Economics in Aviation: the Impact of the Entry of Low-Cost Carriers on Full-Service Carriers - Term Paper Example

Running head: Economics in Aviation Name Institution Department Date The global aviation sector has shown impressive dynamics in recent years. There have been drastic changes in the airline market in both the demand and supply sides. These developments show a marked difference from those in other industries, because unlike the rest of these industries, the changes in the airline industry have not been principally driven by technological factors (Levine, 2007), but also by cultural, institutional and legal developments. Cultural forces have been the major influencing factor in as far as spatial mobility and its associated characteristics are concerned, while institutional and legal developments have impacted of the structure of the airline market. The paper concisely analyses the impact of the entry of low-cost carriers (LCCs) on full service carriers (FSC) in the airline market, also this paper will try to show how history played a part in the gap that exist between Low cost carriers and “full service” carriers, the paper will also try to show how best this gap that exist between low-cost carriers (LCCs) and “full service” carrier can be reduced in the near future (Levine, 2007). Definition: Low Cost Airlines or Low Cost Carriers (LCCs) or ‘no frills airlines’ are airlines that offers low tickets prices to their passengers. These types of airlines first came into being in 1949 in the US, but over the years Low Cost Carriers have gathered momentums with aviation deregulations in the 90s. In the world today, LCCs make up 30 per cent of the global airline market, and the industry have experience rapid growth. In addition, LCCs have low operating costs and are limited in services to a destination, the popularity of these airlines have taken ‘full-service” airline by surprise and, while the response for ‘full-service’ airlines was to compete with LCCs most of big airlines have started introducing their own LCCs under a different brand that is able to compete with LCCs airlines. Typically LCCs business model have the following characteristics: LCCs offer economy class only, aircraft are smaller and operate over a shorter distances, offer one-way levels, have no pre-allocated seating, most of these airlines fly to secondary airports and take advantage of low landing fees, book only and unbundle ancillary charges. The airline industry has experienced deep changes on the supply side in the last twenty years. Over this period of time, the industry has been transformed into a free-market from its initial domination by carriers that were state owned and which operated in a market under strict regulation. During the initial period, the European air routes were occupied by one or two flag carriers and the air fares were determined by bilateral agreements between states.(Karivate, 2009).The deregulation of the European airline market occurred some ten years after that of the United States. This is because although three policy packages came into effect in 1988, 1990 and 1993, total deregulation of the industry not witnessed until 1997. The most important package was however the third one, because with it came the full deregulation of access and pricing capacity. The deregulation and privatization process, which came about as a consequence of the latter, has drastically transformed the airline market structure (Cooper, 2001). Many airlines have responded to these developments through signing alliances geared at placing them in a strategic position to exploit economies of scale, as well as improving their operations. The airlines network has also experienced a revolution from the initial point-to-point system to a hub-and-spoke system. International alliances have also resulted in the formation of the spokes and multi-hub system (Karivate, 2009). Low Cost Carriers (LCCs) will sell their travelling tickets at a cheaper price but they will make more money by changing for booking over the phone, meal onboard, changing you’re exceeding baggage limits and booking. Not all the LCCs will implement all the characteristics of business models mentioned above, for example, some LCCs would operate more than one airplane type, while others will differentiate themselves with allocated seating, others will have high operating costs but their fares will be lower. For instance JetBlue Airways offer in-flight entertainments to their customers in every passenger seat, but other Low cost airlines are limited on what to implement based on laws that are found in areas of their operations, such as Ryanair Airways which are required not to remove the window blinds from its airplanes as required by the Irish Aviation Authority Laws (Levine, 2007). Most of Lower Cost Carriers (LCCs) have strong leadership in business travel, for example JetBlue’s in US and Continental have a large and loyal customer base who are frequent fliers with their carriers, often at considerable expense. The airline has consistently