VanDuzer Report - Summary

Executive Summary

Anticompetitive Pricing Practices and the Competition Act
Theory, Law and Practice

by J. Anthony VanDuzer and Gilles Paquet, University of Ottawa

Introduction

Anticompetitive pricing practices are frequently the subject of complaints to the Competition Bureau. In the five years beginning April 1, 1994, the Bureau received 931 complaints about alleged unfair pricing practices, such as predatory pricing, price discrimination and price maintenance. Despite the substantial volume of complaints, however, relatively few have been the subject of formal inquiries, even fewer are the subject of litigation and only a fraction of those have been successful.

Recently, concerns were raised regarding the effectiveness of the Competition Act provisions dealing with pricing practices and the Bureau's enforcement of them in the context of the debate on Bill C- 235, a private member’s bill which proposed to amend the Competition Act with the objective of better addressing certain forms of anticompetitive pricing activities. As a consequence of its consideration of the Bill, the Standing Committee on Industry resolved to review the pricing provisions of the Competition Act and their enforcement.

In anticipation of the Industry Committee’s review, in June 1999, the Commissioner engaged the authors of this report to conduct this independent study of the provisions of the Competition Act dealing with anticompetitive pricing and their enforcement by the Bureau.

PART I
Developing a Competition Policy Framework for Anticompetitive Pricing

Introduction

Section 1.1 of the Competition Act describes the purposes of Canadian competition law as follows:

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to maintain and encourage competition in Canada in order to promote the efficiency and adaptability of the Canadian economy, to expand opportunities for Canadian participation in world markets, to ensure that small and medium-sized enterprises have an equitable opportunity to participate in the Canadian economy, and to provide consumers with competitive prices and product choices.

Section 1.1 has been interpreted by the Bureau as endorsing the principle that competition law is geared to the maintenance and promotion of competition as a process, and not to the protection of competitors. Such an interpretation recognizes that a normal characteristic of competition is that some market participants may not thrive or even survive while others prosper because of their superior competitive performance. This dynamic effect of competition is essential to ensure that the efficiency benefits of competition are realized. Reductions in the number of competitors should be permitted in the interests of efficiency where the survivor is a more efficient competitor, the reduction is not caused by anticompetitive conduct and the marketplace after the reduction in competition remains sufficiently competitive, taking into account potential as well as actual competition. Of course, protecting the competitive process will mean protecting competitors in some situations where they are threatened by anticompetitive conduct or their elimination would result in insufficient remaining competition. Distinguishing anticompetitive conduct from acceptable marketplace behaviour and determining what level of competition is sufficient are extremely difficult.

Because the purpose clause of the Competition Act states that competition is to be sought as a way to ensure opportunities for some particular subsets of enterprises, some competitors may legitimately expect broader protection through this law than a single minded commitment to the competitive process based solely on efficiency considerations would dictate. In other words, the purpose clause may be interpreted as expressing an intention to proscribe anticompetitive behaviour, even where the outcome is the removal of a less efficient competitor and sufficient competition remains in the market place. In this way, protecting fair and equitable opportunities for small and medium sized enterprises could lead to difficult tradeoffs with the promotion of efficiency.

In relation to anticompetitive pricing, respecting these sometimes competing interests is made more difficult by the evolving understanding of the economic effects and likely incidence of potentially anticompetitive pricing practices. Designing effective competition law rules is further complicated by changes in the marketplace. The challenge is to ensure that the law continues to fulfil its objectives as the markets to which it applies develop.

Economic Analysis

Introduction

Most economic analysis of competition policy is concerned with how to protect the competitive process by ensuring that markets function efficiently. From this perspective, the challenge is to design a regime which provides relief where pricing behaviour is actually destructive of efficiency enhancing competition. A pricing practice should be considered anticompetitive, for example, where it creates a risk that future prices and other terms of sale will be less favourable to consumers than they would be otherwise. In this Part, we discuss the circumstances in which pricing practices are considered anticompetitive under economic theory.

Price Discrimination

Price discrimination means charging different prices to different customers, whether other businesses or final consumers, for the same product where the differences in price do not reflect differences in the cost to the supplier of serving the customers. Three conditions are necessary for a firm to discriminate.

1. The firm must have sufficient market power to set price (otherwise customers charged higher prices would choose to purchase from a competing supplier).
2. The firm must be able to identify different classes of customers with different levels of sensitivity to the price of the product. These differences may arise because of different needs, income levels or uses of the product.
3. There is limited opportunity for customers to resell to each other. It must not be possible for customers paying a low price to sell to those for whom the product is priced more expensively.

