1 

# Response to Supplementary Comments of Hubert Horan

Robert Willig 1

, Mark Israel 2

, Bryan Keating 3

, and Jonathan Orszag 4

In “Supplementary Comments” filed in th is docket on October 19, 2010, Hubert Horan claims that the findings in our October 13, 2010 report “appear highly dubious” and unlikely to “survive a serious, objective review.” 5 He bases this claim on a series of economic arguments that are filled with fact ual errors, fundamental flaws in economic logic, misstatements about the founda tions for our conclusions, apparent misunderstandings of the parties’ internal an alytic tools, and incorrect citations to published literature. As a resu lt, his comments are not credible at all and irrelevant to a reasoned analysis of the issues in this docket.

In the interest of time, we do not attempt to catalogue every flaw in Mr. Horan’s comments. Rather, we point to several egregious errors, which are sufficient to demonstrate that the comments should be disregarded in their entirety.

1. Mr. Horan claims that we are “proposi ng a totally new basis for connect market pricing gains that is totally inconsistent with ‘double marginalizati on’ based claims,” and that the “two approaches...are mutually exclusive; one cannot accept one approach without rejecting the other.” 6

This claim is nonsense. Not only are the two approaches entirely consistent with one another; they are two legs of the same f undamental economic logic. Indeed, far from repudiating the standard pr ice-reducing effects due to the elimination of double marginalization, we incorporate them as a co re part of our quantif ication of benefits. 7

1 Professor of Economics and Public Affairs, Princeton University and Senior Consultant, Compass Lexecon. 2 Senior Vice President, Compass Lexecon. 3 Vice President, Compass Lexecon. 4 Senior Managing Director and member of Executive Committee, Compass Lexecon. 5 Supplementary Comments of Hubert Horan, Joint Application of Delta Air Lines, Inc.; Virgin Blue Airlines PTY LTD; Virgin Blue International Airlines PTY LTD d/b/a V Australia; Pacific Blue Airlines (NZ) LTD; and Pacific Blue Airlines (Aust) PTY LTD

, Docket DOT-OST-2009- 0155 (hereinafter

“ Horan Supplementary Comments ”), p. 2. 6 Horan Supplementary Comments, p. 5

. 7 Robert Willig, Mark Israel, Bryan Keating, an d Jonathan Orszag, “Measuring Consumer Benefits from Antitrust Immunity for Delta Air Lines and Virgin Blue Carriers,” Appendix to Joint Applicants’ Response to Show Cause Order 2010-9-4, Joint Application of Delta Air Lines, Inc.; Virgin Blue Airlines PTY LTD; Virgin Blue International Airlines PTY LT D d/b/a V Australia; Pacific Blue Airlines (NZ) LTD;2 We then go on to note that the same economic logic that implies that , following the provision of antitrust immunity and the crea tion of a metal-neutral joint venture, the parties will have an incentive to cut prices on formerly interline itineraries also implies that the parties will have an incentive to make (potentially costly) capacity, scheduling, and other operational decisions to enhance quality and attr act more consumers. The underlying logic holds that through the joint venture both Delta and the Virgin Blue carriers will internalize all of the profits crea ted by attracting additional passengers to the combined network, so that the parties’ incent ives are strengthened both to lower prices and enhance quality in order to attract those passengers.

Far from asking the DOT to make an e ither/or decision betw een two conflicting methodologies, our approach simply says that both the price-reduction and qualityenhancement components of this standard economic model (on which, as Mr. Horan notes, the DOT has long relied) 8 should be considered as consumer benefits. Put differently, our approach says that, when evaluating the pricing effects of granting antitrust immunity, it is appropriate to consider quality-adjusted prices. There is no valid controversy about this approach.

2. Mr. Horan claims that in its work on th e Delta-Northwest merger, the Department of Justice (DOJ) “discovered that benefit claims based on QSI-models...were ‘wildly inconsistent’” with predictions based on the model “actually used in the carriers’ normal
course of business.” 9

This is a complete misstatement of the DOJ’s conclusion. The model that DOJ refers to as “actually used in the carrier s’ normal course of business” is, in fact, the carriers’ QSI model . Indeed, in analyzing the Delta-North west merger, DOJ used the QSI model exactly as we do here , by working from the forecasted increase in demand derived from the QSI model and then converting this incr ease in demand into an implied change in
consumer welfare based on demand elasti city estimates from the literature. 10 Hence, the approach that we implemented in Section II.A of our report is the same approach favored by DOJ in the Delta-Northwest merger, prec isely because it relies on predicted demand shifts from the model used by Delta in the regular course of business.

