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JAYS FOODS, INC. v. FRITO-LAY

August 1, 1985

JAYS FOODS, INC., A CORPORATION, PLAINTIFF,
v.
FRITO-LAY, INC., A CORPORATION, DEFENDANT.



The opinion of the court was delivered by: Moran, District Judge.

MEMORANDUM AND ORDER

This action, in which plaintiff Jays Foods (Jays) alleges that it was a victim of predatory pricing, comes before this court ten years after the seminal article by Professors Areeda and Turner which outlined a cost-based definition of predatory pricing. Areeda and Turner, Predatory Pricing and Related Practices Under Section 2 of the Sherman Act, 88 Harv.L.Rev. 697 (1975). Defendant Frito-Lay's (Frito-Lay) motion for summary judgment on Count I requires this court to determine what fealty to give cost-based tests of predatory pricing in light of a decade of judicial responses to the article and its progeny. It also comes in the wake of full and complete discovery. The question, therefore, is whether there is sufficient evidence to create triable issues.

I.

Frito-Lay is a national producer of a full range of salty snack foods such as potato chips and pretzels. Its competitors include regional suppliers of a more limited range of snack foods. Jays is one of these regional competitors. Its primary product is potato chips and its market consists of parts of Illinois, Wisconsin, Michigan and Indiana.

In an antitrust case plaintiff has the burden of establishing the relevant product and geographic markets. See L.A. Draper & Son v. Wheelabrator-Frye Co., 735 F.2d 414 (11th Cir. 1984). While Jays' complaint covers several products and geographic markets, for purposes of the motion for summary judgment the relevant geographic market is the Chicago area and the relevant product is potato chips. The summary judgment motion is further focused on the sale of potato chips in supermarkets. Supermarket sales account for over 60 per cent of the total sales of snack foods. The Chicago market is presumably the center of Frito-Lay's allegedly illegal competitive practices, and is the largest market served by Jays.

Potato chip sale levels are related to the amount of supermarket shelf space available to a supplier. Sales levels are also related to promotional incentives given stores and their customers. Sufficient shelf space is also required to introduce new products. Stores allocate shelf space to suppliers on the basis of the sales of each supplier's products.

There seems to be little doubt that in the day-to-day commercial warfare between snack food suppliers the key battle is over shelf space. Frito-Lay believed that the company with the greatest share of potato chip business would control the entire salty snack sections of the supermarkets. Because potato chip sales were the core of the regional competitors' strength, Frito-Lay especially sought to increase its market share of potato chips. In its complaint Jays alleges that Frito-Lay provided misleading and inaccurate market studies to major retailer chains in order to increase its share of shelf space at the expense of other competitors. Frito-Lay also allegedly engaged in advertising and promotional practices which helped it to secure additional shelf space. Finally, Frito-Lay allegedly used its dominance in the corn chip market as leverage to induce stores to provide additional shelf space for its other products.

During the 1974-1980 period which is the subject of this lawsuit,*fn1 Jays was the larger of the two potato chip suppliers in the Chicago area. During the same period Jays was apparently attempting to expand into other salty food product lines and become a supplier of a full range of snack products. Both companies' sales grew during this period. In 1974 Frito-Lay's Chicago division had total sales of $7,559,630 and showed a loss of $35,329. By 1980 its sales had nearly doubled to $13,545,170 and its profits had reached $1,057,830. The record does not contain figures for Jays' performance in the Chicago market. Jays' total net sales grew from $22,970,172 in 1974 to $44,352,969 in 1980. Jays' pretax profits rose from $139,749 in 1974 to $2,319,620 in 1977, before tapering off to $948,557 in 1980. The record does not indicate what shifts occurred in each company's share of the Chicago potato chip market.*fn2

The record makes clear that Chicago was one of the "problem" markets for Frito-Lay. Frito-Lay faced strong local competition in potato chip sales and its performance lagged relative to other markets. Consequently, Frito-Lay devoted extra promotional and advertising resources to the Chicago market. These promotions included substantial price discounts, some of which were unauthorized, and a strong emphasis on potato chips in the supermarket display shelves ("overfacing").

The record suggests that Frito-Lay set its prices with an eye towards competitive conditions. A summary of Frito-Lay's pricing objectives identified three approaches to pricing based on market conditions. In high-growth product categories, where Frito-Lay had market leadership, prices were to be set "most aggressively." In low-growth categories, where Frito-Lay had shared market leadership, prices were to be less aggressive. Finally, in "low-growth categories where we do not dominate we will price competitively (e.g. potato chips)."

