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5
ANALYSIS OF ENTRY AND EXIT... 52
5.1 Purpose ... 53
5.2 Data ... 53
5.2.1 Data
construction ... 54
5.2.2 Strengths and weaknesses of the data set... 56
5.3 Methodology ... 56
5.4
Entry, exit and welfare effects ... 58
5.5
Entry and exit over time... 59
5.5.1 The 1996 entry wave ... 63
5.5.2 The 2004 entry wave ... 64
5.5.3 Airlines
1993-2006 ... 66
5.6
Entry, exit and market concentration ... 67
5.7
Entry, exit and incumbent behaviour ... 74
5.8
Entry, exit and prices ... 80
5.9
The German Airline Market in 2006... 83
5.9.1 Route
network... 85
5.9.2 Market
shares ... 86
5.9.3 Brand
competition... 88
5.10 Summary
of
Results... 90
6 IMPEDIMENTS
TO
COMPETITION ... 93
6.1 Barriers
to
entry... 93
6.1.1 Strategic
barriers
to
entry... 94
6.1.2 Structural barriers to entry ... 94
6.2
Alliances an economic necessity? ... 96
7 SUMMARY ... 99
Appendix... 101
A Glossary ... 101
B Freedoms of the Air ... 103
C Germany's International and Regional Airports ... 104
D IATA Airport and Airline Codes... 106
E Additional Tables and Statistics ... 107
References... 116
LIST OF ILLUSTRATIONS
FIGURES
Figure 2-1: Multi-level air transport ... 12
Figure 3-1: Passenger load factor on inner-German routes... 31
Figure 4-1: German airport network ... 34
Figure 4-2: German airports according to PAX ... 37
Figure 4-3: Demand for air travel and GDP ... 41
Figure 4-4: World passenger development 1996-2005 ... 42
Figure 4-5: Air traffic growth until 2015. ... 43
Figure 4-6: Development of LCC route network. ... 45
Figure 4-7: Capacity growth of Low Cost Carriers for Europe and Germany 2001-2006 ... 46
Figure 5-1: Operated routes with no entry 1993-2006 ... 61
Figure 5-2: Aggregated entry, exit and net entry rates (%) 1993-2006 ... 62
Figure 5-3: Airlines 1993-2006... 66
Figure 5-4: Number of routes (total: 25) with given number of operating airlines 1993-2006 .. 68
Figure 5-5: Number of LON routes (total: 8) with given number of airlines 1993-2006 ... 69
Figure 5-6: Distribution of non-monopolistic routes 1993-2006 ... 70
Figure 5-7: Entry, exit and output ... 76
Figure 5-8: Development of frequency on route BERDUS ... 79
Figure 5-9: Price indices Germany 2000-2006 (2000=100) ... 81
Figure 5-10: Operating carriers on inner-German routes 2006... 84
Figure 5-11: Airline route networks 2006 ... 86
Figure 5-12: Airline ownership and control 2006 ... 89
TABLES
Table 2-1: Overview of deregulatory measures... 19
Table 4-1: Comparison of transport modes for short-haul inner-German routes ... 50
Table 5-1: Entry and exit activity 1993-2006... 60
Table 5-2: Route entry and exit in 1996 ... 63
Table 5-3: Route entry and exit 2004-2005 ... 65
Table 5-4: Average number of airlines per operated route... 71
Table 5-5: Herfindahl index and numbers-equivalent of firms... 72
Table 5-6: Number of different airlines on inner-German and LON routes 1993-2006 ... 73
Table 5-7: Effects of firm entry and exit on capacity and frequency... 75
Table 5-8: Correlation of Lufthansa output with entry and exit ... 78
Table 5-9: Airline route networks 2006... 85
Table 5-10: Market shares and concentration ratios 1993-2006 ... 87
Table 5-11: 4U versus X3 competition... 87
5
ABBREVIATIONS
Art. Article (law)
ASA air service agreement
ATC air traffic control
ATM air traffic management
BKartA Bundeskartellamt / Federal cartel office
BMVBS Bundesministerium für Verkehr, Bau und Stadtentwicklung / Federal Ministry of
Transport, Building and Urban Affairs
CRS computer reservation system
DFS Deutsche Flugsicherung GmbH / German air traffic controller
DLR Deutsches Zentrum für Luft- und Raumfahrt / German Aerospace Center
cp. compare
EC Regulation of the European Commission [law]
EC DG European Commission Directorate-General
ECJ Court of Justice of the European Communities
EEC Council Regulation (of the Council of the European Union) [law]
FFP frequent flyer program
H Herfindahl index
IATA International Air Transport Association
ICAO International Civil Aviation Organisation
ICE Inter City Express (German high speed train)
LCC Low Cost Carrier
LuftVG Luftverkehrsgesetz / Air Traffic Act of Germany
LuftVZO Luftverkehrs-Zulassungs-Ordnung / Air Traffic Authorisation Ordinance
NEF numbers-equivalent of firm (inverse of Herfindahl index)
OAG OAG Worldwide Ltd. (global travel and transport information company)
p.a. per annum
para. paragraph [law]
PAX passengers
resp. respectively
RPK revenue passenger-kilometres
TACO travel agent commission override program
6
ACKNOWLEDGEMENTS
I would like to thank Prof. Benjamin Bental, Ph.D., for giving me the opportunity to
conduct my thesis with him and for providing me with freedom in regard to the choice of topic.
Special thanks go to the German Aerospace Center, Insitute of Air Transport and Airport
Reseach, in particular to Prof. Dr. Hansjochen Ehmer and Dr. Peter Berster who gave me access
to their data base without which this thesis would not have been possible. I am especially
grateful to Dr. Peter Berster who supported my first steps in the field of airline economics with
a great patience for the questions arising. Last but not least, I am gratefully acknowledging the
scholarship from the Stiftung der Deutschen Wirtschaft which gave me the opportunity to
conduct my studies in a qualitatively high manner, including semesters in Moscow and Paris
and additional education by means of seminars and workshops.
7
1 Introduction
"The airline industry is an enigma."
(Rigas Doganis, 2006)
1
The airline industry is an industry of contradictions: international by its nature yet bound
to national, bilateral or at best to multilateral economic regulations and legal restrictions. It is an
industry of dynamic growth and change, greatly influenced by new technologies and
innovations.
2
It is highly cyclical while strongly correlating with GDP and frequently put into
turbulences via internal and external shocks.
3
Despite its dynamic growth, the airline industry
turns out to be of only marginal profitability.
4
Trends towards "deregulation" (U.S.) or
"liberalization" (EU) have fostered the dynamics of change that did not only produce the
suspected outcomes of competition and increased social welfare but that shook airlines, markets
and resulted in periods of high losses with airlines filing for bankruptcy, the emergence of
stronger networks, new business models and a new structure of the industry as a whole.
The Federal Aviation Act of 1958 of the United States of America, still the basic
governing statute, declared a policy to adapt the air transportation system "to the present and
future needs of the domestic and foreign commerce of the United States, the Postal Service, and
the national defense."
