Strategic Heal Behaviour

Under perfectly competitive conditions a firm’s strategy to alter its relative position in the market can amount to nothing more than increasing its output, which is of no interest from a competition policy/law viewpoint as it has a negligible effect on others in the market. Other strategies such as product differentiation would shift the firm into another analytical market. Similarly, under monopolistic conditions strategic behaviour is usually unnecessary, since a monopolist’s position in the market cannot alter as *228 it has no rivals, actual or potential.

[FN15] Yet even a monopolist is not entirely free from competition and so if the monopolist raises its prices sufficiently it will lose sales. Consequently a brewer, for example, who is assumed to be the sole supplier of beer in some geographic market may adopt price or non-price strategies intended to win sales from other alcoholic beverages such as wine and spirits. Under oligopolistic conditions, the firm recognises its interdependence and the need to take into account other firms’ reactions when making its decisions.

“In oligopoly, there are few enough suppliers so that the profits of each firm depend on the actions of all firms, and some or all firms are aware of this mutual dependence. ” [FN16] The implicit assumption of the structure-conduct- performance approach that firms simply respond to the market structure is rejected when strategic behaviour is taken into account. Rather it is recognised that firms may actively undertake to alter their competitive environment through their own conduct, that is they may undertake strategic behaviour for this purpose.

The firm recognises that it has the freedom to make decisions to alter its commercial environment. According to Porter (1985), in any industry “the rules of competition are embodied in five competitive forces: the entry of new competitors, the threat of substitutes, the bargaining power of buyers, the bargaining power of suppliers, and the rivalry amongst the existing competitors. ” [FN17] Porter argues that while the strength of these factors varies between industries and through time, through their influence on price, costs and investment they determine the ability of a firm to be profitable.

That is, industry profitability is a function of industry structure. Where Porter differs from the traditional structuralist approach is in his belief that firms have the ability to alter industry structure through the strategies which they adopt. These strategies not only influence the profitability of the firm within the industry but may improve industry structure and profitability (or may destroy it). Porter also points out that industry leaders can have a disproportionate impact on structure, because of their size and influence over buyers, suppliers and other competitors.

At the same time, leaders’ large market shares guarantee that anything that changes overall industry structure will affect them as well. A leader, then, must constantly balance its own competitive position against the health of the industry as a whole. Often leaders are better off taking actions to improve or protect industry structure rather than seeking greater competitive advantage for themselves. [FN18] In order to achieve a sustainable competitive advantage, a firm must develop an advantage derived from the firm’s ability to cope better with the five forces which shape industry structure than can its rivals.

The three general strategies which a firm can pursue are to be the lowest cost producer or to supply differentiated products broadly across the market; alternatively, a firm may target its operations to a particular market niche aiming to best meet the requirements of those buyers whether on the basis of cost or differentiated product. Recognition that under certain circumstances firms can undertake strategic behaviour renders a purely structuralist approach to market analysis inappropriate. Possible Strategies Generally, strategic behaviour is part of a healthy competitive process: it is not inherently anti-competitive.

Whether strategic behaviour is anti- competitive or not depends on the nature and purpose of the conduct. However, anti-competitive conduct has been the focus to date for much of the discussion of strategic behaviour. Firms use many techniques to prevent rivals from entering a market, to drive rivals out of business or to reduce rivals’ profits. Strategies may be designed to enable a firm to scare off potential rivals by changing the rivals’ beliefs about how aggressively the firm will behave in future. The strategies adopted by firms differ according to differences in assets, skills, price, distribution methods and the like.

Strategies are expressed across time through investment and by tactical moves and countermoves. A firm may decide to invest in order to achieve scale economies as part of a broader strategic plan. This may prevent entry by ensuring that a new entrant would be unable to secure enough of the market to enable it to reach minimum efficient scale within some reasonable time frame. Alternatively, the firm may have created sufficient excess capacity credibly to threaten to drop the price to marginal cost following entry. Other methods of entry deterrence include limit pricing, predatory pricing and raising rivals’ costs.

