PRICE-COST TESTS IN ANTITRUST ANALYSIS OF SINGLE PRODUCT LOYALTY CONTRACTS

Transcription

1 PRICE-COST TESTS IN ANTITRUST ANALYSIS OF SINGLE PRODUCT LOYALTY CONTRACTS BENJAMIN KLEIN ANDRES V. LERNER* There is substantial disagreement regarding whether predatory pricing or exclusive dealing principles should be the controlling antitrust legal standard for the evaluation of single product loyalty discount contracts. 1 The Third Circuit in ZF Meritor v. Eaton Corp. 2 resolved this issue by focusing on whether price discounts were the clearly predominant mechanism of exclusion in the loyalty contract. 3 Eaton, which had about an 80 percent share of sales of heavy-duty truck transmissions, introduced loyalty contracts in 2000 that provided upfront payments and price rebates to the four major truck manufacturer buyers if they met a sliding scale of minimum purchase shares, generally set between 85 and 95 percent. 4 Eaton urged the court in evaluating these contracts to adopt a Brooke Group 5 price-cost test and to conclude that Eaton had not engaged in anticompetitive conduct because Plaintiffs did not prove or even attempt to prove that Eaton priced its transmissions below an appropri- * The authors are, respectively, Professor Emeritus of Economics, UCLA, and Executive Vice President, Compass Lexecon. The research in this article has not been sponsored or paid for by any organization and neither author has consulted on any of the cases analyzed in this article. We have benefited from comments and discussions with Leah Brannon, George Cary, Dan Crane, Don Hibner, Kelly Fayne, Kevin Murphy, Richard Steuer, Mike Waldman, and Josh Wright. Valuable research assistance was provided by Steve Stanis and editorial assistance provided by Adam Sieff, Francesca Pisano, and Karen Otto. 1 Sean P. Gates, Antitrust by Analogy: Developing Rules for Loyalty Rebates and Bundled Discounts, 79 ANTITRUST L.J. 99 (2013) (provides recent survey of the case law and the current ongoing debate) F.3d 254 (3d Cir. 2012). 3 Id. at Id. at 265. The minimum purchase shares for Freightliner ranged between 86.5% and 92%; for International between %; for PACCAR between 90 95%; and for Volvo, which manufactured a significant quantity of its own transmissions, between 70 78%. Id. The contracts were instituted after Meritor, Eaton s primary rival, announced plans to expand through a joint venture it entered in mid-1999 with a large German company, ZF Friedrichshafen. Id. at Brooke Grp. Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993) Antitrust Law Journal No. 3 (2016). Copyright 2016 American Bar Association. Reproduced by permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Electronic copy available at:

2 632 ANTITRUST LAW JOURNAL [Vol. 80 ate measure of its costs. 6 The court rejected this argument, holding that, consistent with previous antitrust case law regarding single product loyalty contracts, predatory pricing principles, including the price-cost test, would control [only] if this case presented solely a challenge to Eaton s pricing practices. 7 The court emphasized that, in addition to price discounts contingent on the purchase of a minimum share of Eaton products, the Eaton loyalty contracts included other terms that required truck manufacturers to favor Eaton products, specifically that Eaton transmissions be listed in truck manufacturer catalogues (or data books ) as the standard, lowest price offering. 8 Furthermore, two of the four contracts required the truck manufacturer to remove competitors products from its data book entirely. 9 The court also found that truck manufacturers faced the risk of contract termination or reduced availability of supply if they failed to meet Eaton s minimum purchase share and preferred distribution contract terms. 10 This led the court to conclude that price itself was not the clearly predominant mechanism of exclusion. 11 Hence, the court determined that the Eaton loyalty contracts should not be evaluated in terms of a price-cost test but on a rule-of-reason exclusive dealing standard, under which the contracts were found to violate antitrust law. 12 This article clarifies the Meritor framework of analysis by, first, examining what it means for price to be the predominant mechanism of exclusion in a loyalty contract. It is essential to distinguish between two types of contract terms in a loyalty contract: (1) contract terms that specify buyer performance conditions, such as minimum purchase share; and (2) contract terms that incentivize buyers to meet these performance conditions, such as the loss of price discounts if the performance conditions are not fulfilled. More complex loyalty contracts include contract terms that may specify additional buyer performance conditions, such as Eaton s preferential listing and pricing distribution requirements, or specify additional buyer incentives, such as Eaton s ability to terminate or restrict supply to buyers who fail to meet contract performance conditions. Use of a price-cost test requires price to be the predominant mechanism of exclusion in a loyalty contract in the sense of the second type of contract term, namely that the contractual incentive mechanism by which buyers are 6 Meritor, 696 F.3d at Id. at Id. at Id. at Id. at Id. 12 Id. at 281. Electronic copy available at:

