Jordan Grant

Econ 571

April 21, 2016

An Antitrust Analysis of

Conwood Company, L.P V United States Tobacco Company

Introduction

This paper is concerned with the case of Conwood Company, L.P (Conwood) V United

States Tobacco Company (hereinafter, referred to as USTC) and the antitrust violations of

concern within the case. By employing a rigorous economic analysis of the competitive effects

of the conduct at issue, it will be determined whether the actions of the firm are economically

justifiable. The defendant in the case was accused of monopolization and the attempted exclusion

of competitors. Aggressive practices to reduce the visibility of rival product included the illicit

targeting of rival product racks, and exclusive agreements that allowed the defendant a direct say

in the product placement of the competitor. However, while the defendant’s actions were out of

hand, there are some notable efficiency gains. Efficient pricing, the increase in profits and the

potential effects on health are a few to be aware of. In this discussion, it shall be shown that

while USTC’s behaviour was considerably indecent, the economic effects were beneficial and

this should be an example of when the law should produce revisions that are truly in the support

of social welfare.

Section I: Case Summary

The case summary will provide a detailed overview of the legal proceedings. Section I.I

will highlight the legal requirements of the case. Section I.II will review the allegations of the

plaintiff. Section I.III will comment on the case theory that the plaintiffs relied on and Section

I.IV will comment on the case theory of the Defendants. Finally, Section I.V will report on the

Decision by the ruling body and the Rationale behind that decision.

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Section I.I: The Legal Requirements for Conviction

The law requires that a party at fault for unlawful monopolization must possess

monopoly power in the relevant market or willfully attempt to increase or maintain market power

for anti-competitive purposes rather than in methods to improve the quality of the product. It

must be demonstrated that the defendant acquired or maintained market power by excluding

rivals and that these actions were enacted with the intention to eliminate competition.

The plaintiff must define the relevant market by considering the product and geographic

market. That in which, the consumer is able to easily substitute to another product within the

appropriate region based on the demand elasticity and available substitutes. In this way it can be

observed how the decisions of firms have impacted consumers. If it can be proven that the firm’s

behaviour was not to increase efficiency, then this can be assumed to be predatory behaviour.

This behaviour must not be confused with scale advantages that occur when firms are able to

achieve economies of scale due to size. However, when firms are able to raise price, this should

at least be considered as a sign that the firm has the ability to create, enhance or maintain market

power.

Single events could be considered under tort law if the action does not constitute a

substantial lessening of competition. What is of significance in antitrust regulation is that a

firm’s conduct substantially lessened competition or that the firm’s actions created, enhanced or

maintained market power. That is, the firm’s action either raised the rivals’ costs or hurt the

ability of the rivals to generate profit. If it can be established that the actions of a firm were of

this nature and not that of a general tort, then the case becomes an antitrust issue and will be

brought to the Federal Trade Commission for review.

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Section I.II: The Allegations of the Plaintiffs

The Plaintiff, Conwood, brought charges against the defendant, United States Tobacco

Company on the basis that USTC used their market power to exclude competition.

USTC stands accused of using its monopoly position by taking advantage of their

preferential product placement and abuse of competitor racks to exclude competitors from the

moist snuff market. USTC is to be charged for the following anti-competitive conduct (1)

Unlawful Monopolization, in violation of Section 2 of the Sherman Act1; (2) Violations of

Section 43(a) of the Lanham Act2; (3) Tortious Interference with contract; (4) Tortious

Interference with prospective advantage; (5) Violations of the Kentucky Revised Statute, Section

365.0503; (6) Product Defamation; (7) Unjust Enrichment; and (8) Conversion/Trover. In other

1 Section 2 of the Sherman Act: Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony, and, on conviction thereof, shall be punished by fine not exceeding $100,000,000 if a corporation, or, if any other person, $1,000,000, or by imprisonment not exceeding 10 years, or by both said punishments, in the discretion of the court.

2Section 43(a) of the Lanham Act: (a) Civil action (1) Any person who, on or in connection with any goods or services, or any container for goods, uses in commerce any word, term, name, symbol, or device, or any combination thereof, or any false designation of origin, false or misleading description of fact, or false or misleading representation of fact, which— (A)is likely to cause confusion, or to cause mistake, or to deceive as to the affiliation, connection, or association of such person with another person, or as to the origin, sponsorship, or approval of his or her goods, services, or commercial activities by another person, or(B) in commercial advertising or promotion, misrepresents the nature, characteristics, qualities, or geographic origin of his or her or another person’s goods, services, or commercial activities, shall be liable in a civil action by any person who believes that he or she is or is likely to be damaged by such act.(2) As used in this subsection, the term “any person” includes any State, instrumentality of a State or employee of a State or instrumentality of a State acting in his or her official capacity. Any State, and any such instrumentality, officer, or employee, shall be subject to the provisions of this chapter in the same manner and to the same extent as any nongovernmental entity.(3) In a civil action for trade dress infringement under this chapter for trade dress not registered on the principal register, the person who asserts trade dress protection has the burden of proving that the matter sought to be protected is not functional.

3 The Kentucky Revised Statute Section 365.050 Unfair trade practices: The secret payment or allowance of rebates, refunds, commissions or unearned discounts, whether in the form of money or otherwise, or secretly extending to certain purchasers special services or privileges not extended to all purchasers purchasing upon like terms and conditions, to the injury of a competitor, and where such payment or allowance tends to destroy competition, is an unfair trade practice, and no person shall resort to such trade practice.

