The Economic Impact of Air Cabotage Restrictions in the United States

No. 18-52 Spring 2019 MERCATUS GRADUATE POLICY ESSAY THE ECONOMIC IMPACT OF AIR CABOTAGE RESTRICTIONS IN THE UNITED STATES by Adam Simons The opinions expressed in this Graduate Policy Essay are the author’s and do not represent Abstract Air cabotage, or the ability of foreign airline carriers to fly domestic routes, is exceptionally rare. Widespread adoption would yield significant economic benefits. Despite this, government restrictions on air cabotage prevail around the world, creating government-granted oligopoly in the airline industry. By comparing the US model with that of the EU, I assess the economic impact of cabotage restriction in the United States, using recent mergers as a proxy for reduced competition. My findings are consistent with theories of oligopolistic competition and reveal that Europe’s model has allowed for more competitive pricing, while the lack of competition in the US has led to a steady increase in prices. I find that one feasible method of achieving air cabotage is for the US to engage in bilateral air cabotage agreements. Author Bio Adam Simons is currently an International Trade Compliance Analyst at the US Department of Commerce. He is an alumnus of the MA Program in the Department of Economics at George Mason University and was also a Mercatus Center MA Fellow. He graduated in May of 2018. Adam graduated from the University of Nebraska – Lincoln with a BA in Political Science and a minor in Economics. He previously worked as an office manager for the National Institutes of Health, as a program assistant for the Anthropology Department at the National Museum of Natural History, and as an intern in the US Senate. His research interests include development economics, technology policy, and trade policy. Committee Members Anne Hobson, program manager, Academic and Student Programs, Mercatus Center at George Mason University Malia Dalesandry, program manager, Academic and Student Programs, Mercatus Center at George Mason University Jayme Lemke, associate director, academic and student programs, and senior fellow for the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University Mercatus MA Fellows may select the Mercatus Graduate Policy Essay option in fulfillment of their requirement to conduct a significant research project. Mercatus Graduate Policy Essays offer a novel application of a well-defined economic theoretical framework to an underexplored topic in policy. Essays offer an in-depth literature review of the theoretical frame being employed, present original findings and/or analysis and conclude with policy recommendations. The views expressed here are not necessarily the views of the Mercatus Center or Mercatus Center Academic and Student Programs. Acknowledgements Many thanks to my advisors for helping me complete this project and getting me to look at my research question from different perspectives. In particular, I want to thank Anne Hobson, Malia Dalesandry, and Professor Ben Baldanza for their time, advice, and encouragement. I would not have finished my essay without you, so, thank you! 1 Table of Contents Introduction………………………………………………………………………………………..3 The History of Airline Liberalization Policy and Competition…………………………………...4 Methodology……………………………………………………..………………………………..7 Figure 1. The Definition of Price as A Function of Total Revenue and Quantity………...9 Findings…………………………………………………………………………………………...9 Table 1; Figure 2. American Airline Industry RASM from 1995-2016…………...…….10 Table 2; Figure 3. Lufthansa Group RASM from 1996-2016……………………….…..11 Table 3; Figure 4. International Airlines Group RASM from 1995-2016…………….....12 Figure 5. European Airlines by Total Capacity (Available Seats)……………………….13 Figure 6. The Stag Hunt Game for Air Route Liberalization……………………………16 Conclusion……………………………………………………………………………………….18 2 Introduction Nearly two billion passengers traveled by air worldwide in 2016. Air transportation’s total economic impact is estimated at USD 2.7 trillion, globally (ATAG 2016). In recent decades, liberalization and competition in the airline industry resulted in significant gains for passengers globally. Yet a majority of national governments maintain air transport restrictions that prevent competition, increase fares, and lower service quality. Air cabotage, or the ability of foreign airline carriers to fly domestic routes, would yield substantial economic benefits. Despite this, government restrictions on this freedom prevail around the world, creating government- sanctioned oligopolies. This paper seeks to measure how restrictions on air cabotage in the US harm consumers. Having experienced firsthand the advantages of a competitive airline industry—namely, affordable, comfortable commercial flights to