Antitrust Law, Second Edition

Index

PREFACE

The first edition of this book, published a quarter of a century ago, bore the subtitle An Economic Perspective, implying there were other perspectives. The implication was spelled out in the preface, where I announced that the purpose of the book was to expound and defend the economic approach to antitrust law. In the intervening years, the other perspectives have largely fallen away,¹ a change that I have marked by dropping the subtitle from this new edition. Michael Jacobs, it is true, argues that the populist political views that once were influential in antitrust haven't really disappeared, rather that they undergird the postChicago antitrust economics that he argues has challenged the hegemony of the Chicago School.² He says that, at bottom, the debate between Chicago and post-Chicago economists implicates contending articles of political faith.³ I disagree. Jacobs's Manichaean view is based on extreme versions of the contending positions concerning the robustness of free markets, and also on a confusion of motive and theory. Political values, temperament, and a host of other non analytical factors influence a choice of theoretical positions, but it doesn't follow that the theories themselves have a political character. As Jacobs acknowledges, the disputants are in complete agreement…that considerations of allocative efficiency alone should guide antitrust policy. Their debate centers on the answers to subsidiary questions regarding the best means of attaining that agreed-upon end.⁴ Questions of instrumental rationality can usually be resolved without delving into underlying political or personal motivations.⁵

There is still a need to explain the economic approach to new generations of lawyers and students, to update the approach in light of theoretical advances since the mid-1970s, and to apply it to the new issues of antitrust law that have emerged in the last quarter century. Nevertheless, the jeremiad of 1976 is here replaced by the story of a profound, a revolutionary, change in law. Much of antitrust law in 1976 was an intellectual disgrace. Today, antitrust law is a body of economically rational principles largely though not entirely congruent with the principles set forth in the first edition. The chief worry at present is not doctrine or direction, but implementation.

In the preface to the first edition, I wrote:

During the period in which these articles [on which the book was based] were appearing, the antitrust laws were achieving a level of prominence in public discussion such as they had not known since the days of Thurman Arnold in the early 1940s. The ITT scandal, the filing by the Justice Department of well-publicized actions designed to break up IBM and AT&T, the explosion of private antitrust actions exemplified by the judgment (later reversed) of almost $300 million that Telex obtained against IBM, the growing tendency to attribute economic problems—recession, inflation, high gasoline prices, or whatever—to the conspiratorial machinations of Big Business, and the recent amendment to the Sherman Act making violation of the act a felony punishable by up to three years imprisonment and (in the case of corporate defendants) a $1 million fine—all have served to rivet the nation's attention on antitrust policy. But more than notoriety is involved. The reach of antitrust policy has broadened and its thrust has deepened, and in the process confusion about both its aims and methods has grown. The conventional tools of antitrust analysis have not stood up well under the pressures of rapid expansion of the role and importance of antitrust enforcement.

No sensible person would write so ominously about antitrust enforcement today. Antitrust has to a great extent been normalized, domesticated. Its political, its ideological, character has receded in tandem with growing agreement on its premises.⁶ This trend was visible by the end of the decade of the seventies,⁷ though not to everyone,⁸ even much later.⁹ Almost everyone professionally involved in antitrust today—whether as litigator, prosecutor, judge, academic, or informed observer—not only agrees that the only goal of the antitrust laws should be to promote economic welfare, but also agrees on the essential tenets of economic theory that should be used to determine the consistency of specific business practices with that goal. Agrees, that is, that economic welfare should be understood in terms of the economist's concept of efficiency; that business firms should be assumed to be rational profit maximizers, so that the issue in evaluating the antitrust significance of a particular business practice should be whether it is a means by which a rational profit maximizer can increase its profits at the expense of efficiency;¹⁰ and that the design of antitrust rules should take into account the costs and benefits of individualized assessment of challenged practices relative to the costs and benefits of rule-of-thumb prohibitions, notably the per se rules of antitrust illegality.