Empirical evidence confirming the existence of price discrimination can be found relatively easily. Price discrimination, however, is not inherently anticompetitive. Indeed, it is very difficult to identify simple indicia of anticompetitive price discrimination. Much depends on the circumstances of each case. Often discrimination may be preferable to a situation in which discrimination is not practised.

If price discrimination simply results in expanding a market, an increase in welfare will result. If we assume that some groups of consumers would not ordinarily purchase any product at the price a non-discriminating seller would charge if it was restricted to a single-pricing strategy, these groups would be better off if the seller was willing and able to sell them product at a lower price. Price discrimination of this kind can increase total output and welfare. The low price buyers are better off and those buying at the price which would otherwise be charged are no worse off.

To the extent that the discriminator charges more than it would if discrimination were prohibited, discrimination will impose a loss on the consumers paying the higher price. How one views the distributive effect represented by this transfer to the price discriminator will be affected by various factors. These include whether the discriminator also discriminates by selling below the price it would charge in a single price world and whether there are efficiencies associated with the discrimination. For example, through discriminating, the discriminator may be able to expand production to a more efficient level.

In short, the consequences of the discrimination are difficult to characterize in the abstract. Any competition law provision designed to address anticompetitive price discrimination should be restricted to true price discrimination as defined at the beginning of this section. As well, some competitive effects test will be necessary because the existence and nature of any anticompetitive effect will depend upon the particular circumstances in which discrimination occurs in each case. Assessment of the competitive effects of discrimination will be difficult, imposing a need for significant data and difficult microeconomic forecasts of demand and other variables.

Predatory Pricing

Predatory pricing occurs where a firm temporarily charges particularly low prices in an attempt to deter market entry by new competitors, to drive out existing competitors, or to discipline competitors. While low pricing is commonly complained about by firms struggling to compete, it is hard to distinguish predation from aggressive competition in practice.

Prior to the 1980's, predation was regarded by economists as likely to be rare. This view was based on the assumption that to become an economically rational strategy for a firm there must be a reasonable prospect of recouping its losses after a successful low pricing campaign and that prospects for recoupment are low in the absence of high barriers to entry. If high prices were charged by a supposed predator after successfully eliminating or deterring competitors from entering a market with low barriers to entry, others would enter to take advantage of the high prices and the price would not be sustainable.

More recently, some sophisticated theoretical claims have been made suggesting a wider array of circumstances in which predation may be a rational strategy. Predation is more likely to be successful where the predator has better access to capital than the victim. Predation may be used to create a reputation for toughness. The reputation created by an act of predation at one time may be sufficient to deter future entry on an ongoing basis, allowing the predator to raise prices to recoup its investment in predation. Incumbent dominant firms may also successfully predate by lowering price upon entry by a new firm to send a signal either that demand is weak or that the predator's costs are so low that they can afford to reduce prices. In either case, the intended message may be that there is no prospect of profitable entry. In these ways, firms may use strategic behaviour to create barriers to entry.

Pricing can only be considered predatory where it is below some measure of the predator's cost. Most economists agree that prices below the predator’s marginal cost of production are likely to be predatory, though because of the difficulty of assessing marginal cost, average variable cost is often used as a proxy. Similarly, in most circumstances, prices above average total cost will not be predatory. Whether prices between average variable cost and average total cost are predatory will depend upon the predator’s market share, barriers to entry and other circumstances in the market.

Some commentators have suggested that evidence of intent is useful to distinguish true predation from pro-competitive price cutting. The difficulty with such an approach is that it is often impossible to produce reliable evidence of intent.

Empirical studies have found cases of predation. Nevertheless, there remains substantial disagreement regarding the prevalence of the practice.

The basic indicators of predation may be identified as follows, though none is conclusive.

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1. Market power defined by reference to market shares and barriers to entry. In the absence of market power, the prospect of recouping the costs of a predatory campaign is small.

2. A policy of selling at prices below some measure of the predator’s cost.

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(A) Where sales are at prices below average total cost and the predator has no pro-competitive explanation, such as

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(I) meeting competition or changes in demand conditions; or
(II) excess supply.

(B) Where sales are at prices below average variable costs.

3. Evidence of predatory intent.

This simple listing raises but does not address, the challenge of how each of these indicators may be used in practice.

Price Maintenance

Price maintenance occurs where a firm tries to set a minimum price at which another firm can sell its product. Where price maintenance occurs horizontally between competitors who agree to fix their prices it is unambiguously anticompetitive. Where price maintenance is vertical, such as where a retailer agrees that it will not sell the products of a wholesale supplier for less than some price specified by the supplier, the effect on competition is more difficult to assess.

