Airline Industry in the Philippines PDF

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THE AIRLINE INDUSTRY IN THE PHILIPPINES! ! ! ! ! Submitted to:! Ms. Viory Yvonne T. Janeo! ! ! ! ! ! ! By:! Justin Andrei Cabangon! Frances Angeli Carlos! Janadale Leene Coralde! Anne Nicole De Castro! Allyriane Marya Nicanor! Ma. Cristel Ann Sy! Kriztia Credenda Torayno! ! ! ! In Partial Fulfillment of the Requirements in! Intermediate Microeconomics ! ! ! ! March 18, 2016! !

2! ! INTRODUCTION! In the Philippines, the different firms in the airline industry have brought many Filipinos and tourists across various international and local destinations at present. This has brought development in the fast mobility of the citizens. ! This development in transportation would also correlate a positive significance to the progress in the Philippine economy. However, this has not been the usual case. ! In this study, it starts with the discussion on the history of the airline industry towards its kind of evolution at present. The discussion starts from how the Philippine Government holds its overall control in 1952. After some years, it has instituted an official flag carrier named Philippine Airlines in 1973. This monopoly has not given the mobility compared to what is experienced today and instead instigated various issues. These issues are discussed in more detail in Chapter 1 such that the liberalization in 1995 was the key to the entry of more airline firms. ! Aside from studying its history, it is inevitable not to discuss the different policies that regulate the activities in the airline industry. These policies are discussed in more detail in Chapter 2.! With the understanding of its evolution, one has the background to further understand how the airline industry plays in the economy and establishes development. The concrete way of approaching such understanding is to study the details of its market structure. The discussion includes the tackling of the 0.3 rating of the airline industry as obtained from the 2012 Hirschman-Herfindahl Index (HHI) of the industry. The rating denotes that the industry is tight-loose oligopolistic. This is discussed in more detail in Chapter 3.

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Furthermore, this study discusses the general pricing strategies of the airline firms in the Philippines and how they strategize and raise more profits. Also, this includes the concrete case of how Cebu Pacific incorporate not just the general strategies but also various specific business strategies to reach its target markets and raise more profits. ! Lastly, this paper will discuss how the decrease of the fuel prices in the world market affect the decision of the airline industry monitoring body, the Civil Aeronautics Board to stipulate the removal of fuel surcharge in 2015 and how it is observed by the airline firms. ! !

3! ! ! CHAPTER I! THE HISTORY OF THE AIRLINE INDUSTRY IN THE PHILIPPINES! ! Pre-Liberalization! In 1952, the Philippine Government passed the Civil Aeronautics Act which the goals and purposes are mentioned by Manuela as he discusses: ! ! To spearhead policymaking for the passenger airline industry, the Philippine Government passed the Civil Aeronautics Act (Republic Act 776) in 1952. It gave the Civil Aeronautics Board (CAB) and the Air Transportation Office (ATO) the authority to promote adequate, economical, and efficient passenger airline service and those of other carriers at reasonable charges and promote competition between passenger airlines and other carriers to the extent necessary in order to ensure the development of the Philippine air transportation system. CAB administers the economic regulation of the industry while ATO supervises the technical aspect (n.d). !

! In 1973, one airline was granted a virtual monopoly in the aviation industry in the country. Philippine Airlines, founded by a group of businessmen led by Andres Soriano, was granted the monopoly causing other airlines to be closed down (Filipinas Orient Airlines and Air Manila Inc.). The airline’s profile narrates its first operations:! ! A month after being incorporated by a group of Filipino businessmen, Philippine Airlines takes to the skies with a twin-engine, five-seater Beech Model 18 aircraft from Nielsen airfield in Makati to Baguio.!

! In September of the same year, the Philippine government invests in PAL, paving the way for the airline's nationalization. PAL begins service to Cebu in September 2. It then became the first Asian airline to cross the Pacific when it operated a chartered Douglas DC-4 on the first of several flights to ferry home initially 40 US servicemen. Each crossing took 41 hours with fuelling stops at Guam, Wake, Kwajelein and Honolulu in July 31, 1946 (PAL, web).!

