U.S. Antitrust Law: A Primer Howard A. Shelanski, U.C. Berkeley

U.S. Antitrust Law: A PrimerHoward A. Shelanski, U.C. Berkeley Nanterre—Paris X November 2006

Agenda • Sections 1 and 2 of the Sherman Act • Collusion and Monopolization • Section 7 of the Clayton Act • Merger policy • Antitrust and Telecommunications in the United States

Origins of U.S. Antitrust Law • Late 19th century populist revolt against big business • Small farmers and tradesmen feared the rise of large, powerful “trusts” in key industries like oil, rail transport, and steel. • Sherman Antitrust Act (1890) • U.S. Congress passes the first national antitrust law in response.

Scope of the Sherman Act • Theory behind the Act was to restrain large business enterprises in 2 ways: • Prohibit collusion and coordination among business enterprises to the detriment of consumers and other businesses (Section 1 of the Sherman Act). • Prohibit activities by powerful firms that create or maintain monopoly power for those firms (Section 2 of the Sherman Act).

Text of Sherman Act §§ 1 and 2 • Section 1 • “Every contract combination . . . or conspiracy in restraint of trade or commerce . . . is declared to be illegal.” • Section 2 • “Every person who shall monopolize, or attempt to monopolize . . . any part of trade or commerce . . . shall be deemed guilty of a felony.”

Problem: Text is Very Broad • Read literally, the Act would prohibit much beneficial business activity • Examples, Section 1: The literal text prohibits professional partnerships, joint R&D, and small purchasing cooperatives. • Examples, Section 2: Prohibits monopoly itself; could bar using superior technology or scale economies to under-price competitors if such conduct could lead to monopoly, yet this benefits consumers. • Challenge: How to apply the Sherman Act to achieve its goals, but without being overly restrictive?

Meeting the Challenge: Application of the Sherman Act: Section 1 • U.S. Courts in 1911 determined that Section 1 only means to prohibit “unreasonable” restraints of trade. • “Reasonable” restraints of trade are those that help economic progress and that lead to more efficient markets.

What Conduct is “Unreasonable” Under Section 1? • Unreasonable restraints of trade are those that have the overall effect of reducing economic competition

How Do Courts and Agencies Decide what is “Unreasonable”? • Courts have created two classes of conduct: • Conduct that is always illegal:Courts early on determined that some conduct is so inherently harmful to competition that it is presumed illegal, regardless of circumstances. This conduct is illegal per se under § 1. • Price fixing agreements • Agreements to divide territories • Output restrictions

Section 1, Illegal conduct (Cont’d) • Conduct that is sometimes illegal: Other conduct might benefit competition under some conditions but be harmful under other conditions. This conduct is not always illegal, but is reviewed case-by-case under a “rule of reason.” • Information exchanges among rivals • Standard setting bodies • Restraints necessary to create a product or allow a market to function.

Modern Trend in Enforcement of Section 1 of the Sherman Act • Per se violations like price fixing are prosecuted aggressively, and no justifications or defenses are usually accepted. Lack of market power, for example, or protection of public safety, are not allowable defenses. • Rule-of-reason violations are treated more deferentially, and the enforcer has a heavy burden of showing harm to competition.

Meeting the Challenge: Application of Section 2 • The central contradiction of Section 2 is that aggressive competition, the very conduct the Sherman Act wishes to encourage, could lead to monopoly, the very outcome the Sherman Act seeks to prevent. • How to distinguish anticompetitive aggression from vigorous competition?

Application of § 2, Cont’d • For several decades, the courts adopted a restricted approach under which conduct that harmed competitors was punished, regardless of potential benefits to consumers. • Illustrative case is U.S. v. Alcoa in which the court held Alcoa had broken the law by expanding plant capacity in advance of increased customer orders. • The court acknowledged that that Alcoa’s plant expansion helped customers by avoiding disruptions in supply during a time of growing demand, and that Alcoa gained efficient economies of scale. • Nonetheless, the court held that Alcoa’s actions made market entry difficult for competitors, and hence tended toward monopoly under Section 2.

