade 2008
for more on this). However, in the context of car retailing in Belgium, Nurski and Verboven
(2011) find some evidence that exclusive dealing restrictions may be detrimental to consum-
ers. We briefly revisit this study in our discussion of VRs in the EU in Section 16.3.5.
16.3.2. Exclusive Territories

The 1890 Sherman Act made allocating exclusive territories per se illegal in the United
States, and this situation persisted until the Supreme Court’s 1977 decision in Continental
T.V. v. GTE Sylvania Inc. Since that time, exclusive territories have been subject to a
rule-of-reason standard. Moreover, examples where manufacturers provide exclusive
territories to their distributors are easy to find. For example, wholesale beer distribu-
tors and retail automobile dealers often operate under exclusive territorial clauses that
protect them from entry of sellers of the same brand in their geographic selling areas.
As a matter of fact, state laws governing new car sales in almost all US states make it a
requirement for manufacturers to demonstrate “need” to establish a new dealership in
a dealer’s “Relevant Market Area,” as defined in the statute (rather than the territory the
manufacturer might have defined).11 In other words, state laws impose a requirement
that antitrust laws deem potentially detrimental to consumers.
An early example of the use of territorial restrictions in the United States—exclusivity
in the distribution of Sealy mattresses—is the focus of a study by Mueller and Geithman
(1991). Sealy introduced territorial restrictions in 1926, and those restrictions were
found to be illegal under US antitrust law by the Supreme Court in 1967. However, the
first ban proved to be ineffectual, as Sealy found ways to circumvent the law. As a conse-
quence, a private antitrust suit was brought against Sealy and the new territorial restric-
tions were banned in 1975. Mueller and Geithman conclude that the restraints indeed
had anticompetitive effects, as they led to local monopoly power and reduced output.12
From an efficiency perspective, however, exclusive territories can be used to provide some
security to distributors and franchisees, or at least clarify how the manufacturer or franchi-
sor’s future plans might affect downstream operations. Table 16.3 shows the frequency with
which franchisors in different industries offered exclusive territories to their franchisees
according to the International Franchise Association (IFA) and Frandata’s (1998) analysis
of franchise disclosure documents. In this table, any form of exclusive territory, described
by geography, population, miles, or number of vehicles, is counted as a yes. The table con-
firms that the majority of franchisors offered some form of territorial protection to their
franchisees. Moreover, Azoulay and Shane (2001) found that a contractual guarantee of an
exclusive territory significantly increased the likelihood that new franchised chains survive
11
See Lafontaine and Scott Morton (2010) for more on this.
12
However, see Eckard (1994) for a criticism of their methodology.
Table 16.3 Exclusive Territories

Number of Number with
Sector franchisors exclusive territories %
Automotive 89 62 70
Baked goods 39 28 72
Building and construction 70 61 87
Business services 57 42 74
Children products and services 27 24 89
Education products and services 21 20 95
Fast food 197 136 69
Lodging 39 13 33
Maintenance services 77 49 64
Personnel services 35 33 94
Printing 21 14 67
Real estate 39 26 67
Restaurants 99 79 80
Retail: Food 60 27 45
Retail: Nonfood 130 101 78
Service businesses 105 90 86
Sports and recreation 37 31 85
Travel 14 8 57
Total 1156 844 73
Source: IFA Educational Foundation and Frandata Corp. (1998), as

reproduced in Blair and Lafontaine (2005), c hapter 8.
beyond their first few years in business. They interpret this to mean that territorial protec-
tion is so important to franchisees that young franchise systems that fail to offer such pro-
tection from encroachment are unable to attract franchisees, which leads to their failure.
Interestingly, 83.5% of the 170 new franchisors in Azoulay and Shane’s (2001) data
offered territorial protection. By contrast, in a 1993 study of the largest 50 restaurant fran-
chisors, the Frandata Corporation found that only 26 of them offered some form of territo-
rial exclusivity.13 This is much lower than the proportion in Azoulay and Shane, or than the
80% reported in table 16.3 for the sit-down restaurant industry, or even the 69% reported
for the fast-food industry. It appears then that large franchisors, for whom claims of ter-
ritorial encroachment are more likely to be an issue, have a lower than average propensity
to offer territorial protection. Anecdotal evidence from Love (1986), who mentions how
Ray Kroc, the founder of the McDonald’s franchise system, offered exclusive territories
to early franchisees, but then reduced the size of the territories over time and eliminated
them entirely by 1969, suggests that the tendency of new franchisors to offer this protec-
tion while established franchisors do not do so as frequently, is a within-firm effect.
13 Study results mentioned in Encroachment Issues in the Restaurant Industry, 2nd Quarter Franchise
Update 14, 1994.

While one might expect that concerns over antitrust may be the reason that franchi-
sors eschew the use of exclusive territories as they become large, or more dominant in
their market, Azoulay and Shane (2001) mention an alternative motive for eliminating
territorial protection as a franchisor becomes better established. They report that the
main reason that franchisors give for not offering exclusive territories is the concern that
“exclusivity would allow franchisees to hold them up through underdevelopment.” In
the words of one franchisor, “If they (franchisees) can’t afford new stores and they don’t
operate well, they will slow down our growth if we can’t put someone else in the area”
(353). Hence, development can be postponed due to franchisee liquidity constraints or,
even worse, because a particular franchisee is not talented or ambitious enough to oper-
ate more stores. Such concerns reduce the willingness of franchisors to provide territo-
rial guarantees.14 This problem is, of course, not insurmountable. In particular, grants
of exclusive territories could be made contingent on some objective measures of fran-
chisee performance. Such contingency clauses are common in master franchise agree-
ments. Indeed, master franchise contracts not only provide territorial guarantees to the
master franchisee, they also typically stipulate a fee to be paid for the rights to develop
the franchise in the territory as well as a development schedule within the territory in
question. The franchisor then evaluates the franchisee’s performance in terms of num-
ber of outlets opened, and the territorial guarantee is predicated on this number reach-
ing specific target values over time. The drawback to this approach is that the targets
may be unrealistic, causing the master franchise agreement to fail.15
More generally, it is good practice for franchisors to state explicitly what they consider
to be reasonable sales and profit levels per outlet, and for franchisees to know upfront
that new outlets will be added when outlet sales in the region go above those levels. These
types of safeguards for franchisors and franchisees go much beyond the simple grant of a
territory, and are more closely aligned with other types of practices that franchisors cur-
rently use to minimize tension over geographic and other forms of expansion.
As mentioned briefly above, in addition to federal antitrust laws that govern exclusive
territories, state regulations have resulted in territorial protection for new car dealers
in the United States.16 All states require that car dealers be licensed in the state, thereby
14 See also Mathewson and Winter (1994) for a model emphasizing the role of exclusive territories in
setting the starting point of future renegotiation processes in franchise relationships.

15 See Kalnins (2004) on the frequency of failure of master franchise agreements in international
markets, which he attributes to development schedules that are too aggressive.

16 According to Dicke (1992), early dealer contracts at Ford, for example, also involved territorial
exclusivity, even before the Sealy contracts. He notes that the standard yearly contracts introduced in
1908 by the company were simple, but covered such matters as pricing, quantity forcing, and territorial
protection. Specifically, “a dealer agreed to purchase a set number of cars each month at a discount of
15% to 25% and to sell them only at prices established by Ford” (Dicke 1992, 64). Dealers were also bound
to keep an inventory of parts and make repairs on all cars made by Ford, whether they had made the
sale or not. “In exchange for meeting the terms of his contract, the dealer received the exclusive right to
sell Ford products in a clearly defined area. . . . Ford reserved the right to fine and/or cancel any dealer
who engaged in cross-selling, that is selling to customers who lived outside the dealer’s territory, or
‘bootlegging,’ as the wholesaling of cars to unauthorized dealers was called” (65).
preventing manufacturers from retailing cars directly, or through other channels. In

addition, most states protect auto dealers against what they refer to as encroachment
by requiring that a car manufacturer demonstrate a “need” to establish a new dealer-
ship. Combined, these restrictions prevent manufacturers from adjusting dealer net-
works to match changing demand patterns. They have also been a major impediment
to the development of, for example, Internet distribution of new cars. Finally, in almost
all states it is illegal for manufacturers to require that franchisees purchase vehicles
that they have not ordered, which amounts to a prohibition against quantity forcing.
Unfortunately, a dealer who has an exclusive territory might exercise market power in
that region, with the result that prices are too high and quantities sold too low from the
manufacturer’s point of view. In the absence of regulation, the manufacturer could turn
to quantity forcing to lower prices, increase total surplus, and reduce deadweight loss.
As should be clear from the description of the state laws however, car manufacturers are
not able to address the problem via quantity forcing, opening new dealerships, or sell-
ing cars directly to customers. The consequence, according to the few studies that have
considered the effect of these state laws, is that cars sell at higher prices than they would
absent the laws. For example, Smith (1982) finds that the territorial exclusivity for car
dealers has led to higher prices and lower service levels, that is, fewer hours of operation.
The Petroleum Marketing Practices Act at the federal level, and state laws govern-
ing liquor distribution, also provide territorial protection to dealers. Contrary to the
findings for autos, however, in the beer industry Sass and Saurman (1993) conclude that
territorial exclusivity, whether mandated or privately chosen, leads to higher demand
through its effect on promotion, which is procompetitive or at least not anticompetitive.
Most recently, a few authors have assessed the effects, both potential and actual,
of the change in policy that resulted in a ban of exclusive territories in new car retail-
ing in the EU. Brenkers and Verboven (2006) find that, if a manufacturer’s capacity to
grant exclusive territories and to choose dealers selectively resulted in double margins,
the change to a system where manufacturers could no longer grant exclusive territo-
ries would greatly benefit car buyers via reduced prices. In contrast, Zanarone (2009),
who examined the effect of banning exclusive territories on the other clauses found in
the franchise contracts of 19 car dealer networks in Italy, found that prior to the ban
manufacturers relied on a mix of exclusive territories and quantity floors. After the ban,
they introduced standards on verifiable marketing and service inputs, such as floors on
advertising and the number of salespeople. He interprets this as evidence that manu-
facturers used exclusive territories to prevent free riding and induce desired dealer
services. Thus, once exclusive territories were prohibited, they switched to other con-
tractual devices to achieve the same goals, presumably at higher cost.
In sum, the evidence that relates to the motives for adopting, and the effects of using,
exclusive territories is somewhat mixed. Often, other restraints are used along with
exclusive territories, and conclusions reached in the literature are sensitive to the set
of other restraints used or available to manufacturers. Thus much more work will be
needed before a consensus on the effects of particular restraints such as exclusive ter-
ritories can be reached.
16.3.3. Tying
Among vertical restraints, tying has one of the most varied legal histories.17 For one
thing, unlike exclusive dealing and exclusive territories, tying is still per se illegal under
US law.18 However, for it to be so, certain conditions must be met, which seems like a
contradiction in terms. In addition to the existence of a tie, which would be sufficient
in other per se circumstances, the following conditions must apply: First, the two prod-
ucts or services must be separate, which eliminates tying claims for products such as left
and right shoes. Second, the seller must have sufficient market power in the tying good
market, which eliminates cases where the buyer has many alternative trading partners
in that market. And third, the arrangements must affect a “not insubstantial” amount
of commerce, which eliminates arrangements that have little economic importance. In
practice, these conditions mean that, with respect to tying, per se illegality is not very
different from a rule-of-reason standard.
The use of tying contracts to ensure input quality and thereby protect the value of a
manufacturer’s or franchisor’s trademark has a long history. It has also been subject to
various legal restrictions under US antitrust laws and EU competition policy. A major
early test of tying in distribution occurred in the United States in 1917 when the Motion
Picture Patents Company, the first great film trust, was sued for tying the sale of movie
projectors to the purchase of films. The defendant lost the case, but on the basis of pat-
ent, not antitrust law. Nevertheless, this case gave rise to the leverage theory of tying
(Gift 2008).
Other landmark decisions involved major oil refiners in the United States, all of whom
required that lessee dealers operating under their brands sell only their gasoline. Prior
to the 1960s, most of them extended that requirement to include tires, batteries, and
accessories, allegedly to ensure the quality of all products and services offered at their
dealerships. Those requirements, however, were found to be in violation of US antitrust
laws.19 As to open supply, that is, the notion that dealers might be allowed to sell gasoline
from different sources under their refiner’s trade name, Marvel (1995) notes that “The
Lanham Act, governing trademarks, was interpreted to require retailers to keep gasoline
of different brands physically separate, stored in separate tanks and dispensed through
separate and clearly marked pumps. Few dealers availed themselves of the opportunity
to operate multibrand outlets” (213).
Tying similarly became an issue in later years for business-format franchising. In
its 1971 Siegel v. Chicken Delight decision, the court held that the requirement that
franchisees in a fast-food chain purchase paper products and other inputs from their
franchisor was an illegal tie. The court reasoned that in this type of business, the fran-
chisor could ensure product and input quality, and thus consistency, by providing its
franchisees with a set of approved suppliers rather than requiring that the franchisee
17
For a more general discussion of tying, see Hovenkamp and Hovenkamp, chapter 14 in this volume.
18
Tying became per se illegal with the International Salt Co. v. United States decision in 1947.
19 See Marvel (1995) for a detailed discussion and references to relevant court cases.
purchase the input from the franchisor (who obtained it in turn from the manufac-
turer). This decision has been interpreted to mean that a business-format franchisor’s
trademark and method of doing business is a tying product that, for antitrust pur-
poses, should be considered separate from food or other items that franchisees are
required to purchase from their franchisors. Later, in Krehl v. Baskin-Robbins Ice Cream
Company (1982), a franchisee alleged that Baskin-Robbins illegally tied its ice cream to
the Baskin-Robbins trademark. Although ice-cream stores are often considered a type
of business-format franchise, the court nonetheless noted that “the franchised outlets
serve merely as conduits through which the trademarked goods of the franchisor flow
to the ultimate consumer.” The court thus found that Baskin-Robbins ice cream was
not a separate product from the Baskin-Robbins trademark, and as such there was no
tie-in. In other words, as in traditional franchising, the court found that input purchase
requirements in the subset of franchised chains that amount to distribution franchises
were not tying arrangements.
The practical result of this jurisprudence has been that most business-format fran-
chise contracts in the United States today rely on approved suppliers rather than input
purchase requirements for purposes of quality control, except in the special cases
where the input is proprietary or indistinguishable from the trademark in customer’s
minds. This can be seen in table 16.4, which shows the frequency with which franchi-
sors required that franchisees buy some inputs from them in 1988 and 1989, the only
years for which information on such requirements is available for a large number of
franchisors (see Blair and Lafontaine 2005, ch. 6). The data indicate that franchisors
involved in various types of retail activities frequently impose input purchase require-
ments. Franchisors that provide mostly services, on the other hand, typically do not
require that franchisees buy inputs from them. What may seem surprising, however,
is the frequency of purchase requirements in the restaurant and fast-food sectors.
Michael (2000) examined the use of tying in these sectors, using the franchise disclo-
sure documents of 100 different restaurant and fast-food franchisors. He found that 30
of them required franchisees to purchase some product from the franchisor. Among
the 30 firms with purchase requirements, on average the value of required purchases
represented about 8.4% of all franchisees’ wholesale purchases. Moreover, consistent
with the arguments above, firms with the largest proportions of purchase require-
ments tended to sell only proprietary products, such as batter for pancake houses or
ice cream for family restaurants (e.g., Brigham’s and Howard Johnson respectively).
Given that a consequence of the Chicken Delight decision was to rule out one of the
“per-unit” type of mechanism by which franchisors could extract franchisee rent, it
would be expected to lead to an increase in reliance on royalty rates and advertising
fees by those franchisors who are constrained by this ruling. And indeed, the data in
Blair and Lafontaine (2005, ch. 3) show that royalty rates are lower for business-format
franchisors involved in retail compared to services, which again is consistent with the
idea that in distribution franchises, franchisors extract some profits via markups on the
products they sell to franchisees in a manner similar to traditional franchising.
Table 16.4 Mandatory Purchase Requirements

1988 1989
Number of Number with Number of Number with
Sector franchisors requirement Percent franchisors requirement Percent
Automotive 56 13 23.2 54 14 25.9

Business 96 19 19.8 93 14 15.1
Contractors 18 7 38.9 20 7 35.0
Cosmetic 14 3 21.4 17 4 23.5
Education 8 1 12.5 12 5 41.7
Fast food 119 51 42.9 112 45 40.2
Health and fitness 20 11 55.0 12 6 50.0
Home furnishings 14 4 28.6 14 4 28.6
Hotels and motels 9 1 11.1 5 1 20.0
Maintenance 45 12 26.7 47 16 34.0
Personal services 52 14 26.9 56 14 25.0
Real estate 15 1 6.7 17 5 29.4
Recreation 11 4 36.4 11 5 45.5
Rental 15 2 13.3 18 3 16.7
Restaurants 37 16 43.2 39 18 46.2
Retail food 22 13 59.1 22 12 54.5
Retail other 92 22 23.9 81 24 29.6
Total 643 194 30.2 630 197 31.3
Source: Blair and Lafontaine (2005), c hapter 6.
Like the separate products aspect of tying, market definition issues also have proved
controversial. In particular, a spate of franchise tying suits that occurred in the 1990s
can be traced to a notion of market definition spawned by the Supreme Court’s 1992
decision in Eastman Kodak v. Image Technical Services. This case involved the tie of one
aftermarket product (repair services) to another (repair parts). Specifically, for years,
Kodak sold its proprietary repair parts to independent service organizations (ISOs) so
they could provide maintenance and repair services to owners of Kodak copiers and
micrographic equipment. When Kodak changed its policy and refused to sell its repair
parts to the ISOs, Kodak became the only source of maintenance and repair services to
its end customers. Image Technical Service and 17 other ISOs sued Kodak, alleging that
it had illegally tied its service to its repair parts.
Kodak argued that since it sold its equipment in competition with other manufactur-
ers, it could not have appreciable economic power in the aftermarket for repair parts
(tying good). In essence, Kodak argued that the relevant product market for antitrust
analysis is the primary market for photocopying and micrographic equipment, rather
than the aftermarket for repair parts. The Supreme Court, however, rejected Kodak’s
reasoning and ruled that the relevant market for determining market power is based
on “the choices available to Kodak equipment owners.” Accordingly, it held that the
relevant market was the market for replacement parts for Kodak equipment. Moreover,
since the repair parts were proprietary, Kodak was found to have a market share of virtu-
ally 100%. The Supreme Court concluded that since repair parts for Kodak equipment
are unique (i.e., neither IBM nor Xerox repair parts will fit a Kodak copier), the owners
of Kodak copiers were now “locked in” to Kodak services if they wanted to keep their
copiers operational. The only alternative was to switch to another brand of copier. But
the Court reasoned that the high costs associated with switching prevented this option
from being economically viable and provided Kodak with the power to exploit the
locked-in owners.20
Franchisees employed the lock-in argument to support their claims of illegal tying in
the franchise tying cases of the 1990’s, simultaneously asserting that the market for the
tying product was restricted to the market for the defendant’s franchise, and the market
for the tied product was the market for supplies to a particular franchise system. The
cases also focused on the franchisor’s refusal to approve or allow alternate sources of
supply, or restrictive policies of approving alternate suppliers.
Among these cases, Queen City Pizza, Inc. v. Domino’s Pizza, Inc. (1996, 1997) was the
most influential. Queen City Pizza and 10 other Domino’s Pizza franchisees, along with
the International Franchise Advisory Council, filed suit against Domino’s, alleging vari-
ous antitrust violations, including two tying claims. First, they alleged that Domino’s
illegally tied other ingredients and supplies to the purchase of fresh pizza dough, and
second, they alleged that Domino’s illegally tied ingredients and supplies to the franchise
license itself. Integral to these complaints were the allegations that Domino’s unreason-
ably withheld its approval of alternative sources of supply and provided incomplete
product specifications, thereby eliminating viable competitive sources of supplies to
the franchise system. The net effect was that Domino’s franchisees purchased approxi-
mately 90% of their ingredients and supplies from the franchisor even though Domino’s
typically did not produce these goods; rather, it purchased them from third parties and
resold them to its franchisees.
Interestingly, the court concluded that Kodak was not applicable in the context of
franchise tying suits, and the Queen City litigation ultimately was resolved in favor of the
franchisor. The district court noted that “[t]‌he economic power DPI [Domino’s Pizza
Inc.] possesses results not from the unique nature of the product or from its market
share in the fast food franchise business, but from the franchise agreement.” The Third
Circuit affirmed the lower court’s reasoning, and further noted: “If Domino’s Pizza, Inc.
acted unreasonably when, under the franchise agreement, it restricted plaintiffs’ ability
to purchase supplies from other sources, plaintiffs’ remedy, if any, is not under the anti-
trust laws.” In other words, the court made a distinction between a franchisor’s pre- and
postcontractual market power. This, in our view, is correct.
20 For an analysis of the reasons for vertical restraints by durable good producers, see Blair and
Herndon (1996). It should also be noted that switching to an IBM copier merely locks one in to a different
repair parts supplier. Thus, it does not solve the customer’s problem.
Barkoff (2008) notes that this and other decisions since that time make it unlikely
that franchisees today would be successful in a franchise tying case. And indeed, there
is some evidence that a few business-format franchisors, including Domino’s, have now
put in place extensive distribution systems with the goal of supplying most of the inputs
that their franchisees need. Thus the effect of Chicken Delight seems to have dissipated
in the last decade or two. Although the move from antitrust to contract law has many
advantages, in particular the removal of treble damages, it is not without problems. As
Grimes (1999) points out, a franchisor could collude with a designated vendor (named
in a sourcing requirement), allowing the vendor to charge a high price in return for a
rebate. This could lead the franchisor to search for the highest rebate rather than the best
quality/price package.21 This problem, however, is not resolved under the standard rem-
edy of approved supplier programs proposed in, and largely adopted after, the Chicken
Delight decision unless franchisors are required to approve several suppliers for each
input in each market, a task that is not only demanding, but also unlikely to yield the
kind of purchasing economies that franchisees often seek from their affiliation with a
franchisor.

Resale price maintenance, or RPM, has an even more checkered antitrust history in the
United States.22 Indeed, in 1911 the US Supreme Court declared minimum RPM to be
per se illegal, and in 1968 the Court extended the minimum RPM per se rule to include
maximum RPM. However, in 1997 the Court overruled its 1968 extension to maximum
RPM, and in 2007 it overturned its ban on minimum RPM.23 Nevertheless, since many
states have their own RPM laws, the legal status of minimum RPM in the United States is
far from clear today.
Comparing the United States to the EU, the treatment of maximum RPM was more
stringent in the United States after the Albrecht v. Herald Company decision in 1968. In
its 1997 State Oil Company v. Khan decision, however, the Court returned the antitrust
treatment of maximum resale price fixing to a rule-of-reason standard. This decision,
which for all intents and purposes, permits maximum resale price restraints, has made
the treatment of maximum RPM in the United States closer to that of the EU. On the
other hand, the 2007 Supreme Court decision in Leegin Creative Products, Inc. v. PSKS,
Inc., also moved minimum resale price maintenance to a rule-of-reason standard. This
has widened the gap in policy between the two regions, since minimum RPM remains a
hard core offense in the EU.
The Leegin case involved a manufacturer of leather goods and accessories (Leegin)
and one of its retail distributors (PKSK). Leegin had a policy of refusing to sell its
21
Note that input prices are not stipulated in franchise contracts.
22
For a more general discussion of RPM, see Klein, chapter 12 in this volume.
23 Note that setting a specific price is both minimum and maximum RPM.
products to retailers who priced below its suggested retail prices. When Leegin learned
that PKSK was discounting, it suspended sales to that retailer. In response, PKSK sued
Leegin, alleging illegal RPM. However, PKSK lost its case. The Leegin decision made it
no longer per se illegal for manufacturers and franchisors to impose minimum retail
prices on goods that they sell to franchisees for resale. Nevertheless, individual state
antitrust laws, as well as the hostility of some state attorneys general towards minimum
RPM, can make it difficult for such firms to control downstream prices.24 Furthermore,
since business-format franchisors “sell” intellectual property such as trademarks, rather
than goods, the legacy of Leegin for that sector is unclear.
In general, franchise RPM cases in the United States suggest that franchisors have
been constrained more often by rules against maximum resale price maintenance than
those against minimum RPM. In other words, when franchisors have tried to control
their franchisees’ prices, they have exerted pressure for their franchisees to reduce rather
than increase their prices (see, e.g., Blair and Lafontaine 2007, ch. 7). There are a number
of possible reasons for franchisors’ concern with lower prices. For one, franchisees with
exclusive territories can exercise market power and thus charge prices that are too high
from the franchisor’s perspective per the usual double-margins argument. Moreover,
maintaining a maximum price level might also be a way to overcome demand externali-
ties. Indeed, when brand loyalty is important, franchisees who charge high prices can
damage the brand and thus reduce sales at other establishments as well as their own.
Unlike franchisors, franchisees do not capture this externality. Finally, in some circum-
stances, royalties on sales might lead upstream firms to care more about downstream rev-
enues than downstream profits, which would cause a similar divergence in desired prices.
As with the other vertical restraints, the theoretical effects of RPM are ambiguous.
Unfortunately, given the historically harsh treatment of such practices, it has also been
difficult to examine the effects of RPM, maximum or minimum, empirically. Ippolito
(1991), however, is a rare exception. She examined the population of all 203 reported cases
of resale price maintenance in the United States between 1975 and 1982, a period during
which a fairly broad interpretation of what constitutes RPM was adopted by the courts,
and during which, she argues, the courts adhered quite strictly to the per se standard. She
shows first that vertical restraints are often used together. Firms simultaneously relied
on other vertical restraints in 122 of the RPM cases, most frequently territorial, tying, or
customer restrictions (49, 31, and 32 of the cases respectively). Cases of RPM also often
involved other charges, in particular horizontal price fixing in 30, and refusal to deal in
40 of the cases. In addition, she finds evidence that a nontrivial portion of RPM cases,
namely 65% of all private, and 68% of all public cases in her data, arose in contexts where
products can be classified as complex, new, or infrequently purchased, which are the types
24 Even though, in contrast to federal law, the fair trade laws that were adopted by many states after
the depression allowed minimum RPM, in recent years some states (e.g., Maryland in 2009) have passed
laws that permit a per se challenge to minimum RPM. For a discussion of federal/state conflicts, see
Joseph (2010) and Barkoff (2010) and the references therein. The effect of the change in Maryland has
been analyzed by Bailey and Leonard (2010) and found to be minimal for video games.
of products where the special services theory for RPM is most likely to hold. Another
largely overlapping segment of both private and public cases arose in resale contexts where
dealers can influence the quality of the final good or the customer’s experience in impor-
tant ways. Here again, manufacturer controlled pricing can alleviate the fundamental
principal-agent problem that efficiency motives and organizational economics empha-
size. Yet another set of mostly franchising cases seems well explained by concerns over ver-
tical sales-effort externality problems. She concludes that collusion was not the primary
explanation for the RPM practices that were prosecuted during this period.
To the best of our knowledge, the more recent, changing stance regarding the role of
RPM in franchise and distribution has not led to significant changes in the contracting
practices of franchisors and manufacturers per se. However, there are signs that some
franchisors are trying to assume more control over the prices that their franchisees set.
For example, McDonald’s has removed a statement from its website—a statement that
was quoted in Blair and Lafontaine (2005, ch. 7)—to the effect that franchisees are free
to choose retail prices. For its part, Burger King recently settled a dispute with its fran-
chisees over the maximum prices of some menu items. We believe that, before Khan, the
franchisees in that dispute would have had a stronger hand.
16.3.5. Contract Adaptation in the EU

Despite changes in the antitrust treatment of tying and resale price maintenance over
the last couple of decades, large changes in the form and content of franchise or distribu-
tion agreements have not occurred in the United States. However, some practices and
clauses related to territories and other sources of competition have been expanded and/
or clarified. Similarly, some franchisors have increased the extent to which they provide
inputs to their franchisees.
During the same period, however, more dramatic changes have occurred in the
antitrust treatment of vertical restraints in Europe. After a series of decisions regard-
ing franchise relationships in the late 1980s, the European Commission (EC) adopted
a Block Exemption Regulation on franchise agreements, which took effect on February
1, 1989, and remained in effect until May 2000. It was then superseded by a new 2000
Block Exemption Regulation (BER) on Vertical Restraints. Finally, the 2000 BER
and Guidelines for Vertical Restraints were replaced by new 2010 versions, which are
expected to remain in force until June 2022. This is in sharp contrast to the United States,
where there are no comprehensive guidelines on vertical restraints.25 In what follows,
we briefly summarize the effects of the EU legal changes on franchising and contrast the
treatment of restraints in the EU with that in the United States.
The original Block Exemption on franchise agreements gave franchisors a great deal
of flexibility to impose or rely on exclusive territories, exclusive dealing, tying, and some
25 After the 1985 Vertical Restraints Guidelines were rescinded by the Clinton administration, no new
comprehensive policy document has appeared.

price restraints—but minimum RPM was still not allowed. The BER and Guidelines on
Vertical Restraints are in general stricter, but they do provide a safe haven under which
small firms are exempt. In practice, because most franchisors fall within the safe heaven,
that is, they have less than 30% of the market, as do their franchisees, the effects of the
new Guidelines are likely to be felt most extensively in distribution franchises, such as car,
beer, and gasoline retailing. On the other hand, the goal of opening competition across
markets within the EU led to rules against territorial restrictions that are more stringent
than they used to be for franchise firms, and more stringent than in the United States. In
addition, restrictions on Internet presence and distribution, which are discussed exten-
sively in the latest Guidelines, are now viewed as more strict in the EU. Finally, the EU
Vertical Restraints Regulation includes rules related to post-term noncompete clauses,
or noncompete obligations imposed on a buyer after the termination of a contract with
a seller. The guidelines require that they be “indispensable to protect know-how trans-
ferred by the supplier to the buyer,”26 limited to only the point of sale used during the con-
tract, and no longer than one year. In the United States, there is no consistent noncompete
policy, with some states enforcing, while others do not enforce, such restrictions.
The automobile industry has received particularly close scrutiny from EU competi-
tion authorities. In 1995 the European Commission passed a regulation whose stated
goals were to strengthen the competitiveness of dealers and improve market access to
spare parts for both producers of competing parts, and independent repairers.27 In 2002
it enacted Regulation 1400/2002, a regulation that, among other things, eliminated
exclusive territories and sales targets or quantity forcing. With the exception of certain
hard core practices, however, the 2002 automotive block exemption also created safe
havens for car manufacturers, distributors, and repair shops.
In 2010, a new automotive BER (Regulation No 461/2010) was passed that superseded
the 2002 version. This new BER is generally considered to be less restrictive. In par-
ticular, as of 2013, new car sales, like business-format franchising contracts, were sub-
ject only to the general BER on Vertical Restraints. Repairs, maintenance, and spare
parts—the aftermarket—have been subject to the new automotive BER since 2010, and
are treated somewhat more harshly by said BER. The distinction between the two mar-
kets was made because the primary market was thought to be workably competitive,
whereas problems were perceived to remain in the after market.
We highlight some of the most important differences between the old and new
regimes.28 In the new car market, manufacturers will be able to impose exclusive dealing
restrictions that cover up to 80% of a dealer’s requirements instead of the former limit
of 30%. In addition, the market share thresholds will be 30% for both up- and down-
stream firms, whereas formerly only the manufacturer’s share was considered. Also, as
26 European Commission, Guidelines on Vertical Restraints (2010/C130/01) in Official Journal of the
European Union No. C 130, p. 1, of May 19, 2010.

27 See European Commission, General Directorate IV—Competition, Distribution of Motor Vehicles
(Regulation (EC) No. 1475/95 published in the Official Journal, L 145 of 29 June 1995), Explanatory
Brochure.
28 For more on the new block exemption for autos, see Zuehlke and De Stefano (2010).
long as the market share thresholds are met, it will be possible to impose clauses that
prevent dealers from opening new dealerships. Exclusive territorial clauses are still pro-
hibited. In the aftermarket, authorized repair networks are unapt to benefit from the
block exemption because markets are treated as brand specific, and thus market shares
more easily exceed the thresholds. Moreover, technical information must now be made
available to independent repairers; manufacturers are not allowed to use warranties to
prevent owners from using independent repair service providers; and spare parts must
be freely available to all service facilities.
Not surprisingly, given these changes in policy, the automobile sector also has been
the subject of empirical studies. It should come as no surprise, for example, that franchi-
sors and dealers have adapted their behavior in response to changes in their environ-
ment. Of particular interest, we note again that public policy towards vertical restraints
in franchise contracts can have unforeseen consequences. This is true because franchi-
sors have many tools at their disposal to control franchisees, and so banning one practice
can lead to the adoption of others. Thus Zanarone’s (2009) study of how some franchi-
sors adapted to changes in the 2002 EU law towards vertical restraints shows that, once
exclusive territories became illegal, the number of car manufacturers that imposed price
ceilings, required dealers to abide by a variety of explicit standards, and required dealers
to contribute to an advertising fund that the manufacturer controlled, went up signifi-
cantly. He explains the latter two changes as direct responses to reduced dealer incen-
tives to advertise and provide presales services. As for price ceilings, he argues that they
may have become necessary to prevent dealers from circumventing quantity floors—
something he suggests they could do by selling aggressively outside their territories
while maintaining supranormal prices in their own, perhaps isolated, markets.
Nurski and Verboven (2011) studied the likely effect of the change in regulation in
the new car market in Belgium. They found that a ban on exclusive dealing would
benefit consumers in this market in that it would favor smaller entrants and provide
buyers with increased spatial availability. They therefore concluded that the European
Commission’s 2010 decision to facilitate exclusive dealing might not have been war-
ranted. Unfortunately, their analyses abstract away from the type of dealer incentive and
cost issues that efficiency arguments for exclusive dealing typically focus on.
Finally, although the EU controls competition policy that affects more than one
member state, individual member states deal with those practices that affect competi-
tion within national boundaries. In that context, the UK Office of Fair Trading (OFT)
recently undertook a major review of the newspaper and magazine distribution
industry. In 2009, however, it announced that it would not refer the sector to the UK
Competition Commission. In other words, it did not find sufficient evidence of compet-
itive harm to pursue a case. A key reason for this was that developments benefiting con-
sumers had come about from the review and self-assessment of distribution agreements
undertaken by members of the industry. However, the sector was not given a clean bill of
health, and the OFT did not rule out the possibility of further review.
The OFT ruling is consistent with the empirical findings of Ferrari and Verboven (2011)
concerning Belgian magazine distribution. In particular, those authors find evidence
suggesting that a government ban on restrictive licensing or on uniform wholesale prices

would have little effect on upstream profits. They conclude that the rationale for those
practices is unlikely to be anticompetitive, and should be sought elsewhere.
16.4. Conclusion
The extent to which federal antitrust law in the United States is binding on the nature of
franchise contracts is surely less today than it was in the 1970s and 1980s. To illustrate,
Barkoff (2008) notes that in the mid-1970s:
The need for the franchise lawyer to be educated in matters of antitrust law had been
exacerbated by the antitrust decisions in the 1960’s . . . today one would not be wrong
to describe antitrust law as being almost irrelevant with respect to the franchise com-
munity. A slight exaggeration? Yes, but not that far off. (Barkoff 2008, 1)
In particular, with the 1997 State Oil v. Kahn decision, maximum RPM—the type of
price restraint that franchisors have tended to impose—has been returned to the rule of
reason. Since, in a competitive environment, retail price is no higher under maximum
RPM than it would be otherwise,29 most economists believe that this restraint should
not be per se unlawful. Similarly, in the years since the 1971 Chicken Delight tying deci-
sion, there has been a clear trend away from the logic in that case. In particular, in one
important subsequent decision, the Queen City Pizza v. Domino’s Pizza Inc., which was
specific to franchising, the US Court of Appeals for the Third Circuit rejected the logic
proposed in the then recent Kodak case. Instead it ruled that as long as the input pur-
chase requirements imposed by a franchisor were explicit, described in its franchise
contract, such requirements would not be considered a violation of antitrust laws.
While US federal antitrust regulation seems to have much less impact on fran-
chise contracts today, state antitrust laws may still be relied upon in some contexts.
Furthermore, state laws governing the distribution of goods such as cars, gasoline, and
beer continue to affect the types of vertical restraints that can, or must, be applied to
these relationships.
The conflict between federal and numerous state antitrust laws, as well as cross-state
variation in the standards of enforcement, are problems that continue to inhibit the
rational development of franchising in the United States. This is the case because many
franchisors operate nationally, and are thus subject to regulation by numerous jurisdic-
tions. Given the division of power in the United States, we are not optimistic that fed-
eral/state harmonization will occur in the near future.30
29
In an oligopoly, however, maximum RPM can actually raise retail prices (see Perry and Besanko 1991).
30
Of course, many US franchisors also operate internationally, and harmonization across countries is
even less likely.
In the EU, meanwhile, the new block exemption and vertical restraints guidelines put
in place in 2000 and then in 2010 have modified the treatment of franchise contracts,
especially clarifying issues surrounding the use of exclusive territories and Internet dis-
tribution for firms operating in the Union. But here again, individual country antitrust
laws can affect what can be included in distribution and franchise contracts, or even the
existence of certain types of contracts,31 and how these relationships work.
Experimentation is part and parcel of the evolution of any mode of organization, and
franchising is no exception. As a business organization, franchising has evolved, and will
continue to evolve. Presumably, what works well is retained and refined and what does
not work well is discarded in an evolutionary manner. The changing legal environment
has been one of the factors leading to changes and refinements. For example, the strat-
egy initially adopted by Chicken Delight, which was to earn income by requiring fran-
chisees to purchase inputs exclusively from the franchisor instead of relying solely on a
sales-based royalty or fixed fee, was found in violation of US antitrust laws. As a result
of this decision, business-format franchisors moved away from input purchase require-
ments toward approved supplier clauses and adopted approaches where the franchisor
is available as a potential, but not a required, source of supplies. This same decision also
implied that business-format franchisors would move toward franchise fees and royalties
on sales as their main sources of income. However, in recent years, the increased toler-
ance of antitrust authorities towards requirements stipulated in franchise contracts has
led at least some franchisors to increase the role they play in the sourcing of inputs for
their franchisees. Similarly, disputes over territorial rights in the quick-service restaurant
sector and in hotel chains in the 1990s led many of the firms in those industries to include
much more detailed territorial definitions in their contracts. Franchisors also have devel-
oped more systematic review processes for new sites and adopted policies for allocat-
ing new units to owners of nearby outlets, thereby resolving at least part of the conflict.
In industries where encroachment through alternative channels (e.g., Internet sales) has
been more problematic, a number of franchisors have worked on ways to channel part of
the sales or profits to local franchisees, while others have opted to stay out of the alterna-
tive channels. In all cases, franchise contracts, and hence franchisor-franchisee relation-
ships, have been modified as the institutional and legal environments have evolved. This
process is a slow one, but we believe that the trend towards treating vertical issues within
the context of contract rather than antitrust law is here to stay.32 We view this as a positive
development, one that allows disputes between franchisors and franchisees, that is, par-
ties to a contractual relationship, to be brought forth and decided in the United States by
reference to actual, rather than treble, damages. Nevertheless it is not a panacea as some
postcontract issues may still raise legitimate antitrust concerns (see also Barkoff 2010).
31 See Slade (1998) for an analysis of a UK decision that limited dual distribution in beer retailing, a
common practice in Europe that is illegal under post-Prohibition state laws in the United States.
32 In some sense the treatment of vertical restraints has come full circle: for example, the first tying
case was decided under patent, not antitrust law. See Hovenkamp and Hovenkamp (2010).
Acknowledgments
This chapter borrows from some of our joint work, especially Lafontaine and Slade
(2008 and 2013), as well as from Blair and Lafontaine (2005).
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PA R T I I I
C OL LU SION A M ON G
O ST E N SI B L E
C OM P E T I TOR S
CHAPTER 17
C A RT E L S A N D C OL LU SION
Economic Theory and Experimental Economics
JAY PIL CHOI AND HEIKO GERLACH
17.1. Introduction
The essence of market competition is to attract customers by delivering better and less
costly products, and the goal of antitrust laws is to preserve competitive market environ-
ments. Collusion is an agreement—tacit or explicit—among horizontal competitors to
suppress competition by coordinating their prices and quantities. This coordination is
intended to raise prices and earn higher profits at the expense of consumers. Given this
intention, collusion is deemed to be per se illegal in the United States, EU, and virtu-
ally every country with antitrust laws, and it is considered the top priority in antitrust
enforcement.1 For instance, Section 1 of the Sherman Act in the US states:
Every contract, combination in the form of trust or otherwise, or conspiracy, in
restraint of trade or commerce among the several States, or with foreign nations, is
declared to be illegal.
Similarly, Article 101 of the Treaty on the Functioning of the European Union (2009)
declares all agreements between undertakings that “have as their objective or effect
the prevention, restriction or distortion of competition” to be “incompatible” with the
European Union’s internal market. This chapter provides a selective review of economic
theory and experimental evidence on cartels and collusion. In particular, we highlight
1 US Supreme Court justice Antonin Scalia designates collusion as “supreme evil of antitrust”
(Verizon Communications v. Law Offices of Curtis V. Trinko, 540 U.S. 398, 408 (2004)) and the European
commissioner for competition Mario Monti calls cartels “cancers on the open market.”
416 Jay Pil Choi and Heiko Gerlach
the role of incentives in collusion and cartel formation, and we identify conditions that are
conducive to collusive behavior.2 We then discuss enforcement against collusion with a par-
ticular focus on the recent work on leniency programs and cartel screening. Finally, we look
at experimental evidence on cartel formation and the effects of competition policy.
17.2. Theory of Collusion
As emphasized by Whinston (2006), one implication of the illegality of a collusive

agreement is that it is not enforceable in the court. When a party to the agreement does
not honor the contract and deviates, other parties cannot rely on the court because such
an attempt puts them at the risk of being prosecuted. Thus, any (tacit or explicit) col-
lusive agreement should be self-enforcing. That is, it should induce cartel members to
adhere to the agreement without the intervention of the court. The following illustrates
a canonical model of self-enforcing collusion in repeated games using a very simple styl-
ized Bertrand price competition model. This model is then used as a benchmark to dis-
cuss the factors that facilitate or hinder cartel formation.
Suppose that there are two firms in the market that produce homogenous products
with a constant marginal cost of c. If they set the same price, firms share the market
demand equally at the given price. If one firm sets a price lower than the other, the firm
with a lower price attracts all consumers. In a static, one-off competition between firms,
it is easy to show that the only equilibrium is for both firms to set their prices at the com-
mon marginal cost of c. However, if the game is played repeatedly over time, firms can
potentially sustain collusion by punishing any deviating firms with price wars.
To see this, consider the following strategy in an infinite horizon model with the stage
game described above being played in each period.3 Both firms set the monopoly price
pm and each receives half of the monopoly profit Πm in every period t as long as pm has
been played by both firms up to that time period. Otherwise, they set the price equal
to the static Nash equilibrium price of c that leads to a profit of zero.4 Now consider
2
The economics literature has been very successful in characterizing the set of possible agreements that
are sustainable as a collusive outcome, but it is more or less silent on how a particular agreement is reached.
3 Collusion requires an infinite horizon or stochastic termination of the game. Otherwise, the logic of
backward induction implies that we have a competitive outcome in each period as long as the stage game
has a unique Nash equilibrium.
4 This punishment is credible in the sense that given the other firms enact the punishment, an
individual firm has no incentive to deviate. However, firms might have a collective interest to avoid costly
punishment and renegotiate the agreement towards a Pareto-superior continuation of the game. If such
renegotiation takes place, the initial threat of punishment is eroded and the strategy is not sustainable.
Farrell and Maskin (1989) elaborate this point and propose a renegotiation-proof equilibrium
instead. In such an equilibrium firms use asymmetric punishment strategies that are immune to
Pareto-improving renegotiation. In this vein, McCutcheon (1997) argues that cartels are more likely to
Cartels and Collusion 417
conditions under which this strategy can be sustained as a subgame perfect equilib-
rium.5 Each firm maximizes the present discounted value of its profits. Let δ denote the
discount factor.
The optimal deviation strategy is one that just undercuts the monopoly price, thereby
capturing the whole monopoly profit in the current period, but receives zero profit from
the next period on. The incentive compatibility (IC) condition that such a deviation
is unprofitable and that each firm charges pm, assuming that the other one also plays
according to the putative equilibrium strategy, is given by
Πm Πm
+ (δ + δ 2 + δ 3 + ⋅⋅⋅) ≥ ∏ m + 0(δ + δ 2 + δ 3 + ⋅⋅⋅) (IC)
2 2
This condition can be rewritten as
LL =
∏ m
2 3
(δ + δ + δ + ⋅⋅⋅) =
δ ∏
m
≥
∏ m
= SG .
2 1− δ 2 2
LL represents the discounted long-term loss from a deviation due to the breakdown of
the cartel. SG represents the short-term gain from attracting 50% of the total demand at
the monopoly price. The IC condition is satisfied if and only if δ ≥ ½. That is, if firms are
sufficiently patient and care about future profits enough, the LL outweighs the SG and
firms are not willing to deviate from collusion.
17.3. Factors Facilitating Collusion
There is a rich literature extending the canonical model above to explore conditions
under which collusion is facilitated. In the following we present a selective discussion
with a focus on more recent contributions to this literature.
form if the cost of negotiation is neither too high nor too low. For low values, firms are unable to sustain a
renegotiation-proof equilibrium, whereas for high values, the initial cartel meeting would be too costly.
5 The folk theorem states that any feasible payoffs between zero and the fully collusive outcome can be
sustained as an equilibrium in this game if the discount factor is sufficiently close to 1. We focus on the most
collusive (symmetric) equilibrium. See Fudenberg and Maskin (1984) for more details on the folk theorem.
17.3.1. Number of Firms, Symmetry, and Concentration

We can easily generalize the basic model to explore the effects of the number of firms on
collusion incentives. Let there be n firms in the market with the number of firms repre-
senting the degree of market concentration. Then, the IC condition becomes
LL(n) =
∏ m
2 3
(δ + δ + δ + ⋅⋅⋅) =
δ ∏
≥
(n − 1)∏ m
≥
(n − 1)∏ m m
= SG(n).
n 1− δ n n n
This implies that the discount factor required for collusion is given by δ ≥ δ* (n) = n /
(n − 1). Observe that δ*(n) is increasing in n; it is more difficult to sustain collusion with
a larger number of firms. More cartel members reduce the collusive profit per firm. As a
result, the temptation to deviate is higher because the short-term gains from deviation
SG(n) increases while the long-term loss from deviation LL(n) decreases.
So far we have just assumed that there is an agreement in place and focused only on
incentives to carry out the agreement among participants. If all firms are symmetric, the
most natural agreement point is a symmetric outcome that would maximize the indus-
try profit. However, if firms are different in important dimensions (such as capacities,
cost structures, and product characteristics), it may not be clear how the market should
be divided among them, which may make a mutually acceptable agreement difficult to
achieve. In addition, even if they can agree on an outcome, asymmetry restricts the set of
sustainable collusive outcomes due to differential incentives to deviate. Compte, Jenny,
and Rey (2002), for instance, consider a model of collusion in which firms differ only in
their capacities. They show that the firm with the largest capacity has the highest incen-
tive to deviate from collusion, while the ability of firms with small capacities to punish
such deviation is limited. A more equal distribution of capacities makes firms’ incen-
tives more aligned and facilitates collusion.6
17.3.2. Demand Conditions

We have considered a stationary demand that does not change over time. The evolution
of demand can have effects on the sustainability of collusion. If firms are operating in
6
Vasconcelos (2005) derives a similar result showing that collusion is easier when capital is
transferred from the largest firm to the smallest firm. See also Bos and Harrington (2010), who analyze
the effect of firm asymmetry while endogenizing the composition of a cartel rather than assuming an
all-inclusive cartel. They show that there exists a stable cartel that involves only the largest firms, while
firms with sufficiently small capacity are not cartel members. In such a case, cartel members set a price
that serves as an “umbrella,” with non-cartel members undercutting the cartel price and supplying at
their capacity.
a growing market, it is easier to sustain collusion because future profits become more
important in such a market. Mathematically, the effect of a growing market is equivalent
to an increase in the discount factor if demand expansion is modeled as a scale param-
eter of the demand function. Similarly, collusion becomes more difficult to sustain if the
market demand is declining over time.
Rotemberg and Saloner (1986) show that if demand is fluctuating over time, it is
more difficult to sustain collusion in high-demand states. They consider a model
with independent and identically distributed demand shocks. The implication of
this assumption is that the loss from deviation is the same regardless of the cur-
rent demand state. However, the short-term gain from deviation is higher when
the demand state is higher. As a result, to maintain IC in the high-demand states, it
may be necessary to collude at a price less than the full monopoly price. Haltiwanger
and Harrington (1991) extend the analysis of fluctuating demand to allow for cycli-
cal demand pattern. With a cyclical demand pattern, the severity of punishment
for deviation depends on whether the current period is in the up or down phase of
the demand cycle, whereas the temptation to cheat depends on the current level of
demand. This implies that for a given level of demand, collusive prices tend to be
higher in booms than in recessions.7
17.3.3. Multimarket Contact

If the same set of firms competes in several markets, they may recognize their interde-
pendency better and refrain from vigorous competition. The idea that contact across
markets can affect the degree of sustainable collusion was first proposed by Edwards
(1955, 337). He reasoned that firms that compete against each other across multiple
markets “may hesitate to fight local wars vigorously because the prospects of local gain
are not worth the risk of general warfare.” Bernheim and Whinston (1990) formalize
Edwards’s idea that the multiplicity of contacts among conglomerate firms may induce
“mutual forbearance” and “blunt the edge of their competition.” They show that mul-
timarket contacts can be used as a mechanism to pool the incentive constraints across
markets. When there is slack in the incentive constraint in one market, the pooling of
the incentive constraints allows the slack to be transferred to the other market where
the constraint is binding, thereby aiding collusion in the market with the binding
constraint.
To illustrate the idea of multimarket contact, consider two firms, 1 and 2, competing
in two markets, A and B that are unrelated in other aspects. Let SGi be the short-term
7
Bagwell and Staiger (1997) define a boom as a sequence of periods of high demand growth and a
recession as a sequence of periods of low demand growth. They show that collusive prices are weakly
procyclical when growth rates are positively correlated through time and countercyclical when there is a
negative correlation.
gains from deviating from a collusive agreement and LLi be the long-term losses from
such a deviation in market I = A, B. Then, a necessary and sufficient condition for a col-
lusive agreement to be sustainable in market i is
LLi ≥ SGi .
Now consider a situation in which the following conditions hold: LLA > SGA and LLB <
SGB. This implies that if these two markets are considered separately, a collusive agree-
ment is sustainable in market A, but not in B. Suppose firms realize the interdependency
and punish in both markets when there is a deviation in any market. Such a punish-
ment strategy entails that the optimal deviation is to cut prices in both markets. In turn,
the overall IC condition can be satisfied if we pool the two individual IC conditions
together, that is,
LLA − SGA ≥ SGB − LLB .
Collusion in both markets is sustainable if the slack in the incentive constraint of market
A (LLA – SGA) outweighs the gains from deviating in market B (SGB − LLB). In other
words, multimarket contact allows shifting slack collusive rents from the more collu-
sive market to the less collusive market B.8 This logic also implies that if both markets
are symmetric, multimarket contact is irrelevant. Several papers have identified fur-
ther benefits of multimarket contact, which do arise with symmetric markets. Spagnolo
(1999) shows that when market profits enter a concave objective function, multimarket
contact may be beneficial, as it reduces the short-run gains from deviation and increases
the value of future losses compared. Matsushima (2001) points out that with imperfect
monitoring multimarket contact might have a procollusive effect as it makes the detec-
tion of deviation easier. Choi and Gerlach (2013) consider demand linkages between
markets and derive that collusion in one market is easier (harder) to sustain when prod-
ucts are substitutes (complements).
17.3.4. Imperfect Observability and Monitoring

Successful collusion requires that noncompliance is observed and punished. When each
firm’s pricing or output decisions are transparent and observable, any firm’s deviation
from the agreed strategy can be easily detected and disciplined appropriately. In the
absence of perfect monitoring, collusive agreements tend to break down due to firms’
8 If the pooled IC constraint is not satisfied, the optimal strategy is to treat each market separately and
collude in only one market where the IC constraint is satisfied. See Bernheim and Whinston (1990) for
more details.
incentives to engage in secret price cuts (Stigler 1964). Green and Porter (1984) formal-
ize this problem in a setting with imperfect public monitoring.9
While firms are unable to directly observe the industry demand level and the quanti-
ties set by their rivals, the resulting market price is publicly available. In such a scenario,
firms face an inference problem when confronted with low market prices. A low market
price can arise due to either a negative demand shock or a quantity expansion by a cartel
member. If firms attribute low prices to quantity deviations and engage in a grim strat-
egy of permanently reverting back to competitive Cournot behavior, they run the risk of
being stuck with low prices even if no one has engaged in secret price cuts in the event of
a negative demand shock. On the other hand, if firms give the “benefit of the doubt” and
attribute low demand to a negative demand shock, each firm will have an incentive to
engage in secret cartel deviations, and collusion will not be sustainable.
Green and Porter (1984) show that the optimal collusive strategy may entail the use of
a trigger price to which firms compare the current price before choosing their quantity.
If the market price falls short of this trigger price, firms revert to competitive quanti-
ties for a fixed amount of time before resuming collusion until the next trigger and so
on.10 The optimal collusive strategy prevents deviations by balancing the short-run gains
from overproducing with the expected future loss from triggering price wars (periods
of low prices due to competitive quantities). On the equilibrium path, price wars occur
in low-demand periods although all firms adhere to their collusive strategy. This is in
sharp contrast to the perfect monitoring case where a credible threat of punishment is
sufficient to deter deviation from the collusive equilibrium. In Green and Porter (1984),
costly price wars constitute a necessary evil for the cartel to sustain collusion when
direct information on its members’ strategies is unavailable.11 In turn, the occasional
breakout of price wars should not be construed as a sign of unsustainability of collusion.
Sannikov and Skrzypacz (2007) consider a similar framework where market price
information arrives continuously and depends on the total supply level plus a random
shock. They show that collusion with imperfect public monitoring is impossible when
9
In models with public monitoring, firms receive public signals generated by price or output choices.
Hence, the continuation play can always be constructed as an equilibrium of the repeated game, and the
dynamic programming technique of Abreu, Pearce, and Stacchetti (1986, 1990) and Fudenberg, Levine,
and Maskin (1994) can be applied to establish folk theorems. If, by contrast, firms receive private signals,
this recursive structure is destroyed. In models with private monitoring, communication can generate
a publicly observable history on which the continuation play can be conditioned and the recursive
structure recovered (Kandori and Matsushima 1998; Compte 1998).
10 Green and Porter (1984) considered a restricted set of these “trigger strategy” profiles with a
predetermined T-period punishment phase. Abreu, Pearce, and Stacchetti (1986) provide a more general
analysis that eschews the restriction to trigger strategy profiles. They characterize optimal pure strategy
symmetric equilibria, in which the most collusive solution is described by two regions in the signal space
and two actions. Thus, the duration of the punishment phase is stochastic rather than fixed at T as in
Green and Porter (1984).
11 Green and Porter (1984) use strongly symmetric equilibria, in which firms only recur to symmetric
stage game action profiles. By contrast, Fudenberg, Levine, and Maskin (1994) show that if the cartel can
play asymmetric equilibria, the cost of inefficient price wars can be reduced. Indeed, the Folk Theorem
applies and monopoly profits are attainable in the limit as the firms become more patient.
firms’ interactions become too frequent (or, equivalently, firms’ production becomes
more flexible). More generally, they derive that the frequency of market interaction has a
nonmonotonic effect on collusion; first it increases and then decreases collusive payoffs.
As the time between actions increases, the gains from deviation in a given period go up,
which hurts collusion. By contrast, when frequency increases (and time between actions
decreases), firms look at noisier information to infer deviation and trigger price wars
too often. Hence, collusive payoffs first increase and then decrease with the frequency
of interaction. Harrington and Skrzypacz (2007) consider a model in which firms are
unable to observe other firms’ prices and individual demand shocks whereas market
shares (out of the inelastic total demand) are publicly available. They consider market
share trigger strategies and show, among other things, that collusion cannot be sustained
if firms recur to symmetric punishments. The intuition is that if one duopolist cuts his
price, he increases the probability that his market share exceeds the trigger value, but at
the same time this reduces the probability that the rival’s market share triggers the pun-
ishment phase. By contrast, collusive equilibria with asymmetric punishments, such as
buy-in or buy-back agreements, are sustainable. Harrington and Skrzypacz (2011) fur-
ther consider the effectiveness of such asymmetric punishments in an informational
setting in which both firms’ prices and quantities are private information, but players
engage in costless communication on their sales and make side payments based on the
reports in the form of guaranteed buy-ins or buy-backs. The properties of the equilib-
rium they characterize fits broadly with the collusive mechanisms adopted in a number
of prominent recent cartel cases such as in the citric acid, lysine, and vitamins markets.
17.3.5. Incomplete Information and Communication

A recent related strand of the literature analyzes cartel formation and organization when
firms hold asymmetric information but are able to observe rivals’ strategies. The main
focus of these papers is to characterize the optimal cartel organization with respect to
pricing and punishment, as well as to discuss the role of communication among the car-
tel members. Athey and Bagwell (2001) consider a repeated game duopoly with inelas-
tic demand in which firms’ costs can either be high or low, with independent draws in
each period. Each firm knows its own cost realization but not the cost level of its rival.
Athey and Bagwell characterize an asymmetric perfect public equilibrium that imple-
ments first-best profits and induces firms to truthfully communicate their cost level.
Productive (firm) efficiency is achieved by allocating reporting high-cost firms a higher
future market share. In a similar setup, Athey, Bagwell, and Sanchirico (2004) consider
a continuum of cost types and show that the optimal strongly symmetric perfect public
equilibrium sacrifices productive efficiency by using a rigid, nonsorting price scheme
in order to deter high-cost firms from mimicking low-cost types. Athey and Bagwell
(2008) consider persistent cost shocks to firms and derive some interesting results.
When the initial distribution is log-concave and shocks are perfectly consistent, then
the equilibrium that maximizes the cartel’s ex ante profits is again pooling. That is, firms
share the market at the consumer’s reservation price. When log-concavity does not hold,
equilibria with an initial learning phase and lower prices might be better than pooling.
By contrast, when persistence is not too high relative to firms’ patience, firms achieve
the first-best equilibrium with productive efficiency as in Athey and Bagwell (2001).
Hanazono and Yang (2007) and Gerlach (2009) consider optimal collusion when
firms receive private information about the industry demand level. The first paper shows
that in the absence of communication, the optimal cartel organization might imply
price rigidity. The second paper allows for communication among firms and demon-
strates that a collusive scheme in which firms only communicate in high-demand peri-
ods approaches the first-best cartel organization when the signal noise goes to zero.
17.3.6. Vertical Mergers and Restraints

The nature of vertical relationships and contracts between upstream and downstream
firms can have important effects on collusion. In fact, many cases of collusion have
involved intermediate goods industries, while the bulk of the theory on collusion con-
cerns firms selling to final consumers. To address this issue, Nocke and White (2007)
examine collusion among upstream firms selling to strategic downstream firms that are
competitors to each other. In particular, they investigate the impact of vertical merg-
ers on the upstream firms’ ability to collude. They identify several channels through
which vertical merger affects collusion in a setting where upstream firms compete in
two-part tariffs for the business of downstream firms. First, vertical mergers give rise to
an outlets effect: the deviation profits of cheating unintegrated firms are reduced as the
downstream affiliates of their integrated rivals internalize the effects of their purchase
decisions on their own upstream firms’ profits and refuse to accept the offer of a devi-
ating firm. As a result, collusion is facilitated with vertical merger. However, there is a
countervailing punishment effect: the merged entity suffers less from punishment when
it deviates compared to a stand-alone upstream firm, because its downstream firms may
earn positive profits in the punishment phase. Thus, the net effect of vertical merger on
collusion by upstream firms depends on the relative magnitude of these two counter-
vailing forces. However, Nocke and White show that the outlets effect in general domi-
nates the punishment effect and vertical merger tends to facilitate collusion.12
Vertical restraints that limit competition among retailers can have a facilitating effect on
upstream collusion. For instance, Rey and Stiglitz (1995) show how exclusive territories can
serve as a mechanism to reduce interbrand competition at the upstream level. In the con-
text of a repeated game, Jullien and Rey (2007) formalize the idea that resale price mainte-
nance (RPM) can help upstream firms collude. They consider a market environment that
12
The baseline model of Nocke and White (2007) assumes that upstream two-part tariff offers and
downstream retail prices are set simultaneously. They also consider an alternative timing in which
downstream firms set their retail prices after they have observed upstream offers, and identify two
additional effects that further facilitate collusion: the reaction effect and the lack-of-commitment effect.
is subject to local demand and cost shocks, which requires retail prices to respond to retail-
ers’ information about the relevant shocks for efficiency. RPM thus entails efficiency loss
and increases the short-run gains from deviation, but makes the detection of deviations
easier. Jullien and Rey characterize conditions under which RPM can facilitate collusion
and show that it reduces total welfare whenever firms choose to adopt.
17.4. Cartels and Antitrust

Enforcement
Given the substantial body of literature on identifying factors that facilitate or hinder the
formation of cartels, it is somewhat surprising that until recently there has been very little
research devoted to the effects of an active competition policy against cartels. The two main
weapons of antitrust authorities in the fight against cartels are leniency programs and sur-
prise inspections (“dawn raids”) (OECD 2003). Leniency programs promise a reduction in
government fines in exchange for direct evidence from cartel participants. Direct evidence
includes statements or documents explicitly detailing the agreement and identifying the
parties to it. Such direct evidence is typically sufficient to convict the cartel. Surprise inspec-
tions are based on cartel screening, which involves the collection of circumstantial evidence
from market observation or buyers’ complaints. When the antitrust authority reaches an
evidence level that justifies further investigation, it can trigger dawn raids to search firms’
headquarters for more evidence to convict the cartel. In most jurisdictions, circumstan-
tial evidence is not sufficient to prosecute a cartel but can be successfully used if there is
additional evidence that firms communicated or reached an agreement otherwise. In what
follows, we first review the recent theoretical literature on the effects and effectiveness of
leniency programs. We then canvas different strands of literature related to cartel screening
and cartel behavior in the presence of an antitrust authority.
17.4.1. Leniency Programs

A corporate leniency program offers reduced penalties to cartel members in exchange
for revealing direct evidence and cooperating with the antitrust authority during the
prosecution phase. In practice, the designs of leniency programs differ with respect to
(1) whether leniency is given before and/or after the launch of an investigation, (2) the
amount of leniency for the second and third firm to come forward, (3) minimum evi-
dence disclosure standards, (4) exclusion of cartel ringleaders, and (5) the existence of
individual leniency programs.13
13 See Spagnolo (2008) for a comprehensive survey and a detailed discussion of institutional
differences across different leniency programs.

