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Anti-Trust Implicit Collusion There is a common interest among

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					                                                   Anti-Trust



                 Implicit Collusion



        There is a common interest among sellers of the same goods to collude. As Adam Smith noted,
“People of the same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the public, or in some contrivance to raise prices.” 1 Adam
Smith was a fierce opponent of the then common, practice of governments to give groups charters that
would allow them to control entry into markets in which these favored groups participated. But, as
Smith observed, it is not always necessary for there to be any formal, legally enforceable agreements to
sustain cooperation amongst potential competitors as “ …even where they (members of the same trade)
have never been incorporated, yet the corporation spirit, jealousy of strangers, the aversion to take
apprentices, or to communicate the secrets of their trade, generally prevail in them, and often teach
them, by voluntary associations and agreements, to prevent that free competition which they cannot
prevent by bye-laws. The trades which employ but a small number of hands run most easily into such
combinations.”2



          In the United States, the formation of large firms through the merger of former competitors
was a hallmark of the Gilded Age. These merged firms were called trusts, since the newly formed firm
was created by the owners of various companies by irrevocably assigning to the trust the shares in their
own companies. In exchange, they received certificates issued by the trust. The board of directors of
the trust then acted as trustees for the owners who had assigned the trust their shares. As trustees, they
were obligated to exercise the shares they hold in the interest of the people who have entrusted their
shares to them. This allowed the trust to coordinate the activities of the combined firms so as to
‘rationalize’ production and extract monopoly profits.

          The trusts themselves tended to supplant pooling agreements among independent
competitors, since pooling agreements were illegal, and therefore suffered from the lack of
enforceability.3 While there is a common interest in firms to collude, it is in the interest of any member
to defect from an agreement, as long as the other members continue to collude, and as long as the
defector cannot be detected and punished. Without legal enforceability, pooling agreements required
members of the pool to trust the actions of one another. When that trust breaks down as the result of
one participant’s defection, so does the agreement. But this hurts all competitors. By contrast, if the
collusive agreement were legally enforceable, only the defector is subject to punishment. This is one
reason that mergers of competitors via trusts such as Standard Oil and United States Steel were superior

1
  Adam Smith, The Wealth of Nations, Book One, Chapter 10.
2
  Adam Smith, ibid.
3
 William Ripley, editor, Trusts, Pools and Corporations, Ginn & Company, Boston, 1905
to pooling agreements. Trusts and mergers which are viewed as anti-competitive are now illegal in the
United States.4 This, of course does not eliminate the incentive to collude. But it does place a bigger
burden upon the ability to trust one’s co-conspirators.



         ‘Facilitating practices‘

          Maintaining trust among cartel members typically involves the existence of a good system for
exchange of information. For example, a group of competitors may sign a pooling agreement in which
each member of the pool agrees to sell at a common posted price. If most of the buyers of goods
produced by cartel members are small, any deviation to private negotiation between buyer and seller is
not likely to have much of an impact on cartel profits. But, if there are a few large buyers, there is a
strong incentive to secret, private negotiations which will be harmful to the cartel. One way of deterring
secret agreements between buyers and sellers that violate the cartel’s pricing agreement is to write
contracts with ‘most favored nation’(MFC) clauses. An MFC clause requires a seller to offer the same
price to all buyers, thereby deterring a seller from deviating from a posted price policy. Similarly,
offering to meet or beat any competitor’s price, a “best-price” policy helps co-conspirators to deter one-
another from secret price cuts.

         Firms that produced tetraethyl lead as an antiknock additive to gasoline commonly used these
business practices. They posted prices and they wrote contracts with most favored nation clauses and
offers to meet the best price of competitors. Four companies dominated the production of tetraethyl
lead. The demand for this product grew until 1975 when all new cars were required to have catalytic
mufflers that would be damaged by leaded gasoline. This produced a dramatic drop in the demand for
leaded gasoline and a large increase in excess capacity of tetraethyl lead producers. In a competitive
market, this would have led to large reductions in the price of tetraethyl lead. But the industry, with
only four producers, was an oligopoly, not a competitive industry. Oligopolists could, in principle, resist
price declines without engaging in any illegal, anticompetitive practices and, in fact, prices did not fall.
Nevertheless, the Federal Trade Commission brought legal action against them.

