Loyalty discounts and theories of harm in the Intel investigations

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1 Journal of Antitrust Enforcement, Vol. 2, No. 1 (2014), pp doi: /jaenfo/jnt011 Published on Advance Access October 11, 2013 Loyalty discounts and theories of harm in the Intel investigations Patrick DeGraba* and John Simpson In its investigation of Intel, the Federal Trade Commission appears to have been pursuing a downstream competition theory of harm, in which Intel Corporation made fixed payments to original equipment manufacturers (OEMs) in exchange for not using AMD processors. This allowed Intel to charge supra-competitive processor prices to OEMs and allowed OEMs to charge supra-competitive computer prices to consumers thereby extracting supra-competitive rents from computer markets. These rents finance the payments for exclusivity. This article uses public documents to illustrate the types of evidence that would be needed to prove the existence of harm under this theory. It also identifies the type of evidence used by the European Commission when it analysed Intel s practices under its As Efficient Competitor Test. Finally, it highlights major differences between the two theories. Keywords: exclusive dealing, foreclosure, monopolization, dominant firm JEL codes: K21, L12, L13 and D43 I. Introduction Over the past 10 years, several competition agencies and private plaintiffs sued Intel Corporation based in part on the claim that Intel offered original equipment manufacturers (OEMs) market share or volume discounts in order to foreclose competition in certain CPU markets. 1 These lawsuits produced a relatively * Federal Trade Commission, 600 Pennsylvania Avenue, NW, Washington, DC 20580, USA. pdegraba@ftc.gov The Brattle Group, 1850 M Street NW, Washington, DC 20036, USA. john.simpson@brattle.com. Both DeGraba and Simpson worked on the Federal Trade Commission s investigation of Intel as staff economists. Simpson now works at The Brattle Group. The views expressed in this paper are those of the authors and do not necessarily represent those of the Commission. The authors thank John Yun for help analyzing the data and thank Joseph Farrell, Geoffrey Green, and David Schmidt for helpful comments. 1 Recent legal actions involving Intel include a private antitrust action by AMD, which was settled, a court challenge by the United States Federal Trade Commission, which was settled, a Decision by the European Union Commission (EU Decision) that Intel had abused its dominant position, a court challenge by the New York State Attorney General (NYAG Complaint) which was settled. See Advanced Micro Devices, Inc. and AMD International Sales & Services, Ltd. v Intel Corp. and Intel Kabushiki Kaisha, in the United States District Court for the District of Delaware, Civil Action No (JJF) subsequently consolidated for the purpose of discovery as part of MDL No , entitled In re Intel Corporation Microprocessor Litigation; (AMD Complaint) In the Matter of Intel Corporation, a corporation, Docket No. 9341; Case COMP/C-3/ Intel, Comm n Decision, 2009 (13 May 2009) (EU Decision 2009) < accessed 20 March Published by Oxford University Press This work is written by US Government employees and is in the public domain in the US.

2 2014 Loyalty discounts and theories of harm in Intel investigations 171 detailed description of both the structure of Intel s discounts and the markets in which they were used. Using this public evidence, we consider two possible theories of how such discounts could harm competition. The first theory, which we will call The Downstream Competition Theory, argues the following: (i) Intel s volume and market share discounts often represented a lump-sum payment because they applied to the first units sold once some volume or market share thresholds were met; (ii) Intel used these lump-sum payments along with other lump-sum consideration to obtain exclusivity with a set of buyers that collectively had market power in certain downstream markets; and (iii) Intel used this exclusivity to maintain supra-competitive prices for CPUs. Statements in the Federal Trade Commission s (FTC) Aid to Public Comment suggest that it was at least sympathetic to this theory. The second theory, which we call the As Efficient Competitor Test posits that some share of Intel s sales was contestable and that Intel s discounts represented effectively below-cost pricing on those sales, which would foreclose an as efficient competitor. AMD s Complaint in its private litigation and the European Commission s (EC) decision s lengthy discussion of how Intel s discounts could prevent an as efficient competitor from competing for contestable sales suggest that they used this theory to analyse Intel s behaviour. 2 In considering these two theories, we do not intend to argue that Intel s market share and volume discounts were necessarily anticompetitive. Nor, do we intend to fully review the economic or legal literatures on exclusive dealing. 3 Rather, our intent is to describe possible economic theories for understanding the information cited by the EC, the FTC, and the New York State Attorney General (NYAG) and to highlight the differences between those theories including differences in the evidence required by the theories: (i) that the Downstream Competition Theory can find harm when effective price is above average avoidable cost while the As Efficient Competitor Test cannot, and (ii) that the Downstream Competition Theory implies an increase in prices to end users while the loyalty discounts are in place whereas the As Efficient Competitor Test could be consistent either with prices falling or prices rising while the discounts are in place. 2013; State of New York, by Attorney General Andrew M Cuomo v Intel Corporation, in the United States District Court for the District of Delaware, CA No (JJF). For information about Intel s conduct, we rely principally on the allegations in Complaint, State of New York, by Attorney General Andrew M. Cuomo v Intel Corporation, in the United States District Court for the District of Delaware, CA No (JJF) (NYAG Complaint) < accessed 20 March The SEC also filed suit against Dell for improperly treating rebates received from Intel as sales revenue rather than as reductions in costs, thus overstating its sales. Securities and Exchange Commission v Dell Inc., Michael S. Dell, Kevin B. Rollins, James M. Schnieder, Leslie L. Jackson, Nicholas A.R. Dunning, Case 1:10-cv DDC. 2 See Commission Decision of 13 May 2009, COMP/ Intel < ICT/intel_provisional_decision.pdf> accessed 20 March For a recent review, see Michael Whinston, Lectures on Antitrust Economics (MIT Press 2006)

