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A note on Hanover Shoe.

I. Introduction

Hanover Shoe was a private antitrust suit against the United Shoe Machinery Corporation (United) by one of its customers, Hanover Shoe, Inc. (Hanover).(1) The decision is quite remarkable for at least two reasons. First and foremost, Hanover Shoe played a landmark role in defining the antitrust standing of private plaintiffs. In particular, this case is known primarily for the proposition that a defendant may not reduce its damage exposure on the theory that the plaintiff passed on to its customers all or part of any overcharge that it suffered. Hanover Shoe, therefore, forbids the defensive use of the pass-on theory.(2) Second, this decision raises some interesting issues with respect to the identification and measurement of damages. In our view, the Supreme Court prescribed a damage calculation in Hanover Shoe that is entirely wrong. It is the Court's failure to identify a correct damage measure that we address here.

II. The genesis of Hanover Shoe

In United States v. United Shoe Machinery Corp., a landmark antitrust decision, United was charged with illegally monopolizing the shoe machinery market in the United States.(3) Although there were domestic and foreign shoe machinery manufacturers that could supply all of the machines necessary to organize a complete shoe factory, United enjoyed a market share of some 75%-85%.(4) The Court attributed United's market dominance to three things: (1) its original formation, (2) the superiority of its products and services, and (3) its system of never selling, but only leasing its machinery.

United's original formation, which was the product of horizontal mergers, had been subject to judicial review and had been found legal.(5) As a result, Judge Wyzanski found United's original formation to be beyond reproach.(6)

To the extent that United's market dominance was the result of superior products, business acumen, or historic accident,(7) its prices may well have been above the competitive level, but would not have been legally objectionable. This, of course, is the correct public policy from an economic perspective if we want to encourage desirable economic performance. United's superior service was particularly important to shoe manufacturers because machinery breakdowns stopped production entirely and thereby imposed substantial losses on the shoe manufacturer.(8) Certainly, public policy should not condemn a firm that achieves a large market share by offering better products and better service than its rivals offer. After all, the point of fostering competition is to insure this sort of economic performance. In fact, Judge Wyzanski did not condemn United for its superior products and service, but he did condemn the lease-only policy.(9)

Judge Wyzanski acknowledged that United's leasing system was "honestly industrial" since it was the sort of business practice that other honorable firms had found to be useful. In fact, he recognized that United's lease-only policy had not originated with United. Nor was United the only shoe machinery supplier following the practice. On the contrary, United's lease-only policy conformed to long-standing industry traditions dating back to the Civil War. Moreover, United's customers had voiced no strong objections to United's practice. Nonetheless, Judge Wyzanski found these leasing practices to be objectionable.

Judge Wyzanski's analysis rested on his reading of Alcoa(10) and Griffith.(11) Taken together, these landmark decisions meant to Judge Wyzanski that "one who has acquired an overwhelming share of the market `monopolizes' whenever he does business.(12) But he also found this inference of an illegal monopoly to be just a rebuttable presumption:

... the defendant may escape statutory liability if it bears the burden

of proving that it owes its monopoly solely to superior skill, superior

products, natural advantages.... economic or technological efficiency

.... low margins of profit maintained permanently and without

discrimination, or licenses conferred by, and used within, the

limits of law....(13)

Thus, Judge Wyzanski recognized that market dominance was not necessarily illegal provided that it was inevitable.

In United's case, however, Judge Wyzanski found that

(1) defendant has, and exercises, such overwhelming strength in the

shoe machinery market that it controls that market, (2) this strength

excludes some potential, and limits some actual, competition, and (3)

this strength is not attributable solely to defendant's ability, economies

of scale, research, natural advantages, and adaptation to inevitable

economic laws.(14)

In particular, Judge Wyzanski found that United's own business policies erected barriers to competition. While United's leasing system was responsible for much of United's market power, these leasing policies did not flow inevitably from United's superior ability, natural forces, or law. Instead, United's leasing practices were seen as contracts, arrangements, and policies that "furthered the dominance of one firm"(15) rather than encouraging competition on the merits. As a result, Judge Wyzanski decided that United's leasing practices "are unnatural barriers; they unnecessarily exclude actual and potential competition; they restrict a free market."(16) Hence, United's policy of never selling, but only leasing, its most important machines constituted illegal monopolizing behavior in violation of section 2 of the Sherman Act.(17) It is important to note that Judge Wyzanski's determination that United's practices resulted in an illegal monopoly of the shoe machinery industry has been widely criticized.(18)

