Canadian ruling on ''avoidable cost'' test diverges dramatically from U.S. approach
Canadian Competition Tribunal's analysis of ''avoidable costs'' in the Air Canada case diverges from the U.S. approach and may have repercussions far beyond the airline industry.
Katherine L. Kay and Danielle K. Royal
The Canadian Competition Tribunal (the Tribunal) recently released its Reasons and Findings in the Air Canada case regarding the appropriate way to measure whether a domestic airline has engaged in anti-competitive below-cost pricing. The decision was released shortly after that of the U.S. Court of Appeals (10th Circuit) in the American Airlines case, where the U.S. government alleged that American Airlines (AMR) engaged in predatory pricing on certain routes out of Dallas-Fort Worth. The Tribunal's approach to the appropriate price-cost test in the context of a predatory pricing analysis is markedly different from that approved by the U.S. Court of Appeal in American Airlines.
This is the first time that the so-called "avoidable cost" test has been considered by the Tribunal. The economic concept of "avoidable cost" as a means of testing for predatory conduct had not been used in Canadian competition law prior to its addition to the Competition Act (the Act) as part of airline-specific amendments in 2000. It replaced, in the context of the airline industry, the "average variable cost" test that had previously been used in predatory pricing jurisprudence. Since then, the Commissioner of Competition (the Commissioner) has indicated in both draft and final enforcement guidelines that the "avoidable cost" test will be used by the Competition Bureau in its approach to abuse of dominance generally, as well as in considering below-cost pricing under the pricing provisions found in section 50(1)(b) and 50(1)(c) of the Act. Thus, the approach adopted by the Tribunal in Air Canada has important repercussions for analysis conducted in other industries and under different provisions of the Act.
The Canadian Approach
In March 2001, the Commissioner filed a notice of application with the Tribunal alleging that from April 2000 to March 2001 Air Canada had abused its dominant position, contrary to section 79 of the Act. The application alleged that Air Canada had committed anti-competitive acts by "operating and increasing capacity at fares that do not cover the avoidable cost of providing the service," in contravention of paragraphs 1(a) and (b) of the Regulations Respecting Anti-Competitive Acts of Persons Operating a Domestic Service (the Airline Regulations), on certain specified routes in Eastern Canada on which WestJet and CanJet had commenced service.
At the request of both parties, the Tribunal divided the hearing into two phases. Phase one would elicit the Tribunal's answers to a number of questions intended to provide guidance on the proper interpretation and application of the avoidable cost test, which the Airline Regulations prescribe but do not define. Phase two, if necessary, would address the larger issue of whether Air Canada's actions violated the abuse of dominance provisions of the Act.
Among the questions for the Tribunal in phase one of the hearing were determinations about: (1) the appropriate unit or units of capacity to examine; (2) what categories of costs are avoidable and when they become avoidable; (3) the appropriate time period or periods to examine; and (4) what, if any, recognition should be given to "beyond contribution" in performing a revenue-cost test.
The Tribunal's Reasons and Findings regarding these questions are summarized below:
Unit of Capacity: The Tribunal found that the appropriate unit of capacity to examine in conducting the avoidable cost test is a uni-directional schedule flight (i.e., a regularly scheduled one-way flight). According to the Tribunal, "applying the avoidable cost test at the route level risks obscuring [anti-competitive] conduct where it may be occurring."
Avoidable Costs: Air Canada's internal cost accounting system allocates all of its costs, including overhead, to each flight. While the Tribunal noted that "the allocation of fixed costs to a flight or route will vary, possibly quite significantly, depending upon the particular [allocation] rule adopted," it nonetheless concluded that such allocated costs should be included in an avoidable cost test. The Tribunal found that, for the purpose of determining avoidable costs, all of Air Canada's non-overhead costs should be considered avoidable. As only 10% of Air Canada's costs are categorized as overhead, the Tribunal's decision means that about 90% of Air Canada's total costs (including all of its aircraft ownership costs) are considered to be avoidable for purposes of the test.
