Excessive-pricing-paper-LdP-and-LB-Aug-09-2

Staying safe – dominant firms’ pricing decisions in industries where high prices not attract entry Louise du Plessis1 and Lizél Blignaut2 Third Annual Competition Commission, Competition Tribunal and Mandela Institute Conference on Competition Law, Economics and Policy in South Africa Senior associate and economist in the Competition Department at Edward Nathan Sonnenbergs Inc Executive and economist in the Competition Department at Edward Nathan Sonnenbergs Inc 2 Introduction 1.1 The South African economy is characterised by concentrated markets, with many dominant firms, monopolies or near monopolies operating in markets with high or prohibitive barriers to entry Dominant firms have an additional responsibility in terms of the Competition Act, Act 89 of 1998 (“the Competition Act”) in that they have to ensure that their activities not fall within the type of conduct considered to be abuses of dominance In particular, the Competition Act, with its excessive pricing provision, requires these firms to ensure that they not charge their customers prices that bear no reasonable relation to the economic value of the good or service provided, and is above that economic value What exactly is meant by “economic value” and a “reasonable relation” between price and economic value is not clear ex facie the Competition Act itself nor from current South African jurisprudence 1.2 Excessive pricing from either a policy or economic and legal assessment perspective is not a simple issue, so much so that in the Unites States of America (“US”) excessive or monopoly pricing is not regulated, whereas in the European Union (“EU”) - like South Africa - excessive pricing is considered an abuse of dominance 1.3 Economic theory suggests that the most efficient way to determine prices is through demand and supply considerations and that high prices and profits are economic signals that will attract entry and expansion However, the extent to which dominant firms can rely on demand and supply interactions alone for their pricing decisions and still stay safe from contravening the Competition Act is unclear and probably not consistent along all markets This is because new entry or capacity expansion is a key component in the process of free interaction of demand and supply so that efficient, long run equilibrium can be obtained High and non-transitory barriers to entry therefore greatly inhibit the free interaction of demand and supply in a market 1.4 Against this background, the purpose of this paper is to review the economic literature to seek guidance on the meaning, definition and determination of economic value, competitive prices, fair value, and other supporting theories Furthermore, this paper will review international and South African case precedent on excessive pricing In particular, the paper will examine the four step test for the analysis of excessive pricing as set out by the Competition Appeal Court (“CAC”) 1.5 We conclude with some guidance to dominant firms on their pricing strategies, drawing from the literature studies, international case law and the ArcelorMittal SA case precedent.3 Defining a fair price: economic theory 2.1 The mansion of economic theory has many rooms, and like many other economic theories, thoughts and concepts there is no general agreement amongst economists on what a “fair” price is or even what the correct measure of economic value is Economists agonised for many years about the differences between the value-inuse and value-in-exchange of products Classical economists like David Ricardo held a cost based theory of value whilst, simplistically, Marxist economists predominantly adhere to a labour theory of value postulating that a “fair” price of a product is equal to the value that labour has added to it4 70/CAC/APR07, available at http://www.comptrib.co.za/list_judgement.asp?jid=1049 Marx, K “Capital” (Frederick Engels ed 1887) and JA Schumpeter “History of Economic Analysis” (E Boody Schumpeter ed Oxford University Press Oxford 1954) pt III, c in Evans & Padilla, 2004 2.2 The cost-of-production theory of value is the theory that the price of an object or condition is determined by the sum of the cost of the resources that went into making it (a theory of value is an explanation of what determines the prices of commodities and services) The cost can compose any of the factors of production (including labour, capital, or land), raw materials and taxation In particular, it is the marginal value and the marginal cost of the last unit traded that jointly determine a price In competitive markets the price of a good or a service should equal its marginal cost of production5 2.3 For Neo-classical economists, the “fair” value of a good or service is given by its “competitive” market price, which is the equilibrium price that would result from the free interaction of demand and supply in a competitive market Theoretically, the free interaction of demand and supply can be described as follows: Begin in a position of short run and long run equilibrium and suppose that demand increases (due to, for example, an increase in income) In the short run there is an immediate move to a new increased equilibrium price where the new quantity demanded equals the quantity supplied Existing firms all receive higher profits at the higher price and the higher profits attract new entry More firms will enter the industry, increasing the quantity supplied at each price level As more products come to market, there is excess supply at the higher price Over time, price will decrease to the level where the new demand equals the new supply, establishing a new long run equilibrium 2.4 From the above, it is therefore clear that new entry or capacity expansion is a key component in the process of free interaction of demand and supply in order for long run equilibrium to be attained High and non-transitory barriers to entry therefore greatly inhibit the free interaction of demand and supply in a market 2.5 Economic theory thus leads us to two possible fundamentals to determine economic value: One finds a value foundation in the production costs of the product under scrutiny (thus only in supply factors) and the other finds a value foundation in the competitive price as