Living Economics

In early 1995 American Airlines (AA)'s regular fare between Dallas and Kansas City was $108 before low-cost start-up Vanguard Airlines Inc. entered the market. AA, by far the largest airline serving the Dallas/Fort Worth hub, responded by matching Vanguard's fares at $80 and almost doubled the number of daily flights to 14. When Vanguard finally gave up in December 1995, American restored its old fare and scaled back the number of flights. Similar fate met two other start-up carriers that offered low-fare service from Dallas to various mid-western cities.

In May 1999, the government filed an anti-trust lawsuit against AA alleging "predatory pricing" But the U.S. District Judge ruled against the Justice Department and in favor of AA.

According to the US law, a firm is guilty of predatory pricing if it sells products or services for less than its average variable cost (AVC) and makes up for the resulting losses by raising prices above competitive levels once its rivals are forced out of the market. AA, currently the largest airline in the world after its recent acquisition of Trans World Airlines, says that it had every right to match the fares offered by its contender. And with fares lower, it was justified in adding more planes to meet increased demand. It also says that it only raised fares to the previous level when the rivals left, not to a higher level to recoup losses.

But if at lower fares AA was able to carry more passengers without incurring a loss under competition, it must be making a handsome profit when it can restore the old fares by reducing flights under monopoly?

The reason why AA could out-compete its start-up rivals is because it could successfully defend its market share. Given the same low fares between AA and its rivals, passengers understandably stayed with AA because its large network of connecting flights between hundreds of cities offered convenience that start-ups serving only a niche market could not match. But the substantial costs of creating and operating this network can be covered only by ensuring a sufficient volume of passengers and by dividing these costs across the carrier's many routes. Lowering fares permanently may not generate enough revenues to cover these high network fixed costs.

If the niche markets were big enough to allow the start-ups to gain a large enough market share to be viable, AA might have been forced to permanently lower its fares just to be competitive.