3 172 Journal of Antitrust Enforcement VOL. 2 The remainder of the article is organized into five main sections. The second section describes the competitive threat that Intel faced from AMD. The third section describes and compares the two possible theories under which to analyse Intel s use of market share and volume discounts. The fourth section identifies specific computer and CPU markets and explains how the market structures that must be in place for the theories to hold could be shown to be in place. The fifth section reviews the publically available evidence that supports these theories of harm, matching evidence to the specific elements of the theories in the identified markets. The sixth section concludes. II. AMD s emergence as a competitive threat to Intel Intel principally makes CPUs, which are integrated circuits that serve as the brain of a computer. Intel sells its CPUs primarily to OEMs such as Dell, HP, and IBM. CPU manufacturers compete to make sales to OEMs based on the price and performance of their CPUs, their design and manufacturing capabilities, and their reputation for reliably supplying high-quality CPUs. OEMs then compete among themselves to make computer sales to final consumers. An instruction set architecture ( architecture ) refers to the manner in which a CPU interprets and executes instructions from a computer s software. In the 1970s, various companies made a variety of CPUs utilizing different architectures. In 1981, IBM selected Intel s 8086 processor, which embodied the x86 architecture, for use in its personal computers. As part of its selection process, however, IBM required Intel to license its existing design to second-source manufacturers including AMD. Over the next several years, the use of CPUs with the x86 architecture increased dramatically. In 1985, Intel introduced a new x86 design (the 386 CPU) and claimed that AMD did not have the right under the original second-sourcing agreement to clone this design. AMD sued, and the resulting legal battles led to a settlement in 1995 in which AMD received a perpetual license to Intel s x86 instruction set. AMD then began to design its own x86 CPUs and by roughly 1999 had begun to achieve design parity with Intel for some types of CPUs. In 2003, AMD introduced its Opteron, Athlon 64, and Mobile Athlon 64 CPUs, which had the advantage over existing Intel CPUs of being able to run both 64-bit and 32-bit software. In addition, the Opteron CPU, which was designed for servers, substantially outperformed existing Intel server CPUs in many respects. 4 AMD s development of these CPUs represented the first major threat to Intel s dominant position in x86 CPUs. Intel responded to this threat with a variety of different actions. Some, such as improving its products were procompetitive. Others such as its use of volume and market share discounts may have been anticompetitive. 4 For example, see EU Decision paras 153 6; NYAG Complaint paras

4 2014 Loyalty discounts and theories of harm in Intel investigations 173 III. Theories for analysing Intel s discounts Both private and government lawsuits allege that Intel responded to increased competition from AMD by offering major OEMs financial and non-financial consideration in exchange for maintaining exclusive or near-exclusive relationships. These relationships can be analysed using a Downstream Competition Theory or an As Efficient Competitor Test. Downstream competition theory Several recent papers in the economic literature identify circumstances in which an incumbent monopolist, facing an equally or more efficient entrant, can exclude such an entrant by offering competing downstream firms payments for exclusivity. 5 Because Intel sold its CPUs to OEMs who then competed intensely among themselves to make sales to final consumers, 6 some variant of the theory described in these papers would provide a possible anticompetitive explanation for Intel s use of volume and market share discounts. The intuition for the theory is as follows. The incumbent offers a lump-sum payment to downstream buyers in exchange for exclusivity, and sells them the input at the per unit monopoly price. The entrant offers to sell its input to buyers at a much lower price. However, each buyer realizes that if it accepts the entrant s low price, then the incumbent will lower its price to the other buyers who remain exclusive. This will result in downstream competition that will compete away most of the profits from the entrant s low input price, leaving only a small additional profit from buying from the entrant. 7 The downstream seller purchasing from the entrant would also forfeit the exclusivity payment offered by the incumbent. When the forfeited payment exceeds the small additional profit, each buyer would unilaterally prefer to accept the incumbent s offer and maintain 5 See John Simpson and Abraham L. Wickelgren, Naked Exclusion, Efficient Breach, and Downstream Competition (2007) 97(3) Am Econ Rev 1305; John Simpson and Abraham L Wickelgren, Bundled Discounts, Leverage Theory, and Downstream Competition [2007] Am L & Econ Rev 370; Jose Miguel Abito and Julian Wright, Exclusive Dealing with Imperfect Downstream Competition [2008] Int l J of Indus Org 227; Patrick DeGraba, Naked exclusion by a dominant input supplier: Exclusive contracting and loyalty discounts (2013) Int J Ind Organ accessed 7 October The basic idea underlying this theory is also discussed in Thomas Krattenmaker and Steven Salop, Anticompetitive Exclusion: Raising Rival s Costs to Achieve Power over Price (1986) 96(2) Yale LJ 209; Einer Elhauge, How Loyalty Discounts Can Perversely Discourage Discounting (2009) 5 J Competition L & Econ 189. While Chiara Fumagalli and Massimo Motta (2006) find that exclusion becomes more difficult as downstream competition increases, this result relies on the assumption that the entrant can offer lower prices than the incumbent and that only buyers with the lowest costs participate in the downstream market. With these assumptions, a buyer can monopolize the downstream market if it rejects the incumbent s offer while its rivals accept the incumbent s offer. Simpson and Wickelgren argue that this result represents a special case because a small amount of downstream product market differentiation would enable a higher cost buyer to participate in the market. See Chiara Fumagalli and Massimo Motta, Exclusive Dealing and Entry when Buyers Compete (2006) 96(3) Am Econ Rev See Intel s Response to NYAG Complaint, para Even if a single buyer were to purchase from the entrant and shade its price just a little to win additional sales, the incumbent would lose those sales and have an incentive to lower input prices to at least one of its loyal buyers to compete for those sales. This will result in competition for all those customers that could be served by goods using the entrant s input.

