Predatory Foreclosure, Bundled Discounts, and Loyalty Rebates: The Case of Virgin Atlantic/British Airways

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Predatory Foreclosure, Bundled Discounts, and Loyalty Rebates: The Case of Virgin Atlantic/British Airways
Bates White
                                                                                   Fourth Annual
                                                                             Antitrust Conference

               Predatory Foreclosure, Bundled Discounts, and
              Loyalty Rebates: The Case of Virgin Atlantic/British
                                  Airways

                                       B. Douglas Bernheim, Ph.D.
                    Professor of Economics, Stanford University and Princeton University
                                        Partner, Bates White, LLC

© 2007 Bates White, LLC
Overview

  • Ongoing policy discussion about bundled discounts and loyalty rebates
         Both policy and law are evolving in US, EU, and around the world
         Recognition that effect may be pro-competitive in some circumstances
         Controversy and confusion concerning anti-competitive effects
         Some conflicting decisions, e.g., US versus EC on Virgin Atlantic v. British Airways*

  • Agenda for talk: address central issues concerning anticompetitive effects
         What is the applicable theory?
         What are the appropriate tests?
                 • What to look for in pricing
                 • What to look for in other market conditions
         Does the type of context matter?
                 • Ortho-like context: One (or more) monopoly product, one (or more) competitive product
                 • Virgin-like context: All products are equally vulnerable, but scale or scope of challenge is
                   limited
        *   See appendix for background on Virgin Atlantic v. British Airways case

© 2007 Bates White, LLC

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Overview of potentially applicable economic theories

  • Two possible frameworks
         Bundling or tying
         Exclusive contracting

  • Bundling, tying, and exclusion are not necessarily anticompetitive
         All sales foreclose competitors from those sales
         Chicago critique
         Theories overcome the Chicago critique through different mechanisms
               • Theory of bundling and tying (Whinston) is about changing the bundler’s incentives so that
                 the bundler will behave more aggressively
               • Theory of exclusive dealing (Bernheim and Whinston, Whinston and Segal) is about
                 weakening competitor by reducing scale or scope, to extract rents elsewhere

  • Relation to “predatory pricing” requires clarification
         Court’s interpretation in Virgin

© 2007 Bates White, LLC

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The bundling/tying mechanism: Theory (1)

  • Standard context
         Monopoly product A, competitive product B
         Product B competitor must pay either an entry cost or an ongoing fixed cost

  • Bundling changes the monopolist’s incentives
         If the competitor steals a customer, the monopolist will lose the monopoly rents on
          product A
         Monopolist therefore prices the bundle more aggressively than it would price product
          B alone

  • With the monopolist behaving more aggressively, the competitor’s profits may
      not cover fixed costs or costs of entry. Therefore, the entrant is deterred from
      entering or induced to exit.

  • Note: the theory assumes that the monopolist can commit in advance to
      bundling. May wish to unbundle when it comes time to set price in competition
      with the entrant.
© 2007 Bates White, LLC

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The bundling/tying mechanism: Theory (2)

  • The theory does not necessarily require asymmetry between the products
         Suppose the competitor can enter either against product A or against product B
         Due to limitations of scope, competitor cannot enter in both product A and product B
         Theory is essentially unchanged
         Relevant to Virgin case (Heathrow slot constraints)

  • For similar reasons, the theory does not necessarily require multiple products
         Suppose the entrant will have scale limitations and that buyers are large
         The theory remains applicable (different units are like different products)

© 2007 Bates White, LLC

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The bundling/tying mechanism: Theory (3)

  • In principle, bundled discounts and loyalty rebates can create anti-competitive
      effects through the same mechanism
         Example: set the price of product A equal to the combined desired prices of products
          A and B, and offer product B for free
         As long as the incremental charge for product B is sufficiently low, it will never be
          economical to buy the two products other than as a bundle

  • Is the commitment credible?
         Contracts: duration, costs of negotiating new structure
         Reputation
         Pro-competitive effects
               • If bundling is only slightly against the monopolist’s interest ex post, then only a slight
                 efficiency advantage could suffice to sustain a large anticompetitive effect
               • Balancing is then required

© 2007 Bates White, LLC

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The bundling/tying mechanism: Elements of proof

  • Scale and/or scope of competitor is necessarily limited
         Theory assumes that competition with the entire bundle is impossible
         Entry into one product may be blocked, or
         Number of entrant’s offerings may be limited, or
         Scale of entry may be limited

  • Bundled discounts/loyalty rebates constitute meaningful bundling/tying (will
      return to this issue)

  • Explanation for failure to unbundle when competitor is present
  • Bundle/tie makes or has made entry, expansion, or continued operation
      uneconomical over some time period (may be temporary)

  • Entry, expansion, or continued operation of competitor over the relevant time
      period would benefit consumers (e.g., through lower prices)

© 2007 Bates White, LLC

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The exclusive dealing mechanism: Theory (1)

  • Pro-competitive reasons for exclusivity are well-known
         E.g., Standard Fashion required exclusivity to prevent stores from selling knock-
          offs—protected Standard’s investment in design
         E.g., Sylvania offered exclusive territories to induce efficient investment by retailers

  • Chicago “one monopoly rent” critique is correct in some circumstances
         Suppose two sellers compete for one buyer
         Assume exclusion is inefficient: pie is bigger without exclusion than with exclusion
         For any outcome with exclusion, there’s an outcome without exclusion in which all
          three parties do better. Wouldn’t they negotiate to that outcome?

