Harris, Robert G.

Sullivan, Lawrence A.

English

Penn Law: Legal Scholarship Repository

1981]MORE ON PASSING ON: A REPLY TO COOTERAND TO VITON AND WINSTONROBERT G. HARRIS tANDLAWRENCE A. SULLIVAN itThe essays by Cooter' and by Viton and Winston 2 criticizeand elaborate on aspects of our Article published previously inthis Review.3 Both essays contain interesting points that are tech-nically correct. Neither warrants any substantive change in ouranalysis of passing on, in our policy conclusions, or in the tech-niques for adjudicating passing-on issues described in our Article.REPLY TO PROFESSOR COOTERIn any situation in which passing on would be an issue, thedirect purchaser is, by economic definition, buying a "factor input,"not a "final product." Because of this, Professor Cooter argues,both the Supreme Court's decision in Illinois Brick Co. v. Illinois4and our Article were incorrect in using a version of tax incidencetheory that does not account directly for factor "substitution toestimate the extent of passing on. But given our goal of developinga workable policy for litigation in markets in which significantmonopoly overcharges are actually encountered, the scant attentionpaid to factor substitution is all that the topic deserves. For tworeasons, we remain convinced that "[t]he possibility of significantfactor substitution by [direct purchasers] . . . implies an elasticdemand curve between [the manufacturer and direct purchasers].... ,in which case monopolistic pricing is highly improbable.Hence, it is reasonable to assume that factor substitution is rela-tively low in passing-on cases."f Assistant Professor of Business Administration, University-of California, Berke-ley. B.A. 1965, M.A. 1973, Michigan State University; Ph.D. 1977, University ofCalifornia, Berkeley.f Earl Warren Professor of Public Law, University of California, Berkeley.A.B. 1948, University of California, Los Angeles; J.D. 1951, Harvard University.I Cooter, Passing on the Monopoly Overcharge: A Further Comment onEconomic Theory, 129 U. PA. L. REv. 1523 (1981).2 Viton & Winston, Passing on the Monopoly Overcharge: The Welfare Implica-tions, 129 U. PA. L. REv. 1516 (1981).3 Harris & Sullivan, Passing on the Monopoly Overcharge: A, ComprehensivePolicy Analysis, 128 U. PA. L. REv. 269 (1979).4431 U.S. 720 (1977).5 Harris & Sullivan, supra note 3, at 292 n.59.(1533)1534 UNIVERSITY OF PENNSYLVANIA LAW REVIEWThe first reason factor substitution is less significant than Pro--fessor Cooter argues concerns the way managerial decisions aremade. Cooter employs a version of neoclassical production theorythat assumes: (1) that manufacturers face an infinite array of choicesregarding the combination of inputs in producing any particularoutput; (2) that manufacturers have constant and costless access toall information about all these alternatives, and (3) that managersconstantly minimize production costs by extremely fine and continu-ous adjustments of factor inputs as relative factor prices change.6If these assumptions were accurate, factor substitution would cost-lessly and effortlessly occur as soon as a monopolist or a cartelraised prices. Thus, not only would the passing-on problembe greatly diminished, but also the problem of monopoly over-charges itself would be much alleviated.Professor Cooter's assumptions about managerial behavior,however, do not conform to reality. Herbert Simon's behaviorialmodel of the firm is much closer to the truth (though admittedlyless susceptible to elegant mathematical techniques). 7 Managersmay well face a vast array of possible combinations of inputs. Butthey are constrained by limited time, limited information, limitedenergy, and limited mental capacity. Consequently, they are lim-ited-and deliberately limit themselves-in their range of choices.Input combinations are seldom reinvestigated, let alone changed,unless some substantial perturbation thrusts the input question ontothe agenda for managerial attention. Even then, managers gatherand evaluate only information that is reasonably accessible. More-over, there is always inertial pressure against making any changethat will alter purchasing relationships unless the change promisesa substantial cost reduction that appears likely to continue for asignificant period of time.The second reason that input substitution is less significantthan Professor Cooter presumes concerns technological limitations.8In his analysis, Cooter compares his model of perfect substitutabilityto only the most restrictive example of limited factor substitutabil-ity-namely, fixed factor proportions (when there is one, and onlyone, technologically feasible proportion of inputs). More complex,and probably more frequent, are the intermediate cases in which6 These assumptions are embodied in the smooth, curved line in Cooter's Figure4. See Cooter, stipra note 1, at 1528.7See Harris & Sullivan, supra note 3, at 299-303, 301 n.70.8Tndeed, although technological limitations on factor substitution are logicallyseparable from limitations rooted in managerial behavior, the two are not mutuallyexclusive. Technological limitations may bound a zone within which managers donot consider changing input factor proportions.