The analysis of leniency programs in antitrust follows and builds on the literature
on self-reporting and general law enforcement. Kaplow and Shavell (1994) and Malik
(1993) analyze the optimal design and the efficiency of self-reporting schemes. An indi-
vidual violator has an incentive to self-report his harmful act if the authority proposes a
reduced sanction that equals (or is slightly less than) the expected value of not reporting,
which is the (full) stipulated sanction times the probability of apprehension and pros-
ecution. This policy ensures that individuals who commit the act self-report in equilib-
rium, whereas the authority audits nonoffenders with a positive probability. Thus, for a
given audit probability, self-reporting permits the authority to save on costly auditing,
while the individual’s expected return from the act and deterrence are the same as with-
out a self-reporting policy. The use of self-reporting thus strictly increases welfare.14 The
most important difference between this literature and the analysis of leniency policies in
antitrust is that cartels, by definition, are multiagent crimes and require self-enforcing
cooperation to prevent opportunistic deviation by individual firms. Hence, the analysis
of leniency programs in antitrust requires a dynamic or repeated game framework that
accounts for (1) the cartel members’ incentives to adhere to the cartel strategy, (2) the
incentives to self-report, and (3) the interaction between the two sets of incentives.15
The antitrust literature has identified three basic effects of leniency programs on car-
tel sustainability and self-reporting incentives of cartel members. To illustrate these
effects, consider the following simple example. Suppose a two-firm cartel has broken
up and both firms hold incriminating direct evidence they could present to the antitrust
authority. The antitrust authority has a simple leniency policy in place. The first firm to
present evidence that leads to the prosecution of the cartel receives a reduced fine F − L,
whereas the other cartel member pays the full fine F > 0. The policy parameter L ≥ 0
measures the amount of leniency granted by the authority. If both firms apply simulta-
neously for leniency, each firm receives the reduced fine with probability ½. If no firm
applies, the antitrust authority uses its circumstantial evidence and is able to convict
the cartel with probability p, in which case firms pay the full fine F. Independent of the
leniency program, firms occur a cost of D if and only if they are convicted. This cost rep-
resents damage payments to customers, criminal sanctions for the management, and/or
reputational loss. The strategic situation for the firms can be represented in the normal
form shown in figure 17.1.
14 Innes (1999a, 1999b) extends the framework and shows that self-reporting has a positive effect
on ex post violator remediation. Innes (2001) allows violators to engage in avoidance activities and
demonstrates that self-reporting is beneficial since it reduces the wasteful cost of avoidance. Gerlach
(2013) considers the case where the authority is unable to commit to an investigation effort and shows
that leniency programs are efficient if and only if the harm of the act is not too large.
15 Leniency programs are also related to the literature on plea bargaining and in particular
multilateral plea bargaining (Kobayashi 1992). Plea bargaining occurs after the start of an investigation,
whereas leniency policies aim to induce spontaneous self-reports of cartels. Leniency programs also
guarantee automatic leniency, whereas the amount of amnesty in plea bargaining is uncertain and
depends more closely on the evidence held by the antitrust authority.
Firm 2
apply not apply
apply –D–F+L/2, –D–F+L/2 -D-F+L, –D–F

Firm 1
not apply –D–F, –D–F+L –p(D+F), –p(D+F)
FIGURE 17.1 The Self-Reporting Game with Leniency
Expected sancation p(D+F)
D+F-L/2
3
D+F-L
1
p
1-L/(D+F) 1-L/[2(D+F)]
FIGURE 17.2 The Effects of Leniency on Self-Reporting and Expected Sanctions
Note that (apply, apply) is always a Nash equilibrium of this game. Given that the rival
applies for leniency and the cartel is convicted, not applying would mean that the firm
forgoes the opportunity to race for the fine reduction. There is a second Nash equilib-
rium (not apply, not apply) if p(D + F) ≥ D + F − L or
L ≤ (1 − p)(D + F ) or p ≤ 1 − L / (D + F ). (LP)

Firms can sustain an equilibrium with no self-reporting if and only if the fine reduction
proposed by the leniency program is less than the expected fine savings from concealing
in the hope that the antitrust authority is unable to convict the firms.
Figure 17.2 compares the expected sanctions of the two pure-strategy equilibria
(apply, apply) and (not apply, not apply) as a function of the probability of conviction p.
Clearly, whenever the (not apply, not apply) equilibrium exists and condition (LP) holds,
firms expect lower sanctions in this equilibrium compared to the self-reporting equilib-
rium. Hence, equilibrium selection based on Pareto dominance suggests that firms are
not self-reporting if and only if condition (LP) is satisfied. This leads to a discontinuity
(a jump) in the expected sanctions at parameter values where condition (LP) holds with
equality. For low values of p, the antitrust authority holds little circumstantial evidence
and the firms do not self-report in equilibrium.
Figure 17.2 also shows that for intermediate values of p in [1 − L / (D + F), 1 − L /
(2(D + F))], where self-reporting is the unique equilibrium, firms would be better off
in the equilibrium without self-reporting. However, each firm has a unilateral incen-
tive to deviate and self-report the cartel. In this case, the leniency program turns the
self-reporting game into the classic prisoner’s dilemma where apply is the dominant
strategy.
What are the effects of increasing leniency on the expected sanctions and the incen-
tives to self-report? First, raising L makes it more attractive for a firm to deviate from
(not apply, not apply) and condition (1) becomes harder to satisfy. The cutoff for the
self-reporting equilibrium in figure 17.2 shifts to the left and there is self-reporting for
lower values of p. This is the source of the Deviator Amnesty effect.16 This effect increases
cartel detection with direct evidence and is strictly positive for the antitrust authority.
Second, more leniency induces firms to shift from the (not apply, not apply) equilibrium
to the equilibrium in which both firms rush to be the first firm to come forward in order
to receive leniency from the antitrust authority. The switch in equilibrium regime dis-
continuously increases the expected sanctions for firms. This Race to the Courthouse
effect is also positive for the antitrust authority. From an ex ante point of view, leniency
increases the expected sanctions on the collusive equilibrium path and thus reduces
expected cartel profits and increases deterrence. Finally, there is a third effect for
parameter values at which an increase in leniency has no effect on the equilibrium out-
come since firms would self-report no matter what. In figure 17.2 this holds for values
p > 1 − L(D + F). Here an increase in leniency simple reduces the expected sanctions for
firms. This raises ex ante collusive profits and reduces cartel deterrence. This negative
effect of leniency is referred to as the Cartel Amnesty effect.
In order to evaluate the net impact of these effects on deterrence and characterize
an optimal leniency policy, a dynamic theory of cartel formation, prosecution, and
self-reporting is necessary. Harrington (2008) sets up a repeated oligopoly model of
collusion, which incorporates all three effects in one framework. In each period, the
antitrust authority (AA) opens an investigation with an exogenous probability. During
an investigation the AA holds circumstantial evidence, which would—absent any
self-reporting—allow a successful prosecution with probability p. This conviction prob-
ability is randomly drawn from a continuous distribution function and observed by all
firms. Firms then simultaneously decide whether to adhere to the cartel’s market strat-
egy and whether to self-report. Once the cartel has been convicted, firms are unable to
form a cartel again. The AA’s leniency program is similar to the simple model above. The
first firm to come forward pays a reduced fine, whereas all other convicted firms pay the
full fine. The amount of leniency is the only policy variable in this model.
16
The nomenclature of these effects follows Harrington (2008).
The analysis focuses on cutoff strategies of the following type. If in a given period p is
sufficiently small, firms collude. For intermediate values, firms compete, and for high
values of the conviction probability, firms compete and report their past cartel activity.
Deviations are punished by infinite reversion to the static Nash equilibrium. The sus-
tainability of cartel is thus a function of the endogenously determined cutoff values and
the cartel members’ expected profits in each of these equilibrium regimes. The existence
of the three effects described above depends on the amount of leniency given. For high
levels of leniency, only the Deviator Amnesty effect and the Cartel Amnesty effect are at
work. Here the former effect dominates, which means that at least locally (for a generous
policy) more leniency increases ex ante deterrence. By contrast, if leniency is sufficiently
small, there only exist the Race to the Courthouse effect and the Cartel Amnesty effect.
In this case either effect can dominate. Overall, the optimal corporate leniency policy is
either one that waives all penalties or one with moderate levels of leniency.
Two further results in Harrington (2008) are noteworthy. First, within this frame-
work it is always optimal to give leniency only to the first firm to come forward. Giving
amnesty to the second firm does not increase the incentive of an individual to deviate
from an equilibrium in which firms are supposed not to apply. As in our simple model
above, the Deviator Amnesty effect is only affected by the leniency the first firm receives.
However, ex ante, more leniency for the second firm reduces expected sanctions along
the collusive equilibrium path and leads to more cartel formation. Furthermore, the
analysis shows that it might be optimal to condition admission to the leniency program
on the amount of circumstantial information that the AA possesses. In fact, a feature
of several corporate leniency programs is that leniency is only awarded if the informa-
tion significantly contributes to successful prosecution of the cartel. To see this, con-
sider again our model above. For values p ≥ 1 − L / (2(D + F)), the unique equilibrium
is for firms to report, which yields lower expected sanctions compared to a situation
without a leniency program. In other words, if the conviction probability is high, the
leniency program shields the firms from higher sanctions. Hence, excluding firms from
the leniency program reduces the negative Cartel Amnesty effect and increases ex ante
expected deterrence.
Motta and Polo (2003) is the first paper to discuss the effects of leniency programs in
a dynamic model. This paper differs in two key aspects (and some other minor features).
Once an investigation into the industry starts (which occurs with some exogenous prob-
ability), the conviction probability can take exactly one value p > 0 (as opposed to a con-
tinuous random variable in Harrington 2008). This implies that the cartel behavior after
the launch of an investigation along the equilibrium path is ex ante determined. Firms
choose one of three options: collude and report, collude and conceal, or do not collude
at all. As a consequence, the amount of leniency has no impact on the expected profits
on the collusive equilibrium path without self-reporting, and the Run to the Courthouse
effect does not exist in this framework. The model also assumes a different stage game
timing. First, firms choose simultaneously their market strategy. If a firm deviates from
the cartel strategy, it is impossible for the AA to convict the firm. Then, if an investiga-
tion opens, the firms decide whether to self-report for a given market strategy. Hence,
an equilibrium without self-reporting only exists if the incentive constraint at the mar-
ket strategy stage and at the self-reporting stage is satisfied. Since the amount of leniency
does not affect the former constraint, it follows that the Deviator Amnesty effect is only
present for parameter values at which the self-reporting constraint is more restrictive.
This is the case when the conviction probability is sufficiently high. By contrast, the third
effect, the Cartel Amnesty effect, is always present in this model. An interesting aspect
of the analysis of Motta and Polo (2003) is that the AA has a richer policy instrument set
than in Harrington (2008). An AA chooses the amount of leniency and the investment
in ex ante monitoring (which positively affects the probability that an investigation
starts) and ex post investigation (which increases the probability of successful convic-
tion p). In a first step, it is shown that full leniency is optimal only if it induces firms to
collude and self-report in equilibrium. If firms collude and conceal or if no cartel forms,
it is optimal to minimize the Cartel Amnesty effect and not to award any leniency. In a
second step, the optimal enforcement policy is determined as a function of the resources
of the AA. Deterring collusion (and not offering leniency) is optimal if the authority has
sufficient resources. With fewer resources available, the AA optimally chooses between
two collusion regimes: a regime without reporting and no leniency or a regime with
reporting and full amnesty. In order to provide self-reporting incentives the AA has to
commit to a high prosecution effort p, which is costly. Thus, a leniency program is opti-
mal if the AA’s resources are intermediate. By contrast, if the AA’s budget is small, it is
optimal not to give leniency and induce firms to collude without self-reporting.
Spagnolo (2004) and Aubert, Kovacic, and Rey (2006) both consider frameworks in
which firms have to apply for leniency before an investigation is opened. In each period
there is an exogenous probability that an investigation opens. Once the investigation is
launched it leads with probability 1 to the conviction of the cartel. This approach thus
focuses on the effect of leniency on cartel deterrence. In fact, leniency programs are not
used in equilibrium as it is not optimal for firms to collude and self-report the cartel
immediately afterwards. Hence, of the three effects identified above, only the Deviator
Amnesty effect is at work. Consequently, more leniency always reduces cartel stability,
and both papers advocate not only fine reductions for leniency applicants but rewards
for the first firm to come forward. They argue that positive rewards provide more
leverage and might be necessary to induce self-reporting and deter cartel formation.17
Additionally, Spagnolo (2004) shows that a program that rewards the first firm with a
fines-financed bounty can completely deter cartels at a finite level of fines and without
any prosecution cost for the AA. Another interesting feature of this paper is the dis-
cussion of the idea that leniency programs spread mistrust among cartel members and
introduce strategic risk. To capture this effect, the risk dominance criterion is used to
compare the two pure strategy equilibria (apply, apply) and (not apply, not apply). It is
demonstrated that moderate leniency programs (stipulating reduced fines rather than
rewards) increase the riskiness of the (not apply, not apply) equilibrium and thus raise
17 In our simple model above, rewards (that is, L > F) are necessary to induce self-reporting if and
only if the conviction probability is small relative to fines and damages, i.e. P < D / (D + F).
cartel deterrence. This mistrust effect is stronger if the leniency program only admits the
first firm to come forward. An interesting feature of Aubert, Rey, and Kovacic (2006) is
their discussion of how individual leniency programs might be able to complement cor-
porate leniency program. In situations where corporate leniency programs are not able
to induce self-reporting from firms, AAs can offer a bounty and individual amnesty to
employees reporting incriminating direct evidence. In order to prevent employees from
reporting, cartel members have to increase their pay to informed employees. This makes
collusion less profitable and increases ex ante deterrence. Cartel members thus have an
interest in minimizing the number of informed employees.
Finally, Choi and Gerlach (2012b) analyze cartel formation and self-reporting incen-
tives when firms operate in several geographical markets and face antitrust enforcement
in different jurisdictions. They use the framework of Harrington (2008) with a fixed
conviction probability like in Motta and Polo (2003). When international antitrust pros-
ecution is uncoordinated, multimarket contact allows firms to reduce self-reporting in
equilibrium and sustain cartels more effectively. The reason is that partial self-reporting
strategies allow firms to pool cartel stability constraints and transfer slack from one
market to prevent self-reporting in the other market. The effectiveness of coopera-
tion and information sharing among antitrust authorities is a function of how much
and which type of information is shared. Sharing cartel leads and evidence gathered
by the antitrust authority unambiguously raises global welfare. By contrast, sharing
information obtained from leniency applicants can increase or decrease the incentives
to self-report. In the absence of confidentiality agreements, leniency applicants opti-
mally apply in both jurisdictions or not at all (rather than in one jurisdiction only). If
antitrust penalties and conviction probabilities are relatively low, information sharing
induces firms not to report any cartel under investigation. This analysis thus warrants
a cautious approach of antitrust authorities with respect to sharing information from
self-reporting companies.
17.4.2. Screening and Detection

Screening refers to the collection of circumstantial evidence that can be used to (1) iden-
tify suspect markets for further investigation, (2) increase the likelihood of conviction
in order to induce cartel members to self-report using a leniency program and (3) raise
general cartel deterrence. Circumstantial evidence consists of economic evidence and
“communication” evidence. Economic evidence can be structural, relating to industry
characteristics that are more conducive to cartel formation (as discussed in section 17.2),
or behavioral. Behavioral evidence identifies firm conduct that suggests that a cartel
agreement has been reached, such as parallel price movements or a surprising increase
(or decrease) in prices. Economic evidence in itself is not sufficient to convict a cartel.
However, cartel cases have been brought when the authorities held economic and com-
munication evidence. Communication evidence is evidence that cartel operators met or
otherwise communicated, but does not describe the substance of their communications.
This includes meetings at trade associations or internal documents that demonstrate

detailed knowledge of competitors’ pricing strategies.18
Behavioral screening by buyers or antitrust authorities exposes cartel members to
detection and prosecution and introduces additional constraints on cartel behavior.
A cartel does not only have to deter individual members’ defections but also choose
a cartel strategy to avoid detection and minimize the risk of antitrust enforcement.
The earlier literature on cartel screening focused on avoiding detection, taking inter-
nal cartel stability as given. This includes papers like Block, Nold, and Sidak (1983) and
Feinberg (1980, 1984). They analyze situations where the probability of conviction is an
exogenous function of the price-markup of the cartel. Thus, cartels optimally reduce the
price below the monopoly level to avoid antitrust enforcement and penalties. A degen-
erate form of this setup, where full collusion results in an exogenous conviction prob-
ability, has been extensively used in the literature on leniency programs and by some
more recent papers on antitrust enforcement with multimarket contact (Choi and
Gerlach 2012a, 2013). Choi and Gerlach (2012a) analyze cartel formation and interna-
tional antitrust enforcement when multinational firms operate in several jurisdictions
with local antitrust authorities. Trade and arbitrage create a negative demand linkage
between the local markets, and the sustainability of collusion in one market is affected
by the existence of collusion in the other market. This interdependence leads to exter-
nalities in local antitrust enforcement, and there might be an over- or underprovision of
cartel prosecution from a global welfare point of view. The paper also derives conditions
under which information sharing among antitrust authorities can achieve the globally
first-best enforcement outcome.
Besanko and Spulber (1989) is the first paper to endogenize the functional rela-
tionship between the cartel’s price behavior and the detection probability in a static
principal-agent model of antitrust enforcement under asymmetric information. The
antitrust authority is unable to observe the cost level of the cartel and conditions its
audit (or dawn raid) probabilities and antitrust fines on the observed price in the
industry. Faced with this policy, the cartel decides whether to set competitive or col-
lusive prices as a function of its cost type. The optimal policy has the following features.
It is optimal to audit only when prices are high. This might result in erroneously audit-
ing competitive, high-cost industries in order to prevent more severe price collusion
in low-cost industries. Moreover, it is always optimal to allow some minor degree of
collusion in low-cost industries instead of recurring to costly audits to deter collusion
entirely. While the analysis yields some interesting insights, its use is somewhat limited
by the fact that often antitrust authorities do not hold sufficiently precise information
on industry prices. This informational constraint is less of a concern in models of pri-
vate antitrust lawsuits where buyers screen for cartels. In the models of Salant (1987)
and Baker (1988) buyers observe the cartel’s production cost and strategically increase
their demand in anticipation of being awarded damages, which are a function of the
18
See section 4 of Marshall and Marx (2012) for a comprehensive discussion of the detection of cartels
using economic evidence.
cartel’s cost overcharge. This perverse incentive offsets the increase in the cartel’s price
due to the expected increase in penalties. As a consequence, the cartel produces exactly
the unconstrained monopoly quantity, and private cartel enforcement is neutral. By
contrast, in Besanko and Spulber (1990), consumers are unable to observe the cartel’s
cost level. In this case a higher price does not necessarily imply that the antitrust viola-
tion is more severe. Hence, buyers are less inclined to strategically increase demand in
the hope of collecting treble damages in a private antitrust lawsuit. Asymmetric infor-
mation thus entails that private antitrust enforcement can have a strictly positive wel-
fare effect.19
A first step towards a dynamic theory of cartel pricing and screening is made in
Harrington (2004, 2005). Harrington (2005) characterizes the optimal cartel price path
from the noncollusive to its steady-state level in the presence of buyer detection and
(accumulating) damage awards. The buyer detection process is assumed to be exoge-
nous.20 In a given period, the detection probability increases in the size of the cartel’s
price change from the previous period. In other words, big price movements make buy-
ers suspicious that a cartel is operating. Upon detection, the cartel has to award damages
to the buyers, which are a function of the current and past price levels. The impact of
past overcharges on damages decreases over time. Furthermore, it is assumed that the
discount factor is sufficiently high such that the usual incentive constraints for cartel
stability are satisfied. The cartel’s optimal price path is shown to exist for fairly general
functional forms of the detection probability and the damage awards. In the transition
to the steady-state level, the cartel price is nondecreasing over time. The steady-state car-
tel price is strictly below the monopoly level when penalties include (price dependent)
damage awards. When penalties are price independent, the cartel reaches the monop-
oly price in the long run. The reason for this result is that in the steady state, marginal
price changes have a negligible effect on detection and only affect penalties through the
damage awards. If penalties are not sensitive to the cartel’s price, the monopoly price is
achieved at no cost. The paper also reports an interesting comparative static result for
the steady-state price. The damage awards are based on the difference between cartel
price and the (but for) competitive price. If the damages are calculated at a more pun-
ishing, that is, lower but-for price, the cartel’s optimal steady-state price goes up. The
reason for this is that instead of reducing the price to lower the damage per unit sold,
it is optimal to increase the price and reduce the number of units subject to damage
awards. Thus, contrary to the static models of buyer detection discussed above, damage
awards can create perverse incentives for the cartel even in the presence of nonstrategic
19
Spiller (1986) achieves a similar result by introducing limited liability for the cartel’s damage
awards.
20 In a related paper, Harrington and Chen (2006) model the buyers’ belief formation process more
explicitly. Buyers are unable to anticipate the optimal cartel price path but they react to structural breaks
in the pricing pattern by inferring collusion statistically from past prices. Numerical solutions of the
cartel’s optimal pricing problem show that there is a transitory and a stationary cartel phase. In the
stationary cartel phase, collusion reduces the price variance generated by the underlying cost shocks.
buyers. Harrington (2004) considers the same framework and analyzes the case where
the discount factor is lower and the incentive constraints for cartel stability (ICC) may
be binding. Numerical analysis shows that if the ICC is binding, the optimal cartel price
might be first increasing and then decreasing. The author explains this result by decom-
posing the effects of the two dynamic forces at work. If penalties are independent of the
price level but the detection probability increases in the absolute value of price changes,
then the optimal price path satisfying the ICC is always nondecreasing. Deviations from
a planned price hike reduce the detection probability. Hence, if the firms have no incen-
tive to deviate from a planned price increase, then there is also no incentive to deviate
when prices remain stable. A reduction in cartel prices is thus never necessary to main-
tain cartel stability. At the other extreme, if the detection probability is independent of
prices and prices only affect damage awards, then a nonincreasing continuation price
path is optimal. The payment of damages is more likely on the equilibrium path. Since
damage awards with an active cartel grow faster over time, the cartel needs to reduce the
equilibrium cartel price in order to satisfy the ICC and prevent deviations. The paper
also shows that—given the assumed screening technology—antitrust policy might have
the undesired effect of making cartels more stable since deviations increase the prob-
ability of detection.
17.5. Experimental Evidence
Due to the illicit nature of collusion, it is difficult to test the theory of collusion with
empirical data.21 In response, there has been a stream of studies over the last two decades
testing some of the theoretical models in experimental settings. First we briefly discuss
studies that relate to conditions that facilitate or hinder collusion. Then we have a more
detailed look at the emerging experimental literature on collusion with an active anti-
trust authority.
17.5.1. Experimental Evidence on Collusion

Feinberg and Husted (1993) test the effect of the discount factor on the extent of collu-
sion in a laboratory setting by running Cournot sessions with high and low continuation
probabilities (as proxy for discount factors). They confirm the theory by documenting
that collusion emerges as an equilibrium only with the high probability of continua-
tion. Similarly, Dal Bo (2005) finds that cooperation increases with the probability of
21 See chapter 18 in this volume by Levenstein and Suslow for empirical evidence on cartels and
collusion. This section is also complementary to c hapter 10 in volume 1 of this Handbook by Müller and
Normann, “Experimental Economics in Antitrust.”
continuation and that infinitely repeated games result in higher levels of cooperation
than finitely repeated ones of the same expected length.22
Huck, Normann, and Oechssler (2004) study the impact of the number of firms in an
industry on the competitiveness of Cournot markets, and they show that a collusive out-
come is indeed only possible with a small number of firms. In particular, they find that
collusion is possible with two firms, the typical Nash outcome results with three firms,
and there is never a collusive outcome with four or more firms.
One well-established and robust outcome in experiments is that preplay communica-
tion and announcement significantly enhances the ability to collude (Davis and Holt
1990, Cason and Davis 1995). Since these communications are essentially a cheap talk,
they cannot affect the incentives to sustain collusion. However, they help in coordinat-
ing on a particular collusive outcome since the folk theorem tells us that there is a con-
tinuum of equilibria in infinitely repeated games with a sufficiently high discount factor.
Fonseca and Normann (2011) also explore the impact of communication on the ability
to collude in experimental markets. They run experiments with n ∈{2,4,6,8} firms and
find strong evidence that communication facilitates collusion for any number of firms.
Nevertheless, it turns out that the gain from communication is nonmonotonic in the
number of firms, with the largest gain being found when the market has four firms. In
addition, they find that tacit collusion is common with two firms, but very rare with four
or more firms.
By contrast, the experimental evidence on ex post sharing of information is not yet
fully settled. Theory predicts that the publication of actions and profits of market partic-
ipants makes monitoring easier and the punishment of deviation more effective, which
facilitates collusion. The experimental results indeed confirm that sharing of informa-
tion on market conditions such as demand and cost leads to a more collusive outcome
(Feinberg and Snyder 2002). More surprisingly, Huck, Normann, and Oechssler (2000)
show that sharing of firm-specific information about action and profits of the firms
leads to a more competitive outcome, a puzzling result that contradicts the theory. They
attribute this outcome to imitative behavior by less successful firms. In a similar vein,
Rojas (2012) finds that information about demand might facilitate collusion more than
monitoring.
Phillips and Mason (1992) test the idea of mutual forbearance via multimarket con-
tact in experimental conglomerate markets in an attempt to provide experimental evi-
dence of the theory of multimarket contact formalized by Bernheim and Whinston
(1990). They consider two markets with different demand and cost conditions.
However, they do not find support for the notion that conglomeration causes more
cooperation in both markets. Rather, they find that compared to single-market out-
comes, multimarket contact induces more cooperative behavior in a more competi-
tive market than in an isolated market, whereas it induces more competitive behavior
in a relatively cooperative market under controlled single-market experiments. In
22 Dal Bo and Frechette (2011) further show that cooperation in repeated games does not necessarily
increase as players gain more experience.

addition, they find that the relative gain from more cooperation in the more competi-
tive market outweighs the relative loss from less cooperation in the other, which results
in higher overall profits.
Mason, Phillips, and Nowell (1992) investigate the effect of firm asymmetry on col-
lusion. They compare market outcomes under symmetric cost conditions with those
under asymmetric cost conditions and find that in asymmetric markets it is more dif-
ficult to sustain collusion, and it takes longer to reach equilibrium compared to in sym-
metric ones.
17.5.2. Experimental Evidence on Leniency Programs

The fact that is hard to observe the population of active cartels also means that it is dif-
ficult to assess the success of policy measures against cartels. Does an increase in cartel
detection mean that the policy is indeed working, or is the policy ineffective and the
number of cartels has increased?23 This fundamental data problem favors experimental
studies as a potentially useful tool to shed some light on the potential effects of antitrust
policy against cartels.
The first experimental study to investigate the effectiveness of policies against
cartels is Apesteguia, Dufwenberg, and Selten (2007). They set up a static game of
cartel formation and self-reporting in three stages. In the first stage, players can
decide whether to form a cartel or not. If all three players in a market agree, the car-
tel forms and the players are allowed to discuss their pricing strategy. In the second
stage, they set prices along a discrete demand function, which reflects a homogenous
good Bertrand tripoly. Finally, the players learn all prices and can decide whether to
self-report the cartel or not. A cartel is only prosecuted if at least one firm self-reports.
The authors look at four different treatments. “Ideal” is the competitive benchmark,
in which players are not allowed to form cartels and only the second stage is played.
“Standard” allows players to form cartels and self-report. However, there is no leni-
ency as all firms of a self-reported cartel are fined 10% of their revenues. In “Leniency,”
if one firm reports the cartel, it receives full amnesty, whereas all other firms pay 10% of
their revenues. If two (three) firms report, then each of these firms pays a 5% (6.667%)
fine. Finally, in “Bonus” whistleblowers are not only exempt from fines but share the
total collected fines as reward. The overall setup of this experiment, in particular
the fact that there is no detection by the antitrust authority and that firms observe
prices before self-reporting, is somewhat geared towards the idea that self-reporting
might be used as a threat to enforce collusive pricing. This is also borne out by the
results. The Standard treatment yields the highest prices, significantly above those in
23
Harrington and Chang (2009) is a first step towards addressing this issue from a theoretical point
of view. They develop a model of cartel formation and dissolution, which allows them to endogenously
generate the populations of active cartels and detected cartels. Policy changes affecting the population of
detected are then used to trace changes to latent, active cartels.
the competitive benchmark Ideal. The prices in Leniency are just above the competi-
tive benchmark, whereas Bonus performs badly (in allocative terms) with high prices
close to the Standard treatment.
Subsequent studies use a simulated repeated game framework and are closer to the
theoretical models discussed above. Hinloopen and Soetevent (2008) directly build
on Apesteguia, Dufwenberg, and Selten (2007) and use their three-phase model
as the stage game of a repeated game experiment with uncertain horizon. They
introduce two useful modifications. Leniency is given as a function of the order of
reports. The first firm receives full amnesty, the second firm gets a 50% reduction,
while the last firm pays the full 10% of current revenues. Furthermore, communica-
tion makes firms liable and, in the absence of self-reporting, entails a 15% chance of
being detected by the antitrust authority. The main results are as follows. The average
prices in the cartel treatments with and without antitrust enforcement do not sig-
nificantly differ from the competitive benchmark. The leniency treatment, however,
yields considerably lower prices. The authors decompose this price effect of leniency
programs. First, compared to the antitrust treatment without leniency, leniency pro-
grams more than halve the percentage of cartels formed from 27% to 13%. This is the
cartel amnesty effect from the theoretical models discussed above. The second factor
is that cartels that do form in the leniency treatment are not as successful in rais-
ing the price as cartels in other treatments. It is shown that the agreed-upon price
is undercut in the leniency treatment by one or more cartel members in 97% of the
cases compared to 75% in other treatments.
Bigoni and coauthors (2012) investigate similar research questions but propose sev-
eral modifications to the design setup. The most important one is that they allow firms
to self-report at two points in the game. Firms can either self-report at the price-setting
stage or after firms have set prices. This assumption introduces the Deviator Amnesty
effect of leniency programs into the experimental setup. Moreover, the authors use a dis-
crete price-setting duopoly with differentiated goods and consider a different design for
the uncertain horizon assumption.24 Antitrust fines are fixed and independent of cur-
rent revenues. Four main treatments are considered. “Laissez-Faire” is the setup where
discussing prices and forming cartels is legal and self-reporting is not available. In “Fine”
cartel members can report the cartel, but there is no leniency and all firms pay the full
fine. “Leniency” considers a policy program that rewards the first firm to come forward;
if both firms apply, they both get 50% of the fine reduction. Finally, there is a treatment
“Reward,” in which the reporting firm is awarded the fine paid by the other firm. Several
results are noteworthy. First, in the Leniency and the Reward treatment, as expected,
many subjects combined price deviation with self-reporting. At the same time, there was
also a high rate of self-reporting after the price stage in cases where price deviators did
not self-report. Hence, self-reports were used as a punishment for price deviation, as in
the previous studies. The authors argue that these reports are more likely to be altruistic
24 At the end of each round of play, subjects are assigned a new competitor with a probability of 15%.
After 20 periods, the game ends if there has been a rematch.

punishments.25 While interesting, this argument casts some doubt on how important this
strategic punishment might be in practice when the stakes for cartel members are sig-
nificantly higher. Second, as predicted, antitrust enforcement in all of its three treatments
increases cartel deterrence relative to Laissez-Faire. Moreover, Leniency and Rewards
drastically increase cartel detection due to higher rates of self-reporting. The welfare
ranking of the four treatments in terms of average prices reveals that Fine yields the high-
est average price, higher than the Laissez-Faire treatment without any antitrust enforce-
ment. By contrast, the average price in Leniency is significantly lower than in Fine but
not significantly different from Laissez-Faire. Overall, Rewards is the only treatment that
significantly reduces average prices relative to Laissez-Faire and Leniency. These results
are due to the fact that average prices when cartels actually form are significantly higher
in all policy treatments relative to Laissez-Faire. In turn, it is likely that the welfare rank-
ing is mainly driven by the possibility of strategic (possibly altruistic) punishment via
self-reporting in the policy treatments. Finally, the paper gives some interesting results on
the postconviction behavior of cartelists. In the Leniency and Rewards treatment recidi-
vism, that is, the probability that cartels reform after conviction, is significantly higher
than in Fine. This is consistent with the view that self-reporting destroys trust and makes
future collusion harder to sustain. This could also explain the observation that when car-
tels are not reforming, the postconviction price in Leniency remains low, whereas in Fine
firms seem to reach a tacit agreement and prices rise gradually.
Using the same experimental framework, Bigoni and coauthors (2010) consider how
the legal framework of antitrust enforcement affects the incentives to collude. In particu-
lar, they look at four different treatments that vary the probability of conviction in the
absence of self-reports, that is, p, and the level of the antitrust fines F. The study shows
that, for the same expected penalty from the antitrust authority (that is, holding pF con-
stant), the probability of communication in order to coordinate prices is lower when F
is higher (and p lower). This holds for the Fine and the Leniency treatment alike. At the
same time, as in the companion study, the probability of communication is higher in
Fine. The authors also argue that subjects appear to perceive past fine payments as salient
events, which may have an undue impact on the decision to reform a cartel after convic-
tion. The experimental findings show that the fines paid by a subject in previous periods
due to detections as well as the number of detections itself, have a significant and substan-
tially negative effect on the propensity to communicate in Fine but not in Leniency.
The body of literature on experimental cartel formation and antitrust enforcement
is still very small. While it seems too early to draw any conclusions from the available
evidence, the early papers all suggest that leniency programs are an effective weapon in
the arsenal of antitrust authorities. Leniency increases cartel deterrence and lowers the
prices that are sustained on the cartel’s equilibrium path. However, more experimental
work is needed to distinguish effects that are relevant to the formation of cartels in prac-
tice and those effects that are specific to the laboratory setting.
25 To make this point, the authors run an additional treatment where subjects are rematched each
period. In this setup there is no direct gain from self-reporting, but the self-reporting rates are even higher.
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CHAPTER 18
C A RT E L S A N D C OL LU SION
Empirical Evidence
MARGARET C. LEVENSTEIN AND VALERIE Y. SUSLOW
18.1. Introduction
The incentive to coordinate behavior in order to increase profits is a powerful one.

Despite the now widespread legal prohibitions on explicit coordination, firms continue
to form cartels to restrict output or set prices. Cartels occur in a wide range of industries
and they engage in a range of behaviors in their efforts to increase profits. They may
set prices, rig bids, allocate markets or customers, make side payments to one another,
and even develop elaborate structures for implementing and hiding their activities. In
this chapter, we discuss the variety of techniques that cartels use to increase prices and
profits. While we emphasize that cartels are pervasive across a variety of industries and
are more stable than one might expect, they also require fairly elaborate techniques to
achieve these goals. This suggests that tacit collusion, without communication, may be
harder than one might otherwise presume.
Empirical research has informed our understanding of the determinants of the for-
mation, prevalence, and duration of cartels. Studies of national and international mar-
kets across the twentieth century find cartels in a variety of products and services, and
these cartels typically last between five and eight years. The most important determi-
nant of cartel breakup is effective antitrust policy. While it has often been presumed that
cartels’ demise results from cheating by member firms tempted by short-term profits,
empirical analysis suggests that cheating rarely destroys cartels. The potential profits
from collusion provide sufficient incentives for cartels to develop creative ways to limit
the temptations that inevitably arise.
While scholars and policymakers have often been concerned that business cycle down-
turns are associated with cartel formation, the evidence we review here does not suggest
strong cyclical effects. There is evidence that cartels are formed during periods of falling
prices, but these are more likely to be the result of market integration or an increase in
competitive intensity than macroeconomic fluctuations. Similarly, cartel breakup does
not evidence strong cyclicality. In the sections that follow we address cartel formation and
breakup, how cartels raise prices, and the effects their actions have. We focus on recent
empirical analyses that constitute the current state of knowledge on these topics. See
Levenstein and Suslow (2006a) for a more comprehensive overview of the earlier litera-
ture. We conclude with a discussion of the effectiveness of antitrust and leniency policy.
18.2. Cartel Prevalence
Perhaps the most surprising thing about cartels is how pervasive they are. Over a cen-
tury after the United States first adopted laws making price-fixing a felony, and two
decades after the United States, the European Commission, and competition authori-
ties around the world reached consensus that hard core cartels would not be tolerated,
cartels continue to form. They form in local markets with relatively small firms, and they
form in highly concentrated global markets dominated by multiproduct multinationals.
Connor (2007) assembles evidence on the operation of cartels in 279 markets between
1888 and 2005. These include at least 57 that were operating legally and over 100 that had
international membership.1 The Great Britain Board of Trade (1976) studied 125 cartels
active in Britain prior to World War II. Many of these were international cartels. As is
the case today, they operated primarily in sophisticated intermediate goods industries,
including electrical and other manufacturing machinery, chemicals, coal and steel, tex-
tiles, paper, glass, and nonferrous metals (91–92). George Symeonidis found that in the
UK in the 1950s, 36% of industries self-reported having collusive agreements; another
26% self-reported some form of coordination.2 A comparable study of Finnish car-
tels found that about a third of all industries self-reported having a cartel.3 Fölster and
Peltzman (2010) examine similar data for registered cartels in Sweden: “Around 1990,
1 Connor (2007) lists all the cartels in his sample along with industry, country, and some details
regarding the cartel’s operation and prosecution (74, table 2; 136–53, table A1).
2 For his classification of individual industries, see Symeonidis (2002), table 3.1 and 69–71. For his
mechanism for classifying industries as collusive, competitive or ambiguous, see 61–65.

3 Hyytinen, Steen, and Toivanen (2011) use a sample of legal cartels in Finland from 1951 to 1990
to estimate the prevalence of cartels during this period of government-sanctioned price-fixing. The
sample covers 234 manufacturing industries: in 109 of these industries there was at least one cartel of
national scope during the sample period. For the remainder of the sample, no cartel was registered, but
it is unknown whether a cartel existed. They present a Hidden Markov Model that “consists of a hidden
process and an observation process that reveals information on the hidden state of the industry for some
periods, but not for others” (2).
444 Margaret C. Levenstein and Valerie Y. Suslow
there were over one thousand cartel agreements registered, affecting about 15% of total
sales of goods and services” (255). Audretsch (1989) reports that there were “more than
300 legal cartels in West Germany as of January 1987” (580).
Posner’s (1970) landmark study of antitrust enforcement in the United States cata-
logued 989 cases involving a horizontal conspiracy between 1890 and 1969. Posner, like
others who have since studied US price-fixing, used the Commerce Clearing House
Trade Regulation Reporter (CCH) to draw a picture of the breadth of cartel activity in
the United States. The CCH reports all antitrust convictions by the US Department of
Justice (DOJ). Using CCH data from 1955 to 1997, Gallo et al. (2000) reports 688 horizon-
tal per se violations. Bryant and Eckard (1991) use CCH data to estimate the probabil-
ity of cartel detection; they report 184 price-fixing indictments between 1961 and 1988.4
Calculating a rough average of the number of domestic cartel cases per year, we find a
range of 12 to 16 cases per year (using Posner’s and Gallo’s broader definition) and about
6.5 per year (from Bryant and Eckard). From 1992 to 2013 there were approximately 1040
DOJ cartel convictions, or about 47 convictions per year.5 It is important to note that in
most cases a cartel results in more than one conviction, so this average of raw data from
contemporary US cases is not comparable to those of earlier studies. However, it does
indicate that cartels are still active in the US market despite increased enforcement.
On average, cartels in the Bryant and Eckard sample lasted a little over five and
a half years.6 Using comparable CCH data, the average duration of collusion of
US price-fixing cases over the last 50 years is a little longer, about 6 years. While the
mid-twentieth-century cases include some convictions of large, well-known firms, as in
the famous GE-Westinghouse electrical equipment conspiracy of the 1950s, many of the
convicted firms were relatively small and in geographically well-defined markets, such
as road paving and school milk.7 While these markets are still prone to collusion, cartels
consisting of multinational firms in global markets now capture headlines.
International cartels are not a new phenomenon. Liefmann (1927), for example,
documented 40 international cartel agreements from the late nineteenth century (129).
Regarding the early twentieth century, Joel Davidow (1983) states: “In the pre–World
War II era, cartels were as popular at the international level as they were at the national.
Various studies estimated that during the 1930s, 30 to 40% of all world trade in manu-
factured goods was cartelized” (351). International cartels were probably less pervasive in
the late twentieth century. Levenstein and Suslow (2004) estimate that $190 billion of global
trade was affected by international cartels in 1997, representing less than 4% of all global
trade (815).
4
“We treat nolo contendere (“no contest”) pleas as equivalent to guilty pleas and convictions in
constituting evidence of a conspiracy.” Bryant and Eckard (1991), 532.
5 Authors’ calculations from individual cases listed on US Department of Justice website. Antitrust
Case Filings, US Department of Justice, accessed April 4, 2014, http://www.justice.gov/atr/cases.

6 Calculated from data provide by Bryant and Eckard (1991).
7 Lanzillotti (1996), Lee (1999), Porter and Zona (1999), and Scott (2000) all study cartels in public
provision of school milk. Feinstein, Block, and Nold (1985), Porter and Zona (1993), and Gupta (2001)
study price fixing in highway construction. For more on the electrical equipment conspiracy, see Bane
(1973) and Baker and Faulkner (1993).
Many countries provide or have provided a mechanism for industries to register coop-
erative export agreements. These agreements sometimes, but not always, explicitly provide
for cooperative price setting. They often include coordination and sharing of marketing
and transportation costs.8 While these registries have largely disappeared along with their
explicit exemptions from antitrust laws, hundreds of industries participated in such agree-
ments during the twentieth century.9 For example, the US Webb-Pomerene Act of 1918 gives
an antitrust exemption to firms that create voluntary associations for cooperation in export
activities. Andrew Dick’s (1996a) study found 125 Webb-Pomerene Associations were cre-
ated between 1920 and 1965. In 1975, Australia reported 69 registered export associations,
Japan had 180 in 1973, and Germany had 227 in 1972.10 The United States had only approxi-
mately 30 export associations registered under the Webb-Pomerene Act by the 1970s. The
Export Trading Company Act of 1982 expanded the scope of the permissible activities and
limited potential liability, generating new interest in export exemptions. In 2002, there were
150 companies registered under this Act in the United States.11
Cartels are not only widespread across time and geography, they occur across a variety
of products and sectors. Levenstein and Suslow (2011) assemble a sample of 81 interna-
tional cartels prosecuted by the US Department of Justice or the European Commission
between 1990 and 2010. Most of these were in intermediate manufactured goods and
services and span a variety of industries:
Forty percent are in chemicals, especially food additives. Another quarter are in a
variety of other manufacturing industries, with multiple cartel convictions in steel,
carbon and graphite products, plastics, and paper industries. Cartels were also found
in specialized services, such as fine arts auctions and specialized tanker shipping.
The only major sector that does not appear in the sample is final consumer goods.
(Levenstein and Suslow 2011, 462–63)
There are some industries that seem particularly prone to collusive activity, across space
and time. Levenstein and Suslow (2006a, table 3) discuss a number of historical exam-
ples of industries in which there are repeated episodes of collusion. Industries as varied
as shipping and sugar, which are characterized by relatively high fixed costs, rarely seem
to maintain stable competition. There are also firms that seem drawn to cooperative
behavior.12 This may reflect firm or industry culture. For example, Spar (1994) argued
8 Dick (1996b) analyzes the difference between Webb-Pomerene Associations that focused on price
and those that focused on joint marketing activities.

9 Levenstein and Suslow (2005) discuss changes in the laws underlying these registrations and explicit
exemptions in 55 countries (801–17).

10 Levenstein and Suslow (2005), 793. Jacquemin, Nambu, and Dewez (1981) examine 545 Japanese
export cartels between 1960 and 1970. See also Levenstein and Suslow (2006a), 50n.
11 Levenstein and Suslow (2005), table 1, 818–19.
12 For example, Degussa was convicted of price fixing by the European Commission for participation
in cartels in methionine (1986–1999), methacrylate (1997–2002), organic peroxides (1971–1999),

hydrogen peroxide and perborates (1994–2000), and vitamin B3 (1992–1998). See Levenstein and Suslow
(2010), 34n.
that the culture of cooperation in the early diamond industry facilitated collusion. In
the early twentieth century United States, intense competition was sometime consid-
ered unethical because it deprived others of their livelihood (Levenstein 2012, 8). There
are also contemporary industries whose culture and business practices appear to facili-
tate or encourage collusion. For example, in a post-2008 financial crisis municipal bond
market case, industry observers claim that bid rigging was considered normal business
practice:
But the reason no one was whispering isn’t that their actions weren’t illegal—it’s
because the bid rigging was so incredibly common the defendants simply forgot to be
ashamed of it. “The tapes illustrate the cavalier attitude which the financial community
brought toward this behavior,” says Michael Hausfeld, a renowned class-action attor-
ney. . . . “It became the predominant mode of transacting business.” (Taibbi 2012, 82)
Recidivism may also be evidence of learning on the part of managers and firms.
Participants in a cartel in one market may transfer their experience to other markets.
18.3. Cartel Formation
Economists’ theoretical models provide limited insight into why an industry that
could profitably collude might not do so.13 The empirical literature on cartel formation
is equally sparse.14 In general cartel formation is not publicly observed, and therefore
is harder to measure than breakup. There are relatively few natural experiments that
a researcher can use to test hypotheses about conditions under which cartels may be
more likely to form. Changes in enforcement offer one such opportunity. There is evi-
dence that changes in antitrust policy affect the incentive to form a cartel. For example,
scholars have argued that the temporary suspension of antitrust enforcement during the
period of the National Recovery Act in the United States (1933–1935) encouraged cartel
formation (Alexander 1994; Krepps 1997).
Conversely, increases in enforcement may discourage cartel formation. The most
prominent example of the latter is the restructuring of leniency programs in the
mid-1990s in the United States and the subsequent adoption of similar programs in
numerous other countries around the world. The impact of leniency is nuanced and
depends on policy design. Chen and Harrington (2007) demonstrate that while full
13 See, for example, Filson et al. (2001), Schmitt and Weder (1998), Bos and Harrington (2010), Eaton
and Eswaran (1998), Hviid (1992), Kuipers and Olaizola (2008), Prokop (1999), and Thoron (1998).
14 See, for example, Filson et al. (2001) on formation of federally sanctioned agricultural cooperatives
(“marketing orders”), Schmitt and Weder (1998) on cartel formation and sunk costs, Alexander (1994)
and Krepps (1997) on the National Industrial Recovery Act, and Dick (1996a), testing a model of cartel
formation on a Webb-Pomerene cartel data set.
leniency decreases the incentive to form cartels, since it makes defection more profit-
able, partial leniency combined with imperfect detection can provide cartels with a tool
to punish defectors. It follows that partial leniency can increase the profitability of collu-
sion and the likelihood of cartel formation.15
The essential question regarding cartel formation is why an industry that was not
colluding yesterday would start colluding today. The literature often frames this as a
question of the relationship between the business cycle and cartel formation: do firms
that were not colluding start doing so during economic downturns? While cartels seem
to form during periods of falling prices, the existing evidence suggests that formation
occurs in response to increases in the intensity of competition. That is, what matters is
the nature of competition in a particular market, rather than declines in the aggregate
price level.16
Although data are limited, one can further explore this question of the possible link
between cartel formation and business cycles. Levenstein and Suslow (2006a) include a
meta-analysis of case studies of cartels that formed between 1857 and 1950 (67, table 10).
These studies vary in their methodology and data; in order to have some consistency,
we focus on 12 US cartels and compare to NBER business cycle reference dates for this
subsample.17 We find that eight (67%) began in years during which there was a reces-
sion.18 Alone, one might draw the conclusion from this that cartels are much more
likely to form during recessions. However, 63% of the years between 1857 and 1950
experienced recessions. Cartels in this subsample started disproportionately in years
with recessions, but not excessively so, given that there were many recession years dur-
ing this period.19 A similar analysis of the 71 cartel episodes in Suslow (2005)’s interwar
sample (1918–1938) finds that 55% of the cartels began during months that were reces-
sions. Over this period, 43% of the months were recession months. As in the sample
of 12 case studies, cartels started disproportionately during recessions, but not over-
whelmingly so.
15 Spagnolo (2000; 2008) makes a similar point that partial amnesty can increase the set of collusive
equilibria. Thus, it is possible that leniency policies that reduce liability, but do not entirely eliminate it,
facilitate collusion. See Aubert, Rey, and Kovacic (2006) for a proposal to improve leniency programs.
16 “Many studies report that a cartel was formed during a period of falling prices, but this is not
always, or even usually, associated with falling demand (either for the particular product or in the
general economy). Instead, falling prices were often the result of entry or the integration of previously
distinct markets” (Levenstein and Suslow 2006a, 67). See also Levenstein and Suslow (2011).
17 It is important to note that cartel formation is often measured with error. We use the start date of
the first known agreement between any two cartel members as reported by the competition authority in
its enforcement action. In some cases, the cartel may have begun earlier, but the authorities do not have
evidence of explicit communication.
18 NBER business cycle reference dates, from 1857 to the present, can be found at US Business Cycle
Expansions and Contractions, National Bureau of Economics Research, September 20, 2010, www.nber.
org/cycles.html.
19 The NBER dates the beginning of a recession to a particular month. For most cartels, we only know
the year of cartel formation. Any cartel that began during a year when there was a recession is counted
as “starting during a recession year” even though it may have started before or after the months of the
recession.
Turning to Bryant and Eckard’s (1991) sample of US horizontal price-fixing conspira-

cies that formed between 1932 and 1985, we find that 39% formed during years in which
there was a recession.20 Thirty-nine percent of these years are designated by the NBER
as experiencing a recession. This evidence does not indicate any relationship between
cartel formation and business cycle downturns. For about a third of the sample, we also
know the month or quarter in which the conspiracy began. For this subsample, about
25% of the cartels formed during months in which the US economy was in recession.
NBER designates about 21% of the months between 1932 and 1985 as recessionary. Again,
this admittedly rough characterization of the data does not suggest that cartels are more
likely to form during recessions.21
Finally, we turn to Levenstein and Suslow’s (2011) sample of contemporary interna-
tional cartels prosecuted by the US DOJ or the European Commission. For this chap-
ter, we have updated the sample to include all convictions through the end of 2011. We
find that only 11% of the cartels started during recessionary months. This undoubtedly
reflects in part the dampening of the business cycle during the period 1971 to 2004,
when these cartels were formed: a mere 13% of the months within this period were reces-
sionary.22 For this sample in particular, it is important to recognize that start dates are
negotiated with the authorities. The only cartels included in the data set are those that
have been selected for us by the legal process; this is not likely to be a random selection
of cartels. Because earlier reported start dates increase fines, firms have an incentive to
negotiate for a later reported start date. Unless the authorities have conclusive evidence
of cartel activity, they are more likely to settle on a later date and a guilty plea than risk
a trial over an earlier start date. Because cartels do not form all at once, and because
their formation is almost always furtive, reported start dates are almost surely later than
actual start dates, on average, but it is unlikely that there is any systematic bias in mea-
suring their formation relative to the business cycle.
NBER business cycle reference dates capture economy-wide recessions, not
sector-specific price fluctuations. Cartels do often form in response to falling prices for
particular goods, but these are not necessarily linked to falling aggregate price levels asso-
ciated with downturns in overall economic activity. Firms may have been responding to
20
We are extremely grateful to Bryant and Eckard for their willingness to share their data with us.
21
The finding is comparable to Andrew Dick’s (1996a) study of the formation of Webb-Pomerene
Associations between 1920 and 1965. He finds no association between the timing of the formation of export
association and fluctuations in export demand (215, table 4). He defines downturns as periods of declining
prices in the broad sector in which the cartel is operating. As he explains in Dick (1996b), “I define business
cycle timing based on U.S. export price movements. To assure exogeneity with respect to a cartel’s actions,
business reference cycles are measured using one of four broad export price indexes-foods, crude materials,
semifinished manufactures, or finished manufactures, depending on the cartelized product. . . . I define a
dummy variable CYCLE that equals one if the cartel’s sector was in a peak-to-trough period (a downturn)
. . . and equals zero if the sector was in a trough-to-peak period (an upturn)” (270–71).
22 Suslow’s (2005) and Levenstein and Suslow’s (2011) samples both consist of international cartels.
NBER business cycle reference dates are for the US economy. These are likely highly correlated with the
business cycles of the relevant countries, but certainly not perfectly. During the 1920s the US economy
was probably stronger than many European economies, thus our estimate of the proportion of cartels
formed during downturns might be an underestimate.
falling prices, but prices were often falling because of events in a specific market. A com-
mon “explanation” for cartel formation is that some industry participant became more
aggressive, cutting prices or going after others’ customers. In some cases this reflects an
internal change in strategy on the part of an incumbent firm, such as a change in leader-
ship. But in many cases, there is a clear underlying exogenous economic reason for this
change in behavior such as entry, fluctuating exchange rates, or market integration. For
example, European integration and broader globalization increased competitive inten-
sity in many markets. In one illustrative case, hydrogen peroxide producers reported to
European Commission investigators that their cartel formed following the expansion
of Nordic and former East German producers.23 Similarly, the European Commission
reported: “In early 1986 Rhone-Poulenc and Degussa contacted Nippon Soda and
Sumitomo because they felt that the Japanese [methionine] producers were encroach-
ing on ‘their’ home markets. . . .”24 In a third example, ferry operators shipping freight
across the English Channel formed a cartel after the United Kingdom withdrew from the
European Monetary System. The depreciation of the pound led to falling real revenues
for Continental firms, “requiring” a coordinated response on both sides of the Channel.25
There are also industries where cartels seem to form repeatedly. Following the meet-
ing of the 2012 International Competition Network, Phil Evans wrote: “The cartel dis-
cussions . . . all appeared to point to a factor in cartel formation that is rarely talked
about—the fact that some industries appear to have cultures of behaviour that appear
to more easily step over into cartelisation, than others. This is one of the ‘softer issues’
that emerged during discussions that need exploring, but that the agencies themselves
are unlikely to be in a particularly strong position to do so.”26 It would be useful to have
research that analyzes characteristics of business or national culture that make cartel
formation more likely. This could provide insight into the challenges to cartel forma-
tion, building on research on cartel formation and maintenance costs as discussed
in Bradburd and Over (1982) and Alexander (1994). Such an analysis might also pro-
vide the basis for effective outreach and educational tools for competition authorities
attempting to change business norms and encourage a culture of competition.
18.4. How Do Cartels Set Prices?
What kinds of agreements do cartels come to in order to raise prices? Sometimes they
simply agree not to undercut one another. Other times they agree to specific prices,
23
Commission Decision 2006/903/EC (Hydrogen Peroxide and Perborate), 2006 O.J. (L 353) 54.
24
Commission Decision 2003/674/EC (Methionine), 2003 O.J. (L 255) 1.
25 Commission Decision 97/84/EC (Ferry Operators-Currency Surcharges), 1996 O.J. (L 026) 23.
26 Phil Evans, Reflections on ICN (Rio) 2012, Competition Online Forum, May 7, 2012, http://groups.
yahoo.com/group/CompetitionOnlineForum.
which the authorities and the conspirators often refer to as target prices. They may
only agree to a minimum price, so that it is permissible for firms to charge different
prices. Under such an agreement, firms may still negotiate prices with their own cus-
tomers. Cartel members may agree to specific percentage increases; in other cases,
the agreements coordinate prices to limit secular declines in price. The latter occurs
both for products that are at the end of the product life cycle (e.g., fax paper, vid-
eotapes) and products that have been affected by aggregate fluctuations in demand.
Cartel members may agree to coordinate the timing of price announcements. In
some cases, the timing of price announcements is intentionally manipulated to dis-
guise collusive activity, with the initial price announcement rotating among cartel
members (e.g., electrical carbon) or is intentionally staggered (e.g., MCAA). Cartels
may engage in coordinated price discrimination, agreeing to vary prices across cus-
tomers, geography, distribution channels, and the product portfolio (e.g., sorbates).
Some cartels focus on the spread between prices in different markets in order to limit
arbitrage. For example, cartels may respond to exchange rate fluctuations by adjust-
ing prices across markets.
While much of this behavior is similar to or the same as what one would predict for
a monopoly firm, some is specific to cartels. In particular, cartels attempt to hide their
coordination from customers and competition authorities. They also make agreements
to engage in specific behaviors that facilitate monitoring of one another’s pricing by, for
example, making public price announcements. Successful collusion requires extensive
communication, both in private and via public signals.27
Cartels set parameters over the many dimensions in which they might compete. At
times they agree to restrict or coordinate rebates, discounts, surcharges, transportation
costs, or the provision of credit. The cartel may also agree to set the length of permissible
contracts. The cartel may also agree to limit the length of permissible contracts. This
prevents the temptation for a firm to undercut other firms by promising to supply at the
current price for a longer period than the competition is offering.
Where the product has multiple components that are combined to make a
customer-specific product, collusion may be more difficult. This too can be over-
come.28 As was the case in the 1950s US electrical equipment conspiracy, such car-
tels may publish a price list or a price book from which the collusive price can be
constructed. For example, the electrical and mechanical carbon and graphite prod-
ucts cartel attempted to set prices in a market where there were “literally thousands
of varieties. . . . Most often they are customer-designed.”29 They resolved this by
27 For more discussion of how cartel conspirators communicate see Harrington (2006) and
Levenstein and Suslow (2006b).

28 In the 1920s, the US Federal Trade Commission encouraged firms to adopt uniform cost-accounting
systems in order to facilitate tacit collusion in markets like these where complicated products were
believed to lead firms to charge prices below their own costs. It was hoped that using similar cost
accounting systems to price their products would dampen competition. Levenstein (1998), 35.
29 Commission Decision 2204/. . ./EC (Electrical and Mechanical Carbon and Graphite Products),
2003 http://ec.europa.eu/competition/antitrust/cases/dec_docs/38359/38359_36_1.pdf.
Table 18.1 What Do Cartels Do?

Cartel mechanism Frequency
Shares, regions, or customers were 80%

explicitly assigned to cartel members
Sales information was exchanged for 79%
monitoring purposes
Trade association facilitated 31%
agreement
Cartel members agreed to and 33%
implemented compensation scheme
Cartel took actions to exclude 36%
nonmembers
Cartel took retaliatory actions against 19%
members who cheated
Source: Adapted from Levenstein and Suslow

(2011), 471, table 3.
establishing a “basic material price” and adding charges for additional machining or
components:
[E]‌ach member would arrive in principle at exactly the same price increase, in rela-
tive terms, for each additional cubic centimetre of carbon used or for each additional
screw or other tooling added. Then they multiplied by a “currency co-efficient” and
“quantity co-efficient.” (Commission Decision, Electrical and Mechanical Carbon
and Graphite Products)
In most cases, agreement on price is not sufficient. Thus, cartels generally assign output
levels or market shares.30 In Levenstein and Suslow (2011), 80% of international cartels had
some sort of market allocation (table 18.1). They may allocate geographic markets to mem-
bers, but increasingly, in a twenty-first-century world of global supply chains, cartels allo-
cate customers. This may make it harder to detect and enforce collusion on a national scale
and highlights the importance of international coordination among antitrust authorities.
Where necessary, cartels buy output from one another in order to maintain these quan-
tity agreements. This is similar to the behavior of an efficient monopolist who reallocates
production among plants. One difference is that while more efficient cartel members may
be able to extract larger quotas from their coconspirators, there is rarely any systematic
30 Harrington and Skrzypacz (2011) provide a theoretical explanation of this common practice.
Setting price and quantity is redundant in a world of perfect information, but not in the world of
uncertainty in which these cartels operate.
attempt to allocate production or output according to firm costs (Athey and Bagwell
2001). In Levenstein and Suslow (2011), about one-third of the cartels used a mechanism
to compensate one another when one firm’s sales exceeded its cartel allocation (table 1).
These agreements do not cover all dimensions along which cartel members could
compete, but they certainly discuss and come to agreement on many of them. In some
cases, where the cartel restricts sales in one geographical area, firms respond by compet-
ing in other parts of the world. Analogously, if a cartel restricts price and output, firms
may compete in other dimensions, such as offering preferred terms or higher quality.
Some of these other terms are much harder for cartels to limit and police. Cartels address
these challenges by sharing information and monitoring one another, which virtually all
cartels do (80% in table 18.1). In order to protect the cartel’s market share, they may agree
to acquire competitors or to refrain from sharing technology with cartel outsiders (36%
engaged in activity to exclude or eliminate noncartel producers, table 18.1).
Agreement alone is not sufficient. Cartels engage in three types of behavior to ensure
that their members adhere to the agreement. They enhance “the information that firms
have about one another and the market; [compensate] one another when firms’ sales vary
from assigned quotas due to factors outside of their control, such as random fluctuations
in demand; and [punish] firms when violations do occur” (Levenstein and Suslow 2012,
458–59). We have found that compensation schemes are very effective—much more so
than punishments—at keeping cartels together. Nineteen percent of the cartels in table
18.1 punished one another for violating cartel agreements, but these cartels tended to be
less stable (Levenstein and Suslow 2012, 476). Harrington and Skrzypacz (2011) demon-
strate that in markets with private quantities and prices, monitoring and compensation
arrangements allow cartels to arrive at a collusive equilibrium. They do so by creating
incentives for truthful reporting. These schema also create evidentiary trails that deserve
attention from competition authorities. In particular, information sharing and interfirm
sales, while having potential procompetitive justification, are shown both theoretically
and in practice to be very useful collusive tools (Levenstein and Suslow 2006b).
The most successful cartels do not simply agree to a certain set of parameters. They
create organizations or governance structures that allow them to address challenges that
arise sequentially, expand the scope of the agreement, and provide flexibility in chang-
ing economic conditions. For example, Genesove and Mullin (2001) describe collu-
sion among sugar producers in the 1920s and 1930s: “meetings embodied a governance
structure for the agreement, ensuring its adaptation to (typically endogenous) changing
circumstances” (380). For a discussion of the variety of organizational structures that
cartels used for self-governance in the late twentieth century, see Levenstein and Suslow
(2006b). In the most sophisticated cartels, top-level management sets overall cartel
strategy, but the inherent uncertainty of the economic environment requires ongoing
communication and decision-making among operational employees.31
31 See Levenstein and Suslow (2006b), table 1. For rich descriptions of the inner workings of these
cartels see Connor (2008) and Harrington and Skrzypacz (2011).

18.5. How Do Cartels Affect Prices?
While much attention has been given to the dynamic effects of collusion and coopera-
tion, the price effects associated with collusion can have a sizable economic impact that
should not be ignored. Unfortunately, objective estimates of the effects of cartels on
prices (not to mention deadweight loss) are relatively few. In 1989 Cohen and Scheffman
wrote that “there is a sparse . . . economics literature attempting to estimate the markup
in price-fixing cases” (344).32 The situation has not changed dramatically in the inter-
vening decades.
Science has often been stymied because the only researchers with access to the data
necessary to estimate counterfactual prices that would allow one to make objective esti-
mates of price effects are researchers who are hired in contested court cases. These esti-
mates are, quite reasonably, influenced by their intended purpose, but this undermines
their usefulness in establishing the overall effects of cartels. For example, Cohen and
Scheffman (1989) attempt to back out price effects from Block, Nold, and Sidak’s (1981)
study reporting a 2.87% average settlement in seven class action cases in the mid-1970s
(Cohen and Scheffman 1989, 345). They suggest that the 2.87% should be divided by
three (for treble damages) and the number of years of each case, resulting in a low esti-
mate of the price effects of collusion. But it is odd to use settlements to estimate price
effects, rather than the other way around. In particular, the size of settlements may
depend more on what is possible to prove in court than on economic effects.
Werden (2008) provides a useful summary of the research on price effects. Much of
this research has focused on bid-rigging in which there is repeated price formation and
the winning (and sometimes losing) bids are often public information (see also Porter
and Zona 1999). Werden cites six studies of bid-rigging conspiracies, which found that
collusion raised prices between 6.5% and 30% (436). Froeb, Koyak, and Werden (1993)
estimate an 18% to 30% price increase resulting from a conspiracy that targeted the US
Defense Department’s purchases of frozen seafood. Bid-rigging seems to be particularly
common in public procurement, in part because government transparency and anti-
corruption rules can make cartel enforcement easier. Transparency makes for good
government, but it also makes it easier for cartel participants to detect, and therefore
deter, defection. The problem is sufficiently pervasive that the US Justice Department
initiated a training program for government officials to “detect and report collusive
and fraudulent conduct” during the implementation of the 2009 American Recovery
and Reinvestment Act program (Hammond 2009). Several competition agencies have
been actively using econometric screens to detect price fixing. For example, Brazil used
32
Cohen and Scheffman (1989), 344–45, report two studies estimating cartel effects: the corrugated
container cartel allegedly raised prices between 7.8% and 26% (Finkelstein and Levenbach 1983) and the
Washington baker cartel at least 15% (Federal Trade Commission 1967). Newmark (1988) argues that the
bakers’ effect was closer to zero.
screening to identify which of several hundred gasoline markets was most likely to have
been the victim of collusive pricing (Ragazzo 2012).33
While noting that “studies of the effects of price fixing are far less common” (2008,
436), Werden concludes that “cartels prosecuted as felonies in the U.S. typically had
substantial effects—at least 10% on average” (436). Connor and Lande (2005) argue
that the 10% figure, which is used by the US Justice Department in calculating dam-
ages, underestimates the impact.34 Connor (2008) examines the price effects of sev-
eral global cartels in food additives and related markets. He finds prices increases of
between 12% and 28%.35 Levenstein, Sivadasan, and Suslow (2011) examine price
effects for seven international cartels and find significant declines in prices following
the breakup of each of the cartels selected for analysis.36 However, these cartels were
selected for further analysis precisely because of the decline in the price of the product
at the time of the cartel’s demise. Thus, one cannot extrapolate from these case studies
to cartels generally.
Levenstein, Sivadasan, and Suslow (2011) illustrate a more general point about research
on cartels. Given the multiplicity of equilibria in oligopoly models, it is often most use-
ful to generate stylized facts from meta-analysis of multiple case studies of individual
markets. This is particularly true when studying price effects. It is impossible to estimate
meaningfully the effects of collusion on price cross-sectionally. Sutton (1997, 67–68)
makes this point and suggests alternative econometric techniques based on establishing
“bounds” around possible outcomes consistent with particular forms of competition.
The obvious limitation of this line of research is the lack of necessary data for most
cartels. Most civil cases end with settlement agreements that protect the confidential-
ity of the data used to estimate cartel effects. Criminal cases in the United States are
almost all resolved with a plea bargain with virtually no information made public. The
European Commission has published a great deal of descriptive information on how
cartels organize and operate. Unfortunately, competition authorities are not charged
with making data on prices, quantities, or costs available for scientific research.
Measurement of price effects is also complicated by the difficulty in estimating a coun-
terfactual price. This is not only because prices are often hidden; It is also that cartels influ-
ence entry, the pace of technological change, and other characteristics of the market that
33 See also Mena-Labarthe (2012), who writes that “the Mexican Competition Commission has made
some efforts to use screening to detect collusion and to prioritize investigation resources” (3). For advances
in screening techniques, see Abrantes-Metz et al. (2006). For an overview of the potential of screens to
detect explicit collusion, see Abrantes-Metz and Metz (2012). See also Bolotova, Connor, and Miller (2008).
34 See also Connor and Bolotova (2006), which examines 800 cartels over the last 250 years. They
find an average price effect of 29% (1134). OECD (2002) notes the general lack of any measure of cartel
harm: “Real-world data on actual harm is sparse” (9). The OECD does provide “estimates of harm” for 14
cartels for which such an estimate could be determined. These estimates range from 3% to 65% (9, par. 21;
annex A). A useful and accessible summary of the effects of cartels can be found in Whinston (2008), 20–38.
35 Connor (2008) reports ranges for estimates of overcharges for vitamins (339), lysine (235), and
citric acid (165).

36 The price is defined as the ratio of trade value to trade quantity for each specific product. The
average price reported is for each product, year, and bilateral trade pair.
in turn affect price. Levenstein and Suslow (2011) found that over a third of contempo-
rary international cartels engaged in behavior designed to restrict entry. For example,
“members of the electrical carbon cartel refused to supply any graphite to an East German
competitor that had entered the international market after unification” (472). Thus a coun-
terfactual price, absent explicit collusion today, but given today’s industry structure, might
not be the right counterfactual. Symeonidis (2002) is the exception that proves the rule in
that his analysis does examine the endogeneity of industry structure. He is able to do this
because there was a specific historical episode with an exogenous change in competition
rules that allows him to identify the counterfactual industry structure. He uses this to infer
the effects of collusion on productivity, advertising and research and development expen-
ditures.37 But in even in this case, it is not possible to estimate counterfactual prices.
18.6. What Causes Cartel Breakup?
Since Stigler (1964), economists have focused on cheating as the most significant chal-
lenge to cartels, but historically, bargaining, coordination, and entry have been the most
frequent causes of cartel breakup (Levenstein and Suslow 2006a, 45). With the emer-
gence of a “hard core” cartels and the adoption of the leniency policies discussed above,
antitrust action is responsible for most cartel breakup today: about 80% of the cartels in
Levenstein and Suslow (2011) were ended by antitrust intervention. The precipitating
cause of cartel breakup in this sample of contemporary international cartels is reported
in table 18.2.
There are several lessons to draw from this sample about the economic causes under-
lying cartel breakup. Our statistical analysis suggests two primary factors that increase
the likelihood of cartel breakup: the financial fragility of a cartel member or the entry of
a new producer (Levenstein and Suslow 2011, 485).38 Cartels are fairly savvy about the
challenges that they face, including the oft-discussed incentive of members to cheat on
cartel agreements. We find that
cartels that have to punish their members are relatively unstable cartels. Many cartels
suffer from a “little” cheating; this cheating does not result in punishment, let alone
cartel death. Cartels use compensation mechanisms to limit the incentive to cheat as
well to respond to variation in demand—which they know will occur. Cartels that use
such compensation mechanisms are more likely to endure. Cartels that punish are fre-
quently suffering from fundamental disagreements about how to divide markets or set
37
For details on the impact on R & D and advertising see Symeonidis (2002). For productivity,
profitability and wages, see Symeonidis (2007) and Symeonidis (2008).
38 This is consistent with the repeated game literature on cartels, but suggests that firm-specific
discount rates are more relevant than market interest rates in determining cartel stability.
Table 18.2 What Causes Cartel Breakup?

