Merger Madness

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Not since the days when Liddy "I never saw an airline merger I didn't like" Dole headed up the U.S. Department of Transportation have there been so many carriers proposing to get together in so many unnatural ways. This time around, the result could conceivably be a U.S. market dominated by only three huge air carriers. One can imagine what would happen to the holy grail of airline competition. AVweb's Ken Cubbin did sit down to imagine what the world could look like if these proposed mergers are approved. Here's his take on what the U.S. Departments of Transportation and Justice should consider before allowing these mergers to go through.

If the Justice Department does not step in and halt the process, the U.S. domestic airline industry may soon be dominated by three mega-carriers. United may purchase US Airways, American may join forces with TWA and/or Northwest and Delta may absorb Continental or America West — at least that's the way things stood earlier this year. Perhaps next week Northwest may buy Continental and Delta may buy Alaska Airlines; who knows? To complicate matters, American has offered to buy a significant portion of US Airways and Northwest has been ordered by the Justice Department to divest its part-ownership of Continental.

Abbott and Costello Rule

Who's on first? What's on second?

Get my drift? The status quo keeps changing daily and it's darn-near impossible to keep up with who's buying whom. But it seems inevitable that there will be consolidation of the major airlines from which three mega-airlines will emerge. If the mergers are approved by the Departments of Transportation (DOT) and Justice, consumers and politicians are concerned that ticket prices may significantly rise. Are these concerns warranted? Not necessarily. At least not if the DOT and Justice follow my advice and apply stringent conditions before granting approval.

Putting aside for the moment the emerging reluctance on Capitol Hill to approve these mergers without the carriers making meaningful progress toward minimizing delays and improving customer service, I decided to use the principle of supply and demand to analyze the likelihood of rampant ticket price increases if we are left with three mega-airlines. Keep in mind that I'm a student and not a professor of economics, and that this analysis is relative to conditions I have set before the mergers receive DOT and Justice Department approval. In this case, I am the supreme arbitrator in when, how, and in what form airline mergers will be permitted to proceed.

Setting The Stage

As a condition of approving the proposed airline mergers, the DOT and Justice Department must demand that the newly formed mega-airlines divest a significant percentage of their gates at hub airports in order to facilitate niche airline competition. They must also ensure that major airlines cannot hold more than 25 percent of niche airline stock, otherwise 'puppet' competitors might be set up to regain lost slots at hubs.

Congress must forgo the impetus to re-regulate airlines despite the ranting of some self-interested politicians; however, the Justice Department must ensure that airlines do not engage in predatory pricing practices. Since predatory pricing allegations are extremely difficult to prove, the DOT will need to limit how a major airline responds to a niche airline competitor in the future. Now I know this is contradictory to my claim that there should be no re-regulation of the airlines, but this point is critical to maintaining niche market competition. Although the very nature of a free market means that competitors must be able to respond as they see fit, in this case, major airlines should be limited to matching niche market competitors fares and seats available. For example, a major airline would not be permitted to offer twice the number of flights at its niche competitor's price.

It's The Economy, Stupid...

Significant factors, such as threats of re-regulation, labor disputes, airline failures and increased fuel costs will affect the supply of airline seats in the near future. Economic indicators suggest strongly that the U.S. economy is significantly slowing and this will result in a reduction in demand for airline travel. Although the Fed has already reduced interest rates, the lag effect will mean that the economy will slow a little further before picking up by the end of this year — at least, that's the popular opinion.

1985 Southwest Airlines (SWA) buys Muse Air (takes over Dallas rival)
1986 DL buys Western Airlines (gains Salt Lake City hub)
1986 NWA buys Republic Airlines (eliminates Minneapolis/St. Paul competitor)
1986 Texas Air buys Eastern Airlines (Frank Lorenzo adds another major airline to his CA, New York Air empire)
1986 Trans World Airlines (TWA) buys Ozark (eliminates a St. Louis rival)
1986 UAL buys Pan American World Airways (PanAm) Pacific routes (U.S.A's biggest domestic carrier enters Asian market)
1987 AAL buys Air Cal (gains Californian stronghold)
1987 USA buys Pacific Southwest Airlines (PSA) (northeast airline gains Californian strong-hold)
1987 USA buys Piedmont Aviation (gains Charlotte hub and strengthens route system in southeast)
1988 Corporate raider, Carl Icahn, buys TWA
1990 AAL buys Eastern Airlines Latin American routes (gains Miami hub and becomes U.S. leader in South America)
1991 DL buys PanAm Shuttle and Pan Am's European routes (becomes major player in trans-Atlantic market and Boston-New York-Washington corridor)
1993 SWA buys Morris Air (expands by buying Salt Lake City based discounter modeled after it)
1998 SWA buys Morris Air (expands by buying Salt Lake City based discounter modeled after it)
1998 NWA buys majority stake in CA (deemed virtual merger by Justice Department and NWA ordered to divest CA's stock)
Table 1: Airline Mergers and Acquisitions After Deregulation

