Thursday, April 10, 2008

Competition, open skies ...and bust?

Shyam Ponappa / August 4, 2005

Worldwide, large airline companies have become fewer in number, with wafer-thin margins

Ten years ago, Fortune magazine carried an article questioning the free market paradigm for airlines (“Why Air Travel Doesn’t Work,” Timothy K Smith with Ronald B Lieber, April 3, 1995). In India, it is time to revisit this question. Not rhetorically but with serious interest, to help decide how certain sectors should develop in order to better facilitate stable, productive economic activity.

The article was about the little-known but powerful concept of the “empty core” in game theory. In its simplest form, the implication is that if a capital-intensive sector with scale economies and high sunk costs (that are not recoverable on exit) has too many suppliers, they will undercut each other to create turbulence without stability; this is the “empty core”.

Interestingly, ocean liner companies recognised since their inception in the 1870s, as did governments, that the structure of the market precluded free-market entry and exit (William Sjostrom, “Liner Shipping: Modelling Competition and Collusion,” in Handbook of Maritime Economics and Business, Costas Th Grammenos (ed), London: Lloyds of London Press, 2002, pp. 307-326, “Shipping conferences” have been setting (“fixing”) prices since then.

The regulatory structure of the industry allows carriers to collude on pricing free from antitrust scrutiny. This is because economies of scale, and the fixed costs of the business, e.g. ships, just like aircraft for airline networks, or rolling stock (and rail) for railways, or assets in the energy industries, are very large compared to the marginal costs of servicing an additional customer.

While price theory leads us to expect that cartels would be unstable and disintegrate, shipping conferences survive. The reason is that their business has an empty core. No stable equilibrium is possible through free-market pricing when there are many players in a sector with scale economies, because unstable coalitions form to cut prices in a downward spiral. This is unlike what happens, for instance, for consumer goods such as soap or toothpaste, where the startup and exit costs are not as high.

What the article in Fortune posited then is coming to pass. Worldwide, large airline companies have become fewer in number, with wafer-thin margins supporting huge investments teetering on the brink. There are two kinds of exceptions, however.

The first is the cherry pickers who select high-traffic city pairs for remunerative services, while ignoring the needs of people elsewhere, like Jet Airways was until recently in India, or Southwest Airlines is in America. In India, an ever more emasculated Indian Airlines served the less remunerative towns, while starved of capital for aircraft and all that goes with that condition in running a business.

Ergo, Jet has grown from 4 to 50 aircraft and 42 per cent of the market, while IA at 38 per cent has shrunk from a dominant position to less than half the market, and has bled half to death. In the US, there were the hub-and-spokes of United Airlines, American Airlines, and Delta, as against the city pairs of Southwest Airlines.

The second type of exception comprises the low-cost airlines that perpetuate the turbulence of an empty-core market. These aberrations are accentuated by regulated easy access (e.g. common carrier access) given to small players, associated with under capitalisation and easy credit, as well as overproduction of assets.

The uncertainties are similar for all capital-intensive, cyclical industries, whether for automobiles, energy, or forest products. The need to treat infrastructure differently, however, arises because of its significant effect on productivity across all other sectors.

Viewed in this manner, it becomes apparent that instability in infrastructure is very damaging to overall productivity, with a multiplier effect on other sectors. Other than transport (air, rail, water, roadways), other infrastructure sectors include energy, telecommunications, basic education, and health, and at the next level, basic financial services.

Absent some kind of conspiracy of silence, it is difficult to understand why there is so little media coverage and interest in research in core theory, given its potentially iconoclastic findings. Perhaps core theory is still little-known largely because it goes against the present market orthodoxy, i.e. the ideology or dogma of free markets and free trade. Whatever the reason, there is insufficient application of this concept that is at the crux of competition and regulation.

It behoves us, therefore, to not accept uncritically the received wisdom of free market theology (or Marxism, for that matter!), for India has to find and make its own economic way. It helps if we make informed choices. In the sequence of analysis, the first steps are “what are the facts” and “how best to understand them”, and core theory is an essential construct in this process.

Political or philosophical frames of reference can follow. Before deciding on the approach to privatisation, competition, or regulation, we and especially our policy makers need to understand this concept and its effects.

Academics such as Lester Telser, Kenneth Button, William Sjostrom, and Hercules Haralambides have done considerable work on core theory in several sectors. We could use their findings to help make decisions on competition, open skies, and in general, for all enabling sectors. The aim: to balance better customer choices and lower prices (efficiency) through competition, with scale economies and network effects.

This will help to more consciously develop our economy to the extent that we are able to solve the “independent regulator” dilemma, i.e. where necessary, resort to restricted rather than open competition, because limited competition with good regulation could yield the greatest public benefits in empty-core sectors. The challenge will be to set up truly independent regulation systems and fill them with good people. The difficulty of both should not deter us.

We have tremendous assets in our public sector, and the way forward may be to try to build on their strengths too, not arbitrarily constrain them (airlines, energy companies) or view privatisation as a panacea.

Then, these enterprises could strive for and develop the best professional management, and seek strategic alliances to help build and keep a leading edge. This could be combined with getting the right mix of public participation in ownership and profits, with the government positioned for strategic trusteeship as well as revenues for expenditure for the public interest.

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