The economic effects of alliances are not always what they seem March 1999

The recent alliance of Iberia with British Airways and American Airlines will only serve to increase the antipathy of the EU competition commissioner Karel Van Miert towards alliances. He says he is not against them in principle but suspects they are undoing much of the benefits that liberalisation is otherwise bringing to the internal European aviation market. Indeed, it is difficult to see how the combination could do anything to serve anyone other than the two airlines, if you look at fares between Madrid and London.

But some of Mr Van Miert’s other sallies against alliances could be undermined by recent academic work, eagerly seized upon by United Airlines and Lufthansa for their hearings with Mr Van Miert’s officials, which suggest that consumers gain not just in service but in fare reductions from the creation of international alliances.

Two economists at the University of Illinois, Jan K. Brueckner and W. Tom Whalen, have trawled through flight data collected by the US Department of Transportation’s passenger surveys to study fares paid by passengers travelling on alliance airlines for a given journey and those using two separate airlines in a classic interlining ticket of the old sort. Their conclusion: non–allied carriers charge 36% above those fares charged by alliance partners. This is the first indication of any reliable sort that consumers gain more than convenience, lounges and extra air miles from alliances.

All this may seem counter–intuitive since alliances, from simple code–sharing upwards, are basically a device to control capacity on given routes for the convenience of the airlines. Normally when two or more players combine or collude in any product market the consumer tends to suffer. Yet aviation once again seems to produce slightly different results. The answer to this defiance of A–level economics is that what airlines are really selling is access to a network of origins and destinations rather than tickets from A to B. Once you look at airlines and at alliances in terms of such networks and their economics, the results are interesting in that they seem to indicate a consumer benefit for most flights and no loss of benefit for those simple A to B routes where network economics are irrelevant.

The essence of alliances is that they produce networks for airlines to sell tickets across without incurring any extra investment. Such networks achieve efficiencies by collecting traffic from a variety of dispersed “thin” markets, routing it through central hubs and disseminating it through “pipeline” routes to other hubs (from which it is then dispersed into “thin” markets at the destination end). As with networks in other service industries, these alliance networks have an inherent economic incentive to expand service to — and collect traffic from — the widest possible range of local markets. There may be little or no profit to be made at the extremities, but the whole system conspires to produce accelerating scale economies at the hubs and on the fat pipeline routes. This is achieved by better use of terminal facilities, expensive aircraft and marketing campaign expenditure, not to mention well–paid flight crews rostered to do more hours or flying fuller aircraft.

A failed argument for BA

When British Airways tried to sell its proposed intimate alliance with American — virtually a merger in all but share ownership — it failed notably to get across the network economics argument. One reason for the failure was that the alliance contained very heavy overlap on many London- US routes, such as New York, Boston and Dallas. In some cases the combined market share of the two airlines was either 100% or not far off it. But London–New York is an atypical airline market these days, since most of its traffic is gateway–to gateway rather than transfer. BA currently has just under 40% of its Heathrow passengers as transfer from somewhere else, and it is trying to reduce this proportion (or at least the low–yield transfer passengers) in order to concentrate on more lucrative business traffic between the world’s two main financial centres. But the converse is true at most continental hubs such as Frankfurt, Schipol, Paris Charles de Gaulle and Brussels, where transfer passengers are two thirds or more of passengers. This means that alliance network economics apply more to them than to other hubs.

When two firms merge to shrink competition and grow market share they achieve scale economies simply by pooling their assets and eliminating the least efficient. Actually, most academic work shows they try to do this but fail, in the case of friendly mergers, because they parcel out capacity cuts in a sub–optimal way. In the case of hostile takeovers, nearly all the research shows that the only gainers are the shareholders of the acquired company who sold out for a cash offer. They capture the takeover premium the acquirer is forced to pay. The airline industry might contemplate how much the acquisition of McDonnell Douglas and Rockwell has to do with the current woes of Boeing, whose shares have fallen so low that its chairman himself warned last month it could itself now be prey rather than predator.

In the case of airlines, national ownership rules inhibit most international mergers or takeovers and traffic rights under bilateral air treaties limit the possibility of capacity reduction. Instead the partners have to capture the scale economies of the network by co–operative pricing. This is possible because of the plethora of open skies deals that the US government has negotiated with European countries. These have been driven through by the administration largely as a second–best solution to global liberalisation (a practical impossibility) as a way of facilitating the growth and expansion of the US’s carriers around the world. Since they give US airlines access potentially to the whole European market through a deal with one member country of the EU, while giving no real access behind US gateways they are ludicrously one–sided. With these deals goes immunity from antitrust rules on price collusion, hence for co–operative pricing.

As the Illinois authors explain, “under co–operative pricing each of the alliance partners recognises that asking for a high return for its portion of an interline ticket raises the overall fare, which in turn hurts the other partner by depressing traffic in the market. Taking the other partner’s interest into account, each alliance partner thus moderates its pursuit of higher revenues, and the result is a lower interline fare”. They have modelled the fare setting of non–allied and allied airlines and found that when setting fares for a section of an interlined journey, the non–allied airlines think only of themselves, getting what they can for that sector without any regard to the revenue and competitive effects of the total journey. This creates what the authors call negative externalities. These are internalised by alliance partners taking a broader picture of the total fare, setting it lower to maximise revenues and so offering the traveller a lower fare.

The effects of a Lufthansa/SAS split

The authors looked at how this analysis would affect consumers in the event that United’s alliance with Lufthansa and with SAS were dissolved (the other Star partners were not included in the study). United and Lufthansa together serve 1,089 interline city pair markets, while United and SAS serve 169 markets. Total traffic is estimated in these markets to be 46,780 passengers per quarter. The authors conclude that if United’s alliances were dissolved, fares would rise and the welfare loss to passengers doing interline journeys would total between $50m and $82m per year. Now this must all be providing food for thought for Mr Van Miert’s people, whose main response so far has been to ask for slot surrender at Frankfurt and a curbing of frequency on some busy routes — as if cutting capacity was going to do anything to reduce fares instead of increase them. The regulators are trapped in the illusion that new carriers are going to spring up like warriors from the dragon seeds sown by the edicts of Brussels.

Now the Illinois work might be fine for network economics, but it lurches into problems when it comes to the sort of origin–destination traffic over London and New York that de–railed the alliance plans of BA and AA. The authors did study the effects, through their computer model, of scrapping the alliance on gateway to gateway flights. They found that fares could possibly rise by 5%, but that the statistical chances of this happening were so low that “the effect cannot be distinguished from zero”. Hence there is no clear evidence of consumer loss from OD passengers at gateway airports where the allies have overlapping services and co–operative prices. How convenient for United and Lufthansa. Pull the other one.