Imputation rules and a vertical price squeeze

Imputation rules and a vertical price squeeze1 Stephen P. King

Rodney Maddock

Department of Economics

School of Business

The University of Melbourne

La Trobe University

Parkville, Victoria

Bundoora, Victoria

Australia

Australia 11 April, 2001

1 Corresponding

author S. King, e.mail: [email protected]. We

would like to thank AAPT for supporting this research and seminar participants at the Australian Competition and Consumer Commission and an anonymous referee for their useful comments. The views expressed in this paper are those of the authors.

Abstract Infrastructure access in telecommunications, energy and transport raises new possibilities for anti-competitive behaviour. In this paper, we examine how a vertically integrated, regulated access provider might engage in a price squeeze to eliminate an efficient competitor. We explore how imputation rules based on regulated access prices can be used to detect a price squeeze and show that there are two basic forms of imputation rule that can be used by competition authorities. These rules highlight different aspects of a price squeeze. The rules are flexible and can be applied to multiple product firms and to situations with differential access costs. We highlight the link between retail-level market power of the integrated access provider and the use of imputation rules. Overall, we show how imputation rules can provide competition regulators like the Australian Competition and Consumer Commission with a powerful group of diagnostic tests to detect an anti-competitive price squeeze.

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1

Introduction

Reform to infrastructure industries in the past fifteen years has changed the interaction between public and private firms in Australia. State owned enterprises in electricity, gas, telecommunications and transport, have been reformed and privatised. The bottle-neck essential facilities controlled by these firms have been opened to other producers through access regimes. Competition has led to a range of new service providers and regulation has been used to control both access prices and prices charged to retail customers. Essential facility access procedures have been explicitly introduced into the Trade Practices Act, 1974 through Part IIIA. This sets out procedures for the declaration of services that satisfy certain ‘essentiality’ characteristics and for the determination of access terms and conditions for these services if commercial negotiations between access seekers and the access provider fail. For example, Part IIIA procedures were recently used to declare certain facilities at Sydney Airport.1 Regulated access to bottleneck facilities creates the potential for new forms of anti-competitive behaviour. A vertically integrated access provider may engage in a ‘price squeeze’ to harm its upstream or downstream competitors. This paper considers the potential for such anti-competitive behaviour and presents a series of formal tests that can be used by the authorities and courts to help them determine whether an integrated firm is engaging in a price squeeze. In some industries, such as electricity in Victoria, reform has involved substantial vertical and horizontal restructuring. Other sectors have faced little if any vertical restructuring. For example, in telecommunications, Telstra retains ownership of the local phone network and simultaneously competes 1 See

Sydney International Airport (2000) ACompT 1 (1 March).

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in long distance and data telephony. The desirability of having a vertically integrated firm controlling an essential production facility and simultaneously competing in downstream competitive markets has been extensively debated in the economic and public policy literature.2 Concerns have been raised that the integrated firm will delay the provision of (upstream essential facility) access to its retail competitors.3 An integrated firm might also degrade the quality of access that it provides to its retail competitors.4 If the access price is regulated then the integrated firm might have incentives to distort retail competition to affect its upstream regulation.5 Finally, the integrated firm might have an incentive to use a vertical price squeeze to distort downstream competition and render its retail rivals unviable. 2 For

example, in the economic literature, see J. Vickers, (1995) “Competition and

regulation in vertically related markets”, Review of Economic Studies, 62, 1-17 and S. King (1999) “Price discrimination, separation and access: protecting competition or protecting competitors?”, Australian Journal of Management, 21-35. For debate relating to vertical separation in the gas and telecommunications industries respectively, see C. Lapuerta and B. Moselle, (1999) “Network industries, third party access and competition law in the European Union”, Northwestern Journal of International Law and Business, 19, 454-478; and T. Brennan, (1987) “Why regulated firms should be kept out of unregulated markets: understanding the divestiture in United States v. AT&T ”, Antitrust Bulletin, 32, 741-793. S. King and R. Maddock (1996) Unlocking the infrastructure: the reform of public utilities in Australia, Allen and Unwin, Sydney, provides an overview in the context of Australian reform. 3 See Lapuerta and Moselle, op. cit. note 2. M. Armstrong, S. Cowan and J. Vickers, (1994) Regulatory reform: economic analysis and the British experience, MIT Press, Cambridge, MA. discuss access delay by the vertically integrated BT, in the context of UK telecommunications. 4 N. Economides (1998) “The incentive for non-price discrimination by an input monopolist”, International Journal of Industrial Organization, 16, 271-284, discusses the incentives for such quality distortion. 5 Brennan, op. cit. note 2.

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“A price squeeze occurs when a supplier of an essential facility reduces the margin between the price for an essential facility and the price that it charges for a retail product in the competitive downstream market”.6 A price squeeze will reduce the profits of downstream competitors and may force them to exit the market. To see this, suppose that it costs $2 to transform each unit of the essential input into a unit of final product. If the integrated firm sets an access price for the input and a retail price with a margin of less than $2, then an equally efficient access seeker will be unable to profitably compete. For example, suppose that the access price is set at $1 per unit of final output. If the integrated firm sets a retail price of at least $3, then competitors will be able to enter the downstream market, buy the essential input and set a retail price to match the integrated firm while recovering the $2 margin needed to remain viable. However, if the integrated firm sets a retail price below $3, it is impossible for retail competitors to meet this price and cover both the access price and their $2 per unit retail costs. In general, a firm can only institute a price squeeze if it is involved in both the supply of an upstream input and the retail production and sale of a product that uses the input. In other words, one firm is integrated over two separate functional stages of production. The ‘victim’ must be a retaillevel firm that is dependent on the upstream supply of the input from the integrated firm. In particular, the victim must not have other competitive sources of supply for the input. The victim must also be engaged in active competition at the retail level with the integrated firm. Thus, both the integrated firm and the victim must be producing products that are the same or are relatively close substitutes at the retail level. To institute a 6 J.

Hausman and T. Tardiff, (1995) “Efficient local exchange competition”, The An-

titrust Bulletin, 40, 529-556 at p.536.

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price squeeze, the integrated firm must raise the price that it charges for its essential input and/or lower the price that it charges for its retail output. By doing this, the integrated firm will ‘squeeze’ the profit margin that can be achieved by its retail competitor. The aim of a price squeeze, in general, is either the elimination of the retail competitor or the weakening of the retail competitor’s position in the market. In this sense, a vertical price squeeze is similar to predatory pricing in that it involves an attempt by one firm to use its market power to force an efficient competitor to leave the market. A price squeeze could also be used as a retaliatory device by the integrated firm to try and punish a retail competitor or to try and convince the competitor to behave in a tacitly collusive fashion.7 . A price squeeze shares some of the features of predatory pricing, particularly when instigated by a regulated firm.8 “Predatory pricing is a strategy that requires a dominant incumbent firm to cut price below rivals’ average cost, even if this means accepting short-run losses, to drive rivals from the market. Once rivals leave the market, the incumbent raises price and collects sufficient economic profit to make the present-discounted return from predatory pricing positive”.9 If the integrated firm faces a regulated access price for its essential upstream input, so that it cannot raise this price, then it engages in a price squeeze by lowering its retail price. Like predatory pricing, the integrated firm can lower its retail price to a level that renders its 7 See

also N. Cornell, (1996) “The use of economics in public policy debate in telecom-

munications”, Quarterly Review of Economics and Finance, 36 (special edition), 73-84 8 R. Noll, (1995) “The role of antitrust in telecommunications”, Antitrust Bulletin 40, 501-528, notes that predatory pricing, vertical price squeeze and some forms of cross subsidisation are closely related anti-competitive practices. 9 S. Martin, (1993) Advanced Industrial Economics, Blackwells, Oxford at p.74.

