Entry in Russian airline market1 By Roman Chustuzian and Alexis Belianin International College of Economics and Finance Higher School of Economics, Moscow, Russia First Draft, April 2009 1. Introduction The Russian airline market is unique due to a combination of factors. Geographically, Russia is the largest country in the world, and air routes are by far the quickest (and sometimes unique) mean of transportation. Historically, this country has deeply enrooted tradition in airspace industry and air transport. Economically, this area of the national economy underwent the dramatic period of transition, combining terrific downfall in aircraft production (from over 200 per year in the late 1980s to less than 10 in the 2000s) combined with boost in the business of private carriers. Finally, this industry remains one of the most receptive to income shifts in the Russian economy: In 2000 – 2007, the Russian air passenger transportation industry grew by approximately 10% per year, which made new market entries attractive for airlines. On the other hand, the industry underwent significant consolidation from 393 airlines in 1994 to 198 in 2007, with over 50% of the market held by five largest players. That meant the airlines had to consider seriously the competitive implications of their moves and the moves of their rivals. Hence airlines needed to make sure that their strategic actions were optimal. Market entry is one of the key strategic actions airlines take. Like other researchers2, we model (airline) market entry with a discrete choice model. But unlike previous works, we focus on the Russian air passenger transportation (RAPT) industry. Since Russia is a developing country, the RAPT industry participants face higher uncertainty as compared to their counterparts in developed countries. To capture this uncertainty, we consider several entry models based on different assumptions. Our favourite among these is the mixed logit model, which allows for flexibility in the covariance matrix, capturing nonlinearity and interdependence of of the regressors’ effects on the probability of entry. Inasmuch as this model allows for airline‐specific regressor coefficients, it should be deemed superior to the other models in terms of both predictive accuracy and empirical validity for business purposes. In economics literature, there has been quite substantive attention to entry, and the airline industry benefited from a bulk of this attention. Canonical works on entry, beginning from Breshahan and Reiss (1990; 1991) and, in the context of airline industry, Berry (1992), were aimed mostly at the elicitation of the factors affecting decision to enter a particular market, built under various assumptions about market and firm heterogeneity. The focus of our analysis is rather different: we seek for modeling a bunch of entry strategies compared from the business viewpoint. It may be the case that the airline is unable to enter a market prescribed by the ranking for reasons unobserved by the econometrician. Then, it should move one level down in the ranking and consider entering the next‐ranked market. This idea illustrates that our model may be applied in practice. It is so especially because our dataset covers all possible routes (markets) between 34 Russian cities with highest passenger traffic, which routes likely constitute all the markets the airline would consider entering. 1 Preliminary and incomplete (not for circulation). Comments are most welcomed. 2 Examples include Berry (1992), Sinclair (1995) and Oliveira (2008). 1 The rest of the paper is organized as follows. In the next section, we characterize the Russian air passenger transport industry (RAPT). Section 3 briefly reviews the existing literature and sets up our hypotheses. Section 4 describes the formal structural entry model set forth for the estimation strategy. Section 5 contains and discusses the data used. Finally, section 6 reports our results and concludes.. 2. The Russian Air Passenger Transportation (RAPT) Industry3 2.1 General outlook Over the recent years, the Russian air passenger transportation (RAPT) industry has been in contradictory conditions. On the one hand, it was growing by considerable 10% on average in 2000-2007, with unprecedented 18% in 2007 (see figure 1). For comparison, consider the 2007 average global industry growth of only 7.4%. On the other hand, the problems faced by the industry inhibited its development and sometimes were destructive. Figure 1: Size and Growth of the Russian Air Passenger Transportation Industry Source: ATO Sourcebook 2008 Besides, the RAPT industry’s size was insignificant internationally, constituting 45.1 million passengers or 110.8 billion passenger-kilometers in 2007, which was only 2% of the global market. By contrast, Europe’s share was 34%, Asia and Pacific Basin countries’ – 31.8%, and the North America’s – 18.8%. 2.2. Positive industry trends Clearly, the RAPT industry in its recent development owes much to a boost of consumer demand, which is in turn driven by Russia’s growing income from oil and gas export4. However, it would be a mistake to 3 Written from the standpoint of the 2007 year end. 4 Note, however, that those passengers were mostly either business executives or tourists, whose demand for air transportation was inelastic. 