PHILIPPINE ANALYSIS The Evolution of the Philippine Airline Industry

This article documents the changes in the Philippine airline industry since 1995, the year the government liberalized the civil aviation industry. A monopoly for more than 20 years, liberalization trans- formed the domestic industry into virtual duopolies in major airline markets while minor routes remain virtual monopolies, suggesting that the government’s goal to make the industry more competitive has not been realized.

By Wilfred Manuela To spearhead policymaking for the cross-subsidization allowed PAL to passenger airline industry, the provide airline service in thinly trav- Philippine Government passed the eled routes. Civil Aeronautics Act (Republic Act 776) in 1952. It gave the Civil The Social Costs of Monopoly Power Aeronautics Board (CAB) and the Air Regulation of the US airline industry Transportation Office (ATO) the resulted in a government-supervised authority to promote adequate, eco- cartel (Keeler 1972; Poole and Butler nomical, and efficient passenger air- 1999), while the ’ one-air- line service and those of other carriers line policy resulted in a government- at reasonable charges and promote authorized monopoly. Although the competition between passenger air- government compelled PAL to subsi- between 1994 and 1995 even without lines and other carriers to the extent dize missionary routes, increasing a competitor to preempt a potential necessary in order to ensure the devel- output for the entire domestic indus- rival, indicating that PAL has been opment of the Philippine air trans- try, the airline restricted the number of restricting output before liberaliza- portation system. CAB administers departures and passenger seats in a tion. Although the mere transfer from the economic regulation of the indus- number of high-density markets. passengers to PAL does not, by itself, try while ATO supervises the techni- affect efficiency, the restriction of out- cal aspect. The government liberal- The number of passenger seats in the put below competitive levels in some ized the airline industry in 1995 under – and Manila–Davao markets has resulted in efficiency Executive Order (EO) 219. markets increased 38 percent and 75 losses. Economists have estimated percent, respectively, from the previ- that the deadweight loss that results The passage of two Letters of ous year when Grand Air entered from restriction of output and higher Instructions (151 and 151A) in 1973 these markets in 1995 (see table 1), prices ranges from a negligible ushered in a major policy shift for the indicating that PAL restricted output amount to as much as 13 percent of industry, granting Philippine before the industry was liberalized. gross national product and that even a (PAL) a virtual monopoly of the coun- The entry of three airlines in the relatively small deadweight loss may try’s civil aviation industry. The pas- Manila–Iloilo market in 1996 also be associated with a large redistribu- sage of Presidential Decree 1590 in resulted in a 61 percent increase in the tion of wealth (Carlton and Perloff 1978 gave PAL a new franchise but number of passenger seats from a year 1994). The resources used to hire with a provision that the franchise earlier, while the Manila–Cagayan de economists, lobbyists, and lawyers to should not be interpreted as an exclu- Oro market experienced a 30 percent argue the case of PAL before the sive grant of privileges. The industry, increase in the number of passenger Philippine congress is also a cost to however, remained uncontested seats between 1995 and 1996. society because these resources could between 1973 and 1994 compelling PAL increased the number of passen- have been used for more productive the government to regulate fares to ger seats supplied in the ends. The airline monopoly in the prevent PAL from engaging in Manila–Bacolod market by 42 percent Philippines resulted in financial losses monopoly pricing, capping the air- line’s return on investment (ROI) to 12 percent. The ROI regulation allowed PAL to recover losses through government subsidies and to charge higher fares in high-density markets to subsidize unprofitable routes. Although extremely inefficient Table 1: Total Passenger Seats in the Top Five Markets Source: Civil Aero- and a drain on government coffers, the nautics Board

