PRICE THEORY, COMPETITION, AND THE RULE OF REASON Alan J. Meese1 Everyone knows that antitrust law should protect and further “competition.” But what exactly is competition? A grocer might “compete” by (falsely) claiming that her rival is selling poisoned beef or (falsely) claiming that her own beef is more nutritious. She might also price below her own costs or those of her rival, driving him out of business and taking over the market, at least for a time. A firm that makes film might “compete” against its rivals by inventing a better film or by redesigning a popular camera to use only its brand of film, expanding its own market share as a result. While each of these practices is “competitive” in one sense, any rational society should distinguish among them. All would applaud the invention of a new film, but most would agree that slander and false advertising are not “competition” in any sense that society wishes to embrace. The distinction between these practices could rest on some abstract conception of (legitimate) “competition.” Most, however, would adopt a more instrumental definition, distinguishing among various practices based upon their perceived social utility. Such an approach would treat as “competitive” any practice that, under the circumstances, would seem to further society’s welfare when compared to the status quo. 1Visiting Professor of Law, The University of Virginia; Cabell Research Professor of Law, The College of William and Mary. J.D., The University of Chicago, A.B., The College of William and Mary. The author thanks George Cohen, Paul Mahoney, Steven Salop, George Triantis, and participants in a faculty workshop at the University of Virginia for helpful questions and comments on an earlier version of this article. The William and Mary School of Law supported this project with a generous summer research grant. Felicia Burton assisted in preparation of the manuscript. 1 If “competition” however defined, is our desideratum, then it might seem that its antithesis, cooperation, is a bad thing. Not so fast. To be sure, Ford and General Motors should not “cooperate” when setting prices. But what if the same two firms merge, eliminating competition between them while at the same time realizing significant economies of scale that enhance the new firm’s ability to compete in the larger marketplace? Similarly, two or more employers should not “cooperate” when setting the wages of their respective employees. However, what if a college sports league adopts a rule forbidding members to pay their “student-athletes” more than tuition plus room and board, claiming that the policy prevents “college” football from deteriorating into semi-pro football?2 Finally, grocers should not divide territories among themselves. Nevertheless, what if dozens of small grocers pool their resources to form a joint venture that develops a private label brand and assigns each member a particular territory in which it will have the exclusive right — and thus powerful incentives — to promote and sell the brand?3 As each of these examples should show, socially useful “competition” often requires some cooperation, cooperation that reduces or even eliminates rivalry between the cooperating parties. Indeed, when we speak of “a firm” engaged in “unilateral” activities, we are almost always referring to what economists call a “nexus of contracts” between employees, managers and suppliers of capital, contracts that snuff out competition between the parties to them. (Partners at Skadden, Arps do not bid against each other for the labor of associates.) If society defines as “competitive” all marketplace activity that enhances its welfare, then many forms of cooperation, even those that 2See NCAA v. Bd. of Regents of the University Of Oklahoma, 468 U.S. 85 (1984). 3See United States v. TOPCO, 405 U.S. 596 (1972). 2 eliminate “competition” between cooperating parties, are “competitive” in the sense that is relevant for antitrust purposes. A society that seeks to encourage useful “competition” must construct an institutional framework that channels individual initiative in “competitive” directions.4 Thus, society must prevent those “unilateral” acts, like slander, that reduce welfare. It must also enforce those contracts that implement useful cooperation. Finally, it must forbid those agreements that entail “undue” or “harmful” cooperation and thereby undermine society’s welfare.5 Section 1 of the Sherman Act, which forbids contracts “in restraint of trade,” polices the line between acceptable (“competitive”) and unacceptable (“anticompetitive”) cooperation.6 Like “competition,” the term “restraint of trade” does not define itself; all contracts, like all cooperation, restrain trade or competition in some sense. For nearly a century, then, courts have expressly held that the Sherman Act forbids only unreasonable restraints, usually purporting to judge “reasonableness” according to economic effect. In modern parlance, courts applying this “Rule of Reason” ask whether a contract “promotes” competition or, instead, “destroys” it, by creating or exercising market power. 