Appendix — Transamerica Computer Co. v. International Business Machines Corp.

3 -tt* -—

No. OB, 1

IN THE

ALEXANDER L. S7E%

CLERK

Supreme Court of the United tates

OcTOBER TERM 1983

TRANSAMERICA COMPLTER COMPANY. INC..

Petitioner.

y

INTERNATIONAL BUSINESS MACHINES CORPORATION.

Respondent.

APPENDIX TO PETITION

FOR A WRIT OF CERTIORARI

RICHARD J. LUCAS

(Counsel of Record)

WILLIAM L. RILEY

G. Kip EDWarDs

STEVEN A. Baick

Tower C. SNow, Jr.

Of OrRICK. HERRINGTON &

SUTCLIFFE

A Professional Corporation

600 Montgomery Street

San Francisco, California 94111

Telephone: (415) 392-1122

Attorneys for Petitioner

Transamerica Computer

Company, Inc.

August |, 1983

TABLE OF CONTENTS

APPENDIX A

Opinion of the United States Court of Appeals for the

Ninth Circuit entered on February 15, 1983

APPENDIX B

Opinion of the United States District Court for the North-

ern District of California entered on October 18, 1979. as

amended on December 20, 1979

APPENDIX C

Order of the United States District Court for the Northern

District of California entered on October 3, 1978, ruling

on various pretrial motions

APPENDIX D

Order of the United States District Court for the Northern

District of California entered on November 14, 1978.

clarifying its Order of October 3, 1978

APPENDIX E

Order of the United States Court of Appeals for the Ninth

Circuit entered on May 2, 1983, denying petition for

rehearing and rejecting suggestion for rehearing en banc

APPENDIX A

IN THE

Bnited States Court of Appeals

FOR THE NINTH CIRCUIT

TRANSAMERICA COMPUTER COMPANY.

INC.. a corporation. | No. 80-4048

Appellant,

, OPINION

Vv.

INTERNATIONAL BUSINESS MACHINES | February 15, 1983

CORPORATION, a corporation. |

Appellee. |

—

Before: PREGERSON and CaNBy. Circuit Judges. and Lucas.*

District Judge.

PREGERSON. Circuit Judge:

Appellant Transamenca Computer Company ( Trans-

america). a wholly owned subsidiary of Transamerica Corpo-

ration, alleges that Appellee International Business Machines

(IBM) violated Section 2 of the Sherman Act. 15 U.S.C. § 2.

when it took various actions to combat emerging competition in

the “plug-compatible” peripherals market. The district court

held that IBM’s actions did not violate the antitrust laws.

On appeal. Transamerica challenges the district court’s

ruling that IBM’s acts did not “unreasonably restrict” com-

petition and, in particular, challenges the court’s test for

predatory pricing. We affirm the district court’s decision but

modify its test for predatory pricing.

Background

At the heart of a computer system is the central processing

unit (CPU), which houses arithmetical and logical electronic

circuits. Attached to the CPU are devices called “peripherals.”

which perform input, output, storage, and control functions.

IBM, long the dominant force in the computer industry, was,

and remains, the major supplier of both CPUs and peripherals.

* The Honorable Malcolm Lucas. United States District Judge for the

Central District of California, sitting by designation.

2

In 1967, a number of companies began offering plug-

compatible peripherals—devices which could be attached to

IBM’s CPUs. These plug-compatible manufacturers (PCMs)

enjoyed immediate market success because they offered, at

substantial discounts, plug-compatible peripherals that per-

formed as well as or better than IBM’s peripherals.

Transamerica was formed to supply needed capital to

PCMs. In financing transactions central to this case, Trans-

america purchased millions of dollars of peripherals from two

PCMs, Marshall Industries and Telex Corporation, which had

previously leased these items to end users. Under this arrange-

ment, these PCMs raised substantial capital, and Transamerica,

in addition to acquiring the equipment and underlying leases,

received substantial tax advantages.

IBM responded to vigorous competition from the PCMs by

engaging in a number of programs which Transamerica charac-

terizes as violations of the Sherman Act. These challenged

programs included:

(1) Leasing Program—Pnor to May 1971, IBM

customers could either buy peripheral equipment or lease it

on a month-to-month basis. In May 1971, IBM announced

an additional method of leasing peripheral equipment—a

Fixed-Term Lease Plan under which customers could lease

peripheral equipment for one year at an eight percent

discount below the month-to-month rate, or for two years

at a sixteen percent discount.

(2) Design Changes—In the early 1970s, IBM rede-

signed the interface between the CPU and the peripherals

of three tape drive systems so that PCM’s peripherals

would no longer be compatible with IBM’s CPUs. IBM

also removed an optional selector channel from two CPU

models, the System 370 Models 115 and 125, so that

PCM’s peripherals could no longer be used with those

models.

(3) Pricing Behavior—Also in the early 1970s, IBM

introduced several ‘‘new” products—basically repackaged

versions of prior peripherals—at lower prices.

3

Whether one characterizes IBM’s actions as “meeting”

competition or precluding’ competition, there is no doubt that

IBM's strategy worked. Transamerica, along with fifteen out of

seventeen companies involved with plug-compatible pe-

ripherals. left the market after suffering huge losses.

Because of IBM's actions in the peripherals market. Trans-

america sued IBM for violations of the antitrust laws. Several

other companies involved with plug-compatible peripherals

also brought suits against IBM. Although initially consolidated,

the actions were tried separately. Two of those actions,

involving issues and facts similar to those presented here, have

already been before this court. In both instances we upheld

directed verdicts for IBM. California Computer Products, Inc.

v. IBM. 623 F.2d 727 (9th Cir. 1979) (CalComp): Memorex

Corp. v. IBM, 636 F.2d 1188 (9th Cir. 1980). cert. denied, 452

U.S. 972 (1981) (Memorex).

The instant case went to trial before a jury in December

1978. The trial consumed 120 days. After deliberating for ten

days. the jury deadlocked and was discharged. Under a pretrial

stipulation, the district judge then became the trier of fact. He

ruled for IBM on all major issues. He held that ( |) IBM was

not a monopolist in either the general computer systems rnarket

or the peripherals market: (2) assuming, arguendo, that IBM

possessed monopoly power. its leasing program. its design

changes—with the exception of the design of the System 370

Models 118 and 12S—and its pricing behavior did not unrea-

sonably restrain competition: (3) IBM had not attempted to

monopolize the general computer systems market or the pe-

ripherals market; and (4) assuming that Transamerica estab-

lished antitrust liability, it had not proved that it suffered

antitrust damages. The district court also found that IBM’s

redesign of the System 370 Models 115 and 125 would have

unreasonably restricted competition had IBM been a monopo-

list. but since IBM was not 2 monopolist and since Trans-

america suffered no damages resulting from that design change,

IBM’s redesign of the two CPUs did not render IBM liable for

antitrust damages. Jn re BM Peripheral E DP Devices Antitrust

Litigation, Transamerica Computer Co., Inc. v. IBM, 481 F.

Supp. 965 (N.D. Cal. 1979) ( Transamerica Computer).

~#

Standard of Review

Transamerica challenges several of the district court’s

findings of fact.' The district court’s findings may not be

reversed unless clearly erroneous. Fed. R. Civ. P. 52(a). Under

this standard

[a] finding is “clearly erroneous” when although there is

evidence to support it, the reviewing court on the entire

evidence is left with the definite and firm conviction that a

mistake has been committed.

United States v. United States Gypsum Co., 333 U.S. 364, 395

(1948).

Monopolization and Attempt to Monopolize

Transamerica charges that IBM either monopolized or

attempted to monopolize certain segments of the computer

market. These separate offenses are governed by different tests.

To establish monopolization, a plaintiff must prove:

(1) possession of monopoly power in the relevant

market:

(2) willful acquisition or maintenance of that power:

and

(3) causal “antitrust” injury.

CalComp, 613 F.2d at 735.

To establish that a defendant attempted to monopolize, a

plaintiff must prove:

‘Transamerica also challenges a number of jury instructions. arguing

that

[|b jecause this was a jury trial and hecause there was no waiver of the

jury. this court has the same duty to review the instructions and if

erroneous and prejudicial. to reverse the judgment below as it would in

any other jury tnal.

Transamerica Brief at 27

Transamenica, however. freely and unconditionally stipulated before tnal

that the district court would decide the case if the jury was unable to reach a

verdict. The stipulation was intended to avoid the expense of a retrial

10/20/78 Tr. 8-10; 11/17/78 Tr. 18-20. By so stipulating. Transamenca

agreed to a court tnal if the jury deadlocked. and thus instructions given to

the deadlocked jury are irrelevant to this appeal

an

(1) specific intent to control prices or destroy com-

petition with respect to a part of commerce:

(2) predatory or anticompetitive conduct directed to

accomplishing the unlawful purpose:

(3) a dangerous probability of success; and

(4) causal “antitrust” injury.

Id. at 736.

There is an important relationship between the second

elements of these two offenses. Conduct that does not constitute

“willful acquisition or maintenance” of monopoly power (thus

precluding establishment of the offense of monopolization)

cannot constitute the “predatory or anticompetitive conduct”

required to establish the offense of attempt to monopolize. See

CalComp, 613 F.2d at 738. quoting 3 P. Areeda & D. Turner,

Antitrust Law © 828, at 321 (1978) (“conduct lawful for a

monopolist must. @ fortiori, be excluded as a basis for the

attempt offense.”’). We will analyze IBM's conduct with this

principle in mind. We will assume that IBM possessed monop-

oly power. If IBM’s conduct proves lawful despite that assump-

tion, then, @ fortiori, IBM's conduct could not constitute an

attempt to monopolize, thereby eliminating the need to con-

sider this offense.

Leasing Practices

Transamerica alleges that IBM's Fixed Term Lease Plan

(FTP) unreasonably restrained competition. Plaintiffs in both

CalComp and Memorex challenged the legality of the FTP.

Both times, this court upheld directed verdicts in favor of IBM

on that issue. CalComp, 613 F.2d at 741-42; Memorex, 636 F.2d

at 1188. The district court here also concluded that the FTP was

legal. Transamerica Computer, 481 F. Supp. at 1001-02.

Transamerica asserts that this court's previous decisions on

the FTP are not controlling because they were based on

findings of fact proved erroneous in the instant trial. The district

court’s findings of fact, however, are indistinguishable from the

findings in CalComp and Memorex. Transamerica has not

demonstrated that the district court's findings in the instant case

are clearly erroneous. Therefore, the holdings of Ca/Comp and

6

Memorex control our disposition of this issue, and the district

court’s holding must be affirmed. See also Greyhound Computer

Corp. v. IBM, 559 F.2d 488, 498-99 (9th Cir. 1977), cert.

denied, 434 U.S. 1040 (1978).

Design Changes

IBM’s design changes challenged in this case—redesign of

the interface between the CPU and certain peripherals—are of

the same type as those previously contested in CalComp and

Memorex. Those cases upheld the legality of IBM’s design

changes. The district court here made a similar ruling, finding

that the contested changes were improvements in the products,

were not unreasonably restrictive of competition, and hence did

not violate the Sherman Act.? Transamerica Computer, 481 F.

Supp. at 1003-05. Transamerica has not demonstrated how the

design changes in this case can be distinguished from the

changes in the two other cases or how the district court's

findings are clearly erroneous. Again, on the authority of

CalComp and Memorex, we affirm the district court's ruling that

the interface changes were not unreasonable. See also Telex

Corp. v. IBM, 510 F.2d 894, 902, 906 (10th Cir. 1975), rev’g

367 F. Supp. 258 (N.D. Okla. 1973), cert. dismissed, 423 U.S.

802 (1975).

Transamerica also charges that IBM's redesign of the

System 370 Model 115 and 125 CPUs unreasonably restricted

competition. The 115 and 125 models were the smaliest of

IBM’s System 370 CPUs. The models included a channel for

attaching slower speed devices. The district court found that

IBM redesigned the models to operate just short of the speed

that would have enabled peripherals manufactured by PCMs to

attach, and thus that the change unreasonably restricted com-

petition. Transamerica Computer, 481 F. Supp. at 1006-08.

2 This court has stated that in determining whether a defendant's conduct

constitutes the willful acquisition or maintenance of monopoly power required

for the offense of monopolization, “the test is whether the defendant's acts.

otherwise lawful, were unreasonably restrictive of competition.” CalComp,

613 F 2d at 735-36 ( footnote omitted) (emphasis in original). Likewise, we

have said that to determine whether defendant's conduct constitutes the kind

of predatory or anticompetitive action required for the offense of attempt to

monopolize, “individual conduct is measured against the same ‘reason-

ableness’ standard.” /d. at 737,

The district court. however, refused to award Transamerica

damages for two reasons. First, it found that IBM did not

possess monopoly power in the requisite market. Second. it

found that Transamerica did not suffer any injury as a result of

IBM's conduct because

[t]he market for the tapes excluded by this conduct was

insignificant. Only tape drives with data rates between 30

and SOKB were affected. Those were older. lower perfor-

mance technology devices that would only have been

competitive at prices far below those contemplated in

Transamerica’s damage claim. Transamerica probably

owned some of them, but its President didn’t know how

many. and any Transamerica owned were purchased in the

second Telex tape contract. Because that contract was not

an arms-length transaction, this Court would be reluctant

to award Transamerica any damages on the equipment

purchased thereunder. Also. there is no evidence that

Transamerica in the past supplied peripherals for the

11$/125 migrator systems, or that it intended to, or took

any steps to supply peripherals for the I15 and 128

systems.

Transamerica Computer, 481 F. Supp. at 1008 n.109.

We need not consider the first of these findings—that IBM

lacked monopoly power—because we hold that the district

court’s finding that Transamerica suffered no damages attribut-

able to the redesign of the Models 115 and 125 is not clearly

erroneous. Without proving antitrust injury. Transamerica can-

not recover for the antitrust violation if, in fact. any violation

occurred. CalComp, 613 F.2d at 732. We affirm the district

court’s holdings on IBM's design changes.

Predatory Pricing

A. The District Court's Findings

In response to the challenge from the PCMs, IBM in-

troduced several “new” products which actually were repack-

aged versions of existing products. The “new” products were

priced below the older versions. Transamerica asserts that these

lower prices were predatory.

The district court carefully examined these price cuts.

Transamerica Computer, 481 F. Supp. at 996-1002. It con-

cluded that IBM expected the new products to “return substan-

tial profits,” id. at 997; that, in fact. the products were profit-

able: and that the prices at issue exceeded the average total cost

of producing the products. /d. at 1002. After an extensive

analysis, the court concluded that IBM's pricing policy was

legal.

The district court's finding that the challenged prices

exceeded IBM's average cost is not clearly erroneous.? The

district court, however, applied an incorrect test in deciding

whether such prices were predatory. We set out the correct test

below, apply that test to this case, and conclude that IBM’s

pricing policy was legal.

7 At trial, IBM presented evidence that the prices challenged by Trans-

america were above average total cost. Transamerica contended that IBM's

Prices. after application of several accounting adjustments. were below

average total cost. The district court held that the adjustments were

inappropriate. Transmerica Computer, 481 F. Supp. at 998-1001. Trans-

america does not appeal this ruling

Transamerica also asked the district court to include “impact costs” in

calculating IBM's profits. Impact costs are the “reduction in anticipated future

Prohts on an existing product line caused hy the introduction of a new product

line.” Jn re IBM Peripheral EDP Devices Litigation, Transamerica Computer

Co., Inc. v. 1BM, 459 F. Supp. 626, 631 (N.D. Cal. 1978). The district court

ruled before trial that impact costs should not be included in calculating total

costs because to do so would create a disincentive to research and innovation

and because impact costs are difficult to calculate. /d. Despite this pre-trial

ruling, Transamerica was allowed to introduce evidence of impact costs.

Transamerica Brief at 21, $0; 72 Tr. 1244-519, 73 Tr. 12541-47, 12568-97,

12614-19, 12645-S0, 12666-87. Transamerica does not contend on appeal that

it was precluded from introducing any evidence on impact costs.

Although evidence of impact costs was before the district court, it did not

discuss such costs in reaching its findings of fact on Transamerica's predatory

pricing claim. On appeal, Transamerica contends the district court committed

Prejudicial error in foreclosing consideration of impact costs.

Our review of the record indicates that these costs were speculative.

IBM's old products were also being displaced by products produced by

PCMs. While IBM might have “lost” profits through the introduction of new

Products, it arguably would have lost more without the new products. The

profits that Transamerica claims IBM could have reaped from its old products

might never have been realized by 1BM because of competition from the

PCMs. In these circumstances, we cannot say that the district court was clearly

erroneous in not including impact costs in its calculations. Bur see Ordover

and Willig, An Economic Definition of Predation: Pricing and Product

Innovation, 91 Yale LJ. 8, 26 1.49 (1981). We do not foreclose the possibility

that impact costs ought to be considered when appropriate.

y

B. The Economic and Legal Background

We differ with the district court on the proper analysis of

situations where a defendant's prices are alleged to be pred-

atory even though they exceed the defendant's average total

cost. To analyze such situations. a preliminary discussion ot

economic terminology and legal precedents is helpful.