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retail rivals unviable. In so doing, the integrated firm is forgoing short-term profits through its low retail price. But it engages in the squeeze in the belief that it will later recoup any profits that are lost in the short term through a reduction in retail competition in the long term. Unlike predatory pricing, however, the integrated firm need not make a loss during a price squeeze.10 In the United States there have been a number of cases involving allegations of a price squeeze by a regulated firm.11 In Australia, a price squeeze that was instituted for an anti-competitive purpose would be illegal under s.46 of the Trade Practices Act. Formally, s.46(1) states that “[a] corporation that has a substantial degree of power in a market shall not take advantage of that power for the purpose of (a) eliminating or substantially damaging a competitor of the corporation or a body corporate that is related to the corporation in that or any other market; (b) preventing the entry of a person into that or any other market; or (c) deterring or preventing a person from engaging in competitive conduct in that or any other market.” There have been a number of cases under s.46 that have involved pricing between vertical production levels.12 The potential for a price squeeze by a regulated firm has 10 In

other words, by engaging in a price squeeze, the integrated firm is not making as

much profit as it otherwise would make in the short term, but it need not be making an actual loss in the short term. This is because the integrated firm can still be making a profit from its sales of the essential input. 11 For a summary of older cases and related discussion see P. Areeda and D. Turner, (1978) Antitrust Law: an analysis of antitrust principles and their application, Aspen Law and Business, New York, vol. 3, 231-244. More recent decisions include Town of Concord v. Boston Edison C., 915 F.2d 17 (1st. Cir. 1990), 499 US 931 (1991), and California Public Utilities Commission, Decision 94-09-065, September 15, 1994. 12 For example, Pont Data Australia Pty Ltd v. ASX Operations Pty Ltd, (1990), ATPR 41-007 and Taprobane Tours WA Pty Ltd v. Singapore Airlines Ltd, (1990), ATPR, 41-054. S. Corones (1991) “Crossing a shadowy barrier: recent price squeeze cases”, Australian Business Law Review, 19, 284-296, presents a summary of some of the Australian cases.

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been raised in public debate.13 However, there has not yet been any legal action brought against a regulated firm for a price squeeze under the Trade Practices Act. U.S. courts and regulators have considered how a price squeeze might be recognised. A useful approach that has been discussed in the U.S. is the use of an imputation rule. This rule analyses the retail prices charged by the integrated firm and considers whether or not they would be profitable if the integrated firm had to pay the same access prices as its non-integrated competitors. If the retail prices would not be profitable, then the the integrated firm is engaging in a price squeeze. In other words, the retail prices set by the integrated firm are judged against a cost benchmark that includes a cost of the essential input given by the access price charged to the integrated firm’s retail rivals. This rule was expressed formally by the California Public Utilities Commission in 1989. “[T]o prevent anticompetitive price squeezes, the local exchange carriers should be required to impute the tariffed rate of any function deemed to be a monopoly building block in the rates of the bundled tariff service which included that monopoly function”.14 Returning to the simple example above, if the access price is $1 per unit of final output and downstream value-added costs the integrated firm $2 per unit then the imputed retail price would be $3 – the access price, $1 plus the retail level costs $2. As we noted above, a firm that was at least as efficient as the integrated firm would be able to compete with the integrated firm at a price of $3 or more, but may not be able to compete if the retail price fell below $3. If the integrated firm set a price below the imputed retail price of 13 For

example, see S. King and R. Maddock (1999) “Imputation rules and the regulation

of anti-competitive behaviour in telecommunications”, mimeo, University of Melbourne. 14 Decision 89-10-031, October 12, 1989 at 141.

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$3 it would be engaging in a price squeeze.15 Most of the discussion about imputation rules to date has been at a relatively superficial level. There has been little discussion about the different types of potential imputation rules or how an imputation rule should be implemented. This stands in stark contrast to the debate on predatory pricing. A wide variety of tests have been suggested to aid both competition authorities and the courts in determining whether or not retail pricing is predatory. These tests infer that retail pricing is predatory if it is below, for example, short run marginal cost, average variable cost, average total cost, incremental cost or avoidable cost.16 Some tests have involved the use of multiple pricing benchmarks or of procedural tests.17 Other predation tests involve the use of both price and non-price features of market behaviour.18 There is clearly 15 Such

a low retail price, however, need not lead the integrated firm to make a loss. If

the integrated firm’s cost of producing a unit of access is $0.50 but the regulated access price is $1, then the integrated firm can lower its own retail price to $2.50 before it risks making a loss on the basis of its own production costs, including the production cost of the essential input. The reason for this difference is that the access price of $1 is above the marginal cost of access $0.50. While the non-integrated retailers face a cost given by the access price, the integrated firm produces the essential input and faces the true marginal cost of that input, $0.50. 16 See P. Areeda and D. Turner, (1975) “Predatory pricing and related practices under Section 2 of the Sherman Act”, Harvard Law Review, 88, 697-733; D. Greer, (1979) “A critique of Areeda and Turner’s standard for predatory practices”, Antitrust Bulletin, 24, 233-261; R. Posner, (1976) Antitrust law: an economic perspective, University of Chicago Press, Chicago; and W. Baumol, (1996) “Predation and the logic of the average variable cost test”, Journal of Law and Economics, 39, 49-72. The average incremental cost rule was used in the U.S. case of MCI Communications Corp. v AT& T, (1993) 708 F.2d 1081, 486 U.S. 891. 17 For example, O. Williamson, (1977) “Predatory pricing: a strategic and welfare analysis”, Yale Law Journal, 87, 284-340. 18 For example, P. Joskow and A. Klevorick, (1979) “A framework for analyzing preda-

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considerable debate about the best test for predatory pricing. These tests and the debate surrounding them, provides invaluable guidance to both competition authorities and the courts in determining whether particular pricing is, in fact, predatory. This ‘embarrassment of riches’ regarding predatory pricing stands in stark contrast to the lack of debate on vertical price squeeze. Little formal guidance is provided in the academic literature regarding price squeeze behaviour.19 This paper seeks to partially redress this problem. Our starting point is the imputation rules that have been discussed in the U.S. literature. Our analysis, however, shows that there are a range of alternative imputation rules. Each of these rules will be appropriate in different situations. These rules must be used with care. For example, we show that imputation rules will only detect a price squeeze if the integrated firm has market power in both the upstream market, where it has a monopoly, and the relevant retail market.20 Our analysis focuses on the situation where the integrated firm has a regulated upstream price. While this means that we do not discuss more general possibilities of a price squeeze, our analysis captures the area of most concern to regulators and authorities facing newly privatised firms or industries that have been recently opened to competition. Our results will be most applicable to telecommunications, energy, transport and other utility industries that have been subject to extensive reform over the past fifteen years. tory pricing policy”, Yale Law Journal, v.89, 213-270. 19 Hausman and Tardiff, op. cit. note 6, provides one example. 20 Potential access issues and anti-competitive behaviour also arise if there is limited upstream competition by a small number of facility providers. Our interest here, however, is on access to monopoly essential facilities.

