PRICE-COST TESTS IN ANTITRUST ANALYSIS OF
SINGLE PRODUCT LOYALTY CONTRACTS
BENJAMIN KLEIN
ANDRES V. LERNER*
There is substantial disagreement regarding whether predatory pricing or
exclusive dealing principles should be the controlling antitrust legal standard
for the evaluation of single product loyalty discount contracts.1 The Third Circuit in ZF Meritor v. Eaton Corp.2 resolved this issue by focusing on whether
price discounts were “the clearly predominant mechanism of exclusion” in the
loyalty contract.3 Eaton, which had about an 80 percent share of sales of
heavy-duty truck transmissions, introduced loyalty contracts in 2000 that provided upfront payments and price rebates to the four major truck manufacturer
buyers if they met a sliding scale of minimum purchase shares, generally set
between 85 and 95 percent.4 Eaton urged the court in evaluating these contracts to adopt a Brooke Group5 price-cost test and to conclude that Eaton had
not engaged in anticompetitive conduct “because Plaintiffs did not prove—or
even attempt to prove—that Eaton priced its transmissions below an appropri-
* The authors are, respectively, Professor Emeritus of Economics, UCLA, and Executive
Vice President, Compass Lexecon. The research in this article has not been sponsored or paid for
by any organization and neither author has consulted on any of the cases analyzed in this article.
We have benefited from comments and discussions with Leah Brannon, George Cary, Dan
Crane, Don Hibner, Kelly Fayne, Kevin Murphy, Richard Steuer, Mike Waldman, and Josh
Wright. Valuable research assistance was provided by Steve Stanis and editorial assistance provided by Adam Sieff, Francesca Pisano, and Karen Otto.
1 Sean P. Gates, Antitrust by Analogy: Developing Rules for Loyalty Rebates and Bundled
Discounts, 79 ANTITRUST L.J. 99 (2013) (provides recent survey of the case law and the current
ongoing debate).
2 696 F.3d 254 (3d Cir. 2012).
3 Id. at 275.
4 Id. at 265. The minimum purchase shares for Freightliner ranged between 86.5% and 92%;
for International between 87–97.5%; for PACCAR between 90–95%; and for Volvo, which manufactured a significant quantity of its own transmissions, between 70–78%. Id. The contracts
were instituted after Meritor, Eaton’s primary rival, announced plans to expand through a joint
venture it entered in mid-1999 with a large German company, ZF Friedrichshafen. Id. at 264.
5 Brooke Grp. Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209 (1993).
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80 Antitrust Law Journal No. 3 (2016). Copyright 2016 American Bar Association.
Reproduced by permission. All rights reserved. This information or any portion thereof may
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Bar Association.
Electronic copy available at: http://ssrn.com/abstract=2775455
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ate measure of its costs.”6 The court rejected this argument, holding that, consistent with previous antitrust case law regarding single product loyalty
contracts, “predatory pricing principles, including the price-cost test, would
control [only] if this case presented solely a challenge to Eaton’s pricing
practices.”7
The court emphasized that, in addition to price discounts contingent on the
purchase of a minimum share of Eaton products, the Eaton loyalty contracts
included other terms that required truck manufacturers to favor Eaton products, specifically that Eaton transmissions be listed in truck manufacturer catalogues (or “data books”) as the standard, lowest price offering.8 Furthermore,
two of the four contracts required the truck manufacturer to remove competitors’ products from its data book entirely.9 The court also found that truck
manufacturers faced the risk of contract termination or reduced availability of
supply if they failed to meet Eaton’s minimum purchase share and preferred
distribution contract terms.10 This led the court to conclude that “price itself
was not the clearly predominant mechanism of exclusion.”11 Hence, the court
determined that the Eaton loyalty contracts should not be evaluated in terms
of a price-cost test but on a rule-of-reason exclusive dealing standard, under
which the contracts were found to violate antitrust law.12
This article clarifies the Meritor framework of analysis by, first, examining
what it means for price to be “the predominant mechanism of exclusion” in a
loyalty contract. It is essential to distinguish between two types of contract
terms in a loyalty contract: (1) contract terms that specify buyer performance
conditions, such as minimum purchase share; and (2) contract terms that incentivize buyers to meet these performance conditions, such as the loss of
price discounts if the performance conditions are not fulfilled. More complex
loyalty contracts include contract terms that may specify additional buyer performance conditions, such as Eaton’s preferential listing and pricing distribution requirements, or specify additional buyer incentives, such as Eaton’s
ability to terminate or restrict supply to buyers who fail to meet contract performance conditions.
Use of a price-cost test requires price to be “the predominant mechanism of
exclusion” in a loyalty contract in the sense of the second type of contract
term, namely that the contractual incentive mechanism by which buyers are
Meritor, 696 F.3d at 269.
Id. at 273–74.
8 Id. at 277–78.
9 Id. at 265–66.
10 Id. at 277–78.
11 Id.
12 Id. at 281.
6
7
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induced to meet contractually specified performance conditions consists
predominantly of the loss of price discounts. When price discounts are the
mechanism that incentivizes buyers to meet loyalty contract performance conditions, equally efficient rivals can compete for sales as long as price is
greater than cost, a condition that holds independent of the contract terms that
are used to specify performance conditions. A loyalty contract, for example,
may include preferential distribution requirements in addition to minimum
purchase share performance conditions. However, as long as price is the “predominant mechanism of exclusion” and price is greater than cost, buyers can
reject all the contract performance conditions because the only consequential
cost they bear is the loss of price discounts that equally efficient rivals can
meet. On the other hand, when significant non-price incentive mechanisms
also are present in a loyalty contract, such as the termination and supply risks
present in the Eaton loyalty contracts, the essential insight of Meritor is that
price greater than cost cannot be used as a test of liability because the ability
of equally efficient rivals to compete will depend upon the sum of price and
non-price incentive mechanisms in the loyalty contract.
When price is “the predominant incentive mechanism,” a price-cost test can
be used to evaluate single product loyalty contracts. However, both economics
and previous loyalty contract case law indicate that a simple Brooke Group
average price-cost test is applicable only when all sales are “contestable,” in
the sense that rivals can compete for all of a buyer’s purchases. More generally, consumer preferences for an established firm’s products may imply that
some of the established firm’s sales are “incontestable” sales for which rivals
are not able to economically compete. In that case the Brooke Group antitrust
safe harbor test must be modified, with loyalty discounts applied only to the
contestable sales. If the discount attributed price of contestable sales, defined
by allocating all discounts to contestable sales, is above costs, equally efficient rivals then can compete for contestable sales.
An important insight of this article is that consumer product preferences
that create incontestable sales also provide a procompetitive motivation for
loyalty discounts. Because individual firm demand curves as a consequence of
consumer preferences are negatively sloped, the single competitive price will
be greater than marginal cost, often substantially greater than marginal cost in
high fixed cost, high margin industries. For example, the first case to apply
the Third Circuit Meritor reasoning, Eisai v. Sanofi-Aventis,13 dealt with Sanofi’s loyalty contracts on sales of its pharmaceutical products to hospitals
where the single, profit-maximizing price was substantially greater than marginal cost. In this circumstance firms have a competitive incentive to use loyalty contracts to offer buyers contingent price discounts in return for increased
13
No. 08-4168 (MLC), 2014 U.S. Dist. LEXIS 46791 (D.N.J. Mar. 28, 2014).
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purchases. The appropriate antitrust standard for evaluation of single product
loyalty contracts requires distinguishing this procompetitive economic motivation for loyalty contracts from the use of a loyalty contract to leverage the
consumer surplus on incontestable sales to create a de facto “all-or-nothing”
exclusive dealing arrangement that anticompetitively forecloses rivals.
An economic framework is presented in this article that distinguishes between these alternative uses of loyalty discounts and derives criteria by which
loyalty contracts may be evaluated within this framework consistent with current antitrust law. The analysis is facilitated with an economic model that
analytically defines consumer product preferences and thereby clarifies the
economic relationship between product preferences, incontestable sales, and
the use of loyalty discounts as a way to increase incremental sales either by
reducing the price of contestable sales or by leveraging incontestable sales.
Consistent with Meritor, whether attributed price is greater than cost under
predatory pricing antitrust principles is shown to be the essential economic
factor that determines the ability of equally efficient rivals to compete in the
face of a loyalty contract whenever price is “the predominant mechanism of
exclusion” in the contract.
This conclusion is contrasted with the view of some antitrust scholars who
have recently argued that single product loyalty contracts should always be
analyzed under a rule-of-reason exclusive dealing standard, and that price-cost
evidence is irrelevant.14 This view fails to recognize that both the procompetitive benefits and potential anticompetitive effects of loyalty price discounts
are often the same as in predatory pricing. The view also incorrectly assumes
that merely because loyalty discounts are contingent on exclusive purchases
that the contract amounts to a de facto “all-or-nothing” exclusive dealing arrangement. Even when conditions imply that a loyalty contract should be
evaluated under a rule-of-reason exclusive dealing standard, such as when
signifiant non-price incentive mechanisms are present in the contract, the first
step of the analysis must involve a determination that the buyer has no economic choice but to meet the exclusive purchase condition, that is, that the
contract involves de facto exclusive dealing. Only then does the analysis
move to an evaluation of the procompetitive and anticompetitive effects of
exclusive dealing.
14 Cf., e.g., Gates, supra note 1, at 129–33 (similarly analogizing loyalty contracts to exclusive
dealing); Steven C. Salop, Exclusionary Conduct, Effect on Consumers and the Flawed ProfitSacrifice Standard, 73 ANTITRUST L.J. 311 (2006); Joshua D. Wright, Simple but Wrong or
Complex but More Accurate? The Case for an Exclusive Dealing-Based Approach to Evaluating
Loyalty Discounts, Remarks at the Bates White 10th Annual Antitrust Conference (June 3,
2013), www.ftc.gov/sites/default/files/documents/public_statements/simple-wrong-or-complexmore-accurate-case-exclusive-dealing-based-approach-evaluating-loyalty/130603bateswhite.pdf.
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I. LOYALTY CONTRACT ANALYSIS IN MERITOR
A. THE INAPPLICABILITY OF PRICE-COST TESTS WHEN A LOYALTY
CONTRACT INCLUDES NON-PRICE INCENTIVE MECHANISMS
The court in Meritor proposed a framework for the analysis of single product loyalty contracts where an initial determination is made regarding whether
price is the predominant incentive mechanism in the contract. When price is
the predominant incentive mechanism, in the sense that buyers have the incentive to meet the loyalty contract performance conditions primarily or solely
because of the financial penalty of the threatened loss of the loyalty price
discounts, the court concluded that the loyalty contract should be evaluated
using a Brooke Group price-cost standard. The court reasoned that when price
is the predominant incentive mechanism in a loyalty contract, price greater
than cost should be a sufficient condition to reject antitrust liability because
“prices are unlikely to exclude equally efficient rivals unless they are belowcost.”15 Therefore, “the price-cost test tells us that, so long as the price is
above-cost, the procompetitive justifications for, and the benefits of, lowering
prices far outweigh any potential anticompetitive effects.”16
On the other hand, if the incentive mechanism in a loyalty contract includes
non-price incentive mechanisms, the price-cost test does not provide a correct
answer to the question of whether equally efficient rivals can compete for
sales. This is the major insight of Meritor, where the court concluded that the
Eaton contracts should not be evaluated under a price-cost test because the
Eaton contracts included a number of significant non-price mechanisms of
exclusion. If truck manufacturers did not meet the minimum purchase and
other required distribution conditions in the Eaton loyalty contracts, they
faced expected costs that were greater than Eaton merely withdrawing its loyalty price discounts.
One non-price incentive mechanism in Eaton’s loyalty contracts described
by the court was Eaton’s right to terminate the contract if a manufacturer
failed to meet the contractually agreed upon minimum purchase share. Eaton’s contracts included this term with two of the four truck manufacturers,
Freightliner and Volvo.17 Termination would impose a particularly large cost
on a truck manufacturer because Eaton heavy-duty truck transmissions were
considered essential for truck manufacturers to remain in business.18 However,
Eaton’s right to terminate was not equivalent to an explicit “all-or-nothing”
Meritor, 696 F.3d at 281.
Id. at 275 (citing Brooke Grp. Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209,
223 (1993); Concord Boat Corp. v. Brunswick Corp., 207 F.3d 1039, 1062 (8th Cir. 2000)).
17 Id. at 278.
18 Id. at 282.
15
16
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contract term that unambiguously stated no product would be supplied if the
truck manufacturer did not meet the required purchase share. The two truck
manufacturers only faced a risk of termination, and it is not obvious what they
perceived to be the likelihood that Eaton would exercise its right of
termination.
In fact, the one example where either of these manufacturers failed to meet
their purchase requirements, namely Freightliner’s failure to meet its market
share target in 2002, did not result in Eaton’s exercise of its right of termination.19 But it is reasonable to conclude, as the court did, that the two truck
manufacturers likely perceived some risk of termination if they failed to meet
purchase requirements. In any event, Eaton’s contractual right of termination
imposed a potential cost on the two manufacturers because it provided Eaton
with additional power to renegotiate new, more burdensome supply terms in
the event either of the manufacturers did not meet purchase requirements.20
Another non-price incentive mechanism that all four manufacturers faced
was the risk that Eaton would limit the supply of its products, especially products that might be in short supply, if contract requirements were not met.21 In
contrast to termination, reduced supply of particular products, especially new
products in short supply, may have imposed a significant cost on non-cooperating truck manufacturers that did not meet the Eaton minimum purchase
share and other preferred distribution contractual requirements without entailing a significant cost on Eaton.
The Meritor court also discussed a number of distribution restrictions present in the Eaton loyalty contracts beyond the minimum purchase requirement
that are not normally present in loyalty contracts. Specifically, all four loyalty
contracts required that Eaton products be listed as the standard, lowest priced
transmissions in the manufacturer’s data book, and two contracts required that
non-Eaton products be removed entirely from the data books.22 These contract
19 Id. at 336 (Greenberg, J., dissenting). The only other example cited where a truck manufacturer failed at some point to fully meet its Eaton purchase share target involved PACCAR, a
truck manufacturer that was not operating under an Eaton right of termination agreement. In that
case Eaton merely withdrew its price discounts and continued to supply product at unchanged
terms. Id. at 283 n.15.
20 The Meritor dissent stated that it was unlikely Eaton would ever actually exercise its termination right and refuse to supply product to a manufacturer because there were only four truck
manufacturer buyers, each of which accounted for a significant share of total Eaton sales. Id. at
335–36 (Greenberg, J., dissenting). However, this does not mean the two truck manufacturers
perceived absolutely no risk of termination. Although the cost to Eaton from the exercise of its
right of termination was large, the associated cost to a truck manufacturer of termination may
have been even larger, so a termination threat may have been credible.
21 This was described in the testimony of a truck manufacturer executive. Id. at 277.
22 The Eaton contract with International required exclusive listing of Eaton products in the
electronic data book, but permitted rival product listings in the printed data book. The Eaton
2000 contract with Freightliner included exclusive listings of Eaton transmissions in both the
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restrictions represented a major change from Eaton’s previous contracts.
