Wednesday, December 31, 2014

Happy New Year!

It is time to say farewell to 2014 and to welcome 2015.  This blog closes out the year with three New Year's Eve photos of the Wren Building at the College of William and Mary in Virginia.  (A statue of Lord Botetourt is barely visible in the foreground of the third photo.) The Wren, presumably where Bishop Madison lectured on Political Economy and other subjects, is the oldest extant college building in the United States.  The building, where some classes are still held, remains the heart of the College more than three centuries after its construction.  

Happy New Year!  

Tuesday, December 30, 2014

Robert Bork and Transaction Cost Economics

Lawyer and Scientist

Economic science and antitrust doctrine go hand in hand.  Over a century ago, in Standard Oil v. United States, 221 U.S. 1 (1911), the Supreme Court famously announced that the Sherman Act bans only those agreements and other conduct that results in monopoly or the consequences of monopoly. The Court identified three (and only three) such consequences: (1) output below the competitive level; (2) prices above the competitive level; and (3) quality below the competitive level. Thus, as Justice Stevens explained for the Court in National Society of Professional Engineers v. United States, 435 U.S. 679 (1978), Standard Oil is based upon "economic conceptions," and courts applying  the decision's "Rule of Reason" must focus solely on a challenged restraint's impact upon "competitive conditions."  It is thus no surprise that advances in economic science have influenced the content of antitrust doctrine over the past century or more.  As Herbert Hovenkamp put it over two decades ago:

"One of the great myths about American antitrust policy is that courts began to adopt an 'economic approach' to antitrust problems only in the 1970s.  At most this 'revolution' in antitrust policy represented a change in economic models.  Antitrust policy has been forged by economic ideology from its inception."

See Herbert Hovenkamp, Enterprise and American Law, 268 (1991).

Of course, judges are not economists, and they lack the leisure time and expertise necessary to keep abreast of the latest developments in economic science.  At the same time, economists are generally not lawyers, with the result that many will have difficulty "translating" developments in economic science into appropriate proposed changes in antitrust doctrine.  For decades, then, economically sophisticated legal scholars have played the role of translators, bridging the divide between economists and economic science, on the one hand, and generalist judges, on the other.   Successful translators have included Robert Bork, Philip Areeda, Donald Turner, Frank Easterbrook, Herbert Hovenkamp, and Richard Posner.  

This account of the relationship between economic science and antitrust doctrine treats economic science as exogenous and legal scholars and judges as passive recipients of developments in economics.  Indeed, some legal scholars have described their contributions in exactly this way.  For instance, Robert Bork claimed that his work simply assessed and critiqued antitrust doctrine in light of what he called "conventional price theory" and "basic price theory."  See e.g. Robert H. Bork, The Antitrust Paradox, 117 (1978) (invoking "conventional price theory"); Robert H. Bork, Resale Price Maintenance and Consumer Welfare, 77 Yale L. J. 950, 952 (1968) (invoking "basic price theory").   Richard Posner also claimed that the Chicago School of Antitrust Analysis was simply a manifestation of rigorous application of "price theory" to antitrust problem, an approach that Posner characterized as "novel."  See Richard A. Posner, The Chicago School of Antitrust Analysis, 127 U. Penn. L. Rev. 925 (1979).  By characterizing their contributions as mere applications of scientific principles determined elsewhere, these and other scholars could enhance the authority and persuasiveness of their proposals.

The assumption that economic science is exogenous to the legal academy is roughly true. There is, however, one counter-example suggesting that this assumption is not entirely accurate, namely, Robert Bork's contributions to the body of economic theory known as Transaction Cost Economics.  Contrary to his modest claim that he merely applied basic price theory to antitrust problems, Bork also made original contributions to economic science.  Ironically, these contributions actually undermined certain facets of price theory, particularly price theory's account of non-standard contracts. As previously explained on this blog, basic price theory identified two and only two rationales for complete or partial vertical integration: (1) the realization of technological efficiencies or (2) the acquisition or extension of market power.  By their nature, technological efficiencies arise "within" individual firms, during production and before sale.  However, non-standard contracts (minimum rpm, exclusive territories and the like) necessarily reach beyond the boundaries of the manufacturer to control the behavior of other firms, particularly wholesalers and retailers.  As a result, price theorists naturally assumed that such agreements cannot produce efficiencies and thus inferred that they were instead efforts to acquire or preserve market power.  The result was the so-called "inhospitality tradition" of antitrust, which was particularly hostile to various forms of partial contractual integration.

