Competition is the backbone of US economic policy. Competition advocacy is also thriving internationally. Promoting competition is broadly accepted as the best available tool for promoting consumer well-being. Competition officials, who regularly try to protect the public from anticompetitive special interest legislation, are justifiably jaded about complaints of excess competition. Although the economic crisis has prompted some policymakers to reconsider basic assumptions, the virtues of competition are not among them. Nonetheless to effectively advocate competition, officials must understand when competition itself is the problem’s cause, not its cure. Market competition, while harming some participants, often benefits society. But does competition always benefit society? This is antitrust’s blind spot. After outlining the virtues of competition, and discussing some well-accepted exceptions to competition law, this article addresses four scenarios where competition yields suboptimal results.
Americans love to compete. More Americans strongly agreed than any other surveyed country’s residents that they like situations where they compete.1 Praised in various contexts,2 competition is the backbone of US economic policy. The US Supreme Court observed, ‘The heart of our national economic policy long has been faith in the value of competition.’3 The belief in competition is not only embodied in the antitrust laws. Every US executive agency, for example, is legally required to have an advocate for competition.4
Competition advocacy is thriving internationally.5 The past 20 years witnessed more countries with antitrust laws and the birth and growth of the International Competition Network (ICN), an international organization of governmental competition authorities, with over 100 member countries.6 Although different constituencies accept to different degrees the benefits of competition and competition policy, the strongest competition advocates, in an ICN survey, were among the academic community, consumer associations, media, and nongovernmental organizations.7 ‘Within OECD countries, competition is now broadly accepted as the best available mechanism for maximising the things that one can demand from an economic system in most circumstances.’8
Preserving competition is, of course, the central tenet of America’s antitrust laws:
Competition officials regularly try to protect the public from anticompetitive special interest legislation.10 They are justifiably jaded about complaints of excessive competition. As one court observed, ‘Entertaining claims of excessive competition would undermine the functions of the antitrust laws.’11 This is especially relevant in an economic crisis, when competition is an attractive target. A US Department of Justice (DOJ) official observed:
The Sherman Act was designed to be a comprehensive charter of economic liberty aimed at preserving free and unfettered competition as the rule of trade. It rests on the premise that the unrestrained interaction of competitive forces will yield the best allocation of our economic resources, the lowest prices, the highest quality and the greatest material progress, while at the same time providing an environment conductive to the preservation of our democratic political and social institutions. But even were that premise open to question, the policy unequivocally laid down by the Act is competition.9
These days, it is unlikely that well-counseled firms will explicitly argue that they need to be saved from ‘ruinous’ or ‘cutthroat’ competition. But, under one name or another, this idea is likely to resurface. For example, two merging firms may well argue that ongoing competition will leave them with insufficient profits to make valuable and necessary investments to serve consumers. This is effectively a version of the ‘ruinous competition’ argument that should be treated skeptically.12
Although the economic crisis has prompted some policymakers to reconsider basic assumptions, the virtues of competition are not among them.13 Nonetheless to effectively advocate competition, officials must understand when competition itself is the cause, not the remedy, of the problem. Market competition, while harming some participants, often benefits society.14 But does competition always benefit society? This is antitrust’s blind spot.
One could argue that the problem is not economic competition per se, but poor regulatory controls. This is a valid point. Part of competition’s appeal is that no consensus exists on its meaning.15 Competition does not exist abstractly, but is influenced by the existing legal and informal institutions.16 A chicken–egg dilemma follows: Is the problem with competition itself or the legal and informal institutions that yielded this type of competition? One’s view depends in part on one’s ideological reference point—namely the belief of competition existing outside a regulatory framework, necessitating governmental intervention in the marketplace versus the belief that regulatory forces help create and define competition in the market, necessitating improvements to the legal framework.
This article identifies the problem as competition itself, since under most theories of competition, markets characterized with low entry barriers (and recent entry) should not be prone to the market failures described herein.17 Whatever the theory (failure of competition or regulations), society is worse off as a result.
The section ‘The virtues of competition’ outlines the virtues of competition. The section ‘Competition sacrificed’ discusses some well-accepted exceptions to competition policy. The section ‘The dark side of competition’ addresses four scenarios where competition yields a suboptimal result.
The virtues of competition
Among competition’s many virtues, the Supreme Court observed, are its being ‘the best method of allocating resources in a free market’ and ‘that all elements of a bargain-quality, service, safety, and durability-and not just the immediate cost, are favorably affected by the free opportunity to select among alternative offers’.18 Competition can yield:
lower costs and prices for goods and services,
more choices and variety,
greater efficiency and productivity,
economic development and growth,
greater wealth equality,
a stronger democracy by dispersing economic power, and
greater wellbeing by promoting individual initiative, liberty, and free association.19
Competition’s virtues are so ingrained within the antitrust community that competition often takes a religious quality. The Ordoliberal, Austrian, Chicago, post-Chicago, Harvard, and Populist schools, for example, can disagree over how competition plays outs in markets, the proper antitrust goals, and the legal standards to effectuate the goals. But they unabashedly agree that competition itself is good. Antitrust policies and enforcement priorities can change with incoming administrations. But the DOJ and US Federal Trade Commission (FTC) steadfastly target horizontal restraints and erection of entry barriers via legislation.20 Competition authorities from around the world may disagree over substantive and procedural issues, but they all advocate competition.21 Indeed the labels ‘pro-competitive’ and ‘anticompetitive’ are synonymous with socially beneficial and detrimental conduct.
Some policies that ostensibly restrict competition are justified for promoting competition. Intellectual property rights, for example, can restrict competition along some dimensions (such as the use of a trade name). But the belief is that intellectual property and antitrust policies, rather than conflict, complement one another in promoting innovation and competition.22 Likewise, contractual non-compete clauses are justified for their pro-competitive benefits.23
Given their faith in competition’s healing powers, antitrust officials and courts typically distrust complaints about competition.24 They are rightfully wary when industry groups or other government agencies decry competition as ruinous or destructive. First, consumers can pay more for poorer quality products or services, and have fewer choices. Second, governmental or private restraints can raise exit costs and inhibit innovation. Third, economic regulation can attract special interest groups to lobby for regulations that benefit them to society’s detriment. Competitors, challenged by new rivals or new forms of competition, may turn to regulators for help. Competitors may ask governmental agencies under the guise of consumer protection to prohibit or restrict certain pro-competitive activity, such as discounts to their clients. They may enlist the government to increase trade barriers or for other protectionist measures. Such ‘rent-seeking’ behavior benefits lobbyists and lawyers, but can substantially waste scarce resources. Finally, impeding competition can cause significant anti-democratic outcomes, like concentrated economic and political power, political instability, and corruption.25
Accordingly, antitrust officials are justly suspicious when regulatory bodies decide that a company’s entry would ‘tend to a destructive competition in markets already adequately served and would not be in the public interest’.26 Such decisions are best left to consumers, not regulators.
