Tuesday, May 18, 2010

Barriers to Entry

Following the May 3 announcement that Continental and United Airlines would consummate a $3 billion merger to form the world's largest air carrier, there has been a torrent of news stories, op-eds, and public statements from lawmakers and government officials on the pros and cons of the tie-up for the U.S. air transport market.  Opponents of the merger argue that it will lead to higher prices and fewer route options for consumers.  There is some plausibility to these two charges.  Any merger between competitors leads to some reduction in competition and, assuming the deal has a significant effect on the number of participants in a given market (in this scenario, reducing the number of major network carriers from five to four), perhaps increases the risk of oligopolistic pricing.  Assuming competent management is placed in charge of the enterprise, rational business decisions such as reducing or eliminating unprofitable service offerings is likely to follow. 

On the other hand, it is far from an inevitability that fewer actors in a given market means higher prices.  There is always a temptation for one or more participants to "cheat" by shading their prices.  Additionally, the possibility of additional revenues in a given market will invite new entrants which eventually compete down the price of service.  To counter these basic observations, some argue that an admixture of unstable capital markets and a general unease with respect to investment in the often volatile aviation industry creates a barrier to entry.  Perhaps, though such claims have yet to be substantiated with hard evidence.  Paying too much mind to these claims also distracts from the most significant barriers to entry, namely the Government laws and policies which bar foreign airlines and capital from penetrating the U.S. air transport market.

Like most countries worldwide, the U.S. reserves cabotage, i.e., the right to operate air service between two points within its territory, for its national carriers.  So, for example, British Airways (BA), on a flight departing London, cannot put down passengers (or cargo) in New York; take on new passengers (or cargo); and then continue on to its final destination in, say, Los Angeles.  Though extending cabotage privileges to foreign airlines would probably only affect the competitive makeup on the most heavily trafficked U.S. domestic routes, it would at least help assuage fears that a drop in domestic carriers in these lucrative markets automatically means higher prices.

A more onerous entry barrier than the cabotage restriction is the federal statutory requirement that an airline must be 75% owned and actually controlled by U.S. citizens before receiving operating authority from the Department of Transportation.  This investment restriction means that foreign airlines such as BA are barred from establishing a subsidiary for the purposes of competing in the U.S. domestic market.  It also means that existing U.S. air carriers do not have access to sources of foreign capital which could allow them to sustain (or expand) their operations without necessarily resorting to consolidation or complete exit from the marketplace.

If the pending Continental/United merger raises legislator concerns about the competitive makeup of the U.S. air transport market, then lawmakers in Washington need to rethink these protectionist artifices.  In the meantime, the U.S. industry should be given the freedom to organize itself in response to shifts in consumer demand and the rising costs of doing business. 

http://lawprofessors.typepad.com/aviation/2010/05/barriers-to-entry-1.html

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