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A model of air cargo liberalization: passenger vs. all-cargo carriers
Transportation Research Part E 38 (2002) 175–191 www.elsevier.com/locate/tre
A model of air cargo liberalization: passenger vs. all-cargo carriers Anming Zhang
a,b,*
, Yimin Zhang
a
a
b
Department of Economics and Finance, City University of Hong Kong, Hong Kong Faculty of Commerce and Business Administration, University of British Columbia, Vancouver, BC, Canada V6T 1Z2
Abstract This paper employs a multi-market oligopoly model to examine the effect of cargo liberalization on competition between all-cargo carriers and mixed passenger/cargo carriers. We find that if home carriers engage in the joint production of cargo and passenger services, whereas foreign carriers produce the two outputs separately, then unilateral cargo liberalization by the home country will reduce home firm profits and increase foreign profits, and raise air fares for passenger travel when foreign competition in the passenger sector is limited. Our analysis suggests that the separation of air cargo and passenger rights might be fraught with difficulty in Asia due to the characteristics of its air cargo market, in which most passenger carriers have substantial cargo businesses and operate ‘‘combi’’ fleets. Ó 2002 Elsevier Science Ltd. All rights reserved.
1. Introduction For the last few years, there has been a growing interest in the liberalization of air cargo services. This interest has arisen in part due to the fast growth of the sector and in part due to a push by shippers, traders, and major freighters, especially air express operators. For the last decade or so, the streamlining of business supply chains has made air cargo in general, and air express in particular, the fastest growing areas in the dynamic freight sector. Companies need to reduce inventories and the time that it takes to move a product to the market. Product life spans are also shortening in many industries (e.g., computers, pharmaceuticals, and designer clothes). Whilst some companies have turned to ‘‘virtual warehousing’’, which involves keeping goods in transit as a substitute for holding them in storage, a growing community of e-commerce retailers has begun *
Corresponding author. Address: Faculty of Commerce and Business Administration, University of British Columbia, Vancouver, BC, Canada V6T 1Z2. Tel.: +1-604-822-8420; fax: +1-604-822-9574. E-mail address: [email protected] (A. Zhang). 1366-5545/02/$ - see front matter Ó 2002 Elsevier Science Ltd. All rights reserved. PII: S 1 3 6 6 - 5 5 4 5 ( 0 2 ) 0 0 0 0 4 - 2
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to rely on strategically located ‘‘fulfillment centers’’ to enable speedy and economical delivery of goods bought online. Furthermore, as a result of continuous declines in tariffs and other trade barriers, international fragmentation, i.e., the outsourcing of various production blocks to countries that possess a comparative advantage in a specific type of productive activity, has become a major economic force for those firms planning to remain competitive. This has increased the demand for international service links in the form of air cargo services, and has intensified the search for a more efficient trade regime. The existing bilateral system that governs international aviation is under increasing pressure to keep pace with worldwide economic and trade expansion. As substantial liberalization in the air passenger sector is unlikely to occur in the near future, it has been proposed that air cargo rights should be separated from air passenger rights and liberalized through the multilateral services liberalization program. At the same time, recent bilateral agreements between the United States and some economies in the Asia-Pacific region (Taiwan, the Philippines, Brunei, and Singapore) include seventh-freedom traffic rights on cargo (i.e., the hubbing or change of gauge rights in a foreign territory), although limits are imposed on fifth-freedom rights for passenger travel. For governments involved in the negotiation of air service agreements, the key issue is likely to be that the negotiation of passenger rights might not easily be separated from the negotiation of cargo rights for those carriers which rely on cargo business for a substantial share of their revenue. As will be illustrated below, particular circumstances in the US aviation environment have resulted in the emergence of dedicated air cargo and air express carriers as the major forces in the air cargo business. In the distant past, however, most air service agreements were built on rights to carry passengers. The rights of airlines to carry cargo frequently depended entirely on the use of belly space in passenger aircraft. This bias is being remedied, but there are still many aviation markets in which no specific air cargo rights have been negotiated. Whilst this situation is a matter of little concern to airlines without dedicated cargo aircraft, or with negligible cargo businesses, it is clearly much more important to those airlines with substantial air cargo businesses. For dedicated air cargo carriers, the issue is critical. It is noteworthy that at a recent OECD workshop on the reform of air cargo regulation, delegates expressed concern that ‘‘all-cargo and integrated services would be the only or major beneficiaries from any regulatory reform process, and ‘‘combi’’ aircraft (both belly cargo and main deck) would not benefit appropriately’’ (OECD, 1999). Despite its growing importance, few published papers have examined the effects of international airfreight service liberalization. In this paper we provide a background discussion of international air cargo service liberalization, and an analytical model of such liberalization. In particular, we seek to gain a better understanding of the effects of unilateral cargo liberalization on the home country’s profit and welfare. For example, over the last few years there have been many calls for Hong Kong to unilaterally liberalize its fifth/seventh freedom rights for the air cargo business (whilst retaining restrictions on fifth-freedom rights for passenger travel). We shall examine whether this would be a Pareto move for the home country, and ascertain the likely profit outcomes for both foreign and home carriers. We employ a multi-market oligopoly model, and use it to examine the effect of cargo liberalization on competition between all-cargo carriers and mixed passenger/cargo carriers. Our model explicitly recognizes three important features of international aviation. First, the international air transport industry can be divided into cargo and passenger sectors, and the industry has been regulated by an elaborate structure of bilateral agreements. These agreements generally specify
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services (passenger or cargo) and routes that can operate between the two countries, designate airlines and the capacity of each airline, and stipulate fare-setting mechanisms. It appears that liberalization of the air passenger sector will not be likely in the near future, but air cargo liberalization is feasible in the short term (Kasper and Hindley, 1999). Second, air cargo service is provided under different production circumstances by passenger carriers and all-cargo carriers, which include integrated carriers and express delivery operators (more discussion on this point will follow throughout the paper). Third, the industry is characterized as an oligopoly, owing in part to the bilateral system. Thus, an oligopoly model that explicitly incorporates the joint production of passenger carriers is appropriate in addressing the effects of air cargo service liberalization. We find that if home carriers engage in the joint production of cargo and passenger services, whereas foreign carriers produce the two outputs separately, then unilateral cargo liberalization by the home country will reduce home firm profits and increase foreign profits, and raise air fares for passenger travel when foreign competition in the passenger sector is limited. Furthermore, our analysis suggests that the separation of air cargo and passenger rights might be fraught with difficulty in Asia because of the characteristics of its air cargo market, in which most passenger carriers have substantial cargo business and operate ‘‘combi’’ fleets. The liberalization of international air transport services has been the subject of numerous papers. Most papers have focused on the air passenger market. For example, a number of empirical studies have addressed the effect of air passenger liberalization on various types of routes. Dresner and Tretheway (1992) analyzed the effect of liberalization on pricing in trans-Atlantic markets. Maillebiau and Hansen (1995) studied the welfare effects of bilateral liberalization on trans-Atlantic routes through the impact of both fares and service quality. Marin (1995) studied the effect of the liberalization of bilateral agreements on fares in European aviation markets. Schipper et al. (2001) examined liberalization effects on intra-European routes. However, few published papers have examined the effects of liberalization on international air cargo services. Zhang and Zhang (2001) provide a general discussion of various issues related to the topic. Another useful general reference has been published by the Logistics Institute Asia-Pacific (TLIAP, 2000). We know of no published paper that considers the effects of air cargo service liberalization within a theoretical framework. This paper is organized as follows. Section 2 briefly describes the background of liberalization in international aviation, the basic characteristics of air cargo service, and the pattern of cargo and passenger services between the US and Asia. Section 3 establishes the basic model and analyses the effects of air cargo liberalization in which home carriers face competition only in the cargo market. Section 4 considers the general case in which competition exists in both the passenger and cargo markets, and Section 5 contains our concluding remarks.
2. Background 2.1. Air cargo liberalization The air cargo volume throughout the world is strongly linked to trade growth. In effect, it has grown slightly faster than the international trade volume; the average annual growth in
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freight-ton kilometers on international scheduled services during the last decade was 7.9%. 1 Moreover, just-in-time pressures and the vertical integration of the logistics industry along with the increasing trend towards outsourcing distribution have led to much faster growth in the air express market than in the total air cargo market. Annual growth in international express cargo has averaged nearly 24% since 1992. Finally, e-commerce is likely to generate increased demand for air cargo, particularly in the time-definite, express market. The passage of the Domestic All-Cargo Deregulation Statute of 1977 in the US eliminated the Civil Aeronautics Board’s control over entry into and exit from the all-cargo market (Carron, 1981). In November 1979, amendments to the Federal Aviation Act deregulated domestic all-cargo air service in the United States, removing government control over rates and routes. Limits on aircraft size were also eliminated. Deregulation was promoted on the promise of lower rates and improved service to shippers. Indeed, it has been found that deregulation, along with the use of just-in-time production, has stimulated air cargo growth in the US (Larson, 1998). In contrast, all commercial aspects of international air transportation have been governed by bilateral air services agreements (ASAs) since the Chicago Convention in 1944. ASAs are based on the principle of reciprocity, that is, an equal and fair exchange of rights between countries with different market sizes, different geographical locations and economic interests, and airlines of different strengths. These agreements establish a set of rules that identify those airlines of the contracting parties which have rights to fly on particular routes, determine the capacity that can be provided by each of the designated airlines, and limit the capacity that can be offered by airlines from third countries. Thus, bilateral ASAs significantly influence the aviation industry because, unlike shipping, airlines require rights to fly passengers or cargo to and from other countries. Restrictions are often imposed on the ability for a carrier to operate services to destinations where there is a perceived business opportunity. The bilateral system is under increasing pressure to keep pace with general international economic and trade expansion (Findlay, 1999). The Uruguay Round succeeded in applying multilateral trade concepts to three limited aspects of the air transport sector, in the form of a separate Annex on Air Transport Services under GATS. 2 These aspects included aircraft repair and maintenance; the selling and marketing of air transport services; and computer reservation system services. The Annex specifically excluded anything that affects traffic rights and services directly related to exercise of those rights. 3
1
For the past decade, airfreight traffic growth has also outpaced air passenger traffic growth by 1–2% each year (Reynolds-Feighan, 2001). 2 A fourth aspect, Ground Handling Services, was considered until late in the Uruguay Round but eventually discarded. 3 Traffic rights were defined in the widest sense to include routes, capacity, pricing, and the criteria for the designation of airlines. Specifically, paragraph 6(d) of the Annex states: ‘‘traffic rights mean the right for scheduled and nonscheduled services to operate and/or carry passengers, cargo and mail for remuneration or hire from, to, within, or over the territory of a member, including points to be served, routes to be operated, types of traffic to be carried, capacity to be provided, tariffs to be charged and their conditions, and criteria for designation of airlines, including such criteria as number, ownership and control’’.
