The market power model of contract formation: how outmoded economic theory still distorts antitrust doctrine.

Author:Meese, Alan J.
Position:II. Price Theory, Workable Competition, and the "Market Power" Model of Contract Formation E. Legal Realism through Conclusion, with footnotes, p. 1331-1370
  1. Legal Realism

    Price theory was not the only possible external influence on antitrust doctrine during the inhospitality era; there were other possible determinants as well. In particular, the Legal Realism movement gathered steam during this period and exercised significant influence over the manner in which courts and scholars assessed legal rules and relationships. (169) Realism offered a critique of classical laissez-faire jurisprudence, which treated markets as inherently competitive and contracts as generally voluntary efforts to advance the interests of both parties. (170) Realists admonished courts to look behind formal relationships, particularly market relationships, and examine their true empirical nature when constructing legal rules that addressed them. (171) Perhaps Realism, and not price theory, explains the "market power" model of contract formation and various resulting doctrines. (172)

    According to Realists, many apparently voluntary market relationships were in fact "coercive," for two distinct reasons. First, one party to a contractual relationship often possessed "bargaining power," which Realists sometimes equated with market or monopoly power. In these cases, Realists said, the stronger party could impose contractual terms on unwilling parties. (173) Second, and more fundamentally, Realists noted that all contractual bargains depended upon the ownership of private property, which the state created and protected with force. (174) As a result, any bargain resulted from state coercion, without which one party could simply occupy and use "the other's" property without consent, (175) Many Realists even refer to private contracts as "private legislation. (176)

    Certainly early antitrust jurisprudence reflected the strong influence of classical political economy and derivative liberty of contract, thereby presenting a tempting target for Realists. (177) Under this approach, contracts were presumed "normal" or "ordinary," unless the plaintiff could show that they produced "monopoly or its consequences," i.e., an exercise of market power leading to higher prices, reduced output, or reduced quality. (178) Exclusionary agreements, even if entered by a monopolist, were no exception. Such contracts, it was said, were completely voluntary and reflected each party's judgment that the agreements worked to its respective advantage. (179) They were thus lawful absent proof that they produced the consequences of monopoly without offsetting benefits. (180)

    Subsequent decisions employing the "abuse of power" formulation rejected various premises of classical political economy. Moreover, courts employing this formulation reached results that Realists would have found congenial. Indeed, at least one leading realist, Thurmond Arnold, expressly invoked concerns about the coercion of dealers and others when calling for more aggressive antitrust regulation of the supplier/dealer relationship. (181)

    At the same time, the doctrinal landscape that ultimately emerged during the inhospitality era and survives to this day was more consistent with price theory than it was with Legal Realism. Realism, after all, merely counseled courts to examine relevant circumstances, but offered no explicit theory guiding such consideration. Price theory, on the other hand, with its theory of barriers to entry, helped explain why firms could possess and exercise market power without state assistance, thereby suggesting that private markets could produce "coercive" results. (182) Moreover, none of the antitrust doctrines discussed above took Realist insights to their logical conclusion and declared all market relationships "coercive" because of the implicit involvement of state force. For instance, the "use of power" offense under [section] 2 required proof that the defendant possessed significant monopoly power. (183) Also, the per se rule against tying contracts required proof that the defendant in fact possessed "economic power" in the tying product market. (184) To be sure, Supreme Court dicta sometimes claimed that the mere existence of numerous ties suggested that proponents of agreements possessed the market power necessary to impose them. (185) However, this conclusion flowed from price theory's inability to identify a non-coercive method of forming such agreements. (186) Even here, however, the Court qualified these assertions by referencing defendants' market advantages and suggesting that defendants could avoid inferences of market power by proving that the restraints produced benefits explaining the purchaser's (voluntary) agreement. (187) Finally, as explained earlier, the Court retained the in pari delicto defense for those cases in which parties bargained on an equal footing, contrary to the apparent implications of Legal Realism. (188)

