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The Evolution of the Aviation Industry: Lessons Learned?

The Evolution of the Aviation Industry: Lessons Learned?

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An essay for the 2011 Undergraduate Awards (Ireland) Competition by Jennifer Cowman. Originally submitted for bess at Trinity College, University of Dublin, with lecturer Dr. Sean Barett in the category of Economics
An essay for the 2011 Undergraduate Awards (Ireland) Competition by Jennifer Cowman. Originally submitted for bess at Trinity College, University of Dublin, with lecturer Dr. Sean Barett in the category of Economics

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Published by: Undergraduate Awards on Aug 31, 2012
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Economics, as the „science of constrained choice‟, is primarily concerned with efficiency. Thus competition,
through deregulation and contestability strikes at the heart of economics and particularly the transport paradigm.In order to explore the theory of deregulation and contestability and indeed extrapolate its value, this paper willexamine the aviation industry. It will begin by briefly discussing the historical evolution of the industry withrespect to deregulation before examining the effects which have been derived from such a process. SubsequentlyI will expand on contestability theory, identifying its principles evident within the aviation industry. Finally Iwill consider three sectors, namely medicine, pharmacy, and medical insurance, which could learn from theevolution of this industry. To conclude I will summarize my findings in the context of the regulation debate.
The Aviation Industry; A Regulatory Transition
In this section I will consider how deregulation emerged and evolved within the aviation industry. I will do thisfirstly with respect to the US, the birth place of airline deregulation and subsequently in the context of theIreland which is arguably the most dramatic and successful example of airline deregulation (Barrett, 2008b).Prior to deregulation, the Civil Aeronautics Board (CAB) imposed strict regulation on the US airline industry bycreating barriers to entry and exit; while new firms were prohibited from entering the industry, existing firmswere forced to service routes which many airlines deemed unviable (Borenstein, 1992). In addition the CABemployed other means of regulation such as price controls, business structure restrictions, service qualitymandates, financial controls, cargo regulations and employment procedures (Thierer, 1998; Sinha, 2001;Pickrell, 1991). Thus the American airline industry was essentially regulated in every conceivable manner, theconsequence of which was retarded competition and blatant inefficiencies (Thierer, 1998; Sheth et al, 2007;Dobson, 1995; Kahn , 1988). This view was confirmed by Alfred E. Kahn, the former CAB chairman, who wasto become the tour de force behind airline deregulation;
“thousands and thousands of restrictions on where you
must land and how many stops you can make before you land and what percentage of your trips can be off-route
and who has the right to do what and with which and to whom”
(Thierer citing Kahn, 1998:3).The shift toward deregulation
began in 1975 when CAB, at the behest of John Robson the newly elected CABchairman, returned to experiments in price discounts or
“Super Saver”
fares, a practice which it had previouslydeemed as a violation of its mandate to deliver fair prices (Sinha, 2001: 106; Borenstein, 1992; Winston, 1993,1998; Pickrell, 1991; Button, 1991)
The movement gained momentum when CAB began to introduce freedom of entry, a policy which precipitateda backlash from some of the entrenched incumbents who proceeded to sue the regulatory body for allegedlybreeching its congressional mandate (Borenstein, 1992). However the proceedings were halted by the AirlineDeregulation Act in 1978 which sought to reinstate free competition (Borenstein, 1992; Schwieterman, 1985;Poole & Butler, 1999; Sheth et al, 2007). The act, signed on October 24
1978 by President Carter, abolished allregulations which the CAB had previously employed to hinder competition, including but not limited to theremoval of prices controls, entry and exit restrictions and route authorization (Thierer, 1998). Deregulation of the US airline industry was completed in 1984 when the removal of all remaining restrictions on price, entry andexit were implemented (Winston, 1998; McCarthy, 2001). Furthermore, illustrating a rather symbolic stance forderegulation, the CAB was abolished by Congress, with its remaining roles transferred to the Department of Transportation (Pickrell, 1991).At the heart of US airline regulation and indeed deregulation was the CAB itself; this dramatic and autonomousshift can be traced back to Kahn and his predecessor Robson, both of whom saw beyond the status quo andacted in the public interest. It was arguably this distinct change in value judgements which lead to deregulation,not just in the US but across the globe.We can illustrate the diffusion of the deregulation model with reference to the Irish case, the significance of which was noted by Barrett (2008b:573);
