No June The Antitrust Assault on Orbitz and on Consumers by yououghtaknowme


									No. 441                                            June 6, 2002

                                  Online Travel Services
              The Antitrust Assault on Orbitz—and on Consumers
                                                by James V. DeLong

                                          Executive Summary

         Orbitz, which sells airline tickets to travelers over      The antitrust attack on Orbitz is highly tech-
     the Internet, is owned by 5 major airlines and affili-      nical and is directed at provisions of the charter
     ated with 30 more. Its charter requires it to display       that require the participating airlines to provide
     flight and fare information in an unbiased manner,          Orbitz with all fares that they make publicly
     sorted only by price, number of stops, length of trip,      available, which is alleged to create excessive
     and other basic criteria.                                   power over ticket selling. Another cause of
         Despite the fact that Orbitz has plenty of              antitrust concern is that Orbitz might in some
     competition, other players in the industry have             fashion enable airlines to coordinate, and raise,
     trotted out antitrust arguments to try to keep it           their fares.
     from operating or cripple it with regulations.                 Neither charge is valid. The charter provisions
     The intensity of the assault should set off alarms,         that are drawing fire are necessary to the creation
     because it is simply the latest example of                  of an unbiased information source. The real
     antitrust being used to suppress competition                motivation of most opponents is their vested
     rather than to promote it.                                  interest in the status quo.
         Orbitz was created because the founding airlines           The seriousness with which the attack is
     have a strong interest in fostering sources of com-         being taken by the government, the press, and
     prehensive, unbiased information on schedules,              the public illustrates a general failing of con-
     fares, and seat availability. Improved information          temporary antitrust regulation. Antitrust enjoys
     will decrease airline operating costs and promote           an excellent image, primarily because of the
     their interest in filling as many seats as possible.        belief that it protects consumers. But in practice,
         Orbitz is also introducing new software for             the energy behind antitrust policy often comes
     booking reservations. This will introduce com-              from firms that are threatened by new arrange-
     petition and reduce fees in a part of the industry          ments. Pressure from such firms is skewing
     that now derives market power from government               antitrust policy into a series of efforts to sup-
     regulation. It will also restructure the industry to        press innovation for the benefit of industry
     reflect the new economic realities of the Internet.         incumbents and to the detriment of consumers.

     James V. DeLong is a senior fellow with the Competitive Enterprise Institute’s Project on Technology and
      Despite the                                                               antitrust energy often means that industry
plethora of com-                   Introduction                                 incumbents are worried because an innova-
                                                                                tor is about to eliminate inefficiencies from
     petition, the       Orbitz, which started operations on June 1,            which the incumbents make money.
  antitrust wasps    2001, sells airline tickets over the Internet. It is           On analysis, this is the case with Orbitz.
                     owned by 5 major carriers and supported to a               Ostensibly, the protesters fear some vague
      are buzzing    lesser degree by 30 more “charter associates.”             “anti-competitive” harm because Orbitz is sup-
fiercely and have    Its charter requires it to display information in          ported by the carriers. In fact, industry incum-
gotten the ear of    an unbiased manner, sorted only by price,                  bents fear the loss of existing opportunities to
                     number of stops, length of trip, or other basic            profit from inefficiency, bad information, and
 the government.     criteria. It is bound to avoid favoritism that is          pricing power based on government regulation.
                     based on the identity of the carrier, advertising          But the constantly reiterated purpose of the
                     on Orbitz, sponsorship, or any other factor                antitrust laws is to encourage, not prevent, this
                     not related to price or quality of service.1 The           type of harm.7Orbitz’s opponents are, in fact,
                     five owners have almost 80 percent of the                  trying to use the antitrust laws as a barrier to
                     domestic airline travel market, and the associ-            changes that will benefit consumers. The high
                     ates account for “a majority of the remaining              decibel level of the squawking indicates that
                     20 percent.”2                                              these potential benefits are large.
                         Orbitz has many competitors, both online
                     and off. There are more than 33,000 travel
                     agencies, ranging from one-person shops to                       The Airline Industry
                     giant American Express, and 270 of them are
                     online. Seventy percent of tickets are sold by                 The airline industry has a number of
                     conventional travel agents. The market share               special characteristics:
                     of online services is about 7 percent (of which                Low Variable Costs. Establishing an airline is
                     the airlines themselves have more than half),              difficult and expensive. But once it is operat-
                     and analysts expect that the Internet’s share of           ing, adding more flights costs little; 80 to 90
                     sales in 2003 will be only 11 percent.3                    percent of total costs are fixed in advance of
                         Despite the plethora of competition, the               individual flights.8And once a flight is sched-
                     antitrust wasps are buzzing fiercely and have got-         uled, the marginal cost of filling a seat that
                     ten the ear of the government. Before Orbitz was           would otherwise go empty produces addi-
                     allowed to begin operations it had to obtain the           tional revenue at a cost of almost zero—the
                     blessing of the Department of Transportation               fuel used by a 200-pound passenger/luggage
                     (DOT).4 It succeeded, despite questioning by               combination on a flight of 2,370 miles is
                     more than 20 state attorneys general and the               about 7.5 gallons, which costs less than $10.9
                     opposition of a host of industry incumbents.               So the marginal cost of carrying the addi-
                         The opponents, undaunted by this initial               tional passenger is less than $10 in fuel plus
                     failure, succeeded in having a statement insert-           a few dollars for food and drink.
                     ed into a congressional conference report in                   Expiration. A seat cannot be stockpiled.
                     November 2001 directing DOT to reexamine                   Once the flight leaves, its value goes to zero.
                     the issue.5 In March 2002, DOT sent a letter               Airlines live and die by small changes in their
                     requesting yet more information from Orbitz                percentages of seats filled.
                     and its sponsors, seeking “to determine                        Cooperation/Competition. The United States
                     whether the terms of participation in Orbitz are           has 429 airports with regularly scheduled
                     unreasonably restricting competition in the air-           commercial operations, which creates 91,806
                     line and airline distribution businesses.”6                possible origin-destination pairs. When one
                         For anyone who values competition and                  adds in connecting flights through interme-
                     cheap travel, the persistence of this antitrust            diate airports, the number of possible trips
                     interest should set off alarms. A high level of            that can be taken mounts to the billions.

