Competition or Predation Whats going on up there

1
Competition or PredationWhats going on up there?

• A look at the Air Canada and American Airlines
  predatory pricing cases
• David McAllister
• Charles Schwartzman
• November 26, 2003
• This presentation was prepared for delivery to a
  class at the the Economics Department at Queens
  University. The comments and conclusions herein
  are those of the presenters.

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Similar Cases, Different Results

• July 3, 2003, the U.S. Court of Appeals 10th
  Circuit upheld summary judgment in favour of
  American Airlines the government failed to
  establish that American priced below an
  appropriate measure of cost
• July 22, 2003, the Competition Tribunal held that
  Air Canada committed anti-competitive acts by
  operating or adding capacity at fares that did
  not cover the avoidable cost of providing the
  service

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Overview

• Predatory pricing
• The role of cost revenue tests in predation
  analysis
• Background and theory of both cases
• What explains the different outcomes
• Conclusions

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Predatory Pricing

• Anti-trust scholars debate its existence
• But most agree that it is rarely tried and more
  rarely successful
• The outward symptoms are identical to competition
• Falling prices
• Bitter rivalries between firms
• Competitors exiting a market

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Conventional Definition

• A dominant firm with market power
• high market share
• in an industry with barriers to entry
• engages in below cost sales
• with the object or intent to eliminate a
  competitor or damage competition and
• has the ability to recoup losses through future
  price increases

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Economic Tests for Predation

• Recoupment necessary to show harm to consumers
• Comparison of costs to prices or revenues
  necessary to establish the essential element of
  below cost pricing

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Cost / Price Test

• Critical to distinguish predation from
  competition
• Incumbents must be able to respond to new
  entrants and they need to know the limits to
  which they can go
• Courts clearly favour an objective test
• The Areeda and Turner (1975) average variable
  cost (AVC) test, as a proxy for marginal cost,
  has most commonly been accepted

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Cost Definitions 101

• Variable vary with changes in output, either in
  direct proportion, or by steps
• Fixed do not change with the level of output
• Marginal the cost of producing an additional
  increment of output (difficult to measure, cannot
  be determined by conventional accounting methods)
• Average Variable adopted as a proxy for
  marginal cost
• Sunk a cost that has already been incurred and
  cannot be changed or recovered by the firm
• Common an indivisible cost associated with two
  or more outputs

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Think of a Traffic Light

• Green light if price exceeds total cost it is
  presumptively lawful not predatory
• Yellow light if price exceeds AVC but is below
  total cost, this is loss minimizing and, absent
  strong evidence of intent to lessen competition
  or aggressive price cutting, lawful
• Red light price below AVC is presumptively
  predatory absent an valid business justification
  such as a perishable commodity

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Logic of the AVC Test

• When price is below AVC the firm is loosing on
  each unit sold
• The firm would be economically better off to
  cease production
• Irrational behaviour unless the motive is to
  eliminate or damage competition
• Force an equally efficient rival out of the
  market
• Conversely if price exceeds AVC, it will pay a
  competitor to stay in the market at least for the
  short term

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Shortcoming of the AVC Test

• Historically, industries with low average
  variable costs (AVC) have been as a practical
  matter largely immune from predatory pricing
  claims. The reason is simple. Predatory pricing
  claims require the plaintiff to establish, among
  other things, that the defendant priced below an
  appropriate measure of cost.Consequently, in
  industries where average variable costs are very
  low, plaintiffs are unlikely to be able to prove
  that defendants have priced below AVC, even when
  defendants have drastically slashed prices.
  Airlines are a classic example of such an
  industry. (Wilmer, Cutler Pickering)

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Avoidable Cost

• William Baumol (1996) Predation and the Logic of
  the Average Variable Cost Test
• An evolution or refinement of the Areeda Turner
  AVC test
• Recognizes that in a multi-product firm, there
  may be non-sunk fixed costs that are avoidable
• The logic of the avoidable cost approach is the
  same as AVC, but it is potentially a more
  meaningful test for predation because it captures
  more than variable costs

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Non-Sunk Fixed Costs

• Baumols airplane example
• (an airplane) is a fixed cost and does not
  become a variable cost even in the long-run,
  because one cannot run an airline on the route
  with zero airplanes. In contrast, this cost is
  not sunk because, if traffic between New York and
  Milwaukee declines drastically, the plane can be
  shifted to serve another route

