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Unit 5: Refusal to Supply, Essential Facilities and Margin Squeeze -…
Unit 5: Refusal to Supply, Essential Facilities and Margin Squeeze
Refusal to supply - An upstream supplier can simply refuse to supply to a downstream competitor, forcing it to exit the downstream market. The upstream suppliers can also supply on certain terms on which no other customer will be willing to buy. Charging an excessively high price for the input would be an example.
Margin Squeeze or Price Squeeze
- If the firm is operating upstream and downstream markets, it will set two prices: price for upstream input and price for downstream product. The firm could set prices such that there is little or no margin between the two. It could set these prices such that competitors will not be able to transform the input into a final product. This could force competitors to exit the market.
- A refusal to supply or margin squeeze is most likely to have an effect when there are no viable substitutes for the input so the firms are unable to switch to an alternative input.
Vertical foreclosures and restraints, IP rights.
(1) Ability to engage in Vertical Foreclosure:
- Structure of the market : most of the anticompetitive issues arise when a firm is present in both the upstream and downstream (where it is also competing with retailers) or where it is present and it is attempting to enter another.
- Bottlenecks, essential inputs and facilities:
Essential input could be a facility or raw material or an IP right. What makes the product an essential input is (a) no substitutes, (b) Other firms could not start producing it in the same cost and same period of time, (c) upstream market is supplied by a monopolist but the downstream market could be supplied by competing firms.
- Often it is obvious to see that essential inputs are produced my monopolists because they involve high fixed costs - railways, airports, ports, etc.
Foreclosure of competition:
- supplier of essential input can restrict competition in the downstream market by refusing to supply to one or more downstream firms. If there is no access to the essential input, downstream players are not able to produce the downstream product.
- The strategies available for foreclosure depend on whether the upstream supplier of the essential input is vertically integrated or not
Outright Refusal to Supply:
This is fairly straightforward as there is just refusal to supply the essential input to the downstream market. Fo example, commercial solvents used to produce a raw material to manufacture a tuberculosis drug. But when commercial solvents entered the market for downstream tuberclosis drug, it refused to supply the required input to other competing downstream firms, thereby foreclosing competition.
Constructive Refusal to Supply:
The supplier of the essential input can also increase prices to the extent that it becomes uneconomic for the downstream market to purchase this input, thereby forcing downstream firms to exit the market.
Margin or Price Squeeze:
The upstream monopolist in this case charges a wholesale price to competing downstream firm W and its own downstream price p, the firm can strategise so as to make the difference between w and p as small as possible, forcing the competing downstream firm to exit the market because of the uneconomic outcomes. Increasing W and decreasing P is a predatory strategy and often involves short-term loss of profits, So they usually just increase wholesale prices so they dont have to forgo profits.
Exclusive Contracts
Upstream firms can write exclusive contracts with downstream firms, thereby excluding other downstream firms. The downstream firm that is in an exclusive contract will have to pay a premium for the service.
Discrimination Upstream monopolists can discriminate in favour of certain downstream firms, like for instance provide discounts or provide more easy access to the essential input, in turn affecting competing downstream firms adversely and forcing them to exit the market.
Vertical Tying or Bundling
Downstream firms can buy the essential input contingent on purchasing the vertically integrated firm's downstream product. In such cases, the margin for competing firms become 0.
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Chicago Critique:
By foreclosing competition in the downstream market, a vertically integrated firm can become a monopolist in the downstream market. By establishing this monopoly, the firm will raise prices and reduce output. This ignores the fact that the firm is already a monopolist in the upstream market, and that it can earn monopolistic rents in the upstream market - so what further advantage does it gain by monopolising the downstream market?
One key insight from this theory is that vertically integrated firms may be able to earn monopoly profits only one go at a time.
- Essential Input F for Downstream good U
- Derived Demand for U, i.e., demand depends on production of F
- Du = Df - MCf
- Downstream firm will be willing to pay for any unit of F is the price they receive for F minus MC
- Upstream monopolist maximises its profit by supplying Qu* where MCu = MRu
- Suppose the upstream monopolist is vertically integrated, its demand curve is equal to the downstream demand curve with new marginal cost MCu + MCf > It supplies the quantity Qf* where its marginal cost equals marginal revenue
- The equilibrium still remains the same, as a result the monopoly profits are still the same.
Assumptions:
- No other substitute for U and neither is entry in the upstream market possible for U
- It has no other uses (other than) producing F
- Each unit of F needs a fixed amount of U units
- Upstream monopolist has a constant marginal cost
- All downstream firms have the marginal costs as each other.
There is only one monopoly profit that can be exploited and the monopolist could already capture it by charging U > It gains nothing by monopolising F as well. This led to the conclusion that provided certain assumptions, an upstream monopolist has no incentive to attempt to foreclose and monopolise the downstream market. In fact if other firms are producing F more efficiently, upstream monopolist may earn lower profits by vertically integrating downstream. Therefore it would be possible for the upstream monopolist to integrate downstream only if it is more efficient in producing F compared to its rivals.
