Thesis Bart Final

THE PRICE SQUEEZE AND ITS IMPLICATIONS

BART MAYENS

Thesis submitted to obtain

the degree of Master in

Applied Economics

Promotor: Dr. J. Vandekerckhove

- 2010 -

KATHOLIEKE UNIVERSITEIT

LEUVEN

FACULTY OF BUSINESS AND ECONOMICS

Bart Mayens

THE PRICE SQUEEZE AND ITS IMPLICATIONS

Abstract:

A price squeeze is a particular form of anticompetitive conduct whereby a vertically

integrated firm raises the wholesale price of the vital input it delivers and/or lowers the

retail price of the end-product. By doing so, the margin of a non-integrated rival firm is

constricted making it hard to operate profitable on the downstream market. This thesis

aims at unraveling the economic implications of a price squeeze, both for the

implementing firm, as well as for regulatory bodies and competition authorities. In

addition, it quantifies the effects of a price squeeze on market outcomes and welfare

by comparing it with the situation it is regulated for. Absent of a squeeze, we find prices

to drop and higher consumer and total welfare, although the latter to a lesser extent.

Promotor: Prof. Dr. J. Vandekerckhove

- 2010 -

FACULTY OF BUSINESS AND ECONOMICS

KATHOLIEKE UNIVERSITEIT

LEUVEN

I

Acknowledgements

This thesis is the result of multiple years of interesting studies at the University of

Leuven, but would never have been possible without the help of other people.

Foremost, sincere gratitude is hereby extending to my promoter and assistant Jan

Vandekerckhove who guided me through the writing process. He never ceased to offer

help, appealing remarks and very useful input and inspirations throughout the

elaboration of this thesis. I also want to thank Jan for the amicable way of staying in

touch, full of conversations about our shared soccer and Club Brugge passion. All of

this made it after all a pleasant work.

I also want to thank my parents, offering me the gratefully appreciated opportunity of

studying at the university of Leuven, most likely the starting point of a hopefully

interesting future career.

Finally, I am deeply indebted to all my friends, supporting me in difficult moments and

offer me the chance of changing minds, going for a vibrant party, a drink, a nice talk or

a good soccer game.

Bart Mayens,

Leuven, May 2010

II

Table of contents

Acknowledgements ........................................................................................................... I

Table of contents .............................................................................................................. II

General Introduction .......................................................................................................... 1

Chapter 1 Economic analysis of the price squeeze .................................................... 4

1.1 Price squeeze: a definition ................................................................................. 4

1.2 The price squeeze and its related theoretical concepts ...................................... 7

1.2.1 Upstream related concepts ............................................................................. 8

1.2.2 Downstream related concept: predatory pricing.......................................... 12

1.3 An economic understanding of the price squeeze ........................................... 13

1.3.1 Necessary conditions ................................................................................... 13

1.3.2 Profitability analysis .................................................................................... 16

1.3.3 Implementation modes ................................................................................ 18

Chapter 2 Preventing the price squeeze by means of regulation .............................. 21

2.1 Illustrating the importance of regulation: the case of network industries ....... 21

2.2 Regulatory environments ................................................................................ 24

2.2.1 Full regulation ............................................................................................. 24

2.2.2 Partial regulation ......................................................................................... 25

2.2.3 No regulation ............................................................................................... 25

2.3 Implementation of regulation .......................................................................... 26

2.3.1 Overview ..................................................................................................... 26

2.3.2 Wholesale price regulation .......................................................................... 27

2.3.3 Retail price regulation ................................................................................. 32

2.3.4 Summing up ................................................................................................ 34

2.4 Conclusion ....................................................................................................... 34

Chapter 3 Law and economics of antitrust ............................................................... 36

3.1 The approach taken: relevant market power and the imputation test .............. 36

3.1.1 Relevant market ........................................................................................... 36

3.1.2 Market power .............................................................................................. 37

3.1.3 Imputation test ............................................................................................. 39

3.2 Identifying the anticompetitive nature of a price squeeze ............................... 42

3.3 Landmark cases: how courts handled an allegation ........................................ 45

III

3.3.1 Europe ......................................................................................................... 45

3.3.2 United States ................................................................................................ 48

3.3.3 Price squeeze cases: conclusions ................................................................. 52

3.4 Conclusion ....................................................................................................... 54

Chapter 4 Modelling the effects of the imputation rule ........................................... 55

4.1 The model and methodology ........................................................................... 55

4.2 Does a price squeeze arise? ............................................................................. 56

4.3 The impact of the imputation rule ................................................................... 58

4.3.1 The impact of the imputation rule on market outcomes .............................. 60

4.3.2 The impact of the impution rule on welfare ................................................ 63

4.4 Conclusion and policy implications ................................................................ 65

General Conclusion. ........................................................ Error! Bookmark not defined.

List of figures .................................................................................................................. 71

List of tables .................................................................................................................... 72

Sources ............................................................................................................................ 73

1

General Introduction

The capitalistic market economy based on perfectly competitive markets is driven by an

invisible hand towards a Pareto-optimal allocation of resources. This theoretical insight

is well known as the first theorem of welfare economics. It results in profit

maximization by firms on the one hand, and utility optimization of consumers at the

other hand as prices are the lowest and quantities produced the highest as is

economically feasible (De Bondt, 2006).

Competition authorities are installed to safeguard this theoretical insight. They act as the

principal patron of consumers to prevent them from failing markets, diverging from an

optimal outcome through higher prices and a restricted output. This is where antitrust,

or competition law arises. It provides legal foundations in order to protect optimal

market competition by convicting anti-competitive business practices which are to the

detriment of society.

Such anti-competitive practices are numerous and often secret in build-up. The price

squeeze is a particular one by which a vertically integrated operator attempts to narrow

the margin of its non-integrated rival on the downstream market in order to chill the

competitive forces downstream. Given that it monopolistically supplies a vital input in

the production process it can raise the price of the essential input it charges to its rival or

lower the retail price to consumers, both bringing about a narrowing effect on the

margin of the non-integrated firm active downstream.

The price squeeze doctrine is an appealing one. It finds itself on the crossroad between

two well documented competition-harming practices. On the retail level it is closely

related to the well-known predatory pricing conduct, i.e. charging low prices to

consumers in order to drive competitors out of the market. On the wholesale level it

shares the characteristics of foreclosure, i.e. restricting access to an essential input. A

margin squeeze embraces both, hence interrelating two otherwise distinct business

practices on one and the same vertical market. Consequently, this yields a difficult

analysis by which competition authorities are asked a tough job in handling with such

an allegation:

2

‘It is difficult enough for courts to identify and remedy an alleged anticompetitive

practice at one level, such as predatory pricing in retail markets or a violation of a

duty�to�deal [foreclosure] doctrine at the wholesale level. Recognizing price

squeeze claims would require courts simultaneously to police both the wholesale

and retail prices to ensure that rival firms are not being squeezed.’1

How well familiar the economics of predatory pricing and foreclosure are, so less

literature is to be found that focuses on the economical mechanisms of a typical margin

squeeze (Crocioni & Veljanovski (2003) as well as Geradin and O’Donoghue (2005)

are the most notable). On the other hand, articles that review and discuss authorities’

judgments on price squeeze allegations brought before court are comprehensive (see

Hovenkamp & Hovenkamp (2009); Sidak (2008) and Vaheesan (2008)) just as

applications to specific regulated markets (Goelzhauser (2004); Spiwak (1993) and

Brunekreeft et al., (2005)).

Nevertheless, a sound and well-documented economic study is essential and advisable

in order to shape an understanding of a margin squeeze claim. This is even more at hand

given the recent legal developments in the United States, putting the price squeeze

doctrine in the midst of attention by rejecting to use a regulatory rule that prevents a

margin squeeze to come forth. Accordingly, the court’s verdict in backing away from a

price squeeze as violating antitrust law in the US calls for examining the economic

significance of its judgment.

In accordance, this thesis aims to, (i) clarify the economic building-blocks of a price

squeeze by providing a thorough insight in the practice and how it can be prevented

using regulatory mechanisms; (ii) presenting the typical complexities arising for

antitrust law when facing a price squeeze allegation; (iii) by using a formal model,

simulating the impact of a price squeeze on market outcome and society in general

compared to the situation absent of it as a consequence of regulatory prevention.

The remainder of this work will be structured as follows. Chapter 1 lines out the basic

ingredients of a price squeeze. It provides an extensive definition, discusses its 1 Case 555 U.S.___(2009), p. 13.

3

associations with other anti-competitive practices and summarizes a margin squeeze’s

economic requirements and consequences for the undertaking firm. Chapter 2 focuses

on the regulatory tools in order to prevent a price squeeze to occur. The desirability of

regulation is supported, as well as specific pricing rules a firm has to obey with, giving

rise to a certain regulatory environment for the integrated firm. Chapter 3 summarizes

the judiciary treatment of a margin squeeze allegation. It points out the difficulties in

dealing with a claim and provides an overview on historical decisionary practices.

Chapter 4 finally provides a formal analysis in order to line out the economic

consequences of avoiding a price squeeze by means of regulatory prevention.

4

Chapter 1 Economic analysis of the price squeeze

Although the practice of a price squeeze might seem clear-cut at first sight, a severe

revision of a margin squeeze requires a profound economic analysis as to shed light on

its basic requirements, ingredients, execution modes and consequences for the operating

firm. This is a necessary first-step approach since acquaintance with the basic building

blocks of a price squeeze is indispensable for the residue of this work. Accordingly, this

chapter aims at fulfilling these essential economic insights.

The remainder of this chapter will be structured as follows. First, a precise definition is

provided in order to line out the typical set-up of the practice. Second, its relationship

with other anti-competitive arrangements is discussed. Third, the economic implications

for the undertaker are provided, highlighting the necessary conditions in order to

implement a price squeeze, the profitability consequences for the undertaking firm and

finally the different modes of execution.

1.1 Price squeeze: a definition

A price squeeze, also called margin squeeze,2 is the action whereby a vertically

integrated firm monopolistically supplying an essential input negatively influences the

margin between retail and wholesale price of its downstream competitor(s)3 by raising

the input price it charges to its downstream rival(s) and/or lowering the retail price of

the end-product to consumers. In doing so, it attempts to chill competition by

eliminating rivals from the competitive downstream process (Crocioni & Veljanovski,

2003; Bouckaert & Verboven, 2003; Polo 2007).

The definition above nonetheless implies a particular market structure (see Figure 1).

On the upstream market, only one firm is controlling an essential input which is

necessary for the downstream firms to produce the end-product. Hence, there exists an

upstream monopoly, providing an input crucial to the production process. The

downstream market is characterized by on the one hand the non-integrated firms buying

2 Both terms will be used together in the remainder of the work. 3 In what follows, mostly one non-integrated firm will be assumed to clarify concepts.

5

the input from the upstream monopolist and on the other hand the downstream affiliate

of the vertically integrated firm.

As a consequence of vertical integration, shown by the dotted line in Figure 1, the

upstream division of the integrated firm can set a friendly wholesale price (e.g. transfer

price) for its downstream subsidiary while at the same time charging a (much) higher

input price to the non-integrated downstream rival firm. Since the downstream

competitor faces no other alternatives, it has to buy the input in order to deliver the

product to consumers (provided that no bypass is possible, see later), its profit margin is

thus dependant on the wholesale price charged by the upstream affiliate of the

integrated firm.

In addition, a lower retail price charged to consumers by the downstream affiliate will

aggravate the negative effect on the non-integrated firm’s margin since the downstream

competitor has to match this lower price, thus impinging on its margin.4

If now the situation arises where the wholesale price is too high compared with the

retail price set by the integrated firm, the non-integrated company can suffer a ‘squeeze’

on its margin: the difference between the wholesale price it needs to pay for the

4 This is nothing more than a standard oligopolistic competitive process : in case of a homogenous

product, consumers naturraly switch to the producer offering the product at the lowest price.

Figure 1: Typical set up of a price squeeze (Ovum, 2009)

essential input and the retail price

profitable in the market, or to enter a market.

Thus, in sum and stated more formally (

occurs whenever –

: the retail price set by the downstream subsidiary of the vertical integrated firm

: the wholesale

: downstream costs of the non

This can be achieved by the undertaker

, lowering or a combination of both.

We clarify a price squeeze which uses

example (King & Maddock, 2

higher or the combinatorial case

Suppose the transforma

€2 (= ) for each unit. Whether or not the non

profitably with the verticall

and the retail price it can charge to consumers becomes

market, or to enter a market.

Thus, in sum and stated more formally (Canoy et al., 2004, p.150), a price squeeze

< , with


: the wholesale price set by the upstream subsidiary set by the integrated firm

: downstream costs of the non-integrated firm (e.g. transformation costs).

This can be achieved by the undertaker (that is, the integrated operator)

or a combination of both.

We clarify a price squeeze which uses as its implementation device by

ing & Maddock, 2002; see Figure 2). The same exercise can be done for a

or the combinatorial case.

Suppose the transformation from an essential input towards a final product costs a firm

for each unit. Whether or not the non-integrated firm will be able to compete

profitably with the vertically integrated operator depends on the margin it can obtain.

Upstream division

w = €1

Transformation costs =

Downstream division

p = €3 (Situation 1)

p = €2 (Situation 2)

Non-integrated rival

Figure 2: Numerical example

6

becomes too small to stay

, 2004, p.150), a price squeeze


set by the integrated firm

integrated firm (e.g. transformation costs).

(that is, the integrated operator) through raising

as its implementation device by a numerical

; see Figure 2). The same exercise can be done for a

a final product costs a firm

integrated firm will be able to compete

depends on the margin it can obtain.

Transformation costs = €2

integrated rival

7

The integrated firm can charge a wholesale price (�) of €1 per unit while at the same

time offer a retail price (�� of €3 per unit to the market. In this case, the downstream

competitor will be able to cover its transformation cost of €2 (€3 - €1 = €2).