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The approach of the ‘‘GATS 2000’’ negotiations once again raises the issue of how––and to what extent––the airline sector should be dealt with by the World Trade Organization. 4 Various possibilities of expanding the scope of the services included in the Annex have been advanced by governments, international organizations, and various trade associations in the last few years. One prominent proposal is to include some of the services involving traffic rights, specifically allcargo services and express delivery services, under the Annex of the GATS. As substantial liberalization in the air passenger sector is not likely in the near future, the debate on this proposal centers on whether air cargo rights should be separated from air passenger rights and liberalized first through the multilateral services liberalization program of the GATS. 2.2. Features of air cargo service The main reason for liberalizing air cargo service first is that air cargo has features that are distinct from air passenger service. Human air travelers prefer to fly directly to their destination whenever possible. If a transfer is necessary, then they prefer the shortest possible waiting time at the hub airport (Carlton et al., 1980). They also prefer an attractive airport environment that is rich in diversions, or endowed with facilities that enable them to work, to make the waiting time as productive and enjoyable as possible. The passage of cargo is relatively indifferent to such preferences. Whether cargo travels direct, or hubs through one or more airports, is of lesser consequence than for passengers. Cargo is also insensitive to transfer flight synchronization and airport terminal services. However, the passage of cargo is sensitive to other factors, including whether a change of aircraft is required, whether pallets need to be broken down and rebuilt, and the cost of trans-shipment handling. In addition, air cargo flows are unbalanced, or ‘‘uni-directional’’: cargo tends to move from manufacturing to distribution centers, or from production to consumption centers. Other than the apparent bilateral imbalance of cargo flows between Asia and North America, there are imbalances even within the same region. Moreover, such imbalances can be endemic. This is because the inbound/outbound imbalance is fundamentally influenced by import/export imbalances between countries or regions. In contrast, passenger air travel is much more balanced: passengers tend to make a two-way journey (from home to the destination and back again). Consequently, air cargo rates vary greatly according to the direction of travel, and all-cargo carriers sometimes design their networks with ‘‘big circle’’ routes, whilst passenger carriers tend to fly east and west or north and south along the same linear route linking two cities. As a result of these differences, all-cargo carriers sometimes have different routing needs and optimal network strategies than passenger carriers (Kuby and Gary, 1993; Chestler, 1985). For this reason, among others, all-cargo carriers argue that separate all-cargo air traffic rights must be negotiated quite distinctly from the air traffic rights negotiated in bilateral ASAs on behalf of passenger carriers. For example, because passenger traffic is bi-directional it is more natural for countries to negotiate passenger traffic rights on a reciprocal basis than to negotiate cargo rights.
4
‘‘GATS 2000’’ refers to the new round of multilateral negotiations on services trade under the GATS, which was mandated to start in 2000.
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2.3. Different patterns of cargo and passenger services: the US vs. Asia The air transport industry can be divided into cargo and passenger sectors. Cargo can be carried in the belly compartment of a passenger aircraft, or in a freighter aircraft configured exclusively for that use. ‘‘Combi’’ aircraft are also used, in which passengers occupy the front section of the aircraft and cargo occupies the back section. In Hong Kong, for example, between 55% and 60% of airfreight is carried in the belly compartments of passenger aircraft, and the two sectors overlap in a significant way. For mixed passenger/cargo carriers, passenger revenue is still significantly larger than cargo revenue. This can be seen from Table 1, in which passenger revenue accounts for 70% or more of the total for most airlines. Table 1 also reveals different patterns of cargo and passenger services in US and Asian airlines. The structure of passenger air travel across Asia is quite different from that in the domestic US market in many respects. What is critically important is that average journey lengths are longer, and many passenger carriers rely heavily on wide-bodied aircraft as they have developed route networks both domestically and internationally. Hence, these passenger carriers have a greater ability to carry large volumes of air cargo. Many have placed strategic emphasis on the growth of cargo business along their passenger route networks, and have come to generate a significant proportion of their total revenue from the carriage of cargo. A different pattern of development has occurred in the world’s largest air cargo market. In the United States, the fact that most passenger carriers use narrow-bodied aircraft for domestic operation has severely limited their capacity to carry cargo. Using a variety of pure freighter aircraft, dedicated air cargo operators have emerged and raised their share of the total cargo carried from 4% to 60% over the last 20 years. There are indications that both FedEx and UPS are keen to expand their cargo businesses in the Asia-Pacific region. In effect, recent bilateral agreements between the US and some Asia-Pacific economies include seventh-freedom traffic rights on cargo, although limits are imposed on fifth-freedom rights for passenger travel. This provision is intended to help FedEx and UPS to establish mini-hubs in Asia (Oum, 1998). The Table 1 Cargo share of revenue for major US and Asian airlines US carriers ‘‘Combi’’ airlines United American Northwest Delta Continental
Cargo airlines FedEx UPS Airborne Express
Cargo share (%) 5.2 4 7 4 3.5
100 100 53
Source: Airline Business (November, 1999).
Asian carriers
Cargo share (%)
Korean Air Singapore Airlines Japan Airlines Cathay Pacific China Airlines EVA Asiana Thai Airways
27.2 23.0 13.4 26.4 33.7 39.6 24.9 16.5
Nippon Cargo
96.3
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trend will inevitably intensify competition between mixed passenger/cargo carriers and all-cargo carriers. It appears that some of the US carriers (e.g., UPS) support the proposal to liberalize air cargo first under the GATS, whilst most Asian carriers reject the proposal. As will be illustrated below, liberalizing the air cargo sector before the air passenger sector may result in differential impacts on US and Asian carriers, and the separation of air cargo and passenger rights may be fraught with difficulty because of the inter-linkage of passenger and air cargo business in Asia. For this reason, the International Air Transport Association (IATA), an inter-airline trade association, is yet to develop an industry view on the proposal.
3. Basic model and effects of liberalization To examine the profit and welfare effects of a country’s unilateral cargo liberalization, we consider first that two firms are offering air transport services in the country’s international market. Firm A is a foreign carrier that offers only air cargo service, whilst the home carrier, firm B, offers both cargo and passenger services. Thus, the foreign firm is an all-cargo carrier, whereas the home firm is a passenger (‘‘combi’’) carrier. The foreign carrier offers cargo services between the country under consideration and other parts of the world, which are permitted by existing bilateral/multilateral ASAs between the home and foreign countries. Cargo service, denoted as market 1, is the primary market under consideration, whereas passenger service is considered as the secondary market, and is denoted as market 2. Letting Ski be firm is sales revenue (S for sales) in market k (k ¼ 1, 2), the profit of each firm can be written as: B A A B A A ð1Þ pA xA 1 ; x1 ; l ¼ S1 x1 ; x1 C1 x1 ; l B B B A B B A B B B B ð2Þ pB xA 1 ; x1 ; x2 ¼ S1 x1 ; x1 þ S2 x2 ; x2 C x1 ; x2 where x denotes specific outputs, and C i denotes firm is total cost, i ¼ A, B. The liberalization of air cargo service, denoted l (l for liberalization), is assumed to affect the costs of the all-cargo carrier: oC1A 6 0; ol
o2 C1A <0 oloxA 1
ð3Þ
That is, cargo liberalization reduces firm A’s total cost and marginal cost. As the passenger sector is still under the restrictive bilateral system, the costs of the passenger carrier remain unaffected by cargo liberalization. 5 It is worth noting that, in general, liberalization increases the freedom for existing carriers to determine routes, set fares, and set capacities with minimum government interferences. 6 In our 5
See Section 5 for further discussion on the relaxation of this assumption. Liberalization may also open markets to greater competition by allowing additional carriers to operate. In this paper we will not consider this case. In practice, given the size asymmetry between countries, the smaller countries in general are more reluctant to allow free entry than to allow free capacity and fare decisions by existing carriers. In addition, even if free entry is allowed, economies of scale and scope (network) in airline business may likely prevent new entrants in international markets. 6
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model, the cargo liberalization is reflected and approximated by a reduction in the cargo carrier’s operating costs. In other words, the restrictive system is entirely reflected in the higher costs of operating cargo service (i.e., higher than the levels would the restrictions be abolished), and there are no restrictions in terms of firms’ freedom in output decisions both before and after liberalization. Given the cost structure, which is affected by the (exogenous) policy regime, each firm chooses its outputs to maximize profits. This is a useful modeling simplification that allows us to focus on the main effects of airfreight liberalization. 7 The passenger carrier, firm B, uses the belly space in passenger aircraft to carry cargo, so passenger and cargo services are not produced independently. In other words, firm B engages in a joint production of two outputs, and we assume that there are joint economies (or, economies of scope) in the process: pB12
o2 pB o2 C B ¼ >0 oxB1 oxB2 oxB1 oxB2
ð4Þ
That is, an increase (decrease) in cargo output will reduce (increase) the marginal cost of passenger output, and vice versa. Note that, although the ‘‘combi’’ carrier achieves economies by jointly producing passenger and freight traffic, its costs may be higher than those of the all-freight carrier since the two outputs are not completely substitutable in production. As mentioned in Section 2, a consignment of cargo tends to move in a single direction: from manufacturing to distribution centers, or from production to consumption centers, whilst passengers tend to travel to and from centers of commerce, production, and leisure. This difference suggests that passenger carriers using combination aircraft and thus filling belly space with cargo may not have optimally efficient operations for both passengers and cargo on a given route, and that an imbalance of inbound/outbound cargo can be significant on many given routes. The two firms compete in the cargo market, in the sense that oS1i < 0; oxj1
o2 S1i < 0; oxi1 oxj1
i 6¼ j; i; j ¼ A; B
ð5Þ
Thus, an output increase by a firm will reduce the rival firm’s total revenue and marginal revenue. B The first inequality says that xA 1 and x1 are substitutes, whereas the second inequality says that they are ‘‘strategic substitutes’’ (see, e.g., Bulow et al., 1985; Tirole, 1988). We now investigate the effect of cargo liberalization on the provision of cargo and passenger services in the home market, by conducting comparative statics analysis with respect to equilibrium outputs. Specifically, we consider an output equilibrium that arises when A chooses xA 1 and B chooses xB1 and xB2 to maximize their respective profits: B B Max pA xA 1 ; x1 ; x2 ; l ; xA 1
7
B B Max pB xA 1 ; x1 ; x2 xB ;xB 1 2
Liberalization may also likely affect carriers’ revenue. We discuss this in the Section 5.
