American Consortium on European Union Studies (ACES)
Cases on Transatlantic Relations, No. 2
U.S. versus EU Competition Policy:
The Boeing-McDonnell Douglas Merger
Michael J. Harrison
This case was written for Prof. C. Randall Henning of the School of International Service at American University and Editor of ACES Cases on Transatlantic Relations Nos. 1-3. Michael J. Harrison is a graduate student at American University, one of the institutional members of the ACES consortium. They wish to acknowledge Jonathan Miller, Eleanor M. Fox, Edward M. Graham, Hasdai Westbrook and Jeffrey Saunders for extensive and helpful comments on drafts. Any errors or omissions that might remain are the author’s alone. Copies of the case can be downloaded free of charge, and information on other cases in this series can be found, at the ACES website: www.american.edu/aces/pages/publications.html.
Copyright © 2003 American Consortium on European Union Studies
This case is one of a series on transatlantic relations developed by the American Consortium on European Union Studies (ACES), a center organized by five universities in the Washington D.C. area. Teaching essential concepts and principles concerning the politics and economics of transatlantic relations is the central purpose of the case series. Each case explores its particular topic as a specific instance of more general patterns of conflict and cooperation between the European Union and the United States. European integration, EU and U.S. policymaking, and their consequences for transatlantic conflict and negotiation are thus basic themes in the series. The multiplicity of layers of policy authority on each side of the Atlantic, and shifts in the location of that authority, also feature prominently in these cases. Each case thus conveys information on specific problems in order to provide a factual foundation for students to discuss broader principles as well as the particular policy dispute. These cases are written to assist instructors of upper-level undergraduate and graduate courses in government, business and economics in general and are configured for courses in International Relations, Foreign Economic Policy and European studies in particular. We welcome your feedback on the individual cases and the series as a whole.
C. Randall Henning
Permission to use, copy, and distribute this case or excerpts from this case is granted provided that (1) this copyright and permission notice appears in all reproductions (excerpts of up to two paragraphs need only reference the case in full); (2) use is for noncommercial educational purposes only; (3) the manual or excerpts are not modified in any way; and (4) no figures or graphic images are used, copied, or distributed separate
from accompanying text. Requests beyond that scope should be directed to the Executive Director of the American Consortium on European Union Studies (ACES).
“Many people believe that possession of unchallenged economic power deadens initiative, discourages thrift and depresses energy; that immunity from competition is a narcotic, and rivalry is a stimulant, to industrial progress; that the spur of constant stress is necessary to counteract inevitable disposition to let well enough alone.”
– Judge Learned Hand, U.S. v. Aluminum Company of America, 1945
“Today’s global mergers go beyond the simple combination of activities in different regions of the world: they might be better described as the worldwide integration and consolidation of such activities. As a result, many of the transactions, which have taken place in recent years, have significantly modified on a global scale the fundamentals of competition in the industries concerned.”
– EU Competition Commissioner Mario Monti, May 20011
Introduction and Overview
Boeing’s announcement of a planned $13 billion merger with McDonnell Douglas in December 1996 raised serious concerns on both sides of the Atlantic about the market power of the combined firm. Boeing, the world’s largest commercial aircraft producer, was proposing to acquire the world’s third largest producer. The number-two producer, Europe’s Airbus, would be disadvantaged in an industry worth $20 billion each year. In the world market for large commercial aircraft, which has undergone substantial consolidation throughout its history, only two significant producers would remain.2 Competition authorities in the United States and European Union immediately set out to investigate the implications of the merger.
This market is characterized by high start-up costs, long production runs and a limited number of buyers. Prices for individual aircraft can reach as high as $156 million to $182 million for a new Boeing 747-400. Competition for each new order is fierce. With only two producers remaining, competition for market share in the cyclical industry would become a zero-sum game between Boeing and Airbus. The merger with McDonnell Douglas would immediately give Boeing a two-thirds share of the market, double that of Airbus.
In the United States, antitrust authorities faced pressure from industry and the Defense Department to allow the merger to go through, in part because it would give Boeing a competitive advantage over Airbus. In the European Union, competition authorities vowed to scuttle the merger, an act which would protect the European champion. The line between competition policy and industrial policy was thus blurred.
This case explores the distinctions between U.S. and EU competition policy in a key industry. The first section of this case discusses the structure of the market for commercial aircraft, including the role of industry consolidation. The second section examines the details of the Boeing-McDonnell Douglas merger. The third section provides a comparison of U.S. and EU competition policy, as well as a discussion of extraterritoriality in competition policy. The fourth section details the transatlantic conflict that brought the United States and European Union to the brink of a trade war in the middle of 1997.
The International Market in Commercial Aircraft
In the 100 years since the era of flight began, hundreds of aircraft manufacturers have come and gone. The economics of the aerospace industry, and the commercial aircraft industry in particular, are marked by high start-up costs and the need to achieve economies of scale in order to produce efficiently. The low number of buyers of commercial aircraft – overwhelmingly the airlines of the world, along with governments and wealthy individuals – create a demand structure in which only the most efficient, lowest-cost producers have a chance to compete for a limited number of orders in a given timeframe. While some producers simply faded from existence, stronger firms swallowed up others. This consolidation in the commercial aircraft industry, occurring in both Europe and the United States, resulted in three firms controlling large commercial aircraft production by the mid-1980s: Boeing, Airbus and McDonnell-Douglas.
