United-Continental merger raises fears of higher airfares
6/22/2010 7:01 AM

By Dan Reed, USA TODAY
If United and Continental airlines merge, passengers will end up paying higher fares — right?
Aaron Gellman, who's spent 40 years in and around the airline industry as an analyst, consultant, researcher, teacher and board member, is convinced of it.

"Concentration in any industry leads to higher prices," says the veteran transportation economist who teaches at Northwestern University in Chicago.

By implication that means the proposed merger announced last month between United (UAUA) and Continental (CAL)— to create the world's biggest airline and trim to four the number of the USA's big "legacy" airlines with routes around the country and the globe — won't be a good deal for travelers.

But that may not be true in today's air travel market, in which competition from low-cost airlines has grown even as big legacy airlines have merged and formed partnerships.
The best evidence: Airfares today are cheap by historical measure.

There have been a dozen mergers between conventional network airlines since the U.S. airline industry was deregulated in 1978. And the most desirable routes of defunct carriers such as Pan Am, Eastern and Braniff have been assimilated into the remaining airlines' sprawling networks.
Although ticket prices are rising now, the average basic domestic fare in the fourth quarter of last year was $319, according to data from the Transportation Department's Bureau of Transportation Statistics.

(Basic fares as reported by airlines generally exclude taxes, fees and surcharges.) That was during the recession. And it was down from $345 in 2008, when airlines raised fares rapidly in response to high oil prices.

But even that $345 average basic fare, a record high in nominal terms, was inexpensive once inflation is taken into account. If fares had risen at the rate of inflation since 1996, the average fourth-quarter fare in 2008 would have been $374. It would have been $379 in last year's fourth quarter, based the Bureau of Labor Statistics' consumer price index.

"Clearly, there are other factors in the price of fares besides consolidation and concentration," says economist William Swelbar, a research engineer at MIT's International Center for Air Transportation.

No. 3 plus No. 4 equals No. 1

The Justice Department's antitrust division will decide whether United, currently the third-largest of the country's conventional network airlines, can merge with No. 4 Continental to form a carrier that would surpass the traffic of Delta Air Lines, which became the world's largest in 2008 by buying Northwest.

The merged airline, proposed May 3 by United CEO Glenn Tilton and Continental CEO Jeff Smisek, would fly under United's name. It would have nearly $30 billion a year in revenue, about 70,000 workers and a fleet of up to 600 mainline jets and about 1,000 regional aircraft operated by affiliates. The new United Airlines would carry about 144 million passengers a year to 370 destinations in 59 nations.

The two CEOs estimate the new United could generate an extra $800 million to $900 million a year in revenue by 2013 by offering the broadest global travel network in the world. Ideally, they say, this would make it more attractive to more travelers and to corporations seeking volume contracts with an airline that can get people to the most markets with greatest ease. They argue that their airlines must combine to compete profitably.

The merger would accelerate the trend toward consolidation of traditional carriers. In the USA, it would reduce the field of competitors to just four — maybe even three if, as many analysts suggest, American responds by acquiring US Airways.

At the heart of whether the Justice Department will approve a new megacarrier is whether competition would be reduced so much that the nation's big, network airlines could drastically raise fares to maximize profits.

That's the concern of industry analysts such as Gellman and of some in Congress such as Rep. James Oberstar, D-Minn., chairman of the House Transportation and Infrastructure Committee, who opposes the merger.

In a congressional hearing last week, Oberstar told the United and Continental CEOs, "You guys hate competition. You want to be the competitor that dominates the market." The merger, he said, would leave "little choice for passengers, little choice for cities and little choice for competition."

Continental CEO Smisek, however, argued, "This is a brutally competitive industry. It is today and will be after this merger."

Congress cannot block the merger, but it can seek to influence the Justice Department's decision. Sen. Kay Bailey Hutchison, D-Texas, said at a Senate Commerce Committee hearing last week that she thought the merger would be approved. If it is, Oberstar warned, he'd seek to re-regulate the industry to protect consumers.

Different kind of merger?

Close partnerships already exist in the industry. United and Continental, for instance, are members of the 27-carrier Star global airline alliance. The two nearly merged in 2008. And last year they received an antitrust waiver from the government allowing them to combine their international operations as if they were a single carrier. Their joint venture is not yet fully operational. But even if the Justice Department opposes the full merger, the joint venture will survive.

