1

How Airline Markets Work…Or Do They?

Severin Borenstein, U.C. Berkeleyand

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

5

Figure 0: U.S. Domestic Airline Output and Real Average Price, 1978-2005

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100,000

200,000

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900,00019

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6

Figure 0.5: U.S. Domestic Airline Output and Average Price, 1948-2005

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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

9

Figure 7: Within-Route and Cross-Route Price Dispersion, 1979-2005

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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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Cross-Route Dispersion

Within Carrier-Route Dispersion

Within-Route Dispersion

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

11

United Airlines 1969

Eastern Airlines 1965

Western Airlines, 1966

1967

Source: www.airchives.com

Figure 2: Selected Airline Route Maps, 1965-1969.

12

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Figure 8: Airline Entries, Exits, and Bankruptcies, 1979-2004

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Entries Exits BankruptciesSource: William Jordan, 2005.

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 86-95

• Some light-handed economic regulation remains– Denied boarding compensation

– On-time information reporting

• Continued improvement in airline safety

15

Figure 3: Airline Industry Average Domestic Load Factors and Real Yield, 1938-2005

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9519

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U. S. Domestic Load Factor Real Price per RPM (in 2005 constant cents)

16

Figure 10: Domestic U.S. Airline Service, 1984-2005 (monthly)

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Nonstop City-Pairs Served

Daily Departure-Seats (000)

Daily Departures (0)

Daily Passengers (000)

Source: Authors' Calculations from T100 Service Segment Data

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

18

Figure 4: Real Yield (Rev/passenger-mile) vs. DOT Standard Industry Fare Level, 1979-2005

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$/R

PM

($2

005)

Yield

SIFL

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

23

Figure 13: Implied Year-to-Year Demand Changes for Air Travel, 1961-2005

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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

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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%

25

Figure 16: Changes in Implied Demand, RPMs, ASMs and Load Factor, 1979-2005

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55%

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100%Demand Change

RPM Change

ASM Change

Load Factor

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."

27

Figure 14: Implied Demand and Labor Cost Changes, 1989-2005

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0%

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10%

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

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 2007-08

30

Figure 15: Implied Demand and Fuel Cost per ASM Changes, 1989-2005

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0%

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1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

31

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

32

Figure 16.5: Actual, Low-Volatility and Simulated Domestic Operating Profits1990-2005

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2005

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Actual

Low-Volatility

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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

34

Figure 16.5: Actual, Low-Volatility and Simulated Domestic Operating Profits1990-2005

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Low-Volatility

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

38

Figure 18: Dispersion in Airport Premia Across 50 Largest U.S. Airports, 1979-2005

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90th 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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Jet Blue

Frontier

Air Tran

America West

Midway

Spirit

People Express

PSA

Reno

ATA

Southwest

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Figure 6: Domestic Market Share of Southwest and All Low-Cost Carriers, 1984-2005

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All Low-Cost Carriers

Southwest

42

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

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?