Toward a Unified Theory of Exclusionary Vertical Restraints Daniel A. Crane University of Michigan Law School Graciela Miralles European University Institute June 17, 2010

Variety of exclusionary vertical practices Exclusive dealingExclusive dealing TyingTying Predatory pricingPredatory pricing BundlingBundling Bundled discountsBundled discounts Market share discountsMarket share discounts Loyalty rebatesLoyalty rebates

Our project: Both broad and narrow Broad: Comprehensive framework for addressing all exclusionary vertical restraintsBroad: Comprehensive framework for addressing all exclusionary vertical restraints Narrow: Just exclusionary vertical restraints.Narrow: Just exclusionary vertical restraints. –Not addressing collusion or exploitation

Collusion: Agreeing with your competitor to stop competing in order to secure a mutually beneficial outcome, at the expense of someone else.

Austria vs. Germany 1982 Group Stage

Exploitation: Taking advantage of someone else's weakness to extract an excessive amount of surplus.

World Cup Qualifying 2001 Australia 31, American Samoa 0

Exclusion: Disabling one's competitor from competing by anticompetitive means.

Oh dear.

Exclusion, collusion, and exploitation Different legal tests. Plaintiff must identify which theory it is pursuing.

Both US and EU law lack a consistent framework Three sources of confusion: –Price vs. non-price –Single product vs. multi-product –Primary line vs. secondary line

US Example Primary line price discrimination = predatory pricing.Primary line price discrimination = predatory pricing. Secondary price discrimination requires no market power, no injury to competitive process, not even threat to competitor's continuation in market.Secondary price discrimination requires no market power, no injury to competitive process, not even threat to competitor's continuation in market.

US Example Bundled discounting:Bundled discounting: –LePage's: don't analogize to predatory pricing; analogize to tying and exclusive dealing. –PeaceHealth: analogize to predatory pricing, using discount reallocation test.

EU Example Delimitis: Exclusive dealing agreement under Article 101 analyzed under a substantial foreclosure framework.Delimitis: Exclusive dealing agreement under Article 101 analyzed under a substantial foreclosure framework. Michelin II: Loyalty rebates analyzed under Article 102 form-based approach without regard to amount of foreclosure or general effects on the market.Michelin II: Loyalty rebates analyzed under Article 102 form-based approach without regard to amount of foreclosure or general effects on the market.

Comprehensive two-part test, regardless of form of restraint ForeclosureForeclosure SubstantialSubstantial

Foreclosure [V]irtually every contract to buy forecloses or excludes alternative sellers from some portion of the market, namely the portion consisting of what was bought.[V]irtually every contract to buy forecloses or excludes alternative sellers from some portion of the market, namely the portion consisting of what was bought. -Judge (now Justice) Stephen Breyer, Barry Wright v. ITT Grinnell (1983). Too broad; foreclosure becomes a useless category.Too broad; foreclosure becomes a useless category.

Our test A restraint "forecloses" if it denies equally efficient rivals a reasonable sales opportunity.A restraint "forecloses" if it denies equally efficient rivals a reasonable sales opportunity. Different applications depending on kind of restraint, but all answering same ultimate question.Different applications depending on kind of restraint, but all answering same ultimate question.

Example: Exclusive dealing Exclusive dealing may not foreclose if rival could reasonably offer its own competitive exclusive dealing contract. But, may foreclose if (for example):Exclusive dealing may not foreclose if rival could reasonably offer its own competitive exclusive dealing contract. But, may foreclose if (for example): –New entrant facing preexisting long-term exclusives –Exclusive is for too large a piece of business for small rival to bid. –Dominant firm is "must carry" brand.

Example: Predatory pricing and bundled discounts Below-cost pricing forecloses (but may not be substantial)Below-cost pricing forecloses (but may not be substantial) An above-cost bundled discount may foreclose if the rival could not offer its own above-cost competitive discount in the competitive market.An above-cost bundled discount may foreclose if the rival could not offer its own above-cost competitive discount in the competitive market. –Discount reallocation test determines whether or not there is foreclosure.