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words; USTC acted as a monopolist in accordance with the Sherman Act; mislead consumers in

accordance with the Lanham Act; USTC orchestrated tortious activity that inflicted harm on

another party through contractual agreements and USTC potentially benefitted from that harm,

The Kentucky Revised Statute refers to engaging in exclusive deals that harm competition,

Product Defamation refers to communicated false statements with the intention to harm

reputation of competitor product, Unjust enrichment refers to profits that arise from costs

inflicted on a competitor, Conversion refers to a common law tort where a party takes advantage

of some property right, where they lack the appropriate property right.

Section I.III: The Case Theory of the Plaintiffs

The Plaintiff relied heavily on witness and expert testimony. The relevant market was

considered to be the moist snuff market in North America. Due to the addictive nature of the

product, product demand was very inelastic, and for a long period USTC was able to raise the

price of their products significantly while the output demanded increased. Conwood argued that

USTC abused its market power in the market of moist snuff. The efficiency concerns of the

plaintiff, observed how consumers were made worse off due to the actions of USTC, showing

that while output increased there was also a significant increase in price. The plaintiff argued that

the actions of the defendant hurt the rival (Conwood). It was noted that the industry experienced

growth, however that the growth of USTC’s competitors had been significantly slowed.

An expert witness used statistical methods such as a regression analysis and yardstick

comparison to prove the plaintiff’s claims. These tests indicated that in situations where alleged

misconduct occurred, there was an impact on the profit potential of the area and this effect was

not prevalent in situations absent of such conduct. As well, using other similar competitive

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processes as benchmarks, it was shown that there was an anticompetitive effect, which occurred

that was not present in other industries used as references. Cross comparisons were made

between regions in which Conwood held a strong foothold.

Section I.IV: The Case Theory of the Defendants

The defendant did not refute Conwood’s claims as to the market definition. Nor did

USTC deny the presence of their market power. However, USTC held that their actions were

competitive and not anti-competitive. USTC argues that the conduct amounts to no more than

sporadic torts and aggressive marketing strategy; that while they were able to secure exclusive

deals, increase prices significantly and act in many ways as a monopolist, their actions never

foreclosed competition. Some of the conduct at issue was demand enhancing rather than

predatory and allowed for more efficient shelf use that was one of the factors that lead to

industry growth. Some of the opportunities afforded to them in the distribution of moist snuff

product, were not exclusive. USTC refuted the claims of the expert witnesses hired by Conwood

on the basis of their bias. USTC claimed that the regression analysis was non-admissible on the

basis that the model was ‘not subject to ascertainable rate of error and has no basis in the

literature.’4 The courts did not affirm this argument.

Section I.V: The Decision by the Ruling Body and its Rationale.

The ruling body affirmed the allegations made by Conwood, that USTC, used its

monopoly position to substantially lessen competition. The courts believed that the evidence was

sufficient and found the argument; that but for USTC’s conduct, Conwood would have been able

to achieve a greater market share, to be persuasive. USTC’s actions were not isolated cases of

4 Conwood Co., L.P. v. U.S. Tobacco Co., 290 F.3d 768 (2002)

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harm against Conwood. For the attempt to exclude competition, the district court USTC was to

compensate Conwood $350,000,000 in damages for their misconduct. In the appeal courts, the

initial ruling held and the appellant’s claims against the initial case were denied.

Section II: The Economics of the Case

This section will discuss the relevant Economic theory needed to assess the evidence in

this case. Section II.I will define market power and its relevance in antitrust. Section II.II will

comment on the purposes of antitrust. Section II.III will speak to market definition and the

relevant market. Section II.IV explains the Vertical Pricing Externality and Exclusive Dealing.

Section II.V provides a brief economic analysis of Cheap Exclusion. In Section II.VI, there will

be a brief introduction to Health Economics and to conclude, Section II.VII will review an

important economic concept known as Pareto Efficiency.

Section II.I: Market Power

Market Power is the ability of a firm to raise price or to influence other factors that will

allow the firm to make excess returns beyond competitive levels, where competitive levels are

considered to be Long Run Average Costs rather than Short Run Marginal Costs. The ability to

exercise market power is constrained by demand substitution and supply substitution; where

demand substitution reflects the availability of next best alternatives for consumers to switch to

and the desirability of substitution, and where supply substitution reflects the desire and ability

that competing firms can cover a shock in supply should a firm, attempting to exercise market

power, restrict its output. A high willingness and ability of firms and consumers to change their

behaviour will determine the market power of a firm. If a firm raises price hoping to increase

profits, and consumers substitute or refuse to purchase, thus incurring losses on the marginal

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units in excess of the gains on the inframarginal units, the firm will not have exercised market

power (this effect can be measured by the Elasticity of demand). Likewise if the firm restricts

output to raise price and other firms can cover the supply, the firm will not be able to increase

price and thus is unable to exercise market power (this effect can be measured by the Elasticity

of supply).

Firms and their agents are purposed with the goal of profit maximization. If a firm can

exercise market power, the firm will do so. This can create an issue in markets where product

demand is inelastic. As demand elasticity decreases, the firm has more incentive to price higher

as the effectiveness of natural restraints such as competition, or changes in consumer behaviour

is reduced. This can lead to excessively high pricing, and in many cases it is very difficult to

determine what the right level of controls should be, to ensure that consumers are not exploited.

These restraints are crucial as firms are aggressive in their pursuit to maximize profits. New

entrants will join markets where there are excess returns until all excess returns are exhausted. In

most cases, it can be assumed for any particular action that a firm undertakes, there is no possible

alternative that would yield a higher payoff, (otherwise the firm would have taken on that

alternative option). Firms will always attempt to increase profits and will only take on actions

that may increase costs if this increases profits in the future. Likewise firms will not attempt to

be exclusionary unless, their actions are economically justifiable.