About 5,000 flights are scheduled each day.                 each flight is called “yield management,” and it
Given this complexity, most airlines adopt the              depends heavily on extensive information
hub-and-spoke mode of operating because of                  about travelers’ preferences and reactions to
its benefits in keeping passengers on the air-              prices and on sophisticated computer pro-
line that originated the flight, maximizing                 grams.
aircraft and crew utilization, and providing                    Some Degree of Secrecy. The difference
maintenance efficiently. 10 A hub city for one              between the average fares that an airline must
airline is a spoke for others, which creates                receive if it is to stay in business and the low
multiple ways to travel between any particular              fare that it should rationally take if necessary
city pair and necessitates a high degree of                 to fill an otherwise empty seat creates a sticky
interaction among airlines. The whole indus-                problem. Logically, if an airplane that is ready
try is one giant network within which firms                 to leave the gate in Chicago heading for San
must both cooperate and compete.                            Francisco has an empty seat and a passenger
    Frequent Fliers. People who take more than              offers the airline in the neighborhood of $25
10 trips per year account for 8 percent of all              for a ticket (enough to cover the marginal
passengers but 40 percent of all trips.11 To an             cost of fuel and food), the airline would prof-
airline, these customers are gold.                          it by taking the deal. But an airline cannot
    Government Involvement. Federal airmail                 have people flying on $25 tickets without           Orbitz’s oppo-
contracts helped found the airline industry.                poisoning its relationship with higher-pay-         nents are trying
Safety regulation, air traffic control, and acci-           ing passengers, so it is reluctant to offer such    to use the
dent investigation are federal government                   bargains openly. On the other hand, it can
functions. The Antitrust Division of the U. S.              offer bargains if the product can be differen-      antitrust laws as a
Department of Justice keeps watch for “anti-                tiated in some way and if the true price is not     barrier to
competitive” mergers and pricing practices.                 made public, so airlines will sell steeply dis-
State and local governments are responsible                 counted tickets to travel agents who offer          changes that will
for airport construction and operation. From                packages that combine air fares, accommo-           benefit con-
1938 to 1978 the Civil Aeronautics Board                    dations, and other services, or to consolida-       sumers.
controlled routes and fares. The Department                 tors who buy blocks of tickets and sell them
of Transportation has regulatory power to                   independently. The term used in the trade is
prevent “unfair” practices, which it uses to                “opaque fares.”
regulate the airline reservation business.                      Dependence on Intermediaries. Airlines reward
    These characteristics dictate basic indus-              intermediaries, such as travel agents, who can
try strategies as follows.                                  deliver customers, especially repeat cus-
    Product differentiation and price discrimination.       tomers. Because just a few seats per flight can
Airlines want to sell as many seats as possible             make the difference between hefty profits and
for full price, but as flight times draw near they          crushing losses, any intermediary capable of
must try to fill the otherwise empty seats for              delivering customers enjoys substantial bar-
whatever they can get. The result is the complex            gaining power in dealing with airlines.
structure of advance reservations and Saturday                  Dependence on Computers. Highly sophisti-
night stays, efforts to distinguish business and            cated systems are needed to keep track of
personal travelers, advance purchases, nonre-               equipment, schedules, seat availability, fares,
fundability, negotiated discounts, last-minute              and individual bookings for a considerable
bargains, and blind auctions where the bidder               period into the future. Airlines were early and
does not know the airline on which he will fly.             heavy investors in mainframe technology
Over 90 percent of all tickets sold by U.S. air-            back in the 1970s, funding much pioneering
lines are discounted, and the discounts average             work in databases.13 Without the computer,
two-thirds off of the full fare.12 The calculation          the current structure of deregulation com-
of how many seats to offer at what price in                 bined with multiple and shifting fares would
order to achieve the maximum return from                    be impossible.

                                                                              Computer Reservation Systems
                                  Selling Tickets                                 Computer reservation systems, which are
                                                                              not well known to the public, are operated by
                          As befits the complexity of the industry,           independent companies that provide travel
                       the system for making reservations and sell-           agents with information about flights and
                       ing tickets is convoluted. It includes five            seat availability and book reservations. These
                       major players: airlines, computer reservation          companies were started by airlines during the
                       systems (CRSs), conventional travel agents,            1970s and soon fell under DOT regulations
                       the Department of Transportation, and the              designed to prevent any airline from using a
                       new Internet information and reservation               captive CRS to obtain a competitive advan-
                       services. It also includes others with special-        tage.15 (To a large extent, the airlines have
                       ized roles: the Airline Tariff Publishing              divested their ownership; remaining airline
                       Company, which is a computerized central               stakes are in the 10 percent to 15 percent
                       clearinghouse for fare information, and the            range.) Any reservation not made by an air-
                       Official Airline Guide, which performs the             line itself goes through a CRS.
                       same function for schedules. Firms called                  CRSs charge the airlines, not the agents, a
                       “consolidators” serve as marketers for blocks          booking fee of around $3.50 per flight seg-
                       of tickets. Priceline and other sites distribute       ment, and the average round trip has four
                       cut-rate tickets through auctions. The                 segments. CRSs have steadily raised their
                       Antitrust Division of the Department of                prices in real terms even as the cost of com-
                       Justice polices competition in the industry,           puting in every other area of national life has
                       creating an overlap with the functions of the          fallen drastically. The fee per segment was
                       DOT. And all of these entities interact with           $1.00 in 1984. If fees had kept pace with
                       the operational side of the airline companies.         inflation, the segment fee would be about
                                                                              $1.70, half its current cost. If the price had
                       Airlines                                               dropped comparably to other computer
                           The airlines sell tickets at counters, by          costs, it would be in the pennies.
                       telephone, and through websites. Individual                Four major CRSs exist—Sabre, Worldspan,
                       airlines also maintain the computer databas-           Amadeus, and Galileo. A travel agency need
                       es on flights, fares, and reservations that pro-       belong to only one, because every airline
                       vide the raw material for searches by other            accepts reservations from all four. If an air-
                       participants.                                          line owns a stake in any CRS, it is compelled
                           Marketing and ticket distribution consti-          by DOT regulation to participate in all. If it
The airlines want      tute up to 20 percent of an airline’s total            does not, it still deals with all CRSs because
                       expenses. The costs of booking a ticket vary           each has control over a bloc of travel agents.
to reduce market-      greatly depending on the medium by which                   Competition among CRSs takes the form
ing costs, restruc-    the reservation is made. In 1999, America              of signing up as many travel agencies as possi-
     ture relations    West estimated its average costs for various           ble. Signing bonuses are common and can be
                       methods of distribution as follows: 14                 substantial.16 However, the industry practice is
with travel agents                                                            to sign travel agents to long-term contracts, so
to reflect the new         • Conventional travel agent—$23                    at this point the shares of the major CRSs are
      reality of the       • Online travel agent—$20                          quite stable and the industry seems to be stat-
                           • Airline reservation agent—$13                    ic. New entry is not practical for a number of
   Internet world,         • Airline website—$6                               reasons, especially existing long-term con-
  and undermine                                                               tracts, the nature of the technology used, and
                          Obviously, airlines prefer to sell tickets          the inhibitions imposed by DOT regulations.
 the power of the      through their own channels, but given the                  The CRSs are sophisticated about the
              CRSs.    importance of boosting load factors, no                structure of their industry and have no incen-
                       channel can be ignored.                                tive to compete by lowering booking fees. That

