Introduction
The Airline industry is a major service industry that has been in the limelight since the terrorist attacks of 11 September 2001 in the United States. After that tragic event, several airlines collapsed or had to be bailed out by their governments. They included Sabena, Swissair and Canada 3000, all of which closed down, while Air New Zealand, the Polish airline LOT and many others were saved by capital injections from their governments.
Prior to that, during the last four decades, the airline industry has undergone tremendous growth especially in the realm of technological change. This has resulted in falling costs and fares which have stimulated a very rapid growth in demand for its services. During the first half of this rapid growth period, scheduled airlines enjoyed considerable protection from both internal and external competition. According with the product lifecycle theory, growth of the airlines industry was much faster in the 1950s and 1960s when aviation was a new industry than it is today when it is reaching maturity. In the 1950s and 1960s the world’s air traffic, measured in terms of tonne kilometers carried, grew on average at around 14-15 per cent each year. In the decade 1970-79 the annual growth was close to 10 per cent.
This still meant that air traffic, and the airlines with it, doubled in size every seven years or so. In the following ten years to 1989 growth declined to around 6 per cent annually and in the decade up to 1999 growth was down slightly at 5.2 per cent.
The airline industry’s growth appears to be cyclical. Nevertheless the underlying trend has been one of declining profits and consistently good growth in demand. Profits have been marginal in the airline industry even during the days when the industry was protected from internal competition. This is the paradox. According to a research paper titled “Where Are the Airlines Headed?” by Rubin, Rose M., Joy and Justin N. (2005) the airline industry is undergoing unprecedented change due to economic and non-economic events, increasing competition from low-fare carriers, technological developments, and changes in industry.
Measuring Profitability
The traditional measure of profitability, namely the rate of return on assets employed, cannot be applied to the airline industry as a whole. This is because of the difficulty of estimating real asset values for airlines with varied depreciation policies, using varying proportions of leased equipment and often receiving direct or indirect government subsidy in a variety of forms. Another measure of profitability commonly used among airlines is the operating ratio, which is the annual operating or net profit or loss expressed as a percentage of the total annual revenue. This is calculated annually for the world’s airlines by the International Civil Aviation Organization (ICAO).
It is the net profit after payment of interest and any other non-operating items. Profits in the airline industry can fluctuate wildly, precipitating exit. The reason for these fluctuations is that an airline’s costs are largely driven by labor and fuel, which are fixed in the short run. Hence, moderate fluctuations in demand, such as those caused by the events of September 11, can hugely affect profits. The robust earnings of most airlines in 1998 and 1999 can be traced both to the booming economy that spurred demand, particularly for high-fare business travelers, and to low fuel prices.
Waves of Dramatic Change
Since the late 1970s, airlines have endured two waves of dramatic change and restructuring that heavily affected consumers and their travel decision making. The first wave occurred post deregulation with fare competition, industry expansion, and development of the hub-and-spoke system. The second wave occurred through industry consolidation in the latter half of the 1980s (Kim and Singal 1993). Consumers are now impacted by a third wave of changes in the industry, the most radical since the 1978 deregulation. These structural changes are particularly evident in the ticket procurement process, the hub-and-spoke route network infrastructure, industry consolidation, and the market factors that led to the emergence of low-fare carriers.
Statistics
In 2001, commercial airlines carried nearly 450 million passengers for leisure, personal, and business travel, an increase of approximately 250% since the 1978 industry deregulation (U.S. Department of Transportation Bureau of Transportation Statistics 2002). Despite this long-term growth, the number of passengers increased only about 1.5 % annually from 1997 to 2001 (U.S. Department of Transportation Bureau of Transportation Statistics 2002).
These fluctuations are attributed to changes in external environmental forces. An airline company is affected by both macro- and micro- environmental forces. The macro external environment consists of factors such as the economy, unemployment levels, inflation, the demographics of the population, governmental legislation and regulations, political power and stability, technology and even the values and lifestyles of the society at large. The micro external environment includes factors such as the size and growth rate of the market, the depth and breadth of products in the market, the uniqueness of these products, the existence or availability of distribution channels, technological changes, the make up of the buyer and seller market, etc
Supply versus Demand
There is a tendency among airline managers to concentrate on supply considerations at the expense of demand factors. Airlines can monitor various aspects of supply through the following performance indicators: engine shut-down rates per 1,000 hours, punctuality, annual utilization of aircraft and crews, maintenance man hours per aircraft and unit costs per tonne kilometer. Performance indicators on the demand side are often ignored.
Too many airlines, among them smaller international carriers, assume that if their supply of services is efficient and low-cost profitability should follow. What determines profitability is the airline’s ability to produce unit revenues which are higher than its unit costs.