© 2007 Bates White, LLC

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The exclusive dealing mechanism: Theory (2)

  • Exclusion can be anticompetitive in other circumstances
         Again, two sellers compete for one buyer
         Suppose exclusion of one of the sellers results in rent extraction from someone else
         Then the total size of the pie available to the three (not including the someone else) may be
          bigger with exclusion than without
         In that case, for any outcome without exclusion, there’s an outcome with exclusion that makes
          the buyer and the excluding seller both better off. They will negotiate to that outcome.

  • Why would exclusion of one of the sellers result in rent extraction from someone else?
         Excluded firm is weakened in another context: e.g., excluded firm either exits (partially or
          completely), fails to enter (partially or completely), or operates with higher variable costs (due
          to reduced investment or loss of economies of scale or scope)
         Since excluding firm has less competition in that other context, it can extract more rents from
          buyer(s) in that context
         Known as a “contracting externality”

© 2007 Bates White, LLC

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The exclusive dealing mechanism: Theory (3)

  • Who are the other parties from whom the rents that justify exclusion are
      extracted?
         Buyers in other markets
               • Product
               • Geography
               • Time

         Other buyers in the same market (“naked exclusion”)

  • Note: the theory assumes that the scope for negotiations is limited
         Including the other parties, the total pie is always smaller with inefficient exclusion
         The other parties have an incentive to join the negotiations over exclusivity
         It may be difficult or impossible for the other affected parties to join the negotiation
          over exclusion (e.g., future customers)

  • Bundled discounts and loyalty rebates may function as payments not to deal
      with a competitor, at least for some chunk of business
© 2007 Bates White, LLC

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The exclusive dealing mechanism: Elements of proof

  • Bundled discounts/loyalty rebates constitute an effective payment not to deal
      with competitor (will return to this issue)

  • Identification of the parties (buyers other than the one in question) from whom
      rents will be extracted

  • Evidence that the excluded party will be weakened in competing for another
      buyer by virtue of the exclusion
         Failure to enter or induced exit
         Failure to make capacity-expanding or cost-reducing investments
         Increased variable costs (NOT just average costs) due to loss of scale or scope
         Assessment must be made based on complementary exclusion, not total exclusion.
          Ex: exclusive deals with two buyers, each of whom purchases 30%; must lose 40%
          of market to be weakened. In that case, can’t sustain the naked exclusion
          mechanism.

  • Demonstration that weakening of the competitor would harm those consumers
      (e.g., through higher prices)
© 2007 Bates White, LLC

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Elements of proof: Meaningful bundle/tie, or payment not to deal

  • In either case, can identify a tie or a payment not to deal through incremental
      pricing below incremental cost
         Ortho-like test
         Can be applied in other types of contexts, e.g. Virgin

  • Must be evaluated relative to feasible scale and scope of the competitor
         For back-to-first-dollar discounts, the incremental price is always below incremental
          cost over some range (e.g., could be 60% to 62% of the market)
         The incremental price must be below incremental cost over the feasible scale and/or
          scope associated with the contested portion of the market
         If, for example, the feasible scale/scope of the competitor matches that of the
          alleged wrongdoer, the bundled discounts/loyalty rebates should not be suspect

© 2007 Bates White, LLC

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Elements of proof: Meaningful bundle/tie or payment not to deal

  • Whose costs: the firm practicing the foreclosure, or the competitor?
  • When competitor’s costs are higher, should use the cost of the foreclosing firm
         If incremental price is between the two costs, it could still be anticompetitive,
          however:
         Exclusion of a less efficient competitor automatically has a pro-competitive
          justification
         Alternative standard risks making too much illegal, e.g., straight prices (without any
          provision for discounts) below rival’s cost

  • When the competitor’s costs are lower: should probably use the cost of the
      competitor (otherwise the discounts do not necessarily bundle/tie/exclude)

© 2007 Bates White, LLC

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Relationship to predatory pricing (1)

  • Common element: a price below cost. However, the mechanisms are
      completely different

  • The predatory pricing mechanism
         Below-cost pricing is temporary, and recoupment is in the future
         Must explain why predator can sustain prices below costs, while prey can’t
         Must explain why prey cannot re-enter when prices rise

