Recent court decisions could have a big impact on big business (and small business)

This has been a big year for business in the courts. A U.S. district court approved the AT&T-Time Warner merger, the Supreme Court upheld Amex’s agreements with merchants, and a circuit court pushed back on the Federal Trade Commission’s vague and heavy handed policing of companies’ consumer data safeguards.

These three decisions mark a new era in the intersection of law and economics.

AT&T-Time Warner

AT&T-Time Warner is a vertical merger, a combination of firms with a buyer-seller relationship. Time Warner creates and broadcasts content via outlets such as HBO, CNN, and TNT. AT&T distributes content via services such as DirecTV.

Economists see little risk to competition from vertical mergers, although there are some idiosyncratic circumstances in which competition could be harmed. Nevertheless, the U.S. Department of Justice went to court to block the merger.

The last time the goverment sued to block a merger was more than 40 years ago, and the government lost. Since then, the government relied on the threat of litigation to extract settlements from the merging parties. For example, in the 1996 merger between Time Warner and Turner, the FTC required limits on how the new company could bundle HBO with less desirable channels and eliminated agreements that allowed TCI (a cable company that partially owned Turner) to carry Turner channels at preferential rates.

With AT&T-Time Warner, the government took a big risk, and lost. It was a big risk because (1) it’s a vertical merger, and (2) the case against the merger was weak. The government’s expert argued consumers would face an extra 45 cents a month on their cable bills if the merger went through, but under cross-examination, conceded it might be as little as 13 cents a month. That’s a big difference and raised big questions about the reliability of the expert’s model.

Judge Richard J. Leon’s 170+ page ruling agreed that the government’s case was weak and its expert was not credible. While it’s easy to cheer a victory of big business over big government, the real victory was the judge’s heavy reliance on facts, data, and analysis rather than speculation over the potential for consumer harm. That’s a big deal and may make the way for more vertical mergers.

Ohio v. American Express

The Supreme Court’s ruling in Amex may seem obscure. The court backed American Express Co.’s policy of preventing retailers from offering customers incentives to pay with cheaper cards.

Amex charges higher fees to merchants than do other cards, such as Visa, MasterCard, and Discover. Amex cardholders also have higher incomes and tend to spend more at stores than those associated with other networks. And, Amex offers its cardholders better benefits, services, and rewards than the other cards. Merchants don’t like Amex because of the higher fees, customers prefer Amex because of the card’s perks.

Amex, and other card companies, operate in what is known as a two-sided market. Put simply, they have two sets of customers: merchants who pay swipe fees, and consumers who pay fees and interest.

Part of Amex’s agreement with merchants is an “anti-steering” provision that bars merchants from offering discounts for using non-Amex cards. The U.S. Justice Department and a group of states sued the company, alleging the Amex rules limited merchants’ ability to reduce their costs from accepting credit cards, which meant higher retail prices. Amex argued that the higher prices charged to merchants were kicked back to its cardholders in the form of more and better perks.

The Supreme Court found that the Justice Department and states focused exclusively on one side (merchant fees) of the two-sided market. The courts says the government can’t meet its burden by showing some effect on some part of the market. Instead, they must demonstrate, “increased cost of credit card transactions … reduced number of credit card transactions, or otherwise stifled competition.” The government could not prove any of those things.

We live in a world two-sided markets. Amazon may be the biggest two-sided market in the history of the world, linking buyers and sellers. Smartphones such as iPhones and Android devices are two-sided markets, linking consumers with app developers. The Supreme Court’s ruling in Amex sets a standard for how antitrust law should treat the economics of two-sided markets.

LabMD

LabMD is another matter that seems obscure, but could have big impacts on the administrative state.

Since the early 2000s, the FTC has brought charges against more than 150 companies alleging they had bad security or privacy practices. LabMD was one of them, when its computer system was compromised by professional hackers in 2008. The FTC claimed that LabMD’s failure to adequately protect customer data was an “unfair” business practice.

Challenging the FTC can get very expensive and the agency used the threat of litigation to secure settlements from dozens of companies. It then used those settlements to convince everyone else that those settlements constituted binding law and enforceable security standards.

Because no one ever forced the FTC to defend what it was doing in court, the FTC’s assertion of legal authority became a self-fulfilling prophecy. LabMD, however, chose to challege the FTC. The fight drove LabMD out of business, but public interest law firm Cause of Action and lawyers at Ropes & Gray took the case on a pro bono basis.

