Airline Deregulation in the Philippines

March 26, 2010 ECO2

Airline Deregulation:
A Comparative Report

Submitted by:
Jan Abigail Maravilla
Harold De Guzman
Mario Giordano Sarmiento
Lady Valles
Marlon Antojado

Submitted to:
Mr. Paul Caampued III

ABSTRACT

This study provides a comparative analysis of the state of the airline industry before and after deregulation. The paper considers most if not all possible areas of growth and development that will affect the airline transportation industry. It generates hypotheses about passenger growth, quality of service, and markets served. The paper concludes with a discussion of the pros and cons of deregulation.

Introduction

Deregulation, in simple terms, is a liberalization of an industry from government policies that control its production, and other key factors including market entry or exit. Deregulation is aimed to break down cartels and monopolies by encouraging new players in an industry. Based loosely on a laissez-faire type of leadership and control, it assumes that the lesser control and restrictions an industry has, the more efficient it can be. President Ronald Reagan and Prime Minister Margaret Thatcher are the forerunners of the deregulation race. During Reagan’s presidency, “the reduction in economic regulation that started in the Carter administration continued […] eased or eliminated price controls on oil, natural gas, cable TV, long-distance telephone service, interstate bus service, and ocean shipping.”

The foremost incident of deregulation happened during President Richard Nixon’s administration in late 1971 . This focused on transportation, mainly on rail and truck transportation. The first airline deregulation in America happened in 1978 due to the Airline Deregulation Act under President Jimmy Carter’s administration.

Deregulation aims to boost the economy by encouraging competition and competence. As Adam Thierer wrote, “"The first step toward creating a free market in electricity is to repeal the federal statutes and regulations that hinder […] competition and consumer choice.

Background: Pre-EO219

This study is limited to the Philippines’ passenger airline industry. The boundary point of the comparison is the year 1995 which is the year that the airline industry was liberated under Executive Order 219.

In 1952, the Philippine Government passed the Civil Aeronautics Act which gave birth to the Civil Aeronautics Board (CAB) and the Air Transportation Office (ATO). These departments were given the authority to “promote adequate, economical, and efficient passenger airline service […] at reasonable charges and promote competition”

Until deregulation, Philippine Airlines had a virtual monopoly of the passenger airline industry due to the passage of two Letters of Instructions (151 and 151A) in 1973. Although Presidential Decree 1590 was the nearest thing to encouraging competition although it only gave PAL a new franchise.

This monopoly which was maintained between 1973 and 1994 led to a domino effect of macroeconomic proportions. This position of control gave PAL an opportunity to dictate the price of airfare. This limited supply increased the price and the government had to intervene because of the obvious advantage of the firm over the households. PAL’s Return of Investment was capped at 12% by the government. This gave PAL a cushion of assurance and did not foster growth or improvement of quality of service. The government, over the course of time had to subsidize PAL’s losses and this cross-subsidization hurt the government’s funds and the consumers’ comfort.

This monopoly’s guarantee of short supply meant that they can choose to service only the profitable markets and once again, the government had to intervene. The government brandished its subsidy to compel PAL to provide for missionary routes but to this, PAL responded by limiting its flights and passenger seats in higher density markets. This very well meant that they produced inside their Production Possibilities Frontier (PPF) curve which ultimately meant inefficiency.

EO 219

President Fidel V. Ramos spearheaded deregulation in the Philippines. Executive Order 219 removed restrictions on routes and flight frequencies. This meant that operators are free to leave any unprofitable routes. Government control on fares and charges are also limited to areas where only one service provider existed. This removed the 12% Return on Investment guarantee that PAL enjoyed for more than two decades.

Results: Post-EO219

Right off the bat, new players which include Grand Air, Cebu Pacific, Air Philippines, Asian Spirit, Mindanao Express, and SEAir entered.

The first year alone, the total passenger seats available increased in the 5 main routes. Manila-Cebu increased by 38%, Manila-Davao increased by 75%, and Manila-Bacolod increased by 42%. Manila-Iloilo increased by 5% in the first year and increased another 30% in the 1995-1996 spot. Although most of the growth can be attributed to new players in the industry, the Manila-Bacolod market increased without a new competitor, proving that PAL has been limiting production and producing inside their PPF curve.

Table 1: Total Passenger seats in the Top 5 markets (CAB) 1994 1995 1996 1997
Manila-Cebu 1196265 1647797 2080542 2207365
Manila-Davao 436511 762447 1001111 1103104
Manila-Iloilo 396054 416624 669931 762100
Manila-Bacolod 287531 408947 421150 593854
Manila-Cagayan de Oro 300302 309435 401169 548618

After liberalization, PAL, Cebu Pacific, and Air Philippines opted to purchase bigger aircraft for high-density markets. Smaller planes were used in limited areas which have smaller markets.

The new entrants and the competition on fares and quality intensified and the concentration ratio table revealed that PAL suffered a loss of market share

Figure 1: Four-Firm Concentration Ratio Annual Revenue Share in Percent Source

Liberalization also brought about a growth in passenger traffic because of the pull down in fares. The competition offered the passenger year-round discounts and there was a noticeable increase in passenger traffic (Table 2).

