In Apple v Epic, 9th Circuit Should Remember that Antitrust Forbids Enhancing, not Exercising, Market Power - International Center for Law & Economics
Focus Areas:    Antitrust | Apple | Competition

In Apple v Epic, 9th Circuit Should Remember that Antitrust Forbids Enhancing, not Exercising, Market Power

Truth on the Market View Original

[The following is adapted from an amicus brief filed by the author and other professors of law & economics to the 9th U.S. Circuit Court of Appeals in the case of Epic Games v. Apple.]

Every voluntary transaction between a buyer and seller involves the creation of surplus—the difference between the subjective value a buyer attaches to the thing and the seller’s cost of producing and selling the item. Price and other contract terms determine how that surplus is split between the buyer and seller.

In more competitive markets, producers must allow greater surplus to consumers (typically by lowering prices) or they will lose sales to rivals. When a producer faces less competition because its offering is more unique, it need not give up as much surplus to retain sales. It can extract for itself more of the surplus generated by the sale of its product. A firm’s ability to enhance its profits by raising price above the level that would prevail in a competitive market (where firms are concerned about losing sales to rivals) is market power.

Antitrust law recognizes that innovators like Apple are lawfully entitled to exercise their legitimately obtained market power to extract whatever surplus they can derive from transactions involving their innovations—in this case, Apple’s innovative mobile operating system (iOS) and mobile devices—so long as they do not somehow enhance their market power through those transactions. Allowing firms to profit from innovation serves the procompetitive policies of antitrust law by providing strong incentives for innovation by all competitors.

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Epic has challenged two policies that are part of Apple’s business model for monetizing its innovative app platform. One policy requires developers to distribute iOS apps exclusively through Apple’s App Store. The other requires developers to use Apple’s proprietary In App Purchase system (IAP) in conjunction with any payments that app users make while using an iOS app. Apple then retains a share (typically 30%) of the revenues from App Store sales and from app users’ purchases of digital goods using IAP.

The challenged policies provide Apple a way to exercise its legitimately obtained market power to extract some of the surplus created by iOS app sales and in-app purchases. Apple, however, could still collect the same surplus it currently extracts from iOS app transactions even without those two policies. For example, it could require app developers to contribute a portion of their revenues to obtain access to the software development tools and the 150,000 application programming interfaces (APIs) needed to produce operable iOS apps.

Because the challenged policies do not foreclose competition in any market, but only enable Apple to collect surplus it could extract using other means, the policies do not extend Apple’s market power. That is critical.

Antitrust law distinguishes between behavior that enables a dominant firm to enhance its market power by weakening competitive constraints and conduct by which a firm exercises that power solely to extract a greater proportion of the surplus its innovations create. While the former conduct is forbidden, the latter is not.

And for good reason. Allowing exercises of market power that merely extract surplus without enhancing or expanding power fosters dynamic efficiency in two ways: such an approach both motivates innovation with the prospect of higher profits and enables innovation because higher returns often finance further innovative efforts in pursuit of still greater returns. Allowing surplus extraction that does not enhance market power also avoids intractable questions that would turn antitrust courts into price regulators.

Because the policies Epic has challenged do not increase or expand the scope of any market power Apple may possess, they should not give rise to antitrust liability.

Nor should the challenged policies be condemned on the ground that Apple could extract the surplus to which it is entitled using less restrictive means. The Supreme Court recently warned that “antitrust law does not require businesses to use anything like the least restrictive means of achieving legitimate business purposes.” Counseling judicial restraint is the law of unintended consequences. As then-Circuit Court Judge Stephen Breyer wrote in 1983’s Barry Wright Corp. v. ITT Grinnell Corp.intrusion may “prove counter-productive, undercutting the very economic ends [it] seek[s] to serve.”

So it is here. Alternative approaches in which Apple simply charged developers a fee (flat or revenue-based) for the digital amenities required to produce operable iOS apps would likely reduce consumer welfare relative to the status quo. That is the opposite of what antitrust law strives to achieve.

Antitrust Doesn’t Forbid Profiting from Market Power in Ways that Don’t Enhance that Power

Although “Congress designed the Sherman Act as a ‘consumer welfare prescription,’” Reiter v. Sonotone Corp., 442 U.S. 330, 343 (1979), short-run harm to consumers is not sufficient to condemn a business practice under the Sherman Act. The challenged practice must also involve an enhancement of market power.

As Dennis Carlton and Ken Heyer observed, two different types of market-power-related business behavior may injure consumers. One is an exercise of market power, whereby a firm that lacks competitive constraints may increase its profits by constricting its output to drive up prices. The other is an effort by a firm to enhance its market power by weakening competitive constraints, whether by using its own market power to exclude rivals or raise their costs or by entering into an anticompetitive agreement (or merger) with one or more competitors.

