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Regulation Magazine

What's Wrong with Price Fixing:
Responding to the New Critics of Antitrust

Michael E. DeBow

Michael E. DeBow is assistant professor at the Cumberland School of
Law, Samford University. From 1984 to 1985 he was attorney-adviser to the
chairman of the Federal Trade Commission, and from 1985 to 1986 he was special
assistant to the assistant attorney general, Antitrust Division,
U.S. Department of Justice.

Horizontal price fixing, involving conspiracy among competitors, is the archetypal violation of antitrust law. The law has dealt with this violation more harshly, and more predictably, than any other in antitrust's century-long existence. Today, after a decade of dramatic changes in other areas of antitrust doctrine and enforcement policy, the prohibition against horizontal price fixing constitutes the largely undisturbed core of antitrust law.

Even scholars identified with the "Chicago school" (Particularly Robert H. Bork, Richard A. Posner, and Frank H. Easterbrook), whose academic work has been at least partially responsible for many recent changes in antitrust, have defended the prohibition of horizontal price-fixing agreements. In a 1979 article describing the Chicago-school view, Posner explained that "only explicit price fixing and very large horizontal mergers" are "worthy of serious concern." In fact, the prohibition of horizontal price fixing has enjoyed consistent support from lawyers and economists across the American political spectrum. It is reasonable to conclude that the overwhelming majority of both conservative and liberal students of antitrust law would agree with Bork that the "contributions to consumer welfare over the decades" from the law's prohibition of price fixing "have been enormous."

In light of this, the Reagan Administration chose to make the prosecution of price-fixing conspiracies the centerpiece of its antitrust enforcement agenda. The US Department of Justice has prosecuted record numbers of price-fixing conspiracies since 1981.

It may come as a surprise, however, that in addition to critics on the left who urge a more adventuresome federal antitrust agenda, there are a few critics to the right of the Chicago school. This small but tenacious group argues for the repeal of all antitrust statutes.

The chief proponents of repeal are Professor Dominick I. Armentano of the University of Hartford and Fred L. Smith, Jr. of the Competitive Enterprise Institute in Washington, DC. They draw on arguments developed by several scholars including Professors Donald Dewey (Columbia University), Jack C. High (George Mason University), Mario J. Rizzo (New York University), Lester G. Telser (University of Chicago), George Bittlingmayer (Wissenschaftszentrum Berlin für Sozialforschung), and Gerald P. O'Driscoll (Federal Reserve Bank of Dallas). I refer to these authors collectively as the "new critics" of antitrust.

Repeal of the antitrust laws would allow firms to engage in numerous practices now forbidden or discouraged the most significant of which is horizontal price fixing. Those new critics who argue that price fixing should be legal have lodged two kinds of objections to the law: economic objections to the neoclassical economic theory typically employed to justify the law, and philosophical objections to the operation of the law. Several of the new critics are identified with the "Austrian school" of economics, which counts Ludwig von Mises and Nobel laureate Friedrich A. von Hayck as its most important twentieth century practitioners. The philosophical objections raised by Armentano and Smith are, in essence, of libertarian origin.

Although the recent history of antitrust provides ample evidence that the popularity of an antitrust doctrine does not guarantee its economic rationality, I argue below that the rule against price fixing deserves the widespread assent it has received. Both logic and empirical evidence cut sharply against an economic argument for repeal of the rules against price fixing.

Further, at least two of the most prominent scholars in the Austrian and libertarian traditions do not share the new critics' enthusiasm for price fixing.
Before examining the arguments of the new critics, a brief explanation of the existing rules against price fixing is in order.

Antitrust Doctrine and Neoclassical Economics

Section 1 of the Sherman Act declares illegal every contract, combination.. .or conspiracy, in restraint of trade." As currently interpreted, the principal effect of this statute is to prohibit "naked" price-fixing agreements, defined as agreements among competitors that set the price at which they will sell their products and that are not accompanied by any significant integration of the firms' productive activities. (Because prices may also be fixed by agreements to rig bids or to allocate customers, the term "price fixing" as used in this article includes these practices.)

A naked price-fixing agreement is, in effect, an agreement to act as a cartel. Within the familiar framework of neoclassical economics, the case against cartels is quite straightforward. A cartel agreement threatens to reduce the amount of a product available for purchase and to increase its price, thereby distorting the functioning of the marketplace by causing resources to be switched from production of the affected product to other, less highly valued uses. The social benefits from naked price fixing are thought to be small or nonexistent since there is no integration of the firms' activities.

