- Email: [email protected]
Dimensions of predatory pricing in air travel markets
ARTICLE IN PRESS
Journal of Air Transport Management 10 (2004) 87–95
Dimensions of predatory pricing in air travel markets William G. Morrison School of business and Economics, Wilfrid Laurier University, Waterloo, Ont., Canada
Abstract This paper highlights how particular characteristics of air travel markets impact key dimensions of predatory pricing investigations. The paper suggests that product complementarity, product differentiation and the existence of internally flexible capacity create particular challenges in defining and measuring the extent of predation in air travel markets. These ‘dimensions of predation’ are applied to recent predatory pricing allegations in Germany. r 2003 Elsevier Ltd. All rights reserved. Keywords: Predatory behaviour; Product differentiation; German airlines
1. Introduction Predatory pricing in general has been a troublesome topic for economists both on theoretical and practical grounds. Theoretical problems have existed partly because many traditional models of market structure were static in nature and at best only suggest ‘pseudo’ dynamics. This seems inappropriate for predatory pricing questions that relate to the dynamic evolution of market structures, and the endogenous effect of competitive strategies on evolutionary paths. A separate problem relates to the ‘classic Chicago’ school attack on the rationality of predatory pricing. Church and Ware (1999) describe the Chicago attack as stemming ‘‘ymainly from the idea that every costly period of predatory pricing would have to be followed by a period of ‘recoupment’—high prices recover the losses experienced in the predatory price war. The high prices of the recoupment period will encourage entry again, either by the same firm or by a new entrant’’ (p. 645). This view while neglecting several important elements of the problem (reputation effects and asymmetries in information or financial resources for example) seems to have had a disproportionate impact on legislative frameworks. This is particularly true in North America where the underlying premise appears to be that such strategies are seldom tried and are even more rarely E-mail address: [email protected] (W.G. Morrison). 0969-6997/$ - see front matter r 2003 Elsevier Ltd. All rights reserved. doi:10.1016/j.jairtraman.2003.10.004
successful. Yet this apparent lack of willingness to accept the possible existence or predatory pricing is more likely derived from our inability to detect and accurately measure the extent to which pricing strategies can be harmful to competition over the longer term. The danger is always that we are not able to distinguish between conduct which is harmful to competition and that which is harmful to one or more competitors as the result of healthy competition. On balance, policymakers and academics have favoured the possibility of successful predatory pricing against the possibility of discouraged or ‘chilled’ competition as a result of aggressive competition laws. The general difficulties facing predatory pricing investigations in general are amplified in air travel markets due a persistently dynamic evolution over time and some unique characteristics. As pointed out in Gillen and Morrison (2003), air travel markets have evolved from the fully connected networks that existed prior to deregulation into markets where hub-and-spoke networks have been dominant followed by international alliances and consolidation and the global emergence of value-based airlines. Examining the airline industry today, the co-existence of full service carriers and value-based carriers serves to highlight some key characteristics that shape the modes of competition, particularly between these rather divergent business models. This paper attempts to place much needed focus on these industry characteristics as they relate to predatory pricing. I that the problems they create point to competition policies that define clear
ARTICLE IN PRESS 88
W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
‘rules of the game’. Recent allegations of predatory pricing in Germany serve to highlight some of the issues that relate the dimensions of pricing and competition in air travel to the measurement of predation and impact of competition policy rules on the industry.
2. Comparing predatory pricing rules and procedures
The UK and European legislation draws on precedents set in the AKZO case of 1985. AKZO Chemie, a division of AKZO NV was a Dutch chemical company that, among other things, was involved in the market of flour bleach in the United Kingdom. In this market, AKZO was the dominant firm, with a 65% market share. AKZO was found to be abusing its dominant position and fined h10 million. In determining the case, the European Court of Justice stated: ‘‘Price below average variable costy by means of which a dominant undertaking seeks to eliminate a competitor must be regarded as abusive. A dominant undertaking has no interest in applying such prices except that of eliminating competitors so as to enable it subsequently to raise its prices by taking advantage of its monopolistic position, since each sale generates a loss, namely the total amount of the fixed costsy and, at least part of the variable costs relating to the unit produced’’ (AKZO Chemie BV v EC Commission (1991) ECR I-3359 at para. 71–72).1
Predatory pricing institutions are similar around the world, yet exhibit subtle differences. The following sub-sections provide a brief comparison of relevant legislation, administering bodies and decision criteria in a representative sub-sample of international jurisdictions. 2.1. Germany In Germany the relevant competition legislation is the Gesetz gegen Wettbewerbsbeschrankungen (GWB)—the . Act Against the Restraint of Competition, which is administered by the Bundeskartellamt. Predatory pricing appears as an abuse of dominance provision in section 20(4) of the GWB, which sets out four criteria to be satisfied: (1) The alleged predator must be dominant in the market (determined using the principles in 19(2) of the GWB). (2) The predatory pricing behaviour must be of sufficient duration. German law states that the offending action cannot happen ‘merely occasionally’ for predation to exist: usually 3 weeks or longer. (3) Pricing must be below ‘average operating costs’. (4) No ‘objective justification’ can be made by the accused firm if criteria 1–3 are satisfied.
2.2. United Kingdom Britain like many European countries has prohibitions against predatory pricing at both a national and supranational level. Specific to the United Kingdom is the Competition Act of 1998. Predatory pricing is contained in ‘Chapter 2’ prohibitions within the act, related to abuse of dominant position. The UK legislation is a two-part decision process wherein dominance must be established first, prior to a determination as to whether there was abuse of dominance. In determining whether a firm is abusing its power through predatory pricing, the UK takes much from the EU experience, especially with respect to price–cost relationships.
Thus under the UK legislation, prices below variable costs are regarded per se predatory, and prices in between average variable cost and average total cost can define instances of predatory pricing if intent can be proven. Again the AKZO case highlights this perspective: ‘‘Moreover prices below average total costs, that is to say, fixed costs plus variable costs, but above average variable costs, must be regarded as abusive if they are determined as part of a plan for eliminating a competitory’’ (AKZO Chemie BV v EC Commission (1991) ECR I-3359 at para. 71–72). 2.3. European Union Article 86 under the treaty of Rome deals with competition and fair trade. Predatory pricing in relation to article 86 was first considered by the European Commission in 1966. Later, the articles were renumbered under the treaty of Amsterdam with the relevant legislation now contained in article 82. The article prohibits abuse of dominance and includes in its examples ‘‘Directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions’’. To determine if there is a case of predatory pricing under Article 82, two elements must be satisfied. Firstly, a firm must be shown to be in a dominant position—this being accomplished by defining the relevant market, examining market share and considering factors such as barriers to entry. Secondly, the action of the dominant firm must be shown to be an abuse, which involves a 1
This case was appealed but the decision was upheld in 1991.
