june 15, 2006: 1t. brennan, bundling three “mini” essays on bundling tim brennan professor,...
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June 15, 2006: 1T. Brennan, Bundling
Three “mini” essays on bundling
Tim Brennan
Professor, Public Policy and Economics, UMBCSenior Fellow, Resources for the Future
2006: T.D. MacDonald Chair, Canadian Competition Bureau(relevant disclaimer applies)
Bureau of EconomicsFederal Trade Commission
Washington, DC
June 15, 2006
June 15, 2006: 2T. Brennan, Bundling
Outline
• “Essay 1”: Critiquing Nalebuff’s bundling model– Profits and consumer welfare increase in any equilibrium,
even with exit of non-bundler
– Would justify horizontal market allocation
– Exclusionary harm not in the model
• “Essay 2”: Bundling in the context of reframed monopolization– Monopolization includes not one category of acts, but two
– Some involve a “proximate good,” with bad affects from strategic reactions – e.g., predation, bundling (Microsoft, Nalebuff model)
– Others, however, involve a “proximate bad”: Complementary Market Monopolization (CMM)
– Exclusionary contracts, loyalty discounts in this category, NOT predation
• “Essay 3”: Applications, screens, standards, questions
June 15, 2006: 3T. Brennan, Bundling
Essay 1: Nalebuff summary
• Bundling literature previously ambiguous
– Price discrimination
– Correlations of demand across goods
• Nalebuff critique
– A monopoly over one good bundles it with another?
– Commendably clear, simple model
– No profit sacrifice
– Reduces profits of unbundled seller; may drive out of the market
• Unambiguous policy conclusions
– Strong finding of exclusion, entry deterrence
– Supports (fairly) strict anti-bundling policy
– Resolve the long standing problem of whether bundling is anticompetitive?
June 15, 2006: 4T. Brennan, Bundling
Nalebuff’s basic model
• A, B unbundled only AB bundle sold AB bundle, B sold
• Properties
– Monopoly price below 1, purchased by those with VA + VB > PAB
– With both sold, only B purchased by those with VB > PB, VA < PAB - PB
– Independent demands, uniformly distributed between 0, 1
PAB
VA
VB1
1
0
VA
VB1
1
0
VA
VB1
1
0PB PBPAB
PAB - PB
PABbuy A
buy B
buy A, B buy AB bundle buy AB bundle
buy B
June 15, 2006: 5T. Brennan, Bundling
Base case, worst equilibrium case (B exits)
• No bundling base case
– PA, PB = .5
– Consumer surplus = .25
– Total surplus = .75
• Bundler has monopoly (B exits)
– QAB = 1 – PAB2/2
– ΠAB = PABQAB = PAB[1 – PAB2/2]
– PAB* = ≈ .816
– ΠAB ≈ .544
• CSAB ≈ .275, greater than with no bundling
• Total surplus ≈ .819, greater than with no bundling
June 15, 2006: 6T. Brennan, Bundling
Bundling by A, B stays
• B’s response to PAB (simultaneous or sequential)
– QB = [PAB – PB][1 – PB]
– ΠB = PB[PAB – PB][1 – PB]
– PB =
– CSB =
• Effects of B on the bundler and its customers
– QAB = [1 – PAB] + PB
– ΠAB = PAB[1 – PAB] + PABPB
– PAB =
– CSAB =
BBABB P1PP
2
P-1
3
PP1P1 2ABABAB
4
1P
2
3
2
1P11
6
12
AB3
B
2
P- 1
2
P
2
1 BB
June 15, 2006: 7T. Brennan, Bundling
Two models if the non-bundler stays
• Simultaneous Bertrand pricing
– Solve simultaneously
– PAB =
– PB =
• Sequential pricing, bundler goes first
– Define PB as function of PAB as above
– Calculate A’s profit with B’s optimum reaction
– Numerical methods applied
2
P- 1
2
P
2
1 BB
3
PP1P1 2ABABAB
June 15, 2006: 8T. Brennan, Bundling
Bundling excludes because it’s competitive!
