CHAPTER 3 ECONOMIC CHARACTERISTICS OF THE AIRLINE INDUSTRY

Transcription

1 CHAPTER 3 ECONOMIC CHARACTERISTICS OF THE AIRLINE INDUSTRY 3.1 INTRODUCTION The purpose of this chapter is to deal with the economic characteristics of the airline industry. The special nature of the airline industry as a network infrastructure industry will be examined. A number of characteristics in the airline industry will be identified that are indicative of an oligopoly. It will also be demonstrated that certain unique economic network characteristics exist in the airline industry. It will become evident that, as a result of these unique and special characteristics, it may not be advisable to treat the air transport industry on the same basis as other sectors of the economy from a competition perspective. The sources of economies of scale, scope and density in the airline industry will be identified and well as the effect of airline networks on competition. The effect of declining overall volumes on airline competition and the viability network business travel pricing model of the hub-and-spoke airlines as well as the emergence of new low cost carriers and their characteristics will be examined. Price discrimination in the airline industry generally and specifically in South Africa will be examined in this chapter. Specific objectives that will be established are: The special nature of the airline industry as a network infrastructure industry. Certain characteristics of the airline industry will be identified, including: o Characteristics that may demonstrate an oligopoly in the airline industry. o Unique economic characteristics of the airline industry. o Competition in the airline industry in comparison with competition in other industries. o Economies of scale, scope and density in the airline industry. o The effect of airline networks on competition. Chapter 3 Page 121

2 The operation of a deregulated airline industry that would include: o Yield management and hub-and-spoke route systems of large network airlines and the potentially unfair competitive responses to entry by low cost airlines involving price and capacity which results in a decline in airline competition as a consequence of the market power in airline markets that result from these commercial practices. o The effect of a decline in overall volumes on airline networks and the viability of the network business travel pricing model of the hub-and-spoke airlines which has led to the development of specific characteristics of new low-cost carriers as well as the responses of hub airlines to competition from low-cost carriers. o The occurrence of price (fare) dispersion in the airline industry. Fare restrictions as a means of differential pricing and the use of yield management to be able to discriminate on price o The effect of price discrimination on the economic welfare of consumers in the domestic airline services and in particular in South Africa. 3.2 THE SPECIAL NATURE OF THE AIRLINE INDUSTRY AS A NETWORK INFRASTRUCTURE INDUSTRY The Competition Commission in South Africa described the airline industry as a network industry. It stated that there were numerous competitive concerns regarding network industries. 1) The OECD described network infrastructure industries as industries that have commonly been subject to government ownership or regulation and have a number of features that make regulatory reform especially attractive, difficult and interesting to competition authorities. 2) The Competition Commission in South Africa stated that these industries are special in that they connect the consumers of their products and services by means of a network of some sort. Examples of network infrastructure industries include the telephone network, the electricity network, and the road, rail, and water supply and airline networks. Chapter 3 Page 122

3 Although different in the nature of their products, these industries share several features that are reflected in the common occurrence of broadly similar competition concerns: The bigger the network, the more useful it is. There are competition problems associated with dominant, integrated firms in network industries. A new entrant is initially able to compete by providing one service. The response by the incumbent, integrated firm might be to cross-subsidise its prices in respect of that service, by raising the prices of its other services where it faces no competition and thus has market power. The incumbent could refuse access to an essential facility. 3) The raising of switching costs between one service (offered by the new entrant) and another (offered only by the incumbent). For example, a dominant airline might schedule its feeder flights to arrive immediately before the departure of its connecting flights, whereas a new entrant might only secure a landing slot that feeds too late or too early into the incumbent s flight. 4) The CAA in the UK stated that: The airline industry is a network business in which the demand for air services on a particular airport-pair, city-pair, or even country-pair is derived from a multitude of separate origin/destination markets. Consequently, market definition in airline competition cases can sometimes be quite complex. In addition, the indivisibility of capacity can result in extremely low short-run marginal costs, with consequent difficulties in applying competition law to cases involving allegations of predatory pricing. 5) Van Siclen S also identified a number of key characteristics that have a bearing on regulation and competition in network industries: Provision of an essential service to the economy In many countries these industries have been traditionally state owned. Such companies often have public service obligations (implying requirements to provide some services even where it is not economically viable for them to do so.) The result is that the reform of these sectors is often highly politicised. Sunk and unrecoverable costs Many of their costs are sunk and unrecoverable once they are committed. In particular, if there is a desire to attract voluntary private investment, the regulatory Chapter 3 Page 123