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Overall, we show that authorities can gain significant insight into the behaviour of vertically integrated incumbents by using a staged approach based on ‘marginal’ and ‘average’ imputation rules. If retail pricing by an integrated firm that controls an essential input violates these rules, then the authorities have a cause for concern. At a minimum, they should investigate further to see if a price squeeze is occurring. The paper proceeds as follows. Section 2 defines two classes of imputation rules. The following section shows how they operate in the context of a vertical price squeeze. Section 4 shows the relationship between the imputation rules and market power and shows the need to establish that the firm accused of a vertical price squeeze has relevant retail-level market power. The rest of the paper is devoted to extensions: section 5 to the case of a multiple product firm and section 6 to the case where access costs differ.

2

Imputation rules

At its simplest, an imputation rule states that the vertically integrated access provider cannot set a price for a final product so that the revenue it receives from the sale of that product is less than the price of the relevant access inputs as seen by the integrated firm’s competitors plus the incremental cost of any additional value-added services required for the final product. In other words, the imputation rule requires that the revenue received by the integrated firm for any product would cover production costs if the firm actually had to buy access from itself. An imputation rule limits the ability of the integrated access provider to set retail prices that are unviable for its competitors. It does not prevent all types of potential competitive abuse by the integrated firm. For example,

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the integrated firm might find it profitable to undermine its competitors by lowering the quality of the access product. For example, with rail access, the integrated firm might constrain its retail competitors by limiting the availability of desirable track times or by delaying competitors trains through manipulation of track management. An imputation rule will not prevent such quality degradation. Similarly, an imputation rule does not prevent a vertically integrated access provider from trying to raise the access price charged to downstream competitors although if this occurs the imputation rule does require the incumbent’s own prices to be consistent with the access charge. An imputation rule allows the integrated incumbent to engage in legitimate forms of competitive behaviour. The integrated firm can still compete with downstream firms on price, service quality or other aspects of service. But, with an imputation rule, the integrated firm cannot set prices that would not be commercially feasible if it was on a ‘level playing field’ with the other downstream firms. Just as there are alternative cost-based rules that can be used to judge predatory behaviour by a firm, there are a number of different imputation rules that may be relevant to different situations. For example, an imputation rule might require that the total revenue made by the integrated firm on a product covers the total cost of supplying that product with imputed access prices. Such a rule would help determine whether or not the integrated firm is selling an entire product at an anti-competitive low price ‘on average’. Alternatively, an imputation rule might focus on the marginal production costs. Such a rule would help determine if the incumbent firm was pricing at an anti-competitive level for certain key sales. If downstream marginal production costs are increasing – so that the cost associated with a unit of

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extra downstream production increases as total output rises – a marginal imputation rule would help determine if the integrated firm was deliberately ‘flooding’ the market with anti-competitive intent. The rule would show that some of the access provider’s retail sales would be unprofitable if it had to buy access at the same price as its competitors. These two forms of imputation rules can be formally defined as follows. Definition (Imputation rules): A revenue imputation rule requires that for any final product sold by the integrated firm, the revenue that the firm earns from the sale of that product is no less than the cost of producing that product calculated as if the integrated firm was buying access at the same price(s) as its non-integrated downstream competitors.21 A marginal imputation rule requires that for any final product sold by the integrated firm, the (marginal) price at which the firm sells that product is no less than the marginal cost of that product calculated as if the integrated firm was buying access at the same price(s) as its non-integrated downstream competitors.

3

Imputation rules and a vertical price squeeze

As noted in the introduction, a vertical price squeeze is similar to predatory pricing in that it involves an attempt by one firm to use its market power to force an efficient competitor to leave the market. Unlike predatory pricing, a vertical price squeeze need not involve the aggressor firm selling at a loss. Because of the vertical integration of the production process the aggressor firm can squeeze a competitor in the retail market without necessarily selling below its own overall costs. The imputation rules are designed to detect such 21 This

rule is well defined for a single product firm. But for a multiple product firm, it

is not obvious what is the cost of producing the output of a single product. We discuss multi-product firms below.

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a price squeeze. To see how the imputation rules work, suppose that a group of firms compete by producing and selling a homogeneous final product. To produce this product each firm needs to buy an essential upstream input that is supplied by a monopoly. Each unit of the final product requires one unit of the essential input, and the price of the input is set at a. Thus, a is the ‘access price’ paid by the downstream firms.22 This access price exceeds the marginal cost of production of the essential input. For simplicity, we assume that the upstream input is produced with a constant marginal cost technology, and that the per unit cost of the input is given by c, so that a − c is positive. It costs an extra k dollars to turn one unit of the essential input into one unit of the final output. Finally, the upstream monopoly is integrated into the downstream market so that one of the retail players is a subsidiary of the upstream monopoly. The upstream monopoly will be able to use its downstream subsidiary to launch a price squeeze. Given this information about the structure and production costs in the retail market, we know that legitimate competition between the retail firms will result in a retail price, P , that is at least equal to a + k. This price will allow each non-integrated firm to just recover its per unit production costs. A higher price will allow the retail firms to earn positive economic profits, while a lower price will force the non-integrated retail firms out of business. Since its cost is c + k, the integrated firm will make positive economic profits even if the retail price is equal to a + k: it makes a − c profit on every unit of the essential input that it sells to its retail competitors. For a retail price of P , the firm will also make P − c − k on each unit sold by its retail 22 This

price, for example, might be fixed by government regulation or by an arbitration

under Part IIIA of the Trade Practices Act.

