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 .„
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CRPY F &)
n CANADIAN TRANSPORTATION RESEARCH
LE GROUPE DE REDIERCHES SUR LES TRANSPORTS AU CANADi

21st ANNUAL MEETINL

PROCEEDINGS

VANCOUVER, B.C.
MAY 1986

A
 ENTRY BARRIERS AND ANTI-COMPETITIVE BEHAVIOUR
IN A DEREGULATED CANADIAN AIRLINE MARKET

by

David W. Gillen*
Tae H. Oum and Michael W. Tretheway**

I. Introduction

'Freedom to Move', a white paper providing a framework for

reform in Canadian Transportation, will be translated into
legis-
lation in 1986. This ministerial discussion paper proposes a
virtual deregulation of the domestic airline industry
. The
motivation for moving to a free market is to allow Canada to reap
the positive benefits of competition, including lower fares,
a
broader offering of price-service quality combinations, improve-
ments in productive efficiency, and greater innovation. Opening
the industry up to greater competition can also have negative
aspects. One potential negative factor is anti-competitive or
predatory behaviour by firms. Such action would mitigate the
benefits of deregulation. As the Canadian airline industry makes
the transition to a free market environment, the issue
of anti-
competitive behaviour should be raised as such behavior
will
affect the ultimate success of the new policy.

Anti-competitive behaviour can take many forms. One form

attempts to raise rivals' operating costs; raising fees for
computer reservation or ground handling services provided
to a
competitor are good examples. A second form of anti-competi
tive
behaviour creates marketing disadvantages for smaller carriers
.
For example, the dominance of a carrier in the allocati
on of
airport facilities may create a significant marketing disadvan
-
tage for a smaller or new carrier. A third form of anti-competi-
tive behaviour is with respect to capacity and frequency in city-
pair markets. A dominant firm may drive rivals out of a market
by flooding it with excess capacity. A fourth strategy
is pro-
duct innovation via devices such as frequent flyer programs new
,
classes of service or reservation systems with advance seat
selection. The fifth form and the one which generally receives
the most attention is predatory pricing.
We define predatory
pricing as a firm selling its product below cost with an intent
to eliminate rivals and subsequently earn monopoly
profits.

The need to examine anti-competitive behaviour in the U.S.

before and during its deregulation was not evident, and,
in fact,
considered much of a non-issue. This conclusion was based
on the
idea that airline markets with their highly mobile capital
and

1 Gillen et al.
484

lack of entry or exit barriers were "contestable". A firm would

not find it advantageous to engage in predatory pricing. Car-
riers facing predation would quickly (and at no cost) transfer
their resources to other markets. As soon as a successful preda-
tor raised prices in a newly monopolized market, other carriers
would enter with their highly mobile capital and drive prices
down to normal levels. More recently, several U.S. economists
[Bailey and Punzar (1984), Levine (1984), Kahn (1984)1 have
a
raised issues suggesting anti-competitive behaviour could be
significant emerging problem in the U.S.

In Canada, there are several characteristics unique to

Canadian air transport suggesting even greater concern for the
potential of anti-competitive behaviour. First, Canada is domi-
nated by a single carrier which serves roughly 50% of the domes-
tic market. With this dominance, there is a greater incentive to
predate because of both the greater expected success and lower
costs of predation.

Second, the dominant carrier is Crown owned and the per-

ceived costs of capital among its decision-makers may be lower
than that in the private sector. This suggests that the expected
cost of predatory behaviour may be lower for it.

Third, the Canadian market has a greater proportion of low

density city-pair routes implying predatory pricing is more like-
ly to occur than in the U.S. It has been suggested that the
success of U.S. deregulation is due to its many markets which
can support several carriers. There is concern, at least in some
quarters, that the thin routes in Canada will only support single
carriers and thus create a relatively larger incentive for preda-
tion. The low density and small overall size of the Canadian
market also create incentives for agreements between carriers to
s.
provide "exclusive feed" with potential predatory consequence

These issues, taken together, indicate anti-competitive

behaviour could be a significant impediment in Canada to achiev-
ing the theoretical gains of airline deregulation. This concern
is particularly great in the years just following the policy
change, because it is in this transitional phase that existing
and new firms may be most vulnerable to predation.

