Enforcement Policy Regarding Unfair Exclusionary Conduct in the Air Transportation Industry

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

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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.

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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]

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