5
These three aspects of public interest in air transport did and still do
motivate both domestic and international regulation on the aspects of market access,
designation, flight frequency and capacity as well as fares. In 1978, however, the Airline
1
Rigas Doganis is non-executive director of South African Airways and former CEO of Olympic Airways, Greece. He is lecturing in air
transport and author of books on the international airline business. See Doganis (2006), p. xii.
2
Growth is measured in multiple ways. Literature usually refers to (revenue) tonne-kilometres resp. (revenue) passenger-kilometres (see
Glossary). Growth may also be approximated via the total number of passengers (PAX) of an airline or on (a) route(s) in a period of time,
usually referring to either weekly or annual data. Growth in the airline industry is said to be "dynamic" because it is forecasted to be strong -
ICAO predicts a growth rate of 5.8% (5.6%) in scheduled airline passenger traffic for 2007(2008).
3
Worldwide air traffic (measured in passenger-kilometres) is said to have an income elasticity of 2. Thus, changes in GDP affect the airline
industry strongly although there might be a time lag. See Doganis (2006), p. 17. External shocks such as the terrorist attacks of 2001 (U.S.)
and 2006 (UK) have a strong dampening affect on traffic although the overall growth rate recovers and returns to the original trend. See Airbus
(2002), p. 12 and ICAO (2005), p. 6.
4
Net profit of all ICAO airlines was 1% of revenue in 2005; see ICAO (2005), p. 6. Even in the profitable years of 1997-99, net profit was only
between 2-3% and negative net profit usually exceeds (in absolute terms) positive net profits. See Doganis (2006), pp. 4-8.
5
In O'Connor (1995), p.13.
8
Deregulation Act became law and with it entry and exit controls were abolished (with some
exceptions) and regulation of air fares was virtually eliminated.
6
As a result the shape of the
U.S. domestic market changed dramatically: many new small firms evolved with the number of
operating carriers nearly doubling whereas existing airlines expanded into new routes.
7
Route
density increased as did the rate of competition while air fares dropped substantially and with it
airline profitability. Incumbent carriers began to set up hubs and controlled feeder flights on
spoke routes by acquiring commuter airlines, which resulted in the reduction of direct flights
and an increase in the average fare on hub routes.
8
Moreover, the mid-1980s brought "a series of
mergers and a general trend toward consolidation into fewer but larger airlines" whereas the
1990s forced many airlines into bankruptcy.
9
Only Southwest Airlines, the first carrier using the
new no frills, low cost business model, prospered. Legacy carriers, in response, continued to
strengthen their networks and started to engage heavily in alliances, the latter remain until today
a controversy on whether being a way to undermine competition or an economic necessity. All
the same, the upshot of U.S. deregulation remains positive, leaving the industry with a better
cost structure and a higher operating efficiency. Even though many new entrants and some
former large carriers disappeared, the remaining airlines that managed to survive do now show a
strong capability to compete.
10
As the incidents from the U.S. domestic airline market suggest, "deregulation" or
"liberalization" is not a process that can be described by a simple equation where reducing
regulatory barriers equals market entry equals more competition equals lower fares and higher
welfare. Instead, regulatory barriers to entry tend to be replaced by competitive barriers to entry,
consolidation in the competitive market might lead to a market concentration even higher than
under regulation and state subsidies might be the last possibility to save large carriers that are of
6
Regulation continues with respect to "minimal essential services at small points". Moreover, the U.S. domestic market remains closed for non-
national ("substantially owned and effectively controlled by their own nationals") carriers. In fact, the U.S. domestic market is with respect to
rights granted for international air traffic still very restrictive. Cp. O'Connor (1995).
7
Cp. Gillen (2001), p. 42.
8
Morrison and Winston (1995) give an analysis on the negative welfare effects of the hub-and-spoke system due to fewer (direct) routes and a
"hub-premium", however the hub system also increases the frequency of flights on spoke routes.
9
O'Connor (1995), p. vii. Apart from Southwest Airlines all new interstate entrants of the 1978 to the early 1980s disappeared again in the late
1980s via acquisitions (cp. Morrison and Winston [1995]). Among the airlines that went into bankruptcy was also the trunk carrier Pan
American, the former monopolist on U.S. international routes.
10
Morrison and Winston (1995) find that despite the various strategies of airlines to limit competition passengers reaped gains from deregulation
that remain considerable. Campbell (1999) also argues that deregulation led to the elimination of weaker competitors with a more efficient
industry by means of lower costs and an improved yield management.
9
national importance not withstanding the somewhat symbolic role of national flag carriers. In
the end, as the U.S. experience shows, deregulation posed to airlines the question of how to
survive and of whether and how to regulate deregulation to officials. Nevertheless, with the
largely positive effect in mind, Europe liberalized its airline industry to transfer the single
European market also to its skies.
11
The European liberalization process went even beyond U.S. deregulation boundaries and
results for the European economic area seem to be positive: the number of scheduled airlines in
the European Union increased steadily as did the number of intra-community routes.
12
However,
many entrants exited shortly after entry, consolidation is strongly evidenced, stronger networks
developed and alliances undermine competition.
13
Contrary to expectations, the average price
level of Europe's air fares did not drop; in fact it even increased despite the existence of more
promotional tariffs.
14
The result is surprising since new entrants, mostly low cost carriers, seem
to offer endless possibilities for passengers to fly to any destination in Europe for a fare even
below "cab prices". Current literature capitalizes on this "low cost revolution". Yet, when
focusing on low cost carriers, which frequent secondary airports rather than primary airports,
large routes like those connecting hubs remain mostly out of sight. Moreover, to the best of my
knowledge, there is little information on whether and how a former closed national market has
changed within its boundaries.
15
Yet, to evaluate the liberalization's aftermath it is these routes
that need to be looked upon since remaining oligopolistic or even monopolistic national (hub)
routes that unite a large share of passenger traffic would challenge the achievements.
Accordingly, for the analysis of entry and exit in the post-liberalized German airline
market this paper singles out the eight largest airports of Germany and analyses all routes
between these airports for a period of 13 years from 1993, when the Third Liberalization
11
Art. 2 EC Treaty [Treaty establishing the European Community]: ,,The Community shall have as its task, by establishing a common market and
an economic and monetary union...".
12
Cp. EC DG Energy and Transport (2007/02) Website and OAG (2006).
13
O'Connor (1995), pp. 32-34 and Campbell (1999), p.73 both pronounce the impediments to competition via hub-and-spoke systems, merger
and acquisitions as well as alliances. Doganis (2006) even devotes a whole chapter to the topic of alliances. Yet, the American approach to
alliances seems to be more "laissez-faire" than the European, with Americans rather viewing alliances as an economic necessity instead of an
impediment to competition. (cp. Campbell [1999]). Supposedly, whether to sentence an alliance or not is a case decision: if the existence of an
alliance on a certain route deters entry or unites former competitors, than it is certainly true that competition is hampered.
