Asymmetric regulation and airport dominance in international aviation: evidence from the London-New York market.

1. Introduction

One of the most important recent developments in international business has been the gradual deregulation of international airline markets. The potential benefits of allowing the market forces to govern international aviation are enormous. For example, the European Union (EU) has estimated that consumers will gain as much as $5.8 billion per year from the establishment of the currently negotiated "open aviation area" to include North America, the EU, and the North Atlantic Ocean (The Economist, 2 October 2003). Strong political opposition to the deregulation process is, however, likely to make partial deregulation a reality for the near future. Further, on a number of international airline markets, regulatory restrictions have been partially removed in such a way that different players face different entry and other barriers. Such an institutional structure--I will call it asymmetric regulation (1)--can compromise the idea of deregulation and fail to bring the expected welfare gains.

Another important feature of the airline industry is the presence of airports dominated by a single airline, which creates opportunities for exercising market power by the dominant carrier. Borenstein (1989) showed that airlines charge higher fares for their services to/from the airport at which they have a dominant position. Additional evidence has come from Evans and Kessides (1993); Berry, Carnall, and Spiller (1996); and Lee and Luengo-Prado (2005). Evans and Kessides conclude (by estimating reduced-form fixed effects price regressions) that the airport dominance contributes more than the route dominance to an airline's ability to charge higher fares. Berry, Carnall, and Spiller (through structural estimation of a differentiated-product oligopoly model) find that the dominant airlines' power to charge higher fares is restricted to business travelers. Lee and Luengo-Prado suggest that "hub premia" can largely be explained by the mix of travelers flying to/from the dominated airport. Thus, the airport dominance has been established to play a role on the domestic U.S. market. It is not clear, however, whether this effect also applies to the more regulated international routes, especially in light of Marin (1995), who suggested that on the European markets, the airport dominance effect on fares was absent in regulated environments and negative--opposite that in the United States--on deregulated routes.

This article uses the London-New York market to measure the price effects of asymmetric regulation on the affected carriers. To obtain effects of airport dominance on the international airline markets, two New York originating routes (New York-Frankfurt and New York-Paris) are used. In fact, transatlantic routes originating in New York provide an ideal environment for examining both issues. On the London-New York market, asymmetric regulation takes the form of access restrictions to LHR for some airlines. Also, Continental Airlines (CO) has a dominant position at Newark's Liberty airport. The London-New York market also allows mitigating the limitations that data availability and market structure put on empirical research on the international airline markets. Abundant price data are available only for the U.S. carriers. (2) On most international routes, only one U.S. carrier offers nonstop service, with several notable exceptions. Chicago (with two U.S. carriers) and New York (with five U.S. carriers operating transoceanic flights at the time period considered in this article) are the two airports where several U.S. carriers compete on a number of transoceanic markets. Los Angeles-Tokyo (with three U.S. carriers), San Francisco-Tokyo, Los Angeles-London, and Seattle-Tokyo (with two U.S. carriers each) are examples of single markets with competition between the U.S. airlines.

New York has an advantage over other airports with competition between the U.S. carriers on the transoceanic markets in terms of measuring the effects of airport dominance. Chicago has a virtually symmetric duopoly between American Airlines (AA) and United Airlines (UA) at O'Hare airport; Los Angeles is not strictly dominated by any carrier, and Seattle is not dominated by any of the carriers performing transoceanic flights. Although San Francisco is a hub for UA, there is only one market out of that city for which my exercise can be performed; metropolitan New York, however, has both asymmetries, allowing identification of the airport dominance effect, and a good number of transatlantic markets on which the U.S. carriers compete. In addition to that, about half of the passengers traveling on the London New York market travel between these two cities, as opposed to the London-New York route as a segment of the journey. This is a large fraction compared with other transatlantic corridors (Shibata 2001). Finally, the London-New York market is attractive for understanding the future of deregulated international air travel, and an increase may be expected in the number of competitors on other routes as entry and other barriers are relaxed.

To disentangle the price effects of asymmetric regulation and airport dominance, I employ a difference-in-differences approach, applied to a subset of itineraries from the International Data Bank 1A (DB1A) of the U.S. Department of Transportation. A similar approach was used by Borenstein (1990, 1991) to measure the market power effects of airline mergers and airport dominance on the U.S. market.

I find negative price effects of asymmetric regulation for the restricted carrier (CO, in this case). Yet, fare decreases due to the regulation effect are offset by Continental's large positive airport-dominance effect on the transatlantic routes.

Previous research (Marin 1995) suggested that, even on the deregulated routes within the EU, incumbent airlines have an advantage over the new entrants because of better access to airport facilities and economies of scope. My results indicate that asymmetric partial deregulation (a likely reality in light of the political influences in the industry) can indeed pose a problem for both incumbent airlines and potential entrants facing less favorable treatment under a given regulatory regime. Although it is unlikely that asymmetric regulation can be considered desirable in the airline industry, (3) I can suggest that an asymmetric regulatory regime favoring airlines with airport dominance (a setup likely to emerge given that national carriers are often both dominant ones and those enjoying protection from their governments) can indeed compromise the idea of deregulation. Yet, available data substantially limit the scope of my study to allow far-reaching policy implications.

The article is organized as follows. Section 2 briefly describes the current regulation and deregulation efforts on international airline markets, including a description of the entry barriers specific to the London-New York route. Section 3 analyzes a sample of international itineraries in order to identify and estimate the effects of airport dominance and asymmetric regulation on fares charged by different carriers on the London-New York market. Section 4 concludes and offers directions for further research.

2. Institutions

International Airline Market and Its Deregulation

For decades, countries saw aviation as primarily a matter of national prestige and sovereignty (The Economist, 2 October 2003). This resulted in excessive protection of countries' airlines from international competition. As a consequence, the international airline industry, the very aim of which is to facilitate connections between the countries and make the world more open, has until recently maintained substantial artificial barriers to entry and competition. These barriers allowed the airlines (with assistance from their governments) to create one of the largest international cartels in history in terms of its scope. This cartel operated through the International Air Transport Association (IATA), which periodically gathered representatives of almost all airlines operating international services to decide--by unanimous consent--what fares to charge on almost all international routes. According to The Economist (2003), the IATA "amounted to an amazing global cartel (4) that made OPEC look amateurish." The entry barriers were specified by the complicated system of bilateral intergovernmental treaties defining the rules of the game (a typical bilateral agreement identified how many carriers could be designated to fly between the countries and on what routes, specifying capacity, frequency, and fares). In most cases, fares agreed upon at the above-mentioned IATA conferences became integral parts of such agreements. (5)