As I am writing these lines, the commercial airline industry finds itself in the middle of the deepest crisis it has ever faced. The Covid-19 pandemic and the subsequent severe travel restrictions that have been introduced by governments to attempt to limit the spread of the virus have yielded a drastic reduction in passenger air travel volume across the world. According to IATA estimates, 2020 passenger volume was around one third of that in 2019, and a recovery to the level of the last full pre-pandemic year is not expected until 2023. In many places, commercial aircraft in-flight have become a rare sight. Today, in Singapore, where I am currently based, Changi airport handles fewer than 10 per cent of its pre-pandemic flight volume. The increase in air cargo business has not for most airlines been enough to offset the revenues lost due to the drastic fall in passenger operations. Some of the smaller carriers have disappeared. Most larger airlines have been kept afloat through government assistance.

It goes without saying that in this second edition I will have to discuss the impact of the Covid-19 pandemic on the aviation sector. Some experts and commentators are suggesting that the pandemic will change the airline industry “forever”. I am more inclined to subscribe to the view that most of the effects of this disruption will dissipate within the next decade. Perhaps a subsequent edition of this book will be able to answer that question definitively.

It is important to note from the outset that this book is not about the impact of the pandemic on the airline industry. It is a book about the economics of the aviation sector, with the emphasis on airlines. The pandemic – or any other large-scale external shock – will not change the underlying economics of the sector. Moreover, a clear understanding of the core economics of airlines will help us understand and potentially predict the effects of the pandemic on the industry.

Aviation facilitates trade, plays an instrumental role in the development of tourism, and provides employment to millions of people. At the same time, airlines have traditionally been viewed as national symbols, which has resulted in heavy regulation and significant artificial barriers to competition, even in such otherwise open and developed economies as the United States.

One of the longer-term trends in the airline industry has been towards cheaper airfares. As we can see from Figure 3.1, between 1995 and 2019 inflation adjusted average airfares in the US market have fallen by nearly a third. The second quarter of 2020 (the first full quarter of the pandemic and the latest for which the data are available at the time of writing) saw average airfares drop by $100 (or over 25 per cent) in real terms as compared to the same quarter of 2019, reflecting precipitous fall in demand for air travel.

The other well-known feature of airline pricing is that airfares tend to be very dispersed. In an earlier study, Borenstein and Rose demonstrated that fares paid by two randomly selected passengers on a flight will be on average about 30 per cent apart (Borenstein & Rose 1994).

So, how do airlines come up with those fares? Why do prices change so often? Will I necessarily pay less if I book well in advance? Has the passenger sitting next to me paid more or less than I did? How can a flight be “overbooked” – is the airline not aware of how many seats there are on its planes? Why can't I get a refund if I am unable to travel? These are questions I suspect we’ve all asked ourselves. In this chapter, I will try to provide some answers, and more generally explain how an airline sets its prices.

The pricing system used by airlines is complex. This complexity is driven by the characteristics of the product the airlines sell, the heterogeneity of the airline's customers (i.e., leisure versus business travellers), and the need to fill up as many seats as possible to take advantage of economies of traffic density. Recall that the concept of economies of traffic density refers to the fact that per passenger costs are lowest when the flight is full. The pricing systems used by airlines are known as yield management (YM) or revenue management (RM) systems. Throughout this chapter, I will be using these names and acronyms interchangeably.

A short history of liberalization of international markets

To understand international aviation, it is important to realize that for many governments (and indeed for some citizens) an airline based in the country is more than just a firm. It is an embodiment of a country's prestige and a source of pride. While many governments no longer view their airlines as national symbols akin to their flag (there is a reason why national airlines have traditionally been called “flag carriers” in the industry jargon); for many countries this is still effectively the case. And what do you do with a national symbol? You take pride in it, and you protect it.

The fact of the matter is that the airline industry, the very purpose of which is to facilitate international business, connect people, and make the world a more accessible and more open place, has itself been, and to a substantial degree still remains, subject to some of the most bizarre restrictions to competition ever invented. It is true that regulation, protectionism, restriction of foreign firms’ access, price controls, and other restrictions to free trade have not been confined to the airline markets. And furthermore, until the late-1970s government intervention was the name of the game in many industries, both domestic and international. Many key companies in different industries were regulated monopolies, some government-owned, their market position protected by law – one need only think about AT&T in the US and the railways in Britain. In the 1960s and 1970s, the list of such protected monopolies was rather long.