4 regime has to be credible and predictable. According to Van Siclen S, creating this credibility and predictability is one of the basic tasks of a regulator. Natural monopolies Some parts of network industries probably have to be monopolies while other parts can be competitive. Van Siclen S stated that when the least costly way to provide a good or service is by a single entity, it is referred to in economics, as a natural monopoly. In her assessment, a co-ordination function would be a natural monopoly. She emphasised that natural monopoly is a technical economic concept and the modifier natural should not be considered a synonym for inevitable or durable. The concept is based on costs, with no reference to substitutes, and therefore no reference to markets. In her assessment, many existing monopolies are not natural monopolies, but instead exist for reasons unrelated to their current cost features. In addition, many sectors that fall under the economic definition of a natural monopoly are not, or at least should not be organised in the form of an actual monopoly. Rapid technological change Rapid change in the level of demand is often brought about by technological change in a related market. In the view of Van Siclen S, changes in technology and demand can upset long held beliefs about feasible structures of the industry and optimal regulation. Technological advances change competition in certain sectors of an industry and may eliminate much of a monopoly. This could imply further changes in the regulation. technological change can also reduce the importance for competition. Further common ownership of different modes may threaten competition, according to Van Siclen S. 6) The characteristics of network industries and the unique application of commercial practices as a result of such characteristics in the airline industry have an effect on the capability of Chapter 3 Page 124

5 competition law, as applied in the economy generally, to address the different issues raised in the airline industry. In this regard, it is recommended that any corrective measures should duly take account of such characteristics of the airline industry, when commercial conduct is considered from a competition perspective. The need to adjust the application of competition policy specifically in the airline industry, as a result of such characteristics, is an important issue that has been considered in Canada especially and is discussed later in the study. 3.3 CHARACTERISTICS OF THE AIRLINE INDUSTRY THAT DEMONSTRATE AN OLIGOPOLY An oligopoly is defined as an industry composed of a few firms producing either similar or differentiated products. According to Wells AT, the airline industry is typically characterised as an oligopolistic industry as a result of the following: High barriers to entry. Few sellers in the market. A product of similar nature. Substantial economies of scale. Growth through merger. Mutual dependence of airlines. Price rigidity and non-price competition. Price transparency and collusion. The abovementioned analysis by Wells AT concluded that the airline industry is closely approximating an oligopolistic market structure. 7) This conclusion has important implications both for competitive analysis and as regards the remedies that are required in order to increase competitive forces in the air transport market. Chapter 3 Page 125

6 3.4 OTHER UNIQUE ECONOMIC CHARACTERISTICS OF THE AIR- LINE INDUSTRY GOVERNMENT FINANCIAL ASSISTANCE Unlike other oligopolistic industries, various governmental units have played major roles in financing the growth and development of the airport-airways system. Wells AT concluded that the airline industry has historically benefited from the financing of major cost elements of the industry by various governmental units. 8) HIGH TECHNOLOGICAL TURNOVER With regard to capital spending by airlines, Wells AT states that technological advances and competition have forced the carriers to undertake a re-equipment cycle on an average of every eight years. Besides requiring huge amounts of capital spending, heavy expenses in hiring and training personnel and in modifying facilities to accommodate the new aircraft and associated equipment are required in the airline industry. 9) HIGH LABOUR AND FUEL EXPENSES Wells AT also pointed out that airlines require employees with highly developed skills that are expensive. 10) In addition, the airline industry is subjected to the severe increases in fuel prices the air carriers have experienced over the past 15 years. According to Wells AT, labour and fuel costs typically represent around 60 percent of a carrier's operating expenses. 11) SENSITIVITY TO ECONOMIC FLUCTUATIONS With regard to the susceptibility of air transportation demand to the business cycle, Wells AT stated that while the impact of a recession is not unique to the airline industry, the airline industry is much slower in recovering as spending on air travel is discretionary and follows general recovery in the economy a year to 18 months afterwards. Chapter 3 Page 126

7 Wells AT found that airlines experience a high rate of traffic growth during periods of prosperity but when the economy moves into a recessionary period, the carriers normally experience substantial excess capacity. 12) CLOSE GOVERNMENT INVOLVEMENT AND REGULATION Wells AT stated that unlike other oligopolistic industries, the airlines have a long history of both support and regulation by government (although this has also been the case in other transportation modes). 13) This was clearly demonstrated by the recent financial aid provided by the USA and other countries as a result of the effect of the terrorist attacks of 11 September Eight industry-specific features of governmental involvement in the air transport industry Havel BF, identified eight industry-specific features that in his view established the structural faults and contradictions of a long prevailing regime that distinguish the air transport industry from other industries and demonstrate the level of government involvement in the air transport industry: The doctrine of sovereign national airspace, sanctified in the Chicago Convention as the basis for government control of the world airline industry for the past thirty years. The piecemeal negotiated exchange of fair traffic rights and other conditions of airspace access through bilateral treaties as opposed to free multilateral grant. The doctrine of cabotage, which has been used to exclude foreign airlines from traffic rights on domestic point-to-point routes. The nationality principle, by which each state reserves its domestic cabotage routes, and designation under its bilateral treaties designates carriers that are owned and controlled by the state or its citizens to serve international routes. The practice of public ownership of national "flag carriers, supported by incidents of state support that include subsidy programmes and protection from market competition. Government efforts to fine-tune regulatory control of the tremendous power of computerised yield management technology, and to ensure a fair distribution of access to scarce airport slot and gate facilities. Chapter 3 Page 127