5 174 Journal of Antitrust Enforcement VOL. 2 exclusivity, rather than purchase from the entrant at a low price. 8 Thus, the incumbent s strategy enables it to maintain supra-competitive prices in the downstream input market while excluding the entrant. The above intuition also can be seen through a simple numerical example. Suppose a downstream seller sells 100 units at a retail price of $10, pays $6 per unit to the incumbent for each input, and has $3 per unit of other costs. Assume that the incumbent s marginal cost of the input is $4 and an entrant s marginal cost of the input is $3.50. Assume further that if the downstream seller buys from the entrant at $3.50 per unit, the incumbent would lower its price to $4 per unit for customers who remain loyal, the resulting downstream competition would lower the retail price from $10 to $8, and the downstream seller who purchased from the entrant would now sell 120 units rather than 100 units. In this case, the downstream seller earns $80 more ($180 (120 units at a per unit profit of $1.50) - $100 (100 units at a per unit profit of $1.00)) buying from the entrant rather than from the incumbent, while the incumbent loses $200 of profit on this buyer. Given this outcome, the incumbent would only need to pay the seller $80, for the seller to remain exclusive. Moreover, the payment would easily pass the As Efficient Competitor Test as long as the amount of contestable sales exceeded 40 units. This numerical example illustrates a general rule. When the markup on the monopolized input is high, the cost advantage (or equivalently the performance advantage) of the entrant s product is low, the incumbent is willing to lower price significantly to match the entrant s price, and most of the input price reductions will be passed on to end users, then the needed payment to induce each seller to remain loyal is low. As suggested above, in the Downstream Competition Theory, the form of consideration that the incumbent offers for exclusivity must be lump-sum: if the upstream incumbent simply offered lower input prices, then competition in the downstream market would lead to lower final goods prices, which would benefit consumers but not upstream input suppliers or downstream sellers. These lump-sum payments, can take a variety of forms. The most direct is just a lump-sum payment for exclusivity. Here, the lump-sum payment could be an explicit fixed payment or a discount applied to the purchase of infra-marginal units. In the latter case, the discount is a lump-sum because the buyer receives the same total discount irrespective of how many units it sells beyond some threshold. A second type involves a discount based on a seller s share of a buyer s purchases ( market segment share ). 9 For instance, the seller might offer the buyer a 8 This theory could be viewed as the incumbent monopolist forming a coalition with downstream buyers to extract monopoly rents from final consumers. Note, however, that depending on the circumstances, downstream buyers may be passive or even unwilling participants in this coalition. 9 See Willard Tom, David Balto, and Neil Averitt, Anticompetitive Aspects of Market-share Discounts and Other Incentives to Exclusive Dealing [1999] Antitrust L J

6 2014 Loyalty discounts and theories of harm in Intel investigations 175 contract in which the buyer gets a modest discount off all its purchases only if it makes 90 per cent of its purchase from the seller. With such a contract, the retroactive extension of the per-unit discount represents a lump-sum payment, the market segment share target makes the contract effectively exclusive, and the modest size of the discount maintains supra-competitive pricing. 10 A seller can also offer other monetary consideration in exchange for exclusivity. For example, the seller might offer financing for a joint R&D effort or a contribution to the cost of cooperative advertising on the condition of exclusivity. Such consideration would meet the requirement of the theory as long as it does not increase downstream competition in a manner that results in lower prices. For example, advertising support that merely displaces advertising spending that a buyer would have incurred anyway would not increase competition and would thus meet the requirement of the theory. Where buyers have a need to purchase at least some of their inputs from a particular seller, that seller might also threaten to withhold a key input unless it obtains exclusivity. For example, an input supplier might provide technical information that a buyer needs to design its products to accommodate an improvement in the input. By threatening to withhold such information, a supplier might compel a buyer to enter into an exclusive or near-exclusive relationship. Similarly, a supplier might ordinarily ration its product proportionally to buyers during times of shortage. By threatening to short a buyer who is not exclusive during such times, a supplier might compel the buyer to enter into an exclusive relationship. (Note, however, that a supplier might have valid business reasons for such behaviour. For instance, a supplier might be concerned that a non-exclusive buyer might share the supplier s technical information with the supplier s rival. A supplier might also favour exclusive customers during periods of shortage because it believes that these buyers have no alternative source of supply.) While these payment forms may appear quite different on their face, they all have the same economic impact. These payment forms provide an incentive for the buyer to remain loyal to the incumbent without lowering per-unit input prices, which because of downstream competition among buyers would ultimately lead to the dissipation of industry profits. As also suggested above, the incumbent must ensure that a group of downstream buyers that collectively have market power continue to purchase inputs from it at supra-competitive prices. In the extreme benchmark example where 10 An incumbent monopolist theoretically could use a volume discount to mimic the effect of a market segment share contract if it knows the level of a buyer s demand and if demand for the buyer s product varies little with price. However, note that the assumption that demand for the buyer s product varies little with price would seem unlikely to hold in an environment in which buyers compete intensely. Also, Simpson and Wickelgren show that bundled discounts can sometimes be an effective means of leveraging a monopoly in one market into another. That said, such discounts require a careful analysis since firms often use bundled discounts, which provide discounts across markets, for efficiency reasons. See Simpson and Wickelgren (n 5) 372.