4See F.A. Hayek, Free Enterprise And Competitive Order, 110-114 in INDIVIDUALISM AND ECONOMIC ORDER (1948). See also Ronald H. Coase, The Institutional Structure Of Production, 82 Am. Econ. Rev. 713, 717-18 (1992) (background structure of legal entitlements can affect nature of economic activity and thus allocation of resources). 5See Hayek, Free Enterprise And Competitive Order, at 115 (“We cannot regard ‘freedom of contract’ as a real answer to our problems if we know that not all contracts ought to be made enforceable and in fact are bound to argue that contracts ‘in restraint of trade’ ought not be enforced.”). 6Section 2, by contrast, polices unilateral acts. See Copperweld Corp. v. Independence Tube Corp., 467 U.S. 752 (1984) (explaining the respective domains of Sections 1 and 2 of the Sherman Act). 3 Some contracts are so plainly harmful that courts condemn them with little analysis, deeming them “unreasonable per se.” Most contracts survive such condemnation, however, and undergo more careful scrutiny, under what courts (redundantly) call “the Rule of Reason.” Courts, scholars and the enforcement agencies have articulated a three step test to govern analysis under this Rule of Reason. First, a plaintiff must establish a prima facie case by showing that the restraint produces tangible anticompetitive harm, a showing that usually consists of proof of “actual detrimental effects” such as increased price or reduced output. Second, the defendants must prove that their agreement produces “procompetitive” benefits that outweigh the harm implicit in plaintiff’s prima facie case. Third, even if the defendants can make such a showing, the plaintiff can still prevail by proving that the defendants can achieve the same benefits by means of a “less restrictive alternative.” This three part test, it is said, helps courts distinguish those contracts that “harm” or “destroy” competition, by creating or exercising market power, from those that promote it. This article offers a critique of the modern Rule of Reason and the vision of “competition” on which it depends. As shown below, the present structure of Rule of Reason analysis as articulated by courts, the enforcement agencies and most leading scholars rests on an outmoded model of “competition” and is thus inherently biased against contractual integration that produces non-technological efficiencies. More precisely, the modern structure of Rule of Reason analysis rests upon a vision of competition derived from neoclassical price theory, the economic paradigm that dominated industrial organization for much of the twentieth century. According to this paradigm, “competition” consists of constant technological rivalry between autonomous firms, unconstrained by so-called “non-standard” contracts, that is, agreements that constrain the discretion of purchasers and competitors. This rivalry, it is said, results in an “equilibrium” of “competitive” 4 prices, output, and other terms of trade, an equilibrium that maximizes social welfare. Within this paradigm, any contractual arrangement that produces output, prices or other terms of trade that depart from the “competitive” baseline is prima facie “anticompetitive” and properly subject to condemnation absent concrete proof of some justification that “outweighs” the harm. Price theory’s definition of “competition” drives each aspect of the modern Rule of Reason described above. For instance, decisions allowing plaintiffs to establish a prima facie case by proving “actual detrimental effects” rest upon a presumption that any departure from the prices or other terms of trade produced by technological rivalry reflects an “anticompetitive” exercise of market power. Similarly, the requirement that procompetitive benefits “offset” or “outweigh” anticompetitive effects by reducing prices or preventing their increase rests upon price theory’s partial equilibrium trade-off model and its assumption that any benefits resulting from a contract or transaction coexist with anticompetitive effects reflected in a prima facie case. Given this assumption, courts naturally conclude that any benefits produced by such a contract coexist with anticompetitive harm, harm that courts must “balance” against benefits. Indeed, the same assumption, i.e., that benefits necessarily coexist with anticompetitive harm, drives the requirement that, where possible, defendants achieve any procompetitive benefits through means less restrictive