ECONOMIC ANALYSIS GROUP DISCUSSION PAPER

ECONOMIC ANALYSIS GROUP DISCUSSION PAPER Antitrust Immunity Grants to Joint Venture Agreements: Evidence from International Airline Alliances by William Gillespie and Oliver M. Richard* EAG 11-1 2012 version EAG Discussion Papers are the primary vehicle used to disseminate research from economists in the Economic Analysis Group (EAG) of the Antitrust Division. These papers are intended to inform interested individuals and institutions of EAG s research program and to stimulate comment and criticism on economic issues related to antitrust policy and regulation. The Antitrust Division encourages independent research by its economists. The views expressed herein are entirely those of the author and are not purported to reflect those of the United States Department of Justice. Information on the EAG research program and discussion paper series may be obtained from Russell Pittman, Director of Economic Research, Economic Analysis Group, Antitrust Division, U.S. Department of Justice, 450 5 th Street NW, Suite 9446, Washington, DC 20530, or by e-mail at russell.pittman@usdoj.gov. Comments on specific papers may be addressed directly to the authors at the same mailing address or at their e-mail address. Recent EAG Discussion Paper and EAG Competition Advocacy Paper titles are listed at the end of this paper. To obtain a complete list of titles or to request single copies of individual papers, please write to Kathy Burt at the above mailing address or at kathy.burt@usdoj.gov or call (202) 307-5794. Beginning with papers issued in 1999, copies of individual papers are also available from the Social Science Research Network at www.ssrn.com. In addition, recent papers are now available on the DoJ website at http://www.usdoj.gov/atr/public/eag/ discussion_papers.htm. *Oliver M. Richard is Assistant Chief, Economic Litigation Section, Antitrust Division, U.S. Department of Justice. He is the economics staff manager on civil antitrust matters in Transportation and Energy, and he has a PhD from the Kellogg Graduate School of Management, Northwestern University. William Gillespie is Research Economist, Economic Analysis Group, Antitrust Division, U.S. Department of Justice. He has a PhD in economics from Yale University. The views expressed herein are those of the authors and are not purported to represent the views of the U.S. Department of Justice. The Antitrust Division encourages independent research on the part of its economists. The authors are especially grateful to Jan Brueckner, Dennis Carlton, Donna Kooperstein, Marius Schwartz, Jill Ptacek, Jean-Francois Richard, Carl Shapiro, and William Stallings for helpful insights. Electronic copy available at: http://ssrn.com/abstract=1764083

Abstract This article provides evidence from the airline industry on the competitive effects of grants of antitrust immunity by regulatory agencies to certain joint venture agreements. In the airline industry, the U.S. Department of Transportation retains the statutory authority to approve and immunize from the U.S. antitrust laws, under a public interest standard, joint venture agreements relating to international air transportation. Agreements subject to this statute include international airline alliances, which are marketing joint ventures between carriers worldwide. The evidence shows that recent grants of antitrust immunity to international airline alliances affecting U.S.- E.U. passengers would have raised concerns under an antitrust standard. Electronic copy available at: http://ssrn.com/abstract=1764083

1. Introduction The U.S. Department of Transportation (DOT) has the statutory authority to approve and immunize from the U.S. antitrust laws, under a public interest standard, agreements relating to international air transportation (49 U.S.C. 41308-41309). Agreements subject to this statute include international airline alliances, which are marketing joint ventures (JVs) between carriers worldwide that allow an airline to market seats on its partners flights. Over the period 2008-2010, in proceedings affecting air passenger traffic between the U.S. and the E.U., DOT granted antitrust immunity to the principal participants in the 3 major international alliances (the Star, SkyTeam, and oneworld alliances). Antitrust immunized carriers across these 3 alliances carry over 82% of the 50 million passengers who fly annually between the U.S. and the E.U. 1 Though foreign policy goals were long a key factor in DOT s decisions, these recent DOT proceedings focused on claims of competitive harm and benefits as a result of antitrust immunity grants to international airline alliances. This article examines the merits of these claims under an antitrust standard. A grant of antitrust immunity to participants in a JV agreement enables these firms to collude on prices, service levels, and other competitively sensitive matters. Antitrust concerns in DOT proceedings have focused on the loss of competition in trans-atlantic routes where the JV partners offer competing non-stop flights, so called non-stop overlaps. Applicants have downplayed concerns arguing that a grant of antitrust immunity to two JV participants is not equivalent to the loss of a competitor, because both JV partners generally continue to serve the overlap routes. Applicants have also argued that antitrust immunity enables the JV partners to deliver significant benefits, principally in the form of lower fares to passengers traveling with connecting itineraries offered by the JV (itineraries that require intermediate stops). Applicants have supported these claims with evidence in the academic literature that shows, based mostly on 1990s data, that antitrust immunized alliances benefit passengers who travel with connecting itineraries and may not harm passengers in non-stop overlaps. This article provides newer evidence based on data for 2005-2011. The evidence shows that a grant of antitrust immunity to two competing non-stop carriers in a trans-atlantic route has a fare effect that is equivalent to the loss of an independent competitor, and fares are significantly higher in routes with fewer independent competitors. This finding supports the normal antitrust presumption that eliminating or substantially reducing competition through collaboration or merger enhances the market power of the remaining suppliers and leads to higher prices, harming consumers. An antitrust immunized JV also is not a merger, and the data indicate that immunized JV participants do not achieve the pricing efficiencies associated with unified control. The evidence further shows that, within the major alliances, antitrust immunized arrangements do not allow the JV partners to reduce fares for connecting trans-atlantic passengers below those sold under non-immunized arrangements. This evidence undermines Applicants claims that antitrust immunity is reasonably necessary for the accomplishment of pricing efficiencies in airline JVs. Accordingly, given the clear benefits of competition in terms 1 DOT Order 2010-2-8 at 14.