Table 2: Passenger Traffic in Top Fifteen Airline Markets
City-Pair Passenger Traffic % Change Number of Airlines 1994 2003 1994 2003
Manila-Cebu 927105 1315406 42 1 3
Manila-Davao 341788 763270 123 1 3
Manila-Iloilo 345359 568491 65 1 3
Manila-CDO 249251 450861 81 1 3
Manila-Bacolod 238938 430782 80 1 3
Manila-Tacloban 204366 303476 48 1 2
Manila-Zamboanga 123425 220252 78 1 3
Manila-Kalibo 201447 218595 9 1 3
Cebu-Davao 110675 175692 59 1 2
Manila-Puerto Princesa 110715 168641 52 1 3
Manila-Dumaguete 79372 149804 89 1 2
Manila-Caticlan 26102 147813 348 1 2
Manila-Gen. Santos 27355 143541 425 1 2
Manila-Butuan 32149 106396 231 1 2
Cebu-Iloilo 98137 104436 6 1 2

EO 219 gave the airlines liberty to enter and exit any route. This gave the higher-density markets more choices and lower fares because they compete intensely for the market share. This also resulted to smaller-density markets losing PAL’s services because the focus shifted to greener pastures especially since Cebu Pacific gained an increasing share of the market. PAL left 34 routes in 1999 and some of these were picked up by Asian Spirit (1999) and SEAir (2003).

Conclusion

The most noticeable change in comparing the Pre-EO219 state to the Post-EO219 state is the power shift which occurred because of the entrance of competition. Philippine Airlines, which have been producing inside the PPF knowingly to squeeze the demand curve and maximize profit, lost its power. This can be seen, not only in the Manila-Bacolod increase in spite of no entrants, but also in the choice of bigger aircrafts which only happened because Cebu Pacific started using bigger aircrafts. This power, which cost the country’s Gross National Product as much as 13%, shifted to the consumers. The power struggle between the government, the consumers, and PAL improved the quality of service and the pricing because the power of choice liberated the consumers of the pressure PAL used to have on prices. The lower prices, the availability of choice and competition, and the end of government subsidized 12% ROI are obvious positive effects of deregulation.

Deregulation, at least in these early stages, and its first decade, also brought with it some negative results. Just to be fair, the competition provided by the five new entrants still doesn’t guarantee a sustainable and perfect competition. This can be seen and observed from Mindanao Express and Grand Air’s exit in 1999. PAL’s more than 50% market share and Cebu Pacific’s rise to 30% showed an oligopoly with 2 dominant players. An industry with less than 6 firms is not a guarantee of sustainable competition.

The 34 markets that PAL decided not to service fell on Asian Spirit’s and SEAir’s shoulders and control. However, 11 markets have lost service altogether. There is also less frequent service in up to seven markets.

The discounts and price decrease brought about by the competition did not spread throughout the whole country and those routes without the absence of competition charge rates that are equivalent of PAL’s business class fares. This leads to shorter flights costing more per kilometer than longer ones because of the use of smaller aircraft.

Upon careful study, it is safe to say that deregulation should happen. Upon comparison, however, there really are equal pros and cons. The negative results are slowly diminishing because of the push and pull that is happening between the airlines and the consumers. This has not reached a plateau of safety and strength but the industry is slowly journeying towards that goal. Deregulation itself is a key to a country’s success in economics but at present, in comparison, the best is yet to come. The changes observed, no matter how big they are, are still previews of what is bound to happen if an environment that welcomes competition is sustained.

References

Cooper, MN (1999) “Freeing public policy from the deregulation debate, tphe airline industry comes of age,”

http://www.consumerfed.org/abaair1.pdf

http://www.aerlines.nl/issue_36/36_Manuela_Evolution_Philippine_Airline_Industry.pdf

http://www.econlib.org/library/Enc1/Reaganomics.html

Rose, Seely and Barrett, Tracey (2006). "The Best Transportation System in the World". from the selected National Archive White House Files. University of Ohio State Press. http://www.ohiostatepress.org/index.htm?books/book%20pages/rose%20best.html. Retrieved 2008-01-12.

Thierer, Adam D. (13 April 1998), A Five-Point Checklist For Successful Electricity Deregulation Legislation, Heritage Foundation, http://www.heritage.org/research/energyandenvironment/bg1169.cfm, retrieved 2009-04-26

References: Cooper, MN (1999) “Freeing public policy from the deregulation debate, tphe airline industry comes of age,” http://www.consumerfed.org/abaair1.pdf http://www.aerlines.nl/issue_36/36_Manuela_Evolution_Philippine_Airline_Industry.pdf http://www.econlib.org/library/Enc1/Reaganomics.html Rose, Seely and Barrett, Tracey (2006). "The Best Transportation System in the World". from the selected National Archive White House Files. University of Ohio State Press. http://www.ohiostatepress.org/index.htm?books/book%20pages/rose%20best.html. Retrieved 2008-01-12. Thierer, Adam D. (13 April 1998), A Five-Point Checklist For Successful Electricity Deregulation Legislation, Heritage Foundation, http://www.heritage.org/research/energyandenvironment/bg1169.cfm, retrieved 2009-04-26