Excessive Pricing: Quo Vadis

Excessive pricing: quo vadis?

Authors: Paul Anderson, Stephan Malherbeand Fathima Sheik

14 August 2009: Draft paper – not for quotation

Abstract

The Tribunal and Competition Appeal Court decisions in the Mittal case display sharply divergent approaches to Section 8(a),which prohibits excessive pricing by dominant firms and may be the section in the Competition Act with the most public support. The CAC decision is based on the better legal interpretation of the existing legislation, and the Court had harsh words for the Tribunal. But the CAC declined to engage with the very real policy and institutional dilemmas that motivated the Tribunal's approach, flawed as it might have been. These issues are not esoteric as many business decisions -- both pricing and investment -- will be guided, or at least influenced, by our law on this point.

The paper will identify the policy dilemmas that led the Tribunal to rule in the manner it did, before analysing the very real difficulties of, respectively, an economic, informational, financial theoryand regulatory best practice nature of applyingSection 8(a) in keeping with the CAC decision. This analysis is informed by the practical interaction we have had with companies trying to get to grips with this interpretation of the Act. The paper then proceeds to identify whether some of these problems could be addressed within the ambit of the competition authority and the courts, or whether they may require a reconsideration by the legislator.

The authors of this paper are economists at Genesis Analytics. The views expressed in this paper are those of the authors and do not necessarily represent the views of Genesis Analytics.

Introduction

Section 8(a) of the Competition Act prohibits dominant firms from charging “excessive prices to the detriment of consumers”. To underscore the seriousness of this prohibition, excessive pricing is one of only five prohibitions for which first time offenders can be levied an administrative fine (of up to 10% of annual turnover). Although an excessive price is defined in the Section 1 of the Act as “a price for a good or service which bears no reasonable relation to the economic value of that good or service”this definition’s delphic ambiguity results in a heavy burden for the bodies charged with interpreting the section. The process of developing the law through case-driven interpretation can be a long one. In the meanwhile, firms are unclear as to how to balance the mandate from shareholders to maximise profits with the imperative of ensuring compliance with the Competition Act.

To date the only case of excessive pricing heard before the Tribunal is that of Mittal(brought against it by Harmony and Durban Roodepoort Deep).[1] The Tribunal’s approach in this matter was, however, recently rejected by the Competition Appeal Court (“CAC”).[2]The CAC had harsh words for the Tribunal, stating it had used a “fundamentally flawed” approach in their assessment of the case and ordered it be referred back to the Tribunal for further analysis with some guidelines on how to proceed.The long-awaited CAC decision is based on the better legal interpretation of the existing legislation. But it unfortunately does not fully resolve the issue of how excessive pricing should be assessed in practice; nor does it engage with the very real policy and institutional dilemmas that motivated the Tribunal's approach, flawed as it might have been. These issues are not esoteric business decisions – both pricing and investment – will be guided, or at least influenced, by our law on this point.

This paper identifies the policy dilemmas that led the Tribunal to rule in the manner it did, and analyses the very real difficulties of an economic, informational, financial theory and regulatory best practice nature associated with applying Section 8(a) in keeping with the CAC decision. This analysis is informed by the practical interaction we have had with companies trying to get to grips with this interpretation of the Competition Act and lessons learned from broader regulatory experience. This paper then proceeds to identify whether some of these problems could be addressed within the ambit of the competition authority and the courts, or whether they may require reconsideration by the legislator.

The Tribunal’s approach to excessive pricing

The parties and their economic experts involved in the Mittal matter submitted reams of cost, price and profitability analysis to the Tribunal in their respective assessments of Mittal’s pricing.[3]However, in its finding the Tribunal departed from the approaches put forward by both Mittal and Harmony,as well as from the approaches commonly applied in international jurisprudence. Instead the Tribunal took an unorthodox approach by applyingwhat could be described as a “structural” test to evaluate the charge of excessive pricing, stating:

“. . . [W]e treat excessive pricing as a phenomenon that may arise from a particular structure and that itself may be the basis for ancillary conduct that is utilised in order to sustain supra-competitive prices.”[4]

In terms of this approach, the Tribunal indicated that the following would be required for a finding of excessive pricing:

1. Super-dominance. The firm must be not only be dominant, but rather “super-dominant” in the relevant market – this was seen to be an essential precondition for the practice of excessive pricing. According to the Tribunal, section 8(a) of the Act should apply only to those “rare beasts who are subject neither to the constraining presence of a regulator or of a potential entrant”[5]. Hence the market in question should be (i) uncontested (monopolised), (ii) incontestable (subject to overwhelming entry barriers), and (iii) unregulated (not subject to price regulation).

