[Federal Register Volume 63, Number 69 (Friday, April 10, 1998)]
[Notices]
[Pages 17919-17922]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 98-9488]
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DEPARTMENT OF TRANSPORTATION
Office of the Secretary
[Docket No. OST-98-3713, Notice 98-16]
Enforcement Policy Regarding Unfair Exclusionary Conduct in the
Air Transportation Industry
AGENCY: Office of the Secretary, DOT.
ACTION: Request for comments.
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SUMMARY: This notice sets forth a proposed Statement of the Department
of Transportation's Enforcement Policy Regarding Unfair Exclusionary
Conduct in the Air Transportation Industry. By this notice, the
Department is inviting interested persons to comment on the statement.
The Department is acting on the basis of informal complaints.
DATES: Comments must be submitted on or before June 9, 1998. Reply
comments must be submitted on or before July 9, 1998.
ADDRESSES: To facilitate the consideration of comments, each commenter
should file eight copies of each set of comments. Comments must be
filed in Room PL-401, Docket OST-98-3713, U.S. Department of
Transportation, 400 Seventh Street, SW., Washington, DC 20590. Late-
filed comments will be considered to the extent possible.
FOR FURTHER INFORMATION CONTACT: Jim Craun, Director (202-366-1032), or
Randy Bennett, Deputy Director (202-366-1053), Office of Aviation and
International Economics, Office of the Assistant Secretary for Aviation
and International Affairs, or Betsy Wolf (202-366-9349), Senior Trial
Attorney, Office of the Assistant General Counsel for Aviation
Enforcement and Proceedings, U.S. Department of Transportation, 400
Seventh St. SW., Washington, DC 20590.
SUPPLEMENTARY INFORMATION: This proposed Statement of the Department of
Transportation's Enforcement Policy Regarding Unfair Exclusionary
Conduct in the Air Transportation Industry was developed by the
Department of Transportation in consultation with the Department of
Justice. It sets forth tentative findings and guidelines for use by the
Department of Transportation in evaluating whether major air carriers'
competitive responses to new entry
[[Page 17920]]
warrant enforcement action under 49 U.S.C. 41712. We will give all
comments we receive thorough consideration in deciding whether and in
what form to make this statement final.
Statement of Enforcement Policy Regarding Unfair Exclusionary
Conduct
Congress has put a premium on competition in the air transportation
industry in the policy goals enumerated in 49 U.S.C. 40101. The
Department of Transportation thus has a mandate to foster and encourage
legitimate competition. We believe that legitimate competition
encompasses a wide range of potential responses by major carriers to
new entry into their hub markets 1--responses involving
price reductions or capacity increases, or both, or even neither. Some
of the responses we have observed, however, appear to be straying
beyond the confines of legitimate competition into the region of unfair
competition, behavior which, by virtue of 49 U.S. 41712, we have not
only a mandate but an obligation to prohibit.
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\1\ We use the term new entrant to mean an independent airline
that has started jet service within the last ten years and pursues a
competitive strategy of charging low fares. We use the term ``major
carrier'' to mean the major carrier that operates the hub at issue.
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Following Congress's deregulation of the air transportation
industry in 1978, all of the major air carriers restructured their
route systems into ``hub-and-spoke'' networks. Major carriers have long
charged considerably higher fares in most of their ``spoke'' city-
pairs, or the ``local hub markets,'' than in other city-pairs of
comparable distance and density. In recent years, when small, new-
entrant carriers have instituted new low-fare service in major
carriers' local hub markets, the major carriers have increasingly
responded with strategies of price reductions and capacity increases
designed not to maximize their own profits but rather to deprive the
new entrants of vital traffic and revenues. Once a new entrant has
ceased its service, the major carrier will typically retrench its
capacity in the market or raise its fares to at least their pre-entry
levels, or both. The major carrier thus accepts lower profits in the
short run in order to secure higher profits in the long run. This
strategy can benefit the major carrier prospectively as well, in that
it dissuades other carriers from attempting low-fare entry. It can hurt
consumers in the long run by depriving them of the benefits of
competition. In those instances where the major carrier's strategy
amounts to unfair competition, we must take enforcement action in order
to preserve the competitive process.
