© 2005 Cleary Gottlieb Steen & Hamilton LLP. All rights reserved. Some thoughts on predatory pricing in the context of the Article 82 EC review Robert O’Donoghue Brussels, June 17, 2005 Global Competition Law Centre Conference, 2005

2 Agenda  Issue #1: what to do with common costs  Issue #2: the role of intent evidence  Issue #3: recoupment  Issue # 4: above cost unconditional price cuts  Issue #5: defences

3 Issue #1: the problem of commons costs  Problem: where two product share common or joint costs, you can calculate total cost, but not average cost  If a firm produces both cars and trucks and has common costs then, while it is possible to identify total cost or variable cost, it is not possible to add together cars and cars and trucks to get an average cost  Real issue in practice, since most firms have common costs  Not clear what the solution is or should be

4 Issue #1: the problem of commons costs  Solution #1: do nothing - focus only on incremental costs and revenue since these guide business decisions  But this can create significant bias against rivals with stand-alone activities  Solution #2: use stand-alone costs.  But wholly inappropriate since higher than dominant firm’s actual costs  Solution #3: allocate costs between operations in some reasonable way.  But well-known that all methods of common cost allocation are problematic

5 Issue #1: the problem of commons costs  Support for common cost allocation: –Ahmed Saeed mentions fully allocated cost test –Postal Notice also mentions need to allocate costs between competitive and non-competitive operations  Support for incremental costs only approach –Deutsche Post – Commission applied incremental costs test (LRIC) to competitive market –But strong suggestion that this was because of legal obligation to offer universal service mail –Firm without legal obligation could take shut down decision –Absent legal obligation, LRIC approach could offer dominant firm too much freedom to decide which of its costs in the competitive market were incremental and which were not

6 Issue #1: the problem of commons costs  Resolving the common cost “problem” –LRIC generally to be preferred, since it most closely accords with actual business decisions –Common cost allocation only potentially relevant where common costs are “substantial” –If so, allocation should be subject to test of “reasonableness.” –If “reasonable,” allocate costs. Various methods of common cost allocation: (1) Ramsey pricing; (2) equal proportionate mark up; (3) in proportion to turnover; (4) arm’s length negotiation. (2) and (3) the most practical, though flawed. –Any doubt, benefit goes to defendant

7 Issue # 2: the role of intent evidence  Second AKZO rule: prices above AVC but below ATC abusive where part of a plan to eliminate a competitor.  Wanadoo: first major case in which evidence of (mainly subjective) intent played a role  “Plan to preempt the market by stealing the march on competitors.” (para. 111); “regardless of the short-term financial disadvantage” (para. 135); serious internal doubts about future economic viability of losses (para. 139)  Commission draws a distinction between formal presentations to management and informal remarks made to or by sales staff, attaching a higher value to the former.  Documents must also show such intent on the part of senior staff capable of having a material influence on company policy.  Focus on the totality of evidence, not isolated statements

8 Issue # 2: the role of intent evidence  Significant problems with subjective intent evidence  Some Wanadoo statements very similar to vigorous competition statements.  Dangerous in particular because prices above AVC are rational, at least in the short-term  Better to look at more objective evidence of intent: whether the strategy was incrementally profitable or not  Avoidable cost test useful: would it have been cheaper to stay in business or shut down?  Prices that pass both the AVC and average avoidable cost tests should conclusively show an absence of predatory behaviour

9 Issue #3: recoupment  Many economists argue that, absent proof of recoupment, below cost prices are a net boon for consumers  Status of recoupment under Article 82 not clear: –Rejected, on the facts, in Tetra Pak II –Wanadoo – rejected recoupment as a formal requirement but went on to consider ability to recoup in any event –Issue was whether “the obstacles to entry guarantee the dominant undertaking the maintenance in the long term of a large degree of market concentration in its favour” (para. 337) –Commission identified a number of strategic barriers: (1) disincentives to switching subscribers on the part of existing customers; (2) high costs of entering and acquiring critical size in the broadband market (e.g., fixed costs, advertising costs); (3) self-building of the upstream infrastructure needed for a broadband network was not viable; and (4) Wanadoo was well on its way to restoring profitable margins, whereas new entrants were not.

10 Issue #3: recoupment  Commission’s approach reasonable on the whole  Some problems with recoupment in practice: –Perverse results: lower the price cut, the harder to recoup –Speculation as to future market conditions difficult: whoever bears the burden will likely lose –Anti-competitive effects possible absent full recoupment, e.g., maintaining monopoly, reputation effects, oligopoly effects –Not unreasonable in law to punish conduct that ought to be self-deterring  Remember: recoupment under U.S. law rooted in case where the firm was not already dominant (Brooke Group oligopoly)  Existing dominance raises reasonable inference of successful predation: let defendant rebut it

11 Issue # 4: above cost unconditional prices  Surprisingly, many more cases on abusive above-cost unconditional prices than below-cost (Hilti, Irish Sugar, CEWAL)  Economic case for anti-competitive effect of such price cuts can be made, in theory (see Vickers and Armstrong (1993))  Not clear in practice whether restrictions on such price cuts enhance competition overall –Unnecessary for less efficient firms who would have entered absent such a restriction –Unnecessary for more efficient firms who would have entered anyway –No point in protecting firms who are less efficient, but become as efficient over time: capital markets should fund such firms anyway –No point in protecting less efficient firms who would remain so decreases welfare, since competition would eliminate them anyway  In any event, implementation difficulties render a general restriction unworkable

12 Issue #4: above cost unconditional prices  Strong case for treating all above cost unconditional discounts as lawful, due mainly to implementation issues  If review under Article 82 is to be kept, need to articulate legal basis: –Exclusionary “intent” cannot be the rule, since this is also the second AKZO rule –“Superdominance” impossible to define outside of a monopoly and would confuse the law further –Enforcement, if any, should be confined to cases of several, cumulative abuses, i.e., a multi-layered exclusionary strategy

13 Issue #5: defences  Recent economic work shows that pricing below cost may have legitimate explanation (Brodley et al (2000))  But serious disconnect between theory that certain defences are admissible and actual acceptance  Meeting competition. Based on notion that dominant firms can compete and should not sit idly by where there is competition. Short-run profit maximising response.  Prices below AVC. Meeting competition defence initially rejected by Areeda & Turner. But accepted in Berlingske Gratisaviser (2002) where dominant firm matched, but did not undercut, rival’s price. Wanadoo ambiguous on the issue.

14 Issue #5: defences  Prices above AVC but below ATC. Meeting competition in principle more likely to apply. Issue turns on intent, but better to apply objective test based on avoidable cost. Dominant firm should be allowed to undercut and not only match.  Prices above ATC. Should be conclusively legal – no need for defence  Relevance of selective pricing –Treated as exacerbating factor in the case law, presumably because it makes the losses less costly and more sustainable –Seems odd to say that firm could avoid liability by incurring more widespread losses –Better view is that selective pricing does not in itself evidence predatory intent, but, when coupled with other evidence of exclusionary intent, such an inference may be appropriate and the meeting competition defence therefore inapplicable

15 Issue #5: defences  Other defences deserve serious consideration –Market-expanding efficiencies –Promotional offers –Loss-leading –Loss-minimising –Excess capacity –Mistake –Obsolescent goods