Brand proliferation and intensive advertising, often in conjunction with other factors such as limited economies of scale, are *229 other strategies which may be used by a firm to deter entry. Research and development, the basis for achieving dynamic efficiencies, may under certain circumstances also assist a firm to shut its rivals out of the market. Strategic Behaviour in European Cases AKZO [FN19] Several successful predatory pricing cases have been brought in Europe, including those against AKZO and Tetra Pak.

In 1985 the European Commission found that AKZO had abused a dominant position by cutting prices in order to exclude a competitor (Engineering and Chemical Supplies–ECS) from the market. ECS had complained that AKZO had attempted to put it out of business by sustained and systematic price cutting from late in 1980 to mid-1982 when the complaint was made. The Commission’s decision was appealed to the European Court of Justice which in 1993 upheld the original decision. AKZO is part of a diversified, multinational chemical and fibres group of companies.

One of its products, benzoyl-peroxide, is used as a bleaching agent in flour production (in the United Kingdom and Ireland only), as well as in the plastics industry. ECS, a small privately owned company, commenced supply of benzoyl-peroxide to the U. K. plastics industry in 1969, based on product acquired from AKZO UK; in 1977 it began its own production. In 1979 it began supplying the plastics industry on the Continent. In response, AKZO threatened to drop prices, concentrating on the United Kingdom where its action would cause most harm to ECS and least harm to itself.

ECS took legal action but the matter was settled with AKZO undertaking not to reduce its normal selling prices for benzoyl peroxide in the United Kingdom or elsewhere for either plastics or flour additives. Shortly after this, AKZO increased its prices for flour additives in the United Kingdom. During the subsequent period AKZO raised prices by 10 per cent annually and ECS followed. The subsequent claim of predatory pricing by ECS against AKZO related to sales of benzoyl peroxide to flour millers in the United Kingdom where AKZO and ECS were the only suppliers of a complete range of flour additives.

There were two large buyers (RHM & Spillers) supplied by AKZO; Allied Mills was supplied by ECS. AKZO supplied around one third of the independents and ECS supplied the balance. The production costs of ECS were lower than those of AKZO and ECS supplied Allied Mills and the larger independents at prices 10 per cent lower than those of AKZO, but market shares remained fairly stable. Early in 1980, AKZO raised prices to its U. K. customers; this time ECS did not follow and so the price differential between the two suppliers increased.

Spillers and RHM asked ECS for price quotes and ECS quoted a price corresponding to its supply price for Allied Mills. To retain the business AKZO was forced to drop its price. Around October 1980, Spillers sought a quote from ECS on a fixed price contract for 6-12 months. AKZO then offered a price below that offered by ECS (and below its average variable cost) but on the condition that Spillers obtained all of its requirements from AKZO. A similar move was made by RHM, with a similar response. Late in 1980 AKZO approached ECS’s main customer, Allied Mills, and offered a special low price.

In December 1980, these approaches were successfully extended to large independents. In order to retain these customers ECS was forced to match these reductions but market share was gradually lost. Then, in January 1983, AKZO offered a further price reduction despite increases in labour and material costs. In July 1983 the Commission imposed minimum prices on AKZO. Philps and Moras (1993) argue that the pattern of conduct described above is not suggestive of predatory pricing. [FN20] They conclude that the market was characterised by a dominant firm (AKZO) and a follower (ECS).

The price cutting was started by ECS which converted from follower to price leader. [FN21] Philps and Moras explicitly assume that ECS had a sufficiently large cost advantage to enable it to be the market leader despite its small market share. They conclude that “the U. K. flour additives market moves from a price leadership situation towards a more competitive one as a result of the initial low price quotations by ECS … the story is one of active competition, initiated by ECS. ” There is another possible interpretation of the facts of this case.

The original situation could be characterised as tacit collusion; Philps and Moras refer to the relationship between the two firms during the 1970s in the United Kingdom as one of “friendly collaboration”. [FN24] They concluded that the 1979 settlement indicated that AKZO “was willing to collaborate”. [FN25] Thus, when ECS departed from this understanding and deliberately dropped its prices, AKZO, which believed that it possessed market power as the price leader, may have attempted to use that market power to discipline or punish ECS for its action.

