Telecom/Saturn Report - Part 1

This document is sourced from an electronic version and does not include appendices which were supplied to theCommission in hardcopy;

pagination may also differ from the original.

memorandum

Wellington

J2853

To:

Commission

(COI - Cathie Harrison)

From:

Jo Bransgrove

Andrew Brice

Tim Grimwade

Date:

30 July 1998

Subject:

TERMINATION REPORT:

TELECOM'S PRICING OF FIXED TELEPHONY SERVICES IN LOWER HUTT

TABLE OF CONTENTS

INTRODUCTION....................................................................................................3

BACKGROUND......................................................................................................3

PREDATORY PRICING.........................................................................................5

The Commission's Approach to Predatory Pricing .......................6

A Cost-Based Analysis .....................................................................6

The Relevant Cost Measure .........................................................8

Average Incremental Cost ..................................... 10

Costing of Telephony Services in Lower Hutt ........................11

Selective Discounting / Cross-Subsidisation ...........................14

The Kiwi Share Obligation ......................................................15

The Impact of Telecom's Pricing on Saturn .........................17

The Scope of the Commission's Analysis ..............................18

COMPETITION ANALYSIS.......................................................................19

SECTION 36 .................................................................................................19

Relevant Markets ....................................................................19

Dominant Position ..................................................................24

Using a Dominant Position for a Prohibited Purpose .........25

Anti-Competitive Purpose ........................................ 27

Temporal Issues ........................................................27

Additional Issues ....................................................28

[ ] ............................................................................31

Conclusion .......................................................................................32

SECTION 27........................................................................................................32

Relevant Market ..............................................................................33

Contract, Arrangement or Understanding ...................................33

Purpose or (Likely) Effect...............................................................34

Substantial Lessening of Competition ..........................................36

Conclusion........................................................................................39

RECOMMENDATION ........................................................................................40

INTRODUCTION

1. In early May 1998, Commission staff became aware through media reports that Telecom New Zealand Limited (Telecom) was discounting its prices to its Lower Hutt customers, including the offering of a "loyalty rebate", purportedly in response to the entry of Saturn Communications Limited (Saturn) into local telephony in that region.
2. Staff were concerned that Telecom's conduct in lowering its prices in only Lower Hutt may be a use of a dominant position in contravention of section 36 of the Commerce Act (the Act), or constitute an arrangement that substantially lessens competition in breach of section 27 of the Act. Both Telecom and Saturn have readily assisted staff with their investigation and have each provided considerable, relevant information.
3. Staff have concluded that Telecom's pricing in Lower Hutt does not disclose a breach of sections 27 or 36 of the Commerce Act. Staff recommend:

• that the present investigation be terminated and the parties advised accordingly; and
• that, in view of the Commission's interest in promoting competitive conduct in telecommunications markets, the Commission continue to monitor developments and compliance with the Commerce Act in the relevant markets.

BACKGROUND

4. Saturn is a Petone-based company providing cable television and telephony services to the Wellington region. #1 In the long term, it expects around [ ] per cent of its revenues to come from telephony, and [ ] per cent from its pay TV operations. On 29 April 1998, Saturn launched a local telephony service for residents in the Lower Hutt area. It provides a range of telephony services including local, toll and international calls. It is the first company to activate a second local telephone network in competition with Telecom. A list of services and pricing offered by Saturn can be found on its rate sheets attached at Annexure 1.
5. Saturn has activated its network past 30,000 homes in the Lower Hutt area. The remaining area of the Wellington region [ ]
6. On 7 May 1998 Telecom responded to Saturn's entry into Lower Hutt, offering a range of 'package deals' specifically for Lower Hutt residential customers in the Saturn target area. Telecom's offer applies to eligible Lower Hutt residential customers and is effective from 7 May 1998 until 31 March 1999. While the standard price for Telecom's "Homeline" service (ie. the standard line rental) remains, arguably, at $35.66 the following new options are available:

• Homeline + a $5 rebate on the total spent if the customer uses Telecom for tolls; or
• Homeline + two enhanced services (eg Call Waiting, Call Minder, Caller Display) for $37.95 per month; or
• Homeline + three enhanced services for $39.95 per month; or
• Homeline + four enhanced services for $41.95 per month; or
• $4.50 "Talk All Day" (ie. for a national tolls call) in conjunction with any of the four above packages; or
• Second line offer at $29.95 in conjunction with any of the first four above packages.#2

