Deregulation of the Airline Industry - Research Paper Example

? College: Introduction Deregulation refers to the simplification or removal of government regulations and rules that constrain free operations of market forces, the term does not primarily mean elimination of the laws that protect property rights no does it mean the reduction of government control in business activities to create a Laissez-Faire or free kind of market. Deregulation simply implies scaling back the state roles in a given sector or industry in the economy (Collier and European University Institute 3). Deregulation is different from market liberalization, which mainly involves more market players entering the market, deregulation touches on regulation and the guaranteeing consumers their rights on the minimum and maximum prices offered in the market as determined by supply and demand forces. A good example of deregulation is the airline and the telecommunications industries in most countries including Europe and United States. Deregulation often arise from economic agents who identify failures and problems in their regulatory framework, add pressure to the norms shaking the existing rules of game through institutionalized and legitimized logics change. As mentioned by Collier and European University Institute (1998, p. 3), two forces that have been key in driving pressure for change in industries that have embraced deregulation are the rising concern about negative impacts of economic regulation particularly on industries’ competitiveness, this has resulted in the drive for deregulation that focuses on the liberalization of the industrial sectors and privatization of some of the state-owned firms. Emphasis has particularly been on breaking monopoly powers and enhancing competition, while this has been critical, it has also been important for governments to identify the environmental implications of deregulation in sectors like energy where free market forces and competition influences technology as well as fuel prices. The other factor that has been key in driving deregulation has been the command-and-control measures of environment and their effectiveness that have been highly scrutinized. Government intervention with policies and standard has been viewed as insufficient and too lax and this has driven the need for deregulation. Deregulation of the airline industry Airline market was one of the heavily regulated public utilities in the past few decades. Regulatory reform has been central in most countries’ economic policy trend since mid-1970s, airline deregulation rose from the failures of countries to arrive at multi-lateral settlement on pricing, traffic rights, and capacity mainly in Geneva in 1947, and in Chicago in 1944 that mirrored the protectionist policies and rules that hindered entrepreneurial and competition activities (Winston 1263). Regulation of the mentioned aspects therefore became central in bilateral negotiations held by governments and airlines, these negotiations have seen dramatic changes whereby traffic rights are settled by states’ bilateral agreements, control of frequencies and capacity became subject to bilateral state agreements or to inter-airline agreements, tariffs setting came to be done by the International Airline Transport Association (the IATA). Airline industry in Europe is one of such cases in the economic policy reforms. Deregulation began as essential economic decisions concerning traffic rights (entry), capacities as well as pricing were ruled by either suppliers (representatives) or the governments. U.K and U.S signed the 1946 Bermuda agreement that opened for future agreements increasing freedom rights and ending the frequency and capacity controls (Collier and European University Institute 13). Bermuda agreement did not explicitly indicate that tariffs setting were to be done by IATA, in 1978, U.S. signed the act on domestic airline deregulation and this put pressure to the international airline regulatory system resulting in various bilateral negotiations in 1970s that focused on general international deregulation. The process resulted in gradual liberalization of the U.S to and from routes that in turn affected other countries bilateral including U.K Canada agreement of 1987 and U.K-Netherlands agreement of 1984 (Button and Swann 259). This liberalization was however localized and uncoordinated and most countries except U.S. were reluctant to renegotiate the bilateral systematically and more eagerly. Deregulation in the airline market in Europe Airline industry in Europe was initially completely regulated until towards the end of 1980s and was characterized by some restricted bilateral consisting of market sharing often with revenue pooling, fare agreements, and capacity control. European airline industry was under stringent regulation before 1980s. Deregulation occurred in the airline market in two main ways; first it occurred through liberalization of the bilateral between the individual states, the UK and Netherlands agreement set standard for more liberal bilateral (Button and Swann 261). Towards the end of 1980s, European Union began developing a deregulatory policy to guide the airline market, unlike the U.S counterparts whose airline deregulation was rapid, European airline market deregulation proceeded step by step in what is commonly known as deregulation packages. The 1987 gradual liberalization package marked the first step through the signing of Rome Treaty, this granted European Commission power to give exemptions to rules on tariffs, capacity sharing, and revenue pooling. Exemptions to some important categories of the agreements reflect EC’s gradual approach to persuading member states to embrace and accept future progressive liberalization. These exemptions were limited in duration. Liberalization measures became significant and played a great role in preparing for other EU aviation packages. Effects of Europe’s airline deregulation Deregulation of European airline market has brought great changes in the market, it has acted like a barrier to exit and entry to the market and this makes broad distinction between dynamic and static effects, in terms of static sense, competition has been narrowed down conferring some degree of monopolistic power to European airlines, economic theories have predicted higher prices and lower output in the deregulate airline markets than in the regulated environments but these markets have shown great competitiveness (Winston and Morrison 8). In the dynamic sense, deregulation creates an environment for innovation, which is often inhibited by regulation, it allows for optimization of business processes through reducing competitiveness in the industry, this is reflected by lower costs, higher service quality and customer satisfaction. Regulation combines high prices and high costs and therefore does not result in high profits as opposed to deregulation. This characterization has been found relevant in European airline industry. Effects of deregulation approach to airline market operations shows that new airline firms have entered the market and the capacity has significantly increased capacity, deregulation involves pricing freedom, it has caused downward pressure on prices as well as