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The Economics of Margin Squeeze∗

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The Economics of Margin Squeeze∗ The Economics of Margin Squeeze∗ Bruno Jullieny, Patrick Reyzand Claudia Saavedrax IDEI Report October 2013, revised march 2014 Abstract The paper discusses economic theories of harm for anti-competitive margin squeeze by unregulated and regulated vertically integrated firms. We review both predation and foreclosure theories, as well as the mere exploitation of upstream market power. We show that foreclosure provides an appropriate framework in the case of an unregulated firm, whereas a firm under tight wholesale regulation should be evaluated under the predation paradigm, with an adequate test that we characterize. Finally, although non-exclusionary exploitation of upstream market power may also induce a margin squeeze, banning such a squeeze has ambiguous effects on the competitive outcome; hence, alternative measures, such as a cap on the access price, may provide a better policy. ∗This article has benefited from support by the IDEI/Orange Convention. The views expressed in this paper are purely the authors' responsibility. yToulouse School of Economics (CNRS, GREMAQ and IDEI) zToulouse School of Economics (GREMAQ and IDEI) xOrange Contents Executive summary 1 1 Introduction 3 2 Overview of margin squeeze case law 5 3 Margin squeeze and exclusionary abuse 7 3.1 Predation and margin squeeze . .7 3.1.1 The nature of predatory pricing . .7 3.1.2 Existing predatory theories of harm . .8 3.1.3 The difficulties for applications to margin squeeze . 10 3.2 Foreclosure theory as a theory of harm . 11 3.2.1 The nature of vertical and horizontal foreclosure . 11 3.2.2 The Chicago critique . 13 3.2.3 The modern theory of vertical foreclosure . 15 3.2.4 Horizontal foreclosure and dynamic linkages . 16 3.3 Lessons for margin squeeze . 18 4 Margin squeeze and exploitative abuse 19 4.1 Introduction . 19 4.2 The exercise of market power may lead to a margin squeeze . 20 4.2.1 The case of homogenous product: pricing and opportunity cost 20 4.2.2 More strategic effects . 23 4.2.3 The case of differentiated products: a similar analysis . 23 4.3 Banning margin squeeze: pro and anti-competitive effects . 25 5 Margin squeeze and access regulation 27 6 A sacrifice test adjusted for vertical integration 29 7 Conclusion 30 A Learning-by-doing 32 A.1 Efficiency . 32 A.2 Competitive upstream market . 32 A.3 Unregulated upstream monopoly . 33 A.4 Regulated upstream monopoly . 34 A.5 Banning margin squeeze . 35 B Exploitative abuse 36 B.1 Framework . 36 B.2 Margin squeeze regulation . 37 B.3 Variable relative efficiency . 38 B.4 Input mix . 38 B.5 Price leadership . 39 Executive summary A margin squeeze may occur when the dominant provider of an input is vertically in- tegrated in retail activities that compete with its downstream customers. The notion refers to the possibility that the combination of retail and wholesale prices adopted by the vertically integrated firm may make downstream competitors unprofitable, even though their services are socially valuable. Margin squeeze may be viewed as a particular form of predation or of vertical foreclosure, or as an abuse of different nature. Whether or not a margin squeeze is treated as a separate abuse should ultimately depend on whether there is a specific theory of harm, distinct from existing theories. Hence, we first discuss classic as well as more recent theories of harms and their implications. We identify two very different rationales that may result into a margin squeeze, and which raise different issues both for the economic analysis and for the policy implications. On the one hand, margin squeeze can be viewed as an exclusionary abuse, targeting downstream competitors. One the other hand, a margin squeeze can be viewed as an exploitative abuse by dominant firms. In the first approach, the behavior is the result of the willingness to exclude competitors from the market. A coherent theory of harm must here overcome the well-known Chicago critique: As there is \only one monopoly profit,” one must explain why a vertically integrated upstream monopoly wishes to exclude efficient downstream retailers from the market, given that it could use the wholesale price to appropriate the value of efficiencies. This is particularly relevant for predation theories, at least in the case of unregulated firms. By contrast, modern foreclo- sure theories overcome this critique. These include vertical foreclosure scenarios - where the market power of upstream monopoly may be undermined by problems of opportunism and credibility - and horizontal foreclosure scenarios - where the inte- grated firm attempts to protect its upstream monopoly from potential competition by downstream customers. An alternative approach to margin squeeze is to explain the behavior as a mere result of the exercise of upstream market power and the attempt, by the owner of an upstream bottleneck, to maximize its monopoly rent. We show that it is often optimal for the integrated firm