Number of Average
Cause of breakup cartels duration (years)
Antitrust death
Follow-on investigation 13 8.8
Customer complaint 7 4.0
Other sources (including 29 8.2
whistle-blowers)
Natural death
Amnesty application 17 10.3
Cheating 6 7.7
Growing fringe 7 6.4
Unknown cause of breakup 2 4.5
All cartels 81 8.1
Source: Adapted from Levenstein and Suslow (2011), 468, table 2.
prices. Pervasive and repeated violations of the terms of a cartel agreement do result in
retaliatory punishments, but these punishments do not save the cartel. They undermine
trust and lead to cartel breakup. (485)
As discussed above, substantial attention has been given to cartel stability over the busi-
ness cycle. In Levenstein and Suslow (2011) we test for the impact of the business cycle on
cartel breakup among international cartels. We find that “[n]‌either common knowledge
measures of business cycles nor measures of unexpected shocks to demand appear to have
any significant effect on cartel stability” (483). This contrasts with studies of earlier cartels
that found significant effects of the Great Depression on cartel duration. This may reflect
the greater severity and depth of business cycle fluctuations before World War II. However,
Levenstein and Suslow (2006a) report that case studies, even during this earlier period,
rarely find any role for macroeconomic fluctuations on cartel stability (67).
Since 1993, when the DOJ revised and expanded its amnesty policy to offer auto-
matic amnesty to the first cartel member to confess voluntarily, leniency policies have
been the primary tool of cartel detection and breakup.39 The European Commission
adopted a similar policy in 1996 and strengthened it in 2002.40 Both the DOJ and the
EC have increased the severity of penalties, with multiple fines above the DOJ’s older
39
The DOJ has had a corporate amnesty program since 1978, but the earlier program was ambiguous
and ineffective. See Corporate Leniency Policy, Department of Justice Antitrust Division, August 10,
1993, http://www.justice.gov/atr/public/guidelines/0091.htm; Individual Leniency Policy, Department
of Justice Antitrust Division, August 10, 1994, http://www.justice.gov/atr/public/guidelines/0092.htm.
Hammond (2009) states: “The revised Corporate Leniency Program has resulted in a surge in amnesty
applications. Under the old policy, the Division obtained roughly one amnesty application per year.
Under the new policy, the application rate has jumped to roughly two per month” (10).
40 Leniency Policy, European Commission, last updated April 16, 2012, http://ec.europa.eu/
competition/cartels/leniency/leniency.html. There are other conditions required for full immunity,

statutory limit of $10 million and more frequent prison sentences in the United States.
Multiple jurisdictions have expanded the opportunities for customers to undertake pri-
vate actions, suing for damages caused by cartels. The number of cartel prosecutions has
increased dramatically since the adoption of these policies. Despite almost two decades
of more active enforcement, the rate of cartel discoveries seems not to have abated.41
As discussed above, theory suggests that leniency may have positive, insignificant,
or even perverse negative effects on the probability of cartel breakup. Spagnolo (2000,
2007) demonstrates that partial amnesty can be used as a threat to prevent cheating,
which could facilitate collusion.42 Thus, the existence of private damage suits limits the
effectiveness of leniency policies. While these suits bring sizable private resources to
bear in the anticartel fight, those resources are primarily directed toward known car-
tels, not new cartel detection. These private damage suits may increase deterrence by
increasing expected penalties, but they may create perverse effects if they allow cartels
to use the threat of reporting a cartel to authorities as a tool of cartel discipline. This
suggests that deterrence might be better enhanced by increasing individual penalties,
including jail terms, rather than creating or expanding private antitrust enforcement.
Harrington and Chang (2009) distinguish between the impact of leniency on detec-
tion of existing cartels and deterrence of future cartels. The continuing stream of confes-
sions suggests that while leniency policies may have increased deterrence, many firms
still find it profitable to form cartels. There is a small but growing empirical literature
aimed at evaluating the impact of leniency policy. Levenstein and Suslow (2011) find
that the average duration of international cartels ending with amnesty application is
10.3 years, somewhat longer than average cartel duration (see table 18.2). Disentangling
the effects of leniency policy is methodologically very challenging, but those studies that
have attempted it have found that leniency is effective. Miller (2009) examines all US
Department of Justice cartel indictments between 1985 and 2005. He finds “that leniency
enhances deterrence and detection capabilities [leading to] a 59% lower cartel formation
rate and a 62% higher cartel detection rate. . . .”43
Even a successful leniency program is likely to discover the least profitable cartels.
For example, when Rhône-Poulenc requested amnesty for its participation in the
methionine cartel, it continued to participate and hide its participation in the methyl-
glucamine cartel. The methionine cartel was at risk of collapse due to entry from a large,
such as immediately ending the infringement and not serving as the cartel ring leader. See also
Directorate-General for Competition, European Commission (2003), 32nd Report on Competition
Policy 2002, pars. 19–20, Belgium: Office for Official Publications of the European Communities, http://
ec.europa.eu/competition/publications/annual_report/2002/en.pdf.
41 See, for example, Joseph Wayland’s 2012 speech, “Litigation in the Antitrust Division,” reporting
that the US Department of Justice has “obtained more than $2 billion in criminal fines and more than
88,000 days of jail time for criminal defendants since the start of 2009” (6).
42 For further discussion of strategic responses to amnesty, see Harrington and Chang (2009) and
Miller (2009).
43 Brenner (2009) examines 53 EC cartel cases from 1990 to 2003 and concludes that “the program
provides incentives to reveal information on criminal activities,” but he was unable to show conclusively
whether leniency increased cartel breakup or reduced the incentive to collude (639).
well-established firm. The methylglucamine cartel was a successful duopoly with no

imminent threat to its stability.44 This suggests that while leniency is a useful tool, it is
not sufficient. The most profitable cartels will not be destabilized.
While the optimal level of deterrence is presumably not perfect deterrence, the con-
tinuing stream of cartel confessions suggests that current policy should be strengthened.
This is particularly challenging in current economic conditions. If anything, there has
been pressure on competition authorities to reduce fines so as not to bankrupt fragile
firms (Levenstein and Suslow 2010). It may be that punishments that target individual
managers with both fines and imprisonment or removal from corporate leadership (e.g.,
industry or leadership disbarment) will be more effective than simply increasing corpo-
rate fines (Ginsburg and Wright 2010). Other tools targeting corporate behavior and
structure, such as consent agreements that provide ongoing monitoring or enhanced
scrutiny of postcartel mergers, may also be necessary.45
It is possible that leniency generates so many confessions that it consumes the
resources of competition authorities to the neglect of other methods for detecting car-
tels. If it is the most successful and stable cartels that leniency misses, it is important that
the authorities have both the resources and the strategic vision to continue active detec-
tion beyond leniency. This may be particularly challenging in a resource-constrained
environment when it appears that leniency is doing all that is necessary.
18.7. Conclusion
As with examinations of any kind of criminal activity, empirical research on cartels is

challenging. Cartel members hide their activities. Legal authorities, balancing numer-
ous demands in deciding how much information to make public, suppress much of what
they learn about cartels. Despite this, creative research strategies have been employed to
establish some basic stylized facts about cartels. On average cartels last between five and
eight years. The variance in cartel duration is high, but this average holds across time,
space, and industries. The incentive to cheat, rather than causing cartel breakdown,
leads to extensive communication and the adoption of sophisticated countervailing
organizational mechanisms.
Cartels are pervasive. They are probably less pervasive than in previous centuries, but
they still operate in many markets. Cartels form in response to declining prices, but do
not form disproportionately during business cycle downturns. Similarly, cartel breakup
is remarkably free of cyclicality, especially since the Great Depression.
44
For details regarding these two cartels, see Levenstein and Suslow (2011), 466–67.
45
There is an emerging literature examining post-cartel mergers. For example, see Davies, Ormosi,
and Graffenberger (2014), Hüschelrath and Smuda (2012), and Marx and Zhou (2014).
Firms attempt to collude along as many dimensions as firms attempt to compete.

These include prices, quantities, market shares, contract duration, credit terms, trans-
portation costs, and access to technology. Understanding how cartels actually set
prices can inform the design of more effective techniques for detecting collusion. For
example, some cartels set customer-specific prices. This implies that looking for uni-
form prices may be an unsatisfactory screen for collusion in markets with large or
concentrated customers. On the other hand, some cartels strategically reduce price
variance across markets, so changes in price spreads may be a meaningful signal of
active cartel efforts.
While some individual cartels do not succeed in raising prices, virtually all studies
find that, on average, they raise prices to some extent. Because the US DOJ has long used
10% as a guideline in its sentencing, many studies implicitly or explicitly ask whether
this is a good estimate of cartel effect. Most studies find effects at least that large, but
there are surprisingly few rigorous studies of price effects because data availability is
severely limited.
Antitrust is the most important force leading to cartel breakup. The adoption of
amnesty and leniency policies, combined with dramatic increases in the largest fines, has
led to the demise of many cartels that had negatively affected global markets. However,
there are limitations to the effectiveness of these policies as currently designed. Cartels
continue to form, suggesting that deterrence may still be insufficient. Leniency policy
is also more likely to catch cartels that are generating limited profits at the time they are
revealed. Given scarce resources, it is important not to let leniency policies crowd out
other anticartel enforcement tools.
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CHAPTER 19
TAC I T C O L LU SIO N I N OL IG OP OLY
EDWARD J. GREEN, ROBERT C. MARSHALL, AND

LESLIE M. MAR X
19.1. Introduction
In this chapter, we examine the economics literature on tacit collusion in oligopoly

markets and take steps toward clarifying the relation between tacit collusion in the eco-
nomics and legal literature. Economists distinguish between tacit and explicit collusion.
Lawyers, using a slightly different vocabulary, distinguish between tacit coordination,
tacit agreement, and explicit collusion. In hopes of facilitating clearer communication
between economists and lawyers, in this chapter we attempt to provide a coherent reso-
lution of the vernaculars used in the economics and legal literature regarding collusion.1
Perhaps the easiest place to begin is to define explicit collusion. It is our understand-
ing that both the economics and legal professions use the term “explicit collusion” to
mean an agreement among competitors that relies on interfirm communication and/or
transfers to suppress rivalry.2 In the United States, Section 1 of the Sherman Act makes
explicit collusion illegal, forbidding agreements that unreasonably restrain competition
and affect interstate commerce.3
1
It is important to note that there is substantial debate within the legal profession on the meaning of
these terms, as most recently noted by Kaplow (2011). See also Kaplow and Shapiro (2007) and Kaplow
(2013). In this chapter, in order to take steps toward clarifying communication between economists and
lawyers, we opt for specific definitions of terms but recognize that there remain both substantial debate
among legal scholars and latitude for interpretation by courts regarding these definitions.
2 As we discuss legal concepts it should always be understood that it is our interpretation as
economists, not as legal scholars, since we are not the latter.

3 See Turner (1962). The Sherman Act states: “Every contract, combination in the form of trust or
otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign
nations, is declared to be illegal” (15 USC § 1).
Tacit Collusion in Oligopoly 465
As described in the seminal work of Stigler (1964), the key problem faced by firms
attempting to collude is the need to deter secret deviations. The successful suppres-
sion of rivalry, elevating prices and restricting output relative to what it otherwise
would be, creates incentives for secret price cutting by the firms. Thus, as described by
Stigler, in order to successfully collude, firms must put in place collusive structures to
govern the interaction among the colluding firms and between the colluding firms and
other market participants. These necessary structures include pricing, allocation, and
enforcement structures.4 One would typically expect that the establishment and imple-
mentation of these structures would require communication and possibly transfers
among the colluding firms, in which case the conduct would fall under the heading of
explicit collusion.
However, firms in an oligopoly can be expected to recognize their mutual interde-
pendence in the market. Each firm realizes that its profits depend not only on its own
actions, but also on the actions of its rivals. It is possible that firms, each possessing this
insight and understanding that its competitors all possess it, might be able to succeed in
the implementation or even the establishment of a collusive agreement without com-
munication. There has been broad agreement in principle that monopoly conduct can
arise spontaneously in highly concentrated markets that satisfy some other (possibly
restrictive) conditions. But, because economists have not yet been able to character-
ize those conditions with full confidence and precision, there has been room for courts
to vary from one another. Since the 1980s, legal scholars have couched essentially this
point in the language of an “extra ingredient” of centralization. As stated in Kovacic and
coauthors (2011):
In highly concentrated markets, the recognition of interdependence can lead firms

to coordinate their conduct simply by observing and reacting to their competitors’
moves. In some instances, such oligopolistic coordination yields parallel behavior
(e.g., parallel price movements) that approaches the results that one might associate
with a traditional agreement to set prices, output levels, or other conditions of trade.
The line that distinguishes tacit agreements (which are subject to section 1 scru-
tiny) from mere tacit coordination stemming from oligopolistic interdependence
(which eludes section 1’s reach) is indistinct. The size of the safe harbor that Theatre
Enterprises recognized depends on what conduct courts regard as the extra ingredi-
ent of centralized orchestration of policy which will carry parallel action over the
line into the forbidden zone of implied contract and combination. [Schwartz, Flynn,
and First, 1983] Courts enjoy broad discretion to establish the reach of section 1 by
defining this extra ingredient broadly or narrowly. (Kovacic et al., 2011, 405)
4 For elaboration on collusive structures, see Marshall and Marx (2012, c

hapter 6). Levenstein and
Suslow (in this volume) state, “While it has often been presumed that cartels’ demise results from
cheating by member firms tempted by short-term profits, empirical analysis suggests that cheating rarely
destroys cartels. The potential profits from collusion provide sufficient incentives for cartels to develop
creative ways to limit the temptations that inevitably arise.”
466 Edward J. Green, Robert C. Marshall, and Leslie M. Marx
In this chapter, we offer a way to distinguish between the legal profession’s use of tacit
coordination and tacit agreement as in the above quote and to reconcile those with
notions from the economics literature.
In order to parse the language of the economics profession and the language of the
legal profession, it will be useful to recognize that in order to collude, firms have to
solve two broad problems: how to initiate a collusive arrangement and how to imple-
ment that arrangement. As described by Isaac and Plott (1981), “First an opportunity for
conspiracy must exist. . . . The opportunity to conspire must be followed by an attempt
to conspire. The attempt to conspire must be followed by an actual conspiracy and the
resulting conspiracy must have an impact on the market” (Isaac and Plott, 1981, 1).
The problem of initiating collusion involves coming to agreement on what the collu-
sive structures required to deter secret deviations will be. This includes coming to agree-
ment (reaching at least mutual knowledge, and perhaps common knowledge) regarding
the mechanism for elevating prices, how the rents from collusion will be split among the
firms, and how deviations will be detected and deterred. The problem of implementa-
tion involves managing the ongoing operation of the collusive arrangement, including
the implementation of the collusive structures. The pricing structures may require coor-
dination of price increases, the allocation structures may require transfers among the
firms to achieve the agreed division of the collusive gain and to ensure incentive com-
patibility of the arrangement, and the enforcement structures may require information
collection to stay in sync about the environment and to maintain compliance.
Solving the two broad problems of initiation and implementation may require explicit
communication among the firms. This is particularly true in environments with strate-
gic buyers. As noted by Isaac and Plott (1981, 2), “Markets have two sides, and those on
the other side and not a party to the conspiracy may not passively acquiesce to the estab-
lishment of such a conspiracy. The market reactions might be such that the efforts of the
conspirators are rendered ineffectual.”
Collusion without communication at the implementation stage would require that
the firms establish during the initiation stage a contingent agreement specifying reac-
tions to observable outcomes during implementation,5 in particular specifying what
outcome would trigger reversion to noncollusive behavior (or, on a temporary basis, to
even more severe retaliation). Depending on the product, market, and industry, the set
of contingencies may be too numerous or too complicated for there to be the absence
of communication during implementation. However, in some environments, which
we discuss below, the problem of initiation or implementation may be solvable without
explicit communication or transfers.
Table 19.1 illustrates our interpretation of how the economics and legal professions
would classify coordination depending on whether there were communication or trans-
fers and either the initiation or implementation stage. It is important to note that this is
5 In the context of illegal agreements, there is no distinction between verifiable and observable, unless
we consider a third-party cartel organizer with quasi-judicial powers (see Marshall and Marx, 2012,
chapter 6.6).
Table 19.1 An Interpretation of Economics versus Legal Terminology

Communication/transfers
Unifying
Initiation Implementation Economics Law terminology
1. Yes or noa Yes Explicit Explicit Strong

collusion collusion explicit
collusion
2. Yes No Explicit Tacit Weak
collusion agreement explicit
collusion
3. No No Tacit (implicit) Tacit Tacit
collusion coordination coordination
aAn industry with a history of collusion that has resumed collusive conduct after a hiatus
may not need communication at the initiation phase.
one interpretation, and that both some legal scholars and some courts may interpret the
terms in different ways.6
As described in table 19.1, communication or transfers at the implementation stage is
sufficient for either the economics or legal profession to classify the conduct as explicit
collusion.7 The economics literature would also classify conduct as explicit collusion
if there were only communication or transfers at the initiation stage; however, that is
likely the case that the legal literature would term tacit agreement.8 With no commu-
nication or transfers at either the initiation or implementation stage,9 the economics
literature would refer to the conduct as tacit collusion or implicit collusion (in what fol-
lows we use only tacit collusion), while the legal profession would likely refer to this
6 “All concur that express agreements are a subset of interdependent behavior that counts, that is,
triggers liability. There is, however, no sharp consensus either on the boundaries of this subset or on
whether other subsets, such as one including tacit agreements, also suffice. These and other questions
are interrelated. For example, if express agreements are defined broadly, to include what others might
deem to be tacit agreements, then express agreements might be viewed as exhausting the space of
interdependent behavior that suffices, supposing that the only other candidate behavior involves tacit
agreements. Many, including the Supreme Court in both earlier decisions and its most recent. . ., do in
fact state that tacit agreements are sufficient, yet it is hard to know what to make of these proclamations
given the great ambiguity of the term” (Kaplow, 2011, 700).
7 Direct interaction that is disguised through the use of an intermediary, such as a trade association,
would be included in the definition of direct interaction. “The communication among colluding sellers
needed to insure successful price reporting may be indirect, in that it all proceeds through a trade
association or statistical service, but it is none the less explicit” (Kaysen, 1951, 266). On this point, Kaysen
(1951) cites the Maple Flooring Manufacturers Association discussed in 268 U.S. 563 (1925).
8 Kaplow (2011, 700) notes that there is no clear consensus in the law as to the illegality of a “tacit
agreement.” It is our impression that this speaks to the lack of agreement regarding the definition of
“tacit agreement” in the law. Again, we are posing one interpretation to take steps forward in clarifying
communication between lawyers and economists.
9 With the understanding that transfers would require communication, in some cases we limit our
description to requiring only an absence of communication.

as tacit coordination—it appears that tacit coordination in the legal profession refers
to long-run recognized mutual interdependence among oligopolists that generates out-
comes that exceed those that would be realized under myopic interaction (static Nash
equilibrium) without any direct interfirm communication or transfers.
Adding to the complexity of parsing terminology, some economics literature focuses
only on the implementation stage of a collusive arrangement. In those cases, the out-
come may be described in the economics literature as tacit collusion, even though it may
be clear that communication would be required in order to initiate the arrangement.
In these cases, the label “tacit” applies only to the implementation stage, not to the col-
lusive arrangement as a whole. This was recognized by Green and Porter (1984). Green
and Porter analyze a collusive arrangement that does not require communication at the
implementation stage, but they recognize the need for communication at the initiation
stage, saying:
It is logically possible for this agreement to be a tacit one which arises spontaneously.
Nevertheless, in view of the relative complexity of the conduct to be specified by this
particular equilibrium and of the need for close coordination among its participants,
it seems natural to assume here that the equilibrium arises from an explicit agree-
ment. (Green and Porter, 1984, 89 n. 5)
In the remainder of the chapter, we continue this discussion and provide examples. In
section 19.2, we consider when the economic environment might be such that collu-
sive profits can be achieved without communication and, thus, when tacit coordination
is sufficient to elevate profits versus when strong or weak explicit collusion would be
required. In section 19.3, we discuss the evolution of the theory of explicit collusion in
the economics literature, particularly as related to the question of under what circum-
stances explicit coordination among sellers would be required during the operation of
the cartel in order to achieve prices above a competitive level. In section 19.4, we focus
on the issue of coordination during the initiation stage. We conclude with section 19.5,
which comments on the role of tacit coordination in antitrust litigation.
19.2. Tacit Coordination versus Strong

and Weak Explicit Collusion
Antitrust practitioners turn to the industrial organization economics literature for

guidance regarding the issues concerning initiation and implementation of collusive
agreements among firms in an industry. In this light, we provide comments regard-
ing the key economic results and link these results to the issues confronted by anti-
trust practitioners as they evaluate a product/market/industry for a potential collusive
agreement.
In the economics literature, a standard folk theorem characterizes the set of equilibria
of a repeated oligopoly game and shows that for sufficiently patient firms (or for suffi-
ciently short delay between repetitions of the game), the set of equilibria includes strat-
egy profiles that generate the monopoly outcome.10 A folk theorem says that, in some
environment, the problem of operating the cartel can be solved without setting up any
ongoing, centralized mechanism of coordination—there is no need for explicit account-
ing, settlement, and enforcement.11
However, folk theorems deal with the implementation of collusion, and have nothing
to say about its initiation. The folk theorem itself does not address whether firms would
choose to play the strategies that generate the monopoly outcome nor how firms might
coordinate on those strategies. As stated in Ivaldi and coauthors (2003, 6), “While eco-
nomic theory provides many insights on the nature of tacitly collusive conducts, it says
little on how a particular industry will or will not coordinate on a collusive equilibrium,
and on which one.”
The economics literature addressing collusion without communication at the imple-
mentation stage typically considers repeated interaction among firms that allows the
firms to maintain higher prices with the (possibly implied) threat that deviation would
trigger retaliation. Retaliation mechanisms must be both credible and sufficient (see
Ivaldi et al., 2003). For sufficiency, the reduced payoffs from the retaliation must be suf-
ficiently large to deter deviations in the first place, and in order to be credible, it must be
in the best interest of the firms to follow through on the retaliation following the obser-
vation of a deviation.
The folk theorem literature typically assumes away the problem of cartel initiation by
characterizing the set of Nash equilibria without communication in the implementation
stage (see, for example, Fudenberg and Maskin, 1986). In a Nash equilibrium each player
chooses a best response to the strategies of the other players, which means identifying
the set of Nash equilibria means essentially identifying outcomes that could arise in the
implementation stage if firms were to coordinate on strategies that support that out-
come in the initiation stage.
The gas station example of Carlton, Gertner, and Rosenfield (1997) fits within this
framework—two firms compete by setting prices, where those prices are perfectly
observable and can be adjusted instantaneously, and profit of each firm is determined
by the two prices and a fixed demand curve. Carlton, Gertner, and Rosenfield (1997)
10 The first folk theorem (cf. Friedman, 1977) assumed perfect information and perfectly patient
players. The next generation (e.g., Fudenberg and Maskin, 1986; Radner, 1986) assumed near perfect
patience (i.e., a discount factor asymptotic to 1) and perfectly correlated information. The current state of
the art (cf. Mailath and Samuelson, 2006) makes much less stringent assumptions about information, but
continues be phrased in terms of theorems about the asymptotic approach to perfect patience. Current
folk theorems strongly support the idea that a collusive arrangement can be operated in an environment
that is not informationally rich if producers are sufficiently patient. Econometric studies (e.g., Porter’s
[1983b] study of the JEC cartel), as well as information disclosed in court proceedings, show that various
groups of producers have been sufficiently patient for successful operation.
11 For a discussion of the canonical model of weak explicit collusion in a repeated-game model of
Bertrand price competition, see Choi and Gerlach in this volume.

note, in this environment, that one would not be surprised to find that tacit coordina-
tion (involving no communication) could support the monopoly outcome. Any devia-
tions from monopoly pricing would be immediately observed and met by a response
from the other firm.
However, such equilibria can be sufficiently complex that it is difficult to believe that
firms could coordinate on a particular outcome without communication.12 As described
in Stigler (1964), the central problem facing a cartel is secret price cutting by cartel mem-
bers, so effective collusion requires that firms establish collusive structures, including
pricing, allocation, and enforcement structures, in order to avert secret deviations (see
also Marshall and Marx, 2012, chapter 6). Thus, one would expect that collusion would
at least require communication at the initiation stage in order to establish the neces-
sary collusive structures, although it is possible the conspirators might not need further
communication once the collusive structures are established.13
In the gas station example of Carlton, Gertner, and Rosenfield (1997), no round of pre-
liminary communication was used before the implementation stage, but it is a rare cir-
cumstance when that could be effective. For example, there may be several equilibria that
provide payoffs in excess of the static Nash equilibrium, and formation stage communica-
tion may be needed to coordinate on a given equilibrium. Given the absence of implemen-
tation phase communication, the firms may need to select an equilibrium that is not payoff
maximizing in order to avoid secret deviations, such as hidden loyalty rebates. Retail gas
stations in Canada have been accused of strong explicit collusion in recent years, suggest-
ing that the incremental elevation of prices at the pump required interfirm communica-
tion at the implementation stage. Excerpts from the announcements of the price-fixing
conspiracy investigations by the Canadian Competition Bureau are as follows:
During the investigation, the Bureau uncovered evidence of agreements between

competitors to fix the price at the pump where gasoline was sold to consumers. The
evidence indicated that participants carried out the conspiracy mainly by phoning
one another to agree on the price of gasoline and about the timing of price increases,
contrary to the conspiracy provision, section 45 of the Competition Act.14
12 The equilibria in question include those in which certain market outcomes trigger a Nash-reversion
punishment phase as in Porter (1983a) and Green and Porter (1984), and other equilibria involve more
sophisticated stick-and-carrot strategies as in Abreu (1986) and Abreu, Pearce, and Stacchetti (1986,
1990). Athey, Bagwell, and Sanchirico (2004) assume firms observe the realized prices of their rivals. As
long as this information is available without communication, these equilibria would be viewed as weak
explicit collusion.
13 Levenstein and Suslow (in this volume) state, “The most successful cartels do not simply agree to a
certain set of parameters. They create organizations or governance structures that allow them to address
challenges that arise sequentially, expand the scope of the agreement, and provide flexibility in changing
economic conditions. . . . In the most sophisticated cartels, top- level management sets overall cartel
strategy, but the inherent uncertainty of the economic environment requires ongoing communication
and decision-making among operational employees.”
14 Competition Bureau Announces New Price-Fixing Charges in Quebec Gasoline Cartel, July 15, 2010,
http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/03261.html.
Today’s criminal charges and guilty pleas are the result of an extensive Bureau
investigation that found evidence that gas retailers or their representatives in these
local markets phoned each other and agreed on the price they would charge custom-
ers for gasoline. The Bureau’s investigation into potential price-fixing in the retail
gasoline market continues in the Southeastern Ontario market.15
These investigations do not imply that there was no elevation of price relative to static
Nash from tacit coordination, or even weak explicit collusion, prior to the explicit inter-
firm communication during the implementation phase. However, the investigations
highlight that strong explicit collusion was thought to be incrementally profitable by the
colluding firms relative to the tacit coordination or weak explicit collusion that they had
functioned under prior to the use of implementation phase communication.
Furthermore, the buyers in the Carlton, Gertner, and Rosenfield (1997) gas station
example are not players in the game and so have no ability to take actions that might
disrupt the ability of the two firms to maintain their tacit coordination. When buyers
are players, they have an incentive to pursue strategies that disrupt equilibria that allow
the sellers to capture supracompetitive profits. Buyer resistance limits the ability of firms
to maintain collusive prices through only tacit coordination because buyer resistance
exploits the lack of communication, monitoring, and enforcement characterizing tacit
coordination.
If prices are not observable and demand has at least a small random component, then
one enters the environment where the combination of a need for equilibrium path pun-
ishments with asymmetry of information about market outcomes has the consequence
that perfect collusion is not possible without communication at the operation stage.
Other changes in the environment reinforce the need for implementation-stage com-
munication, including moving away from posted prices to, for example, competitive
procurements and allowing buyers to be true players in the game.
Collusive equilibria in games with repeated interaction that are supported by rever-
sion to noncooperative behavior or some other equilibrium punishment, theoretically
speaking, do not require communication among the firms in the implementation stage.
Equilibria such as the collusive equilibrium constructed in Green and Porter (1984) are
discussed in the law literature as “oligopoly pricing” or as consciously parallel decisions
of a few dominant sellers in an industry to maintain the same high noncompetitive
price.16 The idea is that this type of behavior might arise “without overt communication
or agreement, but solely through a rational calculation by each seller of what the con-
sequences of his price decision would be, taking into account the probable or virtually
certain reactions of his competitors” (Turner, 1962, 661).
In the environment of Green and Porter (1984), demand uncertainty prevents firms
from being able to monitor perfectly the quantity choices of their rivals. Because of this,
15 Gasoline Companies Plead Guilty to Price-Fixing in Kingston and Brockville, Ontario, March 20,
2012, http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/03447.html.
16 Posner (1976, 40) refers to this as “tacit collusion.”
punishment periods are triggered in equilibrium. In this environment, even in the opti-
mal collusive mechanism without implementation-stage communication, there will be
punishment periods with low profits for the firms, and the periods of high profits may
not yield profits as high as under strong explicit collusion. In an environment with quan-
tity competition and demand uncertainty, the choice of the quantity targets in coopera-
tive periods must balance the cartel’s desire to decrease those targets to increase payoffs
in cooperative periods and the cartel’s desire to increase those targets to reduce the fre-
quency of punishment periods, where payoffs are low. The more aggressive are the car-
tel’s quantity restrictions, the greater is the incentive for unilateral deviations, which,
in this model, can only be prevented by making it more likely that such deviations will
trigger a punishment period.
The analysis of collusive mechanisms without implementation-stage communica-
tion in theoretical environments can provide valuable insights into collusive behavior.
However, in few real-world environments would the informational requirements be
met for there to be tacit coordination equilibria or weak explicit collusion equilibria that
provide firms with the same level of profits as through strong explicit collusion, where
communication occurs at both the initiation and implementation phase.17
As described in Marshall and Marx (2012, chapter 1.4), when purchases are suffi-
ciently large and infrequent, or demand is sufficiently uncertain, or buyers are strate-
gic, even though firms are engaged in repeated interaction over time, they may not be
able to accomplish payoff-maximizing collusive outcomes.18 With enough lumpiness
or randomness or difficulty interpreting responses from buyers, a firm often cannot
rely on repeated play to discipline its rivals. Without communication and transfers, the
sellers are left in a tough spot in terms of trying to achieve substantially elevated prices
and profits. Secret deviations induced by self-interested profit maximization will creep
into their conduct, and joint profits will fall short of monopoly levels.19 Strong explicit
17 “Oligopolists behaving in a legal and consciously parallel fashion could achieve high and rising
prices, even as costs remain stable, by engaging in price leadership. The odds that they could achieve a
price and profit increase and maintain incredibly high incumbency rate—that is, maintain the very same
distribution of municipal contracts year after year—are miniscule, however, unless the oligopolists were
communicating with one another.” City of Tuscaloosa v. Harcros Chem., Inc., 158 F.3d 548, 565 (11th Cir.
1998). The clear presumption of the court in this case was that buyers, the municipalities in Stateplace,
Alabama, would conduct competitive procurements and push back against price increases by the sellers
to the effect that incumbency rates would be volatile. It was not the presumption of the court that the
buyers were passive. Rather, the court presumed that the buyers were players in the game, and thus much
different from the customers of the gas stations in Carlton, Gertner, and Rosenfield (1997).
18 See Ivaldi et al. (2003) on how the feasibility of weak explicit collusion is affected by the number
of firms, asymmetries among firms, entry barriers, market transparency, demand growth, innovation,
product differentiation, multimarket contact, and other factors. See Choi and Gerlach (in this volume)
on how the feasibility of weak explicit collusion is affected by the number of firms, symmetry and
concentration, demand conditions, multimarket contact, imperfect observability and monitoring,
incomplete information and communication, vertical mergers and restraints, and the presence of
antitrust leniency programs.
19 The difficulties associated with sustaining successful tacit collusion when buyers make purchases
infrequently or demand is uncertain can be seen formally in Tirole’s (1988, c hapter 6.7.1, 262–65)
collusion gives the firms the additional tools of communication and interfirm transfers
that may allow them to achieve the joint profit-maximizing price.20
19.2.1. Illustration
In what follows, we describe the distinction between static competition, tacit coordina-
tion, weak explicit collusion, and strong explicit collusion using a series of examples.
These examples are drawn from chapter 1 of Marshall and Marx (2012).
19.2.1.1. Example 1: Observable Posted Prices

Consider a small town where, on opposing street corners, there are two firms that sell
the same product.21 These firms are the only two firms that sell this product in the town.
Other firms who sell products exactly like this are at least 150 miles away from this town.
The firms can post a price at their location for everyone to see. Each firm can post a
price exactly once a day at exactly the same time. Consumers buy from the vendor offer-
ing the best value. Absent any nonprice competition between the firms, if the two firms
post the same price, then they each get half of market demand.
19.2.1.1.1. Scenario 1: Gas Stations—Static Environment

We begin by assuming the firms are two gas stations, and we label them as A and
B. Suppose that each one of these gas stations buys its gasoline for $2 per gallon and that,
because demand is noisy, each knows that a price somewhere between $2.90 and $3 per
gallon maximizes their combined profits. In a static environment, where no firm was
concerned about future profits, rivalry between the firms implies that the price would be
the marginal cost, or $2.01 if pricing is done in cent increments.
19.2.1.1.2. Scenario 2: Gas Stations—Dynamic Environment, Uncertain Demand

Now change this environment to allow more dynamic interaction. Suppose that the
future matters almost as much as the present to each of the gas station owners. It is natu-
ral to think of the folk theorem, which suggests that the monopoly outcome should be
possible without implementation-stage communication, but without communication,
what price would be selected between $2.90 and $3.00?22 Perhaps the two firms can settle
quickly on a price such as $2.90, but with a small amount of communication at the ini-
tiation phase they may be able to agree to higher price, say $3. In this case, weak explicit
collusion would allow the two firms to achieve a bigger payoff than tacit coordination.
exposition of Green and Porter’s (1984) model of tacitly collusive behavior (Marshall and Marx, 2012,
chapter 1.10).
20 Levenstein and Suslow (2011, table 3) show that approximately one-third of the cartels they consider
used a mechanism to arrange transfers when a cartel member’s sales exceeded its cartel allocation.
21 This example is based on Carlton, Gertner, and Rosenfield (1997).
22 For empirical evidence of collusion in retail gasoline, see Borenstein and Shepard (1996). See also
Slade (1992).
19.2.1.1.3. Scenario 3: Gas Stations—Dynamic Environment, Uncertain Demand,

Nonprice Competition
But suppose there are nonprice dimensions for interfirm rivalry such as loyalty rebates,
cleanliness of facilities, service for cars, and a variety of items available in the service sta-
tion shop. If both firms are charging $2.90 through tacit coordination, but firm A starts
to experience an erosion of its market share, then firm A would infer that firm B is com-
peting on nonprice dimensions. Firm A can then either cut its price or increase non-
price offerings.
In this kind of environment, with nonprice competition available to each firm, it may
not be possible for each firm to experience an increase in profits from an increase in
price—each firm may invest in the nonprice competition to an extent that no incre-
mental profit is left from the price increase. But the two firms could communicate at
the initiation of collusive play and commit to the absence of nonprice competition. If
the market share of any firm falls significantly below 50%, then they know there was a
breach in that the other firm was offering nonprice enhancements, implying that the
agreement will end and prices will revert to marginal cost. Each firm may recognize
that without communication during implementation it will not be possible to main-
tain a price of $3—there will be just too much temptation for nonprice competition.
But they may determine a lower price, say $2.15, where they are each relatively confident
that the initiation-stage communication regarding assurances of nonprice incremental
enhancements will be honored, since the payoff to a secret deviation is just too low (rela-
tive to a price of $2.90).
There may also be a lower price, such as $2.10, that the firms need no initiation
stage communication to achieve. Specifically, the payoff to investment in nonprice
enhancements is just too low when the price is $2.10 for either firm to undertake it—a
slightly higher price would induce such investments in the absence of initiation-stage
communication.
In this example, tacit coordination at $2.10, weak explicit collusion at $2.15, and strong
explicit collusion at $3 are each conceptually possible.
The price increment that can be achieved with weak explicit collusion depends on the
magnitude of the investment each firm would need to make in secret nonprice actions
to deviate without direct detection. If the investment is small, then the price increment
above $2.10 that can be achieved with weak explicit collusion is small. Similarly, if the
investment is large, then the price increment will be much larger.
19.2.1.2. Example 2: Unobservable Bid Prices

We now change things again. Suppose that the two firms are not gas stations but instead
are manufacturers of plastic industrial bags used for packaging a number of different
types of finished products.
If you think about a plastic bag that is used for packaging some types of processed
vegetables, fertilizer, or ready-mix concrete, there will be printing on the bag. Many
firms that package and ship their product, or are engaged in the business of shipping,
buy plastic industrial bags. There are standard bags constructed of standard materials
with no printing. An example might be an 18 × 12 inch 3ml thick bag. However, these
kinds of bags are typically a small percentage of sales for an industrial bag plant. Rather,
most sales are to manufacturers or shipping companies that buy large numbers of bags
of specific sizes, where the material used in the bag construction, the thickness of the
bag, and the printing on the bags are specified by the buyer.
Almost all of the purchases of such bags will be done by procurement. Specifically, a
buyer will invite bag plants to submit bids, where the details of the bag size/thickness,
material used, and printing will be part of the bid solicitation. The bag plants may post
a price for the aforementioned 18 × 12 inch standard bag and may offer such bags at
the posted price in small volumes at each firm’s office location, but the bulk of sales for
each bag plant will be through procurements. The posted price for a standard bag has no
effect on the bid submitted by any bag plant in a procurement, and the buyers know that.
Each bag plant has a reasonably good idea of the costs of its rival. Also, unlike the gas
station example, where no consumer is going to drive 150 miles each way to buy gas from
a cheaper nonlocal gas vendor, it is economically viable to buy bags from a bag plant that
is 150 miles away, although such a bag plant has additional transport costs. The bid by
any bag plant in any procurement is not revealed by the buyer to the competing firm—
a bag plant only knows if it won or lost any given procurement. For this example, we
assume that each bag plant values the future highly.
If we consider an environment with just large buyers, the two bag plants can poten-
tially agree on bids to submit at the initiation phase to make sure that the work is shared
in a relatively equal way. If one bag plant has won a recent large contract, then the other
bag plant can win the next one. The two bag plants can potentially develop initiation
phase contingent plans about the bids each will submit. Thus, the behavior can be sup-
ported with weak explicit collusion.
19.2.1.2.1. Scenario 4: Bag Plants—a Small Number of Large Strategic Buyers,

Uncertain Demand
To answer the question as to why strong explicit collusion might be required above and
beyond weak explicit collusion, suppose that buyers are small in number, large in size,
and strategic. In addition, assume demand is uncertain. Suppose that the large buyers
conduct procurements infrequently and at irregular intervals. Suppose that each bag
plant expects to receive, in total, one bid solicitation each quarter. Furthermore, suppose
that these large buyers may choose to extend their current bag contract terms for a year
or more without reconducting a procurement. There are not many contract awards each
year—on average, only four per year. If one bag plant receives only one or even none of
the awards, then it will be in dire straits.
For a given procurement, suppose that a bag plant submits a bid that is close to the joint
monopoly price and observes that it loses the award. This could be from one or more of
four causes: (1) random bad luck, (2) its competitor undercut it in the bidding, (3) there
was a negative demand shock in the market that affected both bag plants but the shock
was unknown as such to either bag plant, and (4) the buyer acted strategically by offering
the contract award to a competitor with extended award length if the bid price were low-
ered by that firm. Suppose the bag plant in question loses a second procurement. Now the
bag plant that has not won a contract in six months is really feeling the financial pinch.
Strong explicit collusion can resolve the conundrum for the two firms. By commu-
nicating and monitoring one another during the implementation phase the firms are
able to eliminate certain conjectured causes for the lack of an award and directly address
buyer resistance.
Weak explicit collusion is much more difficult to implement. The number and com-
plexity of contingencies that would need to be specified at the initiation phase is substan-
tial. Creating contingent plans to address the entire range of potential buyer resistance
would be like creating a contingent plan for a chess game.
The results of Green and Porter (1984) imply that even a minor incremental payoff
from tacit coordination would not be possible. When a procurement environment has
this much noise from a number of sources, direct interfirm communication at both the
initiation and implementation phase is needed to suppress interfirm rivalry.
19.2.1.2.2. Scenario 5: Bag Plants—Many Nonstrategic Buyers,

Uncertain Demand
Consider another scenario where there are many small manufacturers buying bags with
great regularity. Suppose that these buyers are all in the same business. For example,
they make frozen French fries. They need bags to ship their frozen French fries. But sup-
pose that frozen French fry demand for these local manufacturers is highly unstable,
and the instability affects each of them in a similar way. Suppose that the bag plants can-
not observe frozen French fry demand conditions. Furthermore, each bag plant cannot
observe how much production is occurring at its rival’s plant. In normal demand condi-
tions, each bag plant expects to receive 500 bid solicitations each quarter. But a given
frozen French fry manufacturer may decide not to make any award in a given quarter if
demand conditions are sufficiently depressed.
Suppose that a bag plant submits bids over the course of a quarter that are at the joint
profit-maximizing level. If it observes that it has won approximately 250 of 500 solicitations,
then it will continue to hold to that price. But, if it observes that it has won 125 of 500 solicita-
tions, then the bag plant has some serious questions to address. Are the frozen French fry
manufacturers experiencing a negative demand shock, or has the other bag plant undercut
the joint profit-maximizing price to obtain more awards, or is some of both occurring?
By assumption, the bag plant in question is unable to determine the cause for the
reduced number of contract awards. As a consequence, a bag plant will reduce its
bid below the joint profit-maximizing price and move it toward the marginal cost of
production. To see this, note that if the bag plant does not react based on the belief
that bad outcomes are attributable to negative demand shocks and not the conduct
of its rival, then the rival would take advantage of this belief by undercutting the
high-priced bag plant.
In this case, strong explicit collusion can elevate profits, probably to the joint
profit-maximizing level. But weak explicit collusion can produce a payoff above static
Nash albeit below strong explicit collusion. Initiation-stage communication can resolve
the price that each firm will bid at the procurements. The weak explicit collusion
described here is the same as that in Green and Porter (1984).
19.2.2. Context for Merger Reviews

The issues of tacit and explicit collusion also arise in the context of merger reviews. The
2010 Horizontal Merger Guidelines (Guidelines) of the US Department of Justice and
Federal Trade Commission discuss concerns about “express collusion,” by which they
presumably mean strong explicit collusion, and also about “coordinated interaction.”23
According to the Guidelines (24–25):
Coordinated interaction includes a range of conduct. Coordinated interaction can

involve the explicit negotiation of a common understanding of how firms will com-
pete or refrain from competing. Such conduct typically would itself violate the anti-
trust laws. Coordinated interaction also can involve a similar common understanding
that is not explicitly negotiated but would be enforced by the detection and punish-
ment of deviations that would undermine the coordinated interaction. Coordinated
interaction alternatively can involve parallel accommodating conduct not pursuant to
a prior understanding. Parallel accommodating conduct includes situations in which
each rival’s response to competitive moves made by others is individually rational, and
not motivated by retaliation or deterrence nor intended to sustain an agreed-upon
market outcome, but nevertheless emboldens price increases and weakens competi-
tive incentives to reduce prices or offer customers better terms. Coordinated interac-
tion includes conduct not otherwise condemned by the antitrust laws.
Thus, it appears that the Guidelines intend for the term “coordinated interaction” to
encompass conduct ranging from tacit coordination to strong explicit collusion and
apparently more. For an attempt to disentangle the notion of parallel accommodat-
ing conduct, which is introduced in the 2010 revision of the Guidelines, from existing
notions of collusion, see Harrington (2012).
19.3. Evolution of the Theory of

Explicit Collusion
Before the arrival of formal dynamic game theory, ideas on collusion without commu-
nication relied on two theories: focal points and price leadership. The theory of focal
23
The Guidelines are available at http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf.
points stated in Schelling’s (1960) The Strategy of Conflict played an important role in the
justification of tacit coordination as shown in Scherer (1970, 192): “Even a price that has
no particular uniqueness or compulsion in its own right may become a focal point sim-
ply by virtue of having been quoted repeatedly.” On price leadership, when Bain (1968)
analyzed conventions and agreements to set a price leader, he argued:
Evidence of such direct consensual action not being found (and it seldom is), it is
more usual to recognize price leadership as a form of tacit collusion, resulting from
the existence of an unspoken agreement. The notion of tacit agreement, however, is
itself somewhat nebulous, and it seems perhaps equally appropriate to designate the
conduct pattern in question as one of interdependent seller action without basis in
agreement. (Bain, 1968, 312)
From this starting point evolved the analysis of collusion in terms of repeated and
dynamic games using the tools of game theory.24 The focus was on the tension described
by Bagwell and Staiger (1997, 82): “Collusion is a balancing act. Each colluding firm bal-
ances the short-term temptation to cut its price against the expected long-term cost of
the price war that such an act might instigate.” In this literature, the threat of punish-
ment of deviations is the force driving collusive outcomes. Naturally, the ability of firms
to detect deviations plays an important role.
At the same time as one community of economists was developing the relatively informal
theories of focal points and price leadership, another community was developing explicit,
formal theories of equilibrium in repeated games. However, after having flourished for more
than a decade, by the mid-1960s game theory was viewed by many economists as a sterile
mathematical field that was too highly schematic to be applied successfully to collusion or
to other concrete issues of economics and social science. Large credit for superseding that
negative view is due to James W. Friedman. Both through his own research and through his
lucid presentation of the game-theoretic ideas in Oligopoly and the Theory of Games (1977),
Friedman educated “mainstream” IO economists about the way of thinking and the spe-
cific results and techniques developed by game theorists in the 1960s and 1970s. One of his
important, specific contributions was to frame repeated games in a discounted-payoff con-
text, rather than using the limit-of-payoffs criteria that had dominated preceding research.
By doing so, he brought into focus the crucial role of the trade-off between short- and
long-term costs and benefits that Bagwell and Staiger’s summary emphasizes.
The main limitation of Friedman’s theory of collusion without implementation-stage
communication was its restriction of attention to an environment with perfect monitor-
ing. Abreu (1986) provided the capstone of that research program by characterizing the
maximum profits that can be sustained without implementation-stage communication
or transfers in terms of the most severe punishments for defection that colluders could
impose on one another.
24 See Choi and Gerlach (in this volume) for a review of experimental evidence on collusion and
antitrust leniency programs.

The literature advanced to consider the possibility of collusion without

implementation-stage communication, that is, weak explicit collusion in our ter-
minology, in ever more complex environments. For the case of imperfect monitor-
ing, Green and Porter (1984) show that some degree of collusion can be achieved in
a quantity-setting supergame even when firms are not able to perfectly observe their
opponents actions. Abreu, Pearce, and Stacchetti (1986) study the same issues as
Abreu (1986) but for the imperfect monitoring case.25 Brock and Scheinkman (1985)
and Lambson (1994) study weak explicit collusion in price-setting supergames. The
first shows that some degree of price elevation can be achieved and study how this is
affected by the number of firms in the industry. The second studies the maximum prof-
its achievable through weak explicit collusion and shows that the structure of the most
severe (optimal) punishments is much simpler in price-setting supergames than in
quantity-setting supergames. Finally, Benoit and Krishna (1987) study weak explicit col-
lusion in a model in which firms choose both quantities and prices.
Additional complexities are considered in literature that considers environ-
ments with incomplete information. In environments with incomplete information,
belief-free equilibria are important for private monitoring. If players observe different
signals—for example, an oligopolistic market in which each firm observes only its prof-
its but no prices, quantities, or other firms’ profits—then beliefs about what other play-
ers are observing complicate the equilibrium analysis. But still, given that the signals
are informative enough, it is possible to sustain some level of collusion with a subset of
subgame perfect equilibria in which beliefs about what the other players have observed
play no role, the belief-free equilibria (see Ely and Valimaki, 2002; Ely, Hörner, and
Olszewski, 2005).
In environments with incomplete information about the profitability of a market,
recent work shows that collusive payoffs may still be possible without communica-
tion at the implementation stage. See, for example, Yamamoto (2014) and Schenone
(2012).26 In this literature, in some cases, the necessary conditions for folk theorem type
25 Abreu, Pearce, and Stacchetti (1990) rely on a different method to solve for the equilibria of
dynamic games, using the notion of self-generation, which allows applications to asymmetric games.
26 The results of Yamamoto (2014) imply that under some conditions a cartel can self-enforce
some degree of collusion even if firms do not know how profitable the market is. The environment is
a two-player game with a public randomization device and private monitoring. The state of the world
is chosen by nature at the beginning of play and it influences the distribution of signals and/or payoff
functions of the stage game. Yamamoto’s (2014) solution concept is belief-free ex post equilibria (BFXE).
In a BFXE a player’s best response does not depend on her beliefs about the state of the world or her
beliefs about her opponents’ private information. A folk theorem for this environment/solution is not
obtained, but some degree of collusion is sustainable. Schenone (2012) considers an environment different
from Yamamoto’s. First, instead of private monitoring, Schenone’s game is one of perfect monitoring.
Second, each player knows its own payoff, and the state of the world can be uniquely identified by pooling
together the information of all players. Schenone finds conditions that are both necessary and sufficient
for a perfect Bayesian equilibrium folk theorem. The conditions are also necessary and sufficient for a
belief-free equilibria folk theorem to hold. In this case, the solution concept is perfect type-contingent ex
post equilibria, which is equivalent to a belief-free equilibrium under perfect monitoring.
results are restrictive, telling us that a folk theorem does not hold for a wide range of
games.
Additional challenges to the legal interpretation of firm behavior and enforcement
of antitrust laws are raised by more recent literature such as Hörner and Jamison
(2007), which presents a model in which almost no information is required to sus-
tain full collusion. The model consists of an infinitely repeated price-setting game
with inelastic demand. At each period, each firm draws a per unit cost that can be
either high or low. Costs are private information. At each period, the firm with the
lowest price gets the whole demand and if more than one firm set the lowest price, a
randomly selected firm gets the whole demand. A firm only observes its own price
and whether it sells. In this model, full collusion is understood as an equilibrium in
which in almost all periods a low price gets the sale, and the firm charges a price close
to the monopoly price. The main result states that if firms are patient enough, they
can get arbitrarily close to the monopoly outcome without implementation-stage
communication.
19.4. The Initiation Phase of Collusion
Prior to this point, our discussion has focused primarily on the question of under what
circumstances explicit coordination among sellers would be required during the opera-
tion of the cartel, in order to be successful in maintaining prices above a competitive level.
However, we have emphasized that coordination might also be necessary prior to the car-
tel beginning to operate, in order to agree on a mechanism by which subsequent collusion
would be enforced and on how the rents from successful collusion would be distributed
among the cartel’s members. We now turn to the questions: under what conditions would
such explicit coordination/communication ex ante be required, and under what conditions
would it even be helpful, in order for a viable cartel to be born? Throughout most of our
investigation, we maintain the view taken in the several preceding sections that industry
conduct is a Nash equilibrium outcome of strategic interaction between agents in the mar-
ket environment.
19.4.1. Nash Equilibrium as Self-Enforcing Agreement

A widely held interpretation of a Nash equilibrium is that it is a self-enforcing agreement
among the players of a game (Myerson 1991). Taking this interpretation literally, a Nash
equilibrium could not be tacit coordination, since an agreement cannot be reached
without communication.
A less restrictive interpretation is that players conduct themselves as though they had
previously reached an agreement among themselves, and moreover the counterfactual
agreement would enforce itself. That is, the prior meeting to reach and ratify an agree-
ment can be treated as a parable rather than as an actual historical event, much as the
political theorists interpret the “social contract.” Aumann and Brandenburger (1995,
1162–63) have made explicit what such a counterfactual account of agreement entails:
Suppose that the game being played [by two players] (i.e., both payoff functions), the
rationality of the players, and their conjectures [about the probabilities with which
actions their respective opponents will take] are mutually known. Then the conjec-
tures constitute a Nash equilibrium. . . . [Moreover, suppose that there are more than
two players, that] their payoff functions and their rationality are mutually known,
and that their conjectures [about one another’s actions] are commonly known. Then
[their conjectures coincide and constitute] a Nash equilibrium.27
To say that something is mutually known just means that everyone knows it. To say that
it is commonly known means that everyone knows it, everyone knows that everyone
else knows it, and so forth. People generally do not need to meet, in order to have mutual
knowledge of some aspect of their shared environment. For example, if ten people read
this sentence, then they have mutual knowledge that it begins with a three-letter word.
But, unless they are all read the sentence in one another’s presence (in which case, they
are meeting) or they subsequently discuss the sentence after having read it (in which
case they also meet, subsequently to their reading), presumably none would know that
the others know this fact.
Moreover, although direct observation (without communication) by all competi-
tors is sufficient to establish mutual knowledge of an observable fact, it is not sufficient
to establish mutual knowledge of one another’s intentions. In particular, given that
repeated games of the sort considered above have both competitive and collusive equi-
libria, one competitor cannot observe which equilibrium another expects everyone else
to play (and so will play himself). Thus, in any cartel situation—even a duopoly—it is
difficult to see how prospectives would achieve mutual knowledge of each other’s intent
to collude, unless they were to communicate those intentions to one another. Common
knowledge, and mutual knowledge about other players’ mental states (e.g., intentions,
beliefs) is called higher-order knowledge.
So, let’s formulate a two-part Need to Meet (NTM) principle:
1) In general, players cannot arrive at a Nash equilibrium by a process of reasoning,

unless they attain higher-order knowledge of one another’s conjectures. In par-
ticular, they cannot “reason their way” to a collusive Nash equilibrium without
attaining higher-order knowledge.
2) Such higher-order knowledge cannot be attained, in practice, without having an
explicit meeting.
27 Because we will not discuss it here, we have omitted a common-prior assumption of Aumann and
Brandenburger’s result.
Let us acknowledge, before going further, that the NTM principle is not a logical con-
sequence of Aumann and Brandenburger’s result. They have framed a sufficient con-
dition for Nash equilibrium, while the NTM principle envisions common knowledge,
and hence occurrence of a meeting, as a necessary condition. They write (1163) that “It
is always possible for the players to blunder into a Nash equilibrium ‘by accident,’ [but
a higher-order-knowledge assumption] cannot be . . . significantly weakened.”28 But,
attaining such higher-order knowledge is virtually a necessary prerequisite for players
(e.g., sellers in a market) to reason their way to any particular type of Nash conduct, col-
lusive or otherwise. Henceforth we will treat it as being necessary. That is, we stipulate
clause (1) of the NTM condition.
If clause (1) of the NTM condition holds, then clause (2) is tantamount to an assertion
that higher-order knowledge of competitors’ intent to collude must always be reached
explicitly, rather than tacitly. In the next two sections, we assess clause (2).
19.4.2. What Does “Arrive by Reasoning” Mean?

We have identified a situation in which Aumann and Brandenburger’s
higher-order-belief conditions are satisfied, and in which there is a self-confirming con-
jecture that a particular Nash equilibrium will be played, with a situation in which the
players have arrived by reasoning at the equilibrium. This situation is contrasted with
the one in which, in Aumann and Brandenburger’s words, the players have blundered
into an equilibrium by accident. But to make this identification is of no help for assessing
whether or not clause (2) is reasonable. To make that assessment, we need an explicit
account of the process that players are envisioned to follow. That account is provided
by the theory of rationalizable play. A player is rational if he plays an action that is a
best response to his conjecture (represented by a probability measure over opponents’
possible actions) of what actions other players may take. The first step of his reason-
ing process is to eliminate actions that would not be a best response to any conjecture
about what others might do. Then, he would put himself in the shoes of other play-
ers, whom he knows to be rational. He would realize that, at a minimum, each of them
would also be eliminating any never-a-best-response actions. At that point, the player
would review his actions that have survived being eliminated in the first round. Has
any of those actions been retained solely because it would be a best response to some
opponent’s action that is never a best response for the opponent? In that case, he knows
that the opponent will not play the action in question, so he should eliminate the action
that he retained on account of it. When each player has gone through this second round
of eliminating actions, and has again put himself in the shoes of other players who have
done likewise, there will be a third round, and so on. A player’s actions that survive
elimination in every round, forever, are rationalizable for that player. Pearce (1984) and
28 Aumann and Brandenburger (1995, sec. 5) show that their result would fail if any of the conditions
were weakened significantly.

Bernheim (1984) formulated the concept of rationalizability, and they showed that all
actions played (with positive probability) in a (mixed-strategy) Nash equilibrium must
be rationalizable. Tan and Werlang (1988) showed that a profile of actions in a game is
rationalizable for the respective players if and only their being played is consistent with
it being common knowledge that all players are rational.29 That is, the iterative process of
reasoning by which players determine their rationalizable actions (a) never eliminates
any action that is ever played in any Nash equilibrium, and (b) always eliminates any
action that would be inconsistent with common knowledge of rationality.
In view of these results, rationalizability is evidently the right concept to make precise
the idea of “arrival by reasoning” at Nash play in a game.
19.4.3. The (Im)plausibility of Arriving at

Collusion by Reasoning
The standard, intuitive view of tacit coordination in the IO/legal literature seems to
be as follows. At the beginning of the story, each of prospective colluders is ponder-
ing whether to act competitively or monopolistically. These agents do not commu-
nicate with one another. Nevertheless, it is common knowledge that all of them want
to maximize their respective profits, and it is also common knowledge that there is a
self-enforcing profile of actions such as has been discussed above in section 19.2.1, which
would solve the problem of maximizing joint profits and distributing them equitably
(according to some standard that they commonly know that they all embrace) subject
to the constraint that collusion must be self-enforcing. In this situation, according to the
intuitive view, each agent should conjecture that the other agents will play as specified
in that profit-maximizing equilibrium, and therefore should also play according to the
equilibrium because the equilibrium is a self-enforcing arrangement.
This statement of the intuitive view is ambiguous between two versions. One ver-
sion—let’s call it the convergent-elimination view—assumes that, bootstrapping from
just the facts that have been stipulated to be common knowledge, the iterative elimina-
tion procedure will zero in on precisely the profit-maximizing Nash equilibrium. That
is, that equilibrium profile of actions will be the unique profile of actions that survives
the iterative-elimination process. The other version—let’s call it the focal-point view—
recognizes that the rationalizable actions are those that could be chosen by agents with
arbitrary beliefs (subject only to having certainty of the facts that are stipulated to be
common knowledge) and makes a further assumption that all of the agents’ beliefs place
very high prior probability on the profit-maximizing equilibrium being played. On this
view, the role of the iterated-elimination process is to condition probabilities repeat-
edly on higher-order-belief conditions, raising agents’ probability assessments from the
29 Again here, we are giving a brief incomplete statement of a result in order to avoid digression from
the topic of the chapter.

initial, very high levels to virtual certainty that the profit-maximizing equilibrium will
be played.
The explication of “reasoning to an equilibrium” as rationalizability shows that the
convergent-elimination view is completely untenable. To begin, the game among pro-
spective colluders always has a competitive Nash equilibrium, as well as possibly hav-
ing a collusive one. Property (a) of rationalizability is that no action consistent with
any Nash equilibrium is ever eliminated. Thus, at most, rationalizability might estab-
lish that some Nash equilibrium or other might be played, but it could not establish
that the collusive equilibrium specifically would be played. Further analysis is even
less favorable than that to the convergent-elimination view. Specifically, rational-
izability is such a weak solution concept that it is consistent with it being common
knowledge that no player will play a Nash strategy.30 Convergence to Nash equilib-
rium in general, let alone to a specific Nash equilibrium of a multiple-equilibrium
game, cannot be achieved entirely from the “Archimedean lever” of common knowl-
edge of rationality.
The focal-point view is logically coherent, because it adds a strong hypothesis about
the prospective colluders’ prior beliefs to the minimal hypothesis of common knowl-
edge of rationality. The focal-point view is as plausible, but only as plausible, as is that
hypothesis. The gist of the argument for the hypothesis is that, when players of a game
share a common background, and when that common background is common knowl-
edge among them, then their conjectures are much closer to being coincident than
would be the case if they lacked such shared experience.31
Consider the plausibility of the focal-point view with respect to the spectrum of cases
of collusion described in section 19.2.1. Three questions should be considered:
(1) Is it plausible that all prospective colluders would conjecture that some Nash
equilibrium would be played?
(2) If so, then is it plausible that they would all conjecture that some collusive equi-
librium (that is, one that would achieve an above-competitive level of profit)
would be played?
(3) If so, would their conjectures all be (nearly) identical, so that they collectively
would succeed in playing a specific, collusive equilibrium?
30 Bernheim (1984, 1011–12) provides an example of a game that has a unique Nash equilibrium. It
is a pure-strategy equilibrium in which each player plays one specific action with certainty. However,
that Nash action is not the player’s only rationalizable action. To the contrary, there is a set of profiles of
actions, in each of which all players play non-Nash actions, such that rational players can have common
knowledge of those profiles as conjectures.
31 The focal-point view was first set forth by Schelling (1960). Schelling envisioned two people who
have common knowledge that they need to meet in Manhattan, but have not had an opportunity to
communicate about where they should meet. He suggested that two tourists would both go to the Empire
State Building, while two NYC natives would both go to Grand Central Station. That is, a common
background makes a particular Nash equilibrium to be focal, but which equilibrium were to become
focal would depend on specifics of the background.
Let’s stipulate for now that the answer to questions (1) and (2) are affirmative.
Certainly the predominant economic modeling strategy in IO is to assume Nash play.
We will further consider question (2) below, but at the very least, a collusive equilibrium
is a natural conjecture in a context where it is common knowledge that everyone wants
to maximize profits.
In our basic example of gas-station duopolists, affirmative answers to questions
(1) and (2) strongly suggest an affirmative answer to question (3), as well. This implica-
tion reflects our assumptions in the example, such as that gasoline is an undifferentiated
product, that competitors have no private information about their respective costs, and
that price discrimination of any sort is impossible for any seller to implement. It is not
quite true that there is a unique profit-maximizing equilibrium in this setting, but there
is a unique price-maximizing equilibrium path, and it is a deterministic path. It does not
matter much, then, what kind of punishments the colluders believe would be imposed
off the equilibrium path. In fact, as long as each colluder conjectures that he would be
punished with sufficient severity if he were to break the cartel, the equilibrium path of
play will be realized. This outcome is robust to that type of heterogeneity of conjectures.
But the farther one moves away from the basic example, the less plausible it is that
industry participants would share a focal point. Consider three representative reasons
why coordination would be unlikely to be achieved in various situations:
• In a differentiated-product oligopoly, joint profit maximization is no longer

salient. Rather, there is a Pareto frontier of profit-maximizing price profiles.
Because of imperfect substitutability, a seller can be better off to maintain a price
somewhat above its competitor’s price than to sell at the competitive price. A firm
that charges a high price, but one that is slightly lower than its competitor’s price,
gets the lion’s share of the rents. The division of rents would be determined by the
competitors’ respective bargaining power against one another. If each competitor
believes that it is in the strongest bargaining position, for example, then the vari-
ous competitors’ conjectures will correspond to different points on their Pareto
frontier of profitability, and coordination on a focal Nash equilibrium will fail.
• Even if competitors agree about what is their desired imputation of rents, there
are a plethora of ways to achieve it. Consider, for example, the notorious cartel
of electrical-generator manufacturers in the 1950s. Bidding in procurement auc-
tions was rigged by a scheme that selected a winner according to the phase of the
moon on the day bids were requested. As long as purchasers remained unaware of
the arrangement, the lunar phase would be random, so the selection of the win-
ning bidder would be equitable. But, certainly it could not have been common
knowledge, prior to any communication, that this was the scheme that would be
adopted. That is no more a focal point than using the last two digits of the number
(mod 4) of shares traded on the New York Stock Exchange on the day prior to
the opening of bidding. Or, one month prior to the opening of bidding. Or, the
high temperature (mod 4) in Chicago on that day, as reported by the US National
Weather Service. The number of equally salient candidates for a coordination
device is huge. To implement a Nash equilibrium, it is not sufficient for cartel par-
ticipants to agree that they will split the market in a way that provides equal shares
in the long run. They must have a unanimous conjecture about precisely how the
splitting will be done.
• In an environment with private information, the equilibrium path will be sto-
chastic. If “punishment phases” are randomly triggered by outcomes such as steep
decline in demand at the cartel price, for which a deviation from collusion has a
high likelihood-ratio statistic (even though deviation is not believed to have actu-
ally occurred), then colluders face a coordination problem. If the “punishment” is
not going to last forever, then all colluders must abandon it simultaneously. The
reason is that, while anyone acts as prescribed in that phase, prices tend to remain
low. Thus, if someone continues that conduct for longer than the others conjec-
ture, then they will perceive the resulting low price to be occurring during the
active-monopoly phase of the cartel and will initiate the punishment phase. With
that phase being in force most of the time, the cartel will not be profitable. But
there are many equilibria corresponding to various rules about when to re-enter
the active-monopoly phase, none of which is an obvious candidate to be a focal
point. One candidate, the profit-maximizing equilibrium, involves successive pun-
ishment phases of independent, random duration. (Abreu, Pearce, and Stacchetti,
1986). Analogously to the problem of random selection of the respective winning
bidders in a sequence of rigged auctions, there is indeterminacy in the selection of
the randomizing device, and coordination will fail unless all participants adopt the
same device.
To summarize, there are two versions of the idea that sellers in a market might coor-
dinate on a specific pattern of collusive conduct without the need to communicate
plans with one another. One version, that such coordination would occur simply as a
result of the sellers following the logic of optimization in their shared situation—that
is, the idea of “reasoning to an equilibrium”—does not survive careful game-theoretic
analysis. The other version—the focal-point view—is logically sound. Nevertheless,
because most market environments are sufficiently complex that there are numerous
possible ways to collude, none of which will work unless it is adopted by all of the sig-
nificant market participants, that view suggests that it is difficult, and probably rare,
for successful collusion to obtain in the absence of explicit communication. The excep-
tion to this generalization is a market that is so simple and transparent—such as the
gas-station-duopoly example discussed earlier—that there is a unique candidate for
the optimal collusive agreement.
19.4.4. Risk Dominance as an Obstacle to Collusion