Suppose now that the integrated firm lowers its retail price � to €2. The non-integrated

operator will then face a margin of €1 (€3 - €2) which is not sufficient to cover the

transformation cost of €2. It thus is victim of a price squeeze: its profit margin turns

negative given the pricing policy of the integrated firm.

The practice of affecting the margin of downstream rivals’ can work as a mechanism for

the upstream monopolist to extend (leverage) its market power from the upstream

market into the downstream market and is therefore regarded as an anticompetitive

practice by competition authorities.5

Before modifying wholesale and retail prices, the vertically integrated firm enjoyed

market power on the upstream market only. After having altered the downstream rivals’

margin effectively for a long enough period, the competitors on the downstream market

will be forced to leave (or not to enter) it, as they cannot obtain a profitable margin.

Since the integrated incumbent faces no competition on the market because of the exit

of its competitors, it can enjoy market power downstream, hence being able to raise

retail prices freely to consumers. The price squeeze thus works as a mechanism to

leverage market power from one vertical market to another.

The reader will most likely have noticed the margin squeeze’s relation with other anti-

competitive arrangements. Lowering the retail price in order to drive one or more

competitors out of the market reminds us for instance of predatory pricing. In addition,

charging rival firms a higher wholesale price tends to foreclosure of a vital input, or

equally, to raise a rival firm’s costs. Accordingly, the next section classifies these

related practices and summarizes their associations with a price squeeze.

1.2 The price squeeze and its related theoretical concepts

Conceptually, the price squeeze doctrine lies at the crossroad between upstream vertical

arrangements in order to leverage market power downwards at the one hand and

5 See Chapter 3. For the moment the anticompetitive nature is simply put forward.

8

predatory pricing at the retail level at the other hand. This section aims at interrelating

these notions with the margin squeeze practice. We first review the price squeeze’s

connection with its upstream related concepts. We then turn attention to its relation

with predatory pricing.

1.2.1 Upstream related concepts

1.2.1.1 Vertical foreclosure

Vertical foreclosure refers to the action of refusing proper access to an upstream

monopolistically supplied bottleneck input through vertically integrating into the

adjacent downstream market.6 The intent of such a strategy is thus to toughen its non-

integrated rivals position with the ultimate purpose of softening competition on the

market (Aron, 2002; Rey & Tirole, 2003).

The strategy of vertical foreclosure can differ in extent. In a refusal to deal case, the

bottleneck input is completely left unavailable for the non-integrated firms. Differently,

the incumbent firm can price discriminate and thus charge a different price for different

downstream firms buying the same essential input (Rey & Tirole, 2003).

The concept of a price squeeze captures the basic idea of vertical foreclosure: when

raising the wholesale price for the input to its rival firms, the integrated operator indeed

attempts to refuse access to the essential product/service. Nonetheless, a margin squeeze

can be put into practice without effectively foreclosing the bottleneck input. That is,

when lowering the retail price, a price squeeze can occur while the non-integrated firm

is not foreclosed from the input. Stated otherwise, the point of attention in a price

squeeze claim is the margin between two related prices rather than a single wholesale

price foreclosing an input. The notion of a margin squeeze is thus more broader

compared to vertical foreclosure since the former can be attained by lowering the retail

price as well.

6 To be exact, vertical foreclosure can even come about in the absence of vertical integration, for example

by tying the bottleneck input with some specified downstream products (Rey & Tirole, 2003). For matters

of simplicity and relatedness we limit the analysis to foreclosure in the presence of vertical integration.

9

1.2.1.2 Raising rivals’ costs

Raising rivals’ costs (RRC) is the practice whereby a firm intends to increase the costs

of one or more of its rivals, hence being able to increase its own price without losing

market share (Motta, 2004). By doing so, a firm can affect the margin of its competitors

with the aim of softening competition on the market. In the presence of vertical

integration, the input supplier can thus attempt to raise its downstream rivals’ costs with

the purpose of leveraging market power from the upstream to the downstream market

(Weisman & Kang, 2001).

The RRC strategy may look as a very attractive practice to firms for mainly two

reasons, as noted by Salop and Sheffman (1983). First, there is no need to sacrifice

profits in the short run, as competing with a high-cost rival will always be profit

enhancing. Second, RRC does not require superior financial resources as it is the case

with predatory pricing because the rival firm can negatively affect its rivals profit

without having to face a drawback itself. These cost-raising strategies can therefore be

quite cheap to engage in and therefore be more credible to adopt.

There are a number of practices that can be labeled as RRC (Krattenmaker & Salop,

1986). One of these is foreclosing the supply of an input, since forcing non-integrated

firms paying more for the input (or completely excluding them) will naturally raise their

costs.7 Additionally, non-price actions such as sabotage are embraced by the concept of

RRC (e.g. Beard et al., 2001), as well as the inducement of collusive behavior among

suppliers.8

How does a price squeeze relate to the well-documented RRC strategy? Intuitively, a

price squeeze shares the characteristics of RRC in the case the wholesale price is used:

the non-integrated rival has to buy an essential input at a more expensive price, thus it

faces higher costs. A price squeeze can therefore been seen as a “special” case of RRC.

7 Foreclosure implies thus raising rivals’ costs while the opposite does not hold. 8 Krattenmaker and Salop (1986) label this as a “cartel ringmaster”. Simply stated, this refers to the

agreement between a firm and multiple suppliers to raise the input price of the ringmasters’ rival (Tom &

Wells, 2003).

This is indeed correct, nevertheless Grout (2000

RRC and a margin squeeze. Compared with a classic

price squeeze often lacks a specific benchmark. That is,

a comparison with a clear cost benchmark while

the determination of two absolute levels. Grout (2000

‘It [the price squeeze] does not carry a presumption that the dominant firm’s

prices are different from what they would otherwise have been. In

notion of RRC is based on a change in costs and in this sense is more suggestive

of intent. It is comparing the outcome with some benchmark that must bear some

relation to where prices would be if the vertically integrated firm had persued a

policy other than one of RRC.

Figure 3 sums up the above relationships, in the assumption of a price squeeze which

uses the wholesale price as its main

implies RRC while the reverse is not true. Second, RR

whereas the opposite holds. Finally, the notions of for

related in the case the input price is raised to obtain a price squeeze.

Both the price squeeze and its related concepts, foreclosure and RRC, share the same

characteristic of attempting to leverage market power to the downstream market in the

Figure

d correct, nevertheless Grout (2000) points out a major

RRC and a margin squeeze. Compared with a classical RRC case, the investigation of a

price squeeze often lacks a specific benchmark. That is, the concept of RRC is based on

a comparison with a clear cost benchmark while conversely a price squeeze concerns

the determination of two absolute levels. Grout (2000, p.32) explains:

price squeeze] does not carry a presumption that the dominant firm’s

prices are different from what they would otherwise have been. In




policy other than one of RRC.’


uses the wholesale price as its main device (Price Squeeze ( ))

implies RRC while the reverse is not true. Second, RRC does not imply a price squeeze

whereas the opposite holds. Finally, the notions of foreclosure and

in the case the input price is raised to obtain a price squeeze.



Foreclosure

Price Squeeze (w)RRC

Figure 3: Foreclosure, RRC and the price squeeze

10

ints out a major difference between

RRC case, the investigation of a

the concept of RRC is based on

conversely a price squeeze concerns

) explains:

price squeeze] does not carry a presumption that the dominant firm’s

prices are different from what they would otherwise have been. In contrast, the





)). Foreclosure always

C does not imply a price squeeze

eclosure and margin squeeze are

in the case the input price is raised to obtain a price squeeze.



Squeeze (w)

RRC and the price squeeze

11

context of a vertically integrated undertaker. Nevertheless, the rationality of such a

leveraging strategy has long been rejected in economic literature. A brief overview of

this theoretical discourse is provided next.

1.2.1.3 Theories on leveraging strategies

Some influential scholars have historically been very skeptical towards the above

notions dealing with the vertical extension of market power. Nonetheless, modern

contributions argument these insights have been incorrect by making use of new

techniques (Viscusi et al., 2005; Aron, 2002).9

Proponents of the Chicago School in law and economics, throughout the 1960s and

1970s, have doubted the rationality of vertical leveraging. These arguments are reflected

in the so called “single monopoly profit” theory (Bork, 1978; Posner 1976). Put simple,

Bork and Posner argue a firm who has market power upstream will lack the incentives

to extend this power as it can capture all the profits by virtue of its upstream monopoly.

It simply charges the profit maximizing price upstream. Thus, vertical integration will

not act as a tool to practice anticompetitive operations. If integration should take place,

it is due to efficiency reasons to the benefit of consumers (e.g. reduction of transaction

costs and elimination of double marginalization).

This well discussed insight is however subject to some strict assumptions, such as a

perfectly competitive downstream market and a sequential monopoly market structure.

Game theory and other modern economic tools have been permitting to alter these

assumtions reaching divergent conclusions. An important contribution in this respect

was Hart and Tirole’s “commitment problem” (1990), where it was shown that an

upstream monopolist can have incentives to integrate forward because it wants to

restore monopoly power, rather than extend it. Furthermore, using oligopolistic models,

Salinger (1988), Salop and Sheffman (1983) and Ordover et al. (1990) showed the

rationality of a leveraging strategy can sustain in equilibrium.

9 See also Riordan (2008) and Tirole (2006) for more extensive overviews.

12

Newer lines of research in the post-Chicago time span thus formalized the rationality of

leveraging strategies, including a price squeeze. Hence, the margin squeeze doctrine

finds itself theoretically supported.

1.2.2 Downstream related concept: predatory pricing

Apart from its relatedness with upstream concepts, the reader will likely be aware of the

association with standard predatory pricing, i.e. the conduct of setting low retail prices

by which profits are foregone on the short run in order to recoup these lost profits on the

long run due to minor competition (Motta, 2004).

Indeed, lowering the retail price in order to attain a margin squeeze is nothing more than

predatory pricing in the context of vertical integration: each share the initial same

purpose of softening competition on the downstream market by making use of a specific

pricing policy (lowering the retail price). Both do so as they believe the sacrifice of

short-term profits will pay of in the long term through the exclusion of a downstream

competitor.

Nonetheless, King and Maddock (2002) point out an important distinction between a

decreasing retail price in a margin squeeze case and classical predatory pricing. The

long-term perspective – the recoupment period – is what highlights the difference

between both. In standard predatory pricing, recoupment follows in a different,

succeeding period. When implementing a predatory price squeeze however, recoupment

can follow immediately since profits can still be made upstream through selling the

essential input. In other words, the retail price can be lowered while in the same period

foregone profits are recouped by means of the upstream division (given the vertical

integration) (Geradin & O’Donoghue, 2005).

The margin squeeze’s close connection with predatory pricing downstream, and its

relatedness with the upstream concepts of foreclosure and raising rivals’ costs points to

its particular composition, converging multiple anti-competitive practices. As this

section made clear it is however to be distinguished from a mere amalgam of the above

mentioned connected practices. Consequently, the next section aims at providing the

particular economic implications of a price squeeze for the undertaking firm.

13

1.3 An economic understanding of the price squeeze

In this section we will explore the practice of a price squeeze in depth. The purpose is

threefold. First, it examines the concrete implementation conditions surrounding the

price squeeze. The second part presents an overview on the profitability consequences

for the undertaking firm. Finally, a classification of different modes of implementing

the practice will be provided.

1.3.1 Necessary conditions

Five conditions are required before a firm can undertake a price squeeze successfully

(Geradin & O’Donoghue, 2005; Crocioni & Veljanovski, 2003). The vertically

integrated firm should enjoy market power on the upstream market, an essential input

must be provided, vertical integration has to be present and finally retail and wholesale

prices have to be set in such a way a non-integrated downstream firm is excluded from

the market.

If the first four conditions are satisfied, a company meets requirements to put a price

squeeze into practice. If on top of this condition five is satisfied aswell, a price squeeze

is indeed implemented.

1.3.1.1 Dominance on the upstream market

First, the undertaker has to enjoy dominance on the upstream market. Dominance refers

to the market power a firm enjoys on a certain relevant market, expressed by the ability

to raise prices above the competitive level (Motta, 2004).

If a firm lacks a sufficient amount of market power, it will not be able to influence

prices. In such a case, because of the existence of competitive manufacturers on the

upstream market, the prices charged for the input by the upstream firms will approach

the marginal cost of the input (in the case of a perfectly competitive market prices will

equal marginal cost). Thus, a firm without market power is not able to raise the price of

the input and in doing so engaging in a price squeeze.10

10 Note in the case of multiple input suppliers, lowering the retail price as an instrument to squeeze

margins would have no bite. Both the downstream affiliate and the non-integrated firm will buy the

essential input at a same (marginal cost) price.

14

1.3.1.2 Owner of an essential input

Second, the upstream firm has to supply an input that is sufficiently essential so that no

bypass is possible. In order to avoid bypass, some subconditions are lined out by

Crocioni and Veljanovski (2003).

First, no substitutes should be available. In the case where alternative inputs are

available on the market, the non-integrated firm will naturally switch to the substitute

input when facing a price increase.

Second, the input has to play an exclusive role in the production process of the end

product in order to be essential. This relates to the necessity of using a fixed proportion

technology in the production process since a price increase on a specific input cannot be

answered by replacing the more expensive input with a cheaper one in such a

technology.

Finally, the upstream product should be of fundamental importance in the downstream

market. If the end-product is not essential, a non-integrated firm can avoid the input by

producing a substitute end-product since it makes use of other components, hence

evading the price squeeze.

Note the distinction between the first two conditions, i.e. dominance upstream and

providing an essential input, however closely related to each other. Both are not

mutually exclusive but are to be satisfied jointly. To clarify, consider an example

(Vandekerckhove J., personal communication, 09/12/09).

Imagine a firm is providing an essential input to the production of books, say sheets of

papers. However providing an input indispensable for the production of the end-

product, the firm does not need to be necessarily dominant on the market. That is, other

upstream firms can also provide this input to the downstream firms. As a consequence,

it cannot influence the wholesale price. On the other hand a firm can easily enjoy

market power while not providing an essential input. One can certainly assume that in

times to come, e-books will provide a good alternative to paper sheets in the production

of books. Although the producer of paper sheets is dominant on the input market, it

15

faces other substitutes which renege him to increase the price of its paper as this would

not have any effect in the presence of substitute products.