Predatory pricing occurs when a company that controls a

substantial market share lowers its prices to drive out com-

petition so that it can charge monopoly prices. and reap

monopoly profits. at a later time. William Inglis & Sons Baking

Co. v. LTT Continental Baking Co.. Inc., 668 F.2d 1014. 1031-

32 (9th Cir. 1981). cert. denied, 103 S. Cr. $8 (1982): Janich

Bros.. Inc. v. American Distilling Co.. $70 F.2d 848. 856 (9th

Cir. 1977). cert. denied. 439 U.S. 829 (1978): L. Sullivan.

Handbook of the Law of Antitrust 109 (1977). It can be

difficult. however. to distinguish predatory price cuts intended

to eliminate competition from legitimate price cuts designed to

meet or beat competition. An influential attempt to clarify the

distinction was made by Professors Phillip Areeda and Donald

Turner. who proposed a “cost-based™ test for predation.‘

Under such a test. the relation between the cost of producing a

product and the price charged for it is the criterion for

determining whether the price is predatory.

Economists. however. measure a firm’s costs in a number

of ways. and these measures are relevant in understanding the

Areeda-Turner proposal and this court's reaction to it. Costs are

divided into fixed costs (those that do not vary with changes in

output) and variable costs (which do so vary). Total cost is the

sum of fixed and variable costs. Marginal cost is the increment

to total cost that results from producing an additional unit of

output. Average cost, or average total cost, is obtained by

dividing total cost by output. Likewise. average variable cost is

the sum of all variable costs divided by output. Average cost Is

thus higher than average variable cost for all output levels.®

4 Areeda Turner. Predatom Pricing and Related Practices Under Section

> of the Sherman Act, 8% Harv. L. Rev. 697 (1978)

‘See 3 P Areeda & D. Turner. Antitrust Law © 712 fora full discussion

ft these terms

10

Areeda and Turner suggest that prices be considered per se

lawful (i.e, non-predatory) if they exceed the defendant's

marginal cost or average variable cost.6 and that prices be

considered per se illegal ( predatory) if they are below marginal

or average variable cost.” The rationale for this cost-based per

se test is the belief that a company that makes a profit, however

small, on each additional product does so because it is efficient,

and should not face antitrust challenges, whereas a company

that loses money on the sale of an additional product is doing

sO presumably for anti-competitive reasons.

The Areeda-Turner test has provoked much judicial and

academic comment.® This court has been influenced by the

Areeda-Turner tes: without unqualifiedly embracing it. In a

series of opinions during the three years preceding the district

®Areeda and Turner favor using marginal cost as “the economically

sound division between acceptable, competitive behavior and ‘below-cost’

predation.” Areeda & Turner, supra note 4, at 716. They recognized,

however, that marginal cost is usually difficult or impossible to compute and

suggested using average variable cost—which is likely to approximate

marginal cost—as a surrogate. Jd. at 716-18

” Areeda and Turner make an exception where marginal cost exceeds

average total cost. In this rare case, the price “floor” for permissible pncing is

average total cost. Areeda & Turner. supra note 4, at 7|3

® While no courts have explicitly adopted the Areeda-Turner test in its

entirety for all cases, a number of courts have adopted elements of the

Areeda-Turner test. See, e.g. Northeastern Tel. Co. v. American Tel. & Tel.

Co., 651 F.2d 76, 87-88 (2d Cir. 1981), cert. denied, 48§ US. 973 (1982);

Chillicothe Sand & Gravel Co. v. Martin Marietta Corp., 6\$ F.2d 427, 43|-32

(7th Cir. 1980); Pacific Eng'g & Prod. Co. v. Kerr-McGee Corp., $§\ F.2d

790, 797 (10th Cir.), cert. denied, 434 US. 879 (1977): National Ass'n of

Regulatory Util. Comm'rs v. FCC, $25 F.2d 630, 637-38 & n.34(DC. Cir),

cert. denied, 425 U.S. 992 (1976); International Air Indus. Inc. v. American

Excelsior Co., 517 F.2d 714, 723-25 (Sth Cir. 1978). cert. denied, 424 US.

943 (1976).

The Areeda-Turner test also generated a number of counter proposals

for evaluating predatory pricing. Sullivan, for example, suggests that courts

look to “human animus” in market conduct. He would focus on the “traces” a

predator leaves behind, such as documents containing information about

competitors. Sullivan, Economics and More Humanistic Disciplines: What are

the Sources of Wisdom for Antitrust?, 127 U. Pa. L. Rev. 1214, 1229-30, 1232

(1977).

Joskow and Klevorick suggest a complex cost-based test in which market

structure is considered and the defendants have a greater burden to produce

documentation of their costs. Joskow & Klevorick. A Framework for

Analyzing Predatory Pricing Policy, 89 Yale LJ. 213 (1979)

( Footnote continued on following page)

court's decision reviewed here.? we approved the use of mar-

ginal or average variable cost in establishing predation without

making that mode of proof exclusive. as Areeda and Turner

advocate. Indeed. we adopted neither the Areeda-Turner test's

conclusive presumption that prices above marginal or average

variable cost are legal. nor its conclusive presumption that

prices below that cut-off point are predatory. It is true that in

Hanson v. Shell Oil Co., $41 F.2d 1352. 1359 1.6 (9th Cir.

1976). cert. denied, 429 U.S. 1074 (1977). we spoke of “proof

of pricing below marginal or average variable cost” as a

“prerequisite to the prima facie showing of an attempt to

monopolize.” Nevertheless, we suggested that prices above

marginal or average variable cost might. In appropriate circum-

stances. be found predatory. id. at 1358 n.5, and we reiterated

that point in CalComp, 613 F.2d at 743. We also explicitly

denied that prices below marginal or average variable cost were

per se unlawful. Hanson, $41 F.2d at 1359 n.6. In short. the

closest we were willing to move to the Areeda-Turner approach

was to acknowledge that a “price set at or above marginal cost

should not ordinarily form the basis for an antitrust violation.”

Janich Bros., Inc. v. American Distilling Co., 570 F.2d at 857

( footnote omitted) (emphasis added).

Any doubt that this circuit rejects the per se aspects of the

Areeda-Turner test was dispelled in William Inglis & Sons

Baking Co. v. ITT Continental Baking Co., Inc., 668 F.2d 1014

Footnote continued from preceding page)

Williamson considers output a more important factor than cost or price

He would prohibit a monopolist confronted with a new competitor from

increasing its output for twelve to eighteen months. This restraint would

diminish as the entrant gained experience and economies of scale. William-

son. Predatory Pricing, 87 Yale L.J. 284 (1977).

For the most recent discussion of these ideas and the Areeda-Turner test

see Note. Predatory Pricing: The Retreat From the AVC Rule and the Search

for a Practical Alternative, 22 B.C.L. Rev. 467 (1981)

See also Ordover and Willig. An Economic Definition of Predation:

Pricing and Product Innovation, 91 Yale LJ. 8 (1981); Baumol. Quasi-

Permanence of Price Reductions: A Policy for Prevention of Predatory Pricing,

89 Yale LJ. | (1979); Williamson, Predatory Pricing: A Strategic and

Welfare Anaksis, 87 Yale L.J. 284 (1977).

9 California Computer Products, Inc. v. 1BM, 613 F.2d 727 (9th Cir.

1979): Janich Bros., Inc. v. American Distilling Co., $70 F.2d 848 (9th Cir.

1977). cert. denied, 439 U.S. 829 (1978); Hanson v. Shell Oil Co., $41 F.2d

1382 (9th Cir. 1976). cert. denied, 429 US. 1074 (1977).

12

(9th Cir. 1981), cert. denied, 103 S. Ct. 58 (1982), decided

after the district court’s decision in the instant case. In Jnglis we

explained that prices are predatory when their justification

rests, “not on their effectiveness in minimizing losses, but on

their tendency to eliminate rivals and create a market structure

enabling the seller to recoup his losses.” Jd. at 1035.10 We

emphasized that this standard, “and not rigid adherence to a

particular cost-based rule . . . must govern our analysis of

alleged predatory pricing.” Jd. Yet Inglis did not, as Trans-

america contends here. repudiate all cost-based tests. Rather, it

laid down a cost-based test for allocating the burden of proof

on the predation issue in place of one designed (like the

Areeda-Turner test) to resolve that issue conclusively:

[To establish predatory pricing a plaintiff must prove that

the anticipated benefits of defendant’s price depended on

its tendency to discipline or eliminate competition and

thereby enhance the firm’s long-term ability to reap the

benefits of monopoly power. If the defendant’s prices were

below average total cost but above average variable cost,

the plainuff bears the burden of showing defendant’s

pricing was predatory. If. however, the plaintiff proves that

the defendant's prices were below average variable cost,

the plaintiff has established a prima facie case of predatory

pricing and the burden shifts to the defendant to prove that

the prices were justified without regard to any anticipated

destructive effect they might have on competitors.

Id. at 1035-36.

C. The Treatment of Prices Above Average Total Cost

The Inglis test. quoted above, addresses only two cate-

gories of prices—those below average variable cost ( which.

under burden shifting, the defendant must prove are non-

predatory)'' and those above average variable cost but below

average total cost ( which the plaintiff has the burden of proving

are predatory). The Jnglis test says nothing about how to

evaluate prices for antitrust purposes that exceed average total

cost. Indeed, Jnglis explicitly left this queston open. 668 F.2d at

1035 n.30.

'° See also D & S Redi-Mix v Sierra Redi-Mix & Contracting Co., 692

F.2d 1245, 1249 ( 9th Cir. 1982).

'* Of course, plaintiff inmally bears the burden ef proving that defend-

ant’s price did in fact fall into this category of suspect prices.

13

In the instant case. the district: court, which did not have

the benefit of Inglis and its clarification of our previous

discussions of the Areeda-Turner test. held that prices above

average total cost “should be conclusively presumed legal.”

Transamerica Computer, 481 F.Supp. at 991.'2 We disagree for

several reasons.

First. this court has already recognized that prices ex-

ceeding average total cost might nevertheless be predatory in

some circumstances. The specific example we discussed was

“limit pricing.” in which a monopolist séts prices above average

total cost but below the short-term profit-maximizing level so as

to discourage new entrants and thereby maximize profits over

the long run. See 3 P. Areeda & D. Turner. supra, © 714b. We

explained that “limit pricing by a monopolist might. on a record

which presented the issue. be held an impermissible predator

practice. ’* CalComp, 613 F.2d at 743. A similar pricing strategy

would be for a monopolist to make temporary reductions to a

level above average total cost but below the profit-maximizing

Price whenever a new entrant appears ready to enter the

market. One or two such reductions could discourage potential

entrants in a market that requires sizable initial investments.

leaving the monopolist free to raise his prices to monopoly

levels. See 3 P. Areeda & D. Turner. supra, © 714c. Such a

Pricing strategy. like limit pricing. could well be found pred-

atory.'3

Second. the district court’s per se test rests on the notion

that price reductions to average total cost result from efficient

production and harm only less efficient competitors. Trans-

america Computer, 481 F. Supp. at 991. But companies may

lower their prices for temporary strategic reasons as well. One

'? To this extent the district court was. as it noted. agreeing with Areeda

and Turner Transamerica Computer. 48\ F Supp at 991. It disagreed with

them. however. by concluding that prices below average total cost are not per

se lawful even if they exceed average vanable cost. /d at 991-95 The

treatment of prices hetween average total cost and average vanable cost has

since heen settled in this circurt by /ng/is and is not at issue here.

‘We do not mean to suggest that all pncing that is not profit

maximizing in the short run is illegal. As we stated in /mgiis, prices below the

level at which profit is maximized “may legitimately be justified on long-term

considerations. as long as those do not include the anticipation of enhanced

market power as a result of predation.” /nglis. 668 F.2d at 1034 1.29

14

critic of the Areeda-Turner test points out that a monopolist can

employ price strategies that jeopardize consumers’ long-run

welfare without lowering prices below average total cost and

concludes that “it is unrealistic and even analytically wrong to

apply a simple short-run price-cost rule for determining

whether exclusionary pricing by a monopolist is socially

undesirable and therefore predatory.” Scherer, Predatory Pric-

ing and the Sherman Act: A Comment, 89 Harv. L. Rev. 869.

890 (1976). It may be difficult in many or most instances to

assess the long-run consequences of challenged pricing pol-

icles.’ But where those difficulties can be overcome, the law

should not prevent plaintiffs from proving antitrust violations.

Third, the uncertainty and imprecision inherent in

determining “costs” counsel against basing conclusive presump-

tions On the relation between prices and costs. Assessing those

relations for the products of a multi-product firm requires

allocating known and estimated costs and revenues among

various products. While accounting problems do not warrant

ignoring cost figures completely, they do make it unwise to rely

exclusively on such figures.

Finally. we should hesitate to create a “free zone” in which

monopolists can exploit their power without fear of scrutiny by

the law. A rule based exclusively on cost forecloses consid-

eration of other important factors, such as intent. market power,

market structure, and long-run behavior in evaluating the

predatory impact of a pricing decision. "5

“* Cf Areeda & Turner. Scherer on Predator, Pricing: A Repl. 89 Harv

L. Rev 891. 897 (1976): 3 P. Areeda & D. Turner. supra note §. € 715. at

166-67

‘SThe Seventh Circuit also recognizes the importance of considering

non-price factors in evaluating whether a pricing policy is predatory Chilli-

cothe Sand & Gravel Co. v. Martin Marietta Corp.. 61§ F 2d 427. 432 (7th

Cir 1980). see also MCI Communications Corp. v. American Tel. & Tel Co..

F 2d—at— 58. Nos. 80-2171. 80-2288 (7th Cir Jan. 12. 1983). CF

Pacie Engg & Prod. Co. v Kerr-McGee Corp. $51 Fld 790. 797 (10th

Cir). cert. denied, 434 LS 479 (1977)

This ts also the position of the National Commission for the Review of

Antitrust Laws and Procedures. Report to the President and the Attorney

General (Jan 22. 1979). As the Deputy Attorney General for the Antitrust

Division noted. cost-based tests do not “truly reflect marketplace realities and

provide for anticompetitive behavior.” He also noted that even Areeda and

Turner “are now troubled by excluding factors like direct evidence of intent.”

(hoetnde atnued on tollowineg page)

1S

For these reasons, we disagree with the district court's

conclusion that prices above average total cost should be legal

per se. Rather. we believe that Jnglis adopted the proper

approach to the use of cost figures in determining whether

prices are predatory: cost categories should be used to allocate

the burden of proof on the issue of predation. By this approach.

we give due weight to the economic considerations which

suggest that prices are presumptively lawful if they exceed

marginal or average variable cost and presumptively predatory

if they do not. And. of course, this approach does not preclude a

litigant from introducing evidence sufficient to overcome these

presumptions. Inglis followed this approach in evaluating prices

below average variable cost and prices between average vari-

able cost and average total cost. The logic of the Inglis

approach applies with equal force in evaluating prices above

average total cost.

The test for determining the antitrust legality of prices that

exceed average total cost should be consistent with the Jnglis

approach and with our view that cost-price relations should not

be the exclusive method of proving predation. In addition, the

test should be consistent with the economic analysis of Areeda

and Turner. Their analysis indicates that prices above average

total cost will rarely be predatory." Therefore. it is appropriate

to impose on the plaintiff a greater burden of proving that

prices above average total cost are predatory than the burden

imposed by Inglis to prove that prices between average variable

and average total cost are predatory. We therefore hold that if

the challenged prices exceed average total cost, the plainuff

must prove by clear and convincing evidence—i.e., that it 1s

highly probably true—that the defendant's pricing policy was

predatory.

. Footnote continued from preceding page)

Remarks of Ky P. Ewing. Jr. Deputy Assistant Attorney General. Antitrust

Division. before the Fifth Annual Symposium on Antitrust Law. The South-

western Legal Foundation, Dallas. Texas. on May 9. 1980. [1980] Trade

Reg Rep (CCH) © 55.936. The report recommends that the Sherman Act

should be amended to provide that. although marginal cost should be

considered in determining whether prices are predatory. a showing of pricing

helow marginal cost should not be a prerequisite to make out an attempt to

monopolize based on pricing practices Report to the President at 40

'® Predatory pricing should not be countenanced merely because it would

he difficult to detect in situations where price exceeds average total cost. See

Chillcothe Sand & Gravel Co. ¥ Martin Marietta Corp., 618 F 2d 427, 432

(9th Cir, 1980) (“Section 2 of the Sherman Act makes no exceptions for cases

involving administrative difficulty ~)

16

D. The Proper Test Applied to This Case

While we modify the test applied by the district court, we

affirm the court’s decision that IBM's pricing policy did not

violate the antitrust laws. 17

The district court found that IBM’s prices were above its

average total cost. Transamerica Computer, 481 F. Supp. at

1002. This finding was not clearly erroneous. Thus, to prevail

on its claim of predatory pricing, Transamerica must prove by

clear and convincing evidence that IBM’s pricing policy unrea-

sonably restricted competition. The exhaustive trial record,

containing a plethora of evidence on pricing behavior, market

structure, production costs, marketing strategies, and other

related information, fails to provide any clear and convincing

evidence of predatory pricing.’® Transamerica did not, for

example, introduce evidence that IBM’s prices rose once com-

petition had left the market. The only price increases cited by

Transamerica were modest increases in the mid-1970s. During

that inflationary period, however, IBM increased prices on all

its products, not just those involved in this case. Transamerica

did not prove that IBM engaged in limit pricing.'9 Trans-

america simply introduced evidence of an initial price cut,

'7*We may uphold correct conclusions of law even though they are

reached for the wrong reason or for no reason, and we may affirm a correct

decision on any basis supported by the record.” United States v. Washington,

641 F.2d 1368, 1371 (9th Cir. 1981), cert. denied sub nom. Duwamish Indian

Tribe v. Washington, 454 U.S. 1143 (1982).

