The Development of the European Approach to Art. 102

May 1st, 2010

The European Union has its origins in the common market for coal and steel established by the Treaty of Paris of 1952. The aim of the ECSC Treaty was to contribute, through the common market for coal and steel, to economic expansion, growth of employment and a rising standard of living. In the light of the establishment of the common market, the ECSC Treaty introduced the free movement of products without customs duties or taxes. It prohibited discriminatory measures or practices, subsidies, aids granted by States or special charges imposed by States and restrictive practices. The Treaty’s Article 66 contained provisions that would allow the newly created “High Authority” to intervene in case of distortions of competition on the markets for coal and steel: economic concentrations in the coal and steel sectors were subject to a notification procedure and had to be authorised before they could proceed, and Article 66(7) empowered the High Authority to make recommendations to prevent enterprises with a dominant position from using that position for purposes contrary to those of the Treaty, and if necessary, to impose remedies. 

The origins of the concept of dominance evoked in Article 66(7) of the ECSC Treaty can be traced back to German competition law, which used this concept since the Abuse Regulation of 1923. One reason for adopting the term dominance rather than the term “monopolization”, used in the American Sherman Act, was the influence that the German competition law had on the drafter of the ECSC Treaty, Jean Monnet. The notion of dominance has been addressed both in law and economics. In the realm of economics, dominance has been analyzed by theories dealing with market leadership in oligopolistic market structures. In the realm of law, the concept of dominance is found in two sets of legal provisions, namely Article 102 and the EC Merger Regulation. The legal definition of dominance has been an issue of intense debate. The standard legal definition of dominance was laid down by the Court of Justice in United Brands. The Court of Justice stated that: The dominant position thus referred to (by Article [102]) relates to a position of economic strength enjoyed by an undertaking which enables it to prevent effective competition being maintained on the relevant market by affording it the power to behave to an appreciable extent independently of its competitors, customers and ultimately of its consumers. In Hoffmann-La Roche the Court of Justice defined dominance as “a position of economic strength enjoyed by an undertaking, which enables it to behave to an appreciable extent independently of its competitors, its customers and ultimately of consumers”. The Court of Justice further stated in Hoffman-La Roche: Furthermore although the importance of the market shares may vary from one market to another the view may legitimately be taken that very large shares are in themselves, and save in exceptional circumstances, evidence of the existence of a dominant position. An undertaking which has a very large market share and holds it for some time (…) is by virtue of that share in a position of strength… The statement from Hoffman-La Roche contains no definition of what is to be meant  by “some time”. Thus, the lack of a consistent definition might result in an arbitrary interpretation. In Continental Can, the Commission, in defining a “dominant position”, focused on the ability of entities to behave independently in making decisions that affect the market as a whole. There has been some attempt to use a consistent approach to the term in merger cases: the formulation of dominance in United Brands was echoed in the Court of Justice Kali-Salz decision with respect to collective dominance. As mentioned above, the definition of dominance contains two elements: the ability to prevent effective competition and the ability to behave independently. However, what is unclear is how these two elements relate to each other.

Four requirements must be met for the application of Article 102. One (or more, in the case of collective dominance) undertaking(s) must be in a dominant position, and such position must be held within the common market or a substantial part of it. In addition, there must be an abuse and this must have an effect on inter-State trade. Dominance is analyzed in relation to three variables: the product market, the geographical market and the temporal market.  Importantly, Article 102 does not prohibit the existence of a dominant position, rather it only prohibits its abuse. The main types of abuse are: excessive pricing (United Brands), predatory pricing (AKZO), discriminatory pricing (United Brands), refusal to supply (Commercial Solvents), tying and bundling (Hilti, Tetra Pak II), loyalty rebates (Hoffman-La Roche), abuse of intellectual property rights (Magill) and vexatious litigation (Promedia). As the judgment in Continental Can clarified though, Article 102 did not set out an exhaustive enumeration of the types of abuses of a dominant position.

