What is Tying?
Tying or a “tie-in” is an agreement to sell one product (“tying good”) on the condition that the buyer also purchases a different product (“tied good”).[1] This agreement can take the form of an explicit contract or it can be non-contractual as a de facto (i.e., actual) consequence of the manufacturer’s product design or sales decisions. For example:
- A franchisor may choose to explicitly bind its franchisee to purchase certain supplies and inputs from the franchisor itself. In this case, the franchise license (tying good) is tied to the supplies (tied good). For example, in Siegel v. Chicken Delight a chicken franchise was sued by one of its franchisees for tying the franchise license to the purchase of cookers, fryers, mixes, and paper product supplies such as the kits and buckets in which chicken meals are sold.[2]
- Prior to 2004, Visa and MasterCard explicitly tied merchants’ acceptance of their respective credit cards (tying good) to acceptance of their respective signature debit cards[3] (tied good).[4]In a 2006 U.S. Supreme Court case, Illinois Tool Works explicitly tied the purchase of print heads used in the stamping of barcodes to the purchase of ink.[5]
- Video game companies like Sony, Microsoft, and Nintendo de facto tie the purchase of game consoles to the purchase of their respective games since their consoles will not operate other companies’ games.
- Apple, through its digital rights management technology, de facto ties its iPod music player to music purchased online from its iTunes music store. In addition, until April 2007, Apple also went the other direction and fully tied purchases online from its iTunes music store to its iPod music player.[6]
Potential Economic Harm from Tying
The typical harmful or anticompetitive scenario associated with tying is a leveraging scenario involving market power in the tying good. The concern is that a manufacturer with strong market power in product A (tying good) will tie it to product B (tied good), in which the manufacturer has no market power, thereby leveraging market power from product A to product B. If this leveraging effect is significant it may shut out or “foreclose” otherwise viable competition in B, resulting in higher prices and consumer harm. This could map into business costs in different ways, including lengthy and expensive litigation, negative antitrust judgments, and adverse consumer perception.
This type of claim was made against Kodak in 1987 by independent service organizations (ISOs).[7] The ISOs claimed that Kodak illegally tied the sale of its copiers (A) to the service of those copiers (B) by instituting a rule in which replacement parts would only be made available to buyers who either serviced their machines through Kodak or self-serviced their machines. The ISOs claimed this practice foreclosed them from the service market, effectively giving Kodak a service monopoly and violating antitrust laws.
The leverage theory has also been employed to explain how a manufacturer may maintain a monopoly in product A by tying the purchase of product B, foreclosing competitors in B that may become future competitive threats in A. This type of claim was made in Microsoft III,[8] an antitrust lawsuit filed by the government in 1998. The government claimed that Microsoft tied its dominant Windows operating system (A) to its inferior Internet Explorer web browser (B) in an effort to foreclose the dominant web browser of the time, Netscape Navigator, believing them to be a future competitive threat to the monopoly power its Windows platform enjoyed. Microsoft lost the case and, originally, was to be broken up into two separate companies, one selling operating systems and another that would sell program applications. Although the company avoided the break up on appeal and subsequent settlement, the tie-in decision risked a significant potential business cost.
The leverage theory appeared in the court system well before any formal economic analysis. In the mid-1900s, the leverage theory was attacked by the Chicago School of economic thought and efficiency- and revenue-maximizing justifications were analyzed. Currently, the leverage theory is viewed as a valid concern both legally and economically under certain market conditions (although not necessarily identical conditions).[9]
Tying or a “tie-in” is an agreement to sell one product (the “tying good”) on the condition that the buyer also purchases a different product (the “tied good”).
Efficiency- and Revenue-Maximizing Reasons for Tying
In addition to potentially monopolistic or anticompetitive reasons for tying, there are also efficiency- and revenue-maximizing reasons for tying that are non-monopolistic in nature and can be beneficial to the company and society.
1. Lower transaction costs
In certain situations, tying can lower the transactions costs of doing business. Simply put, it is more cost-efficient to sell some products together as a package. Selling an automobile with the seats, tires, and batteries pre-installed saves the company the transaction costs of installing a potentially different type for each consumer, and saves the consumer the transaction costs of installing their own.