3. Mr. Horan asserts that our analysis “ assumed some current Qantas and United passengers shifted to Delta/Virgin because it assumed all passengers have a greater

and Pacific Blue Airlines (Aust) PTY LTD

, Docket DOT-OST-2009-0155 (hereinafter “ Compass Lexecon Study ”) , ¶¶ 6, 18-26

. 8 Horan Supplementary Comments , p. 1

. 9 Id, pp. 2-3

. 10 Ken Heyer, Carl Shapiro, and Jeffrey Wilder (2009), “The Year in Review: Economics at the Antitrust Division, 2008-2009,” Review of Industrial Organization, 6-8.3 preference for ‘ATI connections’ than th ey do for ‘codeshare non-ATI connections.’” 11 [Emphasis Added]. He implies that such demand shifts may not occur in the “real
world.” 12

In fact, in using Delta’s QSI model, all we assumed about consumer demand is that the empirically based demand predictions that come out of Delta’s QSI model are reliable, as reflected in the fact that Delta uses th e model to make regular-course-of-business scheduling, capacity, and other ope rational decisions. QSI models relate the “real world” observed demand for various itiner aries to the characteristics of the itineraries, including how many online or interline c onnections each itinerary cont ains. The model finds that “in the real world,” on net, more passengers fly on itineraries with fewer interline (and correspondingly more online) connections. 13 Hence, the combination of price changes and quality changes associated with movi ng from interline to online connections increases consumer demand for the itiner ary, thus generating increased consumer welfare, which our orig inal filing quantified.

For Mr. Horan validly to claim that the pr edicted demand shift would not occur in the “real world,” he would need to demonstrate th at the standard demand prediction tool that Delta relies on to make regular-course-of- business operational decisions somehow does not apply to the effect of th e joint venture. Mr. Horan pr ovides no such demonstration, and his claim is just baseless rhetoric.

4. Mr. Horan makes incorrect assertions about the details of Delta’s implementation of the QSI model to generate predicted passe nger increases from the joint venture:

• Mr. Horan incorrectly asserts that we have not demonstrated that “the results were not artificially distorted” by using befo re and after schedules that reflected changes other than just ATI. 14 To the contrary, to pr edict the effects of the transaction using its QSI model, Delta used exactly the same schedule for the preand post-transaction worlds. Post-trans action, Delta just tr eated connections between Delta and Virgin Blue carriers ( on itineraries for which either Delta or Virgin Australia operated the trans-Paci fic segment) as if they were online connections to reflect the effect of the metal-neutral joint venture. 15 Similarly, in

11 Supplemental Horan Comments , p. 3. 12 Supplemental Horan Comments, p. 3

. 13 It is true that, as Mr. Horan observes, Delta’s QSI model does not separately control for price. This means that the model does not hold price consta nt when studying how itiner ary characteristics affect demand, but rather measures the overall observed eff ect of these characteristics on demand, where that effect can come through a combination of asso ciated price differences and quality differences. 14 Supplemental Horan Comments, p.3

. 15 Compass Lexecon Study, ¶ 11. Under the JV scenario, Delta’s network planners also placed DL code on all VA flights from SYD and BNE, and placed VA code on all DL flights from LAX.4 computing benefits based on our own ec onometric analysis (Section II.B of the Compass Lexecon Study )

, we used the same schedule pre- and post-transaction, just changing Delta/Virgin Blue itin eraries from “non-immune alliance” to “online.”

• Mr. Horan incorrectly asserts that th e measured consumer welfare gains “improperly conflate alleged gains from increased nonstop service and alleged gains from gains for connecting passengers on the existing capacity base.” 16 To the contrary, as noted above, our welf are calculations are based on the same schedule pre- and post-transaction, just changing what had been Delta/Virgin interline connections to connections with online characteristics to reflect the joint venture. Hence, measured consumer bene fits come entirely from the combination of lower prices and higher quality on connecting itineraries. Benefits flowing from the parties’ plans to increase cap acity, add new routes, etc. are above and beyond the computed benefits.

