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.   

New Jersey v. Economic Liberty

Praised Vertical Integration; Won Nobel Prize 

Thinks It Knows Better

A free society allows its citizens to engage in voluntary commercial exchange, so long as such exchange does not impose economic harm on unconsenting third parties.    Unfortunately the State of New Jersey takes a different view.  Last month the Garden State's Motor Vehicle Commission announced that Tesla Motors may only sell its cars in New Jersey via franchised automobile dealers.  (See this story in the New Jersey Star-Ledger describing the new rule).  The rule effectively bans Tesla's strategy of forward vertical integration.  Pursuant to this strategy, the firm operates two company-owned show rooms in the state, thereby "eliminating the middleman" and taking direct responsibility for explaining the virtues, limitations and prices of its products   Such vertical integration is a widespread practice, to say the very least. 

For the first several decades of the 20th Century, economists were hostile to most vertical integration, preferring the more fragmented market structure endorsed by New Jersey.  Indeed, as previously explained on this blog,

"[Early in the 20th Century] economists identified two, and only two, possible reasons for complete vertical integration. First, such integration could create technological efficiencies and thus reduce production costs. Second, integration could foreclose rivals from important sources of inputs, thereby creating or fortifying the integrating party's market power.  Thus, when economists, or, for that matter, antitrust courts or enforcement agencies, could not identify any efficiency purposes for such integration, they naturally inferred that the conduct was anticompetitive."

However, as Ronald Coase (pictured above) explained long ago, such vertical integration can produce other, non-technological benefits as well.  In particular, such integration can eliminate the costs of relying upon more decentralized markets, that is, "transacting," to conduct economic activity.  Such "transaction costs" can take many forms, including the risk that one's trading partner will engage in opportunistic behavior.  Indeed, Tesla recently asserted that franchised automobile dealers have a vested interest in promoting the sales of gasoline-powered automobiles over electric powered vehicles like Tesla's, with the result that reliance upon a system of franchised retailers will result in under-promotion of Teslas.

To be sure, franchised dealers can provide valuable services to consumers both before and after the purchase of a new or used automobile.   It is thus no surprise that many consumers prefer to purchase automobiles from such dealers instead of from other individuals or from Tesla.  However, such services are not free.  Instead, dealers quite properly pass along the costs of such services to consumers by marking up the price of the vehicle sold.   Apparently Tesla and some consumers believe that these additional services are not worth the additional price, leading both to embrace a different method of distribution.

As previously explained on this blog when discussing a (failed) effort in North Carolina to impose similar limits, free societies respect the rights of entrepreneurs and consumers to make such choices absent any apparent harm to third parties.  Moreover, given Telsa' tiny share of the automobile market there is no plausible risk that such integration is an anticompetitive tactic designed to gain or maintain market power.  It thus makes sense to interpret Tesla's innovative approach to marketing as an effort to minimize the cost distribution, a result that would enhance Tesla's welfare and the welfare of the consumers it serves.    Tesla's appraisal of the relative costs and benefits of relying upon its own show rooms instead of independent dealers may turn out to be incorrect, but free societies leave such decisions to firms and consumers, without coercive paternalistic intervention by state legislatures.  (See also this excellent discussion by Daniel Crane, on the Truth on the Market Blog last summer, that makes some similar points.)

Nonetheless, some continue to claim that such interference with basic economic freedoms serves legitimate purposes.  For instance, a recent story in CNN Money cites unnamed "advocates of the law" saying it aims "to encourage price competition and ensure customers have access to warranty and recall services."    Last week, 70 economists and law professors, including this blogger, signed a letter condemning the ban on Tesla's direct distribution.  The letter expressly considers the various rationales that proponents of the legislation have proffered and concludes, quite properly, that:

"We have not heard a single argument for a direct distribution ban that makes any sense.  To the contrary, these arguments simply bolster our belief that the regulations in question are motivated by economic protectionism that favors dealers at the expense of consumers and innovative technologies."

I should add that banning Tesla's preferred method of distribution may also protect other manufacturers of automobiles, by forcing Tesla to employ a more expensive and less effective method of distribution and thus discouraging procompetitive entry into the New Jersey market.  If so,  the ban may produce even more harm than initially supposed. 

