A new rule kicks in today requiring airlines to include all taxes and mandatory fees in their advertised fares.  The rule, part of a broader “passengers’ bill of rights”-type regulation promulgated by the Department of Transportation, is being sold as a proconsumer mandate:  It purportedly protects consumers from the sticker shock that results when they learn that the true consumer price for a flight, due to taxes and mandatory fees, is much higher than the advertised price.

But how consumer-friendly is this rule?  Won’t it be easier to raise taxes and fees when they aren’t presented as a line item, when consumers aren’t “startled” to see the exorbitant amount they’re paying for government services?  Value-added taxes (VATs), which tax the incremental value added at each stage of production and are generally included in the posted price for an item, have proven easier to raise than sales taxes, which are added at the register.  That’s because the latter are more visible so that increases are more likely to generate political opposition.  While VATs are common throughout Europe, they’re virtually non-existent in the United States, in part because we Americans have recognized the important role “tax sticker shock” plays in creating political accountability.

Consumer advocates, nevertheless, are lauding the new Department of Transportation rule.  They don’t seem to realize that higher taxes are bad for consumers and that taxes are more likely to rise when the government can hide them.  They also seem to care little about consumer sovereignty.  Don’t consumers have a right to know how much they’re paying to have scads of Homeland Security officers bark orders at them and gawk at their privates?

 

Filed under: advertising, consumer protection, regulation, taxes

Regular readers will know that several of us TOTM bloggers are fans of the “decision-theoretic” approach to antitrust law.  Such an approach, which Josh and Geoff often call an “error cost” approach, recognizes that antitrust liability rules may misfire in two directions:  they may wrongly acquit harmful practices, and they may wrongly convict beneficial (or benign) behavior.  Accordingly, liability rules should be structured to minimize total error costs (welfare losses from condemning good stuff and acquitting bad stuff), while keeping in check the costs of administering the rules (e.g., the costs courts and business planners incur in applying the rules).  The goal, in other words, should be to minimize the sum of decision and error costs.  As I have elsewhere demonstrated, the Roberts Court’s antitrust jurisprudence seems to embrace this sort of approach.

One of my long-term projects (once I jettison some administrative responsibilities, like co-chairing my school’s dean search committee!) will be to apply the decision-theoretic approach to regulation generally.  I hope to build upon some classic regulatory scholarship, like Alfred Kahn’s Economics of Regulation (1970) and Justice Breyer’s Regulation and Its Reform (1984), to craft a systematic regulatory model that both avoids “regulatory mismatch” (applying the wrong regulatory fix to a particular type of market failure) and incorporates the decision-theoretic perspective. 

In the meantime, I’ve been thinking about insider trading regulation.  Our friend Professor Bainbridge recently invited me to contribute to a volume he’s editing on insider trading.  I’m planning to conduct a decision-theoretic analysis of actual and proposed insider trading regulation.

Such regulation is a terrific candidate for decision-theoretic analysis because stock trading on the basis of material, nonpublic information itself is a “mixed bag” practice:  Some instances of insider trading are, on net, socially beneficial; others create net welfare losses.  Contrast, for example, two famous insider trading cases:

• In SEC v. Texas Gulf Sulphur, mining company insiders who knew of an unannounced ore discovery purchased stock in their company, knowing that the stock price would rise when the discovery was announced.  Their trading activity caused the stock price to rise over time.  Such price movement might have tipped off landowners in the vicinity of the deposit and caused them not to sell their property to the company (or to do so only at a high price), in which case the traders’ activity would have thwarted a valuable corporate opportunity.  If corporations cannot exploit their discoveries of hidden value (because of insider trading), they’ll be less likely to seek out hidden value in the first place, and social welfare will be reduced.  TGS thus represents “bad” insider trading.  
• Dirks v. SEC, by contrast, illustrates “good” insider trading.  In that case, an insider tipped a securities analyst that a company was grossly overvalued because of rampant fraud.  The analyst recommended that his clients sell (or buy puts on) the stock of the fraud-ridden corporation.  That trading helped expose the fraud, creating social value in the form of more accurate stock prices.

These are just two examples of how insider trading may reduce or enhance social welfare.  In general, instances of insider trading may reduce social welfare by preventing firms from exploiting and thus creating valuable information (as in TGS), by creating incentives for deliberate mismanagement (because insiders can benefit from “bad news” and might therefore be encouraged to “create” it), and perhaps by limiting stock market liquidity or reducing market efficiency by increasing bid-ask spreads.  On the other hand, instances of insider trading may enhance social welfare by making stock markets more efficient (so that prices better reflect firms’ expected profitability and capital is more appropriately channeled), by reducing firms’ compensation costs (as the right to engage in insider trading replaces managers’ cash compensation—on this point, see the excellent work by our former blog colleague, Todd Henderson), and by reducing the corporate mismanagement and subsequent wealth destruction that comes from stock mispricing (mainly overvaluation of equity—see work by Michael Jensen and yours truly).

Because insider trading is sometimes good and sometimes bad, rules restricting it may err in two directions:  they may acquit/encourage bad instances, or they may condemn/prevent good instances.  In either case, social welfare suffers.  Accordingly, the optimal regulatory regime would seek to minimize the sum of losses from improper condemnations and improper acquittals (total error costs), while keeping administrative costs in check.