As the previous section discusses, competition, given its virtues, is the backbone of US economic policy. But competition, while often praised, is also criticized.27 One economic reality, as this section outlines, is that competition and antitrust law do not permeate all social and economic activity.
Activity not subject to competition
Life would be more stressful if we competed for everything. Competition cannot always be preferred over cooperation. Cooperation is often more appealing and socially rewarding.28 Society and competitors at times benefit when rivals cooperate in joint ventures and addressing societal needs (such as supporting education for specific trades). The divide between cooperation and competition is beyond this article’s scope.29 But one important issue is when competition makes people less cooperative, promotes selfishness and free-riding, reduces contributions to public goods, and leaves society worse off.30
Social and religious norms exclude or curtail competition in many daily settings. Commuting to work, in theory, is not a competitive sport. Parents should not foster competition among their children for their affection.31 None of the pleasurable daily or weekly activities (ie intimate relations, socializing after work, relaxing, dinner, lunch, praying/worship) necessarily implicate competition.32 Parishioners are discouraged from competing for better pews and parking spaces. Nor do the mainstream religions endorse a deity who wants people to compete for His love.
Antitrust norms do not translate easily in these social or religious settings. For example, if private companies agree to not cold call each other’s employees for employment opportunities, they face antitrust liability.33 Some religions arguably compete for new members.34 But it is doubtful that religious leaders are liable for agreeing not to proselytize each other’s members and to share information to enforce such agreements.35
Some goods and services are not subject to market competition.36 Although a market may otherwise form between willing buyers and sellers, the country’s laws and informal norms prevent these markets’ formation or curtail the economic competition therein. One example is human organs. Among the concerns economist Alvin Roth identifies are (i) ‘objectification’—pricing a thing or service moves it into a class of impersonal objects to which it does not belong [eg payment for organs transforms a good deed (donating one’s organs) into a bad one (marketing and selling one’s organs that violates human dignity)]; (ii) ‘coercion’—giving money ‘might leave some people, particularly the poor, open to exploitation from which they deserve protection’; and (iii) the ‘slippery slope’—monetizing transactions ‘may cause society to slide down a slippery slope to genuinely repugnant transactions’ [eg lenders use organs as collateral for debts, and opens up sale of body parts generally (including eyes, arms, legs, etc.)].37
This is not fixed. Markets once considered repugnant (eg lending money for interest, life insurance for adults) are no longer. Markets that are repugnant today (eg slavery), once were not.
The US antitrust laws apply across most industries and to nearly all forms of business organizations. But the Court noted:
Surely it cannot be said … that competition is of itself a national policy. To do so would disregard not only those areas of economic activity so long committed to government monopoly as no longer to be thought open to competition, such as the post office, cf., e.g., 17 Stat. 292 (criminal offense to establish unauthorized post office; provision since superseded), and those areas, loosely spoken of as natural monopolies or-more broadly-public utilities, in which active regulation has been found necessary to compensate for the inability of competition to provide adequate regulation. It would most strikingly disregard areas where policy has shifted from one of prohibiting restraints on competition to one of providing relief from the rigors of competition, as has been true of railroads.38
Some or all economic activity in various industries is expressly immunized from antitrust liability.39 Other significant areas of the economy are subject to implied antitrust immunity. The Court’s state action doctrine, for example, reflects the realities of state and local governments’ displacing competition for other aims.40
Noncommercial activities intended to promote social causes
Economic activity, even if not immunized, may fall outside the scope of the antitrust law. Although Congress intended the Sherman Act to apply to commercial activity, its legislative history ‘reveals that it was not intended to reach noncommercial activities that are intended to promote social causes’.41 Senator John Sherman did not oppose one proposed change to his bill that would exclude temperance organizations seeking to enforce state laws that discourage the use of liquor. But Sherman did not see:
any reason for putting in temperance societies any more than churches or school-houses or any other kind of moral or educational associations that may be organized. Such an association is not in any sense a combination arrangement made to interfere with interstate commerce.42
Thus, the Sherman Act’s ‘trade or commerce’ element applies to transactions one can characterize as ‘business’ or ‘commercial’.43 Several courts have held that if universities agree on the eligibility criteria for their student athletes, their eligibility rules are not subject to antitrust scrutiny.44 Rather than intending to provide the universities with a commercial advantage, these rules governing recruiting, improper inducements, and academic fraud primarily seek ‘to ensure fair competition in intercollegiate athletics’.45
Unfair methods of competition
Courts routinely reject the defense that every method of competing, such as passing one’s goods off the brand of another, benefits society.46 Although competition is beneficial, not all forms of competition are beneficial. Just as athletic contests distinguish between fair and foul play, the law distinguishes between fair and unfair methods of competition.47 This legislative policy recognizes that some methods of competition are socially undesirable. As one treatise observed:
on ethical, religious and social sources, American law has developed a minimum level or standard of ‘fairness’ in competitive rivalry. The law of unfair competition has developed as a kind of Marquis of Queensbury code for competitive infighting. To pursue the analogy, it would be equally as unacceptable for the contestants in a prize-fight to agree privately to ‘throw the fight’ as it would be for one contestant to insert a horseshoe in his glove.48
* * *
In reviewing the section ‘Competition sacrificed’, the antitrust community would not quibble about eliminating or limiting competition in noncommercial activities. The antitrust community would debate over what constitutes fair and unfair methods of competition, but agree that not all methods of competition are desirable. The community would likely tolerate price and service regulations in some industries (eg natural monopolies) where competition is not feasible.49 As for antitrust immunities, the consensus within the antitrust community is that they reflect the victory of special interest groups and the collective action problem of citizens.50 Antitrust immunity is rarely a good thing, is rarely justifiable on the grounds of improving societal wellbeing, often outlives its intended purpose, and should be read ‘narrowly, with beady eyes and green eyeshades’.51
For most other commercial activity, however, competition on the merits is the presumed policy. As one American court observed:
Few, if any, antitrust practitioners would disagree.
