CHAPTER 3
ECONOMIC CHARACTERISTICS OF THE AIRLINE INDUSTRY
3.1
INTRODUCTION
The purpose of this chapter is to deal with the economic characteristics of the airline
industry.
The special nature of the airline industry as a network infrastructure industry will be
examined. A number of characteristics in the airline industry will be identified that are
indicative of an oligopoly.
It will also be demonstrated that certain unique economic
network characteristics exist in the airline industry. It will become evident that, as a result of
these unique and special characteristics, it may not be advisable to treat the air transport
industry on the same basis as other sectors of the economy from a competition perspective.
The sources of economies of scale, scope and density in the airline industry will be identified
and well as the effect of airline networks on competition. The effect of declining overall
volumes on airline competition and the viability network business travel pricing model of the
hub-and-spoke airlines as well as the emergence of new low cost carriers and their
characteristics will be examined. Price discrimination in the airline industry generally and
specifically in South Africa will be examined in this chapter.
Specific objectives that will be established are:
•
The special nature of the airline industry as a network infrastructure industry.
•
Certain characteristics of the airline industry will be identified, including:
o Characteristics that may demonstrate an oligopoly in the airline industry.
o Unique economic characteristics of the airline industry.
o Competition in the airline industry in comparison with competition in other
industries.
o Economies of scale, scope and density in the airline industry.
o The effect of airline networks on competition.
Chapter 3 Page 121
•
The operation of a deregulated airline industry that would include:
o Yield management and hub-and-spoke route systems of large network airlines
and the potentially unfair competitive responses to entry by low cost airlines
involving price and capacity which results in a decline in airline competition
as a consequence of the market power in airline markets that result from these
commercial practices.
o The effect of a decline in overall volumes on airline networks and the viability
of the network business travel pricing model of the hub-and-spoke airlines
which has led to the development of specific characteristics of new low-cost
carriers as well as the responses of hub airlines to competition from low-cost
carriers.
o The occurrence of price (fare) dispersion in the airline industry. Fare
restrictions as a means of differential pricing and the use of yield management
to be able to discriminate on price
o The effect of price discrimination on the economic welfare of consumers in
the domestic airline services and in particular in South Africa.
3.2
THE SPECIAL NATURE OF THE AIRLINE INDUSTRY AS A
NETWORK INFRASTRUCTURE INDUSTRY
The Competition Commission in South Africa described the airline industry as a network
industry. It stated that there were numerous competitive concerns regarding network
industries. 1)
The OECD described network infrastructure industries as industries that have commonly
been subject to government ownership or regulation and have a number of features that make
regulatory reform especially attractive, difficult and interesting to competition authorities. 2)
The Competition Commission in South Africa stated that these industries are special in that
they connect the consumers of their products and services by means of a network of some
sort. Examples of network infrastructure industries include the telephone network, the
electricity network, and the road, rail, and water supply and airline networks.
Chapter 3 Page 122
Although different in the nature of their products, these industries share several features that
are reflected in the common occurrence of broadly similar competition concerns:
•
The bigger the network, the more useful it is.
•
There are competition problems associated with dominant, integrated firms in
network industries. A new entrant is initially able to compete by providing one
service. The response by the incumbent, integrated firm might be to cross-subsidise
its prices in respect of that service, by raising the prices of its other services where it
faces no competition and thus has market power.
•
The incumbent could refuse access to an essential facility. 3)
•
The raising of switching costs between one service (offered by the new entrant) and
another (offered only by the incumbent). For example, a dominant airline might
schedule its feeder flights to arrive immediately before the departure of its connecting
flights, whereas a new entrant might only secure a landing slot that feeds too late or
too early into the incumbent’s flight. 4)
The CAA in the UK stated that:
•
The airline industry is a network business in which the demand for air services on a
particular airport-pair, city-pair, or even country-pair is derived from a multitude of
separate origin/destination markets. Consequently, market definition in airline
competition cases can sometimes be quite complex.
•
In addition, the ‘indivisibility’ of capacity can result in extremely low short-run
marginal costs, with consequent difficulties in applying competition law to cases
involving allegations of predatory pricing. 5)
Van Siclen S also identified a number of key characteristics that have a bearing on regulation
and competition in network industries:
•
Provision of an essential service to the economy
In many countries these industries have been traditionally state owned. Such
companies often have public service obligations (implying requirements to provide
some services even where it is not economically viable for them to do so.) The result
is that the reform of these sectors is often highly politicised.
•
Sunk and unrecoverable costs
Many of their costs are sunk and unrecoverable once they are committed. In
particular, if there is a desire to attract voluntary private investment, the regulatory
Chapter 3 Page 123
regime has to be credible and predictable. According to Van Siclen S, creating this
credibility and predictability is one of the basic tasks of a regulator.
•
Natural monopolies
Some parts of network industries probably have to be monopolies while other parts
can be competitive.
Van Siclen S stated that when the least costly way to provide a good or service is by a
single entity, it is referred to in economics, as a “natural monopoly”. In her
assessment, a co-ordination function would be a natural monopoly. She emphasised
that “natural monopoly” is a technical economic concept and the modifier “natural”
should not be considered a synonym for “inevitable” or “durable”. The concept is
based on costs, with no reference to substitutes, and therefore no reference to
markets.
In her assessment, many existing monopolies are not “natural monopolies,” but
instead exist for reasons unrelated to their current cost features. In addition, many
sectors that fall under the economic definition of a natural monopoly are not, or at
least should not be organised in the form of an actual monopoly.
•
Rapid technological change
Rapid change in the level of demand is often brought about by technological change
in a related market. In the view of Van Siclen S, changes in technology and demand
can upset long held beliefs about feasible structures of the industry and optimal
regulation.
Technological advances change competition in certain sectors of an industry and may
eliminate much of a monopoly. This could imply further changes in the regulation.
technological change can also reduce the importance for competition. Further
common ownership of different modes may threaten competition, according to Van
Siclen S. 6)
The characteristics of network industries and the unique application of commercial practices
as a result of such characteristics in the airline industry have an effect on the capability of
Chapter 3 Page 124
competition law, as applied in the economy generally, to address the different issues raised in
the airline industry. In this regard, it is recommended that any corrective measures should
duly take account of such characteristics of the airline industry, when commercial conduct is
considered from a competition perspective.
The need to adjust the application of competition policy specifically in the airline industry, as
a result of such characteristics, is an important issue that has been considered in Canada
especially and is discussed later in the study.
3.3
CHARACTERISTICS
OF
THE
AIRLINE
INDUSTRY
THAT
DEMONSTRATE AN OLIGOPOLY
An oligopoly is defined as an industry composed of a few firms producing either similar or
differentiated products. According to Wells AT, the airline industry is typically characterised
as an oligopolistic industry as a result of the following:
•
High barriers to entry.
•
Few sellers in the market.
•
A product of similar nature.
•
Substantial economies of scale.
•
Growth through merger.
•
Mutual dependence of airlines.
•
Price rigidity and non-price competition.
•
Price transparency and collusion.
The abovementioned analysis by Wells AT concluded that the airline industry is “closely approximating an oligopolistic market structure”. 7)
This conclusion has important implications both for competitive analysis and as regards the
remedies that are required in order to increase competitive forces in the air transport market.
Chapter 3 Page 125
3.4
OTHER UNIQUE ECONOMIC CHARACTERISTICS OF THE AIRLINE INDUSTRY
3.4.1
GOVERNMENT FINANCIAL ASSISTANCE
Unlike other oligopolistic industries, various governmental units have played major roles in
financing the growth and development of the airport-airways system.
Wells AT concluded that the airline industry has historically benefited from the financing of
major cost elements of the industry by various governmental units. 8)
3.4.2
HIGH TECHNOLOGICAL TURNOVER
With regard to capital spending by airlines, Wells AT states that technological advances and
competition have forced the carriers to undertake a re-equipment cycle on an average of
every eight years. Besides requiring huge amounts of capital spending, heavy expenses in
hiring and training personnel and in modifying facilities to accommodate the new aircraft and
associated equipment are required in the airline industry. 9)
3.4.3
HIGH LABOUR AND FUEL EXPENSES
Wells AT also pointed out that airlines require employees with highly developed skills that
are expensive. 10) In addition, the airline industry is subjected to the severe increases in fuel
prices the air carriers have experienced over the past 15 years. According to Wells AT,
labour and fuel costs typically represent around 60 percent of a carrier's operating expenses.
11)
3.4.4
SENSITIVITY TO ECONOMIC FLUCTUATIONS
With regard to the susceptibility of air transportation demand to the business cycle, Wells AT
stated that while the impact of a recession is not unique to the airline industry, the airline
industry is much slower in recovering as spending on air travel is discretionary and follows
general recovery in the economy a year to 18 months afterwards.
Chapter 3 Page 126
Wells AT found that airlines experience a high rate of traffic growth during periods of
prosperity but when the economy moves into a recessionary period, the carriers normally
experience substantial excess capacity. 12)
3.4.5
CLOSE GOVERNMENT INVOLVEMENT AND REGULATION
Wells AT stated that unlike other oligopolistic industries, the airlines have a long history of
both support and regulation by government (although this has also been the case in other
transportation modes). 13) This was clearly demonstrated by the recent financial aid provided
by the USA and other countries as a result of the effect of the terrorist attacks of 11
September 2001.
3.4.5.1
Eight industry-specific features of governmental involvement in the air
transport industry
Havel BF, identified eight industry-specific features that in his view established the structural
faults and contradictions of a long prevailing regime that distinguish the air transport industry
from other industries and demonstrate the level of government involvement in the air
transport industry:
•
The doctrine of sovereign national airspace, sanctified in the Chicago Convention as
the basis for government control of the world airline industry for the past thirty years.
•
The piecemeal negotiated exchange of fair traffic rights and other conditions of
airspace access through bilateral treaties as opposed to free multilateral grant.
•
The doctrine of cabotage, which has been used to exclude foreign airlines from traffic
rights on domestic point-to-point routes.
•
The nationality principle, by which each state reserves its domestic cabotage routes,
and designation under its bilateral treaties designates carriers that are owned and
controlled by the state or its citizens to serve international routes.
•
The practice of public ownership of national "flag carriers”, supported by incidents of
state support that include subsidy programmes and protection from market
competition.
•
Government efforts to fine-tune regulatory control of the tremendous power of
computerised yield management technology, and to ensure a fair distribution of
access to scarce airport slot and gate facilities.
Chapter 3 Page 127
•
The evolution of levels of strategic co-operation among airlines of different
affiliations, including the device of code-sharing, all of which reflect a partial
entrepreneurial evasion, with varying levels of official government complicity, of the
precepts of cabotage and nationality.
•
Confinement
of
authentic
multilateral
co-operation
to
technical
and
logistical matters such as ticket interlining (with the striking exception of the
discredited practice of collective price-setting through the tariff conferences of the
IATA). 14)
These demonstrate the high degree of government involvement that certainly will have a
damping effect on the free working of market forces.
The above-mentioned features are further discussed in annexure “B”. It is, however, also
necessary to take note of governmental intervention in the conduct of airline operations. In
this regard, the following are important:
•
CRSs.
•
The distribution of scarce airport runway and terminal resources (the slot and gate
problem).
•
Strategic co-operation among airlines of different affiliations, including the device of
code-sharing.
•
Multilateral co-operation in technical and logistical matters.
3.4.5.2
Regulatory intervention by governments in the operation of air
transport services (CRS and airport slots and gates)
According to Havel BF, there has been a desire by the USA and EU authorities to liberate
their
aviation
industries from
prior
regulatory
supervision
but
the
switch
to
competition policy is occasionally blocked by unusual regulatory challenges that are
unique to the industry being deregulated. Within the USA and EU air transport industries,
two recent developments present challenges that have special resonance for the
reform of international aviation: the rapid diffusion in the industry of CRS and the
distribution of scarce airport runway and terminal resources (the slot and gate problem).
Chapter 3 Page 128
The predicate for invasive government regulation of CRSs and airport access, two apparently
unrelated aspects of air transport, remains that of competition policy as in the opinion of
Havel BF, each is allegedly capable of:
•
Foreclosing the entry of new airlines, or
•
Forestalling system expansion by existing carriers, and
•
Further both CRSs and airport access have been used in a manner detrimental to a
competitive marketplace.
The solutions proposed, in the main, a return to ex ante regulatory controls to load the market
structure in favour of weaker players (non-owners of CRSs or start-up carriers seeking
airport space). 15)
3.4.5.3
Strategic co-operation among airlines (including the device of codesharing)
Havel BF noted the “evolution of levels of strategic co-operation amongst airlines of
different affiliation, including the device of code-sharing”. In his opinion these measures
reflect a “partial entrepreneurial evasion (with varying levels of official government
complicity) of the precepts of cabotage and nationality”. 16)
3.4.5.4
Multilateral co-operation limited to technical and logistical matters
Havel BF also identified bona fide multilateral co-operation in technical and
logistical matters such as ticket interlining with the striking exception of the
discredited practice of collective price-setting through the tariff conferences of the IATA.
17)
3.5
COMPETITION IN THE AIRLINE INDUSTRY
3.5.1
SPECIAL CHARACTERISTICS OF THE AIRLINE INDUSTRY
The airline industry can be described as a network industry (a system of links (routes) that
connect nodes (airports)). 18)
Chapter 3 Page 129
According to the Nordic competition authorities, a number of interesting characteristics exist
in the aviation industry in terms of:
•
Networking.
•
Cost structure.
•
Yield management.
•
Marketing strategies, and
•
Switching costs and lock-in effects. 19)
3.5.2
COMPETITION IN THE AIRLINE INDUSTRY IN COMPARISON
WITH COMPETITION IN OTHER INDUSTRIES
Competition in the airline industry differs from competition in many other industries because
of the following:
•
Airlines compete using multiple competitive tools, and
•
Airlines compete over networks (not only on a route to route (city-pair) basis). In this
regard, the airline industry can be described as a network industry consisting of a
system of links (routes) that connect nodes (airports). 20)
3.5.3
MULTIPLE DIMENSIONS OF AIRLINE COMPETITION
Airlines compete over the following multiple dimensions:
•
Ticket price.
•
Frequency (number of flights a day) and the timing of those flights.
•
Characteristics of the flight itinerary (non stop, continuing single-plane service, or
connecting service).
•
In-flight amenities including:
o Service level, food, in-flight entertainment
o Seat pitch (how closely spaced together)
o Ground amenities, including club lounges
•
Loyalty schemes (rebates to the client and travellers) in the form of:
o FFPs.
o TACOs.
o Corporate discounts. 21)
Chapter 3 Page 130
It is therefore essential that in the analysis of competition in the air transport market, due
regard should be had to all the dimensions in which airlines compete and not only to the
singular dimension of price.
3.5.4
COMPETITION OVER NETWORKS IN THE AIRLINE INDUSTRY
Differences in competition over networks in the airline industry differs from that in the
telecommunications or information technology industries as follows:
•
Telecommunications and information technology
Primary network effects are increasing returns to scale from large fixed costs coupled
with extremely low variable costs and externalities, and increasing benefits to each
user when a new user is added.
•
Airlines
Principal effects of network competition are the ability to manage flow traffic and
compete over alternative routings and the market power that comes with dominant
hubs in route networks. 22)
A particularly efficient way of organising an aviation network is the hub-and-spoke mode of
operation. Rather than operating a large number of point-to-point, non-stop routes, the airline
company channels all or most passengers through a hub airport, from which all connections
extend like the spokes of a wheel. In this way the number of different non-stop routes needed
to serve all possible pairs of destinations is drastically reduced, allowing for quite remarkable
cost savings. 23)
The FFPs are thus liable to strengthen any dominant position and to reinforce the anticompetitive effects of hub-and-spoke networks. They therefore act as important barriers to
entry. 24)
The hub airline therefore tends to dominate its hub airport and the area around it. No other
airline is able to offer a comparable frequency of service into or out of the hub. Owing to the
important network economic effects at play, the hub airline will often be able to crosssubsidise feeder routes into the hub, so as to effectively outdo any smaller rival airline which
may want to offer services on just one or a few spokes. 25)
Chapter 3 Page 131
The aviation industry exhibits a number of interesting characteristics in terms of networking,
cost structure, yield management, and marketing strategies. The ability to manage flow
traffic and compete over alternative routings and the market power that comes with dominant
hubs in route networks should also be taken into account when analysing competition in the
air transport market.
3.6
NETWORK EXTERNALITIES, ECONOMIES OF SCALE, SCOPE
AND DENSITY
3.6.1
INTRODUCTION
The aviation industry is also characterised by large network externalities, in the sense that the
costs and revenues involved in carrying passengers on different, interconnected routes are
interdependent. According to the Nordic Task Force on Airline Competition (NTFAC), there
are large economies of scale, scope and density present in the aviation industry. These
externalities may originate either at:
•
The supply (production) side, or
•
The demand (consumption) side. 26)
Supply side economies of scale (also called increasing returns to scale) exist when the
average production costs decline with the number of units produced. A common source of
economies of scale on the supply side is the combination of a large fixed cost and small
constant marginal costs.
Economies of scope signify that it costs less to produce services jointly by one firm rather
than separately by different firms.
Economies of density exist if an airline’s unit costs, or the air travellers’ generalised costs,
decline when the airline adds flights or seats on existing routes. 27)
Other typical characteristics of network industries are switching costs and lock-in effects.
High switching costs result in customers being locked in. This limits competition between
Chapter 3 Page 132
operators by preventing competition from eroding price differentials from a dominant carrier.
28)
Hunnicutt CA stated that network industries may have fundamentally different characteristics
than the traditional industries that classic microeconomic models have been based on. As a
result, network effects have important public policy implications. Hunnicutt CA was of the
opinion that aviation public policy makers of the future would have to take into account not
just supply side efficiency that was central in the traditional models, but demand side effects
as well. These include many of the strategies that the airlines have perfected such as loyalty
programmes including FFPs that have been designed to raise the switching costs for the best
customers. 29)
As a result, this section will distinguish between the various economies in the airline industry
from both the supply (production) side and the demand (consumption) side.
3.6.2
ECONOMIES OF SCALE
Table 3.1:
Economies of scale
Economies of scale on the supply Economies
(production) side
Average
production
of
scale
on
the
demand
(consumption) side
costs
(cost
per Demand for a good increases with the total
passenger kilometre) decline with the number of goods sold
number of units produced (in batch size).
Such economies can be affected by:
Such effects are of limited importance in the
•
Using larger aircraft size (aircraft)
airline industry.
