How to Prey on Predators? - The Lufthansa-Germania Case by

WHU Graduate School of Management
Institute for Industrial Organization
How to Prey on Predators? The Lufthansa-Germania Case
by
Kai Hüschelrath (WHU Graduate School of Management)
Date
March 2003
Abstract
The apparent problem in today’s predation antitrust cases is the differentiation
between ‘normal’ competitive behavior and anti-competitive predatory
behavior. But suggest a case, in which a predation strategy was clearly
identified and proven by the antitrust authority. Immediately, another problem
enters the scene: What should be done with the predator? Should he only
abandon his predatory behavior, should he pay a fine, or are other sanctions the
right way to prey on the predator? The paper provides a discussion of this
problem by means of the Lufthansa-Germania decision of the German Federal
Cartel Office in 2002.
Keywords
Competition Policy, Predatory Pricing, Sanctions, Airline Industry, Germany
JEL Class
L41
Notes
I would like to thank the audiences at the European Transport Conference in
Cambridge (UK), the Hohenheimer Oberseminar in Hamburg and the German
Aviation Research Society Workshop in Berlin for valuable comments on
related papers.
Address
Kai Hüschelrath, WHU Graduate School of Management, Institute for
Industrial Organization, Burgplatz 2, 56179 Vallendar, Germany, email:
hueschel@whu.edu, Tel: ++49-(0)261-6509-272, Fax: ++49-(0)261-6509-279,
Web: www.whu.edu/mikro
1
Kai Hüschelrath
HOW TO PREY ON PREDATORS?
–
THE LUFTHANSA-GERMANIA CASE
„In
markets where an incumbent monopoly enjoys
significant advantages over potential entrants, but another
firm enters and provides buyers with a substantial discount,
the monopoly should be prevented from responding with
substantial price cuts or significant product enhancements
until the entrant has had a reasonable time to recover its
entry costs and become viable, or until the entrant’s share
grows enough so that the monopoly loses its dominance.“
Edlin (2002)
1
INTRODUCTION
Predatory pricing strategies have traditionally been a major field of dispute in antitrust
economics. In former times the controversy surrounded the question whether predatory
pricing can be a rational business strategy at all. With the occurrence and the intensive use of
game-theoretic techniques, most economists nowadays can answer this question with a clear
‘yes’.
Consequential, the focus of academic research has switched from the rationalization
problem to the detection problem. In other words, if predatory pricing is accepted as a rational
but often anti-competitive business strategy, the central problems for antitrust authorities lie in
the identification and proof of such an socially undesirable strategy. Especially the
differentiation between normal competitive behavior and anti-competitive predatory behavior
has turned out to be the main problem during such investigations, as demonstrated recently by
the United States vs. American Airlines decision.
But now suppose a case, in which a predation strategy was clearly identified and
proven by the antitrust authority. Immediately, the authority faces a third antitrust problem of
predation strategies (besides rationality check and detection): What should be done with the
predator? Should he only abandon the predatory behavior, should he pay a fine, or are
remedies the right way to ‘punish’ predatory behavior?
It was exactly this problem, the German Federal Cartel Office (the ‘Bundeskartellamt’) was confronted with, when it had to decide the so-called Lufthansa-Germania case in
February 2002. The authority solved the problem by prohibiting the predator (Lufthansa) from
demanding a price for a one-way ticket per passenger on the Frankfurt-Berlin route, which is
not at least 35 Euro above Germania’s (the new entrant) price, as long as Lufthansa does not
have to charge more than 134 Euro as a result. The allegation remains valid for two years.
Against this background, the paper has the aim to show, that the so-called ‘minimumprice-distance-rule’ of the Federal Cartel Office – although probably helpful in promoting
2
competition in the short run – has a few essential drawbacks and should therefore be replaced
by an ex-ante incentive approach which tries to abolish the incentives of dominant firms to
use predation strategies.
To reach this aim, the next section gives a brief definition of predation. In the
subsequent third section, the Lufthansa-Germania decision is portrayed in greater detail.
Afterwards, section four tries to answer the question of “How to prey on predators?” by a
simple classification adopted from the analysis of merger remedies. Section five concludes.
2
A BRIEF DEFINITION OF PREDATION
There are probably as much definitions of predation as definition attempts. According to a
paper by Farrell and Katz ((2001), p. 2) predatory behavior can be schematically thought of as
occurring in two phases: A predation phase and a recoupment phase. In the first phase, the
predator tenders a product that offers „too“ much value to the consumers (e.g. the price is too
low, the quality is too high, or the product is too innovative) and thus weakens rivals. In the
second phase, the recoupment phase, the predatory firm takes advantage of the weakened rival
and reduces the consumer value of its products to a level below the competitive one.
A more straightforward definition attempt comes from Dodgson et al. ((1990), S. 2).
They define predatory behavior „... as the foregoing of maximum current profits in order to
eliminate competitors or deter or delay entry, so that greater profits can be earned in the
longer run“. A game-theoretic definition of predation is introduced by Cabral and Riordan
(1997, p. 160). For them, “[a]n action is predatory if - a different action would increase the
likelihood that rivals remain viable and – the different action would be more profitable under
the counterfactual hypotheses that the rival’s viability were unaffected“.
In a nutshell, a predation strategy can be divided into two phases: In the first phase,
the alleged predator take prices down to a “unusually low level” with the aim of achieving
changes in market structure (e.g. forced exit or deterrence of entry) and/or a change in the
nature of competition (e.g. due to a tough reputation) and/or in the nature of demand (e.g.
consumer switching from the market-leaving entrant to the incumbent) in the recoupment
phase (see Frontier Economics (2002), p.1). These changes allow the recoupment. The intent
of the different predation theories is to show that these outcomes have the potential to
outweigh the losses from the predatory pricing phase. In this sense, predation strategies can be
seen as normal ‘investment decisions’ ... investments in market power.