8 The evolution of levels of strategic co-operation among airlines of different affiliations, including the device of code-sharing, all of which reflect a partial entrepreneurial evasion, with varying levels of official government complicity, of the precepts of cabotage and nationality. Confinement of authentic multilateral co-operation to technical and logistical matters such as ticket interlining (with the striking exception of the discredited practice of collective price-setting through the tariff conferences of the IATA). 14) These demonstrate the high degree of government involvement that certainly will have a damping effect on the free working of market forces. The above-mentioned features are further discussed in annexure B. It is, however, also necessary to take note of governmental intervention in the conduct of airline operations. In this regard, the following are important: CRSs. The distribution of scarce airport runway and terminal resources (the slot and gate problem). Strategic co-operation among airlines of different affiliations, including the device of code-sharing. Multilateral co-operation in technical and logistical matters Regulatory intervention by governments in the operation of air transport services (CRS and airport slots and gates) According to Havel BF, there has been a desire by the USA and EU authorities to liberate their aviation industries from prior regulatory supervision but the switch to competition policy is occasionally blocked by unusual regulatory challenges that are unique to the industry being deregulated. Within the USA and EU air transport industries, two recent developments present challenges that have special resonance for the reform of international aviation: the rapid diffusion in the industry of CRS and the distribution of scarce airport runway and terminal resources (the slot and gate problem). Chapter 3 Page 128

9 The predicate for invasive government regulation of CRSs and airport access, two apparently unrelated aspects of air transport, remains that of competition policy as in the opinion of Havel BF, each is allegedly capable of: Foreclosing the entry of new airlines, or Forestalling system expansion by existing carriers, and Further both CRSs and airport access have been used in a manner detrimental to a competitive marketplace. The solutions proposed, in the main, a return to ex ante regulatory controls to load the market structure in favour of weaker players (non-owners of CRSs or start-up carriers seeking airport space). 15) Strategic co-operation among airlines (including the device of codesharing) Havel BF noted the evolution of levels of strategic co-operation amongst airlines of different affiliation, including the device of code-sharing. In his opinion these measures reflect a partial entrepreneurial evasion (with varying levels of official government complicity) of the precepts of cabotage and nationality. 16) Multilateral co-operation limited to technical and logistical matters Havel BF also identified bona fide multilateral co-operation in technical and logistical matters such as ticket interlining with the striking exception of the discredited practice of collective price-setting through the tariff conferences of the IATA. 17) 3.5 COMPETITION IN THE AIRLINE INDUSTRY SPECIAL CHARACTERISTICS OF THE AIRLINE INDUSTRY The airline industry can be described as a network industry (a system of links (routes) that connect nodes (airports)). 18) Chapter 3 Page 129

10 According to the Nordic competition authorities, a number of interesting characteristics exist in the aviation industry in terms of: Networking. Cost structure. Yield management. Marketing strategies, and Switching costs and lock-in effects. 19) COMPETITION IN THE AIRLINE INDUSTRY IN COMPARISON WITH COMPETITION IN OTHER INDUSTRIES Competition in the airline industry differs from competition in many other industries because of the following: Airlines compete using multiple competitive tools, and Airlines compete over networks (not only on a route to route (city-pair) basis). In this regard, the airline industry can be described as a network industry consisting of a system of links (routes) that connect nodes (airports). 20) MULTIPLE DIMENSIONS OF AIRLINE COMPETITION Airlines compete over the following multiple dimensions: Ticket price. Frequency (number of flights a day) and the timing of those flights. Characteristics of the flight itinerary (non stop, continuing single-plane service, or connecting service). In-flight amenities including: o Service level, food, in-flight entertainment o Seat pitch (how closely spaced together) o Ground amenities, including club lounges Loyalty schemes (rebates to the client and travellers) in the form of: o FFPs. o TACOs. o Corporate discounts. 21) Chapter 3 Page 130