would gain them no new travel agency clients.               overrides in 1997, and 69 percent of those             Orbitz expects to
(On the contrary, it would lessen their ability             indicated that they sometimes book a specif-           become prof-
to give rebates.) In fact, the airlines are held            ic airline as a result. GAO says that travel
captive by a combination of regulatory                      agencies estimate that the customer defers to          itable in late
requirements and fear of losing vital bookings.             the agent about 25 percent of the time, and            2002, relying
                                                            that overrides are often a “tie-breaker.”21
Travel Agents                                                   Agents are also given rebates by the CRSs;
                                                                                                                   totally on com-
    Agents perform multiple, complicated, and               these are usually linked to the volume of              missions and fees
sometimes conflicting functions. They are, at               bookings generated. It is estimated that               and not on subsi-
different times and to differing degrees:                   rebates to a large travel agency amount to
                                                            about one-third of the booking fees generat-           dies from the air-
    1. Neutral intermediaries who sell tickets              ed by that agency for the CRS. Travel agents           lines.
       for any airline for which a passenger                who deal with businesses may share the com-
       wants a ticket.                                      missions and CRS rebates with their clients.
    2. Agents working on behalf of travelers                Some agents are captives of companies,
       locating the lowest fares or best flights            established to recapture those payments for
       according to the travelers’ criteria.                their owners.
    3. Entrepreneurs who steer passengers                       As the Internet developed, the information
       toward whichever airline rewards them                functions performed by agents became less
       most handsomely, even if that airline                valuable, and the airlines began pressuring for
       is higher in price or less convenient for            cuts. By 2000, base commissions had fallen to
       the traveler. (This is not usually known             $4.3 billion as a result of the dollar level caps
       to the travelers.) 17                                imposed by airlines on commissions for
    4. Packagers of travel and other services               domestic flights.
       (e.g., airline, hotel, rental car, tours) that           In response, an increasing number of
       can be sold to travelers as a bundle.                agents began collecting fees directly from
                                                            travelers. By 1999, about 40 percent did so.
    Deregulation and the consequent increase                    In March 2002, Delta announced that it was
in complexity of the fare structure created an              cutting base commissions to zero, while retain-
important niche for travel agents as suppliers              ing overrides of an undisclosed nature. Within
of information and a bonanza for the agents                 a week the rest of the six biggest airlines fol-
themselves. In 1977, travel agents were respon-             lowed suit—American, United, Continental,
sible for 38 percent of bookings, and commis-               Northwest, and U.S. Airways. “Without com-
sions were between 4 and 5 percent. After                   mission revenues,” said the Wall Street Journal,
deregulation, agents’ share of the bookings                 “travel agents are expected to increase fees they
rose to 85 percent by the early 1990s, and com-             charge to book travelers. . . . That, in turn, could
missions rose to a peak of 11 percent.18                    lead more consumers to buy their tickets
    In 1993, airlines spent $7.6 billion on base            online, which benefits the airlines.”22
commissions, which is well over 10 times the
average profit of $634 million that the whole               Government
industry earns in an average year. 19                           The Department of Transportation regu-
    Commissions can be levied directly on the               lates the airlines. In the 1970s and thereafter,
price of a ticket sold (“base”) or they can take            as individual airlines invested in CRS systems,
the form of “overrides”—incentive payments                  two types of complaints were voiced by airlines
for meeting overall sales quotas, or other spe-             and travel agents: (1) an airline-owned CRS
cial payments from the industry. The exis-                  would slant the display of possible flights to
tence of such rewards promotes steering, of                 favor those of its owner, to the disadvantage of
course.20 A 1998 survey found that 52 per-                  other airlines, and (2) existing travel agents
cent of domestic travel agencies received                   would be affected negatively.

