Information Costs, Lifecycle Costs, Swithching Costs, and Lock-In

By Victoria E. Brieant and Paul S. Schmidtberger

Published in The Antitrust Counselor, October 15, 1998

I. Introduction

This article will analyze the role of information costs, lifecycle costs, switching costs, and lock-in in the context of market power determinations under the antitrust laws. The article will begin with a detailed analysis of how the Supreme Court addressed those issues in its recent pronouncement on antitrust: Eastman Kodak Co. v. Image Technical Services, Inc./1/

Next, this article will argue for an expansive use of such practical indicia of market imperfections, and provide an overview of how Image Technical Services made its case for greater deference to the realities of information costs and related market imperfections. The article will conclude that it is increasingly clear that customers are either unable or unwilling to adequately assess lifecycle costs at the point of purchase for high cost consumer durables, a factor that may now be forcefully argued under Kodak.

II. Kodak

A. Background and Overview

The Kodak case originated with a suit brought by a group of independent service organizations (ISOS) against Kodak after Kodak changed its policies regarding access to Kodak replacement parts for its copiers.

Specifically, the new policy adopted by Kodak permitted access to replacement parts for Kodak's copiers only for customers who were under contract with Kodak for service and maintenance. Customers who sought the services of ISOs were denied access to parts.

The plaintiffs, a group of eighteen ISOS, claimed that Kodak was both illegally tying its parts, which are unique, to service, and monopolizing the market for service of Kodak copiers. The ISOs alleged, inter alia, that Kodak had unlawfully tied the sale of service for Kodak machines to the sale of parts, in violation of Section I of the Sherman Act, and had unlawfully monopolized and attempted to monopolize the sale of service for Kodak machines, in violation of Section 2 of that Act. 15 U.S.C. Sections 1, 2.

The trial court entered summary judgment in favor of Kodak after limited discovery. The trial court expressed the view that, regardless of the facts that could be brought forth through discovery or further proceedings, plaintiffs' theory made no economic sense. In other words, the district court accepted Kodak's argument that Kodak could not have market power over Kodak parts and service (aftermarkets) because Kodak does not have a large enough share of the market for basic equipment (ie., - copiers or equipment) to have market power in the basic equipment market./2/ In short, Kodak argued that competition in the primary market prevents Kodak per se from committing antitrust violations in the aftermarket.

The Ninth Circuit reversed, concluding that the ISOs had presented sufficient evidence to raise a genuine issue of fact concerning Kodak's market power in the service an parts markets. It rejected Kodak's contention that a lack of market power in the service and parts market must necessarily be assumed when such power is absent in the equipment market.

The Supreme Court affirmed. It rejected Kodak's argument that competition in the market for copiers was interbrand competition whereas competition for service was intrabrand./3/ Rather, the Supreme Court held that in the relevant market, ie., service for Kodak copiers, ISOs are in direct competition with Kodak.

B. Information Costs; Lifecycle Costs; Switching Costs

At the heart of Kodak's argument is the economic theory that a manufacturer is prevented from illegally raising its prices for parts or service because of the negative effects this would ostensibly have on the basic equipment market. This theory rests on the assumption that customers are able to consider the lifetime costs of particular machines at or before the time of purchase. The Kodak Court found this argument implausible, stating that "[m]uch of this information is difficult some of it impossible - to acquire at the time of purchase."/4/ Rather, the Court agreed with the ISOs that they should have the opportunity to demonstrate their premise - that service is a separate consideration for purchasers of high-technology equipment. As a result, the Court concluded that "it makes little sense to assume, in the absence of any evidentiary support, that equipment-purchasing decisions are based on an accurate assessment of the total cost of equipment, service and parts over the lifetime of the machine."/5/

Despite much evidence that Kodak possessed power in the parts market,/6/ Kodak argued that its monopoly share of the parts market could not amount to monopoly power because competition existed in the equipment market. In other words, Kodak asserts that no violation is possible because if Kodak raised its parts or service prices above competitive levels, potential customers would simply stop buying Kodak equipment./7/ Kodak advanced this theory as a per se rule whereby equipment competition should preclude any finding of monopoly power in derivative aftermarkets./8/

In rejecting Kodak's economic theory, the Supreme Court focused on whether Kodak's theory reflected actual market behavior.

