Collusion and Predatory Pricing in the Airline Industry

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It is a dilemma trying to decide the difference between predatory pricing and what is simply healthy price competition. Nowhere is this more apparent than in the airline industry.

Before 1978, airlines were strictly controlled by the federal government, which set maximum and minimum prices for fares, controlled routes, and approved entry/exit. All this changed in 1978 with the deregulation of the airlines, intended to encourage competition, ultimately lowering fares in the consumers’ best interest. But that freedom did open it up to the possibility that this competition would precipitate predatory pricing.

There are distinctive features of the airline industry which make it especially vulnerable to predatory pricing. Its unusual cost structure includes high fixed costs related to buying and servicing planes, setting up a hub infrastructure, and low marginal costs for each additional passenger. With low MC, it’s easy for large airlines to readily lower prices and drive out competitors who haven’t yet recouped their fixed costs to become profitable. If new airlines entered the market frequently, it would be irrational for legacy airlines to price predatorily as their sacrifice would be met with another new entrant and an inability to set monopoly pricing post-exit. The unusual cost structure of high fixed costs and low marginal costs is why it’s especially vulnerable to predatory pricing. We can also argue, as the DOJ argued, that capacity can be an alternative benchmark to price in predation cases (AA, 33).

Due to their large size, legacy carriers have the freedom to dynamically change their seat capacity. This also opens the door for them to strategically use price discrimination in ticketing sales, such as frequent-flyer programs generated through the vastness of their network.

Another distinct feature, and possibly its most impactful, is that incumbents have a wide range of flights to offer as a result of their hub and spoke network. Through this high load factor, legacy carriers can offer a breadth of routes with connections and many more flights. These differentiate their product from LCCs which can only provide direct flights. Through the hub-and-spoke network, majors enjoy economy-of-scope advantages as it's cheaper to offer multiple flights from a hub than direct flights.

On the subject of the different perspectives of predatory pricing, there is an enormous difference between how economists think as opposed to jurists. Economists take into account an extraordinarily broad spectrum of both the seen and unseen factors. Jurists consider much narrower circumstances and consequences for each action as they purely deal with accounting costs. During the sacrifice period, economists take into account overall profits, including those from routes that are not in direct competition with LCCs. The jurist looks at only the one route in question.

Although the price may not be below average variable accounting cost, the price that the incumbent charges is still higher than the price it would’ve charged had it not pushed the LCC out of the market during the sacrifice period.

So, is there predatory pricing in the airline industry? The economist says yes because they know that decision-making is made “in the margins,” accounting for incremental impacts. The jurist has more of a black-and-white, binary perspective that does not account for the incalculable details that must be considered. In fact, cumulatively, over the years, the DOJ has been presenting an increasingly stronger economic argument.

As far as tests used to prove or disprove predatory pricing, the Areeda-Turner test is flawed because it compares prices to average variable accounting costs. They do not include opportunity costs and therefore present a lower benchmark than if the economic average variable cost was used. This favors the defendant unequivocally because it is a harder criterion to meet. The three-pronged test established in the Brooke Group opinion involves first determining if the defendant has price-setting power and is able to plausibly set a price above marginal cost following the exit of the potential entrant. The second test involves comparing price to a measure of cost, but since it uses the aforementioned Areeda-Turner test, it is problematic.

Finally, the third step determines whether recoupment could reasonably cover the losses of sacrifice. It should first be said that the idea of recoupment is not exclusive to predatory pricing. Having said that, any profit-maximizing firm that undertakes any costly endeavor eventually, even if in the long run, seeks to recover that loss (Recoupment and Predatory Pricing Analysis, Journal of Legal Analysis). In addition, recoupment can take place in markets other than the one in which predatory pricing was alleged (Predation In The Airline Industry, DOJ). Indeed, an incumbent’s reputation for bullying could actually deter other LCCs from entering into other spokes of the same hub. Therefore, recoupment is the most difficult bar to meet due to the subtlety and subjectivity of its definition. If this is a prerequisite for predatory pricing, it might never be proven legally.

As a matter of fact, predatory pricing is illegal, whether or not there even is recoupment. It is the anti-competitive nature that should be punished separately and apart because the damage will have already been done by forcing an artificially produced exit of a rival (Predatory Pricing and Recoupment, Columbia Law Review).

Lastly, I believe the reason I could not find any predatory pricing judgment in the airline industry can largely be attributed to these difficulties in proving recoupment and due to the general lack of clarity on the other standards.

If I were to give you my opinion as to whether or not there is predatory pricing in the US airline industry, because I think of myself much more as an economist than a jurist, I would say yes - especially if they were to drop the recoupment prerequisite!

Bibliography:

Louis Kaplow, Recoupment and Predatory Pricing Analysis, Journal of Legal Analysis, Volume 10, 2018, Pages 46–112, https://doi.org/10.1093/jla/lay003

Antitrust Division | Predation In The Airline Industry | United States Department of Justice. 25 June 2015, https://www.justice.gov/atr/speech/predation-airline-industry.

Predatory Pricing and Recoupment, www.law.uci.edu/faculty/full-time/leslie/PredatoryPricing.pdf. Accessed 4 Apr. 2024.