june 15, 2006: 1t. brennan, bundling three “mini” essays on bundling tim brennan professor,...

June 15, 2006: 1T. Brennan, Bundling

Three “mini” essays on bundling

Tim Brennan

Professor, Public Policy and Economics, UMBCSenior Fellow, Resources for the Future

2006: T.D. MacDonald Chair, Canadian Competition Bureau(relevant disclaimer applies)

Bureau of EconomicsFederal Trade Commission

Washington, DC

June 15, 2006


Outline

• “Essay 1”: Critiquing Nalebuff’s bundling model– Profits and consumer welfare increase in any equilibrium,

even with exit of non-bundler

– Would justify horizontal market allocation

– Exclusionary harm not in the model

• “Essay 2”: Bundling in the context of reframed monopolization– Monopolization includes not one category of acts, but two

– Some involve a “proximate good,” with bad affects from strategic reactions – e.g., predation, bundling (Microsoft, Nalebuff model)

– Others, however, involve a “proximate bad”: Complementary Market Monopolization (CMM)

– Exclusionary contracts, loyalty discounts in this category, NOT predation

• “Essay 3”: Applications, screens, standards, questions


Essay 1: Nalebuff summary

• Bundling literature previously ambiguous

– Price discrimination

– Correlations of demand across goods

• Nalebuff critique

– A monopoly over one good bundles it with another?

– Commendably clear, simple model

– No profit sacrifice

– Reduces profits of unbundled seller; may drive out of the market

• Unambiguous policy conclusions

– Strong finding of exclusion, entry deterrence

– Supports (fairly) strict anti-bundling policy

– Resolve the long standing problem of whether bundling is anticompetitive?


Nalebuff’s basic model

• A, B unbundled only AB bundle sold AB bundle, B sold

• Properties

– Monopoly price below 1, purchased by those with VA + VB > PAB

– With both sold, only B purchased by those with VB > PB, VA < PAB - PB

– Independent demands, uniformly distributed between 0, 1

PAB

VA

VB1

1

0

VA

VB1

1

0

VA

VB1

1

0PB PBPAB

PAB - PB

PABbuy A

buy B

buy A, B buy AB bundle buy AB bundle

buy B


Base case, worst equilibrium case (B exits)

• No bundling base case

– PA, PB = .5

– Consumer surplus = .25

– Total surplus = .75

• Bundler has monopoly (B exits)

– QAB = 1 – PAB2/2

– ΠAB = PABQAB = PAB[1 – PAB2/2]

– PAB* = ≈ .816

– ΠAB ≈ .544

• CSAB ≈ .275, greater than with no bundling

• Total surplus ≈ .819, greater than with no bundling


Bundling by A, B stays

• B’s response to PAB (simultaneous or sequential)

– QB = [PAB – PB][1 – PB]

– ΠB = PB[PAB – PB][1 – PB]

– PB =

– CSB =

• Effects of B on the bundler and its customers

– QAB = [1 – PAB] + PB

– ΠAB = PAB[1 – PAB] + PABPB

– PAB =

– CSAB =

BBABB P1PP

2

P-1

3

PP1P1 2ABABAB

4

1P

2

3

2

1P11

6

12

AB3

B

2

P- 1

2

P

2

1 BB


Two models if the non-bundler stays

• Simultaneous Bertrand pricing

– Solve simultaneously

– PAB =

– PB =

• Sequential pricing, bundler goes first

– Define PB as function of PAB as above

– Calculate A’s profit with B’s optimum reaction

– Numerical methods applied

2

P- 1

2

P

2

1 BB

3

PP1P1 2ABABAB


Bundling excludes because it’s competitive!

Setting A’s price A profit B price B profit Cons.

surplus Total

surplus

1) A, B sold by separate monopolists .5 (just A) .25 .5 .25 .25 .750

2) A sells bundle at 1, B stays at .5 1 .375 .5 .125 .208 .708

3) A sells bundle at 1, B optimizes 1 .278 .333 .148 .265 .691

4) A sets bundle price before B, knowing B stays

.68 .374 .265 .081 .424 .879

5) A sets bundle price where it does at least as well if B exits than if it stays

.408 .374 0 0 .603 .977

6) At the price in (5), B stays .408 .308 .179 .034 .623 .965

7) B leaves at maximum price leadership price in (4)

.68 .523 0 0 .372 .895

8) A bundles A and B, B stays, price set simultaneously (Bertrand)

.59 .366 .24 .064 .484 .914

9) A maximizes A-B bundle profit as monopolist, with no B

.816 .544 0 0 .275 .819

10) A sells A and B unbundled, B sells B, Bertrand competition

.5 (just A) .25 0 0 .625 .875

11) Both A and B bundle 0 0 0 (both) 0 1 1


Antitrust implications

• Implications for antitrust per se rules in US

– If bundling that excludes is bad, market allocation t must be good

– Contradicts US per se rule

– “Unduly” standard in S. 45?