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
determination of whether the accused firms prices were below average variable cost. Along with the UK, the EU uses the AZKO case to define its price–cost tests for predatory conduct. Unlike the USA, is no requirement in EC law that a dominant firm can recoup lost profits from a pricing strategy that generates losses. The precedent for this was stated in the 1997 Tetra Pak II case: ‘‘yIt would not be appropriate, in the circumstances of the present case, to require in addition proof that Tetra Pak had a realistic chance of recouping its losses. It must be possible to penalize predatory pricing whenever there is a risk that competitors will be eliminated.’’ (Tetra Pak II 1997 4 CMLR 662). 2.4. Australia Competition policy is governed in Australia through the trade practices act (TPA) of 1974 and administered through the Australian Competition and Consumer Commission. Predatory pricing falls under Section 46 of the TPA, which deals with instances where a firm has taken advantage of a substantial degree of market power, the effect of which is to substantially lessen competition. Section 46 has gone through a number of changes (1976, 1979, 1993) which have placed more emphasis on market power as a test of dominance and broadened the scope of the legislation to all forms of businesses. Importantly, in 1999 a retail market inquiry recommended that onus be put on the defendant to prove their actions were not predacious. Predatory pricing is defined as ‘a price set at a level for the purpose of eliminating a competitor or keeping a potential competitor from entering the market’. Until very recently, below cost pricing not deemed essential under Australian law, rather the consideration was whether pricing was for an illegal purpose (i.e. intent to engage in predatory pricing). However in a recent case, [Boral Masonry Ltd. v. ACCC, (2003)] the Australian High Court reversed a finding of predatory pricing at the Federal Court level. In its decision, the High Court ruled that recoupment via pricing at supra-competitive levels was required for a finding of predatory pricing. This ruling, suggests a move away from prior relative emphasis on intent without recoupment and places the Australian decision more in line with US competition policy. 2.5. Canada Competition in Canada is governed by the Competition Act. The Act sets out two bodies that review and regulate competition: the Competition Bureau and the Competition Tribunal. The former monitors firms, assesses complaints and investigates allegations anti-
89
competitive behaviour while the latter is a judicial body that hears and formulates decisions on competition cases brought forward by the competition bureau. Predation is covered under both civil and criminal law and is defined under Section 50(1)(c) of the Competition Act as a policy of selling at unreasonably low prices that have the effect, tendency or intent to substantially lessen competition or eliminate a competitor. Interpreting the law suggests a two-stage process, in which the competition bureau must first determine if the firm had a policy of selling at unreasonably low prices. If this criterion is met then the actual or intended impact is assessed. Unreasonable prices are those found to be below average avoidable cost—a measure which is more easily measured than average variable costs. Average avoidable costs includes product-specific fixed costs but not sunk costs. 2.6. United States Competition policy in America was brought into existence with the Sherman act of 1890, with the Clayton Act of 1914 (amended in 1936) clarifying and elaborating on the original provisions of the Sherman Act. Current anti-trust policy is enforced via litigation in three ways: a suit brought by the anti-trust division of the Department of Justice, civil action by the Federal Trade Commission or litigation by private citizens. In the post war years, predatory pricing allegations were usually dismissed, given the lack of a clear definition of predatory pricing in the legislation. It was not until after 1975, that the Agreeda–Turner criterion of pricing below average variable cost was adopted as a necessary condition for predatory pricing. The next major change in the interpretation of Sherman Act Section 2 was the oft-cited Brooke Case in 1993. Under Brooke, for a predatory pricing case to be won, two criteria must be satisfied: pricing must be below average variable cost and there must be proof of recoupment of losses incurred during the period of alleged predation.2 The burden of proof lies with the plaintiff, who must demonstrate either that the dominant firm recouped its losses, or that increased market and pricing power or other economic conditions make recoupment likely. Furthermore, US courts have not embraced reputation building as a legitimate means of recouping losses sustained though predatory pricing. In summary, international comparisons of competition policy show that in most if not all jurisdictions, predatory pricing rules fall under abuse of dominance provisions that typically emphasize a three-stage process. This process is presented in Morrison (2003) as a 2
The outcome of Brooke case clearly raised the level of difficulty in proving predation in the US: no plaintiff has won a predation case since 1993.
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
90
ALLEGATION OF PREDATORY PRICING
No
Does the defendant hold a significant degree of market power? Yes Determination of defendant’s price in relation to costs
No
ATC > P Yes Yes
AAC > P
No
No
Did the defendant intend or have the effect of substantially lessening competition?
Yes
Can the defendant recoup foregone profits? No Yes
Allegation Dismissed
Allegation Upheld
Fig. 1. A stylized predatory pricing investigation algorithm.
stylized decision algorithm, as shown in Fig. 1. Suppressing some elements and emphasizing others in the algorithm allow us to match it to particular cases and/or jurisdictions. As illustrated in Fig. 1, the algorithm has three main decision nodes, relating to the defendant’s market power and behaviour before, during and after the period of alleged predation. The three key decision nodes in the process are as follows: (a) Prior to alleged predation: did the defendant hold a significant degree of market power? (b) During the period of alleged predation: what was the defendant’s price in relation to costs of production? More specifically what was the defendant’s price (P) in relation to the defendant’s total average cost (ATC) and average avoidable cost (AAC). This yields three possibilities: (i) P>ATC (ii) AAC>P (iii) ATC>P>AAV (c) After the period of alleged predation: Can/could the defendant reasonably expect to recoup profits foregone during the period of the alleged predation? The first decision node, requires that the accused firm have sufficient market power to abuse a dominant position. The second decision node is key to most predatory pricing investigations. Here, the accused
firm’s prices are compared to some practical measure of average cost. If price is below average total cost, then we still need to know whether or not pricing was below some practical measure of average variable cost. It is now generally accepted that average variable costs are most often too difficult to measure, particularly in multiproduct markets, and that average avoidable cost is a reasonable second-best measure. If price is found to be below average avoidable cost, then the defendant can be said to have incurred avoidable losses. If on the other hand price falls between average avoidable cost and average total cost, competition authorities are faced with a grey area where intent or other contributory factors must be considered, such as the relative efficiency of the alleged victim, the possibility of reputation effects and the future extent of technical or other strategic barriers. In the grey area, it becomes more difficult to relate the exit of a competitor to a lessening of competition. For example Button’s (2003) argument concerning the possibility of an empty core in the market could be used to provide a plausible alternative explanation of events thought to be consistent with predatory pricing. Thus measurement problems would appear to place a great deal of weight on the ability of any investigation to show pricing below average avoidable cost as a necessary condition for a finding of ‘per se’ predation. The third decision node in the algorithm asks whether the accused firm can recoup the profits forgone during the predatory pricing period. If the defendant set its price below average avoidable cost but cannot recoup forgone profits, then in some jurisdictions (the US in particular), the allegation of predatory pricing will not be upheld.
3. Dimensions of pricing and competition in air travel Recent predatory pricing cases in passenger aviation have typically involved entry by a value-based airline (VBA) into one or more markets in which there is dominant incumbent full-service airline (FSA). The response to such entry by the FSA then generates allegations from the VBA of unfair competition, designed to cause or hasten their exit from the market. In this context, there are three important and somewhat unique dimensions of pricing and competition in air travel markets that impact the effectiveness or effect the impact of predatory pricing rules and procedures. These are product complementarities, ‘internally flexible’ capital and product differentiation. 3.1. Product complementarities The connectivity between nodes of an FSA network define a product service bundle that is bound up in the
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
operation of hub-and-spoke network. The service bundle includes bags that are checked through from origin to final destination and time saving convenience in transit with synchronized arrivals and departures at the hub along with sufficient frequencies to provide added flexibility. However if air travel markets are defined as city pairs, we must recognize that there is going to be demand complementarities between spokes connected through an FSA’s hub. FSA’s are thus likely to argue that a competition authority should not regard any city pair in isolation with respect to pricing, as doing so would be to ignore the ‘beyond revenues’ that are generated from travellers whose demand for travel from some origin city to the hub is conditional upon their continued travel from the hub to some other destination city.3 However competition authorities should be wary of the ‘marketing promotion’ argument; that low ticket prices on one route are simply a means of promoting ‘beyond’ travel and hence ‘beyond’ revenues. The intention of promotional pricing should be to target those consumers who have either a revealed or latent demand for continuing travel beyond a given city pair. That is, there is nothing to prevent FSA’s from bundling multiple city pairs for promotion pricing, however this is not the same as offering uniformly low prices to travelers, of whom only a portion demand beyond travel.