To clarify the general concept consider Figure 1. It assumes a monopoly market at the
beginning of the market. The monopolistic firm sets the price where marginal revenue equals
marginal cost and thus maximizes profits. It gains a so-called ‘excess profit’, which is derived
out of the difference between the monopoly profit π Mono and the duopoly profit π Duo.
At the point t entry, a rival firm enters the market. If the incumbent accepts the rival in
the market, then both firms will make a duopoly profit of π Duo. In case of price competition,
the profit in the Bertrand equilibrium is zero. In case of quantity competition the profit in the
Cournot equilibrium is (by presumption) positive but not necessarily equal for both firms. In
both constellations the incumbent would lose its excess profit.
Besides entry accommodation, the incumbent has the possibility to lower the price by
such an amount, that the entrant (as well as the incumbent) makes losses and is forced to exit
the market at the time t exit. After the exit of the new entrant, the incumbent is again in the
position to set the old monopoly price and gain the old monopoly profits π Mono until the
market ends or another rival firm enters the market.
3
Figure 1: ‘Predation Investment’ in future excess profits
with π IMono > π IDuo ≥ 0 > π IPr ed and π EDuo ≥ 0 > π EPr ed .
Given this argumentation, the individual (firm) rationality of predatory pricing as a business
strategy depends on the evaluation of the following parameters:
(1) Level of losses in the predation periods (πL) with πL ≡ π Pred - π Duo
(2) Level of excess profits after the exit of entrant (πE) with πE ≡ π Mono - π Duo
(3) Number of predation periods (k)
(4) Number of periods after the exit of entrant (m)
(5) Discounting factor of future profits (π) with π ≡ 1/(1+r)
In the style of Figure 1 and under disregard of (5) the condition for rational predation can be
written as
k
∑
t =1
m
π tL ≤
∑π
E
t .
t = k +1
It is above the scope of this paper to give a detailed survey of key factors which interact with
the parameters (1)-(5) and therefore influence the rationality of predation (see Martin (1994),
p. 452-465 for a nice roundup). To given an example, consider barriers to entry. The overall
profit in the post-predation period depends on the level of the monopoly profits and the length
of the post-predation period. The length of the post-predation period depends on the
possibilities of other firms to enter the market (e.g. extent of barriers to (re-)entry, (sunk)
entry costs). It turns out that the rationality of predation critically depends on the extent of
barriers to entry resp. entry costs.
4
Another factor is the discount rate of the predator. 1 If the discount rate is high, than the
predator gives great weight to the short-run losses of a predation strategy and gives little
weight to the monopoly profits after the predation period. Vice versa, it is obvious that the
lower the discount rate, the more likely is predation to occur.
This basic understanding of predation have been criticized and challenged by many
scholars (preferably from the Chicago-School) in a variety of ways. They contradict the above
arguments with the aim of showing that predation is a rare and normally irrational strategy.
One argument e.g. is that predation is an expensive strategy and therefore won’t be chosen
very often (‘an acquisition of the victim is often cheaper’). Another argument attacks the
recoupment period argument by saying that it is implausible that the predator can foreclose
the market effectively for new entrants in the post-predation period (and therefore is not able
to earn the recoupment). A further argument states that investors have an profit-driven
incentive to help efficient victims with credits to survive the predation period. As a rational
predator can foresee this, the predation strategy becomes unprofitable and therefore irrational.
These exemplary disputes around the rationality of predation were solved by the
consequent use of game-theoretic models (‘The Long Purse’, ‘Reputation Models’ or
‘Signaling Models’; see Church/Ware (2000), pp. 647-654). These models - based on the
theory of games of incomplete information – solve Selten’s Chain-Store Paradox (see
Kate/Niels (2002), pp. 6-9) and show that predation can be a rational business strategy by
achieving changes in market structure, the change of the nature of competition and/or in the
nature of market demand (see Roberts (1987), p. 157-195 for a survey).
Due to these successful rationality proofs of predation strategies, the research interest
has switched to the problem of strategy detection. With this respect, especially two
approaches have been discussed extensively: per-se rules, which intent to solve the detection
problem by the application of a simple pricing rule, and the rule-of-reason approach, which
tries to give a flexible framework to guide the analysis of a certain case of alleged predation.
Recently, the integration of the game-theoretic insights in a corresponding framework
has been the main research question in antitrust economics concerning predation (see Bolton
et al. (2000)). This seems to be an important task as the strategic theories of predation haven’t
been adopted by most of the courts so far.
3
THE LUFTHANSA-GERMANIA CASE
At the beginning an introductory description of the incidents in the market is given.
Subsequently, the resulting antitrust case is illustrated in its main features. Herefrom, the
essential key questions are derived. Some of them are analyzed in greater detail in the
following sections.
3.1
The facts
On 12th November 2001 the Germania Fluggesellschaft mbH 2 (‚Germania‘) has started
scheduled flights between Frankfurt/Main and Berlin/Tegel for the first time. By then
1
By taking the discounting factor into account, the condition for rational predation can be written via
(
)
(
π L 1 + δ + δ 2 + ... + δ k ≤ π E δ k + 1 + δ k + 2 + ... + δ m
)

.


The Germania Fluggesellschaft mbH is not a completely new company in the German airline industry. The
company offers charter-connections to holiday regions since 1978 in cooperation with big travel agencies.
and some transformations as
2
(
)
 1− δ m − k
π
1 − δ k +1 ≤ π E δ k +1 
 1− δ
1− δ

L
5
Germania was operating only in the German charter market. The price for a flexible one-way
economy ticket without fundamental restrictions (see details below) was 99 Euro (including
passenger fees and added value tax). A round-trip cost 198 Euro. Germania offered four
flights in each direction per working day (see Bundeskartellamt (2002), p. 2-3).
