Foreign Competition Should be Allowed in the Canadian Airline Industry
It is called "cabotage", and the federal government is both economically and morally obligated to allow it
This post is one and I recently published in our joint Substack newsletter titled Ride On: The Drive for Better Transportation Systems (which I naturally highly recommend to anyone who is interested in transportation). These are separate Substack newsletters not only because Michaelle and I co-author only of them, but also because the two newsletters have different themes: this one on international economics and foreign policy, and the co-authored one on transportation. However, today’s topic covers both themes very nicely, so given recent news about Flair Airlines (some of it not so positive for that air carrier), I want to expose this article to as wide an audience as possible.
Many Canadian airlines have come and gone since deregulation in 1988, including Canadian Airlines (acquired by Air Canada in January 2000), Royal Airlines (acquired by Canada 3000 in January 2001), CanJet (acquired by Canada 3000 in April 2001), Roots Air (acquired by Air Canada in May 2001 after less than six weeks in business), Canada 3000 (bankrupt in November 2001, leaving thousands of passengers stranded with no warning), and JetsGo (entered bankruptcy protection in March 2005, leaving thousands of passengers stranded without warning at the beginning of March break).
There was no shortage of blame given to Air Canada for alleged predatory practices, but these failures were often due to bad business decisions, such as JetsGo’s weekly (and perfectly predictable) “Toonie Tuesday” sale where it would charge $2 for one direction of a round-trip flight every Tuesday; naturally, customers would wait until Tuesday to book their flights so the airline had some problems remaining profitable.
Today, Canada has only two major airlines which have survived over the long run: Air Canada and WestJet, the latter being successful because it wisely grew both slowly and carefully. Porter Airlines has also been successful since its launch in 2006, and it has also done so by wisely growing slowly and carefully, while also largely avoiding direct competition with Air Canada — only in recent years has Porter gone beyond offering short-haul flights out of the Toronto Island airport.
One might ask if there will be more entry to compete with these three airlines. While that possibility cannot be absolutely dismissed, history indicates the probability of success is low for a new entrant.
Should we then conclude Canada can only support two or three airlines? This might be the case if we assume the industry’s market structure will remain unchanged, and there are indeed no signs it will change in the near future. However, we will argue this lack of competition is largely due to entry barriers created by federal government regulations, specifically its prohibition against cabotage: the right to offer transport services between two Canadian locations by foreign entities.
We will argue that if these restrictions are lifted and foreign air carriers are allowed to transport passengers on domestic Canadian routes, then air passenger services will improve for Canadian consumers and for the economy as a whole, even if it does harm certain Canadian airlines. Even employees of Canadian airlines could emerge better off from cabotage if foreign airlines hire them — after all, if a foreign airline replaces a Canadian one, the victor still needs employees to service these routes.
In other words, as we will argue again and again throughout this post, governments should be protecting competition, not individual competitors. And to be clear, the sins of political protectionism must be borne by Liberal and Conservative governments — including former-Prime Minister Stephen Harper’s governments, of which current CPC leader Pierre Poilievre was a member, so their hands are dirty, too.
But before moving on, I invite you to please consider a paid subscription to this newsletter, as it will help me afford the time and other resources to do the research I so love to do for you. Either way, I am happy to have you here with me!
Entry Barriers in the Canadian Airline Industry
Before we can identify entry barriers, we need to define them. Stigler (1968, 67) defines a barrier to entry as “a cost to producing (at some or every rate of output) which must be borne by a firm which seeks to enter an industry which is not borne by firms already in the industry.” This is the definition often used in the literature, which distinguishes the normal cost of doing business — such as hiring employees and finding office space — from costs the incumbent does not have to incur.
Entry barriers can be “innocent” when they are not bad. This is important to keep in mind because some people want to break up all entry barriers regardless of the merits. It is for this reason von Weizsacker (1980, 400) extends Stigler’s definition as follows: a barrier to entry is “a cost of producing which must be borne by a firm which seeks to enter an industry and which implies a distortion in the allocation of resources from the social point of view.” Thus, a more efficient cost structure of the incumbent will not be considered a barrier to entry because it is social welfare improving.
Cairns and Galbraith (1980, 808) use this definition to argue there are demand-side barriers through the “artificial linking of demands for different goods and services”. In such a case, barriers to entry can exist with no cost advantage for the incumbent and no economies of scale, scope, or density. In this issue of Walls and Bridges, we will employ this definition of entry barriers, while still taking it into account a cost advantage is not an entry barrier.