14
Cp. Jung (1999), p.31. and EC DG Transport and Energy (2006), p.117.
15
Gillen (2001) analyses the effects of liberalized international bilaterals for the Northern German region resp. Hamburg airport. The most recent
study on entry and exit after liberalization in the UK market focuses on routes between UK and EU airports. See Gil-Moltó and Piga (2006).
10
Package was enacted, until 2006. The objective is to observe whether the legislative
liberalization of the European sky had an effect on the entry and exit dynamics on large national
routes as significant sub-markets. Beforehand, the European liberalization process will be
summarized in Chapter 2. Beginning with an introduction to the different levels of air transport,
a description of the non-liberalized European air transport market follows. The Chapter then
continues by introducing both the legal and economical motivations for the liberalization
process to begin and summarizes the important legislative measures that lead to the shape of the
industry as existent today. Chapter 3 then deals with the role of entry and exit as a proxy for the
level of competition and the contestability of a market from the theoretical point of view.
Thereby a brief summary on entry research as well as a set of models that deal with excess
capacity as entry deterrence will be introduced. However, as the airline industry is somewhat
special neither model perfectly fits and a simple proposal for a model of airline entry is made.
Subsequently, in order to gain further insight into the industry, the German airline market is
defined and characterized according to its infrastructure for both air and ground in Chapter 4.
Further attention is given to the characteristics of demand and supply, thereby outlining special
challenges faced by airlines operating within the German regional market. With the legislative,
theoretic and economic background in mind, the actual analysis of entry and exit is presented in
Chapter 5. Thereby, entry and exit statistics are presented over time and routes. Moreover,
market concentration and incumbent behaviour is analysed. Also, the effects on consumer
welfare and prices are commented upon in short. Furthermore, an overview on the structure of
the German airline market in 2006 gives further insight by covering the incumbents, their route
network, market shares and interdependences. As both entry dynamics and entry deterring
strategies turn out to be rather weak or insignificant, Chapter 6 devotes further attention to
airline-market specific barriers to entry of structural kind. Also, the role of alliances as either
impediment to competition or economic necessity will be looked upon shortly. Finally, the
paper is summarized in Chapter 7.
11
2 The Liberalization Process of Europe's Skies
"Nothing like the system of government imposed impediments to economic decision-making
exists in any other sector of international trade."
(Jeffrey Shane, 1992)
16
As mentioned above, air transport is despite its purely international sphere bound to rather
national legislation. Subsequently, aviation is confronted with several levels of either national or
supranational law. Likewise, air transport can be classified into either domestic or international
traffic not withstanding the economic differentiation of traffic according to length of haul.
17
However, with the foundation of the European Community that later became the European
Union, a third level took shape: the intra-European traffic. Figure 2-1 presents the different
organizational levels of air transport schematically.
Figure 2-1: Multi-level air transport
Source: Following Gillen (2001), p.67.
16
Jeff Shane is Under Secretary for Policy of the Department of Transportation (U.S.A.) in the Bush Administration since March 2003.
[In Doganis (2006), p. 27.]
17
Length of haul is the distance of freight resp. passengers carried, which can be of short, medium or long type. See Glossary.
THIRD COUNTRY
Primary airport
Secondary airport
EUROPEAN UNION
GERMANY
c
a
b
b'
12
Generally speaking, domestic air transport (a) is all intra-national air traffic between a
country's airports no matter the type of airport. International air transport (c) is all air traffic
between two countries, usually via primary airports only. Intra-European air transport (b) is all
air traffic between the airports of the member states of the European Union while traffic
frequents both primary and secondary airports directly.
18
2.1 Pre-Liberalization Status Quo
Without the European liberalization, all domestic air traffic fell only under national laws
and control, regulated in the case of Germany via the basic governing statute, the Basic Law of
the Federal Republic of Germany, in combination with the Air Traffic Act
("Luftverkehrsgesetz" [LuftVG]). Competition within this domestic market is, next to being
subject to federal policy, controlled by the Bundeskartellamt [BKartA], the German federal
cartel office. All international transport to and from Germany is regulated via air service
agreements [ASAs]. These air service agreements are usually bilateral and each uniquely agreed
upon between the two countries of origin-destination relationship. As of December 2006,
Germany held ASAs with 138 different countries.
19
Intra-European traffic, without the EU
liberalization, consequently is also regulated by bilateral agreements between each of the
member states of the European Union, while each agreement is unique of its type and with
respect to the rights granted.
20
It is worth mentioning that bilateral air service agreements are trade agreements between
governments with typically both parties to the agreement trying to strengthen their national flag
carriers on the route. Moreover, market access (what airports a foreign airline may serve) and
18
Airports are classified in multiple ways, which can be technical, economical or organizational-based; thus, there is no unique classification for
civil airports. Literature most commonly refers to primary and secondary airports. This paper follows the terminology. One may think of
primary airports as large airports that handle both domestic and short- to long-haul international traffic, while secondary airports handle
domestic to medium-haul international traffic only. Consequently, primary airports are also of larger size in terms of passengers handled.
Section 4.1.1 will treat the distinction of airports in more detail.
19
This includes countries that are now members of the European Union with whom Germany however had agreed upon air service agreements
already before. Source: Luftrecht-Online (2007/02) Website.
20
See Appendix B Freedoms of the Air. Only transit rights (First and Second Freedom) are granted on a multilateral basis via the "Transit
Agreement" of 1944. The granting of Third and Fourth Freedom Rights (the rights of an airline of one country to carry traffic to and from
another country) are subject to bilateral negotiation so are the Fifth to Seventh Freedoms but as special case since a third country is involved.
The Eight and Ninth Freedoms (cabotage rights) have not been granted yet within bilateral ASAs, however, as we will see, the European
liberalization went further.
13
designation (how many airlines may serve a route) as well as even frequencies (how often a
foreign airline may serve a certain route) and capacities (with what seat capacity this route may
be served by the foreign airline) are agreed upon.
21
Furthermore, most bilateral ASAs support
the respective airlines to agree on air fares, with airlines also being "encouraged to use the
tariff-fixing machinery of the International Air Transport Association (IATA) [...]. However,
both governments must approve such fares and tariffs. This is the so-called `double approval'
regime."
22
Obviously a system of bilateral ASAs within the European Union with their
regulatory character to predetermine market access, designation, frequency, capacity and fares
would not allow for "an internal market characterised by the abolition, as between Member
States, of obstacles to the free movement of goods, persons, services and capital".
23
2.2 Liberalization of Intra-European Air Transport
The liberalization of the European market for air transport is a process of more than 20
years of continuous proposals, guidelines and ordinances.