Let’s further consider an infinite-horizon version of the gas-station duopoly. Suppose
that the stations are identical, having a fixed cost F of operation and selling gas at
constant marginal cost. Moreover, suppose that there are only two prices that could be
charged: a high pH and a low pL .
Let’s make an assumption that the gas stations will continue to charge pH forever if
they both charge that price initially, but that they will both charge pL subsequently if
they do not both charge pH the first time. This assumption expresses, in stark form, the
idea that initial success in collusion establishes a successful long-term arrangement, but
that any convergence to collusion after an initial failure to collude would be slow enough
that the present discounted value of eventual collusive profits would be low.
If both sellers charge pH, then each receives half of the monopoly profit M in each
period, and the cartel continues forever. Thus, the discounted present value of partici-
pating in the cartel is ρM , where ρ > 1.32 If they both charge the low pL, then each earns
zero profit.33 If they start out making opposite choices, then the high-price station ini-
tially sells no gas but bears its fixed cost, losing F, while the low-price station initially
earns revenue pL D( pL ) = 2F and consequently earns positive profit F net of its fixed
cost. Subsequently to the initial period, by the assumption above, both stations charge pL
and earn zero profit. These payoffs are summarized by the following matrix.
pH pL
ρM / 2 F
pH
ρM / 2 −F
−F 0
pL
F 0
If the interest rate is low (so that ρ is large), M is large, and F is small, then ρM / 2 > F ,
and both symmetric-price profiles are Nash equilibria, with the collusive one (that is, for
both sellers to charge pH) being the more profitable one. Profitability seems to make col-
lusion a focal point. However, there is a countervailing argument. A seller who sets price
pH will suffer a loss if, contrary to his conjecture, the other seller charges pL. In contrast,
a seller who sets price pL will make an unanticipated profit if, contrary to his conjecture,
the other seller charges pH. In this sense, setting pL is the less risky choice. Indeed, if
a seller conjectured that the other seller was equally likely to charge pL or pH, then he
would charge pL in order to maximize his expected profit.
The technical name for this property of the low-price equilibrium is risk dominance. It
was introduced by Harsanyi and Selten (1988), who proposed the tracing procedure as an
account of how rational players choose among multiple Nash equilibria of a game that
32
If the duopolists face 1-period interest rate r, then ρ = (1 + r ) / r .
33
So, if D(p) is market demand at price p, then pL D( pL ) / 2 = F . Note that, as pointed out by
Edgeworth, this price would not be a Bertrand equilibrium (and, with positive F, no Bertrand
equilibrium would exist) if a seller could marginally lower its price and capture the entire market.
they are playing.34 Roughly speaking, their proposal was first to discard all but the Pareto
frontier of the Nash equilibrium set, and then to use risk dominance to select among
the remaining equilibria. But Aumann (1990) subsequently argued, in effect, that such
a lexicographic priority for Pareto efficiency was misguided, and that risk dominance is
actually the more compelling criterion. Harsanyi (1995) accepted Aumann’s argument
and formulated a new equilibrium-selection theory based solely on a version of risk
dominance.
The case for the risk-dominant equilibrium being played is even further strengthened
by research of Carlsson and van Damme (1993). They consider games such as the one
above, to which they add the realistic consideration that players’ information about one
another’s payoffs is accurate but not perfectly precise. Imagine, for example, that two
gas-station owners are franchisees of different chains and are contractually obligated
to use their respective franchisers as their sole suppliers of gasoline. Each supplier sets
its price at any date in a way that closely reflects the market price of crude petroleum,
and each gas station owner can read the price of crude in the newspaper but cannot
directly observe the wholesale refined-gas price of his competitor’s supplier. Thus, each
owner is highly confident that the other purchases gas at a price very close to his own
price, but does not know his competitor’s price—or, consequently, his competitor’s pay-
off function—with complete accuracy. The generalization of Nash equilibrium to such
a situation is Bayesian Nash equilibrium, and Carlsson and van Damme prove that the
risk-dominant Nash equilibrium of the complete-information game corresponds to the
unique Bayesian Nash equilibrium of the incomplete-information version of the game,
even as the precision of information tends to certainty.35
Carlsson and van Damme’s formal proof is a piece of mathematical analysis that
may seem to be a magician’s hat trick, but they provide a discussion that makes it seem
much more intuitive. Recall the distinction between mutual knowledge and common
knowledge that was introduced above. Something is mutual knowledge among a group
of competitors if each knows it. A synonym for mutual knowledge is first-order knowl-
edge. Define the competitors to have second-order knowledge of some fact if each of them
both knows the fact itself and knows that the others know it. Third- and higher-order
knowledge are defined successively in this way. A fact is common knowledge if there is
first-order and second-order and . . . nth-order and . . . knowledge of it. When informa-
tion is sufficiently precise, it can be nth-order knowledge (for very high n) that ratio-
nal competitors will charge the monopoly price (that is, will play the payoff-dominant
but risk-dominated strategy), but that is never common knowledge unless informa-
tion about competitors’ payoffs is absolutely precise. Rubinstein (1989) has shown
that no finite level of belief is sufficient to make it rational for everyone to play the
payoff-dominant Bayesian Nash equilibrium. Only common knowledge will do. This
same insight is the economic content of Carlsson and van Damme’s result.
34 See Harsanyi and Selten (1988) for a formal definition of risk dominance and discussion of its
significance.
35 Actually, Carlsson and van Damme prove an even stronger conclusion than this.
Two rejoinders to the foregoing arguments why the risk-dominant equilibrium would
be played are available. One rejoinder, specific to Carlsson and van Damme’s argument,
is that the technical assumptions of their theorem are more restrictive than their account
of the assumptions’ intuitive content would suggest, and that those technical assump-
tions are unlikely to hold exactly. This rejoinder can be rebutted, in turn, by the observa-
tion that assumptions of scientific theories invariably fail to correspond precisely to the
truth. In a specific form, the rejoinder simply expresses an antiscientific attitude, and it
is not worthy of being taken seriously. At this point, there is nothing further to be said
on either side. Probably neither party to the discussion will have persuaded the other,
and their views will be as far apart as when they began. Just as it is not likely to produce
scientific agreement, this line of argument is also unlikely to produce consensus about
practical questions of competition policy or jurisprudence.
A much more compelling and interesting rejoinder is based on an argument made
by Aumann (1990). To begin to set forth this rejoinder, let’s step back for a moment
and put Carlsson and van Damme’s argument in context. Someone who uses that
argument to argue that monopolistic outcomes cannot arise from tacit coordination
intends, presumably, to contrast tacit coordination with weak explicit collusion involv-
ing overt negotiation of a cartel arrangement, and to assert that the cartel members
could possibly reach common knowledge of their collusive intent through communi-
cation. But Aumann claims to refute that assertion.36 According to Aumann, a player
can credibly communicate to an opponent that he would like the opponent to play the
payoff-dominant strategy, but he cannot credibly communicate to the opponent that he
will play the payoff-dominant strategy himself. The upshot is that the risk-dominant
(that is, nonmonopolistic) equilibrium is the only one that could rationally be played,
even if there is unlimited opportunity for explicit communication among prospective
colluders.
The conjunction of Aumann’s conclusion (that explicit collusion cannot be more
feasible than tacit coordination is) and Carlsson and van Damme’s conclusion (that
tacit coordination is not feasible) flies in the face of the incontrovertible evidence that
explicit collusion has sometimes occurred and been stable through long intervals of
time.37 Thus, if the soundness of Aumann’s argument is conceded, then Carlsson and
van Damme’s conclusion must be denied.
Again, though, there is a rebuttal to the rejoinder. The rebuttal is that there is experi-
mental evidence against Aumann’s view. Specifically, Charness (2000) reports an exper-
iment in which a high proportion of subjects played a payoff-dominant, risk-dominated
equilibrium after having had opportunity for explicit communication, but in which that
equilibrium was rarely played by subjects who had not had such an opportunity.38 On
36 Moreover Harsanyi, a game theorist of unparalleled subtlety and insight, was persuaded by
Aumann’s argument.
37 On the prevalence of cartels, see Levenstein and Suslow (in this volume).
38 Charness cites some previous research that also suggests that conclusion. See also Choi and Gerlach
(in this volume).

the basis of this evidence, someone might decide to reject Aumann’s conclusion (even
if he could not pinpoint where the logic of Aumann’s argument for it goes wrong), and
could consequently hold the view that explicit collusion is likely to occur but that tacit
coordination is implausible.
19.4.5. Initial Capital Investment as Communication

So far in this section, we have supposed that industry conduct begins immediately with
decisions about output or pricing, with capital investment implicitly having been deter-
mined previously and not being subject to adjustment. That is, investment (or capacity)
is not a strategic choice. The argument of Aumann that has just been discussed, in par-
ticular, is formulated in that context.
Now, let’s reconsider that argument in the context of an industry with a two-stage
life. In the first stage, an incumbent with large production capacity is joined by an
entrant who bears an investment cost of acquiring capacity. (Whatever cost the
incumbent may have borne in the past to build capacity, is now “sunk cost” and will
not figure in the analysis that we make under these assumptions.) In the second stage,
the firms will be quantity-setting competitors who choose their respective outputs
at every date (0, 1, 2, . . .) subject to their respective capacity constraints. These con-
straints are at the exogenous (but nonbinding) level for the incumbent and the level
determined by stage-1 investment for the entrant, and cannot be adjusted during stage
2. At each date, firms produce perfect-substitute goods and the market price is per-
turbed by a demand shock that the firms cannot observe, as in the model of Green and
Porter (1984).
As in the preceding discussion we simplify the analysis by supposing that only finitely
many—in this case, three—output levels are feasible. One is the static Cournot level. Call
this output q2 . The other two feasible levels are parameters of the joint-profit-maximizing
equilibrium of the Green-Porter environment that Abreu, Pearce, and Stacchetti (1986)
(APS) have characterized. In that equilibrium, each firm produces output q1 < q2 , which
is approximately the static monopoly output, in the “cooperative” phase of equilibrium;
and each produces a maximin output q3 > q2 during reversionary episodes. Thus we
specify {q1 , q2 , q3 } to be the set of feasible output levels.
Given this assumption about feasible output levels, it is natural to specify also that, in
stage 1, the entrant must choose a capacity level in {q1 , q2 , q3 }.
Now, the question is, can the entrant credibly signal collusive intent and also motivate
the incumbent to collude by choosing some particular level of capacity.
Of course, the entrant could do more than signaling—he could commit always to pro-
duce the collusive output—by choosing capacity q1 . But, if the entrant did that, then he
would lose the capability to punish the incumbent for not reciprocating in collusion.
The incumbent would make strictly higher profit in any period by producing q2 than
by producing q1 , and so would never produce q1 . The resulting industry conduct would
not be collusive.
Nevertheless, the entrant would succeed in both signaling collusive intent and also
motivating the incumbent to collude as well, if he were to choose capacity q3 . The ratio-
nal incumbent should understand the implication of that choice in terms of a thought
process that game theorists call forward induction. He should think as follows: If the
entrant conjectured that I were going to play static Cournot, then he would be cer-
tain that he would never benefit (either directly or indirectly, by setting incentives for
me) by producing more than q2 . Therefore, he would be sacrificing profit by making
more costly investment to acquire capacity q3 . Since he is a profit maximizer, I deduce
(by modus tollens) that his conjecture is that we are going to play the APS equilibrium
rather than the static Cournot equilibrium in stage 2. Consequently, if I were to produce
more than q1 at the initial production date, then with high probability, the market price
would be lower than the trigger price, and he—with certainty that I am behaving iden-
tically—would switch to the reversionary output level q3 , which would be bad for my
profitability. That is, my conjecture is that he is going to produce the monopoly level of
output as long as the market price stays above the trigger price, and my Nash response to
that conduct is to do likewise.
The foregoing analysis follows closely the analysis of forward induction first proposed
by van Damme (1989) for equilibrium of the burning-the-dollar game. That is a two-stage
game, in which some particular single-stage game with several Nash equilibria is to be
played in stage 2. In stage 1, one of the players has the opportunity publicly to burn a
dollar bill. This action has no implication whatsoever for the feasibility of strategies or
for the payoffs to any player of strategy profiles in stage 2. Nevertheless, the two-stage
game has a unique equilibrium consistent with forward induction: the player does not
burn the dollar, and even though he abstains from that action, the Nash equilibrium
most favorable to him is played in stage 2. The analogy between the oligopoly game dis-
cussed here and the burning-the-dollar game is not exact, because the analogue of burn-
ing a dollar bill would be to invest in even more capacity than is required to play the
APS equilibrium, and we have specified that option not to be available. Nevertheless, the
logic of the incumbent’s thought process described above is precisely that spelled out in
the analysis of burning the dollar.
Alternately, consider an industry such as production of a good that has just been
invented by a nonproducer (e.g., by a government laboratory), so that all prospective
producers make simultaneous capacity choices in stage 1. Does forward induction also
select the APS equilibrium in this environment?
The answer is negative. Ben-Porath and Dekel (1992) have shown that, if both players
of a single-stage game have the opportunity to publicly burn a dollar beforehand, then
all equilibria of the single-stage game can be consistent with forward induction.
The upshot is that there is a theoretical model in which capacity choice functions as
communication of collusive intent in the context of one, specific, initial configuration of
an industry, but that the model does not show investment invariably to succeed to func-
tion in that way. In the current state of its development, game theory does not provide
any more concrete guidance about how general may be the circumstances in which tacit
coordination might arise via forward-induction reasoning.
19.4.6. Blundering into Tacit Coordination

In the introductory section of this chapter, we stated, “There has been broad agreement
in principle that monopoly conduct can arise spontaneously in highly concentrated
markets that satisfy some other (possibly restrictive) conditions.” Building largely on the
analysis provided by Aumann (1990) and Aumann and Brandenburger (1995) of Nash
equilibrium as an outcome of rational interaction among players, we have found on the
whole that the conditions for monopoly conduct to arise spontaneously as a result of
such rational interaction are indeed restrictive.
But Aumann and Brandenburger provided sufficient conditions for players’ conjectures
to be a Nash equilibrium, not necessary ones. They mentioned the possibility that play-
ers might “blunder into an equilibrium by accident,” even in a situation where their suf-
ficient conditions for Nash equilibrium were not satisfied.
To assess this possibility requires a complement to the theory of outcomes of rational
interaction under strong assumptions about higher-order knowledge of other players’
rationality: a theory of equilibrium as a long-run outcome of “blundering” by (predomi-
nantly) rational agents. Those agents can be modeled as making “optimal” decisions
based on understanding their environment and on knowing what actions other players
are using (on average, at least), but without consideration of what other agents might be
thinking and of how their future actions might change as a result of their own optimiza-
tion/reasoning processes. This complementary theory is the topic of evolutionary game
theory. Like other theories, this one is actually a family of related models. Virtually all
evolutionary models have the implication that behavior almost surely approaches some
Nash equilibrium in the long run. The models that make the most precise predictions
introduce a low level (made asymptotic to zero, in formal analysis) of irrational behavior
that corresponds to mutation in a biological population. The canonical models of this
sort were formulated by Young (1993) and by Kandori, Mailath, and Rob (1993). Analysis
of those models provides a formal foundation for the informal Aumann-Harsanyi argu-
ment that when one Nash equilibrium is payoff dominant and another one is risk domi-
nant, play will converge to the risk-dominant equilibrium. As they relate to our analysis
in section 19.4.4, those models suggest that firms will not blunder into tacit coordination.
However, by relaxing only slightly the assumptions of those models about the opti-
mality of nonmutant actions, Fudenberg and Imhof (2008) formulate a model in which
the efficient outcome can be selected in repeated prisoner’s dilemma games that are the
abstract analogue of the repeated-interaction environments discussed earlier in this
chapter. Thus, Fudenberg and Imhof ’s model lends some support to a favorable view
toward the possibility of competitors blundering into tacit coordination.
Sabourian and Juang (2008) ably survey general issues regarding use of evolution-
ary game theory to select the most plausible among the Nash equilibria in an environ-
ment. As they mention, the predictions of particular evolutionary models are sensitive
to the specific assumptions that are incorporated in those models, and that might not be
persuasive to a skeptic. Bergin and Lipman (1996) have shown that, if “mutations” are
modeled as being state dependent, then any strict Nash equilibrium (that is, equilibrium
in which each player’s Nash action is strictly preferred to all of his other actions) can be
selected. The gist of Bergin and Lipman’s research is that, until economists develop intu-
itively compelling justifications for specific mutation processes, evolutionary game the-
ory will remain an insightful but inconclusive framework for reasoning about whether
“blundering” will lead to payoff-dominant (that is, tacitly coordinated) outcomes, or to
risk-dominant (that is, noncollusively oligopolistic) ones.
19.5. Tacit Coordination in

Antitrust Litigation
A potentially collusive pattern of prices is a violation of the first section of the Sherman Act
only if it is shown that there is an agreement among competitors. Unfortunately, there is no
recipe to identify agreements from economic circumstantial evidence if the environment
is such that collusive prices may arise without communication. Posner (2001) states that
in some circumstances competing sellers might be able to coordinate their pric-

ing without conspiring in the usual sense of the term—that is, without any overt or
detectable acts of communication. This is the phenomenon that lawyers call “con-
scious parallelism” and some economists term “oligopolistic interdependence,” but
which I prefer to call tacit collusion in contrast to explicit collusion of the formal
cartel or its underground counterpart. (Posner, 2001, 52–53)
In the same chapter, Posner (2001) tells the history of the price-fixing criminalization
including the possibility of tacit coordination. He argues that just after the Sherman Act,
judges and lawyers based their cases in the mere fact of explicit collusion and not in the
economic consequences, probably because lawyers were more comfortable with con-
spiracy doctrine that with an economic theory of pricing. Posner (2001) points out the
inadequacy of considering the existence of overt communication as the only decisive
factor in collusion prosecution. Once the economic effects are taken into account, one
must consider the possibility that a seemingly collusive price may have been reached
without communication or even an agreement but from the understanding of the stra-
tegic interdependence. Posner (2001) approaches the issue of what constitutes a tacit
agreement by referring to Turner (1962). For Turner (1962), whether a pattern of prices
was reached through an agreement or not could be “considered purely as a problem in
linguistic definition.” Posner (2001) then discusses when “plus factors” may allow the
inference of explicit collusion from economic evidence.39
39 See Kovacic et al. (2011) on identifying the strength of various plus factors.
Baker (1993) also reached the conclusion that distinguishing an “agreement” among
competitors when the evidence is “entirely circumstantial” is difficult from both a legal
and an economic perspective:
Courts and commentators have debated for decades whether parallel price changes
by oligopolists who recognize their interdependence provide a sufficient basis for a
court to infer an unlawful horizontal agreement under Sherman Act 1, and if not
what additional circumstantial evidence is required to prove a conspiracy. (Baker,
1993, 144)
Baker (1993) concludes that regardless of the requirements to distinguish among coordi-
nation and agreement, antitrust policy should prevent practices that facilitate oligopoly
coordination, which is the approach of the European Commission.
Turning to Europe, Garces-Tolon, Neven, and Seabright (2009) and Ivaldi and coau-
thors (2007) analyze the evolution of tacit coordination in Europe from 1990, year in
which merger control became a responsibility of the European Union. Ivaldi and coau-
thors (2007) point out that tacit coordination, or collective dominance as it is called by
the European Commission, has been a controversial issue. According to the article, the
interpretation of collective dominance in litigation used to have no structural links and
it was not until recent years that it was more precisely specified. Consistency is up to
some point due to a regulation in 2004 in which the Commission declared “incompati-
ble with the EC treaties mergers that create or strengthen a dominant position as a result
of which effective competition would be significantly impeded” (Ivaldi et al., 2007, 217–
18). In this sense, the European Commission is relying on game theory, mainly results
on subgame perfect equilibrium in repeated games, to determine whether or not a con-
centration or a merger is strengthening a dominant position. An analysis of how results
in repeated games have been used in litigation can be found in Garces-Tolon, Neven,
and Seabright (2009). Ivaldi and coauthors (2007) also analyze the impact of game the-
ory on European merger policy.
We hope this chapter facilitates communication between lawyers and economists on
these issues by providing a common language and framework for discussion. It is clear
that for years to come antitrust enforcement authorities will wrestle with the identifica-
tion of what types of conduct violate antitrust laws.
Acknowledgments
The authors thank the Human Capital Foundation (http://www.hcfoundation.ru/en/),

and especially Andrey Vavilov, for financial support. The paper benefited from discus-
sions with Roger Blair, Louis Kaplow, Bill Kovacic, Vijay Krishna, Steven Schulenberg,
and Danny Sokol. We thank Gustavo Gudiño for valuable research assistance.
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CHAPTER 20
AU C T IO N S A N D B I D R IG G I N G
KEN HENDRICKS, R. PRESTON MCAFEE, AND

MICHAEL A. WILLIAMS
20.1. Introduction and Overview
20.1.1. Auctions
An auction is “a market institution with an explicit set of rules determining resource
allocation and prices on the basis of bids from the market participants” (McAfee and
McMillan, 1987).1 Auctions are among the oldest market institutions; “marriage auc-
tions” for brides were used in Babylon as early as 500 BC. Products commonly bought
and sold using auctions include art and jewelry, US Treasury Bills, used cars, the assets
of bankrupt companies, and radio spectrum. Auctions are also commonly used in the
government procurement of goods and services. Online auctions comprise a significant
portion of the rapidly growing electronic commerce marketplace.
Auction theory provides an explicit model of price formation. Traditional mod-
els of competition that furnish equilibrium prices given demand and supply char-
acteristics, such as Cournot and Bertrand models of competition, do not explain the
price-formation process in terms of buyer-seller interactions. In contrast, auction mech-
anisms explicitly lay out rules that govern the formation of prices. A typical auction con-
sists of a single auctioneer, responsible for selling an object, and a number of bidders
who wish to buy the object. The auctioneer may announce a reserve price, that is, the
1 A number of survey papers on auction theory and empirical work have been published. See, e.g.,
McAfee and McMillan (1987), Wilson (1992), Klemperer (1999), and Hendricks and Porter (2007). In
addition, Klemperer (2008) analyzes the use and misuse of bidding markets in antitrust economics.
Auctions and Bid Rigging 499
lowest price at which the object would be sold. There are four basic types of single-item
auctions analyzed in the economics literature: (1) the English auction, (2) the Dutch
auction, (3) the first-price sealed-bid (FPSB) auction, and (4) the second-price sealed
bid (SPSB) auction (also called a Vickrey auction).
These four types of auctions are characterized by the following two proper-
ties: (1) whether bids are open or closed (i.e., sealed) and (2) whether the winning bidder
pays an amount equal to the winning bid or the highest losing bid. An English auction
is an open-bid auction in which bidders sequentially raise the price of the item until no
bidder is willing to raise it further. A Dutch auction is an open-bid auction that proceeds
in the opposite direction: The seller begins the auction at a particular high price, and
lowers the price until a bidder is willing to purchase the item. In both FPSB and Dutch
auctions, the winning bidders pay an amount equal to the winning bid. In a closed auc-
tion, each bidder may submit only a single, sealed bid (that is, no bidder may observe
another bidder’s bid). The seller then considers all submitted bids simultaneously. In
FPSB and SPSB auctions, bids are submitted in a sealed fashion and are considered
simultaneously by the seller to determine the winning bidder. In a FPSB auction, the
highest bidder wins the item and pays an amount equal to the highest bid, that is, the
winning bid. In a SPSB auction, the highest bidder wins the item and pays an amount
equal to the second-highest bid, that is, the highest losing bid. In all four auction for-
mats, the seller does not sell the item if the price determined by the auction is below the
reserve price.
In the theoretical literature on auctions, such as Milgrom and Weber (1982), English
auctions are usually approximated by Japanese auctions for the sake of analytical con-
venience. In a Japanese auction, the seller starts the auction with the price of the item at
a minimum level. Each bidder presses and holds down a button while the price of the
item is raised continuously. Bidders drop out of the auction by releasing their button
when the price of the item exceeds their willingness to pay, that is, their valuation. Each
bidder can observe all of the bids. The auction ends when the second-highest bidder
drops out, so the winning bidder is the last remaining bidder. The continuous increase
in price in a Japanese auction simplifies the theoretical analysis and makes it trans-
parent that the winning bid in an English auction is approximately the second-highest
valuation.
20.1.2. Standard Auction Models

The economic literature on auctions typically distinguishes two extreme types of infor-
mation environments: private value (PV) and common value (CV). In a PV auction,
each bidder knows her own value but not those of other bidders. For example, an art auc-
tion with art collectors who do not intend to resell the item would be analyzed using the
PV framework. Each bidder’s valuation is a personal characteristic that does not depend
on other bidders’ valuations. In a CV auction, the value of the item up for auction is the
same for all bidders, but that value is unknown to the bidders before the auction. Prior to
500 Ken Hendricks, R. Preston McAfee, and Michael A. Williams
bidding, bidders receive different private signals about the true value of the object. For
example, in an offshore oil tract auction, bidders conduct their own geologic research to
form their private estimates of the value of an offshore tract.
The standard economic model of an auction consists of a single seller and n bid-
ders, i = 1, 2, ..., n, who bid at an auction to purchase a single indivisible good. Bidder
i’s valuation for the good is Vi , a real-valued random variable distributed according
to the cumulative probability distribution Fi . The value of V is known only to bidder
i , but Fi is known to the seller and the remaining bidders. In the symmetric indepen-
dent private value model (IPV), the valuations of bidders are assumed to be indepen-
dent draws from the same distribution F. In the CV model, the valuations of bidders
are informative signals about a common value V unobservable to the bidders. In this
case, Vi is typically modeled as an independent draw from a conditional distribution,
H (.| V ) , known to the bidders. Bidders in a common value auction are susceptible to
the “winner’s curse.” A bidder tends to win when she overestimates V and wins rarely
when she underestimates V . The PV and CV frameworks also have been merged to
study auction models in which bidders’ information consists of both private and com-
mon value components; see, for example, Milgrom and Weber (1982) or Goeree and
Offerman (2003).
Auctions are generally modeled as a Bayesian game, and bidders have Bayesian-Nash
equilibrium bidding strategies. In a FPSB IPV auction, the unique equilibrium
with n risk-neutral,x
symmetric bidders is the collection of bidding functions
∫ −∞
bi (vi ) = vi − [( n −1
F ( s ) ds ) / F (x )n −1 ] for each i = 1, 2,…, n . So each bidder bids less than
her value, and the markdown factor decreases with the number of bidders. In contrast,
in a SPSB PV auction, each bidder has a weakly dominant strategy to bid her valuation,
regardless of the number of bidders. In a FPSB CV auction, each bidder shades her bid
relative to her expected value of the object conditional on winning. However, the shad-
ing factor typically increases with the number of bidders due to the winner’s curse. In
SPSB CV auctions, the equilibrium is not in dominant strategies and not unique without
some refinement. One equilibrium involves bidding more than the average value (spe-
cifically bidding the value conditional on a second bidder having the same signal). In
this case, the actual bid will exceed the willingness to pay, although the second-highest
bid, the price, will not.
A fundamental (and remarkable) result in auction theory is the revenue equivalence
theorem for IPV auctions. An auction mechanism (e.g., an English or Dutch auction)
is efficient if the mechanism allocates the object to the bidder with the highest valua-
tion (Dasgupta and Maskin, 2000). The revenue equivalence theorem essentially states
that all efficient, symmetric IPV auctions yield the same expected revenue. Thus, for
IPV auctions, the expected winning bid is the same whether the auction mechanism
is English, Dutch, FPSB, or SPSB. A necessary assumption for the theorem to hold is
that the bidder with the lowest feasible valuation expects zero surplus. A first version of
this result was obtained by Vickrey (1961) and later generalized by Myerson (1981) and
Riley and Samuelson (1981). The revenue equivalence result does not hold, in general,
for common-value auctions.
20.1.3. Collusion in Auctions: Bid Rigging

In a bid-rigging scheme, bidders agree to collude to limit competition and obtain the
good for a lower price (or higher in the case of procurement) than would result in the
absence of such explicit collusion.2 A group of bidders who collude in an auction is
called a bidding ring. Bidding rings may be all-inclusive, that is, include every bidder
participating in an auction, or incomplete, consisting only of a subset of the set of all
bidders. As Marshall and Marx (2012, p. 175) summarize: “Colluding bidders suppress
their rivalry through the elimination of meaningful bids by all colluding bidders except
for the ring bidder with the highest value. All other details and logistics of bidder col-
lusion flow from this foundational principle of the ring.” Bid rigging is generally illegal
in the United States, the EU, China, and many other countries.3 Bid rigging is the most
common form of explicit collusion in auction markets (the other, less common, form
being explicit collusion between one or more bidders and the auctioneer). This should
be expected since noncooperative behavior is not jointly optimal for bidders. Bidders
are collectively better off colluding and transferring gains from trade from the seller to
the ring.
Rings differ from cartels insofar as they focus on individual auctions rather than a
broad cross-section of product and geographical markets. The focus simplifies the task
of a ring: it needs to coordinate the bids submitted by bidders. However, in doing so,
rings face some of the same challenges as cartels: detection by the antitrust agencies
or by the seller, internal enforcement, entry, and private information about the gains
from trade. The ability of rings to solve these problems, and the nature of the solution,
depends on the type of auction the seller uses.
One solution is to have all bidders submit identical bids, preferably at or near the
reserve price, and let the seller randomly select the winning bidder. This scheme wastes
a lot of the potential surplus from collusion because the good is unlikely to go to the
bidder with the highest valuation. It is also difficult to enforce. Individual bidders have
a strong incentive to bid slightly more than the agreed-upon price and win the good for
sure. It is also easy to detect. Not surprisingly, this simple form of collusive bidding has
become much less common after the US Federal Trade Commission prosecuted numer-
ous cases of identical bidding in the mid-twentieth century. A second solution is to have
2 There is a substantial economic literature on noncooperative, tacit collusion in auctions. For
theoretical analyses, see, e.g., Brusco and Lopomo (2002), Fabra (2003), and Blume and Heidhues
(2006). For empirical analysis, see, e.g., Cramton and Schwartz (2000) and Ishii (2009). For
experimental analyses, see, e.g., Sherstyuk (1999), Sherstyuk (2002), Kwasnica and Sherstyuk (2007),
Li and Plott (2008), Sherstyuk and Dulatre (2008), Boone et al. (2009), Haan, Schoonbeek, and Winkel
(2009), Potters (2009), Phillips and Menkhaus (2009), Brown, Plott, and Sullivan (2009), Hinloopen
and Onderstal (2010), and Müller and Normann in volume 1 of this Handbook. In addition, there is also a
substantial economic literature on corruption in auctions, i.e., bidders colluding with the auctioneer. See,
e.g., Compte, Lambert-Mogiliansky, and Verdier (2005). We do not analyze these literatures here.
3 An interesting exception in the United States is the legality of explicit bid rigging in hostile takeovers
of publicly traded companies. See McAfee et al. (1993).

bidders pay kickbacks to each other as payment for either refusing to bid or for submit-
ting “phantom” bids, that is, intentionally losing bids. In order to avoid detection, bid-
ders coordinate on the amount of the “serious” bid, and then “nonserious” bidders place
phantom bids. This technique requires more communication and explicit discussion of
prices, but makes collusion more difficult to detect by antitrust authorities using statisti-
cal methods (see discussion below).
The side payments among bidders can also solve the problem of private information.
The gains from trade captured by the ring from the seller, called the collusive surplus,
are maximized when the serious bid is submitted by the ring member with the high-
est valuation. But in order to make this assignment, the members of the ring need to
be incentivized to reveal their valuations. In one-shot auctions, rings typically solve
this issue by holding a knockout auction, either before or after the seller’s auction, for
example, Marshall and Marx (2012). The bidder with the highest valuation typically
wins the knockout auction. The ring members share a sum of money equal to the dif-
ference between the price in the ring’s knockout auction and the price in the original
auction.
How the collusive surplus is allocated among ring members depends on the nature
of the ring. If the ring members are symmetric, for example, their valuations are drawn
from the same distribution, the ring may agree to allocate equal shares of the collusive
surplus to each ring member. Alternatively, if some members of the ring are economi-
cally stronger than others, for example, have lower costs or higher valuations, the ring
may allocate the collusive surplus based on those characteristics; see Graham, Marshall,
and Richard (1990). For example, Asker (2010) analyzes how members of a bidding ring
for the purchase of stamps in the United States allocated the collusive surplus among
ring members depending on their bids in a knockout auction. Ring members shared
each increment between bids in the knockout auction, provided their bids were above
the auction price in the original auction. Half the increment was kept by the winner of
the knockout auction, with the balance shared equally between those bidders who bid
equal to or more than the incremental bid in the knockout auction.
In some auctions, for example, procurement contracts and corporate takeovers, a
bid-rigging ring may allocate the collusive surplus by using subcontracts between ring
members, by bringing “losing” ring bidders back into the deal as equity owners, or by
splitting the takeover target into pieces (see McAfee et al., 1993).
In repeated auctions, the ring has more scope for meeting the challenges of collusion.
The simplest assignment is for ring members simply to take turns, with each being the
sole bidder in a given auction. More sophisticated bid rotation schemes involve bidders
communicating with each other regarding items they would like to win. The ring can
solve the incentive problem without knockout auctions or side payments by agreeing on
future allocations (Athey and Bagwell, 2001). Bidders can keep a “tally sheet” recording
each bidder’s winnings to ensure the bidders’ wins approximately balance out over time.
This type of scheme is more efficient than simple bid rotation schemes, but requires
more coordination and communication, thus increasing the likelihood the collusion is
discovered and prosecuted by antitrust authorities.
The enforcement issue is also more easily solved by rings in repeated auctions. To
deter bidders from cheating on a collusive agreement in repeated auctions, the ring
can punish members who cheat by reversion to non-cooperative bidding. A “bidding
war” ensues in which all firms pay high prices and earn low profits until the collusive
agreement can be reestablished (see, e.g., Porter, 1983 and 2005 in the context of a
railroad cartel).
In what follows, we will survey the literature on the theory and practice of bidding
rings in one-shot auctions and in repeated auctions. The main theme is how the type of
auction, whether it is first-price or second-price, sealed bid or oral, affects the incentive
of bidders to collude and the way in which they collude.
20.2. Bid Rigging: Theory
20.2.1. The Incentive to Collude in Different Auction Formats

Economic theory shows that the incentive of bidders to collude in an auction depends
in part on the auction format (see, e.g., Robinson, 1985, Waehrer, 1999, and Marshall and
Marx, 2007). In an ascending bid auction, for example, an English auction, the ring bids
up to the highest valuation of its members. This bidding strategy is the same as if the ring
member with the highest valuation had bid when there was no collusion. Thus, if in the
presence of the bidding ring a non-ring member wins the auction, that non-ring mem-
ber pays the same price that she would have paid in the absence of the ring. As Marshall
and Marx (2012, p. 176) discuss, this has an important implication: “if a ring wins, and
there are gains to their collusion, then the ring captures all of those gains; however, if the
ring loses, there are no gains from the collusion for non-ring bidders. The collusion is
self-contained in this sense.”
In contrast, at a sealed-bid auction, for example, a FPSB auction, the ring submits
a bid lower than the amount that the ring member with the highest valuation would
have bid in the absence of the collusion. This shading of the ring’s bid can sometimes
result in a non-ring member winning the collusive auction when that non-ring mem-
ber would not have won the auction in the absence of the collusion. As Marshall and
Marx (2012, p. 176) note: “the extra bid shading by the highest-valuing colluding bidder
opens the possibility that the ring does not capture all the gains to its collusive conduct.
The non-colluding bidders are beneficiaries, in expected terms, from the collusion.
. . .The leakage of some of the collusive gain to the outside bidders, which is absent at the
ascending-bid auction, means the incentives for suppression of rivalry through collu-
sion are typically weaker at the sealed-bid auction than at the ascending-bid auction.”
An interesting corollary to this discussion relates to the incentives of non-ring mem-
bers to join a ring. In the case of ascending bid auctions, non-ring members have no
incentive to remain outside of the ring, since the ring captures all the collusive gains.
In contrast, in the case of FPSB auctions, non-ring members may find it more profit-
able on average to remain outside the ring since the collusive gains leak out to non-ring
members.
20.2.2. Bid Rigging in One-Shot versus Repeated Auctions

Given an auction format, what is the optimal, incentive-compatible collusive mecha-
nism? Is the collusive mechanism efficient? Is it unique? Economic theory attempts to
answer these questions. A primary issue in the theoretical analysis of bid rigging is sta-
bility. A collusive scheme cannot be sustained in the absence of an appropriate enforce-
ment device, such as side payments or punishments. In the absence of such a device,
bidders have an incentive to lie about their valuations or otherwise deviate from the
collusive scheme. Theoretical studies of bid rigging in auctions fall into two broad
areas: collusion in one-shot auctions and collusion in repeated auctions.
20.2.2.1. Bid Rigging in One-Shot Auctions

Graham and Marshall (1987) develop models of bidding rings in SPSB and English IPV
auctions. They assume that all bidders are ex ante identical in the sense that their valu-
ations are drawn from the same distribution. They describe a collusion mechanism in
which, prior to the main auction, each ring member submits a sealed “reported bid” to
a risk-neutral ring center. The ring center determines the two highest reported bids and
selects the member with the highest reported bid to act as the sole bidder in the actual
auction. The ring center specifies that the bid submitted in the actual auction should
equal the highest reported bid submitted to the ring. Other ring members are instructed
to bid zero or not submit a bid. If the ring member wins the main auction, she pays the
auctioneer an amount equal to the second-highest bid of all bids submitted in the main
auction. She also must pay the ring center the difference between (1) the second-highest
reported bid to the ring and (2) the second-highest bid of all bids submitted in the main
auction, if this amount is positive.
Graham and Marshall show that the auctioneer’s best response to the formation of a
bidding ring is to set a reserve price that increases as a function of the number of bid-
ders in the ring. For any given number of bidders in a ring, each ring member’s payoff
to collusion decreases as the reserve price increases. Thus, for any given reserve price,
the expected payoff to ring members increases as the number of bidders in the ring
increases. Therefore, the Nash equilibrium is characterized by (1) a ring that includes all
bidders and (2) a reserve price optimal for such a ring.
From an ex ante perspective, the ring center’s expected payments to ring members
equal the center’s expected revenues from the ring member who submits the high-
est reported bid to the ring. In this sense, the ring center is ex ante budget balancing.
However, a difficulty with the Graham and Marshall collusion mechanism is that the
ring center is not ex post budget balancing. That is, ex post the center’s expected payouts
exceed its expected revenues.
Mailath and Zemsky (1991) relax the identical-bidder assumption in Graham and
Marshall (1987) and show that an ex post budget balancing efficient collusion can be
achieved in a second-price auction. Furthermore, this outcome is possible even for a
proper subset of bidders. They construct an explicit mechanism that implements this ex
post efficient collusive result. With this efficient mechanism, the collusive surplus can
always be divided up in such a way that, not only will every bidder wish to participate,
but every subset of bidders will also wish to participate. As a consequence, no subset of
bidders can do better by colluding among themselves and excluding the other bidders.
That is, there exist allocations of the collusive surplus achieved by the ring coalition that
make each subring better off than it could be in the absence of the ring.
In contrast to the study of bidding rings in SBSP and English auctions, McAfee and
McMillan (1992) analyze bidding rings in a FPSB IPV game.4 They define two types of
cartels: weak cartels in which cartel members cannot make side payments, and strong
cartels in which side payments are permitted. For weak cartels, they prove that the opti-
mal collusive scheme (for a large class of valuation distribution functions) is identical
bidding. All bidders with valuations above the reserve price bid the reserve price, and
those with valuations below the reserve price submit bids equal to zero. They show that
the optimal collusive scheme is inefficient, since the winning bidder is picked at random
by the auctioneer out of all the bidders submitting identical bids. Thus, the winning bid-
der is not necessarily the bidder with the highest valuation for the object.
For strong cartels, McAfee and McMillan (1992) demonstrate that an efficient, opti-
mal mechanism exists for all-inclusive rings. They show this mechanism can be imple-
mented by having the bidders hold a first “knockout” FPSB auction, and then having
the winner of this knockout round participate in the actual auction if that winner’s bid
in the knockout round exceeds the reserve price. The winning cartel member then pays
each of the losers an equal share of the difference between her bid in the prior, knockout
auction and the reserve price.
McAfee and McMillan (1992) characterize optimal collusive mechanisms when
members of the bidding ring report their valuations to a direct, incentive-compatible
mechanism, for example, a “center.” McAfee and McMillan assume the center specifies
and enforces the bids. Marshall and Marx (2007) and Lopomo, Marx, and Sun (2011)
extend the model of McAfee and McMillan (1992) by assuming the center cannot con-
trol the bids ring members submit at the auction, but the center can enforce side pay-
ments between ring members. Lopomo, Marx, and Sun (2011) show in this case that
no collusive mechanism exists that improves bidders’ payoffs relative to noncooperative
4 McAfee and McMillan (1992) focus on private value auctions because the optimal ring mechanism
in the pure common value case is trivial. Efficiency is attained regardless of which member gets the right
to bid in the seller’s auction. Thus, an all-inclusive ring can use some exogenous method to allocate the
right to one of its members, such as a random allocation with equal probability weights, and ask each
bidder to report her valuation.
bidding even if side payments that depend only on ring members’ reported valuations
are allowed.
Lopomo, Marshall, and Marx (2005) show that in ascending-bid auctions, ring mem-
bers can have an incentive to bid in ways that can cause the ring to win the item even
though a non-ring bidder has the highest valuation. The ring mechanism may cause a
ring member’s reported valuation to increase her payment if another member of the
ring wins the auction. In this case, ring members have an incentive to report valuations
in excess of their actual valuations. This causes the ring’s highest valuation to increase,
so that the ring may win the auction even though a non-ring bidder has the highest valu-
ation. Similarly, if the ring uses a knockout auction, ring members may have an incen-
tive to bid in excess of their valuations if their payment in the knockout auction depends
on their bids.
Lopomo, Marshall, and Marx’s inefficiency result depends on two assumptions. First,
there is no preauction communication among the ring members regarding their valua-
tions. Second, the ring must ex post balance its budget. If the first assumption does not
hold, then the results of Mailath and Zemsky (1991) show that an efficient explicit collu-
sion mechanism exists. If the second assumption does not hold, then a modified version
of the collusive mechanism in Graham and Marshall (1987) yields efficient explicit collu-
sion without preauction communication.
Finally, Hendricks, Porter, and Tan (2008) analyze whether efficient collusion is pos-
sible in FPSB common value auctions. Assuming a ring forms, efficiency is trivially
obtained since the value of the item by definition is the same, that is, common, to all bid-
ders. So which particular ring member acquires the item is irrelevant from the perspec-
tive of the efficiency of the collusion. However, Hendricks, Porter, and Tan show that the
ring may be unable to form in the first place, even if the cartel is legal.
Hendricks, Porter, and Tan show that in a common value auction, buyers who
receive high signals regarding the true value of the object may prefer not to join a bid-
ding ring. In the absence of a bidding ring, a buyer’s only expected payment is to the
seller in the main auction. In the presence of a bidding ring, a buyer’s expected pay-
ment is the sum of two components: (1) the payment to the seller in the main auction
and (2) the payment to other buyers in the knockout round. The expected payment of
a buyer with a high signal to the seller in the main auction is lower with the bidding
ring. However, with the bidding ring, low-signal bidders, free from worry regarding
the winner’s curse, bid aggressively in the knockout round. Thus, the expected sum of
(1) the payment to the seller in the main auction in the presence of a bidding ring and
(2) payments to other buyers in the knockout round may be greater than the expected
payment to the seller in the main auction in the absence of a bidding ring. In this case,
a buyer who receives a high signal regarding the true value of the object prefers not to
join a bidding ring.
In summary, the literature on collusion in one-shot auctions establishes that bidders
can collude efficiently in an IPV environment if they can engage in preauction com-
munication and make side transfers to each other. Communication is essential because
members of the ring have to reveal their private values in order to allocate the object to
the member with the highest value. Side transfers are needed to ensure that the mem-
bers tell the truth and bid accordingly.
20.2.2.2. Bid Rigging in Repeated Auctions

The theory of repeated games suggests that repeated play makes it easier for bidders to
collude, since they can condition their behavior on bids and enforce collusive outcomes
by threatening to respond to deviations with competitive bidding. This form of collu-
sion is known as tacit collusion, and it is not illegal. The celebrated folk theorem estab-
lishes that sufficiently patient players can construct a self-enforcing scheme in which
they act as would a single firm and, thereby, achieve first-best collusive profits. However,
this result assumes that players do not have private information. Therefore, an impor-
tant question addressed in the literature on collusion in repeated auctions is whether an
all-inclusive ring in an IPV environment can earn first-best collusive profits when mem-
bers do not communicate or make side transfers to each other.
Before proceeding, we define efficient collusion in repeated auctions. A collusive
scheme is efficient if, in each auction, the ring (1) bids if and only if the highest valuation
of its members exceeds the reserve price; (2) never pays the seller more than the reserve
price; and (3) assigns the object to the member with the highest valuation. Efficient col-
lusion is basically a (random) bid rotation scheme in which each member gets to win
whenever her valuation is the highest and exceeds the reserve price. By definition, effi-
cient collusion maximizes the ex post surplus of the ring and generates first-best collu-
sive profits.
In a seminal contribution, Skrzypacz and Hopenhayn (2004) establish that tacit col-
lusion cannot achieve first-best collusive profits when bids are private information. They
consider a model in which bidders bid repeatedly for identical objects sold sequentially
over time. The seller publicly announces whether the object is sold and the identity of
the winner but does not provide any information on the bids or the identities of the
losing bidders. The bidders’ private valuations are distributed independently and iden-
tically across bidders and auctions. The auction format can be any one of the standard
first-price or second-price auctions. Bidders cannot communicate or make side trans-
fers to each other. In this environment, the authors derive an upper bound on the profits
that a ring can obtain and show that this upper bound is substantially smaller than the
profits in an efficient collusive scheme.
The authors also characterize the types of collusive schemes that can achieve the
upper bound on profits. They first note that any scheme in which, following every pub-
lic history, bidders adopt symmetric bidding strategies does no better than a simple
bid rotation scheme. This result corresponds to the weak cartel result of McAfee and
McMillan (1992). That is, symmetric continuation values imply that the bidders share
equally in future punishments and rewards so there are no transfers and, in that case, the
best the ring can do is bid rotation. The schemes that do better than bid rotation involve
treating bidders differently based on their history of wins and losses. The idea is to pun-
ish bidders that have more wins with a lower probability of winning, and even possible
exclusion, in future auctions. As a result, winners have lower continuation values than
losers, and these differences work like transfers. But, despite these transfers, the lack of
communication reduces collusive profits below the efficient level.
Athey, Bagwell, and Sanchirico (2004) explore this trade-off between efficiency
and profits in an infinitely repeated Bertrand game with inelastic demand. The firms’
costs are independently and identically distributed across firms and periods. The stage
game is equivalent to a procurement auction since the firm that sets the lowest price
wins the entire market. Consequently, the model is essentially the same as Skrzypacz
and Hopenhayn except that bids are publicly observed. The authors characterize the
set of symmetric equilibria and obtain two striking results. First, they show that, in any
collusive equilibrium in which bidders use monotone bid functions, the ring achieves
efficiency (due to the sorting of types) but earns profits that are no better than those gen-
erated by the noncooperative equilibrium. Second, the symmetric scheme that yields
the highest profit to the ring involves rigid pricing; that is, bidders bid the reserve price
and the seller randomly chooses a winner. This result is similar to the result obtained
by Skrzypacz and Hopenhayn and generalizes the weak cartel result of McAfee and
McMillan (1992) to repeated auctions with observable bids.
If tacit collusion is inefficient, can communication among the members of the ring
regarding their private information help them achieve first-best collusive profits? And,
if so, what does the collusive scheme look like? These questions have been addressed in
several papers.
Athey and Bagwell (2001) consider a simplified version of the infinitely repeated
Bertrand game discussed above. There are only two firms and their costs in each period
are identical and independent Bernoulli random variables: “high” with probability η
and “low” with probability 1 − η. As noted above, their model is equivalent to a repeated
procurement auction. The firms explicitly, albeit illegally, collude. The authors assume
that (1) the firms can communicate with each other in each period regarding their cur-
rent costs, but (2) they cannot make side payments (so as to reduce the probability of
detection by the antitrust authorities). Prices, that is, bids, are public information.
The main result of their paper is that a sufficiently patient ring can achieve the
first-best collusive profits. The efficient collusive scheme is similar to one that Skrzypacz
and Hopenhayn construct to show that a ring can do better than bid rotation. In each
period, the high-cost bidder does not bid and the low-cost bidder bids the reserve
price. However, the high-cost bidder is favored in future auctions with a higher prob-
ability of being selected in the event that both bidders have same cost. These future
“market-share” favors have no impact on efficiency since they only occur in periods in
which the firms’ realized costs are the same. But the market-share favors mean that the
continuation value of the low-cost bidder is lower than the continuation value of the
high-cost bidder, and this difference acts like a transfer. The only issue is whether the
magnitudes of the feasible market-share favors are sufficient to incentivize bidders to
cooperate and report their costs truthfully. The authors show that, if the firms do not
discount future profits too heavily, the answer is yes.
Aoyagi (2003) analyzes a model of infinitely repeated auctions consisting of two sym-
metric bidders who bid every period on a single indivisible good. The auction format can
be either first-price or second-price. The private signals of the bidders are real-valued and
identically and independently distributed across bidders and auctions. The bidders report
their private signals to a communication device, called a “center,” to coordinate their bids
in each auction. After receiving the reported signals, the center subsequently instructs the
bidders on how to bid in the auction. A “collusion scheme” consists of the center’s choice
of instruction rule in every period as a function of the reports and the public histories. The
public history is the sequence of instruction rules chosen by the center in past auctions and
the bids in those auctions. A collusion scheme is an equilibrium if, for each bidder, telling
the truth about her valuations is incentive compatible, and it is rational to adhere to the
instructions. Aoyagi studies a class of dynamic bid rotation schemes with “grim trigger”
punishments. In these schemes, the players begin in the collusion phase in which only one
bidder is instructed to bid in a given stage auction. If a player deviates from the instruc-
tions, a punishment phase is triggered in which the one-shot Nash equilibrium results.
Aoyagi’s dynamic bid rotation scheme works as follows. In the first phase, the center
uses the efficient instruction rule. That rule instructs the bidder with the higher valua-
tion (based on the bidders’ reported valuations to the center) to bid the reserve price if
and only if the valuation exceeds the reserve price. The center instructs the other bidder
not to bid. The difficulty is that the efficient instruction rule is not incentive compat-
ible. Each bidder has an incentive to overstate their reported valuations to the center in
hopes of winning the auction at the reserve price. To solve this problem, the bid rotation
scheme has a second phase in which the payoff to the bidder with the highest reported
valuation is reduced relative to the other bidder with some positive probability. The
instruction rule in this phase is incentive compatible. The bid rotation scheme proceeds
in this second phase for a fixed number of periods before reverting to the first stage.
The collusive profits from Aoyagi’s scheme are not first-best but, as in Skrzypacz and
Hopenhayn’s model, they are higher than the profits the ring would obtain from the
scheme in which the bidders take turns winning at the reserve price independently of
their values. The main difference between his model and that of Athey and Bagwell is
the cardinality of the set of valuations. In the Athey and Bagwell model the set is finite,
but in Aoyagi’s model the set is the unit interval. Thus, the kind of “market-share” favors
that Athey and Bagwell use in their optimal collusion scheme is not possible in Aoyagi’s
model, since the probability of both bidders having the same valuation is zero.
In a subsequent paper, Aoyagi (2007) uses the same model but with a finite type space
to show that a ring can achieve the first-best collusive profits. The optimal collusion
scheme is fully efficient, that is, each bidder’s equilibrium payoff is close to what she
would get if the object were allocated at the reserve price to the highest-valuation bid-
der in every stage auction. Using a similar dynamic bid rotation scheme to that in his
2003 paper, which allows for bidder communication, Aoyagi identifies conditions under
which an equilibrium collusion scheme is fully efficient.
One conclusion of the literature on repeated auctions is that bidders do not have to
use side payments to implement the efficient bid rotation scheme. Strategies in which
current losers are rewarded in future play can provide sufficient incentives for bidders to
cooperate. A second conclusion is that sellers can make it difficult for bidders to achieve
first-best profits by not making bids public. In this case, bidders have to communicate
to earn the full benefits from collusion, which makes a ring illegal and easier to detect.
A third conclusion is that, when bidders are sufficiently patient, communication is suf-
ficient to achieve first-best collusion profits.
20.3. Bid Rigging: Empirical Studies
20.3.1. Empirical Studies of Bid Rigging in Auctions

Porter and Zona (1993) examine bidding for state highway construction procurement
auctions in Long Island, New York, from 1979 to 1985.5 The New York Department of
Transportation (“DOT”) awarded approximately $120 million in 186 separate high-
way contracts in this period. The DOT used the FPSB auction format in its highway
construction procurement auctions. Porter and Zona first evaluate whether the char-
acteristics of these procurement auctions would tend to facilitate collusion. The first
characteristic of the auctions is the public nature of certain information. Prior to a
given procurement auction, the DOT made public a “Plan Buyers List” that listed the
firms that purchased the plans for that highway construction project. Thus, cartel
members had knowledge of the set of potential bidders against whom they would bid
before each procurement auction. On the day the winning (low) bidder was selected,
the DOT publicly announced all bids and the identity of each bidder. As Porter and
Zona note, this information allowed cartel members to detect deviations from an
agreement. The second characteristic of the auctions is the DOT’s inelastic demand.
Out of the 186 highway procurement auctions, 185 were ultimately funded and
awarded to the low bidder. Thus, any increase in the winning (low) bid caused by suc-
cessful collusion was captured as profits by the cartel. The third characteristic of the
auctions is the structure of the market for highway construction services. Porter and
Zona note that on the 25 largest construction jobs, the four largest firms accounted
for 45% of the bids. The fourth characteristic of the market is the opportunity for the
firms to communicate. Most of the bidders belonged to the same local trade associa-
tions, and joint bidding was allowed. The fifth characteristic was that the DOT tended
to run its procurement auctions for larger jobs on a regular basis, at the beginning
of each year. As Porter and Zona note, the regularity of the auctions would tend to
make calculating the discounted present value of continued collusion more predict-
able. The final characteristic was that the highway construction firms were relatively
homogeneous. They used the same technologies and purchased inputs from the same
suppliers.
5
See also Doane et al. in this volume for a discussion of detecting explicit collusion.
Porter and Zona next identify five firms as possible members of a highway construc-
tion cartel. One of the firms was convicted in federal court of bid rigging on a highway
construction job in Long Island in 1984, and the other four firms were unindicted co-
conspirators. The same five firms had been named as participants in bid-rigging con-
spiracies in other antitrust or racketeering suits in New York. Using this information,
Porter and Zona divide their data into two sets: (1) bids from firms other than the five
possible cartel firms (called bids from “competitive firms”) and (2) bids from the five
possible cartel firms. They also restrict their data set to 75 road-paving jobs that had at
least two bids from competitive firms.
Porter and Zona first estimate a regression model in which the dependent variable is
the log of a firm’s bid. The independent variables consist of measures of a firm’s capac-
ity and capacity utilization, and dummy variables indicating whether the firm’s head-
quarters was on Long Island, and for competitive firms, whether that firm previously
had won a highway construction auction on Long Island. Using first the bids from com-
petitive firms, Porter and Zona conclude that the estimated regression fits the data rea-
sonably well and the coefficient estimates have the expected signs. In contrast, using
bids from the cartel firms, many of the estimated regression coefficients do not have the
expected signs. A Chow test for equality of the estimated coefficients in the two regres-
sions rejects the null hypothesis that the coefficients in the two regressions are equal. On
the basis of these results, Porter and Zona conclude that they can reject the null hypoth-
esis of no bid rigging.
Finally, Porter and Zona estimate a second regression model that uses the same
independent variables, but changes the dependent variable to the rank of a firm’s bid
in a given auction, rather than the dollar value of its bid as used in their first regression
model. They first estimate this model using bids from competitive firms. They estimate
three regressions, one using all the bids, one using just the low bids, and another using
all bids other than the low bid. Comparing the estimated coefficients in the three regres-
sions, they cannot reject the null hypothesis of no model misspecification. On this basis,
they cannot conclude that the bids from competitive firms are generated by different
processes depending on whether the bids are low or not.
Porter and Zona then estimate the same regression model using bids from the cartel
firms, again estimating three regressions, one using all the bids, one using just the low
bids, and one using all bids other than the low bid. Comparing the estimated coefficients
in the three regressions, they reject the null hypothesis of no model misspecification. On
this basis, they find that they can conclude that the bids from cartel firms are generated
by different processes depending on whether the bids are low or not. They reject the null
hypothesis of no phantom bidding and conclude that these five firms engaged in bid
rigging.
Baldwin, Marshall, and Richard (1997) examine the winning bids and characteristics
for 108 oral auctions for timber sold by the Forest Service in the Pacific Northwest from
1975 to 1981. Baldwin, Marshall, and Richard described several salient features of the
auctions. First, the Forest Service’s reserve prices in the auctions are very low. Second,
old-growth timber is quite heterogeneous. Bidders invest substantial resources to
develop their own valuations of specific forest tracts. Third, second-growth or young
timber is relatively homogenous and of lower quality than old-growth timber. Fourth,
despite the fact that timber is extremely heavy per dollar of value, firms with mills within
100 miles of a given forest tract have approximately the same costs of cutting and trans-
porting the logs. Fifth, the mills differ substantially in terms of their efficiency, which is
measured by the quantity of merchantable board feet that can be extracted from a given
log. Logging firms closely guard information regarding the efficiencies of their mills.
Finally, prior to each oral auction, the Forest Service publicly releases the number of
qualified bidders, and after each auction, the Forest Service makes public the quantity of
timber purchased by each firm. In contrast, private sellers of timber do not make such
information public.
Given the importance of private information held by logging firms regarding the
efficiency of their mills, Baldwin, Marshall, and Richard use an IPV model. In order
to reduce the heterogeneous nature of the product, they restrict their data set to auc-
tions for second-growth timber. Baldwin, Marshall, and Richard attempt to determine
whether, after controlling for demand conditions, variations in winning (low) bids are
better explained by collusion or by variations in the supply of timber. They estimate sev-
eral models: (1) the noncooperative (i.e., noncollusive) model without considering sup-
ply effects; (2) the collusive model without supply effects; (3) the noncooperative model
with supply effects, and two nesting models that include both collusion and supply
effects. They conclude that their results strongly suggest that variation in the winning
bids is best explained by collusion and not by noncooperative behavior or changes in
supply conditions. They estimate that collusion reduces the auction revenues received
by the Forest Service by approximately 7.9% across all the auctions. However, for a subset
of 13 auctions that had particularly low winning bids, the loss in revenues to the Forest
Service was approximately 52.9%.
Athey, Levin, and Seira (2011) examine Forest Service auctions that occurred in
Idaho-Montana and California between 1982 and 1990. (See also Athey and Levin,
2001, for analyses of Forest Service auctions.) Since the Forest Service used both open
and sealed bids, Athey, Levin, and Seira are able to test how prices and revenues vary
between the two auction formats. They show that sealed bid auctions attract more small
bidders and tend to yield higher revenues to the Forest Service. Bidders may be log-
gers (i.e., small firms without manufacturing capacity) or mills (i.e., larger firms with
manufacturing capacity). They estimate a structural IPV model that allows for entry
on the part of bidders, and then they use that model to predict prices and revenues in
Idaho-Montana and California with open or sealed bid auctions. They find that average
open auction sales prices and average sealed bids in California are close to their pre-
dicted values, assuming firms behave competitively. This competitive result also holds
for average sealed bids in Idaho-Montana. However, average open auction sales prices
in Idaho-Montana are statistically different than both predicted competitive and col-
lusive prices. Athey, Levin, and Seira (p. 251) conclude that “mildly cooperative behav-
ior on the part of participating mills appears to provide a better match than either the
competitive or fully collusive extremes.” To further test for the presence of collusion in
Idaho-Montana auctions, the authors compare average sales prices in both open and
sealed bid auctions as a function of the number of mills. When the number of mills is
zero or one (recall that bidders can be loggers or mills), their predicted competitive
prices are close to the actual prices. However, when the number of mills is two or more,
their predicted competitive prices are substantially above the actual prices. They con-
clude this finding is consistent with collusive bidding.
Given these results, Athey, Levin, and Seira investigate the welfare consequences of
the Forest Service using either open or sealed bidding exclusively. They use two alternate
specifications of mill bidding behavior: competitive behavior and collusive behavior 18%
of the time, that is, the frequency of collusive behavior that best matches the observed
open auction prices in Idaho-Montana. With the assumption of competitive behavior,
they find that average revenues to the Forest Service are nearly the same with open or
sealed bid auctions. However, with the more realistic assumption of collusive behavior
(18% of the time), they find that the average revenues to the Forest Service would be sub-
stantially higher with sealed bid auctions than with open auctions. This result follows
from their finding that sealed bid auctions encourage more participation from smaller
bidders.
Porter and Zona (1999) study procurement auctions conducted by Ohio school dis-
tricts for milk. The State of Ohio charged 13 dairies with bid rigging in the period 1980–
1990. Porter and Zona prepared expert reports on behalf of the plaintiff in State of Ohio
v. Louis Trauth Dairies, Inc. et al. Their article analyzes whether the behavior of three of
the alleged conspirators located near Cincinnati is more consistent with competition or
collusion. Using data collected in the litigation, they create a sample of bids for a control
group of firms not accused of bid rigging and a sample of bids for the three firms accused
of bid rigging.
They first estimate a probit regression to calculate the probability that a control firm
will submit a bid as a function of the distance between a relevant school district and
that firm’s nearest milk processing plant. They find that the probability falls as distance
increases. For example, the probability that a control firm with a plant very near a school
district will bid in a milk procurement auction run by that district exceeds 50%, but
falls essentially to zero when the distance exceeds 75 miles. They next estimate an OLS
regression to calculate how a control firm’s bid changes as distance increases. They find
that, all else equal, a control firm’s bid increases by approximately 0.5 cents per half pint
when the distance increases by 50 miles. Given that the average price per half pint was
approximately 13 cents in this period, this amounts to approximately a 4% increase in the
control firms’ bid.
Comparing these results for the group of control firms to the three alleged bid-rigging
firms, Porter and Zona find that the alleged conspirators bid more frequently than the
control group model predicts at longer distances, for example, in excess of 60 miles.
They also find that two of the three alleged conspirators actually bid less the further
away their plants are to the relevant school district. Porter and Zona interpret these
results as showing an “inverted price umbrella,” with higher bids in school milk auctions
close to the conspirators’ plants and lower bids at more distant locations. They conclude
the evidence is consistent with a local conspiracy in the Cincinnati area and inconsis-
tent with competitive behavior. Finally, their empirical results show that the bid rigging
increased the prices paid for milk by school districts by approximately 6.5%.
Bajari and Ye (2003) use auction theory and empirical methods to distinguish com-
petitive from collusive bidding behavior. They develop a general procurement auction
model with asymmetric bidders, for example, bidders with different costs. They then
derive a series of necessary and sufficient conditions for a distribution of bids to be con-
sistent with bids generated by a model with competitive bidding. For example, one con-
dition is that, given publicly available information that affects all firms’ bids, competitive
bidding necessarily implies that the bids of any two firms must be independently dis-
tributed. Bajari and Ye use this condition to evaluate whether the bids made by con-
struction firms in the Midwest are more consistent with competition or collusion. They
regress firms’ bids on several explanatory variables, for example, distance from a firm’s
location to the job site; the minimal distance of its rivals to the job site; the firm’s capac-
ity; and the maximum free capacity of its rivals. They test whether the regression residu-
als for any pair of firms are correlated. If they reject the null hypothesis of no correlation,
then the two firms’ bids are not independently distributed and so cannot be consistent
with competition. They reject the null hypothesis for one pair of firms that bid against
each other a large number of times.
Bajari and Ye derive a second condition stating that competitive bidding necessarily
implies that each firm’s estimated coefficient for any given explanatory variable in the
bid regression should be the same. Their test results identify a specific pair of firms that
fails this “exchangeability” test. Interestingly, one of the two firms in this pair is also one
of the two firms in the pair that fails the “conditional independence” test. Bajari and Ye
conclude that these three firms constitute a candidate cartel. However, they also empha-
size that their test results could be explained by conduct other than collusion. They con-
clude that an economist finding such results should consult with industry experts to
make sure the inconsistencies with the competitive bidding model do not result from
ignorance of the industry cost structure.
Rather than attempting to distinguish firms engaged in bid rigging from firms act-
ing competitively, Pesendorfer (2000) analyzes the characteristics of two documented
school milk cartels in Florida and Texas from 1980 to 1991. All the firms in his study pled
guilty to price-fixing allegations brought by the US Department of Justice. Pesendorfer
first shows that the market shares of firms in the Florida cartel fluctuated more than the
market shares of firms in the Texas cartel. He examines several noncollusive explana-
tions for this fact: (1) less potential competition in Texas; (2) some cartel members in
Texas may bid on only a small subset of the school milk contracts; (3) a decline in the
number of contracts per school district in Florida; and (4) an individual cartel member
in Florida may have had costs that were correlated over time (e.g., high cost realizations
in one year followed by low realizations the next year) that would cause its market share
to fluctuate substantially over time. Pesendorfer finds that the empirical evidence does
not support any of these noncollusive explanations. He concludes that the best explana-
tion for the larger market share fluctuations in Florida is that cartel members in that
state used side payments, rather than a market allocation agreement, to operate their
cartel. That is, they operated a strong cartel. In contrast, the Texas cartel operated by
dividing the state into different geographic regions and specifying which firms should
win in which regions. That is, they operated a weak cartel.
Pesendorfer also analyzes theoretically the efficiency of weak cartels. Recall that an
auction mechanism is efficient if the mechanism allocates the object to the bidder with
the highest valuation. Or alternatively, a cartel mechanism is efficient if it designates the
member with the lowest cost to submit the lowest cartel bid. Pesendorfer shows that
weak cartels cannot be efficient as long as the number of procurement contracts offered
simultaneously by the buyer is finite. However, he shows that a weak cartel can use a
mechanism (the “Ranking Mechanism”) in which each cartel member announces a
ranking of the procurement contracts according to her costs. The member who ranks
a contract highest (assigns the highest preference) will be the sole cartel bidder for that
contract. If several cartel members rank a contract at the same position, the sole bid-
der can be determined by a coin toss. Pesendorfer shows the Ranking Mechanism is
incentive compatible (i.e., cartel members will truthfully reveal their costs). Moreover,
the mechanism converges to the optimal, efficient outcome as the number of contracts
increases. Finally, Pesendorfer notes that 136 contracts are awarded every year in Texas,
which leads him to conclude that the weak Texas cartel is likely almost efficient.6
20.3.2. Experimental Studies of Bid Rigging in Auctions

Isaac and Plott (1981) is the first experimental study of explicit collusion in an auction
format. Their study addresses two primary questions. First, antitrust laws presume that
opportunities to conspire, attempts to conspire, and successful conspiracies are closely
linked. Is this presumption correct when the organizational costs of conspiracy are low?
Second, which economic model of the price and output effects of price-fixing conspira-
cies best explains the observed behavior in their experiments? Isaac and Plott perform
seven experiments using a double-auction mechanism in which buyers and sellers both
make price offers. They first run three auctions in which neither buyers nor sellers have
the opportunity to collude explicitly. They then run two auctions in which sellers are
allowed to collude explicitly, without the knowledge of buyers. Finally, they run two
auctions in which buyers are allowed to collude explicitly, without the knowledge of sell-
ers. The explicit collusion was restricted in that participants could not reveal their pri-
vate valuations or discuss side payments.
Their basic finding is that, compared to the no-collusion auctions, both the seller- and
buyer-collusion auctions are less competitive. Regarding their first question, Isaac and
Plott reach several conclusions. First, in an environment with low costs of explicit collu-
sion, buyers and sellers attempt to reach an agreement. Second, the attempts to reach an
6 See Abrantes-Metz et al. (2006) for a discussion of the use of econometric screening methods to
detect collusion in the retail gasoline industry.

agreement result in a coordinated pricing strategy. Third, the pricing conspiracies have
substantial, anticompetitive effects on equilibrium prices and quantities. With respect to
price dynamics observed in the experiments, Isaac and Plott note that price changes in the
three noncollusive experiments were always in the direction of the predicted equilibrium
price. In contrast, prices in both the seller- and buyer-collusion auctions were more erratic,
often moving away from the predicted cartel price. The average price change from period
to period was also larger in the collusive experiments than in the noncollusive experiments.
Finally, regarding their second question, Isaac and Plott conclude that the text-
book cartel model best describes the behavior observed in the collusive experiments.
However, the prices in these experiments generally did not converge to the predicted
cartel price, as participants had difficulty maintaining agreed-upon prices. In follow-on
research, Isaac, Ramey, and Williams (1984) show that the double-auction mechanism
used by Isaac and Plott (1981) tends to make the enforcement of price-fixing agreements
more difficult than posted offer prices.
Isaac and Walker (1985) study sealed-bid auctions experimentally. They investigate
two questions. First, in a series of FPSB auctions for identical items, are winning bids
affected by revealing the losing bids from prior auctions? Second, does the ability of
buyers to collude explicitly reduce the winning bids? They conducted a total of 30 exper-
iments. In 10 of the experiments, explicit collusion was not allowed and buyers were not
informed of losing bids in prior auctions. In 10 of the experiments, explicit collusion was
not allowed and buyers were informed of losing bids in prior auctions. In the final 10
experiments, explicit collusion was allowed. In five of the collusive auctions buyers were
not informed of losing bids in prior auctions, and in the other five collusive auctions
buyers were informed of the losing bids. With respect to their two questions, Isaac and
Walker find that the revelation of losing bids reduces the prices paid by buyers in subse-
quent auctions. They also find that the ability to collude explicitly reduces winning bids.
However, the collusive prices were not affected by whether losing bids were revealed.
Kwasnica (2000) evaluates experimentally the strategies used by auction participants
to collude. Using a series of simultaneous, first-price auctions, he addresses three empir-
ical questions: (1) Do bidders form cooperative agreements in simultaneous first-price
auctions? (2) If so, what types of strategies do they utilize? (3) What effect do these strat-
egies have on the outcome of the auction? The auction format consisted of 10 separate
experiments. In each experiment a total of five objects were sold to five buyers in five
simultaneous single-unit first-price auctions. This format was chosen to facilitate collu-
sion. The auctions ran for 17–22 periods. In periods 1–5 participants were not allowed to
communicate, but they were allowed to communicate thereafter. The communication
was restricted in that participants could not reveal their private valuations or discuss
side payments. In six of the 10 experiments the bidders had symmetric valuations, and
in the remaining four experiments they had asymmetric valuations. In the latter, one
bidder’s valuations were substantially higher than the symmetric valuations of the other
four bidders. Finally, in six of the auctions, participants were informed of the winning
bid and the identity of the winning bidder, while in the remaining four auctions partici-
pants were only informed of the winning bid.
Consistent with Issac and Walker (1985), Kwasnica finds that bidders formed coop-
erative agreements in all 10 experiments. More interestingly, he finds that in seven of the
10 experiments participants used a bid rotation mechanism. They were able to obtain
approximately 90% of the total surplus in the auctions. In other words, they achieved
approximately 90% of the maximum possible efficiency, which would occur if the win-
ning bidder had the highest valuation in each auction. Kwasnica concludes that the
Ranking Mechanism proposed by Pesendorfer (2000) best describes the behavioral
strategy chosen by the bidders.
Finally, in three of the experiments, Kwasnica finds that bidders deviated from incentive
compatible strategies. Instead, they selected a linear bid reduction strategy; for example,
they agreed to bid 1% of their valuations. Participants used a linear bid reduction strategy
only in experiments in which they had symmetric valuations and knew the identity of the
winning bidder. Although a linear bid reduction strategy was not incentive compatible,
under the experimental framework such a strategy led to higher profits than the incentive
compatible, bid-rotation strategy. Kwasnica concludes that asymmetry of bidders’ valua-
tions and less information leads bidders to revert to incentive compatible strategies.7
20.4. Deterring Bid Rigging
In theory, explicit collusion in auctions always can be prevented. The difficulty is that the
information required to do so is essentially impossible to obtain. Che and Kim (2006,
2009) show how to convert any given auction mechanism into a collusion-proof auction,
that is, an auction in which a bidding ring cannot earn profits. In such a collusion-proof
auction, the seller’s expected total revenue will be the same as in a revenue-maximizing
auction in the absence of collusion. However, as discussed by Marshall and Marx (2012),
the Che and Kim collusion-proof mechanism is impractical, as it requires the following:
1. The mechanism requires all bidders, including losing bidders, to make pay-
ments to the auctioneer. However, the auctioneer may cheat by demanding
higher-than-required payments from the bidders. This means that all the bid-
ders must be able to verify that the auctioneer has implemented the mechanism
correctly.
2. To establish the collusion-proof mechanism, the auctioneer must know the
number of bidders and the set of types of the bidders, that is, their valuations,
as well as the identities and types of two of the bidders in the ring. In Che and
Kim (2006), bidders must agree to participate in the mechanism prior to the
ring-formation game. In addition, the identities of the bidders that will have the
7 Other experimental studies of explicit collusion in auctions include Davis and Wilson (2002) and
Phillips, Menkhaus, and Coatney (2003).