Of course, even before World War II, Ronald Coase undermined price theory's account of vertical integration, demonstrating that such integration could reduce transaction costs, regardless of any technological efficiencies.  See R.H. Coase, The Nature of the Firm, 4 Economica (n.s.) 381 (1937). However, this contribution went unnoticed at the time, exhibiting no influence on economic theory itself, let alone antitrust doctrine.  Indeed, according to conventional wisdom (including the work of Coase himself), no one understood or applied Coase's insight until various economists, particularly Oliver Williamson, rediscovered and expanded upon Coase's insight, particularly by expanding the definition of transaction costs to include the risk of opportunism that can arise due to relationship specific investments.

There is no doubt that Williamson played the preeminent role in bringing attention to Coase's insight and developing the transaction cost paradigm of industrial organization.  For this work he properly earned the Nobel Prize in Economic Science.   At the same time, this essay, prepared for a conference at Yale Law School and recently published by this blogger, contends that Robert Bork, although not an economist, played a hitherto unappreciated role in rediscovering Coase's transaction cost explanation for vertical integration.

As the essay shows, in a 1966 article, Bork critiqued the conventional wisdom regarding certain forms of contractual integration, particularly: (1) vertical contractual integration between a manufacturer and its dealers and (2) horizontal contractual integration between partners in an otherwise valid joint venture.  See Robert H. Bork, The Rule of Reason and the Per Se Concept: Price Fixing and Market Division II, 75 Yale L. J. 373 (1966).  (For more on Bork's revolutionary contributions to antitrust thought, go here.)  This critique cited Coase's 1937 work for the proposition that "contractual" integration and "ownership" integration can be alternative means of achieving the same economic objectives, an assertion at odds with price theory's technological conception of the firm.  (By contrast, Lester Telser's transaction cost interpretation of minimum resale price maintenance, on which Bork also drew, did not mention Coase.) Moreover, Bork also employed transaction cost reasoning to explain how exclusive territories (both vertical and horizontal), customer restrictions and ancillary horizontal minimum price fixing could overcome various costs of relying upon unfettered atomistic markets to conduct economic activity.  In so doing, he expressly assumed the existence of post-transaction opportunism, a condition unknown to price theory, albeit not in so many words.  That is, Bork assumed that a manufacturer's or joint venture's reliance upon an unfettered market to distribute goods could result in "parasitical" behavior by some distributors, behavior that would "take advantage" of and "victimize" fellow trading partners by "appropriating" to the parasite the contributions of others.  Parties would anticipate such opportunism, he said, and respond by adopting non-standard agreements that could prevent such behavior and, for instance, ensure an optimal quantity and type of promotional expenditure. 

Bork also explained how relegating manufacturers and joint ventures to the alternative of specifying the promotional obligations of distributors would entail prohibitive information and monitoring costs, costs that price theory simply assumed away, such as a manufacturer’s cost of ascertaining the appropriate type and amount of promotion for each dealer’s locality.  Thus, Bork conducted the sort of comparative analysis of alternative contractual mechanisms that today is a hallmark of transaction cost analysis.  Indeed, Bork even went so far as to characterize vertically-imposed exclusive territories as contractual property rights that aligned the interests of manufacturers and dealers, thereby departing from price theory's assumption of fixed property rights. (For additional elaboration on the "property rights" interpretation of intrabrand restraints, go here.)

In short, despite his repeated invocation of "price theory" as the only appropriate source of economic knowledge relevant to antitrust, Bork himself rejected various price-theoretic assumptions and developed tools of transaction cost economics to offer a novel interpretation of various non-standard agreements that price theory's "inhospitality tradition" had condemned.  Instead of functioning as a passive recipient of scientific change, Bork helped initiate such change himself.  Hopefully Bork's contributions to economic science will receive the notoriety they deserve.   

Thursday, December 25, 2014

Christmas Story Marathon in Full Swing!

The annual 24 hour Christmas Story Marathon is in full swing.  TNT and TBS are simulcasting the marathon, the last installment of which airs at 6:00 PM today.  The Seattle Times labels the show a top pick among Christmas movies this year. 
In 2011, this blogger offered a list of the movie's ten best quotes.   Here are five more gems from this Christmas classic, in no particular order.

