Competing Against Bundled Discounts: Lessons from Regional Airlines

Thomas A. Lambert August 16, 2011

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Flying back from a hiking trip to spectacular Glacier National Park (see pics below the fold), I overheard a flight attendant say something that made me think of, what else?, bundled discounts. “We also fly for Delta,” the United flight attendant told the woman in front of me. That’s when I realized I was really flying on Skywest, a regional airline that provides service to the major airlines.

Skywest, it seems, flies between major airlines’ hub cities (Salt Lake City for Delta, Denver for United) and smaller destinations like Kalispell, Bozeman, Jackson Hole, etc. (Full route map here.) It does so, though, under the auspices of the major airlines, so one never buys a “Skywest” ticket, always a Delta or United ticket. (This is pretty common. Columbia, Missouri, where I teach, is serviced by Pinnacle Airlines, which flies back and forth between Columbia and Memphis for Delta.)

So what has this to do with bundled discounts? Well, first recall why such discounts (price-cuts conditioned on purchasing products from multiple product markets) create anticompetitive concerns. Courts, regulators, and scholars have worried that a multi-product seller may use bundled discounts to exclude equally or more efficient rivals that sell less extensive lines of products. In theory, a multi-product seller who has market power over at least one of its products (i.e., the ability to charge an above-cost price for that product) could offer a bundled discount that results in an above-cost (and thus non-predatory) price for the bundle, but would still tend to exclude an equally efficient, but less diversified, rival.

The classic example of this strategy involves a bundled discount offered by a producer of shampoo and conditioner. Suppose that manufacturer A sells both shampoo and conditioner, is a monopolist in the conditioner market, and competes in the shampoo market against manufacturer B, which sells only shampoo. B is the more efficient shampoo manufacturer, producing shampoo at a cost of $1.25 a bottle compared to A’s cost of $1.50 per bottle. A’s cost of producing a bottle of conditioner is $2.50. If purchased separately, A’s per-bottle prices for shampoo and conditioner are $2.00 and $4.00, respectively. But A offers customers a $1.00 bundled discount, charging only $5.00 for the shampoo/conditioner package. While this discounted price is still above A’s cost for the bundle ($4.00), it could tend to exclude B. Assuming that shampoo buyers must also buy conditioner (in equal proportions), buyers would have to pay A’s unbundled conditioner price of $4.00 if they purchased B’s shampoo and would thus be unwilling to pay more than $1.00 for the B brand of shampoo. That price, though, is below B’s $1.25 cost. Thus, A’s bundled discount would tend to exclude B from the market even though (1) the discounted price ($5.00) is above A’s aggregate cost for the bundle ($4.00), and (2) B is the more efficient shampoo producer.

Regional airlines like Skywest and Pinnacle find themselves in the same position as the shampoo-only manufacturer. A significant impediment to these smaller airlines is the major carriers’ ability to offer a type of bundled discount — a price for a “bundle” of flights going from departure point to hub to destination that is significantly lower than the sum of the prices of two flights, one from departure point to hub and the other from hub to destination. For example, a Delta flight from Columbia, Missouri to Memphis (a Delta hub) to New York City might cost $400, while purchasing separate flights from Columbia to Memphis and then from Memphis to NYC might cost a total of $500 ($200 for the Columbia to Memphis leg and $300 for the Memphis to NYC leg). This is, in effect, a bundled discount of $100. If Pinnacle wanted to compete for passengers flying from Columbia to NYC, it would have to absorb the entire amount of the package discount on the single leg it offered (Columbia to Memphis), charging no more than $100 for the flight. That price, though, may be below its cost.

Despite this impediment, regional airlines like Pinnacle and Skywest have not been driven out of business by the major carriers’ pricing strategies. Instead, they have remained in business and have often delivered higher profits than their major carrier rivals. How did they accomplish this feat? By becoming suppliers to the major air carriers, offering to provide short-haul air service more efficiently than the majors.

So what are the implications for legal restrictions on bundled discounts? A number of commentators have suggested that a bundled discount should be illegal if it would result in below-cost pricing on the competitive product after the entire amount of the discount is attributed to that product. They take this position because they assume that such a discount would exclude an equally efficient, single-product rival by forcing it to price below its own cost.

The continued existence of Pinnacle, Sky West, and the other regional airlines, though, undermines this assumption. Equally or more efficient single-product rivals confronted with the sort of bundled discount discussed above have a way to stay in business: they can become suppliers to the bundled discounter. If they are, in fact, more efficient than the discounter, it should jump on the opportunity to outsource production to them. Thus, I would argue, a plaintiff complaining of exclusion by a bundled discount that does not run afoul of standard predatory pricing rules should have to show, among other things, that it could not stay in business by becoming a supplier to its discounting rival. (It should also have to show that it could not replicate the bundle by collaborating with other product suppliers.)

For greater discussion of the appropriate liability rule for bundled discounts, see Part III of this article and Part IV of this article. For some Glacier photos, see below the fold.