As explained in the Introduction, Coase’s insight is that there is no deadweight loss in the absence of transaction costs. If there is to be a concern about the inefficiency that is created by market power, it must be true that transaction costs exist to impede achievement of efficiency. (Of course, even if total surplus is maximized, consumer surplus can be lowered by the use of market power. All of our results apply even when the objective is to maximize consumer surplus.) By transaction costs, we mean those costs that provide the information to a firm on how to price as well as those costs that a firm must incur to prevent arbitrage among consumers to whom the firm is charging different prices. In this section, we describe several examples where either the industry practices or market structure affects these transaction costs.

Although we hope these examples (and those in our companion paper) are persuasive to the skeptical reader, we note that the point about market structure’s influencing the ability to engage in non-uniform pricing is actually an old one in industrial organization. The classic example is the vertical integration of Alcoa before the 1940s. Alcoa vertically integrated forward into the high-elasticity end products that used aluminum ingot, and thereby attained the ability to prevent arbitrage. This enabled Alcoa effectively to practice price discrimination between the producers of the low- and high- elasticity end products. This example is often used to explain Alcoa’s decisions to integrate vertically into certain end products (and not others) that used aluminum ingots—the product that was assumed to be monopolized by Alcoa—as an input (see Carlton and Perloff 2004).

The required effort and cost to engage in nonlinear pricing may well depend on firm conduct and industry market structure. Hence, firm conduct or market structure (or changes in them) can affect the relevant transaction costs. Let us illustrate this last point with several examples, each of which is interesting in its own right since each is related to many situations that arise routinely in antitrust. Each of the examples shows that the ability to practice nonlinear pricing can be influenced by conduct that often raises antitrust scrutiny.

Firm Conduct–Loyalty Discounts

Suppose a dominant firm institutes a policy of granting loyalty discounts as long as a customer buys 80 % of its aggregate purchases of that category of inputs from the firm. This can clearly be a way for a firm to gain information about the total demand of the customer—information that the firm might otherwise have a hard time figuring out. Armed with this information, the firm could figure out how this customer’s demand varies over the business cycle and could devise various types of nonlinear (including discriminatory) pricing mechanisms. These mechanisms could enable both the customer and the firm to be better off because, absent the information, the customer might be faced with a linear price schedule that we know is inefficient in the presence of market power to the extent that price exceeds marginal cost.

Many times these pricing schemes are claimed to be exclusionary, and that might well be so. But the fact that the schemes allow nonlinear pricing could be a benefit that outweighs the exclusionary effects. Of course, if the exclusionary effect is substantial so that the effect of the pricing scheme is to prevent what would otherwise be competitive pricing, then we know that there is an antitrust harm.

Merger to Monopoly with Efficiencies

As another example, consider a merger to monopoly of two firms, where the merger creates some productive efficiency. One standard analysis is to ask by how much the price under monopoly will rise compared to the price under duopoly. The analyst will attempt to determine whether the efficiency gain offsets the harm from the loss of competition. But that analysis holds constant the pricing mechanism; it assumes the use of uniform pricing both pre- and post-merger.

But why is that a good assumption? Following Coase, we know that the outcome with uniform pricing can be improved upon from society’s viewpoint as long as the transaction costs are not too high for such a pricing mechanism, and we know that all parties can be made better off under such a mechanism. We also know that the ability to price discriminate can be made more difficult by the presence of competing firms. In the presence of a competing firm, any attempt to charge some customers higher prices on average may be easy to undermine, as the customers that pay the higher average prices turn to others that may be able to purchase and then resell at lower prices—especially as resale may be facilitated by the competing firm. Therefore, it may be possible to use more sophisticated pricing mechanisms post-merger than uniform pricing because of the elimination of competition.

Suppose that it is possible to use two-part tariffs rather than uniform pricing post-merger, because of the lowered transaction costs of engaging in non-uniform pricing. Might that not be relevant to determining the desirability of the merger? We are unaware of such merger simulations that involve nonlinear pricing in the existing economics literature; but in the next section we summarize some results from the recent development of such a model (see Carlton and Keating forthcoming).

The results show that this nonlinear pricing model can give very different answers with regard to the desirability of a merger compared to our standard merger simulation, especially in the presence of production efficiencies. One reason is that production efficiencies are most important when output is large. Since output is likely greater with nonlinear pricing than with linear pricing, it follows that one likely effect of a traditional analysis that assumes linear pricing is to underestimate the efficiency gains from a merger when the merger will lead to production efficiencies and also to a more sophisticated pricing mechanism. In essence, the more sophisticated pricing can significantly alter the evaluation of the merger compared to an analysis that assumes uniform pricing.

This example involved a horizontal merger. Similar principles apply to vertical mergers. We give two examples: The first involves a common concern that is related to vertical foreclosure, while the second involves a combination of vertical and horizontal concerns.

Vertical Merger to Foreclose

Suppose that an input monopolist sells to several downstream firms that compete amongst themselves. The monopolist buys one of the downstream firms. The other downstream firms complain that the merged firm will have an incentive to foreclose them from (or raise their costs for) the input in order to benefit the downstream division of the vertically integrated firm. There are numerous models of such foreclosure in the literature (see, e.g., Ordover et al. 1990). Most, if not all, of the models that involve vertical foreclosure assume some inefficient pricing between firms and then show, depending on the details of the assumptions (e.g., Cournot vs. Bertrand), that the vertical integration can cause harm through foreclosure.