11 It is therefore essential that in the analysis of competition in the air transport market, due regard should be had to all the dimensions in which airlines compete and not only to the singular dimension of price COMPETITION OVER NETWORKS IN THE AIRLINE INDUSTRY Differences in competition over networks in the airline industry differs from that in the telecommunications or information technology industries as follows: Telecommunications and information technology Primary network effects are increasing returns to scale from large fixed costs coupled with extremely low variable costs and externalities, and increasing benefits to each user when a new user is added. Airlines Principal effects of network competition are the ability to manage flow traffic and compete over alternative routings and the market power that comes with dominant hubs in route networks. 22) A particularly efficient way of organising an aviation network is the hub-and-spoke mode of operation. Rather than operating a large number of point-to-point, non-stop routes, the airline company channels all or most passengers through a hub airport, from which all connections extend like the spokes of a wheel. In this way the number of different non-stop routes needed to serve all possible pairs of destinations is drastically reduced, allowing for quite remarkable cost savings. 23) The FFPs are thus liable to strengthen any dominant position and to reinforce the anticompetitive effects of hub-and-spoke networks. They therefore act as important barriers to entry. 24) The hub airline therefore tends to dominate its hub airport and the area around it. No other airline is able to offer a comparable frequency of service into or out of the hub. Owing to the important network economic effects at play, the hub airline will often be able to crosssubsidise feeder routes into the hub, so as to effectively outdo any smaller rival airline which may want to offer services on just one or a few spokes. 25) Chapter 3 Page 131

12 The aviation industry exhibits a number of interesting characteristics in terms of networking, cost structure, yield management, and marketing strategies. The ability to manage flow traffic and compete over alternative routings and the market power that comes with dominant hubs in route networks should also be taken into account when analysing competition in the air transport market. 3.6 NETWORK EXTERNALITIES, ECONOMIES OF SCALE, SCOPE AND DENSITY INTRODUCTION The aviation industry is also characterised by large network externalities, in the sense that the costs and revenues involved in carrying passengers on different, interconnected routes are interdependent. According to the Nordic Task Force on Airline Competition (NTFAC), there are large economies of scale, scope and density present in the aviation industry. These externalities may originate either at: The supply (production) side, or The demand (consumption) side. 26) Supply side economies of scale (also called increasing returns to scale) exist when the average production costs decline with the number of units produced. A common source of economies of scale on the supply side is the combination of a large fixed cost and small constant marginal costs. Economies of scope signify that it costs less to produce services jointly by one firm rather than separately by different firms. Economies of density exist if an airline s unit costs, or the air travellers generalised costs, decline when the airline adds flights or seats on existing routes. 27) Other typical characteristics of network industries are switching costs and lock-in effects. High switching costs result in customers being locked in. This limits competition between Chapter 3 Page 132

13 operators by preventing competition from eroding price differentials from a dominant carrier. 28) Hunnicutt CA stated that network industries may have fundamentally different characteristics than the traditional industries that classic microeconomic models have been based on. As a result, network effects have important public policy implications. Hunnicutt CA was of the opinion that aviation public policy makers of the future would have to take into account not just supply side efficiency that was central in the traditional models, but demand side effects as well. These include many of the strategies that the airlines have perfected such as loyalty programmes including FFPs that have been designed to raise the switching costs for the best customers. 29) As a result, this section will distinguish between the various economies in the airline industry from both the supply (production) side and the demand (consumption) side ECONOMIES OF SCALE Table 3.1: Economies of scale Economies of scale on the supply (production) side Average production costs (cost per passenger kilometre) decline with the number of units produced (in batch size). Such economies can be affected by: Using larger aircraft size (aircraft) Increasing load factor and Longer stage length. 30) Economies of scale due to firm size are, however, quickly exhausted in the airline industry. Economies of scale on the demand (consumption) side Demand for a good increases with the total number of goods sold Such effects are of limited importance in the airline industry. Larger aircraft may appear more comfortable and secure to the traveller and induce a very limited additional air travel demand. 32) Chapter 3 Page 133

14 Large fixed costs and small variable costs give rise to a minimum viable scale, which has to be exceeded in order for the firm to earn a profit in the market. 31) Source: Compiled from: The Nordic task force on airline competition, Report from the Nordic competition authorities, competitive airlines. Towards a more vigorous competition policy in relation to the air travel market no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June Using a larger aircraft reduces the cost per passenger where certain costs do not rise proportionally with the number of seats. Economies of vehicle size are well known in transport industries, including in airline operations. The estimated economies of aircraft size are, according to the NTFAC, often exaggerated since costs are compared for the different aircraft on their typical routes. Since larger aircraft tend to be used on longer distances, the economies of stage length influence the comparison. Specific estimates of scale economies at vehicle level may therefore be overstated if no adjustment is made for the effects of differences in stage length. 33) Longer stage length reduces the costs per passenger in two ways: Landing fees, handling cost, and ground manoeuvring cost fall relative to the passenger kilometres flown (produced). The capacity of the aircraft is better utilised since the aircraft is grounded for a shorter time. Turn-around between flights is reduced with longer stage lengths and fewer landings per period. 34) The optimal aircraft size follows from route characteristics. This implies that the unit cost per revenue passenger kilometre mirrors the network operated by an airline. A large airline operating the network of a medium sized airline will incur similar unit costs on that part of its operations to those incurred by the smaller carrier. There are no significant economies of scale from operating costs at the firm level. 35) Chapter 3 Page 134

