kenneth m. davidson's reality ignored: how milton … ignored with... · kenneth m....

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Kenneth M. Davidson's REALITY IGNORED: How Milton Friedman and Chicago Economics Undermined American Institutions and Endangered the Global Economy

Preface by Bert Foer

September 27, 2011

One of my memories as a law student at the University of Chicago is of hearing my First Amendment

professor, the eminent Harry Kalven, introduce his friend the eminent Chicago sociologist Edward Shils, with

the encomium that Shils had “one of the best furnished minds of our time.” I think of Ken Davidson, who

did his undergraduate work at Chicago, as having an unusually well-furnished mind. Kalven would have

found him to be good company. We are fortunate to have Ken on the AAI Advisory Board and our readers

are familiar with his commentaries, drawing on something like 27 years of experience at the Federal Trade

Commission and his continuing work as a competition consultant especially in transitional economies.

Ken’s breadth of reading is reflected in his recent book about the impact of the Chicago School, Reality

Ignored, which carries the subtitle, How Milton Friedman and Chicago Economics Undermined American

Institutions and Endangered the Global Economy. Ken has agreed to make excerpts of this fine book

available to our readers.

A little more background on our relationship may be in order. In the mid-1970’s, I was Assistant Director for

Special Projects of the FTC’s Bureau of Competition. I hired Ken as my Deputy. He had been a law

professor at the University of Buffalo and had co-authored two casebooks that were the first in their fields,

one on US taxation of foreign income (with Boris Bittker) and another on sex-based discrimination (with

Ruth Bader Ginsburg). In addition he had written an extensive law review article describing the role of the

American government in the development of its economy. He had little if any knowledge of antitrust, but he

had an obviously quick mind, was extremely well-read, and asked penetrating questions. I figured that an

Office of Special Projects would need creativity, quick minds, and the ability to deal with a wide variety of

issues. (Later I hired another lawyer whose references told me he had a lot of ideas but only one out of ten

was any good. How often do you find anyone who can generate any good ideas?)

Ken did not disappoint. He mastered the law and economics of antitrust very quickly and helped us to take

on subjects like strategic planning, capital markets, failing companies, conglomerate mergers, taxation,

emerging markets, and international competition. (Little did we know that we were generating the seeds of

what would later become the AAI.) Ken grew to love this field in which new questions must continually be

asked. Long after I had fled the government (when Ronald Reagan was elected president), he stayed, taking

on a variety of assignments usually involving planning or evaluation. Perhaps his most noted accomplishment

was a first-time report on the effectiveness of remedies in merger cases where he and Naomi Licker

documented many shortcomings of Commission orders. Ken retired in 2005, but as the book and his post-

retirement work with the AAI demonstrates, he remains an active participant in the profession.

From his arrival at the FTC, Ken was surprised to discover that the University of Chicago’s economics

department and law school were beginning to dominate the world of antitrust. As the subtitle of his book

does more than suggest, he is a critic. Indeed, he is one of its most devastating critics. The excerpts that we

reproduce with his permission include the book’s introduction in which he talks about the role of theory and

the dangers it can represent in economics and public policy, and a chapter titled “Bork’s Imaginary

Monopolization,” which with verve and insight traces the impact of Robert Bork, particularly on the

campaign he led to reduce the liability of large businesses for the harms they can cause. Ken is particularly

effective in dealing with the Borkean shredding of predatory pricing, in which a new theory based on the

assumption of profit maximization has by now been accepted by the Supreme Court despite all the evidence

to the contrary. Only Marx can really help us understand this, as when Groucho asked, “Are you going to

believe what I tell you, or what your eyes tell you?”

Even those who have spent substantial time with Matsushita and Brown & Williamson will find Ken’s treatment

enlightening. The scope of this book –detailed in the table of contents—is as broad as the influence of

Chicago Economics. It builds on Ken’s early work on the role of government in the economy and shows how

simplistic assumptions have contributed to current economic problems of the United States and the world.

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REALITY IGNORED

__________________________________________________________________

How Milton Friedman and Chicago Economics Undermined American Institutions and Endangered the Global Economy

________________________________________________________________

Kenneth M. Davidson

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Contents

Foreword xi

Introduction: Theory Matters xv

Part I: Foundations of the Chicago School 1

Chapter 1: Stigler and the Origins of the Chicago School 2

Chapter 2: Friedman and the Agenda of the Chicago School 12

Part II: Chicago School Antitrust 30

Chapter 3: The Chicago School in Action 31

Chapter 4: Developments in Antitrust Law 37

Chapter 5: Antitrust’s Immovable Object: The Robinson-Patman Act 49

Chapter 6: Mergers and Richard Posner 55

Chapter 7: Implementing Chicago Merger Theory 66

A New Chicago School Merger Rationale 71

Chapter 8: Bork’s Imaginary Monopolization 74

Chapter 9: The Chicago School and the Future of Antitrust 91

Part III: The Flawed Public Policy Framework of the Chicago School 105

Chapter 10: Chicago and the Question of Self Regulating Market 107

Chapter 11: Deregulation 115

Federal Transportation Deregulation 116

State Deregulation 121

A Note on Ethical Rules in the Medical Professions and Other Professions 125

Chapter 12: Organizational Behavior and the Theory of the Firm 128

Chicago Theory of Organization 129

The Problem with Using a Price Theory Model 131

The Complexity of Large Corporations 136

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The Creation of the Efficient Large Corporation 137

Understanding the Modern Corporation 141

Corporate Structure, Competition and Innovation 149

Corporate Structure versus Industry Structure 155

Motivational Theories 157

The Chicago School Omission 164

Chapter 13: Unions, Labor, and Management 167

Chapter 14: Transforming the American Economy 175

Part IV: Privatizing Government 186

Chapter 15: The Size of Government Institutions 188

Chapter 16: The Structure of National Security

Institutions 193

The Iraq War 194

Privatizing the Defense Department 199

Competitive Sourcing Programs of the Defense Department 200

Chapter 17: Police, Private Security Guards, and Gated Communities 207

Chapter 18: Public Education 213

How Much Should Government Spend? 225

Part V: Financial Disarray and Deregulation 229

Chapter 19: Money, Monetarism and Macroeconomics 233

The New Deal framework 233

The Sea Change of the 1970s 236

The Reagan/Friedman Revolution 238

Money and Monetary Policy 242

The Definition of Money 244

Chapter 20: Opaque Money: The Financial Markets in

Action 252

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How New Ventures Obtain Capital 253

The Role of Organized Capital Markets 256

Misleading Market Signals 261

Bad Investments and Regulated Markets 261

Speculative Bubbles and Follow the Lemming 273

Ponzi Schemes 278

Moral Hazards, Conflicts of Interest and Other People’s Money 282

The Quest for the Riskless Investment 296

Epilogue: The Market Works 318

Selected Bibliography 331

Index 338

Acknowledgments 350

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Introduction: Theory Matters xv

Introduction: Theory Matters !

Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist ... It is ideas, not vested interests, which

are dangerous for good or evil.

John Maynard Keynes’ warning in the General Theory of Employment, Interest, and Money applies to economists both living and dead. Yet we need theories to identify relevant facts, to propose testable explanatory hypotheses, and to test whether the facts support an explanatory hypothesis. When we believe in theories, we use them to guide our actions in an indeterminate world. Too often we do not have the facts we need to predict or decide economic effects in individual cases. In those circumstances, we rely on theory.

Chicago School Economics is a theory. For over forty years it has provided the intellectual fodder for dismantling government regulation of business and transforming a pre-1970 understanding of American antitrust law. Chicago Economics provided the intellectual underpinnings for Ronald Reagan’s declaration that “Government is not the solution to our problems: government is the problem.” Senator Phil Gramm added the finishing touches by securing the repeal of the Glass-Steagall Act that separated banking firms from brokerage and investment banking firms and the Commodities Futures Modernization Act of 2000 that liberated the trading of securities derivatives from all regulation. These two laws combined with a “me first” personal or social ideology has led us to the 20th Century decline of American manufacturing industries and the global financial crisis that began in 2008. In retrospect, the financial crisis should have been a predictable result of abandoning government regulation. The Chicago School has always been in favor of relying on markets to solve public problems but even it has not always favored abandoning government regulation.

This book traces some of the history and irony in the spread of the Chicago Gospel that has coincided with deregulation, the failure of the Long Term Capital Management fund, the Enron scandal, and more significantly the world wide subprime and derivative financial debacle. The legislation that made the debacle possible prohibited government agencies from regulating contract rights of large investors to trade

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xvi Reality Ignored

derivative securities. It seems that as we try to cure the current crisis we should look at some of the steps that brought us to where we are. Instead, the Tea Party activists seem intent on resurrecting the Chicago Gospel that markets are entirely self regulating in the public interest and that government intervention to protect the public is inevitably wrong.

In the early 1950s, Milton Friedman wrote a defense of the methodology of “positive economics” used by the then nascent Chicago School. In accordance with other positivist theories, Friedman argued that people should not evaluate his economic theories based on the realism or accuracy of their assumptions. That reference was to various assumptions used in Chicago School Economics about how people act: sellers seek to maximize their profits and understand what actions will accomplish that goal, and consumers know about the quality and price of products and services that are available to them and seek to minimize their costs. He knew, as we all know, that these assumptions are not always true. Sellers go out of business every day because they do not understand what consumers want or what they will pay. Consumers sometimes buy a higher priced item, sometimes because they believe its price demonstrates that it is better. There are people who want products because they are popular or for lots of other non-utilitarian reasons.

