Vertical Price Squeezing

Vertical price squeezing is a particular type of anti-competitive conduct that may be engaged in by incumbent operators. This form of conduct can occur if the incumbent provides services in two or more vertical markets. Vertical markets are sometimes labelled upstream and downstream markets. For example, the oil production market is upstream of the oil refining market, which in turn is upstream of the gasoline sales market. Instead of upstream and downstream, the terms wholesale and retail are often used.

Vertical price squeezing can occur when an operator with market power controls certain services that are key inputs for competitors in downstream markets, and where those same key inputs are used by the operator or its affiliates to compete in the same downstream market.

To take an example, in telecommunications markets, the incumbent often controls local access and switching services. Consider one such service - the provision of dedicated local circuits from customer premises to local exchanges. Dedicated local circuits can be viewed as "Upstream" services. These services are used as input by the incumbents in providing "downstream" services, such as dedicated internet access services. Dedicated local circuits are also a key input for competitors who provide dedicated internet access services. In other words, both the incumbent and other suppliers compete in the downstream market for dedicated internet access services.

If the incumbent decided to engage in vertical price squeezing, it could increase the price to competitors for the upstream input (i.e. dedicated local circuit rates) - while leaving its downstream prices the same (i.e. prices for its dedicated internet access services). The effect would be to reduce or eliminate the profits (or margins) of competitors. Their margins would be squeezed. To increase the squeezing effect, the incumbent could also reduce its downstream prices for internet access. This would be a two-way or margin squeeze.

Put another way, an incumbent can often squeeze the margins of competitors by raising wholesale prices paid by competitors, while at the same time lowering retail prices on competitor services.

A simplified numerical example of a vertical price squeeze is included in Box 1-5.

Box 1- 5:
Example of Vertical Price Squeeze by Incumbent Operator
Cost to incumbent of upstream facility (e.g. dedicated loop)	$90
Price charged by incumbent to competitor for loop	$120
Cost of providing retail services to end users (e.g. dedicated Internet access service) in addition to loop cost (e.g. marketing, billing, etc.)	$20
Price charged by incumbent to end users for dedicated Internet access services	$130

Wholesale Cost Imputation Requirement

To prevent vertical price squeezing, a telecommunications regular may impose a wholesale cost imputation requirement, along the lines set out in Box 1-6.

Box 1- 6:

Basic Elements of Wholesale Cost Imputation Requirement

Conditions for Application Applies to a monopoly or dominant provider of “wholesale services” Where the dominant provider also competes in market for “retail services” that require the wholesale services at inputs. Basic Rules Dominant provider must provide evidence to the regulator that its retail prices are no lower than the sum of the following: The price it is charging competitors for the wholesale services that form part of the retail services (this price is said to be “imputed” in the cost of the dominant provider whether it actually incurs this cost or not) The actual incremental costs (above the imputed wholesale costs) that are incurred by the dominant supplier in providing the retail services. For example, marketing, billing, etc. costs

Variations on this type of imputation approach have been used by various regulators and competition authorities. It is relatively simple to use (compared to detailed accounting separations or cost allocations). To return to the margin squeezing examples in Box 1-5, it does not matter whether the actual cost of the wholesale service is $90, $120 or some other number. What the imputation requirement assures is that the same cost for essential wholesale services is imputed to the dominant operator's retail services as is passed on its competitors.

Imputation: A Canadian Example

A form of the wholesale cost imputation requirement has been applied by the Canadian regulator in response to complaints of targeted retail price discounting by incumbent operators. The CRTC's approach was tailored to the rather unique circumstances of the Canadian market. In that market, the CRTC established a universal service program in the form of subsidy for the access deficit incurred by operators in higher cost areas.

All long distance operators, including new entrants, are required to make a contribution payment to subsidise the deficit described above. However, as noted in our detailed discussion of the Canadian example, Incumbent local operators continue to receive the vast majority of contribution payments. Initially, the CRTC did not specifically require the incumbent operators to account for their own use of the local access network in providing competitive services. That is, it did not require incumbents to make contribution payments to themselves. This led to the potential for vertical price squeezing by incumbents. The CRTC's Response to this situation is described in Box 1-7.

Box 1- 7:

Case Study: The CRTC Imputation Test

In1994 (Decision 94-13), the CRTC described the targeted price responses of incumbent operators to new entrants as follows: Under a scenario of unrestrained target pricing by the telephone companies, competitors could be faced with the situation in which they must compete against telephone company prices that embody a contribution amount that is lower than the competitor contribution cost in that market segment. The Commission considers that, due to their previous status as monopoly toll providers, the telephone companies have an established and generally predominant share in all market segments. As a result, their traffic mix, the presence of barriers to entry and the existence of customer inertia would permit them, on a sustained basis, to recover contribution from the most highly contested market segments at a level below the contribution amount (payable by competitors). As a result of these concerns, the CRTC implemented an imputed test to ensure that incumbents’ prices in competitive networks were subject to similar cost recovery requirements as competitors. This imputation test, as modified in a later CRTC decision (Telecom Decision CRTC 94-19), has the following requirements: Revenues for each service offered by an incumbent must equal or exceed the sum of: The costs for bottleneck services used by the company in the provision of the services in question, using tariffed rates of those bottleneck services (the Operator Access Tariff”) The causal costs specifically attributed to the services, which are additional to the costs covered in the above bullet Any applicable contribution payments

This imputation test is similar to the one described in Box 1-7. The main difference is that the CRTC imputes contribution subsidies, as well as wholesale facilities costs, as costs that must be covered in the incumbents' retail prices. The CRTC took the position that so long as a service recovers these inputted costs, plus the direct causal costs of the retail service, targeted pricing would not be anti-competitive.