7 176 Journal of Antitrust Enforcement VOL. 2 end users view the downstream buyers products as perfect substitutes, buyers are not capacity constrained, and buyers compete by setting prices, a single buyer that obtains a competitive per-unit price from either the incumbent or the entrant can spark competition that drives end user prices to competitive levels. Thus, in this case, the incumbent must get all buyers to accept lump-sum payments (or something equivalent) in exchange for exclusivity and agreeing to pay supra-competitive per unit prices. In the more common case where the downstream market is less competitive, either because product differentiation leads to some market segmentation or because the entrant s buyers are capacity constrained, an incumbent might still be able to monopolize a large portion of the market if it were able to confine the entrant s products to a small part of the market. 11 To do this, the incumbent would need to sign exclusive contracts with buyers who collectively had market power with respect to a group of customers. Thus, to recap, the following conditions must hold for the Downstream Competition Theory discussed above to apply: Buyers compete intensely among themselves. The incumbent must have exclusive or near-exclusive relationships with downstream buyers that collectively have market power with respect to some customers. The payment for exclusivity must not result in low marginal input prices. In other words, there should be evidence that the incumbent gave downstream firms some consideration of a fixed nature for not using the entrant s input. The incumbent must have the ability and incentive to lower its prices if a downstream buyer purchases from the entrant. As with any anticompetitive theory, in addition to verifying that the necessary conditions hold, it is important to look for the following competitive effects: Prices are higher in those markets and at those times in which the incumbent has exclusive relationships with downstream buyers that collectively have market power. Output is lower in those markets and at those times in which the incumbent has exclusive relationships with downstream buyers that collectively have market power. Since neither the FTC nor the NYAG cases ultimately went to trial, it is difficult to say for certain what theory or theories they would have pursued. That said, 11 See eg DeGraba (fn 5).

8 2014 Loyalty discounts and theories of harm in Intel investigations 177 statements in the FTC s Aid to Public Comment suggest that it had concerns based on the above theory. The FTC s Aid to Public comment notes: 12 These practices [use of exclusive contracts] severely limited the number of instances in which OEMs selling non-intel-based PCs competed directly against OEMs selling Intel-based PCs, especially in servers and in commercial desktops and notebooks. When an OEM selling Intel-based PCs competed against OEMs selling AMD-based PCs, Intel often had to sell CPUs at competitive prices. When such competition was eliminated, Intel could sell CPUs at supra-competitive prices. Consequently, it was able simultaneously to charge above-competitive prices and at the same time to exclude its rivals, resulting in both higher prices and fewer choices for consumers. While the NYAG Complaint contains a large amount of information about Intel s conduct, it is unclear from the complaint exactly what theory of harm the NYAG would have developed. That said, some statements in the NYAG complaint seem consistent with the Downstream Competition Theory. For example, the complaint states: Intel used the monopoly profits thus preserved to favor complicit OEMs, and punish recalcitrant ones. By complying with Intel s anticompetitive wishes, an OEM could gain substantial rewards, while its competitors, and consumers, suffered most of the consequences. 13 As Efficient Competitor Test The European Union Commission s analysis of Intel s use of volume and market share discounts followed a different path. According to the Commission Decision, Intel s actions could be found to constitute an abuse of dominance if the EU Commission could show that Intel is dominant, and that...the discount tends to remove or restrict the buyers [sic] freedom to remove or to choose its sources of supply. 14 The Commission decision also stated: [F]or the purposes of establishing an infringement of Article 82 EC, it is not necessary to demonstrate that the abuse in question had a concrete effect on the markets 12 Analysis of Proposed Consent Order to Aid Public Comment in the Matter of Intel Corporation, Docket No < accessed 20 March The FTC did state, In addition, Intel s retroactive quantity discounts were of a type that could readily disguise effective belowcost pricing, which would, under the circumstances, present a strong risk of predatory effects. However, it is clear that the FTC viewed one of the harms from Intel s exclusivity arrangements as allowing Intel to maintain high prices. It stated, The Complaint alleges that these arrangements did not represent competition on the merits, were designed to minimize pass-through of rebates to consumers.... Later it stated, This effectively allowed Intel to compete by raising the effective prices of AMD s and Via s products rather than lowering the effective prices of its own....the end result was that Intel could make a rival s actual low prices look very costly to customers without Intel s needing to reduce its own prices or expand its own output. 13 NYAG Complaint EU Commission decision paras 923 (italics in original). Formally the Commission considered two classes of conduct. The first included the conditional rebates and other payments for maintaining a certain share level of Intel CPUs, The included naked restraints, which included payments and other inducements to not sell existing non-intel CPU based machines in certain markets and to not complete the development of non-intel based machines that were under development.