The previous monopolist on this route – the Deutsche Lufthansa AG 3 (‚Lufthansa‘) –
offered 14 daily flight frequencies (in both directions) to a price of 485 Euro for the full
flexible round-trip ticket in the economy class. After Lufthansa noticed the imminent market
entry by Germania, it reacted (even before the entry actually took place) on 9th November
2001 by the introduction of a new one-way tariff of 100 Euro in the Economy class. A roundtrip ticket cost 200 Euro. Therefore, Lufthansa cuts tariffs by about 58 percent. Restrictively,
it should be mentioned that only a relatively small contingent was offered under the new
tariffs. In other words, the new tariffs amended the existing fully-flexible tariffs in the
economy class (see Bundeskartellamt (2002), p. 2-3).
Germania responded to the move of Lufthansa on 12th November 2001 with a tariff
reduction from 99 Euro to 55 Euro. Following the report of an official of Germania, the
customers otherwise had no incentive to fly with Germania (with a price difference of only
one Euro), especially because Lufthansa has certain auxiliary services like service on board,
airport lounges, frequent flyer programs or more daily flight connections.
By the turn of the year 2001-2002 both airlines again changed their prices. Lufthansa
replaced the tariffs to 100 Euro by a tariff slightly above. By the time of the decision of the
Federal Cartel Office in mid February, the tariff was 105,11 Euro for a flight from Berlin to
Frankfurt and 105,31 Euro for a flight from Frankfurt to Berlin. Therefore a round-trip was
available for 210,42 Euro. Furthermore, Lufthansa introduced several restrictions for the new
tariffs, e.g. a fee for reclassification of 22 Euro and a duty to book outbound and inboundflights separately. These restrictions are more or less equal to Germania’s. It is especially
important to mention, that the new tariffs were not subject to the typical restrictions to
separate business travelers from leisure travelers like minimum stay, a reclassification ban or
a Sunday rule (see Bundeskartellamt (2002), p. 3).
Germania raised its fares on the 1st January 2002 from 55 to 99 Euro. The motivation
for this step was the awareness, that the break-even point was not reachable with a tariff of 55
Euro. Following the tariff increase the demand for Germania tickets broke in by 39 Percent.
The demand of Lufthansa stayed almost the same between December 2001 and January 2002.
Nevertheless Germania is a new entrant in the scheduled flights market. Germania is privately owned by the
German millionaire Hinrich Bischoff. The business concept of Germania is described by the company itself
as: „Germania is your alternative .. if you’re interested in safety and the best price-performance ratio in
scheduled and charter flights (Source: http://www.germaniaairline.de/dstart01m.htm).
3
The roots of the Deutsche Lufthansa AG (Lufthansa) go back to the year 1926. After the Second World War
the airline was re-founded and largely owned by the state (Federal Republic of Germany, Federal State of
Northrhine-Westphalia and the German Federal Railways). By the beginning of the 1990‘s Lufthansa had its
worst-ever economic crisis. In the following, Lufthansa was privatized step by step until the end of 1997.
Since that year, Lufthansa is also an important member of the worldwide “Star Alliance” together with the
founding members Air Canada, SAS, Thai Airways und United Airlines. In the German market, Lufthansa
was and is a monopolist in most of the markets. During the last couple of years Lufthansa was challenged by
several low cost carriers, but only with very limited success. Lufthansa operates a big hub at Frankfurt/Main
airport and a smaller one at Munich airport.
6
3.2
The Case
In the following, first the decision of the Federal Cartel Office is described in greater detail.
Subsequent, the central economic content of the motivations of the Federal Cartel Office is
analyzed.
3.2.1 The decision
On 18th February 2002 the Federal Cartel Office decided the following due to the abuse of a
dominant position following Section 19 of the German ‚Act Against Restraints of
Competition“: 4 Lufthansa is prohibited from demanding a price (including passenger fees)
for a one-way ticket per passenger on the Frankfurt-Berlin route, which is not at least 35 Euro
above Germania’s price, as long as DLH does not have to charge more than 134 Euro as a
result. The allegation is inoperative for tickets with ‚hard‘ ticket restrictions like a
reclassification ban and/or a minimum stay and/or a Sunday rule. The allegation remains valid
for two years, as within this period Germania should have gained sufficient recognition and
established a clientele base (see Bundeskartellamt (2002), p. 1).
3.2.2 The motivations
The decision of the Bundeskartellamt is separated into two (economically relevant) parts.
First, some introductory remarks of the Federal Cartel Office which fortify the assumption of
the abuse of a dominant position by Lufthansa are given. The second part contains the
ultimate case decision.
3.2.2.1 Introductory propositions
Before starting the entire analysis of the abuse of a dominant position, the Federal Cartel
Office makes (at least) three economically relevant propositions, which are briefly mentioned
in the following:
Proposition 1: With the introduction of the new tariff, Lufthansa not only adjusted to
Germania’s price but factually undercut it.
In the explanatory statement, the Federal Cartel Office mentioned that the reduced fare of
Lufthansa contains several auxiliary services like service on board, the frequent flyer
program, the more daily flight connections, the usage of lounges, the better access to travel
agencies and computer reservation systems, the existing airline network, the advantage of
reputation especially among business travelers, the better seats in the airplane and the travel
commission override programs between Lufthansa and most of the 100 biggest firms in
Germany (see Bundeskartellamt (2002), p. 11-12).