Time Periods: The Tribunal found that the avoidable cost test should be performed in monthly increments, but did not address the issue of "over what time period these costs become avoidable." The Tribunal appears to have concluded that an evaluation of such a time period was not required because it views an avoidable cost as such irrespective of time.
Beyond Contribution: The Tribunal recognized that beyond contribution could be a legitimate business reason for operating a scheduled flight below avoidable cost, but it refused to include it in the calculation of avoidable costs.
Having structured the avoidable cost test in this fashion, the Tribunal then examined the two sample routes considered in the first phase of the application and concluded that as Air Canada had operated and increased capacity on flights on those routes at fares that did not cover the avoidable cost, they had engaged in anti-competitive acts within the meaning of section 79 of the Act. Left for another phase of the case are the balance of factors to be considered in an abuse of dominance analysis under section 79, including market power, whether there had been a "practice" of anti-competitive acts, and whether the acts resulted in a substantial lessening or prevention of competition.
The U.S. Approach
In 2001, the U.S. government brought an action against AMR alleging monopolization and attempted monopolization through predatory pricing in violation of Section 2 of the Sherman Act. The action was dismissed in the first instance on AMR's motion for summary judgment, the Court concluding that the government had failed to demonstrate a genuine issue of material fact regarding the allegations that AMR had: (1) priced its product on the routes in question below cost; and (2) intended to recoup these losses by charging supra-competitive prices. The government appealed this decision.
In its appeal, the government focused on the appropriate measure of costs to be applied to determine whether AMR had engaged in inappropriate below-cost pricing. The Court of Appeal recognized that various cost measures may serve as proxies for marginal cost and in a predatory pricing analysis, but went on to find that four price-cost tests proposed by the government were "invalid as a matter of law, fatally flawed in their application, and fundamentally unreliable". The appeal was dismissed.
Among the price-cost tests rejected by the Court was a test similar to the test adopted by the Tribunal in Canada. This test included all of AMR's allocated costs characterized by its internal decisional-accounting system (AAIMSPAM) as variable over an 18-month period, plus aircraft costs. The costs were derived by allocating the variable costs incurred by AMR with respect to all of its operations at Dallas-Fort Worth airport to the flight level. The Court rejected the government's argument that cost allocation is a key component of managerial accounting and a relevant and sensible method by which to assign costs for decision-making purposes. Since the test included arbitrarily allocated variable costs, the Court found that it did not measure only the avoidable cost of AMR's capacity additions and therefore could not be relied upon. The Court stated that "because some of those variable costs do not vary proportionately with the level of flight activity, they are allocated arbitrarily to a flight or route by AAIMSPAN."
The Court also rejected the other price-cost tests proposed by the U.S. government, including one that considered the appropriate measure of costs to be 97%-99% of AMR's total costs. According to the Court, using these cost measures would be the equivalent of applying an average total cost test, and that, since these tests rely on arbitrary allocation of costs among different classes of service, they cannot purport to identify those costs which are caused by a product or service. As for beyond contribution, both parties in the American Airlines case agreed that beyond contribution should be included in the measure of revenue used in the revenue-cost test.
Ultimately, the Court of Appeal concluded the government did not succeed in establishing a genuine issue of material fact as to pricing below an appropriate measure of cost, and the appeal was dismissed.
Conclusions and Repercussions
The applicable price-cost tests used to identify predatory pricing in the airline industry are now significantly different in Canada and the United States. The result of the Tribunal's test, in our view, is over-inclusive and has the potential to label as anti-competitive behaviour that is perfectly legitimate. Moreover, the Tribunal's avoidable costs approach departs markedly from the jurisprudence (in Canada, the United States and elsewhere) and appears inconsistent with the rationale articulated in the jurisprudence and the economic literature for examining revenues (or, more typically, price) compared to costs in a predatory pricing analysis. To the extent that the Tribunal's approach might be applied by the Commissioner or, ultimately, by the Tribunal or a court under other provisions of the Act, the Air Canada decision requires further scrutiny and analysis.