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Bureau and Air Canada Agreed on the Avoidable
Cost Concept

• Competition Tribunal
• Both the Commissioner and Air Canada have
  introduced expert economic evidence that the
  avoidable cost test is an appropriate way to
  identify anti-competitive conduct in the airline
  industry. Hence, even in the absence of the
  airline regulations, operating capacity below
  avoidable cost could be found to constitute an
  anti-competitive act. (Air Canada, para. 48)

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Bureau and Air Canada Disagreed How to Apply the
Test

• Unit of capacity to consider flight vs. route
• What costs are avoidable and when
• Time period for analysis
• Consideration of beyond revenue - value of
  flights providing feed traffic to the network
• Tribunal to answer these 4 questions in Phase I
  hearing

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Definition of Avoidable Cost

• Competition Tribunal
• All costs that can be avoided by not producing
  the good or service in question. In general, the
  avoidable cost of offering a service will consist
  of the variable costs and the product-specific
  fixed costs that are not sunk. (Air Canada,
  para. 76)

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Avoidable Cost Formula

• Calculated on an asm (available seat mile)
  basis
• Revenue O/D, plus pro-rate of connecting
  passengers and cargo compared to
• Avoidable costs - variable expenses (e.g. fuel)
  plus non-sunk product specific fixed costs (e.g.
  aircraft)
• Offside the test if revenue is insufficient to
  cover avoidable cost

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The Airline Industry

• Believed to be susceptible to predation
• Dominant carriers have mobile assets and ability
  to target new entrants with price cuts and added
  capacity
• New entrants vulnerable to cash burn
• Low variable costs limit effectiveness of the
  traditional Areeda Turner approach

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Two Cases Similar Facts

• Air Canada and American dominant
• Both full-service network carriers operating a
  hub and spoke system
• Each responded to the entry of low-cost carriers
  by adding capacity, lowering fares (usually to
  match), or altering yield management to make more
  low-priced seats available
• LCCs have different business model

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Case Theory U.S.

• USDOJs theory was that the incremental revenue
  earned by American did not cover the incremental
  cost of the capacity it added
• American intended to recoup its losses by
  establishing a reputation for predatory pricing
  to defend its DFW hub
• Evidence showed that American was successful
  driving low-cost carriers off of the routes in
  question

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Case Theory U.S.

• District court repudiated the reputation theory
  of predation as fundamentally misguided,
  contrary to law, and unsupported by the
  uncontroverted facts
• Also concluded that there was no dangerous
  probability that American could recoup any
  losses
• Appeal court only addressed the issue of whether
  American priced below AVC and did not deal with
  recoupment or reputation theory

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Case Theory - Canada

• Bureau alleged Air Canadas responses were part
  of a strategy to keep low-cost carriers out of
  eastern Canada and to defend Fort Pearson
• Air Canadas responses were directed against the
  eastward expansion of WestJet and the entry of
  CanJet in 2000
• Revenues were insufficient to the cover avoidable
  cost of scheduled flights

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AVC vs. Avoidable Cost

• The U.S. Courts used the traditional approach of
  AVC, e.g. aircraft, some labour and many common
  costs, treated as fixed, not variable
• Competition Tribunal used avoidable cost as set
  out in airline regulations, and concluded that
  other than overheads, virtually all costs were
  avoidable
• Tribunal adopted a conceptual approach based on
  a hypothetical flight cancellation

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Unit of Analysis

• U.S. courts looked cumulatively at all flights on
  a route
• Tribunal accepted to examine individual schedule
  flights
• U.S. courts considered variability or
  avoidability of costs from the perspective of the
  company
• Tribunal focus was on flights

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Costs U.S. Case

• USDOJ proffered four tests related to Americans
  capacity additions, all rejected by the Court as
  invalid as they did not reflect variability or
  avoidability
• two tests were partially based on fully allocated
  total costs
• two others were described as short-run profit
  maximization or sacrifice tests i.e. it was
  predatory because American could have made more
  money flying other routes