Even with the degree of consensus just described, there is much room for debate over specific practices, cases, and rules. And much ground for concern with such practical, and, in the academic literature, often neglected aspects of antitrust enforcement as the role of the jury, the broader issue (which subsumes the question of the jury's role) of the importance of expertise in minimizing errors in antitrust adjudication, the need to balance expedition against due process, and the daunting challenge of designing antitrust remedies that are effective without being anticompetitive. There are still pessimists who believe that when the actual administration of antitrust is taken into account, the debits outweigh the credits and we would do well to curtail antitrust enforcement drastically or even to repeal the antitrust laws altogether.¹¹ These proposals are academic. The antitrust laws are here to stay, and the practical question is how to administer them better—more rationally, more accurately, more expeditiously, more efficiently.

But I also find the proposals unconvincing. They are based primarily on disagreement with appellate decisions in a selective sample of antitrust cases; and civil cases that get as far as an appeal are disproportionately toss-ups, because one-sided cases rarely get that far. Therefore a legal regime that effectively deters antisocial conduct will nevertheless generate a fringe of dubious applications of its doctrines, furnishing much fodder for critics. If, moreover, antitrust law has almost since its beginning been much influenced by economics, and economics is an improving discipline, we should expect studies that are based primarily on old cases, as the studies on which proposals to repeal or severely truncate antitrust law mainly are,¹² to give a misleading picture of the present and likely future performance of the field. It would be like depreciating modern biology because of the mistakes made by Aristotle. Much of this book is devoted to criticism of the old (some not so old) cases, partly to try to head off the recurrence of the errors made in them but partly also to show how far the law has progressed toward economic rationality.

I thank David Bird, Daniel Davis, Bryan Dayton, Schan Duff, Ethan Fenn, Peter Gey, Boris Kasten, Ryan Meyers, and Matthew Stevens for their helpful research assistance; Kenneth Dam, Harold Demsetz, William Landes, Bernard Meltzer, George Priest, and the late Donald Turner for their comments on portions of the manuscript of the first edition; and Michael Boudin, Dennis Carlton, David Friedman, Edward Morrison, and John Tryneski for their extremely helpful suggestions regarding the present edition. Portions of chapters 8 and 10 have been published previously as Antitrust in the New Economy, 68 Antitrust Law Journal 925 (2001); © 2001 The American Bar Association, all rights reserved, reprinted by permission. I thank Dennis Carlton, Larry Downes, and William Landes, as well as participants in sessions at which an earlier version of that article was presented, for their helpful comments on it. My ideas on antitrust continue to bear the stamp of Aaron Director and the late George Stigler, and it is a pleasure as well as a duty to acknowledge once again my profound intellectual debts to both those great economists.

1. See Michael S. Jacobs, An Essay on the Normative Foundations of Antitrust Economics, 74 North Carolina Law Review 219, 236-40 (1995).

2. Id. at 259-66.

3. Id. at 259.

4. Id. See also David A. Balto, Antitrust Enforcement in the Clinton Administration, 9 Cornell Journal of Law and Public Policy 61 (1999).

5. I do, however, discuss the populist approach to antitrust briefly in chapter 1, as it may have some influence with judges who are only nominally committed to the economic approach.

6. For a good discussion of this trend in regard to policy toward mergers, see George A. Hay and Gregory J. Werden, Horizontal Mergers: Law, Policy, and Economics, 83 American Economic Review Papers and Proceedings 173 (May 1993).

7. See Richard A. Posner, The Chicago School of Antitrust Analysis, 127 University of Pennsylvania Law Review 925 (1979).

8. There is nothing quite so compelling as an idea whose time is passing…. [I]ts publication [the publication of the first edition of this book] comes at a time when the limits of traditional microeconomics as a tool of antitrust policy have become starkly apparent, limitations which suggest that antitrust law should be moving outside the economist's world rather than burrowing more deeply into it, Harry First, Book Review, 52 New York University Law Review 947 (1977).

