Carve-Outs Under Airline Antitrust Immunity in the Public Interest

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September 2009 (1)

Carve-Outs Under Airline Antitrust

Immunity: In the Public Interest?

Jan K. Brueckner & Stef Proost

University of California, Irvine & KU Leuven,Belgium


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GCP: The Antitrust Chronicle September 2009 (1)

2 www.competitionpolicyinternational.com -- Competition Policy International, Inc.Copying, reprinting, or distributing this article is forbidden by anyone other than the publisher or author.

Carve-Outs Under Airline Antitrust Immunity: In the Public Interest?

Jan K. Brueckner and Stef Proost

1

rohibitionsoncrossborderairlinemergersprecludefullintegrationofU.S.andforeign

carriers,butagrantofantitrustimmunity(ATI)allowssubstantialcooperationbetween

aU.S.airlineanditsforeignalliancepartners.Immunityallowscollaborationintheprovisionof

international service in two principal types of markets. One market type involves travel

between smaller U.S. and foreign cities,which requires an interline trip that crosses the

networksofthetwoalliancepartners.Theothermarkettypeinvolvesnonstoptravelbetween

thepartners (larger)hub cities,where overlapping service allows the trip tobemadeusing

either theU.S.airlineor itspartner. Immunityhasoftenbeengranted inconjunctionwithan

openskies

agreement

between

the

United

States

and

the

home

country

of

apartner

airline.

The effectsof alliances andATIon airfareshavebeen extensively investigated in the

economicsliterature.Theorypredictsthat,for interlinetrips,cooperationinfaresettingunder

ATI eliminates a type of double marginalization. Instead of noncooperatively setting the

components of an interline fare for travel across two networks, the two carriers underATI

jointlysettheentirefare,reducingtheirtwoseparatemarkupstoone.Theresult isa lower

interline fare, which raises traffic in thesemarkets while benefiting passengers as well as

airlines.Bycontrast, inallowingcooperationonoverlappingnonstophubtohub routes,ATI

introduces a potential anticompetitive effect.Cooperating carriersmay have an incentive to

raise fares fororigindestinationpassengersontheseroutes,restricting thenumberofhubto

hubtickets

sold

and

boosting

the

carriers

combined

profits.

This

effect

may

emerge

even

thoughinterlinetrafficusingthehubtohubrouterises.

Brueckner2provides a theoretical analysisofbotheffects, showing that,while thenet

welfareimpactonconsumersisgenerallyambiguous,thebeneficialimpactininterlinemarkets

is likely to offset thepotential negative effect in the hubtohubmarket,making the overall

effectofATIpositive.Thisoutcome isespecially likelywhen thehubtohubmarket is small

relative to the full set of interline markets, involving relatively few origindestination

passengers.

Brueckner andWhalen,3 Brueckner,4 andWhalen5 provide empirical evidence on the

sizeoftheinterlinefarediscountfromcooperativepricing,whichmaybeaslargeas25percent.

1JanK.BruecknerisProfessorofEconomicsatUniversityofCalifornia,Irvine,andAcademicAffiliate,LECG,

LLC;StefProostisAcademicCoordinatorfortheDepartmentofEconomicsoftheKatholiekeUniversiteitLeuven

(K.U.Leuven), Belgium.2J.K.Brueckner,TheEconomicsofInternationalCodesharing:AnAnalysisofAirlineAlliances,INTLJ.INDUS.ORG.

19,14751498,(2001).3J.K.Brueckner&W.T.Whalen,ThePriceEffectsofInternationalAirlineAlliances,J.L.&ECON.43,503545,(2000).4J.K.Brueckner,InternationalAirfaresintheAgeofAlliances:TheEffectsofCodesharingandAntitrustImmunity,R.

ECON.&STAT.85,105118,(2003).


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BruecknerandWhalen6alsoshow that the fare impactofalliancecooperationonhubtohub

routesiseffectivelyzero,contrarytoexpectations.

