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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