Thus unit revenues are also important; which means, demands must also be studied. In fact, profitability depends on the interplay of three key performance variables: unit cost (usually measured per available tonne kilometer, that is, per unit of capacity), unit revenues or yields (measured per revenue tonne kilometer, that is, per unit of output sold) and load factor, which indicates how much of the capacity produced has actually been sold. To achieve a profitable matching of supply and demand airlines need to get the balance between unit costs, unit revenues and load factor right. For this it is crucial for airline managers to have a thorough understanding of the demand they are trying to satisfy. Aircraft selection, route development, scheduling, product planning and pricing and advertising are just some of the many decision areas depending on the demand factor. Supply of and demand for air services are dependent on each other.
Aircraft types and speeds, departure and arrival times, frequency of service, the level of air fares, in-flight service, the quality of ground handling and other features of supply will influence demand for an airline’s services. Conversely, the demand will itself affect those supply features. The density of passenger demand, its seasonality, the purpose of travel, the distance to be traveled, the nature of the freight demand and other demand aspects should influence the way in which air services are supplied and will impact costs. An understanding and evaluation of the demand for air transport leads to the provision of services which themselves affect the demand.
New adjustments to the supply then take place to meet changes in the demand, and this interactive process continues. Recently, macroeconomic and microeconomic market factors in the airline industry have reduced demand and increased elasticity of demand (e.g., responsiveness of buyers to a change in price). Such changes in demand would motivate an oligopoly industry to reduce supply, and the airlines have responded by decreasing the supply of passenger seats to reduce costs and maintain prices. The elasticity of demand for leisure travel airfares, which comprise almost 85 % of all airline tickets purchased (Tully 2001), is a relatively high 2.4 (Mackinac Center for Public Policy 1997).
For example, a 10% fare reduction potentially increases sales by 24%. Thus, consumers are highly responsive to price changes, and most choose the lowest fare available, regardless of the airline. In contrast, the elasticity of demand for business travel has traditionally been an inelastic 0.1 (Mackinac Center for Public Policy 1997); however, this may change due to the increasing number of substitutes and travel delays.
Socio-economic variables
Sex, age, income level, stage in the life cycle, size of family and occupation are some of the many socio-economic variables that impact on travel patterns. The key variables affecting behavior will clearly be different if one is traveling for business, or leisure, or visiting friends and relatives. They will also differ for the separate market segments within each of these categories.
Three Generic Strategies of Porter
Michel Porter suggests that a company’s overall competitive strategy must consist of business approaches and initiatives it must follow to attract new customers, withstand the competitive environment and strengthen it market position. Porter classified competitive strategies into three generic types based on three distinct approaches: low-cost leadership, niche or differentiation (Flouris and Oswald, 2006). The low-cost leadership approach is based on being the overall low-cost provider in the industry. Example: Ryanair. Niche approach is based on concentrating on a narrow buyer segment and having a competitive advantage by offering customized products or services to the customers. Example: aloha Air (geographic niche), Concorde (customer niche) and Chalk (product line niche). The differentiation approach aims at providing differences in the product for which the public is willing to pay extra. Example: Singapore Airlines (Flouris and Oswald, 2006).
Segmentation and Pricing – Low Cost Strategy: America West’s Scott Kirby called the airline industry a “commodity industry” suggesting that the public did not know the differences between United, American, Delta, Southwest and JetBlue. He felt that the public considered price alone when making a purchasing decision. In the case of airlines, there are segments based on many dimensions. On important dimension is that of leisure passengers and business passengers.
While leisure passengers may value the price factor high, when it comes to business travel, the focus is more on schedule than price. However, even business passengers tend to pay attention to prices during periods of economic downturns. They are also concerned about in-flight amenities in the case of long distance flights. Low cost leadership strategy works best when the buyers are price sensitive and when price competition among rivals is a dominant competitive force. When there are many competitors in the industry and rivalry is strong, a low-cost leadership position would be worthwhile.
Differentiation Strategy: In the case of adopting a differentiation strategy, the airlines provide a service with some distinguishable feature for which the customer is willing to pay a premium. The premium price paid by the customer is a profit incentive to the company. JetBlue Airways is a good example of differentiation strategy as applied by a low-cost airline carrier. JetBlue offered DirectTV in 2002 in its flights which was a unique feature not offered by other carriers in the United States at that time. Differentiation strategies are best suited when the needs and preferences of the buyers are so diverse that standardized products will not be able to satisfy the need of the customers. The competitive strengths of a differentiation strategy lie in the fact that differentiation strategy helps buyers develop loyalty to brands they like. Moreover, the airline firms are placed in a better position to withstand efforts of suppliers to raise prices because buyer is willing to pay premium. One of the major shortcomings of the differentiated strategy is that it is very difficult to remain continually unique in the minds of the customers.