My contribution to Prof. Bainbridge’s insider trading book will employ decision theory to evaluate three actual or proposed approaches to regulating insider trading:  (1) the “level playing field” paradigm, apparently favored by many prosecutors and securities regulators, which would condemn any stock trading on the basis of material, nonpublic information; (2) the legal status quo, which deems “fraudulent” any insider trading where the trader owes either a fiduciary duty to his trading partner or a duty of trust or confidence to the source of his nonpublic information; and (3) a laissez-faire, “contractarian” approach, which would permit corporations and sources of nonpublic information to posit their own rules about when insiders and informed outsiders may trade on the basis of material, nonpublic information.  I’ll then propose a fourth disclosure-based alternative aimed at maximizing social welfare by enhancing the social benefits and reducing the social costs of insider trading, while keeping decision costs in check. 

Stay tuned…I’ll be trying out a few of the paper’s ideas on TOTM.  I look forward to hearing our informed readers’ thoughts.

Filed under: 10b-5, error costs, insider trading, law and economics, markets, regulation, securities regulation

The American Antitrust Institute has announced plans to draft a comprehensive set of jury instructions for antitrust trials.  According to AAI president Bert Foer:

In Sherman Act Section 1 and Section 2 civil cases, judges tend to gravitate towards the ABA Model Instructions as the gold standard for impartial instructions. … The AAI believes the ABA model instructions are, in some situations, confusing, out of date, or do not adequately effectuate the goals of the antitrust laws. To provide an alternative, the AAI will develop a set of jury instructions that can be widely disseminated to lawyers and judges.

Foer is certainly right about existing jury instructions.  They’re often confusing and frequently provide so little guidance that jurors are effectively invited simply to “pick a winner.”  Crafting clearer, more concrete jury instructions would benefit the antitrust enterprise and further AAI’s stated mission “to increase the role of competition [and] assure that competition works in the interests of consumers.”

But clarity alone is not enough.  Any new jury instructions should set forth (in clear terms) liability standards whose substance enhances the effectiveness of the antitrust.  Here’s where I worry about the AAI project.

Throughout its history, AAI has shown little regard for the inherent limits of antitrust.  Those limits arise because the antitrust laws (1) embody somewhat vague standards that factfinders must flesh out ex post (e.g., they forbid “unreasonable” restraints of trade and “unreasonably” exclusionary conduct by monopolists) and (2) are privately enforceable in lawsuits giving rise to treble damages.  The former feature ensures that courts, regulators, and business planners face difficulty in evaluating the legality of business practices.  The latter guarantees that they’re regularly called upon to do so.  It also discourages borderline practices that might wrongly be deemed, after the fact, to be anticompetitive.  Antitrust therefore creates significant “decision costs” (in both adjudication and counseling) and “error costs” (in the form of either market power resulting from improper acquittals or foregone efficiencies resulting from improper convictions and the chilling of procompetitive conduct).  Those decision and error costs constitute the limits of antitrust and are inexorable:

• you can’t decrease decision costs (by simplifying a liability rule) without increasing error costs (incorrect judgments and enhanced chilling effect);
• you can’t decrease error costs (by making the rule more nuanced in order to better separate pro- from anticompetitive conduct) without increasing decision costs; 
• you can’t reduce false acquittals (by easing the plaintiff’s proof burden or cutting back on affirmative defenses) without increasing false convictions, and vice-versa.

In light of this unhappy situation, antitrust liability standards should be crafted so as to minimize the sum of decision and error costs.  As I have recently explained, the Roberts Court has taken this tack in its eight major antitrust decisions.

AAI, by contrast, has shown little concern for false positives and seems to equate an effective antitrust regime with one that produces more liability.  Time and again, the Institute has advocated “pro-plaintiff” liability rules that threaten high error costs in the form of false convictions (and the chilling effect that follows).  In all but one of the Roberts Court’s antitrust decisions (which, as noted, are consistent with a “decision-theoretic” framework that would help minimize the sum of decision and error costs), AAI has advocated a pro-plaintiff position that the Supreme Court ultimately rejected.  (See AAI’s positions in Twombly, Leegin, Credit Suisse, Dagher, Weyerhaeuser, LinkLine, and Independent Ink.)  This is a stunningly bad record. 

Moreover, AAI remains out of antitrust’s mainstream (which now acknowledges antitrust’s inherent limits and the need to constrain error costs) on practices involving somewhat unsettled liability rules.  Consider, for example, AAI’s views on: 

• Resale Price Maintenance (RPM).  Even after Leegin abrogated the per se rule against minimum RPM, AAI urged courts to adopt a rule of reason that would burden a defendant with “justifying” any instance of RPM that results in an increase in consumer prices.  Such an approach is likely to generate excessive liability because all instances of RPM — even those aimed at such procompetitive effects as the elimination of free-riding, the facilitation of new entry, or encouraging “non-free-rideable” demand-enhancing services — involve an increase in consumer prices.  AAI’s preferred rule essentially amounts to a presumption of illegality for RPM.  As I explained in this article, such an approach would involve huge error costs (and certainly wouldn’t minimize the sum of decision and error costs).
   
• Loyalty Rebates.  Efficiency-minded antitrust scholars have generally concluded that there should be a safe harbor for single-product loyalty rebates resulting in an above-cost discounted price for the product at issue.  The leading case on loyalty rebates, the Eight Circuit’s Concord Boat decision, agrees.  The thinking behind such a safe harbor is that any equally efficient rival could match a defendant’s loyalty rebate that resulted in an above-cost discounted price; permitting liability on the basis of such a rebate would chill discounting and create a price umbrella for relatively inefficient rivals.  AAI, however, has urged courts to reject the safe harbor approved in Concord Boat.
   
• Bundled Discounts.   Efficiency-minded antitrust scholars have also approved a safe harbor for some sorts of multi-product or “bundled”
   discounts: such a discount should be legal if each product in the bundle is priced above cost when the entire amount of the bundled discount is attributed to that single product.  The Ninth Circuit approved this safe harbor in its PeaceHealth decision.  Again, the rationale behind the safe harbor is that an equally efficient, single-product rival could meet any bundled discount resulting an above-cost pricing under this so-called “discount attribution” test.  And again, AAI has opposed this safe harbor.