        Because the FTC had no evidence of an actual conspiracy amongst tetraethyl lead producers, the
Commission’s case depended upon a determination that the business practices substantially eliminated
price competition that would otherwise have taken place. But they had to make this argument in the
absence of empirical evidence that these business practices actually make a difference in the price
charged for a commodity. The defendants argued that their business practices were common to many
businesses and were desired by customers. Furthermore, they argued, competition takes place along
several dimensions and there was substantial non-price competition. The conceptual argument that the
business practices identified by the FTC as being responsible for the absence of price competition was
4
 The Sherman anti-trust Act was passed in 1890. Its purpose was to make “Every contract, combination in the
form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with
foreign nations, is declared to be illegal." The Clayton Act (1914) prohibited various business practices that were
considered anti-competitive. It also prohibited mergers and acquisitions that would have the effect of
substantially lessening competition or tend to create a monopoly.
persuasive to an administrative law judge. However, an appellate court found that there was no
evidence that these practices actually had any effect on prices that could not be attributable to the
structure of the industry alone and found in favor of the defendants.

        Charles Plott, an economist at California Institute of Technology served as a consultant to the
FTC in the Ethyl Case. Stimulated by that case, he and his colleague, David Grether, designed an
experiment to test whether or not the disputed business practices had an effect on prices. They
designed a laboratory market whose structural features were scaled to match the tetraethyl lead
market. Subjects traded under different business practice conditions. When trade was conducted with
none of the facilitating conditions (no publication of prices, no advanced price announcements and no
most favored nation clauses) trades took place at prices that were above the competitive equilibrium
level. This reflects the influence of the oligopolistic market structure that was in place. However, these
prices were substantially lower than what was observed when all of the facilitating conditions were
operative. This experiment provided the first direct evidence that the combined use of public price
postings, advanced notice and most favored nation practices has a substantial effect on pricing, over
and above any effect of market structure.5

         Subsequent to the Ethyl Case several cases brought by private parties complaining of the anti-
competitive features of these facilitating business practices have been brought. The practice of public
posting of announcements of future price changes was challenged as anti-competitive in both the
wholesale gasoline market and in the U.S. airlines market. In these cases, consent decrees stopped the
practice of announcing future price increases that could be rescinded prior to taking effect, but set no
precedent.6 What was not stopped was the practice of announcing a price increase effective on the day
it was announced and then rescinding it shortly thereafter upon seeing that competitors did not follow
with their own price increase.7 Amalia Miller studied the effect of the FTC case on airline pricing. She
found that “Prices fell in response to the investigation but increased following the settlement, while the
number of tickets sold in affected markets declined. … The ATP case had at best a temporary effect on
airline collusion.”8




5
  David Grether and Charles Plott, The Effect of Market Practices in Oligopolistic Markets: An Experimental
Examination of the Ethyl Case, Economic Inquiry, 1984, pp. 479-507
6
  George Hay, Practices that Facilitate Cooperation: The Ethyl Case, in J Kwoka and L. White, eds. The Antitrust
Revolution: Economics, Competition and Policy,
http://www.oup.com/us/companion.websites/9780195322972/cases_author/?view=usa
7
  Severin Borenstein, Rapid Communication and Price Fixing: The Airline Tariff Publishing company
Casehttp://faculty.haas.berkeley.edu/borenste/download/ATPCASE1.PDF,
8
  Amalia R. Miller, Did the Airline Tariff Publishing Case Reduce Collusion?, Journal of Law and Economics , Vol. 53,
No. 3 (August 2010), pp. 569-586
           Identifying Defection

           A cartel will often wish to ‘divide the market’ among its members. But, buyers have an
incentive to seek bids from multiple sellers and there are random factors that influence demand in any
market. So, if each producer signs private contracts for delivery of its product, without additional
information a producer may not be able to verify that the price it is able to get in “its market” was not
influenced by competitors who were seeking contracts outside their own assigned territory. When
markets are divided by country, import-export statistics provide the kind of information needed to
monitor cartel member behavior. A cartel need not use assignment of specific geographic areas or of
specific customers to limit competition amongst its members. It can agree on restricting total output
through an allocation of the total output among all of its members. This type of agreement requires
monitoring of total production and/or sales of the individual cartel members. The gathering of such data
can be facilitated by a third party, such as an accounting or consulting firm, or by trade organizations. In
a review of sixteen European Commission anti-trust cases where the cartel used a market share
allocation, Marshall and Marx found that ten of the sixteen cartels used a third party facilitator. 9