2 attribute the RAPT industry’s development only to Russia’s large income from oil and gas export. In fact, airlines made substantial efforts to improve their businesses. Old-generation aircraft were being replaced with modern aircraft at an increasing rate5, up-to-date safety procedures and e-tickets were being introduced, low-cost and hub airport business models were introduced as well. Further more, airlines were bringing their standards in accordance with international, discussed participation in global airline alliances and showed interest in acquiring foreign assets and in establishing branch offices abroad; which is true not only of the industry leaders but also of those whose market shares ranked 6-15. Nevertheless, the industry remained highly concentrated, with the market leader Aeroflot-RA holding 18% and 5 leading airlines holding 52% of the market. RAPT industry also saw a great improvement in the regulatory sphere in 2007 – route licensing was abandoned. Until then, an airline was required to receive a license not for air passenger transportation in general, but for each (domestic)6 route it wished to operate on. That rule enabled the Ministry for Transportation to impose quotas on the number of flights, and hence to reduce the total number of carriers by driving the unprofitable ones out of the business. The state of affairs was challenged by the Federal Antitrust Service (FAS) which sought to establish a rule providing enough competition. In the end, the route licensing was abolished in favor of general air passenger transportation licensing. That greatly diminished administrative difficulties faced by the airlines. Some of other positive trends were the emergence of a group of talented top-managers; little competition with other kinds of transport on routes between the European part of Russia and the Far East, and within the Far East; closeness of the domestic air passenger transportation market for foreign airlines; the possibility of regulation of transitory flights through Russia. Figure 2: Number of Airlines 2.3. Negative industry features in Russian Civil Aviation Before discussing the negative features of the RAPT industry, it is essential to understand their fundamental causes. The most important of them was the industry distress in the 1990s, after the USSR collapse. According to the rating agency Expert RA, the distress was caused by the following factors: • historical: the USSR economy was planned and had guaranteed centralized Source: Federal Agency for Air Transport 5 This tendency played a key role: Russian old-generation fuel-inefficient aircraft were being replaced with modern efficient aircraft, obtained mostly from foreign suppliers. That was important for cost-cutting (see below). 6 For international flights, airlines need a special approval of the government, which is quite difficult to get. 3 purchases, direct fare regulation, etc; • domestic economy: after 1991, ticket fares increased because of a rise in prices of inputs (fuel); • political: the industry lacked governmental monitoring and support, which were of poor quality; • international economy: Russian airlines faced tough competition on foreign markets, as well as increasing requirements in safety and fuel emission; • Organizational: the aircraft manufacturing industry lacked cooperation, while the RAPT industry was too much segmented. Those were the major causes of the RAPT industry distress in the 1990s, which determined many of the 2000-2007 industry’s problems. Figure 3: Total Market Shares of 30 Leading Airlines by Passengers Carried in 2007 1 Aeroflot‐RA 18.1% 2 Sibir 51.6% 3 Russia 4 Transaero 5 UTair 6 VIM‐avia 7 KrasAir 8 Atlant‐Soyuz 68.5% 9 Uralskie Avialinii 10 Aeroflot‐Nord 11 Tatarstan 12 Aeroflot‐Don 13 Domodedovskie 78.2% 14 Vladivostok Avia 15 Orenburgskie Avialinii 16 Dalavia 17 Sky Express 18 KD Avia 85.4% 19 Kavminvodyavia 20 Avialinii Kubani 21 Yakutia 22 Kogalymavia 23 Aviaprad 24 Gazpromavia 25 Yamal 92.9% 26 Samara 27 Avialinii Dagestana 28 Alrosa‐Avia 29 Interavia 30 Saratovskie Avialinii Source: ATO Sourcebook 4 Next, the fleet of Russian airlines was largely obsolete: old-generation Russian aircraft, which were fuel-inefficient7, constituted 75% of passenger air fleet in 2007. Consequently, the average fuel efficiency in the industry was about 50% less than that of foreign fleet exploited in Russia. Thus, airlines had to spend more on fuel, and on maintenance and repairing too, because most of the fleet were rather old. Regional airlines could hardly replace old-generation Russian aircraft with new jets. The reason was that customers in regions had too little money to provide the demand generating enough revenues for jet replacement. In general, low income of regional customers, coupled with limited investment by the government, hindered the growth of RAPT industry and especially its domestic and regional segments.