Before 2000, Meritor’s products were listed in all truck manufacturer data
books, and in some cases Meritor products actually received preferred
positioning.23
The acceptance by truck manufacturers of these Eaton preferential display
and pricing loyalty contract terms made it substantially more difficult for
Meritor to respond to Eaton’s loyalty contracts by reducing its prices. Even if
Meritor lowered its price to truck manufacturers substantially below Eaton’s
price, Meritor products could not be displayed by such a truck manufacturer
as a lower-priced alternative in its data book. A truck manufacturer’s acceptance of these restrictive distribution conditions in Eaton’s loyalty contracts
therefore had a significant negative effect on a manufacturer’s ability to substitute Meritor transmissions for Eaton’s transmissions and on the ability of
Meritor to compete.
However, while acceptance of these restricted distribution contract terms
may have significantly influenced final customer demand and hence truck
manufacturer purchases of Eaton transmissions, the restricted distribution
terms were only performance conditions that supplemented contractually
specified minimum buyer purchase conditions, not incentive mechanisms that
determined if truck manufacturers would decide to meet these restricted distribution conditions. The particular way in which Eaton’s loyalty contracts specified required buyer performance, with a minimum purchase share, preferred
pricing, and data book listings requirements, is independent of how the loyalty
contract incentivized buyers to meet these performance conditions. If the only
incentive mechanism was the loss of loyalty discounts, price greater than cost
would imply that equally efficient rivals could effectively compete by offering
discounts sufficient to induce buyers to reject these other performance conditions along with the minimum purchase share conditions. However, because
there were significant non-price incentive mechanisms in the Eaton loyalty
electronic and printed data books but reserved Freightliner’s right to list ZF Meritor’s FreedomLine products. In 2002 the Freightliner contract was revised so that if any rival products were
actually listed by Freightliner, Eaton had the right to renegotiate the discount schedule. Id. at
265–66.
23 Id. at 266. There is the economic question of why a loyalty contract may include distribution restrictions in addition to minimum purchase share conditions as part of the buyer performance requirements. The same result would be achievable, for example, by contractually
specifying solely a minimum required buyer purchase share without any other restrictions and
permitting the buyer to choose the best way to meet the required purchase share. However, this
may not define desired buyer performance requirements efficiently in all circumstances. In particular, minimum purchase share and preferred distribution contract terms may be complementary aspects of buyer performance that are economically important to specify separately. This is
discussed, infra at note 90, in relation to the Sanofi loyalty contracts with hospitals for the supply
of its blood clotting drug. Eisai Inc. v. Sanofi-Aventis U.S., No. 08-4168 (MLC), 2014 U.S. Dist.
LEXIS 46791 (D.N.J. Mar. 28, 2014).
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contract associated with the risk of termination faced by two truck manufacturers and the reduced availability of supply faced by all four truck manufacturers, price greater than cost would not imply that equally efficient rivals
could compete.
The court contrasted price discounts with excusive dealing arrangements.
Although “prices are unlikely to exclude equally efficient rivals unless they
are below-cost, exclusive dealing arrangements can exclude equally efficient
(or potentially equally efficient) rivals, and thereby harm competition, irrespective of below-cost pricing.”24 Once a firm establishes an exclusive dealing
arrangement, “other firms may be driven out not because they cannot compete
on a price basis, but because they are never given an opportunity to compete,
despite their ability to offer products with significant customer demand.”25
The court further explained that “[a]n express exclusivity requirement . . . is
not necessary”26 for a loyalty contract to create a situation where rivals “are
never given an opportunity to compete.” One must “look past the terms of the
contract to ascertain the relationship between the parties and the effect of the
agreement ‘in the real world.’”27 In this regard, the court noted that “contracts
in which discounts are linked to purchase (volume or market share) targets are
frequently challenged as de facto exclusive dealing arrangements on the
grounds that the discounts induce customers to deal exclusively with the firm
offering the rebates.”28
The court concluded that the Eaton loyalty contracts amounted to de facto
exclusive dealing arrangements where equally efficient rivals did not have the
ability to compete based on the direct evidence that all truck manufacturers
actually met the exclusive purchase conditions and the testimony of a truck
24 Meritor, 696 F.3d at 281 (citing United States v. Dentsply Int’l, Inc., 399 F.3d 181, 191 (3d
Cir. 2005)).
25 Id.
26 Id. at 270 (citing LePage’s Inc. v. 3M, 324 F.3d 141, 157 (3d Cir. 2003)).
27 Id. at 281 (citing Dentsply, 399 F.3d at 191, 194).
28 Id. at 275. Defining exclusive dealing contracts to include de facto exclusive contracts
where there is not an explicit exclusive purchase contractual requirement but where the contract
creates incentives for buyers to purchase the exclusive quantity is consistent with the Supreme
Court view that the relevant antitrust question with regard to exclusive dealing is whether the
contract has the “practical effect” of excluding rivals. See Tampa Elec. Co. v. Nashville Coal
Co., 365 U.S. 320, 326 (1961). Exclusive purchases are defined in this article to include cases
where price discounts are contingent on the buyer purchasing a substantial but possibly less than
100% share of purchases from the seller. This “partial exclusivity” definition is adopted by Willard K. Tom, David A. Balto & Neil W. Averitt, Anticompetitive Aspects of Market-Share Discounts and Other Incentives to Exclusive Dealing, 67 ANTITRUST L.J. 615 (2000). The economic
rationale for the use of partial rather than 100% purchase requirements is discussed infra at text
accompanying note 71. A contract with discounts contingent on full or partial exclusivity
purchase requirements does not mean the contract is an exclusive dealing arrangement unless the
buyer has no economic choice but to meet the full or partial exclusivity purchase requirement if
they wish to deal with the firm.
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manufacturer executive that truck manufacturers were “essentially forced” to
accept the Eaton contract terms or face costs that included “a big risk of cancellation of the contract, price increases, and shortages if the market [was]
difficult.”29 Therefore, the sum of the price and non-price incentive mechanisms present in the Eaton loyalty contracts provided buyers with no economic choice but to accept the Eaton minimum purchase and distribution
restrictions. The court consequently affirmed that “a jury could have concluded that, under the circumstances, the market penetration targets were as
effective as express purchase requirements ‘because no risk averse business
would jeopardize its relationship with the largest manufacturer of transmissions in the market.’”30
B. PRICE-COST ANALYSIS MUST BE MODIFIED
OF INCONTESTABLE SALES
FOR THE
PRESENCE
Even when price is the sole incentive mechanism in a loyalty contract, contrary to the Meritor court’s conclusion, a simple Brooke Group average pricecost test is not the appropriate standard for evaluation of the contract if the
loyalty contract involves some incontestable sales for which rivals cannot reasonably compete.31 The established firm’s average price can be greater than
costs yet equally efficient rivals may not be able to compete because when
price discounts are allocated to the contestable sales for which they can economically compete, the rivals face an implicit price net of the established
firm’s discounts that is less than costs. For example, in many cases loyalty
discounts are first-unit discounts where the loyalty contract may pass a
Brooke Group average price greater than cost standard, yet when all the price
discounts are allocated to contestable sales, the implied discount attributed
price of contestable sales is less than costs. Therefore, equally efficient rivals
cannot make above cost competitive offers for contestable sales and the buyer
will have no economic choice but to meet the seller’s exclusivity purchase
requirements. When price is the sole incentive mechanism in a loyalty contract, a price-cost test is still the appropriate antitrust standard, but the Brooke
Group test must be modified to a discount attribution price-cost test that applies only to contestable sales.32
Meritor, 696 F.3d at 277.
Id. at 283 (citing ZF Meritor v. Eaton Corp., 769 F. Supp. 2d 684, 692 (D. Del. 2011)).
31 Incontestable sales have been defined somewhat more narrowly as sales that rivals cannot
economically compete for “in any event.” Communication from the Commission—Guidance on
the Commission’s Enforcement Priorities in Applying Article 82 of the EC Treaty, 2009 O.J. (C
45) 7, ¶¶ 39, 42 (Feb. 24, 2009).
32 The EU Commission Guidelines similarly consider passing the discount attribution test to
be an antitrust safe harbor for single product loyalty contracts. Id. The Commission used the
failure of a discount attribution test as part of its analysis in finding Intel’s loyalty discounts
anticompetitive. See Case COMP/C-3/37.990—Intel, Comm’n Decision, 2009 O.J. (C 227) 13
(May 13, 2009). The decision of the EU General Court on Intel’s appeal, however, did not adopt
29
30
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Meritor supports the contrary conclusion that an unmodified simple Brooke
Group price-cost test is consistent with single product loyalty contract law
when price is the “predominant mechanism of exclusion” in a loyalty contract
by referring to three previous single product loyalty contract rulings33—NicSand, Inc. v. 3M Co.,34 Barry Wright Corp. v. ITT Grinnell Corp.,35 and Concord Boat Corp. v. Brunswick Corp.36 However, although price is the
predominant incentive mechanism in these three cases, it is only when all
sales are contestable that a simple Brooke Group average price above cost test
is the economically appropriate measure of whether equally efficient rivals
can compete for sales in the face of a single product loyalty contract.
This fully contestable sales condition fits only two of the three cases cited
by the court, NicSand and Barry Wright, cases where suppliers were essentially competing for all of a buyer’s purchases. Specifically, in NicSand suppliers of automotive sandpaper competed for the business of six large retailers
with up-front payments in return for exclusive agreements.37 With only one
exception, the retailers devoted shelf space to only one brand and therefore
the alternative suppliers were competing for all the sales at a retailer,38 with
the upfront payments economically equivalent to first-unit price discounts.39
Similarly, in Barry Wright, Pacific Scientific, a supplier of a type of shock
absorber used as a safety device in nuclear power plants, entered a two-tothree-year contract with Grinnell for a large share of purchases at a discounted
price that replaced a similar discounted price in return for an exclusive
purchase contract earlier entered with Grinnell by Barry Wright.40
Because all sales were contestable in NicSand and Barry Wright, the simple
Brooke Group price-cost test should be and was considered the applicable
standard in those cases. In fact, Brooke Group itself involved a loyalty contract for generic, unbranded cigarettes that “were more or less fungible” bethe discount attribution test framework and instead held that conditional loyalty contracts used by
an established firm were essentially a per se illegal abuse of dominance. Case T-286/09—Intel,
Judgment of the General Court (June 12, 2014), ec.europa.eu/competition/sectors/ict/intel.html.
33 Meritor, 696 F.3d at 275.
34 507 F.3d 442, 452 (6th Cir. 2007).
35 724 F.2d 227, 236 (1st Cir. 1983).
36 207 F.3d 1039, 1061 (8th Cir. 2000).
37 NicSand, 507 F.3d at 447.
38 Id.
39 The court correctly considered the upfront payments as legally and economically equivalent
to price discounts—that is, as “nothing more than ‘price reductions offered to the buyers for the
exclusive right to supply a set of stores under multi-year contracts.’” Id. at 452.
40 Barry Wright, 724 F.2d at 229. Another clear case where the firms were competing to be the
exclusive supplier and, hence, where all sales should be considered contestable is RaceTires
America, Inc. v. Hoosier Racing Tire Corp., 614 F.3d 57, 83 (3d Cir. 2010), where the court
noted that “[i]t is well established that competition among business to serve as an exclusive
supplier should actually be encouraged.”
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tween suppliers,41 and hence sales were fully contestable. Furthermore,
contrary to how Brooke Group is commonly described in terms of unconditional price discounts, the price discounts at issue were volume discounts contingent on increased distributor purchases of generic cigarettes.42
The third case cited by the court, Concord Boat, did not involve a loyalty
contract where all sales were contestable. The case involved the loyalty contracts of Brunswick, a market leading supplier of stern drive boat engines with
a 75 percent market share.43 In contrast to the fully contestable sales of NicSand and Barry Wright, Brunswick was the established supplier of generally
preferred products, and rival boat engine suppliers were not competing with
Brunswick to be the exclusive supplier to boat builders. Some of Brunswick’s
sales were incontestable, in the sense that rivals could not reasonably be expected to economically compete for all of a boat builder’s sales. Therefore, a
simple Brooke Group price greater than cost standard would not be economically appropriate and, as we shall see, the court in Concord Boat did not rely
on such a standard.44
II. THE USE OF LOYALTY CONTRACTS TO EXPAND SALES
WITH CONTINGENT PRICE DISCOUNTS
Once an established seller has some incontestable sales, antitrust analysis of
the seller’s use of a loyalty contract is complicated by the fact that the seller
now has the incentive to expand sales, and it becomes necessary to distinguish
between the two general ways in which a loyalty contract may be used to
profitably expand incremental sales: (1) by using contingent price discounts to
reduce the price of contestable sales, or (2) by leveraging the consumer surplus on incontestable sales. The first method by which a loyalty contract may
expand sales is examined in this section, Part II, and the second method examined in the following section, Part III. In both of these cases the potential
anticompetitive problem involves the creation of conditions in which equally
efficient rivals cannot compete in the face of the loyalty contract. The antitrust
standard of analysis for these conditions is discussed in Part IV.
Brooke Grp. Ltd. v. Brown & Williamson Tobacco Corp., 509 U.S. 209, 215 (1993).
Id. Price discounts were contingent on increased purchases, not an increased share of
purchases. However, as described infra in Part II.C.1, the essential economic characteristic of a
loyalty contract is the conditionality of price discounts on increased purchases, with the conditionality defined in terms of purchase share rather than absolute sales merely an efficient contract
specification in some circumstances.
43 Concord Boat, 207 F.3d at 1044. Brunswick’s loyalty contracts included a sliding scale of
discounts of up to 3% if a boat builder purchased 80% of its boat engine requirements from
Brunswick. Id.
44 The court’s standard of analysis in Concord Boat is discussed infra at text accompanying
notes 109–113.
41
42
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A. CONSUMER PREFERENCES CREATE
THE
INCENTIVE
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TO
EXPAND SALES
To illuminate the economics of single product loyalty contracts when some
sales are incontestable, it is useful to consider an economic model where suppliers sell differentiated products that are preferred to a greater or lesser extent
by different consumers. Incontestable sales then depend, on the extent of consumer preferences for an established firm’s products. When a firm’s products
are significantly preferred by many consumers to a rival firm’s products, the
sales to these consumers may be incontestable.
We assume for simplicity that there are two suppliers of a particular type of
product (for example, transmissions in Meritor and drugs in Eisai). There is
an established supplier of a more highly preferred product that accounts for a
larger share of market sales, denoted as product A (supplied by Eaton or Sanofi), and a smaller rival supplier of product B (supplied by Meritor or Eisai).