91
network does create a credible threat because the capacity need not be permanently assigned to a particular city pair. If a strategy of lower prices and increased capacity result in the exit of one or more rival in a city pair market where entry occurred, the incumbent FSA can then redeploy capacity elsewhere in the network and return to lower capacity and higher prices. Consequently, competition authorities have argued that aircraft costs should be included as a productspecific cost in the calculation of average avoidable costs associated with a given city pair market. The FSA defence against this is that aircraft are not avoidable costs, as disposal (rather than redeployment) would be financially and time-wise costly. However, with the market defined as a city pair, and the fact that aircraft can be redeployed elsewhere in the network suggests that aircraft costs should be included, particularly when it can be demonstrated that the opportunity cost of redeployment (in the form of foregone profits on other city pair markets) is positive. Although the redeployment of capacity may seem to bias AAC tests against FSAs, it would also affect any VBA who increased frequency on a route in response to entry by redeploying aircraft from other potentially more profitable city-pair markets. 3.3. Product differentiation
3.2. Internally flexible capacity and the calculation of average avoidable cost If average avoidable cost is to be used to gauge whether alleged predatory prices resulted in avoidable losses, it becomes crucial to be able to identify and measure product-specific fixed costs and sunk costs.4 When FSAs respond to entry in a city pair market, price cutting is often accompanied by an increase in capacity, in the form of increased frequency or by redeployment of larger aircraft on existing flights. Again, FSA’s defend such actions as an appropriate adjustment to handle the increase in demand that they expect to accompany price reductions. However such a redeployment of capacity facilitates predation (with or without intent) by creating a credible means by which an incumbent firm can flood the market with low-priced tickets. While a permanent investment in large amounts of excess capacity typically does not define a credible threat, (the standard ‘limit output’ problem in industrial organization) the deployment of large or additional aircraft from elsewhere in an FSA 3 VBA’s also operate networks with some degree of connectivity, and therefore some demand complementarities, however the degree of connectivity is reduced by the unbundling of service components in return for lower ticket prices. 4 Recall that average avoidable costs include product-specific fixed costs, but exclude sunk costs.
The interaction between FSAs and VBAs necessarily implies competition involving both vertical and horizontal product differentiation. The implications for predatory pricing are straightforward at a superficial level of analysis, but in fact create difficult measurements problems when examined in more detail. Consider the defence of a FSA accused of predatory pricing after significantly lowering its prices only for city pairs where a new VBA has begun operations. The FSA will argue that this is merely the forces of competition at work and that it should be allowed to match the prices of its rivals. The FSA might also cite Baumol’s (1996) arguments that the benchmark costs should be those of the plaintiff, since matching the price of a more efficient rival should not result in the exit of that rival. That is, as long as the FSA’s price is above the average avoidable costs of the VBA, the pricing policy should not be judged to be predatory. However this argument does not hold when there is a significant degree of vertical product differentiation. Typically, FSA’s offer more services or higher magnitudes of service quality, including meals, frequent flier points, greater connectivity and frequency of flights. Therefore price matching by an FSA with vertically differentiated product of higher quality is in fact de facto price undercutting. Price matching with higher service quality is nothing but the result of good competition if the firm maintains
ARTICLE IN PRESS 92
W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
a price in excess of total average cost. However, the tricky question that competition bureaus must address is: does any price exist below average total cost for which the FSA can be said to be sufficiently covering the costs of additional services not offered by the VBA? One way to approach answering this question, would be to assume that price-matching by the FSA in the absence of additional services would be appropriate. Consequently, a price premium (reflecting the value of additional services supplied by the FSA to travellers) could be calculated and added to the VBA’s price to arrive at a quality adjusted price at which the FSA can be assumed to be covering average avoidable costs that include these services. Practically however, using a demand-based valuation of the FSAs additional services requires that the competition authority is able uncover the distribution of consumer preferences over the particular bundle of services offered by the FSA. Serious errors in this calculation could occur, depending on the methods used to calculate the premium. For example, suppose that the FSA offers two additional services. Even if the competition authority correctly estimates customer valuations for each of these services, they may not arrive at the correct measure of the optimal bundled price. That is, if reservation prices for the two services are negatively correlated across customers, an average of individual valuations could overestimate or underestimate the optimal (revenue-maximizing) bundled price. So in cases where FSAs offer more than one additional service, the competition authority would need to know the distribution of preferences over the additional service bundle across travellers. Furthermore, traveller preferences over some elements of the FSA service bundle may define a combination of vertical and horizontal differentiation. For example, flight frequency might be thought of as a form of vertical product differentiation for passengers with open tickets. More frequency means more flexibility which, ceteris paribus is a good thing. However, we can also conjecture that these same travellers will have most-preferred departure or arrival-time windows, the implication being that the value placed on additional frequency is not simply proportional to the number of flights offered, but also depends on when the flights are offered. Another practical problem is that an administered price premium constraint imposed by the competition authority would have to be flexible enough to account for any future changes in the levels or number of additional services offered by the FSA or the VBA. Lastly, by calculating a price premium based on consumers’ willingness-to-pay for additional services rather than the cost of these services, the competition authority creates an upward bias that could generate a price floor in excess of ATC.
The alternative to using consumer valuations, is to focus on the FSA’s own costs and the measurement of average avoidable costs. Since AAC includes product-specific fixed costs, some part of the cost of the additional services will be accounted for (meals for example). However, there are also likely to be sunk costs that contribute to a FSAs service bundle such as frequent flier programs and ticketing systems that would underestimate the average costs of offering its additional service bundle. A recent accusation of predatory pricing by Germania Airlines against Lufhansa serves to illustrate how this third dimension of predatory pricing affects the measurement, conclusions and impact of a predatory pricing investigation.
4. The Lufthansa–Germania predatory pricing case In November 2001, German VBA, Germania, entered the city pair market between Berlin–Tegel and Frankfurt–Main with a scheduled flight service for which it offered a one-way fully flexible fare of h99. Lufthansa (LH) was the incumbent FSA operating on this city pair. As far as the German competition authority (the Bundeskartellamt) was concerned, the ticket conditions (flexibility) associated with this fare matched that of a LH economy ticket aimed at the business travel segment on the same city pair. LH reacted to the entry of Germania by offering a similar fully flexible round-trip economy ticket at a total price of h200, when an outward and return flight were combined (though booked separately). Consequently, for a traveller interested in a round trip, the average LH fare one-way was h100. The Bundeskartellamt compared LH’s new fare with the fully flexible economy fares previously offered and determined that the new fare represented a reduction, of almost 60% (the preentry fare was h485). Towards the end of the year, Germania responded to this by lowering its one-way fare even more from h99 to h55. However, this price was not sustained and by early 2002, the Germania fare had returned to h99. By December of 2001, discussions were occurring between the Bundeskartellamt and LH such that LH submitted ‘‘extensive documentation’’ on its pricing schemes.5 In an effort to avoid a formal reaction from the competition authority, LH raised its fares slightly in January 2002 from the average of h100 to approximately h105. However, this was not enough to placate the Bundeskartellamt and in February 2002, LH was charged with predatory pricing on the flights between Berlin–Tegel and Frankfurt–Main. 5 See Lufthansa Press Release: ‘‘Lufthansa resists official pricing dictate’’ (30.01.02).
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
Early in 2002, well in advance of any determination as the validity of predatory pricing allegations, the Bundeskartellamt imposed a price restriction on LH. The restriction required that LH charge h35 more than Germania as long as the Germania fare was h99 or lower. The restriction also stated that if Germania fares rose above h99, LH could continue to offer a fare of h134. The duration for this price restriction on LH was set at 2 years by the Bundeskartellamt, based on the following argument: ‘‘This restriction is justified in that within two years Germania should have gained sufficient recognition and established a clientele base. Germania’s operational procedures and other competition factors should have also improved to such an extent that protection against predatory conduct on the scale as provided by this decision should no longer be necessary.’’6 The Bundeskartellamt clearly took the approach suggested by the discussion of product differentiation in Section 3.1, above, stating that the premium was required because LH provided additional services on its flights that were not offered by Germania. Nevertheless, the Bundeskartellamt also charged that LH was setting its prices below its ‘‘average operating costs per passenger’’, and stated that: ‘‘The only rational explanation for this pricing strategy is that it is an attempt to force Germania from this route and to recoup resulting losses at a later stage by discontinuing this price tariff and resorting to previous ones. Recent cases on the Munich–London (Stansted) and Munich–Frankfurt routes are further evidence of this strategy. In both cases DLH significantly raised its prices after its rivals, Go-Fly and Deutsche BA, had abandoned these routes.’’7 LH appealed this decision in the fall of 2002 and while the imposition of a premium price penalty was upheld by the court, the size of the premium was reduced to h32.50. Several questions arise from this case in light of the issues discussed in this paper. What role did product complementarities and ‘beyond’ revenues play either in LH’s defence or the determinations of the Bundeskartellamt and the court? In its price–cost calculations, what was the measure of ‘‘average operating cost’’ used by the Bundeskartellamt? Did LH redeploy capacity when it lowered its prices and did this affect the measure of average operating cost? How did the Bundeskartellamt calculate the price premium it imposed on LH? 6 Bundeskartellamt news Lufthansa from hindering its 7 Bundeskartellamt news Lufthansa from hindering its
release, ‘‘Bundeskartellamt prohibits rival Germania’’, (19.02.2002). release, ‘‘Bundeskartellamt prohibits rival Germania’’, (19.02.2002).