determined in a competitive market where resources move unfettered by structural or other constraints (a free interaction between demand and supply factors) A question that remains is how to identify or define a “competitive” price in practice We discuss this in the next section Linking economic price theory to competition policy Economic theory 3.1 Economic theory shows that markets are most efficient (as measured by productive and allocative efficiency) when prices are based on the interaction of both demand and supply factors in a free market When prices are higher than at competitive levels, consumers are worse off and overall welfare is reduced At lower prices than competitive levels, firms fail to receive an appropriate return on their investments, which results in insufficient entry and / or inefficient exit Furthermore, when there is a shortage of a product, a price rise will serve to ration the available supply to those buyers who value it the most and thus the product will be used in areas where the most value is added This equilibrium price will be (i) productively efficient (as goods and services will be produced by the most efficient firms, i.e those with the lowest marginal cost of production) and (ii) allocatively efficient (as all consumers willing to pay a price in excess of the marginal cost of production will be supplied) – see Geradin, 2007, page Marshall, A “Principles of Economics” (Macmillan London 1890) in Evans & Padilla, 2004 A competitive price is the price where quantity demanded = quantity supplied 4 3.2 Monopolist pricing occurs when a single producer restricts output to the quantity where marginal costs equals marginal revenue, but recovers at the price level of marginal value from the consumer At the restricted output level marginal value is greater than marginal cost, leading to inefficient allocation of resources, a loss of consumer welfare and a deadweight welfare loss to society 3.3 One of the objectives of competition policy is to make markets efficient and to provide consumers with competitive prices and product choices To this end, competition authorities aim to create market conditions that will ensure that the market works well so that the outcome is efficient prices Furthermore, some jurisdictions (including South Africa) also have an outright prohibition on excessive pricing to address inefficient and exploitative prices, particularly in circumstances where it is not possible for prices to be set by freely interacting competitive forces (i.e demand and supply factors) 3.4 The control of excessive prices is based on the principle that, while in competitive markets the price of a good or a service should equal its marginal cost of production,8 and such price is determined by demand and supply factors, the same outcome is not guaranteed when the equilibrium price exceeds the competitive price due to the exercise of market power by the supplier of such good or service In such cases, the price thus set will lead to allocative and productive inefficiencies Consumer welfare will be affected by transfers of rents from consumers to producers (as consumers will have to pay higher prices than those prevailing in a competitive market) and production may be carried out by both efficient and less efficient firms (if prices exceed marginal costs, firms pricing above such marginal costs are able to stay in business) In such industries, preventing dominant firms from imposing “excessive” prices, i.e prices “in excess” of the competitive prices, is thus justified by the need to prevent such inefficiencies.9 Provisions of the Competition Act 3.5 In South Africa, section of the Competition Act deals with prohibited abuses of dominance and states that – “It is prohibited for a dominant firm to (a) charge an excessive price to the detriment of consumers;” Section 1(ix) of the Competition Act states that an ‘excessive price’ “means a price for a good or service which – (aa) and bears no reasonable relation to the economic value of that good or service; (bb) is higher than the value referred to in subparagraph (aa);” Competition policy 3.6 Excessive pricing is an antitrust offence in a limited number of jurisdictions While high prices can lead to violations of competition rules in South Africa, the EU, its Member States and a limited number of countries, other nations (including the US) This equilibrium price will be (i) allocatively efficient (as all consumers willing to pay a price in excess of the marginal cost of production will be supplied) and (ii) productively efficient (as goods and services will be produced by the most efficient firms, i.e those with the lowest marginal cost of production) – See Geradin, 2007, page Geradin, 2007 page consider that the charging of high prices should not be controlled by competition authorities, as the market will self-correct any pricing excesses by dominant firms because excessive prices will attract new entrants10 or because of the lack of sufficient market friendly remedies to correct excessive prices 3.7 In the EU, Article 82(a) of Treaty of Rome (the “EC Treaty”) deals with excessive prices, and states that a firm with market power abuses its dominant position if it “directly or indirectly” imposes “unfair purchase or selling prices or other unfair trading conditions.”11 In short, a dominant firm violates Article 82(a) if it charges unfairly high prices to its customers or, alternatively, if it pays unfairly low prices to its suppliers.12 3.8 These pricing practices would also constitute a Chapter II violation according to Section 18 of the 1998 UK Competition Act, 13 and likewise would violate the competition laws of the other EU Member States These practices are considered to be an “exploitative” abuse because they may result in a direct loss of consumer welfare.14 3.9 Pricing abuses represent a significant share of abuse of dominance cases initiated every year by EU and EU Member States’ competition authorities The vast majority of such cases concern exclusionary abuses, which include pricing strategies adopted by dominant firms to foreclose competitors Such strategies include a wide variety of measures, such as predatory pricing, price squeezes, loyalty rebates, selective price cuts, and the like Only a small minority of