1.  "The snap of a few sparks, a quick whiff of ozone, and the lamp blazed forth in unparalleled glory."  (Ralphie as an adult) (narrating)

2.    "In our world you were either a bully, a toady or a hapless victim."  (Ralphie as an adult) (narrating)

3.     "In the heat of battle my father wove a tapestry of obscenities that, so far as we know is still hanging in space over Lake Michigan."  (Ralphie as an adult) (narrating)
4.     "Probably from his father."  (Mrs. Schwartz, explaining where Ralph learned a particular word)
5.     "You were always jealous of this lamp.  Jealous.  Jealous because I won."  (Mr. Parker)

Wednesday, December 24, 2014

FDR's and Churchill's 1941 Christmas Eve Addresses to the American People

On Christmas Eve 1941, less than three weeks after the Nation entered World War II, the two leaders of the Free World, President Roosevelt and Winston Churchill, delivered consecutive addresses to the American people from the White House.  President Roosevelt spoke first and ended his address with an introduction of the British Prime Minister.  Both addresses are reproduced below in full. 
"Fellow workers for freedom:  There are many men and women in America --- sincere and faithful men and women --- who are asking themselves this Christmas:  How can we light our trees? How can we give our gifts?  How can we meet and worship with love and with uplifted spirit and heart in a world at war, a world of fighting and suffering and death?  How can we pause, even for a day, even for Christmas Day, in our urgent labor of arming a decent humanity against the enemies which beset it?  How can we put the world aside, as men and women put the world aside in peaceful years, to rejoice in the birth of Christ?  These are natural—inevitable—questions in every part of the world which is resisting the evil thing.  And even as we ask these questions, we know the answer. There is another preparation demanded of this Nation beyond and beside the preparation of weapons and materials of war. There is demanded also of us the preparation of our hearts; the arming of our hearts. And when we make ready our hearts for the labor and the suffering and the ultimate victory which lie ahead, then we observe Christmas Day—with all of its memories and all of its meanings—as we should.  Looking into the days to come, I have set aside a day of prayer, and in that Proclamation I have said:

'The year 1941 has brought upon our Nation a war of aggression by powers dominated by arrogant rulers whose selfish purpose is to destroy free institutions. They would thereby take from the freedom-loving peoples of the earth the hard-won liberties gained over many centuries.  The new year of 1942 calls for the courage and the resolution of old and young to help to win a world struggle in order that we may preserve all we hold dear.  We are confident in our devotion to country, in our love of freedom, in our inheritance of courage. But our strength, as the strength of all men everywhere, is of greater avail as God upholds us.
Therefore, I... do hereby appoint the first day of the year 1942 as a day of prayer, of asking forgiveness for our shortcomings of the past, of consecration to the tasks of the present, of asking God's help in days to come. We need His guidance that this people may be humble in spirit but strong in the conviction of the right; steadfast to endure sacrifice, and brave to achieve a victory of liberty and peace.'

Our strongest weapon in this war is that conviction of the dignity and brotherhood of man which Christmas Day signifies-more than any other day or any other symbol. Against enemies who preach the principles of hate and practice them, we set our faith in human love and in God's care for us and all men everywhere.  It is in that spirit, and with particular thoughtfulness of those, our sons and brothers, who serve in our armed forces on land and sea, near and far- those who serve for us and endure for us that we light our Christmas candles now across the continent from one coast to the other on this Christmas Eve.  We have joined with many other Nations and peoples in a very great cause. Millions of them have been engaged in the task of defending good with their life-blood for months and for years.
One of their great leaders stands beside me. He and his people in many parts of the world are having their Christmas trees with their little children around them, just as we do here. He and his people have pointed the way in courage and in sacrifice for the sake of little children everywhere.  And so I am asking my associate, my old and good friend, to say a word to the people of America, old and young, tonight Winston Churchill, Prime Minister of Great Britain."
Prime Minister Churchill then addressed the American people as follows:
"I spend this anniversary and festival far from my country, far from my family, yet I cannot truthfully say that I feel far from home.  Whether it be the ties of blood on my mother's side, or the friendships I have developed here over many years of active life, or the commanding sentiment of comradeship in the common cause of great peoples who speak the same language, who kneel at the same altars and, to a very large extent, pursue the same ideals, I cannot feel myself a stranger here in the centre and at the summit of the United States.  I feel a sense of unity and fraternal association which, added to the kindliness of your welcome,  convinces me that I have a right to sit at your fireside and share your Christmas joys.