•
Increasing load factor and
•
Longer stage length. 30)
Larger aircraft may appear more comfortable
and secure to the traveller and induce a very
Economies of scale due to firm size are, limited additional air travel demand. 32)
however, quickly exhausted in the airline
industry.
Chapter 3 Page 133
Large fixed costs and small variable costs
give rise to a minimum viable scale, which
has to be exceeded in order for the firm to
earn a profit in the market. 31)
Source: Compiled from: The Nordic task force on airline competition, Report from the Nordic competition
authorities, competitive airlines. Towards a more vigorous competition policy in relation to the air travel
market no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June 2002.
Using a larger aircraft reduces the cost per passenger where certain costs do not rise
proportionally with the number of seats. Economies of vehicle size are well known in
transport industries, including in airline operations.
The estimated economies of aircraft size are, according to the NTFAC, often exaggerated
since costs are compared for the different aircraft on their typical routes. Since larger aircraft
tend to be used on longer distances, the economies of stage length influence the comparison.
Specific estimates of scale economies at vehicle level may therefore be overstated if no
adjustment is made for the effects of differences in stage length. 33)
Longer stage length reduces the costs per passenger in two ways:
•
Landing fees, handling cost, and ground manoeuvring cost fall relative to the
passenger kilometres flown (produced).
•
The capacity of the aircraft is better utilised since the aircraft is grounded for a shorter
time. Turn-around between flights is reduced with longer stage lengths and fewer
landings per period. 34)
The optimal aircraft size follows from route characteristics. This implies that the unit cost per
revenue passenger kilometre mirrors the network operated by an airline. A large airline
operating the network of a medium sized airline will incur similar unit costs on that part of its
operations to those incurred by the smaller carrier. There are no significant economies of
scale from operating costs at the firm level. 35)
Chapter 3 Page 134
3.6.3
ECONOMIES OF SCOPE
Table 3.2:
Economies of Scope
Economies of scope on the supply Economies
(production) side
of
scope
on
the
demand
(consumption) side
It costs less to produce services jointly by The most important economies of scope are
one firm rather than separately by found on the demand side.
different firms.
Arise when more routes are served within A carrier offering a larger network of services
the network of an airline (the size of the will be more attractive to the traveller, since he
will have more destinations to choose from and
network of routes). 36)
a larger probability of finding a suitable
By
operating
several
interconnected connection from the particular origin to any
routes, the airline is able to utilise aircraft, given destination. 39)
crew, reservation systems, marketing
devices, and other overhead cost items in Economies of scope on the demand side are
various production lines or city-pair intensified by marketing practices:
connections. 37)
•
FFPs.
•
TACOS.
Economies of scope may be particularly •
Corporate discount schemes.
important when slot capacity at airports is
limited.
These create synthetic economies of scope on
the demand side as they make it more attractive
Airlines operating several flights out of for passengers and travel agents to concentrate
one airport gain the flexibility to adjust their demand at one airline. 40)
their network to changes in the demand
pattern. 38)
Increase the loyalty of the customers toward the
airlines through an artificial increase in the
switching costs.
Consumer preferences when more routes are
served are connected to the concept of switching
costs that customers have to pay when they shift
Chapter 3 Page 135
from one supplier to another. 41)
Source: Compiled from; The Nordic task force on airline competition, report from the Nordic competition
authorities, competitive airlines: Towards a more vigorous competition policy in relation to the air travel market
no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June 2002.
The NTFAC stated that the most important economies of scope from the production side in
the aviation industry arise from the complementarily of routes within the network. By
operating several interconnected routes, the airline is able to utilise aircraft, crew, reservation
systems, marketing devices and other overhead cost items in various production lines (citypair connections). 42)
These complementarities are important for several reasons:
•
An airline that supplies end-to-end trips consisting of at least two legs but only
operates on one of the leg routes has to buy a seat on this route from another airline.
In contrast, an airline that operates on both legs can supply all parts of the same endto-end flight itself. In general, this difference gives a competitive advantage to the
latter airline. If competition on the leg routes is imperfect, the selling airline marks up
the price of the seat above marginal costs. This mark-up is a cost to the buying airline,
which means that an airline operating on both legs can supply the end-to-end flight at
a lower cost than an airline that operates on only one of them. The selling airline is
able to raise its rival’s cost.
•
Operation within a network requires a close coordination at airport nodes. Incoming
flights must be co-ordinated with outgoing flights and arrive at gates close to the
gates of the relevant outgoing flights. As a result, economies of scope may be
particularly important when slot capacity at airports is limited. Airlines operating
several flights out of one airport obtain flexibility to adjust their network to changes
in the demand pattern. They may switch the use of a slot from one route to another,
when demand develops differently in two market segments. Thus an airline will enjoy
flexibility by concentrating several routes on a hub airport. 43)
Much of this coordination depends on city-pair specific investment at the hub airport. If two
legs forming an end-to-end flight are operated by independent airlines, unforeseen events on
the first leg may not be accounted for by the airline that operates the second leg.
Furthermore, free-rider problems may mean that all the necessary investments are not made,
and having made the necessary city-pair specific investments, the airlines are exposed to
Chapter 3 Page 136
strategic behaviour by their rivals. Both problems may mean that the transaction costs in the
hub airport are higher than if one airline operates all leg routes. 44)
Economies of scope emanating from the demand side are even more important, according to
the NTFAC. These occur when the demand for a range of goods (routes) is larger than if the
same goods were offered individually. The demand for an airline’s services increases with
the number of routes that are covered by its network. A carrier offering a larger network of
services will be more attractive to the traveller, since he or she will have more destinations to
choose from and a larger probability of finding a suitable connection from her particular
origin to any given destination.
Economies of scope on the demand side of the airline industry are due to two factors:
•
Consumer preferences, and
•
Marketing practices. 45)
Consumer preferences
Economies of scope on the demand side are due to the larger number of routes served and are
connected to the concept of switching costs, which customers have to pay when they shift
from one supplier to another.
Typical switching costs relate to:
•
Contracts.
•
Training.
•
Learning.
•
Data conversion.
•
Search costs, and
•
Loyalty costs. 46)
The NTFAC stated that switching costs may appear in the airline industry because many
people prefer a trip by a single airline compared to one involving two or more airlines. A
high quality end-to-end journey via a connecting airport requires that the passengers be able
to go through the connection without delays, baggage handling problems, extra costs, or
other unforeseeable events. The NTFAC was, however, of the opinion that the risk of such
events is often perceived as higher when two or more airlines are involved. In addition, some
Chapter 3 Page 137
passengers think that travelling by one airline is more comfortable than using two or more
carriers.
Switching costs mean that the airlines realise economies of scale on the demand side by
increasing the number of routes. An increase in the number of routes means fewer transfers
between aircraft for the passengers. As many passengers prefer fewer shifts, more routes
make the airline’s services more attractive to the passenger, and as a consequence, the airline
will encounter an increased demand. 47)
Marketing practices
Economies of scope on the demand side are often intensified by the marketing practices of
the airlines. Examples of such marketing practices are FFPs and travel agent agreements.
Schemes and programmes such as these create synthetic economies of scope on the demand
side because they make it more attractive for passengers and travel agents to concentrate their
demand at one or a few airlines. The schemes and programmes increase the loyalty of the
customers toward the airlines through an artificial increase in the switching costs. 48)
3.6.4
ECONOMIES OF DENSITY
An airline’s unit costs decline when the airline adds flights or seats on existing routes. 49)
Table 3.3:
Economies of density
Economies of density on the supply Economies of density on the demand
(production) side
(consumption) side
In airlines, supply side economies of Even more important are the demand side
density exist if an airline’s unit cost economies
of
density. A
higher
route
declines when the airline adds flights or frequency will decrease the average time cost
seats on existing routes, primarily because experienced by the traveller and hence induce
of improved utilisation of aircraft capacity a higher demand for air transport, especially
and crew. 50)
from business travellers. 52)
Competitive advantage in a large hub-and- This feedback mechanism, implying that the
Chapter 3 Page 138
spoke network. Adding destinations to a demand for travel in a network is in a sense
hub-and-spoke network shows decreasing self-reinforcing, is referred to as the Mohring
returns to firm or network size. This effect. As the demand for travel increases, a
negative effect is dominated by the positive higher frequency of departures can be
supported, and the individual user incurs a
effect of economies of traffic density.
smaller average generalised cost. This in turn
Passengers who must travel via a hub also induces a still higher demand, and so on until
face an increase in trip duration as equilibrium is reached. 53)
compared to a direct point-to-point service.
Longer
flights
increase
the
airlines’
operating costs and the passenger’s total
travel time.
As a result, the economies of density
involved in hubbing must be considered
against the disadvantage of increased trip
duration
and
the
inconvenience
of
passengers having to transfer between
flights. 51)
Source: Compiled from; The Nordic task force on airline competition, report from the Nordic competition
authorities, competitive airlines towards a more vigorous competition policy in relation to the air travel market
no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June 2002.
Of particular importance for the economies of density involved in aviation networks is the
hub-and-spoke mode of operation. According to the NTFAC, a hub airline channels all or
most passengers through a hub airport, from which all connections extend like the spokes of
a wheel. In this way the number of different non-stop routes needed to serve all possible pairs
of destinations is drastically reduced, allowing for quite remarkable cost savings.
According to the NTFAC, the most important economies of scope in the aviation industry
stem precisely from the carriers’ opportunities to consolidate traffic by employing a hub-andspoke network. This consolidation enables airlines to derive economies of density from
directing passengers via hubs, since they may use larger aircraft and/or fly with higher
frequencies. The lower number of routes in the hub-and-spoke network means that by
Chapter 3 Page 139
transforming its network from a point-to-point network into a hub-and-spoke network, an
airline is able to reduce its costs without lowering the number of destinations served. 54)
3.6.5
ECONOMIES OF ALLIANCES
Table 3.4:
Economies of alliances
Economies of alliances on the supply
Economies of alliances on the demand
(production) side
(consumption) side
Airlines form alliances in order to exploit More extensive networks are more attractive to
each other’s networks and to strengthen customers and offer larger economies of scope
the competitive positions of all alliance to the carrier.
partners.
Establishing an alliance with an “adjacent”
Alliances should be treated with the same carrier may also be an efficient way for
vigour as traditional mergers. 55)
competitors to divide the market between them.
56)
Source: Compiled from; The Nordic task force on airline competition, Report from the Nordic competition
authorities, Competitive airlines towards a more vigorous competition policy in relation to the air travel market
no. 1/2002, Copenhagen/Helsinki/Oslo/Stockholm, 18 June 2002.
3.6.6
SWITCHING COSTS AND LOCK-IN EFFECTS
Switching costs limit competition between operators by stopping competition to erode price
differentials from a dominant carrier. 57) High switching costs result in customers being
locked in. 58)
3.7
THE EFFECT OF AIRLINE NETWORKS ON COMPETITION
The increasing returns to scale, scope and density in the airline industry have several anticompetitive implications, according to the NTFAC. These include:
•
Economies of scale on the supply side set a natural limit to the number of competitors
that can operate without economic loss on a given route. The combination of a large
fixed cost and small variable cost gives rise to a minimum viable scale, which has to
be exceeded in order for the firm to earn a profit in the market. Aircraft can easily be
Chapter 3 Page 140
transferred between routes, but each aircraft operating on a given route incurs a fixed
cost.
•
Economies of scope on the demand side may reduce the competition in the airline
industry, as they give the airlines an incentive to merge or join alliances with other
airlines so as to increase the number of routes offered and the flight frequency on
every route. Entry is often not possible on the scale of one or a few products. To be
competitive, and exploit the economies of scope, each firm in the industry often has
to produce a full range of products.
•
The hub-and-spoke system of operation, while economically efficient to the
individual carrier firm, seems to give rise to strong anti-competitive effects. The
economies of scope and density characteristic of these networks are such as to grant
the (one and only) hub airline very considerable market power at and around its hub.
As a result, different airlines have an incentive to operate hubs at different airports.
The hub-and-spoke system as operated among a set of large individual carriers is
therefore able to divide the market between the airlines. Although the networks of
different carriers overlap, very few origin-destination pairs will exhibit more than two
carriers operating non-stop flights. 59)
•
The competitive advantage of hub-and-spoke networks is effectively reinforced
through the loyalty programmes operated by the carriers. A FFP becomes more
attractive to the traveller the larger the carrier’s network of destinations, and vice
versa.
•
The competitive advantages allow the hub airline to dominate most routes out of the
hub airport.
•
Most major airlines have joined alliances with other airlines that operate in
complementary regions or continents. A few global alliances cover more than fifty
percent of the world passenger market.
•
The development of the airline industry in the years after the liberalisation was
influenced by the role of network economics. By building hub-and-spoke networks
the large airlines had, however, managed to enhance their competitiveness by
exploiting technical economies of scope (or density).
•
The cost advantages related to network economics are not always reflected in lower
airfares. In many cases dominance of a hub-and-spoke network gives rise to market
power, which is exploited by the airlines to increase the fares especially on outgoing
Chapter 3 Page 141
flights from airports that are highly dominated by the hub airline. Hub airlines have
market power on almost all spokes out of the hub airport.
•
The incremental cost of operating an extra route in a hub-and-spoke network is often
smaller than suggested by the average unit cost of the network. An extra route may
generate feeder traffic (and associated revenue) to the larger network. It will be
relatively inexpensive for an incumbent hub airline to cross-subsidise a single spoke
route or a limited set of such routes. This leaves a dominant hub airline with ample
opportunity to fight a rival new entrant through increased capacity, disproportionately
reduced fares, and/or other predatory strategies. Unless met by timely and resolute
interventions on the part of the competition authorities, such strategies could make
the market almost incontestable, according to the NTFAC. 60)
3.8
THE OPERATION OF A DEREGULATED AIRLINE INDUSTRY
3.8.1
INTRODUCTION
The US DOT concluded that, contrary to the predictions generally made at the time of
deregulation, actual experience demonstrated that “deregulated airline markets are not
contestable” and that “incumbent airlines can and do obtain market power on certain types of
routes”. As a result of the fact that incumbent airlines “can obtain market power on some
kinds of routes", the US Administration stated that the DOT should "take action against
exclusionary practices that end or deter attempts by competitors to serve such routes”. 61)
The US DOT stated that “deregulation overall has been very successful and greatly benefited
consumers, since most airline markets are competitive and the vast proportion of airline
passengers travel in markets that have competitive service”.
The US DOT motivated their conclusion with the following statistics:
•
More than eighty percent of airline passengers travel in markets that have two or
more competitors.
•
The number of domestic passengers has tripled since 1979.
•
Traffic in competitive markets has grown even more.
Chapter 3 Page 142
•
The number of passengers in markets with two or more competitors has almost
quadrupled since 1979.
•
The number of passengers in markets with three or more competitors has eased
almost six fold and now accounts for about forty percent of all traffic.
•
The number of passengers in markets with three or more competitors exceeds the
total number of passengers in 1979.
•
The increased competition is reflected in the fares paid by passengers, since
inflation-adjusted fares have declined by about thirty-five percent since deregulation.
The US DOT reported, however, that deregulated airline markets functioned differently from
the way expected at the time of deregulation. At the time of deregulation, industry analysts
assumed that in a deregulated environment:
•
Any airline could enter any route and that the threat of entry would cause incumbent
airlines to maintain low fares to discourage entry (potential competition).
•
The more nimble airlines able to enter the industry after deregulation would capture a
large share of the traffic from the less efficient established airlines.
•
Airlines were thought likely to offer relatively simple fare structures. 62)
According to the US DOT the operation of the deregulated industry has been quite different
from the expectations at the time of deregulation:
•
Industry analysts had not expected every major airline to adopt a hub-and-spoke route
system. Airlines generally operated linear route systems during the regulatory era, as
did the intrastate airlines operating in California and Texas. 63) After deregulation
each of the holdover airlines (airlines that existed prior to the deregulation of the
airline industry) established a hub-and-spoke system. Hub-and-spoke systems enable
the hubbing airline to operate a more frequent service in spoke markets than could be
supported only by local traffic. Hub-and-spoke systems therefore benefit travellers in
most markets. However hub-and-spoke route systems make entry in many markets
difficult, owing tothe fact that any airline serving a route from one of its hubs will
have substantial competitive advantages over an entrant, unless the entrant either
serves the route from one of its own hubs or has significantly lower costs than the
hubbing airline. 64)
•
Deregulation did not lead to the simplified fare structure anticipated by many
observers. Economists had expected airlines operating under deregulation to offer
Chapter 3 Page 143
unrestricted low fares, an expectation based in part on the assumption that firms
entering the industry with low costs would keep incumbent airlines from being able to
create a complex fare structure. 65) 66) The actual result was quite different from the
expected one. The fare structures of airlines became extraordinarily complicated.
