David J. St.

Clair

Microeconomics for Managers

Chapter 13
A Final Look at Competition: Antitrust Policies

Competition and Antitrust: Legal Parameters of the Firms Environment

Lets return to Smiths Formula one more time. Smith argued that markets
would work well in channeling self-interest into serving the public interest
provided that there was sufficient competition in markets. We have characterized
the ongoing debate in economics and public policy circles as a 200-year-old
dispute over whether there is or is not sufficient competition to warrant a laissezfaire policy. Proponents of laissez-faire generally point to there being more,
rather than less, competition to support for their position. They advocate only
minimal government intervention to establish the infrastructure necessary for
markets to work. They also seek to confine antitrust policy to laws that restrict
specific anti-competitive practices. It should be pointed out that these proponents
of the market and limited government intervention are not anarchists they
advocate restricted intervention, not an absence of government involvement.
On the other side, those who see too little competition generally advocate
more, rather than less, antitrust intervention. Again, the question is degree few
advocate socialism or an end to markets.
The 200-year-old question has gone hand in hand with these policy
debates. In this last chapter, we will look at the legal product of this debate that
has unfolded over the last century.

Antitrust: The Issues

Antitrust law often confuses students because it is usually presented as a

bunch of laws and court cases without any meaningful context. This is especially
the case when one drops in "cold" on a complicated case such as the Microsoft
case. To remedy this, a short discussion of five laws and fourteen court cases
follows. This short list (and it really is the short, short list) chronicles the
development of U.S. antitrust law. This discussion of statute and case law is

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preceded by an equally important discussion of the economic and historical

background. The Microsoft case is presented last.
This discussion primarily deals with U.S. antitrust cases and laws. The
goal is not to make you a legal scholar (or worse, a lawyer). The goal is to give
you a solid background on the legal and economic issues in the ongoing policy
disputes over maintaining competition in markets.
In addition, there is nothing uniquely American about these issues.
Historically, the U.S. took the initiative in antitrust legislation and case law, and
U.S. antitrust laws remain the most stringent in the world. Today, more than 60
countries around the world have antitrust laws on the books, many patterned on
American law. Most importantly, the European Union is in the process of creating
European antitrust laws and Russia is also enacting antitrust laws needed to
maintain competition in post-Soviet markets. The Europeans and the Russians
have built on U.S. antitrust experience and they have had to contend with the
same issues encountered below. Looking further down the road, it is likely that
China will also have to address these issues as the Chinese economy grows and
develops.

Background: The Common Law

English common law serves as a base for American antitrust laws. From
the English common law, the role of case law in creating a body of law was
established. Case law is based on court rulings in specific cases that are then
held to be applicable to everyone else.
The common law also established the principle that a contract in restraint
of trade was unenforceable. As the discussion of the German wood pulp cartel
case (below) illustrates, this has often not been the case in other countries.
In addition, English common law outlawed three specific practices as
restraint of trade: forestalling, regrating, and engrossing. Forestalling was
meeting suppliers outside of the market place, usually on their way to market,
and buying up the supply before it reached the market. Regrating was buying in
the market with the intent to remove supply and profit from sales at a higher
price. Engrossing was buying up stocks of goods to "corner" the market. These
illegal practices are clearly more relevant to an earlier day of rural village
markets. However, the precedent that the law could disallow certain types of
practices in order to keep markets competitive was established under common
law. In addition, American statute laws of the late nineteenth century are
basically an elaboration and extensions in the common law tradition.

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Background: Seeking Relief from "Destructive Competition"

Common law established precedent for government intervention to
promote and maintain competition, but it was the rise of big business enterprises
in the nineteenth century that established the need for such policies. The
practices specifically addressed by the common law are rather antiquarian and
not readily applicable to modern industry. In order to understand antitrust issues
and the evolution of government regulation, it is necessary to briefly look at the
problems of big business from a business perspective. Andrew Carnegie
provided such a perspective and coined a term, "destructive competition," that
summarized his view of the competitive environment after the Civil War. It is
important to emphasize that "destructive competition" is not the same as
"creative destruction," which is a completely different concept.
Carnegie emigrated to the U.S. when he was thirteen and worked his way
up from menial jobs to become the leader of one of the largest steel companies
in the world. He was renowned for his managerial skills and his willingness to
expand during recessions and depressions. He was ruthless in a day when
ruthlessness was a requisite for survival. Later in life, he retired by selling his
interests in the public offering that created U.S. Steel in 1901. He spent his
retirement fishing and engaged in philanthropy.
Carnegie was also an astute and articulate business spokesman.
Philosophically, he supported the social ideal of competition, but he also
understood the problems created by large-scale enterprise. In particular, he gave
a perceptive description of the rationale and evolution of the various forms of
combination and collusion that were typical of the late-nineteenth century.
Carnegie observed that a condition of excess supply in a market drove
down the price, usually to levels below cost. Profits were thus eliminated. At this
point, Carnegie observed that the reaction of large-scale enterprises was very
different from the scenario envisioned by Adam Smith. Regarding the low prices
and lack of profits during periods of excess capacity, Carnegie wrote:
" Political economy says that here the trouble will end. Goods will
not be produced at less than cost. This was true when Adam Smith wrote,
but it is not quite true to-day. As manufacturing is carried on to-day, in
enormous establishments with five to ten millions of dollars of capital
invested,. it costs the manufacturer much less to run at a loss per ton or
per year than to check his production. Stoppage would be serious indeed.
The condition of cheap manufacture is running full. Twenty sources of
expense are fixed charges, many of which stoppage would only increase.
Therefore the article is produced for months and, in some cases I have
known, for years, not only without profit or without interest on capital, but
to the impairment of the capital invested"

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(A. Carnegie, "The Bugaboo of trusts," North American Review, Vol. 148 (February,
1889), as quoted in C. Hession and H. Sardy, The Ascent to Affluence, (Boston: Allyn
and Bacon, 1969) p. 465).

Carnegie went on to describe how gentlemen's agreement, pools, trusts,

etc all grew out of efforts of business owners to find relief from this destructive
competition. These, as well as the holding company and combinations through
mergers that were to follow, were merely different organizational forms
undertaken to address the problem of destructive competition. In many respects,
the history of big business trusts or monopolies in the late nineteenth century is
the story of the quest for an organizational form that worked and avoided the
antitrust laws.

Antitrust Statute Law

Statute laws are passed by Congress and signed by the President (or
allowed to become law without presidential signature or veto). Our most
important federal antitrust laws are:

Sherman Antitrust Act (1890)

Clayton Act (1914)

Federal Trade Commission Act (1914)

Celler-Kefauver Act (1950)

Hart-Scott-Rodino Act (1976)

Each of these laws will be briefly described, emphasizing their principle

contribution to U.S. antitrust policy.

Sherman Act (1890)

In the 1870s and 1880s, public resentment of trusts and the fears of
businessmen of having to deal with separate state antitrust prosecutions resulted
in the passage of the federal Sherman Act in 1890. The core of the act is
embodied in two major provisions:

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"Sec. 1. Every contract, combination in the form of a trust or

otherwise, or conspiracy, in restraint of trade or commerce among
the several states, or with foreign nations is hereby declared to be
illegal."
"Sec. 2. Every person who shall monopolize, or attempt to
monopolize, or combine or conspire with any person or persons, to
monopolize any part of the trade or commerce among the several
states, or with foreign nations, shall be deemed guilty of a
misdemeanor."
The Sherman Antitrust Act made monopoly and "restraints of trade" (e.g.,
collusive price fixing or the dividing up of markets among competitors) criminal
offenses. Either the Department of Justice or parties injured by monopoly or anticompetitive behavior could file law suits under the Sherman Act. The Sherman
Act also provided for fines and/or imprisonment for offenders.
The Sherman Act is one of the few statutes that non-lawyers have little
problem reading and understanding. There in was the problem. While the law
appears to be simple and straight-forward, it proved to be anything but in case
law application. Cases such as the E.C. Knight case (below) sought to limit its
application and most other cases have sought to establish what the Sherman Act
meant.