Consideration must be had that a firm’s goals to make more profits is not an economic

problem. Economic problems arise from inefficiency and deadweight loss. If firms are able to

raise price profitably, without increasing deadweight loss, then their actions may be

economically justifiable. Likewise if a firm is able to create efficiencies that reduce costs and are

more profitable for those involved, this may be beneficial. The cases where firm’s actions

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generate deadweight loss, require observation; restraints and punishment may also arise as

necessary responses if these actions are found to be abusive and lead to inefficiency.

Section II.II: Antitrust

Antitrust is the set of rules and legislation that have been developed to restrain the ability

of firms to exercise market power, by promoting a competitive market. In the United States, the

Federal Trade Commission or the United States Department of Justice oversees antitrust cases.

Agencies of the antitrust are tasked with investigating anti-competitive behaviour that

substantially lessens competition. To be specific, cases that create, maintain and enhance market

power. The exercise of market power itself is not sufficient to warrant antitrust violation as

antitrust law is aimed at cases where the conduct of a firm, raised rival’s costs or impacted rivals

potential for revenue. Competition is attractive to this body, as it is commonly believed that

competition is the most effective manner to encourage firms to act efficiently; driving down

prices, reducing deadweight loss and increasing consumer surplus. As a result, the cases that are

put under the scrutiny of competition law, involve monopolization, mergers and price fixing;

where conduct goes beyond attempts to increase own product quality or firm efficiency, and may

involve tortious activity to impact rival product costs. Antitrust violations employ a triple-

damages policy that encourages competing firms to bring these cases to court and acts as a

deterrent to firms who have considered using anti-competitive behaviour to increase long run

profits.

Section II.III: Market Definition

In antitrust law, the first step is to adequately define the relevant market. This task is

known as market definition. The market definition is developed by considering the relevant

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product and geographic markets and deciding whether the defendant possesses market power.

“Geographic market” is defined as area of effective competition, the locale in which consumers

of product or service can turn for alternative sources of supply5. The evidence in this case should

identify the products that consumers would be willing or able to substitute to in defining the

relevant market. Products that are “reasonably interchangeable by consumers for the same

purposes.”6 This is usually considered through the Hypothetical Monopolist Test. It is important

to be thorough in the analysis of market definition, as markets being improperly defined will

significantly impact the result and most likely lead to errors.

The Hypothetical Monopolist Test7 is an economic test used to identify a relevant market;

by observing a Small but Significant Non-Transitory Increase in Price (SSNIP), would the firm

be able to increase profits? If it would not be profitable, then this means that the market is too

narrow and should be expanded to include other products; this would indicate the ability of

consumers to substitute to other products if the firm were to raise price. If it is profitable to

administer the SSNIP then the market is accurately defined. For if a firm could adequately raise

prices profitably, this would suggest an inability for consumers to substitute, and that within the

relevant market, for which the firm has control over a set of products, the firm would be able to

exercise market power.

5 Conwood Co., L.P. v. U.S. Tobacco Co., 290 F.3d 768 (2002)6 Du- Pont Cellophane: In this case, there was a market definition problem where the market was defined to be too broad, because the judge had erred in realizing that the SSNIP was not profit maximizing at prevailing levels as the monopolist had risen prices to the elastic section of the demand curve. This error has been referred to as the cellophane fallacy, and the reasonable interchangeability clause created to avoid it in the future. 7See Section 1.0. The 2010 U.S. Horizontal Merger Guidelines discuss application of the HMT to the product and geographic dimension individually. See Section 4.1.1 (product) and Sections 4.2.1 and 4.2.2 (geographic). The HMT is also defined in the ACCC’s Merger Enforcement Guidelines: “ The HMT determines the smallest area in product and geographic space within which a hypothetical current and future profit-maximizing monopolist could effectively exercise market power. In general, the exercise of market power by the hypothetical monopolist is characterized by the imposition of a small but significant and non-transitory increase in price (SSNIP) above the price level that would prevail without the merger, assuming the terms of sale of all other products are held constant

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Section II.IV: Vertical Pricing Externality and Exclusive Dealing

In markets with an upstream producer and a downstream retailer, there is an issue that

arises of a vertical pricing externality. This externality is derived from the inefficiencies that are

developed when two firms with similar but uncoordinated objectives attempt to profit maximize

without considering the impact on the other firm. This is known as double marginalization,

where two firms that are vertically aligned derive their profits separately, which causes these

firms to produce at their own profit maximizing condition rather than a coordinated solution that

generates more profits in total. Through vertical integration or coordinated behaviour the cost

increase due to this misalignment in firm objectives can be diminished. This may lead firms to

transact through exclusive deals. Exclusive dealing can be defined as a contractual requirement

by which retailers or distributors promise a supplier that they will not handle the goods of

competing producers8 (2012, p. 11). Exclusive dealing can also take the form of an agreement that

gives exclusive permissions or uses of services to a contracted party. While the act itself of

exclusive dealing does not solve the vertical pricing externality, the resulting contract involves

some exchange that is mutually beneficial to both parties and could potentially result in cost

savings in some form. The double marginalization effect that arises by firms, individually

determining the profit maximizing price and output, will be negated by successfully aligning

firms’ objectives through vertically integrating the firms.