Antitrust law does not condemn all agreements among horizontal competitors. Some horizontal agreements, under some circumstances, hold out the possibility of generating cost savings or other efficiencies that benefit consumers. An example would bean agreement among competitors to form a joint venture to conduct research and development activities that would not otherwise be undertaken. In such a case, a court would proceed under the "rule of reason" and attempt to weigh the likely efficiency gains against any likely anticompetitive effects in order to determine the agreement's legality.

By comparison, naked price-fixing agreements, once proved, are illegal per se; the law requires no elaborate inquiry as to the precise harm they have caused or the business excuse for their use. The neoclassical view of the costs and benefits associated with naked price fixing supports the presumption in antitrust law that such agreements restrain trade.

The New Critics' Economic Case

Accepting the neoclassical model for purposes of argument, Armentano, Smith, and others hold that the law seriously overestimates the costs of price fixing and fails to recognize its benefits. More fundamentally, some of the new critics argue that it is beyond the ability of judges and juries to perform the neoclassical benefit-cost analysis embedded in both the per se rule and the rule of reason.

Costs. Arrnentano, in his recent book Antitrust Policy: The Case for Repeal, contends that "although [price-fixing] agreements may intend to restrict production and increase group profits, they are generally not able to do so." Two familiar arguments are offered in support of this contention. First, the higher, cartel-administered prices will attract new firms to enter the industry- absent bafflers to entry-and prices will be driven back toward the competitive level. Second, each member of the cartel has an incentive to cheat on the cartel agreement by secretly lowering its price and substantially expanding its share of the market, thus increasing its profits at the expense of the other cartel members. As a result, the new critics claim, cartels are inherently unstable and unlikely to be effective in maintaining artificially high prices; the social costs of price fixing are thus overstated.

Economists of almost every stripe would agree, in principle, that cartels are inherently unstable. The key question-not considered carefully by the new critics-is how quickly the forces of competition act to defeat cartel pricing. This is an empirical question, and the available evidence suggests that cartel agreements can, in fact, be quite long-lived. Perhaps the best known US cartel, the electrical equipment cartel of the l950s, operated to one degree or another for roughly a decade before it was uncovered by the Department of Justice in 1959. According to Douglas H. Ginsburg, former assistant US attorney general and now federal circuit judge, the government's efforts to prosecute price fixers have "often involved continuous conspiracies more than 10 years old." Ginsburg concludes, "it is quite probable that many conspiracies operated for decades without ever being discovered." While new entry and internal dissension may be capable of eliminating some kinds of price-fixing conspiracies in short order, the evidence clearly shows that others succumb to these forces only in the long run.

The new critics respond by arguing that, in fact, the price-fixing conspiracies targeted in landmark cases over the years have not been effective cartels. In Antitrust and Monopoly: Anatomy of a Policy Failure, Armentano reviewed three of the most famous price-fixing cases-U.S. v. Addyston Pipe and Steel Company, US v. Trenton Potteries Company, and the electrical equipment cases-and concluded that each involved "ineffectual price and output agreements." In his discussion of the electrical equipment cartel, Armentano relies heavily on the economic research of Ralph Sultan and the congressional testimony of General Electric and Westinghouse executives for evidence that the conspiracies had little or no effect on prices and profits. The testimony of industry executives facing treble-damage lawsuits surely deserves some skepticism. Further, Armentano neglects to mention that Sultan's initial conclusions have been called into question by Sultan's own subsequent research as well as by the research of three economists at the Federal Trade Commission, David F. Lean, Jonathan D. Ogur, and Robert P. Rogers. In a 1985 study, Lean, Ogur, and Rogers found that the conspiracy had a significant effect on industry rates of return, although the effect was stronger in some product lines than in others.

While there is evidence to support either conclusion as to the overall effectiveness of the electrical equipment conspiracies, there are numerous recent cases in which price-fixing agreements had a clear, positive impact on prices. For example, a large number of the bid-rigging agreements prosecuted by the Justice Department in the late 1970s and 1980s had resulted in huge overcharges on a wide range of construction contracts. An estimate by the US Department of Transportation in the early l980s put the amount of collusive highway construction overcharges at between 2.5 percent and 5 percent of total federal highway expenditures, or between $260 million and $520 million annually.