opportunity to form a ring (only one ring is allowed to form) is fixed prior to
the bidders agreeing or not to participate in the collusion-proof mechanism. As
shown in Che and Kim (2009), under certain conditions, similar results hold
when bidders first decide whether to collude and then decide whether to partici-
pate in the auctioneer’s collusion-proof mechanism.
3. The bidding ring must submit a bid for every ring member, despite possible
incentives for the ring to suppress some members’ bids.
Given these practical drawbacks to the Che and Kim collusion-proof mechanism,
economists have investigated other ways to deter explicit collusion in auctions. The lit-
erature offers several general suggestions (Klemperer, 2002; Marshall and Marx, 2009;
Marshall and Marx, 2012). First, the use of FPSB auctions instead of English auctions
should reduce collusion. Recall that bid-rigging agreements are stable in English auc-
tions since no bidder has an incentive to cheat on the agreement since the cartel will
bid up to the highest valuation of its members. In contrast, in FPSB auctions, the cartel
must reduce its bid below the highest valuation of its members in order to earn positive
expected profits. This reduction in the bid provides ring members the incentive to cheat
on the agreement by outbidding the cartel. Hu, Offerman, and Onderstal (2011) provide
experimental results that suggest using the Amsterdam second-price auction, which
combines aspects of both FPSB and English auctions, to reduce collusion.8 Second, the
auctioneer should limit the information provided to bidders regarding the number of
bidders, their identities, their bids, including their losing bids if a similar auction will
occur in the future. Finally, the auctioneer should not hold auctions at regular inter-
vals and for relatively small items; instead the auctioneer should hold auctions at longer,
irregular intervals and for relatively large items, for example, packages of separate items.
This increases the costs of creating and maintaining a bidding ring by raising the gains
to cheating.
20.5. Conclusions and Open Questions
In his classic article on collusion, Stigler (1964) observed that “the system of sealed
bids, publicly opened with full identification of each bidder’s price and specifications,
8 The Amsterdam second-price auction has two phases (Goeree and Offerman, 2004). In phase 1, the
auctioneer raises the price successively and bidders drop out when the price exceeds their individual
valuation. This process continues until two bidders remain. The price at which the third-highest bidder
drops out defines the endogenous reserve price or “bottom” price for the second phase. In phase 2,
both remaining bidders independently submit sealed bids, which must be at least as high as the bottom
price. The highest bidder wins and pays a price equal to the second-highest sealed bid. Both bidders
in the phase two receive a premium, which equals a fraction 0 < α < 0.5 of the difference between the
second-highest sealed bid and the bottom price.
is the ideal instrument for the detection of price-cutting” and argued that collusion is
always more effective when the market is more transparent. Open auctions are often
more transparent than sealed bid auctions because bidders learn about the participa-
tion and bids of their rivals in real time. But, even in sealed bid auctions, the seller
can choose how much information to make public before and after the auction. The
less information the seller reports, the harder it is for the ring to achieve the gains
from collusion. Indeed, the conclusion of the literature surveyed in this paper is that
a seller should use a first-price, sealed bid auction and reveal as little information as
possible.
This conclusion, however, is based mainly on analyses of private value, single-item
auctions. In common value auctions or multi-item auctions, the lack of transparency
in the price-formation process can lead to inefficient allocations and lower revenues.
For example, in common value auctions, bidders bid more aggressively in ascend-
ing bid auctions than in sealed bid auctions because they are able to learn about their
rivals’ information, mitigating the effects of the winner’s curse. In auctions of spectrum
licenses or oil and gas leases where spatial complementarities are important, bidders
can more easily acquire their desired bundles and face less risk doing so in a multiround
ascending bid auction than in a single round of sealed bids. Thus, in most situations,
the choice of auction mechanism is likely to involve an important trade-off. On the one
hand, more transparent auction mechanisms can yield greater efficiency and revenues
when bidders behave competitively; on the other hand, they are also more vulnerable to
collusion. A greater understanding of this trade-off is one of the big open questions in
auction design.
The theory literature has focused almost exclusively on the case of an all-inclusive
ring.9 However, in practice, most rings involve subsets of bidders—not all bidders.
Extending the theory to include partial rings is an important, although difficult,
topic. Partial rings introduce asymmetries into the auction, and characterizing equi-
librium bidding when the bidder types are drawn from asymmetric distributions is
complicated.
Finally, an important policy issue is to examine the rules under which the federal
government in the United States operates as a buyer or seller. The Federal Acquisition
Regulations, the Freedom of Information Act, and other regulations mandate transpar-
ency. The constraints that these rules impose on the choice of auction design may be
quite costly.
9 Two exceptions are McAfee (1994) and McAfee and McMillan (1992), who show that, in first-price
environments, the equilibrium ring in a cartel formation game generally does not include all of the
bidders.
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CHAPTER 21
S C R E E N I N G F O R C OL LU SION A S A
PROBLEM OF INFERENCE
MICHAEL J. D OANE, LUKE M. FROEB, DAVID S. SIBLEY, AND

BRIJESH P. PINTO
21.1. Introduction
In 1993, in the course of doing other research, Bill Christie and Paul Schultz noticed that
market makers were avoiding odd-eighth quotes on some of the most heavily traded
NASDAQ stocks. They tested and rejected a number of cost-based explanations for the
practice, and concluded that it was the result of collusion. The obvious benefit of odd-
eighth avoidance is that it raises the bid-ask spread, a measure of the “price” that market
makers charge for selling and buying stocks, to at least $0.25, over the regulatory mini-
mum of $0.125. At the time, the cost of trading stocks on NASDAQ was about twice the
cost of trading stocks on the NYSE, which used a more competitive auction-like mecha-
nism (Morgenson, 1993).
When the Los Angeles Times reported on the Christie and Schultz (1994) research, the
NASDAQ market makers suddenly (within a day) stopped avoiding odd-eighth quotes,
and the bid-ask spread on many stocks was cut in half. Professors Christie, Schultz, and
Harris (1994) then published a companion piece titled “Why Did NASDAQ Market
Makers Stop Avoiding Odd Eighth Quotes?” which reached the same conclusion as
the original article. Together, the two papers lead to a raft of private suits and investiga-
tions by the US Department of Justice and the Securities and Exchange Commission.
Although not originally designed as such, their research is arguably one of the most suc-
cessful collusive screens ever, and settlements to the antitrust suits have changed the way
that NASDAQ market makers trade stocks.
524 Michael J. Doane, Luke M. Froeb, David S. Sibley, and Brijesh P. Pinto
On October 12, 2012, US representative Edward Markey wrote a letter to the chair-
man of the US Federal Trade Commission (FTC) asking him to investigate whether oil
companies and refiners were “manipulating” gasoline prices in New England (Markey,
2012; FTC, 2012). His request was triggered by the observation that while oil prices had
been falling, gasoline prices had not fallen by as much. Partially in response to these
kinds of requests, a decade ago, the FTC began regularly screening gasoline prices for
collusion. Although the screening has yet to uncover any conspiracies, screening seems
to be catching on, as countries like Brazil and Mexico have started similar programs
(Levenstein and Suslow, in this volume; Abrantes-Metz and Froeb, 2008; Abrantes-Metz
and Bajari, 2010; Harrington, 2008).
The question motivating this chapter is “How well do screens for collusion work?” It
is hard to answer by looking at successful follow-on prosecutions. If a screen finds no
collusion, it could be that the screen is not working or that there is no collusion to be
found. If a screen does find collusion, one has to look carefully at the resolution of the
legal process to determine exactly what happened. Even the NASDAQ market makers
never admitted colluding, and there is some uncertainty as to how the conspiracy actu-
ally worked. Despite evidence of explicit communication, there were weak incentives
for market makers to offer better quotes (even without colluding) because better quotes
did not necessarily capture more order flow (Morgenson, 1993). Perhaps because of this
uncertainty, the Department of Justice chose to file a civil antitrust suit, which has a
lower burden of proof, rather than a criminal one.
So rather than looking at follow-on prosecutions, we address the issue by modeling
screening as a problem of inference whose essential elements include a competitive null
hypothesis, a collusive alternative, and an empirical indicator to differentiate between
them. For example, Christie and Schultz (1994) were implicitly using a screen based on a
null hypothesis that costs were determining prices, a collusive alternative that odd-eighth
avoidance was increasing the “price” of trading, and a variety of empirical indicators to rule
out cost-based explanations and to show that odd-eighth avoidance was increasing price.
Likewise, Representative Markey was implicitly using a screen based on the null
hypothesis that competitive behavior results in a higher pass-through rate from whole-
sale cost to retail price, the collusive alternative that cartels have a lower pass-through
rate, and estimated pass-through rates from oil prices to retail gasoline prices as an
empirical indicator to differentiate between the two. Broken down into these elements, it
becomes easy to critique his screen. In this case, Congressman Markey’s hypothesis that
collusion has lowered pass-through rates is at odds with simple models of price-setting
behavior (Yde and Vita, 1996; Froeb, Tschantz, and Werden, 2005). If these models char-
acterize behavior in the gasoline industry, then the screen is likely to be a poor indicator
of collusion.
In this chapter, we use the taxonomy to better understand the conditions under which
screens are likely to succeed or fail. The first is that the empirical indicator may be too
“weak” to differentiate between H0 and H1 (e.g., Kovacic et al., 2011).
The second is that the null hypothesis is not indicative of competition or that the
alternative is not indicative of collusion. For example, Representative Markey’s implicit
Screening for Collusion as a Problem of Inference 525
screen may work in some theoretical models, or may characterize some actual cases
of collusion. But absent evidence that the collusion or competition takes the assumed
forms, the screen’s conclusions will be noisy indicators of collusion, at best. We call this
the problem of “model fit.”
The third reason that a screen may fail is that the world is neither H0 nor H1. In this
case, differentiating between H0 and H1 is not useful if the world is really H2. This third
criticism is similar to the second and stems from the same issue of model fit. Before using
a screen to differentiate between collusion (H0) and competition (H1), it is important to
try to rule out the existence of H2. This idea is illustrated by the NASDAQ screen. Christie
and Schultz (1994) and Christie, Harris, and Schultz (1994) rule out several different
cost-based explanations for odd-eighth avoidance, like adverse selection (informed trad-
ers are more likely to trade at favorable quotes) and the cost of holding inventory until an
order arrives. Essentially, they reject a variety of hypotheses in favor of H1.1
In what follows, we formally draw the analogy between screening and Bayesian
hypothesis testing. Next, we review and discuss the theoretical and empirical literature,
breaking down each screen into its essential elements. We conclude by offering advice
to academics designing screens, and practitioners using them: if you know what form
competition (H0) and collusion (H1) are likely to take, and have a strong empirical indi-
cator to distinguish between the two, then a screen is likely to be successful. If, however,
you do not know the forms that competition and collusion are likely to take, or cannot
rule out the likelihood of alternate behavior (H2), then the screen is more likely to be
plagued by type I or type II errors.
We choose to ignore the problem of strategic behavior on the part of the colluders to
evade a known that can be thought of as a type of deterrence. We do this not because it
is not an important problem (every successful screen has this shortcoming) but rather
because screening is so young. We have to know whether screening is an efficient way to
detect conspiracies before we address the more difficult question of whether screens can
also deter them.
21.2. Screening as a Problem of

Inference
21.2.1. Bayesian Hypothesis Testing

To study screens, we use the metaphor of statistical inference by specifying the com-
peting hypotheses, competition (H0) versus collusion (H1), and a variable X that can
1 Alternatively, H0 can be thought of as a composite hypothesis. For example, if H2 is another
competitive (noncollusive) hypothesis, then the researcher tries to differentiate between H0 or H2 vs. H1.
differentiate between them. Each hypothesis is related to the variable by a distribution

function,
H 0 : X ~ f0

H1 : X ~ f1
and the problem of inference is how to determine which hypothesis generated the
observable data x = {x1 , x2 , …, xn } . Each data point xi could be an individual obser-
vation, for example, on price or on margin, or a vector of what Kovacic and coauthors
(2011) call “indicator variables” or “plus factors.”
Although much of our analysis could be done using the metaphor of classical hypoth-
esis testing, we choose to work within the Bayesian framework because it can accom-
modate both “structural” screening, based on prior beliefs, and “behavioral” screening,
based on data (Harrington, 2006). Our goal is to compute the posterior probability of
collusion given the data
P ( x | H1 ) P ( H1 )
P ( H1 | x ) = .
P ( x | H 0 ) P ( H 0 ) + P ( x | H1 ) P ( H1 )

To do this, we have to specify prior beliefs, P (H 0 ) and P (H1 ), which are informed by
structural indicators such as evidence of past collusion or product homogeneity (e.g.,
Stigler, 1964) or whether the government is the potential conspiracy victim (e.g., Froeb,
Koyak, and Werden 1993). A “neutral” or “uninformative” prior would have a prior
belief characterized by P (H 0 ) = P (H1 ) = 0.5 .
These assumptions imply a prior belief about the data generating process,
f prior ( x ) = γ f 0 ( x ) + (1 − γ ) f1 ( x ) ,

where γ = P (H 0 ) represents our prior assessment that the industry is competitive. After
seeing the data, we construct the likelihoods of the competing hypotheses,
n
L0 ( x ) = ∏ f 0 (xi )
i =1
n
L1 ( x ) = ∏ f1 ( xi ) .
i =1
They tell us how likely it is that each hypothesis generated the data. As written, the likeli-
hood equations imply that each piece of data, or each indicator variable, is independent
and drawn from the same continuous distribution (iid), but this is not necessary. The
likelihoods could be constructed from a vector of correlated factors, or from non-iid or
discrete data. We update our prior beliefs using the likelihood ratio or “Bayes Factor,”
θ  γ   L0 ( x ) 
= ,
1 − θ  1 − γ   L1 ( x ) 

which says that the posterior odds equals the prior odds times the likelihood ratio. The
posterior belief about the data-generating process is
f posterior ( x ) = θf 0 ( x ) + (1 − θ) f1 ( x ) ,

where θ = P (H 0 | x ) and (1 − θ) = P (H1 | x ) is the posterior probability that H0 and H1

are true. This represents our beliefs after updating them with data.
The final element to the screen is a way to turn the posterior belief into action. Here we
could imagine that a decision-maker (presumably a competition agency) could decide
to investigate an industry further if
P ( H1 | x ) > α ,

which says that the probability of collusion is higher than some threshold. Some have
characterized α = .5 as “preponderance of evidence” standard and α = .95 as a “beyond
all reasonable doubt” standard. Alternatively, the decision-maker could optimally
choose α to minimize an expected loss function based on the costs of enforcement
errors (CI , CII ) as in Cooper and coauthors (2005). In this case, investigate further if
expected cost of type I error (failure to investigate when collusion is present) is greater
than the expected cost of type II error (investigation when no collusion is present),
P ( H 0 | x ) CI > P ( H1 | x ) CII ,
or
P (H 0 | x ) CII
> .
P ( H1 | x ) CI

Easterbrook (1984) argues that the market will more readily correct false acquittals than
false prosecutions, or that CII > CI , which would imply a higher optimal threshold for
investigation.
Even though few screens are characterized as a problem of inference, implicitly this is
what each is trying to do. Formally classifying them in this way allows us to understand
their elements, and more importantly to understand the conditions under which one
would expect them to succeed or fail.
The first reason for failure is that X is what Kovacic and coauthors (2011) call a “weak”
indicator. In this case, the likelihood ratio will be near 1, and the posterior odds will be close
to the prior odds. In other words, the likelihood does not help us to distinguish between the
two hypotheses. In contrast, a “strong” indicator variable will have a likelihood ratio away
from 1, which would shift the posterior odds towards one of the two competing hypotheses.
The second reason for failure is that the null hypothesis is not indicative of competi-
tion or that the alternative is not indicative of collusion. So even if the data can tell us
whether H0 or H1 is more likely to have generated the data, this doesn’t tell us very much
about whether collusion is present. To see how this leads to errors, imagine that H0 could
be consistent with either competition or collusion, but that H1 is consistent only with
collusion. If the likelihood favors the competitive hypothesis such that P (H1 | x ) < α, no
further investigation is taken. In this case, the screen is likely to miss collusive behavior.
Conversely, imagine that H0 is consistent only with competition, but H1 is consistent
with either competition or collusion. If the likelihood favors the collusive hypothesis
such that P (H1 | x ) > α, further investigation is taken. In this case, the screen will allo-
cate prosecutorial resources to an investigation with a low probability of finding collu-
sion. When both H0 and H1 are consistent with both competition and collusion, the
probability that the screen will commit both types of errors is high.
This mistake occurs when the theoretical models or assumptions on which the screens
are based do not fit the significant features of competition in the industry being stud-
ied. If the theoretical models do not adequately characterize behavior in the industry to
which the screen is being applied, or if the collusive or competitive outcomes depend on
factors that cannot be observed or verified, then the screen is likely to work poorly. We
refer to this problem as one of model “fit.”
Some of the screens are based on instances of past collusion. For example, as discussed
more fully below, Abrantes-Metz and coauthors (2006) note that when a frozen fish con-
spiracy collapsed, the price went down by over 16%, but the standard deviation of price
(over time) went up by over 200%. Using this empirical analogy, they construct a screen
based on the coefficient of variation of price, and apply it to retail gasoline. However, unless
collusion in the gasoline industry takes a form similar to collusion in frozen fish sold by
auction to the government, then the screen is unlikely to work very well. This is the same
problem of fit, but here the “fit” is to a past instance of collusion, not a theoretical model.
21.2.2. Screening versus Testing

One obvious question is what happens if neither H0 nor H1 generated the data? Our
Bayesian framework can be easily modified to admit a third alternative, which we call H2:
H 0 : X ~ f0
H1 : X ~ f1
H 2 : X ~ f2 .
If H2 is known, this becomes what is known as a problem of “model selection,” where

we choose between three alternatives. As above, we begin with a prior belief about the
data-generating process,
f prior ( x ) = γ 0 f 0 ( x ) + γ 1 f1 ( x ) + (1 − γ 0 − γ 1 ) f 2 ( x ) ,

which we update with the likelihood in an analogous way.

If we don’t know about the existence of H2, the results of the previous section still
hold; that is, we can still compute the relative odds of H0 versus H1, but the compu-
tation of the posterior probabilities will be wrong. In this case, we will mistakenly
compute
P ( x | H1 ) P ( H1 )
P ( H1 | x ) =
P ( x | H 0 ) P ( H 0 ) + P ( x | H1 ) P ( H1 )

instead of
P ( x | H1 ) P ( H1 )
P ( H1 | x ) = .
P ( x | H 0 ) P ( H 0 ) + P ( x | H1 ) P ( H1 ) + P ( x | H 2 ) P ( H 2 )

We find that this is a useful way to think about the difference between what we call test-
ing and screening. If you are “testing” for collusion, you know that the world is either
H0 or H1, but if you are “screening” for collusion, you recognize that there may be other
alternatives, like H2.
In other words, when “testing,” all you have to worry about is “sampling uncertainty.”
With enough data, or with good enough indicator variables, you can estimate the pos-
terior probability with precision and take appropriate action. In contrast, when you are
unsure about the possibility of other alternatives (H2), the posterior probability will
reflect “model uncertainty” in addition to sampling uncertainty. This is closely related
to the problem of model fit discussed above. If you know that the world is either H0
or H1 (and that H0 implies competition and that H1 implies collusion), with a strong
enough indicator variable, you can distinguish collusion from competition. However, if
the world can also be H2, then distinguishing between H0 and H1 is not likely to tell you
very much about collusion or competition.
21.3. Theoretical Screens
The purpose of this section is to review some theoretical models of cartels and collu-
sive behavior that have been used to construct screens. By reviewing the literature, we
highlight the significant features of competition that each model is designed to capture,
in addition to the maintained assumptions on which the models are built. We elucidate
these features and assumptions for the purpose of highlighting the problem of model
fit. Unless the model on which the screen is based captures the significant features of
competition in the industry being screened, the screen is likely to perform poorly. The
literature is summarized in table 21.1.
Green and Porter (1984) show that periodic episodes of sharp drops in colluding firms’
prices and profits may be indicative of cartel self-enforcement. Departing from Stigler’s
(1964) notion that these episodes reflect the instability of cartels, Green and Porter show
instead that cartels may use price wars as a self-policing device. In their model, demand
is uncertain, and colluding firms engage in collusive behavior or Cournot behavior
depending on whether or not the market price is above an agreed-upon “trigger” price.
The alternative hypothesis of collusion is that output levels follow a switching process
triggered by drops in the market price. Green and Porter suggest that the American rail
freight industry in the 1880s is an example of an industry that satisfies their assumptions
on industry structure, and exhibits the kind of collusion that they model.
Rotemberg and Saloner (1986) analyze an infinite-horizon dynamic model with
observable demand shocks in which firms compete either in Cournot or in Bertrand
fashion. In their model, a colluding firm’s incentive to cheat by undercutting the col-
lusive price is greater when demand is high. They show that in periods of high demand,
colluding firms are likely to behave more competitively. During these periods, the mar-
ginal benefit gained by a colluding firm from “cheating” on the cartel is greater since the
share of market captured is larger. In response, the cartel reduces the collusive price to
reduce the incentive to cheat. This behavior generates countercyclical price and margin
movements; that is, the collusive price and margin is lower when demand is high and
higher when demand is low (H1). The competitive hypothesis (H0) of competition is
that price and margins are procyclical with respect to observable demand shocks.
Athey, Bagwell, and Sanchirico (2004) develop a theory linking collusion and price
rigidity. They show that if firms are sufficiently patient and the distribution of firms’
costs is log-concave, then optimal symmetric collusion in equilibrium is characterized
both by price rigidity and by the absence of price wars. Athey, Bagwell, and Sanchirico
analyze the equilibrium of an infinite-horizon, repeated game model in which the stage
game is one of Bertrand competition among symmetric firms. Each firm possesses
private information about its marginal cost of production, and cost levels are indepen-
dently and identically distributed across firms. As discussed below, several empirical
studies cite this paper as suggesting that price rigidity (H1) can serve as a screen of col-
lusive behavior in an industry that satisfies their structural assumptions. Under the null
hypothesis of competition (H0), price varies more closely with cost.
Marshall, Marx, and Raiff (2008) analyze price announcements in the vitamins
industry, with a view to detecting collusion in the industry after 1985 They model
public price announcements in an industry with homogenous products and capac-
ity constraints as a multiperiod game and show that in the absence of explicit col-
lusive behavior (H0) (1) there exist equilibria in which none of the firms makes
price announcements; (2) there exist equilibria in which the larger firm leads a
joint announcement, or makes a singleton announcement—the larger firm makes
an announcement in an earlier period, while the smaller firm does not make an
announcement but sets its price in a later period; and (3) no equilibria exist in which
the smaller firm makes a singleton announcement or leads a joint announcement.
Marshall, Marx, and Raiff observe frequent joint price announcements in the collusive
post-1985 period. They also find that, relative to the pre-1985 period, announcements
were made well in advance of effective dates in the collusive period. Furthermore,
they observe that the timing of price announcements in the collusive period is consis-
tent with regularly scheduled cartel meetings. For these reasons, the authors conclude
that the empirical implications of their model are largely consistent with the absence
of explicit collusion in the vitamins industry prior to 1985, but consistent with the
presence of explicit collusion after 1985. Thus, according to Marshall, Marx, and Raiff
the model suggests collusive behavior in the vitamins industry after 1985. We describe
their empirical analysis in section 21.4.
There is also a literature on optimal cartel pricing when detection is a possibility.
Harrington and Chen (2006) study a dynamic model of oligopoly with stochastic costs,
in which a firm that forms a cartel is detected with some probability. They assume that
firms have a common constant marginal cost of production and, essentially, that a firm’s
cost in a given period equals the sum of its cost in the previous period and a normally
distributed cost shock. Further, “buyers have the maintained hypothesis that price is an
affine function of cost and cost changes are normally distributed but do not know the
coefficients to the pricing function or the moments of the cost distribution” (p. 1191).
Their analysis, while admittedly exploratory and relying on strong maintained assump-
tions, is an attempt to enrich our understanding of cartel pricing behavior. Simulating
their model produces cartel price paths with a transition phase followed by a stationary
phase in which collusion (H1) reduces price variation (X). The simulated cartel price
paths resemble the price paths of real cartels, and they take this as an encouraging sign
that their model may help develop empirical tests for cartel detection.
We take away two things from this brief review of theory. First is that these models
of collusive behavior are all somewhat stylized, based on a number of assumptions that
may not comport well with reality. What is important for our purposes is whether these
models can capture the significant features of competition in the industries to which
Table 21.1 Collusion Theories
Study Model issue Assumptions H1: Collusion x: Indicator variable
Maintain cartel
Green & (1) Firms choose outputs; (2) market prices Firms each choose a set cartel outputs Output level: Output follows a switching
outputs given
Porter depend on market output and the realization unless market price falls below an process triggered by a low market price.
imperfect
(1984) of an unobserved demand shock; (3) firms agreed “trigger” level; at that point
information
choose outputs before each firm reverts to its Cournot
about demand.
the realization of the demand shock; infinite output given its expectations about
time horizon. the demand shock.
Rotemberg Cartel pricing (1) Firms can be either Cartel prices are chosen to Price level: Cartel prices are countercyclical:
& Saloner with observable Cournot or Bertrand; (2) market make it unprofitable to defect when current demand is high relative to
(1986) demand shocks demand curve depends on prices from them, given the known expected future demand, the temptation to
that are iid over (outputs) and the realization of state of demand and cheat is greatest, meaning that cartel prices
time. an observable demand shock. expectations about the must fall to deter cheating; and vice versa
future. when current demand is low.
Harrington Optimal cartel (1) Firms have identical marginal Cartel price paths exhibit a transition Price level: cartel price path exhibits a
& Chen pricing when cost, (2) cost is a specific stochastic phase and a stationary phase. During transition and a stationary phase.
(2006) detection is a process, (3) buyers believe transition phase, price is independent
possibility price is a random walk, (4) buyers of cost. During stationary phase, price
do not know collusive responds to cost shocks.
pricing function.
Marshall, Inferring (1) Predictions generated by a benchmark (1) In cases of known collusion, did the (1) Likelihood of price announcements: The
Marx, & collusion from model of price announcements; (2) the pattern of price announcements differ likelihood of price announcements does
Raiff the absence or price announcement model assumes from in the same industry not depend on costs of demand, but on the
(2008) existence of fixed capacities and homogeneous during noncollusive period? (2) advance length of time since the last set of price
preannounced products; (3) the subgame perfect announcements of price change under announcements. (2) Frequency of price
price changes equilibrium of this game involves a price collusion should be public, rather than announcements: The frequency of price
leader (the largest firm) announcing price private; (3) price announcements should announcements increases greatly relative to a
change before smaller firms; (4) under come just before existing contracts are “clean” period.
collusion, firms preannounce price renewed, so as to convince a strategic
increases to convince strategic buyers buyer that there is no reason to switch
that the price increases reflect general sellers; they should not reflect cost or
cost increases, and that strategic buying demand changes, but rather the
will not be profitable; (5) absent length of time since the most recent
collusion, individual sellers do not expiration date of a contract
have this concern, and do not between a cartel seller and its
preannounce price changes. customer.
Athey, Can a cartel (1) Bertrand stage game, in which the Result is that cartel pricing will display Price level: Cartel prices will display rigidity.
Bagwell, & subject to costs low-priced firm(s) get all the business; rigidity if cartel firms are patient enough
Sanchirico shocks display (2) each firm gets an iid. cost shock each and if the distribution function of
(2004) rigid pricing, in period, which is private information; future cost shocks is log-concave.
accordance with (3) each firm has identical beliefs about Would need to test for these, which
much collusion future cost shocks; (4) each firm reports would be difficult. If one could verify
folklore? its current period cost value to the cartel, these conditions, then H0 is that the
along with the price implied by that stage game is Bertrand and H1 is that
cost; (5) each firm can credibly you would never see sticky prices. If
precommit to this price mechanism; you did, this rules out the stage game,
(6) transfers are possible between cartel implying collusion.
members; (7) each firm maximizes
expected present value over infinite
time horizon; (8) sequential
equilibrium concept for cartel.
screens based on them are applied. This is another way of articulating the problem of
“model fit.”
Second, there are a variety of ways to collude. The models reviewed illustrate a vari-
ety of ways that firms can fix prices, but firms can also rig bids, allocate customers,
agree to shut down capacity, refrain from advertising or price discriminating, or even
collude on organizational form (Shor and Chen, 2009) as ways to reduce competition.
When using a screen based on one of these models, it is important to first figure out
how competition and collusion work and whether the screen would help you distin-
guish one from the other.
21.4. Empirical Screens
The empirical literature on collusive screens may be categorized broadly into the follow-
ing categories: (1) screens based on the first and second moments of the price distribu-
tion;2 (2) screens based on structural modeling; and (3) screens based on various cartel
markers derived from models of firms’ pricing behavior. Table 21.1 presents a sample of
recent or significant papers that fall into these categories.
We use our earlier distinction between “screens” and “tests” for collusion in that
screens are designed to find unknown episodes of collusion, while tests are designed to
test whether indicator variables (X) can correctly identify known or suspected episodes
of collusion. Sometimes the distinction is not so clear or useful, but it is designed to
capture the idea that if you know the form of the conspiracy (H1) and how it differs from
competition (H0), then it should be easier to find a variable that correctly identifies the
conspiracy because you are more confident that your empirical model “fits” the form
of the collusion. Screens, on the other hand, are more exploratory in nature because
the form of competition or collusion is not known, or because there may exist alternate
hypotheses (H2) not contemplated by the screen.
21.4.1. Screens Based on First and Second Moments of

Price Distribution
Empirical screens for collusive conduct have generally involved the examination of pric-
ing patterns that might be indicative of collusion. Along these lines, the US Department
of Justice has identified five pricing patterns as possible indicators of explicit collu-
sion: (1) prices remain identical for long periods of time; (2) prices start to become iden-
tical after being different previously; (3) price increases that appear not to be explained
2 A variation of this theme include studies that have examined changes in the first and second
moments of market shares and price-cost margins. See, for example, Genosove and Mullin (2001).
by exogenous cost increases; (4) elimination of price discounts in a market where dis-

counts historically were given, and (5) local customers pay higher prices than more
distant customers (DOJ, n.d.). Empirical screens found in the academic literature have
tended to follow this approach with much research focused on examining changes in
the first and second moments of the price distribution. Below we discuss papers that are
representative of this body of research.
Froeb, Koyak, and Werden (1993) propose a method for estimating the price effects
of bid-rigging and price-fixing conspiracies based on the level of prices that controls
for cost differences and other factors that may be responsible for observed price dif-
ferences between collusive and competitive periods.3 They apply their estimator to
a known conspiracy involving bid rigging in the sale of frozen seafood to the Defense
Personnel and Support Center (“DPSC”) in Philadelphia.4 Based on an inspection of
quantity-weighted bid prices for frozen perch filets in procurements from July 10, 1984,
through September 27, 1989, the authors divide their data into three distinct periods: a
preconspiracy period characterized by relatively constant prices despite big seasonal
swings in fresh fish prices, September 19, 1986 to July 20, 1988; a “transition” period dur-
ing which the conspiracy collapsed characterized by a rapid decline in the price of fro-
zen perch while cost rose, mid-July 1988 to mid-September 1988; and a postconspiracy
period, September 28, 1988 to September 27, 1989. The null hypothesis (competition)
is that the price of frozen perch was not statistically lower (on average) in the postcon-
spiracy period than the preconspiracy period,5 controlling for cost differences.
To estimate “but-for” conspiracy prices, the authors use weekly time series data in the
postconspiracy period and fit a regression model of frozen perch log price as a function
of current and lagged costs, as measured by fresh perch log prices. The model is used to
backcast but-for conspiracy price in two earlier periods that preceded the collapse of the
bid-rigging scheme. They find the price during the conspiracy period is significantly
above the but-for predicted price in every auction, with an average cartel markup in the
range of 23.1% to 30.4%, depending on the period chosen to define the conspiratorial
conduct.
By examining the first and second moments from the same conspiracy collapse,
Abrantes-Metz and coauthors (“AFG&T”) (2006), propose a screen based on the stan-
dard deviation of price normalized by its mean, or the coefficient of variation. They find
that while the mean price decreased by 16%, the coefficient of variation increased by
332% following the conspiracy collapse. The mean and standard deviation of the cost is
also higher under competition, but not by nearly enough to account for the increase in
price. Thus, the authors conclude that during the postconspiracy period, price began to
covary more closely with cost, and thus exhibited larger variation (over time).
3 They note that prior studies finding that profits or prices fell after antitrust enforcement action are
unreliable because they ignore cost differences and other factors (see, for example, Erickson, 1976 and
Parker, 1969).
4 Five companies and associated individuals pleaded guilty to separate felonies and were fined.
5 The authors assume that the gap between the two periods represents a transition from collusion to
competition.
Based on this finding, the authors hypothesize that other conspiracies would exhibit
similar patterns, and apply their “variance screen” to retail gasoline stations in Louisville,
Kentucky in 1996–2002. The Louisville area is considered a good candidate for collusion
because gasoline in Kentucky at both wholesale and retail is moderately concentrated
and uses a unique formation of gasoline, that is, reformulated gasoline. They note that
while a cartel the size of a city would be costly to organize and police, there may be a
degree of market power conferred by the elimination of localized competition. The vari-
ance screen would identify a potential cartel as a cluster of gasoline stations located close
to one another exhibiting lower price variation and higher prices relative to other sta-
tions in the city. They find no such clusters and conclude competitive conduct is a more
plausible explanation than collusion.
In contrast, Bolotova, Connor, and Miller (2008) find mixed evidence that price vari-
ance during collusion is lower than that observed prior to the formation of a cartel. The
study considers two well-documented episodes of collusion: the lysine cartel (1991–1995)
and the citric acid cartel (1992–1995). They hypothesize that the mean price is higher
and the variance of the price is lower during collusive than noncollusive periods. Using
monthly average contract citric acid prices and average monthly lysine prices, their sta-
tistical analysis is based on extensions of the traditional autoregressive conditional het-
eroskedasticity (“ARCH”) and generalized ARCH models. They find that mean prices
are higher in both cartels during the collusive period. However, they find price variance
is lower during the lysine cartel, but higher during the citric acid conspiracy than it was
during more competitive periods. The authors suggest that foreign competition might
account for this outcome. They conclude that the variance screen may be a useful tool to
detect conspiracies that do not significantly raise price but tend to homogenize business
practices, which may raise profits and also reduce variance.
Abrantes-Metz and coauthors (2012) examine manipulation of the US dollar
one-month LIBOR rate. Their paper is motivated by a May 29, 2008, Wall Street Journal
article suggesting that several global banks were reporting LIBOR quotes significantly
below those implied by prevailing credit default swap (“CDS”). To test this claim, they
compare LIBOR with other short-term borrowing rates, analyze individual bank quotes,
and compare these individual quotes to CDS spreads during three periods: January 1,
2007–August 8, 2007 (Period 1), August 9, 2007–April 16, 2008 (Period 2), and April 17,
2008–May 30, 2008 (Period 3). The three periods are separated by two dates in which
major news events occurred: (1) on August 9, 2007, there were related press releases
on (a) a coordinated intervention by the European Central Bank, the Federal Reserve
Bank, and the Bank of Japan; (b) AIG’s warning that defaults were spreading beyond the
subprime sector; and (c) BNP Paribas’s suspension of three mortgage-backed funds; and
(2) on April 17, 2008, the British Banding Association announced its intent to investigate
its LIBOR-setting process.
Their screening methodology proposes three tests for collusion. First, they examine
the relationship between LIBOR and other major benchmarks, assuming those to be
nonmanipulated at the time they are used as benchmarks. Specifically, they test whether
the LIBOR rate is manipulated downward during Period 2, relative to Periods 1 or
3. They cannot reject the null hypothesis that LIBOR rates are the same as the predicted
rate. Thus, they conclude that the evidence on the average level of the LIBOR rate is con-
sistent with the absence of a material manipulation.
The authors also examine the pattern of individual LIBOR quotes by 16 participating
banks. In particular, they examine how likely it is it that a large number of banks will
submit identical LIBOR quotes without coordinating. To that end, they first examine
the intraday variance of these individual quotes. They also calculate the frequency with
which each bank appears in the “deciding group,”6 and identify banks that tend to be
in the deciding group most often. They hypothesize that ‘‘manipulative’’ banks should
cluster together in nonrandom patterns. To test this, the authors compute pairwise cor-
relations between all possible bank-pairs and calculate the frequency with which each
bank appears in the deciding group, and identify a group of banks that tend to be in the
deciding group very often. From this analysis, the null hypothesis of nonrandom clus-
tering patterns is rejected, raising the possibility of manipulation.
The third collusion test follows from an analysis of the relationships between indi-
vidual LIBOR quotes and proxies for individual borrowing costs as determined by CDS
spreads. In particular, they examine whether banks with relatively low CDS spreads are
also banks with relatively low LIBOR quotes. They detect several banks whose ordinal
positions in LIBOR quotes are unrelated to their ordinal positions in CDS spreads, and
raise the possibility of manipulation.
Abrantes-Metz and Addanki (2007) propose a variance (over time) screen to detect
manipulation of commodity prices based on an analysis of the Hunt Brothers’ silver
manipulation episode of 1979–1980. Their screen is based on the notion that manipula-
tion provides an informational advantage to manipulators over the rest of the market
(i.e., market participants are fooled). This implies that when market participants form
expectations on the likely levels of future prices, these forecasts are systematically wrong
more often than they would otherwise have been in the absence of manipulation. Thus,
the variable of interest is the variance in the forecasting error of future spot prices. If the
collusion is effective in reducing prices, this will result in more negative forecast errors.
Using daily futures and spot prices for silver from Comex from February 1975 through
April 2004, their analysis examines the relationship between the futures contract price
at maturity date T and the realized spot price on that date. They find that the coefficient
of variation of the forecast errors is larger during the manipulation period, and that this
result holds when regression analysis is used to control for changes in macroeconomic
conditions.
Abrantes-Metz and Metz (2012) attempt to determine how far screens can go in dis-
tinguishing explicit from tacit collusion. In doing so, they consider evidence from the
LIBOR setting. Their purpose is to determine whether movements in LIBOR rates are
best explained by noncooperative behavior, tacit collusion, or explicit collusion. Their
analysis is based on an inspection of the coefficient of variation (across banks) in daily
6 LIBOR is established as the simple average of the middle set of eight quotes that are submitted by the
16 participating banks. These eight banks comprise the “deciding group.”

LIBOR quotes for a cross section of 16 participating banks. They find that the coefficient
of variation is near zero from early August 2006 through early August 2007, becoming
abruptly positive thereafter. They note that if all banks were submitting unique quotes
each day (which happened to average to the same level day after day), the coefficient
of variation would be larger. On the other hand, if all banks submitted essentially the
same quote, the coefficient of variation would be low, and if the middle eight quotes
were identical, it would be zero.
Their test for noncooperative behavior is whether the observed convergence across
LIBOR quotes from the 16 participating banks is explained by identical borrowing costs.
If so, they note that the triggering of the financial crisis would have affected all banks
equally. Since the banks considered differ significantly in terms of their characteristics
and borrowing costs (i.e., they have asset portfolios of varying risk, varying liability
structures, and participate to different degrees in different market segments), they reject
the noncooperative hypothesis.
To distinguish between tacit and explicit collusion, the hypothesis is that the data
would be more consistent with tacit collusion if banks were “learning” from the stra-
tegic reaction of the other banks. In this setting, a transition period would be observed
in which the variation of intraday quotes would be decreasing towards zero. Since an
abrupt transition to zero is observed, they conclude the data are inconsistent with tacit
collusion. The authors note that the tacit collusion hypothesis is further complicated by
the fact that individual bank quotes are sealed and are made public only after the LIBOR
is computed. Thus, if the banks submit the same quote day after day, and other banks
were learning and converging toward that common quote, the data may be described
as consistent with tacit collusion. On the other hand, if many banks submit a common
sealed quote one day, and a common but different sealed quote the next day, tacit col-
lusion is a less likely explanation. Based on an inspection of individual bank quotes,
they conclude that the tacit collusion (or learning theory) hypothesis does not fit the
data well, leaving explicit collusion as the explanation that is most consistent with the
observed LIBOR quotes.
Eruthku and Hildebrand (2010) employ a differences-in-differences approach to
determine whether a public announcement of an antitrust investigation (which trig-
gered the collapse of a cartel) may be used to detect a price-fixing conspiracy. In May
2006, the Canadian Competition Bureau publically announced its investigation of
retail gasoline markets in some local markets in Quebec. The authors’ test for col-
lusion is whether retail prices fell following the announcement. The study employs
weekly retail and wholesale prices for the period May 31, 2005–May 22, 2007, provid-
ing 52 weeks of data before and after the announcement. In a difference-in-difference
regression analysis, Sherbrook is the “treatment” city and Montreal and Quebec City
are “control” cities. They find that the announcement decreased the price differential
between Sherbrook and Montreal by 1.75 cents per liter. This reduction is statistically
significant at the 5% level. Interestingly, the authors find that the variance of retail
prices for all cities in their sample increased after the announcement, but not signifi-
cantly so.
Jiménez and Perdiguero (2011) apply a price variance (over time) screen to the
retail gasoline market in the Canary Islands, Spain. The Canary Islands were selected
because retail gasoline markets on different islands have different market struc-
tures. On some islands the markets have more than one supplier, while each of the
remaining two islands is monopolized by a single supplier, the DISA company. The
authors find that the coefficient of variation of the companies on oligopolistic islands
is between 1.06% and 8% higher in the oligopolistic islands. From this, they conclude
that a monopolistic firm follows a more rigid price path than do retail outlets on the
oligopolistic islands. However, we note that the null hypothesis that the difference in
means between the two groups is zero is not rejected using a 95% level of significance.
The authors conclude that analyzing the results of the variance screen without com-
paring them to a benchmark would not enable them to draw any definitive conclu-
sions. Note also that the use of the monopoly islands as a collusive benchmark (H1)
may not be a good metaphor for kind of price rigidity that might occur when multiple
firms try to coordinate pricing.
The authors also employ a screen to try to find pockets of retailers with higher prices
and lower coefficients of variation, similar to the screen used by AFG&T (2006). Their
competitive benchmark is a retail gasoline supplier that traditionally competes more
aggressively on price: PCAN. The study tests whether PCAN stimulates competition
using two different approaches. The first involved examining prices and the coefficient
of variation for prices in towns with and without PCAN gas stations. They find prices are
always higher and the coefficient of variation smaller if PCAN is not present. The second
test is whether the presence of an independent retailer within a half-mile radius is cor-
related to lower and more variable gasoline prices. They find both. Based on the variance
screens, they conclude that the average performance of the gas retail outlets (excluding
those run by PCAN) is very close to that shown on a monopolistic island, and further
from CPAN.
Genesove and Mullin (2001) review the rules of the Sugar Institute and meetings/
notes among its members. The trade association was formed in December 1927 fol-
lowing several years of declining margins and excess capacity. The trade association’s
14 members comprised nearly all the cane sugar refining capacity in the United States.
The cartel did not directly fix output or set prices but instead homogenized business
practices, thereby facilitating members’ ability to detect secret price cuts. The study is
based on the average weekly prices of refined sugar and its primary input cost, raw sugar,
in the United States from 1914 to 1941. Using these data, the authors calculate the yearly
price-cost margin for sugar refining in the United States for three periods: before, dur-
ing, and after the cartel period. The authors use a Lerner Index equal to 11% as a bench-
mark for monopoly pricing. This was the margin in 1892 when US domestic refiners’
share and margin reached their highest level. The authors’ hypothesis is that price-cost
margins are higher and the variance of margin lower in collusive period than competi-
tion. The authors find that the conspiracy raised price-cost margins to about 75% of the
monopoly level and the variance in this margin dropped by nearly 100% while the cartel
remained active.
As noted above, the use of variance screens has become rather widespread in empiri-
cal work. For example, Brannon (2003) summarizes research performed for the Joint
Economic Committee, US Congress on the effects of resale price maintenance laws
on petrol prices and station attrition in Wisconsin. The study concluded that the State
of Wisconsin enacted a policy that implicitly taxes its citizens for the benefit not just
of small independent stations but also for the large multinational oil companies that
operate in Wisconsin. The article calculates the average margin and the variance for
two markets that were affected by this legislation, as well as a control group market.
The results show that the average margin was higher in the collusive markets, while the
findings as regards to variance were not particularly conclusive. In another example,
Abrantes-Metz and Pereira (2007) analyzed the mobile phone sector in Portugal before
and after the entry of a new operator, Optimus.7
21.4.2. Screens Based on Structural Models

Christie and Schultz (1994) provide evidence to show that in 1991, NASDAQ deal-
ers avoided odd-eighth quotes for 70 of 100 large, actively traded NASDAQ securities,
including Apple Computer and Lotus development. The avoidance of odd-eighth quotes
ensured an inside spread of at least $0.25 for these securities. The authors compare the
dollar spreads for the NASDAQ and NYSE/AMEX stocks and find a systematic differ-
ence in the frequency of odd-eighth spreads in the two pools. For example, odd-eighth
spreads of $0.125 and $0.375 occur nearly three times as often for NYSE/AMEX securi-
ties as for NASDAQ securities, where the spreads are mostly in even-eighths, such as
$0.25, $0.50, and $0.75. The authors test which of three hypotheses best explains this
odd-eighth avoidance: (1) coarse pricing increments to lower negotiation costs, (2) cost
determinants of the spread, and (3) tacit collusion among dealers.
Finding that, in the data, larger trades are far more likely to occur on odd-eighth
spreads than smaller trades, the authors rule out the first hypothesis of negotiation costs.
Next, the authors use logistic regression analysis to determine that economic deter-
minants such as volume, volatility, market capitalization, and stock price do not play a
role in predicting the probability that stocks are quoted using odd eighths. By elimina-
tion, the authors conclude that the only remaining hypothesis explaining the absence
of odd-eighth spreads for NASDAQ securities is tacit collusion among market makers.
Bresnahan (1987) attempts to explain a dramatic increase in US automobile produc-
tion that occurred in 1955. In 1955, relative to the two surrounding years, automobile
production was higher by 45% and quality-adjusted prices lower. The paper tests the
hypothesis that there was a supply shock of a specific form: a one-year increase in the
competitiveness of conduct in the industry. A structural model of supply and demand
is estimated to test the fit of various firm behavioral hypotheses. Nonnested (Cox)
7 Other papers that discuss or apply the approach include Esposito and Ferroro (2006), Muthusamy
et al. (2008), Abrantes-Metz (2011), and Abrantes-Metz and Bajari (2011).

hypothesis tests find that the collusive outcome fits the data best in 1954 and in 1956,
while the competitive outcome fits the data best in 1955. Bresnahan’s paper is regarded as
one of the few empirical studies finding evidence of tacit collusion.
Rapson (2009) attempts to replicate the findings from Bresnahan’s 1987 study to
determine whether the conclusion of tacit collusion hinged on restrictive assumptions
about demand. In particular, he examines the independence of irrelevant alternatives
assumption (“IIA”) which makes demand a function only of the price and quality of
adjacent models on the quality spectrum, rendering nonadjacent price changes irrel-
evant to predicted demand. Rapson notes that the restrictive demand specification
could cause intrafirm pricing strategies consistent with differentiated product Bertrand
to be mistakenly interpreted as collusion. To allow for more realistic demand behav-
ior, he employs a random coefficients logit model. He finds that for no year can
Bertrand competition be rejected in favor of tacit collusion. However, his results also
indicate that firms were not maximizing profit during this period. He concludes that a
firm-competition model is rejected in favor of brand competition in 1955, and is a better
fit (though insignificantly) in 1954 and 1956.
Structural models have also been developed to analyze bidder collusion in auctions.
In an early paper commenting on the paucity (at the time) of economic literature on
the subject of collusion in auctions, Hendricks and Porter (1989) pointed out that the
characteristics of a collusive scheme in an auction depend on the rules of the auction
and the nature of auctioned object. They also expressed surprise that the empirical lit-
erature on collusion in auctions was lacking even as detailed data sets were publicly
available.
Porter and Zona (1993) develop an econometric test to detect “phantom bidding” in
procurement auctions, based on the differences in bidding between cartel members and
nonmembers. Their test exploits information on who was and was not in the cartel, and
the form of the conspiracy (cartel members used phantom bidding). Using procurement
auction data from the New York State Department of Transportation (“DOT”), Porter
and Zona apply their test to Nassau and Suffolk county DOT contract lettings from 1979
to 1985, and find that the behavior of the collusive firms—one convicted in federal court
of bid rigging and four unindicted coconspirators—was statistically different from that
firms that did not belong to cartel.
In a related paper, Porter and Zona (1999) develop a test to detect bid rigging in school
milk procurement auctions. They list several characteristics of the school milk procure-
ment market that facilitate their analysis: an auction design that was well understood, a
relatively homogenous product, a fixed set of potential bidders in the short run, and a
straightforward production process. In 1994, the State of Ohio charged 13 dairies with
bid rigging in school milk procurement auctions from 1980 to 1990. They compare the
bidding behavior of three defendant firms to that of nondefendant firms and find that
each defendant firm’s bidding function is statistically different from the bidding func-
tions of nondefendant firms. Porter and Zona also estimate the increase in price result-
ing from the collusion. They determine that bid rigging resulted in a 6.5% increase in the
price of milk paid by the school districts.
Table 21.2 Empirical Tests/Screens
Study Screen? H1: Collusion H0: Competition X: Variable Data Conclusion Comments
Category 1
Froeb, Koyak, & Test DOJ investigation Postcollusion period Price level Weekly time series, Collusion raised Cost of fresh fish used
Werden (1993) identified by drop in 1984–89. Aggregate price by 23%. as regressors (current
price weekly bid prices and and lagged) to control
cost of fresh perch. for cost
Genesove & Test Profit margins higher and No change in profit Annual profit margins Average weekly prices Conspiracy raised price Paper reviewed the
Mullin (2001) variance of margin lower margin or variance in calculated from prices of refined and raw cost margin to about 75% rules of the Sugar
profit margin of refined and raw sugar in US, 1914–41; of the monopoly level; Institute and meetings
sugar output of Atlantic rivals outside of collusive and communications
refiners; imports of agreement responded to among members.
refined sugar; and price increase by increasing
Conspiracy did not fix
domestic sugar beet output; variance in profit
prices or output but
production margin dropped by nearly
homogenized business
100% during conspiracy.
practices to make
price cutting more
transparent.
Abrantes- Test Same as Froeb, Koyak, Same as Froeb, Koyak Price coefficient of Same as Froeb, Koyak & Collusion raised price No control for cost
Metz et al. & Werden (1993) & Werden (1993) variation Werden (1993) coefficient of variation by
(2006) 332%.
Screen Geographic clusters of gas No such clusters Price coefficient of Daily time series, No clusters of significantly Imputed missing
stations with significantly variation 1996–2002. Price data lower price data using AR(1)
lower price variance at 279 gas stations in price variance process. No control
Louisville. found for cost.
Abrantes- Test Future spot prices are Future spot prices Forecasting error of Daily data on futures Apply approach to the Hunt Some evidence that
Metz & Addanki harder to predict using are easier to predict future spot prices. and spot prices for Brothers silver manipulation spot prices are more
(2007) current spot prices in using current spot Control variables include silver from Comex, episode of early 1980s, and volatile when they are
presence of collusion in prices in presence of monthly interest rate, 2/1975–4/2004. find that under manipulation above futures prices,
spot market. competition in spot 10-yr. T- bill rate, S&P the forecasting error is than when they are
market. 500 Index, monthly more volatile than under below.
exchange rates for a nonmanipulation, controlling
basket of commodities. for market fundamentals
Bolotova, Test Mean price is higher and No support for Price level and Monthly average Mean prices are higher in “Variance is a useful
Connor, & Miller variance in price is lower. hypothesized variance. Analysis contract citric acid both citric acid and lysine tool for detecting
(2008) changes in first based on extensions prices (2/1990– cartels; price variance conspiracies that
and second of the autoregressive 4/1997) and during the do not significantly
moments of conditional average monthly lysine conspiracy was raise price but
price distribution heteroskedasticity lysine (1/1990– lower, whereas variance tend to control the
(ARCH) model and 6/1996) during the citric acid price variance by
generalized ARCH conspiracy was higher homogenization of
(GARCH). than it was during more business practices,
competitive periods. which may raise
profits.”
Abrantes- Screen One-month LIBOR rate Noncooperative Coefficient of variation Daily one-month Reject noncooperative There are particular
Metz & Metz nearly constant from outcome: for individual one-month LIBOR quotes for 16 hypothesis because circumstances
(2012) 8/2006–8/2007. convergence across LIBOR quotes for 16 participating banks banks do not have under which screens
Almost no variation in LIBOR quotes due to banks. Comparisons surveyed by the British identical borrowing costs can go one extra
the middle eight bank identical borrowing of LIBOR rate to T-bill Banking Association, and would be affected by step in helping to
quotes during same costs; triggering of rate and federal funds 2006–8. financial crisis in distinguish explicit
period. Tacit collusion: financial crisis would effective rate different ways. Reject from tacit collusion.
if banks were “learning” affect all banks tacit collusion because They correspond to
from strategic equally. convergence was situations in which
interaction, there immediate and sealed one can observe
would be a transition bids for individual the dynamics of
towards convergence banks moved to same collusion; in this
to an identical rate. bid from day to day. case, the quoting
Explicit collision: banks Explicit collusion is patterns in order
sealed bids move the remaining to identify how the
simultaneously to explanation. bids/quotes may
same bid from day have become
to day. identical.
(Continued)
Table 21.2 Continued
Abrantes- Screen Manipulated LIBOR rates 1: LIBOR rates are Spread comparisons Rates analyzed for 3 Actual LIBOR rates are not Cost control is
Metz et al. are lower. higher. of one-month LIBOR periods: 1/1/2007– statistically different from Federal Funds Rate
(2012) rate to one-month 8/8/2009 (Period 1); predicted rate. Cannot reject
(cont.) T-bill and the Federal 8/9/2007–4/16/2008 null.
Fund effective rate. (Period 2); and
Comparison of actual 4/17/2008–
and predicted LIBOR 5/30/2008 (Period 3)
rates in manipulation
period based on
regression analysis in
clean period, LIBOR
rate = f(federal funds
rates).
Screen Individual LIBOR quotes 2: Individual Coefficient of variation Same as above Individual quotes in Period
of “manipulative” banks LIBOR quotes of for individual one-month 1 are more tightly clustered
are clustered together in “manipulative” banks LIBOR quotes for 16 than in other periods. Reject
nonrandom patterns. are not clustered in banks null.
nonrandom patterns.
Screen Banks with relatively low 3: No negative Correlations of Same as above Some outlier banks ordinal
(high) collateral debt correlation between a individual bank LIBOR position in LIBOR quotes is
swap (CDS) spreads are bank’s LIBOR rate and quotes and CDS spreads unrelated to their ordinal
also banks with high its CDS spread and bank market position in CDS spreads.
(low) LIBOR quotes. capitalization
Jiminez & Screen Higher price coefficient Price variation Price coefficient of Prices of petrol 95 Gas stations in an oligopoly Author’s
Perdiguero of variation relative to a not different variation and diesel, weekly have a higher coefficient of note: Missing data
2012) competitive benchmark from competitive time series, September variation. filled in using
benchmark 2008 to April 2009 (24 interpolation.
weeks); 420 petrol 95
stations and 391 diesel
stations
Category 2: Structural models

Bresnahan (1987) Test Firms set prices to Each firms sets prices Equilibrium prices and Automobile price, 1954 and 1956 Author notes that
maximize their joint to maximize its own quantities calculated by quantities, and generate a superior findings are robust
profits. profit, taking the solving demand systems characteristics, model fit under collusion against alternative
prices of other firms’ and firm first-order 1954–56. hypothesis. specifications.
products as given. conditions. Nonnested
(Cox) hypothesis tests.
Porter & Zona Test Phantom bidding No phantom bidding Log of a firm’s bid on a Subset of all Nassau Cartel firms’ bids are
(1993) particular job and Suffolk county DOT statistically different from
contract lettings from competitive firms’ bids.
April 1979 through
March 1985; 575 bids
were submitted on 116
projects.
Christie & Schultz Test Avoidance of odd-eighth Avoidance of Equals 1 if a security is Inside quotes for 100 Avoidance of odd-eighth Earlier, the
(1994) quotes is attributable to odd-eighth quotes quoted in odd-eighths large, actively traded quotes is not attributable authors rule out
tacit collusion among is attributable (logistic regression) NASDAQ securities and to economic determinants that odd-eighth
bidders. to economic for 100 comparable of spread. Tacit collusion avoidance results
determinants of NYSE/AMEX securities, among market makers is from coarse price
spread such as for the year 1991 the only explanation of increments to lower
volume, volatility, avoidance of odd-eighths. negotiation costs.
market capitalization,
and stock price, and
collusion is absent.
(Continued)
Table 21.2 Continued
Porter & Zona Test Bidding behavior is Bidding behavior is Equals 1 if bid is School milk Collusion raised market
(1999) inconsistent with that consistent with that submitted in a district procurement data for prices by about 6.5%.
of control group of of control group of (probit regression) 509 districts in Ohio
nondefendants. nondefendants from 1980 through
1990
Bajari & Ye (2003) Screen Bids are independent Bids are not For a given firm and Detailed bidding Among 23 pairs with at
after controlling for all conditionally project, the ratio of the information for least four simultaneous
information about costs. independent. amount bid by the firm almost all the bids, the null hypothesis
on the project to the public and private cannot be rejected
engineer’s cost estimate road construction except for four pairs of
for the project projects conducted firms. In only one pair did
in Minnesota, North bidders bid against each
Dakota, and South other more than a handful
Dakota during the of times.
years 1994–98. Data
set contains nearly
Screen Bids are Bids are not For a given firm and Only one pair
18,000 procurement
exchangeable: costs exchangeable. project, the ratio of the (different from the
auctions.
alone should determine amount bid by the firm four above) fails the
how firms bid. Holding on the project to the exchangeability test.
cost information engineer’s cost estimate Also, the bidders in the
constant, a firm’s bid for the project. pair bid against each
shouldn’t depend on other more than a
the identities of its handful of times.
competitors.
Screen Probability of Firm’s private cost Pair 1 failing C.I. and
collusion is low. (estimated), used to pair 2 failing exch were
calculate marginal models 2 and 3, model 1
likelihood of each model, was competition. Posterior
in turn used to calculate probability of competitive
posterior probabilities model is highest.
that equilibrium model is
competitive/collusive
Eruthku & Screen Canadian Competition Postinvestigation Weekly retail gasoline Weekly data in Announcement of Cost control is
Hilderbrand Bureau investigation of announcement pricing. Difference-in- cities during conspiracy triggered a wholesale gasoline
(2010) retail gasoline pricing in decline in retail difference regression period 5/31/2005– 1.75 cents per litre price.
Sherbrook, Canada gasoline pricing model using prices in 5/22/2007; 52 decline in prices. Stiglerian theory
three cities: Sherbrook, weeks before and after of collusion leads
Montreal, and Quebec. announcement to ambiguous
conclusion regarding
likely collusion in
Sherbrook.
Category 3: Collusive market other than first and second moments of price distribution
Blanckenburg & Screen (2) Low level of capacity (1) No permanent (1) Differenced indicator 1980–2007 annual The System of Collusive Author’s note: SCM
Geist (2009) utilization, (2) slackness excess capacities, that measures the time-series data Markers indicates that is more suitable for
of price adjustments (2) positive difference between for five German the Cement industry was the detection of
to exogenous shocks, correlation, (3) no supply and demand industries. German collusive during the long-term cartels.
(3) excess rates of return, permanent excess rate quantities, (2) change cement industry is relevant time period, and
(4) nearly constant of return, (4) positive in nominal price level, the test market for that all other industries
capacities, (5) lower correlation between (3) difference between a cartel (lasted for were competitive.
variance of price rate of return a rate of return 21 years, 1981–2002).
changes, and (6) lower difference and representing all firms Four competitive
variance of capacity capacity growth prevalent in the market German industries
growth rate rate changes, under consideration were considered—
(5) higher variance and a broader industry automobile,
of price changes, and class comparison rate electrical, chemical,
(6) higher variance of of return, (4) capacity and mechanical
capacity growth D15 growth rate industries.
rate changes
Bajari and Ye (2003) develop a screen to detect bidder collusion in procurement auc-
tions where bidders are asymmetric with respect to their ex ante costs. They posit two
conditions that are necessary and sufficient for competition in their model: conditional
independence and exchangeability. Under conditional independence, bids are indepen-
dent after controlling for publicly observable cost information. Exchangeability implies
that only costs, not the identities of other bidders, determine how a firm bids. Thus, Bajari
and Ye’s null hypothesis of competition is that bids satisfy both conditional independence
and exchangeability. Bajari and Ye apply their screen to the market for asphalt contracts in
the 1994–1998 period, a market with a known history of collusion in the 1980s. They iden-
tify two pairs of firms that fail both the conditional independence and the exchangeability
tests. Next, they use a Bayesian framework to choose among three alternative models of
industry equilibrium: (1) competitive bidding by all firms, (2) collusive bidding by the first
pair and competitive bidding by all other firms, and (3) collusive bidding by the second
pair and competitive bidding by all other firms. They find that the posterior probability
of the competitive model is the highest, and conclude that the bidding in the market is
competitive.
Marshall, Marx, and Raiff (2008) perform an empirical analysis to determine whether
the timing of price announcements (X) after 1985 in the vitamins industry is the result of
collusion rather than the result of demand and cost phenomena (H0). They construct a
data set comprising the dates and number of public price announcements in the United
States during the time period 1970–2001 for 10 vitamin products. The authors estimate
a logit model for the probability that firms announce a price change in a given month
as a function of the number of months elapsed since the previous announced price
change, and demand and supply effects. The estimated coefficients of the logit regres-
sion show that for the two time periods prior to 1985, the time elapsed from the previ-
ous announcement does not have a significant effect on the probability of a new price
announcement. However, the time elapsed from the previous announcement has a sig-
nificant effect on the probability of a new price announcement for the two periods after
1985. Among demand and supply factors, the only variable with a significant coefficient
for any time period is the exchange-rate, with a significant coefficient in the first time
period after 1985. The authors interpret the results of the logit regression as implying that
after 1985, the timing of public price announcements is tied to the timing of cartel meet-
ings. Marshall, Marx, and Raiff conclude that the probability of new price announce-
ments provides a potentially valuable tool for the identification of explicit collusion. The
alternative hypothesis of collusion (H1) is that there is a much higher probability of price
announcements (X) relative to a “clean” period.
21.4.3. Screens Based on Collusive Markers Other Than

Price Screens
Collusive markers other than price have been have been used to try to detect cartels.
Economic theory predicts that certain industry characteristics manifest differently
under the presence of collusive behavior than under that of competitive behavior. These
characteristics have to do with industry processes such as market clearing, technologi-
cal innovation, rate of return, and product innovation among others (see Lorenz 2008).
The outcomes of these processes are different under competitive and collusive behavior,
and, thus, serve as a means to detect cartels.
Blanckenburg and Geist (2009) postulate these six markers as a tool for testing the
“workability of markets.” These markers are (1) utilization rate of capacities, (2) correla-
tion between the utilization rate of capacities and price changes, (3) difference between
the rate of return in the industry and a broader comparison rate of return, (4) correla-
tion between the rate of return difference and capacity growth rate changes, (5) variance
of price changes, and (6) variance of capacity growth rate changes. Table 21.2 shows the
null and alternative hypotheses associated with these markers. While Blanckenburg and
Geist admit that cartel formation is only one of many reasons for the nonworkability
of markets, they suggest that the system of collusive markers can be used by antitrust
authorities as an aid in the detection of long-term cartels. They also apply their screen as
an empirical test using annual time-series data on five German industries from 1980 to
2007. Among the five German industries they consider is the German cement industry,
which is known to have had a cartel that lasted from 1981 to 2002. The other four indus-
tries serve as competitive benchmarks. Blanckenberg and Geist’s system of markers cor-
rectly identifies the cement industry as collusive and the others as competitive.
21.5. Conclusion
Collusion screens (and tests) have been used in an informal way to help determine how
to allocate scarce prosecutorial resources. Give their history, some might object to our
formal characterization of screens by analogy to Bayesian hypothesis testing. But all
screens are designed to help us make better decisions, so understanding exactly how
they do this allows us to reduce a collusion screen to its essential elements. We can com-
pare and contrast the growing number of screens that have been proposed by academics
or used by practitioners in table 21.3.
Formally modeling screening also allows us to better understand the conditions
under which screens are likely to fail. The first is that the empirical indicator may not
be able to differentiate between competition (H0) and collusion (H1). The second is
that the null hypothesis is not indicative of competition or that the alternative is not
indicative of collusion. The third is that the world is neither H0 nor H1. The second and
third, often underappreciated reasons for failure, are due to what we call the problem of
“model fit”: the screen is based on assumptions that do not fit the industry to which the
screen is being applied.
This criticism is similar to that leveled against the use of structural oligopoly mod-
els for merger screening (Werden et al., 2004). Before a structural model is used
Table 21.3 Summary of Findings

