A proposed solution to the problem of parallel pricing in oligopolistic markets.

• Author: Devlin, Alan

INTRODUCTION I. THE ECONOMICS OF OLIGOPOLISTIC PRICING A. Monopoly B. Perfect Competition C. Oligopolistic Pricing 1. Single-period games 2. Multi-period games D. Economic Insights II. THE CURRENT LEGAL STANDARD A. The Courts' Treatment of Oligopolistic Pricing B. Donald Turner's Controlling Rationale C. The Advantages Associated with Donald Turner's Approach D. The Shortcomings of Professor Turner's View III. JUDGE POSNER'S SUGGESTED SOLUTION A. The Example of a Simple Duopoly B. The Positive Implications of the Rule 1. Exploring the assumptions of the model C. The Negative Implications of the Rule 1. Expanding the model of simple duopoly 2. The problem of marginal application 3. Relaxing the assumption of zero fixed cost and constant marginal cost 4. An encouraging result IV. THE SUGGESTED SOLUTION V. TESTING THE PROPOSED RULE OF LAW A. A Simple Duopoly B. A More Realistic Model CONCLUSION INTRODUCTION

This Note seeks to address a systemic and difficult issue in the field of antitrust, namely the problem of proving concerted action for the purpose of price-fixing claims in oligopolistic markets, (l) While antitrust law has been markedly successful in eliminating express cartels, (2) competition policy has been equally noteworthy for its failure to effectively address instances of parallel pricing that may have an economically analogous effect to explicit price-fixing. (3) Though the law has long viewed this shortcoming as an inevitable consequence of market structure, this Note will articulate both a different conclusion and a novel solution.

An oligopoly is a market in which the level of concentration causes firms residing therein to operate strategically. (4) In other words, an oligopolist must factor the expected reaction of its competitors into its first order condition for profit maximization. A firm operating in a monopolized market, or one subject to perfect competition, simply equates marginal revenue with marginal cost in setting price. (5) Doing so in an oligopolized market is not profit-maximizing, however, as the profitability of a given price depends on the price being charged by other firms in the market. This is so because, in selling its goods, a firm will have a unilateral impact on the residual demand facing the other firms in the market. (6)

A major, and very interesting, problem arises in the context of such markets, where it may be possible for oligopolists to reach a self-sustaining, supracompetitive equilibrium. Essentially, it may be feasible for a group of firms to reach a collusive outcome without overt acts of detectable communication. Such tacit collusion results from a "meeting of the minds," whereby competitors recognize that it is in their collective best interests to set price or quantity equal to the collusive level. (7) In such circumstances, application of the antitrust laws becomes challenging. This difficulty emanates from the makeup of the antitrust regime put in place by the Sherman Act.

Section 2 of that Act prohibits firms with monopoly power from improperly maintaining or abusing their dominance. (8) Most firms operating within an oligopoly do so without possessing or exercising such puissance, however. As a result, their unilateral actions cannot be attacked under the Act.

Firms lacking monopoly power can nonetheless be found guilty of violating the Sherman Act under section 1 when they act in concert with their competitors. Accordingly, "contract[s], combination[s,] ... or conspirac[ies] in restraint of trade" may be held illegal, if unreasonable. (9) Hence, at a theoretical level, concerted action by oligopolists can be reached by section 1. The difficulty, which has so far proven to be prohibitive, lies in demonstrating that oligopolists' parallel pricing is a manifestation of concerted, rather than unilateral, behavior.

The problem is acute and may fairly be characterized as one of the most serious in the field of antitrust law, for the economic consequences of a failure to fill the current "gap" are ominous. (10) This is so as instances of firms pricing in parallel at supracompetitive levels are ubiquitous. (11) The fact that such equilibria are readily observable highlights a continuing flaw in the application of competition law. It shall be seen, however, that finding a solution to the problem is far from straightforward and will inevitably be draped in controversy.

