Monday, May 19, 1998 1:25 p.m. ebr March 20, 1999. April 22, 2000, formatting changes. Copies of this paper can be found at Www.bus.indiana.edu/~erasmuse/@Articles/Unpublished/99exrep.txt. Naked Exclusion: Theory and Law By Eric B. Rasmusen, J. Mark Ramseyer, and John Shepard Wiley Jr. We are grateful to Professors Segal and Whinston for improving our analysis and we are pleased they reach similar results. The main results are two. First, normally a firm cannot use contracts with its customers or suppliers to inefficiently exclude a rival from competition, because the high price of these contracts make this strategy unprofitable. Chicagoans like Robert Bork made this point decades ago, and it is important and correct. Second, and in contrast, exclusionary contracts can be profitable, effective, and socially inefficient -- under certain conditions. One condition is that firms in the industry must be able to operate only at or above some minimum efficient scale. Another condition is that the victims -- customers or suppliers -- must expect that the exclusionary tactic will succeed, and be unable to coordinate their actions to defeat the tactic. An excluding firm in this situation can buy naked exclusion affordably because it can buffalo victims into selling cheaply; the victims lack the bargaining position to demand the social value of what they surrender. At a theoretical limit, the excluding firm can gain the exclusionary rights for free. This striking result has implications for antitrust policy by suggesting that naked exclusion poses a potentially serious and inefficient threat to competition -- at least in theory. As with any theory, one wants empirical evidence of real-world applicability. A preliminary empirical note is cautionary and ironic: this theory does not apply to the very cases in which the United States Supreme Court forged the law most relevant to this field. A simple legal label for contracts of naked exclusion is "exclusive dealing": "You agree to deal only with me, and not with my competitors." The Supreme Court majority in Jefferson Parish wrote that reigning law flows from the decisions in Standard Stations and Tampa Electric. [1] These three cases, however, do not fit the theory in Rasmusen, Ramseyer, and Wiley (1991) and Segal and Whinston (199_) ("RRW-SW"). Take Jefferson Parish. The East Jefferson Hospital in New Orleans maintained an exclusive arrangement with a group of anesthesiologists called Roux and Associates. The hospital agreed to obtain all anesthesiology from Roux. The justices found no exclusive dealing problem. Crucial to the RRW-SW analysis, the Jefferson Parish plaintiff (an anesthesiologist named Dr. Hyde) never proved that the Roux group (I, in SW's notation) could expect to lock up through the hospital anything close to N* -- the number of patients that would foreclose Dr. Hyde from achieving a minimum efficient scale of production. Instead there were at least 20 hospitals in the New Orleans area and about 70 per cent of the patients living in a portion of New Orleans went to hospitals other than East Jefferson. Most likely, exclusive dealing was just an efficient way for the hospital to combat opportunism and promote cooperation among anesthesiologists. See Lynk and Morrisey (1987); Lynk (1994). Or take Standard Stations. Standard Oil required its gas station franchisees to buy all their gasoline from Standard Oil. The government successfully challenged these contracts. Although the plaintiff's victory in Standard Station might suggest that the RRW-SW analysis applied to these facts, it does not. Standard Oil (the I) then had less than a quarter of the gallons sold in the western U.S. It is not immediately clear how much of the market Standard would need to secure to prevent another firm R from remaining profitable (that is, it was not clear how large N* might be) -- but whatever it was, Standard could not have expected to obtain it through buyer disorganization. Whether the excluder is large or has market power is irrelevant to the RRW-SW analysis; if the excluder has a 70 percent market share, for instance, but an entrant could operate efficiently with 10 percent, then this analysis does not apply. The fact that over 75 competitors remained in the market to compete with Standard showed that something was at work besides naked exclusion. See also Marvel (1982). Finally, take Tampa Electric. The local Tampa utility burned petroleum to produce electricity. Tampa Electric then decided to introduce a coal-powered generation plant, and went to Nashville Coal for the coal. In going to Appalachia, however, Tampa Electric encountered crowds of competing coal suppliers. Under the challenged contract, for 20 years Nashville was to provide all the coal Tampa Electric used. Yet according to the Supreme Court, Nashville locked up only 1 percent of the coal market in the southeastern U.S. Nashville sued to rescind on the grounds that its own contract violated the Sherman Act. The Court rejected Nashville's suit, and properly so according to the RRW-SW analysis. Whatever N* might be in this context, with all of 1 percent of the market, Nashville could not have hoped to lock it up. These three cases are legally relevant, but they fail to show whether the kind of naked exclusion that RRW-SW hypothesize ever really happens. To put the point conversely, the RRW-SW theory obviously is not the only explanation for exclusive dealing. As Judge (now Justice) Breyer has written, exclusive dealing "often" serves legitimate business purposes. [2] The RRW-SW theory does not support outlawing exclusive dealing on a per se or summary basis. Any sensible legal test would have to be considerably more discriminating. A fourth notable Supreme Court case illustrates a practical limit on the RRW-SW theory. In Lorain Journal, the eponymous local monopoly newspaper warned advertisers in Lorain that it would accept their advertising only if they agreed not to advertise with new radio station WEOL. [3] The Supreme Court outlawed the conduct of the Journal's publisher as "an attempt by the publisher to destroy WEOL and, at the same time, to regain the publisher's pre-1948 substantial monopoly over the mass dissemination of all news and advertising." Lorain Journal commands continuing interest and debate. Professor Bork (1978 & New Intro. 