For dominance to exist the undertaking concerned must not be subject to active competitive constraints. In other words, it must have substantial market power. It is also not required for a finding of dominance that the undertaking in question has eliminated all opportunity for competition on the market. In conducting the analysis of whether the allegedly dominant undertaking is indeed dominant, it is relevant to adopt an economic approach and assess in particular the market position of the allegedly dominant undertaking, the market positions of competitors, barriers to expansion and entry, and the market positions of buyers. The existence of a dominant position may derive from several factors which, taken separately, are not necessarily determinative. The concept of dominance has been analyzed by leading economists in the Report by the Economic Advisory Group on Competition Policy “An economic approach to Article 82”. According to this Report, traditional means of establishing dominance through information about market structure are proxies for the determination of dominance – they  assess the ability to exert power and impose abusive behavior on other market participants. It is clear that an economic approach is needed, in order to be sure that one is evaluating the alleged competitive harm on the basis of how competition in the particular market actually works and what the practice in question means for market participants. The standard for assessing whether a given practice is detrimental to competition or whether it is a legitimate tool of competition should be derived from the effects of the practice on consumers. Most important,  the Economic Advisory Group argued that taking a more the economic or effects-based approach towards Article 102 implies that there is no need to establish a preliminary and separate assessment of dominance. The emphasis should be on establishing significant competitive harm which is already proof of dominance (since a non-dominant company would not have the ability to impose anticompetitive foreclosure). We should emphasize an argument made by the Economic Advisory Group: ..in proposing to reduce the role of separate assessments of dominance and to integrate the substantive assessment of dominance with the procedure for establishing competitive harm itself, we depart from the tradition of case law concerning Art. 102 of the Treaty, but not, we believe, from the legal norm itself. Article 102 of the Treaty is concerned not just with dominance as such, but with abuses of dominance. The case law tradition of having separate assessments of dominance and of abusiveness of behaviour simplifies procedures, but this simplification involves a loss of precision in the implementation of the legal norm…The structural indicators which traditionally serve as proxies for “dominance” provide an appropriate measure of power in some markets, but not in others. In a market where these indicators do not properly measure the firm’s ability to impose abusive behaviour on others, the competition authority’s intervention under traditional modes of procedure is likely to be inappropriate, too harsh in some cases and too lenient in others. Given that the Treaty itself does not provide a separate definition of dominance, let alone call for any of the traditionally used indicators as such, it seems more appropriate to have the implementation of the Treaty itself focus on the abuses and to treat the assessment of dominance in this context. They also argue that: This approach also allows us to capture in a balanced and meaningful way the notion of special responsibility of a dominant firm… Since in this analysis we do not need to assess the existence of dominance separately, the special responsibility implicitly applies to any conduct and firm that (is able to) interfere and distort the competitive process of entry into the market. Both these points illustrate a generalization of the application of Article 102 to any conduct and firm that (is able to) interfere and distort the competitive process of entry into the market. A thorough assessment of the conditions for entry, -- of  how easy  and/or rapid entry is always essential in order to judge the ability of a firm or firms to harm consumers. The Economic Advisory Group adds that an economic approach to Article 102 should focus on improving consumer welfare and, thus, should avoid confusion between the protection of competition and the protection of competitors. An economic-based approach would require a careful examination of how competition works in each particular market in order to evaluate how specific unilateral conduct affects consumer welfare. Such an approach would ensure that anti-competitive behavior does not outwit legal provisions and guarantees that the statutory provisions do not unduly thwart pro-competitive strategies. On this basis, it is important to draw the foundations for an economic approach to Art. 102 from the economic theory of antitrust policy.

 Economic analysis of abuse of dominance issues: old and new approaches

Much of the academic debate on the role of antitrust policy has taken place in the U.S., where the field was first established in the 19th century. Only subsequently, and with a certain delay, did it spread to Europe. During the 1950s and ’60s, the studies associated with the University of Chicago Law School introduced a systematic economic approach to antitrust focusing on the defense of consumers and, in economic terms, on the protection of consumer surplus and/or total welfare as the primary objectives of antitrust policy. Most scholars in this tradition had a laissez-faire view of mergers and exclusionary practices: the idea was that when there are entrants that provide a strong competitive pressure in a given sector, mergers are mostly aimed at creating beneficial cost efficiencies, and aggressive strategies such as bundling, price discrimination and exclusive dealing are not necessarily anti-competitive, but instead usually have an efficiency rationale.

