Price Parity Clauses: Setting a new legal standard

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Editor’s note: This post is part of a series showcasing Barcelona GSE master projects by students in the Class of 2018. The project is a required component of every master program.


Authors:

Samantha Catalina Guerrero Putz and Josep Peya

Master’s Program:

Competition and Market Regulation

Paper Abstract:

Under the context of digital platforms who act as an intermediary between consumers and sellers, Price Parity Clauses (PPCs) is a contractual restriction for the seller not to sell at a lower price through any other channel (the so-called wide PPCs), or only in its own channel (narrow PPCs). These clauses present a trade-off between efficiencies and anticompetitive effects. On one side, PPCs act as a committing device of the seller to solve the show-rooming effect suffered by platforms (a particular form of free- riding), at the same time that it ensures platforms viability and enhances its incentives to invest and innovate. On the other side, PPCs allow platforms to charge higher fees, and lead to foreclosure of the market. Currently, neither the EC nor NCAs have set a clear guidance on how to assess these clauses. The main contribution of this paper is to set a legal standard for both wide and narrow PPCs using the cost-error analysis. The conclusions we arrived to are that wide PPCs should be per se illegal; and narrow PPCs should be presumed legal unless proven otherwise, except if narrow PPCs are eliminating the competitive restraints of the platform, in which case the standard should be that of rebuttable presumption of illegality.

Conclusions:

  1. Digital Economy will rise the use of Digital Platforms. Network externalities inherent to two-sided markets lead to high market power that make platforms an indispensable ally.
  2. Digital Platforms use PPCs and this is capturing the interest of Competition Authorities. But there is no consensus with respect to the legal standard.
  3. PPCs present a trade-off: On the one hand efficiencies results in reduction of search costs, prevents showrooming, incentives on investment and innovation. On the other hand, anti-competitive effects arise, creating high fees, foreclosure, collusion.
  4. The results of our cost-error analysis are that Wide PPCs Min Type II error, therefore should be Per se illegal. Narrow PPCs Min Type I error: Rebuttable Presumption of Legality, except if (i) One-Stop Shop/Network; (ii) Brand Positioning; (iii) Switching costs: Min. Type II: Rebuttable Presumption of illegality

Download the full paper [pdf]


More about the Competition and Market Regulation Program at the Barcelona Graduate School of Economics

2017 Competition Curtain Raiser, Part 1: Excessive Pricing

1168_1epanutin-anti-epilepsy-drug-spl-c0068990Photo credit: Pulse.

This is the first in a series of posts highlighting competition issues and cases that are set to drive the debate in Europe this year.

Pfizer and Flynn Pharma: a major decision from the CMA

On 7 December 2016, the United Kingdom’s (UK’s) Competition and Markets Authority (CMA) issued a potentially precedent-setting decision against pharmaceutical producer Pfizer and distributor Flynn Pharma, imposing a fine of nearly £90 million for excessive pricing.

In September 2012, Pfizer sold the distribution rights to its anti-epilepsy drug Epanutin (phenytoin sodium) to Flynn Pharma, which debranded (or “genericised”) the drug, with the effect that it was no longer subject to price regulation. Following the sale, Pfizer increased its price for phenytoin sodium to Flynn Pharma by between 780% and 1,600% relative to the price at which it had previously sold the drug in the UK, and in turn Flynn Pharma increased the wholesale price of the drug to between 2,300% and 2,600% of the former price.

A key feature of phenytoin sodium appears to be that patients taking the drug cannot readily switch to the same drug manufactured by another producer, since even minor differences in production processes could affect the efficacy of the drug in treating epilepsy in individual patients. Therefore, despite the fact that the drug was genericised, the CMA appears to have found that Pfizer and Flynn Pharma retained a de facto monopoly over the sale of the drug to existing patients taking Epanutin. Such a finding would also imply that alternative epilepsy treatments were not viable substitutes for phenytoin sodium in respect of the relevant patients, and were therefore not included in the definition of the relevant market.

The excessive pricing debate

The prohibition of excessive or unfair pricing by dominant firms is a controversial part of UK and European competition law (it has no meaningful counterpart in US legislation or case law). On the one hand, there are strong economic arguments, at least from a static point of view, for preventing a dominant firm from exploiting its monopoly position by charging prices higher than the theoretical competitive price. One of the key results of microeconomic theory (and indeed the foundation of competition policy) is that monopoly pricing lowers overall welfare compared to a competitive market outcome, since the monopoly maximises profits by producing a less-than-efficient quantity of the relevant good and selling it at a higher-than-efficient price.