of lower prices for consumers, regulators should be wary of calls to further decrease competition in international aviation in pursuit of increasingly uncertain benefits. 2 The article is structured as follow. Section 2 provides background on airline alliances and the review process at DOT. Sections 3 and 4 provide newer evidence on the fare effects of antitrust immunized alliances. Sections 5 and 6 discuss certain exemptions that DOT has attached to immunity grants and public interest factors in recent DOT reviews. Section 7 concludes. Appendices include technical details on the data and empirical analyses. 2. International Aviation and Airline Alliances Open Skies agreements between the U.S. and E.U. countries have over the past seventeen years lifted regulatory restrictions on the number of carriers that may provide trans-atlantic air service as well as the number of flights and the fares that they offer. These agreements yet have not lifted cabotage, which is the right of a country s airline(s) to carry air traffic that originates and terminates within the boundaries of another country. Air France, for example, may not carry passengers that originate and end their trip within the U.S. Additionally, ownership rules in the U.S. and the E.U. continue to preclude mergers between U.S. and E.U. carriers. In this regulatory setting, to expand the reach of their network abroad, carriers worldwide have formed marketing joint ventures, known as alliances, relating to international air travel. Participants first decide on which international routes to include in their agreement. Each carrier may then market seats on flights operated by its partner(s) to form travel itineraries in the routes included in the agreement. These itineraries are listed in schedules once by each airline with its own flight number and two-letter code. This practice is known as code-sharing. It allows an airline to market to its customers flights to destinations served by its partner(s) without having to operate additional aircraft. For example, Delta Airlines and Air France are members of the SkyTeam alliance. Delta flies to Paris, France, but not to Toulouse, France. As a SkyTeam member, Delta may market to its customers a connecting flight from Atlanta to Toulouse that pairs a Delta flight from Atlanta to Paris with an Air France flight from Paris to Toulouse. Delta customers will book their ticket with Delta and see a Delta flight number and code on both flight segments of the itinerary, even though Air France operates the Paris-Toulouse flight. If the alliance partners are not competitors (as could be true on many routes like Atlanta- Toulouse), then no antitrust immunity is needed and the partners may jointly decide on fares and other competitively sensitive matters. If the alliance partners are competitors and the alliance agreement is arms-length, then the carrier operating the flight determines seat availability for the marketing partner, but each airline sets prices competitively. All sales revenues go to the operating carrier, and the marketing carrier gets a booking fee to cover handling costs. The partners may in certain instances adjust flight schedules and operations to provide seamless service on code-share flights. They may also agree to link their frequent-flyer programs to allow a customer to use frequent-flyer miles accumulated with one airline to redeem awards with a partner. If the alliance partners are competitors and the alliance agreement is granted antitrust 2 This article and its conclusions were referred to in Regulators have been too soft on the big transatlantic carriers, THE ECONOMIST, 11/12/2011. 2

immunity, then the partners may jointly decide on fares, schedules, and other competitively sensitive matters across the routes that they include in the alliance agreement. As of 2011, almost all large carriers worldwide have joined one of 3 major alliances: (i) SkyTeam, with 15 members including Delta/Northwest and Air France/KLM; (ii) Star, with 27 members including United/Continental, Lufthansa, and Air Canada; (iii) oneworld, with 12 members including American and British Airways. DOT reports that participants in these 3 alliances combined to carry over 87% of the 48,495,038 passengers who flew between the U.S. and the E.U. in the 12-month period ending June 2009. Airlines in Star combined for about a 36% share of the U.S.-E.U. passenger traffic; those in SkyTeam for about a 29% market share, and those in oneworld for a 22% share. 3 Though the U.S. Congress transferred jurisdiction over airline mergers from DOT to the U.S. Department of Justice (DOJ) in 1988, DOT retains the statutory authority to approve and immunize from the U.S. antitrust laws agreements relating to international air transportation. There is no corresponding authority for DOT or DOJ to grant immunity from the U.S. antitrust laws to domestic alliances between U.S. carriers. Participants in a domestic airline JV may under the Business Review process ask from the U.S. antitrust agencies for a statement of their current enforcement intentions with respect to the proposed business conduct in the JV. DOT has granted antitrust immunity over the past seventeen years to participants in over twenty international alliance agreements, including to the principal participants in the 3 major alliances. [No carrier belongs to more than one of the three major alliances. Carriers in these alliances may have other code-share agreements, typically regional in scope, with carriers not in their alliance.] Table 1 lists key dates for the 3 major alliances. Some carriers in SkyTeam and Star obtained antitrust immunity grants in the 1990s and early 2000s. Since mid-2008, most of the large carriers in each of the 3 alliances have been granted antitrust immunity. As a result, though over twenty carriers offer trans-atlantic flights, antitrust immunized carriers in the 3 major alliances combine to carry over 82% of the U.S.-E.U. traffic (based on DOT data for the year ending June 2009, factoring in immunity grants through 2010). DOT s review of international alliance agreements has two steps. DOT first determines whether an agreement substantially reduces or eliminates competition. 49 U.S.C. 41309(b). DOT applies the principles contained in the antitrust agencies Horizontal Merger Guidelines and uses the Clayton Act test, which requires us to consider whether the Alliance Agreements are likely to substantially reduce competition and facilitate the exercise of market power in relevant markets. 4 If DOT determines that an agreement is anti-competitive, then DOT must disapprove it unless DOT finds that the agreement is necessary to meet a serious transportation need or to achieve important public benefits and there is no less anti-competitive alternative. 49 U.S.C. 41309(b). If DOT approves an anti-competitive agreement on those grounds, then it must exempt it from the antitrust laws. 49 U.S.C. 41308(c). Second, if DOT finds that an agreement does not reduce or eliminate competition and is consistent with the public interest, then DOT must approve it. But exemption from the antitrust laws is authorized only if it is required by the 3 DOT Order 2010-2-8 at 14. 4 DOT Order 2009-4-5 at 11. 3

