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Holding Up an Airline

by Brian Viard

February 24, 2014

Pilots from istockphoto-Resized

The peculiar problem of pilot scarcity in China might be resolved with simple economics.

From 1968 to 1973 US commercial airliners were skyjacked nearly once a week disrupting the aviation system.[1] Increased security measures eventually reduced such events to a rarity; but in China there is a different kind of hold-up problem disrupting airlines and their employees. Airline pilots recently began a petition drive asking the government to remove restrictions that prevent them from switching employers. The pilots want to get out of their existing employment contracts and move to a different airline offering a higher salary or better working conditions. In 2005, the Civil Aviation Administration of China, which regulates civilian airlines in China, enacted rules that make it difficult for pilots to switch airlines. At the same time, no rules exist that govern pilot resignations.

Since rules on leaving are unspecified and the large airlines in China are all state-owned enterprises, the airlines effectively veto pilots’ requests. The airlines usually respond to pilots who attempt to end their contracts by suspending their work and pay and withholding their licenses so that they are unable to fly for another airline. It is estimated that 200 to 300 pilots may now be in such a position. In addition to the petition drive more than 1,000 lawsuits concerning pilot resignations have arisen since 2005.

The case of pilot Zhao Hong–one of the main petition sponsors–has attracted particular attention and illustrates the issues. Zhao attempted to resign his position with Air China three years ago. The airline rejected his resignation, prompting Zhao to file a lawsuit and help start the petition drive which as of September had over 400 signatories. He may soon finalize his departure through mediation with the airline but some outstanding issues remain.

Although the immediate conditions for these conflicts are straightforward, there is a deeper economic issue at play. The immediate conditions are caused by the tremendous increase in air travel demand within China. This has increased demand for pilots and their pay. Pilot scarcity increases airlines’ desires to retain pilots and simultaneously encourages pilots to shop around for higher-paying jobs at rival airlines. Private, start-up carriers like Spring Airlines who have no pre-existing pipeline of pilots pay above-market salaries exacerbating the problem.

But a deeper force underlies these immediate triggers and will shape the labor market for pilots over the long run. This is what economists call a “hold-up problem”. Like skyjacking, an economic “hold-up problem” harms both airlines and their employees. The key is that it takes a lot of time and money to create a seasoned pilot–especially one seasoned enough to captain a plane. It is estimated to take a decade before a pilot has accumulated the requisite flight hours to become a captain and this costs an airline $200,000. Since only a captain is allowed to command a plane, one is required for each flight. With estimates that China’s aircraft fleet may triple in the next two decades, that is a lot of captains. Although the number of domestic pilots has quadrupled since 2000 most of these have not yet made it to captain. The resulting shortage has prompted some Chinese carriers to hire foreign pilots at salaries above those in the US.

How does this create a “hold-up problem”? The airline’s worry is that once they have invested in training a captain, the pilot will move to a competing airline offering a higher salary. The other airline can afford a higher salary because it does not incur the training costs. This is called the “hold-up problem” because the pilot, once trained, can demand a higher salary threatening to leave for a higher salary at another carrier. This makes it sound like the pilot is the bad guy but that is not the case. When a “hold-up problem” occurs it is bad for both sides. The problem is that the two parties would like to cooperate but may refrain from doing so for fear that they will give the other party greater bargaining power. The airlines know that they will be taken advantage of once they invest in training a captain and will therefore be reluctant to invest to begin with. This is also bad for pilots because they need airlines to invest in their training.

Markets are usually able to solve a “hold-up problem”. The most common solution is a long-term contract. A contract that prevents a pilot from leaving a carrier too quickly after training ends would provide the proper incentive for the carrier to invest in the training and, in turn, the pilot to benefit from the training. The tricky part is how long a contract. It is not efficient or fair to impose a lifetime contract as some of the legacy carriers seem to be demanding. This would not allow for changes over time in pilots’ preferences for which airlines to work at or airlines preferences in whom to hire. On the other hand, allowing a pilot to leave immediately after training ends is not efficient either. This would risk the investment disincentives created by the “hold-up problem”.

A convenient way to resolve this tug-of-war is to specify a long-term contract but allow pilots to terminate the contract early by paying a penalty. This way if a pilot wants to leave early for a competing airline, their employer is effectively reimbursed for their investment in training. The competing airline will be willing to compensate the pilot for the penalty because they avoid the training costs. At the same time, pilots and airlines are free to search for better employee-employer matches. As an added bonus, better matches will stimulate interest in piloting as a profession and help alleviate the long-run shortage.

[1] According to The Skies Belong to Us: Love and Terror in the Golden Age of Hijacking, Brendan I. Korener, Crown Publishing Group, New York, 2013.

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