This exclusive dealing, on face value, can increase the opportunity for an upstream firm

to exercise market power. The firm, who is able to secure the exclusive agreement, has the

8 Joseph Mahoney and David Crank. 2012. Vertical Coordination: The Choice of Organizational Form. University of Illinois. p.1-24

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ability to make excess returns, by reducing the competitive nature of the product and foreclosing

competition. At the same time the conduct can increase efficiency, and be beneficial to

consumers, manufacturers and downstream retailers. This makes it tricky to control; there are

incentives for firms to benefit from taking advantage of an exclusive contractual arrangement.

Cost savings also arise as the outsourcing of the role to the manufacturer, reduces costs in the

downstream, which gives downstream firms the ability to reduce prices for consumers. The

Chicago Critique of Exclusive dealing9 affirms that the efficiency gains must be sufficient to

cover deadweight loss, thus making both parties better off. In this case, the efficiency is created

through the reduction in costs that the downstream retailer can pass on to the upstream

manufacturer. The downstream cannot hire category captains for each product that they offer in a

cost efficient manner; by reducing costs, hiring less category captains, they also reduce the

profitability of product placement, likewise if they are to hire the optimal amount of labour to be

effective in placing product, there will be an impact on profits as labour costs will rise. In this

case it would be beneficial to place the responsibility of category management on the upstream

producer, while the upstream producer will have an incentive to prioritize the success of their

own product, they also have a constraint in that if their actions cost the downstream firms more

than the benefit that is created, then the downstream firm can and will promptly change to the

next best opportunity. The incentives cannot be achieved without efficiencies and vice versa.

Therefore it must be decided whether in this case anticompetitive behaviour, may be efficient

and preferred to the mandate of the competition enforcement agencies.

9The Chicago Critique of Exclusive Dealing states: Exclusionary agreements cannot be imposed on buyers rather they have to agree and they will only agree if they are not made worse off. In this view of the world buyers should be able to anticipate if agreeing to an exclusionary contract increases the market power of a seller and if that means the price they pay will increase, or they are otherwise harmed, they will not agree to the exclusionary agreement without compensation. Compensation is only profitable for the seller if there are efficiencies attributable to exclusive dealing. Consequently, exclusive agreements are never entered into to create, enhance, or maintain market power. They are entered into realize efficiencies.

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Section II.V: Cheap Exclusion

Cheap exclusion refers to two sets of practices; it includes actions that are low cost

efforts to exclude competition, and are very difficult to observe, as well as attempts to exclude

competition that are considered to have a slight impact; two definitions of the word Cheap that

reflect its use; to describe something being inexpensive, or, seemingly vulgar and unnecessary

conduct to achieve a desired outcome. In either case, cheap exclusion may lead to inefficiencies;

if a firm is able to exclude a competitor at a low cost, this increases their ability to exercise

market power, as well if the actions may not be economically justifiable then there could have

been a beneficial alternative use of the resources that was not realized.

Section II.VI: Health Economics

In microeconomics, there is a huge focus on the behaviour of firms, but in the larger field

of study, economics has applications in the social sphere and in health. Health economics, deals

with the efficiency of healthcare, social costs and methods of dealing with health concerns, and

achieving the optimal well-being for a people. As such, this branch of economics uses tools such

as taxes; to deter unhealthy behaviour, and allocating funding to improve the functions of the

healthcare system, such that people’s lives can be improved in the most cost-effective manner

possible. While not a focus of antitrust law, social welfare has always been a concern of

economists, especially in cases where there are health implications that governments can spend

excessive amounts for expensive initiatives.

Externalities are problems that arise from overconsumption and neglecting effects on

third parties. A good example of this would be if two parties contracted to build a statue that cast

a huge shadow. The shadow has an impact on a neighbour who highly values sunlight on their

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property. This would be considered a cost to the neighbour, however the third parties have

neglected it. If they had considered the impact on the third party they would have changed their

behaviour, and consumed less. Likewise, there are also internalities, where an individual may

neglect a cost they impose on themselves. In which case, reduced consumption would be optimal

for the individual.

The internality model (see fig 1) would include a high private marginal cost and a low

private marginal cost of consumption. In a competitive world, without intervention, the prices

will be driven to private marginal costs, as consumers’ demand the lowest price and firms are

forced to price down to marginal cost due to Bertrand competition. This creates an internality

that can only be eroded with taxes or higher prices that will shift the output demanded to the

optimal amount. Therefore, with government intervention or the exercise of market power, prices

may be raised to the appropriate levels. It may be difficult to find an efficient equilibrium in this

model; therefore, a tradeoff between deadweight loss and the externality may be necessary.

Section II.VII: Pareto Efficiency

Pareto efficiency is often considered to be the gold standard in economics in terms of

Efficiency. Pareto efficient outcomes refer to those in which no one can be made better off

without making one party worse off. Thus it can be seen why a Pareto efficient outcome is so

desirable. Potential Pareto improvements can refer to outcomes in which one party may be made

better off at the cost of the other being made worse off, however the net benefit is positive. In

this way, the winner can compensate the loser and still be a winner.

