Streetwise Professor

May 29, 2019

The Econ 101 of Apple v. Pepper

Filed under: Economics,Politics,Regulation — cpirrong @ 6:40 pm

The Supreme Court made something of a splash recently in its Apple v. Pepper antitrust decision, which some have interpreted as undermining the limitation in the Illinois Brick case that only direct purchasers can sue for antitrust damages. The majority decision claims that it is adhering to the “bright line” of Illinois Brick. Apple demonstrates, however, that any blanket limitation on who has antitrust standing can lead to perverse outcomes.

The facts in Apple are that Apple’s App Store is allegedly a monopoly that it can exploit to raise the price of apps sold through the store. Apple collected its fee (in the form of a commission) from app sellers, and collected no fee from buyers using the store. Apple claimed that app buyers have no standing to sue because they bought the apps from the app sellers, not Apple, meaning that they were indirect purchasers, and hence no standing to sue under Illinois Brick. A 5-4 majority decided otherwise.

The economics of this are straightforward. It is basically a version of tax incidence analysis, which says that the distribution of the burden of a tax is the same, regardless of whether the government collects the tax from sellers, or from buyers. In the present instance, the burden of Apple’s supercompetitive charge would be the same regardless of whether Apple charges app suppliers or consumers for access to the App Store.

That fact alone should raise alarms about the efficiency (and fairness) of a blanket denial of antitrust standing, depending on who is the “first purchaser” or who the putative monopolist charges the supercompetitive price.

A simple supply-demand diagram illustrates the point.

The blue line is the demand for apps. The red line is the supply of apps. The demand for the App Store is a derived demand: it is derived from the supply and demand for apps, and equals the vertical distance between the supply and demand curves. In the diagram, App Store Demand is the gray line. It is downward sloping, indicating that the App Store has market power. It chooses a quantity such that its marginal revenue (the yellow line) equals marginal cost (assumed to be zero).

Given the supply and demand for apps, the profit maximizing quantity is 25, which is half the competitive quantity of 50 (given by the intersection of the supply and demand curves). Apple collects 50 per app sold.

The only prices that clear the market involve consumers paying 75 per app, and sellers receiving 25 for app. This outcome can be obtained in several ways. Apple could charge suppliers a commission of 50, which they would pass on, collecting 75 from consumers and netting 25. Or, apple could charge buyers a fee of 50, which would mean that they would only pay developers 25 per unit for the 25 units they buy.

So who pays what and who gets what depends not a whit on whom Apple charges.

This means that prohibiting one or the other users of the App Store for suing for damages means that they will be uncompensated: the party that can sue can be either overcompensated, or perhaps undercompensated too.

In the example, the competitive price is 50, meaning that the buyers overpay by 25. If they can’t sue, they are SOL and suffer a loss greater than the overcharge (25) times the number of units (25). Their loss is greater because of the deadweight loss: there are 25 units that consumers would have bought absent the monopoly, but don’t purchase when it exists. This deadweight loss (the “welfare triangle”) is one-half times the units not consumed (25) times the markup paid by consumers (25).

If only the sellers have antitrust standing, because they pay Apple the 50/unit, they are overcompensated if they are awarded their unit sales (25) times the full Apple overcharge of 50. The 1250 in compensation exceeds their loss in surplus which is their share of the overcharge (25) times the units sold (25) plus the deadweight loss (25*25/2) (for a total of 937.5). If the sellers are awarded only their share of the overcharge (25) on the units they sell (25) they would be undercompensated like the buyers.

Therefore, since the losses due to monopoly power are shared between the App Store sellers and buyers, restricting compensation to only one of them results in undercompensation to the party that can’t sue for damages, and (depending on how the damages to the party with standing are calculated) can overcompensate or undercompensate the party with standing. This mismatch between harm and compensation potentially undermines the deterrent effect of private antitrust actions, and also means that the antitrust law has largely arbitrary distributive effects, especially since there is no necessary connection between who suffers the most harm and who has standing to sue: who suffers the most harm depends on supply and demand elasticities, and if unlike the simple analysis above demand is much less elastic than supply, consumers are harmed more.