However, enforcing a prohibition against excessive pricing presents various difficulties. One of these is to establish a benchmark price against which the actual price charged by the dominant firm is to be evaluated, and deciding whether the margin above this benchmark is excessive. According to the CMA press release, it appears to have had regard both to the initial regulated price of phenytoin sodium, and the price charged by Pfizer in other European countries, in reaching a finding of excessive pricing.

It is important to note, however, that there is no inherent reason why such prices should represent useful comparators. In other words, although a price increase of 2,600% naturally appears alarming at first glance, a range of factors could have resulted in the initial price being very low, especially if it was regulated. In this case, Pfizer and Flynn Pharma argue that the regulated price of Epanutin in the UK prior to September 2012 had been loss-making. It remains to be seen how the CMA established a relevant benchmark when its non-confidential decision is made public.

A further risk in enforcing a prohibition of excessive pricing, partly related to the issue discussed above, is that it could have a negative impact on firms’ dynamic incentives to invest across the economy. For example, over-enforcement could prevent a firm from earning economic profits where it has innovated in order to gain a temporary competitive advantage. More generally, over-enforcement runs the risk of creating uncertainty, and thereby lowering incentives to invest, if businesses fear that their future profits will be capped by a competition authority at a level which they cannot predict in advance.

For such reasons, economists such as Massimo Motta and Jorge Padilla (both teaching in the Competition masters at BGSE)  have proposed that excessive pricing provisions should be enforced only in cases where there is little or no prospect of the relevant market eventually correcting itself, and where a sector regulator would not be better placed than the competition authority to intervene (among further restrictive conditions). In this case the CMA may have concluded that the inability of other phenytoin sodium producers to compete for existing Epanutin patients created such a situation where entry is infeasible. Even so, the question remains whether this issue could not better be addressed through amending existing drug price regulation. The release of the CMA’s final decision is likely shed more light on this issue.

What to look out for in 2017

In the meantime, Flynn Pharma has appealed the CMA’s decision to the Competition Appeals Tribunal (CAT). 2017 could therefore reveal how the CAT views the different considerations surrounding excessive pricing, and to what extent the CMA decision will be applicable to other drugs and industries. The finding of excessive pricing also raises the prospect that Flynn Pharma’s customers, and specifically the UK Department of Health, could sue it for damages resulting from the high price, which would raise further interesting issues in so-called “private”  excessive pricing enforcement.

References

Evans, D.S. & Padilla, A.J. 2005. “Excessive Prices: Using Economics to Define Administrable Legal Rules”. Journal of Competition Law and Economics 1(1), pp. 97–122.

Motta, M & de Streel, A. 2007. “Excessive Pricing in Competition Law: Never say Never?” The Pros and Cons of High Prices, pp. 14-46. Swedish Competition Authority.

Price parity in two-sided markets: a new perspective

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects by students in the Class of 2016. The project is a required component of every master program.


Authors:
Sara Del Vecchio, César Ulate

Master’s Program:

Competition and Market Regulation

Paper Abstract:

Online platforms are believed to be beneficial to consumers in a number of ways. They facilitate consumers’ search and comparison, which in turn fosters competition between sellers. They drive the so called long tail effect that increases the variety of products offered, improving the consumer’s ability to find the right match for their needs. Platforms might adopt some particular measures aimed at protecting their profits, and potentially the viability of their business model. In the past few years, many online platforms have been under the scrutiny of various competition authorities regarding a particular clause they include in their contracts with sellers commonly called ’price parity clause’ or more specifically Across Platform Parity Agreement (APPA), this limits the seller’s ability to set lower prices (or better conditions) on other sale channels. At face value, price parity seems like a restriction on sellers’ pricing abilities which benefits consumers, as they can enjoy increased value service at apparently no additional cost.

We build a stylized model and we show that platforms can increase welfare and have pro-competitive effects, while price parity clauses are generally harmful for consumers surplus and welfare, nevertheless they can be good if they are indispensable for the platform viability.

Introduction:

The price parity clause included in platforms’ contracts with sellers, can be categorized as narrow or wide according to the scope of the price limitation. As illustrated in the figure below a ‘narrow APPA’ (the purple rectangular in the figure) refers to a clause where the seller is restricted from charging a lower price on their direct channel. By contrast, a ’wide APPA’ (the orange rectangular in the figure) is when the seller is limited from setting a lower price not only on their own website but also on any other competing platform. This will allow the platform to make claims, such as the ’best price guarantee’ as shown in the figure.

chart
Narrow & Wide Across-Platform Parity Agreements

Online platforms often argue that they need to include this constraint on seller’s price, otherwise consumers would just free ride on the platform services, and then complete the transaction on the seller’s own website which offers a lower price. At the same time, such clause in the seller-platform contract might generate anticompetitive effects, In particular, they may raise costs for sellers, which in turn are reflected into higher prices for consumers. Sellers pay a fee to intermediaries, which are insulated from competitive pressure due to the price parity clause itself.