The Road Not Taken: German vs. American Approaches to Antitrust

The United States was one of the first countries to develop strong antitrust
laws and today retains the most stringent laws in the world. Historically, most
European countries have either not had any meaningful antitrust laws, or have
actively sought to suppress competition rather than foster and promote it.
Germany is often cited as an example of this different approach. Indeed,
the difference between the United States and much of the world can be seen in
the divergent paths taken by Germany and the United States in the 1890s. The
Sherman Act established the basic approach to antitrust that would, with twists
and turns, create the U.S. antitrust policy that we know today.
In 1893, a German court case established a very different foundation for
German policy toward competition and monopoly. A Wood Pulp Manufacturers
Cartel was established in Germany in the 1890s. The cartel members formally
joined the cartel in a contract that called for the cartel members to fix prices and
adhere to output quotas. In effect, the cartel created a joint monopoly that
eliminated competition.

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After joining the cartel, one firm decided to quit the cartel and compete for
business in the market. The cartel sued the firm for breach of contract in a
German court.
Under American common law, this case would have resulted in the court
refusing to uphold the contract because it was clearly in restraint of trade. Under
the Sherman Act, evidence of such a contract to fix prices would have amounted
to self-incrimination; that is, it would have been proof of a violation of the law. In
all likelihood, the cartel would never have filed the suit in an American court in
the first place.
However, the German cartel took the wayward firm to court. The German
court held that the departing firm was in breach of contract. It ruled that a cartel
contract was not illegal unless its terms were so extreme as to be injurious to the
public interest. The court ruled that this was not the case here. In addition, the
German court went on to declare that "ruinous competition" was not in the public
interest, and that a cartel, by eliminating ruinous competition, could be "especially
useful for the economy as a whole." According to the court, it was good policy to
promote socially responsible cartels.
The effect of this and other German rulings was to embrace restraint of
trade as good public policy. In addition, "ruinous competition" is remarkable close
to Carnegie's "destructive competition." The difference lies primarily in how the
two doctrines were treated in the U.S. versus Germany. German cartels grew in
importance before World War II, reaching a peak during National Socialism.
Cartels continued to be the norm rather than the exception in post-war Germany.
In addition, until the recent development of a vigorous EU antitrust policy, the
German approach rather than American policies held sway in Europe. In fact, the
European Union can trace its roots to the European Coal and Steel Cartel in the
1950s. While the European Union is currently pursuing an antitrust policy more
similar to American policy, the roots of cartels and protectionism run deep in
Europe and are not likely to be easily purged.

The Clayton Act (1914)

In 1914, the Clayton Act sought to address specific anti-competitive practices.
Specifically, the act outlawed:

Price discrimination with the intent to restrict competition.

"Tying contracts" that require a buyer interested in one product to also buy
another of the firm's products as a condition of sale.

Acquisition of stocks of competing corporations when the effect is to lessen

competition.

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Formation of interlocking directorates (where a director of one firms is also a

board member of a competing firm).

Paying a broker's fee for which no broker services are rendered.

Perhaps most importantly, the Clayton Act introduced "illegal per se" into
antitrust enforcement. Illegal per se activities are practices that are illegal
regardless of intent or consequences (for example, the degree to which
competition is reduced). A practice that is illegal per se needs only be proven to
have occurred to obtain a conviction. Motive and the extent of injury are not
relevant. On the other hand, there are practices that are not illegal per se, but
which can be illegal if the intent is to restrict competition or the effect is to
significantly restrict competition.
For example, price fixing and tying contracts are illegal per se under the
Clayton Act. In contrast, price discrimination is not illegal per se. A successful
antitrust prosecution for price discrimination would have to demonstrate intent
and/or the effect of significantly reducing competition. "Exclusive contracts" (for
example, exclusive dealerships, authorized service reps, etc.) also illustrate the
distinction. Exclusive contracts are not illegal per se, but could be violations of
antitrust laws depending on motive and consequences.

On Tying Contracts: When Illegal Per Se gets a Bit Fuzzy

Tying contracts (also known as Tie-in Sales or Tying Arrangements) are
illegal per se under the Clayton Act. However, the law on tying has actually
proven to be ambiguous at best. Tying means that a firm with market power in
the sale of one good (the tying product) forces a customer for the tying product to
buy another product (the tied product) as a condition of sale. The classic
example might be IBM, the dominant maker of large mainframe computers (with
a market share in the eighty percent plus range) requiring its computer
customers to purchase IBM typewriters as a condition for purchasing its
computers. The rationale for this tying arrangement was to use IBMs near
monopoly in computers to force sales in the highly competitive typewriter market.
While it is easy to see how tying reduces competition in this case (and
why it was made illegal per se in the Clayton Act), the issue becomes much less
clear when we consider tying arrangements that exist de facto in the normal
course of business. For example, when you buy shoes, you are forced to buy two
shoes. What if you only needed one shoe? Why is the sale of the right shoe tied
to the left shoe? (The puns here are almost too hard to resist, but we will resist
temptation.) Amputees have long dealt with this issue and spare-shoe banks
cannot completely eliminate their problem of having to purchase unnecessary
footwear.

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Or consider your purchase of a new car. Your Honda came with a Honda
engine. What if you wanted a Honda car, but one powered by a Toyota engine?
Your purchase was tied. We could also use another term and say that your
purchase of a Honda was bundled, in the sense that it was a collection of
separate components assembled without the buyer having the option of choosing
different components. (Note: options packages do not negate this point these
packages are all selected by Honda to differentiate their product to appeal to
different buyers they do not allow the buyer a full range of component
selection, especially among non-Honda component suppliers.)
Are these practices anti-competitive? It may be anti-competitive in its
effects on engine producers in the automobile example. How can independent
engine makers survive in a world where auto assemblers tie the sale of their own
engines to the rest of the car? In fact, in the U.S. before 1930, there were a large
number of independent engine manufacturers who competed for contracts to
supply engines for automobile manufacturers. Their business dried up as auto
assemblers bundled their own engines in their vehicles. In this case, the
combination of bundling and vertical integration of engine manufacturing lead to
the elimination of the market for engines manufacturers.
It may be worth pointing out that boats are often sold without engines,
allowing the boat buyer to purchase an engine of her choice. Why are boats sold
without bundling the engines with the hull? Apparently, boat buyers prefer the
freedom to select different engine (for different boating uses) over the
advantages afforded through bundling.
So, while the law says that tying is illegal per under the Clayton Act, in
practice it must be a different story. It seems that motivation and intent must be
considered when applying the law regarding tying contracts. Bundling offers
customers seamless and effective integration of components. In fact, notice how
the public generally reacts negatively to after-market components that are
installed by car owners. (For example, that car alarm that you installed on your
vehicle will always be viewed suspiciously compared to a factory-installed alarm;
the latter are prone to problems while factory-installed usually means troublefree.)
Going forward, the law on tying arrangements will need to wrestle with the
issue of when bundling is, and is not, tantamount to tying. The issue is likely to
focus on bundling in high tech industries. In all likelihood, the motives behind
bundling and the competitive effects will be the determining factors. In any case,
specific enforcement criteria will have to await case law rulings.

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The Federal Trade Commission Act (1914)

In 1914, the Federal Trade Commission Act created a five-member
Federal Trade Commission (FTC) and charged it with the responsibility of
enforcing the antitrust laws, in particular the Clayton Act. The FTC was given the
power to investigate unfair competitive practices on its own initiative or at the
request of injured firms. The Commission could hold public hearings on such
complaints and, if necessary, issue cease and desist orders when "unfair
methods of competition in commerce" were discovered. The act both broadened
the range of illegal business behavior and established an independent antitrust
agency with the authority to investigate and initiate court cases.

