(Reprinted from HKCER Letters, Vol. 6, January 1991) 

 

The New Airport and Aviation in Hong Kong --
A New Perspective : Comment and Reply

 

Following the publication of the article by Dr. Kai-Sun Kwong entitled "The New Airport and Aviation in Hong Kong - A New Perspective" in the previous issue of the HKCER Letters, the Editor received a letter from Mr. R. T. Stirland who had extensive criticisms of the article. Since one of the purposes of this publication is to provide a forum for the discussion of various ideas and issues, Mr. Stirland's letter is reproduced below with his permission, for the benefit of readers who might be interested in the issues. Dr. Kwong's reply follows.

Comment by R. T. Stirland

I refer to the article in your newsletter No. 5 entitled "The New Airport and Aviation in Hong Kong - A New Perspective." This article is completely divorced from the reality of actual airline economics and unsupported by facts. Nor is it "a new perspective," as Dr. Kwong has put forward these ideas previously, and they have been rejected as impractical.

The whole thesis is based on faulty logic, since the new airport, with two runways capable of independent operation, would have little or no constraint on demand for slots for some considerable time after inauguration; therefore there will be little scope for differential pricing of slots, slot auctions, or peak-period landing fee surcharges.

However, perhaps the most serious aspect of this article is the underlying assumption that Hong Kong's air services suffer from suppressed demand, and that air services agreements are merely mechanisms for arranging a cartel among airlines. An examination of the facts, rather than theory, demonstrates that this is simply not true. First, the article assumes that the volume and capacity of airlines serving Hong Kong is determined by "the demand for air travel in Hong Kong." The reality is that the Hong Kong market is a very limited component of total demand, given its size relative to other markets such as Japan, Taiwan, the U.S., and Europe, so that even for a Hong Kong-based airline such as Cathay Pacific, passengers and revenue originating in Hong Kong constitute no more than a quarter of its total carriage.

Secondly, much of the balance of the 75 percent originating abroad is passenger traffic which has been stimulated by the provision of air services to visit Hong Kong, to transit Hong Kong, or to stop over in Hong Kong, often by providing lower fares than competitors who would take these passengers directly to their destination or to an alternative destination. In other words, the current level of passenger traffic through Kai Tak is supply-driven, not genuinely demand-driven, because on most routes supply currently outstrips true origin/destination demand.

Thirdly, it is totally false to postulate that the interests of consumers and the interests of airlines are mutually exclusive; without the consumers, the airlines could not exist, and in most cases, the consumers have actually been created by the airlines opening of new routes; use of promotional fares and stopover packages; advertising; faster services; and a steady reduction in the real cost of air travel, that is, looking at the cost before inflation and measured against growth of disposable income and the cost of other discretionary expenditure.

Fourthly, the routes in and out of Hong Kong are served by a plethora of airlines, good, bad, and indifferent. Half an hour in a Hong Kong travel agency would show Dr. Kwong that the airlines with poor reputations are willing to offer lower fares than the airlines which enjoy high reputations; airlines offering to carry passengers with a change of aircraft en route, over sectors where they have no direct rights-- e.g. Gulfair to London via Bahrain or China Air Lines to the U.S. via Taipei-- charge lower fares than those flying direct or non-stop, and in periods of low demand, published fares can be reduced by up to 50 percent. This is hardly evidence of a cartel or a market with inadequate capacity.

The lessons of domestic deregulation in the U.S., to which Dr. Kwong refers, are that in a totally deregulated world, only a handful of superefficient airlines survive, and having once driven out of business their less efficient old rivals and the new entrants to the market, they are then free to increase prices to the limits of price elasticity, and sometimes beyond. The current virtual duopoly of American and United Airlines, combined with the bankruptcy of Eastern, Continental, and many others, bears witness to this.

In the international sphere, deregulation would ultimately have the same effect, with the world dominated by a few megacarriers and their subsidiaries. Small, inefficient airlines would not survive; new entrants such as Asiana in Korea, Evergreen in Taiwan and Emirates in Dubai would never get started in the face of unbridled competition from these megacarriers. Fares, except in the short periods during which the megacarriers were in the process of destroying a new entrant, would reflect their domination of the market.

Of course, politically, no government could tolerate the destruction of its own airline and the hegemony of the megacarriers, and for that reason most governments are opposed to deregulation while welcoming liberalization. These are two entirely different concepts. The article does not appear to recognize these facts.

