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The Economics of Margin Squeeze A short history of nearly everything Dr. Jorge Padilla Managing Director LECG Europe Brussels-London-Madrid-Paris PowerPoint PPT Presentation


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

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The Economics of Margin Squeeze A short history of nearly everything Dr. Jorge Padilla Managing Director LECG Europe Brussels-London-Madrid-Paris

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Slide1 l.jpg

Margin Squeeze under EC Competition Law

organized by GCLC and BT

London, 10 December 2004

The Economics of Margin SqueezeA short history of nearly everything Dr. Jorge PadillaManaging Director LECG EuropeBrussels-London-Madrid-Paris


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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?


Positive economics l.jpg

Positive economics


What s a margin squeeze l.jpg

U

Firm 1

w

Margin = Retail Price – Wholesale Price < Downstream Costs

D1

D2

Firm2

Firm 1

p1

p2

Consumers

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.


What s a margin squeeze5 l.jpg

Retail Price < Downstream Costs + Wholesale price

What’s a margin squeeze?

  • Predation:

    • It can do so by charging a downstream price that is too lowrelative to the input price, with the result of driving out some or all downstream rivals, or at least significantly weakening their competitive positions.

U

Firm 1

w

D1

D2

Firm2

Firm 1

p1

p2

Consumers


What s a margin squeeze6 l.jpg

Retail Price – Downstream Costs < Wholesale Price

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

Firm 1

w

D1

D2

Firm2

Firm 1

p1

p2

Consumers


Nihil novum sub sole l.jpg

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


The sacrifice fallacy l.jpg

U

Firm 1

w

D1

D2

Firm2

Firm 1

p1

p2

Consumers

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


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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

      • Informational asymmetries

        • Signaling

        • Reputation effects

      • Financial asymmetries

  • Incentives:

    • Upstream losses

      • Regulated prices upstream

      • 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

Total

Present

Future

Current losses cannot constitute evidence of intent or likely exclusionary effect in emerging markets

Revenues

Costs


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Any sensible approach implies assumptions about future revenues and costs

Discounted Cash Flows

  • Revenues

    • Time evolution of prices

    • Excluding anti-competitive profits

  • Costs

    • Inter-temporal allocation of start up costs

      • Infrastructure costs

      • Customer acquisition costs

    • Time evolution of costs

      • Economies of scale

      • Learning by doing, etc.

Future

Total


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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

      • 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:

      • Modified per se rules

      • 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:

        • Imputation test?

      • Modified per se rules:

        • Exceptional circumstances test?


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Administrable rules

  • The costs of type I and type II errors:


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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 Squeeze

A short history of nearly everything

Dr. Jorge Padilla

Managing Director

[email protected]

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


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