public interest; even then immunity is authorized only to the extent necessary to allow the person to proceed with the transaction specifically approved by the order and with any transaction necessarily contemplated by the order. 49 U.S.C. 41309(b) and 41308(b). DOT s review thus encompasses both a competitive analysis of the transaction and public interest considerations. DOT has long stated that U.S. foreign policy goals are a key element of these [public] benefits 5, and many grants of antitrust immunity to international alliances were used in large part to further foreign policy goals, such as Open Skies agreements. Grants of antitrust immunity presumably provided assurances to a country s policy-makers that decisions within an alliance would be made in the joint interest of all participating carriers, including the smaller country carriers in the alliance. Since the signing of the U.S-E.U. Open Skies agreement in April 2007, the recent DOT proceedings affecting U.S.-E.U. passenger traffic (proceedings for SkyTeam in 2008, Star in 2009, and oneworld in 2010) have focused instead on claims of competitive harm and benefits as a result of antitrust immunity grants to international airline alliances. The issues spanned claims of lost competition in non-stop overlaps and of network and pricing integration benefits by antitrust immunized alliance carriers. In this article, we examine the merits of these claims under an antitrust standard. 3. Competitive Effects: Analysis of Fare Effects for Non-stop Passengers Relevant markets in the airline industry, known as routes, consist of scheduled passenger air service between a point of origin and a point of destination (points can be airports or cities). In DOT proceedings, a trans-atlantic route has been defined as the provision of non-stop scheduled air passenger service in a non-directional city-pair with an endpoint in the U.S. and an endpoint in the E.U., Switzerland or Norway. [The robustness of competitive effects findings to the inclusion of connect air passenger service in the relevant market is examined in this Section.] Granting antitrust immunity to participants in an alliance agreement eliminates competition between these carriers in their non-stop overlaps, which are the routes where they principally compete. Numerous studies of the domestic U.S. airline industry since deregulation show that the number of competitors serving a route matters and that reducing the number of non-stop competitors leads to significant fare increases. For example, Peters computes actual fare increases of 7% to 29% following the loss of non-stop competition in domestic routes involved in mergers. 6 Likewise, Brueckner and Whalen find using 1997 data that, in international routes, each extra non-stop competitor lowers average fares by 5%, all else equal. 7 The evidence on the competitive effects of antitrust immunity grants is more limited. Blair, Mak, and Bonham as well as Kamita find that when two inter-islands Hawaiian carriers were granted temporary antitrust immunity in 2002-2003, fares rose by 10% to 20% in routes where the two carriers were the only providers of non-stop service. 8 Internationally, Brueckner 5 DOT Order 2010-9-4 at 4. 6 Craig Peters, Airline Merger Simulation, J. OF LAW AND ECONOMICS 49, 627-649 (2006). 7 Jan Brueckner & W. Tom Whalen, The price effects of international airline alliances, J. OF LAW AND ECONOMICS 43, 503-545 (2000). 8 Roger D. Blair, James Mak, & Carl Bonham, Collusive Duopoly: The Economic Effects of the Aloha and Hawaiian Airlines Agreement to Reduce Capacity, ANTITRUST L.J. 74, 409-438 (2007). Rene Kamita, Analyzing the Effects 4

