Quantitative assessment of vertical restraints (2) Date, place and title of the Conference/seminar
Name of consultant and position
The Intel case In July 2007, the European Commission issued a Statement of Objection (SO) concerning Intel’s abusive conduct for 5 major computer OEM. A second SO, with additional evidence and involved parties was referred by the German C.A. and was issued in July 2008. Dell, HP, Acer, NEC, IBM and Lenovo, as well as a European retailer of microelectronic devices suffered from exclusionary marketing arrangements as well as other practices made by Intel, with the aim of reinforcing and expanding its dominant position to the expense of AMD. 2
The relevant market The product market is that of CPU (Central Processing Units). CPUs can be divided into x86 architecture and non-x86. The x86 is Intel’s standard design, which can run both Windows OS and Unix OS. There were many manufacturers of x86 CPUs before year 2000. They all exited the market, leaving only Intel, with a share of about 70%, and its competitor, AMD. The geographic relevant market is worldwide.
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Barriers to entry There are great entry barriers to the market, given mainly by: • R&D sunk costs • IP rights for the CPU architectures • High-tech production facilities • Considerable brand loyalty In light of Intel’s market share and the presence of entry barriers, the EC found Intel enjoying a dominant position. 4
Dominance and unlawful conducts In light of Intel’s market share and the presence of entry barriers, the EC found Intel enjoying a dominant position. Intel had two different kinds of unlawful conducts against its trading partners: • Conditional rebates • Naked restrictions
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Conditional rebates Intel awarded major OEMs high rebates, conditioned on excusive dealing restraints: • Dell was required to buy only Intel CPUs • HP had to purchase no less than 95%of its CPU needs from Intel, the remaining 5% yet subject to additional restraints. • NEC, had to purchase at least 80% of its CPU needs from Intel • Lenovo as Dell, was forced to purchase only Intel CPUs. 6
Establishing the infringement The Commission finds that the conditional rebates granted by Intel constitute fidelity rebates which fulfill the conditions of the Hoffmann-La Roche case-law. Beyond showing that case-law conditions were fulfilled, the Decision also conducted an economic analysis of the capability of the rebates to foreclose a competitor which would be as efficient as Intel, albeit not dominant.
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‘As efficient competitor’ analysis The test establishes at what price a competitor which is ‘as efficient’ as Intel would have to offer CPUs in order to compensate an OEM for the loss of any Intel rebate. It is a hypothetical exercise, which test whether a competitor which is as efficient as Intel but which seeks to offer a product that does not have as broad a sales base as that of Intel is foreclosed from entering. This analysis is in principle independent of whether or not AMD was actually able to enter. 8
Factors to be considered The analysis takes into consideration three factors: • the contestable share, which is the amount of a customer's purchase requirements that can realistically be switched to a new competitor in any given period • a relevant time horizon, which was defined as ‘at most 1 year’, which is the standard length of rebates programs, in this industry • a relevant measure of viable cost, that being ‘average avoidable costs’ 9
The rationale behind the ‘three factors’ If Intel’s rebate scheme means that given the contestable share, in order to compensate an OEM for the loss of the Intel rebate, an as efficient competitor has to offer its products below a viable measure of Intel's cost, then it means that the rebate was capable of foreclosing that competitor. This would thereby deprive final consumers of the choice between different products, of Intel and AMD, which the OEM would otherwise have chosen to offer, under normal competition in ‘price’ and quality (‘merits’ of the product) 10
A correct measure of ‘viable costs’ In order to base its assessment on a conservative cost measure, the Commission uses average avoidable costs (AAC) as a benchmark to assess the exclusionary effect of Intel's rebate schemes. If an as efficient competitor is forced to price below AAC, this clearly means that competition is foreclosed because the as efficient competitor incurs losses by making (incremental) sales to customers covered by the dominant firm's conduct. 11
Average Avoidable Costs The EC states that Intel’s approximation of AAC included "spending that can be attributed directly to the production of microprocessors" but did not include "R&D, marketing, and general and administrative expenses. They also do not include other costs of sales that cannot directly be attributed to specific parts". Thus this measure of cost clearly underestimated the avoidable cost in as much as it did not include types of cost that are avoidable. 12
Cost of Goods Sold Since Intel estimations were not backed up by real data, thus being not verifiable, the Commission chose as a prima facie measure, the Cost of Goods Sold (CoGS), which was directly available from Intel's audited accounts. The 2007 SO thus contained estimates of costs comprising 35% of the average selling price. Interestingly, the Commission indicated that some elements of variable, and thus avoidable, cost elements might be included in Intel's Marketing, General & Administrative expenses, which Intel had treated as non avoidable. 13
The econometric analysis The econometric analysis in the Intel case is brought in by Intel consultants to challenge the Commission choice of CoGS as a benchmark. Intel follows a "structured method" which relies on 'economic judgment', internal sources and the use of regression analysis, in order to determine whether a given cost component is to be considered avoidable or unavoidable.
