FLYING INTO TROUBLE 9 - EfN"w conomy t-

Flying into trouble

De-regulation benefits are unclear and auctioning 'slots' is crazy

ir transport 'de-regulation' in the United States was directly inspired Ab y neo-classical ideas about freely

competitive and self-balancing markets. As Professor Alfred Kahn once declared, this is probably "as close as we can get in the social sciences to an experiment". Experiment or not, the advocates of de-regulation had no doubts about the outcome. They made confi- dent predictions about the future structure of the industry and how it would behave.

The US legislation has triggered similar moves elsewhere. Al- though they prefer the term 'liberalisation', it is now an axiom for policy advisers in Brussels and London that the less regulation of air transport, the bet- ter. But such a proposi- tion needs testing against experience, particularly in the US.

Three predictions

(mainly small) operators. 0 As a result, air fares would become more

closely related to product costs. The resulting free and stable markets would allow efficiently managed firms to enjoy financial health.

After 15 years of de-regulation, the results could hardly be clearer:

airline concentration has been rapid on a global, let alone US, scale

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2 1950 1954 I958 1962 1966 I970 1974 1978 1981 1986 1990

'Airline yield is the average fare revenue to he airline per passenger mile Aown Source: Melvin A Brenner Associates, lm.

D Fares are less closely related to product costs than ever be- fore

0 The financial losses suffered in recent years by many American carriers have been huge.

Fares have, on aver- age, come down mark- edly since 1978. But the most cursory inspec- tion of fares before de- regulation shows they were trending steadily downwards for sev-

were made by the de-regulation advocates. As there are no significant airline econo- mies of scale, the US industry would quickly become composed of myriads of

eral decades, while airlines enjoyed modest profits (see Chart above). There is no evi- dence that US domestic fare levels are gener- ally lower than they would have been under

1070-3535/95/010009 + 05 508.0010 0 1995 THE DRYDEN PRESS

10 NEW ECONOMY

traditional regulation. Indeed, some re- spected American judges claim they are higher.

As for the service passengers get, although the US industry is very efficient by world standards, public dissatisfaction is high. Fare variations between routes and between dif- ferent passengers on identical journeys, the inconvenience of circuitous routings and the need frequently to change aircraft at hubs have stimulated political attempts to bring back regulation. Public pressure has ensured substantial residual monitoring in areas such as punctuality and baggage-handling. A trend towards more detailed public interven- tion is part of the reality we now examine.

Dog fight It was predicted that the famous old trunk carriers such as American, Delta and United would be fortunate even to survive de-regu- lation. Conditions were ideal for new en- trants to the market - a surplus of experienced la- bour, easy finance and avia- tion authorities eager to help them. The 36 regulated op- erators of 1978 were joined by almost 200 new carriers.

Well over three-quarters of those new entrants have now disappeared. Most of

trol of infrastructure - terminals, gates and 'slots'; ownership of Computerised Reserva- tions Systems (CnS); influence over the retail trade, with the ability to make large commis- sion payments; the ability to mount attractive loyalty schemes for customers; well-estab- lished marketing images; and, not least, the ability to attract able managers. The majors draw on all these strengths to manage capac- ity and pricing with pin-point selectivity.

Recently, there has been another flood of new entrants. Because these small newcomers depend on otherwise unemployed resources, however, there are built-in limits to their growth. For example, any expansion by major camers would quickly attract the best of their pilots to better paid jobs. Virtually no new en- trant has successfully emerged from a 'niche' market to compete against the majors. The new- comers' chances of survival depend, in no small measure, on the continued protection of the US authorities. Although the Clinton administra-

"Tying to impose a simplistic free market approach leads to the

introduction of unwieldy mechanisms which tend to negate the whole purpose"

the rest tend to have commer- cial agreements with the major airlines. They feed traffic to and/or use the identifier codes of a large airline. As for the three biggest op- erators, they now have almost 60 per cent of US domestic traffic. Indeed, the top six have nearly 90 per cent. The US industry is well on the way to a structure like that in motor cars or soft drinks, with just two or three dominant players.

Far from balanced competition, this is an elimination contest. The advantages enjoyed by the majors include: extensive hub-and- spokes networks which allow them to 'steer' traffic and dominate particular auports; con-

tion lacks formal regulatory powers, it has twisted the arms of some majors to pre- vent them from matching new services or fares.

Screen wars How distant the reality is from any notion of balanced competition may be illus- trated by the CRS. Three or

four of these, owned by the biggest airlines, have a dominant position in the retail trade. Travel agents tend to sell the flights they can most conveniently look up on their video screens because that saves time. If fares and agency commissions are identical, a flight timing shown on the top line of the first dis- play will be sold in preference to one lower down. Display position can thus have a mas- sive impact on ticket sales.

