Fares, Mergers and Cabotage in the US Airline Market

Kenneth ButtonSchool of Public Policy

George Mason University

6th Annual “Competition and Regulation in Network Industries Conference”

Brussels, November 22, 2013

Who was Alfred Kahn• Born in Paterson, New Jersey, on Oct. 17, 1917• Graduated NYU at 18, summa cum laude and first in his class. He earned his PhD in

economics from Yale in 1942 after graduate study at NYU and the University of Missouri.• Before World War II, he worked in Washington for the Brookings Institution and the antitrust

division of the Justice Department. After serving in the army, he became Chairman of the Department of Economics at Ripon College.

• He moved to Cornell University in 1947, where he served as Chairman of the Department of Economics, as a member of the Board of Trustees of the University and as Dean of the College of Arts and Sciences.

• In 1974 he became chairman of the New York Public Service Commission, and later served as Chairman of the Civil Aeronautics Board (1977-1979), and Chairman of the Council on Wage and Price Stability through 1980.

• He served on many private boards, on commissions addressing regulated and deregulating industries such as electricity, telecommunications, and transportation. He maintained a long relationship with NERA Economic Consulting.

• Kahn died in Ithaca at the age of 93, on December 27, 2010

Kahn’s expectations

Kahn’s Rationale for Deregulation

1) Airlines were wasteful because they were not competing on price

2) The airlines had massive excess capacity and could not price discriminate to fill seats

3) Lack of competition kept fares high at a time of rising inflation

First Measured Century Interview

Air transportation deregulation

Outcome of Deregulation

• More fare choices• Lower average fares• More direct and indirect services• Considerable growth in low cost carriers• Development of hub-and-spoke networks• Increased use of air transportation• Airlines sought to protect markets

The outcome

“If the Wright brothers were alive today Wilbur would have to fire Orville to reduce costs”

Herb Kelleher,

Former President of Southwest Airlines, 1994

Fears/expectations/outcomes

• On entry of low cost carriers not fully anticipated– The “pleasant surprise “of the initial large scale entry– The rapid departure of many carriers and re-concentration of the industry– The growth of fortress hubs

• Misled by a misunderstanding of the importance of various economies of scale.

• On anti trust laws was disappointed– “ a lamentable failure of the administration to enforce the policies of anti-trust

laws.”

• On price discrimination did not follow logic of his own work– “much of the price discrimination will disappear.”

• Ignored his own belief that marginal costs are nearly zero in air transport and thus discrimination is a way to recover costs. Also that airlines have some monopoly; Kahn advocated price ceilings in monopoly markets.

Fears/expectations/outcomes

• On congestion the blame lies with the authorities– Partly due to the success of deregulation– “The deprivation has, however, resulted also from major derelictions by

government” in terms of investment and pricing

Airlines are cash registers

Air transportation value chain

Airlines (American/United/Delta/Southwest)

Airframe manufactures (Boeing/Airbus)Air navigation service providers (FAA)Aero engines (GE/RR/Pratt-Whitney)Airports (Generally local monopolies)

Global distribution systems (Amadeus/Galileo/Worldspan/Sabre)Computer travel agents (numerous)

Fuel suppliers (numerous)

Thoughts on mergers and competition“…competition from Southwest, JetBlue, or other airlines would not be sufficient to prevent the anticompetitive consequences of the merger…Southwest, the only major, non-network airline, and the other smaller carriers have networks and business models that differ significantly from the legacy airlines.” US Department of Justice)

BUT IT HAS BEEN THE UNCONVENTIONAL THAT HAS HELPED DRIVE DOWN FARES :1. American Airlines in 1980s

– Frequent flyer programs– Yield management– CRS systems– Two- tier pay structure

2. Southwest Airlines 1990s– Low cost carrier (“Southwest Effect”)

3. Ryanair 2000s– Super-low cost carrier– Serious unbundling

US airline operating margins

1988198919901991199219931994199519961997199819992000200120022003200420052006200720082009201020112012

-10

-8

-6

-4

-2

0

2

4

6

8

Accumulated losses of US airlines since

US airlines average domestic fares (1990 prices)

Cabotage

“… the government could actively attempt to make markets more competitive…above all by allowing foreign airlines to compete for domestic traffic either directly or by investing in American carriers.”

Alfred E. Kahn

Quasi-adjusted fares allowing for baggage and reservations change fees and frequent flyer awards

2007 2008 2009 2010 2011 2012300

310

320

330

340

350

360

370

380

390

Adjusted fare comparisons

• Implicit comparisons have been made between 2009 fares and those in 2012, and clearly this would suggest significant rises in the adjusted fare. This, however, takes no account of fuels price fluctuations.

• Comparisons of 2008 and 2012 fares on the basis that fuel prices were roughly comparable in these years. Again a relatively large adjusted fare increase is seen.

• Comparisons of 2007 (or an earlier year) and 2012 that indicate a rise in the adjusted fare of nearly 13%, but this is set against an increase in fuel price over the period of 44%. Fuel prices being about a third or more of airline costs, would suggest that much, if not all of the rise, in the adjusted fare is due to higher operating costs

Jet-fuel prices (cent/gallons)

Domestic available seat miles (million)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012620

640

660

680

700

720

740

760

Chart Title

Flights at selected airports

Load factors

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 201260

65

70

75

80

85

Average distance domestic passenger (return flights in miles)

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 20122180

2200

2220

2240

2260

2280

2300

2320

2340

2360

2380

Why cabotage?

• New ideas– Different business models

• Large, foreign carriers– Ability to withstand the any predatory actions by incumbents

• Lower fares• Services more attuned to where there have been withdrawals

– Ryanair’s average return journey is about 1000 miles

Web accessed fares June 16th for return flights September 17th to 20th, 2013

Road maps to cabotage?

• Access to essential air services tendering– Routes are allocated separately– Services not suited to most foreign low cost carriers

• Access to hubs/routes abandoned by legacy carriers– Reregulation – agency needed to decide which routes for each type of

carrier.– Deprives legacy hub users of services of formmeign carriers

• Investment in legacy carriers– Adds greater financial security but no real incentive for innovation

• Full access to US domestic market– Allows both competition with existing system and in-fill where routes

have been abandoned.

.. and the very final thought: don’t panic

“Ladies and gentleman, this is your captain speaking. We have a small problem. All four engines have stopped. We are doing our damnedest to get them going again. I trust you are not in too much distress.”

Captain Eric Moody

British Airways

Announcement to passengers after flying through volcanic ash in a B-747