‘® At trial Transamerica was not precluded from introducing evidence of

predatory pricing. The district court's ruling that prices above average total

cost are per se legal was made after the trial concluded.

‘9 While Transamenica contends that it proved that IBM engaged in limit

pricing. the evidence suggests otherwise. Limit pricing exists where entry

barriers are “great enough to prevent other entry.” Hanson, 541 F 2d at 1358

n.$, or are “extremely high.” Pierce Packing Co. v. John Morrell & Co., 633

F.2d 1362. 1366 ( 9th Cir. 1980). Here. the district court found that the entry

barriers to the peripherals market were “extraordinanly low.” Transamerica

Computer, 48\ F. Supp. at 987

Further. a limit price is designed to deter entry into the market. To be

limiting, therefore, the price must generally be below competitors’ prices

Here. “IBM's prices did not undercut the PCM’s prices, they did not even

equal them, they merely closed the gap: the PCM’s prices were still lower." /d.

at 1002

The evidence also suggests that IBM's prices did not have a limiting

effect. A number of companies entered the peripherals market and took

substantial business from IBM. /d. at 986 The cariy success of the PCMs

suggests that no limit pricing occurred.

( Footnote continued on following page)

i7

hardly an unusual act in the computer industry or unusual in

the face of competition. Transamerica’s evidence of predatory

pricing falls far short of the type of clear and convincing

evidence that would permit the trier of fact to find predatory

pricing when prices were above average total cost.

Conclusion

Thus. even assuming that IBM possessed monopoly power

in the relevant market, its lease plan, design changes. and

pricing policy did not constitute unreasonable restrictions on

competition. On this record, IBM was entitled to judgment as a

matter of law. Therefore. we need not consider whether the

district court erred in finding that IBM did not possess monop-

oly power. Transamerica Computer, 481 F. Supp. at 974-87, or

that Transamerica had failed to prove damages. Id. at 1010-21.

The judgment is AFFIRMED.

Lucas. District Judge. concurring:

| agree that the judgment of the district court in favor of

defendant should be affirmed. I disagree. however. with the

court’s modification of the trial court’s test for predatory

pricing.

Professors Areeda and Turner. in their article. Predaton

Pricing and Related Practices Under Section 2 of the Sherman

Act, 8&8 Harv. L. Rev. 697 (1975), proposed an exhaustive per

‘se rule for determining whether pricing conduct should be

deemed predatory: (1) prices above reasonably anticipated

average variable cost should be conclusively presumed lawful:

and (2) prices below reasonably anticipated average variable

/ Footnote continued from preceding page)

Finally. while Ca/Comp held that “limit pricing by a monopolist might.

on a record which presented the issue. be held an impermissible predatory

practice.” 613 F.2d at 743, CalComp found that IBM's prices did not

constitute limit pricing but rather were a law ful response to competition. /d.

Transamerica’s evidence is indistinguishable from CalComp’s. As in Cal-

Comp. we find that the evidence does not indicate that IBM engaged in limit

pricing

18

cost should be conclusively presumed unlawful.’ In the nearly

seven years since this article appeared many courts have

considered this suggestion. See Spivak. Monopolization Under

Sherman Act, Section 2, 50 Antitrust Law Journal 285, 313-14

n.132 (1982). Although it appears that no court has adopted

this proposed rule without modification or qualification, many

courts have agreed with Areeda and Turner that the relation-

ship between prices and average variable cost is of significance

in evaluating pricing behavior under the Sherman Act. Jd. This

court, in William Inglis & Sons Co. v. ITT Continental Baking

Co., Inc., 668 F.2d 1014 (9th Cir. 1981). cert. denied, 103 S. Ct.

58 (1982). made clear that the relationship was to be used to

allocate the burden of proof on the issue of predation, rather

than to resolve the issue conclusively. In thus modifying Areeda

and Turner’s suggested rule. the court explicitly declined to

address their more modest yet important suggestion that prices

above average total cost should be conclusively presumed

legal.2 Judge Schnacke found this limited rule to be sound and

used it in granting judgment in favor of defendant. In my

opinion, the trial court was correct.

In rejecting the approach taken by Judge Schnacke. the

court expresses four concerns. First the court points out that

under certain circumstances price reductions might properly be

labeled “predatory” even though prices never fall to average

total cost or below. Two examples are given, both of which

have often been discussed by the academics and by the courts:

limit pricing and temporary price reductions in an industry with

‘Noting “marginal cost data are typically unavailable.” Professors

Areeda and Turner use average variable cost as a surrogate for marginal cost.

Areeda & Turner, Predatory Pricing and Related Practices Under Section 2 of

the Sherman Act, 88 Harv. L. Rev. 697, 717 (1975)

2 Inglis, supra, 668 F.2d 1014, 1035 n.30. Average total cost is. by

definition, always higher than average variable cost. See Areeda & Turner.

supra note |, at 700-01. A per se rule tied to average total cost creates,

therefore, a smaller area in which pricing conduct will be presumed to be

legal than a rule tied to average variable cost. (It is true that average variable

cost 1s used as a surrogate for marginal cost and that marginal cost can, in

some unusual cases, exceed average total cost. Jd Areeda and Turner modify

their marginal cost rule in these cases. however, to provide that prices below

marginal cost are legal if they exceed average total cost. Jd. at 712-13.)

19

high entry barriers. See. e.g.. Areeda & Turner. supra, at 705-

O09: In re IBM Peripheral EDP Devices Antitrust Litigation,

Transamerica Computer Co., Inc. v. 1BM, 481 F. Supp. 965

(N.D. Cal. 1979) [ Transamerica Computer|; Scherer, Pred-

atory Pricing and the Sherman Act: A Comment, 89 Harv. L.

Rev. 869 (1976). The second concern voiced by the court ts

that the district court erred in assuming that all “price reduc-

tions to average total cost result from efficient production and

harm only less efficient competitors.” Ante, at 13. This.

however. merely restates the first concern noted by the court.

for the only price reductions not attributable to efficient produc-

tion Which should be labeled “predatory” are those which harm

equally or more efficient competitors. These fall into the two

categories noted in the above examples. Indeed. the court's

tinal argument. that “we should hesitate to create a ‘free zone?

in which monopolists can exploit their power without fear of

scrutiny by the law.” expresses the same fear voiced in the first

two arguments.

The fear that some pricing conduct in the realm above

average total cost might have socially undesirable effects in the

long run does not. however. necessarily provide an adequate

justification for adopting the rule approved by the court. One

must also evaluate the practical utility of the rule. the con-

sequences of adopting such a rule. and the advantages which a

contrary rule. in this case a per se rule, might provide.

The court concedes that pricing conduct above average

total cost will only “rarely” have socially undesirable effects

and, thus, constitute predation. Anre, at 15.9 Thus, even absent

any practical problems of proof. the court's rule will seldom

yield a result different from that which a per se rule would yield.

The court also recognizes, however, that there will be problems

) Even Spivak. who disagrees vigorously with the price tests put forward

by Areeda and Turner, concedes that where prices are above average total

cost, courts could “almost invariably” decide the predatory pricing issue on

cost data alone. See Spivak, Monopolization Under Sherman Act Section 2, $0

Antitrust L.J. 285, 318-16 (1982)

20

of proof in this area. Ante, at 14 n.14. It will be extremely

difficult if not impossible to prove up facts sufficient to support a

finding of predation where prices do not drop below average

total cost. See Transamerica Computer, supra, 481 F. Supp. at

991. These practical difficulties, combined with the higher

burden of proof imposed by the court today, raise a serious

question as to whether liability will in fact be imposed in those

rare cases in which it might be.

Yet while the court's rule is likely to have little practical

utility, it could well inhibit socially desirable conduct. As Judge

Schnacke noted below:

It would be all but impossible to distinguish between

above cost limit pricing conduct and a monopolist’s

procompetitive reaction to lower priced competitors. One

external characteristic is common to both cases, a lowered

price. An attempt to attach liability to the one will surely

inhibit the indistinguishable other.

Transamerica Computer, supra, at 991 (footnotes omitted).

Furthermore, the rule approved by the court may well increase

the number of meritless antitrust actions filed: withou!

reasonable “safe harbor” in which to seek shelter, osc:

monopolist engaged in legal price competition above average

total cost will be a potential target for attack by a competitor

attempting to prove that its case Is one of the rare instances of

predatory pricing conduct.

In addition to these shortcomings, it cannot be doubted

that the court's rule will increase the difficulty of trying complex

antitrust cases. Cf. Inglis, supra, at 1063-64 (Judge Wallace

dissenting from denial to rehear en banc voiced similar concerns

with the court's rejection of the marginal cost rule). A per se

rule. by contrast, would provide a manageable way of signifi-

cantly simplifying some aspects of many cases.

In addition to the court's fear of monopolist exploitation of

the “free zone” above average total cost, the court gives an

additional ground for rejecting a per se rule: the difficulty of

calculating costs. Because such costs are difficult to calculate,

the court finds it unwise to base conclusive presumptions on the

21

price-cost relationship. Though difficult. the task of calculating

costs is not impossible. As with other difficult factual issues, the

finder of fact. aided by expert testimony, will, I believe. be able

to determine average total cost with reasonable precision. Thus,

| cannot agree that the difficulty of calculating costs warrants

rejection of a useful and sound decisional tool such as the per se

test tied to average total cost.

On balance. I find the limited per se rule adopted by Judge

Schnacke to be preferable to the test approved by the court

today. I would affirm the judgment without modifying the trial

court's test for predatory pricing.

APPENDIX B

IN THE

United States District Court

FOR THE NORTHERN DISTRICT OF CALIFORNIA

In re IBM Peripheral EDP Devices

Antitrust Litigation

\VIDL No. 163-RM

TRANSAMERICA COMPUTER COMPANY, |

INC.. a corporation, — C-73-1832 RHS

Plaintiff. OPINION

¥ ” October 18, 1979

INTERNATIONAL BUSINESS MACHINES AS AMENDED

CORPORATION, a corporation, December 20, 1979

Defendant. J

The opinion heretofore filed is revised and amended to

read as follows:

Plaintiff. Transamerica Computer Company. Inc. (*Trans-

america’), has alleged that certain activites of Defendant.

International Business Machines Corporation (“IBM”). vio-

lated Section 2 of the Sherman Act which forbids the monopoli-

zation or attempted monopolization of any part of trade or

commerce. '

An appreciation of the nature of the computer industry and

the parties’ respective roles is helpful to an understanding of.

and indispensable to an evaluation of. that conduct.

Computers. like the punched card accounting equipment

that preceded them. depend upon the capabilities of the

electronic circuits. Because of the laws of physics involved, an

electronic circuit, if properly designed. is capable of performing

‘IS USC Section 2

both arithmetic and logical functions. For instance. it is

possible to design a circuit that will add two numbers together

(an arithmetic function), and another circuit that will compare

the result of the addition to a third number and choose between

various alternatives on the basis of that comparison (a logical

function). The sequence of arithmetic and logical functions

that are to be performed is known as a program. With punched

card accounting equipment, programs were “hard-wired,” that

Is, the sequence of functions to be performed by the arithmetic

and logical circuits was predetermined, and could only be

altered by actually switching wires around within the machine.

In 1951, in response to the needs of the Bureau of the

Census, Sperry Rand Corporation introduced the first stored-

program computer, the Univac |. The first computer differed

from its predecessors in that it was possible easily to alter the

program that determined the sequence of functions to be

performed. No longer was it necessary to “hard-wire” the

program; the sequence of functions desired could now be

indicated to the computer through “softer” and more flexible

means. A program could be punched into a series of cards and

the content of those cards could then be read into the computer.

The computer would turn to this data read in from the cards for

instructions as to what arithmetic and logical functions it was to

perform, and in what sequence. A program could be altered

simply by altering a punched card. and new programs could be

carried out merely by causing the machine to read in a different

set of punched cards.

IBM offered its first electronic computer in 1953. That

machine, like those offered by competitors, utilized vacuum

tubes to perform the electronic circuit functions. Before long,

this first generation of computers was ourmoded by a second-

generation whose transistorized circuits performed more eco-

nomically and more reliably. In 1964, IBM announced a series

of machines. the System/360; these were the first of the third

generation computers. The 360s not only employed improved

components ( integrated circuits replaced transistors ), they also

relied upon a single general design or architecture for a broad

spectrum of machines. That meant that one computer was

3

capable of efficiently performing both scientific and commercial

tasks. and. perhaps most important, it meant that customers

who outgrew their smaller machines could “migrate” to larger

machines without the need to change their existing programs:

the whole 360 family of computers was program-compatible to

an unprecedented degree. As a result. System/360 was a

tremendous commercial success.

In 1970 IBM announced its 370 system, a further signifi-

cant improvement. and superior to the 360 system.

The new 370 system involved improved central processing

units as well as new and improved peripherals. All of the acts

Transamerica claims caused it damage were related to the

introduction of the 370 system.

IBM is a supplier of computer systems, supplying all. or

nearly all of the user's computing needs. It offers a wide range

of services and products, both software and hardware.2

The hardware of a computing system consists of a central

Processing unit (“CPU”), which houses the arithmetic and

logical electronic circuits, and a Variety of peripheral gear.

The functions of peripherals include: storing data for later

access by the CPU; feeding data into the CPU (input): and

accepting data from the CPU (output). A machine capable of

reading data on punched cards and transferring that data to the

CPU is considered an input peripheral, while a printer attached

to the CPU functions as an output peripheral. Some peripherals

perform all three functions. Disk drives and tape drives are

examples of peripherals capable of storing data, inputting data,

and outputting data. Data is stored on disks and is “randomly”

accessed very rapidly by an access arm with the capability of

reading or writing data. The access arm can be made to move

to a particular track on the disk where the data is to be read or

written. Tape drives are used for reading and writing data

sequentially. Random access of data on tape reels is impractical

because it is so time consuming.

* Programs have come to be known as “software” while the term

“hardware” has heen reserved to refer to the Physical machinery associated

with che computer

4

The tape and disk drives which attached to System/360

CPUs were a lucrative part of IBM’s business, so lucrative in

fact, that they attracted competition. In the late 1960's, several

companies began marketing copies of IBM’s tapes, disks and

printers, which were “plug-compatible” with IBM CPUs. A

user could simply unplug the IBM peripheral, substitute the

cheaper copy, and plug it into the IBM CPU. The companies

providing this new competition became known in the industry

as plug-compatible manufacturers (‘“*PCMs"’).

The PCMs enjoyed a tremendous success. They were

offering equivalent or better performance at a substantial

discount. But in order to sustain their growth the PCMs needed

funds. Most computer systems were leased rather than sold.

This meant that the PCMs were unable to realize a quick return

on their capital investment; much of their capital was tied up in

ownership of leased machines, an investment that would not be

recouped for years. The PCMs needed money to finance the

manufacture of machines to meet a growing demand as well as

to pay for the engineering costs of developing new products.

They sought financing from a variety of sources: the sale of

equity and debt securities; bank loans; the use of leasing

companies; and more complex arrangements.

Transamerica Computer Company, Inc., was incorporated

in late 1967 as a wholly-owned subsidiary of Transamerica

Corporation, a large non-bank financial conglomerate with

wholly-owned subsidiaries in the insurance, auto rental, motion

picture and other businesses. The parent was well financed,

with nearly unlimited credit, and desired a “window to the

computer industry." Transamerica made a number of ventures

into computer related financing. The transactions central to this

case are Transamerica’s purchase of millions of dollars worth of

on-lease tapes and disks from two PCMs, Marshall Industries

(**Marshall’’) and Telex Corporation (*Telex"’).

These manufacturers leased their equipment to end users.

