Toward a Unified Theory of Toward a Unified Theory of Exclusionary Vertical Exclusionary Vertical

RestraintsRestraints

Daniel A. CraneDaniel A. CraneUniversity of Michigan Law SchoolUniversity of Michigan Law School

Graciela MirallesGraciela MirallesEuropean University InstituteEuropean University Institute

June 17, 2010June 17, 2010

Variety of exclusionary vertical Variety of exclusionary vertical practicespractices

• Exclusive dealingExclusive dealing• TyingTying• Predatory pricingPredatory pricing• BundlingBundling

• Bundled discountsBundled discounts• Market share Market share

discountsdiscounts• Loyalty rebatesLoyalty rebates

Our project: Both broad and narrowOur project: Both broad and narrow

• BroadBroad: Comprehensive framework for : Comprehensive framework for addressing all exclusionary vertical addressing all exclusionary vertical restraintsrestraints

• NarrowNarrow: Just : Just exclusionaryexclusionary vertical vertical restraints. restraints. – Not addressing collusion or exploitationNot addressing collusion or exploitation

Collusion:Collusion:

Agreeing with your competitor to stop Agreeing with your competitor to stop competing in order to secure a mutually competing in order to secure a mutually

beneficial outcome, at the expense of beneficial outcome, at the expense of someone else.someone else.

Austria vs. GermanyAustria vs. Germany1982 Group Stage1982 Group Stage

Exploitation:Exploitation:

Taking advantage of someone else's Taking advantage of someone else's weakness to extract an excessive weakness to extract an excessive

amount of surplus.amount of surplus.

World Cup Qualifying 2001World Cup Qualifying 2001Australia 31, American Samoa 0Australia 31, American Samoa 0

Exclusion:Exclusion:

Disabling one's competitor from Disabling one's competitor from competing by anticompetitive means.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 Both US and EU law lack a consistent frameworkconsistent framework

• Three sources of confusion:– Price vs. non-price– Single product vs. multi-product– Primary line vs. secondary line

US ExampleUS Example

• Primary line price discrimination = Primary line price discrimination = predatory pricing.predatory pricing.

• Secondary price discrimination requires no Secondary price discrimination requires no market power, no injury to competitive market power, no injury to competitive process, not even threat to competitor's process, not even threat to competitor's continuation in market.continuation in market.

US ExampleUS Example

• Bundled discounting:Bundled discounting:– LePage'sLePage's: don't analogize to predatory pricing; : don't analogize to predatory pricing;

analogize to tying and exclusive dealing.analogize to tying and exclusive dealing.– PeaceHealthPeaceHealth: analogize to predatory pricing, : analogize to predatory pricing,

using discount reallocation test.using discount reallocation test.

EU ExampleEU Example

• DelimitisDelimitis: Exclusive dealing agreement : Exclusive dealing agreement under Article 101 analyzed under a under Article 101 analyzed under a substantial foreclosure framework.substantial foreclosure framework.

• Michelin IIMichelin II: Loyalty rebates analyzed under : Loyalty rebates analyzed under Article 102 form-based approach without Article 102 form-based approach without regard to amount of foreclosure or general regard to amount of foreclosure or general effects on the market.effects on the market.

Comprehensive two-part test, Comprehensive two-part test, regardless of form of restraintregardless of form of restraint

• ForeclosureForeclosure

• SubstantialSubstantial

ForeclosureForeclosure

• ““[V]irtually every contract to buy [V]irtually every contract to buy ‘forecloses’ or ‘excludes’ alternative sellers ‘forecloses’ or ‘excludes’ alternative sellers from from somesome portion of the market, namely portion of the market, namely the portion consisting of what was bought.” the portion consisting of what was bought.”

-Judge (now Justice) Stephen Breyer, -Judge (now Justice) Stephen Breyer, Barry Barry Wright v. ITT Grinnell Wright v. ITT Grinnell (1983).(1983).

• Too broad; foreclosure becomes a useless Too broad; foreclosure becomes a useless category.category.

Our testOur test

• A restraint "forecloses" if it denies equally A restraint "forecloses" if it denies equally efficient rivals a reasonable sales efficient rivals a reasonable sales opportunity.opportunity.

• Different applications depending on kind of Different applications depending on kind of restraint, but all answering same ultimate restraint, but all answering same ultimate question.question.

Example: Exclusive dealingExample: Exclusive dealing

• Exclusive dealing may not foreclose if rival Exclusive dealing may not foreclose if rival could reasonably offer its own competitive could reasonably offer its own competitive exclusive dealing contract. But, may exclusive dealing contract. But, may foreclose if (for example):foreclose if (for example):– New entrant facing preexisting long-term New entrant facing preexisting long-term

exclusivesexclusives– Exclusive is for too large a piece of business for Exclusive is for too large a piece of business for

small rival to bid.small rival to bid.– Dominant firm is "must carry" brand.Dominant firm is "must carry" brand.