[Vol. 12.9:153X.some substitutability, but not an unlimited amount, is possible. Asshown in our Figure 1, this condition of limited substitutability isnot represented by a smooth curve like that in Professor Cooter'sFigure 4, but has "kinks" (that is, the curve is not continuouslydifferentiable).9FIGURE 1QyQyI 2Qx x QxIn these circumstances, small changes in relative factor pricesmight have no effect on the least-cost factor proportions. If, forexample, the relative prices of factors X and Y were those presentedby the price P1, then the cost-minimizing factor proportion is repre-sented by the intersection Q, Q . Suppose now that the producersof factor Y cartelize and increase their price to a supracompetitivelevel-this price shift is represented by price line P.. Nevertheless,Q Q, remains the cost-minimizing combination of inputs. Only'a very large shift in the relative prices of X and Y would make it9 For a complete economic analysis of production theory, see W. BAumox, Eco-NoMic THEORY AND OPERATIONS ANALYSIs (4th ed. 1977) (especially cl. 12).19811 DISCUSSION 15351536 UNIVERSITY OF PENNSYLVANIA LAW REVIEWrational for the firm to change its factor proportions (to, sayQd, Q,). Thus, small price changes have no effect on factor pro-portions, whereas a substantial change in relative prices can havea correspondingly large effect on the quantity of X and Y purchased.This analysis brings us to the point made in our Article andthe reason why factor substitutability was relegated to a footnote.10Given both the behavioral limits of managerial decisionmaking andthe technological limits on factor substitutability, only a significantchange in relative factor prices is likely to induce factor substitu-tion. But potential price fixers (or other overchargers) are as likely,or more likely, than are their customers to have information aboutthese limits. In these circumstances, as noted in our original foot-note, price fixers are not likely to raise prices to the point at whichthey would suffer large output losses owing to factor substitutionby direct purchasers.'We do not suggest that factor substitutability should be ig-nored in passing-on litigation. As Professor Cooter suggests, itwould be a relatively straightforward exercise for a court to deter-mine whether a significant degree of factor substitution had actu-ally occurred. If it had, the burden imposed on final consumerswould be reduced. But even then (as Professor Cooter agrees) thefinal consumers-not the direct purchasers-would bear the burden.Thus, Professor Cooter's essay impeaches neither our assertion thatindirect purchasers should have the opportunity to prove and re-cover their losses nor the method we described for determiningwhat portion of the total overcharge is allocable to purchasers ateach vertical stage.REPLY TO PROFESSORS VrroN AND WINSTONAlthough our Article extends and supplements price theorywith behavioral and institutional considerations, it is nonethelesstrue, as Professors Viton and Winston say, that our analysis is "par-tial." We assumed that courts hearing passing-on cases wouldexamine only one vertical distribution chain and would ignorepossible imperfections in related markets. We did not assume that a10 See Harris & Sullivan, supra note 3, at 292 n.59.11 To confirm our claim that factor substitutability is not frequently an importantissue, we reviewed the economic facts in the sixty-five recent price fixing casessummarized in the Appendix accompanying our Article. Id. 355-60. Althoughlacking in the information needed to make precise determinations, it is readily ap-parent that factor substitutability would have occurred in very few of these cases.Further, we are of the opinion that factor substitutability was unimportant or non-existent in all of the twenty-eight cases in which we ascribed the rate of passing onas "high."[Vol. 12.9:153aDISCUSSIONcourt in an antitrust case should try to deal with the whole economyor any larger portion of it than the market in which the challengedtrade restraint applies. 