The Sherman Act, embodying as it does a preference for competition, has been since its enactment almost an economic constitution for our complex national economy. A fair approach in the accommodation between the seemingly disparate goals of regulation and competition should be to assume that competition, and thus antitrust law, does operate unless clearly displaced.52
The dark side of competition
In condemning private and public anti-competitive restraints, competition officials and courts invariably prescribe competition as the cure. Increasing competition ‘improves a country’s performance, opens business opportunities to its citizens and reduces the cost of goods and services throughout the economy’.53 Competition, officials recognize, does not cure every market failure (such as from negative externalities or public goods).54 Fierce competition ultimately may yield oligopolies or monopolies. But that is a function of market conditions, not competition itself. Competition itself cannot cause market failures.
Although competition is often beneficial, is competition ‘always’ beneficial? Economist Irving Fisher over a century ago examined two assumptions of any laissez-faire doctrine:
In relaxing these two assumptions, Fisher discussed how competition is not always beneficial. In the past decade, the economic literature has identified several scenarios where the problem is not too little competition, or concerns over unfair methods of competition, but the suboptimal effects from competition itself.
first, each individual is the best judge of what subserves his own interest, and the motive of self-interest leads him to secure the maximum of well-being for himself; and, secondly, since society is merely the sum of individuals, the effort of each to secure the maximum of well-being for himself has as its necessary effect to secure thereby also the maximum of well-being for society as a whole.55
Using the recent advances in behavioral economics, subsections ‘Behavioral exploitation’ and ‘Competitive escalation paradigm’ examine Fisher’s first assumption. Surveying some recent empirical economic work, subsections ‘When individual and group interests diverge’ and ‘When competition among intermediaries reduces accuracy’ examine Fisher’s second assumption.
Competition policy typically assumes that market participants can best judge what subserves their interests.56 Once we relax the assumption of market participants’ rationality and willpower, then competition at times leaves consumers and society worse off. Suboptimal competition can arise when firms compete in fostering and exploiting demand-driven biases or imperfect willpower.
To illustrate, suppose many consumers share certain biases and limited willpower. Competition benefits society when firms compete to help consumers obtain or find solutions for their bounded rationality and willpower. Alternatively, competition harms society when firms compete to better exploit consumers’ bounded rationality or willpower. Suboptimal competition is unlikely if firms inform bounded rational consumers of other firms’ attempts to exploit them. Providing this information is another facet of competition—trust us, we will not exploit you.57 This is not always true.58 Rather than compete to build consumers’ trust in their business, firms instead compete in devising better or new ways to exploit consumers, such as:
using framing effects and changing the reference point, such that the price change is viewed as a discount, rather than a surcharge;59
anchoring consumers to an artificially high suggested retail price, from which bounded rational consumers negotiate;60
adding decoy options (such as restaurant’s adding higher priced wine) to steer consumers to higher margin goods and services;61
using the sunk cost fallacy to remind consumers of the financial commitment they already made to induce them to continue paying installments on items, whose value is less than the remainder of payments;
using the focusing illusion in advertisements (ie consumers predicting greater personal happiness from consumption of the advertised good and not accounting one’s adaptation to the new product);64 and
The credit card industry provides one example. Some consumers do not understand the complex, opaque ways late fees and interest rates are calculated, and are overoptimistic on their ability and willpower to timely pay off the credit card purchases.67 They underestimate the costs of their future borrowings and overestimate their likelihood of switching to lower interest credit.68 The consumers choose credit cards with lower annual fees (but higher financing fees and penalties) over better-suited products (eg credit cards with higher annual fees but lower interest rates and late payment penalties).69
Rational companies can exploit consumers’ biases.70 One former CEO, for example, explained how his credit card company targeted low-income customers ‘by offering “free” credit cards that carried heavy hidden fees’.71 The former CEO explained how these ads targeted consumers’ optimism: ‘When people make the buying decision, they don’t look at the penalty fees because they never believe they’ll be late. They never believe they’ll be over limit, right?’72
For other credit card competitors, exploiting consumer biases makes more sense than incurring the costs to debias.73 If a credit card issuer invests in educating consumers of the likely total costs of using the credit card, their bounded willpower, and their overconfidence, other competitors can free ride on the company’s educational efforts and quickly offer similar credit cards with lower fees. Alternatively, the debiased consumers do not remain with the helpful credit card company. Instead they switch to the remaining exploiting credit card firms, where they, along with the other sophisticated customers, benefit from the exploitation (such as getting airline miles for their purchases, while not incurring any late fees).74 Under either scenario, debiasing reduces the credit card company’s profits, without offering any lasting competitive advantage. Consequently, the industry profits more in exploiting consumers’ bounded rationality. Naïve consumers will not demand better-suited products. Firms have little financial incentive to help naïve consumers choose better products.75 Market supply skews toward products and services that exploit or reinforce consumers’ bounded willpower and rationality.
This problem, of course, can arise under oligopolies or monopolies. But here entry and greater competition, as one recent survey found, can worsen, rather than improve, the situation:
Nor is behavioral exploitation the typical cartel problem, whereby firms collude explicitly (agreeing how they will compete or refrain from competing) or tacitly (which still involves detecting and punishing any deviations that ‘undermine the coordinated interaction’).77 Instead behavioral exploitation is more like parallel accommodating conduct, where ‘each rival’s response to competitive moves made by others is individually rational, and not motivated by retaliation or deterrence nor intended to sustain an agreed-upon market outcome, but nevertheless emboldens price increases and weakens competitive incentives to reduce prices or offer customers better terms’.78 Firms compete in devising cleverer ways to attract and exploit bounded rational consumers with imperfect willpower.