Despitethisabsenceofameasuredfareimpact,concernsaboutpotentialanticompetitive

effectsinhubtohubmarketspersist.Inresponse,regulatorshaveoccasionallyimposedcarve

outs in suchmarketswhengrantingATI.A carveoutprohibits collaboration inhubtohub

faresetting,whileallowingcooperationinothermarkets.Forexample,ingrantingimmunityto

United and Lufthansa (founding partners of the Star alliance), the U.S. Department of

Transportation (DOT) imposed carveouts in the ChicagoFrankfurt and Washington

(Dulles)Frankfurtmarkets, which connect United and Lufthansa hubs, while allowing the

carrierstosetfarescooperativelyelsewhere.Bycontrast,initsearlygrantofATItoNorthwest

andKLM,carveoutswerenot imposed intheirhubtohubmarkets (DetroitAmsterdamand

MinneapolisAmsterdam),mainlybasedon the small sizeof thesemarkets. Similarly, carve

outswerenot imposed in any of themarkets connecting thehubs ofDelta andAir France,

foundingmembersoftheSkyTeamalliance(AtlantaParis,amongothers).

Recently, however, carveouts have emerged as a contentious regulatory issue. In its

tentativeapprovalofStarallianceATI forContinental (a formerSkyTeammember), theDOT

requirednonewhubtohubcarveouts.However,inanadvisoryopinion,theU.S.Department

of Justice (DOJ) strongly recommended a number of such carveouts as well as other

limitationstothescopeofATI,andinitsfinalorder,theDOTacquiescedinmanyoftheDOJ

carveout recommendations (seeDOJ7 andDOT8).These carveouts involved routesbetween

theNewYork area and several secondary Star hubs (Stockholm,Zurich,Copenhagen), and

routesbetweenContinentalshubsandAirCanadasTorontohubalongwithseveraladditional

Canadianendpoints.

Despite

the

centrality

of

carve

outs

in

this

latest

ATI

decision,

the

economics

literature

onalliancesoffersno treatmentwhatsoeverof this topic.Since thecarveout issue is likely to

arise infutureATIcases,especiallythependingATIapplicationofAmericanAirlines,British

Airways,andIberia(AA,BA,andIB),wehavedevelopedatheoreticaltreatmentofthe

carveoutissueusingahighlystylizedmodelbasedontheoneanalyzedbyBrueckner9(seeour

workingpaper10).

Themodeladdsakey feature to thisearlieranalytical framework,which capturesan

importantnewdevelopmentinthestructureofalliancesthatisgermanetothecarveoutissue:

Theemergenceofthejointventureasacommonallianceform.Underajointventure(JV)

5W.T.Whalen,APanelDataAnalysisofCodeSharing,AntitrustImmunityandOpenSkiesTreatiesinInternational

AviationMarkets,R.INDUS.ORG.30,3961,(2007).6Supra,note3.7U.S.DepartmentofJustice,PublicVersion,CommentsoftheDepartmentofJusticeontheShowCauseOrder,inDOT

DocketOST20080234,(2009).8U.S.DepartmentofTransportation,FinalOrder,inDOTDocketOST20080234,(2009).9Supra,note2.10J.K.Brueckner&StefProost,CarveOutsUnderAirlineAntitrustImmunity,unpublishedpaper,Universityof

California,Irvine,(2009).


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alliance,thecarriersengageincomprehensiverevenuesharingoninternationalroutes,sothata

partners revenue from a passenger is independent of which airline actually provides the

service.Thisarrangementleadstowhatisknownasametalneutralalliancestructure,inthe

sense that the identityof the metal (the aircraft) involved in transportationof aparticular

passengerisirrelevanttoindividualairlinerevenue.AlthoughNorthwestandKLMoperatedaJValliancestartingintheearly1990s,thisformhasonlyrecentlyspreadtotheotheralliances.

SkyTeamoperatesaJVasdoestheStaralliance(withContinentalnowparticipating),andthe

pendingATIapplicationofAA,BA,andIBalsoenvisionsajointventure.

