Econ 520-Microeconomics for Business Decisions
Course Research Project/Presentation:
A Look Into The Potential Merge of Spirit and JetBlue Airlines
Katherine Garcia
Katherine_g5@hotmail.com
University of Illinois Chicago
Econ 520-Microeconomics for Business Decisions
Table of Contents
Introduction
Demand Model
Demand Model Expectations
Price elasticity of demand expectations
Cost Profile
Game Theory
Public Policy
Leading Indicators
Conclusion
References
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4
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7
9
11
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Introduction
In recent years, the aviation industry has faced many challenges, from being one of the
industries affected significantly by the COVID-19 pandemic to an aircraft pilot shortage, their
financial performance serves as a crucial barometer of their operational resilience in an already
competitive market. Spirit Airlines, known as an ultra-low-cost carrier with Headquarters in
Florida, USA which beginnings date to 1964, announced in July 2022, that a deal had been
reached between Spirit and JetBlue Airlines, an airline from 2000 with headquarters in New York
City. Said deal would result in a combination that would create America´s fifth-largest airline. A
competitor against Delta, United, American, and Southwest Airlines. Nevertheless, since October
31, 2023, a court in which the federal government is trying to stop the $3.8 billion merger
started.
Considering the volatility of the aviation industry, reflecting not only in the conventional
supply and demand model but all the external factors that influence the cost such as fluctuations
in fuel prices, economic conditions, weather elements, and unforeseen external circumstances,
understanding the financial dynamics of this business is essential to effectively overcome the
challenges posed by their volatile setting.
Based on the idea that financial performance determines the competitive positioning of an
airline, the investment attractiveness, the capital for expansion and technological incorporation,
and customer impact, a deep understanding of the financial dynamics is fundamental to assessing
strategic decisions that align with long-term sustainability and growth, leading to the utilization
of this as demand measuring tool.
Through demand modeling, cost profiling, game theory applications, considerations of
public policy, examination of leading indicators, and a comprehensive conclusion, this analysis
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aims to provide a clear understanding of the financial scenery that could shape the trajectory of
Spirit and JetBlue airlines.
Demand Model
Aviation has revolutionized traveling, shortening times, resources, and increasing travel
efficiency.
When the COVID-19 Pandemic took place, airlines were considered the biggest destroyer
of value among the aviation subsectors for shareholders. Commercial air traveling experienced
significant disruptions and restrictions, facing unprecedented challenges with a decline in
demand (Bouwer, Krishnan, Saxon, & Tufft, 2022).
In this case, demand is not particular to the companies analyzed for this paper but for
general commercial air travel. In the U.S., the measurable factors that influence demand for this
kind of travel are:
•
Airfare cost: Many factors determine the price of airfare, such as airline, class, departure
and destination, operational costs, season, and fuel prices.
•
Included services-goods: demand for an airline is affected by services or goods that can
be included with the airfare such as luggage, inflight entertainment, snacks and or
beverages included, seat selection, etc.
•
Employment Rates: Travel is mostly divided between leisure and business. When
referring to leisure, low unemployment causes consumer confidence and increases
demand for travel.
•
Economic Growth: When an economy is flourishing, businesses grow which leads to
corporate travel.
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•
Aviation Regulations: Security measures imposed such as regulations by the government
and airlines can impact the economic value attributed to travel by customers.
•
Cultural and social events: Major events like holidays, concerts, festivals, sports events,
etc. can often trigger a higher demand for specific travel routes and/or dates.
•
Health concerns: Pandemics, vaccination, and health requirements affect demand for air
travel.
•
Political conditions: Travel decisions can be affected by political events such as wars,
visa requirements, and public law.
•
Seasonality: Demand for warm destinations increases from cold destinations and demand
for colder destinations is associated with winter activities such as skiing and
snowboarding. School breaks are also related to this demand since Spring and Winter
breaks impact air travel demand. Some airlines even create specific routes through
different seasons of dedicate more of their resources to these routes in specific seasons.
Among the factors that influence demand for air travel but are too difficult to measure are
customers´ experience and preference or loyalty, fears such as fear of flying and fear of heights,
and daily weather.
Demand Model Expectations
•
Airfare cost: Spirit Airlines is known as an ultra-low-cost airline, while JetBlue has a low
cost. If these airlines were to increase their airfare cost, customers would move on to
other airlines which would reduce demand for Spirit and JetBlue flights.
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•
Included services-goods: This can sometimes be a deciding factor for a customer to go
for a specific carrier over another. While some passengers prefer to travel in business
class prioritizing comfort, others have different demands and decide they don´t need
elements such as the included alcoholic beverages in their airfare.