We hereby put all air carriers on notice, therefore, that as a
matter of policy, we propose to consider that a major carrier is
engaging in unfair exclusionary practices in violation of 49 U.S.C.
41712 if, in response to new entry into one or more of its local hub
markets, it pursues a strategy of price cuts or capacity increases, or
both, that either (1) causes it to forego more revenue than all of the
new entrant's capacity could have diverted from it or (2) results in
substantially lower operating profits--or greater operating losses--in
the short run than would a reasonable alternative strategy for
competing with the new entrant. Any strategy this costly to the major
carrier in the short term is economically rational only if it
eventually forces the new entrant to exit the market, after which the
major carrier can readily recoup the revenues it has sacrificed to
achieve this end. We will therefore be focusing our enforcement efforts
on this strategy while continuing our scrutiny of any other strategies
that may threaten competition.
Our policy represents a balance between the imperative of
encouraging legitimate competition in all of its various forms and the
imperative of prohibiting unfair methods of competition that ultimately
deprive consumers of the range of prices and services that legitimate
competition would otherwise afford them. This policy does not represent
an attempt by the Department to reregulate the air transportation
industry: we are neither prescribing nor proscribing any fares or
capacity levels in any market. Rather, we are carrying out our
statutory responsibility to ensure that if a new-entrant carrier's
entry into a major carrier's hub markets fails, it fails on the merits,
not due to unfair methods of competition.
Background
The competitive benefits of deregulation have been exhaustively
documented in numerous studies. Among other things, the major carriers'
development of hub-and-spoke networks has brought most domestic air
travelers more extensive service, more frequent service, and lower
fares. Also widely documented are the competitive advantages in serving
local markets that a major carrier enjoys at its hub. Flow traffic, or
the passengers that the major carrier is transporting from their
origins to their destinations by way of its hub, typically accounts for
more than half of the traffic in local hub markets. Flow traffic thus
allows the major carrier to operate higher frequencies in local markets
than the local traffic alone would support. In turn, in local markets
served by more than one carrier, the major carrier's higher frequency
attracts a greater share of the local traffic than that carrier would
otherwise carry.2 Due to its more extensive route network,
the major carrier is also able to offer a frequent flyer program and
commission overrides--i.e., higher commissions to travel agents for a
higher volume of sales--that are more effective. These factors, too,
confer competitive advantages on the major carrier in local hub
markets.
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\2\ This phenomenon, called the ``S-Curve'' effect, reflects the
value that time-sensitive travelers place on schedule frequency.
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These advantages have translated into the power to charge higher
local fares. A major carrier usually provides all of the service in
most of its local hub markets, the exceptions being mainly city-pairs
whose other endpoints are hubs of other major carriers or city-pairs
served by low-fare carriers. Many local hub markets that have enough
traffic to support competitive nonstop service are nonetheless served
only by the major carrier. In the absence of competition, the major
carrier is able to charge fares that exceed its fares in non-hub
markets of comparable distance and density by upwards of 40 percent, or
at least $100 to $150 per round trip. Even in those local hub markets
in which the major carrier competes with another major carrier, load
factors may be relatively low, but fares are relatively high. We have
observed, in fact, that low-fare service has provided the only
effective price competition in major carriers' local hub markets.
Major carriers use sophisticated yield-management techniques to
price-discriminate and thereby maximize their revenues. They can
monitor sales and fine-tune fares, change fare offerings for individual
flights as frequently as conditions may warrant, and segment each city-
pair market so that those passengers needing the greatest flexibility
pay the highest premiums while passengers needing progressively less
flexibility pay progressively lower fares. The lowest fares, which
typically carry heavy restrictions, provide revenue for seats that the
carrier would otherwise fly empty. It is in the carrier's interest, of
course, to sell each seat at the highest fare that it can. Generally,
major carriers find it most profitable to focus on high-fare service,
leaving much of the demand for low-fare service in many local hub
markets unserved.
