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The long flight from special to general interests in air transport policy Sveinn Vidar Gudmundsson* Although paradigm changes in policy such as the inclusion of air transport in the EU Environmental Trading Scheme (ETS) are characterized by general interests winning over special interests, tensions remain.

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o understand what hinders major regulatory reform in the general public interest is of great importance for the ongoing international liberalisation process and also the uptake of air transport environment regulation. The hindering factor according to Levine (2006) is “slack” “...the effect of information and monitoring costs that shield the actions of the regulator from observation by a rational electorate.” Slack insulates the general public from regulatory processes allowing the agent to pursue special interests. Global deregulation process

If the Deregulation Act of 1978 was a first step towards world air transport liberalisation, the 1979 US International Air Transportation Competition Promotion Act was the 2nd step to effectively spread air transport liberalisation around the world. Nations have liberalized their domestic markets, following the US example, with variations reflecting different market situations. Countries worth mentioning are India, Canada, Australia, United Arab Emirates, Singapore, Korea and Chile. According to ICAO, in 2006, 31 percent of country pairs with nonstop services and about 49 percent of the seat capacity offered was between nations that have liberalised their air transport through open skies or liberalised multilateral agreements (Fu, Oum and Zhang, 2010). US Open Skies agreements entered the international aviation landscape when the first such agreement was signed in 1992 between the US and the Netherlands. In 2010 over 96 such agreements had been signed with the US and a total of 142 open skies agreements had been concluded worldwide in 2008 (Fu, Oum and Zhang, 2010). A grand majority of studies and reports on liberalisation in air transport show overwhelming evidence of general welfare gains and economic growth worldwide. Regardless of these gains there are still challenges to the international liberalisation process that will increasingly be complemented by the need for a worldwide environmental regulation of air transport.

What was learned?

Soon it was apparent that in the US deregulation caused instability in markets, something that was not the norm before. Regulation had maintained industry stability, so much was clear. Just to give an idea, a large number of new carriers entered service in the first years of deregulation, about 89 of them, but by 1987, 83 carriers had failed, and by 1998 only three scheduled jet operators were surviving from the first few years of deregulation (Gudmundsson, 1998): Southwest Airlines, America West (Chapter 11 1991-1994, was re-branded USAir in 2005) and Midwest Express (sold to TPG Capital and Northwest in 2008). The only apparently sustainable deregulation success story – Southwest Airlines – continuously grew at a slow pace by industry standards. Whereas airline entrepreneurs and analysts continue to measure success by hyper growth, Southwest guards its financial stability by avoiding major cities and the competition, resulting in a high proportion of monopoly routes in the network, but never charging monopoly fares. Airlines that are true to their strategies seem to do better – the primary activity of a low cost airline is to keep costs down and the primary activity of a network carrier is to strengthen the network. History tells us that a departure from the strategy fundamentals is hardly ever profitable. From a strategy stand point it is the classical question of what to do and what not to do. Competition protection regulation

Soon many deregulation analysts would point out that we need regulation to protect newcomers to the industry, carriers that regardless of their much lower cost structure, tended to fail. However, from a regulatory standpoint this has been a difficult task, and some would argue that it was better left to the firms themselves. We can try to understand why. The FAA held a special lottery of 152 slots in high density airports with only new entrant airlines eligible, but only four years after the lottery 139 of the slots were in the hands of the incumbents again (Gudmundsson, 1998). Should the new entrants have been prevented from realizing the value of the slots in the market? The answer

*Professor, Toulouse Business School,France. Email:

Network Industries Quarterly | vol. 13 | no 1 | 2011

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appears “no”: to earmark these slots for new entrants only would create a financial disadvantage for those very carriers. A similar story can be told of the Computer Reservations System (CRS) regulation that was supposed to reduce the halo effect of CRS ownership by prioritizing listings and preventing the hosts favouring their own flights. Many independent regional airlines interlined or fed the incumbent carriers in their hubs. With the prioritizing of the listings these flights fell to a third display category as connecting flights, with direct flights being in the first category. At the time of the initiation of the CRS regulation Air Wisconsin had 80 percent of their sales through travel agents and 40 percent connecting with United Airlines. The regulation caused an estmated loss of 20’000 passengers (Gudmundsson, 1998) and effectively pushed the regional carrier into the arms of the incumbent. Regulation and airline business models