1.3.1.3 Vertical integration

Third, vertical integration, or any form of contracting simulating this, acts as a crucial

instrument to adopt a price squeeze. Stated different, the undertaker must be active on

the upstream market (by providing the essential input) and on the downstream market as

well (by providing the end-product to consumers).

Given the integration, the owner of the essential input can internalize wholesale rates for

the upstream product. The firm can thus price discriminate among its own downstream

affiliate and the non-integrated firm.11 Hence, the internal transfer price acts as a

mechanism to cross-subsidize profits within the firm. Note that if no integration would

be present, it can only charge one price to the whole market, at best the highest price it

can ask for the input dependant on its market power (Crocioni & Veljanovski, 2003).

1.3.1.4 Supra-competitive profits on the downstream market

Recall from Section 1.2.1.3 recent scientific work on vertical leveraging (that is; post-

Chicago School) seem to agree leveraging strategies can only be profitable in the

absence of a perfectly competitive downstream market (e.g. Whinston, 1990; Ordover et

al. 1990; Hart & Tirole 1990). Thus, in order to employ an efficient price squeeze, the

downstream market should earn supra-competitive profits, i.e. the undertaker is able to

influence downstream market prices. Yet, dominance is not mandatory to implement the

practice since it is eventually the goal of it rather than a requisite (Geradin &

O’Donoghue, 2005; Crocioni & Veljanovski, 2003).

1.3.1.5 Level and duration of wholesale and retail prices

Wholesale and/or retail prices should be set in such a way that the margin of the

downstream competitor is not profitable to remain active in the market. This pricing

policy has nonetheless to be practiced long enough by the undertaking firm before an

effectual price squeeze has occurred (Crocioni & Veljanovski, 2003). Only on the long

11 In fact, price discrimination is not a necessary requisite to implement a price squeeze. Since this

variant is most easy to capture it is for now presented this way. See further, Section 1.3.3.

16

run the downstream rival firm will suffer, as short-term price adjustments can be

compensated by earlier or future profits.

Table I sums up the above. The transition from the situation where a company satisfies

the first four conditions to the situation it also satisfies condition five depends on the

likelihood a firm will have incentives to do so. It is to this point that we turn next.

Table I: Required conditions

Condition Note:

1 Dominance upstream

2 Essential input Subconditions to be satisfied

3 Vertical integration

4 Imperfect competition downstream Dominance not mandatory

5 Prices & Duration Enabling efficient price squeeze

1.3.2 Profitability analysis

Nothwitstanding the apparent attractiveness of a margin squeeze on the long run (recall:

the elimination of a rival downstream firm as to leverage monopoly power to the

downstream market), profitibality consequences are in fact far from univocal for the

undertaking firm. Indeed, a margin squeeze yields two effects, both having an opposite

effect on total profits of the integrated firm (that is: the sum of profits of the

downstream and the upstream affiliate) (Geradin & O’Donoghue, 2003).

The first effect appears upstream. Since the non-integrated rival is also a customer of

the upstream subsidiary given that it buys the essential input from it, the elimination of

this downstream rival will distort profits from the upstream affiliate. Indeed,

implementing a margin squeeze aims at getting rid of downstream rivals, and thus

consumers. Consequently, squeezing out downstream rivals lowers demand upstream

and reduces profitability of the upstream division of the integrated firm.

Second, a less competitive market downstream as a result of a margin squeeze implies

naturally additional sales for the downstream subsidiary. Consumers buying the end-

17

product face ex-post, after a squeeze has taken place yielding reduced competition, less

choice to buy their product of interest. Accordingly, demand downstream increases,

giving rise to higher profits for the downstream division.

It thus remains to be seen whether a price squeeze indeed raises total profits of the

integrated firm, and thus creates incentives in implementing so. Nevertheless, some

general tendencies can be classified (Geradin & O’Donoghue, 2003).

First, incentives (total profits) depends on the marginal profitability of both the

upstream and the downstream market. A more profitable upstream market relative to the

downstream one implies less incentives to squeeze since the first effect is expected to

dominate over the second. Equally, a relatively higher profitable downstream market

yields higher exclusionary incentives.

Next, profits of the downstream subsidiary naturally depends on the share of demand it

can attain after the exit of one of more non-intregrated rival firms. If rival firms on the

downstream market can pick up ‘lost’ customers of the excluded company/companies

more easily, total profits will, ceteris paribus, raise. Accordingly, incentives to

implement a margin squeeze will be higher.

Third and in lign with the second point, incentives will be higher (lower) when facing a

homogenous product (differentiated products). Facing the case of perfect homogenous

products, profits of the downstream subsidiary can raise relatively more to the case

where products would be (slightly) different, since lost consumers are much more easier

to capture.

Besides these common trends, more formal studies have devoted attention to this

profitability question as well.. King and Maddock (1999) for instance show that when

firms compete à la Cournot and offer a homogenous product, engaging in a price

squeeze by raising the wholesale price of the input for the downstream rival is profit

enhancing for the integrated firm. Thus, the upstream – negative – effect on profits is

weighted out by the downstream – positive – effect.

18

1.3.3 Implementation modes

The margins of downstream competitors can be affected by setting too low a retail

price, or too high a wholesale price, see Figure 4.

In addition, Crocioni and Veljanovski (2003) indentify three types of price squeezes: a

discriminatory one, a non-discriminatory one, and a predatory price squeeze.

Figure 4: Alternative ways of implementing a price squeeze (Ovum, 2009)

By altering the wholesale prise and leaving the retail price unaffected (the second bar of

Figure 4) a discriminatory or non-discriminatory margin squeeze can take place.

The first comes about when the vertically integrated firm charges a higher price for the

essential input to its non-integrated rival while not doing so for its own downstream

affiliate.

In the latter case no price discrimination takes place. That is, the wholesale price is

raised for the whole downstram market: both the subsidiary and the non-integrated firm.

Notwithstanding both will face higher costs given the price increase, the integrated firm

is however able to cross-subsidize by means of the upstream affiliate. The only

dissimilarity between a discriminatory and a non-discriminatory margin squeeze is

therefore of distributive nature. When facing an international entity active in different

19

tax-rate countries this distinction can however be an significant point of attention

(Crocioni & Veljanovski, 2003).

Unlike the two preceding implementation modes, a predatory price squeeze focuses on

the retail price charged to the consumers. As shown by the third bar of Figure 4, the

price of the end-product will be lowered whereas the wholesale price is left unchanged.

None of the mentioned types of price squeezes are mutually exclusive. In practice

however, regulatory environments imposed by authorities often diminish the available

tools. The next chapter will focus on these mechanisms imposed by regulatory

authorities by which remedies to the price squeeze are presented. The law and

economics of antitrust, the ex-post judiciary approach, will be dealt with in Chapter 3.

1.4 Conclusion

A price squeeze refers to the anti-competitive way of setting wholesale and retail prices

by an integrated firm who supplies a vital input into the production process. Its

objective is to loose competition on the downstream market where it competes with

non-integrated rivals. In order to achieve, the integrated operator attempts to narrow its

rival firms’ margins by charging a higher wholesale price and/or a lower retail price.

This pricing mechanism finds itself related to other well documented anti-competitive

practices. On the wholesale level it shares similarities with vertical foreclosure and

raising rivals’ costs, while on the retail level it is strongly related to predatory pricing.

However connected, a price squeeze has its particular characteristics making it a distinct

practice to implement. Critical conditions are required in order to implement an

effectice margin squeeze who is able to drive competitor(s) out of the downstream

market: vertical integration, upstream market power, the delivery of an essential input

and an imperfectly competitive market downstream.

Profitability prospects for the integrated firm are ambigious due to two opposite forces.

On the one hand the upstream affiliate cancels out an own consumer, since a non-

integrated firm buys the essential input from the integrated firm’s subsidiary. On the

other hand however, the downstream affiliate will face less competition on the

20

downstream market, thus able to extract more revenue. Some forces influence these

tendencies.

Finally, the executing firm faces different ways of implementing a price squeeze. It can

alter the wholesale price, the retail price or a combination of both. Depending on its

choice, a discriminatory, a non-discriminatory or a predatory price squeeze comes forth.

21

Chapter 2 Preventing the price squeeze by means of

regulation

A price squeeze can be prevented by imposing regulatory constraints. Authorities

possess of a broad toolbox of instruments in order to limit free competition. In doing so,

they aim at avoiding potentially harmful practices, affecting social welfare to the

detriment of consumers. Accordingly, a price squeeze can be regulated for since it could

distort competition through monopolizing an otherwise more competitive downstream

market.

This chapter will be organized as follows. First the general nature and importance of

regulation is illustrated by focusing on one particular type of industry, i.e. network

industries. The second part describes the different regulatory environments an

undertaking firm can face. Finally the third part lines out the implementation of specific

regulatory mechanisms to prevent a price squeeze.

2.1 Illustrating the importance of regulation: the case of network

industries

A firm satisfying all four conditions lined out previously (dominance on the upstream

market, providing an essential input, supplying an imperfect competitive downstream

market and vertical integration) can engage in a price squeeze. Therefore, regulatory

authorities provide constraints, diminishing the ability of a firm to reside in such a

practice. Hence, ex-ante controls are implemented, in contrast to ex-post antitrust

judgment by the courts (see Chapter 3).

Regulation is a highly desirable tool to safeguard economic efficiency in industries

which are very prone to welfare reducing conduct of firms. Network industries are

illustrative since they often consist of a natural monopoly resulting from high fixed

costs incurred by the implementation of a network. Regulation thus provides a solution

for potential market failures in the presence of such a monopoly (Baron, 2005, p. 324).

Network industries are characterized by the existence of a network that moves products,

people or information from one place to another, such as transport networks (cf.

railways), information networks (cf. telephony) or utility networks (cf. electricity)

22

(Federaal Planbureau, 2006, p. 21). In the electricity industry for example, distribution

of the generated electricity is provided by a network of cables, transporting the utility

over a certain area.

The complexity with network industries lies in the combination of naturally competitive

and monopolistic activies. That is, the typical production chain consists of segments that

tend to be supplied competitive to consumers while others tend to be monopolistic.

Lapuerta and Moselle (1999, p. 454) explain:

‘Each of these industries combines activities that are potentially competitive

such as generation of electricity, with ones that are naturally monopolistic such

as transmission of electricity. This combination produces a unique set of

challenges to competition law and policy in designing a market structure and

regulatory framework which maximizes the benefits of liberalization while

effectively controlling any tendencies to monopolistic abuse.’

Concerning the electricity industry, a natural monopoly exists on the level of

transmission and distribution, since the implementation of such a network requires

massive investments and hence high fixed costs. Consequently, competition in the

supply and generation of electricity requires so called “access” to the infrastructure

networks, controlled by a regional provider (Weisman & Kang, 2001). Thus, the

network can here be seen as the essential input in order to produce/deliver the end-

product (electricity) (see Table II).

Regarding the telecommunications industry, the point of interest concerns the use by

long-distance carriers of services supplied by regional companies. In the United States

for example, players on the long-distance market such as AT&T and Sprint are seeking

access to the essential services provided by the Regional Bell Operating Companies

(RBOCs). Access here refers to the fact that a long distance carrier has to pay the

RBOC for transporting a long distance call from the calling party to the long distance

carrier’s network and to transport the call from the long distance carrier’s network to the

23

called party (Biglaiser & DeGraba, 2001).12 Here, the essential input concerns thus

origination and termination services (“local loop”), in order to provide the end-product

(calls/messages) (see Table II).

Table II: Network industries and their components

Industry Essential input/service Access seekers

Electricity Transmission/distribution

network

Generation/supply

Telecommunications Local loop Long distance carriers

Both industries are of growing interest for policymakers given the possible entrance of

access providers into the downstream market. Since the Telecommunications Act of

1996 for instance, entrance of RBOCs in the long distance interLATA market is

allowed under certain conditions (Baron, 2005, p. 333).13 Hence, an essential input

provider would then be able to vertically integrate, which gives rise to possible price

squeezing conduct. Equally, the Energy Policy Act of 1992 consists of a relaxation of

prohibitions for access providers to enter the downstream market as to stimulate

competition (Weisman & Kang, 2001).

This market-opening liberalization process requires an attentive stance by authorities.

Given the resulting vertical integration, the upstream monopolist (the network provider)

can raise network usage charges or lower retail prices and by doing so implement a

margin squeeze. Pricing rules have been established by economists and policymakers to

control for these potentially abusive policies. Companies face these regulatory issues

and this results in certain regulatory environments, which will be discussed next.

12 Or stated otherwise (DeGraba, 2003) : ‘When selling long distance calling, an inter-exchange carrier

uses its own facilities to carry a call between cities but purchases the use of RBOC facilities in the cities

of the calling and the called party to route the call between their own points of presence in the cities to

the parties to the call. These purchases are referred to as “access”’. 13 Entry into the long distance market is however conditional. A 14-point competitive checklist has to be

completed as to ensure that the entrance is in “public interest” (See 47 USC §271).

24

2.2 Regulatory environments

A company willing to implement a margin squeeze can face three regulatory

environments (Bouckaert & Verboven, 2003). Under full regulation, both the upstream

and the downstream prices are regulated.14 When facing a partial regulation, only the

upstream price is regulated. Under no regulation, all prices can be chosen

unconstrained.15 These environments influence the ability to undertake a certain type of

price squeeze as classified in section 1.3.2.

2.2.1 Full regulation

When full regulation is at hand, both the wholesale price and retail price are regulated

hence (theoretically) eliminating the prospect of a price squeeze. Facing this regulatory

environment, a firm loses both instruments to imply such a practice as it cannot raise its

wholesale price nor lower its retail price to consumers since both are controlled for by

the government. Consequently, no type of price squeeze can occur in this case, see

Table III (Crocioni & Veljanovski, 2003).