Airlines offer many different types of fares subject to many different conditions or
rules. Airlines use yield management to determine how many seats would be offered
at each fare (and limit the number of seats available to each fare class) with the
objective of selling as many seats as possible at higher fare classes. This enables
airlines to discriminate and charge higher fares to business travellers interested in
obtaining frequent service (time sensitive passengers) while offering lower fares to
leisure travellers interested in saving money and less interested in the number of
flights available in any market or the timing of those flights. 67) 68) 69) The
implementation of advances in information technology made it possible for the
airlines to implement detailed yield management systems which increased their
ability to engage in market segmentation and price discrimination. The technology
has enabled each airline to allocate seats among the many different fare classes
offered on a flight in accordance with a predicted demand for each type of fare. 70) In
addition, CRSs have played an important role in airline distribution. Travel agents,
who sell the great majority of airline tickets, rely on the CRSs to determine what
airline services and fares are available and to make bookings. The CRSs provide a
very efficient method of carrying out these tasks. 71) To enable travel agents to
advise their customers effectively, the CRSs contain the publicly available fare
classes of almost all airlines and show whether such fare classes are available or sold
out on particular flights. An incumbent airline can learn from a CRS what fares are
being charged by a new rival and can plan its response especially if such CRS is
owned or controlled by such airline. 72) 73)
•
Contrary to expectations at the time of deregulation, almost all of the current major
airlines were major airlines before deregulation. Industry observers had predicted
when deregulation began that the major airlines of that time would have trouble
adjusting to a deregulated environment, in part because they had relatively high
operating costs. Airlines entering the industry after deregulation were expected to
become a major segment of the industry since they would be more efficient and not
handicapped with the high-cost practices of the airlines doing business before
deregulation. 74)
Chapter 3 Page 144
•
The proponents of deregulation assumed that there were no economies of scale or
scope in the airline industry, and they overlooked the physical barriers to entry that
became important when the regulatory scheme no longer made entry and route
expansion difficult. The unavailability of airport facilities, for example, has hindered
expansion efforts by new entrants. 75) 76) An incumbent airline in such a market can
effectively prevent entry if it can obtain control of such scarce resources and deny
them to entrants, even if it is not using them. Significant economies of scale and
scope proved to exist in the deregulated industry, as shown by the importance of
travel agent override commissions and FFPs. These economies are particularly
important on the revenue side, another development unforeseen at the time of
deregulation. Analysts then focused on airline costs, an important factor under
regulation, rather than the ability to generate revenues, a factor which has become
critical since deregulation. 77)
•
According to Dutta R, there are far more economies of scale on the revenue side than
on the cost side. He stated that “revenue synergy” is derived from the power of huband-spoke networks. If an airline has have fifty flights into a hub as opposed to three
flights into a hub that in his view this creates a “huge power” as a result of the
frequency of operations. In addition, customers want to go to many destinations and
prefer the carrier that serves all their needs, and that creates some economies from a
frequent flyer basis. 78) 79)
•
As was expected, many firms entered the airline industry in the first ten years after
deregulation. Contrary to expectations, few survived. Until recent years the industry
included only four significant airlines that began scheduled interstate service after
deregulation – Southwest, which had operated as an intrastate airline in Texas before
deregulation; America West; Midwest Express; and American Trans Air, which
began as a charter airline. The other new entrants generally failed, in part because of
management mistakes and an inability to cope with recessions. 80) Competitive
responses from stronger network airlines intended to eliminate competition may have
undermined the ability of some new entrants to remain in business. 81) 82) Some of
the major pre-deregulation airlines, of course, like Eastern and Pan American, also
failed. 83) Of the nine passenger airlines with current annual operating revenues of
more than US $1 billion, all but America West and Southwest started operating
interstate scheduled passenger flights long before the airline industry was deregulated
(the seven that began operations before deregulation are American, Continental,
Chapter 3 Page 145
Delta, Northwest, TWA, United, and AA). The surviving pre-deregulation airlines
have become more efficient since deregulation. Their ability to survive despite their
higher costs, and the failure of almost all of the new entrant airlines that started up in
the early years of deregulation (with substantially lower costs) suggested that the
major airlines’ route systems and the scale and scope of their operations gave them
important competitive advantages. 84) 85) This is an important aspect of airline
competition as it implies that efficiency and lower cost are not determinants of
success in the airline industry.
•
The expected ability of virtually any airline to enter any route proved unrealistic. 86)
•
A number of economists had assumed that the contestability theory would apply to
the deregulated airline industry. Under that theory, as described by Professor Levine
M, 87) potential entry by new firms serves to discipline the behaviour of participants
in real world markets where a small number of firms (oligopoly) participate. It was
thought that firms actually operating in a given market would necessarily reduce their
prices to levels consistent with the costs of their potential entrant rivals. Otherwise,
entry will occur and they will be replaced. Whether airline markets are contestable is
important in determining whether there are threats to airline competition, since few
airline markets are likely to have many competitors. If airline markets were
contestable, firms outside a market could enter it so easily that the threat of potential
entry would make the incumbent firms operate efficiently and charge competitive
prices. 88)
Contestability could exist only under three conditions:
o “Equal access to economies of scale and to technology, whether expressed as
access to competitive levels of unit costs or as equivalent access to product
quality.
o No sunk costs, a firm can enter and exit without entry and exit costs, including
operating losses resulting from predation, and
o Price sustainability, there is a set of prices that can occur after the entry of at
least one firm which will support profitable operation”. 89)
Chapter 3 Page 146
•
The Secretary of the DOT concluded that “contestability has proven inapplicable in
the airline industry”. 90) 91) for the following reasons:
o An airline entering a market incurs certain sunk costs that cannot be recovered
if it exits, for example, advertising costs and the cost of setting up facilities at
the new airport.
o Travellers will be reluctant to book an airline that exits and re-enters a market,
moreover, given the significant possibility that the airline may again leave the
market before the date of their planned flight and the loss of pre-payment for
such flight. As a result, airlines cannot freely enter routes due to expected
initial lack of support by clients.
o An incumbent airline does not need to lower fares to discourage entry before
it happens – an incumbent airline can immediately change its fare structure if
another airline announces plans to enter one of its markets. The threat of entry
thus puts little pressure on incumbent airlines to reduce fares. 92) 93)
o Airlines developed marketing programmes designed to gain the loyalty of
their customers and travel agents. Airlines, for example, created travel agent
override commission programmes to encourage travel agents to book the
airline offering the incentive commissions. These commission programmes
are usually structured so that the airline with the largest market share in a
travel agent’s area will have the most attractive commission programme.
These programmes are attractive to many travel agents. FFPs purchase
passenger loyalty in order to attract repeat business. 94) 95)
o The US DOT nevertheless found that “nonetheless, deregulation has been
very successful despite the inaccuracy of many predictions on how the
deregulated industry would operate. And while competition in some markets
may be less vigorous than predicted, all airlines, both those operating before
deregulation and those created since, have had to reshape their operations to
become efficient and cope with the competitive demands of the deregulated
environment”. 96)
Two of the unexpected results of deregulation, hub-and-spoke route systems and yield
management, were crucial to the analysis of competitive issues in the proceedings regarding
unfair or exclusionary competitive practices by the US DOT. The major findings and
Chapter 3 Page 147
conclusions of the Secretary of the DOT in this regard as well as those pertaining to the
development of a new generation of low cost airlines are set out in 3.8.4 below.
Johannesburg International Airport in South Africa has to a great extent developed into the
hub of larger airlines in the private sector in South Africa. As a result, many of the
characteristics of hub-airports in the USA are also be applicable to South Africa. Yield
management is practiced by SAA and some of the airlines in the private sector. It may well
be that yield management systems unfairly discriminate against members of the public by
limiting the availability of the number of seats per fare class (especially the availability of
cheaper fare classes) and at the same time promoting such tariffs without disclosing the
limited extent of seat availability to the public. This also results in confusion relating to what
the “going rate” for a particular flight will be.
3.8.2
YIELD MANAGEMENT
According to the US DOT, yield management has enabled the airlines, especially the
network airlines, to develop complex fare structures designed to maximises revenues on each
flight through price discrimination. Airlines attempt to sell as many seats as possible at the
highest fares, those charged for unrestricted travel, and as few seats as possible at the lowest
discount fares. Passengers paying the highest fares obtain the advantages of flexibility and
last-minute access to seats. They can book seats just before the flight, change their
reservation without penalty, and obtain a full refund if they do not to use the booking.
Passengers travelling on most discount fares, in contrast, typically have to book seats several
days or more before the flight, have to pay in advance for their seats, cannot change a
reservation without paying a penalty, and cannot obtain a cash refund if they cancel their trip.
Although business travellers can use some discount fares, the cheapest discount fares
frequently have a Saturday night stay requirement to discourage business travellers from
using them. To save seats for passengers willing to pay for unrestricted fares bought shortly
or immediately before the flight, airlines limit the number of seats made available at the
lower fare levels. 97) 98)
Unlike the low cost airlines, the network airlines have relatively little interest in attracting
travellers who insist on paying low fares for air travel, even though the network airlines do
Chapter 3 Page 148
sell many discount-fare seats. They have structured their operations so as to attract travellers
willing to pay more for better and more frequent service. If an airline charges higher fares to
those travellers, it may be able “to generate sufficient revenue to provide the product, but no
more than that if competition is effective”. 99) 100)
The airlines’ yield management systems mean that passengers on the same flight will have
paid different fares, depending on how far in advance they made their booking and how
many restrictions they were willing to accept in return for a lower fare. No airline has been
able to maintain a simple fare structure. The discrimination in fares also reflects the
willingness of business travellers, but not leisure travellers, to pay for frequent and
convenient flights. 101) 102) 103) Low cost airlines have less complex fare structures than
the network airlines.
Although network airlines serving a market allocate different numbers of seats to each fare
level, they tend to charge similar amounts for each type of fare offered in a market (for
example, 21-day advance-purchase fares and unrestricted economy fares). Each network
airline usually matches the fare levels offered by its network competitors in a market,
although not necessarily the number of seats made available at each fare. An airline that has a
competitive advantage in a non stop market will be able to sell more seats at unrestricted
fares and so can afford to make fewer seats available for discount fare passengers. A hubbing
carrier is able to offer a service advantage relative to a non-hubbing carrier, which permits it
to attract a relatively larger portion of time-sensitive (primarily business) travellers, serving
to raise its average yield.
Even if both airlines serving a route have a hub at one of the endpoints, the airline with a
competitive advantage can obtain significantly higher yields. 104)
3.8.3
HUB-AND-SPOKE ROUTE SYSTEMS
Airlines with hub-and-spoke route systems carry most travellers in long haul markets by
flying them from their origin point to a hub, where the passengers transfer to other flights
bound for their destination. This enables a hubbing airline to attract both local traffic
(passengers flying between the hub and another point) and flow traffic (passengers travelling
from one point to another over the hub).
Chapter 3 Page 149
The network airlines’ hub-and-spoke systems give flow passengers more connection options
for travel from their point of origin to their destination. Travellers in the long-haul markets
benefit from increased service options, since several airlines compete for flow traffic with
connections over their hubs. 105)
A network airline will have a large share of the traffic and flights at its hub. It typically will
carry at least half of the local traffic at each of its hub airports. 106) 107)
While hub-and-spoke systems benefit travellers in the flow markets (and make possible more
frequent service for travellers in the local markets), they also create substantial competitive
advantages for a network airline in its hub markets.
Those advantages make it difficult for other airlines to compete in those markets and enable
the incumbent hub airline to charge higher fares for the following reasons:
•
The combination of local and flow traffic enables the hubbing airline to offer more
flights in all of the markets at its hub, providing a substantial competitive edge. Nonhubbing competitors will capture little flow traffic and so cannot operate as many
flights. The airline that offers the most flights in a market typically obtains a
disproportionate share of the traffic in that market, so the inability of a competitor to
operate as many flights will likely reduce its ability to attract passengers for the few
flights that it does operate. 108) 109)
•
The hubbing airline serves the most destinations from the hub and offers the most
flights in all or almost all its hub markets, so the hub city’s residents will find its FFP
more attractive than programmes offered by competing airlines that serve fewer
destinations and operate fewer flights from the city. Residents flying on the hub
airline will accumulate award miles more quickly and have a better choice of
destinations for awards. 110) but since award benefits are non-linear, residents will
prefer the hub airline since they will obtain awards more quickly. 111)
•
The hub airline’s travel agent override commission programme will be the most
attractive programme for travel agents in the hub city. An airline that dominates a city
will typically structure its override commission programme to leverage its dominant
share of the local airline market. The airline that is most often booked by the agent
will offer the most remunerative override commission programme for the travel
agents in the area and thereby gain a larger share of their bookings. 112) 113)
Chapter 3 Page 150
•
The hub airline’s dominance of the local market at the hub city gives it greater name
recognition. Travellers will be more likely to call that airline when they wish to book
airline seats. 114) In addition, the hub airline can spread advertising costs over a
greater number of markets, so it will have lower advertising expenses than will an
airline serving fewer markets at the hub city. 115)
Because a hubbing airline obtains the above-mentioned competitive advantages, its hub
markets tend to have little competition. The virtual disappearance of hubs with two hubbing
network airlines suggests that the competitive advantages possessed by the larger hubbing
airline make it difficult for a second airline to operate a hub at the same city. However, since
a hub airline can operate most efficiently in its hub markets, it will likely add new routes
from its hub, not from cities that are not hubs. Each network airline focuses on routes that
have one of its hubs as an endpoint, and it rarely serves a competitor’s non-stop hub markets.
116)
Where a network airline entered a competitor’s total hub route system it seems to represent
signalling that the airline entering is doing so in retaliation against the competing airline’s
increased competition in one of the first airline’s major markets. Generally the competitive
advantages enjoyed by a network airline at its hub preclude other network airlines from
operating as efficiently or profitably as the first hubbing airline. 117)
Hub airlines therefore usually have market power at their hubs, as shown by hub premiums –
average fares in most hub markets are substantially higher than in comparable non-hub
markets. Professors Oster and Strong cited figures presented by Professors Borenstein S to
the Transportation Research Board on January 21, 1999, that show hub premiums in the USA
as high as 62 percent at Charlotte, 51 percent at Cincinnati and Pittsburgh, and 41 percent at
Minneapolis-St. Paul. 118) On the other hand, little or no hub premium exists at network
airline hubs that receive a significant amount of service from the low cost carrier Southwest,
such as St. Louis and Salt Lake City. 119) 120) 121)
Hub premiums have persisted over time. Hubs without a significant level of low cost carrier
service had larger fare premiums in 1997 than they did in 1988. 122). Travellers in markets
with low cost carrier competition, on the other hand, obtain both the low fares offered by low
cost airlines and the more frequent service and wider range of destinations offered by a
Chapter 3 Page 151
hubbing airline. While hubs give travellers better service, the ability of network airlines to
continue operating hubs after entry by a low cost carrier indicates that the higher fares
charged by network airlines in hub markets without competition reflect in part market power,
not costs, demand characteristics, or service features.
A network airline with market power at a hub can obtain higher yields in the hub markets
largely by limiting the capacity of its flights, with the result that business travellers who are
willing to accept high fares will fill up most of the relatively limited number of seats offered
by the network airline. The limited number of seats offered means that the network airline
has little incentive to make seats available to passengers willing to fly only if they can obtain
low fares. Hub markets, of course, still have frequent service, since frequent connecting
banks of flights are a necessary part of hub-and-spoke operations, but they would have even
more service in a competitive environment. 123)
The operation of hub-and-spoke networks is one of the many commercial practices adopted
by airlines following deregulation to exploit the economies of scope that exist in the air
transport industry, as analysed in 4.3 of chapter 4. Recently, the viability of the network
business travel pricing model of the hub-and-spoke airlines has undergone a fundamental
shift with respect to levels of business travel to support such operations, as identified in 3.9
below.
3.8.4
THE DEVELOPMENT OF A NEW GENERATION OF LOW COST
AIRLINES
In this section, the importance for consumers of establishing low fare competition especially
in hub-markets that are dominated by large network airlines is demonstrated on the basis of
conclusions arrived on in the USA.
Low cost carriers, both in the USA (like SWA, JetBlue, AirTran Airways, American Trans
Air, Frontier and Spirit Airlines) and in Europe (like Ryanair, easyJet, Airline Co, Virgin
Express, Buzz) have recently achieved tremendous growth while financial difficulties are
being experienced by full-service network airlines (like American, Continental, Delta,
Northwest and American Airways as well as Air Canada) that have experienced a reduction
of volumes of traffic. This issue is further discussed in 3.9 below.
Chapter 3 Page 152
While the low cost airlines generally use yield management, they offer a smaller range of
fares than the network airlines and impose fewer restrictions on their lowest fares. 124) The
more recently established low cost airlines have more limited route systems than Southwest
and do not have Southwest’s financial strength or as much of a brand reputation. While
Southwest enters new routes with frequent flights, the newer low cost airlines often enter
markets by operating relatively few daily flights. Some of the newer low cost airlines, unlike
Southwest, rely on hub-and-spoke route systems.
The low cost airlines have lower operating costs than the network airlines, except for
America West and possibly the network airlines’ low fare subsidiaries. 125)
Every low cost carrier had adjusted costs per available seat-mile that were significantly
below the costs of any network airline (except America West). While the network airlines do
not focus on carrying low fare traffic, several of them have developed low cost subsidiaries
that seek to compete with Southwest and other low cost airlines for price-sensitive travellers
(e.g. Shuttle by United, Delta Express and American Airways’ MetroJet). 126)
The services offered by Southwest and the newer low cost airlines greatly benefit many
consumers: they both give travellers access to substantially lower fares and greatly increase
the size of the market by stimulating traffic. In 1997, short-haul markets (markets under 750
miles, 1200 kilometres) with low fare service had a nominal average fare of $84, while shorthaul markets without such service had a nominal average fare of $175. Traffic in short-haul
markets with low fare service has quadrupled since 1979, while traffic in short-haul markets
without such service has grown by only 48 percent since 1979. 127)
The Secretary for Transportation of the USA concluded that low cost airlines provide
important service and competitive benefits in that fare levels are much lower and traffic
levels are much higher on routes served by low cost airlines. He also noted that whilst
competition by the low cost airlines provides obvious benefits, especially for cost-sensitive
consumers, consumers benefit from all forms of airline competition. In this regard, he noted
that Midwest Express chose to compete by offering service features not matched by other
airlines and considered attractive by many travellers. As such, Midwest Express has operated
successfully by offering premium service at fares comparable to those charged by other
airlines. While network airlines cannot practicably compete effectively at another network
Chapter 3 Page 153
airline’s hub, a low cost carrier with lower costs than network airlines and effective
management can compete effectively in such hub markets, which typically have relatively
high fares. The Secretary for Transportation of the USA concluded that a new service by a
low cost carrier is likely to be the only way that many hub markets will ever benefit from
competitive airline service. 128)
3.8.5
POTENTIALLY UNFAIR COMPETITIVE RESPONSES TO ENTRY
BY LOW COST AIRLINES
Since a hubbing airline will most likely have only limited competition in most of its hub
markets if it can deter entry by low cost airlines, Oster and Strong regarded it as profitable
for an incumbent airline to attempt to eliminate actual competition if it can. The low cost
carrier’s presence in a hub market takes away the hubbing airline’s ability to charge fares
above competitive levels. 129) If the low cost carrier becomes established in one hub market,
it may well expand into other markets at the hub. 130)
Several low cost airlines, often supported by communities and airports, have complained to
the US DOT that a low cost carrier’s entry into a network airline’s market, typically a hub
market, has led the incumbent to sharply cut its fares and increase the number of seats sold at
low fares (and often its capacity on the route) with the intention of making the route
unprofitable for the entrant.
Complaints were also received by the US DOT about other behaviour, not just pricing and
capacity strategies, seemingly designed to make entry impossible or at least unprofitable as
airlines compete in multiple ways, not just on price and schedules. 131)
Such complaints included allegation that incumbent airlines:
•
Awarded bonus override commissions to travel agents that book the incumbent airline
rather than the airline entering the market, thereby making it more difficult for the
entrant to obtain bookings from those agents’ customers.
•
Took other steps that prejudiced the competitive position of an entrant airline, for
example, refusals to sign joint baggage and ticketing agreements with the entrant,
even though airlines typically have such agreements with most other airlines.
Chapter 3 Page 154
•
Refused to sublease gates and other airport facilities to entrants, even though they are
not being fully used, when comparable facilities are not available from any other
source.
•
Allegedly purchased the slots that come on the market to keep entrants from
obtaining slots at slot-restricted airports.