15 3.6.3 ECONOMIES OF SCOPE Table 3.2: Economies of Scope Economies of scope on the supply (production) side It costs less to produce services jointly by one firm rather than separately by different firms. Economies of scope on the demand (consumption) side The most important economies of scope are found on the demand side. Arise when more routes are served within the network of an airline (the size of the network of routes). 36) By operating several interconnected routes, the airline is able to utilise aircraft, crew, reservation systems, marketing devices, and other overhead cost items in various production lines or city-pair connections. 37) Economies of scope may be particularly important when slot capacity at airports is limited. Airlines operating several flights out of one airport gain the flexibility to adjust their network to changes in the demand pattern. 38) A carrier offering a larger network of services will be more attractive to the traveller, since he will have more destinations to choose from and a larger probability of finding a suitable connection from the particular origin to any given destination. 39) Economies of scope on the demand side are intensified by marketing practices: FFPs. TACOS. Corporate discount schemes. These create synthetic economies of scope on the demand side as they make it more attractive for passengers and travel agents to concentrate their demand at one airline. 40) Increase the loyalty of the customers toward the airlines through an artificial increase in the switching costs. Consumer preferences when more routes are served are connected to the concept of switching costs that customers have to pay when they shift Chapter 3 Page 135

16 from one supplier to another. 41) Source: Compiled from; The Nordic task force on airline competition, report from the Nordic competition authorities, competitive airlines: Towards a more vigorous competition policy in relation to the air travel market no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June The NTFAC stated that the most important economies of scope from the production side in the aviation industry arise from the complementarily of routes within the network. By operating several interconnected routes, the airline is able to utilise aircraft, crew, reservation systems, marketing devices and other overhead cost items in various production lines (citypair connections). 42) These complementarities are important for several reasons: An airline that supplies end-to-end trips consisting of at least two legs but only operates on one of the leg routes has to buy a seat on this route from another airline. In contrast, an airline that operates on both legs can supply all parts of the same endto-end flight itself. In general, this difference gives a competitive advantage to the latter airline. If competition on the leg routes is imperfect, the selling airline marks up the price of the seat above marginal costs. This mark-up is a cost to the buying airline, which means that an airline operating on both legs can supply the end-to-end flight at a lower cost than an airline that operates on only one of them. The selling airline is able to raise its rival s cost. Operation within a network requires a close coordination at airport nodes. Incoming flights must be co-ordinated with outgoing flights and arrive at gates close to the gates of the relevant outgoing flights. As a result, economies of scope may be particularly important when slot capacity at airports is limited. Airlines operating several flights out of one airport obtain flexibility to adjust their network to changes in the demand pattern. They may switch the use of a slot from one route to another, when demand develops differently in two market segments. Thus an airline will enjoy flexibility by concentrating several routes on a hub airport. 43) Much of this coordination depends on city-pair specific investment at the hub airport. If two legs forming an end-to-end flight are operated by independent airlines, unforeseen events on the first leg may not be accounted for by the airline that operates the second leg. Furthermore, free-rider problems may mean that all the necessary investments are not made, and having made the necessary city-pair specific investments, the airlines are exposed to Chapter 3 Page 136

17 strategic behaviour by their rivals. Both problems may mean that the transaction costs in the hub airport are higher than if one airline operates all leg routes. 44) Economies of scope emanating from the demand side are even more important, according to the NTFAC. These occur when the demand for a range of goods (routes) is larger than if the same goods were offered individually. The demand for an airline s services increases with the number of routes that are covered by its network. A carrier offering a larger network of services will be more attractive to the traveller, since he or she will have more destinations to choose from and a larger probability of finding a suitable connection from her particular origin to any given destination. Economies of scope on the demand side of the airline industry are due to two factors: Consumer preferences, and Marketing practices. 45) Consumer preferences Economies of scope on the demand side are due to the larger number of routes served and are connected to the concept of switching costs, which customers have to pay when they shift from one supplier to another. Typical switching costs relate to: Contracts. Training. Learning. Data conversion. Search costs, and Loyalty costs. 46) The NTFAC stated that switching costs may appear in the airline industry because many people prefer a trip by a single airline compared to one involving two or more airlines. A high quality end-to-end journey via a connecting airport requires that the passengers be able to go through the connection without delays, baggage handling problems, extra costs, or other unforeseeable events. The NTFAC was, however, of the opinion that the risk of such events is often perceived as higher when two or more airlines are involved. In addition, some Chapter 3 Page 137