• To elaborate: If the anti-bundling argument were correct …

– It would be desirable if an AB bundler and a B seller colluded to divide the market

– B pays A to stay in A and leave the monopoly to B

– Should market allocation be per se legal?

• Results here support aversion to market allocation

• Entry by one firm into another’s appears good


Summary: Results

• Consumer, total welfare increase with bundling in all equilibria

– Bundler as monopoly after exclusion

– Bundler as price leader

– Bertrand

– B loses, but bundler, consumers win

• Other effects could be greater

– Entry by A into B without bundling increases welfare more, but only if B would not have exited

– Mutual bundling drives prices in both markets to zero

• Important omissions

– Fixed costs of bundling spent; B’s fixed costs avoided

– Correlations of demand across products

– Results could be artifact, especially monopoly increasing welfare


Summary: Lessons

• Shortcoming of Nalebuff paper

– Intuition of proximate harm rests on non-equilibrium results

– Not necessarily robust result, but undercuts claim here

• Why does exclusionary conduct increase welfare?

– Bundling not short term predatory

– Bundling creates competition in previously monopolized B market

– Competition is exclusionary, too

• But model at hand supports bundling, unless goal to protect competitor

• Exclusionary effect not modeled


Are models of this type even relevant?

• Leading cases intermediate, not final product (more below)

• Intermediate good buyers are not proxies for end users

– They compete among one another

– Interdependent demands

– Another market to monopolize

• Prior economic analysis

– Katz, price discrimination can raise price to both

– Ordover and Panzar, optimal cost recovery prices uniform, positive even with 0 MC

• Political effect: Why regulators care about discrimination more than absolute price level

• Applies to (almost) all tying/bundling models, not just Nalebuff

• Which leads to …


Essay #2: Rethinking monopolization law

• Sherman §2 in U.S. law, S.79 in Canada, Article 82 in the E.U.

– Abuse of dominance

– Predatory pricing

– Foreclosure

– “Raising rivals’ costs”

– Exclusive dealing

– Tying/bundling/rebates/loyalty discounts

• Persistently controversial

– Market power presumably horizontal, not vertical

– Practices reduce demand for monopolist’s product

– Too much competition: Low prices, more products

– Does monopolization law protect competitors, not competition?


The fallacious Section 2 “rivalry” syllogism

• Premise 1: Section 2 cases about hurting rivals

• Premise 2: Because competition hurts rivals, the burden of proof in cases based on rival injury should be very high ()

• Conclusion: Section 2 cases bear a very high () burden

• “Chicago school” accepts both premises, conclusion

• Post-Chicago/populist activist school rejects Premise 2

– Reject conclusion

– Protect competition by protecting competitors?

– CA-US “Positive Comity Principles” (II.1) put “ability of persons to compete” ahead of “competition” under areas of potential harm

• Proposal: Instead, reject Premise 1, focus on new monopoly, not “dominant” firm “abusing” weak “rivals”


How: First, classifying business practices

Distant effects

Proximate effects Bad Good

Bad PBDB PBDG

Good PGDB PGDG


Examples

Proximate Effects

Distant effects

Bad Good

Bad

PBDB: Price fixing,

market allocation, horizontal mergers

PBDG: “Rule of reason,”

efficiency defenses, vertical

restraints

Good

PGDB:Predatory

pricing, bundling (Nalebuff), capacity

expansion, preemptive

patents

PGDG:Market generally, buyer-to-seller,

complement providers


Subdividing monopolization cases

Distant effects

Proximate effects Bad Good

Bad

PBDB: Exclusion, complementary

market monopolization via contract or rebate, regulatory evasion

PBDG: Vertical restraints without negative strategic effects,

efficiency defenses for

exclusion

Good

PGDB, as before:Predatory pricing,

bundling (Nalebuff), capacity

expansion, preemptive

patents

PGDG: Distant harms

unproven, failure to exclude or

recoup


Failure to distinguish, and its costs

• US: Treat PBDB like PGDB

– Cases far too difficult

– The fallacious syllogism

– Erroneous screens

• EU: Treat PGDB like PBDB

– Presumption of bad behavior even with proximate goods

– Dominance => abuse?

