The use (and abuse) of price-cost tests The use (and abuse) of price-cost tests for predationfor predation

Lessons from the Wanadoo caseLessons from the Wanadoo case

Miguel de la ManoMiguel de la Mano**

Member of the Chief Economist’s OfficeMember of the Chief Economist’s OfficeDG COMP, European CommissionDG COMP, European Commission

ACE, Toulouse 29 November 2007

*The views expressed are those of the author and do not necessarily reflect those of DG COMP or the European Commission

DefinitionDefinition

Ordover & Willig (1981) define predatory conduct as a Ordover & Willig (1981) define predatory conduct as a strategy “strategy “that that sacrificessacrifices part of the profit that could be part of the profit that could be earned under competitive circumstances were the rival earned under competitive circumstances were the rival to remain viable, in order to to remain viable, in order to induce exitinduce exit and gain and gain consequent additional monopoly profitconsequent 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 Predation is not rational Predation is costlyPredation is costly:: and increases with the market and increases with the market

share of the predator, while the victim’s losses are share of the predator, while the victim’s losses are smaller, the smaller its market share.smaller, the smaller its market share.

Since predation can only be temporary, the prey will not exit..

Not even a dominant firm can successfully predate on Not even a dominant firm can successfully predate on equally or more efficient rivals.equally or more efficient rivals.

A predator would ultimately raise prices or behave less A predator would ultimately raise prices or behave less aggressively to recoup initial loses.aggressively to recoup initial loses.

If the industry is profitable in the long term, lenders should If the industry is profitable in the long term, lenders should be prepared to back the prey through any period of be prepared to back the prey through any period of temporary losses.temporary losses.

Predation cannot lead to permanent exclusion: : Even if the prey ceased operations during the Even if the prey ceased operations during the predatory phase, either it or a successor would predatory phase, either it or a successor would reenter during the recoupment phase, making use reenter during the recoupment phase, making use of the prey’s original assets.of the prey’s original assets.

Insight 1: Predation may work if prey Insight 1: Predation may work if prey is financially constrainedis financially constrained

The prey is dependent upon some source of The prey is dependent upon some source of external financing (i.e. it is financially external financing (i.e. it is financially constrained)constrained)

The predator seeks to manipulate that The predator seeks to manipulate that relationship between the prey and its investors.relationship between the prey and its investors.

For example, the predator may reduce prices For example, the predator may reduce prices in order to reduce the profitability of its rivals.in order to reduce the profitability of its rivals.

Lenders may be unable to determine whether Lenders may be unable to determine whether the default stems from (a) predatory pricing, the default stems from (a) predatory pricing, (b) or the debtor’s poor performance or (c) see (b) or the debtor’s poor performance or (c) see low profitability as as a signal that prospects in low profitability as as a signal that prospects in this market are limited.this market are limited.

Lenders may decide to pull the plugLenders may decide to pull the plug

Insight 2: Asymmetric information Insight 2: Asymmetric information reinforces exclusionary effects of reinforces exclusionary effects of

predationpredation Rivals will enter the market if they believe the Rivals will enter the market if they believe the

dominant firm is a high-cost provider, but will not dominant firm is a high-cost provider, but will not enter the market or will choose to exit the market if enter the market or will choose to exit the market if they believe the dominant firm is a low-cost they believe the dominant firm is a low-cost provider.provider.

A predator may drastically reduces prices to A predator may drastically reduces prices to mislead the prey to believe that the predator has mislead the prey to believe that the predator has lower costs and to exit the market.lower costs and to exit the market.

Observing the predator’s low price, the prey Observing the predator’s low price, the prey rationally believes that there is a least some rationally believes that there is a least some probability that the predator has reduced costs. probability that the predator has reduced costs. This lowers the prey’s expected returns and causes This lowers the prey’s expected returns and causes the prey to exit.the prey to exit.

Similar models: test-market predation (secret price Similar models: test-market predation (secret price cuts) signal jamming (public price cuts)cuts) signal jamming (public price cuts)

In all cases: Predation to mislead rivals in believing In all cases: Predation to mislead rivals in believing the market is unprofitablethe market is unprofitable

Insight 3: Reputational effects can Insight 3: Reputational effects can make predation a cheap and effective make predation a cheap and effective

strategy (across time and space)strategy (across time and space) The predator seeks to convey a reputation for The predator seeks to convey a reputation for

“toughness” and a willingness to defend its “toughness” and a willingness to defend its market at virtually any cost.market at virtually any cost.