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4! ! Hence after the government granted PAL with the monopoly to run operations in the country in 1973, the latter was given a new franchise but with provisions in 1978. These are: a) Government regulated fares to prevent PAL from engaging in monopoly pricing; b) ROI of PAL was capped to 12%; and c) PAL recovered losses through government subsidies and charging higher fares in high density markers (Ansay, 2011). ! The effects to the market would be: a) restricted number of departures and passenger seats in a number of high density markets; b) restriction of output below competitive levels has resulted to efficiency losses; and c) limited output in some markets resulted to higher fares. ! Carlton and Perloff also supported the general claim of Manuela in his The Social Costs of Monopoly Power. They talk about how PAL’s monopoly causes a strain in the economy certain “deadweight loss that results from restriction of output and higher prices ranges from a negligible amount to as much as 13 percent of gross national product and that even a relatively small deadweight loss may be associated with a large redistribution of wealth” (as cited in Manuela, 2013).! Hence, there was an attempt for reform during former President Cory Aquino’s term circa 1988. The administration wanted a healthy and regulated competition among the airline firms in the country. ! ! Liberalization! In 1995, the government liberalized the airline industry under Executive Order (EO) 219. First, domestic and international civil aviation liberalization policy was further established. This was followed by restrictions and on routes/flight frequencies as well as government control on fares were removed. ! This further encouraged two other airline firms to operate in any routes. It encouraged competition. ! Mendoza (2011) describes the transition:! The civil aviation industry in the Philippines was dominated by PAL until the government finally opened this sector in 1995. Following the entry of new airlines like Cebu Pacific, Air Philippines and Asian Spirit (now ZestAir), PAL’s market share was cut in half, declining from 96 percent in 1995 to about 49 percent in 1999. PAL nevertheless remains a dominant

5! ! player in the market with about 50 percent market share in recent years, but Cebu Pacific has captured significant ground, accounting for about 30 percent market share.!

! Deregulation brought about a surge in domestic air travel in the country, thanks to more flights and more competitive pricing. The Manila-Iloilo route alone experienced an 83 percent increase in the number of travelers just two years after deregulation. Passengers from Manila to Davao and from Manila to Cebu also shot up by 45 percent and 34 percent, respectively, during this period. !

! More attractive pricing clearly played a role in successfully contesting market share from PAL. There is also evidence that PAL restricted output—and this was quickly undone by the entry of more players. A recent empirical study suggests that average airfares are about 10 percent lower after liberalization, and that up to 90 percent of domestic airline passengers benefited from lower fares. !

! The industry is not without challenges, however. Competition did improve for the most profitable routes, but the less profitable routes (or so-called missionary routes) could be left behind. PAL used to serve these routes through a cross-subsidy between the more profitable and less profitable destinations. However, with the break-up of its monopoly, and the apparent focus of the new entrants on the more profitable routes, up to 11 markets formerly served by PAL have lost airline service.!

! Table 1. Summary of Airline Industry Information1!

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Airlines!

Year of Deregulation!

1995!

Companies before Deregulation!

Philippine Airlines (PAL)!

Companies after

PAL, Cebu Pacific, SEAir, Air

Deregulation!

Philippines, and ZestAir! Domestic:!

Herfindahl-Hirschman Competition Indicator! (Higher values reflect more market concentration; Date or event in parentheses)!

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10, 000 (1994)!

●

3, 680 (2010)!

! International: ! ●

2, 548 (2010)!

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 1! Herfindahl-Hirschman

Index prior to and after deregulation, with year in parenthesis. The HHI it is the sum of the squared market shares of the each company in the industry. The index approximates the value zero when the industry has more firms with similar size. A higher value therefore signals potentially weaker competition and more concentration in the industry. For illustration, the US Department of Justice, Federal Trade Commission characterizes an HHI of 1500 and below as “unconcentrated”, 1500-2500 as “moderately concentrated” and 2500 and above as “highly concentrated”. !