This is a strange Christmas Eve.  Almost the whole world is locked in deadly struggle, and, with the most terrible weapons which science can devise, the nations advance upon each other.  Ill would it be for us this Christmastide if we were not sure that no greed for the land or wealth of any other people, no vulgar ambition, no morbid lust for material gain at the expense of others, had led us to the field.  Here, in the midst of war, raging and roaring over all the lands and seas, creeping nearer to our hearts and homes, here, amid all the tumult, we have tonight the peace of the spirit in each cottage home and in every generous heart.  Therefore we may cast aside for this night at least the cares and dangers which beset us, and make for the children an evening of happiness in a world of storm.  Here, then, for one night only, each home throughout the English-speaking world should be a brightly-lighted island of happiness and peace.

Let the children have their night of fun and laughter.  Let the gifts of Father Christmas delight their play.  Let us grown-ups share to the full in their unstinted pleasures before we turn again to the stern task and the formidable years that lie before us, resolved that, by our sacrifice and daring, these same children shall not be robbed of their inheritance or denied their right to live in a free and decent world.

And so, in God's mercy, a happy Christmas to you all."

Portland Maine's 14th Annual Christmas Boat Parade of Lights


Earlier this month Portland, Maine held its annual Christmas Boat Parade of Lights.  The evening event features vessels of various shapes and sizes decorated with Christmas lights and sailing through Portland Harbor.  Founded in 2001, the parade has featured up to 37 vessels, including one or more ferries from the Casco Bay Lines, like that pictured above.  (See here for these and other historical details.)     Go here for a video of the event, set to "O Come O Come Emmanuel."  Go here for two spectacular photos of the fireworks display at the end of the event.  Finally, go here for a video of the 2009 parade.

Monday, December 22, 2014

Is the Free Market Broken? Hardly.

Wants to Fix What's Not Broken

Senator Elizabeth Warren (pictured above) has convinced herself that the free market is "broken," thereby justifying intrusive and coercive regulation to fix market outcomes.  According to this article, the Senator has offered three examples of such disrepair: (1) student debt (apparently including both the amount of debt and the interest rates that students pay), (2) wages that are in some cases lower than necessary to support a family, large or small and (3) insufficient financial regulation.  She would have the national government repair the market by, for instance, coercively raising the minimum wage and lowering student loan interest rates to the rate that the Federal Reserve charges individual banks.   (See here and here)  This rate, the so-called "discount rate," is less than one percent. (See here).     Senator Warren's indictment of the free market does not withstand scrutiny and reflects confusion about the proper objectives of this critical social institution.  As will be seen, it will be useful to compare her views regarding the appropriate objectives of the market with those of Frank Knight, one of the most influential and thoughtful economists of the 20th Century. 

1. What Americans call "the market" is a social institution that depends upon various background legal rules, particularly private property, free contract and legal prohibitions on fraud and duress. Frank Knight ably described the free market system as follows:

"Ours is a system of 'private property,' 'free competition,' and 'contract.'  This means that every productive resource or agent, including labor power, typically 'belongs' to some person who is free within the legal conditions of marketing, to get what he can out of its use."

See Frank H. Knight, The Economic Organization, 11 (1951).

2. Any critique of a social institution must begin by identifying a plausible set of objectives society expects the institution to achieve. For instance, while society can (and should) expect its system of education to produce a literate populace, it cannot expect that system to produce a safe and abundant food supply.  Thus, while proof that many high school graduates cannot read or write would indict the educational system, proof that many people go hungry would not.

3. In the same way, any critique of the free market must begin by specifying the objectives that society legitimately expects the market to achieve.  Does society expect the market to defend the nation from foreign attack?  Eliminate cruelty to animals?  Prevent the spread of infectious disease? If the answer to any of these questions is "yes," the market is "broken," and coercive regulatory intervention is appropriate.  But of course, no rational society would expect the free market as such (as opposed to other social institutions), to achieve any of these objectives.  

4. What, then, can society properly ask of free markets? Frank Knight would have answered the question as follows: society should expect markets to allocate resources (including labor) and organize production efficiently so as to maximize the amount of "want satisfaction" that consumers derive from society's given endowment of resources and know how.  See generally Knight, The Economic Organization, at 9-10.   A secondary but related objective involves assuring what Knight calls "economic maintenance and progress."  See id. at 12-14.  In particular, a well-functioning market will ensure optimal allocation of resources toward capital investment (including investments in human capital) and technological progress.   In the medium and longer run, such investments can enhance the nation's overall productivity and thus its ability to produce goods and services that provide want satisfaction. 