24
Both the European Commission's
Directorate-General for Competition and the Directorate-General for Energy and Transport
followed two complementary lines of approach for a liberalized European air transport system:
on the one hand, to ensure competition that will not be distorted via uncompetitive practices
imposed by individual governments or the industry itself in order to be in line with the goals set
in the "Treaty establishing the European Community" (EC DG Competition); on the other hand,
to foster an airline industry that will be able to capitalise on the effects of liberalization through
improvements in the industry's cost structure, gains in efficiency and a stronger competitiveness
(EC DG Energy and Transport). In particular the DG Transport and Energy's initiative was not
only incited by internal but also by external factors: the deregulation of the U.S. domestic
market, despite and because of its turbulences, lead to highly competitive U.S. carriers. In
addition, U.S. public policy began to promote a further liberalization of international air service
agreements in 1978 that aimed not only at allowing direct competition on Trans-Atlantic routes
21
Cp. Doganis (2006), pp. 27-31.
22
Doganis (2006), p. 28.
23
Art. 3 para. 1.c EC Treaty [Treaty establishing the European Community]
24
Cp. Piepelow (1997) pp. 94-110; Gillen (2001), pp. 29-40; Jung (1999), pp. 13-32 and Doganis (2006), pp. 31-66.
14
but also tried to achieve better market access for U.S. carriers into the European market.
25
Nonetheless, following the "Treaty establishing the European Community", which was signed
on March 25, 1957, the liberalization process of the European airline market was no
phenomenon that swapped over the Atlantic Ocean but that, not withstanding influences
through the experiences of U.S. deregulation, has its own raison d'être.
The initiative to liberalize the European airline industry commenced as early as in the
1970s with the European Commission trying to develop a common air transport policy that was
submitted to the Council of the European Union. Yet, success failed to appear although the
Court of Justice of the European Communities [ECJ] has ruled in 1974 that all principal articles
of the EC Treaty do also apply to the transport industry.
26
Furthermore, although the legal
postulates were set ever since 1974 and despite the Council of the European Union's action plan
in 1978, two memoranda by the European Commission in 1979 and 1984 as well as another
sentence of the ECJ in 1986, which (among other things) laid down that competition law of the
EC Treaty fully applies to air transport, liberalization did not gather way. It was not until 1988,
when the first out of three Liberalization Packages became effective, that the liberalization of
the European airline market did accelerate and began to transform the regulatory framework to
what it has become today.
2.2.1 The three Liberalization Packages
The First Liberalization Package, which was enacted on January 1, 1988, reinforced the
ECJ ruling of 1986 by explicitly acknowledging that all competition rules of the EC Treaty do
apply to air transport but most importantly, it enacted a package of measures concentrating on
the core aspects of regulation: market access, designation control, capacity approval and fare
agreements. As a consequence, the fares regime became more liberal by adjusting fares to long-
term costs, yet still under the double approval regime. Market access was facilitated by allowing
airlines to open new routes between their home country's primary airports and the foreign
country's secondary airports. Moreover, the capacity rule, which assigned capacities to the
25
U.S. "open skies" is somewhat asymmetric: it does not grant foreign airlines full access to the U.S. market by limiting market access to few
gateway airports only, while U.S. carriers may fly to Europe from any U.S. airport. Cp. Campbell (1999), p. 96. Section 2.3 will treat the
international air traffic liberalization, characterized by U.S. "open-market" and "open-skies" agreements, in more detail.
26
Art. 2 EC Treaty, Art. 3 EC Treaty [common market] and Art. 81-89 EC Treaty [rules on competition and state aid].
15
designated airlines typically by an equal share of 50:50, was relaxed to 60:40. Also, the single
designation regime, which authorized one airline per country only to operate a route, was
mitigated by permitting multiple designations on routes if the annual passenger volume
exceeded a predefined amount. Last but not least, the Fifth Freedom of the Air, the right granted
by a state to another state to land and to take on passenger traffic to or from a third state in the
territory of the foreign state, was enhanced but remained bound to capacity restrictions and
airport access.
The Second Liberalization Package was ratified on November 1, 1990 according to plan.
Its main issues were a further liberalization of the tariff-fixing regime that established zones
around fares, still adjusted to long-term costs of an airline, within which fares were
automatically approved. Fares below this zone fell into the double approval, fares above into the
new double disapproval regime.
27
Airlines were also allowed to adjust their fares to approved
fares of competing airlines provided that service with respect to quality was equipollent.
Moreover, the capacity rule was further softened by allowing designated carriers to raise
capacity over time (max. 7.5 percentage points per flight schedule period) as long as not
exceeding 60% of total route capacity. Routes connecting secondary airports only were fully
freed from this regulated capacity allocation. In addition, route passenger volumes to allow for
multiple designations were lowered. With respect to the Freedoms of the Air, routes connecting
primary airports of one country with secondary airports of another were granted full Third and
Fourth Freedom Rights without any further exemptions. Likewise, exemptions to the Fifth
Freedom Right with respect to the airports served were basically abolished while capacity
constraints were reduced. Regulation remained, similar to U.S. deregulation, for small routes
between secondary airports. The Second Liberalization Package installed measures that both
protected small regional carriers from competition by larger carriers as well as promoted
airlines to operate routes that would otherwise not be operated as a result of an airline's
economic considerations.
28
The Third Liberalization Package, enacted on January 1, 1993, was the last Liberalization
Package of the series and incorporated an extensive set of prescriptions. Among them were the
27
Both countries to a route need to disapprove a fare for it to be rejected (double disapproval) vs. approving it (double approval).
28
Regional airlines that operated routes with small propeller aircraft were protected from competition by airlines with jet airplanes. Routes that
would not be operated as a result of rational-economical decision-making could be promoted by allowing an airline to monopolise this route
for a certain time period.
16
directions to grant open market access on routes, to fully liberalize the fare regime from state
exertion of influence, regulations for slot allocation, by-laws that allow for an efficient use of
the European Cartel Law as well as detailed regularisations considering computer reservation
systems [CRS].
29
Specifically, both the restrictions on multiple designations as well as on
capacity were fully eliminated.
30
The tariff-fixing machinery was completely abandoned and
fares were left subject to the market mechanism only.
31
Furthermore, competition rules of the
EC Treaty were set to be fully applicable to both air transport between the member states and
within a member state. As a result, the control of competitive practices further falls into the
scope of national cartel authorities as well as into the Commission's.
32
Moreover, native
discrimination concerning the establishment and operation of airlines within the European
Union but outside their home country was eliminated by relaxing the ownership role. Before,
every member state applied different rules for the granting and maintenance of operating
licences, which certainly implied advantages for own nationals. Also, the so-called national
ownership rule allowed only airlines that were "substantially owned and effectively controlled
by their own nationals" to operate certain routes.
33
The Third Liberalization Package established
common criteria European airlines have to comply with in order to be granted with an operating
license by a member state of the European Union, and the community ownership rule was
introduced, which widened the "substantial ownership" and "effective control" to any member
state of the EU, not necessarily the state of registration.