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The first-order conditions for profit maximization are (subscripts denoting partial derivatives): A B B pA A1 x1 ; x1 ; x2 ; l ¼ 0 B B pBB1 xA ð6Þ 1 ; x1 ; x2 ¼ 0 B B pBB2 xA 1 ; x1 ; x2 ¼ 0 and the second-order conditions are assumed to hold. The three equations in (6) then determine a B B Cournot–Nash equilibrium, which is denoted as xA 1 ðlÞ, x1 ðlÞ and x2 ðlÞ. Substituting the equilibrium outputs into (6) and then differentiating the resulting first-order conditions with respect to l, we obtain: 10 1 1 0 0 A pA pA1 A1 pA dxA pA A1 B1 A1 B2 1 =dl A1 l CB C C B B pB ð7Þ @ B1 A1 pBB1 B1 pBB1 B2 A@ dxB1 =dl A ¼ @ 0 A B dx2 =dl 0 pBB2 A1 pBB2 B1 pBB2 B2 2 A A A A 2 A A A B B where pA A1 A1 o p =ox1 ox1 , etc., and pA1 l o p =ox1 ol. Solving for dx1 =dl, dx1 =dl and dx2 =dl, B and noting pB2 A1 ¼ 0, we have
pA dxA A l 1 ¼ 1 pBB1 B1 pBB2 B2 pBB1 B2 pBB2 B1 dl D A B p dx1 A l ¼ 1 pBB2 B2 pBB1 A1 dl D pA dxB2 A l ¼ 1 pBB1 A1 pBB2 B1 dl D
ð8Þ ð9Þ ð10Þ
2 A A B B B In the above equations, pA A1 l ¼ o C =olox1 > 0 by (3), pB2 B1 ¼ p12 > 0 by (4), pB1 A1 2 B A B B B B B B o S1 =ox1 ox1 < 0 by (5), and pB2 B2 < 0 and pB1 B1 pB2 B2 pB1 B2 pB2 B1 > 0 by the second-order conditions. Further, D denotes the determinant of the matrix in (7). We assume, as is standard in the literature on oligopoly, that the equilibrium is (locally strictly) stable, which implies that D is B B negative. Therefore, (8)–(10) can be signed: dxA 1 =dl > 0, dx1 =dl < 0 and dx2 =dl < 0, leading to:
Proposition 1. With foreign competition only in air cargo service, the unilateral cargo liberalization will increase foreign cargo output, reduce the home carrier’s cargo output, and reduce total passenger output in the home market. As a consequence, the price for passenger travel will rise and passenger welfare will fall. The intuition associated with this result is clear: Cargo liberalization raises marginal profitability of the foreign all-cargo carrier. This allows the foreign carrier to commit to greater cargo output. Since the firms’ outputs are strategic substitutes in the cargo market, such a commitment will induce a contraction in the home firm’s cargo output. This contraction will raise the marginal cost of providing passenger services for the home carrier however, owing to the existence of joint economies, thereby leading to an output reduction in the passenger market as well. In the absence of foreign competition in the passenger market, air passengers would then face higher prices and their welfare would fall as a result.
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Furthermore, the unilateral liberalization will reduce the home profit: dpB dxA dxB dxB oS B dxA 1 ¼ pBA1 1 þ pBB1 1 þ pBB2 2 ¼ A1 <0 dl dl dl dl ox1 dl
ð11Þ
A where pBB1 ¼ 0 and pBB2 ¼ 0 by the first-order conditions, oS1B =oxA 1 < 0 by (5), and dx1 =dl > 0 by Proposition 1. Essentially, the output expansion by the foreign carrier following the home country’s liberalization policy hurts the home firm’s profit, because the two carriers offer substitutable services. On the other hand, the liberalization would benefit the foreign firm: B dpA dxA oS1A dxB1 oC1A A dx1 A 1 ¼ pA þ p þ p >0 ¼ A1 B1 l dl dl dl oxB1 dl ol
ð12Þ
A B A where pA A1 ¼ 0 by the first-order condition, oS1 =ox1 < 0 by (5), and oC1 =ol < 0 by (3). There are two sources for this foreign gain. The direct effect, captured by the second term of (12), is that liberalization reduces the foreign firm’s total cost; while the indirect effect, captured by the first term of (12), is that liberalization induces the home firm to contract which in turn benefits the foreign firm because of substitutable products. The indirect gain is often called the ‘‘strategic effect,’’ since it is associated with a phenomenon in which a first-stage policy affects another firm’s second-stage behavior in a fashion that advances own interests. Thus, liberalization of the air cargo sector may have differential impacts on air carriers. In effect, for this reason, IATA, the trade association that represents the interests of airlines, has still to develop an industry view on the issue. As indicated above, the price effect is unambiguous in the passenger market: the price for air passenger service will rise. On the other hand, the price effect is less clear in the cargo market: the foreign firm will increase its output while the home firm will reduce its output. If the cargo outputs are homogenous, then we can add the two outputs: h
i pA dxA dxB A l 1 þ 1 ¼ 1 pBB1 B1 pBB2 B2 pBB1 B2 pBB2 B1 pBB2 B2 pBB1 A1 ð13Þ dl dl D
The first bracketed term on the right-hand side of (13) is positive but the second term is also positive. It is not clear in general which term will dominate; in effect, specific functional forms and parameters are needed to assess the changes in total output and hence price. Generally, total cargo output is more likely to rise (and hence the cargo price is more likely to fall) if the two outputs are less substitutable, or if the home carrier’s products are less related to each other.
4. Foreign competition in both cargo and passenger markets In Section 3, foreign competition occurred only in the air cargo market. In such cases, unilateral cargo liberalization by the home country harms both the home carrier and consumers of the passenger service, and might harm consumers of the cargo service. Even when the users of the airfreight service gain, air passengers might lose more, which will lead to a welfare reduction for the domestic country. In this section, we consider a situation in which foreign competition occurs in both the cargo and passenger markets. Whilst the home carrier still engages in joint production of cargo and
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passenger services using ‘‘combi’’ passenger aircraft, the foreign carrier offers services using its two subsidiaries: the cargo subsidiary using all-cargo air freighter, and the passenger subsidiary using narrow-body passenger-only aircraft. 8 So there is minimal interaction on the costs (and the revenues) of producing cargo and passenger services for the foreign carrier. The foreign carrier offers passenger business under the restrictive bilateral system. As before, the restrictive system is reflected (and approximated) in its higher costs of operating passenger service (i.e., higher than the levels would the restrictions be abolished). We attempt to investigate the question: Given zero cost interaction for the foreign firm, how does cargo liberalization affect the provision of cargo and passenger services in the home country? Now, the foreign and home carriers engage in head-to-head competition in both markets. We continue to use market 1 to represent airfreight service, and use market 2 for passenger service. A The foreign firm, A, has an output vector xA ðxA 1 ; x2 Þ, and the home firm, B, has an output B B B i vector x ðx1 ; x2 Þ. Letting Sk be firm is sales revenue in market k (k ¼ 1, 2), the profit of each firm may be written as: B A A B A A A A A A ð14Þ pA xA ; xB ; l ¼ S1A xA 1 ; x1 þ S2 x2 ; x2 C1 x1 ; l C2 x2 ¼ p1 þ p2 B B A B B B B pB xA ; xB ¼ S1B xA ð15Þ 1 ; x1 þ S2 x2 ; x2 C x1 ; x2 A A A A A where pA k Sk Ck represent subsidiary profits of the foreign firm A, and C ðx1 ; x2 ; lÞ ¼ A A C1A ðxA 1 ; lÞ þ C2 ðx2 Þ is firm A’s total cost. A unilateral cargo liberalization by the home country is assumed to affect costs of the foreign all-cargo operation, which is given by (3). Furthermore, in a B given market k, the outputs xA k and xk are both substitutes and ‘‘strategic substitutes’’ in that, respectively,
oSki < 0; oxjk
o2 Ski < 0; oxik oxjk
i 6¼ j; i; j ¼ A; B
ð16Þ
for k ¼ 1, 2. Finally, while carrier B engages in a joint production of two outputs with economies of scope, which is given by (4), the costs of two outputs are unrelated for the foreign carrier. We shall show that a policy change in one market can have important impacts on the firms’ strategic positions not only in that market (cargo service), but also in the second market (passenger service). We demonstrate the results by examining the comparative statics effects of liberalization in air cargo on equilibrium outputs. Although the procedure is similar to the one used in Section 3, the analysis is more complicated. This is because when the oligopolists now come into contact in more than one market, the possibilities of strategic interaction are substantially enlarged and complicated due to multi-market interaction. Differentiating the firms’ first-order conditions with respect to l and solving for dxA =dl and dxB =dl, we have 8
Some major airlines do have their all-cargo subsidiaries. Examples include Lufthansa Cargo (under Lufthansa), Nippon Cargo (under ANA), and China Cargo Airlines (under China Eastern Airlines), all of which are significant cargo operators in their markets. As discussed earlier in the text, although there are joint economies, passenger carriers using combination aircraft may not provide optimally efficient services to both passengers and cargo. Alternatively, we could assume that the foreign ‘‘carrier’’ actually consists of two separate foreign competitors, one in the freight business and the other in the passenger business. Examples include the US carriers. As discussed later in this section, our results will remain in this case.
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dxA 1 A B 1 ðpA ð17Þ ¼ I RA B RA AA Þ pAl dl 1 B A 1 A dxB RA ðpAA Þ pAl ð18Þ ¼ I RBA RA B dl In (17) and (18), I is the identity matrix, piii ðo2 pi =oxik oxim Þ are the 2 2 Hessian matrices (i ¼ A, A A 2 A A 2 A A A 2 A A B), and pA Al ¼ ðp1l ; p2l Þ ðo p =ox1 ol; o p =ox2 olÞ. From (14), p1l ¼ o C =olox1 > 0 by (3), A 2 A A i whereas p2l ¼ o C =olox2 ¼ 0. Furthermore, Rj denote the derivatives of the ‘‘reaction funcA A 1 A B B B 1 B tions’’: RA B oR =oxB ¼ ðpAA Þ pAB and RA oR =oxA ¼ ðpBB Þ pBA . Proposition 2. With foreign competition in both air cargo and passenger services, we have dxA1 =dl > 0, dxA2 =dl > 0, dxB1 =dl < 0 and dxB2 =dl < 0. Therefore, the unilateral cargo liberalization will increase foreign cargo and passenger outputs, while reducing home cargo and passenger outputs. The proof of Proposition 2 is quite technical and is given in Appendix A. An examination of (A.3) and (A.4) in the appendix reveals that liberalization will increase firm A’s output in market 1 and reduce B’s output in that market. Moreover, the strategic effect of liberalization on the firms’ outputs is stronger with the presence of a second market (passenger service) than without such a market. Both terms on the right-hand side of (A.4) are negative, with the second term capturing the (negative) multi-market effects of the liberalization on B’s output in the primary market. Perhaps more interesting is the effect of the liberalization on the firms’ market share rivalry in the secondary passenger product. Although the liberalization affects only the cost of the foreign carrier’s cargo operation and there is no cost interaction between foreign cargo and passenger operations, the liberalization will still increase foreign passenger output (while decreasing home passenger output). This is because the reduction by the home firm in the passenger market, owing to a higher cost following its reduction in cargo output, would make the foreign firm more aggressive in that market and expand air passenger service. Since the foreign firm will increase both cargo and passenger outputs, the undesirable effect of a unilateral liberalization identified in the situation where foreign competition occurs only in the cargo market, is alleviated when foreign competition occurs in both cargo and passenger markets. The aggregate output and price effects are generally undetermined in both cargo and passenger services, depending on the effect of joint economies and the cost-reduction effect of liberalization, as well as the degree of substitutability of the firms’ outputs. 9 While the general impact on prices and consumer welfare is ambiguous, the effect of a unilateral liberalization on firm profits is unambiguous. Both cargo and passenger subsidiaries of the foreign firm will increase their profits: dpA oS A dxB oC A 1 ¼ 1B 1 1 > 0 dl ox1 dl ol
ð19Þ
9 Note that this result is not necessarily inconsistent with the previous studies (mainly on the air passenger market) that have found that liberalization (or domestic deregulation) has led to reduced prices and increased traffic. The latter would occur if the foreign firm expansion outweighs the home firm contraction, which can be shown for certain demand and cost specifications.