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Section III: Relevant Facts

Tobacco is produced in many forms, but they are typically distinguished in two types,

smoking and smokeless tobacco. Smoking tobacco product includes cigarettes, cigars, vapes and

more. Smokeless tobacco includes dry snuff, a powdery substance that is inhaled through the

nose, and moist snuff, a coarse grind of tobacco that is chewed between the lip and the gum and

spat out after use. The moist snuff product is of relevance in this case. All forms of tobacco are

likely to cause health issues; cancers of the lung may develop from smoking, gum cancer may be

caused from the consumption of moist tobacco. As well, all forms of tobacco are heavily

regulated in the means in which they are advertised. In many cases, the only form of marketing is

at the point of sale. Packaging and product shelf design are usually the major influencer in

consumer’s decisions. Price may also be a factor, however due to the addictive nature of the

product, consumer demand may be very inelastic and as such may not be very sensitive to price

increases. No evidence indicates cross-elasticity between tobacco products, however it should be

considered for market definition purposes. It is true that consumer preferences for moist snuff are

very specific. The demand for snuff is significantly less than that for cigarettes snuff makes up a

significantly smaller portion of the market.10

In 1911, the American Tobacco Company, sometimes referred to as the Duke Tobacco

Trust, was split up for antitrust violations in regards to monopolization; this lead to the following

spinoff firms; United States Tobacco Company, Helme, which later becomes Conwood

Company, and Swisher. These companies manufactured various tobacco products. However,

USTC became the single provider of moist snuff product since 1911 for more than 60 years. In

10 “Smokeless Tobacco: Health Effects”. CDC.CDC. April 6, 2016

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the 1970s, Conwood, which had been producing dry snuff, entered the market for moist snuff

product. USTC acted in many ways as a monopolist and as time progressed their actions

escalated to a point where there actions were clearly wrong.

From 1979 to 1999, USTC administered significant price increases of 8-10% on an

annual basis. USTC also benefitted from exclusive deals that they arranged with downstream

retailers. These deals involved the control of product placement through category management.

Category management has become increasingly popular with downstream firms, as it helps to

increase profits through better visibility. In many cases, the category manager role would be

outsourced, fully or partially, to upstream firms who were more informed about the product and

could therefore provide a more informed decision in terms of product allocation. In the 1990s,

more aggressive tactics were used; witness testimony and other evidence indicates that USTC

hired employees who were trained to infiltrate retailer outlets and sabotage product shelves with

permission from the retailer outlet. If permission was not granted or they were asked to stop, they

would use deceptive measures to achieve the task. These USTC employees would then break

down competitor shelves, and move product onto their shelves, which impacted the effectiveness

of Conwood’s Point of Sale advertising. Marketing, at the point of sale was considered to be the

major influencer in consumer decisions. The conduct was said to cost Conwood approximately

$100,000 per month to fix the racks and contributed to significant loss in sales. Economists refer

to this behaviour as cheap exclusion; inexpensive or vulgar attempts to exclude competition and

maintain monopoly rents. This included attempts (some successful, others were not) to negotiate

control over brand placement with downstream retailers, willful and repeated sabotage of

competitor product racks and the control over brand placement to directly increase their own

product sales at the potential detriment of competitors.

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Minor substitution did occur between products as USTC was able to raise price by 8-10%

at which, was met with a 1% fall in demand. USTC displayed significant market power in moist

snuff. Consumer Demand was inelastic and the firm was able to profitably raise price

significantly and repeatedly. Aggressive behaviour against competitor product racks and product

placement controls through the practice of category management, impaired the effectiveness of

Conwood’s marketing efforts as visibility was a major influencer in consumers’ decisions. USTC

stands accused of monopolistic practices by Conwood co. on the basis of Exclusive Dealing,

Category Management and Rack Interference. These actions were considered to be a form of

unlawful monopolization and potentially resulted in a substantial lessening of competition.

Exclusive dealing is the action of bargaining for preferential treatment that would not be

otherwise available to other competitors; it must be proven that there was an anticompetitive

effect that arose from the use of an exclusive deal in order for it to constitute an antitrust

infringement. Category Management is the practice of managing the allocation of product on

shelves in a manner that is most profitable for the retailer. Category Managers are the decision

makers in this process. A category manager is responsible for ensuring the most profitable

allocation of product; in some cases category managers are outsourced to the upstream firm. This

can lower costs in the downstream, as the downstream firm does not have to hire a category

manager of their own. It must be proven that the conduct of the category manager was anti-

competitive to constitute an antitrust violation. Rack interference refers to the process of

manipulating product racks in a manner that impacted sales; this could include actions of

sabotage against products, and product racks. It must be demonstrated that this action impacted

revenues of the rival’s product to constitute an antitrust violation.

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USTC bargained for preferential product placement and in some cases had a direct say in

the category management process. Other evidence suggested that USTC representatives

destroyed or manipulated competitor racks. These actions were considered anti-competitive

because they restricted consumer information sets. There were limited means of advertising as

tobacco companies were faced with significant marketing regulation. As a result product

visibility was a major influencer in a consumer’s decision. The conduct reduced the ability of

consumers to substitute. Conwood's expert witness, Dr. Leftwich, used statistical tests to test for

a significant reduction in Conwood’s sales. It was found that in areas in which the alleged

conduct occurred, there was evidence of the conduct having impacted sales.

The United States District Court for the Western District of Kentucky, affirmed the

allegations against USTC. Expert and relevant witness testimony verified these claims. USTC

denied that they had attempted to form an exclusive deal for category captain with downstream

retailers. However, this was later confirmed by Walmart to be true in that USTC had attempted

to arrange an exclusive deal to manage product placement within downstream outlets. USTC

appealed the original court’s verdict and the case was brought to the United States Court of

Appeals, Sixth Circuit11.