To add insult to injury, on the heels of the government's victory, Hanover filed suit for damages that it allegedly suffered as a result of United's lease-only policy. In short, it alleged that it was a victim of United's monopolizing practice. Hanover claimed as damages the difference between the sums that it had paid to United in rentals and the amounts that it would have paid had United sold the machines to Hanover.(19) The Supreme Court agreed that Hanover was entitled to recover the difference between the lease payment and the hypothetical sale price of the machines after accounting for the capital costs that were saved by not having purchased the machines.

First, we will argue that the lease versus purchase distinction is not the appropriate measure of damages. Rather, the appropriate measure of damages is the difference between the lease payments actually made and the rates that would have been charged (whether the machinery was purchased or leased) absent the lease-only policy. We will further argue that Hanover's measure of damages is conceptually meaningless since profit-maximizing behavior by United would have resulted in a life-cycle price for shoe machinery that is the same regardless of whether that machinery is leased or sold.(20) Consequently, as a first approximation, the damages as measured in Hanover Shoe should have been zero.

III. Proper measure of damage

In a monopoly case, the proper measure of damages is the difference between the monopoly price and the price that would have prevailed "but for" the illegal monopolization.(21) To the extent that United's market dominance was the result of superior products, business acumen, or historic accident, its prices presumably would have been legally unobjectionable albeit above the competitive level. As noted previously, Judge Wyzanski attributed United's dominance to its original formation, its superior products and service, and its lease-only policy. Only the last of the three elements was deemed legally objectionable. Thus, a proper measure of damages must untangle the influence of each source of monopoly in order to isolate the effect of the leasing policy. If the damage calculation fails to do this, then it will include supracompetitive returns that do not flow from anything forbidden by the antitrust laws.

The proper measure of damages is not the difference between the actual lease terms and some hypothetical purchase option. Instead, Hanover should have been required to estimate the difference between the actual lease terms and those that would have prevailed if United's leasing system had not enhanced (or "furthered") its market dominance. This would permit United to retain the benefits that are due to its original formation, which was legal, and its superior products and service, which are socially desirable. At the same time, it would allow Hanover to recover the illegal monopoly overcharge. In practice, disaggregating these effects would be a formidable empirical challenge. But to do otherwise is to punish, and thereby deter, desirable economic performance.

IV. Hanover Shoe's damage claim

As noted above, the Court-approved measure of damage to Hanover was the difference between the sum it had paid to United in machine rentals and what it would have paid had United been willing to sell those machines. It is not obvious, however, that Hanover actually suffered any damages under this measure. To see why, we must consider the cost to a shoe manufacturer of leasing versus purchasing a shoe machine.

When a shoe manufacturer leases a machine with a life of T years, the present value of the rental payments R is

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where [L.sub.t] is the annual lease payment, r is the discount rate, and [Sigma] denotes the summation over the life of the machine. Since United retains ownership of the machine, it will receive the salvage value (S) at the end of the machine's useful life. As a matter of practice, United also maintained the machine for the lessee. Consequently, United's net revenue (NR) from leasing is

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

where [M.sub.t] is the expected maintenance and repair cost in year t,(22) and S is the salvage value, which is received in year T. We can compare this leasing outcome to a simple sale. If United had sold the machine instead, its revenue would simply be the price (P) at which it sold the machine.