cases concern exploitative abuses that cover instances where a dominant firm is accused of exploiting its customers by setting excessive prices 3.10 As stated above, US antitrust law does not prohibit excessive pricing In particular, in Berkey Photo, Inc v Eastman Kodak Co., the Court of Appeals for the Second Circuit said: “Setting a high price may be a use of monopoly power, but it is not in itself anticompetitive … Judicial oversight of pricing policies would place the courts in a role akin to that of a public regulatory commission …”15 3.11 Likewise, the Supreme Court stated in Trinko: “The mere possession of monopoly power, and the concomitant charging of monopoly prices, is not only not unlawful; it is an important element of the freemarket system The opportunity to charge monopoly prices—at least for a short 10 See, e.g., Motta, M and de Streel, A “Exploitative and Exclusionary Excessive Prices in EU Law” in Ehlermann, D and Atanasiu, I (eds.), What Is an Abuse of a Dominant Position?, Oxford: Hart Publishing, 2006, p.91 at p.108 (“[E]xploitative practices are self-correcting because excessive prices will attract new entrants”) in Geradin, 2007 11 Treaty on European Union (Amsterdam Treaty) art 82 12 This article will only concentrate on excessive pricing provisions 13 Competition Act 1998 (UK) c 41, s 18 Before the Competition Act 1998, the Fair Trading Act of 1973 regulated trading practices The Competition Act 1998 and the Enterprise Act 2002 have replaced many of its provisions – see Evans & Padilla, 2004, page 14 EC competition law and the competition laws of the Member States also condemn as abusive those pricing policies, including excessive pricing, that result in the “exclusion” of competitors from the market, as they may harm consumers indirectly 15 Berkey Photo, Inc v Eastman Kodak Co 603 F 2d 263, 294 (2nd Cir 1979), cert denied 444 US 1093 (1980) in Evans & Padilla, 2004, page 31 6 period—is what attracts “business acumen” in the first place; it induces risk taking that produces innovation and economic growth”16 Case precedent 4.1 The assessment of excessive pricing contraventions faces conceptual and practical difficulties Conceptually, what constitutes “unfair” or “excessive” pricing has been the subject of protracted debate between policy makers, academics, and courts From a practical perspective, the question is how competition authorities could distinguish between competitive prices and unfairly high prices 4.2 Against this background, this section will review the South African and international case-law in dealing with the control of excessive prices South African precedent 4.3 A recent judgement by the Competition Appeal Court (“CAC”) upheld an appeal by Mittal Steel South Africa Limited (“Mittal”)17, Macsteel International Holdings BV (“MI”) and Macsteel Holdings (Proprietary) Limited against the decision of the Competition Tribunal (“Tribunal”) regarding the alleged excessive pricing by Mittal in the sale by it of flat steel products in the South African market 18 4.4 This judgement sheds some light on the manner in which excessive pricing is to be assessed under the Competition Act, but still does not clearly illuminate the path As a matter of fact, the CAC judgement is clearer on how not to assess excessive pricing than it is on how to actually assess it 4.5 In March 2008 the Tribunal found that Mittal had contravened section 8(a) of the Competition Act The Tribunal did not a comparison or analysis of price and reasonable economic value and did not find per se Mittal’s practice of selling to the domestic market at import parity prices as excessive pricing Rather, the Commission focused on domestic sales prices and conditions imposed on the resale of products In the words of the CAC, the Tribunal found that ‘Mittal shorts the domestic market by ensuring that (its) excess production is not available in South Africa at a lower price than its own domestic price’ and ruled further that the arrangement between Mittal and MI was the ‘essential ancillary conduct… whereby Mittal SA abuses its structural advantage to maintain its pre-selected price level’ Mittal’s structural advantage arose, according to the Tribunal, from Mittal’s ‘super dominant’ position as an ‘uncontested firm in an incontestable market’ Such ‘super dominance’ was, according to the Tribunal, a prerequisite for a finding of excessive pricing The Tribunal, from a policy perspective it seems, wanted to follow a USbased approach in that high prices will attract entry and should thus be left unregulated, except where markets are incontestable and unregulated 4.6 The CAC criticised the Tribunal for applying its policy objectives instead of the specific language of the Act and stated that the Tribunal is bound to apply the Act… ‘The words chosen by the legislature when enacting section 8(a) (and the definition of ‘excessive price’) clearly and unambiguously indicate that what is prohibited is the ‘charging’ of an excessive ‘price’, not so-called ‘ancillary abusive conduct’ designed to take advantage of a particular market structure’ 16 Verizon Communications, Inc v Law Offices of Curtis V Trinko, LLP 157 L Ed 2d 823, 836 (2004) in Evans & Padilla, 2004, page 31 17 Currently ArcelorMittal South Africa Limited 18 70/CAC/APR07, available at http://www.comptrib.co.za/list_judgement.asp?jid=1049 4.7 The CAC found that the wording of section 8(a) requires four steps in order to determine whether an excessive price has been charged to the detriment of consumers : 4.7.1 first, the determination of the actual price charged; 4.7.2 second, the economic value of the good or service must be ascertained; 4.7.3 third, if the actual price exceeds the economic value, it must be determined whether the difference between them is unreasonable; and if so, 4.7.4 it must be determined if the charging of the excessive price is to the detriment of consumers 4.8 On the bases of the foregoing, the CAC remitted the matter to the Tribunal for reassessment on the basis of the four stage test articulated by the CAC 4.9 The analytical challenges that remain relate to the assessment of the economic value of the good or service and determining what would be an unreasonable difference between the price and the economic value International