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The First Annual Conference on Competition Law, Economics and Policy in South Africa

Monday, 21 May 2007 Chalsty Teaching and Conference Centre, Oliver Schreiner School of Law Building, University of the Witwatersrand, West Campus

Aviation Industry Topic: Standards to Evaluate Predatory Behaviour

Presentation by: Dr. Joachim Vermooten E-mail: [email protected] Cell: 083 468 2111 Mecan Consultancy (Pty) Ltd (Micro Economics and Accountancy Network)

Key Competition Issue Predatory Behaviour in Airline Industry • Airline Industry perspective • Statutory Standards o South Africa o USA - Re-authorisation of US DOT (1998 to 2001) o Canada – Legislation (Abuse of Dominance) and Regulations (Anticompetitive Acts of persons operating a Domestic Air Service)

• Key cases o o o o

USA – American Airlines (AMR) – (1999 to 3 July 2003) Canada - Air Canada - July 2003 Germany - Lufthansa/Germania – 22 February 2002 USA - Spirit Airlines Inc. v Northwest Airlines Inc. - 9 November 2005

• Salient Principles to Consider





Salient Competition Concerns in the Airline Industry 

Airline Alliances and Code-share Agreements o Mergers and Acquisitions o Collusive Restrictive Practices o Abuse of Dominance



Predatory behaviour by means of: o Price o A combination of price and capacity Incumbent overlay network of new entrant and swamp the low fare market with frequency or capacity (more seats) whilst protecting its high revenue market with loyalty schemes

o Using competitive tools other than price and quantity Bracketing of flights (Schedule flight by a few minutes to those of smaller airlines) forcing them out of the market



Abuse of dominance -

Foreclosing access to travel agents by abusing dominance of CRSs (warning travel agencies not to issue tickets for the competitors using its mechanical or manual ticketing systems) Co-ordination by means of Commercial inter-airline agreements (e.g. Code-sharing, co-ordination of schedules and Franchising) reducing competition Impediments to gate access and other airport facilities or services Refusing to interline, joint ticketing and baggage handling/transfer services Loyalty Schemes (Large Volume Discounts, Travel Agent Commission Overrides (TACOs), Frequent Flyer Programmes (FFPs))

The Old Fashioned Way of doing Business • First: We cut our prices, substantially • Then: We drive our competitors from the market • Finally: We increase our prices

Predatory Behaviour in the Airline Industry

Predatory Behaviour (Particular form of anti-competitive behaviour, or abuse of dominant position) • The practice of temporarily selling at prices below cost, with the intention of driving a competitor from the market, so that in the future prices can be raised and higher profits be made (Hanlom P) • Existing firms reduce the profitability of entry by: – setting lower prices, or – by producing greater output, or – by producing different mixes of output, – so that the potential profits of entrants are reduced. – The predatory firm sacrifice some of their own profits in the short term in order to recoup such (investment) with higher profits later. (Dodgson IS, Katsoulacos Y and Pryke RWS)

• The foregoing of maximum current profit in order to eliminate competitors or deter or delay entry, so that greater profits can be earned in the longer run. (Dodgson IS, Katsoulacos Y and Pryke RWS)

Predation Process in the Airline Industry • Major airline establishes dominance at hub airport • Dominance allows major airline to price well above competitive levels • Upon new entry at a major airline’s hub, dominant airline responds with below-cost pricing, capacity dumping, and/or a number of other predatory practices until the new entrant is driven out from the market • Once the new entrant is driven out of the market, dominant airline raises prices to levels higher than those prevailing before the new entrant attempted entry Source: Prof Paul Stephen Dempsey Predation, Competition & Antitrust Law: Turbulence In The Airline Industry. 2002

Clash of Business Models Competition between FSCs and LCCs Differentiation – Full Service Network Carriers (FSCs) (Market segmentation, different value propositions, Business Fare Model, Ramsey Pricing)

– Economies of Scope (Networks, Hubs, Loyalty Schemes)

Low Price Competition – Economies of Scale – Low Cost Carriers (LCCs) (Limited service offering, Processes, Standardisation)

