Bundled Discounts and Foreclosure in Wholesale Markets *** PRELIMINARY AND INCOMPLETE ***

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1 Bundled Discounts and Foreclosure in Wholesale Markets *** PRELIMINARY AND INCOMPLETE *** Enrique Ide and Juan-Pablo Montero January 25, 2016 Abstract Can a multi-product firm offer bundled-discounts to foreclose a more efficient singleproduct supplier? We show that the degree of downstream competition is key. Bundleddiscounts are successful in depriving single-product rivals of scale economies only to the extent that buyers are disorganized and their valuations heterogeneous. This holds when suppliers deal directly with final consumers or when retailers compete intensely, but it is lost in the case of local monopolies. Intense downstream competition also provides the incumbent with a form of endogenous commitment, making exclusion even easier when compared to the case where manufacturers sell directly to final consumers. 1 Extended abstract Offering discounts to buyers that purchase distinct products from the same supplier is a widespread phenomenon. Much of literature on bundling has focused on its use as a pricediscrimination tool, whether in monopoly (Adams and Yellen 1976, McAfee et al 1989, Chen and Riordan 2013) or in oligopoly (Gans and King 2006, Thanassoulis 2007, Armstrong and Vickers 2010). Nalebuff (2004 and 2005) was the first to call our attention to a completely different aspect of bundling, its potential use as an entry-deterrance tool. In these papers, 1 there is an incumbent supplier that is a monopoly in the market for one product, say A, but faces competition in the market for a second product, say B. Nalebuff (2004 and 2005) shows that by selling products A Ide: Stanford GSB (eide@stanford.edu); Montero: PUC-Chile Economics (jmontero@uc.cl). 1 See also Peitz (2008) and Greenlee et al (2008) for similar arguments. 1

2 and B as a bundle, as opposed to selling them separately, the incumbent can significantly lower the potential profits of a rival supplier of product B. Because of a potential anticompetitive outcome (i.e., deterrence or eviction of more efficient rival), these bundled discounts have risen and will continue to raise much concern among antitrust authorities as illustrated by many cases: EU Commission v. Hoffman-La Roche (1976), LePage v. 3M (2003) and Cablevision v. Viacom (2013), to name a few. While insightful in identifying how the bundling of multiple products can significantly affect the profits of one-product suppliers, the existing literature provides partial understanding of its anticompetitive implications. As mentioned by Armstrong (2013), one main reason is that retailers, which are present in all cases above, are absent in all existing models; they assume that suppliers sell directly to final consumers. 2 The second reason is about the underlying mechanism explaining exclusion. Exclusion in these models follows a distinct logic of the post-chicago models (see Ide-Montero-Figueroa, IMF, 2016). It is more closely related to a price-discrimination argument. Since the incumbent cannot perfectly price discriminate across consumers in market A, he uses market B to better price discriminate and extract additional surplus in market A. 3 So exclusion in these models is not driven by a standard leverage argument of extending monopoly power from market A to market B, but quite the opposite, by the use of an otherwise competitive market to extract additional surplus in a monopoly market, which, according to Bork (1976), should not constitute an antitrust violation. 4 In this paper we maintain the basic structure of an incumbent supplier of two products, A and B, and a rival supplier of one product, B. But we depart sharply from existing models in two aspects. First, and following the above cases, we assume that final consumers are not served directly by the suppliers but indirectly through retail buyers. We consider two levels of retail competition; one in which retailers do not compete at all (monopoly retailers) and one in which they compete intensely for final consumers (undifferentiated Bertrand retailers). The second departure from existing models is that we completely abstract from the price-discrimination motive for bundling. The only reason for using bundling in our model is for strategic entry- 2 Microsoft is a case that does not involve retailers. Microsoft sells directly to final consumers. 3 In some cases (partial) exclusion in market B is used to better extract information rents in market A. See Calzolari and Denicolo (2015). 4 Bork (1976) argues that the use of market B shouldn t be viewed as an antitrust violation because the incumbent is not extending or leveraging its monopoly power from market A to market B. He continues that if monopoly power in market A does not by itself represent an antitrust violation, then the incumbent should be allowed to bundle in order to better exploit its legal monopoly. On the other hand, if the monopoly in market A is illegal because, for example, it was acquired through illegal means, then the authorities should challenge the existence of the monopoly in market A as opposed to focusing on the bundle. 2