case precedent European Union 4.10 The criteria for assessing whether a price is “unfair” within the meaning of Article 82 of the EC Treaty were established in some of the first competition cases brought before the European Court of Justice (“ECJ”) In its United Brands ruling, the ECJ held that a price is “excessive” when “it has no reasonable relation to the economic value of the product supplied”, and that “(t)his excess could, inter alia, be determined objectively if it were possible for it to be calculated by making a comparison between the selling price of the product in question and its cost of production, which would disclose the amount of the profit margin”19 4.11 Importantly, the ECJ adopted the following two-stage approach for determining whether a price is excessive Specifically, one would have to: “[Examine w]hether the difference between the costs actually incurred and the price actually charged is excessive”; and “[I]f the answer to this question is in the affirmative, [determine] whether a price has been imposed which is either unfair in itself or when compared to competing products”.20 4.12 In other words, a comparison between the price and the cost is first carried out to reveal the profit margin achieved by the dominant firm If that profit margin is found to be “excessive”, the dominant firm’s pricing policy needs to be further investigated in order to determine whether the price is “unfair” 4.13 The ECJ’s judgment, however, did not provide further guidance on the application of this test In particular, it did not clarify the basis on which to determine whether a 19 See ECJ, United Brands Company and United Brands Continentaal BV v Commission, 27/76 [1978] ECR-207 at section 251 in Geradin, 2007, page 20 See ECJ, United Brands Company and United Brands Continentaal BV v Commission, 27/76 [1978] ECR-207 at section 252 in Geradin, 2007, page 8 price-cost difference is excessive Similarly, it did not explain what an “unfair” price would be when applying the second stage of the test 4.14 Unfortunately, subsequent cases referred to the ECJ only led to sporadic pronouncements on the methods applicable for establishing an excessive price within the meaning of Article 82 EC The ECJ even seemed to abandon the United Brands two-stage test, in favour of a more “integrated” approach based on various categories of benchmarking In a first line of cases, the ECJ directly compared the pricing policy of a dominant firm with the prices of equivalent firms active on neighbouring geographic markets.21 In a second line of cases, the ECJ undertook to make comparisons between the prices charged by the same dominant firm (i) to various customers and (ii) over time.22 4.15 To date, it is thus difficult to find consistency in the standards relied on by the ECJ The lack of clarity of the case-law is further aggravated by isolated rulings applying a different methodology For example, in National Association of Licensed Opencast Operators (NALOO) v Commission,23, the Court of First Instance (“CFI”) applied an “efficient demand” benchmark, i.e it checked whether dominant firm’s efficient customers could still achieve profits, without suffering a competitive disadvantage 4.16 The most recent pronouncement of the EU Commission suggests that the two-stage test espoused in United Brands remains the relevant analytical framework for assessing whether a price is excessive 4.17 In Scandlines Sverige AB v Port of Helsingborg, the EU Commission recalled that the evidence of an “excessive” profit margin was not sufficient in itself to establish an abuse 4.18 The EU Commission underlined that it was bound to prove the existence of an “unfair” price pursuant to the second step of the United Brands test, thus making it clear that the two conditions for a finding of abusive excessive pricing set in United Brands were cumulative In other words, a finding of abuse cannot be reached when only one of such conditions is met.24 4.19 In particular, at paragraph 158 the EU Commission stated in its decision of 23 July 2004: “In any event, even if it were to be assumed that the profit margin of HHAB [the dominant firm] is high (or even “excessive”), this would not be sufficient to conclude that the price charged bears no reasonable relation to the economic value of the services provided The Commission would have to proceed to the second question as set out by the Court in United Brands, in order to determine whether the prices 21 See ECJ, Lucazeau and others v SACEM and others, 110/88 [1989] ECR-2811 at section 25 (“When an undertaking holding a dominant position imposes scales of fees for its services which are appreciably higher than those charged in other Member States and where a comparison of the fee levels has been made on a consistent basis, that difference must be regarded as indicative of an abuse of a dominant position”) in Geradin, 2007, page See also ECJ, Corinne Bodson v SA Pompes funèbres des régions libérées, 30/87 [1988] ECR-2479 (to determine whether prices are unfair, “[I]t must be possible to make a comparison between the prices charged by the group of undertakings which hold concessions and prices charged elsewhere”) in Geradin, 2007, page 22 See ECJ, British Leyland Public Limited Company v Commission, 226/84 [1986] ECR-3263 at sections 27-28 in Geradin, 2007, page (where the Court recalled – in the lines of the United Brands language – that a price is excessive where it is “disproportionate to the economic value of the service provided” 23 T-89/98 [2001] ECR II-515 at section 72 in Geradin, 2007, page 24 Ibid at paragraph 158 charged to the ferry operators are unfair, either in themselves or when compared to other ports” 25 4.20 The EU Commission further cautioned in the Port of Helsingborg case that the difference between revenue and cost was not a sufficient basis for finding excessive pricing and suggested that ‘customers demand’ was also a relevant determinant of price To this end, the EU Commission considered that “determination of the economic value of the product/service should also take account of other non-cost related factors, especially as regards the demand-side aspects of the product/service concerned.”26 4.21 This means that the higher prices imposed by a dominant firm may simply reflect