In order to analyze the hypothetical purchase option, which is relevant to Hanover's claim, we begin by assuming that United had selected the lease terms rationally, i.e., that it selected the profit-maximizing value of L. Now, given whatever market power United possessed, if it had sold the machines, it would have similarly selected a profit-maximizing sales price (P). In other words, it would have selected an initial sales price such that we have

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

This equation can be rearranged algebraically to yield

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

The left-hand side reflects the present value of the cost to the shoe manufacturer of leasing the machine from United. The righthand side reflects the present value of the cost to the shoe manufacturer of purchasing the machine, where the maintenance and repair expenses are now the responsibility of the shoe manufacturer and the salvage value is credited to the shoe manufacturer. A final algebraic rearrangement,

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

shows that leasing is simply a financing mechanism. Instead of initially making one lump-sum payment for the durable, the shoe manufacturer makes periodic payments over T periods to the machinery producer. In either case, the net present value of the cost to the buyer will be the same. This will be true irrespective of market structure due to profit-maximizing behavior by the shoe machinery producer. Consequently, if United had selected the profit-maximizing lease terms and an economically equivalent price, then the net present value of the equipment cost would have been the same to the shoe manufacturer whether the machinery had been leased or purchased. As a result, Hanover's damages should have been zero. Given this result, the burden should fall on Hanover to explain how its costs under the lease-only policy could exceed its costs if a purchase option had been made available.

In fact, there are circumstances under which the net present value of the lease payments may differ from an optimal sales price, but these would appear to be inapplicable to Hanover Shoe's situation. We will briefly address three such cases. First, consider Coase's observation that durability works against the exercise of monopoly power because it is hard for a monopolist to make a credible commitment to limit future production.(23) The monopolist may offer the durable on a short-term lease to signal its commitment to limiting production and thereby increase its ability to exploit its monopoly. This strategy will permit the monopolist to increase the net present value of the rental payments above the sales price. United, however, did not employ short-term leases. Instead, most of its leases were for 10 years. Since longer leases make leasing more like buying, Coase's observation would not appear to be a likely explanation for United's leasing practices.

Second, if shoe manufacturers face uncertainty regarding the life of the machine or the extent of maintenance and repair costs and the shoe manufacturers are more risk averse than United, then they will be willing to pay a premium for United to bear the risk.(24) This difference between the total lease payment and the hypothetical purchase option, however, has nothing to do with monopoly. In fact, the premium is a payment for insurance coverage and cannot be considered an overcharge of any kind.

Finally, if the shoe manufacturer and United face differing costs of capital, then the cost of leasing will differ from that of purchasing. In Hanover Shoe, United complained that the damage calculations did not properly account for the cost of capital since Hanover would have had to invest its own capital in the machines if it had bought them. There is an opportunity cost of having capital tied up in the machine. But United also had opportunity costs when it leased the machine. These costs would have been reflected in the lease terms and, as a consequence, Hanover would have incurred its own opportunity costs if it had bought the machine or United's opportunity costs if it had leased them. If United and Hanover had equal access to the capital market, this should have been a wash. If they did not have equal access to the capital market, then there would have been a difference between the lease cost and the purchase price, but this difference would have had nothing to do with monopoly. For Hanover to have had a legitimate claim on this basis (a claim that it did not make), Hanover would have had to demonstrate that it had more advantageous access to the capital market than did United, but was unable to take advantage of this due to the lease-only policy. Note, however, that this inability does not stem from an antitrust violation. Note also that, if Hanover had less advantageous access to the capital market than did United, the lease-only practice might have benefited Hanover.

V. Hanover's damage calculations

For Hanover to have proved a positive damage figure using its measure, it would have had to prove that the present value of the lease payments exceeded the cost of ownership.(25) In other words, Hanover would have had to show that

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]

Now, if an appropriate discount rate can be found, it would have been relatively easy to establish the present value of the lease payments over the life of the contract. But the rest of the calculation poses some serious problems. Since United employed a lease-only policy, there was no direct information on the value of P, the initial purchase price. Moreover, United actually maintained the machines and, therefore, Hanover's records would not have reflected the costs of maintenance. Finally, the salvage value, i.e., the price of a second-hand machine T years old, is not obvious since there was no second-hand market. Thus, estimating damages was a daunting task to say the least. Undeterred by this formidable problem, Hanover provided a damage calculation based on estimates of P, M, and S.

