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Strategic airline policy in the globalizing airline networks.

caused by such a policy can in fact be more than offset by the additional revenue resulting from it.

19 See J.A. Brander and B.J. Spencer (1985), "Export subsidies and International Market Share Rivalry," Journal of International Economics, Vol. 16, pp. 227-242.

20 See A.K. Dixit (1987), "Strategic Aspects of Trade Policy," in Bewley, T.F. ed., Advances in Economic Theory: The Fifth World Congress of Econometric Society (New York: Cambridge University Press), and E. Helpman and P. Krugman (1989), "Trade Policy and Market Structure," (Mass.: The MIT Press), for The airline industry in North America has changed dramatically over the last fifteen years, due primarily to the deregulation of the U.S. market in 1978, and the southern Canadian market in 1988. This deregulation allowed the airlines to set up efficient hub-and-spoke networks, and has led to organizational consolidation within the airline industry. The twenty trunk and local service carriers which existed in the U.S. in the mid-1970s have now been consolidated into seven major carriers. The liberalization of airline regulation in Canada, which began in 1984, encouraged a similar consolidation within the Canadian airline industry. Over the last five years, CP Air, Wardair, and four former regional carriers (PWA, Nordair, Quebecair, and EPA) have been integrated into Canadian Airlines International (CAI), creating essentially a duopoly market shared between CAI and Air Canada.(1)

Consolidation has also begun in Europe, as exemplified by the merger between British Airways and British Caledonian in 1987 and the acquisition of UTA and Air Inter by Air France. Since the European Community entered the virtually "open border" arrangement among its member states in January 1993, there will surely be an even greater consolidation of its airline industry, as the major carriers jockey to become one of Europe's dominant airlines.(2) The desire for economic efficiency will lead to a rationalization and strengthening of European hub-and-spoke networks similar to the North American experience.

Most consumers prefer to fly with a large airline which has an extensive international network.(3) This preference will induce airlines to establish global networks in order to attract passengers in the increasingly competitive environment. This globalization is inevitable and it is simply a matter of time until global networks form. Each global network will likely be formed by linking one or more gateway hubs located on each continent. The location of these intercontinental gateways will significantly influence airline employment and other related economic activities in their host countries.

This article argues that successful global airline networks will be created by alliances of carriers from different continents and that a nation's ability to attract major intercontinental gateways and associated commercial aviation activities depends greatly on the home carrier's ability to become a senior partner in a global alliance network. Further, this article addresses the following questions: What qualities of a carrier make it attractive as a senior partner in an alliance? Is there a need for a national strategic airline policy in order to increase the likelihood that a nation's carrier will become a senior partner? What are the benefits and costs of adopting such a strategic policy?

The following section defines the term "global network" and describes the reasons why global networks will be formed through carrier alliances. It also provides some early indications of such networks. The remaining sections investigate the characteristics which make a carrier attractive as a senior alliance partner in a global network; outline the strategic policy options for improving a carrier's attractiveness; describe the strategic options for Canada, with their costs and benefits; and indicate directions for future research.


In this article, a global airline network is defined as an airline network capable of providing service to most of the large and medium-sized cities around the world, particularly in North America, Europe, and Asia. A global network can collect or feed traffic from many points throughout the world, channel that traffic onto its long haul routes, and distribute it through collection systems on other continents. A global alliance network is a global airline network formed by a group of affiliated airlines which offer seamless services to consumers through a joint use of computer reservation system, throughfares and ticketing, automatic baggage transfer, coordinated flight schedules, codesharing of flights,(4) joint marketing, sharing of a frequent flyer program, etc. For all practical purposes, it is like using a single airline company as far as consumers and travel agents are concerned. The affiliated carriers forming a global alliance network may also conduct jointly the activities for enhancing efficiency and meeting service quality standards such as purchase of aircraft and fuel, major maintenance, computer systems, crew and other employee training, etc.

Global networks will most likely be formed through "strong" alliances between existing air carriers, involving sizeable but minority equity stakes in each other's ownership.(5) The major factors in support of this proposition are described below.

Creation of Open Skies Continental Blocs

Restrictions governing continental air transportation have been diminishing within North America, Europe, and Asia, and this liberalization is expected to continue. The eventual outcome will be an "open skies" regime within each continent, within which any airline will be free to offer service between any city-pair on the continent. For example, Canada and the U.S. are currently renegotiating their bilateral air agreement with the expressed goal of substantially liberalizing transborder air services. As the effects of the Canada-U.S. Free Trade Agreement are realized, it is inevitable that these two countries will move toward a completely open skies regime (which will likely include Mexico).(6)

The Association of South-East Asian Nations (ASEAN) has had discussions on forming an open skies bloc in that region. Japan, Korea, Hong Kong, and Taiwan already have fairly liberal access to each other's air transport markets. Growth in intra-Asia traffic and transpacific trade will eventually lead to the formation of cross-country hub-and-spoke networks in Asia. As of January 1, 1993, EEC air carriers are allowed to serve any city-pair in the Community, excepting a pair within the territory of a single member state. Member states of the European Free Trade Association (EFTA) have also expressed an interest in joining the European open skies bloc. These developments set the stage for the rationalization of the European airline structure and the evolution of economically efficient hub-and-spoke systems.(7)

The formation of open skies continental blocs will mitigate a foreign carrier's ability to extend its own network into another continent unless the carrier aligns with one or more of that continent's indigenous carriers. Although it is probable that international air transport services will be further liberalized, it is unlikely that the international market will ever be deregulated to the same extent as the intra-continental market. That is, some regulatory constraints on market entry, capacity, and pricing will continue to exist in the future. Clearly, a foreign carrier will feel far more constrained in setting up an efficient hub-and-spoke network or establishing marketing and computerized reservations systems (CRS) channels on another continent than would the indigenous carriers. An alliance with an indigenous carrier will provide an offshore carrier with effective access to this market.