What is also evident from the record is that Frito-Lay's guide in setting prices was its corporate financial goals. Its pricing decisions were "designed to maintain total corporate gross margin at target level of 50%."

According to Jays, Frito-Lay also sold potato chips in Chicago for a lower profit in order to increase its market share. Frito-Lay purportedly was willing to lower its profit in Chicago and other problem markets because it could subsidize these lower profits with the higher profits earned in markets where it faced little or no competition. Frito-Lay's prices for identical products varied from market to market, at least in part because Frito-Lay took over regional companies with established price patterns. Regional price variations also resulted from the different competitive conditions faced by Frito-Lay in various markets. Frito-Lay prices for some potato chip products in the Chicago market were lower for significant periods than prices for the same products in other markets.

Jays' first amended complaint contains three counts. Count I alleges that Frito-Lay has engaged in predatory pricing in violation of Section 2 of the Sherman Act. Count II is brought under Section 2 of the Clayton Act and alleges that Frito-Lay has engaged in illegal price discrimination. Count III contains pendent claims brought under the deceptive trade practices laws of the states served by Jays and alleges that Frito-Lay engaged in anti-competitive conduct. Jays claims that it sustained a loss totalling $4,311,806.73 for fiscal years 1975-1981, because of its inability to increase prices to reach a 6% pre-tax rate of return as a result of Frito-Lay's anti-competitive conduct.

II.

In Count I Jays claims that Frito-Lay attempted to monopolize the Chicago market for potato chips in violation of Section 2 of the Sherman Act. 15 U.S.C. § 2. The elements of an attempt to monopolize are (1) intent to control prices or destroy competition with respect to a part of commerce; (2) predatory or anti-competitive conduct directed at accomplishing the unlawful purpose; and (3) a dangerous probability of success. Chillicothe Sand & Gravel Co. v. Martin Marietta Corp., 615 F.2d 427, 430 (7th Cir. 1980).

The parties agree on the definition of predatory pricing as the dominant firm's deliberate sacrifice of current revenues through lower prices for the purpose of driving rivals out of the market. Once it has vanquished its rivals, the dominant firm can more than recoup its short-term losses through higher profits earned in the absence of competition. MCI Communications Corp. v. American Telephone & Telegraph Co., 708 F.2d 1081, 1112 (7th Cir.), cert. denied, ___ U.S. ___, 104 S.Ct. 234, 78 L.Ed.2d 226 (1983). The parties disagree on the proper test for predation, namely, the sufficiency of cost-based measures of predation and the relevance of non-cost indicia of predatory intent.

The modern era of predatory pricing analysis was ushered in by Professors Areeda and Turner. Areeda & Turner, Predatory Pricing and Related Practices Under Section 2 of the Sherman Act, 88 Harv.L.Rev. 697 (1975). They argued that prices at or above marginal cost, even if not profit-maximizing, generally should be presumed to be non-predatory. Id. at 711. Marginal cost is the "increment to total cost that results from producing an additional increment of output." Because marginal costs are difficult to determine, Areeda and Turner advanced average variable cost as an acceptable surrogate for marginal cost. Id. at 716-718. Variable costs are costs which vary in a short run with changes in output. Such costs include items such as materials, labor, fuel, use depreciation, and a return on investment needed to attract enough working capital to pay for variable costs. Average variable cost is total variable cost divided by output. Fixed costs, in contrast, are costs which in the short run do not vary with changes in output. Fixed costs include such items as management expenses, interest on bonded debts and other items of irreducible overhead. Total cost is the sum of fixed and variable costs and average total cost is the total cost divided by output. See generally Northeastern Telephone Co. v. American Telephone & Telegraph Co., 651 F.2d 76 (2d Cir. 1981).