Test Type Study Product / Industry Conclusion
First Froeb, Koyak, and Werden (1993) Frozen fish Bid rigging
Moment Genesove and Mullun (2001) Refined and raw sugar Collusion
Bolotova, Connor, and Miller (2008) Lysine Collusion
Bolotova, Connor, and Miller (2008) Citric acid Collusion
Abrantes-Metz et al. (2012) LIBOR No collusion
Second Genesove and Mullun (2001) Refined and raw sugar Collusion
Moment Abrantes-Metz and Addanki (2007) Commodity prices Market manipulation
Bolotova, Connor, and Miller (2008) Lysine Collusion
Bolotova, Connor, and Miller (2008) Citric Acid Competition
Abrantes-Metz and Metz (2012) LIBOR Manipulation
Abrantes-Metz, Kraten, Metz, and LIBOR Explicit collusion
Seow (2012)
Jiménez and Perdiguero (2012) Petrol 95 and diesel Oligopoly pricing
Structural Bresnahan (1987) Automobile Tacit collusion
Model Porter and Zona (1993) Highway construction Phantom bidding
contracts
Christie, Harris, and Schultz (1994) NASDAQ securities Collusion
Porter and Zona (1999) School milk supply contracts Bid rigging
Bajari and Ye (2003) Seal coating contracts Competition
Marshall, Marx, and Raiff (2008) Vitamins Explicit collusion
Rapson (2009) Automobile Competition
Eruthku and Hildebrand (2010) Gasoline (Retail) Price-fixing
conspiracy
to predict whether mergers will raise price, enforcers should make sure that the
model is able to characterize the significant features of observed competition within
the industry. The analogy to criticism of the use of structural models for collusion
screening is obvious.
Less obvious is the analogy to screens based on indicator variables chosen from past
episodes of collusion. Here the assumption on which the screen is based is that the
industry being screened exhibits collusive and competitive behavior similar to that of
the industry in which collusion occurred. Before the screen is used, practitioners should
make sure that the industry “fits” this often implicit assumption.
As a final note of caution, it is important to remember that all models, both the-
oretical and empirical, are abstractions away from reality. This means that one can
always find some feature of the industry being screened that is at odds with the model
assumptions. But the art of model building is to determine whether this omission is
likely to bias the screen’s predictions, or whether the screen works well despite the
omission.
Acknowledgments
We acknowledge useful comments from Joe Harrington, David Sappington, Danny

Sokol, Bart Victor, and seminar participants at Vanderbilt University and the University
of Florida.
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CHAPTER 22
C OM P E T I T IO N P OL IC Y F OR
I N D U S T RY S TA N DA R D S
RICHARD GILBERT
22.1. Introduction
Standards are all around us. Screws fit into nuts thanks to standards. There are stan-
dards for weights and measures, professional certifications, time zones, money, wire-
less communications, plumbing fixtures, electrical components, and green buildings,
to name just a few of the very many categories of economic activity impacted by stan-
dards. Despite the vast number of standards that impact commerce and daily life, stan-
dards often impress by their absence. Fire engines responding to the 1991 firestorm in
Oakland, California, carried hoses that were incompatible with the local fire hydrants
(Seek and Evans, 2004). The charger that refreshes my mobile phone is unlikely to work
with yours, my word processor may not be fully compatible with your word processor
(or with an earlier version of my own word processor), and if we travel abroad we should
bring adapter plugs—lots of them.
This chapter surveys competition issues raised by the development of industry
standards, whether accomplished through a formal standard-setting committee
structure or the unilateral conduct of a single sponsor. The focus is on the trade-off
between the benefits from standards and possible costs that standards and the activ-
ity of standard development may impose on consumers. A particular focus is on
the consequences of intellectual property rights for standards. The topics are large
and this chapter does not attempt a comprehensive survey, but rather complements
several other surveys of standards and their economic impacts, examples of which
include Farrell and Saloner (1987), David and Greenstein (1990), Katz and Shapiro
Competition Policy for Industry Standards 555
(1994), Matutes and Regibeau (1996), Shapiro (2001), Lemley (2002), ABA (2005),
and Simcoe (2006).
22.1.1. Types of Standards

Standards have different functions. Compatibility standards (also called interoperability
standards) are specifications that assure that one component will function as intended
with another component. For example, the Small Computer Systems Interface (SCSI)
specifies how small and medium-size computer processors communicate with external
devices such as disk storage devices, printers, and scanners.
Interoperability standards have mushroomed with the need for computers and tele-
communications devices to function smoothly with complementary components and
with advances in communications between devices and over the Internet. Biddle, White,
and Woods (2010) concluded that a modern laptop computer has components that
implement at least 251 different interoperability standards. The sources of these standards
vary with 90 developed by formal standard development organizations, 112 developed in
less formal consortia, and the remainder sponsored by individual companies.
Quality and safety standards inform consumers about important product character-
istics and may limit products that may be sold. The green building certification informs
commercial tenants about the building’s energy performance and environment impacts.
The classification scheme established by the Gemological Institute of America informs
consumers about a diamond’s color, clarity, imperfections, and weight. The State
of California requires petroleum refiners to produce and sell gasoline that meets the
California reformulated gasoline emissions standard.
Many standards help to coordinate economic activity. Interoperability standards
have an explicit coordination function by ensuring that components work together.
Standardized time and geographic time zones coordinate activity by allowing people to
agree about the time of day. Currency standards, such as the $20 bill, help to coordinate
economic exchange.
22.2. The Development of Standards
The International Organization for Standardization defines a standard as a “document,

established by consensus and approved by a recognized body, that provides, for com-
mon and repeated use, rules, guidelines or characteristics for activities or their results,
aimed at the achievement of the optimum degree of order in a given context.”1 A broader
1 ISO/IEC Directives Part 2, Rules for the Structure and Drafting of International Standards, Edition
6.0 2011-04.
556 Richard Gilbert
definition embraces product or interface specifications developed through coordination

or by independent action. Coordination can occur in a standard development organiza-
tion (SDO) that holds regular meetings and follows defined procedures to specify and
promulgate standards. Less formal organizations called standard-setting organizations
(SSOs) also develop standards. As the line between SDOs and SSOs is often blurred,
I use the term SSO to refer to both formal and less formal organizations that specify and
promulgate standards.
SSOs can be agencies of a government, organizations that have some affiliation with a
government, or private. Compliance with a standard may be mandatory, meaning that
parties engaged in commercial activity covered by the standard must employ the stan-
dard. Examples of mandatory standards include analog and digital broadcast standards,
fuel emission standards, state and local building codes, and reflectivity standards for
highway signs. These are de jure standards, although that term is sometimes applied to
any standard developed by a formal standard development organization. More com-
monly, compliance with a standard is voluntary.
Private parties, acting individually, often develop specifications or protocols that are
widely adopted and become de facto industry standards. Examples include Microsoft’s
Office Open XML file format or Hewlett-Packard’s PCL protocol for computer print-
ers. De facto standards sometimes become adopted as formal standards. The Portable
Document Format developed by Adobe is an example.
Another dimension of standards and the standard development process is the degree
to which the standard or the process is “open” (Krechmer, 2009). Standard development
is open if the process is transparent, participation is available to any interested party, and
consensus determines the choice of a standard. The standard itself is open if it is freely
available and unencumbered by intellectual property rights such as patents, copyrights,
and trademarks, although, according to some a standard can be open and protected by
intellectual property rights if those rights are licensed to any interested party at reason-
able and non-discriminatory terms.
22.2.1. International Standard-Setting Organizations

Three organizations headquartered in Geneva, Switzerland, operate at an intergov-
ernmental level and develop standards intended for international application. ISO
(the International Organization for Standardization) is a nongovernmental organiza-
tion that is the world’s largest developer and publisher of international standards. The
International Telecommunications Union (ITU) is an agency of the United Nations
responsible for standards development in information and communication tech-
nologies. The third Geneva-based agency that develops international standards is the
International Electrotechnical Commission (IEC), which provides a forum for compa-
nies, industries, and governments to develop international standards for electrical, elec-
tronic, and related technologies.
22.2.2. National and Regional Standard-Setting Organizations

Several organizations set standards for adoption at a regional level. In the European
Union, the European Telecommunications Standards Institute (ETSI) is responsible for
standardization of information and communication technologies within Europe and is
the European counterpart to the ITU. Its accomplishments include the GSM technol-
ogy for mobile communications. Nearly every country has a recognized standards body
that acts as the country’s representative to the ISO. In the United States that body is the
American National Standards Institute (ANSI). ISO representatives from other coun-
tries include the British Standards Institution, the German Institute for Standardization,
the French Association for Standardization, the Standardization Administration of
China, the Japanese Industrial Standards Committee, and more than 100 others.
22.2.3. ANSI-Approved and Other US SSOs

The American National Standards Institute (ANSI) coordinates the US voluntary
consensus standards system by providing a forum for the development of policies on
standards issues. ANSI also accredits organizations that meet its requirements for open-
ness, balance, consensus, and due process in the development of voluntary national
standards. ANSI’s members include more than 1,000 companies, government agen-
cies, institutions, and international organizations. At the end of 2006 about 200 orga-
nizations were accredited by ANSI for standards development. The total number of
American National Standards at that time exceeded 10,000.
Numerous other organizations engage in standards development but are not formally
accredited by ANSI either because they have not sought accreditation or because ANSI
has not verified that the organizations conform to its requirements for openness, bal-
ance, consensus, and due process. Nonetheless, these organizations may develop and
publish standards that obtain ANSI certification and may obtain certification by one of
the international standardization organizations. These organizations include influential
standard-setting consortia such as the Internet Engineering Task Force and the World
Wide Web Consortium.
22.3. Competition Principles for

Standard-Setting Organizations
Standards benefit consumers in many ways. Quality and safety standards provide
valuable information about product characteristics and can prevent the sale of
558 Richard Gilbert
shoddy or potentially hazardous products. Compatibility standards benefit consum-

ers and producers by facilitating product adoption and promoting compatible solu-
tions. Furthermore, cooperation to choose a standard can avoid or mitigate a costly
“standards war” in which parties promote incompatible solutions. Competition to
adopt a standard can be particularly intense and costly in markets characterized by
strong network effects that support “winner-takes-all” or “winner-takes-most” mar-
ket outcomes (Besen and Farrell, 1994, Shapiro and Varian, 1999). Familiar exam-
ples of rival standards in markets with network effects include the Betamax and
VHS video tape formats, competing DVD formats (Dranove and Gandal, 2003),
Blu-ray and HD high-definition recording media, and WiMax versus LTE and other
fourth-generation mobile communications standards. Some standards wars splinter
the market to such an extent that no winner emerges. An example is quadraphonic
sound (Postrel, 1990).
Standards can impose costs on consumers by reducing the diversity of products on
the market, by restricting entry of suppliers, and by foreclosing or raising barriers to
alternative implementations. Some exclusion is inevitable because the procompetitive
purpose of standards is to focus industry efforts on one solution at the expense of others
or to impose conditions that all suppliers must satisfy. Requiring surgeons to be board
certified after years of training reduces the likelihood of being practiced upon by a char-
latan, but the process of setting a quality standard can be manipulated to restrict the
supply of surgeons in order to increase their compensation. Furthermore, a certification
requirement that applies to all surgeons may be too restrictive for some types of medical
procedures that can be performed with lesser skill sets.
Standard development can provide a venue for competitors to act jointly to exclude
rivals or fix prices. For example, practicing members of occupations can lobby legis-
latures for standards that limit competition from unlicensed suppliers, and many
service occupations have succeeded in doing so (Kleiner, 2000; Edlin and Haw, forth-
coming). At a more subtle level, a standard can facilitate collusion by making the sup-
ply of products more homogeneous, thereby making it easier for firms to monitor their
rivals’ prices. Product homogeneity from standardization also can soften price competi-
tion by discouraging firms from offering competitive alternatives that depart from the
standard. A standard that requires refrigerator manufacturers to meet or exceed an effi-
ciency standard can increase costs, raise barriers to entry, make it easier for manufactur-
ers to collude on higher prices, and prevent competition from cheaper units that do not
meet the efficiency standard. Of course any adverse effects would have to be balanced
against the benefits from lower energy usage.
The timing of standard development also can have social costs if the process moves
too slowly and delays procompetitive solutions or if the process moves too quickly and
prematurely focuses market activities on an inferior technology, such as occurred in
Japan for high-definition television (Farrell and Shapiro, 1992).
22.3.1. Standard Setting as a Venue for Price Fixing

and Exclusion
Standard setting is likely to encounter antitrust concerns if the practice directly limits
price competition. For example, in National Society of Professional Engineers v. United
States, a professional society’s canons of ethics prohibited members from submitting
competitive bids for engineering services. The Supreme Court affirmed an injunction
prohibiting the association from adopting the rules or similar guidelines.2
The US Federal Trade Commission challenged an agreement by the National
Macaroni Manufacturer’s Association concerning the relative proportions of wheat
grains used in macaroni products, which the Commission argued was intended to mod-
erate price competition for wheat grains that were in short supply. A court of appeals
held that the actions of the Association constituted a combination to unlawfully fix
prices in violation of Section 5 of the Federal Trade Commission Act.
Several cases have alleged anticompetitive exclusion of rival suppliers or technologies
by members of an SSO. In Wilk v. American Medical Ass’n, the plaintiff challenged a resolu-
tion adopted by the American Medical Association that labeled chiropractors “an unscien-
tific cult” and implicitly made it unethical for a physician to associate with a chiropractor.
The court required the AMA to retract this resolution, finding that the AMA failed to show
that it was justified by a concern for patients. In TruePosition Inc. v. LM Ericsson Telephone
Company, et al., the plaintiff alleged that defendants conspired to favor their own tech-
nologies and to block the adoption of TruePosition’s technology for enabling emergency
responders to more accurately locate mobile phone users into new standards being devel-
oped for fourth-generation wireless networks. The defendants petitioned the court to dis-
miss the case, but the court refused, allowing the case to move forward.
22.3.2. Standard Setting as a Joint Venture

An organization that brings representatives of independent firms together to develop a
standard is a joint venture. Joint ventures can create benefits, but also can impose costs on
consumers. The participants in the SSO often include competitors and if the standard is
successful, it is likely to have an effect on competition and prices. Firms that employ the
standard in their products and the consumers that buy them are likely to benefit, while
firms and consumers that are stranded with incompatible products may suffer.
2
Case citations are listed at the end of this chapter. The discussion of antitrust law in this chapter is
limited to US case decisions and is intended for illustration and not as a survey of the relevant law.
560 Richard Gilbert
With few exceptions, antitrust authorities have accepted the choices determined
by standard-setting organizations if standards were developed following an open
and transparent process, participation in standard setting was unrestricted and
non-discriminatory, and compliance with the standard is voluntary. Yet unlike the out-
come of market competition that generally benefits consumers by resulting in lower
prices, there is no corresponding “invisible hand” principle that standard-setting bod-
ies will coordinate on the best standard, even if the process of standard setting is open
and transparent.
To illustrate the problem, suppose there are two alternative standards X and Y and three
types of SSO participants affected by the standard, labeled A, B, and C. For example, A, B,
and C may represent producers of different products that implement the standard. To keep
the numbers simple, suppose each type has one vote in a standard-setting organization.
Table 22.1a shows the value to each SSO participant from standard X and standard Y.
Table 22.1a Values That SSO Participants

Place on Alternative Technology Choices
Technology
Agent X Y
A 5 6
B 3 2
C 4 3
In table 22.1a, technology X has greater total value. It has a total value of 12 and tech-
nology Y has a total value of 11. Agents B and C would vote for technology X, and it will
prevail if the SSO follows a majority (or a two-thirds majority) voting rule.
Table 22.1b differs from table 22.1a only in that agent A places a value of 10 on technol-
ogy Y, rather than 6. As a result technology Y is the superior choice because it has a total
value of 15, compared to 12 for technology X. However, technology X will prevail if the
SSO follows a majority (or a two-thirds majority) voting rule.
Table 22.1b Values That SSO Participants

Place on Alternative Technology Choices
Technology
Agent X Y
A 5 10
B 3 2
C 4 3
The point of this simple illustration is that due process with open representation does
not ensure that standard-setting organizations will make choices that maximize total
welfare. Arrow (1950) established this result as a theorem that voting rules generally
cannot assure outcomes that satisfy reasonable conditions for rational choice. This does
not imply that consensus rules cannot be efficient. If the members of a standard-setting
organization fairly represent the interests of all the parties that may benefit from the
standard, the participants in the SSO may have opportunities to steer votes toward
socially desirable outcomes. In the example corresponding to table 22.1b, agent A may
offer two units of value to agent B (or C) in return for a vote in favor of technology Y. But
the opportunities for such trades may be limited.
Standard-setting organizations develop and promulgate thousands of standards that
constrain the desired business strategies of firms and the choices of consumers, includ-
ing firms and consumers that do not participate in the development of the standards.
Although courts have been sensitive to antitrust issues that may arise in the context of
collaboratively set standards, they generally have focused on circumstances involving the
manipulation of the standard-setting process or the improper use of the resulting standard
to gain competitive advantage over rivals rather than on the merits of alternative stan-
dards. In this respect the courts’ actions are consistent with monopolization cases in which
the focus is typically on practices that may interfere with competition to become domi-
nant or on practices that maintain a dominant position in a market rather than on domi-
nance itself. In U.S. v. Microsoft, the district and appellate courts did not dwell on whether a
different personal computer operating system and browser platform would be superior to
the Windows/Internet Explorer platform. Rather, the courts’ focus was whether Microsoft
interfered with the competitive process to maintain its market dominance.
22.3.3. Corruption of the Standard-Setting Process

Courts have intervened when there is evidence that the standard-setting process has
been manipulated to favor particular interests (Anton and Yao, 1995). ANSI accredita-
tion requires that standards developers adhere to principles of consensus, due process,
and openness.3 According to ANSI, any organization, company, government agency,
or individual with a direct and material interest in the activities of the standards body
should have a right to participate in the development and selection of the standard.
Consensus does not mean unanimity, but rather an absence of sustained opposition to
substantial issues (Farrell and Simcoe, 2012).
22.3.3.1. Vote Stacking

A potential abuse of the standard-setting process involves “vote stacking,” in which
members of a standards body recruit participants to vote affirmatively for their interests.
3 ANSI Standards Activities Overview, available at http://www.ansi.org/standards_activities/
overview/overview.aspx?menuid=3, accessed May 3, 2012.

562 Richard Gilbert
Allied Tube & Conduit Corp. v. Indian Head concerned approval by the National Fire
Prevention Association (NFPA) of a standard for the use of plastic conduit for electrical
wiring. The NFPA publishes the National Electrical Code, which establishes require-
ments for the design and installation of electrical wiring systems. Indian Head, a manu-
facturer of plastic conduit, submitted a proposal to extend the Code to approve the use
of plastic as well as the conventional steel conduit. The proposal was approved by one
of the NFPA’s professional panels, and under the Association rules could be adopted
into the Code by a simple majority of the members attending the Association’s annual
meeting.
Before the meeting was held, Allied, the largest producer of steel conduit in the United
States, members of the steel industry, other steel conduit manufacturers, and indepen-
dent sales agents collectively agreed to recruit new Association members whose only
function was to vote against the proposal to approve the use of plastic conduit. Their
recruiting efforts were successful and the proposal was defeated. In response Indian
Head sued, alleging that Allied and others had unreasonably restrained trade in the
electrical conduit market in violation of Section 1 of the Sherman Act. A jury delivered a
verdict that the conduct violated the antitrust laws.
The case subsequently endured reversals and appeals, largely focusing on whether the
conduct was permissible activity to influence legislation, because the National Electrical
Code was routinely adopted into law by a substantial number of state and local gov-
ernments. The Supreme Court ultimately sustained the jury verdict and agreed that
the proper standard was whether the anticompetitive effects of Allied’s actions out-
weighed any procompetitive benefits of standard setting. The Court stated that “What
[Allied] may not do (without exposing itself to possible antitrust liability for direct inju-
ries) is bias the process by, as in this case, stacking the private standard-setting body
with decision-makers sharing their economic interest in restraining competition.” The
Court, however, did not define “stacking,” nor did it explain why vote stacking should
not survive a rule-of-reason analysis.
While the recruiting of participants in a standard-setting organization with instruc-
tions to support or oppose proposed standards appears improper on its face, partici-
pation in standard-setting meetings is driven by economic interests, and firms with
more at stake in the standards process tend to supply more participants to relevant
standard-setting organizations (Simcoe, 2012). Vote stacking could be defined as recruit-
ing participants who are not employees of interested firms, but that distinction has little
substance for large firms that can tap a large labor pool as potential representatives.
Furthermore, it is not clear without further analysis that vote stacking results in infe-
rior economic outcomes compared to more limited representation in a standard-setting
organization. If vote stacking is defined by recruiting more participants than are neces-
sary to evaluate the merits of proposed standards, this activity clearly incurs social costs
that include the recruiting efforts and the opportunity costs of the recruited participants.
It is likely that firms will incur recruiting costs in proportion to the private benefits they
expect from their preferred standard relative to alternatives. A firm that expects to ben-
efit from a particular standard has an incentive to incur costs to achieve that standard.
Moreover, private values more generally motivate efforts to influence the adoption of
standards, whether or not those efforts may include packing standard-setting commit-
tees with friendly voters.
Despite its costs, vote stacking could have plausible benefits compared to a majority
or supermajority voting rule, which does not necessarily select the best standard. Vote
stacking is similar to what is called an “all-pay auction.” In an all-pay auction the bidders
pay the amounts they bid regardless of whether their bids are successful. Examples of
conduct with characteristics of an all-pay auction include election campaigns, political
lobbying, and research and development competition for a patent or for a technology
with strong network effects. There is a single victor in these examples but all partici-
pants who compete to be the winner incur irreversible costs. In the vote stacking anal-
ogy the “bid” is the cost of recruiting participants in the standard-setting organization
with instructions to vote for or against a proposal on behalf of a party with interests in
the outcome.
To further evaluate the costs and potential merits of vote-stacking as an all-pay auc-
tion, suppose two firms participate in the standard-setting process and choose to sup-
port either of two technology standards, denoted by X and y . Let X1 be the value of
standard X to firm 1 and X2 the value of standard X to firm 2. Standard Y has value Y1
to firm 1 and Y2 to firm 2. Firm 1 prefers standard X if X1 > Y1 and firm 2 prefers stan-
dard y if Y2 > X 2 . Let V1 = X1 − Y1 and V2 = Y2 − X 2 and suppose both V1 and V2 are
positive, so that firm 1 strictly prefers standard X and firm 2 strictly prefers standard Y.
Furthermore, assume that V1 > V2 , which implies that standard X has a higher total
value to both firms than does standard Y (that is , X1 + X 2 > Y1 + Y2 ).
Firm 1 is willing to pay up to V1 to get its preferred standard and firm 2 is willing to pay
up to V2 for its preferred standard. These are the private values of standards to each par-
ticipant and not their social values. Nonetheless, vote stacking might result in desirable
outcomes if the private values of alternative standards are proportional to their social
values.4 Further analysis, however, shows that even with this favorable assumption, vote
stacking does not necessarily result in the certain selection of the best standard.
To see this, suppose that a simple majority vote is sufficient to adopt a standard, a firm’s
costs increase with the number of recruited voters, both firms incur costs to recruit vot-
ers, and firm 1 recruits more voters than firm 2. This cannot be a profit-maximizing out-
come for firm 2. Firm 2 will not prevail in the contest for the desired standard, so it may
as well cut its losses by not recruiting any voters. But if firm 2 does not recruit voters,
then firm 1 can save by recruiting fewer voters. However, if firm 1 recruits fewer voters,
firm 2 might then increase its recruiting efforts to prevail in the standard selection. This
circular argument shows that there is no “pure strategy equilibrium” of this competition
in which each firm knows how many voters will participate in the standard-setting pro-
cess. A profit-maximizing equilibrium exists, however, if the firms play a “mixed strat-
egy” in which the firms recruit a random number of voters.
4 That would be the case if the ratio of producer to consumer surplus is the same for the alternative
standards.
564 Richard Gilbert
An implication of random recruiting is that each firm has some positive probability
of obtaining its desired standard, for otherwise it would not incur the cost of recruiting
voters. Hillman and Riley (1989) analyze an all-pay auction that is similar to this exam-
ple. They consider an all-pay auction with one item for sale and two bidders. Bidder 1
has a value of V1 for the item and bidder 2 has a value of V2 . They show that when the
bidders use equilibrium bid strategies in which they bid amounts with different prob-
abilities, if V1 > V2 , the probability that bidder 1 wins the auction is: 1 − (1 / 2)[V2 / V1 ].
Applying this result to the choice of a standard, the “item” for sale is the right to
choose the technology standard, which has value V1 to one of the participants in the
standard-setting activity and value V2 to the other participant. The bid is the effort to pack
the standard-setting committee to vote for the preferred standard. Suppose that V2 is only
half as large as V1 . Following the bid strategies in Hillman and Riley (1989), the probabil-
ity that vote stacking will result in a win for the technology with the higher value is only
75%; there is a 25% probability that the inferior technology will emerge as the standard.
This analysis shows that vote stacking incurs social costs and does not necessarily
result in the selection of a standard with the greatest private or social benefit relative to
alternatives. The analysis is only an example. Modifying the voting rule for adopting a
standard from a simple majority to a supermajority introduces complications because
it is possible that no technology wins a sufficient plurality to gain adoption as a stan-
dard. The incentive to recruit randomly could disappear if technology values and the
correspondence between votes and recruiting effort are uncertain; however, this does
not ensure that socially desirable standards necessarily will emerge from a process that
allows parties to recruit participants in standards committees to vote on their behalf.
Despite the fact that the example in this section is highly simplified, it provides cause
to doubt whether allowing parties in a SSO to recruit members on their behalf would
lead to better technology adoption decisions than would occur with restrictions on vote
stacking. Furthermore, packing standard-setting committees with disinterested partici-
pants can frustrate negotiations that could lead to adoption of a socially desirable stan-
dard. These are reasons why the recruitment of voters in standard-setting committees
should potentially fail a rule-of-reason test, as in Allied Tube v. Indian Head. Of course
standard selection committees do not necessarily converge on the standard with the
greatest social benefit even if interested parties do not pack committees with friendly
voters. Furthermore, it is difficult to know how to draw the line between vote stacking
and the supply to a standard selection committee of numerous participants that repre-
sent a party’s private interests.
22.3.3.2. Disparagement of Alternative Proposals

Another example of alleged subversion of the standard-setting process is in American
Society of Mechanical Engineers v. Hydrolevel Corp. The plaintiff Hydrolevel was a man-
ufacturer of low-water cutoff valves for boilers. Hydrolevel alleged that a member of
the American Society of Mechanical Engineers (ASME) subcommittee employed by a
competitor improperly induced the subcommittee chairman to issue a letter indicat-
ing that Hydrolevel’s product did not meet the ASME’s safety standards. A jury found
that “ASME has conspired with others to restrain trade unreasonably . . . by disparag-
ing Hydrolevel’s cut-off through a misrepresentation of the Boiler and Pressure Vessel
Code.” The Supreme Court affirmed the verdict, noting in its opinion the potential for
competitors to abuse the process of standard setting in order to gain improper advan-
tage in the marketplace. As in Allied Tube, here a competitor expended effort to influ-
ence the outcome of the standard-setting process by means unrelated to the merits of
the alternatives. In this case the effort was lobbying to obtain a false opinion about the
characteristics of the rival product.
22.4. Competition Principles for

Unilaterally Determined Standards
Standards that are sponsored by a single entity sometimes achieve broad market accep-
tance without the imprimatur of a standard-setting organization. Examples include
the Intel x86 microprocessor architecture, Microsoft’s Windows application program-
ming interfaces, Apple Quicktime, and Adobe Flash. These standards are typically pro-
prietary, meaning that the firm that sponsors the standard (and possibly others) owns
intellectual property rights that cover use of the standard. Proprietary standards may be
licensed separately or bundled with a product.
Firms often have strong incentives to promote the use of a standard, particularly in
markets with network effects that reinforce demand. Sponsors of alternative standards
may compete to become the dominant standard by subsidizing sales in the short run
or by engaging in activities such as bundling a product employing the standard for
free with other products that increase the opportunity to gain market acceptance for
the standard. Sometimes firms are successful in promoting a standard and enjoying the
benefits of network effects while maintaining ownership of the standard. Other times
firms choose to relax control of a proprietary standard, trading off the advantage of con-
trol for broader market acceptance, despite the increase in competition that may result
if the standard is not proprietary. Adobe licensed its Portable Document Format stan-
dard without charge before it was released as an open standard published by the ISO.
Cisco licenses its Telepresence Interoperability Protocol for videoconferencing on a
royalty-free basis.
Several cases have alleged unlawful unilateral conduct among sponsors of alterna-
tive standards in the competition to become a dominant standard, although assessing
when such competition represents competition on the merits and when it crosses the
line to become exclusionary is often difficult. In U.S. v. Microsoft, the complaint initially
included allegations that Microsoft distributed its Internet Explorer browser for free, but
the Department of Justice did not pursue a predatory pricing theory at trial and the dis-
trict court opinion noted that Microsoft’s free distribution of Internet Explorer benefited
consumers. Relatedly, the Department has not challenged premature announcements
566 Richard Gilbert
of new products in an attempt to capitalize on network effects by attracting a base of

customers through a bandwagon effect or in an attempt to maintain an installed base
of customers by encouraging customers to forestall purchases of competing products
(Farrell and Saloner, 1986).
In the contest to promote a desired standard a firm may take actions that disadvan-
tage a competing standard. Conduct by a firm with monopoly power that excludes rivals
by foreclosing access to efficient distribution channels or inputs can raise antitrust con-
cerns if there are no offsetting benefits. The complaint in U.S. v. Microsoft is an example
of such an allegation, focusing on conduct by Microsoft to deny distribution opportuni-
ties to Netscape’s Navigator web browser. The Netscape browser did not compete with
the Microsoft Windows operating system, and indeed was a complement to the oper-
ating system and increased its value. However, the complaint alleged an “applications
barrier to entry” to competitors of the Windows platform that could be surmounted by
providing Netscape Navigator as an alternative platform for applications. By foreclosing
access to Netscape’s browser, Microsoft sought to maintain the applications barrier to
entry for the development of competing platforms.
When a firm controls a compatibility standard, the firm may profit by promoting
the supply of interoperable products and services by other parties in some situations,
while in other situations the firm may profit by discouraging the supply of competing
interoperable products and services. Interoperability embraces a wide range of activities
including physical compatibility, software interfaces, digital rights management (such
as Apple’s Fairplay technology for iTunes), and communications protocols, and is a mat-
ter of degree. A firm that controls a component of a system can benefit from competition
that lowers the prices and increases the diversity of complementary components, which
makes the system more attractive to consumers and increases their willingness-to-pay
for the component.
However, the owner of a component that is necessary to achieve interoperability also
may choose to limit intraplatform or interplatform compatibility to pursue a strategy of
price discrimination or to raise barriers to new competition (Farrell, 2007). A firm can
use control over a complementary component such as replacement printer cartridges
to meter demand and charge higher prices to more intensive users. The Microsoft case
illustrated the control of compatibility to raise barriers to entry. Sponsors of compatibil-
ity standards can control interoperability through trade secrets, access to copyrights and
patents, contractual restrictions, and frequent design changes (Samuelson, 2009).
While antitrust policy frowns on conduct by a firm with monopoly power that excludes
rivals with no offsetting benefits, a firm generally has no obligation to promote its rivals’
products or a rival standard (Garza et al., 2007). The economic welfare effects of interop-
erability are complex and depend on particular market circumstances. Interoperability
often promotes consumer welfare by increasing the diversity of complementary products
and by encouraging competition among suppliers of those products. This can promote
a virtual cycle that results in lower costs and greater consumer benefits if there are scale
economies or positive network effects. However, compatibility also can incur costs by
limiting technological alternatives and can impede competition in some circumstances.
Sellers of incompatible systems can have greater incentives to innovate than sellers of
compatible components. A firm that sells a system comprised of several components has
greater sales to amortize research and development expenditures compared to a firm that
sells only an individual component (Farrell and Weiser, 2004). Network effects reinforce
the expectation of a high reward because a single product or standard is likely to domi-
nate a market when network effects are large. The expectation of a high reward motivates
firms to compete aggressively to become dominant. While consumers may pay a price
for market dominance, they also benefit from the intense competition that occurs in the
battle for dominance (Shapiro and Varian, 1999, Farrell and Klemperer, 2007).
When markets can support different incompatible systems, competition among those
systems can benefit consumers relative to a market with compatible components. When
a firm sells a system whose components are incompatible with the components of other
systems, the sale of another unit earns a margin on all of the firm’s system components.
This margin is an inducement to cut prices to win the sale. In contrast, when a firm
sells a compatible component, some of the benefit of a price cut is lost to other sell-
ers of compatible components by increasing the demand for those products (Matutes
and Regibeau, 1988). When firms sell incompatible systems, the increased incentive for
price competition benefits consumers, although compatibility also benefits consumers
by increasing the diversity of available products and by facilitating competition among
independent suppliers of complementary components. Thus there is no simple conclu-
sion that “compatibility” is always superior to “incompatibility.”
22.5. Intellectual Property
The focus of this section is on patents that are essential to comply with a standard,
although much of the discussion also applies to other intellectual property rights such as
copyrights and trademarks. Standard-setting organizations differ in their policies with
respect to developing standards that require access to proprietary intellectual prop-
erty rights. The American National Standards Institute patent policy states, “There is
no objection in principle to drafting an American National Standard (ANS) in terms
that include the use of an essential patent claim (one whose use would be required for
compliance with that standard) if it is considered that technical reasons justify this
approach” (ANSI, 2008). Other standard-setting organizations, such as the World Wide
Web Consortium, are less receptive to proprietary technologies. With some exceptions,
the World Wide Web Consortium’s patent policy requires that licenses for essential pat-
ents be made available on a royalty-free basis.
When firms own intellectual property that is necessary to employ a standard, there
is a potential tension between what Simcoe (2006) calls value creation and value cap-
ture. The cost of proprietary intellectual property rights limits the adoption and use of
a standard and interferes with the potential value that the standard can create. Owners
568 Richard Gilbert
of intellectual property rights may accept this limitation if those rights enable the own-
ers to appropriate a greater share of the value created by the standard. This trade-off,
however, omits an additional tension, which is that intellectual property rights pro-
vide incentives for innovation and for innovators to participate in the development of
standards.
22.5.1. The Potential for Patent Holdup

Firms and consumers often make investments that are specific to the use of a particu-
lar standard, such as applications for the Windows operating system, interface designs
for computer memories, or a library of DVDs. Switching to a different technology, such
as a different computer operating system or different optical recording medium, may
require new investments. Firms and consumers are “locked in” to a standard if it is not
economically feasible to incur the costs of switching to a new standard. Even if irre-
versible investment costs are not large, the difficulty of coordinating substitution to an
alternative technology can pose a barrier to switching, particularly when technologies
exhibit networks effects, as is often the case for interoperability standards.
When firms and consumers are locked into the standard, owners of proprietary rights
that are essential to comply with the standard can have the economic power to charge
high royalties and impose burdensome licensing terms. The term “patent holdup” is
sometimes used to characterize attempts to charge such high royalties or impose bur-
densome terms “ex post,” after firms and consumers have made investments that are
specific to a standard.
If participants in a standard-setting organization are aware of the existence of propri-
etary rights that cover a proposed standard and the likely royalties that may be charged
for those rights “ex ante,” before firms and consumers make investments that are specific
to a proposed standard, they can make informed decisions that account for the risk of
holdup. A minimum requirement for informed decision-making is disclosure of patents
that are essential to make or use products that comply with a standard. The term “patent
ambush” is sometimes used to describe a high royalty demand after a participant in a
standard-setting organization fails to disclose to the SSO’s members the existence of the
patent or patent application when the standard was first established.
Standard-setting organizations differ in their disclosure policies (Lemley, 2002,
Bekkers and Updegrove, 2012), and competition authorities have been reluctant to
impose rigid disclosure rules. An obligation to identify individual patents and patent
applications that are essential to a standard is complex and expensive, particularly for
technologies in a crowded patent space. MPEG LA lists more than 900 essential pat-
ents and 150 essential patent families for the MPEG-2 standard.5 Participants in the
ETSI standard-setting organization declared more than 750 US patents as essential
5 MPEG LA, MPEG-2 Patent Portfolio License Briefing, August 4, 2010, at 4. A patent family is a set of
patents filed in different countries for a particular invention.

to W-CDMA, a third-generation mobile telecommunications standard (Bekkers,

Bongard, and Nuvolari, 2011), and more than 500 unique patent families as essential
to the fourth-generation LTE cellular standard (Blind et al., 2011). Note that a declara-
tion of an essential patent is not a confirmation that the patent is actually essential to a
standard.
Furthermore, a disclosure requirement for planned patent applications may force
firms to expose valuable trade secrets, potentially jeopardizing future patent protec-
tion by contributing inventions to the common pool of knowledge, and may discourage
firms from participating in the standard-setting process. An alternative to mandatory
disclosure is a blanket commitment in which SSO participants agree to license any
essential claims at reasonable terms without disclosing patents in advance. While a
default commitment to license any standard-essential patent at RAND (reasonable
and non-discriminatory) terms may address the problem of patent ambush, it leaves
uncertain whether particular patent claims cover a particular proposal. This is less of
a concern when SSOs, such as the World Wide Web Consortium, require royalty-free
licensing commitments.
22.5.2. Reasonable and Non-discriminatory

Licensing Commitments
If a patented technology is essential to comply with a standard, most standard-setting
organizations, and all ANSI-accredited standard development organizations, require
the patent owner to make a license available for the purpose of implementing the stan-
dard either royalty-free or under reasonable terms that are free of any unfair discrimi-
nation. The latter condition is called a RAND (reasonable and non-discriminatory) or
FRAND (fair, reasonable and non-discriminatory) licensing obligation, and the former
is called RF (for royalty-free) or F/RAND-z, for zero royalty.6
The policies of standard-setting organizations differ on many issues, such as whether
standard-essential patents (SEPs) are limited to patents with claims that are technically
necessary to comply with a standard or may include patents that are commercially nec-
essary, the obligations of patent owners to disclose patents and patent applications (or
other intellectual property) that they represent to be essential to a proposed standard,
and whether licensing obligations remain in force if a member withdraws from the SSO.
Moreover, SSO policies typically are silent on critical issues such as the specifics and con-
tractual form of RAND licensing obligations, whether licensing obligations travel with
the patent if they are sold or assigned to another entity, and the consequences for failing
to abide by the SSO’s policies. As a consequence it has been the job of antitrust enforce-
ment agencies and the courts to fill in the missing dimensions of RAND commitments.
6 I make no distinction between “RAND” and “FRAND.” Note that a royalty-free license is not the
same as an agreement not to assert a patent right, because a license may be royalty-free, but may impose
other terms and conditions.
570 Richard Gilbert
22.5.2.1. RAND Royalties

Competition authorities and a number of scholars have endorsed the principle that a
“fair and reasonable” royalty should reflect its incremental value relative to the next-best
alternative, assessed before firms and consumers make investments that are specific to
the technology. The Federal Trade Commission (2011) concludes that “Courts should
cap the royalty at the incremental value of the patented technology over alternatives
available at the time the standard was chosen.” Swanson and Baumol (2005) suggest that
standard-setting organizations should conduct an auction in which sponsors of pat-
ented technologies submit bids that describe their intended licensing terms and imply
that bids will reflect technologies’ incremental values.
While the incremental value principle has theoretical appeal (see, e.g., Farrell et al., 2007),
it does not have general acceptance as the interpretation of fair and reasonable licensing
terms (Patterson, 2002). Some commentators have argued that a licensing agreement is fair
and reasonable if it is the outcome of arm’s-length bargaining, even if that bargaining occurs
after firms and consumers have made investments that are specific to a standard (see, e.g.,
Geradin and Rato, 2007). Furthermore, no SSO has yet offered a workable definition of
RAND licensing terms and, as of this writing, US courts have not converged on a particular
methodology to assess when royalty terms fail to be fair or reasonable.
The determination of a fair and reasonable royalty for a patent is particularly diffi-
cult when the patent is one of many that are essential to practice a standard, as is often
the case for compatibility standards. Every essential patent has a potential claim to the
entire value of the product for which it is essential, because by definition the product
cannot be made, sold, or used without access to each essential technology. However, this
yields a contradiction when there is more than one essential patent. Approaches such as
assigning equal values to essential patents are arbitrary, as patents may differ in quality,
in their values relative to alternative technologies that were available when the standard
was being developed, the probability that the patent is valid, and in the extent to which
they are essential for different products that comply with a standard.7
The participants in the development of standards include patent owners and imple-
menters of patented technologies who often have different business models that affect
their assessments of a reasonable royalty. Implementers are firms that sell products that
embody the patented technologies. These firms may be content to earn revenues pri-
marily from the sale of products rather than from patent licenses. Other firms, includ-
ing those that specialize in technology innovation, have business models that depend
on earning revenues from patent licensing. A technology implementer may be unac-
customed to charging or paying significant royalties, while a technology innovator may
deem a royalty to be unreasonable if it does not provide an adequate return on invest-
ment. These contrasting perspectives cloud the meaning of “fair and reasonable” licens-
ing terms and explain why most standard-setting organizations have demurred from
7 For illustrations of royalty allocations for complementary technologies under different assumptions,
see Layne-Farrar, Padilla, and Schmalensee (2007) and Salant (2007).

offering specific definitions of RAND commitments in their intellectual property policy

statements.
Enforcement agencies and many commentators agree that RAND commitments
should prevent a patent owner from “holding up” a standard by demanding high royal-
ties after firms and consumers have made investments that are specific to the standard.
Such holdup occurs if the costs to firms and consumers of switching to a different stan-
dard are large and royalties capture these costs. There is, however, an additional concern
that patent owners may demand royalties that exceed any reasonable allocation of value
to their patents. The result can be a total royalty “stack” that harms the adoption and use
of products that employ the patents (Lemley and Shapiro, 2007), even if the cumulative
royalties do not reach a level that may constitute holdup.
If some patent owners are content to charge low royalties, this increases the net value
available to other patent owners. Suppose there is a technology for implementing secure
wireless communications that is worth $2 more than the next best alternative for every
handset that employs the technology. Furthermore, suppose that ten patents are essen-
tial to make, sell, or use that technology, all are valid, and do not differ in quality or avail-
able alternatives. An equal allocation of the $2 value would allocate $0.20 to each patent,
ignoring any other inputs that may be necessary to achieve the technology’s value. But
suppose that five of the patent owners would be content to license their patents at a zero
royalty. That leaves the full $2 value for allocation to the remaining five patents. With an
equal allocation rule they could each charge a “reasonable” royalty of $0.40.
When multiple patents are essential to use a standard and some technology imple-
menters are content to charge zero or low royalties, this leaves more “headroom” for
other patentees to charge relatively higher royalties. It is open question whether these
higher royalties would be considered fair and reasonable. For a patent owner that is
accustomed to licensing technology without charge or for less than its apportioned
value of $0.20, allowing other owners of essential patents to charge more than $0.20 may
appear unreasonable. Moreover, if all patent owners move to a business model in which
they seek their share of the value of the patented technologies, the result can be a total
royalty burden that is so large that it impedes the adoption and use of the standard.
22.5.2.2. RAND and Cross-Licenses

Firms often enter into cross-licensing arrangements of large patent portfolios (Grindley
and Teece, 1997). These arrangements give the parties the ability to operate free of pat-
ent disputes in a broad area of economic activity. Parties may enter into cross-licensing
arrangements that involve patents with RAND commitments. However, insistence on a
cross-license as a condition for a license to a patent with a RAND commitment compli-
cates the determination of the royalty in the transaction because the royalty depends on
the values of the patents that are cross-licensed.
For illustration, putting aside the ambiguities of RAND, suppose there is agree-
ment that the RAND royalty for a standard-essential patent is $0.50 per unit. Instead
of offering the patent for license at a royalty of $0.50 per unit, suppose the owner of
the patent insists on a royalty-free cross-license to the licensee’s patents. If the licensee’s
572 Richard Gilbert
patents are also worth $0.50 per unit, this is equivalent to a transaction in which the
standard-essential patent is licensed at its RAND value of $0.50 per unit. But if the
licensee’s patents are worth $1 per unit, the implicit royalty for the standard-essential
patent is $1, which exceeds its RAND value.
Allegations of cross-licensing demands that violate RAND commitments play at cen-
ter stage in the smartphone patent wars. Motorola and several other suppliers of smart-
phones own patents that have been declared essential for communications employing
cellular and wireless network standards such as the third-generation UMTS standard
and the 802.11 Wi-Fi family of standards, which are subject to RAND licensing com-
mitments. Apple owns patents on desirable smartphone features such as pinch-to-
zoom and text recognition. These technologies have not been declared essential to
a standard and are not subject to RAND licensing commitments, and until recently
Apple owned no standard-essential patents.8 Motorola accused Apple of violating
its RAND-encumbered SEPs (Apple v. Motorola) and offered to license these patents
to Apple, but at a royalty that Apple considered to be excessive.9 Alternatively, Apple
represented that Motorola offered to cross-license its SEPs if Apple would enter into a
cross-license to its smartphone patent portfolio.10 This offer would be a Hobson’s choice
if the cross-license effectively values the RAND-encumbered patents at a royalty similar
to or larger than Motorola’s initial royalty offer for its SEPs.
22.5.2.3. RAND and Injunctions

A patent gives its owner the right to exclude others from making, using, or selling the
article protected by the patent, but that right is not unconditional, as the Supreme Court
noted in its eBay v. MercExchange decision. The right to exclude is a powerful tool for
a patent owner even if it is not exercised because the patent owner can use the threat
of exclusion to negotiate more favorable licensing terms (Farrell and Shapiro, 2008).
The exclusion threat is particularly powerful when firms and consumers make invest-
ments that are specific to the standard. The opportunities for a technology user to avoid
infringement by designing around a patent are severely limited when the patented tech-
nology is essential to comply with a standard. If the patent covers a feature in the 802.11
Wi-Fi standard, eliminating that feature could make a product inoperable for wireless
connectivity. The power of the exclusion threat is compounded when the patent covers one
of many technologies that are essential to make or use a product (Gilbert, 2010). Returning
8 Apple acquired rights to numerous standard-essential patents through its participation in the
acquisitions of patent portfolios previously owned by Novell and Nortel.

9 In Apple v. Samsung, the court concluded that Motorola did not establish that its royalty demand
based on a portfolio value equal to 2.25% of Apple’s product revenues was consistent with the
requirements of a RAND royalty. In a separate case involving different products, an administrative
law judge concluded that Motorola’s offer to Microsoft of a 2.25% royalty “could not possibly have been
accepted by Microsoft” (In the Matter of Certain Gaming and Entertainment Consoles).
10 The European Commission reported that “[A]‌ccording to Apple, Motorola Mobility has insisted
that Apple cross-license its full non-SEP portfolio in exchange for Motorola Mobility’s SEPs.” GOOGLE/
MOTOROLA MOBILITY, Case No. COMP/M.6381, para. 89 (Feb. 2012).
to the example of ten patents that are essential for a technology that has a value of $2, a single
patent owner can demand the full $2 if it can exclude others from its patent even if nine
other patents are also essential to the technology.11
If a RAND commitment requires a patentee to forgo the threat of an injunction, this has
profound implications on licensing negotiations because it puts courts in the position of
determining a reasonable royalty instead of possibly granting an injunction if parties can-
not agree to licensing terms. Arguably, the commitment to license is the RAND promise’s
core function and meaning (Miller, 2007). It is not, however, settled that a RAND commit-
ment forgoes the opportunity for a patentee to seek injunctive relief. Some argue that the
RAND commitment is by definition an obligation to grant a license and therefore is plainly
inconsistent with a demand for injunctive relief,12 while others maintain that an injunction
is warranted if the patent owner makes a reasonable licensing offer that is refused. A middle
ground limits injunctions to circumstances in which the owner of a patent with a RAND
commitment has made a licensing offer that a court or agreed-upon arbitrator has validated
as being reasonable, the offer was refused, and continued infringement of the patent would
create injury that could not be compensated.
Patent owners are testing the limits of injunctive relief for patents subject to RAND
commitments by bringing infringement suits to the International Trade Commission.
The ITC provides a venue to adjudicate infringement of intellectual property through
the importation and/or sale of imported goods protected by US patents under 19 U.S.C.
§1337 (commonly referred to as “Section 337”). The ITC has the power to prohibit
imports from entering US borders (an exclusion order) or to prohibit parties from dis-
tributing or selling infringing articles from existing US inventories (a cease-and-desist
order) (Yeh, 2012). The Commission has some flexibility to tailor the scope of the order
and to delay its onset, but unlike the courts, the ITC lacks the authority to award mon-
etary damages for patent infringement. Since many products are manufactured abroad,
the ITC is often available as a venue for patent holders to challenge alleged infringers. In
2011 every major smartphone manufacturer was a party to a patent infringement action
at the ITC (Chien and Lemley, 2012).
As a form of injunctive relief, the threat of an exclusion order at the ITC may allow
owners of standard-essential patents with RAND commitments to negotiate royalties
that are inconsistent with those RAND commitments, because the infringer has little
power to bargain if excluded by the ITC from the US market.13 In deciding whether to
issue an exclusion or cease-and-desist order for patent infringement the Commission
has scope to consider the public interest, which includes findings on the public health
11 In Apple v. Motorola, a witness for Motorola claimed that a single essential patent can command
40%–50% of the value of the entire portfolio, even if the portfolio includes 100 essential patents. The
court, however, rejected this claim.
12 See the submission of Commissioner Rosch in Third Party United States Federal Trade
Commission’s Statement On The Public Interest, In The Matter Of Certain Wireless Communication
Devices, Portable Music And Data Processing Devices, Computers And Components Thereof, United States
International Trade Commission, Inv. No. 337-TA-745.
13 See Third Party United States Federal Trade Commission’s Statement On The Public Interest, In
The Matter Of Certain Gaming And Entertainment Consoles, Related Software, And Components Thereof,
574 Richard Gilbert
and welfare, competitive conditions in the US economy, the production of like or directly
competitive articles in the United States, and US consumers.14 The ability to hold up an
industry by refusing to license standard-essential patents with RAND commitments
at reasonable terms has important consequences for competitive conditions in the US
economy and for US consumers. In past cases the Commission has only very rarely
invoked these considerations to permit infringing imports (Chien and Lemley, 2012).
The Commission has notified requests for statements about public interest impacts in its
proceedings relating to patents with RAND licensing obligations; however, the extent to
which the Commission will consider these effects has yet to be determined.
22.5.2.4. Sales and Assignments of RAND-Encumbered Patents

Another factor that is relevant to the RAND commitment is whether it binds the pat-
ent or only its owner. If it is the latter, the RAND commitment may be lost if the patent
is sold or assigned to a party that has not made a commitment to license its patents on
RAND terms. Patents are easily sold or assigned. Reneging on a RAND commitment
does not fit neatly into traditional antitrust paradigms that focus on collusion or the
acquisition or maintenance of monopoly power. Nonetheless, it is clear that a RAND
commitment is toothless if the commitment does not remain with a patent that is sold or
assigned to a different party.
The US Federal Trade Commission alleged that Negotiated Data Solutions (N-data)
reneged on a RAND commitment when it acquired rights from National Semiconductor
for a patent that was declared essential to the IEEE’s Ethernet local area networking
standard. The Commission challenged N-data’s conduct as an unfair method of com-
petition and unfair acts or practices under Section 5 of the Federal Trade Commission
Act and negotiated a consent order in which N-data agreed to comply with the RAND
commitment.15
22.5.3. Antitrust Concerns from Failure to Disclose

Standard-Essential Patents
The failure of a patent owner involved in standard setting to disclose the existence of a
patent or patent application that covers a proposed standard may give rise to a monopo-
lization claim under the Sherman Act or to a claim of unfair competition or practices
under Section 5 of the Federal Trade Commission Act. Such “patent ambush” antitrust
United States International Trade Commission, Inv. No. 337-TA-752; Submission of 19 Economics and
Law Professors, In the Matter of Certain Wireless Communications Devices, Portable Music and Data
Processing Devices, Computers, and Components Thereof, United States International Trade Commission,
Inv. No. 337-TA-745; and Prepared Statement of The Federal Trade Commission before the US Senate
Committee on the Judiciary Concerning “Oversight of the Impact on Competition of Exclusion Orders
to Enforce Standard-Essential Patents,” Washington, DC, July 11, 2012.
14
19 USC § 1337—Unfair practices in import trade.
15
In re Negotiated Data Services LLC, FTC File No. 051 0094, Decision and Order (Jan. 23 2008).
claims have been brought by private parties and by government antitrust enforcement
agencies. In Dell Computer Corp. the FTC complained that Dell falsely certified to the
Video Electronics Standards Association (VESA) that it did not own patents that cov-
ered a standard for communicating information between a computer’s central processor
and peripheral devices (a computer “bus”). Dell sought to enforce its patent rights after
adoption of the VESA-approved bus. Dell and the FTC entered into a consent decree
prohibiting Dell from enforcing its patent rights on the VESA bus design.
Patents also were at stake in a complaint brought by the FTC against the Union Oil
Company of California (Unocal), alleging failure by Unocal to disclose that it owned
patent rights covering a proposed standard for reformulated gasoline that was subse-
quently adopted by the California Air Resources Board. Unocal agreed not to enforce its
relevant patents as part of a consent order for its acquisition by Chevron.16
In a case with a long history involving government and private plaintiffs, the Federal
Trade Commission charged Rambus with failing to disclose patent applications cov-
ering standards for dynamic random access memory devices (DRAMs) developed
by the Joint Electron Device Engineering Council (JEDEC). Rambus participated
in the JEDEC committee for DRAM standards for a period of time during which it
did not disclose that it had patent applications that covered standards being devel-
oped for DRAMs. The FTC alleged that Rambus’s silence and subsequent enforce-
ment of its patents was a patent ambush in violation of Section 5 of the Federal Trade
Commission Act.
An FTC administrative law judge dismissed the Rambus complaint, concluding
that JEDEC policies did not obligate Rambus to disclose its patent applications and
that its conduct was not anticompetitive. The Commission, however, reversed the
ALJ’s decision. Rambus appealed the Commission verdict and the court of appeals
ultimately decided in favor of Rambus. The court noted that Rambus had no patent
applications on file when it left JEDEC and that JEDEC policies did not clearly require
disclosure of unfiled but planned applications for patents that may be necessary to
make or use standard-compliant products. Furthermore, the court concluded that the
Commission did not prove that JEDEC’s members would not have chosen the Rambus
technologies even if they were aware of its patent applications. The lack of disclosure
had no competitive effect if JEDEC’s members would have included the Rambus tech-
nologies in its DRAM specification without insisting on a RAND commitment. The
fact that JEDEC’s members might have imposed a RAND licensing condition if they
had been aware of the Rambus patent applications did not sway the court. The court
reasoned that even a monopolist has latitude to determine its prices without trigger-
ing antitrust liability.
The court drew a distinction between the unlawful acquisition of a monopoly and
conduct that allows an otherwise legitimate monopolist to increase its price. The court
reasoned that to the extent that Rambus had a monopoly it was a consequence of its
16 US Federal Trade Commission, “Dual Consent Orders Resolve Competitive Concerns About
Chevron’s $18 Billion Purchase of Unocal, FTC’s 2003 Complaint Against Unocal,” June 10, 2005.
576 Richard Gilbert
lawful patents, and given that monopoly it was not an antitrust violation for Rambus
to set a high price. Indeed, the court noted that a higher price encourages more com-
petition from alternative technologies and therefore does not harm the competitive
process.
The court did not weigh the probability that JEDEC either would have excluded
the Rambus technologies from the DRAM standards or would have imposed a
RAND condition if its members had been aware of Rambus’s intended patent appli-
cations. If JEDEC would have excluded the Rambus technologies, it is possible that
the failure to disclose its plans enabled Rambus to acquire a monopoly. If JEDEC
would have included the Rambus technologies in the standard but imposed a RAND
obligation, then it is possible that the failure to disclose allowed Rambus to achieve
more monopoly power (i.e., a higher price) than it otherwise would have been able to
exercise.
The distinction between achieving a monopoly and achieving more monopoly power
has little economic significance. A monopoly does not confer the ability to set any price.
Even a monopolist faces competition if its price is high enough—if only for a share of
consumers’ wallets—and a profit-maximizing monopolist sets a price high enough to
make its demand at least partially elastic, since otherwise it would have an incentive to
increase its price. Hence the difference between acquiring a monopoly and acquiring
more monopoly power is a matter of degree and not a fundamental economic distinc-
tion. Of course significant competitive effects could be absent if the standard does not
achieve market acceptance or if the patent that is allegedly concealed is not essential to
comply with the standard.
Rights holders have not fared so well in other standards-related cases alleging fail-
ure to comply with patent disclosure and RAND licensing obligations. In Broadcom
v. Qualcomm a court denied a motion to dismiss antitrust allegations that Qualcomm
violated a commitment to license wideband CDMA technology at FRAND terms. The
court held that a patent holder’s intentionally false promise to license essential pro-
prietary technology on FRAND terms, coupled with a standard-setting organization’s
reliance on that promise when including the technology in a standard, and the patent
holder’s subsequent breach of that promise, is actionable anticompetitive conduct. In
a separate case the Court of Appeals for the Federal Circuit sanctioned Qualcomm for
failing to disclose patents to a standard-setting organization related to the H.264 video
standard. The court applied the legal principles of waiver, equitable estoppel, and patent
misuse, leading some scholars to conclude that these doctrines are more likely to capture
conduct before standard-setting organizations that may harm consumers (Hovenkamp,
2007, Merges and Kuhn, 2009, Contreras, 2011). However, if the conduct actually harms
consumers, this leaves unanswered why the appropriate doctrine to evaluate such con-
duct should not be antitrust law.
In the Rambus and Qualcomm cases it was the patentee’s conduct that was the
focus of potential antitrust liability. It is conceivable that a standard-setting organiza-
tion as well as its members could be found liable for violating the antitrust laws if the
SSO permits standards to be developed with no limitations, the standard succeeds in
establishing market power, and its members abuse this latitude to develop standards
that promote their joint interests at the expense of consumers (Skitol, 2005). However,
any evaluation of such conduct would have to recognize that standard setting is critical
for a well-functioning economy and therefore must give considerable deference to the
activities of SSOs (Carrier, 2003).17
A clear RAND requirement for standard-essential patents and patent applications
may appear to be the solution to the risk of ex post holdup, but that oversimplifies the
trade-offs involved in developing standards that invoke proprietary intellectual prop-
erty rights. Participation in a standard-setting organization is voluntary. If SSOs impose
licensing obligations that deny patent owners an opportunity to earn a reasonable return
on their inventions, they will choose not to participate in standard-setting activities at
these organizations. Patent owners that do not participate in the standard development
process generally are not subject to RAND licensing obligations and therefore would
have greater latitude to charge high royalties after firms and consumers make invest-
ments that are specific to the standard.
The competitive dynamics within and among standard-setting organizations are
complex. Technology sponsors compete to have their technologies adopted in a stan-
dard. Standard-setting organizations compete with other SSOs and with unilateral
efforts of firms to develop de facto standards. A consequence of this competition is that
sponsors of technologies that have few competitive alternatives are unlikely to accept
restrictive licensing terms and SSOs may adopt measures such as vague RAND com-
mitments that are relatively favorable to these rights holders in order to encourage their
participation (Lerner and Tirole, 2006, Chiao, Lerner, and Tirole, 2007). Sponsors of
weaker technologies are willing to participate in SSOs and accept stronger licensing
commitments in order to obtain greater influence in the development of a standard. The
RAND obligation is a quid pro quo for this influence, but the value of influence is dimin-
ished if participation in standard-setting activities triggers RAND obligations that leave
little opportunity to monetize inventions.
22.5.4. Overly Broad Declarations of Essential Patents, Overly

Broad Standard Specifications, and Package Licensing of
Standard Essential Patents
Failure to disclose essential patents raises concerns about potential holdup, but con-
cerns also can arise if firms disclose too many patents. Excessive disclosure can occur
17 Moreover, Teece and Sherry (2003) argue that total welfare is maximized if SSO members make
technology choices based solely on performance and real resource costs without regard to licensing
costs. However, high royalties can create deadweight losses from underutilization of a technology that
can offset performance benefits or resource savings. Furthermore, royalties and other licensing terms are
relevant because they affect incentives for innovation and rent-seeking (Patterson, 2003).
578 Richard Gilbert
if firms incorrectly claim patents to be essential to comply with the standard. A study
of patents declared essential to third-generation cellular standards concluded that only
about 21% of the patents were technically essential to make, sell or use products that
comply with the standards (Goodman and Myers, 2005), although a larger number may
be commercially essential because they cover the best implementation of the standard.
Excessive disclosure also can occur if a standard specification is too broad, in the sense
that it includes patented technologies that are not necessary to achieve the procompeti-
tive objectives of the standard. In addition, patent owners can increase the number of
patents they declare as essential to a standard by arbitrarily subdividing patent claims
into multiple patent applications.
Patents that are declared to be essential to a standard are sometimes involved in
cross-licensing arrangements or licensed as a package by their owners or by a group
of owners acting through a licensing agent, as in a formal patent pool. Overstating the
number of essential patents can benefit a party to a cross-licensing arrangement by mak-
ing it appear that the party has a stronger patent portfolio. Including non-essential pat-
ents in a package license can raise issues related to licensing costs and the allocation of
licensing revenues if the patents are licensed jointly. A per-patent royalty would reward
all patents, even if they were not essential to comply with the standard. Patent pools
sometimes address this concern by allocating licensing revenues in proportion to an
assessment of patent values (Lerner, Strojwas, and Tirole 2007). In addition, the inclu-
sion of non-essential patents in a package license can shelter competition that would
otherwise occur between patent owners if the patented technologies are substitutes for
each other, as the Federal Trade Commission alleged in its complaint against Summit
Technology and VISX.
The Court of Appeals for the Federal Circuit addressed alleged exclusionary effects
from package licenses that included non-essential as well as standard-essential pat-
ents in Princo v. International Trade Comm’n. The case concerned patents related to
a standard for recordable and rewritable compact discs. Philips and Sony developed
two different methods to encode information on a disc so that a CD writer could main-
tain proper alignment while writing data to the disc. Both methods were patented. The
parties adopted the Philips method in the compact disc standard. Sony and Philips
licensed their patents for the CD standard as a package, which included the Sony and
well as the Philips patents for the two different methods for encoding information on
the disc.
Princo challenged the package license as a tied sale that obligated the licensee to pur-
chase rights to patents that it did not require, namely, the patents on the Sony method,
and required licensees to pay for the Philips encoding technology even if it did not
intend to use that technology. The Federal Circuit opined that a package license was
not a tied sale because it did not obligate licensees to use a particular technology but
merely gave its licensee the option of using the patents in the package. The court’s opin-
ion endorsed the efficiencies from package licensing and recognized that for a particular
application there is a single profit-maximizing royalty for a package that includes at least
one patent that is essential for that application, even if the patent includes other patents
that are not essential (Gilbert, 2010).18 The court also found that Princo failed to show
that competition would have been viable using the Sony technology.
A separate potential concern from overly broad claims of essential patents is the
manipulation of standards to impose RAND licensing obligations on patented technol-
ogies when those technologies are commercially desirable, but not technically essential,
to achieve benefits from standardization such as interoperability. Including a technol-
ogy in a formal standard generally imposes obligations to license the technology at
RAND terms if the patent owner participates in the development of the standard, which
then allows implementers to obtain access to the technology at favorable terms. This
concern may be theoretical because the patent owner can avoid RAND licensing obli-
gations by refusing to participate in the standard development process, but the owner
could have other interests that mandate participation. If owners of technologies that are
commercially desirable but not technically essential to a standard are compelled to offer
the technologies at RAND terms, whether such obligations would promote economic
welfare depends on many factors, including whether the technologies are genuinely
essential for commercial feasibility and the effects of involuntary RAND obligations on
incentives for innovation.
22.5.5. Ex Ante Bargaining as an Alternative to