The Court began its analysis by noting certain descriptive failings in Kodak's theory. Most notably, the court hypothesized that if higher service prices actually did lead to a drop in equipment sales, then lower service costs should lead to an increase in equipment sales. As a result, the Court surmised that Kodak would welcome the entry of lower-priced ISOs into the service market. Instead, the sparse factual record demonstrated Kodak's concerted efforts to eliminate ISOS. Moreover, the Court noted that despite Kodak's success in eliminating lower-priced ISOS, Kodak's equipment sales had not ostensibly suffered from the increase in service prices its theory would naturally predict./9/

Kodak's response to these criticisms was to postulate a "marketing strategy" whereby total costs to customers of Kodak equipment are spread over time, ie., subcompetitive equipment prices are balanced with supracompetitive service prices, resulting in an overall competitive price./10/ The Court found the ISOs' criticisms of Kodak's explanations to be "forceful." That is, "the existence of significant information and switching costs ... could create a less responsive connection between service and parts prices and equipment sales."/l1/

Thus, the Court recognized that in order for prices in the service market to impact upon equipment demand, the consumer would have to be informed of the "total cost of the 'package' - equipment, service and parts at the time of purchase; that is, consumers must engage in accurate lifecycle pricing."/12/ The Court next recognized that lifecycle pricing of complex durable goods is "difficult and costly," and would require a "substantial amount of raw data" and "sophisticated analysis."/13/ Additionally, Kodak recognizes that some of the information is impossible to acquire at the time of purchase due to the fact that prices for service and parts may change and that lifecycle costs will be customer specific./14/

In response, Kodak argued that these customer information needs could be satisfied from competitors in the equipment market. Though the Court considered that possibility to be a question of fact, its framing of the analysis demonstrates a marked skepticism, most notably the doubt that a competitor in the equipment market would have reliable information a out t e lifecycle costs of other manufacturers' equipment or the needs of customers not its own./15/

More significantly, the Court queried that "even if consumers were capable of acquiring and processing the complex body of information, they may choose not to do SO.@'/l6/ The Court attributed this reluctance primarily to the costs involved, and provided an example from particularly close to home - the government itself. The Court noted that governments "often treat service as an operating expense and equipment as a capital expense, delegating each to a different department."/17/

The Court did appear to give Kodak's argument somewhat more credence with respect to large-volume, sophisticated purchasers "who will undertake the comparative studies and insist, in return for their patronage, that Kodak charge them competitive lifecycle prices."/18/ However, even in that context the Court was skeptical.

The Court disfavored this argument for two reasons. First, the Court surmised that if the number of sophisticated customers were small, the profit to be gained by supracompetitive pricing in the service market could make it worthwhile for Kodak to let sophisticated customers go elsewhere. Second, and more importantly, the Court postulated that Kodak could price-discriminate between sophisticated and uninformed customers by varying the terms of the package, refuting the idea that the sophistication of certain players will necessarily hold prices down for others.

The Court indicated that the potential for the latter may already be a reality, given the fact that Kodak willingly sells parts to customers who self-service, but refuses to sell parts to those customers that employ ISOS. Again reflecting the practicalities of the market, the Court noted that companies with self-maintaining staff are more likely to be sophisticated high volume users. As a result, the Court reached its holding that "it makes little sense to assume, in the absence of any evidentiary support, that equipment-purchasing decisions are based on an accurate assessment of the total cost of equipment service, and parts over the lifetime of the machine."/19/

Next, the Kodak Court held that Kodak's theory was further undermined by the existence of "switching costs," referring to the fact that where costs of switching are high, consumers are "locked-in" and will tolerate certain service price increases before changing equipment. In other words, so long as the switching costs are high, supracompetitive service prices may be exacted. Further, the Court postulated that again price discrimination between lock-in customers and new customers could be viable./20/

The Court supported this by faking note of the fact that the initial cost of Kodak equipment is high; and that because the equipment is unique, switching costs are particularly high. Additionally, Kodak's own evidence demonstrated a range of prices for equipment parts and services packages for different customers.