Setting A’s price A profit B price B profit Cons.
surplus Total
surplus
1) A, B sold by separate monopolists .5 (just A) .25 .5 .25 .25 .750
2) A sells bundle at 1, B stays at .5 1 .375 .5 .125 .208 .708
3) A sells bundle at 1, B optimizes 1 .278 .333 .148 .265 .691
4) A sets bundle price before B, knowing B stays
.68 .374 .265 .081 .424 .879
5) A sets bundle price where it does at least as well if B exits than if it stays
.408 .374 0 0 .603 .977
6) At the price in (5), B stays .408 .308 .179 .034 .623 .965
7) B leaves at maximum price leadership price in (4)
.68 .523 0 0 .372 .895
8) A bundles A and B, B stays, price set simultaneously (Bertrand)
.59 .366 .24 .064 .484 .914
9) A maximizes A-B bundle profit as monopolist, with no B
.816 .544 0 0 .275 .819
10) A sells A and B unbundled, B sells B, Bertrand competition
.5 (just A) .25 0 0 .625 .875
11) Both A and B bundle 0 0 0 (both) 0 1 1
June 15, 2006: 9T. Brennan, Bundling
Antitrust implications
• Implications for antitrust per se rules in US
– If bundling that excludes is bad, market allocation t must be good
– Contradicts US per se rule
– “Unduly” standard in S. 45?
• To elaborate: If the anti-bundling argument were correct …
– It would be desirable if an AB bundler and a B seller colluded to divide the market
– B pays A to stay in A and leave the monopoly to B
– Should market allocation be per se legal?
• Results here support aversion to market allocation
• Entry by one firm into another’s appears good
June 15, 2006: 10T. Brennan, Bundling
Summary: Results
• Consumer, total welfare increase with bundling in all equilibria
– Bundler as monopoly after exclusion
– Bundler as price leader
– Bertrand
– B loses, but bundler, consumers win
• Other effects could be greater
– Entry by A into B without bundling increases welfare more, but only if B would not have exited
– Mutual bundling drives prices in both markets to zero
• Important omissions
– Fixed costs of bundling spent; B’s fixed costs avoided
– Correlations of demand across products
– Results could be artifact, especially monopoly increasing welfare
June 15, 2006: 11T. Brennan, Bundling
Summary: Lessons
• Shortcoming of Nalebuff paper
– Intuition of proximate harm rests on non-equilibrium results
– Not necessarily robust result, but undercuts claim here
• Why does exclusionary conduct increase welfare?
– Bundling not short term predatory
– Bundling creates competition in previously monopolized B market
– Competition is exclusionary, too
• But model at hand supports bundling, unless goal to protect competitor
• Exclusionary effect not modeled
June 15, 2006: 12T. Brennan, Bundling
Are models of this type even relevant?
• Leading cases intermediate, not final product (more below)
• Intermediate good buyers are not proxies for end users
– They compete among one another
– Interdependent demands
– Another market to monopolize
• Prior economic analysis
– Katz, price discrimination can raise price to both
– Ordover and Panzar, optimal cost recovery prices uniform, positive even with 0 MC
• Political effect: Why regulators care about discrimination more than absolute price level
• Applies to (almost) all tying/bundling models, not just Nalebuff
• Which leads to …
June 15, 2006: 13T. Brennan, Bundling
Essay #2: Rethinking monopolization law
• Sherman §2 in U.S. law, S.79 in Canada, Article 82 in the E.U.
– Abuse of dominance
– Predatory pricing
– Foreclosure
– “Raising rivals’ costs”
– Exclusive dealing
– Tying/bundling/rebates/loyalty discounts
• Persistently controversial
– Market power presumably horizontal, not vertical
– Practices reduce demand for monopolist’s product
– Too much competition: Low prices, more products
– Does monopolization law protect competitors, not competition?