Liberalization still calls for the trading between states of economic opportunities of roughly equivalent value for their airlines. If a state has bartered access to its airports by a Hong Kong airline for equivalent rights for its own airline, and then that airline is subsequently obliged to bid high prices for the right to land according to its chosen schedule, then the state in question will naturally feel that it has got a worthless agreement and its airlines have been discriminated against. Slot auctions would only be practical in an ideal world where all governments and airport authorities adopted the same policy. We do not live in an ideal world, and consequently, both the U.S. administration and the U.K. Civil Aviation Authority have rejected this idea as impractical. There can, therefore, be no chance of its adoption at an airport such as Hong Kong’s which is heavily used by U.S. and U.K. airlines. Incidentally, U.S. domestic airlines do not acquire smaller ones to capture their time slots, as Dr. Kwong alleges, but to acquire their terminal gates, which is something totally different.

Turning to the idea of differentiation of landing fees as an examination of airline economics reveals that variations would need to be huge to cause airlines to change their schedules, and those schedules are in turn often dictated by slot requirements at other airports. It is, in any case, common ground between airlines and nearly all governments that airport charges should be cost-related, and differential pricing on the scale required would immediately cause allegations of unfair barriers and retaliatory action by foreign governments.

I do not wish to enter a debate about the cost of the new airport, but Dr. Kwong has no evidence that a new airport could not be a viable enterprise, that the "management structure" of Kai Tak is inappropriate to Chep Lap Kok, or that liberalization or even deregulation would have a significant impact on the total level of frequencies through the airport. It should also be pointed out that a ten-year payback on a major construction project with a life of 40 to 50 years is actually quite short by international standards, and that "payback" and "profit," in accounting terms, are two entirely different things. But the really erroneous idea in this particular passage is that by so-called "rational pricing," revenue would be increased and the "public need not subsidize airport construction."

First, the assumption must be that, if revenue is higher than it would be under a conventional landing fee system, the differential pricing has higher rates in the peak periods but no compensatory reduction in the slack periods. And, as argued earlier, if the peak fees are high enough to have a significant impact, they must be very high indeed in comparison to normal fees. Such a system would obviously have a deterrent effect on some airlines evaluating operations to Hong Kong, particulary if they were operating in a totally deregulated environment. Also, it would cripple any Hong Kong-based airline, as it would be burdened with these additional costs for every single flight it operated, unlike its foreign rivals who would not be facing similar costs at their home airports. Total movements are therefore likely to be lower rather than higher, and total revenue hence less.

Second, if a system of bidding for landing slots is introduced, virtually nothing would be paid for slots in the slack periods where there was only one bidder, and the greater revenue collected for peak slots would be counterbalanced by these reductions, with nil net increase in revenue.

Thirdly, all airline costs are ultimately passed on to the passenger in the form of air fares, and higher revenue for the airport means higher costs for the airlines which means higher fares. Those Hong Kong residents who used the airport for travel would then be paying a disproportionate amount of the cost, whereas many others who do not travel but who benefit from travel-related industries such as tourism, hotels, shops, travel agencies, plus all those who work in industries using air freight (25 percent of all Hong Kong exports by value) would not be bearing any part of the cost. It is, in any case, totally misleading to talk of the public "subsidizing" airport construction, however one looks at it. Either it is a public utility, part of the infrastructure such as roads, bridges, sewerage, and water systems, to which all taxpayers contribute and from which they all benefit, or alternatively it is a self-financing project, such as the MTR or a cross-harbor tunnel, where the user pays. The word "subsidy" has a definite meaning which is a money grant contributed to keep down the price of a commodity or the expense of a commercial undertaking held to be of public utility. In neither case does the word "subsidy" accurately define the financing of the airport project.

Dr. Kwong may not be aware that Hong Kong already is a major hub for air traffic in the Pacific area, and the unchallenged gateway to China, by virtue of being the only port with services to interior points in China such as Guilin and Hangzhou. Ironically, the only routes where greater liberalization is required and demand suppressed by inadequate capacity are the routes between Hong Kong and China. They are also the routes which demonstrate that if one practices unilateral deregulation, and allows unlimited access without demanding reciprocal concessions, foreign governments will take everything and grant nothing, creating a monopoly for their own airline. The lack of competitive pressure then leads to abysmal service and extortionate fares.