The most striking result of the literature so far is that increasing competition through fostering entry of more firms may not on its own always improve outcomes for consumers. Indeed competition may not help when there are at least some consumers who do not search properly or have difficulties judging quality and prices … In the presence of such consumers it is no longer clear that firms necessarily have an incentive to compete by offering better deals. Rather, they can focus on exploiting biased consumers who are very likely to purchase from them regardless of price and quality. These effects can be made worse through firms' deliberate attempts to make price comparisons and search harder (through complex pricing, shrouding, etc) and obscure product quality. The incentives to engage in such activities become more intense when there are more competitors.76
It is important to note that once we relax the assumptions of rationality and willpower, it does not follow that competition ‘always’ yields suboptimal outcomes.79 This suboptimal competition depends first on firms’ ability to identify and exploit consumers whose biases, heuristics, and willpower make them particularly vulnerable. Second, after identifying these consumers, firms must be able to exploit them.80 Third, the payoff from exploiting must exceed the likely payoff from debiasing consumers.81 Firms lack an incentive to debias if sophisticated consumers, for example, support the exploiting firms as the myopic consumers subsidize their perks.82 Finally, naïve consumers cannot otherwise quickly debias by being provided information or otherwise learning from their errors and adjusting. Thus, with enough naïve consumers to profitably exploit in these markets, firms will compete in devising better ways to exploit them.
Consequently, both antitrust and consumer protection law can complement each other in promoting the opportunity for consumers to choose among the firms’ helpful solutions for their problems, while foreclosing suboptimal competition, where companies exploit consumers’ biases and imperfect willpower to the consumers’ and society’s detriment.
Competitive escalation paradigm
The previous subsection describes suboptimal competition to exploit consumers’ biases and imperfect willpower. But firms, like consumers, are also susceptible to biases and heuristics. In competitive settings—such as auctions and bidding wars—overconfidence and passion may trump reason, leading participants to overpay for the purchased assets.83 Unlike demand-driven biases (eg overconfident consumers demanding inappropriate financial products), competition should check supply-driven biases. Consumers, in competitive markets, presumably punish firms’ costly biases by taking their business elsewhere. If repeated biased decision-making is not punished, the problem is too little, rather than too much, competition.
One exception is the competitive escalation paradigm, when ‘two parties engage in an activity that is clearly irrational in terms of the expected outcomes to both sides, despite the fact that it is difficult to identify specific irrational actions by either party’.84 To demonstrate this paradigm, Professors Max Bazerman and Don Moore auction a $20 bill.85 The auction proceeds in dollar increments. The highest bidder wins the $20 bill; but the second highest bidder, as the loser, must pay the auctioneer his or her bid. (So if the highest bid is $4, the winner receives $16; if the second highest bid is $3, the loser must pay $3 to the auctioneer.)
Bidding over $20 for a $20 bill is illogical. Given the cost of losing, it is also illogical to enter a bidding war. But if everyone believes this, no one bids—also illogical. If only one person bids, that person gets a bargain. Once multiple bidders emerge, the second highest bidder fears having to pay and escalates the commitment. As a result, the bidding in experiments with undergraduate students, graduate students, and executives ‘typically ends between $20 and $70, but hits $100 with some regularity’.86
Bazerman and Moore analogize their experiment to merger contests. Competitors A and B, in their example, fear being competitively disadvantaged if the other acquires cheaply Company C, a key supplier or buyer.87 Company C, worth $1 billion as a standalone company, is worth $1.2 billion under either Firm A’s or B’s ownership. If Firm A acquires Company C, then Firm B, having lost its key supplier or buyer, would be significantly disadvantaged, at an estimated cost of $500 million. The same applies to Firm A if Firm B acquires Company C. Firms A and B may rationally decide to enter the bidding contest. Both are better off if the other cannot acquire Company C, nonetheless neither can afford the other to acquire the firm. Firms A and B, to avoid the $0.5 billion loss, could escalate the bidding to around $1.7 billion.88 One example of this competitive escalation paradigm, argue Bazerman and Moore, is when Johnson & Johnson and Boston Scientific overbid for Guidant.89
Here clear antitrust standards can benefit the competitors. If they both know they cannot acquire Company C under the antitrust laws, neither will bid. Antitrust, while not always preventing the competitive escalation paradigm, can prevent overbidding in highly concentrated industries where market forces cannot punish firms that overbid.
When individual and group interests diverge
Suppose the first assumption Fisher identifies is satisfied—people aptly judge what serves their interest, which leads them to maximize their well-being. One avoids the problem of behavioral exploitation and perhaps the competitive escalation paradigm. Nonetheless, as this subsection discusses, competition can be suboptimal if the second key assumption Fisher identifies is relaxed—namely the effort of each person to secure well-being has as its necessary effect to maximize society’s overall well-being.
Competition benefits society when individual and group interests and incentives are aligned (or at least do not conflict). Difficulties arise when individual interests and group interests diverge.90 Indeed economist Robert Frank recently predicted in a 100 years, most economists will identify as their discipline’s intellectual father, Charles Darwin:
As Darwin saw clearly, the fact that unfettered competition in nature often fails to promote the common good has nothing to do with monopoly exploitation. Rather, it’s a simple consequence of an often sharp divergence between individual and group interests.91
One area of suboptimal competition is where advantages and disadvantages are relative.92 Frank used the bull elk as an example. It is in each elk’s interest to have relatively larger antlers to defeat other bull elks. But the larger antlers compromise the elks’ mobility, handicapping the group overall.93
Hockey players are another example. Hockey players prefer wearing helmets. But to secure a relative competitive advantage, one player chooses to play without a helmet. The other players follow. None now have a competitive advantage from playing helmetless. Collectively the hockey players are worse off.94 Fisher’s example involves patrons competing to exit a theater on fire; it is in each individual’s interest to get ahead of others, but ‘the very intensity of such efforts in the aggregate defeat their own ends’.95
A recent example is Wall Street traders who inject testosterone to obtain a competitive advantage.96 One study found that traders’ daily testosterone ‘was significantly higher on days when traders made more than their 1-month daily average than on other days’; the ‘results suggest that high morning testosterone predicts greater profitability for the rest of that day’.97 Higher testosterone levels, studies found, increased ‘search persistence, appetite for risk, and fearlessness in the face of novelty, qualities that would augment the performance of any trader who had a positive expected return’.98 Male and female traders, weighing the benefits and risks, can rationally decide to increase their testosterone levels to gain a competitive advantage over other traders (or at least not be competitively disadvantaged against higher testosterone traders).99 However, as other traders undertake hormone treatments, the traders no longer enjoy a competitive advantage. They and society are collectively worse off.100
Below are five additional scenarios where competition for a relative advantage can leave the competitors collectively and society worse off.