June 15, 2006: 14T. Brennan, Bundling
The fallacious Section 2 “rivalry” syllogism
• Premise 1: Section 2 cases about hurting rivals
• Premise 2: Because competition hurts rivals, the burden of proof in cases based on rival injury should be very high ()
• Conclusion: Section 2 cases bear a very high () burden
• “Chicago school” accepts both premises, conclusion
• Post-Chicago/populist activist school rejects Premise 2
– Reject conclusion
– Protect competition by protecting competitors?
– CA-US “Positive Comity Principles” (II.1) put “ability of persons to compete” ahead of “competition” under areas of potential harm
• Proposal: Instead, reject Premise 1, focus on new monopoly, not “dominant” firm “abusing” weak “rivals”
June 15, 2006: 15T. Brennan, Bundling
How: First, classifying business practices
Distant effects
Proximate effects Bad Good
Bad PBDB PBDG
Good PGDB PGDG
June 15, 2006: 16T. Brennan, Bundling
Examples
Proximate Effects
Distant effects
Bad Good
Bad
PBDB: Price fixing,
market allocation, horizontal mergers
PBDG: “Rule of reason,”
efficiency defenses, vertical
restraints
Good
PGDB:Predatory
pricing, bundling (Nalebuff), capacity
expansion, preemptive
patents
PGDG:Market generally, buyer-to-seller,
complement providers
June 15, 2006: 17T. Brennan, Bundling
Subdividing monopolization cases
Distant effects
Proximate effects Bad Good
Bad
PBDB: Exclusion, complementary
market monopolization via contract or rebate, regulatory evasion
PBDG: Vertical restraints without negative strategic effects,
efficiency defenses for
exclusion
Good
PGDB, as before:Predatory pricing,
bundling (Nalebuff), capacity
expansion, preemptive
patents
PGDG: Distant harms
unproven, failure to exclude or
recoup
June 15, 2006: 18T. Brennan, Bundling
Failure to distinguish, and its costs
• US: Treat PBDB like PGDB
– Cases far too difficult
– The fallacious syllogism
– Erroneous screens
• EU: Treat PGDB like PBDB
– Presumption of bad behavior even with proximate goods
– Dominance => abuse?
– Willingness to consider “efficiency offenses”
• Erroneous quest for the “holy grail” of a single monopolization standard
June 15, 2006: 19T. Brennan, Bundling
Complementary market monopolization (CMM)• Truism: To exclude rivals or raise BTE, must raise
complement prices
– => Acquiring market power over an complement
– “Exclusion,” “foreclosure” as tying up the market for the complement
• Barriers to entry raised outside the market, not within the market
• Typical examples
– Retailing
– Distribution
• Relevant market is the complement, not the upstream product
– Treat conduct as if merger, HMGs for market delineation
– Share of complement market controlled, e.g., via exclusionary contracts
– Is that market easy to enter?
June 15, 2006: 20T. Brennan, Bundling
CMM application issues
• CMM necessary and sufficient criterion for harm
– No power in complementary market, no ability to raise entry barriers
– “Price” increase not necessarily explicit if complement exclusively used by single firm
• Finesse (in part) market delineation for monopoly
– Cellophane fallacy, profits tests fail
– Problem still needs to be solved, but for regulation, not antitrust
• Vertical relevance (i.e., does the “standard” market matter?)
– Market delineation: Like using buyer information in a merger
– Derived demand: Are affected buyers a relevant market?
– Flesh out “unilateral” HMG story: Can X% firm raise input price?