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dpA oS A dxB 2 ¼ 2B 2 > 0 dl ox2 dl
187
ð20Þ
using (3), (16), and Proposition 2. On the other hand, the home firm will see its profit fall: dpB oS1B dxA oS B dxA 2 ¼ A 1 þ A2 <0 dl ox1 dl ox2 dl
ð21Þ
Thus, if the prices of two products remain more or less the same as the pre-liberalization levels, then the unilateral liberalization policy harms the home country. It is useful to note that the analysis of this section also applies to the cases where two independent foreign carriers, one all-cargo carrier and the other all-passenger carrier, compete with the home carrier that conducts mixed passenger/cargo operations (by using ‘‘combi’’ aircraft). This is seen from (14) where A’s profit can be separated into two components, one for each (independent) subsidiary, and from the fact that both demand and cost are independent across the two subsidiaries. The above analysis may shed some lights on the aviation policy debate in Hong Kong. Hong Kong’s airlines use the belly space in passenger aircraft to carry cargo (55–60%), so the passenger and cargo markets are not independent to each other. In addition, cargo revenue accounts for more than 26% of Cathay Pacific’s total revenue. If Hong Kong unilaterally opened its fifth/ seventh freedom cargo rights to the US (for example), Hong Kong carriers would likely be at a competitive disadvantage to the US carriers such as FedEx and UPS. This is because, as the US domestic market, the world’s largest air cargo market, is open only to US carriers (‘‘no cabotage’’), Hong Kong carriers would, other things being equal, have a higher unit cost than US carriers, owing to economies of scale and economies of network in the airline business. 10 If the cost disadvantage did exist, Hong Kong carriers would lose cargo business to US carriers, which would further raise the cost of operating ‘‘combi’’ aircraft, since passenger and cargo are jointly produced and there are economies of scope and scale. The Hong Kong airlines might then reduce their passenger output by cutting frequency. The foreign all-passenger airlines (e.g., United Airlines and Northwest) would increase their passenger output, leading to a situation where Hong Kong ‘‘combi’’ carriers lose market share and profit in both cargo and passenger markets. Of course, the adverse effect on the home carriers does not necessarily imply that the policy is also detrimental to Hong Kong. The Hong Kong economy as a whole might benefit if users (shippers, passengers) could enjoy lower user charges, better network connections and better services. Nonetheless, our results suggest that the price effect is in general ambiguous, and there is a body of evidence worldwide to suggest that success of a hub depends heavily on the successful development of home carriers.
10 See Kasper and Hindley (1999) for a very interesting discussion on the role of the airline economies of scale and economies of network in the liberalization of international aviation. Another reason is that US carriers may be able to serve Hong Kong–Asian routes more freely than Hong Kong carriers, in particular while countries around Asia continue to maintain restrictive bilateral treaties with Hong Kong (Oum, 1998; Dodwell and Zhang, 2000).
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5. Concluding remarks The main objective of this article is to contribute to a better understanding of the liberalization of international air cargo service. In our relatively simple model, we found that if home carriers engage in the joint production of cargo and passenger services, whereas foreign carriers produce the two outputs separately, then unilateral cargo liberalization by the home country will reduce home firm profits and raise air fares for passenger travel when foreign competition in the passenger sector is limited. Our analysis thus suggests that the separation of air cargo and passenger rights might be fraught with difficulty in Asia due to the characteristics of its air cargo market, where most passenger carriers have substantial cargo business and operate ‘‘combi’’ fleets. Although specific attention should be given to the optimal air traffic needs of dedicated cargo carriers and airlines with dedicated freighters in their fleet, this should not occur in the absence of a balanced approach that accounts for the entire spectrum of air cargo and passenger services, including services by mixed passenger/cargo carriers. One implication of our analysis is that given the liberalization trend in air cargo, competitive responses by passenger airlines with substantial cargo businesses might include the acquisition of dedicated cargo aircraft, as well as the negotiation of air service deals that allow them to use both passenger and pure freighter aircraft on many passenger routes. A few combination carriers have already attempted to compete head-on with these integrators by entering the air express, doorto-door market in partnership with freighter and shipping companies. For example, Cathay Pacific recently expanded its services to the express industry, mainly with its Wholesale Courier and Cargo Express services. The airline has also entered into an innovative arrangement with DHL to provide overnight short-haul cargo services to Asian destinations, exploiting the nighttime capacity available at Hong Kong’s new airport when passenger aircraft would otherwise be ‘‘parked’’ (Dodwell and Zhang, 2000). In the paper we have assumed, for simplicity, that the cargo liberalization is captured by a reduction in cargo carriers’ costs whilst costs of passenger carriers remain unchanged. It is conceivable that the liberalization may enhance carriers’ revenues as well. So long as the revenueenhancing effect is asymmetric (i.e., it enhances cargo carriers’ revenue more than passenger carriers’ revenue), then our basic results should remain intact. More generally, the main purpose of our paper is to explore the implications on outputs, profits, and welfare of international cargo service liberalization when such a policy affects costs (or revenues) of the passenger and all-cargo carriers asymmetrically. Our results would not hold if the policy affected the costs/revenues of both types of airlines in a similar way. We suggest three areas for further study. First, whilst this paper focuses on the unilateral liberalization of air cargo services, it is important, and practical, to examine the incentives for multilateral liberalization by extending the analysis to both home and foreign countries. Second, it would be interesting and useful to investigate what would occur should both cargo and passenger services be liberalized. Finally, as indicated in Section 2, all-cargo carriers may have different routing needs than passenger carriers and thus require different sets of air traffic rights. This supports the case for liberalizing air cargo services first. In this paper we focus on the fact that most passenger carriers have substantial cargo business and operate ‘‘combi’’ fleets, and derive the result that the separation of air cargo and passenger rights might be difficult. Combining both
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aspects in a single model and examining the resultant optimal policy would be an interesting area of future research. Acknowledgements We would like to thank an anonymous referee for very helpful comments. We also thank Sveinn Gudmundsson, Tae Oum, and the participants at the Sixth Air Transport Research Group (ATRG) Conference, JeJu, Korea, 2001, and the ninth WCTR Conference, Seoul, 2001, for useful comments and discussions. The financial support of a Competitive Earmarked Research Grant from the Research Grant Council of Hong Kong (no. 9040384), a Strategic Research Grant from the City University of Hong Kong (no. 7000893), and from the Research Center for International Economics, City University of Hong Kong, is gratefully acknowledged.
Appendix A Proof of Proposition 2. First we note that the matrix pA AB has non-zero ellements only in the diB ox agonal, and the kth element in the diagonal, o2 pA =oxA k k , is negative by condition (16). Likewise, 1 B pBA is a negative diagonal matrix. Next, the inverse of the Hessian matrix, ðpA AA Þ , can be expressed as
A 1 p22 pA A 1 12 ðpAA Þ ¼ A A A D p21 p11 A A A A where DA pA 11 p22 p12 p21 is the determinant of pAA . Applying the second-order condition that 1 A A are pAA be negative definite, we see that D > 0 and hence the diagonal elements of ðpA AA Þ B A A negative, whereas the off-diagonal elements are zero since p12 ð¼ p21 Þ ¼ 0. Similarly, D > 0 and 1 the diagonal elements of ðpBBB Þ are negative, whereas the off-diagonal elements are negative, B since p12 > 0. For the purpose of comparative statics analysis, we assume that the multi-market equilibrium under consideration is stable. Then the stability condition implies that the magnitude of the eiB A B 1 genvalues of matrix RA B RA must be less than unity. Hence, by the Neumann lemma, ðI RB RA Þ exists and
a1 b1 A B 1 A B A B 2 A B k ðA:1Þ ðI RB RA Þ ¼ 1 þ ðRB RA Þ þ ðRB RA Þ þ þ ðRB RA Þ þ c1 d1 B It can be easily verified that the off-diagonal elements of RA B RA are positive given that there are B joint economies, whereas the diagonal elements are positive. Given these signs of RA B RA , the series P A B k ðRB RA Þ must also converge to a matrix that has the same signs. In other words, we should have a1 , b1 , c1 , d1 > 0. 1 exists and By the same reasoning, ðI RBA RA BÞ
a2 b2 B A 1 B A B A 2 B A k ðA:2Þ ðI RA RB Þ ¼ 1 þ ðRA RB Þ þ ðRA RB Þ þ þ ðRA RB Þ þ c2 d2
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where a2 , b2 , c2 , d2 > 0. Using (A.1), (A.2), (17) and (18), dxA =dl and dxB =dl can be calculated as dxA a1 pA 1 22 A p1l ¼ A dl D 2 B dxB1 ða2 pB11 b2 pB12 ÞpA 22 o p pA ¼ 1l dl oxB1 oxA DA DB 1 dxA c1 pA 2 22 A p1l ¼ A dl D 2 B dxB2 ðc2 pB11 d2 pB12 ÞpA 22 o p ¼ pA 1l dl oxB1 oxA DA DB 1
ðA:3Þ ðA:4Þ ðA:5Þ ðA:6Þ
From (A.3)–(A.6) and other results identified above, it can be easily verified that, if there are joint economies of production between cargo and passenger services for firm B, then dxA 1 =dl > 0, B B =dl > 0, dx =dl < 0 and dx =dl < 0. dxA 2 1 2 References Bulow, J.I., Geanakoplos, J.D., Klemperer, P.D., 1985. Multimarket oligopoly: strategic substitutes and complements. Journal of Political Economy 93 (3), 488–511. Carlton, D.W., Landes, W.M., Posner, R.A., 1980. Benefits and costs of airline mergers: a case study. Bell Journal of Economics 11, 65–83. Carron, A.S., 1981. Transition to a Free Market: Deregulation of the Air Cargo Industry. Brookings Institution, Washington. Chestler, L., 1985. Overnight air express: spatial pattern, competition and the future of small package delivery services. Transportation Quarterly 39, 59–71. Dodwell, D., Zhang, A., 2000. Air cargo at Hong Kong’s Service: an analysis of current and future roles, and policy priorities. Mimco, City University of Hong Kong, Hong Kong, unpublished. Dresner, M., Tretheway, M.W., 1992. Modeling and testing the effect of market structure on price: the case of international air transport. Journal of Transport Economics and Policy 26 (2), 171–184. Findlay, C., 1999. Air transport. In: East Asia Conference on Options for the WTO 2000 Negotiations, July 1999. PECC/TPF and World Bank, Manila. Kasper, D.M., Hindley, B., 1999. Liberalization in the transport sector: will GATS fly? In: Services 2000: New Directions in Services Trade Liberalization Conference, 2 June 1999. Washington, DC. Kuby, M.J., Gary, R.G., 1993. The hub network design problem with stopovers and feeders: the case of federal express. Transportation Research, A 27, 1–12. Larson, P., 1998. Air cargo deregulation and JIT: two 20th anniversaries in american logistics. Transportation Quarterly 52 (2), 49–60. Maillebiau, E., Hansen, M., 1995. Demand and consumer welfare impacts of international airline liberalization: the case of the North Atlantic. Journal of Transport Economics and Policy 29 (2), 115–136. Marin, P.L., 1995. Competition in European aviation: pricing policy and market structure. Journal of Industrial Economics 43 (2), 141–159. OECD, 1999. Discussion summary. Transport Division of the OECD’s Directorate for Science, Technology and Industry, 12 July 1999. Oum, T.H., 1998. Overview of regulatory changes in international air transport and Asian strategies towards the US open skies initiatives. Journal of Air Transport Management 4, 127–134. Reynolds-Feighan, A., 2001. Air-freight logistics. In: Brewer, A.M., Button, K.J., Hensher, D.A. (Eds.), Handbook of Logistics and Supply-Chain Management. Elsevier Pergamon, Oxford, pp. 431–440.
