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

Congratulations to Maureen Ohlhausen on the announcement that President Obama intends to nominate her to replace William Kovacic on the Federal Trade Commission.  This is an excellent appointment.  The Washington Post observes:

Ohlhausen comes from Wilkinson Barker Knauer law firm, where she is a partner in the firm’s privacy, data protection and cyber security practice. Before going to the firm, she was a policy counsel at trade group Business Software Alliance.

She is also an FTC veteran. Ohlhausen served as a director in the Office of Policy Planning from 2004 to 2008 where she worked on issues related to e-commerce and advertising. She worked on an Internet access task force that explored net neutrality debates and the competition in the broadband industry.

Maureen is also a George Mason alum, and occasional adjunct professor, which is great news for the school in its own right.  I’ve had the pleasure of working with Maureen at the Commission.  She is thoughtful, understands competition law and consumer protection at a high-level, has deep institutional knowledge of markets high-tech markets, and is an excellent addition to the Commission.

Congratulations!

Filed under: antitrust, federal trade commission

Our search neutrality paper has received some recent attention.  While the initial response from Gordon Crovitz in the Wall Street Journal was favorable, critics are now voicing their responses.  Although we appreciate FairSearch’s attempt to engage with our paper’s central claims, its response is really little more than an extended non-sequitur and fails to contribute to the debate meaningfully.

Read the full piece here.

In the last post, I discussed possible characterizations of Google’s conduct for purposes of antitrust analysis.  A firm grasp of the economic implications of the different conceptualizations of Google’s conduct is a necessary – but not sufficient – precondition for appreciating the inconsistencies underlying the proposed remedies for Google’s alleged competitive harms.  In this post, I want to turn to a different question: assuming arguendo a competitive problem associated with Google’s algorithmic rankings – an assumption I do not think is warranted, supported by the evidence, or even consistent with the relevant literature on vertical contractual relationships – how might antitrust enforcers conceive of an appropriate and consumer-welfare-conscious remedy?  Antitrust agencies, economists, and competition policy scholars have all appropriately stressed the importance of considering a potential remedy prior to, rather than following, an antitrust investigation; this is good advice not only because of the benefits of thinking rigorously and realistically about remedial design, but also because clear thinking about remedies upfront might illuminate something about the competitive nature of the conduct at issue.

Somewhat ironically, former DOJ Antitrust Division Assistant Attorney General Tom Barnett – now counsel for Expedia, one of the most prominent would-be antitrust plaintiffs against Google – warned (in his prior, rather than his present, role) that “[i]mplementing a remedy that is too broad runs the risk of distorting markets, impairing competition, and prohibiting perfectly legal and efficient conduct,” and that “forcing a firm to share the benefits of its investments and relieving its rivals of the incentive to develop comparable assets of their own, access remedies can reduce the competitive vitality of an industry.”  Barnett also noted that “[t]here seems to be consensus that we should prohibit unilateral conduct only where it is demonstrated through rigorous economic analysis to harm competition and thereby harm consumer welfare.”  Well said.  With these warnings well in-hand, we must turn to two inter-related concerns necessary to appreciating the potential consequences of a remedy for Google’s conduct: (1) the menu of potential remedies available for an antitrust suit against Google, and (2) the efficacy of these potential remedies from a consumer-welfare, rather than firm-welfare, perspective.

What are the potential remedies?

The burgeoning search neutrality crowd presents no lack of proposed remedies; indeed, if there is one segment in which Google’s critics have proven themselves prolific, it is in their constant ingenuity conceiving ways to bring governmental intervention to bear upon Google.  Professor Ben Edelman has usefully aggregated and discussed several of the alternatives, four of which bear mention:  (1) a la Frank Pasquale and Oren Bracha, the creation of a “Federal Search Commission,” (2) a la the regulations surrounding the Customer Reservation Systems (CRS) in the 1990s, a prohibition on rankings that order listings “us[ing] any factors directly or indirectly relating to” whether the search engine is affiliated with the link, (3) mandatory disclosure of all manual adjustments to algorithmic search, and (4) transfer of the “browser choice” menu of the EC Microsoft litigation to the Google search context, requiring Google to offer users a choice of five or so rivals whenever a user enters particular queries.