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subsidiary. Overall, even if the retail price is only a + k, the integrated firm makes a − c dollars on every item sold at the retail level. A vertical price squeeze occurs when the integrated firm’s retail subsidiary sets its retail price at a level below a+k. Such a retail price cannot be matched in the long term by the non-integrated retailers. These retailers face per unit costs of a + k so if the retail price is below this level for any reasonable length of time, the non-integrated firms will be driven out of business. Unlike predatory pricing, a vertical price squeeze does not necessarily involve the integrated firm selling at a price below production costs. To see this, suppose that the integrated firm’s retail subsidiary sets a price below a + k but above c + k. The non-integrated retail competitors will lose money if they match this price because their costs are a + k per unit. But the integrated firm has lower per unit production costs of c + k. So as long as the integrated firm does not drive the retail price down below c + k per unit, it will cover its production costs. Because of this, standard predatory pricing tests that rely on comparing price to production costs will fail to detect a vertical price squeeze. The fact that the integrated firm is pricing ‘above cost’ during a vertical price squeeze does not mean that the squeeze has no economic cost to that firm. In fact, the integrated firm gives up profit during a price squeeze. In standard competition, the integrated firm will make at least a − c dollars on every retail sale. During a price squeeze, the retail price drops and so does the integrated firm’s profit. The profit still remains positive so long as the retail price exceeds c + k, but not as high as under standard competition. In this sense, the vertical price squeeze involves an opportunity cost for the integrated firm. Its profits are positive but not as high as they could be during a price squeeze. The integrated firm is foregoing current profits in

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order to damage its retail competitors or to drive them from the market. An imputation rule can detect a price squeeze. The rule evaluates the integrated firm’s pricing policy as if it faced the same access costs as its non-integrated retail competitors. As a result, the rule detects when prices are unviable for (equally efficient) retail competitors. In our example, if the integrated retailer sets a price below a + k then it violates both the average and the marginal imputation rules. First, consider the marginal imputation rule. The imputed marginal cost of access for the integrated firm is given by the access price a. The cost of turning the essential input into final product for the integrated firm is k. So the imputed marginal cost of the retail product for the integrated firm is a + k. If the integrated firm sets a price below a + k it violates the marginal imputation rule. Second, for the revenue imputation rule, suppose that the integrated firm sells q units of the retail output. As both marginal costs and the access price are constant and there are no fixed costs of production in our simple example, the revenue received by the integrated retailer if it sets a price p is just pq. The imputed cost of producing q units is simply (a + k)q The revenue imputation rule is violated if pq − (a + k)q is less than zero, which occurs if the integrated firm sets a retail price below a + k. For our example, both the marginal and the revenue imputation rules perfectly detect a price squeeze. If the integrated firm violated either of these rules then it would most likely be engaging in anti-competitive conduct with an aim of either deterring retail level competition or eliminating retail level competition. The integrated firm would be forgoing current profits by setting a price that makes retail competition unviable. This would only be rational for the firm if it later expected to recoup such a loss through increased future

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profits.23 In general, the two forms of imputation rule will differ. The ‘sensitivity’ of each rule to potential anti-competitive conduct will depend on the nature of the access price, the presence of fixed costs at the retail level and whether retail production involves constant or increasing marginal costs.24 For example, suppose that access to the essential input is supplied with a simple linear price. If retail level marginal costs are increasing then the marginal imputation rule will tend to be a stronger test than the revenue imputation rule. The integrated firm might fail to satisfy the marginal imputation rule even though it is setting a price that will not drive equally efficient retail competitors out of business in the long run. Even so, the failure to satisfy the marginal rule suggests that the integrated firm might be attempting use its market power over the essential input to restrict the market share of non-integrated competitors. 23 Just

as with predatory pricing, short term sales that violate the imputation rules

may have other, pro-competitive justifications. For example, if the integrated retailer was market-testing a new product or had just entered a new market. However, such justifications for forgoing profits and potentially damaging competitors are generally only reasonable in the short-term. 24 If there are fixed production costs, these are picked up by the average imputation rule but not the marginal rule. If marginal costs are increasing as retail output rises, the average imputation rule allows costs to be ‘averaged’ over all output, while the marginal imputation rule prevents this and can detect anti-competitive prices that are targeted at key customers. If retail level production involves always decreasing marginal costs then this suggests that retail production involves a natural monopoly technology and that long term competition is unviable. For a discussion of natural monopoly, see King and Maddock op. cit. note 2; J. Panzar (1989) “Technological determinants of firm and industry structure”in R. Schmalensee and R. Willig (eds) Handbook of Industrial Organization, vol.1., North Holland, Amsterdam; or M. Waterson (1987) “Recent developments in the theory of natural monopoly”, Journal of Economic Surveys, 1, 59-80.

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Alternatively, suppose that retail prices and the price of the essential input are non-linear. Retail prices might involve customers paying a fixed fee then a per unit charge. Telecommunications represents one example where long-distance call prices often involve a ‘flag fall’ and a ‘per additional minute charge’. Similar non-linear charges may be set for access. In these circumstances the marginal imputation rule might be difficult to apply and the revenue imputation rule can provide a clearer picture of any potentially anticompetitive pricing by the integrated firm. Because the marginal imputation rule and the revenue imputation rule can provide different information, it can be beneficial to consider both rules when trying to detect a price squeeze. If either of these rules are violated then the integrated firm’s retail pricing behaviour will warrant further investigation. If both are violated then it is likely that a vertical price squeeze is occurring. This said, like cost tests for predatory pricing, imputation rules are diagnostic tests that should aid competition authorities. The rules indicate that a problem might exist but formal investigation is still required to establish whether or not there is anti-competitive behaviour.

4

Imputation rules and market power

If the price of access was set by a regulator at the (short run) marginal cost of access then the marginal imputation rule would be identical to the marginalcost-based predatory pricing test. Similarly, for such an access price, the revenue imputation rule would be equivalent to either the average variable cost or the average cost predatory pricing tests. Thus, if the access price is set equal to marginal cost, the imputation rules become standard predatory

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pricing tests. However, the imputation rules and the predatory pricing tests diverge as soon as the access price is set above short-run marginal cost. If access prices are set above marginal access costs, then an imputation rule can detect anti-competitive behaviour. But it might also detect relatively benign market behaviour that is simply a result of the high regulated access price. To see this, suppose that the access price exceeds marginal cost but that all firms competing in the downstream market, including the integrated firm, behave in a perfectly competitive manner. Further, suppose that both the integrated and non-integrated retailers are equally efficient in the retail sector. Each firm acts as if it has no market power and takes the price of the retail product as beyond its control. Given this retail price, each firm will individually set its retail output to maximise its own profits. The integrated firm however faces lower (marginal) retail costs. Because it internally supplies itself with the access product, the integrated firm will consider the true marginal cost of the access product when making its retail output decision. In contrast, all other retail firms face higher (marginal) costs. They purchase the access product at the inflated access price that exceeds marginal cost. The integrated firm, because it faces lower costs, will find it profitable to produce more output at the given retail price than will non-integrated retailers. This relatively high retail output level is not the result of any abuse of retail market power by the integrated firm. It occurs because the regulated access price exceeds marginal cost. In this situation the integrated firm will fail both a revenue imputation rule and a marginal imputation rule – simply because it produces more retail output. For the marginal rule, each non-integrated firm will want to increase its output so long as the price for the retail product exceeds the marginal cost of production. The non-integrated firms maximise profit by expanding