Hopefully New Jersey will rethink  this unjustified interference with basic economic liberty.

Some Thoughts on the Legacy of Ronald Coase

 

Taught Us Why Firms Exist, And Much More

 

 

Earlier this week Ronald Coase passed away at 102.  Coase was the Clinton R. Musser Professor of Economics Emeritus at the University of Chicago Law School.   The University of Chicago has published an obituary here.

In 1991, Coase won the Nobel Prize in Economic Science.  The statement by the Royal Swedish Academy of Sciences that accompanied the award credited Coase with a "Breakthrough in Understanding the Institutional Structure of the Economy."   The Academy explained the "breakthrough" as follows:

"By means of a radical extension of economic micro theory, Ronald Coase succeeded in specifying principles for explaining the institutional structure of the economy, thereby also making new contributions to our understanding of the way the economy functions.  . . . .  Coase showed that traditional basic microeconomic theory was incomplete because it only included production and transport costs, whereas it neglected the costs of entering into and executing contracts and managing organizations. Such costs are commonly known as transaction costs and they account for a considerable share of the total use of resources in the economy. Thus, traditional theory had not embodied all of the restrictions which bind the allocations of economic agents. When transaction costs are taken into account, it turns out that the existence of firms, different corporate forms, variations in contract arrangements, the structure of the financial system and even fundamental features of the legal system can be given relatively simple explanations. By incorporating different types of transaction costs, Coase paved the way for a systematic analysis of institutions in the economic system and their significance." 

 

The core of Coase's contributions can be found in two articles:  The Problem of Social Cost, 3 J. Law and Economics 1 (1960) and The Nature of the Firm, 4 Economica (n.s.) 381 (1937).  Coase summarized and restated these contributions in his Nobel Lecture, The Institutional Structure of Production, 82 American Economic Review 713 (1992).

 In "The Nature of the Firm," Coase began by noting that a competitive, decentralized market economy "worked itself," without any central direction.  Despite this fact, much economic activity occurs within firms which, as Coase noted, involve a significant amount of planning.  For instance, owners do not make repeated daily or hourly bargains with employees about what tasks employees should perform, but instead simply direct them to perform this or that task.  Coase then posed the following question:

"Having regard to the fact that if production is regulated by price movements, production could be carried on without any organization [that is, without any firms] at all, well might we ask; Why is there any organization?"

When Coase posed this question in 1937, economists universally identified two, and only two, possible reasons for complete vertical integration in a decentralized market economy.  First, such integration could create technological efficiencies and thus reduce production costs.  The classic example of such technologically-induced integration was the combination of iron production and steel manufacture under single ownership.  See George J. Stigler, The Extent and Bases of Monopoly, 32 Amer. Econ. Rev. 1, 22 (1942) (referring to the "hot strip mill" as the "stock example" of "technological economies" that can result from vertical integration).  Such a combination, it was said, would avoid the cost of reheating iron ingot before transforming that ingot into steel.     Second, forward or backward integration could foreclose rivals from important  sources of inputs, thereby creating or fortifying the integrating party's market power.  See Stigler, Extent and Bases of Monopoly, 32 Amer. Econ. Rev. at 22. 

 

Coase offered a completely different explanation for vertical integration and thus the existence of firms.  According to Coase, reliance upon the decentralized market to conduct economic activity was not costless, contrary to what economists generally assumed in their static models.   See Coase, Nature of the Firm, 4 Economica at 390, n. 4 (noting that "static theory" assumes that all prices are known to everyone but that "this is clearly not true of the real world").  Instead, such reliance entailed various costs of arranging and consumating a transaction, what economists would later call "transaction costs."  See Coase, Nature of the Firm, 4 Economica at 390 ("The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.")    According to Coase, such costs included the costs of discovering the prices of various inputs as well as the cost of negotiating with the input's owner over the terms of sale, including, for instance, wages and other terms governing contracts for labor.   By integrating vertically and thus performing an additional task itself, then, a firm could avoid such transaction costs it would otherwise incur.  When it came to individual labor, for instance, vertical integration replaced numerous discrete contracts for labor services with one overall contract, the employment contract, pursuant to which an individual employee agreed to follow the directions of the owner of the firm within certain limits, in return for a fixed wage.      