                            DOT, acting at the behest of industry                   to customers about flights and allow the cus-
                        incumbents, issued rules in 1984 and 1992                   tomers to book their own flights. For the most
                        designed to protect against bias in the dis-                part, online agencies obtain information and
                        play of information by the CRSs, and to pro-                book seats through the same channels as ordi-
                        tect travel agents. 23                                      nary travel agents: the OAG for schedules, the
                            Achieving those purposes had ancillary                  ATPCO for fares, and the CRSs for seat avail-
                        effects, however. The airlines were prevented               ability and specific bookings. However, Orbitz
                        from using investment in computer systems as                and Expedia have each developed software
                        a tool to change the structure of the ticket-sell-          more powerful than that used by the CRSs to
                        ing industry. Continuing investment in CRSs                 search out seat availability information and
                        was also discouraged because the rules ensured              present consumers with more options. They
                        that carriers that chose not to invest would not            still use CRSs to book seats. Orbitz, and possi-
                        be disadvantaged. DOT and many industry                     bly other online services, are working on
                        participants assume, or pretend, that the rules             “direct connect” computer programs to make
                        embody reasonable requirements. No one criti-               their own bookings, bypassing the existing
                        cizes the rules because no one wants to irk the             CRSs. Orbitz’s system is scheduled to go into
                        regulator. In truth, the rules are a recipe for scle-       operation in May 2002.25
Travel agents find      rosis and inefficiency, protecting incumbents                   Online agencies make money, like ordi-
it increasingly dif-    and ensuring that CRSs will maintain substan-               nary travel agents, from commissions paid by
 ficult to convince     tial market power over airlines.                            airlines and from rebates from CRSs. They,
                            The current rules expired in March 1997,                too, are moving in the direction of charging
 airlines to pay for    but they have been extended annually while                  consumers, and Orbitz now charges a fee of
      their services.   DOT reviews them to decide if substantive                   $5.00 per booking. Online agencies also run
                        changes are needed. They will now expire on                 advertising, and the extent to which advertis-
                        March 31, 2003.24                                           ing purchases induce them to slant their
                                                                                    information is a matter of acrid controversy.
                        The Internet                                                Orbitz’s charter forbids this. Both Expedia
                            The first sale of a ticket online was by                and Travelocity deny that it happens.
                        Alaska Airlines in 1995. Since then, the
                        Internet has burgeoned. Every airline has a
                        website for selling tickets. Some 270 broader                      Airline Motives for
                        online services exist, plus uncounted web-                          Creating Orbitz
                        sites run by existing travel agencies. The most
                        important services are:                                         The airlines, individually and as a group,
                                                                                    have three strong reasons for creating a
                           • Travelocity,  owned by Sabre, which is                 source of broad and unbiased information
                             the largest CRS. Sabre also has the                    about fares and seat availability, and, ulti-
                             largest business travel management ser-                mately, an alternative channel for booking
                             vice (GetThere) and is a major supplier                seats. They want to reduce marketing costs,
                             of data processing services to the airline             restructure relations with travel agents to
                             industry, including some of the airlines               reflect the new reality of the Internet world,
                             that are sponsoring Orbitz.                            and undermine the power of the CRSs.
                           • Expedia, which was started by Microsoft
                             and is now owned by USA Networks,                      Reduce Marketing Costs
                             recently overtook Travelocity as the                       Each airline wants to reduce marketing
                             biggest online site.                                   costs so that it can cut fares and energize
                           • Orbitz, created by a consortium of airlines.           demand. Of course, each would like to reduce
                                                                                    its own costs while keeping those of its com-
                           The online agencies provide information                  petitors high, but, given the extent to which

the airlines are intertwined, this is not possi-        customers: “Do your search through Orbitz,
ble. If they play King of the Hill, they will           then book through me and we will share the
drag each other down and increase costs for             commission,” is missing a business opportu-
all. To reduce costs, however, members of a             nity. Even when a fee is charged, the traveler
network must cooperate.                                 may receive services that exceed the value of
    The need for cooperation has always exist-          the fee, subsidized by the agent’s commis-
ed—imagine making travel arrangements if                sions from the airlines.
airlines refused to pool information on                     The online services are responding by
schedules and fares and forced every passen-            establishing services for customers that mir-
ger to seek information from each individual            ror those provided by travel agents, such as
airline instead of consulting the airline guide         alerts about schedule changes, reminders,
or a travel agent. Establishing a system of             and help lines. They are betting that auto-
broad, unbiased online information for con-             mated services can, in the long run, be more
sumers (i.e., creating Orbitz)—is the logical           effective and cheaper.
extension of the preexisting system of report-              Also, the problem of foregoing payment
ing information to the OAG and ATPCO.                   for services may be short lived. As market
    A logical question is why the airlines              forces bring commission payments into
decided to create Orbitz instead of waiting             alignment with actual value added to the
for market incentives to induce third parties           transaction, the online services will be in a
to create unbiased services.                            good position, providing the best informa-
    The answer lies in a combination of impa-           tion at the lowest cost. Even in the short run,
tience and uncertainty. Impatience because it           Orbitz and Expedia are optimistic. Orbitz
could take time for such services to develop,           expects to become profitable in late 2002,
and the gains to the airlines from the existence        relying totally on commissions and fees and
of unbiased information are so great that they          not on subsidies from the airlines. Expedia,
cannot afford to wait. Uncertainty because it is        which relies not just on commissions but on
not absolutely certain that an unbiased online          packaging travel services and selling seats
service would be economically viable.                   and rooms on consignment, made a profit in
    The potential problem is that online ser-           the last quarter of 2001.27
vices provide travelers with significant infor-             Nonetheless, a rational airline should be
mation for which they may not get paid—                 concerned that short-term financial pressures
travelers can research online, then book from           might lead any online service to bias its dis-
a travel agent or from the airline itself. The          plays and auction its viewers to whoever bids
sites get far more browsers than buyers, 26and,         the most for that bias. 28 The creation of a ser-    Through Orbitz,
while the percentage of buyers will rise as cus-        vice such as Orbitz, which has non-bias guar-
tomers grow familiar with the service, signif-          anteed by its charter, is a logical way to ensure    the airlines are
icant incentives will continue to operate to            that temptation is resisted, not only by Orbitz      helping to fund a
the detriment of online sites.                          but by other Internet companies as well.             new generation of
    If a travel agent does not charge the travel-
er a service fee, then there is an obvious incen-       Recast Relations with Travel Agents to               reservation-mak-
tive for the traveler to use an online agency to        Reflect the Reality of the Internet World            ing technology
obtain information and then book the reser-                A second airline interest is to recast rela-
vations through a travel agent. This costs the          tionships with travel agents to reflect their
                                                                                                             that will end the
customer nothing and saves a little time, and           current functions and the value they add to          DOT-created CRS
the use of an intermediary can provide trou-            transactions.                                        pricing power.
ble-shooting services if plans go awry. Also, a            The combination of deregulation and the
savvy buyer, such as a business, can negotiate          initial stages of the computer revolution
with the agent for a share of commissions and           resulted in a complex and shifting fare struc-
CRS rebates. Any agent who does not tell his            ture. This gave travel agents a vital role in col-