7. The comparable packages (including GST) are as follows:

8. Telecom's packages have been designed to meet those packages offered by Saturn. Further, with the $5 loyalty rebate, Telecom's Homeline will be priced at a minimum $30.66, compared with Saturn's $29.95 for home line rental.
9. Saturn's business plan [ ] Saturn has been surprised by Telecom's market reaction. Assumptions used in Saturn's business plan [ ]

PREDATORY PRICING

10. Staff were concerned that Telecom's pricing response to Saturn's entry may constitute a breach of the Commerce Act. It has been put to the Commission that Telecom's pricing is predatory, in that its prices are deliberately set to eliminate and/or deter competition. This will be illegal if it breaches the Commerce Act (the relevant provisions of which are sections 27 and 36 - discussed further below).
11. It should be noted that "predatory pricing" is not mentioned in the Act. It is discussed here to describe a type of behaviour which has been subject to considerable economic and legal analysis world-wide (though in a far more limited scope in relation to New Zealand). It is considered that the pricing conduct of Telecom can be placed in useful perspective within the framework of a predatory pricing analysis. It is of course recognised that the statutory and ultimate question to be answered is whether the price cutting by Telecom constitutes a breach of sections 27 or 36.
12. Typically, predatory pricing involves the predator lowering its prices to a point at which competitors are forced to operate at a loss, or to recognise that they would operate at a loss if they entered the market. A predatory price will usually force the preying firm to sustain losses as well.
13. It is generally accepted that low prices are not to be condemned unless they are likely to be detrimental to consumer welfare. However, predation is dynamic, and is detrimental to competition in the long run as competitors exit the market, and the predator can then raise prices and collect supranormal profits. #3
14. However, the objection to predatory pricing is not confined to the harm to consumers through the raising of prices back to monopoly levels. Predatory pricing, even if unsuccessful, can reduce investment incentives and innovation, and deter new entry or expansion by more efficient firms. Productive and dynamic efficiency can both be harmed. Predatory pricing may pose a special threat in rapidly growing, high technology network industries where the value of a good increases with the number of users. Where a new entrant with better technology is deterred from competing, or pricing by the incumbent is sufficiently low to induce consumers to use the old technology, innovation is stifled. Further, allocative efficiency can be adversely affected through inefficient pricing when sales take place at less than their cost.
15. However, the scenario of the abusive practice of predatory pricing which targets a new entrant is to be distinguished from situations where a dominant firm is entitled to meet competition through price cutting, even if such price-cutting is selective. Theoretically it would seem that price differentiation between markets where entry occurs and does not occur is to some extent desirable because it steers investments by new entrants towards those markets where prices are higher. Constraining price responses in potentially competitive markets can blunt this information role of prices and induce wasteful investment.

The Commission's Approach to Predatory Pricing

16. The Commission's approach to predatory pricing consists of a two-tiered process by which it filters out implausible cases. The process involves, first, establishing the plausibility of whether predatory pricing has actually occurred. Under a section 36 analysis, this would involve examining various issues relating to the question of dominance. The second tier is to conduct an investigation as to whether predatory pricing is actually occurring. In respect of section 36, this involves examining whether the dominant position has been used for an anti-competitive purpose.
17. One issue that assists in an examination of predatory pricing is whether the predator can sustain considerable losses with reasonable confidence of being able to recoup at least the amount of loss after competition has been eliminated/deterred. Another issue to be determined is whether there is a reasonable justification for the pricing: if a firm can hold price below cost persistently without a reasonable justification, this will be a factor pointing towards the existence of an anti-competitive purpose. These and other issues that may indicate anti-competitive purpose will be discussed further below.