Section IV: The Case Analysis

Section IV.I discusses market definition in this case. Section IV.II discusses the barriers

to entry, the anticompetitive conduct at issue. Section IV.III, discusses market power. Section

IV.IV examines the case theory applied by the defendant and by the plaintiff. Section IV.V

11The Court of Appeals, Clay, Circuit Judge, held that: (1) there was sufficient evidence for jury to find willful maintenance of monopoly power;(2)there was sufficient evidence showing that plaintiff’s injury flowed from defendant’s anticompetitive activity; (3)district court did not abuse its discretion in determining that plaintiff’s expert’s methodology was sufficiently reliable or relevant;(4) there was sufficient evidence to support jury’s award of damages.

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argues the potential efficiency to be aware of and Section IV.VI concludes with an alternative

judgment for each of the charges brought against the defendant.

Section IV.I: Market Definition

The case did not implement the Hypothetical Monopolist Test, however through the

indirect approach, where we can use the evidence to imply that a SSNIP, would most likely pass

if we knew the pricing information, cross elasticities, etc. there was a small but significant price

increase of 8%-10%, (5%-8% is considered to be the standard) which was non-Transitory, that

being within a year. As the test would be passed then that means that moist snuff tobacco, should

be considered the relevant product market. However, would this behaviour change in any way if

USTC were able to control the price of other tobacco goods in the industry? Tobacco products

have very different characteristics than the average product. It is a product that consumers

become addicted to and have significant repeat uses. As well, there are substantial health issues

that develop, including a variety of cancers that arise from the method of consumption. Inelastic

demand and health concerns are some of the major factors that impact the industry and so using

this standard test may not work in this unique situation. The increases in price should be

approached differently in this case, due to the product characteristics highlighted above.

Section IV.II: Barriers to Entry

USTC’s contractual control over product placement and rack interference partially

impacted the ability for Conwood to compete.

Category Management was highly desirable to the upstream manufacturers. Given the

restrictions on advertising, product visibility was the major influencer in consumer’s decisions.

As such, firms were willing to pay for the Category captain. The downstream firms would have

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to employ a category captain to direct the placement of product to maximize profits. There were

two costs to be aware of here, the direct cost of hiring employees who could do a sufficient job

and the indirect costs of the captain’s performance, which required the captain to be extremely

knowledgeable of the product selection to be able to organize an arrangement of products that

would maximize profits in the downstream. If a downstream retailer were to insource category

management, then the retailer is at risk of increasing costs or suffering from loss in potential

sales. Therefore, it would be beneficial to a firm in the downstream to outsource the process to

the lowest cost option that would increase profitability. In this case, the best option for category

captain was USTC. USTC took on the costs of employing a category captain, and was

knowledgeable enough about the market to make the most profitable selection. One could argue

that USTC had a biased towards their own products, however if the cost savings for the

downstream retailer were less than the potential revenues generated by USTC, the retailers

would revert to hiring their own category captain, or Conwood could compete to be the category

captain if they could provide an even more profitable selection. If Conwood, could provide a

more profitable selection than USTC, that would increase the profits of Conwood and the

downstream retailer, then Conwood would compete for the position. Therefore it must be

assumed that while the process potentially harmed Conwood, costs were reduced and profits

were maximized for the downstream retailers and thus, USTC was the best fit for Category

Captain.

In the process of securing category captain, USTC had to arrange an agreement with a

downstream retailer to create a pareto improving arrangement; an exclusive deal between USTC

and the retailers that allowed some vertical integration through reallocating of costs. Exclusive

dealing did increase the market power of USTC, creating barriers for Conwood to obtain

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competitive shelf allocations, but it also lead to cost savings for the retailers and the effects on

Conwood must have been lesser than the benefits that were realized by USTC and the retailers.

It is a balance between a contracting externality on a competing firm and a vertical pricing

externality due to the unrealized efficiency gains. However, since there is not sufficient evidence

to suggest a significant negative net effect on Conwood, then Category Management has not

been an effective barrier to entry.

The cheap exclusion conduct was also an issue. Consumer choice was alleged to be

restricted due to USTC’s actions. As well, it was despicable and obviously anticompetitive as it

involved USTC representatives physically sabotaging product racks for competitor products.

This increased the chance that consumers would have to buy higher priced substitutes. Conwood

lost sales of their low priced substitute product. Consumers were harmed because they were

forced to buy higher priced tobacco products. Perhaps USTC was able to harm sales of their

competitor in a manner that increased their own profits. If so, the margins on the additional units

that USTC stole were greater than the wages of employing a team of saboteurs. In which case,

the anticompetitive conduct would be profitable. Furthermore, if the margins on the additional

units that USTC stole were greater than the wages of employing a team of saboteurs plus the loss

to Conwood on the margins they would have received, then the seemingly vulgar conduct

represents a potential pareto improvement. It is most likely that this was the case, as the negative

net effect was minimal and USTC repeatedly attacked competitor shelves. It increased USTC’s

profits, so they continued, the conduct did not foreclose competitors, and competitors did not

experience a significant negative net effect on sales. Cheap exclusion was not an effective barrier

to entry.

Section IV.III: Market Power

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Market power was exercised, as the firm was able to raise price beyond competitive

levels, or the relative price level at which Conwood kept their price at. The price increases were

not in proportion to quality increases, and USTC acknowledged in private, their attempt to

exclude these price-value substitutes. However, demand was highly inelastic and so it is possible

that at prevailing levels prices were below the efficient levels or demand for the product was also

growing at a slow pace.

Section IV.IV: Case theory

The argument provided by USTC was coherent. Since the effect on competition was

negligible; the actions did not make competitors worse off, as the plaintiff claims and this is true

because the competitors’ profits grew during the alleged anticompetitive harm. The argument is

consistent with the theory as USTC’s claims that they were not acting anti-competitively, could

be supported by the lack of a substantial lessening of competition.