The purpose of this paper is to explore the potential for

anti-competitive behaviour in Canadian airline markets arising
from barriers to entry. - It is the absence of entry (and exit)
barriers that determines whether or not markets are contestable.
Markets with entry barriers are less contestable and thus provide
better opportunity for predation and subsequent monopoly beha-
vior. The focus here is on the entry barriers themselves, rather
than on the types of predatory behavior they elicit. The latter
is worthy of a separate treatment. Because of a number of recent
innovations in the industry, this paper will further focus its
attention on product differentiation as a barrier to entry.

2 Gillen et al.
 485

The next section briefly summarizes the traditional and new

literature on barriers to entry. Section III examines potential
entry barriers such as frequent flyer programs, travel agent
buying power, computer reservation systems, airport access and
shared designator codes. "Hubbing" and the strategic choice of
network and service levels are also assessed, and how these are
affected by the above issues. The conclusions are contained in
section IV.

II Old and New Views on Barriers to Entry

The traditional industrial organization paradigm of "struc-

ture-conduct-performance" [Scherer, 1980] is a sequential theory,
albeit with feedback effects. Elements of industry structure,
such as product differentiation, were treated as exogenous
.
These boundaries elicit certain types of behaviour (conduct)
which in turn affected performance measures, for example, profi-
tability. More recent literature, rather than taking the sequen-
tial model, view the conduct or rivalry among firms as depending
simultaneously upon the availability of substitute products,
entry and exit barriers, and the bargaining power of both buyers
and sellers. Thus, elements of industry structure, such as
whether or not substitute products are available, will depend on
industry conduct, which in turn depends on industry structure.

One element that is common to entry barriers, availability

of substitute products and buyer bargaining power is product
differentiation: how a product can vary in characteristics or
attributes, whether real or perceived. Recent contributions
[Caves and Porter, 19771 have characterized product differentia-
tion as endogenous noting that it can be a source as well as a
result of strategic behaviour. It is, they also point out, only
one of many influences shaping performance as well as structure
.

A product or service can be differentiated physically, geo-

graphically, by a means of attached or ancillary services, and by
perception through advertising or built up good will. Each of
these factors are akin to unit cost advantages because they pro-
vide a wedge between the incumbent firm's cost and price
(as
determined by a potential entrant's cost). This allows the in
firm to engage in "limit" pricing. Product differentia-
tion is, therefore, an entry barrier, behind which the firm can
earn supra-normal profit. An entrant must come into the industry
at a higher price (or at sufficient volume if there are economies
of scale) to overcome his cost disadvantage. In the absence
of
entry barriers, firms must keep their price-cost margins and
their costs low in order to make entry unattractive.

Product differentiation is akin to geographic location ad-

vantages. According to recent writers, existing firms produce a
number of products so there will be no point in product space an
existing or new firm could move into and find profitable. The
consequence of this behaviour is that the industry will produce a

3 Gillen et al.
486

broad array of products, but firms within the industry may only
provide a subset of this array. The result may be a barrier to
entry. The presence of scope economies is likely to make product
variety a potentially successful entry deterrent strategy, since
the additional cost of expanding a product line may be low.1
There can also be threshold effects in advertising and promotion.
One has to examine barriers to entry for new firms as well as
barriers to cross entry into the product group of another' firm in
the industry.

In summary, product differentiation can create an entry

barrier by essentially driving a wedge between the incumbent's
costs and its price as determined by a potential entrant's costs.
Product differentiation in a multiproduct firm can be used as an
entry deterrent strategy. Contrary to the traditional litera-
ture, the ability for predation depends also on barriers to
cross-entry when economies of scope are present among the pro-
ducts. Furthermore, firms with a variety of differentiated
products have more ability to engage in predatory pricing on a
subset of its products without revealing the true cost of each
product. This could be a substantial entry barrier. Finally
product differentiation through product proliferation can create
a reputation effect which can deter entry from a subset of the
products provided by an industry.