Strategic Models of Foreclosure:
- Restoring upstream market power
In order to earn monopoly profits, the upstream monopolist has to charge monopolistic prices, once it has sold units at this price, it has more incentive to supply more units of output to new entrants in the downstream market. These sales will lead to increase in downstream output which will decrease the price of the downstream good. For example, airport supplying landing and departing slots for airlines. Airline will therefore refuse to pay monopoly price unless it receives a commitment that the airport will not supply to other airlines. The ability to pay monopoly price will depend on the bargaining strengths of the upstream and the downstream firms.
Defensive Leveraging
The threat of new entrants and innovation can incentivise the upstream monopolist to monopolise the downstream monopolist in anticipation of new entrants and other disruptive technologies.
Incentive to partially foreclose:
Some firms may restrict output of downstream rivals so their own downstream unit can get a larger share in the market. It might do this by increasing prices or restricting output
In certain situations, a vertically integrated monopolist may prefer downstream rivals to be present:
- Inferior competition upstream - although upstream monopolist controls supply, there maybe inferior substitutes. The monopolist loses profits on these sales.
- Product differentiation in the downstream market: more differentiated the products, the less the direct competition for the monopolists products. This excludes benefits of excluding rivals. If the downstream rivals produce differentiated products, demand in the downstream market
- Demand in the downstream market maybe higher than the upstream market, and it may lose out if it tried to monopolise the downstream market.
Relaxing the assumptions of the Chicago Critique:
- One of the assumptions was that the input and the output are used in fixed proportions, however goods can be produced using higher or lower quantities of the input. For example, airlines could switch to airlines depending on the slots given by the airport (upstream) - when they substitute, airlines will not end up earning monopoly rents.
- another key assumption is that the downstream market is perfectly competitive. When there is market power at both the upstream and downstream levels, may lead to a phenomenon called double marginalisation. The restriction of output at the downstream level affects the upstream firm but benefits the downstream firm.
Problem of double marginalisation:
- Market demand curve D
- assumption is that there is a single downstream monopolist
- Pu = MCu
- Downstream monopolist will further mark up this price to Pf*
- Insert Double marginalisation chart
Benefits of vertical integration:
- Free riding between downstream firms : example of test drive being offered by dealer 1 and car (At a reduced cost) by dealer 2.
- Free riding between upstream firms
- Hold up problems and specific investments
- Quality certification
- Double marginalisation : consumers end up paying more and output is restricted, also firms end up making lesser profits than in the case where profits are lower.
Implications for the policy: Forcing an upstream monopolist to all downstream competitors might undermine efficiency.
Incentives to invest:
- First we consider how an obligation to supply will affect social welfare both in the short run and the long run
- Any distinctions to be drawn between physical assets and intellectual property rights?
Considering a case where the upstream firm is the sole supplier of an input that is:
(a) access to a physical asset
(b) physical product or a raw material
(c) a service
(d) right to use knowledge protected by a patent
following assumptions are made:
(a) upstream firm has made significant investments to create the input
(b) upstream firm is vertically integrated and operates in a downstream market where it uses the input to produce a downstream good.
(c) exclusive access to the input has enabled them to produce a downstream good that was not there previously in the market.
Dynamic and Static effects :
(1) Dynamic Losses - When a new product is introduced, value created is the area between market demand curve and supply curve. Each unit of output has the social value of (value that consumers place on the product) minus (cost of producing it).
(2) Static Gains : If the obligation to supply reduces incentives to invest and innovate, there will be a reduction in the number of products created - which will reduce the profits for firms and consumer surplus as well.
The positive effect will be greatest when market power is largest (by refusal to supply)
Margin Squeeze
- A margin squeeze exists when an efficient downstream firm cannot cover its costs given the downstream and upstream price:
Retail price - Wholesale price < efficient downstream costsThis formula is used to see if there was a margin squeeze at all
- constructive refusal to supply:
Retail price - efficient downstream costs < wholesale price
Retail price < Efficient downstream costs + wholesale price
Problems with the margin squeeze test:
- Identifying efficient downstream costs
- selecting an appropriate cost measure
- allocating costs between different activities
- margin squeeze and a pro competitive strategies
- There is a problem in picking out the efficient downstream costs
- considering the actual downstream costs may not be reliable as these firms may turn out to be inefficient and their costs would be higher than what we are essentially looking for
- we would then only identify margin squeeze where inefficient firms are excluded from the market (reducing social welfare)
- vertically integrated firm might be forced to raise prices to a level that accommodates inefficient competitors. If the vertically integrated firm has lower costs than competitors, we would end up preventing the vertically integrated firm from competing on price against less efficient rivals
An alternative approach maybe to use the vertically integrated firm's own downstream costs as a proxy for an efficient downstream competitor
Identifying an appropriate cost measure
Average Variable Costs, Average Avoidable Costs, Long Run Incremental Average Costs,