93
With the exception of the last question, there are few details available in English at the time of writing. This is perhaps because a final court decision on the case has yet to be made. On the question of pricing and revenues, LH press release of January 2002 seems to emphasize the number of different fares the airline offers, taking the position that: ‘‘Since Lufthansa alone is operating with 1.5 million fares in a fully liberalised market, it is unacceptable that the Cartel Office should act as a regulatory body on just a single tariff’’ and that ‘‘Decisive, however, for a route’s profitability is the sum of all revenues from operating on it’’.8 The news statements from the Bundeskartellamt have not as yet given any details as to the definition or calculation of average operating costs. Nor are there any details concerning any redeployment of larger aircraft or increased frequency on the city pair in question. Only the question of how the premium was calculated can be answered in sufficient detail to related to the issues raised in this paper concerning product differentiation. The calculation of the initial premium of h35 is described by the Bundeskartellamt as a conservative estimate of the value of services offered by LH that were not offered by Germania. Specifically, the premium was calculated as the sum of: h3ðdrink þ newspaperÞ þ h12ðthe value of frequent flyer miles
calculated on the basis that 40 flights would allow for a free flight valued at h484Þ þ h25ðthe estimated value of the flight frequency offered by LHÞ:
This gave a total of h40, but the premium imposed was h35, reflecting a somewhat ad hoc adjustment in the name of using conservative estimates. When the appeal decision was made, the court lowered the Bundeskartellamt’s estimate of h12 for frequent flier miles by h9.50. Consequently, the court recalculated the premium to be the Bundeskartellamt’s original estimate of h40 less h9.50=h32.50. There are some troubling factors in the account of these calculations. The case transcript indicates that the calculation of h25 for frequency of service (left unchanged in the appeal decision) was based on a US marketing research study by Ostrowski et al. (1991).9 The study (an unpublished working paper) was cited as empirical evidence that business travellers are willing to pay up to an additional 25% of the original price for the most flexible fight schedule. While initial criticism might 8 9
Lufthansa Press Release (30.01.02). As reported in Bundeskartellamt, B9-144/01.
ARTICLE IN PRESS 94
W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
have been levelled at the Bundeskartellamt’s lack of peer-reviewed research in support of their calculations, it turns out that a more recent paper by the same authors is published. Ostrowski et al. (1993), report the results of a survey of US travellers, in which they were asked to compare elements of service quality along with pricing between two FSAs. The survey took the form of a self-administered questionnaire distributed to enplaning and deplaning passengers ‘‘of several major airlines’’ during 1992. We might pause here to consider whether comparisons by travellers (who were much more likely to be frequent fliers) comparing service quality factors between two FSAs is the appropriate basis on which to base decisions regarding competition between a FSA and a VBA.10 Ostrowski et al. reports that respondents were asked to allocate 10 points between four factors in their travel decision: ticket price, schedule convenience, frequent flyer program, and airline preference. These responses were compared between the FSAs. The results indicate (with no significant difference between each airline), that the average number of points allocated to schedule convenience was 3.4 in each case. However the standard deviation around this allocation is approximately 2.48 suggesting that the index rating of scheduling convenience could lie anywhere in the range (0.98–5.88). Although a similar table reporting mean values appears in the transcript of the LH–Germania case, however no standard deviations are reported. Other results in Ostrowski et al. are not reported in the Bundeskartellamt’s calculation of premium values. In particular, regressions aimed at showing the relation between ‘‘retained preference’’ for an airline and such variables as ‘‘best schedule’’ and ‘‘best frequent flier program’’ are reported with adjusted R2 values no greater than 3.86 and as low as 0.09. The point here is not to criticize the Bundeskartellamt for recognizing that price matching should be adjusted for service quality. Rather it is to emphasize the difficulty in defining clear and accurate measures of what the quality-adjusted premium should be. Another troubling element of the Bundeskartellamt’s decision is the statement that the price premium is to remain in effect for 2 years, by which time Germania should have become sufficiently established that it will no longer be vulnerable to predatory pricing tactics. This determination does not follow logically from the authority’s earlier justification for the price premium as being the additional services offered by LH. If the justification for the premium is correct, then in 2 years, there is unlikely to be any change in the vulnerability of Germania to price-matching by LH, unless Germania evolves into an FSA. 10 Ostrowski et al. state that over 40% of the total sample had flown more than eight times in the last year.
Lastly, the price constraint imposed on LH was designed as a sliding premium that would diminish if Germania started increasing its price above h99. This was presumably put in place to mitigate the problem of the Bundeskartellamt facilitating the coordination of higher prices by both airlines. However what about the state of future competition between LH and other VBAs in other markets. If both LH and the VBAs now expect a similar premium to be imposed in other markets, then the effect is to pre-impose a change in the reaction functions of the airlines. The precedent set by this case could therefore result in higher prices charged by VBAs competing with LH in the future.
5. Concluding comments Given the existence of demand complementarity, product differentiation and internally flexible capacity in airline networks, what elements of the investigation algorithm make the most practical economic sense? The Lufthansa–Germania case illustrates the pitfalls and difficulties in directly administering price premiums to prevent de facto price undercutting by FSAs against VBAs. Is this preferable to the approach of the Competition Bureau (2001) in Canada, which can issue a ‘cease and desist’ order that prohibits the an alleged predatory pricing policy until a determination can be made. Practically, it places the onus on the accused airline to rework its pricing policy in an environment of uncertainty over what an acceptable pricing policy is. It is important in the air travel industry as in other sectors that current and potential market participants have a clear understanding of the rules of the game. This is never more important in an industry where firms are competing directly or indirectly in markets around the world. Given problems of measurement and timeliness and the particular characteristics of the air travel industry, the way forward for the airline industry is to simplify the institutions governing predatory pricing and move to a more harmonized and transparent process. In this regard a better approach would be to make competition policy rules clear with regards to what are sunk costs and what are product-specific fixed costs that should be included in the calculation of average avoidable costs. In particular redeployed aircraft capacity to a city pair should be included in the calculation of average avoidable cost for that market, particularly if the redeployment can be related to foregone profits elsewhere in the network. Having a clear definition of how average avoidable costs are measured in air travel markets would allow for a more straightforward price– cost test and negate the need for the imposition of price premiums in markets where VBAs compete with FSAs. There will always be issues of measurement error, but a price–cost test would minimize these and provide clear
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
rules of the game to incumbents and potential entrants alike. Acknowledgements I wish to thank David Gillen, David Starkie and participants at the Hamburg Aviation Conference for comments on an earlier draft. I alone am responsible for any errors. References Baumol, W.J., 1996. Predation and the logic of the average variable cost test. Journal of Law and Economics 39, 49–72.
95
Button, K.J., 2003. Does the theory of the core explain why airlines fail to cover their long-run costs of capital? Journal of Air Transportation Management 9, 5–14. Competition Bureau (Industry Canada), 2001. Enforcement guidelines on the abuse of dominance in the airline industry. Industry Canada, Ottawa. Church, J., Ware, R., 1999. Industrial Organization: A Strategic Approach. Irwin McGraw-Hill, New York. Gillen, D., Morrison, W., 2003. Legacy carriers and upstarts: regulation, competition and evolution of networks in aviation markets, School of Business and Economics, Wilfrid Laurier University, Waterloo. Morrison, W.G., 2003. On the existence of predatory pricing in air travel markets, School of Business and Economics, Wilfrid Laurier University, Waterloo. Ostrowski, P., O’Brian, T., Gordon, G., 1993. Service quality and customer loyalty in the commercial airline industry. Journal of Travel Research 32.
