In the low-returns aviation market, how many airlines should India have?

At the heart of commercial aviation industry's problems lies deregulation

Kingfisher Airlines went bankrupt. Air India is finding it hard to pay salaries. Jet Airways is in similar trouble as well. Elsewhere, Lufthansa is not in the pinkest of health financially. Nor is United Airlines. Nor are a whole host of other airlines. The list is altogether too long.

  

But then that’s the airline business for you – glamorous, though not as much as it used to be; cyclical; beset by excessive competition; plagued by unpredictable short-run costs; and, therefore, always yielding low returns to the investors. It is a sobering thought that in any ten-year period the industry as a whole earns less than one per cent return. 

It sells the most perishable commodity in the world -- in the form of an empty seat -- after spending millions on creating it. It tries to brand what has become a commodity and spends hundreds of millions on that as well. As businesses go, therefore, it is a very stupid one.

Nor is this a new phenomenon, caused by high oil prices which are the usual whipping boy. Or by poor management which comes a close second; or strikes, or high wages or debt or all the usual reasons that we read about. 

These things matter, of course. But the real fault lies in its stars, or as economists might say, the flaw is structural. 

At the heart of the commercial aviation industry’s problems lies deregulation, the Jimmy Carter induced policies of the late 1970s. The US aviation industry was deregulated in 1978. Everyone else followed suit over the next dozen years. Result: global overcapacity in a business that is hugely sensitive to costs. 

True that the consumer has benefitted on price. But now passengers suffer untold indignities on quality of service. Flying was once a pleasure. It is now a torture.

The economics

One huge problem is that, relative to other businesses, there is very little professional economic research into an industry that has one of the biggest investment and employment multipliers. This has led to mainly financial analysis which while necessary is not sufficient. 

The first question economists would ask is about the degree of competition which is sustainable in such a highly capital-intensive industry. In other words, what is the optimal level of competition on a route -- two, three, four, five, six or more airlines? The key economic issue, therefore, is whether to have large, medium or small oligopolies.

Then there is the issue of cross-subsidisation. Should it be intra-firm or across firms? Or should it depend on outright subsidies from the government? 

The third question would link both these to the minimum rate of return that is needed to keep the aviation business healthy and what that rate should be.

Excessive competition has meant that the larger the number of airlines, the greater will be the need for intra-airline cross-subsidisation as each airline focuses on a variant of the Ramsey Rule. This would be that firms that operate networks must maximise revenue, not profits.

The Ramsey Rule, devised by the mathematician Frank Ramsey nearly a hundred years ago, seeks to minimize deadweight losses which happen when both producers -- and consumers -- make inefficient choices. The airline industry is a near-perfect example of this, not least because governments make silly policies and bureaucrats make silly rules. 

Ramsey had intended the rule for those tax systems that sought to raise a fixed amount of revenue by trying to equalise the ratio of the marginal deadweight loss to marginal revenue. The airline industry should be following this rule but doesn’t. 

Little wonder that it is always teetering on the brink, looking for government handouts and angel investors.

What’s to be done?

Domestically, India should allow only three airlines on routes that are of longer than 120 minutes flying time, and around a dozen on the ones that require less than 120 minutes. This will fundamentally alter the capital needs and therefore the deadweight loss, as also its ratio to marginal revenue.

If this is done, the rest will fall in place.