and Whalen find that an antitrust immunity grant to two competing carriers in a route raises fares by 5%, which is an effect similar in magnitude to that of the loss of a non-stop competitor, but they fail to reject the claim that the immunity grant has no effect on fares. 9 This Section uses data for the period 2005-2011 to provide newer findings on the effects of antitrust immunity grants on fares sold to passengers traveling in trans-atlantic routes. The data are the publicly available DB1B data maintained by DOT. The data are compiled quarterly and represent a 10% random sample of tickets either ticketed by a U.S. carrier or where a U.S. carrier operated at least one flight in the ticket's itinerary. The focus is on economy-class tickets sold for non-stop travel in all trans-atlantic routes with non-stop service between the twenty largest cities in each of the U.S. and the E.U over the period 2005-2011, almost all of which are hubs for U.S. and E.U. carriers. [Cities were ranked by number of trans-atlantic departures.] The data include 117 trans-atlantic routes, and economy-class tickets represent 90% of all tickets sold in these routes. Table 2 lists summary route statistics. Appendix A provides further technical details on the data and model used in this Section. Different airlines serving a route non-stop are counted as independent competitors ( competitors ) unless they are immunized members of the same alliance ( ATI carriers ), in which case they represent a single competitor. Non-immunized members of the same alliance are assumed to be vigorous competitors. If not, then the price effects subsequently estimated from the loss of a non-stop competitor may underscore the magnitude of the true price effects. Most trans-atlantic routes have few competitors. In 2011 quarter four, 57% of the routes in the data have one competitor, 28% have two competitors, and 15% have three or more competitors. Recent grants of antitrust immunity have reduced the number of competitors in trans- Atlantic routes. The 2008 grant to the SkyTeam alliance reduced the number of competitors in each of Detroit-Paris, Atlanta-Amsterdam, and NYC-Amsterdam. The 2009 grant to Star reduced the number of competitors in NYC-Frankfurt and NYC-Zurich [It would have eliminated one competitor in six routes, but DOT attached exemptions to its grant; see Section 5.] The 2010 grant to oneworld reduced the number of competitors in Dallas-London, Boston-London, Miami- London, Miami-Madrid, NYC-Madrid, and NYC-London. In 2011 quarter four, there are a total of 17 trans-atlantic routes where two ATI carriers offer non-stop service and the number of competitors is reduced by one as a result of immunity grants. In 8 of these routes, the two ATI carriers are the only providers of non-stop service and the antitrust immunity grant has reduced the number of competitors from 2-to-1. Based on DB1B data, 36% of all passengers who flew non-stop on U.S. carriers in the trans-atlantic routes in the data flew in these 17 routes that are directly affected by immunity grants. of Temporary Antitrust Immunity: The Aloha-Hawaiian Immunity Agreement, J. OF LAW AND ECONOMICS 53, 239-261 (2010). In response to the terrorist attacks of 09/11/200, the U.S. Congress passed the Aviation and Transportation Security Act of 2001. The Act, which has since expired, included a provision that allowed DOT to grant antitrust immunity to carriers in States with extraordinary air transportation needs. This provision only applied to intra-state routes. [See Section 116, Aviation and Transportation Security Act of 2001, Pub. L. 107-171, 115 Stat. 624 (Nov. 19, 2001).] Under this Act, DOT temporarily granted immunity from the U.S. antitrust laws to Aloha Airlines and Hawaiian Airlines in inter-island routes in Hawaii in the period from 12/2002 to 10/2003. 9 Supra note 7. 5

Applicants argue in DOT filings that the fare effect of an antitrust immunity grant differs from that of the loss of a competitor because an immunity grant does not lead to the exit of a carrier, as evidenced by the many routes where two ATI carriers have maintained their respective non-stop service after grants of immunity. In particular, in all overlap routes affected by recent immunity grants, but for Detroit-Paris, each of the newly immunized carriers has offered after immunity the same number of non-stop flights it had pre-immunity. In Detroit-Paris, Northwest ended its non-stop service in January 2009, leaving immunized partner Air France as the sole non-stop carrier in the route, and the number of daily non-stop flights was cut from two-to-one. Applicants assert that immunized carriers have in fact a strong incentive to expand capacity on hub-to-hub routes [to better serve flow traffic], and the added capacity will naturally put downward pressure on fares sold to local passengers in these overlap routes. 10 The data do not readily support Applicants capacity expansion claim. Schedule data for instance show that immunized carriers have not expanded non-stop service relative to pre-immunity levels in trans- Atlantic hub-to-hub routes affected by the recent immunity grants. Table 3 also lists data on nonstop capacity offered by the immunized carriers in each alliance. Since 2005, the data generally do not show growth in non-stop service by immunized carriers in their trans-atlantic hub-to-hub routes relative to other trans-atlantic routes served by these carriers. Even if antitrust immunity were to induce the carriers to expand their hub-to-hub capacity by an additional amount beyond that achieved with a non-immunized alliance, it does not follow that this expanded capacity would lead to lower fares for local passengers in hub-to-hub routes. Applicants assert that the incentive to expand capacity is to better compete for flow traffic. They provide however no evidence to support the conclusion that expanded capacity would create excess capacity specifically for local traffic and that would, in turn, provide an incentive to offer lower non-stop fares. Applicants use highly sophisticated yield management systems that are designed to maximize the profits they can capture given the flights they are operating. With the lessening of competition in a route as a result of an immunity grant, Applicants have a strong incentive to operate their yield management systems in a manner that leads to higher fares for local traffic in that route. The fare effects of the number of competitors and presence of an additional ATI carrier in a route are tested empirically using a panel approach. Under this approach, fare effects from competition are estimated based on changes over time in the number of competitors in a route. The economic model specifies that average one-way fares for non-stop travel in a route vary based on the number of competitors, the presence of an additional ATI carrier, carrier-yearquarter effects, and route fixed effects. The presence of an additional ATI carrier is denoted by a variable that equals 1 in a route when there is such a carrier and 0 otherwise. The carrier-yearquarter effects identify the carriers that sold the non-stop tickets in a route in a given year-quarter and control for any factors, such as marketing, service, or costs, which are invariant to a carrier across routes at that time. The route fixed effects absorb all factors that are invariant over time in a route, such as distance, population, and potentially the number of competitors. The model is estimated using the ordinary least squares method, and robust standard errors are computed. 10 See Joint Applicants Supplemental Comments (DOT-OST-2008-0252) at 4 and 7. Emphasis is in original text. 6

