Executive Summary
This paper considers the recent phenomenon of U.S. air carriers shifting resources into international markets. It identifies anticompetitive reasons for such behavior and then provides empirical evidence to support the claims. Finally, it discusses the antitrust policy implications raised by the airlines.
How to Succeed in Business Without Really Trying
The Anticompetitive Retreat of U.S. Airlines into International Markets
Toby Roberts[†]
I. Introduction
In 1979 the economist Alfred Kahn stewarded the U.S. into a new era of commercial aviation history.[1] Deregulation revolutionized the airline industry, bringing with it such novelties as hub-and-spoke route networks,[2] yield management,[3] overbooking,[4] and “getting bumped.”[5] Bitter disputes between unionized labor groups and airline management as well as endemic bankruptcy did not deter consumers,[6] who silently accepted such inconveniences in exchange for a 25-year decrease in nominal (to say nothing of real) airfare prices.[7] The number of domestic carriers and flights skyrocketed and a journey by air quickly became a commodity accessible to most rather than a luxury enjoyed by a privileged few.[8]
Amidst the excitement of an increasingly competitive domestic market, the international air travel market remained under the rubric of copious regulation and bilateral treaties. During the 1990s momentum built for deregulation in international markets, principally through the open-skies framework, but thus far the results have been slow to materialize, limited in scope, and even more limited in effect. As a consequence, travelers now face two very different regimes when purchasing an airline ticket, depending on whether or not their journey includes an international component: in the domestic market they enjoy the benefits of cutthroat competition while in the international market they face fewer options and higher fares.
Airlines have taken notice of this disparity. From January 1980 to August 2001, the industry increased international capacity at a rate nearly double that of domestic capacity.[9] The September 2001 terrorist attacks on New York and Washington, DC brought on an acute demand shock for air travel generally, and the effects resonated particularly severely on international routes. By the end of 2003, domestic capacity had fallen 15% from its August 2001 level; international capacity had fallen 21%.[10]
The beginning of 2004 marked a new direction for the industry. The demand shock from the terrorist attacks had largely, if not completely, subsided.[11] Yet the legacy carriers[12]—those with the only substantial international service—still faced the dual threat of high oil prices and increasingly intense competition from their low cost domestic rivals.[13] In response, they began shifting resources from domestic to international routes. In some cases, the purpose of this strategy was made explicit: Glenn Tilton, the CEO of United, said his airline had “‘taken a long hard look about whether there was something inherently uncompetitive with our business model’ in comparison to low-fare airlines.”[14] Gerald Grinstein, Delta’s CEO, mentioned the need “to carve out new territory in the aviation marketplace” in detailing Delta’s turnaround plan, which included an expansion overseas.[15]
The results were dramatic. In the year ending January 2005, U.S. airlines increased international capacity by 12.6% in comparison with a scant 0.1% increase in domestic capacity.[16] In this paper I will argue that the recent reallocation of resources from domestic to international markets is anticompetitive and stems from the potential to realize monopolistic profits outside the U.S. Part II outlines the history of international air travel regulation and discusses the recent but still ineffectual efforts at deregulation. Part III discusses the various incentives that the legacy carriers have to expand overseas. Part IV presents empirical evidence of this phenomenon. In Part V, I discuss some of the implications to consumers, including the relevance to a likely new round of industry consolidation. Part VI concludes.