4
Section 19 of the German ‚Act Against Restraints Of Competition‘ says in Paragraph 1 that „The abusive
exploitation of a dominant position by one or several undertakings shall be prohibited.“ ... (4) An abuse
exists in particular if a dominant undertaking, as a supplier or purchaser of certain kinds of goods or
commercial services, 1. impairs the ability to compete of other undertakings in a manner affecting
competition in the market and without any objective justification; 2. demands payment or other business
terms which differ from those which would very likely arise if effective competition existed; in this context,
particularly the conduct of undertakings in comparable markets where effective competition prevails shall be
taken into account; ...“
7
In the following, the Federal Cartel Office tries to calculate the benefit in money's worth of
some of the auxiliary services. The motivation for this step is the belief that it is essential for
the predation analysis to find out if ‘enough’ people are ready to switch from Lufthansa to
Germania (see Bundeskartellamt (2002), p. 6-13).
For example, the benefit in money’s worth for the frequent flyer program is calculated
in the following way: Every flight with the new fare is rewarded with at least 500 miles in the
program. A normal flight within Germany is rewarded with 1000 miles. A free bonus flight
(worth in average: 488 Euro) is provided, if 20000 miles have been reached. This means that
such a free flight is falling due after 40 flights. Therefore, the benefit in money’s worth of the
frequent flyer program for one flight can be calculated as 12 Euro (see Bundeskartellamt
(2002), p. 7-8).
The Federal Cartel Office also tries to calculate the benefit of money’s worth of the
higher daily flight frequencies of Lufthansa. They assume a time advantage of about one hour
for customers of Lufthansa and estimated the benefit between 25 and 60 Euro. The Federal
Cartel Office concludes that the price of Lufthansa must be at least this amount higher in
comparison Germania’s price to compensate for the higher frequencies of Lufthansa (see
Bundeskartellamt (2002), p. 10-11).
Proposition 2: Due to the low Lufthansa tariff, Germania is stripped of its only possibility to
compete with Lufthansa.
The Federal Cartel Office argues that Germania has clear disadvantages (compared to
Lufthansa) in the auxiliary service sections flight frequencies, seat comfort, frequent flyer
program, access to lounges and service on board. In the service sections safety, punctuality,
efficient check-in and free choosing of seats, the Federal Cartel Office evaluates that neither
Lufthansa nor Germania has a clear advantage. From this it follows that Germania has
competition possibilities only in the sections price and cabin personal. The Federal Cartel
Office argues further that if Lufthansa prey this last competition possibility from Germania,
it’ll have no change to attract enough passengers to operate efficiently (see Bundeskartellamt
(2002), p. 9-10).
Proposition 3: The new low fare tariff of Lufthansa don’t cover the average costs per
passenger.
Following the (not published) calculations of the Federal Cartel Office, Lufthansa don’t cover
the average costs per passenger with the low fare tariff of 105 Euro. This is the result of an
analysis of the route profitability analysis of Lufthansa. (see Bundeskartellamt (2002), p. 1213).
Due to these introductory propositions the Bundeskartellamt comes to the assumption
that Lufthansa abuses its dominant position in the market with prices which are not at least 35
Euro above the price of Germania as long as Germania did not raise its tariff over 99 Euro
(see Bundeskartellamt (2002), p. 14).
3.2.2.2 The central motivations for the decision
Following the guidelines of Section 19 of the German ‚Act against Restraints of Competition‘
the investigation has to start with the delineation of the relevant market followed by the
determination that the company of interest has a dominant position in this market. Afterwards
the abusive exploitation of this dominant position must be established.
8
A
RELEVANT MARKET AND DOMINANT POSITION
The Federal Cartel Office only provides a very short analysis of the relevant market. It
implicitly sees business flights between Frankfurt and Berlin as a separate relevant market
which consequently has to be separated from the more time-insensitive leisure travelers. 5 The
Federal Cartel Office especially mentions that the possible substitution alternatives – going by
car or rail – are no real alternative for business travelers due to the significantly longer trip
duration.
By excluding rail and car demand from the overall travel demand between Frankfurt
and Berlin, Germania had (to the time of the decision) a market share of about 10% on the
Frankfurt-Berlin Route. Therefore, the Federal Cartel Office concludes that Lufthansa is the
dominant firm in this market. The dominant general resources of Lufthansa compared to
Germania are used as another argument to fortify this view 6 (see Bundeskartellamt (2002), p.
14).
B
DETERMINATION OF THE ABUSE OF A DOMINANT POSITION
The determination of the abuse of a dominant position usually takes place in three steps. After
formulating the allegation, the Federal Cartel office has to show the suitability of the price
reduction to reach the presumed goal of Lufthansa. Then, the Federal Cartel Office has to
prove the actual existence of such a strategy.
Alleged violation of Section 19
In the opinion of the FCO the introduction of the new tariff of 100 Euro by Lufthansa in
response to the entry of Germania was “predatory behavior” 7. Such a predatory price has the
purpose and is capable to rule out Germania from the route (see Bundeskartellamt (2002), p.
14-15).
Suitability of the price decrease to reach the assumed aim
The damage of the competition possibilities of Germania has significant effects on future
competition in the market for scheduled flights between Frankfurt and Berlin. Lufthansa had a
5
In a recent investigation, Crocioni (2000) analyses the definition of airline markets in the U.S. and the EU.
He found that the relevant market was defined as ‘city pairs’ in the U.S. or ‘routes’ in the EU. Whereas the
U.S. DOT always includes both one-stop and non-stop flights, the EU commission only includes nonstop
flights. The distinction seems justified by the fact that substitutability between the two types of services
emerges more clearly in the case of long-haul flights. In other words, the degree of substitutability from
connecting flights could be higher for long-haul routes than for short-haul. The U.S. as well as the EU
tended to include both leisure and business travelers to the same relevant market. This might be theoretically
incorrect, but justified by the fact that supply substitutability among the different fare categories is easy.
