Pricing abuses under art. 82 A closer look at predation

1. GCLC lunch talk 2 November 2004 Pricing abuses under art. 82A closer look at predation Benoît Durand Chief Economist Team DG Competition Disclaimer: The views expressed in this presentation do not necessarily reflect an official position of the European Commission or any of its commissioners.

2. Pricing abuses • Excessive pricing • Fidelity rebates • Margin squeeze • Predatory pricing

3. Predatory prices: the current legal test • AKZO • Price below AVC are predatory • (“must be regarded as abusive”) • Price below ATC (and above AVC) are predatory if intent is shown • (“must be regarded as abusive if [.] part of a plan”)

4. Probable recoupment? • Tetra Pak II • No need to show probable recoupment (“not necessary to demonstrate [.] reasonable prospect of recouping losses”) • Only reason for a firm to price below cost is to eliminate competition

5. Early economic critique (I) • The Chicago School’s critique • A price war is more costly for the dominant firm • Below cost pricing is thus only temporary • The prey recognizes this and fights back • If in need, the prey has access to credit market to resist aggressive pricing (“deep pockets”)

6. Early economic critique (II) • Why would a dominant firm lower its price below cost if it has no chances of recouping its losses? • Predatory pricing is thus irrational and therefore it rarely occurs • Skepticism echoed in the US supreme court decision Brooke Group (1994)

7. Modern economic theories • Predation is a rational strategy; but need dynamic framework • Sacrifice profit in the short-run (pricing below what would be optimal) • Exclude or discipline rivals, or prevent entry => injure competition • Then recoup initial losses once competition is eliminated

8. Strategic approach to predation • Introducing asymmetric and imperfect information => predation is a profit maximizing strategy • Financial predation • Signaling models • Reputation • Limit pricing

9. Financial predation (I) • Akin to “long purse” (“deep pockets”) story, but somewhat different • The focus is on the prey’s financial situation • Does the prey have also “deep pockets”? • If prey relies on external funds for entry or expansion, predation is possible. Why? => Capital market imperfection

10. Financial predation (II) • Lenders have imperfect information • Cannot verify precisely whether the borrowed money is used efficiently • By threatening to cut off funding when the prey’s performance is poor, the lenders attempt to regain control • But lenders have no ability to recognize predatory episodes from cost inefficiencies or mismanagement etc… • Lenders rely on retained earnings (internal assets) to grant additional funds

11. Financial predation (III) • The predator observes the prey’s dependence on capital markets • Aggressive behavior to affect the prey’s short-run profitability • The prey’s cost of capital will rise as investors reduce or withdraw financial support • The prey exits or scales down operation

12. Reputation effect (I) • A “weak” incumbent fights aggressively a new entrant • Lowers price; expands capacity etc… • Sacrifices current profits • Invest in building a reputation for “toughness” • Asymmetric information => future entrants do not know whether the incumbent will be aggressive • Current aggressive behavior is observed by future entrants => signal

13. Reputation effect (II) • Reputation acts as additional barriers to entry • Markets where aggressive behavior occurs • But also in related markets where incumbent is active • Recoupment may occur in several markets • This is maybe very profitable when reputation affects many markets • American Airlines case=> DoJ allegation

14. Limit pricing: cost signaling (I) • The cost of the incumbent firm is private information (not observed by rivals) • The incumbent charges low price to signal low cost of production • Thanks to new product development, technical innovation, new management etc… • But is the incumbent bluffing? May be sacrificing current profits.

15. Limit pricing: cost signaling (II) • Based on beliefs rivals will have to decide between • Staying but face a likely more cost-efficient opponent => low expected profit • Leaving the market => other less profitable opportunities if incumbent is bluffing • Predation is harmful when rivals exit when in fact they should have stayed

16. More economics? • Current legal test presumes below cost pricing is illegal for dominant firms • Analytically unsatisfactory – firms are irrational in this framework • Does not address early economic critique • Not a powerful test – alone does not allow to separate legitimate pricing from predatory pricing • Pricing below cost occurs also for market expansion reasons • Use modern economic theories?

17. Competition or predation? • But modern theories => “fuzzy resemblance” between competition and predation • Aggressive behavior maybe perfectly legitimate • Why would an incumbent firm accommodate entry? • In reputation game, no other choice but being tough, otherwise may induce further entry • Which criteria permit to tell when aggressive conduct is detrimental to welfare?

18. Which way forward? • Bolton, Brodley & Riordan (2000) proposal for the US post Brooke • Facilitating market structure • Scheme of predation & supporting evidence • Probable recoupment • Pricing below cost • Business justification

19. The way forward • Need to build a coherent theory of predation • Use economist tool kit to explain firm’s conduct • Fit the theory to the facts • Probable recoupment • Bring evidence that competition (exclusion or discipline rivals) has been injured by predation allowing the dominant firm to recoup • Can be exceedingly difficult to show • Evidence of pricing below cost • Which cost measure? • Can also be very difficult to demonstrate • Dominant firm’s defense • Below-cost pricing for other reasons than predation