Claims that cartels historically have been unstable and ineffective run into another difficulty: they may argue for continuing the prohibition of cartel agreements more than they argue for repealing it. Because price-fixing conspiracies are illegal, they must be carried out in secret. The panics to an agreement have an incentive to deceive each other and to cheat on the agreement, but they cannot resort to the courts or to any other open forum to compel compliance, it is no surprise, therefore, that cartel agreements today are less robust than legitimate contracts. The forces tending to weaken and ultimately destroy cartels would be much attenuated in the world envisioned by the new critics-a world without section 1 of the Sherman Act. Without section 1 cartels would enjoy a benign legal environment: freed of the need to operate secretly, they would become more adept in reaching and enforcing agreements. Were these agreements treated as legally enforceable, cartel discipline would be enhanced further by enlisting the courts as cartel managers.

The Organization of Petroleum Exporting Countries provides an interesting example of the kind of cartel the new critics would permit. Few would suggest that OPEC has been either short-lived or ineffective. (One estimate by Professor Gordon hillock of the University of Arizona is that OPEC effected a transfer of resources to its members on the order of $50 billion in its first year of operation.) Repeal of the antitrust laws would certainly encourage firms to seek to establish OPEC-like mechanisms for their industries, and would clearly enhance the average cartel's ability to restrict production and extract higher prices.

In short, even if the new critics could demonstrate that cartel agreements are generally fragile and ineffective under the current legal rules, that alone would not support the repeal of the legal prohibition against cartels. The real question that needs to be answered is whether cartels would be fragile and ineffective in a world without antitrust. Both logic and experience strongly suggest that the answer would be "no.'

Benefits. Armentano argues that "efficiencies and cost savings to society may indeed be associated" with price-fixing agreements. He and other new critics thus postulate that the traditional economic and legal analysis of price-fixing agreements errs by vastly underestimating the benefits generated by this practice.

The benefit most often claimed for price fixing is the elimination of some uncertainty for the parties to the agreement. In support of this claim Armentano cites Dewey, who argues that collusion is a method for firms to reduce uncertainty and, by extension, to reduce the cost of investment and marketing mistakes.

At least two features of Dewey's analysis, however, limit its usefulness. The first is that Dewey includes both price fixing and information sharing among competitors in his definition of collusion, and proceeds as if the law treated these two types of behavior with equal severity. It does not. Thus, to the extent that uncertainty can be eliminated by the use of legally permissible information sharing-among members of a trade association, for example-the case for repeal of the prohibition on price fixing is less compelling.

The second limiting feature of Dewey's analysis is the way in which collusion is modeled. Specifically, Dewey assumes free entry into the cartelized industry, a condition which he describes as the absence of impediments to newcomers in the form of "legislation, ignorance, an imperfect capital market, or technical handicap." Without "free entry" in this sense, Dewey's conclusions regarding the beneficial nature of price fixing are seriously undermined.

The absence of ignorance in Dewey's model involves "open membership" in the cartel as a "requirement for permitting collusion," that is, a government-imposed requirement that members of the cartel make public all information "made possible by collusion." Such a regulatory scheme would surely be distasteful to most of the new critics. At the very least, such a scheme would depend on, rather than eliminate, the government as an overseer of market behavior: incumbent cartel members would continue to have an incentive to keep information secret even if a pro-cartel statute required disclosure, and this would have to be policed by the government. Dewey fails to show us the way out of substantial government involvement regarding price fixing.

Another line of research invoked by Armentano and Smith is a branch of cooperative game theory known as the "theory of the core." Core theory, as developed by Telser and Bittlingmayer, holds that under certain conditions-including the presence of decreasing average costs-a competitive, non-colluding industry will not reach an equilibrium price and output. The industry will be unstable, subject to wild, unpredictable swings in prices and output. Under this senario, consumers are actually better off if firms choose some mechanism for dividing the firms choose some mechanism for dividing the market, thus eliminating some of the uncertainty imposed on them by market structure.

Bittlingmayer attempts to prove that the cast-iron pipe industry under scrutiny in the Addyston Pipe case fits this model. He argues that the pipe firms were driven into a price-fixing conspiracy by industry conditions. Armentano puts considerable emphasis on Bittlingmayer's research in maintaining that collusion may have beneficial effects, although Armentano also argues that the collusion at issue in Addyston Pipe was frustrated by "inevitable rivalry within the conspiracy." Bittlingmayer's findings have been called into question in 1986 study by Michael A. Williams who concluded that "a competitive market equilibrium existed for the Addyston Pipe firms." Thus, it remains to be documented that there are any real instances of an industry for which collusion is necessary.