These are but a few examples of AAI’s wildly pro-plaintiff view of antitrust—a view that ultimately injures consumers by ignoring the error costs (e.g., thwarted procompetitive business practices) associated with false convictions.  So in the end, I’m a bit worried about AAI’s jury instruction project.  If the Institute can simply provide clarity without pushing substantive liability standards in its preferred, pro-plaintiff (error cost-insensitive) direction, antitrust will be better off because of its efforts.  But I’m not optimistic.

Filed under: antitrust, bundled discounts, business, consumer protection, error costs, exclusionary conduct, regulation, resale price maintenance

TOTM alumnus Todd Henderson recently pointed me to a short, ten-question interview Time Magazine conducted with Nobel prize-winning economist Daniel Kahneman.  Prof. Kahneman is a founding father of behavioral economics, which rejects the rational choice model of human behavior (i.e., humans are rational self-interest maximizers) in favor of a more complicated model that incorporates a number of systematic irrationalities (e.g., the so-called endowment effect, under which people value items they own more than they’d be willing to pay to acquire those same items if they didn’t own them). 

 I’ve been interested in behavioral economics since I took Cass Sunstein’s “Elements of the Law” course as a first-year law student.  Prof. Sunstein is a leading figure in the “behavioral law and economics” movement, which advocates structuring laws and regulations to account for the various irrationalities purportedly revealed by behavioral economics.  Most famously, behavioral L&E calls for the imposition of default rules that “nudge” humans toward outcomes they’d likely choose but for the irrationalities and myopia with which they are beset.

 I’ve long been somewhat suspicious of the behavioral L&E project.  As I once explained in a short response essay entitled Two Mistakes Behavioralists Make,  I suspect that behavioral L&E types are too quick to reject rational explanations for observed human behavior and that they too hastily advocate a governmental fix for irrational behavior.  Time’s interview with Prof. Kahneman did little to allay those two concerns.

Asked to identify his “favorite experiment that demonstrates our blindness to our own blindness,” Prof. Kahneman responded:

It’s one someone else did.  During [the ’90s] when there was terrorist activity in Thailand, people were asked how much they’d pay for a travel-insurance policy that pays $100,000 in case of death for any reason.  Others were asked how much they’d pay for a policy that pays $100,000 for death in a terrorist act.  And people will pay more for the second, even though it’s less likely.

 This answer pattern is admittedly strange.  Since death from a terrorist attack is, a fortiori, less likely than death from any cause, it makes no sense to pay the same amount for the two insurance policies; the “regardless of cause” life insurance policy should command a far higher price.  So maybe people are wildly irrational in comparing risks and the value of risk mitigation measures.

 Or maybe, as boundedly rational (but not systematically irrational) beings, they just don’t want to waste effort answering silly, hypothetical questions about the maximum amount they’d pay for stuff.  I remember exercises in Prof. Sunstein’s class in which we were split into groups and asked to state either how much we’d pay to obtain a certain object or, assuming we owned the object, how much we’d demand as a sales price.  I distinctly recall thinking how artificial the question was.  Given the low stakes of the exercise, I quickly wrote down some number and returned to thinking about what I would have for lunch, what was going to be on Sunstein’s exam, and whether I had adequately prepared for my next class.  I suspect my classmates did as well.  Was it not fully rational for us to conserve our limited mental resources by giving quick, thoughtless answers to wholly hypothetical, zero-stakes questions?

If so, then there are two possible reasons for subjects’ strange answers to the terrorism insurance questions Kahneman cites:  Subjects could be wildly irrational with respect to risk assessment and the value of protective measures, or they might rationally choose to give hasty answers to silly questions that don’t matter.  What we need is some way to choose between these irrational and rational accounts of the answer pattern.

Perhaps the best thing to do would be to examine people’s revealed preferences by looking at what they actually do when they’re spending money to protect against risk.  If Kahneman’s explanation for subjects’ strange answers were sound, we’d see people paying hefty premiums for terrorism insurance.  Profit-seeking insurance companies, in turn, would scramble to create and market such risk protection, realizing that they could charge irrational consumers far more than their expected liabilities.  But we don’t see this sort of thing.

That suggests that the alternative, “rational” (or at least not systematically irrational) account is the more compelling story:  Subjects pestered with questions about how much hypothetical money they’d spend on hypothetical insurance products decide not to invest too much in the decision and just spit out an answer.  As we all learn as kids, you a ask a silly question, you get a silly answer.

So again we see the behavioralist tendency to discount the rational account too quickly.  But what about the second common behavioralist mistake (i.e., hastily jumping from an observation about human irrationality to the conclusion that a governmental fix is warranted)?  On that issue, consider this portion of the interview:

Time:  You endorse a kind of libertarian paternalism that gives people freedom of choice but frames the choice so they are nudged toward the option that’s better for them.  Are you worried that experts will misuse that?

Kahneman:  What psychology and behavioral economics have shown is that people don’t think very carefully.  They’re influenced by all sorts of superficial things in their decisionmaking, and they procrastinate and don’t read the small print.  You’ve got to create situations so they’ll make better decisions for themselves.