For instance, according to this view, bundling is generally done for price discrimination purposes and not for exclusionary purposes.  According to the so-called single-monopoly profit theorem a monopolist in one market cannot use tying or any other practice to leverage market power in a secondary market where entry is free. Similarly, exclusive dealing cannot be used to exclude more efficient entrants because consumers would need compensation to sign an exclusivity agreement, yet the gains created by an entrant are too large to be compensated by an inefficient incumbent. Finally, according to a widespread view in the Chicago school, there is no such thing as predatory pricing: the main reason is that, if the predator can sustain the initial losses needed to induce the exit of a rival, the rival can also sustain the induced losses (on condition that credit markets are working properly), therefore predatory pricing would be ineffective. Notice, however, that Posner has recently taken a less extreme position, proposing a moderate standard for judging practices claimed to be exclusionary: “in every case in which such a practice is alleged, the plaintiff must prove first that the defendant has monopoly power and second that the challenged practice is likely in the circumstances to exclude from the defendant's market an equally or more efficient competitor. The defendant can rebut by proving that although it is a monopolist and the challenged practice exclusionary, the practice is, on balance, efficient”. This efficiency defense is at the basis of the “rule of reason” approach, for which a business practice is not “per se” illegal, but can be justified if it does not harm consumers or if it creates efficiencies.

The Chicago school provided fundamental insights into many antitrust issues, but it failed to provide a complete understanding of the behavior of market leaders. In particular, it limited most of its analysis to the understanding of how monopolistic and perfectly competitive markets work, and in a few cases it focused on markets characterized by a monopolist facing a competitive fringe of potential entrants. However, it largely neglected the role of imperfect competition and technological conditions departing from those assumed under perfect competition. Dismissing the important advances in the application of game theory, the Chicago school ignored the role of the strategic interactions between incumbents and entrants. The consequence was that its approach to exclusionary practices has been often biased against a pro-competitive role played by the incumbents without an updated theoretical support, and it has been neglected in practice whenever markets were characterized by imperfect competition.

In the 80s, while the Chicago school was succeeding in raising the threshold for antitrust intervention in the US, a (later called) post-Chicago approach started to expand its influence amongst economists and, in the following decade, also amongst antitrust scholars. This approach has introduced new game theoretic tools to study complex market structures and derive sound normative implications, always for the maximization of consumer surplus (in line with the economic consensus). For instance, with reference to exclusionary practices, the post-Chicago approach has shown that in the presence of strategic commitments to undertake preliminary investments, asymmetric information between firms, limited forms of irrational (non-profit-maximizing) behavior or credit market imperfections, predatory pricing can be an equilibrium strategy for the incumbent, deterring entry and harming consumers. Similarly, it has shown that bundling can be used to strengthen price competition and exclude a rival from a secondary market. Analogously, many other strategies can have an exclusionary purpose, while mergers have typically an accommodating purpose which again hurts consumers. One should keep in mind that many of the conclusions of the post-Chicago approach  depend on a number of restrictive assumptions. For example, predatory pricing has been shown to be exclusionary under extreme circumstances, including forms of irrational behavior (in reputation models) or pervasive market imperfections, and, even when exclusion emerges under more plausible conditions, it is not necessarily associated with a pricing below cost or even with reductions in consumer welfare (in signaling models), which is what should matter from an antitrust point of view.
Another crucial limitation of the post-Chicago approach and modern game theoretic literature that has been identified in the most recent literature is that in most cases, they have focused on the behavior of incumbent monopolists facing a single potential entrant. To cite only the best-known examples, this was the case for the Dixit model of entry deterrence, the models by Milgrom and Roberts of predatory pricing, by Fudenberg and Tirole on strategic investment, by Rey and Stiglitz and Bonanno and Vickers on vertical restraints, by Whinston on bundling for entry deterrence purposes and by Fumagalli and Motta and Abito and Wright on exclusive dealing, as well as many other works based on analysis of duopolies.  Also most of the standard results on the behavior of incumbents in terms of pricing, R&D investments, mergers, quality choices and vertical and horizontal differentiation are derived in simple oligopolistic models, where the incumbent chooses its own strategies in competition with a fixed number of competitors. While this analysis simplifies the interaction between incumbents and competitors, it can be highly misleading, since it assumes away the possibility of endogenous entry, and therefore limits its relevance to situations where the incumbent already has an exogenous amount of market power. In most (unregulated) markets entry of firms can be regarded as endogenous (if the analysis examines conduct over a reasonable period of time), therefore a relevant benchmark for antitrust theory must be the analysis of strategies by leaders in markets where the number of competitors is endogenous.