Both these unserved consumers and travelers paying fare premiums in
local
[[Page 17921]]
hub markets stand to reap substantial benefits from new competition.
Southwest, a low-fare carrier certificated before deregulation, and
various new-entrant carriers have shown that a non-hub carrier can
compete successfully with a major carrier in the latter's hub
markets.3 By charging lower fares, the new entrant can
profitably serve that portion of a local market's demand which the
major carrier has mostly not been serving; the resultant competition
can bring fares down for most travelers. Traffic stimulation and
reductions in average fares can both be dramatic. According to a study
by this Department, low-fare competition saved over 100 million
travelers an estimated $6.3 billion in the year that ended September
30, 1995.4 At Salt Lake City, for example, local markets
served by Morris Air and Southwest saw their traffic triple and their
average fares decrease by half, while local markets served only by the
dominant carrier saw their fares increase. By late 1995, the average
fares in local markets served by Morris Air and Southwest were only
one-third as high as fares in other local Salt Lake City markets.
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\3\ Southwest has scored the broadest and longest-lived success
with this strategy, having established a strong presence in numerous
local markets at a number of hubs. New-entrant carriers such as
ValuJet (now AirTran Airlines), Morris Air (before being acquired by
Southwest), and Frontier have entered local markets at Atlanta, Salt
Lake City, and Denver, respectively. Vanguard, another new-entrant
carrier, has pursued a strategy of providing direct service between
Kansas City and several hubs.
\4\ The Low Cost Airline Service Revolution, April 1996. A
goodly portion of the savings occurred in local hub markets.
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The Problem
The major carriers view competition by new entrants as a threat to
their ability to maximize revenues through price-discrimination. As
noted, not only will the previously unserved consumers take advantage
of a new entrant's low fares, but so, too, will at least some of the
consumers that have been paying the major carrier's higher fares.
Regardless of how the major carrier chooses to respond to the new
entry, the more low-fare capacity available in the market, the less of
its high-fare traffic the major carrier will retain. The stakes are
high: a major carrier's fare premiums in its local hub markets can mean
revenues of tens of millions of dollars annually over its revenues in
markets where fares are disciplined by competition.
In some instances, a major carrier will choose to coexist with the
low-fare competitor and tailor its response to the latter's entry
accordingly. For example, at cities like Dallas and Houston, the major
carriers tolerate Southwest's major presence in local markets by not
competing aggressively for local passengers. Instead, they focus their
efforts on carrying flow passengers to feed their networks. At the
other extreme, the major carrier will choose to drive the new entrant
from the market. It will adopt a strategy involving drastic price cuts
and flooding the market with new low-fare capacity (and perhaps
offering ``bonus'' frequent flyer miles and higher commission overrides
for travel agents as well) in order to keep the new entrant from
achieving its break-even load factor and thus force its withdrawal.
Before the new entrant does withdraw, the major carrier, with its
higher cost structure, will carry more low-fare passengers than the new
entrant, thereby incurring substantial self-diversion of revenues--
i.e., it will provide unrestricted low-fare service to passengers who
would otherwise be willing to pay higher fares for service without
restrictions. Consumers, for their part, enjoy unprecedented benefits
in the short term. After the new entrant's withdrawal, however, the
major carrier drops the added capacity and raises its fares at least to
their original level. By accepting substantial self-diversion in the
short run, the major prevents the new entrant from establishing itself
as a competitor in a potentially large array of markets. Consumers thus
lose the benefits of this competition indefinitely.5
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\5\ Economists have recognized that consumers are harmed if a
dominant firm eliminates competition from firms of equal or greater
efficiency by cutting its prices and increasing its capacity, even
if its prices are not below its costs. See Ordover and Willig, ``An
Economic Definition of Predation: Pricing and Product Innovation,''
Yale Law Journal, (Vol. 91:8, 1981).
