Unfriendly Skies

Clifford Winston and Robert W. Crandall
Robert W. Crandall Adjunct Senior Fellow - Technology Policy Institute

December 18, 2006

Almost on cue, members of Congress have responded to US Airways’ interest in acquiring Delta Air Lines, and a possible deal between United Airlines and Continental Airlines, with predictions that fares will rise, service will be reduced, and more mergers will surely follow. Not to appear soft on threats to competition, the Justice Department has expressed its concern that the proposed mergers raise antitrust concerns and has vowed to conduct thorough investigations.

Mergers may harm consumers if they are the route to (or the root of) market power and ultimately allow the combined firm to increase consumer prices and reduce service. In such cases, enforcement of the antitrust laws could improve consumer welfare by blocking the mergers before they occur and by discouraging future harmful mergers. But our research suggests that government efforts to address such threats do little to improve consumer welfare and sometimes actually reduce it. More importantly, government often misses fruitful opportunities to benefit consumers because it eschews market-oriented policies.

The empirical evidence on the main factors that influence airlines to merge their operations does not suggest that these mergers are driven by a desire to obtain market power. In a 2000 paper, Steven Morrison and Clifford Winston analyzed the determinants of all the actual and attempted airline mergers since the 1978 deregulation. They found that carriers are generally not motivated to merge for anticompetitive reasons, but rather by the acquiring carriers’ desire to expand their international routes — which are far more profitable than most domestic routes due to government-to-government agreements that limit entry — and by the acquired carriers’ need to be rescued from financial distress.

Clearly, gaining access to additional international routes is an important consideration in the two mergers under discussion. US Airways would gain from having access to international routes currently served by Delta, and United and Continental could gain from expanding their portfolio of international routes. Because Delta is in the process of emerging from bankruptcy, it appears to have solved its financial problems on its own and is therefore not enthusiastic about a merger with US Airways.

What about evidence on the effects of previous mergers on travelers? In the aforementioned paper, the authors found that the USAir-Piedmont merger and the Northwest-Republic and TWA-Ozark mergers, which were opposed by the Justice Department but approved by the U.S. Department of Transportation (at the time DOT had jurisdiction in the matter), had benign effects on fares while increasing travelers’ accumulation of frequent flier miles.

Today’s airline industry has become very competitive because of the expansion of low-cost carriers such as Southwest, JetBlue and AirTran, whose combined market share currently approaches one-third of the domestic market. Any potential anticompetitive effects of a US Airways-Delta merger or a United-Continental merger would be quickly tempered by the responses of these low-cost carriers. The larger “legacy” (pre-deregulation) carriers now face competition from low-cost carriers on nearly three-quarters of their domestic routes. Low cost carriers have expanded their presence even to such markets as Philadelphia and Pittsburgh that had traditionally been dominated by legacy carriers, and they are poised to provide additional capacity in any markets that are adversely affected by any of the proposed mergers. Low-cost carriers can and do move very quickly to mitigate any increase in fares initiated by the legacy carriers — whether caused by a merger or simply by unilateral action.

Ultimately, the effect on travelers of changes in airline market structure caused by mergers or other forces depends on the specific carriers that exit a market and the specific carriers that take their place. For example, a recent study found that in the year 2000 travelers would have been $20 billion worse off due to higher fares and less frequent service if Southwest Airlines did not exist at all. In contrast, consumers would actually have been better off during that year if US Airways had left the industry because more efficient carriers, such as Southwest, would have entered its routes. Because any initial contraction in service and increase in fares by merged legacy carriers is likely to attract entry by low-cost carriers, fares would quickly decline to or possibly below pre-merger levels and return service frequency to or possibly above pre-merger levels. Trustbusters would be prudent if they simply exercised a reasonable degree of patience in the wake of such combinations.

Rather than attempt to combat airline mergers, government policy makers could have a much more beneficial impact on the welfare of air travelers by pursuing policies that increase competition on international and domestic routes. With one swift stroke, deregulation of international markets would eliminate a major motivation for many of the mergers. The U.S. government has been negotiating so-called “Open Skies” agreements with other countries for several years, but negotiations have invariably stalled for a variety of reasons. One issue is the government-mandated limit on foreign ownership of U.S. carriers, currently capped at 49%. Ending any limits on foreign ownership would also make it easier for struggling U.S. carriers to attract foreign capital to help solve their financial problems and possibly eliminate another major reason that carriers seek a merger.

Allowing foreign carriers to serve U.S. domestic routes (cabotage) would provide another source of competition that would benefit air travelers. Think of how foreign transplants have transformed the automobile and steel industries to the benefit of consumers. Sir Richard Branson has expressed an interest in starting up a Virgin Airways operation in the U.S. but faces ownership issues, among other obstacles.

Still another way that policy makers could potentially stimulate airline competition is to privatize U.S. airports, thereby allowing them to compete aggressively for air carrier service. Competitive entry at some airports is constrained by insufficient gates and terminal space. Given the contractual relationship governing publicly owned airports and the incumbent airlines that help pay their bonds, some airports have limited incentives to attract additional carriers.

Federal policy makers’ attempts to correct market failures, such as those deriving from monopoly power, have in practice frequently been an abject failure, and missed opportunities to improve market performance. The latest round of proposed airline mergers illustrates the problem: Policy makers will undoubtedly find it politically expedient to use the antitrust laws in an inappropriate manner, instead of standing up to the entrenched interests who oppose changes in current government policies that would have a far more beneficial impact on competition in the airline industry.