The Celler-Kefauver Act (1950)

The Celler-Kefauver Act (1950) prohibited a firm from acquiring the
physical assets (e.g., buildings and equipment) of competitors when the
acquisition would reduce competition (the Clayton Act outlawed mergers through
stock acquisition). This closed a loop hole in the antitrust laws relating to
horizontal mergers. However, the most important part of the Celler-Kefauver Act
was its deletion of language from the Clayton Act that effectively limited antitrust
laws to horizontal monopoly. (Section 7 of the Clayton Act had made mergers
illegal where the effect may be to "substantially lessen competition between the
corporation whose stock is acquired and the corporation making the acquisition,"
that is, reducing competition between horizontal competitors. By eliminating this
language, antitrust laws covered vertical and conglomerate mergers that might
substantially lessen competition anywhere.) When firms use vertical acquisitions
to eliminate competition, economists call it "vertical market foreclosure." The
Celler-Kefauver Act effectively made vertical market foreclosure illegal.

The Hart-Scott-Rodino Act (1976)

The Hart-Scott-Rodino Act (1976) made a significant change in antitrust
policy by requiring pre-merger notification and approval by the Justice
Department and the FTC prior to the merger. The law covers mergers regardless
of business ownership status (for example, the law covers proprietorships and
partnerships, not just corporations). The threshold (the size of the deal involved)
is very low, so most mergers must comply with the Hart-Scott-Rodino
requirements. Approval must be received from both regulatory bodies prior to the

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merger. Approval may be conditional on modifications in the merger or

divestitures of overlapping assets.
Prior to the Hart-Scott-Rodino Act, antitrust policies were usually applied
reactively. Firms merged or were well into the process of merging when the
government reacted with a suit to block or undo the merger. The Hart-ScottRodino Act made antitrust policy more pro-active by requiring pre-merger
notification, review, and approval.
The Hart-Scot-Rodino Act requires notification and approval of both the
Justice Department and the FTC. There is a similar notification and approval
requirement imposed by the European Union. This is not based on the HartScott-Rodino Act, but rather on newly created European Union antitrust laws that
cover firms operating in Europe. Today, any merger involving an American firm
with business dealings in Europe must provide pre-merger notification and obtain
the approval of the Justice Department, the FTC, and the European Union's
Competition Commission.

Recent Considerations
In recent years, the analysis of proposed mergers has shifted from
counting the number of firms in a market to predicting how a particular merger
will affect price. For example, in 1994, Microsoft tried to purchase Intuit, the
maker of Quicken (a personal finance software package that was a substitute for
a Microsoft product). The government blocked the merger because it would have
reduced the competition in the personal finance software market. The
government does not oppose all corporate mergers, however. It allows mergers
leading to a new firm that would combine production, marketing, or administrative
operations to lower costs. In 1997, the Justice Department and the FTC released
new guidelines for proposed mergers. Companies that present evidence of a
merger to reduce costs and lower prices, better products, or better service (i.e.,
greater efficiency), might be granted permission to merge. Since 1994, the
Justice Department has been particularly interested in vertical market foreclosure
cases involving foreclosed technology. In other words, they are particularly keen
to prevent new technologies (not simply competing firms) from being foreclosed
from the market.

Antitrust Case Law

Statute law is only part of our law. Laws are applied, clarified, and
modified in court cases. Rulings in court cases set precedents, or standards, as

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to what the law means and how it is to be administered. Case law is as

important, and often more important, than statute law.
The following cases illustrate the contribution of case law to creating
antitrust law. The narratives are deliberately brief, focusing in most instances on
one or two critical points. While there are thousands of cases, and many
addressing other important aspects of antitrust law, these cases generally give
students a solid grasp of antitrust issues. They also afford a good example of the
interplay between statute and case law that extends well beyond the economic
question at hand.

E.C. Knight (1895) and Northern Securities (1904)

The American Sugar Refinery was charged with violating the Sherman Act
when it sought to acquire four Pennsylvania sugar refiners. The acquisitions gave
American Sugar Refinery 95 percent of the nation's sugar refining business. The
Supreme Court acquitted American Sugar because it held that the Sherman Act
only applied to Interstate Commerce, strictly defined. According to the Court,
manufacturing was, by its very nature, not interstate commerce (that is, moving
goods across state or national boundaries).
The E.C. Knight case effectively made all industry exempt from the
Sherman Act. A wave of mergers ensued. The 1900 Census found
manufacturing dominated by 185 manufacturing combinations with a combined
invested capital of $3,093 million. The nation's entire invested capital stock was
$8,975 million. The 185 combinations thus owned about 34.4 percent of the
nation's capital. Only 18 of the combinations had been created before 1897,
attesting to the size of the wave of mergers that followed in the wake of the E.C.
Knight ruling. In the merger movement that followed the Knight case, 1,800 firms
disappeared in 93 consolidations. Seventy-two of these consolidations acquired
more than a 40 percent market share. Of these, 42 acquired more than a 70
percent market share.
The courts reversed itself in a series of cases, culminated by the Northern
Securities case in 1904. In this case, the court upheld the applicability of the
Sherman Act to manufacturing, choosing to give a very different interpretation of
the Congress' Constitutional powers to regulate "interstate commerce." The
result of this reversal was the abrupt ending of the Merger Movement (18971904). While the court reversed its position, it did not try to undo the mergers that
had occurred in the wake of the E.C. Knight case.
It should be noted that reversal of case law is not unique to antitrust or
economic policy. For example, in Plessy v. Ferguson (1896), the Supreme Court
declared "separate but equal" to be constitutional, supporting legal segregation.
This ruling was reversed in Brown v. Board of Education of Topeka (1954).

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Standard Oil (1911) and American Tobacco (1911)

John D. Rockefeller's Standard Oil Trust was formed in 1882 when
Rockefeller got the owners of 40 oil companies to turn over control of their
refineries to him in "trust." A trust was a very old legal form under English
common law that had traditionally been used to establish a trustee to oversee the
affairs of minors, widows, and incompetents. Rockefeller's genius was in his new
and innovative use for this old practice. The trust controlled over 90 percent of
the market for refined petroleum products, with the trustees (Rockefeller) running
the trust like a monopoly. In 1911, the government ordered the breakup of
Standard Oil. (Prior to the suit, Standard Oil had converted from a trust to a
corporation.) The Supreme Court found that Rockefeller had used "unnatural
methods" to maintain monopoly power and to drive rivals out of business. For
example, he had coerced railroads into giving him special rates for shipping and
spied on competitors. The government broke up Standard Oil into 34 separate
companies (among them were such giants as Exxon, Standard Oil of California,
Standard Oil of Ohio, etc.).
The Standard Oil Case also introduced the "Rule of Reason" into antitrust
enforcement. Under this doctrine, large firms and their practices were to be
subjected to a reasonableness criterion, that is, there was reasonable vs.
unreasonable restraint of trade. In the case of Standard Oil, the courts held that
their tactics and "unnatural methods" had been very unreasonable.
The American Tobacco Company had bought out 30 of its competitors
and acquired control of about 95 percent of the U.S. cigarette market. The
Supreme Court found that American Tobacco maintained its monopoly power by
driving its rivals out of business and by forcing exclusive contracts on
wholesalers that prevented them from purchasing cigarettes from other
companies. The court upheld the "Rule of Reason" established in the Standard
Oil case earlier in the year, found American Tobacco "unreasonable," and
ordered a breakup of the company in 1911.