Indeed, in the past few years many online intermediaries have been under the scrutiny of various competition authorities regarding APPAs that they were including in their contracts with sellers. There have been several cases across the world related to this clause, starting from the Apple eBook case in 2013, until the recent series of investigations in Europe regarding the online travel agent Booking.com.

In particular, the Booking.com case shows some inconsistencies in the decisions across Europe, in most of the countries (including UK, France, Italy and Sweden), Booking.com settled by agreeing to allow online travel agents, to offer lower room rates via Booking.com’s competitors, by dropping its wide APPA, restoring competition between online travel agencies. The commitments do allow Booking.com to retain its narrow APPA for prices and booking conditions, ensuring hotels offer the same rates and conditions that are provided on their own direct website. In Germany, instead, the Bundeskartellamt decided also to prohibit the narrow APPA. Nevertheless, in France they recently passed a Law (la Loi Macron) whereby they made APPAs illegal per se, with the aim of liberalising the economy and boosting growth. Furthermore, would be desirable more guidance on how to set out the most appropriate theory of harm in order to have convergence at European level in relation to these clauses.

Modeling Approach:

In this paper we build a stylised model with three different types of rational agents: (i) sellers, (ii) platforms and (iii) consumers. They all take sequential decisions in an infinitely repeated game. We include different search costs for consumers depending on the channel used to search and purchase a product. We focus only on pure strategies that lead to a particular Sub-Game Perfect Nash Equilibrium (SPNE) where all agents participate. We compare this SPNE across different scenarios: from the setting where there is a monopoly platforms, to the setting where we have competing platforms. We look at the equilibrium prices and welfare that arise in each of these scenarios with and without narrow and wide APPAs. Finally, we compare it to the counter-factual where no platform operates in the market.

Findings and Conclusion:

In terms of policy approach towards these clauses, our findings are in line with great part of the literature with respect to wide APPAs. Our model suggests that under no condition this clause can have pro-competitive effects, therefore the current European move towards a prohibition seems economically sound and sensible. With regards to narrow APPAs, instead, we believe the current call in many European countries for an outright ban could be detrimental for welfare, as it overlooks the benefits that platforms bring to the market. Indeed, we find that under some conditions these clauses despite limiting competition, do lead to efficiencies that the authorities should take into account.

We conclude that the existence of a platform is in general good, because as a first order effect it increases the number of transactions and reduces search costs for consumers. However, we find that prices will only be lower if there is effective competition between platforms. Furthermore, if the platform is not able to recover its costs though sales, then the viability of the platform may depend on the existence of the APPA. Hence, as shown the narrow APPA decreases welfare unless it is indispensable for the platform to operate.

Three-legged Centipede Game

An essay by Chaoran Sun ’15, Barcelona GSE Master Program in Competition and Market Regulation


Robert Aumann once complained in the foreword of Roth and Sotomayor (1992):

It is sometimes asserted that game theory is not “descriptive” of the “real world”, that people don’t behave according to game-theoretic prescriptions. To back up such assertions, some workers have conducted experiments using poorly motivated subjects, subjects who do not understand what they are about and are paid off by pittance, as if such experiments represents the real world.

Indeed, it is all too familiar for us hearing people cite Rosenthal’s centipede Game as an evidence that game theory is not “descriptive” of the “real world”. When faced with the follow-up question as to why game theory doesn’t work, they usually pointed out that it lies in game theorists’ obsession of some obviously mistaken assumptions associating with common knowledge, unbounded rationality, et cetera.

In this essay, we argue that, at least for Rosenthal’s centipede game, it’s not the case game theory is inconsistent with the findings of experiments that subjects don’t wind up on the backward induction path. To be precise, even though we accept the strong assumption of common belief of rationality, which is everyone believe everyone plays rationally, everyone believe everyone believe everyone plays rationally, ad infinitum, we shouldn’t expect backward induction path as an unavoidable outcome. The example presented here is well-known, and this essay only serves for expository purpose.