After it was on lease, the equipment was “sold” to Trans-

america under an arrangement by which the manufacturers

were obligated to collect the rents, to service and maintain the

equipment, and to remarket it as leases expired. Unlike some

leasing companies which buy equipment, find users, collect

rentals, etc., Transamerica had no function except to supply

capital. In many cases the end users were unaware of Trans-

america’s ownership of their equipment, and, indeed, at various

times there was considerable doubt as to whether specific

equipment was owned by Transamerica or the manufacturer.

The arrangements also contemplated that, after Transamerica

had been reimbursed some agreed amount, further rental

revenues would be shared between it and the manufacturer.

There were two important reasons for this structuring of what

was basically a financing arrangement. First, Transamerica

expected that, as “owner” of the equipment, it would be

permitted to take, for the substantial benefit of its parent, the

investment tax credit then available under the tax laws. And,

second, the manufacturers hoped to treat the transfers of title to

Transamerica as sales, thus increasing their current profit

picture, and aiding them in sales of their corporate stock.

Neither of these benefits would have resulted if Transamerica

had simply lent money to the manufacturer.

Telex and Marshall were but two of the companies which

were successful in displacing IBM peripheral equipment by

offering it at prices well below those IBM was charging. IBM

responded to the PCM competition by offering certain of its

own products at substantially reduced prices, and by offering its

peripherals for lease on longer and better terms than it had

previously. In addition, new CPUs were introduced that were

incompatible with the PCMs’ existing peripherals. These ac-

tions, and others described herein, are those that Transamerica

contends were the means by which IBM monopolized and

attempted to monopolize in violation of Section 2.

Following a seven month trial, a jury was unable to reach a

unanimous verdict on any of the issues presented. The parties,

before commencement of the trial, foresaw that possibility, and,

stipulated that the case would be submitted to the Court for

decision in the event of jury disagreement. (It might be well for

the courts or Congress to consider whether such an arrange-

ment might be compelled by the trial judge in advance of trial.

No one case should be allowed to monopolize the court’s time

6

indefinitely to the exclusion of the rights of other litigants. If,

after one long jury trial, it becomes apparent that further jury

trials would be inordinately time consuming, without realistic

expectation that the issues would be resolved, the matter should

be resolved otherwise. The best method would seem to be by

decision of the trial judge on the evidence presented at the jury

trial. )

This Court, having heard and fully reviewed all of the

evidence, has made the findings of fact and come to the

conclusions of law that are incorporated in this opinion.

In order to establish that IBM monopolized in violation of

Section 2 of the Sherman Act, plaintiff must prove:

(1) that the defendant was in possession of monopoly

power in a relevant market; and either

(2) that the defendant has willfully acquired or

maintained that power;‘ or

(3) that the defendant used its monopoly power,

whether lawfully or unlawfully acquired, to foreclose com-

petition, to gain a competitive advantage, or to destroy a

competitor.§

The first essential inquiry must be whether IBM possessed

monopoly power; whether it had the power to control prices in,

or to exclude competition from some relevant market® during

the years here in question, 1969 to 1973.

315 U.S.C. Section 2.

4 United States v. Grinnell Corp., 384 U.S. $63, $70-71 (1966) [“Grin-

nell”); California Computer Products, Inc., et al., v. International Business

Machines Corporation, 613 F.2d 727 (%h Cir. 1979) [“CalComp”|;

Greyhound Computer Corp. v. International Business Machines Corporation,

$59 F.2d 488, 492 (9th Cir. 1977), cert. denied, 434 US. 1040 (1978)

| “Greyhound”’}.

$ United States v. Griffith, 334 U.S. 100, 107 (1948); Berkey Photo, Inc.

v. Eastman Kodak Company, 603 F.2d 263 (2d Cir. 1979) [“Berkey”|,; Telex

Corp. v. International Business Machines, Corp., §\0 F.2d 394, 926-28 ( 10th

Cir.), cert. dismissed, 423 U.S. 802 (1975) [“Telex”}.

® United States v. E. 1. duPont de Nemours & Co., 351 U.S. 377, 391

(1956) (“duPont”); CalComp, supra n. 4, at 734; Greyhound, supra n. 4, $59

F.2d at 496,

In general, two types of evidence are relevant to an

appraisal of defendant's ability to control price or exclude

competition. The first category can be broadly labelled “market

structure.” and encompasses evidence that is relevant to an

estimation of the nature and significance of constraints on

defendant's power. The second category, “market perform-

ance” relates to a comparison between the actual past function-

ing of the market and the manner in which monopolized or

competitive markets are predicted to function.

A. Market Structure.

Economic theory teaches that a monopolist. because it is in

a position to control price by varying the quantity of goods it

produces and sells. will be able to sell its goods at a price higher

than would prevail were the market competitive.” As a result it

will earn supra-normal profits. In competitive markets, two

forces are at work which inhibit the ability of a firm to charge

more than the competitive price level and earn more than a

normal profit. First, if a producer raises its price above the

price for competing goods, then customer demand for the

higher-priced article will fall off in favor of cheaper alternatives,

and the producer will be forced to lower its price again.

Second. even if the producer were able to charge relatively

more for its product for a time, the resultant supra-normal

profits would lure new competitors into the market, and the

additional supply of competing goods that they offer to custom-

ers would cause prices and profits to return to competitive

levels.® If that first force (**demand substitutability”) and that

second force (‘supply substitutability”) are sufficient checks

upon defendant's power to control price. than the market in

effectively competitive. If not, defendant is a monopolist.

? See P. Areeda. Antitrust Analysis 13 n. 33 (1974)

8 /d.

8

An inquiry into demand substitutability calls for a defini-

tion of the relevant market and measurement of defendant's

share of that market. The relevant market is comprised of

defendant’s product, products that are fungible, and of those

products which the customer would consider to be reasonable

alternatives.’° If a small increase in the price of product A will

cause customers to shift their allegiance to product B, then the

cross-elasticity of demand is high, the products are reasonable

alternatives, and they belong in the same relevant market.

The geographic aspects of the relevant market must also be

considered.'’ Thus, if small changes in the price of a product in

one location will cause customers to turn to alternatives avail-

able in another location, then the quantity of reasonably

alternative products supplied at both locations should be con-

sidered as part of the relevant market. The relevant geographic

market is the area of effective competition within which the

seller operates and to which the purchaser can practically turn

for supplies. '?

With the relevant market defined, the defendant’s share of

that market can be measured. A relatively small market share

would lead to the inference that monopoly power was not

present since the ready availability of substitutes would defeat

attempts to use that power. The larger defendant’s market

share, the stronger is the inference that competitors would be

unable to effectively check exercises of monopoly power."

9 Walker Inc. v. Food Machinery, 382 U.S. 172, 177 (1965); Twin City

Sportservice Inc. v. Charles O. Finley and Co., $12 F.2d 1264, 1270 ( 9th Cir.

1975); Case-Swayne Co. v. Sunkist Growers, Inc., 369 F.2d 449, 454 ( 9th Cir.

1966), rev'd on other grounds, 389 US. 384 (1967).

‘0 duPont, supra n. 6, at 395. Note that in some circumstances services or

a combination of services and products may provide reasonable alternatives

to the selection of a product. Grinnell, supra n. 4, at $72. The use of the term

“product” here does not indicate that this possibility has not been considered.

"! Case-Swayne Co. v. Sunkist Growers, Inc., 369 F.2d 449, 454 ( 9th Cir.

1966). rev'd on other grounds, 389 US. 384 ( 1967).

12 Otter Tail Power Co. v. United States, 410 U.S. 366, 369 n. 1 (1973);

Tampa Electric Co. v. Nashville Coal Co., 365 U.S. 320, 327 (1961).

13 See Grinnell, supra n. 4 at $71; Greyhound, supra n. 4 at 496; Twin City

Sportservice Inc. v. Charles O. Finley & Co., $12 F.2d 1264, 1270 (9th Cir.

1975); United States y. United Shoe Machinery Corp., \10 F. Supp. 295, 343

(D. Mass. 1953), aff'd per curiam, 347 U.S. $21 (1954) (“United Shoe").

9

The distribution of the share of the market not supplied by

defendant is also telling. Defendant's share is more likely to

indicate monopoly power if the rest of the market is widely

distributed among many small competing suppliers than it

would be if the size of competitors and the market share held

by them approached defendant’s size and share. '4

Under some circumstances it may be proper to apply the

concept of supply substitutability to the definition and measure-

ment of the relevant market and to include within the market

any suppliers which might readily and easily enter by producing

a reasonably acceptable alternative product.

The greater the barriers faced by a new entrant, the more

probable it is that control of a particular market share would

enable defendant to exercise monopoly power. '5

Anything that tends to inhibit firms from readily and ad

entering the marketplace can be analyzed as an entry barr

Thus, the capital an entrant would have to invest is a factor, as

are the employee skill levels required for a firm to be successful.

Product differentiation, product loyalty, or any customer dis-

inclination to accept the product from different suppliers are

hurdles the new entrant may have to overcome. And, the

existence of economies of scale or a dwindling market demand

would make entry difficult.

Within a market, as defined by demand cross-elasticity

considerations, economically significant submarkets may ex-

ist.‘6 Submarkets are zones of actual or potential competition’’

that are sufficiently distinct from the larger market that one firm

4 See Greyhound, supra n. 4, at 496-97; Pacific Coast Agricultural Export

Association v. Sunkist Growers, Inc., 526 F.2d 1196, 1204 (9th Cir. 1975),

cert. denied, 425 U.S. 959 (1976).

'S See generally, L. Sullivan, Antitrust, Section 23 at 77 (“Sullivan”),

Von Kalinowski, Antitrust Laws and Trade Regulations, Vol. 1., Section 8.02

[3]. p. 8-36 (“Von Kalinowski"}.

'® Brown Shoe Co. v. United States, 370 U.S. 294, 325 (1962) [“Brown

Shoe"’|; International T. & T. Corp. v. General T. & E. Corp., $18 F.2d 913,

932 (9th Cir. 1975).

‘7 International T. & T. Corp. v. General T. & E. Corp., 518 F.2d 913,

932 (9th Cir. 1975).

10

could exercise the power to control price or the power to

exclude competition within them. '@

Practical aids in identification of such zones of competition

include industry or public recognition of the submarket as a

separate economic entity, the product's peculiar characteristics

and uses, unique production facilities, distinct customers, dis-

tinct prices, sensitivity to price changes, and specialized ven-

dors.'9 If these indicia indicate a submarket exists, market

structure and market performance should be examined to

determine whether defendant is in possession of monopoly

power, 20

B. Market Performance.

Evidence of the actual operation of the market or submar-

ket can also provide valuable clues as to the existence of

monopoly power. If defendant has, in the past, successfully

controlled price or excluded competition, that is direct and

convincing evidence that it had the power to do so.2'

Less direct evidence can also be persuasive. Many courts

have examined defendant's profit record on the theory that

persistent excess profits are inconsistent with the competitive

model and attributable to the possession of monopoly power.22

Monopoly is also expected to result in technological stagnation.

Without a competitive spur, the monopolist is thought not to

8 Cf. Grinnell, supra n. 4, at $73. Note that existence of a submarket

does not necessarily negate the relevancy of the larger market. U.S. v.

Phillipsburg National Bank, 399 U.S. 350, 360 (1970).

‘9 Brown Shoe, supra n. 16, at 325; Case-Swayne Co. v. Sunkist Growers,

Inc., 369 F.2d 449, 454-55 (9th Cir. 1966), rev'd on other grounds, 389 US.

384 ( 1967). .

20 See Von Kalindwski, supra n. 15, Vol. I, Section 8.02 [2], p. 8-23.

2’ Moore v. James H. Matthews & Co., $580 F.2d 1207, 1219 (9th Cir.

1977); Power Replacements Corp. v. Air Preheater Co., Inc., 356 F. Supp. 872,

896-97 (E.D. Pa. 1973).

22 duPont, supra n. 6, at 404: United States v. Aluminum Co. of America,

148 F.2d 416, 426-27 (2d Cir. 1948) [“Alcoa"]; Banana Distributors v.

United Fruit Company, 162 F. Supp. 32, 39 (S.D.N.Y. 1958): United States v.

General Electric Co., 82 F. Supp 753, 894-95 (D.NJ. 1949). But profit

evidence can mislead and should not be too heavily relied on. 2 P. Areeda

and D. Turner, Antitrust Law, Section $12c, pp. 336-37 (1978): Sullivan,

supra n. 1S, at 84-86.

11

have any incentive to innovate. Thus, the rate of technological

progress in the industry is relevant.??

In a competitive industry firms are expected to be “price

takers.” That is, they will be unable to affect price by variations

in the quantity of goods they offer for sale. Where it appears

defendant was a “price maker,” able to choose among a range

of price options in order to achieve its profit goals, or able to

disregard cost and set price according to utility to the consumer

(functional pricing), it may indicate monopoly power.*4 2s

Market history, in terms of entry and growth of new firms

or exit of failed firms, and whether concentration is increasing

or decreasing are additional factors that can indicate whether

the competitive process is functioning properly or not.26

Transamerica asserts that IBM had monopoly power in

three markets:

1. The manufacture and placement of general pur-

pose electronic digital computer systems (“systems mar-

ket’);

2. The manufacture and placement of tape drives and

their controllers plug-compatible to IBM CPUs (“tape

market’); and

3. The manufacture and placement of disk drives and

their controllers plug-compatible to IBM CPUs (“disk

market”).

22 Greyhound, supra n. 4, at 497; United Shoe, supra n. \3, at 331. But see

F. Scherer, Industrial Market Structure and Economic Performance 363-78

(1970), advancing the thesis that dominated market with low entry barriers is

the setting that is most conducive to innovation

24 See 2 P. Areeda and D. Turner, Antitrust Law, Section $07, p. 331

(1978): Sullivan, supra n. 1S, at 80.

28 See 2 P. Areeda and D. Turner, Antitrust Law, Section $14a, p. 341-42

(1978): Sullivan, supra n. 1S, at 88-89.

26 Hudson Val. Asbestos Corp. v. Tougher H. & P. Co., Inc., 510 F.2d

1140, 1144 (2d Cir. 1975); Cole v. Hughes Tool Co., 215 F.2d 924, 938 ( 10th

Cir. 1984): ILC Peripherals v. International Business Machines, 458 F. Supp.

423, 431 (N.D. Cal. 1978).

12

C. The General Purpose Systems Market.

Computer systems are the functioning combination of

hardware (CPUs and peripherals) and software that a user

may employ to satisfy data processing requirements. Trans-

america draws a distinction between general purpose systems

and special purpose systems. Special purpose systems are those

that are designed for and dedicated to specialized applications.

For instance, a special purpose computer system might be

utilized to control a manufacturing or a chemical process.

General purpose systems, on the other hand, are those that are

capable of easily and economically being adapted to a variety

of data processing applications. A general purpose computer

system might be used to process a company’s payroll, to update

its books of account, or to allow its engineers to solve complex

mathematical problems while sitting at a remote terminal.

Some (but not all) general purpose systems are capable of

performing all these tasks concurrently. By definition, all gener-

al purpose systems allow the user to switc., easily from one task

to another.

This Court accepts the view that the market for general

purpose computer systems should be analyzed separately from

the market for special purpose computer systems. The systems

sold to satisfy these different needs are not readily inter-

changeable and different suppliers specialize in each of the

markets.

Transamerica’s definition of the systems market is, how-

ever, too narrow. Only suppliers of complete systems are

included, suppliers of parts of systems are ignored. Firms which

offer the user parts of systems have become a major competitive

force in the computer industry, and, because they significantly

constrain IBM’s power to control the price of the system it sells,

a market definition that ignores them is incorrect.

At one time the only option a general purpose systems user

had was to choose between suppliers of complete systems. If an

IBM user was dissatisfied with IBM’s peripheral equipment or

with IBM’s software, the only recourse was to remove the entire

IBM system as a unit, and replace it with an entire system from

13

another manufacturer. Since that time, literally thousands of

companies have entered the systems market, not as suppliers of

entire systems, but rather as specialists providing users with

replacements for parts of their computer systems. IBM did not

charge the user one price for an entire computer system, rather

they priced each component of their systems individually. That

meant that companies which focused on replacing parts of a

system could offer the user a better price on that part and the

user was still free to acquire the rest of the system from IBM.

The PCMs are perhaps the best example of such special-

ists. Some PCMs got their start by copying IBM’s tape drives

and offering them to IBM’s systems customers. Other PCMs

specialized in replacing IBM’s disk subsystems with their own

versions. Still others recognized a competitive opportunity in

supplying printers for use on IBM’s systems, and some PCMs

competed with IBM for sales of the electronic memories

attached to IBM CPUs.

Entry barriers proved remarkably low, and the PCMs

proliferated. Today, a user could replace practically every part

of an IBM system with hardware from a PCM. The same is true

for software. Software firms offer programs to users of IBM

systems that are reasonable alternatives to the programs avail-

able from IBM. And the entry barriers faced by an entrepre-

neur with a software package to sell are truly insignificant.