The argument provided by Conwood was coherent, and evidence suggests that the

defendant’s actions were profit maximizing due to the abuse of their market power. The case

lacks consistency with the theory, as the actions under investigation while predatory do not

negatively impact sales. Sales still grew during the period in which the alleged activity impacted

Conwood, and so all exclusionary activity seems to have stunted growth rather than negate it. It

will need to be considered whether, but for the conduct of the defendant would sales have been

higher, in which case the case would be consistent. However, since it is very difficult to

determine what sales would have been absent the conduct of USTC, great care must be taken to

deliver a normative analysis as to what sales should have been.

Section IV.V: Efficiency

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The Price increases passed the SSNIP; they were excessive and inelastic consumer

demand was exploited. However, should the tobacco industry not be charging higher prices? One

of the issues with tobacco prices is that they are low due to competition, in this case we have a

firm who has had a monopoly for 50+ years and they are constantly raising prices. If the tobacco

industry is willing to price higher, then there should be the ability to do so, given that the firm

may be able to signal to consumer’s the optimal level of consumption through higher prices.

The consumer of a tobacco product pays the cost of the tobacco product as well as the

margin that the firm is willing to charge, and any taxes that are placed in excess. A consumer

receives a benefit from use as well as a cost, the difference in which should be equal to their

willingness to pay less the amount that it costs an individual to consume the product. The

consumer receives the benefit today and their costs in health in the future. If, consumers would

weigh the benefits and costs, considering the discount factor on health in the future, the potential

for addiction, continual financial cost of tobacco consumption as well as every potential health

concern and comparing that to the benefit they can receive today, then that is not a problem. A

consumer who is adequately informed should be free to make his or her own decisions.

However, consider that most tobacco users are not adequately informed about the totality of the

health concerns that they are faced with. Youth smoking is particularly a problem as a majority

of smokers begin before the age of 19 and their “ability to make fully-informed, appropriately

forward looking decisions is questioned by society in many contexts” (Gruber, 2003)12. Thus,

education of the total costs is not enough to allow pricing that does not lead to overconsumption.

There are two solutions to this problem; increase information/educate consumers so that

the consumer can make better decisions or the firm can increase price to deter new users.

12 Jonathon Gruber. 2003. The New Economics of Smoking. The National Bureau of Economic Research

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Education might prove to be expensive and so it may be better to encourage higher prices. Taxes

and regulatory controls do part of the job and have been effective tools in deterring tobacco use

in the past13. However, a more natural tool to consider may be monopoly pricing. Monopoly

prices approach the point where the marginal revenue is equal to the marginal cost. That is, the

prices induce demand substitution, such that if a firm raises it price, they will lose the equivalent

in units they could have provided. This is because monopoly prices move up the demand curve

to a point where consumer demand is elastic. If the pricing has induced consumers to consider

more carefully whether or not to buy the tobacco product, then the mechanism may be effective

in simulating improved information.

In fig1 below, the consumer has a downward sloping demand curve for tobacco, that

represents their marginal benefit from each unit of consumption, and a private marginal cost

curve. PMC1 represents the private marginal cost of an individual with inadequate information,

and PMC2 represents an individual with adequate information. A firm will derive their demand

functions from these curves. If a firm charges a low price the consumer will consume an

undesirable amount Qu. If a firm increases prices, it is more likely to impact the consumer’s

decision process, as they must determine that the higher price is worth it, given all the costs they

consider. It is unlikely for prices to converge on this socially optimal level on their own, however

as long as prices induce substitution; the firm is producing at the elastic section of their demand

curve such that consumer’s decide whether to consume or not, this may be efficient.

13 Tobacco Free Initiative/Taxation. WHO. WHO. April 2,2016

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Fig 114

Low priced substitutes of tobacco should not be incentivized to carry on low prices.

Governments themselves attempt to deter new tobacco users and affect the behaviour of

consumers by administering taxes in the tobacco industry. In a perverse way, it can be beneficial

for a firm that charges higher prices on bad goods to attempt to exclude low price substitutes and

raise price beyond competitive levels. In this way, prices approach the social optimal level,

rather than the low private marginal cost that the competitive firms are driven to, and consumers

prefer, which leads to overconsumption.

Section IV.VI: Alternative Judgment

On the count of unlawful monopolization, USTC's actions exemplified an abuse of

market power that would indicate an attempt and desire to monopolize the market. However,

there was no substantial lessening of competition. Competitor market share grew within the

relevant time period. While aggressive, the conduct effectively failed to restrict competitive

forces. As monopolization is decided under a rule of reason approach, where there must be the

14 Fig 1 shows the internality incurred by a tobacco user. The cost difference between PMC1 and PMC2 is difficult to determine. It may be at monopoly levels as monopoly prices induce elastic demand.

24

intention and the effect, given that there was no significant negative net effect, I find USTC, not

guilty of unlawful monopolization.

In regards to the violations of the Lanham Act, consumers were misled. As the product

shelves were the most crucial point to attract the attention of a potential buyer, USTC likely

impaired consumer's abilities to make informed decisions. Therefore, USTC is guilty for

violations of the Lanham Act Section 43 (a).

Tortious activity did occur, however in regards to the contracted category management

activity, as downstream retailers must have at least been made better off, there must have been

efficiency gains to uphold the agreement. The practice of category management is common, and

while it provides opportunity to be abused, the firm is constrained in that they must consider the

profits of the downstream retailer. Due to the efficiency gains, I find the accused, not guilty of

tortious interference through contract. However, the tort was created with the desire to cause

harm to the profits of the competitor at which the defendant stood to benefit. I find the defendant

guilty of tortious interference with prospective advantage.

