Federal Trade Commission Protecting America's Consumers

DKT/CASE NO.:P951201

TITLE: HEARINGS ON GLOBAL AND INNOVATION-BASED COMPETITION

PLACE: Washington, D.C.

DATE: October 19, 1995

PAGES: 453 through 640

Meeting Before the Commission

C O R R E C T E D C O P Y

JANUARY 10, 1996

Date: October 19, 1995

Docket No.:P951201

FEDERAL TRADE COMMISSION

I N D E X

WITNESS: EXAMINATION

None.

E X H I B I T S
FOR IDENTIFICATION

Commission's:

None.

FEDERAL TRADE COMMISSION

In the Matter of: )

)
) Docket No.: P951201
HEARINGS ON GLOBAL AND )
INNOVATION-BASED COMPETITION )
Thursday,
October 19, 1995
Federal Trade Commission
Sixth and Pennsylvania Avenues
Room 432
Washington, D.C. 20580

The above-entitled matter came on for hearing,
pursuant to notice, at 9:40 a.m.

SPEAKERS:

ROBERT PITOFSKY
Chairman, Federal Trade Commission

ROSCOE B. STAREK, III
Commissioner, Federal Trade Commission

JANET D. STEIGER
Commissioner, Federal Trade Commission

CHRISTINE A. VARNEY
Commissioner, Federal Trade Commission

SUSAN S. DE SANTI
Director, Policy Planning

DEBRA VALENTINE
Deputy Director, Policy Planning

JOHN HILKE
Economist, Bureau of Economics

SPEAKERS (Continued):

RICHARD FRUEHAN
Carnegie-Mellon, Sloan Foundation Steel Study

TERRENCE W. FAULKNER
Kodak

ANTHONY M. SANTOMERO
University of Pennsylvania
Sloan Foundation Financial Services Study

THOMAS R. HOWELL
Dewey Ballantine
Coalition for Open Trade

DONALD I BAKER
Baker & Miller

ROBERT B. BELL
Wiley, Rein & Fielding
Counsel for Kodak

LLOYD CONSTANTINE
Constantine & Partners

MARK LEDDY
Cleary, Gootlieb, Steen & Hamilton

PHILIP B. NELSON
Economists Inc.

P R O C E E D I N G S

CHAIRMAN PITOFSKY: Good morning, everyone.

I would like to get started. Today we are going to continue our look at the changing competitive environment, and we'll be hearing about increasingly integrated global competition and about an economy in which technological information and innovation is changing the way firms operate.

Once again, we are fortunate to have two people who have conducted studies, financed, I guess, in part by the Sloan Foundation, which help us to give a grounding to our theoretical discussions and some real facts about industries.

Professor Fruehan of Carnegie Mellon will be discussing how the U.S. steel industry has responded to intense competition.

Professor Anthony Santomero of the Wharton School will focus on changes in the financial sector where technological information is changing that industry.

We'll also be hearing from Terrence Faulkner of Eastman Kodak who will describe his experience in markets characterized by technology-intensive competition and globalization.

And Tom Howell, who is an attorney, represents the Coalition for Open Trade.

Professor Richard Fruehan has been at Carnegie Mellon since 1980. He organized the Center for Iron and Steelmaking Research, an NSF Industry/University Cooperative Research Center, and is the Director.

The Center currently has 25 industrial company members, including those in the U.S., Europe, and Asia. He is also the Director of the Sloan Steel Industry Competitiveness Study, a $5 million program involving several universities.

He has authored something like 150 books and papers on various subjects in his field.

It's a pleasure to welcome you here, Dr. Fruehan.

MR. FRUEHAN: Thank you very much.

I appreciate this opportunity to take part in these hearings and to discussion the changing nature of competition in the steel industry, the need for new technologies, and whether adjustments to antitrust laws, regulation, and the enforcement of these are required.

More specifically, I will discuss how innovation takes place, the economic drivers for technologies in the form of steelmaking process and products, and how these technologies will be developed and commercialized in the steel industry.

However, before examining technology, it is useful to examine the changes in the steel industry in the past 30 years and how the industry competes in a global economy.

It is interesting to compare the international status of the U.S. steel industry 30 years ago and today. Thirty years ago, the U.S. industry had the image of being a dominant industry with control of world prices; and the U.S. Government was vigilant in insuring the industry strictly adhere to antitrust laws and regulation.

For example, in the early 1960's at the time of the famous confrontation between President Kennedy and the U.S. steel industry, the industry produced over 25 percent of the steel in the world. Today, that figure has dropped dramatically to below 13 percent.

U.S. Steel was the largest steel firm in the world, producing over 30 percent of the steel for the U.S. market. Bethlehem Steel and other U.S. integrated companies were also among the largest steel companies in the world.

By 1993, only U.S. Steel remained on the list of the top 10 steel producers in the world with only half the production of Nippon Steel in Japan, POSCO in Korea, and Usinor Sacilor in France. No U.S. company produces more than 13 percent of the U.S. steel consumption.

Thirty years ago imports were negligible. Today they are about 30 million tons, representing about 25 to 30 percent of total steel consumption. Today the American steel industry is highly fragmented, with no dominant firms. The companies are not large by international standards, and imports play a significant role in determining steel prices.

As a comparison, there are only three domestic auto companies in the United States. Whereas, there are over 20 competitive steel companies and a high level of imports.

The American steel industry's competitiveness eroded in the 1960's, 70's, and early 80's but has since made a remarkable recovery. The industry has increased productivity by nearly 300 percent in the past decade, become the low-cost producer for the U.S. market, and can produce the vast majority of the grades of steel required by the U.S. industry.

Quality has greatly improved, as exemplified by the rejection rates of poor quality steels by a major U.S. automotive company. In the mid 1980's, the rejection rates were 7 to 8 percent. By 1994, they dropped to below 1/2 of 1 percent, even though the quality standards had increased.

This recovery was accomplished in part by closing around 50 million tons per year of inefficient capacity or about 35 percent of the total and concentrating resources with new technologies in the remaining plants.

During the same period, production in other countries with mature economies and overcapacity, their capacity was not significantly reduced. In some cases, in particular Europe, the companies avoided closure by government assistance. In most cases foreign companies maintained production at reasonably high levels by exporting steel and selling it at below the costs of that in their own country.

The significant improvement in the U.S. industry can also be, in part, attributed to intense national and foreign competition. In the U.S., the scrap-based industry, sometimes referred to as "minimills" -- although, they're not very mini any more; one of the new mills is going to produce over 2 million tons of steel -- these new minimills, by using a low-cost technology, relatively inexpensive scrap and more flexible non-union labor has taken away most of the lower quality steel markets and forced the integrated producers to focus on higher quality products and improve their performance.

Foreign produces in the early 1980's could produce steels of better quality than the U.S. producer, forcing the U.S. integrates to improve in order to remain and regain their market share. Therefore, fair competition has been good for the industry. However, as will be discussed, unfair competition in the form of dumped or subsidized steel greatly reduces the industry's ability to compete.

Maintaining relatively high levels of production is critical for steel companies to be profitable so they have the resources to develop and implement new technologies and to insure an adequate return on their investment.

The capital cost of integrated steel production is enormous. Whereas, no new integrated plants have been built in 20 years, estimate of capital range from $1,000 to $1,500 per annual ton of production. If you compare this with other major industries, the rate of return on this kind of investment is very low.

A four million ton per year plant would cost four to six billion dollars. In addition, there are other fixed costs, in particular labor. Therefore, for a company to get adequate return on capital and cover other fixed costs, it must run at or near capacity and have reasonable selling prices.

In general, if a company is running at less than 80 percent capacity, it loses money, while above 90 percent it's making a profit. Therefore, if the U.S. industry loses as much as 10, or even 5 million tons of its market to unfair traded steel, it's loses its ability to be profitable and ability to invest in new technologies.

Steel imports in 1973 to '76 averaged 12 to 14 percent of consumption but increased steadily to 26 percent by 1984. Imports then decreased to about 18 percent for the period of 1988 to 1992, in part due to the VRA's and in part because the industry became more competitive.

In the early 1990's, the U.S. Commerce department found there was a significant amount of subsidized or dumped imports into the U.S. and imposed temporary duties.

Later, the ITC found that there was only damage to the industry in about half of those cases, and many of these duties were removed. Currently, imports represent 25 to 30 percent of steel consumption.

In understanding the global steel market, it must be noted that many former steel companies are controlled or influenced in national or regional policies. In Japan, MITI sets voluntary production guidelines and provides a forum to bring together industry leaders, government officials, bankers, and other interested parties. Issues such as pricing, output, joint research and rationalization are discussed.

In Europe, the EC or EU has played a similar role.

In addition, there's strong evidence of an international steel cartel which includes many of the international companies with the exception of the U.S.

Through a series of bilateral and multinational agreements, quotas are set with regards to steel trade. At first glance, this may not appear to be of great concern since the U.S. is not involved. However, since there is a worldwide overcapacity in steel production, the U.S. becomes the target for excess capacity.

This is particular true during periods of low demand. In order to maintain production at acceptable levels, non-U.S. firms must export steel, and the only outlet is the U.S. They will sell at costs significantly lower than in their own country in order to maintain production levels. As mentioned earlier, the loss of the additional 5 to 10 million tons above the normal imports drastically affects the profitability of U.S. firms.

With this background, I would now like to address innovations in the steel industry. There have only been two truly revolutionary steelmaking technologies in the past 50 years: oxygen steelmaking and continuous casting.

Oxygen steelmaking reduced the time to produce steel from over five hours in the open hearth to 40 minutes, while continuous casting greatly improved yields, quality, and total energy efficiency.

Today in the U.S., all the integrated production uses oxygen steelmaking, and virtually all of the steel is continuously cast. It took about 20 years for these to replace the older technologies, primarily due to high capital costs.

The vast majority of steelmaking innovation has been incremental and revolutionary. However, the cumulative effect has been tremendous.

I would like to give one example, the development of the high-productivity electric arc furnace. In 1970, it took 180 minutes, 600 kilowatts of energy, and 3 hours of labor to produce one ton of steel in an electric arc furnace.

Today, it takes about 55 minutes, 400 kilowatts of energy, and less than one half of a man hour of labor to produce the same ton.

The U.S. has become a leader in efficiency in the electric arc furnace steel production. This was not accomplished by a single technology but rather about a dozen innovations, including ultra-high power furnaces, oxy-fuel burners, water-cooled panels, and secondary refining. Similar, but possibly less dramatic improvements have occurred in other areas, such as the iron blast furnace.

You may ask if the thin slab casting technology is revolutionary. The process has caused a steelmaking revolution, but the process itself was an incremental change in conventional casting. Plants consisting of a high-productivity EAF and a thin slab caster with inline rolling or similar technology greatly reduces the costs of producing the steel and are being built at an astounding rate. Between 1990 and the year 2000, 18 to 20 million tons per year of such capacity will be built in the United States, revolutionizing the steel industry.

Similarly, one may argue that no completely new steels have been developed in the past 20 years, simply modifications of existing grades. However, half of the steel tonnage produced today is of grades that did not exist 20 years ago. You only have to look at your automobile to appreciate this. Steels for the auto markets are more formable, corrosion resistant, and have a much greater strength-to-weight ratio.

Therefore, whereas new technologies and products have been incremental improvements, the cumulative effect has been enormous.

Due to a number of economic drivers, the rate of change in the steel industry is expected to increase dramatically. The industry is going through a technological revolution which will not only change how steel is made but also the structure of the industry.

The U.S. industry, as opposed to the recent past, is a leader in this revolution. The drivers include the need to reduce capital, environmental concerns and costs, potential raw material shortages, in particular for coke and quality scrap, and ever-increasing customer demands.

To satisfy these drivers, the industry must have processes which produce iron directly with coal, processes that recycle waste oxides, and processes to produce scrap substitutes.

In the past 10 years, the U.S. industry has been playing technological "catch up." It, therefore, could rely on purchased technologies developed elsewhere. However, the industry has caught up. It is now a leader and has a unique set of drivers and, therefore, cannot completely rely on purchased technology in the future.

Since technology is playing a major role in structuring the future steel industry, it is useful to benchmark the U.S. steel industry's R&D capabilities. This was done as part of the Sloan Steel Industry Study.

The major U.S. integrated plants, as you can see on this graph, invest, on average, about .5 of 1 percent in R&D, whereas the international competitors -- such as Nippon Steel, POSCO, and Usinor Sacilor -- this figure is more than double.

For each million tons of production, the U.S. group has 10 researchers, while the number for the international group is over 30. The U.S. scrap-based industry, "minimills," have even less R&D and depend almost exclusively on purchased technology, usually from overseas.

Foreign steel companies make use of national and regional problems and government subsidies for research. For example, the EC funds major research programs while MITI plays a similar role in Japan.

For example, the Japanese have a major program to develop an environmentally friendly steelmaking process funded at over $1 billion primarily by the government. They have also spent five times as much on a process similar to the AISI-DOE direct coal-based ironmaking process, for their similar process

Efforts such as our engineering center at Carnegie Mellon University are collaborative but very small and receive no significant government funding.

About 10 key future steelmaking technologies have been identified as part of our Sloan Study. These are shown on this overview. They range from direct ironmaking technologies, through cokemaking, scrap improvement, all the way down to strip casting.

We asked the major companies if these were critical to their future. As you can see, on average, about 75 answered in the affirmative. Then we asked if you have any current program in the development of these technologies. On average, less than 30 percent indicated they did.

What we see is a technology gap between the U.S. and its global competitors. This may be the result of the U.S. industry's ability to simply purchase technology, poor financial performance in the past decade, or to the fragmentation of the industry so that the critical mass for effective R&D does not exist in a single company.

In terms of antitrust laws and enforcement, I believe they should be less restrictive in the areas of research, development and commercialization of new technologies.

The U.S. industry is fragmented; the companies are smaller than their international competitors; and they do not have the technical and financial resources to carry out a major development program alone.

R&D in any industry can be expensive. However, commercialization of new technologies in the steel industry is extremely costly and with considerable risk.

For example a new direct ironmaking facility unit of one million tons would cost over $250 million. No single company can afford to take the risk on such a technology. Such programs must be a major joint venture. And if the major driver is to satisfy government-imposed environmental regulations, partial government funding should be available for the initial commercial units.

No new integrated facility has been built in the U.S. in over 40 years. The cost would be four to six billion dollars. No single company can afford this. If such a plan is required to remain competitive, joint ventures of U.S. companies should be allowed for such purposes.

In fact, mergers of major U.S. companies would not adversely affect competition, because currently the industry is highly fragmented; and imports and scrap-based producers will always supply adequate competition.

Similarly, the merger of scrap-based producers would not hinder competition. Let me give you one example. If National Steel, Inland Steel, and AK -- three of the six major U.S. firms -- were to merge, their total production would be less than POSCO's in Korea, Nippon Steel's in Japan, Usinor Sacilor's in France, and similar to that of British Steel's in Great Britain. Their production would be less than half of the amount of steel that is imported.

With regards to imports, the U.S. Government should carefully examine evidence concerning the international steel cartel that makes the U.S. the dumping ground for steel resulting from the need of foreign companies to maintain high levels of production.

In conclusion, the steel industry and its companies are no longer dominant in the global economy, and the U.S. industry is highly fragmented.

The industry has made a significant comeback in the past decade, spurred in part by national and international competition. In the recent past, the industry has relied on purchased technologies but may not be able to in the future. The industry's R&D capabilities are less than half of its international competitors.

With regards to antitrust laws and regulation, collaborative R&D should not only be allowed but encouraged. Joint commercialization of new technologies must be allowed because of their excessive costs and risks.

Furthermore, major mergers would not affect the highly competitive nature of the industry.

Finally, the government should be sure the U.S. industry is not being injured by unfair cartels which make the U.S. the dumping ground for overcapacity.

Thank you for your attention.

(Pause.)

CHAIRMAN PITOFSKY: Thank you very much.

If we can, let me ask you a couple of questions.

Two striking things about the steel industry. One is it's about as de-concentrated as any major industry that we are likely to look at; but, two, it's made quite a nice comeback. It may not be dominant in the world, but it certainly is profitable and successful.

It sounds to my like the only adverse consequence of de-concentration is creating an efficient scale for R&D. You urged that the antitrust laws be quite permissive about R&D. It would be hard to be any more permissive than we are.

So that leads me to the question: Is there joint R&D going on in the steel industry of which you are aware?

MR. FRUEHAN: Yes, there is joint R&D at several levels. There is a small basic research activity such as ours, but that's quite small.

U.S. Steel and Bethlehem Steel have a joint research exchange agreement where they look at programs together, primarily in the front end of the business.

But when I talk about -- I'm really talking about the major technologies that have to be developed, the ones in which companies are going to have to invest 10 or 20 researchers and tens of millions of dollars. This is where the critical mass doesn't exist for these kinds of activities.

CHAIRMAN PITOFSKY: It does not now exist? There is not that kind of major commitment to joint R&D for new technologies?

MR. FRUEHAN: Well, there was the AISI direct steelmaking project; and there is also the process of looking at advanced process control.

But if you compare these activities to the $1 billion activity that MITI is sponsoring in Japan or if you look at the kinds of group activities that have gone on in the European Community, these are relatively small.

COMMISSIONER VARNEY: But it's not because the U.S. antitrust laws are precluding the U.S. steel companies from undertaking these kind of R&D joint efforts, are they?

MR. FRUEHAN: I don't know the answer to that.

COMMISSIONER VARNEY: Okay.

COMMISSIONER STAREK: I wouldn't think so, because like any industry, they can take advantage of the National Cooperative Research Act of '84 and the '92 amendments, which permits these R&D joint ventures to go forward.

MR. FRUEHAN: May I ask: Where does R&D stop and commercialization begin? Because R&D in the steel industry is expensive, yes. Commercialization is enormous. The step between AISI direct steelmaking unit, where we were spending tens of millions of dollars, becomes hundreds of millions of dollars to go to the next scale.

That, I think, is the critical step.

COMMISSIONER VARNEY: But, again, I really don't know the answers to these, and I have never looked at these before.

But wouldn't it be up to the companies to create a joint venture R&D agreement and then they would delineate where the commercialization takes place and where the R&D might separate out from the commercialization what their interests are in the commercialization and then we would, presumably, take a look at the joint venture agreement, which is predominantly an R&D agreement?

Again, I think I'm in agreement with everything you said. I'm just not sure if there is an antitrust barrier to doing what is the logical next step that needs to get done in the steel industry.

MS. DeSANTI: Let me ask you, maybe it would help if you could talk a little bit about what you mean by commercialization.

Are you talking about, once the R&D has been done for new technologies, then there's a joint venture that builds one plant that then operates according to that new technology and there are sales from that plant?

MR. FRUEHAN: Yes. The big step in the steel industry is building that first unit. Nobody wants to build the first unit. Everybody is in a race to be the second, okay? because there are so many risks involved and there are so many uncertainties when you put together the first such unit.

I'll give you an example of a new technology. It's a not a U.S. technology; it's a European technology. It's the COREX process. It's going to cost something like six or eight hundred million dollars to build the first unit with cogeneration associated with it.

That's an enormous amount of money for a single company to be looking at it with the kind of returns that they are getting. So consequently there hasn't been one built in the United States. Whereas, there has been one built in South Africa; there are several being built in Korea, et cetera.

MS. DeSANTI: And after the production step, would, then, joint sales be necessary?

MR. FRUEHAN: Yes.

Depending on where you are in the process, you are so far from the end product, it doesn't necessarily have to affect the competitiveness of the final product.

COMMISSIONER VARNEY: Presumably, then, where we could evidence more flexibility is on the front end if there were to be a proposed joint venture on R&D that was very open ended as to what was going to happen on the commercialization end of it in terms of our flexibility.

MR. FRUEHAN: I think that's a fair conclusion, yes.

CHAIRMAN PITOFSKY: Other questions?

COMMISSIONER STAREK: Why do you suppose there hasn't been more consolidation in this industry?

As the Chairman pointed out, it's very concentrated and up against large competitors on --

MR. FRUEHAN: There's a variety of reasons. I think that if you look at the development of steel technologies, the oxygen steelmaking technology came in in the 1960's; and continuous casting was not fully implemented for another 10 or 15 years. That meant there was a large surplus of scrap in the United States that led to the development of what people call the "minimill." I prefer to call it the scrap-based electric furnace producer. This began to fragment the industry. That was one step.

The next step is there has not been a major integrated plant built in 40 years. There is no way for the integrated plants to build a whole new plant because that takes $5 billion; and the kinds of returns that they have been getting in the past decades, it's hard to justify that kind of investment.

So the industry has found a way to be economical with a one million ton plant down in the South or Southwest where there are no unions to worry about, lots of scraps, closer to markets; and so that particular plant or that particular company flourishes; and so you have a multitude of these plants being built. And this fragments the industry.

It's not necessarily a bad thing. On the other hand, it reduces the critical mass that's required for major developments; and if you really want to have a major new plant, then you're not going to have the critical mass.

And you're going to say: Well, let's keep on building scrap-based plants. We're going to have a scrap shortage, not necessarily a total scrap shortage; but we're going to have a scrap shortage for the quality that is that's required for these scrap-based producers to go into the higher value-added markets.

