A STUDY of the EFFECTS of KOREAN AIRLINE DEREGULATION: the Impact of Low Cost Carriers (Lccs) Entry on Air Travel Demand And
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A STUDY OF THE EFFECTS OF KOREAN AIRLINE DEREGULATION: The Impact of Low Cost Carriers (LCCs) Entry on Air Travel Demand and Welfare Gains A Dissertation Presented to the Faculty of the Graduate School of Cornell University in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy by Joo Yeon Sun August 2012 © 2012 Joo Yeon Sun ALL RIGHTS RESERVED A STUDY OF THE EFFECTS OF KOREAN AIRLINE DEREGULATION: The Impact of Low Cost Carriers (LCCs) Entry on Air Travel Demand and Welfare Gains Joo Yeon Sun, Ph.D. Cornell University 2012 This dissertation examines the consequences of the Korean Airline Deregulation Act of May 2008. I propose an empirical methodology for analyzing demand and supply in differentiated product markets that measures welfare effects due to the entry of Low Cost Carriers (LCCs) from two perspectives: pre- and post-deregulation. I have built a panel of airline carrier level data for each of the seven domestic non-stop routes from June 2006 to October 2010 to investigate whether the deregulation policy is desirable for increasing the net welfare gains to air passengers, and for promoting competition among airline carriers. Chapter 1 explains the implementation and effects of the Act change on the Korean airline industry. The Act removed restrictions imposed on both aircraft size and aircraft age for the non-scheduled air service carriers so that all LCCs were able to operate jet aircraft which had more than 100 seats per airplane. Since May 2008, the competition, long dominated by two legacy carriers, Korean Air (KAL) and Asiana Air (AAR), has intensified as emerging LCCs have began offering lower air fares. Chapter 2 outlines the empirical framework of the nested logit model and applies it to two categories of city pair routes in Korea: five Jeju island routes and two inland routes. A priori there are expectations of differences in both types of travelers and in alternatives to air transportation, thus differences in air travel demand sensitivity to price and non-price factors, such as frequent flights and aircraft size. In this chapter, I find evidence of a common sensi- tivity to price across the Jeju island routes and the inland routes and route-specific response to flight characteristics. Thus, I propose a joint constrained model in terms of price sensitivity where the param- eter for price variable is constrained to be the same across all seven routes, but the flight characteristics should be permitted to have route-specific effects. Frequent flights, larger air- craft, evenly distributed flight schedules on peak-demand hours (lunchtime for some routes), and shorter airtime duration generate a higher utility for air passengers. Chapter 3 models the supply side and legacy carriers’ strategic responses to the emer- gence of LCCs. The two legacy carriers established their own subsidiary LCCs (dependent LCCs). KAL entered some routes with its subsidiary LCC, JNA, while AAR rebadged to ABL, its subsidiary LCC, replacing their prior service. Chapter 4 integrates the demand- and supply-side in order to derive average price elas- ticities for air travel demand, implied marginal costs and Lerner indices for each carrier’s flights. Price-cost markups are recovered after the demand parameters are first obtained and then inserted in the pricing equation. The estimated results for a dominant airline carrier on some inland routes are inconsistent with the static profit maximization assumption, having inelastic demand elasticities and negative marginal costs. Chapter 5 contributes to the literature on the spatial competition of the airline industry. Empirical findings using time-series data from June 2006 to October 2010 in this chapter suggest that the effects of competition on the degree of inter-firm departure times differenti- ation would have a different impact across the Jeju island routes and the inland route in the deregulated period. Chapter 6 evaluates the welfare gains due to the entry of LCCs. I calculate welfare gains from various types of post-deregulation entry behaviors that are driven by the change in market structure. I find a few entries (i.e., none in half the markets) induced by deregulation. The welfare calculations imply that consumer welfare results are mixed and total welfare results have little evidence to support welfare improvement. I find the introduction of fuel surcharge to be the major obstacles hindering benefits from the Act change for aggregate consumers and industry-wide producers at times of unusually high fuel