Application of § 2, Cont’d • Alcoa was later criticized for focusing on the fate of competitors rather than on the process of competition, and for punishing good commercial and competitive behavior. • But Alcoa was typical of its time: the courts punished many actions as per se (i.e. always illegal) violations of Section 2. For example: • Vertical restraints by producers • Tying the sale of two products • Below cost (“predatory”) pricing • Exclusive dealing.

Application of § 2, Cont’d • Interestingly, Alcoa also contained the seeds of more modern enforcement of Section 2. The case is most remembered not for its final decision, but for the court’s statement that the antitrust laws should not punish successful competitors, and that monopoly obtained through honest skill, foresight, and hard work is not illegal under Section 2.

Modern Enforcement of § 2 • From the 1960’s through the 1980’s, many scholars, enforcement officials, and courts began to criticize application of Section 2 as overly aggressive and harmful to competition. • Over time, enforcement shifted from guarding against the risk of monopoly (Alcoa), to guarding against the risk of deterring aggressive competition and beneficial economic arrangments.

Modern Enforcement of § 2, Cont’d • Courts began to move away from per se illegality under Section 2. They did this in two ways: • Treating more conduct under the “rule of reason” • E.g. exclusive dealing, vertical non-price restraints, refusals to deal. • Making remaining per se violations harder to prove • E.g. predatory pricing, vertical price restraints, tying.

Summary of Current State of the Law under the Sherman Act • Section 1 punishes price fixing, territorial divisions, and output restraints strictly. All other activity is under the rule of reason and is punished only upon strong proof of anticompetitive effect. • Section 2 is applied cautiously, treating most conduct under the rule of reason and only punishing actions that unreasonably block entry, and/or foreclose competitors’ access to customers or necessary inputs. Section 2 protects the competitive process, not individual competitors.

Lessons from Sherman Act • Antitrust law takes time to evolve. The basic principle that competition improves consumer welfare is sound. But actual business practices may have ambiguous effects, so “the devil is in the details” in deciding where to enforce. • The evolution of antitrust law into specific enforcement practices and legal precedent will depend on a country’s unique economic context. Where the economy is strong and competition is well established, more aggressive conduct can be allowed. Where monopoly is common or likely, greater restraint may be required.

Practical Objectives for Antitrust Law in new Markets • Perfect competition is a textbook fiction. The goal is instead to protect the development of enough competition that consumers do not face monopoly. • Emphasis should be on preventing emerging competitors from colluding, and on preventing any one competitor from foreclosing access to customers or inputs. • Where competition is not well established, it might make sense to worry more about the survival of competitors than about deterring vigorously competitive conduct. • The institution of the competitive market must be built before worrying about how freely it operates.

Merger Enforcement in the U.S. • To understand merger policy in the U.S. it is helpful to go back to Section 1 of the Sherman Act. Taken literally, that law would prohibit any merger. • Passage of the Clayton Act in 1914 reflects the recognition that some mergers are acceptable. The question for merger law is, which ones?

Section 7 of the Clayton Act • Section 7 is the central merger statute in the U.S. • It prohibits any merger whose effect “may be substantially to lessen competition, or to tend to create a monopoly in any line of commerce.”

Early Application of Section 7 • Until the 1970’s, courts interpreted the text literally, often focusing on the words “or tend” to create a monopoly. • In the Brown Shoe case (1962), the U.S. Supreme Court blocked a merger that would have given one shoe manufacturer control over 8% of retail shoe outlets. • In the Von’s case (1966), the Supreme Court blocked a merger that would have given one grocery chain a 7.5% market share. • In the Philadelphia National Bank case, the Supreme Court ruled that mergers to a 30% market share were virtually illegal per se.

Early Merger Policy, Cont’d • The emphasis in all the above cases was preventing a tendency toward consolidation. The cases stated clearly that an important objective of merger policy was protecting the place of small businesses in the American economy, • Efficiency was a secondary concern, and the cases made clear that increased consolidation was a problem even without evidence of harmful effects on prices for consumers.

Modern Merger Policy • Within a decade after Vons, the U.S. Supreme Court sharply changed direction in its review of merger law. • In General Dynamics (1974), the Court said that it was necessary for the government to prove harmful effects from a merger, not mere consolidation.