As Coase noted at the time, this explanation for vertical integration had nothing to do with market power or monopoly considerations. Nor did this explanation depend upon any reduction in technological production costs.  On the contrary, Coase's explanation completely undermined the "technological" account of vertical integration.  After all, absent transaction costs, independent economic actors can, by contract, create any technological combination of labor, capital and other inputs they collectively choose, without integrating vertically.   See Oliver E. Williamson, The Economic Institutions of Capitalism, 86-90 (1985) (explaining why technological considerations cannot explain vertical integration); Victor P. Goldberg, Production Functions and Transaction Costs, 397, in Issues in Contemporary Microeconomics & Welfare (George R. Feiwel, ed. 1985)  (explaining that technical economies cannot explain firm boundaries because, absent transaction costs, such economies can “be achieved equally well [by market contracting] if the factors of production are owned by independent individuals.”).  For instance, assume that making iron and steel in close proximity reduces production costs for the reasons explained above.  If so, then parties can, by contract, agree to locate their production facilities next door to each other, even "under the same roof," without vertical integration that combines such facilities under a single owner.   Thus, there must be some other motive, aside from a desire to operate in close proximity, that induces vertical integration in this setting.  Coase found that motive in transaction costs.  It is no understatement to say, as the Economist did yesterday, that Ronald Coase "explained why firms exist."  (See also e.g. here.)


Coase's argument about the rationale for complete integration also inspired others who were seeking explanations for partial contractual integration.  During the 1960s, for instance, Robert Bork relied upon The Nature of the Firm for the proposition that  "contract integration" and "ownership integration" were economically identical phenomena, both of which could reduce the costs of relying upon atomistic markets to distribute a manufacturer's product.   See Robert H. Bork, The Rule of Reason and the Per Se Concept: Price Fixing and Market Division, 75 Yale L. J. 383 (1966).   (Even before Bork, Lester Telser had argued that minimum resale price maintenance could encourage dealers to engage in optimal promotion of a manufacturer's product, by preventing dealers from free riding on the promotional expenditures of their fellow dealers.  See Lester G. Telser, Why Do Manufacturers Want Fair Trade?, 3 J. Law & Economics 86 (1960).  Unlike Bork, however, Telser did not cite Coase.)  For instance, Bork argued that vertically-imposed exclusive territories and exclusive territories ancillary to the formation of a joint venture could encourage promotional expenditures by dealers and joint venture partners by ensuring that each party could recapture the benefits of such expenditures.  

Subsequently other scholars, including Oliver Williamson and Benjamin Klein, would also identify transaction cost rationales for partial integration.   Such work also expanded the definition of "transaction costs" that could give rise to both partial and complete integration.  While Coase had focused on the cost of discerning prices and negotiating and memorializing agreements, costs analogous to technological production costs, these other scholars called attention to the problem of opportunism by trading partners, the risk of which constituted a cost of relying upon the market to conduct economic activity.  See generally Benjamin Klein, Transaction Cost Determinants of "Unfair" Contractual Arrangements, 70 American Economic Review 356 (1980); Benjamin Klein, Robert Crawford and Armen Alchian, Vertical Integration, Appropriable Rents and the Competitive Contracting Process, 21 J. L. & Econ. 297 (1978); Oliver E. Williamson, Markets and Hierarchies (1975).   See also Bork, Price Fixing and Market Division, 75 Yale L. J. at 382  (characterizing dealer free riding as "parasitical" conduct that "victimized" fellow venturers by "appropriating" to [the free rider] the contributions of other members of the group").   
 

