High Speed Rail Europe
High Speed Rail Europe : High-Speed Rail’s Competition, Coordination, & Potential Merger with Major Carrier Airlines in the Western European Market
The public transportation market landscape in Western Europe is undergoing a profound change. Profit margins of short-range flights operated by national carriers such as Air France Lufthansa have shrunk dramatically due to their competition the High Speed Rail (HSR), traditionally viewed as a close substitute. This inefficient price competition has prompted a lose lose scenario in which neither HSR nor airlines deliver their expected revenue-generating capacity.
We perform a positive and normative analysis of a possible merger between national high-speed rail (HSR) operator and national airline service in Western Europe, motivated by a change transportation demand due to greater climate change concern. Examining the key metrics in substitutability, capacity constraints, and regulations, we have discovered the following insights:
1. HSR outperforms short-term flights in both operational efficiency and profit margins given the awakening of environmentally conscious consumption habits.
2. Since both supply and demand of long-range flights are less elastic, HSR would capture the market for short-range flights by establishing direct links to hub airports.
3. A merger benefits both HSR, which pivots towards serving airport-to-airport transits, and national carriers, which directs more resources on intercontinental flights. Suchmergerbuilds on compatible incentives from European Union’s policy orientations.
4. Debates about the merger’s anti-competitiveness mainly rests on the uneven distribution of welfare across differentiated consumers, not the market concentration itself. While implications of demand shocks to the transportation industry remain unclear given insufficient empirical data, such a merger improves the risk resistance capability for both product markets, especially the presently vulnerable airlines.
Similar patterns of market consolidation include the US Internet Service Provider industry and the Chinese micro-loan service industry.
The design-and-build market for High-Speed Rail (HSR) in Western Europe consists of limited buyers and suppliers in the discrete demand. A decade ago, HSR and local airlines were mainly close substitutes as horizontally differentiated products in the short-range domestic European public transit market. Subject to heavy governmental regulations, they have few viable escapes to Bertrand’s paradox due to limited product differentiation and saturated capacity. We Found the recent wave of environmentalism greatly influenced consumer preference over domestic short-range products. As a result of the change in the basic market conditions, theHSRemerged as the greener and cheaper option and would extract a significant market share, credible signaling the major airlines to quit the competition in short-range domestic flights.
As a response, the segmented short-range HSR and mid-to-long range airlines nolongerview themselves as substitutes, but rather as complements. We predict that a legacy airline that dominates the hub airports would attempt to coordinate with HSR in planning and building rail directly connecting cities to the airport through integrated service. This service, as well as new services such as the transfer of luggage from trains to plains, would be a specific asset for the hub airline. This coordination will go unchallenged by the government because it increases the efficiency and overall social welfare of the passengers and there are positive externalities involved. Rather than attempting to extract surplus from consumers, coordination allows thehubairline to provide a better product, and it is therefore pro-competitive.
We analyze the incentive compatibility constraints faced by HSR firms over this coordination. We predict that a merger between HSR and airlines would be the necessary and only possible option for such coordination. The alternative, exclusive contracting, is susceptible to unforeseeable contingency and lack of reinforcement in the rent-seeking behavior from the airlines and rigid governmental regulation for the HSR industry. Exclusive contracting betweenHSR and a hub airline would suffer from many of the same problems as seen in the GM-FisherBodies case study. The construction of the track would require a significant fixed cost investment by one party, in this case, the HSR, while the expected profits for the HSR would almost exclusively be due to the exclusive contracting rights, without which the track is worth very little. After these fixed costs are already invested, the hub airline would be incentivized to attempt to renegotiate a better contract, as HSR would maintain very little leverage in negotiations. This problem is exacerbated by asymmetrical regulation of the European HSRandairline markets further hampering HSR’s ability to respond to changes in the hub airline strategies. With only one airline per market, competition between airlines for contractingwithHSR would not solve this issue. HSR’s best strategy is therefore not to produce the track, conjecturing that airlines’ promise in shared profit is not credible. A merger emerges as the incredible commitment airlines could offer such that a railway would be confident enough to build the track, which would be beneficial for consumers, HSR, and the hub airlines.
The implication of the air-high speed rail merger is twofold. On one hand, the consolidation of the mass transportation market in one nation results in weaker bargaining power for the low-cost carriers (LCC), which directly compete with both national carriers and high-speed rail. From this perspective, the merger is discouraging competition within the domestic market.
On the other hand, the merger would result in an increase in operational efficiencyasawhole in the transportation market. This would lead to better quality service, and therefore increase competitiveness against neighboring countries. We believe that the local national government would approve the merger because it is pro-competitive against foreign firms and therefore ultimately beneficial to the welfare of the nation. We also believe that the merging
firms would have a credible argument that the increase in quality of service outweighs concerns about increased market consolidation. While the increased price of the joint product will be eventually offset by the increased quality, we predict that the overall consumer welfare increase is unevenly split between different categories of passengers. Since business travelers careless about price, they would benefit from this approved merger for the increased quality. Conversely, many leisure travelers would suffer more from the increased price than they would gain from the jump in quality.
High-Speed Rail Industry Background
High Speed Rail (HSR) is a growing, effective, and efficient mode of transportation that is a combination of infrastructure, rolling stocks, and operational aspects (Antonov, 2020). The Infrastructure portion includes tracks designed to handle speeds of up to 250km/h. Operating And Building HSR networks involves very high fixed costs. The supply roles in building include designing and building the network, the control of the movement of trains, operation, and supply of trains, the maintenance, and the acquisition of signaling and communication systems. HSRnetworks offer three main services: intercity, regional, and commuter services. Our product of interest is the Western European city-pairs of HSR.
With more than 124 billion passenger kilometers (reported in 2016), HSR is an integral part of Europe’s transport system with most of the lines concentrated in France, Italy, Germany, andSpain. Major manufacturers include French company Alstom, Canadian Bombardier, and German company Siemens. A robust cross-border high-speed rail network located near airports connects most Western European countries. A significant portion of the demand for HSRinwestern Europe is diverted from air travel, particularly with regard to intercity travel from
different countries with relatively short distances–e.g., Brussels to Paris and Madrid toParis. Passengers find rail travel more attractive because of the low prices(relative to those of airlines), reliability(less susceptible to weather-related delays), and the comfort-enhancing high-service quality. In most Western European countries, governments have sought to enhance competition in the industry by vertically separating operation and management.
While the governments retain ownership of the track infrastructure, they allot to private firms the maintenance and operation of the HSR through concessions– contracts that give firms exclusive access to operate the rail for an agreed period of time. Through these concession contracts, governments regulate the industry and influence prices while firms extract value from operational services. However, these contracts are sometimes mired with incomplete contract issues that have to do with mostly the difficulty of predicting or attaining a certain level of performance.
The high-speed rail product can be offered as a package that combines design, construction, and operation. With the recent exception of Spain, once a firmwins the designandplan contract of a particular route, they automatically win the contract for operation and maintenance. The Winner Takes All model strongly influences the HSR firms’ competitive strategies.
The Western European high-speed rail market is characterized by the following: 1) the relatively flat terrain enables the HSR to be constructed at a relatively lower cost and faster time;
2) Very few places with medium to hug population density cannot be reached via HSR;
3) Each country has its own HSR operation firm, and the design-and-build market is robust with major players competing for limited projects issued by governments; 4) medium-to-high speed rail mainly connects two cities of medium-to-high population densities in the same country, with notable exceptions in the Netherlands-Belgium-Luxembourg corridor (Interrail, 2017).
Image 1. Western European High-Speed Rail Framework (Bloomberg, 2018) Governmental Regulation
HSR is one of the heaviest regulated means of mass transportation in WesternEurope. Firms’ actions, including procurement, designing, building, and operating are subject to governmental approval.
The liberalization of the rail design-and-build sector with the operation sector in Spain has not brought profound change to the way of HSR firms and the government’s interaction.
