1. 1 1 The Economics of Margin Squeeze A short history of nearly everything Dr. Jorge Padilla Managing Director LECG Europe Brussels-London-Madrid-Paris London, 10 December 2004 Margin Squeeze under EC Competition Law organized by GCLC and BT

2. 2 2 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?

3. 3 3 Positive economics

4. 4 4 Whats 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. Margin = Retail Price – Wholesale Price < Downstream Costs U D1D1 D2D2 Consumers Firm 1 Firm 2 w p1p1 p2p2

5. 5 5 Whats 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. Retail Price < Downstream Costs + Wholesale price U D1D1 D2D2 Consumers Firm 1 Firm 2 w p1p1 p2p2

6. 6 6 Whats 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 D1D1 D2D2 Consumers Firm 1 Firm 2 w p1p1 p2p2 Retail Price – Downstream Costs < Wholesale Price

7. 7 7 Nihil novum sub sole Margin squeeze Predation Refusal to deal Margin = Retail Price – Wholesale Price < Downstream Costs Retail Price < Downstream Costs + Wholesale price Retail Price – Downstream Costs < Wholesale Price

8. 8 8 The sacrifice fallacy The claim that margin squeeze is different than predation because it involves no sacrifice is incorrect True p 1 < w implies no direct losses for vertically integrated firm 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 D 2 sells differentiated products and/or is more cost efficient – Chicago critique U D1D1 D2D2 Consumers Firm 1 Firm 2 w p1p1 p2p2

9. 9 9 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

10. 10 Showing margin squeeze is not enough Ability: Market power upstream and downstream Barriers to entry and re-entry Asymmetries between predator and prey oInformational asymmetries Signaling Reputation effects oFinancial asymmetries Incentives: Upstream losses oRegulated prices upstream oBusiness stealing effect

11. 11 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

12. 12 A plain vanilla static analysis is necessarily misleading In many markets, privately and socially optimal pricing policies are dynamic: current losses, overall positive profits Costs Revenues PresentFuture Total Current losses cannot constitute evidence of intent or likely exclusionary effect in emerging markets

13. 13 Any sensible approach implies assumptions about future revenues and costs Revenues Time evolution of prices Excluding anti-competitive profits Costs Inter-temporal allocation of start up costs oInfrastructure costs oCustomer acquisition costs Time evolution of costs oEconomies of scale oLearning by doing, etc. Discounted Cash Flows TotalFuture

14. 14 Normative economics

15. 15 Welfare implications Allocative versus productive efficiency It may be efficient to exclude as efficient competitors and exclude as efficient entrants oExcessive 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

16. 16 Designing administrable rules

17. 17 Administrable rules Alternative legal standards: Per se rules Rule of reason Hybrid rules: oModified per se rules oStructured rule of reason Selection criteria: Minimizing the expected cost of error Be cheap to administer Give economic agents predictability

18. 18 Administrable rules Choosing the right rule: Per se rules dont work Rule of reason is very difficult and bound to lead to erroneous decisions Options: Structured rule of reason: 3 stages Rebuttable presumptions: oImputation test? Modified per se rules: oExceptional circumstances test?

19. 19 Administrable rules The costs of type I and type II errors:

20. 20 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

21. 21 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

22. 22 The Economics of Margin Squeeze A short history of nearly everything Dr. Jorge Padilla Managing Director jpadilla@lecg.com 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