5. Mr. Horan fundamentally mischaracterizes how the econometric analyses presented in Section II.B of the Compass Lexecon Study use historical data to measure the effect of antitrust immunity on prices and quality fo r connecting itineraries. For example:

• Mr. Horan claims that our study “totally ignores huge correl ations” between our type-of-service categories (online, ATI, non-immune alliance, etc.) and other factors (“schedule competitiveness, freque nt flyer loyalty, local market presence, the level of price competition”). 17

It is not clear what Mr. Horan means by this claim. If he means that, for itineraries on a given route, at a given point in time, and marketed by a given carrier, the schedule and fre quent flyer benefits may be more attractive on ATI itineraries than on non-immune itin eraries, then we agree— such ATI advantages are precisely the types of quality benefits from ATI service that we seek to

measure . If, instead, he means that thes e characteristics vary by marketing carrier, route, and time-period in ways that may be correlated with the prevalence of ATI service, then we also agree, and this is precisely why we include “fixed effects” for the route, time period, and ma rketing carrier, which entirely control for any such differences. As such, our results are entirely driven by variation in prices and shares for a given marketing carri er's itineraries, on a given route, in a given time period, based on whether the sp ecific itinerary in question is online, ATI, non-immune alliance, or non-alliance.

16 Supplemental Horan Comments, p. 4

. 17 Id.5 • Mr. Horan incorrectly asserts that our “reg ressions are largely driven by structural differences between the North Atlantic...a nd the Pacific and Latin markets” and that we have no basis to claim that the coefficients represent “pricing differences between different connections that would be observed within markets with similar structural/competitive conditions.” 18 Once again, this assertion reflects only miscomprehension of our presented me thodology. As noted above, because of our fixed effects, our results are entirely driven by variation in price and shares across itineraries on a given route , not on a comparison across routes with different competitive conditions.

• Mr. Horan incorrectly asserts that we do not address the Show Cause Order's concerns that “measuring pricing shifts sole ly attributable to ATI is very difficult under conditions where other much more powerful factors (global recession, major recent competitive shifts) would tend to overwhelm any impacts that alliance pricing might have.” 19 Mr. Horan again completely miscomprehends the design of our study that includes a full set of year-quarter fixe d effects to control fully for any such changes (as well as fi xed effects to control for any variation across carriers or routes). Fortunately, the data are rich enough to allow us to measure the pricing effects of ATI by comparing prices across itineraries marketed by a given carrier, on a give n route, in a given time period.

6. Mr. Horan claims as flaws several aspect s of the study that actually make its benefit estimates quite conservative. For example:

• Mr. Horan incorrectly claims that if consumers have strong preference for ATI itineraries, “Qantas-American and others will surely apply to match these advantages, and the ‘consumer welfare’ gains Compass Lexecon is claiming will be wiped out.” 20 We certainly agree that, inasmuch as Delta/Virgin Blue ATI itineraries have lower prices and higher quality than current Delta/Virgin Blue interline itineraries, th e joint venture may elicit competitive responses, through which other carriers seek to lower prices or increase quality perhaps via their own applications for antitrust immunity (w hich could be reviewed by DOT on their own merits). But far from what Mr. Ho ran views as wiping out consumer welfare benefits, this would increase the bene fits substantially, as consumers would

18 Id, pp. 4-5

. 19 Id, p. 5. 20 Id, p. 4.6 benefit from improved quality and lower pr ices on multiple carriers, rather than on just Delta/Virgin itineraries. 21

• Mr. Horan correctly notes that our model only quantif ies the increase in demand that the joint venture generates by attr acting passengers who otherwise would
have flown on other carriers but inst ead choose to switch to Delta/Virgin. 22 Basic economic logic tells us that, in addition to the passengers who change carriers, there will be new passengers, who othe rwise would not have flown but are attracted by the lower prices and improved se rvice from the joint venture. This is another potentially large source of consumer benefits that our models conservatively omit.

21 Mr. Horan’s claim is analogous to arguing that, if competitors r eact to one another’s lower prices by lowering their own prices, this wipes out the co nsumer welfare gains from lower prices. This is obviously false. 22 Id, p. 4.CERTIFICATE OF SERVICE

A copy of the foregoing has been serv ed this 22nd day of October, 2010, upon the following persons via email:

robert.rivkin@dot.gov susan.kurland@dot.gov susan.mcdermott@dot.gov christa.fornarotto@dot.gov bob.goldner@dot.gov todd.homan@dot.gov peter.irvine@dot.gov christopher.mandel@dot.gov UrsKR@state.gov Jeremy.Parkinson@infrastructure.gov.au sascha.vanderbellen@delta.com jeff.morgan@delta.com anita.mosner@hklaw.com carl.nelson@aa.com howard_kass@usairways.com benjamin.slocum@usairways.com hkamen@coair.com dan.weiss@coair.com jeffrey.manley@united.com steve.morrissey@united.com jhill@dlalaw.com horanaviation@gmail.com info@airlineinfo.com