Although price squeezes are theoretically ruled out in this case, two remarks have to be

made. First, Bouckaert and Verboven (2003) clarify a so called “regulatory price

squeeze” can still occur. A price squeeze then comes about as a mere artifact of the

regulatory environment. More precise, the wholesale and retail price would be regulated

as such that the aggregate, i.e. the sum of both, would fail to pass an ex-post price

squeeze test (“imputation test”, which finds out if a price squeeze takes place, see

Chapter 3). The margin squeeze is then nothing more than the unintentional result of

regulatory policies put into practice by governmental bodies.

Second, even though prices cannot be influenced by the undertaker, scholars have

pointed out the danger of non-price discrimination, often referred to as “sabotage”

(Economides, 1998; Mandy, 2000). This conduct is one particular device from the

14 The upstream price and downstream price are used as synonyms for the wholesale price and the retail

price respectively. 15 Note we do not refer to the other side of partial regulation: a regulated upstream price combined with

an unregulated downstream price. As explained by Geradin & O’Donoghue (2005, p. 20) this case is

unlikely to arise since an unregulated upstream price implies competition on this market. A price squeeze

is therefore unable to arise as it requires an upstream monopoly.

25

toolbox of the previously discussed Racing Rivals Costs strategy (see 1.2.1.2.). A firm

can for example attempt to degrade the quality of interconnection or to increase the

process time of orders as a substitute for price-altering conduct such as a margin

squeeze. Regulators can deal with these issues by imposing for instance minimum levels

of service (Bouckaert & Verboven, 2003).

2.2.2 Partial regulation

A company facing a partially regulated environment loses the upstream wholesale price

as a device to squeeze the margins of its downstream competitors. However, the retail

price can still be chosen unreservedly by which a predatory price squeeze can still arise.

Discriminatory and non-discriminatory price squeezes are nevertheless ruled out, as the

upstream price is not at the disposal of the undertaker, see Table III (Crocioni &

Veljanovski, 2003; Bouckaert & Verboven, 2003).

Remarkably, the incentives of a firm to undertake a predatory price squeeze can be

affected by the regulated upstream price, as noted by Biglaiser and DeGraba (2001).

Assuming a regulated wholesale price ex-ante, they show that a raise of this price by the

regulatory authorities yields two effects. First, the incentives of predatory pricing are

lowered because of increased profits as a consequence of the higher wholesale price.

Second, the predatory price is set at a lower level by the vertically integrated input

supplier to tempt competitors to leave the market because of the higher profits of the

integrated operator, making predation less costly. The former effect is dominating the

latter by which a higher regulated upstream price thus reduces the incentives of

predation and hence a predatory price squeeze.

2.2.3 No regulation

Under no regulation, both the wholesale price and the retail price can be set

unconstrained. Accordingly, all three types of price squeezes can occur. That is, given a

free retail price a predatory price squeeze can be implemented by lowering the retail

price and/or foreclosure can arise by manipulating a free wholesale price, see Table III.

Summing up in Table III, under full regulation all type of price squeezes are controlled

for, nevertheless non-price squeezes labeled as “sabotage” can still occur by raising

rivals’ costs. When facing a partially regulated environment, only a predatory price

26

squeeze remains feasible as the input price is determined by authorities. In the absence

of regulation, the vertically integrated firm can decide on both its wholesale and retail

price, thus being able to engage in all three types of price squeezes.

Authorities can attain one of the mentioned regulatory environments by implementing

different forms of regulation. Wholesale and retail prices are then constrained by

making use of specific regulatory tools in order to partially or entirely avoid a margin

squeeze. These will be discussed next.

Table III: Regulatory environment versus type of price squeeze (Based on Crocioni

and Veljanovski (2003); Bouckaert and Verboven (2003))

Discriminatory

price squeeze

Non-discriminatory

price squeeze

Predatory price

squeeze

Full regulation Prevented Prevented Prevented

Partial regulation Prevented Prevented Feasible

No regulation Feasible Feasible Feasible

2.3 Implementation of regulation

2.3.1 Overview

Economists and policymakers can implement several tools of regulation to prevent a

price squeeze. The discourse that follows will have its focus on the regulation of both

the retail and the wholesale price of the vertically integrated firm, in contrast to more

drastical structural interventions.

These latter interventions often seek to dismantle the vertical integration by means of

vertical separation to deal with anti-competitive practices of a vertically integrated

monopolist. Alternatively, the market structure can be altered by fostering investments

upstream to provide new alternatives for the input or to stimulate competition (ICT

Regulation Toolkit, n.d.(a)). In our framework, lined out in Section 1.3.1, the former

would imply that the condition of vertical integration is not met while the latter provides

a mechanism preventing the dominance or the essentiality of the input upstream.

27

However, since such structural adjustments often suffer from negative externalities or

are not feasible to implement, price regulation has recently taken the upperhand to deal

with a price squeeze (Dewenter & Haucap, 2006). To illustrate, vertical separation

neglects positive effects of vertical integration while stimulating competition upstream

can be a long and tough process.

Finally note that the degree of price regulation is not a trivial choice. When wholesale

prices are set too high, say “low” regulation, the vertically integrated monopolist might

become too indolent and consequently lack the incentives to invest in proper

infrastructure.16 On the contrary, too low access prices, say “heavy” regulation, could

invoke the entrance or stay of inefficient players on the downstream market (Sarmento

& Brandão, 2007). In like manner, the right balance has to be find on the retail level

leaving the regulated firm with proper market incentives.

We first line out wholesale price regulation. Thereafter, retail price regulation is

discribed. In both we discuss several modes of regulating prices.

2.3.2 Wholesale price regulation

In order to avoid the non-integrated firm to face an inflated input price, regulatory

bodies can control the upstream wholesale charge it faces. Upstream price regulation

can be implemented in several ways: we discuss a cost-based approach, a price-based

approach and the Efficient Component Pricing Rule rule. Each will be dealt with in

turn.

2.3.2.1 Cost-based regulation

When implementing cost-based regulation, regulated prices are mainly based on costs

(Vogelsang, 2003). What type of cost to be used is however not a straightforward

choice. Prices could be set at marginal cost, implying no margin is being made by the

regulated firm. In this case, a social first-best solution would result but is not feasible

since the monopolist cannot cover its fixed and common costs (Baron, 2005).

16 Quite a lot of literature has explored the relationship between investment of the incumbent monopolist

and regulation. See for example Gans (2001) and Valletti (2003).

28

Alternatively, prices could be set equal to the long-run incremental costs with or

without a markup to cover fixed and common costs.

Using such a cost-based approach, a price squeeze can be prevented by predetermine the

upstream input price. The vertically integrated firm would then have to set its wholesale

price equal to a predefined cost-based level, losing its ability to raise the input price. To

illustrate, using the model lined out by Bouckaert and Verboven (2003), the wholesale

price could be set at

� � �� .

The first term, ��, refers to the upstream production costs of the essential input. The

second term adds partially or completely (dependant on α) interconnection costs, �, to

the wholesale price.17

Although cost-based regulation is attractive since it preserves the direct linkage between

costs and final prices, regulators often suffer with incorrect cost and markup

determinations and complex informational requirements (Vogelsang, 2003). A too low

markup, for instance, could invoke the bottleneck monopolist to exclude its rivals from

the downstream market to compensate for this heavy handed regulation. As a

consequence, regulation would in this case be foster exclusionary behavior, instead of

preventing it (Vogelsang, 2003; Laffont & Tirole, 2000, Section 4.5).

Moreover, cost-based prices provide no incentives to lower costs and hence increase

efficiency. If costs are lowered, the undertaker is actually penalized since the wholesale

price will accordingly be revised downwards (Larson & Weisman, 1998).

2.3.2.2 Price-based regulation: price cap

Alternatively, the wholesale price of the integrated monopolist can be constrained by

making use of price-based regulation. An excessively inflated wholesale price is then

prevented by implementing a price cap. Such a price cap consists of a price ceiling,

under which a firm hase complete freedom to set its price. Typically, one price cap is

17 Interconnection costs are additional upstream costs incurred by the integrated input provider to deliver

the essential input to the non-integrated firms. In telecommunications for instance, � would be costs for

providing a non-integrated firm access to the local loop (e.g. compatability costs). See Bouckaert and

Verboven (2003).

29

defined for a certain group of products/services within one firm. The price ceiling is

then calculated for the bundle based on the Consumer Price index. Hence, prices of each

product/service in the package can be chosen freely as long as the weighted average of

the group does not exceed the cap (Liston, 1993).

Two types of price caps are distinguished: a partial price cap and a global price cap.

Under a partial price cap, only wholesale services are incorporated in a bundle. In a

global price cap, as proposed by Laffont and Tirole (1996), both wholesale and retail

services are intertwined in one single bundle. The latter case thus stresses on the

importance of the interdependence between both prices.

Given the nature of a price squeeze, a partial price cap is most advisable. To see this,

consider the implementation of a global price cap. In such a case, a price squeeze is still

possible since a higher wholesale price could be compensated by a lower retail price

while still respecting the global price ceiling. Therefore, additional restrictions on the

pricing flexibility would be necessary (Laffont & Tirole, 2000). A partial price cap was

indeed considered in the UK in 1997 as well as in the US in 1991 to control for price

squeezing behavior (Vogelsang, 2003).

Making use of a price cap is particularly attractive as it does not require that much

detailed information as in the case with cost-based regulation. Moreover, it can increase

firms’ incentives to reduce costs, for example by investing in process innovations, since

it would be difficult not to to exceed the price cap in the presence of high costs while

still earning a margin (that is: operating inefficient). Indeed, price caps are currently an

often used tool of regulation in telecommunicatinos in a large part of the world (ICT

Regulation Toolkit, n.d.(b)).

2.3.2.3 The Efficient Component Pricing Rule

A frequently discussed device of regulation is the so called Efficient Component Pricing

Rule (hereinafter ECPR), also referred to as the retail-minus rule, strongly advocated by

Baumol (1983) and Willig (1979). The ECPR provides a formula to set an industry-

efficient wholesale price for the upstream essential input. It states that the price charged

for the input should equal the sum of two components: the direct costs incurred by the

integrated firm as a consequence of access provision and the opportunity cost it faces.

30

The former expresses all costs in order to sell the upstream input to its rivals, e.g.

upstream production and interconnection costs. The latter refers to the integrated firm’s

lost profits in the retail market given that it provides access which yields additional

competition downstream (Armstrong, 2002).

In sum, the ECPR can be expressed as (Armstrong, 2002):

Access price = cost of providing access + opportunity cost.

Or in a formal way:

� � ��

��

� � � � ��

using the notations introduced above and with �� the downstream processing costs of

the integrated firm.

The mechanisms behind the ECPR are most easy to capture by considering an example

(Grant, 2004, pp. 65-66). Imagine the integrated firm has a marginal cost of providing

access equal to �� (��) per unit. Assume � � �. In order to produce the finished

product it faces an additional processing cost downstream of �� (��) per unit. Suppose

in addition a retail price of �� (�). The integrated operator can thus obtain a profit of

�� per unit sold to consumers.

Suppose now the integrated firm sells it vital input to a rival firm downstream which

uses this input in order to deliver the same final good. What price should it charge? The

ECPR dictates the non-integrated rival should pay �� (direct costs of providing access =

+ the foregone profit margin �� (opportunity cost) = �� per unit.18

How does such a rule prevents a price squeeze? Generally speaking, the ECPR takes

away a vertically integrated firm’s incentives to discriminate among its non-integrated

rivals since it is compensated for providing access to its downstream rivals through the

18 Note however we expect a 1/1 relationship between lost sales in the downstream market by the

integrated firm and additional sales by the non-integrated firm in this market. That is, selling one unit of

the vital input to the downstream rival firm will cause the integrated firm to lose one unit of sales for each

extra unit the rival firm sells to consumers. Conceptually this is noted as the ‘displacement ratio’. See

Armstrong and Porter (2007, p.1674) or Armstrong (2002).

31

opportunity cost in the ECPR price. Hence, the incentives to leverage its market power

downstream and exclude its competitors are reduced (Hawthorne & Morris, 2008). Even

more, implementing a price squeeze turns out to be unfeasible when facing the ECPR

rule. The wholesale price is fixed by the rule and thus cannot be raised. Apart from this,

lowering the retail price in order to employ a margin squeeze is equally unattainable: a

lower retail price lowers the opportunity cost and as a result the wholesale price. Both

are thus linked to each other and cannot be altered independently.

The ECPR rule is indeed considered in practice to control for margin squeeze abuse.

Oftel (the British telecommunications regulator) judged the ECPR rule as an adequate

tool to prevent British Telecom, an essential provider of broadband internet acces, of

anticompetitive conduct (Oftel, 1994).

An ECPR pricing rule is compelling for two reasons. First, it puts forward a regulated

wholesale rate using a very simple formula. Accordingly, it requires low informational

input compared to other forms of regulation such as cost-based pricing (Dewenter &

Haucap, 2006, p.12).

Second, it assures that only efficient players will be able to operate on the downstream

market (Grant, 2004; White, 2005). To see this, think of an entrant who faces a

downstream cost of ��. This is higher than the integrated firm’s cost of providing

the final good by which the entrant is thus less efficient. When willing to operate on the

market, the entrant will now incur total costs of ��, which equals �� (the

wholesale price for the essential input defined by the ECPR rule) + �� (its additional

production costs).

Given a retail price of ��, the entrant would therefore not be able to operate profitably.

Quick calculations show that profitable entry is only possible when downstream rivals’

production costs are less than or equal to ��, that is: below the production costs of the

integrated firm.

How appealing the ECPR rule might be, its general applicability has largely been

contested both in literature (see for example Economides and White (1995)) as well by

practitioners (see below). The main point of confusion regards the retail price, which is

said to be given (Vogelsang, 2003).

