Competition Issues in the Canadian Airline Industry

1
Competition Issues in the Canadian Airline
Industry

• 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.

2
Overview

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

3
Industry Background

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

4
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

5
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

6
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

7
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

8
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

9
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

10
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

11
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

12
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)

13
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

14
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

15
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

16
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)

17
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

18
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)

19
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
  avoidable
• Costs generally avoidable in a period of one
  month
• No consideration of beyond revenues at initial
  stage of analysis (may be a legitimate business
  justification)
• Average revenues per flight the proper approach
  to measuring revenues not focus on individual
  fares

20
Avoidability of Costs

• 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

21
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

22
Changes to the Industry

• Entry by low-cost carriers WestJet, CanJet,
  Jetsgo
• 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

23
Bureau Response to Change

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

24
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

25
Conclusions

• 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.