To begin, let’s have a look at technical difficulties. Since there’s no way for a player to mind-read another player, it’s absurd to assume away the possibility that one player’s subjective belief on her opponent’s strategy doesn’t coincide with the objective one1. Furthermore, we can’t stop there. What about players’ belief on their opponent’s belief, belief on beliefs on beliefs…If you wonder high-order beliefs might only have a negligible effect on the outcome of games, think about the dirty face and sage game and Rubinstein’s electronic mail game. This ever-increasing hierarchy of beliefs makes a fine line for common knowledge of game structure, the starting point of every game theory analysis, impossible. In a series of conceptual breakthroughs, Harsanyi (1967-68) postulated that this belief hierarchy can be summarized as a type so that “relaxing” the stringent requirement of common knowledge is tantamount to adding types in a game of incomplete information. It is also noteworthy that, a belief of a higher rank contains strictly more information than those of lower ranks, so it’s reasonable to require that beliefs of different ranks shan’t contradict with each other. The technical breakthrough came when Mertens and Zamir (1985) cast belief hierarchy with this coherency property into a category theory object, inverse limit and went on proving that Harsanyi universal type space attains a self-referential property, each player’s type is equivalent to a joint distribution of her opponent’s strategy and type. Now we have set the stage for the analysis of the centipede game.

centipede game

Consider a three-legged centipede game of incomplete information with Harsanyi’s universal type space. Ann of type a believes that Bob plays “In”, while Ann of type b believes that Bob plays “Out” . Bob, on the other hand believes Ann is type b and plays “Out”. Then we have:

Claim. At state (a, (In, Out), Out) whose outcome is different from backward induction path, Ann and Bob share a common belief of rationality.

What we need to verify for common belief of rationality are, at the given state:

  1. What Ann believes implies Ann is rational.
  2. What Ann believes Bob believes implies that Ann believes Bob is rational.
  3. What Ann believes Bob believes Ann believes implies Ann believes Bob believes Ann is rational.

. . . . . .

Notice that we only need to check the first three steps, what Ann believes Bob believes Ann believes is the same as what Ann believes Bob believes Ann believes…Bob believes Ann believes. They’re indeed the case. Next, apply the same procedure to a case with Ann and Bob interchanged.

Remark. When conducting experiments, we should be careful about how well subjects understand games they’re playing, how well they know about the opponents they’re play- ing against. Experimental findings in disfavor of backward induction might indicate that epistemic conditions for backward induction are not satisfied. Common knowledge of game structure and common belief of rationality, saving us from arbitrariness of off- equilibrium paths, could be relevant to resolving real world economic problems, if put into perspective.

References

  1. Aumann, Robert J. Backward induction and common knowledge of rationality. Games and Economic Behavior (1995), 6-19.
  2. Aumann, Robert J. On the Centipede Game. Games and Economic Behavior (1998), 97-105.
  3. Binmore, Ken. A Note on Backward Induction. Games and Economic Behavior (1996), 135-137.
  4. Harsanyi, John. Games on incomplete information played by Bayesian players. Parts I, II, III. Management Science (1967-1968), 159-182, 320-334, 486-502.
  5. Mertens, Jean. F. and Shmuel Zamir. Formulation of Bayesian analysis for games with incomplete information. International Journal of Game Theory (1985), 1-29.
  6. Roth, Alvin E., Sotomayor, Marilda A. Oliveira Two-Sided Matching: A Study in Game-Theoretic Modeling and Analysis. Cambridge University Press (1992).
  7. Stalnaker, Robert. Knowledge, belief and counterfactual reasoning in games. Economics and Philosophy (1996), 133-163.

One of central question in game theory was under what setting, common belief of rationality implies backward induction. When Aumann(1995), (1998) derive backward induction path as a consequence of common knowledge of rationality rather than common belief of rationality, it attracted a lot of criticism related to the aforementioned reasoning that knowledge, for being necessarily true, is too strong (see Binmore(1996) and Stalnaker(1996)). In this essay, when we say a player believes an event, it means that player believes that this event is obtained with probability 1.

Providing effective mechanisms to fight barriers to competition in Mexico

Editor’s note: This post is part of a series showcasing Barcelona GSE master projects by students in the Class of 2015. The project is a required component of every master program.


Author:
Fernando Cota

Master’s Program:
Competition and Market Regulation

Paper Abstract:

The project analyses the current legal faculties that the Mexican Competition Authority has to fight and remove barriers to competition. Given the limited powers of the authority and the pervasive character of those barriers and their negative impact on Mexico’s economy, the Authority’s faculties are considered insufficient. Then the project studies the Spanish Ley de Garantía de Unidad de Mercado and how that law provides effective mechanisms to fight some barriers to competition. Finally, considering Mexico’s constitutional and institutional framework, the project proposes some modifications in the Competition Law in order to incorporate those mechanisms.