Coase's 1960 work, the Problem of Social Cost, was equally revolutionary.   Before 1960, economists often asserted that market failure in the form of externalities could co-exist with perfect competition.  In 1957, for instance, future Nobel Laureate George Stigler opined that perfect competition would result in an optimal allocation of resources, unless there were positive or negative externalities which, according to Stigler, "the competitive individual ignores." See George J. Stigler, Perfect Competition, Historically Contemplated, 65 J. Pol. Econ. 1, 16-17 (1957).  More than two decades earlier, Arthur Cecil Pigou had similarly contended that externalities could persist in a world of "simple competition."  See  A.C. Pigou, The Economics of Welfare (1932).   Moreover, economists uniformly believed that some form of government intervention was necessary to correct such externalities.   Where "negative" externalities were concerned, such intervention could include so-called "Pigouvian taxes," or traditional "command and control" regulation. Where "positive externalities" were involved, such intervention could include state ownership, subsidies, and/or altering background rules so as to better specify and protect property rights.

The Problem of Social Cost debunked this universal consensus, altering how economists and others think about externalities and market failure.  In particular, Coase demonstrated that "market failure" is not an absolute or exogenous condition but instead depends upon the presence of transaction costs.  Indeed, Coase demonstrated that, in a world with no transaction costs, private parties --- what Stigler had called "the competitive individual" --- would internalize such externalities by bargaining, thereby eliminating any market failure.  (Coase also explained how some externalities do not result in market failure, given that the value of the activity producing the externality could exceed the resulting harm.  In such cases, internalizing the cost of harm via bargaining or otherwise will not alter the activity.)   This insight gave rise to what Stigler would later call the "Coase Theorem," i.e., that "under perfect competition, private and social costs will be equal."      See  George J. Stigler, The Theory of Price 133 (4th Edition 1966).

To be sure, as Coase himself recognized, transaction costs are never completely absent in the real world.  Still, such costs are often low enough that parties can negotiate to overcome a market failure that would otherwise result from an initial allocation and definition of legal entitlements.  Business format franchising provides a classic example of such bargaining.  Instead of creating and then owning franchise outlets itself, the franchisor grants licenses to independent operators, each of whom is thus entitled to operate under the franchisor's trademark.  Franchisors could stop there, allowing each franchisee to operate however he or she pleased.  In the real world, however, granting franchisees such absolute discretion in an unfettered market would result in market failure, as each individual franchisee made product design and quality decisions that would impact other members of the franchise system.  Not surprisingly, then, franchisors often include detailed provisions in contracts granting franchisees the right to operate under the franchise trademark, provisions designed to ensure optimal franchisee investments in quality.  See Paul Rubin, The Theory of the Firm and the Structure of the Franchise Contract, 21 J. Law & Economics 223 (1978).  As Coase would later explain, the legal system can facilitate such contracting by, for instance, making it easier to form contracts that overcome market failure.  See Ronald H. Coase, The Firm, the Market and the Law, 28 in Ronald H. Coase, The Firm, The Market and the Law (1988).

 

Taken together, Coase's work had obvious implications for numerous fields of legal study, including "common law" subjects such as Contract, Property and Tort, as well as statutory subjects such as Corporations and Antitrust.   For instance, Coase's assertion that the business firm is a particular type of contract inspired scholars to model corporations and other firms as a "nexus of contracts," the creation and maintenance of which the State could  facilitate by promulgating enabling corporate law consisting of mainly default rules that parties to the corporate contract could alter by satisfying formal requirements, such as shareholder vote.    See Frank H. Easterbrook and Daniel Fischel, The Economic Structure of Corporate Law (1991). 

 

Transaction cost economics also had a profound impact on antitrust law and policy.  During the 1950s and 1960s, courts articulating antitrust doctrine became increasingly hostile to various forms of complete and partial integration.  Such hostility followed naturally from the dominant economic account of the causes and consequences of such integration.  As noted earlier, economists believed that the only benefits of vertical integration were technological in nature. These supposed benefits naturally arose "within" the firm, as part of the process of production.  Thus, when economists, or, for that matter, antitrust courts or enforcement agencies, could not identify any efficiency purposes for such integration, they naturally inferred that the conduct was an anticompetitive effort  to obtain or protect market power.  Hostility toward partial contractual integration such as minimum and maximum resale price maintenance, tying, exclusive dealing, exclusive territories and exclusive supply contracts was particularly intense.  After all, such agreements reached beyond the firm, controlling the activities of trading partners before a firm took title to inputs or after a firm relinquished title by selling a finished product.  As a result, there were simply no apparent efficiency purposes of such agreements, which reduced rivalry of one form or another and thus reduced competition without any offsetting benefits.   The result was the so-called "inhospitality tradition" of antitrust law, pursuant to which the Supreme Court condemned vertical mergers in unconcentrated markets under Section 7 of the Clayton Act as well as  various forms of partial integration as unlawful per se or nearly so under Section 1 of the Sherman Act.


