Transcript Slide 1

ACE, Toulouse 29 November 2007
The use (and abuse) of price-cost tests for predation
Lessons from the Wanadoo case
Miguel de la Mano*
Member of the Chief Economist’s Office
DG COMP, European Commission
*The views expressed are those of the author and do not necessarily reflect those of DG COMP or the
European Commission
Definition
Ordover & Willig (1981) define predatory conduct as a
strategy “that sacrifices part of the profit that could be
earned under competitive circumstances were the rival
to remain viable, in order to induce exit and gain
consequent additional monopoly profit”.
• Much broader than just pricing
• Strategy in two stages, which is (partly) how to
distinguish it from normal competition
• Tricky part: why/how does the predator’s behavior today
influence whether the prey wants to be in the market
tomorrow?
Predation is not rational
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Predation is costly: and increases with the market share of
the predator, while the victim’s losses are smaller, the smaller
its market share.
Since predation can only be temporary, the prey will not
exit.
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Not even a dominant firm can successfully predate on equally or more
efficient rivals.
A predator would ultimately raise prices or behave less aggressively to
recoup initial loses.
If the industry is profitable in the long term, lenders should be
prepared to back the prey through any period of temporary losses.
Predation cannot lead to permanent exclusion: Even if the
prey ceased operations during the predatory phase, either it or
a successor would reenter during the recoupment phase,
making use of the prey’s original assets.
Insight 1: Predation may work if prey is financially
constrained
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The prey is dependent upon some source of external
financing (i.e. it is financially constrained)
The predator seeks to manipulate that relationship
between the prey and its investors.
For example, the predator may reduce prices in order to
reduce the profitability of its rivals.
Lenders may be unable to determine whether the
default stems from (a) predatory pricing, (b) or the
debtor’s poor performance or (c) see low profitability as
as a signal that prospects in this market are limited.
Lenders may decide to pull the plug
Insight 2: Asymmetric information
reinforces exclusionary effects of predation
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Rivals will enter the market if they believe the dominant firm is
a high-cost provider, but will not enter the market or will
choose to exit the market if they believe the dominant firm is a
low-cost provider.
A predator may drastically reduces prices to mislead the prey to
believe that the predator has lower costs and to exit the market.
Observing the predator’s low price, the prey rationally believes
that there is a least some probability that the predator has
reduced costs. This lowers the prey’s expected returns and
causes the prey to exit.
Similar models: test-market predation (secret price cuts) signal
jamming (public price cuts)
In all cases: Predation to mislead rivals in believing the market is
unprofitable
Insight 3: Reputational effects can make predation a
cheap and effective strategy (across time and space)
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The predator seeks to convey a reputation for
“toughness” and a willingness to defend its market at
virtually any cost.
The predator reduces prices in one market to induce
the prey and potential entrants to believe that it will cut
price at a later time or in other markets.
The predator seeks to establish a reputation as a cutthroat competitor, based on some perceived special
advantage or characteristic.
Key criteria in modern theories of
predation
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Models require some type of asymmetric
information—in the possession of the predator that is
not common knowledge.
Models typically assume that the predator enjoys some
financial or cost advantage over its prey.
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If the prey is in a superior financial position or if it is known
to have lower costs than the predator, there is no real
prospect for predatory behavior.
Models are of limited relevance when the prey’s
presence in the predatory market is driven primarily by
strategic or defensive considerations rather than
financial considerations.
Spirit case (US)
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Textbook example of what predatory pricing would look like:
 Northwest’s prices in the Detroit-Boston and DetroitPhiladelphia city pairs are high.
 Spirit enters, Northwest’s prices fall dramatically.
 Spirit exits, Northwest’s prices jump up.
Spirit Airlines pulled capacity out of Detroit quickly when
Northwest cut its fares but Spirit could not re-enter because
Spirit had difficulties of access to gates at the Detroit airport.
Circuit Court seems to suggest that at least in the market
circumstances of this case, Northwest’s conduct may have been
predatory even if its fare structure exceeds “an appropriate
measure of average variable costs.”
Policy considerations
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Challenge: to distinguish highly competitive pricing from
predatory pricing. A price-cutter may simply be responding to
new competition, or to a downturn in market demand.
There is the possibility of Type I errors (labeling a price cut
predatory when it is actually competitive- a false positive) and
Type II errors (labeling a price cut competitive when it is actually
predatory – a false negative).