1. Ancillary conduct. The firm must also have engaged in conduct designed to take advantage of those structural opportunities for the purposes of higher pricing. This is referred to by the Tribunal as so-called “ancillary conduct”.It is not entirely clear exactly what the Tribunal intended “ancillary conduct” to constitute, however in the Mittal case it related to the prohibition of Mittal’s export partner from reselling certain flat-steel products in South Africa.[6],[7]

The Tribunal justified this structural test and their approach of not engaging in the arguments of the complainants and the defendants on the grounds that “…this would effectively have the competition authorities adopt, by virtue of Section 8(a), the methodologies of price regulation.”[8] Indeed the Tribunal offered opposition to any interpretation of the Section 8(a) which assigned a role of de facto price regulator to the Tribunal where they would in essence be required to “determine whether existing price levels are ‘right’ or ‘wrong’ (non-excessive or excessive) and , if ‘wrong’ (excessive) to determine and impose the ‘right’ (non-excessive) price.”[9] The Tribunal, inter alia, pointed to the following policy and institutional dilemmas that would arise were competition authorities to don the mantle of price regulator:

Firstly, the Tribunal highlighted the fact that the fundamental task of competition authorities was to protect and defend competitive structures in a market and that price determination “is thus not characteristically part of the armory of competition enforcement”[10]

Secondly, the Tribunal pointed to the fact that given its institutional setting and mandate it was not well suited for the task of price regulation.

“. . . the requirement to enforce the proscription of excessive pricing is not accompanied by the sort of powers and practices normally associated with price regulation. If the legislature had intended section 8(a) to convert a competition authority into a price regulator then it would surely have provided us with the powers and resources appropriate to that considerable task. Consider the process by which the sector regulators – each with their own statutory foundation and specialist powers and resources – determine and police pricing in the telecommunications and electricity markets and then consider whether the legislature can possibly have intended that this be replicated in the steel or any other industry by way of the insertion of a single nine word clause in the Competition Act. This cannot be. . . Indeed a survey of the European jurisprudence serves to confirm our view of the pitfalls of competition authorities assuming a price regulating function as part of their excessive pricing jurisdiction. It is precisely to avoid the confusion and uncertainty generated by the jurisprudential maze . . . that price regulators are accorded a specific statutory basis which assigns them appropriate price determination powers and indeed, often prescribes that specific price determination mechanism that is to be employed.”[11]

Thirdly, the Tribunal seemed to also recognise (although in a footnote) that in a situation where an excessive price were found – but where there was no intervention made to alter the structure of a market – then competition authorities may need to continue the price setting function for that market on an on-going basis.

“. . . if the price is determined without intervening in either the underlying structural conditions and the ancillary conduct which cumulatively gives rise to the excessive price, the competition authority will have to maintain its regulatory role because the administratively determined price cannot be ‘right’ for all time. This, of course, precisely describes the modus operandi of an ex-ante price regulator but is antithetical to that of an ex post regulator that responds to conduct that is allegedly in breach of a statutory obligation.”[12]

The CAC’s approach to excessive pricing

The CAC’s Mittal ruling did not engage directly with the institutional concerns raised by the Tribunal. Instead it assessed the Tribunal’s structural approach against the wording of the Act, and found it wanting. The CAC stated that the Tribunal’s approach was “fundamentally flawed”[13]and that the Tribunal’s structural test and notion of “super-dominance” found no support in the Act.[14]The CAC referred the matter back to the Tribunal to re-evaluate the evidence in line with the requirements of the Act.

Having rejected the structural test, the CAC instructs the Tribunal to engage in four distinct enquiries that emerge from reading Section 8(a) together with the definition of an excessive price (as found in Section 1 of the Act):

(i)first, to determine the actual price of the good or service which is alleged to be excessive;

(ii)second, to determine the economic value of the good or service expressed in monetary terms;

(iii)third, to determine whether the actual price is higher than the economic value and whether this difference is unreasonable;

(iv)fourth is to evaluate whether the charging of the excessive price is to the detriment of consumers.[15]

We have italicised the ‘economic value’ and ‘unreasonable difference’ as the application of the prohibition turns on what is meant by these terms.

The CAC directed that the legislature must have intended the ‘economic value’ of a product to be “the notional price of the good or service under assumed conditions of long-run competitive equilibrium.”[16]Drawing on European precedent and a thoughtful amicus curiae opinion written by Petersen, Le Roux and Maenetje, the CAC concluded that the price under conditions of long-run competitive equilibrium, and hence ‘economic value’, would in effect equal the total cost of providing the product. The cost would include a “normal rate of return” to providers of capital without which in the long run the industry would not be sustainable.[17] The CAC also points out that the calculation of economic value relates, in part, to the costs faced by a firm in a competitive market and is not “derived from circumstances peculiar to the particular firm”.[18]

In adopting cost as the basis for its approach, the CAC echoed the decision of the European Court of Justice in United Brands[19], a decision that has a particular resonance in our law as it is the source of the language used in our Act to define ‘excessive price’.[20] The passage relevant to the CAC’s reasoning is in para. 252 of that judgment (underscore added):

“The question therefore to be determined is whether the difference between the costs actually incurred and the price actually charged is excessive and, if the answer to this question is in the affirmative, to consider whether a price has been imposed which is either unfair in itself or when compared to competing products.”