III Product Differentiation in Canadian Air Transport

The importance of entry barriers for airline markets is due

to their determination of the contestability of those markets.
Contestability is needed to promote efficient production and cost
based fares in the absence of regulation. If a market is contes-
table, then prices should be the same whether or not there are
actual competitors. It is the threat of competition rather than
the presence of competition that prevents monopolistic practices.
In view of the recent findings of Bailey and Panzar (1984) that
prices in U.S. airline markets are lower with actual competition,
it is important to determine whether product differentiation
constitutes a significant entry barrier to actual competition.

There are a number of sources of product differentiation in

airline markets. Canadian carriers already offer a range of fare
classes from first class to business class, to no frills re-
stricted service. These price-quality offerings cover a broad
range in product space with little room for entry by carriers
with a new, differentiated product.

Products can also be differentiated by attached services.

Carriers offer frequent flyer programs to build customer loyalty.
Shared designator codes allow a small carrier to gain from the
reputation of a larger carrier and the larger carrier obtains the
feed from the smaller carrier. Computer reservation systems,
(hereafter CRS) can provide special services such as seat assign-
ment.

4 Gillen et al.
 487

A. Computer Reservation Systems

Computer reservation systems (CRS) control and assist in

analyzing the vast quantities of market information in the air-
line industry. They also play the most critical role in the dis-
tribution of the airline's product. In the mid to late 1970s,
CRS systems were brought directly into the office of the travel
agents. Agents seldom have more than one CRS system in their
offices, as one system provides information on flights of all
carriers. The airline owning a specific CRS system in an agent's
office has great potential for inducing that agent to favour its
own flights, at the expense of its competitors.

Up to 80% of all airline tickets are booked by travel

agents. Roughly 90% of all Canadian travel agents have a CRS
system in their office. Of those agents which are automated,
over 80% use Air Canada's RESERVEC system. Further, almost all
of the largest travel agencies are Air Canada users. Clearly,
Air Canada is in a position to potentially control a very sub-
stantial portion of total ticket sales in Canada.

There are several methods by which a CRS vendor (i.e an air-

line) can use the system to influence which airline the agent
will book a passenger on. Foremost is the introduction of bias
in the display of information on the CRS screen to favour
the
vendor. American Airlines has found that 53.5 % of all of its
SABRE system sales come from the first line of the first screen
displayed, and that over 90% of all sales come from somewhere on
the first screen.2 Further, U.S. airlines have testified that
the introduction of bias in their systems increase their sales
by
up to 20%. 3

In addition to the bias, there are more subtle ways in which

an air carrier can use its CRS system to influence
a travel
agent's choice. For example, the CRS system can be used to
monitor the bookings of specific travel agencies. This valuable
information can be utilized to design incentives for that speci-
fic agency so that they will favour the vendor. Without any
doubt, unless restricted by the government, a CRS vendor has
substantial opportunity to influence and control travel agents,
and thereby control the distribution of airline products.
The
airline with a widely-adopted CRS can raise fees for listing its
competitor's flights, and thus raise its cost.

CRS systems create entry barriers at two levels. The first

level is as an entry barrier into the CRS vendor market. Agents
rarely use more than one CRS vendor. The vendor generally re-
quires fairly long term contracts with the agent. This makes it
difficult for the agent to change vendors. In addition, the sunk
costs of training staff to use (and master) a specific vendor's
system create another barrier to entry. Here in Canada,
CP Air
has been attempting to make major inroads
into the CRS vendor

5 Gillen et al.
988

few agents it
market. It has been largely unsuccessful, and the
has been able to sign up are generally smaller.

market,
In addition to entry barriers into the CRS vendor
into
being a vendor of a CRS service creates a barrier to entry
a marked
the airline market. Carriers vending CRS systems have
ceteris
advantage in selling airline services. This means that,
have a
paribus, an airline with a widely-adopted CRS system can
lower cost structure or charge higher prices than its competi-
tors.

B. Frequent Flyer Programs

These programs make business travellers repeat buyers of an

airline's services by introducing a new incentive of maximizing
personal benefit by patronizing a single carrier. The airlines
have found these programs to be effective in building brand
loyalty.