Geoff and I discuss several of these potential remedies in our paper, If Search Neutrality is the Answer, What’s the Question?  It suffices to say that we find significant consumer welfare threats from the creation of a new regulatory agency designed to impose “neutral” search results.  For now, I prefer to focus on the second of these remedies – analogized to CRS technology in the 1990s – here; Professor Edelman not only explains proposed CRS-inspired regulation, but does so in effusive terms:

A first insight comes from recognizing that regulators have already – successfully! – addressed the problem of bias in information services. One key area of intervention was customer reservation systems (CRS’s), the computer networks that let travel agents see flight availability and pricing for various major airlines. Three decades ago, when CRS’s were largely owned by the various airlines, some airlines favored their own flights. For example, when a travel agent searched for flights through Apollo, a CRS then owned by United Airlines, United flights would come up first – even if other carriers offered lower prices or nonstop service. The Department of Justice intervened, culminating in rules prohibiting any CRS owned by an airline from ordering listings “us[ing] any factors directly or indirectly relating to carrier identity” (14 CFR 255.4). Certainly one could argue that these rules were an undue intrusion: A travel agent was always free to find a different CRS, and further additional searches could have uncovered alternative flights. Yet most travel agents hesitated to switch CRS’s, and extra searches would be both time-consuming and error-prone. Prohibiting biased listings was the better approach.

The same principle applies in the context of web search. On this theory, Google ought not rank results by any metric that distinctively favors Google. I credit that web search considers myriad web sites – far more than the number of airlines, flights, or fares. And I credit that web search considers more attributes of each web page – not just airfare price, transit time, and number of stops. But these differences only grant a search engine more room to innovate. These differences don’t change the underlying reasoning, so compelling in the CRS context, that a system provider must not design its rules to systematically put itself first.

The analogy is a superficially attractive one, and we’re tempted to entertain it, so far as it goes.  Organizational questions inhere in both settings, and similarly so: both flights and search results must be ordinally ranked, and before CRS regulation, a host airline’s flights often appeared before those of rival airlines.  Indeed, we will take Edelman’s analogy at face value.  Problematically for Professor Edelman and others pushing the CRS-style remedy, a fuller exploration of CRS regulation reveals this market intervention – well, put simply, wasn’t so successful after all.  Not for consumers anyway.  It did, however, generate (economically) predictable consequences: reduced consumer welfare through reduced innovation. Let’s explore the consequences of Edelman’s analogy further below the fold.

History of CRS Antitrust Suits and Regulation

Early air travel primarily consisted of “interline” flights – flights on more than one carrier to reach a final destination.  CRSs arose to enable airlines to coordinate these trips for their customers across multiple airlines, which necessitated compiling information about rival airlines, their routes, fares, and other price- and quality-relevant information.  Major airlines predominantly owned CRSs at this time, which served both competitive and cooperative ends; this combination of economic forces naturally drew antitrust advocates’ attention.

CRS regulation proponents proffered numerous arguments as to the potentially anticompetitive nature and behavior of CRS-owning airlines.  For example, they claimed that CRS-owning airlines engaged in “dirty tricks,” such as using their CRSs to terminate passengers’ reservations on smaller, rival airlines and to rebook customers on their own flights, and refusing to allow smaller airlines to become CRS co-hosts, thereby preventing these smaller airlines from being listed in search results.  CRS-owning airlines faced further allegations of excluding rivals through contractual provisions, such as long-term commitments from travel agents.  Proponents of antitrust enforcement alleged that the nature of the CRS market created significant barriers to entry and provided CRS-owning airlines with significant cost advantages to selling their own flights.  These cost advantages purportedly derived from two main sources: (1) quality advantages that airline-owned CRSs enjoyed, as they could commit to providing comprehensive and accurate information about the owner airline’s flight schedule, and (2) joint ownership of CRSs, which facilitated coordination between airlines and CRSs, thereby decreasing the distribution and information costs.