If unilateral action    lecting information for consumers about                  reservations, packages, and other aspects of
   is “anti-competi-    fares and routes. Now that this function can             travel would work smoothly. A lack of com-
                        be performed more effectively and efficiently            missions would also indicate that information
      tive” and joint   by computers, travel agents find it increas-             had improved and that middlemen no longer
action is also “anti-   ingly difficult to convince airlines to pay for          had the capacity to steer business in return for
                        their services. Before the airlines eliminated           rebates.
        competitive,”   them in March 2002, base commissions had                    Delta, when it eliminated base commis-
    exactly what can    fallen steadily since 1995, to about 5 percent.          sions (though it plans to “continue to pay
     the industry do    They were also capped in dollar terms. 29                individually negotiated incentive commis-
                            Not surprisingly, travel agents would like           sions to select agents”), explained the move:30
       that would be    to maintain high commission levels, because
“pro-competitive”?      they could use computers to search cheaply                   Technology has fundamentally changed
                        and then pocket the money. But high com-                     airline ticket distribution practices. The
                        missions no longer reflect the economic                      rapid growth of electronic ticketing and
                        value of the function.                                       the Internet allows customers to shop
                            In another role, travel agents steered cus-              for, buy and receive Delta tickets, on
                        tomers to whichever airline bid the most,                    their own terms. The cost of distribution
                        often unbeknownst to the passengers. The                     through electronic channels is much
                        airlines were well aware of this, but they                   lower than traditional means. . . . Travel
                        could not afford to alienate agents and so                   agents remain an important part of
                        they acquiesced. Today, they need not play                   Delta’s sales network. They are success-
                        this game—if unbiased information is avail-                  fully adapting to the new competitive
                        able, passengers will catch on quickly, and                  environment. . . . Some customers clear-
                        the power of the agents to steer passengers                  ly prefer to arrange travel through a trav-
                        will decline precipitously. If agents can no                 el agent because of the unique expertise
                        longer deliver passengers, and airlines no                   they provide. The elimination of pub-
                        longer must pay them for steering, the air-                  lished base commissions at Delta
                        lines can put the savings back into reduc-                   removes one of the last vestiges of a com-
                        tions in price and improvements in service, to               mission program developed in a regulat-
                        the benefit of travelers and the airlines them-              ed environment.
                        selves. Airlines want to hasten this restruc-
                        turing. Hence, they support a service that                  Other airlines followed, and the Wall Street
                        provides the broad and unbiased informa-                 Journal’s “Middle Seat” columnist interpreted
                        tion necessary to let the market work.                   the trend as “good news for consumers—
                            Airlines also want to retain their ability to        mostly.” He reasoned that the move will
                        reward travel agents who do perform impor-               strengthen the airlines financial position,
                        tant economic functions, primarily putting               which is good for consumers in the long run,
                        together travel packages and marketing them              and that it will reduce the travel agents’
                        to customers who might not otherwise trav-               “divided loyalties”—the split between the cus-
                        el, or who might otherwise travel on some                tomers and the airlines that pays them.31 But
                        other airline. The Orbitz charter specifically           he sees the overrides as presenting a continu-
                        reserves the airlines’ right to make special             ing problem of divided loyalties. This is cer-
                        fare deals as long as they are not offered pub-          tainly true—but it is a problem that can be
                        licly. Packages and bulk sales are allowed.              solved if travelers demand disclosure.
                            In the long term, the best solution for con-
                        sumers would be for airlines to pay no com-              Create Competition in Booking
                        missions, and for travel agents to be paid by            Reservations and Reduce the Pricing
                        the travelers. If consumers paid directly for ser-       Power of the CRSs
                        vices received, the market for information,                The third motive for creating Orbitz was

that the airlines were weary of what they                advantage would be anti-competitive. Now, in
regard as the excessive charges of the CRSs—             the context of Orbitz, it is argued that joint
$14 and up in booking fees for the average               action is anti-competitive. If unilateral action
round trip was seen as piracy, way out of line           is “anti-competitve” and joint action is also
with costs and, thus, with the prices that               “anti-competitive,” exactly what can the indus-
would prevail in a freely competitive market.            try do that would be “pro-competitive”?
    The DOT rules are to blame for the situa-
tion. Starting in the 1980, DOT was anxious              The Orbitz Business Plan
to avoid giving any airline an advantage as a                Orbitz’s business plan reflects the purpos-
reward for making investments in computeri-              es outlined above.35 It is based on: (1) a
zation and CRSs and reduced the incentive for            promise to display fares in an unbiased man-
new firms to enter the market and invest in              ner, ranked solely by cost and number of
such systems. And by forcing each airline to             stops, and not slanted to favor the offerings
participate in all CRSs, it ensured that CRSs            of any supplier or sponsor, (2) superior soft-
would have little incentive to compete with              ware that will find more flight options than
each other on either price or quality.32 The             are now available from other services, (3)
result is a system that, in the words of William         sharing with participating airlines any CRS
Hannigan, president of Sabre, the largest CRS,           fee refunds received by Orbitz, and (4) a           How does an
provides a “legal ability to print money.”33             capacity to connect directly to airline host        industry achieve
    Through Orbitz, the airlines are helping             systems, bypassing the existing CRSs and            the benefits of
to fund a new generation of reservation-mak-             introducing competition into the business of
ing technology that will end the DOT-creat-              booking seats.                                      reasonable coop-
ed CRS pricing power. This alone is worth                    The plan also includes provisions to make       eration without
the cost to the airlines of setting up Orbitz,           Orbitz a broader business, to include (1) a
which was around $150 million. Booking                   “hand-holding” service to inform customers
                                                                                                             running afoul of
fees are 2.7 percent of the cost of the average          of the status of their plans and (2) a provider     the antitrust
ticket, a total of $2 billion per year. The arith-       of travel packages that integrate airline reser-    authorities?
metic shows that a reduction in booking fees             vations with other services, such as hotels.
of only 4 percent would repay the airlines’                  Finally, Orbitz’s charter has several fea-
costs for Orbitz in a year.                              tures designed to solve the “prisoner’s dilem-
    In reality, the reductions will be much more         ma” that arises in any deal between firms that
than that. When Orbitz’s reservation system              are in a mixed cooperative-competitive rela-
comes online, its price for a booking will be $4         tionship, especially firms belonging to a net-
per ticket, versus the current CRS price of              work as intricately intertwined as that of the
about $14 for a four-segment round trip ticket.          airlines. Each airline’s “druthers” would be to
    Furthermore, much of the new technology              reduce its own distribution costs while those
is not proprietary to Orbitz. The basic search           of its competitors remain high. Thus, from
engine was developed by ITA Software, a com-             the standpoint of any individual airline, the
pany founded by a group of MIT alumni, and               best solution would be for a site such as
is available to all comers, including other trav-        Orbitz to contain all the fares offered by the
el agents and airlines.34                                airline’s competitors, but for the airline itself
    There is considerable irony in the current           to reserve special low fares that it revealed
attacks charging that Orbitz must be “anti-              only on its own website.
competitive” because it is a product of joint                Obviously, if each airline tried this, the
action by the airlines. Thirty years ago, when           whole system would fall apart. Each airline
individual airlines attempted to obtain com-             would save out its lowest fares for its own
petitive advantage by acting unilaterally to cre-        website, or for some other favorite location,
ate CRSs, the government imposed rules to                and there would be no source of comprehen-
forestall them, arguing that any unilateral              sive information.

