The airline industry: Predatory practices?

Lalu A. Damanhuri, Infrastructure Planning & Development Specialist, Committee for Infrastructure Development Policy (KKPPI), Jakarta

With the promulgation of government regulation PP No. 40/95 concerning air transportation -- followed by a few ministerial decrees -- a comprehensive legal framework for the development of the airline industry is now in place.

The policy initiative and the legislation have paved the way for new entrants in the air transportation industry. The ability to serve new and growing markets, to fashion more extensive route networks and to charge low fares had been severely constrained by regulations.

These reconfigured services could be implemented in no small degree due to innovations in technology that enabled the development of sophisticated yield management systems.

Such systems allow airlines to offer and quickly change the mix of high and low-fare seat capacity on any given flight, as well as to manage both origin and destination traffic flow over the entire network.

As the constraints on airline operations were lifted by deregulation and the airlines quickly exercised their new route and fare freedoms, consumers in many markets reaped substantial benefits.

The benefits became less attributable to the actions of the major network airlines and more attributable to the actions of a small number of low-fare carriers. By the late 1990s, the major airlines' domestic route networks had become fairly stable and were built around hub airports dominated by a single or double carrier.

These hub-based networks established geographic areas in which each major network airline has substantial presence and market power, especially in short-haul, smaller markets. Thus the benefits of deregulation have increasingly come from competition among major network carriers in long-haul markets and from lower fares in short-haul markets served by low-fare carriers.

In many of the markets not served by low-fare carriers, the benefits of deregulation may well be eroding. Entry by a low-fare carrier either into the industry or into a new market is not easy. New business ventures in all industries have a high failure rate, and new airlines are no exception.

However, new airlines -- or established airlines entering new markets -- must have an opportunity to compete for business on the basis of the product or services they offer, rather than be forced to contend with predatory practices by the incumbent carriers.

An analysis of predatory practices has focused on predatory pricing -- usually defined as a company pricing its product below an appropriate measure of cost with the intent of driving a financially weaker competitor out of business and establishing or re-establishing monopoly power.

Defining the appropriate price to compare with the marginal or average variable cost is also difficult. Airlines, of course, charge multiple prices for the seats on a single flight.

Some differences in price are due to markedly different service, such as first class, business class and economy class. Other differences reflect discount fares and their various restrictions.

The most common restriction requires an advance purchase, such as Garuda. These restrictions mostly reflect attempts at price discrimination by airlines to maximize revenue from a particular flight by segmenting passengers according to their flexibility, and charging those with less flexibility higher fares.

Because airlines have the potential to compete with multiple tools, of which the ticket price is only one, a narrowly defined predatory-pricing standard is almost certainly inadequate. Were public policy to focus only on the ticket price, airlines would have ample ways to engage in what are clearly predatory practices without violating a narrow predatory pricing standard.

Similarly, because airlines compete through networks rather than just in single city-pair markets, focusing only on the market without considering the potential network effects is also likely to be inadequate.

Conceptually, an airline could even engage in predatory practices by making use of its network -- without changing its behavior in any way in the specific city-pair market entered by the new carrier.

The following table shows the fare offerings of the airlines providing service on the Jakarta-Surabaya route. What is striking is the degree of similarity in the fares offered by these major carriers, particularly in the low-fare range.

While each airline uses different fare codes, the corresponding fares are remarkably similar. In this market, Garuda, Mandala and Bouraq offer several fares that do not seem to have a counterpart with the other airlines, such as Indonesian Air, Star Air and Pelita Air to a lesser extent. Also, Mandala does not seem to offer the very highest first class fares. A similar pattern prevails in other markets that were examined.

How can the airlines achieve this uniformity in their fare offerings? The answer would appear to lie with the computer reservations systems that allow competitors' prices to be observed.

These fares are posted on the reservations systems well in advance of any bookings made for these flights. The time lag between posting the fares and booking any substantial number of passengers gives each airline an opportunity to see what the other airlines are charging and to make any needed adjustments.

There is no benefit from predatory behavior because the airlines do not have the market power necessary to recoup the losses incurred while driving a competitor out of the market. The evidence clearly suggests that there is market power at some of the major carriers' large hubs.

Some evidence of this market power is the persistence of fare premiums at these hubs. Hub premiums represent the extent to which fares to and from hub cities are higher than average fares on similar routes throughout the domestic route system.

The characteristics of our airline industry, and the persistence of market power at hub airports, make predatory practices a recurring possibility in the domestic airline industry. As such, they are a legitimate concern for competition policy.

Because the presence of low-fare carrier service has such a dramatic effect on hub premiums, predatory practices are specially likely to be targeted at low-fare new entrants, although such practices need not be confined to these situations. Since many of the continuing gains from airline deregulation come from the presence of low-fare carriers, an industry characterized by vigorous opportunities for entry is essential for continuing consumer gains.