1 How Airline Markets Work… Or Do They? Severin Borenstein, U.C. Berkeley and Nancy L. Rose, MIT.
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Transcript of 1 How Airline Markets Work… Or Do They? Severin Borenstein, U.C. Berkeley and Nancy L. Rose, MIT.
![Page 1: 1 How Airline Markets Work… Or Do They? Severin Borenstein, U.C. Berkeley and Nancy L. Rose, MIT.](https://reader036.fdocuments.net/reader036/viewer/2022062619/55160add550346cf6f8b5fdf/html5/thumbnails/1.jpg)
1
How Airline Markets Work…Or Do They?
Severin Borenstein, U.C. Berkeleyand
Nancy L. Rose, MIT
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Airline Regulation
• In most of the world, national ownership– Development and national defense arguments– One or two state-owned airlines
• In U.S., economic regulation of private airlines– Prices subject to CAB approval
• Mostly set on a national basis, not by-market– Route entry subject to CAB approval
• Required showing public interest benefits• No harm to incumbents
• Intl Routes subject to bilateral agreements (still)– Very restrictive agreements, recently more competitive
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CAB Domestic Airline Regulation
• Fares/entry set to assure profitability– Incentive/Disincentive regulation
• CAB resistance to discriminatory fares
• Lots of non-price competition– Frequency competition led to low load factors
• Airline profits very volatile
• Contrast w/low intrastate CA/TX/FL fares
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Airline Deregulation
• In 1978, deregulation came about from– Contrast with intrastate fares– Political/Policy leadership of Kennedy/Kahn– Support of a few carriers, UA, but not most– Opposition of labor– Accompanied by Essential Air Service program
for small cities that continues today
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Figure 0: U.S. Domestic Airline Output and Real Average Price, 1978-2005
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Figure 0.5: U.S. Domestic Airline Output and Average Price, 1948-2005
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Prices and Output Around Deregulation
• Decline in Real Prices– Dropped 20% in 10 years after deregulation– But down 19% in 10 years before deregulation
• Growth in passenger volume– Up 80% in 10 years after deregulation– But up 107% is 10 years before deregulation
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Prices Since Deregulation
• Price Level has Declined– but 26% still paid above regulated benchmark in 2005
• Dominated airports have higher prices– But difference has declined in last decade
• Price Dispersion increased, but has recently declined– Across routes– Among passengers on the same route
• Introduction of Loyalty Programs– FFPs, TACOs, Corporate Discounts
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Figure 7: Within-Route and Cross-Route Price Dispersion, 1979-2005
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Within-Route Dispersion
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Structure Since Deregulation
• Carrier systems reorganized into networks
• Integration (vertical and horizontal)– Through mergers– Through alliances
• Lots of Entry, Lots of Exit– Recent growth of low-cost airlines
• Bankruptcies– Small effects on price or service
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United Airlines 1969
Eastern Airlines 1965
Western Airlines, 1966
1967
Source: www.airchives.com
Figure 2: Selected Airline Route Maps, 1965-1969.
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Figure 8: Airline Entries, Exits, and Bankruptcies, 1979-2004
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Service Since Deregulation• Much higher load factors => less comfort• increase/decrease of in-flight amenities
– technology improvements vs cost cutting
• Increase in the number of nonstop city-pairs– stagnated around time of hub formations 86-95
• Some light-handed economic regulation remains– Denied boarding compensation
– On-time information reporting
• Continued improvement in airline safety
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Figure 3: Airline Industry Average Domestic Load Factors and Real Yield, 1938-2005
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Figure 10: Domestic U.S. Airline Service, 1984-2005 (monthly)
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Source: Authors' Calculations from T100 Service Segment Data
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Measuring Deregulation Benefits• Growth in passenger volume
– 80% in 10 years after deregulation, 107% in 10 years before• Growth in service levels
– Nonstop service way up, but mostly since RJs• Prices down compared to SIFL
– $28b consumer surplus gain in 2005– In SIFL, all productivity gains are exogenous– But SIFL is calculated for a 55% load factor
• Adjustment to 77% eliminates ¾ of consumer gains– SIFL probably overstates regulated fares
• Real Issue: What is the counterfactual?• Passengers changing planes no more often, after
adjusting for trip distance
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Figure 4: Real Yield (Rev/passenger-mile) vs. DOT Standard Industry Fare Level, 1979-2005
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Deregulation/Privatization outside the U.S.
• Much later start, but rapidly catching up in the EU (also progress in Australia)– Acceleration after 1997 reforms, full cabotage
• Over 40% of within-EU capacity is now discount carriers or tour/charter flights– Disproportionately to/from the UK
• Slow progress on international routes, but recent open skies agreement
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Issues in the Deregulated Airline Industry
• Profit Volatility and Sustainability
• Competition and Market Power
• Government-controlled infrastructure
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Is Competition in the Airline Industry Sustainable?