Structural Barriers to Entry
Ability to Get Funding and Equipment
New entrants might face difficulties obtaining capital, and this is especially true in the airline industry. It is well known that very few airlines survive in Canada — even Air Canada entered bankruptcy protection after 9/11. If there are times when even Air Canada cannot make a profit with a near monopoly, then investors will naturally be averse to investing in the industry.
It would also be difficult for a new airline to convince aircraft manufacturers to lease planes to it, again due to uncertainty it will survive: if an aircraft manufacturer leases an aircraft to the airline, it does not want it to go out of business in six months. As demonstrated in the introduction of this post, the plethora of airline failures over the last 25 years indeed justifies these concerns. Therefore, the leasor might not lease the plane to the entrant, or else lease it at a very high rate of interest, which raises the entrant’s costs. However, this is not a problem for a foreign carrier since it already has the equipment and a proven track record of success; even if it does need funding, then its superior access to capital would reduce its probability of failure.
Government Regulations
Government regulations from both sides of the border also act as barriers to entry. For example, Canadian airlines need approval from the Minister of Transportation to operate — sometimes justifiably, such as for safety reasons. It seems this barrier to entry is not significant though, since airlines in Canada are often granted access to operate even if they do not last very long. So the main problem here is getting the federal government to cooperate with foreign entrants, since even with cabotage, it might grant preferential treatment to domestically-owned and operated air carriers.
Other regulatory barriers to entry — particularly for short-haul routes — are the fees charged by third parties in addition to base fares, such as security charges, NAVCAN fees, insurance, and airport improvement fees. Right or wrong, these fees can add significant costs to a one-way fare. However, we do not know any reason why relaxing foreign ownership restrictions would soften this barrier.
An argument made to defend regulatory barriers is we need domestically-owned and operated airlines for national security reasons. However, ending foreign ownership restrictions will not prohibit the federal government from enforcing regulations on safety and security. Furthermore, the Competition Act still applies to all firms which operate in Canada, regardless of national origin. Then there is the fact that in the event of a national emergency, the federal government still has the power to seize any aircraft for however long it sees fit.
A second argument in defense of regulatory barriers is Canadian jobs will be lost if foreign airlines are permitted to operate on domestic routes, which might be true for a specific airline like Air Canada. However, Canadians will still be hired by foreign airlines operating Canadian routes; if the Canadian government really is so concerned about it, it can still require airlines to hire Canadian workers for certain positions — although again, we do not believe it is necessary for most workers since U.S. residents will not commute to and from the Edmonton airport every day, for example.
In fact, there might be even more jobs for Canadians because a competitive industry is expected to produce more output than a monopolist. Besides, a government’s role is to protect competition, not individual competitors — it should not put itself in charge of choosing winners and losers.
Strategic Barriers to Entry
Loyalty Programs
Cairns and Galbraith (1990) argue that even if a new entrant attempts to offer a rebate program of its own, the incumbent can make a more attractive offer to its customers due to the size of its network. Of course, this applies for a completely new entrant, as opposed to existing airlines which are expanding their networks. Thus, the incumbent can charge a higher-than-competitive price and still maintain market share without any absolute cost advantage, and without any economies of scale, scope, or density.
We believe loyalty programs (a.k.a. “frequent flyer programs”) are barriers to entry, especially with respect to attracting business travelers who are the main beneficiaries of such programs. Cabotage will soften this barrier by allowing foreign carriers to offer their own loyalty programs on domestic routes. Therefore, customers who base their choice of airline, in part on accumulating points will be more willing to patronize foreign carriers for both domestic and international routes.
Frequencies and Airport Dominance
The more frequencies an incumbent offers during a certain period of time, the more difficult it is for a new entrant to enter the market, which is a barrier to entry with respect to both business and leisure passengers. The reason is when a person wants to fly from Point A to Point B, they typically want the flexibility to fly when they want to fly — especially business-class customers who are relatively time constrained. While the new entrant could schedule flights for these peak hours, it would be difficult to get the critical mass necessary to affect the market power of the incumbent.
In short, the new entrant would not be taken seriously by passengers because it does not have enough frequencies to compete. However, if a major foreign carrier enters the market and is able to get enough slots, it would be in a better position to achieve critical mass.
Reputations of Airlines with Consumers
An airline’s reputation with consumers, both in terms of safety and the likelihood of survival is a barrier to entry because when a person buys a ticket several months in advance, they want to be confident the airline will remain in operation to honour this ticket; that passenger would then be hesitant to patronize a new entrant, especially if they know the history of airline failures such as Canada 3000 and JetsGo. However, foreign carriers already have reputations as reliable in terms of honouring tickets, so these barriers to entry would not be relevant for them.
