What is the Rule of Reason?

by | Jan 23, 2023 | Antitrust

Some business practices, called per se violations, so obviously violate the antitrust law of the United States that an American court would always consider any such practice to be an antitrust violation. But other conduct may cause antitrust injury, but may not. To evaluate such complex business practices an American court would apply the Rule of Reason.

A court applies Rule of Reason analysis when it is using Section 1 of the Sherman Act to evaluate an agreement between competitors. Any agreement will, by definition, impose a restraint of trade. The Sherman Act, however, only prohibits an agreement which imposes an unreasonable restraint of trade.

To determine if the agreement imposes such an unreasonable restraint of trade a court would, following extensive Supreme Court precedent, apply a 3-prong test:

  1. First the plaintiff, the one making the antitrust claim, must show that the restraint harms competition.
  2. If the restraint does harm competition, then the defendant can show how, in some way, the restraint encourages firms to conduct business.
    For example, it may encourage business formation.
  3. 3. If the restraint does encourage business activity, then the plaintiff would try to show that another, less restrictive agreement, would achieve the same market result. If it would, then the agreement would violate the Sherman Act

1. Restraint Harms Competition

Case law makes very clear the competitive effect of the allegedly unreasonable restraint must harm competition itself, not just a competitor. To show harm to competition plaintiffs usually use what a court would call the indirect method. To do this the plaintiff must:

  • Define the relevant market
    The market includes both current producers and those who could produce the product. It also includes similar products which consumers could also use. Plaintiff use complex economic analysis to determine which products are sufficiently similar.The geographic area in which the competitors do business.
  • Show that the defendant has market power in this market.
    A 30% market share may be sufficient to establish market power. A court would also consider all market circumstances, such as barriers to entry and the strength of other competitors.

An unreasonable restraint of trade is one which harms competition. And a defendant would harm competition if it used its market power to:

  • Raise prices, or
  • Restrict output, or
  • Reduce quality, or
  • Create or enhance a company’s market power.

2. Procompetitive Justification

In the typical antitrust case, the defendant would claim that the exclusionary conduct is justified because it:

  • Enhanced efficiency, or
  • Promoted inter-brand competition, or
  • Increased customer service by preventing other retailers from benefiting from one retailer’s investment in customer service, or
  • Increased output, or
  • Improved product quality, or
  • Helped create a new product, or
  • Protected intellectual property

3. Less Restrictive Alternative

In this step antitrust analysis can become complex. If the defendant has provided a sufficient procompetitive justification, then, to show a violation of the Sherman Antitrust Act, the plaintiff must show that a less restriction alternative would have achieved the same goal while having less of an anticompetitive effect.

A restraint on trade can be included in horizontal agreements or vertical agreements. Horizontal agreements are among competitors and federal antitrust law, and therefore the Antitrust Division of the Dept. of Justice, and the Federal Trade Commission, are usually suspicious of such agreements.

These authorities, and courts, are less suspicious of vertical restraints. One type of restraint they may be inclined to look at, however, are resale price maintenance agreements, agreements in which a manufacture or distributor tells a retailer what price to charge consumers. An authority or court would be particularly concerned if the firm seemed to be abusing its market power. Further, some state antitrust laws make resale price maintenance agreements per se illegal.