Oligopolies in Transportation and Related Markets: The 2001 Air Canada Predation Case
One of your Ride On writers started his career by working on this case for the Competition Bureau, and he still has fond memories of it for how it made him the economist he is today.
This is a post your Ride On writers published a couple years ago, but it fits really nicely within the current series on oligopolies, so we want to share it again today.
Since the Canadian airline industry was deregulated in 1988, a plethora of airlines have gone out of business, including Canadian Airlines International, Royal Airlines, Jetsgo, CanJet (twice!), Canada 3000, Roots Air (yes, the clothing company created an airline), Wardair, Greyhound Airlines (yes, the bus company had an airline, too), and so on and so forth. Throughout it all, Air Canada was often branded responsible for many of these failures due to alleged anti-competitive practices.
If we are honest, many — if not most — of these accusations against Air Canada were unsubstantiated and opportunistic, but there have been cases where it indeed seemed to price “too low to be legal”. The most exciting one started on March 5, 2001 when the Competition Bureau’s Commissioner of Competition, Konrad von Finckenstein filed a Notice of Application with the Competition Tribunal, alleging Air Canada violated the Canadian Competition Act. The Bureau’s application was motivated by the alleged anti-competitive responses of Air Canada to entry of two “low-cost carriers”:
WestJet: Air Canada allegedly responded to its entry on the Hamilton/Moncton route in early 2000 by increasing capacity on this route (as well as three other eastern Canadian routes) at substantially lower fares than WestJet charged, which did not cover Air Canada’s avoidable costs (to be defined later in this post).
CanJet: Air Canada allegedly responded to its entry on three Halifax routes by substantially lowering its fares on these routes to ones below its avoidable costs.
Note that Air Canada’s alleged predatory practices did not just involve lower prices, but also excess capacity. When the allegations against Air Canada were made in 2001, the following had to be shown to make a case under Section 79 of the Competition Act:
One or more persons substantially or completely controlled, throughout Canada or any area thereof, a class or species of business. In other words, the defendant must have market power.
That person or those persons had engaged in, or were engaging in a practice of anti-competitive acts.
The practice has had, was having, or was likely to have the effect of preventing or lessening competition substantially in a market, taking into account any superior competitive performance.
If all elements were proved, then the Competition Tribunal could make an order prohibiting all or any of those persons from engaging in that practice.
The hearing was divided into two phases, where the first phase began in September 2001. It addressed the following issues:
What is the appropriate unit(s) of capacity to study (e.g., flight, route, network)?
What categories of costs are avoidable and when do they become avoidable?
What is the appropriate time period or time periods to examine?
What, if any recognition should be given to “beyond contribution”?
These questions were answered by applying the test to two sample routes, and using data for April 1, 2000 to March 5, 2001. After these questions were answered, the purpose of the second phase of the hearing was to deal with the balance of the Commissioner’s application. Specifically, do the answers to these questions suggest Air Canada was in violation of of the Competition Act?
However, after a series of unfortunate events that delayed the hearing more than once — the tragedy of September 11, 2001, Air Canada’s subsequent filing for bankruptcy protection under the Companies’ Creditors Arrangement Act (CCAA), and the need to constitute a new Tribunal panel in 2002 — Phase II ended before it even began: on October 29, 2004, the new Commissioner of Competition (Sheridan Scott) announced the litigation between the Bureau and Air Canada had been resolved.
The Competition Tribunal’s decision in the Air Canada case was the first in Canada to provide an interpretation of the Avoidable Cost Test in terms of alleged predation. It had implications for how the test should be carried out in subsequent airline cases in Canada, as well as how it might be carried out in other jurisdictions. It also had more general implications for how an Avoidable Cost Test should be carried out in other possible cases of predation brought under the abuse of dominance provisions. Thus, this case provided guidance regarding what kind of competition is healthy and what kind of competition is too aggressive — both economically and legally.
The Air Canada case was a landmark competition case in several ways, one of which is it gave businesses clarity regarding how the competition authority would approach measuring avoidable costs, and thus understand how to compete strategically without being too aggressive.
In general, it provided a nice backdrop for analyzing why businesses do what they do, which can be summarized with the following key questions answered in Principles of Microeconomics courses under different scenarios:
How much will they produce (if anything at all)?
How much labour and capital will they use?
What prices will they set?
What are the welfare implications of a firm’s decisions?
Why do firms engage in forms of non-price (strategic) competition?