18 passengers think that travelling by one airline is more comfortable than using two or more carriers. Switching costs mean that the airlines realise economies of scale on the demand side by increasing the number of routes. An increase in the number of routes means fewer transfers between aircraft for the passengers. As many passengers prefer fewer shifts, more routes make the airline s services more attractive to the passenger, and as a consequence, the airline will encounter an increased demand. 47) Marketing practices Economies of scope on the demand side are often intensified by the marketing practices of the airlines. Examples of such marketing practices are FFPs and travel agent agreements. Schemes and programmes such as these create synthetic economies of scope on the demand side because they make it more attractive for passengers and travel agents to concentrate their demand at one or a few airlines. The schemes and programmes increase the loyalty of the customers toward the airlines through an artificial increase in the switching costs. 48) ECONOMIES OF DENSITY An airline s unit costs decline when the airline adds flights or seats on existing routes. 49) Table 3.3: Economies of density Economies of density on the supply (production) side In airlines, supply side economies of density exist if an airline s unit cost declines when the airline adds flights or seats on existing routes, primarily because of improved utilisation of aircraft capacity and crew. 50) Economies of density on the demand (consumption) side Even more important are the demand side economies of density. A higher route frequency will decrease the average time cost experienced by the traveller and hence induce a higher demand for air transport, especially from business travellers. 52) Competitive advantage in a large hub-and- This feedback mechanism, implying that the Chapter 3 Page 138

19 spoke network. Adding destinations to a hub-and-spoke network shows decreasing returns to firm or network size. This negative effect is dominated by the positive effect of economies of traffic density. Passengers who must travel via a hub also face an increase in trip duration as compared to a direct point-to-point service. demand for travel in a network is in a sense self-reinforcing, is referred to as the Mohring effect. As the demand for travel increases, a higher frequency of departures can be supported, and the individual user incurs a smaller average generalised cost. This in turn induces a still higher demand, and so on until equilibrium is reached. 53) Longer flights increase the airlines operating costs and the passenger s total travel time. As a result, the economies of density involved in hubbing must be considered against the disadvantage of increased trip duration and the inconvenience of passengers having to transfer between flights. 51) Source: Compiled from; The Nordic task force on airline competition, report from the Nordic competition authorities, competitive airlines towards a more vigorous competition policy in relation to the air travel market no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June Of particular importance for the economies of density involved in aviation networks is the hub-and-spoke mode of operation. According to the NTFAC, a hub airline channels all or most passengers through a hub airport, from which all connections extend like the spokes of a wheel. In this way the number of different non-stop routes needed to serve all possible pairs of destinations is drastically reduced, allowing for quite remarkable cost savings. According to the NTFAC, the most important economies of scope in the aviation industry stem precisely from the carriers opportunities to consolidate traffic by employing a hub-andspoke network. This consolidation enables airlines to derive economies of density from directing passengers via hubs, since they may use larger aircraft and/or fly with higher frequencies. The lower number of routes in the hub-and-spoke network means that by Chapter 3 Page 139

20 transforming its network from a point-to-point network into a hub-and-spoke network, an airline is able to reduce its costs without lowering the number of destinations served. 54) ECONOMIES OF ALLIANCES Table 3.4: Economies of alliances Economies of alliances on the supply (production) side Airlines form alliances in order to exploit each other s networks and to strengthen the competitive positions of all alliance partners. Alliances should be treated with the same vigour as traditional mergers. 55) Economies of alliances on the demand (consumption) side More extensive networks are more attractive to customers and offer larger economies of scope to the carrier. Establishing an alliance with an adjacent carrier may also be an efficient way for competitors to divide the market between them. 56) Source: Compiled from; The Nordic task force on airline competition, Report from the Nordic competition authorities, Competitive airlines towards a more vigorous competition policy in relation to the air travel market no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June SWITCHING COSTS AND LOCK-IN EFFECTS Switching costs limit competition between operators by stopping competition to erode price differentials from a dominant carrier. 57) High switching costs result in customers being locked in. 58) 3.7 THE EFFECT OF AIRLINE NETWORKS ON COMPETITION The increasing returns to scale, scope and density in the airline industry have several anticompetitive implications, according to the NTFAC. These include: Economies of scale on the supply side set a natural limit to the number of competitors that can operate without economic loss on a given route. The combination of a large fixed cost and small variable cost gives rise to a minimum viable scale, which has to be exceeded in order for the firm to earn a profit in the market. Aircraft can easily be Chapter 3 Page 140