If the majority of consumers value an automobile without pre-installed seats, tires, and batteries, the competitive market will adjust.[10] However, in this circumstance consumers reveal through the market that they tend to prefer these products sold together as a tied package or bundle, due in part to the reduced transaction costs. Many competitive companies engage in this type of tying and it is non-monopolistic.
2. Protect product quality and prevent customer confusion
Tying can be a method by which a seller prevents customer confusion and/or protects product quality. This type of situation is most commonly seen when product A is used complementary to product B (e.g., copiers and paper, printers and ink cartridges, etc.). The manufacturer may be able to protect its quality and brand name by tying the sale of A to B. This would have value to the manufacturer and overall social value if consumers used an inferior product B, resulting in an overall product A&B that performs at a less-than-optimum level. If this occurs, and consumers do not know the exact reason for the poor performance, they may blame the manufacturer of A when the poor performance was due to an inferior B. Preventing manufacturers of inferior B from free-riding on brand A would prevent customer confusion and enhance brand quality.
Franchisors frequently claim the need to tie the use of the franchise license to the purchase of supplies in order to prevent a franchisee from attempting to lower its costs by using inferior supplies from a low-quality seller. If this results in a poor customer experience it is likely to negatively impact the impression of the overall brand rather than be confined to the franchisee’s single store.[11]
This type of claim was also recently proffered by Visa with respect to credit card and signature debit card acceptance. The concern was that a merchant may be able to free-ride on the Visa brand name by displaying the Visa flag in its window but yet not accepting the full range of Visa products, namely Visa signature debit. If this confuses a customer at the point-of-sale, it may impose a negative impact on the Visa brand even though the decision to not accept Visa signature debit was made unilaterally by the merchant. This type of tying to enhance quality or prevent confusion and free-riding is profit-enhancing to the firm, socially beneficial, and non-monopolistic.
3. Accomodate low- and high-intensity usage consumers
Tying is frequently used as a method by which a seller price discriminates between customer types. This type of tie is referred to as a metering or requirements tie.[12] It generally occurs in the context of an aftermarket, where a consumer makes an initial purchase of product A and then can make repeat purchases of a complementary product B. A common example is that of printers (A) and ink cartridges (B). If the printer company engages in a familiar cost-plus markup strategy, then the high-cost printer will have a relatively high price and the low-cost ink cartridge will have a relatively low price.
The idea behind price discrimination in this context is that consumers tend to have different intensities of printer usage. High-intensity usage consumers tend to print large volumes and have a high willingness-to-pay while low-intensity usage consumers tend to print small volumes and have a low willingness-to-pay. Thus, the manufacturer can increase revenue relative to a cost-plus markup strategy by lowering the price of the initial, one-time purchase printer and raising the price of the aftermarket, repeat purchase ink cartridge. In this way, the ink cartridge becomes the mechanism by which consumers’ intensity of usage is metered, inducing high-intensity users to pay a higher overall price for printing services and low-intensity users a lower overall price. This basic idea holds for a variety of other aftermarket situations: razors (A) and razor blades (B), video game consoles (A) and video games (B), and Illinois Tool Works print heads (A) and ink (B).
Although the name “price discrimination” sounds unpleasant, it is revenue-maximizing for the firm and, economically speaking, it is typically viewed as either welfare-enhancing or socially benign since it generally results in lower prices for a significant group of consumers (the low willingness-to-pay or price-sensitive consumers) and often increases production output.
Legal History of Tying
The legal origins of tying have their roots in patent cases. In 1917, the U.S. Supreme Court decided a case in which Motion Picture Patents Co., a movie projector company, tied the sale of movie projectors to the films to be exhibited by the purchasing theaters.[13] When a theater ignored this restriction and exhibited unauthorized films, Motion Picture Patents Co. sued for patent infringement. Although the case was decided from a patent infringement perspective, it led to the monopolistic leverage theory of tying.