•
Used slots for relatively unprofitable markets in order to prevent losing such slots to a
potential entrant (“baby sitting” of slots). 132)
The Secretary agreed with the TRB panel that incumbents could use such tactics as “limiting
access to airports by restricting the availability of slots and gates; influencing CRS listings;
and offering special travel agent incentives” “to the detriment of smaller rivals, possibly
denying the opportunity to compete fully on the basis of relative costs and the attractiveness
of their offerings”. 133) The panel also stated that the DOT “has an important role in
preserving and enhancing opportunities for competitive entry in the airline industry”. It stated
that the DOT “should ensure that airlines are not exploiting their relationships with airports,
air traffic control access, CRSs, and travel agents to hinder competition and to limit entry
opportunities”. 134) 135)
3.8.6
QUESTIONABLE
RESPONSES
INVOLVING
PRICE
AND
CAPACITY
The Secretary of the US DOT stated that the most controversial competitive responses to
entry involved sharp fare cuts, a large increase in the number of seats sold at low fares, and
often an increase in total capacity. An incumbent airline will often need to cut its fares when
a competitor enters the market. He was of the opinion that a low cost carrier’s entry should
not usually require the incumbent airline to match the new entrant’s fare levels and make
large numbers of seats available at those levels or to eliminate restrictions on its discount
fares owing to the fact that network airlines typically offer service features unmatched by
most low cost airlines.
In some cases the incumbent network airline has nonetheless responded to entry in ways that
appear to him to be economically irrational, unless the entrant exits the market or reduces its
service. In these cases, the hubbing airline cuts its fares and increases the availability of its
lowest fares by so much that it obtains much lower revenues and profits than it would have
Chapter 3 Page 155
obtained if it had chosen a more moderate response. In extreme cases the incumbent airline
cuts its fares to match the new entrant’s fare levels, eliminates all or most of its restrictions
on discount fares, and greatly expands the availability of discount-fare seats. 136)
The incumbent airline often adds flights as well and increases traffic as a result of the wide
availability of low fares. The incumbent airline, however, incurs a substantial amount of
self-diversion – it sells so many seats at low fares with minimal restrictions that it no longer
sells significant numbers of higher fare seats (self-diversion means a reduction in revenues
caused by the airline’s own actions, not by its competitor’s actions). As a result, although the
incumbent carries many more passengers, its total revenues are well below the revenues
realisable through a more moderate response to entry.
When the incumbent airline responds to entry by slashing fares and making low discount
fares much more available, the new entrant airline usually cannot obtain enough traffic to
sustain its service. The readily availability of low fares on the incumbent airline, which offers
service features not offered by the new entrant airline and has an established reputation, dries
up the traffic available to the entrant. The new entrant exits the market owing to the financial
impact, and the incumbent airline then increases its fares and sharply reduces the availability
of its lowest discount fares. The entrant’s exit can occur within several months of entry. 137)
An incumbent airline, like any firm, would normally prefer to obtain as much revenue as
possible for the services it has chosen to provide. The airline would be unlikely to voluntarily
reduce its own revenues by charging lower fares than it could have charged unless it intended
to keep travellers from booking the entrant airline. 138)
The Secretary of the DOT concluded that the investigation into competitive responses by
network airlines to entry by a low cost carrier has shown that network airlines can and
sometimes do respond to entry with the apparent intent of eliminating or reducing
competition. He referred to one airline’s internal documents that indicated its intent to
eliminate new competition through fare reductions, a greatly increased availability of low
fare seats, and some added capacity. The network airline expected that it would then attract
almost all discount fare travellers away from the new entrant and compel its exit. According
to the Secretary, the network airline knew that it would thereby reduce its short-term
Chapter 3 Page 156
revenues more than was necessary to meet the new competition, but it accepted those losses
as the price to pay for regaining its market power in its hub markets. 139)
The Secretary of the DOT stated that this kind of competitive response harms consumers
over the long term. In the short run the public benefits – fares are much lower and discountfare seats are easily obtained from both airlines. Travellers can enjoy both low fares and the
service features offered by the hub airline, such as more frequent flights and more attractive
FFP benefits. In the long run, however, the public loses – the new entrant’s competition is
eliminated and fares go up to their previous levels or even higher. 140)
It was the view of the Secretary of the DOT that a hubbing airline would not need to respond
so aggressively if its objective was to maximise its revenues rather than eliminate
competition, as a hubbing airline has substantial competitive advantages that should enable it
to retain higher-yield traffic due to the fact that airlines compete on many service features,
not just price. Some of the many service features of network airlines are:
•
They operate more frequent services and have an established brand.
•
They offer more attractive FFPs and TACOs.
•
Business travellers often choose an airline in order to obtain frequent flyer miles.
•
Incumbents are likely to have the advantage of a reputation for reliable service,
whereas a new entrant would not have such a reputation. 141).
•
The hub airline’s flow traffic attracted by its network operations will support its
service even if it loses some local passengers to an entrant.
•
The entrant could not capture the flow passengers unless it also operated a hub at the
same city. 142) 143)
The Secretary of the DOT stated that experience in other markets demonstrated that network
airlines could compete with low cost airlines without flooding the market with low fare seats.
Network airlines have found ways of coexisting with low fare competitors like the toleration
of Southwest’s major presence in local markets has been tolerated by major carriers not
competing aggressively for local passengers, but focussing on carrying flow traffic to feed
their networks. There are cases where the hubbing airline did not try to deny Southwest a
significant share of the market by offering a large number of discount-fare seats at low fares.
144)
Chapter 3 Page 157
In addition, the Secretary found examples where network airlines did not invariably respond
to entry by low cost airlines other than Southwest by sharply cutting fares and making the
low fares available on large numbers of seats.
Even an airline as successful as Southwest cannot necessarily expect to obtain large profits
from competing with the network airlines in their hub markets, which indicates that network
airlines have substantial competitive strengths of their own in competing against a successful
low cost carrier. Southwest “deliberately avoids” confrontations with the major airlines.
Southwest itself stated that barriers to entry remain high at many concentrated airports
because of the competitive advantages of the incumbent carriers that potential new entrants
cannot begin to match, and that these barriers to competition are overwhelmingly the result
of powerful marketing advantages and tactics used by dominant incumbent carriers to protect
their concentrated markets from low cost competitors. 145)
The conclusion of the Secretary of the DOT that an incumbent airline can effectively
eliminate competition through predatory-type behaviour is consistent with recent economic
thinking. He formed the view that while economists for some time viewed predation as an
ineffective strategy, they have re-examined the question of predation and concluded that
predation is more likely to occur and to be more rational than was thought earlier. He stated
that “it is now the consensus view in modern economics that predatory pricing can be a
successful and fully rational business strategy. Sound empirical and experimental studies, as
well as modern economic theory, have shown that predation is not rare”. 146)
The Secretary of the DOT stated that predatory-type behaviour might be effective in the
airline industry precisely because of the fact that aircraft are so mobile and can be moved
from one route to another. The mobility of aircraft was originally thought to be a guarantee
that airline markets would be competitive. However, as shown, airlines incur significant sunk
costs in entering a new airport, a factor which can discourage entry. On the other hand, when
entry occurs, the incumbent hub airline can easily shift aircraft from other markets to
increase capacity in the market served by the new competitor. An airline that dominates a
market thus can quickly expand its capacity on a route without making an irretrievable
investment, since it can easily re-deploy the aircraft to other markets when the entrant has
been forced to exit or reduce service. In addition, the ready availability of fare and
Chapter 3 Page 158
availability information on competing airlines through the CRS facilitates an airline’s ability
to engage in anti-competitive conduct. The CRSs, moreover, generally sell route-by-route
booking data on individual airlines to airlines participating in a system, which enables each
airline buying the data to learn how many seats are being sold on its competitors, for each
travel agent using the system. 147)
As a result, the Secretary of the US DOT stated that the Administration has concluded that
the potential for predatory-type behaviour by incumbent airlines is great enough that the
Department to implement strategies, such as enforcement action, that will effectively prevent
such conduct (and other conduct intended to eliminate or reduce competition). 148
3.8.7
THE DECLINE IN AIRLINE COMPETITION
The Secretary of the US DOT stated that there are signs that competition has declined in
recent years, even though most markets remain very competitive. The number of routes with
competition between airlines having a significant presence in the market has declined.
In addition, travellers in some markets have benefited significantly less from deregulation.
Inflation-adjusted fares have declined substantially since deregulation in long-haul markets
(markets over 750 miles, 1,200 kilometres in length) and in short-haul markets that have low
cost carrier service.
When adjusted for inflation, average fares in short-haul markets with low cost carrier service
have fallen by 36 percent since 1979 and have increased by 26 percent in other short-haul
markets over the same period. Passengers in the short-haul markets without low cost carrier
service make up almost one fourth of all domestic passengers. 149) The TRB panel also
found signs indicating that the US airline industry has become somewhat less competitive in
recent years. 150)
After the May 1996 ValuJet crash, new entry into the airline industry virtually stopped until
the US DOT proposed its enforcement policy. No firm applied for the authority needed to
operate scheduled passenger service with jet aircraft in 1997 or 1998 and actually began
service (save for National Airlines, which applied after the proposed enforcement policy’s
publication).
Chapter 3 Page 159
The Secretary of the DOT stated that entry ceased around the time when, according to the
low cost airlines, network airlines became much more aggressive in responding to
competition by the low cost airlines. Following the publication of the proposed policy,
several low cost airlines began operating, including Access Air, Sun Country (Sun Country
had been operating only charter service until 1999), and Jet Blue. He was of the opinion that
the publication of the proposed policy and the DOJ’s suit against American may have
encouraged the renewed interest in entering the industry. The number of passengers in
markets with low cost carrier service declined in 1997 for the first time in recent years, but in
1999 both the absolute and relative number of such passengers reached record highs. The
Secretary of the DOT suggested that the proposed guidelines of the DOT and the DOJ suit
against AA have benefited competition. 151)
3.8.8
MARKET POWER IN AIRLINE MARKETS
The Secretary of the DOT concluded that successful past predation could itself operate as an
entry and re-entry barrier, particularly where reputation effects are present. As such, the
would-be entrant would anticipate that any attempt to enter the market would evoke a
predatory response from the incumbent. Anticipating that response, the would-be entrant
would decline to enter the particular market. 152)
3.8.9
FREQUENCY
OF
APPARENT
UNFAIR
EXCLUSIONARY
CONDUCT
The US DOT claimed to have seen a number of cases where an incumbent airline crafted its
response to entry with the apparent goal of eliminating competition, since the response
appears to be economically irrational unless it forces the entrant to end or reduce its service.
153)
The network airlines contended that there was no systemic problem in the airline industry as
in their view such conduct rarely occurs and that there was no need to adopt enforcement
standards on airline competition under section 411.
The Secretary of the DOT concluded that unfair exclusionary conduct seems to be more
common than claimed by network airlines and that the Department would be justified in
Chapter 3 Page 160
taking action against competitive responses designed to eliminate competition and create
market power, even if incumbent airlines rarely engaged in such conduct. Professor Kahn A
also endorsed the approach of the US DOT.
The Secretary also stated that if the network airlines are correct in claiming that this type of
conduct hardly ever occurs, enforcement action like that the US DOT had proposed would
have little impact on the industry and would only have an effect on the network airlines’
scheduling and fare decisions in rare cases. 154)
According to the Secretary, the network airlines understated the seriousness of unreasonably
aggressive competitive responses for the following reasons:
•
Driving a new entrant from one market deters entry in other markets (or causes entry
to occur on a smaller scale).
•
The network airlines concluded that potentially exclusionary competitive responses
hardly ever occur, but the US DOT identified several such instances.
•
The DOJ’s complaint against American alleged, on the basis of internal American
documents, that American had adopted a strategy of using responses to low cost
carrier entry at Dallas Fort Worth (DFW) that would eliminate such competition and
that American carried out that strategy against several such airlines.
•
The low cost airlines have repeatedly maintained that unfair competitive responses by
major airlines are a substantial barrier to their growth and success. 155)
Levine M stated that “apparent predation attempts have been plentiful”. 156)
The findings of the analysis of the US DOT were consistent with the view of Levine M who
described the salient features of an incumbent’s predation strategy as follows:
•
Match, or better yet, beat the new entrant’s lowest fare with a low fare restricted to
confine its attractiveness to the leisure-oriented, price-sensitive sector of the market.
•
Match business-oriented fares and offer extra benefits to retain the loyalties of travel
agents and frequent flyers.
•
Add frequency where possible, to “sandwich” the new entrant’s departures between
one’s own departures.
Chapter 3 Page 161
•
Make sure enough seats are available on your flights in the market to accommodate
increases in traffic caused by the fare war. In short, leave no traveller with either a
price or a schedule incentive to fly the new entrant.
•
If the new entrant attempts to lower prices, the incumbent matches the prices of the
new entrant, no matter how low the fare. The objective of matching is to subject the
new entrant to a prolonged period of operation at low load factors.
•
This strategy saps the entrant’s working capital while inhibiting trials that would
disseminate favourable information about the new entrant. 157)
This Administration’s conclusion that predatory-type behaviour occurred often enough in the
airline industry to justify Department action on the issue is consistent with the most recent
studies and analyses conducted by economists, that believe that predatory behaviour is a
successful and rational business strategy that is more common than believed in earlier years.
158)
3.9
THE EFFECT OF A DECLINE IN OVERALL VOLUMES ON
AIRLINE NETWORKS
3.9.1
VIABILITY OF THE NETWORK BUSINESS TRAVEL PRICING
MODEL OF THE HUB-AND-SPOKE AIRLINES
The operation of hub-and-spoke networks is one of the many commercial practices adopted
by airlines following deregulation to exploit the economies of scope that exist in the air
transport industry as identified in 3.8.3 above and analysed in 4.3 of chapter 4. Some
practical aspects are also highlighted in 4.11.5.2 of chapter 4.
According to Davidowitch G, the economics of the airline industry have recently undergone
a fundamental shift with respect to levels of business travel and the viability of the hub-andspoke model, with the effect that strategic responses will take time to develop and
implement. 159)
Chapter 3 Page 162
In response to the early development of the discount airline sector the old-line carriers
adopted hub-and-spoke systems, discounted fares, FFPs and similar marketing techniques.
160)
According to Levine ME, the airlines expanded rapidly during the late 1990s, when the
economy of the USA was vibrant and growing. Unions took advantage of the growth to
negotiate favourable contracts that raised labour costs in the airline industry to unprecedented
levels.
In order to afford these higher costs, airlines attempted to raise fares. As leisure travellers do
not buy expensive tickets, airlines focused on business travellers booking tickets on short
notice, who valued the convenience of frequent service at nearby airports. Levine ME noted
that business fares rose almost 50 percent between 1999 and 2001. In addition, walk-up
business fares often were 10 times more than leisure fares booked in advance. 161)
According to O’Toole K and Field D, size really did matter in the past. In the days of limited
competition, the champions were those that could dominate their home markets and take a
powerful hold of the distribution chain.
Sub-scale competitors were simply “killed or
acquired”. This relates to aggressive actions by hub airlines that involved a combination of
increase in capacity and lowering of fares in order to eliminate competitors and new entrants.
162) Recently, measures were adopted by the US DOT to prevent such anti-competitive
behaviour. This aspect is fully discussed in chapter 7.
There was plenty of growth to conceal the worst of any structural flaws in the cost base.
In the assessment of Levine ME, this strategy by network carriers of focusing on business
travellers for high yield tickets has backfired for the following reasons:
•
Business travellers looked to travel on leisure fares even if it meant advance
purchases and Saturday night stays, and
•
Business travellers started to use airlines with cheaper fares. 163)
O’Toole K and Field D stated that the United Airlines bankruptcy filing added fuel to the
doomsayers' predictions of the impending failure of the full-service network model. O’Toole
Chapter 3 Page 163
K and Field D concluded, however, that the root cause of the current “malaise” may have
more to do with a lack of market focus than with too much “hubbing”. 164)
As a result, the discount sector flourished again. SWA grew rapidly and is now the most
profitable airline in the industry. Soon other discount airlines appeared which resulted in a
quarter of tickets sold in the USA being on a discount airline, compared to less than a tenth
four years ago. 165)
The terrorist attacks of 11 September 2001 had the following results:
•
Initially many business travellers stayed home.
•
When they finally did start to fly again, more alternatives were available than ever
before and it was not necessary to pay the exorbitant prices of the late 1990's.
Business travellers could fly on a discount airline or find a cheap Internet fare on one
of the traditional airlines.
•
Even when business improved, the old high fare structure did not come back.
Business travellers found other airlines that charges much less, even if they had to
drive to alternative airports. The implication was that the hub-and-spoke airlines
would have to offer more competitive fares to all customers.
•
The very same hub-and-spoke system that the airlines created in response to
deregulation is now being exploited by the discount airlines, which operate on its
fringes.
According to Levine ME, the established airlines need not abandon the hub-and-spoke
system, which has served both airlines and passengers well, but need to operate it more
efficiently.
In his assessment, airlines have to do the restructuring that they have been putting off for the
better part of a decade. This restructuring can be done under the protection of bankruptcy or
outside it. But in the assessment of Levine ME, it will succeed only if bankruptcy is a threat,
which would mean no more federal loan guarantees.
If they can reduce labour, equipment and other costs to more reasonable levels, these airlines
will find that the hub-and-spoke system will allow them to prosper. By concentrating their
flights at a hub, they can offer more frequent service to more destinations than the discount
Chapter 3 Page 164
airlines, which would enable them to offer reasonable fares on many seats by using the
Internet or other technologies. Only this kind of restructuring will enable airlines like United,
American, Delta and Northwest to run their businesses profitably. 166)
According to Levine ME, most airlines have a business model that was created against a
background of high traffic and high fares. Following 11 September 2001, he was of the
opinion that the overall market had changed substantially and was further of the opinion that
the airline industry would have to begin the painful process of restructuring.
Levine ME stated that the plight of United Airlines in having its application for state
financial aid (in the form of $1.8 billion in federal loan guarantees) turned down by the Air
Transportation Stabilisation Board was not unique as its precarious financial situation was
shared by all of the large hub-and-spoke airlines that survived deregulation (American,
Continental, Delta, Northwest and American Airways (which is already in bankruptcy)) to a
greater or lesser degree.
In his assessment these airlines are competing for customers with a greatly expanded
discount airline sector, and they all have contractual commitments (in terms of labour, fleet
and infrastructure) that they can no longer meet.