Economic and Firm Structure of the Market
The commercial aircraft industry is marked by very high barriers to entry, and firms have to sell a significant number of aircraft in order to make any profit at all. The costs of developing a commercial aircraft are monumental. Boeing is believed to have spent more than $5 billion developing the 777, its latest all-new aircraft, which was launched in 1990 and entered service in 1995. Airbus, meanwhile, is spending a purported $11 billion on its super-jumbo project, the A380.3 Production runs are small – Boeing delivered a total of 381 airplanes in 2002 – and products must be tailored to buyers’ specifications on size, range (distance an aircraft can fly) and efficiency.4 Since a commercial aircraft is expected to last 20-30 years, firms must commit to providing maintenance, service and spare parts over the life of the aircraft. The long service life of commercial aircraft, coupled with the fickle nature of demand for air travel, also makes the commercial aircraft industry highly susceptible to cyclical swings in the market – demand boomed during the late 1990s, but has declined in the post-September 11 economic downturn.
A commercial aircraft is comprised of millions of components from a myriad of industries. The vast majority of research and development (R&D) is spent on planning the integration of these components into propulsion, electronic, hydraulic and avionics systems in a prototype aircraft.5 The sheer complexity of a commercial aircraft makes it an exceptionally difficult product to design and produce. There is a high emphasis in the industry on innovation; often, innovations in seemingly unrelated industries like metallurgy, rubber and electronics can be put to use in commercial aircraft production.
There are three critical considerations in determining the cost of producing commercial aircraft: static economies of scale, dynamic economies of scale, and economies of scope. Static economies of scale result when the average cost of production decreases as more units are produced. By definition, fixed costs remain the same no matter how many airplanes are produced, so a portion of the fixed costs is built into the average cost of each aircraft. As fixed costs – particularly the costs of research and development, which can make up two-thirds of the total fixed costs – are spread among more units, the average cost of each unit decreases.
Dynamic economies of scale in the commercial aircraft industry are the result of strong learning effects in the process by which an aircraft is actually assembled. With millions of components to assemble, timing is absolutely critical; even if some of those components can be put together beforehand, there are still thousands of activities that must be done in order and correctly in a carefully coordinated process.6 As more aircraft are produced, the producers figure out ways to produce them faster, cheaper and more efficiently. The commercial aircraft industry has been found to have a learning elasticity of 0.2, meaning for every doubling of output, production costs decrease 20 percent.7 Since production costs are often expressed in man-hours, an example in which the labor required to produce the first aircraft is indexed at 100 man-hours shows that the first 100 aircraft would require an average of 35 man-hours to produce, while the labor necessary to produce the first 500 aircraft falls to an average of 20 man-hours. The first Airbus A300, for example, required 340,000 man-hours to complete, while the 87th copy of the A300 required only 78,000 man-hours.8
Economies of scope refer to a situation in which processes used to build one type of product can be applied to the production of other products. Because the processes involved in producing, for example, an Airbus A300, are similar to the processes involved in the production of the Airbus A340, Airbus is able to exploit the lessons from the A300 to decrease its production costs for its A340. Incentive exists, then, for a commercial aircraft producer to develop a family of aircraft to serve the passenger capacity needs of its clients, as well as long-, medium- and short-range aircraft. Airbus is unique in one aspect of its economy of scope; it uses the same cockpit design for most of its aircraft. Not only does this reduce production costs, it reduces training and maintenance costs for airlines. Pilots have to familiarize themselves with only one set of controls to be able to fly several different types of aircraft, and mechanics can be trained to repair similar components across a family of aircraft.
These three characteristics – static economies of scale, dynamic economies of scale, and economies of scope – make launching new models a risky business and force concentration of the industry into a few number or producers.. Depending on the model, “[a] firm has to sell roughly 600 units of a new airplane just to break even. This usually takes eight years – twelve if development time is included.”9 With development costs continuing to increase, each time a manufacturer attempts to launch a new model of aircraft, it has to lay out a massive amount of capital – occasionally “betting the company” on a new model, as was the case with Boeing’s 747 – and hope that worldwide demand will push production past the break-even point.
As firms produce units of one particular product family, the cost per unit never reaches a minimum for models over 100 seats, the category in which all Airbus and Boeing commercial aircraft fit.10 While experts divide the market for commercial aircraft into two segments, narrow-body (100-200 passengers, range of 2,000 to 4,000 nautical miles, usually single-aisle) and wide-body (over 200 passengers, range of over 4,000 nautical miles, usually double-aisle), the structure of these two markets and competition issues facing them are similar.11 If a firm were to minimize costs by producing enough aircraft to take advantage of all economies of scale and scope, the number of aircraft produced would exceed the number demanded by the market, leaving many aircraft unsold. The bottom of the cost curve, in other words, extends beyond the size of the global market. As Laura Tyson argues, the industry is thus a natural monopoly: given enough time, and assuming a free market, the number of firms can be expected to decline to one.
Some economists, such as Tyson, have defended subsidies to some firms to avoid such a monopoly.12 Many airlines (especially very large ones), however, want two commercial aircraft producers because they do not want to be dependent on only one supplier. Patronizing multiple competitors in the industry also encourages price competition and innovation.