Limited Knowledge of the Market

A foreign carrier attempting to establish a major base in another continent will be at a disadvantage compared to the continent's indigenous carriers because of its relatively limited knowledge of the markets, consumer preference, culture, marketing channels, and so on.

Time and Financial Resources

A successful global network is likely to generate in excess of $30 billion in revenue.(8) Creating a single organization for an agency of this size would require financial and organizational resources beyond the reach of even the largest existing carrier. Even in the case where a mega-carrier could arrange for sufficient financing, it would take a long time for the carrier to develop a viable network and management system outside of its home continent.

Limits on Takeover and Foreign Ownership

There are legal, political, and institutional constraints on mergers and takeovers between airlines of different nations. By law, foreign nationals may not own more than 25 percent of voting shares of any airline in the U.S. or Canada. In addition, such legislation typically requires de facto control to remain in the hands of home country nationals, regardless of the size of the foreign equity stake. Where legal requirements do not exist, other countries have special review provisions (the UK Minister of Transport can revoke the license of an airline deemed to be "no longer UK controlled," for instance). The implication is that it would be impossible for a mega-carrier to expand into other continents through mergers and acquisitions.

Limitation by Bilateral Agreements

Bilateral agreements between countries generally specify that the participating airline be substantially owned by nationals of the home country. This provision was meant to prevent a third nation from participating under the bilateral umbrella when one of the two nations elects not to exercise its own rights, but it has the effect of restricting the emergence of a potential multi-national airline.(9)

Government Ownership and National Prestige

Many countries associate national prestige with the existence of an independent "national flag" airline. Takeovers or mergers of such airlines by foreign interests would be politically unacceptable to the domestic governments, and would undoubtedly be resisted. Furthermore, many of the airlines are partly or wholly owned by the government itself, making takeovers and mergers even more difficult.

In sum, a mega-carrier faces severe limitations in establishing networks on other continents through mergers and acquisitions. Instead, global airline networks will normally be developed through alliances between major continentally-based carriers. Creation of a lasting global network requires strong alliances among carriers, with significant network and cost benefits for all members and inducements for each member not to defect to another alliance. Cross-holding of equity shares and cross-representation in the partners' boards of directors thus become important elements for cementing a durable global alliance network.

Early Indications of Possible Global Alliances

International alliances are in the early stages of development, and without doubt will continually evolve in response to competitive pressure and market growth. The following global alliances are likely current possibilities.

Delta Airlines, Swissair, and Singapore Airlines. In 1989, Delta, Swissair, and Singapore formed the first trilateral airline partnership, which initially involved joint marketing activities such as coordinated schedules and the sharing of airport terminals and check-in facilities. Their cooperation now includes a codesharing operation on Singapore's U.S. co-terminal routes served by Delta, and will encompass joint purchasing activities in the near future. The three airlines have also strengthened their alliance with minor equity exchanges of 5 percent.

Their combined route network currently spans five continents, with the noticeable gap being South America. Delta is apparently interested in obtaining a stake in Venezuela's Aeropostal, which could play a feeder carrier role in this global network. In addition, Singapore has a feeder relationship with its subsidiary Tradewinds in Southeast Asia, while Swissair has formed a "European Quality Alliance" (EQA) with Austrian Airlines and SAS. The EQA currently involves marketing cooperation, although the airlines have agreed to intensify their joint efforts through a "higher level of commitment."(10) Other likely partners of the EQA include Spanair and Airlines of Britain, of which SAS owns 49 percent and 24.9 percent, respectively.

British Airways and USAir. The acquisition by British Airways (BA) of 44 percent of USAir (21 percent of voting shares only due to the foreign ownership limitation for a U.S. airline) has established the nucleus for a global network.(11) BA is also interested in investing in Trans World Airways (TWA), which dominates St. Louis hub and which has a significant presence in New York's JFK Airport. Together this alliance would create the largest network in the world, with a combined revenue in excess of $16 billion (U.S. dollars). In addition, British Airways owns one-third of Air Russia, a Moscow-based joint venture with Aeroflot and others, and has acquired 49 percent of a German regional airline (renamed Deutsche BA) in order to build Europe's first hub-and-spoke system.(12) British Airways is likely to seek a similar alliance with Cathay Pacific, exploiting its historic ties with Hong Kong.(13)

Until very recently, British Airways was also involved in negotiations with KLM to establish a holding company that would have combined their marketing and maintenance services. (This followed their failed attempt to form an affiliation with Sabena under the new name of Sabena World Airlines.) Under the proposed plan, the two airlines would have continued to use their existing names, but the eventual result would have been a fully merged airline. While talks have broken off, it is too early to conclude that no alliance between the two carriers will be established.

Northwest Airlines and KLM Royal Dutch Airlines. In 1990, Northwest and KLM entered into a marketing agreement which was solidified by KLM's subsequent investment in the U.S. carrier. KLM's share has since increased to 25 percent of the voting stock and 49 percent of total equity, the maximum permitted by the Department of Transportation's most recent interpretation of the U.S. ownership law. In November 1992, the U.S. Department of Transportation approved a request by Northwest and KLM to function as one airline and to cooperate in such areas as pricing and strategy. The two airlines plan to provide seamless services to customers by creating "a joint identity by operating under the same trademark and using the same branding for aircraft exterior and interiors, uniforms, vehicles, and stationery."(14)

Although their networks have extensive links to Asia, Northwest and KLM will likely seek an Asian partner to access traffic originating from beyond their gateway points. Potential candidates include Philippines Airlines and Hong Kong's Cathay Pacific Airways. Both Northwest and British Airways are apparently interested in acquiring a stake in the soon-to-be privatized Philippines Airlines.

In other regions, KLM owns 14.9 percent of Air UK, while Northwest has a 20 percent interest in Hawaiian Airlines and is apparently interested in acquiring a stake in Qantas Airways.