3 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 633 induced to meet contractually specified performance conditions consists predominantly of the loss of price discounts. When price discounts are the mechanism that incentivizes buyers to meet loyalty contract performance conditions, equally efficient rivals can compete for sales as long as price is greater than cost, a condition that holds independent of the contract terms that are used to specify performance conditions. A loyalty contract, for example, may include preferential distribution requirements in addition to minimum purchase share performance conditions. However, as long as price is the predominant mechanism of exclusion and price is greater than cost, buyers can reject all the contract performance conditions because the only consequential cost they bear is the loss of price discounts that equally efficient rivals can meet. On the other hand, when significant non-price incentive mechanisms also are present in a loyalty contract, such as the termination and supply risks present in the Eaton loyalty contracts, the essential insight of Meritor is that price greater than cost cannot be used as a test of liability because the ability of equally efficient rivals to compete will depend upon the sum of price and non-price incentive mechanisms in the loyalty contract. When price is the predominant incentive mechanism, a price-cost test can be used to evaluate single product loyalty contracts. However, both economics and previous loyalty contract case law indicate that a simple Brooke Group average price-cost test is applicable only when all sales are contestable, in the sense that rivals can compete for all of a buyer s purchases. More generally, consumer preferences for an established firm s products may imply that some of the established firm s sales are incontestable sales for which rivals are not able to economically compete. In that case the Brooke Group antitrust safe harbor test must be modified, with loyalty discounts applied only to the contestable sales. If the discount attributed price of contestable sales, defined by allocating all discounts to contestable sales, is above costs, equally efficient rivals then can compete for contestable sales. An important insight of this article is that consumer product preferences that create incontestable sales also provide a procompetitive motivation for loyalty discounts. Because individual firm demand curves as a consequence of consumer preferences are negatively sloped, the single competitive price will be greater than marginal cost, often substantially greater than marginal cost in high fixed cost, high margin industries. For example, the first case to apply the Third Circuit Meritor reasoning, Eisai v. Sanofi-Aventis, 13 dealt with Sanofi s loyalty contracts on sales of its pharmaceutical products to hospitals where the single, profit-maximizing price was substantially greater than marginal cost. In this circumstance firms have a competitive incentive to use loyalty contracts to offer buyers contingent price discounts in return for increased 13 No (MLC), 2014 U.S. Dist. LEXIS (D.N.J. Mar. 28, 2014).

4 634 ANTITRUST LAW JOURNAL [Vol. 80 purchases. The appropriate antitrust standard for evaluation of single product loyalty contracts requires distinguishing this procompetitive economic motivation for loyalty contracts from the use of a loyalty contract to leverage the consumer surplus on incontestable sales to create a de facto all-or-nothing exclusive dealing arrangement that anticompetitively forecloses rivals. An economic framework is presented in this article that distinguishes between these alternative uses of loyalty discounts and derives criteria by which loyalty contracts may be evaluated within this framework consistent with current antitrust law. The analysis is facilitated with an economic model that analytically defines consumer product preferences and thereby clarifies the economic relationship between product preferences, incontestable sales, and the use of loyalty discounts as a way to increase incremental sales either by reducing the price of contestable sales or by leveraging incontestable sales. Consistent with Meritor, whether attributed price is greater than cost under predatory pricing antitrust principles is shown to be the essential economic factor that determines the ability of equally efficient rivals to compete in the face of a loyalty contract whenever price is the predominant mechanism of exclusion in the contract. This conclusion is contrasted with the view of some antitrust scholars who have recently argued that single product loyalty contracts should always be analyzed under a rule-of-reason exclusive dealing standard, and that price-cost evidence is irrelevant. 14 This view fails to recognize that both the procompetitive benefits and potential anticompetitive effects of loyalty price discounts are often the same as in predatory pricing. The view also incorrectly assumes that merely because loyalty discounts are contingent on exclusive purchases that the contract amounts to a de facto all-or-nothing exclusive dealing arrangement. Even when conditions imply that a loyalty contract should be evaluated under a rule-of-reason exclusive dealing standard, such as when signifiant non-price incentive mechanisms are present in the contract, the first step of the analysis must involve a determination that the buyer has no economic choice but to meet the exclusive purchase condition, that is, that the contract involves de facto exclusive dealing. Only then does the analysis move to an evaluation of the procompetitive and anticompetitive effects of exclusive dealing. 14 Cf., e.g., Gates, supra note 1, at (similarly analogizing loyalty contracts to exclusive dealing); Steven C. Salop, Exclusionary Conduct, Effect on Consumers and the Flawed Profit- Sacrifice Standard, 73 ANTITRUST L.J. 311 (2006); Joshua D. Wright, Simple but Wrong or Complex but More Accurate? The Case for an Exclusive Dealing-Based Approach to Evaluating Loyalty Discounts, Remarks at the Bates White 10th Annual Antitrust Conference (June 3, 2013),