Naturally, an airline that has spent billions of dollars on CRS will not favour the timings of its rivals at the expense of its own. Disputes have therefore arisen about display bias, and

FLYING INTO TROUBLE 11

regulatory rules have been made governing such displays. The rules are tending to be- come more detailed about how flights, con- nections and tariffs should be set out. The result is a battle of wits between CRS owners and legislators. In Europe as well as in the United States, legislators are driving CRS to- wards becoming a public utility.

CRS systems, like airhes, are rapidly be- coming globalised. Indeed, there are fears in the industry that external players - combining computers, satellite or optic cable communi- cations and control of retail outlets -may take control of travel distribution. By harnessing advanced technology and economies of scale, ticketing costs may well be cut far below any- thing the airlines can match.

Wherever such trends lead, it will certainly not be in a direction favoured by Professor Kahn. The CRS systems cannot be broken up or de-invented. But perhaps ‘free market’ thinking can solve the simpler problems of infrastructure such as runway congestion.

Access to runways A ’slot’ is a planned timing for landing or takeoff. Traditionally, slots have been allo- cated by mutual agreement between carriers. A free market approach is to auction scarce capacity to the highest bidders. The severe congestion, growing at prime airports across western Europe, could thus be relieved and a significant barrier to competition removed.

The problem is acute at London Heathrow. Even though Heathrow already operates at an intensity thought impossible only a few years ago, many more airlines want to gain access. Indeed if there was a truly free market in air- ports, with no operational, environmental or political barriers to expansion, there would emerge a single, immense airport for London.

The first problem with rationing slots by price is that airlines already consider Heathrow charges extortionate. The former British Airports Authority (BAA) has become a retail supermarket cum privatised tax farmer rather than a transport utility. Allow-

ing it to squeeze even more revenue from air- lines would raise sensitive diplomatic issues.

However, it would have little effect on op- erational behaviour, because many interna- tional airlines still have their schedules re- stricted by time zones and the nature of de- mand. Timings are so constrained that a twice-yearly international scheduling confer- ence is required to allocate compatible slots. Many North Atlantic operators have to arrive at Heathrow in the early morning. So raising charges would not shift these captive services.

Most foreign airlines would absorb higher charges across their complete service network - averaging the costs out over all their passen- gers. UK carriers, with a much greater propor- tion of their services at Heathrow, would thus be at a disadvantage. Furthermore, major car- riers would be able to absorb the charges more easily than small airlines and new entrants with their limited networks and resources.

It may be argued that the only proper test is to charge the passenger directly, influenc- ing travel decisions at source. However, as the Civil Aviation Authority (CAA) has pointed out, such charges are difficult to administer, difficult to set without a long period of trial and error and create political problems.

Pricing in action Free market enthusiasts will be suspicious of these arguments, so we must examine real- life attempts to introduce pricing systems. The best-known example comes from the USA where it applies to four of the most heavily congested airports.

The initial stock of slots was divided into categories, for ’international’, ’commuter’ and ‘essential’ air services. Within each cate- gory, slots were distributed on a ’grandpar- ent’ basis -what an airline already possessed, it was allowed to keep. Once the slots had been allocated, they were given a ’lottery number’ indicating an order of sacrifice. If access is required for, say, a new international service, the slot with the highest priority num- ber is taken away from its current holder.

12 NEW ECONOMY

Thus there is an element of bingo. There is also a ’use-it-or-lose’ rule which

can lead to perverse results. Carriers may op- erate near-empty planes, just to keep slots. Those slots taken back by the authorities to provide for new entrants are reallocated by lot, without charge. Airlines are allowed to buy and sell slots within categories, and there is a slot exchange, run by the carriers. With a prime slot worth several million dollars, only the majors can afford to buy them.

Complex bureaucracy The attempt to apply free market principles has led to a complex and bureaucratic system few people understand. In the EU, the British government tried to find agenuinely ideologi- cal solution. One scheme was termed a ’mar- ket hybrid’. This required prior definition of groups of services, with a subdivision into bundles of commercially viable frequencies - the units for buying and selling.

Holders of slots would have been obliged to auction off 20 per cent of their grandparent holdings, although they could bid to regain them. Slot trading would have been con- ducted by an independent broker, as part of three levels of administration needed to run the scheme. Those simple and famdiar curves of demand and supply were transmuted into 300 pages of dense organisational logic.

The British government was ready to cre- ate the highly complex mechanisms required to operate this ’free market’, but could fmd no other EU government prepared to take the idea seriously. Perhaps the final straw was that airlines from outside the European Com- munity would also have faced substantial in- creases in airport charges.

Complex international airline networks, built up over a long period, cannot be treated like a ’spot’ market. Although slots are in no way the property of the airlines holding them, operators must be given a reasonably secure basis for planning. Trying to impose a sim- plistic free market approach in a situation marked by these, and other, complexities

leads to the introduction of unwieldy mecha- nisms. And these tend to negate the whole purpose of the exercise.