1993 p. 345) gave a classic predation explanation of the case, while Brennan (1989, 1992) offered a refined and formal model to similar effect. Lopatka and Kleit (1995, pp. 1257, 1274-75, 1286-96) criticized Bork and Brennan, claiming instead that the Journal's conduct was either a rational effort to prevent inefficient input substitution by advertisers, or else was merely "irascible." Most recently, attorney Robert Bork (1998) has represented Netscape and has attacked competitor Microsoft by claiming "[t]he parallel between The [Lorain] Journal's action and Microsoft's behavior is exact." At first glance, the Lorain Journal case would indeed seem to fit the RRW- SW analysis. WEOL would be R, and the Lorain Journal would be I. Aiming to run WEOL out of business and then to raise advertising prices, the Journal hoped to lock up N* of the advertisers and thereby to prevent the radio station from having enough advertising base to remain profitable. The minimum efficient scale for a radio station could be significant in relation to the size of a small and isolated market. The Court stated (p. 153) that "WEOL's greatest potential source of income was local Lorain advertising. Loss of that was a major threat to its existence." If correct, the RRW-SW analysis of Lorain Journal would answer Lopatka and Kleit's complaint (pp. 1274-75) that the classic predation account of the case is weak because the Journal would have to pay its advertisers an unattractively high price to induce them to boycott WEOL. The RRW-SW analysis suggests how the Journal and its advertisers could have rationally expected that the threat would have been effective, so exclusive dealing might not have cost the Journal very much. The implication would be that the Court was right to enjoin the Lorain Journal from trying to force its advertisers to boycott WEOL. There are, however, three objections to applying the RRW-SW theory to Lorain Journal. First, victim coordination as Innes and Sexton (1994) describe should be easiest in a small town setting where there are only a few advertisers who might all belong the same church and Lions Club. In Lorain Journal, however, we know from Lopatka & Kleit (p. 1267) that there were at least 54 advertisers. Second, the RRW-SW analysis highlights a factor that courts have not: whether the rival actually has entered the market. If rival WEOL can credibly commit to stay in the market for some period of time, the Journal cannot costlessly induce advertisers to boycott its rival. If WEOL has already invested heavily in entering the market and will not soon leave, then the customers will not sign exclusionary contracts with the Journal without a bribe. Instead, the Journal would need to compensate them for losing access to WEOL during the period during which it survives. Exclusion might still be profitable, but it would not be free. Third, Lopatka & Kleit argue that the exclusionary contracts took only about 15 percent of WEOL's revenue and would not have driven it from the market. If there were true, and were common knowledge, the RRW-SW theory cannot apply. Whether the returns on equity for WEOL of 2 and 11 percent that Lopatka & Kleit (p. 1279) record for the two years of exclusion were enough for long-term survival, however, remains an open question. We are indebted to Professors Segal and Whinston for their theoretical contribution. As we expect Segal and Whinston would agree, this theory does not support summary or per se illegality for exclusive dealing. Rather, one must check the model's assumptions against reality case by case. References Brennan, Timothy J.,"Exclusive Dealing, Limiting Outside Activity, and Conflict of Interest," Southern Economic Journal, 1989, 56, 323-35. Brennan, Timothy J., "Refusing to Cooperate with Competitors: A Theory of Boycotts," Journal of Law and Economics, October 1992, 35, 247-64. Bork, Robert, What Antitrust Is All About, New York Times, page A23 (5/4/98). Bork, Robert, The Antitrust Paradox: A Policy At War With Itself, New York: Basic Books, 1978, New Intro. 1993. Innes, R., and Sexton, R.J., "Strategic Buyers and Exclusionary Contracts," American Economic Review, 1994, 84, 566-84. Lopatka, J.E., and Kleit, A.N., "The Mystery of Lorain Journal and the Quest for Foreclosure in Antitrust," Texas Law Review, 1995, 73, 1255-1306. Lynk, W.J., "Tying and Exclusive Dealing: Jefferson Parish Hospital v. Hyde," in Kwoka and White, The Antitrust Revolution; New York: HarperCollinsCollegePublishers, 2d ed. 1994. Lynk, W.J., and Morrisey, M., "The Economic Basis of Hyde: Are Market Power and Hospital Exclusive Contracts Related?" Journal of Law and Economics, 1987, 30, 399-421. Marvel, H.P., "Exclusive Dealing," Journal of Law and Economics, 1982, 25, 1-25. Rasmusen, Eric B., Ramseyer, J. Mark, and Wiley, John Shepard, Jr., "Naked Exclusion," American Economic Review, 1991, 81, 1137-45. Segal, Ilya and Whinston, Michael D. ,``Naked Exclusion: Comment,'' American Economic Review, 1998, ____, _____. Wiley, John Shepard, Jr., "Exclusionary Agreements," The New Palgrave Dictionary of Economics and the Law, 1998, ___, ___. Notes * Copr. 1998. Comments welcome: EBR, Indiana University, Kelley School of Business, Room 450, 1309 East 10th St., Bloomington, IN 47405-1701, erasmuse@indiana.edu, Php.Indiana.edu/~erasmuse; (812) 855-9219 (voice), (812) 855-3354 (fax); JMR, Harvard Law School, Cambridge, MA 02138; JSW, UCLA Law School, Los Angeles CA 90095-1476, wiley@law.ucla.edu, (310) 825-3072 (voice), (310) 206-6489 (fax). 1. Jefferson Parish Hospital District No. 2 v. Hyde, 466 U.S. 2, 7, 30 n.51 (1984) (citing Standard Oil Co. v. United States (Standard Stations), 337 U.S. 293 (1949), and Tampa Electric Co. v. Nashville Coal Co., 365 U.S. 320 (1961)). Wiley (1998) discusses these three cases. 2. Interface Group, Inc v. Massachusetts Port Authority, 816 F.2d 9, 11 (1st Cir. 1987). 3. Lorain Journal Co. v. United States, 342 U.S. 143, 153 (1951).