We can certainly argue that regulation is not always fair, but we can also argue that some regulations are unnecessary and undermining network level strategies that reduce competition without welfare losses. For instance Southwest Airlines probably didn’t care that much about competition enhancing regulation as it did not compete for slots with the legacy carriers and mostly avoided CRSs. Not necessarily because the airline “avoided” direct competition but rather because of the low cost business model. Travel agent bookings though CRSs and use of slots in high density airports, added costs, and avoiding unnecessary costs was the name of the game when operating a low cost strategy. In other words, the very things that reinforced the business model of low cost carriers also provided protection against direct competition from the incumbents (Gudmundsson, 1998). There are few if any success stories of low cost airlines seeking out competition with larger carriers and surviving. The policy maker may see this as lack of adequate regulatory protection in a competitive market, whilst a strategy analyst may see this as the difference between seeking out “red oceans” opposed to “blue oceans” (Kim and Mauborgne, 2005). Reverting back to the other side of the story, the incumbent airlines, American Airlines was especially ingenious in affecting industry forces that tend to push down margins: they invented yield management systems to increase the dispersion of fares, frequent flyer programs to reduce switching tendencies, used hub and spoke system to reinforce network coverage and computer reservation systems to make sure that their flights were an option for as many travellers as possible. Just as Southwest Airlines was ingenious in avoiding activities that had detrimental impact on their low cost base, American Airlines was us18


ing the tactics of a network airline. Yet, the great difference between the companies was that American Airlines’ profitability was unstable while that of Southwest was stable. In other words competitive advantage is not permanent in a deregulated competitive market and stability is dependent on a complex set of factors embedded in business models. However, protecting position through regulation is yielding to special interests and can hardly bring innovative airlines to a better relative position in the industry. Are there economies to firm scale in the industry?

There is still a strong belief among airline managers that firm scale is important. We often hear that eventually there will be only few major players in deregulated markets. These claims have appeared both in Europe and in the USA. Surprisingly, to the advocates of this view, there is little evidence of firm scale efficiencies in the industry and several studies have found either no economies to firm scale or only a negligible effect (Caves, 1962; Oum and Zhang, 1997). If this is the case airline mergers can only be explained on the basis of market power rather than efficiency gains regardless of claims to the contrary. What this means is that efficiency gains claimed on certain activities of a larger (merged) entity are lost on other activities that become less efficient with increased size. The world’s largest airlines are not the world’s most profitable or efficient airlines. The absence of strong scale economies was important in justifying the deregulation of network industries in the first place, this must not be forgotten when industry concentration takes place leading to calls for re-regulation. So far as new entry is not made impossible by the regulator, innovators will find ways to challenge the incumbents, since the fastest way to claim efficiency improvements of merged entities is to shed inefficient routes, creating room for innovative carriers to enter. That being said, there are certainly density and scope economies in the industry. The former being associated with the hub and spoke route structure. So, if there are any clear scale economies in the airlines it is in the size of the aircraft itself, so flying a large number of flights through a central point fills larger planes serving far more destinations than would otherwise be possible. Of course this comes at a cost, lower aircraft utilization, but load factors are higher. From firm level to network level regulatory policy

Hub and spoke and later alliances played an important role in strengthening the network of the incumbent carriers. Gomez Casseras (1994) expressed this well by saying that competition between airlines is less a matter of individual firms competing against individual firms but of airline groups competing against airline groups, or to

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be more precise, networks competing against networks. However, airline hubs and alliances were seen as exogenous to airline competition rather than endogenous and much effort was spent on how to eliminate or neutralize these strategic benefits (Levine, 2006). Indeed these advantages are a special focus of antitrust in the United States. The industry was seen as being competitive and network effects as impediment to this competition. Yet, alliance networks are not identical and play an important role in the value generation of network carriers (Levine, 2006). The treatment of the network airlines by the regulator needs therefore to be elevated from the firm level to the network level. Economic deregulation to environment regulation