So, we can't continually build scrap-based plants because there's something called "the conversation of mass." There's not enough iron units out there to do that. So we're going to need virgin iron units being made either in a blast furnace or COREX or some new technology. And that's going to require a lot of capital.

COMMISSIONER STAREK: Just one last question. If there is strong evidence that there's an international cartel operating that is excluding the U.S. companies, why don't our companies sue?

MR. FRUEHAN: I think we have an expert on the panel who knows a lot more than I do about this, and I'll leave any comments to him if that's okay.

I'm a lot of things. A lawyer, I am not.

MS. DeSANTI: I want to go back to the R&D issue and just clarify for a little bit more about where I think the antitrust intersection is.

Under the recent amendments to the National Cooperative Research and Production Act, it's clear that companies could form a joint venture, file a notification that would give them single damages rather than treble damages for any suit that was brought. But the antitrust leniency has not extended into the joint selling of the product, which is part of what I'm asking about with regard to sales.

What are other factors other than antitrust, however, that may be impediments to these types of joint ventures forming?

What sorts of business factors may be operating to deter companies from forming these joint ventures?

MR. FRUEHAN: My experience has been -- and I'm talking about front-end developments only -- is that companies make independent decisions on where they are going to go.

Let me give you one example. Bethlehem Steel made an independent decision to upgrade all of its cokemaking facilities and spend several hundred millions of dollars. Their enthusiasm for a coal-based direct steelmaking process became less intense. Whereas, maybe some of the other companies had an interest in such development.

So decisions are made by individual companies that may affect whether they want to see these kind of joint developments going forward. It may, in fact, negatively impact their competitiveness in the short run.

MS. DeSANTI: I see. So they can have different short-run incentives that would conflict with what may be an overall long-run incentive for the industry.

MR. FRUEHAN: That is correct. And it comes back to, you know, do we have a national economic program, et cetera, et cetera, for the long-term. But we have individual companies making individual decisions that are the best for them at that time.

MS. DeSANTI: I would also like to follow up, we have been hearing some in other industries about collaboration with customers that's ongoing that's facilitating R&D.

Is any of that occurring in the steel industry?

MR. FRUEHAN: Yes, there's quite a bit of that going on in the steel industry. I think the best examples of this are the cooperative agreements with the automotive manufactures and things of that sort. We're looking and trying to develop lower-weight materials for the automotive market, more corrosive-resistant materials.

I think those could be improved, but they have certainly gone a long way in the steel industry to get more involved with the customer. And I don't know if you would say it was necessarily big, joint R&D developments; but certainly there is a lot more cooperation in defining goals and what has to be done.

MS. DeSANTI: But, again, that's not the type of collaboration that would get us to the new technology; is that correct?

MR. FRUEHAN: No. My major concern is the front-end of steelmaking. Before you get down to the competitive product, where if you want to build a new blast furnace, we are talking a half billion dollars if we are going to build a state of the art blast furnace. And this is where the problem is. Or if we're going to develop this new direct ironmaking process or a scrap substitute process.

MS. DeSANTI: Just to change the subject a little, to what extent is geographic location near the customers important in sales of steel?

MR. FRUEHAN: In some markets, it's quite important and others it's not. I personally believe geographic concern is not necessarily as important as some people think. I mean you can't be out in Utah and produce something for somebody in Maine; but you don't have to be right next door either.

I think in locating plants more important concerns are what kind of labor laws there are, what's the scrap supply, what is the general transportation system. Because to produce a ton of steel, you have to transport into your plant over two and a half tons of material; and you only send out one ton of material. So in some senses, if you are thinking about transportation it's more important to be closer to the source of the raw materials.

MS. DeSANTI: And my final question is: Could you expand a little bit on the difference between how the U.S. steel industry went through its adjustment when its competitive position was declining versus how that occurred in Europe, what you think the costs and benefits were of the two different processes?

MR. FRUEHAN: Yeah, I would be glad to.

By the way, that was a major part of our Sloan Study; and we have several working papers on that. So if want to fax me or something, I will see that you get those.

But we made several trips to Europe and, more recently, to Japan. It was done in the United States much faster, and it was a much more painful readjustment. But in the long-term, it was probably more efficient.

In Europe, they are still haggling over the shutting down of plants and redistributing production. And they actually just recently gave up; they swept it under the rug because they could afford to do that because we are in a steel boom right now and there isn't this great need to shut down capacity.

But once the steel industry goes through one of its valleys again, that's going to be a major issue in Europe, this capacity reduction.

But they have been trying to do it by planning, and government subsidies have always kept inefficient plants running in Europe. Whereas, in the U.S., the only thing that has kept some of them is bankruptcy laws. But in the U.S., it was much more painful, much more sudden, and probably more efficient.

CHAIRMAN PITOFSKY: Thank you.

We move now from steel to an entirely different segment of the economy and that's financial services.

Dr. Anthony Santomero is the Richard K. Mellon Professor of Finance and Director of the Wharton Financial Institution Center at The Wharton School at the University of Pennsylvania.

He is a leading author on financial institution risk management and banking structure and a recognized consultant to major banks and regulatory agencies in the U.S., Europe, and the Far East.

As a leading consultant, he has advised the Federal Reserve Board of Governors, the FDIC, and the General Accounting Office on a wide range of issues relating to capital regulation and structural reform.

Dr. Santomero.

MR. SANTOMERO: Well, it is a pleasure being here. And it is a different industry, and it will be a different presentation as well.

What I will try to do is talk a little bit about what's going on in the financial sector that is driving the change in the banking industry; talk a little bit about what we've been investigating in connection with those changes; and then try to step back a little bit and sort of say, all right, what are the lessons as they relate to the FTC's interests that we are coming up with, rather indirectly, I may add. Only because of our Center's focus being more on the microeconomic issues of managing the individual institutions.

The first thing I would point out is that the banking industry is going through a dramatic change, as we see if we just pick up the newspaper yesterday and saw the most recent contested merger offer.

When we look at things like that, the first things we tend to do, as academicians, is sit back and sort of say, let's try to understand what this industry does for a living and figure out how its industrial structure follows from its drivers, namely the features of the industry that are essential.

From our, perspective come down to saying that the banking industry basically does only three things for the economy. They are three rather important things, but they come down to basically three things.

The first is it provides the necessary financial resources for real sector investment in the economy. And in that regard, it has many competitors in the direct capital market and other substitute industries.

Secondly, it provides savers a vehicle for investment that is increasingly important as the baby boomers get older and as savings through this vehicle seem to be declining in fact.

And, third, the industry basically deals with the risk between these two players. I'm trying to build a very large steel plant at the time when I want a demand deposit that I can write a check on tomorrow morning is somewhat problematic, and the firm is left in the middle of dealing with savers on one hand that want liquidity and low risk and investment opportunities that are higher risk and, indeed, much longer term.

From that perspective, the banking industry has its roots and, if you will, makes loans and takes deposits. Over the last 30 years -- and it's about that long -- the industry, however, has been undergoing substantial change. The best way to summarize the change is a decline in market share, and one can question whether or not that has been a decline in the industry itself or a decline in the industry's position vis-a-vis the overall financial community.

We provide you, in the handout that I provided for these hearings, a series of tables that illustrates the decline in its position.

Starting off first with Table 1, which is a banking share in the total financial sector, funding from 1952 to about 1994, and using the Flow of Funds data of the Board of Governors, you'll notice that the market share of the banking industry has declined from roughly 50 percent to roughly 25 over that period of consideration.

Now, most of us recognize that and have little pieces of what's going on and think about, for example, as a phenomenon associated with money market funds, taking deposits out of the banking industry.

The adjoining tables argue, however, that it's much more broad based than that. Indeed, if you look at the lending activity of the industry, you will notice the commercial and industrial loans have been declining over that same period of time while finance company loans have been expanding rather dramatically, and commercial paper has continued to be important.

On the commercial side, you can make the case that primary borrowers are, in fact, not using the banks to any appreciable extent these days, going directly to the market, rather than through the banking industry.

On the other side of their balance sheet, looking at their deposit base, Table 3 illustrates that bank time and savings deposits have been declining rather consistently over the same period of time relative to fixed income mutual funds.

And, indeed, if you move to Table 5, their transaction balances have dropped rather dramatically relative to money market mutual funds, something that at least I know from personal experience and I'm sure some of you do as well.

Now, you might step back and say: What's driving the changes in this industry? One answer, in some sense the superficial one, is, well, competitors have taken market share. But let's try to figure out what's driving the volatility in the industry itself.

And if you look over this period of time, we kind of center on four things that are driving the changes in the industry.

The first is that the economic environment that the industry experienced over the last half century has been an economic environment that has not been very congenial for a banking industry that's supposed to make long-term loans with regulated prices on their liability side.

We have had unstable financial environments; we've had global competition; we've had an expansion of inflation into double digits and then down to low levels.

As a result of that, the industry's original charts and original design didn't fit very well with the macroeconomic environment in which we were operating our financial community and, indeed, the industrial community as well.

Second, there has been competitive pressure on this industry. But the competitive pressure on the industry has come in different ways.

We usually think of competition, or at least I usually think of competition from the point of view of new entrants in the marketplace; and, clearly, there has been new entry into this place, both in terms of non-banks into banking-type products and in foreign banks into the American banking market in various ways.

But, in addition, we have had competition because customers are getting smarter; therefore, isolated markets have been disappearing to a greater extent than, perhaps, people, years ago, thought it would.

And in addition, financial innovation has changed the very nature of the products and the ability to compete. The example I like thinking of in that regard is the mortgage market, a mortgage which, when I grew up, was something a bank gave and held because they had no choice suddenly gets put together in computer technology and sold off in 47 different ways to 25 different players.

The third area that's important to understand the changes in this market is the technological change that has taken place.

Telecommunications and computer technology have had an enormous affect on this industry. In many respects you can argue that actually the industry is being dragged into this revolution as opposed to leading it.

And what has happened, first of all, is technology has changed the cost of remote access to the customer and has changed the nature of the market itself.

Second, computer technology has made products possible that were not possible before. For example, again the mortgage example, we could not have diced and chopped up mortgages the way we did if we were doing it by hand.

I guess it was about in 1970, the Federal Reserve Bank of Atlanta actually did a study in which they suggested that every white collar working in the United States would be clearing checks if the technology didn't change. And while the technology did change, now we are dicing and chopping and passing all over the place.

Finally, our whole notion of regulation has changed, and that's caused changes in the industry. Regulation used to be, when I was a graduate student, centered around the issue of competition on one hand, safety and soundness on the other; and that was usually a prescription for, more or less, status quo definitions of markets and products.

Over time, however, there has been an urge towards more efficiency; there has been an urge towards satisfying the saver rather than protecting the bank from a competitive market for its deposit base.

The net result is there has been a willingness to consider changes in markets, everything from geography to product definition, that has caused the industry to change.

As a result of that, the industry is functioning in an environment in the 1990's and in the year 2000 that's going to be quite different than the industry -- that I remember when I grew up in the banking area.

We concentrate on it by saying that what that means is, the impact of all these changes is the industry has to be much more attuned to, number one, managing its profit. It could no longer depend upon the regulatory notion of a fair rate of return in its environment; and, therefore, has to think about profit drivers and competitive positions and products that make money and products that lose money.

And, secondly, it has to manage its risk much more carefully. It has to manage its risk much more carefully, first of all, because the world is a more dangerous place; and, second of all, the cushions in that world are, by the nature of this competition change, a lot softer. And as a result, we have to worry about it.

In that context, the financial service industry study that has been conducted under the Sloan grant has tried to examine what's going on in the industry from the point of view of the main drivers of these two things; namely, profitability analysis and risk analysis.

We have done so by having four major research projects. And what we tend to do is we build a research project around a team of faculty that spend about a year or two sounding out whether or not this is something that's important, not only can we do it or do we want to do it, but rather, is it a main driver of the performance of the industry; and then, after a while, figuring out whether we can do it and then rolling it out.

In that process, we have rolled out four major projects in the study. The first one I have listed in my discussion is risk management, which I myself am responsible for most directly; but it was, in fact, the second major project we embarked.

The first one was on the study of productivity and efficiency in the industry, worrying about the managing of profit, if you will.

The way we thought about it was the use of capital and labor in the industry and what was driving its change and how effective was the industry in analyzing it.

The second piece, which is the first project in your list, is the risk management area. And there, we decided that the second major problem with the industry was managing risk. How do you manage risk for an organization that is as complex as the banking industry firms that we're talking about here?

Managing risk is pretty easy if you're managing the risk of a particular instrument or a particular trade. Or at least finance knows how to approach that problem and, to a first approximation, can do it well. It doesn't mean they do do it well. It means they can do it well.

The big challenge for the industry is: How do you manage a very large organization of 100 or $200 billion portfolio? And how do you capture what, indeed, you have in your portfolio and what the risks are distributed throughout the organization?

So risk management became a second major focus of the industry study.

The third area we are ramping up on are competitive structures of markets: What's the right structure for a financial service industry? What's the right structure in terms of product array for the banking industry? Is the German style of universal banking better or less good? Is the Japanese, the keiretsu structure, better or less good? Interestingly enough, when we started this project, you would have had one answer on that second question. Right now, there's quite a different answer. And trying to analyze what's really going on with these structures is why universities exist, I guess.

The fourth project, which we are just starting to roll out, is a study of the mutual fund industry, as an industry. Most of the time, when we study mutual funds, we study performance and rank performance. And there's an endless series of performance analyses and rankings out there. But what we were going to be starting on is a study of the industry itself as a member of the financial service community so we understand what's really going on behind the mutual funds and the money market mutual fund competitors.

Now, what are we getting so far by way of results?

Well, if I can turn to page 5 of my remarks, I'll spend a little bit of time -- and only that -- on some of the results we're getting in terms of risk management.

The way we think about risk management for the financial service sector is that the financial service sector is, indeed, in the middle of the financial flows of the economy.

The environment that I just described before is effectively changing the environment in which the institution is functioning. That results in a series of financial risks that the firm has to deal with and manage. And we have captured that in the diagram as the usual definitions of market risk, credit risk, counterparty risk, operational risk, a whole series of other risks like legal, regulatory, environmental risks.

And what we have been doing is spending our time on the question of, okay, given the flow of a financial transaction -- and for the major firms, you have to keep in mind a firm of $100 billion in asset size is not uncommon in the first tier, that means their capital will flow through the bank at about $100 billion a day. So the total balance sheet and the flows have to be kept in sync. It's not like most other organizations where a balance sheet isn't really the flow through.

In that kind of environment, what we have been investigating is, all right, with this kind of flow through, how do you manage your risks? What risks should be managed? What kind of organizational structures are best suitable to handling these risks?

And, interestingly enough, what you see is the industry is evolving to answer these questions. One way of describing some of the financial innovations that have taken place in the financial sector is that these financial innovations are ways of transferring risk rather than taking risk.

The simplest example I can offer you in the financial service industry is the pension fund area, where years ago a pension fund was guaranteed by the pension fund provider, and now we have the difference between defined benefit and defined payment plans.

What's happening is risk is being shifted. And that is happening throughout the financial sector. And what we have been investigating is: Should risk be absorbed by the industry? When should it be transferred? If it is being absorbed by the industry, what are the best systems set up to deal with these risks?

Now, there has been a lot of discussion recently about disasters in the risk-taking industry, most recently things like Barings and Daiwa. But the truth of the matter is, those aren't the kinds of things that trouble the industry most. Those are control problems. Those are control problems associated with the inability of the system to function and keep tabs on who is taking the risks.

The more complicated problems of the industry to get its hand around is: How do you measure the risks that are present in the industry? How do you know what your risk is?

Because, indeed, if you look at the business cycle exposure in terms of exposures to risk, over the last 20 years enormous volumes of losses have taken place on credit risks. How do you measure credit risk? How do you measure the quality of the portfolio? How do you measure your loss expectations in the portfolio? That's a major concern.

Interest rate risk: How do you measure it in your total position? And how do you deal with it?

So our study in risk management is centering on managerial needs to understand the risk in an environment that is changing.

The second area that I want to spend a little time on and talk about our results is in the are of market performance productivity and efficiency.

I mentioned to you when we started the projects, what we generally did is we got together with the industry and said: Look, is this an important issue?

And one of the things we did very early in the project was we concentrated on the question of process in the industry; and we sent out a team to six different banks that were relatively homogeneous -- and by that I mean, about the same size, about the same geographic franchise -- and we asked them very simple questions like: How do you open up a checking account? The answer was, anywhere from 6 to 45 different computer screens and anywhere from 10 to 50 minutes. We figured, well, there is a lot of heterogeneity here. This is probably something we should worry about.

We, therefore, spent a good deal of time trying to map the process and to analyze the differences in process. The second area we spent a good deal of time on is the use of technology.

Number one, how do you decide to make a technological investment? And, number two, how are you using the technology capability that is presently on the table?

Our results there have been quite substantial. Indeed, our total sample in terms of a very large survey of process and expenditures is 70 percent of the entire retail deposit base of the United States. That's our sample. Needless to say, we have got a lot of data pointing.

What we are finding is that there is, indeed, a large amount of heterogeneity in terms of process in the industry. That's number one.

Number two, technology is a major feature. Technological expense is a major feature of the industry; yet, the use of technology is pretty primitive at this point. And what I mean by that is, number one, the decision to invest in technology is usually not grounded in the kind of rigor that one would expect or hope. It is usually in terms of a strategic advantage. And you say: Well, what does that mean? Well, we have to do it. Well, have you looked at the numbers as to whether or not it's advisable to do it? And the answer is: Well, yeah, we cooked up the numbers, so it's advisable to do it.

Number two, technological functionality is far greater than the actual use. That is to say, if we actually spent no money on technology over the next, I would say, three years and actually taught people how to use the function that they have, we could dramatically increase the technology of the industry.

Number three, we looked at how we are using people. And here again is a wide array of results. And we tried to correlate the results to actual outcomes. And what we seem to be finding -- and this is a tentative result -- is that there are basically two models that are relatively efficient in this industry: One model of no empowerment, which might be described as a mass production model; and the second one of tailored products. This is, after all, a service industry where the service providers and the service users are intertwined in a very special way.

And as a result, to the extent that you can provide personalized tailored services and charge for those services, that's an effective product array.

But what we find is anything in the middle doesn't work. You can't give people a little power or even quite a lot of power. You either have to allow them to control the process, or you have to take away all freedom of control, because the two extremes are the only ones that are efficient; and the industry is slowly evolving along those lines.

Human resource practices are an issue in the industry for a number of reasons. The first of which is the example I just gave you: How you use them for effective production. The second is that employment levels are quite high in the industry, and employment levels are declining in the industry because of an over-banking phenomenon which is taken as given.

Now, with this set of results, what can we say? Or to put it more broadly, if we look at this in the context of all of the work we have been doing in the financial sector, what does it have to say about the nature of the financial sector that is relevant to the way the FTC thinks about questions of the market?

I offer you a few observations. The first is, one of the things that we have found to be clear is that the banking industry doesn't exist. There is something called the financial service industry. And that the differences across the banking industry are probably larger than the differences across competitors in any particular product array.

In that regard, we want to think about the state of the industry from the point of the state of the financial sector rather than the state of any particular set of banks.

Who are the players? Well, the players change according to what product you're talking about, what geography you're talking about, and what level of product. There is an international banking market. There is a national banking market. There is a local banking market. There is a market for credit cards. There's a market for C&I loans. The net result is competitors vary.

And when you start talking about individuals and you sort of say, who is your competitor to, let us say, the bank, the usual answer is, for what? And where? And the answers, therefore, change in a kind of overlapping of markets and competitors. And that's an important thing to keep aware of.

A number of years ago, I served as a visiting scholar to the Federal Reserve. At that time, we used to spend a lot of our time defining markets by hills and valleys and rivers and mountains for Pennsylvania in the third district. There are no hills and valleys in the telecommunications system. There are no hills and valleys in the mailbox. And for many products, that's really what the competitive environment is.

We end by saying: There are really no simple answers to this. And part of the reason is the market is still in transition; the industry is still in transition, as evidenced by the continued consolidation not only in the banking market but also starting to occur in the mutual fund market and has occurred in the investment banking market. This is an industry that is very much in transition.

And the net result is, players change, market shares changes, rather dramatically; and as long as you don't depend upon lifetime employment, it's a fairly dynamic place to work.

Thank you.

(Pause.)

CHAIRMAN PITOFSKY: Thank you.

I wonder if you would say a little more about the international market. Which are the products that, today or in the next five years or ten years, are likely to be described as in international market?

If someone wants to borrow a billion dollars to build a new steel mill, is that an international market transaction today?

MR. SANTOMERO: Yes.

I guess the way I think about it is, in fact, this notion of clusters of transactions in a three-tiered market, the first tier being kind of the international capital market. And in that international capital market, you have the whole set of players internationally in both bonds and direct lending and syndication.

The second, the national marketplace -- and rather obviously, you know, some firms will be in both or move from one to the next. But there is a national credits market, for example. The number of transactions are uniquely national just because of the laws that regulate those transactions and the need for physical identification, like clearing systems.

And the third, local markets. And local markets themselves used to be, quite literally, towns but are, increasingly, regions these days with competition within a region being the dominant kind of competition rather then the very local market area.

CHAIRMAN PITOFSKY: Thank you.

