William and Mary Law School

An Excerpt from "Monopolization, Exclusion, and the Theory of the Firm"

An excerpt from Professor Meese’s article, "Monopolization, Exclusion, and the Theory of the Firm" (Minnesota Law Review 2005) is below.  For the full article, please click here.

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Section 2 of the Sherman Act penalizes those firms that "monopolize" or "attempt to monopolize" any relevant market. Unfortunately, the term "monopolize" does not define itself. In one sense "monopolization" is any conduct that leads to or protects monopoly. Still, the statute does not purport to forbid the mere status of monopoly, and such a definition of "monopolize" would sweep quite broadly. After all, firms may take over a market, or protect a monopoly they already have, in a variety of ways. At one extreme, firms can murder their competitors or destroy their factories. At the other extreme, firms can build a better mousetrap or reduce the cost of building an average mousetrap. Finally, a firm that produces a better mousetrap can devise some method for minimizing the cost of distributing the trap to consumers.

Each of these tactics can create or protect monopoly. In that sense, then, each such tactic "monopolizes" the market in question. Nonetheless, any rational society would want to distinguish between the various tactics that might produce or protect a monopoly. The innovative firm that invents the better mousetrap may harm its rivals, but at the same time, also does society a great service. The injured rival that burns down the innovator's factory or slanders its product does not. A defensible definition of "monopolize" would presumably distinguish between the two.

For nearly a century, antitrust courts have maintained just such a distinction.  In particular, early decisions held that "normal" or "ordinary" conduct does not offend the Sherman Act, including section 2, even if such conduct leads to or protects a monopoly.  More recently, courts have relied upon a slightly different formulation, condemning only that conduct which they deem "exclusionary."  

Neither formulation is particularly illuminating on its face. For one thing, business practices do not announce themselves as "normal" or "abnormal." Moreover, an inquiry into whether a practice is "exclusionary" merely restarts the inquiry into the meaning of "monopolize." After all, the firm that invents a better mousetrap "excludes" its competitors from the market just as surely as the firm that employs force or other tortious tactics.

Current law seeks additional precision by drawing a distinction between two different sorts of conduct that can "exclude" rival firms from the marketplace. On the one hand, "internal" conduct, including decisions on product design, marketing strategies, refusals to buy or sell, and pricing and output, are treated as "competition on the merits" and presumed lawful, even if they drive competitors from the marketplace. This presumption is extremely robust: plaintiffs can only rebut it by showing that, for instance, a particular price is below some measure of cost, or that the practice produces no plausible benefits. Thus, the vast majority of internal conduct, including above-cost pricing, is simply lawful per se, even if such conduct has led, or will lead, to a monopoly by excluding rivals. On the other hand, "external" conduct, that is, agreements or other practices that contractually constrain other firms, are presumed unlawful whenever they impair or tend to impair significantly the opportunities of rivals. While this presumption is rebuttable, defendants that seek to do so face a heavy burden. Not only must defendants show that the challenged arrangement produces significant benefits; they must also show that the practice is no broader than necessary to achieve those benefits. Thus, even where such conduct produces more benefits than harm, courts will still condemn it if plaintiffs establish that there is a "less restrictive means" of achieving  the objective in question. This distinction between "internal" and "contractual" exclusion corresponds roughly to a distinction between property and contract. While conduct that takes place "within" the firm and excludes rivals involves the exercise of a single entity's property rights, contractual exclusion involves agreements with one or more other firms.

This Article offers a critique of antitrust's distinction between "internal" and "contractual" exclusion as well as the preference for property-based "competition on the merits" on which this distinction rests. In particular, the Article shows that antitrust's modern distinction between "competition on the merits" and contractual exclusion reflects the undue influence of neoclassical price theory, the economic paradigm that dominated the study of industrial organization for most of the twentieth century. Price theory, it is shown, produced a theory of the firm and related model of "workable competition" that naturally gave rise to a distinction between "internal" and "contractual" exclusion.