Discount airlines like, SWA, JetBlue, AirTran Airways, American Trans Air, Frontier and
Spirit Airlines provide the competitive spur that would ensure that deregulation benefited the
public by offering customers more choice by exploiting the fringes of the hub-and-spoke
systems. As such, they are forcing the established airlines to become more nimble. 167) 168)
In Europe, Ryanair, easyJet, Airline Co, Virgin Express, Buzz are moving more deeply into
competing with the flag carriers. 169) 170)
Coy P and Zellner W reported that Carty DJ, the Chief Executive of AA had stated that the
airline industry's pricing model was badly broken and that “many of our customers feel as
though they're being cheated. It's clear that something dramatic needs to be done.” The
critical problem was the economics of the carriers' far-flung networks, in which dozens of
"spoke" cities are served through a handful of "hub" airports. In good times, hubs enable the
airlines to provide frequent service to many cities with short layovers. But the hub-and-spoke
Chapter 3 Page 165
networks of big carriers are enormously expensive to run and business travellers seem no
longer willing to pay the high-ticket prices that make them viable. 171)
According to Belobaba PP, it's very difficult to incrementally dismantle a hub. The risk for
hub airlines is that if they cut back too much, they will surrender the one advantage
(frequency of service) they have over discount point-to-point carriers, such as SWA. 172)
The hub-and-spoke system feeds a carrier's passengers from its smaller markets into larger
ones, from which it operates banks of flights to more lucrative destinations. McCartney S
stated that until lately, hubs generated enough revenue to make up for the high cost of
staffing multiple gates and of keeping aircraft and baggage handlers there idle between
waves of connecting flights. 173)
The blanket coverage of a large network airline is aimed at minimising layover times, by
scheduling lots of flights to arrive and depart within narrow windows of time called “banks”.
This requires leasing many gates and having lots of ground crew, who are idle between
different arriving and departing banks of flights. In addition, aircraft and their expensive
flight crews spend more time on the ground than point-to-point crews do because they have
to wait for connecting flights. Coy P and Zellner W stated that hub airlines' labour costs
would not seem so high if they got more hours of useful work out of their employees.
The necessity of charging high fares makes hub carriers vulnerable to attack from both above
and below. Some high-paid business travellers are turning to private jets, while the budgetconscious are switching to low cost airlines, including point-to-point carriers. Coy P and
Zellner W observed that hubbing, which was a competitive advantage in the '90s, is
becoming a competitive disadvantage, but also stated that hub-and-spoke systems will never
disappear entirely, because only they can provide frequent flights to many cities with short
layovers. In order to save money, hubbing airlines were likely to spread their flights out
instead of concentrating them in banks, thus lengthening layovers. In the longer run, airlines
will merge and close hubs. Coy P and Zellner W reported that Crandall R, the ex-chief of
AA, who created some of the first hubs stated that “there will be less service, and it will be
less convenient to travel" in future as airlines would schedule flights more evenly, cutting
congestion by building in longer layovers. 174)
Chapter 3 Page 166
According to Stieghorst T, the plunge in demand after September 11 exposed the high level
of fixed costs of the hub system, which are hard to scale back rapidly. A legacy of higher
labour costs compounds the problem. As long as the big carriers kept lucrative business
flyers, however, they could rationalise losing some leisure customers. The big carriers offset
cheap vacation (leisure) fares by hiking business fares, on the theory that corporations would
absorb the difference as a cost of doing business. But when the economy stalled and full-fare
tickets remained, 10 times the cost of more restricted ones, business flyers balked and
passengers were lost to low cost carriers. Neither business nor leisure fares could be raised
and cost cutting risked labour unrest, which no mainline carrier seemed eager to add to its list
of troubles. Losses are however forcing them to respond. AA is modifying its hub-and-spoke
system to make flights less bunched together in its Chicago and Dallas hubs. For passengers
it means more waiting between flights, but American will improve its efficiency. 175)
In summary, the effects of the terrorist attacks of 11 September 2001 on the network business
travel pricing model were as follows:
•
The network business travel-pricing model was created against a background of high
traffic and high fares. 176)
•
The network business travel pricing model exploited network size for scope
advantages and enabled customers to be locked in by means of artificial switching
costs. Hub airlines may have over-expanded in attempting to gain scope advantages.
177)
•
Circumstances changed in that growth is no longer assured and corporate clients are
cutting back on travel costs. 178)
•
Corporate business flyers are becoming price sensitive and getting smarter in
identifying lower cost flights. More companies are requiring employees to travel on
restricted airfares to save on corporate travel costs (less expensive but less flexible).
179) 180)
•
The Web and Internet have put the distribution chain beyond CRS control in certain
countries. Internet websites provide powerful tools for finding and taking advantage
of deeply discounted fares (for travellers, travel agents and corporate travel
managers). 181) 182)
•
The big airlines (full-service retailers of flights) have massive fixed costs that are not
easy to scale back. They built expensive hub-and-spoke route systems and signed
Chapter 3 Page 167
costly labour contracts that they had hoped to finance by charging high-margin
business fares. 183)
•
There appears to be an optimum size for network airlines beyond which the financial
risk of a downturn in the economy needs to be managed.
•
Airlines need to be acutely focused on just what they are selling. 184)
•
Financial difficulties are shared by all of the large hub-and-spoke airlines that
survived deregulation as a result of the difficulties of scaling down operations. 185)
3.9.2
NEW LOW COST CARRIER CHARACTERISTICS
Low cost carriers enjoyed tremendous growth while financial difficulties were experienced
by full-service network airlines. Some advantages that low cost carriers have over fullservice network airlines are:
•
Businesses are acutely focused on just what they are selling.
•
Fast-paced schedules with minimal downtime between flights. 186)
•
Consumers have freer access to fare-price information. Web sites list all the fares
available between any two airports. 187)
•
Low cost carriers have younger fleets, which require less maintenance. 188)
•
Low cost carriers have younger labour forces that aren't tied to complicated,
inefficient labour contracts. Labour costs at most of the discount airlines are lower
than the bigger, unionised competitors. 189)
•
Low cost carriers stick to one model of aircraft thus minimising maintenance,
operating and training costs and spare parts. This also simplifies processes. 190) 191)
•
Selective route structures that minimise competition. 192)
•
Instead of having aircraft and crews sit around and wait for passengers at hub
airports, low cost carriers maintain fast-paced schedules with minimal downtime
between flights. 193)
•
Focus on going after the leisure traveller. Most of the low cost airlines left the
majority of business travellers to the major airlines. This requires a simple marketing
plan and lower marketing costs. 194)
•
Low cost carriers had difficulties to obtain access to travel agents or corporate travel
departments but are now easy to find on the Internet. 195)
Chapter 3 Page 168
•
Downscaling hub-and-spoke systems to make flights less bunched together which
would mean more waiting between flights for passengers at hubs to improve
efficiency in comparison to high frequency shuttle services of low cost carriers. 196)
3.9.3
RESPONSES OF HUB AIRLINES TO COMPETITION BY LOWCOST CARRIERS
The responses of hub airlines (as identified in 3.8.3 above and analysed in 4.3 of chapter 4) in
the changed circumstances identified in 3.9.1 above, to competition by low cost airlines in
the USA and in Europe were to:
•
Selectively match fares, (but now the hub airlines are confronted with low fare
competition on about three quarters of their routes). 197)
•
Set up copycat subsidiaries to attract price-sensitive passengers (but without lowenough costs, those carriers have failed). 198)
•
Quote prices on a flight-by-flight basis based on timing of departure (and not pricing).
199)
•
Reduce the six or seven different types of aircraft that are used in operations. 200)
•
Reduce capacity by downsizing aircraft and eliminating unprofitable flights and
routes, retiring older aircraft, deferring major new purchases. 201)
•
Obtain a major airline partner. 202)
•
Seek major concessions from unions and management. 203)
•
Fundamentally reform the pricing structure in order to stay competitive in this
environment. 204)
•
Seek state aid and upon refusal seek bankruptcy protection under Chapter 11. 205)
•
Focus on productivity and efficiency. 206)
•
Sell assets and raise cash. 207)
According to Grossman D, downsizing to smaller jets may eliminate empty seats and reduce
operating costs but that strategy can backfire too as much of the airline industry's profit
comes from last-minute business travellers who pay full fare. Selling out all a particular
flight’s seats in advance and losing last minute, full-fare business travellers would leave a
“lot of money on the table for competitors with larger jets to grab". 208)
Chapter 3 Page 169
3.9.4
SUMMARY AND IMPLICATIONS FOR SOUTH AFRICA
It is evident that the airline industry has undergone a fundamental shift with respect to levels
of business travel and the viability of the hub-and-spoke model in the USA and Europe.
Higher cost airlines attempted to raise fares relying on marketing techniques which gave
them a powerful hold of the distribution chain. Some examples were FFPs, corporate
discount agreements and TACOs and discriminatory pricing practice utilising CRS
applications. As leisure travellers do not buy expensive tickets, airlines focused on business
travellers booking tickets on short notice, who value the convenience of frequent service at
nearby airports.
A number of factors contributed to changed circumstances that affected the network model,
inter alia:
•
Economic conditions forced customers that travel for business reasons to seek
cheaper alternatives. This need to economise became more important than the lock-in
(binding) effect of a number of the marketing techniques referred to above.
•
A serious drop in volumes of passengers making use of air travel highlighted the
difficulty network airlines experience in reducing costs. This resulted in extreme
financial difficulties for the large network airlines.
•
New entrant airlines had to focus on what exactly the product comprises that is
offered.
•
A framework of prevention of anti-competitive behaviour and the abuse of
dominance prevented larger airlines from targeted action against new low cost
carriers especially with regard to a combination of pricing and capacity actions.
•
CRS codes of conduct and Internet applications made it possible to restrict and bypass CRS practices that were discriminatory against smaller airlines and favoured
large airlines.
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With regard to South Africa, the writer is of the opinion that South Africa may have been
sheltered from the severity of such market factors in the USA and Europe for the following
reasons:
•
The downturn in passenger volumes was not as severe as in the USA and Europe
while the number of international visitors to South Africa increased and the Rand/US
Dollar exchange rate improved substantially.
•
SAA is a fully owned state airline.
•
No CRS code of conduct has been implemented and SAA controls the dominant CRS
system.
•
The exclusionary effect of marketing techniques, which provide a powerful hold on
the distribution chain in this industry, has not been eroded substantially.
•
No effective framework of prevention of anti-competitive behaviour exists and the
abuse of dominance cases seem to be bogged down by review procedures. As a result,
the dominant airline is not effectively prevented from targeted action against new low
cost carriers, especially with regard to a combination of pricing and capacity actions.
As a result, due regard should be had to on the extremity of these developments in the USA
and Europe as these factors will eventually affect competition in South Africa. The most
important lesson is that the size of a network airline would have to managed very carefully.
This would be in contrast to a focus is based on maximisation of a dominant airline’s size
through the marketing techniques that were referred to above and that offer scope
advantages.
Overall, the writer recommends the following:
•
The government should ensure that the size of operations of SAA is limited in
competitive markets and its increases in capacity is not excessive in relation to the
growth expectations in the market, which might lead to difficulties in adjusting in
periods of an overall market decline. In this regard, there is a risk of the continued
existence of one large dominant network airline in circumstances of sudden decline in
overall traffic volumes, as has been seen in the case of Sabena, Swissair and United
Airlines. It is evident that there is an optimum limit to the size of an airline as is the
case in other industries.
•
The government should implement an adequate framework to prevent anticompetitive behaviour and prevent the abuse of dominance. In addition, measures
Chapter 3 Page 171
should be introduced that would ensure that the process of remedial intervention
would not be bogged down by review procedures.
3.10
DEVELOPMENTS RELATING TO AIR FARES
3.10.1
INTRODUCTION
The findings of the Committee for a Study of Competition in the US airline industry of the
Transportation Research Board of the National Academy of Sciences (TRB) with regard to
general economic development and trends relating to fares and airline competition were
published in July 1999 as Special Report 255 Entry and competition in the United States
airline industry: issues and opportunities. The trends in fares charged by airlines are
discussed in this chapter, and include
•
Price (fare) dispersion in the airline industry.
•
Ramsey pricing within the airline industry.
•
Fare restrictions as a means of differential pricing.
•
Trends in fare dispersion.
•
Using yield management systems to discriminate between prices and allocate
capacity. 209)
The TRB found that dominant airlines had gained too much market power and were
exploiting it by raising fares well above the cost of service. Although the industry’s average
fares declined during the1990s, the widening in the range of fares became a more prominent
issue. Fares varied greatly by market and even among individual travellers seated side-byside on the same flights. As travel demand recovered in the early 1990s, airlines began
experimenting with higher fares and new low cost airlines emerged. Many of these start up
carriers used the equipment and labour shed by the large airlines during the recession and
earlier failures. However, in 1996, the highly publicised crash of a ValuJet airliner damaged
the reputation of low cost carriers, contributing to the financial failure of some and
discouraging start-ups in general. 210)
The TRB observed that even before the ValuJet crash, some start-up airlines had complained
about what they perceived as intentionally injurious, or “predatory,” tactics by incumbents.
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By the mid-1990s, alarm over the major airlines’ financial condition was superseded by
concern that financially strengthened incumbents were actively seeking the demise of startups and systematically suppressing competition. Meanwhile, public discontent with airline
service and pricing practices particularly the higher fares charged to business passengers
travelling on unrestricted tickets, was rising. Enjoying dramatic growth in travel demand, the
airlines were increasingly viewed as being uninterested in their main customers. Despite
these concerns, the TRB stated that consumers continued to benefit overall from a
deregulated industry, which is still characterised by significant price competition, including
frequent "fare wars" that attract many bargain-seeking travellers. Adjusted for inflation, it
found that average fares decreased 25 percent from 1990 to 1998. However, the industry’s
operating costs, as well as fares, were largely stable after the middle of the decade, perhaps
drifting slightly upward. Most of the reductions in fares during the 1990s occurred early in
the decade. Since 1995, trends have been relatively flat. 211)
3.10.2
COMPARISON OF THE CHANGES IN AVERAGE FARES WITH
CHANGES IN UNDERLYING PRODUCTION COSTS
The US DOTs Standard Industry Fare Level (SIFL) depicts changes in airline operating costs
on a seat-mile basis. Changes in the SIFL indicated that much of the overall decline in
average fares (or yield) during the 1990s was actually caused by declining jet fuel costs. The
trends also indicated that fare levels did not increase in relation to costs, which suggested that
the gains from deregulation have not been eroding over time. The competitive pressures
brought about by deregulation have compelled cost reductions, which were regarded as
further evidence of the continuing benefits of deregulation. As the decade of the 1990s
progressed, airlines refined their ability to charge different fares to different groups of
travellers. This widened the spread in fares paid. Unable to take advantage of the heavily
restricted low-price tickets, time-sensitive business travellers increasingly expressed concern
that the fares they were being charged were far above the cost of providing the service in an
efficient manner. 212)
As in most other studies in the USA, reference was often made to “average fares,” and
average fare data are used in many of the data analyses. The airlines, however, served two
distinct types of customers - business and leisure travellers. Airlines have become skilled at
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distinguishing these passengers and charging them widely differing fares by imposing
purchase restrictions. As a result, in addition to average fares, actual fares paid, sorted by
restriction type, would be meaningful in examining trends in fares. It was not apparent for the
TRB, how such data could be gathered and analysed in a meaningful way, because
“restricted” or “discounted” fares were terms that could not easily or uniformly be defined.
213)
The TRB concluded, however, that, although imperfect, in an industry in which buyers are
paying widely differing prices, market averages still remain the most informative and reliable
price measure available when considering trends in fares. 214)
3.10.3
PRICE (FARE) DISPERSION IN THE AIRLINE INDUSTRY
Fare dispersion has grown since deregulation. According to the TRB, there were two general
reasons why buyers, in any industry, may be charged different prices for products that appear
to be the same or nearly the same for reasons that are “both efficiency-and welfareenhancing.“ These were:
•
That the direct costs of supplying different prices to different groups of customers are
in fact different, such as the costs associated with delivering the product to the point
of sale.
•
That costs are incurred in circumstances in which, while the products and costs of
supplying them are effectively similar significant economies of scale and scope were
operating in the supply of the different airline products. When a firm sells the same
product or almost identical products at different prices to different buyers (or at
different mark-ups on marginal cost), price discrimination is said to have occurred.
Under the latter circumstance, prices set uniformly at their marginal costs would not
recover the total costs of supplying them, including fixed and overhead expenses, and
it becomes necessary to charge buyers collectively prices in excess of incremental
cost if the products are to continue to be supplied. In this situation, if the seller can
take advantage of the fact that buyers attach widely different values to the same
product and segment buyers on the basis of their different product valuations, an
airline can charge prices that are above marginal cost to those who are least sensitive
to price. The seller may then generate sufficient revenue to provide all the different
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products. Excessive overall price exploitation would be avoided if effective
competition is at a sufficient level. 215)
The major airlines claimed that fare differentials (that is, variations in fares between business
and leisure travellers) are caused in large measure by direct differences in cost, such as those
associated with flying during peak or congested periods. Unfortunately, the TRB noted that
too little empirical evidence was submitted by the airlines to support this main assertion. The
TRB considered the possibility that too many common or shared costs may exist in the
airline industry, making the allocation of cost among different classes of services arbitrary.
216)
3.10.4
RAMSEY PRICING WITHIN THE AIRLINE INDUSTRY
The TRB stated that generally economists have maintained that prices set at a level equal to
the marginal costs of producing goods or services are optimal (that is, welfare maximising).