– A small margin can create a huge competitive advantage
June 15, 2006: 21T. Brennan, Bundling
Essay 3: Applying CMM to bundling
• As noted, leading cases intermediate, not final product
– Concord Boat v. Brunswick (engine discounts to manufacturers)
– LePages v. 3M (discounts for carrying 3M’s house brand tape)
– Ortho Diagnostic Systems v. Abbott Laboratories (Abbott discounted virus screening tests but legal as above Ortho’s costs)
– SmithKline v. Eli Lilly (Lilly bundled antibiotics in sales to hospitals)
• State of U.S. law
– SmithKline won: Bundle price need not be below variable cost
– LePages won at divided Third Circuit Court of Appeal; Supreme Court denied review
– DOJ, FTC: Review would be “premature”; issues “novel and difficult”
– Dominant topic in antitrust debate—Gavil’s “compensated exclusion” cases
June 15, 2006: 22T. Brennan, Bundling
Canadian pioneering: Canada Pipe
• Allegations (from initial Bureau notice of application)
– Canada Pipe holds monopoly in relevant market in cast iron drain pipe
– Instituted “Stocking Distributor Program” provides rebates (up to 20%) for distributors who purchase exclusively from Canada Pipe
– Equivalent to exclusive dealing, forecloses distribution
• Lost at trial (from Tribunal decision)
– SDP exclusive, but with no anticompetitive effects; not “predatory, exclusionary, or disciplinary”
– Found some entry from imports and a new manufacturer
– No switching costs; SDP not contractual, distributors could leave at any time
• Currently under appeal
June 15, 2006: 23T. Brennan, Bundling
Viewpoints on bundled rebates
• Is the relevant test a predation-based standard?
– Does discount lead to pricing below cost?
– Does/would it exclude equally efficient competitor?
• Greenlee, Reitman, Sibley
– Bundling tying or exclusion, not predatory pricing (contra Tirole)
– Extract surplus from A through supra-competitive pricing of B
– Welfare can go up or down
• Test not against cost, but whether A firm bundling B raises stand-alone price of A.
– SmithKline decided correctly, but wrong reason
– Nalebuff’s model contradicts test; welfare and stand-alone A price both rise
• But these models apply to end users, not complement markets
June 15, 2006: 24T. Brennan, Bundling
Other recent viewpoints
• Carlton: Fundamental issue is nonlinear pricing
– Relevant test is price discrimination (good) vs. exclusion (bad)
– Requires strategic interaction
– Incremental price of bundle above MC of bundled good
• Ordover: Bundling problem essentially predatory
– Strategic bundling hard to model
– Requires contracting, capital market imperfections
• Warren-Boulton: Loyalty discounts collusive, not exclusionary
– Loyalty discounts efficient, allow volume discounts independent of size of buyer
– But also collusive, commit to sell X% to buyers
– Entrant may prefer to take 100- X% at monopoly price
June 15, 2006: 25T. Brennan, Bundling
Elhauge’s monopolization test
• Does a practice by a monopolist discriminate against rivals?
• Allows refusals to deal if uniform, but not targeted
• Fundamental flaw: Does it work when most needed?
– Some inputs are bought only by rivals
– Network elements, operations support in telecom markets
– Bridge access in Terminal Railroad
• Either no discrimination, since only rivals are buyers
• Or discrimination an almost certain byproduct of vertical integration, making VI by a monopolist abusive per se
• Also, is price discrimination OK? (Carlton, IIOC)
June 15, 2006: 26T. Brennan, Bundling
Bundle discounts via CMM: A first screen
• Issue fundamentally static upstream monopolization
– Not tying for rent extraction (Nalebuff, Sibley et al.),
– Nor commitment (Whinston)
• Intermediate good focus
• First screen: Whether bundling ties up complement market
– Necessary and sufficient condition
– MEGs approach to market definition, informed by “buyer” market
• Examples
– Outlets needed to sell unbranded tape
– Distributors of false teeth to denture labs
– Distributors of cast-iron drain pipe
June 15, 2006: 27T. Brennan, Bundling
Second tentative screen
• Resemblance to exclusive dealing
– Penalties for breach of exclusive dealing = Lost variable profits
– Is loss of discount equivalent to breach payment?
– Lost variable profits as breach penalty => SRMC as price test
• Is exclusive dealing breach the right quantitative standard?
– How much does the rebate raise the price of distribution to an entrant?