However, the work of Bork, Telser, Williamson, Klein and others completely undermined the economic premises of the inhospitality tradition, by explaining how complete and partial integration were often voluntary methods of overcoming market failures and thus producing non-technological efficiencies. See Oliver E. Williamson, The Economic Institutions of Capitalism, 28 (1985) (articulating rebuttable presumption that partial and complete integration has transaction cost origins).  See also here, explaining Bork's contributions in this regard.  Thus, beginning with Continental T.V. v. GTE Sylvania, 433 U.S. 36 (1977), the Supreme Court has repudiated or narrowed  several per se rules announced during the inhospitality era.  At the same time, the antitrust enforcement agencies have reversed their previous hostility to vertical mergers, and lower courts have uniformly adopted a more friendly stance to such transactions. Society's economic welfare has increased significantly as a result, thanks in large part to Ronald Coase.  Society is richer, literally, as a result.

 

Happy Birthday, Ronald Coase

102 Years Young

This Blogger wishes Ronald Coase, Professor Emeritus at the University of Chicago Law School, a happy birthday.  Born in 1910, Coase is 102 years old today.  As many readers know, Coase received the Nobel Prize in Economic Sciences in 1991.  Here is an excerpt from the Royal Swedish Academy's Press Release announcing the award:

"Coase showed that traditional basic microeconomic theory was incomplete because it only included production and transport costs, whereas it neglected the costs of entering into and executing contracts and managing organizations.  Such costs are commonly known as transaction costs and they account for a considerable share of the total use of resources in the economy.  Thus, traditional theory had not embodied all of the restrictions which bind the allocations of economic agents.  When transaction costs are taken into account, it turns out that the existence of firms, different corporate forms, variations in contract arrangements, the structure of the financial system and even fundamental features of the legal system can be given relatively simple explanations.  By incorporating different types of transaction costs, Coase paved the way for a systematic analysis of institutions in the economic system and their significance."

Coase’s work is the foundation of what modern scholars call “Transaction Cost Economics “ (“TCE” for short).  Coase began that work in 1937, with his now famous article “The Nature of the Firm.” As explained in a previous post, TCE eventually revolutionized antitrust law and policy, by altering how economists viewed both complete vertical integration and partial contractual integration via non-standard contracts such as exclusive dealing, minimum resale price maintenance, exclusive territories,  location clauses and tying agreements.  When Coase published "The Nature of the Firm," economists identified two, and only two, possible reasons for complete vertical integration.  First, such integration could create technological efficiencies and thus reduce production costs.  Second, integration could foreclose rivals from important  sources of inputs, thereby creating or fortifying the integrating party's market power.  Thus, when economists, or, for that matter, antitrust courts or enforcement agencies, could not identify any efficiency purposes for such integration, they naturally inferred that the conduct was anticompetitive.  The result was the so-called "inhospitality tradition" of antitrust law.

Coase's work and the resulting transaction cost revolution completely undermined these accounts of complete and partial integration.  According to Coase, reliance upon an unfettered market to conduct economic activity entailed various costs, what he dubbed "transaction costs."  By integrating vertically, then, a firm could avoid such transaction costs.  As Coase noted at the time, this explanation had nothing to do with market power or monopoly considerations.  Nor did this explanation depend upon any reduction in technological production costs.