Journal of Air Transport Management 10 (2004) 87–95
Dimensions of predatory pricing in air travel markets William G. Morrison School of business and Economics, Wilfrid Laurier University, Waterloo, Ont., Canada
Abstract This paper highlights how particular characteristics of air travel markets impact key dimensions of predatory pricing investigations. The paper suggests that product complementarity, product differentiation and the existence of internally flexible capacity create particular challenges in defining and measuring the extent of predation in air travel markets. These ‘dimensions of predation’ are applied to recent predatory pricing allegations in Germany. r 2003 Elsevier Ltd. All rights reserved. Keywords: Predatory behaviour; Product differentiation; German airlines
1. Introduction Predatory pricing in general has been a troublesome topic for economists both on theoretical and practical grounds. Theoretical problems have existed partly because many traditional models of market structure were static in nature and at best only suggest ‘pseudo’ dynamics. This seems inappropriate for predatory pricing questions that relate to the dynamic evolution of market structures, and the endogenous effect of competitive strategies on evolutionary paths. A separate problem relates to the ‘classic Chicago’ school attack on the rationality of predatory pricing. Church and Ware (1999) describe the Chicago attack as stemming ‘‘ymainly from the idea that every costly period of predatory pricing would have to be followed by a period of ‘recoupment’—high prices recover the losses experienced in the predatory price war. The high prices of the recoupment period will encourage entry again, either by the same firm or by a new entrant’’ (p. 645). This view while neglecting several important elements of the problem (reputation effects and asymmetries in information or financial resources for example) seems to have had a disproportionate impact on legislative frameworks. This is particularly true in North America where the underlying premise appears to be that such strategies are seldom tried and are even more rarely E-mail address: [email protected] (W.G. Morrison). 0969-6997/$ - see front matter r 2003 Elsevier Ltd. All rights reserved. doi:10.1016/j.jairtraman.2003.10.004
successful. Yet this apparent lack of willingness to accept the possible existence or predatory pricing is more likely derived from our inability to detect and accurately measure the extent to which pricing strategies can be harmful to competition over the longer term. The danger is always that we are not able to distinguish between conduct which is harmful to competition and that which is harmful to one or more competitors as the result of healthy competition. On balance, policymakers and academics have favoured the possibility of successful predatory pricing against the possibility of discouraged or ‘chilled’ competition as a result of aggressive competition laws. The general difficulties facing predatory pricing investigations in general are amplified in air travel markets due a persistently dynamic evolution over time and some unique characteristics. As pointed out in Gillen and Morrison (2003), air travel markets have evolved from the fully connected networks that existed prior to deregulation into markets where hub-and-spoke networks have been dominant followed by international alliances and consolidation and the global emergence of value-based airlines. Examining the airline industry today, the co-existence of full service carriers and value-based carriers serves to highlight some key characteristics that shape the modes of competition, particularly between these rather divergent business models. This paper attempts to place much needed focus on these industry characteristics as they relate to predatory pricing. I that the problems they create point to competition policies that define clear
ARTICLE IN PRESS 88
W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
‘rules of the game’. Recent allegations of predatory pricing in Germany serve to highlight some of the issues that relate the dimensions of pricing and competition in air travel to the measurement of predation and impact of competition policy rules on the industry.
2. Comparing predatory pricing rules and procedures
The UK and European legislation draws on precedents set in the AKZO case of 1985. AKZO Chemie, a division of AKZO NV was a Dutch chemical company that, among other things, was involved in the market of flour bleach in the United Kingdom. In this market, AKZO was the dominant firm, with a 65% market share. AKZO was found to be abusing its dominant position and fined h10 million. In determining the case, the European Court of Justice stated: ‘‘Price below average variable costy by means of which a dominant undertaking seeks to eliminate a competitor must be regarded as abusive. A dominant undertaking has no interest in applying such prices except that of eliminating competitors so as to enable it subsequently to raise its prices by taking advantage of its monopolistic position, since each sale generates a loss, namely the total amount of the fixed costsy and, at least part of the variable costs relating to the unit produced’’ (AKZO Chemie BV v EC Commission (1991) ECR I-3359 at para. 71–72).1
Predatory pricing institutions are similar around the world, yet exhibit subtle differences. The following sub-sections provide a brief comparison of relevant legislation, administering bodies and decision criteria in a representative sub-sample of international jurisdictions. 2.1. Germany In Germany the relevant competition legislation is the Gesetz gegen Wettbewerbsbeschrankungen (GWB)—the . Act Against the Restraint of Competition, which is administered by the Bundeskartellamt. Predatory pricing appears as an abuse of dominance provision in section 20(4) of the GWB, which sets out four criteria to be satisfied: (1) The alleged predator must be dominant in the market (determined using the principles in 19(2) of the GWB). (2) The predatory pricing behaviour must be of sufficient duration. German law states that the offending action cannot happen ‘merely occasionally’ for predation to exist: usually 3 weeks or longer. (3) Pricing must be below ‘average operating costs’. (4) No ‘objective justification’ can be made by the accused firm if criteria 1–3 are satisfied.
2.2. United Kingdom Britain like many European countries has prohibitions against predatory pricing at both a national and supranational level. Specific to the United Kingdom is the Competition Act of 1998. Predatory pricing is contained in ‘Chapter 2’ prohibitions within the act, related to abuse of dominant position. The UK legislation is a two-part decision process wherein dominance must be established first, prior to a determination as to whether there was abuse of dominance. In determining whether a firm is abusing its power through predatory pricing, the UK takes much from the EU experience, especially with respect to price–cost relationships.
Thus under the UK legislation, prices below variable costs are regarded per se predatory, and prices in between average variable cost and average total cost can define instances of predatory pricing if intent can be proven. Again the AKZO case highlights this perspective: ‘‘Moreover prices below average total costs, that is to say, fixed costs plus variable costs, but above average variable costs, must be regarded as abusive if they are determined as part of a plan for eliminating a competitory’’ (AKZO Chemie BV v EC Commission (1991) ECR I-3359 at para. 71–72). 2.3. European Union Article 86 under the treaty of Rome deals with competition and fair trade. Predatory pricing in relation to article 86 was first considered by the European Commission in 1966. Later, the articles were renumbered under the treaty of Amsterdam with the relevant legislation now contained in article 82. The article prohibits abuse of dominance and includes in its examples ‘‘Directly or indirectly imposing unfair purchase or selling prices or other unfair trading conditions’’. To determine if there is a case of predatory pricing under Article 82, two elements must be satisfied. Firstly, a firm must be shown to be in a dominant position—this being accomplished by defining the relevant market, examining market share and considering factors such as barriers to entry. Secondly, the action of the dominant firm must be shown to be an abuse, which involves a 1
This case was appealed but the decision was upheld in 1991.