Continental Airlines and SAS.(15) In 1989, Continental and SAS entered into a comprehensive marketing agreement which included codesharing on transatlantic routes operated by SAS. Although its initial shareholding was 9.9 percent, SAS has since increased its interest in Continental's parent company to 18.4 percent.

Their combined route network, however, lacks substantial coverage in Asia, South America, and Africa. Currently, SAS has codesharing arrangements with both Thai Airways International and All Nippon Airways, which, in turn, has entered into a marketing agreement with VASP of Brazil. In addition, SAS has a 35 percent interest in LAN Chilean Airlines, which feeds South American traffic to SAS at its hub in Madrid. More significant, though, is the SAS alliance with Austrian Airlines and Swissair, which is expected to involve an equity swap sometime in the near future.

Other Possibilities. Lufthansa and Japan Air Lines have recently formed a strategic alliance, details of which have not yet been released. In 1990, both airlines acquired minority interests in DHL International (Netherlands) and DHL Corporation (U.S.), which provide express package and freight delivery service worldwide. In addition, Lufthansa has formed a marketing alliance with Finnair, a former EQA member, while Japan Air Lines owns 7.5 percent of its codesharing partner Air New Zealand and is rumoured to be interested in acquiring a stake in Philippines Airlines.

Air France and Sabena have signed a partnership agreement(16) under which Air France will acquire a 37.5 percent stake in Sabena for $122 million (U.S.). The airline has already acquired its French competitors, UTA and Air Inter, and is reportedly purchasing a 25 percent interest in CSA, Czechoslovakia's airline. Given their limited global coverage, it is likely that Air France and Sabena are considering an alignment with U.S. Asian carriers.


Two general forms of alliance are anticipated. Some alliances may be formed by a mixture of these two prototypes:

(1) One mega-carrier creating an alliance network by aligning with several junior partners in each of the other continents. The senior airline would be responsible for network policy and coordination, including computer reservations system and pricing and capacity decisions, and would provide much of the long-haul international services and operate major hub airports in the network.

(2) An alliance among large senior partners, one from each continent, supplemented by regional feeder carriers within the continents as junior partners. The senior partner is likely to have a substantial equity position in the junior partners within its continent, and would be responsible to the network for efficient network operations within the continent itself, including the operation of continental hubs.

Of these two forms, the latter is expected to be more successful than the former. In (2), since each of the senior partners would have major network and market share within its continent, the resulting global network would enjoy a large share of the global market, and thus would be able to offer a higher frequency of service from one end of its global network to the other. Other benefits, such as joint purchases of aircraft and coordinated ground handling and major aircraft maintenance, are likely to be greater in this from of alliance than for (1).

Global networks will be formed by partners who can offer a combination of advantages to the alliance. These include the following:

* Market coverage. Complementarity in route networks is vital, so that each member brings a substantial market coverage to the network which it could not otherwise achieve.

* Candidates for senior partnership will have one or more continental hub airports which are suitable for development as international gateways. A senior partner will need to have a solid traffic base within the entire continental market along with an international scope to facilitate connections with major alliance partners in other continents.

* Compatible management philosophies, management styles, and corporate image. Network coordination of schedules, reservation systems, ground handling routines, and so on will require a great deal of inter-airline cooperation. Similarity in brand (quality) image is important for the alliance to be successful.

* Efficient cost structure. To be attractive as an alliance partner, the airline must be perceived as a winner in the long run. Cost efficiency vis-a-vis its competitors is an important attribute for becoming a winner.

* Financial stability. Potential partners with high debt loads or substantial uncertainty with respect to long-term economic viability will be unattractive.

Because of the enormous size of the North American market, each alliance will include a major North American airline. Given the current state of the North American air industry, this implies that there will be a total of five or six networks spanning the globe, based on American Airlines (American), United Airlines (United), Delta, USAir, and one or two others. Each alliance will also include one major European player (British Airways, Lufthansa, Air France, KLM Royal Dutch Airlines) plus one or more consortia of current second-tier airlines (Swissair, SAS, Alitalia, Iberia, Air Austria), and likely one Far Eastern airline (JAL, ANA, Cathay Pacific, Singapore Air, one or more of KAL, Garuda, Air India, Thai International, etc.). Other subsidiary airlines would provide feeder services through the appropriate hubs to other areas (Africa, South America, the Middle East, Eastern Europe, etc.).

The size and economic rationale underlying the current locations of the major U.S. hubs means that the U.S. partners will probably retain much of their current domestic network structure. Each alliance will likely center around one or two European hubs. In Asia, the markets are smaller and more geographically dispersed than North America or Western Europe. Thus, alliance networks in this region may include one partner in eastern Asia and another partner in western Asia.

Consequences of Not Joining a Network

The four or five global alliance networks will dominate intercontinental passenger markets. The first air carriers to successfully form a global network will reap the greatest benefits. The success of the first network will induce other carriers in each continent to immediately form similar global networks. Since most passengers will prefer to travel using a global network, the carriers left out of the process are likely to lose market share and eventually either go out of business or become feeder carriers to a global network.


The overriding policy objective of a national government should be to maximize the long-run welfare of its citizens.(17) In economic terms, this means that governments should set policies which will maximize the long-run combined consumer and producer surpluses from the economic activities. In terms of policy toward the airline industry, the government could simply allow market forces to dictate the form of the national air network. This may mean that the domestic marketplace can be highly competitive, with multiple (small) airlines. In view of the globalization of airline networks, this policy could eventually turn national air carriers into feeder carriers for large foreign airlines since each global airline network will seek to maximize its own profits, implying a network structure which achieves maximum efficiency. In the short run, this would increase consumer surplus through the provision of low-cost, convenient air transportation to the nation. In the longer run, however, consumer surplus would not continue to increase and, concurrently, producer surplus would be exported as many of the commercial airline activities (i.e., headquarters functions, major maintenance operations, reservation services, flight crew bases, and hubbing of traffic) are shifted to the large carriers' bases in foreign countries. Of course, this will reduce the number of opportunities for domestic carriers to earn producer surplus and thus reduce the total surplus the country can earn from its airline industry in the long run.

