Thesis Strategic behaviour, barriers to entry and barriers to mobility : an investigation into the European airline industry from 1993 to 1997 HUBER, Hans Joséf Abstract L'étude s'appuie sur la littérature économique sur les économies d'échelle, la différenciation des produits, les coûts échoués, les avantages des coûts absolus et la contestabilité des marchés. Au plan empirique, l'incidence des barrières à l'entrée sur les prix des vols a été mesurée par une analyse de ségression basée sur les changements de tarifs opérés par les lignes aériennes entre 1993 et 1997. Les analyses empiriques mettent en évidence les écarts de tarifs significatifs en fonction de la dominance sur les hubs et l'excès de capacité dans la fréquence des vols sur ces hubs, une subvention croisée grâce aux routes intercontinentales et, d'autre part, par le contrôle des systèmes informatiques de réservation. Reference HUBER, Hans Joséf. Strategic behaviour, barriers to entry and barriers to mobility : an investigation into the European airline industry from 1993 to 1997. Thèse de doctorat : Univ. Genève, 2001, no. SES 515 DOI : 10.13097/archive-ouverte/unige:117 Available at: http://archive-ouverte.unige.ch/unige:117 Disclaimer: layout of this document may differ from the published version. 1 / 1 Strategic behaviour, barriers to entry and barriers to mobility: An investigation into the European airline industry from 1993 to 1997 Thèse présentée à la Faculté des sciences économiques et sociales de l’Université de Genève Par Hans J. Huber pour l’obtention du grade de Docteur ès sciences économiques et sociales mention gestion d’entreprise Membres du jury de thèse : Mme. Victoria Curzon Price Professeur, Genève, directrice de thèse M. Fabrizio Carlevaro Professeur, Genève, président du jury M. Xavier Gilbert Professeur, IMD Lausanne M. Bernard Morard Professeur, Genève Thèse no 515 Editions IMD Genève, 2001 La Faculté des sciences économiques et sociales, sur préavis du jury, a autorisé l’impression de la présente thèse, sans entendre, par là, émettre aucune opinion sur les propositions qui s’y trouvent énoncées et qui n’engagent que la responsabilité de leur auteur. Genève, le 6 Juillet 2001 Le doyen Beat Bürgenmeier Impression d’après le manuscrit de l’auteur 2 A Marlène Schmid 3 I Introduction I.1 From the first to the third package of airline deregulation I.2 Three different schools of entry barriers II Economies of scale II.1 Explaining the concept of economies of scale II.2 A model for limit pricing (Bain-Sylos-Modigliani) II.3 Are there economies of scale in the airline industry? II.3.1 General cost drivers in the industry II.3.2 Economies of scale versus density II.3.2.1 Defining the differences II.3.2.2 Introducing hubs and spokes II.3.2.3 What brings down unit costs? II.3.3 Tracing cost curves for the airline industry II.3.4 Economies on European routes II.3.4.1 Stage lengths of European routes II.3.4.2 Hub concentration at the origin or destination airport II.4 Implications for strategic behaviour II.5 Describing maintained output III Product differentiation III.1 Definition III.2 The issue of switching costs III.3 Differentiation as a means for higher prices for incumbent airlines III.4 The means of differentiating airline services III.4.1 “Active” differentiation III.4.1.1 Advertising III.4.1.2 Brand loyalty III.4.1.3 Flight frequency III.4.1.4 Point to point III.4.1.5 Service quality III.4.1.6 Unique value proposition 4 III.4.2 “Passive” differentiation III.4.2.1 Ticket classes indicating differentiation III.4.2.2 A survey of airlines’ tendency towards passive differentiation III.5 When differentiation meets scale effects: lever or constraint? III.6 The alternative with less differentiation III.7 Finding the optimal degree of differentiation while allowing for entry IV Sunk costs IV.1 The role of commitment IV.2 Commitment with excess capacity IV.3 Sunk costs in the airline industry IV.3.1 Air transport capacity IV.3.1.1 Aircraft size as commitment? IV.3.1.2 Routes as commitment? IV.3.1.3 Flight frequency as commitment? IV.3.1.4 Hub-and-spoke operations as commitment? IV.3.2 The commitment in frequent flyer programmes IV.3.3 Computer reservation systems IV.3.4 Alliances: Code sharing and franchising IV.3.5 Advertising IV.4 The Dixit model applied to sunk costs in the airline business IV.4.1 Entry deterrence by committing to flight frequency IV.4.2 Consequences of strategic behaviour with computer reservation systems IV.4.3 Consequences of interlining behaviour (post-entry) IV.4.4 Consequences of strategic behaviour with franchising IV.5 A comparison between Dixit and Bain-Sylos-Modigliani 5 V Absolute cost advantages V.1 What are absolute cost advantages? V.2 The incumbent’s strategic behaviour creating absolute cost advantages