                           Therefore, if good information is to exist,          ket even though no one knows about them.
                       each participant must bind itself to provide             One can spin a defense of this logic, but not
                       Orbitz with its lowest fares. That is why the            easily or convincingly. The defense is particu-
                       Orbitz charter contains, and must contain, a             larly difficult in the context of the airline
                       “most-favored-nation” clause whereby each                industry, with its numerous alternatives for
                       participant makes available to Orbitz all fares          traveling between any two given places and
                       that are made available to the general public.           its constantly shifting prices.
                       (This category does not include fares that                   The concern about a monopoly of the
                       reflect corporate or government discounts,               reservations business is equally far fetched.
                       special fares for meetings or groups, and con-           To understand this conclusion, one can con-
                       solidator fares. Also, if a competitor offers            duct extensive analysis of the possible impact
                       special terms favorable to the airline, and              of the “most-favored-nation” and promo-
                       Orbitz refuses to provide comparable terms,              tional provisions of the Orbitz charter. Or
                       the airline is free to proceed with the special          one can take a shortcut by recognizing the
                       deal. Airlines can also provide “opaque fares”           fact that the provisions will not give Orbitz
                       to other agents because they are made avail-             undue market power because such a result
                       able as part of special travel packages or               would be contrary to the interests of the
                       through blind auctions, and are thus not                 founding airlines, especially the charter asso-
                       “publicly available.”)                                   ciates, who are not stupid.
                                                                                    The airlines want to reduce their distribu-
                       Opposition to Orbitz                                     tion costs. As a part of this, they must ensure
                           The antitrust objections to Orbitz take              that there is competition among outside dis-
                       two forms.                                               tributors; the airlines do not want to give any
                           The first is that Orbitz will affect the mar-        organization the power to jack up the price
                       ket for air travel by inhibiting discounting             of airline tickets. The rational charter associ-
                       and allowing carriers to coordinate their                ate will wish all online information compa-
                       fares. The second is that Orbitz will domi-              nies, not just Orbitz, a long and prosperous
                       nate the market for air travel reservations, to          existence. It will encourage them all, and fos-
                       the detriment of other travel agents.                    ter competition that reduces their charges to
                           Both arguments rest on requirements in               the bone.36
                       the Orbitz charter. The “most-favored-                       Even the five Orbitz owners should be
                       nation” clause is the principal target, but              promoting competition, not an Orbitz
                       another charter provision that provokes                  monopoly. The financial benefits to them
    A more logical     attack requires the participating carriers to            from reducing booking fees and distribution
                       spend money to promote Orbitz and allows                 costs are generally enormous, dwarfing any
  explanation for      them to fulfill this obligation by providing             possible profits that Orbitz might earn.
 Southwest’s con-      some cheap fares exclusively to Orbitz.                      In general, the problem confronting
       cern is that        Neither the “fare coordination” nor the              Orbitz is an old one, since it affects every
                       “reservations” argument is persuasive,                   trade association and standard-setting orga-
Orbitz will reduce     despite the considerable ink that has been               nization: How does an industry achieve the
other airlines’ dis-   spilled on them.                                         benefits of reasonable cooperation without
                           The “fare coordination” argument is close            running afoul of the antitrust authorities?
   tribution costs,    to incomprehensible. Airlines already have                   The Internet and the possibility of effi-
     thus enabling     excellent information about fares, published             ciency-enhancing industrywide e-commerce
   them to reduce      in the same sources (ATPCO and OAG) from                 initiatives present this old problem in a new
                       which Orbitz gets its information. So the                form, and in 2000 the antitrust authorities
 fares and cutting     argument depends on a logic that holds that              issued two guiding documents. 37 Orbitz’s
 Southwest’s cost      secret discounts exist and that these are cru-           charter provisions track these documents
                       cial to the functioning of a competitive mar-            quite closely. 38

