The economics of pass-on

The Competition Bulletin is pleased to announce that Oxera Consulting will be contributing a short series of blogs on key economic concepts for competition lawyers. Robin Noble, Oxera Associate Director and an expert economist on commercial and competition law damages actions, is our first guest blogger. His post discusses the issue of pass-on—ie, the extent to which the purchaser of a cartelised product passes on the overcharge, and therefore its losses, to its own downstream customers. Robin can be contacted at robin.noble@oxera.com.

Introduction

Pass-on is a key issue in virtually all cartel damages claims in the EU. It can make or break a claim: assuming that pass-on is a valid defence to a damages claim, complete pass-on means a claimant cannot claim for any absorbed overcharge, the main head of loss in these actions.

This post focuses on two points. First, it provides a brief summary of the key insights provided by economic theory; second, it discusses two important real-world issues: cost plus pricing, and price-pointing.

Pass-on theory

Economic theory provides three useful benchmarks for assessing pass-on.

At one end of the spectrum is complete pass-on, where the full value of the input cost change caused by the cartel is translated into a change in the retail price of the product. In other words, if the wholesale input cost for a firm rises by £1, in complete pass-on the retail price charged by that firm also rises by £1. Economic theory predicts that this outcome will be found when the market resembles perfect competition (and when the wholesale input cost increase affects all firms in the market). This can seem counterintuitive. However, the reasoning is that when competition is vigorous, firms’ prices and costs are closely aligned, and so changes in costs that affect all players will result in changes in prices—otherwise firms will start making losses and seek to exit the market. While most markets are not perfectly competitive, empirical evidence suggests that there are a number that are sufficiently competitive that high pass-on rates are the outcome—see, for example, the recent OFT inquiry into petrol retailing, which found pass-on rates close to 100%.

At the other end of the spectrum is complete absorption, where the full value of the input cost change is absorbed by the downstream claimant. This may occur if the claimants compete with suppliers that buy non-cartelised inputs—for example, European manufacturers who compete with imports from China, and who would therefore suffer a loss of market share if they were to pass on any overcharge. In some sectors economic regulation of downstream prices might also lead to this outcome. For example, the regulation of rail fares in the UK, which are usually indexed to a measure of inflation, does not relate directly to the costs of operating trains, and so will not directly reflect input cost changes.

In between these two lie outcomes that are driven by the degree of market power held by the retailer. A classic theoretical finding in economics is that a monopolist would seek to pass on around 50% of a cost increase. It could, of course, raise its price by more, and pass on 75% or 100%, but by doing so it would lose more sales than if it raised the price by 50%. It could also choose to raise its price by less than 50%, even choosing to keep prices constant, absorbing the full increase in input costs. By doing so it would reduce the margin on its sales.

The 50% outcome is therefore the result of a trade-off made by the monopolist retailer seeking to maximise its margin (by raising the price) while also minimising the loss of sales (due to the increase in price). Whether the optimal outcome is actually 50%, or a little higher or lower, depends on factors such as the degree of price sensitivity and the loyalty of its customers. It also depends on the degree of competition that the firm faces: the more competitors it faces, the more the situation will resemble the perfect competition outcome of complete pass-on.

Cost plus pricing and price-pointing

There are instances where simple economic theory may not be sufficient to explain the likely pass-on outcomes. One interesting example is the use of mechanistic pricing rules, such as when retailers mark up the cost of a product by a fixed percentage to determine the selling price.

For example, a retailer might buy (or produce) a product for £8.00, apply a 25% mark-up, and price the product for sale at £10.00. If the input cost rose by £1.00 to £9.00, the retail price would rise to £11.25. If the £1.00 input cost rise were due solely to a cartel between manufacturers of the product, the retailers’ cost plus pricing rule would suggest that it completely passed on the overcharge. Arguably, the retailer has passed on more than 100% of the overcharge, since its margin has also risen. It was earning £2.00 before the input cost rise, and is now earning £2.25, implying a pass-on rate of 125% (a 100% pass-on rate would imply that the margin stayed the same at £2.00).

A key question, however, is whether the mechanistic pricing rule—in this case, the 25% mark-up—did remain the same during the period of the cartel overcharge. This is particularly important in the retailing context, where pricing rules of this kind are often found, but where other pricing rules, such as price-pointing, are also used. Retailers often prefer ‘attractive’ price points, such as £9.95 rather than £10.05, or, to continue the example, a rounded price of £11.00 or £11.50 rather than £11.25.

Newspapers are another example of this. The price of the print edition of The Times has remained at £1 for over three years, but input costs, such as the price of newsprint, have changed substantially over the same period. Arguably, newspapers have a degree of market power, due to the loyalty of their readership, so perhaps are best represented by the monopolist example above, since they will lose only a small proportion of their readers if they raise their price. However, having an attractive price point is likely to outweigh the incentive to pass on the input cost change.

Two closing comments:

–      theory provides a useful starting point and, in some situations, is sufficient;

–      there are various practical price-setting mechanisms that depart from the theory, and some factual and empirical analysis is therefore important in most cases.

Leave a comment

Filed under Abuse, Agreements, Damages

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s