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

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

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

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

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

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”

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

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

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

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