Substitutability of air transport by other modes of transport play no role in the U.S. (due to longer flight
distances and an underdeveloped rail network) and even in the EU no case exists to date, where trains have
been included into the relevant market for a short-haul route. As far as the entry analysis is concerned, the
U.S. antitrust authorities relied on the contestability theory for a long time. It is only in the late cases that
some potential entry barriers are identified and analyzed. The EU Commission has been more inclined to
identify entry barriers arising from airlines’ behavior as well as institutional entry barriers, especially access
to ‘essential facilities’ like computer reservation systems or airport facilities.
6
The exact market shares are confidential information.
7
The Federal Cartel Office defines predatory behavior as follows: „predatory behavior is aggressive market
conduct ... by dominant firms with the aim of ruling out competitors from the market, to discipline them or
to deter them from new market entry” (Bundeskartellamt (2002), p. 15, translated by the author)
9
monopoly position before the market entry of Germania and would regain it after the exit of
Germania. The defense of the newcomer therefore would have a considerable interference for
competition. The suitability of the strategy is therefore given (see Bundeskartellamt (2002), p.
17)
Actual existence of the presumed predation strategy
The FCO first assesses that the new Lufthansa tariff affect the competition possibilities of
Germania. The reaction of Lufthansa seriously endanger the chance of Germania to establish
a new service on this route.
The usage of a tariff of 105,21 Euro by Lufthansa constitutes – in conjunction with the
auxiliary services of Lufthansa – a factual underselling of at least 35 Euro under the
acceptance of operative losses. The revenue per passenger is significantly smaller than the
average costs per passenger.
Such a strategy is rational only then when it has the aim of ruling Germania out of the
market. Afterwards the losses can be recouped by increasing prices up to the monopoly level.
In addition to that, the actual behavior of Lufthansa might set a deterrent signal to other
potential entrants in this and other routes. Therefore, the Federal Cartel Office interprets the
introduction of the low tariff as aimed at and capable to rule Germania out of the market (see
Bundeskartellamt (2002), p. 17-21). The other evidence tighten this presumption:
•
Lufthansa introduced the new tariff selectively only on the route, where the new entrant
has started service. The tariff aims at the same group of passengers (business travelers)
and Lufthansa introduces the same restrictions to the new tariff as Germania.
•
Lufthansa’s price reduction almost up to the level of Germania’s is factual a clear
underselling, because Lufthansa’s tariff includes a lot of auxiliary services. Lufthansa’s
tariff matching forecloses the possibility of Germania to reach a sufficient switching rate
of price-sensitive business travelers from Lufthansa to Germania.
•
Experiences with market entries in other Lufthansa monopoly markets (by other
competitors) have shown the general suitability of a predation strategy to rule out
competitors (e.g. after entry of ‘Go-Fly’ in the London/Stansted-Munich market).
•
Price comparisons with the only other competitive air transport market within Germany
(between Berlin and Munich) showed that Lufthansa’s Frankfurt-Berlin tariff was
significantly below the price of a ticket in the Berlin-Munich market (441 Euro). In this
market Lufthansa competes with ‘Deutsche BA’.
•
Furthermore, Lufthansa has high financial power and is therefore able to survive a price
war. The ‘predatory investment’ is therefore possible as well.
Due to these (and some other omitted) reasons the Federal Cartel Office acts on the
assumption that the pricing policy of Lufthansa in the Frankfurt-Berlin market has the aim to
rule out the competitor Germania. Therefore, predatory intent is proven.
C
EFFICIENCY DEFENSE
The Federal Cartel Office asserts that no objective justification for the underselling strategy
exists. The aim of Lufthansa’s strategy is the recovery and consolidation of its monopoly
10
position in the market. Even the special importance of the Lufthansa Hub in Frankfurt/Main
(and the corresponding economies) do not justify the pricing strategy of Lufthansa.
The Federal Cartel Office states further that ‘long-run protection of competitive
structures’ also mean that - in cases of market dominance – the chances for an intensification
of competition must be obtained to remain the markets open (see Bundeskartellamt (2002), p.
21).
D
FIXING THE SANCTIONS
Fixing the minimum price distance
The fixing of the minimum price distance of 35 Euro occurs according to the best judgement
of the Federal Cartel Office. It is based on the calculations of the benefit in money’s worth of
the auxiliary services mentioned above. The Federal Cartel Office expects that after the
introduction of the minimum price distance, the predatory effect disappears and that the
normal competitive pressure will appear in the market. The Federal Cartel Office further
mentions, that the used rule does to deliver unlimited protection for Germania. Because
Germania stated that it can reach the break-even level at a price of 99 Euro, the protection
interest vanishes with increasing prices of Germania (see Bundeskartellamt (2002), p. 21-22).
Fixing of the validity of the minimum price distance
The sanction is valid for two years. The Federal Cartel Office justified this fixing with the
fact, that the need for a minimum price distance has gone, when the new competitor has
established in the market (e.g. reputation, optimization of competition parameters) and
therefore the predatory effect has been reduced (see Bundeskartellamt (2002), p. 22-23).
3.3
The key questions
The Lufthansa-Germania case raises at least two complexes of interesting economic
questions. In the focus of the first complex could be the question, if the behavior of Lufthansa
was really predatory. As the Federal Cartel Office does not deal with a complete theory-based
framework for predatory pricing (e.g. like the most recent one by Bolton et al. (2000)), there
is space for critique and different opinions on the case. Unfortunately, due to the
confidentiality of all cost and demand data, a rigorous analysis wouldn’t be possible. Beyond
that, it is questionable whether such a complete case analysis would deliver brand-new
insights in the antitrust economics of predatory pricing (see Hüschelrath (2003) for a detailed
analysis).