Friedman’s defense was that using profit maximizing assumptions about economics, people would provide accurate predictions about how competitive markets work. He makes a provocative (or perhaps silly) analogy that the assumption of profit maximization is like a biologist who might assert that a tree acts “as if each leaf deliberately sought to maximize the amount of sunlight it receives.” Is this a persuasive analogy? Would the attribution of deliberation to trees make a difference to biological theory? If we believe trees might be persuaded not to maximize sunlight, does that belief improve our predictions or open up avenues of useful research? Friedman argued that because the market punishes sellers and consumers who do not act in accordance with the profit maximizing assumptions, the predictions are accurate and therefore it does not matter if the description of how people decide to act is inaccurate. Unfortunately, many of these predictions of how markets work are true only in the long run. And, as Keynes is also famous for pointing out, in the long run we are all dead.

If the influence of the Chicago School were solely based on its numerical predictions or on a research agenda for academics, this defense of

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Introduction: Theory Matters xvii

positive (as opposed to normative) economics might be relevant. However, over the last half century the influence of the Chicago School has been greatest in areas where its theory and the assumptions on which that theory is based, rather than its factual support, have formed the basis for public policy. We have been told for half a century that markets know best notwithstanding many incidents that should have reminded us of economic disasters of the past. We have been repeatedly told that those problems were results of government regulation. We now face the greatest economic crisis in seventy years and it comes from the least regulated market in our economy. This book suggests that some significant part of this crisis is due to politicians and courts following the advice of Chicago School Economics.

The best known representatives of the Chicago School in the second half of the twentieth century were Milton Friedman and George Stigler. This book therefore begins with a review of two of their best known works. These two economists trained together at the University of Chicago in the 1930s and became lifelong friends. They received their PhDs there and taught there for many years, although Stigler did not join the Chicago faculty until 1958. For all of these similarities, their fields of study were very different. Friedman specialized in macroeconomic theory and advocated non-Keynesian policies about monetary policy. Stigler is best known for his microeconomic work on price theory. Each won the Nobel Prize for his technical contributions to economics.

Of course there is not now and never has been a text that defines Chicago School Economics. It is a term that developed as scholars, politicians, and members of the public took sides on issues of importance to them. I have focused on the impact of Friedman and Stigler on American society because for many their work in the 1950s, 1960s and 1970s epitomized the Chicago School. Although I quote liberally from their writings, this is not an exhaustive or scholarly analysis of their writings or of the technical work of persons allied with or opposed to their conclusions. Rather it is an impressionistic review of the impact of their work on American society and public debate. My focus is on the origins and development of Chicago theory and the consequences of that development which has been much broader than their technical work. The impact of these two economists and that of the Chicago School has transformed the way Americans and many others see the proper allocation of authority between government and economic markets.

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xviii Reality Ignored

From its earliest days Chicago School Economics was criticized on the grounds that it claimed that the “market” could solve all or almost all non criminal disputes. That is, the market, based on voluntary contract negotiations, provides the fairest and best method for allocating resources and for resolving disputes between individuals. Kenneth Arrow, another Nobel Prize winning economist, pointed out what he considered a fundamental flaw in this theory that price negotiations could resolve all disputes. In his 1974 book, The Limits of Organization, he presented his classic statement of the flaw:

Trust is an important lubricant of a social system. It is extremely efficient; it saves a lot of trouble to have a fair reliance on other people’s word. Unfortunately this is not a commodity which can be bought very easily. If you have to buy it, you already have some doubts about what you have bought. Trust and similar values, loyalty or truth-telling, are examples of what the economists would call “externalities.” They are goods, they are commodities; they have real practical economic value; they increase the efficiency of the system, enable you to produce more goods or more of whatever values you hold in high esteem. But they are not commodities for which trade on the open market is technically possible or even meaningful.

Notwithstanding this criticism, the Chicago School has had an enormous and continuing impact on American public policy from the middle of the 20th century to the present. This continued impact is curious, however. As we shall see, the Chicago School faith in the benign effects of a society based on voluntary transactions has evolved in an unpredictable way. It began with a view that in order to have a properly functioning “free market” the government must drastically curtail the ability of businesses to build and maintain concentrated economic power. Early incarnations advocated forbidding corporations to retain their earnings or to purchase other businesses. The explicit fear was that the disproportionate power of big businesses would distort commercial markets and corrupt political freedoms.

Over time, however, the concern with undue business power as a threat to freedom shifted to a concern with undue government regulation of business as a threat to individual political freedoms. Ultimately, the connection between concentrated economic power and political freedoms was severed entirely and the focus of the Chicago School turned entirely

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Introduction: Theory Matters xix

to a theory of freedom of contract. The unfettered focus on contractual freedom changed the Chicago School from an ideology that was disposed to restrain the power of large businesses to a libertarian business ideology that is disposed to restrain the regulatory powers of government.

It is important in this discussion of economics, theory, and public policy to remember that no one fully understands how a market economy operates. In 1776, Adam Smith described the continuing mystery of The Wealth of Nations, the businessman (or woman) “generally . . . intends neither to promote the public interest, nor knows how much he is promoting it. . . . [H]e intends only his own gain, and is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.” Since he wrote we have learned a great deal about market economies. We have developed many theories to explain economic growth and decline, relations between supply and demand, how businesses are organized, what role governments can play in an economy and much more, but all of these theories are incomplete. A market economy is described by scientists as an emergent system: it organizes itself. It is not designed or planned by any person or groups of persons. Like evolution, or the cosmic universe, we have invented theories which explain parts of these self organizing systems in an attempt to discover how our world works. There are large gaps where we cannot explain how these systems work. This is a humbling fact.

It may not be surprising that the political successes of the Chicago School do not rest on rigorous empirical proof of detailed economic theory. The Keynesian revolution, which was written in the 1930s to solve the economic problems of the Great Depression, was not fully adopted in the United States until the passage of the Employment Act of 1946 after the Depression and World War II. The evidence that its insights were correct is best reflected in American economic growth during the 25 years following the passage of that Act. Similarly, the Chicago School’s influence emerged during what appeared to be a failure of neo-Keynesian economics in the 1970s when the American economy was hit by a series of disasters, starting with the failure to raise taxes to pay for the Vietnam War, the inflationary impact of OPEC oil price increases, the reexamination of federal regulatory policy, the Iranian hostage crisis, and the election of Ronald Reagan on a platform that condemned government regulation as the problem and celebrated rugged individualism as the solution. This book explores the origins and consequences of implementing this romantic vision of America.

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xx Reality Ignored

The romantic rugged self sufficient individual is one of two competing American images. It is celebrated in the Horatio Alger stories, the Lone Ranger, and the heroes of Ayn Rand libertarian novels and the careers of John Jacob Astor, Louisa May Alcott, Cornelius Vanderbilt, Harriet Tubman, Thomas Edison, Henry Ford, Bill Gates, Billie Jean King, Joe Louis, Muhammad Ali, Arnold Palmer, Tiger Woods, John McEnroe and John Wayne. That image competes with the Continental Congress which wrote the Declaration of Independence, the 1787 convention in Philadelphia which wrote a Constitution to form “a more perfect union,” over two centuries of legislation that supported the creation of a national transportation system, the abolitionist movement, the union movement, the New Deal safety nets, the civil rights movements, and the armies of men and women who have defended our nation in times of war and national disaster.

As individuals who left the unfairness of some “old world,” or established social order, we sometimes believe that we, or our ancestors, risked everything and proved that in America a person can survive and prosper on his or her own. As a nation of immigrants, we want to believe that individuals can make their own way in our world. However history has repeatedly shown that, especially in times of economic or social peril, we need the cooperation of neighbors to build a barn, to manage a school, to protect a neighborhood, so we have joined churches, fraternal organizations, political parties and many other organizations that create strength through joint efforts. Nevertheless, we want to believe that anyone can become President, or CEO of Microsoft, or win the lottery.

Both images are true but each reflects only a partial view of America. Chicago School Economics has drawn its model of human behavior from the individualistic self sufficient image of Americans, an image of individuals who are free to choose and who can succeed by individual effort alone. As an academic model, this simplification has its uses in analyzing certain kinds of economic issues. As a political philosophy, it is a dangerously incomplete view of the necessary role of government and the social need for values that facilitate cooperation.

Part I traces the historical foundations of the Chicago School; how it was transformed from a 1930s concern about private concentrations of economic power to a 1960s concern about the power of government. This transformation took place after the Chicago School decided that human behavior could be

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Introduction: Theory Matters xxi

described as interactions of individuals responding rationally to economic incentives. Within this economic framework, it became possible to develop an ideology that assumed individuals pursuing their private interests would enter only into transactions voluntarily and only with a full understanding of the consequences of those transactions. Based on this framework Milton Friedman and the Chicago School asserted that the enforcement of property rights and contractual freedom held the key to the creation of the best possible society which would be endangered by most types of government regulation.