MACHINERY PRICES (P) United began selling machinery in 1955 according to market conditions that existed in 1955. Hanover's expert estimated the "but for" prices in earlier years by deflating the 1955 prices according to the Consumer Price Index, All Items (CPI). This procedure may be flawed for several reasons. First, as an indicator of inflationary changes generally, changes in the CPI may not accurately reflect varying conditions in the shoe machinery market. To the extent that they do not, the estimated prices will be inaccurate. Second, to the extent that these estimated prices differed from their leasing equivalents, Hanover should have had to explain United's irrational "but for" behavior. If it could not do this, the damage calculations should have been deemed speculative.(26) Third, Hanover's procedure did not take into account improvements in the machines or in the technology employed in producing those machines. Simple scale economies or learning by doing can reduce production costs over time. Finally, competitive forces in a specific industry can vary over time, but will not necessarily be reflected in the CPI, which applies to the economy generally.

MAINTENANCE COSTS (M) The maintenance costs generally were incurred by United even though the contracts imposed that obligation on the lessees. Hanover performed the maintenance on twenty machines during the 12-month period, September 1, 1961-August 31, 1962. These costs were used to estimate the cost of maintaining thirty-seven other machines that it elected not to maintain. Clearly, there is ample room for inaccuracies to creep in here.

SALVAGE VALUES (S) According to the original decree, United had to devise a plan to terminate outstanding leases and make the lease-only machines that were already in place available for sale. Since these prices for used machinery were not established at the time that the "but for" transactions were to have occurred, problems of estimation loom large.

SUMMARY Because of the difficulties in estimating "but for" prices and costs, Hanover's damage calculations may well have been speculative.(27) This raises the issue of what one could have done that would have provided less speculative estimates. It is not clear that more accurate estimates were possible. To demand more precision might have precluded recovery, but to permit the procedure actually used is to approve of damages that may be wholly unrelated to any injury.

VI. Concluding remarks

In Hanover Shoe, the damage inquiry was wrong for two reasons. As we have argued above, the damage inquiry was misdirected. Judge Wyzanski found that United's leasing system enhanced United's monopoly power by foreclosing its competition. In this event, damages would have arisen because the exclusionary leasing practices led to an increased overcharge due to United's enhanced market power. The proper measure of damages should have been aimed at the return to the enhanced market power that resulted from United's lease-only policy. In addition, as we have demonstrated, Hanover's measure of damages should have been zero since United's profit-maximizing lease terms and its profit-maximizing sales terms would have been economically equivalent. Thus, the damage measure approved by the Supreme Court ought to have led nowhere. The fact that Hanover's expert was able to estimate damages based on a conceptually incorrect measure indicates the presence of errors in his estimates of machinery prices, maintenance costs, and salvage values.

(1) Hanover Shoe, Inc. v. United Shoe Machinery Corporation, 392 U.S. 481 (1968).

(2) Some 10 years later, Illinois Brick made this rule symmetric by not allowing the customers of overcharged antitrust victims to sue on the theory that they paid higher prices because some portion of the overcharge was passed on to them. Illinois Brick Co. v. Illinois, 431 U.S. 720 (1977). There is some dispute about the wisdom of the Illinois Brick decision. For comprehensive analyses that reach opposite conclusions, see William M. Landes & Richard A. Posner, Should Indirect Purchasers Have Standing to Sue Under the Antitrust Laws? An Economic Analysis of the Rule of Illinois Brick, 46 U. CHI L. REV. 602 (1979), and Robert G. Harris & Lawrence A. Sullivan, Passing on the Monopoly Overcharge: A Comprehensive Policy Analysis, 128 U. PA. L. REV. 269 (1979).

(3) 110 F. Supp. 295 (D. Mass. 1953).

(4) Generally, a market share of 75%-85% results in a judicial presumption of monopoly power. This is a bit simplistic and the presumption may be entirely incorrect. See Roger D. Blair & Amanda K. Esquibel, The Role of Areeda, Turner, and Economic Theory in Measuring Monopoly Power, 41 ANTITRUST BULL. 781 (1996).

(5) United States v. United Shoe Machinery Company of New Jersey, 247 U.S. 32 (1917).

(6) 110 F. Supp. at 344.

(7) In United States v. Grinnell Corporation, 384 U.S. 563, 570-71 (1966), the Court set out a two-prong test for illegal monopolization: "(1) the possession of monopoly power in the relevant market and (2) the willful acquisition or maintenance of that power as distinguished from growth or development as a consequence of a superior product, business acumen, or historic accident" (emphasis added).

