PASS ON? ASK THE RIGHT QUESTION!

by Paolo Buccirossi and Alessia Marrazzo

We surfed the web looking for a nice quote pointing out the importance of asking the right question and we were spoilt for choice. It seems that most thinkers, whatever their field, had something to say about it. Then we found a sentence that fits our purpose perfectly. It goes: “We thought that we had the answers, it was the questions we had wrong”. Its author is Bono, the U2 frontman. Maybe he’s not the best authority, compared to Einstein, Cantor, Jung and the others. But that is our choice.

In (almost) every action for damages involving an overcharge, such as that likely caused by a cartel, sooner or later the pass on theme will emerge. Parties, experts, and judges ask the following question: did the direct purchaser of the product whose price was inflated pass on the overcharge to their customers? The question is further articulated in order to ascertain if the direct purchaser had the ability and the incentive to do so. Hence, additional and complementary questions arise, such as: could the claimant increase the selling price so as to recover, at least partially, the higher cost incurred to buy the cartelized input? What would be the reaction of other competitors and customers if it decided to charge a higher price? Tons of ink are then spent to find the answers to these questions. Unfortunately, they are wrong. Not necessarily the answers, surely the questions.

In dealing with the pass on, the right question to ask is: which price would the direct purchaser have charged to its customers if it had paid a lower price to purchase the input affected by the infringement, that is the input price that it paid minus the overcharge?

Let us clarify in which respects the latter question differs from the former (in case you did not notice the difference):

• the right question looks at a counterfactual world, the wrong question enquires an historical and factual reality;
• the right question tries to figure out what would have occurred if a firm lowered its price, while the wrong one asks if the same firm would have raised its price.

The first difference is the crucial one. The whole quantification exercise involves the reconstruction of a counterfactual scenario: what would have occurred in the absence of the infringement?

The estimation of the overcharge requires identifying the price that the upstream firms would have charged had the infringement not occurred, e.g. the price that would have prevailed in the absence of a cartel. The counterfactual upstream price is reasonably lower than the actual one: it is unlikely that a cartel caused a lower price.

The estimation of the pass on requires identifying the price that the downstream firms would have charged had the infringement not occurred, e.g. the price that would have prevailed in the absence of a cartel in the upstream market. Once again, the counterfactual downstream price is reasonably lower than the actual one: it is unlikely (to say the least) that the downstream firms would have charged a higher price had they incurred a lower cost.

Thus, to quantify the pass-on, parties, experts and judges should figure out the pricing decision of the downstream firm in case it faced a lower price of the upstream input, and estimate to what extent the downstream price would have been lower than the factual value in the absence of the infringement (and of the overcharge).

At this point the reaction might be: so far so good, but why bother with such punctilious clarifications? The reason is that we have seen many times courts and experts take the wrong road, misled by the wrong question. Let us give some examples. In several cases we read similar statements: “claimant faced strong buyers who enjoy significant bargaining power and would have resisted a price increase fiercely; therefore, it is unlikely that the claimant could have passed on the overcharge”; “although contracts include a price-indexing mechanism, in reality that clause has never been applied, showing that the cost increase was not passed on to customers”; “the claimant’s price was stable or falling during the infringement period, which indicates that it did not raise its price to offset the overcharge”; “the downstream market is highly competitive, so it is unlikely that claimants would actually be able to raise their price, which rules out any pass on”.

These statements may seem persuasive. Yet, they are wrong. When the right question is asked their wrongfulness becomes apparent. Let us prove it. First, if a claimant faces buyers with strong bargaining power, it is reasonable to argue that the buyer would have forced the seller to charge a lower price, had the seller’s cost been lower. Hence, the conclusion is that some pass on is likely. Second, if the contract links the selling price to the cost of a certain input, it indicates that that input matters in the downstream price formation: in a counterfactual scenario in which the input price was lower, the selling price would have been lower. Therefore, the pass on is possible. Third, no one would dare to argue that a declining price of a cartelized good is sufficient to prove that there was not an overcharge, since the price decrease could have been stronger in the absence of the cartel. Similarly, a historical reduction of the downstream price is perfectly compatible with the pass on story. Fourth, economic theory shows that cost pass through is likely to be stronger with perfect competition and this statement is intuitive when there is a cost reduction.

In conclusion: asking the right question is a good start to find the correct answer. And this is true also when investigating the pass on of an overcharge. The only reason we see for asking the wrong question is a form of linguistic laziness: avoid third conditionals. That is not enough!