Frequent flyer programs have several costs associated with

them. The first is the cost of starting up the program. This
l
will include market research, advertising expenses, promotiona
cost of
materials and administrative expenses. The second is the
are
operating the program. Significant amounts of computer time
number of staff are required to process the
required and a large
millions of frequent flyer coupons. The third is the cost of
actually providing the air travel award. If a recipient of a
frequent flyer award used a seat that would otherwise have been
the
empty, then this cost is very low. On the other hand, if
to
frequent flyer preempts someone who would have been willing
pay for the seat, then the opportunity cost of the frequent flyer
program can be quite high.

flyer
There are also economies of network size in frequent
programs. Customers of a carrier with a wide geographic coverage
a
will find it easier to accumulate points if they patronize such
only
carrier. Perhaps this carrier needs to give a bonus award
on
after every thirty trips. Customers of a smaller air carrier,
will find it difficult to accumulate points for
the other hand,
it
several reasons: the carrier flies to fewer destinations, and
will
might be flying shorter stage lengths and thus the consumer
be accruing fewer mileage bonus points. The small carrier may
find it necessary to award a bonus more frequently, perhaps after
every 15th flight, in order to retain the travellers, hence in-
creasing his costs relative to the large network carrier.

Frequent flyer programs can be viewed as a method for rais-

ing the costs of rivals, especially smaller rivals. These pro-
grams have been extremely effective in both the U.S. and Canada.
In the U.S., almost every carrier, including small third level
carriers, have a frequent flyer program. In Canada where pro-
grams are just over a year old most airlines are already a member
of a program or intending to join one shortly. Further, it is

6 Gillen et al.
often the case that small carriers may be required to pay a fee
in order to join the frequent flyer program of a large airline.

Membership in the frequent flyer program of a large air

carrier has probably become a prerequisite for entry of a new
carrier. This can become a significant entry barrier if small
new carriers are barred from membership in larger carriers' pro-
grams.

C. Use of Shared Designator Codes

Another recent development which differentiates a product

and may constitute an entry barrier is the use of shared designa-
tor codes. The use of a major airline's flight designator code
by a smaller airline has become quite common as carriers imple-
ment traffic sharing agreements. The sharing of a major air-
line's designator code with a smaller air carrier has several
advantages for both. The major airline will now be seen by con-
sumers as providing service to a larger set of cities. In addi-
tion, the major airline is able to obtain a larger share of the
smaller airline's feed traffic. The smaller airline achieves an
increase in traffic due to the perception by consumers that its
flights are actually with the larger air carrier. Usually,
agreements to share designator codes also involve coordination of
schedules and certain guarantees on minimum service levels.

The use of shared designator codes has made its way into
the Canadian airline industry. Air B.C., for instance, uses the
designation of CP Air for its Victoria-Vancouver service as part
of the Air B.C.-CP Air operating agreement. No CTC involvement
was required for this agreement. In fact, the CTC appears to
look with favour on the use of share designator codes. The
anticipation is that the use of shared designator code will prove
mutually advantageous and will increase the probability of the
survival of many of the smaller regionals and commuters.

There are many ways in which the shared designator codes may
be considered as an attempt to raise one's rivals' (actual or
potential) costs. Consider the following hypothetical example.
There are two commuter air carriers in a market: Shared Airline
and Loaner. Airline. Shared Airline enters into an agreement with
a big airline. Because of this, Shared Airline enjoys a sub-
stantial increase in traffic. This of course causes a reduction
in demand for Loaner Airline. To counter this, Loaner Airline
may find it necessary to enter into an agreement with another big
airline. Because all the Big Airlines already have aggreements
With commuters, it may be necessary for Loaner Airline to pay a
fee for this privilege, or it may have to raise its costs in
Other ways, such as by increasing its service quality, frequency
or reliability in order to meet the requirements of
the other big
air carrier. Should the loss of traffic by Loaner Airlines be
sufficiently large, it may be necessary for it to change its
equipment or other operating procedures. This can be costly. At

7 Gillen et al
490

the very least it will reduce its exploitation of density econo-

mies resulting in higher unit costs.

D. Airport Access

The U.S. deregulation experience teaches us that constraints

on airport access, such as departure and landing slots, gates,
terminal space (lounges for business class passengers, counter
space) etc. could be a significant barrier to entry for new
carriers. There are numerous cases in the U.S. where potential
entrants were discouraged at major airports and were forced to
adjust to less attractive departure times or to operate out of
less attractive airports, or simply never became operational.