Part II illustrates how the refocused concerns of the Chicago School helped transform the enforcement of American antitrust laws. Antitrust laws that were enacted as a response to public fears about private economic power became instead a Chicago influenced ideology that defended the freedom and prerogatives of powerful private businesses. The assumption that transactions are presumptively voluntary, absent direct evidence of coercion or conspiracy, allowed the Chicago School to argue with great success that competitive market forces are sufficient to protect businesses and consumers and promote the economy.

Part III describes ways in which the Chicago School free market theory has transcended its academic origins and become an ideology that exalts the benefits of private market exchanges, denigrates regulatory efforts to channel market forces, and rejects the ability of non market forces to support our social, political and commercial institutions. This free market ideology offers attractively simplistic solutions to complex public policy issues. Unfortunately the theoretical free market does not reflect the complexities of how businesses operate in the commercial world. As a result, undue reliance on free markets has frequently led our country in wrong directions during the past half century.

Part IV discusses the impact of Chicago rhetoric on the size, operations, and functions of government. Attempts to implement these Chicago ideas sometimes have resulted in what appear to be parodies of what might have been intended. Programs to make governmentsmaller, for example, have resulted in a larger and less coordinated federal bureaucracy.

Part V considers Chicago contributions to our current financial disaster. The problems created by overly simplistic economic assumptions about business transactions have been magnified by equally naïve Chicago assumptions about how financial markets operate. History has

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xxii Reality Ignored

shown repeatedly that individuals lack the information that would allow them to act in the ways that Chicago Economics predicts and, furthermore, they make decisions that include more than economic considerations. The failure to include noneconomic factors, such as trust, and the failure to appreciate the unpredictability of the future has led the Chicago School to promote disastrous financial policies that ignore the lessons of history.

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Bork’s Imaginary Monopolization 74

Chapter 8: Bork’s Imaginary Monopolization

The most ardent antitrust advocate of Chicago School price theory is Robert Bork. His advocacy has had a profound effect on the antitrust decisions of the United States Supreme Court. While those decisions also have altered decisions in other areas of law that have reduced the liability of businesses for their actions, Bork’s arguments were directed at the application of antitrust law.

Bork has had a career that is as distinguished as Posner’s, but it has been much more controversial. He graduated from the University of Chicago law school and began his teaching career at Yale Law School in 1962 after practicing law for eight years. His career was marked by two highly political events. As acting Attorney General, upon receiving orders from the President, he fired Special Prosecutor Archibald Cox who was investigating President Nixon and matters related to the Watergate Scandal. Later when serving as a Judge on the United States Court of Appeals for the District of Columbia, Bork was nominated by President Reagan to become a Justice of the Supreme Court. His nomination was highly controversial because of his strongly voiced views on various legal issues. The Senate rejected his nomination. Following the rejection, Bork resigned his judgeship, joined the American Enterprise Institute as a fellow and returned to teaching. His scholarship has focused on two fields, constitutional law and antitrust law. His approaches to these subjects have also been controversial, in part because the approaches appears to use inconsistent methods of legal analysis. He is an advocate of interpreting the Constitution in accordance with his reading of the original intentions of those who wrote the document. In contrast, his view of antitrust not only disregards the statements of the framers of the Sherman Antitrust Act, it insists that that Act and the subsequent antitrust laws be interpreted in accordance with an economic theory that had not even been formulated at the time the Sherman Act was passed and thus could not have been the intention of the drafters. His recent writings include: The Tempting of America (1993); The Antitrust Paradox (revised 1996); and Slouching Towards Gomorrah: Modern Liberalism and American Decline (2003).

Bork’s prominence in antitrust became indisputable after the Supreme Court’s 1986 decision in Matsushita v. Zenith. The Court’s opinion states “there is a consensus among commentators that predatory pricing schemes are rarely tried, and even more rarely successful.” On the basis

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of that “consensus,” the Court overruled the decision of the Third Circuit Court of Appeals, and reinstated the decision of the District Court that had dismissed the case on a motion for summary judgment. In other words, the Supreme Court held that regardless of any proof that might have been offered at trial by the plaintiff, no reasonable jury could find that the defendants were trying to run it out of business by selling their television sets below cost. This is an astonishing conclusion given that the Court seems to agree that selling below cost to eliminate a competitor would constitute a violation of the antitrust laws.

Matsushita represents a stunning victory for the Chicago School and personal vindication for Robert Bork whose views were the “consensus” referred to in the decision. By adopting Bork’s approach, the Court abandons the search for facts to resolve an antitrust legal question and replaces it with a decision based on economic theory. A passage from The Antitrust Paradox is the Court’s lead in to its statement about the consensus among economists about predatory pricing so it is worth examining how Bork’s reasoning created a logic that appears to replace fact with theory.

In chapter 6, “The Method of Antitrust Analysis,” Bork asserts that he relies on Friedman’s positive economics formulation described earlier. He quotes with approval Friedman’s metaphor that equates economic axioms of human behavior to those of a biologist who asserts a tree consciously decides to seek sun for its leaves. This metaphor seems to be an assertion that behavioral axioms are basically irrelevant to economic science but may be useful mnemonic fables by which to summarize more precise economic models. But for those uneasy about the use of fables or unrealistic assumptions, he draws on another example from Friedman’s essay.

Bork quotes this second passage at length to show that businessmen do engage in profit maximization even though they often deny having such an intention and even though the data needed to perform the calculations to implement profit maximizing strategies are not likely to exist:

Consider the problem of predicting the shots made by an expert billiard player. It seems not at all unreasonable that excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated

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mathematical formulas that would give the optimum direction of travel, could estimate accurately by eye the angles, etc., describing the location of the balls, could make lightning calculations from the formulas and could then make the balls travel in the direction indicated by the formulas. Our confidence in this hypothesis is not based on the belief that billiard players, even expert ones, can or do go through the process described; it derives rather from the belief that, unless in some way or other they were capable of reaching the same result, they would not be expert billiard players.

Before continuing with the quoted excerpt, it should be noted that the flaws in this analogy might cause a first year law student to become an object of mockery by his or her classmates. First, as any viewer of the movie, The Hustler, knows predicting whether an expert pool player’s shots will go in the pocket is not so easy. (Pool is similar to billiards, but the differences make this discussion simpler.) The expert pool player may deliberately miss shots to lure an unsuspecting victim as the early scenes of the movie demonstrate or as later scenes illustrate the tensions of a match may distract a player in ways that Newton’s laws of motion do not contemplate. So it is only in some settings that the as if predictions are even likely to parallel events.

Moreover, having spent a part of the year that I attended a graduate program at the Yale Law School learning how to play billiards, I can testify that the way in which one learns to play makes another, more important difference from the profit maximization analogy. My billiards mentor told me, he could explain the basics of the game in half an hour and show me a few useful tricks but after that it depended on me. As Jascha Heifitz is reported to have answered when asked how to get to Carnegie Hall, “Practice, practice, practice.” Notice also there is a vast difference between practicing billiards or the violin and practicing business decisions. In billiards and violin playing, the student gets immediate feedback indicating whether the student is playing correctly or has made an error whereas a business executive may never know if his pricing decisions are profit maximizing in the short run or in the longer term. The executive’s feedback is more as if a person learning to play pool practiced all day but was not allowed to see whether any of his shots put the balls in the pocket; rather he was simply told at the end of the day what percentage of the shots he had taken had gone into

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77 Reality Ignored

pockets. It would take more than fancy math to figure out how to play in that situation.

Bork concludes the Friedman quote as follows:

The billiard player, if asked, how he decides where to hit the ball, may say that he “just figures it out” but then also rubs a rabbit foot just to make sure; and the businessman may say he prices at average cost, with of course some minor deviations when the market makes it necessary. The one statement is about as helpful as the other, and neither is a relevant test of the associated hypothesis.

What then is a relevant test? Bork plays around with the issue of profit maximization quoting Stigler asking business executives, “would a higher or lower price of the product yield a larger profit? The answer was usually, no.” Bork also quotes Armen Alchian:

What would otherwise appear to be merely customary ‘orthodox,’ nonrational rules of behavior turn out to be codified imitations of observed success, e.g., ‘conventional’ markup, price ‘followship,’ ‘orthodox’ accounting and operating ratios, ‘proper’ advertising policy.

Bork concludes:

Such rules serve the function that habit and custom perform in other areas of life. Without them, moment-to-moment behavior would pose insuperable complexities. The firm will do better or worse as its rules of thumb prove to have survival value or not, and as it has or lacks the ability to alter them to meet circumstances.

There you have it. The entirety of the evidence that Bork presents to show that profit maximization is the goal or practice of all businesses and that if it isn’t the market will weed out those who do not “maximize.” This does not seem to account for the answer given to Stigler’s questions to business executives. They appear to say, I think I am charging the right price but I am not sure. Alchian’s “codification” sounds more like support for price leadership theories rather than independent price maximization strategies. At most, it reminds me of the joke about two men being chased by a bear, one says to the other “Aren’t you worried

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that bear can run faster than either of us?” “No I am really slow,” says the other cheerfully, “but I can run faster than you.” Does it matter if the market eliminates only the worst of the worst, rather than rewards the best of the best? Does it matter if the elimination takes years to occur and many other factors contribute to the failure of one business or the success of another?

