How the big U.S. airlines try to avoid competing with each other

August 14, 2013

In 2005, there were nine major airlines flying inside the United States. Today, there are just five: Delta, United, Southwest, American Airlines, and US Airways:

airline mergers
(U.S. Department of Justice)

More recently, US Airways and American Airlines are trying to combine forces, bringing the total down to four. And that seems to be a step too far for antitrust officials at the U.S. Department of Justice, who filed a lawsuit Tuesday to block the $11 billion merger, which would create the largest airline on the planet.

The full complaint (pdf) from the Justice Department makes for fascinating reading, and reveals a fair bit about the odd economics of the airline industry — especially on how the big airlines do and don't compete with each other in this post-merger world. Here are a few highlights:

1) The big remaining U.S. airlines now try to avoid competing with each other. The complaint notes that three of the four remaining "legacy carriers" — namely, Delta, America, and United — appear to have a gentleman's agreement not to undercut each other on pricing along certain routes:

If, for example, United offers nonstop service on a route, and Delta and American offer connecting service on that same route, Delta and American typically charge the same price for their connecting service as United charges for its nonstop service.

As American executives observed, the legacy airlines “generally respect the pricing of the non-stop carrier [on a given route],” even though it means offering connecting service at the same price as nonstop service.

2) Big airlines have all sorts of ways to coordinate fares with each other. First, there are "cross-market initiatives," or CMIs. Essentially, the airlines threaten each other with destructive price wars in order to keep fares high:

A CMI occurs where two or more airlines compete against each other on multiple routes. If an airline offers discounted fares in one market, an affected competitor often responds with discounts in another market—a CMI—where the discounting airline prefers a higher fare. CMIs often cause an airline to withdraw fare discounts.

The airlines also share real-time airfare data in order to coordinate prices. Back in 1992, the U.S. government filed a lawsuit to stop several airlines, including US Airways and American, from engaging in that practice. But that prohibition has now expired:

[A]ll airlines have complete, accurate, and real-time access to every detail of every airline’s published fare structure on every route through the airline-owned Airline Tariff Publishing Company (“ATPCO”). ... The airlines use ATPCO to monitor and analyze each other’s fares and fare changes and implement strategies designed to coordinate pricing.

Airlines have previously used ATPCO to engage in coordinated behavior. In 1992, the United States filed a lawsuit to stop several airlines, including both defendants, from using their ATPCO filings as a signaling device to facilitate agreements on fares. That lawsuit resulted in a consent decree, now expired.

3) US Airways, however, has long been an outlier in forcing competition. When US Airways flies a route, it tends to offer sharp discounts through its "Advantage Fares," a program that offers cheap connecting service. So when US Airways is flying a route, the other three legacy carriers have to lower their own prices:

But American, Delta, and United frequently do charge lower prices for their connecting service on routes where US Airways offers nonstop service. They do so to respond to US Airways’ use of Advantage Fares on other routes.

A good example: The complaint offers a screenshot of fares for a round-trip flight between Miami and Cincinnati on Aug. 13 and 14. Notice that American Airlines is the only airline with a nonstop flight between the two cities, priced at $740. And the two other legacy carriers — United and Delta — aren't even trying to compete. But US Airways is offering a much cheaper connecting flight, at $471:

Now, US Airways isn't entirely virtuous here. In 2010, US Airways executives sent a rival CEO an email complaining that the rival airline;s "triple miles" discounts were undermining all the other airlines' profitability. (This is on p. 17 of the complaint, and note that the rival CEO called the email "inappropriate" and forwarded it to his lawyer.)

4) The merger might mean an end to US Airways's aggressive discounts. Here's why antitrust officials are worried. If US Airways merged with American Airlines, it would no longer have as much incentive to undercut the other carriers. And that would mean higher prices for travelers:

If the merger were approved, US Airways’ economic rationale for offering Advantage Fares would likely go away. ... [T]he revenues generated from Advantage Fares would shrink as American’s current nonstop routes would cease to be targets for Advantage Fares.

The bottom line is that the merged airline would likely abandon Advantage Fares, eliminating significant competition and causing consumers to pay hundreds of millions of dollars more.

5) Airline officials believe that consolidation would mean higher prices and fees. The complaint quotes US Airways executives on this very point:

Since 2005, there has been a wave of consolidation in the industry. US Airways has cheered these successive mergers, with its CEO stating in 2011 that “fewer airlines” is a “good thing.” US Airways’ President explained this thinking that same year: “Three successful fare increases – [we are] able to pass along to customers because of consolidation.” (emphasis added).

Similarly, he boasted at a 2012 industry conference: “Consolidation has also . . . allowed the industry to do things like ancillary revenues [e.g., checked bag and ticket change fees] . . . . That is a structural permanent change to the industry and one that’s impossible to overstate the benefit from it.”

Now, a key caveat: Not everyone thinks consolidation would necessarily mean soaring ticket prices. A report from PricewaterhouseCoopers in 2012 argued that recent “mega-mergers” haven’t led to “dramatically higher airfares or drastically reduced competition on most routes.” (Though note the use of "most.")

Still, the Justice Department is putting more weight on testimony from people who actually run the airlines. And US Airways's executives seem awfully confident that the merger will allow them to raise prices and stop the tide of unprofitability that has plagued the airline industry since deregulation in the 1970s.

6) Competition from Southwest and JetBlue might not be enough to keep the legacy carriers honest. Antitrust officials think it's unlikely that cheaper carriers like Southwest and JetBlue will be able to keep prices down. For one, those two budget airlines don't have the same extensive domestic network as the legacy carriers. And you don't have to believe the U.S. government on this point. Just listen to what US Airways execs say:

Traditionally, Southwest and other smaller carriers have been less likely to participate in coordinated pricing or service reductions. For example, Southwest does not charge customers for a first checked bag or ticket change fees. Yet that has not deterred the legacy carriers from continuing, and even increasing, those fees.

In November 2011, a senior US Airways executive explained to her boss the reason. “Our employees know full well that the real competition for us is [American], [Delta], and [United]. Yes we compete with Southwest and JetBlue, but the product is different and the customer base is also different.”

It also helps that, if US Airways and American merged, the resulting company would dominate key hubs around the country. For instance, the new airline would control fully 69 percent of the take-off and landing spots at D.C.'s Reagan National Airport. That makes it physically difficult for an outside carrier to come in and compete.

Now, it's entirely possible that the U.S. Department of Justice is wrong on some of these points. Or perhaps there's a better way to look at this: Yes, consolidation will bring higher prices, but that might be preferable to having a cutthroat airline industry that's consistently unprofitable — a point my colleague Steve Pearlstein has made. (Note that the U.S. airline industry had a profit margin of about 0.1 percent in 2012, and that was a good year.)

For their part, US Airways and American think the merger will be broadly beneficial. "Integrating the complementary networks of American and US Airways to benefit passengers is the motivation for bringing these airlines together," the companies said in a statement. "Blocking this pro-competitive merger will deny customers access to a broader airline network that gives them more choices."

Still the Justice Department complaint quotes various airlines officials saying a bunch of other things on the topic, and it's worth a browse for those interested in the subject.

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