A market definition should “recognize competition where,

in fact, competition exists,”2? and should include all significant

competition even though that competition differs in form or

nature.28 Transamerica’s systems market definition fails this

fundamental test. By assuming that only manufacturers offering

complete systems compete with IBM, Transamerica ignores the

fact that IBM systems users had other reasonable alternatives;

they could replace parts of their IBM systems. In many ways,

partial replacement was a more significant constraining force

than total replacement. Customers found partial replacement

attractive because it did not involve a scrapping of the user’s

27 Brown Shoe, supra n. 16, at 326.

26 United States v. Continental Can Co., 378 U.S. 441, 449-50 ( 1964).

14

investment in programming and personnel skills, and it allowed

users to reduce data processing costs without abandoning

entirely the security of the IBM fold. Partial replacement of

parts of IBM systems was a significant constraining force on

IBM’s market power during the 1969-1973 time period.29

Billions of dollars worth of equipment was being replaced

piecemeal by IBM systems users. A market definition that

ignores this cannot be accepted.

Some minicomputers ( minis), small, relatively inexpensive

computer systems should also have been included in Trans-

america’s general purpose systems market definition. Trans-

america included the smaller IBM systems, but excluded the

thousands of minis that were directly competitive with those

small IBM systems. That exclusion would have had more

validity in the past. When they were first introduced minis were

limited, or at least thought to be limited to special purpose

applications. But things changed. By May, 1970, Comput-

erworld, a widely read industry newspaper, recognized that the

“... M€w minicomputers and microcomputers showed drastic

changes in design that make them truly general Purpose....

For the first time, they offer a reasonable alternative to ‘full-

sized’ systems.” Advertisements by minicomputer manufac-

turers emphasized that theme, and apparently users got the

message. In August of 1972, Computerworld reported:

“They [minis] are being used as true general purpose

computers, running a range of applications such as order

entry, sales analysis, payables, receivables, general ledger,

inventory control, payroll, price ticket printing and credit

authorization .. ..”

During the relevant time period minis were being sold as

reasonable alternatives to the smaller general purpose systems

offered by IBM. When connected together, several minis were a

reasonable alternative to the acquisition of larger systems. And

minis, whether used as data collection devices, intelligent

terminals, pre-processors, or stand-alone systems, could ease

the workload of larger general purpose systems, thereby

29 The IBM actions of which Transamerica complains all took place

within a ten month period, September 1970 to July 1971.

15

providing the user with a viable alternative to the acquisition of

a more powerful system. The competition minis provided was

significant, and their exclusion from the systems market defini-

tion was incorrect.

IBM also faced other constraints not contemplated by

Transamerica’s systems market definition. Service bureaus buy

computing systems and make them available to others by

renting Out time on them or doing work on them for the benefit

of end-users. Time-sharing companies make their computers

available to many users who access them concurrently via

remote terminals. In both cases, users may turn to such

companies during peak periods, or for the specialized services

they offer. Leasing companies are financial intermediaries; they

buy computer systems, or parts of computer systems, from

manufacturers and lease them to users. Service bureaus, time-

sharing companies and leasing companies all provide signifi-

cant competition for IBM. However, their exclusion from the

market definition is analytically correct. These companies all

buy computers from systems manufacturers, add some financial

or technical services, then turn around and offer the computers

to the end user. Their basic product is computing power. Their

basic raw material is a computer system. Since they all must

buy equipment from manufacturers, if one manufacturer has

the power to control price at the time of the initial sale, it has

the power to indirectly control the price at which the computer

re-enters the market with the added services. Where it is

possible that a defendant might indirectly control the price at

which goods re-enter the market, that alternative source of

goods should be excluded from the market definition. But the

nature and the volume of the business done by service bureaus,

time-sharing companies, and leasing companies need not be

totally ignored. Although exclusion from market definition is

called for, the constraints these companies provide decrease the

likelihood that defendant’s market share reflects monopoly

power.

This Court agrees with Transamerica’s contention that the

concept of supply substitutability does not affect the systems

% Alcoa, supra n. 44, at 425.

16

market definition since there has been no evidence that any

firms are in a position to readily shift their production facilities

into the manufacture of general purpose systems, and also

agrees that the United States constitutes the relevant geo-

graphic market.

Transamerica has made no effort to measure IBM’s share

of the market as this Court would define it, i.e., including

minicomputer manufacturers, software suppliers, and PCMs as

competitors. Nonetheless, the evidence of IBM’s market share,

in the market as defined by Transamerica, will be examined for

whatever light it might shed on the issue of IBM’s market

power.

The most common measurement of market shares is a

comparison of the competitors’ annual sales.2’ Here, Trans-

america, however, has used what is called the “installed base”

method.

Included in each company’s installed base for any year are

all computer systems ever leased or sold by that company

which are still in use in that year. Those systems, no matter how

old they are, are valued at their original purchase price or their

current purchase price, whichever is higher. Transamerica

insists that this method is appropriate because the general

purpose computer systems market is predominantly a lease

market. Any measurement that failed to recognize past activity,

they argue, would ignore the substantial revenues IBM enjoys

from machines leased and shipped in the past and ignore the

substantial hold IBM has on those customers due to software

lock-in.%

The computer industry is characterized by cyclical devel-

opment or “generations” of computer equipment. These cycles

3° See United States v. Pabst Brewing Company, 384 US. $46, 550

(1966): United States v. Von's Grocery Co., 384 U.S. 270, 272 (1966).

32 Software lock-in is a term used to describe the disinclination of users to

switch from one computer manufacturer’s line of equipment to another’s. Ifa

user were to switch allegiance, it would incur substantial costs in converting its

existing programs to the formats required by the other manufacturer's

machine. As a result, over 80 percent of all users remain with the same

manufacturer when they replace their general purpose systems.

17

can be expected to produce sharp fluctuations in one company’s

share of annual shipments, and the tendency of the installed

base method to smooth out these swings is another advantage

claimed for it.

Installed base is a method traditionally employed by the

computer industry, including at one time IBM itself, and this

too is a reason advanced for its adoption here.

IBM counters that installed base reflects more history than

current market power. IBM is nght. IBM has been successful in

the computer field almost since the industry’s inception. Thus,

inclusion of all IBM machines still in use distorts their share.

The successes of newer companies (such as the PCMs) are

camouflaged by the large installed bases of more established

manufacturers.

The installed base method credits IBM with purchased

machines from which it no longer enjoys any revenue, and even

with machines that have come back into the market to compete

against it. Machines sold in an earlier year to leasing com-

panies, time-sharing companies, service bureaus, and used

machines are all attributed to IBM’s market share in later years.

Transamerica insists this is proper because IBM, as the orginal

manufacturer, indirectly controls the prces at which such

machines and services can be offered. While such reasoning

supports an exclusion of this competition from market defini-

tion, it does not warrant an attribution of the value of their

capital equipment to the manufacturer’s market share except in

the year of the initial sale.3

The lease nature of the business is an insufficient reason for

abandoning an annualized approach. By 1973, less than half of

IBM’s general purpose systems were leased. And if software

lock-in, or any other factor, persuades users not to switch

vendors, then the future successes that installed base would

predict will ultimately be reflected in annual shipment data.

One of Transamerica’s industry market share experts, recogniz-

ing the infirmities of installed base, recently discontinued his

use of that method.

33 Transamerica’s reliance on Alcoa, supra n. 44, at 424-25, is misplaced.

The Court there excluded secondary ingot from the market definition. It did

not include the secondary ingot in defendant's market share.

18

It is not necessary to discard all of Transamerica’s data

because the installed base measurement method is unaccept-

able. Annual shipments can be approximated from the in-

stalled base figures in evidence by subtracting one year’s

installed base from the following year’s. This will yield a figure

for net shipments. Net shipments appear to be a more desirable

indicator than gross shipments because many computers are

shipped to users who return their older machines to the

manufacturer. Cyclical fluctuations can be accounted for by

averaging the share figures for several years.

In some of its data Transamerica has included the value of

equipment placed by the PCMs as part of IBM’s share. This is

clearly incorrect, and Transamerica has offered no convincing

rationale for it. It would be possible to rehabilitate this data by

extracting from IBM’s share the value of disks and tapes

supplied by PCMs. However, the value of PCM supplied

printers, electronic memories, and other gear cannot be sepa-

rated out, providing still another reason for viewing the resul-

ting figures cautiously.

IBM’s share of net shipments (less all PCM products) has

been calculated to be: 65.4 percent; 67.9 percent; 51.4 percent;

56.4 percent; 56.5 percent; 30.6 percent; and 64.4 percent, for

the years 1969 through 1975 respectively. Over the entire seven-

year period IBM shipped 57.4 percent of all general purpose

systems (net). The next largest share was shipped by the PCMs

as a group with 14 percent over the seven years. Burroughs was

the second largest manufacturer of systems with 7.7 percent,

following by Univac with 4.9 percent, and Honeywell with 4.6

percent.

Even in a properly defined market these market share

Statistics would not be overwhelming. Other courts have

doubted whether sixty percent of a market would be enough.35

But while a finding of monopoly power is not foreclosed by

IBM’s share if the setting is conducive to the exercise of such

3% See defendant's exhibits 6183 and 6515A.

38 Alcoa, supra n. 44, at 424.

19

power and if other indicators confirm its presence,2® such a

finding is certainly not compelled by these market shares.

The distribution of the remainder of the market serves to

enhance IBM’s power. No single manufacturer approaches the

success IBM enjoys. However, their shares are growing while

IBM’s is shrinking. IBM’s share tends generally downward,

indicating that monopoly power is not present, or, if present,

that the monopolist’s grip is weakening.

Consistent ‘.\) .-normal profits may be attributable to an

ability to contro! price. Here IBM’s profits have been very

substantial. Its after-tax return on equity during the 1964 to

1973 period was consistently 30 to 70 percent above the

Fortune 500 median, while its after-tax return on sales doubled

and sometimes tripled the industrial giants’ median. But the

inference that a defendant that enjoys healthy profits only does

so because of an unhealthy market structure is not a strong one.

Good management, superior efficiency and differences in ac-

counting provide explanations that are just as plausible, and

none of those explanations is inconsistent with an effectively

competitive market.

One thing excessive profits can be expected to result in is

increased entry by firms hungry to participate in the rich

rewards. Transamerica says that this has not occurred because

the entry barners faced by potential entrants are insur-

mountable, It is true that enormous barriers are faced by firms

wishing to enter this market as suppliers of complete computer

systems. Between $500 million and $1 billion in capital would

be required; a national network of sales and maintenance

offices staffed with highly skilled personnel is imperative; the

entrant would have to fund research and development projects;

a broad product line must be offered; and customer loyalty due

to software lock-in would have to be overcome. Because such a

large commitment would be involved for entry as a systems

supplier, it is not surprising to find that there has been no new

entry on that basis since the early 1960's.

3% The Ninth Circuit has expressly affirmed findings of monopoly power

where defendant's share was 45-70 percent. Pacific Coast Agr Export

Association ¥. Sunkist Growers, Inc., 526 F.2d 1196, 1204 (9h Cir. 1975),

cert. denied, 425 U.S. 959 ( 1976).

20

The fiaw in Transamerica’s entry barrier analysis is a

consequence of its market definition error. Competition and

entry in this market does not occur on only a full-system basis.

Entry could, and did occur where companies recognized profit-

able opportunities in less inclusive offerings.

Storage Technology Corporation, one of the most success-

ful PCMs, was started by a bright engineer with $225,000 in

equity capital, and experienced phenomenal growth. It was not

alone. In 1970, International Data Corporation (IDC), a

company specializing in statistical studies of the computer

industry, reported:

“Just 15 years ago, the number of companies in the

infant industry could be counted on the fingers of one

hand; today well over 4,000 companies produce comput-

ers, related equipment and supplies, or offer data proces-

sing and programming services.”

IDC thought there had been “an explosive proliferation of

options for the computer user.” In 1971, Transamerica, in a

presentation to its parent Board of Directors, agreed, saying:

“The frequency of entry into the data processing

industry is quite high compared with any other industry,

and there are usually, at any one time, more competitors

than anyone would really like to have.”

The new entrants were growing. From 1967 to 1975 the

value of PCM equipment attached to IBM systems increased

from $15.8 million to $2.6 billion. In the same period, leasing

companies jumped from holding 8.3 percent of the IBM CPUs

to 26.7 percent. And the market as a whole was growing; most

of IBM’s full-systems competitors participated in that growth.

Digital Equipment Corporation (DEC), for example, was

founded in 1957 with DEC initial capitalization of $70,000. By

1977 it had computer related revenues of $1.1 billion. One

commentator has referred t© IBM's systems competitors as the

“billion dollar dwarfs.”

This is not the story of a stagnant, dominated industry.

There is no doubt that the pace of technological progress in the

21

computer industry is extraordinary. Commentators are fond of

saying that had the auto industry kept the same pace over the

last 30 years, a Rolls-Royce would cost $2.50 today and would

have an EPA gas rating of 2,000,000 miles per gallon.

There is some evidence that IBM sought to maximize

profits by choosing a price for its products from a range of

alternative prices. But that is not necessarily inconsistent with

an effectively competitive market. The range of price options

available to IBM was never so broad that it would set a price

without regard to competitors’ prices. And, in most cases, the

range was only theoretical, because competitive pressures, not

IBM preference, dictated which price had to be adopted.

This market was not monopolized. IBM did not control

prices, it reacted to the prices set by others. IBM’s market share

(if the market had been properly defined) was below 57

percent and falling. Entry was easy for anyone with a good idea

and the courage to exploit it, and new entrants, along with the

old, grew and prospered. This Court finds that Transamerica

has failed to prove that IBM had monopoly power in the

general purpose systems market.

Nonetheless, Transamerica’s other contentions will be con-

sidered on the assumption that IBM did have such monopoly

power.

D. Tape and Disk Markets.

The hardware of a computing system was previously

described as consisting of a CPU and peripherals. Further

refinement of that over-simplification is necessary for an under-

standing of the peripherals markets alleged to be relevant.

Certain control functions must be performed if peripheral

gear is to function properly. The access arm of a disk drive, for

example, must be positioned over the proper track before data

can be read from, or written onto that track. These control

functions can be performed by the arithmetic and logical

circuits of the CPU, in which case the control function is said to

be “integrated” into the CPU. But when the CPU is tied up

with control functions, it is not free to perform more sophis-

22

ticated tasks, and so an alternative design was incorporated into

the architecture of System/360. Most of the peripherals attach-

able to System/360 CPUs were not integrated. The control

functions were performed by two independent “boxes” or

machines with arithmetic and logical circuits: channels and

control units.

A limited number of channels could be attached to most

System/360 CPUs. Channels funnel data into the CPU’s main

electronic memory, and take from the memory data that is to be

written onto any of the peripheral devices that may attach to

the channel, and send it to its destination. Channels perform

control functions common to a variety of penpheral gear.

It is possible to attach a number of control units to each

channel on the system, and the peripheral devices attach to the

control unit. Control units perform the control functions that are

required by the specific type of peripheral that attaches to it.

Thus, one type of tape drive, expecting specific control func-

tions to be performed, only attaches to a specific type of control

unit. Other types of tape drives require a different control unit,

and the same is true of disks. But various types of control units

can be attached to the same channel.

PCMs typically supplied a combined package of disks and

disk control units attachable to, or “plug-compatible” with,

IBM channels. This meant that the user could remove the IBM

control unit and disk combination (known as a “subsystem”),

plug in the PCMs’ replacements and the computing system

would continue to function with very little inconvenience. That

was so because the PCMs had duplicated the “interface”

between the IBM channel and the IBM disk control units. An

interface has both physical aspects (in terms of the number of

wires involved and their arrangement in a connector), and

protocol aspects (what a given pulse sequence on a particular

wire is understood to indicate by the machine receiving the

pulse ).

Unlike PCM disk suppliers who provide subsystems, PCM

tape suppliers concentrated initially on tape drives and gener-

ally did not sell tape control units. Thus, the interface that they

duplicated was the interface between IBM tapes and IBM

control units.

23

Although many computer manufacturers designed their

systems with this CPU-channel-control unit-peripheral hier-

archy of control functions, no other systems were designed so

that the interface between the channel and control unit ( disks )

or the interface between the control unit and peripheral device

(tapes) was precisely the same as the corresponding IBM

interface. Thus, tape drives and disk drive-control unit com-

binations developed for use on IBM’s System/360 could not,

without some interface modifications, be plugged into another

computer manufacturer’s system, and vice versa.

The two peripherals markets alleged by Transamerica

consist of tape drives and tape control units, and disk drives and

disk control units that can be plugged into IBM CPUs without

any modifications, 1.¢., that are plug-compatible.

These peripherals markets will be examined together. Both

markets, if they can be so described, became economically

significant in the late 1960’s, when PCMs began duplicating the

peripherals that would attach to IBM’s computers. Prior to that

time some of the PCMs supplied peripherals to IBM’s general

purpose systems competitors, who then incorporated them into

the systems they offered. When the systems competitors took to

manufacturing their own peripherals, the PCMs turned their

attention to marketing peripheral replacements to IBM users.