Policy should balance the risk of error in a manner that
maximizes expected consumer welfare.
Over-enforcement that results in a Type I error is likely to entail
high social costs because it will give firms pause in lowering
prices out of fear that such behavior will be condemned as being
predatory.
EU traditional approach:
AKZO and Wanadoo
legal
ATC
Dominance
+
Requires intent
AVC
illegal
Note the AKZO approach is not easy to apply.
• assessing costs and prices requires a detailed and complex
investigation of the dominant firm’s cost structure and revenues.
• price-cost tests are generally inappropriate in cases of non-price
predation
• the concept of intent is too subjective to be operational. Absence
of intent does not prove price competition while evidence of intent
does not prove predation.
3-step structured rule of reason
(de la Mano and Durand, 2005)
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Predation is risky but effective under the right
circumstances.
Proof of predation involves showing that the alleged
predation: (a) has taken place and (b) is economically
rational.
Need to show:
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Sacrifice: The defendant has sacrificed profits.
Likely Exclusion: As a result, one or more rivals have or
likely will be excluded from competing with the alleged
predator in some market.
Likely Recoupment: Once rivals are excluded, the alleged
predator can exercise increased market power and thereby
recoup the initial sacrifice
Defense
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Evidence of sacrifice, (likely) exclusion and (likely)
recoupment creates a presumption of predation.
This presumption should be rebuttable since seemingly
predatory behavior can also enhance efficiency and
increase consumer welfare. The defendants can provide
evidence that
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(i) it has not deviated from a short-run profit maximization
strategy
(ii) exclusion of rivals is due to exogenous circumstances
unrelated to the defendant’s aggressive behavior and/or
(iii) the initial profit sacrifice leads to market expanding
efficiencies, which fully offset their exclusionary effect.
Proof of Sacrifice
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First best:
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Evidence that the predator is not optimising in the
short-run. But this requires significant information
(demand, conduct, cost etc.. - now and in the future)
Second best:
Assessment of alternative course of actions
 Incremental revenues vs. Incremental costs
 Price-cost tests
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Recoupment
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The prospect of recouping is akin to the prospect of becoming
dominant
Being dominant may not be bad proxy
But important differences:
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Dominance: ex-ante market power
Recoupment: increased market power ex-post
Asymmetry of Entry and Exit Conditions matters
Dominance
Recoupment
Identity of the prey matters
Predation to acquire dominance
Firms leave, but assets stay
Capacity constrained dominant firm
Reputation as predator is the entry
barrier
Burden of proof on the parties?
This does not resolve the under-enforcement problem
Structured rule of reason vs.
per se rules (e.g. AKZO)
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Easier to administer: profit sacrifice can be proven even without a complex
and controversial analysis of average costs and average prices and without
entering into a debate as to which is the relevant cost standard.
Sliding scale: the more convincing the evidence as regards likely exclusion
and recoupment the less detail is required to establish sacrifice. E.g.: evidence
of below cost pricing is contentious but:
 likely exclusion results from financial constraints, reputational or signaling
effects
 Likely recoupment is shown on traditional market structure analysis postexclusion.
Less false negatives: e.g. if a firm engages in non-price predation a
comparison of prices and costs can be seriously misleading, if at all possible.
Less false positives: There is no predation if conduct is not rational, either
because it cannot credibly lead to exclusion or entry deterrence, or because
some competition constraints will remain making the prospect of
recoupment unrealistic.