Telser's ongoing research in this area ma yet affect our understanding of both the competitive and cooperative aspects of markets. Hi research to this point, however, does not support the conclusion that the prohibition of price fixing is unnecessary. In fact, Telser explicitly notes that in his model "it would not be possible to have at efficient allocation using [collusive] price floors: Instead of allowing fins to conspire to fix prices, Telser counsels the approval of industry use of upper bounds on the quantities each firm car sell," but with the firms otherwise "competing freely for customers." This would allow a four of market division that is now illegal; it would not, however, condone simple price fixing. It is also important to note, as Professor John S. Wiley argued in his 1987 critique of core theory, that Telser and Bittlingmayer leave judges to act as surrogate cartel managers, a task Wiley describes as "hopelessly unwieldy." Wherever Telser's research leads, it does not prescribe a return to laissez Faire and should not be casually invoked to support the abandonment of antitrust law.

Beyond Costs and Benefits. There is still a more radical critique of antitrust than that outlined above, which draws on the "subjectivist' attack on neoclassical economics. As explained in O'Driscoll and Rizzo's 1985 book, The Economies of Time and Ignorance, subjectivists assert that "competitive values or allocations [are not] independently ascertainable apart from actual market results." Thus the divination of hypothetical ideally competitive price-and-output levels is beyond our ability; we cannot create a "shadow' ideal market with which to compare actual market prices and outputs. As O'Driscoll and Rizzo bluntly put it, in the "absence of competitive markets, economic theory cannot tell us what is optimal." Taken literally, this view would appear to make it impossible to say that a cartel charges a higher price than would be charged in a competitive market, or that this causes any damage to consumers. O'Driscoll and Rizzo dismiss government intervention such as antitrust as "particularistic intervention at the micro level," and as "socialism writ small."

In this last statement, O'Driscoll and Rizzo invoke one of the Austrian school's finest achievements: the demonstration by von Mises and Hayek that, because of the necessarily incomplete information and poor incentives available to them, socialist central planners cannot manage an economy in such a way as to duplicate the performance of a free-market economy. But the Austrian contribution to the "socialist calculation" debate, important as it is, appears to be wholly inapplicable to the part of antitrust law that concerns us. Put simply, a rule prohibiting price fixing does not require the prior specification of equilibrium prices and quantities, and thus does not involve the deployment of the techniques of socialist planning on a case-by-case basis. After all, a firm convicted of price fixing is subject only to fines and damages (and its officers to jail ten); government price regulation is not an available sanction.

To see this point more clearly, consider a simple bid-rigging agreement on a public construction project. We can assume that but for the agreement, the bid the government would accept would be lower than the "rigged" bid. (If this is not true the conspirators are risking possible criminal and civil prosecution in a futile quest for higher profits.) As a result, some harm is visited on the taxpaying public. Either the tax burden must be increased to pay the overcharge, or government funds must be diverted to cover the overcharge. This conclusion does not require that we be able to specify exactly what the bid would have been, or ideally should have been, absent the conspiracy. (Although the computation of damages in antitrust cases does involve such considerations, this does not go to the fundamental merits of the prohibition on price fixing.)

High uses an argument similar to that of O'Driscoll and Rizzo, placing his critique of rules against price fixing in a dynamic context. In a 1984 study High asserts that "cartels, which have no socially redeeming value in static theory, promote efficiency in a world of incomplete knowledge and uncertainty," and that inefficient cartels, "like other inefficient business practices, will be eliminated through losses or entry." High asserts that there are benefits from price fixing, then goes on to argue that it is beyond the capacity of judges and juries to make comparisons between the asserted benefits and the costs of price fixing.

Bork, responding to the new critics, admits that the per se rule against price fixing presents several problems, the most serious being "that judges and juries are sometimes not competent to identify the presence of price fixing." Bork's proffered solution is "to improve the theory of cartel behavior and then educate judges so that they do not confuse common forms of competition with collusion." Having said this, Bork defends the continued per se prohibition of price fixing on familiar grounds: that the law may act, in many cases, to end cartels more quickly than would market competition; that the law further exerts a deterrent effect against price fixing; and that the judicial economy promoted by a per se rule is desirable, particularly with respect to price fixing, where the probability of damage to consumers is high and the probability of real efficiency gains from the practice appears to be low.