The second interesting complex is the question raised in the title of the paper: “How to
prey on predators?” This question is especially interesting, because most of the predation
cases so far got stuck at the latest in the detection phase and therefore never reached the
‘sanction phase’. The Lufthansa-Germania Case therefore is especially interesting, because a
predator is convicted and the Federal Cartel Office had to solve the sanctioning problem. As
far as the solution of the Federal Cartel Office – the minimum-price-distance rule - is
concerned, it is interesting to ask whether such a rule is a) helpful in fighting predators and b)
the best possible answer to the problem of (sanctioning) predation? The following section
tries to give answers to these questions.
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4
HOW TO PREY ON PREDATORS? – ECONOMIC APPROACHES
The previous section delivered the central question of how to sanction predators after their
misconduct is proved. The solution of the Federal Cartel Office was the introduction of a
‘minimum price distance’ between the predator’s and the victim’s price for a limited time
period. This section tries to classify this concept of the Federal Cartel Office, criticize it and
proposes other policies against predation strategies. To reach this aim it is quite important to
give some brief ideas about the general aim and possible options of action for an antitrust
authority.
As far as the aim of an antitrust authority is concerned, it might best be described as the
“maintenance and promotion of competition”. It should be added that this aim has to be
reached with the lowest possible cost burden. This general aim should guide the choice of the
right option. Concerning the ‘options toolbox’, the antitrust authority can always choose
between the simple order to end the abuse of a dominant position, to impose a fine and/or to
dispose other sanctions.
Focusing on the sanctions option for the moment, Lévêque (2000), p. 3) provides a
classification of possible ways to formulate sanctions. He defines the following general
targets for sanctions:
(1) A firm’s environment (e.g. threat of antitrust penalties)
(2) A firm’s outputs (e.g. price, quantity, quality)
(3) A firm’s frontiers (e.g. structural antitrust sanctions or remedies 8 )
Given these targets, Lévêque differentiates between two policy instruments to reach the
desired effect (‘maintenance and promotion of competition’):
(1) (ex-post) command-and-control(‘regulatory’) approach or
(2) (ex-ante) incentives approach.
To give a general example, a command-and-control approach with respect to the firm’s
outputs would be a cost-plus regulation, whereas a price-cap regulation would be an ex-ante
incentive approach. A command-and-control approach with respect to a firm’s frontiers would
be the installation of chinese walls between different parts of a company to avoid
communication. A ex-ante incentive approach would be the divestiture of the company in
different sub-parts.
Turning to the Lufthansa-Germania case, the Federal Cartel Office chose a ‘minimum price
distance’ rule. In the classification above, the Federal Cartel Office used an (ex-post)
8
Sanctions for predators and merger remedies have certain similarities. In both cases the antitrust authority
must have well founded prospects about future competition in the market and must construct the remedy or
sanction in a way that promotes the aim of the whole action. The literature on merger remedies in essence
differentiates between behavioral or structural remedies. Structural remedies “... include divestiture of an
entire ongoing business, or partial divestiture ... [whereas] ... behavioral remedies .. consist of engagements
by the merging parties not to abuse of certain assets available to them” (Motta et al. (2002), p.3)
Motta et al. ((2002), p. 2) especially pointed out that not all remedies are applicable to a certain case.
The right choice critically depends on the main objective of the remedy or sanction. Another problem Motta
mentions is that an optimal remedy in theory might not be effective in reality due to the incomplete
information situation between the antitrust authority and the company. Furthermore the remedies differ in
the engagement required to the antitrust authority, e.g. because behavioral remedies must be monitored to
ensure correct conduct. On the other hand, structural remedies are more risky, because they are nonreversible.
12
command-and-control approach with the target ‘firm outputs’ (in this case ‘price’). The
following paragraphs will discuss the economic implications of this classification and will
propose other solutions to the problem. The analysis is divided into two parts: the ex-post
command-and-control (‘regulatory’) approach and the ex-ante incentives approach.
4.1
The ex-post regulatory approach
The Federal Cartel Office actively describes the upper-aim of their mission with the
“maintenance and promotion of competition”. It adds that ‘long-run protection of competitive
structures’ also mean that - in cases of market dominance – the chances for an intensification
of competition must be obtained to remain the markets open (see Bundeskartellamt (2002), p.
21).The minimum price distance rule therefore must be evaluated with this central aim in
mind.
Against this background, the essential advantage of the rule is that it has the potential
to reduce the predation effect in the market. Therefore, the chance for competition to grow
and to maintain is definitely greater than without such a rule. In the face of the unsuccessfulness of most of the predation cases in the past, the rule also might be a first hint for more
severe predatory pricing rules (at least in the airline industry) in the future. It seems clear that
the rule promotes the central aim of the Federal Cartel Office mentioned above. The decision
and the rule show that predation is accepted by the Federal Cartel Office as an anticompetitive strategy (at least in the airline industry) and that the Office is willing to intervene
if such strategies are used by incumbent firms.
In spite of these central advantages of the rule, an economics view has to ask if the aim
has been reached ‘completely’ and – if yes – with the lowest possible cost burden. The
following analysis will show that the minimum price distance rule contains a lot of drawbacks
which reduce its effectiveness and desirability:
First, to constitute the essential parameters of the rule (especially the amplitude of the
price distance and the period of validity) the authority must have a precise picture about the
industry and their likely development. Furthermore, the authority must have well founded
insights on how the parameter characteristics might change market conduct and overall
competition in the short- and in the long-run. This might be (dependent on the industry in
question) a very ambitious aim for an antitrust authority.