Example: Secondary line price discrimination Must disadvantaged retailer sell below cost in order to remain competitive with advantaged retailer?Must disadvantaged retailer sell below cost in order to remain competitive with advantaged retailer? –If not, no foreclosure.

Substantial Legal test: Does amount of foreclosure deny rival a reasonable opportunity to survive in the market?Legal test: Does amount of foreclosure deny rival a reasonable opportunity to survive in the market? Economic test: Is rival reasonably able to reach and maintain minimum viable scale by competing for business in the non- foreclosed segment of the market?Economic test: Is rival reasonably able to reach and maintain minimum viable scale by competing for business in the non- foreclosed segment of the market?

Minimum viable scale Total sales new entrant needs to achieve hurdle rate on invested capital. (Salop, 1986)Total sales new entrant needs to achieve hurdle rate on invested capital. (Salop, 1986) Familiar concept from horizontal merger analysis.Familiar concept from horizontal merger analysis.

The tricky part: Incumbency advantage Even in non-foreclosed segment, incumbent/dominant firm may have decided advantage:Even in non-foreclosed segment, incumbent/dominant firm may have decided advantage: –Customer loyalty –Switching costs –Brand preference

Effect of incumbency advantage on "substantiality" 50% market foreclosure50% market foreclosure 20% minimum viable scale20% minimum viable scale 70% incumbency advantage.70% incumbency advantage. New entrant's initial share is 15%, < mvsNew entrant's initial share is 15%, < mvs

But, legal test must look past first round Incumbency advantages can degenerate quickly.Incumbency advantages can degenerate quickly. Even in a completely non-foreclosed market, new entrant often must absorb losses for years to reach mvs.Even in a completely non-foreclosed market, new entrant often must absorb losses for years to reach mvs.

Illustration Static market with 2,000 units purchased monthlyStatic market with 2,000 units purchased monthly 50% foreclosure50% foreclosure 90% incumbency advantage90% incumbency advantage Minimum viable scale: 20% (400 units)Minimum viable scale: 20% (400 units)

Implication: As a general rule, foreclosure should not be deemed substantial if the minimum viable scale is less than the units or revenues in the non-foreclosed segment of the market divided by the number of competitors.As a general rule, foreclosure should not be deemed substantial if the minimum viable scale is less than the units or revenues in the non-foreclosed segment of the market divided by the number of competitors. In a two-firm market, foreclosure is never substantial if mvs < 50% of non-foreclosed segment.In a two-firm market, foreclosure is never substantial if mvs < 50% of non-foreclosed segment.

Qualifications New entrant often claims superior price or technology, hence should more than overcome any incumbency advantage.New entrant often claims superior price or technology, hence should more than overcome any incumbency advantage. If there are very long intervals in the competitive cycle, then incumbency advantage may erode slowly. But then market may be a natural monopoly.If there are very long intervals in the competitive cycle, then incumbency advantage may erode slowly. But then market may be a natural monopoly. Markets with partial foreclosure and many competing firms raise special questions:Markets with partial foreclosure and many competing firms raise special questions: –Aggregate foreclosure? –Generic probability of success falls with multiple competitors. –Exclusion of any one competitor may have little competitive significance.

Concluding Thoughts Unified test adds rigor and consistency, but does not eliminate all difficulties.Unified test adds rigor and consistency, but does not eliminate all difficulties. Opportune time to pursue unified test on both continents:Opportune time to pursue unified test on both continents: –"Antitrust policy toward vertical restraints is the biggest substantive issue facing antitrust. Richard Posner, –EU: shift toward effects-based rules.

Toward a Unified Theory of Exclusionary Vertical Restraints Daniel A. Crane University of Michigan Law School Graciela Miralles European University Institute June 17, 2010