Case E6
Airline Deregulation in
the USA and Europe
A case study of contestable markets
If a market is highly contestable, the mere threat of competition may be successful in keeping
prices and profits down. Of course, established firms would not like this! They would be keen
to erect barriers to entry and to make exit more costly for any firm that did enter.
Governments around the world are generally in favour of increased competition and
frown on the erection of entry barriers (see Chapter 21, section 1). This means that they
generally prefer not to intervene if markets are competitive or highly contestable, but may
attempt to regulate the prices, profits or behaviour of firms where competition or
contestability is limited. Conversely, if markets have been regulated and yet are potentially
competitive, many governments have then deregulated them (i.e. removed regulations).
A good case study of deregulation and contestability (or lack of it) is the airline industry.
The USA
The airline industry in the United States has been deregulated since 1978. Prior to this, air
routes were allocated by the government, with the result that many airlines operated as
monopolies or shared the route with just one other airline. Now there exists a policy of ‘open
skies’.
Initially the consequences were dramatic, with lower fares and, over many routes, a
greater choice of airlines. The Brookings Institute calculated that, in the first ten years of
deregulation, the lower fares saved consumers some $100 billion. One consequence of the
increased competition was that many US airlines went out of business. Gone are famous
names such as Eastern and PanAm. In the depth of the 1992 recession, 32 American carriers
went out of business.
Even where routes continued to be operated by just one or two airlines, fares still fell if
the route was contestable: if the entry and exit costs remained low. In 1992, despite the
bankruptcies, 23 new carriers were established in North America, and many routes were taken
over by existing carriers.
But deregulation did not made all routes more contestable. In some cases the reverse
happened. In a situation of rising costs and falling revenues, there were mergers and takeovers
of the vulnerable airlines. By 2000 just seven airlines accounted for over 90 per cent of
American domestic air travel, compared with fifteen in 1984. With this move towards greater
monopolisation, some airlines managed to make their routes less contestable. The result was
that airfares over the 1990s rose faster than prices in general.
A key ingredient in making routes less contestable was the development of a system of air
routes radiating out from about 30 key or ‘hub’ airports. With waves of flights scheduled to
arrive and depart within a short space of time, passengers can make easy connections at these
hub airports.
The problem is that several of these hub airports hub airports became dominated by single
airlines which, through economies of scale and the ownership or control of various airport
facilities, such as boarding gates or check-in areas, could effectively keep out potential
entrants. The problem was worse in congested airports where room for a new entrant could
only be made if existing airlines cut back their flights: something they will obviously resist.
By 2002, at 15 of the hub airports, including some of the busiest, the dominant airline had a
market share in excess of 70 per cent.
The airlines have also used measures to increase ‘customer loyalty’ and thereby make
entry barriers higher. These measures include frequent flier rewards, deals with travel agents
and code sharing with ‘partner’ airlines.
In the 2000s, however, the domestic US airlines market has become more competitive
again, thanks to the growth of low-cost carriers (LCCs). These accounted for just 7 per cent of
US domestic passengers in 1990. By 2006 this had risen to over 25 per cent. With operating
costs some 25 to 50 per cent lower than the large hub-and-spoke carriers, they have become a
highly effective competitive force on routes between city pairs. The competition has forced
the major carriers to cut their own prices on these routes.
A danger here is that big airlines may undercut the prices of small new entrants so as to
drive them out of the market. Such ‘predatory pricing’ (see page 150), however, is illegal and
the Department of Justice has begun investigating several cases.
Europe
Until the early 1990s, the European air transport industry was highly regulated, with
governments controlling routes. National routes were often licensed to the national airline and
international routes to the two respective national airlines. Since 1993, the industry has been
progressively deregulated and competition has increased, with a growing availability of
discount fares. Now, within the EU, airlines are free to charge whatever they like, and any EU
airline can fly on any route it wants, providing it can get the slots at the airports at either end.
As in the USA, however, whilst increased competition has benefited passengers, many of
the airlines have tried to make their routes less contestable by erecting entry barriers.
Predatory pricing has occurred, as the established airlines have tried to drive out new
competitors. What is more, the proliferation of fare categories has made it hard for consumers
to compare prices, and established carriers’ highly publicised fares often have many
restrictions, with most people having to pay considerably higher fares. As in the USA, code
sharing and airline alliances have reduced competition. Finally, at busy airports, such as
Heathrow, the shortage of check-in and boarding gates, runways and airspace has provided a
major barrier to new entrants.
Nevertheless, low-cost airlines, such as easyJet, Ryanair and FlyBE, have increasingly
provided effective competition for the established national and short-haul international
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carriers, which have been forced to cut fares on routes where they directly compete. Low-cost
airlines have been able to enter the market by using other airports, such as Stanstead and
Luton in the case of London, and various regional airports throughout Europe. The question is
whether the middle-sized national carriers, with relatively high fixed costs, will be able to
survive the competition. The filing for bankruptcy and subsequent baling out of Swissair and
Sabena (the Belgian airline) following the September 2001 attack on the World Trade Center
in New York, illustrates the vulnerability of such airlines. It is likely that several of the
medium-sized carriers will have to merge or be taken over by a big carrier.
Questions
1. Make a list of those factors that determine the contestability of a particular air route.
2. In the UK, train operators compete for franchises to run services on a particular route. The
franchises are normally for 7, 10, 12 or 15 years. The franchise specifies prices and
minimum levels of services (frequency, timing and quality). Would this be a good system
to adopt in the airline market over particular routes? How is the airline market similar
to/different from the rail market in this regard?
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