a variety of cities—I was motivated to research the differences between countries that allow airlines more “freedoms of the air” versus those that allow fewer of them. These “freedoms of the air” describe certain rights of air transportation, ranging from the most basic: the first freedom of the air grants a foreign airline the right to use their airspace; to the most comprehensive: the ninth freedom, air cabotage, affords a foreign airline the rights to both begin and end a flight in domestic territory (Szakal 2013). This paper is unique in that it compares the price changes over time between a market that allows no form of air cabotage (US), and a market under a cabotage agreement between dozens of countries (the EU). For the purposes of this research paper, I focus on passenger air travel. 3 The History of Airline Liberalization Policy and Competition Over the past several decades airline liberalization has promoted competition and led to an increase in consumer surplus in the United States. Prior to the introduction of airline liberalization policy, the US airline industry faced a severe lack of competition. The Civil Aeronautics Board (CAB), established in 1938, determined which US cities and routes would be served, the ticket prices for each flight, and which airlines had the right to operate on each route. This ensured there could be no competition in a market run by regulatory powers. The CAB was the law of the land until 1978 when President Jimmy Carter signed the Airline Deregulation Act. Gradually, the Act allowed more airlines to serve new and existing routes and allowed more freedom for airlines to set their own ticket prices. Successful intra-state airlines like Southwest were able to take their low-cost model to the rest of the country, providing more frequent and less expensive options for passengers. By lifting strict government control of prices as well as market entry and exit, the Act had the impact of increasing competition and reducing prices for passengers (Sheth et al. 2007: 21–32). American airline liberalization advanced another major step in 2007 with the EU-US Open Skies Agreement. This bilateral agreement allows for transatlantic flights by any airline, European or American. Winston et al. calculated that the 2007 EU Open Skies Agreement, allowing all EU airlines to fly international routes with the US and vice versa, resulted in a gain of $4 billion USD to travelers per year (2015)—a huge boon to passengers. This complements the pro-consumer argument for opening up air routes. In direct opposition to airline deregulation, and liberalization more broadly, is the protectionist argument. Prominent airline lobbying groups regularly make the protectionist case. For example, Airlines for America’s policy priorities state that “the government needs to play its 4 role in ensuring US commercial aviation is operating on a level playing field with foreign competitors” (2018). One common protectionist argument from the airline industry is that the US should not allow foreign competitors access to US markets when they receive benefits from their nation’s government via tax breaks, subsidies, or other public support. The Partnership for Open & Fair Skies (2018) points to three airlines in particular—Emirates, Etihad Airways and Qatar Airways—for receiving too many subsidies from their respective governments. The Partnership has had success in getting the Trump administration to the table with the United Arab Emirates and Qatar in order to end airline subsidies and halt the establishment of new routes into the US (Garcia 2018). Nineteenth century economist Frédéric Bastiat famously lampooned this concern in his candlemaker’s petition, in which he points out that consumers buy from foreign producers when these producers area able to “flood” the market by selling their goods at high quantities and low prices (Bastiat 1845). This, in turn, can harm the domestic industry which cannot compete with these prices. He satirically suggests that candlemakers should lobby for a ban on natural light— by blocking out the Sun—as it quite literally floods the domestic market by providing its “product” at anticompetitive prices (that is to say, free). Behind the satire, Bastiat’s point is that cheap goods and services are a boon to consumers—protecting one industry at the cost to all consumers would be suboptimal (Ibid.). Airline liberalization and competition have been studied extensively, and most of these studies show that it leads to significant gains for consumer welfare (Sheth et al. 2007). Consumer welfare for our purposes means any advantage the consumer gains. For example, this could include lower prices on tickets and ancillary fees, higher quality service, safer flights, or more

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