Date created: 28 November 1996

Last modified: 18 November 1997

Maintained by: John Quiggin

John Quiggin

A sting in this tale of successful reform

The Australian,

August 4, 1995

Airline deregulation is generally agreed to be one of the great success of micro-economic reform in Australia. In place of regulations guaranteeing that exactly two airlines, with parallel schedules, identical planes and identical prices served all of the major domestic routes, we now have almost complete freedom of entry to the market, subject only to safety regulations. In place of a complex set of regulations governing fares, airlines are offer to set whatever fares they choose. A commonly quoted statistic is the Prices Surveillance Authority (PSA) estimate that the real cost of air travel has declined by 24 per cent since deregulation.

It comes as a surprise, then, to learn that standard airfares for economy, business and first class travel have risen by about 10 per cent since deregulation. It is true of course, that most people don't travel on standard fares but on discount fares, and these have become cheaper. The average discounted fare now is around 40 per cent of the full economy fare, compared to about 55 per cent before deregulation. However, the full economy fare has gone up. It turns out that, on average, discount fares have fallen by around 18 per cent since deregulation.

This creates an interesting puzzle. If some categories of fares have risen and others have fallen by only 18 per cent, how can the real cost of air travel have fallen by 24 per cent ? The answer is that the PSA measure is not a price index like the Consumer Price Index or the GDP deflator. Rather it is a simple measure of average revenue per passenger/kilometer. Even if prices were fixed, the PSA measure would decline if the proportion of passengers on discount fares (roughly speaking, the household market) rose relative to those travelling full economy or business class. In addition, because much of the cost of an airline flight is in takeoffs and landings, the cost per passenger/km will decline if the proportion of long-haul flights rise. Both of these things have happened in Australia, as rising incomes make air travel more affordable for the mass public. But changes in the mix of products supplied by the airline industry are irrelevant to the question of whether prices have risen or fallen.

In a situation where some prices have risen and others have fallen, can anything useful be said about the average movement in prices. Within limits, the answer is yes. The economic theory of price indexes is based on the question of how much it would cost to purchase the average bundle of services supplied by the industry. We can obtain one estimate of price movements by deriving weights from the bundle of services supplied supplied before the price change. Another estimate is derived using weights from the bundle of services supplied supplied after the price change. A powerful economic argument shows that the 'true' average price change must lie between these two estimates.

For Australian airlines before deregulation, around 10 per cent of travellers used business and economy fares, paying a premium of around 20 per cent on the full economy fare. Another 45 per cent paid full economy, while the remaining 45 per cent travelled on discount fares. The combination of price changes and market changes in the deregulation period shifted the balance so that full economy fares shrank to around 20 per cent of the market, with discount fares picking up 70 per cent and the premium share unchanged at 10 per cent. (This shift in market composition, combined with an increase in the share of long-haul flights is consistent with the PSA calculations on revenue per passenger/km).

From this data it is a straightforward exercise in undergraduate economics to determine that the average price change is somehere between an increase of 1.2 per cent and a reduction of 3.6 per cent. The so-called Fisher ideal index, widely regarded as the best available, implies an average real price reduction of 1.2 per cent. Whatever index is used, it is safe to conclude that average prices have been almsot completely unaffected by deregulation.

This is not the only area where the impact of deregulation has been small. With minor exceptions the market after deregulation has yielded two airlines, with parallel schedules, similar planes and almost identical prices serving all of the major domestic routes. In fact, the competitive market has almost exactly duplicated the outcomes two airlines policy.

In retrospect this is not particularly suprising. As research on the US airline industry by Professor Peter Forsyth of the University of New England has shown, airline markets of the length and density of those in Australia are typically served by two, and occasionally three, competing carriers. With a small total market, a two-airline outcome is exactly what would be expected.

The survival of parallel scheduling is also a predictable competitive outcome. It is a temporal version of the well-known Hotelling effect in spatial competition, by which two icecream sellers on a beach will both choose to locate next to each other in the middle of the beach. Even though the socially optimal outcome would be for the two stands to be placed at even intervals along the beach, if one icecream seller who located one-third of the way along the beach the other could capture market share by moving closer to the centre (the same model is used to explain why political parties prosper by seeking the middle ground).

As far as pricing is concerned, the results derived here for the airline industry are consistent with the experience of competition in telecommunications, where the average rate of price decline is actually slower than before deregulation and of financial deregulation where margins on standard consumer products have risen since deregulation. Increasingly, it appears that micro-economic reform is a case of 'much ado about nothing.'

John Quiggin is Professor of Economics at James Cook University and author of Great Expectations: Microeconomic reform and Australia, published by Allen & Unwin.

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