A Cost-Based Analysis

18. A cost-based analysis is therefore often central to an analysis of predatory pricing. Predation ordinarily focuses on the predator's costs. #4 The appropriate cost measure is discussed in more detail below.
19. It has been suggested that the standard to be preferred is the lesser of the predator's or rival's avoidable costs (because such a price will not cause a rival to exit unless it is below the rival's Average Variable Cost). #5 The fact that Telecom's prices are apparently not below Telecom's Average Incremental Cost in each of its packages on offer in the Lower Hutt area (see below) would seem to render moot the point as to whether Saturn's costs or Telecom's costs should be an appropriate benchmark for a predatory pricing assessment. [ ] For the purposes of this analysis, it is considered that the predator's costs are relevant.
20. The relevant period for assessing costs is the period of the price cutting, in this case from 7 May 1998 to (at least) 31 March 1999. This period covers the term of the offers of both Saturn and Telecom.
21. However, while it is important, particularly when ascertaining whether a price cutter is acting with an anti-competitive purpose, a cost-based analysis will not be the only aspect relevant to the Commission's analysis of predatory pricing. Not only does cost information need to be viewed with some caution, the relevant provisions of the Commerce Act necessitate consideration of an array of issues.
22. For instance, in Eastern Express, the Court said: #6

It will be for the Judge to decide whether the existence of the proscribed purpose may properly be inferred, with or without the aid of other evidence, from evidence of the conduct of the corporation in relation to the prices it charged. No preordained and fixed categories as to the level of pricing or economic theory or practice of costing necessarily control the drawing of that inference in any particular case. Whether the finding as to purpose which is sought against the corporation should be inferred from the evidence as to pricing must be judged by considering not only the logic of the matter. The Court must also consider whether "general human experience" would be contradicted if the conduct which occurred were unaccompanied by the purpose sought to be proved.

23. Several particular difficulties can exist with a cost-based approach. Indeed, Areeda, who developed the predation cost determination method twenty years earlier, conceded relatively recently that "the difficulties of measuring cost are notorious". #7 Difficulties include the following:

• accounting procedures vary from firm to firm;
• there is not always a consistent distinction between costs and investments;
• in the case of multi-product firms it is not always possible to identify those costs that might be directly attributed to a specific product line; and
• inventory systems vary from firm to firm.

The Relevant Cost Measure

24. The most famous test for predation is that offered by Areeda and Turner.#8 They proposed that a price less than Marginal Cost (MC) is predatory, and that any price above that amount is non-predatory. Areeda and Turner recognised that MC data, which describes how costs vary with each additional unit of output, is not easily computed, and is more of a conceptual tool for economists than an empirical reality.
25. As a surrogate, Areeda and Turner recommend the use of Average Variable Cost (AVC). AVC is calculated by identifying those costs that vary with output, adding them up, and dividing the result by the total number of units produced. #9 Regardless of the differences between MC and AVC a price held persistently below AVC indicates that a firm is not even covering all of its variable costs, let alone its fixed costs. Therefore, without a reasonable justification, a firm operating persistently under such conditions would likely be considered to be predatory pricing, because such a price would not be profitable but for the rewards of predation. In terms of the Commerce Act, such pricing would point towards an anti-competitive purpose.
26. Figure 1 delineates the typical relationship between a firm's short run unit costs.

[Figure 1 placeholder.]

27. Even if a firm is covering its AVC, fixed costs still remain. The Average Total Cost (ATC) to a firm includes both fixed and variable costs, and pricing below ATC for a considerable period may in some instances be considered predatory. Consequently, in cases where price cannot be shown to be below AVC, price should still be compared with ATC. #10 Joskow and Klevorick #11 suggest that:

• a price below AVC is always predatory; and
• a price greater than AVC but less than ATC should be deemed predatory unless the defendant shows that it has or had a reasonable justification for the price.

28. In a U.S. case, William Inglis & Sons Baking Co v ITT Continental Baking Co Inc, it was held that: #12

If the defendant's prices were below average total cost but above average variable cost, the plaintiff bears the burden of showing defendant's pricing was predatory. If, however, the plaintiff proves that the defendant's prices were below average variable cost, the plaintiff has established a prima facie case of predatory pricing and the burden shifts to the defendant to prove that the prices were justified without regard to any anticipated destructive effect they might have on competitors.