The major Canadian airports such as Toronto, Vancouver,

Dorval and Calgary, experience peaking problems during the rush
.hours (7 am to 9 am; 4 pm to 7 pm). This type of airport con-
gestion is likely to get much more serious in the future since
deregulation is likely to increase airport activities signifi-
cantly. This is because; i) deregulated airlines tend to fly
more frequent services using smaller aircraft in an attempt to
attract full fare business passengers, ii) lower fares and a
wider variety of fares are likely to increase air traffic, iii)
the movement toward hub and spoke networks will increase require-
ments for takeoff and landing slots at key airports, and iv)
infrequent jet service in short haul routes tends to be replaced
by high frequency turboprop service. Currently, the representa-
tives of all of the existing airlines form Schedule Coordinating
Committees at major airports in Canada, with one of the two major
carriers (Air Canada and CP Air) taking strong leadership in
allocating the landing/departure slots.

There is a real possibility that potential entrants might

not obtain a fair deal from such committees in getting the
landing/departure slots and timing of flights they desire. This
is particularly so because many of the existing airlines are
already moving to set up their hubs at major airports. By making
available less desirable departure/landing slots, existing
carriers can effectively shift down the potential entrant's
demand curve, and thus make entry less attractive.

The current system of scheduling committee membership, par-

ticularly with the leading role being played by a major carrier,
seems to invite potential abuse in a deregulated market place.
Such behaviour would be especially unfair when one considers that
the federal government subsidizes 56% ($678 million) of the total
operating costs of the airport systems not including the cost of
capital invested, ($1.2 billion in 1984).

There are other access problems that create some entry bar-
riers in the airline industry. In recent years, an increasing
number of airplanes have to wait after landing before they are
assigned to a gate. This raises questions about the adequacy of

8 Gillen et al.
 491

the current procedure for gate assignment in a deregulated en-

vironment. For example, at Vancouver International, Air Canada
assigns those gates on the south side of the terminal, and CP Air
assigns those on the north. There is potential for abuse in this
procedure against smaller and new carriers. At most airports,
Air Canada has historically received the most favourable gates,
or has been successful in preventing a potential entrant from
getting access to "its" unused gate space.

Frequently, the dominant carriers perform ground services

such as aircraft maintenance, baggage handling, ticketing, ser-
vicing, fueling, etc. for smaller carriers. In the case of
Toronto's Terminal 2, this has been formalized in a contract.
Thus there is a potential for the dominant carrier to raise its
smaller rivals' costs simply by charging higher fees for ser-
vices.

E. Advertising as An Entry Barrier

Typically advertising activities have "carry-over" effects

into the future. Therefore, once the money is spent on advertis-
ing it becomes a sunk cost to the firm. In other words, the firm
would not be able to recover the carry-over and cumulative ef-
fects of advertising when and if it wishes to exit the market.
These sunk costs become a barrier to potential entrants.

Since U.S. airline deregulation, there have been several

changes in airline advertising activities. First, the airline
industry has increased its advertising and promotional expendi-
ture from about 1.1 cents per revenue ton-mile in 1978, to about
2.3 cents per revenue ton-mile in 1984.4 Second, advertisements
are focused more on discount fares (to attract discretionary
travellers), and schedule frequency and frequent flyer programs
(to attract business travellers) than the general image building
of the past. Third, carriers rely increasingly heavily on local
newspapers, radio and T.V., and less on national magazines. This
is because the former allow last minute changes as market con-
ditions change, and they can be targeted to specific geographic
markets.

Similar changes have occurred in Canada since the regulatory

liberalization process began in late 1970s. These are partly the
result of the strategic movement on the part of the airlines to
develop defensible niches. While the government should not
intervene in sound management decision on advertising strategies,
there are some disturbing trends in advertising of discount
fares. Some advertising copies do not show restrictions imposed
for qualifying discount fares, and virtually all advertisements
do not reveal seat availability on various discount fares.
It is
clear that airlines use "bait and switch" tactics, hoping to get
customers to call in because of the low fares, and then persuade
them to fly on higher fares when the small number of discount
seats are sold out. Such advertising misleads consumers by not

9 Gillen et al.
492

providing enough information necessary for making sound judge-

ment. This issue needs to be dealt with for successful imple-
mentation of deregulation.