Problems can arise, however, if marginal costs are less than average costs at levels of output
that would prevail if prices had been set uniformly to all buyers. In this situation the revenue
raised by marginal cost pricing will not cover total costs and the producer will not be able to
continue to provide the product as it will not be economic to replace equipment and other
capital in the long term. The loss of the product may create welfare losses, particularly
among those consumers who valued it highly. 217)
A well-known theorem in economics, known as Ramsey pricing (named after one of its
earliest proponents), holds that the welfare losses created by deviating from marginal cost
pricing are minimised if the buyers with inelastic demands are charged the highest prices or
mark-ups above the marginal cost. Including the overhead, fixed, and other costs that
comprise total costs (that are otherwise excluded from marginal costs) in the prices charged
these buyers with inelastic demand results in the least deviation of consumption patterns
from the patterns that would be achieved if uniform prices were set at marginal cost. 218)
The TRB stated that something akin to Ramsey pricing might be practised in the airline
industry. Leisure travellers who are sensitive to price (price-elastic) are charged fares roughly
equal to the marginal cost of serving them, but which are apparently insufficient in the
aggregate to cover the full cost of maintaining the airline networks as they are now
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constituted. US airlines must cover their total costs by competing for capital in private
financial markets. As Ramsey pricing would suggest, they apparently cover any shortfall in
revenues from leisure travellers by charging higher prices, or whatever the traffic will bear,
to price-inelastic business travellers. In the process, moreover, the airlines may have been
able to finance a more extensive network than would have been possible otherwise. 219)
The TRB also stated that those who make the extra contributions are seldom content with this
role. Some may believe they are being held captive to their inelastic demands as a result of
various actions taken by the airlines, such as possible exclusionary behaviour to hold back
new entrants or technologies such as smaller, “regional” jets. A traditional role of economic
regulation, particularly in telecommunications and transportation, has been to smooth out
these surcharges by making them uniform over broad classes of customers, and in the process
making them more politically acceptable. This was usually achieved, with some sacrifice in
welfare (by attenuating the mark-ups on the most inelastic buyers while increasing them on
buyers who are somewhat more sensitive to price). The TRB was of the opinion that the
politically acceptable solution usually led to greater deviation in consumption patterns (from
the marginal cost optimum) than would a strict Ramsey pricing solution. 220)
The TRB stated that, while “a Ramsey pricing scheme can be beneficial in the short-term, it
may be less desirable in the long-term. The Ramsey pricing optimum is strictly static in
character, unless prices adjust quickly or producers have considerable foresight. Ramsey
pricing optimality will be undermined by any changes in the demand elasticity and other
conditions on which it is defined. Indeed, Ramsey pricing creates its own strong incentives
for change. Buyers paying the highest prices, or mark-ups, have incentives to seek
alternatives to the high-priced service. Over time, they will be increasingly successful in
finding such alternatives, or in otherwise adjusting their circumstances to become less reliant
on the product, thus making much of the existing capacity redundant for some period of time
or until industry capacity can be properly adjusted. New technology and other changes and
alternatives (including new competitors) that undermine an established Ramsey pricing
pattern will be unwelcome to incumbent producers”. The TRB was of the view that in the
long term, sustaining such a pricing scheme will usually require government regulation or
monopoly power to bar entry and producers pricing under a Ramsey pricing scheme would
be likely to be hostile to change, even if the change would be otherwise beneficial to
consumers. The Committee’s view was that some of the most counterproductive experiences
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with industry economic regulation have been associated with regulatory regimes to maintain
highly discriminatory pricing by delaying technological changes that would otherwise have
been desirable. As such, they were of the opinion that any price discrimination should sustain
itself only if tested by open entry and competition. 221)
The TRB stated that “evidence of growing fare dispersion has not been supported by
evidence of growing cost dispersion”. Nevertheless a very substantial portion of the fare
differences is explicable in terms of the direct costs of the two kinds of services. The
economies gained from density (e.g., denser routes permit larger planes, with
correspondingly lower costs per seat mile) suggest that fares will typically be lower in dense
markets than in thin ones. Differing constraints on airport and airway capacity, including
terminal charges, can also contribute to differentials in costs, and therefore variations in fares
across markets. Likewise, fares paid by travellers in the same markets can vary widely as a
result of differences in the cost of travelling at different times of the day and week. One
would, for instance, expect higher fares for travel during peak times when demand is greatest
and resources are tight. Travellers booking early are less costly to serve than travellers
booking much later, as holding unsold seats in anticipation of late-booking travellers
increases the risk that the seat will fly empty. Business travellers pay higher fares in part
because they tend to be late bookers, whereas leisure travellers, who pay the lowest fares,
tend to be early bookers. When demand for seats is high, the cost of holding a seat empty in
anticipation of late-booking or “walk-up” travellers, that is, the opportunity cost incurred if
the seat is not eventually sold, may be high. This cost may be reflected in higher fares for
travellers who book late or make last-minute itinerary changes. 222)
The TRB observed that much of the spread in airline fares may be explained by cost
differences, but not all the spread can be so explained, and some is the result of price
discrimination. It noted that airlines have long been able to sort travellers according to their
relative price elasticity by imposing various ticket restrictions. The TRB concluded that the
general ability of airlines to price discriminate might be advantageous to travellers on
balance, at least in the short run. The argument that some price discrimination in the airline
industry can be desirable rests to a large degree on the recognition that the type of product
demanded by schedule-sensitive business travellers differs significantly from the product
demanded by price-sensitive leisure travellers. On short-haul flights, the difference in
preferences between the two kinds of travellers may be the greatest. Leisure travellers in
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these markets are especially sensitive to price owing to the substitutability of driving as a
travel option. Flight frequency may be especially important to business travellers, since
saving relatively small amounts of time is, after all, one of the main reasons for their decision
to fly (rather than drive) in the first place. By being able to identify leisure travellers through
ticket restrictions, the price-discriminating airline can offer discounted fares to fill unsold
seats on flights that might otherwise fly partially empty, but at the same time not permit
business travellers to routinely take advantage of these lower fares. The TRB were of the
opinion that should an airline not have the ability to restrict access to low fare tickets by
time-sensitive travellers, the airline might not be able to cover the total cost of providing the
frequent and extensive service. Where airline operations entail large economies of both scale
and scope (and thus, declining average costs), as in hubs (where the number of routes that
can be served from the hub increases disproportionately with an increase in the number of
scheduled flights) it is possible that fares set uniformly at marginal cost would generate
insufficient revenue to recover total costs, necessitating discriminatory pricing if the hub
airline is to maintain the service. Price discrimination allows carriers to cover both the
operating and capital costs of providing the schedule-intensive service desired by business
travellers, while filling empty seats with leisure travellers whose low fares at least cover their
incremental, or marginal, cost. 223)
The possibility that airlines have become too skilled at identifying price-inelastic travellers
and charge them excessive fares, above the level necessary to efficiently provide the service,
can be identified if the price discriminating airline is reaping monopoly profits (excessive
returns on capital). Such determinations are difficult, involving projections of airline profits
and the effects of the business cycle. A protection against such exploitation is free entry.
Where entry is not artificially impeded, competing services will ensure that the fares charged
to price-inelastic travellers are, in the long-run, reflective of the full (or stand-alone) cost of
efficiently providing the type of service desired. 224)
Some uniformly low cost carriers, such as SWA, have discovered that business travellers are
not completely insensitive to price and are sometimes willing to accept fewer schedule
options in return for substantial fare reductions. In dense markets where airlines charge
excessive fares to price-inelastic travellers, competition from non-network, point-to-point,
and low cost airlines can be expected, especially in the light of the high overhead and fixed
costs associated with creating a brand new, competing hub-and-spoke system. As a result,
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new low fare services tend to focus on dense markets only, where point-to-point service can
be economical. Airline service in many thinner markets (often important to business
travellers) generally remains the domain of the larger carriers with their larger (and higher
fixed cost) networks. The introduction of smaller regional jets, and other new technologies,
may, however, change this situation. 225)
3.10.5
FARE RESTRICTIONS AS A MEANS OF DIFFERENTIAL
PRICING
Before deregulation, airlines concentrated on business travellers. Unscheduled charter service
was permitted for some low fare travel (e.g., tour packages), but in general, the pricesensitive market was neglected. But by the mid-1960s, regulated airlines were increasing
their use of discount economy fares to attract more leisure passengers to fill seats on their
new larger-capacity jet aircraft. Senior citizens, students, and relatives of travellers flying on
full fares were offered discounts of up to 25 percent. Using such differential methods of
pricing, airlines could identify and attract price-sensitive traffic without marking down the
fares charged to regular business travellers. The airlines maintained, and the CAB regulators
presumed, that such discriminatory pricing was needed to ensure the long-run profitability of
the service. Though seldom able to purchase the discounted fares, business travellers were
thought to have benefited owing to the more frequent flights that were available from these
larger aircraft. 226)
Some economists predicted that deregulation would diminish airlines’ ability to differentiate
among types of travellers, because of a general belief that monopoly power (or regulatory
protection) was required for discrimination and a lack of understanding of the economies of
scale and scope that would come to characterise a post-deregulation industry. According to
this view, new and incumbent airlines would tailor their services to particular kinds of
travellers. For example, single-class, service-intensive airlines would cater to business
travellers by providing more spacious seating, frequent departure times, and generous inflight amenities, but charging uniformly high fares to cover the cost of premium service.
Meanwhile, “no-frills” airlines would emerge, offering off-peak, low fare services for mostly
leisure passengers. Under these scenarios, the variation in fares paid by travellers seated sideby side on the same flight would be small. 227)
Chapter 3 Page 179
Although some new single-class carriers did emerge after deregulation, the incumbent
airlines quickly realised that they could efficiently serve both business and leisure travellers
on the same flights. Through hub-and-spoke networks and the economies of consolidating
traffic at central hub airports, airlines could increase the number of scheduled flights from
previous point-to-point schedules. The large increase in flight destinations and frequencies
(i.e. the scope economies) were a boon to business travellers, particularly those travelling to
cities with hub airports. Hub cities such as Charlotte, Cincinnati, and Detroit have
experienced a 50 percent or more increase in scheduled jet departures since 1985. 228)
Airlines also recognises that leisure travellers - self-identified by their willingness to accept
booking restrictions - could be accommodated on many of the same flights as time-sensitive
travellers. Seats that otherwise would fly empty could be sold at a significant discount, yet
still cover incremental, or marginal, costs. Start-up airlines focusing on leisure traffic - but
unable to attract business travellers seeking frequent and convenient flights to numerous
points - were at a significant disadvantage. Many failed within the first few years after
deregulation. Moreover, it soon became evident that certain service amenities could be
offered selectively to high-fare business travellers. These included accrual of free vacation
trips, access to airport club lounges, upgrades to first class, and special boarding privileges.
229)
Since deregulation, airlines have fine-tuned their fares using a complex combination of
purchase terms such as Saturday-night stay-over restrictions, advance purchase requirements,
and penalties for cancellations and exchanges. Yield management practices in which airlines
reassess on a flight-by-flight basis how many seats are to be offered at a discount, by how
much, and when have proliferated and become more sophisticated with experience and
advances in information technology. At any one time, an airline may be offering a dozen or
more different economy fares on a given flight. FFPs, now offered by nearly all airlines; also
identify the most loyal customers who generally are the most price-inelastic. These travellers
receive additional bonus miles and other benefits, particularly when purchasing high-fare
tickets. Airport security requirements that travellers must present personal identification
before boarding have also enhanced the ability of airlines to price discriminate, as low fare
travellers cannot resell their heavily restricted advance-purchase tickets (e.g. through
intermediaries) to late-booking travellers, who must then pay the higher fares. 230)
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3.10.6
TRENDS IN FARE DISPERSION
The TRB compared the median fare paid by passengers in short, medium, and long haul
markets in the USA for 1992, 1995, and 1998 in order to gauge more recent trends in fare
dispersion. The median fare, declined by about 15 to 20 percent over this 6-year period in
three aggregate market groupings, based on market distance. The lowest fares (that is, the
10th percentile fares) fell by about 5 percent in real terms. The higher fare travellers (the 90th
percentile), however, were paying 5 to 25 percent more at the end of the period. It is also
evident that these travellers are paying fares much higher than the median, at least in
comparison with earlier periods (1995 and 1992). 231)
Travellers who paid the highest fares in 1992 paid 2 to 2,1 times the median fare. In 1998,
these high-fare travellers paid 2,7 to 2,9 times the median. The highest fares have risen in
real terms and the medians have declined. The top-fare travellers (95th percentile and above)
accounted for 17 to 18 percent of airline revenue in 1998, compared with 8 to 13 percent in
1992. 232)
Although Southwest charges different fares to travellers based on certain demand and cost
characteristics, by offering discounts for advance purchases it does not vary fares to the same
extent as most other large airlines. High fare travellers (90th percentile) on short-haul
Southwest flights pay about twice the median fare for all Southwest passengers in those
markets. By contrast, high-fare travellers paid three times the median on other larger
incumbent carriers (American, Continental, Delta, Northwest, TWA, United, and AA)
examined collectively. A marked difference in the fare structure of two carriers of similar
size and scope (SWA and AA) was identified. While most short-haul travellers on SWA pay
fares close to the average, the differential between low and high fare travellers on American
Airways was much greater. 233)
A more precise means of measuring trends in fare dispersion is to use the Gini coefficient,
which encompasses the entire distribution of fares, rather than specific percentiles. A Gini
coefficient of zero indicates that all fares are the same; as it moves closer to 1, the fare
distribution is more dispersed. Studies done by the Committee indicated that the Gini
coefficients are much higher today than in 1978, when the CAB limited the amount of fare
variation generally and on individual routes. 234) A comparison of 1990 and 1998 levels
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shows that the Gini coefficient has not changed significantly. Although there was a move
upward from 1995 to 1997, these data do not, by themselves, offer evidence of airlines'
enjoying greater ability to price discriminate during the 1990s. 235)
3.10.7
THE USE OF YIELD MANAGEMENT AS A MEANS OF
DISCRIMINATING ON PRICE
Yield management (identified in 3.8.2 above) has enabled the airlines, especially the network
airlines, to develop complex fare structures designed to maximise revenues on each flight
through price discrimination. Airlines try to sell as many seats as possible at the highest
fares, those charged for unrestricted travel, and as few seats as possible at the lowest discount
fares. Passengers paying the highest fares obtain the advantages of flexibility and last-minute
access to seats. Passengers can book seats just before the flight, change their reservation
without penalty, and obtain a full refund if they do not use the booking. Passengers travelling
on most discount fares, in contrast, typically have to book seats several days or more before
the flight, have to pay in advance for their seats, cannot change a reservation without paying
a penalty, and cannot obtain a cash refund if they cancel their trip. Although business
travellers can use some discount fares, the cheapest discount fares frequently have a Saturday
night stay requirement to discourage business travellers from using them. To save seats for
passengers willing to pay for unrestricted fares bought shortly or immediately before the
flight, airlines limit the number of seats made available at the lower fare levels. 236) 237)
According to Levine ME, unlike the low cost airlines, the network airlines have relatively
little interest in attracting travellers who insist on paying low fares for air travel, even though
the network airlines do sell many discount-fare seats. Network airlines structured their
operations so as to attract travellers willing to pay more for better and more frequent service.
If an airline charges higher fares to those travellers, it may be able “to generate sufficient
revenue to provide the product, but no more than that if competition is effective”. 238) The
airlines’ yield management systems mean that passengers on the same flight will have paid
different fares, depending on how far in advance they made their booking and how many
restrictions they were willing to accept in return for a lower fare. No airline has been able to
maintain a simple fare structure. The discrimination in fares also reflects the willingness of
business travellers, but not leisure travellers, to pay for frequent and convenient flights. 239)
Low cost airlines, however, have less complex fare structures than the network airlines. 240)
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Although network airlines serving a market allocate different numbers of seats to each fare
level, they tend to charge similar amounts for each type of fare offered in a market (for
example, 21-day advance-purchase fares and unrestricted economy fares). Each network
airline usually matches the fare levels offered by its network competitors in a market,
although not necessarily the number of seats made available at each fare. 241)
An airline that has a competitive advantage in a non-stop market will be able to sell more
seats at unrestricted fares and so can afford to make fewer seats available for discount fare
passengers. A hubbing carrier is able to offer a service advantage relative to a non-hubbing
carrier that permits it to attract a relatively larger portion of time-sensitive (primarily
business) travellers, serving to raise its average yield. Even if both airlines serving a route
have a hub at one of the endpoints, the airline with a competitive advantage can obtain
significantly higher yields. As a result, even if two airlines charge the same fares in the same
non-stop markets, one airline can obtain higher average fares owing to the fact that it has a
better mix of traffic. 242)
3.10.8
OTHER FACTORS CONTRIBUTING TO FARE DISPERSION
The TRB stated that the airline industry has been prone to wide cyclical swings. Excess
capacity has been a recurrent problem for the industry during recessions and shortly
afterwards. Excess seat capacity has declined during the decade, as indicated by average load
factors, which rose from 60 percent in 1990 to nearly 70 percent in 1998. Low load factors
early in the decade reflect the drop-off in demand during the 1990 to 1991 recession, coupled
with expanded capacity. More recently, higher load factors reflect an industry with high
demand and intensive use of capacity. In the past (notably in the early 1990s) whenever
failing airlines attempted to generate revenues from underused capacity by sharply lowering
fares, other airlines followed suit by matching their fares. The resulting fare wars benefited
travellers in the short term. However in order for well-run private airlines to survive and
prosper, fares must eventually rise to levels sufficient to recover long-term costs and keep
capital in the industry. Incumbent carriers experienced large losses during the recession of
the early 1990s, but have since experienced positive operating profits, often at record levels.
243)
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The TRB concluded that the increases in unrestricted fares observed in recent years have
been at least partly justified as a means of restoring the industry’s total returns after the large
losses it suffered in the early 1990s. 244)
As a result, while observed increases in the fares charged price-inelastic travellers may be a
manifestation of airlines exercising their market power, the extent to which these fare
increases have been excessive is unclear; that is, the extent to which increases have reflected
the exploitation of this market power. The TRB in the USA stated that the only sure check
against such exploitation is to ensure that opportunities for competitive entry are made
available and not impeded. 245)
From the conclusions of the TRB in the USA it would appear, however, that the only sure
check against exploitation is to ensure that opportunities for competition exist. In the absence
of such fare analysis in the domestic market in South Africa, the focus should be on the
promotion of competition to serve as an automatic check against the exploitation of
passengers. Further study would be necessary in South Africa to identify the overall trends
with regard to fares and yield of air travel in South Africa as well as the determination of the
factors that influence such trends.
3.11
THE EFFECT OF PRICE DISCRIMINATION ON ECONOMIC
WELFARE OF CONSUMERS IN THE DOMESTIC AIRLINE
SERVICES
3.11.1
INTRODUCTION
According to the NTFAC it is well known that the airline industry has been practising price
discrimination for many years. Price discrimination implies that firms are charging different
prices to different customers, and that the price difference cannot be explained by cost
differences. 246)
Chapter 3 Page 184
The following types of price discrimination practices are practiced in the airline industry
according to the NTFAC:
•
Versioning
One can buy an expensive, flexible ticket, which can be changed or even cancelled
without costs. Or one can buy a cheaper ticket, with more or less severe restrictions:
Saturday night stay-over, advance-purchase, etc. These different versions are, in
principle, all available to each and every passenger.
•
Corporate discount schemes
Large customers use their buying power to obtain special fare contracts with an
airline, whereby a certain discount is given on every ticket bought.
•
FFPs
The bonus points earned by frequent flyers can later be exchanged for extra flights,
hotel visits, car rental, etc. 247)
The NTFAC also identified three different degrees of price discrimination:
•
First degree of price discrimination
The seller charges a different price for each unit, so that the price of each unit equals
maximum willingness to pay.