As result, the Court determined that it is a question of fact as to whether information costs and switching costs "foil the simple assumption" that aftermarkets discipline basic equipments markets, so that parts, service, and equipment as a whole are competitive.

C. Lock-in

While pending before the Supreme Court, numerous groups and organizations filed amicus briefs on behalf of both Kodak and the ISOs./21/ In particular, the government purchasing agencies argued that the lock-in theory was particularly plausible in this context because the initial outlay for Kodak equipment is necessarily so substantial, resulting in consumers being locked into the basic equipment purchased.

Furthermore, these amici pointed out that most government agencies are required to use competitive bidding to purchase equipment, which can enable a manufacturer to recoup any losses on its low bid for the basic equipment by charging more for service than ISOs after the government entity is locked-in to the manufacturer's basic equipment, whether photocopiers, computers, or any other high technology that requires significant capital investment./22/

For example, in the 1980s, tens of thousands of U.S. companies invested hundreds of thousands to millions of dollars each in minicomputers to run applications software packages that had been customized, sometimes at great expense, for their companies. These application software packages were "proprietary" to the operating system for the specific manufacturer's minicomputer, meaning they would not run on the operating systems of other manufacturers' minicomputers.

If the manufacturer increased the customer's costs significantly for any aspect of ownership or maintenance for the minicomputer system, the customer must decide whether to pay the increased costs or switch to another manufacturer's computer system. "Switching costs" are perhaps the single most important factor in determining whether a customer is "locked-in," or may migrate to another computer system to avoid the increase cost. There are substantial costs associated with migration. As a result, although many companies discuss migration, as a percentage, relatively few have actually completed a migration to another platform.

For example, for minicomputers, migration costs can include, without limitation, the following categories:

  • fees for consultants to determine the appropriate replacement for the existing computer system;
  • costs for conversion of existing applications software or a new applications software package; and
  • training of personnel on the new hardware; and risks of loss of data in conversions from the old system to the new system.

In circumstances where the consumer has owned his minicomputer for many years and believes he has obtained a sufficient return on his investment, he will be less "locked-in" to his existing platform when faced with these switching costs. In contrast, the consumer who has made the investment in a system some shorter period of time before the manufacturer imposes a new cost of ownership will more likely bear the increased costs of ownership rather than the significantly greater migration costs, which most likely will be comparable to his recent acquisition costs. Thus, the consumer who has had less economic use of his system will be more "locked-in," permitting the manufacturer to impose an increased cost for service or some other component of ownership.

similar manner, while any lawyer has the theoretical alternative of becoming a doctor, in reality one must question whether or not that is a reasonable alternative. To become a doctor, a lawyer would have to give up his or her practice (and income), perhaps defer or service existing student loans; apply to medical school; complete a residency; and at the end of seven or eight years would be a doctor. Thus, while it may be an alternative, and while it may occasionally happen, the two professions are not reasonably interchangeable because of switching costs, and many lawyers are "locked-in" to the legal profession.

right 1997 by the American Law Institute. Reprinted with the permission of the American Law Institute-American Bar Association Committee on Continuing Professional Education. All rights reserved.

Brieant is a partner at Coudert Brothers, resident in the San Francisco office, whose practice focuses on competition in aftermarkets. Mr. Schmidtberger is a senior associate in Coudert Brothers' litigation department in the Paris office. Coudert Brothers began representation of the Kodak plaintiffs in connection with the appeal in the U.S. Supreme Court, with the plaintiffs' original counsel.

FOOTNOTES

1/112 S. Ct. 2072 (1992).

