Antitrust and positional arms races.

Publication: Harvard Journal of Law & Public Policy

Publication Date: 22-JUN-07

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COPYRIGHT 2007 Harvard Society for Law and Public Policy, Inc.

The idea of "winner take all" markets, or harmful "positional races" as the phenomenon is sometimes called, (1) directly clashes with the philosophy of antitrust regulation. (2) Antitrust law advocates competition as the means of achieving its ultimate goal of maximizing welfare. (3) "Positional" competition, however, often produces suboptimal results. (4) Should antitrust law apply to winner-take-all markets, or should this field be left to other governmental regulation?

This Note addresses the relevance of antitrust regulation to winner-take-all markets and proceeds as follows: Part I describes the phenomenon of suboptimal winner-take-all markets, sometimes called "arms races" because they spur participants to race for supremacy. Part II draws the basic lines of relevant antitrust law and considers "arms control agreements" as a tool for mitigating this kind of market failure. Part III is dedicated to a short, positive analysis of such agreements under Section 1 of the Sherman Act. In Part IV, some thoughts on normative and institutional reasons underlying the analysis in Part III are presented. Finally, Part V outlines the conclusions.

I. HARMFUL RACE TO THE TOP

Everybody loves a winner, and the market often agrees, granting enormous rewards for those who win. While the best players win big, others are left behind, reaping rewards that bear little relationship to how close they were to winning or to the magnitude of the difference between their talents and those of the winners. The phenomenon of winner-take-all markets has received extensive attention since the 1980s. (5) In these markets, a large number of entities compete for a relatively small number of positions that offer the possibility of financial rewards far exceeding those that await less successful competitors. (6) Absent significant spillovers, the outcome in many such markets is socially undesirable: new entrants produce a negative externality by reducing the chances of other participants to receive a reward. (7) Markets for sports, entertainment, legal services, and education have many features of winner-take-all markets. (8)

Why is the outcome produced by these markets inefficient? It might be beneficial from a productive point of view because fierce competition produces the best talents and products. Absent such high rewards, the pools of candidates to become the next Michael Jordan, Tiger Woods, or Madonna would be considerably smaller, meaning the top performers would be inferior in comparison with the current level. (9) This outcome, however, is inefficient from an allocative perspective: human resources, money, and time invested in the "race to the top" cost more than the marginal value of the top players' improved performance. (10) This situation is known as an "arms race:" although perfectly rational from the private perspective, the choice to put in additional effort in hopes of becoming the best produces a socially inefficient outcome when the costs of the "race" are at least partially non-recoupable. (11) Why would individuals enter the market? The rational explanation is that before entry occurs, the expected benefit is higher than real and opportunity costs given the existing level of salaries and competition. (12) Post-entry, continuing to invest in improved performance is also perfectly rational--the expected marginal benefit of effort is, indeed, higher than the cost. (13) The irrational explanation for market entry is an overestimation of one's chances to win, which is quite typical for human beings. (14)

From an economic standpoint, a market for positional goods presents another application of zero-sum games. (15) Once individuals are in the market and relative positions are established, additional investment in positional goods is mutually offsetting because the value derived from pure positional goods comes entirely from the relative positioning. In aggregate, the additional investment is waste. A positional good provides at least some utility to the owner through the indirect benefit of signaling his status in society. The world is replete with positional goods--yachts, mansions, engagement rings, education, advertisement--each of which is valued by buyers according to its relative, marginal features in comparison with other goods. The "positional goods race" is a zero-sum game.

II. ARMS CONTROL AGREEMENTS

From the outset, it must be made clear that winner-take-all markets are not always bad. Patent law, for example, facilitates a winner-take-all structure of reward for invention by granting monopoly rights in an invention to the first entrepreneur who completes it. (16) The organization of network industries is also similar to winner-take-all markets. In these industries, a dominant player wins most of the market due to significant demand-side economies of scale from standardization. (17) In both examples, the winner-take-all structure is often beneficial. For patents, there would be considerably less investment in riskier inventions absent the possibility of such high returns. (18) In network industries, standardization is extremely efficient and can be more easily achieved with a single firm dominating the market. (19)

The arms races addressed throughout this Note, however, do not produce such social gains. Instead, winner-take-all markets in higher education, media advertisement, and markets for star players are typically undesirable as measured by total welfare. The welfare effects of arms control in such markets, including potential harm to desirable competition, however, may differ. Besides allowing for reallocation of otherwise wasted resources into more productive industries, agreements may serve other positive goals, like making education more affordable to low-income students in case of higher education, or improving quality of news coverage in case of voluntary codes of behavior adopted by the media companies.

An alternative of regulation by impartial and accountable actors, however, may be a more beneficial or politically acceptable result than self-regulation by the industry. On the other hand, this might not be always the case. For instance, in the communications industry, active intervention of government in media content can be undesirable from a public policy perspective; (20) putting a cap on executives' salaries, proposed from time to time during the recent debate on executive compensation, is actually a tariff regulation, condemned by generations of economists.

All of these factors may lead to different outcomes for arms control agreements in antitrust analysis. Moreover, notwithstanding the same purpose and effect, some agreements may be condemned as illegal per se (without a court's inquiry into the proposed justifications), while others may be reviewed under the "rule of reason" by balancing anticompetitive and procompetitive effects. (21)

After a short presentation of antitrust law on "restraints of trade," the following Subpart will discuss some typical "arms control" arrangements and will attempt to predict their treatment by antitrust law. (22)

A. Rule of Reason

Section 1 of the Sherman Act provides: "Every contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is declared to be illegal." (23) Notwithstanding the statutory language of "every contract," the Supreme Court, in its early landmark antitrust decisions, limited the statutory prohibition to unreasonable restraints. (24) Reasonableness analysis concentrates on the effects of a challenged practice on competition, weighing its possible anticompetitive effects against procompetitive justifications.

Since the early days of the Sherman Act, antitrust review of restraints on trade has been conducted through per se illegality rules or the rule of reason. (25) Per se illegality applies to the practices perceived as so clearly anticompetitive (like price-fixing, market division, or output limits) (26) that no justifications based on their business (or social) virtues are accepted. (27)

In the course of a rule of reason inquiry, the court weighs possible anticompetitive effects against procompetitive effects of the practice. (28) Various relevant factors, such as the intent and purpose of the restriction, the market structure, barriers to entry, and efficiencies, are taken into account. (29) If procompetitive justifications substantially outweigh the harm to competition, and no plausible and less harmful alternative exists, the practice is reasonable and legal. (30) Rule of reason analysis dominates today; application of per se rules is rather limited. (31) The costs of chilling legitimate economic and commercial activity are great under extensive application of per se rules.

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