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6! ! ! In addition, airport infrastructure remains to be inadequate. Even though new domestic firms have shown their competitiveness relative to the once monopoly incumbent, there are some concerns that these same firms may be hard-pressed to compete at the international level, notably once the country opens up to ASEAN competitors as part of the country’s “open skies” policy. Industry experts already forecast the Philippines could be a key battleground for low cost carriers in the region, such as AirAsia (Malaysia) and Tiger Airways (Singapore) once Philippine skies open.!

! Table 2 on Events Approaching Deregulation2! TIME! August 26, 1988! 1995!

March 1996!

AIRLINE! Cebu Air! Cebgo Airlines as SEAir Inc; Tigerair-SEAir! Air Philippines Corporation! Cebu Pacific and Air Philippines Express! Cebu Pacific Air!

1999!

PAL!

2005! December 2010!

Sky Jet (Magnum Air Skyjet, Inc)! AirAsia!

2012! 2011!

Air Juan! Air Republiq Airlines!

February 13, 1995! 1996!

EVENT! Airline was founded! Acquired by JG Summit Holdings (Gokongwei)! Airline was founded! Entered the industry! Entered and started operation on the aviation industry; pioneered the “Low fare, great value” strategy! Owned by private entrepreneurs; policy is progressive liberalization; Lucio Tan held 90% share ownership! Operated December 14, 2012! Founded December 2010; ! Malaysian investor (Tony Fernandes) + 3 Filipinos (Cojuangco Jr., Romero, Hontiveros); ! Air Asia Zest!

! Seaplane operator! Partnership with South Phoenix Airlines!

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!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 2! The increase in competition and the liberalization of the airline industry resulted to lower fares, sizeable increase in passenger traffic due to lack of infrastructures, and travelers endure an undeniable increase in congestion, departure delays, and discomfort due to the enormous response of passengers to the availability of options with regard to fares, flight schedules, and aircraft technology (Kahn 2002). With the increase of new players in the Airline industry, there was a need to regulate their behavior, hence, as to control and regulate matters that affect the industry, the government created policies such as Republic Act, 776 “Civil Aeronautics Act of Philippines”.!

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7! ! Manuela also adds “The Role of CAB under Liberalization”; the “Market Structure under Liberalization”; and the “High Density Markets Under Liberalization”:! ! (On the “Role of CAB under Liberalization)! The airline industry was liberalized in 1995 under EO 219, establishing the domestic and international civil aviation liberalization policy in the country. The EO stipulates the removal of restrictions on routes and flight frequencies, as well as government control on fares and charges. On market entry, the provision encourages at least two operators in any route and operators are free to leave any unprofitable routes. With regard to fare, markets with at least two operators are deregulated, while regulation still applies in single-airline markets. It may appear on the surface that fares and flight frequency are still regulated by CAB due to the airlines’ practice of informing CAB of their intentions. However, the practice of readily granting the airlines’ requests for revisions in airfare and flight frequency and schedule in a matter of days seem to indicate that CAB has been implementing the provisions of EO 219. It simply monitors rates and charges in the domestic airline industry to promote competition and the welfare of consumers. Austria (2000) observes that the role of CAB has been limited to regulating capacity, flight frequency, and airfare in the international air transport sector after 1995. CAB, however, still issues operating permits, approves the routes that airlines serve, and still reviews and approves airfares in single-airline markets. CAB is also a member of the government panel that negotiates air service agreements with other countries.!

! (On “Market Structure under Liberalization”)! The airline industry has changed drastically since 1995—PAL was privatized and restrictions on entry and capacity were lifted. Moreover, government controls on the number of domestic routes served and flight frequency have also been eliminated, as well as restrictions on fares, except in markets with only one airline. In the years following liberalization, the domestic airline industry has attracted as many as five entrants, but this number has dwindled to the following the failures of Grand Air (national operator) and Mindanao Express (regional operator). The demise of new entrants in a relatively short period is comparable to the US experience in the early 1980’s (Kahn 1988 and Borenstein 1992). With the entry of South East Asian Airlines (SEAir) in the scheduled airline sector in 2003, three airlines now compete in major markets (PAL, Cebu Pacific, and Air Philippines) while two airlines serve short-distance routes (Asian Spirit and SEAir), giving passengers at least two choices in some markets, offering them a range of fares, departure frequency, and service quality. The steady decline in PAL’s market share, from 96 percent in 1995 to 49 percent in 1999, indicates that competition has intensified after liberalization. ! The Herfindahl-Hirschman Index (HHI), a measure of industry concentration, sums the squared market shares of each firm in the industry (Carlton and Perloff 1994). When the domestic airline industry is taken as a single market, the HHI is basically stable (see table 3). The US Department of Justice contends, however, that an HHI above 1,800 is considered highly concentrated (Cooper 1999). The much higher HHI observed in the Philippines is due to the dominance of PAL in most routes and the near duopoly that exists between PAL and Cebu Pacific in almost all markets served by both airlines. When the industry is divided into major (more than 20,000 passengers annually) and minor routes, major routes appear to be more concentrated than the entire industry, while minor routes are almost twice as

