In this business it can be safely assumed that where there is a small new entrant a larger predator is never far away.
Liberalisation of the airline industry is normally justified on the grounds that competition encourages the efficient provision of airline services, with carriers offering good quality services at the lowest possible cost and price. The competitive model relies on existing carriers challenging one another in an attempt to improve their position in the industry and on new entrants exploiting the opportunities and preventing incumbents from excessive profiteering in the marketplace.
Of course, there are a number of well known barriers to entry and competition which hinder this process. Lack of sufficient airport capacity is clearly a major problem. But there are also other examples, such as loyalty schemes, which give a large incumbent inherent advantages over new entrants and other smaller carriers.
Then there is predation, a very special type of barrier. Predatory behaviour has caused confusion among some airline managers, who can fail to understand fully both what it is and how to counter it. Put simply, when predatory, the predator deliberately incurs losses, in particular by setting prices below cost, in order to impose losses on the prey and force it to exit the market.
The whole issue of predation caused confusion in the early stages of the US deregulatory process too. Airline managers would complain: 'Governments have made us compete in the marketplace and want us to reduce prices, yet we cannot do our best to price our competitors out of the market.' Indeed Alfred Kahn, former chairman of the Civil Aeronautics Board, coined the phrase 'deregulatory schizophrenia' to describe this thought process.
Competition relies on the ability of airlines to compete and to challenge one another continuously. Although passengers benefit in the short run from lower prices and higher frequencies while a predatory battle is taking place, they will suffer from two harmful effects in the longer run.
First, if the prey was more efficient than the predator but was forced out of the market, predation would jeopardise the tendency towards innovation and efficiency in the industry. Second, successful predation will lead to higher prices and lower frequencies in the long run, as the predator seeks to recoup the short-term losses from its predatory behaviour.
One of the objectives of predation is to gain a reputation for being aggressive. Any future potential competitor will then have second thoughts about engaging in competition with such an airline. Hence, by behaving very aggressively shortly after markets have been liberalised, a carrier may save itself from having to engage in similar competitive fights later on.
Predation is a particularly attractive option for a large carrier facing competition from a smaller one. If the large carrier with many routes sees a competitor entering on one or two of its routes, it can use profits from other routes to finance the battle with the smaller carrier. In other words the established carrier can use its 'deep purse'. The smaller carrier does not enjoy such advantages, runs out of funds, and either exits the route or goes out of business.
But predation can also be a useful strategy for large carriers to discipline other equally large carriers where both airlines' networks overlap on a number of routes. In this instance, an airline would use predation as a way to preclude a second carrier from acting aggressively, by threatening to overreact in another market. This variant of predatory pricing is sometimes referred to as 'discipline pricing': the logic can be summed up in the message 'mess with our market, and we will mess with yours'. In this case predation would not necessarily be a tit-for-tat reaction. The second carrier might have started the fight by behaving aggressively but not predatorily. This way, what could have turned into healthy competition is instead disciplined away through predation.
Hence predation is a means for the larger airlines to eliminate 'dangerous' and efficient new carriers, and keep other major carriers in check.
However, detecting predation is always difficult, particularly in the airline industry where traditional cost/price based approaches are especially hard to apply. This is clearly underlined by the fact that, so far, there have been no successful predation suits in the airline industry.
Nonetheless, there have been a number of cases, both in the US and elsewhere, where the evidence points in the direction of predatory behaviour. However, indecision on the part of the airlines affected, possibly motivated by the lack of a precedent and by the heavy cost of taking action and pursuing complaints, have made predation cases very much an exception. They may also have been deterred by the fact that the European Commission can take up to two years to rule on a complaint.
Yet predation cases have been successful in other industries. For example, in the UK competition agencies have found larger bus companies guilty of predatory action against smaller competitors in the type of multi-market situations that are characteristic of the airline industry.
Traditionally, predation has been defined as pricing below marginal costs, that is, pricing below the cost of producing an extra unit of output. In practice, measuring such marginal costs can be quite difficult, and the more pragmatic criterion of defining predation as pricing below average variable costs has often been adopted.