– For intermediate goods, a small but unavoidable price increase can create great competitive disadvantage
June 15, 2006: 28T. Brennan, Bundling
Cost-based tests: “Exclusive dealing” unpacked• How much does exclusive dealing raise complement price?
– Exclusive contracts not absolute
– Willingness to cover cost of breach
• I incumbent, E entrant, R a retailer
• PE, PI retail prices; WE, WI wholesale prices
• R carries E’s product if
– Without exclusion: PE – WE PI – WI
– With exclusion: PE – WE PI – WI + B, where B is breach penalty
• “Efficient” breach penalty is foregone variable profits
• B = WI – CI, where CI is the incumbent’s short run marginal cost
June 15, 2006: 29T. Brennan, Bundling
Implications for evaluating exclusion, rebates• Implies that retailer will carry product only if
– PE – WE PI – WI + [WI – CI]
– PE – WE PI – CI
• Exclusive contracts force entrant to compete against incumbent’s short-run marginal cost, not wholesale price
• Why is this bad?
– With upstream market power (and maybe without), WE CI
– Courts may find that SRMC off the margin is very low (see also “critical loss” analysis and debate)
– Less efficient competitors could knock down price
– Aside: For a different viewpoint, see “efficient component pricing” models (Baumol and Sidak) and critiques (Economides and White)
June 15, 2006: 30T. Brennan, Bundling
Observations on remedies
• Issue: Has the practice raised the effective price of obtaining distribution?
– The practice itself is not good or bad per se
– True of exclusive dealing, loyalty rebates, bundling …
• Hence, ideal remedy should be not “up or down”, but share based
– OK to exclude, but only if one does not go beyond X% of the relevant complement market (distribution, retailers)
• Effective remedies assume competition in relevant CM
– Prior retail, distribution monopoly a defense
– If monopoly upstream, vertical control stops double marginalization
• Can an upstream monopolist leave money on the table?
June 15, 2006: 31T. Brennan, Bundling
Irrelevant screen 1: Profit sacrifice
• Exclusion via bundling isn’t predation
– Anticompetitive effect is to raise effective price of complements
• Sorting: Any investment has short-run opportunity cost
• Why give primacy to welfare of perpetrator?
– If complement market monopolized, why does price paid matter?
• Gives wrong answer in regulatory evasion network cases (Trinko)
• Unsupported by economic theory
– “Free” innovations can reduce welfare
– Innovations profitably only upon exit can increase welfare
• Screen not applied to collusion, mergers—or Dentsply!
• Produces absolute efficiency defense
– Or intent standard; see “four economists” Trinko brief
June 15, 2006: 32T. Brennan, Bundling
Irrelevant screen 2: Prior dominance
• Focus is on the wrong market
– Dominance neither sufficient (EU) nor necessary (US)
• Inherent contradiction in litigation
– To establish prior monopoly, show high barriers, etc.
– But if entry that hard, does practice at issue matter?
– US v. Microsoft as example
• Dominance as defense, not condition of guilt
– Large size in one market suggests large involvement in complements, e.g., share of distribution with exclusive contracts
– If dominant already, what is the harm from the conduct?
– Posner’s fragile monopoly
June 15, 2006: 33T. Brennan, Bundling
Lessons for bundle discount, rebate cases
• Essay 1: Nalebuff
– Bundling increases economic welfare
– Prohibiting bundling sanctions market allocation agreements
• Essay 2: CMM alternative
– Monopolization cases should be, but are not, divided into two categories, based on whether the initial practice is good or bad
– Bundling cases should be about intermediate, not final, products
– Bundle rebates are not like predation, but equivalent to (wide scale) merger in complementary market (e.g., retailers, distributors)
• Essay 3: CMM applications
– See if bundle takes “monopoly” share of complement market
– Use cost-based tests if the standard for exclusion needs to be the explicit contract – and it probably shouldn’t
– Avoid profit sacrifice, prior dominance screens