The 11th Circuit Court of Appeals ruled the FTC’s approach to developing security standards violates basic principles of due process. The court said the FTC’s basic approach—in which the FTC tries to improve general security practices by suing companies that experience security breaches—violates the basic legal principle that the government can’t punish someone for conduct that the government hasn’t previously explained is problematic.

My colleague at ICLE observes the lesson to learn from LabMD isn’t about the illegitimacy of the FTC’s approach to internet privacy and security. Instead, it says legality of the administrative state is premised on courts placing a check on abusive regulators.

The lessons learned from these three recent cases reflect a profound shift in thinkging about the laws governing economic activity:

  • AT&T-Time Warner indicates that facts matter. Mere speculation of potential harms will not satisfy the court.
  • Amex highlights the growing role two-sided markets play in our economy and provides framework for evaluating competition in these markets.
  • LabMD is a small step in reining in the administrative state. Regulations must be scrutinized before they are imposed and enforced.

In some ways none of these decisions are revolutionary. Instead, they reflect an evolution toward greater transparency in how the law is to be applied and greater scrutiny over how the regulations are imposed.

 

Secret, Pixar, Schumpeter, and Louis CK: The world’s shortest economics lesson

Flash-in-the-pan smartphone app Secret, has announced it’s shutting down after just 16 months and after raising $35 million from investors.

Secret allows users to post anonymous comments and read anonymous comments by others. Add in location services, and users can post and read comments to other people near them. Yes, it’s a bit creepy, but Secret is not alone in the creepy secret business.

Co-founder, David Byttow, made the announcement in a blog post:

Secret, Inc. still has a significant amount of invested capital, but our investors funded the team and the product, and I believe the right thing to do is to return the money rather than attempt to pivot. Innovation requires failure, and I believe in failing fast in order to go on and make only new and different mistakes.

In a world where hi-tech investors are treated as easy marks for fast-talking Millennials, Byttow shows a bit of class with his promise to return the money (although, one wonders if he’ll keep his Ferrari).

More important is Byttow’s acknowledgement that innovation requires failure. Pixar’s John Lasseter puts it best:

Be wrong as fast as you can. Mistakes are an inevitable part of the creative process, so get right down to it and start making them. Even great ideas are wrecked on the road to fruition and then have to be painstakingly reconstructed.

Lasseter’s wisdom is a version of economist Joseph Schumpeter’s concept of creative destruction in which the creation of new technologies destroys older technologies. While some may regret the loss of older technologies, the creation of new technologies pulls the economy forward in ever increasing prosperity.

And, if you don’t want to believe an economist, you can trust a comedian.

Single party rule and state spending: Discipline through disagreement

Ask a politician what the goal of their party is and they will tell you: To dominate the government.

Democrats and Republicans alike would like nothing more that to totally eliminate the other party from the legislature.

That may be good for the party, but new research says its bad for the budget.

A paper published in the Quarterly Journal of Economics finds that political competition reduces overspending by state legislatures (paywall version; free working paper).

The authors develop a model of legislators, some whom have a bias for overspending. In other words, these legislators want to boost current spending and put off any spending cuts.

Their model predicts that when unanimity is anticipated—for example, under one-party rule—legislators give in to the temptation to overspend.

  • On the one hand, if unanimous support for high spending is expected in future legislatures, legislators know that low spending today cannot stop policymakers from raising spending in the future.
  • On the other hand, if unanimous support for low spending in the future legislatures is expected, legislators can spend today and knowing that future legislatures will clean up the mess.

This seems to cross party lines. It was the Republican-dominated Congress that pushed the infamous Bridge to Nowhere.

But, the researchers argue, as legislature gets closer to a 50/50 split of those that are fiscally responsible and those that are spendthrifts, the possibility of gridlock increases. With gridlock, the status quo prevails and spending will not increase as much as the high spenders would like. In that way, political competition leads to fiscal responsibility.

Neat idea, but can you prove it?

The authors do not provide any statistical evidence supporting their model, but past research seems to be consistent with their model.

For example, statistical analysis published in the Review of Economic Studies finds that increases in political competition are associated with:

  • Lower tax revenue as a share of state personal income, meaning residents have greater disposable income;
  • A higher level of infrastructure spending by state governments; and
  • A higher probability that a state uses a right-to-work law, which makes it easier for employers to hire workers and easier for job-seekers to get work.

Thus, there is some evidence that greater political competition is associated with higher growth rates of state personal income per person.

Competition: It’s good for business and good for government.