In this context, AKZO’s action may not be predatory, but it is a misuse of market power intended to deter competition. Tetra Pak [FN26] The Tetra Pak case was in some respects more straightforward than the case involving AKZO. Tetra Pak was found to have abused a dominant position in two markets by charging different prices in different member countries, predatory pricing, tying and placing contractual restrictions on customers. The Commission’s decision survived an appeal to the ECJ.

From research undertaken during the 1950s and 1960s, Tetra Pak had patented a process and the machinery required for aseptic packaging of milk, fruit juice and other liquids. Although the patents had long expired, it effectively remained the monopoly supplier in Europe of these two markets, with a market share of 90 to 95 per cent; PKL accounted for the balance of sales. Given this, it was concluded that Tetra Pak was an inevitable partner for packers in the aseptic markets and this guaranteed it the freedom to act independently.

It was accepted by the Commission (and later by the court) that dominance in these markets was abused through conduct in the non-aseptic packaging and machinery markets where Tetra Pak had only a 50-55 per cent market share and the markets were described as oligopolistic. Its two main rivals were Elopak, with a 27 per cent market share, and PKL, with an 11 per cent share; there were a number of small players as well. It was found that for firms involved in both fresh and long-life liquid food products, Tetra Pak was also a preferred supplier of non-aseptic packaging and machinery.

In addition, dominance of the aseptic markets enabled Tetra Pak to concentrate its retaliatory action on the non-aseptic markets without fear of retaliation in the aseptic markets, that is, damage was limited to the non-aseptic markets. Predatory pricing allegations were found to be proved on the grounds that prices were below cost. Such prices could not be justified on any ground other than putting a competitor out of business and strengthening Tetra Pak’s position in the non-aseptic markets. *231 The Tetra Pak case was mainly concerned with predatory pricing but it too was found to involve conduct intended to tie customers.

Tetra Pak’s standard contracts required that only Tetra Pak cartons could be used on the machines supplied by Tetra Pak and that cartons could be supplied only by Tetra Pak or another company designated by Tetra Pak. This restriction was introduced because Elopak had commenced producing non-aseptic cartons. The court found that these ties were intended to increase the dependence of these firms on Tetra Pak. A number of European cases, including Hoffman-La Roche and Tetra Pak, have identified product range as a deterrent to entry.

Another example is the Ready to Eat Breakfast Cereals case in the United States where the Federal Trade Commission sought to test whether oligopoly was really shared monopoly based on tacit collusion. [FN27] The key features of the industry were intensive advertising; brand proliferation; limited economies of scale; and sustained high profit rates. Although the three main suppliers (Kellogg, General Mills and General Foods) accounted for around 85 per cent of market sales, there was a reasonably large number of smaller participants. Barriers to entry were low. Raw materials were readily available and technology was relatively simple.

Importantly, economies of scale were limited so that minimum efficient scale required only around 5 per cent of market sales. There had been new entry, as well as exit. The existing producers appeared to be highly competitive, responding to consumer requirements with a steady stream of new products. Using a structuralist approach, there might have been concern about the high market concentration but with apparently low entry barriers and vigorous competition, it would be unlikely that conduct within the industry would be regarded as anti- competitive. A different picture emerges, however, when a strategic behaviour model is adopted.

Schmalensee (1978) [FN28] suggests that we begin by assuming that each of the three major producers produces just one product, A, B or C, spread evenly through product space (imagine them equidistant from one another along a straight line). Each is a unique combination of qualities which meets perfectly the requirements of few consumers. Midway between A and B and between B and C is where consumers are least satisfied by the present offering and so would be the best place to target product for a new entrant as it could draw from the least satisfied consumers on either side.

However, imagine that the three existing firms each put another brand into these gaps in the product space and then between those gaps. The effect is to severely limit the profitable positionings open to a new entrant, to increase risk and to reduce the ability to introduce a unique product which will attract shelf space in retail outlets. Viewed in this way and despite ease of entry, brand proliferation together with substantial advertising support made entry so risky that few if any firms were prepared to attempt it.