the fact that the product/service they provide has greater value for the consumers (e.g., due to the prestige of the brand, etc.) than comparable products /services provided by competitors As pointed out by the EU Commission: 27 “[t]he demand-side is relevant mainly because customers are notably willing to pay more for something specific attached to the product/service that they consider valuable This specific feature does not necessarily imply higher production costs for the provider However it is valuable for the customer and also for the provider, and thereby increases the economic value of the product/service.” The Netherlands 4.22 In Dutch law, the legal basis allowing the competition authority and the courts to prohibit excessive prices is found in Article 24 of the Dutch Competition Act, pursuant to which “undertakings are prohibited from abusing a dominant position” It is noteworthy that, while the Dutch competition authority (“NMa”) has conducted nine excessive price investigations, only one led to a finding of excessive prices The decision in question was, however, abandoned following an appeal by the investigated firms 4.23 The test applied by the NMa to determine whether a price is excessive includes examining “whether there is too great a disproportion between the costs and the price actually charged To determine this, the realized return is compared with a measure of the cost of capital For this, the WACC is the measure”.2829 4.24 The NMa generally distinguishes the cost component and the profit component of the dominant undertaking’s prices Excessive prices may be the result of passing on excessive costs and/or an excessive profit margin The NMa usually assesses first whether costs have been correctly allocated to the products or services in question, an exercise we have seen is essential when the company under investigation is a multi-product firm It then compares the return on invested capital with the WACC The determination of a firm’s WACC involves a calculation of its cost of capital in which each category of capital is proportionately weighted All capital sources – common stock, preferred stock, bonds and any other long-term debt – are included in a WACC calculation 25 Ibid at paragraph 158 26 Ibid at paragraph 226 27 Ibid at paragraph 227 28 See NMa decision of 27 September 2005, case 3528/199, UPC, paragraph 40 in Geradin, 2007, page 27 29 WACC refers to Weighted Average Cost of Capital 10 4.25 Only if the return is durably and significantly above the cost of capital does the NMa find that prices are excessive In a number of cases it has particularly emphasized the need for a durable and significant excess before an abuse can be found The United Kingdom 30 4.26 In assessing questions about excessive pricing, the Office of Fair Trading (“OFT”) would usually look for evidence that prices are substantially higher than would be expected in a competitive market, and that there is no effective competitive pressure to bring them down to competitive levels, nor is there likely to be 4.27 The OFT will usually assess excessive pricing cases by considering (i) cost and price benchmarks; and (ii) evidence of excessive profits by the dominant firm The OFT notes in its Guideline 414 that this list of indicators is not exhaustive and that the analysis of excessive prices will depend on the specific facts of the case in hand 4.28 Guideline 414a provides a number of examples of cases where prices and profits of a dominant firm which, at first sight, might appear to be excessive will not amount to an abuse 4.28.1 First, high prices will often occur for short periods within competitive markets For example, an increase in demand that could not be met by current capacity or a supply shock that reduced production capacity would lead to higher prices The OFT considers that where high prices are temporary and / or likely to encourage substantial new investment or new entry, they are unlikely to cause concern; 4.28.2 Second, a firm might be able to sustain supra-normal profits for a period if it was more efficient than its competitors; and 4.28.3 Third, the OFT accepts innovation markets may be characterised by high prices and profits 4.29 The OFT also notes it is important not to interfere in natural market mechanisms where high prices and profits will lead to timely new entry or innovation and thereby increase competition In particular, Guideline 414 makes clear that the OFT is concerned that competition law should not undermine appropriate incentives for undertakings to innovate Concern about excessive prices will be more likely in markets where price levels are persistently high without stimulating new entry or innovation 4.30 In sum, the OFT clearly indicates that in most circumstances high prices not have exploitative features and that correcting such prices may hurt the competitive process Its emphasis on the need not to interfere with dominant firms’ incentives to invest and innovate is particularly important Reducing such incentives is indeed one of the main risks created by price controls 4.31 The UK case-law on excessive pricing is very limited One recent case, however, deserves attention In Attheraces30, the Court of Appeal overturned what had been the first ever final judgment by the High Court finding an abuse of a dominant position in breach of Article 82 EC and of the Chapter II prohibition and giving declaratory relief The Attheraces, judgment is important for a variety of reasons: Court of Appeal, Judgment of February 2007, Attheraces Ltd & Anor v The British Horseracing Board Ltd & Anor Rev [2007] EWCA Civ 38, available at http://www.bailii.org/ew/cases/EWCA/Civ/2007/38.html in Geradin, 2007, page 39 11 4.31.1 First, the Court of Appeals found that prices exceeding costs plus a reasonable margin were not in themselves excessive It found that the price of the product in a competitive market might be above or below the reasonable margin determined through a cost plus analysis Clearly, control of prices under Article 82(a) EC or Chapter II should be distinguished from the sort of rate-of-return regulation carried out by sector-specific regulators with respect to natural monopolies 4.31.2 The Court of Appeals also held that, when assessing a claim of excessive pricing, it is