While it cannot be said that the current antitrust rules prohibiting horizontal price fixing are perfect, neither can it be said that the law raises problems similar to those of socialist central planning.

Antitrust Doctrine and Libertarian Philosophy

Should their economic arguments prove unpersuasive, some of the new critics deploy philosophical objections to antitrust's prohibition of price fixing. The philosophical arguments vary a bit from one critic to another, but basically they employ a "natural rights" theory of property and define a right to fix prices as part of a person's natural right to use his property as he pleases. For example, in 1985 Armentano wrote:

Economic matters aside, [price fixing does] not violate any property rights in the ordinary use of the term-that is, [it does] not involve force, fraud, or misrepresentation- yet [its] regulation or prohibition by the state directly violates the property rights of the market participants. From a strict libertarian or natural rights position, therefore, the antitrust laws are inherently unjust.

In a similar vein, Smith has criticized the Chicago school's efficiency-based defense of the rule against price fixing because it proceeds "as if business had no right in principle to dispose of its property as it sees fit, but only a conditional freedom so long as it helps maximize some social utility function."

Annentano and Smith have not stated whether they favor treating price-fixing agreements as legally enforceable contracts. However, the strong natural rights language they use suggests that they would view such contracts as no different from any other kind. Again this raises the specter of courts acting as referees in disputes among cartel members, penalizing firms for production in excess of contractual limits, for example, or for price discounting that erodes the profits of a fellow cartel member.

The new critics' philosophical claims are not susceptible to a definitive refutation. For this reason, it is reasonable to appeal to authority-in this case, a recognition that two of the best-known exponents of limited government and free markets do not subscribe to the natural rights justification for price fixing. Hayek, for example, in a 1979 treatise expresses support for "a general prohibition of all cartels, if it were consistently carried through." Doubts as to its execution, however, have led him to suggest that the State "declare invalid and legally unenforceable all agreements in restraint of trade, without any exceptions, and to prevent all attempts to enforce them.. by giving [injured parties] a claim for multiple damages."

Richard A. Epstein, perhaps the most visible legal scholar working in the libertarian tradition, has taken a similar approach. In a 1982 study, he argues that it is "possible that a limited set of prohibitions [against price fixing and territorial division of markets] make everyone better off ex ante than they would be under some alternative regime." He defines two alternatives: making price-fixing agreements unenforceable, and allowing actions for damages and injunctions by parties damaged by such agreements. Epstein favors the first alternative because of his "skepticism about the dimensions of the monopoly problem." However, he agrees that "the more aggressive tortlike intervention might be justified if it could produce major welfare gains."

The new critics' intertwining of Austrian economics and libertarian philosophy is, in my judgment, unfortunate. Austrian economics is a useful tool for thinking about markets and government, and one need not become a strict libertarian to appreciate its value. The key contribution of the Austrians is in offering a deeper understanding of the role of markets in coordinating the use of imperfect the widely dispersed information in society. The Austrian view of market interaction can differ dramatically form the standard neoclassical view, and often provides insights not readily available form the latter. The new critic's crusade to make the world safe for price fixing is unlikely to win wider consideration, and acceptance, of Austrian ideas.

Conclusion

The new critics of antitrust do not present a substantial challenge to the conventional wisdom about the legal prohibition against price fixing. Whether or not one accepts neoclassical economics as a framework for analysis, their claims that cartels are unstable, ineffective, or even beneficial, and demanded by natural law, do not withstand close inspection.

Selected Readings

Armentano, Dominick T. Antitrust Policy: The Case for Repeal. Washington, DC: Cato     Institute, 1986.
---. Antitrust and Monopoly: Anatomy of a Policy Failure. New York: John Wiley and Sons, 1982.
Dewey, Donald. "Information, Entry, and Welfare: The Case for Collusion." American     Economic Review, Vol. 69 (1979).
Smith, Fred L., Jr. "Why Not Abolish Antitrust?" Regulation, Jan/Feb (1983).
Telser, Lester G. "Cooperation, Competition and Efficiency." Journal of Law and Economics,     Vol. 28 (1985).
von Hayek, Friedrich A. Law, Legislation and Liberty, Vol. 3. Chicago: University of Chicago     Press, 1979.
Wiley, John S. "Antitrust and Core Theory." University of Chicago Law Review, Vol. 54     (1987).



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