Having already accepted a definition of a systems market

that encompasses all the economic activity on the peripherals

front, perhaps ‘“‘submarket” would be the proper term to apply

here. In any event, the Brown Shoe submarket indicia can

provide valuable clues as to whether plug-compatible tapes and

control units and plug-compatible disks and control units are

sufficiently distinct that they could be monopolized.

Industry recognition of the peripherals markets as separate

economic entities could hardly be more evident. IBM studied

the “tape market” and the “disk market” separately and

referred to them repeatedly by those or similar appellations.

Others in the industry, including witnesses called by both sides,

referred to and treated the tape and disk markets as separate

economic entities.

24

The peculiar uses and characteristics of the products

involved have already been spoken of. Because the interfaces

between IBM CPUs and control units and between IBM control

units and peripherals were unique, the tapes or disks described

as plug-compatible to IBM CPUs could only be used with those

CPUs. Users with systems provided by other manufacturers

could not use them at all, and IBM users could use nothing else.

Thus, customers for plug-compatible tapes and disks were

readily identifiable and distinct.

The production facilities for tapes were different from the

production facilities for disks, and both were different from the

production facilities for other components of the system. IBM’s

main disk facilities were in California; its main tape facilities in

Colorado; and its CPUs were manufactured elsewhere. How-

ever, the production facilities of independents and systems

manufacturers producing non-IBM-plug-compatible tapes and

disks were probably not so different from the facilities for the

corresponding plug-compatible peripherals. This is so because

the tapes and disks were similar in almost all respects save for

the unique interface electronics.

Prices were distinct. In setting its prices IBM was less

influenced by the prices of non-plug-compatible tapes and disks

than by the PCMs’ prices. Users were price sensitive. Lower

prices for equivalent or superior performance was the PCMs’ *

selling point. With it they managed to attract millions of dollars

worth of business away from IBM.

Finally, the PCMs were specialized. Peripherals were their

major activity. Many supplied only plug-compatible tapes or

only plug-compatible disks. Those that supplied both, made the

combination only after experiencing an initial success with the

one device or the other. The Brown Shoe submarket criteria

indicate that the peripherals markets are capable of being

dominated, and the markets should be examined further.

IBM attacks these markets as narrow for three reasons: (| )

they ignore the interchangeability between tapes and disks; (2)

they fail to include as potential suppliers either the systems

manufacturers who make their own peripherals, or the inde-

25

pendents who manufacture peripherals for them; and (3) they

fail to account for the constraint of systems competition on

peripheral price discretion.

IBM’s first argument, that tapes and disks are inter-

changeable, is without merit. In configuring a system, users

have several alternatives. Various types of media are available

to store and access data. Principal among these are tapes, disks

and electronic memory. In that order, data is accessed by the

CPU with increasing rapidity, but also with increasing cost.

Electronic memory is so expensive that it is only used as a

temporary storage area for data. Data is read into the electronic

memory (from a tape or disk perhaps) where the CPU can

readily access and work with it, then written from electronic

memory onto another medium for more permanent storage.

Electronic memory is not really a peripheral, rather more a part

of the CPU itself, and is not a reasonable alternative to either

tape or disk.

For some applications a disk must be used. Where the

CPU must access data frequently, but not necessarily in a serial

fashion, a disk is indispensable; tapes are not an alternative

“regardless of the price differential. Applications where many

users access a central computer through remote terminals (such

as an airline reservations system) are only feasible if the data

for them is kept on disk (or other direct access device). This is

so because every data record on a disk pack can be reached

within a fraction of a second by a lightning-quick access arm.

To reach a particular record on a tape, the tape reel must

be spun until the proper spot is reached. It might take as long as

one minute to reach a particular data record, ages by com-

parison with disk speeds. However, if the records on a tape reel

are sorted so that the CPU can access them seriatim, then the

time required to access records in a tape file is quite acceptable.

So, tapes are typically used only for data which can be accessed

serially, and only disks are used when data must be accessed

randomly. Siill, there is some overlap.

For some serial data files either a tape or disk can be used.

Because the cost of storing data on disks is much greater than

the cost of tape storage, only with relatively short files would

26

the user consider tape and disk to be alternatives. Most system

users employ both disks and tapes.

Indications are that the incidence of actual substitution

between tape and disk is not high. Neither IBM nor the PCMs

considered tape prices when pricing disks or vice versa. IBM’s

Financial Procedures Manual calls for calculation of the impact

on existing products’ profits caused by introduction of a new

product. If tapes and disks were reasonable alternatives, one

would expect that a new tape would impact the profitability of

old disk products and that new disk devices would impact the

profits of existing tape products. Yet, only rarely were such

impact calculations made. The manual also calls for competing

products to be identified. Tapes were not so identified when

disks were introduced, nor were disks, when tapes were in-

troduced.

The head of IBM’s Computer Division testified that slight

variations in the price of disks would not affect the demand for

tapes; that variations of 40, 50 or 100 percent in price would be

required. That is not the high degree of price cross-elasticity

that is required if two products are to be considered reasonable

substitutes and placed in the same market.

IBM’s second argument for a broader market definition,

supply substitutability, calls for the inclusion of firms with a

high cross-elasticity-of production. Th*s contention would re-

quire a finding that producers are capabie of quickly and easily

entering the market to produce alternatives. That finding

cannot be made. Producers of non-plug-compatible peripherals

would have to change the interfaces in their devices to cope

with IBM’s CPUs. Interface changes would cos: hundreds of

thousands, if not millions of dollars, and might require a year to

carry out. Under these circumstances it would be improper to

include this potential competition in the peripherals market

definition.

IBM’s third attack, emphasizing the influence of systems

competition, has merit. The cost of peripherals accounts for 50

to 70 percent of the total cost of a typically configured general

purpose computer system. Efforts made at controlling price in

f

27

the peripherals submarkets would be felt by systems market

competitors because control of peripheral prices translates

indirectly into control of systems prices. If the systems market

were effectively competitive, one would expect that the pres-

sures exerted by that competition would be sufficient to defeat

attempts to wield monopoly power in a peripheral submarket.

Thus, the existence of monopoly power in a peripherals market

must be predicated upon a finding of monopoly power in the

systems market.

Transamerica’s expert economist agreed. He testified that

by definition IBM could not have monopoly power in the

peripherals market if it did not have monopoly power in the

systems market. This Court’s conclusion that IBM lacked

systems market monopoly power is thus fatal to Transamerica’s

peripheral markets claims. Nonetheless, this inquiry will pro-

ceed under the assumption that IBM had a systems monopoly.

As with the systems market, Transamerica combined a

narrow definition of the peripherals market with a distorting

share measurement technique, the installed base. Installed base

measurement makes even less sense here than it did in the

systems market. For many years, IBM faced absolutely no

competition for the tapes and disks that attached to its CPUs.

As a result, it built a tremendous installed base of those

peripherals. Even if the PCMs had won every sale from 1968

onward, many years would have to pass before’ the installed

base figures would show PCM competition was significant. And

the software lock-in argument rings hollow here. By definition,

every product in these markets is plug-compatible; none of the

competitors enjoys any advantages traceable to software lock-

in.

Transamerica’s mistaken failure to recognize systems com-

petition in its market definition invalidates its share measure-

ment data. However, the net shipments of peripherals in the

market, as Transamerica has defined it, can be calculated in the

same manner as net shipments were calculated for the systems

market. The installed base at the end of one year is subtracted

from the installed base at the end of the following year to

indicate net shipments over that year. Thus, the 1969 net

28

shipment figures were calculated by subtracting the 1968 year

end installed base from the 1969 year end installed base. Years

prior to 1969 are ignored. Before that time PCM competition

was insignificant and IBM’s net shipments were almost 100

percent of all net shipments of tapes and disks that hooked onto

its CPUs.

The following two tables show the total net shipments of

peripherals (drives and control units) for the years 1969

through 1975 as derived from the installed base data.37 IBM’s

share appears both in dollars and as a percentage of total. That

portion not attributable to IBM was divided amongst the

PCMs. Dollar figures are shown in terms of thousands of

dollars of monthly rental value.

TAPE MARKET

1969 1970 1971 1972 1973 1974 1975 1969-75

SE iigaecntaes 5,760 737 $19 -19 1443 4,144 2,569 15,155

ey EAST OS 4,547 10S -587 -470 $44 2,409 1.618 8,167

SRO ID ccansiervetivoines 789% 143% . ~ 37.7% S$8.1% 63% 53.8%

DISK MARKET

1969 1970 1971 1972 19731974 1975 1968-75

, eee eae 7,838 15,594 627 $204 10,376 21,738 16,772 78,158

Ei eee Pes le 7,248 13,423 -3,09$ 3,809 7,155 18,409 13,240 60,237

i 92.5% 86.1% °° 3.1% 69% 84.7% 18.9% 77.1%

*_Loss

It would be difficult to conclude that a company possessed

monopoly power in a market where its net shipments were

negative at the very time it allegedly used or maintained that

power. That is the case here. In 1971, IBM was losing ground to

its PCM competitors. That was a relatively lean year for

everyone, but more so for IBM than for its competitors. The

PCMs were increasing their customer base at IBM’s expense.

37 See defendant's exhibits 6528 and 6533.

29

Even the aggregate numbers are unconvincing. IBM’s mere

53.8 percent of the tape market suggests monopoly power is not

present. The 77.1 percent figure in the disk market would

support a monopoly finding, but the significance of this market

share is diminished by the realization that IBM had 100 percent

of the market only a few years before, and the failure of the

market definition to account for systems competition means

these numbers must be viewed circumspectly. These share

figures are also inflated by Transamerica’s inclusion into the

market of products which the PCMs never duplicated, and

areas of the country where PCMs chose not to compete.

. Entry barriers around these markets are extraordinarily

low. The market definition excluded potential suppliers (such

as systems competitors and their independent peripherals

sources) because they were incapable of quickly and easily

supplying substitute products. But the hurdles those potential

suppliers must clear are far lower than those new systems

market entrants face. Firms already producing peripherals have

the production facilities, the trained staffs, and the research and

development expertise needed; all that remains for them is to

study the IBM interface and duplicate it. Two of the most

prominent systems competitors, Univac and CDC, have done

just that. Both manufacture peripherals for their own computer

systems, and also manufacture IBM plug-compatible pe-

ripherals that compete in the markets at issue here. And many

PCMs market their wares to other systems manufacturers as

well as to IBM end-users. While the cost, in time and money, of

developing an interface is sufficient to exclude systems manu-

facturers and independents from the market definition, it does

not provide a formidable entry barrier around the market as

defined.

The entry barriers faced by completely new entrants into

the peripherals market have already been discussed in relation

to the systems market. Those barriers are low, as is demonstrat-

ed by the history of entry into peripherals manufacture. PCMs,

attracted by IBM’s high profits on its peripherals, stormed these

markets and flooded them with cheaper copies of the IBM gear.

IBM, unable to maintain its relatively high price, was forced to

react with lower prices and improved products. This picture is

30

consistent with the dynamics of an effectively competitive

market, not a monopolized one.

This Court will not be misled by the share figures pro-

pounded by Transamerica. Those calculations ignore the

significant constraint of systems competition, and measure the

markets as an aggregation of all peripherals in use, when there

is no reason for doing so. Accurate share figures cannot be

determined from this record, but the data which can be rescued

indicates that IBM did not have market control, and that its

share was not dominant. Entry barriers are low, and entry has

been easy, frequent, and successful. Even if a systems monopoly

were not a prerequisite to peripheral market control, or even if

IBM had a systems monopoly, this Court would find, as it does

here, that Transamerica has failed to prove that IBM had

monopoly power in either the tape or the disk market.

IV.

PRICING CONDUCT

A defendant not in possession of monopoly power may

nonetheless incur antitrust liability by attempting to monopo-

lize. Transamerica alleged that IBM attempted to monopolize

by its pricing conduct, by its design conduct, and by its long-

term leases. IBM’s conduct will be examined first under the

assumption that IBM did possess monopoly power. Following

that, the conduct that would have violated the monopolization

provision of Section 2 will be re-examined to determine wheth-

er, in light of the absence of monopoly power, an attempt to

monopolize has been proved.

IBM responded to the lower prices and increased successes

of the PCMs by offering some of its own products at substan-

ually reduced prices. Transamerica claims that those prices

were predatory and violated the antitrust laws.

The concept that prices can be used as a means of

acquiring Of maintaining monopoly power is not new; it has

long been recognized that financially powerful firms might

coerce or destroy their rivals by pricing at unremunerative

.

31

levels. Attempts to distinguish between predatory pricing and

legal price behavior, by comparing defendant's costs with its

prices, are new. In an article published in 1975, Professors

Areeda and Turner suggested that pricing conduct should be

conclusively presumed legal if price levels exceeded either

defendant’s average variable cost or defendant’s short-run

marginal cost.%® Reaction to the Areeda and Turner proposal

has been mixed. Courts have embraced it; academicians have

criticized and rejected it.

An understanding of the relationship between these cost

measures is critical to an appreciation of the effect that imposi-

tion of the Areeda and Turner rule would have. All three kinds

of cost (average cost, average variable cost, and marginal cost)

will at first decline, then later increase as a firm’s output is

expanded. Average cost (which includes both fixed and vanri-

able costs) will always be greater than average variable cost

(which only includes variable costs). At low output levels,

marginal cost will be less than both of the other cost measures.

As output is increased, marginal cost will mse until at some

point it will be greater than average variable cost ( but less than

average cost). If output is increased still further, marginal cost

will increase to the point that it exceeds both average cost and

average variable cost.%9

A monopolist has the power to control market price by

varying the quantity of goods it offers for sale. As that quantity

is varied, the monopolists’ marginal, average variable, and

average cost will also vary. If market demand would permit it,*°

the monopolist would have the following options: |) setting a

market price in excess of both average cost and marginal cost;

2) setting a market price below average cost but greater than

3% Areeda and Turner, Predatory Pricing and Related Practices Under

Section 2 of the Sherman Act, 88 Harv. L. Rev. 697 (“Areeda and Turner”).

Areeda and Turner recognized that marginal cost data are typically unavail-

able, and suggested that average variable cost could be used as surrogate. /d.

at 716-18 The terminology and definitions employed here are the same as

used by Areeda and Turner. See id. at 700-03.

3%® For a diagramatic representation of the relationship between these

cost measures and the quantity of output, see id. at 701. n. 14.

“ The monopolist would only have these optuons if the demand curve

intersected the average cost curve to the left of minimum average cost.

32

marginal cost; or 3) setting a market price below both average

cost and marginal cost. Areeda and Turner would conclusively

presume the monopolist’s conduct legal if it exercised option | )

or option 2), and would conclusively presume conduct illegal

only if option 3) was chosen.

IBM argues that the Areeda and Turner rule is the law of

the Ninth Circuit and is binding upon this Court. Transamerica

maintains that prior cases are distinguishable, and that a

monopolists’ pricing is illegal if it sets a market price below the

point at which it would maximize profits if the purpose and

effects of that action are to unnecessarily exclude competition.

Neither standard is appropriate in this case. If a monopolist, in

response to actual or threatened entry into a previously con-

trolled market, reduces prices below its full cost, there are

strong implications of conduct that unreasonably restricts com-

petition. Therefore, and for reasons hereinafter stated, the IBM

conduct will be judged against a “full cost” standard.

A. Predatory Pricing Case Law.

In 1976, the Ninth Circuit Court of Appeals, in Hanson v.

Shell Oil Co.4* (“Hanson”), held that a plaintiffs failure to

show that a defendant’s prices were below its marginal or

average variable costs was a failure as a matter of law to

present a prima facie predatory pricing case under Section 2.

One year later. in Janich Bros., Inc. vy. American Distilling

Co.42 (“Janich”), the Ninth Circuit, relying heavily on Areeda

and Turner, upheld a directed verdict against a plaintiff whose

proof suffered from the same insufficiency. If those cases are

binding upon this Court, in this case, then, as IBM suggests,

Transamerica’s predatory pricing allegations must fall as a

matter of law, for there was no evidence of any IBM price

below marginal or average variable costs.

Both Hanson and Janich involved non-monopolists,

charged with attempting to monopolize. In attempt cases, a

plaintiff must establish specific intent to control prices or

destroy competition, predatory or anticompetitive conduct, and

dangerous probability of success. But it may be misleading to

list those three as separate and independent elements. In fact,

#9541 F 2d 1352 (9th Cir 1976). cert. denied. 429 US. 1074 (1977).

42.571) F.2d 848 (9th Cir 1977). cert. demed. 436 US. 921 (1978).