The buyers of the products at issue in the cases we examine are assumed not
to be the ultimate consumers who have different relative preferences for products. Instead the buyers are intermediate firms that demand the product from
suppliers as an input into a final product that is demanded by these consumers
(truck manufacturer buyers of transmissions in Meritor and hospital buyers of
drugs in Eisai).45
Ultimate consumers are assumed to have preferences for the established
firm’s product A relative to the smaller rival’s product B that vary across
consumers. The value a specific individual consumer of a particular buyer of
the product (for example, a consumer of a particular truck manufacturer)
places on product A (Eaton transmissions) is denoted VA and the valuation the
consumer places on the alternative rival product B (Meritor transmissions) is
denoted VB, with each consumer’s relative valuation, or preferences for product A relative to product B, denoted VA−VB. Individual consumer relative
product preferences, VA−VB, vary across consumers, with the distribution of
relative preferences for the consumers who purchase from a particular product
buyer (e.g., consumers who purchase from a particular truck manufacturer)
assumed for illustrative purposes to be distributed uniformly over a $4.00
range as shown in Figure 1. Consumers are ordered along the quantity axis by
their relative preference for product A compared to product B if both products
45 Products demanded by intermediate buyers are the types of products at issue in almost all
loyalty contract antitrust cases. When loyalty contracts are entered into directly with consumers
(for example, a fast-food restaurant that offers a tenth meal free), it is much less likely that the
loyalty contract will involve an exclusive purchase requirement. In addition, the absence of an
intermediate buyer means that there is not a transactor that can serve as the efficient bargaining
agent for a group of consumers by internalizing what would otherwise be individual consumer
demand decisions, as we shall see occurs in these and most other loyalty contract cases.
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were sold at the same price, with the distribution of individual consumer values (VA–VB) assumed to range between $3.80 and minus $0.20.46
VA – VB
$3.80
$1.20
-$0.20
0.65
0.95
1.00 Share of Total
Consumers
FIGURE 1:
CONSUMER RELATIVE PRODUCT PREFERENCES
Figure 1 describes a situation where it is assumed that almost all consumers
prefer product A to product B when they are sold at the same price. The
particular consumers that most highly prefer product A relative to product B
are assumed to place a value on (VA−VB) of $3.80—that is, they would be
indifferent between the products if A were priced $3.80 higher than B. On the
other hand, consumers who least prefer A to B place a value on (VA−VB) of
minus $0.20—that is, they would purchase B even if it were priced at the
same price as A. As we have drawn this schedule, 95 percent of consumers
have a positive value of (VA−VB)—that is, they are assumed to prefer product
A to product B if they were sold at the same price. These relative product
preferences are assumed to be given at a particular point in time. Most consumers prefer the established supplier’s product A to the rival’s product B if
46 This general framework was presented in Benjamin Klein & Kevin M. Murphy, Exclusive
Dealing Intensifies Competition for Distribution, 75 ANTITRUST L.J. 433 (2008) [hereinafter
Klein & Murphy, Exclusive Dealing]. The framework was modified to take account of the fact
that more consumers may prefer one product relative to the other product in Hans Zenger, When
Does Exclusive Dealing Intensify Competition for Distribution? Comment on Klein and Murphy,
77 ANTITRUST L.J. 205 (2010), and the relative preferences assumption adopted in Benjamin
Klein & Kevin M. Murphy, How Exclusivity Is Used to Intensify Competition for Distribution—
Reply to Zenger, 77 ANTITRUST L.J. 691 (2011) [hereinafter Klein & Murphy, Reply].
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they were sold at the same price at this point in time because the established
supplier has a superior market reputation, or because consumers generally
prefer some particular characteristics of the established supplier’s products, or
for some other economic reason.
The slope of the line in Figure 1 can be thought of as the relative demand
schedule for product A, which depends on the degree of consumer preferences
for product A relative to product B and the price of product A relative to
product B. When product A’s price is equal to product B’s price, product A
will account for 95 percent of a buyer’s purchases; if the established supplier
of product A sets a higher price relative to the rival supplier of product B, the
established firm’s sales of A will be lower, as consumers with preferences for
A relative to B that are now less than the price difference shift their purchases
to B.47
The model assumes that a buyer’s increased purchases of a particular
seller’s products involve a one-to-one decrease in the other seller’s product
sales. This is a useful framework in which to analyze the loyalty contracts that
are commonly the subject of antitrust litigation. These cases generally involve
an increased demand for one product relative to another, not merely a buyer
moving down its demand curve and purchasing more of a seller’s products
without reducing the demand for rival products. This certainly describes the
facts in both Eisai and Meritor. The particular products in question—a bloodclotting drug used at hospitals and a transmission demanded by truck manufacturers—are inputs that account for a relatively small share of the total
value of the ultimate product supplied to consumers (hospital services and
trucks). Consequently, we would expect relatively little if any increase in a
hospital’s total purchases of all blood-clotting drugs or a truck manufacturer’s
total purchases of transmissions in response to a contractually negotiated reduction in these product prices as part of a loyalty contract. Seller pricing of
these particular inputs can reasonably be assumed to have little or no influence on overall hospital admissions or on total industry truck sales.
We further assume for expositional simplicity that the average and marginal
cost of providing and selling the products for both the established supplier of
product A and rival supplier of product B is $1.00. Given the relative demand
functions for product A and product B, the $1.00 cost and the assumption that
47 The demand functions underlying the model are Q
A = (1−.5PA+.5PB+a)/2 and QB=
(1−.5PB+.5PA−a)/2, where a, the degree of asymmetry in consumer preferences, is equal to 0.9.
As the demand functions are specified, QA and QB can be interpreted conveniently as the percentage of sales purchased of the two products because, irrespective of prices, the total demand
(QA+QB) is always equal to 1. The demand functions therefore are related to absolute quantity
demand functions where it is assumed that total market demand is given. This specification is
analogous to the demand functions presented in Zenger, supra note 46, and analyzed in Klein &
Murphy, Reply, supra note 46.
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the established and rival suppliers both independently set unitary prices to
maximize their profits, the resulting equilibrium competitive product price of
A is equal to $4.60 and the price of B is $3.40. The supplier of product B,
recognizing that its product is preferred by many fewer consumers than product A, sets a lower price for its products. The $1.20 price gap between product
A and product B implies, as illustrated in Figure 1, that at the equilibrium
price difference, the relative share of sales are 65 percent for product A and
35 percent for product B.48
Figure 2 converts Figure 1 into the share of demand by the particular firm
buyer for seller A’s products—that is, a particular truck manufacturer’s demand for Eaton truck transmissions—assuming that the price of the rival supplier’s product B (Meritor’s transmission price) is set at $3.40. The profitmaximizing price set by the established seller is $4.60, at which point the
quantity demanded by the buyer is 65 percent of the market. An analogous
demand function by the buyer for rival product B given the established
seller’s price of $4.60 implies a price of B of $3.40 and a 35 percent share of
the market.
PA
$7.20
$4.60
L
C
$3.20
Demand
D
$1.00
MC
0.65
1.00
Share of Buyer
Purchases of A
Marginal Revenue
FIGURE 2:
THE ESTABLISHED FIRM’S SINGLE PROFIT-MAXIMIZING PRICE
48 These equilibrium price and quantity values are determined when each firm, given its demand function and the assumed cost of $1.00, maximizes its profit with respect to its own price
holding the competing firm’s price constant, with the two relationships combined to yield the
unique Nash equilibrium values for each firm’s price and sales.
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It is clear from the equilibrium described in Figure 2 that the rival will
consider some of the buyer’s purchases of A to be “incontestable.” Even if the
rival hypothetically reduced the price of its product B by, say, $1.00 to $2.40
and the established firm unrealistically did not react by reducing its price of
product A, so that the price differential between the products was now $2.20,
the established seller of A based on relative consumer preferences for the
products (Figure 1) would still make, at a nearly double price, 40 percent of
the sales.49
Figure 2 illustrates the common situation faced by all product suppliers in
differentiated product markets, where they have a profit incentive, often a
very significant profit incentive, to expand sales on the margin. This is because suppliers of differentiated products face less than perfectly elastic demands and consequently set their profit-maximizing competitive prices above
marginal cost. This equilibrium condition, which describes most markets,
does not mean that such firms necessarily possess antitrust market power.
Consistent with the definition of market power in antitrust law, a firm’s antitrust market power should not be defined in terms of its own elasticity of
demand.50 In addition, such firms may not be earning any profits because the
gap between price and marginal cost may merely cover the firm’s fixed costs.
Many products, such as the transmissions at issue in Meritor and the
pharmaceuticals at issue in Eisai, may involve significant R&D and other capital costs yet have relatively low marginal costs. It does mean, however, that
all such firms have a profit incentive to increase sales at the current price.
At the single price profit-maximizing equilibrium, the established seller’s
profit-maximizing price of $4.60 is substantially greater than the established
seller’s marginal cost of producing additional units of product A of $1.00.
Therefore, if the established firm sells one more unit, it earns more than three
and a half times the cost of producing the unit ($4.60 minus $1.00, or $3.60
extra profit per unit). Similarly, the rival seller of product B faces a demand
curve where it sets price at $3.40, which also is substantially above its $1.00
marginal cost, and thus also has a significant profit incentive to expand
sales.51
49 This example illustrates that the level of contestable sales the rival can compete for depends
not only on the extent of relative consumer preferences for the established firm’s products, but
also on how much the rival can reduce price and remain above costs. A minimum estimate of
incontestable sales may be determined by assuming that the rival reduces its price to marginal
cost of $1.00 and the established firm does not react and keeps its price at $4.60. In that case
there will still be 5% of sales that the rival cannot compete for. The assumption that the established firm does not react by reducing its prices is, of course, unrealistic.
50 Benjamin Klein, Market Power in Antitrust: Economic Analysis After Kodak, 3 SUP. CT.
ECON. REV. 43 (1993).
51 This realistically represents the general underlying economic situation that existed in Eisai
for pharmaceutical purchases by hospitals, where the marginal value to Sanofi of selling an
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We have labeled in Figure 2 what the established supplier potentially has to
gain if it can expand sales at the unchanged price of $4.60 from 65 percent to
100 percent as the total area L+C+D. This would amount to a profit of $3.60
per unit on the 35 percent incremental sales, or a total profit increase of 54
percent (35/65). However, Figure 2 illustrates that if the established supplier
attempted to expand sales merely by reducing price, it would be unprofitable—it would be moving below the profit-maximizing price into the range
where marginal revenue is less than marginal cost. It clearly would not be in
the established supplier’s interest to do this because this would reduce its
profits. Consequently, in these circumstances the established supplier, as well
as the rival, both have a significant financial incentive to expand sales in ways
other than by decreasing their single profit maximizing prices.
B. LOYALTY DISCOUNTS COMPENSATE BUYERS
SALES-SHIFTING SERVICES
FOR
We have implicitly assumed up until now in Figures 1–2 that firm buyers
act as passive middlemen who translate the preferences of their consumers
into the demand for a seller’s product. It is more commonly the case that an
essential part of the competitive process involves the firm buyer serving as
more than just a passive intermediary between the input product seller and its
ultimate consumers. Because consumers also have preferences to purchase
from a particular buyer—that is, from a particular truck manufacturer in Meritor or from a particular hospital in Eisai—they will be somewhat loyal to the
buyer and will not switch between different truck manufacturers or hospitals
solely on the basis of whether the truck manufacturer or hospital provides
their particular preferred truck transmission or blood-clotting drug. This is
particularly the case because the transmission or drug is a relatively small
fraction of the product demanded by the consumer.
Consequently, because the firm buyer possesses the ability to significantly
influence the particular product that its consumers purchase, the buyer has the
ability to act as an efficient bargaining agent for its consumers and to shift
contestable sales to an individual seller in return for the seller’s price reductions. Rather than letting each individual consumer make its product choice by
demanding a product based on its individual preferences, as previously
modeled, the buyer can negotiate price reductions with sellers in return for an
increased purchase commitment that benefits consumers as a group.52 Contestable sales therefore depend not only on consumer preferences and the seller’s
additional unit of its blood-clotting drug, as well as the value to Eisai of selling an additional unit
of its rival blood-clotting drug, was substantially greater than the marginal cost of producing and
marketing an additional unit of their drugs. Sanofi and Eisai therefore were earning very high
profit margins. See discussion infra text accompanying note 92.
52 See Klein & Murphy, Reply, supra note 46.
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price-cost margin, but also on this third economic factor, consumer loyalty to
the buyer and hence the ability of buyers to share-shift sales, with the competitive process involving seller competition for buyer sales-shifting services.
For example, a hospital may approve only one acceptable brand of drug in a
particular therapeutic category in its formulary without significantly affecting
its sales, that is, hospital admissions or doctors demanding privileges at the
hospital. This explains why a hospital buyer, or a GPO (group purchasing
organization) hired to act as the hospital’s purchasing agent, will be able to
obtain better pharmaceutical prices in return for providing competing pharmaceutical companies with a greater share of sales. The lower prices have nothing to do with hospital monopsony market power; the ability to negotiate
lower prices is present even when the hospital buyer has a small market share.
A small individual hospital often may be able to obtain substantially lower
drug prices in return for a purchase share commitment because it has substantial influence over doctor prescribing decisions compared to, for example, a
much larger pharmacy chain that has a much more limited ability to influence
sales. The elasticity of demand faced by both the established and rival seller
increases compared to Figure 2 because each seller now knows they will make
substantially greater sales if they lower price and win the contract for the
buyer’s sales-shifting services.
This competitive process by which a firm buyer acts as a price-reducing
negotiating agent for its customers as a group is economically different from
lower prices offered to ultimate customers in return for greater purchases. For
example, the loyalty contracts in Virgin Atlantic Airways were described as
the way sellers “reward their most loyal customers” with quantity discounts.53
However, the British Airways loyalty contract was with travel agents and corporate buyers, intermediary purchasing agents who had a significant ability to
switch final consumer sales to a designated airline, similar to the ability of
truck manufacturers and hospitals in Meritor and Eisai to switch sales to a
particular truck transmission or blood-clotting drug. The intermediary
purchasing agent can bargain for a lower price more effectively than individual consumers because consumer loyalty to the agent provides the agent with
the ability to internalize what would otherwise be individual consumer
purchase decisions.54
Virgin Atl. Airways v. British Airways, 257 F.3d 256, 265 (2d Cir. 2001).
See Klein & Murphy, Exclusive Dealing, supra note 46. The fact that loyalty contract decisions are generally made by intermediary firms rather than the ultimate consumer should be
contrasted with the experimental evidence in Morell, Glöckner, and Towfigh that consumers
(rather than buyer agents) may not make economically rational decisions about entering and
continuing loyalty rebate arrangements. Alexander Morell, Andreas Glöckner & Emanuel V.
Towfigh, Sticky Rebates: Loyalty Rebates Impede Rational Switching of Consumers, 11 J. COMPETITION L. & ECON. 431 (2015).
53
54
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In this context where buyers have loyal customers and therefore the ability
to determine what products will be supplied to their customers independent of
individual consumer relative product preferences, established sellers have to
compete with rivals for the buyer’s sales-shifting activities which can significantly increase a particular brand’s relative sales. In fact, it will be in the
buyer’s interest to encourage such seller competition for its sales-shifting services. As a consequence, established sellers will be more likely to offer buyers
contingent financial compensation for an increased sales share, with the gains
from trade that result from the seller’s increase in sales from such a loyalty
contract shared with buyers as a consequence of the competitive process.
The loyalty contract that results from this competitive process is a consequence of the established seller and the rival bidding for buyer sales-shifting
services. It is unlikely that the rival seller will find it profitable to make an
offer for the same, say, 95 percent of a buyer’s purchases that may be made
by the established seller. However, effective rival competition does not require the rival to make a competing loyalty contract offer for the same minimum buyer purchase share as the established seller. The rival is merely
competing for the buyer’s sales-shifting services, and for the resulting increased incremental sales. Furthermore, because rival competition for the
buyer’s sales-shifting services will result in better purchase terms, it will be in
the interest of buyers that have the ability to shift sales between sellers to
facilitate rival competition for distribution by not requiring rival head-to-head
bidding for the same share of sales upon which the established seller has made
its loyalty discounts contingent.