The predator reduces prices in one market to The predator reduces prices in one market to induce the prey and potential entrants to induce the prey and potential entrants to believe that it will cut price at a later time or believe that it will cut price at a later time or in other markets.in other markets.

The predator seeks to establish a reputation The predator seeks to establish a reputation as a cut-throat competitor, based on some as a cut-throat competitor, based on some perceived special advantage or perceived special advantage or characteristic.characteristic.

Key criteria in modern Key criteria in modern theories of predationtheories of predation

Models require some type of asymmetric Models require some type of asymmetric information—in the possession of the information—in the possession of the predator that is not common knowledge.predator that is not common knowledge.

Models typically assume that the predator Models typically assume that the predator enjoys some financial or cost advantage over enjoys some financial or cost advantage over its prey.its prey. If the prey is in a superior financial position or if it If the prey is in a superior financial position or if it

is known to have lower costs than the predator, is known to have lower costs than the predator, there is no real prospect for predatory behavior.there is no real prospect for predatory behavior.

Models are of limited relevance when the Models are of limited relevance when the prey’s presence in the predatory market is prey’s presence in the predatory market is driven primarily by strategic or defensive driven primarily by strategic or defensive considerations rather than financial considerations rather than financial considerations.considerations.

Spirit case (US)Spirit case (US) Textbook example of what predatory pricing would look like:

Northwest’s prices in the Detroit-Boston and Detroit-Philadelphia 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 considerationsPolicy considerations Challenge: to distinguish highly competitive pricing Challenge: to distinguish highly competitive pricing

from predatory pricing. A price-cutter may simply from predatory pricing. A price-cutter may simply be responding to new competition, or to a be responding to new competition, or to a downturn in market demand.downturn in market demand.

There is the possibility of Type I errors (labeling a There is the possibility of Type I errors (labeling a price cut predatory when it is actually competitive- price cut predatory when it is actually competitive- a false positive) and Type II errors (labeling a price a false positive) and Type II errors (labeling a price cut competitive when it is actually predatory – a cut competitive when it is actually predatory – a false negative).false negative).

Policy should balance the risk of error in a manner Policy should balance the risk of error in a manner that maximizes expected consumer welfare. that maximizes expected consumer welfare.

Over-enforcement that results in a Type I error is Over-enforcement that results in a Type I error is likely to entail high social costs because it will give likely to entail high social costs because it will give firms pause in lowering prices out of fear that such firms pause in lowering prices out of fear that such behavior will be condemned as being predatory.behavior will be condemned as being predatory.

ATC

AVC

EU traditional approach:EU traditional approach:AKZO and WanadooAKZO and Wanadoo

illegal

Requires intent

legal

Dominance +

Note the AKZO approach is not easy to apply.Note the AKZO approach is not easy to apply.• assessing costs and prices requires a detailed and assessing costs and prices requires a detailed and complex investigation of the dominant firm’s cost complex investigation of the dominant firm’s cost structure and revenues. structure and revenues. • price-cost tests are generally inappropriate in price-cost tests are generally inappropriate in cases of non-price predationcases of non-price predation• the concept of intent is too subjective to be the concept of intent is too subjective to be operational. Absence of intent does not prove price operational. Absence of intent does not prove price competition while evidence of intent does not prove competition while evidence of intent does not prove predation.predation.

3-step structured rule of 3-step structured rule of reasonreason

(de la Mano and Durand, 2005)(de la Mano and Durand, 2005) Predation is risky but effective under the Predation is risky but effective under the

right circumstances.right circumstances. Proof of predation involves showing that Proof of predation involves showing that

the alleged predation: (a) has taken place the alleged predation: (a) has taken place and (b) is economically rational.and (b) is economically rational.

Need to show:Need to show: Sacrifice:Sacrifice: The defendant has The defendant has sacrificed profitssacrificed profits.. Likely Exclusion:Likely Exclusion: As a result, one or more As a result, one or more

rivals have or likely will be rivals have or likely will be excludedexcluded from from competing with the alleged predator in some competing with the alleged predator in some market.market.

Likely Recoupment:Likely Recoupment: Once rivals are excluded, Once rivals are excluded, the alleged predator can exercise increased the alleged predator can exercise increased market power and thereby market power and thereby recourecoupp the initial the initial sacrificesacrifice

DefenseDefense Evidence of sacrifice, (likely) exclusion and Evidence of sacrifice, (likely) exclusion and

(likely) recoupment creates a presumption of (likely) recoupment creates a presumption of predation.predation.