32

This however is a crucial point. In the example above, the retail price was asumed to be

��, yielding a mark-up of ��. Yet, the ECPR does nothing to prevent this, i.e. it is

“insensitive to the market power that has generated the mark-up that the

incumbent is earning by selling at a price of €10 per unit and the consequent

allocative inefficiency imposed on consumers” (White, 2005, p.53).

Thus, the ECPR rule thus does not preclude the exercise of monopolized prices through

the retail price.

The Federal Communications Commission, for instance, which is the US regulator

regarding telecommunications, has rejected the use of ECPR:

‘We conclude that ECPR is an improper method for setting prices (…) the ECPR

does not provide any mechanism for moving prices towards competitive levels; it

simple takes prices as given’19

2.3.3 Retail price regulation

Apart from regulating the wholesale price, the retail price can be controlled for to

prevent too low prices on the retail level. Equally to the wholesale price this can be

done in several ways. Both the cost-based and the price-based approach are discussed

next.

2.3.3.1 Cost-based regulation

Similarly to the wholesale price, the retail price of the vertically integrated firm can be

constrained by making it subject to any form of costs. Consequently, the retail price

cannot be lowered freely by the undertaker, by which it loses the retail price as a device

to implement a margin squeeze.

19 Implementation of the Local Competitions Provisions in the Telecommunications Act of 1996, First

Report and Order, FCC 96-325, par. 709.

33

More precise, the retail price can be set at � � �� , consistent with above used

notations (Bouckaert & Verboven, 2003).

2.3.3.2 Price-based regulation: price floor or the the imputation rule

Alternatively, the retail price can be limited under a price-based approach. By imposing

a price floor, too low retail prices can be prevented (Weisman, 2002).

A retail price floor defines the retail price imposed on consumers conditional on the

wholesale price charged by the integrated firm for the essential input. This regulatory

tool is well known as the “imputation rule”: it obliges the integrated firm to set its retail

prices as if it were to buy the input from itself - at the same price it charges to its non-

integrated downstream rivals - and in doing so to cover its production costs downstream

(ABA Section of Antitrust Law, Telecom Antitrust Handbook, 2005).

Stated otherwise, the imputation rule dictates that all revenue received by selling the

final good to consumers should cover costs of the downstream affiliate of the integrated

firm in the hypothetical situation this division would have to buy the essential input

from itself, i.e. the upstream subsidiary of the integrated firm (King & Maddock,

2002).20

Formally the imputation rule can be stated as (Polo, 2007; Bouckaert & Verboven,

2003):21

� � � � ��

Or rearranged:

� � � �� .

Or even:

� � � � ��

Remark its similarity with the ECPR rule. Hence, its mechanisms to prevent a price

squeeze are equal. The ECPR rule however generally defines an endoginized wholesale

20 The imputation rule is often used as an ex-post judiciary verification tool aswell. This imputation test,

to find out whether a price squeeze has taken place, is in depth discussed in Chapter 3. 21 Note that � corrects for the addional costs of providing the unit to the downstream non-integrated firm,

which thus needs to be deducted or added depending on which inequality is used.

price for a given retail price, while the impution rule is usually written as an inequality

(Polo, 2007). Moreover, some minor nuances exist between both, see for example

Hausman and Tardiff (1995).

2.3.4 Summing up

The above mentioned regulatory devices are brought together

structural interventions, authorities can focus on the upstream wholesale price and/or on

the downstream retail price.

based approach. Alternatively, the wholesale price can be constrained by making use of

the ECPR rule. Likewise, a cost

restrict the latter.

2.4 Conclusion

In this chapter we have illustrated the importance of regulatory intervention to prevent

anticompetitive conduct by means of the case of a network industry. Electricy and

telecommunications indust

government regulation

a price squeeze.


Moreover, some minor nuances exist between both, see for example

Hausman and Tardiff (1995).

Summing up

The above mentioned regulatory devices are brought together in Figure


the downstream retail price. The former can be regulated under a cost


the ECPR rule. Likewise, a cost-based approach or a price floor (imputation rule) can

we have illustrated the importance of regulatory intervention to prevent


telecommunications industries both act as specific practical examples, making

government regulation desirable to prevent welfare distorting business practices such as

Preventing the price squeeze

Structural interventions Price regulation

Wholesale price regulation

ECPR

Cost-based

Price Cap

Retail price regulation

Cost-based

Price Floor (imputation rule)

Figure 5: Regulatory remedies

34


Moreover, some minor nuances exist between both, see for example

in Figure 5. Apart from


The former can be regulated under a cost-based or a price-


based approach or a price floor (imputation rule) can

we have illustrated the importance of regulatory intervention to prevent


act as specific practical examples, making

rable to prevent welfare distorting business practices such as

35

Industries can face three regulatory environments. When the integrated firm can set both

its retail price and its wholesale price unrestricted, no regulation is at hand by which a

price squeeze is not ruled out. In the case the wholesale price is regulated, the

undertaker can only persue a margin squeeze by using the retail price. When full

regulation is at hand, both the wholesale price and retail price are constrained. A price

squeeze is in this case prevented, at least in theory.

Obtaining one of these regulatory environments can be done in several ways. Prices can

be constrained by making them subject to some form of cost. Alternatively, a price cap

or the Efficient Component Pricing Rule at the wholesale-level, or a price floor at the

retail-level can be put in practice, the latter well known as the imputation rule.

Yet, even the finest regulatory devices are unable to completely rule out price squeeze

allegations brought before courts. Hence, the next chapter lines out the arising

implications for antitrust law.

36

Chapter 3 Law and economics of antitrust

Apart from regulation in order to prevent a price squeeze ex-ante (Chapter 2), a price

squeeze can be dealt with ex-post before courts. The plaintiff will then seek relief for

the actions taken by the defendant by which the court faces the tough job to balance all

arguments made by both parties and take a sound decision to the benefit of society.

In accordance, this chapter focuses on the judiciary processes of a margin squeeze

claim. First, the typical approaches taken by courts to deal with an allegation, including

the imputation test by which facts at hand are quantified, are dealt with. Second, the

anticompetitive nature of a price squeeze is discussed in the light of modern antitrust

objectives. Finally, historical decisionary practices, both in Europe as in the United

States, are summarized to highlight different inter- and intra-contintal legal treatments.

3.1 The approach taken: relevant market power and the imputation test

The pattern of action to deal with a typical price squeeze claim consists of three

consecutive steps. First, there is the identification of the relevant market which is then

followed by recognition of market power (Crocioni & Veljanovski, 2003; Stoyanova,

2008, p. 252). Finally, once relevant market power is proven, an imputation test is used

to verify if a price squeeze has taken place. Each of these steps will be considered in

turn.

3.1.1 Relevant market

As in each antitrust case, the approach starts with a definition of the relevant market.

Since a price squeeze entails two interrelated markets, this analysis can raise particular

antitrust questions not yet studied well in case law (Sidak, 2008).

As lined out by the Access Notice,22 two relevant markets have to be defined: the market

in which the end-product is provided to consumers (downstream) and the market

supplying the essential input (upstream). The question then raises which of these has to

be considered first. Should an analysis begin by defining the upstream market first,

followed by the definition of the attached downstream market? Or should on the

22 Notice on the application of the competition rules to access agreements in the telecommunications

sector, 98/C 265/02 (1998), European publication. Herinafter “Access Notice”.

37

contrary the downstream market be dealt with first? Crocioni & Veljanovski (2003)

advocate in favor of the second sequence.

By defining the relevant downstream market firstly, the essentiality of the input can be

assessed correctly (Crocioni & Veljanovski, 2003). To see this, consider a broader

definition of the downstream market. This would naturally involve a wider range of

products delivered to consumers by which alternative substitute end-products are

comprised. Hence, the upstream input can possibly not be regarded essential any longer

for this wider variety of products.

Doing otherwise is nevertheless tempting (Crocioni & Veljanovski, 2003). One is

indeed attracted to start with a definition of the upstream market since this is where

market power arises most clearly. The analysis would then see the essential raw material

or service input market as relevant and try to find out what its relevant adjacent market

is, i.e. where the upstream market power is aimed to leverage to.

This nevertheless leaves space for incorrect judgements of abuse as it takes the

essentiality of the input simply as given. In lining out the relevant downstream market

first, one can immediately evaluate correctly the condition of ‘vital’ input for the

defined downstream market. If a proper definition downstream makes clear the input is

not essential, a price squeeze is not at hand.

3.1.2 Market power

Only when dominance on the relevant market is shown, a price squeeze allegation can

be considered (moreover, market power is the general starting point for any antitrust

case, see Motta, 2004). Nevertheless, should the dominance requirement apply to the

complete vertical market, i.e. both the upstream and downstream one? Or is upstream

market power sufficient in order to continue investigations?

The answer to both questions thus depends on whether downstream dominance is

required.23 There is however far from an agreement concerning this issue. Some

23 Indeed, note that only market power downstream makes no sense: dominance on the upstream market is

required and essential since it is even obligatory to implement a margin squeeze after all, see Section

1.3.1. If this would be not the case, a price squeeze can not occur and hence one can not be found liable.

38

arguments can be made in favor of both perspectives, as summarized by Geradin and

O’Donoghue, 2005.

First, it is noted that a price squeeze is in essence similar to a predatory pricing case in

the context of vertical integration when the retail price is lowered. Accordingly, it

would be strange that no dominance on the respective downstream market would be

required, as this is indispensable in a “classical” predatory pricing allegation to find

abusive conduct.

Second, Geradin and O’Donoghue (2005) are reasoning intuitively that it would be

illogical to require only wholesale dominance given the very nature of a price squeeze:

‘(…) downstream dominance also seems inherent in the basic notion of a margin

squeeze – that a firm controls the prices on two vertically-related markets and can

therefore squeeze the margin between those prices. If a firm only has market

power in relation to prices on one of the markets concerned, it is difficult to see

how a margin squeeze could arise’ (Geradin & O’Donoghue, 2005, p. 50).

On the other hand, instead of making use of already existing market power to maintain

or reinforce a dominant position, a price squeeze can be used as a tool to extend

upstream market power downwards (cf. supra). It would therefore be unwise to require

downstream market power since the margin squeeze acts as a leverage instrument to

attain such power by excluding rivals (Geradin and O’Donoghue, 2005).

Indeed, recall from Section 1.3.1.4 that dominance is not a requisite to implement a

margin squeeze, only a limited influence on prices is. Accordingly, there is a tendency

to conclude downstream dominance to be necessary.

Nonetheless, practical case law tends Geradin and O’Donoghue (2005) to observe that

downstream dominance seems to be crucial to find abusive conduct. As noted, cases in

which a price squeeze allegation was rejected generally did not consist of downstream

dominance (for example BT Broadband 24). On the contrary, in National Carbonising,

24 Case CW/00613/04/03 (2003).

39

British Sugar and Deutsche Telekom25 a price squeeze has been proven while on both

the upstream and downstream market dominance was present.

3.1.3 Imputation test

A third step in finding out whether a price squeeze has taken place is the so called

“imputation test”. First the purpose of the test and its different forms of implementation

are considered. Additionally, we highlight some major points of attention when

adopting the test.

3.1.3.1 Purpose and components

The imputation test is a quantitative tool helping competition authorities to find out

whether a price squeeze has taken place. Its purpose is to prove that an at least equally

efficient downstream competitor is not able to make a sufficient margin in the

downstream market for a long enough period as a consequence of the pricing policies of

the dominant vertically integrated incumbent (Casenote, 2004).

The imputation test reminds the logic of the imputation rule. Both are composed

equally, but differ in practical usage. The imputation rule is an ex-ante regulatory tool

which firms have to comply with when setting wholesale and retail prices, see Section

2.3.3.2. The imputation test on the other hand is used as an ex-post verification

instrument in judging price squeeze claims. By doing so, it provides empirical evidence

that a margin squeeze has arisen.

Hence, the test’s formal notation is closely related to the rule’s notation discussed

above. Accordingly, a price squeeze is found whenever:

� � ��

(see Polo, 2007 and Bouckaert and Verboven, 2003).

Thus, a price squeeze arises when the downstream subsidiary of the integrated firm is

not able to operate profitable for a sufficient amount of time if it would have to pay the

same price for the essential input (�) its downstream rivals need to pay, i.e. its retail

price (�) does not cover the retail costs (��) added up with the input price (corrected for

additional costs (�) incurred by the integrated firm for providing the input).

25 Case 76/185/ECSC (1975), 88/518/EEC (1988) and T-271/03 (2008) respectively.

40

In its Access Notice, the European Commission clarified the use of an imputation test to

check for price squeezing conduct. Two tests are suggested. Test 1, the “equally

efficient operator test”, is described as follows:

‘A price squeeze could be demonstrated by showing that the dominant

company's own downstream operations could not trade profitably on the basis of

the upstream price charged to its competitors by the operating arm of the

dominant company.’26

In our notations, this reads as testing if:

� � �� .

The Commission thus adopts an equal approach in testing for a price squeeze as

literature puts forward, nevertheless without correcting for �.

Test 2 on the other hand, the “reasonably efficient operator test”, uses downstream costs

of a reasonable efficient competitor instead of the downstream division of the integrated

firm:

‘[…] the margin between the price charged to competitors on the downstream

market […] for access and the price which the network operator charges in the

downstream market is insufficient to allow a reasonably efficient service

provider to obtain a normal profit’27

Thus, a margin squeeze is found whenever:

� � ��

with �� the downstream costs of a reasonable efficient firm.

Which of the above approaches should be taken is nevertheless far from clear, nor by

official policy statements, nor by decisional historical practice (Geradin and

O’Donoghue, 2005). Some have clearly advocated in favor of a reasonably-efficient

26 Access Notice, par. 117. 27 Access Notice, par. 118.

41

operator test (see for example Clerckx and de Muyter, 2009) while others argue both

tests have to pass (see for example Grout, 2000).

3.1.3.2 Additional remarks

However at first sight appealing, practical implementation of the imputation test does

not escape from some major complexities. We point out the most important difficulties

in what follows.