To illustrate the economic forces at work, assume that before loyalty contract offers are made sales consist of 65 percent for the established seller’s
products and 35 percent for the smaller rival’s products, as in our hypothetical
example illustrated in Figure 2. Now assume that if the established seller wins
the competition for the buyer’s sales-shifting services contract, its share of
sales to the buyer increases 30 percentage points, from 65 to 95 percent; on
the other hand, assume that if the rival seller wins the competition for buyer
sales shifting, rival’s sales share increases 35 percentage points, from 35 to 70
percent.55 Whatever the relative sales-shifting magnitudes, the established
seller and smaller rival are both competing for the same net shift in their sales
share, in this case the same 65 percentage point shift depending upon whether
they win or lose the competition for the buyer sales-shifting contract. (For the
55 We have assumed these particular numbers to illustrate that a buyer’s ability to shift sales
need not be identical for alternative sellers. In fact, when the starting sales shares are very different, it is likely that the buyer may have more sales it can shift to the rival’s products, as illustrated by the contracts negotiated by Eisai with a number of hospitals described below. The
analysis is the same if the buyer’s ability to shift sales is an identical percentage point shift, for
example, 30 percentage points for both the established seller and the rival.
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established seller: a 95 percent share of sales if it wins the contract compared
to a 30 percent share of sales if it loses the contract; for the rival: a 70 percent
share if it wins compared to 5 percent share if it loses.) Therefore, given the
inability of an established seller to profitably make an “all-or-nothing” contract demand, in many circumstances a rival seller may be able to respond to
an established seller’s loyalty contract and effectively bid for a substantial
share of buyer purchases even when it does not supply a product preferred by
most consumers.
Figure 3 illustrates the case where the established seller is assumed to win
this competition for buyer sales shifting by offering a price decrease from
$4.60 to $4.00 in return for the buyer commitment to make 95 percent of its
purchases from the established seller.56
PA
$7.20
$4.60
$4.00
$3.40
$1.00
a
b
e
d
c
f
Demand
m1
0.65
m2
0.95
MC
Share of Buyer
Purchases of A
Marginal Revenue
FIGURE 3:
PRICE DISCOUNT CONTINGENT ON INCREASED PURCHASES
From the established seller’s point of view, the loyalty contract involves a
loss of profit from collecting a $0.60 lower price on all previously demanded
56 Established seller incremental sales are stated as partial (95%) exclusivity purchase requirements because we assume, as discussed infra note 71, that otherwise the established seller would
have to pay too much (i.e., offer too large a price discount) to buyers to win the contract for a full
exclusive. An analogous incremental demand curve faces the rival seller starting at a price of
$3.40 and a 35% market share.
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units, which accounted for 65 percent of sales. However, the seller now earns
significant additional profit equal to the difference between $4.00 and the
marginal cost of $1.00, or $3.00 per unit, on the 30 percent incremental sales
achieved under the loyalty contract. The seller’s additional profit on incremental sales therefore is 2.3 times greater than the seller’s lost profit on its
pre-existing sales, more than offsetting the lost profit of the price decrease on
the 65 percent of sales.
Figure 3 indicates that the buyer gains the $0.60 discount on its original
purchases accounting for 65 percent of its total purchases in return for agreeing to make an additional 30 percent of incremental purchases from the established seller. On these incremental purchases the buyer gains additional
consumer surplus of abe from moving down the demand curve to point b, but
loses consumer surplus of bdc from moving further down the demand curve to
point c. The buyer has some offsetting losses because the buyer’s loyalty contract commitment, point d in Figure 3, is “off the single price demand curve,”
which means that the consumers’ valuation is less than $4.00 between b
and d.
The fact that point d is off the single price demand curve (as defined by
consumer preferences) does not mean that the buyer has been “forced” to
purchase more of the seller’s products than it desires. The buyer would prefer
to move to point b on the demand curve and buy less at the discounted $4.00
price, but the buyer is receiving the discounted price only because it has the
ability to share-shift sales and is making the 95 percent purchase commitment
to the seller. If the buyer did not commit to the 95 percent share of purchases,
the seller would keep price at $4.60 and not lower the price to $4.00, so that
the buyer (as well as the seller) would be worse off. Instead, the buyer and
seller are now sharing the total joint gains from trade, equal to acm2m1 in
Figure 3, with the buyer and seller both financially incentivized to enter the
contingent loyalty contract. Specifically, the total gains of trade from the illustrative loyalty contract described in Figure 3 are distributed between the seller
and buyer 57 percent to 43 percent.57
57 Because abe equals bdc, the buyer’s net gains are equal to ($0.60)(65) and the seller’s net
gains are equal to ($3.00)(30) – ($0.60)(65). More generally, how the gains from trade from this
competitive process are distributed between the buyer and seller is indeterminate. In the original
Klein and Murphy model, it was assumed for expositional simplicity that all sellers had the same
relative number of consumers that preferred their particular products and there was not an established seller supplying products preferred by most consumers. Klein & Murphy, Exclusive Dealing, supra note 46. In this circumstance all sellers were assumed to bid competitively for an
exclusive contract on an equal basis and buyers obtained all the gains from trade. Under the
conditions described in this article, sharing gains from trade will involve bilateral negotiation
between each buyer and competing sellers, with a particular illustrative sharing result presented
in Figure 3. Murphy et al. describe the range of mutually advantageous price and quantity combinations that may result from this competitive process. Kevin M. Murphy, Edward A. Snyder &
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C. THE ECONOMICALLY EFFICIENT FORM OF SALES-SHIFTING
LOYALTY CONTRACTS
1. Price Discounts Contingent on Sales Share
The primary distinguishing economic characteristic of loyalty discounts
compared to normal price discounts is that loyalty discounts are contingent on
the buyer meeting a particular contractually specified level of purchases.
When the loyalty contract involves the seller’s purchase of buyer sales-shifting services in return for providing the buyer with some of the gains of trade
created by incremental sales, the terms of a contract must involve a contingent
price discount. As we can see from Figure 3, if the procompetitive price discount is not made contractually contingent on increased buyer purchases, sellers will not reduce their single, profit-maximizing prices.
What has sometimes been questioned in the antitrust economics literature is
that the contingency is specified as an increased share of buyer purchases
rather than an increased absolute level of buyer purchases. The “contracts that
reference rivals” literature maintains that, although there may be an efficiency
justification for contingent quantity discounts based on, for example, seller
cost savings associated with increased sales, there is not any procompetitive
economic justification for relating price discounts to the share of a buyer’s
purchases devoted to a particular firm’s products. The claimed absence of any
efficiency justification for a firm to base the price it charges a customer on
whether the customer buys from rival sellers is then used to infer that the only
economic purpose of such contracts must be anticompetitive exclusion.58
Once it is recognized, however, that a loyalty contract involves seller
purchase of buyer sales-shifting services, specification of the contract based
on the share of buyer purchases is likely to be efficient because it more accurately measures the sales-shifting services supplied by the buyer than the absolute quantity of a seller’s products purchased by the buyer. The absolute
quantity of a buyer’s purchases often is not a reasonable benchmark of the
purchases that would have occurred absent buyer sales-shifting because it will
vary significantly over time and across buyers. Contractually defining the
buyer’s sales-shifting services supplied to a seller as a minimum buyer
purchase share of the seller’s products therefore facilitates contracting for
buyer sales-shifting services, both over time as overall market conditions
change and with different-sized buyers. This specification permits small buyers, which also have loyal customers and the ability to shift their purchases
Robert H. Topel, Competitive Discounts and Antitrust Policy, in THE OXFORD HANDBOOK OF
INTERNATIONAL ANTITRUST ECONOMICS 89 (Roger D. Blair & D. Daniel Sokol eds., 2015).
58 This economic literature is summarized in Fiona M. Scott Morton, Contracts that Reference
Rivals, ANTITRUST, Summer 2013, at 72.
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across sellers, to contract for seller payments for share-shifting services on an
equal basis with the largest buyers.
Despite these contract efficiencies of using purchase share as a more accurate measure of buyer supply of sales-shifting services, it has been claimed
that an established firm’s use of price discounts that are contingent on a
greater buyer purchase share of the firm’s products creates anticompetitive
economic incentive effects because it increases the relative prices buyers face
in purchasing rival products. One formulation of this argument describes a
loyalty contract as imposing an artificial “tax” on a buyer’s purchases of rival
products equal to the discount the buyer gives up by not buying from the
established firm.59 Because of this “tax,” rivals may be forced to charge substantially lower prices (or to supply a higher quality product) than they would
otherwise to effectively compete for the buyer’s purchases. Consequently, it is
claimed that the loyalty contract distorts competition by providing the established firm with an advantage without serving any procompetitive purpose.
It is important to recognize that this “tax” in the form of an increase in rival
relative prices is not an increase in actual rival seller costs. The established
firm’s loyalty contract is merely focusing price reductions on the incremental
contestable sales that can be induced by buyer supply of sales share-shifting
services, for which the rival must now more actively compete by similarly
decreasing prices. This incentive effect has nothing to do with the specification of the loyalty contract in terms of the buyer’s purchase share because the
same effect would be present if, for any given total quantity purchased by a
buyer, the established firm instituted a volume discount contract. Specifying
the loyalty contract as the buyer’s share of purchases, rather than the absolute
level sales, is merely a more efficient way to measure the buyer’s sales-shifting services and incremental sales that both the established and rival seller are
competing for and for which they are offering contracts. One thus cannot infer
that a loyalty contract based on a sales share rather than absolute sales serves
no valid economic efficiency purpose and does not involve “competition on
the merits.”
2. First-Unit Price Discounts
Another key antitrust question is whether an established firm’s loyalty contract makes it more difficult for rivals to compete not only because rivals must
now actively compete for buyer sales share-shifting services, but also because
the loyalty contract uses first-unit discounts so that buyers who reject the established firm’s loyalty contract pay a higher price for the incontestable sales
they must purchase. However, if there is no significant non-price incentive
59 Joseph Farrell, Janis K. Pappalardo & Howard Shelanski, Economics at the FTC: Mergers,
Dominant-Firm Conduct, and Consumer Behavior, 37 REV. INDUS. ORG. 263, 267–68 (2010).
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mechanisms, the ability of a loyalty contract to create a situation where
equally efficient rivals do not have the ability to compete depends solely upon
the total amount of the discount and the level of contestable sales to which the
discount is allocated—that is, the discount attribution test. It does not depend
on which sales the contingent discount is stated, that is, on the form in which
the established firm compensates buyers for sales share-shifting services.
It is sometimes argued that if the established firm wished to increase a
buyer’s purchase share to 95 percent as in Figure 3, it should merely decrease
the price on incremental sales between 65 percent and 95 percent. However,
once price discounts are contingent on a 95 percent purchase share, it does not
matter what particular units are discounted as long as the buyer receives the
same per unit time payment that represents its competitive share of the gains
from trade from its ability to share-shift sales between sellers. Therefore, if
the price discount is only on incremental sales rather than the first unit, the
price discount will have to be larger.60 In general, the compensation received
by the buyer will be independent of the form of seller compensation. Therefore, whether buyer compensation occurs in the form of a first-unit price discount, as illustrated in Figure 3, or with adjusted larger price discounts solely
on the incremental sales between 65 and 95 percent induced by the loyalty
contract, or with a lump sum for reaching the 95 percent sales share, the total
magnitude of the compensation will be the same. And none of these alternative compensation arrangements that amount to the same discount attribution
test calculation will prevent equally efficient rivals from competing.
The contrary opinion that rivals face additional difficulties when competing
against an established firm that institutes a first-unit loyalty discount contract
is based upon reasoning illustrated with the hypothetical loyalty price discount
contract described in Figure 4. We assume that a buyer’s total demand is 100
units, so that the number of units can also represent the buyer’s purchase
share, with 75 units or 75 percent purchased from the established firm at a
price of $10 before the established firm makes a loyalty contract offer. Suppose the established firm offers a $1 discount contingent on the buyer
purchasing a minimum 90 percent sales share. Because the $1 discount applies to all purchases before 90 percent, the loyalty contract implies that for
sales close to the minimum required sales share level, the rival faces an effective attributed price that is substantially less than cost. Specifically, the effective attributed price for the 90th unit for a buyer that has purchased 89 units is
negative $80; that is, $9 to purchase the 90th unit minus a $1 savings earned
60 If the price on sales between 65% and 95% described in Figure 3 in terms of first unit
discounts, that would result in a smaller share of the gains from trade going to the buyer (acf) and
a larger share going to the seller (cfm1m2), 20% vs. 80%, rather than 43% vs. 57%.
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on the previous 89 units purchased. Obviously, a rival could not compete for
the 90th unit in the face of such a loyalty contract.61
$20
$10
$0
-$10
Effective Price
-$20
-$30
-$40
-$50
-$60
-$70
-$80
-$90
0
5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Share Purchased from Dominant Firm
FIGURE 4:
FIRST-UNIT LOYALTY PRICE DISCOUNT ATTRIBUTED PRICE
However, the very negative attributed price for the unit immediately before
the minimum contractually specified threshold sales share is not economically
relevant for purposes of assessing a rival’s ability to compete for the buyer’s
sales share-shifting contract, and therefore by itself does not have any competitive significance. The relevant economic question is not whether the rival can
make an alternative profitable offer solely for the 90th unit in the face of the
loyalty contract, which we know the rival cannot do, but whether the rival can
compete by making an alternative contract offer for a range of sales greater
than the residual 10 units at an average price greater than its marginal costs,
which will depend on the extent of contestable sales.
For example, assume that, given the buyer’s ability to share-shift sales, the
rival seller can make an offer for 60 percent of the buyer’s purchases. A buyer
61 This example and illustrative Figure 4 is analogous to the loyalty contract example and
similar figure of an implied negative price of the 90th unit presented by Fiona M. Scott Morton
at the FTC-DOJ Conditional Pricing Practices workshop. Fed. Trade Comm’n & U.S. Dep’t of
Justice, Conditional Pricing Practices: Economic Analysis & Policy Implications Workshop, tr.
at 153, 155–58 (June 23, 2014) (presentation by Fiona M. Scott Morton, Yale Univ. School of
Mgmt.), ftc.gov/system/files/documents/public_events/302251/cpp_workshop_transcript.pdf.
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that accepts such a rival offer would pay $40 more for the other 40 units not
purchased under the rival’s contract (the buyer would pay $10/unit and not $9/
unit because it does not receive the $1/unit discount). If this $40 is allocated
to the 60 units the rival seller is offering to supply, the implicit price the rival
must beat for the buyer to accept the rival’s contract for the 60 units is $8.33.
That is, $9 (the established seller’s price for the 60 units) minus $0.67 (the
lost $40 saving on the 40 units now purchased at $10 rather than $9 from the
established seller, allocated over the 60 units supplied by the rival). If marginal costs are, for example, $2 as illustrated, the rival can certainly make such
an offer.