These claims suffered from serious shortcomings including both a failure to demonstrate harm to competition rather than injury to specific rivals as well as insufficient appreciation for the value of dynamic efficiency and innovation to consumer welfare.  These latter concerns were especially pertinent in the CRS context, as CRSs arose at a time of incredible change – the deregulated airline industry, joined with novel computer technology, necessitated significant and constant innovation.  Courts accordingly generally denied antitrust remedies in these cases – rejecting claims that CRSs imposed unreasonable restraints on competition, denied access to an essential facility, or facilitated monopoly leverage.

Yet, particularly relevant for present purposes, one of the most popular anticompetitive stories was that CRSs practiced “display bias,” defined as ranking the owner airline’s flights above those of all other airlines.  Proponents claimed display bias was particularly harmful in the CRS setting, because only the travel agent, and not the customer, could see the search results, and travel agents might have incentives to book passengers on more expensive flights for which they receive more commission.  Fred Smith describes the investigations surrounding this claim:

These initial CRS services were used mostly by sophisticated travel agents, who could quickly scroll down to a customer’s preferred airline.  But this extra “effort” was considered discriminatory by some at the DOJ and the DOT, and hearings were held to investigate this threat to competition.  Great attention was paid to the “time” required to execute only a few keystrokes, to the “complexity” of re-designing first screens by computer-proficient travel agents, and to the “barriers” placed on such practices by the host CRS provider.

CRS Rules

While courts declined to intervene in the CRS market, the Department of Transportation (DOT) eagerly crafted rules to govern CRS operations.  The DOT’s two primary goals in enacting the 1984 CRS regulations were (1) to incentivize entry into the CRS market and (2) to prevent airline ownership of CRSs from decreasing competition in the downstream passenger air travel market.  One of the most notable rules introduced in the 1984 CRS regulations prohibited display bias.  The DOT changed both this rule and CRS rules as a whole significantly, and by 1997, the DOT required each CRS “(i) to offer at least one integrated display that uses the same criteria for both online and interline connections and (ii) to use elapsed time or non-stop itinerary as a significant factor in selecting the flight options from the database” (Alexander, 2004).  However, the DOT did not categorically forbid display bias; rather, it created several exceptions to this rule – and even allowed airlines to disseminate software that introduced bias into displays.  Additionally, the DOT expressly refused to enforce its anti-bias rules against travel agent displays.

Other CRS rules attempted to reinforce these two goals of additional market entry and preservation of downstream competition.  CRS rules specifically focused on mitigating travel agent switching costs between CRS vendors and reducing any quality advantage incumbent CRSs allegedly had.  Rules prohibited discriminatory booking fees and the tying of travel agent commissions to CRS use, limited contract lengths, prohibited minimum uses and rollover clauses, and required CRSs to give all participating carriers equal service upgrades.

Evidence of CRS Regulation “Success”?

The CRS regulatory experiment had years to run its course; despite the extent and commitment of its regulatory sweep, these rules failed to improve consumer outcomes in any meaningful way.  CRS regulations precipitated neither innovation nor entry, and likely incurred serious allocative efficiency and consumer welfare losses by attempting to prohibit display bias.

First, CRS regulations unambiguously failed in their goal of increasing ease of entry:

Only six CRS vendors offered their services to domestic airlines and travel agents in the mid-1980s. . . If the rules had actually facilitated entry, the number of CRS vendors should have grown or some new entrants should have been seen during the past twenty years.  The evidence, however, is to the contrary.  It remains that ‘[s]ince the [CAB] first adopted CRS rules, no firm has entered the CRS business.’  Meanwhile, there has been a series of mergers coupled with introduction of multinational CRS; the cumulative effect was to reduce the number of CRSs. . . Even if a regulation could successfully facilitate entry by a supplier of CRS services, the gain from such entry would at this point be relatively small, and possibly negative. (Alexander and Lee, 2004) (emphasis added).