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output until the marginal production costs, based on the regulated access price, just equal the price. The integrated firm, however, produces more retail output. Because the integrated firm effectively faces a lower price for the upstream essential input, it has lower marginal costs and will expand production beyond that of non-integrated retail firms. The counter factual posed by the marginal imputation rule asks whether the output level of the integrated firm would be profit maximising if it faced the costs of the non-integrated producers. In this case, it would not be. As a result, the integrated firm would fail the marginal imputation rule. Similarly, as each non-integrated firm is just making zero economic profits, the integrated firm that produces more retail output would make an economic loss if it faced the same access costs as its non-integrated competitors. This is the counter-factual test in the revenue imputation rule so the integrated firm would also fail to satisfy this rule. The relationship between perfect competition with free-entry and the imputation rules is illustrated in figure 1. The curves MCn and MCi give the marginal production costs for the non-integrated and integrated retailers respectively. MCn lies above MCi because the access price paid by the nonintegrated firms exceeds the marginal cost of access. Under perfect retaillevel competition, each firm maximises profits by producing a quantity where marginal cost equals the retail price P . This quantity is Qn for each nonintegrated retailer and Qi for the integrated retailer. Note that Qn is less than Qi. The integrated firm fails to satisfy the marginal imputation rule because its marginal costs, with the imputed access price, would be given by MCn. At output level Qi , these imputed costs exceed the price – the integrated firm would make a loss on its final units of retail production under

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the imputed costs. Under the free entry assumption, the profits of the non-integrated firms must equal zero.25 This means that fixed retail production costs must equal area A on figure 1a. Each non-integrated firm makes revenue given by P times Qn but has variable costs given by area B + D. This area is just the sum of the marginal cost of production for each unit produced by non-integrated firms. Total profit for each non-integrated firm is thus P Qn − B − D less fixed costs. As free entry drives economic profits to zero, these fixed costs must equal A. Consider the integrated firm in figure 1a. If it faced marginal costs MCn then its profit would be P Qi −B−D −I −E −F −A. Again, P Qi is the firm’s revenue, B+D+E+F +I represents the imputed variable costs of production and A is the fixed cost of production. Overall, if it faced the imputed access price the integrated firm would make a loss of I. The integrated firm fails to satisfy the revenue imputation rule. The competitive assumptions made in the above example represent an extreme form of ‘price taking’ behaviour. We assumed that firms had absolutely no market power and that there was free entry by identical non-integrated firms. In reality these assumptions are unlikely to be met. However, the example does highlight that caution is needed when using the imputation rules. These rules may confuse benign competitive behaviour for anti-competitive behaviour. Of course, the same problems arise with predatory pricing tests. These tests may detect competitive loss-leading by a firm that is merely attempting to build up market share through aggressive, pro-competitive behaviour. For 25 If

economic profits were positive then more firms would enter the retail market until

economic profit was driven to zero.

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20

this reason, predation tests are only relevant when the firm that is accused of predatory pricing has market power. Similarly, imputation rules to detect anti-competitive behaviour by an integrated access provider are only relevant when that access provider has market power in the retail market. In summary, before an imputation rule can be used to detect any anticompetitive behaviour by an integrated firm, it must first be determined that the firm has some power in the relevant downstream market.

5

Multiple products and the revenue imputation rule

5.1

Overview

The imputation rules presented in section 2 were defined for a single product. In many situations firms produce multiple products. This does not create any problem for the marginal imputation rule. This rule can still be applied on a product-by-product basis. However where more than one product is being produced in the downstream market using the essential input, the single-product revenue imputation rule might not be well defined. For example, suppose that there are two retail products that share a common input. Further, suppose that each product requires the essential input. If the products are sold individually, then it is easy to determine the product specific revenue. But because of the common cost, it is not possible to define unambiguously the imputed total cost of each product. Should the imputed cost of each product include the common cost, ignore it or be allocated part of the common cost? The move from a single product to multiple outputs raises three issues

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for the revenue imputation rule. 1. How should common costs be treated in a revenue imputation rule? 2. Can the revenue imputation rule deal with different degrees of market power over the different downstream products? 3. How is the revenue imputation rule applied when the integrated firm has different degrees of market power across different customer groups?

5.2

Multiple products and common costs

First, consider the issue of common costs. As above, suppose that there are two downstream products and the upstream producer provides the essential input for these products. There is a regulated access price for the essential input. This price might be non-linear, for example, with a fixed and variable price component each of which can be above their true cost. Downstream production involves both the cost of the essential input, product specific costs and a cost that is common over the two downstream products. As an example, the downstream products might be long distance telephone calls and internet data services. Both products require access to the monopoly local telephone network as an essential input. Downstream production also involves facilities that will be shared between the two types of services, such as some cabling and switching. The fact that there is a shared common cost at the downstream stage makes it difficult to apply the revenue imputation rule to each product separately. If we were to apply this rule to one product alone, then the retail price might satisfy the rule if the common cost is not included as a productspecific cost. The same could apply to the other product if tested separately. Nevertheless it would not be possible for retail competitors of the integrated

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22

firm to produce both products unless common costs were recovered in some way through retail prices. For example, suppose the cost of access is $1 per unit and additional product specific costs are $1 for retail product 1 and $2 for product 2. The integrated firm sells 20 units of each product. Finally, retail production involves a fixed common cost of $10. If the integrated firm set a price of $2 for product 1 then it would satisfy the revenue imputation rule when applied to the increment to costs associated with product 1. Given that product 2 is being produced, the extra per unit imputed cost of product 1 is given by the downstream cost of $1 per unit plus the imputed access cost of $1 per unit – $2 in total. Similarly, if the integrated firm set a price of $3 for product 2 then it would satisfy the revenue imputation rule based solely on the imputed incremental cost of product 2. At these prices, the integrated firm would earn revenue of $100 in total. The sum of its retail-level costs, including the common costs, would be $70. As a result, the integrated firm would make an actual profit so long as its true cost of producing the essential input were no more than $0.75 per unit. However, equally efficient retail competitors who must pay an access price of $1 per unit cannot survive at these prices. No matter what combination of retail products the non-integrated retailers sell, they will lose $10. A simple way to augment the revenue imputation rule to allow for multiple products and common costs involves applying the rule both to each individual product and to the group of retail products. In the above example, the integrated firm’s prices would fail to satisfy a revenue imputation rule applied to both products together. The total revenue from these products is $100 but the imputed cost of production, using the regulated access price, is $110 in total. This approach can be generalised for any number of retail products

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23

and provides us with a multiproduct version of the revenue imputation rule. Definition: The multiproduct revenue imputation rule requires that the integrated firm must satisfy the revenue imputation rule for each individual product in question and for each and every combination of products that shares common costs in the downstream market with the product(s) in question. The multiproduct revenue imputation rule includes the incremental revenue and incremental costs for each product or group of products. For example, if there were three retail products, labeled 1, 2 and 3, then the imputation rule applied to only product 1 would include the incremental costs and revenues just for product 1. The rule applied to the group of products 1 and 2, would only include incremental revenues and costs associated with these two products. If, say, there was a retail level cost that was common to all three products or if essential input pricing involved a fixed fee that was payable regardless of the amount and type of retail output, then these costs would only be included when applying the multiproduct rule to the bundle including all three retail products. The multi-product revenue imputation rule represents a minimal extension of the revenue imputation rule in the presence of common costs. It avoids specific allocation of common costs to individual products. The extension follows a standard approach in economics that when products involve common costs, it may be necessary to consider both individual products and combinations of products. For example, this approach is used to determine if a firm’s pricing involves cross subsidies.26 26 See

for example W. Baumol and J.G. Sidak (1995) Towards Competition in Local

Telephony, MIT Press, Cambridge.

