Law and (Armchair) Economics

One of the many reasons that non-economists should care about economics is the great degree to which economics – and in particular a certain kind of economics – has insinuated itself into law and policymaking in the area of legal regulation of competition. Competition (or “antitrust”) law has come to be dominated over the last forty years by the economics of the Chicago School, and its twin pillars, the hypotheses of efficient markets and rational actors. Though the text of the principal antitrust laws has not changed in nearly a hundred and twenty years, the colonization of antitrust jurisprudence by Chicago-school thought has resulted in increased skepticism by courts and regulators about the ability of market actors to restrain competition absent collusion, and a corresponding reluctance to intervene against conduct by individual firms.

Law, however, seems to have lagged academic economics by some decades. Within the Chicago tradition, “post-Chicago” economists have considered how market inefficiencies like externalities and transaction costs can create opportunities for strategic behavior (roughly, behavior that increases the welfare of an individual firm at greater expense to aggregate welfare) that cannot easily be negated by free market competition. And behavioral economists have shown how systematically “irrational” behavior by market actors can produce exploitable market inefficiencies as well. In short, contemporary economic research has moved beyond working out the consequences of efficient market theory to empirically invalidating the universality of its key assumptions. Yet in law (with the notable exception of the Microsoft case of the 1990s, on which I will write at length another time) it is as if most of these developments in economics since the 1970s had never happened. Perhaps until now.

Last Thursday, the Department of Justice began an antitrust inquiry of IBM regarding monopolization of the mainframe computer market. It is the first major antitrust inquiry regarding conduct by a single firm since the Clinton administration. The move follows the repudiation by current antitrust chief Christine Varney of the hands-off Bush-era guidelines for antitrust enforcement against single firm conduct. Varney rejected the report “because it was driven by two faulty assumptions. First, that anti-competitive conduct is too difficult to distinguish from lawful conduct to be enforced. And second, that enforcement in such instances would result in over-deterrence.”[1]

I call the sort of assumption-driven economics exemplified by the Bush guidelines “armchair economics” because it bases policy on how rational people would behave if markets were a certain way, rather than how actual people do behave in markets as they really are. While the change of administration has clearly brought new thinking to the Department of Justice, the impression of armchair economics may prove more indelible in the jurisprudence of our Supreme Court. I was reminded of this most forcefully when reviewing the Court’s 2004 decision in Verizon v. Trinko for a client last week.

Trinko concerned the obligation of a monopoly firm to deal with its would-be competitors. In the course of severely limiting such a duty, Justice Scalia, writing for the Court, without citation to any authority, pronounced: “The opportunity to charge monopoly prices–at least for a short period–is what attracts ‘business acumen’ in the first place; it induces risk taking that produces innovation and economic growth.”

Does it? Recently, I posted on the peculiar dynamics of pharmaceutical company research and development. I cited Scherer’s research showing that the dependence of expenditures on research in that industry on current cash flows was an exception to the norm best explained by “virtuous rent-seeking” – i.e., the pursuit of monopoly profits by legitimate means that Justice Scalia contends is the rule. More usually, companies invest in research and development with quantifiable (non-monopoly) returns in excess of their cost of capital largely without respect to current cash flows. I also noted analysis by the Congressional Budget Office suggesting that rent-seeking in the pharmaceutical industry may lead to over-investment from the standpoint of total welfare. So even if rent-seeking does drive some business investment, it is not empirically true that all such investment should encouraged.

In short, it is by no means self-evident that the opportunity to charge monopoly prices is a principal driver of business investment, or that investment directed toward that end is always efficient. Whether either proposition is the case in a particular instance is liable to depend on particular facts. It is unfortunate when the highest court’s armchair economics makes fact-imperviousness a feature of positive law.

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