Could Prof. Kahneman have been more evasive?  The question was about an obvious downside of governmental intervention to correct for systematic irrationalities, but Prof. Kahneman, channeling Herman “9-9-9” Cain, just ignored it and repeated his affirmative case.  This is a serious problem for the behavioral L&E crowd:  They think they’re done once they convince you that humans exhibit some irrationalities.  But they’re not.  Just as one may believe in anthropogenic global warming and still oppose efforts to combat it on cost-benefit grounds, one may be skeptical of a nudge strategy even if one believes that humans may, in fact, exhibit some systematic irrationalities.  Individual free choice may have its limits, but governmental decisionmaking (executed by self-serving humans whose own rationality is limited) may amount to a cure that’s worse than the disease.

Readers interested in the promise and limitations of behavioral law and economics should check out TOTM’s all-star Free to Choose Symposium.

 

Filed under: behavioral economics, behavioral economics, economics, free to choose symposium, law and economics, nobel prize, regulation

One of my colleagues recently accepted a publication offer on a law review article, only to receive a later publication offer from a much more prestigious journal.  This sort of occurrence is not uncommon in the legal academy, where scholars submitting articles for publication do not offer to publish their work in a journal but rather solicit publication offers from journals (and generally solicit multiple offers at the same time).  One may easily accept an inferior journal’s offer before receiving another from a preferred journal. 

I’ve been in my colleague’s unfortunate position three times: once when I was trying to become a professor, once during my first semester of teaching, and once in the semester before I went up for tenure.  Each time, breaching my initial publication contract and accepting the later-received offer from the more prestigious journal would have benefited me by an amount far greater than the harm caused to the jilted journal.  Accordingly, the welfare-maximizing outcome would have been for me to breach my initial publication agreement and to pay the put-upon journal an amount equal to the damage caused by my breach.  Such a move would have been Pareto-improving:  I would have been better off, and the original publisher, the breach “victim,” would have been as well off as before I breached.  

As all first-year law students learn (or should learn!), the law of contracts is loaded with doctrines designed to encourage efficient breach and discourage inefficient performance.  Most notable among these is the rule precluding punitive damages for breach of contract:  If a breaching party were required to pay such damages, in addition to the so-called “expectancy” damages necessary to compensate the breach victim for her loss, then promisors contemplating breach might perform even though doing so would cost more than the value of the performance to the promisee.  Such performance would be wasteful.

So why didn’t I — a contracts professor who knows that a promisor’s contract duty is always disjunctive: “perform or pay” — breach my initial publication agreements and offer the jilted journal editors some amount of settlement (say, $1,000 for an epic staff party — an amount far less than the incremental value to me of going with the higher-ranked journal)?  Because of a silly social norm frowning upon such conduct as indicative of a flawed character.  When I was looking for a teaching job, I was informed that breaching a publication agreement is a definite no-no and might impair my job prospects.  After I became a professor, I learned that members of my faculty had threatened to vote against the tenure of professors who breached publication agreements.  To be fair, I’m not sure those faculty members would do so if the breaching professor compensated the jilted journal, effectively “buying himself out” of his contract.  But who would run that risk?

So I empathize with my colleague who now feels stuck publishing in the less prestigious journal.  And, while I recognize the difference between a legal and moral obligation, I would commend the following wise words to those law professors who would imbue law review publishing contracts with “mystic significance”:

Nowhere is the confusion between legal and moral ideas more manifest than in the law of contract.  Among other things, here again the so-called primary rights and duties are invested with a mystic significance beyond what can be assigned and explained.  The duty to keep a contract at common law means a prediction that you must pay damages if you do not keep it — and nothing else.  If you commit a tort, you are liable to pay a compensatory sum.  If you commit a contract, you are liable to pay a compensatory sum unless the promised event comes to pass, and that is all the difference.  But such a mode of looking at the matter stinks in the nostrils of those who think it advantageous to get as much ethics into the law as they can.

Oliver Wendell Holmes, Jr., The Path of the Law, 10 Harv. L. Rev. 457 (1897).  

Filed under: contracts, law school, musings

Let’s start at the very beginning.  When analyzing the merits of any regulation — i.e., any rule that disrupts private ordering by threat of force — one should first ask what problem the regulation aims to avert.  When it comes to the rules banning sales (and thereby preventing purchases) of legal services by unlicensed individuals, most of the familiar market failures pose no concern.  There’s no technological externality (one not mitigated by the price mechanism).  There’s no monopoly problem.  There’s no public good.

The only widely recognized market failure that could exist in this context is information asymmetry — one party to a potential transaction (the provider of legal services) has significantly better information about the subject matter of the transaction (the quality of those services) than does the other (the client).  Not only may some poorly informed clients find themselves “ripped off,” but the market for legal services as a whole may be degraded by a version of George Akerlof’s famous lemons problem.

Akerlof illustrated the systematic adverse effects of asymmetric information by hypothesizing a used car market in which cars vary in value, which is known to the sellers but not to buyers.  Hoping to avoid overpaying for a “lemon,” rational used car buyers will pay no more than the average value of a used car.  This limitation on buyers’ willingness-to-pay causes sellers of above-average cars to withdraw their cars from the market, so that only lemons are available.  And if buyers are rational, they should anticipate that sellers of high-value cars will pull their cars from the market, which should cause them to lower their bid prices even further (to the average value of the non-withdrawn lemons).  Pretty soon, the market will unravel even though there are plenty of high-value cars that could have been sold to purchasers who would have paid a high price had they possessed better information about car quality.

Assuming providers of legal services have better information about service quality than do consumers, mandatory licensing of lawyers may boost consumer confidence and thereby help ensure that high-quality legal services remain available in the market.