How individual and group interests can diverge when firms lobby for a relative competitive advantage
Today corporations and trade groups spend billions of dollars lobbying the federal and state governments.101 Microsoft, for example, historically did little lobbying.102 That changed after the United States filed its antitrust lawsuit. Microsoft now spends millions of dollars annually on lobbying.103 Not surprisingly, given the recent antitrust scrutiny, Google spends even more on lobbying—$9,680,000 alone in 2011.104
The Supreme Court quickened the race to the bottom when it substantially weakened the limitations on corporate political spending, and thereby vastly increased the importance of pleasing large donors to win elections.105 The Court saw itself as removing an important competitive restraint in the marketplace of ideas. But Justice Stevens saw competition’s dark side:
In this transactional spirit, some corporations have affirmatively urged Congress to place limits on their electioneering communications. These corporations fear that officeholders will shake them down for supportive ads, that they will have to spend increasing sums on elections in an ever-escalating arms race with their competitors, and that public trust in business will be eroded. A system that effectively forces corporations to use their shareholders' money both to maintain access to, and to avoid retribution from, elected officials may ultimately prove more harmful than beneficial to many corporations. It can impose a kind of implicit tax.106
The competitive pressure to lobby for a relative advantage (or prevent a relative disadvantage) harms the firms collectively as they ‘feel compelled to keep up with their competitors, particularly in the face of a shakedown by elected officials who write the laws and regulations that corporations must follow on a daily basis’.107 This arms race also undermines a democracy.108 Part of the current malaise, the Occupy Wall Street movement reflects, is the distrust in government given its capture to special interests.109
How individual and group interests can diverge when firms behave unethically for a relative competitive advantage
When auditor Ernst and Young recently surveyed nearly 400 chief financial officers, its findings were disturbing:
When presented with a list of possibly questionable actions that may help the business survive, 47 per cent of CFOs felt one or more could be justified in an economic downturn.
Worryingly, 15 per cent of CFOs surveyed would be willing to make cash payments to win or retain business and 4 per cent view misstating a company's financial performance as justifiable to help a business survive.
While 46 per cent of total respondents agree that company management is likely to cut corners to meet targets, CFOs have an even more pessimistic view (52 per cent).110
Competition, economist Andrei Shleifer discusses, can pressure companies to engage in unethical or criminal behavior, if doing so yields the firm a relative competitive advantage.111 Other recent economic literature discusses how competition can encourage companies to:
invest less in legal compliance and more likely violate the law,112
pay kickbacks to secure business,113
underreport profits to avoid taxes,114 and
manipulate the ordering protocols on liver transplants.115
The studies’ underlying theme is that as competition increases, and profit margins decrease, firms have greater incentive to engage in unethical behavior that improves their costs (relative to competitors). Other firms, given the cost disadvantage, face competitive pressure to follow; such competition collectively leaves the firms and society worse off.116
Not surprisingly the business literature currently argues for a ‘more sophisticated form of capitalism, one imbued with a social purpose’.117 In the past, the concepts of sustainability, fairness, and profitability generally were seen as conflicting. But under a shared value worldview, these concepts are reinforcing.118 Profits can be attained, not through a competitive race to the bottom, but in better helping address societal needs.
How individual and group interests can diverge when financial institutions undertake additional risk for a relative competitive advantage
The conflict between collective and individual interests arose in the financial crisis. Banks, the OECD described, are prone to take substantial risks:
First, the opacity and the long maturity of banks' assets make it easier to cover any misallocation of resources, at least in the short run. Second, the wide dispersion of bank debt among small, uninformed (and often fully insured) investors prevents any effective discipline on banks from the side of depositors. Thus, because banks can behave less prudently without being easily detected or being forced to pay additional funding costs, they have stronger incentives to take risk than firms in other industries. Examples of fraud and excessive risk are numerous in the history of financial systems as the current crisis has also shown.119
An overleveraged financial institution can ignore the small probability that its risky conduct in conjunction with its competitors’ risky conduct may bring down the entire economy.120 To gain additional profits and a competitive advantage, each firm will incur greater leverage. Even for rational-choice theorists like Richard Posner, the government must be a countervailing force to such self-interested rational private behavior by better regulating financial institutions.121 Otherwise competition among rational self-interested ‘law-abiding financiers and consumers can precipitate an economic disaster’.122
One may ask if competition is the problem, then is monopoly the cure. The remedy is neither monopoly nor overregulation (which besides impeding competition, stifles innovation and renders the financial system inefficient or unprofitable). But the remedy is not simply more competition, which can increase the financial system’s instability, as banks increase leverage and risk.123 Instead, the financial industry must be ‘competitive enough to provide a range of services at a reasonable price for consumers, but [is] not prone to periods of excess competition, where risk is under priced (for example, to gain market share) and competitors fail as a result with systemic consequences’.124
How individual and group interests can diverge when firms demand Most-Favored-Nation (MFN) clauses for a relative competitive advantage
MFN clauses, the subject of two recent DOJ enforcement actions, are topical.125 Some courts have embraced MFNs as pro-competitive. MFN clauses, Posner wrote, ‘are standard devices by which buyers try to bargain for low prices, by getting the seller to agree to treat them as favorably as any of their other customers’.126 This ‘is the sort of conduct that the antitrust laws seek to encourage’.127 Likewise, another court found that the MFN’s ‘insisting on a supplier's lowest price—assuming that the price is not “predatory” or below the supplier's incremental cost—tends to further competition on the merits’.128 It seemed ‘silly’ to the court ‘to argue that a policy to pay the same amount for the same service is anticompetitive, even on the part of one who has market power. This, it would seem, is what competition should be all about’.129
Antitrust scholarship has identified MFN’s potential anticompetitive effects.130 The purpose here is to illustrate how individual and collective interests diverge in competitive environments, leaving buyers collectively worse off. The FTC in Ethyl described this divergence:
The appellate court, however, disagreed.132 The MFN, observed the court, ‘assured the smaller refiners that they would not be placed at a competitive disadvantage on account of price discounts to giants such as Standard Oil, Texaco and Gulf’.133
An individual customer may rationally wish to have advance notice of price increases, uniform delivered pricing, or most favored nation clauses available in connection with the purchase of antiknock compounds. However, individual purchasers are often unable to perceive or to measure the overall effect of all sellers pursuing the same practices with many buyers, and do not understand or appreciate the benefit of prohibiting the practices to improve the competitive environment … .a most favored nation clause is perceived by individual buyers to guarantee low prices; whereas widespread use of the clauses has the opposite effect of keeping prices high and uniform. In short, marketing practices that are preferred by both sellers and buyers may still have an anticompetitive effect.131
What the appellate court failed to grasp is that MFNs—while individually rational—can be collectively irrational.134 MFNs assure buyers that others during a specific time period will not pay a lower price. If the buyers fiercely compete, MFNs seemingly provide a relative cost advantage. The buyer need not expend time and expense to negotiate a lower price; it can free ride on other buyers’ efforts. It is in each buyer’s individual interest to secure this cost advantage; thus buyers may demand, and sellers may offer, MFN protection.135 Competition drives buyers to demand MFN protection to lower their transaction costs; the number of buyers willing to invest in procuring a discount shrink. (Why should they uniquely incur the cost, when the benefits accrue to their rivals?) Accordingly, ‘buyer competition to obtain most-favored-customer protection, in the end, can cost buyers as a group’.136
How individual and group interests can diverge when consumers compete for status
Status competition epitomizes competition for relative position among consumers with interdependent preferences.137 The ancient Greek and Roman philosophers,138 early Christian theologians,139 and economists Adam Smith140 and Thorstein Veblen141 described how status competition is never won. Either people adapt to their fancier lifestyle, and envy those on the higher rung.142 Or others catch up in their consumption (eg similarly large homes, extravagant parties), increasing the demand for conspicuous consumption or leisure that provide a relative advantage.