United States Steel (1920)

The United States Steel Company was formed in 1901 when the Morgan
Bank acted as an underwriter in forming the giant company around Andrew
Carnegies steel company. Carnegie wanted to retire and Morgan used the
window afforded by the E.C. Knight case to market the new U.S. Steel shares as
an investment in a steel monopoly. At its inception, U.S. Steel had about 64
percent of the steel market. (Note: the United States steel market was already

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larger than the entire European steel market.) It was arguably the largest
manufacturing company in the world.
Morgan retained influence at U.S. Steel through his backing of U.S. Steel's
Board Chairman, Judge Gary. Judge Gary did not believe in competition,
preferring what he considered to be fair pricing. Gary argued that "price should
always be reasonable. The mere fact that demand is less than supply does not
justify lowering prices. What we want is stability - the avoidance of violent
fluctuations" (I.M. Tarbell, The Life of Elbert H. Gary (New York: Appleton, 1925)
p. 206).
Judge Gary was able, through his efforts to bring stability to his industry,
to maintain price discipline in the steel industry. For example, from May 1901 to
April 1916, the price of steel rails was set at $28 per ton, despite wild fluctuations
in business conditions. Judge Gary was able to accomplish this through collusive
business practices that were well known inside and outside of the industry. For
example, Judge Gary began holding weekly dinners during the recession of
1907. Guests at the dinners were other steel company executives. Steel prices
remained fixed during the recession. The dinners came to an abrupt halt when
the government filed its antitrust suit in 1909 (prior to passage of the Clayton
Act).
U.S. Steel was thus born as a monopoly, resorted to anti-competitive
practices to maintain collusive prices, and retained a commanding share of the
steel market. In its 4-3 ruling, the Supreme Court chose to ignore the monopoly
practices of the company and focus on the size issue. The court held that size
alone was not a compelling criterion in antitrust. Since the courts ignored the
restraint of trade practices, U.S. Steel was acquitted.
The U.S. Steel case threw antitrust prosecution into disarray. The
government dropped many cases and antitrust enforcement seemed to be
gutted. It will be recalled that the Standard Oil case had established the "Rule of
Reason." The U.S. Steel case ruled that size alone was not unreasonable and
U.S. Steel's business practices were declared reasonable. With U.S. Steel's
notorious reputation for price fixing, it was hard to imagine any company ever
being found "unreasonable." A wave of mergers followed the U.S. Steel case,
just as a wave of mergers had followed the E.C. Knight case. This was the
second great wave of mergers in American economic history.
The U.S. Steel case needs to be put in historical context. Many observers
have argued that the court was doing little more than looking for a reason to
acquit U.S. Steel despite its practices. In view of other developments at the time,
this may not be too far from the mark. Many government officials, especially in
the Progressive Era, actually thought that government regulations and antitrust
laws ought to be used to promote rather than restrict cooperative market power
and collusion. For example, the U.S. government encouraged firms to cooperate
during World War I and the belief that cooperation was better than competition
persisted into the interwar period. In 1933, President Roosevelt called upon
many of these same government planners to impose industry cooperation.

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Roosevelts first New Deal, the National Industrial Recovery Administration,

established industry associations (cartels). American companies were forced to
participate in these associations and were required to draft codes of fair
competition (i.e., cooperation) and coordinate their prices. In 1918, the WebbPomerene Act exempted American firms from antitrust laws in the international
market and encouraged American firms to join international cartels. In addition,
the wartime cooperatives were extended and promoted during the 1920s.
Antitrust rulings exempted trade association from antitrust laws so long as they
did not explicitly seek to coordinate prices. In the 1920s, the prevailing attitude in
the country and in the courts seems to have been more akin to Andrew
Carnegie's views than those of Adam Smith. Consequently, the U.S. Steel ruling
may simply reflect this counter tendency to embrace monopoly rather than fight
it.

Alcoa (1945)
The government filed an antitrust suit against Alcoa in 1937, alleging that
it had monopolized the aluminum refining market. The judge in the case found
that Alcoa had more than 90 percent of the market for virgin aluminum (i.e.,
aluminum refined from scrap was excluded from the market). The remainder of
the market was supplied by foreign imports. However, most imports were from
Alcoas wholly-owned Canadian subsidiary.
The most important point in the case stemmed from the judges ruling that
Alcoas market share was "enough to constitute a monopoly." The judge found
that Alcoa had done nothing illegal or unethical in acquiring its monopoly. It had
simply undertaken a policy of anticipating growth in aluminum demand, and then
building the capacity needed to supply the increase in demand ahead of time.
This created a significant barrier to entry for other firms who found it hard to enter
a market where Alcoa seemed to always have more than enough capacity to
satisfy the market. It was clear to the judge that Alcoa was not building the
capacity as an anti-competitive tactic, but was rather simply doing an outstanding
job of anticipating growth in its industry.
However, while the judge exonerated Alcoa of criminal intent, calling Alcoa
one of the cleanest companies that he had ever encountered, he nonetheless
ruled that Alcoa was a monopoly by virtue of its size alone. The judge suggested
that any company of similar size would be found guilty of monopoly in his court. It
made no difference that Alcoa had not used its monopoly power, or had done
nothing illegal in acquiring its monopoly position. According to the court ruling,
the threat of monopoly abuse is inherent in a monopoly and therefore a violation
of the Sherman Act.
The precedent in the Alcoa case was watered down slightly by
subsequent case rulings, but it remains a significant factor in antitrust
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enforcement. Many firms such as Microsoft and Intel have had to consider the
prospects of an antitrust conviction based solely on their size. It is also
interesting to note that the Alcoa ruling is, in many respects, a reversal of the
United States Steel case in 1920. U.S. Steel was a "dirty" company acquitted of
both illegal practices and of being a monopoly based on its market share. The
courts ruled that size alone was not a factor. In the Alcoa case, the company was
squeaky clean, but convicted on size alone.

DuPont (1956)
The DuPont Company was originally charged with attempting to
monopolize, conspiring to monopolize, and monopolizing the market for
cellophane. The government did not pursue the allegations of attempting or
conspiring to monopolize, choosing instead to concentrate on the allegation of
monopoly. DuPont directly accounted for 75 percent of the cellophane market. Its
licensee, Sylvania, accounted for the remaining 25 percent of the market.
Consequently, DuPont and its licensee held 100 percent of the cellophane
market. In the shadow of the Alcoa Case, the numbers did not bode well for
DuPont.
In its defense, DuPont argued that there was no such thing as a market
for cellophane. Instead, it argued that the relevant market was the "flexible
packaging materials" market. This market, according to DuPont, was comprised
of such products as aluminum foil, wax paper, butcher paper, pliofilm, parchment
paper, glassine, and other products which customers could substitute for
cellophane. In this broader market, DuPont held an 18 percent market share.
To substantiate its claim, DuPont introduced cross elasticities of demand.
Large positive cross elasticities are indicative of substitutes. Substitution is the
basis for product competition. DuPonts use of cross elasticities sought to confirm
the presence of substitution and product competition, and to define the relevant
market on the basis of such product competition.
The court sided with DuPont, determining the market to be "flexible
wrapping materials" and acquitting DuPont. The case set the precedent for
defining the relevant market as encompassing all commodities that are
"reasonably interchangeable by consumers for the same purpose." It further
established the precedent of using cross elasticities to establish the boundaries
of the market. The precedents established in this case have been subsequently
refined by other cases, and not all cases have required the use of cross
elasticities. However, the DuPont case remains a precedent setting case on the
critical issue of defining the relevant market for antitrust cases.

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Pabst Brewing (1966)

Pabst Brewery sought to acquire Blatz Brewery. The combined companies
would have had about 4.5 percent of the national beer market, but more than 24
percent of the Wisconsin beer market. The government sought to block the
merger on the grounds that the merger would consolidate the relevant market
and restrict competition. The issue would clearly turn on how to measure the size
of the combination vis--vis the relevant market. The courts held that since beer
was primarily sold in a regional market, the relevant market was the regional
market. The merger was blocked.