Of course, there are downsides to mandatory licensing.  Requiring providers of legal services to attend a three-year accredited law school and to pass a bar exam that tests all sorts of subjects many lawyers never need to know (commercial paper?!) raises barriers to entry into the market for legal services.  Existing attorneys can charge high rates for routine, nearly ministerial tasks because they can avoid competition from individuals who are qualified to perform such tasks but have not jumped through all the hoops required for licensing.  And because licensing requirements raise the fixed cost of becoming a lawyer by mandating an expensive degree, an inordinate amount of class time, and mastery of all sorts of subjects that are, for many lawyers, irrelevant, such requirements tend to raise the rates for legal services even where there is significant competition among lawyers.  In short, any attempt to ensure quality and avoid a lemons problem via licensing will drive up prices and, to put it in terms more appealing to those who don’t like all this econ-talk, “reduce access to justice.”

So a third step in the regulatory analysis (after considering the problem to be averted and the potential adverse effects of regulating to avoid that problem) should be to consider less restrictive alternatives.  In this context, there are some attractive options.

The Kosher Model.  One obvious response would be for the government to do nothing.  All sorts of service transactions involve asymmetric information and yet commonly occur despite government inaction to fix the “problem.”  Housepainters, mechanics, landscapers, plumbers, general contractors, etc. all have better information about service quality than do their clients, but we still have thriving markets for their services.  All sorts of private certifiers – e.g., Better Business Bureaus, Angie’s List, etc. – have emerged to provide consumers with good information about service quality.  Such certifiers compete with each other on quality and often innovate to differentiate themselves from rivals, thereby providing more precise information to consumers.  There are, for example, more than 200 kosher certifying agencies in the United States, enabling observant Jews (who would otherwise be victims of asymmetric information!) to select a certifying symbol that corresponds to their own preferred level of kosher stringency.  It’s easy to imagine a similar certifying system for attorneys.  Some agencies could certify high-quality will drafters, others good DUI lawyers, etc.

The Organic Model.  A more “protective” (paternalistic?) approach would be for the government merely to prescribe a standard for what constitutes a competent lawyer.  The state would, in short, act as a certifier, conferring its seal of approval – the label “licensed lawyer,” or something similar – on individuals who had jumped through certain hoops.  Consumers could then choose to hire one of those individuals or, if their needs were more limited or they knew (perhaps from a private certifier) that a non-accredited individual was nonetheless quite good, could hire someone lacking the state’s endorsement.  This is the tack the government has taken with organic food:  The government has prescribed what the term “organic” means so that consumers will know what they’re getting when they buy an organic product.  But sellers of “nearly organic” foods can still sell their wares and advertise how their offerings differ from conventionally produced products as long as they don’t use the term “organic.”

The state could implement this sort of certification model on either an opt-in or opt-out basis.  Under the former approach, the state would permit providers of legal services to opt in to the lawyer licensing system—and perhaps thereby charge higher rates—if they met the prescribed requirements.  Under an opt-out approach, an unlicensed legal service provider could sell her services only if she first notified her client of her lack of certification and attained the client’s informed consent.

The Status Quo:  Enforce a Non-Waiveable, One-Size-Fits-All Standard.  The crudest possible approach to the legal services market’s information asymmetry problem is the status quo:  prescribe a set of prerequisites that anyone who sells legal services must satisfy.  Of all the approaches considered, this one thwarts the greatest number of mutually beneficial transactions.  While it is the most “protective” of the uninformed consumers who manage to purchase legal services, that protection comes at a cost.  The higher prices occasioned by the status quo render basic legal services beyond the reach of large number of consumers.  Licensed lawyers, of course, benefit from the system, as do the politicians that favor them.

We end up, then, with a spectrum of policy options that proceeds from most to least liberal, as follows:

• Kosher (rely on private certification) –>
• Opt-in Organic (define a label and allow service providers to use it if they meet criteria) –>
• Opt-out Organic (require service providers who do not meet the state’s standards to attain informed consent) –>
• Status Quo (preclude all sales by providers who don’t meet the state’s standards).

As someone who makes his living providing one of the prerequisites to a lucrative licensed lawyer career, I have a personal financial interest in maintaining the status quo.  But as someone who genuinely cares about access to justice and economic expansion, I find the current regulatory approach appalling.  In the end, I would much prefer something akin to the kosher (or maybe the “opt-in organic”) model.

I suppose we’re not all rational, self-interest maximizers after all.

Given the crucial role debit card “swipe” fees played in causing the recent financial crisis, Illinois Senator Dick Durbin insisted that the Dodd-Frank law (you know, the one that left Fannie and Freddie untouched) impose price controls on debit card transactions.  Ben Bernanke, who apparently doesn’t have enough on his plate, was tasked with determining banks’ processing and fraud-related costs and setting a swipe fee that’s just high enough to cover those costs.  Mr. Bernanke first decided that the aggregate cost totaled twelve cents per swipe.  After receiving over 11,000 helpful comments, Mr. Bernanke changed his mind.  Banks’ processing and fraud costs, he decided, are really 21 cents per swipe, plus 0.05 percent of the transaction amount.  In a few weeks (on October 1), the government will require banks to charge no more than that amount for each debit card transaction.

SHOCKINGLY, this price control seems to be altering other aspects of the deals banks strike with their customers.  The WSJ is reporting that a number of banks, facing the prospect of reduced revenues from swipe fees, are going to start charging customers an upfront, non-swipe fee for the right to make debit card purchases.  Wells Fargo, J.P. Morgan Chase, Suntrust, Regions, and Bank of America have announced plans to try or explore these sorts of fees — “Durbin Fees,” you might call them.

Whoever would have guessed that Mr. Durbin’s valiant effort to prevent future financial crises by imposing brute price controls would have had these sorts of unintended consequences?

Fortunately for me, I can just switch to using my credit card, which will not be subject to the price controls imposed by Messrs Durbin and Bernanke.  Because I earn a decent salary and have a good credit history, this sort of a switch won’t really hurt me.  In fact, as banks increase the rewards associated with credit card use (in an attempt to encourage customers to use credit in place of debit cards), I may be able to earn some extra goodies. 