Imputation rules

5.3

24

Non-competitive retail products

A second complication arises if the integrated firm has different degrees of market power in different markets where it sells its retail products. To see this, suppose that the integrated firm produces two distinct retail products, both of which require the essential input. It faces significant competition in the retail market for one of these products but faces little retail competition for the other product.27 The integrated firm will make significant profits on the product that it sells in the non-competitive retail market, and to satisfy the revenue imputation rule it would like to claim that the two products are, in fact, just one product. The non-competitive product will provide the integrated firm with ‘spare’ revenue. If it is able to convince authorities that there is only a single retail product, then the integrated firm will be able to institute a price squeeze in the competitive retail market while using the ‘spare’ revenue to satisfy the revenue imputation rule. The integrated firm would have considerable scope to undermine competition in the competitive retail market without violating the imputation rule by such revenue averaging. To avoid revenue averaging, when applying the revenue imputation rule, the authorities must take care to ensure that products with different degrees of retail-level market power are not grouped together as single products. Even if the authorities correctly separate out relevant retail markets, differential degrees of market power can effect the multi-product revenue imputation rule. To see this, again assume that there are two retail products – one competitive and one not competitive. Further, suppose that retail production involves a common cost. The presence of common retail costs means 27 For

example, there might be perfect competition in the retail market for one product

but the integrated firm might have a monopoly in the retail market for the second product.

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25

that the multi-product revenue imputation rule provides an appropriate test for a price squeeze. However, this rule may fail to detect such a squeeze because of the profits being earned on the non-competitive retail product. So long as the competitive retail product satisfies the single product revenue imputation rule, profits from the non-competitive product can be used to cover all common costs. The key issue that the authorities need to consider in this situation is why there is a lack of competition for one retail product product. There are two alternatives. It might be impossible for non-integrated firms to enter or expand production into the non-competitive retail product because there are entry barriers. Or it might be feasible for non-integrated firms to enter or expand production of the non-competitive product, for example if they make a relevant sunk investment, but the non-integrated firms are reluctant to enter this market, preferring to try and make ‘easier’ profits elsewhere. This second alternative is most likely when there are only a few non-integrated retail firms. These firms might be poorly financed or otherwise under-resourced. They might also prefer to try and compete through regulatory intervention in the competitive retail market rather than make risky investments and enter into the other retail market. Under the second alternative, when non-integrated firms could enter production of the non-competitive retail product but choose not to do so, then there is not an anti-competitive advantage to the integrated firm. Rather, this firm has made the relevant investment and is simply enjoying the returns from that investment. There seems little reason not to simply apply the standard multi-product revenue imputation rule in this situation. Under the first alternative, there are barriers to entry in the non-competitive retail sector. In the longer term, the authorities should investigate the source

Imputation rules

26

of these barriers to entry and may try to eliminate the barriers. In the mean time, the integrated firm should not be allowed to use its profits from the non-competitive product to disguise anti-competitive behaviour in the competitive retail market. To apply the revenue imputation ruole for the competitive sector, the common retail costs need to be considered. In this case there is no unique justifiable way to distribute the common costs between the retail sectors. Rather, the authorities might want to apply the revenue imputation rule using a variety of allocations of the common costs between the two retail markets. If the integrated firm’s pricing fails to satisfy these rules, particularly for relatively low allocations of common costs to the competitive sector, then there is a high probability that the integrated firm is engaged in a vertical price squeeze.

5.4

Market power and customer classes

The integrated firm might also have different degrees of market power across different types of consumers. This creates similar problems to those that arise with differential power over markets. However, differential market power across consumer types might be much harder for regulatory authorities to identify. Suppose the integrated firm faces two types of consumers for its final products. The non-integrated firms, however, can only compete for one type of customer. The other type of customer are ‘locked in’ to the integrated firm. This might occur if one customer group has substantial switching costs when they move to a non-integrated retailer.28 28 This

issue arises in telecommunications. Some consumers place a high value on their

phone numbers. If moving to a non-integrated retailer means giving up this valuable number then the relevant customers are locked in to the entrant. For this reason, Australia,

Imputation rules

27

There are two cases. First, the integrated firm might supply essentially the same product to both competitive and non-competitive consumers, but set different prices. The integrated firm can then gain abnormal profits from the non-competitive customers and use these to establish prices for the competitive customers that cannot be matched by non-integrated firms. This situation is directly analogous to the case considered in section 5.3. Alternatively, the integrated firm might set the same retail price for the two customer types, and this price might satisfy a revenue imputation rule when simultaneously applied to both customer groups. However, the nonintegrated firms might be unable to match this price for only the competitive customers. For example, suppose that the marginal cost of serving an extra customer of either type is constant and identical across customer types. However, the fixed retail costs of serving each competitive customer exceed those of each non-competitive customer. The integrated firm could set a price for the retail product that satisfies both the marginal imputation rule and the revenue imputation rule when jointly applied over both customer types, but does not allow non-integrated firms to effectively compete for the competitive class of customer. To see this, suppose that there are equal numbers of competitive and noncompetitive customers and that the fixed cost of servicing each competitive and non-competitive customer is $2 and $1 respectively. The marginal cost, on top of the essential input, of supplying an extra unit to each customer is $1 regardless of type and the imputed access price for each unit of output is also the US and other countries have required incumbent phone companies to allow customers to ‘port’ their numbers to competing firms. J. Gans, S. King and G. Woodbridge (forthcoming) “Numbers to the people: regulation, ownership and local number portability”, Information Economics and Policy, provide an overview of the problem regulators face with number portability.