Wanadoo case
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Wanadoo: 72% owned by France Telecom
From the end of 1999 to October 2002 marketed its ADSL
services known as Wanadoo ADSL and eXtense
France Telecom held almost 100% of the market for
wholesale ADSL services
Other ISPs could and did offer similar ADSL services
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But needed to rely on France Telecom for building blocks
Limited local loop unbundling
Fast-growing (not emerging) market
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From January 2001 to September 2002 Wanadoo’s market share rose
from 46% to 72%
Five-fold increase of the market size over the same period
Wanadoo Decision
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Commission decision of 16 July 2003: predatory pricing by
Wanadoo
 March 2001 – August 2001: Price < Average Variable Costs
 August 2001 – October 2002:
 Average Variable Costs < Price < Average Total Costs
 Plan to pre-empt the French high speed Internet market
CFI Judgement does not depart from earlier case law and
confirms AKZO as a legally valid path to establish predation:
 Assumption of abuse in case of pricing below AVC;
 Prices above AVC and below ATC to be regarded as
abusive if determined as part of a plan for eliminating a
competitor;
CFI Judgement recognises the
complexity of applying price cost tests:
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Choice of method to establish “sacrifice” entails
complex economic assessment and COMP must be
afforded broad margin of discretion
Decision unlawful only if the applicant proves that the
method used by the Commission is unlawful/
comprises manifest error (§153)
It is not apparent that the method of discounted cash
flow (advocated by Wanadoo) was necessary in the
present case
… and it implicitly opens the door to
an effects-based analysis
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“for the purposes of applying [article 82] showing and anticompetitive object and an anti-competitive effect, may, in some
cases, be one and the same thing. If it is shown that the object
pursued by the conduct of an undertaking in a dominant
position is to restrict competition, that conduct will also be liable
to have such an effect” (§195)
However, warns that identifying effects is not always possible
(although the Court may be referring to a problem of timing not
assessment):
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“where an undertaking in a dominant position actually implements a
practice whose object is to oust a competitor, the fact that the result
hoped for is not achieved is not sufficient to prevent that being an abuse
of a dominant position within the meaning of Article 82 EC” (§196)
In fact it shows that effects can (and
must) be assessed… to establish fines
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“In accordance with [Guidelines on Fines] in assessing the gravity of the infringement,
account must be taken of its nature, its actual impact on the market and the size of
the relevant geographic market”. (259)
“WIN has denied that the infringement in question impacted on the market. However,
various elements indicate the contrary” (§260)
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First of all, WIN’s market share on the high-speed market first increased from 50 to 72%
(§261)
Secondly, one competitor, Mangoosta, disappeared from the market (§ 262)
Thirdly, during the period covered, a significant decline in the market shares of the
competing cable operators was recorded (§ 263)
Fourthly, WIN’s conduct had a deterrent effect on the ability of competitors to enter the
market and to develop (§ 264)
The number of new entries on the market was also marginal (e.g. Dixinet only had 10
subscribers)
Harm to consumers:
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Article 82 EC is not only aimed at practices which may cause damage to consumers directly,
but also at those which are detrimental to them through their impact on an effective
competition structure (§266)
CFI confirms that proof of recoupment is not
a necessary condition but…
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… the justification suggests:
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(a) it refers to actual recoupment and
(b) it does not want to discourage intervention before it is too late!)
First quotes Tetra judgment: ‘[I]t would not be appropriate, in
the circumstances of the present case, to require in addition
proof that Tetra Pak had a realistic chance of recouping its
losses. […] [aim of Article 82] rules out waiting until such a
strategy leads to the actual elimination of competitors.’
Then CFI concludes
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“The Commission was therefore right to take the view that proof of
recoupment of losses was not a precondition to making a finding of
predatory pricing.” (§217)
In fact…
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Commission decision described in detail obstacles to entry and
growth of rivals that would facilitate recoupment
 Disincentives to switching on the part of existing customers
(lock-in effects due to experience nature of ADSL)
 Costs of entering and acquiring a critical size in a mass
market (technical and promotional expenditure, e.g. to build
brand image);
 Cost of alternatives to FT’s wholesale access (e.g. building
own network)
 Easy to exploit ex-post market power due to vertical
integration with FT
Risk of abuse of bright line tests
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Typically two considerations:
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Probability of making depends on the accuracy of the test, but
not only.
Suppose we use a “sacrifice only” test of predation implemented
using the rule: there is predatory sacrifice if P<ATC
Assume:
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Probability of making an error
Consequences of making such error
In 90% of cases where a firm predates price will be below ATC (5% risk
that the firm engages in non-price predation – false negative)
In 90% of cases where there is no predation P>ATC (5% risk that the
firm engages in promotional or penetration pricing – false positive)
Is this a reliable test?
Not very reliable…
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In light of the modern theories of predatory conduct assume
market circumstances for rational predation are present rather
infrequently (only 1% of firms will find predation rational)
Take 1000 dominant companies
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Typically 10 are truly predating. If they predate the price-cost test comes
positive in 9 cases (the remaining firm engages in non-price predation or
above cost predation)
The remaining 990 are not predating but the test can be inaccurate for
them too. Up to 99 of them will price below ATC
So there are 108 positive results in total but only 9 are accurate
So for any case where P<ATC the chance there is predation is low
around 8%, not high as may appear at first sight
Thanks for your
attention