Despite status competition’s durability and prevalence, few praise it. C. S. Lewis, for example, observed that pride generally is the ‘essential vice’ and ‘complete anti-God state of mind’.143 Pride is competition awry: ‘Pride is essentially competitive—is competitive by its very nature—while the other vices are competitive only, so to speak, by accident.’144 Pride, Lewis also wrote, ‘has been the chief cause of misery in every nation and every family since the world began’.145
Status competition not only taxes individuals but society overall.146 As economists that study subjective well-being conclude, ‘[h]igher-income aspirations reduce people’s satisfaction with life.’147 Wealthier people impose a negative externality on poorer people.148 Antitrust norms, such as a per se prohibition of resale price maintenance for status goods,149 are also difficult to reconcile with status competition where individual and collective interests can diverge to consumers’ and society’s detriment.150
Status competition has confounded consumers and economists for centuries. John Maynard Keynes, for example, assumed that with greater productivity and higher living standards, people in developed economies would work only fifteen hours per week.151 He identified two classes of needs—‘those needs which are absolute in the sense that we feel them whatever the situation of our fellow human beings may be, and those which are relative in the sense that we feel them only if their satisfaction lifts us above, makes us feel superior to, our fellows.’152 As its economy developed, Keynes predicted, society would deemphasize the importance of relative needs.153
So why aren’t many Americans, Europeans, and Asians today working 15 or 20 hours per week? Keynes correctly predicted the rise in productivity and real living standards. But he ‘underestimated the appeal of materialism’.154 Fisher, however, grasped this:
Much has been said of late about the importance of living the simple life, but so far as I know there has been no analysis to show why it is not lived. This analysis would reveal that the failure to live it is due to a kind of unconscious cut-throat competition in fashionable society.155
Status competition is often, but not always, detrimental. On the bright side, people voluntarily compete and use Internet peer pressure to change their energy consumption, driving, and exercise habits.156 But status competition is often suboptimal. One interesting empirical study sought to understand why academics cheated by inflating the number of times their papers were downloaded on the Social Science Research Network (SSRN).157 SSRN ranks authors, their papers, and their academic institutions by the number of times the papers are downloaded.158 Some authors repeatedly downloaded their own papers to inflate the publicly recorded download count. Why the deception? Status competition, the study found, was a key contributor.159
* * *
In all five scenarios, competitors seek a relative advantage that ultimately leaves them collectively and society worse off. This suboptimal competition is not a new concept. Many, however, used a pejorative term, instead of competition, to describe it, such as:
a collective action problem,160
a race to the bottom or regulatory arbitrage—where states compete away environmental, safety, and labor protections to obtain a relative advantage,161 or
rational irrationality, whereby the ‘application of rational self-interest in the marketplace leads to an inferior and socially irrational outcome’.162
Some may argue that these scenarios simply involve competitors’ imposing negative externalities on one another. Negative externalities typically involve ‘situations when the effect of production or consumption of goods and services imposes costs or benefits on others which are not reflected in the prices charged for the goods and services being provided’.163 Even if one viewed competition itself as a negative externality that a competitor imposes on rivals, an important distinction exists. Firms—independent of any competitive pressure—at times impose a negative externality to maximize profits. For example, electric power utilities, whether or not a monopoly, will seek to maximize profits by polluting cheaply and having the community bear the environmental and health costs. In contrast, as this subsection discusses, competition induces the firm to impose a negative externality, which absent competitive pressure, the firm would ‘not’ otherwise impose. The utility monopoly, for example, may lobby to keep abay pesky environmentalists, but it would not expend resources on lobbying to secure a relative competitive advantage when its market power is otherwise secure.
When competition among intermediaries reduces accuracy
The previous subsection identifies five scenarios where competition for a relative advantage leaves the competitors and society worse off. This subsection discusses another race to the bottom, namely when consumers pressure an intermediary to shade its findings to the consumers’ liking, but society’s overall detriment. As competition increases in the intermediary’s market, more will be willing to distort their findings and reduce accuracy, which may appeal to the individual customers, but harms society overall.
Underlying democracies is the belief that competition fosters the marketplace of ideas: truth prevails in the widest possible dissemination of information from diverse and antagonistic sources.164 Competition should, and often does, improve accuracy.165
But competition can decrease accuracy when intermediaries, who monitor or report market participants’ businesses, property, goods, services, or behavior, also compete for the market participants’ business. One cannot characterize this simply as an incentives problem, whereby the intermediary shades its findings to the customers’ liking because the customer pays for the service. For if the problem were attributable primarily to misaligned incentives, then the problem would arise in duopolies, and be unaffected by entry and increased competition. Here, misaligned incentives play an important role, but so do increased entry and competition.166 The concern is that competition increases the pressure on intermediaries to engage in unethical behavior.
