Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership ©Copyright 2003 Latham & Watkins. All Rights Reserved.

Exclusionary Conduct in the Airline Industry

John KallaugherLatham & WatkinsVisiting Professor University College London

1

INTRODUCTION

• Recent Airline Cases Highlight Issue of Exclusionary Conduct• AMR – US – July 2003• Air Canada -- Canada – July 2003• Lufthansa/Germania – Germany 2002

• What are lessons for EU?

2

AMR

• AMR responded to low cost entry on DFW city pairs by:• Matching fares• Increasing capacity• Allocating more seats to lower fare classes

• AMR internal models had predicted that these steps would not be profitable

3

AMR

• US law test for predatory pricing • Below appropriate cost measure• Possibility of recoupment

• Issue in AMR was what cost measure to use

• Cost issue was cost of “added capacity”

4

AMR

Cost tests (based on tests used in AMR internal systems):

• Fully allocated earnings plus upline/downline contribution net of costs (NO -- approximated total costs – not variable costs)

• Variable earnings plus upline/downline contribution net of costs (NO arbitrary allocation of system variable cost)

• Short run profit maximization (NO it showed foregone profit as cost)

5

Air Canada

• Two sample routes for application of new predation test in Canadian Airline Regulations

• Competition tribunal considered how “avoidable cost” test of regulations should be applied

6

Air Canada

• Controversial aspect of decision – definition of “redeployment/recapture” and “disposal” as basis for avoiding costs

7

Air Canada

• Tribunal found that• System labour costs• Station labour costs• Aircraft labour costs• Non-labour system and sunk costs• Aircraft ownership and insurance

were all avoidable costs

8

Lufthansa/Germania

• Germania entered FRA-TGL in competitionwith LH

• LH matched Germania fare

• Cartel Office ruled that higher quality of LH product meant that same price was actually undercutting Germania

• LH ordered to increase fare by 35 Euros (30.50 on appeal)

9

Lufthansa/Germania

• Legal Test:Balance interests of parties to protect competitive structures and chances of market entry

• Court found• only objective reason for conduct was to

exclude Germania• But no evidence of subjective intent

10

Comparing the Cases

• Interesting issues on costs• What is avoidable costs?• When are averages relevant?• How do you allocate costs?

• Interesting issues on revenues• Allocation of upline/downline revenue• Do you look at revenue or at fare classes?

11

Legal Test Follows Policy

• Real lesson – abuse test follows policy• US: policy based on consumer welfare/preventing

economic harm means strict cost-based approach

• CANADA: sympathy for cost-based approach tempered by “paramount position” of AC -- more intervention justified

• GERMANY – Ordoliberal structural approach justifies high level of intervention – cost-based test less relevant

12

Policy Choices for Article 82in Airline Sector

• Approach based on effects on structureOr

• Approach based on likely consumer harm

13

Traditional Article 82 Approachis Structural

• The “Field of Dreams” Approach

• Increasing “Barriers to Entry” is Abuse

• Barriers to Entry Defined Broadly

• New Entry Presumptively a “Good Thing”

14

Problems of Structural Approach

• Structural approach is static and historical

• Structural approach requires robust market definition

• Structural approach requires “hands on” intervention

• Structural approach leads to false positives –consumer loss

15

Structural Approach requires Robust Market Definition

• Otherwise no economic validity

• Suggests that should not be applied where market definition is less than robust

16

Market Definition in Air Transportis not “Robust

• No need to revisit question of market definition based on city pair markets

• But this definition is not strong – it does not cover many important aspects of airline competition

17

Aspects of Airline Competition Outside O&D City Pairs

• Network vs. Low cost• Capturing connecting traffic• Planning and capacity allocation• Corporate accounts• Tour operators

18

Consequences of Non-Robust Market Analysis

• Weakness of market definition means that relationship of structural effects to real consumer harm is tenuous

• Competition authority must act on faith

19

Structural Approach Requires Micromanagement by Competition

Authority

• Remember British Midland / Aer Lingus?

• How could Lufthansa know it was supposed to charge 35 Euros more than Germania • Or was it 30.5?

20

Structural Approach leads to Consumer Loss

• Prohibiting Lufthansa price-matching directly harms consumers

• Limiting FFPs directly harms consumers

• Re-allocating slots directly harms consumers

21

Conclusion

• In air transport intervention only makes sense where there is likelihood of consumer harm

• Structural approach is inadequate

• Argues for • strong cost-based tests• Scepticism on non-price abuse