The question of whether a rival can effectively compete for sales in the face
of the established seller’s loyalty contract illustrated in Figure 4 can be described in Figure 5 in terms of what quantity of sales must be contestable to
the rival—that is, what sales does the rival have the ability to compete for—
so that the implied price the rival must offer to match the established firm’s
average price is not below the rival’s costs, and so the established firm’s contract is not de facto exclusive. Figure 5 illustrates the range of the buyer’s
purchases for which the rival can make a competitive alternative contract offer that the buyer would find in its economic interests to accept and forgo the
established seller’s discounts. In general, the empirical feasibility of the rival
being able to offer a competitive contract within this range will depend upon
relative product preferences and the ability of the buyer, acting as its customers’ agent, to shift sales to the rival; that is, on the extent of contestable sales.
As shown in Figure 5, our example implies that, given the relatively low
marginal cost (a situation that, as we shall see, is close to the facts in Eisai),
the rival is prevented from making a competitive offer only for units 11 and
12, the two units immediately before the threshold share of sales at which the
buyer receives a discount. For these units the average prices the rival would
have to offer ($0.91 and $1.67) are below the assumed marginal cost of $2.
However, the rival can profitably match or beat the price of the established
firm if it has the ability to offer the buyer a contract to purchase 13 or more
units. For 13 units, the average price the rival must offer would be $2.31 ($9
minus the forgone $1 saving on each of the 87 units that the buyer continues
to purchase from the established firm, allocated over the 13 units sold by the
rival), which is greater than the assumed marginal cost of $2. The fact that the
product has a low marginal cost and therefore the price/marginal cost difference on incremental sales is high gives the rival wide latitude to compete for
sales in the face of the established firm’s loyalty contract. Although it is extremely unlikely a rival will be able to compete for the same 90 percent share
of sales as the established firm, in these circumstances rivals are very likely to
have the ability to compete for the buyer’s sales share-shifting services, and it
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FIGURE 5:
AVERAGE PRICE RIVAL MUST OFFER TO COMPETE
is therefore highly unlikely that the established firm’s loyalty contract implies
de facto exclusivity.
This analysis is independent of whether the established firm’s loyalty contract involves first-unit discounts or whether the buyer is compensated for the
provision of sales-shifting services with price discounts starting at the contestable range of sales, or anywhere between the first unit and 90 units. It may
appear that first-unit discounts pose more of a competitive concern because
the first-unit price discounts are made on the established firm’s more highly
preferred incontestable sales for which rivals cannot compete, and buyers will
necessarily forgo those discounts if choosing the rival’s competing offer.
However, an established firm compensating buyers for sales share-shifting
services in the form of first-unit price discounts made on all the established
firm’s sales, including the incontestable sales for which the rival cannot compete, does not mean that rivals are forced to compete by offering a contract
that covers a range of sales that includes those incontestable sales. Rival sellers can compete solely for the incremental sales provided by the buyer’s saleshifting services with a larger discount that amounts to a similar payment to
the buyer for the supply of its sales-shifting services.
It may be claimed that an established firm can use a first-unit loyalty discount to create a de facto exclusive contract because a first-unit discount implies a large total discount when the discount is attributed to contestable sales.
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This is the implicit argument underlying Figure 4. However, what a seller is
purchasing with a loyalty contract is buyer sales share-shifting services with
regard to contestable sales. If the seller limits price discounts to a smaller
range of sales than first unit sales, then it must increase the price discount on
the later than first units to adequately compensate the buyer for its sales shareshifting services.
For example, if rather than offering first-unit discounts once the buyer
reaches a 90 percent purchase share, the established firm in our example only
offered discounts on purchases starting at, say, 45 units or 45 percent purchase
share, then the per-unit discount for the buyer sales-shifting services would
have to be $2 rather than $1 to keep buyer compensation unchanged at the
same 90 units. Consequently, there would be the exact same minus $80 price
for the 90th unit. If the price discount were made once the buyer reaches a 90
percent purchase share only on “incremental sales” after, say, 75 units or 75
percent purchase share, then the per-unit discount would have to be $6, and
the price of the 90th unit would similarly be minus $80. The difference in
pricing in all these cases is not in the incentive created to reach the critical
purchase share threshold but in the sales over which the discount must be
averaged to obtain the competitive per-unit-time buyer payment. If the discount for reaching the 90 percent purchase share is paid only on the 90th unit,
then the seller is compensating the buyer with a lump sum payment for reaching the desired purchase share.62
One efficiency advantage of averaging the per-unit-time buyer payment for
reaching a 90 percent purchase share over all units with the use of first-unit
discounts compared to making an equivalent lump sum payment is that it facilitates the measurement of the appropriate payment, which should be related
to the size of the buyer, that is, the actual level of purchases made by the
62 Sales-shifting services may usefully be thought of in terms of the buyer supply of a perunit-time service flow, that is, an increased level of sales per unit time. The services also have a
per-unit-time opportunity cost in that the buyer has the alternative of selling its services for the
period to another seller. Hence, it may make economic sense to consider the purchase of buyer
sales share-shifting services involving an equilibrium per-unit-time payment or price discounts
equivalent to such a per-unit-time payment. Therefore, if price discounts are not made on the first
unit, the discounts would have to be increased to an equivalent per-unit-time lump sum payment.
Supermarket slotting fees are analogous upfront per-unit-time seller payments for buyer salesshifting point-of-sale promotional services. See generally Benjamin Klein & Joshua D. Wright,
The Economics of Slotting Contracts, 50 J.L. & ECON 421 (2007). The court in NicSand considered upfront lump sum competitive seller payments to retailers for the exclusive right to supply a
product as legally equivalent to price discounts, stating that “the ‘payments’ are nothing more
than ‘price reductions offered to the buyers for the exclusive right to supply a set of stores under
multi-year contracts.’” NicSand, Inc. v. 3M Co., 507 F.3d 442, 452 (6th Cir. 2007) (citing Augusta News Co. v. Hudson News Co., 269 F.3d 41, 45 (1st Cir. 2001)). The Eaton loyalty contracts with two manufactures, International and PACCAR, included lump sum payments as well
as price discounts. See ZF Meritor v. Eaton Corp., 696 F.3d 254, 307 (3d Cir. 2012) (Greenberg,
J., dissenting).
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buyer over the period of the contract. Consequently, it is easier to set a single
price discount across buyers of different sizes. Another possible efficiency is
that first-unit discounts may induce increased purchases of incontestable
sales.63 The only other economic difference in averaging the per-unit-time
buyer payment over a smaller number of units rather than all units is that the
marginal price of units after the 90 percent purchase share is lower. However,
this does not have any economic benefit because the buyer is already contractually committed to purchase the efficient share on which the loyalty discounts are contingent. In fact, lower prices on sales beyond the contractually
specified efficient share may actually create inefficient arbitrage incentives.64
3. Higher List Prices
It has been argued that loyalty contracts often include higher list prices.
Therefore, if the loyalty price discounts merely offset the higher list price, the
contract does not provide buyers any actual net price discounts.65 It is claimed
that the higher list price imposes a penalty on incontestable purchases if buy-
63 We have assumed for analytical simplicity in this article that this effect is not present in the
single product loyalty contracts we are analyzing. It is, however, often an economically important effect in bundled discount loyalty contracts, where the increased sales of a separate, higher
margin incontestable good reduces, and may eliminate entirely, any profit sacrifice to the seller
of pricing contestable goods at a discount attributed price that is below cost. Benjamin Klein &
Andres V. Lerner, The Law and Economics of Bundled Pricing: LePages, PeaceHealth, and the
Evolving Antitrust Standard, 53 ANTITRUST BULL. 555, 569–70 (2008) describe this as a potential efficiency of bundled pricing, and Murphy et al. emphasize this as one of the reasons why a
discount attribution test is a conservative test of whether a firm has priced below cost. Murphy et
al., supra note 57.
64 For example, in the last case where $6 discounts are made starting at 75 units, the net price
on all units after the 90% purchase share is reduced to $4, creating an increased incentive for
buyers to purchase greater than the efficient contractually specified share of their requirements
from the seller (for example, greater than the 95% specified share in Figure 3) and reselling their
excess purchases to buyers that do not contract with the firm. This possible disturbance of supply
relationships is one reason it is relatively rare to observe the two-part pricing schemes economists sometimes theoretically propose as the efficient solution. Under these schemes, rather than
the seller contracting with the buyer for the efficient purchase share and compensating the buyer
for its sales-shifting services with what amounts to a per-unit-time payment, the buyer is assumed to make a lump sum payment to the seller in return for the seller’s reduction in price to
marginal cost, with the buyer then purchasing whatever quantity it wishes at that low price. The
claimed efficiency of this alternative is the avoidance of reduced purchases due to a double
marginalization problem. See, e.g., Sreya Kalay, Greg Shaffer & Janusz A. Ordover, All Units
Discounts in Retail Contracts, 13 J. ECON. & MGMT. STRATEGY 429 (2004). However, any
double marginalization reduced purchases problem is avoided with the contingent minimum
purchase share requirement in a loyalty contract. Moreover, as we can see from Figure 3, a price
equal to marginal cost in a two-part pricing scheme, in addition to not committing the buyer to
provide sales-shifting services for the share of sales made to its own customers, would create an
incentive for the buyer to purchase substantially greater quantities to resell to other buyers that
have not made any payment to the seller.
65 Einer Elhauge, Why Above-Cost Price Cuts to Drive Out Entrants Are Not Predatory—And
the Implications for Defining Costs and Market Power, 112 YALE L.J. 681, 698 n.53 (2003).
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ers do not meet the loyalty contract purchase requirements so that buyers face
an “all-or-nothing” exclusive dealing contract demand.66
However, the normal competitive terms of loyalty contracts, where the firm
is increasing sales through price discounts on contestable sales, are likely to
involve an increase in the list price. This is because sellers competing for
buyer sales share-shifting services recognize that if they lose the competition
for buyer acceptance of their loyalty contract, they will end up selling to a
smaller group of consumers who are likely to have a greater preference for its
products than the consumers that would be buying its products in the absence
of loyalty contract competition. Therefore, we would expect the seller that
loses the competition for the buyer’s sales share-shifting loyalty contract and
faces a residual demand by customers who prefer its products to move up its
demand curve and set a higher list price than the non-contingent, single profitmaximizing prices set, for example, in Figure 2.
In Figure 2 the established seller makes 65 percent of sales at a price of
$4.60, with the rival making 35 percent of sales at a price of $3.40. If the
established seller wins the competition for buyer sales share-shifting services
and ends up selling 95 percent of sales at a net price of $4.00 (Figure 3), the
rival will be left with only 5 percent of sales. Alternatively, if the rival wins
the competition, the rival will end up selling substantially more than 35 percent, say 60 percent of sales, and the established seller will be left with only
40 percent of sales. Whichever seller loses the competition for the contract
will end up selling to a smaller remaining set of customers. These remaining
customers prefer the losing seller’s product more than those in the larger set
of customers who would have purchased the losing seller’s products in a hypothetical non-contingent, single-price equilibrium. Thus, the rival and established seller will both find it in their interests to increase their profitmaximizing list prices in connection with loyalty contract competition.
For example, Meritor significantly increased the list prices of its most popular product in 2003.67 This made economic sense because, once Meritor recognized it could not make a competitive offer that would lead truck
manufacturers to reject the Eaton de facto exclusive contract terms, Meritor
was limited to selling to a very narrow group of customers who substantially
preferred its products.68 Clearly it cannot be argued that Meritor’s list price
66 It is unclear why the established seller does not merely make an explicit exclusive dealing
contract demand in these circumstances. Elhauge explains this as a way for a firm to adopt an
exclusive dealing contract while potentially avoiding the greater likelihood of antitrust liability
when the exclusive dealing contract is explicit. Id. at 698 n.53
67 Meritor, 696 F.3d at 309 (Greenberg, J., dissenting).
68 Eaton, on the other hand, introduced loyalty contracts without increasing its list prices.
However, it may be argued that Eaton’s list prices would have otherwise declined because of the
significant excess capacity that had developed in the industry. Id. at 265.
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increase was the exercise of market power or intended to leverage the consumer surplus earned on its remaining customers to create an exclusive dealing arrangement. Meritor was just collecting rents on the value of its brand
name based on the preferences of these remaining customers.
This does not mean that loyalty contracts may not include substantially
higher list prices that are set above the residual demand profit-maximizing
level as a way to leverage the consumer surplus on incontestable sales in order
to create an exclusive dealing arrangement, a strategy that is discussed in Part
III.B. However, it is incorrect to infer solely from the fact that the list price is
increased as part of a loyalty contract offer that this de facto exclusive dealing
strategy has been adopted and that the loyalty contract offer does not provide
an actual discount for increased purchases.
For example, rather than the $4.60 list price and $0.60 discount illustrated
in Figure 3, the loyalty contract offer may involve a higher list price, say
$5.00, and also a larger offsetting discount, say $1.00. In that case, the established seller would move down the demand curve to the same lower $4.00
price if it wins the contract. And the list price increase to $5.00 may be a
profit-maximizing expected part of the competitive loyalty contract offer if
the established seller loses the contract. Despite higher list prices, the normal
competitive process leads in this case to lower net prices, with the buyer,
acting as the efficient bargaining agent for its customers, evaluating the established and rival seller loyalty contract offers and choosing what it considers
the best overall contract terms for all its consumers.
III. THE USE OF LOYALTY CONTRACTS TO EXPAND SALES BY
LEVERAGING INCONTESTABLE SALES
A. AN “ALL-OR-NOTHING” EXCLUSIVE CONTRACT LEVERAGES
INCONTESTABLE SALES
Although all firms selling differentiated products with price greater than
marginal cost have an economic incentive to expand sales, an established firm
that sells products preferred by consumers has the potential to expand sales by
leveraging the consumer surplus earned by the buyer (or the buyer’s customers) on inframarginal purchases by making an “all-or-nothing” contract demand. If the seller refuses to sell any of its products to buyers that do not
exclusively purchase its products, buyers that do meet this seller demand lose
the inframarginal surplus on incontestable sales. This would be the case, for
example, if Eaton refused to sell its transmissions to any truck manufacturer
that did not exclusively purchase its transmissions.69
69 We are assuming in this analysis that the established seller’s “all-or-nothing” exclusive
dealing contract demand is not economically motivated by any economic efficiencies other than
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Figure 6 illustrates the potential feasibility of a seller using an exclusive
dealing contract to leverage consumer surplus on incontestable infra-marginal
sales to prevent buyers from purchasing rival products. If area S, the consumer surplus earned by the buyer’s customers from purchasing the established seller’s product at a price of $4.60, is greater than L, the loss of
consumer surplus if the buyer accepts the requirement to meet the exclusive
purchase share demand, the established seller potentially is able to leverage
consumer preferences for its products to compel buyers to accept “all-or-nothing” exclusivity. The greater is S relative to L, the more likely the seller is
able to make a profitable “all-or-nothing” contract demand. When access to
the established seller’s products is economically essential—for example, when
buyers are not able to remain in business without access to the seller’s products in order to meet the demand by consumers who have a significant preference for seller A’s products—S will be particularly large and the established
seller is much more likely to be able to make a profitable “all-or-nothing”
exclusivity contract demand.70
S greater than L, however, is only a necessary condition for the seller to be
able to make a profitable “all-or-nothing” contract demand. Even when market conditions are as described in Figure 6, an “all-or-nothing” contract demand may be an unprofitable business strategy because the rival supplier may
react by decreasing its price. Figure 6 is drawn assuming that the rival’s price
is set at $3.40. If the rival responds to the established seller’s “all-or-nothing”
demand by decreasing its price, the demand facing the established firm shifts
down, decreasing area S and increasing area L. The ability of the rival to
compete depends upon the gap between its $3.40 price and its marginal cost,
which we have assumed in this case to be especially large and equal to $2.40.