In other words, the minimum price distance rule creates the possibility of a third
possible error 9 in antitrust cases: “... where a court correctly identifies anti-competitive
conduct, but its mode of interference, i.e., its prescribed remedy, harms competition” (Gal
(2000), p. 93).
Second, a big danger of the minimum price distance rule is that the disjunction
between competition and regulatory authorities gets fuzzier. Following Rey ((2000), p. 44),
antitrust authorities normally have the task to check (ex-post) the lawfulness of firms’
activities, whereas industry regulators have more extensive powers. Only regulators usually
act ex-ante and have the industry-specific expertise to set regulatory parameters.
Third, the minimum price distance rule is effective only if the victim remains in the
market until the rule comes into force. As many new entrants don’t have big financial
resources, this means that the antitrust authority has to be quick in analyzing the case. This
might be possible in some cases but hardly possible in others. In other words, the Federal
Cartel Office rule doesn’t seem to be an universal tool for antitrust authorities but more a
9
“Current law and economics literature identifies two main types of errors courts can make in applying
antitrust law. Courts may erroneously label conduct as anti-competitive even though competition is not
harmed. Alternatively, courts may fail to identify, and thus fail to attack, anti-competitive conduct” (Gal
(2000), p. 93).
13
selective option for some cases in some industries (in which the antitrust authority might have
expertise).
Forth, as with any other rule, there is a danger that firm will find ways to avoid the
regulation, e.g. by adjusting other (non-regulated) competition parameters like quality or the
introduction of new (slightly modified) products.
Fifth, the fixing of the price distance might be highly arbitrary. Such arbitrariness is
bad, because the firms won’t be able to predict the reaction of the antitrust authority. This
could mean that socially desirable price cuts don’t take place because firms are afraid of being
punished. Furthermore, if the price distance is chosen to narrow, the predatory incentive may
remain. If the distance is chosen to wide, the competitive pressure for the entrant might be too
low and the incumbent probably makes losses. In other words, it might be the case that the
rule creates or at least protects inefficient entrants.
Sixth, a defined minimum price distance could be problematic, if unexpected cost- or
demand-shocks occur. Such a situation might force the victim to a price increase. Ceteris
paribus, the minimum price distance gets smaller or even lost. It might be theoretically
possible to monitor the industry and to adjust the rule, if such shocks occur. But due to the
scarce resources of competition authorities, it is not very likely that such a rule works terribly
well.
Seventh, the time restriction (two years) of the sanction might be problematic, because
it is questionable, that all predatory threats are gone after two years of protection. The
argument, that Germania might have earned a reputation after two years isn’t very
straightforward, as the only reason to buy a ticket from Germania is the low price – this is the
central ‘reputation’ basis of the firm. And this basis is contestable again after two years of
protection. In other words, the commitment of the Federal Cartel Office, that ‘competition
should be fine in two years’ (after the usage of the rule) creates a possibility for Lufthansa to
start predation (without the threat of punishment) after the rule has expired. To say it a little
bit provocative: After the expiration of the rule, predatory pricing is allowed in the relevant
market because the Federal Cartel Office believes that it is not possible resp. rational.
In a nutshell, the analysis above has shown that the minimum price distance rule of the
Federal Cartel Office has at least the potential to influence the general aims of antitrust
interventions positively. The actual effect depends on the setting of the parameters of the
concept (especially the amplitude of the price distance and the period of validity). The
drawbacks of the rule raise the question after other - more market-based - solutions of the
problem of (sanctioning) predation. Such proposals will be analyzed in the following section.
4.2
The ex-ante incentives approach
Due to the general problems of identifying and sanctioning predation behavior ex-post, it
might be a good idea to think about rules which destroy the incentives for predation strategies
ex-ante, that means before these strategies are actually chosen and played by an incumbent. In
other words, the aim is to create economic incentives for potential predators to adopt socially
desirable behavior. Such a solution to the problem would be very attractive, because e.g. it
could save a lot of resources and would minimizes the different antitrust errors (see footnote 9
above) which could otherwise occur.
The idea of distorting the ex-ante incentives for predation is not new. Baumol (1979)
developed his ‘no postexit price increase’ rule in 1979, motivated by the invention of
Williamson’s (1977) ‘no postentry output increase’ rule two years earlier. Recently, Edlin
(2002) revive the ideas of Baumol and Williamson to construct his own proposal for an exante rule against predation. In the following, the rules of Baumol and Edlin are presented in
greater detail.
14
4.2.1 Baumol’s no postexit price increase rule
The primary motivation of Baumol’s rule (Baumol (1979)) is to completely avoid reliance
upon cost based tests. His rule permits price decreases in response to entry but forbids a
dominant firm to raise prices again for a considerable period of time (Baumol suggests 5
years) after the entrant exited the market.
The calculus of this rule is the following: If a. dominant firm only is allowed to raise
prices after a certain time period after the exit of the victim, the monopoly profits are
unreachable during this time period. As a consequence, the predation strategy gets more
expensive and therefore a usage gets more unlikely. It is important to note that Baumol’s rule
would not forbid price decreases after entry but would forbid the dominant firm to select a
price that it couldn’t live with in longer terms.
On the first look, this rule seems very attractive because it reduces the incentives for
predation strategies almost for free. In other words, the main advantage of the rule is a low
administrative cost burden, because only in the case of an efficiency defense an exact analysis
of the case is necessary.