9 178 Journal of Antitrust Enforcement VOL. 2 concerned. It is sufficient in that respect to demonstrate that the abusive conduct of the undertaking in a dominant position tends to restrict competition or, in other words, that the conduct in question is capable of having or likely to have such an effect. While the EU Commission determined that it did not need to prove that Intel s volume and market share discounts would foreclose other CPU manufacturers, they chose to demonstrate that Intel s payments to OEMs would foreclose competitors by using an As Efficient Competitor Test, which is essentially a price-cost test. 15 In implementing its As Efficient Competitor Test, the EU Commission began by analysing whether Intel was an unavoidable trading partner, which in this case meant that a large share of an OEM s purchases could only be supplied by Intel because many final consumers would only purchase computers with Intel CPUs. 16 The Commission called these sales non-contestable sales. 17 It then determined the quantity of additional Intel units that were purchased by this OEM as a result of the exclusive or near-exclusive arrangement. The Commission called these sales contestable sales. 18 The Commission then estimates the value of the payment for exclusivity and treats this payment as a discount attributable to the contestable share. 19 By dividing this payment by the contestable share, the Commission obtains the effective per-unit discount. Subtracting this discount from Intel s observed price (or the customer authorized price (CAP)) 20 yields the effective price. For the contestable sales, the Commission then considers whether Intel offered financial and non-financial inducements that were so large that Intel s effective price was below an estimate of Intel s average avoidable cost (AAC). 21,22,23 Where the 15 EU Decision paras ibid paras 925, 1005, ibid ibid paras ibid paras 1443, ibid para ibid para 1454, This test can be thought of a one good analogue of the PeaceHealth test. See Cascade Health Solutions v. PeaceHealth, 502 F3d 895, 905 (9th Cir 2007). In the PeaceHealth test there is a monopolist of one good who also produces a second competitive good. The monopolist offers a discount to customers that purchase a bundle containing both the monopolized good and the competitive good, which a firm selling just the competitive good cannot offer. PeaceHealth finds a problem if when all of discount is applied to the competitive good, the effective price of the competitive good is below the incremental cost of producing it. Mechanically one takes the total discount offered for the bundle, divides that by the number of units of the competitive good purchased to get a per unit discount and then that discount is subtracted from the standalone price of the competitive good to obtain an effective price. If that effective price is below the marginal (or incremental) cost of producing the competitive good, then the bundled pricing fails the test and is deemed to be problematic. In this case the EU proposes to treat the non-contestable share as the monopolized good, the contestable share as the competitive good, and the rebate for reaching an overall quantity or market share threshold as the bundled discount. If applying the entire discount to the contestable share results in the effective price of the contestable share being below incremental cost, then the pricing fails the price cost test. See Cascade Health Solutions v PeaceHealth, 515 F3d 883 (9th Cir 2008). 23 In some cases, the Commission used a required share test because the contestable share could not be determined exactly. In these cases, they calculated the difference between the average selling price and AAC (EU Decision, paras ). They then determined the rebate attributable to the contestable share (EU Decision, para 1288). Finally, they estimated the volume of sales that an entrant would need to make to an OEM at AAC

10 2014 Loyalty discounts and theories of harm in Intel investigations 179 Commission determined that these effective prices were below its estimate of Intel s AAC, the Commission determined that Intel s discounts could foreclose an as efficient competitor from the market. For the As Efficient Competitor Test as articulated by the EU Commission to hold, the following conditions must apply: 24 The seller is an unavoidable trading partner. The seller offers some payment that is contingent on the customer maintaining a minimum required share of the seller s good. There is an identifiable contestable sales volume for a customer that exceeds what he would purchase in the absence of the exclusivity or near exclusivity requirement. There is an identifiable amount of discount that would be lost if the customer does not purchase at least the required share. There is an identifiable avoidable cost of producing the contestable share. The effective price of the contestable share (equal to the payments for those units if the exclusivity requirement is not met, minus the discount received for purchasing the required share divided by the contestable share) is less than the average avoidable cost. Comparison of the Downstream Competition Theory and the As Efficient Competitor analyses The Downstream Competition Theory and the As Efficient Competitor Test differ in three key respects. First, the Downstream Competition Theory and the As Efficient Competitor Test can find foreclosure under different conditions. Most notably, the downstream competition analysis can find harm when the observed price (accounting for all rebates) is greater than the average avoidable cost, while the As Efficient Competitor Test will not. This means the payment the incumbent needs to make can be relatively small. Second, in the Downstream Competition Theory, the incumbent must ensure that a group of downstream buyers that collectively have market power continue to buy from it at supra-competitive input prices, while there are no requirements on the significance of firms receiving rebates in the As Efficient Competitor Test. Third, the Downstream Competition Theory requires that the payments that the incumbent uses to obtain exclusive or near-exclusive relationships essentially be in order to offset the loss of Intel s conditional rebate (EU Decision, para 1285). If this volume exceeded the contestable sales, then the Commission concluded that Intel s rebates prevented an equally efficient competitor from making sales to the OEM (EC Decision, paras ). 24 This test can be found in the Commission s guidance on exclusionary conduct. See Guidance on the Commission s enforcement priorities in applying art 82 of the EC Treaty to abusive exclusionary conduct by dominant undertakings (Text with EEA relevance) OJ C45,