Niche Strategy: British Airways and Air France faced a problem due to the high operational cost of the Concorde in the realms of fuel cost, availability and cost of spare parts, and in general, the high cost of maintenance. However, it was marketed using a niche marketing strategy. For $12,754 USD one could travel at twice the speed of sound and travel from New York to London in just under three hours. This was such an exclusive niche market that the Concorde seated only 100 passengers. This type of niche strategy focuses on a specific and unique product line.
Deregulation of 1978
The 1978 deregulation of the U.S. airline industry created an immediate opportunity for short-haul carriers to enter the market. Deregulation increased the competition among regional and national carriers. It eliminated fare controls and abolished all barriers to entry. Carriers were now permitted to select their own routes. Many new entrepreneurial airlines entered the market as a result of deregulation. Under these conditions, airline companies had to rely on their core competencies to be successful. Companies like Southwest Airlines – who have learned to provide quick, efficient, on-time services while keeping costs low- have found sustainability easier. Core competencies are major value creating activities of the company.
Porter’s Five Forces Model
Porter’s Five Forces model suggests that the competition in an industry is determined by five competitive forces: Barriers to entry, the power of the supplier market, the power of the buyer market, power of substitute products and rivalry among industry members. A barrier to entry into an industry occurs when it is difficult for a newcomer to enter into the market. Some barriers to entry are: economies of scale, inability to gain access to patents, brand loyalty, regulations, access to distribution channels and the learning curve In the context of airlines it must be remembered that governmental legislation and regulations can be a major barrier to new entrants.
Prior to the deregulation of the U.S. airline industry, the regulatory environment kept new entrants out of the market. Today, the stringent safety and security regulations imposed on airlines after the disaster of 9/11 pose a new barrier to entrants because of the associated costs. The supplier to an industry can wield a lot of power. A great deal of havoc was caused during a dual factory recall of O-540 crankshafts from Lycoming, since the crankshaft is used widely in aviation engines. The supplier market is comprised of all the companies that provide component parts to the planes. The power is with the supplier when there are few suppliers in the industry and when the component part is important. The buyer market is comprised of all the firms or individuals that purchase the product or service of the industry members.
In the commercial airline industry, one segment of the buyer market is the passenger. The buyer is important and has significant purchasing power when the end user buys in large numbers as they are able to negotiate price concessions. For example, customers flying in large groups expect some kind of price concession from airlines. Travel agents are provided with volume discounts as well as corporations that have a loyalty agreement with certain airlines. With increasing competition there are more threat of substitutes entering the market and also the threat of rivalry. This is seen in the period after deregulation.
Market Structure – Oligopoly
The airline industry is characterized by an oligopoly market structure, a form of imperfect competition in which a limited number of firms dominate the industry. (1) Oligopoly firms have market power in setting or altering prices for their products by establishing various output levels. Since oligopoly firms produce similar outputs and compete with their industry rivals, any action an oligopoly firm takes is noticed by its competitors.
Consequently, rivals may react with price-cutting or other attempts to enhance market share. Thus, the firms in an oligopoly are interdependent, and each recognizes that its market power is vulnerable to erosion by competitors or new market entrants. The standard measure of oligopoly market power is the industry concentration ratio. This ratio relates the market share of the largest firms in the industry to the size of the entire market (Schiller 2003). The Herfindahl-Hirschman Index (HHI) is an alternative approach to assess market power in the form of industry concentration. Oligopolies in general need high capital investment to build capacity, which results in high fixed costs. This is clearly the case of the airline industry, with approximately two-thirds of the cost structure as fixed costs (Air Transport Association 2002).
According to Pettit and Murphy (2001), it is not possible for airlines to generate sufficient profits because of too much capital. However, average cost can be brought down by increasing the number of passengers for each flight for a given fixed capital requirements and flight volumes. As Coy (2002) notes, this also allows airlines to fill every seat at reduced fares. In effect, airline seats are perishable goods once a flight departs. In response to these economic incentives, airlines practice price discrimination to sell the maximum number of seats on each flight. Oligopoly firms, such as airlines, can potentially produce efficiencies that provide better or lower-priced products to consumers.
Because of its oligopoly structure, airlines can achieve economies of scale by route optimization to increase load factors, more efficient use of existing aircraft fleets, decreasing maintenance costs, and leveraging overhead costs for lower operating costs through synergies (Pettit and Murphy 2001), as well as by utilizing various forms of code-share alliances (Sharkey 2003) and cross-ticketing privileges, permitting route expansion and new connecting links. For example, in 2004, Northwest Airlines, Delta, and Continental agreed to permit booking on each other’s flights. While this near-merger strategy is aimed at passenger retention, Sharkey (2003) suggests that it is also likely to reduce flights to smaller or weaker markets. Thus oligopoly market power can be used to restrict competition. It can also help new innovative firms carve out a niche, which is the strategy of the low-fare regional airlines.