I cannot understand the practicality of Dr. Kwong's suggestions that Macao and Shenzhen could be "spokes" for the hub of Hong Kong. The idea of an airport 10 minutes flying time from Hong Kong and serving the same catchment area being a spoke when we already have a hub airport serving "spoke" destinations 1,000 miles or more away four to five times daily with widebody aircraft, is so bizarre and so unrelated to geography, aircraft operating economics, and passenger convenience.

The right to propound opinions and to air views on any given subject must remain sacrosanct; equally those who wish to put forward theories for radical change have a duty to inform themselves about the realities of the situation. Dr. Kwong's theories are inimical to the general welfare of Hong Kong because unilateral deregulation would lead to the destruction of any indigenous airline industry here. Since 70 to80 percent of an airline's expenditure is in its home base, and since 75 percent of Cathay Pacific's revenue is earned outside Hong Kong, the implications for Hong Kong's balance of trade and employment of the demise of the airline are obvious. Slot auctions or differential pricing, for the reasons explained, are likely to reduce the number of services to Hong Kong, drive up air fares, and fail to achieve the stated objective. They have already been rejected as impractical by the countries with the greatest practical knowledge of aviation, and could not, in any case, be relevant at a new airport with unconstrained capacity.

Mr. R. T. Stirland is Director of Corporate Development at Cathay Pacific Airways.

 

Reply by Kai-sun Kwong

My earlier article entitled "The New Airport and Aviation in Hong Kong - A New Perspective" has attracted a spirited response from Mr. Stirland. In his letter, Mr. Stirland suggests that my article did not really present a new perspective, since I had put forward these ideas previously. (I presume he refers to my earlier book entitled, Towards Open Skies and Uncongested Airports, Chinese University Press, 1988). I had no intention to pretend that my ideas in the article were "new" in that sense. Indeed they were not. Similar ideas have been proposed for two decades by numerous economists, including Sir Alan Walters, the former economic adviser to Margaret Thatcher. These ideas have often been rejected as impractical by the airlines, and one wonders whether this is due to the persistent penchant for "impracticality" among economists or the considered policy of the airlines to reject them as such. The purpose of my article was to add a new and neglected perspective to the public discussion of the proposed new airport, namely air services agreements and civil aviation policy.

Airlines and airports are complementary activities; sound policies in one area spill over into the other. More flights enhance the return from investing in an airport, and efficient management of airport facilities increases the demand for air services. A new airport under new management untainted by vested interests can be a unique opportunity to re-think existing policies.

Mr. Stirland denies that air services agreements are restrictive arrangements. If so, how does he explain the fact that air fares per kilometer on routes between Hong Kong and Australia are substantially higher than those between Hong Kong and North America? Indeed this is true of numerous routes in most parts of the world. The ability to implement differential fares on flights of comparable flight distances is conclusive evidence that open competition and free entry is absent. Whenever this happens on a specific route, passengers suffer; and they could be passengers from Hong Kong, the U.S., the U.K., Japan, or anywhere in the world. Suppressed demand is more severe on certain routes and less on others. Mr. Stirland's discussion of suppressed demand does not illuminate the issue at hand. The source of the demand, whether it be from Hong Kong passengers or those elsewhere, does not determine whether there is suppressed demand on a route -- it is the total demand that matters. And it is this demand that has been suppressed through restrictive arrangements.

Mr. Stirland accuses me of faulty logic because the new airport with two runways would have little or no constraint on the demand for slots for some considerable time after inauguration. While it is true that total capacity would have doubled, the prime time slots will remain scarce. Surely no more than two flights can land or take off at the same time. What would be the mechanism for determining which flight will land or take off at a particular time? It is precisely this problem that differential pricing of time slots, slot auctions, or peak-period landing fee charges are meant to resolve. In the absence of such a mechanism, political clout prevails, and this can be a highly inefficient arrangement. Mr. Stirland has simply missed the crucial point.

Mr. Stirland is no doubt correct in pointing out that fares vary with the reputation of the airline; depend on whether the flight is direct, non-stop, or otherwise; and fluctuate with demand conditions. But these will occur regardless of whether the industry is competitive or cartelized. Indeed, under the present arrangement, poorly managed airlines continue to operate because capacity on well-managed ones are restricted. In an open system, the interests of airlines and passengers are not mutually exclusive, while under the present restrictive practices that limit consumer choices, the public interest is not best served.