The entry conditions of the market must be at the core of any economic approach to antitrust. Even if these have been often mentioned in the law & economics literature on antitrust policy, they have only recently been introduced in the theoretical analysis and in its application to antitrust issues. In this section we examine this recent evolution. The traditional industrial organization literature has emphasized the important role played by barriers to entry, but there has been much debate as to definitions of what constitutes a meaningful barrier to entry. Bain associated it with a situation in which established firms can elevate their selling prices above minimal average costs of production without inducing entry in the long run. Broadly speaking, such a situation corresponds to what we define as competition between an exogenous number of firms: even if positive profits can be obtained by a new firm in the market, entry is not possible. Stigler has proposed a different definition of barriers to entry, associating them with costs of production which must be borne by firms seeking to enter an industry but not borne by the incumbents; a similar approach has been prevailing more recently so that we can talk of barriers to entry as sunk costs of entry for the competitors which are above the corresponding costs of the incumbent (or have been already paid by the incumbent). According to this definition, subsequently adopted by the contestability theory of Baumol and others and by the endogenous sunk cost approach of Sutton, sunk costs can be binding on the entry decisions of  followers, therefore, they can be a crucial determinant of the endogeneity of entry in a market. A final category is that of simple fixed costs of entry: these are faced equally by the incumbent and by followers, but they can also represent a binding constraint on entry. While there is a fundamental difference between the concepts of sunk and fixed costs of entry, their role in endogenizing entry is virtually the same, and in the analysis that follows the two concepts will be assimilated more or less into one. Another important aspect concerns the source of these barriers and costs. They can constitute a legitimate cause of antitrust concern if they have been artificially created or enlarged by the incumbent; they cannot if their origin is purely technological. Nevertheless, according to the Chicago approach, it is hard to imagine how artificial barriers could be erected under normal circumstances, as we can conclude from the following position of Bork: If everything that makes entry more difficult is viewed as a barrier, and if barriers are bad, then efficiency is evil. That conclusion is inconsistent with consumer-oriented policy. What must be proved to exist, therefore, is a class of barriers that do not reflect superior efficiency and can be erected by firms to inhibit rivals. I think it clear that no such class of artificial barriers exists.

Recent theoretical advances in industrial organization have proposed an economic approach to antitrust based on the analysis of endogenous market structures, in which profit maximizing strategies and entry decisions by an endogenous number of firms are taken into account to verify the impact of different conducts on consumer surplus and welfare. This approach combines the game-theoretic foundations of the post-Chicago approach with the emphasis on entry pressure typical of the Chicago approach, and can provide a bridge between the two leading approaches. In the endogenous market structure approach entry should be regarded as endogenous not when it is free, as in the perfectly competitive paradigm, but when sunk or fixed costs of entry constrain endogenously the number of firms that interact strategically in a market and therefore their market power. A number of normative results with important implications for competition and innovation policy emerge from this approach. In particular, the theory has shown that whether entry in a market is exogenous or endogenous makes a lot of difference for the way leaders behave. In markets where entry is independent of profitability conditions, market leaders can adopt accommodating strategies to increase prices, or aggressive ones to exclude rivals and then monopolize the market; their strategies tend to harm consumers in both cases. However, when entry is endogenously dependent on profitability conditions in the market, the leaders always adopt aggressive strategies which typically do not harm consumers.