The Merger Guidelines • To create a framework for determining competitive effects of mergers, the U.S. Federal Trade Commission (FTC) and Department of Justice (DOJ), adopted a set of Horizontal Merger Guidelines in 1984. The Guidelines in their current form set out a 4-step merger review process.

Merger Guidelines, Cont’d • 4 steps of merger review: • Step 1: Define the relevant market and calculate how the merger will affect market concentration. • Step 2: If the market concentration is caused by the merger is high enough to raise concern, look at what actual competitive effects of the merger are likely to be. • Key question: Will the merged firm gain market power and be able profitably raise prices to the detriment of consumers?

Merger Guidelines, Cont’d • Step 3: If there are likely to be harmful effects, the burden shifts to the merging parties to show the merger will create efficiencies that cannot otherwise be achieved, and that are sufficient to offset competitive harms. • Where competitive harms are predicted to be large, efficiency defenses to the merger are unlikely to succeed. Efficiencies can tip the balance where the case for harm is close, however.

Merger Guidelines, Cont’d • Step 4: The final step of review under the guidelines is to determine whether there are remedies for the predicted competitive harms. • For example, can the harm be reduced through divestiture of parts of the merged firm’s business? Through licensing of intellectual property?

Market Share and Market Power under the Guidelines • Much can be said about each of the 4 steps just listed. The calculation of market share and presumption about market power in step 1 warrant particular mention. • The Guidelines use the Herfindahl-Hirschman Index (HHI), which one calculates by taking the individual market share of each firm in the market, squaring it, and then adding all the squared figures together to get a single index number. • The HHI communicates two important things: a picture of concentration for the entire relevant market, and a measure of the distribution of market shares across all firms in the market. The HHI is higher where market share is unevenly distributed across firms than if it is evenly distributed, because a market with five evenly-sized firms may be more vigorously competitive than a market with one very big firm and several smaller ones.

Market Share, cont’d • Under the Guidelines, markets with an HHI over 1800 are presumed to be non-competitive, and mergers in such markets are presumed harmful if they increase the HHI by more than 50 points. • To provide some perspective, a market with 5 equal competitors has an HHI of 2000, and a merger of any two of those firms would raise the HHI to 2800, which is presumptively anticompetitive.

Problems with Inferring Market Power from Market Share • The HHI is helpful, but in the end it is just a fancy way to measure market share. Market share, however, is a very imperfect proxy for market power: • Market share is backward looking; it shows where a firm has been, but not where the firm and the market are going.

Reducing Reliance on Market Share • Show competitive effects directly, without detailed market share calculations, where possible. • Enforcement in fact does not happen as often as the Guideline’s 1800 HHI presumption would suggest. So less need for detailed HHI calculations for many mergers.

Merger Process • We have so far looked at the substance of U.S. merger review. We now look at Process. • The FTC and DOJ receive pre-merger notification under the Hart-Scott-Rodino Act (1976) for all transaction over a particular size threshold (e.g. $200 Million). • The Agencies then decide which (FTC or DOJ) will do the review. • The Agency reviews the merger for 90 days. In most cases, the merger is approved at this stage. • If the merger raises competitive concerns, the agency issues a “second request” for information.

Process, Cont’d • It is under a second request that a full, detailed review occurs for 6 months. • At the end of 6 months, the agency can approve the merger as filed, move to block the merger, or reach a settlement with the merging parties to remedy the harms. • Example: SBC/Ameritech merger

Process, Cont’d • If a merger is settled, the settlement must be approved by a U.S. District Court as serving the “public interest.” • The court retains jurisdiction to review the merger later if it becomes concerned the settlement is not being observed. • E.g. Verizon/MCI and SBC/Ameritech

Antitrust in U.S. Telecommunications • Early examples: Challenging the development of the AT&T monopoly, 1912 to 1960. • The break-up of AT&T, 1984. • Merger review and the 1996 Act • Incumbents and their competitors, the Trinko case. • New developments, the Madison River case.

U.S. Antitrust Law: A Primer Howard A. Shelanski, U.C. Berkeley