A tying arrangement violates Section I of the Sherman act if the seller has "appreciable economic power" in the tying product market and if the arrangement affects a substantial volume of commerce in the tied market. Fortner Enters, Inc. v. US. Steel Corp., 394 U.S. 495, 503 (1969). Market power, in turn, has been defined as the power to "force a purchaser to do something he would not do in a competitive market." Jefferson Parish Hosp. Dist. No. 2 v. Hyde, 466 U.S. 2, 21-22 (1984).

Kodak based that argument on Continental T V. v. GTE Sylvania, 433 U.S. 36 (1977), a case that held that any limitation on competition between retailers and a manufacturer (intrabrand competition) is counterbalanced by competition among manufacturers of the same product (interbrand competition).

2/Kodak 112 S. Ct. at 2086.

3/Kodak, 112 S. Ct. at 2087.

The Court noted the ISOs' offer of proof to the effect that certain parts are only available through Kodak; Kodak exerts control over the parts it does not manufacture; Kodak has prohibited independent manufacturers from selling Kodak parts to ISOS; consumers have switched to Kodak service even though they prefer ISO service, which was often better and cheaper; and ISOs have been driven out of business as a result.

4/Kodak, 112 S. Ct. at 2084.

5/Kodak, 112 S. Ct. at 2082.

6/Kodak, 112 S. Ct. at 2085.

7/Id. The Court further noted that Kodak never asserted that it prices its equipment in a subcompetitive manner; and that such an assertion would be inconsistent with its parts pricing for those customers who are self-maintainers, and thus not in competition with Kodak.

8/Id.

9/Id.

10/The Court recognized that a potential consumer would need information regarding price; quality; availability of products necessary for operation, upgrades, or enhancements; service and repair costs; estimates of breakdown frequency; nature of repairs; price of service and length and cost of "down-time." Id.

For example, customers who purchased Kodak photocopiers or micrographics equipment in 1983 could not have foreseen that Kodak would change its spare parts policies in 1985 to eliminate the option of less expensive third-party maintenance.

11/The court identified two incentives for competitors with such information not to disclose it to potential consumers. First, informing consumers would force the competitor to forgo supracompetitive prices in its own services market. Second, any increased sales in equipment will be shared among all other competitors. Kodak, 112 S. Ct. at 2086 n.2 1.

12/Id. at 2086.

13/Id.

14/Id. The Court further noted that Kodak never asserted that it prices its equipment in a subcompetitive manner; and that such an assertion would be inconsistent with its parts pricing for those customers who are self-maintainers, and, thus, not in competition with Kodak.

15/Kodak, 112 S. Ct. at 1087. An amicus brief by the Independent Auto After-Market Associations concluded that consumer perceptions are immune to all but the grossest, sustained disparities in long-term maintenance costs. Brief of Independent Auto After-Market Associations in Support of Respondent at 8.

Under that scenario, Kodak might charge new customers low equipment prices and recover the difference in service; or offer packages with lifetime warranties or long-term service agreements that are not available to locked-in customers.

On behalf of Kodak, some amici included, among others, the Solicitor General; the Motor Vehicle Manufacturers Association of the United States, Inc.; the Association of International Automobile Manufacturers, Inc.; and the Computer and Business Equipment Manufacturers Association. On behalf of the ISOS, some amici included, among others, Computer Service Network International, an organization of over 400 ISOS; the California State Electronics Association; State Farm Mutual Automobile Insurance Company, representing the nations principal automobile insurers; Public Citizen, a nonprofit public interest organization; the National Association of State Purchasing Officials; the National Institute of Governmental Purchasing, Inc.; and Bell Atlantic Business Systems Services, Inc., the world's largest ISO for computers.

16/In support of this argument, the court relied upon Jefferson Parish Hospital District No. 2 v. Hyde, 466 U.S. 2, 27 (1984) (market imperfections, coupled with a share in a market that is below monopoly power, may be sufficient to create market power); Fortner Enterprises v. US. Steel Corp., 394 U.S. 495 (1969) (not every customer need be affected).