First, an imputation test requires precise cost determinations. In its best, the test should

make use of incremental or avoidable costs,28 thus eliminating joint and common

downstream costs from the analysis (Casenote, 2004). In doing so, it is avoided the

vertically integrated firm is penalized for enjoying lower costs due to economies of

scale or scope (Casenote, 2004). If the integrated firm is for instance enjoying the

benefits of economies of scale/scope on a common cost such as a customer-billing

system, the rival firms are likely to have higher costs if impossible to replicate (Frontier

Economics, 2008). Nevertheless, this cost asymmetry is only a reflection of efficiency

differences and should therefore be excluded from the analysis.

Second, prices of the upstream input and the end-product (� and �) can often be non-

linear. They can consist of a fixed charge together with a price per unit (two-part tariffs)

or can include quantity discounts. Moreover, there can be additional revenue sources for

a product. This complexity can be solved by making use of appropriate price indices

(Grout, 2000; Crocioni & Veljanovski, 2003).

Third, the appropriate time frame has to be chosen in order to find out whether the

margin is unprofitable for the non-integrated firm (Ovum, 2009). A static model can be

applied, which evaluates profitabiliaty period by period. Alternatively, the Discounted

28 Incremental costs are those costs that are incurred as a result of selecting one alternative over another.

Avoidable costs are those that can be avoided when a certain decision would not be made (Jiambalvo,

2004). Applied to Test 1 to clarify, incremental costs are all costs incurred by the integrated firm as a

result of supplying the downstream market, while avoidable costs are those that would be avoided if it

whitdraws from the downstream market (Casenote, 2004).

42

Cach Flow method calculates a Net Present Value, estimating profitability over a multi-

period timeframe.

Fourth, in a multi-product case the integrated firm and its rival firms offer more than

one single end-product to consumers. Think for example of a firm active in the

telecommunications industry (Bouckaert & Verboven, 2003). Besides line rental it can

offer call services on a local, regional, or international basis. Nevertheless, the upstream

essential input (local-loop network access) is mandatory to deliver each of these

products/services.

The question then arises on what aggregation level the test should be applied (Bouckaert

& Verboven, 2003). It can be done at a ‘high’ level of aggregation, for instance the

whole relevant downstream market. Alternatively, a more narrower approach can be

chosen, by which a test is done for every single product/service.

Finally, as noted by King and Maddock (2002), it is important to stress that an

imputation test only acts as a guidance towards competition authorities. On its own it

does not provide sufficient proof to conclude that antitrust laws are violated. That is, the

simple fact of finding of a price squeeze vis-à-vis a non-integrated firm is insufficient to

tell whether this conduct was indeed abusive in the light of antitrust objectives. What

are those objectives? And how can one make a distuingish between a margin squeeze

who violates antitrust laws and one that does not? These questions are dealt with in the

next section.

3.2 Identifying the anticompetitive nature of a price squeeze

In the above analyses the anticompetitive nature has up till now implicitly been

assumed. This section attempts to clarify this focal point of attention by balancing both

anti and pro-competitive effects surrounding a price squeeze allegation.

In order to procede however, a precise notion of anticompetitive practices needs to be

provided, since preventing these consists as the ultimate purpose of antitrust policy and

by consequence acts as the fundamental notion in a price squeeze allegation. In short,

the goal of antitrust statues is to protect competition in markets such that consumers will

be better off (Baron, 2005, p. 265). In other words, its intent is not to protect

competitors, but consumers:

43

‘The primary purpose of Article 8[2] is to prevent distortion of competition –

and in particular to safeguard the interests of consumers – rather than to protect

the position of particular competitors’29

A price squeeze allegation should thus be complemented by an economic analysis of the

effects on customers (Baron, 2005, p. 265). Stated otherwise, a rule of reason approach

is to be followed, by which negative and positive effects of the price squeeze practice

are weighted against eachother. Hence, the mere finding of a margin squeeze which is

likely to distort competition and presumably drive one or more downstream rivals out of

the market is on its own not a violation of antitrust statutes. That is, a difference has to

be made between a price squeeze and an anticompetitive price squeeze, where the latter

is harming consumer welfare on the long run by means of higher prices for the products.

Indeed, this approach was rightly followed by judge Breyer in Town of Concord v.

Boston Edison Company:30

‘Traditional antitrust principles will guide our analysis. We shall compare the

[alleged price squeeze’s] likely anticompetitive effects with its potentially

legitimate business justifications. In doing so, we shall bear in mind that a

practice is not “anticompetitive” simply because it harms competitors.’31

The question remains what these pro-competitive effects are. In other words: in what

cases should a price squeeze claim be regarded suspiciously by antitrust courts? Areeda

and Hovenkamp (2001) classify three circumstances leading to a price squeeze in the

presence of pro-competitive effects: a price squeeze as the consequence of altering cost

and demand functions, the elimination of downstream monopoly profits and

inefficiencies of the non-integrated firm.

29 Oscar Bronner GmbH & Co. KG v. Mediaprint Zeitungs-und Zietschriftenverlag GmbH & Co. KG and

Others (D-7/97), Opinion of Advocate General Jacobs, 28 May 1998, par. 58. 30 Case 915 F2d 17 (1990). 31 Id., par. 16.

44

First, a margin squeeze can come about as the byproduct of a change in cost and

demand functions. To illustrate, consider a raise in production costs of the essential

input, say aluminum ingot.32 As a result, the price of the ingot will increase to

compensate for higher costs. When demand for the end-product, say aluminum sheet is

left unchanged (and thus the retail price of the end-product remains unchanged as well),

the non-integrated firm can argue it suffers a squeeze on its margin. Nevertheless, the

“squeeze” is nothing more than the result of a properly adjusting market where the

higher price for ingot is correcting the imbalance between supply and demand functions

(Areeda & Hovenkamp, 2001; Goelzhauser, 2004).

A second pro-competitive justification of a price squeeze is the elimination of a mark-

up on the downstream market. That is, if the non-integrated firm is a monopolist at the

downstream market, the elimination of this player by means of a price squeeze will

likely have a positive effect on consumers since the final price will be lowered. In such

a case where a downstream monopolist is squeezed by an upstream one, the

downstream non-integrated firm cannot claim a price squeeze just to safeguard its own

monopoly profits (Areeda & Hovenkamp, 2001; Goelzhauser, 2004).

Third, courts should be aware of possible efficiency divergences. The integrated

undertaking can perhaps operate more efficient than its non-integrated rival, who is

claiming a price squeeze only because it finds itself facing (much) higher costs

compared to the dominant integrated firm.

Think for example of a vertically integrated input supplier, competing with one

downstream rival to deliver the end-product. If this non-integrated firm operates

however very inefficiently, it will obviously deal with high costs. As a consequence, a

price squeeze claim is likely to arise as the non-integrated firm will argue it cannot

cover its costs as a result of the pricing policies of the integrated firm. Nevertheless, the

incumbent monopolist is doing nothing more than competing on the merits. An

anticompetitive price squeeze is therefore not at hand, since consumers are not harmed

by the logical competitive process of eliminating an inefficient player from the market

(Areeda & Hovenkamp, 2001; Goelzhauser, 2004).

32 Aluminum ingot was the vital input in the famous Alcoa case, see later Section 3.3.2.

45

The above mentioned possible pro-competitive justifications have thus to be taken in

consideration. In Town of Concord v. Boston Edison Company to illustrate, judge

Breyer rejected the plaintiff’s claim by stating there are effects at hand to the benefit of

consumers, being the comparative inefficiency and a monopoly position of the non-

integrated firm.33

Nevertheless, as stated by Sidak (2008), it is remarkable that this “obvious” path to deal

with a price squeeze allegation is often not choosen. After all, not doing so consists in

fact of an implicit violation of traditional antitrust reasoning. How then did courts

handle a price squeeze claim? And what final decisions were made in the leading cases

throughout US and Europe? A review on decisional historical practice is provided in the

next section.

3.3 Landmark cases: how courts handled an allegation

Both in Europe and the US, antitrust courts have dealt with margin squeeze cases over

history. It is interesting to note what decisions were made in what context as to classify

judicial decisions. First, cases in Europe are reviewed, followed by a discussion of US

cases. Based on that we draw some major conclusions.

3.3.1 Europe

The practice of a price squeeze, constituting Article 82 infringement (now Article 102),

has a limited history throughout Europe (Grout, 2000). We first review the historical

cases. After that, we summarize the more recent Deutsche Telekom case.

3.3.1.1 Historical cases

The National Coal Board v. National Carbonising Company case of 197534 concerning

a deregulated industry, was the earliest of few legal cases brought before the

Commission. The National Carbonising Company (NCC) bought all of its coal from

National Coal Board (NCB), who had a dominant position on the upstream market, and

by means of its downstream affiliate also on the retail market, where it competed with

33 Case 915 F2d 17 (1990), par 26-27. 34 Case 76/185/ECSC (1975).

46

NCC to produce hard coke. NCC argued it could no longer compete freely on the retail

market given consecutive price increases by NCB of the coal and thus sought relief.

The Commission rejected the claim but noted however to the possibility of such a

practice:

‘An interprise in a dominant position may have the obligation to arrange its

prices so as to allow a reasonable efficient manufacturer of derivatives a margin

sufficient to enable it to survive in the long term.’35

Thus, regarding means of proof, the Commission adopted the reasonably efficient

operator test (Test 2) (Motta & DeStreel, 2003).

A second formal treatment was found in the sugar industry in British Sugar v. Napier

Brown.36 British Sugar (BS) was found dominant in both the upstream (bulk sugar) and

downstream (retail sugar) market. Napier Brown, the non-integrated company on the

downstream market, argued BS’s pricing policies (including a margin squeeze) were

anticompetitive. The Commission referred again explicitly to a price squeeze:

‘A company which is dominant in the market for both a raw material and a

corresponding end product may not maintain a margin between both prices

which is insufficient to reflect that dominant company’s own costs of

transformation with the result that competition in the derived product is

restricted.’37

The Commission thus considered the equally efficient operator test (Test 1) to show the

existence of the price squeeze (Motta & DeStreel, 2003). Given the specific facts at

hand, BS was eventually fined for predatory pricing.

35 Id. 36 Case 88/518/EEC (1988). 37 Id., par. 66.

47

In 1996, in Pechiny Electrometallurgie v. Industrie des Poudres Spheriques,38 the

Commission rejected a price squeeze claim by Industrie des Poudres Spheriques (IPS).

IPS claimed that its integrated rival Pechiny Electrometallurgie, who was the sole

producer of calcium metal and competed downstream with IPS to deliver broken

calcium metal, was abusing its upstream dominant position by refusing to deal and

abusive pricing. IPS did not settle for the decision however and applied to the Court of

First Instance for annulment. The Court again rejected by arguing there were alternative

inputs available in order to process the end-product. Moreover, it stated:

‘The applicant has failed to prove the very premises on which its argument is

predicated, namely the existence of abusive pricing of the raw material.’39

The Court thus focused on the wholesale price only. Indeed, in its definition of a price

squeeze, merely the upstream price is considered as a device to implement the practice:

‘Price squeezing may be said to take place when an undertaking, (…), sets the

price at which it sells the unprocessed product [upstream input], at such a level

that those who purchase it do not have a sufficient profit margin to remain

competitive [on the downstream market]’40

Given the Court’s ignorance of the downstream price and, as a consequence, the

misunderstanding of the very mechanism of a price squeeze, concerned with a margin

rather than an absolute price level, the decision has accordingly been critized by some

scholars (see Palmigiano, 2005; Crocioni & Veljanovski, 2003).

3.3.1.2 More recent cases: the telecommunications industry

In more recent times, the liberalization of the telecommunications industry has

triggered the amount of price squeeze claims (see Section 2.1), both on European and

national levels (Geradin & O’Donoghue, 2005).

38 Case T-5/97 (2000). 39 Id., par. 179. 40 Id., par. 178.

48

The Deutsche Telekom41 case was the first legal treatment of a price squeeze allegation

in the telecommunications industry dealt with by the Commission. As above, the

defendant Deutsche Telekom (DT) held a dominant position on both the upstream and

the downstream market. A total of 15 rivals of DT, who acted as the integrated provider

of essential local loop-access, sought relief for the pricing policies of DT. Despite

sector-specific regulations on the wholesale price to prevent a price squeeze, the non-

integrated firms complained that DT was practicing anticompetitive squeezing conduct.

The Commission found DT guilty of infringing Article 82 based on the equally efficient

operator test.42

Particularly interesting is how the Commission dealt with the argumentation made by

DT, which contented that, given specific regulation, it was left with no scope to

implement a price squeeze. Accordingly, it asserted that the Commission has no right to

intervene against an undertaking whose prices are regulated. The Commission did not

agree however by arguing regulation did not prevent DT to implement a price squeeze

since it is still in the possibility of engaging in independent anticompetitive conduct by

lowering the retail price.43 The Court of First Instance upheld the Commission’s

decision.

3.3.2 United States

In the United States, the practice of a price squeeze is in violation with Section 2 of the

Sherman Act. As above, we first review the landmark historical cases. We then turn

attention to recent claims in the telecommunications industry.

3.3.2.1 Historical cases

The price squeeze doctrine in the United States started off with the famous US v.

Alcoa44 case. Alcoa was a monopolist in supplying aluminum ingots which acted as the

essential input in producing the end-product aluminum sheets. It was accused by its

non-integrated downstream competitors for charging too high prices for the ingots. In

41 Case 2003/707/EC. 42 Id., par. 179. 43 Id., par. 53 and 54. 44 Case 148 F.2d 416 (1945).

49

addition, Alcoa’s rival firms complained their total costs were higher than the retail

price Alcoa was charging to consumers.

In its decision, the Second Circuit lined out the requirements for a viable price squeeze

claim (Vaheesan, 2008). Besides a monopolized upstream market, the wholesale price

should be no higher than a “fair price” and the retail price should not be set at such a

low level the non-integrated firms cannot make a “living profit”.45 The Circuit adressed

these requisites by making use of a cost-based transfer price test (Hovenkamp &

Hovenkamp, 2009). It calculated whether the margin between the wholesale price for

ingot and the retail price of aluminum sheets were sufficient to cover Alcoa’s own costs.