IBM (1982)
This case never resulted in a court decision. The Justice Department in
the early years of the Reagan Administration dropped it. The decision to drop the
case had less to do with Reagan's politics than with the crucial question as to the
relevant market in the antitrust case.
The government charged IBM with monopolizing the market for "large
main frame computers." In this market, IBM held about 85 percent of the market.
This presented the company with a potential "Alcoa problem."
IBM sought to counter the suit with a two-part strategy. First, IBM used the
same strategy used by DuPont in the cellophane case. IBM argued that the
relevant market was not "large main frame computers," but rather "business
computing machines." Included in this larger market were computers of all sizes,
calculators, adding machines, and cash registers. In this broader market
(especially with the inclusion of cash registers) IBM's market share was below 30
percent. The definition of the market would therefore be a critical matter in the
case and IBM was prepared to use cross elasticities and other evidence to
establish their definition of the market.
The second part of the strategy had IBM dragging out the court
proceedings until the judge died (he was already old and in questionable health).
If the case dragged on and the judge died, the process of appointing a new judge
and the time needed to familiarize the new judge with the case could easily push
the decision off for a decade or more. The entire matter might involve a moot
point by that time. (Part of IBM's effort to delay the case involved the submission
to the court of virtually any and every piece of paper generated by IBM
employees and officials.)
The Reagan Administration did not file the IBM suit but it did request a
review by the Justice Department of the merits of the case and its prognosis. The
review concluded that while the court was not likely to completely accept IBM's

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definition of the market, it was likely to rule that the relevant market was closer to
IBM's definition than to the government's definition. Most private economists
familiar with the case concurred, predicting that the government would lose the
crucial battle of defining the market. In view of the delays, costs, and unlikely
success of the case, the Justice Department dropped the case.

DuPont/General Motors (1961)

This case was one of the first to apply the Celler-Kefauver Act and one of
the few major divestitures (along with the 1911 Standard Oil and American
Tobacco cases) ordered by the courts. DuPont had acquired a controlling interest
in General Motors in 1921 when it bought 25 percent of the company from GMfounder Willie Durant. DuPonts purchase kept General Motor from bankruptcy.
However, it also precluded all other paint companies from selling paint to General
Motors for the next four decades. General Motors was obligated to buy all of its
paint from DuPont. This was "vertical market foreclosure" because a vertical
acquisition was the means to exclude horizontal competitors (that is, the other
paint companies).
DuPont was found in violation of antitrust law on the basis of its vertical
market foreclosure and was ordered to dispose of its General Motors stock. Due
to the size of the stock holdings, the courts allowed DuPont to set up a company,
the Christiana Company, to take control of the stock and dispose of it in an
orderly manner so as to not depress the price of General Motors' stock.

Brown Shoe/Kinney Shoe (1962)

This is another of the early cases seeking to enforce the Celler-Kefauver
Act. Brown Shoe manufactured shoes and Kinney Shoe was the largest shoe
retailer in the country. Brown Shoe sought to acquire Kinney Shoe in a merger.
The market shares in manufacturing and retailing were not very important issues
in the case. Instead, the government sought to block the acquisition on the
grounds that Brown Shoe was using the vertical merger to vertically foreclose the
market to other shoe manufacturers. This case is a good illustration of vertical
market foreclosure because foreclosure took the form of actually removing the
shoes of its competitors from Kinney stores and replacing them with only Brown
Shoes (that is Brown, not brown). The competitor shoe makers were literally
excluded (foreclosed) from this part of the market. Brown Shoe lost the case and
the merger was terminated.

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Staples/Office Depot (1997)

In 1997, the government examined pricing data to predict the price effects
of a merger between two office supply chains, Staples and Office Depot. The
FTC examined the prices and quantities of each item sold by the two chains and
found that the prices charged by Staples were lower in cities where Office Depot
also had a store. The FTC used this logic to convince the court that the proposed
merger of Staples and Office Depot would lead to higher prices by eliminating
Staples' most significant (and often only) rival. Approval required by the HartScott-Rodino Act was denied and the merger blocked.

GE/Honeywell Merger (2001)

General Electric proposed to acquire Honeywell and sought pre-merger
approval from the Justice Department, the FTC, and the European Union. Both
companies are U.S. multinational companies with considerable business
dealings in Europe and other markets around the world.
The Justice Department and the FTC both approved the merger with
minimal stipulations. However, the European Union rejected the merger outright,
citing a reduction in competition. While the decision was couched in terms of
maintaining competition, the real issue in the case was an antitrust criterion
called "portfolio power." The Europeans have embraced "portfolio power" as a
legitimate criterion. However, the U.S. government and most U.S. economists
dismiss "portfolio power" as bogus and contend that it is merely disguised
protectionism (similar in deception to a "soft loan").
Portfolio power is, according to the Europeans, a power that transcends
horizontal or vertical market power. It is a power that accrues to a large firm with
a full, well-rounded portfolio. It is interesting to note that the criterion was first
introduced in a European merger case involving Guinness and Grand
Metropolitan. The combined company became Diageo, the largest liquor
distributor in the world. There was very little overlap in the liquor distribution
businesses of Guinness and Grand Metropolitan, but the European Union held
that Diageo would, by virtue of its full product offerings, enjoy unfair "portfolio
power." Diageo did not pose a threat to any individual market (horizontal power)
or pose a danger of vertical market foreclosure (vertical power) or to the alcoholic
beverage industry as a whole (it was a large firm, but did not enjoy a monopoly).
However, the merger was blocked until the firms agreed to divest themselves of
two brands of whiskey (including the Dewers label) in order to reduce their
"portfolio power."

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As noted above, American economists, both inside and outside of the

government, see no logic in this position. They argue that blocking a merger
simply because it would improve the competitive position of the consolidated firm
is in fact anti-competitive and unfair. The GE/Honeywell merger was blocked
because of the formidable portfolio power that would have accrued to the
consolidated firm. The fact that two American firms had received permission from
two American regulatory bodies was not the salient feature of the case, but it has
heightened tensions across the Atlantic. The case has highlighted the current
disparity between American and European policy and the confusion that it
creates.
European Union antitrust policy is still a work in progress and there may
as yet be a change in its portfolio power criterion. In addition, there have been
persistent rumors that GE may revive its bid for Honeywell and seek a re-hearing
from the European Union. Whether this occurs or not, the issue of portfolio power
is unresolved; it is likely to be a matter of controversy in future antitrust cases.

Microsoft (2000, and continuing)

Microsoft has been the subject of numerous antitrust proceedings. In
1994, the courts declared illegal the tying contracts that Microsoft had with
computer makers. These contracts gave Microsoft royalties from computer
makers that installed the Microsoft operating system on their computers.
However, the original (illegal) agreement stated that Microsoft was to receive a
royalty for every computer made by the firm, even if the firm installed another
operating system on some of its computers.
In the 2000 case, the court found that Microsoft stifled competition in the
software industry through the following:

Microsoft's contracts with computer manufacturers required them to install

Microsoft's Internet Explorer (an Internet browser) on their computers. When
Compaq Corporation announced plans to substitute Netscape's Navigator
(then used by 87 percent of the people browsing the Internet) for Internet
Explorer, Microsoft told Compaq that it had to install Internet Explorer or lose
the license to install the Microsoft operating system.

Microsoft's contracts with computer manufacturers prohibited them from

altering the Windows desktop by removing Microsoft's desktop links to the
Internet.

Microsoft's bundling of Internet Explorer with Windows 95 and its inclusion as

part of Windows 98 tied the operating system to the browser.

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Microsoft used its virtual monopoly in operating systems - more than 90

percent of the market - to gain a monopoly in the browser market. It also used
illegal practices to protect its monopoly in the market for operating systems.

Through its market share, monopoly power, and tying contracts (bundling),
Microsoft was able to effectively foreclose competitors (e.g., Netscape) from
the market as well as foreclosing a competing technology (recall the
emphasis on technology foreclosure announced in 1994).