Pricing Models of Airlines Business Network Pricing Model Full Service Carrier (FSCs)

Offer essentially the same seat at different prices according to time of demand before the flight Different versions controlled by conditions or restrictions of the ticket and availability restricted by Computer Reservation Systems (CRS or GDS) Pax support (foreclosure) by loyalty schemes like Frequent Flyer Programmes (FFPs) Essentially business pricing subsidise economy tariffs

Time Sensitive Traffic Price Inelastic Business Pax

Time Insensitive Traffic Price Conscious Leisure / Discretionary Pax

Low Cost Revenue Model

Low Cost Carriers (LCCs)

Offer higher density of seats in aircraft than traditional airlines and less or no “frills” (reduced service at lower cost) Much simplified fare structures (less conditions or restrictions) of freely available on the internet Pax support as result of low prices Economies result from lower costs and much higher usage (utilisation) of aircraft, (operating higher frequencies) and higher productivity of staff

One class of Leisure Traffic

Traffic Flow the Airline Industry Essential differences between competition in the airline industry as opposed to other industries Principal effects of network competition in the airline industry are the ability to manage flow traffic and compete over alternative routings and the market power that comes with dominant hubs in route networks. •

Airline products compete over Multiple Dimensions of the Airline Product (Service Offering) and

•

Airlines compete over networks (not only route to route (city-pair) basis)

Airlines Compete over Multiple Dimensions of the Airline Product (Service Offering) • Ticket price; • Frequency (Number of flights a day) and the timing of those flights; • Characteristics of the flight itinerary (non stop, continuing single-plane service, or connecting service) • In-flight amenities including: o Service level, Food, In-flight Entertainment o Seat pitch (how closely spaced together);

• Ground amenities including club lounges; • Loyalty schemes (Rebates to the client & traveller) in the form of : o Frequent flier programs o Travel agent commission overrides (TACOs), o Corporate discounts;

Overlay of routes by Network Airlines LCC identifies underserved market opportunity on sector B-C FSC re-routes existing network e.g. Traffic on Sector B-E-H is re-routed as B-C-H Traffic on Sector B-F is re-routed as B-C-F A

D Shift in network routing

B

B

Connecting Traffic

Shift in network routing C

C

Connecting Traffic

F

G

E

H

Network airline respond with substantial lower fares combined with an increase capacity in order to absorb most of the demand for the new entrant’s air services on a particular route

Overlay of routes by Network Airlines LCC identifies underserved market opportunity on sector B-C FSC re-routes existing network e.g. Preceding Segment Traffic Revenue Traffic on Sector B-E-H is re-routed as B-C-H Upline revenue Traffic on Sector B-F is re-routed as B-C-F A

D Shift in network routing

B

B

Connecting Traffic

Shift in network routing C

Beyond Traffic Revenue Downline revenue

C

Connecting Traffic

F

G

E

H

Network airline respond with substantial lower fares combined with an increase capacity in order to absorb most of the demand for the new entrant’s air services on a particular route

Airline Business Practices • Loyalty programs based on demand-side economies of scope o o o o o

• • • • •

Computer reservation systems (CRS) in Yield Management Frequent flyer programme (FFP) Travel agents and commission overrides (TACOs) Corporate discount programs - directly negotiated loyalty schemes Corporate cards and electronic ticketing

Interlining and code sharing Airline alliances Hub-and-spoke organisation of route network – Hub Dominance Revenue Management techniques Anti-competitive behaviour and predation in the air transport market

• Market behaviour of dominant airlines are similar irrespective of being owned in the private sector or the state (public) sector

Characteristics of Airlines • Airlines have very low marginal costs in the very short term

• Substantial price discrimination exists • Seating inventory is highly perishable (Seat not sold cannot be stored) • Very rapid dissemination of price changes through computer reservations systems (CRS) and websites to handle bookings

Compared to firms in other industries a major air carrier can: • Price-discriminate to a much greater extent (makes predation much less expensive to the dominant supplier, and hence a more credible threat to potential entrants), • Adjust prices much faster, and