Moreover, the established seller’s use of an “all-or-nothing” contract demand may be a risky strategy because it may pay rival sellers to specialize in
selling to buyers who would otherwise have purchased some of the estabthe additional profits that can be earned on incremental sales. If there are economic efficiencies
of exclusive dealing—the most widely recognized of which are the prevention of free riding, the
protection of specific investments, and the creation of increased incentives to perform—the seller
can demand an exclusive independent of any surplus earned on infra-marginal sales because the
exclusive lowers effective distribution or other costs, with the savings possibly shared with the
buyer. For a description of exclusive dealing economic efficiencies see, for example, Benjamin
Klein & Andres V. Lerner, The Expanded Economics of Free-Riding: How Exclusive Dealing
Prevents Free Riding and Creates Undivided Loyalty, 74 ANTITRUST L.J. 473 (2007); Howard P.
Marvel, Exclusive Dealing, 25 J.L. & ECON. 1 (1982). A description of the economic efficiencies
of exclusive dealing generally accepted in antitrust law is provided in Jonathan M. Jacobson,
Exclusive Dealing, “Foreclosure,” and Consumer Harm, 70 ANTITRUST L.J. 311 (2002).
70 The court in Meritor, for example, concluded that if a truck manufacturer “decided to
forego the rebates and purchase a significant portion of its requirements from another supplier,
there would still have been a significant demand from truck buyers for Eaton products. Therefore, losing Eaton as a supplier was not an option.” Meritor, 696 F.3d at 278.
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PA
$7.20
S
$4.60
L
C
$3.20
Demand
D
$1.00
MC
0.65
1.00
Share of Buyer
Purchases of A
FIGURE 6:
THE FEASIBILITY OF AN EXCLUSIVE DEALING DEMAND
lished seller’s products but now choose the “nothing” option and purchase
none of the established seller’s products. For example, Figure 6 indicates that
35 percent of the buyer’s customers prefer product B to product A at stated
market prices. Area L represents the loss of consumer surplus by these customers who would have to purchase a truck or hospital services from a truck
manufacturer or hospital that has accepted the established seller’s exclusive
purchase requirement at the unchanged price of $4.60. This group of customers would have preferred to purchase a final product that includes the rival
product and not the established seller’s product (for example, would prefer to
purchase a truck that includes a Meritor transmission and not an Eaton transmission) at the previously unilaterally set individual seller profit-maximizing
prices and consequently are worse off as a result of the buyer’s acceptance of
exclusive dealing. Therefore, the established seller’s “all-or-nothing” contract
demand may create a potential profit opportunity for some buyers (truck manufacturers or hospitals) to choose the “nothing” option and concentrate on
serving solely this group of customers.
Some consumers who prefer product B to product A by the greatest amount
at current prices, that is, those with the greatest per unit consumer surplus loss
located near the 90 to 100 percent buyer purchase share of A level in Figure 6,
may even shift from their desired truck manufacturer or hospital to purchase
from a buyer that rejects the established seller’s exclusivity demand. Because
the potential demand facing a buyer that does not accept the established
seller’s exclusive purchase requirement will be particularly great from the
customers that have such relatively idiosyncratic preferences for the rival’s
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product B relative to the established seller’s product A, it often may be in the
interests of an established seller to demand only a partial exclusive of, say, a
90 percent purchase share. In this way the established seller mitigates the risk
that a buyer will reject its exclusivity demand since buyers of the established
seller’s product A then have the ability to offer rival product B to their relatively few customers that have a strong preference for the rival product.71
B. A LOYALTY CONTRACT MAY SIMILARLY LEVERAGE INCONTESTABLE
SALES TO CREATE A DE FACTO EXCLUSIVE
There are two ways in which a loyalty contract may similarly leverage the
consumer surplus on incontestable sales to create what amounts to an “all-ornothing” exclusive dealing contract. One way is if the seller artificially raises
the list price significantly above the profit-maximizing price described in Part
II.C.3 to the point where all consumer surplus on incontestable sales is eliminated and therefore demand is zero. If the seller then uses loyalty discounts to
reduce the higher list price back to the original price contingent on the buyer
meeting the loyalty exclusive purchase conditions, the contract is economically equivalent to the “all-or-nothing” exclusive dealing contract discussed in
Part III.A. The contract is leveraging incontestable sales to create a de facto
exclusive dealing contract.
For example, in terms of Figure 2, if the established seller increased the list
price to $7.20 (or higher) offset fully with price discounts of $2.60 contingent
on the buyer purchasing exclusively from the seller (so that the net price remained at $4.60), this would be economically equivalent to an “all-or-nothing” exclusive dealing contract. A buyer that does not meet the loyalty
contract exclusive purchase conditions will face a list price so high that its
demand is zero—the buyer therefore is economically forced to “choose” between purchasing all or none of the firm’s products.72
The second way in which a loyalty contract may leverage consumer surplus
on incontestable sales to create an “all-or-nothing” exclusive dealing demand
71 Because more than 10% of consumers may prefer the rival’s product at the current single
prices described in Figure 2, the buying firm must determine how to allocate the limited quantity
of rival products to particular customers. For example, the firm may decide not to display or
advertise the rival product and only make it available to customers that explicitly ask for or insist
upon the rival product, or the firm may artificially set the price of the rival product close to or
above the established seller’s product price to limit rival demand, two tactics analogous to what
Eaton contractually required of truck manufacturers in Meritor. Id. at 265–66.
72 Daniel Crane maintains that such a strategy is highly unlikely to be profitable because the
list price is raised above the profit-maximizing price. Daniel A. Crane, Bargaining over Loyalty,
92 TEX. L. REV. 253, 280 (2003). However, although the seller bears financial risks associated
with instituting such an exclusive contract, namely that some significant number of buyers, as we
have described, will choose “nothing” when presented with an “all-or-nothing” option, this does
not mean that an exclusive dealing strategy is never likely to be profitable.
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is when the loyalty contract includes non-price incentive mechanisms that impose sufficiently large costs on buyers that fail to meet the loyalty contract’s
exclusive purchase requirements. For example, the Eaton loyalty contract
used non-price incentive mechanisms that imposed costs on buyers in the
form of a risk of termination or the potential loss of access to products that
might be in short supply if the buyer did not meet the contract’s exclusive
purchase conditions. These non-price incentive mechanisms related to a reduction in the buyer’s ability to purchase Eaton products therefore involved
the potential loss of consumer surplus on incontestable sales to induce exclusive purchases.
However, in contrast to outright termination and the total loss of access to
supply that results from an “all-or-nothing” contract demand, Eaton’s nonprice incentive mechanisms involved only the potential or partial loss of the
ability to purchase the firm’s products if purchase conditions were not met.
The Eaton non-price mechanisms consequently imposed a somewhat less
costly sanction on truck manufacturer buyers than an “all-or-nothing” contract
would have imposed. In principle, however, the costs associated with the nonprice incentive mechanisms could be large enough, either alone or in combination with the loss of price discounts to create a de facto exclusive dealing
contractual arrangement, similar to what would occur with an “all-or-nothing”
exclusive dealing contract, as the court concluded was the case in Meritor.
IV. ANTITRUST ANALYSIS OF LOYALTY CONTRACTS
A. PRICE-COST ANALYSIS OF LOYALTY CONTRACTS WHEN PRICE IS
PREDOMINANT INCENTIVE MECHANISM
THE
In the case where a loyalty contract predominantly involves the incentive
mechanism of price discounts contingent on incremental sales, the antitrust
framework should involve a Brooke Group predatory pricing type of analysis,
with the price-cost test modified so that price discounts are applied solely to
contestable sales. Although estimates of contestable sales will likely vary considerably across individual buyers and may be difficult for plaintiffs and defendants to agree upon, when price is the predominant incentive mechanism
the economic factors underlying a discount attribution price-cost test provides
a useful framework for the analysis of loyalty contracts.
Specifically, if the attributed price of contestable sales is greater than cost
over a reasonable range of contestable sales estimates, then equally efficient
rivals will be able to compete for contestable sales and a de facto exclusive
dealing arrangement has not been created. Alternatively, if the attributed price
of estimated contestable sales is less than cost so that an equally efficient rival
cannot profitably compete for contestable sales, then the second step of the
analysis under a predatory pricing standard must be undertaken to determine
666
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if the firm instituting the loyalty contract is likely to be able to recoup its
losses with future price increases.73
The only difference between loyalty price discounts and the price discounts
usually analyzed under predatory pricing is that loyalty discounts are contingent upon a buyer commitment to purchase a particular increased quantity.
However, as demonstrated in Part II above, firms that face negatively sloped
demands will not have the incentive to discount prices from the single profitmaximizing price without such a corresponding buyer commitment. As noted,
Brooke Group itself, upon which the current law of predatory pricing is based,
actually involved such contingent price discounts.74 Therefore, loyalty contracts that involve solely price discounts as the incentive mechanism of potential exclusion should be considered an essential element of the competitive
process that generates the same procompetitive benefits of price discounts recognized by the courts in adopting the Brooke Group stringent antitrust liability standard. If the loyalty discounts pass the discount attribution test, it
should be considered an antitrust safe harbor because “so long as the price is
above-cost, the procompetitive justifications for, and the benefits of, lowering
prices far outweigh any potential anticompetitive effects.”75 On the other
hand, if attributed price is less than cost, liability requires, as in Brooke
Group, a showing that recoupment of below-cost pricing in future monopoly
pricing is reasonably likely.
Antitrust evaluation of loyalty contracts where price is the predominant incentive mechanism also must consider whether the loyalty contract involves a
substantial increase in list prices. As described in Part III.B, a substantial list
price increase may create a de facto exclusive dealing arrangement by leveraging the consumer surplus on incontestable sales. However, as described in
Part II.C.3, it is common for a list price increase to be part of loyalty contract
terms to reflect the competitive price of the firm’s remaining incontestable
73 It has been argued that “equally efficient rivals” should not be the relevant standard to
determine if a firm forecloses competition to create a de facto exclusive dealing arrangement by
underpricing contestable sales because higher cost rivals may hold down the prices that would
otherwise be charged by an established seller. See A. Douglas Melamed, Exclusive Dealing
Agreements and Other Exclusionary Conduct—Are There Unifying Principles?, 73 ANTITRUST
L.J. 375, 404 (2006). However, there would be serious inefficiencies in using antitrust law to
require a firm that is not discounting below cost to increase its prices in order to protect high cost
firms or to encourage entry. It is an essential element of market competition that entrants, or
otherwise disadvantaged higher cost firms selling less preferred products, will bear losses over
time as they make investments to cover fixed costs, establish a brand name, and ultimately expand sales. The court in Brooke Group concluded that a firm that increases its sales by pricing to
take advantage of its lower costs, even if it drives out higher-cost rivals, should be considered to
be engaging in competition on the merits. Brooke Grp. Ltd. v. Brown & Williamson Tobacco
Corp., 509 U.S. 209, 223 (1993).
74 See supra note 42.
75 Meritor, 696 F.3d at 275 (citing Brooke Group, 509 U.S. at 223).
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sales if it does not win the contract for contestable sales. Only when the list
price is raised significantly above this competitive profit-maximizing higher
list price is the firm leveraging consumer surplus on incontestable sales to
increase contestable sales rather than merely collecting rents on consumer
preferences for incontestable purchases.
However, in contrast to the case where non-price incentive mechanisms
present in a loyalty contract are not easily measurable so that a discount attribution test cannot be conducted, one can easily perform a discount attribution
test based on the higher list price to determine if the contract prevents equally
efficient rivals from being able to compete. If the discount attributed price,
which takes account of the list price increase, is greater than cost, this means
the loyalty contract has not created a de facto exclusive dealing arrangement
that prevents equally efficient rivals from being able to compete for contestable sales, irrespective of any list price increase. Therefore, when price is the
predominant mechanism of exclusion in a loyalty contract, price less than cost
is a necessary condition for antitrust liability whether or not the list price has
increased.
When the attributed price is less than cost, the next step of the loyalty contract analysis will depend upon whether there has been a significant increase
in list price. If the list price has increased significantly, the discount attributed
price may be less than cost not because the firm is engaging in below cost
pricing of contestable sales, but because the significant list price increase has
leveraged the consumer surplus on incontestable sales. Hence recoupment of
losses on contestable sales by the firm is not a necessary condition for antitrust liability. The loyalty contract must be evaluated under a rule-of-reason
exclusive dealing standard related to an analysis of foreclosure rather than
analysis of likely recoupment under a predatory pricing standard. However, in
all cases where price is the sole incentive mechanism, even when the list price
has been significantly increased, price-cost considerations are an essential element of the initial analysis, and attributed price greater than cost is a sufficient
condition for the absence of antitrust liability.
Some antitrust scholars have argued that all single product loyalty contracts
should be analyzed under a rule-of-reason exclusive dealing standard, and that
price-cost evidence therefore is irrelevant in the evaluation of loyalty contracts.76 The basis of their contention is the claim that the potential anticompetitive problem created by a loyalty contract involves exclusive dealing, not
predatory pricing. However, the potential anticompetitive effect of predatory
pricing ultimately involves the same potential anticompetitive effect of ex-
76
See, e.g., Wright, supra note 14; Salop, supra note 14.
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cluding equally efficient rivals, with the firm then using its dominant market
position to raise market prices.
It is argued by those antitrust scholars that the exclusivity created by an
exclusive dealing contract is different from the exclusivity created by predatory pricing because the potential anticompetitive effects of an exclusive dealing contract are immediate, while, in contrast, the potential anticompetitive
effects of predatory pricing occur only after a lag, during which time consumers receive the benefits of price competition. But if price is the sole incentive
mechanism in a loyalty contract, and there is no leverage of incontestable
sales, the only way the firm can drive equally efficient rivals out of the market
is by pricing contestable sales so that the discount attributed price is less than
cost. Therefore, fully analogous to predatory pricing, consumers receive the
same benefit of prices less than cost until rivals are driven out and a potential
anticompetitive effect occurs when the firm raises prices in an attempt to
recoup losses.
It may be claimed that a loyalty contract is fundamentally different from
predatory pricing because anticompetitive foreclosure of equally efficient rivals can occur with an exclusive loyalty contract even when price is greater
than cost.77 This claim is based on a number of economic models where price
appears to be the only incentive mechanism yet it is not necessary for the firm
to price below cost to create conditions in which equally efficient rivals do not
have the ability to compete. For example, a firm with market power may share
monopoly profit with input suppliers to induce them to agree to refuse to deal
with rivals.78 An alternative model that has been extensively examined in the
theoretical economic literature involves the firm achieving foreclosure without pricing below cost because there is a “rush” by each buyer not to be
among the last buyers not to have entered an exclusive contract with a dominant seller.79
See, e.g., Salop, supra note 14.