(8) United States v. United Shoe Machinery Company of New Jersey, 247 U.S. 32, 63-64 (1917). Service was implicitly included in United's lease agreements.

(9) 110 F. Supp. at 344-45.

(10) United States v. Aluminum Company of America, 148 F.2d 416 (2d Cir. 1945).

(11) United States v. Griffith, 334 U.S. 100 (1948).

(12) 110 F. Supp. at 342.

(13) Id., emphasis added.

(14) Id. at 343, emphasis added.

(15) Id. at 344-45.

(16) Id. at 345.

(17) Id. at 323-25,340-46.

(18) See, e.g., ROGER D. BLAIR & JILL BOYLSTON HERNDON, UNITED SHOE MACHINERY REVISITED (1996); John Shepard Wiley Jr., Eric Rasmusen & J. Mark Ramseyer, The Leasing Monopolist, 37 UCLA L. REV. 693 (1990); Scott E. Masten & Edward A. Snyder, United States versus United Shoe Machinery Corporation: On the Merits, 36 J. L. & ECON. 33 (1993); ROBERT H. BORK, THE ANTITRUST PARADOX 138-42, 170-73 (1993); Scott E. Masten & Edward A. Snyder, The Design and Duration of Contracts: Strategic and Efficiency Considerations, 52 L. & CONTEMP. PROBS. 79 (1989); and Richard A. Posner, Exclusionary Practices and the Antitrust Laws, 41 U. CHI. L. REV. 528 (1973). For a contrary view, see Joseph F. Brodley & Ching-to Ma, Contract Penalties, Monopolizing Strategies, and Antitrust Policy, 45 SWAN. L. REV. 1161 (1993).

(19) Hanover Shoe, 392 U.S. 484 (1968).

(20) Justice Stewart argued in his dissent that United was not even liable to Hanover. He asserted that the earlier judgment against United did not hold that the lease-only policy constituted illegal monopolization; rather, it held that certain types of leases that possessed certain exclusionary provisions were unlawful. 392 U.S. 481,510-13 (1968).

(21) See HERBERT HOVENKAMP, FEDERAL ANTITRUST POLICY 602-04 (1994) for a brief examination of the distinction between legal and illegal monopoly profits.

(22) United Shoe Machinery included maintenance and repair services in the lease payment; i.e., lessees incurred no additional charges for these services.

(23) Ronald H. Coase, Durability and Monopoly, 15 J. L. & ECON. 143 (1972).

(24) For a more technical analysis, see Roger D. Blair & Jill Boylston Herndon, supra note 18.

(25) This was Hanover Shoe's primary damage claim: "the difference between the cost to operate its business with lease-only machinery and the cost to own the machinery." Hanover Shoe, Inc. v. United Shoe Machinery Corporation, 245 F. Supp. 258, 276 (1965). Its alternative claim involved allegations of excessive returns, but it failed to prove this claim. Id.

(26) In Murphy Tugboat Co. v. Crowley, 658 F.2d 1256, 1262 (9th Cir. 1981), cert. denied, 455 U.S. 1018 (1982), the court pointed out that "[i]n a hypothetical economic construction . . . economic rationality must be assumed for all competitors, absent the strongest evidence of chronic irrationality."

(27) For an extensive examination of speculative damages, see Roger D. Blair & William H. Page, "Speculative" Antitrust Damages, 70 WASH. L. REV. 423 (1995).

ROGER D. BLAIR, Huber Hurst Professor, University of Florida.

JILL BOYLSTON HERNDON, Assistant Professor, Hamline University.

AUTHORS' NOTE: We thank William Page for sparking our interest in this topic. Although they must not be blamed for what follows, we appreciate the constructive comments of William Curran, Herbert Hovenkamp, John Lopatka, Tina Miller, and Michael Ryngaert. Finally, we acknowledge the financial support of our respective institutions.
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Title Annotation:calculating damages due to monopoly
Author:Blair, Roger D.; Herndon, Jill Boylston
Publication:Antitrust Bulletin
Date:Jun 22, 1998
Words:3932
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