The threat of entry

We've just seen a classic example of how the threat of entry can impose competitive constraint on an incumbent - Air wars: Air New Zealand slashes fares ahead of Jetstar arrival.

In the airline market, it's clear that actual entry on new routes is not far away, but in the extreme case, incumbents might be held in check merely by the possibility of entry, without entry ever actually happening - the theoretical world of the 'perfectly contestable' market, where incumbents perpetually have to keep looking over their shoulder to check that 'hit and run' entrants aren't on their way.

I have to confess at this point that I get little red dots in front of my eyes when people diss the general idea of contestability. Of course it's true that the 'perfectly contestable' market is a straw man, and no regulator or competition authority in their right minds would rely on it when (say) thinking about approving a merger. But equally the general idea of contestability - which for me looks very like the reverse side of the barriers to entry coin - makes sense. My go-to resource, Viscusi/Vernon/Harrington's Economics of Regulation and Antitrust, says (p164) that "the theory of contestable markets is quite controversial", and that's certainly right, but it also says that "if nothing else, contestability has been instrumental in causing antitrust analyses to reduce their emphasis on concentration and take proper account of potential competition". Right on.

Doing so, however, is no easy matter for a competition authority, especially when it comes to the L-for-likely leg of the LET test: "The LET test is satisfied when entry or expansion in response to a price increase or other exercise of market power is Likely, and sufficient in Extent and Timely enough to constrain the merged firm" (from para 3.96 of the Commerce Commission's Merger and Acquisitions Guidelines). It doesn't want to be a soft touch - waving through every merger because it thinks someone or other will turn up sooner or later and compete effectively with the merged entity. As the guidelines say (para 3.98), "The mere possibility of entry or expansion is insufficient". Equally though it wouldn't want to go to the other extreme, either. There will be occasions (like this airlines one) when it can clearly see who's coming, and when, and how much. But there will also be occasions when there isn't a competition problem, even when the authority won't be able to tell exactly in whose colours the planes will be painted.

Isn't it strange, by the way, that every man and his dog can see the immediate and positive connection between competition and good outcomes for consumers when it comes to air travel, yet many of those same people would die in a ditch to stop the same competitive pressures bringing us better outcomes in health or education or infrastructure?

Pssst! Do you want another US$4 billion?

Deregulation of the airline industry is one of the success stories of economics from a number of perspectives (as I wrote earlier here). It's not often that the politicians take the economists' advice, and rarer still when you have well dug-in interests with a previously protected patch to defend, but deregulation of the airline business not only got adopted in the US, and subsequently internationally to a greater or lesser degree, but has worked out exactly as the economists predicted: competition increased, prices fell, choice expanded, more people could afford to fly, and consumers benefitted hugely.

Oddly enough, until very recently nobody had put a figure on the size of the consumer benefits. Step forward Clifford Winston of the Brookings Institution and Jia Yan of Washington State University, who've done precisely that. Here's the Brookings announcement about their results, and if you want the whole nine yards the announcement has links to a longer media summary and to their academic journal article in the American Economic Journal: Economic Policy.

They principally looked at the impact of the "open skies agreements" that the US negotiated with other countries over 2005-09. Their model enabled them to identify the (substantial) declines in price and increase in choice that followed deregulation: it also let them  do the counterfactual "what if" exercise of running the model as if the deregulation had never happened. In that case (I'm quoting from p396 of the journal article)

eliminating the open skies agreements on US international routes that have been signed between 2005 and 2009 would initially raise fares in all segments, with the greatest effect, 50 percent, on business and first-class fares [it was 21% on full price economy and 13% on discount economy]; reduce passenger demand in all segments and market demand [by 13% overall]; reduce the number of flights; and increase the number of carriers per route. Travelers would lose $3 billion annually, nearly $2 billion from higher fares and $1 billion from fewer flights, indicating that they gained substantially from the open skies agreements that had been negotiated during that period. As noted, we are understating the total gains because we cannot measure the additional long-run effects that would increase the initial gains.