Bork’s “rules of thumb” are precisely what led Herbert Simon and his colleague at Carnegie Mellon University to conclude that businesses do not maximize, because, among other things, they lack the information to do so. Instead, executives “satisfice” perceived demands made by a host of claimants from customers, executives, employees, shareholders, etc.

So having made no progress in his attempt to demonstrate either profit maximization assumption of price theory is correct, Bork returns to his bald assertion that antitrust must use price theory as enunciated by the Chicago School (because there is no other coherent theory of economics) and that the theory must be implemented in the manner he specifies. Bork’s adaptation of price theory to antitrust is summarized (his “crucial point”) in the following paragraph which says in part:

Obviously, only three relationships [between business activities and profit maximizing behavior] are possible, and these correspond to quite different ways of making money. A business may seek to increase its profits by achieving new efficiency (beneficial), by gaining monopoly power and restricting output (detrimental), or by some device not related to either productive or allocative efficiency, such as taking a bookkeeping advantage of some new wrinkle in the tax laws (neutral).

Obviously if the profit maximizing price theory of the Chicago School is wrong, or if it is incomplete, there is no reason that these three relationships describe the complete universe of relationships between business activities and good or bad antitrust outcomes for the public. Putting this aside for the moment, to finally get to what seems to be his “crucial point.” “Allocative efficiency,” rather than productive efficiency or anything else, must be the focal point of antitrust analysis because it is the “best developed branch of price theory.” Therefore:

If a practice does not raise a question of output restriction. . . we must assume that its purpose and therefore its effect are either

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the creation of efficiency or some neutral goal. In that case the practice should be held lawful.

It makes some people uneasy to have to rely entirely upon theory to infer the nature of a reality that is not directly observed. Yet I am convinced both that the theory is good enough to make the task doable and, equally important, that there is no other possible way to proceed.

Relying entirely on a theory I believe to be seriously flawed does make me uneasy, but I agree with some of Bork’s discussion illustrating that it is sometimes impossible, and often difficult, to confirm whether or in what circumstances his theory would provide an appropriate outcome. Needless to say the inability to confirm the theory does not increase my confidence in it.

Is it significant that in discussing the difficulties of confirming empirically some points of his rules, he focuses on those who suggest he would bar too many business activities not too few? His is a theory that would and eventually did vastly contract the number of activities that previously had been condemned by antitrust law.

The most significant aspect of Bork’s chapter 6 is when he says antitrust must rely on theory rather than proof. In saying that, he abandons all pretense that the price theory on which he relies is a positive science and transforms it into deductive syllogisms. It is one thing for Friedman to use lame analogies about the nature of economic man in his explanation of positive economics because he asserts that the value of his models and predictions are in the proof that supports them. But Bork denies the necessity or validity of proof. His price theory is a deductive system in which the axioms provide the answers and events not included in the axioms either do not happen or do not matter. Bork’s adoption of a deductive approach for antitrust analysis traps that analysis in the Flynn “fallacy” which means that all factors not specified in the Chicago model will be ignored because they have not been quantified. Well, enough of Bork’s theory, the issue is how it seems to have influenced the Supreme Court in Matsushita. There are at least two striking features to the Court’s reliance on Bork. First, as noted the Court decides the case on a novel theory that eliminated the fact finding role of the jury. Second, and closely related, the Court relies on Bork’s theory but does not refer to Bork’s factual claims about prior Supreme Court predation cases.

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In his discussion of predation, Bork goes to a lot of trouble to cite a number of distinguished economists who think those previous decisions were not examples of predatory actions and cites some facts that led them to that conclusion. (On the other hand he simply dismisses without any real explanation the distinguished economists and lawyers who defended the outcome of those cases.) Why doesn’t the Court examine those critiques and use them to support its decision?

Part of the answer is the procedural posture of the case. The jury in a district court is supposed to decide the facts of a case, not the judge or any appellate court. The two exceptions to this rule are when the plaintiff’s legal theory is wrong or the facts alleged could not lead any reasonable jury to believe that the facts required by the theory are present. Zenith’s theory seemed to be valid. It alleged it was being run out of business by the predatory (below cost) pricing of Matsushita and the other Japanese tv makers. And Zenith alleged that Matsushita had been engaging in below cost pricing for twenty years in an effort to drive Zenith out of business. If that factual allegation was found to be true by a jury then Zenith should win.

In this situation, the Court could rule against Zenith’s claim only if the factual allegations were inherently incredible (or something like that) so that only an irrational jury would believe the factual allegations. How the Court concludes that this factual allegation is “something like” an inherently incredible assertion appears to rest on an acceptance of the axioms of business behavior that Bork offers. I say appears because the opinion is sufficiently unclear that four dissenting justices just say this is a factual issue and should be sent back to be decided by the jury.

The something like an inherently incredible allegation is the Court’s decision that Zenith must show a “plausible motive” for Matsushita to engage in the behavior alleged. It is not sufficient to show that Matsushita did the forbidden predatory action because low prices are an expected goal of the antitrust laws. Accordingly, the antitrust law must be especially careful not to punish a competitor who offers low prices. Zenith has suggested a motive and offered an expert witness to explain the motive (the Court of Appeals has reversed the District Court for excluding the testimony of that witness). The motive is that Matsushita and the other Japanese companies have enough capacity to supply the Japanese market and the American market with televisions and they want to eliminate Zenith so they can run their factories at full capacity

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and make money on all of their sales. They can afford to sell in the United States at a loss because they sell in Japan at a cartel monopoly price.

Why is this not a plausible motive? The court does not say, but it seems fair to infer from the excerpt from Bork that this is not a “realistic theory of predation” because it does not seem to include recoupment of alleged losses incurred by the Japanese firms during the years they were selling below their costs. For Bork in his book and the Court in this case, the reason that Zenith’s theory is unrealistic is that the alleged price cutting strategy probably is not profit maximizing (and we assume that all firms are profit maximizing because they will be driven out of business if they are not). So, price cutting cannot be successful (i.e., profitable) even if Zenith is driven out of business because (1) it would take too long to recoup the losses from price cutting, (2) the cartel would be unable to sell televisions at monopoly prices in the United States because that collusion would violate the American antitrust laws, and in any case, (3) other firms would enter the US market if the Japanese sold televisions at a monopoly price in the US, etc. Moreover, in Bork’s world, the Japanese firms could not be making monopoly profits in Japan to fund below cost sales in the United States; therefore they would go out of business by selling televisions for less than cost in the United States. Thus the predatory pricing strategy, unless it is quick and decisive in putting the target firm out of business, is essentially impossible; not only is it unlikely to end up earning monopoly profits but it is not realistic to think a firm could persist in such a strategy over a 20 year period of time.

But note this test of realism is based not on what Matsushita is or might be doing, but on what a profit maximizing firm would do or what a firm in a profit maximizing world could do. Zenith was claiming that Matsushita and other Japanese television makers had, for 20 years, been pricing the television sets that they sold in the United States for less than it cost them to make the sets with the intention of driving Zenith out of business. Maybe Zenith was wrong, maybe the Japanese had lower costs and were selling sets in the US at a profit. Or, maybe Matsushita was wrong, maybe it could not drive Zenith out of business.

We know the answer to the second possibility, Zenith and all other manufacturers of televisions in North American did go out of business. So maybe Bork was wrong about the potential for success even though the Japanese seemed to violate Bork’s notion of profit maximizing

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rationality because they were unlikely to recoup their lost profits from below cost sales. Were not American consumers better off from the price cutting, did they not benefit from the lower prices they paid for televisions regardless of the reason the prices were lower? If antitrust laws are only about greater output or lower prices, then maybe Bork’s simplification of the goals of antitrust gives the right answer even if his assumptions about how firms behave are wrong.

The Supreme Court’s opinion seems very close to adopting either Bork’s definition of what a rational firm will do or deciding, like Bork, that the reasons for business actions do not matter if the results are consistent with the goals of antitrust, by this the court means lower prices for consumers. The opinion says, in part:

[M]istaken inferences in cases such as this one are especially costly, because they chill

the very conduct the antitrust laws are designed to protect. [citation omitted]

[W]e must be concerned lest a rule or precedent that authorizes a search for a

particular type of undesirable pricing behavior end up by discouraging legitimate price

competition. [citation omitted]

Leaning so heavily on price effects probably gave Bork a little heartburn because he believes the goals of antitrust are allocative efficiency, not lower prices for consumers, but the framework of relevancy is otherwise very close to his.

One consequence of the Court’s paramount concern with lower prices is that it confirmed a line of cases in which the Supreme Court has departed from the facts of cases to speculate about the impact of antitrust litigation and the possibility of incorrect jury decisions on the efficiency of the American economy. This line of cases is a concern about what are now called “false positives.” The “false positive” line of cases has been used to reject tort claims, antitrust claims, class action certifications and the like on the grounds that a decision against a business might make the business less likely to innovate, less likely to introduce new products, less likely to lower prices on the grounds that any of these actions might subject the businesses to enormous liability in the courts for having harmed consumers or other businesses. Whatever

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misgivings Bork may have had about the emphasis on lower prices is more than compensated for in this set-the-business-community-free-from “false positives” declaration.