11 180 Journal of Antitrust Enforcement VOL. 2 lump-sum in nature, while the As Efficient Competitor Test considers only the size of the payments, but not the form. Despite their differences, both analyses may find the same activities harmful, even though they do not articulate the same theory of harm. For example, both the FTC and the EU Commission found the set of loyalty discounts Intel imposed on Dell, HP, and IBM to be anticompetitive, though the EU Commission does not list as a harm, higher PC prices while the discounts were in effect. Second, the two theories can predict different forms of harm. The Downstream Competition Theory is a complete theory of anticompetitive harm. It explains how volume and market share discounts can be used to maintain supra-competitive prices while the discounts are in effect. In contrast, the As Efficient Competitor Test is only a theory of foreclosure, but not necessarily of specific harm to end users. 25 Thus, a number of competitive harms are consistent with this test. For example, the EU Commission decision stated that the foreclosure,...resulted in a significant reduction of consumer choice 26 and in lower incentives 27 to innovate. 28 In response to an earlier Intel argument that this reduction in consumer choice was accompanied by lower prices, the Commission decision only stated, not all rebates genuinely benefit consumers However, nothing in the decision addresses whether the rebates in question were or were not passed through, and if passed through to what extent. Given that the As Efficient Competitor Test on its own cannot determine if there were some reduction in price that could have compensated end users for the loss of choice, the As Efficient Competitor Test can be consistent with lower per unit CPU prices and lower PC prices when the discounts were in effect, than would have occurred in the but for world. 25 See, Guidance on the Commission s enforcement priorities in applying Article 82 of the EC Treaty to abusive exclusionary conduct by dominant undertakings, para 20 The Commission will normally intervene under Article 82 where, on the basis of cogent and convincing evidence, the allegedly abusive conduct is likely to lead to anti-competitive foreclosure... The paragraph lists a number of conditions under which they will enforce this article. None of these conditions includes evidence of harm to end users. Para 22 states, There may be circumstances where it is not necessary for the Commission to carry out a detailed assessment before concluding that the conduct in question is likely to result in consumer harm. If it appears that the conduct can only raise obstacles to competition and that it creates no efficiencies, its anti-competitive effect may be inferred. < accessed 24 September A reduction in choice does not constitute harm by itself. Intel apparently argued that end users would not be harmed if prices of the remaining products were sufficiently lower as a result of the exclusivity. 27 The As Efficient Competitor Test implies that competitors earn lower profits and make fewer sales than they would absent the exclusive (either as a result of being foreclosed or from having to compete with a dominant firm charging a price effectively below cost) and would therefore be weaker both financially and potentially in reputation in the future. To the extent that such weakness implies less competition in the future, the As Efficient Competitor Test would imply harm to end users in the future. In the Downstream Competition Theory, the presence of such factors is not necessary, but if they are present they would tend to make the anticompetitive harm worse. 28 ibid para See EU Decision, para 1612.

12 2014 Loyalty discounts and theories of harm in Intel investigations 181 IV. Markets and market structures Both of the theories outlined in the previous section require the presence of a dominant firm and at least one small rival in the upstream input markets (ie CPUs). The Downstream Competition Theory also requires downstream firms that purchase the input and then compete vigorously against each other in the final goods market (eg x86 servers, and commercial clients), and that exclusion encompass downstream firms that jointly have market power. This section identifies these markets and shows how one could determine if the upstream market structures anticipated by the theories were in place. Determining whether these market structures are present, requires first defining a market and then analysing market structure. Informally, 30 defining a market requires essentially grouping together the products that are good substitutes for each other. Products in different markets typically are not good substitutes for each other. In the following paragraphs, we briefly review information supporting five distinct markets for both computers and CPUs found in the US and EU analyses. We then briefly analyse the market structure in the upstream CPU markets. We consider the structure of the downstream markets and evidence supporting specific elements of the two theories in the subsequent section. Computer markets Computers can be divided into servers and clients: servers run applications for other computers; clients can run applications themselves or they can access more powerful server computers to run applications (eg surf the internet). Mission critical servers that use Reduced Instruction Set Computing (RISC) chips 31 were poor substitute for and therefore in a separate product market from mainstream servers that used Complex Instruction Set Computing (CISC) CPUs, such as the x86, 32 largely because the installed base of operating systems and application software for one is not transferable to the other. Client computers are differentiated in two main respects, portability and platform stability. While notebooks have the advantage of being portable, during the time of the investigation, a notebook computer could cost up to double that of a comparably equipped desktop. 33 Consequently, users who valued portability 30 The US Department of Justice & Federal Trade Commission, Horizontal Merger Guidelines [2010] < outlines the SSNIP test, which uses diversion between products in response to hypothetical price increases to define markets. This process essentially finds products that are good substitutes. 31 A reduced instruction set is made up of a small number of simple instructions as opposed to many complicated instructions in a complex instruction set. RISC chips perform more instructions than CISC chips in a given time period, but they perform them much faster. 32 See EC Decision, para 803, Gary Anthes, Happy Birthday x86 [2008] Computerworld < accessed 20 March University of Wisconsin Division of Information Technology (DoIT) Showroom, Buyer s Guide: Should I Buy a Laptop or Desktop? < accessed 20 March 2013.