e-zine edition, Issue 36 1 for PAL, largely due to its misman- operating permits, approves the routes sales (Carlton and Perloff 1994). The agement and inefficiency (Austria that airlines serve, and still reviews CR4 for the period 1996–2003 is 2000), while limiting output in some and approves airfares in single-airline shown in table 2. The annual CR4 markets may have resulted in higher markets. CAB is also a member of the ratio indicates that the industry is fares before 1995 (see Manuela government panel that negotiates air basically an oligopoly with two domi- 2007). service agreements with other coun- nant firms. PAL, however, still domi- tries. nates the market with more than 50 The use of bigger aircraft by PAL percent share of the industry’s rev- after 1994 and the choice of bigger Market Structure under Liberalization enues except in 1999 when it with- aircraft by and Air The airline industry has changed dras- drew from missionary routes. PAL’s Philippines indicate that PAL has been tically since 1995—PAL was priva- revenue share has hovered between 50 using smaller aircraft than what is tized and restrictions on entry and and 54 percent although Cebu Pacific required by demand and passenger capacity were lifted. Moreover, gov- has managed to take away revenue preferences before liberalization, ernment controls on the number of share from the incumbent, indicating resulting in more seats per flight. domestic routes served and flight fre- that Cebu Pacific is able to compete quency have also been eliminated, as against PAL. Cooper (1999), however, The Role of CAB under Liberalization well as restrictions on fares, except in argues that an industry must have The airline industry was liberalized in markets with only one airline. In the more than six firms in order for it to 1995 under EO 219, establishing the years following liberalization, the sustain competition in the long run. domestic and international civil avia- domestic airline industry has attracted tion liberalization policy in the coun- as many as five entrants, but this num- The Herfindahl-Hirschman Index try. The EO stipulates the removal of ber has dwindled to three following (HHI), a measure of industry concen- restrictions on routes and flight tration, sums the squared frequencies, as well as govern- Liberalization appears to result in market shares of each firm ment control on fares and in the industry (Carlton and charges. On market entry, the a sizeable increase in passenger Perloff 1994). When the provision encourages at least domestic airline industry is two operators in any route and traffic in most of the 15 biggest taken as a single market, operators are free to leave any airline markets in the country the HHI is basically stable unprofitable routes. With (see table 3). The US regard to fare, markets with at least the failures of Grand Air (national Department of Justice contends, how- two operators are deregulated, while operator) and ever, that an HHI above 1,800 is con- regulation still applies in single-air- (regional operator). The demise of sidered highly concentrated (Cooper line markets. new entrants in a relatively short peri- 1999). The much higher HHI od is comparable to the US experience observed in the Philippines is due to It may appear on the surface that fares in the early 1980’s (Kahn 1988 and the dominance of PAL in most routes and flight frequency are still regulated Borenstein 1992). With the entry of and the near duopoly that exists by CAB due to the airlines’ practice of South East Asian Airlines (SEAir) in between PAL and Cebu Pacific in informing CAB of their intentions. the scheduled airline sector in 2003, almost all markets served by both air- However, the practice of readily three airlines now compete in major lines. granting the airlines’ requests for revi- markets (PAL, Cebu Pacific, and Air sions in airfare and flight frequency Philippines) while two airlines serve When the industry is divided into and schedule in a matter of days seem short-distance routes (Asian Spirit and major (more than 20,000 passengers to indicate that CAB has been imple- SEAir), giving passengers at least two annually) and minor routes, major menting the provisions of EO 219. It choices in some markets, offering routes appear to be more concentrated simply monitors rates and charges in them a range of fares, departure fre- than the entire industry, while minor the domestic airline industry to pro- quency, and service quality. routes are almost twice as concentrat- mote competition and the welfare of ed as the entire industry (see table 3). consumers. The steady decline in PAL’s market The numbers seem to indicate that share, from 96 percent in 1995 to 49 minor routes are virtually single-air- Austria (2000) observes that the role percent in 1999, indicates that compe- line markets while major routes are of CAB has been limited to regulating tition has intensified after liberaliza- virtual duopolies. capacity, flight frequency, and airfare tion. The four-firm concentration ratio in the international air transport sector (CR4) measures the revenue share of High-Density Markets under after 1995. CAB, however, still issues the four largest firms to total industry Liberalization Liberalization appears to result in a sizeable increase in passenger traffic in most of the 15 biggest airline mar- kets in the country (see table 4). Between 1994 and 2003, the number of markets with an annual passenger traffic of at least 100,000 increased from 11 to 15, although most of these markets are virtual duopolies.