Antitrust law forbids behavior that enhances market power but permits actions that merely exercise legitimately obtained market power without somehow enhancing it. For example, simply charging even monopoly prices does not violate Section 2 of the Sherman Act, even though it creates immediate consumer harm by extracting a greater share of the surplus created by the transaction. As per the Supreme Court’s 2004 Trinko decision and the 9th Circuit’s 2020 decision in Qualcomm, a monopolist is entitled to a monopoly price.

The District Court recognized that Apple’s lawfully obtained market power, by definition, gave it the ability to set its price above marginal cost, yet the court repeatedly suggested that there was some optimum price that Apple should charge. For example, the court found significant that “Apple has provided no evidence that the rate it charges bears any quantifiable relation to the service provided,” and complained of the lack of “market forces to test [Apple’s business] proposition or motivate a change.” But a seemingly high price resulting from legitimately obtained market power is not unlawful. Antitrust courts are not price regulators. Unless a price tends to exclude competition—and high prices tend to attract, rather than repel, competitors—a price itself is not anticompetitive.

Apple’s percentage commissions on its suite of mobile-gaming transaction services effectively meter the value of access to its innovative app platform. Neither the conduct nor the effect is anticompetitive.

Epic’s theories would condemn purely extractive exercises of market power that further consumer welfare by promoting dynamic efficiency. Dynamic efficiency—the welfare gains that accrue over time from the development of new and improved products and services—results from innovation, which entails costs and risks for the innovator. Entrepreneurs are more willing to accept those costs and risks as their potential payoff for success rises. And potential payoffs are higher when innovators may earn supracompetitive profits because their unique offerings do not face vigorous competition.

Allowing innovators to earn high profits also mitigates a problem that results from the fact that, as American University’s Jonathan B. Baker put it, “the benefits of innovation to society as a whole greatly exceed the benefits to the firms that develop the innovation.” Because an innovator typically bears all the cost of its innovative efforts while capturing only a fraction of the benefits produced, innovators may not be optimally motivated to produce.

Like all producers, innovators typically do the easier, higher-payoff things first, eventually transitioning to efforts that are costlier and offer less incremental benefit. Optimal production occurs at the point at which the (rising) incremental cost of an effort just equals the (falling) incremental benefit it generates. While efforts beyond that point cost more than the benefits they create, all efforts up to that point create benefits that exceed their costs. If a producer is bearing all the cost of its efforts, but capturing only a portion of the benefits created, it will stop its productive efforts too soon.

Allowing innovators to earn higher profit from their unique creations helps internalize the positive externalities (i.e., benefit spillovers) that result from innovation and therefore helps to secure a closer-to-optimal level of innovative effort. That is why, as Justice Antonin Scalia wrote in Trinko, “the mere possession of monopoly power, and the concomitant charging of monopoly prices … is an important element of the free market system.”  Moreover, the “opportunity to charge monopoly prices—at least for a short period—is what attracts business acumen in the first place; it induces risk taking that produces innovation and economic growth.” Accordingly, even in cases of monopoly power not present here, the possession and exercise of that power “will not be found unlawful unless … accompanied by an element of anticompetitive conduct.

Profits extracted through the exercise of legitimately obtained market power not only motivate innovation, but they also help to fund innovative efforts. While businesses that are forced by competition to charge prices near their incremental cost must secure external funding for significant research and development (R&D) efforts, firms collecting supracompetitive returns can finance R&D internally.

In addition to fostering innovation, antitrust law’s tolerance of non-power-enhancing exercises of market power allows courts to avoid trying to determine which instances of mere surplus extraction should be precluded. Such efforts would cause much more harm than good.

One alternative similar to Epic’s proposals here would prohibit surplus extraction achieved by something apart from pricing alone—say, by a requirement that a buyer of one product also purchase or use another product or service. But condemning more complex instances of mere surplus extraction, while permitting simple monopoly pricing, would be both arbitrary and backward.

It would be backward because, while simple monopoly pricing always reduces overall market output, more complicated methods of extracting surplus (such as metering) often enhance market output and overall social welfare. For example, by allowing a firm with market power to price discriminate according to consumers’ willingness to pay, metering may enable the firm to produce and sell all tying-product units that create greater value than they cost to produce while collecting maximum profits from consumers who attach a high value to the product.

A second alternative—forbidding all pricing that is arguably supracompetitive—would require delineating impossible-to-draw lines. Above-cost pricing by firms with niche products or effective brand differentiation is ubiquitous. Any pricing based on brand differentiation would be subject to challenge whenever a lawyer could portray the price as related to a deleterious form of market power. That alternative would result in inconsistent and unpredictable judicial price regulation.

A third option would preclude exercising market power to extract more surplus than is necessary to motivate and enable innovation. That would be pure judicial price regulation. Courts are poorly equipped for that task, and their inevitable mistakes could significantly chill entrepreneurial innovation and harm consumer welfare.