The economic rationale for prohibiting vertical resale price maintenance under competition law is that it lessens competition by restricting the ability of the retailer to compete on price. It leads to higher prices for consumers and higher margins for retailers, and, in the process, protects inefficient retailers that would not prosper in a truly competitive environment. In the absence of price maintenance, competition would be more likely to eliminate less efficient retailers and lead to price and cost reductions in the long run. Where price maintenance is implemented by a supplier solely in response to pressure from one of the supplier’s large customers seeking to eliminate the low pricing policies of competitors of the customer, the only purpose may be to protect the large customer from price competition.

On the other hand, efficiency is typically served by freedom of contract and many commentators have suggested that vertical resale price maintenance should be permitted, at least in some circumstances. Suppliers may want to encourage resellers to compete on demand determinants other than price, such as service. Resale price maintenance ensures that retailers have an incentive to offer important consumer services because they are precluded from competing on price. Another efficiency explanation is that suppliers, such as those in the designer clothing industry, may want to maintain a certain image of their product which can be damaged by the item being discounted or used as a loss leader.

It is possible to identify some of the economic indicia of anticompetitive vertical price maintenance as follows:

1. The person implementing price maintenance (the “Supplier”) has market power, a characteristic of which is limited opportunities for customers to change suppliers; and
   
   
2. The Supplier does not have an efficiency based justification, such as a desire to increase service or prevent brand impairing practices, which would include loss leadering or misleading advertising.

Challenges of the New Economy

The Canadian economy has become increasingly competitive as a consequence of globalization, due, in part, to the ongoing process of trade liberalization. As well, in certain sectors the channels of distribution have substantially changed. The emergence of “big box” retailing and internet distribution are both a response to and a cause of increased competitiveness. Even more fundamentally, the economy is currently undergoing a radical transformation; it is becoming more and more knowledge-based and increasingly innovation-driven. The following features of the new economy may require a rethinking of competition policy in relation to anticompetitive pricing especially predatory pricing: (1) accelerating technological change; (2) increasing returns and declining or zero marginal cost as units of output increase; (3) market dominance by firms is more likely to be short-lived or non-existent; and (4) the desirability and benefits of setting industry standards.

Legitimate efficiency enhancing competition through low pricing practices is likely to become more pervasive. In some industries, high rates of innovation will continually drive down costs. The prospect of declining marginal costs and increasing returns associated with increased production will also encourage low pricing strategies. Such strategies may be most common where establishing the industry standard may have substantial benefits, such as in software where a program’s value increases with the number of users.

Technology is driving down barriers to entry, both through innovations in marketing and distribution, such as internet sales, and by creating low cost ways of carrying on business. When one combines declining barriers to entry with increasing threats to dominance in some markets from new products and technologies, the likelihood that dominance can be exploited to injure competition through anticompetitive pricing practices is substantially reduced. At the same time, a characteristic of an innovation driven market is that the innovator will be dominant, at least for a time and that there may be efficiencies associated with dominance, including the promotion of further innovation.

In the new economy, the challenge of accurately identifying and taking enforcement action against anticompetitive pricing behaviour will become more daunting. The Competition Bureau will need to be vigilant to ensure that its enforcement policies are both informed by and sensitive to the exigencies of the new economy. In part, this means that competition authorities should increasingly emphasize dynamic over static efficiency goals in their enforcement analysis. Dynamic efficiency recognizes, for example, that innovation is essential to efficiency, that the establishment of a standard may be beneficial to consumers and, in any event, that any standard will not be sustainable in the long term since standards themselves are a significant site of competition.

PART II
Competition Act Provisions Dealing with Anticompetitive Pricing

Price Discrimination

General Discussion

A criminal prohibition on price discrimination was introduced into Canadian law to address concerns that large buyers might be able to use their market power to extract unfairly large discounts from suppliers. The grocery industry was identified as particularly threatened by this type of behaviour. The purpose of the provision was to protect small business.

The essence of the current provision is a prohibition on suppliers engaged in a practice of granting concessions on price to one purchaser which are not available to competing purchasers of the same article in like quality and quantity. The provision contains some significant limitations. Unlike most of the provisions of the Act, it only applies to a "sale" of "articles". Other forms of transactions, such as leases are not included; sales of anything other than an article, such as a service, are not included.

Price Discrimination Enforcement Guidelines

The Price Discrimination Enforcement Guidelines, published by the Bureau in 1992, purport to set out the Bureau's enforcement policy and its interpretation of the price discrimination provisions. The Guidelines indicate that the Bureau is unlikely to take action against a wide range of discounting practices taking the form of discounts which are available upon the purchaser fulfilling some condition, such as performing a service for the seller. Such discounts are not likely to raise issues assuming that they are available to all purchasers who compete with each other.