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
determination of whether the accused firms prices were below average variable cost. Along with the UK, the EU uses the AZKO case to define its price–cost tests for predatory conduct. Unlike the USA, is no requirement in EC law that a dominant firm can recoup lost profits from a pricing strategy that generates losses. The precedent for this was stated in the 1997 Tetra Pak II case: ‘‘yIt would not be appropriate, in the circumstances of the present case, to require in addition proof that Tetra Pak had a realistic chance of recouping its losses. It must be possible to penalize predatory pricing whenever there is a risk that competitors will be eliminated.’’ (Tetra Pak II 1997 4 CMLR 662). 2.4. Australia Competition policy is governed in Australia through the trade practices act (TPA) of 1974 and administered through the Australian Competition and Consumer Commission. Predatory pricing falls under Section 46 of the TPA, which deals with instances where a firm has taken advantage of a substantial degree of market power, the effect of which is to substantially lessen competition. Section 46 has gone through a number of changes (1976, 1979, 1993) which have placed more emphasis on market power as a test of dominance and broadened the scope of the legislation to all forms of businesses. Importantly, in 1999 a retail market inquiry recommended that onus be put on the defendant to prove their actions were not predacious. Predatory pricing is defined as ‘a price set at a level for the purpose of eliminating a competitor or keeping a potential competitor from entering the market’. Until very recently, below cost pricing not deemed essential under Australian law, rather the consideration was whether pricing was for an illegal purpose (i.e. intent to engage in predatory pricing). However in a recent case, [Boral Masonry Ltd. v. ACCC, (2003)] the Australian High Court reversed a finding of predatory pricing at the Federal Court level. In its decision, the High Court ruled that recoupment via pricing at supra-competitive levels was required for a finding of predatory pricing. This ruling, suggests a move away from prior relative emphasis on intent without recoupment and places the Australian decision more in line with US competition policy. 2.5. Canada Competition in Canada is governed by the Competition Act. The Act sets out two bodies that review and regulate competition: the Competition Bureau and the Competition Tribunal. The former monitors firms, assesses complaints and investigates allegations anti-
89
competitive behaviour while the latter is a judicial body that hears and formulates decisions on competition cases brought forward by the competition bureau. Predation is covered under both civil and criminal law and is defined under Section 50(1)(c) of the Competition Act as a policy of selling at unreasonably low prices that have the effect, tendency or intent to substantially lessen competition or eliminate a competitor. Interpreting the law suggests a two-stage process, in which the competition bureau must first determine if the firm had a policy of selling at unreasonably low prices. If this criterion is met then the actual or intended impact is assessed. Unreasonable prices are those found to be below average avoidable cost—a measure which is more easily measured than average variable costs. Average avoidable costs includes product-specific fixed costs but not sunk costs. 2.6. United States Competition policy in America was brought into existence with the Sherman act of 1890, with the Clayton Act of 1914 (amended in 1936) clarifying and elaborating on the original provisions of the Sherman Act. Current anti-trust policy is enforced via litigation in three ways: a suit brought by the anti-trust division of the Department of Justice, civil action by the Federal Trade Commission or litigation by private citizens. In the post war years, predatory pricing allegations were usually dismissed, given the lack of a clear definition of predatory pricing in the legislation. It was not until after 1975, that the Agreeda–Turner criterion of pricing below average variable cost was adopted as a necessary condition for predatory pricing. The next major change in the interpretation of Sherman Act Section 2 was the oft-cited Brooke Case in 1993. Under Brooke, for a predatory pricing case to be won, two criteria must be satisfied: pricing must be below average variable cost and there must be proof of recoupment of losses incurred during the period of alleged predation.2 The burden of proof lies with the plaintiff, who must demonstrate either that the dominant firm recouped its losses, or that increased market and pricing power or other economic conditions make recoupment likely. Furthermore, US courts have not embraced reputation building as a legitimate means of recouping losses sustained though predatory pricing. In summary, international comparisons of competition policy show that in most if not all jurisdictions, predatory pricing rules fall under abuse of dominance provisions that typically emphasize a three-stage process. This process is presented in Morrison (2003) as a 2
The outcome of Brooke case clearly raised the level of difficulty in proving predation in the US: no plaintiff has won a predation case since 1993.
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
90
ALLEGATION OF PREDATORY PRICING
No
Does the defendant hold a significant degree of market power? Yes Determination of defendant’s price in relation to costs
No
ATC > P Yes Yes
AAC > P
No
No
Did the defendant intend or have the effect of substantially lessening competition?
Yes
Can the defendant recoup foregone profits? No Yes
Allegation Dismissed
Allegation Upheld
Fig. 1. A stylized predatory pricing investigation algorithm.
stylized decision algorithm, as shown in Fig. 1. Suppressing some elements and emphasizing others in the algorithm allow us to match it to particular cases and/or jurisdictions. As illustrated in Fig. 1, the algorithm has three main decision nodes, relating to the defendant’s market power and behaviour before, during and after the period of alleged predation. The three key decision nodes in the process are as follows: (a) Prior to alleged predation: did the defendant hold a significant degree of market power? (b) During the period of alleged predation: what was the defendant’s price in relation to costs of production? More specifically what was the defendant’s price (P) in relation to the defendant’s total average cost (ATC) and average avoidable cost (AAC). This yields three possibilities: (i) P>ATC (ii) AAC>P (iii) ATC>P>AAV (c) After the period of alleged predation: Can/could the defendant reasonably expect to recoup profits foregone during the period of the alleged predation? The first decision node, requires that the accused firm have sufficient market power to abuse a dominant position. The second decision node is key to most predatory pricing investigations. Here, the accused
firm’s prices are compared to some practical measure of average cost. If price is below average total cost, then we still need to know whether or not pricing was below some practical measure of average variable cost. It is now generally accepted that average variable costs are most often too difficult to measure, particularly in multiproduct markets, and that average avoidable cost is a reasonable second-best measure. If price is found to be below average avoidable cost, then the defendant can be said to have incurred avoidable losses. If on the other hand price falls between average avoidable cost and average total cost, competition authorities are faced with a grey area where intent or other contributory factors must be considered, such as the relative efficiency of the alleged victim, the possibility of reputation effects and the future extent of technical or other strategic barriers. In the grey area, it becomes more difficult to relate the exit of a competitor to a lessening of competition. For example Button’s (2003) argument concerning the possibility of an empty core in the market could be used to provide a plausible alternative explanation of events thought to be consistent with predatory pricing. Thus measurement problems would appear to place a great deal of weight on the ability of any investigation to show pricing below average avoidable cost as a necessary condition for a finding of ‘per se’ predation. The third decision node in the algorithm asks whether the accused firm can recoup the profits forgone during the predatory pricing period. If the defendant set its price below average avoidable cost but cannot recoup forgone profits, then in some jurisdictions (the US in particular), the allegation of predatory pricing will not be upheld.
3. Dimensions of pricing and competition in air travel Recent predatory pricing cases in passenger aviation have typically involved entry by a value-based airline (VBA) into one or more markets in which there is dominant incumbent full-service airline (FSA). The response to such entry by the FSA then generates allegations from the VBA of unfair competition, designed to cause or hasten their exit from the market. In this context, there are three important and somewhat unique dimensions of pricing and competition in air travel markets that impact the effectiveness or effect the impact of predatory pricing rules and procedures. These are product complementarities, ‘internally flexible’ capital and product differentiation. 3.1. Product complementarities The connectivity between nodes of an FSA network define a product service bundle that is bound up in the
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
operation of hub-and-spoke network. The service bundle includes bags that are checked through from origin to final destination and time saving convenience in transit with synchronized arrivals and departures at the hub along with sufficient frequencies to provide added flexibility. However if air travel markets are defined as city pairs, we must recognize that there is going to be demand complementarities between spokes connected through an FSA’s hub. FSA’s are thus likely to argue that a competition authority should not regard any city pair in isolation with respect to pricing, as doing so would be to ignore the ‘beyond revenues’ that are generated from travellers whose demand for travel from some origin city to the hub is conditional upon their continued travel from the hub to some other destination city.3 However competition authorities should be wary of the ‘marketing promotion’ argument; that low ticket prices on one route are simply a means of promoting ‘beyond’ travel and hence ‘beyond’ revenues. The intention of promotional pricing should be to target those consumers who have either a revealed or latent demand for continuing travel beyond a given city pair. That is, there is nothing to prevent FSA’s from bundling multiple city pairs for promotion pricing, however this is not the same as offering uniformly low prices to travelers, of whom only a portion demand beyond travel.
