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The trustbusters' new tools

Activist competition policy is back in style. Thank big changes in economic thinking

ANY day now, America's Justice Department will decide whether to pursue a sweeping antitrust complaint against Microsoft, the giant of the software industry. It would be the most important competition case of the decade-and not just because Microsoft's shares are heavily traded and its products almost ubiquitous. A case against Microsoft, if it winds up in court, could well hinge on the new ways that economists have found to think about competitive behaviour.

For most of this century, ``industrial organisation''-the branch of economics that studies competition-has been an intellectual backwater. But now, as trustbusters weigh an unprecedented number of mergers (see chart) and all sorts of novel business arrangements that would reshape industries from publishing to defence and accounting to aviation, the intellectual tide has turned. The economic ideas of the 1970s and 1980s argued overwhelmingly that government activism in competition was often unwarranted and counterproductive. Now they are giving way to new thinking that justifies tougher antitrust enforcement. That competition authorities seem to be casting a more sceptical eye is partly thanks to these fresh ideas.

Surprisingly perhaps, the controversies surrounding Microsoft plough little new intellectual ground. Although technophiles are prone to assert that advanced technology has changed everything, few new antritrust problems are posed by Microsoft's purported sins, which involve mostly predation against competitors in a supposed effort to monopolise parts of the software industry. If advanced technology has changed competition policy, it is for another reason entirely: that computers have greatly enhanced economists' ability to crunch numbers and model behaviour. The pages that follow describe these new techniques and the thinking that lies behind them.

Never mind the market

No matter the issue at hand, economists, lawyers and judges are wont to begin their analysis of competition by asking a single question: what market are we worried about? Yet, in one of the most startling developments in industrial organisation, economists have now concluded that ``the market'' does not necessarily matter.

Consider the most basic task of trust-busters: to keep any firm from exercising ``market power'', the ability to set prices higher than competition would allow. In the past, economists sought to measure market power with the Herfindahl-Hirschman Index, which is determined by adding the squares of the market shares of all firms involved. If the Herfindahl is low, there are many competitors and exercising market power should be hard; a high Herfindahl, on the other hand, was thought to warn of a concentrated market in which price rises are easier to sustain.

The Herfindahl's great virtue is its simplicity. But that virtue masks two shortcomings. First, there is often no clear way to define what market is at stake. In the current investigation of the proposed alliance between British Airways and American Airlines, for example, the carriers assert that the relevant market is travel between the United States and Europe (of which their combined share is modest). European Union officials, on the other hand, have focused on travel between the United States and Britain (of which their combined share is huge). Second, even when the scope of the market is clear, the relation between the Herfindahl and market power is not. America's soft-drink industry, to take one example, is noted for price competition although only two firms, Coca-Cola and PepsiCo, control three-quarters of sales.

Frustration with the Herfindahl's failings has led economists in a different direction. Instead of calculating market shares, they seek to gauge if an arrangement such as a merger will drive prices higher than they would be otherwise. According to Jerry Hausman, an economist at the Massachusetts Institute of Technology, economists can actually model oligopolistic behaviour and predict what will happen if the merger goes ahead. This has become possible with the spread of two technologies during the past decade: desktop computers with extraordinary number-crunching power and the scanners used at retailers' check-outs.

These techniques were first applied in 1995, when Interstate Bakeries, America's third-largest wholesale baker, proposed to buy rival Continental Baking. Instead of arguing about whether the market for white bread is separate from the market for rye, the government obtained scanner data from a commercial-information company, providing weekly details about average prices and sales volumes for dozens of different breads in various cities.

Thousands of equations later, economists from the Department of Justice concluded that the price of Interstate's sliced white breads strongly affected sales of Continental's Wonder bread, and vice versa, but made little difference to sales of other white breads or other varieties, such as rye. Having shown that each company's brands were the main restraint on the other's prices, the authorities moved to block the merger. In the end Interstate met their objections by selling some of its brands and bakeries.

The empirical analysis went still further with last year's proposed merger of Staples and Office Depot, two chains of office-supply ``superstores' ' in America. By traditional lights, the merger posed no problems, as thousands of retailers sell office supplies. But when economists hired by the Federal Trade Commission (FTC) scrutinised sales prices and quantities for every item sold by each chain, the computers spotted a pattern: Staples's prices were lower in cities where Office Depot also had a store than in cities where it had none. This was strong and unexpected evidence that the merger would allow Staples to raise prices. A court then blocked the merger.