• Shift resources between markets much more readily (mobility of aircraft) to allow an increase service frequency & number of seats to capture a disproportionate share of traffic. • Access to comprehensive, “real time” information on their competitors’ activities through booking and other data generated by computer reservations systems (CRS) enable airlines can respond to competitive initiatives more precisely, swiftly and in advance, than firms in other industries. • The effect of exclusionary practices is felt very quickly

• A new entrant is most vulnerable and at most risk during the period of becoming established. Aggressive competition is most likely to occur at that time

The controversy in applying a strict standard of Average Variable Cost (AVC) to a network airline • Predatory conduct in the airline industry mostly involves a combination of price and capacity expansion • Excluding or including the cost of the aircraft used in providing capacity in the conduct of aggressive actions of incumbent dominant airlines in response to entry of smaller competitors to the market • Incremental conduct is subjected to a market or system wide pricecost comparison that may be conceal the incremental conduct • The use of AVC implies effective immunity for dominant firms operating with high level of fixed costs and low variable costs (Airlines, network industries and new age industries like software firms) • Aircraft costs appear to be fixed for a network system as a whole but for substantial increases on a specific route they have to be seen as variable

Alternative approaches in dealing with the cost of Aircraft / Seat Deployment •

Kahn AE - Regard principal component of AVC for the airline industry to include opportunity costs being the revenue foregone elsewhere by transferring capacity.

•

Hovenkamp H - Characterise aircraft costs as variable in the definition of AVC due to the nature of the asset – the fact that aircraft can be shifted or transferred from one route to another.

•

U.S. Department of Justice Antitrust Division - Focus on a defined and measurable increment of conduct, when the challenged conduct is a welldefined increment to a clearly established, and non-predatory, course of conduct. The costs and benefits of that incremental conduct can be confidently measured or quantified instead of as a market-wide price-cost comparison.

•

Canadian Competition Tribunal and Competition Act as well as Enforcement Guidelines - Apply the principle of Avoidable Cost as an appropriate cost standard for the airline industry and regard aircraft ownership and insurance costs as avoidable via redeployment or recapture.





Statutory Standards to Evaluate Predatory Behaviour Section 8(d)(iv) of the South African Competition Act: Engage in any of the following exclusionary act…. • Selling services below their marginal or average variable cost • Unless the firm concerned can show technological, efficiency or other pro-competitive gains which outweigh the anti-competitive effect of its act

Anti-competitive acts regulations under Section 78(3) of the Canadian Competition Act from effect of 23 August 2000 include: • Operating capacity on a route or routes at fares that do not cover the avoidable cost of providing the service; • Increasing capacity on a route or routes at fares that do not cover the avoidable cost of providing the service

Enforcement Action Guidelines of US DOT against unfair competitive conduct • Fare reductions and capacity increases intended only to eliminate or reduce competition (that soak up demand for LCC services) • Matching low fares offered by a new entrant only when the incumbent airline greatly increases the availability of low-fare seats or adds capacity.

Comparison between South African Competition Act Canadian Competition Act & Regulations

SOUTH AFRICAN COMPETITION ACT

CANADIAN COMPETITION ACT & REGULATIONS

Selling services

•Operating capacity, or •Increasing capacity

Marginal or average variable Avoidable cost cost (Incremental cost of a series of (Not Incremental cost of a series actions) of actions) Weigh: Operated capacity below Technological, efficiency or other avoidable costs pro-competitive gains, Part of a practice of anticompetitive acts against Whether the conduct is likely to result in a substantial lessening or Anti-competitive effect prevention of competition

Onus of Proof on Welfare Gains Approach in South Africa Two elements to be proved (Section 8(d)(iv)) • Evidence of pricing below marginal or average variable cost (An anti-competitive act is presumed (behaviour is prima facie either unlawful or irrational) • Onus shift to the dominant firm to show “technological, efficiency or other pro-competitive gains which outweigh the anticompetitive effect of its act.” Three elements to be proved (Section 8(c)) • Evidence of pricing below some other appropriate measure of costs not specifically mentioned in the Competition Act (but pricecost relationship must have some support in the literature as an appropriate measure of costs) • Additional evidence of predation beyond mere evidence of costs is necessary. Evidence of recoupment would meet this second test but it is not a requirement as in the US Courts. • The onus is on the plaintiff to establish that the anti-competitive nature of the act “outweighs the technological, efficiency or other pro-competitive gains.”

