Thursday, May 27, 2010

Margin squeeze is an enigma that was highlighted back in 2004, when the first complaint dealing with the issue was lodged with the South African Competition Commission.
After almost five years of investigation, the Commission referred the complaint to the Competition Tribunal for final adjudication on the basis of inducement under section 8(d)(i) and of price discrimination under section 9(1)of the Competition Act No 89 of 1998.
During the hearing, the Commission’s case developed into one of margin squeeze under section 8(c), which the Tribunal encouraged. Section 8(c) prohibits a dominant firm from engaging in an exclusionary act if the anti-competitive effect of that act outweighs its technological, efficiency or other pro-competitive gains. 
An exclusionary is defined as “an act that impedes or prevents a firm entering into or expanding within a market”.
Although margin squeeze was not originally argued, the Tribunal decided – and the Competition Appeal Court (CAC) confirmed – that the definition of exclusionary acts is wide enough to include margin squeeze.
According to the Tribunal, margin squeeze occurs when “a vertically integrated firm with a dominant position an upstream market prevents its non-vertically integrated downstream rivals from achieving an economically viable price-cost margin”.
For example, company X is dominant in the upstream market for the manufacture of ink cartridges that are an essential input into a particular type of ink pen. Company X sells the ink cartridges to its downstream competitor, company Y, for R10 each and, at the same time, sells the ink pen (including the ink cartridge) to its customers for R15.
The ink pen (excluding the ink cartridge) costs R6 to manufacture. Therefore company Y’s total cost of supplying a pen is R16, which is higher than the price at which company X is selling the ink pen into the market. The only way in which company Y can compete with company X is by offering the ink pen at a price that is less than its cost price.
The obvious conclusion is that company X is charging company Y too much for the ink cartridge and thus imposing a margin squeeze on company Y.
The Tribunal defined certain pre-conditions for a margin squeeze case:

the supplier of the input must be a dominant firm and vertically integrated;
the input in question should be in some sense essential to downstream competition;
the vertically integrated dominant firm’s prices would render the activities of an efficient rival uneconomic; and
there are no objective justifications for a dominant firm’s pricing arrangement.

If the first three pre-conditions are met, the dominant firm is then given an opportunity to provide objective justifications for its pricing policy. If, of course, it is unable to do so, it is engaged in an exclusionary act – in particular, a margin squeeze.
The Tribunal decision was taken on appeal, with the CAC confirming that the above pre-conditions had to be met for a margin squeeze case to exist. It concluded that the allegation was best characterised as an exclusionary act under section 8(c) of the Act, on grounds substantially similar to those of the Tribunal.
This is a significant decision for firms that are vertically integrated and operate at two levels of the supply chain.
A firm selling into the downstream market in which it also competes needs to be conscious of what it is charging its competitors for an input in the downstream market. Unless there is an objective justification for the firm’s pricing arrangement, it may ultimately find itself attracting the attention of the competition authorities.