The Impractical Consumer Welfare Standard

As I mentioned in an earlier post, the CPI/CCIA conference at Harvard Law School last month brought together establishment scholars from the left and right to consider the calls for radical antitrust reform emanating from the Open Markets Institute (OMI), calls that have captured the imagination of some sections of the press and the political classes over the past few years. Former US and EU antitrust enforcers spoke at the last panel of the day, including Bill Baer, who headed the Antitrust Division of the Department of Justice for part of the Obama Administration.

Baer kicked off his remarks by stating that antitrust’s consumer welfare standard — a target of OMI, and much discussed on panels earlier that day in Cambridge — should stay, because it’s the only administrable standard available to antitrust.

But is it?

Antitrust’s consumer welfare standard holds that enforcers should challenge only anticompetitive conduct that threatens to harm consumers. The standard is the product of brutal intellectual clashes in the 1960s and 1970s between antitrust’s old establishment, which favored condemnation of all antitcompetitive conduct, regardless of effects on consumers, and a group of law professors and economists associated with the University of Chicago. These Chicago Schoolers succeeded at convincing courts and enforcers in the 1970s and 1980s that all anticompetitive conduct should be subject to a test for harm to consumer welfare, and condemned only if there is in fact harm to consumers.

OMI has tended to condemn the consumer welfare standard because the standard privileges the interests of consumers over the interests of other groups that may be harmed by anticompetitive conduct, notably workers, who suffer when employment alternatives disappear. But the immediate difficulty created by the consumer welfare standard has been more mundane: consumer welfare is hard to measure. Which makes it strange that Baer should think the standard administrable.

To see why the consumer welfare standard is hard to apply, consider the merger of AT&T and TimeWarner. Let us suppose that the merger would lead to reduced costs (because of the elimination of what economists call double marginalization), some improvements in program quality, because, for example, the combined firm can use viewing data to tailor content, and some increased market power, because TimeWarner can now raise prices to other content distributors safe in the knowledge that if negotiations fail and a blackout ensues, TimeWarner will still be able to continue to supply content to AT&T viewers.

The increase in market power suggests that consumers would be harmed by the deal, but whether that actually happens depends on whether either of two escape valves opens.  First, cost reductions associated with the merger could make consumers better off, even after market power effects are taken into account, if some portion of those cost reductions are passed on to consumers in the form of lower, though still monopoly-power-inflated, prices. Second, even if any cost reductions are not passed on to consumers, the improvement in programming quality might itself ultimately make consumers better off, if the improvement is sufficiently large to offset any increase in prices. Given the existence of these two escape valves, determining whether consumers are harmed by the merger requires enforcers to predict the price effects of the merger, along with the dollar value of the improvements in programming quality brought about by the merger, and to compare the difference between the two, known as “consumer surplus”, with the original pre-merger difference between price and programming value to consumers.

That’s hard, because quantifying the value of programming to consumers requires enforcers to deduce the maximum prices that consumers would be willing to pay for the programming, rather than the real prices that consumers actually are paying.

Indeed, measuring consumer welfare is so hard that in practice enforcers don’t even try to measure it, the law be damned. Instead, they just test to see whether the merger will raise prices, pretending that price increases are a good proxy for consumer harm, which of course they are not. If the value of the product to consumers rises by more than prices, for example, then consumers benefit from the merger. By the same token, a merger could drive down quality — perhaps the union of AT&T and TimeWarner would unleash targeted advertising that actually reduces program quality, for example — to such an extent that consumers would end up worse off from the merger even if the merging firms were to share some of their cost savings with consumers by lowering prices.

Enforcers don’t try to measure consumer welfare because they can’t.  And that tells us something important about whether the consumer welfare standard is as administrable as Baer says that it is: namely, that it isn’t administrable at all. Precisely because it is not clear in any case whether consumers are harmed, antitrust enforcers look to see whether prices would rise instead, since prices, thank goodness, are actually observable. Ostriches can relate.

In fact, enforcers don’t even proxy consumer welfare effects by looking exclusively at prices. Instead, they try to distinguish price effects unrelated to anticompetitive conduct, such as price hikes driven by higher energy prices, or other “exogenous” factors, and price effects that are attributable to the vigor of competition in the market. As I indicated in my earlier post on the CPI/CCIA conference, such an inquiry into what might be called “abnormal price effects” is really an inquiry into profit margins — increases in prices that are not driven by increases in costs.