In the interest of transparency, one of your Ride On writers — the economist — worked on the Air Canada case for the Competition Bureau. In fact, it is hard to get him to shut up about it, even though it happened a generation ago! Therefore, we want to stress that everything written in this post is public information, and our key sources can be found on the Competition Tribunal website, as well the following:
Eckert, Andrew and Douglas S. West (2006), “Predation in Airline Markets: A Review of Recent Cases,” in Advances in Airline Economics 1: Competition Policy and Antitrust, Edited by Darin Lee (Amsterdam: Elsevier), 25-52.
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Details of the Air Canada Case
The purpose of this section is to answer the following questions in the context of the Air Canada case:
What exactly does predation mean? Does it just mean pricing too low, or can it involve other strategic behaviour?
How broad in scope does the act have to be? Can the predator concentrate on a few select flights, or does it need to attack its rival across the entire route?
In general, how do we decide whether a cost is “avoidable”? In what ways can a firm avoid a cost?
Should we take into consideration revenues and costs of flights that are linked to the flight in question? If so, how much?
How long does it take for a cost to become “avoidable”? How long does it take a firm to realize that it is losing money, and should therefore pull out of the market?
What if a firm is not losing money? Can low pricing still be anti-competitive?
Question 1: Predation
A firm engages in predatory pricing when it lowers its price to drive rivals out of business and/or to scare off potential entrants, and then raises its price again to recoup the losses incurred during the predatory period. In most definitions, the firm must lower its price below some measure of cost, so it suffers short-term losses in exchange for (larger) long-run gains. It is also typically assumed that the victim has lower costs than the predator; otherwise the predator could price below its rival profitably.
Therefore, it is not enough to say “I cannot price that low, so they are cheating”. If a business is more efficient than its competitor, then we hope they do set lower prices.
But this is not the only way a firm can be a predator: it can also engage in predation by flooding the market with excess capacity. For example, in response to WestJet’s announced entry into the Hamilton/Moncton route, Air Canada might have kept its fares unchanged, but then added another flight to the route to attract passengers who would not have purchased tickets on one of the other flights. It could also increase the aircraft size for an existing flight. While this might seem like good business practice, a problem exists if the revenues generated by Air Canada from the extra passengers do not cover its costs of this extra flight.
Question 2: Scope of the Competition Act
Our earlier example suggests that an airline can practice predation by focusing on a few particular flights, rather than the entire route (or the entire network). This was the position taken by the Bureau, and it was accepted by the Competition Tribunal.
However, Air Canada rejected the scheduled flight as the appropriate unit of capacity. It argued as long as flight operations on a route are profitable, entry by an equally-efficient competitor will be possible. But a problem with looking at the route is predation could go undetected, because the predator could be making substantial losses on a few key flights, but still be profitable on the route as a whole.
One might then ask, even if Air Canada does add an extra flight to its schedule, why does the entrant not add its own flight and compete for the customers? One possible explanation is many passengers have strong preferences regarding when they want to fly, and only so many flights can take off within the preferred time frame.
A second potential explanation is brand loyalty: a passenger might prefer to purchase a ticket from Air Canada rather than from the new entrant, even if the entrant’s price is lower. For example, the customer might be skeptical of the quality of the entrant’s service, or that it will remain in business at all.
An implication of the above arguments is price-matching is not necessarily an optimal strategy. Air Canada — and airlines accused of predation in other countries — argued it had a right to match its competitor’s lower price, even if it was losing money. But if Air Canada already had prime slots and brand loyalty, then it might have been able to charge higher fares and still be profitable.
Question 3: Measuring Costs
If a firm is not covering its costs on a flight then it should change its operations, but what is the appropriate definition of costs for a predation test? Is it unlikely total costs since some costs would have to be incurred even if the firm ceased operations immediately, for example labour, lease payments on the aircraft, etc.
One way to measure costs focuses on average total costs and average variable costs — the Areeda-Turner Test of predation proposed by Areeda and Turner (1975). If a firm cannot even cover its average variable costs, then it would be more profitable (less unprofitable) to cease operations completely — or find a way to reduce these costs. Thus, if a firm does not shut down when pricing below average variable costs, it is alleged to be predatory.
Alternatively, Baumol (1996) argued costs could be divided into avoidable costs and unavoidable costs; the latter includes sunk costs, which are costs that are have already been incurred and can never be recovered. So the question is:
If I shut down now or modify my operations, will I be more profitable — or less unprofitable — than if I instead maintain the status quo?
Some costs are avoidable outright, such as fuel: if a flight is grounded, then no fuel is burned. But the avoidability of other costs are more debatable, so Air Canada argued avoidable costs were much lower than the Commissioner argued — not surprising because lower avoidable costs justify lower legal prices under this test.
One argument made by Air Canada to defend this position was it had “inflexible contracts” with its union employees: even if it shut down operations completely, it would still have to incur the contracted costs. However, the Competition Bureau made two counterarguments:
Air Canada could redeploy planes and labour to different routes, thus making these costs avoidable by redeployment.
