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Friday, June 30, 2017

What happens to private airlines when Air India is privatised?

by Ajay Shah.

What's the impact of privatising Air India upon the rest of the domestic airline industry? Some think that the capital stock of Air India will now be put into more capable hands, and that will intensify competition. Instead of a feeble competitor with assets of Rs.546 billion, we'll have a strong competitor wielding those same assets.

The `zombie firms' literature helps us think about this. A zombie firm is one which ought to go out of business, but is artificially kept on life support. Sometimes, the subsidy is explicit, such as the fiscal injections into Air India. Sometimes, the subsidy is less visible, such as banks extending additional capital to bankrupt firms. Regardless of the method adopted, the basic fact stands: A firm that ought to have gone out of business was given a subsidy through which it sold goods at below cost.

To fix intuition, imagine a market price of Rs.100. Imagine a weak firm that, on its own, is only able to produce at Rs.110. This firm ought to rapidly vanish. But instead, it's given a subsidy of Rs.11 (either by the government or by banks) and it manages to sell at Rs.99. This keeps it going. This also harms the healthy firms in the industry, who have to deal with competition from this dead man walking.

Turning to Air India, in 2014-15 the firm produced a profit after tax that was -28.4% of total income. For each Rs.100 of total income, there was a loss of Rs.28.4. The overall industry was at -11.7%, and the industry average was dragged down by Air India which is a substantial player.

The presence of zombie firms harms healthy firms. It's hard for a healthy firm to compete against one that's getting a subsidy. By this logic, the exit of a zombie firm is good news for each firm left standing in the industry.

If one of the incumbent large Indian airlines buys Air India, the combination will have significant market power, which would be a suboptimal outcome. It would be nice, from the viewpoint of competition policy, if a new player buys Air India. In either event, the low and subsidised prices charged by Air India will end. This will improve the profitability of the domestic airline industry. All healthy firms benefit when we address the problem of zombie firms.

Air India's privatisation is an interesting milestone where we may see some of these effects play out. The issue of zombie firms is, of course, present in many parts of the Indian economy. We have a peculiar arrangement where zombie banks keep zombie firms alive. Disrupting these arrangements holds the key for starting India on the next bout of growth.

1 comment:

  1. While it is interesting to consider Air India as a zombie firm, another angle may also be looked at. Given that airlines have a huge fixed cost in terms of leased/bought aircrafts, it might also make sense to keep the firm operating as long as the operations are covering the variable costs (and a bit more) while generating overall loss. This doesn't need subsidy as long as it happens for a short while. But AI was perennially making loss and needed subsidy. Air India was considering returning many leased aircrafts (to decrease fixed costs) during that period. I am not sure what happened to that move later on. A good analysis would be to see what happens when we combine a big operator like AI with huge fixed assets and slender operating margin, with another firm. If the buying firm has lesser fixed assets and more operating margin (Indigo?), wouldn't it be a good match, save for monopoly concerns? I am not sure.
    And being a (forced) frequent traveler on AI, I must say that AI is anything but cheap on most routes despite all the subsidy it enjoys.

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