Example: Predatory pricing and Example: Predatory pricing and bundled discountsbundled discounts

• Below-cost pricing forecloses (but may not Below-cost pricing forecloses (but may not be substantial)be substantial)

• An above-cost bundled discount may An above-cost bundled discount may foreclose if the rival could not offer its own foreclose if the rival could not offer its own above-cost competitive discount in the above-cost competitive discount in the competitive market.competitive market.– Discount reallocation test determines whether Discount reallocation test determines whether

or not there is foreclosure.or not there is foreclosure.

Example: Secondary line price Example: Secondary line price discriminationdiscrimination

• Must disadvantaged retailer sell below cost Must disadvantaged retailer sell below cost in order to remain competitive with in order to remain competitive with advantaged retailer?advantaged retailer?– If not, no foreclosure.If not, no foreclosure.

SubstantialSubstantial

• Legal testLegal test: Does amount of foreclosure : Does amount of foreclosure deny rival a reasonable opportunity to deny rival a reasonable opportunity to survive in the market?survive in the market?

• Economic testEconomic test: Is rival reasonably able to : Is rival reasonably able to reach and maintain minimum viable scale reach and maintain minimum viable scale by competing for business in the non-by competing for business in the non-foreclosed segment of the market?foreclosed segment of the market?

Minimum viable scaleMinimum viable scale

• Total sales new entrant needs to achieve Total sales new entrant needs to achieve hurdle rate on invested capital. (Salop, hurdle rate on invested capital. (Salop, 1986)1986)

• Familiar concept from horizontal merger Familiar concept from horizontal merger analysis.analysis.

The tricky part: Incumbency The tricky part: Incumbency advantageadvantage

• Even in non-foreclosed segment, Even in non-foreclosed segment, incumbent/dominant firm may have decided incumbent/dominant firm may have decided advantage:advantage:– Customer loyaltyCustomer loyalty– Switching costsSwitching costs– Brand preferenceBrand preference

Effect of incumbency advantage on Effect of incumbency advantage on "substantiality""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 But, legal test must look past first roundround

• Incumbency advantages can degenerate Incumbency advantages can degenerate quickly.quickly.

• Even in a completely non-foreclosed Even in a completely non-foreclosed market, new entrant often must absorb market, new entrant often must absorb losses for years to reach mvs.losses for years to reach mvs.

IllustrationIllustration

• Static market with 2,000 units purchased Static market with 2,000 units purchased monthlymonthly

• 50% foreclosure50% foreclosure

• 90% incumbency advantage90% incumbency advantage

• Minimum viable scale: 20% (400 units)Minimum viable scale: 20% (400 units)

Market Share Change with 90% Incumbency Advantage and Monthly Customer Decision

0

200

400

600

800

1000

1 3 5 7 9 11 13 15 17 19 21 23

Month

Units

Implication:Implication:

• As a general rule, foreclosure should not be As a general rule, foreclosure should not be deemed substantial if the minimum viable deemed substantial if the minimum viable scale is less than the units or revenues in the scale is less than the units or revenues in the non-foreclosed segment of the market non-foreclosed segment of the market divided by the number of competitors. divided by the number of competitors.

• In a two-firm market, foreclosure is never In a two-firm market, foreclosure is never substantial if mvs < 50% of non-foreclosed substantial if mvs < 50% of non-foreclosed segment.segment.

QualificationsQualifications

• New entrant often claims superior price or technology, New entrant often claims superior price or technology, hence should more than overcome any incumbency hence should more than overcome any incumbency advantage.advantage.

• If there are very long intervals in the competitive cycle, If there are very long intervals in the competitive cycle, then incumbency advantage may erode slowly. But then then incumbency advantage may erode slowly. But then market may be a natural monopoly.market may be a natural monopoly.

• Markets with partial foreclosure and many competing Markets with partial foreclosure and many competing firms raise special questions:firms raise special questions:– Aggregate foreclosure?Aggregate foreclosure?– Generic probability of success falls with multiple competitors.Generic probability of success falls with multiple competitors.– Exclusion of any one competitor may have little competitive Exclusion of any one competitor may have little competitive

significance.significance.

Concluding ThoughtsConcluding Thoughts

• Unified test adds rigor and consistency, but Unified test adds rigor and consistency, but does not eliminate all difficulties.does not eliminate all difficulties.

• Opportune time to pursue unified test on Opportune time to pursue unified test on both continents:both continents:– "Antitrust policy toward vertical restraints is "Antitrust policy toward vertical restraints is

the biggest substantive issue facing antitrust.” the biggest substantive issue facing antitrust.” Richard Posner, 2005.Richard Posner, 2005.

– EU: shift toward effects-based rules.EU: shift toward effects-based rules.

Toward a Unified Theory of Toward a Unified Theory of Exclusionary Vertical Exclusionary Vertical

RestraintsRestraints

Daniel A. CraneDaniel A. CraneUniversity of Michigan Law SchoolUniversity of Michigan Law School

Graciela MirallesGraciela MirallesEuropean University InstituteEuropean University Institute

June 17, 2010June 17, 2010