   The real explanation of the antitrust                as Orbitz. And it has another reason to feel           The rest of the
assault lies in the interests of the organiza-          aggrieved by the entry of Orbitz: The current          opponents con-
tions that are leading the attack. Primarily,           industry structure of commissions and
they fear the greater efficiency that will              booking fees creates a price umbrella for a            sist of the usual
accompany better information in the market.             lower-cost service such as Expedia that might          ragtag band of
   Travel agents enjoy collecting high com-             let it earn excellent profits. The company cer-
missions for performing low-cost computer-              tainly has no reason to welcome the entry of
                                                                                                               pseudo “public
ized searches. Some of them also like the pos-          a similarly efficient competitor, especially           interest” and
sibility of auctioning ignorant passengers to           one with deep-pocket funding. However,                 “consumer”
the highest-bidding airline. Not all agents             Expedia has now become part of the USA
engage in this practice, of course, and all of          Networks group, so it is embedded in a net-            groups that
them now know that the existence of the                 work of its own, with access to substantial            somehow wind
Internet numbers its days. But suppressing              outside funding.40
                                                                                                               up on the anti-
Orbitz would allow the practice to continue                 Southwest is the leading airline opponent
for a bit longer.                                       of Orbitz. Southwest operates on a business            consumer side of
   The CRSs obviously want to keep collect-             model different from that of other airlines,           every antitrust
ing their tolls, and they are among the most            relying on point-to-point rather than hub-
influential of the Orbitz opponents. They               and-spoke configuration, specializing in low-          dispute.
have a strong interest in not having people             cost operations, focusing on medium length
understand their true motive, that of block-            trips, and handling its own ticket sales.
ing competition that would erode their exist-               It is branded as the low-cost airline and
ing market power, so they tend to stay behind           sees little benefit from participating in
the scenes.                                             Orbitz or any other online service. Until
   Existing online travel services would like to        recently, Southwest had an arrangement
suppress a well-financed competitor. However,           with Travelocity, but it objected when Orbitz
they cannot argue to the antitrust authorities          published fares that Southwest sent to the
that they do not want competition, so they              OAG, and eventually stopped reporting them
must find alternative arguments.                        to deny access by Orbitz. This step cut off
   The two largest online services,                     Travelocity as well.
Travelocity and Expedia, have quite different               The ostensible basis of Southwest’s objec-
interests. Travelocity, as part of the Sabre            tion to Orbitz is that it would allow the major
group, must defend not only its own inter-              airlines to conspire to raise their fares.41 Even if
ests but those of its parent CRS. Orbitz sees           this charge were true, it would make no sense
Sabre/Travelocity as an important force in              for Southwest to mind. If other carriers raised
the current fight:                                      their fares, the competitive position of
                                                        Southwest would improve. A more logical
    Having purchased its major competi-                 explanation for Southwest’s concern is that
    tors, locked up the major portals                   Orbitz will reduce other airlines’ distribution
    [e.g., AOL, Yahoo], and extended its                costs, thus enabling them to reduce fares and
    tentacles into all areas of e-com-                  cutting Southwest’s cost advantage. CRS fees
    merce, Travelocity, in particular (and              are especially important in this calculation;
    Expedia to a lesser degree), is sitting             Southwest refuses to pay them, which is why
    all but unchallenged on top of a dis-               travelers must book directly through
    tribution sector that is expected to                Southwest. This gives it an out-of-the-gate
    quadruple over the next four years.39               cost advantage of $3.50 per segment.
                                                            The rest of the opponents consist of the
   Expedia may see itself as capable of per-            usual ragtag band of pseudo “public interest”
forming the function of providing unbiased              and “consumer” groups that somehow wind
information, and thus filling the same niche            up on the anti-consumer side of every

antitrust or other regulatory dispute.                    antitrust doctrine that it be repelled.
    None of the protesting groups can demon-
strate that they will suffer the type of harm that
the antitrust laws are designed (at least in theo-                             Notes
ry) to prevent. Indeed, quite the reverse is true.        1. Information on Orbitz’s structure can be found at
Each will suffer the type of harm that the       For a discussion of its relationship
antitrust laws are supposed to encourage—they             with its founding members, see an article by Orbitz
will lose market power that is based on ineffi-           general counsel Gary Doernhoefer, “Orbitz
                                                          Revisited: The Orbitz Perspective,” The Transportation
ciency, friction, and government regulation.              Antitrust Update, American Bar Association, Winter
                                                          2002, p. 23.

               Conclusion                                 2. William F. Adkinson Jr. and Thomas M. Lenard,
                                                          Revise Orbitz’s Flight Plan: Serious Competitive Risks
                                                          Outweigh Questionable Benefits (Washington: Progress
   Antitrust enjoys excellent press, primarily            and Freedom Foundation, June 2001), p. 3.
because of the frequent assertion that it pro-
tects consumers. But theory is not reality, and           3. Kenneth Mead, inspector general, Department of
                                                          Transportation, “Internet Sales of Airline Tickets,”
in practice the energy behind antitrust policy            Statement before the Senate Committee on
rarely comes from consumers, who are a dis-               Commerce, Science, and Transportation, Report no.
organized and inattentive lot, seldom aware               CR-2000-111, July 20, 2000, www.senate. gov/~ com-
that they have a stake in some obscure legal              merce/hearings/0720mea.pdf.
battle. The energy comes from business firms              4. DOT, Office of the Secretary, Letter to Jeffrey G.
threatened by new arrangements. Their pres-               Katz, president, Orbitz, April 13, 2001, available
sure skews antitrust policy into a series of              from author’s files.
efforts to pervert the law to suppress innova-
                                                          5. U.S. House of Representatives, “Conference Report
tion and so benefit industry incumbents, to               [To accompany H.R. 2299],” 107th Congress, 1st sess.,
the detriment of consumers.                               Rept. 107-308, November 30, 2001, p. 47, http://
   As Professors William J. Baumol and          
Janusz A. Ordover wrote in 1985:
                                                          6. “Government Investigation of Online Travel
                                                          Company Orbitz Moves Forward,” March 19, 2002,
    There is a specter that haunts our           /news/edi -
    antitrust institutions. Its threat is                 torial/2894079.htm.
    that, far from serving as the bulwark
                                                          7. See Brunswick Corp. v. Pueblo Bowl-O-Mat, Inc.,
    of competition, these institutions                    429 U.S. 477, 488 (1977): “[R]espondents com-
    will become the most powerful                         plain that by acquiring the failing centers peti-
    instrument in the hands of those                      tioner preserved competition, thereby depriving
    who wish to subvert it. More than                     respondents of the benefits of increased concen-
                                                          tration. The damages respondents obtained are
    that, it threatens to draw great quan-                designed to provide them with the profits they
    tities of resources into the struggle to              would have realized had competition been
    prevent effective competition, there-                 reduced. The antitrust laws, however, were enact-
    by more than offsetting the contri-                   ed for ‘the protection of competition not com-
                                                          petitors’ [citation omitted]. It is inimical to the
    butions to economic efficiency                        purposes of these laws to award damages for the
    promised by antitrust activities.42                   type of injury claimed here.”