The forthcoming globalization of airline networks thus has important implications for airline management and government policy makers. Is there any way for a government and its air carriers to act in unison to alter the terms of the forthcoming globalization involving their country in order to increase the long-run total (consumer and producer) surpluses to the nation? To address this issue, one must turn to the literature of strategic industrial policies.

A strategic industrial policy may be defined as a policy that may not seem desirable when viewed in isolation or with a short-run perspective, but which alters the terms of subsequent competition in the industry to the benefit of the country adopting the policy.(18) For example, an export subsidy policy that would ordinarily lower national welfare in the short run may improve its long-run welfare because of its deterrent effect on foreign competition.(19) In the international trade literature, the last decade has witnessed an active research program investigating the implications of imperfect competition for strategic trade and industrial policies.(20) The theoretical analysis shows that trade and industrial policies may have beneficial strategic effects and, as a result, the national policy prescriptions may differ in significant respects from the "conventional" ones derived assuming (perfectly) competitive conditions.(21) The premise is that, with imperfect competition in international markets, monopoly profits do exist and a national government may wish to pursue policies that secure more profits for its own country. Furthermore, government actions can serve as a "strategic commitment," altering the conditions of the strategic game being played by foreign and domestic firms.(22)

Interpreting this literature for national airline policies, it may be that government policies designed to enhance the attractiveness of its flag carrier as a senior global alliance partner are justifiable for the following two reasons:

(1) The nature of the world airline market is oligopolistic in that it can support only a few (five or six) global networks. Because of high entry barriers these few networks would earn considerable rent, with little room for that rent to be competed away. In this situation, clearly a country would prefer that its carriers become major partners in these global networks.

(2) The existence of external economies gives an additional justification for strategic policies. The term "external economy" may be defined as a benefit from some activity that accrues to other individuals or firms than those engaging in the activity. When domestic carriers become global alliance partners, not only are some of the monopoly rents shifted to the domestic firms, but also the possibility is created for some airports in the country to become intercontinental hubs or gateways. Since major activity centers such as headquarters, maintenance centers, and flight crew bases tend to be located close to hubs, the possession of intercontinental hubs means that the host country would garner the benefits from these activities. A policy which enhances the national carriers' chances of becoming senior global alliance partners is likely to have valuable spillovers because it brings benefits to other sectors of the society.

What would be the content of such strategic airline policies? The characteristics of an attractive senior global partner, discussed earlier, provide a prescription for potentially successful strategic policies which will improve the chance for a nation's carrier of becoming such a senior partner. Such policies may include consolidation of domestic airlines, subsidization of the industry, and pre-investment in airport expansions. In this article we will focus on the airline consolidation-deconsolidation policy and examine whether such a policy will be strategically desirable to a country.(23)

Earlier analysis on the characteristics of an attractive global partner suggests that for a carrier to be a senior partner in a global network, it must have a sufficient size and traffic base to contribute to the alliance network. One obvious way of achieving this is through consolidation of the national airline industry. As described earlier, a wave of airline mergers has taken place in the U.S., and the industry now consists of seven major carriers, three of which are mega-carriers. Further consolidation is probable. Consolidations of domestic airlines are also occurring in other countries, as previously outlined.

The rationale behind these mergers may be based on several factors, including (a) the marketing advantages of being a large carrier, (b) the enhanced opportunity to exploit economies of traffic density, particularly in international routes, and (c) the airlines' need for strategic positioning in preparation for the anticipated formation of global airline networks and to win the subsequent competition in the global marketplace. However, the increase in industry concentration resulting from mergers has raised concerns about anti-competitive behaviour. Motivated partly by these concerns, several countries have recently deconsolidated their airline industries. Examples include Korea (which allowed Asiana to compete with Korean Air), and Japan (which allowed ANA to compete with JAL on international routes).

The important policy question now faced by each nation is: Given the inevitability of the formation of global networks, is consolidation/deconsolidation within the national airline industry desirable? Although the answer to this question will vary from country to country, three types of countries which would experience different consequences from their choice can be identified. The first category is the countries which have the major population and air travel bases within each continent (e.g., the U.S., Germany, and Japan). These countries would be better off allowing the market system to guide the globalization process because the profit or market share maximization process of competing global networks must include carriers residing in these countries. For instance, it is highly improbable that a global network will include North America and exclude a U.S. carrier. In fact, if the U.S. airline industry gets consolidated into three mega-carriers and none of the second-tier carriers survives, it would be a blessing for Canada because it would increase the probability of a Canadian carrier to become a senior North American partner in the fourth global network. Similarly, merging Japan Airlines and ANA would only harm Japan because it would reduce the number of global networks to go through Japan from two to one. The decision to give ANA international route rights was strategically correct because it would increase the chance of attracting a second global network to Japan without jeopardizing the chance of attracting the first one (through JAL's system). Again, if the Japanese government were to decide to merge JAL and ANA, it would increase the chance for Korean Air to become a senior Asian partner in a global network.

The second group of countries are the nations which are located adjacent to a country which has large population and air traffic bases (e.g., Canada, Switzerland, and Korea). In these countries, a strategic airline policy encouraging consolidation of the industry is likely to pay off handsomely as it can enhance the probability of attracting a global network. For example, the consolidation of traffic bases in Canada by merging the two competing carriers will increase attractiveness of its carrier as a senior partner in a global network, as described later in this article.

The third group of countries are isolated countries like Australia, New Zealand, Norway, and Sweden. In these cases, creation of a monopoly through a strategic policy would only reduce domestic consumer surplus without increasing the chance of attracting a global network.


