[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