As such, CRS regulations did not achieve one of their primary objectives – a fact which stands in stark contrast to Edelman’s declaration that CRS rules represent an unequivocal regulatory success.

Most relevant to the search engine bias analogy, the CRS regulations prohibiting bias did not positively affect consumer welfare.  To the contrary, by ignoring the reality that most travel agents took consumer interests into account in their initial choice of CRS operator (even if they do so to a lesser extent in each individual search they conduct for consumers), and that even if residual bias remained, consumers were “informed and repeat players who have their own preferences,” CRS regulations imposed unjustified costs.  As Alexander and Lee describe it

[T]he social value of prohibiting display . . . bias solely to improve the quality of information that consumers receive about travel options appears to be low and may be negative.  Travel agents have strong incentives to protect consumers from poor information, through how they customize their internal display screens, and in their choices of CRS vendors.

Moreover, and predictably, CRS regulations appear to have caused serious harm to the competitive process:

The major competitive advantage of the pre-regulation CRS was that it permitted the leading airlines to slightly disadvantage their leading competitors by placing them a bit farther down on the list of available flights.  United would place American slightly farther down the list, and American would return the favor for United flights.  The result, of course, was that the other airlines received slightly higher ranks than they would have otherwise.  When “bias” was eliminated, United moved up on the American system and vice versa, while all other airlines moved down somewhat.  The antitrust restriction on competitive use of the CRS, then, actually reduced competition.  Moreover, the rules ensured that the United/American market leadership would endure fewer challenges from creative newcomers, since any changes to the system would have to undergo DOT oversight, thus making “sneak attacks” impossible.  The resulting slowdown of CRS technology damaged the competitiveness of these systems.  Much of the innovative lead that these systems had enjoyed slowly eroded as the internet evolved.  Today, much of the air travel business has moved to the internet (as have the airlines themselves) (Smith, 1999).

These competitive losses occurred despite evidence suggesting that CRSs themselves enhanced competition and thus had the predictable positive impact for consumers.  For example, one study found that CRS usage increased travel agents’ productivity by an average of 41% and that in the early 1990s over 95% of travel agents used a CRS – indicating that travel agents were able to assist consumers far more effectively once CRSs became available (Ellig, 1991).  The rules governing contractual terms fared no better; indeed, these also likely reduced consumer welfare:

The prohibited contract practices–long-term contracting and exclusive dealing–that had been regarded as exclusionary might not have proved to be such a critical barrier to entry: entry did not occur, independently of those practices.  Evidence on the dealings between travel agents and CRS vendors, post-regulation, suggests that these practices may have enhanced overall allocative efficiency.  Travel agents appear to have agreed to some, if not all, restrictive contracts with CRS vendors as a means of providing those vendors with assurance that they would be repaid gradually, over time, for their up-front investments in the travel agent, such as investments in equipment or training (Alexander and Lee, 2004).

Accordingly, CRS regulations seem to have threatened innovation by decreasing the likelihood that CRS vendors would recover research and development expenditures without providing a commensurate consumer benefit.