Notedly, the European Parliament considers standardizing HSR service as a long-term agenda. The Commission set the goal of ensuring that the majority of medium-haul passenger transport is carried out by rail by 2050 (EU Commission Report, 2016). In the medium term(by2030), the length of the existing high-speed network should be tripled and a dense rail network all Member States maintained. In the long term, a European high-speed rail network should be completed.
However, the EU makes no provisions on how each country should view the competition between HSR and other means of transportation. The Commission has no legal tools and no powers in the decision-making to ensure that the Member States make rapid progress towards completing the core network corridors or assert one that abides by market competition.
Competition between HSR and Airlines (Short Range Escapes from Bertrand’s Paradox
With viable methods for diminishing competition with LCCs, HSR firms would be less likely to want to coordinate with national airlines. However, competition between HSRandLCCs in the short-distance transportation market is structured such that there are no clear escapes from Bertrand’s Paradox. To demonstrate that this is the case, we will look at each of the four different escapes, and why they do not apply to this market.
Product differentiation does exist in the short-distance transportation market. Given That we are discussing competition between HSR, and LCCs, this is definitionally a differentiated market. Unfortunately, this differentiation does not have a significant effect on the economics involved in the market. Ultimately, while consumers might have slight preferences for air travel or HSR travel, they are really purchasing the ability to travel quickly between two locations, and they care relatively little about how this transportation occurs. Rather, consumers are primarily motivated by price, time, and social factors when choosing which firm to use. Additionally, given the nature of the transportation industry, substantive differentiation within the two subsets of the market is not possible.
Capacity constraints are also not possible to maintain in this market. The primary reason for this is that demand fluctuates so much at different times of both the day and the year. Therefore, HSR firms and airlines must maintain enough capacity to provide service to their
section of the market during busy times. They cannot credibly scale their capacity downduringslower times. Another complication is that Airlines and HSR firms often need to move around their fleet to have enough capacity to meet demand in other markets. Therefore, it is often actually impossible for firms to implicitly agree to intentionally limit their own capacity to escape from Bertrand’s paradox.
The third escape from Bertrand’s paradox is timing. At one point, this did provide a viable path to profits for LCCs. Since LCCs were established before HSR, LCCs had a first-mover advantage as HSR emerged as an entrant in the market. However, LCCs were unable to establish any barriers to entry in the market for HSR firms in addition to the initial fixed costs investment required to build tracks. Therefore, once HSR firms paid these fixed costs and the public began to view HSR as a viable alternative to LCCs for short-distance transportation, the advantage enjoyed by the LCCs quickly disappeared. At this point, there is no realistic way in which any firm can gain a timing advantage over its competitors (Bachman, 2018).
Finally, the last escape from Bertrand’s paradox is collusion. Like the other three escapes, collusion is particularly difficult in the short-distance transportation market. HSRfirms, in particular, are subject to government regulation and oversight. Additionally, HSRfirms are only able to expand to new routes if they are given contracts by the government. Therefore, it is very easy for the government to prevent collusion between HSR firms and LCCs.
In other markets, it is often difficult for the government to prove collusion, even if it is obvious that the two firms are charging more than they should be charging according to Bertrand’s paradox. However, forHSR firms, the government can simply refuse to award firms contracts in the future if it suspects that they are engaging in collusion. Finally, even ignoring government oversight, implicit collusion is by its very nature impossible to enforce and legally dubious. Therefore, if HSRfirms can escape from Bertrand’s paradox through legal, enforceable coordination with national airlines, they will always choose coordination with national airlines over attempting to collude with LCCs.
Change in Consumer Choice
Because of the low negative externalities involved, European governments and political parties have been generally favorable to HSR over airlines. Advertising is also making consumers more aware of the presence of HSR, and its increased time reliability and safety are becoming more common knowledge (Ross, 2019).
With growing concerns about greenhouse emissions, travelers are opting for HSRbecause it is substantially more from voters determined to protect the environment, and are eager to support this effort. For instance, the Green Party of Germany, a country that saw a 0.8% drop in plane travel in 2017, has promised voters to make train travel more affordable in the near future as well as reducing taxes on train-operating firms (Sumers, 2020). This is in keeping with ‘’the new flight shaming movement’’ sweeping across Europe whose most renowned spokesman is the young, Swedishactivist Greta Thunberg:
The flight shame movement first emerged in 2017, when Swedish singer StaffanLindberg announced his decision to give up flying. Other celebrity advocates include biathleteBjörn Ferry, who has committed to traveling to competitions by train, and opera singer MalenaErnman, mother of 16-year-old climate activist Greta Thunberg.
So far, the idea has gathered the most momentum in Sweden. Hashtag #jagstannarpåmarken, which translates as #istayontheground, has become a buzzword. An Instagram account calling out celebrities promoting trips to far-flung destinations has 60,000 followers. Thunberg’s own efforts to avoid flying have raised the profile of the movement yet further, as well as bringing fierce disdain from some quarters (Timperley, 2019).
Air travel is significantly more carbon-intensive than rail travel. An independent research commission organized by Eurostar, an international high-speed railway service company, found that taking a train from Paris to London instead of a plane reduces CO2 emissions per passenger by 90%, from London to Amsterdam the decrease is about 80% and 85%fromLondontoNice(Timperley, 2019). For this reason, consumers, whose traveling preferences have been increasingly shaped by the current environmentalist concerns, are turning to HSR trains as a substitute for short to medium distances travels.
Were it not for the enhanced climate change concerns, the HSR and air travel for short range trips would be viewed as close substitutes. We compare the prices and service frequency of HSR vis-à-vis air travel for several short-range trips using established pairs for distance bands. A
detailed data-wrangling analysis can be provided upon request. Leveraging the data fromEUROSTAT to obtain the number of passengers transported between EU airports as well as the distance-weighted average price for respective means of transport, we observe that there are differential factors between HSR and short-run airlines in terms of distance traveled or cost per route. Without integration, we would expect short-range trips for which there were services actively provided by both HSR and airlines (LCCs) to be priced similarly.
Table 1. The relative distance between airports and major high-speed railway stations, havingdiscounted for the infeasible railway routes such as cross-English-strait.
In the intercity markets in which they compete, HSR trains have a competitive advantage over airtravel foursome routes such as London to Paris, HSR trains are reported to be faster than airplanes, becauseHSR has faster check-in/out times and is closer to city centers. Accounting for fares and travel times, passengers seem to prefer rail travel over air travel on some route–e.g. Madrid-to Barcelona and London to Paris– meaning that HSR and Air travel can be reasonably treated as vertically differentiated products in the domestic market (O’Sullivan, 2020). HSR thus has an absolute advantage in the short-range due to the changed consumer preference driven by environmental awareness compared to hub airlines because 1) it’s cheaper 2)it’s closer to the center 3) it’s environmentally friendly. LCC is still a competitor because 1) it’s cheap. Airlines have none of the definitive advantages in the short-range market, making their best strategy to quit the short distance travel game and strategize their strength.
Before the growing environmentalism, HSR’s main competitors are the short-range flights offered by hub airlines and LCC, and the substitute products differ in that HSRis cheaper, safer, and more environmentally friendly. On the other hand, the airline industry does have an absolute advantage in the speed of travel; however, this difference is overshadowed by check-in, wait, and transit times, especially for shorter distances by air travel. Still, longer distances show how dramatically the speed difference can affect travel time, and due to this, air travel holds comparative advantage over HSR in long-distance travel (O’Sullivan, 2020).
HSR, conversely, holds the comparative advantage in shorter and mid-range traveling distances, with only one caveat: there must be no geographic barriers. HSR infrastructure is tremendously more expensive if not impossible to build through natural obstructions such as rivers, mountains, oceans, and canyons. The flat terrain in Western Europe lowers the difficulty of construction (Interrail, 2017).
