Teaching Horizontal Mergers to Undergraduates: The Case of American Airlines and US Airways

Introduction In this lecture we analyze the welfare impacts of the American Airlines and US Airways merger – Merger description – Williamson model ‘Naive’ model of horizontal mergers – DOJ and FTC Horizontal Merger Guidelines Government decision making process on mergers – Policy implications

Merger Description On December 9, 2013 world's largest airline was created $11 billion dollar merger of AMR Corporation and US Airways Group, parent companies of two out of four remaining legacy airline companies in the United States, American Airlines and US Airways Recent mergers in airline industry – United Airlines and Continental Airlines in 2010 – Northwest Airlines and Delta Airlines in 2008

Merger Description Largest carrier in the world – More than 6,700 daily flights to 336 locations in 56 countries worldwide – About $40 billion in operating revenue – More than 100,000 employees Affected airports – Dallas, TX – Charlotte, NC – Chicago, IL – Philadelphia, PA – Phoenix, AZ

Merger Description Potential welfare impacts – Positive Efficiency gains – Cost savings from integration of facilities, labor, information systems and acquiring similar productive capacities – Network benefits – Negative Welfare losses – Merged airline increases market power on many routes – Leads to price increases, service decreases and welfare losses

Williamson Model Modeling trade-offs from a merger of two competing firms Simplified model of governmental decision making on merger approval Focuses on cost reductions due to company synergies and welfare losses due to market power Does not consider more complicated circumstances like entry, political economy, etc.

Williamson model Pre-merger - Competitive airline industry - American Airlines and US Airways initially operate as competitors, charging a price equal to marginal cost. - MC 1 =AC 1 - Market equilibrium is found at point A, with a price of P 1 per ticket and a quantity of q 1 tickets - The consumer surplus is the triangle P 3 AP 1 - Producer surplus is non- existent due to the constant structure of costs.

Williamson model Post-merger - Monopolistic airline industry - The New American Airlines reduces costs by exploiting newly found economies of scale, shown by MC 2 =AC 2. - The New AA maximizes profit by equating marginal revenue with marginal cost, - New market equilibrium at point B, associated with a price of P 2 per ticket and a quantity of q 2 tickets.

Williamson model Post-merger - At point B: -The consumer surplus is the triangle P 3 BP 2 - Producer surplus is non- existent due to the constant structure of costs

Williamson model Post-merger - At point B: - Deadweight loss is triangle BAC -Due to ticket price increases and service reductions - Efficiency gains are area P 1 CDP 0 - Due to reductions in duplicative operation costs by integrating facilities, labor, and information systems and acquiring similar productive capacities.

Williamson model Welfare impacts - The merger is welfare enhancing is the deadweight loss (BAC) is smaller than the efficiency gains (P 1 CDP 0 ) - The merger is welfare decreasing is the deadweight loss (BAC) is greater than the efficiency gains (P 1 CDP 0 )

DOJ and FTC Horizontal Merger Guidelines (HMG) “The Agencies (DOJ and FTC) seek to identify and challenge competitively harmful mergers while avoiding unnecessary interference with mergers that are either competitively beneficial or neutral” (DOJ and FTC 2010) The process pursued in evaluating the proposed merger of American Airlines and US Airways Address each section of the HMG relevant to the merger

HMG - Evidence of Adverse Competitive Effects Types of evidence – Actual effects observed in consummated mergers – Direct comparisons based on experience – Market shares and concentration in a relevant market – Substantial head-to-head competition – Disruptive role of a merging party Sources of evidence

HMG - Evidence of Adverse Competitive Effects Sources of evidence – Merging parties – Customers – Other industry participants and observers

HMG - Targeted Customers and Price Discrimination Impact of a merger on various groups of customers Price discrimination – Leisure travelers – Business travelers

HMG – Market definition All city pairs served by both of the carriers, including nonstop and connecting services – Hubs like Dallas, TX; Charlotte, NC; Chicago, IL; Philadelphia, PA; Phoenix, AZ No close substitutes for travel beyond 300 miles for both leisure and business travelers

HMG - Market Participants, Market Shares, and Market Concentration Market participants – All the competing airlines in the relevant market, including airlines that fly between the same city pairs the newly merged airline Market concentration – Measured using the HHI – Forecasted increase in HHI beyond 2,500 in more than 1,000 city pairs in which the airlines competed head- to-head prior to the merger, – Average increase in HHI of over 200 points.

HMG - Market Participants, Market Shares, and Market Concentration Market shares

HMG - Coordinated Effects Impact of the merger on coordinated interaction More concentrated airline industry will lead to lower coordination costs, especially among the legacy airlines – Less likely to engage in price competition – More likely to pursue both explicit and tacit collusion – Signaling through transparent price publishing – Cross-market initiatives

HMG - Entry More ‘slots’ in ownership of legacy airlines Special agreements with airport authorities regarding the use of gates, terminals and other airport facilities.

HMG - Efficiencies Agencies are most likely to consider either verified merger specific efficiencies or efficiency claims substantiated by similar past experience US Airways-American Airlines merger predicted efficiencies of about $1.05 billion in 2013

HMG - Efficiencies Cost efficiencies – Economies of scale – integration of facilities, labor, information systems and acquiring similar productive capacities Network efficiencies – Adding destinations to the network – Offering more round-trip options on existing routes – Converting interline service into a single line service – Optimizing the combined fleet of aircraft across a larger hub-and- spoke network – Scheduling improvements – Reducing service in marginally profitable and unprofitable markets – Eliminating inefficient patterns that do not fit within the hub-and- spoke network model

Policy Implications Another merger in an already concentrated industry Policy implications of the merger are still contested and it may take some time to observe its full welfare effects Previous airline mergers lead to higher fares, declines in services, and increases in the cost of ancillary services such as luggage and meals US Airways-American Airlines merger is unlikely to bring many benefits to customers and further increases the hold of the industry by the legacy airlines