33

there is a great deal of interrelation between them. Specific

intent may be established by direct evidence, such as memos or

statements made by corporate officers, or alternatively, specific

intent can be inferred from the defendant’s conduct.43 Dan-

gerous probability can be shown by proof of substantial power

in a relevant market, or it can be inferred from conduct which

independently violates Section | and is of a kind “clearly

threatening to competition or clearly exclusionary,” or it can be

inferred from specific intent.44 In extreme cases only conduct

need be proven directly: specific intent can be inferred from the

conduct and dangerous probability can be inferred from the

specific intent.45

A firm that prices its product at levels above marginal or

average variable cost is not necessarily engaged in clearly

exclusionary conduct. A firm that prices its products below

those levels is. These standards then, are appropriate for

judging the pricing conduct of a firm charged with attempting

to monopolize where no independent evidence of specific intent

and no independent evidence of dangerous probability ( rele-

vant market proof) is admitted. Hanson and Janich were such

cases, and the application of very strict standards to plaintiffs

proof was proper in those circumstances.

However, less egregious conduct may violate Section 2 if

engaged in by a monopolist*6 or by one attempting to monopo-

lize if there is also direct proof of specific intent or direct proof

of a dangerous probability of success.47 Hanson and Janich are

deemed therefore to leave open the appropriate standards to

apply to cases with different facts.

The same is true of Ca/Comp.4® IBM thinks CalComp

foreclosed any further inquiry by adopting the Areeda and

43 Jd. at 853.

44 [d.; Hallmark Industry v. Reynolds Metals Co., 489 F.2d 8, 12 ( 9th Cir.

1973).

48 Janich, supra n. 42, at 854 n. 4.

46 Alcoa, supra n. 44.

47 Greyhound, supra n. 4, at 504-05.

48 Supra n. 4.

34

Turner marginal cost standard. CalComp dealt with the pricing

conduct of a monopolist and decided that if prices were

reasonable they did not violate the law. and that price reduc-

tions which responded to lower prices of competitors, but still

left defendant’s products “substantially profitable,” were rea-

sonable.*? However. Ca/Comp carefully limited its pronounce-

ments to the facts of the case before it. The court recognized

that on a different showing, even profitau.e prices might violate

Section 2 if set by the monopolist to discourage new entrants

(limit pricing). and also held out the possibility that other

aspects of a defendant’s conduct might make prices in excess of

marginal cost predatory. Those “refinements” are at odds

with the fundamentals of the Areeda and Turner analysis,

where it was argued that the prices should be conclusively

presumed to be legal if they exceeded marginal or average

variable cost.$"

It does not seem warranted to conclude that the Ca/Comp

opinion mandates adoption of a conclusion it flatly contradicts.

B. Prices Above Average Cost Should Be Conclusively Pre-

sumed Legal.

Theoretical “perfect” competition does not contemplate

stasis. Economists realize that the prospects of supra-normal

profits will induce entrepreneurs and innovators to supply new

markets or invent new products. For a time, the innovator will

be the market's sole supplier. in possession of monopoly power,

and able to charge a profit maximizing price. with returns well

in excess of “normal” profits. This is the reward that accrues to

those whose ventures into new fields are successful.

Charging a monopoly price and earning monopoly profits

is in no way anticompetitive. To the contrary. it can provide the

competitive incentive that keeps an economy dynamic and

innovative. But the monopoly power that accrues to the in-

novator is not expected to be permanent. High profits will

attract imitators. Initially. the imitators will price their products

43 Jd at 741

% Jd. at 737.

=

5* Areeda and Turner. supra n. 38, at 73

35

incrementally below the innovators’, sufficieni'y low to attract

customers for the goods they can produce, sufficiently high to

preserve as much profit to themselves as possible. Eventually

the market’s supra-normal profits will attract enough new

entrants so that the price will be driven down to the point where

all suppliers are covering their costs and enjoying no more than

a normal profit on their investment (price will equal average

cost). This state of perfect competition will continue until

another innovator starts the innovation-monopoly-imitator-

competition cycle over again.

However, the monopolist may seek to disrupt that com-

petitive process in order to preserve to itself the benefits of

monopoly. For instance, when faced with competition, the

monopolist might choose to price so low that the new entrant.

no matter how efficient, is driven out of business. Once that is

accomplished, the monopolist can return to profit maximization

and supra-normal profits. Extinguishing the competitive threat

in that fashion also serves to raise entry barriers. Potential

entrants will be on notice that even if they have a good product,

efficiently produced and marketed. the monopolist will not

allow them to sell at a price which returns a profit.

The great problem in fixing a legal standard by which

pricing conduct should be measured is that it is extremely

difficult to distinguish between a monopolist’s price reduction

that is a normal, expected component of the dynamic com-

petitive process, and the predatory, undesirable conduct just

described. If the law is overzealous in guarding against pred-

atory pricing, it may well inhibit the competitive dynamics it

seeks to promote.

It is tempting to consider the monopolist’s intent in order to

distinguish between pro and anticompetitive price reductions.

But where is the line between illegal, undesirable, “predatory

intent” and the legal, desirable intent to prevail in the com-

petitive struggle? Appropriately low prices are to be encour-

aged, not discouraged. The punitive impact of the antitrust laws

must not be permitted to compel high prices. Unless some

objective, understandable standard is established for the guid-

ance of businessmen, they must either forego competitive price

36

decreases or risk punitive damages that might turn on some

careless word once spoken in a board room.5¢ Businessmen

must have notice of what is violative of the law. A test based

strictly on intent would not serve that goal.

The first issue to be addressed in adopting a cost-based test

is whether any range of pricing conduct should be beyond the

reach of the law. A “free zone” of price activity would preserve

competitive incentives, but could also sanction undesirable

conduct. If monopolists are allowed with impunity to lower

price to a level equal to their average cost, then the monopolist

might lower its price from the profit maximizing level to a level

competitors cannot meet in order to discourage entry and

preserve the monopoly (limit pricing). Or, entry could be

defeated and discouraged by temporary reductions to average

cost levels, followed by a return to monopoly pricing once the

threat had been vanquished. In either case, the competitive

process would be thwarted, and the monopolist could preserve

its status without risking antitrust liability.

Areeda and Turner considered these possibilities, but

concluded, as this Court does, that preservation of incentives is

more important than the minimal threat to competition present-

ed by a free zone above average cost. Only less efficient

competitors would be eliminated by price manipulations above

the average cost level. Competitors who are as efficient as the

monopolist will continue to make at least normal profits, while

the more efficient will profit more.5%

It would be all but impossible to distinguish between

above cost limit pricing conduct and a monopolist’s pro-

competitive reaction to lower priced competitors.54 One ex-

ternal characteristic is common to both cases, a lowered price.

Any attempt to attach liability to the one will surely inhibit the

indistinguishable other.

52 See Areeda and Turner, supra n. 38, at 699; R. Posner, Antitrust Law:

An Economic Perspective, 189-90 (1976) (“Posner’’); Williamson, Predatory

Pricing: A Strategic and Welfare Analysis, 87 Yale L.J. 284, 287-88 (1977)

(“Williamson”).

53 Areeda and Turner, supra n. 38, at 704-09.

54 Posner, supra n. 52, at 195 n. 39.

37

Even a monopolist is permitted to compete in the battle for

trade.55 And the preservation of competitive incentives, even

for that monopolist, is deemed such an important consideration

that monopolization is condoned where condemnation would

provide a disincentive to compete.5€ Protection of relatively

inefficient competiturs is a lesser consideration.5”? Monopolists

can compete by being more efficient than their rivals,5® and the

most significant manifestation of that efficiency is a lower price.

If the monopoly is attained or preserved because the monopo-

list is profitable at price levels where others are not, so be it.

Lower prices and increased efficiency are to be fostered. This

Court agrees with Areeda and Turner that price reductions

which result in prices that exceed defendant’s average cost

should be conclusively presumed legal.59

C. Prices Below Average Cost Should Not Be Conclusively

Presumed Legal.

Efficiency is no longer the sole determinant of survival once

price is permitted to drop below the monopolists’ average cost:

cash reserves become paramount. If price is insufficient to

cover average cost, the monopolist will be losing money, less

efficient rivals will be losing money. equally efficient nvals will

be losing money, and quite possibly, even more efficient rivals

will be losing money. Average cost is the breakeven price level.

Competitors with average costs equal to the monopolist’s, break

even when the monopolist does. Competitors with average costs

lower than the monopolist’s are more efficient and are making a

profit when the monopolist is just breaking even. If a monopo-

list is permitted to set price as low as marginal cost with

impunity, it can drive from the market all competitors whose

average costs exceed the monopolist’s marginal costs unless

their staying power is as great as the monopolist’s.

55 Greyhound, supra n. 4, at 498-99: Telex, supra n. §, at 927.

56 Berkey, supra n. §, at 273-74.

57 Hanson, supra n. 41, at 1358-59

58 Otter Tail Power Co. v. United States, 410 U.S. 366, 380 (1973):

United Shoe, supra n. 13, at 342.

59 See also International Air Ind., Inc. vy. American Excelsior Co., §\7

F.2d 714, 723 (Sth Cir. 1975), cert. denied, 424 US. 943 (1976); Weber v

Wynne, 431 F. Supp. 1048, 1059 (D.NJ. 1977).

38

The difference between these cost levels can be quite

significant. Evidence in the case at bar suggests IBM’s marginal

costs or average variable costs might be as little as 50 percent of

their average costs. If that is so, then IBM could destroy rivals

who are twice as efficient (their average costs are one-half of

IBM’s), simply because IBM had a bigger bankroll, and fear no

antitrust liability under the Areeda and Turner rule.

Courts which have adopted the Areeda and Turner rule

have not always considered its potential for abuse. In Jnt’l Air

Ind. Inc. v. American Excelsior Co.,© the court recognized that

equally efficient rivals could be driven out but incorrectly

assumed that more efficient competitors were safe.®’ The court

in Weber v. Wynne®2 acknowledged the threat to equally

efficient firms, but said nothing of the fate of the more

efficient.6? The Court in Hanson thought only the less efficient

were endangered:

“If its prices were above its [marginal or average

variable] costs, and nevertheless Shell’s did drive Hanson

out of business, this can only be because Hanson was so

inefficient that at prices at which Shell could make a

reasonable profit he could not.”’!°4!

And finally, Ca/Comp: perpetuated that misconception in

this Circuit:

“The thrust of this analysis is that price reductions set

up to the point of marginal cost are consistent with

competition on the merits, since in this case only less

efficient firms will be disadvantaged, while a firm pricing

below marginal cost by definition incurs losses so that

6 $17 F.2d 714 (Sth Cir. 1975), cert. denied, 424 U.S. 943 (1976).

61 Jd. at 724.

62 431 F. Supp 1048 (D.N.J. 1977).

63 Jd. at 1060 n. 16.

64 Hanson, supra n. 41, at 1358.

39

competition on the basis of efficiency in this situation is

frustrated. “15!

Average cost is the point to which the normal forces of

competition™will tend to lower price. To repeat what is self-

evident, if a firm sells below its average cost it is incurring a

loss, equally efficient firms are incurring a loss, and more

efficient firms (if their average cost is lower than the monopo-

list’s average cost but greater than the price) will also be

incurring a loss. Only firms able to withstand losses for as long

as the monopolist decides to inflict them will survive, others will

perish. If a monopolist is permitted to set a price below its

average cost, competition on the basis of efficiency is frustrated,

and competition on the basis of wealth replaces it.

Areeda and Turner have opted to place a potent weapon in

the hands of the monopolist. Their reasons for doing so should

be carefully examined. They have identified four major reasons

supporting their position:®

(1) it will deter frivolous suits:

(2) a prce floor above marginal cost will tend to

preserve inefficient rivals;

(3) short-run welfare is maximized by pricing at

marginal cost; and

(4) even if long-run welfare is not maximized. long-

run consequences are too speculative to incorporate into a

legal rule.

The first justification smacks of overkill. Surely it is not

necessary to go so far as to allow a monopolist to destroy its

competitors in order to protect that monopolist’s incentive to

$§ CalComp, supra n. 4, at 734. Note that the court in Murphy Tugboat

Co. v. Crowley, 454 F. Supp. 847 (N.D. Cal. 1978), also appeared confused

by the cost terminology: “... pnce above full costs, i.e.. above the level of

average vanable costs to which legitimate competition would tend to lower

it.” Jd. at 852. Full cost (average cost) is the level to which legitimate

competition would tend to lower pmce. Average variable costs are always

lower

% Areeda and Turner, Williamson on Predatory Pricing, 87 Yale LJ.

1337. 1339 (1978)

40

price competitively. A prophylactic rule is required in order to

preserve incentives, but sanctioning all price levels above

average cost serves this purpose as well.®”

Areeda and Turner's second reason is interesting, but

highly questionable. Apparently, they feel it is the monopolist’s

function to destroy less efficient competition,®* and that survival

of inefficient firms is undesirable. Even if there is some value in

the elimination of competitors who are less efficient than the

monopolist, this reasoning overlooks the tendency of a price

floor at marginal cost to destroy equally efficient and more

efficient rivals unless they have pockets as deep as the monopo-

list’s.

The welfare maximization argument is really the most

significant. What is meant is simply that a monopolist with

excess capacity, i.e., average cost exceeds marginal cost, will be

making more goods available to the consumer at lower prices if

allowed to price as low as marginal cost than the monopolist

would if forced to utilize less of its capacity by producing less

and pricing in excess of average cost. Social resources are

wasted because there is a divergence between the cost of the

incremental output ( marginal cost) and the value of that output

to consumers. And, since excess capacity exists, it would be a

waste of social resources to attract new entrants who would

construct even more facilities.®9

That short-run welfare maximization argument is short-

sighted. While it is true that resources are most efficiently

utilized and that consumers benefit when the monopolist prices

at marginal cost, such beneficence cannot be expected to

continue. Once the competitive threat has been extinguished,

the monopolist will return to higher prices and profits. When

that happens, society will suffer a greater welfare loss. Fewer

goods will be produced, efficient capacity will be idled, and

67 Schmalensee, On the Use of Economic Models in Antitrust: The

Realemon Case, 127 U. Pa. L. Review 994, 1029 (1979) (“Schmalensee”)

68 See 3 P. Areeda and D. Turner, Antitrust Law, Section 71 $a, at 16

(1978). Areeda and Turner would also sanction the destruction of equally

efficient competition if there is chronic excess capacity

69 See Arceda and Turner, supra n. 38, at 710-11

4] ‘

consumers will be paying much more than incremental produc-

tion costs. Professor Scherer recognized that the inclination of

monopolies to maximize their profits at the consumers’ expense

would mean that welfare would be maximized if the monopo-

list’s price reduction was checked at some point above marginal

cost. But he was unable to quantify precisely a limitation on

price that would maximize long run welfare, i.e., a price rule

that would insure that the discounted welfare loss from the

anticipated future price gouge would be most offset by the

temporary benefits of lower prices.?2 Professor Williamson is

also suspicious of Areeda and Turner's approach. In his opinion

negligible benefits would flow from temporary price cuts to the

marginal cost level, if followed by a return to monopoly

pricing.”*

Areeda and Turner do not argue with Scherer’s long-run

welfare analysis. They acknowledge that the net long-run

consequences of marginal cost pricing might be adverse be-

cause of its exclusionary effect, but reject consideration of long-

run effects because they are difficult to determine (their fourth

reason for adopting a marginal cost standard).72 Indeed, the

welfare maximization problem is complex. In addition to the

return to monopoly pnces scenario, Scherer described several

other cases, some of which would find welfare maximized with

price limitations above marginal cost, and some with price

limitations below that point.7? However, ease of application is

a poor argument for adopting a rule that admittedly ignores

important considerations of economic efficiency, especially

when the main justification for that rule is economic effi-

ciency. 74

In any event, the marginal cost test is not easy to apply

either. In fact it is frequently impossible to apply.

7° See Scherer, Predatory Pricing and the Sherman Act: A Comment, 89

Harv. L. Rev. 868, 883-900 (1976) (“Scherer”).

7* Williamson, supra n. $2. at 291.

2 Areeda and Turner, Scherer on Predatory Pricing: A Reply, 89 Harv.

L. Rev. 891, 896-97 (1976)

72 Scherer. supra n. 70, at 887-89.

74 See Schmalensee, supra n. 67, at 903.

42

It is almost too easy to criticize rule proposals in this area

as administratively complex. The initial Areeda and Turner

article has engendered much academic discussion and several

counter-proposals. It seems that every attempt to formulate

rules has been criticized by proponents of other rules as an

unworkable solution. Areeda and Turner fare no better. Mar-

ginal cost is not a cost recognized by accountants. It is a figment

of the economist’s imagination. It is not recognized in the books

of account, and thus, it is unlikely that any evidence of margina!

cost could be easily developed. Areeda and Turner recognized

that in their initial article, and suggested average variable cost

could be used as a proxy,’5 and that in situations of strained

capacity an average cost test could be applied.”® But they seem

to have retreated from that position of late, perhaps as a result

of pointed criticism of the logic and feasibility of average cost

and average variable cost tests.77 They now emphasize that

theirs is a short-run marginal cost standard, and that the other

measures are simply approximations of marginal cost. If plain-

tiff can show that marginal cost is significantly higher than

average cost, or if defendant fails to show that average variable

cost IS not significantly below marginal cost, then prices in

excess of the surrogate standard are not safe under their rule.”8

The burden is always on someone to offer marginal cost

evidence, but the data is not there.