One other question. And it's sort of a soft question, but it's one that we hear a lot. It has to do with this waive of mergers among very large banks.

And the issue is this: What are the efficiencies that are driving this waive of mergers?

As has been alleged at times, is the only efficiency sort of laying off people?

When you get two big banks coming together, I mean, are there new products? Are there better products? Or is it just a question of just reducing the labor force?

MR. SANTOMERO: I think this is an enormously important issue, not only for you as a Commission but in general for the market.

Let me try to put together a few pieces in answering that.

The first piece is: What do we know about efficiencies of delivery in the banking marketplace?

There are the following pieces of data -- and these data seem to be worldwide phenomenon, not just American -- economies of scale and scope beyond a very small size don't seem to be very important.

Variations of efficiency, independent of size, seem to be much greater than any economies merely by size.

And no matter where you run that test, that seems to be true. So one way of describing the efficiencies that are alleged to take place associated with merger activities is a more efficient provider of services taking over a less efficient provider of services, not just economies of scale in the delivery of service.

So that's the first thing. And I think the unfortunate part about it, it's kind of like a poker game where everyone thinks they're the winning, most efficient firm; except there are some very clear incidents of wide variation of efficiency for the same size.

The second point I would like to make, which is a different point, has to do with the merger waive itself. And then I'll try to put them all together.

The merger waive, to my mind -- there are two things to keep in mind. One of the things that is happening in this most recent merger waive is that the presumption of over-banked American market is being addressed. Mergers are an exit strategy for many CEO's and many banks.

Second, there are two kinds of mergers that are taking place that are changing the shape of the market place. One is an in-market merger that works directly at the local competitive marketplace and reduces the capacity there. And symptomatic of that would be the Chemical/Chase merger, for example. And you can say the Welds/First Interstate proposal. All right?

The second is an expansion of geography associated with building a large regional network. And by "regions," we're now talking about very large regions. An example there would be First Union and First Fidelity being an obviously, most recent example.

Now, those are totally different animals in terms of why it's being done and how it's being done. They have lots in common. You've got the need to integrate and to bring systems up to speed and to have the organization function as one organization, which frequently takes place in two phases. First of all, everybody merges as equals until one is less equal than the other. So you kind of go through this putting together the organization and then integrating the organization at a later phase.

Now, in the in-market mergers, it's quite clear that the goal of these in-market mergers is to reduce the number of outlets and, therefore, employment and branches, because there are enormous inefficiencies in the present system.

In most of the markets where that has taken place up to this point, it has been markets that are highly contested markets, highly competitive markets; so the fact that there are only three corners of a main intersection with banks rather than four doesn't really bother us very much.

Now, could you follow that to a point where you did worry? Presumably, yes. But that's not what's been happening at this point.

Now, how do you bring new products as a result of this new merger?

Well, there's some capability when you start talking about creating a massive presence. For example, a First Union a First Fidelity where you expand your geographic flow and you build up some expertise which is unique to one organization and bring it to the second organization, you can tell a story that says we have broadened out the product line.

But, indeed, most of the product line broadening doesn't take place through mergers. It takes place either by growing or acquiring other capabilities. The most immediate example that we have seen over the last several years has been the expansion of investment product availability to bank customers through the -- either creation or the purchase of mutual fund capability by the banking industry. And the contested market at the moment happens to be insurance and annuities.

But that's not directly from the mergers but rather from bringing new products through this marketplace. The rationale there is the bankers view themselves as having an array of customers in a geographic franchise; and, therefore, wish to push more products into the set so that their customers don't have to deal with multiple vendors for their financial services.

That's the way we would say it. They'd say they could cross-sell their product array to their existing customers groups.

And, of course, not everybody can do that, because if I had a broker, a savings bank, a commercial bank, and a mutual fund and if they were all trying to sell me all the products, somebody is going to lose in that process. All right? And probably not one of these will get all of the product array, but there's going to be less activity in that regard.

CHAIRMAN PITOFSKY: Very helpful.

Christine?

COMMISSIONER VARNEY: If you had to vote today between German, Japanese, and U.S. styles of competitive markets -- if you did have to vote today -- it sounded as if you were evolving in your evaluation of which of these may be best -- from your competitive perspective of managing risk and improving profit, which one would you go with?

And are our businesses moving more towards German-like styles?

MR. SANTOMERO: Let me just make a couple of comments before I vote.

The nature of these financial sectors are subtly more different than at first appear. Originally, when you start thinking about this question, you think about the German universal bank model as a model where banks are allowed to do a wide array of things, as are investment banks are allowed to do a wide array of things. So it's a levelling of the playing field -- in the terminology that you no doubt have heard quite a lot about -- in terms of product array.

In that regard, I think there is a general consensus of the studies and also in our group that expanding the product array makes sense for the reasons we have been talking about.

There's another set of things that we have been investigating more recently which has to do with the whole nature of corporate governance associated with a German-style universal model. Who controls what as opposed to what products are being offered by whom. And that's a more complicated question, and that's the one we're still in the midst of, first of all, trying to understand.

So that second one, I don't want to vote on.

The first one, however, it seems to be the case that we have concluded -- something that I myself had written about a number of years ago, and maybe that's why we concluded it, I don't know -- and that is that the arbitrary divisions that may have once made sense of geography and product and maturity no longer make sense as a way of thinking about the financial service product array.

CHAIRMAN PITOFSKY: Very good.

Let's take a very brief break. We will resume at five to 11:00.

(Whereupon, a recess was taken from 10:47 a.m. to 11:00 a.m.)

CHAIRMAN PITOFSKY: We ought to resume.

Our third speaker this morning is Terrence Faulkner, Director of Strategic Planning and Vice President of Eastman Kodak.

Previously he was Director of Technology Planning and Imaging and was Assistant to the Director of Research.

Before that, his positions included Laboratory Head of Technical Intelligence and Assistant to the Director of the Photographic Technology Division.

Mr. Faulkner.

MR. FAULKNER: Thank you.

For 150 years, the photography industry has been based on the manufacture of sensitized silver halide materials. That technological basis now in the process of changing, and I will address some of the implications of that technology substitution later in my remarks.

But for clarity, we should first focus on the silver halide manufacturers. The photographic products that they manufacture include the familiar color negative film used by consumers, the colored papers that are used prints, x-ray films, motion picture films, graphics arts films, and a range of other related products. The current set of silver halide manufacturers includes: Kodak, Fuji, Agfa, Konica, DuPont, 3M, Polaroid, International Paper in the form of its subsidiaries Ilford and Anitec, and Mitsubishi.

The first four companies that I listed account for over 80 percent of industry revenues worldwide. And all nine, account for well over 95 percent. Every major participant in this industry must compete on a worldwide basis in order to succeed. And all nine of the companies that I listed do sell their products in the United States.

Global competition has intensified as the rate of growth, and the silver halide business has begun to slow. And it's not surprising that when Eastman Kodak sought to vacate consent decrees originally entered in 1921 and 1954, both the District Court and the Court of Appeals found that the relevant geographic market for amateur color film did include the United States, Western Europe, and Japan.

Now, looking at the technology aspect to this, Kodak invested $860 million in 1994 in research and development, or about 6.3 percent of revenues. And we will spend even more on R&D in 1995. We have consistently ranked in the top 10 companies in the United States in terms of the number of patents awarded.

Our competitors also invest heavily in R&D. Fuji, for example, has been in the list of the top 10 companies receiving U.S. patents for six of the last seven years.

There is a continuing strong competition to achieve the highest levels of product performance. But silver halide technology is now more than 150 years old, and product performance improvements are increasingly expensive to obtain.

Yet, the innovation that we have can, generally, be characterized as incremental in character. One consequence of this increasingly expensive R&D is that the new advanced photographic system, or APS, that will be introduced next year was jointly developed by five companies. Kodak and Fuji were joined by three camera manufacturers. Another reason for that cooperation was the need to have a worldwide standard for the new format.

Even with the sharing of development costs, all of the manufacturers of APS products will need to compete on a global basis in order to achieve a reasonable return on their substantial investments. In past decades, Kodak could drive a new standard by itself; but that is no longer possible.

Silver halide-based photography has already been replaced by electronic imaging in some applications. Electronic news gathering replaced 16 millimeter film in the television market. Later, video cameras and magnetic tape replaced the Super 8 movie cameras and film used for home movies in the consumer market. This technology substitution will continue on an application-by-application basis.

Now it's important to understand that there is not always a sharp boundary between silver halide and digital imaging. Hybrid products, such as Kodak's Photo CD, do exist. And a Photo CD contains digitized images scanned from traditional silver halide film, and this provides a bridge between silver halide and digital imaging.

But I should also note that several of the silver halide manufacturers have developed digital imaging products. Besides Kodak, these include Fuji, Agfa, and Konica.

Like all technology substitutions, this substitution of digital technology for silver halide enables new entrants. Consumer electronic companies, such as Sony, Matshushita, and Sharp, face very low entry barriers. And the same is true, to a lesser degree, of companies in the computer industry such as Apple and Microsoft.

The new digital video motion cameras that have been introduced by Sony, JVC, and Matshushita over the last two months do all contain a still picture function. A very small extension of their electronic products line enables them to offer consumers a color print that's much like the ones obtained from a traditional silver halide camera.

In digital imaging, information and images are much the same thing. Digital technology is enabling the convergence of imaging information and communications. In the vernacular of our times, "bits are bits."

This is dissolving old industry boundaries, and we must now accept the existence of an emerging imaging industry that is much larger than that defined by the nine silver halide manufacturers I mentioned earlier.

Kodak, I believe, is better positioned than any other U.S. company to become a leader in digital imaging. We have invested more than $3 billion in electronical imaging R&D over the last 15 years. But there is no guarantee that we will succeed. Large additional investments in the development of products, channels, and markets will be required to build a successful, value-generating digital imaging business.

The Japanese consumer electronics companies, in particular, have a strong position that can easily be extended into digital imaging. If Kodak fails, then it is likely that the new digital imaging industry will be centered overseas.

Now, to fully appreciate the situation that Kodak and at other silver halide manufacturers face, we must also consider the industry consolidation that is now under way. There are several forces that are driving the consolidation in the silver halide industry, and I've already described the substitution of digital electronics technology for silver halide chemistry.

That limits growth within silver halide, and this, coupled with excess industry capacity, increases price-based competition. The more marginal manufacturers then begin to drop out.

Another force driving industry consolidation is increasing customer power. In the consumer market, a few major customers like WalMart account for an increasingly large percentage of all film sales. These large retailers demand the lowest possible price from the manufacturers, who are competing with one another for scarce shelf space.

And then they often use film as a loss leader to attract consumers into their stores. Smaller retailers then also press for these lower prices.

In the health care market, group purchasing organizations come together to negotiate multi-year contracts for large volumes of x-ray films. Product performance does matter, but price is increasingly the determining factor in who gets the contract. This can lead to a winner takes all outcome where the winners are the companies with the best technologies and the lowest manufacturing cost.

And in silver halide manufacturing, cost is very much a function of scale. Increased scale is an important tool for reducing manufacturing costs, and these reductions are essential since, in some categories, sensitized goods prices are declining at rates in excess of 5 percent per year.

Industry consolidation is taking several forms among the silver halide manufacturers. Some small companies such as Orwo and Oriental, have declared bankruptcy. Some large companies are divesting entire divisions. For example, DuPont is in the process of divesting its Medical Imaging division or they are exiting product lines. Agfa has exited motion picture color negative film. DuPont has exited industrial x-ray film.

Now, as you consider changes to U.S. antitrust policy, the first point that I would make is that markets must be defined globally. That is certainty true in the photographic industry, and I believe that it is increasingly true in many other industries as well.

A second point is that market definition needs to be more forward looking. The rate at which technology is driving change does seem to continually increase. Technology substitution inevitably drives changes in industry boundaries. Kodak saw this emergence of electronic imaging coming more than 15 years ago and did begin to shift its R&D spending accordingly. Just as manufacturers do, government policymakers must also anticipate these kinds of changes when they define market boundaries.

In the case of the photographic industry, we must recognize not only an existing global silver halide industry but also an emerging imaging industry that includes both silver halide and digital electronics companies. And, again, I'm sure that similar trends are occurring in other industries.

The third point that I would make is that antitrust enforces need to be more receptive to allowing U.S. companies to actively participate in an industry consolidation in those cases where that process is occurring. U.S. companies must have the same freedom that foreign companies have to acquire a weak competitor, either in whole or in part; and that could be in the form of a product line, physical assets, other assets, such as intellectual properties or brands.

This is especially critical in industries where there are large fixed costs and manufacturing scale is necessary for survival.

Whatever the letter of Japanese antitrust regulation may be, I have no doubt that the Japanese Government will not stand in the way of a Japanese photographic company when it wants to acquire a competitor.

If a Japanese company can combine the advantage of manufacturing scale with the advantage of a protected home market, then the resultant lack of a level playing field will greatly disadvantage Kodak in the global market. And if Kodak's core silver halide business becomes significantly less profitable, then we will not have the sustained cash flows that we need to fund a successful transition to digital imaging.

This leads into a fourth point. Where foreign competition policy conflicts with U.S. policy in a way that hampers U.S. companies, the U.S. antitrust agencies need to be more active in pushing for open markets and enlightened competition policy.

Finally, I want to thank you for the opportunity to describe the current situation in the photographic industry and to suggest what some of the implications of that situation might be for the revision of antitrust policy.

(Pause.)

CHAIRMAN PITOFSKY: Thank you very much.

Let me ask you the recurring question of these hearings -- and put aside the two consent orders which are unusual and, of course, restrain Kodak in a special way -- are you aware of actual transactions, mergers, joint ventures, licenses, patent arrangements, that American antitrust law prevented Kodak from consummating and especially those where Fuji probably could have gone ahead and done the very same thing under their system?

MR. FAULKNER: Yeah. The current situation, Mr. Chairman, is one more of a dampening effect.

Let's take the case of DuPont which has announced that it wishes to divest its medical imaging division. Naturally, Kodak, obviously, looked at that. And one of the first things external counsel told us is that there was a 100 percent probability that this would be questioned and went on about all of the vast amount of paperwork that we were going to have to generate in order to proceed with that. That had a dampening effect.

Now, there are other factors, of course, that we considered as well. And at this point in time, there hasn't been an actual case where that has occurred, where the blockage has occurred.

My own view is that we are in the early accelerating phase of this industry consolidation, and I expect that there will be, over the next -- whether it's next year or the year after, but at some point in the foreseeable future, an occasion where it will be in Kodak's strategic interests to move forward and consider an acquisition.

And, therefore, what I'm worried about here more is anticipation of a problem than the past existence of a problem.

CHAIRMAN PITOFSKY: Other questions?

Debra.

MS. VALENTINE: You mentioned at one point that, although product attributes mattered, essentially competition -- I think this was in the context of an x-ray product of yours -- was really taking place on the basis of price.

And one of the things that we are hearing at times is that in technology-driven industries, in fact, people do care about product attributes.

Are you finding, generally, that with all of your products, no matter how simple or complicated they are, that at the end of the day, price is really what matters?

MR. FAULKNER: You would have to say it varies appreciably from one product category to another.

Price matters more in a product like color paper where, first of all, you're selling essentially to the trade; and the trade may very well regard color papers as being very similar in their product performance.

For a product like color neg film that is purchased directly by the consumer, performance does matter more. For some especially high-tech products within the medical imaging mammography film, performance will matter more. But, again, over on the graphics film side, there will be categories where price matters more.

So it will be really quite a range of situations across the product categories. But what has changed, what is different, as a function of time, is that price has become increasingly important. It may not, today, be the dominant factor for every category.

MS. VALENTINE: Thank you.

CHAIRMAN PITOFSKY: Susan?

MS. DeSANTI: I have a question. You've talked some about antitrust making market definition more forward looking; and it's certainly one of the issues that has confronted the Commission -- most recently, say, for example, in the Lilly-PCS transaction -- there is an industry that clearly is in transition, analogous to the way you're talking about silver halide going to digital imaging.

And one of the issues that's come up is the sort of process issue of: How would companies react if the Commission were to say: "All right. We are going to limit our reaction to this particular transaction but we're going to keep it under continuing scrutiny."

How would -- and I'd be interested in your views on your company's reaction to that. And, in addition, how would you react if there were a provision for a conditional approval that said: Well, the Commission would condition its approval of the transaction going forward depending on whether certain factors happen in the future, as it looks at the moment like will happen, but where none of us are completely certain actually will?

And that could be entry by others into the market or other kinds of factors.

MR. FAULKNER: I understand, I think, the theory of that. I'm not quite sure how it would work out in practice.

If you gave conditional approval, is your implication, then, that at some later point, several years later, you might ask for it to be broken apart?

MS. DeSANTI: Yes. And that's part of the distinction I'm making between continuing scrutiny which might be, okay, but then later on the Commission has to come in and show that, in fact, things have not worked out as was anticipated, versus conditional approval whereby, you know, "Okay. It didn't work out," we know that it's going to be broken up in some way.

MR. FAULKNER: Yeah. Well, obviously, a continued scrutiny would be preferable to having been blocked in the first place. But I think it would depend on the particular situation.

In some cases, irreversible change might have occurred. Some older manufacturing facilities might have been taken out of production so there -- I can foresee practical problems that might arise. But I have no problem with the theory that you describe. I would just be concerned about what are the practical difficulties that it would encounter.

MS. DeSANTI: Beyond the scrambling of assets or shutting down of assets, are there other practical problems you can imagine?

MR. FAULKNER: In some parts of the industry, of course, relationships are very important. For example, that's true in the motion picture industry, the sale of motion picture films.

Obviously, a change of control would probably permanently change the nature of those kinds of relationships. "Permanently" is probably too strong a word. But it would substantially change them.

CHAIRMAN PITOFSKY: Good. Thank you very much.

Our final speaker this morning is Thomas Howell, a partner at the law firm of Dewey Ballantine. His practice focuses on antitrust, trade regulation, and competition matters. And he represents several corporations in complex antitrust cases.

Currently, Mr. Howell represents Eastman Kodak concerning Japanese market barriers in the consumer photographic film and paper market. He is also counsel of six major U.S. producers of flat-rolled stool products and anti-dumping and countervailing duty actions against foreign producers and represents U.S. firms in disputes with Japan involving semiconductors, soda ash, and telecommunications.

It's a pleasure to welcome you here.

MR. HOWELL: Thank you, Mr. Chairman. I appreciate the opportunity to speak today.

I'm appearing on behalf of the Coalition for Open Trade, or COT, which is a group of U.S. manufacturers and labor unions, which was established to address the problems presented for U.S. competitiveness by private anti-competitive practices abroad.

You've asked us to address the question of when location matters for businesses; and I have attempted to frame the same question a little bit differently to ask: What are the implications for U.S. industries of the dramatic imbalances in the level of national antitrust enforcement in an environment in which competition is increasingly global?

To put it more simply, is a firm based in the United States at a competitive disadvantage internationally relative to a firm based in Europe or Japan simply because of differences in antitrust enforcement and policy?

I would submit to begin with that an imbalance in national antitrust regimes exists between the industrialized countries, and it's dramatic.

The U.S. stands at one pole with the most rigorous enforcement, and Japan is at the other pole. The EU, Canada, Scandinavia, and others fall somewhere in between.

A few statistics highlight just how far apart the poles are. Between 1982 and 1992, the United States handed down 879 criminal convictions for antitrust violations. In the same period, Japan recorded 2 for violations of the Anti-monopoly Law.

During the same period, there were over 8,000 civil antitrust actions brought in U.S. courts; and during the same period in Japan, there were 15. And, thus far, no action has ever succeeded.

Looking behind those figures, one finds patters of institutional behavior and underlying values that differ fundamentally among the industrialized countries.

Here, the Federal Trade Commission and the Antitrust Division have a relatively simple mandate to enforce the laws vigorously -- and they do -- against the anti-competitive business practices. They function, in effect, a lot like law enforcement agencies in other areas.

By contrast, in Japan and the EU and elsewhere antitrust agencies weight the needs of antitrust enforcement against an array of other policy concerns. In some cases, they actually use cartels and other anti-competitive groupings as proactive instruments of industrial policy. And there are many, many examples of this in the last 20 years in both Japan and the EU.

In many other cases -- and probably cases that are of more concern to our association -- anti-competitive groupings are I tacitly other even overtly tolerated by government authorities.

In Japan, enforcement has become so weak that trade associations publish information about horizontal and vertical price discussions in their newsletters among their members.

In one recent case -- I have set forth in my written submission -- an association executive even boasted in the press how he helped to fix prices and then sent the JFTC investigator scurrying away by browbeating them verbally.

The fact that one doesn't read stores like this in the Washington Post simply underscores the dramatic differences that exist between countries in this area, reflecting divergent national traditions that have evolved since the early years of this century out of the early period of industrialization.

Here, the big business "trusts" that grew up after the Civil war gave rise to a popular movement, the "Antitrust" movement that's eventually been enshrined in the antitrust laws in institutions like this one. It's become, as Franklin Roosevelt said, as American as the constitution itself, the antitrust laws. This movement built on earlier traditions of common law hostility toward monopolies that go way back in our history.

Elsewhere, traditions which were much different arose. In Imperial Germany, cartel agreements were enforceable in the courts, and an entire industrial culture grew up based on industrial solidarity and the mitigation of competition in its more extreme forms.