Id. at 322–23. For an illustration see Elizabeth Granitz & Benjamin Klein, Monopolization
by “Raising Rivals’ Costs”: The Standard Oil Case, 39 J.L. & ECON. 1 (1996). Standard Oil
created and enforced what economically amounted to de facto exclusive dealing arrangements
with railroads by sharing monopoly profit with railroads that agreed to charge Standard’s refining rivals substantially higher rail rates. It was not possible for Standard to use an explicit exclusive dealing contract because of railroad common carrier regulations.
79 See Eric B. Rasmussen, J. Mark Ramseyer & John S. Wiley, Jr., Naked Exclusion, 81 AM.
ECON. REV. 1137 (1991); Ilya R. Segal & Michael D. Whinston, Naked Exclusion: Comment, 90
AM. ECON. REV. 296 (2000). There is an “externality” among individual buyer decisions because
each buyer knows that once a sufficient number of buyers enter exclusive contracts, rival sellers
will be effectively foreclosed from the market and the remaining buyers who have not entered
exclusive dealing contracts will be charged a higher price to distribute the dominant seller’s
product.
77
78
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The reasoning in these and other exclusive dealing models, however, cannot be applied to loyalty contracts where the attributed price is greater than
cost unless the loyalty contract includes a separate explicit exclusive dealing
contract term. If the discount attributed price is above costs and there is no
leverage or exclusive dealing term in the loyalty contract, rivals are not contractually or economically prevented from supplying buyers or dealing with
input suppliers under the firm’s loyalty contract and therefore the firm’s rivals
can compete. Buyers can always decide to forgo the discounts and purchase
contestable sales from rivals; and buyers will have an economic incentive to
do so when the attributed price is greater than cost because equally efficient
rivals can make superior offers. This illustrates the general proposition that
when analyzing loyalty contracts we should not incorrectly assume that because loyalty discounts may be contingent on exclusive purchase requirements, the loyalty contract is equivalent to an “all-or-nothing” exclusive
dealing contract.
B. WHAT IT MEANS FOR PRICE TO BE THE PREDOMINANT INCENTIVE
MECHANISM IN A LOYALTY CONTRACT
The use of a Brooke Group predatory pricing type of analysis to evaluate a
loyalty contract depends on price discounts being the predominant incentive
mechanism in the loyalty contract. The essential insight of Meritor is that
when significant non-price incentive mechanisms are present in a loyalty contract, an attributed price-cost test cannot determine if the loyalty contract
amounts to a de facto exclusive dealing arrangement. The attributed price may
be above costs, yet equally efficient rivals may not be able to compete for
contestable sales because the incentive of buyers to meet the loyalty contract
exclusive purchase condition is determined by the sum of the price and nonprice incentive mechanisms. As a practical matter, it is generally not feasible
to implement a modified price-cost calculation that incorporates an estimate
of these non-price incentive mechanism costs, such as the risk of termination
and reduced supply, together with a price-cost measure. Therefore, consistent
with Meritor, when significant non-price incentive mechanisms are present in
a loyalty contract the antitrust analysis must take place under a rule-of-reason
exclusive dealing standard rather than a predatory pricing standard.
A crucial initial question in the antitrust analysis of a loyalty contract therefore involves the determination of whether the loyalty contract includes significant non-price incentive mechanisms. Only when significant non-price
incentive mechanisms are absent should the analysis proceed on a predatory
pricing basis. For example, in Eisai v. Sanofi-Aventis the court adopted of a
Brooke Group price-cost standard to evaluate the loyalty contracts at issue
because it concluded that price discounts were the “predominant mechanism
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of exclusion” in the contracts.80 The loyalty contracts at issue involved the
sale by Sanofi to hospitals of its Lovenox drug that treated blood clotting. The
plaintiff Eisai was a rival seller of an alternative blood-clotting drug, Fragmin,
that entered the market in 2005; and it also used loyalty contracts to sell to
hospitals.81 At the time Eisai entered, Sanofi’s share of the market was near 90
percent, and its loyalty contracts provided a sliding scale of discounts ranging
from 18 percent up to 30 percent off the list price to hospitals that purchased
90 percent or more of their requirements from Sanofi, with hospitals and hospital groups purchasing the largest shares receiving the largest discounts.82
Eisai offered a similar variable schedule of contingent discounts that ranged
up to 40 percent discount for purchase share commitments of 50 percent or
more.83
The court’s reasoning in reaching its conclusion that price was “the predominant mechanism of exclusion” in the Sanofi contracts was fully consistent with how we have defined this condition in terms of whether the contract
incentive mechanism involves primarily price discounts. The court concluded
that Sanofi induced hospital buyers to meet loyalty purchase conditions solely
with “the loss of the steep discounts. Unlike the circumstances in Meritor,
Sanofi did not threaten to cut off or reduce its customers’ supply, and there is
no evidence that hospitals feared the loss of Sanofi as a supplier” if they failed
to meet the Sanofi purchase share conditions.84 Once the court found price to
be “the predominant mechanism of exclusion” in the Sanofi loyalty contract,
it concluded that “the price cost-test applies”85 and granted summary judgment to Sanofi because it concluded that no evidence was presented that
80 Eisai Inc. v. Sanofi-Aventis U.S., No. 08-4168 (MLC), 2014 U.S. Dist. LEXIS 46791, at
*71 (D.N.J. Mar. 28, 2014).
81 The other main competitor to Sanofi’s Lovenox was GlaxoSmithKline’s Arixtra, which had
earlier entered the market after its approval by the FDA in 2001. Id. at *5. A fourth supplier that
had a small market share of sales was LEO Pharma’s Innohep. Id. at *4–5. Sanofi’s Lovenox had
seven or eight FDA-approved indications while Eisai’s Fragmin had five FDA-approved indications. Id. at *7. However, there was very substantial overlap in the indicated uses of Lovenox and
Fragmin. In particular, all four drugs “had indications related to the treatment and/or prevention
of DVT,” “a condition in which a blood clot develops in the body’s veins” and “can result in a
pulmonary embolism if the clot travels to the lungs that was a primary use of these drugs.” Id. at
*2, *8. We assume for analytical simplicity that we are dealing with a single product rather than
multiple products. Consequently, some of the demand for Lovenox by hospitals was incontestable because of buyer preferences, not because of particular indications.
82 Id. at *9, *11–12. Sanofi eliminated its loyalty contracts after generic versions of Lovenox
became available in 2010. Id. at *13.
83 Id. at *3, *32.
84 Id. at *72.
85 Id. at *82 (citing ZF Meritor v. Eaton Corp., 696 F.3d 254, 275, 277 (3d Cir. 2012)).
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Lovenox was ever “sold to hospitals at a price that was below Sanofi’s cost
even after discounts were applied.”86
The plaintiff Eisai used Sanofi’s contract requirement that hospitals not
enter a formulary agreement with a rival drug supplier that placed Lovenox in
a disadvantaged position to argue that price was not “the predominant mechanism of exclusion” in the Sanofi loyalty contract. Eisai claimed this requirement prevented rivals from being able to compete effectively with Sanofi, and
was similar to the restrictive data book distribution and favorable pricing contract requirements present in the Eaton loyalty contracts that were the subject
of Meritor.87 The court explained that, contrary to Eaton’s distribution restrictions, the Sanofi formulary contract restriction did not require hospitals to
provide preferential treatment of Lovenox in their formularies.88 The Sanofi
contracts only required as a condition for receiving loyalty discounts that a
hospital not favor rival drugs by providing Lovenox with inferior formulary or
promotional status. Moreover, in contrast to the Eaton distribution restrictions
where, as a practical matter, truck manufacturer buyers had no economic
choice but to meet the distribution requirements, hospitals as an economic
matter were free to, and frequently did, reject the Sanofi formulary requirement when they entered into loyalty contracts with Eisai and gave up Lovenox
discounts.89
Most importantly, distribution contract terms such as the Sanofi formulary
requirement are not loyalty contract incentive mechanisms—they are buyer
performance requirements that economically supplement the loyalty contract’s minimum purchase share conditions. Consistent with our analysis of
the preferred distribution requirements in the Eaton loyalty contract, the Sanofi requirement that hospitals not favor a rival drug in their formulary if they
were to receive loyalty discounts was not in any way part of the incentive
mechanism used by Sanofi to induce hospitals to meet the loyalty contract
purchase conditions. If the hospital did not meet the threshold purchase share,
or if the Sanofi drug was not placed in an equal or preferred position in the
86 Id. at *72. The court’s decision does not refer to any attempt made by either Sanofi or Eisai
to estimate contestable sales in order to subject Sanofi pricing to a discount attribution price-cost
test.
87 Id. at *78–79. What it meant for a drug to be designated as a preferred drug in a hospital’s
formulary varied significantly across hospitals. Some hospital formulary administrators permitted doctors to freely prescribe non-preferred drugs included in the formulary while other hospital
administrators more actively shifted demand to a designated preferred drug, for example, automatically making a therapeutic interchange to a preferred drug unless explicitly objected to by
the doctor. Other hospital formulary administrators operated in between these two extremes,
actively shifting demand to preferred drugs but requiring prior notification and explicit approval
of the doctor to make any substitution. Id. at *15–17, *77–78.
88 Id. at *78–79.
89 Id. at *79.
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hospital’s formulary, the sole cost borne by the hospital consisted of the loss
of the loyalty price discounts. In contrast, in Meritor a truck manufacturer
buyer that did not meet Eaton’s preferential distribution contract terms also
faced the non-price incentive mechanisms of the risk of termination and the
prospect of reduced availability of product.90
The other arguments Eisai made to support its claim that price was not the
predominant mechanism of exclusion in the Sanofi loyalty contracts did not
rely on the presence of non-price contract incentive mechanisms in the contracts. Instead, Eisai argued that price was not the predominant mechanism of
exclusion in the Sanofi loyalty contracts because Sanofi’s first unit discount
pricing “prevented customers from buying less expensive rival products.”91
The fact that price discounts are first unit discounts does not mean that price is
not the mechanism of exclusion. Moreover, we have described, first unit discount pricing is often an efficient pricing structure for a loyalty contract, and
in this case the fact that Sanofi’s profit margin was 94 percent implied a very
broad range of contestable sales where Sanofi’s loyalty discounts would pass
a discount attributed price greater than cost test.92
This does not mean that hospital buyers would always purchase Eisai’s
Fragmin rather than Sanofi’s Lovenox if Fragmin is less expensive. As we can
see from Figure 2, even without a loyalty contract, an established preferred
product will be able to sell a greater quantity of sales at a higher price. One
cannot use the fact that Sanofi’s Lovenox sold at a higher price than Eisai’s
Fragmin to infer that its loyalty contract used non-price incentive mechanisms
to foreclose rival competition. The higher prices earned by Sanofi should be
thought of as the collection of rents on the enhanced consumer goodwill and
90 The formulary requirement likely was included as an additional performance condition in
the Sanofi loyalty contracts as a way to more accurately measure and compensate hospitals for
their sales-shifting services. Because Sanofi was unlikely to know exactly what the doctor and
hospital administrator preferences were for different drugs in a therapeutic category at a particular hospital at a particular point in time in the absence of any hospital sales-shifting activity in
favor of Sanofi, a drug purchase share alone may not be a good measure of the hospital’s supply
of sales-shifting services. For example, a hospital with preferences for an especially large share
of Lovenox could meet a Sanofi minimum purchase share condition and therefore collect a discount from Sanofi on its Sanofi purchases yet not supply any sales-shifting services to Sanofi.
The hospital in this circumstance may sell its sales-shifting services to a rival drug company by
shifting sales on the margin to rival drugs with preferential formulary treatment of the rival
company’s drugs. The hospital therefore would, in effect, be receiving payment for its salesshifting services twice.
91 Eisai, 2014 U.S. Dist. LEXIS 46791, at *70. Eisai argued that Sanofi’s first unit discount
pricing “bundled contestable and incontestable demand for Lovenox” and imposed “disloyalty
penalties” on the purchase of Eisai products. Id. at *70. The court perceptively noted that Eisai’s
reference to first unit discounts as “penalties” was merely “a matter of semantics.” Id. at *76.
92 Sanofi’s prices were 17.7 times greater than its costs, so that its average profit margin,
(P−C)/P, was equal to 1 – (1/17.7) or 94%. Id. at *73–75. Eisai profit margins were 85%. Id. at
*33. Sanofi’s higher profit margin compared to Eisai was likely due to higher prices based on its
established, buyer preferred position.
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brand loyalty associated with Lovenox and therefore “the natural result of . . .
competition,” not the exclusionary exercise of market power.93 Given Eisai’s
extremely high product profit margins, it is unclear how Eisai concluded that
Sanofi’s loyalty discounts made it impossible for Eisai to profitably compete
for contestable sales. While Eisai was not able to compete for all sales of all
buyers, the court emphasized that Eisai had considerable leeway given its 85
percent profit margin to offer discounts above its listed maximum 40 percent
discount in competing with Sanofi for hospital contracts, and when Eisai increased its discounts it was often successful.94 The court therefore concludes
that “Eisai could, and at times did, compete more vigorously to increase its
market share.”95
C. RULE-OF-REASON EXCLUSIVE DEALING ANALYSIS OF LOYALTY
CONTRACTS INVOLVES A TWO-STEP PROCESS
Even if a preliminary determination is made that non-price incentive mechanisms or a significantly higher list price are present, and therefore that a ruleof-reason exclusive dealing standard should be employed to evaluate the loyalty contract, the rule-of-reason exclusive dealing framework of analysis involves a two-step process. The first step involves an empirical determination
of whether a de facto exclusive dealing arrangement has been created, including a consideration of evidence of whether rivals can and do compete for a
share of sales. Only if it is determined that a de facto exclusive dealing arrangement has been created should the second step be undertaken, which involves weighing the potential anticompetitive foreclosure effects against the
possible procompetitive efficiencies of the exclusive dealing contract.
Recognizing that antitrust rule-of-reason analysis of loyalty contracts entails this two-step process is crucial. One should not assume that discounts
contingent on exclusive purchase conditions in a loyalty contract means that
United States v. Syufy Enters., 903 F. 2d 659, 669 (9th Cir. 1990).
The court used the example of the Memorial Sloan-Kettering Hospital contract that Eisai
won with a 48% price discount on Fragmin contingent on Sloan-Kettering’s commitment to
purchase 70% of its blood-clotting drugs from Eisai. Eisai, 2014 U.S. Dist. LEXIS 46791, at
*33, *73–75. Almost half of Eisai contract offers made outside its list discount guidelines were
ultimately accepted by hospitals. Id. at *33. Eisai calculated what it claimed was a “dead zone”
where “it would cost hospitals more to switch from Lovenox to Fragmin even though Fragmin
was less expensive.” Id. at *73. However, these calculations were made using Eisai list prices
when Eisai could and often did offer price discounts greater than the discounts on its price list.
Id. at *76. This is a sufficient condition for the absence of antitrust liability under a price-cost
standard; a necessary condition would require evidence, as the court recognized, that Sanofi
priced below costs. Supra note 86.