USA and Canadian Statutory Developments • USA Enforcement Action Guidelines with “concurrent” jurisdiction of US DOT to prevent anti-competitive conduct due to failure of AMR (American Airlines Case)

• Canada • •

Enforceable undertakings given by Air Canada to enhance competition in a restructured airline industry Canadian airline restructuring legislation o Guidelines on the Abuse of Dominance in the airline industry o Authority of the Commissioner of Competition to issue a temporary cease and desist order o Authority to the Competition Tribunal to issue an interim order to prevent irreparable harm to competition, while investigation of complaint by the Commissioner underway o Avoidable Cost Standard contained in the Guidelines on Abuse of Dominance in the Airline Industry and Regulations (June 2003) o Judgment in Air Canada Abuse of Dominant Case

Average Avoidable Cost (AAC) • Baumol proposed that average avoidable cost (AAC) be substituted for AVC (average variable cost) in Areeda & Turner’s widely-supported approach to predatory pricing. • AAC was defined as “the average per unit cost that the predator would have avoided during the period of below cost pricing had it not produced the predatory increment of sales.” • AAC is a short run measure because it excludes any sunk costs incurred before the period of predation as these are inescapable. It does not require any allocation between fixed and variable costs which is often problematic (Bolton). • AAC more closely approximates marginal cost because it includes all costs (fixed costs or variable costs) that would have been avoided had the defendant not made the predatory sales (Bolton)

Categories of Avoidable Costs in the Airline Industry Cost Category

Examples

Outright Avoidable

• • • • • •

Avoidable through Redeployment and pax recapture

• Flight crew labour • Cabin crew labour • Aircraft costs

These costs are avoidable in the sense that upon cancelling a flight, the airline would likely redeploy the aircraft and crew to an alternative route. Similarly, if a flight was added the airline would likely redeploy the needed aircraft and crew from another route.

Potentially Avoidable

• • • •

To the extent that these costs are specific to a flight and could be either avoided outright, or avoidable through redeployment of labour to another route, they would be considered avoidable.

Unavoidable

• Executive salaries • Building expenses • General overhead

Travel Agent Commissions Fuel and Oil expenses Navigation Fees Landing Fees Aircraft costs

Maintenance labour Ticketing agent labour Baggage handler labour Reservation labour

Discussion The airline would no longer incur the cost for these items in the event that it cancelled a flight. Similarly, if a flight was added these costs would need to be incurred.

These costs are not specific to a flight and thus are unavoidable in the event that a flight is added or cancelled.

Sources: Competition Bureau: Enforcement Guidelines on the Abuse of Dominance in the Airline Industry. Ottawa. 8 February 2001 Ross TW and Stanbury WT. Policy Proposals for Enhancing Competition in Canadian Airline Markets. April 2001





Important Airline Cases (Cont…) Case

American Airlines AMR

Air Canada

Relevant Dates

13 May 1999 to 27 April 2001 Appeal 11 January 2002 to 3 July 2003 (Over 4 Years)

Issue

American Airlines (FSC) responded to reduced fares from Low Cost Carriers (LCCs) in the DFW area in the mid1990’s for four “core” routes that: Matched LCC fares,  Increased the number of seats eligible for lower fares by means of yield management  Further increased capacity in the form of additional flights  Following the withdrawal of LCC competition, American Airlines raised its fares and reduced the number of flights on the targeted routes.

(20 April 2000/ 5 March 2001 Findings 22 July 2003 (2 years 3 months total elapsed time 3 years 3 months) Air Canada (FSC) responded to LCC entry into Canada domestic routes by adding significant capacity and matching or undercutting WestJet's and Canjet fares During the process Air Canada filed for bankruptcy and creditor protection.

