There has been a lot of anger over air fares in recent months. Everyone has a horror story to tell.

So the government has started intervening. On some routes fares have been reduced very considerably.

Airlines, meanwhile, are unfazed. It’s all a question of supply and demand, they have been saying.

The citizens are therefore justified in asking when supply will catch up with demand. After all, India’s airlines have placed orders for over 1100 aircraft deliverable over the next 5-7 years.

Two of these airlines account for over 90 per cent of market share.

In other words, we have a duopoly. Is this a good thing or bad? Will price gouging stop?

The answer depends on how well you understand the economics of aviation or, for that matter, of all capital intensive businesses. Most people don’t.

They think the higher the competition, the better it is. Nothing could be further from the truth.

I have argued for long that the degree of competition in an industry must be inversely related to its capital intensity. That is, the higher the capital intensity the lower must competition be because otherwise, as the airline industry’s returns show, bankruptcy becomes a regular feature.

It’s no coincidence that the decadal return in the airline industry hovers between one and two per cent and airlines keep going out of business.

The ideal market structure for a capital intensive industry is a monopoly. Take, for example, the Indian Railways. They have, for decades, managed to increase output while keeping fares affordable.

There are two reasons for this. One, the Railways are a public sector monopoly. And two, because of this, they are heavily subsidised by the taxpayer.

That sounds terrible except that when you start counting the economic, and not just the commercial, outcomes of the subsidies they are absolutely worth it. The role that the Railways play in national security alone makes the subsidies worthwhile.

In any case, just see what’s happened to the countries that broke up railway monopolies. It’s not a happy sight.

It’s exactly what’s happening to the airline industry in India: lower availability and higher prices.

The lesson

Remember, as long as Indian Airlines was the only domestic operator and Air India the only international one, both airlines were doing better than after aviation was liberalised in 1993. Then both went bankrupt rapidly. As did many other airlines.

The same thing has happened to telecom also: we now have a duopoly. It is a capital intensive industry and we allowed too much competition. All but two service providers have now vanished.

Duopolies have been studied by economists for a very long time. They are a special form of oligopolistic competition, which is defined as a market structure where there are more than just one player.

Unfortunately, in India, aviation policy has been informed more by fads, fashions and political corruption. Simple economics has always been given short shrift.

Eventually, however, the market has achieved what policy could have from the start. In the intervening period, a huge amount of capital has been destroyed.

Truth be told, policy makers should only choose between the type of duopolistic competition that suits us best. And here the choice is quite clear. The two firms can either choose price competition or output competition. I think Air India and IndiGo have chosen the latter because while price competition has a downward bias, output competition has an upward one.

Network economics

But regardless of the market structure, there’s another aspect in transport economics which determines efficient outcomes. This is that all transport, the moment you connect more than two points, is about networks.

And when you have networks you don’t, or shouldn’t, look to maximise profits. The effort must be to maximise revenue. The firm that can do that at the least cost is the more successful one. Costs are thus critical in the airline business.

Furthermore, revenue maximisation in a network necessitates cross subsidisation between routes. As long as we had monopolies this was done via the A, B and C category routes.

Those categories have gone now but the cross subsidies remain — but in the opposite direction. Instead of high density routes subsidising the low density ones, it’s the low density ones that are subsidising the high density ones.

The reason is high competition on high density routes and network revenue maximisation. A duopoly can end this but that requires a varied fleet that is suitable for the routes being flown. It makes no sense, for example, to fly an A320 on short distance flights.

There is much more to be said on this subject but here suffice it to say that hopefully Air India and IndiGo will work towards acquiring smaller aircraft, too. Maybe they are already doing this.

In India, aviation policy has been informed more by fads, fashions and political corruption. Simple economics has always been given short shrift