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Schipper Y., Rietveld, P., Nijkamp, P., 2001. European airline reform: an empirical welfare analysis. Journal of Transport Economics and Policy, in press. Tirole, J., 1988. The Theory of Industrial Organization. MIT Press, Cambridge. TLIAP, 2000. Air cargo white paper. The Logistics Institute Asia-Pacific. Zhang, A., Zhang, Y., 2001. Issues on liberalization of air cargo services in international aviation. Journal of Air Transport Management, in press.
A model of air cargo liberalization: passenger vs. all-cargo carriers Anming Zhang
a,b,*
, Yimin Zhang
a
a
b
Department of Economics and Finance, City University of Hong Kong, Hong Kong Faculty of Commerce and Business Administration, University of British Columbia, Vancouver, BC, Canada V6T 1Z2
Abstract This paper employs a multi-market oligopoly model to examine the effect of cargo liberalization on competition between all-cargo carriers and mixed passenger/cargo carriers. We find that if home carriers engage in the joint production of cargo and passenger services, whereas foreign carriers produce the two outputs separately, then unilateral cargo liberalization by the home country will reduce home firm profits and increase foreign profits, and raise air fares for passenger travel when foreign competition in the passenger sector is limited. Our analysis suggests that the separation of air cargo and passenger rights might be fraught with difficulty in Asia due to the characteristics of its air cargo market, in which most passenger carriers have substantial cargo businesses and operate ‘‘combi’’ fleets. Ó 2002 Elsevier Science Ltd. All rights reserved.
1. Introduction For the last few years, there has been a growing interest in the liberalization of air cargo services. This interest has arisen in part due to the fast growth of the sector and in part due to a push by shippers, traders, and major freighters, especially air express operators. For the last decade or so, the streamlining of business supply chains has made air cargo in general, and air express in particular, the fastest growing areas in the dynamic freight sector. Companies need to reduce inventories and the time that it takes to move a product to the market. Product life spans are also shortening in many industries (e.g., computers, pharmaceuticals, and designer clothes). Whilst some companies have turned to ‘‘virtual warehousing’’, which involves keeping goods in transit as a substitute for holding them in storage, a growing community of e-commerce retailers has begun *
Corresponding author. Address: Faculty of Commerce and Business Administration, University of British Columbia, Vancouver, BC, Canada V6T 1Z2. Tel.: +1-604-822-8420; fax: +1-604-822-9574. E-mail address: [email protected] (A. Zhang). 1366-5545/02/$ - see front matter Ó 2002 Elsevier Science Ltd. All rights reserved. PII: S 1 3 6 6 - 5 5 4 5 ( 0 2 ) 0 0 0 0 4 - 2
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to rely on strategically located ‘‘fulfillment centers’’ to enable speedy and economical delivery of goods bought online. Furthermore, as a result of continuous declines in tariffs and other trade barriers, international fragmentation, i.e., the outsourcing of various production blocks to countries that possess a comparative advantage in a specific type of productive activity, has become a major economic force for those firms planning to remain competitive. This has increased the demand for international service links in the form of air cargo services, and has intensified the search for a more efficient trade regime. The existing bilateral system that governs international aviation is under increasing pressure to keep pace with worldwide economic and trade expansion. As substantial liberalization in the air passenger sector is unlikely to occur in the near future, it has been proposed that air cargo rights should be separated from air passenger rights and liberalized through the multilateral services liberalization program. At the same time, recent bilateral agreements between the United States and some economies in the Asia-Pacific region (Taiwan, the Philippines, Brunei, and Singapore) include seventh-freedom traffic rights on cargo (i.e., the hubbing or change of gauge rights in a foreign territory), although limits are imposed on fifth-freedom rights for passenger travel. For governments involved in the negotiation of air service agreements, the key issue is likely to be that the negotiation of passenger rights might not easily be separated from the negotiation of cargo rights for those carriers which rely on cargo business for a substantial share of their revenue. As will be illustrated below, particular circumstances in the US aviation environment have resulted in the emergence of dedicated air cargo and air express carriers as the major forces in the air cargo business. In the distant past, however, most air service agreements were built on rights to carry passengers. The rights of airlines to carry cargo frequently depended entirely on the use of belly space in passenger aircraft. This bias is being remedied, but there are still many aviation markets in which no specific air cargo rights have been negotiated. Whilst this situation is a matter of little concern to airlines without dedicated cargo aircraft, or with negligible cargo businesses, it is clearly much more important to those airlines with substantial air cargo businesses. For dedicated air cargo carriers, the issue is critical. It is noteworthy that at a recent OECD workshop on the reform of air cargo regulation, delegates expressed concern that ‘‘all-cargo and integrated services would be the only or major beneficiaries from any regulatory reform process, and ‘‘combi’’ aircraft (both belly cargo and main deck) would not benefit appropriately’’ (OECD, 1999). Despite its growing importance, few published papers have examined the effects of international airfreight service liberalization. In this paper we provide a background discussion of international air cargo service liberalization, and an analytical model of such liberalization. In particular, we seek to gain a better understanding of the effects of unilateral cargo liberalization on the home country’s profit and welfare. For example, over the last few years there have been many calls for Hong Kong to unilaterally liberalize its fifth/seventh freedom rights for the air cargo business (whilst retaining restrictions on fifth-freedom rights for passenger travel). We shall examine whether this would be a Pareto move for the home country, and ascertain the likely profit outcomes for both foreign and home carriers. We employ a multi-market oligopoly model, and use it to examine the effect of cargo liberalization on competition between all-cargo carriers and mixed passenger/cargo carriers. Our model explicitly recognizes three important features of international aviation. First, the international air transport industry can be divided into cargo and passenger sectors, and the industry has been regulated by an elaborate structure of bilateral agreements. These agreements generally specify
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services (passenger or cargo) and routes that can operate between the two countries, designate airlines and the capacity of each airline, and stipulate fare-setting mechanisms. It appears that liberalization of the air passenger sector will not be likely in the near future, but air cargo liberalization is feasible in the short term (Kasper and Hindley, 1999). Second, air cargo service is provided under different production circumstances by passenger carriers and all-cargo carriers, which include integrated carriers and express delivery operators (more discussion on this point will follow throughout the paper). Third, the industry is characterized as an oligopoly, owing in part to the bilateral system. Thus, an oligopoly model that explicitly incorporates the joint production of passenger carriers is appropriate in addressing the effects of air cargo service liberalization. We find that if home carriers engage in the joint production of cargo and passenger services, whereas foreign carriers produce the two outputs separately, then unilateral cargo liberalization by the home country will reduce home firm profits and increase foreign profits, and raise air fares for passenger travel when foreign competition in the passenger sector is limited. Furthermore, our analysis suggests that the separation of air cargo and passenger rights might be fraught with difficulty in Asia because of the characteristics of its air cargo market, in which most passenger carriers have substantial cargo business and operate ‘‘combi’’ fleets. The liberalization of international air transport services has been the subject of numerous papers. Most papers have focused on the air passenger market. For example, a number of empirical studies have addressed the effect of air passenger liberalization on various types of routes. Dresner and Tretheway (1992) analyzed the effect of liberalization on pricing in trans-Atlantic markets. Maillebiau and Hansen (1995) studied the welfare effects of bilateral liberalization on trans-Atlantic routes through the impact of both fares and service quality. Marin (1995) studied the effect of the liberalization of bilateral agreements on fares in European aviation markets. Schipper et al. (2001) examined liberalization effects on intra-European routes. However, few published papers have examined the effects of liberalization on international air cargo services. Zhang and Zhang (2001) provide a general discussion of various issues related to the topic. Another useful general reference has been published by the Logistics Institute Asia-Pacific (TLIAP, 2000). We know of no published paper that considers the effects of air cargo service liberalization within a theoretical framework. This paper is organized as follows. Section 2 briefly describes the background of liberalization in international aviation, the basic characteristics of air cargo service, and the pattern of cargo and passenger services between the US and Asia. Section 3 establishes the basic model and analyses the effects of air cargo liberalization in which home carriers face competition only in the cargo market. Section 4 considers the general case in which competition exists in both the passenger and cargo markets, and Section 5 contains our concluding remarks.
2. Background 2.1. Air cargo liberalization The air cargo volume throughout the world is strongly linked to trade growth. In effect, it has grown slightly faster than the international trade volume; the average annual growth in
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freight-ton kilometers on international scheduled services during the last decade was 7.9%. 1 Moreover, just-in-time pressures and the vertical integration of the logistics industry along with the increasing trend towards outsourcing distribution have led to much faster growth in the air express market than in the total air cargo market. Annual growth in international express cargo has averaged nearly 24% since 1992. Finally, e-commerce is likely to generate increased demand for air cargo, particularly in the time-definite, express market. The passage of the Domestic All-Cargo Deregulation Statute of 1977 in the US eliminated the Civil Aeronautics Board’s control over entry into and exit from the all-cargo market (Carron, 1981). In November 1979, amendments to the Federal Aviation Act deregulated domestic all-cargo air service in the United States, removing government control over rates and routes. Limits on aircraft size were also eliminated. Deregulation was promoted on the promise of lower rates and improved service to shippers. Indeed, it has been found that deregulation, along with the use of just-in-time production, has stimulated air cargo growth in the US (Larson, 1998). In contrast, all commercial aspects of international air transportation have been governed by bilateral air services agreements (ASAs) since the Chicago Convention in 1944. ASAs are based on the principle of reciprocity, that is, an equal and fair exchange of rights between countries with different market sizes, different geographical locations and economic interests, and airlines of different strengths. These agreements establish a set of rules that identify those airlines of the contracting parties which have rights to fly on particular routes, determine the capacity that can be provided by each of the designated airlines, and limit the capacity that can be offered by airlines from third countries. Thus, bilateral ASAs significantly influence the aviation industry because, unlike shipping, airlines require rights to fly passengers or cargo to and from other countries. Restrictions are often imposed on the ability for a carrier to operate services to destinations where there is a perceived business opportunity. The bilateral system is under increasing pressure to keep pace with general international economic and trade expansion (Findlay, 1999). The Uruguay Round succeeded in applying multilateral trade concepts to three limited aspects of the air transport sector, in the form of a separate Annex on Air Transport Services under GATS. 2 These aspects included aircraft repair and maintenance; the selling and marketing of air transport services; and computer reservation system services. The Annex specifically excluded anything that affects traffic rights and services directly related to exercise of those rights. 3
1
For the past decade, airfreight traffic growth has also outpaced air passenger traffic growth by 1–2% each year (Reynolds-Feighan, 2001). 2 A fourth aspect, Ground Handling Services, was considered until late in the Uruguay Round but eventually discarded. 3 Traffic rights were defined in the widest sense to include routes, capacity, pricing, and the criteria for the designation of airlines. Specifically, paragraph 6(d) of the Annex states: ‘‘traffic rights mean the right for scheduled and nonscheduled services to operate and/or carry passengers, cargo and mail for remuneration or hire from, to, within, or over the territory of a member, including points to be served, routes to be operated, types of traffic to be carried, capacity to be provided, tariffs to be charged and their conditions, and criteria for designation of airlines, including such criteria as number, ownership and control’’.