The most important lesson of domestic deregulation in the U.S. is that fares on most routes became lower due to competition among airlines. In the process, inefficient airlines failed to survive the market test. The public has nothing to fear from megacarriers so long as they are not protected from competition. With free entry, these megacarriers are prevented from raising fares above competitive level for fear of being challenged by potential entrants.

The heart of the problem is that, in international civil aviation, air access rights are determined through bilateral air services agreements negotiated between governments on behalf of their airlines. In particular, flight routes and their frequencies for their airlines have to be mutually agreed upon. Since entry into the market is not free, the airlines can charge higher fares than under free competition. The issue is not whether airfares have been falling over time relative to other goods and services, but whether they have fallen to competitive levels. It is not difficult to see that if the maximum allowed capacity between two points is fixed, the incentive for airlines in either country to undercut its counterpart will be quite small. A well-known result in game theory called the Folk Theorem proves that in this situation the motivation for collusion, perhaps implicit, is very strong. The existing air services agreements create scope for such collusion.

A relaxation of restrictions over air access rights is clearly indicated. There are many ways to do this and each has quite different implications. This is an area where there is much debate and a lack of common terminology to describe even simple schemes. To me, unilateral liberalization means a unilateral open-sky policy by a country to allow unlimited access rights to any carrier. Bilateral liberalization means a bilateral open-sky policy negotiated between two countries to allow unlimited mutual access rights for their airlines. Multilateral liberalization means a multilateral open-sky policy among some or all countries in the world that would result in the complete and free entry by all airlines into any route sector.

With unilateral liberalization in Hong Kong, any foreign carrier may use the Hong Kong airport for terminal traffic or as a transit point. The growth in flight frequencies could be enormous, and will generate significant earnings for local industries and the airport. Free competition among airlines will lower fares. The problem, however, is that many countries may maintain their protectionistic stand, and a Hong Kong carrier may lose all its routes. The economic loss to Hong Kong from the demise of a local carrier has to be set against the extra earnings obtained by the airport and local industries, and the consumers' gain in terms of lower fares, better services, and more frequent flights.

A less drastic approach is bilateral liberalization. A bilateral open-sky agreement would introduce competition in direct flights between Hong Kong and the other country. Flight frequencies would increase and fares on some flights would fall. The value that a local carrier obtains from a bilateral open-sky agreement depends on how efficient it is relative to its competitors, and it may not derive "roughly equivalent value" from the agreement. A highly efficient local carrier would not only stay in business but will be able to expand its operations because foreign access rights have been expanded and not diminished. Of course, the local carrier will cease to earn monopoly profit rates, but only competitive rates. But total profits need not fall if it is able to take advantage of the lifting of restrictions to its expansion, secured through the bilateral open-sky agreement. Shareholders of such a carrier would stand to benefit.

I am in favor of Hong Kong adopting a bilateral open-sky policy. It would bring economic benefits to Hong Kong and act as a step towards global liberalization. I also support a policy to allocate landing time slots according to market principles. This issue has to do with how an airport is managed and is a separate one from that of air service agreements. As flight frequencies increase due to liberalization, efficient management of the airport becomes even more important.

Two approaches to allocate landing time slots have been proposed: differentiated pricing and auctioning. Both approaches would entail different landing costs for different time slots. Each approach treats all airlines equally; both domestic and foreign airlines compete equally. In differentiated pricing, a particular time slot will cost the same for every interested airline. In auctioning, the opportunity to bid for any slot is equal among all airlines. Auctions, contrary to what Mr. Stirland alleges, are clearly non-discriminatory. Differentiated pricing, however, has a drawback. The spectrum of prices cannot be changed easily. Even if a time slot at the going price clearly results in excess demand, any attempt to raise the price would be challenged as discriminatory action against the airline holding that slot. If time slots are auctioned instead, then airlines may hold the allotted slots for their own use or transfer them to other airlines at a premium, in which case the transfers are purely private, voluntary transactions. Both differentiated pricing and auctioning are not politically impractical for a new airport to adopt, as would be the case in an existing airport because resistance from the airlines, which treat the time slots as if they were their own private property, would be enormous.