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We propose to consider this latter extreme to be unfair
exclusionary conduct in violation of 49 U.S.C. 41712. We have been
conducting informal investigations in response to informal allegations
of predation, and we have observed behavior consistent with the
behavior described above. The following hypothetical example involving
a local hub market serves to illustrate the problem. Originally, the
major carrier is able to charge one-third of its local passengers a
fare of $350. These passengers generate revenue of $3 million per
quarter, which constitutes half of the major carrier's total local
revenue. After new entry, the major carrier initially continues to
price-discriminate, continues to sell a large number of seats at $350,
and sustains little revenue diversion. Then the major carrier changes
its strategy and offers enough unrestricted seats at the new entrant's
fare of $50 to absorb a large share of the low-fare traffic. It sells
far more seats at low fares than the new entrant's total seat capacity.
Consequently, virtually all of the passengers who once paid $350 now
pay just $50, and instead of $3 million, these passengers now account
for revenue of less than $0.5 million per quarter. To make up the
difference, the major carrier would have to carry six more passengers
for each passenger diverted from the $350 fare to the $50 fare. The
major carrier loses more revenues through self-diversion than it lost
to the new entrant under its initial strategy.
The Department's Mandate
Our mandate under 49 U.S.C. 41712 to prohibit unfair methods of
competition authorizes us to stop air carriers from engaging in conduct
that can be characterized as anticompetitive under antitrust principles
even if it does not amount to a violation of the antitrust laws. The
unfair exclusionary behavior we address here is analogous to (and may
amount to) predation within the meaning of the federal antitrust
laws.6
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\6\ We will continue to work closely with the Department of
Justice in evaluating allegations of anticompetitive behavior, but
we will take enforcement action under 49 U.S.C. 41712 against unfair
exclusionary practices independently.
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Although the Supreme Court has said that predation rarely occurs
and is even more rarely successful, our informal investigations suggest
that the nature of the air transportation industry can at a minimum
allow unfair exclusionary practices to succeed. Compared to firms in
other industries, a major air carrier can price-discriminate to a much
greater extent, adjust prices much faster, and shift resources between
markets much more readily. Through booking and other data generated by
computer reservations systems and other sources, air carriers have
access to comprehensive, ``real time'' information on their
competitors' activities and can thus respond to competitive initiatives
more precisely and swiftly than firms in other industries. In addition,
a major carrier's ability to shift assets quickly between markets
allows it to increase service frequency and capture a disproportionate
share of traffic, thereby reaping the competitive advantage of the S-
Curve effect. These characteristics of the air transportation industry
allow the major carrier to drive a new entrant from a local hub market.
Having observed this behavior, other potential new entrants refrain
from entering, leaving the major carrier free to reap greater profits
indefinitely.
[[Page 17922]]
Enforcement Action
We will determine whether major carriers have engaged in unfair
exclusionary practices on a case-by-case basis according to the
enforcement procedures set forth in Subpart B of 14 CFR Part 302. We
will investigate conduct on our own initiative as well as in response
to formal and informal complaints. Where appropriate, cases will be set
for hearings before administrative law judges. We will apply our policy
prospectively, and we expect to refine our approach based on
experience. We anticipate that in the absence of strong reasons to
believe that a major carrier's response to competition from a new
entrant does not violate 49 U.S.C. 41712, we will institute enforcement
proceedings to determine whether the carrier has engaged in unfair
exclusionary practices when one or more of the following occurs:
(1) The major carrier adds capacity and sells such a large number
of seats at very low fares that the ensuing self-diversion of revenue
results in lower local revenue than would a reasonable alternative
response,
(2) The number of local passengers that the major carrier carries
at the new entrant's low fares (or at similar fares that are
substantially below the major carrier's previous fares) exceeds the new
entrant's total seat capacity, resulting, through self-diversion, in
lower local revenue than would a reasonable alternative response, or
(3) The number of local passengers that the major carrier carries
at the new entrant's low fares (or at similar fares that are
substantially below the major carrier's previous fares) exceeds the
number of low-fare passengers carried by the new entrant, resulting,
through self-diversion, in lower local revenue than would a reasonable
alternative response.