Results are in Table 4 (base model). The model explains 91% of the variation in average one-way non-stop fares across routes (R 2 =0.91), meaning that the model fits the data very well. Results show that, all else equal, average fares in a route increase by $21 for each reduction by one in the number of competitors. This represents an average fare increase of 4.7% based on average fares in Table 2. Controlling for the number of competitors in a route, the fare effect of an additional ATI carrier is small and not statistically different from zero at a 99% confidence level. This supports the claim that an antitrust immunity grant to two competing carriers in a route has a fare effect that is equivalent to the loss of a competitor. In contrast to the research cited by Applicants, which uses 1990s data, the more recent data herein reject at a 99% confidence level the hypothesis that the fare effect of an additional ATI carrier equals that of an additional competitor. That is, the data reject the claim that an antitrust immunity grant to two competing carriers has no effect on fares. The 1990s were the alliances formation years, and results in the present paper are evidence that immunized partners may more fully coordinate and act as a single competitor in the trans-atlantic routes that they serve non-stop. Lastly, across the trans-atlantic routes in the data, the vast majority of economy-class passengers (76%) fly non-stop even though average non-stop fares are 8.3% higher than average connecting fares. Across these routes, there are, in addition to the carriers with non-stop flights, typically over four additional carriers that may offer connecting travel itineraries to passengers. A variable denoting the number of additional carriers with connecting service in a route can be added to the model specification. Results for this extended model are in Table 4; findings are no different from those reported above. Hence, even if connecting service is in the market, the loss of non-stop competition significantly increases concentration levels in trans-atlantic routes, and the data show large, statistically significant fare effects from differences in non-stop competition on the fares paid by the vast majority of passengers. In summary, data for the period 2005-2011 show that an antitrust immunity grant to two competing non-stop carriers in a route has a fare effect that is equivalent to the loss of a non-stop competitor and that fares are significantly higher in routes with fewer non-stop competitors. This evidence supports the normal antitrust presumption that eliminating or substantially reducing competition through a JV or merger enhances the market power of the remaining suppliers and leads to higher prices, harming consumers. 4. Efficiencies Applicants have claimed efficiencies that enhance their ability and incentive to compete and deliver benefits to customers. Under the antitrust agencies Horizontal Merger Guidelines, only efficiencies likely to be accomplished with the transaction and unlikely to be accomplished in its absence are credited. It is incumbent upon the Applicants to substantiate their claims, in part because much of the information relating to efficiencies is uniquely in their possession. In DOT proceedings, Applicants propose to adopt with antitrust immunity revenue sharing arrangements whereby participants pool ticket revenues across the trans-atlantic routes that they agree to include in the JV and, at periodic intervals, share these revenues using a 7

capacity-based formula. 11 They argue that these so-called metal neutral arrangements establish a common bottom line among the alliance participants because it makes them indifferent as to which airline sells a trans-atlantic ticket. This enables the participants to agree to code-share flights across their combined trans-atlantic networks and to offer lower fares for connecting code-share flights. This Section examines these claims. 4.1 Network Integration Applicants argue that revenue sharing arrangements in an antitrust immunized alliance eliminate revenue diversion risk between alliance participants and enable them to agree to open their entire combined transatlantic network (including behind and beyond points) to consumers, thereby making more inventory accessible and offering consumers a greater range and quality of service options ( ) than any of the participants could offer on its own. 12 To illustrate, in proposing in 2009 to form an antitrust immunized JV (which they refer to as JBA ), the oneworld Applicants stated that: While antitrust immunity is not a regulatory prerequisite for full behind/beyond and transatlantic codesharing, American, British Airways and Iberia currently lack the commercial incentive to do so absent the JBA. Without metal neutrality, the risk of diversion makes it more profitable to keep certain key transatlantic segments and behind/beyond points out of the other carrier s reach. For example, British Airways has non-stop service on the Seattle-London route, while American offers connecting service over Chicago. But if American were to place its code on the British Airways flight, a significant number of American s customers might opt for the non-stop British Airways flight. Since that would result in a revenue transfer from American to British Airways, it would be commercially undesirable to place the AA* code on the BA flight unless a balance of benefits could be found on another route (such as Chicago-Frankfurt). The JBA with its metal neutral joint venture completely eliminates this issue regardless of which airline the customer chooses. 13 Though there may be a revenue diversion risk in routes where the alliance partners offer competing flights, they do not need antitrust immunity to agree to include these routes in their alliance. The partners may expect that their code-share flights will deliver sufficient incremental value to customers across their combined routes that the partners will each earn higher revenues on aggregate, even if they incur diversion losses on any one route or passenger. For example, the domestic U.S. alliances between Delta, Northwest, and Continental over the period 2003-2008 and Continental and United over the period 2009-2010 successfully offered code-sharing across routes in their combined domestic networks without any antitrust immunity. An antitrust immunity grant allows the participants in the JV to collude in the routes that they agree to include in the agreement. If the JV partners include in their agreement routes where they offer competing flights, then they may collude, raise prices, and earn incremental profits on these routes simply as a result of the lessening of competition. With antitrust immunity, the JV partners thus have commercial incentives to expand the set of routes in their agreement to 11 DOT-OST-2008-0234-0001 at 14: A capacity-based formula that is subject to adjustment on an annual basis is used for the allocation of revenues. The specific formula is not described in public filings at DOT. 12 DOT-OST-2008-0234-0001 at 17. 13 DOT-OST-2008-0252-0001 at 22. 8