surcharges. Finally, I summarize and discuss some problems with extensions of this approach. BIOGRAPHICAL SKETCH Joo Yeon Sun was born in Seoul, South Korea. She earned her B.A. in Economics from Yonsei University in 2007. From September 2005 to June 2006, she studied economics as undergraduate exchange student at University of Washington, Seattle. She came to Cornell University to pursue her doctoral studies in the fall of 2007. After finishing all requirements for Ph.D. candidacy, Joo Yeon Sun earned her M.A. in Economics in August, 2011, and earned her Ph.D. in Economics in August, 2012 at Cornell University. iii DEDICATION I dedicate this dissertation to my parents: Chan Jae Sun and Bok Hee Cho. iv ACKNOWLEDGMENTS Writing and completing my dissertation was a long and arduous journey. During the process, I have benefited tremendously by many people’s advice and guidance. I would like to express my special thanks to Robert T. Masson, my dissertation supervi- sor. I would never have been able to finish my dissertation without the guidance of him. Pro- fessor Robert T. Masson was extremely careful in the details, and every time I received com- ments on my draft from him, it was obvious that he had read my draft sentence-by-sentence multiple times. Not only did he teach me how to approach empirical issues in imperfectly competitive markets very carefully, he always provided extremely important criticisms and intuitions which I have overlooked previously. This made me reorganize the entire structure of my dissertation multiple times. I would like to thank all of my dissertation committee members, Professor Jeffrey T. Prince and Professor George H. Jakubson. All of their encouragements, criticisms, and guidance made my graduate years at Cornell University intellectually fulfilling. If there are any remaining faults or errors that are left in this final draft, I would like to emphasize that the fault is entirely on my part. This dissertation represents, not a final product, but an ongoing research in empirical economics. I would also like to thank Professor Kap-Young Jeong at Yonsei University and all the people who provided support outside my graduate program at Cornell. Last but not least, I extend my special thanks to my parents and elder brother for their endless support. Joo Yeon Sun Ithaca, New York August, 2012 v Contents 1 Institutional Background 1 1.1 Introduction . 1 1.1.1 The Korean Airline Industry . 6 1.1.2 The Deregulation Act of May 2008: Implementation and Effects . 8 1.1.3 Two Legacy Carriers Fined for Anti-Competitive Actions against LCCs as of March 2010 . 10 1.1.4 Departure Flight Times Differentiation in Airline Competition . 11 2 Modeling the Demand Side 16 2.1 Theoretical Model . 16 2.2 Empirical Model . 18 2.2.1 The Air Travel Demand for Jeju Island Routes . 18 2.2.2 The Air Travel Demand for Inland Routes . 23 2.2.3 Joint Constraints Jeju island, Inland, and All Routes . 26 2.2.4 Instruments . 27 2.2.5 Panel Fixed Effect Estimator for Unobserved Product Characteris- tics, x jt ................................ 29 2.3 Data . 29 2.4 Demand Results . 38 2.4.1 Route by Route Estimates . 39 vi 2.4.1.1 Jeju-Seoul Route ( r = 1 ) (ar > 0) . 40 2.4.1.2 Jeju-Busan Route (r = 2) (ar > 0) . 42 2.4.1.3 Jeju-Cheongju Route ( r = 3 ) (ar > 0) . 44 2.4.1.4 Jeju-Daegu Route ( r = 4 ) (ar > 0) . 46 2.4.1.5 Jeju-Gwangju Route ( r = 5) (ar > 0) . 48 2.4.1.6 Seoul-Busan Route ( r = 6) (ar > 0) . 50 2.4.1.7 Seoul-Gwangju Route (r = 7) (ar > 0) . 52 2.4.2 Do Routes Look Similar . 55 2.4.2.1 Jeju Island Routes . 55 2.4.2.2 Inland Routes . 59 2.4.2.3 Joint Constraint for All Routes, 8r = 1;2;3;4;5;6;7, Jeju Island and Inland Routes . 62 3 The Supply Side 64 3.1 The Theoretical Model . 64 3.1.1 Single Product Firm . 64 3.1.2 Multiproduct Firms (Joint Ownership between Major Airlines and their Own Subsidiary LCCs) . 68 3.1.3 Legacy Carrier Behavior . 73 3.1.3.1 Jeju Island Routes . 75 3.1.3.2 An Inland Route . 85 3.1.3.3 Jeju Island Routes and an Inland Route . 87 4 Integrating the Demand Side and Supply Side 89 4.1 Price Elasticities and Markups . 89 4.1.1 Jeju Island Routes . 90 4.1.1.1 Jeju-Seoul Route ( r = 1 ) . 91 4.1.1.2 Jeju-Busan Route ( r = 2 ) . 99 vii 4.1.1.3 Jeju-Cheongju Route ( r = 3 ) . 107 4.1.2 An Inland Route: Seoul-Busan . 111 4.1.2.1 Seoul-Busan Route ( r = 6 ) . 111 4.1.3 Summary . 116 5 The Supply Side: Airline Flight Scheduling 119 5.1 Inter-Firm Departure Times Differentiation: BtwnDIFF Index . 119 5.2 Predictions . 124 5.3 Model . 128 5.4 Data and Estimation Results: Route-by-Route Estimates . 130 5.4.1 Jeju Island Routes . 130 5.4.1.1 Jeju-Seoul Route ( r =1 ) . 131 5.4.1.2 Jeju-Busan Route ( r =2 ) .