Margin squeeze and predatory prices by multiproduct firms

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Margin squeeze and predatory prices by
multiproduct firms

• Encore, The Hague, 3 April 2008
• Dr Andrea Coscelli

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Overview

• Margin squeeze cases with multiproduct firms
• Some additional considerations on the application
  of predatory pricing tests to multiproduct firms

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Rule of reason vs. simple rules

• Discussion of possible margin squeeze or
  predatory pricing cases involving multiproduct
  firms requires a complex economic analysis under
  a rule of reason approach
• There are no simple rules and a number of
  alternative approaches need to be tested to
  assess whether in fact there is a problem (and
  how significant it is)
• This creates uncertainty for the dominant firms
  involved and problems for the Courts undertaking
  judicial reviews

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Key elements (1 of 2)
What is a margin squeeze?
Competitive market
Bottleneck market
Before margin squeeze
After margin squeeze
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Key elements (2 of 2)

• For the margin squeeze test to be passed
• Retail Price Wholesale Price Downstream Costs
  Competitive Return
• Key modelling inputs
• Downstream (retail) prices
• Upstream (wholesale) prices
• Downstream (retail) costs including a competitive
  rate of return for the downstream activity

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Key precedents in broadband and broadcastingAll
involving multiproduct firms

• CFI in Wanadoo
• EC in Telefonica, Wanadoo and Deutsche Telekom
• Oftel/Ofcom in BT vs. Freeserve (2003), BT
  Together (2004) and BT IPStream (2004)
  investigations
• OPTA and NMa Price Squeeze Guidelines (2001)
• ACCC in Telstra ADSL and 2005 guidelines
• OFT in BSkyB (2002)
• EC and Italian Telecom Regulator in Sky Italia

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Key modelling assumptions

• There are at least 10 significant methodological
  aspects to be considered when modelling a
  specific margin squeeze case
• A number of alternative assumptions can be made
  at each step when choosing the methodology
• Choice driven by features of the specific market
  being investigated, case precedent, available
  data and (at least partially) policy
  considerations of the relevant agency

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1. Downstream cost standard EEO or REO?

• Equally efficient operator (EEO)
• Pros uses incumbents own downstream costs
  favours efficient entrants can be modified to
  approach the REO standard
• Cons economies of scale/scope ? small scale
  entrants might be excluded
• Reasonably efficient operator (REO)
• Pros uses downstream costs of reasonably
  efficient entrant, so can facilitate entry on
  small scale
• Cons entrants data not readily available,
  additional assumptions must be made incumbent
  may set wholesale prices to extract surplus
  generated by more efficient entrants (assuming
  incumbent can price discriminate)
• Features of the retail competition (e.g., do all
  players offer similar bundles/compete across all
  segments?) will play a role in the choice of the
  cost standard to use

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2. Downstream cost standard AVC, LRIC or FAC?

• Average variable costs (AVC)
• Pros correct cost standard for assessing short
  term price points minimal data requirements
  approaches LRIC as review time period increases
  used as the cost standard for antitrust predation
  cases
• Cons not appropriate for assessments of long
  term price points results affected by short term
  variations in costs ignores common costs
• Long run incremental costs (LRIC)
• Pros correct cost standard for assessing long
  term price points can be adapted to include
  efficient replacement costs of assets (forward
  looking LRIC FL-LRIC) or a contribution to
  common costs (LRIC)
• Cons greater data requirements than FAC
  limits the incumbents short term pricing
  flexibility relative to AVC ignores common
  costs which may inhibit entry when the incumbent
  enjoys economies of scope (but it might be
  adjusted to include a contribution to common
  costs)

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2. Downstream cost standard AVC, LRIC or FAC?

• Fully allocated costs (FAC)
• Pros easy to implement from existing accounts
  possibly the only option in markets not subject
  to sector regulation reasonable measure when
  common costs are a large proportion of the costs
  promotes entry as FAC gt LRIC gt AVC (hence a
  conservative standard)
• Cons allocation of common costs is arbitrary
  further limits the incumbents pricing
  flexibility effectively implies a higher margin
  requirement
• Features of the retail competition (e.g., do all
  players offer similar bundles/compete across all
  segments?) will play a role in the choice of the
  cost standard to use

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2. Downstream cost standard AVC, LRIC or FAC?

• Precedents
• AVC not used in telecoms (but many precedents in
  antitrust cases)
• LRIC Oftel/Ofcom in BT Freeserve and BT
  Together EC in Telefonica ACCC
• FAC Ofcom in IPStream (due to data
  availability) OFT in BSkyB (as common costs were
  large) work for Sky Italia

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3. Historic costs or DCF approach?