Of course, lots of folks — especially those who are out of work or have defaulted on some financial obligations because of the financial crisis and ensuing recession — don’t have access to cheap credit.  They can’t avoid Durbin Fees the way I (and Messrs Durbin and Bernanke) can.  Oh well, I’m sure Mr. Durbin and his colleagues can come up with a subsidy for those folks.

Filed under: banking, credit cards, markets, regulation

Flying back from a hiking trip to spectacular Glacier National Park (see pics below the fold), I overheard a flight attendant say something that made me think of, what else?, bundled discounts.  “We also fly for Delta,” the United flight attendant told the woman in front of me.  That’s when I realized I was really flying on Skywest, a regional airline that provides service to the major airlines.

Skywest, it seems, flies between major airlines’ hub cities (Salt Lake City for Delta, Denver for United) and smaller destinations like Kalispell, Bozeman, Jackson Hole, etc.  (Full route map here.)  It does so, though, under the auspices of the major airlines, so one never buys a “Skywest” ticket, always a Delta or United ticket.  (This is pretty common.  Columbia, Missouri, where I teach, is serviced by Pinnacle Airlines, which flies back and forth between Columbia and Memphis for Delta.)

So what has this to do with bundled discounts?  Well, first recall why such discounts (price-cuts conditioned on purchasing products from multiple product markets) create anticompetitive concerns.  Courts, regulators, and scholars have worried that a multi-product seller may use bundled discounts to exclude equally or more efficient rivals that sell less extensive lines of products.  In theory, a multi-product seller who has market power over at least one of its products (i.e., the ability to charge an above-cost price for that product) could offer a bundled discount that results in an above-cost (and thus non-predatory) price for the bundle, but would still tend to exclude an equally efficient, but less diversified, rival.

The classic example of this strategy involves a bundled discount offered by a producer of shampoo and conditioner.  Suppose that manufacturer A sells both shampoo and conditioner, is a monopolist in the conditioner market, and competes in the shampoo market against manufacturer B, which sells only shampoo.  B is the more efficient shampoo manufacturer, producing shampoo at a cost of $1.25 a bottle compared to A’s cost of $1.50 per bottle.  A’s cost of producing a bottle of conditioner is $2.50.  If purchased separately, A’s per-bottle prices for shampoo and conditioner are $2.00 and $4.00, respectively.  But A offers customers a $1.00 bundled discount, charging only $5.00 for the shampoo/conditioner package.  While this discounted price is still above A’s cost for the bundle ($4.00), it could tend to exclude B.  Assuming that shampoo buyers must also buy conditioner (in equal proportions), buyers would have to pay A’s unbundled conditioner price of $4.00 if they purchased B’s shampoo and would thus be unwilling to pay more than $1.00 for the B brand of shampoo.  That price, though, is below B’s $1.25 cost.  Thus, A’s bundled discount would tend to exclude B from the market even though (1) the discounted price ($5.00) is above A’s aggregate cost for the bundle ($4.00), and (2) B is the more efficient shampoo producer.

Regional airlines like Skywest and Pinnacle find themselves in the same position as the shampoo-only manufacturer.  A significant impediment to these smaller airlines is the major carriers’ ability to offer a type of bundled discount — a price for a “bundle” of flights going from departure point to hub to destination that is significantly lower than the sum of the prices of two flights, one from departure point to hub and the other from hub to destination.  For example, a Delta flight from Columbia, Missouri to Memphis (a Delta hub) to New York City might cost $400, while purchasing separate flights from Columbia to Memphis and then from Memphis to NYC might cost a total of $500 ($200 for the Columbia to Memphis leg and $300 for the Memphis to NYC leg). This is, in effect, a bundled discount of $100.  If Pinnacle wanted to compete for passengers flying from Columbia to NYC, it would have to absorb the entire amount of the package discount on the single leg it offered (Columbia to Memphis), charging no more than $100 for the flight.  That price, though, may be below its cost.

Despite this impediment, regional airlines like Pinnacle and Skywest have not been driven out of business by the major carriers’ pricing strategies.  Instead, they have remained in business and have often delivered higher profits than their major carrier rivals.  How did they accomplish this feat?  By becoming suppliers to the major air carriers, offering to provide short-haul air service more efficiently than the majors.

So what are the implications for legal restrictions on bundled discounts?  A number of commentators have suggested that a bundled discount should be illegal if it would result in below-cost pricing on the competitive product after the entire amount of the discount is attributed to that product.  They take this position because they assume that such a discount would exclude an equally efficient, single-product rival by forcing it to price below its own cost.

The continued existence of Pinnacle, Sky West, and the other regional airlines, though, undermines this assumption.  Equally or more efficient single-product rivals confronted with the sort of bundled discount discussed above have a way to stay in business:  they can become suppliers to the bundled discounter.  If they are, in fact, more efficient than the discounter, it should jump on the opportunity to outsource production to them.  Thus, I would argue, a plaintiff complaining of exclusion by a bundled discount that does not run afoul of standard predatory pricing rules should have to show, among other things, that it could not stay in business by becoming a supplier to its discounting rival.  (It should also have to show that it could not replicate the bundle by collaborating with other product suppliers.)

For greater discussion of the appropriate liability rule for bundled discounts, see Part III of this article and Part IV of this article.  For some Glacier photos, see below the fold. 

Filed under: antitrust, bundled discounts, law and economics, regulation

Have you ever had to get on your hands and knees at Office Depot to find precisely the right printer cartridge?  It’s maddening, no?  Why can’t the printer manufacturers just settle on a single design configuration, the way lamp manufacturers use common light bulbs?