Some practitioners, such as Greg Werden of the Department of Justice, suggest that when scanner data or similar information is available, defining a market need no longer be part of antitrust analysis. The courts have yet to accept that view. But this econometric approach has greatly influenced America's competition authorities. ``It started the agencies focusing on stuff that really matters'', says Luke Froeb, an economist at Vanderbilt University in Tennessee. For the first time, they have the ability to predict whether a merger will raise prices for consumers.

That central concern is the legacy of the academics from the University of Chicago who rebuilt industrial organisation in the 1970s and 1980s. Chicago's famously free-market thinkers defined two principles for competition policy. First, they said, governments should stop worrying about size and ask only whether a firm can exert market power. Second, even if a firm gains market power, the effect will usually be temporary, because high profits will attract new competitors. Hence, markets will erode most monopolies more quickly and effectively than will governments.

Incontestable

The Chicago analysis was hugely influential. Some of its tenets, such as an insistence on rigorous economic analysis and on consumers' well- being as the only meaningful gauge, are still widely accepted. But these tenets are now supporting judgments that are far more interventionist than those that went before.

A decade ago, under Chicago's sway, American competition authorities would probably have given the bakery and office-supply mergers their blessing. In doing so, they would also have relied on the theory of contestable markets, one of the most publicised economic ideas of the 1980s. Contestability theory still matters today-but in a way that is opposite to its developers' original conception.

To understand contestability, first recall that monopolies are undesirable because they can restrict output and raise prices so as to increase their own profitability at the expense of consumers. But economists showed in the early 1980s that raising prices is not always in a monopolist' s interest, because it may attract other firms to enter the market. If entry is easy and costless-in other words, if the market is ``contestable' '-a sensible monopolist will forestall competition by setting prices as if it were operating in a competitive market, and there will be no economic harm.

Contestability theory was conceived with telecoms in mind-indeed much of the research was sponsored by American Telephone & Telegraph (AT&T), then fighting attempts to dismantle its national telephone monopoly. But the idea was soon applied to other industries, notably aviation. Go ahead and deregulate routes and fares, the theory taught, because even if only one airline flies on a route, it will keep fares low to deter rivals. Contestability offered a rationale for easing anti- monopoly rules in both America and Britain.

In the enthusiasm, however, one condition was forgotten. For a market to be fully contestable, firms must be able to avoid large sunk costs. The newcomer must be able to make a one-way bet, winning if profits are good, but losing nothing if it should decide to retreat.

The real world is not like that. A bakery would have to advertise its brand in a new market-an investment that would be wasted were it to back away. A new office-supply chain would have to continue paying rent even if it were to close its shops. As a firm weighs whether to sink costs, it knows that the high profits that look so enticing now will shrink with competition. And so, taken to its conclusion, contestability theory leads to an arresting result: the greater the sunk costs, the less the incentive for new firms to compete against an incumbent, which therefore can restrict output and raise prices.

The belief that firms would find clever ways to hinder competition was one of the original motives for anti-monopoly laws. This was a threat that the Chicago theorists did not take seriously. Their predilection was that firms do business in whatever way they find most efficient. Other motivations such as harming rivals are not likely to maximise profits, and are therefore improbable. Robert Bork, a Chicago-trained legal scholar, was one of the most influential antitrust thinkers of the 1970s. He argued that vertical restraints, such as ``tying' ' (requiring the purchaser of one product to buy another) and ``resale price maintenance'' (in which a manufacturer tells retailers what they may charge) are unlikely ever to lead to higher prices and should therefore always be legal.

Of Bork and brokers

Mr Bork says his views have not changed-even though he is now an adviser to Netscape, a software firm that has accused Microsoft of predatory behaviour. What has changed is the sorts of models game theorists employ, which are far richer and more complex than those used two decades ago. ``The Chicago theories assume perfect competition or perfect monopoly, and nothing in between,'' says Steven Salop, an economist at Georgetown University Law School in Washington, DC. ``The post-Chicago school is based on models of strategic competition among oligopolists.''

How, for example, can stockbrokers maintain wide spreads between the price they pay for shares and the price at which they sell them, as occurred until recently on America's NASDAQ stockmarket? Simple game theory suggests that this kind of behaviour will not persist, because each broker will narrow his spread in anticipation of another firm doing so first. But as Derek Morris, head of Britain's Monopolies and Mergers Commission, points out, the ``game'' in that model is ``played'' only once. In the real world, where competitors face off again and again, a company that violates shared but unstated understandings might face retaliation. That makes it disinclined to be a rule-breaker. ``The static game typically gives you non-collusive pricing,'' Mr Morris says. ``But once you have a time dimension, you have conditions in which tacit collusion may occur.''