Read the paper or view presentation slides:

 

The end of the master’s in two acts

Competition and Market Regulation student Fernando Cota ’15 just finished his master project. Here’s how he celebrated:

https://twitter.com/fer_cota/status/609025041460793345

One of the perks of studying in Barcelona…

Graduation is right around the corner! Stay tuned in July and August for examples of this year’s master projects.

Photo Diary: Exams Winter 2015

How masters and PhD students are surviving finals this month…

Staking out a cozy corner in the library

 

It’s all about the snacks

 

Moments of Zen

 

A little help from our friends

 

Have a photo you’d like to share? Email it to thevoice@barcelonagse.eu or mention @barcelonagse on Twitter or Instagram

Bundling, information and two-sided platform competition – Job Market Paper

authorThe following job market paper summary was contributed by Keke Sun (IDEA). Keke is a job market candidate at UAB. Her research interests include Industrial Organization, Venture Capital Markets and Innovation.


Two-sided markets are economic platforms that connect two interdependent groups of users together and enable certain interactions between these two groups of users. The main characteristic of two-sided markets is the indirect network externalities, meaning that one group user’s benefits of joining one platform depends on the number of users of the other group on the same platform. My job market paper studies the impact of pure bundling and the level of consumer information on two-sided platform competition.

The Story

This paper is motivated by the casual observations from the smartphone operating system industry. The operating system (OS) platform connects consumer and application developers, the major competitors are Android by Google and iOS by Apple. Apple also has its amazing in-house handset, iPhone, it bundles the handset with the OS platform.

ios

The Main Results

The leverage theory has established that, in standard one-sided market, if a firm can commit to pure bundling, when consumers have homogeneous valuation of the bundling product, pure bundling reduces equilibrium profits for all firms. Therefore, bundling is usually adopted to deter entry or lead to foreclosure (see Whinston (1990) and Carlton and Waldman (2002) ). However, in a two-sided market, if a platform could commit to aggressive pricing on one side and gain a larger market share. Hence, it becomes more valuable to the users on the other side. I show that, in the presence of asymmetric network externalities, when consumers have homogeneous valuation of the bundling handset, bundling may emerge as a profitable strategy when platforms engage in “divide-and-conquer” strategy: subsidizing the low externality side (consumers) for participation and making profits on the high-externality side (developers). That is, when the benefits of attracting one extra consumer are very strong, committing to aggressive pricing can be profitable without inducing the exit of the rival.

This paper also studies the impact of the level of consumer information on platform competition and the emergence of the bundling decision. Most literature on two-sided markets assumes that all agents have full information about prices and others’ preferences; therefore, can perfectly predict others’ participation decision (see Rochet and Tirole (2003), Caillaud and Jullien (2003), and Armstrong (2006) etc.). Following Hagiu and Halaburda (2014), I use the setting of a hybrid scenario in which some consumers are informed about developer subscription prices and hold responsive expectations about developer participation, while the remaining consumers are uninformed and hold passive expectations. This setting should be a good fit of a situation where information may be less than perfect for some users on different sides of the platform. For instance, some consumers don’t know how much Apple or Google charges the developers for listing applications. Information intensifies price competition with or without bundling. Bundling is more effective in stimulating consumer demand the larger proportion of informed consumers, but bundling is less likely to emerge as the fraction of informed consumers increases.

Strategy and Policy Implications

From a strategy perspective, this paper shows that both platforms have incentives to affect consumers’ knowledge regarding developer subscription prices. Without bundling, both platforms have incentives to withhold the information because consumer information intensifies price competition on both sides. However, when bundling does occur, the two platforms may have different attitudes towards consumer information. The bundling platform prefers a high level of consumer information because bundling is more effective to stimulate consumer demand. The competing platform wishes to withhold the information as it gets worse off as the level of consumer information increases. This paper also shows that when the network externalities are strong, it is more profitable for the platforms to be more aggressive.

From a public policy perspective, this paper provides recommendations concern bundling and information disclosure. Due to the existence of (positive) network externalities, consumer surplus increases with the number of developers on the same platform. Bundling does not only affect consumer subscription prices, but also affects the perceived quality of platforms as it affects developer participation. It has shown that pure bundling improves consumer welfare mainly because it offers a lower subscription price and more application variety to the majority of consumers. For the same reason, even when bundling implements second-degree price discrimination, bundling still improves consumer welfare. Also, information disclosure unambiguously improves consumer surplus by lowering subscription prices on both sides of the platform and improving developer participation. Thus, information disclosure should be encouraged or mandated for consumer’s sake.