Canadian Airline Industry and Its Market

Currently the Canadian airline industry is primarily a duopoly which consists of Air Canada and Canadian Airlines International (CAI). Both of these carriers have extensive regional feeder carrier systems throughout Canada. In addition, there are several charter carriers serving domestic trunk routes and international leisure travellers. Total revenue of the industry is about $7 billion (Canadian). The market shares of these carriers in 1991 were 51 percent, 42 percent, and 7 percent for Air Canada, CAI, and other carriers (including charter carriers), respectively.(24) Air Canada has extensive services to Europe, the Caribbean, and the U.S. markets while CAI serves Asia-Pacific countries, Europe, and South America. CAI also has a minor presence in the Canada-U.S. transborder routes (San Francisco, Los Angeles, and Hawaii).

The total (scheduled and charter) one-way origin-destination traffic volumes in 1989 were 13.2 million passengers in intra-Canada travel (excluding 1.8 million passengers for the domestic portion of international journeys), 13 million for Canada-U.S. transborder travel, and 9.7 million for overseas travel.(25) Note that the transborder passenger volume is approximately the same size as the pure domestic travel volume (excluding the domestic portion of transborder and international journeys).

Strategic Policy Options for Canada

Figure 1 summarizes the relative sizes of Canada's airline markets by market segment and compares them with those of the U.S. It shows that the U.S. intercontinental markets are very large relative to those of Canada. In particular, the traffic volume for Euro-American market (26 million passengers) is over six times the Euro-Canada market (4.2 million), and the traffic volume for U.S.-Asia market (11.4 million) is over eleven times the Canada-Asia market (1 million). This illustrates that market forces will likely result in all of five to six major global networks having their North American base in the U.S. That is, major foreign carriers with global ambitions will seek alliance partners in the U.S. rather than in Canada. This implies that Canadian airlines will become feeder carriers, forwarding most of their transborder and international traffic to the U.S. airline networks.(26)

In early 1992, it became apparent that CAI was having severe cash flow problems, and the airline itself acknowledged that it would not be able to survive in its current form without a major cash injection. The apparent options open to Canada are:

(1) Retain the domestic duopoly by allowing American airlines to acquire a substantial equity stake in CAI, or

(2) Follow a consolidation policy and allow a merger between Air Canada and CAI.

The two options are evaluated below with a special emphasis on their short- and long-term impact on consumers, airline industry, economic activities, and the national welfare. The broad consequences of the two policy options are discussed and detailed anticipated results of the two options are summarized in the following sections.

Overall Consequences of the Two Policy Options

In view of the emerging globalization of airline networks, the two policy options produce radically different consequences for Canada.

Retention of the domestic duopoly. After negotiations between PWA (the parent of CAI) and AMR (the parent of American Airlines) beginning in early 1992, American made an offer in July of 1992 to inject $250 million (Canadian) into CAI in exchange for 25 percent of "voting" shares and a certain amount of non-voting preferred shares of PWA,(27) and rights to provide key management services such as revenue accounting, computerized reservation, fare setting, and certain maintenance activities for a fee. It is apparent that American sought de facto control of Canadian without violating the 25 percent foreign ownership limitation.(28)

If this Canadian-American deal becomes successful, Canada would retain its current duopoly structure and consumers would enjoy the benefits of competition, at least in the short run. However, this would have serious negative consequences on the future of Canada's airline industry by altering the terms of future competition. In particular, the likely consequences of this (AMR+CAI) deal would be:

* Subject to existing regulatory constraints, AMR+CAI would quickly move to integrate flight schedules and routing patterns, and coordinate pricing.

* Pressure for complete and immediate deregulation of the U.S.-Canada transborder markets would intensify. CAI's attractiveness to AMR+CAI (and thus its value) would increase as CAI's access to transborder routes increased (for network and flight integration and coordination), and if AMR+CAI were to obtain unlimited access to the intra-Canada markets, either on its own or through codesharing.

* Over time, some Canadian domestic traffic would be routed through a large U.S. hub of AMR+CAI, likely Chicago. Extension of AMR+CAI's hub-and-spoke system in this way would generate high frequencies and higher load factors.

* The frequency of direct flights between Canada and overseas points might be reduced, as some Canadian traffic would be routed through AMR's U.S. hubs (Chicago, Dallas/Fort Worth, Seattle, and San Francisco or San Jose).

AMR+CAI would also place intense competitive pressure on Air Canada. By offering high frequency, non-stop or one-stop on-line connecting services to most U.S. destinations (under a liberalized bilateral regime), ARM+CAI could offer to consumers higher frequency services to more destinations than could Air Canada. In addition, by enhancing its CRS system within Canada (while at the same time significantly weakening that of Air Canada), AMR+CAI could dramatically improve its control over the distribution channels in Canada. Given that the AMR+CAI cost structure would be much lower than that of Air Canada, AMR+CAI might also choose to support its service advantage with an aggressive pricing strategy. This combination of actions would erode Air Canada's market share of international, transborder, and domestic traffic.

Faced with this development, Air Canada would have to react, presumably in one of the following ways: (a) restructure itself in an attempt to continue as an independent carrier, or (b) develop an arrangement similar to CAI's by aligning with a U.S. mega-carrier (United or Delta). Both of these options would eventually result in Air Canada becoming a feeder carrier to a U.S. network.

Therefore, allowing American to acquire de facto control of Canadian Airlines will eventually result in both Canadian and Air Canada becoming feeder carriers to the U.S. network. If this happens, over time, a large proportion of the airline functions in headquarters, maintenance centers, reservation centers, computer and information systems, and some of the flight crew bases would likely move to the U.S., as the combined carriers rationalize their network, flight routing, and operations in order to improve system efficiency. In addition, as both Air Canada and CAI become feeder carriers, there would be a gradual reduction in direct international flights originating in Canadian cities, since it would be more efficient and convenient for consumers for the combined system to route overseas travellers through U.S. hubs.(29)

In short, under this option of letting American acquire CAI, consumers would likely enjoy the benefits of competition, at least in the short run. However, by losing a major part of Canada's airline industry to the U.S., Canada would forego the economic benefits (including the producer surpluses) associated with the airline industry. In the long run, international travellers to and from Canada would be inconvenienced as the number of overseas destinations and frequencies of flights served directly from Canadian airports would shrink. If Canada adopts this option, all of the major global networks will be anchored in the U.S., and U.S. carriers will be the senior alliance partners in control of the North American portions of the global networks.

