Antitrust balancing in a (near) Coasean world: the case of franchise tying contracts.

Author:Meese, Alan J.

Antitrust law has largely succumbed to the hegemony of balancing. Courts applying the rule of reason are told to balance a restraint's procompetitive effects against its anticompetitive impact.(1) Mergers once deemed anticompetitive solely because they facilitated the exercise of market power are now evaluated by weighing the anticompetitive effects of such increased power against any efficiencies created by the transaction.(2) Finally, some activities once deemed per se illegal are now subject to a balancing approach, either by explicit application of the rule of reason,(3) or by recognition of certain affirmative defenses to otherwise per se violations.(4)

Unlike many other balancing tests, the balancing framework familiar to antitrust scholars and practitioners is at least theoretically objective, if sometimes difficult to apply in practice.(5) Drawing on neoclassical microeconomic analysis, this approach seeks to identify those instances in which anticompetitive effects - higher prices and distortions in the allocation of resources - caused by a restraint outweigh their procompetitive benefits, usually efficiencies in producing a product or service.(6) While there is some dispute as to exactly which effects should count against a restraint - whether, for instance, transfers of wealth from consumers to producers should be deemed an anticompetitive effect(7) - the theoretical economic framework within which these effects are quantified and compared is invariate, and comprise what one scholar calls a basic partial equilibrium welfare economics model."(8)

The law of tying has been a moderately fertile source of such balancing litigation, particularly in the per se context, where judges and scholars have identified several possible procompetitive justifications for otherwise per se illegal arrangements.(9) This article focuses on one such defense, the "franchise goodwill" justification. As courts and others have recognized, a franchise tying contract - that is, a franchise contract that requires a franchisee to purchase inputs from a franchisor as a condition of receiving a franchise - can reduce the agency costs that result from the division of labor that characterizes the relationship between franchisor and franchisee. More precisely, such a requirement can prevent a certain class of opportunistic behavior by franchisees, namely, the failure to provide a product of a quality sufficient to maintain the reputational value of the franchise trademark, while free riding on the quality control efforts of others.(10) Thus, for example, a requirement by a fast food franchisor that its franchisees purchase its food ingredients or paper products might be justified as an attempt to ensure that franchisees do not "skimp" on quality and dilute the reputation of the franchise trademark.(11)

Under current law, once a plaintiff establishes the elements of a per se tying violation, the procompetitive benefits of a reduction in opportunistic behavior must be weighed against the anticompetitive effects of the tie, which presumably has been "forced" on the purchaser by the exercise of market power.(12) This weighing usually is not explicit, but instead takes the form of a less restrictive alternative analysis under which the justification will fail when a less restrictive means of achieving the objective is available, even when the benefits of the tie outweigh any anticompetitive effects.(13)

This article challenges the conventional analysis as applied to franchise tying contracts and questions its application in areas outside the franchise context as well. While consistent with the partial equilibrium welfare analysis employed in antitrust law generally, this conventional analysis is premised on an outdated preoccupation with monopolistic explanations for nonstandard contracts and misconceives the relationship between market power, on the one hand, and tying contracts that serve a procompetitive objective, on the other. In particular, this article demonstrates that a tying contract that reduces agency costs and enhances franchise goodwill by eliminating opportunistic free riding by franchisees is not "forced" on purchasers nor is it otherwise the result of market power. Instead, a contract that produces these benefits is presumably the result of a purely voluntary arrangement that divides between the parties those gains resulting from partial integration, integration that would occur regardless of whether the franchisor possessed market power.