The Microsoft case is a complex case involving many of the statute and case
law points developed above; market share (Alcoa), illegal per se tactics (tying
contracts), and vertical market foreclosure. In addition, a bit of background is
necessary to understand the government's insistence on breaking up Microsoft.
(At this juncture, it does not look like this will happen). The government's
experience with Microsoft in the earlier 1994 case led it to conclude that
Microsoft could not be relied upon to honor a consent decree. Finally, it must be
emphasized that the final verdict in the Microsoft case is not yet in, especially
regarding the charges brought by the European Union.

Antitrust and the 1992 Horizontal Merger Guidelines

The FTC and the Justice Department must approve proposed mergers
and acquisitions under the Hart-Scott-Rodino Act. But what criteria guide the
regulatory review? The Justice Department and the FTC published a guideline
for horizontal mergers in 1982, and a revised guideline in 1992. The Guidelines
can be accessed at: http://www.ftc.gov/bc/docs/horizmer.htm.
There is no need for us to review the entire document here; suffice it to
note a few key features of the Guidelines for antitrust enforcement.
First, the 1982 Horizontal Merger Guidelines (and subsequent updates)
basically make post-merger behavior the primary criteria for accepting or
rejecting a proposed horizontal merger. Mergers that lead to more competition or
increased competitiveness are encouraged as are mergers that are likely to
promote lower consumer prices and/or greater consumer value in terms of
product features and availability. On the other hand, mergers that are likely to
lead to higher prices or mergers that reduce product offerings or competition will
not be allowed (or only allowed after significant modification).
Second, the Guidelines a sensitive to additional factors affecting
competition on the market such as:
1. The definition of the relevant market.

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2. The extent of foreign competition.

3. The extent of product differentiation and non-price competition.

4. The likelihood of new competitors entering the relevant market.

Third, the Guidelines serve to frame the entire merger approval process.
Merger proposals are written to conform to the Guidelines and regulators as well
as the merger principals use the Guidelines in their evaluation and responses. In
other words, the Justice Department and the FTC apply these criteria in reaching
their decisions while the companies involved in the mergers structure their
proposal and responses to address these guidelines and any regulatory
objections.

The Guideline Applied: Coca Cola Tries to Acquire Dr Pepper

For example, Coca Colas proposed acquisition of Dr Pepper in the mid1980s provides a good illustration of how the Guidelines are applied. In 1985,
Coca Cola announced plans to acquire soft drink maker Dr Pepper. To comply
with Hart-Scott-Rodino requirements, Coca Cola submitted data on substitution
and cross elasticities; the FTC did likewise and concluded that the acquisition
would result in price increases of between 5 to 10 percent. This put the merger in
jeopardy (per the 1992 Horizontal Merger Guidelines). Coca Cola responded that
the FTC had misidentified the market; soft drinks were part of a larger drink
market because buyers treated beverages from bottled water to fruit juices as
substitutes. Coca Cola claimed that the acquisition of Dr Pepper would give it
only a slightly bigger market share in the broader drink market and that this
would give it little additional market power with which to raise soft drink prices.
Coca Cola further argued that it was company policy to match prices changes
among its soft drink rivals, especially price changes at Pepsi, and that the
acquisition of Dr Pepper would not change this at all.
The FTC denied the acquisition request based on concerns over Coca
Cola monopolizing the market. Ironically, the FTC seems to have taken an even
narrower view of the market with concerns that the acquisition would give Coca
Cola monopoly pricing power in the pepper-flavor soft drink market. Actually, the
unique flavor of Dr Pepper does not derive from pepper it is derived from
prunes. However, the pepper-flavor sub-market seems to have been established
through Coca Colas earlier attempts to offer a competing product patterned on
Dr Peppers marketing, if not its recipe. Coca Cola had introduced a competitive

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product called Peppo in the late 1960s. When Dr Pepper sued for trademark
infringement, Coca Cola changed the name of the product to Mr Pibb.
Coca Cola appealed the FTC ruling and a court case ensued, however,
Coca Cola abandoned its appeal in 1995 and ended the acquisition attempt. It is
worth noting again that the case was argued by both sides in the context of the
Horizontal Merger Guidelines.

The Herfindahl Index

As noted, post-merger consequences dominate the merger approval
process. However, there is room for structural considerations in the review as
well. The Guidelines reference the Herfindahl Index as a means of measuring
market concentration. The Herfindahl Index replaces older measures of market
concentration such as 4-firm concentration ratios (or 8-firm ratios). These earlier
ratios were merely a summation of the percent of the market served by the top
four (or eight) firms in an industry. While indicative of concentration, the 4-firm
ratio could not distinguish between situations were four firms each had a large
market share, versus situations were some firms were gigantic while the others
were relatively small. Economists have long noted that this was often a very
important factor in explaining behavior in concentrated markets.
The Herfindahl Index overcomes this problem by calculating the sum of
the squares of all firms in the market. By squaring the market shares, larger firms
are accorded greater representation in the index. For example, suppose we have
one firm in a market with a 50 percent market share, followed by three firms with
2 percent market shares apiece. Our 4-firm concentration ratio would be: 50 + 2
+ 2 + 2 = 56. Suppose now that we have s very different scenario: four firms with
roughly equal market shares of 15%, 14%, 14%, and 13%. In this case, our 4firm concentration measure would be: 15 + 14 + 14 + 13 = 56. Our 4-firm
concentration ratios are the same in both cases. However, it is likely that the
competitive environment in the case involving a giant, dominate firm surrounded
by smaller firms will be different from the competitive environment with four firms
of roughly equal size.
Now calculate the Herfindahl Index for these two cases:

Case #1: Squaring and then summing the market shares yields a
Herfindahl Index value of 2512.

Case #2: Squaring and then summing the market shares yields a
Herfindahl Index value of 786.

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While the 4-firm concentration ratios for these two cases are the same, the
Herfindahl Index reading in Case #1 is more than three times the reading in Case
#2, indicating much more concentration. Note that a perfect monopoly (one firm
with 100% of the market) would have a Herfindahl Index value of 10,000.
The Herfindahl Index in the Horizontal Merger Guidelines
Reference to Herfindahl Indexes appears in Section 1.5 of the Horizontal
Merger Guidelines. Herfindahl Index values appear to serve primarily as
threshold criteria, i.e., the size of the Herfindahl Index before and after the
proposed merger must meet minimum threshold criteria in order to warrant an
investigation of its competitive consequences. Specifically:
The following is excerpted from the Guidelines:

1.5 Concentration and Market Shares

Market concentration is a function of the number of firms in a market and their
respective market shares. As an aid to the interpretation of market data, the
Agency will use the Herfindahl-Hirschman Index ("HHI") of market concentration.

The Agency divides the spectrum of market concentration as measured by the

HHI into three regions that can be broadly characterized as: unconcentrated
(HHI below 1000), moderately concentrated (HHI between 1000 and 1800),
and highly concentrated (HHI above 1800). Although the resulting regions
provide a useful framework for merger analysis, the numerical divisions suggest
greater precision than is possible with the available economic tools and
information. Other things being equal, cases falling just above and just below a
threshold present comparable competitive issues. [emphasis added]
1.51 General Standards
In evaluating horizontal mergers, the Agency will consider both the post-merger
market concentration and the increase in concentration resulting from the
merger.
Market concentration is a useful indicator of the likely potential competitive effect
of a merger. The general standards for horizontal mergers are as follows:

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a) Post-Merger HHI Below 1000. The Agency regards markets in this region to
be unconcentrated. Mergers resulting in unconcentrated markets are unlikely to
have adverse competitive effects and ordinarily require no further analysis.
b) Post-Merger HHI Between 1000 and 1800. The Agency regards markets in
this region to be moderately concentrated. Mergers producing an increase in the
HHI of less than 100 points in moderately concentrated markets post-merger are
unlikely to have adverse competitive consequences and ordinarily require no
further analysis. Mergers producing an increase in the HHI of more than 100
points in moderately concentrated markets post-merger potentially raise
significant competitive concerns depending on the factors set forth in Sections 25 of the Guidelines.
c) Post-Merger HHI Above 1800. The Agency regards markets in this region to
be highly concentrated. Mergers producing an increase in the HHI of less than 50
points, even in highly concentrated markets post-merger, are unlikely to have
adverse competitive consequences and ordinarily require no further analysis.
Mergers producing an increase in the HHI of more than 50 points in highly
concentrated markets post-merger potentially raise significant competitive
concerns, depending on the factors set forth in Sections 2-5 of the Guidelines.
Where the post-merger HHI exceeds 1800, it will be presumed that mergers
producing an increase in the HHI of more than 100 points are likely to create or
enhance market power or facilitate its exercise. The presumption may be
overcome by a showing that factors set forth in Sections 2-5 of the Guidelines
make it unlikely that the merger will create or enhance market power or facilitate
its exercise, in light of market concentration and market shares.