And that also has roots in Germany going back to the Middle Ages.

The body of German economic scholarship arose which held that cartels were a superior form of business organizations to the laissez-faire model favored by England and later carried over to the United States.

The German scholars concluded that cartels operating from behind closed markets ensured higher levels of investment and research and development than could occur in open and competitive markets. This view is disparaged, of course, universally by Anglo-American economists; but it reflects attitudes that are widely held abroad and are actually put in practice above.

The German ideas of industrial organization proved very compelling in Japan after visits by study teams to Germany, notably a 1931 visit by prime minister of Japan.

Japan adopted legislation in the '30s that made possible the creation of cartels on an industry-by-industry basis which greatly enhanced the size and power of the Zaibatsu, which were the forerunner of the Keiretsu that we now confront today. Many of Japan's contemporary industrial groups, including Fuji, trace their lineage to this period of early industrial consolidation.

These national cartels were rapidly projected into the international arena so that by the beginning of World War II, by one estimate, over two-thirds of all the goods that moved in international trade were regulated by these private groups, international cartels.

World War II interrupted this process. The United States ended up occupying both Japan and Germany.

We broke up the cartels in Zaibatsu in the late 40's. An anti-monopoly law was imposed on Japan. And a Fair Trade Commission, patterned on this Commission, was set up.

In Germany, cartels and Konzerne or the industrial groups were taken apart by the occupation authorities. We didn't impose, but strongly influenced, arm twisted the German Bundestag to enact anti-cartel legislation in the early '50s; and an anti-cartel agency, the Bundeskartellant, was established.

We advanced a proposal for an International Trade Organization designed to eliminate not only government barriers to trade but private restraints of trade.

It failed in the latter effort. The proposals were incorporated in the Havana Charter in the late '40s, but they were never adopted.

The Justice Department, in the late '40s, brought a series of consent decree actions against the international cartels essentially designed to force American companies out. The assumption was that if the Americans were the biggest companies in various industries -- which they were at that time -- the big cartels would fall apart; and they did when the Americans pulled out. And we saw a new era really of highly competitive behavior in the international markets.

Our antitrust ideas did not win universal acceptance but they gained many adherents in Europe and in Japan.

The influence of our doctrine has receded since the zenith in this period of the late '40s and early '50s. As the Cold War came on, we began to halt our drive against the Konzerne and the Zaibatsu. These groups in both countries began to reconstitute themselves, quietly at first but, ultimately, quite openly.

We saw a dramatic example of this last year when a paper group in Japan was broken up in the late '40s has been re-established in 1994 through a series of mergers and consolidations. And they're back where they were in the '40s before the occupation began.

Anti-cartel legislation was weakly enforced in both countries. And I would say in Germany as well as Japan this was the case. And they were undermined by amendments and bureaucratic hostility from ministries friendly to industry.

In Japan, the Fair Trade Commission generally ignored widespread anti-competitive activity -- and there are dramatic examples of this that have come to light in the Kodak case that has taken place -- across a broad spectrum of Japanese industries; and when, generally, when it's taken action, it's been very weak by our standards.

International cartels re-formed much more quietly then they did before the War, but they are back in business again.

Our own efforts to establish international institutions that would ensure a liberal trading order was successful in terms of government restraints on trade. We have seen a liberalization as a result of the GATT and successive rounds of multi-lateral trade negotiations that have brought government barriers down dramatically.

However, there was never a comparable organization governing restrictive private practices; and as a result, this area is totally unregulated by international discipline.

What's evolved since the War is an imbalance in competition policy. Competition rules you find everywhere. You find them in all the industrialized countries and they are very strictly enforced in one country. This one. It's very spotty elsewhere, which permits a good deal of anti-competitive activity to flourish, not always with impunity.

And there are cartels that are regularly broken up by the European authorities, in particular, DG-IV. But it is still spotty even in the European Union under an activist antitrust commissioner.

In general, the United States has shown less interest in delving into such matters in other countries. The Clinton administration has indicated it's going to devote more attention to restrictive practices abroad. But, in general, our emphasis has been much less.

In the rare cases when we do act, a hue and cry is raised of "U.S. unilateralism, attempts to impose our values on other countries. I am sure that you are aware that every time there's even a hint that U.S. antitrust laws will be enforced, extraterritorially there is a problem, an international problem, a diplomatic problem with other countries.

The result, a modus vivendi has evolved in which we don't meddle too much with these kinds of practices in other countries.

Now what does that mean for U.S. businesses? I would submit that it should be regarded as an unsatisfactory state of affairs. And there are several reasons for that.

First of all, restrictive practices abroad foreclose U.S. participation in foreign markets. That's a problem not only because we lose revenues from foregone exports but because a protected cartelized market serves as a form of subsidy, a profit sanctuary, if you will, which can be used to finance an aggressive R&D and sales strategy all over the world.

Also, in high-tech, a protected market contributes to learning economies. As accumulative volume of output increases, costs are reduced dramatically and can give a protected producer a cost advantage all over the world.

Closed markets and cartels foster dumping in world markets. We have seen examples of this in steel, televisions, semiconductors, consumer photographic paper, telecommunications equipment. In some cases we have seen dumping literally destroy an entire U.S. industry. The most dramatic case was televisions.

Over the long run, the imbalance in competition policy affects the location of industry itself. People don't want to invest in a free-fire zone where dumping is endemic. And one does not see investment taking place there.

Conversely, investments flow towards cartelized markets where economic rents and diminished market risk makes such investments attractive. That phenomenon was recognized by the German economists earlier in this century. We see this phenomenon in the steel industry where as you see there is difficulty in investing in R&D and new plants in this market. In part, a banker who is asked to fund an investment like that will say: Where is my return going to come from?

In some cases, during the recent past, I would say particularly the early '80s, the answer would have been: There will be no return and possible you will lose your original investment as well.

Whereas, in other countries, those kinds of risks were not present. And that was reflected ultimately in the rate of investment and ultimately in the location of industries. You find that the industries -- you find overcapacity in Japan and the EU and, essentially, not enough capacity here to supply our own domestic demands.

Now, a number of factors inhibit effective U.S. problems posed by the imbalance in antitrust enforcement between national markets.

I've identified several here. First, what I call an information problem. We don't know enough about what's going on abroad any more. The burden has fallen on the private sector to do this. We do it sporadically, and the information is very spotty and I guess what an economist would call anecdotal. Our resources are limited. We don't have subpoena power and other resources available to the government.

That leads to a second problem, because there's not enough information, which is a thinking problem. We have, basically, a very theoretical approach to a lot of these issues. It's a widely held view, for example, that has been expressed by an Assistant Attorney General for Antitrust that cartels are inefficient. If our foreign competitors want to form them, then we should go ahead and let them, because they're only hurting themselves.

That theory is a good theory; it's just not consistent with commercial reality. And, as a result, you can see commercial outcomes that reflect flawed thinking on the part of our policymakers.

Third, we have an institutional problem. We have a trade policy apparatus that concerns itself with objectionable foreign government actions that injury U.S. producers. It avoids injurious private conduct with the exception of the anti-dumping remedy.

We have an antitrust policy apparatus that concerns itself with private foreign actions which hurt U.S. consumers. It avoids situations where foreign governments are involved. And it doesn't, generally, concern itself with injury to U.S. producers. The exception there I think is the export foreclosure cases in which we have seen relatively few.

The kind of anti-competitive activity which concerns COT's members -- which is anti-competitive private foreign conduct that hurts U.S. producers -- falls in the cracks between these two institutional structures.

As a practical matter, what U.S. industries have got left to work with institutionally as a remedy is the anti-dumping law. The antitrust remedies have not worked well for U.S. industries who have tried to use them in the international arena. In fact, I'd go so far as to say they just don't work, period, in most cases. I would be very hesitant to propose to a general counsel of one of our clients an antitrust case in most cases as a remedy for the problems they're facing abroad. It's the equivalent of proposing a land war in Asia with the likelihood of similar outcome.

The anti-dumping laws are an important tool, but they're imperfect. Criticism, in fact, of the anti-dumping laws, I think, in part, reflects the fact they've been asked to do too much, to bridge too wide of an institutional gap. They are being used in a variety of situations where the imposition of anti-dumping duties simply is not enough to deal with a very complex international competitive problem.

I'd note that this agency, the Commission, has been known to intervene in anti-dumping actions to impose the imposition of anti-dumping duties which places it in the anomalous role of, in effect, the proponent of anti-competitive combinations abroad.

Now, this is little bit of a -- I'm still sore about this. In one episode about 10 years ago, the Japanese 64 KD ram producers were involved in an anti-dumping action -- this was 1986 -- and the Commission intervened at the International Trade Commission. And they submitted a study that showed that, essentially, the Japanese 64 KD ram industry was a highly competitive industry, that is they were a model of atomistic competition.

The economist who prepared that report did not speak Japanese, had never been to Japan and, as far as I was concerned, didn't know much about what was going on over there.

In fact, had this person read Sankei and Nihon Keizai Shimbun and the other Japanese mainline papers at the time, this person would have learned that those producers were in a production cartel, they were jointly restraining output with the purpose of maintaining higher stable prices. And this was all being reported publicly in Japan.

I cannot imagine what the Japanese must have thought hearing this expert testimony about how their industry was functioning.

That's just an example of the problems I've already mentioned.

The final problem is a growing tendency to prescribe multi-lateral legal rules as a way of resolving these problems. That's a good idea as long as there is a consensus on what the problems are.

I think here, there's a basic difficulty in that we want to discipline these practices. Our trading partners want to discipline us, that is our attempts to regulate or reach out at those practices. And we're coming at the problem from opposite directions. And I see very little hope of a reasonable system of new multi-lateral rules evolving over the near term.

The question, then, arises what the Commission can do under current law or reasonably foreseeable modifications of the law. Really, that's a difficult question. We haven't got the answers to that all together. I think it's commendable that you are making this effort now to sort of take a fresh look at this issue. And COT is going to think about it some more as well.

I will say that the Commission could begin to help address the information deficit. One of the best, I think, studies of this problem that's ever been done was done here in 1916. It was called "Report on Cooperation in America's Export Trade," and it was a comprehensive study drawn from all over the world that is still a classic; and it's an excellent piece of work; and it was an empirical study of the problem in the real world. The Commission can still do that. It's an investigatory agency, and I think it would be a great contribution.

There's maybe a role for expanded Commission activities in export foreclosure cases. That may involve modifications of existing laws.

And one could look, for example, at the anti-dumping law as a way of looking at the mechanisms that have been applied there to obtain information, which is one of the most difficult issues in these kinds of cases. There are ways to do this.

The Commission might consider some of the mechanisms that are used now by the Commerce Department in those kinds of cases.

There is always, I think, a benefit in considering the international context when evaluating a merger. Without getting into that in much depth, I think that in many cases, looking at the milieu in which a U.S. industry is operating internationally is important, considering a merger analysis. And I'm not sure that it's always done.

Finally, I think the idea of a broader dialogue is a good one among the various parts of the government. We had a discussion in the United States in the '30s during the New Deal about the problem of industrial organization.

It was not so much a discussion of the international or global competition as how should industries be organized and how strict should the anti-competitive rules be. We began at one pole in the early '30s with the National Recovery Act, where we essentially had industry cartels or codes of conduct that included price and output regulation.

We ended up at the end of the decade with reinforced Antitrust Division and stronger enforcement, which is ultimately where we have come out at the end of it.

I think the discussion was a very interesting discussion that we had. We had a lot of people coming from all parts of the country to debate this. And I think at the end of it, what emerged was a national consensus and a system that was so good that it's, as President Roosevelt said, become almost as American as the constitution.

I think a debate that embraces a number of agencies and a number of different constituencies on this issue, this issue of global antitrust policy, is a very good idea. And I commend you for taking what I believe to be the first step in this direction.

Thank you.

(Pause.)

CHAIRMAN PITOFSKY: Thank you for the broad review of these issues.

Let me raise this question. It is true that there is a dramatic imbalance between antitrust here and antitrust in other countries, and we are not about to abandon our anti-cartel policy no matter what the Japanese do.

And, of course, in many parts of the world, they are getting somewhat more active in enforcing their law against cartels.

But I gather what you're saying is that, maybe if we enforce our antitrust laws more vigorously when American producers are injured abroad that might be of some assistance.

We are pretty vigorous when American consumers are injured by foreign companies but not when American producers are.

Would you qualify that to say that, at least in the first round, we ought to choose instances where the practices that injure American producers abroad are illegal abroad?

Because there is this great imbalance; and our law is so different from their law, if we start enforcing our law without taking into account the imbalance, then, of course, we get accused of imperialism and that sort of thing.

MR. HOWELL: I think the answer is, yes.

For one thing, the laws are pretty good abroad. Most of the kind of conduct that COT members are concerned about is illegal.

The conduct that Kodak is complaining about is illegal in Japan. And you get away from this whole issue of imposing our values on someone else, all we're saying is -- you could even go so far as to take the way the law is interpreted in those countries, which Kodak has done, and said: All right. How does at the Fair Trade Commission -- how do they apply their own law to this kind of practice according to their only publications and so on? And encourage them to apply the law that way.

That is not an act of imperialism. That's simply saying: You ought to be doing what you say you're doing.

CHAIRMAN PITOFSKY: It's a positive comity notion that at least, first step, we ask them to enforce their law; and then if they don't, we consider what we ought to do.

MR. HOWELL: Yeah. Or if you believe that, in this case, the enforcement efforts would be futile because of the way the agency has conducted itself, then you have to go to the next step.

But I think, yes, you could take care of a lot of this problem simply by securing enforcement of existing law. A lot of this problem would go away.

CHAIRMAN PITOFSKY: Now, I wonder if you would say a little more about the information deficit, the extent to which transparency would be a collateral approach that could help open up markets and so forth?

Are there some examples of that that you have in mind?

MR. HOWELL: Well, in these activities, cartels don't thrive very well under publicity. Japan is an exception, I guess, because this stuff is reported in the papers and nobody seems to care.

You shed light on these activities, though, and they tend to -- people become angry. Customers that are paying higher prices then they think they should be. In fact, it happened in this country at the turn of the century when people began to see what the trusts were costing consumers, how the dumping was giving foreign consumers a better deal than Americans were getting. The result was outrage.

And you actually saw this in Japan last year when the high prices of photo finishing paper came to light as a result of a U.S. anti-dumping action. That became news in Japan, and people began to ask: Why are we paying these ridiculous prices?

So I think getting the information and then getting it out, without anything more, just nothing else, that will help to solve the problem. A few salutary enforcement actions, of course, help to dramatize it, put it in the public eye.

You will find that when the trusts were broken up here, the Antitrust Division didn't go after every industry. They went after a few of them; and they essentially set a public example of a few, and the rest, the culture changed. I think that could be done. There is a role for antitrust enforcement, as Roosevelt used the presidency as a pulpit. You hold up some examples and you say this is terrible; it's not good for anybody in other countries; and it ought to change.

CHAIRMAN PITOFSKY: Thank you.

Other questions?

MS. VALENTINE: Actually, on the "sunshine as disinfectant" theory, I think that Mike Scherer also has thought about this idea of publishing information about cartels. Now, he suggests it's more at a multi-lateral level, that all cartels register, provide information; if they don't, that one investigates.

Are you suggesting that any multi-lateral efforts are less likely to be successful than national ones? Or do you see any use for a multi-lateral approach to just getting information out about cartels?

And, obviously, that would go over time, I think, to reaching a consensus about whether --

MR. HOWELL: The kind of thing you are describing is exactly where the international effort could be useful, because it doesn't require a consensus or value judgments about various kinds of behavior.

We're not saying: Let's have international rules that ban rationalization groups or some other kind of activity that people in Sweden might think is reasonable.

All we're saying is we want you to register and tell us what you're doing. That's certainly a very appropriate role for the OECD or some other multi-lateral body to undertake.

COMMISSIONER STAREK: Do you think that the increased information sharing amongst national competition authorities will help alleviate some of the problems that you have articulated?

MR. HOWELL: I'll tell you some of my concerns.

One is, for example, when our information is given over by our side to Japan, there have been problems in the past with information leaking to expose sources, et cetera, so that the result is, there is an inhibition on our ability or willingness to share information with the U.S. Government. There's a concern that it will be shared, in turn, and then the sources will be breached.

There's also the concern about what we're getting back on the other side. For example, when all this stuff in Japan is occurring and reported in the paper about very blatant, what we would call "per se" violations of the antitrust laws, and yet nothing is reported to our Department of Justice pursuant to these agreements by the JFTC, the question is: What is the value of an agreement like that?

Now, can it be made to work? Sure.

Is it working now? I would question whether it is very well.

COMMISSIONER STAREK: Thank you.

CHAIRMAN PITOFSKY: Well, thank you, all, very much for an exceptionally interesting morning. And we will resume at 1:30 this afternoon.

(Whereupon, at 12:00 p.m., the hearing was recessed, to reconvene this same day at 1:30 p.m.)

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A F T E R N O O N S E S S I O N

1:30 p.m.

COMMISSIONER STEIGER: Okay. The Chairman is delivering remarks outside of the city. He will be here when he gets here.

It is my pleasant duty to thank you on his behalf, on behalf of my colleagues and the wonderful group putting the hearings together.

We know that we have an astonishing array of talent who has given us some time this afternoon. We are extremely grateful and trust we will make this as painless as possible for you. But there's never been anything painless for you guys at the federal level.

The topic is: "Market Definition, Market Power and Entry in Light of Global Competition."

Phil Nelson is a distinguished economist, Principal, Senior Vice President, and Senior Economist at Economists Incorporated.

He's doubly distinguished because he's an FTC alum. This gives him almost a deified status in the place. He served here as economic adviser to Commissioner Calvani, Assistant Director for Competition Analysis and Deputy Assistant Director for Economic Evidence.

His PhD is from Yale, as at least are two other degrees. And he is a member of the American Economic Association and a referee of prestigious journals too many to mention.

With that, we're most anxious to hear what you have to say. Would you start off for us.

MR. NELSON: Okay. I'm glad to be here.

When I was preparing my oral remarks -- there are some written remarks that are available, and I'll give a shortened version of it -- but when I was preparing the oral remarks, I was reminded of a story that a lot of economists know; and since a lot of you are attorneys in the audience, I thought I would share it with you.

The story involves a group consisting of a lawyer, a doctor, and engineer, and an economist debating what profession is God. And so the lawyer, as usual, starts it off and says: God must have been a great lawyer because who, but a great lawyer, could have written the 10 Commandments?

And then the doctor chimes in and says: No, no, no. Long before the 10 Commandments, God created Eve out of Adam's rib. Who, but a great doctor, could have done that?

The engineer jumps in and says: Nah, but long before that, God created the heavens and earth out of chaos. Who, but a great engineer, could have done that?

The economist speaks and says: And who do you think created the chaos?

COMMISSIONER STEIGER: Well done.

MR. NELSON: And so I started thinking about that in terms of this because there is a lot of debate and argument about: If you see some imports, you know, should you include foreign competitors in the market? And to what extent should you include them? And I was wondering whether there really was a lot of disagreement out there.

And the second contribution I thought I might make is to provide at least some overview of the economic analysis that is out there that might address that question.

And so the first thing I did was I sent out a survey to a large number of lawyers, actually 176 lawyers, who are active and practicing before the Federal Trade Commission, the Department of Justice. I got the names, both from an American Bar Association mailing list and then also, because they were clients of the firm and I knew they were active before the Agency.

And so I sent out the survey and basically asked them questions about what they thought the Agency was doing, how the Agency analyzed where they thought they had disagreements with the Agency.

And I got about 10 percent, a little less than 10 percent, of the lawyers I sent it to who responded. So that means I only have about 14 lawyers; although, the results have kept dribbling in, even as of today, I got an additional response.

But even though I only got 14 lawyers to respond so far, these lawyers were very active. They had over 220 filings before the FTC since the new FTC/DOJ merger guidelines were passed. And they actually had 112 cases that involved international firms. And in about 17 of those 112 cases, they say they were involved in some sort of disagreement with the staff attorney that was investigating the matter, vis-a-vis the definition of the geographic market in an international context.

And so given that and there was some diversity of the answers they gave, I thought it would be interesting to share the results of their findings.

And I guess to distill the results, at the back of my paper is actually a summary of the results; but some of the key findings were that, when there was a disagreement between these attorneys and the staff person investigating the matter, the disagreement was usually the FTC person thinking that the market might be narrow, such as a U.S. market, and the private attorney thinking that the market was broader.

And, in fact, there were no examples to the contrary. Although, I am aware of at least one case where it went the other way. They just didn't happen to hit the survey. There's a Pilkington flat glass case the FTC was involved in where the FTC said the market should include Asian imports, and I know that the parties arguing before the FTC wanted to narrow the market because those imports were relatively small.

The disagreements over the scope of the market were not simply factual. They also involved some debates over theory and how you should interpret the facts.

Interestingly enough, several attorneys thought that the presence of imports necessarily meant that additional foreign capacity should be put in the U.S. market. That was a minority of the sample. Most of the attorneys recognized that that would be true only sometimes and then elaborated on why they thought and in what conditions that would be.

