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The Economics of Margin SqueezeA short history of nearly everything
Dr. Jorge PadillaManaging Director LECG EuropeBrussels-London-Madrid-Paris
London, 10 December 2004
Margin Squeeze under EC Competition Laworganized by GCLC and BT
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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.
Margin = Retail Price – Wholesale Price < Downstream Costs
U
D1 D2
Consumers
Firm
1
Firm
1
Firm 2
w
p1 p2
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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.
Retail Price < Downstream Costs + Wholesale price
U
D1 D2
ConsumersFi
rm
1Fi
rm
1
Firm 2
w
p1 p2
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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
D1 D2
ConsumersFi
rm
1Fi
rm
1
Firm 2
w
p1 p2
Retail Price – Downstream Costs < Wholesale Price
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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
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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
But there is an opportunity cost, w, for each unit not sold to downstreamcompetitor
And that opportunity cost may be very large when the wholesale priceis above the upstream marginal cost
And even larger if D2 sells differentiated products and/or is more cost efficient – Chicago critique
U
D1 D2
ConsumersFi
rm
1Fi
rm
1
Firm 2
w
p1 p2
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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
Costs
Revenues
Present Future TotalCurrent losses
cannot constitute evidence of intent or likely exclusionary effect in emerging
markets
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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
o Infrastructure costso Customer acquisition costs
Time evolution of costso Economies of scaleo Learning by doing, etc.
Discounted Cash Flows TotalFuture
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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
Quantity
Demand
Supply
PriceCost
A
B C
Dynamic Loss=A
Static Loss=B+C
Price
Quantity
Demand
Supply
PriceCost
A
B C
Dynamic Loss=A
Static Loss=B+C
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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 SqueezeA short history of nearly everythingDr. Jorge PadillaManaging Directorjpadilla@lecg.com
LECG EuropeBrussels: +32 2 517 6070London: + 44 207 269 0500Madrid: + 34 91 594 7979Paris: + 33 1 5 568 1280www.lecgcp.com