If the 1980s was the age of deregulation of domestic markets, the 1990s was the age of international liberalisation, and the first decade of the millennium was the age of security regulation, then the 2nd decade of the millennium will be the age of environmental regulation. This is the greatest challenge the industry has ever faced, a paradigm change, it is a race with time. As other transport modes adjust more easily to the green economy air transport might end up being the largest proportional user of fossil fuels in the latter half of this century and greatly curtailed in its ability to grow. For this reason there is little doubt that the greatest regulatory challenge in air transport will take place in this domain over the next decade or two and competition regulation, as understood today, will increasingly take the back seat. Environment bodies like the IPCC (1999) report that technological solutions will not suffice for the industry because of its fast growth rate, which implies that air travel must be constrained. If this will eventually happen, regulation will step in affecting the economics of air travel once again, a certain reversal to the deregulation trend we have experienced in the last three decades. The industry may face not only emission permit trading and taxation schemes but also capacity restrictions, in other words competition regulation may shift gradually in orientation from the consumer to sustainability. This being said, one must acknowledge that the world population has never scaled down its mobility, having gone from one system change to another enabling faster travel over longer distances every time. The future of air travel growth rests on our ability to design different vehicles and different mobility systems. Hence, research into how different regulatory schemes for air transport sustainability affect innovation is necessary to assure that such regulation does not inhibit progress: step changes in air transport technologies and systems must be envisioned within regulatory schemes for sustainability.

Conclusion

Failing to allow for network effects in the regulatory process can constrain strategic innovators in a deregulated market reducing long-term welfare gains. Industry competitiveness will be less prominent in policy making as tensions between the economic deregulation of the industry and environmental protection rise. This is likely to increase industry segmentation as different network forms and business models are given room to develop as competition protection regulation play a lesser role and the green economy a greater role. Just as the US led the global liberalisation movement, Europe is leading a paradigm change for the air transport industry through the ETS, bringing great challenges but also responsibilities. The challenge is in applying the ETS to only a part of a globally integrated network, elevated by tensions between the global and the local good, the general versus specific interests, and the responsibility will be to level the resulting competitive inequality between European airlines and the rest. This can only be accomplished through a worldwide adoption of ETS. We may see worldwide efforts to resist the ETS for air transport or we might see a potential regulatory pandemonium as different regulatory approaches are invented to compete with each other in an industry that depends on international cohesion or we might see general interests win over special interests, a Global ETS. The question is whether it will be fast enough?  References Button, K., and Johnson, K., (1998), ‘Incremental versus Trend-Break Change in Airline Regulation’, Transportation Journal, 37(3): 25-34. Caves, D.W. (1962), Air transport and its regulators, Harvard University Press, Cambridge, MA. Fu, X., Oum, T.H., and Zhang A. (2010), ‘Air transport liberalization and its impacts on airline competition and air passenger traffic’, Transportation Journal, 49(4): 24-41. Gomes-Casseres, B. (1994), ‘Group versus group-how alliance networks compete’, Harvard Business Review (July-August): 62-74. Gudmundsson, S.V. (1998), Flying too close to the sun: the success and failure of the new-entrant airlines, Ashgate, Aldershot. IPCC, (1999), Aviation and the Global Atmosphere, Intergovernmental Panel on Climate Change, Geneva, [Accessed 6 3 2009: http:// www.grida.no/climate/ipcc/aviation/index.htm] Kim, W.C. and Mauborgne, R. (2005), Blue Ocean Strategy, Harvard Business School Press. Levine, M.E. (2006), ‘Why Weren’t the Airlines Reregulated?’, Yale Journal on Regulation, Summer; NYU, Law and Economics Research Paper No. 06-18. Oum, T.H. and Zhang,Y. (1997), ‘A Note on Economies of Scale in Transportation’, Journal of Transport Economics and Policy, 31(3): 309-315.


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