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The approach of the ‘‘GATS 2000’’ negotiations once again raises the issue of how––and to what extent––the airline sector should be dealt with by the World Trade Organization. 4 Various possibilities of expanding the scope of the services included in the Annex have been advanced by governments, international organizations, and various trade associations in the last few years. One prominent proposal is to include some of the services involving traffic rights, specifically allcargo services and express delivery services, under the Annex of the GATS. As substantial liberalization in the air passenger sector is not likely in the near future, the debate on this proposal centers on whether air cargo rights should be separated from air passenger rights and liberalized first through the multilateral services liberalization program of the GATS. 2.2. Features of air cargo service The main reason for liberalizing air cargo service first is that air cargo has features that are distinct from air passenger service. Human air travelers prefer to fly directly to their destination whenever possible. If a transfer is necessary, then they prefer the shortest possible waiting time at the hub airport (Carlton et al., 1980). They also prefer an attractive airport environment that is rich in diversions, or endowed with facilities that enable them to work, to make the waiting time as productive and enjoyable as possible. The passage of cargo is relatively indifferent to such preferences. Whether cargo travels direct, or hubs through one or more airports, is of lesser consequence than for passengers. Cargo is also insensitive to transfer flight synchronization and airport terminal services. However, the passage of cargo is sensitive to other factors, including whether a change of aircraft is required, whether pallets need to be broken down and rebuilt, and the cost of trans-shipment handling. In addition, air cargo flows are unbalanced, or ‘‘uni-directional’’: cargo tends to move from manufacturing to distribution centers, or from production to consumption centers. Other than the apparent bilateral imbalance of cargo flows between Asia and North America, there are imbalances even within the same region. Moreover, such imbalances can be endemic. This is because the inbound/outbound imbalance is fundamentally influenced by import/export imbalances between countries or regions. In contrast, passenger air travel is much more balanced: passengers tend to make a two-way journey (from home to the destination and back again). Consequently, air cargo rates vary greatly according to the direction of travel, and all-cargo carriers sometimes design their networks with ‘‘big circle’’ routes, whilst passenger carriers tend to fly east and west or north and south along the same linear route linking two cities. As a result of these differences, all-cargo carriers sometimes have different routing needs and optimal network strategies than passenger carriers (Kuby and Gary, 1993; Chestler, 1985). For this reason, among others, all-cargo carriers argue that separate all-cargo air traffic rights must be negotiated quite distinctly from the air traffic rights negotiated in bilateral ASAs on behalf of passenger carriers. For example, because passenger traffic is bi-directional it is more natural for countries to negotiate passenger traffic rights on a reciprocal basis than to negotiate cargo rights.
4
‘‘GATS 2000’’ refers to the new round of multilateral negotiations on services trade under the GATS, which was mandated to start in 2000.
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2.3. Different patterns of cargo and passenger services: the US vs. Asia The air transport industry can be divided into cargo and passenger sectors. Cargo can be carried in the belly compartment of a passenger aircraft, or in a freighter aircraft configured exclusively for that use. ‘‘Combi’’ aircraft are also used, in which passengers occupy the front section of the aircraft and cargo occupies the back section. In Hong Kong, for example, between 55% and 60% of airfreight is carried in the belly compartments of passenger aircraft, and the two sectors overlap in a significant way. For mixed passenger/cargo carriers, passenger revenue is still significantly larger than cargo revenue. This can be seen from Table 1, in which passenger revenue accounts for 70% or more of the total for most airlines. Table 1 also reveals different patterns of cargo and passenger services in US and Asian airlines. The structure of passenger air travel across Asia is quite different from that in the domestic US market in many respects. What is critically important is that average journey lengths are longer, and many passenger carriers rely heavily on wide-bodied aircraft as they have developed route networks both domestically and internationally. Hence, these passenger carriers have a greater ability to carry large volumes of air cargo. Many have placed strategic emphasis on the growth of cargo business along their passenger route networks, and have come to generate a significant proportion of their total revenue from the carriage of cargo. A different pattern of development has occurred in the world’s largest air cargo market. In the United States, the fact that most passenger carriers use narrow-bodied aircraft for domestic operation has severely limited their capacity to carry cargo. Using a variety of pure freighter aircraft, dedicated air cargo operators have emerged and raised their share of the total cargo carried from 4% to 60% over the last 20 years. There are indications that both FedEx and UPS are keen to expand their cargo businesses in the Asia-Pacific region. In effect, recent bilateral agreements between the US and some Asia-Pacific economies include seventh-freedom traffic rights on cargo, although limits are imposed on fifth-freedom rights for passenger travel. This provision is intended to help FedEx and UPS to establish mini-hubs in Asia (Oum, 1998). The Table 1 Cargo share of revenue for major US and Asian airlines US carriers ‘‘Combi’’ airlines United American Northwest Delta Continental
Cargo airlines FedEx UPS Airborne Express
Cargo share (%) 5.2 4 7 4 3.5
100 100 53
Source: Airline Business (November, 1999).
Asian carriers
Cargo share (%)
Korean Air Singapore Airlines Japan Airlines Cathay Pacific China Airlines EVA Asiana Thai Airways
27.2 23.0 13.4 26.4 33.7 39.6 24.9 16.5
Nippon Cargo
96.3
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trend will inevitably intensify competition between mixed passenger/cargo carriers and all-cargo carriers. It appears that some of the US carriers (e.g., UPS) support the proposal to liberalize air cargo first under the GATS, whilst most Asian carriers reject the proposal. As will be illustrated below, liberalizing the air cargo sector before the air passenger sector may result in differential impacts on US and Asian carriers, and the separation of air cargo and passenger rights may be fraught with difficulty because of the inter-linkage of passenger and air cargo business in Asia. For this reason, the International Air Transport Association (IATA), an inter-airline trade association, is yet to develop an industry view on the proposal.
3. Basic model and effects of liberalization To examine the profit and welfare effects of a country’s unilateral cargo liberalization, we consider first that two firms are offering air transport services in the country’s international market. Firm A is a foreign carrier that offers only air cargo service, whilst the home carrier, firm B, offers both cargo and passenger services. Thus, the foreign firm is an all-cargo carrier, whereas the home firm is a passenger (‘‘combi’’) carrier. The foreign carrier offers cargo services between the country under consideration and other parts of the world, which are permitted by existing bilateral/multilateral ASAs between the home and foreign countries. Cargo service, denoted as market 1, is the primary market under consideration, whereas passenger service is considered as the secondary market, and is denoted as market 2. Letting Ski be firm is sales revenue (S for sales) in market k (k ¼ 1, 2), the profit of each firm can be written as: B A A B A A ð1Þ pA xA 1 ; x1 ; l ¼ S1 x1 ; x1 C1 x1 ; l B B B A B B A B B B B ð2Þ pB xA 1 ; x1 ; x2 ¼ S1 x1 ; x1 þ S2 x2 ; x2 C x1 ; x2 where x denotes specific outputs, and C i denotes firm is total cost, i ¼ A, B. The liberalization of air cargo service, denoted l (l for liberalization), is assumed to affect the costs of the all-cargo carrier: oC1A 6 0; ol
o2 C1A <0 oloxA 1
ð3Þ
That is, cargo liberalization reduces firm A’s total cost and marginal cost. As the passenger sector is still under the restrictive bilateral system, the costs of the passenger carrier remain unaffected by cargo liberalization. 5 It is worth noting that, in general, liberalization increases the freedom for existing carriers to determine routes, set fares, and set capacities with minimum government interferences. 6 In our 5
See Section 5 for further discussion on the relaxation of this assumption. Liberalization may also open markets to greater competition by allowing additional carriers to operate. In this paper we will not consider this case. In practice, given the size asymmetry between countries, the smaller countries in general are more reluctant to allow free entry than to allow free capacity and fare decisions by existing carriers. In addition, even if free entry is allowed, economies of scale and scope (network) in airline business may likely prevent new entrants in international markets. 6
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model, the cargo liberalization is reflected and approximated by a reduction in the cargo carrier’s operating costs. In other words, the restrictive system is entirely reflected in the higher costs of operating cargo service (i.e., higher than the levels would the restrictions be abolished), and there are no restrictions in terms of firms’ freedom in output decisions both before and after liberalization. Given the cost structure, which is affected by the (exogenous) policy regime, each firm chooses its outputs to maximize profits. This is a useful modeling simplification that allows us to focus on the main effects of airfreight liberalization. 7 The passenger carrier, firm B, uses the belly space in passenger aircraft to carry cargo, so passenger and cargo services are not produced independently. In other words, firm B engages in a joint production of two outputs, and we assume that there are joint economies (or, economies of scope) in the process: pB12
o2 pB o2 C B ¼ >0 oxB1 oxB2 oxB1 oxB2
ð4Þ
That is, an increase (decrease) in cargo output will reduce (increase) the marginal cost of passenger output, and vice versa. Note that, although the ‘‘combi’’ carrier achieves economies by jointly producing passenger and freight traffic, its costs may be higher than those of the all-freight carrier since the two outputs are not completely substitutable in production. As mentioned in Section 2, a consignment of cargo tends to move in a single direction: from manufacturing to distribution centers, or from production to consumption centers, whilst passengers tend to travel to and from centers of commerce, production, and leisure. This difference suggests that passenger carriers using combination aircraft and thus filling belly space with cargo may not have optimally efficient operations for both passengers and cargo on a given route, and that an imbalance of inbound/outbound cargo can be significant on many given routes. The two firms compete in the cargo market, in the sense that oS1i < 0; oxj1
o2 S1i < 0; oxi1 oxj1
i 6¼ j; i; j ¼ A; B
ð5Þ
Thus, an output increase by a firm will reduce the rival firm’s total revenue and marginal revenue. B The first inequality says that xA 1 and x1 are substitutes, whereas the second inequality says that they are ‘‘strategic substitutes’’ (see, e.g., Bulow et al., 1985; Tirole, 1988). We now investigate the effect of cargo liberalization on the provision of cargo and passenger services in the home market, by conducting comparative statics analysis with respect to equilibrium outputs. Specifically, we consider an output equilibrium that arises when A chooses xA 1 and B chooses xB1 and xB2 to maximize their respective profits: B B Max pA xA 1 ; x1 ; x2 ; l ; xA 1
7
B B Max pB xA 1 ; x1 ; x2 xB ;xB 1 2
Liberalization may also likely affect carriers’ revenue. We discuss this in the Section 5.