Environmentalism profoundly changes consumer preference in the short-range. HSRemerges as the dominant choice for consumers in short-range mass transportation, overtaking
airlines by 32% (Timperley, 2019). Consumers are convinced that taking HSR is not only economically viable but also socially responsible. The clear loser in the short-range market is the hub airlines, with no price advantage like the LLC and more emission than what consumers would prefer. IATA’s report shows that European carriers lose money on short-haul flights(IATA, 2018). Flights like that from Frankfurt, Lufthansa’s hub, to Cologne, a Germancity, are already operating at a loss, with a high percentage of flights substituted by the HSR(Ross, 2019). For the great picture, the hub airlines survive by concentrating their products on destinations where HSR could not reach — long-range flights. To secure the customer source not just from the city where the hub airport is located, they need to find a sustainable partner in the short-range market. For example, KLM’s recent advertisement advocates consumers to take the Thalys, the national HSR network, to KLM’s hub Schiphol International Airport, suggesting a clear transition of how KLM views HSR: formal competitors, new partners (KLM.com, 2018).
Coordination between HSR and Airlines HSR as a specific asset
The key incentive for coordination between HSR and national airlines is the idea that HSR operating in coordination with national airlines allows for the creation of a specific asset. Without coordination, high-speed rail is the consumer-preferred mode of short-distance transportation. However, HSR firms must spend a considerable fixed cost upfront to construct tracks. The firm can only expect to generate a profit significant enough to justify this cost if it is connecting two locations with a large enough consumer demand for transportation. Ostensibly, one would expect this to be true of a national airport and a major city. Passengers traveling both to and from the airport are seeking public transportation on this route every day (Oliver Wyman, 2019). Moreover, the majority of this route cuts through sparsely populated suburbs with comparatively cheap land (Orbanhttp, 2019). Therefore, it is surprising that HSRfirms have not decided to build tracks on most of these routes.
Unfortunately, the reason for the lack of interest in these routes fromHSRfirms is the necessity of working with national airlines. On most rail routes, consumers travel between the two endpoints for a nearly infinite variety of reasons. On a route between an airport and city center, the only reason that consumers demand HSR services is air travel. For this reason, the national airline in control of the airport can dramatically affect the financial success of the HSR firm (Loh, 2019). The extent to which airlines cooperate with HSR on scheduling and logistics is, therefore, the determining factor in whether the HSR firm can recoup its investment. HSRfirmscan conjecture that airlines would try to use this leverage as a bargaining chip to extract profit from HSR firms after fixed costs have already been expended. This leaves HSRfirms unable to accurately predict their future profits from building tracks connecting airports to city centers, with a major unknown being the outcome of this bargaining process. Unsure of whether thetrack will ultimately be economically viable, HSR firms opt to ignore an area with clear consumer demand in favor of developing a route that is relatively certain to generate a profit. The only way for it to make sense for HSR firms to develop tracks on these routes is clear, explicit, enforceable coordination between HSR and national airlines.
While coordination between HSR and national airlines creates the possibility for a specific asset that could not reach consumers otherwise, this is only significant if that asset is actually an improvement over the status quo. Fortunately, HSR connecting airports to city centers do represent a clear improvement (Freemark, 2010). Consumers have demonstrated that they prefer HSR to air travel over short distances for many different reasons (Bachman, 2018). Therefore, the ability to take trains to airports instead of connecting flights is almost always preferable. Trains are better for the environment, cheaper, and more reliable than planes. Overshort distances, the advantage of inconvenience and travel time enjoyed by airlines over HSR are greatly diminished, as the previous section mentions. It is important to note that consumers who only travel on short-distance intercity routes will not be able to take advantage of the new product. However, while these consumers might be harmed by anti-competitive elements of cooperation, their ability to travel on HSR will be unchanged.
Consumers who travel long distances by plane, on the other hand, will benefit from this coordination. This should increase demand for both HSR and air travel, allowing firms in both industries to increase both price and quantity. Lastly, while coordination between HSR and national airlines allows for the development of a specific asset that is strongly demanded by consumers, there are different ways that this coordination could take place. While we advocate for a merger, it is important to evaluate the pros and cons of mergers, exclusive contracting, and government development of railway tracks.
The key incentive for a merger between HSR and national airlines is the idea that HSR operated in coordination with national airlines allows for the creation of a specific asset. The High-speed rail would be able to serve those consumers of air travelers who need to get somewhere relatively closer after a long flight. This would make the HSR more of a complement to airfare than a substitute, and they’d no longer have to compete in a price war or make capacity constraints. In the hub and spoke model, the HSR will radiate from the airports and cater specifically to consumers who travel through the airport it is connected to. Consumers who want to travel distances comparable to HSR services used to rely mostly on air travel, so the airport has already been established as a hub for travel. Building the HSR hubs elsewhere would pose an inconvenience to those who’ve flown in and want to get to the HSR hub with their luggage(Briginshaw, 2020). Additionally, any advantage the new location holds thanks to its proximity to the city’s residents most likely will not noticeably increase consumer demand since the city’s residents were willing to travel to the airport before anyways and will have better means of transport such as their own vehicle to the airport.
Since HSR takes far too long over large distances, the airport integration allows it access to consumers who wouldn’t otherwise have opted to use HSR. The travel to the HSR hub from the airport would have presented its own hassle, and many would have to now use the HSRtoget to the airport with ease. The new construction also means connections can be made that were not present in the old airport system, and this can be planned to better reflect what the consumer’s demand. Through this network effect, a greater surplus has been made available in the market fortravel through both air and HSR, and HSR can extract a respectable chunk of it.
The source of the Extra Pie
Due to its lower cost, HSR should make routes where it effectively replaces air travel much cheaper, increasing consumer surplus. The promise of environmental cleanliness and support for a new, advanced product will also be enticing and make many travelers more eager to pay. Furthermore, HSR allows for wifi, cell phone usage, and extra space which air travel does
not offer. This enhances the experience for consumers and attracts a bigger crowd. The hub and spoke model also should make long-distance travel much easier by minimizing layovers andholdtimes since high-speed trains do not need time to fill up on gas and tend to be much more prompt (Freemark, 2010).
Under the Hub-and-spoke Model
Most major airlines (national carriers) in Western Europe such as Air France, KLM, Lufthansa, and Swiss adopt a hub-and-spoke system (Briginshaw, 2020). Most HSRlinesinoperation in the same market connect cities of medium or high population densities (Interrail, 2017). Most hub airports of the major airlines such as Paris (CDG), Frankfurt, Brussels, andZurich are congested (Oliver Wyman, 2019). We propose that the coordination betweenHSRand hub airlines has the potential to increase the joint profit given the hub airport has capacity constraints in the number of passengers they can carry or the number of slots available to park the planes. This can be shown in this simple model:
A ——————-long range——————— B (hub) –B1 (HSR Station)—-short-range—- C
Before coordination: AB is solely operated by hub airlines; B (B1)C is competing among hub airlines, HSR, and LCC. Demand for AB is less elastic than the B (B1)C since the latter has more options. Transaction cost is relatively big for passengers to switch from long-range flight to short-range HSR with the additional effort of luggage transport, time, and cost on B- B1.
A ——————-long-range——————– B (hub, HSR station) ——–short-range——— C
After coordination: AB is solely operated by hub airlines; BC is competed between HSR(with its own + hub airline’s capacity) and LCC. Transaction costs between AB (hub airline) andBC(HSR) are greatly reduced. Consumers would prefer HSR due to the reasons stated in the previous section.
If the airline and the HSR decide to coordinate on offering joint service, the hubairlinestops operating route BC, which is now operated by the HSR as nearly a monopolist (full mode substitution takes place between hub airline and HSR). Due to this agreement, the airline is able to release slots in airport B that were reserved for BC to satisfy other markets, particularly those long-range flights like AB. However, this conclusion is built on the premise that Bairport is not capacity constrained. If B’s capacity is constrained to the extent that the hub airline can only operate AB route, then the coordination between HSR would make no difference in the joint profit.
Under this coordination model, passengers willing to travel from city A to city C must travel the route AB by plane and the route BC by train. In general, the coordination would ameliorate the additional connecting time, schedule incompatibilities, baggage claim, etc. It is possible and feasible for airlines and HSR to charge a single ticket for the whole tripbothin-plane and HSR. Coordination occurs when the hub capacity is reaching its upper limits, the airline withdraws from the market where it has a less competitive advantage over HSR.