29. This statement does not, of course, reflect the law to be applied in New Zealand. It is simply raised here to illustrate that pricing that falls in the area above AVC but below ATC appears to lie in a 'grey' area. In such a case, the implications for "purpose" should be less serious than if pricing were to fall below AVC. Here, a cost-based analysis is likely to be secondary to other considerations when determining whether a breach of the Act has been made out. #13
30. Calculation of the ATC of telephony services in the Lower Hutt area requires some allocation of Telecom's annual common costs to this area. Telecom does not currently carry out this allocation, arguing that any such analysis would necessarily be of an arbitrary nature. Baumol et al provide an analysis of the arbitrary nature of 'full cost allocation' and argue that despite the courts moving in the direction of the marginal and incremental analysis that economics suggests, regulators seem vulnerable to an adoption of a fully allocated cost approach. #14
31. Northeastern Telephone Co v American Telephone & Telegraph Co 455 US 943 (1982) appears to lend some support to this view. In Northeastern Telephone it was argued that the defendant engaged in predatory pricing to preserve a monopoly in the sale of certain business telephone equipment. The court adopted the Areeda-Turner test and established the rule that, in the "general" case, there is a presumption that pricing below reasonably anticipated AVC is predatory, but above reasonably anticipated AVC is lawful. The court justified this rule on the grounds that predation is rare and is difficult to distinguish from legitimate competition, and market realities require a clear rule to avoid misapplication. The plaintiff argued for an ATC test rather than the AVC standard, on the basis that the defendant should be held to a higher standard because it was a regulated multi-product firm and was more likely to subsidise its low prices on one product with profits from other areas of its business. The court, however, found no reason to depart from the AVC rule, arguing that the possibility of using the regulatory process to allocate all of the defendant's overhead to regulated services did not require raising the cost standard to ATC. #15

Average Incremental Cost

32. Telecom has been unable to supply the Commission with AVC information. However, Telecom has supplied to the Commission Average Incremental Cost (AIC) information for the supply of telephony services to the Lower Hutt area. Staff note that Telecom does not accept that AIC is the appropriate measure in the circumstances. Rather it considers the appropriate measure is MC. [ ]
33. Incremental costs are those costs, including costs which in the short run would be regarded as fixed, that will be incurred as the result of a decision. They are measured by the change in total costs that arises from a particular decision. In a predation context, AIC is the per unit cost of producing the added output necessary to serve the predatory sales.#16 Baumol and Sidak (1994) define the AIC as:

the difference in the firm's total costs with and without X supplied, divided by the output of X. In other words, it is the cost per unit of X that is added to the firm's total outlays as a result of its supply of the current output of X.

34. It has been said that AIC is a more reliable guide than MC for most purposes in the telecommunications sector, as MC can vary significantly because capacity is usually added in large increments. #17 AIC is a better standard by which to gauge predatory pricing than either AVC or full costs, because it most accurately reflects the costs of serving the predatory sales. #18
35. If the prey competes only within one market arena, as appears to be the case here (and as was the case in Port Nelson #19, where the prey competed only in the under 2,500 tonne pilotage market), then prices below the incremental cost of serving that market can be expected to eliminate an efficient rival. #20 AIC thus appears the proper figure to compare with incremental revenues to determine if the predator's price is remunerative. #21
36. The AIC will therefore be considered in this report as the appropriate benchmark by which to assess the price-cutting by Telecom. It constitutes the most reliable data available, it is a reasonable benchmark by which to gauge predatory pricing, and has been considered the appropriate cost measure by New Zealand Courts. Given that the benchmark is AIC, the theory relating to the "grey" area, discussed above, will be considered applicable for that cost area between AIC and ATC.
37. Figure 2 illustrates a hypothetical AIC curve and the "grey area".

[Figure 2 placeholder.]

Costing of Telephony Services in Lower Hutt

38. Telecom has provided Long Run Average Incremental Cost (LRAIC) and Revenue information for its packages offered in Lower Hutt. This report will look at both the "Homeline less $5 rebate" package, and the "Homeline plus X" packages, when assessing the conduct of Telecom under the Act.
39. The following table summarises the three major permutations in relation to Homeline less the $5 rebate (all figures exclude GST):