Deregulation refers
to “
the states withdrawal of its legal powers to direct the economic conduct (pricing, entryand exit) of nongovernmental bodies
” (Winston, 1993:1263
“No country adopted more enthusiastically than Ireland the policy of 
airline deregulation...No country had 
more dramatic results from aviation deregulation than Ireland”
The context of airline regulation for Ireland differed to that of the US, in that Ireland is a small island withlimited domestic air travel, thus it was the international forum which was to become key for airline deregulation.This however was subject to bilateral aviation agreements whereby air travel between countries was determinedby an agreement between two governments that restricted both prices and supply (Barrett, 1996, 2008b; Pryke,1987; Button & Swan, 1991; Williams, 1994; Doganis, 2002). Furthermore barriers to entry were created by thestipulation that international air travel was restricted to one national airline (Barrett, 1996, 2008b; Williams,1994; Pryke, 1987; Button & Swan, 1991; Doganis, 2002). Thus, despite the diverging context between Irishand US regulation, the extent to which the industries were regulated was similar; price controls, supply controlsand barriers to entry and exit
.In 1984, just as airline deregulation was completed in the US, Transamerica Airlines was prosecuted forbreaching the price controls established by the Minister for Communications (Barrett, 1997, 2008b).While theinjunction was upheld it was
determined that the Minister didn‟t have jurisdiction over travel agents (Barrett,
2008b). In responding to this threat against Irish airline protectionism, the Irish government created the AirTransport Bill which sought to extend the existing legislation so that all airline fares relating to the Irish marketcould be regulated (Barrett, 1997, 2008b). However the act elicited a strong yet negative reaction fromeconomists and members of parliament alike, and the legislation failed.Over the next year a broader shift in public opinion regarding deregulation took place; the success story of theUS had reached the Irish shores and the nostalgia surrounding Aer Lingus was beginning to dissipate (Share,1986; Barrett, 2008b). In October 1984, for the first time, Aer Lingus price requests were rejected, a feat whichwas to become the first move toward market liberalization (Barrett, 2008b). Subsequently Ryanair, a new Irishairline, was permitted to service the Waterford Gatwick route; however deregulation, and indeed Ryanair,finally had its day on May 23
1986 when the Irish government allowed new entrants on the Dublin andLondon- Luton route.Irish airline deregulation proceeded after the unprecedented success of its 1986 debut, with the remainingIreland UK routes opened up to new entrants in 1993-1994 (Barrett, 2008b). Subsequently, the routes tomainland Europe were deregulated in 2006, with new entrant Ryanair engineering low prices which undercutthe incumbent, Aer Lingus, by over 90% (Barrett, 2008b).The most recent progress in airline deregulation concerns both the Irish and US markets; the EU/US open skiesagreement will increase the number of routes between these two countries (Barrett, 2008). In addition it willabolish the compulsory stop in Shannon, the last remaining vestige from the days of protectionism when AerLingus was forced to masquerade as Aer Linte for all US bound flights (Barrett, 2008a, 2008b).
Gains of Airline Deregulation
The benefits of airline deregulation have been similar worldwide, thus I will examine the US and Irish marketsin terms of the main gains derived from airline deregulation.
Price Gains
Perhaps the most remarkable gains which arose from deregulating the aviation industry is that of price. In bothmarkets the price of air travel has fallen by 40 and 75% in the US and Ireland respectively (Thierer, 1998;Barrett, 1996, 1997). I
t‟s estimated that the US cons
umer saves in the region of 6.6 billion dollars
per annum(Winston, 1993).
Volume Gains
As one would intuitively expect, the stark reductions in price stimulated demand for air travel. This was bestillustrated by the Irish-UK market which, exceeding its regulated European counterparts, grew by 184%between 1985 and 1994 (Barrett, 1997). Volume gains are also evident in the US market with more than two anda half times more passengers in 1997 as compared with 1978 (Thierer, 1998).