Consider, for example, a firm contemplating a $5 million investment that might return up to $50 million. Suppose the managers of the firm weighed expected costs and benefits and decided the risky gamble was just worth taking. If the gamble paid off but a court stepped in and capped the firm’s returns at $20 million—a seemingly generous quadrupling of the firm’s investment—future firms in the same position would not make similar investments. A gamble barely worth taking when available returns were estimated at $50 million would not receive a second look if returns could be capped at $20 million on the specious grounds that “excessive operating margins” were “anticompetitive effects.”

The best policy draws the line as the Supreme Court has done, by forbidding enhancements of market power but permitting mere exercises of legitimately obtained market power to extract surplus.

Apple’s App Store and IAP Requirements Do Not Enhance Its Market Power

The policies Epic has challenged do not enhance Apple’s market power in any conceivable market. Apple’s ability to determine how and whether to license elements and uses of its iOS operating system includes determining which applications can run on its iPhones and iPads.  Developers cannot produce operable iOS apps unless Apple grants them access to the APIs required to enable the functionality of the operating system and hardware. In addition, Apple can require developers to obtain digital certificates that will enable their iOS apps to operate when downloaded.

Given this control over its intellectual property, Apple could collect exactly the same surplus it currently extracts from iOS app sales and in-app purchases using different, equally lawful means. Apple could simply withhold access to the APIs or digital certificates needed to run iOS apps unless developers promised to pay it 30% of their revenues from app sales and in-app purchases of digital goods. The challenged policies therefore do not enhance Apple’s market power in the markets Epic has proposed.

Nor do the policies enhance Apple’s market power in the “mobile gaming transactions” market defined by the District Court. Apple neither distributes apps to users of non-iOS platforms nor processes in-app payments made within non-iOS apps, so the challenged policies have no effect on any broader market relating to mobile apps and payments.

And with respect to purchases of or within iOS apps, Apple would have the same ability to extract surplus from such transactions even without the challenged policies. Nothing about the policies enhances that power, though it is possible that consumers prefer the benefits those policies offer, such as the privacy and security benefits recognized by the District Court. That preference might help explain why, although Apple has only a 15% share of the smartphone market, Apple has more than half of the mobile gaming transactions market. But the challenged policies do not provide Apple with any market power it does not already possess.

Condemning Apple’s Policies Would Likely Reduce Consumer Welfare

Because the policies Epic has challenged are not the source of Apple’s ability to extract surplus from iOS app transactions, condemning the policies would be likely to induce Apple to extract surplus using other means. But forcing such changes would likely leave consumers worse off than they are under the status quo.

As an alternative to its current business model, Apple could simply charge developers a flat fee for access to the APIs and digital certifications needed to produce operable iOS apps, but then allow them to use whatever app distribution and in-app payment services they preferred. If the flat fee were sufficiently large, Apple could still earn substantial app-related revenues, while permitting competition among app stores and in-app payment processors.

But a move to this revenue model would be likely to injure consumers by:

  1. reducing the number of apps available at attractive prices;
  2. increasing app developers’ business risks and weakening their incentive to innovate;
  3. diminishing Apple’s incentive to improve its mobile operating system and hardware;
  4. driving up prices for Apple devices; and
  5. impairing user security and privacy.

A second alternative for Apple, should this 9th Circuit condemn the policies Epic has challenged, would be to charge app developers a revenue-based fee for the amenities required to produce operable iOS apps. Charging developers 30% of their revenues from app transactions while allowing them to use whatever app distribution and in-app payment services they preferred, could theoretically allow Apple to collect the surplus it currently extracts—and which antitrust law permits it to collect—while permitting competition in iOS app distribution and in-app payment processing. Such a policy could also avoid many of the difficulties of a flat-fee revenue model. In the end, however, moving to a revenue-based fee model would likely reduce consumer welfare relative to Apple’s current approach.

Charging a revenue-based fee for the amenities required to produce operable iOS apps would entail costs that do not exist under Apple’s current system. By requiring that app sales occur through its App Store and that in-app purchases utilize IAP, Apple currently collects its revenue share immediately at the point of sale. Under a revenue-based license system, Apple would incur additional costs of collecting revenues owed and ensuring that app developers are accurately reporting their revenues. To extract the same revenue under this model, Apple would have to raise its revenue-sharing percentage above its current commission rate to cover its added collection and auditing costs.

Conclusion

The policies Epic has challenged enable Apple to extract surplus from transactions involving the unique product it created, but they do not give it any new market power or shore up its existing market power. Condemning the challenged policies and thereby inducing Apple to use alternative means to extract surplus from iOS app transactions is likely to reduce consumer welfare relative to the status quo. Accordingly, the 9th Circuit should affirm the District Court’s ruling that Apple has not violated antitrust law.