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28

$1. Suppose that the integrated firm sets a price of $2.18 for the retail product and at this price each customer buys 10 units regardless of type. Clearly this pricing satisfies the marginal imputation rule. The imputed marginal price per unit is $2, less than the marginal retail price. Also, this pricing satisfies the revenue imputation rule. The integrated firm receives $21.80 from each customer and, on average, faces imputed costs of $2.15 per unit of the retail product, or $21.50 per customer. However, the non-integrated retail firms that are limited to serving the high-fixed-cost customers cannot match this pricing. These firms face costs of $2.20 per unit when they sell 10 units to each competitive customer, more than the per unit price set by the integrated firm. The problem again is that the integrated firm can use the profits made by charging above cost for the non-competitive customers to allow it to charge below (imputed) cost to the competitive customers while still satisfying the imputation rule over all customers. This is possible in the above example because the non-competitive customers are cheaper to service than the competitive customers. Both of these cases effectively involve third-degree price discrimination between the competitive and non-competitive classes of customer. In the first case, the price discrimination is obvious. The two classes of customer faced different prices. In the second case the price discrimination is more subtle. The two classes of consumer faced the same prices despite having different costs. Further, in both cases the imputation rules applied over all customers, rather than just the competitive set, can fail to detect anti-competitive behaviour. The obvious solution to this problem is for the authorities to investigate why some customers are not competitive and to try and open up these customers for competition. Mandating local number portability in telecom-

Imputation rules

29

munications is one attempt to increase the range of contestable customers. This said, there may remain pockets of non-competitive customers who are only available to the integrated firm. The authorities, when applying the imputation rules, should in general treat customers where there are different degrees of competition as if they were different customers who actually buy different products. This will prevent the integrated firm from circumventing the imputation rules by averaging revenues or costs over different types of customers. There are two points that should be noted. First, the separation of consumer types does not prevent the integrated firm from exploiting legitimate economies of scale in its production. However, where those economies arise because the integrated firm has sole access to one group of customers, the non-integrated firms might have a legitimate cause for concern. Again, the real issue is the reason why one group of customers is non-competitive. If the lack of competition reflects a regulatory barrier or other form of artificial barrier to entry, it might be felt that it is unfair to allow the integrated firm to exploit economies of scale that are unavailable to its competitors. This issue is beyond the scope of our discussion here. Secondly, distinguishing between different classes of customer who face different degrees of market power with respect to the integrated firm might be difficult to implement. This is particularly the case where price discrimination by the integrated firm is subtle, so that the same prices are charged despite differences in cost. As a first pass, authorities might find it useful to distinguish broad groups of consumers who face differential market power and also to consider the source of these differences. If the source of the difference is a competitive advantage that the authorities consider to be illegitimate, then they might like to consider the groups as separate when applying an

Imputation rules

30

imputation rule. If these broad groups prove to be inadequate, then further division of consumer types by differential market power might be warranted.

6

Imputation rules with differential access costs

In some situations, the integrated firm might have a legitimate claim that the simple imputation rules prevent it from lowering its price purely on efficiency grounds. In particular, the integrated firm could argue that it costs it less to provide upstream access services to itself than to provide these same services to its retail competitors. There are two main situations where this might occur. First, if the integrated firm and its retail competitors use the same essential input, the integrated firm might claim that it is cheaper to provide that input internally within the integrated firm rather than externally to a retail competitor. Secondly, the integrated firm and its retail competitors might use slightly different essential inputs. The integrated firm might argue that it is cheaper to provide the relevant retail product using the essential input it supplies to itself rather than the input supplied to the retail competitors. In telecommunications for example, the owner of the local network will only interconnect with dedicated long-distance carriers at certain switches. If the local carrier also competes in retail long distance calls, then it might argue that the essential input that it uses is different to that provided to its retail competitors because it can transfer calls through switches that are not used by its retail competitors. These two ‘low cost’ arguments are clearly closely related. In the telecommunications example, if the essential input is defined as local-network access, then it could be argued that the retail competitors receive a slightly different wholesale product or that it is simply cheaper to provide access within the

Imputation rules

31

integrated firm. The regulator and the courts, however, should regard such claims with extreme caution. It will often be very difficult for regulators and courts to verify the integrated firm’s claims about ‘lower costs’. If the integrated firm is allowed to either avoid the use of the imputation rules or to use a modified form of the imputation rules when it claims such cost savings, then it will allow the firm to use these claims to hide an anti-competitive price squeeze. Hausman and Tardiff have suggested a modification to the imputation rules if the integrated firm really does face lower access costs.29 The basic logic underlying a price squeeze is that the integrated firm is forgoing current profits in an attempt to damage its non-integrated retail competitors. The integrated firm will expect to ‘recoup’ the lost current profits through higher prices in the future. If, however, the integrated firm is currently making more profit through its retail pricing than it would if it allowed its retail competitors to raise their market share, then it is unlikely that the integrated firm is engaging in a price squeeze. Following this logic, the integrated firm can only be said to be engaging in a price squeeze when the profits that it makes from serving its retail customers are less than the profits it would make if it allowed an equally efficient retail competitor to serve those same customers. To see how the imputation rules can be modified to allow for this profit comparison, we can return to the simple example presented in section 3. Once again, suppose that the price of the essential input is fixed, say by regulation, at a so that this is the ‘access price’ paid by the downstream firms. The per unit cost of the input when supplied to a non-integrated downstream firm is given by cn. The integrated firm, however, can supply this input to itself at 29 op.

cit. note 6.

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32

a lower cost of ci per unit. It costs an extra k dollars to turn one unit of the essential input into one unit of the final output. The standard marginal imputation rule would then require that the price set by the integrated firm should exceed the regulated access price a plus the cost of downstream valueadding, k. If a unit of final product was sold by a non-integrated downstream firm then the integrated firm will make profit of a−cn . But the integrated firm can claim that it can make even more profit by under-cutting its retail competitor. This extra profit will arise because the integrated firm has a lower cost when it supplies the essential input to itself. In fact, the integrated firm can argue that so long as its retail price exceeds k + ci + (a − cn) then it is making more profit in the short-term by selling the final product itself rather than allowing a retail competitor to service the customer. This price involves two parts. The first, k + ci is the cost the integrated firm incurs when it supplies the essential input to itself and produces the final product. The second part, (a − cn) is the profit that the integrated firm forgoes when it supplies the product rather than allowing a retail competitor to buy the essential input and sell the product. If its retail price does not fall below k +ci +(a−cn) then the integrated firm is making more profit than if it were selling access to a retail competitor. As a result, following the Hausman and Tardiff argument, the integrated firm could claim that it is not engaged in a price squeeze if its retail price exceeds k + c + (a − c n). We can compare this minimum price with the standard marginal imputation rule. Rearranging the formula, the minimum price that the integrated firm can set and not be worse off than if it sold the essential input to a retail competitor is k + a − (cn − ci ). Hausman and Tardiff consider this price to be the modified imputation rule. The price is the standard imputation

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33

rule, k + a, reduced by the cost saving that the incumbent receives if it is cheaper to supply itself with the essential input rather than to supply a retail competitor. Hausman and Tardiff argue that this is the relevant rule to ensure efficient competition. So long as the integrated firm is allowed to set any price that is at least as high as this modified imputation rule and is not allowed to set a lower price then competition will ensure that the most efficient firm supplies the customer. As a result, they argue that the modified imputation rule should be used to judge a price squeeze.30 The efficiency claim by Hausman and Tardiff is correct, but it is also only relevant when the non-integrated retail firm has lower retail-level costs than the integrated firm. To see this, suppose that the integrated firm and its retail competitors were equally efficient in the retail sector and that they sell a homogeneous final product. Then the minimum price that any nonintegrated retailer can set before it makes a loss is a + k. It will always be more efficient for the integrated firm to provide the final product because of its lower access costs. But the short-term profit maximising strategy for the integrated firm will be to just undercut its retail rivals – to set a price just below a + k. It would never be profit maximising, in the short term, for the integrated firm to set a lower price. In particular, if the integrated firm set a price as low as that suggested by Hausman and Tardiff, then the integrated firm would be forgoing short term profit. A rational firm would only do this if it could perceive some longer term gain in terms of higher profits, for example through a successful price squeeze. The problem with the modified imputation rule suggested by Hausman and Tardiff is that, while it ensures efficient production, it also allows the incumbent to engage in a vertical price squeeze. In fact, when both the inte30 A

similar adjustment can be used for the average imputation rule.