Paper abstract and download available on Keke’s website

The wisdom or stupidity of the crowd(funding)

Pedro Hinojoauthor is a student in the Barcelona GSE Master in Competition and Market Regulation. Follow him on Twitter @pedrohinojo.


Crowdfunding can be defined as the peer-to-peer provision of financial resources, from the crowd to a particular project or venture. This is usually done via online platforms that forego the need of face-to-face interactions, slashing transactions costs and allowing the fundraiser to reach a wider audience.

This phenomenon started with a non-profit orientation, as donations channelled to political or development campaigns. Reward-based crowdfunding became more relevant later on, where a product is delivered to consumers who finance the project pre-development, usually at a discount or with other ‘perks’ (such as limited editions, first releases, recognition or references in the credits). Even if reward-based crowdfunding entails (economic) advantages for the fund providers, it is tagged as non-profit because these consumers value non-economic benefits (Belleflamme et al, 2013), such as the sense of belonging to a community (a reason for the funding scheme’s popularity in creative industries like films, music and videogames). Reward-based crowdfunding is rooted in the marketing concept of crowdsourcing, whereby firms take advantage of the crowd to obtain ideas, feedback, and solutions to corporate challenges (Schwienbacher and Larralde, 2010).

image source: mindwize.nl
image source: mindwize.nl

But crowdfunding has become relevant when moving towards a profit and investment orientation, be it credit-based or (notably less frequently) equity-shaped (Wilson and Testoni, 2014). In this fashion it is bound to become an alternative source of finance to the real economy when the traditional banking channel is temporarily subdued after the crisis (if not permanently due to more stringent capital requirements). Furthermore, it should benefit primarily small, nascent and innovative firms (which are among the most credit-rationed), especially when they produce unique goods whose features can be communicated easily through the internet.

Therefore, crowdfunding platforms put in contact a crowd of investors with entrepreneurs whose projects need financing. In principle, crowdfunding allows lenders to receive a (higher, although riskier) remuneration for their investment and entrepreneurs to get (cheaper) credit for their projects. Apart from these pecuniary benefits, the entrepreneurs can also promote their brand and products and engage with potential customers through crowdfunding platforms. Therefore, these platforms become essential not only to minimize intermediation costs but also to generate network externalities that attract good projects and a huge crowd of investors. Furthermore, projects appealing to crowdfunding have less geographical constraints in finding sources of finance than with traditional vehicles (Agrawal et al, 2013).

Nonetheless, crowdfunding comes at a cost for entrepreneurs (Agrawal et al, 2013). First, they lose the contact with rather professional investors, who can provide even more valuable advice than a crowd of individual consumers. Other sources of finance for these nascent or innovative firms, like venture capital or (to a lesser extent) angel investors, do provide some technical advice (beyond the funding) to assess the project’s feasibility (and help to improve it if needed).

Second, they may have to disclose some information in the online platforms, something which could be critical in nascent and creative/innovative activities. If some commercially sensitive information becomes publicly known to some extent, incumbents (less credit-constrained) can adapt these new ideas to their business, hammering potential competition from new entrants.

Crowdfunding also poses market challenges, given that imperfections which affect the financial sector are amplified. In financial markets information is far from perfect because it is both incomplete and asymmetric. Information is incomplete because agents cannot control results with their actions in an environment of risk and uncertainty. This problem is amplified in the context of crowdfunding where small, nascent and innovative firms are involved, with riskier projects (Llobet, 2014).

Moreover, information is asymmetric for borrowers and lenders, leading to moral hazard and adverse selection. Moral hazard arises because once borrowers have received the funds, they have the incentive to misbehave and refuse repayment, while the lenders find it difficult to monitor whether these eventual repayment problems are caused by misbehaviour or pure bad luck. Adverse selection happens because lenders cannot discriminate borrowers’ quality, so they charge a high cost to offset potential losses (or even ration credit), jeopardizing paradoxically the best borrowers.

Again, asymmetry of information may be amplified within the crowdfunding context. Given that lenders are now a crowd, it is very likely that each of them only holds a small part of the total investment, reducing incentives to carefully monitor with due diligence the borrowers’ ex ante quality or ex post conduct. In this case, the lack of geographic bonds enabled by crowdfunding is a hitch for lenders to track borrowers in the post-investment phase (Wilson and Testoni, 2014).