V.2.1 Learning by doing V.2.2 Raising a rival’s costs V.2.3 Long-term contracts with customers V.3 Absolute cost advantages in the airline business V.3.1 Airport slots V.3.1.1 Some regulatory background V.3.1.2 Development of slot capacity at major European hubs V.3.1.3 Grandfathered rights and hub dominance: Commitment or absolute cost advantage? V.3.2 High wage rates due to unionization V.3.3 Cross subsidies from intercontinental routes V.3.4 Frequent flyer programmes V.4 Expected post-entry behaviour with absolute cost advantages in the airline business VI Perfectly contestable markets VI.1 Contestability theory as the basis for empirical testing VI.2 The issue of price sustainability VI.3 Contestable markets and entry barriers VI.3.1 Contestable markets and fixed costs VI.3.2 Contestable markets and cross-subsidies VI.3.3 Contestable markets and sunk costs VI.3.4 Contestable markets and strategic behaviour VI.4 Perfectly contestable markets and the airline business VI.5 Predictions of contestability theory concerning the airline sector 6 VII Empirical part and conclusions VII.1 Research design VII.1.1 Data and sample selection VII.1.2 Variable selection and analysis of raw data VII.1.3 Estimation VII.2 Cluster, factor and regression analysis VII.2.1 Cluster analysis versus factor analysis VII.2.1.1 Clustering: Preliminaries VII.2.1.2 Clustering: Resulting clusters VII.2.2 Factor analysis of measures associated with entry barriers VII.2.3 Regression analysis and entry barrier measures VII.3 Regression results for incumbent and new entry routes VII.3.1 Results for incumbent routes (Cluster 1) VII.3.2 Interpretation of results (Cluster 1) VII.3.3 Results for new entry routes (Cluster 4) VII.3.4 Interpretation of results (Cluster 4) VII.3.5 Synthesis and comparison of the results VIII Implications for strategy and public policy VIII.1 Strategic implications for incumbents VIII.1.1 Exploiting existing barriers to entry through strategic behaviour VIII.1.2 Creating new barriers to entry VIII.2 Strategic implications for entrants VIII.3 Implications for public policy VIII.3.1 Liberalization of European air traffic has failed VIII.3.2 Economic barriers to entry replace regulatory barriers VIII.3.3 Why privatization will not resolve these market imperfections 7 Strategic behaviour, barriers to entry and barriers to mobility: An investigation into the European airline industry from 1993 to 1997 by Hans J. Huber Abstract This paper investigates entry barriers and the way they impact on strategic behavior and pricing in the context of deregulation within the European airline industry. By using contestability theory to approximate a theoretical optimum, identified entry barriers and their impact on prices can be measured. 35 densely traveled city pairs are examined and clusters are formed that define strategic groups according to operational characteristics. Two clusters that were particularly relevant in the context of liberalization are selected: incumbent routes and routes where new service was started. Price changes in these groups were regressed against suspected entry barriers. Hub dominance and excess capacity in flight frequency on such hubs, along with intercontinental flights and, to a lesser extent, control of computer reservation systems were found to explain significant deviations from market contestability within the most competitive price segments. Successful incumbents are able to replace regulatory barriers by economic barriers to entry. 8 I Introduction Under the influence of deregulation of domestic air transport in the US in 1978 and the signing of the Single European Act in 1986, the European Council aimed to achieve an internal market in the air transport sector. The Council passed legislation under Article 84(2) to abolish the many existing bilateral restrictions on competition and to move from a bilateral to a multilateral system. I.1 From the first to the third package of airline deregulation The Single European Act came into effect on 1 July 1987. The liberalization of air transport envisaged in the Act was begun, though it was done stage by stage because of the different positions which the member states took towards liberalization. Among these, the UK, the Netherlands and Eire were the foremost advocates of liberalization; Germany, France, Spain and Italy on the other hand, with their state owned and heavily subsidized national flag carriers, were at the rear. The process of liberalization was carried out in three stages; each stage usually termed the first, second and third packages, respectively. The first package was adopted by the Council in 1987, the second in 1990 and the third in June 1992. The first package contained regulations laying down the procedure for the application of competition