The Violation of the Kentucky Revised statute has no efficiency basis, other than the

promotion of competition. Per se ruling cannot be enforced on a monopoly case. Monopolization

is considered under a rule of reason approach to ensure that conduct, which may on face value be

considered to be inefficient for the obvious effects on competition, is indeed inefficient. I move

to suspend judgment on this matter indefinitely.

On the charge of Product defamation, I find insufficient evidence to uphold this claim.

The destruction of product shelves is covered under the tortious interference claim and the

conversion/trover covers the issue of moving product to another shelf. Damaged shelves may

25

reflect poorly on the brand, however it must be evident that the actions of USTC impacted

consumers to believe that Conwood’s product was inferior, and this had not occurred. I find

USTC not guilty for Product Defamation.

Unjust enrichment is a purely uneconomic standard. Unjust enrichment can only be

considered inefficient if winners cannot compensate the losers and still be winners. In cases

where there is a Potential Pareto Improvement, the court’s roles should be a redistribution

mechanism from winners to loser. In that way, the courts do not deter economically valuable

behaviour, but rather they accommodate it. As such, I move to suspend judgment on this matter

indefinitely.

Conversion did occur as the defendant abused the property rights of the plaintiff and

wrongfully moved their product. I find the defendant guilty of conversion and subject to trover.

Finally, a Socially Optimal Critique; if the conduct was ultimately beneficial to society,

in that the effects of the hypothetical monopolist lead to a substantial improvement in excess of

the harm that it created, it must be shown that the conduct did have this effect and judgment

moderated as a result.

USTC had attempted to exclude their competitors; some conduct was very clearly

problematic while others had economic justifications. However, there was no substantial

lessening in competition. The efficiency gains of the price increases lead to an increase in total

surplus. USTC raised price significantly, however, it should be considered that the prevailing

price levels may have been too low to begin with. Output grew while prices rose, and even

though USTC had intended to exclude Conwood, the conduct did not have that affect. Potential

Pareto Improvements were created that Conwood was not party to. Potentially, the profits that

26

USTC generated between themselves and the downstream firms were more than significant to

cover the slowed growth of the competitors. Conwood argues that the market would have grown

more absent the conduct, however, most likely at lower prices that would lead to

overconsumption, potentially by youth, who are already significantly at risk of tobacco abuse.

Furthermore, the research provided did not indicate that industry profits were harmed due to

USTC’s actions, but that Conwood’s profits were slowed. A but for analysis, would indicate that

Conwood could have experienced increased growth, but this may have resulted in lower

revenues in both the upstream and downstream. Further research is needed to determine the

efficiency created beyond the competitors, to make a truly efficient decision. To conclude, in

order to file for a section 2 violation of the Sherman Act on the basis of an attempt to

monopolize, it must be shown that the conduct foreclosed competition, and since there was

growth, these clams should be denied.

Conclusion

USTC’s behaviour was shameful, however the economic effects were beneficial and a

unique revision can be made that would be socially optimal. Competition can be beneficial; it

lowers prices, increases quality and helps to increase all of the potential trades that consumers

are willing to make. USTC’s actions lead to higher prices, and a lower ability to substitute.

While there were efficiency gains that arose from USTC’s behaviour, thorough exclusive dealing

with the downstream, the conduct of rack interference was not condonable. However, there was

not a significant negative net effect that occurred. Furthermore this is not the case of a product

that improves the quality of people’s lives. Tobacco is a product that causes serious health issues

and as such should be treated differently than other goods that do improve the lives of

consumers. Those who are making a decision based on efficiency should at least consider the

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Socially Optimal Critique, or some revision that looks out for the best interests of consumers.

Efficiency cannot be achieved by a one rule fits all strategy. If the true goal of antitrust is to

promote an efficient outcome, the, the law must be thorough in its process, in order to deliver the

efficient outcome.

The truth is, tobacco is a harmful product and higher prices are a tool that effectively

reduces consumption, (in this case consumption growth was slowed). If permitting conduct that

creates, enhances or maintains market power will affect consumer demand in a manner that

improves social welfare, then perhaps it should be allowed.

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References

1) Conwood Co., L.P. v. U.S. Tobacco Co., 290 F.3d 768 (2002)

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Martimont The RAND Journal of Economics, Vol. 27, No. 1 (Spring, 1996), pp. 1-31

3) Jonathan B. Baker. 2007. “Market definition: An Analytical Overview”. Antitrust Law

Journal, Vol. 74, No. 1 (2007), pp. 129-17

4) Jonathon Gruber. 2003. The New Economics of Smoking. The National Bureau of

Economic Research

5) Susan A. Creighton, D. Bruce Hoffman, Thomas G. Krattenmaker and Ernest A.Nagata.

2005. “Cheap Exclusion.” Antitrust Law Journal, Vol. 72, No. 3 (2005), pp. 975-995

6) Joshua D. Wright. 2009. “Antitrust Analysis of Category Management: Conwood v

United States Tobacco C0”. Supreme Court Economic Review, Vol. 17, No. 1, pp. 311-

337

7) Michelle Da Pra1 and Carlos Arnade. 2009. Tobacco Product Demand, Cigarette Taxes,

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9) Tobacco Free Initiative/ Taxation.WHO. WHO. April 2,2016

10) Joseph Mahoney and David Crank. 2012. Vertical Coordination: The Choice of

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11) “Smokeless Tobacco: Health Effects”. CDC.CDC. April 6, 2016

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