•
Second degree of price discrimination
Each consumer faces the same price schedule, but the schedule involves different
prices for different amounts of the good purchased.
•
Third degree of price discrimination
Different consumers are charged different prices, but each consumer pays a constant
price for each unit of the good bought. 248)
3.11.2
VERSIONING
According to the NTFAC, versioning implies that the same price schedule is available to all
consumers. The consumers can choose to buy an expensive, high quality version or a cheap,
low quality version. Technically, this was regarded by the NTFAC as an example of second
degree price discrimination as the consumers pay different prices for different amounts of a
different quality of the good purchased. 249)
Chapter 3 Page 185
Versioning usually implies that one version of the product is deliberately made less
attractive. The consumer with a low willingness to pay is offered this inferior version, while
a full quality version remains available to those with a high willingness to pay. 250)
The inferior version must be sufficiently unattractive to the customers with a high
willingness to pay, so that they choose to adhere to rules applicable to the superior quality
version. Otherwise the seller will only be able to charge the same low price to (almost) every
customer.
Typically, an airline would offer the leisure traveller a “damaged” or inflexible ticket (that
has more restrictions or penalties as part of the conditions of sale or use) in order to make the
inexpensive version unattractive to the less price elastic business traveller segment. 251)
In practice, airlines charge different travellers different prices depending on their demand
characteristics:
•
Higher prices are charged to those travellers with more inelastic demand and lower
prices to those travellers with a more elastic demand. The ability to discriminate in
pricing depends on an airline's having market power.
•
Prices based on demand characteristics rather than on the cost of providing the
products are characteristic of a market in which the seller has a degree of market
power.
•
Airlines offer different fares on a given flight, attaching restrictions or conditions of
travel to some fares and, most importantly, offering only a limited number of seats in
some fare categories. 252)
Yield management makes it possible for airlines to charge different travellers different
prices, depending on their demand characteristics. Using computerised yield management
systems, airlines can do the following:
•
Offer seats at multiple prices with varying conditions or restrictions.
•
Manage the number of seats in price categories or classes to charge each individual
passenger as close as possible to the maximum he would be willing to pay.
•
Effectively change its fare offerings by changing the number of seats offered in each
fare category without ever changing any of its published posted prices.
Chapter 3 Page 186
•
Match fares of the new entrant by simply offering a large number of seats in an
existing or new fare category that match the new entrant’s fare offering in response to
entry by a new low fare carrier. Such matching of fares does not need to be across all
seats on all flights. Instead, such matching would more likely be targeted at those
flights that most closely matched the new entrant’s offering of flights. 253) 254)
The NTFAC identified three conditions that may contribute to welfare improving versioning:
•
The fraction of consumers with high willingness to pay is large.
•
Their valuation of extra quality is high, and
•
The other group’s valuation of quality degradation is limited. 255)
The NTFAC did however question whether willingness to pay is based on consumer choice
determined by loyalty schemes like membership of FFPs as opposed to an actual willingness
to pay for the service or conditions of sale. 256)
It is submitted that the working of FFPs, corporate discount schemes and TACO schemes
may substantially affect the working of market forces and also affect the analysis of whether
versioning is actually improving welfare. These factors may actually be more important in
the chain of decisions of purchasing a ticket than the valuation of extra quality of airline
service or conditions of sale by consumers. These factors may have a restrictive effect on
competition.
Versioning may imply that a large part of an aircraft’s capacity may be allocated to fares that
may be set uniformly at marginal cost and would generate insufficient revenue to recover
total costs of its flight, necessitating discriminatory pricing providing the schedule-intensive
service desired by business travellers, while filling empty seats with leisure travellers whose
low fares at least cover their incremental, or marginal, cost. In 3.10.4 above, it was
established that leisure travellers who are sensitive to price (price-elastic) are charged fares
roughly equal to the marginal cost of serving them, but apparently insufficient in the
aggregate to cover the full cost of maintaining the airline networks as they are now
constituted.
As Ramsey pricing would suggest, US airlines apparently cover any shortfall in revenues
from leisure travellers by charging higher prices, or whatever the traffic will bear, to priceChapter 3 Page 187
inelastic business travellers. The TRB was of the opinion that some business travellers
believed they were being held captive to their inelastic demands as a result of various actions
taken by the airlines, such as possible exclusionary behaviour to hold back new entrants or
technologies such as smaller, “regional” jets. 257) As a result, the writer is of the opinion that
versioning may not be in the interest of competition if the average pricing level of the larger
portion of flights results in an economic barrier to entry by low cost airlines.
The NTFAC stated that a large part of the market is made up of business travellers, whose
willingness to pay for quality of service is high. It also questioned whether an alternative to
versioning might be that no low quality version would be offered. Without the ability to price
discriminate, certain routes could in their assessment become unprofitable to the airline and
hence not be served at all. 258) As stated above, the willingness of business travellers to pay
a higher tariff may not be related to the quality of service but due to airline practices that
distort the normal working of market forces. The include FFPs, corporate discount schemes
and TACO schemes. It is submitted that the entry and survival of low cost carriers could play
an important role in developing new routes and expansion of markets in preference to
extensive versioning and Ramsey pricing. This alternative, to increase the competition in
terms of number of airlines would, in the writer’s opinion, be an important objective to
achieve.
As a result, the competitive conditions, frequency of service, the volume of business travel
demand and the willingness to pay would be important when assessing the effect of
versioning.
Versioning also reduce price transparency. The more versions are offered in the market, at
different prices, the harder it becomes for a consumer to compare prices and quality between
suppliers. An incumbent supplier may exploit this to reduce a new entrant’s potential for
attracting customers through price rivalry, thus easing the competitive pressure according to
the NTFAC. 259)
A comparison between fares charged by different airlines and the restrictions imposed on
such fares, which are displayed in CRS in South Africa, is contained in annexure “C1” and
“C2”. These fares do not include directly negotiated tariffs. It is evident that price
discrimination based on the concept of versioning as set out above has generally been
Chapter 3 Page 188
adopted by domestic airlines in South Africa. Whether such pricing resulted from the price
leadership of the dominant airline or as a result of matching of fares disclosed in CRS by the
different airlines is not clear. It may be the result of both.
Within the South African context with a history of discrimination and legislation prohibiting
discrimination, the question is whether price discrimination in the airline industry based on
the restrictions contained in the conditions of sale by a dominant airline is per sé acceptable
from a consumer or competition point of view or whether it should be considered from the
perspective of overall economic welfare enhancement of growing the overall market.
3.11.3
CORPORATE DISCOUNT SCHEMES
The NTFAC stated that large private and public customers (segment A) may be able to
exploit buying power by triggering competition between the producers for an exclusive
contract involving large discounts.
Such price discrimination may actually trigger intense price rivalry in the affected segment,
depending on the number of large private and public customers in the market. 260)
The NTFAC concluded that such price discrimination may be detrimental to welfare, for the
following reasons:
•
Among other customers (say, segment B) there may be no buying power present and
hence no discounts available. The price setting in this segment is no longer
constrained by the competition for large corporate consumers. The company may
therefore increase the price in segment B, without losing business in segment A.
•
The net welfare effect of the price discrimination scheme will depend on the
respective price elasticities of demand in the two segments. If segment A is
comparatively inelastic, even a limited price increase in segment B may lead to a loss
of output and welfare that outweighs the welfare gain in the segment with intense
price rivalry. 261)
Unlike versioning, corporate discount schemes usually discriminate between customers not
on the basis of price elasticity, but on the basis of buying power under competition. Thus
there is no guarantee that the more price-elastic segment receives the lower price; in fact the
Chapter 3 Page 189
opposite may be more likely. This increases the risk that the welfare gain in the large
customer segment A will be more than outweighed by the loss affecting all other clients in
segment B. 262)
The NTFAC stated that such discrimination may jeopardise profits among the firms involved
in price rivalry, resulting in competition no longer being viable, and suggested the following
alternatives:
•
Competition without price discrimination, and
•
Monopoly.
The NTFAC concluded that in most cases welfare will be higher under effective competition
than under monopoly, implying that society as a whole is better off with no third degree price
discrimination in a competitive environment. 263)
The NTFAC concluded that corporate discount schemes are agreements that imply third
degree price discrimination that has ambiguous effects on welfare. Discounts may tend to be
large in segments with quite inelastic demand, and this is regarded as a less than optimal way
for the airlines to cover their fixed costs. Moreover, selective discounts may lead to intense
price rivalry between suppliers. Large customer discounts may therefore lead to exits from
the market, because not all the airlines are able to cover their fixed costs. In a similar manner,
potential entrants might be deterred, knowing that the incumbent airline is able to meet any
challenger by offering selective discounts to large, attractive clients. Since these discounts
are secret and therefore difficult to detect for competition authorities, such price
discrimination may make predation a more credible threat. This suggests that corporate
discount schemes are anti-competitive, especially in a setting with a dominant, incumbent
carrier and smaller potential entrants. 264)
The NTFAC stated that many of these corporate discount schemes take forms that engender
important lock-in effects, as when the rebate is in some way progressive (the percentage
discount given depends on the total volume of sales through a certain period of time on a
certain air travel network). The NTFAC concluded that such agreements provide an incentive
for the buyer to channel his demand to one or a few carriers. 265) As larger carriers would
obtain an inherent advantage compared to smaller ones, such corporate discount schemes
have clear anti-competitive effects.
Chapter 3 Page 190
The NTFAC also stated that corporate discounts may conceivably have the effect of raising
the price for all those companies that do not benefit from them. To compensate for the
dilution effect of corporate discounts on yield, airlines increase their nominal fares. 266)
The NTFAC also concluded that price discrimination through corporate discounts may
actually trigger intense price rivalry in the affected segment of large attractive corporate
clients. As these corporate discounts are directed exclusively to a small set of customers,
without affecting market prices in general, such price discrimination serves to make
predation much less expensive to the dominant supplier, and hence a more credible threat to
potential entrants. As a result, the NTFAC concluded that corporate discount schemes are
anti-competitive, especially in a setting with a dominant, incumbent carrier and smaller
potential entrants. 267)
3.11.4
FFPs
The NTFAC regarded FFPs as second degree price discrimination. The consumers are
rewarded for large purchases, and they receive a special kind of quantity discount. The
discount is, however, given in the form of added quantity and not in the form of a reduced
price.
The extra service provided (for free) is not necessarily of the same type or quality as the good
purchased. Most bonus trips are generally available only on certain flights. Moreover,
although the customer may have earned his or her frequent flyer points buying fully flexible
tickets, the bonus tickets are generally inflexible from the time they are issued. A bonus trip
is, in other words, no ordinary rebate.
FFPs are, according to the NTFAC, more appropriately analysed within the framework of
loyalty or fidelity inducing marketing strategies, which are discussed in 4.7 of chapter 4. 268)
Chapter 3 Page 191
3.12
CONCLUSIONS
3.12.1
PURPOSE
The purpose of this chapter was to deal with the economic characteristics of the airline
industry.
The special nature of the airline industry as a network infrastructure industry was examined.
A number of characteristics were identified in the airline industry that are indicative of
oligopoly; further, certain unique economic network characteristics exist in the airline
industry. The sources of economies of scale, scope and density in the airline industry were
identified as well as the effect of airline networks on competition. The effect of declining
overall volumes on airline competition, the viability network business travel pricing model
(of hub-and-spoke airlines) as well as the emergence of new low cost carriers and their
characteristics were examined. Price discrimination in the airline industry in general was also
examined in this chapter.
3.12.2
SPECIFIC OBJECTIVES: CHARACTERISTICS OF THE AIRLINE
INDUSTRY
Certain economic network characteristics of the airline industry that are a concern from a
competition point of view, were identified in 3.2, including:
•
A number of competitive concerns regarding the airline industry and other network
industries were identified that have an effect on the desirability and ability of the
application of competition law, applicable in the economy in general, in addressing
certain concerns relating to competition in the airline industry. These competitive
concerns include the following:
o Network infrastructure industries have commonly been subject to government
ownership or regulation.
o These industries are special in that they connect consumers of their products
and services by means of a network of some sort.
o Several economic features exist in network infrastructure industries that are
reflected in the common occurrence of broadly similar competition concern:
Š
The bigger the network, the more useful it is.
Chapter 3 Page 192
Š
Competition problems are associated with dominant, integrated firms
in network industries.
-
A new entrant is initially able to compete by providing a
limited service.
-
The response by the incumbent, integrated firm might be to
cross-subsidise its prices in respect of that service, by raising
the prices of its other services where it faces no competition
and thus has market power.
-
The incumbent could refuse access to an essential facility.
-
Switching costs could be raised between one service (offered
by the new entrant) and another (offered only by the
incumbent).
Š
The demand for air services on a particular airport-pair, city-pair, or
even country-pair is derived from a multitude of separate
origin/destination markets. This gives rise to complex market
definitions in airline competition.
Š
The "indivisibility" of capacity can result in extremely low short-run
marginal costs, with consequent difficulties in applying competition
law to cases involving allegations of predatory pricing.
Š
Some public service obligations may exist (requirements to provide
some services even where it is not economic for them to do so) with
the result that the reform may be highly politicised.
Š
Many of the costs are sunk and unrecoverable once they are
committed.
Š
Rapid change in the level of demand is often brought about by
technological change in a related market.
•
The factors that demonstrate that the airline industry represents an oligopoly were
identified in 3.3:
o High barriers to entry.
o Few sellers in the market.
o A product of similar nature.
o Substantial economies of scale.
o Growth through merger.
o Mutual dependence.
Chapter 3 Page 193
o Price rigidity and non-price competition.
o Price transparency and collusion.
•
The unique economic characteristics of the airline industry were identified in 3.4. These
include:
o Government financial assistance.
o High technological turnover.
o High labour and fuel expenses.
o Sensitivity to economic fluctuations.
o Close government involvement and regulation, including:
Š
Eight industry-specific features of governmental involvement in the air
transport market, discussed in 3.4.5.1.
Š
Regulatory intervention by governments in the operation of air transport
services (CRS airport slots and gates), discussed in 3.4.5.2.
Š
Strategic co-operation amongst airlines (including the device of codesharing) in 3.4.5.3.
Š
Multilateral co-operation limited to technical and logistical matters in
3.4.5.4.
•
In 3.5.2 it was established that competition in the airline industry differs from that in
other industries in the following respects:
o Airlines compete using multiple competitive tools as identified in 3.5.3, and
o Airlines compete over networks in that airlines manage flow traffic and
compete over alternative routings and the market power that comes with
dominant hubs in route networks, as identified in 3.5.4.
•
The multiple competitive tools of airlines identified in 3.5.3 includes:
o Ticket price.
o Frequency (number of flights a day) and the timing of those flights.
o Characteristics of the flight itinerary (non stop, continuing single-plane
service, or connecting service).
o In-flight amenities including:
Š
Service level, food, in-flight entertainment.
Š
Seat pitch (how closely spaced together).
Š
Ground amenities including club lounges.
Chapter 3 Page 194
Š
•
Loyalty schemes (rebates to the client and traveller) in the form of:
-
FFPs.
-
TACOs.
-
Corporate discounts.
Economies of scale, scope and density on both the supply side and demand side were
identified and tabulated in 3.6. In 3.6.2 it was established that few economies of scale
exist from a competitive point of view. In 3.6.3, economies of scope on the supply
(production) side are evident from an increase in the number of routes served within
the network of an airline. These arise from the complementary routes within the
network. Economies of scope on the demand (consumption) side are more important
and are intensified by marketing practices, including:
o FFPs.
o TACOs.
o Corporate discount schemes.
Such airline marketing practices create synthetic economies of scope on the demand
(consumption) side in that they make it more attractive for passengers and travel
agents to concentrate their demand on one airline and as such increase the loyalty of
the customers toward such airline through an artificial increase in the switching costs.
In 3.6.4, it was established that supply side economies of density exist if an airline’s
unit cost declines when the airline adds flights or seats on existing routes, primarily as
a result of improved utilisation of aircraft capacity and crew. Adding destinations to a
hub-and-spoke network create economies of traffic density. Demand side economies
of density results from a higher route frequency that induces a higher demand for air
transport. This feedback mechanism, which implies that the demand for travel in a
network is in a sense self-reinforcing, is referred to as the Mohring effect. As the
demand for travel increases, a higher frequency of departures can be supported, and
the individual user incurs a smaller average generalised cost. In 3.6.5 it was
established that economies of alliances on the supply (production) side result from
airlines exploiting each other’s networks to strengthen the competitive positions of all
alliance partners. On the demand (consumption) side, economies of alliances result
from the fact that more extensive networks are more attractive to customers and offer
larger economies of scope to the carrier.
Chapter 3 Page 195
•
The effect of airline networks on competition is discussed in 3.7. The increasing
returns to scale, scope and density in the airline industry have several anticompetitive implications that include the following:
o Economies of scale on the supply side set a natural limit to the number of
competitors that can operate without economic loss on a given route. The
combination of a large fixed cost and small variable cost gives rise to a
minimum viable scale, which has to be exceeded in order for the firm to earn a
profit in the market. Aircraft can easily be transferred between routes, but
each aircraft operating on a given route invokes additional fixed costs.
o
Economies of scope on the demand side may reduce the competition in the
airline industry, as they give the airlines an incentive to merge or enter into
alliances with other airlines so as to increase the number of routes offered and
the flight frequency on every route.
o The hub-and-spoke system of operation, although economically efficient to
the individual carrier, seems to give rise to strong anti-competitive effects by
providing the hub airline with considerable market power at and around its
hub. The competitive advantage of hub-and-spoke networks is effectively
reinforced through the loyalty programmes operated by the carriers.
o Most major airlines have joined alliances with other airlines operating in
complementary regions or continents. A few global alliances cover more than
fifty percent of the world passenger market.
o The cost advantages related to network economics are not always reflected in
lower airfares but in market power which is exploited by the airlines to
increase the fares, especially on outgoing flights from airports that are highly
dominated by the hub airline. Hub airlines have market power on almost all
spokes out of the hub airport.
o The ability of an incumbent hub airline to cross-subsidise a single spoke route
or a limited set of such routes that enables a dominant hub airline with ample
opportunity to fight a rival new entrant through increased capacity,
disproportionately reduced fares, and/or other predatory strategies with ease
and moreover at lower cost than in other industries.
Chapter 3 Page 196
•
The actual operation of a deregulated airline industry was examined in 3.8. The
development of the following was studied:
o Yield management.
o Hub-and-spoke route systems.
o A new generation of low cost airlines.
o Potentially unfair competitive responses to entry by low cost airlines
involving price and capacity.
o The decline in airline competition.
o Market power in airline markets.
o Frequency of apparent unfair exclusionary conduct.
