After mulling it over for a couple of days, here are some first thoughts on FTC vs. Whole Foods. Litigated cases, and especially appellate court decisions, are so rare in Section 7 matters that each decision carries enormous weight in shaping the advice counsel will give their M&A clients and the agencies’ attitude when deciding whether to undertake the cost and uncertainty of litigating merger challenges. It is unfortunate, therefore, that the Whole Foods opinion from the disproportionately influential DC Circuit seems a step backward in Section 7 jurisprudence.

Brown Shoe Retooled. The majority opinion and concurrence cite to Brown Shoe ten times, but only once to Baker Hughes. There are 18 cites to H.J. Heinz, but only for the question what standard a district court must apply in deciding whether to grant the FTC’s motion for a preliminary injunction blocking the merger. There is no cite to Heinz’s discussion of the test for market definition and anticompetitive effects. In Whole Foods, it’s a straight diet of Brown Shoe. One doesn’t like to speak poorly of venerable precedent, but Brown Shoe is a decision that condemned a merger that would have lead to the four largest manufacturers accounting for 23% of the domestic production of shoes. The opinion shows more than a little ambivalence about protecting competition, not competitors, even though Brown Shoe is often cited for that maxim (which the Supreme Court in its recent spade of antitrust decisions has gone out of its way to endorse and enforce). Here is a that passage from Brown Shoe:

It is competition, not competitors, which the Act protects. But we cannot fail to recognize Congress’ desire to promote competition through the protection of viable, small, locally owned business. Congress appreciated that occasional higher costs and prices might result from the maintenance of fragmented industries and markets. It resolved these competing considerations in favor of decentralization. We must give effect to that decision. 370 U.S. 294, 344.

Brown Shoe also shows some ambivalence about how markets can be defined. There is, one the one hand, a very modern sounding reference to cross-elasticity of demand between the product and its substitutes for defining markets. But it is followed in Brown Shoe by an endorsement of the concept of submarkets that are not defined by rigorous economic principles, but rather by the dreaded “practical indicia”:

However, within this broad market [defined by cross-elasticity of demand], well defined submarkets may exist which, in themselves, constitute product markets for antitrust purposes. United States v. E.I. du Pont de Nemours & Co., 353 U. S. 586, 353 U. S. 593-595. The boundaries of such a submarket may be determined by examining such practical indicia as industry or public recognition of the submarket as a separate economic entity, the product’s peculiar characteristics and uses, unique production facilities, distinct customers, distinct prices, sensitivity to price changes, and specialized vendors. Because § 7 of the Clayton Act prohibits any merger which may substantially lessen competition “in any line of commerce” (emphasis supplied), it is necessary to examine the effects of a merger in each such economically significant submarket to determine if there is a reasonable probability that the merger will substantially lessen competition. 370 U.S. at 326.

And here is Judge Brown in 2008:

In short, a core group of particularly dedicated, “distinct customers,” paying “distinct prices,” may constitute a recognizable submarket, Brown Shoe, 370 U.S. at 325, whether they are dedicated because they need a complete “cluster of products,” Phila. Nat’l Bank, 374 U.S. at 356, because their particular circumstances dictate that a product “is the only realistic choice,” SuperTurf, Inc. v. Monsanto Co., 660 F.2d 1275, 1278 (8th Cir. 1981), or because they find a particular product “uniquely attractive,” Nat’l Collegiate Athletic Ass’n v. Bd. of Regents of the Univ. of Okla., 468 U.S. 85, 112 (1984). For example, the existence of core customers dedicated to office supply superstores, with their “unique combination of size, selection, depth[,] and breadth of inventory,” was an important factor distinguishing that submarket. FTC v. Staples, Inc., 970 F. Supp. 1066, 1078–79 (D.D.C. 1997). As always in defining a market, we must “take into account the realities of competition.” Weiss v. York Hosp., 745 F.2d 786, 826 (3d Cir. 1984). We look to the Brown Shoe indicia, among which the economic criteria are primary, see Rothery Storage & Van Co. v. Atlas Van Lines, Inc., 792 F.2d 210, 219 n.4 (D.C. Cir. 1986).

Maybe I shouldn’t be surprised by this. But the passage does more than accept that, given the difficulties of economic analysis, we can supplement it with some common-sense heuristic insights to come up with markets. This approach seems to undermine the acceptance of the theoretical foundations of economic analysis. In Whole Foods, the majority goes on to say that, based on the “unique environment” of the stores and the “core values” of the customers, there is a “submarket” of core customers of Premium, Natural and Organic Supermarkets. The court cites favorably the FTC’s efforts to connect the intangible properties with facts: PNOS carry a much larger selection of natural and organic products and have a much greater concentration of perishables than conventional supermarkets. The court also points out, at another point, that it doesn’t change the analysis that customers cross-shop at conventional supermarkets, and that PNOS check their prices. This, the court reasons, is because “cross-shopping is entirely consistent with the existence of a core group of PNOS customers.”