necessary to consider all the relevant circumstances In this respect, the Court of Appeal held that the High Court had erred by not taking into account the economic value of the product to the purchaser 4.31.3 In line with Port of Helsingborg, the Court of Appeals considered that the value of a product for the buyer was relevant for the purpose of assessing the excessiveness of a price Demand-side considerations were thus relevant factors in excessive price inquiries “Economic value” and “reasonable relation” - learnings from economic theory and case precedent 5.1 While the CAC’s ruling on the an excessive price has been challenges still remain relating service and determining what price and the economic value 5.2 The following learnings as regards the assessment of the economic value of the good or service and determining what would be a “reasonable relation” to that value can be drawn from economic theory and international case precedent: 5.2.1 Mittal SA case sets out the tests to assess whether charged to the detriment of consumers, analytical to the assessment of economic value of the good or would be an unreasonable difference between the Authorities generally use the following tests to assess whether an excessive price has been charged to the detriment of consumers: 5.2.1.1 making a comparison between the selling price of the product in question and its cost of production, which would disclose the profit margin, and whether it exceeds a “reasonable return” (determined by calculating the firm’s WACC) Then, if the profit margin is found to be “excessive”, the dominant firm’s pricing policy is further investigated in order to determine whether the price is “unfair” Prices exceeding costs plus a reasonable margin are therefore not in themselves excessive; 5.2.1.2 comparing the pricing policy of a dominant firm with the prices of equivalent firms active on neighbouring geographic markets; 5.2.1.3 comparing prices charged by the same dominant firm (i) to various customers and (ii) over time; 5.2.1.4 determining whether, at existing prices, the dominant firm’s efficient customers could still achieve profits without suffering a competitive disadvantage – also known as the “efficient demand” benchmark; and 12 5.2.1.5 5.2.2 considering other demand side factors, e.g the economic value of the product / service for the purchaser Furthermore, the following main themes arise: 5.2.2.1 If high prices are temporary and / or likely to encourage substantial new investment or new entry, they are unlikely to cause concern; and 5.2.2.2 To determine the economic value of a product for a buyer, demand factors need to be considered Examples are: 5.2.2.2.1 is there a general shortage of the product (i.e high prices contribute to the efficient allocation of scarce resources)? 5.2.2.2.2 could efficient customers still achieve profits, without suffering a competitive disadvantage? 5.2.3 All of these factors have to be assessed within the context of the free interaction of demand and supply and whether there are any obstacles to this, such as high barriers to entry, the type of risk associated with the dynamics of the market, the duration of the prices, innovation, etc; 5.2.4 Therefore, cost is not the only basis on which prices should be based, or on which a price should be found to be excessive Demand and supply considerations and market conditions are all issues that should be taken into account; 5.2.5 New entry or capacity expansion is a key component in the process of free interaction of demand and supply so that the long run equilibrium can be obtained High and non-transitory barriers to entry therefore greatly inhibits the free interaction of demand and supply in a market; and 5.2.6 As with the absolute value of the economic value of a product, the issue of reasonableness remains a contested one in both theory and in law Some scholars advocate that a price grounding in economic value and a difference made up of factors such as risk, innovation, etc is adequate to show reasonableness and controlling high prices imposed by dominant firms is undesirable in dynamic industries, where investments and innovation are critically important Again, it is challenging to practically translate this view into a quantitative analysis In the EU, for example, a 100% difference between the calculated economic value (based on production costs) and the price charged have been found (in specific instances) to not amount to excessive pricing Selecting a pricing mechanism: guidelines to firms 6.1 The South African prohibition on charging excessive prices to the detriment of consumers relates only to the conduct of dominant firms This is because the presumption is that a firm operating in a market where the majority of product is supplied by other firm(s) will lose sales and customers if it unilaterally charges excessive prices However, customers might have nowhere to turn or limited alternatives when a dominant firm charges an excessive price and, as such, dominant firms have an additional responsibility to ensure that the way in which they 13 set prices and the price level charged not fall foul of section 8(a) of the Competition Act 6.2 The analysis of whether the prices that firms charge are likely to contravene section 8(a) of the Competition Act is by no means a “one size fits all” exercise and should be done on a case by case basis However, having regard to the international case law and the ArcelorMittal SA case precedent outlined above, this section will set out the main pricing mechanisms that are generally used and provide guidelines to dominant firms as to the circumstances in which the use of these pricing mechanisms may attract scrutiny by the competition authorities Export Parity Pricing 6.3 Export parity pricing (also called export achievable pricing) is a pricing policy adopted by suppliers of a good for sales to domestic customers, according to which price is set at the net proceeds per unit from export sales As such, price is set equal to the world price, converted into rand, minus any transport costs (where applicable), taxes or tariff payable (in the destination market) and any other costs the supplier would incur if exporting The export parity price or export achievable price represents the opportunity cost of local sales versus selling the product into the international market 6.4 Export parity price setting as a principle does not relate the selling price of a product to the cost of production and therefore, at least in theory, export parity pricing could result in huge differences between the cost of production and the selling price 6.5 This begets the question – should a dominant firm selling to domestic customers set its prices at “cost-plus-a-reasonable-margin” or is export parity pricing acceptable and “safe”? 