5.  Of course, free markets sometimes fail to maximize such want satisfaction and/or ensure optimal capital investment and technological progress.  For instance, transaction costs can prevent voluntary private bargains from allocating resources to their highest valued use.  The classic example involves an activity that imposes costs --- what economists call "negative externalities" --- on individuals who are not parties to a given transaction.  The result can be be overproduction by the industry in question and thus overuse of resources that would produce more social value elsewhere.  Even the most dedicated adherents to laissez faire have long recognized that governments should intervene to correct such market failures and that such intervention should include, if necessary, coercive restrictions on output.  Moreover, high transaction costs can also result in positive externalities.  For instance, bargaining and information costs may prevent individuals contemplating investments in technological innovation from identifying and securing remuneration from other individuals who might reap the benefits of such investments.  Here again, some coercive intervention in the market, such as the creation of patent rights, might be necessary to ensure adequate investment in the creation of new technology and thus optimal increases in national productivity.

6.  None of Senator Warren's examples qualifies as a manifestation of market failure that somehow suggests that the free market is "broken" and thus ripe for coercive interference.  Take the minimum wage first.  Labor is an input in the production of goods and services, and firms purchase this input in the market, in the same way they purchase other inputs such as steel, electricity or bread.  The wage is simply the price for labor, a price determined by conditions of supply and demand.

It is certainly true that free market determination of the price of labor sometimes results in wages insufficient to support an average-size family.  In the same way, prices for other inputs may be insufficient to guarantee any profit whatsoever to the owners of firms that produce such inputs.  A company that makes and sells high quality steel to automobile companies will earn negative profits and fail if automobile companies forgo steel for aluminum, for instance.  In such cases, the wages of some steel workers will fall to zero as steel companies cease to employ them.  To be sure, one can imagine situations in which such low wages reflect a market failure resulting from an employer's status as the dominant purchaser of labor in a particular market. However, the Senator's proposal to raise the minimum wage would apply to all employment relationships, including those in markets that are competitive, as most labor markets are. Far from exemplifying a broken market, wages in competitive markets reflect a well-functioning economic system at work performing its social function of allocating resources to their most efficient use. Society may in some cases view the resulting wages as unjust, either because they are too high or too low,  Indeed, employers may pay wages as low as the market will bear so as to increase their own share of the fruits of productive activity. However, coercive regulation setting different wages than those set by the market will undermine the market's chief virtue, namely, encouraging the economic actors to organize and allocate productive resources, including labor, in the most useful way possible. Here again Frank Knight is persuasive:

"It is assumed . . . that there is in some effective sense a real positive connection between the productive contribution made by any productive agent and the remuneration which its 'owner' can secure for its use.  Hence, this remuneration (a distributive share) and the wish to make it as large as possible, constitute the chief reliance of society for an incentive to place the agency into use in the general productive system in such a way as to make it as productive as possible.  The strongest argument in favor of such a system as ours is the contention that this direct, selfish motive is the only dependable method, or at least the best method, for guaranteeing that productive forces will be organized and worked efficiently."

See Knight, Economic Organization, at 11-12.

Ironically, then, Senator Warren's proposed "fix," state-determined wages, would itself injure the market and reduce the amount of wealth this critical social institution generates.

None of this is to say that society must stand idly by while some hardworking citizens earn only poverty wages.  On the contrary, there is one obvious method for alleviating such poverty, viz., the earned income tax credit, previously discussed on this blog.  By subsidizing wages, the EITC both makes hard work pay off and avoids the job-destroying impact of the minimum wage. It is thus no surprise that thoughtful experts such as Christina Romer, who once chaired President Obama's Council of Economic Advisors, have advocated the measure as an alternative to the minimum wage. This blogger has previously called on Congress to expand the availability of the EITC.