delivered some of the best customer service in the airline industry, with its operations in many US cities such as Los Angeles, Chicago, DC and San Francisco, the airline has been able to win many big corporate travel contracts in the country. At the moment, many companies in the US, even in this area of restructuring in business travel, are likely to choose those airlines that are ready to offer comprehensive international and domestics service as well as provide amenity benefits and loyalty that many companies expect. For example, JetBlue airline extra-legroom seating in their planes and Southwest’s credit-based frequent flyer programs attracts customers easily. LCCs are airlines whose design puts them in a comfortable position to establish and maintain a competitive advantage over FSCs in so far as costs are concerned. LCCs operate on simple principles of logistics and organization, and they utilize point-to-point connections from smaller airports in their operations, as opposed to the hub-and-spoke configuration that is predominantly employed by FSCs. The use of smaller/ secondary airports result in less expenses for LCCs in terms of handling fees and landing tax in comparison to high expenses of this nature that FSCs have to incur due to their use of mainstream airports. A good example is the use of Stansed and Dublin airports by Ryanair as its central airports in 1999. Through the inclusion of one aircraft in its fleet that was capable of operating for more hours on a daily basis than FSCs, thereby maximizing the utilization hence profits, the airline was able to develop other hubs in Rome Ciampion, Stockholm and Milan Orio. (Levine, 2007). The LCC product is devoid of frills service and differentiation, as well as airport lounges, catering, choice seats, frequent –flyer programs, newspapers, cross-airline rebook possibility and refunds. The LCCs also make use of electronic tickets and direct sales over the internet, thereby keeping their distribution as simple as possible. LCCs were capable of continuing their steady growth after 1999 despite the slump in growth witnesses in FSCs, and did not suffer massive losses in the immediate post- 9/11 period, basically because most of them had not yet rolled out operations in politically-sensitive areas and their low flying rates kept attracting passengers as usual. (Levine, 2007). The expansion of LCCs in the airline industry has also been aided by significant structural developments in the airline market, particularly on the side of demand. Globalization and internationalization processes have not only improved the mobility of cargo, but also of persons. Therefore cargo transport expansion and trade agreements have led to an increase in the number of business travellers. There has also been a development on the side of holiday travelers, with increased preference of short and multiple holidays, this presenting a shift from preference to long holidays, a s it was seen in the past. There has also been a decrease in the enthusiasm of flying in recent years, thereby resulting in the acceptance of lower levels of service by a majority of travelers. A good example of an airline that has met runaway success through the adoption of the new business model of operating LCCs is Southwest airlines operating in the California corridor. Through entering only 3 of the eight airport pairs of OAK-ON in 1989, OAK-BUR in 1990 and OAK-LAX in 1991, Southwest was able to become the biggest carrier in the US in under 4 years, de[site not providing any services to San Francisco, which up until 1989 was the dominant air corridor. Chart 1 illustrates the effect of Southwest entering the OAK-LAX airport pair. Its entry produced both price reductions and increase in air traffic. (Craun & Bennett, 1997). The network model for FSCs has resulted in modest profits, declining average fares and increased productivity in the last twenty or more years. However, the efficacy of this network system was already in question, even before and after the effects of 9/11. By 2003, analysts had predicted that point-to-point operations would take over the greater market share and hubs would be gradually phased out. Developments witnessed in America and later in Europe indicate that LCCs have led to profitable growth due to the offering of low fares. They have been aided by factors such as the recent attention to security, high walk-up fares in FSCs and increased unpopularity of hub airports due to their congestion. Operating on a business model that emphasizes simplicity, LCCs have been able to cut down costs to between 40-50% of incumbent costs in the airline industry This has produced traffic growth of about 300-400% on some routes and created new markets. Increased growth of LCCs ha also produce d increased overlapping with FSCs , for example transcontinental flights were rolled out by Southwest airlines in the United States, and the airline chose a pre-existent network carrier hub city; Philadelphia, as the base for its expansion. (Meyer & Menzies, 2006). There