Where a vertically integrated incumbent firm controls a facility that is an essential input to its retail competitors, this can create a “bottleneck” to competition. The vertically integrated firm may prevent competitive entry by refusing to supply the essential input. Or it may charge a price for the input so high that it is not possible for competitors to operate profitably, given the level of retail prices.
There are two possible cures for this essential facility problem:
- The market may provide a technological solution, by developing feasible substitutes for the facility,
- The government may require the vertically integrated firm to provide equal access to the essential facility to any firm that requests access, including competitors. Typically, this means imposing non-exclusion and non-discrimination obligations on the owners of essential facilities.
Even if the vertically integrated firm agrees to supply the essential facility to its competitors, it may still attempt a vertical price squeeze. A number of remedies for this exist, including:
Figure 1: Remedies for Refusal to Supply and Vertical Price Squeezes
Ex Ante Resale Obligations
Resale obligations require the vertically integrated firm to make its retail services available for resale by any competitor. Competitors gain access to the wholesale components of the service when they resell the vertically integrated firm’s retail services. This approach is used in the United States, under the Telecommunications Act 1996.
The generally accepted price rule for resold services is “retail minus” or “avoided cost discount”. Under this rule, the price paid by resellers is equal to the retail price of the service, less the cost resellers avoid by substituting their own retailing functions for the vertically integrated firm’s.
Not all competitors are interested in using resale as their retail market strategy. Alternative protections against price squeezes may be needed.
Ex Ante Price Floors
A price floor sets a minimum retail price for the incumbent’s retail service, with reference to wholesale prices. A price floor should ensure that competitors that as efficient as the vertically integrated firm are able to cover their costs. The rule for setting a price floor, or "imputation rule" can be stated in a number of ways:
The retail price must be no less than the wholesale price plus the direct incremental cost of the vertically integrated firm’s pure retailing functions.
The retail price must be no less than the vertically integrated firm’s wholesale price, plus the direct incremental cost of the vertically integrated firm's pure retailing functions, plus the difference between the firm’s direct incremental cost to provide the wholesale facility to itself and its direct incremental cost to provide that same facility to its competitors.
The retail price must be no less than the vertically integrated firm’s direct incremental cost to supply the product, plus the profit margin it could earn from selling the essential input to its competitors.
The profit margin on the vertically integrated firm's price for the retail product must be no less than the profit margin it earns from selling the essential input to its competitors.
The above imputation rules are equivalent, but provide different insights into the conditions that must hold for a vertical price squeeze to be impossible.
Ex Post Structural Remedies
Structural remedies seek to separate the wholesale and retail operations of the vertically integrated firm, to remove the opportunity for a price squeeze, through:
- Functional or accounting separation of the firm’s wholesale and retail operations, or
- Full structural separation of the firm’s operations (by divesting either the wholesale or retail operation).
These measures may achieve the objective of preventing a price squeeze, but they can have substantial costs. In particular, under structural separation the firm would lose any efficiencies or cost savings from vertical integration. This loss would ultimately fall on customers, through higher prices.
RELATED INFORMATION
Refusal to Supply
Vertical Price Squeeze