This is likely an important consideration in Apple. It is basic econ (it drops out of the Slutsky equation) that demand tends to be inelastic for goods that represent a small fraction of a consumer’s expenditures: that’s likely the case for apps, which typically cost just a few bucks. Furthermore, given low entry barriers on the app developer side, I would surmise that the supply of apps is highly elastic. Inelastic demand and elastic supply means that consumers bear most of the overcharge. In this case, the misalignment between economic harm and standing to sue based on who pays the fee to Apple is likely acute.

The rationale for Illinois Brick is that parsing out harm when both buyers and sellers are damaged is just too damn hard, and costly. In the context of the simple example, knowing perfectly the distribution of losses from market power requires knowing the supply and demand curves. So fuggedaboutit, and just give everything to the one who writes the check to the monopolist, even though who writes the check has jack all to do with who actually pays the price.

Litigation costs are a legitimate consideration, but not the only consideration. Undermining the efficiency and distributive purposes of the antitrust laws is costly too.

Apple v. Pepper has the virtue of looking past the economically irrelevant issue of privity to the substantive economic effects of the alleged antitrust violation that is before the bar. The Apple majority claims that it is faithfully implementing Illinois Brick, but by looking at the economic substance the decision will prove, in my opinion, the camel’s nose under the tent that will substantially broaden the categories of market participant eligible for antitrust standing.

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5 Comments »

  1. I’d guess that the four topics in economics about which the Man on the Clapham Omnibus is most ignorant (or foolish) are (i) tax incidence, (ii) free trade, (iii) government control of prices, and (iv) comparative advantage. I imply nothing by the order I’ve put those topics in.

    Comment by dearieme — May 30, 2019 @ 5:56 am

  2. Not only am I struggling to understand the graph, I am also struggling to understand your view on this situation.

    I think you are saying that you agree with the liberals on the court who have agreed to allow this case to go forward, but find their claiming to be following an earlier case to be questionable. However, you would appear to also find the decision previous case Illinois Brick to be questionable (actually flat wrong). And that Stare Decisis would require the courts to not to allow the case to go forward? As only Congress (and not the courts, including the USSC) is allowed to change a prior USSC interpretation (aka precedent)? Anti-Trust laws being acts of Congress rather than Constitutional provisions.

    So “Correct on Economics” wrong on “Precedent”?

    A agree with you on the economics, although I struggle with these “simple” graphs!

    Comment by JavelinaTex — May 30, 2019 @ 8:29 am

  3. So should the Apple App store be a regulated utility? How about Sales Force? A while back (about a decade and a half) the publisher of Harper’s Magazine wanted to require Newsstands to carry his publication!

    Comment by JavelinaTex — May 30, 2019 @ 8:32 am

  4. So typical of a large tech company to collect payments, charge a commission, enforce branding standards, block alt-right content with impunity, lock the platform to the app store, and even audit all the code, and yet, when legally convenient, shrug off all responsibility for the effects on price. Gee whiz, the notion that developers rather than users are paying the commission an arbitrary accounting convention; does anyone believe consumers stop paying sales tax when the advertised price includes it?

    Back in the day, IBM argued that what the antitrust regulators called predatory pricing was really a rational product of economies of scale. (And the ensuing decades of court battles over technical minutiae is commonly cited by opponents of antitrust ideology.) A parallel argument would be Apple claiming that app store commissions pay for improved compilers and libraries that make all app developers more efficient, but they can’t even be bothered with such a fig leaf. They want to collect their rents, dammit.

    Comment by M. Rad. — May 30, 2019 @ 6:03 pm

  5. The problem with all such arguments is that it would be legally AOK for Apple to be vertically integrated and to allow no outside apps on its system and then to charge whatever it felt like. The iPhone is not a monopoly ecosystem but rather a minority of the market for smartphones and even less of all phones and even less of all Internet-capable devices. So we have a doctrine that says it’s OK to totally lock out outside developers (and Apple could even contract out development of Apple apps for which it took ownership and it could even pay royalties if it so chose). But it’s not OK to be less monopolistic and run a sales platform for outside developers where Apple edits what goes on and charges whatever royalty makes sense for it? When you buy an iPhone you are buying the Apple “monopoly” over what goes on it and what you have to pay for it, no matter how that “monopoly” is administered (directly via internal app development or indirectly via a royalty passed through by outside developers.

    Comment by srp — June 10, 2019 @ 5:38 pm

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