5 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 635 I. LOYALTY CONTRACT ANALYSIS IN MERITOR A. THE INAPPLICABILITY OF PRICE-COST TESTS WHEN A LOYALTY CONTRACT INCLUDES NON-PRICE INCENTIVE MECHANISMS The court in Meritor proposed a framework for the analysis of single product loyalty contracts where an initial determination is made regarding whether price is the predominant incentive mechanism in the contract. When price is the predominant incentive mechanism, in the sense that buyers have the incentive to meet the loyalty contract performance conditions primarily or solely because of the financial penalty of the threatened loss of the loyalty price discounts, the court concluded that the loyalty contract should be evaluated using a Brooke Group price-cost standard. The court reasoned that when price is the predominant incentive mechanism in a loyalty contract, price greater than cost should be a sufficient condition to reject antitrust liability because prices are unlikely to exclude equally efficient rivals unless they are belowcost. 15 Therefore, the price-cost test tells us that, so long as the price is above-cost, the procompetitive justifications for, and the benefits of, lowering prices far outweigh any potential anticompetitive effects. 16 On the other hand, if the incentive mechanism in a loyalty contract includes non-price incentive mechanisms, the price-cost test does not provide a correct answer to the question of whether equally efficient rivals can compete for sales. This is the major insight of Meritor, where the court concluded that the Eaton contracts should not be evaluated under a price-cost test because the Eaton contracts included a number of significant non-price mechanisms of exclusion. If truck manufacturers did not meet the minimum purchase and other required distribution conditions in the Eaton loyalty contracts, they faced expected costs that were greater than Eaton merely withdrawing its loyalty price discounts. One non-price incentive mechanism in Eaton s loyalty contracts described by the court was Eaton s right to terminate the contract if a manufacturer failed to meet the contractually agreed upon minimum purchase share. Eaton s contracts included this term with two of the four truck manufacturers, Freightliner and Volvo. 17 Termination would impose a particularly large cost on a truck manufacturer because Eaton heavy-duty truck transmissions were considered essential for truck manufacturers to remain in business. 18 However, Eaton s right to terminate was not equivalent to an explicit all-or-nothing 15 Meritor, 696 F.3d at Id. at 275 (citing Brooke Grp. Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209, 223 (1993); Concord Boat Corp. v. Brunswick Corp., 207 F.3d 1039, 1062 (8th Cir. 2000)). 17 Id. at Id. at 282.

6 636 ANTITRUST LAW JOURNAL [Vol. 80 contract term that unambiguously stated no product would be supplied if the truck manufacturer did not meet the required purchase share. The two truck manufacturers only faced a risk of termination, and it is not obvious what they perceived to be the likelihood that Eaton would exercise its right of termination. In fact, the one example where either of these manufacturers failed to meet their purchase requirements, namely Freightliner s failure to meet its market share target in 2002, did not result in Eaton s exercise of its right of termination. 19 But it is reasonable to conclude, as the court did, that the two truck manufacturers likely perceived some risk of termination if they failed to meet purchase requirements. In any event, Eaton s contractual right of termination imposed a potential cost on the two manufacturers because it provided Eaton with additional power to renegotiate new, more burdensome supply terms in the event either of the manufacturers did not meet purchase requirements. 20 Another non-price incentive mechanism that all four manufacturers faced was the risk that Eaton would limit the supply of its products, especially products that might be in short supply, if contract requirements were not met. 21 In contrast to termination, reduced supply of particular products, especially new products in short supply, may have imposed a significant cost on non-cooperating truck manufacturers that did not meet the Eaton minimum purchase share and other preferred distribution contractual requirements without entailing a significant cost on Eaton. The Meritor court also discussed a number of distribution restrictions present in the Eaton loyalty contracts beyond the minimum purchase requirement that are not normally present in loyalty contracts. Specifically, all four loyalty contracts required that Eaton products be listed as the standard, lowest priced transmissions in the manufacturer s data book, and two contracts required that non-eaton products be removed entirely from the data books. 22 These contract 19 Id. at 336 (Greenberg, J., dissenting). The only other example cited where a truck manufacturer failed at some point to fully meet its Eaton purchase share target involved PACCAR, a truck manufacturer that was not operating under an Eaton right of termination agreement. In that case Eaton merely withdrew its price discounts and continued to supply product at unchanged terms. Id. at 283 n The Meritor dissent stated that it was unlikely Eaton would ever actually exercise its termination right and refuse to supply product to a manufacturer because there were only four truck manufacturer buyers, each of which accounted for a significant share of total Eaton sales. Id. at (Greenberg, J., dissenting). However, this does not mean the two truck manufacturers perceived absolutely no risk of termination. Although the cost to Eaton from the exercise of its right of termination was large, the associated cost to a truck manufacturer of termination may have been even larger, so a termination threat may have been credible. 21 This was described in the testimony of a truck manufacturer executive. Id. at The Eaton contract with International required exclusive listing of Eaton products in the electronic data book, but permitted rival product listings in the printed data book. The Eaton 2000 contract with Freightliner included exclusive listings of Eaton transmissions in both the