In addition, this crowd of lenders will be composed mostly of non-professional investors, so, even if they devoted time to assess the borrowers’ projects, they could lack the necessary skills. And, finally, a crowd of investors would have to face problems of collective action. Against this backdrop, the borrowers might also find less incentive to repay if they use crowdfunding platforms as a one-off bet to raise funds, without any discipline effect coming from repeated interactions or reputational issues.

Bearing in mind these market failures, there is some room for regulation. Considering some international cases (such as the US, the UK or Spain), the regulatory response usually adopts a paternalistic tone: restrictions to the investment by agents (especially individuals who are non-professional investors) and to the amount a project can raise. Crowdfunding platforms are subject to registry requirements similar to other financial intermediaries, although there may be exceptions for small projects. These exceptions can be sources of distortions if firms scale down their projects to fall below certain thresholds (Hornuf and Schwienbacher, 2014)

In order for public intervention to beat the market, regulation ought to be well targeted. Limits to the exposure of non-professional (low-income) investors are rational given their lack of skills, the risks of herd behaviour, path dependence (Agrawal et al, 2013), and the high risk-profile of these investments (Dorff, 2013). However, setting stringent caps on the maximum raisable amount for projects may squeeze the sector’s (and the whole economy’s) development.

Furthermore, the sector itself can provide some solutions to these market failures. For instance, crowdfunding platforms normally charge a fee for every successful project, (which raised the same or more funds than it had pledged). This strategy gives the platforms the right incentives (skin in the game) to monitor and screen projects, so that small (non-professional) investors are relieved of that assessment.

Besides, most crowdfunding platforms opt for an All-Or-Nothing (AON) or a ‘provision point mechanism’ model, whereby projects which do not raise the amount of funds they had pledged will not receive anything. Platforms opting for the Keep-It-All scheme (KIA, whereby projects receive all the funds they have raised even without having achieved their goal) would see higher funding costs charged to those projects (Cumming et al, 2014), given that underfunded projects (which would still receive the funds in the KIA scheme) have less likelihood to succeed.

To conclude, crowdfunding offers a promising venue to spur innovation, creativity and firm growth. The regulatory response must allow that development while ensuring that no substantial amounts are invested by those individuals lacking the skills and the resources needed to cope with the complex and risky investments (See Kay, 2014, whose contribution also served as an inspiration for the title of this post).

Mexican Energy Reform: A trigger for competition in the Mexican energy sector – Antonio Massieu ’13

Editor’s note: The following post was written by Barcelona GSE alumnus Antonio Massieu (Competition and Market Regulation ’13). Antonio is Senior Associate at Santamarina & Steta S.C. in Mexico City. 

Flickr / CC
Mexico City illuminated at night / Flickr / CC

The energy industry in Mexico is experiencing the biggest paradigm shift in the past seven decades, since the oil expropriation in the late 30’s. The energy reform that was recently enacted will dramatically change the way the energy sector is developed in Mexico, meaning the most significant economic happening since the execution of NAFTA, in 1994. Said reform will shake the Mexican energy industry vigorously, transforming a monopolistic sector operated by two state companies that performs the vast majority of the productive sector activities, into an open-market industry where players can freely participate through clear and transparent rules, under the regulation of operators and agencies endowed with broad powers. The profound changes brought by the reform occurred both in the substantive areas of the industry and in the institutional structures that shape the energy sector. In one hand, the new legal framework redefined the way the activities that constitute the productive chains of the hydrocarbons and electricity sectors are carried out; in the other hand, the institutions responsible for supervising and regulating the market performance were considerably strengthened.

Naturally, as a new market emerges, market problems also emerge. Therefore, it will be essential that the new Mexican energy market is wrapped by rules and institutions that seek to correct eventual market failures that arise, and that through their actions, establish an appropriate competitive process that yields benefits to competitors, to final consumers, and of course, to the Mexican State.

Oil&Gas

Modifications made to the Mexican Oil&Gas sector meant undoubtedly, the most important change in the whole energy industry, as a result of the energy reform. Said sector becomes an open market, where Petroleos Mexicanos (Pemex) –formerly the State-owned company that carried out all Oil&Gas exploration and exploration (E&E) activities, will compete against other players from the private sector. This competitive process is implemented through tenders conducted by the federal government, where both the private sector and Pemex will freely participate, in order to be granted with contracts for substantive E&E activities. Transparency will be an element of the utmost importance during the bidding rounds, since it will secure that Pemex and the private sector compete on equal grounds; in other words, a fair and clean competition process will only be possible as long as the federal government does not favor Pemex –which despite its participation in the open market, will remain as a state owned company- or any other bidder in the development and further resolution of the aforementioned bidding rounds, or allow any anti-competitive practices to take place (such as collusive behaviors among the bidders).