3 deterrance reasons. In other words, in the absence of an entry threat, the incumbent will never use bundling. We will consider cases of efficient and inefficient entry. The main result of our paper is that the degree of retail competition is key for anticompetitive conduct by the incumbent. Bundled-discounts are successful in depriving a single-product rival of scale economies only to the extent that buyers are disorganized and their valuations heterogeneous. This holds when suppliers deal directly with final consumers or when retailers compete intensely, but it is lost in the case of retail monopolies. Somehow surprising then, to sustain an anticompetitive outcome at the upstream (i.e., wholesale) level, it is key to observe an intense competition at the downstream (i.e., retail) level. We are not the first raise the importance of downstream competition to explain exclusion upstream. Simpson and Wickelgren (2007), Abito and Wright (2008), and Asker and Bar- Isaac (2014) also touch on this. But their mechanisms are completely different than ours. Both Simpson and Wickelgren (2007) and Abito and Wright (2008) focus on exclusive dealing contracts. They show that exclusion with exclusive dealing contracts is virtually costless because intense downstream competition prevents retailers from appropriating any of the benefits of the additional upstream competition brought forward by a more efficient supplier. On the other hand, the mechanism in Asker and Bar-Isaac (2014), on the other hand, is about rent dissipation. Since entry reduces industry profits, the incumbent is willing to transfer some or almost all of his profit reduction from entry back to the retailers in the form of lump-sum rebates as a way to induce them to not facilitate entry. In other words, the incumbent uses these lump-sum rewards to make retailers internalize the effect on his profits of accommodating entry. The exclusionary mechanism in our paper is very different. Intense downstream competition allows the incumbent to exploit the contract incompleteness (or external effect) that arises from consumers heterogenous valuations. But there is more. Unlike when suppliers serve final consumers directly (which also allows the incumbent to exploit external effects), retailer competition also provides the incumbent with a form of endogenous commitment. If the rival supplier decide not to enter (or decide to exit), the incumbent would like to renegotiate the initial offers to the retailers and raise wholesale prices to both of them. The problem is that getting both retailers to renegotiate is not an equilibrium. This makes exclusion even easier when compared to the case where suppliers sell directly to final consumers. 3

4 References Abito, J.M., and Wright, J. (2008), Exclusive Dealing with Imperfect Downstream Competition, International Journal of Industrial Organization 26, Adams, W., and Yellen, J.L. (1976), Commodity Bundling and the Burden of Monopoly, Quarterly Journal of Economics 90, Armstrong, M. (2013), A more general theory of commodity bundling, Journal of Economic Theory 148, Armstrong, M., and Vickers, J. (2010), Competitive nonlinear pricing and bundling, Review of Economic Studies 77, Asker, J., and Bar-Isaac, H. (2014), Raising Retailers Profit: On Vertical Practices and the Exclusion of Rivals, American Economic Review 104, Bork, R. (1978), The Antitrust Paradox, Basic Books. Calzolari, G., and Denicolo, V.(2015), Exclusive Contracts and Market Dominance, American Economic Review. Chen, Y., and Riordan, M. (2013), Profitability of bundling, International Economic Review. Gans, J.S., and King, S.P. (2006), Paying for loyalty: Product bundling in oligopoly, Journal of Industrial Economics 54, Greenlee, P., Reitman, D.,and Sibley, D. (2008), An Antitrust Analysis of Bundled Loyalty Discounts, International Journal of Industrial Organization 26, Ide, E., Montero, J.-P., and Figueroa, N. (2016), Discounts as a barrier to entry, American Economic Review, forthcoming. McAfee, R.P., McMillan, J., and Whinston, M. (1989), Multiproduct monopoly, commodity bundling and the correlation of values, Quarterly Journal of Economics 104, Nalebuff, B. (2004), Bundling as an Entry Barrier, Quarterly Journal of Economics 119, Nalebuff, B. (2005), Exclusionary Bundling, Antitrust Bulletin 3,

5 Peitz, M. (2008), Bundling may blockade entry, International Journal of Industrial Organization 26, Simpson, J., and Wickelgren, A. (2007), Naked exclusion, Efficient Breach, and Downstream Competition, American Economic Review 97, Thanassoulis, J. (2007), Competitive mixed bundling and consumer surplus, Journal of Economics and Management Strategy 16,