The economics of aviation and the question of optimal competition

The closure of Jet Airways provides yet another opportunity to discuss the economics of one of the most important -- but also one of the most despised -- businesses in India: transport. Few know that in India not only is there a paucity of transport economists generally but also that there are no aviation economists at all. 

In the absence of such economists, the whole transport sector is informed by the inadequate intellectual resources and opinion of railwaymen, road engineers, truckers, shippers, managers of ports and the staff of the DGCA. 

This is absolutely ridiculous because transport is one of the most capital-intensive industries in the world and the efficient use of capital is of paramount importance. In India, however, we treat capital either as a pariah or as if it comes for free. 

As a result there is very little professional economic research into an industry that has one of the biggest investment and employment multipliers. Despite that, we have been content to let the industry be run by vested interests who operate by getting the “setting” right with the ministry. 

Overall, therefore confusion prevails. And now bankruptcies as well. Two big ones and several small ones in 25 years is quite absurd and indicative of virtually zero understanding of the economics of the business.

Given its highly capital and skill intensive nature, the first question an economist would ask is about the degree of competition that is sustainable in aviation: what is the optimal level of competition on a route? Two, three, four, five, six or more airlines? Note, I am saying route and not industry. In India we have mixed the two up by allowing virtually free entry into all the major routes because it is not economics and sustainability that determines entry but fixing or setting.

Secondly, there is the question of the nature of cross-subsidisation which is crucial in the transportation industry. Profitable routes subsidise unprofitable ones but in India it is not merely intra-firm but across firms as well. The Category A, B and C method, by the way, involves an implicit subsidy from Air India to private airlines. Since Air India gets subsidised by the taxpayer, it is the private airlines the taxpayer is subsidising. Talk about nonsensical policies. You may as well do it by outright subsidies from the government. That would have the merit of transparency.

The third question an economist would ask is about the rate of return needed to keep the aviation business healthy. What should that rate be? This question more or less determines the answer to the first two because, globally, in any ten-year period the industry as a whole earns just about one per cent. As businesses go it is not a great one.

So in the end what we get for policy to decide is whether the Indian aviation business should comprise large, medium or small oligopolies. If resolved sensibly it yields a solution to the problem of cross-subsidisation: the larger the number of firms, the greater will be the need for intra-firm cross-subsidisation as firms focus on a variant of the Ramsey Rule which says that network firms must maximise revenue instead of profits.

This is best achieved via a public monopoly which far from reducing output, raising prices and making excessive profits as monopolies are expected to, can do the opposite just as Air India and Indian Railways do. 

In short, if we want to avoid a return to public sector transport monopolies, we must decide on the size of the oligopolies in the sector.