This presumption should be rebuttable since This presumption should be rebuttable since seemingly predatory behavior can also enhance seemingly predatory behavior can also enhance efficiency and increase consumer welfare. The efficiency and increase consumer welfare. The defendants can provide evidence thatdefendants can provide evidence that (i) it has not deviated from a short-run profit (i) it has not deviated from a short-run profit

maximization strategymaximization strategy (ii) exclusion of rivals is due to exogenous (ii) exclusion of rivals is due to exogenous

circumstances unrelated to the defendant’s circumstances unrelated to the defendant’s aggressive behavior and/oraggressive behavior and/or

(iii) the initial profit sacrifice leads to market (iii) the initial profit sacrifice leads to market expanding efficiencies, which fully offset their expanding efficiencies, which fully offset their exclusionary effect.exclusionary effect.

Proof of SacrificeProof of Sacrifice

First best:First best: Evidence that the predator is not optimising Evidence that the predator is not optimising

in the short-run. But this requires significant in the short-run. But this requires significant information (demand, conduct, cost etc.. - information (demand, conduct, cost etc.. - now and in the future)now and in the future)

Second best:Second best: Assessment of alternative course of actionsAssessment of alternative course of actions Incremental revenues vs. Incremental costsIncremental revenues vs. Incremental costs Price-cost testsPrice-cost tests

RecoupmentRecoupment The prospect of recouping is akin to the prospect The prospect of recouping is akin to the prospect

of of becomingbecoming dominant dominant Being dominant may not be bad proxyBeing dominant may not be bad proxy But important differences:But important differences:

Dominance: ex-ante market powerDominance: ex-ante market power Recoupment: increased market power ex-postRecoupment: increased market power ex-post Asymmetry of Entry and Exit Conditions mattersAsymmetry of Entry and Exit Conditions matters

DominanceRecoupment

Identity of the prey matters

Firms leave, but assets stay

Capacity constrained dominant firm

Predation to acquire dominance

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 Structured rule of reason vs.vs.

per se rules (e.g. AKZO)per se rules (e.g. AKZO) Easier to administer:Easier to administer: profit sacrifice can be proven even without profit sacrifice can be proven even without

a complex and controversial analysis of average costs and average a complex and controversial analysis of average costs and average prices and without entering into a debate as to which is the prices and without entering into a debate as to which is the relevant cost standard.relevant cost standard.

Sliding scale:Sliding scale: the more convincing the evidence as regards likely the more convincing the evidence as regards likely exclusion and recoupment the less detail is required to establish exclusion and recoupment the less detail is required to establish sacrifice. E.g.: evidence of below cost pricing is contentious but:sacrifice. E.g.: evidence of below cost pricing is contentious but: likely exclusion results from financial constraints, reputational likely exclusion results from financial constraints, reputational

or signaling effectsor signaling effects Likely recoupment is shown on traditional market structure Likely recoupment is shown on traditional market structure

analysis post-exclusion.analysis post-exclusion. Less false negatives: e.g. if a firm engages in non-price e.g. if a firm engages in non-price

predation a comparison of prices and costs can be seriously predation a comparison of prices and costs can be seriously misleading, if at all possible.misleading, if at all possible.

Less false positives:Less false positives: There is no predation if conduct is not There is no predation if conduct is not rational, either because it cannot credibly lead to exclusion or rational, either because it cannot credibly lead to exclusion or entry deterrence, or because some competition constraints will entry deterrence, or because some competition constraints will remain making the prospect of recoupment unrealistic. remain making the prospect of recoupment unrealistic.

Wanadoo caseWanadoo case Wanadoo: 72% owned by France Wanadoo: 72% owned by France Telecom Telecom From the end of 1999 to October 2002 marketed From the end of 1999 to October 2002 marketed

its ADSL services known as Wanadoo ADSL and its ADSL services known as Wanadoo ADSL and eXtenseeXtense

France France Telecom held almost 100% of the market Telecom held almost 100% of the market for wholesale ADSL servicesfor wholesale ADSL services

Other ISPs could and did offer similar ADSL Other ISPs could and did offer similar ADSL servicesservices But needed to rely on France But needed to rely on France Telecom for building blocksTelecom for building blocks Limited local loop unbundlingLimited local loop unbundling

Fast-growing (not emerging) marketFast-growing (not emerging) market From January 2001 to September 2002 Wanadoo’s From January 2001 to September 2002 Wanadoo’s

market share rose from 46% to 72%market share rose from 46% to 72% Five-fold increase of the market size over the same Five-fold increase of the market size over the same

periodperiod

Wanadoo DecisionWanadoo Decision Commission decision of 16 July 2003: predatory pricing by Commission decision of 16 July 2003: predatory pricing by