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34

grated firm and its competitors are equally efficient in the retail sector and all firms produce a homogeneous good, a marginal imputation rule set slightly below the standard imputed price will also ensure efficient production and will not allow for an anti-competitive price squeeze. Using the notation presented above, an imputation rule that allows the integrated firm to set any price above a+k−ε, where ε is small allowance for a more efficient integrated firm to undercut its retail competitors, will ensure efficient production. The integrated firm can always match and just undercut a non-integrated competitor who requires a more costly access input. This imputation rule is also consistent with profit maximising behaviour by the integrated firm. If the integrated firm set any lower price then it would be foregoing current profit, potentially with anti-competitive intent. For practical purposes, this suggests that when the integrated and nonintegrated firms are equally efficient at the retail level, then the marginal imputation rule should not be altered even if the integrated firm has lower wholesale costs. Authorities will never be able to set the imputed price with perfect precision so that a standard application of the rule will give the integrated firm the ability to legitimately undercut a less efficient nonintegrated firm. Further, unlike the modified rule suggested by Hausman and Tardiff, the standard imputation rule is consistent with both efficiency and short-term profit maximisation by the integrated firm, and cannot be used to hide a vertical price squeeze. More generally, the imputation rule should only be altered if the integrated firm can show two cost variations. First, it must show that it costs the integrated firm less to provide itself with access services than to provide its non-integrated retail competitors. Secondly, it must also show that the integrated firm has a cost disadvantage in the retail sector. In such cir-

Imputation rules

35

cumstances, the integrated firm has a legitimate argument that it should be allowed to discount the marginal imputation rule by its own retail level disadvantage up to a maximum discount given by the integrated firm’s wholesale level cost advantage. The modified imputation rule that allows for both efficient production and avoids price squeeze behaviour is presented in figure 2. As before, the saving achieved by the integrated firm when it supplies the essential input to itself rather than to a separate firm is given by (cn − ci ). The vertical axis in figure 2. shows the retail price set under the marginal imputation rule. This price varies according to the retail cost disadvantage of the integrated firm, as measured on the horizontal axis. When there is no difference between retail costs, the marginal imputation rule remains at a + k. If the integrated firm has a retail cost disadvantage, then the imputation price falls dollarfor-dollar with that disadvantage. This is shown by the diagonal line in the figure. But the maximum discount is given by the integrated firm’s wholesale advantage, cn − ci . Any further retail cost disadvantage for the integrated firm does not lead to any change in the price under the imputation rule. We can express the marginal imputation rule in the presence of cost differentials mathematically. Using the notation above, and letting ki and kn be the retail costs of the integrated and non-integrated firms respectively then the augmented marginal imputation rule is given by the larger of a+k −(ki −kn) and a+k −(cn −ci ). This rule will ensure efficient production and is consistent with profit maximising behaviour by the integrated firm. Any violation of this rule suggests a potential for a vertical price squeeze.31 The Hausman and Tardiff rule involves only the second half of this augmented imputation rule. In this sense, Hausman and Tardiff give the inte31 Again,

an analogous approach can be used for the average imputation rule.

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36

grated firm too great a degree of lee-way when it claims to have lower own costs at the wholesale level. The potential for cost differences raises two further issues. First, as noted above, regulators and competition authorities must be wary of cost claims made by the integrated firm to justify a lower imputation rule. Note however, that under our approach, the integrated firm must not only show a wholesale advantage but also a retail disadvantage in order to lower the imputation rule. This makes deliberate distortion more difficult. Even so, when in doubt, the regulator should err on the side of caution and not modify the imputation rule. While this, in some circumstances, might lead to inefficient production, this can be a small social cost compared to the potential harm of allowing the integrated firm to institute a price squeeze through the use of distorted cost information. Secondly, the above discussion has focused on homogeneous retail products. The rule does not require modification when the retail firms produce differentiated products. Such differentiation will tend to mute competition and should lead to higher pricing by the integrated firm. If it violates the imputation rule in such circumstances then this is even stronger evidence of potential anti-competitive behaviour.

7

Conclusion

Infrastructure access in telecommunications, energy and transport raises new possibilities for anti-competitive behaviour. In this paper, we have examined how a vertically integrated, regulated access provider might engage in a price squeeze to eliminate an efficient competitor. We have also explored how imputation rules based on regulated access prices can be used to detect a

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37

price squeeze. Imputation rules have been used overseas, particularly in the U.S., and have been accepted by U.S. regulators. We show, however, that there are two alternative basic formulations for imputation rules. A revenue imputation rule considers the entire revenue generated by the integrated firm from retail sales while a marginal imputation rule focuses on specific customers. These two rules are only identical in certain special circumstances. Otherwise, they capture different aspects of price squeeze behaviour and a violation of either one of the rules should cause concern to competition authorities like the ACCC. We also consider how the revenue imputation rule can be extended to situations of multiple products. In practice, imputation rules are generally only applied to firms that have significant market power. Our analysis shows that this is a necessity rather than a convenience. Imputation rules can provide regulators with incorrect information when applied to a regulated upstream access provider that lacks retail-level market power. Integrated access providers in the U.S. have argued against imputation rules on the basis that they ignore situations where it is cheaper for the integrated firm to provide itself with essential facility access than it is to provide access to other firms. A number of U.S. commentators have suggested modifications to the imputation rules to deal with this possibility. We show that modifications to the standard imputation rules are only economically sensible if the integrated firm has a cost advantage in the provision of the upstream essential input and has a cost disadvantage in downstream production. The modified marginal imputation rule we present allows for both efficient production and the detection of a potential price squeeze. While imputation rules are useful in detecting an anti-competitive price

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38

squeeze, the role of such rules needs to be kept in mind. If an integrated access provider violates one or more imputation rules, then this is a cause for concern. By itself it does not show that the firm has behaved in an unlawful way. The imputation rules are diagnostic tests that should aid competition authorities but do not replace formal investigation. The rules highlight where a competitive problem might exist, but do no more than this.

Imputation rules

39

$ MCn Imputed Marginal Cost MCi P

Qn

Qi

Figure 1: Figure One

Quantity

Imputation rules

40 $ MCn

I P F A B

E D

Qn

Figure 2: Figure 1a

Qi

MCi

Imputation rules

41

Marginal imputation rule

k+ a

k + a - (cn - ci)

0

cn - ci

Figure 3: Figure Two

Retail cost disadvantage