Termination of Rules

The DOT terminated CRS regulations in 2004 in light of their failure to improve competitive outcomes in the CRS market and a growing sense that they were making things worse, not better – which Edelman fails to acknowledge and which certainly undermines his claim that regulators addressed this problem “successfully.”  From the time CRS regulations were first adopted in 1984 until 2004, the CRS market and the associated technology changed significantly, rapidly becoming more complex.  As the market increased in complexity, it became increasingly more difficult for the DOT to effectively regulate.  Two occurrences in particular precipitated de-regulation: (1) the major airlines divested themselves of CRS ownership (despite the absence of any CRS regulations requiring or encouraging divestiture!), and (2) the commercialization of the internet introduced novel forms of substitutes to the CRS system that the CRS regulations did not govern.  Online direct-to-traveler services, such as Travelocity, Expedia and Orbitz provide consumers with a method to choose their own flights, entirely absent travel agent assistance.  More importantly, Expedia and Orbitz each developed direct connection technologies that allow them to make reservations directly with an airline’s internal reservation system – bypassing CRS systems almost completely.  Moreover, Travelocity, Expedia, and Orbitz were never forced to comply with CRS regulations, which allowed them to adopt more consumer-friendly products and innovate in meaningful ways, obsoleting traditional CRSs.  It is unsurprising that Expedia has warned against overly broad regulations in the search engine bias debate – it has first-hand knowledge of how crucial the ability to innovate is.)

These developments, taken in harmony, mean that in order to cause any antitrust harm in the first instance, a hypothetical CRS monopolist must have been interacting with (1) airlines, (2) travel agents, and (3) consumers who all had an insufficient incentive to switch to another alternative in the face of a significant price increase.  Given this nearly insurmountable burden, and the failure of CRS regulations to improve consumer welfare in even the earlier and simpler state of the world, Alexander and Lee find that, by the time CRS regulations were terminated in 2004, they failed to pass a cost-benefit analysis.

Overall, CRS regulations incurred significant consumer welfare losses and rendered the entire CRS system nearly obsolete by stifling its ability to compete with dynamic and innovative online services.  As Ellig notes, “[t]he legal and economic debate over CRS. . . frequently overlooked the peculiar economics of innovation and entrepreneurship.”  Those who claim search engine bias exists (as distinct from valuable product differentiation between engines) and can be meaningfully regulated rely upon this same flawed analysis and expect the same flawed regulatory approach to “fix” whatever issues they perceive as ailing the search engine market.  Search engine regulation will make consumers worse off.  In the meantime, proponents of so-called search neutrality and heavy-handed regulation of organic search results battle over which of a menu of cumbersome and costly regulatory schemes should be adopted in the face of evidence that the approaches are more likely to harm consumers than help them, and even stronger evidence that there is no competitive problem with search in the first place.

Indeed, one benefit of thinking hard about remedies in the first instance is that it may illuminate something about the competitive nature of the conduct one seeks to regulate.  I defer to former AAG Barnett in explaining this point:

Put another way, a bad section 2 remedy risks hurting consumers and competition and thus is worse than no remedy at all. That is why it is important to consider remedies at the outset, before deciding whether a tiger needs catching. Doing so has a number of benefits.  …

Furthermore, contemplation of the remedy may reveal that there is no competitive harm in the first place.  Judge Posner has noted that “[t]he nature of the remedy sought in an antitrust case is often . . . an important clue to the soundness of the antitrust claim.”⁽⁴⁾ The classic non-section 2 example is Pueblo Bowl-O-Mat, where plaintiffs claimed that the antitrust laws prohibited a firm from buying and reinvigorating failing bowling alleys and prayed for an award of the “profits that would have been earned had the acquired centers closed.”⁽⁵⁾ The Supreme Court correctly noted that condemning conduct that increased competition “is inimical to the purposes of [the antitrust] laws”⁽⁶⁾–more competition is not a competitive harm to be remedied. In the section 2 context, one might wish that the Supreme Court had focused on the injunctive relief issued in Aspen Skiing–a compelled joint venture whose ability to enhance competition among ski resorts was not discussed⁽⁷⁾–in assessing whether discontinuing a similar joint venture harmed competition in the first place.⁽⁸⁾

A review of my paper with Geoff reveals several common themes among proposed remedies intimated by the above discussion of CRS regulations.  The proposed remedies consistently: (1) disadvantage Google, (2) advantage its rivals, and (3) have little if anything to do with consumers.  Neither economics nor antitrust history supports such a regulatory scheme; unfortunately, it is consumers that might again ultimately pay the inevitable tax for clumsy regulatory tinkering with product design and competition.