7 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 637 restrictions represented a major change from Eaton s previous contracts. Before 2000, Meritor s products were listed in all truck manufacturer data books, and in some cases Meritor products actually received preferred positioning. 23 The acceptance by truck manufacturers of these Eaton preferential display and pricing loyalty contract terms made it substantially more difficult for Meritor to respond to Eaton s loyalty contracts by reducing its prices. Even if Meritor lowered its price to truck manufacturers substantially below Eaton s price, Meritor products could not be displayed by such a truck manufacturer as a lower-priced alternative in its data book. A truck manufacturer s acceptance of these restrictive distribution conditions in Eaton s loyalty contracts therefore had a significant negative effect on a manufacturer s ability to substitute Meritor transmissions for Eaton s transmissions and on the ability of Meritor to compete. However, while acceptance of these restricted distribution contract terms may have significantly influenced final customer demand and hence truck manufacturer purchases of Eaton transmissions, the restricted distribution terms were only performance conditions that supplemented contractually specified minimum buyer purchase conditions, not incentive mechanisms that determined if truck manufacturers would decide to meet these restricted distribution conditions. The particular way in which Eaton s loyalty contracts specified required buyer performance, with a minimum purchase share, preferred pricing, and data book listings requirements, is independent of how the loyalty contract incentivized buyers to meet these performance conditions. If the only incentive mechanism was the loss of loyalty discounts, price greater than cost would imply that equally efficient rivals could effectively compete by offering discounts sufficient to induce buyers to reject these other performance conditions along with the minimum purchase share conditions. However, because there were significant non-price incentive mechanisms in the Eaton loyalty electronic and printed data books but reserved Freightliner s right to list ZF Meritor s Freedom- Line products. In 2002 the Freightliner contract was revised so that if any rival products were actually listed by Freightliner, Eaton had the right to renegotiate the discount schedule. Id. at Id. at 266. There is the economic question of why a loyalty contract may include distribution restrictions in addition to minimum purchase share conditions as part of the buyer performance requirements. The same result would be achievable, for example, by contractually specifying solely a minimum required buyer purchase share without any other restrictions and permitting the buyer to choose the best way to meet the required purchase share. However, this may not define desired buyer performance requirements efficiently in all circumstances. In particular, minimum purchase share and preferred distribution contract terms may be complementary aspects of buyer performance that are economically important to specify separately. This is discussed, infra at note 90, in relation to the Sanofi loyalty contracts with hospitals for the supply of its blood clotting drug. Eisai Inc. v. Sanofi-Aventis U.S., No (MLC), 2014 U.S. Dist. LEXIS (D.N.J. Mar. 28, 2014).

8 638 ANTITRUST LAW JOURNAL [Vol. 80 contract associated with the risk of termination faced by two truck manufacturers and the reduced availability of supply faced by all four truck manufacturers, price greater than cost would not imply that equally efficient rivals could compete. The court contrasted price discounts with excusive dealing arrangements. Although prices are unlikely to exclude equally efficient rivals unless they are below-cost, exclusive dealing arrangements can exclude equally efficient (or potentially equally efficient) rivals, and thereby harm competition, irrespective of below-cost pricing. 24 Once a firm establishes an exclusive dealing arrangement, other firms may be driven out not because they cannot compete on a price basis, but because they are never given an opportunity to compete, despite their ability to offer products with significant customer demand. 25 The court further explained that [a]n express exclusivity requirement... is not necessary 26 for a loyalty contract to create a situation where rivals are never given an opportunity to compete. One must look past the terms of the contract to ascertain the relationship between the parties and the effect of the agreement in the real world. 27 In this regard, the court noted that contracts in which discounts are linked to purchase (volume or market share) targets are frequently challenged as de facto exclusive dealing arrangements on the grounds that the discounts induce customers to deal exclusively with the firm offering the rebates. 28 The court concluded that the Eaton loyalty contracts amounted to de facto exclusive dealing arrangements where equally efficient rivals did not have the ability to compete based on the direct evidence that all truck manufacturers actually met the exclusive purchase conditions and the testimony of a truck 24 Meritor, 696 F.3d at 281 (citing United States v. Dentsply Int l, Inc., 399 F.3d 181, 191 (3d Cir. 2005)). 25 Id. 26 Id. at 270 (citing LePage s Inc. v. 3M, 324 F.3d 141, 157 (3d Cir. 2003)). 27 Id. at 281 (citing Dentsply, 399 F.3d at 191, 194). 28 Id. at 275. Defining exclusive dealing contracts to include de facto exclusive contracts where there is not an explicit exclusive purchase contractual requirement but where the contract creates incentives for buyers to purchase the exclusive quantity is consistent with the Supreme Court view that the relevant antitrust question with regard to exclusive dealing is whether the contract has the practical effect of excluding rivals. See Tampa Elec. Co. v. Nashville Coal Co., 365 U.S. 320, 326 (1961). Exclusive purchases are defined in this article to include cases where price discounts are contingent on the buyer purchasing a substantial but possibly less than 100% share of purchases from the seller. This partial exclusivity definition is adopted by Willard K. Tom, David A. Balto & Neil W. Averitt, Anticompetitive Aspects of Market-Share Discounts and Other Incentives to Exclusive Dealing, 67 ANTITRUST L.J. 615 (2000). The economic rationale for the use of partial rather than 100% purchase requirements is discussed infra at text accompanying note 71. A contract with discounts contingent on full or partial exclusivity purchase requirements does not mean the contract is an exclusive dealing arrangement unless the buyer has no economic choice but to meet the full or partial exclusivity purchase requirement if they wish to deal with the firm.