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Costs U.S. Case

• Court was critical of the DOJs reliance on costs
  used in Americans flight profitability system
  rather than independent measures of costs
  associated with capacity additions
• U.S. courts held that if a flight was cancelled,
  American would continue to incur aircraft and
  many other common costs
• The appeal decision declined to dictate AVC as
  the definitive proxy for marginal cost in all
  cases

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Costs Air Canada Case

• Tribunal accepted cost figures from Air Canadas
  flight profitability system based on generally
  accepted accounting principles, cost drivers and
  the step-variable nature of many costs
• Also accepted that aircraft and many labour costs
  were avoidable through redeployment to other
  flights

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Costs Air Canada Case

• Costs can be avoided outright, by redeployment or
  disposal
• Redeployment was a key consideration - element of
  opportunity cost requiring the presence of more
  profitable uses for the resources on other routes
• Baumol if costs can be covered by revenues
  earned elsewhere, they are avoidable

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Costs Air Canada Case

• The Tribunal held that is sufficient to show that
  redeployment opportunities were generally and
  realistically available at the time of the
  alleged predation
• It also accepted that some allocated common
  labour costs (such as baggage handlers) are
  divisible and can be treated as avoidable
  through redeployment or passenger recapture if a
  flight is removed from the schedule

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Time Period

• U.S. courts looked at Americans results over 18
  months
• Tribunal willing to apply the initial test over a
  one-month period
• Tribunal may apply a different time frame in
  deciding what constitutes a practice of
  anti-competitive acts in Phase II of the hearing

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Measuring Revenues

• Both cases compared revenues earned on flights
  as opposed to looking at individual fares
• Airline yield management systems provide multiple
  fares on any given flight, hence the average fare
  vs. average avoidable cost is what matters
• Common issue in both cases was how to account for
  beyond contribution the value of a flight
  providing feed traffic to other flights in the
  carriers network

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Pro-rate vs. Beyond Revenue

• Connecting passenger revenue included on a
  mileage pro-rate basis
• Beyond revenue e.g. attributing all of the
  revenue, minus only some portion of incremental
  costs, back to the first flight leg - not
  included
• No universally accepted method of calculating
  beyond revenue
• WestJet does not use the concept of beyond
  revenue to run its network

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Beyond Revenues

• USDOJ credited American with some beyond revenue
• On the facts, the Tribunal found no proper basis
  to include beyond revenues in the calculation
• Air Canada failed to properly address passenger
  recapture, i.e. even if it cancelled a flight, it
  would recapture connecting passengers on other
  flights and would not lose this revenue

34
Price Matching

• Both carriers asserted a meeting the competition
  defence for predatory pricing claims
• U.S. district court accepted it, but appeal court
  declined to rule on the point
• Tribunal did not address it in the Phase I
  decision, it may surface in Phase II
• Such a defence exists in the criminal
  jurisprudence on predatory pricing under the
  Competition Act

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Conclusions

• It is not just which test that is used, but how
  the test is applied, that can produce different
  results in terms of the below cost element of a
  predatory pricing analysis
• The American Airlines case seems to confirm the
  proposition that under the traditional Areeda
  Turner approach, firms in industries with low AVC
  may be virtually immune from predatory pricing
  claims

36
Conclusions

• Based on the Tribunals interpretation, the
  avoidable cost approach may overcome this
  difficulty
• However, the avoidable cost test requires an even
  more intensive and complex case specific
  investigation
• Under the AVC test, it is necessary to identify
  costs that are fixed vs. costs that are variable

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Conclusions

• The avoidable cost test requires that in addition
  to identifying variable costs, fixed costs that
  are avoidable must be distinguished from those
  which are sunk
• Moreover, when avoidability hinges on the
  identification of more profitable redeployment
  opportunities, this introduces another level of
  complexity to the analysis

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Conclusions

• The appeal decision in the U.S. leaves the door
  open a crack on issues such as alternative cost
  standards and the meeting the competition defence
• But the bar for making out a predation case in
  the U.S. remains as high or higher than ever

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Conclusions

• A full comparison of the Air Canada and American
  cases will have to await the Tribunals Phase II
  decision, or the outcome of any appeals
• The Tribunal has yet to address the important
  issues of dominance, practice of
  anti-competitive acts and the effects on
  competition
• The debate over predation is far from over