include routes where they compete, irrespective of whether the JV delivers any incremental value to consumers in these routes. It does not follow that customers in these additional routes benefit. In fact, the results in Section 3 show that consumers in non-stop overlaps would pay higher fares. Applicants have otherwise made few claims in DOT proceedings that a grant of antitrust immunity uniquely enables them to launch new non-stop trans-atlantic service. For example, Star alliance Applicants stated in 2008 that antitrust immunity would enable them to maintain and expand their non-stop services on international routes, but they provided no specifics. In their 2009 filings, oneworld Applicants stated that the immunized JV would help facilitate the launch of new service between Dallas/Fort Worth and Madrid, but American Airlines launched this service in quarter two 2009, more than one year before oneworld got an immunity grant. DOT has also made it clear that antitrust immunity is not required to launch new service. In SkyTeam proceedings in 2005, DOT stated that [T]he mere association of carriers under marketing arrangements such as the SkyTeam alliance creates additional demand that naturally flows over the hub-to-hub routes that serve as network-linking conduits... Continental, which does not have transatlantic immunity and was not even a member of SkyTeam until recently, added Houston-Amsterdam service in May 2002 as it expanded its (non-immunized) marketing cooperation with KLM. Over time, Continental has increased capacity and frequency in that market, despite its lack of transatlantic immunity. These examples illustrate that immunity is not required for the initiation of new transatlantic routes between the hubs of alliance partners. 14 4.2 Analysis of Fare Effects for Connecting Passengers 4.2.1 Double Marginalization Argument Applicants argue that coordination on pricing decisions in antitrust immunized alliances enables the carriers to eliminate the pricing inefficiencies that are inherent in non-immunized alliance arrangements, which tend to produce double marginalization, or a double mark-up of fares, and that by eliminating double marginalization immunized alliances generate substantial fare reductions for connecting trans-atlantic passengers. 15 Consider a connecting travel itinerary that pairs two flights operated by different airlines. Double marginalization occurs when the total fare for the itinerary is the sum of fares set by each airline for its flight and each airline maximizes the profits from its own flight independently of the other airline. Each airline prices its flight too high because it does not take into account that its higher price decreases the other firm s profits by reducing total demand. If the airlines may jointly set the total fare for the itinerary, then they may be able to internalize the pricing mark-up distortion and offer a lower total fare. This may increase their profits as well as consumer welfare. Airlines may jointly set fares if they have antitrust immunity or are not competitors, in which case they do not need antitrust immunity. For instance, international alliance partners rarely offer competing flights in so-called behind/beyond trans-atlantic routes, such as route A- D in Figure 1. 14 DOT Order 2005-12-12 at 36. 15 DOT-OST-2008-0234-0001 at 37-38. 9

That said, pricing arrangements adopted in alliances with no antitrust immunity may as is reduce any double marginalization problem. Rather than try to evaluate each ticket strictly based on revenue each carrier expects to earn, alliance carriers typically adopt a simple expedient: They agree that the carrier operating the flight gets the fare revenues (but for a handling fee paid to the marketing carrier) and, in itineraries that combine flights operated by different carriers, fare revenues are split using arms-length prorate formulas, typically based on distance flown on each carrier. They agree on how to map fare classes into each other s yield management systems. Using these mappings to make sure that the fare class being evaluated is comparable, and provided each carrier has seats available in that fare class, each carrier treats the other s aircraft as its own and independently sets its total fare for the code-share itineraries that pairs its flights with its partners. 16 Empirical evidence in the economics literature on domestic U.S. alliances, which have no antitrust immunity, shows that alliance code-share flights can be competitively priced absent antitrust immunity. For example, Bamberger, Carlton, and Neumann analyze the fare effects of two domestic U.S. alliances in the 1990s. 17 They find that both alliances benefited consumers as average fares fell by about 5% to 7% after the creation of the alliances in routes affected by these alliances. Likewise, Armantier and Richard show that fares were lower by 2% to 3%, on average, in U.S. routes affected by the formation of the domestic alliance between Continental Airlines and Northwest Airlines in 1999. 18 Divergences in incentives between antitrust immunized alliance partners may also affect their ability to optimally price connecting code-share flights. An immunized JV is not a merger. Participants in a JV remain distinct firms that only share the revenues attributable to the routes included in the JV. In the oneworld JV, for example, the common bottom line and joint revenue sharing cover only the trans-atlantic. 19 Suppose, for example, that American is considering how to allocate a seat on its Atlanta-Miami flight after it gets immunity in oneworld. If it sells the seat to an Atlanta-Miami-London passenger, then it must share revenues with its oneworld partners because the route is included in the oneworld agreement. If it sells the seat to an Atlanta-Miami or Atlanta-Miami-Bogota passenger, then it keeps all of the revenues because these routes are not in the oneworld JV. Hence, even if the Atlanta-Miami-London passenger is willing to pay a higher fare for the seat, all else equal, American may not have commercial incentives to price to sell the seat to that passenger, even if doing so maximizes consumer welfare. This may distort 16 Applicants in the oneworld alliance used such fare mapping methods. See Joint Applicants Consolidated Response to Order 2008-12-11 at 12 ( As members of oneworld, the JBA participants already have full fare class mapping. Thus, fare combinability will require only the addition of a rule in each carrier s tariffs... ). 17 Gustavo Bamberger, Dennis Carlton & Lynn Neumann, An empirical investigation of the competitive effects of domestic airline alliances, J. OF LAW AND ECONOMICS 7, 195-222 (2004). 18 Olivier Armantier & Oliver Richard, Evidence on Pricing from the Continental Airlines and Northwest Airlines Code-Share Agreement, ADVANCES IN AIRLINE ECONOMICS, VOL.1: COMPETITION POLICY AND ANTITRUST, edited by Darin Lee. London: Elsevier Press (2006). Olivier Armantier & Oliver Richard, Domestic Airlines Alliances and Consumer Welfare, RAND J. ECONOMICS 39, 875-904 (2008). They show as well that the Continental-Northwest domestic alliance did not impact U.S. consumers significantly on average; it increased the average surplus of connecting passengers but decreased the average surplus of non-stop passengers. 19 [Public] Joint Application for Antitrust Immunity, DOT-OST-2008-0252 August 14, 2008, at 22-23. 10