• Arguments Against Sustainability– industry economic volatility since deregulation– natural monopoly, density economies– empty core
• Counter-Arguments– Service/investment stability/growth since deregulation– industry economic volatility even before deregulation– alternative explanations for volatility
• demand volatility, fixed costs and endog labor cost stickiness• exogenous fuel cost volatility• continuous business experimentation - hubs, pricing, loyalty programs,
organization forms
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Demand Volatility
• Large: 9% growth turned into 6% annual decline in two years in early 1980s
• Std Dev of growth 6.6% compared to 2-3% for coal, gasoline, electricity– Serial correlation much lower for airlines too
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Figure 13: Implied Year-to-Year Demand Changes for Air Travel, 1961-2005
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Demand volatility causes profit volatility when costs/quantity sticky
• Steep SR supply causes more price, less quantity adjustment
• Associated with capital intensive industries, but really just sticky costs– Capital cost average 15% from 1990-2005– Labor cost average 37%– Fuel average 14%, but range 11%-22%
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Figure 16: Changes in Implied Demand, RPMs, ASMs and Load Factor, 1979-2005
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Endogenous Labor Costs
• Northwest Airlines press release, September 1, 2005:
"However, due to [Northwest's] worsening financial condition, in part the result of dramatically higher fuel prices, it is likely that the company will have to increase the $1.1 billion labor-cost savings target."
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Figure 14: Implied Demand and Labor Cost Changes, 1989-2005
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1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
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Between 2000 and 2002
• Demand declined estimated 26%
• Real average price declined 17%
• Output (passenger-miles) declined 6%
• Capacity flown (seat-miles) declined 5%
• Load factor declined from 71% to 70%
• Real labor costs declined 2%– Declined by 22% in the next three years when demand grew 10%
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Fuel Cost Volatility
• Fuel is a fixed cost for a given schedule
• Passthrough of fuel price increase comes from reducing schedule and/or increasing load factor– Little evidence of either effect until the most
recent increases in 2007-08
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Figure 15: Implied Demand and Fuel Cost per ASM Changes, 1989-2005
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How Big Are These Effects?
• A calibration exercise for 1990-2005
• Start from – Complete production flexibility – Constant returns to scale even in short run– Immediate 100% passthrough of fuel prices– All demand shocks absorbed in quantity change
• Result: Constant profit per passenger-mile
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Figure 16.5: Actual, Low-Volatility and Simulated Domestic Operating Profits1990-2005
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More Realistic Parameters
• Assume demand shocks absorbed 30% in quantity, then price adjusts for remainder
• Costs not scalable in short run– Of non-fuel costs, 30% fixed, 20% vary with
passengers, 50% vary with seats
• Actual fuel price volatility• Nearly complete (90%) adjustment of
capacity to passengers
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Figure 16.5: Actual, Low-Volatility and Simulated Domestic Operating Profits1990-2005
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Continuous Business Experimentation
• Hubs • Expansion and contraction
• Organization and timing of “banks”
• Size of local operations
• DL announcement of Cincinnati close
• Pricing– Changes in sorting criteria– Changes in dispersion within routes and across
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Continuous Business Experimentation
• Loyalty programs– Interaction with hubs
– Exploiting principal-agent conflicts
– How far to expand FFPs (independent business?)
– Devaluation of huge liability
• Organizational form– Mergers vs Alliances vs going it alone
– Vertical relationship with distribution
– Labor ownership role
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Competition and Market Power• Failure of contestability theory• Hub-based market power
– artificial advantages from loyalty programs– Std dev of airport premium declined from 23% in 1996
to 12% in 2005 (same as 1979)• Higher prices at concentrated airports and on
concentrated routes– Route concentration diff between hub and non-hub
disappered• Recent trends toward reduced market power
– less fare dispersion across airports and routes– growth of low-cost carriers
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Figure 18: Dispersion in Airport Premia Across 50 Largest U.S. Airports, 1979-2005
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10th Percentile
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Figure 9: Route Level Concentration, 1979-2005
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Figure 5: Real Operating Cost per Available Seat-Mile for Legacy Carriers and Startups, 1984-2005
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Figure 6: Domestic Market Share of Southwest and All Low-Cost Carriers, 1984-2005
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Southwest
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Airline Deregulation andInfrastructure Management
• Allocating scarce airport/airspace capacity– problems with historical allocation– problems with market-based allocation
• Airport facility financing and allocation– Political allocation rather than efficiency?
• Technological innovation– air traffic control
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Research Questions
• Why do large cost differences persist?
• Why have low-cost carriers taken so long to gain market share and why is it finally happening?
• What explains the peak in market power, or at least price dispersion, in 1996 and decline since then?
• Why are Europe's airlines doing better with rising fuel prices?
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Conclusion• Deregulation has probably yielded great benefits for
consumers on average, but not for all– Market power seems to have peaked in mid-1990s
• Airlines have had very volatile earnings in a very volatile business climate – not a big surprise
• Beyond airline earnings, little sign of industry instability– Service levels high – flights & routes served– New investment and entry occurring
• Infrastructure problems continue – not enough deregulation?