And here is where the irony, and not just the falsity, of the claim that the consumer welfare standard is the only administrable antitrust standard shines forth. For the rule that antitrust should condemn anticompetitive conduct that increases profit margins is actually the old standard that the consumer welfare standard was fashioned to replace, the very standard in comparison to which the consumer welfare standard is supposed to be an improvement in administrability, practicality, clarity. The covert inquiry into profit margins that enforcers understand when they are supposed to be testing for consumer harm is nothing but the standard of the mid-20th-century golden age of antitrust. That standard prohibited all anticompetitive conduct, regardless whether the conduct harmed consumers or not, so long as that conduct could be expected to lead to, or protect, market power, defined as the power to earn abnormally high profit margins. The supreme inadministrability of the consumer welfare standard is actually expressed in the fact that enforcers don’t even follow that standard as a technical matter, but still follow the old standard that it was supposed to replace.

But if antitrust is still doing what it has always done in testing for abnormal profits, what explains the remarkable declines in antitrust enforcement since the Chicago School shifted antitrust to the consumer welfare standard in the late 1970s? The answer is that Chicago did not just change the standard on paper from harm to competition to harm to consumers, but also changed the burden of proof required to meet any standard. Thus while enforcers have continued covertly to apply the old standard — which looks at profit margins, not consumer welfare — they have done so with a level of skepticism about their own ability to identify increases in margins that did not exist before the triumph of the Chicago School in the 1970s.

To the extent that this skepticism is warranted, the consumer welfare standard is perhaps no more administrable than the margins alternative. But to the extent that the skepticism is not warranted, the consumer welfare standard is less administrable than the margins alternative. The fact that enforcers have sought in the measurement of profit margins a refuge from the challenge of measuring consumer welfare certainly suggests that margins are easier to measure, and that the consumer welfare standard is the less administrable standard. Either way, the consumer welfare standard is not more administrable than the profit margins alternative that came before it.

Another way to see this is to consider the role of the consumer welfare standard in basic antitrust doctrine. Before 1975, antitrust had two kinds of legal tests. The first, called the per se rule, condemned certain kinds of anticompetitive conduct full stop. The second, called the rule of reason, prohibited anticompetitive conduct by firms possessing, or acquiring through anticompetitive conduct, market power, understood to mean the ability to earn abnormal profits. The focus of the rule of reason on actually proving margins did not imply the unimportance of margins to the per se rule, only the willingness of enforcers to invest more time in proving margins in some cases (rule of reason cases) than in others (per se cases), for which latter it was hoped that proof of anticompetitive conduct alone would be sufficient to signal the existence of abnormal profit margins, at least on average.

Comes now the consumer welfare standard in the 1970s, which appears in the doctrine as an additional element required to meet the rule of reason test. Under that new rule of reason, three things were now required: (1) anticompetitive conduct, (2) market power, and now (3) consumer harm. Thus the consumer welfare standard created a compound test, one that requires both proof of abnormal margins and proof of harm to consumers.

But doing two things is not easier than doing just one of those things. The consumer welfare standard does not make it easier to do antitrust, but harder.

I put this point to the panel in Cambridge, but received only affirmations of faith in reply from several panelists, including former FTC chairs Jon Leibovitz and Bill Kovacic. Why does the consumer welfare standard seem to so many — and not just Baer — to be a practical standard? Why, because it’s an empyrean, an ideal, a beautiful but unobtainable thing. And we mistake the clarity of the vision for clarity of practice.

At least for the moment.

(Don’t the consumer welfare and market power (profit margins) elements in the new rule of reason test collapse into the same thing? No, for the same reason that consumer welfare can’t be proxied by price effects. Suppose that market power does allow AT&T and TimeWarner to raise prices after the merger, but also increases the value of programming to consumers by a greater amount. Consumer welfare increases, but margins also rise. Under the old rule of reason, which only looked at market power (profit margins), there is antitrust liability, but not under the new rule of reason, with its requirement of harm to consumers.)