    In summary, and more globally, it would be impossible to square antitrust's preference for atomistic competition with Realism's conclusion that even contracts entered in competitive markets were coercive. (189) Inhospitality era courts repeatedly invoked a "competitive market" as the summum bonum of antitrust policy--the ideal state of economic affairs from which non-standard agreements departed. (190) This market, however, itself depended upon common law institutions of contract, property and tort; even perfect competition requires, as its foundation, well-defined property rights. (191) Absent such property, there would be no production, trading or resulting prices. (192) And yet, according to Realists, the specter of state force would render all bargains arising in such markets "coercive." Presumably Realists would have said the same thing about all tying contracts, exclusive dealing contracts, and other non-standard agreements. Indeed, during this era, antitrust law even allowed firms to achieve monopoly, via "competition on the merits." (193) In the end, then, price theory and the policy prescriptions that it offered, and not Legal Realism, set the boundaries of antitrust regulation during this period, including those doctrines that depended upon the market power model of contract formation.


    As explained earlier, scholars and jurists have invoked a "market power" model of contract formation when interpreting exclusionary agreements. Indeed, significant current antitrust doctrine rests upon the assumption that firms use market power to coerce others into "agreeing" to exclusionary provisions. To be sure, the Chicago School took issue with these doctrines, arguing that using power to impose such provisions cannot increase a monopolist's profits. Instead, Chicago said, such agreements are either efforts at (efficient) price discrimination or methods of minimizing the cost of generating (usually undefined) efficiencies. However, Chicago did not question the market power model of contract formation, but ironically offered a more precise account of what such imposition entailed.

    As shown below, price theory's model of contract formation rests upon numerous outmoded assumptions--what Ronald Coase would call "blackboard economics"--about the nature of markets and the firms and consumers that inhabit them. A more realistic paradigm, transaction cost economics ("TCE"), offers a superior framework for interpreting non-standard agreements, including those that exclude rivals from portions of the marketplace. TCE suggests that many nonstandard agreements are contractual rearrangements of property rights that reduce the cost of relying upon markets to conduct economic activity by preventing or attenuating prospective opportunistic behavior by the proponent's trading partners. (194) This characterization suggests an alternative model of contract formation, so-called "Coasean Bargains" that have nothing to do with market power, and are instead examples of voluntary integration that redefines the parties' rights and obligations, indistinguishable from garden variety contracts that courts regularly enforce. Similar logic suggests that even exclusionary agreements that reduce welfare are equally voluntary as between the parties to them.

  2. TCE and a New Account of Non-Standard Contracts

    Price theory is no longer the sole basis for industrial organization or antitrust policy. Over the past few decades, economists and antitrust scholars have constructed a new economic framework, TCE, to rival price theory's interpretation of commercial phenomena. (195) TCE has challenged price theory's technological conception of the firm and offered benign explanations for partial integration in the form of non-standard contracts that price theory and the inhospitality tradition treated as harmful expressions of market power.

    Practitioners of TCE examined the consequences of conducting economic activity in an atomistic market, where transactions take place unconstrained by nonstandard agreements. (196) According to TCE, atomistic transacting entails a cost, what practitioners of TCE dubbed a "transaction cost." (197) Scholars found these costs in certain departures from perfect competition. Ronald Coase famously began the transaction cost movement in 1937 by explaining the origin of firms, institutions that price theory had either taken for granted or treated as arising from technological considerations. (198) Reliance on the market, Coase said, entailed bargaining and information costs, costs that actors could avoid by conducting economic activity within a firm, a particular type of non-standard contract, thereby reducing the overall cost of production. (199) Others extended Coase's analysis, emphasizing different departures from perfect competition, such as the passage of time, investments specific to a particular activity, and the risk that one's trading partners will take advantage of the relationship by behaving in an opportunistic manner. (200) Given these conditions, they said, reliance upon an atomistic market could give rise to a risk of...

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