# Presentation: 223394

## Three “mini” essays on bundling

**Tim Brennan**
**Professor, Public Policy and Economics, UMBC****Senior Fellow, Resources for the Future**
**2006: T.D. MacDonald Chair, ****Canadian Competition Bureau****(relevant disclaimer applies)**
**Bureau of Economics****Federal 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 V****A**** + V****B**** > P****AB**
**With both sold, only B purchased by those with V****B**** > P****B****, V****A**** < P****AB**** - P****B**
**Independent demands, uniformly distributed between 0, 1**

## Base case, worst equilibrium case (B exits)

**No bundling base case**
**P****A****, P****B**** = .5**
**Consumer surplus = .25**
**Total surplus = .75**
**Bundler has monopoly (B exits)**
**Q****AB**** = 1 – P****AB****2****/2**
**Π****AB**** = P****AB****Q****AB**** = P****AB****[1 – P****AB****2****/2]**
**P****AB***** =  ≈ .816**
**Π****AB**** ≈ .544**
**CS****AB**** ≈ .275****, greater than with no bundling**
**Total surplus ≈ .819, greater than with no bundling**

## Bundling by A, B stays

**B’s response to P****AB**** (simultaneous or sequential)**
**Q****B**** = [P****AB**** – P****B****][1 – P****B****]**
**Π****B**** = P****B****[P****AB**** – P****B****][1 – P****B****]**
**P****B**** = **
**CS****B**** = **
**Effects of B on the bundler**** and its customers**
**Q****AB**** = [1 – P****AB****] + P****B**
**Π****AB**** = P****AB****[1 – P****AB****] + P****AB****P****B**
**P****AB**** = **
**CS****AB**** = **

## Two models if the non-bundler stays

**Simultaneous Bertrand pricing**
**Solve simultaneously**
**P****AB**** = **
**P****B ****= **
**Sequential pricing, bundler goes first**
**Define P****B**** as function of P****A****B**** as above**
**Calculate A’s profit with B’s optimum reaction**
**Numerical methods applied**

## Bundling excludes because it’s competitive!

## 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**
**P****E****, P****I**** retail prices; W****E****, W****I**** wholesale prices**
**R carries E’s product if**
**Without exclusion: P****E**** – W****E**** ******** P****I**** – W****I**
**With exclusion: P****E**** – W****E**** ******** P****I**** – W****I**** + B, where B is breach penalty**
**“****Efficient” breach penalty is foregone variable profits**
**B = W****I**** – C****I****, where C****I**** is the incumbent’s short run marginal cost**

## Implications for evaluating exclusion, rebates

**Implies that retailer will carry product only if **
**P****E**** – W****E**** ******** P****I**** – W****I**** + [W****I**** – C****I****] **
**P****E**** – W****E**** ******** P****I**** – C****I**** **
**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), W****E**** ******** C****I**** **
**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**