Filed under: antitrust, economics, federal trade commission, google, international center for law & economics, monopolization, technology Tagged: antitrust, Federal Trade Commission, google, search

This is part one of a two part series of posts in which I’ll address the problems associated with discerning an appropriate antitrust remedy to alleged search engine bias.  The first problem – and part – is, of course, how we should conceptualize Google’s allegedly anticompetitive conduct; in the next part, I will address how antitrust regulators should conceive of a potential remedy, assuming arguendo the existence of a problem at all.  Despite some commentators’ assumptions, I do not think the economics indicate any such problem exists.

The question of how to conceptualize Google’s business practices – even its business model! – remains the indispensible starting point for antitrust analysis, including potential remedies; doubly so in the wake of the FTC’s decision to formally investigate Google.  While the next part will focus more directly upon potential remedies that have been proposed by various Google critics, there is a fundamental link between how we conceptualize Google’s provision of search results for the purposes of antitrust analysis and the design of remedies.  Indeed, antitrust enforcers and scholars have taught that thinking hard about remedies upfront can and frequently should influence how we think about the competitive nature of the conduct at issue.  The question of how to conceptualize Google’s organic search results has sparked serious debate, as some have claimed that “Google’s behavior is harder to define” than traditional anticompetitive actions and represents “a new kind of competition.”  Some have also focused upon “search bias” itself as the relevant conduct for antitrust purposes.  Of course, as I’ve pointed out, these statements are not in line with modern antitrust economics and usually precede calls to deviate from traditional consumer-welfare-focused antitrust analysis.

I see two useful conceptual constructs in evaluating “search bias” within the antitrust framework.  Recall that “search bias” typically translates to allegations that Google favors its own affiliated content over that of rivals.  For example, a search query on Google for “map of Arlington, VA” might turn up a map of Arlington from Google Maps in the top link.  These allegations usually concede that we would expect Bing Maps if we ran the same search on Bing.  The complaints from vertical search engines and travel services like Expedia particularly center around the notion that Google’s “entry” into various spaces  –  such as travel services – supported by prominent search rankings disadvantages rivals and may lead to their exit.

Observant readers will note my use of scare quotes around “entry.”  This is not coincidental.  It is not obvious to me that Google necessarily enters a new sector (much less a well-defined antitrust product market) when it directs a user to content in a new format– such as a map, video, or place page.  Google’s primary function is search; users rely on search engines to reduce search and information costs.  I think it is at least as likely that Google’s attempts to provide this content by any chosen metric is simply an attempt to do their cardinal job better: answering user queries with relevant information at a minimum of cost.  Holding that threshold issue aside for a moment, in my mind, there are two ways to classify that conduct in the antitrust framework.

First, one might conceive of search bias allegations as “vertical integration” or vertical contractual activity.  I’ve explored this conception at significant length both in blog posts (see, e.g. here and here) as well as a longer article with Geoff.  The classic antitrust concern in this setting is that a monopolist might foreclose rivals from an input the rivals need to compete effectively.  For example, Google owns YouTube; Google could prominently place YouTube results when users enter queries seeking video content.  (Ignore for the moment that YouTube will necessarily rank highly on other search engines because it is the leading site for video content).  Within this vertical integration framework, there is a standard analysis for understanding when competitive concerns might arise, the conditions that must be satisfied for those concerns to warrant scrutiny, a deeply embedded understanding that harm to rivals must be distinguished from demonstrable harm to competition, and an equally deeply held understanding that these vertical arrangements and relationships are often, even typically, pro-competitive (e.g., in the YouTube example vertical integration likely leads to reduced latency and faster provision of video content).

Second, one might conceptualize organic search results as the product of Google’s algorithm and thus falling into the category of conduct analyzed as “product design” for antitrust purposes.  This algorithm faces competition from other search algorithms and vertical search engines to deliver relevant results to consumers.  It is the design of the algorithm that ranks Google-affiliated content, according to the complaints, preferentially and to the disadvantage of rivals. I explore both beneath the fold.