• Historic costs
• Pros easiest modelling approach as uses
  available data can be adapted to current costs
  can be adapted to economic depreciation (e.g. to
  amortise subscriber acquisition costs (SACs))
• Cons straight line depreciation may allocate
  costs over low utilisation in early years
• Discounted cash flows (DCF)
• Pros explicitly specifies a path for cost
  recovery over time preferable in new and
  emerging markets with high SACs
• Cons based on forecasts ? uncertainty could
  conceal monopoly rents if long period is used
• Precedents
• Historic costs EC in Wanadoo, Telefonica and DT
  Ofcom in BT ISPs OFT in BSkyB
• DCF Oftel in Freeserve EC in Telefonica ACCC
  in Telstra ADSL
• Cohort analysis used by Oftel in BT Freeserve

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4. Time period for profitability assessment

• The relevant time period in margin squeeze
  assessments is the economic life of key
  investments
• If SACs are key investments ? approximate average
  subscriber life
• Shorter period
• Pros data more readily available precludes
  incorporation of monopoly rents
• Cons insufficient time allowed for recovery of
  SACs ? higher margin requirement than necessary
• Longer period
• Pros allows appropriate time for recovery of
  SACs
• Cons data less readily available/reliable risks
  incorporation of monopoly rents

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4. Time period for profitability assessment

• Steady state assumption
• If market is in steady-state then time period is
  much less relevant (use last 12 months of
  management accounts as a reasonable proxy)
• Precedents
• EC in Wanadoo (4 years) EC in Telefonica (5
  years in DCF approach) Oftel/Ofcom in BT
  Freeserve and BT IPStream (5 years) ACCC in
  Telstra ADSL (3 years) OFT in BSkyB (SACs
  depreciated over 10 years)
• Features of retail competition not particularly
  relevant for the choice (dynamic nature of retail
  competition on the other hand is key)

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5. Interconnection costs

• Include costs incurred by entrants (or by the
  incumbent) in interconnecting with the incumbent,
  but not incurred when the incumbent supplies
  itself
• Pros removes the incumbents cost advantage and
  promotes entry
• Cons the incumbent must set retail prices above
  its integrated (wholesale and retail) costs of
  supplying the service ? promotes inefficient
  entry and higher prices for consumers
• Precedents
• Regulators tend to include these costs (e.g.
  Ofcom in BT IPStream and BT Together)
• Features of retail competition not particularly
  relevant for the choice

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6. Level of aggregation how to deal with
variegated retail offers and retail discounts

• Level of aggregation options
• Test each product? Test each service (including
  all products)? Or test the relevant market
  (including all services supplied in the market)?
• Test individual customers? Groups of
  customers? Or all customers in the relevant
  market
• Higher level of aggregation ? greater
  flexibility for recovery of common costs across
  services/customers, but may inhibit entry on a
  smaller scale/scope than the level of aggregation
• Levels of aggregation depend on cost standard
• EEO standard aggregate over all services and
  customers that the incumbent supplies in the
  relevant market
• REO standard aggregate over all
  services/customers that a REO would be likely to
  offer/target

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6. Level of aggregation how to deal with
variegated retail offers and retail discounts

• Combinatorial tests proposed by some regulators
• Revenues from each service/customer incremental
  costs of supplying that service/customer
• Revenues from all services in a relevant market
  sum of incremental and common costs of those
  services
• Precedents
• Regulators tend to prefer highly disaggregated
  tests (e.g. OPTA in Price Squeeze Guidelines
  Oftel/Ofcom test at service level) EC in
  Deutsche Telekom separately tested access and
  calls)
• Sometimes greater aggregation occurs (e.g. EC in
  DT aggregated over analogue, ISDN and ADSL
  access EC in Telefonica conducted the test on
  the aggregate mix of services in the relevant
  market OFT in BSkyB and EC in Sky Italia
  aggregated over basic and premium channels)

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6. Level of aggregation how to deal with
variegated retail offers and retail discounts

• At the product level one would need to test
  whether the revenues of each retail product cover
  the incremental costs of that product
• In practice especially in telecoms it is very
  difficult to assess from the accounts what costs
  are incremental to a specific product if the
  definition of a product is very disaggregated
  (e.g., for retail broadband we define a product
  as a brand/speed/any additional specs (e.g.,
  limit on download volumes))
• How to assess situations where a minority of
  products make a negative contribution (possible
  reasons include legacy products, new products
  etc)?
• Rationale for highly disaggregated tests
  unconvincing (high implementation costs and
  limited benefits)

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7. Bundled retail offers whether to test at the
level of the bundle or test each element

• For example, most telecom and pay TV incumbents
  offer bundles of broadband, voice and pay TV
  services
• EEO standard test whether the bundle revenues
  cover the bundle costs
• A possible alternative approach by regulators
• A regulator might be inclined to test each
  element of the bundle, e.g. test whether the
  incremental revenue from broadband in the bundle
  (attributing all the bundle discount to the
  broadband service) covers the costs of a
  broadband-only operator
• No correct way in economics of pricing a single
  product in a bundle (i.e. no correct way of
  allocating the discount across products)
• This would be a fairly extreme REO assumption