Liberalization and slot-pricing have at least three distinct advantages. First of all, the role of Hong Kong as an international center of trade, tourism and finance is enhanced. Many have argued that the future of Hong Kong lies more in its strength as a services center rather than a manufacturing base. In that light, liberalization seems logical and desirable. Indeed it could be argued that liberalization is almost essential. In view of the global liberalization trend, some countries in the region may well attempt to liberalize ahead of others. Countries that liberalize will experience fast growth in air traffic. Airlines are drawn to such airports as transit points. At present, Hong Kong has a considerable amount of transit and transfer traffic. Much of this traffic could be lost if other countries in the region begin to liberalize. In this respect, the future role of the airports in Macao and Shenzhen, in relation to the new Hong Kong airport, depends partly on the policies in Hong Kong. The market will sort out the most economical mode of transport.

The second advantage is that fares in and out of Hong Kong would be lower through more intense competition. Mr. Stirland has provided examples where indirect flights are significantly cheaper than direct flights. The reason is that consumers prefer direct flights to indirect flights, and the frequencies of direct flights are limited by restrictive air services agreements. The restrictions permit airlines to exercise their monopoly powers on these routes. There is no evidence that the differences in fares can be explained by differences in operating costs. This suggests that as capacity restrictions are lifted, competition would result in more convenient flights and in fares falling closer to operating costs.

When differential slot-pricing or auctioning is implemented, the peak period slots will command higher costs which airlines will pass to the consumers in terms of higher fares. But this margin is not likely to be significant because landing fees are a "tiny component of total operating costs". Moreover, landing in slack periods would be relatively cheap, and accordingly, fares for those flights would be lower. In other words, there will be a wider range of fares from which the consumer may choose.

The third advantage lies in the financing of the new airport. Although the new airport will have two independent runways when completed, for many years after its inauguration only one runway will be in operation. Even when there are two runways, airport capacity is far from being unlimited. There will always be busy and slack periods, and the demand for peak period slots will exceed supply unless a scheme of differential pricing is implemented.

Mr. Stirland argues that the demand for slots is very price-inelastic because airlines are constrained by the availability of slots at other airports and because landing fees are a tiny component of operating costs. If this is true, then differential pricing will be an easy source of airport revenue. Some of the costs will be passed on to consumers, but the amount will be offset by fare reductions due to more flights because of free entry and competition.

The argument that slot fees will be exorbitantly high and will deter airlines from operating in Hong Kong has no merit. The case for liberalization begins with the observation that the current airlines industry suffers from suppressed demand due to restrictive practices. Liberalization presents an opportunity for more flights and routes to come into existence. Airlines would value the opportunity to fly to Hong Kong since they are restricted elsewhere and they would be willing to bid for landing slots because it is profitable to do so. The price of these slots will be set by demand. The problem is that under the current, restrictive system there is no way for them to even make a bid. Because liberalization leads to more flights and the opening of new routes, airlines are unlikely to be deterred by the high landing fees during busy periods.

The argument that a foreign government would refuse to enter into a bilateral open-sky agreement with Hong Kong if its airlines have to subsequently bid high prices for landing slots is simply wrong. Under slot-pricing, both domestic and foreign airlines have to bid for landing slots in Hong Kong. Competition on any route is conducted on an equal basis; no one is discriminated against or privileged. I also fail to see Mr. Stirland's point that "it would cripple any Hong Kong-based airline, as it would be burdened with these additional costs for every single flight it operated, unlike its foreign rivals who would not be facing similar costs at their home airports," unless he implicitly assumes that a Hong Kong-based airline would be subjected to discriminatory pricing arrangements at foreign airports. But surely this can be ruled out at the very outset in any air services agreement.

To maximize airport revenue, auctioning of landing slots is worthy of consideration. The new airport development project is the largest capital project ever undertaken in Hong Kong. If airport revenue falls short of operation and construction costs in present-value terms, then more taxes would have to be raised from the general public to keep other government expenditures unchanged. This is subsidization. In enumerating construction costs, one should realize that the new airport, although much larger than Kai Tak, will have to go through expansion phases over its "40 to 50 years" lifespan. It is therefore important that revenue from all sources be maximized.

Finally, the observation that, politically, no government will tolerate the destruction of its airline, so the case for liberalization is of no practical relevance, may well have been correct in the past. But after a decade of stunning progress towards liberalization in many areas around the world, there is reason for hope. Furthermore, the bad policies of other governments is not a justification for our own bad policies. I would not deny that the political constraints are there, and Mr. Stirland's observations about them are useful.

Dr. Kai-Sun Kwong is a lecturer in Economics at the Chinese University of Hong Kong.

 

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