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Prix fixe: is airline consolidation to blame for sky-high airfares?

After a wave of mergers, few large US airlines remain. Delta planes via www.shutterstock.com

Prix fixe: is airline consolidation to blame for sky-high airfares?

After a wave of mergers, few large US airlines remain. Delta planes via www.shutterstock.com

News last month that the Department of Justice is investigating the biggest three US airlines for possible price-fixing again raises the question of whether the recent wave of mergers has left the market with too few competitors.

A case in point is the sharp drop in oil prices over the past year, which should lead to a decline in airfares. While I was cautiously optimistic that this might happen, I suggested in December that the lack of industry competition would likely prevent fares from following crude prices lower.

Air travelers are probably well aware that this is exactly what happened.

The most recent Department of Transportation data show inflation-adjusted airfares in the fourth quarter were 2% higher than a year earlier, even though the price of jet fuel was down 25% over the same period.

Fuel makes up about 30% of an airline’s total expenses, so a 25% decline in jet fuel prices implies a 7.5% decrease in costs, all else being equal. So is reduced competition to blame for airlines not passing on these savings to passengers in the form of lower fares? And are airlines colluding on price?

The answer to those questions is not as simple as it looks, in part because competition is more than just a question of numbers (10 airlines versus three) and some collusion is actually legal.

Let’s begin by looking at how the US airline industry has consolidated in recent years.

Consolidation and competition

Over the last 15 years or so, the airline industry experienced six large mergers (most notably Delta-Northwest, United-Continental and American-US Airways), the disappearance of several smaller carriers (Aloha, ATA, National) and two successful entries (JetBlue and Virgin America).

That has left us with three large carriers (American, United and Delta) that run hub-and-spoke networks featuring multiple hubs, several airlines that rely more on point-to-point traffic (Southwest, JetBlue, Virgin America) and a few smaller hub-and-spoke players, such as Frontier and Alaska Airlines.

This is part of a global trend, with carriers in both Europe and China, for example, consolidating toward a similar structure. Transatlantic routes are dominated by three joint ventures that together control more than 75% of all passenger capacity.

Of course, the total number of carriers alone does not necessarily correlate with the extent of competition. We might have 10 carriers in the US market but no competition because they don’t compete directly on any routes. On the other hand, we could have just three airlines competing on every route in the country.

Indeed, looking at average market concentration in the US over the past 25 years or so, we see that most nonstop routes are monopolies, a constant that exists regardless of how many total airlines operate across the country.

For example, if you live in Atlanta, the airline most likely to serve any given destination with a nonstop flight will be Delta.

Certainly, “thick” markets such as Los Angeles to New York have attracted a lot of carriers, but “thin” routes such as Atlanta to Albuquerque might only be able to sustain nonstop service of a single carrier, with many passengers connecting at Atlanta to other Delta flights.

In fact, city pairs where only one-stop services are feasible have historically been less concentrated markets as compared with those where nonstop flights are offered. When I lived in Orange County, California, I usually flew from the local John Wayne Airport, connecting to East Coast destinations and beyond via Chicago, Atlanta, Salt Lake City, Denver, Houston or Dallas, depending on the airline.

A passenger living in Orange County now has the same choice of hub airports to connect through as before, but fewer airlines providing such a connection. In a paper I published recently with Paulos Lakew, we demonstrated how airline mergers can disproportionately hurt smaller communities via a reduction is such one-stop competition.

Concentration versus conduct

A rule of competition is that how fiercely companies will end up competing is determined by how easily customers can switch between their products or services. For instance, an airline offering a flight at a time convenient for business travelers may be able to command a higher price than a carrier with a flight to the same destination at a less convenient time, since business passengers may not view the two services as comparable.

So even when multiple airlines offer the same nonstop route, passengers may not view them as interchangeable: one appeals to business travelers, the other to leisure fliers. A 1997 academic study demonstrated that airlines do seem to schedule their flights at different times to avoid price competition.

Another way the appearance of competition may fail to put pressure on prices is through frequent flier programs. Passengers vested into an airline’s loyalty program are often willing to pay a premium for trips with the preferred carrier.

Tacit collusion and soft competition

The key to understanding competition in the airline industry is to realize that several airlines compete year after year and on many markets in what economists call a multi-market contact.

This typically leads to what is known as tacit collusion, in which competition is minimized without any explicit agreement among the market participants. The fewer the number of companies in the market, the more likely there’ll be tacit collusion.

In the airline industry, it means carriers don’t compete aggressively (they keep fares higher and frequency of service relatively lower) in anticipation that competitors will respond in kind. On the flip side, an airline would punish a rival that does not hold up its end of the implicit deal by competing very aggressively.

While explicit collusion in which competitors agree on prices is illegal, and is in fact what the DOJ is investigating some airlines for doing, the tacit kind is perfectly legal.

And the more multi-market contact there is, the more likely you’ll have this tacit collusion and softer competition. In other words, imagine two companies that compete on a wide variety of markets. In some, company A is stronger, in others, company B is dominant. The companies thus have an incentive not to compete too aggressively where they are stronger because it might invite retaliation in markets where they are weaker.

The DOJ itself helped foster this environment in recent decades. It approved each merger after reviewing the overlap of the partner airlines' network, finding little. Thus, it would appear that competition wouldn’t be hurt if they tied up. But at the same time, all these mergers created more multi-market contact throughout the industry, making tacit collusion more likely.

Let’s say, for the sake of example, a decade ago American Airlines competed with Northwest in 100 markets and with Delta in 70 separate markets. After Delta and Northwest merged in 2008, American would now be competing against the combined airline on 170 markets.

The actual amount of multi-market contact is much higher. According to my calculations, American and Delta are both present on over 1,000 airport-pair routes, if we consider both nonstop and one-stop markets.

We are yet to understand the extent to which these increases in multi-market contact might have softened the competition on the US airline market.

So is there enough competition left?

In the end, airline consolidation is a mixed bag. It has led to the disappearance of a number of carriers (in particular, three large network carriers have left the industry through mergers in the last decade), which means less competition and a greater potential for tacit collusion on prices, but also increased efficiency and lower costs (for the airlines), which are sometimes passed along to consumers.

The DOJ is right in paying increased attention to the airline industry – preventing abuse of market power is, after all, its job. But the environment in the industry appears ripe for softer competition to emerge even without explicit price agreements between the carriers. The absence of lower fares in response to substantially lower jet fuel prices is clearly not a good sign.

Unfortunately, there is not much more that the DOJ can or should do. It would be very difficult to make a convincing case for breaking up any of the large network carriers, and price regulation is clearly not an option in the US.

In the longer term, market forces will prevail. If the airlines continue to profit (US carriers are forecast to make US$15.7 billion this year), that may lure new entrants onto the market, creating a more competitive environment.

That may be consumers' only hope for more price competition.