pricing for many connecting code-share flights in antitrust immunized JVs. In fact, the growing number of antitrust immunized carriers within each of the major alliances likely makes it harder to reconcile commercial interests and achieve the pricing efficiencies that are associated with unified control (there are 10 immunized carriers within the Star alliance alone, for example). 4.2.2 Empirical Claims To support their argument that antitrust immunity eliminates double marginalization in the pricing of trans-atlantic code-share flights, Applicants cite economics research that shows that consumers pay significantly lower fares for connecting flights offered through antitrust immunized alliance arrangements rather than through non-immunized alliance arrangements. They cite studies by Brueckner and Whalen that show using 1990s data that, controlling for route and travel itinerary characteristics, fares paid by passengers for connecting flights offered by carriers with immunized JV arrangements were 8% to 15% lower than for flights offered by carriers with non-immunized JV arrangements. 20 These authors argue that immunized carriers charge lower fares to connecting passengers because they internalize a double marginalization problem that arises from the uncoordinated choice of fares in the absence of immunity. Since the 1990s, however, as DOT has highlighted, the competitive structure of the global airline industry has changed in unprecedented ways through mergers, financial restructurings, and additional forms of cooperative agreements. 21 Findings for the 1990s, which were the formation years of alliances, may not apply today. Recent published work also cast doubt on the claim that antitrust immunity is needed to reduce a double marginalization problem in connecting fares. Bilotkach finds using 1999 data that economy-class fares for connecting tickets are no different across international alliances with and without antitrust immunity. 22 Likewise, though Brueckner, Lee, and Singer state that they find using 1998-2009 data that antitrust immunity by itself reduces connecting fares for trans-atlantic passengers, they actually find little, if any, fare effect from immunity for economy-class tickets, which represent 95% of all tickets sold to passengers in their data. 23 Following the economics research cited by Applicants in DOT filings, the analysis in this Section examines fares paid by passengers traveling with connecting itineraries in trans-atlantic routes with no non-stop flights. The data are the DOT s DB1B data over the period 2005-2011. The focus is economy-class tickets, which account for 95% of all tickets sold in these routes. The 20 See supra note 7. See as well Jan Brueckner, International airfares in the age of alliances: The effects of codesharing and antitrust immunity, REVIEW OF ECONOMICS AND STATISTICS 85, 105-118 (2003). W. Tom Whalen, A panel data analysis of code sharing, antitrust immunity and open skies treaties in international aviation markets, REVIEW OF INDUSTRIAL ORGANIZATION 30, 39-61 (2007). 21 DOT Order 2005-12-12 at 32. 22 Vladimir Bilotkach, Price effects of airline consolidation: evidence from a sample of transatlantic markets, EMPIRICAL ECONOMICS 33, 427-448 (2007). 23 Jan Brueckner, Darin Lee & Ethan Singer, Alliances, Codesharing, Antitrust Immunity and International Airfares: Do Previous Patterns Persist?, J. OF COMPETITION LAW AND ECONOMICS, 7(3), 573-602 (2011). The authors apply a methodology similar to that in the prior literature. Their general conclusion obtains from a model that combines data on economy and business class tickets without controlling for fare class differences between tickets. When they estimate their model only on data for trans-atlantic economy-class tickets, they find either no difference or only a 1% reduction in fare from immunity. 11