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The first-order conditions for profit maximization are (subscripts denoting partial derivatives): A B B pA A1 x1 ; x1 ; x2 ; l ¼ 0 B B pBB1 xA ð6Þ 1 ; x1 ; x2 ¼ 0 B B pBB2 xA 1 ; x1 ; x2 ¼ 0 and the second-order conditions are assumed to hold. The three equations in (6) then determine a B B Cournot–Nash equilibrium, which is denoted as xA 1 ðlÞ, x1 ðlÞ and x2 ðlÞ. Substituting the equilibrium outputs into (6) and then differentiating the resulting first-order conditions with respect to l, we obtain: 10 1 1 0 0 A pA pA1 A1 pA dxA pA A1 B1 A1 B2 1 =dl A1 l CB C C B B pB ð7Þ @ B1 A1 pBB1 B1 pBB1 B2 A@ dxB1 =dl A ¼ @ 0 A B dx2 =dl 0 pBB2 A1 pBB2 B1 pBB2 B2 2 A A A A 2 A A A B B where pA A1 A1 o p =ox1 ox1 , etc., and pA1 l o p =ox1 ol. Solving for dx1 =dl, dx1 =dl and dx2 =dl, B and noting pB2 A1 ¼ 0, we have
pA dxA A l 1 ¼ 1 pBB1 B1 pBB2 B2 pBB1 B2 pBB2 B1 dl D A B p dx1 A l ¼ 1 pBB2 B2 pBB1 A1 dl D pA dxB2 A l ¼ 1 pBB1 A1 pBB2 B1 dl D
ð8Þ ð9Þ ð10Þ
2 A A B B B In the above equations, pA A1 l ¼ o C =olox1 > 0 by (3), pB2 B1 ¼ p12 > 0 by (4), pB1 A1 2 B A B B B B B B o S1 =ox1 ox1 < 0 by (5), and pB2 B2 < 0 and pB1 B1 pB2 B2 pB1 B2 pB2 B1 > 0 by the second-order conditions. Further, D denotes the determinant of the matrix in (7). We assume, as is standard in the literature on oligopoly, that the equilibrium is (locally strictly) stable, which implies that D is B B negative. Therefore, (8)–(10) can be signed: dxA 1 =dl > 0, dx1 =dl < 0 and dx2 =dl < 0, leading to:
Proposition 1. With foreign competition only in air cargo service, the unilateral cargo liberalization will increase foreign cargo output, reduce the home carrier’s cargo output, and reduce total passenger output in the home market. As a consequence, the price for passenger travel will rise and passenger welfare will fall. The intuition associated with this result is clear: Cargo liberalization raises marginal profitability of the foreign all-cargo carrier. This allows the foreign carrier to commit to greater cargo output. Since the firms’ outputs are strategic substitutes in the cargo market, such a commitment will induce a contraction in the home firm’s cargo output. This contraction will raise the marginal cost of providing passenger services for the home carrier however, owing to the existence of joint economies, thereby leading to an output reduction in the passenger market as well. In the absence of foreign competition in the passenger market, air passengers would then face higher prices and their welfare would fall as a result.
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Furthermore, the unilateral liberalization will reduce the home profit: dpB dxA dxB dxB oS B dxA 1 ¼ pBA1 1 þ pBB1 1 þ pBB2 2 ¼ A1 <0 dl dl dl dl ox1 dl
ð11Þ
A where pBB1 ¼ 0 and pBB2 ¼ 0 by the first-order conditions, oS1B =oxA 1 < 0 by (5), and dx1 =dl > 0 by Proposition 1. Essentially, the output expansion by the foreign carrier following the home country’s liberalization policy hurts the home firm’s profit, because the two carriers offer substitutable services. On the other hand, the liberalization would benefit the foreign firm: B dpA dxA oS1A dxB1 oC1A A dx1 A 1 ¼ pA þ p þ p >0 ¼ A1 B1 l dl dl dl oxB1 dl ol
ð12Þ
A B A where pA A1 ¼ 0 by the first-order condition, oS1 =ox1 < 0 by (5), and oC1 =ol < 0 by (3). There are two sources for this foreign gain. The direct effect, captured by the second term of (12), is that liberalization reduces the foreign firm’s total cost; while the indirect effect, captured by the first term of (12), is that liberalization induces the home firm to contract which in turn benefits the foreign firm because of substitutable products. The indirect gain is often called the ‘‘strategic effect,’’ since it is associated with a phenomenon in which a first-stage policy affects another firm’s second-stage behavior in a fashion that advances own interests. Thus, liberalization of the air cargo sector may have differential impacts on air carriers. In effect, for this reason, IATA, the trade association that represents the interests of airlines, has still to develop an industry view on the issue. As indicated above, the price effect is unambiguous in the passenger market: the price for air passenger service will rise. On the other hand, the price effect is less clear in the cargo market: the foreign firm will increase its output while the home firm will reduce its output. If the cargo outputs are homogenous, then we can add the two outputs: h
i pA dxA dxB A l 1 þ 1 ¼ 1 pBB1 B1 pBB2 B2 pBB1 B2 pBB2 B1 pBB2 B2 pBB1 A1 ð13Þ dl dl D
The first bracketed term on the right-hand side of (13) is positive but the second term is also positive. It is not clear in general which term will dominate; in effect, specific functional forms and parameters are needed to assess the changes in total output and hence price. Generally, total cargo output is more likely to rise (and hence the cargo price is more likely to fall) if the two outputs are less substitutable, or if the home carrier’s products are less related to each other.
4. Foreign competition in both cargo and passenger markets In Section 3, foreign competition occurred only in the air cargo market. In such cases, unilateral cargo liberalization by the home country harms both the home carrier and consumers of the passenger service, and might harm consumers of the cargo service. Even when the users of the airfreight service gain, air passengers might lose more, which will lead to a welfare reduction for the domestic country. In this section, we consider a situation in which foreign competition occurs in both the cargo and passenger markets. Whilst the home carrier still engages in joint production of cargo and
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passenger services using ‘‘combi’’ passenger aircraft, the foreign carrier offers services using its two subsidiaries: the cargo subsidiary using all-cargo air freighter, and the passenger subsidiary using narrow-body passenger-only aircraft. 8 So there is minimal interaction on the costs (and the revenues) of producing cargo and passenger services for the foreign carrier. The foreign carrier offers passenger business under the restrictive bilateral system. As before, the restrictive system is reflected (and approximated) in its higher costs of operating passenger service (i.e., higher than the levels would the restrictions be abolished). We attempt to investigate the question: Given zero cost interaction for the foreign firm, how does cargo liberalization affect the provision of cargo and passenger services in the home country? Now, the foreign and home carriers engage in head-to-head competition in both markets. We continue to use market 1 to represent airfreight service, and use market 2 for passenger service. A The foreign firm, A, has an output vector xA ðxA 1 ; x2 Þ, and the home firm, B, has an output B B B i vector x ðx1 ; x2 Þ. Letting Sk be firm is sales revenue in market k (k ¼ 1, 2), the profit of each firm may be written as: B A A B A A A A A A ð14Þ pA xA ; xB ; l ¼ S1A xA 1 ; x1 þ S2 x2 ; x2 C1 x1 ; l C2 x2 ¼ p1 þ p2 B B A B B B B pB xA ; xB ¼ S1B xA ð15Þ 1 ; x1 þ S2 x2 ; x2 C x1 ; x2 A A A A A where pA k Sk Ck represent subsidiary profits of the foreign firm A, and C ðx1 ; x2 ; lÞ ¼ A A C1A ðxA 1 ; lÞ þ C2 ðx2 Þ is firm A’s total cost. A unilateral cargo liberalization by the home country is assumed to affect costs of the foreign all-cargo operation, which is given by (3). Furthermore, in a B given market k, the outputs xA k and xk are both substitutes and ‘‘strategic substitutes’’ in that, respectively,
oSki < 0; oxjk
o2 Ski < 0; oxik oxjk
i 6¼ j; i; j ¼ A; B
ð16Þ
for k ¼ 1, 2. Finally, while carrier B engages in a joint production of two outputs with economies of scope, which is given by (4), the costs of two outputs are unrelated for the foreign carrier. We shall show that a policy change in one market can have important impacts on the firms’ strategic positions not only in that market (cargo service), but also in the second market (passenger service). We demonstrate the results by examining the comparative statics effects of liberalization in air cargo on equilibrium outputs. Although the procedure is similar to the one used in Section 3, the analysis is more complicated. This is because when the oligopolists now come into contact in more than one market, the possibilities of strategic interaction are substantially enlarged and complicated due to multi-market interaction. Differentiating the firms’ first-order conditions with respect to l and solving for dxA =dl and dxB =dl, we have 8
Some major airlines do have their all-cargo subsidiaries. Examples include Lufthansa Cargo (under Lufthansa), Nippon Cargo (under ANA), and China Cargo Airlines (under China Eastern Airlines), all of which are significant cargo operators in their markets. As discussed earlier in the text, although there are joint economies, passenger carriers using combination aircraft may not provide optimally efficient services to both passengers and cargo. Alternatively, we could assume that the foreign ‘‘carrier’’ actually consists of two separate foreign competitors, one in the freight business and the other in the passenger business. Examples include the US carriers. As discussed later in this section, our results will remain in this case.