Consolidation policy: merge Air Canada and Canadian Airlines. Consolidating the Canadian airline industry by merging Air Canada and CAI would create an airline comparable in size to a second-tier U.S. carrier (such as USAir), with an annual revenue of about $6 billion (U.S.) (compared to the "big three" mega-carriers, each of which has a revenue greater than $10 billion (U.S.)). The merged airline would be a more attractive partner in a global alliance network because the traffic base for international and transborder markets would be consolidated. In addition, the market shares for AC+CAI on the transborder and international routes would be greater than the sum of their current market shares because traffic bound for a destination not served by one of the carriers is now frequently transferred to a foreign carrier rather than to the competing Canadian carrier.(30) This practice would cease if the two carriers were to merge.

Despite the improvements in the combined international network which would result from the merger, the Canadian market itself would provide too small a traffic base for AC+CAI to be attractive as a major partner in a global alliance network. In addition, the combined carrier would still be too weak structurally to compete effectively against U.S. mega-carriers under a North American open skies regime. AC+CAI would eventually lose a substantial portion of the transborder and international traffic to the U.S. carriers. Without adequate access to the U.S. international travellers market, it is unlikely that major European or Asian carriers would view AC+CAI as an attractive senior partner to cover the North American market for a global network. The attractiveness of AC+CAI as a partner in a global network would be substantially enhanced if it could offer access to the U.S. market. The most practical way for AC+CAI to secure access to the U.S. market would be to form a strong alliance with a second-tier U.S. airline(31) (say, for example, Continental) with a network complementary to AC+CAI's. Potentially these two carriers could jointly become the senior North American partner in a global alliance network. Since the merged Canadian carrier would have extensive international routes, Toronto and Vancouver could be attractive intercontinental gateways for the alliance. An effective access to the international passengers to and from the U.S. through its alliance partner would require that the bilateral agreement be liberalized to grant sixth freedom rights to AC+CAI, and fifth freedom rights to the U.S. airline. This would result in enhanced price and service benefits for Canadian consumers, especially for those living in or near Toronto and Vancouver.

The merger would give the new carrier a virtual monopoly in the intra-Canada markets, though competition in the international and transborder markets would continue through the presence of foreign carriers. There would be an opportunity for charter carriers (Nationair, Canada 3000, Air Transat, etc.), and some regional carriers spun off from CAI,(32) to expand their operations and create some competition with the merged carrier (AC+CAI). Such junior competitors, with the advantage of lower cost structure (particularly labor) and an adequate regulatory protection from the dominant carrier's predatory behaviour, would be able to establish a meaningful presence in important segments of the domestic market, at least in the short run. The fact that a majority of Canadians live within 100 miles of the U.S. border would limit the ability of the dominant carrier to abuse its monopoly power. Despite these controls, however, in the short run consumers are likely to be worse off because a duopoly controls abuses more effectively than other methods.(33)

In the long run, Canada and the U.S. (and possibly Mexico) are likely to have an "open skies" commercial airline policy which will likely include an exchange of cabotage rights between the two countries. This will provide real competition between Canadian and the U.S. carriers in all markets. Therefore, if the AC+CAI merger were approved Canada would have to work with the U.S. to set a firm date for implementing an open skies air policy.

Monopoly power tends to make a firm inefficient through the loss of incentives to improve efficiency. However, in this case, a merger may improve efficiency by removing duplication of airline activities across the country. In addition, a firm commitment on the timing of open skies with the U.S. would induce AC+CAI to improve efficiency in order to prepare for the forthcoming competition with the U.S. carriers.

Detailed Impacts Resulting from the Two Policy Options

The two policy options open to Canada are:

(1) Retaining a domestic duopoly through alliances with U.S. mega-carriers

(2) Consolidating the domestic airlines by merging Air Canada and CAI, and accessing the U.S. market through an alliance with a second-tier U.S. carrier.

Effects on network patterns and traffic volume. Under (1), Air Canadian and CAI's existing networks would be streamlined to feed international and transborder traffic to the controlling U.S. mega-carriers, with the majority of the airlines' activity centers moving to the U.S.

On the other hand, under (1), AC+CAI and the U.S. carrier would become a North American partner in a global network, with AC+CAI exerting considerable influence on the partnership. Toronto would have an excellent chance of becoming the most important international gateway for this alliance. Vancouver would have a good chance of becoming a primary international gateway for Pacific markets. Most of the airline's headquarter functions, maintenance centers, flight crew bases, and other activity centers would likely be retained in Canada.

Under (1), traffic volumes for the intra-Canada and international markets are expected to decrease substantially while traffic volumes in the transborder markets would increase. The total volume of traffic is expected to decline.

Under (2), traffic volumes in transborder and international markets are expected to increase substantially and traffic volume for intra-Canada markets would increase slightly.

Effects on consumer welfare. Under (1), the number of international destinations and flight frequencies from Canada would be reduced as the U.S. carriers will route international traffic through their U.S. hubs. The frequencies on intra-Canada routes would be reduced because of consumers switching their destinations, corporations relocating to hub locations, and the loss of the domestic portions of international and transborder journeys.

Under (2), flight frequencies would increase in the intra-Canada, transborder, and international markets. More international points would be served by direct flights from major airports in Canada.

Under (1), intra-Canada route networks would be restructured to feed traffic to the U.S. mega-carriers' hub-and-spoke networks. Direct flights between Canadian cities would be reduced, and more passengers would need to make one-stop journeys (sometimes involving an interline connection).