You might think the printer manufacturer is trying to enhance its profits simply by forcing you to buy two of its products (the printer + the manufacturer’s own ink cartridge) rather than one (just the printer).  But that story is wrong (or, at best, incomplete).  Printers tend to be sufficiently brand-differentiated to enable manufacturers to charge a price above their marginal cost.  Ink, by contrast, is more like a commodity, so competition among ink manufacturers should drive price down near the level of marginal cost.  A printer manufacturer could fully exercise its market power over its printer — i.e., its ability to profitably charge a printer price that exceeds the printer’s cost — by raising the price of its printer alone.  It could not enhance its profits by charging that price and then requiring purchasers to buy its ink cartridge at some above-cost price.  Consumers would view the requirement to purchase the manufacturer’s “supracompetitively priced” ink cartridge as tantamount to an increase in the price of the printer itself, so the manufacturer’s tie-in would effectively raise the printer price above profit-maximizing levels (i.e., profits would fall, despite the higher effective price, because too many “marginal” consumers — those who value the manufacturer’s printer the least — would curtail their purchases).

If printer buyers consume multiple ink cartridges, though, a printer manufacturer may enhance its profits by tying its printer and its ink cartridges in an attempt to price discriminate among consumers.  The manufacturer would lower its printer price from the profit-maximizing level to some level closer to (but still at or above) its cost, raise the price of its ink cartridge above the competitive level (which should approximate its marginal cost), and require purchasers of its printer to use the manufacturer’s (supracompetitively priced) ink cartridges.  This tack enables the manufacturer to charge higher effective prices to high-intensity users, who are likely to value the printer the most, and lower (but still above-cost) prices to low-intensity users, who likely value the printer the least.  Economists call this sort of tying arrangement a “metering tie-in” because it aims to meter demand for the seller’s tying product (the printer) and charge an effective price that corresponds to a buyer’s likely willingness to pay.

When a seller imposes a metering tie-in, higher-intensity consumers get less “surplus” from their purchases (the difference between their outlays and the amount by which they value what they’re buying), but total market output tends to increase, as the manufacturer sells printers to some buyers who value the printer below the amount the manufacturer would charge for the printer alone (i.e., the profit-maximizing, single-product price).

In his recent high-profile article, Tying, Bundled Discounts, and the Death of the Single Monopoly Profit Theory, Professor Einer Elhauge contends that metering tie-ins like the one described above tend to reduce total and consumer welfare.  He maintains that tie-ins of the type described are a form of welfare-reducing “third-degree” price discrimination.  He illustrates his point using a stylized example involving a printer manufacturer who sells consumers up to three ink cartridges. 

In a response to Professor Elhauge’s interesting article, I attempted to show that his welfare analysis turns on his assumption that printer buyers use only 1, 2, or 3 ink cartridges.  I demonstrated that Professor Elhauge’s hypo generates a different outcome — even assuming that this sort of metering tie-in is “third-degree” price discrimination — if ink cartridges are smaller, so that high-intensity consumers purchase 4 or more ink cartridges.

In some very helpful comments on my forthcoming response article, Professor Herbert Hovenkamp observed that there is a bigger problem with Elhauge’s analysis:  It assumes that the price discrimination here is third-degree price discrimination, when in fact it is second-degree price discrimination.

Below the fold, I discuss Elhauge’s analysis, my initial response (which remains valid), and the more fundamental problem Hovenkamp observed.  (And for those interested, please download my revised response article, which now contains both my original and Hovenkamp’s arguments.)

Since the time of A.C. Pigou, it has been conventional to categorize price discrimination schemes into “degrees.”  First-degree price discrimination occurs when a seller charges each buyer his or her “reservation price” — i.e., the amount  by which the buyer values the product at issue.  Such price discrimination is efficient, because each unit that is valued by at least as much as it costs to produce is produced and sold; there is no “deadweight loss” resulting from the failure to produce units that are valued by more than their incremental production cost.  Because sellers never have access to individuals’ actual reservation prices, first-degree price discrimination does not exist in the real world.

Third-degree price discrimination, by contrast, is quite common.  In a third-degree price discrimination scheme, the seller divides consumers into groups and charges a different price to the members of different groups.  For example, movie theatres usually charge lower prices to senior citizens and students, reasoning that members of those groups have lower reservation prices than do non-student (and thus presumably employed) adults.

Unlike first-degree price discrimination, third-degree price discrimination may reduce total welfare.  Such a welfare reduction may occur because third-degree price discrimination tends to reallocate output from higher-valuing to lower-valuing consumers (which reduces total welfare) and may not increase total market output enough to make up for that welfare loss.  Let me explain.

Unlike first-degree price discrimination, third-degree price discrimination is “imperfect,” because membership in a customer group (e.g., senior citizens) is merely a proxy for willingness-to-pay for the product at issue, and within any group of buyers, there will be a range of reservation prices.  Given that group members differ in their willingness-to-pay, each purchaser category in a third-degree price discrimination scheme will exhibit a downward sloping demand curve, indicative of the fact that more customers within the group will buy the product, and more units will be sold, as the price is reduced.  A monopolist engaged in third-degree price discrimination will therefore consider each group’s demand function and will seek to set each group’s price at the level that maximizes the monopolist’s profits on sales to that group.  At that group-specific price, some low-valuation members will be priced out of the market, even though their willingness-to-pay exceeds both the seller’s costs and the willingness-to-pay of members of favored groups.  For example, if a theatre owner charged $6 for a senior ticket and $9 for a regular adult ticket, a non-senior adult who valued admission at $8.50 would not secure a seat at the show, while a senior who valued admission at only $6.25 would.