But there were a few attorneys that followed the Landes and Posner perspective and thought that if there were imports, everything should come in.

Only one attorney believed that the absence of imports meant that you should exclude foreign competition. Most of the attorneys, again, thought that sometimes you should include it and sometimes you shouldn't include it.

Three attorneys thought that the Agency's approach to market definition was flawed. Most of them thought, you know, it's as good as you can do under the circumstances; and some people even gave it higher marks than that.

And then in the written comments that I got as opposed to sort of the multiple choice questions, a number of them recognized that there were really a lot of detailed market-specific factual evidence that had to be collected to really address this type of question.

And then, finally -- only one person really said this clearly; although, way behind some of the other people's comments, sort of reading between the lines -- which was, when they came into the Agency staffs, they felt they weren't always -- the staff attorneys weren't always putting their cards on the table so that they had difficulties answering some of my questions because they weren't always sure that they had a clear read on what the staff's position was; and they didn't feel that there was that sort of meeting of minds of an argument.

And the attorney that talked about it wasn't sure what one could do about it in a framework where you're looking forward, perhaps, to litigation. But on the other hand, he thought it would advance the ball greatly if both sides were a little bit more open and had a joining of the arguments early on.

That's a quick overview of what the survey results were. Now, turning to sort of the economic analysis that sort of might underlie the issue how to define a geographic market in an international context.

A lot of what I thought has been laid out in a journal article that I wrote with John Hilke, who is here today, and Professor George Hay of the Cornell Law School.

And basically that article points out that if you see imports, you can't be sure that additional imports will discipline the U.S. markets, that there are a lot of structural characteristics that you have to dig into. The simplest way to think about it is simply with a quota out there, you might have the imports at the binding quota but, you know, if prices go up because of a post-merger price increase, you can't get any more imports because the quota is binding.

But there are structural conditions that you can put on the foreign cost curves, the contracts that foreigners have on the supply side; and then also demand side conditions. Like, is the market a differentiated product market? That basically means that after merger, even if there are imports there today, you can't be sure that they will discipline the market.

But the opposite is also true: If you don't see imports today, it does not mean that imports can't disciple the U.S. market. And you know, the most obvious way to see that is that it could be that imports are just about to come into the market; and as soon as you raise the price a little bit in the U.S., they will materialize.

But there are other conditions where imports may never come into the United States, and they can still discipline U.S. prices. And that would be under a cost structure situation where U.S. producers want to sell abroad and they can't price discriminate between the foreign market and the U.S. market; and the foreign competitors keep the prices abroad at the competitive level.

And so by doing that abroad, if other people arbitrage to the U.S. or can do something like that, then the foreigners, by keeping the U.S. businesses at the competitive level abroad, are indirectly disciplining the U.S. market.

I'm not claiming that any of these things occur across the board. But there is at least the theoretical possibility for all of these things.

The one empirical piece of research I've done, which is at the back of the journal article that I did with John Hilke and George Hay, is to look at import levels and how they varied with changes in the value of the dollar.

And there was a period where the dollar went up in value, and you basically didn't see a lot of imports coming into the U.S. And so it was sort of a test of the Landes-Posner technique that if you see some imports today, will they flood the U.S. market if prices go up? And there was sort of a natural experiment. And in a lot of industries, you didn't see a lot of import response.

So, what I take away from the economics of it is basically you have a lot of factual-specific analysis that you have to do; and you've got to dig into cases to get the facts.

And sometimes when the agencies have gone forward, they really haven't had the facts and they've lost in District Court. And I think we'll hear some comments shortly about the Kodak case. My firm was involved in the Baker Hughes case. And I think that the, in that case it would be the Department of Justice -- in both cases, Department of Justice -- there was some issue as to whether they really had all of their facts lined up before they went into the courts.

And the facts I have in mind particularly is what the customers are going to say when you hit the District Courts. In the Baker Hughes case, are the customers going to say: Yes, we would turn to imports?

And I'm not sure that the staff really understood that when they got to District Court in one of those cases, that the customers are going to take the stand and say: Yes, we'll turn to imports.

And I'm not sure in the Kodak case -- I'd be interested to hear how much discovery really the Department of Justice got and whether they really had the discovery to get all of the facts, because the judge threw out some of their evidence for being too scanty. There was some mention of some price data that they only had one year of price data on, and so the judge gave it the back of the hand.

And so I guess the message is, this is a factual intensive enterprise; and you've got to dig into the facts to get it right.

(Pause.)

COMMISSIONER STEIGER: Isn't that really wonderful, an economist saying you cannot rely on theory alone?

You, of course, realize that this is typical of an FTC economist.

I do have a couple of things. I was going to ask if you had any real world examples that you could share and they may be proprietary and you can't, as far as the facts you know, of firms who were in the market and couldn't constrain or were not and could constrain market power in the U.S., do we have any examples?

Or is Baker Hughes the best?

MR. NELSON: Well, in some of the defense mergers I have worried about, you have some issues like whether the Chinese launch vehicles could have disciplined the launch services in the United States.

And so I think -- I mean, I don't know how the staff came down on that; but they certainly seemed to be receptive to some of those arguments when the Commission looked at them, some of the General/Dynamics deals and Lockheed/Martin Marietta deals.

There are those deals. I had a deal involving machine tools, and one of the arguments that I found interesting there -- and, again, I'm never sure exactly how receptive staff was -- is that there's a lot of know-how there. And the know-how can be transported across international boundaries quite easily.

And so there was an issue about whether machine tools for government projects where there was a "Buy America" clause that would normally keep imports out, whether that could define a relevant product market.

And one of the arguments why it might not is that U.S. machine tool manufacturers might be able to adopt the Japanese know-how and compete on those government contracts as U.S.-based enterprises.

And so the foreigners were here, in some sense, in that that they could convey their know-how easily; and it wasn't an issue of the U.S. firms lacking any of the basic technology to implement that know-how.

COMMISSIONER STEIGER: One of our distinguished guests, I think, is going to talk about the discipline of know-how, particularly when used to aid the fringe. And it's an interesting concept, I must say.

This leads to a follow up, obviously, how important are reputational barriers for foreign entry? And are they going to get less? Or are they going to grow higher with a global economy?

It's a terrible question. You may not have an answer.

MR. NELSON: I think that's going to vary on a market-by-market basis.

I am concerned that those are very hard to assess. I had one case -- and this one I will have it remain nameless -- where I had signed affidavits from customers who said they would turn to foreigners, and then a foreign company who said that they were about to enter the U.S. market. But the other Agency down the street was still quite concerned. And the parties chose not to challenge it in court simply because they wanted to get on with their life; so they signed a consent agreement rather than challenge the government.

But the only affidavit that we asked for from either a customer or this one potential entrant that we did not get in that deal was a competitor who said that he didn't like the merger because of the efficiencies that it would create. And we told him: Well, you can say that in the affidavit. We'll submit it to the Agency.

But he wised up and wouldn't sign the affidavit.

But anyway, it's very hard to tell. And it was an industry where the Agency staff was on the record, because of historical mergers in the area, of thinking there were reputational barriers; and we actually put together quite a stack of affidavits to provide support.

There are markets where it's an issue, but it's one that you're going to have a hard time proving.

COMMISSIONER STEIGER: Well, that leads to one last question for me, the likelihood of foreign entry or the extent of the impact of foreign entry. What are practical guides for our staff?

The obvious answer is interview foreign firms. We do that whenever possible. Sometimes you can't.

What other plans of action would you suggest to them?

You obviously said: Interview customers, right?

MR. NELSON: Right. I think interview customers, and look a the documents.

I think in the survey that I got a couple of the respondents thought that the staff was spending a little bit too much time talking to the U.S. people and going the extra mile for the U.S. customers because they were easier to reach and not doing as much investigation of the foreign companies or interviewing people who knew about the way things worked in foreign markets as they might.

And part of that may be the time lag. If nothing else, it's just hard to reach those people in the time frame that you have to deal with, especially in a cash tender offer than in a longer deal.

But the one thing I might add is I think I would push a little harder on that. Although, the flip side of that is I know of other deals that have had some problems because of the translation costs of translating foreign documents.

And so, I think you have to be careful on that end of investigation.

COMMISSIONER STEIGER: John?

MR. HILKE: At one of our earlier sessions, Jim Rill questioned the use of exchange rates as a proxy for how imports would respond to a domestic price increase.

His main point seemed to be that the guidelines are based on a non-transitory price increase while exchange rates may be quite transient.

And I wondered if you have some response to that sort of criticism?

MR. NELSON: I guess I have two responses.

One, even thought the wording in the guidelines talks about a non-transitory price increase, if you look at entry models, economists are always wondering what the potential entrant will think the price will be in the post-entry world. And it could be that most entrants will realize that there will be a relatively rapid price decline.

And so there is this uncertainty on the part of the potential entrant as to what the future price would be. And in the paper that you and I wrote, there is some reference to the fact that at least for exchange rates, there's some -- and perhaps more solid grounds for projecting out in the future what the exchange rates are going to do than maybe there is in terms of strategic responses by an incumbent to a potential entrant in at least a lot of the cases.

I think there is some issues as to whether it is an absolute proxy, but I'm not sure that that particular one is the best way to challenge it.

COMMISSIONER STEIGER: Thank you, Phil, very much. At least we have your coauthor's brain to continue to pick when you get tired of pro bono service to this group.

We'll move, if we may, to Robert Bell, a partner with the law firm Wiley, Rein & Fielding.

Mr. Bell specializes in commercial litigation with an emphasis on antitrust and insurance coverage matters.

He has, to put it mildly, significant experience representing clients before both federal antitrust agencies and represents a host of U.S. corporations, maybe most interestingly for today, including Kodak, in its litigation to terminate old antitrust consent decrees.

He's an active member of the ABA's Antitrust Section, a prolific author with a list of awards and distinctions too long to mention.

But we cannot ignore the fact that he was a Supreme Court Clerk for the distinguished Justice Byron White of the U.S. Supreme Court.

We thank you so much Robert.

MR. BELL: Well, thank you for that generous introduction. And please bear with me, because I have a bad cold.

My hypothesis today is that geographic market definition as it has traditionally been performed under the guidelines is not a particularly useful exercise when we're trying to determine the influence of foreign producers.

Where we can look directly at the ultimate issue of whether merged firms can exercise market power, we ought to do so, rather than looking at that issue through the filter of market definition and market shares, which I think can yield a distorted picture.

The paradigm case that the Commission deals with in this area is where there are two U.S. firms that are proposing to merge; there are foreign firms that are importing into the United States various levels; and the issue is: Should the market definition be expanded beyond the United States to give greater recognition to those foreign firms?

Typically, where this becomes an issue, if you leave the market definition at the U.S. borders, the Commission would decide to challenge the transaction. And the parties are arguing that if you would expand the market definition, the transaction ought to be permissible.

It seems to me, under these circumstances, there's three questions the Commission ought to be asking:

First, how much would imports need to expand to defeat price increase?

As we know, under the merger guidelines, we normally hypothesize a 5 percent price increase. If you assume a price elasticity of 1, typically then, an increase in imports equal to 5 percent of the current sales in the United States would be sufficient to defeat that price increase.

The second question is then, very naturally: Can foreign producers increase their shipments sufficiently to defeat that price increase?

The two typical mechanisms that are called upon there are the excess capacity in the foreign producers, and capacity that may be divertable from one market into the United States.

Now the key here is often going to be how large the increase in foreign shipments that's necessary to defeat a price increase is in comparison to the total output of the foreign goods?

And as this analysis implies -- and as Commissioner Starek, in an article he wrote with Steve Stockum, recognized -- the emphasis is at the margin; and it may be a relatively small increase in foreign output that is sufficient to defeat a domestic price increase.

The third question that is implied here, then, is: Are the foreign goods acceptable substitutes to the U.S.-produced goods?

The answer to that question is pretty easy when you are dealing with homogeneous products. With differentiated products, the answer can be a little bit more difficult. But generally if imports are already coming into the United States and have already been shown to be acceptable to U.S. consumers, that question ought to be answered affirmatively.

Now, if those three questions can be answered in the affirmative, there's really no need to define precisely geographic markets and to assign market shares, because, by definition, there can't be a unilateral exercise of market power.

Of course, you also have to consider the possibility of coordinated interaction under the guidelines.

Now, again, under many circumstances, as the Commission has recognized both in Owens-Illinois and its Donnelly opinion, if even only a small part of the industry refuses to engage in coordinated interaction, it will fail.

That, again, is very much a case-by-case analysis. But in the situation of foreign firms, coordinated interaction is even more difficult because, as exchange rates change constantly, the terms of their interaction has to change constantly as well. And it makes it more difficult for foreign firms to agree either tacitly or directly on how they're going to coordinate their activities.

Now, the kind of analysis that I've just outlined does not avoid some of the difficult questions that have been identified by Don Baker and others regarding quotas, tariffs, and other exercises of governmental power that can interfere with the flow of imports. But it places them in a framework that ought to yield better results when we try to look at these questions.

There's a couple of important ramifications to this kind of analysis as well.

First, where there are large fixed costs in things -- like R&D, fixed investment in plant, and other sunk costs -- there will then be a high ratio of price-to-marginal costs.

That is exactly the situation where supply is going to be most elastic because firms are going to have the strongest incentive to increase their output in response to any opportunity in the U.S. to increase their shipments to the U.S.

A second ramification is that geographic price discrimination outside of the United States is largely irrelevant to this kind of analysis. Geographic market definition does not need to be symmetric.

In other words, foreign producers can constrain the exercise of market power within the U.S. without the converse being true.

And I think an excellent example of that might be the automobile industry in the 1980s even before the Japanese built a lot of plants here. I think at that point the Japanese were constraining the exercise of pricing in the United States; but the converse may not be true, in fact, probably wasn't true. U.S. firms were probably not exercising any restraint on pricing in Japan.

Nevertheless, since the U.S. antitrust laws are trying to focus on U.S. consumers, the analysis ought to look at the ability of foreign producers to constrain U.S. price not at the presence or absence of geographic price discrimination abroad, with the caveat that if you can show that that price discrimination abroad has some impact on the foreign producer's incentive or ability to increase their imports in response to a price change in the United States, it may well be significant.

I certainly don't pretend to have all the answers in this area, but I think that this might be a better way of posing these questions so as to maximize our chances of getting some of these answers right.

Thank you.

(Pause.)

COMMISSIONER STEIGER: Thank you very much.

I hope everybody's taking notes and can have at one another. This has been an extremely useful dialogue. I think Phil indicated there were a multitude of factors. You did say you realize there are other factors that would impact on this 5 percent new theory. And you didn't have all the answers.

But I am curious as to why you seemed to depart from Landes and Posner to the extent that you think, as I understand what you have written for us, that foreign firms with heterogeneous products may, indeed, have a greater influence, and caution that their theory applies best to homogeneous products.

Do you have any specifics on that?

MR. BELL: Yeah. What Landes and Posner say in their article is that, as a strict matter of proof, their model works with homogeneous goods.

They go on to say that they believe it works with differentiated products as long as those products are already being shipped into the United States and have been shown to be acceptable to U.S. consumers.

All I'm really saying is that in some of these differentiated products where you typically have large fixed costs and, therefore, a big difference between price and marginal costs, that's the situation where supply is going to be very elastic and people are going to have a big profit motive to increase their shipments into the United States.

COMMISSIONER STEIGER: For your addition to the theory, is it required that they already be in the United States as product sellers? Or do you think this effect could happen if they had never entered?

MR. BELL: I think it works best where they are already coming into the United States, because I think it may be difficult to show that a product that's not yet coming into the United States is a good substitute for the domestically produced product.

I wouldn't rule it out, but I think it has the greatest application where imports are already coming in.

COMMISSIONER STEIGER: Regarding coordinated interaction, which you are not too concerned about, what would happen to your concern level if, in fact, the European Union did pull off a single currency?

I am not suggesting, by the way, this is happening tomorrow.

MR. BELL: I don't necessarily think that's going to affect interaction between different firms in Europe that may be exporting to the United States. And as long as it doesn't, I don't think it would have any impact on the analysis.

COMMISSIONER STEIGER: Okay.

COMMISSIONER STAREK: Back to Landes and Posner, I think that the way to make the determination -- or it seems to me one of the ways to make the determination as to whether or not the formula that they ascribe in their article is going to be applicable is to do what we normally do in investigations; and that's interview customers and ask customers whether they think that these products are substitutable.

Is that something that you can agree with?

MR. BELL: Well, I think interviewing customers is important, but I think you have to remember that in most of these cases you only need substitution at the margin to make a difference.

And so you may interview 50 customers and you may only get 5 or 10 who say the foreign product is acceptable. But that may be sufficient.

I think with that caveat, I would agree with you.

COMMISSIONER STAREK: Okay. Thank you.

COMMISSIONER STEIGER: Lloyd, as a moment of personal privilege here, is an old friend, if I may say so. You are, of course, are completely wrong about the Republican trust of antitrust. And having said that, we will ignore the first three pages of your paper.

We will not, of course, ignore a very distinguished resume. And it does give me great pleasure to recount it for you.

This is a litigator's litigator at all levels of the federal and state courts, including oral argument before the U.S. Supreme Court.

He's a former Assistant Attorney General, in charge of antitrust enforcement for the State of New York and served in that capacity as Chair of the Antitrust Task Force of the National Association of Attorneys General, which is where we began our association here at the FTC with Lloyd.

He is the principal author NAAG's '87 Merger Guidelines, the Vertical Restraint Guidelines, Antitrust Improvements Act, and the Pre-Merger Disclosure Compact. I might mention, all of them firsts and at the time I think well recognized as enormous efforts in the field for NAAG.

He, of course, has been a Council Member of the ABA Section of Antitrust Law, the NAFTA Task Force and just about everything else that had anything to do with antitrust in the State of New York.

And it is my pleasure to welcome you here, Lloyd. Thank you so much for coming.

MR. CONSTANTINE: Thank you, Commissioner Steiger.

I want to commend the Commissioners and the Commission and the staff for holding these hearings. They feel very nice. It's a nice atmosphere. It feels more like an intelligent conversation among colleagues and friends than testimony. And it's just a very nice atmosphere.

Those of you who have had the misfortune of hearing me speak in the past know that I never start with a joke because it's always my feeling that the truth is always more funny than any joke I could come up with.

And in thinking about some of the issues that we are going to talk about today, I asked myself the question, how markets truly are global; and there are certainly worldwide markets and global markets.

And I thought one of the truly global markets was the market that Judge Posner hypothesized in one of the articles I recall reading that he had written about, a market for human organs, which he felt would be better allocated in a market economy. And that would certainly be a truly global market.

My belief -- and I can only shed a little additional light on this topic -- is heightened by the extraordinary credentials on the panel; and I really mean that. I don't think this is necessarily the best ballpark for me to be playing in. But I have been asked. And I guess I assume that I was invited to testify today because I belong to the fellowship of guideline authors, as you have noted, having written the state's Vertical Guidelines and their Merger Guidelines.

In 1986 with what I have said -- and I see that Commissioner Starek is armed on this -- but I perceived to be a federal antitrust enforcement at its qualitative and quantitate low points in the modern era of antitrust. Although, that's not a topic today. That's a topic for a different day. And the ultimate judgment will be rendered by history on that.

In any event, back in those dark days, the attorneys general of the 50 states asked me to draft merger guidelines, which were ultimately adopted in 1987. The states intended their guidelines to begin the process of filling the void created by federal agency abdication of their responsibility. And these were republicans and democrats who asked me to do this.

Beyond the lawlessness which prevailed in 1986, it is important to recall that the administration that year proposed to repeal Section 7 of the Clayton Act, to grant a partial antitrust exemption to industries distressed by foreign competition, to repeal treble damages, and to repeal joint and several liability.

I'm sure that Mark recalls all of those bills very well.

And it may seem somewhat quixotic now, but at the time, those bills were given a fair chance at passing. And I recall on two days when I was the only government witness who testified against them. Witnesses from both the Federal Trade Commission and the Antitrust Division stepped up and said: That's what we need in American antitrust law; we need to repeal the anti-merger law, treble damages, joint and several liability, and give our distressed industries an antitrust exemption.

In any event, back to today, in drafting the guidelines, I confronted the issue of market definition and, more specifically, the question of whether any different or specific principles should apply in assessing the role of imports in market definition methodology.

The market definition principles which I adopted included the following:

First, a shipments approach for the provision defining the geographic dimension of the relevant market. The area was defined as encompassing the production locations from which the protected interested grew -- that's the group that Congress sought to protect when enacting Section 7 -- where this group obtained 75 percent of their supplies of their relevant product.

This is obviously, for the cognizant, a modification of the Elzinga-Hogarty test.

Second, an instruction to adjust the provisional definition if hard evidence showed that sellers could discriminate on the basis of price, credit terms or priority of shipment among buyers in separate areas within the provisional geographic market.

And I note what my colleague, Mr. Bell, said about the relevance or irrelevance of geographic price discrimination. And maybe we'll talk about that a little bit later.

Third, a directive to adjust market shares to reflect increased imports, whether of domestic or foreign origin, which hard evidence showed would flow into the geographic market in response to a significant non-transitory price increase.

And, finally, and most specifically, I wrote a very short caveat about foreign firms which modified the application of the above three market definitions; and, indeed, it supplemented all of the market definition methodology. And it's so short that I'll read it to you.