           Restrictive Licensing: Effective Cartels



         Patents holders can increase their own monopoly profits by writing license agreements that
effectively restrict price completion among licensees. In addition, patents can be used as a device for
protecting licensees from possible competition from other firms that use different processes. This was a
strategy used by the Hartford Empire Company in the cartelization of the glass container making
business. The Hartford Empire Company held more than 700 patents on machinery used in the
manufacture of glass containers. While it did not manufacture its own machinery it retained title to the
machinery produced on its behalf. This machinery was then licensed to glass bottle makers. There was
only one other company, Owens-Illinois, which held patents on machinery for producing glass
containers. The patents held by Owens-Illinois were used in the only other economical process for mass
production of glass containers. Hartford and Owen-Illinois has a cross-license agreement. The licenses
issued by Hartford restricted the types of bottles the licensee could produce. The licensee paid a royalty
based on their volume of production. Hartford derived the vast majority of its revenues from these
royalties. It therefore had an interest in protecting its licensees from competition from other producers.
One way Hartford provided this protection was by adopting a policy of patenting products and processes
that it did not intend to license in order to prevent others from developing competing lines of
machinery. It called this, “fencing in the competition.” This policy was contrary to the purpose of the
patent law which is to promote the development of new processes.



9
    R. Marshall and L. Marx, The Economics of collusion: Cartels and Bidding Rings, MIT Press, 2012 p. 135
         Hartford did not simply attempt to block the development of competing machinery; it also
placed limitations in its licenses on the quantity of output that a particular licensee could produce of a
particular type of bottle. Furthermore, its policy was to limit the licensing of its equipment to producers
of a specific product so as to control the over-all production of that product, effectively cartelizing
production of the product. Below is a description of their policy.



        Exhibit No. 124

        [Paper from files of Hartford-Empire Company Reproduced at request of agent of Temporary National

        Economics Committee. A. T. Safford, Jr., Secretary.]

        (Written across face: for Mr. Safford.]

                   March 26. 1928.

        Memorandum as to Hartford-Fairmont and Hartford-Empire History and Policy




        …of restricted licensing. That is to say, (a) We licensed the machines only to selected manufacturers of the better type,

        refusing many licensees whom we thought would be price-cutters, and (b) We restricted their fields of manufacture, in each case, to
        certain specific articles, with the idea of preventing too much competition. (c) In order to retain more complete control of the
        situation, we retained title to the machines and simply leased them for a definite period of years, usually 8 or 10 years, with the
        privilege of renewal of a smaller additional term. (5) In specifying the various fields of ware for a given licensee, we have, with a few
        exceptions, based the classification upon the use of the article rather than shape or other physical characteristic. Glass containers
        have so many shapes that it is practically impossible to classify them by shape and very often numerous different shapes will be used
        for the same purpose, so that use of the container

        is the basis for our classification except in a few cases. (6) Quite early in our history we foresaw that the glass industry, like others,

        would doubtless go through a process of combination, which as a matter of fact has occurred. We felt it to be to our best interest, as
        well as for the best interest of the whole industry that we should use our influence to steady the industry as much as possible, with a
        long-distance view towards its general prosperity.




 Or, as Mr. Smith, of Hartford put it when asked about their policy of limiting use of their machinery and
imposing production limits in a market with more than one producer,



        “It is a question of their both living or both being prosperous, not getting at each

other's throats. We want to have them have steady business, steady employment, and we have found a lot of
memorandums where I talked about stabilization, that is what I mean, not great fluctuations in industry, where our
licensees can manufacture steadily, day by day and week by week and month by month and give employment to
                                                                                      10
labor on a steady basis.….In other words, to try to promote a healthy situation.”