Areeda and Turner’s justifications are not convincing. They

argue that a marginal cost test will optimize social welfare.

Then they admit that it will not. They argue that a marginal

cost test is easier to apply than a long-run welfare maximizing

test, then they suggest surrogates because marginal cost data is

impossible to come by. But even if their theory had merit, if all

the world’s economists were of one voice, and like Areeda and

Turner, placed their faith in the monopolist to maximize social

welfare by eliminating competitors from crowded industries

78 Areeda and Turner, supra n. 38, at 716-18, 733.

76 Areeda and Turner, supra n. 38, at 709-10, 732-733.

77 See Williamson, supra n. $2, at 310-12, 333 n. 122, 337 and n. 129;

Scherer, supra n. 70, at 869-83

78 Areeda and Turner, Williamson on Predatory Pricing, 87 Yale L.-J.

1337, 1338-39 (1978)

43

through temporary provision of more and lower priced goods.

the Congress and the courts have already placed their faith

elsewhere. The goal of welfare maximization through proper

resource allocation is to be accomplished by a system of

effective competition, not by reliance on the presumed benefi-

cence of a monopolist.” In the words of Justice Black, the

Sherman Act“... rests on the premise that the unrestrained

interaction of competitive forces will yield the best allocation of

our economic resources, the lowest prices, the highest quality

and the greatest material progress. . .°8° The economic ration-

ale behind the act cannot be overcome by arguments that the

monopolist has provided economic benefits.®'

More than just economic considerations impelled the Con-

gress to adopt competition as the Acts’ unequivocal policy.

Chief Justice Warren said:

* .. We cannot fail to recognize Congress’ desire to

promote competition through the protection of viable.

small, locally owned businesses. Congress appreciated that

occasional higher costs and prices might result from the

maintenance of fragmented industries and markets. It

resolved these competing considerations in favor of

decentralization. “82

Economic considerations aside, justifiable apprehension of

excessive economic power concentrations underlie the law's

aversion to monopolies.®&

Areeda and Turner have made a policy judgment. The

economic analysis used to justify that judgment is incomplete,

and the judgment itself stands contradicted by the economic.

political, and social policies of the Sherman Act. A conclusive

presumption of the legality of an unprofitable low price. merely

because it is above marginal cost, a cost which is all but

"9 Sullivan, supra n. 1S, at 20-21.

8 Northern Pacific Railway Co. v. United States, 356 US. 1, 4( 1988)

8’ See Von Kalinowski, Antitrust Laws and Trade Regulations, Vol. Il.

Section 903 [3]. p. 984 and cases cited therein.

82 Brown Shoe, supra n. 16, at 344.

83 Standard Oil of New Jersey v. United States, 221 US. |. $0 (1911):

Berkey. supra n. §, at 272: Alcoa, supra n. 44, at 427: see generally Pitofsky,

The Political Content of Antitrust, 127 U. Pa. L. Review, 10$1 (1979)

44

incapable of proof, would truly be a “defendant's paradise. "84

This Court rejects it.

D. Prices Below Average Cost Are Illegal If They Are

Unreasonable.

There are no simple bright line tests that are universally

applicable. Williamson proposes a complex set of “per-se”

rules, a different rule to be applied depending upon whether the

dominant firm is reacting to new entrants or already established

firms, whether a short. long or intermediate-run is involved,

and whether the demand function is normal or conditions of

chronic excess supply are found.®5 Scherer calls for evaluation

of the many criteria that would affect long-run welfare max-

imization, examined in the light of the monopolist’s intent and

the structural consequences of its pricing behavior.®

Professor Schmalensee recently attempted to apply the

Williamson rules to the facts of a monopolization case heard

before the Federal Trade Commission, but found them impre-

cise, difficult to apply, and based on an economic model

probably at variance with real world conditions and certainly at

variance with the facts of the case he discussed.8? Having

already rejected Areeda and Turner's approach as incapable of

deing “defensibly applied to all, or even most. cases,” Schma-

lensee concluded that Scherer’s rule of reason analysis was the

only economically defensible policy choice and that an average

cost test could be employed to dismiss patently groundless

charges of predation.®

This approach is not wholly without precedent. In a

thoughtful concurring opinion to the case discussed by Schma-

lensee, Commissioner Pitofsky distinguished Ninth Circuit cases

and applied the same rule.@% The average cost standard

adopted here also finds support in several trade rules promul-

* Williamson, supra n. $2. at 305

8 fd at 33|-37

% Scherer. supra n. 70. at 89

8? Schmalensee. supra n. 67. at 1024-28

% Jd at 1028-29

* Borden Inc, \978 Trade Reg. Rep.. Case No. 21.490 at 21,$17-24

(FTC 1978) ( Pitofsky concurring)

45

gated by the Federal Trade Commission,.® in state statutes

prohibiting below cost sales.9’ in a predatory pricing rule

propounded by Professor Posner, in a recommendation by the

National Commission for the Review of Antitrust Laws and

Procedures that the marginal cost standard be abandoned in

favor of a more flexible analytical approach,% and finally by

the Supreme Court's holding in Utah Pie Co. v. Continental

Banking® that a jury could infer price cuts were predatory if

price was below average cost.9

If the monopolist chooses to price below average cost,

something unusual is taking place. A decision has been made to

sell goods at a loss, and such activity is worthy of investigation.

It may be a predatory act with the design and effect of starving

Out competitors, or it may in some way be justified.

Prices below average cost would be reasonable if the

monopolist was merely liquidating excess, perishable. or obso-

lete merchandise.% Prices below average cost would be war-

ranted if shrinking demand forced the monopolist to minimize

its losses by selling at the best price-cost relationship available

to 1t,97 or where the industry suffers from chronic excess

© See e.g.. 16 C.F.R. Section 23.20 ( Jewelry Industry) and 16 CR.R

Section 26.9 ( refrigeration and/or air conditioning industries )

9' Arkansas Stats. Title 70, Section 303; California Business and Profes-

sional Code, Sections 17026 and 17029; Colorado Revised Code. Section 6-2-

105, Hawa Revised Stats. Title 26, Section 481-3; Kentucky Revised Stats.,

Section 365.030; Montana Code Ann., Section 30-14-202; Washington Re-

vised Code, Section 19.90.010; Wyoming. official cite unavailable. CCH

Trade Reg. Reports. paragraph 35.530

92 Posner, supra n. $2, at 190

% National Commission for the Review of Antitrust Laws and Proce-

dures, Report to the President and the Attorney General, 170-7 ( advance text

January 22. 1979).

94 386 U.S. 685 (1967)

95 {d. at 696-98. Note that this case involved discriminatory pricing

under Section 2(a) of the Clayton Act as amended by the Robinson-Patman

Act, 49 Stat. 1526, 1$ U.S.C. Section 13/4), but that the substantive issues are

the same as those when predatory pricing is charged under Section 2 of the

Sherman Act, 1S U.S.C. Section 2. See 3 P. Areeda and Turner. Antitrust

Law, Section 720¢ at 198-90 (1978)

% Williamson, supra n. $2. at 317-18

9? Posner, supra n. $2, at 193

46

capacity.9 And the same might be true of promotional pricing,

meeting competitors’ prices, or even occasional price wars, if

carried out under appropriate circumstances.% Intent evidence

can prove helpful here. The monopolist’s own evaluation of the

situation, whether it thought it was cutting losses or cutting

throats, can help to clarify the nature of the acts undertaken.

A monopolist’s prices should be judged according to

whether or not they are reasonable, and prices above the

monopolist’s average cost should be per se reasonable. That

standard will be applied to the facts of this case.

E. IBM's Pricing Conduct.

IBM did not simply reduce the prices of its existing

products, instead it responded to PCM competition by in-

troducing several “new” products, all of which were, to some

degree, repackaged versions of prior offerings. By offering the

new products at lower prices, while maintaining higher prices

on the older versions, IBM managed to avoid the disastrous

effect an across-the-board price reduction would have had on

revenues from installed machines, and yet still had a vehicle

with which to challenge the PCMs. It is the prices of these new

products that Transamerica claims were predatory.

In 19€ IBM introduced a disk drive known as the 2311. In

1965 an improved version, the 2314, was announced. At first.

2314-type disks were only available in a package of eight disks

or “spindles” ( plus one spindle as a spare). Later, IBM offered

a one spindle version (the 2312), a two spindle version (the

2318), and a four spindle version (the 2313), all of which could

be connected to the CPU through a control unit (the 2314).

The functional characteristics ( access time, capacity, and data

transfer rate) of all versions were practically identical, and all

are known as ‘“2314-type” disks. The PCMs also marketed

2314-type disks. Most PCMs offered some functional improve-

ments (principally a reduced access time), all offered only

single spindle versions, and all offered lower prices than IBM.

In September of 1970, IBM announced a new computer

system, the System/370, Model 370/145. At the same time. a

% See Pacific Engineering and Prod. Co. of Nevada v. Kerr-McGee C Orp.,

551 F.2d 790 (10th Cir.), cert. denied, 434 US. 879 ( 1977).

% Times-Picayune Publishing Co. v. United States, 345 US. $94, 623

(1953); Knuth v. Erie-Crawford Dairy Cooperative Association, 326 F Supp.

48, 52-53 (W.D. Pa. 1971), aff'd in pert. part, 463 F.2d 470 ( 3rd Cir. 1972 ).

47

three-spindle version of the 2314-type disks was announced for

use on that new system. This new version was known as the

2319A and was code-named “Mallard.” It connected directly to

the System/370 Model 145 CPU (and later to the System/370-

135) by means of an integrated file adapter (“IFA”) which

eliminated the need for a control unit. The 2319A was available

at a monthly rental of $1,000, a price substantially less than

IBM's one, two and four spindle versions (if comparison is

made on a per spindle basis, i.e., monthly rental divided by

number of spindles), and a price Transamerica claims was

predatory.

Three months after the 2319 announcement, in December

of 1970, IBM announced a three-spindle version 2314 for use

on the older System/360 CPUs. This was known as the 2319B.

It attached to the 360 CPU through a control unit (2314B), and

a channel. At the same time IBM announced the 2319A2, a

second set of three spindles for attachment on the 370/145

CPU behind the first set (the 2319A). The 2319B and the

23N9A2 were both priced at $1,000 (monthly rental). Trans-

america claims that price was predatory.

In July of 1971, still another three-spindle 2314-type was

announced: the 2319A3. Unlike the other versions, the 2319A3

(code named **Zoom’’) had its own power supply. It was to be

used exclusively on the 370/135 CPU, where power constraints

had previously limited configurations to a maximum of five

spindles. Zoom extended that maximum to eight. Because of

the extra power equipment, the 2319A3 was priced at $1050

monthly rental, slightly higher than the other 2319s. Trans-

america also claims this price was predatory.

In 1964 and 1965, IBM announced various models of the

2401-type tape drives and 2803 control units. Improved tape

drives, the 2320s, were announced in 1968. In November of

1970, IBM announced an improved control unit, the 3803, and

three new tape drives to go with it, the 3420 Models 3, 5 and 7.

The functional characteristics of the new tapes (data transfer

rate, tape speed, and tape density) were practically identical

with those of the 2420. The combined tape program was code-

named “Aspen.” Transamerica claims that the Aspen prices

were predatory.

48

At the same time as the Aspen announcement, November

of 1970, IBM announced a new model 2401 tape drive, the

2401 Model 8. Two control units for that model, the 2803

Model 3 and the 2804 Model 3, were also announced. This

program was code-named “Mandan.” The 2401 Model 8 was

almost identical to the seven-track version of the 2401 Model 2,

but the price was substantially lower. Transamerica claims that

the Mandan prices were predatory.

IBM analyzed the financial aspects of each of these

programs (the 2319A, the 2319B/A2, the 2319A3, Aspen, and

Mandan) prior to announcement in order to predict the costs,

revenues, and profits that could be expected. A common

procedure was followed in all pre-announcement financial

analyses. The Product Manager. an employee of the engineer-

ing division, identified the forecast assumptions. These includ-

ed a description of the product, competing products, follow-on

products, delivery schedules, etc. The forecast assumptions

were then used to project the number of units that would be

sold and leased at various price levels (the demand function),

and from this the program revenue at those prices could be

calculated. Direct costs (those that could be readily identified

with the product in question) were estimated by the manufac-

turing division. Indirect costs were assigned to the products

through three apportionment methods. By allocating a portion

of the indirect costs (such as corporate overhead) to each

product, as well as the direct costs. IBM followed a full-cost

philosophy of financial analysis and hoped thereby to be able to

predict a program’s profitability. Full costs, direct plus indirect,

were subtracted from revenues, to give predicted program

profits.

Each of the product programs at issue here was expected at

announcement to return substantial profits to IBM. Zoom (the

2319A3), by far the smallest program, was projected to return a

$900,000 profit. or 4.5 percent of revenue; Mandan was ex-

pected to produce $29.2 million in profits, or 33.6 percent of

revenue; Aspen was projected to bring in $473.3 million in

profits, or 26 percent of revenue; the 2319B/A2 program was

predicted to bring in a $71.6 million profit, or 31.5 percent of

49

revenue; and finally, the 2319A was projected to bring in $55.2

million in profits, 31 percent of its revenues. It is only through

the application of several ‘‘adjustments” to the IBM announce-

ment financial analyses that Transamerica is able to claim that

any of the prices at issue here were below average cost. Each of

the adjustments Transamerica suggested is discussed below.

|. The Revenue Apportionment Adjustment.

As mentioned above, IBM uses three apportionment tech-

niques for determining what indirect costs a particular product

or program should bear. The indirect costs that are most closely

associated with engineering are apportioned among products

according to the relationship between that product's direct

engineering costs, and total direct engineering cost. Similarly,

indirect costs that are associated with production are allocated

to the ratio between the product’s direct production costs and

total direct production costs. Finally, indirect costs that are not

otherwise apportionable, such as marketing, general and ad-

ministrative expenses, are apportioned to products according to

the relationship between that product’s revenues and total

revenues.

IBM allocates over 50 percent of a product’s costs through

the revenue apportionment method. Transamerica complains

that this method provides a monopolist with too much flexibil-

ity. They say that where a price cut is involved it permits the

monopolist to drastically reduce price and still not be pricing

below cost because reduction in price means a reduction in

revenue and thus a reduction in revenue-apportioned costs

When revenue is reduced on one product, some of the costs

previously associated with it are automatically transferred to

other products. Transamerica characterizes all the products a*

issue here as disguised price cuts: The 2319s as disguised price

cut versions of the 2314; Mandan as a disguised price cut on

2401 Model 2; and Aspen as a disguised price cut on the 2420

Through its expert accountant Peterson, Transamerica

invokes “generally accepted cost accounting principles,” and

adjusts the revenue-apportioned costs assigned to each of the

products ac issue. Assuming that he was in fact dealing wi.h

price cuts, Peterson increased each new program’s revenue-

50

apportioned costs by multiplying the costs assigned at its

announcement by the ratio between the “old” price and the

lower “new” price.

The basis for Mr. Peterson's adjustment is suspect. The

phrase “generally accepted cost accounting principles” does not

appear in accounting literature. It, like the adjustment it

supposedly requires, appears to have been invented for pur-

poses of this lawsuit.

The adjustment is predicated on the existence of a price cut

when, at least in some circumstances, different products are

clearly involved. And, it assumes that the cost allocated to the

product at the old price was somehow “correct” and should be

maintained, when in fact it is precisely the inability to associate

these expenses with any particular product that makes an

apportionment method necessary. It would be equally logical

(or illogical) to assume the previously assigned costs were too

large and the new ones are “correct.”

Revenue apportionment is a generally accepted and com-

monly used method of indirect cost allocation. IBM used it

consistently long before making the cost analyses at issue here.

Peterson’s adjustment would abandon that consistency, and

with it any assurance that full costs are recovered. Increasing

the costs assigned to one product without somehow decreasing

the costs that other products must bear would lead to an over-

recovery of costs, and make the full-cost recovery rationale and

program profit predictions meaningless.

All methods of indirect cost recovery are arbitrary and

flawed in some respects. The flexibility of revenue apportion-

ment is apparent, yet this Court will not attempt to “correct”

that characteristic by mandating the use of a patch work system

based on one accountant’s views of the facts of this particular

case. To do so would not only be bad accounting, it would be

bad law. Businessmen would have no notice of what was

required to be done if arbitrary adjustments were allowed to be

applied after the fact to their reasonable and consistent cost

accounting.

S|

This is not to suggest that under other circumstances cost

accounting adjustments might not be warranted. Where a

defendant itself abandons consistency in attempts to circumvent

the law, adjustments might be appropriate. That, however, is

not the case here. The revenue apportionment adjustment is

rejected.

2. The Manufacturing Cost Ad

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