This subsection discusses two industries, where, as recent economic studies found, greater competition yielded more unethical conduct among intermediaries. But this problem can arise in other markets as well. Home appraisers, pressured by threats of losing business to competitors, inflate their valuations to the benefit of real estate brokers (who gain higher commissions) and lenders (who make bigger loans and earn greater returns when selling them to investors).167 Facing competitive pressure, lawyers can also adopt ‘a stronger adversarial and client-centered approach in the hope that this stance will be rewarded by clients' preferences’; more complaints about lawyer misconduct ensue.168 Thus markets where intermediaries can manipulate information and test results can enjoy greater efficiency with less competition.
Ratings agencies provide several complementary functions:
The DOJ, as one expects from an antitrust agency, advocated for more entry and competition in the ratings industry, which two firms long dominated. The DOJ asked in 1998 the US Securities and Exchange Commission (SEC) to modify its proposed regulations ‘so that new rating agencies could more easily enter the market, thereby increasing competition’.170 The SEC's proposal ‘would erect a nearly insurmountable barrier to entry by new and well-qualified firms into the market for securities ratings services’, which could have ‘chilling effects on competition and could raise prices for securities ratings’.171 In 2008, in the midst of the financial crisis, the DOJ favorably recalled its advocating ‘the SEC to modify its proposed rules for securities ratings agencies so that new rating agencies could more easily enter the market, thereby increasing competition’.172 The DOJ assumed that increasing competition in the ratings industry would benefit, not harm, investors and society.
(i) to measure the credit risk of an obligor and help to resolve the fundamental information asymmetry between issuers and investors, (ii) to provide a means of comparison of embedded credit risk across issuers, instruments, countries and over time; and (iii) to provide market participants with a common standard or language to use in referring to credit risk.169
One cannot fault the DOJ for assuming that entry, in increasing competition, often benefits consumers. But under an issuer-pays model,173 increasing competition among the ratings agencies, the OECD found, ‘is not an unambiguously positive development, as it can create a bias in favour of inflated ratings under certain circumstances’.174 This became evident after the financial crisis. As the OECD described:
With the expansion of Fitch Ratings, the competitive pressures on the ratings agencies increased.176 The ratings agencies’ cultures changed. They placed greater emphasis on increasing market share and short-term profits. The novel financial instruments they rated, credit default swaps (CDS) and credit debt obligations (CDOs), were a growing and relatively more profitable sector. A competitive race to the bottom ensued. Moody’s in August 2004:
The growth and development of the market in structured finance and associated increase in securitisation activity occurred at a time when Fitch Ratings was becoming a viable competitor to Standard & Poor’s and Moody’s, in effect, breaking up the duopoly the two [rating agencies] had previously enjoyed. The increased competition resulted in significant ratings grade inflation as the agencies competed for market share. Importantly, the ratings inflation was attributable not to the valuation models used by the agencies, but rather to systematic departures from those models, as the agencies made discretionary upward adjustments in ratings in efforts to retain or capture business, a direct consequence of the issuer-pays business model and increased concentration among investment banks. Issuers could credibly threaten to take their business elsewhere.175
unveiled a new credit-rating model that Wall Street banks used to sow the seeds of their own demise. The formula allowed securities firms to sell more top-rated, subprime mortgage-backed bonds than ever before. A week later, Standard & Poor's moved to revise its own methods. An S&P executive urged colleagues to adjust rating requirements for securities backed by commercial properties because of the ‘threat of losing deals’. The world's two largest bond-analysis providers repeatedly eased their standards as they pursued profits from structured investment pools sold by their clients, according to company documents, e-mails and interviews with more than 50 Wall Street professionals. It amounted to a ‘market-share war where criteria were relaxed,’ says former S&P Managing Director Richard Gugliada.177
As one Moody’s executive testified, ‘The threat of losing business to a competitor, even if not realized, absolutely tilted the balance away from an independent arbiter of risk towards a captive facilitator of risk capture.’178 Investment banks, if they did not get the desired rating, threatened to take their business elsewhere.179 The ratings agencies, intent on increasing market share in this growing, highly profitable sector, complied. As the Financial Crisis Inquiry Commission found, Moody’s alone rated nearly 45,000 mortgage-related securities as AAA.180 In contrast, only six private-sector companies were rated AAA in early 2010.181
In 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every working day. The results were disastrous: 83% of the mortgage securities rated triple-A that year ultimately were downgraded.182
Even in the staid world of corporate bonds, increased competition among the ratings agencies led to a worse outcome. One empirical economic study looked at corporate bond and issuer ratings between the mid-1990s and mid-2000s. During this period, Fitch Ratings shook up the S&P/Moody’s duopoly by substantially increasing its share of corporate bond ratings.183 It was Moody’s and S&P’s policy to rate essentially all taxable corporate bonds publicly issued in the USA. So Moody’s and S&P, under their policy, should have had little incentive to inflate their ratings for corporate bonds: ‘even if an issuer refuses to pay for a rating, the raters publish it anyway as an unsolicited rating and thereby compromise any potential advantage of ratings shopping’.184 But even here, as competition intensified, ratings quality for corporate bonds and issuers deteriorated with more AAA ratings by S&P and Moody’s, and greater inability of the ratings to explain bond yields and predict defaults.185
Consequently, increased competition among the ratings agencies, rather than improve ratings quality, reduced quality to society’s detriment. It is now the subject of lawsuits—with allegations that the financial institutions, by ‘play[ing] the [rating] agencies off one another’ and choosing the agency offering the highest percentage of AAA certificates with the least amount of credit enhancements, ‘engender[ed] a race to the bottom in terms of rating quality’.186 The authors of the ratings study concluded that ‘competition most likely weakens reputational incentives for providing quality in the ratings industry and, thereby, undermines quality. The reputational mechanism appears to work best at modest levels of competition.’187
Automotive emissions testing centers
Another recent economic study empirically tested whether more competition among New York’s vehicle emissions testing centers led to a worse outcome—namely testing centers improperly passing vehicles ‘to garner more consumer loyalty for delivering to consumers what they want: a passing Smog Check result’.188
In New York, like other states, automobile owners must have their vehicles periodically tested for pollution control. Owners can choose which private testing center to check their auto’s compliance with the environmental emission standards. In this market, the government fixed the price of emission testing. So the testing centers competed along non-price dimensions (such as quick testing and passing vehicles that otherwise should flunk).189 Car owners could retest any failing car at another facility. Moreover, car owners received a one-year waiver if they spent $450 and the vehicle continued to fail. ‘With these limitations, the short-term benefit of failing a vehicle pales in comparison to the long-term benefit of retaining the customer’s service and repair business.’190
