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Why Airplane Ticket Prices May Soar Unless Courts Step In


Thursday, Sep. 06, 2001

You may someday wind up paying $1500 on a regular basis for airplane tickets. If so, remember the American Airlines case that the Department of Justice lost this past April.

DOJ's Antitrust Division has decided to appeal its trial court defeat. However, in doing so, it will have a long, uphill road. And if the Antitrust Division loses on appeal, the ruling could clear the way for large air carriers to charge whatever they like for travel to and from the hubs they dominate — with little or no concern about inviting competition from other carriers on those routes.

At the dawn of airline deregulation, two famous economists made a bet on whether there would someday be two airline carriers in the U.S. — or only a single one. We are by no means down to a single carrier, but there has been tremendous consolidation among carriers in the past two decades. And in many markets, we will not need to get down to a single carrier for competition to disappear — and prices to skyrocket.

The Advantages of Having A Hub

A large airline with a hub has substantial advantages over competitors. To begin with, it can use its large network to cheaply offer passengers a valuable commodity — surplus seats in the form of frequent-flyer programs.

Another advantage — subtler, but profound — also comes from having a hub. To see the advantage, consider a typical large carrier flight: an American flight from Dallas to Knoxville.

In addition to passengers who simply want to fly from Dallas to Knoxville, the flight will contain many "through" passengers — who originated their travel earlier that day in San Francisco, Los Angeles, or Albuquerque. Indeed, in a typical large hub like American's, roughly half the passengers on a given flight will be through passengers.

Now consider the situation of a small carrier that only flies from Dallas to Knoxville. This carrier cannot defray costs with through passengers, and must fill its planes with passengers traveling only between these two cities. Moreover, it cannot cheaply offer these passengers valuable frequent flier tickets on an extensive network. These disadvantages mean that hard competition from a hub airline like American can cause smaller carriers to lose money — either limiting their aggressiveness or putting them out of business entirely.

The cost advantage of a large hub airline is not limited to the power to crush smaller rivals: More broadly, it is also an advantage over any airline flying into or out of the hub. The hub airline will always have more "through" passengers than rivals (that's why the airport in question is called a "hub," after all) and thus will always have the edge.

Why There Is A High "Hub Premium" Despite Low Hub Costs

If hub passengers are cheap to serve, you might ask, why are such high fares charged to passengers flying to and from hub airports? My colleague Severin Borenstein and other scholars have shown the "hub premium" to be between twenty and forty percent of the fare.

To begin, the simple reason for high hub fares is lack of competition from other airlines at hubs like Dallas-Fort Worth or Minneapolis-St. Paul, each of which is dominated by a single carrier. But that raises another question: Why does the situation stay that way? Why don't rivals come in, and underprice the dominant airlines, offering flyers a better deal?

The very low costs and other advantages of the hub airlines in serving passengers flying to and from a hub city may be the big reason. For example, when other airlines like Vanguard tried to compete with American in its hub, American was apparently able to respond to the entrants with very low prices and expanded service, while still maintaining its profitability.

Hub carriers like American have the best of both worlds. On one hand, when they do not face competition in a hub, they can charge high prices; after all, they are the only option around. That's the basis of the "hub premium."

But on the other hand, if hub carriers do face competition in a hub, they can respond by drastically cutting fares and expanding service without suffering too much themselves. (Remember, it is the "through" passengers that make the real money, so other passengers' fares can drop very low). Once they have killed off or chastened rivals, who cannot compete since they lack the hub advantage, they can raise prices again to their previous high levels, enjoying the hub premium until other rivals try to enter the market again. And next time, rivals may not try.

Ironically, then, the low costs of hub carriers, such as American, may therefore lead these carriers to charge high prices.

You might wonder: Can't the antitrust law do something about this situation? Isn't the very purpose of the law to defeat monopolies like the ones the hub carriers effectively exercise?

In fact, existing antitrust law does not reach situations like those of the hub carriers. That's because under current interpretations of the Sherman Antitrust Act, pricing can only be considered predatory (and therefore illegal) if it is below an appropriate measure of cost. Yet the hub carriers need not price below cost to make their rivals hurt, and to drive them out of the market.

That is because the hub carriers' advantage comes not from the ability to price local tickets below cost, but from the ability to make their profits from "through" passengers, not local ones. Carriers that serve the hub without being the hub carrier don't have that luxury; they need to make money from local passengers, and must price their tickets significantly above their costs.

Accordingly, the DOJ's Antitrust Division lost its trial against American Airlines, because it could not show that American Airlines was pricing below its cost and losing money because of its response to rivals.

The Antitrust Division's Chances on Appeal

On appeal, the DOJ's Antitrust Division can try a number of arguments — but none will be easy to make. It may continue its claim that the case is not a predatory pricing case in the first place. Alternatively, it might try to get fancy in defining price and cost, and show that, in fact, American is illegally pricing below cost after all.

A final option for the Antitrust Division would be to claim that price-cost comparisons don't need to be conducted when firms monopolize or dominate a market. After all, the leading predatory pricing case, Brooke Group, involved a market with several substantial competitors; the Antitrust Division could try to distinguish it on that basis.

This argument might carry some weight with the appeals court. Encouraging competition to thrive is arguably more important in monopolized markets than in those with several competitors. So perhaps in monopolized markets, the strict limitation that only pricing below cost is illegal should be relaxed, and "predatory pricing" should be interpreted to reach other problematic pricing practices.

If the court were to reinterpret the antitrust law this way, the result might be to encourage competition against monopolies not just in the airline industry, but across the board. Alternatively, the court might limit its decision to monopolies that have advantages akin to hub airlines.

Aaron Edlin is a professor of economics and law at UC Berkeley, where he has taught since 1993. He worked for the Clinton Administration as a Senior Economist at the Council of Economic Advisers, covering industrial organization, regulation and antitrust in 1997-98, and has been a visiting professor and research scholar at Columbia, Stanford, and Yale law schools. He received his A.B. from Princeton and his Ph.D. and J.D. from Stanford.

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