Pricing and Competition in the New Zealand Air Travel Market

This article analyses the impact of competition on pricing and price discrimination using data on 2053 flights on thirteen New Zealand routes observed in 2006 and 2007. The following analysis is a good example for the dynamics of competition in an opening closed market.

Contents:

1.0 Abstract and Introduction

2.0 First Part, Literature Review
2.1 The Changing Scene in New Zealand Aviation (Post Deregulation)
2.2 The Proposed Alliance between Air New Zealand & Qantas
2.3 Impact on Competition
2.4 The Impact of Low-Cost Carriers and the Rise of B2C in the Airline Industry
2.5 The Arrival of Pacific Blue and Possible Effects

3.0 The Database
3.1 Price Information
3.2 Cost Information
3.3 Measure of Market Concentration
3.4 Other Variables

4.0 Econometric Analysis
4.1 The Setup
4.2 The Results

5.0 Conclusion

 

2. Literature Review

Since this paper focuses on the New Zealand domestic market, it first provides a brief overview of the on-goings since the deregulation of the airline industry. It then discusses the impact the proposed alliance between Air New Zealand and Qantas would have had in the domestic market, if the airlines' proposals were approved. Furthermore, it talks about how the emergence of low-cost carriers led to the development of the popular Business-to-Consumer (B2C) internet booking system. The latter two being issues which would have, and have had, an effect on how airlines construct their pricing strategies and thus relevant to our discussion.

2.1 The Changing Scene in New Zealand Aviation (Post Deregulation)

New Zealand was at the forefront of airline industry deregulation when in 1986 the government revised the Air Services Licensing Act (1983). Specifically, restrictions relating to foreign investment in domestic airlines were removed which allowed for any foreign carrier to have up to 50% investment in a domestic New Zealand airline.

This deregulation of the New Zealand airline industry prompted a quick response (in 1987) from Australian carrier Ansett Australia (50%), which along with Brierley Investments Ltd (BIL, 27.5%) and the Newmans Group (22.5%) (Patterson and Wallace, 1997) took over Newmans Air and renamed it Ansett New Zealand (Ansett NZ). This newly formed airline broke the monopoly enjoyed by Air New Zealand on the trunk routes of Auckland, Wellington and Christchurch. Hence, the New Zealand public benefited from lower airfares, improved service quality, better on-time performance and more frequent services (Mills, 1991).

In 1988, the government decided to further open the skies by removing the 50% restriction they had imposed on foreign ownership. Consequently, it was acceptable to have a domestic airline fully owned by a foreign carrier and thus the Overseas Investment Commission (OIC) was able to grant any such moves. Ansett Australia reacted swiftly to this new development and purchased the outstanding 50% from BIL and Newmans Group in the same year to take full control of Ansett NZ.

The next major development came in 1996, when Air New Zealand, trying to break into the Australian market, acquired 50% of Ansett Australia from Thomas National Transport (TNT) Holdings. At this point Ansett Australia was jointly owned by two parties, Air New Zealand (50%) and the existing stakeholder, News Corporation (50%). The deal also saw Air New Zealand gain pre-emptive rights for the balance of the company. Later in the year, Ansett NZ was sold to News Corporation, thereby eliminating the possibility of Air New Zealand having complete control of its major domestic rival (Ansett NZ was a wholly owned subsidiary of Ansett Australia which itself was under the part ownership of Air New Zealand).

The following year, Origin Pacific Airways started domestic operations. They initially targeted routes from Nelson on which they would have a monopoly (e.g. Nelson-Palmerston North).

In 1999, things started to get interesting as Singapore Airlines (SIA) attempted to enter into the Australian market by purchasing the 50% stake in Ansett Australia which was held by News Corporation (Thomas, 2001).

In June 2000, Air New Zealand chose to exercise its pre-emptive rights and purchased the remaining 50% of Ansett Australia from New Corporation to take full control of the Australian carrier. This was pre-dominantly seen as a move to obstruct SIA's entry into the Australian market. However, this came at a huge cost as Air New Zealand's debt to equity ratio increased from 107% to 465% (Air New Zealand, 2000).