9. See Louis Kaplow, Antitrust, Law and Economics, and the Courts, Law and Contemporary Problems, Autumn 1987, pp. 181, 184-91. On the incomplete, but nevertheless substantial, convergence of antitrust policy with the position taken in the first edition of this book (indeed, taken five years earlier in my article A Program for the Antitrust Division, 38 University of Chicago Law Review 500 [1971]), see John E. Lopatka and William H. Page, Posner's Program for the Antitrust Division: A Twenty-Five Year Perspective, 48 SMU Law Review 1713 (1995).

10. This is the essential holding of Matsushita Electric Industrial Co. v. Zenith Radio Corp., 475 U.S. 574 (1986), one of many cases confirming the judicial commitment to the economic approach to antitrust.

11. For different shadings of pessimism, see Robert H. Bork, The Antitrust Paradox: A Policy at War with Itself (2d ed. 1993); Dominick T. Armentano, Antitrust and Monopoly: Anatomy of a Policy Failure (1982); The Causes and Consequences of Antitrust: The Public-Choice Perspective (Fred S. McChesney and William F. Shughart II eds., 1995); Thomas J. DiLorenzo, The Origins of Antitrust: An Interest-Group Perspective, in The Rise of Big Business and the Beginnings of Antitrust and Railroad Regulation 1870-1900, vol. 1, p. 63 (Robert F. Himmelberg ed., 1994). See also B. Espen Eckbo, Mergers and the Value of Antitrust Deterrence, 47 Journal of Finance 1005 (1992).

12. See, e.g., the studies usefully summarized in Paul H. Rubin, What Do Economists Think about Antitrust?: A Random Walk down Pennsylvania Avenue, in The Causes and Consequences of Antitrust, note 11 above, at 33. All the studies discussed by Rubin are of cases brought before 1980, and none was decided after 1984.

INTRODUCTION

Like all antitrust cases,

this one must make economic sense.

United States v. Syufy Enterprises

To the layperson a law is a rule written down in a book somewhere. The lawyer realizes that the matter is often a good deal more complicated. There are federal antitrust statutes, and they are brief and readable compared to the Internal Revenue Code. But their operative terms—restraint of trade, substantially to lessen competition, monopolize—are opaque; and the congressional debates and reports that preceded their enactment, and other relevant historical materials, cast only a dim light on the intended meaning of the key terms. The courts have spent many years interpreting, or perhaps more accurately supplying, that meaning. But the course of judicial interpretation has not always run true. And the rules of law as they are articulated and as they are applied to alter behavior are often and in this instance two different things. The result of the common-law (that is, judge-made) character of antitrust law, despite its statutory foundations, and of the practical complications of its enforcement, is a considerable fluidity in the meaning and application of the law, and uncertainty about its effects.

One thing that has long been clear, however, is that antitrust deals with what are at root economic phenomena. The basic phenomenon is that of monopoly or monopolizing, broadly defined to include collusion between competing firms aimed at jacking up the market price above the competitive level, and also practices, such as certain mergers, that create a danger rather than a certainty of monopoly. Monopoly has long engaged the intense interest of economists. There is now a consensus among them concerning the essentials of monopoly theory, and this consensus provides a surer lodestar of antitrust enforcement than the language or background of the statutes themselves or the doctrinal twists and turns that have marked judicial interpretation and application of the statutes.

I devote the first chapter to the exposition of the consensus view. I argue that economic theory provides a solid basis for the belief that monopoly pricing, which results when firms create an artificial scarcity of their product and thereby drive price above its level under competition, is presumptively inefficient in the sense most commonly used by economists in discussing issues of monopoly and competition (the Kaldor-Hicks, or potential Pareto, sense of efficiency). Since efficiency is an important social value, this conclusion establishes a prima facie case for having an antitrust policy. It also implies the limitations of that policy: to the extent that efficiency is the goal of antitrust enforcement, there is no justification for carrying enforcement into areas where competition is less efficient than monopoly because the costs of monopoly pricing are outweighed by the economies of centralizing production in one or a very few firms.¹ That is why I referred to monopoly pricing as presumptively inefficient and as creating merely a prima facie case for having an antitrust policy. Nor is there any justification for using the antitrust laws to attain goals unrelated or antithetical to efficiency, such as promoting a society of small tradespeople, a goal that whatever its intrinsic (and very dubious) merit cannot be attained within the framework of antitrust principles and procedures. The small businessman usually is helped rather than hurt by monopoly, so unless the antitrust laws are stood completely on their head they are an inapt vehicle (compared for example to tax breaks) for assisting small business. Or, as I shall also argue, for promoting a more equal distribution of income or wealth.