to combine a positive access margin, so as to extract rents from competitors, with appropriate retail margins designed to extract rents from final consumers. The optimal retail prices are then based on an \opportunity cost" that accounts for the fact that foregone retail sales by the downstream unit of the integrated firm are partially compensated by wholesale revenue. Because of the access margin, the retail price of the downstream unit of the inte- grated firm acts as a constraint on competitors that reduces double marginalization issues. As a result, the prices of the integrated firms may fail to comply with a margin squeeze test; this, however, does not imply that there is inefficient exclusion of competitors. Banning margin squeeze may lead the integrated firm to reduce the wholesale price or to raise its retail price. While this always benefits downstream competitors, in the latter case the \umbrella effect” may generate an increase in all retail prices; the effect of a ban on consumer surplus and total welfare is therefore 1 ambiguous. As an alternative, a cap on the wholesale price would reduce all retail prices. In the last part, we point out that the Chicago critique no longer applies to predation scenarios when the access price is regulated. Although a high wholesale margin reduces incentives to do so, the integrated firm may then wish to engage into predatory behavior. Hence, in that case an traditional approach based on predation theories of harm may apply. However, the appropriate benchmark is the opportunity cost introduced above, which leads us to propose a new sacrifice test for predation by vertically integrated firms. 2 1 Introduction A margin squeeze may occur when the dominant provider of an input is integrated in retail activities that compete with its downstream customers. The notion refers to the possibility that the combination of retail prices and wholesale prices chosen by the vertically integrated firm renders the services of other retailers unprofitable, even though these services are socially valuable. As stated by the European Commission, \a dominant undertaking may charge a price for the product on the upstream market which, compared to the price it charges on the downstream market, does not allow even an equally efficient competitor to trade profitably in the downstream market on a lasting basis (a so-called `margin squeeze')."1 The margin squeeze doctrine constitutes one point of divergence between the US and EU anti-trust policies. Whereas European courts have repeatedly considered2 that a margin squeeze may constitute a specific and independent abuse, in Trinko and LinkLine,3 the US Supreme Court expressed a different view: It asserted instead that a margin squeeze was not a separate abuse, requiring a specific doctrine, but should fall under existing types of abuse, namely, refusal to deal or predation. Similar views have been expressed by US economists as well { see for instance Carlton (2008) and Sidak (2008). In the EU, Bouckaert and Verboven (2004) distinguish between predation and foreclosure, and conclude that a ban on margin squeeze should be targeted only at predatory squeeze; Spector (2008) also discusses the practice in the context of \raising rivals' costs" theory,4 which does not require the exclusion of competing downstream retailers. Whether or not a margin squeeze is treated as a separate abuse should ultimately depend on whether there is a specific theory of harm, distinct from existing theories. For instance, if a margin squeeze is just one particular form of predation (e.g., costless predation, as stated by Spector (2008)), than the legal standards should be those of predation, possibly adapted to the presence of vertical integration. Indeed, as mentioned by the Commission itself,5 identifying the economic impact of an undertaking's behavior is essential for the assessment of vertical practices. The reason is that the same practice may have pro and anti-competitive effects depending on the context, and conversely different practices may be used for a given goal. This is in particular true for margin squeeze practices. Thus the legal treatment should be grounded in sound economic analysis and a well understood theory of harm. However, despite an extensive legal literature and numerous comments by 1Communication from the Commission | Guidance on the Commission's enforcement priorities in applying Article 82 of the EC Treaty to abusive exclusionary conduct by dominant undertakings (2009/C 45/02). 2See, e.g., Deutsche Telekom case (T-271/03, C-280/08, and Telefonica C-295/12P). 3Verizon Communications, Inc. v. Law Offices of Curtis V. Trinko, 540 U.S. 398 (2004), and Pac. Bell Tel. Co. v. Linkline Commc'ns, Inc., 129 S. Ct. 1109, 1123 (2009). 4Salop and Scheffman (1983, 1987), Ordover, Saloner and Willig (1990). 5See for instance Communication from the Commission | Guidance on the Commission's en- forcement priorities in applying Article 82 of the EC Treaty to abusive exclusionary conduct by dominant undertakings (2009/C 45/02).
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