13 182 Journal of Antitrust Enforcement VOL. 2 would tend to find desktops poor substitutes for notebooks, while users who did not value portability would tend to find notebooks to be poor substitutes for the much cheaper desktops. Platform stability refers to the length of time that a computer with a particular component configuration is produced. Large commercial customers highly value platform stability because platform stability reduces the number of client configurations over which they need to perform the costly process of verifying that their software is compatible. 34 In contrast, households and small businesses typically use software that is validated over virtually all PCs available and so do not face these problems. In addition, commercial customers typically want clients that have few features because much of the computing is done on servers, while small users typically want more feature rich and cutting edge clients. Consequently, commercial clients and consumer clients are typically poor substitutes for each other. These substitution characteristics led to four separate product markets for client computers: consumer desktops, consumer notebooks, commercial desktops, and commercial notebooks. As with servers, clients that do not use x86 CPUs are a poor substitute for clients that use x86 CPUs because of the high cost of transferring programs written for one CPU architecture to another CPU architecture. x86 CPU markets The markets for x86 CPUs track the markets for computers. Each CPU market is defined primarily because of the impracticality of using one type of CPU in a computer type other than that for which it is designated. CPUs used in servers tend to consume more power, have larger and faster cache, and have different pin configurations 35 than CPUs used in client computers. These differences are significant enough that OEMs tend not to substitute CPUs used in clients for CPUs used in servers. Notebook computers place a premium on low power consumption. Thus, CPUs used in desktops tend to be poor substitutes for the more expensive but more energy efficient CPUs used in notebooks. Finally, as noted earlier, buyers of commercial desktops and notebooks highly value platform stability, which requires a long life cycle for the CPU used in a particular platform. Thus, a hypothetical monopolist of x86 CPUs could price discriminate against these customers by assuring a long life cycle for some CPUs but not others. For OEMs serving commercial end users, CPUs without long life cycles would then be a poor substitute for those with long life cycles See eg Scott Ferguson, AMD Eyes Corporate Desktops: The Chip Maker Looks to Make Good on its $5.4 Billion Purchase of ATI [2008] eweek 24 5; John Spooner, AMD-ATI Deal Targets Enterprise Customers: More Integrated Chip Sets Should Create New Business Lines [2006] eweek A CPU connects to the motherboard by a set of pins that plug into a corresponding socket. Only pins with the same configuration as the socket can plug into that socket. 36 Consistent with the definition of such smaller markets, the EC noted that OEMs...generally make clear that the end use of the different categories of computer (that is desktop, notebook or server) determine what CPU is used in that computer and that...the prices of CPUs used in the three segments are generally of a different magnitude EC Decision, paras

14 2014 Loyalty discounts and theories of harm in Intel investigations 183 Intel had a very high share of overall x86 CPU sales. Between 2002 and 2006, for x86 microprocessors, Intel s unit share of CPU sales ranged between 79 and 86 per cent and Intel s revenue share ranged between 84 and 89 per cent. See Table 1. Intel had similarly high market shares in each of the markets for supplying CPUs to OEMs for use in commercial desktops, commercial notebooks, and servers. Given Intel s very high market shares, showing that it had market power would involve showing AMD, Via Technologies, 37 or an entrant would not be able to constrain Intel to set competitive prices, because none would be able to quickly capture a substantial share of Intel s sales in the event Intel charged an above competitive price. The evidence regarding market power had two main components. The first involve competitor s ability to supply the market. AMD s capacity substantially lagged behind that of Intel, and AMD sometimes had trouble meeting demand for its products. 38 While AMD would have been able to serve some additional customers, they could not expand nearly enough to constrain Intel. The second, involved consumer acceptance. Many buyers of commercial CPUs viewed AMD as inferior to Intel for meeting their platform stability needs. 39 Compared to AMD, Via the only other x86 manufacturer, had significantly less production capacity and only served a very small end user market niche. Similarly, entry by new firms did not threaten Intel s market power. Evidence supporting this included the fact that an entrant would need a license from Intel to produce an x86 CPU, and the fact that x86 emulation technology commercialized only by Transmeta managed to gain only a very small market share, selling CPUs for lower power applications. 40 In the server market prior to mid-2003, Intel had market power in supplying x86 server chips because AMD did not offer a competitive x86 CPU. However, this market power declined when AMD offered its Opteron CPU in mid-2003 and HP offered a broad line of AMD-based x86 servers in mid Although Intel was able to maintain a high market share for x86 server CPUs after this, evaluation of bidding records indicate that Intel had to cut its price drastically to do so. This section has identified specific CPU markets where the theories discussed in the previous section could be applied, and it has discussed evidence about whether these upstream markets have the market structure necessary for the theories. Thus, this section presented available evidence that support the claim that Intel had market power, a prerequisite for either theory to hold. The next section focuses on the evidence supporting the individual elements of the two theories of anticompetitive behaviour. 37 Via Technologies is a small Taiwan-based seller of x86 CPUs. It was the only firm other than Intel and AMD that was licensed to produce x86 CPUs. During this time Via had only 1 to 2 per cent global market share. 38 For example, EC Decision, para 872; Sam Jaffe, AMD Is Still Scratching for Respect [2000] BusinessWeek; Ferguson (n 34) 24 5; Spooner (n 34) For example, EC Decision, para 872; Jaffe (n 34); Ferguson (n 34) 24 5; Spooner (n 34) See eg Transmeta Wikipedia < accessed 20 March 2013.