As a second illustration, consider research and development. Firms may compete by trying to find better ways of doing things or by providing superior products, so expenditure on research and development is generally regarded as desirable because it is efficiency-enhancing and pro-competitive. Even where new technology is protected by patents or other forms of intellectual property rights, other firms still have an incentive to innovate. However, under certain conditions research and development and technology restrictions may be anti- competitive.

For example, in the 1930s Alcoa was accused of creating a patents pool which it did not intend to use but which prevented its rivals from gaining access to new technology. In some markets, especially where switching costs are significant and/or there is an asymmetry of information, suppliers may be able to tie their customers such that entrants have little chance of winning them away from the incumbent. Entry is then foreclosed because demand available to new entrants is insufficient to justify entry.

Possibly the simplest of these devices is the use of medium to long term contracts for major customers (these may, however, be in the interests of buyers as well as sellers). The decision in Eastman Kodak Co. v. Image Technical Services, Inc. et al. illustrates a set of circumstances in which strategic behaviour was used to tie customers resulting in anti-competitive effects. [FN29] Kodak is a manufacturer of copiers and micrographics equipment. This equipment requires regular maintenance and servicing; Kodak supplied these services.

Kodak was only one of a number of manufacturers of copiers and micrographics equipment. As *232 such it did not possess market power in the primary market. However, to the extent that parts needed for Kodak equipment could not be replaced with parts from other manufacturers, Kodak had the opportunity to lock in the owners of its equipment and charge them supra-competitive prices for service. Prior to the mid-1980s Kodak sold replacement parts for its equipment (for which there was no substitute) to anyone wishing to purchase them.

Then Kodak altered its supply policy. In future it would only supply parts to buyers of Kodak equipment who used Kodak service or provided their own service, and only if they agreed not to sell parts to the independent service providers. In addition, Kodak requested the original equipment manufacturer of parts not made by Kodak itself not to sell parts to anyone except Kodak. Further, Kodak restricted the availability of used machines to prevent them from becoming an independent source of parts to others.

In short, Kodak introduced a policy intended to limit the participation in supply of parts and service to itself. To achieve this outcome several conditions were necessary. The first was to ensure that Kodak controlled the supply of parts required to provide maintenance and servicing. This was what its strategy was intended to achieve. Secondly, the strategy required an asymmetry of information such that purchasers were not aware of the lifecycle cost of the equipment at the time of purchase.

This is likely where equipment is durable and complex and where intermediaries are not significant in the market. It is also important that switching costs are not insignificant. Given these conditions, a firm without market power in the primary market can create market power for itself in the after market or derivative market. Canon KK v. Green Cartridge, reported by Holmes (1997), [FN30] was a Hong Kong case which was appealed to the Privy Council.

It is discussed here because it has some features which were similar to the Kodak case, although it was essentially a copyright/spare parts matter rather than a competition case. The cartridges used in photocopiers and laser printers contain toner and replacement parts. Some firms supply refilled cartridges. (but not new parts) in competition with Canon but Green was supplying both new cartridges and new parts; it had reverse engineered the latter.

The difference between the Canon and Kodak cases arises in part from differences in the information assumed to be possessed by purchasers and also in switching costs. In the European context the court was prepared to accept that consumers were well informed and that switching costs were not significant. [FN31] Further, in the Canon case there was no pattern of conduct suggestive of an anti-competitive purpose: Canon in no way facilitated Green’s operation in the first place and then later set out to force it from the market.

Implications Recognition by the market participants of their mutual interdependence and its associated uncertainty is the distinguishing feature of oligopolistic markets, not simply the number of market participants or the precise height of barriers to entry. A structuralist approach is not really appropriate for fully analysing the strategic behaviour which results from such a market structure. Failure to take account of strategic behaviour would be of little concern if such conduct was relatively insignificant.

However, particularly since the late 1980s, increasingly market structures have moved towards the uncertainty of oligopoly. We do not presume to suggest that failure to take account of strategic behaviour rather than structural considerations has to date resulted in incorrect decisions in competition cases. However, in the absence of a more systematic approach to strategic behaviour, future findings may err either in condemning conduct which is simply the competitive process at work, or by failing to recognise conduct likely to harm competition.

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