Some aspects of the Guidelines have been criticized as departing from the language of the Act. The requirement that discounts and other concessions be “available” to competing customers is interpreted in a manner which is, arguably, inconsistent with section 50(1)(a) and unduly onerous because it requires suppliers to actually offer discounts to all customers in some circumstances.

Also, the Guidelines appear to create an exemption for enforcement purposes for sales between affiliates, when none exists in the Act. The Bureau may consider transactions between affiliates as being something other than sales and so outside the reach of the price discrimination provision. The jurisprudence on what is a sale, however, is well settled. It seems unlikely that a court would exclude a transaction between affiliates if the formal requirements for a sale, including, in particular, the passing of title, are met.

In a similar way, the Guidelines indicate that all the franchisees in a franchise system may be treated as a single economic unit, such that anyone selling to the franchisees may aggregate all their purchases for the purpose of granting volume discounts. Where the franchisees make their purchases individually and are individually responsible for payment, this interpretation seems doubtful, since separate sales take place between the supplier and each franchisee.

Predatory Pricing

General Discussion

Predatory pricing is a criminal offence under section 50(1)(c) of the Competition Act. Several elements must be established before the offence is proven. The alleged predator must be engaged in business and engaged in a “policy” of selling products at prices which are “unreasonably low.” Also, one of four (4) alternative requirements must be met:

1. the policy must have the effect or tendency of substantially lessening competition;
   
   
2. the policy must have the effect or tendency of eliminating a competitor;
   
   
3. the policy must be designed to substantially lessen competition; or
   
   
4. the policy must be designed to eliminate a competitor.

There has been very little jurisprudence to inform the interpretation of these requirements. In Hoffman-La Roche, it was held that before a policy will be found there must be a conscious decision to sell at an unreasonably low price and there must be continuing or repeated sales, though a written policy need not be found.

"Unreasonably low" was interpreted in the Consumers Glass case. The court stated that the purpose of section 50(1)(c) was to prohibit selling at low prices for an anticompetitive purpose. The Court did not give any indication as to how to identity such a purpose, except to say that an anticompetitive purpose should not be inferred from the fact that a firm sets prices to a particular level with the intention of gaining business from a rival even if the alleged predator knew that pricing at that level would make it difficult for a new entrant to stay in the market. The court stated that setting prices so as to take business away from rivals for the purpose of minimizing losses to a new entrant or maximizing profit is the whole object of competition.

Where a price reduction is defensive, that is, in response to price cutting by a rival, even if it is a pre-emptive response, pricing is unlikely to be found to be unreasonably low unless it is disproportionate, in some way, to the rival's behaviour.

Another factor relevant to determining if prices are unreasonably low is cost. The courts have not been clear on what is the appropriate cost based test. While Consumers Glass and Hoffman-La Roche held that pricing above average total cost could not be predatory, a presumption of predation from pricing below average variable cost has not been adopted, nor has a test been articulated for pricing between average variable cost and average total cost.

The case law provides no real guidance on the interpretation of the four final alternative requirements of section 50(1)(c).

The Predatory Pricing Enforcement Guidelines

In 1992, the Competition Bureau issued the Predatory Pricing Enforcement Guidelines which adopt a two part test to determine whether prices are unreasonably low. First, the Bureau looks at one of the key indicators of predation identified in Part I: market power, including market share and barriers to entry. A market share of 35% is generally considered the threshold below which market power is unlikely to be sufficient. Under the Guidelines, barriers to entry include cost advantages enjoyed by an incumbent firm, such as licensing requirements which the incumbent has already satisfied, costs associated with acquiring market specific assets and control of essential technology or sources of raw materials through vertical integration. The Guidelines acknowledge the possible existence of strategic barriers, such as a reputation for predation.

The second step, in determining whether there is evidence of unreasonableness, is to apply a cost based test. Consistent with Consumers Glass and Hoffman-La Roche, prices above average total cost will not be considered to be unreasonable low. The Guidelines go on to provide specific guidance regarding other price/cost comparisons. Prices less than average variable cost will be considered to be unreasonably low in the absence of some legitimate commercial objective, such as the need to sell off perishable inventory. Whether prices between average total cost and average variable cost will be considered predatory will depend on the circumstances.

The two stage test in the Guidelines is only concerned with the likely effect in the market, with whether the alleged predator is going to be able to recoup its losses. The test itself may not be satisfied where the effect is only to eliminate a competitor. Section 50(1)(c), however, specifically refers to unreasonably low pricing policies having the effect or tendency or eliminating a competitor as well as to policies designed to substantially lessen competition or eliminate a competitor. A policy may be found to be designed to have these effects regardless of whether it has or is likely to have them.