9 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 639 manufacturer executive that truck manufacturers were essentially forced to accept the Eaton contract terms or face costs that included a big risk of cancellation of the contract, price increases, and shortages if the market [was] difficult. 29 Therefore, the sum of the price and non-price incentive mechanisms present in the Eaton loyalty contracts provided buyers with no economic choice but to accept the Eaton minimum purchase and distribution restrictions. The court consequently affirmed that a jury could have concluded that, under the circumstances, the market penetration targets were as effective as express purchase requirements because no risk averse business would jeopardize its relationship with the largest manufacturer of transmissions in the market. 30 B. PRICE-COST ANALYSIS MUST BE MODIFIED FOR THE PRESENCE OF INCONTESTABLE SALES Even when price is the sole incentive mechanism in a loyalty contract, contrary to the Meritor court s conclusion, a simple Brooke Group average pricecost test is not the appropriate standard for evaluation of the contract if the loyalty contract involves some incontestable sales for which rivals cannot reasonably compete. 31 The established firm s average price can be greater than costs yet equally efficient rivals may not be able to compete because when price discounts are allocated to the contestable sales for which they can economically compete, the rivals face an implicit price net of the established firm s discounts that is less than costs. For example, in many cases loyalty discounts are first-unit discounts where the loyalty contract may pass a Brooke Group average price greater than cost standard, yet when all the price discounts are allocated to contestable sales, the implied discount attributed price of contestable sales is less than costs. Therefore, equally efficient rivals cannot make above cost competitive offers for contestable sales and the buyer will have no economic choice but to meet the seller s exclusivity purchase requirements. When price is the sole incentive mechanism in a loyalty contract, a price-cost test is still the appropriate antitrust standard, but the Brooke Group test must be modified to a discount attribution price-cost test that applies only to contestable sales Meritor, 696 F.3d at Id. at 283 (citing ZF Meritor v. Eaton Corp., 769 F. Supp. 2d 684, 692 (D. Del. 2011)). 31 Incontestable sales have been defined somewhat more narrowly as sales that rivals cannot economically compete for in any event. Communication from the Commission Guidance on the Commission s Enforcement Priorities in Applying Article 82 of the EC Treaty, 2009 O.J. (C 45) 7, 39, 42 (Feb. 24, 2009). 32 The EU Commission Guidelines similarly consider passing the discount attribution test to be an antitrust safe harbor for single product loyalty contracts. Id. The Commission used the failure of a discount attribution test as part of its analysis in finding Intel s loyalty discounts anticompetitive. See Case COMP/C-3/ Intel, Comm n Decision, 2009 O.J. (C 227) 13 (May 13, 2009). The decision of the EU General Court on Intel s appeal, however, did not adopt

10 640 ANTITRUST LAW JOURNAL [Vol. 80 Meritor supports the contrary conclusion that an unmodified simple Brooke Group price-cost test is consistent with single product loyalty contract law when price is the predominant mechanism of exclusion in a loyalty contract by referring to three previous single product loyalty contract rulings 33 Nic- Sand, Inc. v. 3M Co., 34 Barry Wright Corp. v. ITT Grinnell Corp., 35 and Concord Boat Corp. v. Brunswick Corp. 36 However, although price is the predominant incentive mechanism in these three cases, it is only when all sales are contestable that a simple Brooke Group average price above cost test is the economically appropriate measure of whether equally efficient rivals can compete for sales in the face of a single product loyalty contract. This fully contestable sales condition fits only two of the three cases cited by the court, NicSand and Barry Wright, cases where suppliers were essentially competing for all of a buyer s purchases. Specifically, in NicSand suppliers of automotive sandpaper competed for the business of six large retailers with up-front payments in return for exclusive agreements. 37 With only one exception, the retailers devoted shelf space to only one brand and therefore the alternative suppliers were competing for all the sales at a retailer, 38 with the upfront payments economically equivalent to first-unit price discounts. 39 Similarly, in Barry Wright, Pacific Scientific, a supplier of a type of shock absorber used as a safety device in nuclear power plants, entered a two-tothree-year contract with Grinnell for a large share of purchases at a discounted price that replaced a similar discounted price in return for an exclusive purchase contract earlier entered with Grinnell by Barry Wright. 40 Because all sales were contestable in NicSand and Barry Wright, the simple Brooke Group price-cost test should be and was considered the applicable standard in those cases. In fact, Brooke Group itself involved a loyalty contract for generic, unbranded cigarettes that were more or less fungible bethe discount attribution test framework and instead held that conditional loyalty contracts used by an established firm were essentially a per se illegal abuse of dominance. Case T-286/09 Intel, Judgment of the General Court (June 12, 2014), ec.europa.eu/competition/sectors/ict/intel.html. 33 Meritor, 696 F.3d at F.3d 442, 452 (6th Cir. 2007) F.2d 227, 236 (1st Cir. 1983) F.3d 1039, 1061 (8th Cir. 2000). 37 NicSand, 507 F.3d at Id. 39 The court correctly considered the upfront payments as legally and economically equivalent to price discounts that is, as nothing more than price reductions offered to the buyers for the exclusive right to supply a set of stores under multi-year contracts. Id. at Barry Wright, 724 F.2d at 229. Another clear case where the firms were competing to be the exclusive supplier and, hence, where all sales should be considered contestable is RaceTires America, Inc. v. Hoosier Racing Tire Corp., 614 F.3d 57, 83 (3d Cir. 2010), where the court noted that [i]t is well established that competition among business to serve as an exclusive supplier should actually be encouraged.