Unfortunately Coase's work lay dormant for three decades, during which time antitrust courts and the enforcement agencies became increasingly hostile to complete and partial vertical integration.  During the mid-1960s, economists and others began to rediscover Coase's 1937 work, perhaps inspired to do so by Coase's "Problem of Social Cost," published in 1960.  Most famously, Oliver Williamson began to rearticulate and expand upon Coase's transaction cost thesis.  In particular, Williamson identified specific investments and the resulting threat of opportunism as an important source of transaction costs.  Moreover, during the same decade, Robert Bork cited Coase's Nature of the Firm in his 1966 work on the Sherman Act's treatment of non-standard contracts.  In particular, Bork explained why various forms of partial integration could align the interests and incentives of the contracting parties, thereby accomplishing the same economic objectives through partial integration that economic actors might otherwise achieve via complete vertical integration.  Most famously, building on the work of Lester Telser (who had not cited Coase), Bork argued that minimum resale price maintenance and non-price restraints such as exclusive territories and location clauses could ensure that independent dealers made optimal investments in promotional effort, thereby facilitating a manufacturer's strategy of relying upon a system of independent dealers to distribute the manufacturer's product.  As previously explained on this blog, this work, along with additional work by Bork and others, convinced the Supreme Court to repudiate numerous decisions from the inhospitality era.

Robert Bork, Antitrust Revolutionary

Economic Subversive

This week brought the sad news that Robert Bork has died, at the age of 85.  Bork had a long and varied career.  (See here and here for remembrances.)  He served in the Marine Corp from 1945-46 and graduated from the College at the University of Chicago in 1948.  He then matriculated at the University of Chicago Law School, which he left to rejoin the Marines during the Korean War.  After Law School he served as a fellow in Law and Economics for one year, practiced law at Kirkland and Ellis in Chicago and then joined the faculty at Yale Law School.  While at Yale, President Nixon nominated and appointed Bork to serve as Solicitor General of the United States in 1973, where Bork served until the end of the Ford Administration in January 1977.  President Reagan nominated Bork to the United States Court of Appeals for the District of Columbia Circuit in 1981 and appointed him after Senate confirmation in 1982.   He retired from that court in 1988.  President Reagan nominated Bork to the Supreme Court in 1987, but the U.S. Senate ignominiously refused to confirm him.  This essay, by former Tenth Circuit Judge Michael McConnell, now Director of the Stanford Constitutional Law Center, explains why the Senate's rejection of Judge Bork helped politicize the Court and diminish the Rule of Law.

Most of the punditry and analysis following Judge Bork's death has focused on his views on the Constitution, particularly his strong and articulate support for an "originalist" approach to constitutional interpretation.  These commentaries have ignored Bork's tremendous influence in another field, namely, Antitrust Law.  For instance, the main piece in the New York Times on Bork's passing, while over 2,000 words long, contains only a brief paragraph about his contributions to antitrust law.  CNN's story on the occasion of Bork's death does not mention Bork's contributions to antitrust law at all, aside from a brief quote of Justice Scalia, who lauds Bork's influence over the field.  Other essays have, like Judge McConnell's, focused on the implications of Bork's nomination and rejection for the confirmation process and the integrity of the courts.  (See here and here.)  These oversights are unfortunate.   Simply put, Bork helped revolutionize the way that scholars, judges and enforcement officials view the appropriate scope of antitrust regulation and thus the role of the federal government in the nation's economy.  More precisely, no individual scholar had a greater influence on antitrust law and policy than Robert Bork.

Many know Bork from his classic book, The Antitrust Paradox, published in 1978.  For instance, one remembrance states "The Antitrust Paradox, published in 1978, shifted the entire focus of antitrust policy toward consumer welfare," without mentioning any previous work.  (See also several similar statements by various participants in this National Review symposium.)   However, Bork's campaign to revolutionize Antitrust started more than a decade and a half before publication of the Antitrust Paradox.   In particular, while at Yale (ironically?) Bork laid the foundation for the so-called "Chicago Revolution" in antitrust law and policy with a series of articles published between 1961 and 1968.  The Antitrust Paradox drew upon these arguments.     In these works, Bork made two broad and fundamental contributions to antitrust analysis, one normative and one technocratic.

