1 How Airline Markets Work… Or Do They? Severin Borenstein, U.C. Berkeley and Nancy L. Rose, MIT

2 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

3 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

4 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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7 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

8 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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10 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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14 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 Some light-handed economic regulation remains –Denied boarding compensation –On-time information reporting Continued improvement in airline safety

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17 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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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 19

20 Issues in the Deregulated Airline Industry Profit Volatility and Sustainability Competition and Market Power Government-controlled infrastructure

21 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

22 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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24 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 –Labor cost average 37% –Fuel average 14%, but range 11%-22%

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26 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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28 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%

29 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

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31 How Big Are These Effects? A calibration exercise for 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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33 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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35 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

36 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

37 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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42 Airline Deregulation and Infrastructure 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

43 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?

44 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?