Having established that the only goal of antitrust law should be to promote efficiency in the economic sense, I next proceed to develop the implications for the law of adopting this goal. My focus is on price-fixing agreements among competing firms and the related problem of oligopoly pricing (or, the term I prefer, tacit collusion) because these appear to be the principal nongovernmental sources of monopolistic pricing, and on mergers that increase the likelihood and efficacy of price fixing whether tacit or explicit. After a brief overview of the antitrust laws in chapter 2, designed to orient the general reader to the remaining chapters, I argue in chapter 3 (the first of the four chapters in part 2 devoted to the problem of collusion, broadly conceived to include mergers that may aggravate the problem) that the best way to prevent collusion is to focus the enforcement of section 1 of the Sherman Act not on the fact of a conspiracy or attempt to fix prices, in the criminal-law sense of these terms, but rather on a quest for evidence, economic in character, of collusive price behavior. Whether there is a conspiracy in the conventional sense of an agreement hashed out in secret hotel meetings or clandestine phone conversations or reflected in elaborate bid-rotation schemes is less important than whether the market price has been jacked above the competitive level by collusion, which may be undetectable by the traditional and very crude tests derived from experience with ordinary criminal conspiracies—which may in fact be purely tacit. There may be no overt communications, negotiations, or express agreements among the colluding firms, though they may signal to each other in various indirect ways and thereby achieve a meeting of the minds. I indicate the kinds of economic evidence that can be used both to identify markets prone to collusion and to demonstrate the existence of collusion in those markets.

The remaining chapters of part 2 show how the inability of the courts and the enforcement agencies to determine the existence of collusive pricing directly has led to all sorts of indirect approaches, most of them deeply flawed in either conception or execution, such as the proposals (now thankfully in abeyance) to break up firms in oligopolistic markets, the too-stringent restrictions on mergers between competitors and with potential competitors, and the awkward (though improving) handling of the problems of restricted distribution and of exchanges of information among competitors. Chapters 4 and 5 discuss two methods of dealing with price fixing, and especially oligopoly pricing, that appeal to people who unlike myself despair of dealing directly with the problem of collusive pricing. The first is the dismemberment of the leading firms in oligopolistic industries. I argue that even if there were no other way of dealing with tacit collusion, dismemberment would be a bad solution; experience with divestiture in merger and monopolization cases suggests that dismemberment would be a futile remedy, unlikely to have the intended effect of restoring competition, and, if not futile, prohibitively costly both directly and in the perverse incentives that it would create. Chapter 5 examines the major Supreme Court cases that have attempted to prevent the emergence of conditions that favor collusion by forbidding mergers between competing or potentially competing firms. Again I emphasize the importance of economic evidence, but I also propose that the judicially created doctrine of potential competition be discarded as a basis for invalidating mergers, though notions of potential competition cannot and should not be completely banished from antitrust analysis. Because market shares so often determine the outcome of a merger case (and of many other types of antitrust case as well), this chapter also examines the crucial step in antitrust litigation of determining which sellers shall be included in and which excluded from the market.

Chapter 6 examines, with respect to exchanges of price information among competing sellers and to resale price maintenance and other restrictions on the distribution of goods, the problem of locating the boundary between collusive practices that should be forbidden and apparently similar practices that should be permitted, and the Supreme Court's often deficient solutions. My conclusion is that the exchange of price information among competitors should be permitted unless they are expressly or tacitly fixing prices and that resale price maintenance, along with the other restrictions that sellers impose on competition among their distributors, should be considered presumptively lawful rather than, as is the present rule with regard to resale price maintenance, per se unlawful.