Unfortunately, a major problem with this rule is that also the incentives for social
desirable price decreases are reduced by the rule of Baumol. „[B]y making price increases
difficult, the rule might also make innocent firms leery of cutting prices, for fear of losing
their ability to raise them later again“ (Phlips (1989), p. 23). Edwards (2002) shows in greater
detail that this might be a big problem, especially in industries with considerable network
effects.
Another disadvantage of the rule derives from the fact that prices underlie a hole
bunch of variations (with different motivations) over time. In case of unexpected cost changes
the dominant firm has to be allowed to raise prices. In such a case the antitrust authority must
investigate (under incomplete information), if the dominant firm should be allowed to raise
the price. Especially this argument shows that the workability of Baumol’s rule is relatively
low, because the reviewing authorities have to ensure that a price cut remains in effect for the
required period following exit (see Phlips (1989), p. 23). Summing up, it turns out that
Baumol’s rule share a lot of disadvantages with the ‘minimum price distance’ rule of the
Federal Cartel Office.
4.2.2 Edlin’s price freezing rule
The proposal of Edlin is in the spirit of the rules of Baumol and Williamson. He proposes a
dynamic standard of predation: „In markets where an incumbent monopoly enjoys significant
advantages over potential entrants, but another firm enters and provides buyers with a
substantial discount, the monopoly should be prevented from responding with substantial
price cuts or significant product enhancements until the entrant has had a reasonable time to
recover its entry costs and become viable, or until the entrant’s share grows enough so that the
monopoly loses its dominance.“ Edlin (2002), p. 945). Edlin usually assumes that if an entrant
prices twenty percent below an incumbent monopoly, the incumbent’s prices will be frozen
for twelve to eighteen months. If the incumbent does not observe these structures, then the
entrant under this proposal can sue successfully for predatory pricing without the need to
demonstrate below-cost pricing or the opportunity for recoupment (see Edlin (2002), p. 946)
In comparison to the Baumol, Edlin’s rule encourages the incumbent to charge low
prices from the start in order to discourage entry (see Edlin (2002), p. 946). Furthermore,
Baumol’s rule aimed at to eliminate the high-price period of recoupment. Therefore,
15
Baumol’s rule would not provide any incentive to price low before entry (like the rule of
Edlin) because it creates no link between post-entry and pre-entry prices (see Edlin (2002), p.
946). Furthermore, Edlin especially sees the administrative ease as a central advantage of his
proposal, because comparing prices and costs is much more difficult than a simple oversight
over market prices. „If an entrant charges a price substantially below the incumbent’s price (I
suggest twenty percent or more), this would generally trigger a price freeze for the incumbent.
Prices are more easily and reliably measured than cost“ (Edlin (2002), p. 969).
Edwards ((2002), p. 188) shows that in many respects Edlin’s rule is similar to the proposals
of Baumol and Williamson. Consequentially, Edlin’s rule is subject to most of the critique
mentioned above. Edwards especially focused his critique on the alleged biggest advantage of
Edlin’s rule: the administrative ease. „ ... [T]he proposal would require, for each industry, or
in each case where a firm develops a monopoly, ongoing micro-management by the courts or
a regulatory agency to determine the appropriate periods of price freezes and to review these
determinations. These determinations would likely be subject to lengthy and ongoing litigious
and non-litigious arguments between the interested parties“ (Edwards (2002), p. 188). It is
further worth mentioning, that the results of Edlin’s proposal are dependant on the case of a
low cost monopoly deterring entry by pricing above its own average variable costs. This
might not necessarily be fact in all cases.
5
CONCLUSION
“How to prey on predators?” was the central question, the German Federal Cartel Office was
confronted with, when it had to decide the so-called Lufthansa-Germania case in February
2002. The authority solved the problem by prohibiting the predator (Lufthansa) from
demanding a price for a one-way ticket per passenger on the Frankfurt-Berlin route, which is
not at least 35 Euro above Germania’s (the new entrant) price, as long as Lufthansa does not
have to charge more than 134 Euro as a result (‘minimum price distance’ rule).
The paper has shown that a competition authority can choose between two different
policy options to sanction predators. Besides the (ex-post) regulatory approach used by the
Federal Cartel Office, there is also the possibility of implementing an (ex-ante) incentives
approach to fight predation strategies and solve the predation problem ‘in advance’.
As far as the regulatory approach is concerned, the paper has shown that the concept
has a clear negative impact on the incentive to play a predation strategy and is therefore
highly desirable. Unfortunately, it has been shown further that the success of the regulatory
approach is impaired by a few severe drawbacks. Including the general problems of
identifying predation behavior ex-post, it has turned out to be a good idea to think about rules
which destroy the incentives for predation strategies ex-ante, that means before these
strategies are actually chosen and played by an incumbent.
The analysis of rules by Baumol and Edlin has clarified that many problems of the
regulatory approach are also virulent in the incentive approach. Indeed, the ex-ante incentive
approach have comparative advantages in especially three important areas. First, such an
approach reduces the need for a complex evaluation of likely future competition in the market
by the antitrust authority. Second, the delineation between regulation tasks and competition
policy tasks – and the corresponding division of work - remains less fuzzier than with an (expost) regulatory approach. Third, the administrative cost burden tends to be lower in an exante incentive approach. Therefore, as a recommendation, the antitrust authorities might think
about the introduction of an ex-ante incentive approach to fight predation strategies. Such a
step would solve the sanctioning problem automatically.
16
Independent of this recommendation, the Lufthansa-Germania decision surely constitutes a
milestone in predation antitrust economics, because the Federal Cartel Office has shown its
willingness to intervene against predators. Furthermore, the Federal Cartel Office has done
pioneering work in solving the problem of sanctioning a predator in a way which is promotive
for the general aim of every antitrust authority - maintaining and promoting competition.
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