Table 2: Four-Firm Concentration Ratio Annual Revenue Share in Percent Source: One of the benefits of liberalization is Civil Aeronautics Board the introduction of airline service in

e-zine edition, Issue 36 2 new markets, either by the incumbent Kahn (2002) notes that cabin space departure delays have become the or the new airlines. Two airline mar- per passenger fell after deregulation in norm. In the US, travelers endure an kets that opened in 1996 the US due to narrower seating to undeniable increase in congestion, (Manila– and accommodate more passengers per departure delays, and discomfort due Manila–Caticlan) experienced phe- flight, which results in higher load to the enormous response of passen- nomenal growth in traffic between factors. In the Philippines, however, gers to the availability of options with 1996 and 2003 (see table 4). The more the average load factor has decreased regard to fares, flight schedules, and than four-fold growth in passenger after 1994 (see figure 1). The observa- aircraft technology (Kahn 2002). In traffic in the Manila-General Santos tion in the top five airline markets that the Philippines, the congestion at air- market may be attributed to the open- load factors are lower under liberal- ports is exacerbated by the lack of ing of an alternate international air- port and the upgrading of the seaport in General Santos, making it a leading destination for business and leisure in the region. The more than three-fold increase in the Manila–Caticlan mar- ket is indicative of ’s rise as a premier tourist destination in the Table 3: Herfindahl-Hirschman Index Source: Civil Aeronautics Board country. The introduction of direct ization is contrary to the findings of adequate infrastructure to support the flights between Manila and Caticlan, Graham, Kaplan, and Sibley (1983) increase in the number of departures however, diverted traffic away from that load factors increased after airline after 1994. Although the current the Manila– market. Kalibo deregulation in the US and that load Medium-Term Philippine used to be the gateway to Boracay factor tends to increase with distance. Development Plan addresses this before the introduction of direct Overall, it appears that capacity has issue in some respects, it will be some flights to Caticlan. been growing faster than demand after time before airport facilities are 1994, at least in the five city-pairs. upgraded. Kahn (2002) adds that as Although airline travel is still out of This may indicate that airlines are for the supply side, the airline indus- reach to most Filipinos, the increased using a combination of bigger aircraft try relies primarily on the government competition in the industry has pro- and more frequent flights as a means to provide adequate air traffic control vided passengers with discounted to compete for passengers and facilities and personnel at airports. fares available throughout the year in increase profitability. The decreasing The practice of price discrimination various forms. As far as the traveler is passenger load factor, however, does among airlines has increased search concerned, the lower fares are the not augur well for the airlines’ prof- costs, making passengers spend more most tangible benefits of liberaliza- itability. The lower load factor time comparing fares among airlines tion. PAL served unprofitable markets observed after liberalization indicates, and travel agencies (relative to 1994 when PAL was the only airline). While CAB admonishes airlines to have an annual ROI of 12 percent in order to reduce the probability of bankruptcy, the airlines tend to engage in cutthroat competition that has driven weaker competitors like Grand Air and Mindanao Express out of the market. The boon to passengers is that fares tend to decrease as com- petition intensifies (Bresnahan and Reiss 1991; Manuela 2007), but this may not be sustainable if some of these airlines fold-up.

Missionary Routes under Liberalization One of the benefits of regulation is the acceptability of an inefficient market outcome due to the provision of airline service in communities that Table 4: Passenger Traffic in Top Fifteen Airline Markets. Source: Civil Aeronautics could otherwise not support an air- Board. Manila-General Santos and Manila-Caticlan data are 1996 and 2003 line. Missionary routes have been cross-subsidized by PAL for decades. through cross-subsidy during regula- however, that domestic flights are less The practice of cross-subsidizing tion by inflating fares in profitable crowded, enhancing the comfort of unprofitable routes persisted until markets. This practice, however, has flying and thus the quality of service 1998 when PAL, feeling intense com- become untenable in a liberalized (Jorge-Calderon 1997). petition from new entrants, aban- environment since PAL has to match doned its missionary routes in 1999 in the lower fares of its rivals in order to There are also downsides to the order to focus on markets with the stay competitive (Austria 2000), increase in passenger traffic. Airports highest passenger traffic and confront which led the airline to abandon its have become more congested due to Cebu Pacific, which has been grab- service in missionary routes. more flights (see figure 2) and flight bing market share from the incum-