        Not surprisingly, following the Hearing, the Anti-trust Division of the U.S. Department of Justice
brought an anti-trust suit against Hartford-Empire. As a result, Hartford was forced to license all of their
patents for modest royalties without restriction. Subsequently, there were numerous antitrust cases
brought where patents were found to play a role in monopolistic practices. The resolution of these suits
involved compulsory licensing of patents by the defendants.11



         What Kind of Behavior is Anti-competitive?

          The purpose of anti-trust legislation is to prevent anti-competitive behavior. It is not intended
to punish firms that secure a dominant market position through skill, the production of a superior
product, or simply by being first to market. Law suits brought against Microsoft for various antitrust
allegations reflect some issues that arise in the application of restraint of competition laws. Microsoft’s
Windows operating system has been widely adopted. Wide adoption of a computer operating system
makes it a very attractive base for the development of new software applications. Conversely, extensive
development of applications for a particular operating system enhance the value of the operating
system. So, Microsoft had an interest in expanding the applications that run on its Windows system. It
was natural, therefore, for Microsoft to not only produce operating systems but also to produce
software applications that could run on that system. Such activity would increase Microsoft’s
domination of the P.C. market. But, consumers would gain, not lose, by having a greater variety of
software applications. An important example of such applications is a web browser. Netscape was an
early, leading developer of a web browser. Its web browser, Netscape Navigator, could be used on a
Microsoft operating system as well as on other operating systems. Microsoft developed its own web
browser, Internet Explorer, to compete with Netscape. Microsoft integrated its web browser into its
Window operating system, effectively selling both as a single bundle. So, when someone bought a
computer with a Windows operating system they were getting Internet Explorer at no additional cost.
But, if they wanted to use Netscape’s browser, they would have to make a separate purchase. The U.S.
Department of Justice argued that because Netscape could be used on other operating systems,
Microsoft’s bundling of its own browser would marginalize Netscape and make operating systems that
competed with Windows less attractive. Under its theory, Microsoft’s integrating of applications with its
operating system was anti-competitive. 12



10
  Investigation of concentration of economic power. Hearings before the Temporary National Economic
Committee, Congress of the United States, Seventy-fifth Congress, third Session [-Seventy-sixth Congress, third
Session], pt.2, Patents at http://www.bpl.org/online/govdocs/temporary_national_economic_committee.htm
11
  See, F.M. Scherer, The Political Economy of Patent Policy Reform in the United States, Journal on Telecommunications and
High Technology Law, Vol 7, at http://www.jthtl.org/articles.php?volume=7

12
 Microsoft was subject to an earlier anti-trust action beginning in 1990. That action focused on
Microsoft’s licensing practices with Original Equipment Manufacturers (OEMs). That action led to a
         Microsoft’s defense was that its Internet Explorer was competing in the browser market and
that such competition was welfare enhancing because competition spurred innovation. Despite the fact
that at that time it had more than 80% of the operating system market, it denied that it had a monopoly
in the market for operating systems and that its market share could not be attributed to any predatory
or anti-competitive behavior on their part. Microsoft was not successful in its defense. In November,
2001 Microsoft settled its suit. It consented to making its operating systems interoperable with third
party software applications and to allowing users to designate default options for software, such as e-
mail, web browsing and media playing. These remedies were designed to reduce barriers to entry into
the applications market, barriers that Judge Jackson found to protect Microsoft’s monopoly in the PC
operating system market.



          There is a certain irony in Judge Jackson’s reasoning. It was in Microsoft’s interest to facilitate,
not restrict, development of applications for Windows. It recognized this by providing independent
software vendors (ISVs) various functions and services that make it easier for them to develop
applications that would run on windows. This was done free of any charge by Microsoft. This
subsidization of ISVs facilitated the creation of tens of thousands of applications that ran on Microsoft’s
operating system. The abundance of these applications was undoubtedly responsible for the dominance
of Microsoft’s near monopoly position in the PC operating system market. Furthermore, prior to
Microsoft’s development of its own browser, it was Netscape that had a monopoly position in the
market for browsers. That monopoly reduced the potential demand for P.Cs. So, Microsoft had a
material interest in creating a competitive product and selling it at a low price—even giving it away.
While this harmed Netscape, it was good for browser users.13

