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Nonlinear Pricing in Vertically Related Industries

Final Report Summary - NONLIN (Nonlinear pricing in vertically related industries)

This project focuses on nonlinear pricing in vertically related industries. Nonlinear pricing refers to mechanisms in which the unit price of a product varies with the number of units offered or consumed. Frequent flyer programs are an example of nonlinear pricing directed to the final consumers. The use of such schemes in retail markets has received substantial attention, but their use in manufacturer-retailer relationships where they are more common is yet to be fully understood.

In vertical industries nonlinear pricing typically involves discounts where higher volume purchases lead to lower prices. Some of these discounts make buyers purchase more from the firm employing the discount and less from its rivals. Such loyalty inducing discounts frequently come under antitrust scrutiny when employed by upstream firms with substantial upstream market power. The major anticompetitive concern is potential foreclosure of an upstream rival.

Quantity and market share rollback discounts are made conditional on reaching a volume or share of a buyer's purchases from the supplier target and imply a lower price for all units not only the incremental units. A common element of these discounts is their ability to generate negative prices at the margin for some range of purchases by the retailer. They pose a challenge to economic theory as it is difficult to explain why a firm would charge less for a larger order if its intentions were benign. This challenge was a likely cause of the prevalent harsh antitrust approach to these schemes.

But insightful economic research indicates that associating dominant firms' use of such discounts with foreclosure incentives might be inappropriate. Moreover, firms commonly employ such discounts in settings where no foreclosure concern exists. Private parties in antitrust cases presented several efficiency effects to such loyalty inducing discounts. Nonetheless, economic research is late in demonstrating the efficiency increase loyalty inducing discounts can provide for vertical chains.

Recent developments in European and US case law indicated the necessity of economic research in loyalty discounts. The accumulated knowledge is still far from offering a comprehensive list of circumstances where loyalty discounts provide efficiencies that would not be available under alternative pricing schemes. Disentangling the underlying motivations for loyalty discounts is essential for building up the capability of competition policy enforcement to separate anticompetitive instances from benign instances.

This project studies the role loyalty discounts in firms' benign commercial behaviour and identifies circumstances where loyalty discounts are likely to generate efficiencies. Market share discounts provide a risk sharing mechanism between retailers and suppliers when demand is stochastic. In many industries suppliers and retailers agree on wholesale price before the actual demand is realised. Then, if a demand shock affects competing products similarly a market-share discount allows the supplier to share the market risk with the retailer. So, when retailers are risk averse such discount is likely to increase pricing efficiency.

Recent controversial antitrust decisions called for improvement in the application of Article 82 of the EC Treaty. The past approach to loyalty rebates considered their use by dominant firms a per se abuse, partly because no benign rationale for using such discounts was well understood. If exclusionary potential is evident and the benefits are not intelligible then a per se prohibition seems to bear a low risks. But, when a practice is known to be capable of producing both harm and benefits, an effect-based approach as adopted in 2008 is more appropriate. Therefore, understanding the efficiency provided by loyalty rebates is an essential step in the intended transition from a legalistic definition based approach to the new economic assessment based approach.