Part 3 shifts focus to exclusionary practices. There is an important distinction, both in economics and in law, between practices by which competing firms agree not to compete with each other and practices by which a firm or group of firms seeks to obtain or maintain a monopoly by intimidating, destroying, deterring, or otherwise excluding competitors or potential competitors from the market. The economic theory of monopoly was developed to explain practices of the first sort and until recently had relatively little to say about practices of the second sort. This led some economists and lawyers identified with the Chicago School to the view that there was no economic basis for concern with the exclusionary practices—perhaps they did not exist at all, and, if they did, they were so rare as not to be worth worrying about. In my opinion, one that I expressed in the first edition of this book (despite my own identification then and now with the Chicago School), this view is overstated. There is an economic basis for concern with at least some exclusionary practices, in at least some circumstances; and a few practices that are not exclusionary (though so classified in the law), like persistent price discrimination, may still be undesirable on strictly economic grounds. Chapter 7 attempts to develop a set of practical rules, grounded in economic analysis, that will enable courts to deal with the alleged exclusionary practices, including tie-in agreements, vertical integration, exclusive dealing, and boycotts. Chapter 8 applies those rules to the new economy (consisting primarily of computer-software, Internet-related, and telecommunications firms), where there is renewed concern with exclusionary practices.

Chapter 9, the first of the two chapters (constituting part 4 of the book) dealing expressly with the administration of antitrust law, asks how the antitrust statutes, and the major judicial doctrines based often loosely on them, can be tidied up both to eliminate the remaining inconsistencies and redundancies in existing antitrust doctrine and to conform to the specific proposals advanced in earlier chapters. Finally, in chapter 10 I turn to the vexing question of the practical enforcement of the antitrust laws. Here I consider such issues as the overlap in enforcement responsibilities among the Department of Justice, the Federal Trade Commission, state attorneys general, and private plaintiffs; the role of criminal penalties in the enforcement of the antitrust laws; and the role of equitable remedies, including divestiture, in the overall scheme of antitrust enforcement.

Such is the book in brief. Readers familiar with the first edition will recognize the basic structure and point of view while noticing many changes in detail and much new material reflecting the new case law and economic thinking of the past quarter century, as well as the change in tone explained in the preface.

1. It might be possible to have one's cake and eat it by limiting the price charged by the efficient monopolist. That is the premise of public utility regulation, but, as I believe all competent students of antitrust agree, it is not a feasible project for antitrust law.

PART ONE

SETTING THE STAGE

ONE

The Costs—and Occasionally the Benefits—of Monopoly

Economic analysis offers reasons—some firmly rooted in economic theory, some more conjectural—why monopoly reduces economic efficiency in some (not all) circumstances. My primary purpose in this chapter is to explain the theory of monopoly in terms comprehensible to readers who have no previous knowledge of economics yet I hope not wholly uninteresting to those possessed of such knowledge, and to develop the relevance of the theory to antitrust policy. My secondary purpose is to argue that the economic theory of monopoly provides the only sound basis for antitrust policy.

A monopolist is a seller (or group of sellers acting like a single seller) who can change the price at which his product will sell in the market by changing the quantity that he sells. Concretely, by reducing his output he can raise his price above the cost of supplying the market, which is the price level that competition would bring about, the competitive price. This power over price, the essence of the economic concept of monopoly, derives from the fact that market price is inverse to quantity. Some people will value the product more than other people do, so if supply is curtailed they will bid the price up to make sure they get it. Conversely, as supply is increased, the price must fall to induce people who value the product less to buy it. The seller who controls the supply of a product can therefore raise his price by restricting the amount supplied.