Ourtheoryadoptsaparticularanalyticalrepresentationofajointventure,whichaffects

themodelsportrayal of hubtohub routes. In the absence of aJV, the alliancepartners are

assumedtooperateseparateservicesonthehubtohubroute,notcapturingthefullbenefitsof

integration.With aJV, however, the hubtohub services are consolidated, as under a true

merger. This difference affects the exploitation of economies of traffic density (increasing

returns to scale) on the hubtohub route. Economies of density are a hallmark of airline

networkmodels,andtheirexistence impliesthatcostperpassengerfallsasthetrafficvolumeonarouterises,aresultoftheuseoflarger,moreefficientaircraftandthespreadingoffixed

endpoint costs over more passengers. While a nonJV alliance divides hubtohub traffic

between two separateairlineoperations, aJValliance consolidates this trafficundera single

unified entity, achieving (under themodel) greater efficiencies from higher traffic density.

Given the stylizednatureof the framework,otherefficiencies from theJValliance, including

moreeffective scheduling, cannotbe captured. For a good discussion of the nature of such

additionalbenefits,seetheresponseofAmericanAirlinestothecriticismbytheDOJ.11

With thisrepresentationofaJValliance, the tradeoff involved incarveoutsbecomes

clear. By preventing collaboration in the hubtohub market, a carveout eliminates a key

element of a JV alliance, consolidation of operations on this route. This loss reduces theefficiency of the alliance, raising costperpassenger on the hubtohub route.Offsetting this

downside,however,arepotentialcompetitivegains.Inparticular,eliminatingcollaborationin

the hubtohubmarket prevents a possible anticompetitive increase in the hubtohub fare

underthealliance.Whetherthecarveoutisharmfulorbeneficialdependsontheneteffectof

thesetwoforces.Iftheefficiency loss issubstantialrelativetoanycompetitivegains,thenthe

carveoutcanbeharmful,whileasmallefficiencylosswillyieldtheoppositeverdict.

Another importantinsightoftheanalysis isthatimpositionofacarveoutonanonJV

alliancehasnoefficiencydownsideand isthusdesirableinthecontextofthemodel.Inother

words, sincenonJV alliancepartnersdonotoperate consolidated serviceon thehubtohub

route,banningcollaborationon this routegeneratesnoefficiency loss.However,competitive

benefitsemerge,sothatthecarveoutisinthepublicinterest,leadingtoabetteroutcomethana

nonJValliancewithoutacarveout.

11AmericanAirlines,ResponseofAmericanAirlinestothecommentsoftheDepartmentofJustice,inDOTDocket

OST20080234,(2009).


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It is interesting tonote that theDOTs final order in theContinentalStarATI case is

consistentwith this logic.Carveoutswere imposed only on routes that are not part of the

enlargedjointventure (calledA++).CarveoutsonJV routeswerenot required, and existing

carveoutson theroutesconnectingChicagoandWashington toFrankfurt (whicharepartof

theJV)wereremoved.

Basedontheseideas,theanalysisgeneratesthefollowingpossiblerankingsofalliances:

RankingI RankingIIalliancewithcarve

out

JValliance

JValliance alliancewithcarve

out

nonJValliance nonJValliance

A nonJV alliance is always the lowest ranked given that it reduces hubtohub

competitionwithoutanyoffsettingefficiencygain.But,followingtheabovelogic,aJValliance

couldeitherbefirstorsecondinthealliancerankings.Ifitsefficiencygainoffsetstheeffectof

lost hubtohub competition, then theJV alliance is superior to an alliancewith a carveout

(wherecompetitionispreservedbutefficiencyissacrificed).Conversely,ifitsefficiencygainis

more thanoffsetby the lostcompetition, then theJValliance is inferior toanalliancewitha

carveout.Ouranalysisquantifiesthistradeoff,showingthattheJVallianceissuperiorwhen

economiesoftrafficdensity(thesourceofefficiencygainsinthemodel)arestrong.Thistypeof

argument,whichtheairlinesthemselveshaveusedtoargueagainstcarveouts,isvalidatedbyouranalysis.Thus,regulatorsmaywishtogiveitsomecredence.

Carve-Outs Under Airline Antitrust Immunity in the Public Interest

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