"Foreign firms presently supplying the relevant market will be assigned market shares in the same manner as domestic firms according to their actual current sales in the relevant market. Foreign firms and their productive capacity are inherently a less reliable check on market power by domestic firms because foreign firms face a variety of barriers to continuing sales or increasing their sales. These barriers include import quotas, voluntary quantitative restrictions, tariffs, and fluctuations in exchange rates -- all which we have heard about -- when such barriers exist, market share based upon historical sales data will be reduced."

This caveat was modest, it was unexceptional, and it was hardly original. It and the other market definition principles I have cited were readopted in the state's 1983 Merger Guidelines. And nothing, nothing, which has transpired in the intervening years suggests to me that these principles were not sound then and that they are not still sound.

This methodology recognizes that the geographic dimension of the relevant market can be local or it can be global or somewhere in between.

It instructs that likely supply responses to price increases alter market shares when they are demonstrated with strong and compelling evidence. Most importantly, it says that a healthy and realistic degree of caution should still be exercised by enforcement agencies and courts before defining global or declining application of the antitrust laws on the basis of predicted foreign supply response.

These principles are close to analogous principles in both the 1984 and 1992 federal guidelines. More importantly, they are even closer to the actual practice of both the FTC and the Antitrust Division. They reflect a fact-based and pragmatic approach for recognizing the clear trend toward increasing trade among nations and the application of the American antitrust laws.

And, without exception, the enforcement posture of the Commission in cases such as Olin, Owens-Illinois, Occidental Petroleum, B.F. Goodrich, and most recently, Del Monte and the Mustad case reflect a sound, fact-oriented approach to the consideration of imports in market definition.

And those cases, as you know, span your careers and reflect your work. And I think, basically, the Commission, for many years, gets an unadulterated A in this area. And my students will tell you I'm a tough grader. So you get an A. And there's no doubt about it, at least in my mind.

The Commission's actions speak with more precision and eloquence than I can about how tariffs, transportation costs, fluctuations in exchange rates, U.S. protectionist measures, and the preferences of American buyers for American goods counsel against the automatic equation of foreign competition with competition based in the United States.

Indeed, recent industrial case studies suggest that one successful foreign import -- that of so-called "just in time" production techniques -- favor local suppliers and, all things considered, tend to contract the geographic scope of effective competition in certain industries.

This is not to say that the Commission and the Antitrust Division -- and more precisely the Antitrust Division -- have not encountered trouble in the application of a principled methodology for factoring foreign competition into market definitions. The greatest and most serious trouble has occurred when the agencies have paid too little attention to facts and too much attention to economic theory.

And I'm glad that this began with our economist Mr. Nelson making that point. But I think that is the basic point that I have to make is the basic orientation of the guidelines which we wrote. And that I think it is a basic fact of a litigator's life.

One example of this is the infamous Bakers Hughes case, which has already been alluded to, where, first, the learned Judge Gesell -- the learned and late Judge Gesell -- and later then-D.C. Circuit Judge Clarence Thomas, hoisted the Antitrust Division on its own theoretical petard.

Indeed, it was clear to me at the time that Judge Gesell, a great jurist, was punishing the government for what he believed were theoretical economic excesses in previous cases such as FTC v. Coca Cola.

The Second Circuit's decision last August in U.S. v. Eastman Kodak is the most painful and certainly the most recent example of how the government is punished for eschewing hard, factual development in the pursuit of what the great Fred Rowe has called "the Faustian Pact of Law and Economics."

And I should say about the Kodak case, I think my problem is with the reasoning of the courts, both the District Court and the Circuit Court, not the result I believe that Kodak should have been freed of both of those decrees. I think that Kodak is a wonderful company. And I never buy anything other than Kodak film because clearly I think it's superior; and I pay a huge premium for it all over the place. But I think that my colleague here probably did a wonderful job in lawyering. But my problem is with the reasoning of the courts.

In this Kodak decision, the court was able to reject the government's assertion that the United States was the geographic dimension of an amateur color photographic film market.

The court also found that Kodak lacked market power despite a 67 percent domestic share, when measured by unit sales, and a 75 share when measured in dollars.

Kodak's market share was six times great than its nearest rival Fuji, despite Fuji's lower prices, despite its fleet of blimps, and despite a $2 million infomercial which had recently been made by former President Reagan, as you recall.

Despite all of that, Kodak was also able to charge retailers 10 percent more for its film while maintaining what the Circuit Court characterized as "Kodak's dominant position in the United States."

Instead of focusing on and developing facts, the government was drawn into a losing battle of economic theories.

Now, I'm from New York, so I understand what I'm talking about now.

The Circuit Court decision was authored by Upstate New York Judge Roger Miner about Upstate New York's biggest employer, Kodak, is the antitrust equivalent of the Simi Valley verdict in the police beating of Rodney King. Although, perhaps some other comparisons may come to mind.

The local bias, however, is reflected far more strongly in the opinion of the Western District where Kodak resides. Waging this fight on the battleground of theory allowed the courts to play: "Heads-Kodak wins. Tails-the U.S. loses." And they did this with relative impunity.

In rejecting the government's assertion of a U.S. film market while adopting a worldwide market definition, the court's and Kodak relied upon two economic theories:

First the shipment theory of Elzinga and Hogarty, which should have and could have been properly trumped by strong evidence of price discrimination.

Second, the courts and Kodak relied upon the Landes and Posner hypothesis for assuming the existence of global markets, when foreign firms account for as little as 5 percent of the sales in the U.S. and such firms have excess capacity.

Landes and Posner include the entire capacity of foreign forms in computing market shares regardless of whether substantial portions of this capacity are otherwise committed.

The defining moment of Judge Posner's career appears to have been when he successfully argued before the Supreme Court on behalf of the United States in the notorious Vons Grocery case.

Since then, Judge Posner's antitrust theories have exhibited the tendencies of a person obsessed by the need to perform excessive penance for his perceived sin.

In this case, he has authored a theory to make it virtually impossible for any other enforcer to ever successfully challenge another merger. No matter that in the history of the world, no market has ever performed according to this hypothesis and no matter that sound economic principles demonstrate why no market could ever perform this way. The hometown bought it.

The U.S. countered with economic gambits of its own, such as the argument that Kodak's so-called "own price elasticity" of two demonstrated that it was earning the excessive associated with market power.

This is the government's own version of "heads, I win," since the traditional argument is that a low "own price elasticity" is a sign of market power, permitting a firm to profitably raise price.

The government also harped on one of its economic darlings -- they always do this -- the "Cellophane Fallacy."

What the U.S. apparently failed to do was provide more than cursory evidence of Kodak's ability to price discriminate among film buyers in the U.S., Western Europe, and Japan. Better development of these facts would, as the court noted, have successfully rebutted the assertion of a worldwide market.

The government also, apparently, focused almost exclusively on Kodak film's retail price premium of 4.5 percent over Fuji instead of the 10 percent, which Kodak was able to profitably charge retailers while maintaining its six-fold lead in market share over Fuji.

By the way, emphasizing the significance of the alleged retail premium of only 4.5 percent, which fell to almost nothing at mass merchandisers, the government missed the boat.

The government also failed to marshal and exploit other facts at hand. The record reflected the fact that while there was little, if any, difference in the retail price of Kodak and Fuji at mass merchandisers, such as WalMart, those outlets recorded the highest levels of Fuji sales. Kodak films sold better, relative to Fuji, at smaller stores where Kodak film commanded a significant premium.

These facts supplement the strong record evidence that U.S. buyers considered Kodak film superior, like myself, and would pay more for it. The existence of a significant price premium at smaller stores both validated and reinforced this perception and preference.

Quality validation is what I think I learned in my economics class.

This strong preference supports the assertion that Kodak had and exercised market power, not necessarily unlawfully acquired market power, but had market power.

The best that can be said of this horrible decision and the contributing failure of fact-based advocacy is that it did little harm. As I have noted, I think Kodak should have been freed of both of those decrees; and they were.

My concluding point is just this, that the FTC practice does not, does not, need modification. It properly considers the role of imports, assessing the geographic dimension of relevant markets. I think the decisions emanating from the FTC are very, very learned and very, very well reasoned and very fact-based. Heavy reliance on those facts and factual analysis will result in the Commission continuing to do the right thing.

And I did my only little empirical analysis, like our economist, before I got here. I walked into the first door that was right near our office in New York where the film was selling at and actually took a picture of it, but I don't have an overhead projector. But here's the Fuji film and the Kodak film. They are right next to.

And here's Kodak at $5.49 a roll and Fuji at $3.69. And I can tell you that this a completely, accurate and random sample of the entire properly defined United States amateur photographic film market.

(Pause.)

COMMISSIONER STEIGER: Absolutely good enough for me.

The only problem, Lloyd, with leaving some of these thorny issues of antitrust history to history is that you are such a prodigious penman that you're going to get your side down before I get mine. That's really quite unfair.

I did have two things, if you wouldn't mind. The one is kind of amorphous. You refer in your earlier remarks to hard evidence of imports, hard evidence of whether they would increase, or defeat a use of market power here.

Please, define "hard evidence."

And second of all, will you go to your caveat. It may be I just don't understand it. But when such barriers exist, market share based on historical sales data will be reduced?

Why would you reduce it? And by how much would you reduce market share?

I'm not sure I understand it.

MR. CONSTANTINE: It seems to me that if -- and it's a special case, obviously -- but if, in the last five years a market share has been thus but that is prior to the recently adopted protection measures which Congress has just come forth, which happens in some cases, a quantitative restriction, a quota, or if exchange rates have fluctuated in a way which his unfavorable to that market share, then, obviously, you would want to change that.

If the dollar has become much weaker, than historical market share data may no longer reflect the competitive presence of that company in the market.

So that's why you might want to -- it's a small point. It's not a big point. It's a caveat. There are general principles stated in the guideline. But it says: Look, historical market share data may understate the significance of a foreign company; it may overstate it.

It just says: Look at the facts. Look at what's going on. Is there a quota? Is there a change in tariffs? Is there a change in exchange rates? That's really all that is said.

And if you could, you asked an initial question, which I would like to answer. I was ready to jump on that one, but I have lost it now.

COMMISSIONER STEIGER: Okay. A follow up very quickly, we had distinguished speakers here Wednesday, I believe, who suggested that you have to discount currency fluctuations. They may be rapid. They may be incremental. They really are not the force or the factor in foreign trade or in antitrust analysis that we may believe they are.

You disagree with that, I think.

MR. CONSTANTINE: I disagree with that. And I have noted in the last few years, you know, while we have all been decrying the weakness of the dollar versus the yen, and now the dollar has recovered, that has, obviously, a tremendous salutary affect on our ability to sell goods in certain places abroad.

And it seems to me that the record of history on that is that exchange rates are very significant. And I would defer to, again, what Mr. Nelson said.

But back to -- now I do recall what you said. What is hard evidence?

Okay. Hard evidence -- and I'll take this from Kodak; and this was noted by the court and appears to be the case; and I have reviewed the briefs in the Kodak case -- there seems to be a lack of willingness or an ability to develop facts that were there. I mean, just reading the Circuit Court and District Court opinions, there were so many facts which sort of jumped out at me as asking follow-up questions about how the wholesale price premium worked and how Fuji was going to implement the strategy which I heard about three times of making sure that its prices were a certain level below Kodak at retail.

That would have gotten somebody else at either the division of the Commission doing another kind of an investigation.

There seems to be facts to be developed, facts about geographic price discrimination, facts about the wholesale price premium, many facts which did not seem to be the place where the government placed its reliance, rather upon the assertion of economic theory, not necessarily -- and I think what your question was: How do you prove -- how do you get hard evidence of supply responses?

Well, obviously, the best hard evidence of supply responses is to pick historically the most analogous situation, which has occurred -- these things tend to be cyclical; they happen over and over again -- and to look back to the most analogous, relevant situation in the recent past, try to hold that constant for as many factors as possible and see, did it happen last time? Did it happen last time that when these prices went up that all of the capacity of anybody selling 5 percent in the United States automatically came into the United States and disciplined the price increase and they stopped selling to their domestic buyers and they stopped selling in Europe and they stopped selling every place else in the world, which is the Landes-Posner hypothesis.

Now, Attorney Bell has pointed out that you do not need all of the capacity coming in to necessarily discipline a price increase.

My point is a much more modest point which is that the hypothesis is demonstrably wrong and that all of the capacity -- all of the sales to begin with but then all of the capacity should be considered to be in the market.

COMMISSIONER STEIGER: Thank you.

I think to make sure that we don't miss Donald Baker, we will move because we have Lloyd captive for a little longer.

COMMISSIONER STEIGER: Donald I. Baker. I will refer to him as a great friend of antitrust, certainly one of the more perceptive critics, even though sometimes I don't like what he says, of the antitrust agencies.

He is with the firm of Baker & Miller, which does focus, primarily on joint ventures, mergers, licensing, network disputes, and international transactions.

He is a former Assistant Attorney General in charge of the Antitrust Division. We call him the "Former General." He's the only career member of the Antitrust Division, that at least I know of, who was appointed Assistant Attorney General.

He was also a trial attorney and section chief at DOJ and a Deputy Assistant Attorney General for Regulated Industries Appeals and Foreign Commerce, certainly, both being matters of extraordinary interest in today's world marketplace and our local concerns with Telecom.

He's a member of the Panel of Distinguished Neutrals, appointed by the CPR Legal Program to Develop Alternatives to Litigation and, of course, a long-standing member of the ABA Antitrust Section.

He poses a very distinguished academic career before us as well, including a BA from the University of Cambridge.

So it is with great pleasure that we welcome another, we hope, friend of antitrust.

MR. BAKER: Well, this is an environment, as Lloyd Constantine said, where one can feel very friendly. I commend you and your distinguished successor and your colleagues for having these hearings. I think this is, indeed, one of the ideas that the Congress when it tasked the Federal Trade Commission Act and many critics over many years suggested that it became too much of a litigation and too much of an adversary agency and not enough of a fact-finding agency.

COMMISSIONER STEIGER: I must leap in for the record and say all credit for this goes to Bob Pitofsky who thought of it, found the right people to put it together, and deserves 100 percent of the credit.

It is, I think, exactly a traditional function of this Agency that's been lost in the past two decades.

But thank you.

MR. BAKER: Anyway, I am honored to be here. I am flattered by your kind words and hope to be able to say something that's worthy of your time.

As I sat here, I couldn't help but think back to a day probably 12 or 13 years ago when I was sitting here getting paid.

COMMISSIONER STEIGER: Jab, jab.

MR. BAKER: And I was getting paid by General Motors to advocate the GM/Toyota joint venture.

Well, at the time I owned a Toyota and a Chevette. And people come down here and make arguments on behalf of clients that aren't, you know, there's a certain amount of license and enthusiasm. I mean that was just absolutely straight-up testimony. General Motors' position that they needed Toyota to learn how to make small cars was proven in my garage.

I mean, the handling of that case is one of the most important contributions of the Commission to the whole question of thinking about global competition, because global competition is more than flow of goods.

As I indicate in my outline, I have written a lot of stuff on this, including one with David Balto, of the Commission Staff, including one back in the 70's which I had in galley when the Attorney General, who was Edward Levy, appointed me Assistant Attorney General and wasn't sure he agreed with it. And so you had an uncommonly interesting footnote that said here is this person who has been appointed to be the head of the antitrust division; the views don't necessarily represent the Department of Justice.

But they probably did.

I wanted to look very quickly at really the politics of the whole situation. One of the economists said it almost a decade ago that the politics of free trade is much more trickier than the economics. I'm not sure about "much more trickier," but maybe that's the way they say it in London. But it is clearly trickier.

And it seemed to me that if we stick to the economic characteristics, we are only talking about part of the story. I sat here and just listed in the outline what seemed to me to be obvious global markets, sort of big ticket research intensive risky manufacturing of ventures like jet engines and telephone switches and so forth.

The second was major commodity markets where transportation costs are not insurmountable like oil and aluminum. And this sort of follows up on your point that you only have to have some incremental flows to affect the value.

The third one was high value, time sensitive financial markets. The fourth one was experience centered in markets for larger risky projects such as engineering and reinsurance. And with reinsurance, of course, one can remember the odd result of the Hartford case that the American primary insurers were exempt under the McKarren Act and the foreign reinsurers were subject to liability under the other majority's opinion.

The next category -- welcome. And I've stalled around waiting for your arrival.

CHAIRMAN PITOFSKY: You've picked everything up by now

MR. BAKER: One word, though, Mr. Chairman. I think these hearings are at great idea. And in your absence Commissioner Steiger said, in response to my enthusiasm on that point, some very kind things about you; and I want to second them. But I couldn't say them as well as she did.

The next one was global distribution markets, most notably satellite communications which are just sort of tearing things up all across national frontiers. And finally, the last one, are long distance communications and transportation.

Now, there is nothing magic in this list of six, but it is worth noting that only two of the six really involve goods, that the other four involve services of various shapes and forms.

Now, let's stop and run through the economic barriers to broad international competition. One, of course, is high transportation costs in relation to value for some products.

The next is product differentiation and differing consumer tastes; and, obviously, the Commission's decision in Brunswick v. Yamaha is particularly interesting in that, in that Yamaha had developed a consumer reputation in one product and was deemed a potential entrance with another.

The third one was language. You see this in computer programs. You see this a lot in entertainment programs where you have to be prepared to translate in order to get across frontiers. Of course, in some countries like Canada or Belgium, you have to be able to translate in order to cross the middle of the country.

Distribution needs were the next economic barrier, and that obviously involves a front-end cost.

The next one was exchange rates, which, Commissioner Steiger, you have asked about several times. My perception on the exchange rate issue is that it is a risk. If you are trying to decide whether to establish a business in the United Kingdom, you have to think about the uncertainty that exchange rates impose on the thing, whether it goes up or down.

My view is it is a mild, maybe more than mild, barrier to international entry. It is not so much a barrier to immediate short-term exports, because you were selling them now and getting paid for them now, if you're lucky.

COMMISSIONER STEIGER: Very interesting distinction. Thank you.

MR. BAKER: Then I threw in historic national standards, left-hand drive -- this is my Cambridge background -- was just an example.

Now, pursuing my point that the politics is a lot trickier than the economics in international trade and presents you, as an Agency, presents us, as your advisors and advocates and all the rest -- critics, too, I suppose -- with real problems.

Let me just run them through just to make sure we have a similar list. One is entry control. And that may be at the product level where things like FDA approval is required. It may be pure entry control, like international aviation rights. There was a mention "Buy U.S." policy. I worked on a joint merger a decade ago involving ball bearings which are were at very high if you only looked at the production and nothing much to talk about if you looked at the world. And the key thing was that the Defense Department had under 30 millimeter ball bearings for defense applications had to be proved in the United States.

The next one is foreign ownership restrictions.

The next one is domestic subsidies on tax relieves in foreign markets, what the Europeans would call state aids. Those, it seem to me, are a distortion and they may or may not be permanent. They may, in the case of goods, be subject to countervailing duty, treatment; so you need some discount.

Tariffs, import quotas, trade law remedies: All of these are real risks.

Now, if you take this collection and hypothesize that the Commission is considering a merger between, let's say, Alcoa and Kaiser, in the summer of 1993. Aluminum ingot is pouring in from the former Soviet Block. I mean, the price is tumbling hand over fist. You'd have all the immediate indicia of a global market. They would -- I shouldn't say -- no doubt, we are on the verge of maybe really dumping for hard currency. We are constraining the market marvelously.

Well, what happens out of this? And the story from there on is familiar. The Europeans put a quota on the United States, and the EC get together and enter into an inter-governmental agreement with the Russians that they will cut their capacity. The Russians issue a press release that says that they sure wouldn't enter into this agreement unless they were sure that the American producers were going to enter into reductions in capacity. The American producers say, of course we couldn't agree to reduce capacity because that would be terrible and we would be punished by our friends in Washington everywhere else.

And so they sign the agreement; and then you look around and you read the American metals market and one plant's being shuttered after another. And you have something that begins to at least look like an oligopoly to reduce a capacity. And aluminum prices go up almost twice, 1.5.

Now, with hindsight, my advocacy in the summer of '93 for the Alcoa/Kaiser merger looks laughable. I mean, even without a merger, they were able to raise the price one and a half times as much, to the annoyance of the soft drink companies and people like that.

And so, clearly what went wrong?

But I mean, how do we take harder cases? And I guess what I am urging -- and my article on -- in the Cardozo Law Review that I cite in the beginning of the outline -- argues for is you've just got to factor in political realities.

You start off, and the first political reality is constituency service has been one of the great end of government at least since the medieval guilds. And what it means, of course, is protecting the inside producers against the outsiders who don't do it our way.

The second related point is that the producer and labor groups on the inside are almost invariably more powerful politically than the consumer groups.

The third point is that if the foreigner is really successful in disrupting the domestic market, as the Russians were with aluminum, something's going to be done about it politically.

Now, having said all of that, I think frankly the United States has been better than most leading industrial countries in the degree of openness of markets, not all markets. Sugar is terrible, and a few things like that. But a lot of them are quite open, and our consumers are better served.