It is true that even in a highly competitive market, with many sellers selling the identical product, each would have some power over price; for if any seller reduced his output, the total output of the market would be smaller, at least temporarily, and the market price would therefore rise at least temporarily. But when a seller produces only a small fraction of the market's total output, the change in total output brought about by a fractional reduction in his output is unlikely to be great enough to affect the market price significantly; his power over price is slight and can be ignored. It is slight for a deeper reason. The smaller his output is in relation to that of the remaining sellers in the market, the likelier it is that any cut in his output will be promptly offset by an increase in the output of the other sellers, each of whom would need to increase his output only slightly in order to restore the market's total output to its level before the first seller's reduction. The incentive of the other sellers to increase their output comes from the fact that any increase in the market price over a seller's costs¹ will open up a gap between price and cost that every seller will have an incentive to exploit by increasing his output, since until the gap is closed each additional unit sold will yield a supracompetitive return.

The sole seller of a product, a monopolist, need not worry, or at least need not worry as much, that if he raises his price above what a normal competitive price would be—that is, a price that would just cover his cost, including a profit just sufficient to attract the capital that he needs—the other sellers of the product will expand their output of the product and so drive the price back down. There are no other sellers. True, the higher price will give firms in other markets an incentive to enter this one in order to reap the monopoly profits available there. But presumably entry into the market will take time, so that unless the formation of the monopoly was anticipated well in advance the monopolist will enjoy a significant though not necessarily a permanent power over price.

It remains to be considered why and how he will exercise that power. We may assume that every firm wants to maximize its profits—the excess of its total revenue over its total cost. That is a close enough approximation to the truth to provide a generally adequate guide to antitrust policy, although we shall have to consider qualifying it when we discuss nonprofit firms in chapter 3.

Suppose that just before the market became monopolized, the market price was equal to the cost of making and selling the product in question. (Cost to the economist is a comprehensive concept and thus includes, as I have already indicated, a reasonable return on equity capital, which is the return necessary to attract the equity capital that the firm needs.) In that event the market price will be the competitive price. If the monopolist reduces his output below the competitive level, the market price will rise. How will his costs and revenues, and hence profits, be affected? His total cost will be lower since he will be producing less, while his revenue—price times output—will be higher or lower at the new price and output depending on whether the proportional increase in price is greater or less than the proportional reduction in output. Clearly, if the price increase is proportionately greater than the reduction in units sold, the price increase will be profitable to the firm. Its total revenue will be higher, while its total cost will be lower since it will be producing less, and so the difference between its revenue and cost—its profit—will be greater than at the competitive price.

The statement that the monopolist's cost will be lower because he will be producing less assumes that his total cost varies with his output; if it does not, a reduction in output will not reduce his cost. The cost of production generally involves both costs that are fixed in relation to output—such as the cost of buying a corporate charter, which is invariant to the corporation's output, or the cost of producing a software product, which is invariant to the number of copies of the product that are sold—and variable costs, which are costs that vary with output. Only variable costs are affected by a firm's decision on how much to produce of a given product. More precisely, in deciding whether to increase or reduce output by one unit, a firm will consider the effect of the decision on its marginal cost, that is, the effect on its total costs of a small change in output. It would not make sense to base a change in output on a cost that was unaffected by the change.

The monopolist will never be content to charge a price at which the demand for his product is inelastic, that is, a price at which the proportional reduction in the quantity demanded as a result of raising price slightly would be less than the proportional increase in price. Suppose the demand for the firm's product at a price of $5 is 1,000 units but at a price of $5.05 would be 999 units. Then demand is inelastic at an output of 1,000 units because a 1 percent increase in the price would bring about a proportionately smaller decrease in quantity demanded (one-tenth of 1 percent), with the result that the higher price would yield the monopolist a larger total revenue—$5,044.95 compared to $5,000. And since output would be less, his total costs would be no greater, and so the price increase would have to be profitable.