The U.S. economy, under the steerage of the Federal Reserve, should recover and grow at an average of 3 percent from 2003 to 2005. Given the Justice Department's new criteria for predatory pricing protection, new entrants will enter the market and mega-airlines will be unable to monopolize heavy-demand routes. As the economy picks up, demand may outstrip supply for a short period as it takes longer to add seats to the market than it does to subtract them. This will result in marginal price increases from 2003 to 2004. However, subject to oil prices stabilizing at reasonable levels in the medium term (a wild card), labor cost containment and stability in the global foreign exchange markets, supply should increase to match demand by the end of 2003.

Given the set of circumstances I have outlined, ticket prices will probably not increase in the two years after merger approvals other than for fuel price and labor price increases. In fact, United has vowed not to increase prices for two years in order to increase its chances of gaining regulatory authorities' approval. However, after that time, marginal ticket price increases will probably occur. The size of that increase will largely depend on how many new niche airline competitors have entered the market. But if the conditions I have outlined for the Justice Department and DOT to approve the mergers are set, new entrants to the market is assured.

Sound too good to be true? Let's see if I can convince you.

What Brought Us To This Present Situation?

The U.S. airline industry was transformed under The Airline Deregulation Act of 1978. Almost immediately, as can be seen from Table 1, a flurry of merger activity took place as airlines struggled to consolidate and expand their route structures.

Merger opponents declared that competition was at an end, that fares would skyrocket and service plummet as a result of deregulation. History, however, proved the pundits wrong. Ticket prices, as measured in inflation-adjusted constant 1982 dollars, have actually decreased by approximately 40 percent.

Then And Now...

1. USA passengers will gain benefits of UAL's global route system.
2. UAL's extensive east-west system will fit nicely with USA's north-south system creating the first truly efficient nationwide network.
3. USA's hubs in Charlotte, Philadelphia and Pittsburgh will add potential domestic and international route expansion.
4. Assets will be divested in Washington DC and other markets to satisfy the Justice Department and to ensure future competition from regional operators.
5. Frequent flyer programs will be consolidated offering passengers more destinations than any other airline program.
6. Travel agents are guaranteed no reduction in domestic standard base commission rates for two years following close of merger.
7. No increases to domestic fare structure for two years following close of merger, except for increases in fuel costs and CPI.

Table 2: Passenger Benefits Gained by UAL and USA Merger

After deregulation, on the supply side, new low-cost entrants entered the market, energy costs declined, labor costs were contained and more fuel efficient aircraft were brought into service.

Because aviation infrastructure has remained under government control, expansion of airports and air traffic control systems have not matched the rapid expansion of air travel. As a result, today's aviation infrastructure is strained to capacity and passenger complaints over lengthy delays and airline service have skyrocketed. For example, the DOT recently reported that 9,606 complaints about airline service were lodged in 1998; this reflects a 25 percent increase over the year before.

... Congress Reacts ...

With the passage of AIR-21, a bill signed by President Clinton in 2000 that will allocate funds to improve aviation infrastructure, improvement and expansion of aviation facilities are underway. However, airlines state that the system is strained to capacity now and the only way for them to increase efficiency in the near term is to merge. For example, UAL has issued a statement reflecting how passengers will be benefited by its merger with US Airways. These points are summarized in Table 2.

On the other hand, politicians and consumers are concerned that the current domestic market share of airlines as depicted in Figure 1 will be transformed into an oligopoly situation where the three proposed mergers (not yet determined) will dominate 81 percent of the domestic market. See Figure 2.


Figure 1, Domestic Market Share Of Major Airlines
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Click image for larger version)

Congress voted to allow the airlines time to voluntarily address passenger service problems and airlines responded by introducing a series of commitments to their passengers (See Table 3.) Unfortunately, passenger complaints are still forthcoming and Congress is once again threatening legislation — it seems that it's just a matter of time before some legislation is enacted.

...Oligopoly Attributes...