It thus applied a “primitive” version of the equally efficient operator test (Hovenkamp

& Hovenkamp, 2009) and found Alcoa guilty of price squeezing conduct.

The above described method of dealing with the claim has however been subject to a

fair amount of critique since the analysis does not take into account any possible pro-

competitive effects (see for example Sidak, 2008). Stated otherwise, its focus is merely

on competitors rather than on welfare effects to the detriment of consumers. Moreover,

the Circuit makes use of somewhat vague terms (how does one define a “fair price” and

a “living profit”?), which seems to be incompatible with modern anti-trust handling

(Sidak, 2008).

Contrary to the Alcoa case, Town of Concord v. Boston Edison Co.46 referred to a

regulated energy industry. The plaintiffs complained that Boston Edison Co., a

vertically integrated provider of electricity, was raising its wholesale price without

adequately raising the retail price. The defendant was eventually not found guilty based

on a comparison between pro- and anti-competitive effects of the practice. Moreover,

the First Circuit concluded that full regulatory oversight (both the wholesale and retail

price are regulated) barred a price squeeze claim:

45 Id., par. 437 and 438. 46 Case 915 F.2d (1990).

50

‘(…) these principles lead us to conclude that a price squeeze of the sort at issue

here does not ordinarily violate Sherman Act Sec. 2 where the defendant’s prices

are regulated at both the [upstream] and [downstream] levels.’47

The First Circuit thus argues that regulatory adiminstrative processes can prevent a price

squeeze. Nevertheless, as added by the First Circuit, price squeeze allegations in the

context of unregulated or partially regulated industries still call for antitrust

examination.48

City of Anaheim v. S. Cal. Edison Co.49 addressed a similar setting. The Ninth Circuit

deviated however from the above decision by arguing full regulatory oversight does not

bar a price squeeze claim since there exist still space to implement such a practice

because of regulatory imperfections, thus referring to a regulatory price squeeze (see

Section 2.2.1):

‘Nevertheless, because the regulatory systems do not work in perfect harmony, it

is possible for a utility to manipulate its filings and requests in a manner that

causes a, at least temporary, squeeze which might be just as effective as one

perpetrated by an unregulated actor.’50

Nothwitstanding the claim was allowed to proceed, the Ninth Circuit decided in favor of

the defendant by claiming the plaintiff was not able to proof the input was essential in

the production process.

3.3.2.2 More recent cases: the telecommunications industry

More recently, the price squeeze doctrine came in the midst of attention as a

consequence of a series of allegations in the telecommunications industry. Given

different treatments by different Circuits in more or less the same cases, the Supreme

47 Id., par. 29. 48 Id. 49 Case 955 F.2d 1373 (1992). 50 Id., par. 15.

51

Court eventually intervened, which consequently gave serious doubts whether the price

squeeze is a stand-alone abuse under Section 2 of the Sherman Act.

Both Covad Communications Co. v. Bell South Corp.51 (treated by the Eleventh Circuit)

and Pacific Bell Telephone Co. v. linkLine Communications Inc.52 (treated by the Ninth

Circuit) dealt with similar circumstances: digital subscriber line (DSL) providers

complained that Pacific Bell/Bell South had raised the wholesale price for using the

network (local loop) while lowering the retail price of DSL. However, there was far

from an equal treatment between both Circuits.

The Eleventh Circuit argued a price squeeze claim should not proceed whenever the

defendant has no obligatory antitrust duty to deal with the plaintiff. That is, as reasoned

by the Circuit, whenever the vertically integrated firm is not obliged by law to provide

access to its essential input/facility, there is nothing wrong in setting prices which result

in a lower margin for its downstream competitors unless the margin squeeze violates

predatory pricing standards.53,54 Consequently, if one wants to bring forth a viable

allegation it has to show there is a likely case of predatory pricing (Jacobson & Rucker,

2008). If not, the claim can simply not proceed.

In linkLine, the Ninth Circuit on the other hand decided not to bar the price squeeze

claim in the same absence of a duty to deal, however as the result of a far from

unanimious decision. Judge Gould for instance held dat the court should have dismissed

the complaint in compliance with the Eleventh Circuit. Given this divergence in

opinions, the Supreme Court eventually intervened. It reversed the court’s decision in

favor of the defendant. The case thus did not proceed by using the same reasoning as

adopted by the Eleventh Circuit (Jacobson & Rucker, 2008).

51 Case 374 F.3d 1044 (2004). 52 Case 503 F.3d 876 (2007). 53 Case 374 F.3d 1044 (2004) par. 17. 54 Note that such an antitrust duty to deal arises very rarely in competition law. Only in one single case

this has arisen so far, see Case 472 US 585, 601 (1985) (Barnett et al., 2009).

52

Accordingly, in declining the linkLine claim the Supreme Court took the opportunity to

reject the use of an imputation rule preventing a margin squeeze (see Section 2.3.3.2).

Nevertheless, it did so without a complemented analysis of the test’s economic impacts

on market outcomes and society.55,56

3.3.3 Price squeeze cases: conclusions

The above overview calls for comparative conclusions. Two questions will be adressed.

First, how does the legal treatment of a claim differ between Europe and the United

States? Second, how consistent are decisions within each continent?

Regarding the first question, the doctrine of a price squeeze is uncontested as part of

Article 102 infringment in Europe (Motta & DeStreel, 2003). That is, in order to prove a

price squeeze the Commission calculates the margin between retail and wholesale

prices by making use of an imputation test, as done in National Coal Board v. National

Carbonising Company, British Sugar v. Napier Brown and Deutsche Telekom. It is thus

not required to show predatory pricing on the retail level, and/or excessive pricing at the

wholesale level as was considered (and accordingly critized) in Pechiny

Electrometallurgie v. Industrie des Poudres Spheriques. Indeed, in a recent official

publication the Commission noted:

‘(…) the abusive nature of a margin squeeze is connected with the spread

between the upstream prices and the downstream prices. In other words, there is

no need for the Commission to demonstrate that either the wholesale or the

retail prices are abusive in themselves. In this sense, margin squeeze is a stand-

alone abuse under Article 82.’57

This is contrary to the United States, where given the recent decision by the Supreme

Court in linkLine the price squeeze doctrine is on the balance. This gives doubts to the

validity of future price squeeze claims in the US since the Supreme Court dissected the

price squeeze into one of either violating an antitrust duty to deal (regarding the

55 Case 555 U.S.____14. 56 See Chapter 4 providing a formal analysis of the economic effects of the imputation rule. 57 Working party No. 2 on Competition and Regulation, DAF/COMP/WP2/WD(2009)32

53

wholesale price) or violating predatory pricing standards (regarding the retail price)

(Willkie Farr & Galagher LLP, 2009):

‘Plaintiffs’ price-squeeze claim, looking to the relation between retail and

wholesale prices, is thus nothing more than an amalgamation of a mertiless

claim at the retail level and a meritless claim at the wholesale level. If there is

no duty to deal at the wholesale level and no predatory pricing at the retail level,

then a firm is certainly not required to price both of these services in a manner

that preserves its rivals’ margins.’58

Thus, although not saying explicitly, the Supreme Court has in its decision thus not

recognized the price squeeze as a stand-alone abuse of Section 2 of the Sherman Act.

Consequently, there is a strong divergence in approach between the United States and

Europe. While the doctrine in Europe is incontestable, this is not the case in the United

States.

Second, even within each continent there is lack of judiciar consistency. In Europe, the

court misunderstanded the different modes of implementing a price squeeze in Industrie

des Poudres Spheriques. In other cases, decisions are based on an imputation test,

nevertheless without complementing it with a thorough economic analysis (Motta &

DeStreel, 2003). After all, an imputation test is insufficient to make the difference

between a margin squeeze and an anti-competitive margin squeeze. It merely acts as an

(important) supporting tool which is however to be complemented with a welfare

analysis (King & Maddock, 2002; Motta & DeStreel, 2003)

The lack of uniformity is even more clear in the United States. An almost equal claim

was treated different by the courts, after which the Supreme Court intervened to pursue

an uniform way of dealing with an allegation. In doing so however, it repealed the

classical Alcoa decision since it is implicitly abolishing the price squeeze doctrine as a

stand-alone abuse (Dechert, 2009; Barnett et al., 2009).

58 Case 129 S. Ct. 1109 (2009) par. 12.

54

3.4 Conclusion

In this chapter attention was devoted to the judiciary processes of an anticompetitive

price squeeze, infringing antitrust law both in Europe (Article 102) and the United

States (Section 2 of the Sherman Act).

A margin squeeze allegation typically involves a primarily assessment of market power

on the relevant upstream and downstream market. In the light of correctly evaluating the

essentiality of the upstream input, it is advisable to define the downstream market first,

after which the related upstream market is considered.

Market power on the relevant upstream market is indispensable to find abusive conduct.

There is less of a uniform vision regarding the downstream market however. In any

case, most of the historical cases brought before the court found liability in the presence

of market power on both the upstream and the downstream market.

Whether there is an abuse of antitrust laws can be assessed by using the imputation test.

This test calculates if a plaintiff’s margin is indeed insufficient as a result of the pricing

practices of the integrated firm. Nevertheless, practical implementation suffers from

complexities and should be complemented by a rigourous economic analysis. This

analysis is indeed crucial as it points out the difference between a legal price squeeze

resulting from pro-competitive effects and an anticompetitive price squeeze to the

detriment of consumers.

The legal background of the price squeeze doctrine highlights a divergent approach

between Europe and the United States. Judiciary decisions in Europe recognize the

nature of the practice, and consider it hence as a stand-alone abuse of antitrust law. In

the US, on the other hand, recent developments point to a more reserved approach by

which a typical allegation will find it comparatively harder to find the defendant liable.

Even more, besides these opposing treatments both continents face difficulties in

implementing a uniform way of dealing with an allegation.

55

Chapter 4 Modelling the effects of the imputation rule

The purpose of this Chapter is to model the economic consequences of imposing an

imputation rule, as lined out in Chapter 2, in order to prevent a margin squeeze. More

specifically, the situation in which the vertically integrated firm can freely set prices is

compared with the situation in which it has to obey the imputation rule.

Such a formal analysis is particularly interesting since the Supreme Court in the US

recently rejected to recognize the price squeeze as an abuse of antitrust law in the

linkLine case (2009). Hence, the Court denied to implement the imputation rule since it

did not observe the margin squeeze as being anticompetitive, exclusive of any economic

analysis of rejecting the rule.

In accordance, the question raises whether the use of an imputation rule can be justified

from a welfare perspective. In order to address this, we use a simple model and

methodology which will be lined out in Section 4.1. Using this industry set-up, Section

4.2 finds out the likelihood of a price squeeze to arise. In Section 4.3 we summarize the

effects of the imputation rule on market outcomes and welfare. Section 4.4 finally

provides some policy implications reviewing the decision made in linkLine.

4.1 The model and methodology

We assume a vertically integrated firm, say Firm A, monopolistically supplying an

essential input for which it charges its sole downstream rival, say Firm B a wholesale

price,

�.

A standard quadratic utility function (Singh & Vives, 1984) yields the following linear

inverse demand functions:

��

��

with

� � �

the degree of horizontal product differentiation, measuring consumers perception for the

end-product. If σ = 0, products are perfectly independent, thus differentiated. Products

are homogenous, thus perfect substitutes if and only if σ = 1.

56

To produce the end-product, both firms have to pay a constant unit cost � as well as a

fixed cost . Profit functions are thus

!� � �� (1)

for Firm A, consisting of its retail turnover profits and upstream profits since it sells the

essential input at a price � to Firm B. Firm B’s profits are equal to

!� � �� (2)

and it is clear it faces an extra production cost of � as it has to buy the essential input

for each unit of output ��.

We consider a two-stage game. In the first stage, the integrated Firm A decides on its

optimal �. Given this, both firms compete with quantities (Cournot competition) in the

second stage and thus set their optimal �� and ��.

Solving this model makes us able to detect whether a price squeeze occurs. We assume

a price squeeze takes places as soon as

!� � �� (3)

with !� defined as the pseudo-profits of the downstream subsidiary of Firm A in the

hypothetical situation it has to pay the same price � for the essential input. We thus

make use of the “equally efficient operator imputation test”, see Section 3.1.3.1.

Hence, we ask ourselves if, given this model and its assumptions, the integrated firm

will act so as it squeezes its downstream competitor. The next section provides an

answer, highlighting the necessity of an imputation rule. We then concentrate on the

welfare and market outcome effects of the test in Section 4.3.

4.2 Does a price squeeze arise?

In order to highlight the economic implications of the imputation rule, one has first to

identify when such a rule comes into consideration. This is equal to unravel when a

price squeeze comes forth in the basic model depicted above. Indeed, only when a

margin squeeze is found, an imputation rule makes sense. We thus decipher the two-

stage game in order to find out under which conditions a price squeeze arises.

The model is worked out by making use of backward induction. We thus start off by

solving stage two of the game, yielding the optimal �� and �� under Cournot

57

competition. Maximizing (1) and (2) simultaneously over their outputs gives us the

maximizing output levels of both firms in function of the input price:

��

�� " � #

(4)

��

�� " � #

(5)

Substituting these expressions in (1) allows us to find � of stage one by maximizing (1)

over �:

� �

�� #��$ � ��"�

(6)

A price squeeze turns up as soon as condition (3) holds. We thus substitute the above

results for ��, �� and � in (3) and plot the downstream profits of the integrated Firm A

as a function of �, using numerical values for �, � and . The resulting graph can be

found in Figure 6.

We find negative pseudo-profits for all values of �, indicating a price squeeze arises in

equilibrium for any level of product differentiation for values of � � ��, � � �� and

� ��, as depicted in Figure 6.59 This result holds when modifying the parameter’s

values. Even in a low-cost scenario (e.g. � � and � � �) a price squeeze still occurs.