21 transferred between routes, but each aircraft operating on a given route incurs a fixed cost. Economies of scope on the demand side may reduce the competition in the airline industry, as they give the airlines an incentive to merge or join alliances with other airlines so as to increase the number of routes offered and the flight frequency on every route. Entry is often not possible on the scale of one or a few products. To be competitive, and exploit the economies of scope, each firm in the industry often has to produce a full range of products. The hub-and-spoke system of operation, while economically efficient to the individual carrier firm, seems to give rise to strong anti-competitive effects. The economies of scope and density characteristic of these networks are such as to grant the (one and only) hub airline very considerable market power at and around its hub. As a result, different airlines have an incentive to operate hubs at different airports. The hub-and-spoke system as operated among a set of large individual carriers is therefore able to divide the market between the airlines. Although the networks of different carriers overlap, very few origin-destination pairs will exhibit more than two carriers operating non-stop flights. 59) The competitive advantage of hub-and-spoke networks is effectively reinforced through the loyalty programmes operated by the carriers. A FFP becomes more attractive to the traveller the larger the carrier s network of destinations, and vice versa. The competitive advantages allow the hub airline to dominate most routes out of the hub airport. Most major airlines have joined alliances with other airlines that operate in complementary regions or continents. A few global alliances cover more than fifty percent of the world passenger market. The development of the airline industry in the years after the liberalisation was influenced by the role of network economics. By building hub-and-spoke networks the large airlines had, however, managed to enhance their competitiveness by exploiting technical economies of scope (or density). The cost advantages related to network economics are not always reflected in lower airfares. In many cases dominance of a hub-and-spoke network gives rise to market power, which is exploited by the airlines to increase the fares especially on outgoing Chapter 3 Page 141

22 flights from airports that are highly dominated by the hub airline. Hub airlines have market power on almost all spokes out of the hub airport. The incremental cost of operating an extra route in a hub-and-spoke network is often smaller than suggested by the average unit cost of the network. An extra route may generate feeder traffic (and associated revenue) to the larger network. It will be relatively inexpensive for an incumbent hub airline to cross-subsidise a single spoke route or a limited set of such routes. This leaves a dominant hub airline with ample opportunity to fight a rival new entrant through increased capacity, disproportionately reduced fares, and/or other predatory strategies. Unless met by timely and resolute interventions on the part of the competition authorities, such strategies could make the market almost incontestable, according to the NTFAC. 60) 3.8 THE OPERATION OF A DEREGULATED AIRLINE INDUSTRY INTRODUCTION The US DOT concluded that, contrary to the predictions generally made at the time of deregulation, actual experience demonstrated that deregulated airline markets are not contestable and that incumbent airlines can and do obtain market power on certain types of routes. As a result of the fact that incumbent airlines can obtain market power on some kinds of routes", the US Administration stated that the DOT should "take action against exclusionary practices that end or deter attempts by competitors to serve such routes. 61) The US DOT stated that deregulation overall has been very successful and greatly benefited consumers, since most airline markets are competitive and the vast proportion of airline passengers travel in markets that have competitive service. The US DOT motivated their conclusion with the following statistics: More than eighty percent of airline passengers travel in markets that have two or more competitors. The number of domestic passengers has tripled since Traffic in competitive markets has grown even more. Chapter 3 Page 142

23 The number of passengers in markets with two or more competitors has almost quadrupled since The number of passengers in markets with three or more competitors has eased almost six fold and now accounts for about forty percent of all traffic. The number of passengers in markets with three or more competitors exceeds the total number of passengers in The increased competition is reflected in the fares paid by passengers, since inflation-adjusted fares have declined by about thirty-five percent since deregulation. The US DOT reported, however, that deregulated airline markets functioned differently from the way expected at the time of deregulation. At the time of deregulation, industry analysts assumed that in a deregulated environment: Any airline could enter any route and that the threat of entry would cause incumbent airlines to maintain low fares to discourage entry (potential competition). The more nimble airlines able to enter the industry after deregulation would capture a large share of the traffic from the less efficient established airlines. Airlines were thought likely to offer relatively simple fare structures. 62) According to the US DOT the operation of the deregulated industry has been quite different from the expectations at the time of deregulation: Industry analysts had not expected every major airline to adopt a hub-and-spoke route system. Airlines generally operated linear route systems during the regulatory era, as did the intrastate airlines operating in California and Texas. 63) After deregulation each of the holdover airlines (airlines that existed prior to the deregulation of the airline industry) established a hub-and-spoke system. Hub-and-spoke systems enable the hubbing airline to operate a more frequent service in spoke markets than could be supported only by local traffic. Hub-and-spoke systems therefore benefit travellers in most markets. However hub-and-spoke route systems make entry in many markets difficult, owing tothe fact that any airline serving a route from one of its hubs will have substantial competitive advantages over an entrant, unless the entrant either serves the route from one of its own hubs or has significantly lower costs than the hubbing airline. 64) Deregulation did not lead to the simplified fare structure anticipated by many observers. Economists had expected airlines operating under deregulation to offer Chapter 3 Page 143