Efficiency Benefits of Foreign Competition
The primary goal of the federal government should be to promote an airline industry that is as economically efficient as possible. With that in mind, if foreign competition was allowed to flourish in the domestic market, then we might see efficiency benefits because it would be able to take advantage of a U.S. hub — not only for flights to U.S. destinations, but also flights between two Canadian points, thus leading to gains in Canadian passenger welfare. And it is not just consumer welfare that could improve, because greater efficiencies also contribute to an abundant and growing economy.
We will now discuss two areas in which efficiencies can be gained by allowing foreign compeitition on Canadian domestic routes: hub-and-spoke networks and economies of density. We will then argue airline alliances — which are legal — are not perfect substitutes for cabotage.
Hub-and-Spoke Networks
There are a few reasons why a hub-and-spoke network is more efficient than a point-to-point system, but we will first explain what is meant by a hub-and-spoke system. We will refer to the figure below for this argument.
Suppose the market is characterized by a point-to-point system where one can travel between any two points around the border of the circle, but they cannot travel inside the circle through Point H. In other words, a passenger can travel from point A to Point B, Point B to Point D, etc.
Now suppose an airline begins operating at Point H, in addition to the other eight points. This point is the “hub”, and the lines connecting it to the other destinations are known as “spokes” — this system looks like a bicycle wheel, thus its name. Also suppose for simplicity that passengers can no longer travel along the edge of the wheel, but instead must travel through the hub which implies they need to make a connection/stopover at point H.
To put this into a more realistic context, hubs in Canada have been formed in Calgary, Hamilton, and Toronto, so flights between city-pairs travel through these hubs rather than directly from origin to destination. This is why historically, people travelling from certain eastern-Canadian destinations to Regina have been required to first touch-down in Calgary, even though Calgary is further west than Regina.
Passengers who previously used the point-to-point system might now take longer to reach their destinations, while others can face shorter travel distances. Despite the inconvenience for the former set of travellers, Brueckner and Pels (2003) argue the overall cost of transporting them is slightly lower than under the point-to-point network, so hub-and-spoke is more cost-efficient. They also argue high travel volumes on spoke routes allow for higher flight frequencies than with a point-to-point system.
Moreover, the authors argue nationalism leads to too much circuitousness, since even when a U.S. airline legally takes passengers from a Canadian origin to a U.S. destination, it cannot make a stop in another Canadian city along the way. If airlines are allowed to practice cabotage, then they might find more efficient routes.
What’s more, Brueckner and Spiller (1994) argue that by adding a hub-and-spoke network, competition can be enhanced due to the ability of an airline to add a spoke onto its existing hub. If foreign carriers are allowed to operate in Canada and one of them merges with Air Canada, then the merged entity could take advantage of this new ability to compete and offer more alternatives to Canadian customers. They argue the concentration caused by hub-and-spoke networks can be offset by the efficiency gains of a hub-and-spoke network.
Giving more options to Canadian passengers is also good when one considers the substantial additional costs imposed on passengers when they miss connections or baggage is lost. So even if there are more one-stop flights as a result of a merger, consumers will be more willing to accept this discomfort in exchange for less uncertainty regarding the above costs.
Economies of Density
According to Brueckner, Dyer, and Spiller (1992), economies of density arise, in part because higher traffic density on a route allows the airline to use larger, more efficient aircraft, and to operate its equipment more intensively (at higher load factors). Their hypothesis is any force that increases traffic volume on the spokes of the network will reduce fares in the market it serves. However this also means higher airfares at the hub since there is greater concentration, so consumer benefits should be compared to these higher prices to determine whether the consumer is better off overall.
Airline Alliances
Some airlines form alliances to get around the cabotage regulations. Brueckner and Pels (2004) argue alliances generally create economic benefits for airline passengers by lowering their fares, which seems counterintuitive because cooperation between competitors typically leads to nothing good for consumers. Nonetheless, it does make sense theoretically because interline trips are a joint product resulting from their combined efforts; economic theory shows if the providers of a joint product cooperate then the price will be lower than under non-cooperative behavior.
However, alliances are still not optimal because when airlines set fares independently, they will not take into account the fact that a higher fare will negatively affect the other airline’s revenues; in other words, there is a negative externality. If the two airlines were allowed to maximize their joint profits, then they would be able to reduce the overall fare paid, and still increase their joint profits. Thus, consumers and airlines are both better off, but this would violate antitrust laws.