e-zine edition, Issue 36 3 Figure 1:Passenger Load Factor in Top Five Markets. Figure 2:Number of Roundtrip Flights Annually in Top Five Source: Civil Aeronautics Board Markets. Source: Civil Aeronautics Board bent in major routes. As a result, the Conclusion number of routes that PAL served fell This article has presented the changes Graham D. R., D. P. Kaplan, and D. S. from 56 markets in 1998 to 22 mar- in the Philippine domestic airline Sibley (1983) “Efficiency and competition kets in 1999 (see table 5). Some of industry since 1995. in the airline industry,” Bell Journal of the missionary routes abandoned by Economics and Management Science (Spring), 118–138. PAL were later served by Asian Spirit The findings suggest that the impact from 1999 onwards and SEAir start- of liberalization on the domestic Jorge-Calderon, J. D. (1997) “A demand ing 2003. industry is mixed. Departure frequen- model for scheduled airline services on cy increased in the most profitable international European routes,” Journal of The number of missionary routes markets, while smaller communities Air Transport Management, Vol. 3, No. 1, served by Asian Spirit and SEAir, either lost service altogether or expe- 23–35. however, is less than the number of rienced sizeable declines in departure routes abandoned by PAL. If we frequency and capacity. Furthermore, Kahn, A. E. (1988) “Surprises of airline account for the overlap in the opera- some markets served by a single air- deregulation,” American Economic tions of the two airlines, some 11 line have relatively higher fares, con- Review (May), 316–322. markets that used to be served by sistent with the impact of deregula- Kahn, A. E. (2002) “Airline deregulation.” PAL in 1998 have lost airline service. tion on the US domestic airline indus- The Concise Encyclopedia of Economics, Another negative impact of liberal- try. Henderson D. R. (ed.), Indianapolis: ization is the reduction in the number Liberty Fund, Inc. [Online] available at of passenger seats in some markets, References http://www.econlib.org/library/Enc/Airlin although improvements in land trans- Austria, M. S. (2000) “The state of com- eDeregulatio.html; accessed on 17 port and sea transport may have con- petition and market structure of the December 2004. tributed to the decline in demand, and Philippine air transport industry.” PASCN thus capacity. Less frequent service in Discussion Paper No. 2000-12, Philippine Keeler, T. E. (1972) “Airline regulation seven markets (see table 6) after lib- Institute for Development Studies. and market performance,” Bell Journal of eralization resulted in sizeable Economics and Management Science Borenstein, S. (1992) “The evolution of (Autumn), 399–424. declines in capacity between 1994 US airline competition,” Journal of and 2003 due to the airlines’ realloca- Economic Perspectives, Vol. 6, No. 2 Manuela Jr., W. S. (2007) “Airline liberal- tion of resources to more profitable (Spring), 45–73. ization effects on fare: The case of the routes. Philippines,” Journal of Business Bresnahan, T. F. and P. C. Reiss (1991) Research, Vol. 60, No. 2, 161–167. Despite the provisions of EO 219 that “Entry and competition in concentrated fares remain regulated in markets markets,” Journal of Political Economy, Poole Jr., R. W. and V. Butler (1999). served by one carrier, airlines serving Vol. 99, No. 5 (October), 977–1009. “Airline deregulation: The unfinished rev- secondary and tertiary routes charge olution,” Regulation Magazine 22:1 Carlton, D. W. and J. M. Perloff (1994) (Spring), 1–8. [Online] available at higher fares due to the absence of Modern industrial organization, 3rd edi- competition (Austria 2000), charging tion, Addison-Wesley Publishing http://www.cato.org/pubs/regulation/regv the equivalent of PAL’s business class Company. 22n1/airline.pdf; accessed on 17 fares. The higher fare is necessary to December 2004. cover for the higher cost per seat- Civil Aeronautics Board for airline-related kilometer on smaller aircraft that are data. About the Author used in these routes, making shorter Wilfred S. Manuela Jr. is assistant flights cost more per kilometer than Cooper, M. N. (1999) “Freeing public pol- professor at the University of the longer ones (Kahn 2002). The higher icy from the deregulation debate: The air- Philippines, Diliman, Quezon City fare observed in these routes is con- line industry comes of age,” presented at (http://www.upd.edu.ph) the American Bar Association, Forum on sistent with the findings of Graham, Air and Space Law: The Year in Aviation He wrote a dissertation on the Kaplan, and Sibley (1983) that, fol- on January 22, 1999. [Online] available at Philippine airline industry. lowing deregulation, fares increased http://www.consumerfed.org/abaair1.pdf# in short-haul markets in the US. , accessed on April 4, 2005.

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