•
Employment Rates: When people lose their jobs, leisure is the first thing they cut on, this
causes a drop in demand for the services offered by airlines.
•
Economic Growth: As with leisure, when companies experience financial losses, they
change their operations model, transitioning from travel to lower-cost alternatives such as
video conferences which directly impacts demand for air travel.
•
Aviation Regulations: When the regulations for air travel are modified, people are less
likely to choose this way of traveling causing a drop in demand. This was reflected
recently in the COVID-19 pandemic. Another example of this could be the different
regulations in place for breastfeeding mothers since when flying internationally, each
country has its own regulations in place which affects the demand for this way of
transportation.
•
Cultural and social events: If there were no events like these, people might have less
availability or reason to air travel and the demand for this service would drop.
•
Health concerns: People are less likely to travel to places where a significant amount of
people are suffering from a specific disease or while a pandemic is taking place-COVID19 being the most recent example of this. Some territories also have vaccination
requirements that can create hesitance in people to travel resulting in a drop in demand.
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•
Political conditions: Some countries have laws that directly affect demand for travel
altogether to these destinations, an example of this could be a mandatory requirement
such as the obligatory use of hijab in Iran.
•
Seasonality: If weather seasons were not a factor to take into consideration when looking
at demand, the aviation industry might not experience high or low seasons, which would
result in a steadier demand throughout the year.
Price elasticity of demand
Price elasticity of demand is a quantitative tool utilized by economists to understand how
supply and demand for a product change compared to the change in its price. Mathematically
speaking, this is expressed as:
Percentage Change in Quantity Demanded
Price Elasticity of Demand =
Percentage Chance in Price
This can also be categorized into different types, among them are elastic and inelastic. A
price elasticity of demand is considered elastic when the change in price is greater than one,
meaning it is a significant change. It is considered inelastic when the price changes by less than
1, being an insignificant change (The Investopedia Team, 2023; Frank, 2021).
In relation to aviation and its demand model expectations, price elasticity is considered
elastic for the following factors: airfare cost, employment rates, and economic growth since a
change in this factor, the price for this service would be significant.
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It can be considered inelastic in the following factors under the circumstances mentioned:
services-goods, aviation regulations, cultural and social events, health concerns, political
conditions, and seasonality.
However, it could be argued that some of the inelastic factors can sometimes become
elastic under certain circumstances. Using the aviation regulations for example: the breastfeeding
airport´s policy might not affect the male population as much as it can affect the female
population so the price elasticity in this example is inelastic for aviation regulations. However,
when COVID-19 hit and these regulations were modified with a restricted policy in place, the
price elasticity of demand became elastic since it significantly affected the aviation industry.
Baldanza (2023), assures that “airline passengers are highly elastic…their economic
behavior. Small changes in price result in relatively large changes in demand.” Many airlines –
Spirit among them- have adopted a business model in which cheap fares are offered and the
customer can select different goods and services as add-ons. This often results in attracting
people by the low entry price and a better reflection of consumer demand and willingness to pay.
However, Sitaraman (2023), assures “Airlines make money when they cut costs and increase
profits, which can mean worse service for flyers. If we want to make flying less miserable,
policymakers -and the traveling public- will have to tackle these incentives”.
Considering there are many different ways of traveling, for many people, air travel is
considered a luxury which could mean its price elasticity is inelastic. It can be argued however
that in some scenarios, this way of travel is the most economically reasonable -especially
considering the shorter times this takes compared to its competitors- and that the airfare might be
the factor that plays a bigger role in it so its elasticity could be elastic.
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Cost Profile
The cost structure of an airline is determined by many aspects such as operational cost,
profitability, and competition. Two elements take relevance when analyzing the cost profile of
Spirit and JetBlue airlines: variable costs and fixed costs.
Agarwal & Agarwal (2022), define variable cost as the expenditure incurred by the
producer of a service or good. This cost increases or decreases based on the company´s
production or sales volume, meaning that when production increases, the variable cost does too
(Kenton, 2023).
Fixed cost on the other side, is not dependable on the production, it doesn´t fluctuate based on
the number of goods or services produced by the company since they are costs related to
recurring expenses not entirely related to production like rent, taxes, depreciation, etc. (Hayes,
2023).
Some examples of fixed costs for airlines like Spirit and JetBlue are aircraft cost and
lease, aircraft line maintenance or day-to-day operations, infrastructure rent (hangars, airport
facilities, and office spaces), office staff salaries and benefits, crew yearly training/certifications,
and depreciation of equipment.