The two conceptions are not mutually exclusive.  The antitrust implications of the two different conceptions of Google’s organic search are significant.  Courts and agencies generally give wide latitude to product design decisions, through with some prominent exceptions (Microsoft, FTC v. Intel).  Courts are skeptical to intervene on the basis of complaints about product design by rivals because they concerned that such intervention will chill innovation.  Concern for false positives play a central part in the analysis, as do concerns that any remedy will involve judicial oversight of product innovation.  Plaintiffs can and do, from time to time, win these cases, but the product-design conception carries with it a heavy deference for design decisions.

The “vertical” (in the antitrust sense) conception of Google’s search results requires us to think about the economics of algorithmic search ranking, placement choices, and the economics of vertical relationships between a content provider and a search engine.  There are many economic reasons for vertical contractual relationships between such content or product providers and retailers.  Coca-Cola pays retailers for promotional shelf space, manufacturers compensate retailers by granting them exclusive territories, and product manufacturers and distributors often enter into exclusive relationships in which the distributor does not simply feature or promote the manufacturer’s product, but does so to the exclusion of all of the manufacturer’s rivals.

The anticompetitive narrative of Google’s conduct focuses heavily on that prominent placement within Google’s rankings, e.g. the first link or one towards the top of the page, results in a substantial amount of traffic.  This is no doubt true; it is not a sufficient condition for proving competitive harm.  It is equally true that eye-level and other premium level shelf space in the supermarket generates more sales than other placements within the store.  There is good economic reason for manufacturers to pay retailers for premium shelf space (see Klein and Wright, 2007); and evidence that these arrangements are good for consumers (Wright, 2008).  Retailers’ shelf space decisions, and decisions to promote one product over another, are often influenced by contractual incentives; and it is a good thing for consumers.   Now consider the case when the retailer shelf space decision is influenced not by contractual incentive and compensation, but by ownership.  This is really just a special case – as ownership aligns the incentives (like the contract would) of the manufacturer and retailer.  For example, a supermarket might promote its own private label brand in eye-level shelf space.  Alternatively, in a category management relationship, a retailer might delegate a specific manufacturer as “category captain” and allow it significant influence over product selection and shelf space placement decisions.  Note that in the case of exclusive relationships, the presumption that such arrangements are pro-competitive applies to shelf placement that would entirely exclude a rival from the shelf, not just demote it.

In economics, the theoretical and empirical verdict is in about these sorts of vertical contractual relationships: while they can be anticompetitive under some circumstances, the appropriate presumption is that they are generally pro-competitive and a part of the normal competitive process until proven otherwise.  How we conceptualize placement of search results, including those affiliated with the search engine (e.g. Google Maps on Google or Bing Maps on Bing), should influence how we think about the appropriate burden of production facing would-be antitrust plaintiffs, including the Federal Trade Commission.

Indeed, these two models offer important trade-offs for antitrust analysis.  To wit, in my view, the vertical integration model provides a still difficult, but relatively easier case for potential rivals to make under existing case law, but it also integrates efficiencies directly into the analysis.  For example, vertical integration and exclusive dealing cases accept as a starting point the notion that such arrangements are often efficient.  On the other hand, while potential plaintiffs have a tougher initial burden in a product design case, the focus often turns to how the design impacts interoperability and whether the defendant can defend its technical design choices.   Having explored the potential conceptual constructs for characterizing Google’s conduct for the purpose of antitrust analysis, my next post will link those concepts to a discussion of potential remedies, exploring the proposed remedies for Google’s conduct, a relevant historical parallel to today’s “search bias” debate raised by some as a model of regulatory success, and a discussion of the economic non sequiturs surrounding the case against Google as juxtaposed against these proposed remedies.