   The assault on Orbitz is proving that their            8. General Accounting Office, Aviation Competition,
                                                          GAO-01-832, July 2001, p. 22.
concern was well justified. It is also part of a
larger assault on e-commerce being conduct-               9. See Boeing Company, Product Technical Specs,
ed by middlemen who fear erosion of                       717. A fully loaded 717 weighs 121,000 pounds,
monopoly market power.43 It is important to               including a fuel weight of 29,500 pounds (3,933
the future of the Internet, e-commerce, and               gallons) and has a range of 2,370 statute miles.
                                                          Thus, by simple arithmetic, each gallon transports

27 pounds, and it takes 7.4 gallons to transport 200           the Department of Transportation, Statement
pounds, www.                     before the Committee on Commerce, Science,
technical.html. The 717 carries 106 passengers, so             and Transportation (July 20, 2000), p. 4.
the average expenditure of fuel per pasenger is 37
gallons, counting the weight of the plane as well as           21. General Accounting Office, “Domestic
the passenger.                                                 Aviation: Effects of Changes in How Airline Tickets
                                                               Are Sold,” GAO/RCED-99–221, July 1999, p. 20.
10. However, Southwest Airlines and some others
have made a very successful business by specializ-             22. Martha Brannigan and Kortney Stringer,
ing in low-cost fares and point-to-point routes                “American and Continental Join Delta in Elimina-
instead of hub-and-spoke.                                      ting Most Commissions,” Wall Street Journal, March
                                                               19, 2002.
11. Air Transport Association, “Airline Econom-
ics,” in The Airline Handbook—Online Version, Chap.            23. “Carrier-Owned Computer Reservation Systems,”
4,         edu/cfr/cfr.php.
                                                               24. Department of Transportation, NPRM,
12. Ibid.                                                      “Extension of Computer Reservation Systems
                                                               (CRS) Regulations,” Federal Register 67(Feb. 15,
13. Global Aviation Associates, “The History and               2002): 7100,
Outlook for Travel Distribution in the PC-Based                cgi-bin/waisgate.cgi?WAISdocID=80967731856
Internet Environment,” February 2001. Report pre-              +1+0+0&WAISaction=retrieve.
pared for Orbitz.
                                                               25. Orbitz uses software developed by ITA, which
14. Merrill Lynch, “e-Commerce: Virtually Here:                also sells to other airline businesses. Delta recently
Airlines,” April 8, 1999, p. 3, www.e-commerce.                announced that it is converting its internal opera- Cited in General                 tions to ITA’s software. See
Accounting Office, “Domestic Aviation: Effects of              news/.
Changes in How Airline Tickets Are Sold,”
GAO/RCED-99-221 (July 1999), p. 17.                            26. At Travelocity, as of July 2001, 9 percent of the
                                                               visitors made a reservation. This was up from 4 per-
15. See Fred Smith, “The Case for Reforming the                cent the year before. Amon Cohen, “Inside Track,”
Antitrust Regulations (If Repeal Is Not an                     Financial Times, July 24, 2001.
Option),” Harvard Journal of Law and Public Policy
23, no. 1 (Fall 1999): 25.                                     27. Eric Hellweg, “It’s Not Just Amazon. These Net
                                                               Businesses Are Also Profitable,” Business 2.0, Feb.
16. Global Aviation Associates, p. 58. A CRS may               12, 2001,
pay $10,000 to $15,000 to retain a five-terminal
agency, and as much as $50,000 to induce one to                28. A CRS owned by an airline is forbidden to bias
switch. At $3.54 per segment booking fee, and an               its display, but an online site directed at con-
average of three segments per trip, a $50,000 pay-             sumers is not within the definition of a CRS.
ment is recovered by 3,571 reservations booked. A
mid-size travel agency may book over 13,000 tick-              29. “Orbitz and Travel Agents,”
ets per year.                                                  newsroom.

17. See Michelle Higgins, “Now Boarding Your                   30. Delta Airlines, press release, “Delta Eliminates
Travel Agent,” Wall Street Journal, December 14,               ‘Base’ Commissions for Travel Agents in the
2001: “Even though he uses the same corporate                  United States and Canada,” March 14, 2002,
travel agent every three months, [a Michigan insur-  
ance executive] says he had ‘no clue’ such perks
existed. ‘Just like anything . . . you want to know the        31. McCartney, note 19.
ins and outs of who’s getting bonuses for what.’”
                                                               32. See, for example, Antitrust Division, Department
18. “Orbitz and Travel Agents,” www.orbitz.                    of Justice, “Comments on Proposed Rule on
com/newsroom.                                                  Computer Reservation Systems,” Department of
                                                               Transportation, Dkt OST-96-1145, Sept. 19, 1996,
19. Scott McCartney, “Airlines Move to End Most      
Commissions Is Good News for Consumers—                        htm. Final ruling can be found in the Federal Register 62
Mostly,” Wall Street Journal, March 21, 2002.                  (November 5, 1997): 59784.

20. A. Bradley Mims, deputy assistant secretary of             33. Amon Cohen, “Inside Track,” Financial Times,

July 24, 2001.                                             38. See Doernhoefer.

34. See Sarah Milstein, “How to Get There? It              39. DOT, “Comments of Orbitz” (Sept. 22, 2000), p. 27.
Counts the Ways,” New York Times, April 21, 2002,
p. BU 5,                              40. Jim Hu, “USA Networks to Buy Expedia
                                                           Stake,” C/NET, July 16, 2001,
35. See                                    com/2100-1017-269959.html?legacy=cnet.

36. See, for example, DOT, “Request for                    41. DOT, Comments of Southwest Airlines,
Comments on Computer Reservation System                    Inc. (Oct. 31, 2000).
(CRS) Regulations,” Federal Register 62 (November
7, 1997): 60195; “Supplemental Comments of                 42. “Use of Antitrust to Subvert Competition,”
American Airlines” (September 22, 2000), pp. 8–11.         Journal of Law and Economics 28 (May 1985),
                                                           reprinted in CEI Antitrust Reform Project,
37. Department of Justice, “Antitrust Guidelines           Antitrust Reader (1997).
for Collaborations Among Competitors” (April
2000),            43. Robert D. Atkinson, “”The Revenge of the
pdf; and Federal Trade Commission, “Entering the           Dis-intermediated”, Progressive Policy Institute
21st Century: Competition Policy in the World of           Policy Paper (Jan. 2001),
B2B Electronic Marketplaces,” (October 2000).              uments/ disintermediated.pdf.

Published by the Cato Institute, Policy Analysis is a regular series evaluating government policies and offer-
ing proposals for reform. Nothing in Policy Analysis should be construed as necessarily reflecting the views
of the Cato Institute or as an attempt to aid or hinder the passage of any bill before congress. Contact the
Cato Institute for reprint permission. Additional copies of Policy Analysis are $6.00 each ($3.00 each for five
or more). To order, or for a complete listing of available studies, write the Cato Institute, 1000 Massachusetts
Ave., N.W., Washington, D.C. 20001, call toll free 1-800-767-1241 (noon - 9 p.m. eastern time), fax (202) 842-
3490, or visit our website at


To top