WanadooWanadoo March 2001 – August 2001: Price < Average Variable March 2001 – August 2001: Price < Average Variable

CostsCosts August 2001 – October 2002:August 2001 – October 2002:

Average Variable Costs < Price < Average Total Average Variable Costs < Price < Average Total CostsCosts

Plan to pre-empt the French high speed Internet Plan to pre-empt the French high speed Internet marketmarket

CFI Judgement does not depart from earlier case law and confirms AKZO as a legally valid path to establish onfirms AKZO as a legally valid path to establish predation:predation:

Assumption of abuse in case of pricing below AVC;Assumption of abuse in case of pricing below AVC; Prices above AVC and below ATC to be regarded as Prices above AVC and below ATC to be regarded as

abusive if determined as part of a plan for eliminating abusive if determined as part of a plan for eliminating a competitor;a competitor;

CFI Judgement recognises the CFI Judgement recognises the complexity of applying price complexity of applying price

cost tests:cost tests: Choice of method to establish “sacrifice” Choice of method to establish “sacrifice”

entails complex economic assessment and entails complex economic assessment and COMP must be afforded broad margin of COMP must be afforded broad margin of discretiondiscretion

Decision unlawful only if the applicant Decision unlawful only if the applicant proves that the method used by the proves that the method used by the Commission is unlawful/ comprises manifest Commission is unlawful/ comprises manifest error (error (§153)§153)

It is not apparent that the method of It is not apparent that the method of discounted cash flow (advocated by discounted cash flow (advocated by Wanadoo) was necessary in the present Wanadoo) was necessary in the present casecase

… … and it implicitly opens and it implicitly opens the door to an effects-based the door to an effects-based

analysisanalysis ““for the purposes of applying [article 82] showing for the purposes of applying [article 82] showing

and anti-competitive object and an anti-competitive and anti-competitive object and an anti-competitive effect, may, effect, may, in some casesin some cases, be one and the same , be one and the same thing. If it is shown that the object pursued by the thing. If it is shown that the object pursued by the conduct of an undertaking in a dominant position is conduct of an undertaking in a dominant position is to restrict competition, that conduct will also be to restrict competition, that conduct will also be liable to have such an effect” (liable to have such an effect” (§195)§195)

However, warns that identifying effects is not always However, warns that identifying effects is not always possible (although the Court may be referring to a possible (although the Court may be referring to a problem of timing not assessment):problem of timing not assessment): ““where an undertaking in a dominant position actually where an undertaking in a dominant position actually

implements a practice whose object is to oust a competitor, implements a practice whose object is to oust a competitor, the fact that the result hoped for is not achieved is not the fact that the result hoped for is not achieved is not sufficient to prevent that being an abuse of a dominant sufficient to prevent that being an abuse of a dominant position within the meaning of Article 82 EC” position within the meaning of Article 82 EC” ((§196)§196)

In fact it shows that effects In fact it shows that effects can (and must) be assessed… can (and must) be assessed…

to establish finesto establish fines ““In accordance with [Guidelines on Fines] in assessing the gravity of the In accordance with [Guidelines on Fines] in assessing the gravity of the

infringement, account must be taken of its nature, infringement, account must be taken of its nature, its actual impact on its actual impact on the marketthe market and the size of the relevant geographic market”. (259) and the size of the relevant geographic market”. (259)

““WIN has denied that the infringement in question impacted on the WIN has denied that the infringement in question impacted on the market. However, various elements indicate the contrary” (market. However, various elements indicate the contrary” (§§260)260)

First of all, WIN’s market share on the high-speed market first increased from First of all, WIN’s market share on the high-speed market first increased from 50 to 72% (50 to 72% (§§261)261)

Secondly, one competitor, Mangoosta, disappeared from the market (Secondly, one competitor, Mangoosta, disappeared from the market (§§ 262) 262) Thirdly, during the period covered, a significant decline in the market shares of Thirdly, during the period covered, a significant decline in the market shares of

the competing cable operators was recorded (the competing cable operators was recorded (§§ 263) 263) Fourthly, WIN’s conduct had a deterrent effect on the ability of competitors to Fourthly, WIN’s conduct had a deterrent effect on the ability of competitors to

enter the market and to develop (enter the market and to develop (§§ 264) 264) The number of new entries on the market was also marginal (e.g. Dixinet only The number of new entries on the market was also marginal (e.g. Dixinet only

had 10 subscribers)had 10 subscribers) Harm to consumers:Harm to consumers:

Article 82 EC is not only aimed at practices which may cause damage to 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 consumers directly, but also at those which are detrimental to them through their impact on an effective competition structure (their impact on an effective competition structure (§§266)266)

CFI confirms that proof of CFI confirms that proof of recoupment is not a necessary recoupment is not a necessary

condition but…condition but… … … the justification suggests:the justification suggests:

(a) it refers to actual recoupment and(a) it refers to actual recoupment and (b) it does not want to discourage intervention before it is (b) it does not want to discourage intervention before it is

too late!)too late!) First quotes Tetra judgment: First quotes Tetra judgment: ‘[I]t would not be ‘[I]t would not be

appropriate, in the circumstances of the present appropriate, in the circumstances of the present case, to require in addition proof that Tetra Pak had case, to require in addition proof that Tetra Pak had a realistic chance of recouping its losses. […] [aim a realistic chance of recouping its losses. […] [aim of Article 82] rules out waiting until such a strategy of Article 82] rules out waiting until such a strategy leads to the actual elimination of competitors.’ leads to the actual elimination of competitors.’

Then CFI concludesThen CFI concludes ““The Commission was therefore right to take the view that The Commission was therefore right to take the view that

proof of recoupment of losses was not a precondition to proof of recoupment of losses was not a precondition to making a finding of predatory pricing.” (making a finding of predatory pricing.” (§217)§217)

In fact…In fact… Commission decision described in detail obstacles to Commission decision described in detail obstacles to

entry and growth of rivals that would facilitate entry and growth of rivals that would facilitate recoupmentrecoupment Disincentives to switching on the part of existing Disincentives to switching on the part of existing

customers (lock-in effects due to experience nature customers (lock-in effects due to experience nature of ADSL)of ADSL)

Costs of entering and acquiring a critical size in a Costs of entering and acquiring a critical size in a mass market (technical and promotional mass market (technical and promotional expenditure, e.g. to build brand image);expenditure, e.g. to build brand image);

Cost of alternatives to FT’s wholesale access (e.g. Cost of alternatives to FT’s wholesale access (e.g. building own network)building own network)

Easy to exploit ex-post market power due to vertical Easy to exploit ex-post market power due to vertical integration with FTintegration with FT

Risk of abuse of bright Risk of abuse of bright line testsline tests

Typically two considerations:Typically two considerations: Probability of making an errorProbability of making an error Consequences of making such errorConsequences of making such error

Probability of making depends on the accuracy of Probability of making depends on the accuracy of the test, but not only.the test, but not only.

Suppose we use a “sacrifice only” test of predation Suppose we use a “sacrifice only” test of predation implemented using the rule: there is predatory implemented using the rule: there is predatory sacrifice if P<ATCsacrifice if P<ATC

Assume:Assume: In 90% of cases where a firm predates price will be below In 90% of cases where a firm predates price will be below

ATC (5% risk that the firm engages in non-price predation – ATC (5% risk that the firm engages in non-price predation – false negative)false negative)

In 90% of cases where there is no predation P>ATC (5% In 90% of cases where there is no predation P>ATC (5% risk that the firm engages in promotional or penetration risk that the firm engages in promotional or penetration pricing – false positive)pricing – false positive)

Is this a reliable test?Is this a reliable test?

Not very reliable…Not very reliable… In light of the modern theories of predatory conduct In light of the modern theories of predatory conduct

assume market circumstances for rational predation assume market circumstances for rational predation are present rather infrequently (only 1% of firms are present rather infrequently (only 1% of firms will find predation rational)will find predation rational)

Take 1000 dominant companiesTake 1000 dominant companies Typically 10 are truly predating. If they predate the price-Typically 10 are truly predating. If they predate the price-

cost test comes positive in 9 cases (the remaining firm cost test comes positive in 9 cases (the remaining firm engages in non-price predation or above cost predation)engages in non-price predation or above cost predation)

The remaining 990 are not predating but the test can be The remaining 990 are not predating but the test can be inaccurate for them too. Up to 99 of them will price below inaccurate for them too. Up to 99 of them will price below ATCATC

So there are 108 positive results in total but only 9 are So there are 108 positive results in total but only 9 are accurateaccurate

So for any case where P<ATC the chance there is predation So for any case where P<ATC the chance there is predation is low around 8%, not high as may appear at first sightis low around 8%, not high as may appear at first sight

Thanks for your Thanks for your attentionattention