If the integrated firm thus would charge its equilibrium � to its own downstream

affiliate, the downstream division would not be able to attain a positive profit.

59 All remaining graphs will be presented using these numerical values, unless clearly stated otherwise.

58

Since a margin squeeze always prevails, the use of an imputation rule can be

investigated.

Consequently, we are able to compare the ‘laissez-faire’ situation by which authorities

do not recognize any antiturst violation by ignoring anticompetitive price squeezing

conduct with the situation they would do so. The latter case is thus equivalent of

interfering in the business process: the integrated firm has to alter its market behavior

according to the demands of competition authorities, reflected by the imputation rule.

4.3 The impact of the imputation rule

We quantify and compare the outcome of two scenarios:

(1) No interference by competiton authorities. This is the standard setting by which

the vertically integrated firm optimizes without any constraints. By using the

imputation test, we find a price squeeze to arise, see above.

(2) Interference by competition authorities. The imputation test is used as an

imposed rule which the vertically integrated firm has to obey in order to prevent

the margin squeeze.

Scenario 2 thus alters the market outcome by imposing an additional condition on the

maximization problem of the vertically integrated firm. Authorities oblige the integrated

firm to satisfy (3) by which it now has to deviate from its profit maximizing �.

Figure 6: Negative downstream profits of Firm A

59

As in Scenario 1, we solve Scenario 2 by backward induction. Stage 2 is equivalent,

yielding the same optimal �� and �� as shown above, see (4) and (5). Thus, both firms

solve simultaneously their maximization problem %&'!( �)*+),+

with - � ./ 0.

Stage 1 however requires the integrated firm to set its � in accordance with (3) so that

no price squeeze arises (that is, its downstream subsidiary breaks even). Formally, this

is nothing more than solving the following equation with respect to �, substituting for

the stage 1-found ��:

!� 1 �� .

This yields � as depicted by the red line in Figure 7 in function of �. The blue line

shows � as found in Scenario 1 and is the graphical representation of (6). Comparing

both, Figure 7 shows the direct effect of the impution rule: � is comparatively lower for

any value of �, which is indeed inherent to the rule.

.

Figure 7: ω with and without the imputation rule

60

The divergence in the wholesale price, as a result of the imputation rule, is on its turn

expected to alter market outcomes and consumer and total welfare.

The input price is indeed present in both profit functions as shown in (1) and (2), and

thus is expected to alter profits of Firm A and Firm B in the situation with the

imputation rule (Scenario 2), compared to the situation without the rule (Scenario 1).

In addition, both �� and �� are functions of �, as illustrated by (4) and (5). As a

consequence, a different � in each scenario modifies consumer welfare through prices,

calculated by making use of the inverse demand functions.

In what follows we line out the impact of the imputation rule on profits and prices. We

then provide a welfare analysis.

4.3.1 The impact of the imputation rule on market outcomes

We analyse the differences in firms’ profits in both scenarios. We simply substitute the

expressions for ��, �� and � of both Scenarios into the respective profit function, as

given by (1) and (2) and graph the results, again in function of �.

Concerning the integrated Firm A, we find as a general result that is realizes lower

profits when it is subject to the imputation rule, compared to Scenario 1 where it is not.

This is indeed what economic theory predicts: under Scenario 2 upstream profits for the

integrated firm will be lower since it charges a lower price for the essential input to its

downstream rival, due to the imputation rule. A lower reservation price � and a higher

fixed cost enlarge this effect: both yield a higher difference in profits.

Figure 8 graphs the total profit of Firm A under both scenarios. We use � � �� since

this allows a more clearer graphical representation.

61

Figure 9 depicts total profit of Firm B under both scenarios. We find higher profits

under Scenario 2 (with the imputation rule) compared to Scenario 1 (without the

imputation rule) as a general result. This again is intuitive: the imputation rule precisely

yields a lower �, which is to the benefit of Firm B for it can now buy its essential input

at a cheaper price.60

60 We however observe negative total profits for the non-integrated firm when using lower values of �

(e.g. � � ��) for a high value of � (less differentiated products), thus implying Firm B will not be active

on the market in such a case. A higher �, or a lower solves this effect.

Figure 8: Effect on Firm A’s profit

62

To continue, Figure 10 illustrates the effect of the imputation rule on final (retail) prices

charged by both firms to consumers. Price A represents the final price charged by the

integrated Firm A. In the same token, Price B shows the price charged by Firm B. We

observe both prices to lower under Scenario 2 (with the imputation rule). As a

consequence, we can expect a positive effect on consumer welfare. We provide a

welfare analysis in the next section.

Figure 9: Effect on Firm B’s profit

63

4.3.2 The impact of the impution rule on welfare

In what follows we analyse the effect of the rule adopted under Scenario 2 on welfare.

We define consumer surplus in accordance with Singh and Vives’ (1983) quasi-linear

utility function (1984):

23-4-35 � �� 6��

� ��.

Consumer surplus (CS) then can be written as:

�7 � 23-4-35 � �� .

Producer surplus (PS) is nothing more than total profits achieved by both firms in the

duopoly:

87 � !� � !�.

Finally, total surplus (TS) is the unweighted sum of CS and PS:

97 � �7 � 87.

Figure 10: Influence on prices

64

Given lower prices, we expect an incease in consumer welfare. This is indeed what we

observe in Figure 11, illustrating a higher level of consumer welfare when constraining

Firm A to the imputation rule.

Using � � ��, we find an incease in Consumer Surplus mounting up to:

�7:;<= � �7>?:;<=

�7>?:;<=��#@A��A � ��BB�A��$

��BB�A��$� ��

with �7>?:;<= referring to Scenario 1 and �7:;<= referring to Scenario 2. Thus, making

use of an imputation rule in reversing the price squeeze benefits consumers as their

surplus raises about 5%.

Figure 12 finally shows the effect of the imputation rule on total welfare. The increase

in consumer surplus carries over to total surplus: we again observe an increase in

welfare although to a lesser extent. Again using � � �� we find a numerical value of:

Figure 11: Consumer Surplus

65

97:;<= � 97>?:;<=

97>?:;<=��$@B�$� � ��A�$��

��A�$�� B�

with 97>?:;<= = Scenario 1 and 97:;<= = Scenario 2. Hence, total surplus raises about

3% when implementing the imputation rule.

We thus find an incease in consumer and total surplus. We summarize some policy

implications in the next section.

4.4 Conclusion and policy implications

This chapter has aimed to explore the economic implications of the imputation rule.

Building on a formal model, it has been shown that imposing the rule in order to prevent

a margin squeeze raises consumer and total surplus. Profits of the integrated firm are

expected to drop slightly, while profits of the non-integrated firm will raise.

These results stress on the importance of correctly identifying a price squeeze situation.

Imposing the imputation rule fosters competition downstream through lower prices to

Figure 12: Total Surplus

66

consumers, both by the integrated as the non-integrated firm. Consequently, the

recognition of an anticompetitive price squeeze and hence the imposement of the rule in

order to reverse it is to the benefit of welfare, in particular that of consumers.

This sheds light on the recent decision in linkLine by the Supreme Court, in which it

denied to intervene by means of an imputation rule:

‘Whether or not that test is adminstrable, it lacks any grounding in our antitrust

jurisprudence. An upstream monopolist with no duty to deal is free to charge

whatever wholesale price it would like; antitrust law did not forbid lawfully

obtained monopolies from charging monopoly prices.’61

Nevertheless, the results above are contrary to the Supreme Courts way of dealing with

a claim. If the Court had identified a price squeeze as being different from either

predatory pricing at the retail level or foreclosure at the wholesale level, the rule could

have operated in function of modern antitrust principles, i.e. protecting the interest of

consumers.

Of course, this is not to say the Court made a wrong decision in the particular linkLine

case as the model presented here is far too restrictive and is not able to duplicate the

exact industry setting in which the claim arised. However, it emphasizes and quantifies

the detrimental effects of a margin squeeze in a simple set-up, which is allegedly the

basis to analyse more complex situations.

Moreover, essential is how price squeeze allegations will be dealt with in the future. If

competition authorities in the United States are expected to be consistent with the

linkLine case, bringing forth a viable price squeeze claim will be a tough task. Hence,

our results argue this might be the wrong path chosen.

Regardless of the arguments above, the Supreme Court in the US attempted to impose

clear rules by the decision taken. This is indeed important since a clear way of dealing

with a claim can help businesses to steer conduct in the right direction without too much

uncertainty whether a specific behavior is unlawful (Barnett et al., 2009).

61 Case 555___US (2009), p. 14.

67

Although this might indeed come forth within the United States, the question remains

whether this will be the case on an inter-continental basis. It is hard to see how such a

divergent approach between Europe and the US what matters the same practice can be

seen as facilitating for businesses operating on a global scale.

The model depicted above is restrictive. It focuses solely on quantity competition and

simplifies the industry setting by using standard profit functions and only one

downstream rival. Accordingly, future research could for instance extend the analysis

by incorporating the outcomes of price competition (Bertrand-model) or investigate

market behavior when one firm acts as a leader and the other follows (Stackelberg-

model).

68

General Conclusion

This master thesis has aimed to explore the law and economics of a price squeeze, the

anti-competitive conduct by which an integrated operator attempts to narrow the margin

of a non-integrated downstream rival as to relax competitive constraints. The work was

structured around four chapters, enlightening the diverse arising implications resulting

from such a practice.

Chapter 1 illustrated the conceptual relatedness with other anti-competitive

arrangements and unraveled the economic implications for the vertically integrated

firm. It lined out the different required conditions in order to carry out a margin

squeeze. Profitibality consequences were shown to be equivocal by yielding two

opposite effects. Finally, the chapter classified how the integrated firm can implement a

price squeeze through altering the wholesale and/or retail price, giving rise to three

different types of price squeezes.

Knowing the economic mechanisms of a price squeeze as lined out in Chapter 1, the

second chapter provided on overview on the implications for regulatory bodies.

Regulators can focus on structural interventions, or more appropriate, constrain the

upstream/wholesale price and/or the downstream/retail price. It was shown how the

amount of regulation yields a regulatory environment for the integrated firm, hence

influencing the ability to execute a price squeeze. Such regulation can be attained by

providing different regulatory pricing-rules. Apart from traditional cost-based

regulation, the Efficient Component Pricing Rule for instance directly takes away

incentives of a price squeeze.

Chapter 3 lined out the legal antitrust implications. It summarized how courts deal with

a price squeeze claim and what complexities they accordingly face. Courts face

difficulties in proving relevant market power since a margin squeeze allegation involves

two interrelated markets. Competition authorities use an imputation test to quantify the

likelihood of a price squeeze ex-post. The chapter however summed up the

complications arising when facing practical usage. Finally, the most notable cases were

presented in order to shed light on historical decisionary practice, including the linkLine

case, were the US Supreme Court rejected the price squeeze as antitrust abuse.

69

Chapter 4 combined the insights gained in the previous ones. It analyzed the effects of

the use of an imputation rule, the regulatory device presented in Chapter 2. Preventing a

price squeeze to arise by means of the rule lowers profits of the integrated firm while

those of the non-integrated firm, victim of the squeeze, are raised. Prices to consumers

are shown to decline, yielding a beneficial effect on consumer, and to a lesser extent,

total welfare. These results are relevant since they shed light on the Supreme Court’s

decision in linkLine as lined out in Chapter 3, by which it rejected the usefulness of the

imputation rule.

This thesis brings forth important policy implications. The increasing liberalization of

markets does not rule out anti-competitive behavior by firms. Regulators face the

difficult task of finding the balance between a laissez-faire attitude and a more stern

approach. Regulatory bodies should possess a sound understading of competition-

deterring practices such as a price squeeze in order to develop the appropriate regulatory

remedies. By analyzing the economic implications for the undertaking firm well,

suitable rules can be implemented, ruling out anti-competitive policies of firms while

not affecting firms’ society-enhancing incentives such as investment decisions.

Well-developed and implemented regulatory devices have on their turn a positive

influence on the harmony between regulators and courts. Sound regulation makes

allegations brought before courts less likely, reducing the cost of society as a

consequence of long and expensive legal cases.

Nevertheless, claims are of course inevitable. Dealing with an allegation requires courts

to deeply analyze the facts at hand and make a decision to the benefit of society in

general. Again a balance have to be found between spending resources on the one hand

and making accurate decisions on the other hand. Economic analyses can facilitate this

trade-off. Indeed, this thesis showed how a price squeeze is to the detriment of society

by affecting consumer and total welfare in a relevant way, providing courts with (basic)

assistant insights.

These insights are indispensable in guiding courts into the right direction, making

consistent judgments which on their turn yields clear rules for operating businesses.

70

Accordingly, transparant laws are able to guide firms’ conduct, leaving them with the

appropriate business incentives left.

It goes beyond saying a lot of future research can be done. Less restrictive formal modes

will be able to better simulate market behavior and interaction, hence improving

insights in the practice. Apart from this, research could focus on the implications of a

margin squeeze in less obvious environments, e.g. emerging markets or specific

industry structures.

71

List of figures

Figure 1: Typical set up of a price squeeze ....................................................................... 5

Figure 2: Numerical example ............................................................................................ 6

Figure 3: Foreclosure, RRC and the price squeeze ......................................................... 10

Figure 4: Alternative ways of implementing a price squeeze ......................................... 18

Figure 5: Regulatory remedies ........................................................................................ 34

Figure 6: Negative downstream profits of Firm A .......................................................... 58

Figure 7: ω with and without the imputation rule ........................................................... 59

Figure 8: Effect on Firm A’s profit ................................................................................. 61

Figure 9: Effect on Firm B’s profit ................................................................................. 62

Figure 10: Influence on prices ......................................................................................... 63

Figure 11: Consumer Surplus .......................................................................................... 64

Figure 12: Total Surplus .................................................................................................. 65

72

List of tables

Table I: Required conditions ........................................................................................... 16

Table II: Network industries and their components ........................................................ 23

Table III: Regulatory environment versus type of price squeeze .................................... 26

73

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