Due to the
 protectionist stance adopted in relation to state airlines, the airline wouldn‟t be
permitted to fail andexit the market.
US dollars at their 1990 parity.
Macroeconomic Gains
can contend that air travel and tourism are complementary goods, thus it‟s a basic economic argument that
when the price of a complementary good falls, the demand for its counterpart increases. Its estimated that airlinederegulation in the Irish market is correlated to a 60% rise in visitor numbers and accounted for 25,000 new jobsin tourism between 1987-1993 (Barrett, 1996, 1997).It is also asserted that the most recent progression of deregulation, the EU/US open skies agreement, will havemacroeconomic benefits for Ireland by facilitating free trade, and due to the coupling of Irish and US economies(Barrett, 2008a).
The Airline Industry and Contestability
Proponents of airline deregulation used contestable market theory, and the assertion that such would beapplicable to the aviation industry, to bolster their case (Borenstein, 1992). It is now appropriate to examine thecompetitive market structure to identify whether these assertions came to fruition.Contestable market theory can be considered as a substitute for perfect competition, in that it was devised byBaumol, Panzar and Willig (1982) to reconcile realistic market conditions with the efficient outcomes associatedwith perfectly competitive markets (Sinha, 2001; Brock, 1983; Morrison & Winston, 1987). The criteria forcontestability are as follows;
Freedom of Entry;
A new entrant must not face any barriers to entering a new market, including but notlimited to any costs associated with market entrance that are not
borne by the incumbent 
(Tye,1990:3; Baumol, 1982; Brock, 1983).
Freedom of Exit;
In a similar fashion incumbents must not face barriers to exiting existing market (Sinha,2001; Baumol, 1982; Barrett, 1999).
Asymmetric Time Lags;
In order to permit what is commonly referred to as “hit and run entry” there must
be sufficient time lags to allow a new or prospective entrant to enter the market, enjoy supernormal profits,and exit before the incumbents are able to engage in predatory pricing thereby eroding all profits to zero(Sinha, 2001; Tye, 1990).The criteria outlined above underpin the central hypothesis of contestable market theory; the threat of potentialentrants disciplines incumbents (Tye, 1990).If we refer back to the earlier analysis of the regulatory transition of the aviation industry, from regulated toderegulated, it becomes apparent that prior to deregulation the criteria for contestability were breached; in boththe US and Irish cases barriers to entry and exit were in place, not in the form of costs per say, but in the form of artificial barriers created by government intervention. Furthermore, deregulation, by permitting freedom of entryand exit, attempted to create a contestable airline industry. The similarity between the measures of deregulationand the criteria for contestability was not lost on Baumol and Willig;
some remarkable decisions in the regulatory and antitrust arenas [that] rely explicitly on the theory of contestability
(Tye citing Baumol & Willig, 1990:1).While theoretically the deregulated airline industry is consistent with the theory of contestability, we mustquestion whether the same is true in practice. While Graham et al (1983), Bailey et al (1985), Moore (1986) and
(Sinha, 1987) all find evidence to suggest that in practice contestability isn‟t applicable to the airline industry,
there are studies which support the assertion, namely Bailey and Panzar (1981) and Morrison and Winston(1986) (Sinha, 2001; Borenstein, 1992; Hurdle et al, 1989).Interestingly, Morrsion and Winston (1986, 1987) use
Bain‟s (
) version of „imperfect contestability‟,meaning that while the threat of potential entry doesn‟t guarantee a welfare maximizin
g outcome, as in the caseof perfect contestability, it does influence the behaviour of incumbents (Sinha, 2001; Hurdle, 1989; Morrison &Winston, 1987; Baumol, 1982). There is evidence supporting the hypothesis that the airline industry isconsistent with imperfect contestability (Morrison & Winston, 1986, 1987). This being said there seems to beconsensus around the argument that actual competition
“plays a more significant role”
than the threat of potential competition (Sinha, 2001:119). This is illustrated in the Irish case on the remaining Irish- UK rountes;despite the fact that deregulation had already begun and indeed succeeded in 1986, the remaining routes werenot contestable.

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