II. History of International Commercial Air Service Regulation
The airline industry has a long and sordid history of anticompetitive behavior, especially in relation to foreign routes. The widespread belief—whether real or perceived—that the industry has an “inherent tendency toward gradual elimination of competitors” has historically led policymakers to solutions of regulation.[17] Regulating international air service has never been straightforward; it requires negotiating with at least one and often many other sovereign countries to reach any sort of coherent framework. Notwithstanding the significant transaction costs generated by negotiating international agreements on a bilateral basis, nearly all of the current international air transport agreements in force govern only two countries.[18] One reason for this stubbornness is that many countries no doubt feel they can obtain a better bargain if they negotiate bilaterally rather than multilaterally. The other significant factor is that in 1944 an international conference in Chicago set forth the legal framework for international aviation. This had the effect of lowering the transaction costs of bargaining by channeling expectations.[19]
The Chicago Convention,[20] as the document produced by the convention became known, accomplished several objectives but utterly failed to resolve important economic issues. The conference itself established a common terminology for various economic rights necessary for conducting international air service, known as the five freedoms.[21] The fifth freedom rights, or the right carry passenger traffic between two foreign countries, proved the most contentious.[22] Today, this presents less of an issue due to the advent of long haul jumbo jet aircraft, but in the propeller age, an international flight would usually need to make stops in intermediate countries. Airlines wanted the flexibility to drop off and pick up passengers at those stopover points, but many of the delegations, fearful of the competitive impact this would have had on their own national airlines, refused to countenance such blanket liberalization.[23] In fact, many of the participants wanted to take the opposite approach: to create an international body that would allocate international routes and frequencies among airlines of the member states.[24]
The failure to reach a multilateral agreement on economic freedoms at the Chicago conference has shaped the course of international regulation ever since, primarily by making bilateral agreements the norm. However, it did provide certain guarantees against economic discrimination, mainly in relation to overflights (flights that pass through a country’s territory without landing).[25] Moreover, it adopted a standard form for use in promulgating bilateral agreements in order to promote uniformity as much as possible.[26]
Given the absence of an overarching agreement, states retained the authority themselves to allocate routes and frequencies and to set fares within the context of each bilateral agreement they concluded. In the U.S., this regulatory power fell under the governance of the 1938 Civil Aeronautics Act,[27] which vested authority in a five-member Civil Aeronautics Board (CAB). No airline could operate on a route without first procuring a “certificate of public convenience and necessity” from the CAB.[28] In making such determinations, the CAB followed a “presumption doctrine”—meaning “a strong, although not conclusive, presumption in favor of competition on any route which offered sufficient traffic to support competing services without unreasonable increase of total operating cost.”[29]
In the 1940s members of Congress flirted with the idea of creating a single national carrier with the exclusive right to provide U.S. flag service to other countries. Senator McCarran of Nevada introduced a bill that would “foster the development and encourage...a system of international air transportation” by “avoid[ing] destructive rivalries between American companies abroad and [presenting] a united American front against the competition of foreign air monopolies.”[30] Ultimately, the bill failed to make it out of committee,[31] and the international regulatory regime continued under a growing collection of bilateral treaties.
Bilateral agreements control the number of carriers (designations) permitted to serve a country,[32] the number of flights (frequencies)—either per carrier or total—allowed between the countries,[33] the restrictions on pricing decisions,[34] and in some cases, even the authorized capacity.[35] In 1992, the U.S. began pushing for its bilateral agreements with E.U. countries to follow an open skies framework:
[A]n open skies agreement allows access to all routes between the United States and the European country; provides for the greatest possible degree of freedom in pricing; prohibits restrictions on the capacity and frequency of flights on these routes; and allows unrestricted route and traffic rights, such as an airline’s ability to serve intermediate destinations and points beyond the countries that are parties to the agreement, to change the size of aircraft used, to serve “coterminal” airports, and to exercise fifth freedom rights.[36]
The U.S. and the Netherlands signed the first such accord in 1992, and many others have since followed between the U.S. and countries around the globe. Appendix A provides a list of U.S. open skies agreements signed to date.
III. Incentives to Shift Resources to International Routes
Deregulation in the domestic market unleashed competition from low cost carriers (LCCs) that steadily ate away at the existing carriers’ profits.[37] While scores of new entrants in the early 1980s ultimately failed, the overall level of competition increased dramatically. Pre-deregulation economists predicted a situation approaching perfect competition,[38] which has partly borne out, at least to the extent that an industry with a limited number of firms could ever approach perfect competition. At a route level, airline competition today is roughly double the pre-deregulation level.[39] The courts, too, have recognized the changed competitive landscape. As the Seventh Circuit noted, “the airplanes and other capital equipment of the airline industry are highly mobile, and now that the industry has been deregulated there no longer are legal barriers to airlines’ redeploying their equipment, and swiftly too, to any city pair in which ticket prices are above marginal costs.”[40]
This rosy picture of domestic competition does not mean that no barriers to entry remain. While the legal barriers have largely disappeared, entering the airline business requires an enormous amount of capital initially to purchase aircraft and other fixed costs.[41] However, given well-functioning finance markets in the U.S., it seems reasonable to suspect that, given an opportunity to make profits in the airline industry, a willing lender would surface.