2If one assumes that all markets in the economy, save one, areeither perfectly competitive or subject only to mutually offsettingdistortions, Professors Viton and Winston are correct in noting thatimposition of an "overcharge" in one of the competitive marketsmight actually improve allocative efficiency (that is, "welfare," asthey use that term) because the newly imposed overcharge might"correct" for the defect in the one noncompetitive market. Giventhe interdependence of markets, one can picture a situation inwhich two "wrongs" might make a "right," or might at least bebetter than one "wrong." In the specific example offered by Pro-fessors Viton and Winston, that of unregulated trucking versusregulated railroad service, if all other markets are assumed to becompetitive, allocative efficiency might be improved by motor car-rier prices in excess of marginal costs.' sIt is a considerable leap, however, to argue from that singletwo-market example, that the Illinois Brick decision might as a rule(that is, over a number of cases), produce results that are economi-cally superior to the results implied by our analysis. There aretwo main reasons why we challenge that position.First, there is a matter of economics: If one accepts the restric-tive, value-laden assumptions embodied in neoclassical theory (or,for that matter, in any system of economic thought), it is possibleto logically prove certain results. For example, if one assumes,inter alia, that the prices of all other products are equal to theirmarginal social cost of production, one can prove that allocativeefficiency would be increased if the price of the product underanalysis were also equal to its marginal social cost of production.If the assumption about the prices of other products were not true(and, of course, those required assumptions never are true), eco-nomic theory simply cannot prove at what price the analyzed prod-12 There is a long tradition of "general analysis" in theoretical economics which,purportedly, incorporates all economic action and activities simultaneously. Analysisof this kind requires an extraordinarily high level of abstraction and highly restrictiveassumptions regarding the technical and behavioral characteristics of an economy.Consequently, it is seldom used in policy related analyses. The law characteristicallydeals in particularities and mid-level generalizations and rarely, if ever, attempts asweeping, general analysis of economic or equity issues. So far as we are aware, noantitrust court has ever attempted a general analysis.18 A similar problem of "second-best"-involving the same two industries-wasemphasized in an analysis of railroad regulatory policy toward branch line abandon-ments. See R. Harris, Simple Analytics of Rail Costs and Disinvestment Criteria,Transportation Research Record No. 687, at 19 (1978).1981]1538 UNIVERSITY OF PENNSYLVANIA LAW REVIEWuct must sell to maximize allocative efficiency. This is known asthe problem of "second best," and the thrust of the Viton-Winstonessay is that we have ignored it.Far from ignoring the second-best dilemma, each of us haselsewhere cited it as a major reason why policy cannot be basedsolely on, and why caution is essential regarding the results of,economic theory.14 Our disagreement with Professors Viton andWinston does not concern the existence of the dilemma, but ratherwhat to do about it. They treat allocative efficiency-a generalequilibrium condition-as the sole goal of antitrust law. Yet, theyapparently think second-best problems can be solved by lookingonly at one or two markets adjacent to that in which an antitrustrestraint arises. If those markets are all competitive, presumablyViton and Winston would have the court apply antitrust principlesto try to make the restrained market more competitive, assumingthat this would bring the economy as a whole closer to allocativeefficiency. In such an instance, we infer, they would allow indirectpurchasers to sue for monopoly overcharges. If, however, one ormore adjacent markets is not competitive, Professors Viton andWinston presumably would have the court countenance monopoliza-tion or cartelization in the restrained market.15We are persuaded, by contrast, that second-best problems ac-tually make it infeasible to use allocative efficiency as the basicgoal of antitrust policy.' 6 The second-best problem is not the dan-ger that an antitrust correction in one market is likely to yield aglobal loss in allocative efficiency. The problem, rather, is thatthere exists no theoretical or empirical basis for drawing any in-ference about what effect a correction in one market will have onallocative efficiency. An antitrust action may result in a closerrelationship between price and costs in a particular market. But ifone specifies allocative efficiency as the sole goal of antitrust (asViton and Winston implicitly do), one must judge every antitrustlaw suit by asking whether it moves the entire economy closer to' 4 See, e.g., L. SuLLIvAN, HANDBOOK OF LAW OF Ai.rrrrTUST 2-7 (1977);Harris, Deregulation: Panacea or Reform, Working Paper of the Center for Trans-portation Policy and Research, Berkeley (presented to Midwest Economic Associationin 1980) (on file with author).15 The implication of their essay is that in such circumstances indirect purchasersshould not have a damage action to recover the amount of an overcharge passed onto them. They do not make clear whether they would allow a damage action tothe direct purchaser, or would allow the government to enjoin or criminally punishthe violation. The logic of their position would appear to preclude any enforcementagainst cartelists in cases in which adjacent markets are not competitive.16 See note 14 supra.