IV Conclusions

There is no question that Canadian airline markets are not

perfectly contestable. We have identified a number of transi-
tional and permanent entry barriers.

The next question is whether or not Canadian airline markets

are reasonably contestable to discourage anti-competitive behavi-
our and other undesirable aspects of market competition. Again,
the answer is no. There are two major concerns. First is the
potential for abuse of unregulated computer reservations systems.
At present, although there are some problems, the existing CRS
system of Air Canada is not posing a major threat to competition
in Canadian airline markets. Nevertheless, the potential for
such abuse raises some concern. Second, is the potential for
government owned air carriers to engage in behaviour that drives
out existing competitors or frustrates potential competitors from
entering, even if such behaviour is unintentional.

im-
Having stated that there are at least two significant
pediments to competitive behaviour in Canadian airline markets,
one might ask whether or not Canadian air transport should be
solu-
reregulated. The answer is no. Reregulation is a drastic
more
tion which is likely to cause (at least in the long run)
problems than it prevents. A more intelligent solution is to
the
prevent abuse by government owned air carriers and to give
competition enforcement authorities sufficient power to prevent
The
anti-competitive abuse of computer reservation systems.
to
competition enforcement agency should also have the ability
entry barriers and to issue whatever rulings may be
monitor other
necessary to prevent them from being used for predation.

can be
The potential for abuse by government-owned carriers
. Baring
handled in many ways. Ideally, they would be privatized
legislation
this, the appropriate government body would pass
a com-
explicitly stating that the air carrier is to behave in
manner. If non-econ omic objectives are to be assigned
petitive
This can
to the carrier, they must be subsidized explicitly.
the poli-
often be difficult to do because of the very nature of
tical process. Privatization, without a doubt, is the best
strategy.

Footnotes

Associate Professor, School of Business and Economics,

*
Wilfrid Laurier University.

10 Gillen et al.
 493

** Associate and Assistant Professor, respectively, Faculty of

Commerce and Business Administration, University of British
Columbia.

1. See for example Schmalensee (1978).

2. U.S. Department of Justice (1983), "Comments in Proposed

Rules of the Department Justice", p. 81. Note that these
figures apply to a very biased system. In an unbiased system
we might expect these numbers to be even higher.

3. Ibid.

4. Source is Air Transport Association of America.

Bibliography

Bailey, E. and J. Panzar (1984), "The Contestability of Airline

Markets During the transition to Deregulation" Journal of
Law and Contemporary Problems. Volume 44. No. 1. Winter
pages 1 to 5/4 to 5.

Caves, R.E. and M.E. Porter (1977), "From Entry Barriers to

Mobility Barriers: Conjectural Decisions and Contrived
Deterents to New Competition," Quarterly Journal of Eco-
nomics. Volume 41, No. 2, May, pages 241-265.

Kahn, A.E. (1984), "The Macroeconomics of Microeconomic Poli-

cies," an address presented to the Society of Government
Economists and the American Economics Association, Dallas,
Dec. 28, 1984.

Levine, M.E. (1984), "Deregulation in Practice: Three Views from

one Participant," and address presented to "Issues over
Entry Control in Canadian Domestic Airline Policy" sponsored
by the Center for Transportation Studies, University of
British Columbia, Vancouver, March 16, 1984.

Scherer, F.M. (1980), Industrial Market Structure and Economic

Performance, 2nd edition, Chicago: Rand McNally.

Schmalensee, Richard (1978), "Entry Deterrents and the Ready to

Eat Breakfast Cereal Industry", Bell Journal of Economics, 9
(Autumn), pages 305-327.

U.S. Department of Justice (1983), "Comments and Proposed Rules

of the Department of Justice," reponse to the CAB Advance
Notice of Proposed Rulemaking - Airline Computer Reserva-
tions Systems, Docket 41686, EDR 466 (November 17).

11 Gillen et al.