In March of that same year, News Corporation had sold Ansett NZ to Tasman Pacific Airlines Limited, a New Zealand-based consortium. From September, Tasman Pacific operated as Qantas New Zealand under a franchise agreement.

In April 2001, Qantas New Zealand's operating company, Tasman Pacific Airlines Limited, was placed into receivership. According to a Qantas spokesperson, "Qantas had no ownership or equity interest in Tasman Pacific" (McMinn, 2001). Only days later Qantas started providing domestic services, at first to cater for the stranded passengers (to protect its brand's image), but then on a permanent basis. In July 2001, Origin started operating code-share flights on behalf of Qantas.

Then in September, Air New Zealand placed its subsidiary, Ansett Holdings Limited, into voluntary administration. In Air New Zealand Limited's Annual Report of 2001, Acting Chairman Jim Farmer stated that high fuel costs and low exchange rates had a significant impact on their profitability. The following month the New Zealand government provided Air New Zealand with an $885m cash injection. The collapses of Ansett Australia and Air New Zealand are considered to be the biggest corporate failures on either side of the Tasman.

In November 2002, Air New Zealand introduced cheap domestic fares with the launch of its 'Express Class'. This was the introduction of the one-way fare system available on the internet, which is proving popular today. According to the airline's press release on 01 November 2002, average fares across the airline's domestic network were decreased by 20 percent, and by about 28 percent on main trunk routes. Some fares were claimed to have been reduced by as much as 50 - 60%.

Then in December, Air New Zealand and Qantas submitted applications to the Commerce Commission in regard to forming a 'strategic alliance'. The following year, the proposal was unsurprisingly rejected by both the New Zealand Commerce Commission and the Australian Competition and Consumer Commission. A more detailed overview on this is provided in the next section.

In 2004, the code-share agreement between Origin Pacific and Qantas was terminated by Qantas. As stated in Origin Pacific's submission to the Commerce Commission, the benefits for Origin Pacific in this agreement were substantial, as it provided for "additional revenue streams from Qantas passengers on code share routes" (Origin Pacific Airways, 2003, p. 5). In 2006, Origin Pacific ceased passenger operations. The financial impact of the loss of the Qantas relationship was too much for the cash-strapped Origin Pacific to bear.

The same year also saw Air New Zealand launch a new online domestic campaign called grabaseat. This campaign sees a range of low domestic fares posted daily on the carrier's website. The fares are priced below the everyday fare pricing structure.

In February 2007, Air New Zealand, followed by Qantas, reduced their domestic fares. In a press release on 19 January 2007, Air New Zealand announced that "fares will fall by up to 26%". A week later Qantas announced that it was also lowering its airfare structure, a move analysts said was in response to Air New Zealand's fare cut (Keown, 2007). The fare cuts could have been seen as an attempt to stimulate demand in a rather static market. After all in December 2006, Qantas had announced that declining passenger numbers was a factor in them stopping their Wellington to Christchurch service. Section 4 of this paper will test the hypothesis of whether or not these fare cuts have taken place.

2.2 The Proposed Alliance between Air New Zealand & Qantas

In December 2002, Qantas and Air New Zealand submitted applications to both the New Zealand Commerce Commission (NZCC) and the Australian Competition and Consumer Commission (ACCC) relating to the implementation of a "strategic alliance arrangement" between the two carriers. The alliance would have seen Air New Zealand and Qantas coordinate their commercial activities for every flight to, from and within New Zealand. This, in effect, would have established a 'cartel' with substantial financial and market power.

The proposal was firmly rejected by both the authorities and an appeal was also turned down by the New Zealand High Court in 2004. In Australia however, the airlines' case was taken on to the Australian Competition Tribunal (ACT), as a re-hearing, where it got approval. ACT stated that competition from Virgin Blue and '5th Freedom' carrier Emirates would continue to provide a strong competitive constraint across the Tasman.