Built on the perfect competition model, price theory treats the business firm as a sort of "black box," an impersonal entity that takes in inputs and transforms them into outputs. In this way, the firm performs a crucial function: the allocation of resources from input markets to output markets. By its nature this process involves the generation of wealth, as firms transform raw materials and other inputs into finished products - property - desired by consumers. The process of transformation, e.g., the amount and type of inputs required to produce a given output, depends upon technology, which determines the firm's production function. According to price theory, after transforming inputs into a finished product, the firm relies upon "the market" - an impersonal, exogenous institution - to transfer the property's title to consumers.

While price theory began with the model of perfect competition, it also recognized certain narrowly defined departures from the model's assumptions. These departures gave rise to the theory of "workable competition," under which activities internal to the firm, such as innovation and replication, alter production technology. Such changes in technology, in turn, lead to improved product quality or productive efficiencies, usually in the form of economies of scale. These improvements manifest themselves by changing the nature or price of the property that the firm could sell to purchasers. Except in extraordinary circumstances, price theory and its workable competition model presume these property-based activities beneficial, even if such practices exclude one or more competitors from the marketplace.

Contractual exclusion fares far worse under price theory's conception of the firm and derivative workable competition model. In the world of workable competition, firms can rely upon costless markets to purchase and sell inputs and outputs. Efficiencies are technological in origin, arising and ending within the boundaries of the firm. Once a firm produces a product and transfers title by selling the item to a consumer or other firm, there is no price-theoretic rationale for the firm to exercise contractual influence over the item or its purchasers by, for instance, forbidding purchasers to buy from others. Within the price-theoretic framework, then, any contract that reaches "beyond" the firm and interferes with the opportunities of rivals is presumed an artificial and unlawful "barrier to entry," obtained through the coercive exercise of market power. Far from furthering workable competition, such conduct actually thwarts "competition on the merits" and is thus presumptively anticompetitive within price theory's workable competition paradigm.

For more than three decades, price theory and its narrow version of "workable competition" exercised significant influence over enforcement agencies and courts, and this influence gave rise to the "inhospitality tradition" of antitrust law.  While price theory and the inhospitality tradition it bred had its most noteworthy impact upon antitrust's treatment of "contracts, combinations and conspiracies" analyzed under section 1 of the Sherman Act, monopolization doctrine did not escape this influence.

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Price theory's own monopoly over the subject of industrial organization did not last forever. Just as price theory's influence reached its peak, a competitor emerged in the form of transaction cost economics (TCE). TCE offered a new explanation for the very existence of firms and, thus, a new lens for examining all forms of conduct - internal and external - that might be deemed "exclusionary" for purposes of section 2. In particular, TCE dispensed with price theory's "technological" conception of the firm and instead suggested that the firm is a special form of contract that arises to avoid the cost of transacting, that is, relying upon the market to conduct economic activity. TCE also revealed that "the firm" is not the only sort of contract that can reduce transaction costs and thus overcome market failure. Instead, many contractual practices that price theory deemed inconsistent with workable competition were in fact methods of reducing the cost of relying upon "the market" to conduct economic activity in the same way that reliance on the firm itself reduces such costs. Given its conclusion that "the firm" is just one more nonstandard contract, TCE suggests that any line between "contractual" and property-based forms of exclusion is illusory and based upon a misconception of the economic distinction between firms and markets. In fact, TCE suggests that many nonstandard contracts, including the firm, can create the economic equivalent of property rights by concentrating the costs and benefits of particular activities in a "single owner," even in cases in which the firm does not hold title to its inputs or outputs. By creating such "contractual property," parties can overcome market failures and thus enhance society's welfare by producing a more efficient allocation of resources.

While the Supreme Court has on occasion invoked TCE in litigation under section 1 of the Sherman Act, courts have not internalized the lessons of TCE when developing monopolization doctrine. To the contrary, as the recent United States v. Microsoft Corp. case illustrates, monopolization doctrine has been comparatively impervious to the teachings of TCE, even within expert enforcement agencies. As a result, monopolization doctrine has remained relatively unchanged since the 1950s. Rational administration of the antitrust laws requires courts supervising monopolization litigation to learn the lessons of TCE and apply them when developing antitrust doctrine under section 2.