Several statements in the Guidelines suggest that meeting the two stage test is not an absolute threshold requirement for proceeding with a complaint about predatory pricing. The Guidelines indicate that unreasonable low prices may be inferred from all the circumstances including, evidence of predatory intent and the exclusion or elimination of competitors. The thrust of the Guidelines, however, is to de-emphasise these bases of liability.

Price Maintenance

General Discussion

Under section 61 of the Competition Act, it is illegal for a person engaged in business to attempt to influence upward or discourage the reduction of the price at which any other person engaged in business offers or supplies a product in Canada by “any agreement, threat, promise or like means”. Requests, discussion, persuasion and suggestions directed toward the maintenance of prices, however, are all permitted. Breach of the provision is a criminal offence.

Refusing to supply or otherwise discriminating against a person because of that person's low pricing policy is similarly prohibited. It is sufficient for a conviction, if the low pricing policy is one of the reasons for the refusal. Section 61(10) provides four (4) defences for refusing to supply. A supplier may refuse to supply a person where that person is making a practice of any of the following:

1. using products supplied as loss leaders;
   
   
2. using products supplied not for the purpose of selling them for a profit but to attract customers to buy other products;
   
   
3. engaging in misleading advertising in respect of the products supplied; and
   
   
4. not providing the level of service that purchasers of the products might reasonably expect.

Under section 61(6) no person may, by threat, promise or any like means attempt to induce a supplier, as a condition of doing business with the supplier, to refuse to supply a product to a particular person because of the low pricing policy of that person.

Abuse of Dominance

The abuse of dominance provision was introduced into Canadian competition law in 1986 to replace the criminal monopoly provision. The purpose of the provision is not to address the fact of structural dominance in a market, but to provide relief where dominance has been used to abuse the interests of consumers or producers. While the old monopoly provision and the provisions prohibiting price discrimination, predatory pricing, and resale price maintenance create criminal offences under the Competition Act, the provisions dealing with abuse of dominant position provide for civil review by the Competition Tribunal applying the civil standard of proof.

Section 79(1) provides as follows:

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Where, on application by the Commissioner, the Tribunal finds that

1. one or more persons substantially or completely control, throughout Canada or any area thereof, a class or species of business,
2. that person or those persons have engaged in or are engaging in a practice of anti-competitive acts, and
3. the practice has had, is having or is likely to have the effect of preventing or lessening competition substantially in a market,

the Tribunal may make an order prohibiting all or any of those persons from engaging in that practice.

In order to assess the degree of control by the allegedly dominant firm, the first step is to define the relevant product and geographic dimensions of the market. "(S)ubstantial control" has been equated with market power, meaning that the allegedly dominant firm has the ability to maintain prices above competitive levels for a considerable period. The primary indicators of market power are market share and barriers to entry. High market share alone will give rise to a presumption of dominance. In Laidlaw, the Tribunal stated that dominance would not be presumed where market share is below 50%.

Once dominance is established the Tribunal must determine that the dominant firm has engaged in a practice of anticompetitive acts which has had, is having or is likely to have the effect of preventing or lessening competition substantially. Section 78 of the Competition Act lists a number of anticompetitive practices which the Competition Tribunal may find to constitute abuse. Some of the types of behaviour referred to in section 78 relate to pricing. In any case, the list is not exhaustive and, in several cases, acts outside those specified in section 78 have been found to be abusive. Price manipulation may be used by a dominant firm in a wide variety of ways to discipline, deter or eliminate competitors. In the abuse cases so far, however, pricing issues have played a relatively small role.

One of the anticompetitive acts alleged in NutraSweet was predatory pricing. Although, ultimately, the Tribunal did not find evidence of predation it made several comments which will undoubtedly inform the manner in which predation will be dealt with in future cases. First, the Tribunal accepted that predation could be an anticompetitive act under section 79. Second, the Tribunal stated that pricing below marginal cost should be deemed predatory. Third, the Tribunal indicated that predation is not a rational strategy unless there is some prospect of recoupment and accepted that a firm may signal an intention to predate in one market by predatory activity in another.

Finally, the Tribunal must find a substantial lessening of competition. This test has been held to require that the anticompetitive acts of the dominant firm preserve or add to the dominant firm's market power. In particular, the Tribunal will ask whether the action creates or strengthens barriers to entry as well assessing the magnitude of this effect. The Tribunal must also give consideration to the possibility that the practice was a result of “superior competitive performance.”

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