        In sum, the fact that a company has a very large share of a market does not mean that it has
done anything to inhibit competition. This is true in markets where consumers benefit from the
development of complementary products that enhance the attractiveness of the product produced by a
particular firm, Microsoft, happened to be the first to produce such a product. This gave it an inherent
advantage. It clearly exploited that advantage, in part, by bundling its browser. In a consent order, it
was required to make an unbundled version of its product available and interoperable with other



consent decree in which Microsoft was, among other things, prohibited from engaging in tied sales or
from restricting a licensed OEM from licensing, purchasing or using a non-Microsoft product. The
complaint with respect to Internet Explorer was that Microsoft’s requirement that OEMs that used its
operating system also provide its browser was a violation of this earlier consent decree. See, Richard
Gilbert, Networks, Standards, and the Use of Market Dominance: Microsoft, in J Kwoka and L. White,
eds. The Antitrust Revolution: Economics, Competition and Policy,
http://www.oup.com/us/companion.websites/9780195322972/cases_author/?view=usa
13
   For a discussion of the Microsoft case see, Nicholas Economides, The Microsoft Antitrust Case ,
http://www.stern.nyu.edu/networks/Microsoft_Antitrust.final.pdf
browsers. While many people now use foxfire by Mozilla as their browser this has done nothing to
diminish Microsoft’s position in the PC market.

        In 2001 Microsoft had a monopoly position in operating systems for personal computers. In
2011, the vast majority of P.Cs still run on Microsoft’s windows systems. But the world of personal
computing has changed enormously. Notebooks and tablet computers are used for many of the same
purposes as are P.C.s. Microsoft’s operating systems do not dominate these markets. Windows is a
minor player in mobile devices such as smart phones. Microsoft’s net worth is now less than Apple’s.
Almost surely, none of the changes in the world of personal computing are attributable to the antitrust
actions taken against Microsoft more than a decade ago.

        Are Technologically Based Monopolies ‘Good’?

           Microsoft’s experience reminds us that a monopoly position today does not guarantee a
monopoly position tomorrow. Competitors do not have to compete by producing what is currently
available. Today’s monopoly profits may spur technical innovations in related products that draw users
from the product that is produced by today’s dominant firm. This is what Schumpeter called the
“process of creative destruction”. Technological advances can provide the opportunity for an inventor
to secure a monopoly position. Schumpeter’s position is that the existence of such a monopoly would,
itself, spur on others to attempt to displace the monopolist and capture those monopoly profits, so that
any technologically based monopoly is likely to be both short-lived and lead to subsequent
improvements that benefit consumers. So, in the Schumpeterian view, a technologically based
monopoly ought not be subject to anti-trust action.

         Frederic Scherer reviewed several cases in which technological innovation led to the emergence
of a dominant firm with substantial market power. In reviewing these cases Scherer asked whether the
dominance of the firms was due to their unambiguous technological leadership and whether, having
secured a monopoly position, did the threat of losing it continue to spur on high levels of technological
innovation. Scherer found that in some cases firms secured a dominant position for reasons other than
their technological superiority, and in no case did the dominant firm preserve its dominance by
maintaining a high rate of introduction of technical advances. Below are short descriptions of Scherer’s
review.

        Standard Oil

        In defending itself against an anti-trust suit Standard Oil emphasized both its technological
innovations in refining and its superior business methods that gave it the economic advantages of
economies of scale. But Scherer found that the number of patents issued per year for petroleum refining
was much higher prior to 1870, when Standard started acquiring competitors than it was during its
period of market dominance. Once Standard Oil was broken up, the pace of patenting actually
increased. Furthermore, while an employee of Standard Oil of Indiana invented a process for obtaining
more gasoline from a barrel of oil, it was not put into use until after Standard Oil of Indiana became an
independent company.
        The Light Bulb Market

         Thomas Edison was a prolific inventor. But he was not the only inventor of incandescent bulbs.
So, Edison (and his successor firm, General Electric) secured their dominant position by acquiring the key
patents of others and by forming a cartel. While Europeans developed a superior metal lamp filament,
General Electric did not adopt metal filaments until its carbon filament patents expired. When they lost
patent protection on their carbon filament, competition from a superior product did spur them on to
make improvements in metal filament lamps by the addition of argon gas. The threat of competition
from technologically superior products did not break the dominance GE secured by cartelization of the
light bulb market.