By the 1940s, the leverage theory had begun to reach its pinnacle as evidenced in two U.S. Supreme Court rulings. In International Salt, [14] a salt company tied the lease of salt injection machines to the purchase of salt for use in the machines. The significance of this case is that the Supreme Court established tying as per se illegal. This essentially meant that tying would be viewed as inherently illegal, without any regard for the circumstances in which it occurs, which stands in contrast to the less stringent “rule of reason” illegality, in which the circumstances and any potential efficiency justifications (like those mentioned above) are considered in addition to any possible harm. Two years later in Standard Oil, the Court further ensconced a harsh notion of tying, stating, “Tying agreements serve hardly any purpose beyond the suppression of competition.”[15]
By the 1980s, the Chicago School’s attack on the leverage theory, as well as analyses of potential efficiency and revenue justifications for tying, had begun to show an effect in the legal realm. In Jefferson Parish,[16] a hospital entered into an exclusive service contract with a specific anesthesiology group, effectively tying its surgical services to specific anesthesiology services. A foreclosed anesthesiologist, Dr. Edwin C. Hyde, sued the hospital for violation of antitrust laws via an illegal tie. The U.S. Supreme Court upheld the per se illegality of tying, subject to certain restrictions, the most important being sufficient market power in the tying good (otherwise there is nothing to leverage).[17] The decision was close at five to four. The majority opinion stated, “It is far too late in the history of our antitrust jurisprudence to question the proposition that certain tying arrangements pose an unacceptable risk of stifling competition and therefore are unreasonable ‘per se.'”[18] However, growing acceptance of alternative explanations for tying was evidenced in Justice Sandra Day O’Connor’s opinion in which she argued for a rule of reason, stating, “The time has therefore come to abandon the ‘per se‘ label and refocus the inquiry on the adverse economic effects, and the potential economic benefits, that the tie may have.”[19]
Recent Tying Decisions
The tides are changing with respect to legal and economic views of tying. Recent cases show the pervasiveness of efficiency- and revenue-maximizing reasons for tying and a movement away from per se illegality to that of a less stringent rule of reason.
In 2001, the D.C. Circuit Court of Appeals refused to apply the per se rule to Microsoft’s tie of its Windows operating system to its Internet Explorer browser in Microsoft III. The Court recognized the potential role of tying efficiencies, stating, “Firms without market power have no incentive to package different pieces of software together unless there are efficiency gains from doing so,” and “there may also be a number of efficiencies that, although very real, have been ignored in the calculations underlying the adoption of a per se rule for tying.”[20] However, the Court also cautioned that its opinion should not be broadly interpreted.[21]
In 2003, U.S. District Judge John Gleeson ruled against Visa in summary judgment on all four required elements of the per se rule of an illegal tie of credit card acceptance with signature debit card acceptance in In re Visa Check. Under a strict per se standard, this would mean Visa was guilty of an illegal tie. However, he then refused to apply the strict per se rule of old and ordered a trial on one additional element: whether there was actually a harmful “foreclosure effect” in the debit card market.[22] Thus, the judge effectively sidestepped the strict per se rule and applied a rule of reason.
In 2006, the Supreme Court provided what was for many antitrust scholars and practitioners a very telling clue about the future of the per se rule of tying antitrust enforcement when, in Illinois Tool, the panel stated, “Over the years, however, this Court’s strong disapproval of tying arrangements has substantially diminished,” while also overturning prior precedent that a patent in the tying good necessarily implies a sufficient measure of market power.[23]
The new Supreme Court, headed by Chief Justice John Roberts, has decided seven antitrust cases in its first two terms. All seven cases have been decided against the plaintiff alleging harmful anticompetitive conduct and in favor of the defendant company engaging in the conduct.[24] Thus far, the Roberts Court has revealed an increased propensity toward the free-market relative to its predecessors. In addition, Illinois Tool was a unanimous decision. Thus, there is consensus when the Court states that its strong disapproval of tying arrangements has substantially diminished.