Of course, governments must find resources to pay for this subsidy. During a recession, governments that embrace the Keynesian economic paradigm can borrow unused private savings and spend the proceeds on a more robust EITC.   If the economy is near full employment, however, such a "borrow and spend" approach can be inflationary, with the result that governments should find the revenues for wage subsidies by cutting spending elsewhere and/or raising taxes.  One obvious source of such funds would be a tax on carbon  emissions.  As previously explained on this blog, such a tax would discourage pollution creating activity while generate revenue.  In this way society can have the best of both worlds:  a free market that generates as much wealth as possible and spending policies that reward work and alleviate poverty.
7.  What about the current system of students loans and resulting student debt and interest payments? Here again, the current system on financing higher education, including the student loan system, is not evidence that the marker is "broken." To be sure, a purely private market will produce insufficient investments in human capital, including higher education.  As previously explained on this blog:

 “The background legal framework prevents individuals who invest in education from granting creditors a security interest in their most valuable asset, namely, the human capital that a college education creates.  A creditor cannot “foreclose” on an individual’s college degree if the borrower defaults on a student loan.”

Moreover, as the same post also explained, state and federal income taxes, which combined produce top marginal rates of nearly 50 percent in some states (and more than 50 percent in California), prevent individuals from internalizing the full benefits of such investments.  As a result, individuals will generally under invest in human capital, even if lenders can perfectly assess the ability of such borrowers to repay and assure repayment when borrowers are able.  The state can respond to this under-investment in various ways, including by founding public universities that charge tuition that is far lower than the cost of the education provided, as every state does. (States could also, of course, provide college-age students with vouchers that students could spend at any qualifying institution, public or private.)  At the University of Virginia, for instance, full tuition covers just 52 percent of the cost of educating an in-state undergraduate student,    Indeed, some private and public universities do not charge tuition, fees or room and board to students from low income families. Some of these same schools provide significant discounts to middle class students as well.  To be sure, a significant proportion (far less than half) of America's students emerge from college with some debt; the average amount equals the cost of a new minivan.  To be sure, a subset of this subset of students graduates with significantly more debt than the average.  However, given the availability of below-cost public education and need-based financial aid, it stands to reason that some (though not all) students who emerge from college with larger than average debt loads voluntarily chose to attend relatively expensive universities in lieu of more modestly-priced options.  It's not clear why such voluntary decisions are evidence of market failure that calls for intervention by the national government.

As previously explained on this blog, government subsidized student loans can also be part of the response to the sort of market failure that results in under-investment in human capital.  Such loans, already provided at below-market rates, further subsidize investments in human capital.  Indeed, under recent reforms, many student loan payments are capped at a percentage of the debtor's income, still further reducing the actual cost of borrowing.  Some borrowers are even eligible for complete loan forgiveness if such capped payments do not suffice to pay off the loan over 20 years.

So far as this blogger is aware, Senator Warren has not explained why the one-two-three punch of (1) below-cost tuition at the nation's public universities, (2) below market interest rates and (3) income-based repayment and possible forgiveness does not suffice to counteract the unfettered market's admitted tendency to produce insufficient investments in human capital.  The existence of a market failure does not justify the adoption of every conceivable policy response to that failure.  Her own proposal --- interest rates of less than one percent for long term student loans already subject to repayment caps and possible forgiveness --- could, when combined with numerous other subsidies for such investments, result in the allocation of too much scarce capital to investments in human capital, further increasing demand for higher education and exacerbating increases in tuition.  Here again, Senator Warren has not made the case that the market, supplemented by public universities and the current system of student loans, is in need of further repair.

8.  What, though, about financial markets?  Surely insufficient federal regulation resulted in the financial crisis and resulting recession in 2008, thereby establishing that the free market is "broken" and in need of additional intrusive regulation,  Here again the Senator has not made her case.  After all, the financial system extant in 2008 hardly exemplified the free market in action. Instead, the national government had intervened in financial markets in various ways that predictably caused market failure and distorted market outcomes.  For instance, the nation's policy of "too big to fail" resulted in dangerous moral hazard, as large banks did not internalize the potential downside of risky investments.  Banks quite predictably made non-optimal investments as a result.  Moreover, the national government encouraged lenders to develop financial products (e.g., no money down mortgages) that extended credit to individuals that did not meet traditional lending standards.  Banks were all too happy to extend such credit, knowing that they could immediately resell many mortgages to the Federal National Mortgage Association (FNMA), which was itself deemed "too big to fail" and thus lacked adequate incentives to examine the quality of mortgages it purchased.  The FNMA, in turn, would either hold these mortgages itself or guarantee their repayment and use them as backing for so-called "mortgage backed securities" that it issued.  (See here for a description of the mechanics of the FNMA's role in the mortgage market.)  Regulators encouraged banks to hold these securities to satisfy capital reserve requirements, even in lieu of other securities.  While federal regulations required banks to hold $4 in high quality reserves (e.g., U.S government bonds) for every $100 in lending, banks could avoid this requirement by holding $1.60 in mortgage-backed securities instead, thereby signaling the national government's confidence in the FNMA's guarantee of the mortgages that backed these securities. Little wonder, then, that, according to this same source, banks held half the outstanding debt backed by sub-prime loans when the financial crisis broke out.  Simply put, the 2008 financial markets were rife with various forms of federal intervention and involvement that produced market failure, moral hazard and also set the table for the 2008 financial crisis.  That crisis hardly qualifies as evidence that the market is broken.