Having been given the approval from ACT, the two airlines came back to the authorities in April 2006 with the proposal of a Tasman Networks Agreement (TNA), which in essence was a similar arrangement as the 'strategic alliance' but limited to the Trans-Tasman routes. However, with the ACCC proposing to deny authorisation, Air New Zealand and Qantas decided to withdraw its applications in November 2006.

2.3 Impact on Competition

Their have been numerous studies done in the past to analyse how airline mergers affect airfares and in particular the increase in airfares that would have resulted if the two carriers, Air New Zealand and Qantas, were to form this cartel.

A well-known study in regard to price changes resulting from airline mergers was that of Kim and Singal (1993) who analysed 14 U.S. airline mergers over the period 1985-1988. Results showed that merging firms increased their fares on average by 9.44% in comparison to routes which were unaffected. Interestingly though, rival firms raised their fares on average by 12.17%. The result could be summed up concisely as - the greater the increase in market concentration resulting from a merger, the greater is the potential for the exercise of market power and the greater is the increase in airfares.

In his submission to the NZCC and the ACCC, Tim Hazledine (2003) made a 'reasonable' adjustment to the NECG interpretation of competitive behaviour. The conjectural variation (CV) parameter was changed from 0, Cournot behaviour, to -0.5, duopoly, in respect to the aggressive price competition observed during that time. The results predicted that the overall market weighted price would increase by approximately 17% in the case of a cartel and the entry of a value-based airline (VBA), while increasing by 34% in the case where no VBA entered.

At the time of the proposal, Air New Zealand and Qantas accounted for more than 90% of the domestic routes, and if the permission to form the alliance was granted, New Zealand would essentially have a monopolistic airline market. Tim Hazledine (2004), as part of his continued evaluation of the proposed cartel, performed a competitive analysis where he presented a 'counterfactual' (no cartel) and 'factual' (cartel) scenario. In this, even the least bad case in terms of higher prices (cartel engaged in Cournot competition with low cost entrant), would result in prices increasing by close to 20%. The realisation of the cartel would indicate a substantial lessening of the competition.

Tretheway (2004a) in his submission to the ACT reported on a panel data model consisting of 1000 U.S. routes from data collected between years 1990-2000. The analysis investigated the effect of the presence of a low-cost carrier (LCC) on a route as well as the effect of having two versus one full-service airlines (FSAs or sometimes referred to as legacy carriers) operating on a route. The results indicated that the effect on average fares of a change in market structure from two FSAs to just a single one given that no LCCs were operating, would be an approximately 33% increase. The 'strategic alliance' could easily correspond to this case as both Air New Zealand and Qantas are legacy carriers and the formation of a cartel would have a detrimental effect on airfares.

The case of Kiwi International represents a good illustration of how the 'cartel' could easily push a weak LCC out of the market. The NZCC dismissed Kiwi's complaint that Air New Zealand's actions had breached the Commerce Act on the grounds that the incumbent airline was not dominant in the market. However, a later study by Haugh and Hazledine (1999, pp. 2 and 28) posed an interesting question. They state, "No doubt Air New Zealand is not dominant, but the duopoly it shares with Qantas probably is, and the interesting economic issue is whether the duopoly predated Kiwi out of the market". They infer that "Air New Zealand and Qantas ceased to play their normal non-cooperative (near-Cournot-Nash) oligopoly game following the entry of Kiwi and switched to aggressively 'competitive' behaviour in order to drive Kiwi from the market".

2.4 The Impact of Low-Cost Carriers and the Rise of B2C in the Airline Industry

The early 1970's saw the launch of a new breed of airlines, a breed that is commonly known today as the low-cost carrier (sometimes referred to as a value-based airline). The name is given from the fact that these airlines have a lower cost structure when compared to the full-service airlines (sometimes referred to as network carriers). They provide a no-frills service to cater for point-to-point short haul services.

The most successful of these (low-cost carriers) is Southwest Airlines (American). Other established airlines which have replicated this new model are Ryanair (Irish), easyJet (English) and Australasia's premier low-cost carrier, Virgin Blue. On 23rd August 2007, Pacific Blue, a subsidiary of Virgin Blue, announced its plans to enter the domestic New Zealand market. More on this will be discussed later.