Competition between HSR firms
Due to the large magnitude of sunk costs associated with becoming an entrant into the HSR industry, the first mover firm in the railroad industry has a significant advantage over subsequent firms. If we assume the government will fund the construction of infrastructure necessary for HSR, the sunk costs themselves can be thought to effectively increase after the initial firm constructs an HSR between two destinations since the government will no longer find it beneficial to fund the same path rather than another. The first entrant also benefits from a full selection of upstream suppliers and a wider selection of routes to build. Assuming the entrant procures government assistance thanks to the utilization of the leading technologies for HSR, they will be able to exclusively contract with the top suppliers of goods needed. This can lead to asset specificity and give an absolute cost advantage to the new incumbent. The first mover also chooses where to build a railway, and can thus secure the location with the highest demand potential.
It may be argued that the additional firm constructing the same route will increase competition and induce price wars, increasing consumer surplus and investment in research and development (R&D). However, the firms could escape this with capacity constraints, which would nullify the effects of competition on surplus, and the new firm would rather create a new surplus in the market and profit from that by establishing a different path elsewhere anyways. Potential entrants can also fuel R&D and compete with incumbents in the procurement of government funding for new pathways by inventing faster, more cost-effective forms of high-speed rail.
The market structure’s entry barriers in the form of cost advantages and product differentiation yield an oligopoly market; however, firms monopolize their individual routes. Substitutes such as flights and cars will not be able to compete since HSR can be supplied at a much lower variable cost, and firms will effectively have nearly full control over price. Most competition between HSR firms will occur only to obtain routes, and the ex-ante market will behave much like a monopoly.
Given the limited buyers and suppliers in the market, HSR firms would look for the first opportunity to negotiate the coordination with hub airlines so that they secure the passengers who used to commit to the hub airlines.
Social Welfare Analysis : Competition between HSR and LCCs
Given the change in consumer preferences, HSR firms will not be competing to a large degree with national airlines whether or not coordination occurs. However, in the absence of coordination between HSR and national airlines, strong competitive incentives will remain between HSR and LCCs. Currently, LCCs operate using a hub and spoke route distribution(O’Sullivan, 2020). In fact, this is very similar to the route distribution of major national airlines, just on a significantly smaller scale. While national airlines maintain hubs in major international airports, LCCs maintain hubs in smaller airports far from the city centers, and theydonot operate flights on long-distance routes (O’Sullivan, 2020). Thus, LCCs operate two categories of routes. They connect small airports with big airports, and they connect small airports with other small airports.
Interestingly, LCCs are complementary to national airlines with respect to the former category. National airlines maintain a dramatic absolute and comparative advantage in terms of long-distance flights, and they are therefore incentivized to devote the vast majority of their resources in that direction. LCCs are often the only option for consumers to take mass transportation from smaller airports to larger airports. Thus, these consumers can connect on a flight with an LCC to a flight with a national airline through the major national hub. Given the comparative advantages of long-distance air travel, this option is preferable to long-distanceHSR, even for environmentally conscious consumers.
Within the second category of LCC routes, LCCs engage in direct competition withHSR. Short distance transportation between smaller markets is suited towards both markets. Additionally, since national airlines generally operate through their major hubs, they are rarely
involved in this type of route, and therefore do not particularly care about the outcome of competition on these routes. Before the change in consumer preferences, LCCs and HSR completed in this field on a somewhat level playing field. HSR provided a cost advantage, whileLCCs countered with quicker trip times and greater convenience. However, after consumers began to prioritize environmentalism, competition between HSR and LCCs on these routes tilted dramatically in favor of HSR. Since infrastructure investments by LCCs are sunk, LCCs will still generate revenue above marginal costs, but these routes are unlikely to generate revenue above-average total costs in the future. Thus, to remain viable, LCCs must be able to offset the loss in other areas.
Fortunately for LCCs, routes connecting small airports to large airports are still potential sources of significant profit (O’Sullivan, 2020). HSR is not capable of offering a competing service on these routes due to the lack of track infrastructure connecting airports to major cities. Similarly, national airlines benefit so much by cooperating with LCCs and focusing on long-distance travel that they are not incentivized to compete directly with LCCs. Even if they did, LCCs enjoy a cost advantage over national airlines. Thus, in the absence of coordination between HSR and national airlines, most LCCs will still have a path to surviving the negative shift in consumer preferences, relying on profits earned through cooperation with national airlines offsetting operating losses on routes where there is direct competition with HSR.
Unfortunately, LCCs’ path to profits with new consumer preferences becomes a lot narrower when HSR coordinates with national airlines. Under this scenario, the same market forces that gave HSR a competitive advantage in routes between small markets also give HSRasimilar advantage in routes between small markets and major markets. Additionally, one of the
few advantages that LCCs maintained over HSR was scheduling coordination with national
airlines. When national airlines instead coordinate primarily with HSR, this advantage moves over to HSR as well. Ultimately, it is very hard to see how LCCs can be economically viable with current consumer preferences toward environmentalism as well as with coordination between HSR and national airlines.
The consequences of diminishing the competitiveness of LCCs are likely to be significant for many consumers. Without competition between LCCs and HSR, and with coordination between HSR and national airlines, there is no longer significant competition on either level of the transportation market. Thus, not only can HSR charge monopoly prices for its section of the transportation market, but the HSR firm and the national airline in control of each major hubcancharge joint monopoly prices for both market levels. While the government can try to use economic regulation to discourage egregious antitrust violations by HSR and national airlines, at the very least these firms will be able to use their expanded market power to charge above what the equilibrium price would be in a competitive market.
Additionally, natural market forces pushing transportation prices higher will make it difficult for the government to identify when a company breaches antitrust law. Given that coordination between HSR and national airlines has created a joint product that concerningBecause is better than the sum of its parts, we would expect that the demand for transportation will increase. This increase in demand will lead to an increase in price. At the same time, it will also incentivize both firms to invest in increasing the capacity to meet the increased market demand. Thus, this type of price increase is actually good for national welfare, as it brings the market toward productive and allocative efficiency and eliminates the shortages that would likely develop if demand increased without a corresponding price increase.
Unfortunately, the expectation of a higher competitive market equilibrium price also camouflages any attempt by the firms to anti-competitively increase the price above the new market equilibrium to generate monopoly profits.
It is important to note that there are other, less negative economic considerations to take into account. Firstly, one of the primary motivations for consumers choosing HSR over LCCs was the price. However, taking HSR to and from major airports is even an option without coordination between HSR and national airlines (Loh, 2019). While decreasing competition from LCCs might increase prices on routes that do not connect with major hub airports, coordination allows for the existence of a lower-cost alternative on routes that do connect with major airports. Even if the price of HSR on these routes is above what it would be in a competitive market, it is still likely to be below what LCCs were charging without coordination between HSR and national airlines due to the dramatically lower operating cost of HSRcompared to LCCs.
Lastly, it is important to consider some positive externalities associated with coordination between HSR and national airlines that are good for social welfare. In addition to being inline with consumer preferences, moving away from air travel on short-distance routes is economically beneficial for the country at large. Short distance air travel imposes a negative externality on society (Timperley, 2019). While different European governments have different policies with regard to punishing pollution, no government succeeds in fully internalizing the externality into the market. Thus, allowing HSR to displace most short-distance air travel leads to positive externalities. Additionally, while not as obvious or as large as the environmental benefits, there are additional positive externalities brought about by coordination betweenHSRand national airlines. HSR is significantly more flexible and less prone to delays and cancellations than air travel. Additionally, allowing for a system in which there is explicit coordination between HSR and national airlines also allows for the creation of a more streamlined scheduling and logistical process. Thus, consumers would miss flights less often, and they would have to budget less time getting through airports (Oliver Wyman, 2019). This would have slight positive effects on a large number of industries that rely to some degree on public transportation.
