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COPYRIGHT 2002 Federal Legal Publications, Inc.
I. Introduction
A price floor, as its name implies, is the absolute minimum price that a firm is permitted to charge for the product or service that it sells. In general, an efficient price floor should be set at a level that reflects all of the incremental resource costs borne by the firm in producing the retail service in question. The primary economic rationale for a price floor is to prevent predatory pricing or an anticompetitive price squeeze.
An anticompetitive price squeeze occurs when the vertically-integrated provider (VIP) engages in some combination of raising the price of the upstream input to production and simultaneously lowering the price of the downstream retail service. (1) These actions serve to "squeeze" the price-cost margins of rivals and may force relatively efficient rivals to exit the market. In theory, once the rivals exit the market, the VIP raises the price of the downstream product--recovering its earlier losses and harvesting additional gain. (2) Hence, an anticompetitive price squeeze is a particular form of predatory pricing.
Price floors or imputation constraints are common in regulated industries. (3) In the telecommunications industry, incumbent local exchange carriers are generally subject to price floors for both their long-distance and local telephone service offerings. (4) Similar rules apply to incumbent electric power companies that are vertically integrated into the generation, transmission and distribution of electricity. These constraints are designed to ensure that the regulated VIP does not leverage its bottleneck control of an essential input to production in the upstream market to realize an artificial competitive advantage in the downstream retail market.
This analysis is motivated by two questions. The first question concerns whether price floors are serving their intended purpose--that of protecting the competitive process. (5) The second question concerns the computation of efficient price floors in the presence of emerging competition in upstream markets and increased product differentiation in downstream markets. The answers to these questions naturally harbor important implications for public policies in regulated industries undergoing a transition to competition. (6)
The format for the remainder of this article is as follows. Section II provides an overview of the key elements necessary for a price squeeze. Section III discusses how price floors can be used strategically by rivals to peg downstream prices at artificially high levels and thereby realize a competitive advantage. Section IV derives a general rule for computing efficient price floors based on the intensity of competition in upstream markets and the degree of product differentiation in downstream markets. Averaging of downstream prices under the price floor constraint is discussed in section V. Section VI examines the rationale for relaxing the price floor constraint on the basis of asymmetric risk-bearing. Section VII summarizes the policy implications of this analysis and concludes. The appendix contains formal proofs for selected results in the main body of the article.
II. Elements of a price squeeze
It is important to be clear at the outset as to the elements required for an anticompetitive price squeeze. First, the VIP must have a bottleneck in the supply of the essential input to downstream production. (7) Otherwise, a downstream rival could simply purchase the essential input to production from an alternative supplier and thereby thwart the attempted price squeeze. Second, the VIP must have the discretion to raise the upstream price and/or lower the downstream price. Third, the VIP must perceive that barriers to entry are sufficiently high that rivals cannot easily re-enter the market in response to higher prices in the downstream market. Fourth, the VIP must believe that a price squeeze constitutes a rational investment in future monopoly profits or market power.
The institutional characteristics of regulated markets casts doubt on each of these assumptions to varying degrees.
First, emerging competition in upstream markets is a reality in regulated industries today. For example, in the telecommunications industry, virtually all of the major long-distance carriers, including AT&T, MCI and Sprint, are involved in efforts to vertically integrate in local and long-distance telephone service markets. (8)
Second, the prices for the upstream input, commonly known as access, (9) are generally subject to regulatory oversight. Hence, the VIP does not have the discretion to raise these prices at will. (10) In many cases, the VIP's downstream prices are also subject to regulatory oversight. This suggests that the VIP will typically not be able to lower these prices and subsequently raise them without regulatory approval. (11) Moreover, regulated firms are increasingly subject to price cap regulation rather than earnings-based regulation. (12) This means that the regulated firm does not normally have the ability to petition the regulator for an increase in prices in the event of financial losses.
Third, the production process in most regulated industries is characterized by a high proportion of sunk costs. (13) This means that while it may be technically possible to drive rivals out of the market with "below cost" pricing, it is generally not possible to drive the productive capacity from the market, at least in the short run. This is significant because any attempt on the part of the VIP to price at supracompetitive levels will likely serve only to entice new entrants into the market and thereby constrain the VIP's pricing discretion.
Fourth, the losses incurred by the VIP in the course of a price squeeze are certain and occur early on; whereas the financial gains from a price squeeze are speculative and occur later on. The following passage is instructive:
If we look at predation as an investment to achieve or increase future monopoly profits, we should keep the arithmetic straight. Future monopoly profits must be discounted appropriately, and may be a long time coming, if they come at all. Near-term costs weigh more heavily and are more certain. A one dollar loss incurred today costs one dollar. At a 10 percent discount rate, an additional dollar profit three years hence is worth about 75 cents. A dollar profit deferred for five years is worth only 62 cents. If it cannot be realized in 10 years, it is worth only 38.5 cents. A dollar profit 25 years hence is worth less than a dime today. It may not pay to count thereafter. (14)
Professor William Baumol observes that "there seems to be general consensus among informed observers that genuine cases of predation are very rare birds." (15) The experimental economics literature appears to offer some confirmation of this proposition:
Based on the results of 11 predatory pricing experiments, our principal conclusion is that, so far, the phenomenon has eluded our search. We are unable to produce predatory pricing in a structural environment that, a priori, we thought was favorable to its emergence. (16)
These findings notwithstanding, it should be noted that economic theory does not suggest that successful predation is impossible, (17) nor do all economists necessarily believe that it is unlikely. (18)
Finally, it should be recognized that the absence of an explicit price floor constraint does not imply that the VIP will have complete discretion in the pricing of its downstream services. The VIP, just like any other firm, would still face prosecution under the antitrust laws if "below cost" pricing was deemed to be predatory or exclusionary in its intent. The real question then is whether it is necessary for regulators to...
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