Where did this concern about false positives come from and why? If it is a real concern, was it not always lurking in antitrust cases? Why did the Supreme Court not consider the chilling effects of its predation cases or its merger cases in the 1950s, or in its early cases against Standard Oil, US Steel, or American Tobacco? After all, it was frequently argued in those early cases that the large monopoly firms were more efficient. One answer is that in all of those cases the Supreme Court viewed the role of antitrust as including more than allocative efficiency considerations. Preventing the concentration of private economic power was seen as one of the prime goals of the antitrust laws.

Anyway, economic learning seemed to demonstrate that the antitrust prohibitions posed little threat to the realization of productive efficiency. If anything, economic learning suggested that the prohibitions, the fight in the marketplace between smaller rivals was likely to produce greater innovation, greater efficiency and lower prices.

This is where Bork’s discussion of all those predation cases that are not mentioned by the Matsushita opinion is important. From the 1960s onward, Bork and others in the Chicago School chipped away at that political/social/economic consensus in the Stigler Report, at the Airlie House conference, in Posner’s book and especially in Bork’s book. History needed to be revised, that is corrected in accordance with axiomatic application of price theory.

The first task was to unhook the antitrust laws from their seemingly incontrovertible Congressional concern with private concentrations of economic power. This would seem to have been a difficult task given the history of support that earlier Chicago School scholars had given to The Case Against Big Business. But beginning with Friedman’s Capitalism & Freedom and the Stigler Report the greater danger moves from private power to concerns about government power. Posner mostly ignores this history apart from relying on Bork. So it is Bork’s articles and the introductory portion of his book that invent the new history of the antitrust laws. That it is a fictional account is not worth disputing because so much has been written on the subject, including for example my AAI colleague Bob Lande’s article Wealth Transfers as the Original and Primary Concern of Antitrust. Suffice it to say that the “allocative

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efficiency” concept that Bork claims as the basis of antitrust was essentially unknown in 1890 and not generally understood in 1914 when the Sherman and Clayton Acts were passed. Indeed, allocative efficiency is still far from being the “best developed branch of price theory.” It might be more accurate to say its claim to describe the total economy is the most dubious aspect of price theory.

Revisionist history of the legislation was a fig leaf. The real work was undermining of the antitrust cases that indicated large businesses used their economic power and market position to dominate markets to the detriment of competitors and consumers. First was the history of the monopolization cases. Bork starts, “John S. McGee published his careful and startling reevaluation of the Standard Oil legend, showing that Standard had not used predatory price cutting in its march to monopoly.” He then quotes McGee:

I am convinced that Standard did not systematically, if ever, use local price cutting in retailing, or anywhere else, to reduce competition. To do so would have been foolish; and, whatever else has been said about them, the old Standard organization was seldom criticized for making less money when it could readily have made more.

Bork explains, “Standard attained its [monopoly] market share by merger rather than predatory pricing.”

Bork’s statement that “Standard had not used predatory pricing” is not supported by the quote from McGee. McGee said, “Standard did not systematically, if ever, use local price cutting.” In other words, price cutting does not seem to have been the favorite or ultimate weapon used by Standard Oil and McGee is not interested in whether it was ever used as part of an overall strategy. The overall strategy of Standard Oil was like the other consolidations of the time, to coordinate the pricing of all major competitors. The basic idea was essentially to create a cartel fixing output and raising prices. The hope of all of the Trusts was that everyone would see the advantage and either join the Trust or sell out to it. Standard’s method’s were ruthless only if a competitor tried to stay independent. Then it was likely to be subject to price cutting and various other predatory practices until the owner joined or sold out. It was, therefore, not at all startling that predatory pricing was not the primary means of achieving monopoly.

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Bork then cites a study by Morris Adelman showing that the case alleging A&P had engaged in predatory pricing was wrongly decided because Adelman concluded that “such behavior would have been theoretically foolish and demonstrated empirically that such behavior never occurred.” In this sentence, it might be more persuasive if Adelman had demonstrated factually that price cutting was never used. The problem with Bork’s evidence on predation is that theory appears to drive the inquiries of his economists and the facts that they look at. And, as noted, Bork does not answer the critiques of lawyers and economists like F.M. Scherer, Areeda and Turner and others who came to different conclusions about predation.

Neither does the Court in Matsushita. Predation is not plausible because theory has shown that it is unlikely to occur. Unlikely is of course different from impossible, but the Court is able to elide the difference by invoking the rule of the possible “chilling effect.” Under these circumstances, it appears that the entire country is sufficiently at risk that juries might come to wrong factual conclusion therefore the jury should be stripped of its traditional fact finding function.

What is the basis for believing in this “chilling effect” and its close relative the “false positive?” What evidence or theory demonstrates that a hoard of false positive cases have had a chilling effect on competition or are likely to have such an effect? The evidence and theory are in the studies by McGee, Adelman and others who believe in the Chicago School price theory model. Those ancient cases are the evidence that American industry will be harmed. Of course in the era following these cases that were wrongly decided (according to Bork) and thereby endangered the American economy, the United States dominated the industrial economies of the world.

It is said that, in the 1950s, a more activist antitrust enforcement program might have saved the American steel industry and invigorated what is now a failing American automobile industry. But it is even more dispiriting that since the 1980s, after the disappearance of much of the American industrial base, that the Borkian Chicago School has diverted antitrust law further from responding to anticompetitive actions by businesses. It is not just that the application in Matsushita may have contributed to the failure of an American industry; it is also the intellectual confinement of the antitrust laws to static price theory when

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we know that the greatest benefits of the market come from the forces of dynamic change, from innovation.

The Supreme Court in Matsushita is willing to heavily weight the scales of justice on the side of the price cutting Japanese firms because it does not perceive any countervailing interests to the short term low price benefits to consumers. Let me suggest that, quite apart from the political concerns of antitrust legislators and early Chicago School economists, innovation presented just such an economic interest for consumers. Zenith had been one of the primary innovators in the manufacture and development of the television industry. With its profits depleted by fighting low cost Japanese producers, Zenith had fewer resources to invest in research and development. We cannot know that winning the case would have saved Zenith or produced great innovations, but we do know that Zenith had been an innovator. Thus, the presumption by the Court that favoring the defendants solely on the basis of selling at a lower price is not necessarily a costless decision for the American economy.

At another level, the notion that businesses do not engage in predatory pricing or predation in general is silly and is a conclusion that could only be deduced from theory, not from experience or observation of life. It is too obvious and too trite to dwell on the fact that aggressive behavior is often an effective means of eliminating and deterring competitors, whether one is talking about stags fighting over a doe, bullies dominating a schoolyard, or monopolists or cartels disciplining price cutters. Strategy theory and history provide examples beyond counting. One can imagine, also, that in situations where entry and exit barriers are low and profits are high, the Chicago assumption that new competitors will enter with the result of reestablishing competition. But the notion that no firm will engage in predation because of the possibility of entry by new firms is simply wrong. The Supreme Court’s failure to acknowledge the existence of other economic values such as innovation or political and social values that are reflected in the legislative histories of the antitrust laws illustrate its adoption of Chicago School antitrust theory and is yet another example of the Flynn “fallacy”. Unfortunately the Chicago School theory together with the false positives fear has taken hold in the Supreme Court in a way that continues to diminish a potentially more useful role for antitrust. The 1993 Supreme Court decision in Brooke Group v. Brown & Williamson provides an example of the further extension Chicago School price theory. It is a

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remarkable case in many ways. First, the lawyers: the plaintiffs claiming predation were represented by Phillip Areeda, who was then the primary author of the leading antitrust treatise in the United States and a critic that Bork did not deign to fully answer in his chapter on predation; Robert Bork represented the defendants who claimed their actions did not constitute unlawful predation. It might have been billed as a battle of the giants or perhaps a battle for the definition of antitrust. Second, the case concerned cigarettes which are notorious health hazards whose sales were being promoted by the legal and allegedly illegal lowers prices. While this second feature seems to have had no effect on the outcome of the case, it tends to remove any public interest in maximizing output or lowering prices which the Chicago School insists are the only proper goals of antitrust. Third, this case unlike Matsushita was decided by a jury, although its verdict was overruled by the District Court Judge. Thus, the case is like Matsushita in that the jury is given no role in the ultimate decision, but we have the benefit of knowing what the jury believed the facts were.

Briefly stated, the facts were as follows. Over the years, the cigarette industry became more concentrated and at the time that matters was composed of three major brands, Phillip Morris the makers of Marlboro, RJR the makers of Winston and Salem, and Brown & Williamson (“B&W”), a subsidiary of British American Tobacco. Brooke Group, the owner of Liggett had a declining market share of 2 percent at the time the events that led to this lawsuit began. Although in general, cigarette manufacturing has been very profitable, Liggett’s declining market share meant that its profits were shrinking and looked as if they might disappear in the future. So it embarked on a program to market lower cost “generic” cigarettes. When this proved to be successful and Liggett gained market share, B&W and then the other major brands created their own lower cost generic cigarettes. Liggett then cut its prices further. There then followed an 18 month price war between B&W and Liggett. Liggett alleged that during the price war B&W sold its generic cigarettes for less than the cost of producing them in order to either force Liggett out of business or to force Liggett to raise the price of its generic cigarettes. The jury found that B&W had engaged in below cost predatory pricing for the purpose of forcing Liggett to raise its prices or to force it out of business. The trial judge overruled the jury on the grounds that Liggett had not shown that B&W could recoup its losses by raising its prices. The court of appeals upheld the District Court judge;

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nevertheless the Supreme Court accepted the case and also upheld the District Court decision.