And the international negotiations like NAFTA and the Uruguay Round, while complicated, tend to reduce, to some degree, the domestic barriers to outside competition because you have the foreign government in on the side of the domestic consumers, because the foreign government wants to sell its gunk -- its producer's gunk here.

And these international agreements, it seems to me, are important because they increase the incentives and opportunities for successful producers. In other words, a producer can look to a larger market to capture if it is successful in developing that better mouse trap, that better jet engine, and so forth.

And, of course, the more open trade environment keeps pressure on the efficiency retarding local labor arrangements, local regulatory arrangements that disadvantage local industries.

I think, as I suggested in the last part of my article -- it's a piece of paper -- I don't think it's possible to ignore these political barriers. Foreign firms are subject to different restraints. Foreign subsidies are less permanent, probably, either as a result of trade negotiations or otherwise. And so you have to deal with it.

Now, it's somewhat monopolization case, in an attempted monopolization case, or a rule of reason case where, to some extent, you're talking a snapshot of the market as it now exists or has been in the recent past; and so you can say, well, trade barriers have been here; trade barriers are this or that.

The merger area which, of course, is a much more important part of your work load is much more difficult because the Congress is really asking the decisionmakers to look at the market five to ten years out and say, but for this merger, would the market be less competitive or not? And that sort of incipient standard, kind of effort really is a forward going, you know, predictive government.

And I think when you have that and you have my Alcoa/Kaiser kind of domestic herfendal-breaking case, you do have to look at the threat of foreign competition; and you really have to do it in a practical way, not in a Landes-Posner way. And part of the practical analysis is the politics.

I, in writing the Cardozo article, I set up a spectrum sort of modeled on the economist spectrum from perfect competition to pure monopoly.

And my spectrum was -- at one extreme, we had perfect market politics, a market in which prices are significantly influenced by political decision, e.g. on monetary or defense procurement policy. Although, the government has not thought to manipulate the market in favor of particular producers.

The second is rational market politics.

The government does not intervene in the market process unless it is necessary to protect the public against clearly defined market imperfections, natural monopoly, fraud, pollution, or unsafe products.

The third I called "workable market politics." Periodic, perhaps, random government intervention in the market process are motivated more by constituency service than any refined principles. But such interventions are not so frequent that they have become the rule rather then the exception.

And the last one is pure market politics. And we can recognize that instantly.

Pervasive government involvement in ensuring specific constituency goals, such as low prices for consumer constituents, high prices for employer constituents and farmer constituents and job security at high wages for worker constituents.

And to the extent that you're looking at a market that is a characterized by one history as opposed to other, you ought to make more pessimistic or more optimistic assumptions on the degree of the political that is likely in response to foreign competition.

Anyway, having said all this and to conclude, market definition is, obviously, a terribly tough exercise. And Section 1.43 of the Merger Guidelines sets out a bunch of factors to consider in foreign firms but doesn't tell you exactly what weight to give them.

The final point I want to make is that most of our thinking and writing -- certainly most of my thinking and writing -- has been on tangible goods. And, indeed, the way you framed the question today about "counting imports" thinks about tangible goods.

As we head to a post-industrial economy in which services are important, communications are important, things that I will call software are ever more important, I'm not sure that our tangible imports-kind of analysis is close to controlling. And it may be that, as you get to things like services, things like entertainment, and so forth, you'll see more government intervention rather than less as a problem.

But, secondly, you may have less faith in transactions, totals of transactions, and measuring the market as opposed to capability.

I'm still not there with Landes and Posner, but I feel more comfortable with them when you're talking about service providing capability than when you're talking about loads of machinery or wheat or cement.

(Pause.)

COMMISSIONER STEIGER: Provocative as always. And your conclusion prompts a dual question and I hope not too complex a one.

One, should we be adopting new competition analysis for your software industry, so to speak, your IP industries and service industries? And do we have to change the Merger Guides to reflect foreign competition, especially as it relates to geographic market?

And I think the two questions are linked.

MR. BAKER: As usual, Commissioner, your questions are provocative; and I'm not sure I know the answer.

I, frankly, have not gone back in connection with preparing this or something else and done the inquiry that your question would invite; and I will invite it on myself with my comment.

And that is, to say, okay. Let's think about service; let's think about communication; let's think about computer operating system; let's think about the great monopolies of what may be the 21st Century and look at the Merger Guidelines.

So in the great tradition of an administration witness up on the Hill, let me think about it and I will give you a written answer.

COMMISSIONER STEIGER: Well, we knew you were going to do that anyway.

MR. BAKER: Well, then I haven't promised anything. But it sounded better than saying: I just don't know.

COMMISSIONER STEIGER: We read everything you write.

The distinguished Mark Leddy is next on our list of folk.

I think we'll give everybody else a chance, however, at Don Baker, since he has offered many avenues of questions and he's going to leave us.

Does anybody else have anything they want to pose to Don?

Mr. Chairman?

CHAIRMAN PITOFSKY: Well, I'm intrigued by your range of interruptibility situations, perfect, workable, pure, et cetera.

What would you think about something approaching a presumption that, if imports had been coming in without political opposition or have surmounted the political opposition, for a period of time, say it's 10 years, that we would be wise to indulge in a presumption that will continue at least at that level, because after 10 years or 15 years they would have established what I would call kind of an economic constituency in the country in which they are exporting to.

MR. BAKER: I have no problem at all with that. I mean, I would make the same presumption of counting them in -- sustained imports counted in for at least the amount that they have actually had, which leads you to the next two questions that you are going to ask me about, which is, take my aluminum example; they are very recent and very large but may be very unstable.

And the second question is: Should we count them in for more than what they actual flows?

And my instinct on the latter is, that if you have imports that are based on substantial scale economies in production, for example, and they have been allowed in for 10 years, you know, your non-trivial sustained period kind of thing, then I might allow them in for more on the grounds that a world scale producer that has imported into the United States has facilities -- I mean, we can begin to qualifying it -- has facilities to produce and import more.

That seems to me to be quite different from the Posner-kind of thing: If you count them all in for everything and you a assume that they will just forget about their consumers back home and so on, for which I'm quite critical in both these articles that I wrote and cited in the materials.

COMMISSIONER STEIGER: As always, we look forward to the next chapter. But you better hurry. You know, we don't have enough time.

MR. BAKER: Well, you know, I sometimes wonder what I'm going to do when I grow up, too.

COMMISSIONER STEIGER: More pro bono work, if you please. We'll be calling on you again.

We will finish our panel this afternoon with yet another very distinguished veteran of both private and public sector antitrust service.

Mark Leddy is now a partner in the Washington office of Cleary, Gottlieb, Steen & Hamilton. He has served a stint in their Brussels' office, unlike many of us who would envy him for that but never quite got that far.

He has, of course, served at the U.S. Department of Justice, joining the Antitrust Division back in New York, back in 1972.

And it is worthy of note that he was named in 1984 Deputy Assistant Attorney General, which is, of course, the highest career position in the Antitrust Division and, indeed, a distinction to have served.

He is a member of the ABA's Clayton Act Committee. He is also a prodigious author of articles and numerous antitrust presentations before a myriad of audiences.

He is also on the editorial board of something we all look for, couldn't live without, and that's the 4th edition of the ABA Antitrust Law Developments. We all hold our breath to find out if it ever is going to arrive; but at least during my tenure, magically, it does, eventually.

MR. LEDDY: Do not hold your breath.

Thank you very much. First, a thank you and an apology. I also join my colleagues in commending this effort to stop and think about the application of antitrust in global markets, innovation markets, and elsewhere. I really think it is a useful exercise for all of us, especially practitioners to try and stop and think about what the right answers are to questions as opposed to what the right answers might be in a particular case.

With respect to the Commissioner's reference to my time in Brussels, I also think the fact that we are able to do this from time to time enables us to be very far ahead on the learning curve of what the right answers to these difficult questions ought to be compared to our enforcement counterparts worldwide.

I don't have a lot to add to my distinguished colleagues. I'm sort of last and least, I think. I would like to, perhaps, comment on some agreements and disagreements I have with them and, by doing that, both shorten my time and lengthen the time for debate, perhaps. But also I think it would reveal my own views on the central issue of the role of imports in antitrust analysis.

Let me refer, as I do in my draft remarks -- and that was the apology: I'm sorry I'm so late, and I hope to give you a final draft shortly.

But in my draft remarks, I start out by reminding myself and everyone else who cares to read them, as Don alluded to, the antitrust merger enforcement, unlike other kinds of antitrust enforcement is predictive in nature.

You are make a judgment based upon present and historical levels of competition and market structure about how the world will be in the future. A very difficult thing for any person, much less institution, to do well. And I'm reminded by Don's point that the politics of trade are more complicated than the economics of trade. That's surely true.

And I detected in Don -- I wish he were still here to hear this so we could debate about it -- sort of a bias against the confidence that markets will continue to internationalize when dealing with antitrust problems and merger enforcement.

I sense that because international trade can be so politicized, in his aluminum example, that you should, in effect, count on barriers to trade perhaps re-emerging in the future, rather than my own bias which would be to count against them.

Because if you look back to when I started in the Antitrust Division, 1971, and now at the internationalization of markets, we've come centuries in terms of the flow of goods worldwide. And the idea that in particular cases we caught to be cautious or err on the side of, well, there probably will be some governmental barriers because medieval guilds and their progeny are generally protective, I think is a mistake. I think if you're going to make a mistake in your predictive judgments, it ought to be on the side of the internationalization of markets.

Because that's really, in my judgment, in my prediction, the way the world is headed. Yes, there's going to be blips on the screen and there are going to be steel quotas in the early 80's and maybe quotas in other products from time to time, but overall -- again, looking at over the medium and long-term, I think markets have internationalized.

Now, let me state what I consider to be the problem and what I think the answer is. And then I will agree and disagree with some of my colleagues.

I think the problem is basically an information problem. I don't think anyone here would disagree that the analytical model for defining a product market, a domestic geographic market, a geographic market on the West Coast for a product is any different from analyzing an international geographic market. The analytical model is the same: How much capacity does it take, in effect, to foil the price increase you hypothesize by the monopolist?

And whether that's coming from Canada or the West Coast or the Gulf Coast really doesn't matter. What concerns people is: How do we know that the Australians are not going to continue to ship? How do we know that Italian stainless steel is going to be continued to be allowed in the country?

It's an information problem. I don't think it's an analytical problem, whether we're talking about the NAAG guidelines of 1987 or the present guidelines or Landes and Posner, they're all talking about the same thing: Don't look at market share, look at what would happen when you hypothesize a price increase.

What kind of response is it going to be on the demand side? That can be, often, just as difficult factually to figure out than a supply side response from outside the United States, sometimes more difficult.

But I don't think there should be a bias against including foreign capacity, which I do detect in some of my colleagues.

And let me go back now to what I said I was going to do, which is to say I'm going to agree with some of what they said and disagree with other things, all in the context of what I consider to be an information problem that is exacerbated by a bias or lack of confidence in the internationalization of markets.

I agree with Phil -- and I hope I don't mischaracterize it; if I do, I'm sure he'll correct me -- that Landes and Posner is, in effect, I think misconstrued; but the popular notion of Landes and Posner, which says: If you have some sales in the market, you include all sales. That's over expansive and too easy. And there are a lot of things you may have to look at in a particular case, a fact-bound case as to whether or not you can make that judgment, whether it's quotas or distribution costs for incremental sales or whatever. You do have to take a look at it. That's important.

And my dispute with Phil is seemingly minor but perhaps not.

Phil says, well, one of the reasons why he's skeptical about including foreign capacity is that he and his firm took a look at what happened when the dollar increased in value; and they didn't see much in the way of flow of imports during that period.

Well, I think, again, that's too much of a generalization; because if you're talking about a particular product -- like I had in the case of the DOJ -- we did look at that period; and, in fact, in that particular product, imports had increased. So we used that as, in effect, an analog for the hypothesized price increase and said: If prices went up 8, 6, 12 percent, this amount of product -- which I can't talk about; I asked the client, and it said no; so I can't talk about it -- I think we convinced the government that that analog was a useful one. In particular, because it met Bob Bell's test that there's enough customers at the margin who would buy this commodity -- which is where I disagree with you -- buy this commodity that would defeat the hypothesized increase.

So I do think that trade flows in response to currency fluctuation, as historical matter, are very useful in predicting what may happen in the future.

With respect to Bob, as I said, I agree with your view that in respective commodities to question to ask, at the margin, how many customers would buy from foreign sources in response to a small but not insignificant price increase? And that can be enough, even though it's a small amount relative to the entire market to defeat a price increase and, therefore, you should include that capacity.

But what do you include? I would only include what I could call "foiling capacity." Going back to the fundamental principle in the 1982 Merger Guidelines of the DOJ, when you are trying to apply the smallest market principle and you ask the question: If the price went up 5 percent, what would happen? Who would foil that cartel? Who would foil that unilateral exercise of market power?

If the answer is -- again, whether it's on the demand or the supply side -- a producer from Toledo, Ohio, or Toledo in Spain, it shouldn't matter. And I agree in a commodity situation a small amount of imports can defeat a price increase; and you should include all of the capacity of that firm.

I disagree, though, Bob, when you apply that model to highly differentiated, heavily branded products, because there, I think, as Landes and Posner recognized, you have to ask more questions about the cost of incremental distribution in the United States. Whether or not the product here is really, in fact, accepted by consumers and not just so-called novelty purchase. That's a poor choice of words, but I think my point is made.

I just think there is a difference in the analytical approach to homogeneous supply responses of geographic markets just as there is when you're trying to define product market dimensions and you're talking about commodities and differentiated products.

With respect to Lloyd, I agree with Lloyd that facts trump theory and that in cases that he's talked about and others that he hasn't, sometimes the government and the defendants have relied too much on theory and have gotten away with it. And that the real core of this predictive exercise is gathering as much information as possible, as early as possible to make as informed a judgment as possible.

And that's where I would recommend that, to the extent the Commission does believe that there ought to be, as I would urge, more deference to the internationalization of markets. That should go down to the staff level, because the staff has to do the work to gather the information to present you with the record and you with the judgment, because if you don't ask early questions about excess capacity abroad, whether or not if the Koreans are selling X product into Malaysia, what would it take for those Koreans to divert those exports to the U.S.? Those questions can be answered. Not perfectly. Just like product market, the NAAG questions can't be answered perfectly. But they can be answered. And those questions ought to be asked early on rather than too late or not at all.

Where I disagree with Lloyd is that I sense from Lloyd, as I do from the NAAG Guidelines, too much skepticism, as I noted in my draft paper, which is the same section Lloyd quoted, in the Guidelines where it says, foreign competition is inherently a less reliable check on domestic price increases.

I guess I disagree with the word "inherent." It's true in some cases. It's not true in some cases. And it's the job of the Commission and merger enforcement generally, to distinguish those cases. And I would try to remove the bias.

Some of our markets in the U.S. have been taken over by foreign competition. Some of our markets are more readily disciplined by foreign competitors rather than domestic competitors. But the hard part is to distinguish those industries one from the other and to follow the analytical model which drives the merger guidelines and try to get as much information as possible.

With respect to Don, I do agree, as I said at the outset, that the politics of international trade have to be factored in. If there is a quota on stainless steel, then you have to factor that in.

But you also have to ask yourself the question: How long is that quota going to last?

Now, if you recall, we're talking -- I think every one of us mentioned in one form or another "Landes-Posner." Landes-Posner is almost 15 years ago. It was an attempt to bring some economic rigor to antitrust analysis; and it succeeded along with a lot of other things.

And it's very easy to say: Well, during the last 20 years or so, the Chicago school's analytical rigor turned the antitrust ship around from when I joined the Antitrust Division to where a merger enforcement is today.

And there's some truth in that.

But, much more importantly what's turned the antitrust boat around is the internationalization of markets. I mean, I remember when I joined the Antitrust Division, there was still investigation of GM as a monopolist in the U.S. going on. And that was 1971.

But today, if you just look simply at what's happened, I think one should be confident that the internationalization of the markets will continue. And if there's going to be a bias -- which I don't think there should be; but I don't think, Don, you should rely necessarily on, for better or for worse, the protectionist tendencies of countries to erect trade barriers. They have to be factored in, And it's your job to predict them. But in the long run, if you have a transaction of two U.S. companies that present very powerful efficiencies and it's a relatively close case on the numbers and you have a relatively strong case, but for the politics of trade, I think you should make that decision on allowing the transaction. I think that's more forward looking than the idea of being concerned about the inevitable, but I think the short-term trend is towards protected markets.

I think I probably summarized my own views and criticized my colleagues enough for the moment. So I think I'll end there, Commissioner.

COMMISSIONER STEIGER: If I ever, God forbid, wind up with a capital charge, I want you to do my closing argument. That was as nice a summation as I have heard of the major points brought forward to us.

With the one exception of allowing Don Baker his bite at the apple early, I would like to suggest a brief recess and then time for all of you to respond or further explore to the extent that you are interested in what Mark has set out as, I think, an extraordinary rich discussion menu.

Don, do you want to put in your last word here?

MR. BAKER: My last word here at least today.

And, again, I apologize. But international competition calls me away.

Mark, I think that you, as always -- and I think back to you in the division when we were colleagues together -- a great ability to paint things rather sharply.

MR. LEDDY: Too sharply, you mean.

MR. BAKER: No, no, no. I think accurately and well.

When you finished up with your wind up and you said: Domestic firm involves major efficiencies is a close case, I wouldn't tip the balance against the merger because of concerns about trade barriers.

I think I probably agree with that.

What happens when you get my Alcoa/Kaiser case, which may or may not be close depending on whether you have a short-term view of the facts or a longer term view of the facts?

Do you take into account whether this is an industry, employment-intensive, highly unionized, better able to protect itself than sort of white color information industry?

It just seems to me -- and the only point that I was making -- and you and I might slightly disagree on how you articulate it and might, if we were over there rather than where we are come slightly differently in close cases, is that traditionally we have understood, as you said at the outset, how to look at transportation costs and things like that; and it make any difference whether the stuff comes from Winnipeg or, you know, Albuquerque, you know, if it's flowing around. And that's going to be one of the biggest issues in the North American area where, very often, you will have closer plants from outside the United States. And so, you will be dealing, perhaps, only with political barriers as a factor. And if you put the political barriers on the side, you'll automatically treat it as a North American market.

And I just think that we haven't looked enough at this issue. I don't have any quick and easy answers, as I said in not answering Commissioner Steiger's first question.

But I do think that it is an issue worth thinking about. And the only thing that separates this stuff from Winnipeg from Albuquerque is that it does go across a national barrier; and if that's relevant, it's relevant; and if it isn't relevant, it isn't relevant.

I can't resist as sort of a final touch -- I don't know whether this client would consent to what I said, my telling his story. The product is beer, which is highly protected in Canada; and he was the international fellow for my client who was a gigantic brewery in the West.

I said to him, if there were no trade barriers to Canada, how far east would you be able to compete. And he said: Oh, at the prices that they are able to charge in that market, I could ship it three times around the world and land it in eastern Canada make quite a lot of money.

COMMISSIONER STEIGER: Good ending. And, as always, provocative.

Can we take just 10 minutes now and give everybody a chance to get a cup of coffee and our court reporter to change the paper, which has got to be running out; and we will resume in 10 minutes for such discussion as you want to consider arguing or commenting among yourselves.

[Recess.]

COMMISSIONER STEIGER: Mr. Reporter, we will go back on the record.

And who would like to open up either in response or in addition?

MR. NELSON: Well, if possible, I'll start just to clarify something.

COMMISSIONER STEIGER: For the reporter, will you start out with your name.

MR. NELSON: I am Philip Nelson.

Mark was talking about the paper in the study of imports that we did to test the Landes and Posner hypothesis. And just to clarify, we actually did -- or tried to do a series of studies, just like the one that Mark described for his case, to try to see if, in the early '80s, when the value of the dollar really went up, whether there was imports in the three digit or four digit SIC codes.

And what we observed was there were a lot of industries where you didn't get the rise in imports that Landes and Posner would have predicted. So we did a lot of mini studies, and Mark did one study where he found the opposite result. And I'm not at all surprised at all that there are some markets where you get the imports. And what we did is found there are some markets where you don't get the imports.

And so the conclusion we reached was you can't, as a general proposition, adopt the Landes and Posner type of test. And so I think Mark and I actually entirely agree about whether one can use imports for those types of tests. And I don't think Mark is probably surprised. In some cases, it comes out one way; and in other markets, it comes out another way.

The other little comment that I had -- well, I guess, two comments on Robert Bell. One is, I really think it was good of him to point out the what I call the critical loss analysis. There are two economic journal articles, one by Barry Harris and Joe Simon, and another by Gail Mosteler and John Morris where both tried to sort of specify critical loss and give you the elasticities.

And my firm has done numerous cases where we've gone into the agencies and used that type of analysis to try to show that -- and I have one in mind in particular which involved metal that goes into catalytic converters and it was able to show that the U.S. metal industry raised the price, the automobile manufacturers could go to Japan and get metal for their catalytic converters, and there was enough capacity in Japan and stuff to defeat the price increase so that there are cases, and the agencies have listened to those cases and walked away when you can show the imports can fill that critical need.

And so I think that's a very effective piece of evidence, and it's something that the people should think about. But, again, it's fact-specific and you need to show that the capacity is there and that the customers will turn.