To understand the regulatory environment in the airline industry, especially on international markets, we have to go back to the 1920s. The Kelly Air Mail Act of 1925 was the first piece of regulation in the then nascent airline industry. The idea behind the Act was to protect the infant industry by awarding private airlines government contracts to deliver mail at regulated rates. The Civil Aeronautics Act of 1938 effectively established regulation on the US domestic inter-state airline markets – this regulation, with a number of changes, was in place for the next 40 years, until the Airline Deregulation Act of 1978.

How airlines manage their fleet

The average age of a passenger car in the United States is about the same as the average age of a commercial aircraft employed by the US airlines – about 11 years. On UK roads, the average age of a car is almost eight years old, while for a British Airways aircraft it is over 13 years. It is very common for aircraft to fly in commercial passenger service for 20–25, and sometimes even up to 30 years. And the end of commercial passenger service does not necessarily mean the end of the life for an airplane – many are converted into freighters and/or continue flying in less developed countries.

Aircraft are the most important and valuable assets an airline has (some argue that take-off and landing slots at some congested airports could sometimes be even more valuable, but this would represent an exception rather than the rule). As aircraft are a durable asset, they can be purchased at either primary (directly from the manufacturer) or secondary markets. Alongside the airlines, many of the commercial aircraft are owned by leasing companies, who then, as the name suggests, lease planes to airlines in return for a monthly payment. The largest such company, called AerCap, owns nearly 1,000 aircraft and works with over 200 customers. By comparison, Delta Air Lines, one of the world's largest airlines, currently has 953 aircraft in its fleet (380 of which, according to CAPA, are inactive as of March 2021 due to lower demand).

Clearly, airlines put a lot of effort into fleet planning. The first decision an airline has to make is on fleet composition – how many aircraft types to have, and how many planes of each type should be in the fleet. This decision is driven by the types of markets the airline serves or plans to serve versus the characteristics of different aircraft available. The airline then needs to decide how to finance the aircraft. Options range from using available cash on hand to loans and leases. The general trade-off here is that while leasing tends to be a more expensive option than debt or equity financing, it also provides for more flexibility.

While air and noise pollution represent a small fraction of total aviation related costs, these issues are often very controversial and visible. Aircraft noise frequently becomes a key issue in airport construction and expansion debates, despite considerable improvements in technology that have made aircraft much quieter over recent decades. An attempt to include aviation into the EU Emissions Trading Scheme from 2012 has met considerable resistance from US and Asian governments, leading to the EU limiting application of ETS to aviation to only intra-EU services.

While being responsible for under 3 per cent of the global CO2 emissions, aviation receives more than its fair share of negative publicity for its contribution to the global greenhouse gas (GHG) emissions. On the other hand, the fact that aviation is one of the very few industries that have, at the global level, made clear commitments to reducing its carbon footprint, gets undeservedly overlooked.

Air and noise pollution, as well as greenhouse gas emissions are classic examples of negative externalities, just like congestion, which we discussed in Chapter 9. Therefore, mechanisms to tackle them include quantity restrictions and/or pricing. In this short chapter, I will be focus on those mechanisms rather than on the details of various air quality and noise restriction standards in effect in different jurisdictions – even though I will provide some examples.

A rather important difference between air and noise pollution is in the extent of their effects. Air pollution has both local and global effects: while aviation clearly affects air quality near airports, pollution generated by aviation activity also contributes to man-made climate change. As such, tackling air pollution generated by aviation requires a concerted global effort – something that is unfortunately largely missing, as I will discuss later. Effects of noise pollution, however, are largely localized on a relatively small number of households. For example, for the last 15 years I have been living within ten miles of airports handling millions of passengers annually (Orange County airport in California, Newcastle International in England, and now Singapore Changi), yet my exposure to aircraft noise pollution has been minimal, as I have lived away from flightpaths. Aircraft noise does however become a controversial issue (and often an important obstacle) in major airport expansion projects.

What are airline alliances?

As extensive as some of the airlines’ networks have recently grown, there are still many city-pairs, travel between which will inevitably require a change of carrier. I travelled regularly on one such route during my graduate school years. At that time, no single airline could take me from Kyiv, Ukraine (this, not Kiev, is the correct Ukrainian spelling of this city's name) to Tucson, Arizona. I could, instead, travel to Phoenix – British Airways could take me there all the way from Kyiv with an overnight stay in London, and Tucson is only two hours’ drive from Phoenix Sky Harbour Airport. But when I chose to travel to or from Tucson, I had to switch airlines along the way. That is when I first learned about airline alliances, codesharing, and other interesting practices. I ended up writing a good chunk of my doctoral dissertation on this very topic.