– Willingness to consider “efficiency offenses”

• Erroneous quest for the “holy grail” of a single monopolization standard


Complementary market monopolization (CMM)• Truism: To exclude rivals or raise BTE, must raise

complement prices

– => Acquiring market power over an complement

– “Exclusion,” “foreclosure” as tying up the market for the complement

• Barriers to entry raised outside the market, not within the market

• Typical examples

– Retailing

– Distribution

• Relevant market is the complement, not the upstream product

– Treat conduct as if merger, HMGs for market delineation

– Share of complement market controlled, e.g., via exclusionary contracts

– Is that market easy to enter?


CMM application issues

• CMM necessary and sufficient criterion for harm

– No power in complementary market, no ability to raise entry barriers

– “Price” increase not necessarily explicit if complement exclusively used by single firm

• Finesse (in part) market delineation for monopoly

– Cellophane fallacy, profits tests fail

– Problem still needs to be solved, but for regulation, not antitrust

• Vertical relevance (i.e., does the “standard” market matter?)

– Market delineation: Like using buyer information in a merger

– Derived demand: Are affected buyers a relevant market?

– Flesh out “unilateral” HMG story: Can X% firm raise input price?

– A small margin can create a huge competitive advantage


Essay 3: Applying CMM to bundling

• As noted, leading cases intermediate, not final product

– Concord Boat v. Brunswick (engine discounts to manufacturers)

– LePages v. 3M (discounts for carrying 3M’s house brand tape)

– Ortho Diagnostic Systems v. Abbott Laboratories (Abbott discounted virus screening tests but legal as above Ortho’s costs)

– SmithKline v. Eli Lilly (Lilly bundled antibiotics in sales to hospitals)

• State of U.S. law

– SmithKline won: Bundle price need not be below variable cost

– LePages won at divided Third Circuit Court of Appeal; Supreme Court denied review

– DOJ, FTC: Review would be “premature”; issues “novel and difficult”

– Dominant topic in antitrust debate—Gavil’s “compensated exclusion” cases


Canadian pioneering: Canada Pipe

• Allegations (from initial Bureau notice of application)

– Canada Pipe holds monopoly in relevant market in cast iron drain pipe

– Instituted “Stocking Distributor Program” provides rebates (up to 20%) for distributors who purchase exclusively from Canada Pipe

– Equivalent to exclusive dealing, forecloses distribution

• Lost at trial (from Tribunal decision)

– SDP exclusive, but with no anticompetitive effects; not “predatory, exclusionary, or disciplinary”

– Found some entry from imports and a new manufacturer

– No switching costs; SDP not contractual, distributors could leave at any time

• Currently under appeal


Viewpoints on bundled rebates

• Is the relevant test a predation-based standard?

– Does discount lead to pricing below cost?

– Does/would it exclude equally efficient competitor?

• Greenlee, Reitman, Sibley

– Bundling tying or exclusion, not predatory pricing (contra Tirole)

– Extract surplus from A through supra-competitive pricing of B

– Welfare can go up or down

• Test not against cost, but whether A firm bundling B raises stand-alone price of A.

– SmithKline decided correctly, but wrong reason

– Nalebuff’s model contradicts test; welfare and stand-alone A price both rise

• But these models apply to end users, not complement markets


Other recent viewpoints

• Carlton: Fundamental issue is nonlinear pricing

– Relevant test is price discrimination (good) vs. exclusion (bad)

– Requires strategic interaction

– Incremental price of bundle above MC of bundled good

• Ordover: Bundling problem essentially predatory

– Strategic bundling hard to model

– Requires contracting, capital market imperfections

• Warren-Boulton: Loyalty discounts collusive, not exclusionary

– Loyalty discounts efficient, allow volume discounts independent of size of buyer

– But also collusive, commit to sell X% to buyers

– Entrant may prefer to take 100- X% at monopoly price


Elhauge’s monopolization test

• Does a practice by a monopolist discriminate against rivals?

• Allows refusals to deal if uniform, but not targeted

• Fundamental flaw: Does it work when most needed?