I had asked a question of -- the second point is I had asked a question of Robert in my opening remarks, and I just was curious if he could describe the discovery that went on in the Kodak case as to whether he thought it was complete where the government just simply didn't ask for additional price data or whether they asked and the judge turned them down. You know, what went on there?

COMMISSIONER STEIGER: May interject one question? Prerogative of the chair.

I did not hear, by the way, in this roundtable, which focused so heavily on Kodak, understandably, any disagreement that the bottom line of the case was rightly decided.

As you address some of these questions, could you also address for me what you think the real world litigation impact however of the reasoning that went behind that bottom line -- what impact will it have on federal and state antitrust presentations and arguments?

MR. BELL: Well, let me respond if I could.

In the Kodak case, the discovery that took place between the date the case was set for trial and the actual trial was fairly minimal; although, the government wasn't denied any discover it sought.

But the reason it was so minimal is because Kodak had gone to the Justice Department in 1990 in an attempt to negotiate a resolution of those old decent decrees. And for about three years, Kodak had supplied lots of information to the government, including lots of documents in its effort to persuade the government to consent to lifting those decrees.

And as a result, the government didn't feel like it needed to take very much discovery, having done a three-year investigation.

I think that some of the kind of evidence that you really need to litigate the cases under some of these theories is very difficult to obtain in any situation.

I mean, if you are going to look, for example, at price discrimination, price discrimination, as economists know, is not just a difference in price, it's a difference in price at least at different margins.

Well that implies, then, that you have got to figure out what the firm's marginal costs is and what its margins are in different areas of the world; and firms aren't just set up in a way that they can provide that kind of information. I mean a lot of that depends on accounting assumptions and other assumptions that make no sense to an economist. So some of this information is pretty elusive at best.

If I could, just let me respond to a couple of Mark's comments. I very much agree with Mark that the bias ought to be in favor of finding markets that are larger than the United States.

And I think if you look at the overall economy and look at trade flows, the amount of trade flows that are really affected by tariffs and quotas and the other kinds of things that some of our comments have focused on is really very small in the context of the overall economy. And I think it would be poor policy to kind of let that very small number of instances kind of wag the bigger dog here.

There's been a little bit of discussion about the exchange rate examples and using that as a proxy for a price increase. I looked the other day in the Council of Economic Advisor's report; and if you look at it, from 1982 to 1992, a period where the U.S. economy was going at about 2 or 3 percent a year, imports into the U.S. doubled, which means they were growing at a rate of roughly 7 percent a year. That was a period, of course, during mid '80s when we did have a big change in relative exchange rates with some important trading partners.

So right there it makes you think that, well, there may be a lag in the kind of response you get with exchange rates. Certainly there is some kind of response.

My experience has been much the same as Mark's. And that is, if you look at a specific industry where imports were already coming in and the distribution system was already there, a change in exchange rates can produce a fairly significant change in import volumes.

And, again, you've just got to look very specifically at each industry to do that.

Finally, I don't think Mark and I really disagree very much on the point about differentiated products. The analysis is more difficult with respect to differentiated products.

And, again, the question is how good a substitute that foreign good is for the U.S. good. If it's not a very good substitute, it's unlikely to be able to exercise a price constraint.

But if you show it is a good substitute through various econometric techniques, then you're probably in a situation where, for the other factors I have mentioned, it may even be a stronger situation than with homogeneous goods because of the supply elasticity you would be dealing with.

COMMISSIONER STEIGER: Mr. Chairman, you had a question?

CHAIRMAN PITOFSKY: Well, yes. It sounds to me that there's general agreement here that automatic rules and everything comes in or nothing comes in is just not acceptable.

And also I think everybody agrees that you would want to be watchful about imports. There are going to be some situations where we know imports are highly interruptible.

I guess the key comes down to Lloyd Constantine's comment that they are inherently unreliable, if that's the way the NAAG guidelines put it. And maybe if you would sort of elaborate on that as to what is meant by inherently suspect, that would help.

MR. CONSTANTINE: Yeah. I think it really says that when assessing whether or not historical market share will continue or whether supply responses would increase market share would occur, you simply have to observe a series of cautions.

And one of the cautions will be, there are -- tariffs exist. Has there been any change. Is there likely to be any change in the tariff structure and quantitative restriction in transportation costs.

If you were dealing with a commodity where transportation costs were a significant portion of the final cost of the commodity, you simply would want to ask the question: Has anything about the transportation of this particular commodity changed over the last year or few months? You would want to know what was going on in shipping. And that's really all.

As I said, in my previous statement, it is a very modest point. It is not methodological xenophobia. What it is, I think it is right thinking in the sense that you should be aware of the fact that since the repeal of the Articles of Confederation, we don't have many -- although we do have some -- we don't have many tariff berries between our states; but we still do have those with respect to foreign countries.

Now, when I think about these issue with respect to Canada and probably increasingly with respect to Mexico, I think almost automatically the assumption will be that: I don't have to think about these things any more with respect to Canada, except I would want to be aware of the fact that there is a highly protective industry.

I would want to be aware of the fact -- if the price of cheese was going up in the United States, I want to know whether raw milk was used in foreign cheese and whether that could easily go over the border or whether not. I remember that particular example occurring with French raw milk cheeses. That's all.

And as I say, it is a modest point. Perhaps the use of the term "inherent," "skepticism" it's too strong. But it's just a semantic error.

COMMISSIONER STEIGER: Kodak litigation impact. I'm not going to let you off.

MR. CONSTANTINE: As I stated, I think that the bottom line was correct because I think the specific restrictions in the decrees had out-lived their usefulness. And it was fine that they were gone. I would have wished that the Justice Department had seen the wisdom of that and simply lifted them without having to have these two decisions.

I think the decisions -- and when I read in the journals now, and there's just recently been an influential article in the New York Law Journal -- saying that this now is the leading decision, I think for a period of time, this will be the leading decision on this issue.

And because of the errors in advocacy and the error in ultimate judgment, I think it is going to be a damaging decision because I think it was wrongly decided.

When I look at this set of fact, again, not using the term "market power" in a pejorative -- I will assume for this that Kodak has market power and that it achieved it through film and business acumen. But when I see film selling at a 10 percent Wholesale premium -- which I consider to be the relevant premium -- doing that over a long period of time and maintaining six times the market share of the next competitor -- who has been in the market for a long time, price is significantly less, has a huge advertising campaign -- to me, that is indication that, both, this is a market and that Kodak is exercising power within that market.

And, therefore, everything that gets me up to that decision, the decision of the Second Circuit and, more specifically, the decision of the Western District, I think is it unfortunate and inevitable that it will be emulated and copied. It will be the first thing that people advocating will have to deal with on both sides; and it will be the first thing that busy judges will look to when writing the next decision. So it's unfortunate.

MS. VALENTINE: Although, what is it really in the decision? If the decision says the government didn't provide us with cost information here or it didn't show anything more than a short synopsis in time, six months or a year, and you, in fact, came in with the facts that you think you see. Won't you be fine?

MR. CONSTANTINE: As I indicated, again, I think that the Justice Department failed to develop certain facts or potential facts which were available to them. And that was their problem.

Even, however, the undeveloped facts and the meager facts at the disposal of the Court and the one I just singled out, market share of 67 or 75 percent, six to seven times the market share of your rival and a 10 percent premium, to me, that was partial summary judgment on that issue.

And I think that's unfortunate. And I don't see anything in the determination which justifies that you can say, as the court did: Well, I would have liked to see more on price discrimination. I would have liked for them to assert, for example, that Kodak was able to discriminate between American buyers, German buyers, and Japanese buyers. And that, then, if Fuji started to flood the market with less expensive film, Kodak could have paid the favor back in the Japanese market, a strategic response and that might have had some moment in the situation, which it might. And the court said they didn't show me that. They showed me meager evidence.

But having said that, they could have done a better job. Justice could have done a better job. But even given the meager facts, I think the decision is in error and an influential error; and I think we will all labor under it.

COMMISSIONER STEIGER: Is that because of the -- simply given the reliance on the Landes-Posner?

I guess that is my underlying question as to whether that is now a standard --

MR. CONSTANTINE: At the risk of sounding parochial and chauvinistic, the Second Circuit is an influential court; and I think that they have resurrected, you know, Freddie Krueger in this particular situation.

And it's unfortunate because I think the hypothesis is so wrong headed to justify it and dignify it in the most recent influential case involving, you know, the history of antitrust. The Kodak case is a big, important case. Now you're seeing the passing of two very important decrees. This is not an insignificant product in a less significant court some place out there. This is going to be an influential case. And it has breathed unjustified life into Landes-Posner.

MR. NELSON: I'll let you have an immediate response, and then I'll jump in.

MR. BELL: Well, I hardly know where to start.

But let me just try to focus the discussion on market definition since I think that's really what we were trying to look at today.

In the Kodak case, we have a situation where one-third of domestic consumption was imported. Those imports had been persistent and ongoing. About 10 percent of U.S. production -- the only producer is Kodak -- was exported.

The government agreed with us that there was a very high supply of elasticity, that the foreign competitors could make a lot of film and they would be more than happy to sell it in the U.S. They had the distribution already in place to sell more.

And, finally, the evidence we put on, which was very interesting, that you can do now with point of sale data that you get off the computer, showed that Kodak film and Fuji were almost perfect substitutes for each other. We showed that when, at various stores, Kodak film goes on sale and the price of Kodak film goes down, the quantity of Kodak film sold goes straight up and the quantity of Fuji goes down.

But conversely, when Fuji film goes on sale and is at a lower price, its volume immediately goes up and the Kodak volume goes down.

So we were able to show that these were very good substitutes, that there had been a high level of persistent imports and there was a high supply elasticity. To me, that is the paradigm of a world market.

We did not rely solely on the Landes-Posner formulation. What our expert testified was that, under any widely accepted market definition notion this was a world market. The testimony was, it's obviously a world market under Landes-Posner because almost anything is; that it met the Elzinga-Hogarty test; it was world market under the Elzinga-Hogarty test; and that it was a world market under the merger guidelines.

So on the issue of world market definition, I think the court was absolutely right, obviously; and I don't think it's a particularly dangerous precedent. I totally agree with Lloyd that it's a very important case, and I think it's the first place the court's are going to look when faced with these kind of issues.

COMMISSIONER STEIGER: I don't know if I feel better or worse.

Go ahead, Phil.

MR. NELSON: Well, maybe I can make you feel a little worse.

COMMISSIONER STEIGER: Well, I depend on it from an economist.

MR. NELSON: What I thought I would do is bring the Kodak test a little closer to home. The FTC has a precedent called the General case, FTC v. General Foods; and it is a kissing cousin of the Kodak case.

The argument by the FTC staff was that there were regional markets in the United States, not a national markets. The FTC staff introduced evidence that General Foods coffee was sold below the price of unroasted green beans in Cleveland, Ohio, Youngstown, sales district of General Foods, at the same time a 50 percent rate of return on invested capital was being earned in the Washington, D.C. market. These numbers are all in the public record, so don't worry about this.

And there were trade dealing principles in the General Foods strategic plans saying: We will charge different prices in different areas of the countries -- actually different discounts in different areas of the country and trade deal different, depending on how large our market share is to the share of the next largest branded competitor.

So there was all sorts of pricing evidence showing a lowering of prices in one part of the country.

It gets through the ALJ and to the Commission. It was a split opinion. And basically Kenneth Elzinga who testified for General Foods argued it was a U.S. market based on shipment patterns data. The Commission adopted a national market; so, therefore, all the regional, strategic behavior evidence was tossed; and the market shares were looked at a national level so that General Foods market share was quite small because it had a small share of the West Coast; and the 50 percent market share for General Foods in the entry markets was ignored.

So that is a very close parallel to the Kodak case. And you've got it on your own precedent.

And so all I can say is --

COMMISSIONER STEIGER: That's the sort of thing the Chairman deals with.

MR. NELSON: Anyway, I think the issue of how you handle geographic market definition when there is a geographic product differentiation, different demand curves, perhaps, in different parts of the world or in different parts of the country is a very tricky issue; and it's probably worth your while thinking about it some.

MS. VALENTINE: Is this why you asked us to reexamine Elzinga/Hogarty and trade flow data?

MR. NELSON: Well, it is a case that I had in mind. John Hilke and I worked on it. It was the first case we ever worked on outside of graduate school. We joined the FTC, and we both testified in this case, at least I didn't testify on geographic market. I think John testified on that.

MR. HILKE: I did.

MR. NELSON: So for what it's worth, you've got a case to think about of your own that's very much like Kodak.

COMMISSIONER STEIGER: I'm glad you told the Chairman.

MS. VALENTINE: Although, in defense of the Second Circuit, I guess what I would argue if I had to argue against, Lloyd is that, in fact, all the Second Circuit held with respect to either Elzinga/Hogarty data or Landes-Posner is that, yes, they do also support the market; but it didn't embrace them. And I think I would be happy to go against Bob Bell and argue that Landes-Posner should not always apply.

But, Rob, one thing that I think we have heard a lot this afternoon is how important facts are. I think Phil started with that, and Lloyd certainly chimed in.

And, obviously, as we sit here, the question is where are we going with all of this? What do you think we should do?

At one point I thought you were almost going to say, analytically the guidelines have it right and we've got it right. I'm not sure if that's where you are or not.

And I guess I would like to hear from all of you in terms of whether the guidelines are fine in form.

But what is your analysis really going to add to what we already do under the guidelines in just looking at hard facts?

Why will assumptions about demand elasticity and foreign firms not colluding, presumably because of exchange rate problems, how is that going to help me? Do I really want to embody that in some sort of approach or presumption?

MR. BELL: Well, I think you can embody the general idea that you don't need to take the intermediate step of trying to precisely define markets and assign markets shares.

I guess I get real nervous when I hear people -- and I heard a little bit of this earlier today -- saying: Well, we've got this market and there's a little of potential for some political interference; so maybe we'll discount this market share a little bit and maybe we'll take this one and maybe we'll add all of their capacity.

It seems like you end up making a lot of assumptions about market share and then giving too much reliance on market share.

I would much rather look at that ultimate question of whether producers abroad can discipline price increase in the United States.

And I don't mean that a price elasticity of one ought to be written in stone. I'm just using that for illustrative purposes. I mean, we know a monopolist will always be at least an that region. And so that's not a bad assumption.

Let me just address the collusion point a little bit. I haven't really thought this through carefully; but I think the Commission's analysis in Donnelly is really very pertinent here.

The Commission really convincingly showed there that a deviation from collusive group by a producer with a relatively small market share could defeat collusion under those facts. And these cases are going to vary all over depending on the facts.

In some cases, collusion may be more likely with foreign producers. You may have a couple of foreign producers that come from places with a history of collusive behavior who are used to antitrust regimes who wink and nod at that; and you may discount that in certain situations. And I think that may be proper under certain facts.

On the other hand, I think there are going to be a lot of times where if you have foreign producers from different countries, there are going to be additional factors that are going to make it even more difficult for them to collude than say, for example, for domestic producers.

And one example of that is exchange rate fluctuations. Just think of an example where you've got a foreign producer and a French producer shipping into the U.S. and you're imaging that they're going to collude, everything the relative exchange rates change the profitability of that collusion changes for one of those two; and they have got to constantly, then, renegotiate the terms of their collusion.

And that's one of the things that starts to make it seem a little bit more unlikely.

COMMISSIONER STEIGER: Why can't they just let it float within the boundary?

MR. BELL: Well, maybe they can. But this is just another barrier to them reaching an agreement that's going to last for any period of time.

COMMISSIONER STEIGER: I press that only because the fluctuations are rarely like this. They are generally incremental, and I could perceive a collusive agreement that we could talk about with the --

MR. BELL: Kind of like the European snake? You float within a band?

COMMISSIONER STEIGER: Well, they seem to be doing it on a daily basis, though.

But I would not disagree with that.

You're very quiet over there having started all this.

Do you want to wind it up for us?

MR. LEDDY: Well, I don't know whether I want to wind it up. But I'll try to respond to some things that were said, and I'll try to answer Debra's question.

One thing that Robert said about margins, that companies really don't know their margins and their relative margins for export opportunities -- at least I thought that's what you said, Robert?

MR. BELL: No. I was actually addressing the geographic price discrimination point and noting that to really determine whether geographic price discrimination is occurring, you've got to know what a company's margin is in each different region of the world you're looking at.

And that can be something very difficult to ascertain as a matter of economics.

MR. LEDDY: Okay. I guess I would like to think about that. But my own experience is that most companies know very closely what their margins where they sell any product they sell.

MR. BELL: Well, but I think you're confusing an accounting margin.

MR. LEDDY: No, I understand the difference between economic margins and accounting margins; although, in the absence of the former, the latter can tell you a lot, not as much as the former; but they can tell you what the relative value of moving your exports is, which is the question I was addressing

MR. BELL: Yeah. Sure.

MR. LEDDY: And to go to Debra's question, I think that's the kind of information the Commission ought to try to capture, both with respect to domestic firms and foreign firms: What are your margins in respect to Commodity X, to gasoline you're selling in Europe, as opposed to the margins of the gasoline you're selling in the U.S.?

And that can tell you a lot, I think, about whether or not the hypothesized price increase in the U.S. will draw gasoline from Rotterdam. I think that's the kind of information, especially in commodity markets, that can help you make these difficulty predictions.

I guess the other point I wanted to make was in response to Lloyd's, I think, helpful characterization of the language inherently suspect as a note of caution; and just to try to put this in some sort historical context, if you recall the very first set of Guidelines to address this issue, the 1982 Merger Guidelines they also used those words, that we will be more cautious, I think is the quote, in looking at foreign production as a possible disciplinary force.

But you also might remember that two years later that was revised in the face of the firestorm of criticism generated by the Republic LTV case when the Justice Department sued on, in effect, a domestic market in a flat and hot rolled sheet, and stainless steel. And people in the administration, like then-Secretary Baldridge and others called it a world class mistake and that the Justice Department ought to be more open, and the FTC ought to be more open to the internationalization of markets.

And as a result, the -- well, after that happened there was a change in the Merger Guidelines in 1984 which was much more open to the idea of foreign competition as a constraint than the 1982 guidelines.

In fact, it said, we may even disregard quotas because over the long-term they are very difficult to predict. And it has been moving back from that to, I think, more caution in the present guidelines.

My only point is the politics of antitrust, whether it's in terms of the international politics, blocking trade or the domestic politics of antitrust, ought not to discourage us from trying to find and utilize the appropriate analytical model, which is look at the facts to determine whether or not, at the margin, foreign competition is going to discipline a domestic price rise and try to remove your biases, if possible.

If, in the close case, though, to reiterate what I said before, there's a choice between skepticism about international trade over the medium- and long-term and confidence that it will continue, I would choose the latter rather than the former.

COMMISSIONER STEIGER: Yes, go ahead, Lloyd.

MR. CONSTANTINE: I was just going to make one very small point, which is: I think what you do is more important than what advocates do.

When I was coming in here to make a point today, I ran out to the store and I bought the Kodak and Fuji film, and I said: See $5.49 for Kodak and $3.69 for Fuji. And what Bob has done as an advocate has said, you know, if you would track that, we would be able to show you that the sales of Fuji surged; and if were representing the other side, I would be able to show you that sales of Fuji did not surge, because that's what we do in these cases. We find the right example, and we lacquer it up and present it to the courts and to the agencies.

But what you do is more important because ultimately you have to choose between the advocates and the information which is pushed at you.

I think that's where historical data becomes very, very important. And just to go back to the point I made before, Fuji has been in this market for a long time; and it's been flying its blimps around and trying to penetrate this market and pricing well below Kodak for this entire period of time. I think a lot more below Kodak than the 10 percent. But in any event, let's just take it at 10 percent.

The bottom line is that at the point of a decision in the case, they stood at one-sixth the market share with 10 percent lowering pricing. To me, that would have ended that discussion.

Certainly the advocates can come forward with the examples that support their case. And I think the lesson from that is that there are facts, and there are facts; and the most important facts, I think, are historical data. I mean it can be projections about what may happen in the future. But there are usually analogous situations in the past. You say: What happened the last time this came around?

And I think those are the kinds of things that courts and agencies sitting as courts have to be very, very attendant to.

And that's the only point. It's just an amplification of a facts point, but I think it bears repeating.

COMMISSIONER STEIGER: Well, I'm glad to hear we shouldn't believe either one of you. Truth lies in the middle.

Mr. Chairman, will you wrap up for us? This has been a wonderful afternoon.

CHAIRMAN PITOFSKY: Well, that's my wrap up. This has been as fine a discussion of this subject I've seen or heard, and I really appreciate you folks coming in and doing such a superb job.

Thank you.

(Whereupon, at 4:04 p.m., the hearing was concluded.)

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C E R T I F I C A T E

DOCKET/FILE NUMBER: P951201

CASE TITLE: GLOBAL AND INNOVATION-BASED COMPETITION

HEARING DATE: October 19, 1995

I HEREBY CERTIFY that the transcript contained herein is a full and accurate transcript of the notes taken by me at the hearing on the above cause before the FEDERAL TRADE COMMISSION to the best of my knowledge and belief.

DATED: October 24, 1995

SIGNATURE OF REPORTER

Gregg J. Poss

(NAME OF REPORTER - TYPED)