An oligopoly is said to exist when a handful of firms produce most of the output in an industry. Economically speaking, the U.S. domestic airline market is in the mature stage of development, and as pointed out by Edward Mansfield, a noted economist, "Since firms cannot maintain growth rates to which they are accustomed merely by protecting market share, there is often a tendency for firms to attack the market shares of their own rivals." Some senators have expressed concerns that a spate of mergers in the airline industry could leave passengers facing higher prices and reduced service. Those concerns are best summed up by a statement by Senator John McCain, "I cannot think of any marketplace that works better for consumers with fewer competitors."

Issue Airlines' Commitment DOT's Position
Lowest Fares To quote lowest fares available on phone and Internet. Rule on unfair and deceptive practices would apply if airline tells passenger fare is lowest when it isn't.
Refunds Try to make credit card refunds in 7 days. If refund takes more than 20 days, it is an unfair practice.
Stranding Pax Overnight Spell out and publicize policy on assisting passengers under these circumstances. N/A
Lost Bags Make every reasonable effort to return mis-routed checked bags in 24 hours. N/A
Delay Information Fliers will promptly be told about delays, cancellations and diversions. Airlines cannot lie about the reason for cancellation, but no further comments or threats made on this issue.
Ground Delays Make every reasonable effort to give food, water, restroom access and medical treatment to passengers on the ground for long periods. Not covered in report.

Table 3: Airlines' Voluntary Promises to Passengers (December 1999)

... Labor Unions ...

Historically, most airline mergers were achieved at a high cost of the acquiring airline, largely because of difficulty in melding two labor forces. For example, when US Airways acquired PSA in 1987, US Airways went from having one of the highest profit margins in the industry to the least profitable. This was largely due to large differences in pay scales and working conditions between the two airlines.

Airlines can hardly satisfy the demands of their current employees, therefore, it will be extremely difficult to meld two dissatisfied workforces. Labor problems have the effect of shifting the airline's supply curve to the left.

... Fuel Costs ...

Labor and fuel are major costs for airlines (Figure 3). Major airlines have the ability to hedge against fluctuations in fuel prices, however, some are more successful than others. Recently, airlines have increased ticket prices due to fuel costs which have virtually doubled since last year.

... Political Threats ...

Assistant U.S. Attorney Joel Klein, head of the Justice Department's antitrust division, has stated that the hub and spoke system that developed after deregulation has driven out competition in many communities. He also added that predatory pricing by the big airlines has been practiced to keep low-cost carriers out of their hubs. In my mind, there is no doubt that Mr. Klein is correct; that is why it is critical that niche airline competition be protected in the future if we are left with three mega-carriers.

In the House of Representatives, an armada of bills that would give fliers information about fares, flight cancellations, frequent-flyer awards and other benefits are in various stages of debate. However, given that the Republican party now dominates Congress, it seems unlikely that any significant re-regulation will occur in the next two years. Airlines will still be pressured into improving customer service, but I can't see a significant shift in supply occurring due to political interference in the short term.

... The Economy ...


Figure 2, Possible Aggregate Share of Domestic Market After Merger
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Click image for larger version)

There is a strong link between GDP growth and travel growth. According to Boeing, this is due to growth in the workforce and by increases in productivity and investment. GDP growth in North America will be lower than projected growth in developing nations. Recently a slowdown in the domestic economy has been suggested as imminent by indicators, such as The Manufacturing Activity Index, Index of Leading Economic Indicators, housing starts decline, a fall in auto sales, a rise in unemployment and a drop in consumer confidence.

As airlines have been purchasing new aircraft in the nineties, a severe slowdown could result in over-capacity and a need for airlines to reduce prices to maintain cash flow. If this were to occur, a price war could break out and a kinked demand curve for each airline would be evident. Basically, this just means that airlines will be stuck between a rock and a hard place - not able to increase ticket prices, and getting little benefit from decreasing ticket prices.


Figure 3, Airline Cost Index For The First Quarter Of 2000
(Click image for larger version)

However, under the leadership of Alan Greenspan, the Federal Reserve has been focused on maintaining economic growth in the region of 3 percent. Recently the Fed reduced interest rates by one-half percent after having already reduced rates by the same amount in early January. This should produce an increase in money supply that will give the economy the boost it needs without threatening to increase inflation.

President Bush has also indicated that he will urge Congress to pass a tax-reduction package that should stimulate consumption. Further, the airlines have developed more sophisticated models that now allow them to better predict demand fluctuations. With reference to Figure 4, note that the difference in airline seating supply — available seat miles (ASM) — was far more volatile and out of synch with demand — revenue passenger miles (RPM) — in the 1980s to 1992. However, from that period to the present, supply and demand have been relatively stable. This indicates that airlines were more prudent when it came to adding supply of seats choosing instead to realize better load factors. For the next five years, I am predicting a virtual match of supply and demand of seats.


