The economics of margin squeeze

The Competition Bulletin is pleased to welcome the second in our series of blogs by Oxera Consulting on key economic concepts for competition lawyers. In this blog, Tuomas Haanperä, a Senior Consultant, discusses the economic issues surrounding follow-on damages claims in margin squeeze cases (where a dominant firm has charged a combination of retail and wholesale prices that prevents other, ‘squeezed’, rivals from competing). This topic was recently discussed at the Oxera Economics Council, a forum of prominent European economic thinkers and academics that meets twice a year to discuss current economic policy topics.

Introduction

There have recently been a number of follow-on damages claims brought by victims of margin squeezes in various European countries – including various claims in the context of telecoms markets and also, in the UK, the water market. The methodologies employed to derive the ‘lost profits’ in such cases are diverse and debatable, and the established case law is relatively scant. As the European Commission’s recent ‘Practical guide’ on damages quantification highlights, there are no one-size-fits-all solutions. Can economists agree on the basic principles?

Right counterfactual?

As in any damages quantification, the aim is to establish what the prices and market outcomes would have been had there been no infringement—ie, the correct counterfactual. If a dominant and vertically integrated telecoms incumbent had engaged in a margin squeeze, the question is whether the appropriate (lawful) counterfactual is one in which wholesale access prices are lower, retail prices are higher, or some combination of the two. Which of these three scenarios is most appropriate depends on the competitive environments in both the upstream and downstream markets.

Does it actually matter for the quantification of harm whether it is the wholesale or the retail price that was ‘wrong’? Possibly not. In theory, if the dominant firm and its rivals sell homogeneous products in the downstream market, and if the squeeze does not affect competition in a dynamic sense (entry and expansion), the quantum of damages depends only on the size of margin with and without the infringement, not on whether the squeeze is caused by abusive retail or wholesale prices.

In such a case, or if it was the wholesale price that was too high and caused the margin squeeze, the quantification is simply the Claimant’s actual volumes of sales multiplied by the difference between the factual and counterfactual margin. For example, if the dominant firm’s margin between retail and wholesale was £1 when it should have been at least £10, the damage is simply the ‘excessive element’—£9—multiplied by volumes. Doing this calculation with the actual volumes would normally give the lower bound estimate of the damages.

However, in many cases the Claimant’s sales volumes might have been higher absent the squeeze—ie, had there been no squeeze, an entrant might have invested in expanding its share of the total market. At the extreme, there may be cases where a competitor was completely foreclosed. In such cases, the Claimant’s actual sales volumes are hardly an appropriate basis to estimate what the revenues and profits would have been in the absence of the squeeze.

Right margin?

Regardless of whether the margin squeeze occurred because retail prices were ‘too low’ or wholesale prices were ‘too high’ (or a combination of the two), the key step in defining the appropriate counterfactual is to establish the size of the margin that would have prevailed had there been no infringement. The size of the margin depends on the assumptions embedded in the margin squeeze assessment—ie, what would have been a ‘competition law-compatible’ combination of wholesale and retail prices. Margin squeeze assessments build on a number of economic assumptions regarding the costs and volumes on the basis of which the appropriate margin is calculated—notably, the assumption as to whether the entrant is equally efficient with the dominant firm, or ‘reasonably efficient’.

Further, a somewhat contentious question is whether the appropriate margin in the counterfactual should be one which exactly avoided the squeeze, or whether it should be something larger. The most conservative basis for the damages claim is one that is based on a margin that just barely complies with competition law. However, the ‘normal’ level of prices in the counterfactual world may have allowed an even wider margin than one that just passes the competition law test. For example, the recent Albion Water judgment by the UK Competition Appeal Tribunal takes a mean average of different lawful cost benchmarks to establish the relevant counterfactual wholesale prices for damages. The economic justification for a wider (than just competition law-compliant) margin is not clear-cut and depends on specific circumstances. (See the Competition Bulletin’s blog on the legal analysis in Albion Water here.)

From counterfactual prices to damages

As explained above, the damages quantification is relatively simple if the damages are captured by the difference in the margin. If the quantification also needs to take into account the lower sales volumes caused by the squeeze, the quantification is more complex, and may require an analysis of what the squeezed company’s market share would have been in the absence of the margin squeeze.

Counterfactual market shares can be based on market share trends before the infringements, or on comparator markets. It tends to be challenging, however, to find suitable comparators that share key characteristics—eg, number of competitors; competitor characteristics, in terms of vertical integration and lifetime in the industry; and maturity of the market as a whole. All other factors (other than the infringement) need to be controlled for in the economic analysis. Alternatively, a theoretical model could be constructed and calibrated to reflect the market structure that prevailed with and without the infringement. These methods can be complemented by financial analysis on cash flows with and without the infringements.

Concluding remarks

When calculating damages, analysts should be careful before jumping to a complex analysis of what the market shares and consequent profits would have been absent the margin squeeze. It is necessary first to understand the specific circumstances in the upstream and especially downstream markets, and to choose the damages quantification approach on that basis. In some cases, simple approaches based only on establishing the difference between a lawful and an infringing margin can be justified from an economic perspective. Where the analysis gets more complex, there are a range of damages quantification tools for economists to choose from.

2 Comments

Filed under Abuse, Damages, Economics, Policy

2 responses to “The economics of margin squeeze

  1. Tomas

    Well and concisely written article. I liked it a lot – thank you for a nice summary…

  2. I believe that the proposed analysis of damages in a margin squeeze case is wrong. While it is clear that, as a matter of EU law, the existence of a margin squeeze is assessed on the basis of the dominant undertakings costs and that is suffices for a margin squeeze to be an abuse that it has the (likely?) potential to cause competitive harm it is far from clear that the same facts would support that actual competitive harm has been caused by a margin squeeze in relation to a specific competitor. I would argue that competitve harm – exclusionary effects – for a specific competitor can only arise if the margin has been insufficient for that competitor to compete in the market. The margin needed by the dominant undertaking irrelevant for this assessment and any lack of sales in an environment where sufficent margins are granted for that competitor should be deemed to be caused by normal competition.

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