Accepting the “inflexible contracts” argument uncritically would give a predator the incentive to purposely make their contracts more inflexible.
In the end, the Competition Tribunal largely accepted the Commissioner’s position with respect to which costs were avoidable, including aircraft costs. The Tribunal was satisfied the Commissioner had shown opportunities for redeployment were generally and reasonably available.
Question 4: Beyond Contribution
There was also the issue of beyond contribution: the difference between beyond revenue and beyond costs. Beyond revenue includes the prorated portions of fares of through and connecting passengers on the route that are allocated to the other flight segments of the trips of through and connecting passengers.
The Commissioner excluded beyond contribution from the measure of revenue for a given flight. He argued that in the event of a flight cancellation, Air Canada could retain the beyond contribution via passenger redeployment to alternative flights. Air Canada had a procedure for calculating beyond contribution, and would include the beyond contribution attributed to a particular flight to the flight’s revenue.
The Tribunal found no basis for including beyond contribution as submitted by Air Canada. It further found that when properly estimated, beyond contribution could be considered a legitimate business reason for operating a schedule flight with revenues below avoidable costs, but it is not to be included in the calculation of the test.
Question 5: Timing Issues
Of course, a loss is not necessarily due to illegal acts on the part of the business. It might have been due to unexpected fluctuations in the economy — such as a recession — or due to a lag in generating profitability reports for a given flight or time period. It might have also been because its avoidable costs were small enough that shutting down would not be a more profitable option.
Thus, the Tribunal needed to consider two questions regarding timing:
How long does it take costs to become avoidable?
How long does it take the firm to realize that it needs to change its operations?
With respect to the first question, the Commissioner’s view was that substantially all of Air Canada’s avoidable costs could be avoided within approximately three months from the time that a decision was made to cancel the flight. However, if capacity is added to a route in response to entry or to a competitor, then all costs associated with the new flight should be considered avoidable at the outset (because no costs are sunk).
As for the appropriate time period to examine, two questions needed to be answered:
How long does it take to realize it is losing money with reasonable accuracy?
What time increments should be used for carrying out the Avoidable Cost Test?
Looking at the first question, the Commissioner argued Air Canada’s reporting system produced the relevant information on flight profitability in short time periods.
With respect to the appropriate time increments for carrying out the Avoidable Cost Test, the Commissioner proposed the test be carried out using monthly data. This period would be long enough to ensure that observations of poor performance for specific operations of a schedule flight were not random. Thus, if Air Canada was estimated to have lost money for three consecutive months on the same flight, then it was alleged to have been abusing its dominance.
On the other hand, Air Canada’s position with respect to timing issues was that all costs avoidable within twelve months of a flight cancellation should be included in the Avoidable Cost Test, because a twelve-month period accounts for seasonality.
There are two problems with using a twelve-month time frame for this purpose: first, a new entrant could be driven from the market well before a year has passed, giving the alleged predator more than enough time to recoup is predatory losses. Second, seasonality is very predictable in the airline industry — for example, peak travel seasons are well-known — so schedules can be adjusted in advance.
The Tribunal did not accept seasonality as a reason to use a twelve-month period; it also decided it is up to the Commissioner to decide the relevant time period for determining whether fares are below avoidable costs. However, it did accept using monthly increments as appropriate, although it could be carried out using shorter time periods as well.
Question 6: Limit Pricing
While the Air Canada case focused on predation, a firm might still be pricing too low to be competitive without losing money: limit pricing. However, many requirements regarding predation must still be present, such as the threat being credible.
Summary Remarks
As noted earlier in this post, Air Canada entered bankruptcy protection in April 2003, so the Tribunal stayed the execution of its decision in the Phase I hearing until the airline emerged from CCAA protection — which it did at the end of September 2004.
Does Air Canada’s filing for bankruptcy protection give clear proof it could not have been a predator in these cases? Our answer — and that of the Bureau — is “no” since the bankruptcy was due to 9/11, which was completely unpredictable to everyone in the airline industry. Furthermore, it is possible Air Canada underestimated WestJet’s staying power, so it is reasonable to believe any alleged predatory behaviour simply was unsuccessful in this circumstance.
The possibility of predatory behaviour by an incumbent network carrier directed at entering or expanding low-cost carriers has been a concern of competition authorities around the world, including Canada, the United States, Europe and Australia. In a number of instances, the incumbent’s response to low-cost carriers was regarded as crossing the line separating aggressive competition from anti-competitive behaviour. Even though it never reached Phase II, the Air Canada case is very important as it provided legal precedent regarding whether the Avoidable Cost Test is appropriate, as well as how it should be conducted.
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