have been various responses by FSCs to the competition brought about by LCCs. These include the application of some or all elements of the new LCC business model through the establishment of ‘airlines within airlines’, i.e creating frills divisions. (Morrell 303).The strategy has been employed with the principle objectives of spinning off profitable business, to counter low cost competition in major markets and to create a test-bed for the adoption of LCCs into mainline FSC operations. However, the competitive climate in today’s airline industry has made the achievement of the first objective elusive. Combining the last two objectives has been the more reasonable option of the three objectives. US Airways, Delta, and Air Canada are examples of FSC airlines that have employed this strategy. (Morrell,2006). The second strategy has taken the shape of the introduction of lower overall costs and greater efficiency while avoiding the offshoot of low costs. This strategy has been employed by Northwest, America West, American and Continental airlines. British Airways is a good example of an airline, which employed the first strategy to enter what then considered as a new market in Europe. Its principle aim was to be in a comfortable position to compete with LCCs such as easyjet and Ryanair. However, this venture was not regarded as a means of evaluation of the new processes, and it ended up undermining any significant reductions in mainline costs. (Meyer & Menzies 2006). Hubs have come under intense debate ever since the fast growth of LCC operations was witnessed in North America and later in Europe in the 1990s. Great developments have thus been made by major FSCs in order to improve the profitability of the hubs. This has led to shifts from ‘directional’ to ‘continuous’ hubbing and hub closures, particularly in the US. In the United States, two major FSC airlines, United and Delta, made the decision to venture into the LCC market in the 2003-2004 financial period During this time, United was under Chapter 11 protection. By this time, the Southwest low cost model which had been largely regarded as the blueprint for this venture had been adopted with marked modifications by various airlines, for example, JetBlue had opted to roll out markedly improved levels of services, while AirTran had successfully combined interline/ hub strategy with low costs. These cases represent the adoption of the ‘airline within airline’ system. However, although this venture only represented only a minority of the system of these airlines, there were all not viable n on the financial front. In fact, the attempts which had been earlier made at adopting this system had achieved more success on feeder routes than on point-to-point routes. (Jacobson, 2004). All the adoptions had maintained the fare structure of Southwest airlines and had resulted in reduced costs through strategies such as; substantial in-flight catering reductions; operating a single type of aircraft for example US and Delta Airways; higher asset and aircraft utilization; increased utilization of crew and reduction in salaries in some instances and ; reduction in costs of distribution in addition to the sale through traditional channels. These airlines did not succeed in bringing down their costs to the levels of Southwest. However, they had much higher break-even load factors. In the United States, Shuttle airlines did not achieve n much in competing with southwest, because the market did not recognize it as having sufficed difference from the mainline services of United airlines. It was also unsuccessful in its attempt at bringing down costs to the level of southwest, and it was unable to increase its load factor to levels that would enable it to achieve compensation for lower yields. The only development was increased aircraft utilization. Research on the pricing response elicited by FSCs upon the entry of LCCs in the market carried out by Alderighi, et. al using monthly data city-pairs to the UK , Germany and the Netherlands from Italy and encompassing the airfares of KLM, British Airways , Alitalia and Lufthansa carriers established that upon the entry of a LCC in a particular route, the FSCs react through the reduction of business and leisure fares. This affects all operating flights of this nature. Furthermore, the entry of LCC exerts greater impact on price in monopolistic market than in a competitive market. (Alderighi et. al, 2005). In the past some strategies for LCCs have been put under microscope by both the governments and regulators around the world, particular in Britain, the issue of “unbundling” of ancillary charges by LCCs- showing taxes, airport fees as separate charges rather than as part of the actual advertised fare- have made travelling fares to be cheaper, and this has made the government and other regulators to enforce action. According to Office of Fair Trading (OFT), passed a law that required all airlines and travel agencies to include all taxes in the advertised prices. Although ‘full service’ airlines had