Among the variable costs we can mention are: crew´s salaries (the hours flown can
fluctuate), aircraft maintenance and repairs, in-flight services, fuel costs, airport fees (landing,
take off, and handling fees), and advertising.
Externalities are another element to take into consideration when analyzing the cost
profile of a service or product since they are the “cost or benefit caused by a producer that is not
financially incurred or received by that producer” (Kenton, 2022).
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These can be positive when there is a positive gain at a private and social level and
“negative when social costs outweigh the private costs” (Kenton, 2022).
For airlines like Spirit and JetBlue, among the positive externalities we can mention are:
•
Employment and economic growth: not only by hiring staff but creating job opportunities
in airports. Air travel also facilitates economic growth by facilitating business and leisure
travel.
•
Global networking: international trading and globalization of goods, services, and even
knowledge are also enhanced by this way of traveling.
•
Tourism and cultural exchange: on side with globalization, airlines give accessibility for
people to explore diverse cultures, places, and experiences at different destinations.
Negative externalities are also present in airlines, these are:
•
Environmental pollution: many airlines aim to be “environmentally friendly”, however,
current commercial aircraft have high CO2 emissions so this footprint is hard to reduce.
JetBlue currently has a zero emissions goal by 2040 while Spirit has an environmental
policy in place, they seem not to have a specific goal in place at the moment.
•
Noise pollution: aircraft produce noise especially while taking off and landing which
often causes noise pollution in surrounding communities this has led to policies in place
that prevent new airports from being operated near metropolitan areas in many cities.
•
Health distress: Airlines and air travel might contribute to the spread of diseases across
different territories which was rapidly observed throughout COVID-19.
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It could be assured that among the variable and fixed costs incurred by the airlines, the
variable factors have a higher impact on cost than the fixed ones, especially considering that
these costs´ price is not determined by the airline but by many other firms on a private and public
level. Based on Spirit´s Q3 2023 report, their total operating cost was $1,447,303, while
JetBlue´s was 2,509,000. From this, it could be argued that 85% fit into Spirit´s variable cost
factors mentioned previously and 93% for JetBlue (Spirit Airlines, 2023; JetBlue Airlines, 2023).
Game Theory
The term “game theory” is utilized to refer to the study of different ways through which
outcomes are produced with respect to preferences by economic agents. Basically, it is the study
of dynamics put in place to understand decisions made by a company and how these decisions
affect others (Stanford Encyclopedia of Philosophy, 1997).
In the context of a potential merger between Spirit and JetBlue airlines, the study of its
game theory gains relevance since the outcome of this choice is affected by other agents and the
application of these games could be insightful to predict whether this merger takes place.
Based on the fact that about 80% of the current commercial aviation market is
concentrated in the 4 major airlines in the US (Delta, American, United, and Southwest), this is
mainly in an Oligopoly since they control the market right now while the low and ultra-low-cost
airlines (Frontier, Spirit, Alaska, JetBlue and Allegiant) play in a Nash equilibrium, each with its
own strategy of offering accessible cost flights. In this case, there might be times when a player
would change their strategy and move from a Nash equilibrium to an Oligopoly which is the case
with Southwest Airlines who participates in both games. This might also be present in the
potential merger of Spirit-JetBlue since if allowed to happen, this airline would move on to be as
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big as the other 4 airlines that currently control de U.S. market. But then, another game comes
into play: Monopoly (Michaels & Tangel, 2023).
Nowadays, airlines control different routes and are in specific major cities which are
considered “hubs”. Spirit´s hub in Florida (FLL, MIA, and MCO airports) is one of the major
hubs this airline counts with, while JetBlue also has hubs in the state (FLL and MCO airports).
This has led to the government´s fear that a merger of these airlines would lessen competition in
these airports/cities and could create a monopoly resulting in fewer options for consumers and
the opportunity to increase prices and control the market in one of the countries´ bigger cities and
in three of the major international airports of the country thru which a total of around 132.4
million out of the 853 million travel by in 2022.
Public Policy
The aviation industry is heavily regulated, by public and private policies, these also play
a significant role in the demand for this service and a tremendous role in the supply. Several
agents come into play when establishing aviation regulations. Among these are:
Civil Aviation Authorities (CAAs), International Civil Aviation Organization (ICAO), Airport
Authorities, Transportation Security Administration (TSA), The Federal Aviation Administration
(FAA), The Department of Transportation (DOT).