        AT&T

        Two individuals, Alexander Graham Bell and Elisha Gray filed for patents on the telephone on
the same day. Gray assigned his patent to Western Union while Bell’s first and subsequent patents were
assigned to firms that eventually became AT&T. Despite the fact that a landline telephone network has
the properties of a natural monopoly, both firms entered into competition to establish telephone
networks. In 1879 Western Union agreed to leave the telephone market. In exchange, Bell agreed not
to compete in the telegraph market, to pay Western Union a portion of its license revenues for a period
of time and to buy out Western Union’s existing telephone network. The Bell companies subsequently
acquired controlling interest in Western Electric, a firm created to supply equipment to Western Union.
This blocked potential competitors from access to equipment that could be used to create a telephone
network. AT&T, the successor to the Bell companies, established long line service and denied
interconnectivity to rivals. When an anti-trust suit forced AT&T to allow interconnection, toll charges
were established that favored Bell affiliates. With a secure monopoly position AT&T was found to be
slow in deploying new technology. After World War II several firms applied for use of the electro-
magnetic spectrum for wireless relay systems. In the face of this potential threat AT&T did respond, as
Schumpeter suggested, and developed and deployed its own two-way radio relay system. But it also
responded by refusing interconnections and by aggressively staking claims to the most desirable relay
locations. It also petitioned the FCC to block access to much of the spectrum to common carriers.

        Xerox

         An independent physicist, Chester Carlson, developed the basic ideas behind xerography.
Without resources to commercially develop his ideas, Carlson’s patent was first assigned to Battelle
Institute which eventually transferred the patent to the Haloid company. Haloid, subsequently renamed
Xerox, introduced the first xerographic copier in 1959. The basic patents were to expire in 1976. Prior to
that date, Xerox agreed to give up their patents, rather than litigating an FTC anti-monopoly complaint.
Their CEO, Peter McColough, believed that they had a competitive edge with a viable brand recognition
and a sales force that would allow them to maintain their market dominance, even without patent
protection. But McColough had seriously underestimated the ability of the Japanese to produce a lower
cost, higher quality copier than Xerox was making. In the Xerox case, as in several of the others, it was
not the threat of losing a monopoly to a superior product that spurred innovation, it was the loss of
patent protection that was the spur to innovation.



        Concluding remarks



         Buyers would like to be in a market where there is active competition for their business. Sellers
would prefer a secure monopoly. One source of monopoly is a grant of monopoly by the government.
It was this source of monopoly that Adam Smith condemned. He was aware that sellers wish to collude,
but was confident that the powerful motivation of self-interest would frustrate their ability to do so. For
Smith, as long as government played no role in supporting monopolies, competition would prevail. Of
course, he was writing before the rise of corporate capitalism. He was also writing before the advent of
the industrial revolution and the importance of innovation in sustaining economic progress.

          The development of large corporations beginning after the Civil War gave rise to an economy in
which many markets were served by only a few large sellers. Oligopolists are acutely aware of how their
own policies affect the way their competitors behave. They have a strong interest in colluding and have
ways of coordinating their policies to their mutual benefit even in the absence of formal agreements. Of
course, if competing firms can develop and police formal agreements without detection by authorities,
they have been known to do this also. The goal of anti-trust policy is to frustrate the efforts of sellers to
collude. But the problem of distinguishing between business policies that are adopted in order to foster
collusion and policies that have more benign motivations is, in the absent of clear evidence of formal
agreements among competitors often frustrates officials charged with administering anti-trust policy.

         Technological innovations are the driving force of our economy. Patent policy recognizes the
importance of innovative activity for social welfare. It provides innovators with the opportunity to
secure monopoly positions. The practical question is whether such positions once secured are so
vulnerable to potential competition from other innovators, that the original innovators remain leaders
in a race for further improvements, or buttress their initial positions with anti-competitive trade
practices that provide no benefit to consumers. Scherer found that firms that were able to maintain a
dominant position did not do so by remaining leaders in innovative practices. Of course, firms that did
not maintain a dominant position, may well have lost them to other firms that were attracted by the
potential for securing extraordinary profits. So Scherer’s findings cannot be taken as a strong argument
against creating monopoly privileges through patent policy.

				
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