This Note will express an opinion on how an antitrust regime should tackle those cases where self-sustaining, output-restricting equilibria can exist absent overt communication of any kind. This question is especially interesting as the law is currently incapable of reaching such market outcomes, though there have been forceful, and highly controversial, arguments that the law ought to be able to do so in appropriate circumstances. (12)

In this regard, Judge Richard Posner has articulated something of a radical view, according to which economic evidence of tacit collusion may in itself lead to a violation of the antitrust laws. (13) It will be shown that such an approach would not be attractive, given that it would perversely cause insolvency in certain markets and lead to inadvertent monopolization in others. Professor Donald Turner, in contrast, has argued that any prohibition of parallel pricing is necessarily improper. (14) Turner's position is characterized by the belief that a ban would require irrational behavior on the part of companies, would effectively compel marginal cost pricing, and would frustrate entry into oligopolistic markets. Yet, it will be demonstrated that these concerns constitute an unsatisfactory foundation for allowing tacit collusion, which is a practice that clearly causes significant societal harm.

This Note seeks to add a new dimension to the Posner-Turner debate, by showing that although Judge Posner's suggestion may be somewhat quixotic, elements of it may nevertheless be successfully employed to achieve a superior outcome. To the extent Professor Turner would believe that prohibition of parallel behavior is inherently inappropriate, it will be shown that he would be mistaken. In short, it will be demonstrated that a suitably moderate version of Judge Posner's approach would carry myriad economic benefits whilst avoiding the concerns advocated by Professor Turner.

The structure of the Note shall be as follows: first, a basic economic framework shall be introduced that will facilitate analysis throughout the remainder of the Note. Second, the current approach taken by the law will be discussed in the context of the rationale supporting the modern rules. Third, Judge Posner's controversial solution will be considered. Last, this Note will attempt to advocate a new approach to the problem of proving tacit collusion.

1. THE ECONOMICS OF OLIGOPOLISTIC PRICING

   In order to make the discussion of oligopolistic behavior more concrete, a representative model will be employed throughout the Note. This model will additionally serve as a baseline for the competitive effect of various rules. Accordingly, a numerical example will illustrate the workings of oligopolistic interdependence and the extent to which the ensuing outcome departs from contexts of competition and monopoly. We begin with the simplest form of oligopoly: a duopoly. Assume that two firms, Alpha and Beta, comprise the market. For the sake of simplicity, it shall be assumed that both firms have identical cost and production functions, that there are no fixed costs, and that the industry demand curve is linear. (15) The industry demand curve and market conditions for our model have the following parameters:

   P = 200 - Q [MC.sub.A] = [AC.sub.A] = [MC.sub.B] = [AC.sub.B]= 20

   where P = price; Q = quantity; MC = marginal cost; and AC = average cost. (16)

   Before applying these figures to various game theoretic models of oligopolistic behavior, we will calculate the outcomes under (1) monopoly, and (2) perfect competition. Doing so will illustrate the effect of those oligopolistic Nash equilibria (17) that are currently beyond the reach of the antitrust laws.

   1. Monopoly

      A monopolist's demand curve is the market demand curve and is, therefore, downward sloping. (18) Consequently, the monopolist can choose between a variety of price levels without having the quantity of its good demanded drop to zero. Like any other firm, the monopolist wishes to maximize its profits. It does so by equating marginal cost (MC) with marginal revenue (MR); that is, it will continue to expand output to the point where the extra cost associated with producing one more unit just equals the incremental revenue brought in by selling that unit. (19) So, the monopolist s profits ([pi]) will increase as the quantity it produces approaches the point where MC = MR, will peak at MC = MR, and [pi] will decline as the quantity it produces begins to exceed the point of output where MC = MR. Thus, the monopoly price for either Alpha or Beta would be 110 and market output would be 90. (20)

   2. Perfect Competition

      Under perfect competition, every producer is a price taker; that is, each firm faces a horizontal demand curve and therefore cannot influence the price at which its good is sold by unilaterally reducing its output. (21) Accordingly, marginal revenue always equals price. (22) In order to maximize profit, the firm facing perfect competition will produce at the point where marginal cost equals marginal revenue. (23) As a result, a firm under perfect competition maximizes profit by producing at the point where price equals marginal cost. (24) Thus, the market price under perfect competition would be 20 and market output would be 180. (25)

      One can readily see by the stark difference in these figures why competition is typically favored over monopoly. Section 1 of the Sherman Act forbids horizontal price-fixing and output-setting agreements so as to avoid the monopoly outcome. Were Alpha and Beta in our example to enter into a collusive...