Why India should have an informal ceiling on number of domestic airlines

India already has six airlines which is one too many if not two and economics suggests that either all will make losses or, even if some make profits, these will be low in relation to the investment

It seems India will have two more airlines this year, one new and another resurrected. Some say one could start flying as early as July.

This is not a good idea. The government — which seems innocent of the economics of capital-intensive businesses — has already issued the licence to the new airline. Fortunately, it’s not the taxpayer who will have to pay the price for this mistake.

We already have six airlines, which is one too many if not two. These are Air India, Vistara, Indigo, Spice Jet, Air Asia, and Go Air. The first three account for over 85 percent of the traffic.

I have for long believed that we need to have an informal ceiling on the number of airlines we allow on the domestic routes. The reason, as mentioned above, is the economic imperatives of high capital intensity. The higher it is, the lower is the probability that the last entrants will survive for very long.

Regardless of how efficiently the airlines are run, singly and combined, the economics of capital-intensive businesses are such that either all will make losses or, even if some make profits, these will be low in relation to the investment. This is true of airlines everywhere, not just India.

That’s why governments need to seek guidance from economics. Specifically, they need to pay attention to what a German economist called Heinrich Freiherr von Stackelberg said back in 1934. Yes, that long ago.

His proposition is known as Stackleberg competition wherein the market leader makes the first move, usually on price but also sometimes on the quantity of output. Then everyone else follows sequentially on quantity. This, as can be seen, is a variant of perfect competition, where all producers face an externally determined price line and adjust their output accordingly.

This is basically what happens in the Stackleberg model. The market leader sets the price, and the others adjust their output to maximise their profits. They don’t compete on price.

The problem arises when, in the pursuit of market share, everyone tries to compete on price. We have seen this happen ever since private airlines were allowed to fly on domestic routes. At one time we had as many as fifteen of them! Nine of them have since perished because, instead of adjusting quantities, they tried to lower fares. But this sort of price competition is futile because of something called Ramsey pricing which applies to networks. It’s named after Frank Ramsey, a mathematician of the last century.

There the objective of the firm is maximise revenue, not profit. While this works fine for monopolies, especially government monopolies, it’s disastrous for competitive markets which try to maximise both by minimising costs. This happens particularly with airlines. Usually, it’s safety that’s the main casualty, or wages and salaries.

There are two ways of adjusting quantity if the airlines will not do it themselves. One is via rationing routes. The other is to limit the number of airlines that can operate on a route. I don’t think the former can work because of the political imperative to expand the network. That’s why it is necessary to limit the number of airlines to just five or six, preferably five.

This would, of course, entail the danger of cartelisation. But that’s more easily dealt with than either price wars or the current methods of increasing the actual fares paid by passengers by charging for everything separately.