Wednesday, December 16, 2009

Do you want your airline to be vertically integrated?

It's the holiday season, and people are booking tickets to visit families. It is definitely the busy season for the airlines. That makes it timely to discuss some economics of airlines. In the spirit of the holidays, here's a question: Is my flight more likely to be canceled if my airline contracts with the regional carrier, rather than owns its own regional carrier?

Well... maybe this isn't a burning question for everyone, but it does have some interesting economic repercussions. Dating back to Coase's seminal article on the Nature of the Firm in 1937, economists have been interested in the boundaries of firms. Why do firms exist? Why isn't there one firm that produces everything? Why do firms grow or shrink over time?

Recent work by Silke Forbes and Mara Lederman provides some interesting answers to these questions in the context of the airline industry (working paper here).

Forbes and Lederman ask, if you're a major airline, what are the benefits of owning your regional carrier's assets rather than contracting with an independent regional airline? The authors find that an airline that contracts everything has one percentage point more cancellations and five minutes longer delays than an airline that owns all its regional carriers (even after netting out the effects of other explanations).

The authors argue that this advantage of owning your regional provider allows for better flexibility in scheduling, and a closer-to-optimal departure and arrival schedule. That sounds like a competitive advantage for airlines that own their regional carriers. So, why on earth would a major airline pass up the opportunity to provide better service? The answer from Forbes and Lederman: It costs more.

A chief disadvantage of vertically integrating with a regional carrier is that independent regional carriers are able to get away with paying lower wages, and hence, have a cost advantage. This is not true if the airline owns its regional carrier. In this case, the unions representing the airlines can force the major airline and its owned regional airline to pay the same wages. As such, the cost advantage is wiped out.

Consequently, some airlines contract routes with independent carriers, while others own their own regional carriers. Others still, operate some routes on contract and others under ownership.

So, the next time you're flying, ask yourself whether your airline is vertically integrated (i.e., owns its regional carrier). If it is, you're less likely to leave late, your flight is less likely to be canceled, and your pilot and flight attendant probably get paid more!

Happy travels.

** By the way, the finding of a 5 minute longer average delay time is significant. A 5 minute shorter delay on average can be interpreted as "If every sixth flight is delayed (and the rest are on time), an owned regional carrier has 30 minutes shorter delays than a contracted regional carrier." In my mind, that's big.

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