11 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 641 tween suppliers, 41 and hence sales were fully contestable. Furthermore, contrary to how Brooke Group is commonly described in terms of unconditional price discounts, the price discounts at issue were volume discounts contingent on increased distributor purchases of generic cigarettes. 42 The third case cited by the court, Concord Boat, did not involve a loyalty contract where all sales were contestable. The case involved the loyalty contracts of Brunswick, a market leading supplier of stern drive boat engines with a 75 percent market share. 43 In contrast to the fully contestable sales of Nic- Sand and Barry Wright, Brunswick was the established supplier of generally preferred products, and rival boat engine suppliers were not competing with Brunswick to be the exclusive supplier to boat builders. Some of Brunswick s sales were incontestable, in the sense that rivals could not reasonably be expected to economically compete for all of a boat builder s sales. Therefore, a simple Brooke Group price greater than cost standard would not be economically appropriate and, as we shall see, the court in Concord Boat did not rely on such a standard. 44 II. THE USE OF LOYALTY CONTRACTS TO EXPAND SALES WITH CONTINGENT PRICE DISCOUNTS Once an established seller has some incontestable sales, antitrust analysis of the seller s use of a loyalty contract is complicated by the fact that the seller now has the incentive to expand sales, and it becomes necessary to distinguish between the two general ways in which a loyalty contract may be used to profitably expand incremental sales: (1) by using contingent price discounts to reduce the price of contestable sales, or (2) by leveraging the consumer surplus on incontestable sales. The first method by which a loyalty contract may expand sales is examined in this section, Part II, and the second method examined in the following section, Part III. In both of these cases the potential anticompetitive problem involves the creation of conditions in which equally efficient rivals cannot compete in the face of the loyalty contract. The antitrust standard of analysis for these conditions is discussed in Part IV. 41 Brooke Grp. Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209, 215 (1993). 42 Id. Price discounts were contingent on increased purchases, not an increased share of purchases. However, as described infra in Part II.C.1, the essential economic characteristic of a loyalty contract is the conditionality of price discounts on increased purchases, with the conditionality defined in terms of purchase share rather than absolute sales merely an efficient contract specification in some circumstances. 43 Concord Boat, 207 F.3d at Brunswick s loyalty contracts included a sliding scale of discounts of up to 3% if a boat builder purchased 80% of its boat engine requirements from Brunswick. Id. 44 The court s standard of analysis in Concord Boat is discussed infra at text accompanying notes

12 642 ANTITRUST LAW JOURNAL [Vol. 80 A. CONSUMER PREFERENCES CREATE THE INCENTIVE TO EXPAND SALES To illuminate the economics of single product loyalty contracts when some sales are incontestable, it is useful to consider an economic model where suppliers sell differentiated products that are preferred to a greater or lesser extent by different consumers. Incontestable sales then depend, on the extent of consumer preferences for an established firm s products. When a firm s products are significantly preferred by many consumers to a rival firm s products, the sales to these consumers may be incontestable. We assume for simplicity that there are two suppliers of a particular type of product (for example, transmissions in Meritor and drugs in Eisai). There is an established supplier of a more highly preferred product that accounts for a larger share of market sales, denoted as product A (supplied by Eaton or Sanofi), and a smaller rival supplier of product B (supplied by Meritor or Eisai). The buyers of the products at issue in the cases we examine are assumed not to be the ultimate consumers who have different relative preferences for products. Instead the buyers are intermediate firms that demand the product from suppliers as an input into a final product that is demanded by these consumers (truck manufacturer buyers of transmissions in Meritor and hospital buyers of drugs in Eisai). 45 Ultimate consumers are assumed to have preferences for the established firm s product A relative to the smaller rival s product B that vary across consumers. The value a specific individual consumer of a particular buyer of the product (for example, a consumer of a particular truck manufacturer) places on product A (Eaton transmissions) is denoted V A and the valuation the consumer places on the alternative rival product B (Meritor transmissions) is denoted V B, with each consumer s relative valuation, or preferences for product A relative to product B, denoted V A V B. Individual consumer relative product preferences, V A V B, vary across consumers, with the distribution of relative preferences for the consumers who purchase from a particular product buyer (e.g., consumers who purchase from a particular truck manufacturer) assumed for illustrative purposes to be distributed uniformly over a $4.00 range as shown in Figure 1. Consumers are ordered along the quantity axis by their relative preference for product A compared to product B if both products 45 Products demanded by intermediate buyers are the types of products at issue in almost all loyalty contract antitrust cases. When loyalty contracts are entered into directly with consumers (for example, a fast-food restaurant that offers a tenth meal free), it is much less likely that the loyalty contract will involve an exclusive purchase requirement. In addition, the absence of an intermediate buyer means that there is not a transactor that can serve as the efficient bargaining agent for a group of consumers by internalizing what would otherwise be individual consumer demand decisions, as we shall see occurs in these and most other loyalty contract cases.

