Working Paper No. 05-26:
The Economics of Loyalty Discounts and Antitrust Law in the United States

Author(s):

Bruce Kobayashi

Date Posted: 2005

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Abstract:

This paper examines the law and economics of loyalty discounts.  While there have been recent advances in the economic analysis of loyalty discounts, this literature is still relatively recent and sparse.  Though some of these papers provide tests that would serve to identify either deviations from short run profit maximization or, in the case of bundled discounts, a reduction in consumer welfare or the exclusion of a hypothetically equally efficient competitor, these tests have several shortcomings. As a result, the economic literature currently does not provide a reliable way to gauge whether the potential harm from the use of loyalty discounts would outweigh any demonstrable benefits from their use.

A review of the major cases involving loyalty and other volume discounts suggests the following general observations.  In the single product case, courts have consistently applied the "not easy to establish' two part test for predatory pricing set out by the Supreme Court in its Brooke Group decision.  As a result, the courts have generally ruled that above-cost volume discounts, including those that use market share discounts and near exclusive thresholds, are lawful and do not violate the antitrust laws.  In cases involving multimarket or bundled rebates, however, courts have not generally followed the Brooke Group Court's presumption that above cost bundled discounts are presumptively legal.  However, they have generally followed the Brooke Group Court"s focus on the actual facts or realities of the marketplace rather than on hypotheticals.  Thus, while the lower courts have considered the theories and tests contained in the recent theoretical literature on loyalty discounts, they have generally refused to find liability absent sufficient proof that the conditions required by these tests apply, and that the underlying tests reflect market realities.   This approach is consistent with the federal courts' generally cautious approach to expanding Section 2 liability, and the recognition of the underdeveloped and untested state of the academic literature.

Moreover, there are significant flaws in the two cases where courts have found use of bundled loyalty rebates to be unlawful.  In SmithKline, the court did focus on data and concluded that an equally efficient competitor would have been excluded by the bundled discounts evaluated in the case.  However, economic theory suggests that the court may have used a flawed standard, and should have instead focused on the fact that changes to the bundled rebate programs served to increase rather than decrease prices.  And the court's decision in LePage's not only suggested use of the same flawed standard, it found liability without requiring sufficient proof that the standard even applied to the facts of the case.