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Competition or Predation Whats going on up there

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... the Air Canada and American Airlines predatory pricing cases. David McAllister ... The American Airlines case seems to confirm the proposition that under the ... – PowerPoint PPT presentation

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Title: 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.

2
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

3
Overview
  • Predatory pricing
  • The role of cost revenue tests in predation
    analysis
  • Background and theory of both cases
  • What explains the different outcomes
  • Conclusions

4
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

5
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

6
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

7
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

8
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

9
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

10
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

11
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)

12
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

13
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

14
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)

15
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

16
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)

17
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

18
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

19
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

20
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

21
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

22
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

23
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

24
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

25
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

26
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

27
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

28
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

29
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

30
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

31
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

32
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

33
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

35
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

37
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

38
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

39
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
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