13 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 643 were sold at the same price, with the distribution of individual consumer values (V A V B ) assumed to range between $3.80 and minus $ V A V B $3.80 $1.20 -$ Share of Total Consumers FIGURE 1: CONSUMER RELATIVE PRODUCT PREFERENCES Figure 1 describes a situation where it is assumed that almost all consumers prefer product A to product B when they are sold at the same price. The particular consumers that most highly prefer product A relative to product B are assumed to place a value on (V A V B ) of $3.80 that is, they would be indifferent between the products if A were priced $3.80 higher than B. On the other hand, consumers who least prefer A to B place a value on (V A V B ) of minus $0.20 that is, they would purchase B even if it were priced at the same price as A. As we have drawn this schedule, 95 percent of consumers have a positive value of (V A V B ) that is, they are assumed to prefer product A to product B if they were sold at the same price. These relative product preferences are assumed to be given at a particular point in time. Most consumers prefer the established supplier s product A to the rival s product B if 46 This general framework was presented in Benjamin Klein & Kevin M. Murphy, Exclusive Dealing Intensifies Competition for Distribution, 75 ANTITRUST L.J. 433 (2008) [hereinafter Klein & Murphy, Exclusive Dealing]. The framework was modified to take account of the fact that more consumers may prefer one product relative to the other product in Hans Zenger, When Does Exclusive Dealing Intensify Competition for Distribution? Comment on Klein and Murphy, 77 ANTITRUST L.J. 205 (2010), and the relative preferences assumption adopted in Benjamin Klein & Kevin M. Murphy, How Exclusivity Is Used to Intensify Competition for Distribution Reply to Zenger, 77 ANTITRUST L.J. 691 (2011) [hereinafter Klein & Murphy, Reply].

14 644 ANTITRUST LAW JOURNAL [Vol. 80 they were sold at the same price at this point in time because the established supplier has a superior market reputation, or because consumers generally prefer some particular characteristics of the established supplier s products, or for some other economic reason. The slope of the line in Figure 1 can be thought of as the relative demand schedule for product A, which depends on the degree of consumer preferences for product A relative to product B and the price of product A relative to product B. When product A s price is equal to product B s price, product A will account for 95 percent of a buyer s purchases; if the established supplier of product A sets a higher price relative to the rival supplier of product B, the established firm s sales of A will be lower, as consumers with preferences for A relative to B that are now less than the price difference shift their purchases to B. 47 The model assumes that a buyer s increased purchases of a particular seller s products involve a one-to-one decrease in the other seller s product sales. This is a useful framework in which to analyze the loyalty contracts that are commonly the subject of antitrust litigation. These cases generally involve an increased demand for one product relative to another, not merely a buyer moving down its demand curve and purchasing more of a seller s products without reducing the demand for rival products. This certainly describes the facts in both Eisai and Meritor. The particular products in question a bloodclotting drug used at hospitals and a transmission demanded by truck manufacturers are inputs that account for a relatively small share of the total value of the ultimate product supplied to consumers (hospital services and trucks). Consequently, we would expect relatively little if any increase in a hospital s total purchases of all blood-clotting drugs or a truck manufacturer s total purchases of transmissions in response to a contractually negotiated reduction in these product prices as part of a loyalty contract. Seller pricing of these particular inputs can reasonably be assumed to have little or no influence on overall hospital admissions or on total industry truck sales. We further assume for expositional simplicity that the average and marginal cost of providing and selling the products for both the established supplier of product A and rival supplier of product B is $1.00. Given the relative demand functions for product A and product B, the $1.00 cost and the assumption that 47 The demand functions underlying the model are Q A = (1.5P A +.5P B +a)/2 and Q B = (1.5P B +.5P A a)/2, where a, the degree of asymmetry in consumer preferences, is equal to 0.9. As the demand functions are specified, Q A and Q B can be interpreted conveniently as the percentage of sales purchased of the two products because, irrespective of prices, the total demand (Q A +Q B ) is always equal to 1. The demand functions therefore are related to absolute quantity demand functions where it is assumed that total market demand is given. This specification is analogous to the demand functions presented in Zenger, supra note 46, and analyzed in Klein & Murphy, Reply, supra note 46.

15 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 645 the established and rival suppliers both independently set unitary prices to maximize their profits, the resulting equilibrium competitive product price of A is equal to $4.60 and the price of B is $3.40. The supplier of product B, recognizing that its product is preferred by many fewer consumers than product A, sets a lower price for its products. The $1.20 price gap between product A and product B implies, as illustrated in Figure 1, that at the equilibrium price difference, the relative share of sales are 65 percent for product A and 35 percent for product B. 48 Figure 2 converts Figure 1 into the share of demand by the particular firm buyer for seller A s products that is, a particular truck manufacturer s demand for Eaton truck transmissions assuming that the price of the rival supplier s product B (Meritor s transmission price) is set at $3.40. The profitmaximizing price set by the established seller is $4.60, at which point the quantity demanded by the buyer is 65 percent of the market. An analogous demand function by the buyer for rival product B given the established seller s price of $4.60 implies a price of B of $3.40 and a 35 percent share of the market. P A $7.20 $4.60 $3.20 C L Demand D $1.00 MC Share of Buyer Purchases of A Marginal Revenue FIGURE 2: THE ESTABLISHED FIRM S SINGLE PROFIT-MAXIMIZING PRICE 48 These equilibrium price and quantity values are determined when each firm, given its demand function and the assumed cost of $1.00, maximizes its profit with respect to its own price holding the competing firm s price constant, with the two relationships combined to yield the unique Nash equilibrium values for each firm s price and sales.