The Supreme Court’s decision has to be one of the high water marks of the triumph of theory over facts. It is not entirely clear why the Court even took the case given that the court of appeals had already affirmed the trial court. The Supreme Court made some modification to that decision but the distinction hardly seemed urgent and the Court’s protestation that it wanted to clear up confusion (and thus save judicial resources) seems a little hollow given the obscure explanation it offers.

The opinion of the Court says that the jury had adequate basis for finding that B&W had priced its cigarettes below cost and further that it had adequate basis for finding that the below cost pricing was done for an anticompetitive purpose, namely forcing Liggett to raise its price to the oligopoly price preferred by the major brands. The apoplectic dissent goes on and on about the amount of evidence that supports these findings. What then is missing? Is this not the evidence that the Court in Matsushita said was missing? In that case it was the possibility of a false positive that led that Court not to allow the case to go to the jury. Here, however, the Court cannot, or at least does not, deny that this is in fact a “true positive.”

B&W did a bad thing, an anticompetitive thing. It is not a delusion, a fantasy of the jury, or an unprovable fact. It is a true fact. Liggett lost $49.6 million because of the below cost sales by B&W. The Supreme Court says so. There should be no danger of unnecessarily frightening timid big businesses from engaging in hard competition. B&W crossed the line and the evidence shows they were or should have been fully aware that what they were doing was illegal. There is no reason to fear chilling of good business behavior.

So what is the problem? The problem cited by the Supreme Court is that there is no evidence that B&W will be able to recoup its below cost losses with anticompetitive profits in the future. The court quotes the decision in Matsushita to show that recoupment is important, but somehow the Court forgets that the reason it was important in Matsushita was to prevent confusion on the part of a jury between hard legal competition and dirty, nasty, anticompetitive competition. Here the evidence and the jury verdict have eliminated that confusion. The answer is clear. The Supreme Court said so.

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The Court’s reasoning is at once both clear and completely obscure. It says:

The record in this case demonstrates that the anticompetitive scheme Liggett alleged, when judged against the realities of the market, does not provide an adequate basis for a finding of liability.

What are these market realities? As far as I can see the most likely reality is that cigarette prices will rise to their former supra-competitive levels whether or not B&W recoups a penny of its lost profits. If it has successfully disciplined Liggett, the lower sub-premium prices will disappear and consumers will be back to paying the oligopoly (monopoly) price even if B&W falls on its sword and dies for the team. The evidence at trial shows that the price of generics did rise and the gap between generics and the more profitable premium cigarettes narrowed. As a social matter, I am not troubled that fewer people may end up smoking if prices go up. As an antitrust matter, the recoupment test is absurd. As a legal matter, the proposition is absurd. We make attempted monopolization unlawful because, like attempted murder, the behavior is bad. Here the District Court Judge stated the documentary evidence of B&W’s anticompetitive intent “was more voluminous that in any other case.” The attempt to prevent a competitor from offering lower prices in order to maintain a cartel price is bad even if the attempt fails, whether or not the business disciplining the cartel cheater makes a profit from the disciplinary action.

The only explanation that makes any sense to me is that the Court was persuaded by Chicago School theory that real businesses do not engage in activities that are not profit maximizing, and predatory pricing is not profit maximizing, therefore B&W could not have been engaged in predation, even though it was. Next to this, the statement in the Wizard of Oz, “pay no attention to the man behind the curtain” makes perfect sense. The Court does not say it is relying on Chicago theory. Instead it reviews a morass of facts about output and pricing that have absolutely nothing to do with whether actions like B&W’s are likely to deter cartel cheaters in the future. These equivocal output and pricing facts are relevant only to the Chicago School model, not to the protection of competition. Here the price cutter, Liggett that defected from the premium cigarette group, was disciplined by a member of that group and the Supreme Court says Liggett cannot be compensated for the economic

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losses it suffered because B&W might not recoup its losses from pricing B&W’s cigarettes below cost. Does this make sense?

I suppose that one might say that Posner and Bork have been vindicated. Some complexities and contradictions of the antitrust laws may have been eliminated by the adoption of the price theory axioms. The cost of this bizarre consistency, if that is what it is, is the elimination of antitrust protection of the public from most anticompetitive behavior.

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Epilogue: The Market Works

The free market has brought us a wonderful variety of products and services that could not have been imagined in earlier eras. We have amounts of food, clothing and shelter for much of the world’s population that surpass what previous generations considered possible. We have sanitation and health care that has eliminated or reduced the incidence of age-old plagues. We have CDs, DVDs, iPods, televisions and computers that reproduce music and performance arts inexpensively with a clarity that could not have been imagined when I was a child. Before the 20th century, these entertainments were luxuries reserved to the rich, but now are broadly shared in richer countries and elsewhere. We have physical mobility, and social and economic mobility thanks to technological innovation and the workings of free markets. The decentralized private market has been a productive generator of ideas and innovations. The commercial marketplace allows individuals to seek acceptance of new products and services in ways that traditional societies or centrally planned economies would not tolerate or could not process. Competition has made goods cheaper, more abundant, and of better quality. Although we cannot credit all things good to markets, they have contributed greatly to the bounty that we enjoy.

We have not gotten to our present privileged position by a simple straightforward path marked by signs that say, this way to the modern market economy. It has been a learning process all the way. By trial and error we find what works in which circumstances. When we are wise, we adopt and institutionalize what works and try to eliminate those things that do more harm than good. We have come a long way in improving our lives but the persistence of pollution, poverty and pestilence prove we have a long way to go.

My introduction to this book quotes Kenneth Arrow to describe how incomplete Chicago School Economics is because it has no way to account for trust in describing market interactions. The unrecognized importance of trust is only one of numerous erroneous assumptions of Chicago theory. It is not limited, as Judge Posner suggests, to misunderstandings about financial markets.

The assumptions that people are rational, knowledgeable, and motivated solely to maximize their monetary rewards are not accurate descriptions

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of all people in all circumstances. The assumption that there are few obstacles that an entrepreneur must overcome to establish a new business is not an accurate description of entry barriers in all circumstances. The assumption that contracts are the product of bargaining between equals is not accurate in all circumstances. The assumption that the market always makes a better choice than the government is not always accurate. The assumption that government regulators are inevitably controlled by those they are responsible for regulating is not always accurate. The assumption that government regulation cannot expand individual choice is not accurate. The assumption that the only competitive harm posed by mergers is price fixing is not always an accurate description. The assumption that people always pursue short term profit maximizing outcomes is not always accurate. The assumption that maximizing short term personal gains will benefit society is not always true. The assumption that personal actions can be accurately represented by the assignment of monetary amounts is not always true. The assumption that accurate records of monetary transactions convey accurate information about people and their businesses is not always true.

These assumptions are true in some circumstances, but not in others. Princeton University professor Daniel Kahneman received the Nobel Prize in Economics for the work that he and Amos Tversky pioneered in behavioral economics. Kahneman and a host of other behavioral economists have shown through empirical experiments that Chicago based assumptions that people will choose the option that maximizes their income are predictably wrong in many settings. A classic example of non-rational behavior is illustrated by the often studied Ultimatum Game. Maurice Stucke, a University of Tennessee law professor describes the game in his seminal law journal article Behavioral Economists at the Gate: Antitrust in the Twenty-First Century:

Suppose you are given $100 on the condition that you share some portion of the $100 with another person (suppose an anonymous person in a cubicle in the adjoining building). If the other person accepts your offer, you can keep the balance. If, however, the other person rejects your offer, then both of you get nothing. How much should you offer?

Stucke answers his question in a footnote that describes both the Chicago based answer and the results of numerous empirical tests:

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Rational choice theory predicts that your offer should be the smallest monetary amount above zero (e.g., one penny), and the recipient should accept any positive offer. Actual studies in more than twenty countries show the contrary: the majority of individuals offer significantly more than the nominal amount (ordinarily forty to fifty percent of the total amount available) and recipients typically (about half the time) reject nominal positive amounts (less than twenty percent of the amount available).

Stucke summarizes numerous other circumstances in which people predictably choose options that defy the assumptions of rational choice.

These studies pose a fundamental problem for Chicago theory, because the key assumption of Chicago School Economics is that people are rational profit maximizers. It underlies virtually all of the other Chicago assumptions listed above. The assumption that people are knowledgeable buyers and sellers is demonstrably wrong in many settings. People buy goods and services from doctors, lawyers, construction companies, and stock brokers even though they lack the information or the education that might allow them to evaluate the quality or safety of their purchases, much less the comparative data that would allow them to feel secure that they have made the least costly choice from the most appropriate provider.

The importance of Chicago assumptions is captured by Stigler, and its weakness laid bare, in his article A Theory of Oligopoly, “If we adhere to the traditional theory of profit-maximizing enterprises, then behavior is no longer something to be assumed but rather something to be deduced.” If behavior can be deduced, then in Brooke Group the Supreme Court can conclude that no predatory behavior has occurred or could have occurred because there is no evidence (yet?) that the price cutter has or will profit from its indisputable below cost pricing. Deductions based on dubious premises cannot be assumed to be accurate.