Given the low transaction costs inherent in the franchisor-franchisee relationship, no rational franchisor with market power would use that power to impose such a tying requirement. Instead, the parties would negotiate for the term, and the franchisor would exercise its power simply by raising the price of the tying product: here, the franchise opportunity itself. Denomination of the benefits created by such a term as a "justification" or an "affirmative defense," then, improperly equates franchise tying contracts with other, presumptively anticompetitive, arrangements. Unlike the ordinary rule of reason or merger analysis, where the presence of market power suggests that procompetitive benefits coexist with anticompetitive effects, proof of procompetitive effects in the franchise context suggests that no legally cognizable anticompetitive effects are present. Thus, the partial equilibrium welfare analysis employed in other antitrust contexts and premised necessarily upon the presence of high transaction costs is ill-suited for the evaluation of tying contracts that produce these procompetitive effects, and, in fact, is unduly biased against such contracts.

The bias inherent in such a partial equilibrium analysis does more than lead to incorrect results. It leads to less efficient methods of controlling free riding and encourages forward integration by franchisors, integration that both destroys efficiencies otherwise realizable via the division of labor inherent in the franchise system and retards the growth of independent small business. In order to eliminate this bias, courts ought to alter the current framework by holding that a franchisor establishes the prima facie legality of a tying contract by proving that it eliminates free riding. Such an approach will not only ensure correct results, it will truncate the full-blown analysis undertaken when evaluating tying contracts, thus reducing litigation costs.

The conclusion offered here has implications beyond the franchise context, premised, as it is, on the inapplicability of a partial equilibrium welfare analysis in low transaction cost settings. When the contract under scrutiny arises in such a setting, a conventional partial equilibrium analysis is ill-suited for a proper evaluation of the result.

  1. Background

    The Supreme Court has stated that "[t]ying agreements serve hardly any purpose beyond the suppression of competition."(14) Yet, the Justices have never held that all contracts that condition the sale of one product upon the purchase of another are illegal. Instead, the Court has developed an elaborate analytical framework, best articulated in Jefferson Parish Hospital District No. 2 v. Hyde,(15) for identifying tying contracts that are the result of anticompetitive "forcing," that is, are imposed through the exercise of market power.(16) Under this approach, a plaintiff may make out a per se violation by proving: (1) the existence of separate products; (2) conditioning the sale of one (tying) product on the purchase of another (tied) product; (3) the seller's possession of power in the market for the tying product, and (4) substantial commerce in the tied product.(17) Proof of these four elements gives rise to a presumption that the challenged arrangement is an illegal tie, that is to say, that the seller is using its market power over the tying product to "force" a buyer to purchase the tied product, and that the arrangement is, on balance, anticompetitive.(18) Despite the "per se" label, however, this presumption is not conclusive. Some lower courts, at least, still admit the possibility of an "affirmative defense," in which a defendant endeavors to show that the arrangement is necessary to advance a procompetitive objective that outweighs the tie's anticompetitive effects.(19)

    When a plaintiff is unable to establish the elements of a per se violation, courts analyze the arrangement under the rule of reason.(20) Under this approach, the plaintiff cannot rely upon the type of presumption present in the per se context, but instead must prove directly that the tie produces anticompetitive effects that outweigh its justifications.(21) Of course, the same procompetitive benefits that might be proffered as justifications for a per se violation are also relevant when such balancing occurs.(22)

    It is against this backdrop that some lower courts have long entertained what might be called a "franchise goodwill" defense - an assertion that the tie ensures that franchisees use inputs of a quality sufficient to maintain the image of the franchise, which is usually associated with a trademark.(23) For instance, in Siegel v. Chicken Delight, Inc.,(24) the Ninth Circuit entertained, but rejected, Chicken Delight's assertion that a requirement that its franchisees purchase from it cooking equipment, food ingredients, and paper products was on balance procompetitive because it ensured that its trademark was associated with a certain level of quality.(25) However, in Mozart Co. v. Mercedes-Benz of North America, Inc.,(26) the court, assuming arguendo that the plaintiff had established the elements of per se liability, found Mercedes's requirement that its dealers use only Mercedes or Mercedes-approved replacement parts justified by goodwill concerns, particularly in light of the jury's finding that no less restrictive alternative adequately advanced Mercedes's interest in quality control.(27)

    Economists have formalized this...

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