  • The bundling/tying mechanism
         Below-cost pricing is on the margin, and recoupment is on inframarginal units (rather
          than in the future)
         Response to competitor’s presence (dropping P) maximizes current profits, given
          commitment to bundle. (Remember, though, that it may be in the firm’s interests to
          unbundle when facing a competitor)

© 2007 Bates White, LLC

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Relationship to predatory pricing (2)

  • The exclusive dealing mechanism
         Depriving competitor of business is assumed to weaken the competitor (due to lost
          economies of scale and/or scope) in theory of exclusive dealing, but not in the
          theory of predatory pricing
         Recoupment in theory of exclusive dealing comes from greater rent extraction in
          contexts where competitor is weakened. No counterpart in theory of predatory
          pricing
         Recoupment may be contemporaneous in the theory of exclusive dealing
          (contemporaneous rent extraction for other products, geographical areas, buyers in
          the same market), but not in theory of predatory pricing

  • With both mechanisms, incremental price below cost is ongoing, not temporary,
      in contrast to the theory of predatory pricing

© 2007 Bates White, LLC

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Point to emphasize concerning incremental cost tests

  • NOT a test for predatory pricing
  • The appropriate scale over which to evaluate incremental prices and costs will
      be case-specific, and depends on the scale and scope of potential entry

  • A demonstration of below-cost incremental pricing is not by itself sufficient to
      establish anticompetitive effects

  • Should not be a per se rule: anti- and pro-competitive effects should be
      evaluated and weighed in each case

  • Incremental cost tests may provide needed clarity and predictability

© 2007 Bates White, LLC

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Concluding remarks

  • U.S. case law is closer to economic principles than commonly believed
  • Ortho test, as an incremental cost test, is consistent with economic principles
         Provided that Ortho test allows economically guided determination of the appropriate
          increment

  • Antitrust Modernization Committee advocates an Ortho-like test
         AMC recommendation is unclear regarding the appropriate increment, referring only
          to “the competitive product”

  • Article 82 discussion guidelines are explicit in comparing the “commercially
      viable share” and the “required share,” i.e., the incremental units

© 2007 Bates White, LLC

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Bates White
                                                                                   Fourth Annual
                                                                             Antitrust Conference

               Predatory Foreclosure, Bundled Discounts, and
              Loyalty Rebates: The Case of Virgin Atlantic/British
                                  Airways

                                       B. Douglas Bernheim, Ph.D.
                    Professor of Economics, Stanford University and Princeton University
                                           Partner, Bates White

© 2007 Bates White, LLC
Virgin Atlantic v. British Airways

  • Virgin Atlantic complained that British Airways engaged in anticompetitive
      pricing by giving travel agencies and corporate customers extremely high-
      powered incentives to increase sales of BA tickets

  • Travel agent commission bonuses were “back to first dollar”
         They accrued for all tickets on the BA flights, but were made contingent on hitting
          increasing year-over-year sales targets
         7% of sales base commission
         Bonus commissions of 3% of international and 1% of domestic sales paid if total
          agency revenue exceeded target. Targets are agency specific, based on growth
          over past sales

  • Corporate accounts had similar discounts with similar marginal incentives
      based on exceeding total revenue targets

© 2007 Bates White, LLC

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Facts: Virgin Atlantic v. British Airways

  • Slot constraints at Heathrow
         BA controlled 39% of “slots” and served over 45% Heathrow traffic, triple the next
          largest competitor, domestic carrier British Midland
         BA had 94 routes from Heathrow, including 19 “monopoly” and 45 “duopoly” routes
         VA controlled 2% of Heathrow slots
         VA had 5 UK–US routes
         Heathrow at capacity (controversy concerning substitutability of Gatwick slots)

  • Composition of demand
         69% of BA’s revenue on US–UK routes came through travel agencies or corporate
          accounts
         Most travel agents and corporations had “network-wide” needs

© 2007 Bates White, LLC

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Virgin Atlantic’s theory of harm

  • Heathrow slot constraints preclude Virgin from becoming a network-wide
      competitor

  • BA’s commission scheme deters Virgin from becoming a competitor on limited
      routes
         With limited entry, customers will continue to fly BA on other routes
         First dollar discount implies incremental price charged for the contested tickets is
          below BA’s incremental cost. (Note: the scale of entry is relevant in applying this
          test)
         Incremental cost estimate based on cost of flights BA added to accommodate sales
          attributable to loyalty program
         Intent and effect of the discount is to exclude or delay the entry of Virgin Atlantic and
          other discount airlines from the market, or to deter or delay their expansion
         According to Virgin, these tactics “made no economic sense” other than the
          exclusionary effect, since BA lost money on the incremental ticket sales

  • BA’s strategy termed “predatory foreclosure”
© 2007 Bates White, LLC

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