Now, this reallocation of welfare from higher-valuing to lower-valuing consumers would not cause the price discrimination scheme to reduce total welfare if the discriminatory scheme sufficiently increased total market output.  For example, if there were lots of seniors who valued theatre admission by an amount just below the price the theatre owner would charge if it had to charge a single non-discriminatory price, but few non-senior adults who valued theatre admission between $6 and $9, the surplus created by bringing new seniors into the market could exceed the surplus lost by reallocating theatre admission from non-senior adults to seniors who valued it less.  But this sort of total output increase is not guaranteed.

In arguing that metering tie-ins tend to injure consumers, Elhauge first contends that such tie-ins constitute a form of third-degree price discrimination.  This is so, he says, because they involve “categorizing tying product buyers into different groups (based on their number of tied product purchases) and charging each group a different effective price for the same tying product (by inflating tied product prices).”  Elhauge then posits an example in which the purported “third-degree” price discrimination scheme reallocates output from higher- to lower-valuing consumers without increasing output.

Elhauge’s example involves a printer and ink producer who has market power over his printer but faces a competitive ink market.  Purchasers of the printer use either one, two, or three ink cartridges and vary linearly in the degree to which they value a cartridge’s worth of printing.  In a somewhat complicated analysis (which I will not summarize here — it’s on pages 432-34 of his article), Elhauge compares output, price, and surplus when the seller can charge only a single profit-maximizing printer price versus when he engages in a metering tie-in.  (In the tying situation, the seller lowers his printer price to the level of marginal cost, ties in ink cartridges, and sets the cartridge price at a level that achieves the effective profit-maximizing price for each group of consumers.)  Elhauge shows that, relative to the single  price scenario, the tie-in arrangement lowers market output, enhances the seller’s profits, and reduces both consumer and total surplus.  Notably, the tie-in Elhauge hypothesizes would not bring any additional consumers into the market.  It would, though, reallocate output from higher-valuing to lower-valuing consumers.

But isn’t this hypothetical, where buyers of the tying product consume, at most, three units of the tied product, awfully unrealistic?  Real-life metering tie-ins typically involve far more refined metering devices that segregate consumers into a much larger number of “groups.”  In my initial response to Elhauge’s article, I demonstrated that use of a “finer” meter — a slightly smaller ink cartridge that would divide the customer base into one-, two-, three-, and four-cartridge groups — would actually enhance total welfare.  It would do so because it would increase total market output by expanding sales to lower-valuation consumers who would not purchase the product at the uniform monopoly price.  (Again, I won’t go through the details of my analysis, which mirrors Elhauge’s but “shrinks” the size of the printer cartridge so that the most intense users purchase four cartridges.  The full analysis is on pages 37-41 of my paper.)

In his comments on my paper, Prof. Hovenkamp observed a further problem with Elhauge’s welfare analysis of metering tie-ins:  He wrongly assumes that they reflect third-degree price discrimination.  In actuality, Hovenkamp says, they involve second-degree price discrimination.  (See detailed analysis (with Erik Hovenkamp) here.) 

Second-degree price discrimination occurs when a seller charges various buyers different per-unit prices for his product but offers all buyers a single price schedule and allows them to select their per-unit price by altering their consumption patterns.  For example, a price schedule incorporating quantity discounts allows any consumer to opt for lower per-unit prices by achieving certain purchase targets.  Similarly, a fare schedule offering different prices for first- and second-class travel enables different consumers to choose different prices.  (While different classes of travel involve different amenities, a class-based fare schedule is still discriminatory in that the different fares involve different ratios of price to marginal cost — i.e., the seller mark-up is greater on first-class.)  Because metering tie-ins offer all consumers the same price schedule, they are best classified as second-degree price discrimination.

Unlike instances of third-degree price discrimination, second-degree price discrimination schemes do not result in the situation where a unit of output is allocated to a member of a “favored” group but denied to a higher-valuing member of a “disfavored” group.  Recall that the movie theatre pricing scheme discussed above ($6/senior ticket, $9/adult ticket) would allocate a seat to a senior citizen valuing admission at $6.25 but not to a non-senior adult valuing it at $8.75.  Contrast that to a fairly typical metering tie-in, such as one where a printer manufacturer lowers its printer price from the profit-maximizing level of $400 to $200 but then requires purchasers to use its paper, which is priced at $.04/sheet rather than the competitive price of $.02/sheet.  The effect of such a tie-in is to convert buyers’ fixed costs (for the printer) to variable costs (for the paper), thereby enabling some low-intensity users — those who don’t make enough prints to justify the high fixed costs — to enter the market.  But the fact that the exact same pricing scheme applies to all consumers ensures that at the margin, all consumers receive the same valuation.  Here, for example, the last copy purchased by the consumers who most value photocopies will create value of $0.04 for the ultimate purchaser, and the last copy purchased by consumers who least value photocopies will create value of $0.04 for the ultimate purchaser.  Thus,  the price discrimination inherent in a metering tie-in, unlike the movie theatre scenario, involves no transfer of surplus from high-value to low-value buyers.

This means that the primary driver of Elhauge’s welfare analysis — the reallocation of output from high- to low-value consumers — doesn’t apply to a metering tie-in.  In my response paper (pages 29-32), I explain why second-degree price discrimination in the form of metering is probably welfare-enhancing in most instances.  But since I’ve just broken the 2,000 word mark on this super-dry post, I’ll let you read that on your own.

If you have comments on the paper, which will be published in the Ohio State Law Journal, please let me know.  I can still do a few edits.

Filed under: antitrust, economics, law and economics, price discrimination, tying, tying