Political and Institutional Barriers to Cabotage
Note: for this section, we use quotes from the early 2000s in large part because I had them readily available in my personal research files from when I was working on airline cases at the Competition Bureau in the early 2000s, and frankly I really like them. Nonetheless, the official views of government agencies such as Transport Canada and the Competition Bureau have not changed since 2001, and these quotes nicely summarize the debate between cabotage advocates and protectionist politicians.
If given the choice, most consumers will choose lower prices, better service, and more frequencies to a national air carrier. Indeed, the fact Canada 3000 and JetsGo were domestic carriers probably offered little consolation to the thousands of passengers who are stranded without warning.
As already discussed, the virtues of cabotage have been argued by economists and non-partisan government officials alike, including the now-former Commissioner of Competition Konrad von Finckenstein, who advised then-Transport Minister David Collenette on October 21, 1999 as follows:
…the government's policies on foreign ownership and cabotage — that is, allowing foreign airlines to fly domestic routes, …are the largest regulatory barrier entry to the airline industry, and the government may wish to reconsider them if a dominant carrier emerges.
Furthermore, Deborah Ward (2002) made similar suggestions when commissioned by Transport Canada to provide recommendations for restructuring the airline industry:
That the government make every effort to reach reciprocal agreements, but be prepared to liberalize air service without direct or immediate reciprocal benefits for carriers, if there is an obvious advantage for Canadians and consumers, and when the liberalization has either no impact on the carrier industry, or when the carrier interests are clearly subsumed by a greater benefit.
…
That, within the context of a liberalization framework, the Government of Canada liberalize the current rules of ownership to allow foreign-ownership of domestic Canadian carriers and a 49% ownership level of international carriers.
Unfortunately the Ministers of Transportation over the years have consistently been closed-minded to this opportunity. For example, in a House of Commons debate from 2001, David Collenette proclaimed:
However let me say this. The United States government, the United States carriers and the United States air unions are not interested in serving point to point within Canada. There is some limited interest on the part of Virgin Atlantic to do that.
Once we allow any of those foreign carriers in, we know what they will do. They will run on the main trunk routes where the money is to be made: Toronto to Vancouver and Toronto to Calgary. Who will suffer? It will be WestJet. It will be Canada 3000 and it will be Air Canada.
A problem with this argument is it is not economically logical. As noted earlier, the primary goal for the federal government should be to promote an airline industry that is as economically efficient as possible. This means the failure of firms, although unfortunate, should be allowed to happen. However, propping up an inefficient dominant airline on nationalistic grounds promotes inefficiencies, which hurts the people the Minister of Transport is supposed to protect: consumers.
Second, it appears U.S. carriers have not been as averse to cabotage as Mr. Collenette claimed. For example, the former President and CEO of American Airlines, Don Carty publicly supported the idea of Canada and U.S. fully liberalizing the airline markets between the two countries. Similarly, former Air Canada President and CEO, Robert Milton also supported cabotage, but only if the U.S. also gave the same rights to Canadian airlines in U.S. markets (“reciprocity”).
While it does make some sense to demand reciprocity before allowing cabotage in Canadian markets, and while respected Canadian economists such as Ross and Stanbury (2001) similarly argued for it, it has been proven these demands never lead to any real changes in airline regulations. At least for politicians, it is just an excuse to continue their protectionist measures as they know no one wants to be the first-mover.
To be clear, it would be optimal if all countries scrapped their cabotage restrictions, because Canadian consumers would still be better off with one-sided cabotage than no cabotage at all — once again (say it with us) the goal should be to protect competition, not specific competitors.
Summary Remarks
Throughout this post, we argued against the regulatory restrictions on foreign based competition, because these regulations promote inefficiencies in the Canadian airline market — they do not benefit the people the regulations are meant to protect: the Canadian traveler.
We have shown there are several barriers to entering the airline industry, most of which can be softened by opening the skies to foreign entry. In addition, the overly aggressive pricing strategies by domestic carriers over the years were largely due to restrictions on competition, first because Air Canada was clearly dominant and wanted to maintain that dominance. Second, as a result of this aggressiveness, low-cost carriers felt pressured to be just as aggressive (JetsGo, anyone?), which led to numerous failures and acquisitions in the early-2000s.
Finally, the arguments made in favor of such regulations, such as national security and safety standards, are misguided because allowing such competition will not take away the power of the federal government to regulate these airlines, even when they are based in foreign countries.
Thus, we respectively disagree with the federal government’s position with respect to airline competition, and urge it change its approach to this matter.