91
network does create a credible threat because the capacity need not be permanently assigned to a particular city pair. If a strategy of lower prices and increased capacity result in the exit of one or more rival in a city pair market where entry occurred, the incumbent FSA can then redeploy capacity elsewhere in the network and return to lower capacity and higher prices. Consequently, competition authorities have argued that aircraft costs should be included as a productspecific cost in the calculation of average avoidable costs associated with a given city pair market. The FSA defence against this is that aircraft are not avoidable costs, as disposal (rather than redeployment) would be financially and time-wise costly. However, with the market defined as a city pair, and the fact that aircraft can be redeployed elsewhere in the network suggests that aircraft costs should be included, particularly when it can be demonstrated that the opportunity cost of redeployment (in the form of foregone profits on other city pair markets) is positive. Although the redeployment of capacity may seem to bias AAC tests against FSAs, it would also affect any VBA who increased frequency on a route in response to entry by redeploying aircraft from other potentially more profitable city-pair markets. 3.3. Product differentiation
3.2. Internally flexible capacity and the calculation of average avoidable cost If average avoidable cost is to be used to gauge whether alleged predatory prices resulted in avoidable losses, it becomes crucial to be able to identify and measure product-specific fixed costs and sunk costs.4 When FSAs respond to entry in a city pair market, price cutting is often accompanied by an increase in capacity, in the form of increased frequency or by redeployment of larger aircraft on existing flights. Again, FSA’s defend such actions as an appropriate adjustment to handle the increase in demand that they expect to accompany price reductions. However such a redeployment of capacity facilitates predation (with or without intent) by creating a credible means by which an incumbent firm can flood the market with low-priced tickets. While a permanent investment in large amounts of excess capacity typically does not define a credible threat, (the standard ‘limit output’ problem in industrial organization) the deployment of large or additional aircraft from elsewhere in an FSA 3 VBA’s also operate networks with some degree of connectivity, and therefore some demand complementarities, however the degree of connectivity is reduced by the unbundling of service components in return for lower ticket prices. 4 Recall that average avoidable costs include product-specific fixed costs, but exclude sunk costs.
The interaction between FSAs and VBAs necessarily implies competition involving both vertical and horizontal product differentiation. The implications for predatory pricing are straightforward at a superficial level of analysis, but in fact create difficult measurements problems when examined in more detail. Consider the defence of a FSA accused of predatory pricing after significantly lowering its prices only for city pairs where a new VBA has begun operations. The FSA will argue that this is merely the forces of competition at work and that it should be allowed to match the prices of its rivals. The FSA might also cite Baumol’s (1996) arguments that the benchmark costs should be those of the plaintiff, since matching the price of a more efficient rival should not result in the exit of that rival. That is, as long as the FSA’s price is above the average avoidable costs of the VBA, the pricing policy should not be judged to be predatory. However this argument does not hold when there is a significant degree of vertical product differentiation. Typically, FSA’s offer more services or higher magnitudes of service quality, including meals, frequent flier points, greater connectivity and frequency of flights. Therefore price matching by an FSA with vertically differentiated product of higher quality is in fact de facto price undercutting. Price matching with higher service quality is nothing but the result of good competition if the firm maintains
ARTICLE IN PRESS 92
W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
a price in excess of total average cost. However, the tricky question that competition bureaus must address is: does any price exist below average total cost for which the FSA can be said to be sufficiently covering the costs of additional services not offered by the VBA? One way to approach answering this question, would be to assume that price-matching by the FSA in the absence of additional services would be appropriate. Consequently, a price premium (reflecting the value of additional services supplied by the FSA to travellers) could be calculated and added to the VBA’s price to arrive at a quality adjusted price at which the FSA can be assumed to be covering average avoidable costs that include these services. Practically however, using a demand-based valuation of the FSAs additional services requires that the competition authority is able uncover the distribution of consumer preferences over the particular bundle of services offered by the FSA. Serious errors in this calculation could occur, depending on the methods used to calculate the premium. For example, suppose that the FSA offers two additional services. Even if the competition authority correctly estimates customer valuations for each of these services, they may not arrive at the correct measure of the optimal bundled price. That is, if reservation prices for the two services are negatively correlated across customers, an average of individual valuations could overestimate or underestimate the optimal (revenue-maximizing) bundled price. So in cases where FSAs offer more than one additional service, the competition authority would need to know the distribution of preferences over the additional service bundle across travellers. Furthermore, traveller preferences over some elements of the FSA service bundle may define a combination of vertical and horizontal differentiation. For example, flight frequency might be thought of as a form of vertical product differentiation for passengers with open tickets. More frequency means more flexibility which, ceteris paribus is a good thing. However, we can also conjecture that these same travellers will have most-preferred departure or arrival-time windows, the implication being that the value placed on additional frequency is not simply proportional to the number of flights offered, but also depends on when the flights are offered. Another practical problem is that an administered price premium constraint imposed by the competition authority would have to be flexible enough to account for any future changes in the levels or number of additional services offered by the FSA or the VBA. Lastly, by calculating a price premium based on consumers’ willingness-to-pay for additional services rather than the cost of these services, the competition authority creates an upward bias that could generate a price floor in excess of ATC.
The alternative to using consumer valuations, is to focus on the FSA’s own costs and the measurement of average avoidable costs. Since AAC includes product-specific fixed costs, some part of the cost of the additional services will be accounted for (meals for example). However, there are also likely to be sunk costs that contribute to a FSAs service bundle such as frequent flier programs and ticketing systems that would underestimate the average costs of offering its additional service bundle. A recent accusation of predatory pricing by Germania Airlines against Lufhansa serves to illustrate how this third dimension of predatory pricing affects the measurement, conclusions and impact of a predatory pricing investigation.
4. The Lufthansa–Germania predatory pricing case In November 2001, German VBA, Germania, entered the city pair market between Berlin–Tegel and Frankfurt–Main with a scheduled flight service for which it offered a one-way fully flexible fare of h99. Lufthansa (LH) was the incumbent FSA operating on this city pair. As far as the German competition authority (the Bundeskartellamt) was concerned, the ticket conditions (flexibility) associated with this fare matched that of a LH economy ticket aimed at the business travel segment on the same city pair. LH reacted to the entry of Germania by offering a similar fully flexible round-trip economy ticket at a total price of h200, when an outward and return flight were combined (though booked separately). Consequently, for a traveller interested in a round trip, the average LH fare one-way was h100. The Bundeskartellamt compared LH’s new fare with the fully flexible economy fares previously offered and determined that the new fare represented a reduction, of almost 60% (the preentry fare was h485). Towards the end of the year, Germania responded to this by lowering its one-way fare even more from h99 to h55. However, this price was not sustained and by early 2002, the Germania fare had returned to h99. By December of 2001, discussions were occurring between the Bundeskartellamt and LH such that LH submitted ‘‘extensive documentation’’ on its pricing schemes.5 In an effort to avoid a formal reaction from the competition authority, LH raised its fares slightly in January 2002 from the average of h100 to approximately h105. However, this was not enough to placate the Bundeskartellamt and in February 2002, LH was charged with predatory pricing on the flights between Berlin–Tegel and Frankfurt–Main. 5 See Lufthansa Press Release: ‘‘Lufthansa resists official pricing dictate’’ (30.01.02).
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
Early in 2002, well in advance of any determination as the validity of predatory pricing allegations, the Bundeskartellamt imposed a price restriction on LH. The restriction required that LH charge h35 more than Germania as long as the Germania fare was h99 or lower. The restriction also stated that if Germania fares rose above h99, LH could continue to offer a fare of h134. The duration for this price restriction on LH was set at 2 years by the Bundeskartellamt, based on the following argument: ‘‘This restriction is justified in that within two years Germania should have gained sufficient recognition and established a clientele base. Germania’s operational procedures and other competition factors should have also improved to such an extent that protection against predatory conduct on the scale as provided by this decision should no longer be necessary.’’6 The Bundeskartellamt clearly took the approach suggested by the discussion of product differentiation in Section 3.1, above, stating that the premium was required because LH provided additional services on its flights that were not offered by Germania. Nevertheless, the Bundeskartellamt also charged that LH was setting its prices below its ‘‘average operating costs per passenger’’, and stated that: ‘‘The only rational explanation for this pricing strategy is that it is an attempt to force Germania from this route and to recoup resulting losses at a later stage by discontinuing this price tariff and resorting to previous ones. Recent cases on the Munich–London (Stansted) and Munich–Frankfurt routes are further evidence of this strategy. In both cases DLH significantly raised its prices after its rivals, Go-Fly and Deutsche BA, had abandoned these routes.’’7 LH appealed this decision in the fall of 2002 and while the imposition of a premium price penalty was upheld by the court, the size of the premium was reduced to h32.50. Several questions arise from this case in light of the issues discussed in this paper. What role did product complementarities and ‘beyond’ revenues play either in LH’s defence or the determinations of the Bundeskartellamt and the court? In its price–cost calculations, what was the measure of ‘‘average operating cost’’ used by the Bundeskartellamt? Did LH redeploy capacity when it lowered its prices and did this affect the measure of average operating cost? How did the Bundeskartellamt calculate the price premium it imposed on LH? 6 Bundeskartellamt news Lufthansa from hindering its 7 Bundeskartellamt news Lufthansa from hindering its
release, ‘‘Bundeskartellamt prohibits rival Germania’’, (19.02.2002). release, ‘‘Bundeskartellamt prohibits rival Germania’’, (19.02.2002).