The British government has now agreed to hand the slot allocation process back to the established airlines. But this is precisely the original source of complaint - the dominant carriers that control infrastructure and still collectively agree their most profitable fares can effectively exclude any new competitive threat at airports such as Heathrow.

Airline self-regulation is hardly acceptable on grounds of consumer interest and compe- tition policy. On the other hand, there is ap- parently no workable alternative. We must therefore look at the problem afresh.

Workable policies Certain approaches, demonstrated to work well in practice, are being studiously ignored in London and Brussels. In Britain, the Civil Aviation Authority has allocated disputed slots through its well-tried route licensing procedures. Indeed, even now the CAA is allowed to allocate slots between UK opera- tors in Japan - but not in Britain.

British licensing procedures allow a wide range of factors to be considered. They may be activated solely where the airlines cannot agree between themselves, or where new en- trants are being unfairly excluded. The same approach could be generalised as part of a Euro-CAA. This would involve the European Commission making choices between air- lines, including those of different member countries, but if the Commission’s bid for ex- ternal negotiating competence proves suc- cessful, it cannot avoid this task.

If anyone should dismiss the idea of a Euro-CAA as ‘bureaucratic’, consider the pre- sent situation. At one time, CAA was respon- sible for airline competition policy, in partner- ship with the Department of Transport. Now there is also the Department of Trade, the Of- fice of Fair Trading, and the Monopolies and Mergers Commission, not to mention the EU Competition Directorate, the EU Transport

FLYING INTO TROUBLE 13

Directorate and the European Court. It is not clear that this proliferation of bu-

reaucracy is leading to better quality decisions. Brussels is taking up to two years to investigate speclfic disputes, and British travellers have been paying higher fares than before.

Hundreds of thousands of fares changes take place in the USA overnight by electronic data transmission, and the same is about to happen in Europe. It is doubtful whether a ‘generalist’ Competition Directorate will ever be able to master the technical issues in- volved. For example, many predatory moves take the form of obscure changes in tariff con- ditions - the ’small print’. This k a job for highly experienced specialists. The next stage may well involve predatory ‘hacking’, and serious allegations have already been made.

Handing over the controls And so to the most bizarre development of all. For many years, the British authorities have countered US attempts to project its legal juris- diction internationally. Attempts to export US anti-trust laws have been rejected. At one time, any US attempt to deal with an allegation made by one British airline against another would have been fiercely rebuffed. The UK authorities have ample powers to deal with such matters through existing licensing regulations. How- ever, as the BA/Virgincase illustrates, the gov- ernment apparently now believes a US lay jury is better qualified to judge such matters than its own regulatory specialists.

Regulatory mediation would constitute a market ’distortion’. This illustrates the obses- sion with one simplistic mechanism to the ex- clusion of all others. As that mechanism does not fit reality very well, employing it whole- heartedly requires a great deal of bureauc- racy, and provides lavish opportunities for the legal industry. We observe this both in Europe and the US, where such activities are flourishing. The drive for competition thus often leads to its opposite, as with certain EU decisions compelling airlines to accept the tickets of supposed competitors.

But however strong the theoretical belief in market forces, when the prospective casualties are smaller private companies, enthusiasm for the elimination contest falls away. What is emerging, without those concerned apparently grasping its sigruficance, is something tending towards the US gridiron football leagues. These have elaborate methods to ensure that the weaker teams are given a helping hand. That may be a sensible policy for airhes too, but it has little to do with the neoclassical axioms that drive current policy making.

Clear visibility Effective policy must start from reality. We should first establish the facts about compe- tition, monopoly, regulation and power poli- tics. We could then ask how the present system could be improved in the light of our chosen objectives. These would no doubt in- clude reducing fares and widening choice, but also take account of wider factors. It would become clear from any such analysis that competition is indeed a valuable mecha- nism but far from an end in itself.

A range of other proven mechanisms is available. Precisely which ones should be used depends upon our objectives. For exam- ple, regulatory pressure has done most over the years to squeeze down ex-UK fares levels, now the lowest in Europe. Moreover, the Brit- ish industry developed its strength and diver- sity under a system of enlightened regulation. This gave airlines relative stability but also allowed them wide commercial freedom. It was an environment in which the BCals, Dan Airs and Lakers could flourish. Note also that dynamic innovators like Federal Express and Southwest emerged before US de-regulation.

Experience thus shows that markets can only take us so far in air transport. It is simply impossible to scrap all regulation. The real questions are ’What are our objectives?’ ’Who is to pursue them?’ and ’What mechanisms can best do the job?’ All this requires much analysis, evidence and discussion. But most of all, it calls for a good dose of common sense 0