In fact, an argument can be made that domestic airfare is currently priced below the perfectly competitive level. Airlines have not recouped their cost of capital for several years.[42] This indicates that the companies have either wasted capital on inefficient projects or that the market has endured supra-competitive prices for a prolonged period. While orthodox economic theory would eschew the latter idea—suggesting that the least efficient firms would simply exit the market—it is not implausible.
Most carriers lease a significant percentage of their fleet.[43] If an airline cannot emerge from bankruptcy and liquidates then its creditors will repossess the aircraft. However, a creditor has little use for an such an expensive asset; in an atmosphere of airline bankruptcies, the surviving companies will not likely be in a position to purchase additional aircraft.[44] It is possible, of course, that the creditors would re-lease their assets in overseas markets experiencing stronger demand for air travel.[45] Equally likely, though, they would renegotiate the lease terms with the ailing carrier, possibly even providing additional financing, in order to keep it afloat.[46] Some money is better than no money.
Moreover, while entry restrictions have eased considerably by deregulation, non-trivial exit barriers remain. Carriers serving smaller communities designated as “essential air service” routes cannot withdraw from those markets without governmental consent.[47] Even in other markets, terminating service rarely occurs without political friction.[48] Trade unions and politicians will often exert considerable pressure on airlines to stay in the communities they represent.[49] Easy entry and difficult exit increase the likelihood of excess capacity and supra-competitive fares. In any event, whether domestic airfares slightly exceed or fall short of the theoretical level, they sufficiently approximate the perfectly competitive level.
The competition sparked by deregulation has intensified over the past 25 years to the point that, in the current environment, the legacy carriers cannot compete. Their low-cost rivals offer more or less the same product for prices below the majors’ break even point.[50] The majors have responded by wrangling salary concessions out of their unionized employees (and unilaterally imposing them on the few non-unionized labor groups),[51] but this band-aid has not stopped the hemorrhaging of cash. Major carriers continue to report staggering losses while the low cost carriers post modest but respectable profits.[52]
What’s a legacy carrier to do? The present consensus favors shifting aircraft overseas to escape unbearable competition at home. From the legacy carrier’s perspective, this strategy offers three main advantages: (1) highly regulated international markets provide legal barriers to entry, ensuring that carriers obtain higher fares than they could domestically; (2) even in open skies countries, certain natural barriers to entry impede U.S. low cost domestic carriers from entering the market; and (3) by increasing its international route network, a legacy carrier can leverage the value of its domestic service.
Bilateral markets (by which I mean those in which the governing air transport agreement is not based on the open skies model),[53] have various restrictions on the number of carriers, routes, and the ability to flexibly set fares. Even countries with more liberal bilateral agreements will not allow the market dynamics to become too competitive:
[T]here is an implicit understanding behind any bilateral agreement that to whatever extent the forces of the marketplace and passenger preference may be allowed to work, they will be curbed in some manner if the airlines of one country begin to dominate the routes granted in the agreement.[54]
Foreign carriers are often productively inefficient relative to U.S. carriers, surviving only for national security or prestige reasons.[55] Therefore, U.S. legacy carriers, while comparatively inefficient to their domestic rivals, should make comfortable profits in bilateral markets by limiting service and raising fares. In a sense, their fate is akin to that of a public utility—they have a fixed market share.
Open skies countries, while having fewer formal barriers to entry, possess more natural barriers to entry than exist in the U.S. market. For instance, differences in language, culture, legal systems, and safety standards all make initial fixed costs higher than for domestic routes. Furthermore, LCCs cannot use the same fleet to serve international destinations as they currently utilize on domestic routes. LCCs fly almost exclusively narrow-body aircraft,[56] which do not have the range necessary to cross oceans.[57] Procuring a fleet of long range international aircraft involves significant additional expenses: wide-body aircraft cost substantially more than narrow-body aircraft; risk premiums to obtain more capital for international routes would undoubtedly increase; and maintaining multiple fleet types raises costs—it is no accident that Southwest Airlines has flown only one fleet type since its inception.