It follows that an empirical enquiry into the costs actually incurred is at the heart of the determination of economic value. The CAC understands the ECJ in United Brands to have rejected the European Commission’s finding of an ‘unfair price’ (in the lexicon of the European law) because of its failure to make the necessary [factual] enquiry.[21]

Below, we return to the controversies that continue to swirl around the ‘unfair price’ rule in the EU, and its application in United Brands and beyond. At this point it need merely be noted that the CAC echoes the United Brands approach without the consideration of these.

Having confirmed the centrality of actual costs, the CAC goes on to indicate that the factual enquiry can be directed by way of empirical exercises that fall short of a full enquiry into costs. Possible “shortcuts” which could be used as indicators as to whether aprice is greater than economic value include:

(i)Instances where a price is “exorbitantly” higher than the “normal” price of similar products.[22]

(ii)Instances where a firm raises their “normal” price substantially without a corresponding rise in costs, or inversely if a firm’s costs fall dramatically without the firm executing a corresponding reduction in prices.[23]

(iii)International price comparisons with firms facing a comparable cost and output structure (and operating in a competitive market).[24]

(iv)Instances where there is significant differentiation between export and domestic customers and where the firm embarks on expansion of production capacity wholly or mainly in order to increase export sales.[25]

Whilst there is an apparent contradiction between the CAC’s principal test and its pragmatic endorsement of ‘short cuts’ it is not a real contradiction: the ‘short cuts’ are effectively proxies, and would seem to be trumped by a comprehensive cost analysis:

“However, there may be no alternative to a detailed exercise in comparative costing. If expert evidence has been given concerning cost data, the necessary adjustments to be made for comparative purposes, the appropriate methodology needed to establish the opportunity cost of capital and allow for depreciation and replenishment of plant etc, then findings based on an evaluation of that evidence will need to be made.”[26]

Having dismissed the Tribunal’s approach as unfounded in law and laid out a route to be followed, the CAC excuses itself from issues of how the complex tasks implied in its principal test ought to be applied. To name one example of many: the CAC expresses no opinion on the critical issue of how to calculate a fair return on capital – even though this topic was exhaustively traversed before the Tribunal. One assumes that this and other matters fall within ‘an evaluation of detailed technical and financial evidence’ which the CAC considers to be the task of the Competition Tribunal rather than itself.[27]

More troubling is the CAC’s lack of consideration of difficulties intrinsic to the assessment of excessive pricing and the very approach it favours that have emerged in the literature. Further, it fails to deal with the difficulties created by thrusting the Tribunal into a role for which it is not equipped, that of price regulator. We now turn to these issues.

The troubled concept of excessive pricing

There are two types of contraventions of excessive (or fair) pricing rules. Contraventions can be exclusionary in nature, i.e. affecting either competition or the ability of a firm to compete – an example would be charging a downstream competitor high price for an input, thus exerting a margin squeeze so as to force the competitor from the market. In our law, exclusionary conduct by dominant firms, including that related to pricing, is well captured by the other elements of Section 8, in particular Section 8(b), Section 8(c) and Section 8(d), and is therefore not the subject of this paper.

Contraventions of Section 8(a), by contrast, are exploitative in nature, i.e. are intended to extract benefit from existing market power rather than to protect or add to market power. In a sense, therefore, it is logically consistent to address excessive pricing in legislation that generally seeks to maximise competition. However logically consistent, though, the ‘exploitative’ pricing rule embodied in Section 8(a) is operationally different from the rest of the Competition Act: whereas the rest of the Act is about protecting competitive processes, Section 8(a) is about simulating competitive outcomes.

This, as numerous authors have pointed out, is where the difficulty comes in.[28]If competitive outcomes were easy to simulate, price controls generally (and not just specifically) would be an accepted policy tool. But they are not, overwhelmed by calculation and other problems. It is also generally recognised in the literature that getting prices wrong can impose significant societal costs in the markets concerned. The most eloquent testimony to the difficulty of applying excessive pricing rules is the reticence on the part of regulators to do so. In Europe – both at the European Commission and at the many national-level competition regulators – resources have only rarely been committed to excessive pricing cases, despite the self-evident appeal of such a regulatory tool. In European cases where ‘unfair pricing’ has come up, it has mostly been in the context of a larger set of complaints (such as margin squeeze) to which a complaint of unfairly excessive pricing was added. A further signal of the inherent difficulty of accurate analysis is that European authorities have also been loath to find, or even allege, unfair pricing unless there were very large discrepancies between the price and what was chosen as the benchmark for fair pricing. European authorities have also struggled to formulate a simple and consistent test for unfair pricing.

We now turn to the principal objections against excessive pricing rules. It is apparent that the three major problems are fairly deep-seated, and are in any event not eliminated by the United Brands test as adopted by the CAC.