Roanoke Times
Copyright (c) 1995, Landmark Communications, Inc.
DATE: WEDNESDAY, September 15, 1993 TAG: 9403090024
SECTION: EDITORIAL PAGE: A9 EDITION: METRO
SOURCE: VIJAY SINGAL
DATELINE: LENGTH: Long
Even if there were no practical problems related to its implementation, tighter regulation is not the answer. A better solution would appear to be f+ilesso regulation; in particular, relaxing our current antitrust policy to give airlines the option of merging.
Current antitrust laws make mergers extremely difficult, forcing an airline that is unable to meet its financial obligations to file for bankruptcy. If the airline does eventually go belly up, the result is reduced competition and higher prices and reduced consumer welfare. Consumers are better off with airline mergers than with airline bankruptcies. This is why.
The current troubles of the industry can largely be attributed to overcapacity. The law of supply and demand states that whenever supply exceeds demand, prices - in this case, air fares - must fall. Due to little product differentiation - an economy seat on one airline is pretty much like that on another - all airlines are hurt by lower fares. But those with the thinnest profit margins suffer the most. These are the airlines that must quit the industry.
Naturally, they fight to survive - by cutting prices further to raise quick cash to pay debts, buy time and postpone death. Financial studies that I co-authored on airline mergers and bankruptcies find that these airlines typically charge fares that are about 10 to 20 percent below their rivals'. The cheap fares trigger a fare war as the more solvent airlines are pressed to cut their fares to maintain market share. Since the fares often end up being below cost, the ailing airline quickly runs out of time.
With daunting antitrust laws, the airline's next move is to file for bankruptcy. Once under Chapter 11 protection, the airline is relieved from the pressure to raise cash. Contrary to popular wisdom, the airline then raises its fares, and its rivals follow. But the increased fares are not high enough for the financially troubled airline to generate a profit. In most cases, the airline soon shuts down.
Who are the winners and losers of an airline bankruptcy? Increases in the stock prices of rival firms during bankruptcy filings provide evidence that it is the rival airlines that gain from reduced competition and higher prices. The losers are stockholders, bondholders, suppliers and employees of the bankrupt (and, in most cases, eventually liquidated) firm, who lose one source of their livelihood. Consumers also lose because they pay higher prices.
Society is much better off when firms have two avenues of exit: mergers as well as bankruptcies. That was the situation during 1985-88 when the U.S. Department of Transportation, as the final authority on airline mergers, allowed mergers to occur. During that period there were no large bankruptcies. Firms on the brink of financial disaster were taken over by other firms, in some cases even before the distressed airlines could begin fare wars.
Today, conditions are different: Antitrust laws apply to the airline industry just as they do to any other unregulated industry. In early 1989, the Department of Justice cautioned airlines that it would not allow mergers to take place freely. No wonder airline mergers are not even attempted, and airlines file for Chapter 11 protection. Since 1988, several large airlines have filed for bankruptcy: Pan Am (since liquidated), TWA (in operation), Continental (since reorganized), Eastern (since liquidated), Midway (since liquidated), and America West (in operation).
Which is better: a merger or a bankruptcy? In both cases, competition is reduced because there is one less competitor. In both cases, suppliers and employees get hurt - although suppliers and employees of a merging firm tend to be better off as some of them are retained by the merged firm. In contrast, the stockholders and bondholders of a merging firm fare much better than stockholders and bondholders of a Chapter 11 firm because the firm, along with its liabilities, is sold to another owner.
The most important difference between mergers and bankruptcies is the effect on consumers. While both mergers and bankruptcies have a tendency to result in decreased competition and increased prices, mergers also tend to lead to more efficient operations that in turn exert a downward pressure on prices, thus benefiting consumers. More efficient operation enables the merged firm to cut costs and earn higher profits, further strengthening its financial condition.
Do such efficiency gains really take place? Financial studies conclude that they undoubtedly do. Thus, in the case of mergers, fare increases due to less competition are offset by fare decreases due to more efficient operations of the merged firm. Bankruptcies, on the other hand, only reduce competition without enhancing efficiency. If airlines are allowed to merge rather than go bankrupt, not only will the industry be stronger, and stockholders and bondholders more secure, but consumers will be better served.
\ Vijay Singal, assistant professor of finance at the R.B. Pamplin College of Business at Virginia Tech, specializes in airline mergers and bankruptcies.
by CNB