As a normative matter, Bork argued that the antitrust laws should have one goal and one goal alone, namely, the maximization of consumer welfare, which Bork equated with allocative efficiency and thus total economic welfare.  To be sure, other scholars embraced a "total welfare" approach before Bork did.  In particular, and as I explained in this article, Harvard-school economists Edward Mason, Donald Turner, and Carl Kaysen also embraced "total welfare" as an exclusive goal of antitrust regulation.  However, Bork's work differed from the work of these scholars in two ways.  First, Bork expressly linked "total welfare" and "efficiency" to "consumer welfare," whereas the Harvard School had not employed the latter term, choosing instead to focus only on "efficiency" as the appropriate goal.  Second, unlike these Harvard scholars, Bork offered a legal defense of total welfare/consumer welfare as an antitrust goal.  In particular, after a thorough review of the legislative history of the Sherman Act, Bork argued that the Congress that passed the Act only "intended" to ban those restraints that reduced total welfare, thus leaving those that enhanced efficient resource allocation unscathed.  See Robert H. Bork, Legislative Intent and the Policy of the Sherman Act, 9 J. L. & Econ. 7 (1966).  Bork also argued that, even if Congress's goal was unclear, courts should nonetheless pursue "consumer welfare" exclusively, because the pursuit of any other goal (e.g., a fair distribution of income) or combinations of goals (e.g. protection of small businesses and efficiency) would require courts to make value choices and trade-offs that were properly left to the legislature.  See  Robert Bork, The Goals of Antitrust Policy, 57 American Econ. Rev. (Papers and Proceedings) 242 (1967).  Some scholars have taken issue with Bork's equation of "consumer welfare" with total welfare, with one scholar referring to this claim as "something [Bork] made up." (See also here for an argument that Congress meant to ban all restraints that increased consumer prices in a relevant market, even if the practice increased total welfare.)    Correct or not, Bork's claim was highly influential.  Indeed, in Reiter v. Sonotone, 442 U.S. 330, 343 (1979) the Supreme Court announced that Congress intended the Sherman Act as a "consumer welfare prescription," citing the Antitrust Paradox for this proposition.

As a technocratic matter, Bork proposed the sort of radical reform in antitrust doctrine necessary to make "consumer welfare" as he defined it the exclusive priority of antitrust law.   Perhaps most famously, Bork rehabilitated the distinction, made famous by William Howard Taft, between "naked" and "ancillary" restraints.  See Addyston Pipe and Steel Co. v. United States, 85 F. 271 (6th Cir. 1898).  Like Taft, Bork argued that naked restraints should be unlawful per se, while ancillary restraints should be analyzed under a forgiving rule of reason.   Moreover, Bork also contended that early Sherman Act case law followed Taft's template, even though courts sometimes used different formulations when articulating antitrust doctrine.  In particular, Bork concluded that Taft's formulation anticipated the "Rule of Reason," articulated in Standard Oil v. United States, 221 U.S. 1 (1911) (discussed here), which banned only those restraints that "unduly restrain trade" by producing "monopoly or its consequences."  See Robert H. Bork, The Rule of Reason and the Per Se Concept: Price Fixing and Market Division, 74 Yale L. J. 775 (1965).  Moreover, employing the latest economic theory of the time (and theory that is still adequate for such purposes today), Bork explained why this distinction between "naked" and "ancillary" restraints would produce results that would maximize "consumer welfare" as he defined it.  See Robert H. Bork, The Rule of Reason and the Per Se Concept: Price Fixing and Market Division, part II, 75 Yale L. J. 373 (1966).   Thus, Bork explained that ancillary restraints could align the incentives of individual venture participants with the welfare of the overall venture and thus produce significant efficiencies and enhance the allocation of resources.  In so doing, he argued persuasively for the expansion for the category of restraints deemed "ancillary" to otherwise lawful objectives.  For instance, relying upon the work of Lester Telser, Bork explained how minimum resale price maintenance or exclusive territories imposed by manufacturers or joint ventures could ensure that dealers or venture partners made adequate investments in promotion, instead of "free riding" on the efforts of other dealers or partners. (Unlike Telser, who had focused only on vertical minimum rpm, Bork focused on horizontal and vertical price and non-price restraints.)   In so doing, Bork drew on the work of Ronald Coase, whose 1937 article on the Nature of the Firm would help Coase earn the Nobel Prize in Economic Science in 1991.  Thus, Bork was an early pioneer in applying transaction cost economics to antitrust problems.   (See here, at pp. 53-54 for an account of Bork's early invocation of Coase and transaction cost considerations).  During this same period, Richard Posner, a later convert to Chicago thinking, contended that non-price vertical restraints rarely produced benefits and should this be presumptively unlawful.