Predatory behaviour also looks less innocent through the lens of sophisticated game theory. Following the Chicago lead, most economists until recently viewed it as pro-competitive. In its most obvious form, one firm charges unrealistically low prices to drive another out of the market. Low prices benefit consumers, went the thinking, and the predator rarely sustains monopoly profits for long.

This reasoning is correct-in some cases. Enforcers ``really do have to worry about scaring off real competition,'' says Jonathan Baker, chief economist at the FTC. However, by simulating complex interactions among firms, economists are able to show that predatory pricing may be highly profitable. Authorities in both Europe and America are studying allegations that big airlines slash fares and add seats when a discount airline starts service on a given route. Such predation would pay off if, by establishing a reputation for aggressive counter-attacks, a carrier could deter competition on other routes. This argument has yet to be tested in American courts, the economics of predatory pricing is still fairly underdeveloped, and there are few theories to distinguish desirable price competition from undesirable predation.

In addition, the academics of the Chicago school failed to identify some other kinds of predatory behaviour:

` Raising rivals' costs. When America's Justice Department moved to block the merger of two aerospace companies, Lockheed-Martin and Northrop Grumman, on March 23rd, among its concerns was the firms' role as components suppliers for other defence contractors. After the merger, might not those subsidiaries offer higher prices or less advanced products to Lockheed's rivals? In a highly competitive industry, the rivals could simply find other suppliers. But in an oligopolistic industry, the government fears, a dominant Lockheed might be able to get away with predatory behaviour, forcing up prices for competitors and thus squeezing their profits. The case is now in court.

` Reducing rivals' revenues. A different sort of predation was behind a Microsoft strategy that obliged computer makers to pay it a royalty on each machine they sold, whether or not it carried Microsoft's software. Frederick Warren-Boulton, a Washington-based economist and former Justice Department official, labels this a ``tax'' on competitors: customers will be unwilling to pay much for other firms' software, as they must already pay for Microsoft's. Microsoft changed its policy in 1995, but a current court case, dealing with its efforts to undercut Netscape by giving away its Internet browser, raises similar issues. ``This is a class of problem that has not been analysed before,'' Mr Warren-Boulton says.

` Connected markets. The Chicago school held that if markets are linked, a firm with a monopoly in one cannot boost profits by monopolising another. That is no longer accepted. If Microsoft monopolises browsers, economists now argue, it could prevent competitors such as Netscape from using browsers to challenge its dominant position in operating software. The European Union is examining similar issues in broadcasting, on the theory that if a firm obtains market power in, say, sports programming, it can leverage that into an even more profitable market position in pay-TV. Martin Cave of Brunel University, near London, believes that this idea could open up whole new areas of investigation for the antitrust authorities.

No monopoly of wisdom

None of these types of predation, it is worth pointing out, can succeed in a highly competitive environment of the kind the Chicago theorists assumed. However, economists have concluded that matters are different if a firm has already gained a dominant position in a market. In that case, predation may strengthen the dominant company's position and generate more profits at the consumers' expense.

Economists themselves, of course, are no less entrepreneurial than other folk. Given prompting, they will happly tout the novelty of their work. So it is perhaps inevitable that some of the ideas now being touted as revolutionary insights may be less startling or useful than advertised.

One example is network effects. The notion is that some businesses- Internet access, credit cards and computer software, to name three- differ fundamentally from other economic activities because the desire for compatibility makes certain forms of competition impractical or even unwanted. Although this sounds dramatic, the consequences for policy are fairly minor and involve old-fashioned regulation. The question of how to keep the owner of an ``essential facility'', such as a credit-card approval network, from exploiting its monopoly power is an old one; the European Union's examination of competition in Internet access raises questions similar to the investigation that led to the break up of AT&T by the American authorities.

The new approach to competition by no means heralds a return to the pre-Chicago days when bigness itself was deemed to be an evil. Indeed, it explicitly emphasises market power rather than size, which was anyway only ever an unsatisfactory proxy. Nor does the new approach mean that trustbusters will bring more cases. ``You still need to prove something bad is happening and get customers to complain about it,'' says Robert Litan, a former antitrust official now with the Brookings Institution in Washington. ``You can't make an antitrust case out of fancy economic theories.'' But the fancy theories will, without doubt, motivate enforcers to investigate business behaviour that hitherto would have raised no eyebrows. They will come to understand new ways in which businesses acquire excessive market power. Consumers should be grateful.

Author not available, The trustbusters' new tools. Vol. 347, The Economist, 05-02-1998.