Transcript The Economics of Marging Squeeze

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Margin Squeeze under EC Competition Law
organized by GCLC and BT
London, 10 December 2004
The Economics of
Margin Squeeze
A short history of
nearly everything
Dr. Jorge Padilla
Managing Director
LECG Europe
Brussels-London-Madrid-Paris
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Introduction
 Positive economics:
 What is a margin squeeze?
 Normative economics:
 What is the impact on consumer welfare?
 Using economics to design administrable
intervention rules:
 How to catch an anti-competitive margin
squeeze?
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Positive economics
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What’s a margin squeeze?
 Definition:
 A vertically integrated firm
holding a dominant position in the
upstream market prevents its
(non-vertically integrated)
downstream competitors from
achieving an economically viable
price-cost margin.
U
w
D1
D2
p1
p2
Consumers
Margin = Retail Price – Wholesale Price < Downstream Costs
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What’s a margin squeeze?
 Predation:
 It can do so by charging a
downstream price that is too
low relative to the input
price, with the result of driving
out some or all downstream
rivals, or at least significantly
weakening their competitive
positions.
U
w
D1
D2
p1
p2
Consumers
Retail Price < Downstream Costs + Wholesale price
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What’s a margin squeeze?
 Vertical foreclosure /
Refusal to deal:
 It can do so by charging a
wholesale price that is too
high relative to the
downstream price, with the
result of driving out some or
all downstream rivals, or at
least significantly weakening
their competitive positions.
U
w
D1
D2
p1
p2
Consumers
Retail Price – Downstream Costs < Wholesale Price
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Nihil novum sub sole
 Margin squeeze
Margin = Retail Price – Wholesale Price < Downstream Costs
 Predation
Retail Price < Downstream Costs + Wholesale price
 Refusal to deal
Retail Price – Downstream Costs < Wholesale Price
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The sacrifice fallacy
 The claim that margin squeeze is different than predation
because it involves no sacrifice is incorrect
 True p1 < w implies no direct
losses for vertically integrated firm
U
w
 But there is an opportunity cost, w,
for each unit not sold to downstream
competitor
 And that opportunity cost may be
very large when the wholesale price
is above the upstream marginal cost
 And even larger if D2 sells
differentiated products and/or is more
cost efficient – Chicago critique
D1
D2
p1
p2
Consumers
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Anticompetitive motivations
 Monopolization of downstream market, or relaxation
of competition in downstream market
 Salop and Scheffman, JIE, 1987
 Restoring market power upstream
 Rey and Tirole, Handbook of IO, forthcoming 2005
 Defensive leveraging
 Carlton and Waldman, RAND JE, 2000
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Showing margin squeeze is not enough
 Ability:
 Market power upstream and downstream
 Barriers to entry and re-entry
 Asymmetries between predator and prey
o Informational asymmetries
• Signaling
• Reputation effects
o Financial asymmetries
 Incentives:
 Upstream losses
o Regulated prices upstream
o Business stealing effect
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Pro-competitive justifications
 Predation:
 Aggressive competition – meeting the competition
 Dynamic pricing in markets with switching costs,
network externalities, experience or credence goods …
 Refusal to deal:
 Static efficiency – free riding in the provision of
services, quality certification, etc.
 Dynamic efficiency – profitability of ex ante
investments
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A “plain vanilla” static analysis is
necessarily misleading
 In many markets, privately and socially optimal pricing
policies are dynamic: current losses, overall positive
profits
Present
Current losses
cannot constitute
evidence of intent or
likely exclusionary
effect in emerging
markets
Future
Total
Revenues
Costs
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Any sensible approach implies assumptions
about future revenues and costs
Discounted Cash Flows
Future
Total
 Revenues
 Time evolution of prices
 Excluding anti-competitive
profits
 Costs
 Inter-temporal allocation of start
up costs
o Infrastructure costs
o Customer acquisition costs
 Time evolution of costs
o Economies of scale
o Learning by doing, etc.
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Normative economics
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Welfare implications
 Allocative versus productive efficiency
 It may be efficient to exclude “as efficient”
competitors and exclude “as efficient” entrants
o Excessive entry, excessive variety
 But it may also be efficient to allow entry of
“inefficient” competitors
 Static versus dynamic efficiency
 Ex ante incentives to innovate and invest
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Designing administrable rules
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Administrable rules
 Alternative legal standards:
 Per se rules
 Rule of reason
 Hybrid rules:
o Modified per se rules
o Structured rule of reason
 Selection criteria:
 Minimizing the expected cost of error
 Be cheap to administer
 Give economic agents predictability
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Administrable rules
 Choosing the right rule:
 Per se rules don’t work
 Rule of reason is very difficult and bound to lead
to erroneous decisions
 Options:
 Structured rule of reason: 3 stages
 Rebuttable presumptions:
o Imputation test?
 Modified per se rules:
o Exceptional circumstances test?
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Administrable rules
 The costs of type I and type II errors:
Price
Supply
Dynamic Loss=A
Static Loss=B+C
A
Price
Cost
B
C
Demand
Quantity
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Administrable rules
 The likelihood of type I versus type II errors:
 Likelihood of error is high
• Dynamic price-cost tests conducted ex post
• Debate over appropriate cost standard in static tests
• Pro-competitive explanations
• Confusing foreclosure with industry shakeouts
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Conclusions
 Nihil Novum Sub Sole
 Any sensible approach implies assumptions
about future revenues and costs
 From a competition policy perspective,
showing a price squeeze is not enough
 There is a need for clear, efficient and
administrable rules; economics has a role to
play in this process
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The Economics of Margin Squeeze
A short history of nearly everything
Dr. Jorge Padilla
Managing Director
[email protected]
LECG Europe
Brussels: +32 2 517 6070
London: + 44 207 269 0500
Madrid: + 34 91 594 7979
Paris: + 33 1 5 568 1280
www.lecgcp.com
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