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dxA 1 A B 1 ðpA ð17Þ ¼ I RA B RA AA Þ pAl dl 1 B A 1 A dxB RA ðpAA Þ pAl ð18Þ ¼ I RBA RA B dl In (17) and (18), I is the identity matrix, piii ðo2 pi =oxik oxim Þ are the 2 2 Hessian matrices (i ¼ A, A A 2 A A 2 A A A 2 A A B), and pA Al ¼ ðp1l ; p2l Þ ðo p =ox1 ol; o p =ox2 olÞ. From (14), p1l ¼ o C =olox1 > 0 by (3), A 2 A A i whereas p2l ¼ o C =olox2 ¼ 0. Furthermore, Rj denote the derivatives of the ‘‘reaction funcA A 1 A B B B 1 B tions’’: RA B oR =oxB ¼ ðpAA Þ pAB and RA oR =oxA ¼ ðpBB Þ pBA . Proposition 2. With foreign competition in both air cargo and passenger services, we have dxA1 =dl > 0, dxA2 =dl > 0, dxB1 =dl < 0 and dxB2 =dl < 0. Therefore, the unilateral cargo liberalization will increase foreign cargo and passenger outputs, while reducing home cargo and passenger outputs. The proof of Proposition 2 is quite technical and is given in Appendix A. An examination of (A.3) and (A.4) in the appendix reveals that liberalization will increase firm A’s output in market 1 and reduce B’s output in that market. Moreover, the strategic effect of liberalization on the firms’ outputs is stronger with the presence of a second market (passenger service) than without such a market. Both terms on the right-hand side of (A.4) are negative, with the second term capturing the (negative) multi-market effects of the liberalization on B’s output in the primary market. Perhaps more interesting is the effect of the liberalization on the firms’ market share rivalry in the secondary passenger product. Although the liberalization affects only the cost of the foreign carrier’s cargo operation and there is no cost interaction between foreign cargo and passenger operations, the liberalization will still increase foreign passenger output (while decreasing home passenger output). This is because the reduction by the home firm in the passenger market, owing to a higher cost following its reduction in cargo output, would make the foreign firm more aggressive in that market and expand air passenger service. Since the foreign firm will increase both cargo and passenger outputs, the undesirable effect of a unilateral liberalization identified in the situation where foreign competition occurs only in the cargo market, is alleviated when foreign competition occurs in both cargo and passenger markets. The aggregate output and price effects are generally undetermined in both cargo and passenger services, depending on the effect of joint economies and the cost-reduction effect of liberalization, as well as the degree of substitutability of the firms’ outputs. 9 While the general impact on prices and consumer welfare is ambiguous, the effect of a unilateral liberalization on firm profits is unambiguous. Both cargo and passenger subsidiaries of the foreign firm will increase their profits: dpA oS A dxB oC A 1 ¼ 1B 1 1 > 0 dl ox1 dl ol
ð19Þ
9 Note that this result is not necessarily inconsistent with the previous studies (mainly on the air passenger market) that have found that liberalization (or domestic deregulation) has led to reduced prices and increased traffic. The latter would occur if the foreign firm expansion outweighs the home firm contraction, which can be shown for certain demand and cost specifications.
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dpA oS A dxB 2 ¼ 2B 2 > 0 dl ox2 dl
187
ð20Þ
using (3), (16), and Proposition 2. On the other hand, the home firm will see its profit fall: dpB oS1B dxA oS B dxA 2 ¼ A 1 þ A2 <0 dl ox1 dl ox2 dl
ð21Þ
Thus, if the prices of two products remain more or less the same as the pre-liberalization levels, then the unilateral liberalization policy harms the home country. It is useful to note that the analysis of this section also applies to the cases where two independent foreign carriers, one all-cargo carrier and the other all-passenger carrier, compete with the home carrier that conducts mixed passenger/cargo operations (by using ‘‘combi’’ aircraft). This is seen from (14) where A’s profit can be separated into two components, one for each (independent) subsidiary, and from the fact that both demand and cost are independent across the two subsidiaries. The above analysis may shed some lights on the aviation policy debate in Hong Kong. Hong Kong’s airlines use the belly space in passenger aircraft to carry cargo (55–60%), so the passenger and cargo markets are not independent to each other. In addition, cargo revenue accounts for more than 26% of Cathay Pacific’s total revenue. If Hong Kong unilaterally opened its fifth/ seventh freedom cargo rights to the US (for example), Hong Kong carriers would likely be at a competitive disadvantage to the US carriers such as FedEx and UPS. This is because, as the US domestic market, the world’s largest air cargo market, is open only to US carriers (‘‘no cabotage’’), Hong Kong carriers would, other things being equal, have a higher unit cost than US carriers, owing to economies of scale and economies of network in the airline business. 10 If the cost disadvantage did exist, Hong Kong carriers would lose cargo business to US carriers, which would further raise the cost of operating ‘‘combi’’ aircraft, since passenger and cargo are jointly produced and there are economies of scope and scale. The Hong Kong airlines might then reduce their passenger output by cutting frequency. The foreign all-passenger airlines (e.g., United Airlines and Northwest) would increase their passenger output, leading to a situation where Hong Kong ‘‘combi’’ carriers lose market share and profit in both cargo and passenger markets. Of course, the adverse effect on the home carriers does not necessarily imply that the policy is also detrimental to Hong Kong. The Hong Kong economy as a whole might benefit if users (shippers, passengers) could enjoy lower user charges, better network connections and better services. Nonetheless, our results suggest that the price effect is in general ambiguous, and there is a body of evidence worldwide to suggest that success of a hub depends heavily on the successful development of home carriers.
10 See Kasper and Hindley (1999) for a very interesting discussion on the role of the airline economies of scale and economies of network in the liberalization of international aviation. Another reason is that US carriers may be able to serve Hong Kong–Asian routes more freely than Hong Kong carriers, in particular while countries around Asia continue to maintain restrictive bilateral treaties with Hong Kong (Oum, 1998; Dodwell and Zhang, 2000).
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5. Concluding remarks The main objective of this article is to contribute to a better understanding of the liberalization of international air cargo service. In our relatively simple model, we found that if home carriers engage in the joint production of cargo and passenger services, whereas foreign carriers produce the two outputs separately, then unilateral cargo liberalization by the home country will reduce home firm profits and raise air fares for passenger travel when foreign competition in the passenger sector is limited. Our analysis thus suggests that the separation of air cargo and passenger rights might be fraught with difficulty in Asia due to the characteristics of its air cargo market, where most passenger carriers have substantial cargo business and operate ‘‘combi’’ fleets. Although specific attention should be given to the optimal air traffic needs of dedicated cargo carriers and airlines with dedicated freighters in their fleet, this should not occur in the absence of a balanced approach that accounts for the entire spectrum of air cargo and passenger services, including services by mixed passenger/cargo carriers. One implication of our analysis is that given the liberalization trend in air cargo, competitive responses by passenger airlines with substantial cargo businesses might include the acquisition of dedicated cargo aircraft, as well as the negotiation of air service deals that allow them to use both passenger and pure freighter aircraft on many passenger routes. A few combination carriers have already attempted to compete head-on with these integrators by entering the air express, doorto-door market in partnership with freighter and shipping companies. For example, Cathay Pacific recently expanded its services to the express industry, mainly with its Wholesale Courier and Cargo Express services. The airline has also entered into an innovative arrangement with DHL to provide overnight short-haul cargo services to Asian destinations, exploiting the nighttime capacity available at Hong Kong’s new airport when passenger aircraft would otherwise be ‘‘parked’’ (Dodwell and Zhang, 2000). In the paper we have assumed, for simplicity, that the cargo liberalization is captured by a reduction in cargo carriers’ costs whilst costs of passenger carriers remain unchanged. It is conceivable that the liberalization may enhance carriers’ revenues as well. So long as the revenueenhancing effect is asymmetric (i.e., it enhances cargo carriers’ revenue more than passenger carriers’ revenue), then our basic results should remain intact. More generally, the main purpose of our paper is to explore the implications on outputs, profits, and welfare of international cargo service liberalization when such a policy affects costs (or revenues) of the passenger and all-cargo carriers asymmetrically. Our results would not hold if the policy affected the costs/revenues of both types of airlines in a similar way. We suggest three areas for further study. First, whilst this paper focuses on the unilateral liberalization of air cargo services, it is important, and practical, to examine the incentives for multilateral liberalization by extending the analysis to both home and foreign countries. Second, it would be interesting and useful to investigate what would occur should both cargo and passenger services be liberalized. Finally, as indicated in Section 2, all-cargo carriers may have different routing needs than passenger carriers and thus require different sets of air traffic rights. This supports the case for liberalizing air cargo services first. In this paper we focus on the fact that most passenger carriers have substantial cargo business and operate ‘‘combi’’ fleets, and derive the result that the separation of air cargo and passenger rights might be difficult. Combining both
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aspects in a single model and examining the resultant optimal policy would be an interesting area of future research. Acknowledgements We would like to thank an anonymous referee for very helpful comments. We also thank Sveinn Gudmundsson, Tae Oum, and the participants at the Sixth Air Transport Research Group (ATRG) Conference, JeJu, Korea, 2001, and the ninth WCTR Conference, Seoul, 2001, for useful comments and discussions. The financial support of a Competitive Earmarked Research Grant from the Research Grant Council of Hong Kong (no. 9040384), a Strategic Research Grant from the City University of Hong Kong (no. 7000893), and from the Research Center for International Economics, City University of Hong Kong, is gratefully acknowledged.
Appendix A Proof of Proposition 2. First we note that the matrix pA AB has non-zero ellements only in the diB ox agonal, and the kth element in the diagonal, o2 pA =oxA k k , is negative by condition (16). Likewise, 1 B pBA is a negative diagonal matrix. Next, the inverse of the Hessian matrix, ðpA AA Þ , can be expressed as
A 1 p22 pA A 1 12 ðpAA Þ ¼ A A A D p21 p11 A A A A where DA pA 11 p22 p12 p21 is the determinant of pAA . Applying the second-order condition that 1 A A are pAA be negative definite, we see that D > 0 and hence the diagonal elements of ðpA AA Þ B A A negative, whereas the off-diagonal elements are zero since p12 ð¼ p21 Þ ¼ 0. Similarly, D > 0 and 1 the diagonal elements of ðpBBB Þ are negative, whereas the off-diagonal elements are negative, B since p12 > 0. For the purpose of comparative statics analysis, we assume that the multi-market equilibrium under consideration is stable. Then the stability condition implies that the magnitude of the eiB A B 1 genvalues of matrix RA B RA must be less than unity. Hence, by the Neumann lemma, ðI RB RA Þ exists and
a1 b1 A B 1 A B A B 2 A B k ðA:1Þ ðI RB RA Þ ¼ 1 þ ðRB RA Þ þ ðRB RA Þ þ þ ðRB RA Þ þ c1 d1 B It can be easily verified that the off-diagonal elements of RA B RA are positive given that there are B joint economies, whereas the diagonal elements are positive. Given these signs of RA B RA , the series P A B k ðRB RA Þ must also converge to a matrix that has the same signs. In other words, we should have a1 , b1 , c1 , d1 > 0. 1 exists and By the same reasoning, ðI RBA RA BÞ
a2 b2 B A 1 B A B A 2 B A k ðA:2Þ ðI RA RB Þ ¼ 1 þ ðRA RB Þ þ ðRA RB Þ þ þ ðRA RB Þ þ c2 d2
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where a2 , b2 , c2 , d2 > 0. Using (A.1), (A.2), (17) and (18), dxA =dl and dxB =dl can be calculated as dxA a1 pA 1 22 A p1l ¼ A dl D 2 B dxB1 ða2 pB11 b2 pB12 ÞpA 22 o p pA ¼ 1l dl oxB1 oxA DA DB 1 dxA c1 pA 2 22 A p1l ¼ A dl D 2 B dxB2 ðc2 pB11 d2 pB12 ÞpA 22 o p ¼ pA 1l dl oxB1 oxA DA DB 1
ðA:3Þ ðA:4Þ ðA:5Þ ðA:6Þ
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