– Some inputs are bought only by rivals

– Network elements, operations support in telecom markets

– Bridge access in Terminal Railroad

• Either no discrimination, since only rivals are buyers

• Or discrimination an almost certain byproduct of vertical integration, making VI by a monopolist abusive per se

• Also, is price discrimination OK? (Carlton, IIOC)


Bundle discounts via CMM: A first screen

• Issue fundamentally static upstream monopolization

– Not tying for rent extraction (Nalebuff, Sibley et al.),

– Nor commitment (Whinston)

• Intermediate good focus

• First screen: Whether bundling ties up complement market

– Necessary and sufficient condition

– MEGs approach to market definition, informed by “buyer” market

• Examples

– Outlets needed to sell unbranded tape

– Distributors of false teeth to denture labs

– Distributors of cast-iron drain pipe


Second tentative screen

• Resemblance to exclusive dealing

– Penalties for breach of exclusive dealing = Lost variable profits

– Is loss of discount equivalent to breach payment?

– Lost variable profits as breach penalty => SRMC as price test

• Is exclusive dealing breach the right quantitative standard?

– How much does the rebate raise the price of distribution to an entrant?

– For intermediate goods, a small but unavoidable price increase can create great competitive disadvantage


Cost-based tests: “Exclusive dealing” unpacked• How much does exclusive dealing raise complement price?

– Exclusive contracts not absolute

– Willingness to cover cost of breach

• I incumbent, E entrant, R a retailer

• PE, PI retail prices; WE, WI wholesale prices

• R carries E’s product if

– Without exclusion: PE – WE PI – WI

– With exclusion: PE – WE PI – WI + B, where B is breach penalty

• “Efficient” breach penalty is foregone variable profits

• B = WI – CI, where CI is the incumbent’s short run marginal cost


Implications for evaluating exclusion, rebates• Implies that retailer will carry product only if

– PE – WE PI – WI + [WI – CI]

– PE – WE PI – CI

• Exclusive contracts force entrant to compete against incumbent’s short-run marginal cost, not wholesale price

• Why is this bad?

– With upstream market power (and maybe without), WE CI

– Courts may find that SRMC off the margin is very low (see also “critical loss” analysis and debate)

– Less efficient competitors could knock down price

– Aside: For a different viewpoint, see “efficient component pricing” models (Baumol and Sidak) and critiques (Economides and White)


Observations on remedies

• Issue: Has the practice raised the effective price of obtaining distribution?

– The practice itself is not good or bad per se

– True of exclusive dealing, loyalty rebates, bundling …

• Hence, ideal remedy should be not “up or down”, but share based

– OK to exclude, but only if one does not go beyond X% of the relevant complement market (distribution, retailers)

• Effective remedies assume competition in relevant CM

– Prior retail, distribution monopoly a defense

– If monopoly upstream, vertical control stops double marginalization

• Can an upstream monopolist leave money on the table?


Irrelevant screen 1: Profit sacrifice

• Exclusion via bundling isn’t predation

– Anticompetitive effect is to raise effective price of complements

• Sorting: Any investment has short-run opportunity cost

• Why give primacy to welfare of perpetrator?

– If complement market monopolized, why does price paid matter?

• Gives wrong answer in regulatory evasion network cases (Trinko)

• Unsupported by economic theory

– “Free” innovations can reduce welfare

– Innovations profitably only upon exit can increase welfare

• Screen not applied to collusion, mergers—or Dentsply!

• Produces absolute efficiency defense

– Or intent standard; see “four economists” Trinko brief


Irrelevant screen 2: Prior dominance

• Focus is on the wrong market

– Dominance neither sufficient (EU) nor necessary (US)

• Inherent contradiction in litigation

– To establish prior monopoly, show high barriers, etc.

– But if entry that hard, does practice at issue matter?

– US v. Microsoft as example

• Dominance as defense, not condition of guilt

– Large size in one market suggests large involvement in complements, e.g., share of distribution with exclusive contracts

– If dominant already, what is the harm from the conduct?

– Posner’s fragile monopoly


Lessons for bundle discount, rebate cases

• Essay 1: Nalebuff

– Bundling increases economic welfare

– Prohibiting bundling sanctions market allocation agreements

• Essay 2: CMM alternative

– Monopolization cases should be, but are not, divided into two categories, based on whether the initial practice is good or bad

– Bundling cases should be about intermediate, not final, products

– Bundle rebates are not like predation, but equivalent to (wide scale) merger in complementary market (e.g., retailers, distributors)

• Essay 3: CMM applications

– See if bundle takes “monopoly” share of complement market

– Use cost-based tests if the standard for exclusion needs to be the explicit contract – and it probably shouldn’t

– Avoid profit sacrifice, prior dominance screens

june 15, 2006: 1t. brennan, bundling three “mini” essays on bundling tim brennan professor,...

Documents

b leaves

effects of b

b optimizes1

b bundle profit

b soldpropertiesmonopoly

monopoly b exitsqab

b unbundledonly ab bundle

b staysbs response