As the term ``reasonable alternative response'' suggests, we by no
means intend to discourage major carriers from competing aggressively
against new entrants in their hub markets. A major carrier can minimize
or even avoid self-diversion of local revenues, for example, by
matching the new entrant's low fares on a restricted basis (and without
significantly increasing capacity) and relying on its own service
advantages to retain high-fare traffic. We have seen that major
carriers can operate profitably in the same markets as low-fare
carriers. As noted, major carriers are competing with Southwest, the
most successful low-fare carrier, on a broad scale and are nevertheless
reporting record or near-record earnings.7 We will consider
whether a major carrier's response to new entry is consistent with its
behavior in markets where it competes with other new-entrant carriers
or with Southwest. Conceivably, a major carrier could both lower its
fares and add capacity in response to competition from a new entrant
without any inordinate sacrifice in local revenues. If the new entrant
remained in the market, consumers would reap great benefits from the
resulting competition, and we would not intercede. Conceivably, too, a
new entrant's service might fail for legitimate competitive reasons:
our enforcement policy will not guarantee new entrants success or even
survival. Optimally, it will give them a level playing field.
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\7\ One major carrier's internal documents that we reviewed as
part of an informal investigation of alleged predation show strong
profits on individual flight segments where it competes with
Southwest.
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The three scenarios set forth above reflect the more extreme and
most obviously suspect responses to new entry that we have observed in
our informal investigations. We do not intend them as an exhaustive
list: we will analyze other types of conduct as well to determine
whether to institute enforcement proceedings.8 Besides
examining service and pricing behavior, we will consider other possible
indicia of unfair competition: for example, allegations that major
carriers are attempting to block new entrants from local markets by
hoarding airport gates, by using contractual arrangements with local
airport authorities to bar access to an airport's infrastructure and
services, or by using bonus frequent flyer awards or travel agent
commission overrides in ways that appear to target new entrants
unfairly.
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\8\ Moreover, our statutory responsibility to prohibit unfair
methods of competition is not limited to the unfair exclusionary
practices addressed here. We will continue to monitor the
competitive behavior of all types of air carriers.
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In an enforcement proceeding, if the administrative law judge finds
that a major carrier has engaged in unfair exclusionary practices in
violation of 49 U.S.C. 41712, the Department will order the carrier to
cease and desist from such practices. Under 49 U.S.C. 46301, violation
of a Department order subjects a carrier to substantial civil
penalties.
We have crafted our policy not to protect competitors but to
protect competition. We hope that it will provide consumers with the
benefits of competition in increasing numbers of local hub markets over
the long term.
Initial Regulatory Flexibility Analysis
The Regulatory Flexibility Act of 1980, 5 U.S.C. 601 et seq., was
enacted by Congress to ensure that small entities are not unnecessarily
and disproportionately burdened by government regulations or actions.
The Act requires agencies to review proposed regulations or actions
that may have a significant economic impact on a substantial number of
small entities. For purposes of this policy statement, small entities
include smaller U.S. airlines. It is the Department's tentative
determination that the proposed enforcement policy would, as explained
above, give smaller airlines a better opportunity to compete against
larger airlines by guarding against exclusionary practices on the part
of the larger airlines. To the extent that the proposed policy results
in increased competition and lower fares, small entities that purchase
airline tickets will benefit. Our proposed policy contains no direct
reporting, record-keeping, or other compliance requirements that would
affect small entities.
Interested persons may address our tentative conclusions under the
Regulatory Flexibility Act in their comments submitted in response to
this request for comments.
Paperwork Reduction Act
This policy statement contains no collection-of-information
requirements subject to the Paperwork Reduction Act, Pub. L. 96-511, 44
U.S.C. Chapter 35.
Federalism Implications
This policy statement would have no substantial direct effects on
the States, on the relationship between the national government and the
States, or on the distribution of power and responsibilities among the
various levels of government. Therefore, in accordance with Executive
Order 12812, we have tentatively determined that this policy does not
have sufficient federalism implications to warrant preparation of a
Federalism Assessment.
(Authority Citation: 49 U.S.C. 41712.)
Issued in Washington, DC on April 6, 1998.
Rodney E. Slater,
Secretary of Transportation.
[FR Doc. 98-9488 Filed 4-9-98; 8:45 am]
BILLING CODE 4910-62-P
