Safeguards and Sustainability of Air Services – Protection for Whom, From Whom?

1. Safeguards and Sustainability of Air Services – Protection for Whom, From Whom? Dr. Peter P. Belobaba Concordia University and MIT March 2003

2. Deregulated, Not Fully Competitive Open Markets • Since US deregulation, pressure for less government control over airline markets has spread worldwide: • A result of the perceived overall success of US deregulation and other experiences in Canada, Australia, Europe and elsewhere • Deregulation has not meant totally free competition: • Gave freedom to airlines to choose routes, frequencies, and prices in domestic markets with less government intervention • But, operational and safety regulations remain, through airline certification, crew training requirements, maintenance standards, etc. • Bilateral agreements still limit access to international markets • Ownership restrictions limit ability of airlines to raise foreign capital • US airlines still required to operate certain “essential air services” • Other regulations govern CRS/GDS distribution channels

3. US Deregulation Experience Generally Positive • Overall benefits have been clearly demonstrated: • US domestic air travel more than doubled in first ten years of deregulation, a growth rate well above pre-deregulation times • Average real (inflation adjusted) air fares continue to decline today • Development of some very successful new low-fare carriers, with rapid growth in recent years (e.g., Southwest, AirTran, JetBlue) • No statistical evidence of reduced airline safety • But some parties have suffered: • Labor unions experienced reduced power, jobs and wages • Greater disparities in fares paid by business and leisure travelers • Small cities saw commuter airlines replace larger jets • Profit volatility and bankruptcies raise questions about airline investment and sustainability of traditional airline operations

4. Changed Competition Under Deregulation • The removal of economic regulations has added new dimensions to airline competitive strategies: • Cost cutting and productivity improvement • Economies of scale in operations to reduce unit costs • Price competition and revenue management to increase revenues • New marketing and distribution programs • Increased network coverage and market dominance • Quite simply, airline managers now actually have to make management decisions and trade-offs: • In contrast to regulated times when government control ensured price increases to cover increased operating costs. • “Airline management” was relatively easy under government regulation and subsidization of flag carriers

5. The March Towards Global Liberalization • Overall success of the US experiment has led other countries to deregulate domestic airline markets: • Australia and Canada were among first to follow • Japan, Brazil, United Kingdom loosened restrictions • European Union has also moved toward “open skies” • Although differences exist, many similar impacts have been observed in deregulation outside the US: • New entrants with lower costs and fares, that face stiff competition and potentially predatory practices from incumbent airlines • Potential for volatility and destructive competition arises, especially in periods of reduced demand and excess capacity • Recent dramatic shifts in airline industry have begun to shift momentum of change to low-cost, low-fare new entrants

6. Protection of New Entrant Airlines • Initial efforts by new entrants to compete were in effectively rebuffed by larger incumbent airlines: • Incumbents had significant advantages of frequency, network coverage, service quality, and frequent flyer programs • Revenue management systems allowed incumbents to match new entrant’s fares while limiting revenue dilution, offering better value • Aggressive responses by incumbents in some cases raised questions of “unfair” competition: • Lower fares and/or increased capacity to drive out new entrant • Potentially predatory actions, subsidized by revenues from other parts of incumbent’s network • Hoarding of gates and/or slots to prevent new entry and growth • Led to serious policy discussion for “re-regulation”

7. The Remarkable Growth of Low Fare Carriers • Recent conditions favorable for low-fare airlines: • Less business travel overall; reduced willingness to pay for premium services; reduced quality of traditional airlines • More stable demand for price-sensitive leisure travel, primarily in high density point-to-point markets • Greater awareness of low-fare options through internet channels, and growing acceptance of “alternative” air travel services • Low-fare carriers now threaten viability of traditional network airlines: • Share of US domestic passengers flown by low-fare carriers increased to 20% in 2002, from 16% in 2000 and only 5.5% in 1990 • Largest low-fare carriers increased both capacity and traffic in 2002, in sharp contrast to most traditional network airlines

8. Who Needs Protection Now? • In North America and Europe, legacy airlines now face unprecedented operating losses: • Major airlines are looking for new “business models” to respond to changed environment and to compete with low-fare airlines • Low-fare competition, combined with Internet distribution and inability to support revenue differentials mean no pricing structure alone can return legacy airlines to profitability • After 2 decades of deregulation, US Major airlines now finally face the reality that their cost structures are simply unsustainable in a competitive environment • Protection for new entrants has become moot: • Southwest, JetBlue, RyanAir and EasyJet are among most profitable airlines in the world, while legacy airlines declare bankruptcy • Government intervention to protect legacy airlines now a possibility

9. When Is Protection Warranted? • Government intervention to “protect” airline services might be warranted in limited cases: • Sustainability of airlines and assurance of air services in developing countries • Where tourism-supported economies depend on air services • Isolated or remote communities requiring air services for movement of population and goods • Under conditions of catastrophic national/global events or war • Even in these situations, not clear that inefficient air carriers should be supported or protected: • Government regulations and (even worse) financial support inevitably cause market distortions and inefficiencies • In most situations, development of new services, by new airlines, with more efficient operating models will ultimately fill any void

10. Sustainability, Not Protection of the Status Quo • Very real need for sustainable air services must not be used as an excuse to prolong inefficiency: • Need for national flag carriers, fear of losing air services often cited as reasons for government protection • Yet, highly regulated national flag carriers have been among the most poorly managed and least efficient airlines in the world • Experiences throughout the world have demonstrated how open market conditions ultimately lead to sustainability and efficiency • A balance between effective safeguards and unnecessary protection is required: • Recognize that many essential air services can and will be provided by more efficient carriers, given reduced regulatory constraints • In nobody’s long-term interest to support and protect inefficient air carriers – emphasis should be on sustainability AND efficiency