The jargon for a trip requiring a change of operating carrier is an interline trip. Interline trips can be tricky for both the passenger and the airlines involved. For the airlines, there are two main issues: how the revenue is shared, and who is responsible for getting the passenger and their luggage to the destination in case that interline connection does not go smoothly. The passenger will of course worry about missed connections, and hope that the luggage will show up at the destination (sometimes the passenger will have to collect the luggage when making the connection). The passenger's biggest worry is of course being stuck at an intermediate airport with no airline willing to take responsibility for his or her onward journey – something that nearly happened to me on my very first trip to the United States.

Interline trips existed before the age of codesharing, alliances and joint ventures. Furthermore, passengers still successfully interline between carriers outside alliances, as well as between airlines belonging to different alliances. Airlines have defined fares they will charge other carriers for accepting such interline passengers. International Air Transport Association (IATA) operates a clearing house that handles financial transactions relating to interline passengers, making sure that everyone gets paid their due.

How do firms compete?

Competition is not a very straightforward concept to define. One can think about markets being competitive if market players actively work to attract consumers via low prices, and periodically launch price wars. However, price, or rather airfare in our case, is just the beginning of the story. Firstly, as already noted, the full price of travel includes not only the monetary expenses, but also expected schedule delay. So, an airline offering five flights per day may end up offering an average passenger a “cheaper” product as compared to a carrier who only flies once per day, even if the latter airline's airfare is lower. A business traveller taking a late afternoon flight with the former airline instead of waiting until the following day to return home with the carrier offering less frequent service may be more than happy to pay higher airfare for a more convenient schedule.

Economists think about any product or service on a market as possessing three key characteristics relevant to analysis of competition: price, location and quality. The latter two terms are broader than just physical location or things we usually associate with quality (such as how luxurious, safe or durable a product is). While location can indeed represent a physical place (e.g., a supermarket's address), it can also signify other product characteristics (such as cocoa content in chocolate or colour of a car). Product quality can indeed include durability, safety, refund conditions, customer service, or even such intangible things as brand reputation.

There is however one major difference between the notions of “location” and “quality”: when prices are the same, different customers will disagree on their ranking of products or services with different “locations”, but not with different “quality”. Other things being equal, I prefer buying my groceries in a supermarket that is most easily accessible from the place where I live (which might not necessarily be the closest in terms of distance from my home). And since people live in different locations, they will inevitably disagree on which supermarket is the most convenient for them. I prefer dark chocolate, while my children will only eat milk chocolate.

Positive effects: what are they and can we measure them?

In this chapter, I will examine the benefits of aviation for regional development. For an economist, addressing this issue involves answering the following three questions. First, what is the nature of the benefits? Second, how can we measure them? And third, should the government intervene to enable those benefits where the market is unable to do so? The first question is a rather multi-faceted one: certainly, removing aviation activities from the economy would be like removing a vital organ from the body – the world would have to change fundamentally to adjust. If one takes this view, then thinking about the economic benefits of aviation activities becomes a rather pointless exercise, similar to trying to measure benefits of lungs or liver to an organism. Since the start of the pandemic, we have seen how devastating cessation of international air travel can be, especially, for those countries that rely heavily on inbound tourism to drive their economy.

When economists think about the nature of economic benefits, they usually talk about the incremental effects of aviation activity on the economy. Bringing a point-to-point low-cost carrier to an island airport will generate more tourist traffic, giving a boost to the island's economy. Adding a network carrier's service from a regional airport to a major hub will make it easier for local businesses to connect to the world, generating more business activity, and increasing both imports into and exports out of the region. Improved connectivity from a local airport will increase attractiveness and competitiveness of the region as a place to do business. These are just some ways aviation activities can benefit regional economy.

Whatever the mechanisms behind the positive economic effects of aviation, measuring them is a non-trivial data analysis exercise. We all know that correlation does not imply causation, but when trying to measure the impact of aviation on the economy from the data available, even understanding the direction of causality is not easy. Do businesses come to an area because it is well-connected to the world through a local airport, or does aviation activity grow because of the growth in the regional economy?