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The econometric analysis (2) Intel uses qualitative evidence to identify the cost is avoidable or unavoidable. Then, quantitative evidence is checked to see if it does not provide a contradictory indication. Intel claims that regression analysis, is used for "assessing the extent to which changes in output affect changes in cost.“
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Regression analysis The output and structure of the regression analysis is kept confidential by the EC, yet, in the decision is explained Intel’s interpretation of regression results: â€˘â€ˆ If a coefficient is statistically significant but very small and both the economic analysis and the qualitative evidence suggest a cost is unavoidable, the cost is deemed unavoidable.
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Regression analysis (2) • If the coefficient on the independent variable (e.g., production volume) is negative and statistically significant, the cost is deemed to be unavoidable too. • In cases in which the qualitative evidence suggests a cost is avoidable, but regression results consistently indicate a lack of a statistically significant coefficient, qualitative inference is rejected.
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Methodological issues The Commission reminds, in the Decision, that there are many well known issues for empirical work, as for instance: • the risk that certain relevant variables are omitted, • the risk that the apparent conditional link or lack thereof is hidden by a higher level process simultaneously conditioning the two variables, • the risk of wrongly specifying the temporal dependence between the variables.
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Omitted variables These critiques are especially relevant to the case, since Intel performs successive regressions with only one independent variable each time: calculations are therefore, in primis, prone to the issue of omitted variables. E.g.: Assume that intermediate goods are substitutable to labor. Assumed also that, as a reaction to a sudden increase in demand, some labor force is reallocated to other direct production tasks. Regressions such Intel’s would show that labor is not significantly correlated with demand, and therefore, labor costs are not avoidable, which is incorrect. 19
Simultaneity “Simultaneity" refers to the fact that the two variables the correlation of which is assessed may be jointly determined in a common process. In the present case, most likely prices, costs and quantities are jointly determined. It is then not possible to infer from the raw correlations what share of each part of the cost can be avoided after a fall in demand, as a fall in output might for instance partly be the consequence of the increase of the price of a raw material that jointly determined the supply and the direct costs. 20
Simultaneity (2) Secondly, it is clear that firms react strategically in order to limit the negative consequences of an increase in their costs. In our example than, the firm would not transfer the increase into price to the full extent in order to limit the subsequent fall in demand. Then, the real direct influence of the change in demand would be underestimated due to simultaneous actions by the firm.
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Simultaneity (3) In the Intel case, an increase in the market price of a raw material, e.g. silicon, is likely to have several simultaneous consequences: a raise in price, but also a reduction in quantity, and a reduction in margins, since Intel has market power. So, this increase in price will decrease demand, creating a conditional negative correlation between sales and the use of silicon. But the overall correlation will be underestimated due to the strategic reaction of the firm in terms of process and pricing. 22
Time series issues The use of time series generally provides useful information but requires special care. It is well known that rigidities exist for the variations of some variables, such as labor for instance. Intel's methodology is likely to falsely conclude that costs which are indeed avoidable (although with a time lag) were unavoidable, as we can see with a simple example.
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Time series issues (2) Consider an example in which labor cost is avoidable, in the sense that output capacity is directly proportional to the number of employees. Assuming contracts with an employee can only be cancelled with three months' notice, the old employee will not be productive anymore and as well, a new employee will require too some months of training before becoming productive.
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Time series issues (3) Now, take that normal production is 100 units with 100 employees. At the beginning of the year, the factory is informed that it should only produce 99 units per quarter. The factory reduces its workforce to 99, but in terms of cost, this only takes effect in the second quarter: the change in cost occurs in different quarters than the change in output.
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Additional downfalls of the analysis The shortfalls of the regression analysis have been clearly outlined. But there is more: regression analysis were conducted where "it is plausible that cost must be incurred to produce or sell x86-compatible CPUs within a one-year period, and in which it is plausible that these costs vary with production levels." As such, the - unreliable - method is mainly applied to further exclude cost components, but not to include other cost components, that do not fall in the above definition. 26
Rejection of false positives In practice, the method is biased towards finding cost to be unavoidable. In a proper methodological framework: • a lack of a statistically significant positive correlation, or the presence of a negative correlation can be used to overturn other evidence suggesting that a cost is avoidable. • yet, a statistically significant positive correlation will not be used to overturn other evidence suggesting that the cost is unavoidable (if the coefficient is small). 27
The importance of the sign We saw that Intel’s consultants model mentions that a significantly negative coefficient in a regression analysis between output level and a cost component will show that the cost is unavoidable. As a matter of fact, in this kind of analysis, the presence of a negative coefficient in the regression is very much unexpected. Should it occur as a result, it is likely to indicate important biases in the estimation, which may be the cause of one or several of the misspecifications of the statistical model. 28
Some best practice When such an unexpected result occurs for one cost category, common scientific sense should have led Intel to question the validity of its model, rather than unquestioningly decide that the cost category is unavoidable, which is to its benefit. By the way, the analysis were conducted by a Professor of Management at the Graduate School of Business at Stanford University, whose name was kept confidential.
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Conclusions The Commission disregarded Intel’s econometric analysis, and in any case the case. The Decision concludes that the conditional rebates granted by Intel to Dell, HP, NEC and MSH constitute an abuse of a dominant position under Article 82. For that, and a number of other infringements, the Commission imposed on Intel a fine of 1 060 000 000 EUR.
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