In the U.S., aviation is mainly regulated by the FAA which regulates civil and
“commercial space transportation, maintain and operate air traffic control and navigation systems
for both civil and military aircraft, and programs relating to aviation safety and the National
Airspace System.” (FAA, 2023).
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The FAA alone has more than 52 aviation safety guidance document types which go from
economic to operational regulations mainly focused on the technical operations of the airlines
and their aircraft while the U.S. Department of Transportation handles the economic, civil, and
consumer protection requirements for airlines.
Airline policies and regulations evolve every day, sometimes based on social, cultural,
economic, and safety situations. An example of this could be the major changes in aviation
regulations in the U.S. after 9/11such as X-rays to all checked baggage, removal of shoes at
airport security, deployment of explosives detection systems with 3D imaging, pilot certification
to carry firearms on board flights and other protective tools, etc. (Schaper, 2021).
Since its announcement, Spirit-JetBlue´s merger has been in the eye of the government,
economists, and the general public since this could lead to higher airfares across the industry,
with one less competitor in the race (and an ultra-low-cost one particularly).
Leading Indicators
Commercial air travel has two main leading indicators which show significant changes in
demand for this service:
•
Aircraft Utilization Rates: This efficiently represents the use of their operations and
provides data regarding the demand for airline services. In their Q3 reports, Spirit and
JetBlue presented 10.8 and 10.7 hours, an increase of 1.9 and 5.9% respectively
compared to 2022.
•
Consumer Satisfaction Index: This reflects consumer´s perceptions and expectations. The
American Customer Satisfaction Index database shows the following data regarding
satisfaction benchmarks by airlines (2023):
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Company
2022
2023
% Change
American
77
78
1%
Southwest
77
78
1%
United
77
77
0%
Delta
77
76
-1%
JetBlue
79
76
-4%
Spirit
63
64
2%
Frontier
66
67
2%
The measurable factors for this database were: Quality of mobile app, reliability of
mobile app (minimal downtime, crashers, lags), website satisfaction, ease of check-in process,
ease of making a reservation, boarding experience, call center satisfaction, cleanliness of cabin
and lavatory, courtesy and helpfulness of flight crew, courtesy and helpfulness of gate staff,
timeliness of arrival, baggage handling, loyalty program, range of flight schedules, availability
and size of overhead storage, quality of premium (purchased) in flight beverage and food, quality
of in-flight entertainment, seat comfort, quality of complimentary in-flight beverage and food.
These indicators offer insights into airlines’ economic and operational factors that define
demand for their services, providing accurate information regarding performance that helps them
to prepare for future challenges.
Conclusion
The proposed merger between Spirit and JetBlue Airlines stands at a critical juncture
since the aviation industry is under constant evolution, from a business economics point of view,
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commercial airlines are a strong but vulnerable business. As the aviation industry faces
challenges that go from the lingering effects of the COVID-19 Pandemic to the complexities of a
very competitive market, the current trial adds another layer of uncertainty.
What would this merge mean? JetBlue would have the size in fleet and routes to compete
against the 4 major U.S. Airlines. Spirit, an ultra-low-cost airline would cease to exist, and this
could potentially salvage the company from its current state since it has struggled to recover
from the pandemic and is currently facing major losses in its fleet by the Pratt & Whitney engine
issues of its A320-200N.
Spirit is the biggest U.S. carrier impacted by a “rare condition in powder metal used to
manufacture certain engine parts” (CH Aviation, 2023) in the A320-200N aircraft since out of its
201 current aircraft, seventy-nine are this model. Possibly all of the aircraft from that model
manufactured between 2015 and 2020 will have to be taken out of service and inspected which
could take up to 60 days per plane. Current forecasting from the airline estimates that in the 4th
quarter of 2023 alone, 10 aircraft will be grounded.
On pair with their engine issues, after 4 consecutive years of loss, in 2023, Spirit´s
financial performance went from a forecasted pre-tax profit of $61M to an adjusted pre-tax loss
of $325M with mixed opinions on its profitability for 2024 (Master Executive Council, 2023).
As the trial comes to an end, based on trials under similar circumstances, it is likely that
this trial will also settle since “the simple fact and economic reality is that scale matter in this
industry…where we sit today, it´s very difficult for small airlines to compete” and if this were
not the case, Spirit airlines would have to make significant operational changes to salvage the
company from a potential bankruptcy while JetBlue would need to figure out a way to join the
Oligopoly in place with its competitors. Nevertheless, whether this merger goes through or not,
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this will very likely change the dynamics of the industry´s structure, putting both airlines´
operations, financial and business decisions to the test.
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