Tuesday, 28 April 2015

Flying high?

Robert Litan, the Brookings economist who last year published Trillion Dollar Economists: how economists and their ideas have transformed business, has written a short article in the latest McKinsey Quarterly based on ideas in the book. It's called 'Economists: Don't leave home without one'.

One of the examples he gives of economic thinking having an enormous impact is transport deregulation, which started with deregulation of airlines in the US in the late 1970s. Not only have consumers benefitted wildly, but so have businesses. As he points out, the whole clicks and mortar world of e-commerce would likely not have got off the ground:
Had the transportation industry not been deregulated in the 1970s and early 1980s, and had the much more efficient and flexible systems built by companies such as UPS not emerged in response to competition, it is difficult to see how Internet retailers like Amazon, which came along roughly two decades later, would have been able to get started or succeed. Amazon would have had to begin with its own fleet of trucks or even planes to escape the strictures of the pre-1980 regulatory regime, a barrier to entry that almost certainly would have been impossible for new retailers to overcome.
I got to wondering if the deregulation of airlines could be seen in the prices we pay for international air travel, and the answer is, yes it can. Statistics NZ has prices series for air travel that, by happy coincidence, go back to March 1981, a little after the first US push to deregulate prices and the industry more generally. You can see them for yourself if you go to Stats' Infoshare and find your way via the Economic Indicators option to the 'CPI - Level 3 Classes for New Zealand'.

What you'll also find there is the price series for domestic air travel, and the comparison between the international and domestic air transport prices raises, for me, some disquieting thoughts.  Here's the graphical picture: I've rebased everything to 100 in March '81, and added what's happened to prices generally since then, as well as what has happened to the prices of some tradable goods (I've used footwear and new cars. I couldn't find a series for 'all tradables' that went back to 1981, so they'll have to stand proxy for what's happened to tradables more generally). For those who prefer numbers to pictures, there's also a table, where I've shown the average annual rate of price increase over the whole 1981-2015 period, and also, since the high inflation of the 1980s isn't so relevant anymore, over the period since the Reserve Bank Act went into effect (from March '90 onwards).



Some of these patterns were exactly what I'd have expected. Inflation in general has dropped since we - and the rest of the developed world - got our monetary policy act together. And I had expected international air travel prices to show only modest price increases over this period - we've had deregulation, increased competition, the rise of the budget airlines, and technological innovations in both aircraft (larger, more fuel-efficient) and airlines' own administrative systems (computerisation). International air transport prices have indeed risen very slowly over the whole period since 1981, and have actually been falling on average over the past 25 years. Other tradables - cars, shoes - show a similar pattern, where outsourcing to cheaper places in the developing world has played a large part, but international air prices have fallen even faster, and you'd have to think that the deregulatory process was one of the more important moving parts. Litan was spot on.

But then you come to domestic air transport prices, which show - to me at least - a disturbingly persistent pattern . Over the entire period, prices have risen a little faster than inflation as a whole, and over the lower-inflation post-Reserve-Bank-Act period have been rising considerably faster.

And that's rather odd, because some of the reasons that non-tradables inflation tends to be higher than tradables inflation don't apply to domestic air transport. True, you can't easily substitute an overseas product for a domestic one, just as you can't easily outsource your doctor's visit or your kids' secondary school to Vietnam or the Philippines: an ultra cheap fare between Dublin and Nice is no good when you want to go to Dunedin. On the other hand, another big reason why non-tradables tend to rise in price relative to non-tradables - it's harder to achieve the productivity gains you get in (say) manufacturing computer equipment because you can't suddenly make brain operations happen in a quarter of the time - doesn't apply. You'd think a good deal of the increases in aircraft and airline system productivity should have fed through to more modest rises in transport prices than we've seen.

