Transcript Document

How Airline Markets Work…
Or Do They?
Severin Borenstein, U.C. Berkeley
and
Nancy L. Rose, MIT
1
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
2
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
3
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
4
Figure0: U.S. DomesticAirlineOutput andReal AveragePrice, 1978-2005
900,000
30
800,000
25
AveragePrice
700,000
Real AveragePrice(2005cents/RPM)
20
500,000
15
400,000
Output
300,000
10
200,000
5
100,000
Year
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
0
1979
0
1978
RPMs(millions/year)
600,000
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Figure0.5: U.S. DomesticAirlineOutput andAveragePrice, 1948-2005
900,000
50
800,000
45
40
700,000
AveragePrice
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600,000
Real AveragePrice(2005cents/RPM)
500,000
25
400,000
20
300,000
15
200,000
10
100,000
Output
5
Year
2003
1998
1993
1988
1983
1978
1973
1968
1963
1958
0
1953
0
1948
RPMs(millions/year)
30
6
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
7
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
8
Figure7: Within-RouteandCross-RoutePriceDispersion, 1979-2005
0.8
Within-RouteDispersion
0.7
0.6
WithinCarrier-RouteDispersion
Coefficient of Variation
0.5
0.4
0.3
Cross-RouteDispersion
0.2
0.1
0
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 039 04 05
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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Figure8: AirlineEntries, Exits, andBankruptcies, 1979-2004
16
14
12
10
8
6
4
2
Source: WilliamJordan, 2005.
Entries
Year
Exits Bankruptcies
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2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
0
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
14
Figure3: AirlineIndustryAverageDomesticLoadFactorsandReal Yield, 1938-2005
95
80
90
70
85
60
80
50
70
65
30
60
55
20
50
10
45
2003
1998
1993
1988
1983
1978
1973
1968
1963
1958
1953
1948
0
1943
40
Year
U. S. Domestic LoadFactor
Real Priceper RPM(in2005constant cents)
15
cents/RPM
40
1938
DomesticPassenger LoadFactor (percent)
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Figure10: DomesticU.S. AirlineService, 1984-2005(monthly)
5000
4500
4000
3500
NonstopCity-Pairs Served
3000
2500
DailyDeparture-Seats (000)
2000
DailyDepartures (0)
1500
DailyPassengers (000)
1000
500
0
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
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Source: Authors' Calculations fromT100ServiceSegment Data
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
17
Figure4: Real Yield(Rev/passenger-mile) vs. DOTStandardIndustryFareLevel, 1979-2005
0.4
0.35
0.3
$/RPM($2005)
0.25
SIFL
0.2
Yield
0.15
0.1
0.05
0
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1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
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
Issues in the Deregulated
Airline Industry
• Profit Volatility and Sustainability
• Competition and Market Power
• Government-controlled infrastructure
20
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
21
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
22
Figure 13: Implied Year-to-Year Demand Changes for Air Travel, 1961-2005
20%
15%
10%
5%
0%
61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
-5%
-10%
-15%
-20%
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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%
24
Figure 16: Changes in Implied Demand, RPMs, ASMs and Load Factor, 1979-2005
20%
100%
Demand Change
RPM Change
ASM Change
95%
Load Factor
15%
90%
10%
85%
5%
80%
0%
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
75%
-5%
70%
-10%
65%
-15%
60%
-20%
55%
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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
10%
5%
0%
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-5%
-10%
-15%
-20%
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2005
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
50%
40%
30%
20%
10%
0%
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-10%
-20%
-30%
30
2005
How Big Are These Effects?
• A calibration exercise for 1990-2005
• Start from
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–
–
–
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 Profits
1990-2005
Domestic Operating Profits (billion $2005)
10.0
Actual
5.0
Low-Volatility
0.0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-5.0
-10.0
32
2005
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 Profits
1990-2005
10.0
Domestic Operating Profits (billion $2005)
Simulated
Actual
5.0
Low-Volatility
0.0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
-5.0
-10.0
34
2005
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
35
Continuous Business
Experimentation
• Loyalty programs
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–
–
–
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
36
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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Figure18: DispersioninAirport PremiaAcross50Largest U.S. Airports, 1979-2005
40%
30%
90thPercentile
20%
75thPercentile
Coefficient of Variation
10%
0%
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
-10%
25thPercentile
-20%
10thPercentile
-30%
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Figure9: RouteLevel Concentration, 1979-2005
0.70
0.60
HubRoutes
0.50
AverageHerfindahl Index
Non-HubRoutes
0.40
0.30
0.20
0.10
0.00
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05
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Figure5: Real OperatingCost per AvailableSeat-Milefor LegacyCarriersandStartups, 19842005
0.16
0.14
Legacy
Jet Blue
Frontier
Air Tran
AmericaWest
Midway
Spirit
PeopleExpress
PSA
Reno
ATA
Southwest
0.12
$/ASM($2005)
0.1
0.08
0.06
0.04
0.02
40
0
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Figure6: DomesticMarket Shareof Southwest andAll Low-Cost Carriers, 1984-2005
25%
20%
DomesticMarket Share
15%
All Low-Cost
Carriers
10%
Southwest
5%
0%
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1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
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
42
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
43
rising fuel prices?
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?
44