yields. Change in the structure of carriers’ routes is deemed one of the significant results of airline deregulation in Europe. Under the regulated market, airlines had to operate a kind of point-to-point network following restrictions on routes. Airline deregulation has brought about a hub-spoke kind of network whereby a hub is established as the centre of a shaped network where passengers are flown before being connected to the flight of destination (Winston and Morrison 9). The shift has been crucial in operations explaining the cost considerations, demand conditions, and economic motivation for the routes restructuring. Under the regulated market, designated carriers fly customers from one point to another in the established network, where the points in the network have equal and constant demands; an airline is challenged to meet the demand by taking a number of flights in a day. However, where the airline industry is deregulated, airlines may fly customers on any route across the network established, the airlines may consider adopting hub-and-spoke network rather than fully-connected network. There are various advantages of such operational changes, this is particularly in cost considerations, aircrafts capacity could be larger than demand where the demand has significantly changed, by operating hub-spoke network, aircrafts can meet similar origin-destination demand for transport at and save marginal costs associated with point-to-point network operation (Winston and Morrison 10). Passengers may not like extra effort and time related to hub-spoke network and this challenges airlines to compare cost savings with possible losses in demand. Hub-spoke network should be warranted where scope of economies has been identified as sufficient to offset the possible losses of revenue. Economies of scope bring about cost saving through the altered route structure depending on the efficiency of aircraft utilization (Winston and Morrison 11). Airlines can utilize the saved capacity to increase frequency and attract more travelers in the market. Revenue losses are determined by travel time changes, relevant demand elasticities, and frequency changes. There are however some cost penalties linked with hub-spoke operations, of significant is the is the increased passenger handling costs arise from connecting them board and disembarking them twice instead of once, Hub-spoke network mainly involves more take-offs and landings that increase landing charge expenses and unit costs(Winston and Morrison 10). In addition, hub-spoke operations requires that flights from various spokes meet at the particular hub at the same period, the system depicts waves of arrivals that are followed by waves of departures and this constitutes complex system of operations as flights must take the shortest possible transfer time. Peak of activities at hub’s airports demand additional cost of extra handling capacity. Cost savings rise from improved utilization of aircrafts but in reality, economies of size are more likely to determine cost savings where unit costs decrease with the size of the aircraft being big. Gains arising from the demand side however override the costs related with increased frequencies across the hubs and spokes. The airlines are able to dramatically increase the number of their city-pair markets in which they operate hub-spoke network, given that a hub comprises of n links, number of markets that are connected via that hub can be given by n(n-1)/2 function, which is a quadratic type of function. Depending on the links operated, a hub-spoke network optimizes the markets served. In addition, hub-spoke networks provide a strategic advantage through the incumbent carriers and the potential entrants, incumbent carriers use these hub-spoke networks as the entry deterring instruments (Button and Swann, 264). Hub dominance helps carriers to charge high prices and therefore earn monopoly rent on the routes that end at the hub. This is the strategic advantage of operating hub-spoke network for airlines in Europe and other countries like U.S. notwithstanding the costs added by operating a hub-spoke network, the associated benefits are by far significant especially in terms of higher market share, increased efficiency in capital or fleet utilization, and strategic advantage. Deregulation has great impact on price and the market structure of airline industry at Europe, economic theory has argued that deregulation influences market equilibrium given its effects on entry and pricing, for instance, deregulation aims at ensuring decline in fares since it allows for increased competitiveness. This is not the case in the regulated market where prices are fixed by the concerned government authority through liberal or competitive agreements. In the deregulated market, incumbent carriers collude and they fix the prices thus allowing for maximization of joint profits. Price competition allows for marginal cost pricing and this often leads to decline in prices after deregulation (Button and Swann, 272). Deregulation allows for creation of duopolists and they earn positive profits, sometimes customers may not even be able to different seats of the two competing airlines, however, the paradox is solved through introduction of capacity constraint. As described by Edgeworth model, multi-period variant shows that one duopolist in a deregulated market may have less capacity than the market demand while the other one may have capacity that is equal to the market demand. In such a case, the second duopolist can the counterpart sell out first, after that he can charge a profit maximizing price in the market, this is an optimal policy in such a case. Where the second duopolist does not do so, the two would engage in a price competition and have zero profits. The deregulated market allows airlines to adjust their market pricing strategies to fit the competitive conditions in the various route markets. Conclusion This study has examined deregulation providing a brief introduction into the topic and has selected European airline market. the study has explored how deregulation occurred in the European airline market and the various effects that deregulation has had in the market including enhanced competitiveness, effective pricing strategies, increased frequencies, cost saving and efficiency in the airlines (Winston 1281). The study is relevant to airline industries that may wish to explore the benefits of deregulation and those that may wish to deregulate their markets. Deregulation has had both positive and negative impacts but its positive gains far override the negative effects making it a viable option for airline markets across globe. Works cited Winston, Clifford. Economic Deregulation: Days of Reckoning for Microeconomists. Journal of Economic Literature, 31, 1263-1289, 1993. Button, Kenneth and Dennis. Swann. European Community Airlines - Deregulation and its Problems, Journal of Common Market Studies 27(4), 259-282, 1996. Collier, Ute and European University Institute. Deregulation in the European Union: environmental perspectives, New York, Routledge, 1998. Winston Clifford and Morrison, Steven. The economic effects of airline deregulation, Washington, DC: Brookings Institution Press, 1986. Read More