I read this to mean that the “practical indicia” have become the trump card to beat economic analysis. At this point I should admit that I don’t believe in submarkets. If there is a product bundle that some customers value to such an extent that they will pay the hypothetical monopolist’s SSNIP, then that product bundle may certainly be a market. But such an approach just highlights the maddening absence of any product market definition at all in the FTC’s case. In its complaint, the FTC stated under the heading Relevant Markets: “The operation of premium natural and organic supermarkets is a distinct ‘line of commmerce’ within the meaning of Seciton 7…” That’s not a market, unless you buy and sell supermarkets for a living. In defining a product market, the products sold in PNOS could be a market, and this brings out the possibility that only certain products sold in PNOS could form a market, to the exclusion of others also sold there. Starting with a bundle of products sold in PNOS makes the distinction between core and marginal customers clearer, because market definition then depends not on Brown Shoe’s practical indicia, but on the customers’ preferences or demand curves, as it should. Core (or inframarginal) and marginal customers, by definition, are terms that reference the same market (substitutable products), and are distinguished only on the basis of the projected reaction of consumers to a hypothetical increase in price. Every customer is a marginal customer if you only raise price high enough.

But the majority opinion in Whole Foods is difficult to follow when it comes to core vs. marginal customers: Judge Brown states that “the district court committed legal error in assuming market definition must depend on marginal consumers,” and that “the district court’s error of law led it to ignore FTC evidence that strongly suggested Whole Foods and Wild Oats compete for core consumers within a PNOS market, even if they also compete on individual products for marginal consumers in the broader market.” The court takes Sheffman’s economic analysis to task for depending “only on the marginal loss of sales.” But it seems clear that in gauging incipient competitive harm, the question to ask is whether the presence of marginal consumers, whose sales would be diverted to traditional supermarkets if the merged parties raised prices, protects the core customers, whose demand is less elastic. And under the Guideline’s SSNIP test, market definition also turns on marginal customers, since diversion in the case of the hypothetical monopolist’s SSNIP determines substitutability. Whether Section 7 acts to protect core customers depends not on whether core customers can be distinguished by intangibles or “practical indicia” but rather on how many marginal costumers there are: if there there are enough marginal customers to make raising prices unprofitable, and price discrimination between core and marginal customers isn’t feasible, the merger is unlikely substantially to lessen competition. The majority states:

In sum, the district court believed the antitrust laws are addressed only to marginal customers. This was an error of law, because in some situations core consumers, demanding exclusively a particular product or package of products, distinguish a submarket. The FTC described the core PNOS customers, explained how PNOS cater to these customers, and showed these customers provided the bulk of PNOS’s business. The FTC put forward economic evidence—which the district court ignored—showing directly how PNOS discriminate on price between their core and marginal customers, thus treating the former as a distinct market.

Price discrimination between core and marginal customers is of course highly relevant, but the concept appears here surrounded by a penumbra of heuristics that makes hard if not impossible to distill guidance on market definition. The only economic evidence of price discrimination between core and marginal customers cited in the opinion is the fact that Whole Foods stores enjoyed lower margins (not prices!) in cities where they competed with Wild Oats stores. One would have hoped for a discussion of how Whole Foods identifies core customers (the ones in Birkenstocks, perhaps?) and manages to charge them higher prices than the marginal customers (in wingtips and high heels, or flip-flops).

So, does the FTC have to define a market? There is another potential source of confusion in the opinion. Judge Brown criticizes the FTC:  “inexplicably, the FTC now asserts a market definition is not necessary in a §7 case.” The FTC suggested in its brief that “market definition is a means to an end—to enable some measurement of market power—not an end in itself.” That seems obvious enough, particularly in unilateral-effects cases where it is often easier to go directly to competitive effects. The Circuit court’s argument for why a market definition is indispensable is to go back 46 years: “only ‘examination of the particular market—its structure, history[,] and probable future—can provide the appropriate setting for judging the probably anticompetitive effects of the merger.’ Brown Shoe, 370 U.S. at 32 n.38.” Again, this reference to Brown Shoe seems to muddy the waters. And the court immediately backpedals from its insistence of a market definition:

‘That is not to say market definition will always be crucial to the FTC’s likelihood of success on the merits. Nor does the FTC necessarily need to settle on a market definition at this preliminary stage…. For example, the FTC may have alternate theories of the merger’s anticompetitive harm [sic], depending on inconsistent market definitions.”

There may be a substantial cost to this ambiguous approach. Litigation to enjoin a merger is preceded by an intense investigation during which the parties on the one hand seek to respond to the agency’s broad document and interrogatory requests, while on the other hand hope to substantively address the agency’s concerns about competitive effects. If the FTC need not settle on some specific theory of competitive harm or a market definition during the investigation, the parties may be at a distinct disadvantage to respond to the FTC’s concern. This effect will be exacerbated by the absence of clear guidance in the DC Circuit’s opinion: it opens the door to vague and impressionistic market definitions. The Whole Foods opinion is a step backward and it runs counter to the strong trend in recent Supreme Court jurisprudence for economic rigor and clear standards to guide businesses and the agencies.

Update: Geoff Manne has an very interesting post in a similar vein on Truth on the Market:

“But wait!,” you say.  Some people have idiosyncratic preferences.  They preferer buying organic tomatoes, zucchini and grapes from premium natural stores–it’s a combination, you see, not only of the food being consumed but also the channel of distribution.  These poor sots will be gouged without competition between Whole Foods and Wild Oats, because they don’t want to shop for produce at Safeway.  And Whole Foods without Wild Oats would easily overcharge these 17 or 18 people in any given market. Yes, indeed.  One can always define a market by focusing on idiosyncratic preferences or product variations.

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