16 646 ANTITRUST LAW JOURNAL [Vol. 80 It is clear from the equilibrium described in Figure 2 that the rival will consider some of the buyer s purchases of A to be incontestable. Even if the rival hypothetically reduced the price of its product B by, say, $1.00 to $2.40 and the established firm unrealistically did not react by reducing its price of product A, so that the price differential between the products was now $2.20, the established seller of A based on relative consumer preferences for the products (Figure 1) would still make, at a nearly double price, 40 percent of the sales. 49 Figure 2 illustrates the common situation faced by all product suppliers in differentiated product markets, where they have a profit incentive, often a very significant profit incentive, to expand sales on the margin. This is because suppliers of differentiated products face less than perfectly elastic demands and consequently set their profit-maximizing competitive prices above marginal cost. This equilibrium condition, which describes most markets, does not mean that such firms necessarily possess antitrust market power. Consistent with the definition of market power in antitrust law, a firm s antitrust market power should not be defined in terms of its own elasticity of demand. 50 In addition, such firms may not be earning any profits because the gap between price and marginal cost may merely cover the firm s fixed costs. Many products, such as the transmissions at issue in Meritor and the pharmaceuticals at issue in Eisai, may involve significant R&D and other capital costs yet have relatively low marginal costs. It does mean, however, that all such firms have a profit incentive to increase sales at the current price. At the single price profit-maximizing equilibrium, the established seller s profit-maximizing price of $4.60 is substantially greater than the established seller s marginal cost of producing additional units of product A of $1.00. Therefore, if the established firm sells one more unit, it earns more than three and a half times the cost of producing the unit ($4.60 minus $1.00, or $3.60 extra profit per unit). Similarly, the rival seller of product B faces a demand curve where it sets price at $3.40, which also is substantially above its $1.00 marginal cost, and thus also has a significant profit incentive to expand sales This example illustrates that the level of contestable sales the rival can compete for depends not only on the extent of relative consumer preferences for the established firm s products, but also on how much the rival can reduce price and remain above costs. A minimum estimate of incontestable sales may be determined by assuming that the rival reduces its price to marginal cost of $1.00 and the established firm does not react and keeps its price at $4.60. In that case there will still be 5% of sales that the rival cannot compete for. The assumption that the established firm does not react by reducing its prices is, of course, unrealistic. 50 Benjamin Klein, Market Power in Antitrust: Economic Analysis After Kodak, 3 SUP. CT. ECON. REV. 43 (1993). 51 This realistically represents the general underlying economic situation that existed in Eisai for pharmaceutical purchases by hospitals, where the marginal value to Sanofi of selling an

17 2016] PRICE-COST TESTS IN ANTITRUST ANALYSIS 647 We have labeled in Figure 2 what the established supplier potentially has to gain if it can expand sales at the unchanged price of $4.60 from 65 percent to 100 percent as the total area L+C+D. This would amount to a profit of $3.60 per unit on the 35 percent incremental sales, or a total profit increase of 54 percent (35/65). However, Figure 2 illustrates that if the established supplier attempted to expand sales merely by reducing price, it would be unprofitable it would be moving below the profit-maximizing price into the range where marginal revenue is less than marginal cost. It clearly would not be in the established supplier s interest to do this because this would reduce its profits. Consequently, in these circumstances the established supplier, as well as the rival, both have a significant financial incentive to expand sales in ways other than by decreasing their single profit maximizing prices. B. LOYALTY DISCOUNTS COMPENSATE BUYERS FOR SALES-SHIFTING SERVICES We have implicitly assumed up until now in Figures 1 2 that firm buyers act as passive middlemen who translate the preferences of their consumers into the demand for a seller s product. It is more commonly the case that an essential part of the competitive process involves the firm buyer serving as more than just a passive intermediary between the input product seller and its ultimate consumers. Because consumers also have preferences to purchase from a particular buyer that is, from a particular truck manufacturer in Meritor or from a particular hospital in Eisai they will be somewhat loyal to the buyer and will not switch between different truck manufacturers or hospitals solely on the basis of whether the truck manufacturer or hospital provides their particular preferred truck transmission or blood-clotting drug. This is particularly the case because the transmission or drug is a relatively small fraction of the product demanded by the consumer. Consequently, because the firm buyer possesses the ability to significantly influence the particular product that its consumers purchase, the buyer has the ability to act as an efficient bargaining agent for its consumers and to shift contestable sales to an individual seller in return for the seller s price reductions. Rather than letting each individual consumer make its product choice by demanding a product based on its individual preferences, as previously modeled, the buyer can negotiate price reductions with sellers in return for an increased purchase commitment that benefits consumers as a group. 52 Contestable sales therefore depend not only on consumer preferences and the seller s additional unit of its blood-clotting drug, as well as the value to Eisai of selling an additional unit of its rival blood-clotting drug, was substantially greater than the marginal cost of producing and marketing an additional unit of their drugs. Sanofi and Eisai therefore were earning very high profit margins. See discussion infra text accompanying note See Klein & Murphy, Reply, supra note 46.