On top of the US$3 billion of gains from the 2005-09 agreements, they also found that consumers benefitted by close to a billion dollars more from agreements negotiated before 2000. And they also extended their model to the routes where the US has yet to negotiate open skies agreements, and found that deregulation and competition would yield a further US$4 billion of consumer benefit. And there are still further gains (actual and potential) left uncounted, including the benefits from domestic deregulation in the US and elsewhere, and the benefits of open skies agreements on routes not involving the US.

The numbers show the shabbiness of airline protectionism: pre deregulation, and to this day in some countries, governments had been giving a tiny group of 'flag carriers' - sometimes just a single operator in a country - free licence to rip off their own citizens. It's both stupid and perverse (as I've previously said, here or here).

You'd  think that by now the rort would be too anachronistic to survive:  the process for all the world is as if a medieval monarch were giving his gracious consent to the trade in beaver pelts. These days, it's who is allowed to fly into or out of Shanghai or Manila, but in essence it's no different to Charles I (as I've just read in Peter Ackroyd's Civil War) deciding who should be allowed to make pens, playing cards or spectacles.

Unfortunately governments still seem unwilling to leave the airline market alone, with the latest bunfight being US airlines' allegation that some Middle Eastern airlines are being given unfair competition-distorting subsidies and the US carriers' attempt to have open skies access for Qatar and the UAE rolled back (here's the Economist's article about the issues). The multi-billion dollar consumer benefits of further liberalisation are still going a-begging.

Flying high?

Robert Litan, the Brookings economist who last year published Trillion Dollar Economists: how economists and their ideas have transformed business, has written a short article in the latest McKinsey Quarterly based on ideas in the book. It's called 'Economists: Don't leave home without one'.

One of the examples he gives of economic thinking having an enormous impact is transport deregulation, which started with deregulation of airlines in the US in the late 1970s. Not only have consumers benefitted wildly, but so have businesses. As he points out, the whole clicks and mortar world of e-commerce would likely not have got off the ground:

Had the transportation industry not been deregulated in the 1970s and early 1980s, and had the much more efficient and flexible systems built by companies such as UPS not emerged in response to competition, it is difficult to see how Internet retailers like Amazon, which came along roughly two decades later, would have been able to get started or succeed. Amazon would have had to begin with its own fleet of trucks or even planes to escape the strictures of the pre-1980 regulatory regime, a barrier to entry that almost certainly would have been impossible for new retailers to overcome.

I got to wondering if the deregulation of airlines could be seen in the prices we pay for international air travel, and the answer is, yes it can. Statistics NZ has prices series for air travel that, by happy coincidence, go back to March 1981, a little after the first US push to deregulate prices and the industry more generally. You can see them for yourself if you go to Stats' Infoshare and find your way via the Economic Indicators option to the 'CPI - Level 3 Classes for New Zealand'.

What you'll also find there is the price series for domestic air travel, and the comparison between the international and domestic air transport prices raises, for me, some disquieting thoughts.  Here's the graphical picture: I've rebased everything to 100 in March '81, and added what's happened to prices generally since then, as well as what has happened to the prices of some tradable goods (I've used footwear and new cars. I couldn't find a series for 'all tradables' that went back to 1981, so they'll have to stand proxy for what's happened to tradables more generally). For those who prefer numbers to pictures, there's also a table, where I've shown the average annual rate of price increase over the whole 1981-2015 period, and also, since the high inflation of the 1980s isn't so relevant anymore, over the period since the Reserve Bank Act went into effect (from March '90 onwards).

Some of these patterns were exactly what I'd have expected. Inflation in general has dropped since we - and the rest of the developed world - got our monetary policy act together. And I had expected international air travel prices to show only modest price increases over this period - we've had deregulation, increased competition, the rise of the budget airlines, and technological innovations in both aircraft (larger, more fuel-efficient) and airlines' own administrative systems (computerisation). International air transport prices have indeed risen very slowly over the whole period since 1981, and have actually been falling on average over the past 25 years. Other tradables - cars, shoes - show a similar pattern, where outsourcing to cheaper places in the developing world has played a large part, but international air prices have fallen even faster, and you'd have to think that the deregulatory process was one of the more important moving parts. Litan was spot on.