Economic research touting likely efficiency justifications and limiting the leverage theory has worked its way up the legal food chain. Today, many antitrust scholars believe the Supreme Court’s decision in Illinois Tool, along with recent lower court decisions, like those in Microsoft III and In re Visa Check, signal the beginning of the end of the per se rule and the forthcoming ushering-in of the less-stringent rule of reason.[25] Many believe the Supreme Court will overturn the per se rule against tying at the very next opportunity.[26] In addition, tying is not mentioned as a per se offense in recent Supreme Court cases.[27]
Business Implications
In the actual business world, a tie-in arrangement is rarely neatly and cleanly sorted solely into one of the two main categories discussed: (1) creating or maintaining monopoly power or (2) maximizing efficiency or revenue. The aforementioned examples of tie-in arrangements in franchising, credit cards, barcode print heads, iPods and iTunes, and operating systems and browsers all had parties on both sides of the aisle, some fighting against the tie-in arrangement as anticompetitive and some fighting for the tie-in arrangement as efficiency-improving. Therefore, the real-life managerial decision-making process for tie-in arrangements requires consideration and analysis of the potential positives and potential negatives.
At some point in time, a manager or group of managers at Visa undertook this process and made the strategic decision to explicitly tie merchant acceptance of credit cards to acceptance of signature debit cards. Those at Apple undertook this process and made the strategic decision to de facto tie the sale of the iPod toonline music purchases at iTunes. Since then, both companies have faced expensive antitrust litigation with the threat of triple damages as a direct consequence of their decisions. In fact, Visa was under the threat of an extremely large monetary damages judgment and settled its case for the “small” amount of $2 billion (MasterCard settled for $1 billion).[28] Thus, one can see the potential value in a complete and thorough evaluation of a tie-in arrangement before the decision is made.
In considering any potential tie-in arrangement, a forward-looking, strategic-thinking manager should, among other things, gather information, consider the economic and legal landscape, and weigh his/her beliefs about the likely benefits as well as the potential costs of expensive litigation and negative antitrust judgments. More complete information about the economic and legal landscape of tie-in arrangements will aid in making the optimal decision, and that is what this article hopes to provide.
Conclusion
It is clear that the legal and economic considerations of tie-in decisions have evolved over the past century and, particularly, in more recent years. The evolution and development of this issue has direct financial implications for today’s business managers. Courts of late have shown a willingness to discount the per se standard on tying and, under an effective rule of reason, consider other justifications that economists have often shown to be both viable and probable.
The historical trend indicates that tie-in arrangements that can be supported by arguments of efficiency factors that improve the company’s bottom line without harming social or consumer welfare may well stand on firm legal footing with positive support from economic considerations. However, tie-in arrangements that cannot be supported adequately by these arguments may expose the company to costly legal action, especially when the company is a dominant player in the tying good. This is accentuated by the fact that such legal action is subject to triple damages.
All product arrangement decisions must consider the typical risk/return factors inherent in all business decisions. In this case it is particularly important for the manager to fully evaluate a potential tie-in arrangement, consider the legal and economic environment, anticipate future financial benefits and costs, and minimize the risk exposure for the company.
[1] An agreement that does not require the buyer to purchase the tied good ,but requires that the buyer not purchase the tied good from any other supplier is also considered a tie. See Northern Pacific Railway Co. et. al. v. United States, 356 U.S. 1, 5-6 (1958).
[2] Siegel v. Chicken Delight, Inc., 448 F.2d 43 (1971). For another example, see Krehl v. Baskin-Robbins Ice Cream Co., 664 F.2d 1348 (1982).
[3] Signature debit is a transaction in which a consumer uses a debit card and authorizes transactions with a signature. This is distinct from PIN debit in which a consumer uses a debit card and authorizes by entering a PIN number on a PIN pad. Signature debit is processed as a Visa or MasterCard transaction. PIN debit is processed by one of the “bug” networks on the back of the debit card. Visa and MasterCard charge the merchant higher transaction fees than the “bug” networks.
[4] The Garden City Group, Inc., Visa Check/MasterMoney Antitrust Litigation, http://ww.inrevisacheckmastermoneyantitrustlitigation.com/. (no longer accessible).
[5] Illinois Tool Works v. Independent Ink, Inc., 547 U.S. 28 (2006).
[6] Donna Higgins. “Antitrust Suit Against Apple Over iPod, iTunes to Proceed,” Computer & Internet Litigation Reporter, 23, no. 9 (09/22/2005).
[7] Eastman Kodak Co. v. Image Technical Services, 504 U.S. 451 (1992).
[8] United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001) (en banc).