This analysis indicates that the monopolist will increase his price to at least the level at which a further price increase would cause a proportionately greater reduction in the quantity demanded. For until that point is reached, every successive price increase will raise total revenue while reducing total cost (or leaving it unchanged, in the extreme case in which all costs are fixed). In other words, the monopolist will always operate in the elastic portion of his demand curve. He may raise his price beyond the level at which demand turns elastic and his total revenues therefore begin to shrink, because he is interested in maximizing profits, not revenues, and so will stop raising his price only when any further increase would reduce his total revenues by more than the reduction in total cost resulting from the smaller quantity produced. In other words, he will raise his price (reduce his output—the one implies the other) until marginal revenue, the effect on his total revenues of the price change, equals marginal cost.² That is the point at which the monopolist's profits are maximized. At a smaller output, he would be giving up a net profit opportunity, while at a higher output he would be losing more revenue from the lower price that he would have to charge than he would be gaining from the additional sale.

The optimum monopoly price may be much higher than the competitive price, depending on the intensity of consumer preference for the monopolized product—how much of it they continue to buy at successively higher prices—in relation to its cost. And the monopoly output will be smaller.³

So we now know that output is smaller under monopoly⁴ than under competition but not that the reduction in output imposes a loss on society. After all, the reduction in output in the monopolized market frees up resources that can and will be put to use in other markets. There is a loss in value, however. The increase in the price of the monopolized product above its cost induces the consumer to substitute products that must cost more (adjusting for any quality difference) to produce (or else the consumer would have substituted them before the price increase), although now they are relatively less expensive, assuming they are priced at a competitive level, that is, at the economically correct measure of cost. Monopoly pricing confronts the consumer with false alternatives: the product that he chooses because it seems cheaper actually requires more of society's scarce resources to produce. Under monopoly, consumer demands are satisfied at a higher cost than necessary.⁵

This analysis identifies the cost of monopoly with the output that the monopolist does not produce, and that a competitive industry would. I have said nothing about the higher prices paid by those consumers who continue to purchase the product at the monopoly price. Those higher prices are the focus of the layperson's concern about monopoly—an example of the often sharp divergence between lay economic intuition and economic analysis. Antitrust economists used to treat the transfer of wealth from consumer to monopoly producer as completely costless to society, on the theory that the loss to the consumer was exactly offset by the gain to the producer.⁶ The only cost of monopoly in that analysis was the loss in value resulting from substitution for the monopolized product, since the loss to the substituting consumers is not recouped by the monopolist or anyone else and is thus a net loss, rather than merely a transfer payment and therefore a mere bookkeeping entry on the social books. But the traditional analysis was shortsighted.⁷ It ignored the fact that an opportunity to obtain a lucrative transfer payment in the form of monopoly profits will attract real resources into efforts by sellers to monopolize and by consumers to avoid being charged monopoly prices (other than by switching to other products, the source of the cost of monopoly on which the conventional economic analysis of monopoly focused). The costs of the resources consumed in these endeavors are costs of monopoly just as much as the costs resulting from the substitution of products that cost society more to produce than the monopolized product, though we'll see that there may sometimes be offsetting benefits in this competition to become or fend off a monopolist.

One way of sharing in monopoly profits is by entering a market in which a monopoly price is being charged, thereby adding to the output of the market and depressing the market price, or by expanding one's output if one is already in such a market. These methods of monopolizing are unlikely to impose net costs on society.⁸ But they are properly analyzed as market responses that reduce the expected gains of monopoly by diminishing the monopolist's power over price rather than as responses that transform expected monopoly gains into costs.

Suppose that a cartel⁹ fixes prices somewhere above the competitive level and the entry of new firms or the expansion of existing firms (whether members or nonmembers of the cartel) is for some reason impeded. Each member of the cartel will have an incentive, by expending resources on making his output more valuable to consumers than the output of the other members of the cartel, to increase his sales relative to the other cartelists and thereby engross a larger share of the cartel profits. The process of increasing nonprice competition (competition in quality, service, credit terms, and so forth) will continue until, at the margin, the costs of the cartel members have risen to the cartel price level. The higher costs are a cost of monopoly, although there is a partially offsetting benefit since the additional nonprice competition has some value, though less than its cost, to the consumer. The reason it is only partially offsetting is that if consumers valued the additional services generated by this competition above its cost, presumably the services would have been produced in a price-competitive market as well. If entry into the cartelists' market is not blocked, the cartelists may expend resources on deterring entry, as we'll see in chapter 7.