Under (2), route networks would be integrated to better serve intra-Canada traffic, as well as other traffic. Some non-stop flights would be maintained between major cities in Canada. There would be more international services to more overseas points directly from Canadian cities under (2) than under (1).

Under (1), Canada would have a duopolistic domestic market with each member being controlled by a U.S. mega-carrier. In the short term, there may be aggressive competition between the duopolists as they battle for market shares in Canada but eventually both carriers will realize the futility of an ongoing price war, and will likely cooperate tacitly, with occasional price rivalry.

Under (2), AC+CAI would enjoy a near-monopoly status in the intra-Canada markets. Although competition from the U.S. carriers for traffic along the southern border of Canada and the emergence of junior competitors would provide some price discipline, consumers are likely to pay higher prices, at least in the short run.

Under (1), the level of competition in transborder markets will be reduced significantly from the current level, in the short run, as the four competitors (AMR, UAL, AC, and CAI) would be reduced to two. In the long run, under both options and assuming an eventual open skies regime, all markets will be competitive.

Effects on economic outputs and employment in Canada. Obviously, an airline which maintains its headquarters, hubs, and major activity centers in Canada can be expected to expend a higher proportion of its revenues within Canada than would a foreign-controlled carrier. Canadian control is thus relevant in generating economic benefits for Canada. Our estimates indicate that the yearly total expenditure in Canada by air carriers will be about $2 billion less than (1) than under (2). Including the effects on the air support sector, the tourism sector, and associated multiplier effects, the total economic output of Canada would be $4.6 billion less per year than under (1) than (2).(34)

In the long run, the direct employment in the commercial airline sector in Canada would be reduced by about 13,000 jobs under (1), whereas the eventual net reduction in employment would be only about 500 jobs under (2). Including the effects on employment in the air support sector, tourism industries, and multiplier effects, Canada is expected to lose 35,000 full-time equivalent jobs under (1), whereas the eventual total loss of employment is expected to be only about 1,300 jobs under (2).(35)

Figure 3 presents the detailed impacts of the options in tabular form.

Comparing the Two Policy Options

Overall, at least in the short run, the AMR+CAI option is preferable in terms of consumer welfare. The AC+CAI option (and an alliance with a second-tier U.S. carrier) is clearly better in terms of (1) positioning the Canadian carrier in preparation for globalization of the industry and the eventual North American open skies regime; (2) Canada's economic output; (3) employment in Canada; and (4) the increased availability to Canadian consumers of non-stop and direct flights to more international destinations. If Canada expects to create an open skies continental bloc with the U.S. in the future, these long-term benefits of allowing the merger between Air Canada and CAI are likely to exceed the short-term loss in consumer welfare.


This article argues that global airline networks will be formed by alliances of carriers from different continents, rather than one mega-carrier creating a global network on its own through mergers and acquisitions. After reviewing the characteristics which make alliance partners desirable, an examination of the options available for a nation to improve the likelihood that its own carriers will become senior alliance partners in the emerging global networks, and thereby retain and/or attract aviation-related economic activities and employment, was made. The most interesting problems in this respect are those faced by a smaller nation in close proximity to a major aviation market. In particular, the consequences of the two strategic policy options such as a country typically faces were analyzed: (1) consolidation of its airline industry in order to increase the attractiveness of the resulting carrier(s) as senior alliance partners, and (2) deconsolidation of the airlines in order to increase competition. Using the Canadian situation as an TABULAR DATA OMITTED example, the type of analyses required to make a proper choice between the consolidation and deconsolidation options was illustrated.

This article advocates that the governments should set policies in such a way as to maximize the long-run combined consumer and producer surpluses plus external economic benefits. Severe economic penalties which are associated with not being a major partner in the global network formation process were pointed out. The adoption of a pro-competitive policy, especially when it is motivated purely by short-run consumer surplus maximization, may significantly reduce the future ability for a nation's carriers to earn surpluses or for that nation to enjoy the increased economic activities and employment arising from senior partner status in a global network. A consolidation policy which has a negative effect on the consumer surplus in the short run may have a large positive present value of the combined surpluses over the long run, by increasing the chance for a nation's carrier to become a senior alliance partner in a global network. This argument is consistent with the emerging literature on strategic trade policy. The strategic industrial policy usually involves trading off short-run benefits for much larger gains in the long run by improving a country's future terms of trade. Likewise, a small country (like Canada) neighboring a large country (the U.S.) may require a consolidation of its airline industry in order to enhance the opportunity for its carrier(s) to become senior partners in a major global network, even though consumer welfare may be reduced in the short run.

With respect to the Canadian situation, unless some action is taken it is likely that global airline networks will bypass Canada altogether. Since the U.S. has over thirty times Canada's domestic passenger volumes, over six times the market with Europe, and over eleven times the market to Asia, natural market processes are likely to induce five or six major global networks to be based through U.S. hubs, and U.S. carriers will be the senior North American alliance partners. Both of the Canadian carriers are likely to become feeder carriers to U.S. networks. However, a strategic consolidation of Air Canada and Canadian Airlines International may create an opportunity for the merged carrier to become a senior North American partner in a major global network if the following two conditions are fulfilled: (1) the merged Canadian carrier must use the consolidation as an opportunity to improve its efficiency to prepare for the forthcoming competition with the U.S. mega-carriers; and (2) the merged carrier must succeed in establishing access to the international passenger markets in the U.S., most likely through an alliance with a U.S. carrier (without loss of domestic control). The analysis has shown that the long-run benefits of this strategic airline policy are likely to greatly exceed the short-term negative consequences of reduced competition.