At this point, we have established that coordination between HSR and national airlines leads to an increase in the quality of service provided to consumers. Unfortunately, we have also shown that this increase in quality of service will come at a cost to the consumers. This cost will take the form of an increase in the average price of transportation. Although some of this price increase is expected due to the increase in quality, some of this price increase is also due to the market consolidation necessary for coordination between HSR and national airlines. Some of these price increases above free-market equilibrium will be partially offset by positive externalities associated with coordination. However, we do not believe that these costs will be fully offset. While we ultimately believe that coordination between HSR and national airlinesisa net positive for the country, and therefore governments will approve this type of merger, we do not believe that this increase in social welfare will be evenly split by everyone. In fact, a subset of the consumer market will almost certainly experience a decrease in welfare as a result of coordination between HSR and national airlines.
Bargaining, Contracting, and Merger
In the previous sections, we have argued that HSR firms have an incentive to coordinate with airlines to design and build a high-speed rail service that directly links to destination airports. This way, high-speed rail substitutes for the domestic continental Europe short-term air routes and thus complements hub airline’s long-range routes. This newly established hub-and-spoke system with high-speed rail as a specific asset to the airlines would not only make the pie bigger (releasing more air slots for long-range, consolidating more passengers, increasing operational efficiency) but also allow the HSR firms and airlines who coordinate to extract from the slices of the pie belonging to HSR firms who don’t coordinate, LCCs, and consumers. (induced demand for hub-and-spoke transportation).
In this section, We will introduce the different ways in which this coordination can be implemented. We will organize our arguments in four areas: 1) why it is infeasible for HSRfirms to coordinate with airlines through exclusive contracting such as code-share alliances(incomplete contracting due to unforeseeable contingency and difficulty of reinforcement) 2)why it is incentive-compatible for HSR and airlines to negotiate a merger (counter-arguments around different cultures, capacity constraints, new hub-and-spokes, and low-cost carriers) 3)what effects would such a merger bring and what risks it can mitigate 4) will the government approve the merger. We are ultimately able to conclude that the airline and the HSRobtainhigher joint profits when they integrate than when they remain separate.
Considering the fact that the design-and-build market for HSR is discrete, consisting of a few possible buyers and suppliers, the airline would not consider an option to seek the high-speed rail product through the market transaction. For example, the Frankfurt airport authority would not open its coordination with several firms building several rails that have the same departure and destination as doing so would yield formidable transaction costs– separating passengers for multiple projects with large fixed costs would result in each operating at a loss (Street, 2019). Additionally, this simply represents a waste of resources, and therefore larger combined average total costs for the two levels of transportation.
A comparatively viable option would be exclusive contracting. In this scenario, the contract is exclusive in that only one HSR firm would coordinate with one airport to build the airport-linking railways. Once the contract is signed, the other firms shall neither set a station in the vicinity to the airport nor commission another railway to supply the airport, which effectively serves as an entry barrier (Lynch, 1984). Suppose Airport A is the hub that exclusively contracts with HSR α which stations at City 1 and 2. Then, the airline using A as a hub would promiseαtobe the only railway product that connects A with 1, with 2, or with 1-2 jointly.
Specifically, airlines would audit the construction of the railway, before forfeiting the routes with possible competing demands (this excludes the routes with extra demand after the HSR exhausts its seats). The airlines should also commit to forfeiting the air routes that constitute a direct competition with the HSR line. For example, the flight from A to 1 and A to 2 should be canceled to maximize HSR’s capacity, effectively transferring the customers who would take the flight to take the HSR to the airport terminal. Specifically, the service can be provided in two ways: theHSR sells seats on the train to the hub airline at a relatively low cost, and then the airline provides international connecting passengers with the combined airline-HSR service; HSRandhub airlines create a specialized business unit to offer the combined airline-HSRservice in the connecting market. Additional service may be offered to facilitate the check-in and luggage experience. Standardized lounges for business travelers, luggage check-in services, and priority boarding are provided in HSR station in 1 or 2 as well as A.
An advertisement from Lufthansa, the German national carrier, envisions a passenger frequenting between Stuggart and Frankfurt who benefits from the ticket-sharing model through exclusive contracting:
“I lived in southern Germany, and Stuttgart was the closest airport.
For an additional 1.5 hours on the high-speed train, I could reach the airport train station in Frankfurt. Stuttgart has only one route to North America – Atlanta – while Frankfurt has countless additional destinations. Many international flights from Stuttgart would first connect to a European hub and then continue to the final destination.
Lufthansa has a ticketing arrangement with Deutsche Bahn to provide train travel from Stuttgart to Frankfurt airport. When I carry my luggage, I can check in my luggage for an airline at Stuttgart. This is much faster than getting a connecting flight, it’s more comfortable, and produces far fewer emissions” (Lufthansa.com, 2017)
The “ticketing arrangement” here refers to the “Rail&Fly” product jointly offered by Lufthansaand Deutsch Bahn (DB) (Lufthansa.com, 2017). By the end of 2019, impacted by the “flight-shame movement”, Lufthansa and DB are contracting to plan to increase the capacity on key HSR routes taking place from mid-December (when rail schedules change) and involve DB services from Aachen, Cologne, Düsseldorf, Stuttgart, and Ulm to Frankfurt airport (which has its own rail station) (Orbanhttp, 2019). It means that while today there are 77 rail links betweenCologne and Frankfurt airport, this number will increase to 119 from mid-December. In the caseof Düsseldorf, the number will more than double to 105. Says Lufthansa board member HarryHohmeister, “We are committed to an efficient and sustainable network of the various modes of transport. This doesn’t just benefit our customers. It is good for the environment”(Lufthansa.com, 2019).
The case of “Rail&Fly” is a typical example of exclusive contracting in the WesternEuropean market. Unlike GM-Fisher Body, it involves not only the HSR and the airline firms but also the governmental transportation authority, who sanctions the HSR project and manages the airport as a public good (Sumers, 2020). Since most countries in Europe have one dominant airline (usually the national carrier) occupying the most pivotal airport as the hub, andonedominant operational rail service, the coordination between HSR and airlines are orchestrated by the authority (Castella, 2013). In the case of Germany, Lufthansa signed a memorandum of understanding with DB on the framework of cooperation. Then, Lufthansa, as the dominant hubairline, negotiated with the Frankfurt Airport to present the increase of induced passenger flowby building a direct HSR link to the airport. The transportation authority then sets up a nominal procurement procedure that eventually serves in DB’s favor (Orbanhttp, 2019). Althoughfinally, the HSR firm signs the exclusive contract with the airport, it ultimately engages in a two-stagecontractual relationship with the airlines.
However, this type of exclusive contracting is subject to be incomplete with unforeseeable contingencies and commitment problems, even though the government’s participation may mitigate some of the enforcement concerns.
Drawbacks for Exclusive Contracting
Exclusivity is vital to the sustainability of coordination, yet it has a big drawback: lack of commitment reinforcement mechanism. One example of the contract suffering from non-exclusivity is the TGV line between Lyon airport and Paris airport (Lyon-France, 2010). Opened in 1994, Lyon’s airport link has been relatively successful with 400,000 annual passengers, but that’s minor compared to a typical city station, such as the suburban Avignon TGVstation, which attracts 2.2 million a year.
There’s a reasonable explanation for the low ridership at Lyon: customers using the same TGV line also have a connection to Paris-CDG, a much larger airport with more flights. Three years after the construction of the Lyon-airport and Paris-airport line, the unexpected increase in demand caught both TGV and Air France off guard. Air France pushed the government to build an additional connection to Lyon and Paris-CDG, effectively making the Lyon-airport station obsolete.