93
With the exception of the last question, there are few details available in English at the time of writing. This is perhaps because a final court decision on the case has yet to be made. On the question of pricing and revenues, LH press release of January 2002 seems to emphasize the number of different fares the airline offers, taking the position that: ‘‘Since Lufthansa alone is operating with 1.5 million fares in a fully liberalised market, it is unacceptable that the Cartel Office should act as a regulatory body on just a single tariff’’ and that ‘‘Decisive, however, for a route’s profitability is the sum of all revenues from operating on it’’.8 The news statements from the Bundeskartellamt have not as yet given any details as to the definition or calculation of average operating costs. Nor are there any details concerning any redeployment of larger aircraft or increased frequency on the city pair in question. Only the question of how the premium was calculated can be answered in sufficient detail to related to the issues raised in this paper concerning product differentiation. The calculation of the initial premium of h35 is described by the Bundeskartellamt as a conservative estimate of the value of services offered by LH that were not offered by Germania. Specifically, the premium was calculated as the sum of: h3ðdrink þ newspaperÞ þ h12ðthe value of frequent flyer miles
calculated on the basis that 40 flights would allow for a free flight valued at h484Þ þ h25ðthe estimated value of the flight frequency offered by LHÞ:
This gave a total of h40, but the premium imposed was h35, reflecting a somewhat ad hoc adjustment in the name of using conservative estimates. When the appeal decision was made, the court lowered the Bundeskartellamt’s estimate of h12 for frequent flier miles by h9.50. Consequently, the court recalculated the premium to be the Bundeskartellamt’s original estimate of h40 less h9.50=h32.50. There are some troubling factors in the account of these calculations. The case transcript indicates that the calculation of h25 for frequency of service (left unchanged in the appeal decision) was based on a US marketing research study by Ostrowski et al. (1991).9 The study (an unpublished working paper) was cited as empirical evidence that business travellers are willing to pay up to an additional 25% of the original price for the most flexible fight schedule. While initial criticism might 8 9
Lufthansa Press Release (30.01.02). As reported in Bundeskartellamt, B9-144/01.
ARTICLE IN PRESS 94
W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
have been levelled at the Bundeskartellamt’s lack of peer-reviewed research in support of their calculations, it turns out that a more recent paper by the same authors is published. Ostrowski et al. (1993), report the results of a survey of US travellers, in which they were asked to compare elements of service quality along with pricing between two FSAs. The survey took the form of a self-administered questionnaire distributed to enplaning and deplaning passengers ‘‘of several major airlines’’ during 1992. We might pause here to consider whether comparisons by travellers (who were much more likely to be frequent fliers) comparing service quality factors between two FSAs is the appropriate basis on which to base decisions regarding competition between a FSA and a VBA.10 Ostrowski et al. reports that respondents were asked to allocate 10 points between four factors in their travel decision: ticket price, schedule convenience, frequent flyer program, and airline preference. These responses were compared between the FSAs. The results indicate (with no significant difference between each airline), that the average number of points allocated to schedule convenience was 3.4 in each case. However the standard deviation around this allocation is approximately 2.48 suggesting that the index rating of scheduling convenience could lie anywhere in the range (0.98–5.88). Although a similar table reporting mean values appears in the transcript of the LH–Germania case, however no standard deviations are reported. Other results in Ostrowski et al. are not reported in the Bundeskartellamt’s calculation of premium values. In particular, regressions aimed at showing the relation between ‘‘retained preference’’ for an airline and such variables as ‘‘best schedule’’ and ‘‘best frequent flier program’’ are reported with adjusted R2 values no greater than 3.86 and as low as 0.09. The point here is not to criticize the Bundeskartellamt for recognizing that price matching should be adjusted for service quality. Rather it is to emphasize the difficulty in defining clear and accurate measures of what the quality-adjusted premium should be. Another troubling element of the Bundeskartellamt’s decision is the statement that the price premium is to remain in effect for 2 years, by which time Germania should have become sufficiently established that it will no longer be vulnerable to predatory pricing tactics. This determination does not follow logically from the authority’s earlier justification for the price premium as being the additional services offered by LH. If the justification for the premium is correct, then in 2 years, there is unlikely to be any change in the vulnerability of Germania to price-matching by LH, unless Germania evolves into an FSA. 10 Ostrowski et al. state that over 40% of the total sample had flown more than eight times in the last year.
Lastly, the price constraint imposed on LH was designed as a sliding premium that would diminish if Germania started increasing its price above h99. This was presumably put in place to mitigate the problem of the Bundeskartellamt facilitating the coordination of higher prices by both airlines. However what about the state of future competition between LH and other VBAs in other markets. If both LH and the VBAs now expect a similar premium to be imposed in other markets, then the effect is to pre-impose a change in the reaction functions of the airlines. The precedent set by this case could therefore result in higher prices charged by VBAs competing with LH in the future.
5. Concluding comments Given the existence of demand complementarity, product differentiation and internally flexible capacity in airline networks, what elements of the investigation algorithm make the most practical economic sense? The Lufthansa–Germania case illustrates the pitfalls and difficulties in directly administering price premiums to prevent de facto price undercutting by FSAs against VBAs. Is this preferable to the approach of the Competition Bureau (2001) in Canada, which can issue a ‘cease and desist’ order that prohibits the an alleged predatory pricing policy until a determination can be made. Practically, it places the onus on the accused airline to rework its pricing policy in an environment of uncertainty over what an acceptable pricing policy is. It is important in the air travel industry as in other sectors that current and potential market participants have a clear understanding of the rules of the game. This is never more important in an industry where firms are competing directly or indirectly in markets around the world. Given problems of measurement and timeliness and the particular characteristics of the air travel industry, the way forward for the airline industry is to simplify the institutions governing predatory pricing and move to a more harmonized and transparent process. In this regard a better approach would be to make competition policy rules clear with regards to what are sunk costs and what are product-specific fixed costs that should be included in the calculation of average avoidable costs. In particular redeployed aircraft capacity to a city pair should be included in the calculation of average avoidable cost for that market, particularly if the redeployment can be related to foregone profits elsewhere in the network. Having a clear definition of how average avoidable costs are measured in air travel markets would allow for a more straightforward price– cost test and negate the need for the imposition of price premiums in markets where VBAs compete with FSAs. There will always be issues of measurement error, but a price–cost test would minimize these and provide clear
ARTICLE IN PRESS W.G. Morrison / Journal of Air Transport Management 10 (2004) 87–95
rules of the game to incumbents and potential entrants alike. Acknowledgements I wish to thank David Gillen, David Starkie and participants at the Hamburg Aviation Conference for comments on an earlier draft. I alone am responsible for any errors. References Baumol, W.J., 1996. Predation and the logic of the average variable cost test. Journal of Law and Economics 39, 49–72.
95
Button, K.J., 2003. Does the theory of the core explain why airlines fail to cover their long-run costs of capital? Journal of Air Transportation Management 9, 5–14. Competition Bureau (Industry Canada), 2001. Enforcement guidelines on the abuse of dominance in the airline industry. Industry Canada, Ottawa. Church, J., Ware, R., 1999. Industrial Organization: A Strategic Approach. Irwin McGraw-Hill, New York. Gillen, D., Morrison, W., 2003. Legacy carriers and upstarts: regulation, competition and evolution of networks in aviation markets, School of Business and Economics, Wilfrid Laurier University, Waterloo. Morrison, W.G., 2003. On the existence of predatory pricing in air travel markets, School of Business and Economics, Wilfrid Laurier University, Waterloo. Ostrowski, P., O’Brian, T., Gordon, G., 1993. Service quality and customer loyalty in the commercial airline industry. Journal of Travel Research 32.