Figure 4, Percent Change In RPM Vs. ASM, 1979 — 2005
(Click image for larger version)

One factor in the economy that many economists are not talking about, is the enormous increase in the wholesale cost of natural gas. Since many electrical power facilities use natural gas as a fuel, electrical power costs will also increase. This will not only impact consumers directly in the form of increased monthly expenses (reducing disposable dollars for consumption) but will significantly increase manufacturing costs. In other words, things might get a whole lot worse before they get better. Let's hope not, but you can bet that Alan Greenspan is not reducing interest rates lickety-split for nothing. He is hoping that the stimulus of lower interest rates will counteract the drop in consumption that is bound to occur for the reasons outlined above.

Conclusion

Despite the slowdown in the U.S. economy, the probability of several low-cost airline failures in the near term will mean capacity will fall to match reduced demand. In the short run, consumers may reduce their discretionary travel, and business travel may also decrease as a function of the economic slowdown. However, since it is inherently more problematic to add aircraft seats to the market (purchase new aircraft) than it is to remove them (park aircraft), there is bound to be a period where demand outstrips supply. This period should last less than one year.

UAL has pledged not to increase prices for two years after their merger with US Airways, other than for fuel costs and consumer price index, and other airline mergers are going to have to reciprocate if they hope to gain approval. There is a possibility that this promise could cause latent upward pressure on prices, particularly if labor problems at the mega-airlines significantly increase costs.

Another wild card in the national economic outlook is the energy crisis in California. Since California has such a significant impact on the nation's economy, unless some solution to its power shortages can be resolved quickly, its manufacturing base will undoubtedly realize higher marginal costs. As I pointed out before, the nation's economy could decline severely before it recovers; however, as a nation, history shows that we are incredibly resourceful. Therefore, I am optimistic that answers will be found for these problems.

The newly-formed mega-airlines might initially find it difficult to meld two labor forces; however, ultimately they should enjoy lower marginal costs due to increased economies of scale, and this should be reflected in stability in ticket prices. Labor problems tend to be easier to resolve in an economic slowdown when employees are fearful at losing their job.

I think it's critical to the future of the airline industry that the DOT and Justice Department set the stage to ensure niche market competition exists after merger approval. Prices on some routes will be way out of proportion with less competitive routes; that is the situation now and that will be the situation in the future. But if they are assured access to hub airports, any number of niche market competitors will jump at the chance to take a slice of pie away from the big boys. Just look at how successful Southwest Airlines has been at this strategy — albeit mainly through secondary airports. Therefore, providing the DOT and Justice Department limit mega-airline reaction to matching prices and seating capacity, predatory pricing tactics will not occur.

Is this limiting free market competition? Absolutely.

Most industries are regulated in various forms anyway, so having to pull the reigns in on the airlines is not unusual.
But if conditions for mergers are not set, what is the alternative?

The answer is, three airlines doing what the hell they please, raising the ire of politicians and raising the specter of full re-regulation.

Service quality has always been proportional to ticket prices, so don't expect to get any improvement in service, with or without the mergers going ahead. The bottom line is, if you want a cheap ticket, don't whine about the legroom.

If the DOT and Justice Department do not take the initiative and insist on divestiture of slots at hub airports before they approve the mergers all bets are off. Pundits who predict an increase in ticket prices coupled with a reduction in service will probably be proved correct. As an analogy, think of the quality of automobile that was forced upon us when there was such limited competition among car manufacturers in this country. Remember when a radio was an optional extra?

Of course, there are other ways to ensure competition continues, such as granting foreign airlines the right to carry passengers on U.S. domestic routes. After all, foreign competition was the way we finally got value for money in the automobile industry. Realistically, however, that is unlikely to happen unless other countries reciprocate. Therefore, the need to maintain competition among the airlines must be addressed domestically.

One final point: For those who think that the airline mergers should be categorically disapproved, think about what would happen if the mergers did not go ahead and some of the major airlines now in service went bust. For example, what if TWA stopped operating, who would pick up the routes?

Right — so what's the difference? We would still be left with fewer airlines.

But, if airlines are permitted to fail in lieu of being taken over by a willing partner, thousands of jobs might be permanently lost. You think you've got a labor problem now, just wait until the airline you work for goes belly-up.

As Shakespeare wrote in Measure For Measure:

The miserable have no other medicine
But only hope.