Filed under: antitrust, economics, federal trade commission, google, monopolization, technology

Excerpt

The FCC published in June its annual report on the state of competition in the mobile services marketplace. Under ordinary circumstances, this 300-plus page tome would sit quietly on the shelf, since, like last year’s report, it ‘‘makes no formal finding as to whether there is, or is not, effective competition in the industry.’’

But these are not ordinary circumstances. Thanks to innovations including new smartphones and tablet computers, application (app) stores and the mania for games such as ‘‘Angry Birds,’’ the mobile industry is perhaps the only sector of the economy where consumer demand is growing explosively.

Meanwhile, the pending merger between AT&T and T-Mobile USA, valued at more than $39 billion, has the potential to accelerate development of the mobile ecosystem. All eyes, including many in Congress, are on the FCC and the Department of Justice. Their review of the deal could take the rest of the year. So the FCC’s refusal to make a definitive finding on the competitive state of the industry has left analysts poring through the report, reading the tea leaves for clues as to how the FCC will evaluate the proposed merger.

Make no mistake: this is some seriously expensive tea. If the deal is rejected, AT&T is reported to have agreed to pay T-Mobile $3 billion in cash for its troubles. Some competitors, notably Sprint, have declared full-scale war, marshaling an army of interest groups and friendly journalists.

But the deal makes good economic sense for consumers. Most important, T-Mobile’s spectrum assets will allow AT&T to roll out a second national 4G LTE (longterm evolution) network to compete with Verizon’s, and expand service to rural customers. (Currently, only 38 percent of rural customers have three or more choices for mobile broadband.)

More to the point, the government has no legal basis for turning down the deal based on its antitrust review. Under the law, the FCC must approve AT&T’s bid to buy T-Mobile USA unless the agency can prove the transaction is not ‘‘in the public interest.’’ While the FCC’s public interest standard is famously undefined, the agency typically balances the benefits of the deal against potential harm to consumers. If the benefits outweigh the harms, the Commission must approve.

The benefits are there, and the harms are few. Though the FCC refuses to acknowledge it explicitly, the report’s impressive detail amply supports what everyone already knows: falling prices, improved quality, dynamic competition and unflagging innovation have led to a golden age of mobile services. Indeed, the three main themes of the report all support AT&T’s contention that competition will thrive and the public’s interests will be well served by combining with T-Mobile.

 

Continue reading 

As I noted in a post last month, the Ninth Circuit recently threw out an antitrust challenge to cable operators’ refusal to provide cable channels on an a la carte, rather than bundled, basis.  (Josh also had some insightful comments on the Ninth Circuit’s Brantley decision.)  In my post, I promised that I would later explain how channel bundling, which permits cable operators to price discriminate and extract greater consumer surplus, may nonetheless benefit consumers by expanding output.  Having just finished incorporating a number of helpful comments Herbert Hovenkamp gave me on a forthcoming tying/bundling article (more about that later!), now seems like a swell time to return to the topic of cable bundling.

Read the full piece here. 

Others have linked to this, but its really a fantastic video of a discussion between Justin Wolfers and Robert Frank discussing happiness and economic growth.

Filed under: behavioral economics, economics

Of likely interest to many of our readers (HT: WSJ):

Christine Varney, the U.S. government’s chief antitrust regulator, is expected to join New York law firm Cravath, Swaine & Moore LLP as a partner later this year, people familiar with the matter said.  Ms. Varney was appointed assistant attorney general for the antitrust division in 2009, and had been at Hogan & Hartson LLP, focusing on the firm’s antitrust and Internet practices.  At Cravath, Ms. Varney will work on antitrust issues related to merger-and-acquisition transactions, the people said.

Former Cravath partner Katherine Forrest worked under Ms. Varney at the Justice Department beginning last October. Ms. Forrest is slated to become a federal judge in the Southern District of New York court.

Cravath is one of the top M&A law firms in New York, working on deals such as the $3 billion sale of retailer J. Crew to a group of private-equity firms including TPG Capital and last year’s merger between Continental Airlines and United Airlines.

 

Filed under: antitrust