David A. Argue has analyzed antitrust economics issues in numerous health care provider and payer sectors. He recently completed "Competition in Utah Health Care Markets," a study of market structures and contracting practices, including bundled discounting, in several health care services markets throughout Utah, on behalf of the Utah state legislature.

The PeaceHealth Standard for Bundled Predation and Recoupment

 A recent Ninth Circuit decision addresses standards for determining if bundled discounts are predatory. Bundled discounting is a pricing strategy in which a multi-product firm sells its products at a lower price if they are purchased as a bundle than if they are purchased separately. Bundled discounting is a common practice in the U. S. economy, including in the health care sector. In Cascade Health Solutions fka McKenzie-Willamette Hospital v. PeaceHealth, however, the plaintiff alleged that PeaceHealth engaged in predatory discounting to gain market power in primary and secondary hospital services. In PeaceHealth, the Ninth Circuit established a more rigorous standard for evaluating a theory of predatory bundled discounting than the Third Circuit had in LePage's v. 3M. The Ninth Circuit's decision also affirmed the price-cost test proposed by the Antitrust Modernization Commission (AMC). Faulty logic, however, led the Ninth Circuit to reject a recoupment standard, a critical second prong of the AMC's recommendation.

Typically, bundled discounts enhance consumer welfare by lowering prices and increasing output. Bundled discounting may be predatory, however, if a firm has market power in at least one, but not all, of its products and attempts to leverage that market power over other products. The additional market power ostensibly is created by weakening or eliminating rivals producing competing products. A test is needed to distinguish between harmful predatory bundled discounting and beneficial competitive pricing. A key element of a test for predatory pricing is whether price is below incremental cost. In a single-product context, price is simply the price charged to consumers of the product, but in a multi-product context, the appropriate price to use in the comparison is less obvious.

The "discount attribution" approach to measuring price, which the AMC recommended and the Ninth Circuit adopted, assigns the discount of the entire bundle to the competitive product. The fully-discounted price of the competitive product is then compared to the incremental cost of producing that product. Logically, this approach reduces a multi-product bundled discount to a single-product pricing strategy. An argument for using the discount attribution approach is that a multi-product firm with market power in a product would not normally discount its price below the monopoly profit-maximizing levels. Thus, the argument continues, any discounts on those products when bundled with a competitive product must be disguised discounts on the competitive product.

The Ninth Circuit refers to the primary alternative to the discount attribution standard as the "aggregate discount" rule. That rule counts the discount as a price reduction for the bundle as a whole and uses the price of the entire bundle in the price-cost comparison. Advocates of the aggregate discount rule argue that bundled discounts often reflect the efficiencies of a multi-product firm exhibiting economies of scope. Economies of scope in producing or distributing the bundle of products may cause a multi-product firm to have lower costs than a single-product firm. The discount attribution approach ignores these economies. In hospital services, in particular, economies of scope are important production characteristics and should not be overlooked.

The second element of predatory pricing is whether a predator could recoup its investment in predation. Because below-cost pricing necessarily results in short-run forgone profits, a rational firm will engage in predation only if it can recoup those forgone profits. Nonetheless, the Ninth Circuit refused to include a recoupment requirement in its analysis of predatory bundled discounting, reasoning that bundled discounts may be predatory without actually causing the predator to incur a loss. The Ninth Circuit failed, however, to understand that while a predator may have positive profits, any below-profit-maximizing prices that are part of a bundled discounting strategy will cause the bundler to forgo some profits that it would have earned without bundling. Those forgone profits must be recouped for predation to be rational.

The Ninth Circuit's rejection of a recoupment standard is particularly curious because the need for recoupment is clear when profits are analyzed in a fashion parallel to the court's discount attribution rule. An example used in the opinion can illustrate this point. Suppose Firm A produces shampoo and conditioner at incremental costs of $1.50 and $2.50, respectively. Competitors produce shampoo but not conditioner. Firm A sells shampoo for $3.00 and conditioner for $5.00, but it sells them bundled for $5.25, giving a $2.75 discount. The Ninth Circuit standard allocates that discount to the competitive product, yielding a price for shampoo of $0.25, well below incremental cost.

The recoupment question concerns whether Firm A's bundled pricing sacrifices profits. Firm A has a profit of $4.00 when it sells shampoo and conditioner separately and a profit of $1.25, or $2.75 less, when it sells them as a bundle. A profit attribution analysis would attribute the entire profit reduction of $2.75 to the shampoo. Firm A's profit on an unbundled sale of shampoo is $1.50, but its profit on a bundled sale of shampoo is negative, a loss of $1.25. Although the bundle as a whole is sold at a profit, the profit attribution test reveals the loss that must be recouped.

Much of the ongoing debate over how to distinguish between beneficial and harmful bundled discounts focuses on defining an appropriate measure of price to be used in a price-cost comparison. The Ninth Circuit's discount attribution approach has some logical appeal, although it inadequately accounts for economies of scope. The Ninth Circuit's failure to require a recoupment standard, in contrast, has no logical appeal and treats profits inconsistently with its treatment of discounts.

Additional Articles in Fall 2007 Issue of Economists Ink

New Applications for Consumer Research

The Supreme Court Establishes a Standard for Predatory Bidding

EI News and Notes