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July 28, 2014

Conditional Pricing Practices and the Limits of Antitrust

By

The Federal Trade Commission’s (FTC) June 23 Workshop on Conditional Pricing Practices featured a broad airing of views on loyalty discounts and bundled pricing, popular vertical business practices that recently have caused much ink to be spilled by the antitrust commentariat.  In addition to predictable academic analyses featuring alternative theoretical anticompetitive effects stories, the Workshop commendably included presentations by Benjamin Klein that featured procompetitive efficiency explanations for loyalty programs and by Daniel Crane that stressed the importance of (1) treating discounts hospitably and (2) requiring proof of harmful foreclosure.  On balance, however, the Workshop provided additional fuel for enforcers who are enthused about applying new anticompetitive effects models to bring “problematic” discounting and bundling to heel.

Before U.S. antitrust enforcement agencies launch a new crusade against novel vertical discounting and bundling contracts, however, they may wish to ponder a few salient factors not emphasized in the Workshop.

First, the United States has the most efficient marketing and distribution system in the world, and it has been growing more efficient in recent decades (this is the one part of the American economy that has been a bright spot).  Consumers have benefited from more shopping convenience and higher quality/lower priced offerings due to the advent of  “big box” superstores, Internet sales engines (and e-commerce in general), and other improvements in both on-line and “bricks and mortar” sales methods.

Second, and relatedly, the Supreme Court’s recognition of vertical contractual efficiencies in GTE-Sylvania (1977) ushered in a period of greatly reduced potential liability for vertical restraints, undoubtedly encouraging economically beneficial marketing improvements.  A new government emphasis on investigating and litigating the merits of novel vertical practices (particularly practices that emphasize discounting, which presumptively benefits consumers) could inject costly new uncertainty into the marketing side of business planning, spawn risk aversion, and deter marketing innovations that reduce costs, thereby harming welfare.  These harms would mushroom to the extent courts mistakenly “bought into” new theories and incorrectly struck down efficient practices.

Third, in applying new theories of competitive harm, the antitrust enforcers should be mindful of Ronald Coase’s admonition that “if an economist finds something—a business practice of one sort or other—that he does not understand, he looks for a monopoly explanation.  And as in this field we are very ignorant, the number of ununderstandable practices tends to be rather large, and the reliance on a monopoly explanation, frequent.”  Competition is a discovery procedure.  Entrepreneurial businesses constantly seek improvements not just in productive efficiency, but in distribution and marketing efficiencies, in order to eclipse their rivals.  As such, entrepreneurs may experiment with new contractual forms (such as bundling and loyalty discounts) in an effort to expand their market shares and grow their firms.  Business persons may not know ex ante which particular forms will work.  They may try out alternatives, sticking with those that succeed and discarding those that fail, without necessarily being able to articulate precisely the reasons for success or failure.  Real results in the market, rather than arcane economic theorems, may be expected to drive their decision-making.   Distribution and marketing methods that are successful will be emulated by others and spread.  Seen in this light (and relatedly, in light of transaction cost economics explanations for “non-standard” contracts), widespread adoption of new vertical contractual devices most likely indicates that they are efficient (they improve distribution, and imitation is the sincerest form of flattery), not that they represent some new competitive threat.  Since an economic model almost always can be ginned up to explain why some new practice may reduce consumer welfare in theory, enforcers should instead focus on hard empirical evidence that output and quality have been reduced due to a restraint before acting.  Unfortunately, the mere threat of costly misbegotten investigations may chill businesses’ interest in experimenting with new and potentially beneficial vertical contractual arrangements, reducing innovation and slowing welfare enhancement (consistent with point two, above).

Fourth, decision theoretic considerations should make enforcers particularly wary of pursuing conditional pricing contracts cases.  Consistent with decision theory, optimal antitrust enforcement should adopt an error cost framework that seeks to minimize the sum of the costs attributable to false positives, false negatives, antitrust administrative costs, and disincentive costs imposed on third parties (the latter may also be viewed as a subset of false positives).  Given the significant potential efficiencies flowing from vertical restraints, and the lack of empirical showing that they are harmful, antitrust enforcers should exercise extreme caution in entertaining proposals to challenge new vertical arrangements, such as conditional pricing mechanisms.  In particular, they should carefully assess the cumulative weight of the high risk of false positives in this area, the significant administrative costs that attend investigations and prosecutions, and the disincentives toward efficient business arrangements (see points two and three above).  Taken together, these factors strongly suggest that the aggressive pursuit of conditional pricing practice investigations would flunk a reasonable cost-benefit calculus.

Fifth, a new U.S. antitrust enforcement crusade against conditional pricing could be used by foreign competition agencies to justify further attacks on efficient vertical practices.  This could add to the harm suffered by companies (including, of course, U.S.-based multinationals) which would be deterred from maintaining and creating new welfare-beneficial distribution methods.  Foreign consumers, of course, would suffer as well.

My caveats should not be read to suggest that the FTC should refrain from pursuing new economic learning on loyalty discounting and bundled pricing, nor on other novel business practices.  Nor should it necessarily eschew all enforcement in the vertical restraints area – although that might not be such a bad idea, given error cost and resource constraint issues.  (Vertical restraints that are part of a cartel enforcement scheme should be treated as cartel conduct, and, as such, should be fair game, of course.)  In order optimally to allocate scarce resources, however, the FTC might benefit by devoting relatively greater attention to the most welfare-inimical competitive abuses – namely, anticompetitive arrangements instigated, shielded, or maintained by government authority.  (Hard core private cartel activity is best left to the Justice Department, which can deploy powerful criminal law tools against such schemes.)

 - Alden Abbott is the Deputy Director of the Edwin Meese III Center for Legal and Judicial Studies and the John, Barbara, and Victoria Rumpel Senior Legal Fellow.

Originally appeared in Truth on the Market

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