Market power without market definition.

• Author: Crane, Daniel A.

ABSTRACT

Antitrust law has traditionally required proof of market power in most cases and has analyzed market power through a market definition/market share lens. In recent years, this indirect or structural approach to proving market power has come under attack as misguided in practice and intellectually incoherent. If market definition collapses in the courts and antitrust agencies, as it seems poised to do, this will rupture antitrust analysis and create urgent pressures for an alternative approach to proving market power through direct evidence. None of the leading theoretic approaches--such as the Lerner Index or a search for supracompetitive profits--provides a robust solution. Further, one of the core premises in modern antitrust analysis--that the presence of high entry barriers is necessary to market power--is deeply flawed. Counterintuitively, the higher the entry barriers, the less likely it is that (1) the accused firm engaged in anticompetitive conduct and (2) the market would have been more competitive but for the alleged conduct. A robust approach to market power would require a tight nexus between the challenged conduct and a plausible competitive counterfactual. This Article articulates first principles of market power, diagnoses sources of confusion in the current caselaw, and scrutinizes the recognized methods of proving market power without reliance on market definition and market shares.

INTRODUCTION

Market power is an indispensable element in all antitrust cases except for those arising under the Sherman Act's rule of per se illegality. (1) Merger, monopolization, and rule of reason cases--the bulk of antitrust--require proof of market power to establish liability. (2) A showing of defendant market power has long been a "screen" through which plaintiffs must pass before advancing the merits of their complaint. (3) Traditionally, courts have required plaintiffs to prove market power by showing the defendant's share of a properly defined relevant market and then examining other structural factors such as entry barriers, demand elasticity, pricing transparency, and customer strength. (4) Market definition has been the necessary first step in this analysis and, because of its technical difficulty, a breaking point for many antitrust complaints. (5)

In recent years, however, traditional market definition has come under severe attack in the legal academy and in the antitrust agencies. In 2010, the Justice Department and the Federal Trade Commission (FTC) drastically revised their Horizontal Merger Guidelines (Horizontal Merger Guidelines or Guidelines) and demoted market definition from the critical starting point to merely one available tool in merger cases. (6) Afterwards, Louis Kaplow, one of the most widely respected theorists of antitrust, published an article in the Harvard Law Review essentially calling the entire enterprise of market definition intellectually bankrupt and questioning whether market definition should ever be required. (7) Shortly thereafter, Herbert Hovenkamp, another highly respected antitrust academic and the senior author of the extraordinarily influential Areeda Antitrust Law treatise, (8) published a paper questioning the need to define markets in merger cases. (9) Given these and other developments, the handwriting is on the wall for market definition.

If market definition falls, so does the entire structure of analysis built on top of it--which is to say, a whole lot of antitrust law--unless a suitable replacement can be found. But there is no clear candidate to take the place of traditional market definition as an indirect means of proving market power. While some caselaw recognizes the theoretical availability of "direct" approaches to proving market power (10) and academic theories abound, the existing theories and doctrines are a smorgasbord of incompatible and often incoherent recipes. Antitrust's analytical core is crumbling and there is no clear replacement.

What is more, some of the key conventional understandings of market power turn out to be misguided. Most fundamentally, antitrust law has generally conceived of market power in an absolute sense by comparing the actual market to some textbook ideal market, without regard to whether the market in question could possibly resemble the ideal market given its economic properties. But market power only makes sense as an expression, in relative terms, of the distance between the market as it is and a competitive counterfactual--the market as it reasonably could be absent anticompetitive conduct. Since antitrust policy aims to reduce the delta between a plausible competitive counterfactual and the actual circumstances, market power should be understood as that delta--the infirmity that antitrust law could correct.

As a result of this grounding misconception, antitrust law has made assumptions about market power that are imprecise, overstated, and potentially misleading. Two are particularly important. First, conventional wisdom holds that the higher the barriers to market entry, the more likely that the firms in the market have engaged in anticompetitive conduct. (11) But the relationship between entry barriers and the competitive counterfactual is not always linear. As structural entry barriers become higher, the firms in the market have reduced incentives to expend capital to exclude rivals since it is decreasingly likely that rivals will be able to enter even absent exclusionary conduct. Hence, the generic probability that firms have engaged in anticompetitive conduct decreases as entry barriers become higher. Similarly, as entry barriers become higher, it is decreasingly likely that there is a competitive counterfactual--a but-for world in which the market is more competitive. Hence, the kind of market power that should be most concerning in exclusion cases is the middling power that arises from markets where entry barriers are surmountable absent anticompetitive conduct. Markets with very high entry barriers--the focus of current market power principles--should be of less interest to antitrust policy on exclusion.

Second, relationships between revenues and costs are only weakly correlated with the normative functions that the market power inquiry is supposed to serve. Thus, for example, the Lerner Index--the leading "direct" measure of market power--quantifies market power based on the excess of price over marginal cost since firms should price at marginal cost under conditions of perfect competition. (12) But using perfect competition as the baseline from which to judge market power in antitrust cases is unworkable since perfect competition cannot exist in markets with differentiated goods and high fixed costs (13)--which is to say, most of the markets where market power is of interest to contemporary antitrust. Other profitability measures proposed in academic literature or caselaw are similarly defective.

Beyond entry barriers and profitability margins, extant caselaw and academic literature propose a number of other criteria to judge market power directly--that is to say, without resort to market definition and market shares. Some of the proposed criteria, such as the presence of price discrimination or the exclusion of competition, are economically unsound or circular. Others, such as diversion ratios, pricing discontinuity, and competitive benchmarking, may be helpful under some circumstances, but pose considerable risks of error and usually cannot suffice to demonstrate market power without confirmation by other criteria. The upshot is that, at present, direct proof of market power is a basket of broken or incomplete tools. Even if the broken tools were discarded, the remaining ones would be unsuitable for proving market power standing alone or, often, even in combination. For all of its perhaps damning faults, the market definition/market share paradigm prescribed a systematic and deductive approach to proving market power. Its demise leaves courts and antitrust agencies groping to analyze market power issues on an ad hoc and inductive basis.

This Article aims to provide a coherent analytical framework for discussing market power in general and direct proof in particular. No set of tools for determining the existence of market power, whether directly or other wise, will be effective unless it begins with analytically sound first principles about how the market power inquiry serves antitrust law's normative aspirations. Thus, Part I of this Article provides grounding principles for inquiries into market power. In particular, it introduces the key concept of the competitive counterfactual, which reorients antitrust law from its current assumptions about perfectly competitive markets toward a more realistic appraisal of plausible competitive scenarios given inherent market features. It also briefly summarizes the infirmities of the "indirect" market definition based approach and the current confusion in the caselaw on direct proof of market power.

Part II critically evaluates the leading contenders for proving market power directly. Some of them, like using profitability margins, the existence of price discrimination, or proof of exclusion of competition, are misguided and should be discarded altogether. Others, like entry barriers, diversion ratios, pricing discontinuity, and competitive benchmarks may be helpful in some cases, although only with awareness of the many potential pitfalls. What emerges after the brush clearing is that current caselaw and academic theory have not yet provided a robust and comprehensive approach to proving market power and that antitrust law will be largely starting from scratch, with a few scattered and incomplete tools, if it moves away from the market definition/market share paradigm.

Part III concludes with four case studies illustrating how a reexamination of first principles of market power could improve antitrust analysis even given the current...