If for some reason nonprice competition were infeasible and entry were blocked, and the expected profits of cartelizing were therefore very large, the analysis would be altered, but not fundamentally. Firms would expend real resources on forming or gaining admission to cartels in order to share in the expected profits. This process of competing to become a monopolist would continue until, at the margin, the expected gains of monopoly were just equal to the costs incurred in becoming a monopolist.

The qualification at the margin in the two preceding paragraphs is important. An activity that encounters sharply diminishing returns will be cut off long before the actor has expended resources equal to the maximum potential gains from the activity. The Microsoft Corporation had billions of dollars at stake in the antitrust suit that the Department of Justice and nineteen states brought against it in 1997, but it did not spend billions of dollars on lawyers and other defenders, because the marginal benefit of additional expenditures would have been less than the marginal cost, and indeed might well have been zero or even negative. Similarly, a would-be monopolist will not expend on obtaining a monopoly an amount equal to the entire present discounted value of his monopoly profits, but will stop at the point where an additional dollar (on advertising, service competition, lawyers, or what have you) would not yield a dollar in expected profits.¹⁰ On the other hand, there may be duplication of expenditures by several would-be monopolists; all these must be reckoned in as well.

The Microsoft example is actually somewhat inapt, because it assumes the existence of antitrust law. The issue under examination in this chapter is the social cost of monopoly in the absence of antitrust, since we need to know that cost, or at least have some sense of its approximate magnitude, in order to know whether to expend resources, and if so how many, on the control of monopoly. Antitrust generates both direct costs of enforcement and of defense, and indirect costs, such as the costs that cartelists incur to conceal their activity from the enforcement agencies. Cartels may forgo cost-minimizing cartel methods, such as exclusive sales agencies, in order to avoid detection. In particular, because cartel agreements are not legally enforceable (this was the common-law rule even before any antitrust laws were enacted), cartelists may be afraid to reduce their productive capacity to the level that is optimal for the cartel's reduced output, since competition may break out at any time. Thus there may be more excess capacity with illegal than legal cartels, and this too is a cost of antitrust law.

Despite this qualification and others to be made later, the tendency of monopoly profits to be converted into social costs places the economist's hostility to monopoly on even firmer ground than it would occupy if the only costs of monopoly were those that stem from the reduction in output brought about by monopoly. As shown in figure 1, if we assume that problems of cartel organization and enforcement and the threat of entry constrain the price level in the typical cartelized (or monopolized) industry to a level only moderately higher than the competitive price level, the social loss that is due to the reduction in output at the higher price—D in figure 1—will be quite small in relation to the total revenues of the industry at either the monopoly or the competitive price.¹¹ The costs of monopoly become much more imposing if MP, the transfer payment from consumers to producers of the monopolized product, is added to D. It is true that MP is only a rough approximation of the actual costs resulting from the competition to become a monopolist. They could be greater or less, as I have already noted. They could be greater because MP ignores expenditures by potential victims of monopoly that have the effect of limiting the monopoly price increase and that are properly counted as costs of monopoly; they could be less because expenditures on monopolizing may generate partially offsetting benefits in the form of additional non price competition and because of the diminishing returns to profit-seeking efforts, illustrated by the example of Microsoft's legal expenditures. But it is a reasonable guess that the total social costs of monopoly will usually exceed D by a significant amount. I am of course speaking here of bad monopoly. If the government grants a firm a monopoly precisely in order to evoke greater expenditures by the firm than competition would—this is the economic rationale of the patent laws—the resulting transformation of expected monopoly gains into social costs does not create a net social loss. This is an important qualification to which I'll return