6.6 As a principle of fairness and free movement of demand and supply, we are of the view that there would be no grounding in competition policy to restrict a seller from selling into the market where the highest price can be achieved (with the proviso that this market needs to show adequate levels of competition) 6.7 As such, setting prices at export parity levels (where the export market is reasonably competitive, as is likely if imports are viable) are unlikely to attract scrutiny by the competition authorities Import Parity Pricing 6.8 Import parity pricing (“IPP”) is a pricing policy adopted by suppliers of a good for their sales to domestic customers according to which price is set at the opportunity cost for the purchaser of a unit of an imported substitute good As such, price is set equal to the world price converted into rand, plus any transport costs, insurance fees, taxes and tariffs and other costs the customer would bear if importing.31 6.9 Again, import parity price setting as a principle does not relate the selling price of a product to the cost of production and therefore, at least in theory, IPP could result in huge differences between the cost of production and the selling price In some cases, import parity prices can be lower than cost incurred by domestic suppliers, particularly in industries where there are no import tariffs, and where transport and other costs the customer would bear if importing are low 32 The import parity price is 31 Parr, 2005, page 32 Ibid at pages and 14 however likely to be higher than cost for goods where import tariffs and transport costs (usually goods with a low ratio of value to volume) are high 6.10 As such, it is important to note that the practice of IPP itself is not by default harmful to consumers and does not necessarily amount to a contravention of section 8(a) of the Competition Act 6.11 Theoretically, firms pricing at IPP so based on supply and demand factors where cost is not the only determinant of price, but also opportunity cost, demand and the availability of substitutes Whether this would constitute excessive pricing or profiteering (i.e when it allows domestic suppliers to cover their costs and make economic profits) will depend on a range of factors, including the firm’s cost structures, import tariffs and transport cost levels 6.12 Furthermore, in terms of the step test set out by the CAC, even if the import parity prices are significantly or unreasonably higher than the economic value of the goods supplied, the charging of such a price must be to the detriment of consumers before it will constitute a contravention in terms of section 8(a) of the Competition Act 6.13 Thus, pricing at IPP can constitute an efficient way of pricing because it is based on opportunity cost, demand and supply factors and in some cases can place a competitive constraint on domestic suppliers In general, however, instances where dominant firms use IPP as a pricing strategy is likely to raise competition concerns include IPP pricing for products where: 6.14 6.13.1 the costs associated with importing the product are high; 6.13.2 consumers are vulnerable and unreasonably high prices are likely to lead to harm to consumers; 6.13.3 barriers to entry are high and high prices cannot attract new entrants; 6.13.4 demand factors not support high price levels; and 6.13.5 high profit margins are not reasonably defendable on the basis of factors such as risk, innovation, etc IPP as a pricing methodology needs to be assessed on a case by case basis However, as the pricing methodology finds little basis in the economic value of the producer, there is potentially risk associated with such a strategy under certain circumstances Auctions as a pricing mechanism 6.14.1 As stated above, price is generally seen as a very effective method for the allocation of resources to those economic activities that value it the most, i.e to those activities that add the most economic welfare in a community 6.14.2 To this end, using auctioning or bidding as a pricing mechanism can be a particularly good allocation method in markets when in the short run the quantity demanded exceeds the quantity supplied 6.14.3 Auctioning allows the market to ration products by limiting the purchase only to those buyers willing and able to pay the price and is usually an effective and efficient method of allocating capacity for the following reasons: 15 6.14.3.1 capacity is automatically allocated to those buyers willing to pay the highest price because they receive the greatest satisfaction/ are able to add and recoup the greatest value; and 6.14.3.2 the high prices and profits are the signal required to attract entrants and are thus just a temporary and necessary phenomenon bound up with the processes of dynamic rivalry 6.14.4 The risk associated with using auctioning as a pricing mechanism is that it could be seen as a mechanism to extract a higher price from customers who have no choice, particularly in industries where the barriers to enter the market are prohibitive to the extent that new entry or capacity expansion is unlikely, thus preventing the market from moving to the long run equilibrium where supply is increased 6.14.5 Thus, while auctioning can be an effective pricing and allocation mechanism in the short run, it could also open firms up for competition scrutiny, particularly in industries where barriers to entry are high, and where high prices are unlikely to attract new entry Pricing based on a predefined price index and adjustment factors 6.14.6 Most long term supply contracts provide for price adjustments based on some predefined base price index to account for inflation, transport and other factors 6.14.7 Whilst such prices may not constitute a problem in the short run (provided that the base price is in the first instance based on sound cost based and / or competitive market factors), over time, divergences may arise between the contract price and the economic value of the product or service 6.14.8 Factors that can affect the divergence between the actual price charged (as per the predetermined contract formula) and the economic value of the product include, for example – 6.14.8.1 the initial base price was not properly benchmarked; 6.14.8.2 changes in supply and / or demand conditions and therefore the opportunity cost of the product; 6.14.9 6.14.8.3 changes in economic conditions, that may lead to significantly higher or lower inflation rates, exchange rates (where applicable) or other adjustment factors than those that relate to the specific relevant market; 6.14.8.4 dynamic or structural changes in the industry that may affect the underlying value of the product / service Thus, setting long term prices based on a predefined base price and other inflationary adjustment factors may be dangerous in the long run as market and industry conditions can change, leading to greater divergences between the price charged and the cost and economic value factors that apply Pricing based on a downstream product’s price 6.14.10 In some instances, particularly for “derived demand markets”, suppliers may choose to base their pricing solely on demand factors by pegging the price of 16 the product or service on a fraction of the price of the product(s) or service(s) supplied by its customers 6.14.11 Clearly, such pricing is not based on the cost of providing the product or service to customers, but is based on demand factors Prices would increase when the demand for the customers’ products is high and such customers are likely to demand more of the “input” product or service under those circumstances Similarly, customers are likely to demand less when the demand for their products is low 6.14.12 The supplier is at risk of setting prices below cost during times of low demand (thus operating at a loss) Similarly a supplier may be set to make very high profits during times of high demand 6.14.13 Such pricing practices will have to be evaluated on a case by case basis but are not necessarily uncompetitive, as they bear a relation to market conditions (demand) and therefore the opportunity cost of the product Also, it is possible that where price is determined as a fixed portion of the selling prices that, as customers pay high prices when they in turn receive high prices for their product, there is likely no real harm to consumers 6.14.14 However, such pricing practices could place firms at risk of competition scrutiny when demand escalates significantly for long periods, particularly in industries where barriers to entry are high (thus preventing an increase in supply and the ability of the market to reach long run equilibrium) Conclusion 7.1 The South African economy is characterised by concentrated markets, with many dominant firms, monopolies or near monopolies operating in markets with high or prohibitive barriers to entry As such, it appears that the South African competition authorities are becoming more vigilant in addressing the inefficiencies that flow from such market structures, which may include using their powers to address “excessive” or “unfair” pricing on the basis of section 8(a) of the Competition Act 7.2 Dominant firms therefore have an increased responsibility to ensure that they not charge their customers prices that bear no reasonable relation to the economic value of the good or service provided, and is above that economic value 7.3 Determining the level at which a price is “excessive” or “unfair” is a difficult and uncertain task Competition authorities have relied on a variety of methods to assess the excessiveness of prices imposed by dominant firms all of which are subject to considerable limitations 7.4 Pricing based on a transparent “efficient cost-plus-reasonable-margin” approach is usually the safest and most defendable pricing policy to implement, but it is not the only basis on which prices may lawfully be determined, or on which comparison to the actual price charged a price should be found to be excessive Demand and supply considerations and market conditions are all issues that should be taken into account However, new entry or capacity expansion is a key component in the process of free interaction of demand and supply so that the long run equilibrium can be obtained High and non-transitory barriers to entry therefore greatly inhibit the free interaction of demand and supply in a market and firms operating in such market should be particularly mindful, and perhaps conservative in selecting an appropriate pricing mechanism 17 References Evans, David S & Padilla, Atilano Jorge, 2004 "Excessive Prices: Using Economics to Define Administrable Legal Rules," CEPR Discussion Papers 4626, C.E.P.R Discussion Papers Geradin, D, 2007 “The Necessary Limits to the Control of “Excessive” Prices by Competition Authorities – A View from Europe,” Tilburg University Legal Studies Working Paper Available at SSRN: http://ssrn.com/abstract=1022678 Gerber, DJ “Law and Competition in Twentieth Century Europe: Protecting Prometheus” (Oxford University Press Oxford 1998) in Evans & Padilla, 2004 Hal R Varian, “Intermediate Microeconomics, A Modern Approach” (5 th W.W Norton & Company 1999) Marshall, A “Principles of Economics” (Macmillan London 1890) in Evans & Padilla, 2004 Marx, K “Capital” (Frederick Engels ed 1887) in Evans & Padilla, 2004 Motta, M and de Streel, A “Exploitative and Exclusionary Excessive Prices in EU Law” in CEhlermann, D and Atanasiu, I (eds.), What Is an Abuse of a Dominant Position?, Oxford: Hart Publishing, 2006, p.91 at p.108 in Geradin, 2007 OFT Guideline 414a, “Assessment of Conduct”, available online http://www.oft.gov.uk/shared_oft/business_leaflets/competition_law/oft414a.pdf Parr, G, 2005 “Import Parity Pricing: A Competitive Constraint or a Source of Market Power?,” TIPS forum 2005 Paper first presented at the biennial conference of the Economic Society of SA in Durban on – September 2005 Schumpeter, JA “History of Economic Analysis” (E Boody Schumpeter ed Oxford University Press Oxford 1954) pt III, c in Evans & Padilla, 2004 at