34
Yet, for the time being, this last large
Liberalization Package remained imperfectly on cabotage rights, which stayed limited to
consecutive cabotage (Eight Freedom of the Air) until April 1, 1997.
35
29
CRS have been used by the owning airline to establish a competitive advantage by biasing query results. See 6.1.1 Strategic barriers to entry.
30
Council Regulation (EEC) No 2408/92 of 23 July 1992 on access for Community air carriers to intra-Community air routes.
31
Council Regulation (EEC) No 2409/92 of 23 July 1992 on fares and rates for air services. However, there are some limited safeguards to
prevent predatory or excessive pricing. Cp. Doganis (2006), p 47.
32
Council Regulation (EEC) No 2410/92 of 23 July 1992 amending Regulation (EEC) No 3975/87 laying down the procedure for the application
of the rules on competition to undertakings in the air transport sector.
33
This still applies to most international routes, although international routes to and from the EU are renewed to adopt the community ownership
rule. See 2.3 Liberalization of International Air Transport and cp. Doganis (2006), pp. 54-59.
34
Council Regulation (EEC) No 2407/92 of 23 July 1992 on licensing of air carriers.
35
Art. 3 para. 2 Council Regulation (EEC) No 2408/92 of 23 July 1992 on access for Community air carriers to intra-Community air routes.:
"Community air carriers shall be permitted by the Member State(s) concerned to exercise traffic rights on routes within the Community."
However, this regulation is offset until April 1, 1997 unless a) "the traffic rights are exercised on a service which constitutes and is
scheduled as an extension of a service from, or as a preliminary of a service to, the State or registration of the carrier" and b) "the air
carrier does not use, for the cabotage service, more than 50 % of its seasonal capacity on the same service of which the cabotage service
constitutes the extension or the preliminary." Thus, cabotage right is limited to a certain capacity and route choice.
17
2.2.2 Cabotage Rights
Cabotage is the right of an airline of foreign nationality to transport domestic traffic of the
granting country: a) entirely within the territory of that state with consecutive airports in the
airline's home country or a foreign country (consecutive cabotage, Eight Freedom of the Air) or
b) entirely within the territory of that state without consecutive airports in the airline's home
country or a foreign country (unlimited cabotage, Ninth Freedom of the Air). With regard to the
scheme displaying the levels of air transport introduced in the beginning of this Chapter,
cabotage refers to all traffic on routes (a) for carriers of non-German nationality and applies for
all carriers of European Union state of registration.
Article 3 paragraph 1 of Council Regulation (EEC) No 2408/92 of 23 July 1992 on the
access for community air carriers to intra-community air routes states that "Community air
carriers shall be permitted by the Member State(s) concerned to exercise traffic rights on routes
within the Community". However, the second paragraph of the same regulation states:
"Notwithstanding paragraph 1, before 1 April 1997 a Member State shall not be required to
authorize cabotage traffic rights within its territory by Community air carriers licensed by
another Member State". Thus, the last stronghold, namely that of intra-state traffic, fell on
April 1, 1997 to be fully opened for competition by allowing any European carrier to enter and
operate these respective routes.
Hence, for the region of the European Union, air transport and thus the airline industry as
such are since then organized within a single European market with no further distinction of
intra-national or cross-border traffic between the member states. Henceforth, domestic air
transport denotes all traffic between any airport of primary or secondary type of any member of
the European Union (denoted in Figure 2-1: Multi-level air transport by lines a and b as well as
by the dashed line b') while international transport marks any traffic from any European airport
to a third country's airport (represented by line c for the case of Germany).
Summarizing the legislative liberalization measures from 1988 to 1997 with respect to
intra-European transport, the following Table 2-1 gives an overview of the most significant
deregulatory changes shaping the industry with regard to entry and competition. Thereby, the
first column lists all pre-liberalization conditions and contrasts them with the measures taken in
each of the three Liberalization Packages. The comparison is differentiated according to the four
core aspects that regulation focused upon: market access, designation, capacity and fares.
18
Table 2-1: Overview of deregulatory measures
Pre-Liberalization
Status
1
st
Liberalization
Package 1988
2
nd
Liberalization
Package 1990
3
rd
Liberalization
Package 1993
Market
Access
All cross-border
traffic greed upon via
bilateral ASAs
Free access on routes
between own primary
and foreign secondary
airports (b');
Fifth Freedom Right
enhanced
No further regulation
on (b') routes; Fifth
Freedom Right further
enhanced; protection
of small regional
routes introduced
Open market access
on all routes;
consecutive cabotage
(1997 unlimited
cabotage); community
ownership rule
Designation
Single (one airline per
country)
Multiple above
specified passenger
volume
Multiple above lower
specified passenger
volume
No designation
regulation
Capacity 50:50
60:40 60:60,
no
capacity
regulation between
primary airports
No capacity
regulation
Fares
Agreed upon via ASA
/ IATA with double
approval of respective
governments
Fares adjusted to
long-term costs under
double approval
regime
Fare zones within
which automatic
approval, below zones
double approval
regime, above double
disapproval
No fare regulation,
fares are left to be
determined by market
mechanisms only
Source: Following Sichelschmidt and Wolf (1993), p. 173.
However, it is noteworthy that European liberalization did neither conclude in 1997 nor
stay restrained on topics regarding airlines directly only. Liberalization went further to areas
such as slot allocation at airports (EEC 95/93 and EC 793/2004), ground handling services
(EEC 96/97) and computer reservation systems (EEC 3089/93 and EEC 323/99), by passing
directives or codes of conduct. Furthermore, liberalization also took on progress with respect to
air traffic management, which cumulated in the 2004 single European sky initiative. Although
this initiative does not directly affect entry and competition between airlines it is yet a step that
will be shortly introduced since it is supported by airlines on the one hand and demonstrates the
profoundness of the European Union skies' restructuring very descriptively on the other hand.
2.2.3 The Single European Sky Initiative 2004
The European skies' traffic is secured by means of 47 different air traffic control
organisations, which are basically nationality bounded.
36
This system proves to be only
36
Data for 2004. Cp. Fischer (2004), p. 23.
19
somewhat efficient, especially when comparing it to the single ATC organization operating the
U.S. air traffic on the basis of ATC costs per flight or flights handled per air controller.
Moreover, "[i]mplementation of the common transport policy requires an efficient air transport
system allowing safe and regular operation of air transport services, thus facilitating the free
movement of goods, persons and services."
37
Consequently, the European Commission plans to reduce the fragmentation of the
European sky with respect to the organisation and use of air space as well as air navigation
services to "create a more integrated European air space: the single European sky".
38
As
Regulation (EC) No 551/2004 states, an "[e]fficient airspace management is fundamental to
increasing the capacity of the air traffic services system, to providing the optimum response to
various user requirements and to achieving the most flexible use of airspace." The key
adjustments are of structural (consolidation and integration), operational (interoperability) and
technological (new technology to be commonly adopted) kind. However, air traffic services
remain a continuous monopoly where benchmarking and best practice shall improve the
performance within the non-competitive environment.