The Supreme Court endorsed Bork's reasoning in Continental T.V. v. GTE Sylvania, 433 U.S. 36 (1977), holding, contrary to previous precedent, that non-price vertical restraints could prevent "free riding" and thus may produce "redeeming virtues" of the sort that preclude per se condemnation.  Instead, the Sylvania Court said, courts should analyze such agreements under a forgiving rule of reason.  (Note that the Court issued Sylvania before publication of the Antitrust Paradox.)  Less than a decade later, the Court applied similar reasoning in the context of horizontal restraints, invoking Sylvania and subsequent work of Judge Bork for the proposition that horizontal agreements between members of  sports leagues could enhance the quality of the league's product, thereby preventing per se condemnation of such restraints.    See NCAA v. Board of Regents of the University of Oklahoma, 464 U.S. 85 (1984).  Shortly thereafter, the Court extended Sylvania, holding that an agreement between a manufacturer and a dealer to terminate another dealer for price cutting was not unlawful per se.  See Business Electronics v. Sharp Electronics, 485 U.S. 717 (1988).  Nearly a decade later, the Court unanimously reversed the per se ban on maximum resale price maintenance.  See State Oil v. Khan, 522 U.S. 3 (1997).  More recently, in Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 U.S. 877 (2007), the Court overturned a 96 year old ban on minimum resale price maintenance, relying upon the work of Bork and others for the proposition that such agreements could combat free riding and thus facilitate promotion of a manufacturer's product.  Each of these decisions, from Sylvania through Leegin, cited Bork's academic work with approval.  To be sure, these decisions cited the work of other scholars as well, but at least some such work simply repeated what Bork had already said a decade or more earlier.

Bork's influence was not confined to the definition and treatment of ancillary restraints.  He also leveled powerful critiques at the Supreme Court's hapless and wealth-destroying merger doctrine, exemplified by cases such as Vons Grocery v. United States, 384 U.S. 270 (1964) and Brown Shoe Co. v. United States, 370 U.S. 294 (1962).  See Robert H. Bork, Anticompetitive Enforcement Doctrines Under Section 7 of the Clayton Act, 39 Tex. L. Rev. 832 (1961).    In both decisions the Supreme Court banned, as contrary to section 7 of the Clayton Act, mergers between firms with small shares in markets characterized by ease of entry.  (In Vons, for instance, the firm created by the challenged merger would have had 8 percent of a market with over 3,000 remaining firms.)  As Bork explained, such mergers could not create or facilitate the exercise of market power.  It was thus logical to infer that parties to such transactions hoped to achieve efficiencies. Bork also leveled powerful critiques against overly intrusive standards governing alleged predatory activity, particularly often-unfounded claims that refusals to deal or vertical integration disadvantaged rivals without creating offsetting efficiencies and thus injured consumers.  See Robert Bork and Ward Bowman, The Crisis in Antitrust, 65 Columbia L. Rev. 363 (1965); Robert H. Bork, Vertical Integration and the Sherman Act, 22 U. Chi. L. Rev. 157 (1954).  In 1986, the Supreme Court, in a unanimous opinion by Justice Stevens, invoked Bork's test for evaluating alleged predatory conduct.  See Aspen Highlands v. Aspen Highlands Ski Co., 472 U.S. 585, 597 n. 33 (1986)(citing the Antitrust Paradox for the proposition that conduct was only predatory if it excluded rivals on some basis other than efficiency).

Obviously Bork was not the only participant in the Chicago Antitrust Revolution.   Moreover, many outside the Chicago School endorsed Chicago School critiques of current doctrine and proposals for reform.  For instance, Bork's work led Harvard School icon Donald Turner to reverse his views on vertical restraints.  However, the record shows that Bork led the way and employed reason, not force, to convince others to follow.