[9] For more information on the strengths and weaknesses of the leverage theory, see Michael Whinston, “Tying, Foreclosure, and Exclusion,” American Economic Review, 80, no. 4, (1990/09): 837-59; Dennis Carlton, Michael Waldman. “The Strategic Use of Tying to Preserve and Create Market Power in Evolving Industries,” The Rand Journal of Economics, 33, no. 2, (2002): 194-220; David Evans, Michael Salinger. “Why Do Firms Bundle and Tie? Evidence from Competitive Markets and Implications for Tying Law,” Yale Journal on Regulation, 22, no. 1, (2005).
[10] For example, in May 2007 Dell announced that it would begin selling computers preinstalled with the Ubuntu operating system (a version of Linux) instead of Microsoft Windows. Dell claims it made this decision based on “overwhelming feedback” on customer preferences. See “Dell to Offer Ubuntu 7.04,” Direct2Dell – The Official Dell blog, http://direct2dell.com/one2one/archive/2007/05/01/13147.aspx. (no longer accessible).
[11] Benjamin Klein, Lester Saft. “The Law and Economics of Franchise Tying Contracts,” Journal of Law and Economics, 28, no. 2, (1985/05): 345-61.
[12] Price discrimination via bundling is another method that is not discussed in this paper.
[13] Motion Picture Patents Co. v. Universal Film, 243 U.S. 502 (1917).
[14] International Salt Co. v. United States, 332 U.S. 392, 396 (1947).
[15] Standard Oil Co. v. United States, 337 U.S. 293, 305 (1949).
[16] Jefferson Parish Hospital Dist. No. 2 v. Hyde, 466 U.S. 2 (1984).
[17] While the modified per se rule was upheld, Jefferson Parish Hospital was found to lack sufficient market power in the tying good to have foreclosed competition.
[18] Jefferson Parish Hospital Dist. No. 2 v. Hyde, 466 U.S. 2 at 9 (1984).
[19] Id. at 35.
[20] United States v. Microsoft Corp., 253 F.3d 34 at 93-94 (D.C. Cir. 2001) (en banc).
[21] Id. at 95.
[22] United States District Court, Eastern District of New York. “April 1, 2003 Summary Judgment Order (denying defendants’ motions and granting in part plaintiffs’ motions),” Visa Check/MasterMoney Antitrust Litigation, http://www.inrevisacheckmastermoneyantitrustlitigation.com/summary.pdf. (no longer accessible). (2003): 2-10.
[23] Illinois Tool Works v. Independent Ink, Inc., 547 U.S. 28 at 35 (2006).
[24] For a total of fourteen in a row. See Einer Elhauge. “Harvard, Not Chicago: Which Antitrust School Drives Recent U.S. Supreme Court Decisions?” Competition Policy International, 3, no. 2, (2007).
[25] See Joe Angland, Susan DeSanti, Commissioner Pamela Jones Harbour, Jon Jacobson, Robby Robertson, Richard Steuer, Gary Zanfagna, Jim Wilson. “Symposium: What’s Next for the Supreme Court?” The Antitrust Source, 7, no. 2, (2007/12); David Evans. “Tying: The Poster Child for Antitrust Modernization,” in Antitrust Policy and Vertical Restraints, Robert W. Hahn (ed.) (Washington, D.C.: Brookings Institution Press, 2006). ; Jonathan Jacobson. “Challenges to Dominant Firm Exclusionary Conduct,” presentation, The Conference Board 2007 Antitrust Conference: Tying—Antitrust Law and Policy, (2007/03); Joshua Wright. “The Roberts Court and the Chicago School of Antitrust: The 2006 Term and Beyond,” Competition Policy International, 3, no. 2, (2007): 24-57.
[26] Id.
[27] Joe Angland, Susan DeSanti, Commissioner Pamela Jones Harbour, Jon Jacobson, Robby Robertson, Richard Steuer, Gary Zanfagna, Jim Wilson. “Symposium: What’s Next for the Supreme Court?” The Antitrust Source, 7, no. 2, (2007/12): 5.
[28] United Stated District Court Eastern District of New York. “June 4, 2003 Visa Settlement Agreement,” Visa Check/MasterMoney Antitrust Litigation, http://www.inrevisacheckmastermoneyantitrustlitigation.com/v_sa.pdf. (no longer accessible).