9.   In sum, free markets have great potential but they also have limits.  Critics must take care lest they attribute to markets objectives they cannot plausibly achieve.  To be sure, transaction costs sometimes result in market failure, including negative or positive externalities.  In such cases, society properly steps in with coercive regulation to correct such failure.  However, failure to achieve distributive justice is not a shortcoming of markets.  On the contrary, markets produce the very wealth that its opponents wish to redistribute, and society can employ taxation to redistribute income for social justice purposes.  Moreover, the presence of some market failure does not thereby justify the simultaneous adoption of every imaginable policy response.  Finally, markets sometimes "fail" because ill-considered regulation or other forms of state intervention distort private incentives and thus induce market actors to engage in wealth-reducing economic activity.  Such state-induced market failure is hardly a justification for even more coercive regulatory intervention. 

Saturday, December 20, 2014

Congratulations on Tony Shaver's 500th Career Win!

Last night William and Mary defeated the Washington College Shoremen, 86-46, extending the Tribe's record for the year to 6-3.  (For the story, including box score, go here.)  The victory was a milestone for head coach Tony Shaver, who chalked up his 500th career coaching victory.  Shaver, who previously coached at Hampden-Sydney College, is enjoying his 12th season at William and Mary.  He is the Tribe's winningest coach, with 142 wins thus far.   Congratulations to Coach Shaver and the Tribe.  Keep up the good work! 

Friday, December 5, 2014

O'Bannon, the Rule of Reason, and the Less Restrictive Alternative Test

Applied Reason to College Athletics

Earlier this year, in O'Bannon et al. v. NCAA, the U.S. District Court for the Northern District of California invalidated the NCAA's policy governing compensation that colleges and universities may provide football and basketball players. (Here is a link to the decision.)  That policy allowed schools to provide players a full grant-in-aid, namely, full tuition, fees, room and board, and the cost of textbooks.  Moreover, the policy also allows schools to provide additional compensation to the neediest student athletes --- those who qualify for federal Pell grants.   

Ordinarily, agreements between rivals regarding the compensation paid to input suppliers are unlawful per se.  Ditto for agreements that govern non-price aspects of the relationship between rivals and input suppliers.  If Ford, Toyota, Honda and General Motors agreed on the salaries or working conditions provided their engineers, for instance, courts would rightly declare the arrangement a buyers' cartel and condemn it as unlawful per se under the Sherman Act.  Ditto if, say, several silicon valley firms or an academic trade association agreed not to hire or "poach" individuals employed by rivals

In NCAA v. Board of Regents of the University of Oklahoma, 468 U.S. 85 (1984), the Supreme Court rejected the analogy between the NCAA's policy on player compensation and the sort of buyers' cartel just described.  As explained in much greater detail here, the Court, in an opinion by Justice John Paul Stevens (pictured above), recognized that, unlike buyer cartels, the NCAA is a legitimate joint venture, the existence of which is necessary to produce a product, college football, that many consumers find attractive.  The Court also recognized that unbridled rivalry between colleges and universities for student-athletes would transform college athletics into semi-pro athletics, thereby undermining consumer demand for the joint venture product.  Thus, the Court expressly noted that, in order to protect the integrity of this product, members of the NCAA must collectively set limits on player compensation.  In so doing, the Court rejected the "cartel" label for such restraints.  (For additional discussion of the NCAA decision by this blogger, go here.) According to the Court:

"The identification of this 'product' with an academic tradition differentiates college football from and makes it more popular than professional sports to which it might otherwise be comparable such as, for example, minor league baseball.  In order to preserve the character and quality of the 'product,' athletes must not be paid, must be required to attend class, and the like.  And the integrity of the 'product' cannot be preserved except by mutual agreement: if an institution adopted such restrictions unilaterally, its effectiveness as a competitor on the field of play might soon be destroyed.  Thus, the NCAA plays a vital role in enabling college football to preserve its character, and as result enables a product to be marketed which might otherwise be unavailable.  In performing this role, its actions widen consumer choice --- not only the choices available to sports fans but also those available to athletes -- and hence can be viewed as procompetitive."