This articles's results indicate that nations in proximity to large airline markets should examine whether or not a strategic airline policy, such as consolidating the two or more carriers and/or expanding the capacity of domestic airports, would enhance its probability of attracting a major global network. The French government allowed Air France to acquire UTA and Air Inter in order to strengthen it, in preparation for the integration of European air space and the forthcoming competition with other major carriers. One of the reasons why the Monopoly and Mergers Commission of the United Kingdom approved the British Airways-British Caledonian merger in 1987 was to strengthen British Airways for the eventual competition with the U.S. mega-carriers.(36)


1 See T.H. Oum, W.T. Stanbury, and M.W. Tretheway (191), "Airline Deregulation in Canada and its Economic Effects," Transportation Journal, Vol. 20(4), pp. 4-22 for a detailed account of regulatory liberalization and deregulation, and a chronology of consolidation in the Canadian airline industry.

2 See Vincent D. and D. Stasinopoulos (1990), "Developments in Transport Policy: the Aviation Policy of the European Community," Journal of Transport Economics and Policy, vol. 24, no. 1, pp. 95-100, and M.W. Tretheway, (1991), "European Air Transport in the 1990s: Deregulating the Internal Market and Changing Relationships with the Rest of the World," Working paper no. 91-TRA-003, Faculty of Commerce, The University of British Columbia, Vancouver, Canada, for detailed chronological accounts of the aviation policy developments in the European Community, and the implications of the liberalization which is scheduled to take place in January 1993.

3 Reasons for this preference include: minimizing the consumers' own cost of route planning since virtually all destinations are served; receiving higher quality service (more frequent flights, on-line connections, coordinated schedules, and so forth); and membership in more attractive frequent flyer programs. See T.H. Oum, A.J. Taylor, and A. Zhang (1992), "Canadian Aviation at the Crossroads: Policy Choices for the New Global Environment," a report prepared for Corporate Strategy Group, Air Canada, for a more detailed discussion.

4 Codesharing means that a flight from A to B on Carrier 1 is shown in the computer reservation system as a flight on Carrier 2. This is important when that flight is combined with a Carrier 2 flight from B to C. The code-sharing arrangement shows the A-B-C flight as being a "single carrier" service, which gets a higher priority on the CRS display than an "interline" service (see M.W. Tretheway and T.H. Oum (1992), Airline Economics: Foundations for Strategy and Policy, Centre for Transportation Studies, The University of British Columbia, Vancouver, Canada). In addition, consumer prefers to complete his or her trip using a single carrier.

5 This could take the form of a simple equity position of one carrier in another (e.g., KLM's 49 percent ownership of Northwest Airlines, and British Airways' proposed purchase of 44 percent share of USAir) or mutual exchange of equity between the carriers involved (e.g. the Delta-Swissair-Singapore Airlines alliance).

6 A transborder open skies regime already exists between the United States and Mexico, and the imminent acceptance of the North American Free Trade Agreement (NAFTA) is likely to spur liberalization of the Canada-Mexico air service agreement.

7 See T.H. Oum and M.W. Tretheway (1990), "Airline Hub and Spoke System," Journal of Transportation Research Forum, vol. 30(2), 380-393, for a discussion on the efficiency of a hub-and-spoke system for serving a given set of origin-destination traffic demands.

8 Mega-carriers in North America (American, United, and Delta), Europe (British Airways, Lufthansa, and Air France), and Asia (Japan Airlines) have an annual revenue ranging between $8 and $15 billion in 1990. The combined revenue of British Airways and USAir is over $16 billion. Therefore, the combined revenue of a global network having a major presence in North America, Europe, and Asia is likely to be about $30 billion in today's U.S. currency. The total operating revenue of the IATA member carriers was $193 billion in 1990. This also supports the size of a global network being about $30 billion since the world's airline industry is likely to be dominated by five or six competing global networks.

9 See M.W. Tretheway (1992), "Global Consolidation Forces in the World Airline Industry," paper presented at the World Conference on Transportation Research, Lyon, France.

10 See "SAS: Playing Partners," Air Transport World, November 1991, pp. 102-106.

11 BA is acquiring 21 percent of the voting common shares of USAir (the maximum allowable since 4 percent is already foreign-owned), and investing the balance in preferred shares. BA's total investment in USAir is about U.S. $750 million. This transaction is being appealed to the U.S. Department of Transportation by Delta Airlines with support from American and United.

12 See "Air Raid: British Air's Bold Global Push," Business Week, August 24, 1992, pp. 54-61.

13 Cathay Pacific is an attractive Asian alliance partner as it is partly owned by CAAC of mainland China, and is expanding its routes into mainland China.

14 See The Globe and Mail, Nov. 18, 1992, B5.

15 At the time this article is being revised for publication, the Board of Directors of Continental Airlines have accepted unanimously approved, with the blessing of unsecured creditors, a $450 million investment by an investor group led by Air Canada. The deal would give Air Canada and Air Partners, a Texas investor group, a 55 percent stake in the restructed Continental, which is expected to come out of the chapter 11 bankruptcy reorganization with a greatly reduced debt load (from currently $5.8 billion to $1.7 billion).

16 See "Air France Acquires 37.5% of Sabena S.A.," Journal of Commerce, April 13, 1992.

17 By definition, strategic policy is designed to enhance a nation's welfare, rather than the total welfare of the world.

18 A more general concept here would be a "strategic move." In his seminal book, T. Schelling (1960), The Strategy of Conflict, (Cambridge: Harvard University Press), defined a strategic move as "one that influences the other person's choice in a manner favourable to oneself by affecting the other person's expectations of how oneself will behave" (p. 160). This concept has been particularly popular in the industrial organization literature, and a prominent example would be investment in excess capacity by a firm in order to deter entry by new competitors. It has been shown (see, for example, A.K. Dixit (1980), "The Role of Investment in Entry Deterrence," Economic Journal, Vol. 90, pp. 95-106) that the expenditure
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Author:Tae Hoon Oum; Taylor, Allison J.; Anming Zhang
Publication:Transportation Journal
Date:Mar 22, 1993
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