Concluding Observations
Remedies
The courts can order firms found in violation of antitrust laws broken up. This
is called divestiture. This remedy is the most extreme action and courts have
used it sparingly. There have only been a handful of large divestitures ordered by
the courts. Firms found guilty of anti-competitive practices can be ordered
through court injunction to stop the practices deemed unlawful. Fines and
imprisonment are also possible sanctions. An antitrust suit brought against a firm
by the government usually involves criminal charges. Private parties injured by
illegal combinations and conspiracies can also bring an antitrust complaint in a
civil suit. In this case, the private firm would have to prove the case itself. Under
English common law, firms injured by anti-competitive practices could sue for
triple damages. This remedy remains in effect today. For example, Al Davis and

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the Oakland Raiders won a civil suit against the NFL and the City of Oakland
following their move to Los Angeles and collected triple damages.
Most antitrust complaints involving allegations of illegal practices end in a
"consent decree." In a consent decree, the firm agrees to stop the offending
practice, but does not admit guilt. In exchange, the government agrees to drop
the case. The incentive for the firm to end a case in this manner stems from its
ability to avoid possible triple damage claims. A criminal conviction would
immediately leave the firm open to triple damage claims from injured parties in
civil suits. Following a conviction in the government's case, the private firms
would not have to prove the antitrust case. They would only have to prove the
amount of their monetary injuries. Microsoft now faces the prospect of numerous
civil suits in the wake of its conviction in the suit brought by the government.

The Relevant Market

Defining the relevant market is crucial in most antitrust cases involving
allegations of monopoly. It is not important in complaints involving practices that
are illegal per se under the law. However, the relevant market is again important
in cases involving practices that are not illegal per se, but illegal when they
restrict competition.
When a suit alleges monopoly or restraint of trade, the first question is:
Monopoly or restraint of trade in what market? The size of the firm can only be
meaningfully understood in relationship to its market.
Determining the relevant market was the critical point in many of the cases
considered above. In the DuPont cellophane case and the IBM case, the firms
successfully challenged the definition of the market and had favorable outcomes
to their suits. Cross elasticities were instrumental in defining the markets in these
cases. In contrast, the judge in the Brown Shoe case ruled early in the case that
the shoe market had three distinct components: men's shoes, women's shoes,
and children's shoes. He refused to hear evidence to the contrary (including
stories of men wearing women's shoes).
The importance of defining the relevant market can also be seen in the Alcoa
case. Alcoa may have lost its case when the judge opted for a very narrow (and
perhaps erroneous) definition of the market. The judge ruled that the aluminum
market encompassed only newly refined aluminum and excluded from the market
aluminum scrap. Since aluminum from scrap competed directly with virgin
aluminum, it is hard to see the wisdom in the judge's decision. However, it is
easy to see the significance of the exclusion. If scrap had been included in the
relevant market, Alcoa's market share would have been only 60-64 percent. If
Alcoa's internal consumption of aluminum had also been eliminated from the
relevant market, Alcoa's share of the open market for aluminum (from both virgin
production and scrap) would have been only 33 percent. These alternative
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definitions of the market, in a case where the size of the firm was the critical
factor, could have had a dramatic effect on the outcome.

Predatoy Pricing Real or Bogus?

The discussion of antitrust laws in the text is certainly not definitive; there
are thousands of antitrust cases and numerous statute laws dealing with
competition and anti-competitive business practices. It would be impossible and
unnecessary to cover them all. The goal here is not to prep you for the law bar
exam; our interest is in economic theory and policy. This short selection of laws
and cases serves this task well.
However, we do need to round-out this discussion by looking at one
additional issue: predatory pricing. Predatory pricing and laws prohibiting the
practice are controversial and poorly understood. Is predatory pricing something
that antitrust officials need to be concerned with? Are antitrust laws against
predatory pricing theoretically justifiable? Are antitrust laws against predatory
pricing actually anti-competitive?

Predatory Pricing
Predatory pricing is a term that everyone thinks they understand - until
they have to actually specify what it is. The term is so fuzzy that most economists
refuse to use it. However, it seems to be a favorite among trial lawyers and
politicians.
The basic feature of predatory pricing is a dramatic price reduction
designed to drive a competitor out of business in order to then create a monopoly
and to raise prices to monopoly price levels. In essence, the predator incurs the
costs of lower revenues and profits in the short run in order to earn monopoly
profits in the long run.

Does Predatory Pricing Actually Exist in the Real World?

The antipathy of most economists to predatory pricing was noted above.
Some have even questioned its existence. For example, Wikipedia notes of
predatory pricing:
[T]here are "virtually no... economists" who believe the theory
behind the concept (though a few believe it is theoretically possible based
on models, there are virtually none who believe it is an empirical

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phenomenon), and that there are no known examples of a company

raising prices after vanquishing all possible competition.
(Quotation marks in original and attributed to Thomas DiLorenzo, "The Myth of
Predatory Pricing," http://www.cato.org/pubs/pas/pa-169es.html).
This position is too extreme. There have been actual cases involving
predatory pricing as the following two cases from the tobacco industry illustrate.

Tobacco Case #1: The 10-cent Cigarette Wars

When the American Tobacco Company was broken up in the 1911
divestiture, it was reorganized into four separate companies: American Tobacco,
R.J. Reynolds, Liggett & Myers, and Lorillard. While formally separate
companies, the four tobacco companies generally pursued similar marketing and
corporate strategies and exhibited parallel behavior.
At the start of the Great Depression, all four firms raised their prices rather
significantly; in 1931, cigarette prices rose to 14 15 cents per pack. These price
increases occurred in the face of declining tobacco-leaf prices and falling
demand for cigarettes.
Because of the lower tobacco-leaf prices, new cigarette firms entered the
market and offered premium cigarettes at 10 cents per pack. By 1932, these new
competitors were able to capture almost a quarter of cigarette sales.
In January 1933, the four majors struck back with price cuts and pressure
on retailers to reduce their margins that put their retail cigarette prices at 10-centper pack (or lower) prices. In addition, very popular brands such as Camel and
Lucky Strike were reportedly sold at below cost during the price war.
After an intense price war with the new 10-cent brands that drove most
(but not all) out of the market, the majors reversed course and raised cigarette
prices. However, cigarette prices never fully recovered to the levels seen at the
start of the 10-cent price wars.
There are two ramifications of this episode worth noting. First, while the
price wars were able to drive most of the newcomers out of the cigarette market,
the policy failed to restore the market share of the majors. Before the 10-cent
brands episode, the majors held a 91% market share in 1930. But by 1939, the
market share of the majors had fallen to 69%. The loss in market share can be
traced directly to two firms that got their start in the American market as 10-cent
brand competitors. The two new competitors were Philip Morris and Brown &
Williamson Tobacco (a U.S. subsidiary of the British American Tobacco
Company. The failure of the majors to recoup market share through the price war

