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Competition Issues in the Canadian Airline Industry


1999 merger gave Air Canada 80% share of domestic passengers carried, 90% of revenues. Air Canada provided competition undertakings to the Bureau ... – PowerPoint PPT presentation

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Title: Competition Issues in the Canadian Airline Industry

Competition Issues in the Canadian Airline
  • David McAllister
  • Charles Schwartzman
  • Competition Bureau
  • November 3, 2004
  • 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.

  • Industry Background
  • Theory and economics of predatory pricing
  • The Air Canada case
  • Industry Changes

Industry Background
  • Industry deregulated in 1987 with the Canada
    Transportation Act
  • Apart from safety certification and compliance
    with foreign ownership limits (25) market forces
  • Open entry
  • Routes
  • Capacity
  • Fares
  • 1995 Open Skies Agreement with the U.S. on
    trans-border services

Air Canada / Canadian Merger
  • 1999 merger gave Air Canada 80 share of domestic
    passengers carried, 90 of revenues
  • Air Canada provided competition undertakings to
    the Bureau
  • Industry specific provisions added to the
    Competition Act focus on predatory pricing
  • Objective to create conditions to foster a
    competitive domestic market without opening the
    market to foreign competition

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
  • New entrants vulnerable to cash burn
  • Low variable costs limit effectiveness of the
    traditional Areeda Turner approach

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

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

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

Cost / Price Test
  • Critical to distinguish predation from
  • 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

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

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
  • Conversely if price exceeds AVC, it will pay a
    competitor to stay in the market at least for the
    short term

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)

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

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

Air Canada Case
  • 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

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)

Bureau and Air Canada Disagreed How to Apply the
  • 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

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)

Tribunal Findings
  • Competition Tribunal used avoidable cost as set
    out in airline regulations, and agreed with the
    Commissioner that
  • Relevant unit of analysis is the flight
  • Other than overheads, virtually all costs were
  • Costs generally avoidable in a period of one
  • No consideration of beyond revenues at initial
    stage of analysis (may be a legitimate business
  • Average revenues per flight the proper approach
    to measuring revenues not focus on individual

Avoidability of Costs
  • Costs can be avoided outright, by redeployment or
  • 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

Unresolved Issues
  • Tribunal clear in Phase I decision the fact
    that Air Canada operated capacity below avoidable
    cost does not necessarily mean engaged in abuse
    of dominance
  • Need to address in Phase II
  • Dominance
  • Practice of anti-competitive acts
  • Substantial lessening of competition

Changes to the Industry
  • Entry by low-cost carriers WestJet, CanJet,
  • Decline in Air Canadas market share to below 60
  • Growth of the Internet as a means of distribution
  • Availability of slots, counters, gates at
    Canadian airports
  • Development of competing loyalty programs
  • Shift in consumer demand emphasis on low fare
    unrestricted tickets
  • Full-service business model broken Air Canada
    forced to restructure under CCAA
  • Market has become competitive

Bureau Response to Change
  • Support rescinding of remaining merger
  • Revised enforcement policy
  • Terminated Tribunal litigation
  • Air Canada not appeal Phase I
  • Bureau not proceed to Phase II

Bureau Enforcement Policy
  • Revised in September
  • Recognize changes in the industry
  • Avoidable cost test not a strict liability need
    a trigger in response to competition
  • Adding capacity
  • Undercutting fares
  • Increase number of low-priced seats
  • Concept of a safe harbor for price matching

  • Merger undertakings and enforcement of the
    airline provisions had the desired effect a
    competitive domestic market
  • Tribunal litigation broke new ground clarified
    the rules for the industry
  • Minister of Transport now looking at liberalizing
    foreign ownership rules, broader open skies
    agreement with the U.S.