Entry Barriers
Airline industry studies prior to September 11, 2001 (Hendricks, Piccione, and Tan 1997) illustrate that hub-and-spoke route networks present a considerable, but possibly penetrable, barrier for new airlines. Although high entry costs of aircraft acquisition and other capital requirements make entry difficult, the industry appears more contestable (e.g., imperfectly competitive but subject to potential entry if warranted by prices or profits) post-9/11, as evidenced by the growth of low-fare carriers. These market entrants can erode a dominant carrier’s market share, even at large hub airports. Mergers are generally used to overcome entry barriers.
But in the case of airlines, antitrust considerations prevent some mergers, even between smaller airlines. Borenstein (1992) suggests that price regulation will be needed as industry consolidation occurs. Blair and Harrison (1999) and Moorman (2000) conclude that antitrust provisions need to be modified and strictly enforced to protect new entrants from unfair competition and anti-competitive acquisitions. Such antitrust activities include prohibiting price undercutting by established carriers or blocking proposed mergers.
Recent Issues
In the past few years, the airline industry has been besieged by a series of unpredicted and uncontrollable exogenous or noneconomic factors, including major international events. Unprecedented terrorist acts involving commercial aircraft, the spread of the severe acute respiratory syndrome (SARS) virus, and a global economic downturn had measurable adverse effects on airline load factors (e.g., percentage of seats occupied). Rising variable costs for fuel, coupled with high and inflexible fixed costs, further reduce the airlines’ ability to compete on the basis of price (Air Transport Association 2002; U.S. Department of Transportation Bureau of Transportation Statistics 2003).
Newman (2003) predicts there will be continuous slow growth in passenger travel even without a new terrorist incident. Since over 160 million Americans now have access to the Internet, the advent of competitive direct airline ticket sales, on both individual airline and discount travel Web sites, has revolutionized the marketing and selling of tickets (Computer Industry Almanac Press Release 2002). The growth of online bookings has been exponential, from $276 million in 1996 to $827 million in 1997 to $3.2 billion in 1999 (Miller 1999), resulting in considerable cost savings for airlines. For example, for America West Airlines, a ticket sold through a travel agent costs $23, while a ticket sold over the Internet costs about $6 (Miller 1999). While the airline industry benefits from the cost saving of online purchases, consumers also benefit from greater price transparency and choice among a large number of fares.
Competition
The major airlines generally enjoyed little competition from low-fare carriers until the late 1990s. The growth of low-fare, highly competitive airlines have increased competition. Southwest Airlines was the most popular earliest known low-price carrier. Price transparency advocated by the internet mandates that airlines adapt to more price-conscious consumers who have the ability to compare price options and fares across airlines. Heightened competition and more knowledge about substitute flights increase consumer price elasticity and intensify the downward pressure on fares.
Future: It is expected that due to airport security measures there will be increase travel time costs and related inconveniences causing a decline in air travel. To reduce consumer travel time and delays attributed to the hub-and-spoke system, the number of direct or point-to-point flights will increase. While the hub-and-spoke system will remain in some reduced form, direct flights will become more feasible as major airlines use smaller, more cost-efficient regional jets for smaller markets (Sharkey 2003) Amenities that were previously standard, such as in-flight meals, are being reduced or eliminated as airlines continue to cut costs.
High-tech fixed-cost amenities, such as individual television consoles and data ports, will become increasingly available for travelers, as airlines search for competitive ways to lure passengers (Newman 2003). Profit margins for new entrants will become more attractive as the cost gap widens between low-cost carriers and larger established airlines. New entrants will fill niche markets, serving particular regions of the country or providing point-to-point service to selected markets. Because low-fare carriers serve as an effective curb against noncompetitive oligopolistic airline pricing, antitrust measures may be required to allow vulnerable start-ups to compete with existing oligopolists.
Conclusion
The airline industry has undergone rapid changes since deregulation in 1978. Economic developments, including increased competition from new low-fare airlines, are shifting the focus of major airlines towards efficiency. Moreover, the advent of the internet has served to enhance price transparency and more time-efficient flight options. However, it is predicted that the airline industry will face uncertain times in the future due to increasing costs, particularly for fuel and security.
Bibliography
Flouris, G. Triant and Oswald, L. Sharon (2006). Designing and Executing Strategy in Aviation. Ashgate Publishing Ltd.