24 unrestricted low fares, an expectation based in part on the assumption that firms entering the industry with low costs would keep incumbent airlines from being able to create a complex fare structure. 65) 66) The actual result was quite different from the expected one. The fare structures of airlines became extraordinarily complicated. Airlines offer many different types of fares subject to many different conditions or rules. Airlines use yield management to determine how many seats would be offered at each fare (and limit the number of seats available to each fare class) with the objective of selling as many seats as possible at higher fare classes. This enables airlines to discriminate and charge higher fares to business travellers interested in obtaining frequent service (time sensitive passengers) while offering lower fares to leisure travellers interested in saving money and less interested in the number of flights available in any market or the timing of those flights. 67) 68) 69) The implementation of advances in information technology made it possible for the airlines to implement detailed yield management systems which increased their ability to engage in market segmentation and price discrimination. The technology has enabled each airline to allocate seats among the many different fare classes offered on a flight in accordance with a predicted demand for each type of fare. 70) In addition, CRSs have played an important role in airline distribution. Travel agents, who sell the great majority of airline tickets, rely on the CRSs to determine what airline services and fares are available and to make bookings. The CRSs provide a very efficient method of carrying out these tasks. 71) To enable travel agents to advise their customers effectively, the CRSs contain the publicly available fare classes of almost all airlines and show whether such fare classes are available or sold out on particular flights. An incumbent airline can learn from a CRS what fares are being charged by a new rival and can plan its response especially if such CRS is owned or controlled by such airline. 72) 73) Contrary to expectations at the time of deregulation, almost all of the current major airlines were major airlines before deregulation. Industry observers had predicted when deregulation began that the major airlines of that time would have trouble adjusting to a deregulated environment, in part because they had relatively high operating costs. Airlines entering the industry after deregulation were expected to become a major segment of the industry since they would be more efficient and not handicapped with the high-cost practices of the airlines doing business before deregulation. 74) Chapter 3 Page 144

25 The proponents of deregulation assumed that there were no economies of scale or scope in the airline industry, and they overlooked the physical barriers to entry that became important when the regulatory scheme no longer made entry and route expansion difficult. The unavailability of airport facilities, for example, has hindered expansion efforts by new entrants. 75) 76) An incumbent airline in such a market can effectively prevent entry if it can obtain control of such scarce resources and deny them to entrants, even if it is not using them. Significant economies of scale and scope proved to exist in the deregulated industry, as shown by the importance of travel agent override commissions and FFPs. These economies are particularly important on the revenue side, another development unforeseen at the time of deregulation. Analysts then focused on airline costs, an important factor under regulation, rather than the ability to generate revenues, a factor which has become critical since deregulation. 77) According to Dutta R, there are far more economies of scale on the revenue side than on the cost side. He stated that revenue synergy is derived from the power of huband-spoke networks. If an airline has have fifty flights into a hub as opposed to three flights into a hub that in his view this creates a huge power as a result of the frequency of operations. In addition, customers want to go to many destinations and prefer the carrier that serves all their needs, and that creates some economies from a frequent flyer basis. 78) 79) As was expected, many firms entered the airline industry in the first ten years after deregulation. Contrary to expectations, few survived. Until recent years the industry included only four significant airlines that began scheduled interstate service after deregulation Southwest, which had operated as an intrastate airline in Texas before deregulation; America West; Midwest Express; and American Trans Air, which began as a charter airline. The other new entrants generally failed, in part because of management mistakes and an inability to cope with recessions. 80) Competitive responses from stronger network airlines intended to eliminate competition may have undermined the ability of some new entrants to remain in business. 81) 82) Some of the major pre-deregulation airlines, of course, like Eastern and Pan American, also failed. 83) Of the nine passenger airlines with current annual operating revenues of more than US $1 billion, all but America West and Southwest started operating interstate scheduled passenger flights long before the airline industry was deregulated (the seven that began operations before deregulation are American, Continental, Chapter 3 Page 145

26 Delta, Northwest, TWA, United, and AA). The surviving pre-deregulation airlines have become more efficient since deregulation. Their ability to survive despite their higher costs, and the failure of almost all of the new entrant airlines that started up in the early years of deregulation (with substantially lower costs) suggested that the major airlines route systems and the scale and scope of their operations gave them important competitive advantages. 84) 85) This is an important aspect of airline competition as it implies that efficiency and lower cost are not determinants of success in the airline industry. The expected ability of virtually any airline to enter any route proved unrealistic. 86) A number of economists had assumed that the contestability theory would apply to the deregulated airline industry. Under that theory, as described by Professor Levine M, 87) potential entry by new firms serves to discipline the behaviour of participants in real world markets where a small number of firms (oligopoly) participate. It was thought that firms actually operating in a given market would necessarily reduce their prices to levels consistent with the costs of their potential entrant rivals. Otherwise, entry will occur and they will be replaced. Whether airline markets are contestable is important in determining whether there are threats to airline competition, since few airline markets are likely to have many competitors. If airline markets were contestable, firms outside a market could enter it so easily that the threat of potential entry would make the incumbent firms operate efficiently and charge competitive prices. 88) Contestability could exist only under three conditions: o Equal access to economies of scale and to technology, whether expressed as access to competitive levels of unit costs or as equivalent access to product quality. o No sunk costs, a firm can enter and exit without entry and exit costs, including operating losses resulting from predation, and o Price sustainability, there is a set of prices that can occur after the entry of at least one firm which will support profitable operation. 89) Chapter 3 Page 146