39
Nevertheless, the single European sky
initiative is a further step towards a more competitive European airline industry as a whole.
2.3 Liberalization of International Air Transport
International air transport is mostly regulated, until today, by means of air service
agreements between each state of origin-destination relationship. These ASAs are typical trade
agreements, as described earlier.
40
However, there were two trends that commenced to transform
these agreements. First, U.S. public policy started already in 1978 to push for an advanced
37
Regulation (EC) No 549/2004 of the European Parliament and of the Council of 10 March 2004 laying down the framework for the creation of
the single European sky.
38
Regulation (EC) No 550/2004 of the European Parliament and of the Council of 10 March 2004 on the provision of air navigation services in
the single European sky (the service provision Regulation).
Regulation (EC) No 551/2004 of the European Parliament and of the Council of 10 March 2004 on the organisation and use of the airspace in
the single European sky (the airspace Regulation).
Regulation (EC) No 552/2004 of the European Parliament and of the Council of 10 March 2004 on the interoperability of the European air
traffic management network (the interoperability Regulation).
39
Cp. EC DG Energy and Transport (2004).
40
See 2.1 Pre-Liberalization Status Quo.
20
liberalization of international air service agreements, which occurred in two phases.
41
This first
generation of "open market" agreements (1978-91) broadened market access by allowing a
wider range of airports to be frequented on international routes, permitted multiple designation,
abandoned capacity and frequency controls, withdrew the anti-trust immunity for IATA air fare
conferences and introduced the double-disapproval regime. The successive second-generation
"open skies" agreements, which evolved since 1992, went further and granted open market
access by allowing an unlimited number of airports to serve as point of departure/arrival for
international air transport. Furthermore, unlimited Fifth Freedom Right was granted and fares
were fully deregulated by allowing free pricing. However, U.S. "open skies" agreements do not
extend to domestic cabotage and apply the national ownership rule. Thus, airlines permitted to
operate a route between the U.S. and the designating state need to be "substantially owned" and
"effectively controlled" by nationals of the respective state.
42
Second, as a result of the European liberalization, European carriers were granted
unlimited traffic rights while ownership and nationality constraints were removed. However,
these rights apply only for inner-European traffic. Most ASAs, just like the U.S. "open skies"
agreements, underlie the national ownership rule and thus distort the common European airline
market by discriminating European carriers on grounds of their nationality.
43
To answer this
problem, the European Commission received, after a case file in front of the Court of Justice of
the European Communities [ECJ] and the respective ruling of the ECJ in November 2002, two
mandates: one to negotiate directly with the United States and the other to negotiate so-called
"horizontal agreements" with other third countries in order to correct the legal deficiencies
within all ASAs between the members of the EU and any other third country. This will allow
European carriers to take off to a third country from any European airport.
44
Consequently,
liberalizing international bilateral air service agreements is another important step for a fully
integrated common European airline industry with no discrimination within domestic and no
further discrimination on international air traffic.
41
Cp. Doganis (2006), pp. 32-45.
42
Moreover, U.S. "open skies" agreements are somewhat asymmetrical to the advantage of U.S. carriers. See Footnote 25.
43
Doganis (2006), p.53. For example, only German airlines may operate the Trans-Atlantic routes between a German and an U.S. airport while
U.S. carriers may enter the European market by transporting traffic from Germany to any other member state of the EU. All other bilateral
ASAs also discriminate European carriers on the ground of their nationality.
44
It was the November 2002 ECJ ruling that also made cross-border mergers and acquisitions feasible within former national flag carriers. M&A
between EU airlines were factually already possible after the Third Liberalization Package though.
21
2.4 Liberalization Review
Just like U.S. deregulation, EU liberalization is no closed construct that eliminated all
impediments to competition with no single future call for action on further liberalization to
remain. In fact, some deficiencies still linger yet those mostly rest on legal intricacies or other
areas within this wide and complex industry.
45
With respect to competition and market access,
the possibility for a state to intervene in regional markets as introduced within the scope of the
Second Liberalization Package is still extant. Furthermore, states may still set up autonomous
rules on how to split transport within an airport system or even limit the exercise of traffic rights
in case of infrastructural or ecological dilemmas. Especially with respect to legal intricacies, for
instance considering the supervisory and exercise power of the European Commission in order
to enforce European Cartel Law, there is certainly a lot to be said, which will nevertheless be
neglected here, due to the focus of this paper. Nonetheless, all regulatory pre-conditions that
suggest to set off dynamics on firm entry and exit were met by passing the Third Liberalization
Package and, most importantly, with the enforcement of unlimited cabotage in 1997. That is,
the market has been fully opened and competition is feasible: the predetermination of
designation, capacity and frequency was abolished and fares are left to be determined by market
forces only. Moreover, the community ownership rule allows cross-border financial investments
without restrictions, even including former national flag carriers due to the November 2002 ECJ
ruling and unlimited cabotage gives airlines the opportunity to operate whatever route desired.
Consequently, the European airline industry now operates in a European domestic market, thus
possibly showing entry dynamics of former "foreign" airlines into another country's formerly
fully closed national market. Therefore, all regulatory preconditions for the analysis of entry
and exit within this paper are fulfilled.
However, it is important to understand that the development of the European air transport
system, in both sky (with respect to air traffic management and international transport) and
ground (with respect to ground service, airport capacities, slot allocations and computer
reservation systems) is not complete, although rulings and initiatives have been already started.
45
For a detailed analysis of the deficiencies of European Liberalization regarding legal entities see Jung (1999), pp. 21-32.
22
3 Theory
"The importance of firm entry and exit as determinants of market performance
is well recognized."
46
This paper analyses the entry and exit dynamics of a former highly regulated and closed
national market with regard to the legislative liberalization process that intended to open the
market for competition. Apart from traditional measures of industry structure such as
concentration ratios, which are static concepts, an industry's performance can be determined
and competition proxied via the dynamic analysis of entry and exit.
47
Therefore, actual firm
entry and exit within an industry or market is tracked over a period of time and allows drawing
several conclusions as a result. First, especially with regard to liberalization, market
accessibility is evidenced when actual entry occurs. Second, the threat of entry and actual entry
in combination with incumbent behaviour allow to draw conclusions on both strategic entry
barriers, anticipated behaviour and remaining structural barriers to entry. Third, entry in
combination with exit, thereby resulting in failure rates and within-industry firm turnover, are a
proxy for "barriers to survival" which differ across as well as within industries over time.
48
3.1 What do we know about entry?
Theoretical and empirical research has already long analysed the drivers, effects and
deterrents of entry. Moreover, actual patterns of entry, survival and exit have been studied and
stylized facts could be derived from both theoretical and empirical work. Geroski (1995)
provided a brief survey on entry research within which he summarized empirical work as a
series of several stylized facts that will be recapitulated briefly:
46
Dunne, Roberts and Samuelson (1988), p. 495.