See NCAA, 468 U.S. at 101-102 (emphasis supplied).  

More technically, the Court essentially held that unbridled competition between NCAA member schools to attract and retain student athletes would result in a market failure and reduce economic welfare, including the welfare of consumers.  Such rivalry, one suspects, could result in six figure salaries for some players at some schools, over and above a full grant-in-aid.  The prospect of such a market failure, the Court believed, distinguished the NCAA's limits on player compensation from otherwise analogous forms of collective wage setting such as the hypothetical agreements between automobile manufacturers mentioned above.  (See this essay by this blogger explaining the role of the market failure paradigm in the antitrust jurisprudence of Justice Stevens, including his opinion in NCAA.) 

The NCAA court did not hold that agreements governing student-athlete compensation are lawful per se.  Instead, such agreements are to be analyzed under Standard Oil's Rule of Reason. After conducting this analysis, the district court in O'Bannon agreed with the NCAA (and the Supreme Court) that the NCAA's limits on student-athlete compensation produce significant procompetitive benefits by, for instance, enhancing consumer demand for college football and basketball.  These benefits, the court apparently assumed, would suffice to justify the restraints.   Nonetheless, the court invalidated the limits, holding that a "less restrictive alternative" would achieve the same benefits.  In particular, the court held that increasing the limit to "cost of attendance" (which includes grant-in-aid plus transportation and supplies), plus $5,000 per year, to be derived from "licensing revenue generated from the use of their names, images, and likenesses during college[,]" would be "less restrictive of competition, while at the same time achieving the same admitted benefits as the current policy.

This blogger has joined a brief amicus curiae by fifteen antitrust scholars taking issue with the district court's application of the less restrictive alternative test.  (Here is a link to the brief.  See here for a story about the brief on ) The brief does not question the role that a properly-applied less restrictive alternative analysis can play in rule of reason analysis.  At the same time, the brief contends that the district court misapplied this test.

Ordinarily the less restrictive alternative test involves identification of a different type of agreement, actually existing somewhere in the marketplace, that produces the same benefits as the agreement under scrutiny.  Thus, in the context of product distribution, courts evaluating vertically-imposed exclusive territories could conceivably conclude that so-called "location clauses" are less restrictive of competition and produce the same benefits in a particular setting as exclusive territories.  Cf. Continental T.V. v. GTE Sylvania, 433 U.S. 36 (1977) (describing location clause and holding that courts should evaluate such restraints under the rule of reason).  However, the O'Bannon court did not identify any such categorically different alternative actually existing in the marketplace.  Instead,  the court simply amended somewhat (upward) the level of compensation that players can potentially receive, without questioning the need for a collectively-set limit on such compensation.

Not surprisingly, then, the brief argues that the district court improperly treated the less restrictive alternative test as a license to substitute its own judgement about appropriate compensation for the judgment of market participants who adopted policies that, according to the court's own findings, produced significant economic benefits. Thus, the district court's approach empowers judges to function as regulatory commissions, recalibrating otherwise reasonable levels of compensation.  Such quasi-regulators would displace beneficial agreements that produce significant economic benefits, simply because the judge believes that a hypothetical variant of the agreement, in this case one involving somewhat higher compensation for some players, would produce marginally greater net benefits than the agreement the parties actually adopted.  However, as Judge Frank Easterbrook --who argued NCAA for the defendants -- once explained when applying the rule of reason in a subsequent case: "the antitrust laws do not deputize district judges as one-man regulatory agencies."   See Chicago Professional Sports Ltd. Partnership and WGN v. National Basketball Association, 95 F.3d 593, 597 (7th Cir. 1996).  Instead, courts must simply ask whether a restraint is "reasonably necessary" to produce the benefits in question.   Hopefully the Ninth Circuit will agree with Judge Easterbrook and properly apply the rule of reason that has, thanks to NCAA and Justice Stevens, been applicable to such restraints for the past three decades.