Competition among these emissions testing centers, the study found, ‘can induce firms to increase quality for their customers in ways that are both illegal and socially costly’.191 In examining 28,002,043 emissions tests from 11,425 New York automobile emissions testing facilities, the study found that as the number of competitors increased in the local automobile emissions market, so too did the pass rates for cars.192 It was highly unlikely, the study found, that vehicle differences explained these higher pass rates. Rather increasing competition produced significantly ‘more illicit leniency only for those cars for which test results are easiest to manipulate’.193 Honest testing sites risked losing business to dishonest competitors:
Under such pressure, firms that strictly follow legal rules may lose considerable market share as customers flee to more lax firms. When competition increases the threat of customer loss, firms are more likely to respond by matching their rivals’ behavior and crossing legal boundaries.194
Antitrust typically treats entrants as superheroes in deterring or defeating the exercise of market power. Here entrants, the study found, were likelier the villains. New vehicle testing entrants with limited customer bases were ‘more likely than incumbents to be lenient in the face of competition’.195 Entrants, rather than remedy market failure, contributed to it.196
The study’s authors concluded with a contrarian view on competition:
Policy makers must consider whether competition is the ideal market structure when corruption, fraud, or other unethical behaviors yield competitive advantages. If customers indeed demand illicit dimensions of quality, firms may feel compelled to cross ethical and legal boundaries simply to survive, often in response to the unethical behavior of just a few of their rivals. In markets with such potential, concentration with abnormally high prices and rents may be preferable, given the reduced prevalence of corruption.197
The Supreme Court recognized that competition could increase vice. But equating ‘competition with deception, like the similar equation with safety hazards’, was for the Court ‘simply too broad’.198 The Court was willing to assume that competition was ‘not entirely conducive to ethical behavior’ but that was ‘not a reason, cognizable under the Sherman Act, for doing away with competition’.199 The Court was unwilling to support ‘a defense based on the assumption that competition itself is unreasonable’.200
This article agrees that a ‘suboptimal competition’ defense is premature. This article simply examines the initial issue of whether competition in a market economy is always good. If, as this article explores, the answer is no, a separate institutional issue is whether we should allow private parties to deal with these types of failures or whether legislation is required. Once antitrust officials recognize that market competition produces at times suboptimal results, the debate shifts to whether the problem of suboptimal competition can be better resolved privately (by perhaps relaxing antitrust scrutiny to private restraints) or with additional governmental regulations (which in turn raises issues over the form of the regulation and who should regulate). Even if one concludes that private restraints were the solution, the economic literature has not developed sufficiently an analytical framework for courts and agencies to apply, consistent with the rule of law, a suboptimal competition defense. Nor is it necessarily superior that independent agencies or courts (rather than elected officials) determine which industries receive a suboptimal competition defense, when, and under what circumstances. Society may prefer that the more publicly accountable elected officials, despite the risk of rent-seeking, should decide when competition is suboptimal.
Accordingly, antitrust officials should continue to advocate competition and challenge private and public anti-competitive restraints. But competition in a market economy, while often good, is not always good. The economic literature draws into question the competition official’s traditional remedy of more competition. The literature should prompt officials to inquire when competition promotes behavioral exploitation, unethical behavior, and misery.
Some may fear this weakens competition advocacy, as rent-seekers will use the exceptions described herein to restrict socially beneficial competition. But to effectively advocate competition, officials must understand when more competition is the problem, not the cure. In better understanding these instances when competition does more harm than good, antitrust officials can more effectively debunk claims of suboptimal competition. By undertaking this inquiry, antitrust officials become smarter and better advocates.
I wish to thank for their helpful comments the participants at Oxford University and George Washington University’s Antitrust Enforcement Symposium and the Midwest Law and Economics Association’s Annual Meeting, Luca Arnaudo, Caron Beaton-Wells, Kenneth Davidson, John Davies, Harry First, Franklin Fisher, Thomas Horton, Max Huffman, Christopher Leslie, Stephen Martin, Jochen Meulman, Anne-Lise Sibony, Randy Stutz, Henry Su, and Spencer Weber Waller. I also thank the University of Tennessee College of Law for the summer research grant.
In trying to drape themselves in the mantle of free competition, defendants are disingenuous. Their decision to simulate plaintiffs' trade dress yields society no benefits. . . . Above-board competition directed at factors such as quality and price is in society's interests. Obtaining sales by facilitating passing off is not. The effect of defendants' copying of [Plaintiffs’ trade dress] is that sales earned by plaintiffs through hard work are lost to pharmacist greed. The Lanham Act and New Jersey common law embody society's belief that that form of ‘competition’ is socially undesirable, and may be restrained.
No group can afford to drop out of the contest for government handouts; members of a group that did would pay the same taxes but receiver fewer benefits, thus redistributing income to the remaining contestants. As in the ‘prisoner's dilemma’ game, however, the result of this individually rational behavior is that everyone is worse off. This creates a kind of ‘race to the bottom,’ in which pork-barrel politics displaces pursuit of the public interest—a situation individuals may deplore even as they find themselves compelled to participate. Even if everybody belonged to a special interest group, so that special interest politics did not affect the distribution of wealth, interest groups still would direct resources to socially unproductive programs.
the Officer Defendants were deliberately reckless in their public statements regarding loan quality and underwriting. First, the confidential witness statements describe a staggering race-to-the-bottom of loan quality and underwriting standards as part of an effort to originate more loans for sale through secondary market transactions. The witnesses catalogue an explosive increase in risky loan products, including interest-only loans, stated income loans, and adjustable-rate loans, and a serious decline in loan quality and underwriting. . . . Several witnesses portray an underwriting system driven by volume and riddled with exceptions. They state that the goal was to ‘push more loans through,’ that ‘there was always someone to sign off on any loan,’ that nearly any loan was approved to meet its sales projections, and that exceptions were commonly made for the otherwise unqualified. There are specific instances of loose standards, as when an employee recommended denial of a loan application but higher-level managers repeatedly approved those loans, or when underwriters allowed rejected loans, usually because borrowers' incomes were too low, a second chance and approved the formerly rejected loans. There is testimony that instructions, according to managers, came from the corporate officers, and that officers had access to information on the effects of these practices, including the rising defaults. There are also indications that the compensation for sales reinforced the disregard for standards and quality as volume was linked to reward.