8! ! concentrated as the entire industry (see table 3). The numbers seem to indicate that minor routes are virtually single-airline markets while major routes are virtual duopolies.!

! (On the “High Density Markets Under Liberalization”)! Liberalization appears to result in a sizeable increase in passenger traffic in most of the 15 biggest airline markets in the country (see table 4). Between 1994 and 2003, the number of markets with an annual passenger traffic of at least 100,000 increased from 11 to 15, although most of these markets are virtual duopolies. One of the benefits of liberalization is the introduction of airline service in new markets, either by the incumbent or the new airlines. Two airline markets that opened in 1996 (Manila–General Santos and Manila– Caticlan) experienced phenomenal growth in traffic between 1996 and 2003 (see table 4). The more than four-fold growth in passenger traffic in the Manila-General Santos market may be attributed to the opening of an alternate international airport and the upgrading of the seaport in General Santos, making it a leading destination for business and leisure in the region. The more than three-fold increase in the Manila–Caticlan market is indicative of Boracay’s rise as a premier tourist destination in the country. The introduction of direct flights between Manila and Caticlan, however, diverted traffic away from the Manila–Kalibo market. Kalibo used to be the gateway to Boracay before the introduction of direct flights to Caticlan. Although airline travel is still out of reach to most Filipinos, the increased competition in the industry has provided passengers with discounted fares available throughout the year in various forms. As far as the traveler is concerned, the lower fares are the most tangible benefits of liberalization. PAL served unprofitable markets. Kahn (2002) notes that cabin space per passenger fell after deregulation in the US due to narrower seating to accommodate more passengers per flight, which results in higher load factors. In the Philippines, however, the average load factor has decreased after 1994. The observation in the top five airline markets that load factors are lower under liberalization is contrary to the findings of Graham, Kaplan,!

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and Sibley (1983) that load factors increased after airline deregulation in the US and that load factor tends to increase with distance. Overall, it appears that capacity has been growing faster than demand after 1994, at least in the five city-pairs. This may indicate that airlines are using a combination of bigger aircraft and more frequent flights as a means to compete for passengers and increase profitability. The decreasing passenger load factor, however, does not augur well for the airlines’ profitability. The lower load factor observed after liberalization indicates, departure delays have become the norm. In the US, travelers endure an undeniable increase in congestion, departure delays, and discomfort due to the enormous response of passengers to the availability of options with regard to fares, flight schedules, and aircraft technology (Kahn 2002). In the Philippines, the congestion at airports is exacerbated

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! 3!Table 3: Herfindahl-Hirschman Index Source: Civil Aeronautics Board! !

9! ! by the lack of adequate infrastructure to support the increase in the number of departures after 1994. Although the current Medium-Term Philippine Development Plan addresses this issue in some respects, it will be some time before airport facilities are upgraded. Kahn (2002) adds that as for the supply side, the airline industry relies primarily on the government to provide adequate air traffic control facilities and personnel at airports. The practice of price discrimination among airlines has increased search costs, making passengers spend more time comparing fares among airlines and travel agencies (relative to 1994 when PAL was the only airline). While CAB admonishes airlines to have an annual ROI of 12 percent in order to reduce the probability of bankruptcy, the airlines tend to engage in cutthroat competition that has driven weaker competitors like Grand Air and Mindanao Express out of the market. The boon...