The excitement of attending a first football match is ingrained in the memory of many fans. They can recall the details of the journey to the ground, who they were with, the merchandise and food being sold outside and the feeling they had on entering the ground for the first time. They can remember the match itself, the emotional involvement of the other spectators around them, the singing and the chanting. I recall catching the number 53 bus from Plumstead Common at the age of six with my parents, walking with the crowds through Maryon Park and standing on the huge East Terrace at The Valley, the home of Charlton Athletic.

For many fans, that first experience begins a lifelong commitment that becomes an important part of their identity. Going to a match is not simply a release from the pressures of everyday life, important though that is, it also represents an opportunity to connect with an extended football family. This may include generations of the same family and old school friends. However, it may also involve “football friends” with whom the only contact is at the game, for a drink beforehand or afterwards. I frequently make the two-hour journey to attend Charlton home games to meet football friends in my birthplace of Greenwich for brunch and a pre-match pint.

Even if after moving away from the club's location, a fan's continuing support for their team can be a means of maintaining and reviving their connection with an area familiar to them. Topophilia, a love of place, and the cultural identity associated with a place, can be a powerful force. Of course, in some ways this is a nostalgic and sentimental interpretation, or at least a constructed version of the experience of football. Many fans never visit the ground of the team they support and simply follow their progress on television and social media. Football is now a global game with supporters of leading teams located all over the world. Inevitably this leads to a tension between a club as a global business, perhaps with foreign owners, and the idea of a club as an expression and embodiment of a particular community.

The most consequential foundational contribution of the Ostromian research program to the field of public administration is the effort to introduce the apparatus of modern “political economy” to the core of the field. The other important contributions to the theories of governance and public administration are, in one way or another, based on, or derived from, that. Following the evolution of public administration as a field, and its relationship with economics since its inception in Woodrow Wilson's effort to institutionalize the new discipline, one realizes that the Ostromian perspective was a turning point. The Ostroms pushed for a change of paradigm, as the main advocates in the field of public administration of the public choice revolution fuelled by scholars such as James Buchanan and Gordon Tullock in the 1960s.

Public administration and political economy developed as two distinctive domains and traditions. Yet, with the burst of the public choice movement in the academic arena in the 1960s, a convergence takes place. Elinor and Vincent Ostrom's contributions emerge as uniquely important in this respect because the two Bloomington scholars were the unquestionable architects of the intellectual junction point. Working in both traditions – public administration and public choice – they created an entire research program aiming at their integration (Aligica 2015; Aligica & Boettke 2009). The attempt to promote public choice as the theoretical foundations in public administration, and public administration as the applied domain of public choice is undoubtedly a major contribution of the Ostroms to both the foundational and the applied social sciences in the twentieth century.

By the beginning of the 1970s Vincent Ostrom recognized an acute “intellectual crisis of public administration”, which created the conditions for a potential new start and a novel approach. The Ostroms’ alternative was to use the new theory of public choice as the foundational theoretical framework for public administration:

In November 2020 the chairman of the EFL, Rick Parry, said that partnerships with betting companies were worth L40 million and an immediate ban would be “potentially catastrophic” (Off the Pitch 2020). His statement emphasizes just how reliant football clubs have become on their financial relationships with betting companies, a relationship that has attracted increasing criticism from advocacy groups and the media and attention from government.

An activity that at one time was seen as a source of innocent pleasure, betting is now recognized as potentially harmful and addictive. Like smoking, alcohol addiction and sugar, betting has become the focus of increased government regulation on its marketing, advertising and tax in recognition of the social harm it can cause (Grant 2018: 52–6). Industries that face such criticism often try to head off direct government intervention by trying to make a case for self-regulation and voluntary levies based on partnership with government. Responsibility for reducing harm, they argue, should rest with the individual addict rather than the industry or society more generally.

The betting industry's political vulnerability was apparent with the success of the campaign against fixed odds betting terminals (FOBTs). Campaigners against them described them as the “crack cocaine” of gambling, arguing that the quick-fire plays and the high stakes involved encourage customers to chase losses. The gambling industry argued that use of FOBTs could be a symptom rather than a cause of problem gambling. The government secured substantial tax revenues from the machines while the industry claimed restrictions on the machines would result in the closure of betting shops. Despite the efforts of the industry, the advocacy campaign was successful and the maximum stake was reduced to L2 (Grant 2018: 56–60).

There has been a long relationship between football and betting. At one time the football “pools” were a significant part of people's lives in the UK. “As late as 1998, 34% of all adults were players” (Forrest 1999: 161). Coupons would be carefully filled in seeking to predict draws, later score draws, in the hope of winning a life-changing prize.