Wednesday, April 24, 2019

When competition causes market failures

The grounding and possible bankruptcy of one of India's biggest airline, Jet Airways, in the world's fastest growing airline market for the last seven years and 54 months of double-digit growth is a great irony. And this comes on top of the bankruptcy at the start of the boom, in 2012, of another major airline, Kingfisher. So what is it about India's airline sector that healthy aggregate growth and mega failures (and weak bottom-lines in general) go together?

This also raises an interesting question about Indian capitalism itself, since this feature is not unique to airline industry. What is it about the Indian market's failure to balance competition with quality and sustainability?

Along with telecommunications, airlines sector is often held out as the two shining examples of the superiority of private sector over the public sector. Deregulation and the entry of private participants have dramatically improved the quality of service delivery. Simultaneously, even as demand has soared, both sectors have witnessed the entry of several service providers and intense competition among them. In both sectors, India has among the largest number of service providers, with fierce competition among them. 

Econ 101 tells us that a market characterised by soaring demand and a good number of suppliers should generate efficient competition. Suppliers would compete intensely to improve their service quality so as to differentiate themselves and thereby capture the rising demand. And the competition would also reduce prices to an efficient equilibrium, one without any rents. 

Instead what has happened in both sectors has been a competitive race to the bottom on pricing. This in turn squeezed their bottom-lines, and made them skimp heavily on investments to improve quality. The result has been deteriorating or stagnant quality. This is an example of how competition can perversely enough lead to market failures. 

It is true that there are policy issues like lowering the tax on Aviation Turbine Fuel (ATF) which the airlines have been demanding. But these apply just as well to all airlines operating in India. And given their behaviours, it would be most likely the case that lower ATF too would be competed away in a race to bottom on price. Further, the airline industry ought to have benefited from the relatively long period of lower and stable fuel prices, which makes up a significant share of the operating costs.

The race to the bottom with pricing has been a constant feature of the Indian telecoms and airline market for a long time. Sample this analysis by Andy Mukherjee from mid-2018,
It’s unclear as to why pricing should behave as if India’s aviation industry is saddled with huge overcapacity. Unable to pay interest and wages, Kingfisher Airlines Ltd. went belly up in late 2012. In almost every month since then, revenue passenger kilometers (a measure of demand) have grown faster than available seat kilometers (a unit of supply), according to the International Air Transport Association. Even in June 2018, when the industry was crashing, domestic air travel grew by 17.6 percent. Not only was it the fastest growth of any major market including China, it was nearly 2 percentage points quicker than India’s own demand expansion in the same month last year. Yet desperate carriers are pampering fliers with promotions they can ill-afford. Jet, for instance, is currently offering a 30 percent discount on base fares to international destinations. This is when its cost of flying one passenger-kilometer, excluding fuel, was 3.17 rupees last fiscal year, according to SBICAP Securities Ltd., compared with 2.53 rupees for SpiceJet and 2.04 rupees for IndiGo. Revenue per available seat kilometer has exceeded all-in costs in just three of the past 14 quarters.
And this,
With the entry of budget carriers such as IndiGo and SpiceJet Ltd. since the mid-2000’s, full-service carriers like Jet Airways that have higher overhead costs -- for in-flight meals and entertainment -- have been forced to offer discounts to passengers looking for a great bargain. For instance, in 2015, SpiceJet offered base fares of as low as 2 cents. Average ticket prices for New Delhi to Mumbai, the world’s third-busiest route, fell 15 percent to 3,334 rupees in July-August from the previous year, according to online travel agent Fares are down 40 percent from 2014, according to Sanjiv Kapoor, the chief commercial officer of Vistara, Singapore Air’s local venture. That compares with a premium rail service for the same route at 4,075 rupees.
Cyclical factors and rapid expansion have been able to paper over some of the debilitating effects of rock-bottom prices. Even the run-away industry leader Indigo may be one shock away from hitting air turbulence.

The market dynamics itself apart, the promoter of Jet Airways has been just as much culpable of reckless business expansion decisions as that of Kingfisher. In fact Jet had been losing money in nine out of the past eleven years. It speaks something about the very narrow and deeply price sensitive Indian market itself that two of the three large full-service airlines have now gone under, and the third, Air India, is surviving only through public subsidy. It is a testament to the inability of these full-service carriers to have figured out a business model required to differentiate themselves from their low-cost counterparts. Should Jet (and Kingfisher) have charted a path very different from the various low-cost airlines, focusing on specific routes and quality of service, and associated calibrated expansion and maintenance of higher prices? 

In telecoms too there has been similar race to the bottom, with Indian operators having among the lowest Average Revenue Per Users (ARPUs) and struggling to mobilise resources for capex. Compounding problems this comes on top of the top-collar winner's curse payouts to acquire spectrum. The result is minimal investments in capacity expansion and technology up-gradation, and being very poorly positioned to transition to the 5G technology.

And this is not confined to just airlines and telecoms. In fact, the same market failure could be generalised to most infrastructure sectors. The power generators and road contractors have never been averse to bidding recklessly and being stuck with contracts which they soon realise they are unable to service sustainably. Besides, they also create piles of non-performing assets for their lenders and attendant need for loan restructurings and tax-payer financed bank recapitalisations. The lenders too do not learn from past experience and repeat their mistakes - the latest bubble in lending to solar renewables generators should show up as NPAs in the coming years.

Clearly the orthodox playbook of Econ 101 does not stand the test of reality. One way of looking at such recurrent crises is to acknowledge it as true "capitalism with exit" and welcome it. Such bankruptcies are to be seen as a cost of a more efficient capitalism. The other way is to view this is as market failure which imposes significant long-term costs on the economy and explore ways to mitigate it.

One response to such market failure is to encourage consolidation and hope for a market with 3-4 (or even 2-3) large players. But this can emerge only through market dynamics and very difficult to be realised through policy actions. The other response is to resort to specific public policy levers to address the contributors to the market failure. But mitigation by way of such policy action runs the risk of incentive distortions, politicisation, and corruption. 

Even with these risks, I am personally inclined to policy response approach. Accordingly, in case of the airlines, there may be a case for the regulators to closely watch the ticket price trends and intervene to pre-empt price wars. Given that a regulator has the responsibility for ensuring the welfare of all market participants, there is perhaps a compelling case for regulators intervening not just in case of price gouging (or price ceilings) but also in case of competitive race to the bottom (or price floors). Even at the risk of incentive distortions and not getting things right, an objective and clearly defined set of principles and guidelines on price floors appears to be a superior alternative to the laissez faire competition approach.   

Similarly the Case II bids for power generation plants should not have given the option of fixed fuel price and should have had mandatory fuel price pass-through - remember the aggressive fixed price bids for the UMPPs which unravelled when the imported coal prices soared. Or there should be some restriction on the number of projects one developer can bid for in any set of tenders - remember the Reliance bids for UMPPs and the recent Adani bids for airports. Or roads sector bids (or even power generation levellized tariffs) which are very significantly off the mark from the internal cost benchmarks should be scrutinised more closely or even rejected. Or should spectrum auctions be structured to explicitly limit revenues mobilisation objectives and keep in mind life-cycle service costs.

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