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

In particular, the Competition Act, with its excessive pricing provision, requires these firms to ensure that they do not charge their customers prices that bear no reasonable relation t

where high prices do 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

1 Senior associate and economist in the Competition Department at Edward Nathan Sonnenbergs Inc

2 Executive and economist in the Competition Department at Edward Nathan Sonnenbergs Inc

1 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 do 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 do 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

2 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-in-use 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

3 70/CAC/APR07, available at http://www.comptrib.co.za/list_judgement.asp?jid=1049

4 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 4 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.6 Theoretically, the free interaction of demand and supply can be described as follows:

Begin in a position of short run and long run equilibrium7 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

3 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

5 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 2.

6 Marshall, A “Principles of Economics” (Macmillan London 1890) in Evans & Padilla, 2004

7 A competitive price is the price where quantity demanded = quantity supplied.

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 8 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) bears no reasonable relation to the economic value of that good or service; and

(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)

8 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 2

9 Geradin, 2007 page 2

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 2.

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.

period—is what attracts “business acumen” in the first place; it induces risk taking that produces innovation and economic growth”16

4 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 do 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 US-based 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;

4.7.3 third, if the actual price exceeds the economic value, it must be

determined whether the difference between them is unreasonable; and if

so,

detriment of consumers

4.8 On the bases of the foregoing, the CAC remitted the matter to the Tribunal for

re-assessment 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 5.

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 5.

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

test espoused in United Brands remains the relevant analytical framework for

assessing whether a price is excessive

the evidence of an “excessive” profit margin was not sufficient in itself to establish

an abuse

“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 6 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 6

22 See ECJ, British Leyland Public Limited Company v Commission, 226/84 [1986] ECR-3263 at sections 27-28 in Geradin, 2007, page 6 (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 6.

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

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

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

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

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 do 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

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:

30 Court of Appeal, Judgment of 2 February 2007, Attheraces Ltd & Anor v The British Horseracing Board Ltd & Anor Rev

2 [2007] EWCA Civ 38, available at http://www.bailii.org/ew/cases/EWCA/Civ/2007/38.html in Geradin, 2007, page 39.