RAND Commitments
Some standard-setting organizations have considered measures to obtain greater cer-
tainty about potential royalty terms for patents that are essential to proposed standards.
In the past, SSOs have shunned discussions of royalty terms out of concern for poten-
tial antitrust exposure. A 2007 policy statement by the IEEE addressed whether prices
could be discussed in meetings of IEEE standards associations. The unequivocal answer
was no (IEEE Standards Association, 2010). More recently, some SSOs have reconsid-
ered this position and have received encouraging guidance from the US Department of
Justice about proposals that would require patent owners to disclose maximum royalties
and the most restrictive terms under which rights holders would license their technolo-
gies, prior to the development of a standard.19
Ex ante disclosure risks the exercise of monopsony power by members of
standard-setting organizations. Members who have a common interest in obtaining
low royalties may act in concert to impose low royalties on owners of patents that are
18 Allowing patents to be licensed separately as well as in a package addresses both the concern that
the package license may exclude competition and the concern that the package would raise royalty
payments by combining substitute patents (Lerner and Tirole, 2004).
19 See Business Review Letter from Thomas O. Barnett, Assistant Att’y Gen., to Robert A. Skitol,
Drinker, Biddle & Reath, LLP (Oct. 30, 2006), available at http://www.justice.gov/atr/public/
busreview/219380.pdf and Business Review Letter from Thomas O. Barnett, Assistant Att’y Gen., to
Michael A. Lindsay, Dorsey & Whitney LLP (Apr. 30, 2007), available at http://www.justice.gov/atr/
public/busreview/222978.pdf.
580 Richard Gilbert
essential to make or use products that comply with the standard. Both the Department
of Justice and the Federal Trade Commission have acknowledged this risk, but also
recognized that ex ante disclosure of maximum royalties and most restrictive licens-
ing terms can provide valuable information to avoid exposure to potential holdup. The
agencies have indicated that they would apply a rule-of-reason framework to evaluate
the relative benefits and risks of joint negotiation of licensing terms.
The tolerance for coordinated conduct by members of an SSO that may exercise buyer
market power should depend on the likelihood and magnitude of ex post holdup. If ex
post holdup is unlikely, coordinated conduct to establish licensing terms ex ante has
little benefit and may distort incentives for innovation by shifting the terms of patent
licenses to favor technology adopters.
If standard-related holdup is likely and substantial, joint negotiation of licensing
terms by the members of an SSO before a standard issues can help fill the void left by
vague RAND commitments to limit possible opportunistic conduct. However, a plau-
sibly less restrictive alternative is to rely on independent bilateral negotiations between
potential licensees and rights holders along with a clear non-discrimination require-
ment (Gilbert, 2011). Preventing undue discrimination between similarly situated
licensees ensures that firms will gain the benefits of licensing terms negotiated by early
adopters before these early adopters and consumers make investments that are specific
to a standard. This alternative policy requires SSOs or the courts to convey the meaning
and requirements of non-discrimination in a technology-licensing context, but it does
not require a precise determination of fair and reasonable royalties.
22.6. Summary Remarks
The development of industry standards is a cooperative activity among representatives

of firms that often compete to supply products covered by the standards. Cooperative
activity by rivals potentially raises antitrust concerns. The decision to endorse a particu-
lar standard can have significant implications for the cost and performance of the prod-
ucts they sell and for competition from products that do not comply with the standard.
The potential for participants in a standard-setting venue to harm competition by favor-
ing one standard over another or by imposing conditions that affect prices of products
covered by the standard cannot be ignored.
Nonetheless, courts and antitrust agencies generally defer to the choices made in
standard-setting organizations when those decisions are made in a consensus process
that is transparent and open to interested parties. The justification for the deferential
treatment of standard setting is not based on a general principle akin to the “invis-
ible hand” that guides market outcomes. There is no guarantee that the members of a
standard-setting organization will choose the “best” standard. Instead, courts acknowl-
edge the likely benefits from standards and implicitly admit that litigation is unlikely
to result in better standards. Antitrust challenges to standard setting, when they have
occurred, often have focused on coordinated conduct that distorts the process to fix
prices or to favor entrenched interests by excluding or imposing costs on rivals.
Technologies that are candidates for standards often require access to proprietary intel-
lectual property rights, particularly in the information and communications technology
industries for which hundreds of patents can be essential to comply with a standard. Most
setting-setting organizations do not prohibit the development of standards that invoke pat-
ented technologies, but require assurance that licenses to these patents be available either
royalty-free or on “reasonable and non-discriminatory” (RAND) terms. Standard-setting
organizations have not clearly delineated the extent of disclosure obligations, the mean-
ing of reasonable or non-discriminatory, or the conditions under with the owner of a pat-
ent with a RAND commitment may seek an injunction to prevent the use of a technology
covered by the patent. Courts also have been slow to define these obligations, and recent
developments at the International Trade Commission will test whether RAND commit-
ments prevent patentees from pursuing exclusion orders at that venue. The resolution of the
dimensions and extent of RAND commitments, or the failure to resolve these characteris-
tics, will have important consequences for the benefits from industry standards.
Acknowledgments
I am grateful for helpful discussions with Jorge Contreras, Bret Dickey, Joe Farrell, Amy
Marasco, Jim Ratliff, Carl Shapiro, and Tim Simcoe. The author has consulted for Apple
and Qualcomm on matters related to standards and standard-essential patents, and has
testified adverse to Rambus on issues related to the disclosure of applications for stan-
dard-essential patents.
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CHAPTER 23
A N T I T RU S T C O R P O R AT E G OV E R NA N C E
A N D C OM P L IA N C E
ROSA M. ABRANTES-METZ AND D. DANIEL SOKOL
23.1. Introduction
The study of cartel detection has been an important part of antitrust scholar-
ship and policy for some time. Most of the development of the literature on cartel
detection has focused at the firm level. This should not be surprising since indus-
trial organization economics focuses on firms and markets. Antitrust scholarship
has not focused as much on compliance and corporate governance within a given
firm. Understanding the internal workings of firms would allow for closer to optimal
deterrence, as this understanding would allow for the calibration of policy around
the incentives within a given firm, its subunits, and individuals who work therein, to
comply with antitrust law.
Both theoretical and empirical work in a number of different fields, including eco-
nomics, accounting, finance, organizational theory, and sociology provide impor-
tant insights indicating that a firm is not merely a single entity in its actions. Rather,
a firm is made up of a number of various components, each of which has its own
incentives that shape firm behavior. This chapter reviews both the antitrust and
the non-antitrust literatures on compliance and corporate governance to provide a
clearer picture of the extant literature and the theoretical and empirical gaps within
the antitrust literature to better inform antitrust policy on detecting cartels. This
chapter explores the scholarship both within and outside of antitrust to better under-
stand internal detection of wrongdoing and improved compliance in the antitrust
cartel context.
Antitrust Corporate Governance and Compliance 587
23.2. Organizational Environment
Cartels are somewhat distinct from other types of white-collar crime such as account-
ing or tax fraud because cartel activity requires coordination across firms. Like other
types of white-collar crime, cartels require that illegal activity be undertaken within
a given firm, which implicates issues of compliance and corporate governance. What
makes cartels distinct from all other types of white-collar crime is that for a cartel to suc-
ceed, there needs to be coordination both within a firm (vertical relations given levels
of management and oversight) as well as across firms (horizontal relations among the
cartel members). This chapter focuses exclusively on cartel vertical relations within a
firm. Chapters in this volume by Choi and Gerlach; Levenstein and Suslow; Hendricks,
McAfee, and Williams; Doane and coauthors; and Green, Marshall, and Marx address
the horizontal issues of cartels.
A firm’s environment and the amount of individual discretion affect decision-making
for the entire organization and may constrain the decision-making of individuals within
it (Finkelstein and Hambrick 1990). Understanding organizational structure and incen-
tives may illuminate how to better structure closer to optimal corporate compliance to
police against antitrust violations. We begin with an analysis of agency costs to better
understand incentives within the firm.
A core part of non-antitrust literature in both economics and finance is the concept of
agency costs (Jensen and Meckling 1976). Within a firm, the agent may have incentives
that differ from those of management. Firms work to reduce this misalignment through
improved monitoring. Strong monitoring can reduce this divergence but might deter
agents from risk taking, which in turn could benefit the firm. Sometimes even if at the
board of directors level the firm wants to comply with antitrust law, its agents may not
(Kaplow 2011).
Corporate crime is an agency cost (Alexander and Cohen 1999). Agency costs and
the ability of the firm to effectively monitor rogue agents also play into the importance
of focusing antitrust cartel detection at the individual level rather than just at the firm
level. For example, a manager may ignore risks because she believes that she will not get
caught for cartel behavior. The inability of antitrust agencies to detect existing cartels
(relative to individuals within firms), the relatively low levels of punishment for individ-
uals who are discovered engaging in cartel behavior (Combe and Monnier 2011; Connor
and Lande 2012), and the low level of cartel detection (Connor 2012; Ormosi 2011) may
affect the risk/reward calculation of a particular manager in participating in a cartel.
The broader non-antitrust literature suggests that many firms behave illegally and
consider many factors in their decision to comply or not to comply, based on the relative
costs and benefits of compliance (Helland 1998). If cartel behavior goes undetected, both
the individual and the company may benefit (and individuals can justify their involve-
ment as somehow saving jobs in the company), because the harms are externalized
588 Rosa M. Abrantes-Metz and D. Daniel Sokol
(Siltaoja and Vehkaperä 2010) and both individual and company benefit from greater
stock price based on the supracompetitive pricing of the cartel (Spagnolo 2008).
There is some general work on managerial incentives regarding managerial effort and
industry competition, such as Scharfstein 1988 and Schmidt 1997. The work on manage-
rial incentives specific to cartels is relatively sparse. Aubert 2007 analyzes the interaction
of managerial incentives to collude in which collusion may be a substitute for increased
managerial effort. The model shows that, due to incentives to collude, firms may behave
inefficiently, which in turn creates even more incentive to collude, as firms cannot eas-
ily control the actions of their employees. Spagnolo (2000) provides a binding contract
from the firm to the manager to support tacit collusion. Similarly, in another work
Spagnolo (2005) suggests that a firm might hire a manager with a preference for income
smoothing, thus creating an incentive to “meet the numbers” via a cartel.
Two recent works offer some policy solutions. Angelucci and Han (2010) suggest that
for a cartel compliance program to be effective, managerial sanctions need to be low.
Another solution may be to penalize shareholders through a dilution of shares so that
if managers undertake cartel activity through poorly aligned incentives, shareholders
will be punished but not to the point that the firm would go bankrupt due to high fines
(Buccirossi and Spagnolo 2008).
The empirical work to date of managerial incentives and cartels is thin. One paper
analyzes managerial compensation among 796 Japanese firms from 1968 to 1992 (Joh
1999) and another examines a sample of German firms involved in coal cartels from 1881
to 1913 (Burhop and Lubbers 2009).
Often bonuses are tied to performance, and successful collusion can reward individu-
als for this reason. The opposite might, however, be even more important—that the fear
of being fired for poor performance may incentivize a midlevel manager who fears los-
ing his job to participate in collusion. Adding to the profit motive for collusion, there
might be a contractual undertaking by firms (where this is not outlawed) to pay the pen-
alties levied on individual employees for their participation in cartel activity. This may
be in the form of informal contracting for jurisdictions where such formal contracts
may be illegal.
One recent empirical study reviews the specific pay mechanisms and other incentives
used by firms to reward individual cartel individual members. In terms of stock options,
cartel individual members are more likely to exercise stock options more rapidly than
individuals in other firms (Gonzalez et al. 2013). Work has yet to be done that examines
actual contractual incentives of individual members of cartels. It may be that one reason
that such studies have not yet been undertaken is due to the nature of what evidence
gets collected for criminal cases. Antitrust enforcers and private plaintiffs are concerned
about the illegality of price fixing and the mechanisms used to undertake it across firms.
The incentive mechanisms within firms do not establish proof of price fixing and hence
are not important for cases. Research into the incentives used in performance contracts
for such individuals and across industries would be useful.
The time horizon of individuals impacts their potential involvement in cartels.
Sometimes the particular individuals involved in the cartel have moved on to other
companies and are not around to deal with the negative consequences of their illegal
activity (Connor and Lande 2012). There is evidence in the airline industry that finan-
cially weak firms are more likely to cause price wars and thus more likely to defect from
a collusive arrangement. The conjectured reason for this is that they effectively have a
short time horizon since there is a nonnegligible probability they will exit the indus-
try through bankruptcy or acquisition (Stephan 2010b). In other cases, the individuals
remain within the company for a long time because they enjoy the rewards of their ille-
gal activity, think that they will not be caught, or know that even if they move to a differ-
ent company, they will still be criminally liable but no longer have the ability to cover up
their misdeeds.
23.3. Firm Indicia of Cartel Activity

and Their Impact on Compliance
Since the mid-1990s, most criminal antitrust violations targeted by US Department of

Justice Antitrust Division involve international cartels. This focus on large-firm inter-
national price fixing is important given that the size of the firm affects its propensity for
criminality. One study using event history analysis finds that larger firms are more prone
to criminal behavior overall (Baucus and Near 2001). Size may be a factor because, as
organizations get larger, agency costs increase and monitoring becomes more difficult.
Organizational design issues may contribute to illegality. As organizations increase
in complexity, firms develop various organizational structures in response (Tushman
and O’Reilly 1997). The larger and more complex an organizational structure, the more
difficult it is to coordinate various organizational subunits. Complexity of organizations
also may increase agency costs (Chen and Hambrick 1995). Because of organizational
size and complexity, it is possible to hide wrongdoing from government officials, and
inside and outside gatekeepers such as in-house counsel or outside auditors. The more
complex the organization, the higher the proclivity within the firm for illegal activity
(McKendall and Wagner 1997).
Given the link between organizational structure and wrongdoing, it seems to be the
case that the internal governance structure within a corporation affects the likelihood of
successfully monitoring illegal behavior and enforcing compliance. For example, inde-
pendent outside directors seem to be more effective than inside directors (members of
the firm’s management team) at policing against corporate fraud (Beasley 1996, 2000;
Uzun, Szewczyk, and Varma 2004) and opportunistic grants of stock options (Bebchuk,
Grinstein, and Peyer 2010). Gonzalez and coauthors (2013) note that cartel member
firms are more likely to have busy directors (directors on many boards) than a typical
board.
Violations of antitrust law may occur because of organizational failure rather than
merely profit seeking on the part of management (Beckenstein and Gabel 1986). Some
firms have a strong compliance culture because incentives have been put into place to
reward strong antitrust compliance. These incentives may take the form of pay incen-
tives, organizational structures that allow for effective monitoring by legal and compli-
ance staff, and the overall creation of certain corporate cultures. For other firms, the
social norms may work towards noncompliance for many of the same reasons. When
individuals are rewarded for unlawful behavior, when monitoring by compliance staff
is not strong, or where country-level norms push toward cartel behavior, these norms
reinforce cartel behavior (Sokol 2012).
23.3.1. Incentive Pay

Firms may change the incentives for illegality for their employees via a focus in incen-
tive pay on long-term rather than short-term gain (Bebchuk and Fried 2004). There
is a principal-agent problem in firms in which the agents (employees) veer from what
is in the shareholders’ best interest in order to maximize the individual employee’s
best interest. One way in which firms reduce the agency cost problem is through
incentive-based pay.
It is more likely that firms that promote short-term gains for pay have individuals
who may undertake criminal behavior to “meet the numbers,” as pay may be linked to
performance. This is not to suggest that all pay for performance is problematic. If offi-
cers and directors have an equity stake in the firm, they have incentives to monitor the
firm for illegal activity when the illegal behavior threatens firm returns (Alexander and
Cohen 1999). In some cases pay for performance better aligns managers’ incentives with
those of the firm (Baber, Janakiraman, and Kang 1996; Morgan and Poulsen 2001).
Only when incentive-based pay is too large may this incentive problem lead to illegal
behavior. Nonlinearities in payoffs, theory would suggest, encourages fraud. It may be
that fraud happens in industries with highly specialized knowledge and high variance,
and maybe incentive contracts work in such an environment. Work in the area of corpo-
rate wrongdoing in other regulatory fields offers some theoretical and empirical basis on
what seems to be correlated with wrongdoing. There is some theoretical support for the
incentives behind this behavior (Fudenberg and Tirole 1995; Hermalin and Weisbach
2012). A number of empirical findings show that CEOs whose pay is incentive-based
are more likely to commit fraud by misreporting material information or manipulating
earnings (Berhstresser and Phillippon 2006; Peng and Röell 2008; John, Ryan, and Tian
2009; Burns and Kedia 2006; Schnatterly 2003). CFO bonuses and stock options have
also been empirically linked to manipulation of earnings (Oberholzer-Gee and Wulf
2012), and in the backdating of stock options (Lie 2005). A similar relationship of too
much pay for performance is linked to corporate tax avoidance (Desai and Dharmapala
2006, 2009).
The role of incentives in shaping behavior has been extended to cartels. If managers
receive bonuses passed on certain profitability metrics, this may encourage members
to meet their performance-based metric by any means necessary—including becoming
involved in a cartel (Buccirossi and Spagnolo 2008). Managers might be willing to risk
joining a cartel if too much of pay is linked to performance, as the short-term incentive
of a significant payout will increase (Gonzalez et al. 2013), especially if the risk of detec-
tion is low both inside the firm from compliance officers and outside the firm from anti-
trust enforcers.
23.3.2. Enforcement and the Impact on Firm Behavior

In public speeches and in the unwillingness to provide credit for penalty mitiga-
tion to companies for strong compliance programs, both the US DOJ and the EU
Directorate-General for Competition in effect utilize a strict liability framework for car-
tel enforcement. Put differently, the fact that a cartel is detected is an indication of a
failed compliance program. This strict liability theory involving cartels and compliance
contradicts the main academic literature in the area of entity liability and punishment.
Arlen and Kraakman (1997) advocate a mixed regime of negligence and strict liability.
A strict liability regime will not ensure compliance in circumstances where the increased
likelihood of uncovering harm by the compliance program outweighs the firm’s ability
to prevent such harm. In such an environment, the firm has a disincentive for any sort of
compliance program that would monitor firm behavior. Therefore, some sort of negli-
gence regime needs to be incorporated into a composite approach to also punish behav-
ior where an entity has demonstrated a “failure to discharge its policing duties.” This
mixed regime is preferable to either a pure strict liability or negligence regime.
In practice, most antitrust regimes are based on strict liability. The strict liabil-
ity regime for antitrust shapes incentives within the firm to continue with criminality
because there is very limited benefit to proactively spending on serious compliance
when the firm (and individuals therein) benefit from nondetection. A system that
enforces individual liability only raises the individual’s expected cost of liability for
wrongdoing but not necessarily that of the firm. By contrast, company-level liability
imposes costs not on the individual but on the shareholders of the company (Arlen
2012). Thus, even if firms want to comply with the antitrust laws, individuals within
firms may have a different set of calculations that may trigger illegal behavior. These
“bad apples” may act illegally no matter how strong the corporate monitoring and com-
pliance program implemented.
The amount of compliance that a firm is willing to perform for antitrust or other
areas of potential wrongdoing results from the nature of legal duties involving corporate
governance of a firm. One reason for the sometimes anemic cartel compliance efforts
by firms is that corporate law does not provide sufficient incentives to create the sort
of internal compliance process that may actually create effective compliance for anti-
trust. These incentives suggest why antitrust compliance seems to encourage only weak
compliance.
Corporate boards under Delaware law have very weak legal duties to monitor the
firms’ actions. The scope for violating such duties is narrow. Given the high threshold for
liability under Caremark,1 there seems to be little incentive for a serious proactive com-
pliance program beyond the minimum required under corporate law. Empirical work
on board liability shows that in practice, there are limited financial penalties for weak
monitoring by the board (Black 2006). The one exception to this set of incentives is that
the scope of liability, should a court find the board of directors to be liable, would make
the violation of corporate law for noncompliance nonexculpable (Bainbridge 2009).
The lack of strong corporate compliance mechanisms overall shapes the nature of firm
compliance in antitrust. Many compliance programs are merely weak or cosmetic, and
companies have incentives to undertake only cosmetic compliance since self-reporting
may hurt the firm (Arlen 2011). The same seems to hold true in the antitrust context
(Sokol 2012).
23.3.3. Senior Management within an Organization

A crucial dimension of better incentives (and to the power of various policies) for com-
pliance takes into account the distinction between managerial incentives and share-
holder incentives and between the incentives of a middle manager and those of a senior
manager. This next section examines the interrelationships between different individu-
als within the firm and across firms to better understand what might constitute effective
compliance in the antitrust setting.
Senior management is an important component of firm governance and compli-
ance (Hambrick 2007; Hambrick and Mason 1984). Different management styles affect
corporate decision-making in a number of areas, such as investment and financial pol-
icy, tax compliance, and organizational strategy (Bertrand and Schoar 2003; Dyreng,
Hanlon, and Maydew 2010). The focus on senior management in antitrust is particularly
important. The majority of individual defendants in cartel cases have been at the level of
a company’s corporate officers (Gallo et al. 2000; Stephan 2010b).
The distinctiveness of criminality within top management of an organization may be
due to the large amount of power that top management possesses and how it impacts
firm culture (Schein 2010). Therefore, the preferences of top management will affect
strategic outcomes of a corporation (Chatterjee and Hambrick 2007; Camerer and
Lovallo 1999). Some work suggests that longer CEO tenure (Miller 2001) and top man-
agement team tenure (Finkelstein and Hambrick 1990) negatively affect the strategic
dynamics of a corporation (Henderson, Miller, and Hambrick 2006). As stability usu-
ally favors cooperative outcomes (Stigler 1964), more stable firm management in an
industry should facilitate collusion. Moreover, younger managers may be “trained” by
the older generation to participate in cartels (Geiss 1967).
Top management’s crimes differ from others within an organization, because the
board of directors more closely monitors senior management than other parts of the
1
In re Caremark Int’l Inc. Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).
firm. There are various internal control devices to better align the incentives of share-
holders and management, so as to improve the quality of oversight and reduce incentives
for cartel activity. For example, companies might issue debt to constrain management
from overinvestment (Harvey, Lins, and Roper 2004). Separation of the CEO and chair-
man position improves the board’s ability to monitor the CEO (Efendi, Srivastava, and
Swanson 2007; Core 2003), as do independent directors who have financial expertise
(Agrawal and Chadha 2005). Similarly, providing equity for directors might give rise to
improved monitoring of management by directors by better aligning director interests
with shareholder interests (Jensen 1993; Ertugrul and Hegde 2008). Moreover, board
diversity serves to better monitor CEOs, based on CEO turnover (Adams and Ferreira
2009; Weisbach 1988).
One cartel-related article (Simpson and Koper 1997) that analyzes 43 antitrust
offenders over 22 years finds that certain top management variables correlate more
with antitrust illegality (CEOs with finance and administrative backgrounds, less top
level turnover, and firm reliance on a single product market) than others. More recent
finance-based work on cartels (Gonzalez et al. 2013) suggests that cartel members firms
(1) tend to file an abnormally large amount of financial restatements, (2) have less effec-
tive monitoring due to foreign or busy (too many board positions) directors, (3) are less
likely to replace directors who resign, and (4) switch auditing firms less often than the
norm.
In the antitrust context, the tone of senior management matters to compliance within
the organization. From a procompliance standpoint, if the CEO mandates antitrust
training, middle managers are more likely to take such compliance seriously. The CEO
must project a sincere desire to comply. This will set the tone for the entire organization
in terms of its antitrust compliance. The CEO must be fully committed to the antitrust
compliance program and be consistent in such commitment (ABA 2010a). The more
powerful the messenger, the more likely that others within the organization will con-
form to the message because of the CEO’s ability to offer compliant managers greater
resources, legitimacy, and power (Oliver 1991). Therefore, the involvement by top man-
agement in criminal activities may merit tougher penalties, since senior management
involvement signals compliance weakness and a corrupt culture overall, including at the
level of board of directors.
23.3.4. Middle Management and Other Employees

Within the firm, middle management may not have the same incentives for compliance
as senior management does. For example, in a divisional organizational model, each
divisional unit may try to maximize the short-term profitability of that particular divi-
sion instead of the entity as a whole (Shin and Stulz 1998). This suggests that organiza-
tional structure may be a contributing cause for misalignment of incentives.
Culture also implicates the behavior of middle managers. To become successful
leaders in companies, middle management and lower-level employees may mimic the
behavior of senior management (Haunschild and Miner 1997). This may include behav-
ior such as cartel involvement if such cartel participation allows these middle managers
to move up the ranks within the firm.
Middle managers may be under significant pressure to meet various performance
targets (Alexander and Cohen 1996). The financial rewards or possibilities for prestige
or promotion for managers for divisional results may be different than for the firm as
a whole (Berger and Ofek 1995). A cartelist may rationally risk criminality because he
wants to save jobs in his group or division. The cartel participant believes that as long
as other firms do the same during a time of economic downturn, a cartel will naturally
break up when the economy improves. For other potential cartelists, the fear of being
caught and punished is a deterrent. However, this deterrent does not apply to others
who are genuine sociopaths, or are desperate, angry, and/or scared of losing a job if they
do not participate in a cartel. In yet other cases, the cartelist may be convinced that she is
smarter than everyone else.
23.4. Culture
23.4.1. Norm Creation

Antitrust scholarship has overlooked the importance of firm culture on compliance.
Beyond the legal regime, there are other incentives within the firm that influence com-
pliance regarding cartel policy. For a cartel to avoid detection by a participating firm’s
employees, there needs to be some level of management that actively participates in the
cartel and other employees who either are unaware of or who turn a blind eye to such
behavior. As noted above, incentives within the firm shape firm behavior and the behav-
ior of its agents. Thus, firm culture creates direct incentives for criminality. A compli-
ance program, if not made part of a corporation’s culture, will be viewed antagonistically
by midlevel management. Such managers may view it as a system to beat in pursuit of
sales and commission.
Illegal activity may become embedded in an organization over time and become
a part of organization culture (Aguilera et al. 2007; Bettenhausen and Murnighan
1985). Unethical changes within an organization may be subtle and gradual, such
that individuals do not realize that they are engaging in illegal behavior (Ashforth
and Anand 2003). Over time, organizations reach a tipping point in their culture
in which illegality becomes a defining element of the organization itself (Maclean
and Behnam 2010). Additionally, rapid growth and unrealistic company perfor-
mance forecasts are factors that indicate an increased likelihood of accounting fraud
(Summers and Sweeney 1998).
Culture plays out within the cartel and compliance culture of various firms. There are
different types of cartelists among individuals and firms. Each of the types of cartelists
possesses its own unique traits based on nationality and size of the company. According
to Sokol’s survey (2012), non-US firms, including Global Fortune 500 firms, seem not
to have a strong cartel compliance culture. Respondents suggested that cartel crimes
are accepted as part of doing business in many foreign firms, although in recent years
respondents suggested that European firms have improved their awareness that cartel
activity could lead to significant penalties and have begun a process of changing their
internal tolerance of such activity. This is far less the case for Asian firms.
The perception by society that illegal acts are immoral may also create increased
deterrence within the firm based on a procompliance culture. There are social costs for
individuals for wrongdoing, such as stigma (Rasmusen 1996). These costs amount to
shaming penalties. These issues implicate corporate culture, which addresses issues of
norms and customs (Hermalin 2012).
Through more effective use of moral shaming, norms can be changed within com-
panies and society at large. This can be done through changing incentives, such as
highlighting the ethical value of compliance. This both decreases the cost of detection,
because others will be on the lookout, and raises the potential cost to participation in
illegal activity. This happens because those who might try to engage in illegal activity
will see that it will hurt them given that such behavior will not be tolerated within the
company. The more that people within the company who view cartel behavior and other
white-collar crimes as on par with capital crimes, the greater the moral outrage that oth-
ers will feel toward the perpetrators of such crime and the more stigma that will attach to
the perpetrator. The mere threat of such stigma should be sufficient to deter some indi-
viduals from participating in cartel activity.
23.4.2. Culture and Stock-Based Cartel Event Studies

Stigma may be felt at the company level in terms of negative stock market returns due to
the loss of “branding.” Reputation effects (via a drop in stock price) may have a signifi-
cant effect on the decision whether or not to undertake crime. The deterrent effect may
be even greater than that of jail or of civil penalties. This work has its origins in Klein
and Leffler (1981). More recent empirical work in other areas of regulation suggests two
possible reputational effects. Finance empirical work shows that the reputational loss
for financial misreporting and fraud is greater than the penalties via the legal system
(Karpoff and Lott 1993; Karpoff, Lee, and Martin 2008a; Engalin 2012). In contrast, in
the environmental realm, the legal penalties imposed matter far more for optimal deter-
rence than do reputational penalties (Karpoff, Lott, and Wehrly 2005).
Antitrust studies of reputational effects on stock performance have been limited and
the results mixed. Motchenkova and van der Laan (2005) provide a theoretical model
that generates reputational loss for large firms across jurisdictions for cartel activi-
ties. Bosch and Eckard (1991) examined the stock returns for firms involved in price
fixing during the period 1962–1980. Their analysis suggested that the majority of the
loss in stock value was due to the readjustment effect of what had been monopoly
profits moving to the competitive price. More recent studies have not been undertaken
to examines the reputation effect of US cartel enforcement since that time, even though
there have been significant changes both to enforcement (the introduction of the leni-
ency program) and to the establishment of the importance of cartel enforcement.
A study on Dutch listed firms that were the target of competition actions of both car-
tel and dominance cases from 1998 to 2008 as well as EC-level cases concerning Dutch
cartels from the same time period finds that the reputational loss, taking into account
the legal costs and readjustment effect of the profit stream, is a more significant deter-
rent than the legal effect (Van den Broek et al. 2012). Though information about a mas-
sive Dutch construction cartel was already publicly available (and financial penalties
already built into the stock price), one study found that after a television show about the
Dutch construction cartel appeared, the stock price of firms mentioned in the televi-
sion show fell by 10%, which suggests a reputational penalty (Graafland 2004). At the
EU level, the most recent work that examines the impact of cartel compliance (most of
the observations) is by Langus, Motta, and Aguzzoni (2013) and Günster and van Dijk
(2010). Langus, Motta, and Aguzzoni found that fines account for between a quarter
and a third of the stock price drop, with the remainder due to a readjustment effect and
almost none to potential reputation effects. Gunster and van Dijk find a 5% stock return
around the time of the dawn raid and a 2% drop at the time of a final decision. They do
not distinguish the loss among fines, the readjustment effect of the profit stream, and
reputational effects.
Other antitrust-related work on the impact of cartel enforcement on stock returns
focuses on the long-term effect of stock prices. This line of work suggests that from a
temporal perspective, companies might be willing to take a reputation hit because of
a more limited effect of cartel enforcement. Thompson and Kaserman 2001, using the
Bosch and Eckard data set, found that 85% of firms in their sample (on a market-adjusted
basis) returned to the preindictment stock price within a year of the antitrust action.
A more recent paper by Detre and coauthors (2005) uses a newer data set (1981–2001)
and finds that the stock price returned to the preindictment level in a time period simi-
lar to that of Thompson and Kaiserman. To our knowledge, no study has examined the
long-term effect of stock prices focusing only on the period since the introduction of the
modern US leniency program.
23.4.3. Compliance Culture

Some of the lack of stigma for cartel cases is more directly tied to a poor compliance
culture by cartel member firms. To date, there has not been a comprehensive study of
the consequence for cartel participants akin to the work regarding managers involved in
financial misrepresentations. Karpoff, Lee, and Martin (2008a) tracked the outcomes of
2,206 individuals for all 788 SEC and DOJ financial representations from 1978 to 2006.
The one antitrust work on this topic, Connor and Lande 2012, reveals alarming statistics
about the acceptance of illegal cartel behavior, although only with a small percentage
(34%) of a total of 103 managers who went to jail for cartel crimes between 1995 and 2010.
Of that group of 25, nine (26%) remain employed by the same company for which they
went to jail for their cartel activity, and another nine (26%) work for a different firm but
within the same industry.
Where there are no explicit restrictions (such as through the terms of a company’s
plea agreement) to rehire convicted felons (as cartel convictions are felonies) who par-
ticipated in cartel activities, social shaming could increase on some level the cost of
participating in such activity. US antitrust is different from other areas of related law
(such as securities law), where convicted (or civilly sanctioned) offenders with some fre-
quency are barred from the industry or where companies can be debarred from doing
business with the government. In the United Kingdom, there is director debarment for
cartel offenses. However, the effect of director debarment on firms has not been studied
empirically in detail, largely because there has only been one debarment.
Blowing the whistle on cartel crimes requires employees to feel empowered within the
organization. Employee incentives may not be aligned with the firm in terms of compli-
ance because an employee or midlevel manager risks losing her job if she comes forward
with information of illegal activity (Dyck, Morse, and Zingales 2010). Thus, in many
cases, the cost of informing outweighs the benefit of remaining silent. The misalignment
of incentives between employees and firm replicates itself in the cartel context. Where
the cartel compliance culture at a firm is weak, there is little incentive for employees to
come forward to report on others within the organization.
Scholarship on the effectiveness of cartel compliance in the United States suggests
that antitrust compliance programs are not effectively integrated within firm culture.
Instead, only a select group of managers (such as at the senior management and gen-
eral counsel level) understand the importance of antitrust compliance, whereas much
of midlevel management and employees do not seem sensitive to the importance of
such compliance generally, seem to forget their training; or seem insensitive to the par-
ticular nuances of what type of collaboration across competitors is illegal (Sokol 2012).
Subsequent generations of employees and managers get trained by their more senior
colleagues in industry practices and thereby pass on company and industry norms. In
many cases entire industries become recidivists when a generation retires and the next
generation relearns how to coordinate with competitors (Levenstein and Suslow 2006).
23.5. Survey Evidence on Compliance
The question of whether or not compliance is effective in embedding antitrust knowl-

edge and to what extent this knowledge deters activity among individuals within a
given firm remains unknown except through survey evidence. Some of this is quantita-
tive and some is qualitative. A number of articles and reports have surveyed practitio-
ners, whether lawyers both in-house and at law firms or businesspeople more generally.
Parker 2011a provides a review of such studies up to 2009. Studies in the UK have sur-
veyed companies about competition compliance and awareness. These include both
academic studies (Rodger 2000, 2005, 2009) and government studies (OFT 2007, 2011).
Rodger’s studies involved surveys that tracked compliance with the UK Competition
Act of 1998, including detailed analysis of some particular companies’ compliance
efforts. The 2007 Office of Fair Trading study found that both businesses and their law-
yers were most concerned with criminal sanctions for cartel offenses. The study also
listed the most common compliance methods and noted that larger businesses tended to
be the most compliant. The 2011 OFT study involved 2,009 telephone interviews across
seven different industries in the United Kingdom. Compliance seemed to be uneven
across all sectors. For a significant minority of firms, there is knowledge of competition
law, but still no compliance. Larger companies are more likely to be aware of competi-
tion law than smaller firms.
In the United States, there have been two studies that survey antitrust lawyers on
compliance issues (Beckenstein and Gabel 1983; Sokol 2012). The Beckenstein and Gabel
study surveys members of the ABA Section of Antitrust Law to understand compliance
by its members. The Sokol study interviews antitrust practitioners (both members of
the ABA Section of Antitrust Law as well as Chambers-ranked US cartel practitioners)
in both quantitative and qualitative surveys and finds certain structural limitations in
organizational behavior within firms that have prevented antitrust compliance pro-
grams from becoming embedded in a way that would reduce cartel activity.
Twenty Swiss antitrust lawyers were the subject of an article (Hüschelrath, Leheyda,
and Beschorner 2011) that illustrates the deterrent effects of enhancements to Swiss car-
tel policy—increased fines and increased evidence gathering. The article attempts to
get at what sort of effect these enhancements have had on foreign companies as well as
smaller and medium-sized Swiss companies, some of which have limited or no interna-
tional exposure. The study noted the difficulty of getting top management to be involved
in the successful creation and implementation of a compliance program.
In Australia, Christine Parker has been the author or coauthor of a number of studies
on competition compliance. Overall she and her coauthors find that cartel enforcement
has changed social norms in Australia but that some compliance is only halfhearted or
has certain implementation problems (Parker and Nielson 2006; Parker, Ainsworth,
and Stepanenko 2004; Parker and Platania-Phung 2012).
Some cartel studies that implicate cartel culture and effectiveness of compliance
involve interviews with cartel participants. The most famous such work is the study by
Geis (1967) of executives involved in the heavy electrical equipment cartel. He quotes
industry leaders who said that they committed no wrongdoing because the activity was
viewed as legitimate in the industry. That is, executives in their view were conform-
ing with, not breaking, the rules. Herling 1962 provides a robust overview of the same
conspiracy and its members. Similarly, Baker and Faulkner (1993) reviewed the court
records from the heavy electrical equipment cartel to understand the motivations of
individual cartel members. According to their analysis, the cartel was built around non-
detection rather than efficiency of the cartel. John Fuller (1962) provides a journalistic
account of these court proceedings to understand the internal mechanisms of the cartel
and its members.
Although no cartel members were interviewed by Genesove and Mullin (2001), they
reviewed weekly notes from the 1927–1936 sugar refining cartel. They explored the
mechanisms of the cartel creation process across firms, including how individuals at
the firms coordinated with each other in full knowledge, and the reasoning that under-
pinned the actions of particular firms and the individuals who represented them at the
cartel meetings.
The folding carton cartel of the 1970s is the subject of work by Sonnenfeld (1981) and
Lawrence and Sonnenfeld (1978). These works provide detailed interviews with execu-
tives of companies that were involved in the cartel to understand the motivation for the
involvement. A more recent study by O’Kane (2011) interviews a single cartel member
in the marine hose conspiracy. Australian qualitative interview research is rich. A num-
ber of studies examine cartels, their individual participants, and their outside lawyers
(Parker, Ainsworth, and Stepanenko 2004; Parker 2006, 2012a, 2012b; Parker et al. 2011).
23.6. The Use of Bounties as Incentives

to Induce Detection by Individuals
The preceding discussion on compliance and culture suggests that there must be some
level of trust based on the norms and culture of a firm. Leniency can destabilize this
trust. However, most of the success of the leniency program around the world has
been with leniency applicants at the firm level. Individuals rarely have been leniency
applicants.
Creating mistrust within firms could lead to the breakdown of cartels. Yet blowing the
whistle on illegal behavior, such as cartels, is not easy. To do so presents significant risks.
As Dyck, Morse, and Zingales (2010) note, employees who blow the whistle face signifi-
cant costs in their companies for doing so. Bowen, Call, and Rajgopal (2010) correlate
whistle-blowing to situations where (1) firms tend to be large companies with significant
goodwill but with poor governance; (2) firms tend to have blurry lines of communica-
tion within the firm, in part because of personnel changes; and (3) these tend to be con-
centrated in industries in which there are significant government purchases. Similarly,
there is little incentive for employees to come forward for cartel information without a
reward since cartel compliance cultures at many firms are weak (Sokol 2012).
Detection may be increased through individual financial incentives within the
firm of blowing the whistle. An antitrust whistle-blowing bounty has been discussed
in a few articles (Aubert, Rey, and Kovacic 2006; Kovacic 2001; Spagnolo 2008).
Whistle-blowing is not foreign to the US enforcement scheme outside of antitrust. The
qui tam statute enables whistle-blowers to receive between 15% and 30% of the money
recovered by the government (Kovacic 2001).
A bounty may work in conjunction with leniency to improve detection, as the South
Korean experience suggests (Spagnolo 2008; Sokol 2011). What has not been established
is the impact of whistle-blowing on the internal dynamics of companies that have been
the subject of antitrust whistle-blowing, or of multinationals that might do business in
the United Kingdom or Korea, such as the breakdown of trust within the firm. Moreover,
cartel bounties may create high administrative costs because employees may overreport
information. Business may become paralyzed if managers fear that every possible decision
might subject them to discipline internally or from antitrust authorities. These drawbacks
have not yet been quantified or thoroughly modeled within the antitrust scholarship.
23.7. The Use of Empirical Screens

in Antitrust Compliance and Their
Relevance for Corporate Governance
Despite their success in many respects, antitrust compliance programs seem to play a
minor role in detecting and possibly deterring antitrust violations relative to other
detection methods. Why may that be the case? There are a variety of reasons. At the
top is that key jurisdictions (e.g., the United States and the European Union) do not
offer credit to corporations for their compliance programs in case antitrust violations
are found. Were such credit offered, it would increase the incentive for corporations to
enhance their compliance programs.
This section explores the potential use of screening methodologies to improve anti-
trust compliance. It begins with an overview of empirical screens and detection of illegal
behavior externally to the corporation. It then discusses the use of screens for internal
monitoring and compliance.
The ability to flag unlawful behavior through economic and statistical analyses is
commonly known as screening. A screen is a statistical test based on an econometric
model and a theory of the alleged illegal behavior, designed to identify whether manipu-
lation, collusion, fraud, or any type of cheating for that matter, may exist in a particular
market, who may be involved, and how long it may have lasted. Screens use commonly
available data such as prices, bids, quotes, spreads, market shares, volumes, and other
data to identify patterns that are anomalous or highly improbable.
Over the last few years, economic analyses in general, and empirical screens in par-
ticular, have become increasingly important in cases of conspiracies and manipulations,
a trend detailed in Abrantes-Metz and Bajari (2009, 2010), Harrington (2006, 2008),
Hüschelrath (2010), and Laitenberger and Hüschelrath (2011). Competition authorities
and other agencies worldwide have begun using screens to detect possible market con-
spiracies and manipulations, and so have defendants and plaintiffs at initial stages of
litigation.
Broadly speaking, screens used in the literature employ two strategies. The first is to
search for improbable events. This type of screen is similar to looking for a cheat in a
casino. For example, the probability that a gambler at a Las Vegas casino will place a win-
ning bet in roulette is roughly 0.5%. During her shift, a roulette dealer may see a handful
of players win five, or even seven, times in a row. However, the probability of winning
20 times in a row is almost zero (though not impossible). If a pit boss sees this occur,
he may not be able to prove that cheating has occurred, but he would be well advised to
watch closely or risk losing a lot of money. One set of collusive screens generalizes this
idea by looking for events that are improbable unless firms in the industry have coordi-
nated their actions.
The second type of screen uses the idea of a control group. A somewhat extreme
example illustrates the idea. In the 1980s, organized crime in New York City operated a
concrete club that rigged bids on contracts over $2 million. During the 1980s, the price
of concrete was 70% higher in New York City than other US cities. While it is true that
the price of many goods and services is higher in New York City, relatively few of those
prices are 70% higher than in other large cities. Prices that are anomalous compared to
other markets suggest a competition problem. In this simple example, we form a control
group for New York by using prices in other cities as a basis for comparison. Most collu-
sion is not this blatant.
When designing and implementing screens, there are two golden rules to keep in
mind, which should be obvious when stated, but which may sometimes be forgotten.
First, “One size does not fit all,” and second, “If you put garbage in, you get garbage out.”
Screens can be very powerful, but these are econometric tools with all the usual caveats,
and they may potentially be misused. Screens, just like any empirical technique, can be
effective only when properly applied; otherwise they risk producing nonsense. See the
discussion by Doane and coauthors in this volume.
The first screening rule states that a screen needs to be designed or at least adjusted
to the situation at hand. Just because a given set of variables and model specifications
proves highly effective when estimating the demand for bread does not mean that those
same variables or specifications work when estimating the demand for cars. In turn, the
second screening rule states that, as is always the case in empirical work, a screen is only
as good as the choices of what is put into it (Abrantes-Metz (2012) discusses in further
detail issues related to the development of screens).
In general, six requirements are key to developing and implementing a good
screen: (1) an understanding of the market at hand, including the nature of competition
and the potential incentives to cheat—both internal and external to a firm; (2) a view
of the likely nature of cheating; (3) a view of how cheating will affect market outcomes;
(4) a set of statistics that can capture both the implications of cheating as well as ordi-
nary, natural relationships between key market variables; (5) empirical or theoretical
support for the screen; and (6) the identification of an appropriate nontainted bench-
mark against which the evidence of cheating can be compared.
Even a screen based on a solid theory of cheating and properly designed and imple-
mented can still produce erroneous conclusions, just as is the case with any other
statistical test: it may indicate that cheating may have existed where one did not (type
I error), or it may fail to flag cheating which did exist (type II error). Again, just as we
would not argue that statistical tests are useless because they have margins of error, we
should apply the same standards to screens. The hope is that type I and type II errors will
not occur with high likelihood, though there is certainly a trade-off between the two.
23.7.1. Types of Screens, Their Users, and Successes in the

Detection of Illegal Behavior
There are different types of screens used in a variety of markets, and this section reviews
some of the most commonly applied. It starts by focusing on screens developed to detect
bid rigging, a popular application of these methods since the strict rules of competitive
bidding help to identify colluders. Next, it discusses screens when only price data are
available, or some measure of cost is also available, including variance screens, which
search for pockets of high or low variances in prices. Screens based on market shares are
discussed next, followed by purely mathematical screens such as Benford’s law, which
describes the rates at which certain digits occur in many data sets. Though these screens
have been applied at the industry level, there is reason to believe, based on the more reg-
ular use of screens in areas such as accounting fraud and FCPA, that firms can undertake
cartel-related screening as a form of monitoring its own employees.
23.7.1.1. Bid Rigging

Bid rigging in competitive tenders is a productive setting to apply screens for three rea-
sons. First, competitive tenders are widely used not only for public sector procurement
but also in financial markets, privatization of public assets, real estate, and many other
transactions. Second, bid rigging is a common antitrust offense, representing a sig-
nificant portion of all international cartels uncovered and associated with long-lasting
cartels (Abrantes-Metz, Connor, and Metz 2013). Third, markets that use competitive
bidding are frequently rich in data. In many countries, statutes require the public disclo-
sure of bids.
There is a large body of empirical literature on collusion in auctions that implements
various types of screens. While these papers span a wide variety of industries, research-
ers have identified common patterns when collusion is known or suspected.
In sealed auctions, firms submit their bids simultaneously, and these are often read
at a previously set date. In the public sector, the lowest bidder is usually awarded the
contract. When firms do not know about each other’s bids, they cannot take them into
consideration when determining their own bid. Hence, each individual bid will likely
primarily reflect market conditions such as costs and local market power. As a result,
competitive bidding implies that bids will be independent after controlling for informa-
tion that is observed by all of the bidders.
When firms collude, by contrast, they need to coordinate their actions. This coordina-
tion is another common factor across bids of members that is observed or known to all
of them, and extends beyond the common factors given by costs and market power. This
additional common factor is expected to increase the correlation across bids, as implied
by an effective coordination. Therefore, collusive bids are highly correlated, even after
controlling for costs and market power variables.
The question then becomes “How much positive correlation across bids is high enough
to raise suspicion of collusion?” The answer is “It depends.” Sometimes the correlation is
so high that the likelihood that it could have been attained without explicit coordination
is almost zero. A famous example is the bids received by the Tennessee Valley Authority
to install conductor cables in the 1950s, in which seven firms submitted (presumably
sealed) identical bids of $198,438,24. It is highly unlikely that independent bidders could
have arrived at bid values identical to the eighth significant digit if acting independently.
Other times, the correlation across bids is significantly higher across bidders in one
particular market, say market A, than across bidders in another particular comparable
market, say market B. If such difference in correlations between the two markets can-
not be explained by a relevant legitimate market condition observable to firms in A but
not observable to firms in B, then it is more likely that it can be explained by explicitly
coordinated behavior across bidders in market A. But if the decision to submit bids is
independent, then such a high degree of correlation is too large and too persistent to be
likely only due to randomness or idiosyncrasies.
This type of pattern was illustrated in an examination of a set of bids submitted to sup-
ply school milk in Ohio between 1980 and 1990, set forth by expert reports for the pros-
ecution on behalf of State of Ohio v. Louis Trauth Dairies, Inc., in which several patterns
in the data were found too improbable to have been reached by a competitive bidding
system (Porter and Zona 1999).2
Economic theory predicts that bids should closely reflect costs in competitive mar-
kets. When firms collude, they break the relationship between bids and costs, with
the objective of attaining higher than competitive profits. Therefore, another set of
bid-rigging screens looks for disconnects between bids and costs, which can be evalu-
ated, for example, by comparing the relationship between bids and costs in the allegedly
tainted market, against that of the untainted markets.
In contrast with the example of the price of concrete in New York discussed earlier,
an examination of bids by highway contractors in the upper Midwest during the 1990s
tended to disprove the existence of conspiracy (Bajari and Ye 2003). When computing
the ratio of the winning bid to the cost estimate, the authors found it was almost equal
to one, suggesting that bids were comparable to properly deflated bids from other mar-
kets, and representing evidence consistent with competitive markets for most of the
bids. Nevertheless, the authors also found evidence consistent with collusion for two
out of the 11 firms studied, the same two firms that had been previously sanctioned for
bid rigging.
2 Other studies of the same nature have also been performed in markets suspected of collusion. Those
include paving contracts (Porter and Zona 1993), Canadian timber (List et al. 2004), and Russian oil and
gas leases (Marshall and Marx 2009).
In addition to the work of academics and consultants as discussed above, the US

Department of Justice Antitrust Division has proposed a number of bidding patterns
as being suggestive of collusion. All of these either look for bids that appear too improb-
able to have been independently submitted or for bids that do not reflect costs and other
legitimate market factors in a way compatible with competition.
Red flags for bid rigging suggested by the US Department of Justice are the following:3
1. The same company always wins a particular procurement. This pattern may be
more suspicious if one or more companies continually submit unsuccessful bids.
2. The same suppliers submit bids and each company seems to take a turn being
the successful bidder.
3. Some bids are much higher than published price lists, previous bids by the same
firms, or engineering cost estimates.
4. Fewer than the normal number of competitors submit bids.
5. A company appears to be bidding substantially higher on some bids than on
other bids, with no apparent cost differences to account for the disparity.
6. Bid prices drop whenever a new or infrequent bidder submits a bid.
7. A successful bidder subcontracts work to competitors that submitted unsuccess-
ful bids on the same project.
8. A company withdraws its successful bid and subsequently is subcontracted work
by the new winning contractor.
When studying whether bidding patterns are the product of collusive agreements,
investigators should realize that the failure to control for relevant components of costs
or competitive factors will likely provide erroneous evidence that collusion existed and/
or that it materially impacted competition.
23.7.1.2. Price Fixing

Successful collusion will cause prices to be higher than the noncooperative oligopoly
prices that would prevail absent collusion. With successful collusion, prices are also
likely to be less volatile. Finally, prices may behave in otherwise unusual ways when
collusion is initiated, when there are episodes of cheating and punishment (e.g., price
wars), and when collusion ends. But there may be alternative explanations for unusual
patterns that may warrant a thorough investigation.
In a 2006 paper, Abrantes-Metz and coauthors propose a price-fixing screen based on
low price variance. The authors used prices and costs of frozen perch fillets purchased
by the Defense Personal Support Center between 1987 and 1989. Data extended from a
collusive agreement, through its break, and the move into competition. During the first
3
The US Department of Justice has identified a set of pricing patterns that are intended to help
identify collusive behavior. See US Depart of Justice, Antitrust Division, An Antitrust Primer: Price
Fixing, Bid Rigging, and Market Allocation Schemes: What They Are and What to Look For, at http://www.
usdoj.gov/atr/public/guidelines/primer-ncu.htm (“DOJ Antitrust Primer”).
period there was collusion in the form of bid rigging among sellers of frozen perch fillets
that led to the fixing of prices. This behavior was uncovered by the Department of Justice
and at the time such investigation became known, the cartel broke apart. The authors
illustrated four expected features of collusion:
1. The average price was higher with coordination than with competition, after
taking account of differences in the cost of fresh perch.4
2. Prices dropped suddenly when the conspiracy collapsed.
3. Prices were more stable, and less responsive to demand and supply shocks with
conspiracy than under competition.
4. Prices followed costs more closely when competition prevailed than when the
conspiracy was in effect.5
These above features and others are used by competition authorities around the world
to assist in the detection of price-fixing conspiracies, and in particular, feature 3 above
relating to low price variance under collusion.
Red flags for price rigging suggested by the Department of Justice are the following:
1. Prices remain identical for long periods of time.

2. Prices previously were different (and start becoming identical).
3. Price increases do not appear to be explainable by increased costs.
4. Discounts are eliminated, especially in a market where discounts historically
were given.
5. Vendors are charging higher prices to local customers than to distant customers.
23.7.1.3. Market Shares

Another type of screen uses data on market shares. The literature and evidence from
uncovered cartels demonstrate that these may attempt to collude by fixing market shares
(Harrington 2006, 2007). Two screens are suggested by the literature: (1) market shares
appear to be too stable over time; and (2) market shares for all firms in a particular market
are negatively correlated over time. The first screen will detect an agreement by the car-
tels to divide the market. Examples of cartels with stable market share agreements include
cartels in copper plumbing tubes, organic peroxides, and several vitamins (A, E, and folic
acid, in particular). The second screen is suggested by dynamic models of collusion (Athey
and Bagwell 2001 and Athey, Bagwell, and Sanchirico 2004). In these models, if a cartel
member deviates from the collusive agreement, it will need to compensate other cartel
members in subsequent time periods. As a result, abnormally high shares for a particular
firm in one period should be followed by a reduction in shares in the following period.
4
According to some estimates, the average cartel raises prices by 25%. See Connor (2007).
5
Kim and Cotterill (2008) found that under collusion the pass-through rate for processed cheese was
21% to 31% while under competition the range was 73% to 103%.
23.7.1.4. Screens Based on Mathematical Laws
Benford’s law is a mathematical formula that describes the regularly occurring distribu-
tion of digits in many data sets. Studies have shown that the law applies to many diverse
data sets, including populations of cities, electricity usage, word frequency, and the daily
returns to the Dow Jones. Because Benford’s law is a naturally occurring pattern in those
data, violations of the law can be used to detect irregularities. In the past, violations have
been used to detect data tampering, manipulation of financial ratios, and tax evasion. For
example, Varian 1972 uses Benford’s law to check the validity of purported scientific data
in social sciences, Nigrini 1996 applies to taxpayer evasion, while Judge and Schechter
2009 usesthis law to detect problems in survey data. Most recently, Abrantes-Metz,
Villas-Boas, and Judge (2011) used Benford’s law to test for unusual patterns in USD
LIBOR, a matter now commonly known as the LIBOR conspiracy and manipulation.
Other collusive markers used to screen for conspiracies are discussed in Harrington
2006.
23.7.1.5. Screens’ Successes

Economic analysis and empirical screening do trigger antitrust cases, such as an Italian
cartel in baby milk and a Dutch cartel in the shrimp industry. Screens are also being suc-
cessfully used to identify potential anticompetitive behavior in gasoline markets by the
US Federal Trade Commission, and to prioritize complaints in the Brazilian gasoline
retail market, leading to raids and the finding of direct evidence of collusion (Ragazzo
2012). In Mexico, the competition authority flagged a conspiracy in pharmaceutical
markets through the use of bid-rigging screens (Mena Labarthe 2012). Market monitor-
ing and screening programs have been adopted by several other competition authori-
ties, such as the European Commission and the South African Competition Authority.
Most recently, per a press article dated September 15, 2012, a Canadian reporter raised
the flag for possible bid rigging in the pavement of roads in Quebec, Canada, by point-
ing to a variety of patterns that seemed unexpected under a competitive setting. Since
then, investigations have been launched and senior officials have resigned. In 2013 the
Quebec government took direct control over the city of Laval, the target of the investiga-
tion, and Quebec’s third largest municipality. The ongoing investigations have intensi-
fied in this escalating procurement scandal involving also Laval’s former Mayor.
Screens have successfully detected cartels in US financial markets. Academics applied
screens to NASDAQ inside spreads (the lowest selling offer minus the highest buying
offer among all dealers) in 1994 and found these to be abnormally high when specific
stocks were trading only at even and not at odd eighths, thus effectively raising dealers’
profit margins. The abnormal pattern of odd-eighths avoidance was published in May
27, 1994, in a paper by Christie and Shultz. Immediately after its publication, NASDAQ
spreads significantly shrank, suggesting (if not revealing) a conspiracy among dealers
and triggering regulatory investigations.
Most recently, the US Department of Justice, the Securities and Exchange
Commission, the Commodities Futures Trading Commission and other regulatory
agencies worldwide are investigating the possibility of a conspiracy to manipulate the

US dollar LIBOR (“LIBOR”) by several major banks, as well as LIBOR denominated
in other currencies, and similar benchmarks including Euribor in Europe and TIBOR
in Japan. These investigations followed the application of empirical screens by the Wall
Street Journal in April and May 2008 and by Abrantes-Metz and coauthors in August
2008. We will focus on this example in the last section of this chapter.
23.7.2. Screens in Internal Monitoring

As useful as screens have proven to be in the detection of illegal behavior by enti-
ties external to the corporation, the same tools used to provide circumstantial evi-
dence of possible wrongdoing can be just as well internally applied by corporations
(Abrantes-Metz and Bajari 2009). For example, there is in principle no reason why
screens could not have detected the NASDAQ odd-eighths avoidance of inside spreads
by NASDAQ itself, had these been internally used to monitor spreads by the exchange.
Similarly, screens could have been used by LIBOR submitters to monitor possible
wrongdoing in these submissions and potentially have avoided the exposure and liabil-
ity currently faced by these institutions.
Screens can have a variety of other specific applications internally to corporations.
They could be used by managers to monitor for fraud in accounting and reimbursement
statements, collusion on employee compensation surveys, or other forms of data manip-
ulation. Furthermore, screens could be used to detect price fixing in purchasing or pro-
curement. Next we will describe some potential applications below. However, note that
the methods we have discussed in the section below can be very powerful and applied to
detect a much wider range of attempts by employees or suppliers to manipulate data.
A first example is the manipulation of financial statements or other forms of account-
ing fraud. In many industries, managers are under intense pressure to produce revenues
and earnings that meet or exceed analysts’ forecasts. This is particularly true for manag-
ers with compensation that is heavily dependent on stock options. If the companies fail
to meet these targets, even by a small amount, share prices may fall considerably.
The screens discussed above could be useful in identifying this sort of fraud. For
example, if a company is falsifying accounting statements not to miss analysts’ fore-
casts, it may smooth these out over time, and in this way produce revenues and earn-
ings that are less volatile than those of comparable companies. This suggests using a
variance screen on revenues, earnings, and stock prices. Additionally, Benford’s law
could be applied to the accounting statements and share prices used to detect falsified
accounting statements. In fact, this law has been used by accountants for several decades
to flag potential data manipulations. As Gonzalez and coauthors (2013) have noted, car-
tel behavior might lead to income smoothing; hence screens that examine accounting
irregularities could detect such manipulation based on cartel activity.
Screens can be used to detect bid rigging or price fixing in purchasing or procurement.
Many institutional bodies, like the federal government, may rely on a large network of
suppliers. Manufacturing companies, big box retailers, and HMOs are all examples of
firms that may rely on a network of thousands of suppliers. Many companies use a com-
petitive process to keep supplier margins competitive. However, suppliers often operate
in concentrated industries and may be tempted to collude in order to earn profits above
the competitive level. The methods we have described above could be applied to screen
for outright supplier collusion or excessive supplier costs.
A recent study by Hüschelrath and Veith (2011) illustrates the power of these tech-
niques if applied internally to corporations. In particular, this study provides evidence
on how screens, had these been used internally by buyer companies, could have detected
the explicit collusive agreement in the upstream German cement markets before such
a cartel was identified by the German Competition Authority. The authors use a data
set with 340,000 market transactions from 36 smaller and larger customers of German
cement producers, and apply a screen that searches for structural changes in prices paid
by buyers, which could not be explained by legitimate market conditions. This applica-
tion correctly identified the ongoing cartel (ex post), establishing the power of screens
applied by buyers to internally detect this illegal behavior, and well ahead of its uncover-
ing by the German Competition Authority.
After having described how screens can be used internally to corporations to flag the
possibility of illegal behavior, in the next subsection we turn to why, when, and how they
should be used in this setting to enhance antitrust compliance.
23.7.3. Why, When, and How to Use Screens in

Antitrust Compliance
The history of major international cartels, and to some extent that of smaller local con-
spiracies, suggests that compliance training, while a necessary tool, is not sufficient.
Screens in the compliance setting may assist in identifying the high-risk areas of a busi-
ness, allow better targeting of audits to those areas, and assist in the monitoring of these
risks in a more efficient way. They employ techniques designed to highlight which parts
of the company merit closer scrutiny, where there should be intensive reviews, and
which units may call for intensive monitoring of internal communications and other
direct actions. Screens can fulfill this role by looking at certain quantifiable red flags and
applying statistical analysis to determine the priority areas for further focus, and in this
way allow a more efficient allocation of resources.
To date, there is a lack of theoretical work that links the use of antitrust screens with
compliance to solve agency cost problems. A firm would use screens to be the first to
detect any possible wrongdoing so it could fully benefit from, for example, leniency
applications in the case of cartel behavior relative to other cartel members.
The first consideration on whether to use screens for internal detection of wrongdoing
is data availability. What types of data are available and for how long? Additionally, can
other data be collected so that screens can be applied moving forward? Other consider-
ations include the following: Has the company been involved in a conspiracy before? Is
this an industry where competition problems tend to exist, (i.e., history of violations or
an industry with other characteristics such as overcapacity)? Are there several oppor-
tunities to rig bids and reach agreements with competitors (i.e., are trade association
meetings and other industry gatherings common)? When several of these conditions
are satisfied (and potentially others as well), then the company should engage in internal
screening. This process does not have to apply to all areas within the company, simply to
those where cheating is more likely, but expertise will be required in the development
and implementation of these tools.
As explained earlier and in more detail in the last section with respect to LIBOR,
there have been multiple examples of entities external to the company detecting cartels
through the use of screens. In terms of cartel detection through internal compliance pro-
grams and the use of screens, though, we are not aware of any example. There are three
points that should be stressed: first, the successful external screens just mentioned could
have, in every case, been developed internally first, meaning there is no a priori reason
an aggressive compliance screening program would not be successful; second, corpora-
tions are not yet employing screens in their compliance programs, so there are not many
chances for successful detections; and third, a strong compliance screen may deter inap-
propriate behavior, and such successes by their nature could never be identified.
23.7.4. LIBOR Detection through Screening and Its

Relevance for Corporate Governance
There is a growing literature on the use of screens and detection regarding LIBOR.
Such behavior was first flagged through screening by the Wall Street Journal (WSJ) in
April and May 2008 and by Abrantes-Metz and coauthors (2008). The WSJ noted that
LIBOR submissions seemed too low with respect to submitters credit default swaps after
the beginning of the financial crisis. Abrantes-Metz and coauthors (2008) noted that
LIBOR was constant day in, day out for many months prior to the financial crisis, while
other comparable rates such as the Federal Funds Effective Rate were not; most banks’
quotes were identical to each other, while other market indicators, such as their pricing
in the capital markets, indicated differences (even if slight) across banks; LIBOR did
not respond to increasing risk at least since late spring and early summer of 2007; the
authors saw signs of possible collusion dating back to prior to financial crisis.6
Other research on LIBOR has been conducted by Snider and Youle (2009, 2010), by
Abrantes-Metz, Villas-Boas, and Judge (2011), and by Abrantes-Metz and Metz (2012).
Snider and Youle present findings supporting their claim that the banks’ LIBOR quotes
are difficult to rationalize by observable cost measures for the period under study,
including a given bank’s quotes in other currency panels. They also introduce a model in
which banks’ possession of LIBOR indexed contracts induces them to produce LIBOR
quotes that are clustered around discontinuities, and using this model the authors show
6 This study was later published in 2011.
that there was a severe clustering in the US dollar LIBOR for the three-month maturity
throughout 2009. Snider and Youle further try to quantify gains from such behavior
and present results showing large exposures to LIBOR by several banks through their
interest rate derivative portfolios, allegedly enabling to profit from the rapid decline of
LIBOR starting in late SUMMER 2007. The authors argue that these exposures may be
the incentive behind a deliberate misreporting of LIBOR quotes by the banks.
Abrantes-Metz, Villas-Boas, and Judge (2011) show that Benford’s law was violated for
the US dollar LIBOR most noticeably from early 2006 through the summer of 2007, but
with continuing anomalous patterns throughout 2009. Abrantes-Metz and Metz (2012)
followed with an analyses similar to bid rigging to explain that, given that LIBOR quotes
are submitted sealed, that they are supposed to be idiosyncratic to each of the banks as
forecasts of their own interbank borrowing costs, and that, though all very highly rated,
these banks are not completely identical to each other in terms of portfolios, exposures
to different markets, and other differentiating factors, simultaneous moves by a large
number of submitters from one day to the following to the exact same submission num-
ber are more consistent with explicit rather than with tacit collusion.
The literature on LIBOR offers some lessons for antitrust compliance and the use of
screens for internal firm detection. There seems to have been unawareness of the clearly
anomalous data patterns by benchmark administrators, regulators, and banks manage-
ment themselves. The auditing procedures at the banks applied to LIBOR submissions were
either inexistent or clearly inadequate. Had such internal mechanisms based on screens
been in place, banks would have been able to be the first to detect illegal behavior in such
submissions, and hopefully to deter future illegal behavior (Abrantes-Metz and Sokol 2012).
Research has yet to focus on the role of risk assessment and program evaluation.
LIBOR illustrates that significant international cartel activity may occur even in situ-
ations where other types of sophisticated internal compliance mechanisms, including
screens, such as for insider trading and accounting fraud, may be used. The specific rela-
tionship between antitrust compliance and other types of compliance remains under-
studied in the corporate governance literature. Relatedly, the role of internal detection
in the merger-and-acquisition context of acquired (target) firms based on insufficient
compliance remains an area for future study.
23.8. Conclusion
This chapter provides an analysis of internal firm compliance and detection of

antitrust cartel activity. Whereas there has been less antitrust literature devoted
to internal firm incentives and compliance, a number of more recent works have
incorporated insights from finance, management, and accounting to enrich under-
standings of antitrust issues. This trend of cross-pollination of ideas and empirical
approaches will continue. Regarding policy, insights into internal detection may
better inform sentencing policy and the refinement of incentives for cartel detection
by agencies around the world. We note that a number of agencies are increasing their
reliance on econometric screens. As more agencies do so, firms that value high levels
of antitrust compliance may do so as well as a way to better mitigate their antitrust
risk profile.
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Index
A&P. See Great Atlantic and Pacific Tea in Senegal, 241–242

Company in Slovak Republic, 237
A&W, 389 in South Africa, 237–238, 241, 248–249
Abrantes-Metz, Rosa M. structural definition, 238
on corporate governance and in Ukraine, 238
compliance, 586, 600, 604, 606–607, in United States, 236
609–610 in Uzbekistan, 237
on screening, 528, 535–540, 542–544 Addanki, S., 537, 542
Abreu, Dilip, 478–479, 490 Added value, 260–261
Abuse-of-dominance, 234–251 Adelman, M.A., 43
behavioral definition, 238 Adobe, 556, 565
in China, 236, 241–242, 244–245 Advanced Micro Devices (AMD), 92, 95, 114
competition and, 237–239 AEC (As-efficient-competitor) test, 168–169
corruption and, 238 Agency costs, corporate governance and
in Costa Rica, 240 compliance and, 587
divestiture, 250 Aghion, Philippe, 148, 171, 176, 204, 317–318, 369
Efficient Component Pricing Rule (ECPR) Aguzzoni, Luca, 596
and, 250 Alcoa, 58
in El Salvador, 240 Alexander, Barbara, 449
enforcement, 237–239 Allied, 562
essential facilities doctrine and, 250 Allocative distortion, 79–80
in EU, 236 Amemiya, Kei, 205
examples of, 239–242 American Bar Association, Antitrust Law
in Hungary, 237 Section, 598
in India, 236–237, 245–248 American Medical Association, 559
in Jamaica, 237, 240–241 American National Standards Institute
in Latvia, 238, 241 (ANSI), 557, 561, 567, 569
legal standard, 235–236 American Recovery and Reinvestment Act
in Lithuania, 237 of 2009, 453
in Mexico, 237 American Society of Mechanical Engineers
overview, 234–235, 250–251 (ASME), 564–565
in Peru, 241 American Sugar Refining Company, 368
in Poland, 237 American Tobacco Company, 44, 58
remedies in, 249–250 Amsterdam second-price auction, 518n8
in Romania, 237 Angelucci, Charles, 588
in Russia, 236, 241–244 ANSI. See American National Standards
sanctions, 249–250 Institute
620 Index
Anthem, 269 bid rigging in, 501–503. See also Bid rigging

Anticompetitive nature of exclusionary collusion in, 501–503
conduct, 7–19 common value auction, 499–500
diminished ability to compete and, 26–29 defined, 498
enhanced market power and, 30 Dutch auction, 499–500
harm to consumers and, 30 English auction, 499–500
negative contracting externalities first-price sealed-bid (FPSB) auction,
and, 31–32 499–500, 503–505, 510, 516, 518
Antitrust Division. See Justice Department Japanese auction, 499
Antitrust Modernization Commission one-shot auctions, bid rigging in, 504–507
intellectual property rights and, 148 overview, 498–499
predatory buying and, 93 private value auction, 499–500
predatory pricing and, 41, 50, 52 repeated auctions, bid rigging in, 507–510
quality commitment discounts and, 110, 116 second-price sealed-bid (SPSB)
Aoyagi, M., 508–509 auction, 499–500, 504–505
Apesteguia, Jose, 436–437 standard models, 499–500
Apple, 129, 260, 565–566, 572 Audretsch, David B., 444
Areeda, Phillip Aumann, Robert J., 481–482, 488–490, 492
on exclusive dealing, 320 Australia
on predatory pricing, 46–47, 49, 54 cartels in, 445
on quantity commitment discounts, 94 corporate governance and compliance
on squeeze claims, 125 in, 598
on tying, 338, 347 vertical restraints in, 384
Areeda-Turner rule, 47–49, 52–54 Avraham, Raphael, 120
Arlen, Jennifer, 591 Azoulay, Pierre, 395–397
“Arrive by reasoning,” 482–486
Arrow, Kenneth, 148, 171, 560 Bagwell, Kyle, 422–423, 478, 508–509, 530, 533
Arrow's Information Paradox, 135 Baidu, 245
As-efficient-competitor (AEC) test, 168–169 Bain, Joe S., 478
Asker, John, 368, 394, 502 Bajari, Patrick, 514, 546, 548, 600
ASME (American Society of Mechanical Baker, Jonathan B., 431, 494
Engineers), 564–565 Baker, Wayne E., 598
Assessment errors, dominant firms Baldwin, L., 511–512
and, 169–170 Bank of Japan, 536
AstraZeneca, 167 Bar-Isaac, Heski, 368
Asymmetry, collusion and, 418n6 Barkoff, Rupert M., 403, 408
Athey, Susan, 422–423, 508–509, 513–514, 530, Baskin-Robbins, 329–330, 343, 400
533 Baumol, William J., 47–48, 55
Attribution test Bayesian hypothesis testing, screening
flaws with, 111–116 and, 525–528
liability thresholds and, 110 Bayesian Nash equilibrium, 488
overview, 105–109 Beckenstein, Alan R., 598
uses of, 111–116 Beijing Netcom, 219–220
Aubert, Cecile, 429–430 Beijing Qihoo Technology, 216, 228–230
Auctions Belgium, franchising in, 395, 407
Amsterdam second-price auction, 518n8 Below-cost pricing in Japan, 202–203
Index 621
Beltone, 309 Bosch, Jean-Claude, 595–596