Chapter 12 on organizational theory suggests that businesses are too complex to pursue profit maximizing strategies. Chicago theory would argue that it makes no difference whether a company is in fact a profit maximizer, competition in the market will eliminate those companies that choose a less than profit maximizing strategy. However, in a world that faces uncertainty at every level of human interactions, it would only be accidental that any business hit upon a profit maximizing strategy and miraculous that a company could choose such strategies in all of its

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research, development, production, financing and marketing decisions and reproduce these maximizing decisions over time. The market may tend to favor better, cheaper products and thereby eliminate some of the least adept businesses but it is a delusion to think that the market chooses the best possible outcome.

What significance does a less grandiose depiction of the market have for Chicago School Economics and public policy? It means that market outcomes are not always or automatically correct, but it does not mean that Chicago scholarship has been worthless. Profit is a powerful motivation in the market and, in many instances, it is the dominant force. In many instances, buyers and sellers can distinguish better from less good products and services and over time will favor the better. Chicago theory often describes interactions in these instances well. The problem is that the instances are not always obvious and therefore the determinants of market outcomes need to be investigated to predict an accurate outcome.

Sometimes we can identify the determinants of human behavior and market interactions. Where these are clear, they should form the basis of legislation, judicial decisions, public policy and business strategies and personal actions. Where these are not so clear, we would be well advised to rely on the persuasiveness of available evidence and theory. Theory often provides us with useful presumptions that allow us to generalize and to make decisions where the facts or the meanings of fact are unclear. The problem with using Chicago Economics in such circumstances is that its theory of human behavior is demonstrably incomplete. If we are to avoid the Flynn Fallacy of ignoring factors that cannot be counted, we need a framework that includes a larger amount of what we know about human behavior and economic interactions.

It is possible to sketch some elements that are missing from the Chicago model of human behavior that are fairly common knowledge. Competition is central to the dynamics of Chicago theory and most other biological and human theories. Cooperation is also central to most other theories of biological and human interaction; it is missing from Chicago theory. Because it is missing from Chicago theories, actions that appear to be beneficial from a Chicago perspective, may in fact be harmful to our economy and our society.

It can be useful to look to biological evidence of the fundamental importance of cooperation. We can see from biology that “cooperation” is

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indispensible even in the midst of competition for food or mates. Lewis Thomas, the doctor, researcher and author, tells us in The Fragile Species about the lives of termites as a way of illustrating our own need for cooperative arrangements:

The [termite] lives on wood, but does not possess its own digestive system for converting cellulose to usable carbohydrate. This is the function of the motile protozoans, single-celled eukaryotes which inhabit its intestine and are passed on from one generation to the next by feeding. The protozoans are in certain species, unable to move about by themselves to ingest the fragments of wood eaten by the termite. They accomplish their movements thanks to the spirochetes attached to their surfaces. And there is more to come. Inside each protozoan, embedded in neat layers just beneath the creature’s surface, are numerous bacteria; these are the ultimate symbionts, contributing the enzymes needed for digesting the wood eaten by the termite, located by the spirochetes, swallowed by the protozoans, and now awaiting conversion to sugar by the bacteria.

Dr. Thomas tells us these stories of biological interdependence to dramatize that all living organisms are interdependent. Each human cell relies on a cooperative arrangement with mitochondria to transform food into usable energy. Human cells which are formed by sexual reproduction and the exchange of the DNA in our chromosomes cannot function without mitochondria. Although mitochondria have lost their cellular membranes during evolution, they have distinct DNA which exists in all human cells. The mitochondria are passed on with the egg of the mother and reproduced in every cell during gestation.

Symbiosis is an evolutionary form of cooperation that leaves the mitochondria no choice, and for that matter, leaves no choice to the protozoans in the gut of the termites, but biological examples of cooperation are not limited to organisms that are locked together for life. Ants and bees and other social insects, herds of mammals and groups of primates act together to protect and promote their groups.

The stories of animal cooperation also include cooperation among predators and prey. In The Origins of Virtue, Matt Ridley tells the story of predator fish that go to reefs to have their mouths and gills cleaned of harmful parasites by 45 different kinds of small fish and shrimps that survive by eating those parasites:

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[T]he cleaners are often the same size and shape as the prey of the fish they clean, yet the cleaners dart in and out of the mouth of their clients , swim through their gills and generally dance with death. Not only are the cleaners unharmed, but the clients give careful and well understood signals when they have had enough and are about to move on; the cleaners react to these signals by leaving straight away.

This cleaner/client relationship is regulated by instinct, and no doubt took eons to evolve into the cooperative program of the fish. The lesson of evolution seems clear, that even among prey and predator cooperation can be a fundamental part of survival.

Human cooperation is not instinctual. It must be learned but it is no less vital. As the reference to Ridley in chapter 10 illustrates, cooperative solutions can be learned fairly quickly by humans under experimental conditions where the people are repeat players in games that make everyone lose if there is no cooperation. Learning to cooperate is also possible in industries where a relatively small number of competitors find it profitable to form a cartel. The Orthodox Jewish diamond cutters of New York are another example of a close knit group that can enforce unwritten agreements even though the profits from cheating could be large.

The modern commercial world is not characterized by neighbors who know each other and buy each other’s products. It is an anonymous marketplace in which we pay by cash or credit card in a store or online. We are not known by the seller and we do not know the seller, the manufacturer or the person who delivers the product. Avner Greif’s history of medieval trade, Institutions and the Path to the Modern Economy, describes how human commercial institutions developed in a way that made it possible to transact business with strangers. The institutions he examines are made possible only when the rules of commercial institutions have been internalized by their members. The rules, the mores of the institution are enforced against those who violate them, but the key to the survival of the institution is the internalization of those rules. Moreover, if they are to endure, the institutions must evolve over time to adapt to changing circumstances. Although we are indirect descendants of the medieval guilds and trading companies, we have borrowed and built on the institutions they created.

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Douglass North, the Nobel Prize winning pioneer of institutional economics describes in his 2005 book, Understanding the Process of Economic Change, a series of institutional changes and the indispensible role of internalized mores that made them possible:

Historically, institutional change has altered the pay-off to cooperative activity (the legal enforcement of contracts, for example), increased the incentives to invent and innovate (patent laws), altered the pay-off to investing in human capital (the development of institutions to integrate the distributed knowledge of complex economies), and lowered transaction costs in markets (the creation of a judicial system that lowers the cost of contract enforcement).

The response of humans to novel situations depends on how novel they are and on the cultural heritage of the actors. . . Economies that had evolved a cultural heritage that led them to innovate institutions of impersonal exchange dealt successfully with this innovation.

The culture North writes about is a culture of trust and institutions that reinforce that trust by economic pay-offs and societal survival. Economies that lack a culture of trust cannot engage in modern commerce.

The abundance of our modern economy depends on trust and the internalization of rules of honest behavior. To be sure, profit incentives, personal rivalries, and the joy of creation also play important parts, but without trust there is no glue to hold together a private enterprise system.

This book has explored a number of instances where the implications of Chicago School Economics point in the wrong direction. The assumption of profit maximizing behavior casts union and management as adversaries, when they are more like the protozoans and bacteria in the gut of termites whose fates are interdependent. The assumption of profit maximizing behavior makes it difficult to see how and why cartels can be durable agreements that are unlikely to be abandoned as a result of profit maximizing cheating by individual members. The assumption of profit maximizing behavior provides tautological evidence that mergers must be efficient despite empirical evidence that they tend to be

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disruptive to employees and communities and unprofitable to shareholders of acquiring corporations.

Maurice Stucke provides a particularly telling behavioral economics experiment that illustrates the inefficiency that translating relationships into monetary terms caused at a for-profit child care center:

[A behavioral economics] study examined what impact, if any, a monetary fine had on curbing undesired behavior (namely parents who picked up their children late from certain private day-care centers). The private day care centers originally had no rule governing parents who picked up their children after 4:00 pm; generally a teacher had to wait with the tardy parent’s child. A fine on tardiness was thereafter introduced in some of the day-care centers, which under rational choice theory, should decrease the incidences of tardiness. Instead, the average number of late-arriving parents increased for these day-care centers. Moreover, after the fine was canceled, the average number of late-arriving parents did not return to the pre-fine levels . . . So why did the monetary penalty increase the undesired behavior? Perhaps, as the authors conclude, parents before were intrinsically motivated to pick up their children on time. The introduction of the fine monetized that lateness into an additional service, offered at a relatively low price.

The intrinsic motivation was presumably predicated on respect for the teachers who had lives of their own that were disrupted by waiting for the late arriving parents.

Respecting others, honesty, loyalty, cooperation and trust are learned values that we hope are internalized and make our lives safer, happier and more efficient. The story of the child care center tell us that these values may be unlearned or put at risk by transforming relationships to be just about the money. When the Chicago School says unequivocally that society benefits from profit maximizing behavior, it encourages everyone to monetize all relationships. The greed-is-good mantra makes it difficult to limit the pay of CEOs. It encourages people to take advantage of all moral hazards because they personally profit from risking or spending other people’s money that is entrusted to them.