15 184 Journal of Antitrust Enforcement VOL. 2 Table 1. Worldwide Intel AMD market shares in x86 PCs Unit share Revenue share Year Intel AMD Intel AMD % 17% 87% 13% % 15% 88% 12% % 14% 89% 11% % 16% 88% 12% % 21% 84% 16% Source: IDC PC Tracker. Limited to microcomputers made with x86 processors from Intel or AMD from 2002 through Includes all PC segments including desktops, notebooks, workstations, and mini-pcs. The IDC data is not sufficiently detailed to determine Intel s and AMD s precise market shares prior to V. Evidence consistent with the two theories of harm from Intel s use of loyalty discounts Evidence consistent with the Downstream Competition Theory As noted above, Intel s alleged use of exclusionary terms can best be analysed by identifying five downstream computer markets and five upstream markets for the CPUs used in each of these markets. The downstream markets are respectively x86 servers, commercial desktops, commercial notebooks, consumer desktops, and consumer notebooks. Tables 2 6 list the market shares for the leading OEMs in these markets for the period 2000 to 2006 and indicate whether these OEMs used Intel CPUs exclusively for each of these years. A quick review of these tables suggests that the Downstream Competition Theory fits the markets for commercial computers better than it fits the markets for consumer computers for two reasons. First, Dell, HP, and IBM (and later Lenovo) have a combined share of roughly 70 per cent in the x86 server market, 70 per cent in the commercial desktop market, and 65 per cent in the commercial notebook market. 41 Thus, in these markets, Intel conceivably could lock up access to a very high share of commercial computer buyers through exclusive contracts with only three firms. This is less the case for consumer notebooks and much less the case for consumer desktops. Second, in the consumer desktop and consumer notebook markets, HP was not exclusive to Intel. 42 The Downstream Competition Theory envisions Intel monopolizing a market by entering into exclusive or near-exclusive relationships with a set of OEMs that 41 IBM sold its client business to Lenovo in Thus for the percentages for commercial desktops and commercial laptops we use Lenovo s share rather than IBM s. 42 Note that Tables 2 6 combine HP and Compaq sales even though HP did not acquire Compaq until 2002.

16 2014 Loyalty discounts and theories of harm in Intel investigations 185 Table 2. x86 server revenue shares by OEM by year-idc data Year Dell HP-Compaq Lenovo IBM Acer Toshiba Fujitsu NEC Others % 40% 0% 13% 1% 1% 5% 4% 21% % 36% 0% 14% 1% 1% 6% 4% 19% % 34% 0% 17% 1% 1% 5% 4% 18% % 33% 0% 18% 1% 1% 5% 3% 18% % 32% 0% 19% 1% 0% 5% 3% 18% % 34% 0% 18% 0% 0% 4% 3% 18% % 35% 0% 18% 0% 0% 4% 3% 18% Source: IDC PC Tracker Segment Data. This data does not include non-x86 PCs. For , the years when the necessary data is available, an OEM s market share is shown in bold if it used only Intel s CPUs and is shown in bold italic if it used less than 5 per cent AMD CPUs. Table 3. Commercial desktop revenue shares by OEM by year-idc data Year Dell HP-Compaq Lenovo IBM Acer Toshiba Fujitsu NEC Others % 29% 1% 10% 1% 1% 8% 4% 16% % 29% 1% 12% 1% 1% 8% 4% 14% % 26% 1% 13% 1% 0% 8% 4% 12% % 23% 1% 14% 1% 0% 8% 5% 12% % 22% 1% 14% 1% 0% 7% 4% 13% % 22% 10% 3% 1% 0% 7% 5% 14% % 23% 12% 0% 1% 0% 7% 4% 14% Source: IDC PC Tracker Segment Data. This data does not include non-x86 PCs. For , the years when the necessary data is available, an OEM s market share is shown in bold if it used only Intel s CPUs and is shown in bold italic if it used less than 5 per cent AMD CPUs. collectively have market power in order to maintain supra-competitive prices. Since detailing the exact form of Intel s relationship with multiple OEMs across multiple markets over several years would be well beyond the scope of this article, this section focuses on identifying two examples in which the Downstream Competition Theory arguably applies and one case in which the As Efficient Competitor Test arguably applies. In doing so, this article seeks to provide the reader with a sense of the types of evidence one would need to show anticompetitive harm under these theories. The examples we consider are the market for commercial desktop computers in 2002 through 2003, the market for x86 servers in mid-2003 through mid-2004, and the market for x86 servers in mid-2004 through mid-2006.