Chapter 1. Economic Underpinnings

• Pages: 1-55

1

CHAPTER I

ECONOMIC UNDERPINNINGS: THE ECONOMICS

OF COMMUNICATIONS NETWORKS, MARKET

POWER, AND VERTICAL FORECLOSURE

THEORIES

A. Introduction

This chapter introduces the concept of market power and explains the

sources of market power in communications industries. The chapter

continues with a discussion of market definition, which is a key element

in the analysis of whether a firm has market power. It concludes with a

general overview of potential anticompetitive effects that flow from the

exercise of market power, with a particular focus on vertical foreclosure

theories. Vertical foreclosure refers generally to the use of vertical

integration or other vertical restraints by an input supplier to achieve

market power in an output market. In communications networks, a

supplier of a key input may also be a downstream competitor, which may

have implications for how the vertically integrated firm and its

customers/competitors deal with each other. The application of the

vertical foreclosure concept is neither simple nor straightforward.

Vertical integration concerns remain a significant driver of

communications policy, and of antitrust litigation initiated by frustrated

competitors.

B. An Introduction to Market Power in Communications Markets

The chief goal of the federal agencies charged with enforcing the

U.S. antitrust laws is to prevent the acquisition of an increased ability to

exercise market power and to prevent the illegal maintenance of market

power. For example, mergers are prohibited under Section 7 of the

Clayton Act if their effect “may be substantially to lessen competition, or

to tend to create a monopoly”1 or are prohibited under Section 1 of the

Sherman Act if they constitute a “contract, combination … or conspiracy

1. 15 U.S.C. § 18.

2 Telecom Antitrust Handbook

in restraint of trade.”2 The 1992 Merger Guidelines of the federal

antitrust agencies lay out the enforcement policy of the agencies with

respect to mergers. The “unifying theme of the Guidelines is that

mergers should not be permitted to create or enhance market power or to

facilitate its exercise.”3 Antitrust enforcement against monopolization or

attempted monopolization is also based on core principles focused on

“market power and separating the legitimate, procompetitive ways it is

acquired and preserved, from the illegitimate, anticompetitive ways.”4

The Federal Communications Commission (FCC) uses a different

framework for evaluating mergers than that of the 1992 Merger

Guidelines, but a key component of the evaluation is a determination of

whether a merger “will allow firms . . . to exercise increased market

power through either unilateral or coordinated anticompetitive

behavior.”5

The analysis of whether or not a merger results in an increased ability

to exercise market power starts with a proper definition of the relevant

market or markets in which the merger is to take place. The 1992

Merger Guidelines take the position that a merger “is unlikely to create

or enhance market power or to facilitate its exercise unless it

significantly increases concentration and results in a concentrated

market, properly defined and measured.”6 The FCC takes a similar

position, arguing that the starting point for the determination of whether

a merged firm will have an increased ability to exercise market power is

the definition of the relevant market or markets in which that power

would be exercised.7

Market power is generally defined as “the ability profitably to

maintain prices above competitive levels for a significant period of

2. 15 U.S.C. § 1.

3. U.S. DEP’T OF JUSTICE & FEDERAL TRADE COMM’N, HORIZONTAL

MERGER GUIDELINES § 1.43 (1992) (with Apr. 8, 1997 revisions to

Section 4 on efficiencies) [hereinafter 1992 MERGER GUIDELINES],

reprinted in 4 Trade Reg. Rep. (CCH) ¶ 13,104.

4. Joel I. Klein, Rethinking Antitrust Policies for the New Economy,

Haas/Berkeley New Economy Forum, May 2000, available at

www.usdoj.gov/atr/public/speeches/4707.htm.

5. Application of WorldCom, Inc. and MCI Communications Corp.,

Memorandum Opinion and Order, 13 F.C.C.R. 18025, ¶ 16 [hereinafter

WorldCom/MCI Order].

6. 1992 MERGER GUIDELINES, supra note 3, § 1.0 (emphasis added).

7. WorldCom/MCI Order, supra note 5, ¶ 16.

Economic Underpinnings 3

time.”8 In the economic model of “perfect competition,” prices are at

competitive levels if they are set equal to the marginal cost of the firms

in the industry.9 Thus, another way of expressing the definition of

market power is that it involves the ability to set and sustain prices above

marginal cost.10

Whether a firm will find it profitable to set prices above competitive

levels is almost entirely a function of the demand conditions facing that

firm.11 A firm in a perfectly competitive industry is a “price taker,”

meaning that it can sell all it wants at the prevailing market price, but it

cannot affect market price. However, a firm with market power in the

above-defined sense faces a downward sloping demand curve, meaning,

as it increases price, it will sell smaller quantities of a particular good.

Any firm that faces such a downward sloping demand curve will set its

profit-maximizing price at a level above marginal cost, even if it faces

substantial competition.12

However, this definition of market power may be misleading. For

example, a firm might have a product that is sufficiently differentiated

from other products that it faces a downward sloping demand curve and

can charge a price above marginal cost. Nonetheless, as long as entry by

other firms is possible, the firm is not likely to be able to earn monopoly

profits.13 The ability to exclude competition is often an important

element of market power, and one which is a hallmark of competitive

concerns in communications industries, as discussed more fully in

Section E of this chapter.

Thus, a more useful definition of market power for antitrust purposes

might be where “a firm or a group of firms is able profitably to maintain

8. 1992 MERGER GUIDELINES, supra note 3, § 0.1.

9. Marginal cost is the increase in cost associated with an additional unit of

output. See, e.g., ROBERT S. PINDYCK & DANIEL L. RUBINFELD,

MICROECONOMICS 85 (6th ed. 2005).

10. Another related way to define market power is the ability to raise price by

restricting output. IIA PHILLIP E. AREEDA, HERBERT HOVENKAMP &

JOHN L. SOLOW, ANTITRUST LAW ¶ 501 (2002).

11. For a discussion of the relationship between market power and the

demand faced by a firm, see Gregory Werden, Demand Elasticities in

Antitrust Analysis, 66 ANTITRUST L.J., 363, 363-414 (1998).

12. PINDYCK & RUBINFELD, supra note 9, at Ch. 10. This situation may arise

in markets with differentiated products, scale economies, or oligopolistic

structure. Id.; see also DENNIS W. CARLTON & JE FFREY M. PERLOFF,

MODERN INDUSTRIAL ORGANIZATION, Chs. 6 and 7 (3d ed. 2000).

13. See, e.g., CARLTON & PERLOFF, supra note 12, at 76.