The Areeda & Turner formula has won wide if cautious acceptance by the courts. Some courts have hewed closely to average variable cost as the conclusive test of predatory pricing. See e.g. Barry Wright Corp. v. ITT Grinnell Corp., 724 F.2d 227 (1st Cir. 1983); Northeastern Telephone, supra. Most courts have recognized the central importance of a cost-based test of predatory pricing, but have noted that in unusual circumstances special market characteristics, such as high entry barriers, might permit a finding of predatory pricing even if prices were above average variable cost but below average total cost. See e.g. Chillicothe Sand & Gravel, 615 F.2d at 431-32; Pacific Engineering & Production Co. v. Kerr McGee Corp., 551 F.2d 790, 797 (10th Cir.), cert. denied, 434 U.S. 879, 98 S.Ct. 234, 54 L.Ed.2d 160 (1977); International Air Industries, Inc. v. American Excelsior Co., 517 F.2d 714, 723-25 (5th Cir. 1975), cert. denied, 424 U.S. 943, 96 S.Ct. 1411, 47 L.Ed.2d 349 (1976). The Ninth Circuit has strayed most from sole reliance on a cost-based test of predation. See Transamerica Computer Co., Inc. v. IBM Corp., 698 F.2d 1377 (9th Cir. 1983). See also D.E. Rogers Associates, Inc. v. Gardner-Denver Co., 718 F.2d 1431 (6th Cir. 1983), cert. denied ___ U.S. ___, 104 S.Ct. 3513, 82 L.Ed.2d 822 (1984). In Transamerica the court held that by reference to non-cost factors a plaintiff could show that a defendant engaged in predatory pricing even if its prices were above average total cost. Id. at 1386-88.*fn3

In Chillicothe Sand & Gravel the Seventh Circuit recognized the centrality of the average variable cost test in the analysis of a predatory pricing claim. It cautioned, however, that non-cost factors were not to be neglected when determining whether a defendant's pricing policy was predatory:

    [W]hile we accept the use of marginal or average
  variable cost as both a relevant and an extremely
  useful factor in determining the presence of
  predatory conduct we are willing to consider the
  presence of other factors in our evaluation of
  whether or not plaintiff has made out a prima facie
  case of monopolizing or attempt to monopolize.

615 F.2d at 432. Indeed, after concluding that defendant's prices were above average variable cost, the Chillicothe court went on to consider and ultimately to reject a variety of non-cost factors which plaintiff had argued revealed defendant's predatory intent. Id. at 432-34.

In MCI Communications Corp. v. American Telephone & Telegraph Co., 708 F.2d 1081 (7th Cir.), cert. denied, ___ U.S. ___, 104 S.Ct. 234, 78 L.Ed.2d 226 (1983), the Seventh Circuit confronted allegations that AT & T had engaged in predatory pricing of two of its services for long distance business communications. MCI, 708 F.2d at 1111. The issue at MCI was not the validity of the Areeda and Turner average variable cost test; neither party ever argued for application of a short run cost standard. 708 F.2d at 1115. While MCI noted some of the shortcomings of the average variable cost test, id. at 1115-16, the decision cannot be read as a repudiation of that test. In fact, the court expressly stated that "pricing below average variable cost is normally one of the most relevant indications of predatory pricing." Id. at 1120, n. 55.

Perhaps the strongest and most repeated criticism of the average variable cost test of predatory pricing is its focus on short term rather than long term costs. See e.g. Scherer, Predatory Pricing and the Sherman Act: A Comment, 89 Harv.L.Rev. 869, 890 (1976). Then Professor Posner, for example, recognized the usefulness of the Areeda and Turner average variable cost formula, but concluded that predatory pricing also exists when a company sells its product below its long-run marginal cost with the intent to exclude a competitor. R. Posner, Antitrust Law, at 189. Long-run marginal costs are costs that must be recovered in order for a business to survive into the indefinite future. Id. Because all costs are variable in the long run, long-run marginal costs include both the fixed and variable components of short-term costs.

In MCI the court adopted the long-run incremental cost of providing the two long distance services as the standard by which to determine if AT & T's prices were predatory. The long-run incremental cost of producing a product is total company cost minus what the total cost of the company would be in the absence of manufacturing the product, divided by the quantity of product being manufactured. See Baumol, Quasi-Permanence of Price Reductions: A Policy for Prevention of Predatory Pricing, 89 Yale L.J. 1, 9, n. 26 (1979). Long-run incremental cost includes fixed as well as variable cost of both capital and operating items. Unlike measures of fully distributed cost, long-run incremental cost is calculated with reference to current and anticipated cost, rather than historical or imbedded cost. MCI, 708 F.2d at 1116-18. The long-run incremental cost test, in short, measures the costs caused by the production of a product. Id. at 1116. Other courts have been slow to adopt the long-run incremental cost approach.

MCI is also important for its discussion of the role of non-cost factors in the analysis of predatory pricing. The court's most complete statement on the issue was:

    We do not intend to imply that in all cases and in
  all circumstances we would only examine the
  price-cost relationship of a product or service. Our
  test merely suggests that a judge and jury may not
  infer predatory intent unless price is below long-run
  incremental cost. . . . [However,] a strong
  presumption of lawfulness must attach when price is
  ...

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