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7. Bundled retail offers whether to test at the
level of the bundle or test each element

• The Spanish Telecommunications regulator (CMT)
  for instance recently allowed bundled offers from
  Telefonica that satisfy a margin squeeze test as
  a whole and for which there is a sufficient
  number of alternative bundled offers from other
  market operators.
• Replicability of the bundles by competing
  operators is key. If efficient rivals can afford
  bundle vs. bundle competition, there is no need
  to test at a more disaggregated level.
• Focus should be on assessing whether there are
  any existing advantages by dominant companies
  (for instance because of vertical integration)
  that could not be replicated by their rivals.
• Actual competition in the downstream markets is
  key to choosing the approach to take

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8. Retail product differentiation

• Implicit assumption in margin squeeze tests is
  that incumbent and entrant retail products are
  homogeneous
• If retail products are differentiated, unclear
  what is meant by an EEO or REO and product
  differentiation must be taken into account (the
  assessment needs to be linked to the view taken
  on product aggregation for the tests)

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9. Discounting at the wholesale level

• Issue What wholesale charge to use if volume
  discounts are offered at wholesale level
• Lowest wholesale charge (consistent with EEO
  standard)
• Pros Benefits consumers by passing on economies
  of scale
• Cons May inhibit entry as entrants need to match
  the incumbents scale
• Highest wholesale charge (consistent with REO
  standard and usually preferred by regulators)
• Pros Promotes entry by ensuring viability for
  small scale entrants (with a view to better
  outcomes for consumers in the long term)
• Cons Encourages inefficient entry (and higher
  prices for consumers in the short to medium term)
• Product range less relevant here as this usually
  relates to volume discounts

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10. Appropriate downstream margin

• Downstream margin
• ROT or WACC?
• ROT may be appropriate for downstream
  distribution company with limited fixed assets
  (OFT in BSkyB UK MMC in mobile phone charges
  inquiry)
• WACC widely used by regulators (e.g. Oftel/Ofcom
  in Freeserve and IPStream AGCOM in Telecom
  Italia cases EC in Telefonica)
• Appropriate measure of WACC?
• Ideal would be to use WACC for a stand alone
  retail operation but stand alone WACC difficult
  to calculate for a division of an integrated
  company
• In practice regulators often use company wide
  WACC as proxy for WACC of retail operation

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10. Appropriate downstream margin

• Downstream margin issues
• Incumbents or entrants WACC?
• The incumbents cost of capital may be lower than
  entrants, as integration reduces risk an
  adjustment may be necessary to reflect a REO
  standard
• Appropriate rate of return?
• BSkyB and Sky Italia 1.5 ROT
• Freeserve and IPStream BT Groups WACC of 13.5
• Telefonica WACC of 15.7

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Predatory pricing tests for multi-product firms

• Must ask whether the revenues from any
  combinations of the firms products fall short of
  the combined avoidable costs of the products.
  These are the combinatorial cost tests originally
  envisaged by Baumol (1996) Predation and the
  Logic of the Average Variable Cost test, Journal
  of Law Economics.
• Avoidable costs refer to the costs that a firm
  could have avoided but for the practice of
  predatory pricing
• This is the same cost test envisaged in the
  Commissions Discussion Paper on Art. 82
  (December 2005)
• Structure to the test needs to be given by
  features of downstream competition in the
  specific market (e.g., this will drive the choice
  of the unit of analysis)

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Predatory pricing tests for multi-product firms

• Example
• Airline sells two products 40 first class and
  200 economy seats
• Costs common to each product are fuel and pilot
  salary 15,000
• AAC of each product is the food for each class of
  passenger (none of the common fixed cost enters
  the incremental cost of either product)
• AAC First Class (40 x 20) 800
• AAC Economy (200 x 5) 1,000
• Suppose first class fare is 100 and economy fare
  is 60 (so AAC are covered)
• Combined incremental revenue (40 x 100) (200
  x 60) 16,000
• Combined avoidable cost 800 1,000 15,000
  16,800
• Predatory pricing test is failed but it this
  the correct unit of analysis (a single flight
  segment)?

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Predatory pricing tests for multi-product firms

• There is a general problem in applying predatory
  pricing tests to multiproduct firms cost
  accounting systems generate detailed product
  specific information that is often inappropriate
  for price/cost tests for predation
• When the analysis of predatory pricing concerns
  relate to only one of the products produced by a
  multiproduct firm the common costs will not
  normally be regarded as avoidable. (See the EC
  Deutsche Post cases for instance)
• When the allegation of predation concerns the
  pricing of a bundle of products that constitutes
  the relevant product market, the assessment will
  be whether the price of the bundle is below
  average avoidable costs for the bundle.