## Saturday, August 08, 2009

### Consequences of Air India being a zombie airline

by Ajay Shah.

Air India has got itself into serious trouble, and private airlines are also doing badly. The CMIE report on air transport for August 2009 shows a bad picture for the airline industry: from the quarter ended June 2007 onwards, in each quarter, the PAT margin was negative.

There are three interesting aspects to the present situation. The first is about the role of the State. Flying by plane is a private good and not a public good. Seats in a plane are rival and excludable. I fly in a plane, I benefit. There is, hence, no role for government to be in this area. Governments in good countries do not run airlines. The right thing to do is to privatise Air India as soon as possible, without trying to engage in a government-led restructuring. In an auction, if the highest bid is a negative number, government should pay this to get the company out of public ownership.

The next point is the cost of a bailout. NHAI highways cost roughly Rs.5 crore per kilometre. Hence, if government puts Rs.5,000 crore into Air India, this comes at the opportunity cost of 1000 km of four-lane highways.

The most interesting dimension, and one that has not been widely noticed in India, is the impact of Air India upon the woes of the aviation industry. Air India today is a zombie airline': a firm which should be dead but isn't only because it is artificially propped up by the government. (The phrase zombie firms' or zombie banks' originates in the experience of Japan in the late 1980s).

If market forces were allowed to work, then Air India would go into liquidation. This would lead to somewhat higher prices for air travel since competition would be reduced. In addition, it would lead to somewhat lower prices for staff (since erstwhile Air India staff would be looking for jobs) and somewhat lower prices for planes (since erstwhile Air India aircraft would be available for purchase or lease).

Other firms in the industry would thus obtain somewhat higher revenues and face somewhat lower costs.

Conversely, when a government steps in to create a zombie firm in an industry, it damages profitability and investment amongst the healthy firms of that industry. If this process goes on for a while, then otherwise healthy firms in an industry will become sick. This was the experience in Japan, when the zombie firms' supported by the government led to sickness spreading amongst other firms and led to a extended period of reduced private corporate investment.

In summary, one reason why the private airline industry as a whole is in the doldrums is that Air India is being artificially kept alive.

1. Although your comments about Air India and its zombie state are valid, I do not agree with the conclusion: "In summary, one reason why the private airline industry as a whole is in the doldrums is that Air India is being artificially kept alive."

There are no state run airlines in the US. Yet, the US airlines have been in doldrums forever. Will foreign entry make things better, or will the ensuing price battle force even more firms out of business?

Given that most airlines are making losses, your conclusion will hold if not just Air India, but any other airline stops operating. Its planes will be acquired by the survivors, and fewer routes will lead to increased demand and prices. Of course, the government still should not be running airlines.

2. I didn't say it's the only reason. I said it is one reason.

Play the thought experiment in your mind that Air India went bust (e.g. as many large airlines in the US have repeatedly done). This would exert an influence on revenues and costs of competitors.

Ergo, by keeping Air India alive as a zombie airline, government is indirectly supressing the profitability of private airlines.

3. You said: Given that most airlines are making losses, your conclusion will hold if not just Air India, but any other airline stops operating. Its planes will be acquired by the survivors, and fewer routes will lead to increased demand and prices.

Yes, I agree. This is the ordinary process of creative destruction. My point is that when we interfere with it, we create zombie firms, which has deeper consequences on the profitability and thus the pace of investment by the private sector.

4. it is not that difficult to extend this sound logic to almost everything -including roads. but so called freemarket folks sometimes thru lazy analysis,sometime thru latent socialistic thinking, like to believe that roads are public goods too.when it is not.

i dont benefit from the roads in posh lutyens area.i dont benefit from the delhi metro. none of these are really public goods for which me and my maid have to pay via taxes-indirect or direct.

as long as the profit motive is looked upon with suspicion,one can always find ways to classify something or the other as a public good.

our good man nandan nilekani is one such.he doesnt believe healthcare can be satisfied via the market.the benevolent govt must do something.
it would have been far more beneficial if his talents were put to getting land records in order . the alst time land records were maintained properly in india, the ICS was in charge. the socialist IAS has no incentive to maintain land records -they can willynilly use eminent domain to build roads or cricket stadia.

anyway,you are 100% on the money about AI.

5. I was flying AI economy class in Jan'09 and was offered free unlimited hard drinks. The guy next to me was surprised as other airlines don't do the same and in response the air hostess was quite proud. I had to remind her that since AI wasn't making profits the costs were potentially being paid by the Indian taxpayer. I lodged a complaint with AI on the same. I did have a couple of free beers - to cover for my taxes.

6. "The sad truth of this industry is that [air travel] has been and remains one of the great bargains for the consumer," said Bill Swelbar, a researcher at the International Center for Air Transportation at the Massachusetts Institute of Technology. "When adjusted for inflation over the last 30 years, fares are down some 50-plus percent. And that just does not make for a sustainable business model"

7. Ajay - while your assertions that AI is a zombie that needs to be disposed off is very valid, a made here that causal relationships can be drawn for many different things. When a conclusion is drawn this is is one of the causes of the woes of the airline industry (implicit that it is a substantial enough cause worthy of being considered), you have to demonstrate that indeed the distortionary effects are substantial enough. You as an economist probably know well enough about this though I doubt generating numbers for what you say are a simple exercise since incremental effects would need to eb quantified.

Without numbers two arguments can be made -

- For international flights, AI tends to be known as low cost, unreliable and bad quality. Plus more often than not, demand seems to exceed supply on international routes to India and thus even when AI charges substantially less than others, other airlines tend to continue to make profits and fill flights (example - increased entry on those routes of new airlines, increased capacity by existing ones)

- On domestic routes, AI (or Indian or whatever they call it now), tends to be expensive and again unreliable. Over capacity is definitely an issue here and AI probably exacerbates things a little. However, due to its higher costs and negative differentiation, I again wonder how much does it distort the market since people probably go to AI only after they have exhausted their choices and thus may not contribute to the woes of the industry.

For distortions on availability of new airlines, again there are so many sick airlines internationally that I suspect availability of planes may not be as big an issue. For labor, yes AI is probably causing a distortion.

8. Airlines cannot sustain it's business on first-class and business-class passengers and so it all comes down to the low-end economy business. As Buffett puts it, economy seats are nothing but commodities. The price is determined by the lowest-cost provider.

Excerpt from Buffett's 2007 letter to shareholders

"The worst sort of business is one that grows rapidly, requires
significant capital to engender the growth, and then earns little or no money. Think airlines. Here a
durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a
farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by
shooting Orville down.
The airline industry’s demand for capital ever since that first flight has been insatiable. Investors
have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.
And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in
1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred
dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always
misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain.
In the decade following our sale, the company went bankrupt. Twice."

9. What I believe that the only reason behind the downfall of AI is not at all due to external factors but it is the internal mis management and corruption. The profitable routes are given away to private operators, not increasing frequencies between metroes while others had 3/4 flight/day. ..there are more reasons ..the main reason is that it has been headed always by a bureaucrat..not by a professional

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