But the analyst should ask what merger-generated changes make foreclosure more likely than it was pre-merger. If, pre-merger, the input monopolist could have contracted with one “independent” downstream firm (e.g., the firm that it is merging with), told the firm “hey, I will advantage you relative to your rivals, so let’s share the profits,” then there would be no gain from the vertical integration.

Suppose that the market conditions pre-merger were such that there were a large number of very detailed and complicated contracts that involved terms that defined nonlinear pricing and exclusion of rivals. Then why should one assume that exclusion would occur post-merger when it does not occur pre-merger when such contracts appear feasible? The only reason would be that the transaction cost of the exclusionary contract that I have just described becomes easier to carry out when the firm is integrated. But why?

If that question cannot be answered, then the regulatory or antitrust authority should be skeptical of the foreclosure argument.Footnote 2 Indeed, one might think that, at least sometimes, it is easier to get away with an exclusionary contract (which is hard to observe) compared to avoiding detection of the possibility of the exclusionary act when there is the full scrutiny of a regulatory or antitrust agency that is evaluating a vertical merger and can impose conditions to prevent exclusion. This is especially possible if there is a regulatory body involved, such as the US Federal Communications Commission (FCC), that operates under a different statutory standard than, say, an antitrust authority.Footnote 3

Horizontal Merger that Leads to Vertical Antitrust Concerns

As a final example that shows how the transaction costs of implementing a price mechanism can change as a result of some antitrust act, consider a horizontal merger that will have vertical implications. Suppose that there is a monopolist that sells to many buyers. Because of either a lack of information or the difficulty in preventing arbitrage, the monopolist can charge only a uniform monopoly price to the many buyers.

Suppose now that several of the buyers merge to form one large firm. In that case, it is easy to imagine a situation in which the large buyer can negotiate with the monopolist while the many remaining small buyers cannot because it is too costly. The large buyer may be able credibly to commit not to engage in arbitrage, succeed in obtaining a lower marginal price than its constituent firms had previously paid, and split the gains of its output expansion with the monopolist through some lump-sum payment (i.e., nonlinear pricing is used for the largest buyer).Footnote 4

The analysis of the consequences of the creation of a large buyer through merger must take into account the changed pricing mechanism that results as a consequence of the merger. The outcome could raise total surplus overall, lead to an expansion of output, and could in principle lead to a harm to the small buyers. If for example, the small buyers have a lower demand elasticity than the large buyer, the small buyers could see their prices rise after the merger. It is problematic to require that a merger, in order to pass antitrust scrutiny, must make each buyer better off (or no worse off), and we would settle for a total surplus (or total consumer surplus) approach, though others may differ.Footnote 5

There is an interesting antitrust wrinkle in this last example: Suppose that the buyers are not final consumers but instead purchase an input from the monopolist and then compete with each other in an output market. Then the higher marginal input price to the small buyers obviously could enhance the market power that the large buyer has in the output market. If the presence of small firms in that output market prevents the large buyer from pricing efficiently (price discriminating) to its customers, then the elimination of the small input buyers through high input prices could lead to even higher profits for our large buyer than would otherwise occur from just the elimination of its competition because the large buyer also becomes better able to price discriminate. If so, then the large buyer and the input monopolist can coordinate and destroy the small buyers, leading to a price-discriminating monopoly in the output market. Then those monopoly profits in the output market can be split (with some attendant transaction cost, no doubt) between the now two monopolists—the input- and output-monopolists.Footnote 6

Notice that even if all input buyers—small and large—could coordinate and bargain efficiently with the input monopolist to obtain marginal cost pricing, the large buyer would refuse because he can make more money by striking a bargain with the input monopolist to drive out the small input buyers. Suppose that we consider the gain to the large buyer from having the monopolist charge a high price to its rivals (the small buyers). Part of that gain comes from the fact that the advantaged large buyer will be able to exercise monopoly power over its consumers in a way not possible before.Footnote 7 By eliminating the competitive constraints on the pricing mechanism in the large buyer’s market, the input monopolist can cause the large buyer’s profits to increase with the result that the input monopolist can capture some of that extra profit for itself.

Of course, we would need to investigate why there is market power in that output market, whether the market power creates deadweight loss, what coalitions can form, and how costly it is for them to form; but it is easy to see that the best way for our input monopolist to exploit his market power could be to skew competition in downstream markets, favor the large buyer, enable the large buyer to price discriminate (through the weakening of the competitive constraints on output pricing by the small buyers), and share in some of the increased downstream profits.Footnote 8 Whether this is the best way to exploit his power will again depend on all the relative transaction costs of dealing with the various coalitions.

The key point is that a central issue in many antitrust matters is how the conduct under antitrust scrutiny alters the ability to exploit the existing and/or newly-created market power. We rarely, if ever, think of things that way. We should, but do not, pay attention to how the various transaction costs of organizing groups both horizontally and vertically may change as a result of a changed market structure.