[Vol. 129:1533that highly particularized condition of system-wide equilibrium.An answer to that question will never be available.A single market correction would move in the direction ofimproving system-wide allocative efficiency only if: (1) all othermarkets could be held unchanged while one was corrected (a theo-retical impossibility); or (2) the ramifications of the correction inthe single market could be traced sufficiently far to warrant a con-fident judgment that, on balance, the system-wide effect was in thecorrect direction (an empirical improbability). Candid and realisticpractitioners of both law and economics must concede that the daywhen courts and juries will be capable of doing or comprehendinganalyses so complex and far reaching is a long way off. For thatmatter, we are still a good distance from the day when economictheorists are able to carry out such an analysis in a rigorous manner.Certainly, Professors Viton and Winston have not done it in theirhypothetical two-market example. Simply noting that the ultimatesystem-wide impacts of any given correction turn on the strengthof interdependence does not put us in possession of the analytictechnology that would enable us to use antitrust to move theeconomy, as a whole, closer to a state of allocatively efficientequilibrium.Consequently, we take issue with Professors Viton and Win-ston's implication that allocative efficiency is the sole measure forcomparing antitrust policies. Our reading of legal history suggeststhat "dread of enhancement of prices," '1 a concern about shiftingincome from consumers to monopolists and cartelists, not allocativeefficiency, is the basic economic goal of antitrust. s This, unlikeallocative efficiency, is a goal that does not depend on economy-wideeffects and that can be advanced in one market at a time.' 917 See Standard Oil Co. v. United States, 221 U.S. 1 (1911).Is See L. Sur.zavr, supra note 14, at 2-8.19 But see Williamson, Assessing Vertical Market Restrictions, 128 U. PA. L.REv. 953, 985-88 (1979), which also criticized the view that we are expressing here.Without making any attempt to show that it would be feasible to do a generalanalysis in an antitrust case, Williamson appears to rely on the theoretically andempirically unfounded assumption that any improvement in price-cost relationshipsin a single market will tend to improve allocative efficiency economy-wide. In effect,Williamson shifts the burden of proof and challenges those who think second-bestproblems may seriously interfere with the prospect of increasing allocative efficiencythrough antitrust to prove him wrong. Because both Williamson and we start bysupporting antitrust enforcement in any market in which a restraint reduces output,it may appear that there is no practical difference between his view and ours. Thelogic of Williamson's position, however, would require that he back away fromantitrust enforcement on facts like those in the Viton-Winston transportation markethypothetical, where the evidence, so far as traced, suggests that allocative efficiencyis not being served. Because we identify the goal of the law as foreclosing wealth19811 DISCUSSION 15391540 UNIVERSITY OF PENNSYLVANIA LAW REVIEW [Vol. 129:1533By emphasizing the "welfare triangle" in their Figure 1 20 (agraphical measure of the "deadweight" loss due to allocative in-efficiency), Professors Viton and Winston fail to acknowledge thedistributional consequences of their hypothetical mark-up of motorcarrier price above marginal cost. Their own graph shows-butthey fail to mention-an income transfer from the users to the pro-ducers of motor carrier services in an amount equal to the rectangleto the left of triangle B. This "distributional rectangle" is never-theless-in their example and in virtually all real cases-consider-ably larger than the "efficiency triangle." Professors Viton andWinston, like most economists, ignore it. Antitrust law, and ouranalysis, does not.transfers from consumers to monopolists or cartelists, we support enforcement in allinstances in which output is restricted by supracompetitive pricing.2 0 Viton & Winston, supra note 2, at 1520.

More on Passing on: A Reply to Cooter and to Viton and Winston

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