pemex
A fair and clean competition process will only be possible as long as the federal government does not favor Pemex / Flickr / CC

As for midstream activities, the energy reform introduced a new market dynamic that will foster a more effective and fair competition process. Currently, the activities of transport, storage and distribution that are developed through the pipeline grid will be operated and managed by a new government agency, the National Center for Control of Natural Gas (CENAGAS). This entity will assume control and ownership of all pipeline infrastructure that today belongs to Pemex[1] – which, due to its economic features, constitutes a natural monopoly-, and administer the activities carried out there. The CENAGAS will operate as a figure internationally known as an “ISO” (independent system operator), and will be obliged to fulfill important mandates, such as granting open and non-discriminatory access to the grid to all participants (including Pemex) and avoid problems of vertical integration in regulated activities, among others.

[1] More the 75% of the pipelines in Mexico belong to Pemex.

Electricity

The electricity sector in Mexico will also be transformed significantly by means of the energy reform, since it will stop being a vertically integrated industry where a State-owned company (Federal Electricity Commission “CFE”) conducts all activities of the productive chain industry, in order to be transformed into a liberalized sector where undertakings (both public and private) will compete against each other in an open market, aiming to satisfy the needs of consumers.

For such purpose, a wholesale spot market will be put into place. Said spot market will seek to replicate international models in order to foster competition among different companies that will be able to generate, trade and supply energy to final users. Domestic supply will be carried out by CFE –at a regulated tariff-, acquiring energy through tender processes, while industrial supply will happen through a free competition process, where generators, suppliers and consumers will complete transactions at market, non-regulated prices. In order to regulate the new market structure, the Government created the National Center of Energy Control (CENACE), which will serve as an ISO, aiming to operate and control the electric grid.

CENACE will be in charge of different relevant tasks, such as the granting of open access to undertakings participating in the electric industry, controlling the allocation of power into the grid (both demand and supply), surveilling the continuous bids posed by market participants into the spot market (in order to avoid coordinated anti-competitive effects) and coordinating the transactions executed by the market players, as well as the configuration of the market, in terms of possible vertical integration in the performance of activities by companies. This market will be particularly interesting in terms of competition policy, since CENACE will be in charge of regulating the operation of a natural monopoly –the electric grid- which is owned by one of the participants of the market, the CFE, which will compete against other undertaking in the activities of generation and supply of power; this represents a very unique case in the world, and will be added as one of the main challenges that Mexican authorities will face with the implementation of the energy reform.

CENACE  operates and controls Mexico's electric grid. / photo
CENACE operates and controls Mexico’s electric grid. / photo credit

Regulators and entities of the energy sector

One of the great challenges of the reform is to establish an institutional framework capable of operating the new emerging energy markets in Mexico, in which various companies (public and private) will interact in a competitive environment, hitherto unknown for the country. Of course, in order to accomplish this goal, it is imperative to create strong institutions, with high degrees of independence, able to issue clear regulations and impose heavy penalties to regulated undertakings.

Both regulatory agencies[1] and ISO’s will need to follow closely the development of the energy markets, and make sure that competition is achieved. Unlike what happened with the IFETEL, which is the independent body responsible for regulating the telecommunications market in Mexico, regulators and ISO’s in the energy sector were not endowed with broad powers in competition policy matters. In this sense, and despite some of its powers seek to create conditions of competition, these institutions will have to interact closely with the Federal Competition Commission, in order to timely detect and punish anti-competitive practices in the industry, in order to correct market failures and increase consumer welfare.

[1] Regulatory Commission of Energy and National Hydrocarbons Commission

Conclusions

Energy reform emerges as a great opportunity for Mexico to join the global trailblazers in the sector. At first glance, the work has been done satisfactorily, as sufficient legal and institutional conditions for implementing competitive markets were generated, where agents will interact correctly, generating consumer welfare. However, the correct development of the industry will depend not just on the rules and the institutions itself, but on the right behavior of both authorities and undertakings. Possibly the only advantage that Mexico has to be the second-to-last country in the world to undertake an opening process of this nature, is that it had the opportunity to study similar processes, and learn from positive and negative experiences in other countries. Now the challenge is to test that knowledge, and build a successful energy sector that can boost growth in the country.

Listen to a radio interview with Antonio Massieu on hydrocarbons in the Mexican energy sector (in Spanish, September 2014)


1 More than 75% of the pipelines in Mexico belong to Pemex.

2 Regulatory Commission of Energy and National Hydrocarbons Commission