Lufthansa (LH) /Germania 12 November 2001 – 22 February 2002

Spirit / Northwest

Germania entered Frankfurt – Berlin (FRA-TGL) route in competition with LH

Spirit Airlines (LCC) entered on the DetroitBoston and DetroitPhiladelphia routes where Northwest Airlines (DSC) offered non-stop service in Dec 1995, which then dramatically reduced its fare and also increased its daily non-stop roundtrip flights.

LH matched fares of Germania but with superior product 12 November 2001 (LCC) Germania started service from Frankfurt to Berlin with one-way fare of € 99 (without strong restrictions). Before the entry, Lufthansa (FSC) as monopolist charged at least €485 for a round-trip economy fare (implying a one way charge of € 242. After Germania’s entry, Lufthansa introduced a new one way €100,- fare

March 2000 – Summary Judgement 31 March 2003, Appeal 9 November 2005

During the Appeal process Northwest filed for bankruptcy under Chapter 11.



Air Canada

Outcome

Summary judgment granted in favour of AMR dismissing the case

Temporary cease and desist order against Air Canada

Finding that failure of US government to demonstrate existence of a genuine issue of material fact: AA priced its product on the routes in question below average variable cost (AVC); and AA intended to recoup these losses by charging supra-competitive prices either on the four core routes themselves, or on those routes where it stands to exclude competition by means of its "reputation for predation”.

Three challenges of Air Canada of the temporary order Application of the Competition Bureau for an order against anticompetitive practices by Air Canada

Lufthansa (LH) /Germania Minimum price distance to be maintained by LH for two years Cartel Office ruled that higher quality of LH product meant that same price was actually undercutting Germania LH ordered to increase fare by 35 Euros (30.50 on appeal

Spirit / Northwest District Court: Summary judgment granted in favour of Northwest dismissing the case on same principles as in AMR case Court of Appeals: reversed the grant of summary judgment in favour of Northwest and remand the case to the district court for further proceedings consistent with its opinions

Judgement sustained by Court of Appeals. Meeting Competition Defence

District court: Held that AA was entitled to summary judgment because American had only matched and not undercut the fares of

Competition Bureau will not take enforcement action General principle, where a dominant carrier reduce fares to levels which match, but do not

Matched pricing adjusted with market values of differentiated product and service levels to be

Matching of Spirit’s fares for a large number of pax who are price sensitive reflected Northwest’s ability to engage in price



Air Canada

Segmentation of Passenger Product (Business/Leisure Traffic)

No

No

Unit of Measurement

Flight

Specific Incremental Fights

Recognition of applicable Revenue

Inclusion of Upline & Downline revenue on the applicable routes

Inclusion of all revenue of competing flights deployed over the competing sector route

Did not distinguish by product group

No recognition for beyond revenue

Lufthansa (LH) /Germania Yes Considered elastic segment of demand and LH product offering to that segment Price per ticket offered

Product/price placed on comparable service levels Reduced LH matched price by market value of the elements of bundled product: €1 newspaper €2 soft drink, €12 value of 500 frequent flyer miles €25 for the higher frequency of flights (Lufthansa flies 14 times a day, Germania operates only 4 flights)

Spirit / Northwest Yes Identified separate product and market in leisure travellers

Per Leisure pax actually carried (not seating capacity provided – ASK/M) Inclusion of revenue of only competing air services Exclude preceding segment revenue Exclude beyond segment revenues



Air Canada

Recognition of applicable Cost Standard

District Court: Measure to use: Average Variable Cost (AVC)

Measure to use: Average Avoidable cost (AVC)

Exclude: Cost of aircraft ownership and insurance Court of Appeals: Confirms use of system wide average variable cost (AVC) Test Exclude: Cost of aircraft ownership and insurance Principle established that: Comparison of incremental cost with incremental revenue = correct interpretation of avoidable cost test

