Qantas v Virgin is a tale of tough competition, but not predatory pricing.

Qantas v Virgin is a tale of tough competition, but not predatory pricing. Photo: Jim Rice

There have been suggestions in the media that Qantas may be flying into some turbulence with the competition regulator over its target of a 65 per cent share of the domestic market. The allegation is that Qantas' fight-fire-with-fire response to Virgin's aggressive capacity expansion has resulted in Qantas rolling out "predatory" low fares.

The short response is that it's not predatory pricing, even though it appears to be. It's worth an explanation

Market share

The Qantas market share target means that if Virgin were to supply an additional 1 million seats to the market – as an example – then Qantas would need to supply an additional 1.86 million seats to preserve a 65 per cent market share. Let's round this up to 2 million additional seats for arguments sake.

The problem this creates for Qantas is that if market demand is not strong enough to fill those additional 3 million seats (2 million from Qantas and 1 million from Virgin) this leads to excess supply, which results in lower average airfares. As Qantas is tipping into the market 1 million more seats than Virgin, then Qantas will need to reduce its airfares by more than Virgin.

What this effectively means is that an aggressive increase in capacity by Virgin demands an aggressive price reduction by Qantas, and this takes on the appearance of predatory pricing.

Predatory pricing, or not

In my view it's not predatory pricing because Qantas is not purposely pricing below its own and Virgin's costs to harm Virgin. It's pricing is the manifestation of a risky and misguided strategy. It's risky because it leaves Qantas yields, and thus earnings, vulnerable to the excess capacity decisions of its competitors – a scenario that is currently being played out.

The vulnerability of Qantas yields, and the appearance of predatory pricing, has been exacerbated by the fact that corporate aviation demand is presently relatively weak and unresponsiveness to changes in airfares.

This means that airfares have to be reduced markedly to entice corporate travellers to fill the additional seats.

ACCC Concerns

It's clear that the Australian Competition and Consumer Commission has always had some concerns about Qantas' 65 per cent market share strategy. I suspect that it is for this reason that Qantas changed its wording so it had a "profit maximising 65% market share" strategy whereas it previously had a "65% line in the sand".

The wording seems to have changed between 2007 and 2009. In the Qantas investor briefing in 2007, on slide 13, it mentions that the “65 per cent line in the sand” is vital to the business. However, in the 2009 investor briefing, on slide 6, the group claims to be “building on a profit maximising 65 per cent market share”.

One of the interesting aspects of this predicament is that Qantas actually rarely meets its 65% objective.

For example, over the year ending June 30, 2013 the Qantas Group's domestic seat kilometres, including those of Qantas Domestic, QantasLink and Jetstar Domestic, amounted to 54,409 million.

According to the Bureau of Infrastructure, Transport and Regional Economics, the market level of domestic seat kilometres was 86,416 million, leaving the Qantas Group with a share of 63 per cent. In the year prior, its share was 63.7 per cent.

Proving profit maximising

While it is one thing to say that your strategy is profit maximising, it is an entirely different matter trying to demonstrate that it is.

If the ACCC investigates this issue properly, the complexity it will need to unravel to get to the bottom of the allegation is enormous.

To start with, when an airline says that a strategy maximises profit, it must actually believe that there is at least one profit tipping point – some point at which adding too much capacity will eventually lead to a reduction in profit.

This tipping point comes about because increasing capacity results in a lower average airfare. If the average airfare falls too far, than the additional revenue that is earned from adding capacity is exceed by the additional cost and fall in profit.

The parameter that links capacity to the average airfare is pivotal to justifying that the strategy is profit maximising, yet I doubt whether it is, or can be, estimated in-house by Qantas or the ACCC.

The additional complexity that Qantas and the ACCC have in unravelling this issue is that the Qantas Group operates in three partially overlapping segments that contribute to the realisation of the 65% share – the corporate market (Qantas mainline), the leisure market (Jetstar) and the regional market (QantasLink).

To determine whether 65 per cent is profit maximising, the ACCC must assess the extent to which capacity increases affect average airfares in each of these segments and also assess the cannibalisation that exists across segments.

For example, it must determine the extent to which an increase in Jetstar capacity affects Qantas average airfares and vice versa.

The ACCC must also assess the extent which its cost base varies with capacity. That, in turn, will depend on whether they are investigating profit maximisation over short, medium or long run horizons.

While Qantas is hungry and wounded, it's not predatory. And even if it was, there is a huge mountain to climb to prove it.

* Tony Webber was Qantas Group chief economist between 2007 and 2011. He is now managing director of Webber Quantitative Consulting and associate professor at the University of Sydney Business School.