complied with the regulation passed within the specified timescale. LCCs were less successful in this respect that made OFT to bring charges against them. FSCs have thus opted to form mergers as a survival strategy in the airline industry. With the increased formation of these mergers, the airline industry is facing reorganization into a cartel run by a few major players. It is predicted that most of the airline traffic in monopoly airports will fall into the control of a few dominate firms , thus making operations in national networks, which have not faced competition from the LCCs and which do not compete with each other frequently, fall into control by a few major players. The predicted result of this reorganization will most certainly be the creation of a less competitive market. (Alderighi et. al, 2005). It was unanticipated some twenty years ago that in years to come, single airlines could bring entire airports under their control. Major airlines use a system of predatory practices to prevent the entry of new competition into the fortress hubs. These practices are usually uncompetitive. Hubs result in the creation of operating efficiencies and economies of scale that make the entry of new competition into the market a near impossibility ( Cooper, 2001). These complications are compounded by traffic concentration at hubs which enable incumbent carriers to be able to benefits from lower costs, as well as derive unique marketing advantages. This is because traffic concentration and prominent hub positions result in the achievement of more options and better reputation within hubs for specific carriers, and also facilitates promotion and advertising, as well as better handling of baggage and greater coordination of scheduling. Therefore, through the formation of mergers, incumbent airlines become capable of creating massive disadvantages for the entry of competition into the market. They not only become capable of diverting traffic to the hubs that they dominate through making deals with travel agents so as to divert traffic, sharing of codes and manipulating computerized reservation systems, but they also deny new entrants the access to the market through precluding the industry entry cost through mechanisms such as extracting extremely high profits on facilities, denying gate space to entrants, and initiating efforts geared at neutralizing the attempts of the new entrants to draw in passengers so as to begin the process of establishing a presence in the industry. Thus the response of dominant carriers to market entry efforts by new entrants encompasses the engagement in blatant generation of predatory prices to create unfavorable market conditions (Cooper, 2001). Therefore, although the formation of mergers results in the concentration of the industry to an extent that the chances of the entry of competition is severely thwarted, this development also leads to the diminishing of the effect of market forces which safeguards the industry against the abuse of power over the market. With the increased concentration of the industry, the possibility of major entrants emerging in the airline industry diminishes. While this might be good news for the FSCs in so much as strategic response to LCC competition is concerned, it is definitely bad news for travellers because the possibility of these carriers engaging in strategic gaming increases, and it will be only a matter of time before these major players will be able to operate in conditions that are insensitive to the needs of travellers, such as sudden increments of travelling fees. In conclusion, with increase in competition globally, most airlines anticipate increase in passenger traffic demand; therefore low cost carriers would be the right to compete effectively in this air transport business. Reference List Alderighi, M., Cento, A., Nijkamp, P. & Rietveld, P. (2005). The Entry of Low-Cost Airlines. University of Amsterdam: Tinbergen Institute. Cooper, M. N. (2001). Mergers between Major Airlines: The Anti- Competitive and Anti- Consumer Effects of the Creation of a Private Cartel, Consumer federation of America, committee on Energy and Commerce. Craun, J.M. & Bennett, R.D. (1997). The Southwest Effect. Airline Deregulation Evolution Continues. US Department of Transportation: Office of Aviation Analysis. Jacobson, D. (2004). The economic Impact of the Airline Industry in the South. Regional Resource, The Council of State Governments. Karivate, S. (2009). Low-Cost Carriers and Low Fares, International Journal of Transport Economics, 21(2): p209-215. Levine, M.E. (2007). Airline Competition in Deregulated Markets: Theory, Firm Strategy, and Public Policy, Yale Journal on Regulation, vol.4: p393-494. Morrell, P. (2006).Airlines within airlines: an analysis of US network airline responses to low cost carriers, Journal of Air Transport Management, vol. 11(5): 303-312. Meyer, John R. & Menzies, Thomas R. (2006). The Dynamics of airline Pricing and Competition. American Economic review, vol. 80. No. 2. (May): p 1-20. Read More