Why International Alliances Are Good for You

Cranky is on vacation, but I’ve lined up some excellent guest bloggers for you while I’m gone. Today I have Aviation Policy Blog author Evan Sparks.

One of the big stories in aviation thus far in 2009 is how international airline alliances have come under heavy fire on Capitol Hill. The “big three”–Star, Skyteam, and Oneworld–have added members and expanded their global reach in recent years. “I have become increasingly concerned with the decline of competition in international markets, particularly between the United States and Europe,” said Jim Oberstar (D-Minn.), the powerful chairman of the House Transportation Committee. “Combined, the . . . alliances account for almost 80 percent of the total world airline capacity, 78 percent of world revenue passenger kilometers and 73 percent of passengers carried. These three alliances control over 87 percent of the traffic between the United States and Europe.”

Back in February, Oberstar introduced legislation to limit the power of these alliances. The international alliances offer more than just codesharing and interline connections. They cooperate in marketing, scheduling, and route planning, and (with an exemption from antitrust regulation granted by the federal government) ticket pricing. The key partners in Skyteam (Delta, Northwest, KLM, and Air France) and Star Alliance enjoy immunity on transatlantic routes. Just last week, the Department of Transportation tentatively approved Continental to join United, Air Canada, and Lufthansa in fare-setting immunity. American, British Airways, and Iberia, the core carriers of Oneworld, are seeking an antitrust exemption themselves.

Oberstar’s legislation–which, according to Aviation Week, was recently inserted into the House version of the FAA reauthorization bill–would constrain these international alliances by limiting the grants of antitrust exemptions to three years, after which the airlines would have to reapply for another three years. This would insert politics into airline regulation decisions. The actual effect would be to discourage airlines from seeking to form alliances, period. Unpredictability of policymaking can sometimes harm businesses even more than bad policy. “Having the sort of ex post facto law that would undo this is a very disconcerting principle to have in the business community,” US Airways executive C. A. Howlett said recently.

By now, you may be thinking that airlines in alliances collude on prices to gouge the little-guy traveler, and that’s certainly the sort of rhetoric you hear coming out of Washington. But that’s not what studies of international codesharing indicate. In a 1998 paper [PDF here], Jan K. Brueckner and W. Tom Whalen found that “alliance partners charge interline fares that are 18-28 percent below those charged by nonallied carriers”–although they found a slight but statistically insignifant uncompetitive effect on flights between “gateway” cities. Why? “First, joint pricing internalizes the negative externalities from the uncoordinated choice of subfares, leading to lower fares. This fare reduction then stimulates traffic, which in turn lowers marginal costs via economies of traffic density, leading to further downward pressure on fares. Our results, which confirm this prediction, are extremely robust to changes in the measurement of competition and the handling of market-specific eff ects.”

Basically, it works like this: Delta sets fares on the Atlanta-Louisville route on its own, as does its alliance partner KLM for the Amsterdam-Bratislava run. Then, the immunized partners collaborate (or collude) on pricing the Atlanta-Amsterdam run. If they didn’t have immunity, they wouldn’t be able to collaborate and individual fares would stand. But because KLM needs passengers on the transatlantic flight from Louisville and because Delta wants to send its passengers on to Bratislava, they need to set an overall fare that makes sense for both carriers in the market. If Delta set its fare on ATL-SDF too high, it would depress feed traffic for the transatlantic flight and thus hinder the joint efforts of both airlines. “Cooperative behavior, however, internalizes the externality, so that a lower fare is chosen.”

Brueckner’s 2003 article in the Review of Economics and Statistics, “International Airfares in the Age of Alliances: The Effects of Codesharing and Antitrust Immunity,” [PDF of early version here] updates his earlier model and finds that “the presence of antitrust immunity reduces the fare by 13-21 percent,” and that the “combined effect [of codesharing and immunity] ranges between 17 and 30 percent.” And what would happen if, as Oberstar wants, alliances were to risk losing immunity every three years? “The estimates show that, when the DOT grants antitrust immunity, substantial benefits arise for an alliance’s interline passengers. . . . [T]he aggregate loss [modeled for Star Alliance passengers] from withdrawal of immunity ranges between $17 and $22 million per quarter, suggesting that the annual gain to the STAR alliance’s interline passengers from the presence of immunity is on the order of $80 million per year.”

Bottom line: airline alliances don’t drive up fares. They do the opposite. Given that alliances actually smooth the travel experience, allowing greater ease in baggage transfer, terminal transfer, through ticketing, and other amenities, it is striking that they actually reduce fares in most cases. Why would policymakers want to change that? Well, that’s a question for another post.

Evan Sparks writes the eponymous Aviation Policy Blog at www.evansparks.com. He lives in Washington, D.C., where by day he is an editor at the American Enterprise Institute. Evan’s writing on aviation policy and other subjects has appeared in the Wall Street Journal, Forbes.com, and The American.

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