But then you come to domestic air transport prices, which show - to me at least - a disturbingly persistent pattern . Over the entire period, prices have risen a little faster than inflation as a whole, and over the lower-inflation post-Reserve-Bank-Act period have been rising considerably faster.

And that's rather odd, because some of the reasons that non-tradables inflation tends to be higher than tradables inflation don't apply to domestic air transport. True, you can't easily substitute an overseas product for a domestic one, just as you can't easily outsource your doctor's visit or your kids' secondary school to Vietnam or the Philippines: an ultra cheap fare between Dublin and Nice is no good when you want to go to Dunedin. On the other hand, another big reason why non-tradables tend to rise in price relative to non-tradables - it's harder to achieve the productivity gains you get in (say) manufacturing computer equipment because you can't suddenly make brain operations happen in a quarter of the time - doesn't apply. You'd think a good deal of the increases in aircraft and airline system productivity should have fed through to more modest rises in transport prices than we've seen.

So why didn't they? Much of the answer must lie in the smaller degree of competitive pressure that non-tradables like domestic air transport must face. In saying that, I recognise that there is some degree of domestic competition in air transport. Like everyone else I'm pleased to have snapped up some very low prices from time to time: on occasions, the cost of flying from Auckland to Wellington has been less than the cost of a return taxi between the North Shore and Auckland Airport. On average, however, the cheapies have not compensated for progressively higher airfares overall: in real terms, relative to the overall CPI, domestic prices are slightly higher than they were in 1981. International air travel prices, in real terms, are hugely lower. The numbers wobble around a bit, but you're paying a quarter or a third of what you would have paid back in 1981.

And I suppose there may be some good operational reasons, other than competition playing too weak a disciplinary role, why the domestic airlines haven't been able to match the falling international prices. They don't, for example, have the access to cheap secondary airports that the budget European and American carriers do: perhaps their fares have to reflect the market power of the airports. Or perhaps they've been lumbered with higher regulatory costs than your typical overseas operator. 

But you're still left with the feeling that competition isn't restraining local air prices as well as it might. It might be a coincidence, but the only time that domestic air price inflation lagged behind CPI price inflation as a whole, as you can see on the graph, was in the late '80s and through most of the '90s - precisely the period when Ansett New Zealand was most active.

Wings clipped. Good

On Tuesday the ACCC said it was minded not to allow a proposed coordination agreement between Qantas and China Eastern on the Sydney-Shanghai route (media release here, full draft decision as a pdf here).

Good. It was hard to see how they could find otherwise as the likely detriments were large and the benefits (though real) small in comparison. As the Summary of the decision noted

Qantas and China Eastern had a combined share of capacity (seats flown) on the Sydney – Shanghai route of 83% over the 12-month period from October 2013 to September 2014

...the ACCC considers that Qantas and China Eastern are the major carriers on the Sydney – Shanghai route and each other’s closest competitors. The competitive constraint they impose on each other is likely to be lost if the Proposed Conduct proceeds.

For these reasons the ACCC considers that the Proposed Conduct is likely to result in significant public detriment. It is likely to give Qantas and China Eastern an increased ability and incentive to unilaterally reduce capacity, or limit growth in capacity, relative to that which would occur in the absence of the Proposed Conduct, thereby allowing the Applicants to increase airfares on the Sydney – Shanghai route

The ACCC considers that the Proposed Conduct is likely to result in a range of public benefits. However, the ACCC considers that the magnitude of these benefits is likely to be limited.

The ACCC considers that on the Sydney – Shanghai route the extent of the reduction in competition, and associated public detriment, is likely to be significant and outweigh any benefits of the Proposed Conduct.

The airline industry, left to its own devices, can be too clubbable by half, and there's a very strong argument for regulators outside the industry, like the ACCC or the Commerce Commission, to be an arbiter of proposals like these: we need someone to take the pro-consumer, and not just the pro-industry, line. I don't know exactly what "regulatory approvals" Air New Zealand says it needs for its proposed coordination with Air China, but I hope they include our competition authority.