95 Id. at *91.
93
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“loyalty discounts are essentially a form of exclusive dealing,”96 or that “exclusive dealing is essentially a special case of market-share-based loyalty discounts where the market-share threshold is equal to one.”97 Loyalty discounts
contingent on exclusive purchases are equivalent to an “all-or-nothing” exclusive dealing contract only if buyers have no economic choice but to meet the
exclusivity purchase condition if they wish to purchase any quantity of the
product.
This two-step process of antitrust analysis was followed in Meritor. Although the court determined that the existence of significant non-price incentive mechanisms in the Eaton loyalty contract meant that the contract had to
be evaluated under a rule-of-reason exclusive dealing standard, the court undertook the initial step of determining whether rivals had the ability to compete in the face of the loyalty contract. The mere existence of non-price
incentive mechanisms in the loyalty contract did not necessarily mean that the
loyalty contracts amounted to de facto exclusive dealing arrangements. The
court relied on evidence of Meritor’s inability to compete in the face of the
Eaton loyalty contracts, documented by Meritor’s rapid loss of sales and its
ultimate exit,98 as well as by testimony of a truck manufacturer executive that
truck manufacturers had no other economic choice and were “essentially
forced” to accept Eaton’s minimum purchase share and preferred product listing and pricing requirements.99 Based on this evidence the court concluded
that Eaton’s loyalty contracts involved de facto exclusive dealing
arrangements.
Only after the court found Eaton’s loyalty contracts created de facto exclusive dealing arrangements did it undertake a rule-of-reason exclusive dealing
analysis. Specifically, in step two the court used Meritor’s exit from the mar96 Jonathan M. Jacobson, A Note on Loyalty Discounts, ANTITRUST SOURCE, June 2010, at 1,
www.americanbar.org/content/dam/aba/publishing/antitrust_source/Jun10_Jacobson6_24f.auth
checkdam.pdf.
97 Wright, supra note 14, at 6. The identification of single product loyalty contracts with
exclusive dealing also has been made by “analogy” in Gates, supra note 1, at 129–33.
98 Meritor’s sales share declined from 17% in mid-1999 to 4% in 2004, before its ultimate exit
from the market in 2007. ZF Meritor v. Eaton Corp., 696 F.3d 254, 264–67 (3d Cir. 2012). The
dissent stated that Meritor’s rapid loss of sales, rather than being due to Eaton’s de facto exclusive loyalty contracts, was consistent with the conclusion that Eaton had better prices and higher
quality, noting that “some of the evidence suggests that both OEMs and truck purchasers held the
opinion that, overall, Meritor’s products were inferior to Eaton’s.” Id. at 335 n.37 (Greenberg, J.,
dissenting). However, it seems unlikely that Meritor’s loss of sales share was due entirely (or
even primarily) to the poor perceived quality of its products when Meritor had close to a 20%
share of sales immediately before Eaton introduced its loyalty contracts. Furthermore, the dissent’s reliance on the fact that Eaton’s prices during the alleged anticompetitive period were
always less than Meritor’s prices was misplaced because it was an Eaton contract requirement,
accepted by all four manufacturers, that Eaton products be the lowest price alternative for truck
manufacturers.
99 Id. at 277.
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ket to conclude that Eaton’s contracts foreclosed a sufficient share of the market and, therefore, had a significant anticompetitive effect.100 Significant
market foreclosure, combined with an absence of any valid procompetitive
rationale for Eaton’s use of exclusive dealing contracts, supported the court’s
finding of antitrust liability.101
Although the court in Eisai did not find that Sanofi’s loyalty contracts included any significant non-price mechanisms of exclusion and concluded that
a price-cost test was the appropriate standard, the court also analyzed the Sanofi contracts under an alternative rule-of-reason exclusive dealing standard,
and did so using this same two-step process. Specifically, the court relied on
the ability of Eisai to compete for sales in the face of the Sanofi loyalty contract to conclude that the loyalty contracts did not create an exclusive dealing
arrangement in the first step of the analysis. The court concluded that Sanofi
never refused to deal with a hospital that did not purchase some specified
minimum quantity or share of Lovenox; hospitals that entered loyalty contracts with Eisai could continue to buy as much Lovenox as they wished at the
undiscounted price.102 Moreover, “[T]he record demonstrates that customers
can and did purchase rival products.”103 The evidence was unambiguous that
numerous hospitals chose Eisai and not Sanofi as their preferred supplier and
continued to purchase significant quantities of Lovenox despite the associated
loss of Sanofi loyalty price discounts. It is therefore obvious that Sanofi’s
loyalty contracts did not involve “all-or-nothing” contracts.
The court further emphasized that Eisai’s sales actually grew rapidly in the
face of the Sanofi loyalty contract,104 resulting in Eisai gaining market share
over the relevant period covered by the litigation,105 a fact the court described
as “most unusual in [exclusive dealing] antirust cases where liability has been
found.”106 Evidence of the ability of rivals to compete for sales indicated that
the Sanofi loyalty contracts did not economically compel hospital buyers to
purchase exclusively from Sanofi. Therefore, the court concluded that the
loyalty contracts were not de facto exclusive dealing contracts. Consequently,
100 Meritor claimed that its market share of only 4% in the presence of the Eaton loyalty contracts was less than the 10% minimum market share necessary for long-term viability. Id. at
264–67.
101 Id. at 286.
102 Eisai Inc. v. Sanofi-Aventis U.S., No. 08-4168 (MLC), 2014 U.S. Dist. LEXIS 46791, at
*12 (D.N.J. Mar. 28, 2014).
103 Id. at *71.
104 Id. at *95.
105 Eisai’s market share of Fragmin sales increased from 4% to 8% while Sanofi’s share of
sales decreased from 92% to 81% over the 2005–2010 period, implying a more than doubling of
total rival sales. GlaxoSmithKline’s Arixtra share increased from 2% to 10%. Id. at *95. The
court notes that Eisai’s sales grew by 44% in 2010 alone. Id. at *32.
106 Id. at *88.
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the court ended its exclusive dealing analysis by concluding there was no
antitrust injury.107 The second step of antitrust analysis under a rule-of-reason
exclusive dealing standard of evaluating the anticompetitive and procompetitive effects therefore was not necessary.108
The court’s reliance in Eisai on evidence of the ability of rivals to compete
to infer the absence of a de facto exclusive dealing arrangement is close to the
court’s reasoning in Concord Boat,109 the third case cited by Meritor for use of
a price-cost test when price is predominant incentive mechanism in the loyalty
contract.110 In fact, neither the defendant nor the plaintiff conducted any type
of price-cost test in Concord Boat. This is not surprising given that there was
no claim in Concord Boat that Brunswick’s discounts had created de facto
exclusive dealing by driving prices (either average discounted prices or the
discount attributed prices of contestable sales) below cost. The court therefore
did not find for Brunswick on the basis that its discounted price, however
measured, was above costs. Instead, the court found in favor of Brunswick by
relying upon the evidence that rivals were able to compete for sales in the face
of Brunswick’s loyalty contract.
107 Id. at *94–95. It may be argued that, even when a de facto exclusive dealing arrangement
has not been created, loyalty contracts make competition more difficult for rivals because the
loyalty contract involves a form of “raising rivals’ costs.” Thomas G. Krattenmaker & Steven C.
Salop, Anticompetitive Exclusion: Raising Rivals’ Costs to Achieve Power over Price, 96 YALE
L.J. 209 (1986). However, Eisai illustrates that the increase in distribution costs may very well
be part of the normal competitive process. The intensification of competition by pharmaceutical
manufacturers for hospital sales-shifting service contracts and the resulting increased price discount involves increased costs to pharmaceutical manufacturers of obtaining hospital distribution. But the relevant antitrust question is not whether the loyalty contract has made it more
difficult for rivals to compete; it is whether the loyalty contract has created a de facto “all-ornothing” exclusive dealing arrangement that prevents equally efficient rivals from being able to
compete.
108 In cases where such an evaluation is undertaken, it has been claimed that the procompetitive
effect of loyalty contracts in intensifying competition for contestable sales may be offset by a
“softening” of seller competition. Einer Elhauge & Abraham L. Wickelgren, Robust Exclusion
and Market Division Through Loyalty Contracts (Harv. Pub. L. Workshop Paper No. 14–12,
Apr. 2, 2014), www.law.harvard.edu/programs/olin_center/papers/pdf/Elhauge_723.pdf. Elhauge
and Wickelgren develop a model where a loyalty contract makes it less likely the established
seller will reduce its list price to compete for additional buyers that are purchasing from, say, a
new entrant, because this will lower the established seller’s effective price below the profitmaximizing price charged to buyers that have already accepted the loyalty contract. However,
this implied “softening” of competition in their model is based on what amounts to a most favored price term in the loyalty contract, not the loyalty contract itself. As we can see from the
Eaton and Sanofi loyalty contracts examined in this article, such a term need not be present in a
loyalty contract.
109 Concord Boat Corp. v. Brunswick Corp., 207 F.3d 1039 (8th Cir. 2000).
110 Meritor specifically cites Concord Boat for the proposition that “in the context of exclusive
dealing, the price-cost test may be utilized as a specific application of the ‘rule-of-reason’ when
the plaintiff alleges that price is the vehicle of exclusion.” ZF Meritor v. Eaton Corp., 696 F.3d
254, 274 (3d Cir. 2012).
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Specifically, the court rejected the plaintiffs’ contention that Brunswick’s
market share loyalty discounts placed customers in “golden handcuffs,” relying on the testimony of a number of plaintiff boat builders that they had
switched a substantial share of their purchases to rival products in response to
competitive offers.111 The court therefore concluded that customers “were free
to walk away from Brunswick’s discounts at any time, and the evidence
showed that they did so when Brunswick’s competitors offered better discounts.”112 Similar to the court’s reasoning in Eisai, the court in Concord Boat
concluded that because Brunswick’s loyalty contracts did not economically
preclude buyers from being able to purchase significant quantities from rivals,
the contract therefore was not a de facto exclusive dealing arrangement. Consequently, an antitrust violation could not be sustained.113
Finally, in all the cases where antitrust evaluation of a loyalty contract occurs under a rule-of-reason exclusive dealing standard and the analysis moves
to the second stage because it has been determined that the loyalty contract
has created a de facto exclusive dealing arrangement, it is important to recognize that the procompetitive efficiencies of the de facto exclusive dealing arrangement created by the loyalty contract should not be identified solely with
the common efficiency justifications for exclusive dealing contracts. Rather
than the economic efficiencies associated with the protection of complementary specific investments and the prevention of free-riding, loyalty contracts
are more often used to obtain the economic efficiencies outlined in this article
of achieving significant gains from trade when non-contingent prices would
otherwise be set above marginal costs. This efficiency motivation explains
why loyalty contracts are more likely to be used with differentiated brand
name products that have low marginal costs, such as the pharmaceutical products that were the subject of Eisai, where the economic benefits associated
with additional incremental sales are likely to be extremely large and where
Concord Boat, 207 F.3d at 1063.
Id.
113 Id. at 1058–60. Similar absence of coercion reasoning has been found sufficient to find in
favor of the defendant in a number of other loyalty contract cases. For example, in Virgin Atlantic the court found “no evidence . . . to show that British Airways’ incentive agreements were
coercive in relation to transatlantic routes identified by Virgin.” Virgin Atl. Airways v. British
Airways, 257 F.3d 256, 270 (2d Cir. 2001); see also Allied Orthopedic Appliances v. Tyco
Health Care Grp. LP, 592 F.3d 991, 1002 (9th Cir. 2009) (“[T]he only rational inference that can
be drawn from some consumers’ adoption of OxiMax is that they regarded it to be a superior
product.”). Other loyalty contract cases have relied on the fact that buyers initiated the competition among sellers for an exclusive as evidence of the absence of seller coercion. This factor was
emphasized, for example, in NicSand to dismiss the case on the basis of a lack of antitrust
standing. See NicSand, Inc. v. 3M Co., 507 F.3d 442, 452–55 (6th Cir. 2007); see also Richard
M. Steuer, Customer-Instigated Exclusive Dealing, 68 ANTITRUST L.J. 239 (2000).
111
112
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the competitive process is likely to result in the sharing of loyalty price discounts with consumers.114
V. CONCLUSION
It is said that hard cases make bad law. However, Meritor and Eisai involve
facts, as characterized by the courts, which make them relatively easy cases.
According to the court in Meritor, the Eaton loyalty contracts amounted to de
facto exclusive dealing contracts that forced truck manufacturers to substantially reduce their purchases of Meritor transmissions and resulted in Meritor’s exit from the heavy-duty truck transmission market. On the other hand,
the court in Eisai concluded that the Sanofi loyalty contracts did not create a
de facto exclusive dealing arrangement where Eisai was “never given an opportunity to compete.”115 The court emphasized that, in contrast to Meritor’s
inability to compete in the face of the Eaton loyalty contracts, there was substantial evidence that Eisai successfully competed for hospital sales and that
Eisai’s sales share increased rapidly over time.
Relatively easy cases, however, may still lead to “bad law” if one uses the
decisions to derive mistaken legal principles. There is an essential difference
between Meritor and Eisai with regard to the appropriate antitrust standard
because significant non-price incentive mechanisms were present in the Eaton
loyalty contracts while price was the sole incentive mechanism in the Sanofi
loyalty contracts. Therefore, rule-of-reason exclusive dealing was the appropriate standard in Meritor and a predatory pricing price-cost test was appropriate in Eisai.
There is a danger in future loyal contract analysis, however, to mistakenly
identify the performance conditions in a loyalty contract that supplement the
minimum purchase share condition, such as the distribution requirements present in both Meritor and Eisai, with non-price contract incentive mechanisms.
This analytical error would lead to the incorrect inference that price was not
the predominant incentive mechanism of exclusion in the loyalty contracts
and that price-cost tests were not appropriate.
114 In Eisai the court used the fact that loyalty contracts were a common element of competition in the market for hospital purchases of pharmaceuticals, with even relatively small firms like
the plaintiff Eisai using such contracts, as additional evidence to support its conclusion that
Sanofi “did not engage in unlawful exclusive dealing.” Eisai Inc. v. Sanofi-Aventis U.S., No. 084168 (MLC), 2014 U.S. Dist. LEXIS 46791, at *97–98 (D.N.J. Mar. 28, 2014). These competitive economic efficiencies of loyalty contracts should be contrasted with the vague description of
loyalty contract efficiencies in previous case law, where the efficiencies of loyalty contracts have
been merely labeled “obvious” (Virgin Atlantic, 257 F.3d at 265), or justified on the basis that
the firm is just “trying to sell its product” (Concord Boat, 207 F.3d at 1062).
115 Meritor, 696 F.3d at 281.
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In addition, in cases where significant non-price incentive mechanisms are
present in a loyalty contract, and therefore price is not the predominant mechanism of exclusion, the Meritor reasoning could mistakenly lead to a rule-ofreason exclusive dealing analysis of a loyalty contract without first demonstrating that the contract actually has created a de facto “all-or-nothing” exclusive arrangement. Adoption of the invalid shortcut of merely assuming
whenever loyalty discounts are contingent on a full or partial exclusive
purchase share that the contract amounts to exclusive dealing would significantly alter single product loyalty contract law and result, to the determinant
of consumers, in many more successful challenges of loyalty contracts in the
more difficult cases that will certainly arise in the future.