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
2
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
3
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
4
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
5
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
6
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
7
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 knockoffs—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
8
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
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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
17
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 highpowered 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
19
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
20
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
21