Since Paris-CDG is a hub, most Lyon residents choose not to take intercontinental flights at Lyon but Paris-CDG. The two TGV stations in central Lyonare also more convenient to most residents of the region via public transportation than the airport stop. This change was profitable for Air France, as they attracted more Lyon residents tousetheir hub, Paris-CDG, instead of low-cost carriers at Lyon Airport. However, the original contract did not address the possibility of Air France’s change in adding or modifying stations after the coordinated line went operational. For Air France, the main “advantage” of theLyonAirport station is for travelers, arriving by plane, who are traveling onwards to the east (LyonFrance, 2019). Air France would gain profit at the underutilization of TGVstation at LyonAirport, through which TGV would suffer an unnecessary loss. The government enforces the nominal contract, but it ultimately sides with the airlines, which propose a more beneficial plan for the overall development of transportation. The government seeks rent from the airlines without considering HSR’s profits, making the contract commitment problematic. Unforeseeable contingencies
The unforeseeable demand might result in HSR holding up the airline’s long-range route profits . For an HSR line to maximize profit, there has to be substantial, sustainable passenger flow from departure to destination. In the earlier negotiation stage, HSR and airlines should have mutually agreed on an indexed compensation for HSR in case the passenger flow significantly changes. However, the estimated passenger flow is subject to a great variance before and after the railway is built (The Transport Politic, 2010). For example, if the increase in the demand for an air-rail ticket is higher than previously estimated, the HSR would find the indexed compensation in the contract lower than their increase of cost to arrange additional trains. Thus, they would hold up the airlines by providing inadequate carrying capacity to the airport, resulting in the airline’s loss of profit in the long-range routes. Because the airline has promised to forfeit the routes that HSR is operating, it would take them transaction cost to provide additional flights to complement the additional carrying capacity that HSR cannot offer.
The same story can go the other way. Airlines lease the slots at the hub airport at a discounted deal. In congested airlines, slots are usually limited for long-range wide-body carriers, even those belonging to the hub airline. If airlines and HSR agree that HSR can carry the full capacity, airlines would lease fewer slots for the narrow-body aircraft and more for wide-body aircraft to concentrate on the long-range markets. If there is residual demand after HSR’soperation in the short term, the only way airlines can meet the demand is to fly wide-body aircraft on the short routes, which usually can take more passengers than the neededexcess. Without a clear estimate of the airport’s capacity constraint, it would be difficult for HSR to schedule the trains that meet the passenger demand accurately without making the airline fly bite back its market share on the short route.
The airlines are more flexible/unpredictable in scheduling flights than HSR is in scheduling trains. Due to the large opportunity cost, it does not make sense for an airline to wait even a few minutes for several additional passengers (Oliver Wyman, 2019). Nevertheless, because of the long-range operational modal, long HSR routes are rarer, making filling seats worth even a modest wait. However, the short-range and frequent demand for HSRis a lot less flexible– trains have to start the exact minute. Therefore, while individual trains maytakeshorter or cost cheaper than short-range flights, they are likely to be more frequent, leveraging the cost higher for HSR to sustain cooperation. This “sacrifice” is hard to quantify or compensate for in the pre-negotiated contract. Another aspect of flexibility is involuntary, but it would also influence the unforeseeable contingency. Lufthansa expresses to the customers that the advantage of taking a rail-air link is that, should the train be delayed, Lufthansa will rebook the train ticket for passengers free of charge (Lufthansa.com, 2020).
However, in no terms haveLufthansa explicitly negotiated with DB on overpotential influx. If a stormy night delays the landing of all long-range flights, the airline would rebook a great number of passengers the train ticket. However, HSR’s short-range punctuality is not influenced by severe weather. It continues to operate during the storm for passengers who take the train only to the airport, not transit to long-range flights. Even in severe weather, its fixed cost is almost the same. However, theairline’s rebooking for delayed passengers forces HSR to arrange additional trains to the airport the other day. This only increases the fixed cost as more trains are used.
Similarly, airlines could offer frequent passengers a bonus of taking the HSR domestically even without taking the flight. This would increase their passenger base at the expense of overburdening the HSRservice–HSR would have to have more trains ready for the uncertain growth of frequent passengers., who would use discounted tickets to take HSR and use full tickets to take long-range flights. All in all, the fixed cost increase of HSR is something the airlines would not take into consideration without a merger.
The airlines also have much more flexibility in switching hub airports than railways. Thus, HSR has little information on how committed the airlines are to “split the dollar” or “stay in the game”. If market fluctuation convinces the airline to switch the hub, they can do so with less effort by flying the aircraft to a new hub. However, once a rail is built, it can only serve a specific destination– the abandoned hub. The loss of demand as a result of the fewer long-range flights would hit the HSR hard because the passenger group they rely on no longer has the incentive to take the HSR on the specific route. If this happened shortly after the HSRfirmspent fixed costs on tracks, the HSR firm would take a huge loss on the route, and it might even go out of business. Airlines can react comparatively quickly to change, but HSR is equipped to handle this type of situation. The HSR does not know what Airlines may already know, thus forcing them to employ only a recreational strategy. It also renders HSR firms unable to accurately assess whether a given track is worth the fixed costs required to build it. Given the catastrophic consequences possible, HSR firms will simply default towards not building the track under almost all circumstances. The construction of the track would require a significant fixed cost investment by one party, in this case, the HSR, while the expected profits for the HSR would almost exclusively be due to the exclusive contracting rights, without which the track is worth very little. Knowing their bargaining advantage in changing hubs, the hub airline would be incentivized to attempt to renegotiate a better contract after the fixed costs of building a railway are already invested. HSR would maintain very little leverage in negotiations because they have neither investment nor time to react to the hub change. Essentially, the airline can holduptheHSR in the second stage of construction. The consequence would not act in favor of the HSR–they may have to accept less share of the revenue or otherwise risk going out of business.
This problem is exacerbated by asymmetrical regulation of the European HSRandairlinemarkets further hampering HSR’s ability to respond to changes in the hub airline’s strategies. The liberalization of the European airline market in 1997 has set a relatively low threshold for the airlines to add, change, or modify flight routes. They hold semi-autonomy to increase or decrease the frequency, and the paperwork for the petition to the transportation department is simplified (IATA, 2018). On the contrary, the railway, including the high-speed rail, is heavily regulated as the government considers it as a public good with huge sunk public investment. A government would not approve a rail planning without an abundance of cost consideration and welfare analysis.
As previously mentioned, the government would coordinate such integration only if there is sufficient, sustainable public welfare generated from the cooperation. Otherwise, it is a better strategy for governments not to build a railway than to build an inefficient one, as this would lead to a huge waste of public funds, and likely an associated political fallout (Castella, 2013). Because airport-linked high-speed rail is a specific asset that does not have any other profitable applications, the governmental approval of its construction would likely evoke intense debate, making a final decision difficult to settle on. For example, in the planning of HS2, the national high-speed rail project for Britain, Tories advocated for a high-speed hub near Heathrow that would allow commuters from the north to make easy connections to international flights, similar to the British Airway’s advocacy.
Labor leaders, however, pronounced in their weekly report that there is no business case for a hub at the airport, and they instead suggested that train riders hoping to get to flights would be able to connect quickly enough to the Crossrail commuter rail line currently under construction (Castella, 2013). If British Airways were better by integrating train tickets into their reservation systems, people arriving at Heathrow from abroad would be able to switch easily to trains heading north to Birminghamor Manchester. But that would only be possible if HS2 is designed with airlines in mind and agreement with those air carriers. In reality, BA’s advocacy was overshadowed by the factional politics that delayed the governmental approval. Even through exclusive contracting, HSR cannot serve as an asset as specific as BA would like it to be due to the regulations. BA, on the other hand, is not likely to fully execute the terms agreed with HSR due to an unsettled approval of the construction plan.
All contingencies considered, HSR’s best strategy is therefore not to produce the track, conjecturing that airlines’ promise in shared profit is not credible. A merger emerges as the only credible commitment airlines could offer such that a railway would be confident enough to build the track, which would be beneficial for consumers, HSR, and the hub airlines.
Merger Incentive and Feasibility
There is mutual interest in the merger between hub airlines and the HSR. Apart from the infeasibility of exclusive contracting, a merger would minimize the double marginalization and maximize scheduling efficiency. A merger has a mutual interest in HSR and airlines. HSR, with an absolute advantage in the short-range, wants to increase its market share and operational profit. Hub airlines, with an absolute advantage in the long-range transportation market, want to come closer to filling flight capacities by attracting more environmentally conscious passengers to their hub.