So why didn't they? Much of the answer must lie in the smaller degree of competitive pressure that non-tradables like domestic air transport must face. In saying that, I recognise that there is some degree of domestic competition in air transport. Like everyone else I'm pleased to have snapped up some very low prices from time to time: on occasions, the cost of flying from Auckland to Wellington has been less than the cost of a return taxi between the North Shore and Auckland Airport. On average, however, the cheapies have not compensated for progressively higher airfares overall: in real terms, relative to the overall CPI, domestic prices are slightly higher than they were in 1981. International air travel prices, in real terms, are hugely lower. The numbers wobble around a bit, but you're paying a quarter or a third of what you would have paid back in 1981.

And I suppose there may be some good operational reasons, other than competition playing too weak a disciplinary role, why the domestic airlines haven't been able to match the falling international prices. They don't, for example, have the access to cheap secondary airports that the budget European and American carriers do: perhaps their fares have to reflect the market power of the airports. Or perhaps they've been lumbered with higher regulatory costs than your typical overseas operator. 

But you're still left with the feeling that competition isn't restraining local air prices as well as it might. It might be a coincidence, but the only time that domestic air price inflation lagged behind CPI price inflation as a whole, as you can see on the graph, was in the late '80s and through most of the '90s - precisely the period when Ansett New Zealand was most active.

10 comments:

  1. Some plausible (to me) explanations:
    1) Greater tech innovation reducing long-haul costs relative to short hops;
    2) Most of the wear and tear on aircraft is likely from take-off and landing costs. Those are fixed regardless of flight duration. Maintenance then might be worse for the short haul flights than long.

    Not saying that competition isn't in there, just a couple of non-competition things that might also matter.

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  2. They sound plausible to me, too, and frankly without industry knowledge and some fancy econometric analysis of big data sets we'll never get to quantify the exact mix of the different moving parts. My guess though would be that even on short hops US and European airfare prices have well lagged local inflation

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  3. The disparity between domestic and international airfares can be explained by the fact that the marginal profits (losses, even) on international routes are constrained by competitors with different cost bases or business models. (PanAm, United and Qantas all withdrew from AKL-LAX after bleeding cash, Emirates achieves profitability DXB-SYD/MEL/BNE vv and dumps the Tasman capacity on the market for marginal revenue.) The domestic operator will then cross-subsidise from a market which has a) few directly comparable competitors due to the market size and b) zero competition from other transport modes for geographical reasons.
    The domestic operator will again cross-subsidise *within* this market, taking profits from routes with no competition (eg any route operated by Air Nelson) to balance lower yields on trunk routes with significant and effective competition.

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  4. Thanks for the comment - that sounds right, too. Another commenter, on Twitter, also thought it would be interesting to look at differences in pricing between trunk and provincial routes, and I agree, but at that point I run into time, data and $ constraints....

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  5. Data constraints, I'd say. Air NZ doesn't publish accounts of its subsidiaries and reliable sources tell me that Air Nelson is the mostly profitable business segment. An interesting research topic could be the city pair pricing imbalance - early morning out/evening back from the regions significantly more expensive than the opposing flow. In the case of NSN-WLG, it can be double, explained perhaps by the need for NSN business people to engage with the outside world. Mountain:Mohammed..

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  6. The literature on passenger transport networks, including airlines, suggests that differences in costs tend to be driven by "economies of density" - i.e. per-passenger costs tend to be lower on more heavily travelled routes. (Interestingly, economies of scale - larger networks - seem less important.) Here's an old but reasonably useful paper on the topic: http://www.jstor.org/stable/2555519

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    Replies
    1. Thanks Peter I'll have a look. Several people have suggested that NZ may well have a lot (relatively) of these low density shorter routes, so that's likely to feature in the story of the divergence between dom and int'l prices

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  7. Smaller/regional networks tend to use less efficient aircraft, shorter legs generate a higher proportion of airport-related operational costs and have proportionally higher fuel burn (shorter cruise phase), variable costs per passenger (RES/CKI/DCS) not dependent on network size, fixed costs distributed over fewer RPKs

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  8. Thanks again - several people (as I noted in replying to Peter Nunn's comment above) have suggested this as a reason why domestic NZ routes may be at a disadvantage to int'l ones

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