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transformed the big Four into the Big Six. By the early 1980s, Philip Morris
would become the largest U.S. cigarette company.
The second notable development from this case was an antitrust suit filed
by the Justice Department in the 1930s alleging collusion among the Big Four.
The companies were convicted of monopolization and conspiracy in 1941.
However, the only sanctions imposed by the court were fines and restrictions
placed on the ability of the firms to communicate and coordinate their activities.
The courts remedy reflects that fact that this case was more about collusion and
price fixing rather than about predatory pricing (i.e., the price cuts were not the
issues that took the courts attention; it was the coordinated action of the four that
lead to their conviction).
Many economists who dismiss predatory pricing often cite both features of
this case as support for their position. First, they note how unsuccessful the
predatory pricing was in driving competitors out of the market. Second, they
agree with the courts that collusion is the issue that the courts should be
concerned with, not predatory pricing.
Tobacco Case #2: Predatory Pricing
While the courts did not deal with predatory pricing directly on the 10-cent
brands price wars, a subsequent case involving tobacco companies did directly
address the issue of predatory pricing and its legality.
In the early 1980s, generic cigarettes from new competitors once again
challenged the majors (now the Big Six). Brown & Williamson was especially
impacted by competition from the new generic brands and it resolved to
aggressively fight back. Brown & Williamson launched a line of value-priced and
generics of its own and aggressively promoted them with lower prices and
rebates. This ignited a price war in the industry that ultimately lead to an antitrust
law suit file by Liggett & Myers alleging that Brown & Williamson had engaged in
predatory pricing. Specifically, Liggett alleged that Brown & Williamson was
selling at price below its average variable costs (AVC).
Many economists and courts had already embraced the selling at prices
below AVC as the criterion for predatory pricing. This had become known as the
Areeda-Turner Test after two economists instrumental in developing the criterion.
[See; Phillip Areeda and Donald Turner, Predatory Pricing and Related
Practices under Section 2 of the Sherman Act, 88 Harvard Law Review 697
(1975)]. The Areeda-Turner Test had been used in other court cases to obtain
predatory pricing convictions.
In the Brown & Williamson case, the courts had to address two questions:
First, did Liggett only have to show that Brown & Williamson had sold at prices
below AVC for a conviction? Second, if selling at prices below AVC was not
sufficient for a conviction, what else was required?

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Regarding the first question, the court ruled in the Brown & Williamson
case that selling at prices below AVC was not sufficient. This ruling meant that
predatory pricing cases could no longer be adjudicated solely on the P<AVC
criterion.
In regard to the second question, the court ruled that the plaintiff (Liggett)
had to demonstrate that the defendant (Brown & Williamson) eventually would
have been able to return prices to a level high enough to recoup or offset the
short-term losses incurred in the predatory pricing. This is called the recoupment
test and it became a major feature of all predatory pricing cases.
More importantly, a lack of evidence about recoupment can result in a
predatory pricing case being dismissed before it even goes to trial. This
increases the burden of proof on the plaintiff.
In the Brown & Williamson case, the courts ruled that competition from
generics was not likely to go away and that Brown & Williamson had little
likelihood of ever raising prices to levels that would recoup their losses from
predatory pricing. The courts therefore ruled that Brown & Williamson was not
guilty.
(These two cases were based in part on: James Brock, The Structure of American
Industry (Upper Saddle River, NJ: Pearson, 2009) pp. 101-102; and pp. 116-17

A Final Run at Smiths Formula

Smith raised the relevant question more than two centuries ago, but a
definitive answer has not been forthcoming. Is there sufficient competition to
enable markets to channel self-interest into promoting social welfare? Or do we
need more antitrust laws and policing to effectively assure desirable social
outcomes?
It should be clear that this question does not have a simple yes or no
answer, nor did Smith ever suggest that it did. Smith was not an anarchist and he
always saw a legitimate role for government to play in establishing markets and
in providing the groundwork, property rights, and legal infrastructure that markets
need. The question was always a matter of where to draw the line?
We cannot resolve this issue here this should remain a question that you
visit repeatedly in the future as the economic environment changes. But as a final
take on this issue, lets consider the question from the perspective of firms that
have tried to seek their fortune by eliminating or restraining competition. While
some have enjoyed limited success at eliminating competition, most have found
it far more difficult than imagined. Most have abandoned their quest for monopoly
in favor of concentrating on making their firm a stronger competitor.

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Adequately supporting this historical observation would consume the

remainder of this course; however, let us consider the experience of one
company Nabisco.

Example: Nabisco Gives Up on Creating a Monopoly

The following is an excerpt from the 1901 Annual Report of the National
Biscuit Company (Nabisco). It has been reprinted from Alfred D.
Chandlers Strategy and Structure, pp. 32-33.
This Company is four years old and it may be of interest to shortly review
its history. . . . When the Company started, it was an aggregation of plants. It is
now an organized business. When we look back over the four years, we find that
a radical change has been wrought in our methods of business. In the past, the
managers of large merchandising corporations have thought it necessary, for
success, to control or limit competition. So when this Company started, it was
believed that we must control competition, and that to do this we must either fight
competition or buy it. The first meant a ruinous war of prices and a great loss of
profits; the second, constantly increasing capitalization. Experience soon proved
to us that, instead of bringing success, either of those courses, if persevered in,
must bring disaster. This led us to reflect whether it was necessary to control
competition. . . . We soon satisfied ourselves that within the Company itself we
must look for success.
We turned our attention and bent our energies to improving the internal
management of our business, to getting full benefit from purchasing our raw
materials in large quantities, to economizing the expenses of manufacture, to
systematizing and rendering more effective our selling department, and above all
things and before all things to improving the quality of our goods and the
condition in which they should reach the customer.
It became the settled policy of this Company to buy out no competition. .
The word biscuit, as used here, is an old American (and British) term for
cracker. Nabisco was created in 1898 through the merger of the American Biscuit
and Manufacturing Company (created out of the merger of 40 Midwestern
bakeries), the New York Biscuit Company (created from 7 Eastern bakeries), and
the United States Baking Company. Nabisco was a merger designed to create a
U.S. cracker monopoly that operated 114 bakeries across the United States.
Nabisco was the product of the E.C. Knight case that ruled that the Sherman Act
did not apply to manufacturing. This is also why the annual report - written in
1901 could be so straight-forward about the companies monopoly strategy.
Industrial monopolies were perfectly legal.
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However, the main point is that Nabisco concluded that a monopoly was
difficult, if not impossible, to attain. Note that, in 1901, the E.C. Knight case had
not yet been overturned and Nabisco was free to pursue its quest for monopoly.
The problem was that it was simply not able to eliminate competition. The
excerpt above is the company telling its shareholders that its monopoly strategy
was not working.
What is equally important was Nabiscos new strategy forget about
trying to monopolize the market and instead direct the firms resources to:

Building its distribution network it stopped selling in bulk to

distributors and began selling in smaller quantities to retailers

Expanding and promoting its brand names

Increasing its advertising

Reducing costs by buying inputs such as flour in bulk

Improving the layout and efficiency of its manufacturing plants

Centralizing the operations and management of the firm

In other words, Nabisco decided that its future lay in taking care of
business first it was going to concentrate on building better products and a
better company. Regarding brands, one of Nabiscos first successes with a
brand-named cracker was its Uneeda Biscuit line (get it: U-need-a-biscuit).
While this early attempt at brand naming is a bit hokey, the company got better at
it and later introduced the phenomenally successful Ritz Cracker in 1934. Today,
Nabisco is a part of Kraft Foods and features such well-known brands as: Chips
Ahoy! Cookies, Fig Newton Cookies, Mallomar Bars, Oreo Cookies, Premium
Saltine Crackers, Triscuits, and Wheat Thins.
One example does certainly not resolve the issue, but firms have usually
found that eliminating competition is not very easy and not very productive it is
simply too hard and they are better off concentrating on the basics of making
better products and making a more competitive firm.

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