sample data include 2,246,963 tickets sold to individual passengers for travel on connecting itineraries across 25,014 trans-atlantic routes. Appendix B lists further details on the data and models used in this Section. There are four types of tickets in the data. A ticket is an online ticket if all flight segments in the ticket are operated and marketed by a single airline (including its regional affiliates). An ATI ticket is a ticket that is sold under antitrust immunized arrangements within one of the three major alliances. A non-ati ticket is a ticket that is sold under non-immunized arrangements within one of the three major alliances. All other tickets in the data list two or more carriers that are not members of the same alliance. This type of ticket, hereafter other agreements tickets, include tickets sold under arrangements between airlines not in alliances or in different alliances. Under these definitions, over the period 2005-2011, 55% of tickets in the data are online, 24% are ATI tickets, 12% are non-ati tickets, and the other 9% are sold using other agreements. As these data indicate, alliance-based travel has become the dominant way most non-online tickets for trans-atlantic travel are sold. This result differs dramatically from the 1990s. Whereas Whalen reports that 38% of U.S.-E.U. connecting passengers purchased tickets sold under other agreements in the 1990s, less than 9% did so over the period 2005-2011. 24 A cross-section approach, similar to that used in the research cited by Applicants, is first used to examine how fares vary across alliance pricing arrangements. It involves specifying a model that controls for all factors that affect all fares in a route equally at a given time (using route-year-quarter fixed effects ) and isolates the remaining difference in fares in that route at that time resulting from the type of ticket and other ticket characteristics. The statistical model specifies that ticket prices paid by individual passengers vary across tickets based on the type of ticket, the alliance that sold the ticket, the number of flight segments in the itinerary, the total mileage flown across flight segments in the itinerary, carrier effects, and route-year-quarter fixed effects. The carrier effects control for factors, such as service or costs, which are specific to the carriers that sold the trans-atlantic flights in the ticket. The route-yearquarter effects control for all factors, such as the competition level, that are invariant to a specific route at a specific time and not simply, as in the literature cited by Applicants, across all routes at a given time or over time in a specific route. The model thus controls for the same factors controlled for in the literature, but also for all additional factors specific to a route in a yearquarter. This permits to more accurately measure differences in fares across types of tickets. The model is estimated using the ordinary least squares method, and robust standard errors are computed. Results are listed in Table 5. The model explains 42% of the variation in fares across routes over time. Results show that, all else equal, online fares are on average 6% lower than ATI fares. This fare difference is statistically different from zero at a 99% confidence level. As online fares already incorporate any pricing efficiencies associated with unified control, this finding undermines Applicants claim that an antitrust immunity grant to an airline JV eliminates a double-marginalization problem in the pricing of connecting fares offered by the alliance. Importantly as well, non-ati fares are estimated to be 0.2% lower than ATI fares, all else equal, 24 Supra note 20. 12

and the data support at a 99% confidence level the hypothesis that non-immunized fares are no different from immunized fares. This finding shows that, within the major alliances, antitrust immunized arrangements do not allow the JV partners to reduce fares for connecting trans- Atlantic passengers below those sold under non-immunized arrangements. This evidence undermines the claim that antitrust immunity is necessary to the accomplishment of pricing efficiencies in the major airline alliances. This analysis may be supplemented with a panel approach that examines how fares sold in a connecting travel itinerary vary as a result of an antitrust immunity grant. If there is a double marginalization problem in the pricing of fares sold in a travel itinerary under non-immunized arrangements, and it is reduced by the immunity grant, then one may expect a reduction in fares in that travel itinerary after the grant. The focus is on connecting travel itineraries sold by the SkyTeam alliance. Prior to 2008, there were two groups of immunized carriers in SkyTeam: (1) Northwest and KLM, and (2) Delta, Air France, Al Italia, and Czech Airlines. These carriers sold fares under immunized arrangements within their group and under non-immunized arrangements with carriers in the other group. In 2008, the six carriers obtained a common grant of immunity. Multi-year data are available on itineraries priced by these carriers under (i) non-immunized arrangements pre-grant and immunized arrangements post-grant ( newly-immunized ), and (ii) immunized arrangements pre- and post-grant ( already-immunized ). DB1B quarterly data for 2006-2007 and 2009-2010 represent, respectively, the pre- and post-grant fare data. The data include 3,294 newlyimmunized itineraries with 22,415 individual tickets sold over both periods and 4,328 alreadyimmunized itineraries with 30,490 tickets. A difference-in-difference analysis is performed to compare fare changes in newly- and already-immunized itineraries after the grant. Ordinary least-squares is used to estimate a model that specifies how ticket fares paid by individual passengers in a given travel itinerary vary after the grant based upon whether that itinerary is newly- or already-immunized. The model includes year and itinerary fixed effects, which control for all factors that are, respectively, invariant to a given year and given itinerary over time. Results are listed in Table 6. If an antitrust immunity grant helps the JV partners reduce a double marginalization problem in pricing, then one may expect a reduction in fares in newly-immunized itineraries relative to already-immunized ones after the grant. The results however show that, all else equal, fare changes after the grant are not statistically different across newly- and already-immunized itineraries. In conclusion, Applicants argue in DOT proceedings that antitrust immunized alliance arrangements reduce a double marginalization problem in the pricing of alliance connecting fares relative to non-immunized arrangements. The data for the period 2005-2011 do not support that claim, significantly undermining claims of pricing efficiencies as a result of immunity grants to international airline JV agreements. 5. Exemptions to Antitrust Immunity Grants To preserve competition in trans-atlantic non-stop overlaps, DOT has at times carved them out (that is, excluded them) from immunity grants, meaning that the JV partners had to remain independent competitors for passengers flying non-stop in these routes. For example, 13