•
The effect of declining overall volumes on competition and networks as a result of the
11 September 2001 events were dealt with in 3.9. The viability of the network
business travel pricing model of the hub-and-spoke airlines was considered in the
light of severe financial difficulties experienced by some of the world’s major
airlines. The development of a new generation of low cost carriers and the responses
of hub airlines to competition by low cost carriers were identified. It was evident that
there is an optimum limit to the size of an airline in the event of a turndown in
volumes where it would be very difficult to scale down a large network airline. A
risk of having one large dominant airline in South Africa was identified.
•
The occurrence of price discrimination in the airline industry was discussed in 3.10.
Fare restrictions as a means of differential pricing result in something akin to Ramsey
in that yield management is used to discriminate prices and conditions. The effect of
price discrimination on the economic welfare of consumers in the domestic airline
services was set out in 3.11. This includes:
o Versioning, set out in 3.11.2 (in which one version of the product is
deliberately made less attractive by exploiting the willingness to pay of
customers) using yield management techniques in CRS.
o Corporate discount schemes set out in 3.11.3.
o FFPs set out in 3.11.4.
Chapter 3 Page 197
3.12.3
SUMMARY OF RECOMMENDATIONS
In 3.12.3 it was recommended that the Competition Commission should investigate price
discrimination in the airline industry in South Africa.
As identified in 3.5.3, it is essential that in analysing competition in the air transport market,
due regard should be had to all the dimensions in which airlines compete and not only the
singular dimension of price.
It is also recommended that a competition analysis bearing on the airline industry should take
aspects like the characteristics of networking, cost structure, yield management and
marketing strategies into account. The ability to manage flow traffic and compete over
alternative routings and the market power that comes with dominant hubs in route networks
should also be taken into account when analysing competition in the air transport market as
identified in 3.5.4.
3.13
SPECIFIC ASPECTS IDENTIFIED IN THE STUDY THAT ARE
RELEVANT TO SOUTH AFRICA
3.13.1
THE SPECIAL NATURE OF THE AIRLINE INDUSTRY AS A
NETWORK INFRASTRUCTURE INDUSTRY
Network infrastructure industries are special in that they connect consumers of their products
and services by means of a network of some sort.
The characteristics of network industries and the unique application of commercial practices
as a result of such characteristics in the airline industry affect the capability of competition
law, as applied in the economy generally, to address the different issues raised in the airline
industry. In this regard, it was established that any corrective measures should duly take
account of such characteristics of the airline industry, when commercial conduct is
considered from a competition perspective.
Chapter 3 Page 198
The airline industry shares several features with other network infrastructure industries that
are reflected in the common occurrence of broadly similar competition concerns:
•
The bigger the network, the more useful it is.
•
There are competition problems associated with dominant, integrated firms in
network industries. A new entrant is initially able to compete by providing a limited
service. The response by the incumbent, integrated firm might be to cross-subsidise
its prices in respect of that service, by raising the prices of its other services where it
faces no competition and thus has market power.
•
The incumbent could refuse access to an essential facility.
•
The raising of switching costs between one service (offered by the new entrant) and
another (offered only by the incumbent). A dominant airline might schedule its feeder
flights to arrive immediately before the departure of its connecting flights, whereas a
new entrant might only secure a landing slot that feeds too late or too early into the
incumbent’s flight.
•
Market definition in airline competition cases can sometimes be quite complex in the
airline industry as the demand for air services on a particular airport-pair, city-pair, or
even country-pair is derived from a multitude of separate origin/destination markets.
•
The "indivisibility" of capacity can result in extremely low short-run marginal costs,
with consequent difficulties in applying competition law to cases involving
allegations of predatory pricing.
•
In many countries these industries have been traditionally state owned. Such
companies often have public service obligations (implying requirements to provide
some services even where it is not economic for them to do so). The result is that the
reform of these sectors is often highly politicised.
•
Many of their costs are sunk and unrecoverable once they are committed. In
particular, if there is a desire to attract voluntary private investment, the regulatory
regime has to be credible and predictable. Creating this credibility and predictability
was one of the basic tasks of a regulator.
•
Rapid change in the level of demand is often brought about by technological change,
which can upset long held beliefs about feasible structures of the industry and
optimal regulation.
Chapter 3 Page 199
3.13.2
CHARACTERISTICS
OF
THE
AIRLINE
INDUSTRY
THAT
DEMONSTRATE AN OLIGOPOLY
It was established that the airline industry is typically characterised as an oligopolistic
industry. This would require remedies that will increase competitive forces in the air
transport market.
3.13.3
OTHER UNIQUE ECONOMIC CHARACTERISTICS OF THE
AIRLINE INDUSTRY
•
Governments have played major roles in financing the growth and development of the
airways system.
•
Airlines require employees with highly developed skills that are expensive. In
addition the airline industry is very hard hit by increases in fuel prices.
•
Air transportation demand is susceptible to the business cycle. While the impact of a
recession is not unique to the airline industry, the airline industry is much slower in
recovering as spending on air travel is discretionary and follows general recovery in
the economy a year to 18 months afterwards.
•
Features of governmental involvement in the air transport industry include:
o The doctrine of sovereign national airspace
o The doctrine of cabotage, which has been used to exclude foreign airlines
from traffic rights on domestic point-to-point routes.
o The nationality principle, by which each state reserves its domestic
cabotage routes, and designation under its bilateral treaties to serve
international routes, to carriers that are owned and controlled by the state or its
citizens.
o The practice of public ownership of national "flag carriers”, supported by
incidents
of
state
support
that
include
subsidy
programmes
and
protection from market competition.
o Government efforts to control the tremendous power of computerised yield
management technology, and to ensure a fair distribution of access to scarce
airport slot and gate facilities.
o The evolution of levels of strategic co-operation among airlines of different
affiliation, including the device of cod -sharing, all of which reflect a partial
Chapter 3 Page 200
entrepreneurial evasion, with varying levels of official government complicity
of the precepts of cabotage and nationality.
o Confinement of authentic multilateral co-operation to technical and
logistical matters such as ticket interlining.
3.13.4
COMPETITION IN THE AIRLINE INDUSTRY
3.13.4.1
Airline competition in comparison to other industries
Competition in the airline industry differs from competition in many other industries because
of the following:
•
Airlines compete using multiple competitive tools, and
•
Airlines compete over networks (not only on a route-to-route [city-pair] basis). In this
regard, the airline industry can be described as a network industry consisting of a
system of links (routes) that connect nodes (airports).
3.13.4.2
Multiple dimensions of airline competition
Airlines compete over the following multiple dimensions:
•
Ticket price.
•
Frequency (number of flights a day) and the timing of those flights.
•
Characteristics of the flight itinerary (non stop, continuing single-plane service, or
connecting service).
•
In-flight amenities including:
o Service level, food, in-flight entertainment.
o Seat pitch (how closely spaced together), and
o Ground amenities including club lounges.
•
Loyalty schemes (rebates to the client and traveller) in the form of:
o FFPs.
o TACOs.
o Corporate discounts.
Chapter 3 Page 201
It is therefore essential that in the analysis of competition in the air transport market due
regard should be had to all the dimensions in which airlines compete and not only to the
singular dimension of price.
The aviation industry exhibits a number of interesting characteristics in terms of networking,
cost structure, yield management, and marketing strategies. The ability to manage flow traffic
and compete over alternative routings and the market power that comes with dominant hubs
in route networks should also be taken into account when analysing competition in the air
transport market.
3.13.5
ECONOMIES OF SCALE, SCOPE AND DENSITY
Network industries may have fundamentally different characteristics from the traditional
industries that classic microeconomic models have been based on. As a result it is necessary
to take into account not just supply side efficiency that was central in the traditional models,
but demand side effects as well. These include many of the strategies that the airlines have
perfected like loyalty programmes, including FFPs, that have been designed to raise the
switching costs for the best customers,
3.13.5.1
Economies of scale
The optimal aircraft size follows from route characteristics. This implies that the unit cost per
revenue passenger kilometre mirrors the network operated by an airline. A large airline
operating the network of a medium sized airline will incur similar unit costs on that part of
its operations to those faced by the smaller carrier. As a result there are no significant
economies of scale from operating costs at the firm level.
3.13.5.2
Economies of scope
Economies of scope that emerge from the demand side are, according to the NTFAC, even
more important than economies of scope that emerge from the supply side.
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Economies of scope on the demand side of the airline industry are due to two factors:
•
Consumer preferences (due to more routes served and more destinations to choose
from resulting in a larger probability of finding a suitable connection as well as the
concept of switching costs, which customers have to pay when they shift from one
supplier to another), and
•
Marketing practices (economies of scope on the demand side are intensified by the
marketing practices of the airlines like FFPs, TACOs and corporate discount
programmes). Such airline marketing practices create synthetic economies of scope on
the demand side because they make it more attractive for passengers and travel agents
to concentrate their demand at one or a few airlines. The schemes and programmes
increase the loyalty of the customers toward the airlines through an artificial increase
in the switching costs. 48)
The loyalty of customers toward airlines is increased through an artificial increase in
switching costs.
3.13.5.3
Economies of ensity
Supply side economies of density exist if an airline’s unit cost declines when the airline adds
flights or seats on existing routes. These are competitive advantages in a large hub-andspoke networks. The demand side economies of density are even more important. A higher
route frequency will decrease the average time cost experienced by the traveller and hence
induce a higher demand for air transport, especially from business travellers.
3.13.5.4
Economics of alliances
Airlines form alliances in order to exploit each other’s networks and to strengthen the
competitive positions of all alliance partners. More extensive networks are more attractive to
customers and offer larger economies of scope to the carrier.
3.13.6
THE OPERATION OF A DEREGULATED AIRLINE INDUSTRY
Contrary to the predictions generally made at the time of deregulation, actual experience has
demonstrated that deregulated airline markets are not contestable and that incumbent airlines
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can and do obtain market power on certain types of routes. Under the contestability theory,
potential entry by new firms serves to discipline the behaviour of participants in real world
markets where a small number of firms (oligopoly) participate. It was concluded, however.
that contestability has proven inapplicable in the airline industry.
The operation of the deregulated industry has been quite different from the expectations at
the time of deregulation:
•
Industry analysts had not expected every major airline to adopt a hub-and-spoke route
system. Airlines generally operated linear route systems during the regulatory era.
After deregulation each of the holdover airlines (airlines that existed prior to the
deregulation of the airline industry) established a hub-and-spoke system that enabled
the hubbing airline to operate a more frequent service in spoke markets than could be
supported only by local traffic.
•
Deregulation did not lead to the simplified fare structure anticipated by many
observers. The fare structures of airlines became extraordinarily complicated.
Airlines offer many different types of fares subject to many different conditions or
rules. Airlines use yield management to determine how many seats would be offered
at each fare (and limit the number of seats available to each fare class) with the
objective of selling as many seats as possible at higher fare classes. This enables
airlines to discriminate and charge higher fares to business travellers interested in
obtaining frequent service (time sensitive passengers) while offering lower fares to
leisure travellers interested in saving money and less interested in the number of
flights available in any market or the timing of those flights. The implementation of
advances in information technology made it possible for the airlines to implement
detailed yield management systems, which increased their ability to engage in market
segmentation and price discrimination. The technology has enabled each airline to
allocate seats among the many different fares classes offered on a flight in accordance
with a predicted demand for each type of fare. In addition, CRSs have played an
important role in airline distribution.
•
Contrary to expectations at the time of deregulation, almost all of the current major
US airlines were major airlines before deregulation. The surviving pre-deregulation
airlines have become more efficient since deregulation. Their ability to survive
despite their higher costs, and the failure of almost all of the new entrant airlines that
started up in the early years of deregulation (with substantially lower costs) suggested
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that the major airlines’ route systems and the scale and scope of their operations gave
them important competitive advantages.
•
The proponents of deregulation assumed that there were no economies of scale or
scope in the airline industry, and overlooked the physical barriers to entry that
became important when the regulatory scheme no longer made entry and route
expansion difficult.
•
Competitive responses from stronger network airlines intended to eliminate
competition may have undermined the ability of some new entrants to remain in
business.
3.13.7
POTENTIALLY UNFAIR COMPETITIVE RESPONSES TO ENTRY
BY LOW COST AIRLINES
It was established that a new service by a low cost carrier is likely to be the only way that
many hub markets will ever benefit from competitive airline service. Since a hubbing airline
will likely have only limited competition in most of its hub markets if it can deter entry by
low cost airlines, it is profitable for an incumbent airline to attempt to eliminate actual
competition if it can.
The following complaints were noted relating to other behaviour, not just pricing and
capacity strategies, seemingly designed to make entry impossible or at least unprofitable:
•
Award bonus override commissions to travel agents that book the incumbent airline
rather than the airline entering the market, thereby making it more difficult for the
entrant to obtain bookings from those agents’ customers.
•
Other steps that prejudice a new entrant airline like refusals to sign joint baggage and
ticketing agreements with the entrant.
Refusals to sublease gates and other airport facilities to entrants (even though they are not
being fully used), when comparable facilities are not available from any other source.
Purchasing slots to keep entrants from obtaining such slots at slot-restricted airports. “Baby
sitting” slots use the slots in relatively unprofitable markets in order to keep from losing them
to a potential entrant.
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3.13.8
PREDATION IN THE AIRLINE INDUSTRY DUE TO ACTIONS
RELATING TO CAPACITY AND PRICING
The most controversial competitive responses to entry in deregulated air transport markets
involve steep fare cuts combined with a large increase in the number of seats sold at low
fares, and often an increase in total capacity. The incumbent airline matches the new
entrant’s fare levels and makes large numbers of seats available at those levels or eliminates
restrictions on its discount fares despite the fact that network airlines typically offer service
features unmatched by most low cost airlines. Such action by an incumbent network airline
would appear to be economically irrational, unless the entrant exits the market or reduces its
service. In extreme cases the incumbent airline cuts its fares to match the new entrant’s fare
levels, eliminates all or most of its restrictions on discount fares, and greatly expands the
availability of discount-fare seats. In the short run the public benefits from much lower fares
and discount-fare seats are easily obtained from both airlines. Travellers can enjoy both low
fares and the service features offered by the hub airline, such as more frequent flights and
more attractive FFP benefits. In the long run, however, the public loses because the new
entrant’s competition is eliminated and fares go up to their previous levels or even higher.
3.13.9
THE NATURE OF THE AIR TRANSPORTATION MARKET IS
CONDU-SIVE TO UNFAIR EXCLUSIONARY AND PREDATORY
PRACTICES
Compared to firms in other industries a major air carrier can:
•
Price-discriminate to a much greater extent (makes predation much less expensive to
the dominant supplier, and hence a more credible threat to potential entrants).
•
Adjust prices much faster.
•
Shift resources between markets much more readily (mobility of aircraft) to allow an
increased service frequency and number of seats to capture a disproportionate share
of traffic, and
•
Gain access to comprehensive, “real time” information on their competitors’
activities through booking and other data generated by CRS. This enables airlines to
respond to competitive initiatives more precisely and swiftly than firms in other
industries, and to respond in advance.
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As a result, specific measures should be taken in the competition policy applicable in
particular to the air transport market.
3.13.10
THE DECLINE IN AIRLINE COMPETITION
There are signs that competition has declined in recent years, even though most markets
remain very competitive. The number of routes with competition between airlines having a
significant presence in the market has declined.
3.13.11
THE EFFECT OF A DECLINE IN OVERALL VOLUMES ON
AIRLINE NETWORKS
The airline industry has undergone a fundamental shift with respect to levels of business
travel and the viability of the hub-and-spoke model in the USA and Europe.
Higher cost airlines attempted to raise fares relying on marketing techniques which provided
a powerful hold on the distribution chain; some examples are FFPs, corporate discount
agreements and TACOs and discriminatory pricing practice utilising CRS applications. As
leisure travellers do not buy expensive tickets, airlines focused on business travellers booking
tickets at short notice, who value the convenience of frequent service at nearby airports.
A number of factors contributed to changed circumstances that affected the network model.
These included the following:
•
The network business travel pricing model exploited network size for scope
advantages and made it possible to lock customers in by means of artificial switching
costs. Hub airlines over-expanded in attempting to gain scope advantages. This
implies that there is an optimum size for airlines beyond which the financial risk of a
downturn in the economy needs to be managed.
•
Circumstances have changed in that growth is no longer assured and corporate clients
are cutting back on travel cost. A serious drop in volumes of passengers making use
of air travel highlighted the difficulty network airlines experience in reducing costs.
This resulted in extreme financial difficulties for the large network airlines.
•
Economic conditions have forced customers to seek cheaper alternatives. This need to
economise has to some extent rivalled the binding effect of a number of the marketing
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techniques. In particular corporate business flyers have become price sensitive and
are getting smarter about identifying lower cost flights. More companies are requiring
employees to travel on restricted airfares to save on corporate travel costs (less
expensive but less flexible).
•
New entrant airlines had to focus on exactly what the product they are offering
comprises.
•
A framework of prevention of anti-competitive behaviour and the abuse of
dominance prevented larger airlines from targeted action against new low cost
carriers, especially with regard to a combination of pricing and capacity actions.
•
CRS codes of conduct and Internet applications made it possible to restrict and bypass CRS practices that were discriminatory against smaller airlines and favoured
large airlines.
3.13.12
DEVELOPMENTS RELATING TO AIR FARES
In practice, airlines charge different travellers different prices, depending on their demand
characteristics:
•
Charging higher prices for those with more inelastic demand and lower prices for
those with more elastic demand discriminate in pricing depends on having market
power.
•
Prices based on demand characteristics rather than on the cost of providing the
product are characteristic of a market in which the seller has a degree of market
power.
Airlines offer different fares on a given flight, attaching restrictions or conditions of travel to
some fares and, most importantly, offering only a limited number of seats in some fare
categories.
3.13.13
YIELD MANAGEMENT AND PRICE MATCHING
Yield management (by means of CRS) offers seats at multiple prices with varying conditions
or restrictions and manages the number of seats in each price category or class to charge each
individual passenger an amount as close as possible to the maximum he would be willing to
pay.
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An airline can effectively change its fare offerings by changing the number of seats offered
in each fare category without ever changing any of its published posted prices.
In response to new entry by a low fare carrier, the airline could match fares by simply
offering a large number of seats in an existing or new fare category that matches the new
entrant’s fare offering.
Such matching need not be across all seats on all flights. Instead, such matching would more
likely be targeted at those flights that most closely matched the new entrant’s offering of
flights.
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