Even though there had been no low-cost carrier in the domestic New Zealand market, the rise of this new breed of airlines plus the spread of the internet led to the introduction of the popular internet based one-way fare system. This has allowed airlines to directly get in touch with the consumer (B2C) by offering their cheapest fares over the internet. Using this new strategy, the airlines aim to cut their costs by eliminating the travel agents so as to reduce commission expenses. Air New Zealand initiated its internet booking system in November 2002 by launching their 'Express Class' fare system. Qantas quickly followed by streamlining their fare structure by introducing one-way internet based fares from June 2003.

These developments in the airline industry have led to suggestions that the full service network carrier model was 'broken'. Tretheway (2004b) states that the fact that the LCCs financially outperformed the FSAs has resulted in the business model for the network carriers being no longer effective. He goes on to say that the introduction of the one-way fares had undermined the price discrimination ability of the FSAs, which classically distinguished between leisure and business travellers by attaching restrictions such as a Saturday night stay-over for a low fare return ticket. Such restrictions acted as a deterrent for business travellers who required flexibility.

However, the 'broken' model claims are contested in a later study by Gillen and Hazledine (2006). Their study focuses on the implications of the rise of the LCCs and the use of the internet based B2C ticketing system using price data of over 1700 flights on forty Canadian and trans-border routes. They find that the FSAs could still charge a 'substantial price premium' relative to the LCCs. The degree of product differentiation between the two types of carriers was sufficient for the FSAs to continue charging a relatively higher price even in the presence of a LCC on a route. They also find that the internet had made it 'easier' for airlines to 'coordinate' the price increases which occurred in the last two weeks before the flight. Business travellers, who have a higher willingness to pay, generally purchase tickets close to the flight date and thus end up paying these high fares. Hence we can safely say that the model is not as 'broken' as it was first suggested.

2.5 The Arrival of Pacific Blue and Possible Effects

On 23 August 2007, Pacific Blue, the three year old New Zealand subsidiary of Virgin Blue, announced plans for new domestic services. It plans to initially fly on the key trunk routes Auckland to Wellington, Auckland to Christchurch and Wellington to Christchurch with services having launched on 12 November 2007. It should be noted that Wellington to Christchurch stood as a monopoly route of Air New Zealand after the withdrawal of Qantas from this route from March 2007, citing competitive pressure and lower load factors.

As to the possible effects this will have on the New Zealand airline market, we refer to NZCC's Final Determination (2003, paragraphs 514 and 515) for some statistical evidence. Steven A. Morrison and Clifford Winston, who were acting on behalf of Qantas and Air New Zealand, found that competitive constraint provided by Virgin Blue in Australia had reduced Qantas's fares on average by 10% on a number of routes. However, a well-known econometrician Jerry Hausman upon running a revised regression found much small impacts. It should also be taken into account that the success of Virgin Blue could have (and quite possibly had) been triggered by the collapse of Ansett leaving greater capacity to be filled.

However, the New Zealand domestic market could represent a different scenario. As mentioned in the New Zealand Herald dated 16 January 2007, analysts predicted that any such move (to introduce domestic flights in New Zealand) will be 'tough' for Pacific Blue given the frequency of flights offered by Air New Zealand on its routes; one of the pitfalls of Qantas is their inability to match these. Also they state that it would be very difficult for the new entrant (Pacific Blue) to capture the business market, something they were struggling at even in Australia. Even though, we still expect to see some impact from its arrival.

Goolsbee and Syverson (2006) state that simply a threat of entry by the low-cost carrier Southwest on a given route in the U.S. results in the incumbent cutting their fares on the affected routes. An interesting fact is that these fare cuts occur before the new entrant starts flying. This theory proved to be spot on, and understandably so, after Air New Zealand reacted almost instantaneously (on the same day) upon Pacific Blue's announcement by lowering their year-round lead-in fares on the trunk routes to match that of Pacific Blue. This can simply be seen as an act of customer retention on the part of the incumbent. It is not an entry deterrent but rather an equilibrium post entry.

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