Are Mergers the Cause of All Air Passenger Woes?

October 26, 2016

Investigative journalists at ProPublica recently published an article on the industry lobbying that accompanied the 2013 merger of American Airlines and US Airways. While we won’t comment on the central accusation about improper influence, there are some points made regarding mergers and the airline industry in the piece that should be addressed.

For one, although we do not know if it is true or not the Department of Justice (DOJ) dropped the case against the merger because of lobbying pressures, what we do know is that DOJ dropped its case in August 2013. And that happened after American sued to get an expedited trial – DOJ wanted to have a trial in March 2014, and American sued to get it done sooner, with the court setting a date of November 2013 . When American got its expedited trial, DOJ dropped the case and decided to negotiate.

This is a common tactic that the DOJ applies during mergers: delay the proceedings and its decision in an attempt to get more concessions from the merging companies – because companies who decide to merge normally want to do it sooner rather than later, so they can reap the benefits of the merger earlier. For example, DOJ applied a similar tactic last year with the proposed merger of two health insurance companies. The process is still going on. In the ongoing merger between Alaska Airlines and Virgin America, the DOJ already let the deadline slip by. By doing this, DOJ creates an incentive for the companies to negotiate with the DOJ, or even abandon the merger altogether if the process is delayed for long enough.

The other point made by the piece is that after American and US Airways merged, the U.S. now only has four major airlines, which together control more than 80 percent of the market. While that is certainly true, the piece then makes a number of conclusions that are not supported by the evidence.

The piece’s first conclusion is that market concentration has led to significant profits for the U.S. airlines at the expense of consumers, and they contrast that situation with Europe. The four biggest U.S. carries (American, Delta, Southwest, and United) are indeed the four biggest airlines worldwide in terms of absolute net revenue. But one can argue that this is a result of their size and the size of the market they operate on. The U.S. is by far the biggest market for aviation, so it seems natural that U.S. airlines post the biggest net revenues. If we look at operating margins, while the U.S. industry has achieved in 2015 an operating margin of 15.2%, this happened in a year where the cost of fuel (airlines biggest or second biggest cost, depending on the year), decreased significantly. Overall, profits per passenger flown declined, a point that Wall Street keeps reminding the airlines of.

Over time, the industry’s profitability is (significantly) below the U.S. average. Also, while the big four airlines dominate in terms of absolute revenues, from an operating margin perspective actually the major winners are the smaller airlines: Spirit, Allegiant, and Alaska all have higher operating margins than the big four. As for the “better” situation in Europe with less profits for the airlines, last year Ryanair was on the news not because its CEO had another proposal to charge for restroom access aboard airplanes, but because Ryanair had a 41% operating margin in a quarter. Ryanair would end the year with a more modest 15%, along the U.S. airlines average for that year, with the difference that Ryanair has such margins for a number of years.

The other main argument is about air fares and ancillary fees. The article notes that fares had decreased by only 4% in 2015, despite a two-thirds reduction in the price of fuel in the same year. This argument fuels a common misconception about how businesses (airlines or otherwise) work. While the price of a product is naturally correlated with the price of the inputs (labor, fuel, etc.), the correlation is not perfect. The main driver of the price of a product is demand. If there is enough demand at a price that covers the costs of making the products, then a company will sell the product. Lower fuel prices allow the airlines to offer lower prices, but that doesn’t mean they will do so. Like with all other companies, they will charge what the market bears. And while we see many, including ProPublica, mentioning how fares have not decreased significantly, we didn’t see many mentioning that fares in 2008 only increased 5%, while fuel increased by 50%. Then, as now, the price of fuel was just another piece in deciding what to charge consumers.

On ancillary fees, the argument is that with more industry consolidation, more and bigger fees ensue. While fees have been indeed been increasing (they now represent around 6% of the average round trip ticket, or $25), the causal link with consolidation is hard to fathom. This greater “de-bundling” of fares started in Europe, with the likes of Ryanair and Easyjet, not in the U.S. (now many European airlines charge fliers for everything in their more barebones fares, including water).

(Ed. Note: ProPublica ignores a key financial motivation behind the increase in U.S. airline ancillary fees – Congress. Base airfares are subject to a 7.5 percent excise tax that must be collected by the airline and passed through by the airline to the consumer – but Congress has been unable to extend that tax to cover ancillary fees, which are currently tax-free. An airline charging a $200 base fare and $75 in ancillary fees pays $15.00 in tax, but an airline charging a base fare of $275 for that same seat and zero ancillary fees would pay $20.63 in taxes. In an industry where profit margins are as thin as they are for airlines, this is a clear incentive for airlines to lower base fares and replace the lost revenue with fees.)

U.S. airlines simply adopt models that seem to work for the industry (previous experiences show that U.S. consumers don’t seem willing to accept having to pay for water, though). For the consumers, de-bundling offers the possibility of only buying the services that they need and reduces cross-subsidization between airline customers. The use of fees is a work in progress for the industry. United just recently adjusted, in some cases downward, some of the fees for using frequent flyer miles. Even Ryanair now assigns seat at check-in for free – and the fee for using the restroom never came to be. We can expect more adjustments in the future.

While there are certainly concerns with excessive market concentration on the airline industry and more competition is always welcome, the true problems are not the widespread use of fees or having airlines making a decent profit. As we have argued before, one of the main issues in terms of competition is access to gates at larger airports. That is the area where our focus should be, not trying to micro-manage airlines’ business decisions.

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