As a result of the merger, the transportation market of Western Europe will be less segmented in terms of means of transportation. Firms will not operate in a single means of transportation. Instead, they offer joint products.
There are several sources of potential efficiency gains. The combined firm can avoid costs related to finding suppliers or customers, negotiating contracts, monitoring whether contractual obligations are being fulfilled, etc. In the case of firms selling complementary products targeting the same customers, a merger can lead to cost savings for market research, marketing and advertising, and distribution costs. This will be elaborated in the pro-competitive argument for implications of market consolidation.
The merger between the national air and rail carriers establishes itself as a mutual credible commitment. On one hand, the government still acts as an auditor and reinforcement of the internal management of the merged firm, so that the goals for profit are united. On the other hand, the merger would endogenize the rent the government seeks in developing the public good and avoid political gridlock due to the preferences of politicians to endorse either the air or rail industry.
The merger is less likely to occur between national air carriers and foreign rail carriers because the compatibility of business practice, law, management structure, and profit goals are low. Furthermore, the commitment for joint profit is not as credible because each division of the merged firm is accountable to their own country’s transportation authority. Sustainable governmental cooperation between West European countries is far less likely than the firm’s cooperation in one government. Policy adjustment in one country would result in a discoordination in the multinational firm. Therefore, since an international merger would increase joint profits less than a domestic merger, airlines will opt for domestic mergers instead.
Implications of Market Consolidation Will the Merger be Approved?
A possible outcome of airline and railway integration is reduced competition on the route following the commercial agreement between the (hub) airline and the HSR which would be the basis for airline and railway integration. This is considered the main, and so far the only, significant disbenefit of airline and railway integration (Castella, 2013).
In short-range transportation, the merger can be seen as horizontal. Because the airline withdraws a product to give HSR more market concentration, the consumers have fewer choices. This merger may also eliminate the low-cost carrier firm that played an important role in keeping the market competitive, for instance, because it was traditionally a price-cutter.
The airline-HSR merger can make successful coordination among firms more likely by making it easier to agree, monitor, or punish. First, the merged firm is predicted to have disproportionately high market share in the short-range segment of mass transportation, the regional market it dominates, usually in a country. This is due to the dual effect of thehubairline’s withdrawal of competitive routes and the consumer preference of lower-emissions HSRover low-cost carriers, as stated before. This can make it easier for firms in the industry to implicitly agree to split the market, e.g. because other firms expect that the merged firm would react especially strongly against any intrusions in its “stronghold” market. Second, as the merger reduces the number of firms, it becomes easier to check whether a firm is deviating from an agreement. Third, a merged firm may be better able to survive a price war, e.g. thanks to lower costs or greater financial resources; this, in turn, can increase the likelihood that the merged firm can successfully punish a deviant firm through a price war (Briginshaw, 2020). Therefore, it’s likely that the merged air-rail firm would increase the price for the joint ticket, which is anti-competitive behavior.
In the long-run transportation market under the hub-and-spoke system, the merger can be seen as non-horizontal. This is because HSR now can be seen as an upstream supplier of passengers taking the downstream product of long-range flights operated by the hub airlines. While non-horizontal consolidation in the market is traditionally not problematic, vertical foreclosure can present challenges to consumer surplus and potential entrants.
The merged firm makes it harder for potential or current competitors to access markets(customer foreclosure) or supplies (input foreclosure). In the case of joint ticketing, customer foreclosure could occur if the long-range airline acquires a large distributor of passengers in the short-range transportation market. The integrated firm could discourage carrying a passenger from the low-cost carriers, the competing firms, or could make it more difficult to do so by imposing disadvantageous terms and conditions, like charging the low-cost carrier passengers extra for baggage (Freemark, 2010). To restore access to these markets, competing firms would need to incur significant costs, e.g. by setting up their own distribution networks. For low-cost carriers that do not operate long-range flights, this is extremely difficult. This raises the costs of rivals and discourages entry into the industry.
Input foreclosure in the air-rail market could occur if an airline firm acquires a supplier of a streamlined scheduling technology and subsequently refuses to cross-license this technology to competitors, the low-cost carriers. This would force competitors to invest in developing their own technology, a costly and lengthy process that raises the costs of competitors, and discourages entry.
In the specific case of complementary air-rail service, foreclosure can also occur through bundling and tying (Economides, 2014). With bundling, products are sold as a package (with or without the option to buy the products separately), such as the joint ticket. With tying, customers having access to purchasing one good (long-range flight) constitutes the purchase of another good (HSR short-range ticket) from the same supplier because products have been designed in such a way that they only work when used together. Both bundling and tying are common practices that do not necessarily lead to anticompetitive consequences. However, a combined firm with market power in one product may use bundling in conglomeration effect to create a strong position in another product, in this case, using long-range flights to create strong market power in the short-range rail. In turn, this may discourage the entry of potential competitors they would now be required to invest in both markets.
For all types of foreclosure, the theoretical possibility of foreclosure does not necessarily mean it will be in the combined firm’s best interest to do so. The merged firm will need to trade off the potential loss of sales in one market (e.g. by refusing to cross-license the technology) with the potential gains in the other market (e.g. the ability to charge higher prices). However, as theEuropean non-horizontal merger guidelines point out, even the likelihood that a merged firm could engage in foreclosure may deter potential entrants (Antonov, 2020). Pro-Competitive Argument
The Air-HSR firms claim that they are motivated by expected efficiency gains from combining their operations. These efficiency gains include lower variable production costs from economies of scale or lower fixed costs by combining legal, marketing, and other “overhead”functions. One typical example of this is the reduced cost of operating air routes of redundant capacity. By consolidating the short-range market to the HSR division, the merged firm saves the cost of operating the short-range aircraft. They can concentrate on developing cost-saving strategies for the long-range routes by rescheduling flights to maximize capacity with the coordination of HSR, without worrying about the hold-up effects (Sholli, 2019). The increased efficiency and quality of the product represents the pro-competitive side of the argument.
The combined firm can avoid costs related to finding suppliers or customers, negotiating contracts, monitoring whether contractual obligations are being fulfilled, etc. A merger can also lead to cost savings for market research, marketing and advertising, and distribution costs for both HSR and airline divisions of the same firm. The joint advertisement helps reduce the overall cost spent on advertisement and increases the efficiency and coverage of advertising. Now, consumers looking for both air and rail travel are exposed to the advertisement on eachothers transportation products. The exogenous benefit of a merger in advertisement lies in the potential to attract additional demand for the joint product (Simon, 2020).
The Air-HSR firms motivate mergers by pointing to expected efficiency gains from combining their operations, such as lower variable production costs from economies of scale or lower fixed costs by combining legal, marketing, and other “overhead” functions. One typical example of this is the reduced cost of operating air routes of redundant capacity. By consolidating the short-range market to the HSR division, the merged firm saves the cost of operating the short-range aircraft (Ross, 2019). They can concentrate on developing cost-saving strategies for the long-range routes by rescheduling flights to maximize capacity with the coordination of HSR, without worrying about the hold-up effects.
The combined firm can avoid costs related to finding suppliers or customers, negotiating contracts, monitoring whether contractual obligations are being fulfilled, etc. A merger can also lead to cost savings for market research, marketing and advertising, and distribution costs for both HSR and airline divisions of the same firm.
For complex complementary products, mergers can facilitate coordination between technical experts by bringing the entire R&D or production process in-house. For instance, developing new schedules for HSR and airlines may require considerable coordination between researchers, and could be facilitated by bringing the teams together in a merged firm. The Unification of the standard ticketing system would improve the management of transportation as a whole.
An additional potential benefit from the air-HSR mergers pertains to resolving spillover problems. For instance, if an international sports event attracts a large number of consumers to take the HSR, any measure to stimulate the sales of HSR (e.g. more marketing, lower prices)would also stimulate sales of long-range flights for non-European travelers, due to unified ticketing and standardized service. Before a merger, the HSR firm would not take into account this spillover effect, as it incurred the full costs but did not receive the full benefits of its promotional efforts. A combined firm would receive the full benefits and hence would have incentive to invest more in both products.