The Chicago Nobel Economist Ronald Coase seems to have recognized something he does not identify in his theory of the firm that creates the

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greater efficiency of the firm over individual contracts for defined services. The source of that efficiency is Douglas McGregor’s theory Y in The Human Side of Enterprise; respect for employees is central to achieving organizational efficiency. To the extent that Chicago School Economics undermines our cultural heritage that promotes respect, loyalty, cooperation and trust, it makes our businesses less efficient and less productive and our lives less satisfying.

There is a case to be made that Bernie Madoff was more destructive to our culture and our economy than the Commodities Futures Modernization Act. Madoff played on all of the cultural factors that support cooperation and trust. He used his religious ties, his educational and charitable donations, his reputation for effectiveness and leadership in the business community to lure in unsuspecting investors. These are qualities that were the foundations of trust in the modern economic society. To betray those trust relationships is to bring into question the basis of commerce.

But the modern economic society has relied on more than knowing your neighbor. After a century and a half of frauds and fakes, manipulation and other financial mischief, we have developed a cluster of rules that obey Ronald Reagan’s injunction that we “trust, but verify.” In the century and a half since the Civil War, we have seen, in the United States, the abuses of trust by businesses and bankers and responded with rules. Some were private rules by the stock exchanges requiring openness and disclosure. Some were court made rules that imposed liability and responsibility for damages knowingly caused or negligently permitted by businesses. Some were legislation or regulation that required businesses to honor the trust they sought from consumer and investors. The legislation required honest disclosure, imposed liability for damages, and established requirements that banks, businesses, and investors to commit their own funds to the ventures that they promoted. We have successful commerce because these rules have, by and large, been internalized as codes of moral behavior.

The lesson that a business must place its own worth or value at stake in its ventures, not just the faith and money of others, has been a constant lesson of history. Banks that hold the obligations of borrowers until repayment stand in a different relationship to their borrowers and their depositors than does a bank that resells its loans. Bank capital and reserve requirements are not only a cushion against bankruptcy, they

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also reflect a tangible commitment to the continued viability of banking transactions. Margin requirements imposed on investors in stocks and down payments by home buyers are not only insurance that they will pay the full price, the initial payments provide immediate feedback to the investor about whether he or she can afford the investment. The point of the initial payments is that they are personal commitments, not bets that carry no more obligation than a lottery ticket. The term earnest money and the phrase, my word is my bond, reflect the moral component of commerce.

This is a lesson that the money-based Chicago Economic theories should be able to appreciate. Profit maximization suggests that if only other people’s money is at risk if an investment fails, but you and the others gain with success, then profit maximization directs that you should invest the other people’s money without regard to the risk of failure. This is the moral hazard of profit maximization when it is unmediated by either ethics or rules that support sensible transactions. The Commodities Futures Modernization Act eliminated both. It violated the lessons of over a century of experience with financial investment. It removed requirements that those who invested share the risk of the investment and eliminated disclosures that might have revealed the nature of the risks to those whose money of investing. Securities derivative transactions are not public. They do not risk the funds of the traders. For the traders, at least, they are bets on which the traders make money up front as commissions and on the outcome if it is positive.

The CFMA created a foundationless anonymous financial market that was supported by Chicago theory to maximize the risk of others for the benefit of those who traded on the market. We do not need to search for hidden villains like Madoff, Ponzi, Ken Lay, Bernie Ebbers or insider traders to find the designers of the CFMA. Merton, Scholes, and Phil Gramm believed in the system that they helped create. They participated in the operation of that system and to greater or lesser extents continue to defend it. They were blinded by the idea that profit maximization produces only good.

The evolutionary development of commercial institutions, described by Greif and North, that there must be an underlying cultural heritage to increase trust in order to decrease transaction costs was ignored. In a single leap, the CFMA system, abandoned the lessons of history, both

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recent and long standing. The market is not self regulating by profit incentives. It requires rules to operate in a manner that aligns personal and public interests. When we ignore those lessons, we risk the financial future of Americans and the trust of the global community that has invested in America and looked to the American system as the way forward to a better life for all societies. If we have undermined that trust we have harmed ourselves and the world.

The alignment of the Chicago School with the view that value is determined by money presents additional problems. The message of that view tells the teacher, the sanitation worker, the day care worker, and the soldier that they are less valuable than the CEO or the stock broker. That is not a message for a sustainable society.

Winston Churchill famously remarked “democracy is the worst form of government except all the others that have been tried.” We might say the same about market economies for many of the same reasons.

A totally democratic government would require everyone to read the provisions of the tax code and thousands of other laws and regulations in order to cast sensible votes. It would overwhelm all of us to even try to know enough to have opinions on the wording of our laws. We have instead attempted to structure our democratic aspirations to make them workable. We live in a representative democracy. Elected officials and their staffs have the responsibility to study the details of issues that are too complicated or too boring for most of us. We have a constitution that is designed to protect our liberties and freedoms. It separates the powers of the legislative, the executive, and the judicial branches of government to reduce the likelihood of tyrannies and establishes personal rights—such as the freedom of speech, trial by jury, and the right to vote—that cannot be taken away even by a political majority, except by constitutional amendments which require supermajorities. We reserve the ultimate power of our democracy to the voters; but we use structural political rules in our attempt to “create a more perfect union.”

Our market economy depends on the independent decisions of individuals: consumers, inventors, workers, manufacturers, and investors. They do not operate in a chaotic marketplace. We have rules about property and contract rights. We have safety and health standards for workers and for consumers. We have disclosure requirements to assist buyers and investors. We require down payments to transform bets into investments. We support these commercial

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relationships by private and governmental activities that help us interpret documents and actions that are too time consuming or too boring for us to understand by ourselves. Consumer reporting services help buyers choose more wisely from the many products that are available. Credit agencies help lenders select appropriate borrowers. Bond rating agencies help investors choose reliable investments. Government disclosure requirements help many of those private institutions gain the information they need to assist us in making choices. Government enforcement of contract rights and marketplace standards reinforces the legal structures that are designed to protect us. Ultimately, however, the legal rules and the private advice organizations are not sufficient if the society does not have cultural norms that support and reinforce formal rules of market behavior. Those formal rules must be based on cultural norms that are internalized so that enforcement and advice are supplements that control the exceptional behavior that defies accepted norms. The market works, but not by itself.

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Preface by Bert Foer, President, American Antitrust Institute

One of my memories as a law student at the University of Chicago is of hearing my First Amendment professor, the eminent Harry Kalven, introduce his friend the eminent Chicago sociologist Edward Shils, with the encomium that Shils had “one of the best furnished minds of our time.” I think of Ken Davidson, who did his undergraduate work at Chicago, as having an unusually well-furnished mind. Kalven would have found him to be good company. We are fortunate to have Ken on the AAI Advisory Board and our readers are familiar with his commentaries, drawing on something like 27 years of experience at the Federal Trade Commission. Ken’s breadth of reading is reflected in his recent book about the impact of the Chicago School, Reality Ignored, which carries the subtitle, How Milton Friedman and Chicago Economics Undermined American Institutions and Endangered the Global Economy. Ken has agreed to make excerpts of this fine book available to our readers. A little more background on our relationship may be in order. In the mid-1970’s, I was Assistant Director for Special Projects of the FTC’s Bureau of Competition. I hired Ken as my Deputy. He had been a professor at the University of Buffalo where he had written a book about tax law. He had little if any knowledge of antitrust, but he had an obviously quick mind, was extremely well-read, and asked penetrating questions. I figured that an Office of Special Projects would need creativity, quick minds, and the ability to deal with a wide variety of issues. (Later I hired another lawyer whose references told me he had a lot of ideas but only one out of ten was any good. How often do you find anyone who can generate any good ideas?) Ken did not disappoint. He mastered the law and economics of antitrust very quickly and helped us to take on subjects like strategic planning, capital markets, failing companies, conglomerate mergers, taxation, emerging markets, and international competition. (Little did we know that we were generating the seeds of what would later become the AAI.) Ken grew to love this field in which new questions must continually be asked. Long after I had fled the government (when Ronald Reagan was elected president), he stayed, taking on a variety of assignments usually involving planning or evaluation. Perhaps his most noted accomplishment was a first-time report on the effectiveness of remedies in merger caseswhere he documented many shortcomings. Ken retired in 20__, but as the book and his post-retirement work with the AAI demonstrates, he remains an active participant in the profession. From his arrival at the FTC, Ken was fascinated by the influence of the University of Chicago’s economics department and law school, which was just at that time beginning to make itself felt in the world of antitrust. As the subtitle of his book does more than suggest, he is a critic. Indeed, he is one of its most devastating critics. The excerpts that we reproduce with his permission include the book’s introduction in which he talks about the role of theory and the dangers it can represent in economics and public policy, and a chapter titled “Bork’s Imaginary Monopolization,” which with verve and insight traces the impact of Robert Bork, particularly on the campaign he led to reduce the liability of large businesses for the harms they can cause. Ken is particularly effective in dealing with the Borkean shredding of predatory pricing, in which a new theory based on the assumption of profit maximization has by now been accepted by the Supreme Court despite all the evidence to the contrary. Only Marx can really help us understand this, as when Groucho asked, “Are you going to believe what I tell you, or what your eyes tell you?” Even those who have spent substantial time with Matsushita and Brown & Williams will find Ken’s treatment enlightening.

kenneth m. davidson's reality ignored: how milton … ignored with... · kenneth m....

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