Feature Articles
How the Chicago School Overshot the Mark
Economic Analysis of Exclusionary Vertical Conduct: Where Chicago Has Overshot the Mark
By Steven C. Salop
Few antitrust issues are less contentious than the analysis of exclusionary vertical conduct and anticompetitive allegations of leverage and foreclosure. These concepts can occur in a wide variety of conduct — tying, exclusive dealing, vertical mergers, refusals to deal, and so on. The Chicago School revolution really began with its analysis of exclusionary vertical restraints and there has been continued controversy ever since.
The Chicago School argument is that the antitrust concepts of anticompetitive foreclosure and anticompetitive leverage are empty and illogical and do not hold up to economic analysis. As for exclusives, the associated argument is that competition for exclusive relationships benefits consumers, just as do other forms of competition. In short, exclusionary vertical conduct is either benign or procompetitive. Thus, the law regarding exclusionary vertical conduct should be very permissive or even per se legal. Judge Posner has suggested the use of a very permissive legal standard, the equally efficient entrant standard, which flows from the Brooke Group standard for predatory pricing.
Here, I do not review the case law on this set of issues. Instead, I examine the economic foundations of the controversy as a way to inform the debate. In my view, the strong economic foundations claimed by Chicago School commentators like Robert Bork do not hold up to economic analysis. The concepts of anticompetitive foreclosure and leverage are not empty and illogical. Competition for exclusives is not a panacea for all vertical exclusion claims. Nor is the predatory pricing paradigm the appropriate framework for analyzing exclusionary vertical conduct. Instead, a more refined analysis must be applied. This analysis implies that the better legal approach would be the rule of reason with its focus on consumer harm, not a proxy rule like the equally efficient entrant standard.
In the section that follows, I analyze anticompetitive foreclosure and the view that competition for exclusives can resolve all concerns about vertical exclusion. At the end, I discuss the issue of the two paradigms for exclusionary vertical conduct and show the fundamental economic flaw in the equally efficient entrant standard.
Vertical Integration and Anticompetitive Foreclosure
Conservative commentators have criticized the concept of anticompetitive foreclosure in the older cases like Brown Shoe. Bork suggested that the foreclosure alleged to occur from vertical mergers was nothing more than a remixing of supplier-customer relationships. As he cleverly put it, competition would be better served if the FTC had held an industry social mixer instead of bringing an antitrust action to enjoin a vertical merger. Those cases did not explain how foreclosure would lead to market power.
However, uncritical acceptance of this critique of foreclosure leads to an overly permissive view of vertical mergers and other exclusionary vertical conduct and restraints, and an overly skeptical view of antitrust allegations based on anticompetitive foreclosure concerns. Modern economic analysis has drawn the logical linkage between foreclosure and market power. In particular, vertical mergers can lead to real foreclosure that creates market power in either the upstream or downstream market under certain identifiable circumstances.
A vertical merger can lead to market power in the downstream market. Suppose that after the merger, the upstream division of the integrated firm refuses to deal with or raises the input price charged to unintegrated downstream competitors. Suppose that these unintegrated competitors lack equally cost-effective alternative sources of the input. Or, suppose that they only have one or two other alternative suppliers, and that those suppliers realize that the behavior of the now-integrated firm increases their market power over the unintegrated firms. In these circumstances, the merged firm may have the incentive to raise prices or refuse to deal, and that conduct will raise the cost of their integrated rivals. If there is insufficient remaining competition in the downstream market among integrated firms or other unintegrated firms that have cost-effective alternative sources of supply, then the downstream price may increase, leading to consumer injury.
Judge Posner’s opinion in JTC Petroleum suggested a variant of this foreclosure analysis. In that case, Posner analyzed the case of a downstream cartel that prevents disruptive competition by a maverick by agreeing with input suppliers to refuse to deal with the maverick. The downstream cartel members compensate the input suppliers by paying a supracompetitive price for the inputs they bought, thereby sharing the cartel profits with those suppliers. Thus, the input suppliers enforce the downstream cartel. In this example, there is no actual vertical integration. Instead, there is anticompetitive “integration by contract.”
A vertical merger also can lead to market power in the upstream market. Suppose that after the merger, the downstream division of the integrated firm were to refuse to purchase from unintegrated input suppliers and instead began to purchase all of its input needs from the upstream division. If the downstream division of the integrated firm represented a large share of the market, withholding its purchases might drive one or more upstream competitors to exit from the market or be forced into a higher cost niche position. Either way, that might give the upstream division of the integrated firm the power and incentive to raise the prices it charges its other competitors.
Leverage theories of tying discussed earlier also may be applied to foreclosure analysis. For example, suppose that there were a purely vertical merger of an upstream monopolist and a downstream monopolist. (In terms of complementary products, the analogy would be a merger among the monopolistic producers of two complementary products, for example, hot dogs and hot dog buns.) That merger could be procompetitive by giving the two firms the incentive to reduce their prices. This is the well-known efficiency benefit of “eliminating double-marginalization.” Before the merger, a price decrease by one of the firms to a level slightly below the monopoly price would decrease its own profits slightly. At the same time, it would increase the demand for the product and the profits of the other firm. The joint profits of the two firms would rise, but in the pre-merger world that opportunity would not be taken unilaterally. After the vertical merger, this mutual benefit of lower prices would be taken into account and would lead to the incentive to reduce prices of both products.
However, this vertical merger also could be anticompetitive by reducing or eliminating the potential for entry.Before the merger, each firm would have the incentive to cooperate with firms who were trying to enter the market of the other firm. Competition into the other market would lead to lower prices in that market and, therefore, higher demand and profits for the complementary product. Indeed, each firm might be a potential entrant into the market of the other firm. In contrast, this incentive to facilitate independent entry would disappear. As a result, entrants would need to enter both markets simultaneously. This requirement of two-level entry may raise barriers to entry and lead to higher prices, even after taking the elimination of double marginalization benefit into account.