From a strict social welfare point of view, a merger is welfare-enhancing if total efficiency gains outweigh the total efficiency losses associated with anti-competitive effects. From the government’s point of view, the merger ultimately makes welfare greater by increasing the quality of the product and efficiency of transportation management. Before that, it has to communicate and monitor two firms, but now only one, so it saves the transaction cost as well. So far, the only drawback of the merger is its damage in the domestic short-range market against LCCs.
Because of the market consolidation, HSR occupies a dominant share of the short range transit market post-merger. The effects of consumer preference and scale economies make its market power significantly greater than the LCCs if LCCs are able to remain in the market. On the other hand, the merger also leads to an increase of scope economies, withonemanagement system operating two segments of mass transportation, a combination of short range and long-range. After the government approves the merger, the merged firm would be well incentivized to increase the price for long-range flights and decrease the price for short-range trains, effectively discouraging LCC from competitive using predatory pricing. Then, as a recoupment, the HSR ticket price would also increase.
The local government is aware of this strategy. However, they would consider whether the increase of social welfare outweighs the cost due to anti-competitive behavior– the policy papers from France, Germany, and Belgium, and Switzerland all encourage citizen’s intermodal
travel and suggest “improving the efficiency of public transportation” as the foremost mission of the transportation authority (Antonov, 2020). This also has to do with their rent-seeking behavior. The government seeks rent from the merger more desperately than a competitive market. A merger between the major carriers of the nation would result in bigger corporate size and thus more proportionate taxes. Furthermore, the government’s goal for transportation is not only to satisfy the citizen’s travel needs but also to facilitate the efficient use of public transportation resources, namely the airports and HSR stations. Congestion at hub airports is one of the main reasons for intermodal cooperation (Oliver Wyman, 2019). A merged firm can decide to divert part of the short-haul traffic to the HSR division, thereby making the relevant slots available for more profitable air routes– the airport thus benefits from this merger by making a better profit out of the slots. In turn, HSR increases its load factor and market share on short-haul routes, which maximizes the use of stations.
Lastly, there is also a prisoner’s dilemma that incentivizes local governments to approve these mergers. Given how seamless international travel is within the European Union, the closest major hub airport to consumers living in one country can often be in another country. Therefore, by increasing the quality of the service provided to consumers who travel through a particular hub airport, consumers in neighboring countries are incentivized to take HSR to that hub airport, even if it means to travel to a different country. In the overlapping market with little differentiation of other sources, the local airline is then able to poach consumers fromforeignairlines, and the local government is consequently able to increase the passenger flow, attract transportation-linked investments, and collect more tax revenue from the operating profit of both divisions of the merged firm. As a result, the neighboring countries will see a corresponding decrease in the hub airport passenger flow and thus the loss in tax revenue, and the onlywayforthese countries to return to the status quo is to approve similar mergers. For example, the exacerbated worries on Charles De Gaulle Airport becoming “the hub of UKtravel” (Simon, 2020) would prompt the UK government to approve a merger that would attract Frenchcustomers to transit at Heathrow. The EU Commission lacks the legal tools to intervene inintra-national mergers as the HSR is generally regulated by the national government (Antonov, 2019). With such competition, the overall quality of service would increase for a period of time, accompanied by a sustainable increase in ticket prices. Due to the national government’s interest in gathering more rent, the Western European transportation market will be marked with quality-and price-matching behaviors among merged Air-HSR firms of different nations. The Unevenly Split Welfare
While we believe that cooperation between HSR and national airlines increases consumer welfare on average, this increase in consumer welfare is not evenly split. To sufficiently evaluate the implications of coordination between HSR and national airlines, we must identify the benefits and drawbacks of coordination, as well as how different segments of the population are affected. We have made clear that coordination between HSR and national airlines leads to a product that is ultimately of higher quality in many areas for all consumers. However, it is also the case that coordination inherently gives one firm an effective monopoly in each hub. Therefore, this firm can extract rent from consumers by charging more than the equilibrium price. For this reason, ignoring the involvement of externalities, whether or not a particular consumer gains from coordination between HSR and national airlines depends on whether they value increased quality of service more than the inevitable increase in the cost of service.
Given the nature of the benefits, business travelers almost uniformly gain from coordination between HSR and national airlines. It is a known fact in the transportation industry that business travelers have a significantly lower price elasticity of demand than leisure travelers(RSS, 2015). Business travelers rarely spend their own money on transportation. Additionally, the value of time and convenience is significantly higher for business travelers, and they will, therefore, spend significant amounts of money on seemingly small quality increases. The entire existence of first-class seats proves that this is the case. Moreover, HSR is significantly more flexible in its timing than air travel. HSR is therefore significantly easier to book on the spot, and it is more likely than short-distance air travel to be available at a given time of the day
(O’Sullivan, 2020). Since business travelers often need to coordinate trips on short notice, these aspects of HSR are disproportionately beneficial to them. Finally, HSR is much more reliably time than air travel. This helps business travelers avoid the large costs associated with missing connecting flight on the way to a meeting.
Unlike business travelers, leisure travelers are very sensitive to changes in price and are often willing to sacrifice convenience for cheaper prices. At the same time, leisure travelers certainly prefer HSR to LCCs for both economic and environmental reasons. Thus, leisure travelers do benefit from the displacement of LCCs by HSR in transit to and from major hub airports. However, while business travelers often take long-distance trips that require transportation on these routes, leisure travelers travel much more infrequently and skew towards shorter routes where HSR was already available. Therefore, leisure travelers have to deal with inflated HSR prices even though they rarely even use the routes created through coordination with national airlines.
Additionally, many of the quality increases associated with coordination matter a lot less to leisure travelers than business travelers. Since leisure travelers travel less frequently and care more about cost, they often book transportation far in advance and careless about wasting transportation time. Thus, reliability and flexibility gains are less significant for leisure consumers, as is coordinated scheduling and logistics. Some leisure travelers who often travel through major hub airports will undoubtedly gain from coordination. However, most will likely see a decrease in their individual welfare. Ironically, given that changes in the preferences of leisure travelers created the incentive for coordination, the welfare gains to leisure travelers are far more inconsistent than the welfare gains to business travelers. In many cases, they’re simply nonexistent. While the leisure travelers mainly cast a vote of confidence on the HSR, they ultimately cast their own loss of surplus from the merger.
“There are no permanent enemies, and no permanent friends, only permanent interests.”This sentence accurately captures the evolving mass transportation market in Western Europe. In This paper, we demonstrate that a change in social thought influences the consumer choice of vertically differentiated products, HSR and flights, turning their substitutability complementarity with the hub airlines’ hub-and-spoke model. We analyze the strategy behind coordination between HSR and hub airlines against the short-range flights by the Low-Cost Carrier. We also examine their incentive compatibility constraint in the planning and building a high-speed rail that directly links to the airport, concluding that a merger is the only viable and sustainable way for hub airline and HSR firms to cooperate. From the Industrial Organization Perspective, we also probe into different arguments on whether the merger would be approved, and ultimately endorse the merger due to governmental interests in social welfare. In theory,a merger could, therefore, increase social welfare while simultaneously hurting a segment of customers.
The limitations of this paper include the lack of nuance in analyzing the consumer surplus for airports with and without capacity constraints. The paper also doesn’t adequately address why the code-sharing model between airlines cannot be suitably and sustainably applied to their HSR model. Because of the lack of quantitative data, the evaluation for the feasibility of a merger stretches a bit thinly. The industrial organization of the internal government is also not taken into consideration in analyzing the prisoner-dilemma portion of the predicted implication. Future analysis will nuance the scheduling negotiation, price conjectures, and welfare enhancement issues.
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High Speed Rail Europe : High-Speed Rail’s Competition, Coordination, & Potential Merger with Major Carrier Airlines in the Western European Market Written by Haoran Tong
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