There are other considerations that the Justice Department will look at when deciding whether to bless the marriage. For instance: Unlike several past mergers between airlines that competed head-to-head on dozens of key routes, a United-Continental union would be an "end-to-end" merger that the Justice Department's evaluation standards are set up to favor. The two carriers offer overlapping non-stop flights on just 13 domestic routes.

"It's fair to say that the short-term effect on routes where merging carriers already compete ... is that fares increase," says Steven Morrison, an economist at Boston's Northeastern University. "But that's only in the short run. The more important question is: 'What's going to happen in the long run?' "

Morrison wrote a 1996 study on the long-term impact mergers have had on fares. It's a study that the Justice Department has used in evaluating antitrust implications of more recent cases. He looked at fares a decade after three mergers in the mid-1980s: TWA and Ozark Airlines, Northwest and Republic airlines, and USAir and Piedmont Airlines.

Fares on what had been overlapping routes by a combined TWA-Ozark and Northwest-Republic rose more than the industry average, he found, but only for a short period.

Ten years after the mergers, fares on those routes were comparable to or below those on other routes.

In the case of USAir and Piedmont, however, fares on routes where they had competed head-to-head were as much as 45% higher 10 years after their 1986 merger than fares on comparable routes around the nation.

Even so, Morrison concluded, mergers don't inevitably push prices up.

"In the short run — yeah, on some routes fares will go up higher than would otherwise be the case," he says. "But in the long run, that's probably not true. And it's very hard to predict because each merger has its own idiosyncrasies in how the two networks fit together, what their operating costs will be, the size and location and nature of cities where their hubs are, the unions involved and who's managing the combined company."

Low-cost competition

Two other variables come into play on whether ticket prices will climb: consumers and, most important, competitors.

Consumers have become accustomed over 32 years of airline deregulation to expect low fares. Some travelers, mostly business travelers, may pay high prices to get where they need to go at a moment's notice. But findings indicate that if prices rise beyond most consumers' level of expectations and comfort, even by only a few dollars, they won't fly.

"There's a price where people say, 'To heck with it, I'm not going, or I'll teleconference, or I'll drive or take the train,' " Morrison says. "Now, my $250 limit may be somebody else's $500 limit. But it's safe to say that the demand curve slopes downward as airlines raise the price."
And then there are competitors. Today, the traditional network carriers face competition from low-cost airlines such as JetBlue, AirTran, Virgin America, Frontier, Spirit and the giant of the discounters: Southwest Airlines.

"There have been circumstances in the past where mergers have taken place and fares moved up," Swelbar says. "But whenever prices move to above-market levels, that's an opportunity for competitors to come in and discipline the market."

Low-cost carriers now have about 30% of the domestic market, according to MIT's Airline Data Project. And, Morrison says, they "aren't shy about taking on the big carriers anymore." United has 10.5% of the market and Continental 7.7%, according to OAG-Aviation Consulting Services.
Even Gellman, who testified before Congress in 2008 in opposition to the Delta-Northwest merger, recognizes the potential of low-cost carriers to keep domestic fares down.

If mergers drive fares too high, he warns, "Southwest will go into their markets and beat the hell out of them. Whatever market Southwest enters, they're the winner."

But low-cost airlines don't fly many international routes. Hubert Horan, a former industry executive and consultant, says that's where the price danger exists for travelers.

Since 2004, trans-Atlantic fares have risen three times faster than fares on domestic routes, Horan told Congress last week. He attributes that to a reduction of competition because of mergers and because of joint-venture arrangements between U.S. network airlines and their foreign partners.

Power to raise prices

Gellman also says that the low-cost carriers' low-fare, high-volume business model won't work in smaller communities.

That leaves network carriers with the broadest and deepest reach into hundreds of U.S. and foreign cities. And that, he says, could give them power to push prices to unfair levels on thousands of routings around the world where there's not likely to be low-cost competition.
Swelbar scoffs at such worries for most U.S. travelers.

"Draw a 200-mile radius around the 69 airports that Southwest now serves," he says. "Ninety-five percent of U.S. air travel demand comes from within those circles.

"That's a staggering number," Swelbar says, "and that's before we even consider the impact of the JetBlues and the AirTrans. It means that for many people who don't like higher fares, the first leg of their vacation will be on the highway to the more distant airport. But they will continue to have access to relatively low-priced air service."