47
Dunne, Roberts and Samuelson (1988) were first to analyse the patterns of firm entry and exit across industries over time.
48
Cp. Dunne, Roberts and Samuelson (1988) and Geroski (1995).
23
As a result of the research conducted so far, it has become common knowledge that
market entry is no rare phenomenon, in fact, "large numbers of firms enter most markets in
most years".
49
However, entry rates highly exceed market penetration rates. Moreover, entry and
exit rates are highly positively correlated, as for example Dunne, Roberts and Samuelson (1988)
have shown within their analysis of firm entry and exit patterns across a large sample of plant-
level data, aggregated to the firm-level, for several U.S. manufacturing industries.
Consequently, as net entry rates are only modest fractions of gross entry rates, the survival rate
of most entrants is low. One reason is the fact that "de novo entry", which is more common, is
less successful. Dunne, Roberts and Samuelson found that entrants, differentiated into new
entrants or diversifying entrants, which, in order to enter, do either need to invest in new
inventory or not, differ substantially with respect to their probability of survival and the size of
the surviving firms. Thereby, "small, young firms" have the highest failure rates.
50
However,
entry on a large-scale as well as very rapid post-entry penetration rates also seem to be
penalized by costs of adjustment. With respect to entry drivers and deterrents, empirical studies
allowed for a derivation of stylized results, some of which show that entry seems to react slowly
to high profits, which might be explained partly by the fact that "economic estimates of the
height of entry barriers suggest that they are high".
49
By contrast, Hilke (1984) proposed that
growth is a better driver of entry. Hence, entry rates seem to be "hard to explain using
conventional measures of profitability and entry barriers", especially when trying to explain
variations of entry over time.
49
Yet, it is known that entry rates come in different waves,
frequently containing different entrants, which often peak in the early phase of the life of a
market. As for incumbent behaviour, empirical results show that incumbents tend to respond
selectively to entry. Thereby, prices are rather unusually employed as entry-deterring strategy.
In fact, the range of methods used to prevent entry such as limit or predatory pricing,
advertising, capacity extensions or learning curve strategies as well as economies of scale and
scope do not only appear to vary across industries but seem to be rather limited in use.
Main empirical findings on the determinants of firm entry and exit over the last thirty
years, notably within the last decade, showed that limit pricing is among the least used entry
deterrence strategies whereas advertising and R&D intensity are strong respectively moderate
49
Geroski (1995), pp. 421-440.
50
Dunne, Roberts and Samuelson (1988), p. 496.
24
barriers to entry, as well as widely used.
51
Also, economies of scale seem to constitute a
significant barrier to entry thereby acting as substitute for entry deterrence strategies. As the
required scale of entry increases, the rate of entry decreases. Subsequently, with a high
minimum efficient size of entry, entry deterrence is less frequently necessary.
51
Excess capacity,
however, gives raise to divergent concepts. While empirical research mostly finds that excess
capacity is both an insignificant barrier to entry and rarely used as entry deterrence strategy,
several theoretical studies provided the basis for "the use of excess capacity as a successful
barrier to entry."
52
3.2 Entry deterrence and dynamic competition
Theoretical research proposed that excess capacity can act as a barrier to entry. Thereby,
excess capacity is seen as a pre-emptive credible commitment to an aggressive post-entry
competition. Accordingly, incumbent firms signal their ability to increase production and
engage in price wars in case of entry so as to threaten the possible entrant with lower profits in
the post-entry equilibrium and thus discouraging entry.
53
Spence (1997), who employed Cournot
competition in the post-entry subgame, suggested that potential entrants believed incumbents to
expand output to the installed capacity level following entry and therefore refrained from entry.
However, this model is not subgame perfect since Cournot competition would always lead to
oligopoly output rather than the expanded (monopoly) output threatened via excess capacity.
54
Thus, excess capacity would not be a credible commitment but incumbents would carry idle
capacity. Dixit (1980), however, showed that even if subgame perfection is imposed, the choice
of capacity can be used strategically to deter entry and Bulow, Geanakoplos and Klemperer
(1985) demonstrated that idle capacity can indeed be found in a perfect equilibrium. Given a
constant elasticity of demand, an incumbent can build up enough capacity to create zero profits
for an entrant but would restrict output if entry did not occur in order to maximize profits and
51
Cp. Cincera and Galgau (2005), pp. 81-83.
52
Mathis and Koscianski (1996), p. 264.
53
Cp. Benoît and Krishna (1991), Allen (1993) and Mathis and Koscianski (1996) for the summary on excess capacity research.
54
Note that in Cournot competition firms are price-takers and demand is assumed to be linear in the models under study thereby a two-firm case
is assumed (entry into a monopoly market). As prices fall as output is increased, in order to maximize profits, the former monopolistic firm
needs to decrease output rather than expand it given entry.
25
would thus carry idle capacity.
55
Furthermore, Ware (1984) pointed out that entry deterrence via
excess capacity resulted from the incumbent's first mover advantage.
56
Besides those Nash-
Cournot quantity-setting models (with post-entry Cournot competition) also models with
Bertrand competition in the subgame came to the conclusion that excess capacity can be used to
deter entry. Allen (1993) found that, given a post-entry Bertrand-Edgeworth framework, some
parameter values for the capacity level chosen even blockade entry with positive profits for the
incumbent whereas other parameter values deter entry with resulting at least non-negative
profits. Nonetheless, irrespective of different subgames, the generally underlying game-
theoretic approach is basically a simple model of limit capacity.
3.2.1 A model of limit capacity
A game-theoretic three-stage model can demonstrate how excess capacity might limit
entry in an industry.
57
Suppose two firms may chose whether and how to enter an industry.
Thereby, their choice is threefold: the firms may either not enter or enter on either large or small
scale. Accordingly, the height of investment differs. Demand within this single homogenous
goods market is linear. Marginal costs for production until the capacity limit for the capacity-
constrained small firm are zero (or constant in other models e.g. Allen [1993]). The firm
entering on a large scale has zero (resp. constant) marginal production costs for an
unconstrained quantity. Firms make their entry decision sequentially; thereby firm 1 decides
prior to firm 2 (equivalent to the first mover advantage of incumbents). In the third stage, firms
compete by either choosing quantities (Cournot subgame) or by setting prices (Bertrand
subgame) given capacity. The subgame perfect equilibrium can then be found by backward
induction, assuming entry first and solving the firms mutual best response functions for the
combinations of both firms entering on large scale, both firms entering on small scale or only
one firm entering on small scale. With the respective profits of the subgame computed and the
investment costs factored in, the payoffs can be determined. Note that the game is of one-shot
type, thus the profits of the single first period need to exceed the investment costs for a firm to
enter (non-negative payoffs). As a result, it is only optimal for firm 2 to enter the industry on a
55
Cp. Mathis and Koscianski (1996).
56
Cp. Benoît and Krishna (1991).
57
Cp. Watson (2002), pp. 152-155.