Includes all product specific cost: System labour costs Station labour costs Aircraft labour costs Non-labour system and sunk costs Aircraft ownership and insurance Exclude: Sunk Costs of which some contribute to FSC product offering  Frequent Flyer Systems  Ticketing systems  Airport Services

Lufthansa (LH) /Germania Measurement: No objective cost necessary No evidence of subjective intent required Legal Test: Balance interests of parties to protect competitive structures and chances of market entry

Spirit / Northwest Measurement: Incremental cost of incremental action on variable basis. Common-variable costs shared among all passengers on a flight (Most costs) Still treated as variable costs of the route as airline could avoid incurring all of them by exiting the route and redeploying the aircraft to an alternative route (Pilots, flight attendants, fuel to fly the empty plane, ownership of the plane, and servicing without regard to the actual number of passengers on the aircraft airline once flying a specific route is committed to Passenger-variable costs that include the costs associated with processing the ticket, beverage and food service (if any), incremental fuel required to carry the passenger, and baggage service. The passenger-variable costs are quite minimal compared to the common-variable costs, or non-passenger variable costs of the



Air Canada

Controversial aspect of decision

System wide costs and not costs of incremental actions

Definition of “redeployment or pax recapture” and “disposal” as basis for avoiding costs

A market-wide AVC test will disguise the nature of this type of predatory conduct

Lufthansa (LH) /Germania Cost standard not essential Effects based approach

Costs become avoidable immediately

Spirit / Northwest Segmentation of revenue per Pax Carried. Assume variable common costs per pax of both segmented markets is the same

Opportunity cost test ?

Firms with low AVC in the relevant market (airlines and software firms) are virtually immune from predatory pricing claims in the USA as long as Courts rely only on AVC

Avoidable Cost Test Clarified Important principle: Costs avoidable through redeployment or pax recapture

Court found only objective reason for conduct was to exclude Germania

Examining the marginal or incremental costs per pax carried associated with Northwest’s response to Spirit compared with the additional revenues received by Northwest as a result of incurring the costs of the campaign Focused on revenue from the additional flights (extra capacity) that Northwest added (at discounted fares) as alleged predation was executed through those additional flights

USA: Balance between Segmented Market, Unit of Measurement, Relevant Market, Revenue and Basis of Cost Measurement Spirit v Northwest (Appeal against Summary Judgement)

AMR Case American Airlines

Relevant Market

Excluded from Relevant Market

Market Definition

Leisure / Price Sensitive pax

 

Business / Time Sensitive pax Connecting pax

Total-passenger market on the two relevant geographic routes

Prices (Revenue)

Low yield revenue from contested local traffic



High yield business traffic revenue (Price discrimination) Connecting pax

All revenue

Costs

Pro rata costs per pax carried (Costs attributable to all customers as proxy for the costs associated with price-sensitive passengers)

Pro rata costs per allocated for High yield business and connecting pax carried

Average Variable Costs

Unit – Actual Pax carried (Not Seating capacity provided)

Contested Local Pax

 

Flights



Business / Time Sensitive pax Connecting pax

REQUIREMENT FOR CONVICTION Price below Cost? Intent to cause Recoupment AVC or AAC Likelihood of of Lost Profits exit by rival Europe Y N N N Y N Australia N Y N Canada Y N N N Y N United States Y N Y South Africa Y N Y Y Y N Adapted and updated from WG Morisson 6th Hamburg Aviation Conference, Hamburg Germany, February 2003





Salient Principles to Consider • Marginal / Average Variable Cost in a network deployment is infinitely small (committed fixed costs) • Average Variable Cost as basis of unit measurement • Develop conduct guidelines - the rules of the game • Rapid temporary intervention • Change of onus of proof in dominant markets especially re rapid intervention • Context of Market Definition • Unit of Measurement • Determination of price standards (demand side calculation) and • Determination of cost standards (supply side calculation) • Comparability of principles relating to market definition in Pricing and Costs • Per Sé or Effects Based Test (directed to the outcome of conduct) • Safe Harbour rules • Locus standi on international routes • Harmonisation of international competition rules