40. Telecom has indicated that in each permutation, revenue is above AIC. [ ]
41. The basic cost for Telecom's Homeline service is [ ] which itself is comprised of two portions, a single line resource cost of [ ] (which accounts for network related costs as well as costs of service calls, enquiries, faults dispatch etc), and a local call resource cost of [ ]. The standard price for Homeline is $35.66, although with the loyalty rebate, the minimum price will be $30.66.
42. The single line resource AIC identified by Telecom has been calculated through the use of a costing model to which Telecom exchange information is applied. That exchange information is based upon a sample of exchanges throughout New Zealand (where the exchanges are classified according to demand density). The sample exchange results are then applied to exchanges with similar characteristics. #23
43. A further model is used to assess the costs of local calls. It also models the existing network and assesses how it would need to be expanded to cope with increasing volumes of traffic. Allowance has been made for the fixed costs in the network and the nationwide figure is used (there being no relevant breakdown for Lower Hutt) and reduced to an average cost per minute.
44. Staff were concerned that there was no independent confirmation of figures supplied by Telecom, and sought international cost comparisons, a sensitivity analysis allowing for the various assumptions Telecom makes in its models, and information providing independent support of the costing information provided to the Commission. [ ]
45. Staff have made comparisons of figures provided by Telecom with cost information provided by Saturn in order to verify the reasonableness of Telecom's figures, to the extent possible. Staff have concluded that the figures provided by Telecom are not unreasonable. Staff do, however, note that ultimately the Commission is reliant on the fact that the figures provided by Telecom are accurate.
46. Telecom's AIC information and revenues for the "Homeline plus X" packages offered in Lower Hutt area are identified in the table below. As with cost information relating to the Homeline less $5 rebate package, the costs of the "Homeline plus X" packages are calculated with reference to the foregone KSO contribution. All figures exclude GST.

47. Telecom has assumed in the costing of its various packages that:

• The sample exchange results can be applied to the Lower Hutt exchange area.
• Telecom's national average toll revenue of [ ] can be applied to Lower Hutt. [ ]
• The average toll minutes per customer per month amounts to [ ]
• Telecom loses [ ] per month in interconnect revenue each time a line is won from Saturn. This is the lost net interconnect payment when a line is won back from a competitor, and assumes [ ]
• that Telecom's net toll interconnect revenue amounts to [ ] per month. [ ]

48. O

    n the basis of the information provided, it appears that the revenues earned by Telecom in the Lower Hutt area are above the AIC for each available package that Telecom has introduced since Saturn's entry. It is not clear that Telecom's prices would be above the ATC for the provision of telephony services in Lower Hutt as the required additional data was not reasonably available from Telecom. Therefore staff conclude that Telecom's prices are above AIC and may or may not be above ATC. Staff classify Telecom's costs as falling within the "grey" area.

Selective Discounting / Cross-Subsidisation

49. Telecom is lowering its prices through its discount packages only in Lower Hutt. [ ] Telecom claims it has not lowered its line rental, but has simply offered a loyalty rebate which is only available if customers use Telecom for tolls. The rebate is not available to toll-barred customers (unless they have PIN numbers or are only toll-barred internationally). [

    ] Customers do not have to make any toll calls to qualify for the rebate.

50. Saturn claims the effect of the rebate is to cut standard line rental from $35.66 to $30.66 (compared with $29.95 offered by Saturn), meaning that while the minimum Telecom bill in Lower Hutt is $30.66, it is $35.66 elsewhere in New Zealand. Saturn is of the opinion that Telecom is using its line rental prices of $35.66 throughout New Zealand to subsidise its Lower Hutt pricing schedules.
51. While Telecom classifies the discount as a "loyalty rebate", its effect is to discriminate between those customers in Lower Hutt and those elsewhere in New Zealand. This issue is of importance when considering the market and the purpose of the rebate, and is discussed later in more detail.
52. Relying only on cost data, particularly when it falls within the "grey" area previously mentioned, is unhelpful in determining whether there is a breach of the Act. In this instance it will be necessary to evaluate Telecom's actions in light of the cost data together with all other circumstances surrounding the conduct. This approach is consistent with that preferred by the Court of Appeal in Port Nelson v Commerce Commission,

    #24 where it indicated that "no assistance is gained by attempting to define the bounds of 'predatory' pricing. It is preferable

    to concentrate on the terms of the statute." However, there is still a place for a cost-based analysis in providing guidance as to whether sections 27 and 36 are contravened, and in assisting in determining the necessary scope for further analysis.

53. Saturn notes that its core concern is one of regional/discriminatory pricing by Telecom. #25 The costs put to the Commission by Telecom are those relating to Lower Hutt. Detailed figures for the greater Wellington area and for New Zealand as a whole were not available, although the Commission has been given AIC figures for the single line resource cost component of the AIC of providing fixed telephony services in Wellington and New Zealand - [

    ]

54. Saturn argues that Telecom's pricing should be viewed nationally and thus the cross-subsidisation necessitated by the KSO be taken into account. [

    ]