The Airline Industry
“That vast network of routes that connect cities throughout the country”
Characteristics of Air Transport
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An oligopoly: “Oli” meaning few
Few companies producing a similar product
• Other oligopolies include:
What Do Airlines Sell?
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They sell service that is intangible
What happens is passengers commute from point A to point B
People are really buying time savings
The airlines differentiate there product through service
Differentiating the Product
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Schedules
• Frequency
• Destinations
Frequent Flyer Programs
Prestige Lounges
Meals
Oligopolistic Characteristics of the Air Transport Sector
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Number and Size of Carriers
High Barriers to Entry
Economies of Scale
Growth Through Merger
Mutual Price Dependence
Non-price Competition
Number and Size of Carriers
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The current major carriers are large and seem to change often
Low-cost carriers now fly about 40% of passengers
Code-sharing is becoming more routine everyday
The legacy carriers are on the brink of bankruptcy
It takes more than a cheap seat, a Southwest to make” (Lehrer, 1990)
High Entry Barriers
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Namely Costs
• People requirements
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• Management - Labor
• Staff - Line
Aircraft
Fuel
Maintenance
Marketing
Economy of Scale
• Most airlines employ thousands of people
• More manpower (sic.) can move more product
• If volume of output falls (possibly during an economic downturn) per unit costs
rise
• Economies of Scale are usually reached quickly: Where does an increase in
cost make little increase in revenues
• How can technology be utilized
Benefits of Economy of Scale
• More specialization
• Greater purchasing power
• Resources to perform more complicated tasks (heavy maintenance checks)
• More opportunities to use manpower in contract work
• Airlines must grow and often do so through merger and acquisition
Merger
• In an acquisition one company purchases an interest in another
• A merger is the acquisition of one firm by another, either through purchase of
stock or direct purchase of assets, and the merging of operations.
• Basically, two airlines become one. The purchasee is incorporated (or
merged) into the purchasers airline
• There were a huge number of mergers in the 1980s and 1990s
Merger and Acquisition History: Delta Air Lines
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Formed in 1929
• Monroe, LA
• Agricultural work
Out of business in 1930
Resumed operations in 1934
Acquired and merged with Chicago and Southern Airlines in 1953
Acquired and merged with
Western Air Lines in 1987
Acquires some of Pan Am routes in 1991
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Acquires Comair in 1999
Is really in trouble!
Predatory Pricing
• “There have been instances in which a new, small carrier has offered low price
service between a major carrier’s hub and a spoke city, only to find the major
carrier cutting its own airfares and increasing the number of seats-- or even
airplanes-- on those routes and sacrificing short-term profits with only one goal
in mind: to drive the new entrant out of the market and then raise its own fares
to their original level or higher, and cut back its level of service.”
Mutual Price Dependence
• With so few airlines, one must watch the rivals closely
• A price increase/reduction is usually matched – but not always
• Be careful of “price-fixing” Are there hidden “signals?”
• Your professor thinks the airlines charge too little!
• A 1979 $219 ticket should now cost ($219/.384 = $570.31)
Non-price Competition
• Since the airlines can’t compete on price alone, there must be something that
is “value-added.”
• All the perks of the past are about gone so what’s left?
• Today’s perks include:
• More liberal upgrades
• Preferred boarding
• Preferred seating
• Expedited baggage handling
• Free drink coupons
Some Unique Airline Problems
• High Technology Turnover
• Route Structure Challenges
• Limited Airport Space
• Fluctuating Fuel Prices
• High Labor Costs
• High Cash Flow
• Highly Unionized
• Labor Intensive
• Thin Profit Margins
• Seasonal
High Technological Turnover
• The chief asset of an airline is its airplanes
• Advances in aircraft design and competition make airlines re-equip every eight
to ten years - Technological advances create turnover
• ATA forecasts capital requirements of $65 billion for the ten year period
between 1996 to 2005
• Airframes do not wear out quickly – technology does!
Route Structure Challenges
• Hub and Spoke route systems tend to crush new airline entrants
• Predatory pricing by the major airlines at their “hub” often sinks anyone who
comes into their backyard
• The “fortress hub” is said to raise ticket prices
• The new Low-cost carriers are making major dents
Limited Airport Space
• Major airlines control most of the gate space at their hubs and are unwilling to
sell it
• Many of the busiest airports are at capacity
• There are high density airports where slots are difficult to acquire
• However, Southwest have always gone to secondary airports (MDW v. ORD)
(BWI v. DCA) This is an old Peoplexpress trick
High Labor Costs
• Airline industry is highly unionized
• Wages tend to be higher than average (perhaps)
• According to the book in 1996 average wage was $48,331 a year
• Management teams are well compensated also
• Most companies offer full benefits
Fluctuating Fuel Prices
• Airlines consider this expense uncontrollable since the price of fuel can vary
widely
• 1981 - $1.052 per gallon
• Early 1990 - $.60 per gallon
• Late 1990 - $1.10 per gallon (Gulf War)
• Late 2004 - $1.28 per gallon
• It is often said that a one cent change in fuel prices can effect the “bottom line”
by a million dollars
High Cash Flow
• Large airlines own large fleets of expensive aircraft which depreciate in value
over time
• A substantial positive cash flow (profits plus depreciation) is usually generated
• Most airlines use their cash flow to repay debt or acquire new aircraft
• When profits and cash flow decline, an airline's ability to repay debt and
acquire new aircraft is jeopardized
Labor Intensive
• Each major airline employs a virtual army of:
• Pilots, flight attendants, mechanics, baggage handlers
• Reservation agents, gate agents, security guards
• Cooks, cleaners, managers, accountants, lawyers
• Computers have enabled airlines to automate many tasks
• In a service business, customers require, and often demand a lot of personal
attention
• More than one-third of the revenue generated each day by the airlines goes to
pay its workforce
Highly Unionized
• A long history of regulation + high unionization
• Labor costs are among the highest of any industry
• Prior to deregulation, air fares and freight rates were set on a cost-plus basis
• Unions were able to negotiate high rates of pay
• With the appearance of low-cost competitors, many airlines are under
pressure to lower their labor costs
• Accomplishing that goal is very complicated
Thin Profit Margins
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Bottom line is razor thin
Net profit is from 1 – 2% (US industry about 5%)
Travelers see tickets prices as high compared to other goods and services
Cost of providing the service keep increasing
Airlines must still pay stockholders and invest in equipment and facilities
Seasonal
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The airline business also is very seasonal
• Summer is extremely busy
• Winter is slow
• Thanksgiving and Christmas holidays are short peaks
• Many peaks and valleys in travel patterns
• Revenue rises and falls significantly
10/24/08