Benford's Law, 602, 606–607, 610 Bounties as incentives to induce
Benoit, Jean-Pierre, 479 detection, 599–600
Ben-Porath, Elchanan, 491 Bowen, Robert M., 599
Bergen, Mark, 304, 394 Bowman, Ward S., 333
Bergin, James, 492–493 Bradburd, Ralph, 449
Bernheim, B. Douglas, 3, 311–312, 365, 419, Brandeis, Louis, 333–334
434, 483 Brandenburger, Adam, 481–482, 492
Bertrand markets Brannon, I., 540
bid rigging in, 498, 508 Brazil
collusion in, 416, 435 cartels in, 453–454
screening in, 530, 541 screening in, 524, 606
Besanko, David, 254, 266, 431–432 Breakup of cartels, causes of, 455–458
Bessen, James, 138 Brenkers, Randy, 398
Betamax, 558 Bresnahan, T., 540–541, 545
Biddle, Brad, 555 Breyer, Stephen, 58, 382
Bid rigging, 498–519 British Banking Association, 536
in auctions, 501–503 British Standards Institution, 557
in Bertrand markets, 498, 508 Broadway-Hale, 123–125, 127
in China, 501 Brock, William A., 479
in Cournot markets, 498 Brodley, Joseph F., 52
deterrence of, 517–518 Bryant, Peter G., 444, 448
empirical evidence, 510–515 Bundling
in EU, 501 as exclusionary conduct, 18, 22–24
experimental evidence, 515–517 explicit bundling, 104–105
incentive for collusion, 503–504 implicit bundling, 104–105
Nash equilibrium and, 500, 504 intellectual property rights, 343–344
in one-shot auctions, 504–507 quality commitment discounts and, 102,
overview, 498–503, 518–519 104–105
in repeated auctions, 507–510 Burger King, 354, 389
screening for, 602–604 “Burning the dollar” game, 491
theory of, 503–510 Burns, Malcolm R., 44
in United States, 501–502 Bush, George H.W., 194
Bigoni, Marta, 436–437 Business-format franchising, 390
Blair, Roger D., 343, 400, 405 Business strategy, 253–272
Blanckenberg, K., 547, 549 added value, 260–261
Block, Michael K., 431, 453 competitive advantage, 261–266. See also
Blue Cross and Blue Shield Association, 314 Competitive advantage
Blundering into tacit collusion, 492–493 complementarities in, 258
Blu-ray, 558 consumer surplus and, 255, 258–260
Bohannan, Christina, 132, 148, 334, 343, economic framework, 253–254
345–346 enhancing value creation, 256–258
Böhm, Franz, 161–163, 182 “Five Forces,” 255, 258–260, 263
Bolotova, Y., 536, 543 overview, 253–255, 271–272
Bolton, Patrick, 52, 204, 317–318, 369 producer surplus and, 255, 258–260
Bork, Robert H., 9, 311–312, 318, 337 rivalry and, 258–260
622 Index
Business strategy (cont.) in Mexico, 454n33

scope of firm, 266–271 Nash equilibrium and, 426–428
sustainability of competitive in Netherlands, 596
advantage, 264–266 overview, 415–416, 442–443, 458–459
synergies, 267–268 prevalence of, 443–446
trade-offs in, 257–258 price setting by, 449–452
value creation and capture recession, effect on formation of, 447–449
framework, 255–261 screening, 430–433
“But for” prices, 180–182 in Sweden, 443–444
Buyback options, 352 in United Kingdom, 443–444
in United States, 443–446
California Air Resources Board, 575 CDS (Credit default swaps), 536–537
Call, Andrew C., 599 Census Bureau, 390
Canada Certification services, 280–281
Competition Bureau Canada, 470, 538 Chang, Myong-Hun, 457
franchising in, 388–389 Charness, Gary, 489
screening in, 606 Che, Y.-K., 517–518
vertical restraints in, 353, 372, 384 Chen, Chia-Wen, 394, 446
Can System, 203 Chen, J., 531–532
Caremark, 101 Chevron, 575
Carlsson, Hans, 488–489 Chicago School
Carlton, Dennis W., 370, 469–471 decision theory and, 165
Carrefour, 329 dynamic efficiencies and, 171
Cartels intellectual property rights and, 140
in Australia, 445 on tying, 337–338
in Brazil, 453–454 on vertical restraints, 352
breakup, causes of, 455–458 Chicken Delight, 409
competition, effect on formation of, 447 China
competition and, 162 abuse-of-dominance in, 236, 241–242,
concerted squeezing and, 128–129 244–245
corporate governance and compliance, Anti-Monopoly Commission, 211–212, 215
effect of firm indicia of cartel activity Anti-Monopoly Law of 2007 (AML), 188,
on, 589–594 210–221, 225–231
detection, 430–433 Anti-Unfair Competition Law, 213, 218
effects on prices, 453–455 bid rigging in, 501
empirical evidence of collusion, 442–459 buying at unfairly low price in, 217–218
enforcement and, 424–433 China Telcom, 219–220
in EU, 443–446 China Unicom, 219–220
experimental evidence of definition of market dominance in, 214
collusion, 433–435 discriminatory practices in, 218–219
in Finland, 443 dominant market position in, 214–215
formation of, 446–449 Draft Guidelines for Anti-Monopoly
in Germany, 444–445, 455 Enforcement in the Field of Intellectual
hub-and-spoke cartels, 128–129 Property Rights, 225–226
in Japan, 191, 445 EU enforcement structure compared, 217–
leniency programs and, 424–430, 435–437 218, 225, 227, 244
Index 623
exclusive dealing in, 222–224 US enforcement structure compared, 225

Guidelines Concerning the Definition of China Internet Network Information
Relevant Markets, 215–216, 228 Center, 229
Intellectual Property Division, 212 China Netcom, 219
intellectual property rights in, 225–226 China Telecom, 215, 219, 227
Japan compared, 230–232 China Unicom, 215, 219, 227
joint dominance in, 215 Choi, Jay Pil, 415, 420, 430–431, 587
Judicial Interpretation on the Application Christie, William G., 523–525, 540, 545, 606
of Laws to Anti-Monopoly Private Church & Dwight, 326
Actions, 213 Cisco, 565
legal provisions of AML, 211–212 Clark, John M., 41
liability in, 213 Clayton Act of 1914
Ministry of Commerce, 212, 227 exclusive dealing and, 305–306
monopoly in, 210–232 Japanese antitrust law compared, 189
National Development and Reform predatory pricing under, 45
Commission (NDRC), 211–213, 215, quality commitment discounts and, 90n4
217–219, 221–227, 230–231, 244–245 tying under, 331, 347
non-price-related abuse of dominance vertical restraints under, 372, 379
in, 221–230 Coase, Ronald H., 267
overview, 188, 210–211, 227–230 Coca-Cola, 35, 95, 283, 388–389
predatory pricing in, 218 Cohen, Mark A., 453
presumption of market dominance in, 215 Collusion
price discrimination in, 220–221 asymmetry and, 418n6
Price Law, 213–214, 218, 220–221, 231 in auctions, 501–503
price-related abuse of dominance in Bertrand markets, 416, 435
in, 217–221 bid rigging, 498–519. See also Bid rigging
private actions in, 212–213 in cartels. See Cartels
Qihoo v. Tencent, 228–230 concentration and, 418
refusals to deal in, 221–222 corporate governance and compliance
Regulation on Anti-Price Monopoly, 212, and, 586–611. See also Corporate
217–218, 221–224, 227, 230 governance and compliance
Regulation on Prohibiting the Abuse of a in Cournot markets, 421, 433–434
Market Dominant Position, 212, 214, demand conditions and, 418–419
217–218, 221–222, 224, 227, 230 empirical evidence, 442–459
Regulation on the Prevention of Below Cost experimental evidence, 433–435
Dumping Conduct, 218 factors facilitating, 417–424
relevant laws, 213–214 folk theorem and, 417n5
relevant market in, 215–216 game theory and, 416–417
rule-of-reason analysis in, 216–217 imperfect observability and monitoring
selling at unfairly high price in, 217–218 and, 420–422
State Administration for Industry and incomplete information and
Commerce (SAIC), 211–212, 214–215, communication and, 422–423
217–218, 221–222, 224–225, 227, 230–231, multimarket contact and, 419–420
244–245 in NASDAQ, 523–525, 540
state-owned enterprises (SOEs), 226–227 number of firms and, 418
Supreme People's Court, 212–213, 215 screening for, 523–551. See also Screening
tying in, 224–225 self-enforcing nature of, 416
624 Index
Collusion (cont.) Concerted squeezing

standard setting and, 554–581. See also cartels and, 128–129
Standard setting overview, 128–129
strong explicit collusion, 468–477 railroad industry and, 128
symmetry and, 418 unilateral squeezing compared, 122–125
tacit collusion, 464–494. See also Tacit Connor, Robert A., 443, 454, 536, 543, 596
collusion Consignment selling arrangements, 352
theory of, 416–417 Consumer Goods Pricing Act of 1975, 373
vertical mergers and, 423–424 Consumers, exclusionary conduct and harm
vertical restraints and, 423–424 to, 30
weak explicit collusion, 468–477 Consumer surplus, 255, 258–260
Comanor, William B., 288 Contract adaptation, franchising
Commerce Clearing House Trade Regulation and, 405–408
Reporter, 444 Contracts that reference rivals (CRRs), 89–90
Commerce Department, franchising Convergent-elimination view, 483–486
and, 389–390 Conwood, 325–326
Commodities Futures Trading Commission, Cooper, James, 355, 371, 527
screening and, 606–607 Corporate governance and
Common value auction, 499–500 compliance, 586–611
Communication in tacit collusion, 466–468 agency costs and, 587
Compatibility standards, 555 in Australia, 598
Competition bid rigging, screening for, 602–604
cartels, effect on formation of, 447 bounties as incentives to induce
cartels and, 162 detection, 599–600
in developing countries, 237–239 cartel activity, firm indicia of, 589–594
diminished ability to compete, exclusionary compliance, use of screens in, 608–609
conduct and, 26–29 compliance culture, 596–597
economic power versus, 162–163 culture, 594–597
monopsony compared, 74 empirical evidence, 597–599
standard setting and, 554–581. See also employees and, 593–594
Standard setting enforcement and, 591–592
Competitive advantage, 261–266 in EU, 596
accumulated market experience and, 266 in Germany, 588
benefit-based advantage, 262–263 incentive pay, 590–591
cost-based advantage, 262 internal monitoring, screens in, 607–608
defined, 261 in Japan, 588
niche-based advantage, 263 LIBOR, screening for, 609–610
resource protection and, 264–265 market share, screening for, 605
sustainability of, 264–266 mathematical laws, screens based on, 606
Competitive discounts. See Quantity middle management and, 593–594
commitment discounts norm creation, 594–595
Complementarities in business strategy, 258 organizational environment, 587–589
Complements, tying of, 339–341 overview, 586, 610–611
Compliance. See Corporate governance and price fixing, screening for, 604–605
compliance screens, use of, 600–610
Compte, Olivier, 418 senior management and, 592–593
Concentration, collusion and, 418 in South Korea, 600
Index 625
stock-based cartel event studies, 595–596 Demand curves, quality commitment

success of screens, 606–607 discounts and, 95–97
in Switzerland, 598 Demand effects, RRC theory and, 64
in United Kingdom, 597–598, 600 DeNA Co., Ltd, 209
in United States, 597–598 Deneckere, Raymond, 364
Corruption, abuse-of-dominance and, 238 Dentsply, 321–324
Costa Rica, abuse-of-dominance in, 240 Denture industry, exclusive dealing
Cotropia, Christopher A., 138 in, 321–324
Cotter, Thomas F., 132 Detection, cartels and, 430–433
Counterstrategies, RRC theory and, 64 Deterrence of bid rigging, 517–518
Cournot, Augustin, 355 Detre, Joshua D., 596
Cournot markets Deutsches Institut für Normung, 557
bid rigging in, 498 Deutsche Telekom, 167, 240
collusion in, 421, 433–434 Developing countries, monopoly in, 234–251.
screening in, 530 See also Abuse-of-dominance
Credit default swaps (CDS), 536–537 Dick, Andrew R., 445
Cross-licenses of patents, 571–572 Dicke, Thomas S., 388
CRRs (Contracts that reference rivals), 89–90 Digicel, 240
Diminished ability to compete, exclusionary
Dach, Christian, 279 conduct and, 26–29
Dairy Queen, 343 Direct interaction, tacit collusion and, 467n7
Dal Bo, Pedro, 433 Discount Pricing Consumer Protection Act
Damages (proposed), 373n27
in Japan, 196–199 Discounts. See Quantity commitment
liquidated damages, 317n40 discounts; specific discount
tying, 347–348 Discriminatory practices
Dandong Yichuang Yaoye Co., Ltd., 223 in China, 218–219
David, Paul A., 554 in Japan, 207–209
Davidow, Joel, 444 Disparagement of alternative proposals,
Dealer property rights, exclusive dealing standard setting and, 564–565
and, 324–326 Divestiture in abuse-of-dominance cases, 250
Decision theory, 164–171 DLF, 247
assessment errors and, 169–170 Dnes, Antony W., 389
Chicago School and, 165 Doane, Michael J., 523, 587
in EU, 165–166 DOJ. See Justice Department
information deficiencies and, 168–169 Dominant firms, 153–184
overview, 164–165, 170–171 as-efficient-competitor (AEC) test, 168–169
self-enforcement and, 166–170 assessment errors and, 169–170
special responsibility of dominant firms attempted monopolization, 156
and, 166–167 “but for” prices, 180–182
TFEU and, 166–171 competition on merits, 158, 174–176
Defense Department, cartels and, 453 decision theory and, 164–171. See also
Defense Personnel Support Center, 535, 604 Decision theory
Degussa, 449 dynamic efficiencies and, 171–178
Dekel, Eddie, 491 in EU, 153–184
Dell, 92, 575 excessive pricing and, 178–182. See also
Demand conditions, collusion and, 418–419 Excessive pricing
626 Index
Dominant firms (cont.) ECPR (Efficient Component Pricing Rule),

exclusionary conduct and, 154–155 abuse-of-dominance and, 250
exploitative abuses, 155–156 Edlin, Aaron S., 47, 51
information deficiencies and, 168–169 Edwards, Corwin D., 419
innovation and, 171–178 Efficiencies
interaction between, 176–177 production cost efficiencies, 342
interpretation differences between Sherman quality control efficiencies, 342–343
Act and TFEU, 156–160 RRC theory and, 64
monopolization versus abuse, 154–155 vertical restraints and, 359–364
ordoliberalism and, 160–164. See also Efficient Component Pricing Rule (ECPR),
Ordoliberalism abuse-of-dominance and, 250
overview, 153–154, 182–184 Elhauge, Einer, 52
protection of competitive process, 158–159, Eli Lilly & Co., 92
172–174 El Salvador, abuse-of-dominance in, 240
self-enforcement by, 166–170 Elzinga, Kenneth G., 40, 43
special responsibility of, 157, 166–167 Employees, corporate governance and
in United States, 153–184 compliance and, 593–594
wording differences between Sherman Act Empresa de Servicios Publicos de
and TFEU, 154–156 Heredia, 240
Domino's Pizza, 343, 402–403 Enforcement regimes
Donggang Hongda Pharmaceutical Co., cartels and, 424–433
Ltd., 223 in developing countries, 237–239
Dorfman, Robert, 360 in Japan, 195–199
Dorfman-Steiner theorem, 360–361 predatory pricing and, 45–49
Double marginalization, tying and, 339–341 England. See United Kingdom
Dufwenberg, Martin, 436–437 English auction, 499–500
du Pont, 58 Enhanced market power, exclusionary
Dutch auction, 499–500 conduct and, 30
Dutta, Shantanu, 304, 394 Entrant-tax-by-contract theory of exclusive
DVDs, 558 dealing, 316–318
Dyck, Alexander, 599 Eruthku, C., 538, 547
Dynamic efficiencies Essential facilities, 121, 250
Chicago School and, 171 ETSI (European Telecommunications
dominant firms and, 171–178 Standards Institute), 557, 568
Eucken, Walter, 161–163, 178, 182
Easterbrook, Frank H., 53, 67, 156–157, 159, Euribor, 607
165, 527 European Central Bank, 536
Eaton, 92 European Commission
Eckard, E. Woodrow, Jr., 444, 448, 595–596 abuse and, 155
Economies of joint provision, 341–344 Block Exemption Regulation on Vertical
intellectual property bundling, 343–344 Restraints, 405–406
overview, 341 cartels and, 445, 448–449, 454, 456, 591
package licensing, 343–344 competition on merits and, 175
production cost efficiencies, 342 decision theory and, 167–169
quality control efficiencies, 342–343 Directorate-General for Competition, 157,
Economies of scale, quality commitment 591
discounts and, 103n33 excessive pricing and, 179–181
Index 627
exclusionary conduct and, 24n45 Evans, Phil, 449

Guidance Paper, 157, 159 Ex ante bargaining, patents and, 579–580
Guidelines on Vertical Restraints, 297–301, Excel (software), 206
358, 367, 375–378, 380–383, 405–406 Excessive pricing, 178–182
nonhorizontal merger guidelines, 69–70 “but for” prices, 180–182
RRC theory and, 69–70 ordoliberalism and, 178–179
screening and, 606 overview, 178
tacit collusion and, 494 practical objections against
Technology Transfer and Research enforcement, 179–180
and Development Block Exemption Exclusionary conduct, 3–36
Regulations, 147n37 anticompetitive nature of, 7–19, 26–32
European Community Treaty, intellectual bundling, 18, 22–24
property rights under, 147 defined, 3
European Court of First Instance determination of, 20–26
intellectual property rights and, 141 diminished ability to compete and, 26–29
vertical restraints and, 378 duration of, 29n52
European Court of Justice and General Court enhanced market power and, 30
decision theory and, 168–169 evaluation of, 19–32
excessive pricing and, 179 examples of procompetitive nature, 34–35
predatory pricing and, 46 exclusionary conditions, 15–19
protection of competitive process and, harm to consumers and, 30
158–159, 173–174 “hold-up problem,” 7 n10
European Telecommunications Standards in Japan, 200–209
Institute (ETSI), 557, 568 loyalty discounts, 5n5, 18n37, 32n57
European Union. See also Treaty on the mechanism of, 8–14
Functioning of the European Union modes of conduct implicating
abuse-of-dominance standard in, 236 mechanism, 15
bid rigging in, 501 negative contracting externalities
cartels in, 443–446 and, 7–13, 31–32
Chinese enforcement structure 100% exclusive deals, 15
compared, 217–218, 225, 227, 244 overview, 3–6, 35–36
corporate governance and compliance patents and, 4n3
in, 596 practices involving exclusionary
decision theory in, 165–166 conditions, 15–17
dominant firms in, 153–184. See also practices not involving exclusionary
Dominant firms conditions, 17–19
essential facilities doctrine in, 250 predatory pricing, 17–18, 21
exclusive dealing in, 306–307 procompetitive nature of, 32–35
franchising in, 387, 405–408 quality commitment discounts and, 102
intellectual property rights in, 142, 146–147 rule-of-reason analysis, 4–6
Japanese enforcement structure “signal jamming problem,” 27n48
compared, 201 single-product pricing, 18, 24
mergers in, 269n9 in soft drink industry, 35
predatory pricing in, 46, 51 standard setting as venue for, 559
resale price maintenance in, 297–301 tying, 5n6, 19, 25
vertical restraints in, 352–353, 366, 371–384 volume discounts, 18n37, 24–25
Evans, David S., 342 Exclusive dealing, 304–326
628 Index
assessment of harm, 320–324 Merger Guidelines. See Merger Guidelines

in China, 222–224 quality commitment discounts and, 92
dealer property rights and, 324–326 RRC theory and, 67
in denture industry, 321–324 screening and, 524, 606
entrant-tax-by-contract theory of, 316–318 standard setting and, 559, 570, 574–575, 578,
in EU, 306–307 580
ex post exclusive dealing, 318–320 tacit collusion and, 477
externalities, role of, 311–313 tying and, 331
franchising and, 393–395 vertical restraints and, 353
in health insurance, 314–315 Federal Trade Commission Act of 1914, 189,
in hearing aid industry, 307–309 306, 331, 559, 574–575
in Japan, 203–205 Feinberg, Robert M., 431, 433
linear versus nonlinear contracts, 311n29 Ferrari, Stijn, 407
naked exclusion theory of, 313–316 Fidelity discounts as exclusionary
in optical industry, 310–311 conduct, 5n5, 18n37, 32n57
overview, 304–307, 326 Finland, cartels in, 443
partial exclusive dealing, 304 First-price sealed-bid (FPSB) auction, 499–
as property right creation, 307–311 500, 503–505, 510, 516, 518
quantity commitment discounts and, 100 Fisher, Franklin M., 48
theories of, 311–320 “Five Forces,” 255, 258–260, 263
vertical restraints and, 379–381 Focal points, tacit collusion and, 477–478,
Exclusive distribution. See Franchising 483–486
Exclusive territories Folk theorem
franchising and, 393, 395–398 collusion and, 417n5
vertical restraints and, 374–376 tacit collusion and, 469, 479–480
Exclusivity restraints, 352, 365–367, 369–370 Fölster, Stefan, 443
Explicit bundling, 104–105 Fonseca, Miguel A., 434
Export Trading Company Act of 1982, 445 Foreclosure
Ex post exclusive dealing, 318–320 quality commitment discounts and, 102
Express agreements, tacit collusion tying and, 337–338
and, 467n6 Forest Service, 511–513
Externalities Fox, Eleanor M., 159
exclusive dealing, role in, 311–313 FPSB (First-price sealed-bid) auction. See
negative contracting externalities, First-price sealed-bid (FPSB) auction
exclusionary conduct and, 7–13, 31–32 Franchising, 387–410
in Belgium, 395, 407
Facebook, 176 in Canada, 388–389
Farrell, Joseph, 266, 554 contract adaptation and, 405–408
Faulkner, Robert R., 598 in EU, 387, 405–408
Federal Acquisitions Regulations, 519 exclusive dealing and, 393–395
Federal Reserve Bank, 536 exclusive territories and, 393, 395–398
Federal Trade Commission (FTC) in Germany, 388
bid rigging and, 501 historical background, 388–392
exclusionary conduct and, 16n30 mandatory purchase requirements in, 401
exclusive dealing and, 306, 309–311 overview, 387–388, 408–409
Japanese enforcement structure resale price maintenance and, 393, 403–405
compared, 195 role of antitrust law, 393–408
Index 629
statistics, 390–392 screening in, 608

traditional versus business-format vertical restraints in, 384
franchising, 390 Gertner, Robert H., 469–471
tying and, 393, 399–403 Gilbert, Richard, 554
in United States, 387–392 Gillette, 268
Frandata Corporation, 395–396 Glaxo, 101
Freedom of Information Act of 1966, 519 Goeree, Jacob K., 500
Free-riding, 278–281 Gonzalez, Tanja Artiga ???, 589, 607
in brand image retail services, 280–281 Google, 176, 260, 272
certification services and, 280–281 Gould, J. R., 287
in retail services, 278–279 Gould, Jay, 128
“showrooming,” 279 Governance. See Corporate governance and
Freiburg School. See Ordoliberalism compliance
French Association for Standardization, 557 Graham, D., 502, 504–506
Friedman, James W., 478 Granitz, Elizabeth, 67
Froeb, Luke M., 453, 523, 535, 542 Grantback provisions, intellectual property
FTC. See Federal Trade Commission rights and, 140–141
Fudenberg, Drew, 492 Great Atlantic and Pacific Tea Company
Fuji Iron and Steel Company, 193 (A&P), 43, 58, 268
Fuller, John, 598 Great Britain. See United Kingdom
GREE, 209
Gabel, H. Landis, 598 Green, Edward J.
Gal, Michal S., 159 on collusion, 421
Gallo, Joseph C., 444 on corporate governance and
Game theory compliance, 587
“burning the dollar” game, 491 on screening, 530, 532
collusion and, 416–417 on tacit collusion, 464, 471, 476–477, 479, 490
tacit collusion and, 478–479 Greenstein, Shane, 554
Garces-Tolon, E., 494 Grimes, Warren, 403
Gasoline industry, tacit collusion in, 473–474 Günster, Andrea, 596
Gates, Bill, 338
Geis, Gilbert, 598 Haltiwanger, John, 419
Geist, A., 547, 549 Han, Martijn A., 588
Geithman, Frederick E., 395 Hanazono, Makoto, 423
General Agreement on Tariffs and Trade Hand, Learned, 126
(GATT), 193 Harm to consumers, 30
General Electric, 368, 444 Harper, Martha Matilda, 389
Genesove, David, 452, 539, 542, 599 Harper Beauty Shops, 389
Geradin, Damien, 180 Harrington, Joseph E., Jr.
Gerlach, Heiko, 415, 420, 423, 430–431, 587 on cartels, 419, 422, 427–429, 432–433, 446,
Germany 452, 457
antitrust law in, 163 on corporate governance and
cartels in, 444–445, 455 compliance, 600
Competition Authority, 608 on screening, 531–532
corporate governance and compliance on tacit collusion, 477
in, 588 Harris, H. Stephan, 195
franchising in, 388 Harris, J. H., 523, 525
630 Index
Harsanyi, John C., 487–488 ICN. See International Competition Network

Hart-Scott-Rodino Act of 1976, 268 Idiosyncratic per se rule, tying and, 330–331
Hatch-Waxman Act of 1984, 68, 143, 149 IEC (International Electrochemical
Health insurance, exclusive dealing Commission), 556
in, 314–315 IFA (International Franchise
Health maintenance organizations Association), 395–396
(HMOs), 95 Image Technical Service, 401
Hearing aid industry, exclusive dealing IMF (International Monetary Fund), 193
in, 307–309 Imhof, Lorens A., 492
Heeb, Randall, 3, 365 Imperfect observability and monitoring,
Heide, Jan B., 304, 394 collusion and, 420–422
Heimler, Alberto, 234, 250 Implicit bundling, 104–105
Hemphill, C. Scott, 56 Incentive pay, 590–591
Hendricks, Ken, 498, 506, 541, 587 Incomplete information and communication,
Herling, John, 598 collusion and, 422–423
Hewlett-Packard, 92, 556 India
Heyer, Ken, 370 abuse-of-dominance in, 236–237, 245–248
Higgins, Richard S., 62 Competition Act of 2002, 245, 247
High-technology markets, tying in, 345–346 Competition Commission, 246–247
Hildebrand, V., 538, 547 MCX Stock Exchange, 247
Hillman, Arye L., 564 National Stock Exchange, 247
Hinloopen, Jeroen, 436 Indian Head, 562
HMOs (Health maintenance Industry standard setting. See Standard setting
organizations), 95 Inference, screening as problem of, 525–530
“Hold-up problem,” 7n10 Bayesian hypothesis testing and, 525–528
Hopenhayn, H., 507–509 testing versus screening, 528–530
Hörner, J., 480 Information deficiencies, dominant firms
Housekeeper (software), 229–230 and, 168–169
Hovenkamp, Erik, 329 Initial capital investment as communication of
Hovenkamp, Herbert tacit collusion, 490–491
on exclusive dealing, 320 Injunctions, patents and, 572–574
on innovation, 132, 148 Innovation, 132–149
on predatory pricing, 50, 53 aggressiveness of antitrust law and, 145–148
on quantity commitment discounts, 94 dominant firms and, 171–178
on tying, 329, 334, 338, 343, 345–347 intellectual property rights and, 134–141
on vertical restraints, 380 leniency toward joint conduct, role of
Howard Johnson, 389 antitrust law in, 144–145
Hu, A., 518 overview, 132–134, 148–149
Hub-and-spoke cartels, 128–129 patents and, 134–141
Hubei Salt Industry Group, 224–225 penalizing noncompetitive practices, role of
Huck, Steffen, 434 antitrust law in, 143–144
Hungary, abuse-of-dominance in, 237 role of antitrust law in promoting,
Hüschelrath, Kai, 600, 608 141–148
Husted, Thomas A., 433 Intel Corporation, 92, 95, 101, 176–177,
204–205, 260
Iacobucci, Edward M., 351 Intellectual property rights
Ichitaro (software), 206 bundling, 343–344
Index 631
in China, 225–226 Japan

empirical evidence, 138–139 Act against Delay in Payment of
in EU, 142, 146–147 Subcontract Proceeds, Etc. to
exclusive rights in, 135–136 Subcontractors, 192
grantback provisions and, 140–141 Action of Prohibition of Privation
innovation and, 134–139 Monopolization and Maintenance of Fair
patents. See Patents Trade (AMA), 188–197, 199, 201–203,
prospect theory and, 137–138 209–210, 230–231
relationship with antitrust law, 139–141 below-cost pricing in, 202–203
social benefits versus social costs, 136–137 cartels in, 191, 445
standard setting and, 567–580 China compared, 230–232
venture capitalists and, 138 civil procedure in, 199
Internal monitoring, screening in, 607–608 competition policy versus industrial policy
International Competition Network in, 193
(ICN), 234, 237–240, 449 control in, 201
International Electrochemical Commission corporate governance and compliance
(IEC), 556 in, 588
International Franchise Association discriminatory treatment in, 207–209
(IFA), 395–396 enforcement structure in, 195–199
International Monetary Fund (IMF), 193 entrepreneurs in, 200
International Organization for EU enforcement structure compared, 201
Standardization (ISO), 555–557 exclusionary conduct in, 200–209
International Telecommunications Union exclusive dealing in, 203–205
(ITU), 556–557 Fair Trade Commission, 189–190, 193–210,
International Trade Commission (ITC), 68, 231
573, 581 future trends, 209–210
Internet Guidelines for Exclusionary Private
distribution restrictions, 367 Monopolization under the
online retailing, resale price maintenance Antimonopoly Act, 200–204, 206–207,
(RPM) of, 277–301. See also Resale price 231–232
maintenance (RPM) historical background of AMA, 190–194
Internet Explorer, 175, 259, 561, 565 Intel, 204–205
Interoperability standards, 555 Intellectual Property Guidelines, 209
Isaac, R. Mark, 466, 515–517 JASRAC, 205
ISO (International Organization for Law of the Elimination of Excessive
Standardization), 555–557 Concentration of Economic Power
Italy, screening in, 606 (LECP), 191, 193
ITC (International Trade Commission), 68, Microsoft, 206
573, 581 Ministry of Internal Affairs and
ITU (International Telecommunications Communications, 208
Union), 556–557 Ministry of International Trade and
Ivaldi, Marc, 469, 494 Industry, 191
Ivoclar, 322–324 monopoly in, 188–210
1977 Amendment to AMA, 193–194
Jamaica, abuse-of-dominance in, 237, original AMA, 190–193
240–241 overview, 188–190, 209–210
Jamison, Julian, 480 particular field of trade in, 201–202
632 Index
private monopolization in, 199–202 price fixing and, 605

procedures in monopoly cases, 196 quality commitment discounts and, 93–94,
refusal to supply in, 207–209 110, 112–114, 116–117
sanctions in, 196–199 RRC theory and, 67
screening in, 606 screening and, 523, 534, 606–607
Shinpan hearings, 196 standard setting and, 565, 579–580
SSNIP test, 201–202 tacit collusion and, 477
Structural Impediments Initiative, 194 vertical restraints and, 353
substantial restraint of competition in, 202 Just Systems, 206
Supreme Commander of Allied Forces
and, 191 Kandori, Michihiro, 492
Supreme Court, 196, 202, 208 Kaplow, Louis, 425
surcharges in, 196–199 Karpoff, Jonathan M., 596
Toshiba Elevator, 206–207 Kaserman, David L., 596
tying in, 205–207 Katz, Michael L., 554
US enforcement structure compared, 189, Kell West Regional Hospital, 112–113
201 Kim, J., 517–518
Japanese auction, 499 Kime, Posey T., 190
Japanese Industrial Standards Committee, 557 Kitch, Edmund, 137
Japanese Society for Rights of Authors, Klein, Benjamin
Composers and Publishers on exclusive dealing, 304, 325
(JASRAC), 205 on franchising, 389
JEDEC (Joint Electron Device Engineering on quantity commitment discounts, 99
Council), 575 on reputation effects, 595
Jenny, Frédéric, 418 on resale price maintenance, 277
Jiménez, J. L., 539, 545 on RRC theory, 67
John Hancock, 314 on tying, 343
Johnson & Johnson, 95, 100–101, 105, 113 on vertical restraints, 363
Joint Economic Committee, 540 Klein-Murphy theorem, 368
Joint Electron Device Engineering Council Klemperer, Paul, 266
(JEDEC), 575–576 Klevorick, Alvin K., 48, 50, 56
Joint venture, standard setting as, 559–561 Klor's, 123–125
Joskow, Paul L., 48, 50, 56 Kodak, 58, 377, 401–402, 408
Juang, Wei-Torng, 492 Koller, Roland H., 43
Judge, George, 606, 609–610 Koukou Guard (software), 229
Jullien, Bruno, 423–424 Kovacic, William, 429–430, 465, 526, 528
Justice Department (DOJ) Koyak, Robert A., 453, 535, 542
bid rigging and, 514, 604 Kraakman, Reiner, 591
cartels and, 444–445, 448, 454, 456–457, Krattenmaker, Thomas G., 65, 127
459, 589, 591 Kreps, David, 44
CRRs and, 89–90 Krishna, Vijay, 479
exclusive dealing and, 314–315 Krishnan, Ranjani, 364
intellectual property rights and, 139–140 Kroc, Ray, 396
Japanese enforcement structure Kwasnica, A., 516–517
compared, 195
Merger Guidelines. See Merger Guidelines Lafontaine, Francine, 343, 371, 387, 400, 405
monopolization and, 155 Laitenberger, Ulrich, 600
Index 633
Lambson, Val E., 479 Mandatory purchase requirements in

Lande, Robert H., 454, 596 franchising, 401
Landeo, Claudia M., 315–316 MAP (Minimum advertised price)
Langus, Gregor, 596 policies, 291–292
Lanham Act of 1946, 399 Margolis, Stephen E., 345
Larouche, Pierre, 153 Market power
Latvia, abuse-of-dominance in, 238, 241 enhanced market power, exclusionary
Lawrence, Paul R., 599 conduct and, 30
Lee, D. Scott, 596 tying and, 332–333
Leegin Creative Products, Inc., 403–404 Market share, screening for, 605
Leffler, K., 595 Market share discounts
Lemley, Mark A., 138, 555 CRRs and, 90n2
Leniency programs as exclusionary conduct, 5n5, 18n37, 32n57
cartels and, 424–430, 435–437 Markey, Edward, 524
experimental evidence, 435–437 Marshall, Robert C.
Lenovo, 101 on bid rigging, 501–506, 511–512, 517
LePage's, 91, 105 on corporate governance and
Lerner Index, monopsony and, 73 compliance, 587
Levenstein, Margaret C., 442, 443–445, on screening, 531, 533, 548
447–448, 451–452, 454–457, 587 on tacit collusion, 464, 472–473
Leverage theory, tying and, 333–334 Martin, Gerald S., 596
Levin, J., 513–514 Marvel, Howard P., 287, 304, 308, 364, 365, 399
LIBOR, screening and, 536–538, 606–607, Marx, Leslie M.
609–610 on bid rigging, 501–503, 505–506, 517
Liebowitz, Stan J., 345 on corporate governance and
Liefmann, Robert, 444 compliance, 587
Lin, Ping, 188 on screening, 531, 533, 548
Lipman, Barton L., 492–493 on tacit collusion, 464, 472–473
Li Qing, 219 Mason, Charles F., 434–435
Liquidated damages, 317n40 Masten, Scott E., 317
Lithuania, abuse-of-dominance in, 237 Master Kang, 217–218
Localized price cutting, 43n7 Mathematical laws, screening based on, 606
Lock-in doctrine, 332 Matsushima, Hitoshi, 420
Long, Clarisa, 138 Matutes, Carmen, 555
“Long purse” theory, 42, 45 Mayer Laboratories, 326
Lopatka, John E., 72 Mazzeo, Michael J., 253
Lopomo, G., 505–506 McAfee, R. Preston, 498, 505, 507–508, 587
Lotus 1-2-3 (software), 206 McCafferty, Stephen, 287
Loyalty contracts, 351 McCormick Harvesting Company, 388
Loyalty discounts McDevitt, Ryan C., 253
economics of, 100–102 McDonald's, 343, 354, 389, 396, 405
as exclusionary conduct, 5n5, 18n37, 32n57 McGee, John S., 40–45, 48, 51, 56
LTE, 558, 569 McGuire Act of 1952, 373
McMillan, J., 505, 507–508
Magrane-Houston, 379 Medco, 101
Mailath, George J., 492, 505–506 Medicaid, 314
Malik, Arun, 425 Medicare, 314
634 Index
Mehta, Kirtikumar, 234, 250 Business strategy

Merger Guidelines in China, 210–232. See also China
Japanese enforcement structure in developing countries, 234–251. See also
compared, 201 Abuse-of-dominance
tacit collusion and, 477 dominant firms, 153–184. See also
Mergers. See also Vertical mergers Dominant firms
in EU, 269n9 exclusionary conduct and, 3–36. See also
Mestmäcker, Ernst-Joachim, 156–157, 163 Exclusionary conduct
“Metering,” 334–335 innovation and, 132–149. See also
Metz, Albert, 537, 543, 609–610 Innovation
Meurer, Michael J., 138 in Japan, 188–210. See also Japan
Mexico predatory buying, 72–87. See also Predatory
abuse-of-dominance in, 237 buying
cartels in, 454n33 predatory pricing, 40–58. See also
Competition Commission, 454n33 Predatory pricing
screening in, 524, 606 quantity commitment discounts, 89–117.
Michael, Steven C., 400 See also Quantity commitment discounts
Microsoft RRC theory and, 62–70. See also Raising
competition on merits and, 175 rivals' costs (RRC) theory
competitive advantage and, 272 squeeze claims, 120–129. See also Squeeze
as dominant firm, 176–177 claims
exclusive dealing and, 319n44 Monopsony
intellectual property rights and, 141 competition compared, 74
in Japan, 206 dominant buyer and, 75–76
RRC theory and, 64 economics of, 73–77
standard setting and, 565–566 input markets and, 74–76
tying and, 338 Lerner Index and, 73
unilateral squeezing and, 126 output markets and, 76–77
value creation and capture framework predatory buying and, 72–73. See also
and, 259 Predatory buying
vertical restraints and, 372, 378, 384 Morse, Adair, 599
Microsoft Office (software), 556 Morton Salt, 345–346
Microsoft Word (software), 206 Mossel Jamaica Limited, 240
Middle management, corporate governance Motchenkova, Evgenia, 595
and compliance and, 593–594 Motion Picture Patents Company, 399
Miksch, Leonhard, 178–179 Motorola, 572
Milgrom, Paul, 53, 499–500 Motta, Massimo, 428–430, 596
Miller, D., 536, 543 Mueller, Willard F., 395
Miller, Nathan H., 457 Mullin, Wallace P., 452, 539, 542, 599
Miller-Tydings Act of 1937, 373 Multimarket contact, collusion and, 419–420
Mills, David E., 40 Muris, Timothy J., 68
Minimum advertised price (MAP) Murphy, Kevin M., 89, 99, 304, 325
policies, 291–292 Myerson, R., 500
Misuse, tying and, 345–346
Miwa, Yoshiro, 195 Naked exclusion theory of exclusive
Monopoly dealing, 313–316
business strategy and, 253–272. See also NASDAQ, screening and, 523–525, 540,
Index 635
606–607 Oechssler, Jorg, 434

Nash equilibrium Offerman, Theo, 500, 518
Bayesian Nash equilibrium, 488 Ohashi, Hiroshi, 188, 195
bid rigging and, 500, 504 Oligopoly, tacit collusion in, 464–494. See
cartels and, 426–428 also Tacit collusion
tacit collusion and, 469–470, 480–482, Oligopoly and the Theory of Games
490–493 (Friedman), 478
vertical restraints and, 370 Omnibus Trade Act of 1988, 194
National Electrical Code, 562 Onderstal, S., 518
National Fire Prevention Association, 562 One-shot auctions, bid rigging in, 504–507
National Industrial Recovery Act of 1933, 446 Online retailing, resale price maintenance
National Macaroni Manufacturer's (RPM) of, 277–301. See also Resale price
Association, 559 maintenance (RPM)
National Semiconductor, 574 Optical industry, exclusive dealing in, 310–311
NavTeq, 69 Orbach, Barak, 120
Negative contracting externalities, Ordoliberalism, 160–164
exclusionary conduct and, 7–13, 31–32 competition versus economic
Negotiated Data Solutions, 574 power, 162–163
Netherlands excessive pricing and, 178–179
cartels in, 596 as general legal and economic
screening in, 606 theory, 160–161
Netscape (browser), 338, 566 overview, 160, 164, 183–184
Neven, D., 494 in TFEU, 163–164
New York Transportation Department, threat from economic power and, 161–162
510–511, 541 Ordover, Janusz A., 42, 44, 50, 65, 235
Nigrini, Mark, 606 Organization for Economic Cooperation and
Nihon Network Vision, 203 Development (OECD) Global Forum on
Nike, 299 Competition Policy, 240–241
“Nine No-Nos,” 139–140 Over, Mead, Jr., 449
Nippon Soda, 449 Overpurchasing model, RRC theory
Nippon Steel, 193 compared, 64
Nippon Telegraph, 208
Nocke, Volker, 423 Package licensing, 343–344
Nokia, 69 Pareto efficiency, vertical restraints and, 358
Nold, Frederick C., 431, 453 Parker, Christine, 598
Nonlinear pricing schedules, 351 Partial exclusive dealing, 304
Normann, Hans-Theo, 434 Partial exclusivity discounts as exclusionary
Norm creation, 594–595 conduct, 5n5, 18n37, 32n57
Nowell, Clifford, 435 Patent Act of 1952, 139n15, 143, 330–331, 345
Number of firms, collusion and, 418 Patent and Trademark Office, RRC theory
Nurski, Laura, 395, 407 and, 67
Patents
O'Brien, Daniel P., 355, 371 cross-licenses of, 571–572
Observable posted prices, tacit collusion empirical evidence, 138–139
and, 473–474 ex ante bargaining and, 579–580
OECD Global Forum on Competition exclusionary conduct and, 4n3
Policy, 240–241 exclusive rights in, 135–136
636 Index
failure to disclose standard-essential allocative distortion, 80

patents, 574–577 caselaw, 77–78
injunctions and, 572–574 completely different rivals and monopoly
innovation and, 134–141 power, 82–84
overly broad declarations of completely different rivals and no
standard-essential patents, 577–579 monopoly power, 78–82
package licensing of standard-essential dominant seller and, 83
patents, 577–579 economics of, 73–77
prospect theory and, 137–138 monopsony and, 72–73
reasonable and non-discriminatory no allocative distortion, 79
licensing commitments, 569–574 overview, 72–73, 87
royalties, 570–571 same competitors in input and output
sale and assignment of, 574 markets, 84–86
social benefits versus social costs, 136–137 Predatory pricing, 40–58
standard setting and patent Areeda-Turner rule, 47–49, 52–54
holdup, 568–569 Brooke Group, 49–53
venture capitalists and, 138 in China, 218
Pathmark, 268 economics of, 41–45
Pearce, David G., 479, 482, 490 enforcement and, 45–49
Peck, James, 364 in EU, 46, 51
Peltzman, Sam, 443 as exclusionary conduct, 17–18, 21
PepsiCo, 35, 95, 270, 283 intent, 46–47
Perdiguero, J., 539 localized price cutting, 43n7
Pereira, P., 540 “long purse” theory, 42, 45
Peru, abuse-of-dominance in, 241 overview, 40–41, 57–58
Pesendorfer, M., 514–515, 517 price-cost comparisons in, 49–50, 54–56
Petroleum Marketing Practices Act of 1978, recoupment in, 50–51, 56–57
398 Preston, L. E., 287
Philips, 578 Price ceilings, 352
Phillips, Owen R., 434–435 Price-cost comparisons in predatory
Phlips, Louis, 49 pricing, 54–56
Pinto, Brijesh P., 523 Price discrimination
Pioneer Foods, 248 in China, 220–221
Pitofsky, Robert, 280, 287 tying and, 334–337
Pittman, Russell, 235 Price fixing
Plastic bags, tacit collusion and, 474–477 screening for, 604–605
Plott, Charles R., 466, 515–516 standard setting as venue for, 559
Poland, abuse-of-dominance in, 237 Price floors, 352
Polo, Michele, 428–430 Price leadership, tacit collusion and, 472n17,
Porter, Michael, 255–260, 263 477–478
Porter, Robert H. Price setting by cartels, 449–452
on bid rigging, 506, 510–511, 513 Price squeezes, 121
on cartels, 421 Pricing, predatory. See Predatory pricing
on screening, 530, 532, 541, 545–546 Princo, 578–579
on tacit collusion, 471, 476–477, 479, 490 Private value auction, 499–500
Posner, Richard A., 444, 493 Procompetitive nature of exclusionary
Predatory buying, 72–87 conduct
Index 637
examples, 34–35 demand effects and, 64

overview, 32–34 efficiencies and, 64
Procter & Gamble, 268 limitations of, 65–66
Producer surplus, 255, 258–260 overpurchasing model compared, 64
Production cost efficiencies, 342 overview, 70
Property right creation, exclusive dealing policy implications of, 67–68
as, 307–311 strengths of, 65
Prospect theory, patents and, 137–138 vertical mergers and, 68–70
PSKS, Inc., 403–404 Rajgopal, Shivaram, 599
Purchase share discounts as exclusionary Rambus, 575–576
conduct, 5n5, 18n37, 32n57 Ramey, Garey, 516
Ramseyer, J. Mark, 195, 313–316
Qihoo 360 (software), 229 RAND (Reasonable and non-discriminatory)
Qualcomm, 576 licensing commitments. See Patents
Quality and safety standards, 555 Rapson, David, 541
Quality control efficiencies, 342–343 Rasmusen, Eric B., 313–316
Quantity commitment discounts, 89–117 RealNetworks, 319n44
attribution test for exclusion, 105–109 Reasonable and non-discriminatory (RAND)
bundling and, 102, 104–105 licensing commitments. See Patents
contracts that reference rivals Recession, effect on formation of
(CRRs), 89–90 cartels, 447–449
demand curves and, 95–97 Recoupment in predatory pricing, 56–57
division of gains from, 98–100 Refusals to deal
economics of, 94–102 in China, 221–222
economies of scale and, 103n33 overview, 121
exclusionary conduct and, 102 Refusal to supply in Japan, 207–209
flaws with attribution test, 111–116 Regibeau, Pierre, 555
foreclosure and, 102 Remedies
HMOs and, 95 in Japan, 196–199
indicators of harm to competition, 116 liquidated damages, 317n40
legal context, 91–94 tying, 347–348
liability thresholds and attribution test, 110 Renren, 245
loyalty discounts, 100–102 Repeated auctions, bid rigging in, 507–510
mutual gains from, 95–98 Resale price maintenance (RPM)
overview, 89–91, 117 anticompetitive motivations for, 292–297
policy context, 91–94 antitrust standard of analysis, 297–298
potential harm to competition, 102–105 brand image retail services, control of
tests for harm to competition, 105 free-riding in, 280–281
uses of attribution test, 111–116 certification services and, 280–281
Queen City Pizza, 343, 402, 408 compensation of retailers for providing
interbrand retailing services, 283–286
Raiff, M., 531, 548 discretion over retail services with
Railroad industry, concerted squeezing interbrand but not interretailer demand
in, 128 effects, 281–283
Raising rivals' costs (RRC) theory, 62–70 effective retail distribution,
assessment of, 65–66 preserving, 281–292
counterstrategies, 64 in EU, 297–301
638 Index
Resale price maintenance (RPM) (cont.) See also Resale price maintenance (RPM)
franchising and, 393, 403–405 RRC theory. See Raising rivals' costs (RRC)
free-riding, control of, 278–281 theory
impulse purchases and, 287 Rubinstein, Ariel, 488
manufacturer control of online retailing Rule-of-reason analysis
and, 299–301 in China, 216–217
manufacturer-motivated, 292–294 exclusionary conduct, 4–6
manufacturer's distribution network Russia
damaged by retailer price abuse-of-dominance in, 236, 241–244
discounting, 286–289 Federal Antimonopoly Service, 242, 244
minimum advertised price (MAP) policies
and, 291–292 Sabourian, Hamid, 492
of online retailing, 277–301 Saft, Lester F., 343
outlets hypothesis, 287 Saks Fifth Avenue, 367
overview, 277–278, 301 Salant, Steven W., 431
procompetitive rationales for, 298–299 Salinger, Michael A., 342
protection of retail distribution network, Saloner, Garth, 44, 65, 419, 530, 532, 554
use for, 289–292 Salop, Steven C., 52, 65–66, 127, 312
regulation of, 297–301 Samuelson, W., 500
retailer-motivated, 294–297 Sanchirico, Chris, 422, 508, 530, 533
retail services, control of free-riding Sanctions in abuse-of-dominance
in, 278–279 cases, 249–250
“showrooming,” 279 San Francisco Peace Treaty, 191
slotting allowances and, 285 Sannikov, Yulij, 421
in United States, 297–301 Sass, Tim R., 394, 398
vertical restraints and, 368, 372–374 Saurman, David S., 398
Restraint of trade in Japan, 202 Scalia, Antonin, 172, 415n1
Rey, Patrick, 369, 418, 423–424, 429–430 Scharfstein, David, 588
Rey-Stiglitz theorem, 369 Schechter, Laura, 606
Rhône-Poulenc, 449, 457 Scheffman, David T., 62, 65–66, 312, 453
Richard, J.-F., 502, 511–512 Scheinkman, Jose A., 479
Riley, John G., 500, 564 Schelling, Thomas, 478
Riordan, Michael H., 52 Schenone, P., 479
Risk dominance as obstacle to tacit Scherer, Frederic M., 47, 288, 478
collusion, 486–490 Schinkel, Maarten Pieter, 153
Risk-sharing, tying and, 344–345 Schmalensee, Richard, 334
Rob, Rafael, 492 Schmidt, Klaus M., 588
Roberts, John, 53 Schott Glass, 246
Rodger, Barry J., 598 Schultz, Paul H., 523–525, 540, 545, 606
Rojas, Christian, 434 Schumpeter, Joseph, 137, 148, 171
Romania, abuse-of-dominance in, 237 Schwartz, W., 65
Rosenfield, Andrew M., 469–471 Scott Morton, Fiona, 254
Rotemberg, Julio J., 419, 530, 532 Screening, 523–551
Royalties Bayesian hypothesis testing and, 525–528
patents, 570–571 in Bertrand markets, 530, 541
vertical restraints and, 351 for bid rigging, 602–604
RPM (Resale price maintenance), 277–301. in Brazil, 524, 606
Index 639
in Canada, 606 Shanghai Xuanting Entertainment Co.

cartels and, 430–433 Ltd., 244
collusive markets other than price screens, Shapiro, Carl, 147–148, 554–555
based on, 548–549 Shavell, Steven, 425
compliance, use in, 608–609 Shenzhen Tencent Computer System Co.
in corporate governance and Ltd., 228
compliance, 600–610 Sherman Act of 1890
in Cournot markets, 530 attempted monopolization under, 156
empirical screens, 534 collusion under, 415
first and second moments of price competition on merits under, 158
distribution, based on, 534–540 decision theory and, 169
in Germany, 608 dominant firms under, 153–184. See also
inference, as problem of, 525–530 Dominant firms
in internal monitoring, 607–608 exclusive dealing and, 305–306
in Italy, 606 franchising under, 395
in Japan, 606 intellectual property rights and, 140–142
LIBOR and, 536–538, 606–607, 609–610 Japanese antitrust law compared, 189
for market share, 605 monopolization under, 154–155
mathematical laws, based on, 606 patents and, 139n15
in Mexico, 524, 606 predatory pricing under, 40, 45, 52, 58
NASDAQ and, 523–525, 540, 606–607 quality commitment discounts and, 110
in Netherlands, 606 special responsibility of dominant firms
overview, 523–525, 549–550 under, 157
for price fixing, 604–605 standard setting and, 562, 574
in South Africa, 606 tacit collusion and, 464, 493
structural models, based on, 540–548 tying under, 330–331
success of, 606–607 vertical restraints under, 372, 379
testing versus, 528–530 Shire, 123
theoretical screens, 530–534 “Showrooming,” 279
SCSI (Small Computer Systems Interface), 555 Sibley, David S., 523
Seabright, Paul, 494 Sidak, Joseph G., 431, 453
Sealy, 395 “Signal jamming problem,” 27n48
Second-price sealed-bid (SPSB) Simcoe, Timothy, 555, 567
auction, 499–500, 504–505 Sinclair, 394
Securities and Exchange Commission, Singer Sewing Machine Company, 388
screening and, 523, 606–607 Single-product pricing as exclusionary
Seira, E., 513–514 conduct, 18, 24
Self-distribution, tying and, 344–345 Sivadasan, Jagadeesh, 454
Selten, Reinhard, 44, 436–437, 487 Skrzypacz, Andrzej, 421–422, 452, 507–509
Senegal, abuse-of-dominance in, 241–242 Slade, Margaret E., 371, 387
Senior management, corporate governance Slotting allowances
and compliance and, 592–593 resale price maintenance and, 285
Separate products test, tying and, 341 unilateral squeezing and, 127n34
Shanda Interactive Entertainment Ltd., 244 as vertical restraints, 352
Shandong Weifang Shuntong Pharmaceuticals Slovak Republic, abuse-of-dominance in, 237
Co., Ltd., 223–224, 245 “Small but significant and nontransitory increase
Shane, Scott, 395–397 in price” (SSNIP) test, 201–202, 216
640 Index
Small Computer Systems Interface (SCSI), 555 Standard auction models, 499–500
Smith, Richard L., II, 398 Standard Fashion, 379
Snider, Connan, 609 Standardization Administration of China, 557
Snyder, Edward A., 89, 317 Standard Oil Company, 41–42
Soetevent, Adrian, 436 Standard setting, 554–581
Soft drink industry, exclusionary conduct compatibility standards, 555
in, 35 corruption of process, 561–565
Sokol, D. Daniel, 586, 595, 598 development of standards, 555–557
Sonnenfeld, Jeffrey, 599 disparagement of alternative proposals
Sony, 204, 578 and, 564–565
South Africa ex ante bargaining and, 579–580
abuse-of-dominance in, 237–238, 241, exclusionary conduct, as venue for, 559
248–249 failure to disclose standard-essential
Competition Authority, 606 patents, 574–577
Competition Commission, 248 intellectual property rights and, 567–580
Competition Tribunal, 249 interoperability standards, 555
screening in, 606 as joint venture, 559–561
South African Airways, 248 overly broad declarations of
South Korea, corporate governance and standard-essential patents, 577–579
compliance in, 600 overly broad standard
Southwest Airlines, 265 specifications, 577–579
Spagnolo, Giancarlo, 420, 429, 457, 588 overview, 554–555, 580–581
Spar, Debora L., 445 package licensing of standard-essential
Special responsibility of dominant firms, 157, patents, 577–579
166–167 patent holdup and, 568–569
Spengler, Joseph, 355 price fixing, as venue for, 559
Spier, Kathryn E., 315–316 quality and safety standards, 555
SPSB (Second-price sealed-bid) reasonable and non-discriminatory
auction, 499–500, 504–505 licensing commitments, 569–574
Spulber, Daniel F., 431–432 types of standards, 555
Squeeze claims, 120–129 unilaterally determined standards, 565–567
cartels and, 128–129 vote stacking and, 561–564
concerted squeezing, 122–125, 128–129 Standard-setting organizations (SSOs)
essential facilities, 121 ANSI-approved SSOs, 557
in nonintegrated firms, 127 competition principles, 557–565
overview, 120–122, 129 innovation and, 144, 146
price squeezes, 121 international SSOs, 556
railroad industry and, 128 national SSOs, 557
refusals to deal, 121 regional SSOs, 557
slotting allowances and, 127n34 Steiner, Peter O., 360
unilateral squeezing, 122–127 Stewart, Potter, 116
in vertically integrated firms, 125–127 Stigler, George J., 455, 465, 470, 478, 518–519,
SSNIP (“Small but significant and 530
nontransitory increase in price”) Stiglitz, Joseph, 369, 423
test, 201–202, 216 Stock-based cartel event studies, 595–596
SSOs. See Standard-setting organizations The Strategy of Conflict (Schelling), 478
Stacchetti, Ennio, 479, 490 Strong explicit collusion, 468–477
Index 641
Structural Impediments Initiative, 194 self-enforcement of, 479n26, 480–482

Sumitomo, 449 strong explicit collusion versus, 468–477
Summit Technology, 578 unobservable bid prices and, 474–477
Sun, P., 505 weak explicit collusion versus, 468–477
Super 301, 194 Taiwan, abuse-of-dominance in, 241
Suppiger, 345–346 Tan, G., 506
Suslow, Valerie Y., 442, 443–445, 447–448, Tan, Tommy C.-C., 483
451–452, 454–457, 587 Tarbell, Ida M., 41
Sustainability of competitive TeleAtlas, 69
advantage, 264–266 Telephone East Corporation, 208
Sutton, John, 454 Telser, Lester, 368
Sweden, cartels in, 443–444 Tencent Technology Co. Ltd., 216, 228–230
Switzerland, corporate governance and Tennessee Valley Authority, 603
compliance in, 598 Terminal Railroad Association of St.
Sylvania, 375 Louis, 128
Symeonidis, George, 443, 455 Territorial restraints, 352, 364–365, 369
Symmetry, collusion and, 418 Testing versus screening, 528–530
Synergies, 267–268 TFEU. See Treaty on the Functioning of the
European Union
Tacit collusion, 464–494 Thompson, John S., 596
antitrust litigation and, 493–494 3M, 91, 105
“arrive by reasoning,” 482–486 TIBOR, 607
Bayesian Nash equilibrium, 488 Tiffany, 367
blundering into, 492–493 TOK, 242
“burning the dollar” game and, 491 Tom Tom, 69
communication in, 466–468 Topel, Robert H., 89
convergent-elimination view, 483–486 Toshiba, 204
defined, 464 Toshiba Elevator, 206–207
direct interaction and, 467n7 Toys “R” Us, 129
economics versus legal terminology, 467 Trade-offs in business strategy, 257–258
evolution of theory, 477–480 Traditional franchising, 390
express agreements and, 467n6 Transitions Optical, 310–311
focal points and, 477–478, 483–486 Treaty of Rome (1957), 179
folk theorem and, 469, 479–480 Treaty on the Functioning of the European
game theory and, 478–479 Union (2009)
in gasoline industry, 473–474 abuse under, 154–155
illustrations, 473–477 collusion under, 415
initial capital investment as competition on merits under, 158, 174
communication, 490–491 decision theory and, 166–171
initial phase of collusion, 480–493 dominant firms under, 153–184. See also
Nash equilibrium and, 469–470, 480–482, Dominant firms
490–493 excessive pricing and, 178–181
observable posted prices and, 473–474 exclusive dealing and, 306–307
overview, 464–468 exploitative abuses under, 155–156
plastic bags and, 474–477 intellectual property rights under, 147n37
price leadership and, 472n17, 477–478 interaction between dominant firms
risk dominance as obstacle to, 486–490 and, 176–177
642 Index
Treaty on the Functioning of the European Ukraine, abuse-of-dominance in, 238

Union (2009) (cont.) UNCTAD (United Nations Conference on
ordoliberalism in, 163–164 Trade and Development), 236
predatory pricing under, 46 Unilateral squeezing, 122–127
protection of competitive process concerted squeezing compared, 122–125
under, 158–159, 173–174 in nonintegrated firms, 127
special responsibility of dominant firms slotting allowances and, 127n34
under, 157 in vertically integrated firms, 125–127
vertical restraints under, 372, 374 Union Oil Company of California, 575
Turner, Donald F., 46–47, 49, 54, 493 United Kingdom
Twitter, 176 Board of Trade, 443
Tyco, 95 cartels in, 443–444
Tying, 329–348 Competition Act of 1998, 598
in China, 224–225 Competition Commission, 407
of complements, 339–341 corporate governance and compliance
damages, 347–348 in, 597–598, 600
double marginalization and, 339–341 Office of Fair Trading, 407, 598
economies of joint provision and, 341–344. vertical restraints in, 353
See also Economies of joint provision United Nations Conference on Trade and
effects of, 333–338 Development (UNCTAD), 236
as exclusionary conduct, 5n6, 19, 25 United Regional Health System, 112–113,
foreclosure and, 337–338 314–315
franchising and, 393, 399–403 United States. See also specific Act or
in high-technology markets, 345–346 governmental entity
identification of, 329–330 abuse-of-dominance standard in, 236
idiosyncratic per se rule and, 330–331 bid rigging in, 501–502
in Japan, 205–207 cartels in, 443–446
leverage theory and, 333–334 Chinese enforcement structure
lock-in doctrine, 332 compared, 225
market power and, 332–333 corporate governance and compliance
“metering,” 334–335 in, 597–598
minimum conditions for competitive dominant firms in, 153–184. See also
harm, 332–333 Dominant firms
misuse and, 345–346 franchising in, 387–392
motives, 333–338 Japanese enforcement structure
overview, 329–330, 348 compared, 189, 201
price discrimination and, 334–337 resale price maintenance in, 297–301
remedies, 347–348 vertical restraints in, 352–353, 366, 371–384
risk-sharing and, 344–345 United States Tobacco Company, 127, 325
self-distribution and, 344–345 Uno, Sosuke, 194
separate products test and, 341 Unobservable bid prices, tacit collusion
statutory coverage, 330–331 and, 474–477
variable proportion ties, 336 U.S. Steel, 58, 193
vertical restraints and, 352, 365–367, Usen Broadband Networks, 203
369–370, 376–378 Uzbekistan, abuse-of-dominance in, 237
Index 643
Value creation and capture exclusive territories and, 374–376

framework, 255–261 exclusivity restraints, 352, 365–367,
added value, 260–261 369–370
consumer surplus and, 255, 258–260 in Germany, 384
enhancing value creation, 256–258 Internet distribution restrictions, 367
“Five Forces,” 255, 258–260 law versus economics, 381–384
overview, 255–256 loyalty contracts, 351
producer surplus and, 255, 258–260 Nash equilibrium and, 370
rivalry and, 258–260 nonlinear pricing schedules, 351
Van Baal, Sebastian, 279 overview, 351–353, 381–384
van Damme, Eric, 488–489, 491 Pareto efficiency and, 358
van der Laan, Rob, 595 price ceilings, 352
van Dijk, Mathijs A., 596 price floors, 352
Variable proportion ties, 336 resale price maintenance and, 368, 372–374
Varian, Hal, 606 royalty contracts, 351
Varney, Christine, 93 single firm incentives, 359–364
Veith, Tobias, 608 slotting allowances, 352
Venture capitalists, patents and, 138 territorial restraints, 352, 364–365, 369
Verboven, Frank, 395, 398, 407 tying and, 352, 365–367, 369–370, 376–378
Vertical integration in United Kingdom, 353
exclusive dealing and, 304–326. See also in United States, 352–353, 366, 371–384
Exclusive dealing VHS videotapes, 558
franchising and, 387–410. See also Vickers, John, 51
Franchising Vickrey, W., 500
resale price maintenance (RPM), 277–301. Video Electronics Standards Association
See also Resale price maintenance (RPM) (VESA), 575
tying and, 329–348. See also Tying Villas-Boas, Sofia, 606, 609–610
unilateral squeezing and, 125–127 VISX, 578
vertical restraints, 351–384. See also Vertical Vita Zahnfabrik, 322–324
restraints Vladivostok Avia Open Co., 242, 244
Vertical mergers Volume discounts as exclusionary
collusion and, 423–424 conduct, 18n37, 24–25
RRC theory and, 68–70 Vote stacking, standard setting and, 561–564
Vertical restraints, 351–384
anticompetitive uses, 368–371 W
in Australia, 384 Walker, J., 516–517
buyback options, 352 Walmart, 268, 329
in Canada, 353, 372, 384 Weak explicit collusion, 468–477
collusion and, 423–424 Webb-Pomerene Act of 1918, 445
consignment selling arrangements, 352 Weber, R., 499–500
economics of, 353–367 Weifang Huaxin Pharmaceuticals & Trading
efficiencies and, 359–364 Co., Ltd., 223–224, 245
empirical evidence, 371 WellPoint, 269
in EU, 352–353, 366, 371–384 Wendy's, 354
exclusive dealing and, 379–381 Werden, Gregory L., 453, 535, 542
644 Index
Werlang, S.R. da Costa, 483 Woods, Sean, 555

Westinghouse, 368, 444 World Wide Web Consortium, 567, 569
Whinston, Michael D. Wuchang Salt, 224–225
on collusion, 416, 419, 434
on exclusive dealing, 311–312, 317 Xu Kunlin, 221
on Japan, 204
on tying, 334 Yamamoto, Y., 479
on vertical restraints, 370 Yamey, Basil, 43
White, Andrew, 555 Yang, Huanxing, 423
White, Lucy, 423 Yawata Iron and Steel Company, 193
Wiley, John S., Jr., 313–316 Ye, L., 514, 546, 548
Williams, Michael A., 498, 516, 587 Youle, Thomas, 609
Williamson, Oliver, 47–48, 360 Young, Peyton, 492
Willig, Robert D., 42, 50
Wilson, Robert, 44 Zambia, abuse-of-dominance in, 237, 241
WiMax, 558 Zanarone, Susanne, 398, 407
Windows (operating system), 175, 372, 378, Zemsky, P., 505–506
561, 565–566 Zhang, X. J., 217
Windows Media Player, 372, 378 Zingales, Luigi, 599
Winter, Ralph A., 351, 363–364 Zona, Douglas J., 510–511, 513, 541, 545–546

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10. Monopolization in Developing Countries 234

21. Screening for Collusion as a Problem of Inference 523

Rosa M. Abrantes-Metz, Adjunct Associate Professor, Stern School of Business,

RO GER D. BLAIR AND D. DANIEL SOKOL

Antitrust economics is a subset of industrial organization economics. What makes

B. D OUGLAS BERNHEIM AND RANDAL HEEB

“Exclusionary conduct” is a phrase commonly used to describe practices that a firm

appropriate when the conduct resembles modes of nonexclusionary competition that

1.2. Why Is Exclusionary Conduct

1.2.1. The Mechanism

harm in Regional Health (http://www.justice.gov/atr/cases/unitedregional.html).

Consequently, every customer would be better off if no deals were consummated;

anticompetitive and procompetitive exclusionary conduct (see Melamed 2005; Werden

1.2.2. Modes of Conduct That Potentially Implicate the

1.2.3. Practices That Involve Exclusionary Conditions

1.2.4. Practices That Do Not Involve Exclusionary Conditions

than that held by a textbook monopolist.

1.3. Evaluating Exclusionary Conduct

Having elaborated on the primary economic mechanism through which exclusionary

1.3.1. Determining Whether Conduct Is Exclusionary

Unfortunately, if the challenged conduct does not involve exclusionary conditions,

to gain positions of leadership in emerging industries, to benefit from learning-by-doing, or to generate

(because it reduces subsequent competition). And yet, there is no particular reason to

1.3.2. Determining If Exclusionary Conduct Has

lement 1: Diminished ability to compete

We will elaborate on each of these elements in turn.

1.3.2.1. Element 1 (Diminished Ability to Compete)

1.3.2.2. Element 2 (Enhanced Market Power)

1.3.2.3. Element 3 (Harm to Consumers)

1.3.2.4. Element 4 (Negative Contracting Externalities)

markets.” See Bernheim and Whinston (1999).

1.4. Determining If Exclusionary

circumstances, those inefficiencies may be reduced when the relationship excludes

requires an examination of the types of market imperfections and associated contract-

1.4.1. Some Illustrative Examples

1.5. Concluding Remarks

combination of both sound economic principles and reasonable, practical compro-

Farrell, Joseph. 2005. Deconstructing Chicago on Exclusive Dealing. University of California,

United States v. Grinnell Corp., 384 U.S. 563 (1966).

KENNETH G. ELZINGA AND DAVID E. MILLS

2.2. The Economics of Predatory

Esposito offer an alternative interpretation of events (2011, p. 245).

2.3. Predatory Pricing and Antitrust

2.4. Brooke Group

Robinson-Patman Act and Section 2 of the Sherman Act.

rule-of-reason analysis which vulnerable, inefficient, or disgruntled rivals should be pre-

2.5. Implementing Brooke Group

2.5.1. Price-Cost Comparisons

United States v. American Tobacco Company, 221 U.S. 106 (1911).

DAVID T. SCHEFFMAN AND RICHARD S. HIGGINS

3.1. Overview of Theory

3.1.1. The Theory Is More General Than the Model of

3.2. Demand Effects and Efficiencies

3.4.1. Strengths of the RRC Analysis

3.4.2. Limitations of the RRC Analysis

2 Particularly Salop and Scheffman (1987).

3.5. Policy Implications of RRC

0 Qf Qdf Q* Quantity

0 Qf Qdf Q* Quantity

0 Qf Qdf Q* Quantity

Qf ′ Qdf ′ Q*′

show the marginal revenue curve in fi gure 5.1 in order to reduce clutter.