26
small scale if firm 1 did either not enter (exited) or entered on a small scale (no capacity
expansion). Consequently, a rational firm 1 knows that overinvesting in capacity (large scale
entry) would prevent firm 2 to enter. Firm 1 consequently invests in a capacity it would not
invest in given no threat of entry and thus sacrifices profitability in order to deter entry. As a
result, within this theoretical framework, capacity may indeed deter entry.
3.2.2 Excess capacity as prospect for collusion
All of the aforementioned models are of static type with a one-shot post-entry game.
Benoît and Krishna (1991), however, introduced a dynamic setup. Their model, based upon
Allen (1986), is a three stage game within which two identical firms make sequential capacity
decisions followed by post-entry price competition. The Bertrand subgame is extended from a
one-shot matter to an infinite horizon repeated game within which firms compete by choosing
prices continuously. The role of the first mover with respect to the capacity decision is similar to
the static models, so is the assumption of a homogenous product, the linear demand function
and the general setup where firms choose to either not enter or to enter on either large or small
scale, thereby investing accordingly into capacity. However, the dynamic specification, with the
advantage of being more realistic and the disadvantage of suffering from a lack of
predictability, results in a fully contrary conclusion. Benoît and Krishna's argument is that
"commitments that make predatory behaviour in the post-entry game credible also increase the
prospects for collusion."
58
As a consequence, excess capacity may both deter entry and
encourage entry. Thereby, entry deterrence would be strong if for a given capacity of firm 1 all
possible equilibria would result in a profit for firm 2 that would not cover this firm's fixed entry
costs (discounted to the present value). Weak entry deterrence occurs, if only the worst
equilibrium does not cover firm 2's entry costs. However, as excess capacity lowers the profits
of all firms in the worst equilibrium, the possibility of collusion increases. An "optimistic firm"
might thus be encouraged to enter by assuming that the firms in the industry will collude.
Consequently, large capacity actually may foster entry. Benoît and Krishna further argue that
entry may instead be deterred by choosing a low capacity level and charging a high price,
thereby capacity might even fall below the monopoly level. However, as noted before, a
58
Benoît and Krishna (1991), p. 478.
27
dynamic model has no unique equilibrium. Hence, "the question of entry deterrence is clouded
by the issue of which equilibrium will be selected in the post-entry game."
59
The likelihood of
excess capacity to prospect collusion is therefore also dependent on other industry factors. A
history of cooperation, a stable or at least predictable demand function, easily monitored prices
and the presence of an industry leader are factors that suggest accommodation rather than
deterrence, so does the existence of exit barriers. Nonetheless, albeit different approaches and
divergent conclusions, none of the above models perfectly fit to the competition and entry
conditions evidenced within the airline industry.
3.3 A four-stage game of airline market entry
Entering into an airline market is surprisingly less complex and challenging as maybe
assumed. First, a market is defined at the city pair level (between the airports of two different
cities) or even at the route level (between two airports).
60
An existing airline that plans to enter a
certain route faces no structural entry barriers of legal kind, given unconstrained capacities on
both endpoint airports to the route.
61
Furthermore, supposing an airline already operates one or
both airports to a route, entry may occur quickly and with low sunk costs (Bailey and
Panzar [1981]).
62
Thereby, airlines already operating at both endpoints impose the highest threat
of entry.
63
Additional to airport presence, also an airline's route structure is of importance.
Herein, airlines may draw on network economies which can lower the efficient scale of
operation on a certain route
and improve airline cost structures by means of economies of scope.
Especially hub operations influence airline cost factors positively through higher load factors
(economies of density) and longer stage lengths between hubs (economies of scale).
64
Consequently, hubbing airlines may even enter a route which would be unprofitable for a point-
59
Benoît and Krishna (1991), p. 482.
60
Some researchers define a market on the route level, mentioning the importance of demand segmentation (e.g. Borenstein [1989]) while others
stay on the city pair level. This paper also defines a market as a city pair but uses route as synonym. For further definitions see Section 5.3.
61
This applies to all domestic European routes for all airlines of EU state of registration since April 1, 1997.
62
Cp. Borenstein (1992).
63
Berry (1992) demonstrated for U.S. DOT O&D survey data that the airlines serving both endpoints to a route were more than 600 times more
likely to enter a route than carriers not serving any endpoint. Airlines serving one endpoint still imposed a 36 times higher possibility to enter.
64
Cp. Morrison and Winston (1995).
28
to-point carrier. Thereby, entry may also occur by vertical integration from code-share
agreements to mergers or acquisitions with regional commuter airlines.
62
Last but not least, entry
may also occur by new airlines. Establishing a scheduled air service is far from being
impossible. In order to obtain an operating license an "undertaking"
65
needs to comply with
Council Regulation (EEC) No 2407/92 of 23 July 1992 on the licensing of air carriers. With
respect to the minimum efficient firm size, an airline should have a fleet of at least three
aircrafts so as to be able to operate at reasonable scale. Hereby, investment costs for aircraft
inventory can be tapered via different leasing models, from simple aircraft leasing to fully
operational leasing including crew, insurance and maintenance (Calder [2003]).
66
Consequently,
the aforementioned models with sequential capacity choice and post-entry price competition are
not reasonably applicable due to their insufficient consideration of network economies and the
assumption of homogenous firms.
The actual market under analysis differs even further. Five out of eight airports are fully
coordinated.
67
Herein, Germany is no regional exception; in fact about 230 airports worldwide
are fully coordinated.
68
Accordingly, structural barriers to entry do exist. Also, as a result of
airport slot allocation, airlines are not flexible to change flight plans within the fixed biannual
flight schedules. What is more, capacity is actually two-dimensional as it is determined by the
number of flights and each flight's aircraft seat capacity. Consequently, under the given slot
allocation process where flight frequency is pre-determined for a six months period and
incumbent carriers have the first-mover advantage, airline market entry could actually be
described as a four-stage process:
First, incumbents choose flight frequencies followed in stage two by new entrants if
remaining slots are available (if incumbents chose the maximal frequency, the game ends
already after the first stage with blockaded entry and incumbent payoffs). In stage three, airlines
simultaneously determine capacity by adjusting their aircrafts to the route. Thereby, fleet
65
"Undertaking" means "any natural person, any legal person, whether profit-making or not, or any official body whether having its own legal
personality or not" according to EEC No. 2207/92.
66
Cp. Halm (2006), pp. 18-19. On route level, two daily connections (both directions) are said to be the minimum. // Leasing types: financial
lease (aircraft financing) vs. operational lease (aircraft renting) dry (only aircraft) or wet (fully operational including crew, insurance and
maintenance etc.).
67
Fully coordinated airports have constrained capacity and their slots (landing and take-off times) are allocated by a biannual regulatory process.
See 4.1.2 Slots, slot pools and slot allocation for the detailed treatment.
68
Number according to telephone interview with Germany's airport coordinator, Mr. Claus Ulrich on March 1, 2007.
29
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