In the well known Akzo case, the European authorities applied a more complex approach under which pricing behaviour would be deemed predatory if prices were greater than average variable costs but lower than average total costs, and if it could be shown that the pricing behaviour was part of a wider plan to eliminate a competitor. This approach is therefore concerned with the question of intent.
However for airlines, the first question to be addressed is that of the appropriate definition of cost to be used in assessing predation. Any definition based on short run marginal cost is generally inappropriate in the airline industry. Once a decision has been made to provide a flight, the cost of an extra passenger on the plane is very low - just a few dollars for extra fuel, meals and so forth - and so the short-run marginal cost of air travel is close to zero. It would be absurd then if prices could only be regarded as predatory if they were below this level.
The simple marginal cost rule is thus not appropriate for airlines. Instead, the crucial issue is whether an airline deliberately incurs losses in order to eliminate or discipline a competitor. Examples would include cases where an airline deliberately schedules a flight which it knows will be unprofitable, or when it reduces fares below the levels which would maximise its yield from the flights, given the pricing policies andservice schedules set by its competitors.
Of course proving such predation in practice is difficult, but the average variable cost rule suggests that airlines should not deliberately operate flights where average yield is expected to be below average variable cost. In addition, no particular group of passengers should be carried at an average yield below the average variable cost of carrying them.
The important conclusion is that economic arguments can be constructed to support an outcome which is economically beneficial for the airline industry and society at large.
Furthermore, the importance of new entry in an industry as dynamic as the airline business is such that the rules to prevent predation should be clearly specified. Managers of small newly established carriers should be confident that any niche they have identified in which they may put their inherent competitive advantages to good use will not be wrecked by the financial muscle of larger competitors. This is especially true in a market like Europe, where the issue is aggravated by the fact that funds to finance predation could possibly come from state aids to national flag carriers.
On the other hand, airline managers must be aware of the current difficulties of pressing ahead with complaints of predation. The fact that there have been no successful predation cases in the airline industry, even where such claims might have been justified, does send signals to the marketplace.
The latest two complaints in Europe, by World Airlines and EasyJet, have added to the adverse body of evidence, although it is not clear whether predation actually took place in either case. World Airlines filed its complaint shortly before ceasing operations when London City Airport grounded its aircraft due to mounting debts. In its complaint filed last October, EasyJet accused KLM of predatory pricing on the London-Amsterdam route. Commission officials have visited KLM but no information regarding the results of their investigations has yet been released. With the proposed American Airlines-British Airways alliance and the Boeing-
McDonnell Douglas merger to scrutinise, the Commission has other priorities.
Should a complaint be filed, information requirements would generally involve management accounts, so as to enable investigating agencies to isolate avoidable costs from other costs. The agencies would normally require such data from the defendant as well. Evidence on the timing of competitive moves is also important as a way of inferring intent.
In this respect two practical issues are worth raising. First, there is a possibility that new entrants might make losses in the first few years. This does not mean that there are necessarily grounds for thinking the smaller new entrant airline may be predating on the larger carrier. Predation is dependent on avoidable costs, that is costs which could be saved from removing a given service. These therefore exclude any startup costs which the airline might be financing in the first few years of operation.
Second, competition agencies need to be sceptical of predation claims from failing airlines. One of the few fully documented airline predation investigations was that by the Australian Federal Trade Practices Commission (TPC) into Compass Airlines. Compass claimed that it had been forced out of business by the established high-cost airlines which had matched its lower fares. However there was little else the larger airlines could do to stay in business, and Compass' strategic plans had been based on the completely unrealistic premise that the existing airlines would not react to its entry. Often, too, Compass cut fares further in a way that exacerbated its own losses. Not surprisingly, the TPC ruled that the established airlines' actions had not been anti-competitive.
Nevertheless predation can - and very probably does - occur in the airline industry. The extent to which it can be prevented could determine the overall success of deregulation in Europe. It is important, therefore, that the relevant authorities address the issue with special care. A new entrant is unlikely to achieve very much with a new slot if it is too easy for the incumbent to wipe out its inherent competitive advantage. Competition agencies such as the European Commission need to be persuaded to act quickly and decisively in this regard.
Source: Airline Business