A few examples will illustrate  the point. Consider unilateral conduct by a firm. A firm competing with a single rival could engage in accommodating pricing to increase mark ups (i.e.: choosing a high price to induce the rival to do the same), or in predatory pricing to induce the exit of the rival, but a firm facing endogenous entry of competitors will ordinarily adopt aggressive pricing strategies without exclusionary purposes. As a second example, consider bundling. Let us think of a monopolist in a primary market which competes with a single rival in the market for the secondary good. A commitment to bundle strengthens competition in the secondary market. Therefore, in case of entry of the single rival, it reduces the profits of the monopolist in both markets. However, in case of entry deterrence, the monopolist remains alone and can choose the monopolistic price of the bundle: even if this delivers lower profits than the uncostrained monopolistic prices, under weak conditions it is a profitable strategy and reduces consumer utility. This is a classic example of a predatory strategy aimed at inducing exit and establishing a monopoly. This conclusion, however, can be highly misleading when entry is endogenous: the assumption of a single rival neglects the possibility of additional competitors and further entry in the secondary market, which is quite important in many real world cases. If the secondary market is characterized by endogenous entry, the monopolist of the primary market will  always choose  to be aggressive in this market, and bundling may be the right way to commit to an aggressive strategy. Bundling would not necessarily deter entry in this case, especially if there is a high degree of product differentiation in the secondary market, but may instead increase competition in this market and reduce prices, with positive effects on consumers.

Let us move to vertical restraints now. Imagine that an incumbent manufacturer is threatened by a more efficient entrant, and both can only sell to consumers through retailers. If the number of retailers is exogenous, the incumbent may deter entry with an exclusive dealing contract with each retailer: this is the case when the competition downstream is strong enough and the retailers can be easily convinced to sign an exclusive agreement which will lead to high prices. However, when entry in the downstream market is endogenous, high prices only attract entry of new retailers which will be served by the entrant manufacturer. In such a case, exclusive dealing contracts can only be unprofitable (under linear prices) or pro-competitive (they lead to aggressive pricing without deterring entry in the presence of two-part tariffs).

Finally, consider a merger between two firms in a market with price competition: if the number of firms is fixed (for instance because they have an exclusive and superior technology), this stimulates an accommodating behavior by the merged entity, which tends to increase prices and profits, but when entry is endogenous this attracts entry and defeats the strategic purpose of the merger. The conditions under which such a merger can hurt consumers have been investigated recently for horizontal mergers, but the same results apply to the more complex case of vertical mergers.
Thus it should be evident that efficiency reasons can still motivate aggressive pricing, bundling, exclusive dealing or mergers. In this respect, the overall flavor of the endogenous market structure approach is reminiscent of the Chicago school, while the analysis is based on game theoretic foundations consistent with the post-Chicago tradition (and can be seen as complementary to it).

The relevance of these results depends on the relevance of the hypothesis that entry is endogenous in a given  market. One may argue that in most markets entry can be usually regarded as endogenous in the medium and long run, but not in the short run. If this is the case, and if antitrust policy is aimed at correcting distortions in the medium and long run (as opposed to short run distortions which self-correct through market mechanisms), then the results of the endogenous entry approach are potentially relevant for policymakers. However, if antitrust policy is also aimed at correcting short run distortions emerging in the absence of entry pressure, the traditional post-Chicago analysis based on exogenous entry applies. Antitrust enforcement thus needs to make a policy choice – whether the objective is to ensure an absence of distortions over the short-term, as well as the medium- and longer-term --, and an economic assessment – of whether entry conditions in the time-frame chosen are endogenous or not.  A rule of reason approach allows implementation on a case-by-case basis, taking account of the policy choice (elimination of short-term vs. elimination of medium- or longer-term distortions). We strongly argue in favor of such a rule of reason approach for the European antitrust policy.

Send us your feedback and comments about this article