Saturday, March 10, 2007

The Price of Airline Safety

by Berly

We at kaFE depok rarely post on actual events. Maybe since most of us are students so we are more exposed to methodological and theoretical aspects of economics while the daily experience are more in contact with European livelihood.

But the recent Garuda accident in Jogja definitely worth a mention. It took away the sense of security in domestic flying. Almost as if we found out that some of Blue Bird drivers are criminals. Previous accidents are all occurred at private and budget airline, thus critics pointed out for a supposed link between low ticket price and flight safety.

Not anymore. Garuda is definitely not selling the cheapest ticket for Jakarta-Jogja route. So finally people (hopefully) can disentangle price from safety.

Is it really cost that much to apply safety measure? In the short run it will cost more but with low reputation of safety then there will be less people buying the ticket meaning less revenue. The first question is within subject, mean one company applying two different treatments. The second question is more tricky, will airline with better safety have higher ticket price?

The answer is not necessarily. Ryain air is the top budget airline in Europe with the chepest price that could range below 10 euro (before airport tax) if you ordered one month or more before the flight. Yet, it obtained high profit (329 million euros in second half 2006) and very high passenger (more than 750 flights a day) with no recent history of accident. The safety record of other main budget airlne (EasyJet, AirBerlin, TransAvia) are also very good.

An efficient airline can deliver high safety and low ticket price. Many cost items can be cut. Food on the plane? just unbundled and sale to those willing to pay. Flight entertainment and free goodies? Forget it. Personnel? Make those pretty air steward served double duty at ticket counter in the airport before take off. Revenue? Institute a dynamic ticket pricing where those that buy ticket earlier (thus having lower opportunity cost of time and value flexibility less) to get it at lower price. Today Ryanair even charge if we check-in luggage in additional to cabin luggage.

So should we all sit down, calculate the expected probability accident and risk premium we are willing to pay for safety? You could, but the complexity of the calculation, technicality of safety procedure and the possibility of death certainly raise some difficulties.

This situation resemble asymmetric information problem where the customer know less about a product than the sellers. Since the effectivity of setting up a mechanism design and incentive compability constraint is in doubt, the remedy would be to increase information flow.

EU has an agency that empowered to conduct random safety check of airline and then rank them accordingly. Those with unacceptable lowest will be ban from Europe sky, meaning huge loss of revenue while the low-but-still-acceptable airline is given warning. More important, the ranking are post online and quoted by major newspaper (to read more click here, here, and here). The concept has many similar with rating agency such as Moody or S&P. Thus, the low rank should provide premium (lower ticket price or more perk) to be selected. Equipped with the information; customers are free to choose among airlines.

So what we need is an Asean-wide agency, staffed with prffesional from all over Asean with similar responsibility as in EU. A national agency would be more susceptible to political pressure and bribe and high safety country would raise the standard due to reputation confern. Of course, there should be sufficient salary for the inspector, monetary incentive if they found security flaw and severe punishment for bribery. There is already Asia Pacific branch of International Civil Aviation Organization that can serve or assist the embryo of such agency. Who said economist always dislike regulation and against government role?

*** update:
The article has been published in Paras Indonesia with minor modifications (to read click here)


The Dreamer said...

Well done

anymatters said...

If we're talking about the severity and probability of accident, we consider an insurance premium which is nothing to do with the airfare.

This may impact the cost of travel and life insurance premium for Indonesians taking into account the frequency of flights.

berly said...

just keep reaching for the unreachable dream :-D


I dont explicitely include insurance in the post for simplicity.

Airlines purchase insurance (I think they legally obligated to) for their airplanes. If the objective and credible safety rating exist, then insurance companies will tie the premium to the rating just like in the financial market.

Therefore, less safe airline will have to pay higher insurance fee which will result in higher ticket price (ceteris paribus). Thus, internalize (some of) the externality and give incentive for airlines to tighten safety procedure.

anymatters said...

I'm not sure if premiums are part of production costs in pricing strategy. However, if premiums could be included as fixed costs, it should be part of pricing strategy. Then, the airfare could be higher.

Anyway, by buying insurance, the airlines still normally hold their profit margin in case of accident. Even at the same level of airfares, the losses will be covered.

Some good insurance may cover post-hoc losses, meaning to cover some losses occured after the accident (in a prolonged period).

johnorford said...

I think the the point overlooked by the Indonesian airline industry is not necessarily the "cost" of safety, but the value created by safety.

Imagine the premiums that could now be demanded by an Indonesian carrier which had an excellent safety record.

Hopefully airlines will realise this now!

Berly said...

Insurance companies' profit are directly related to accident probability and insurance fee. With a credible safety rating in place it is not too much to predict that they will try to (at least) equalize the expected cost and expected benefit (insurance fee). Therefore the less safe airline will pay higher insurance fee which result in higher operating cost. Thus, internalize the externalities and provide market incentive to increase safety.

I completely agree with you. In a way Garuda (before the accident) was able to justified their higher price due to better safety. Indonesia urgently need a credible safety rating agency.