Cross-subsidization does not occur since a firm earning only normal profits cannot afford to sell any of its products at low prices that do not cover its cost. Predatory pricing is therefore abolished as a weapon of unfair competition. Economists argued that predatory pricing does not even bring profit for the firm in the long run. The UK government face a problem of distinguishing it from ‘innocent competition moreover after the introduction of ‘no-frills’ airlines where the they can afford to put up a lower price due to low operating cost. The existence of these no-frills airlines will be explained further later.
Although the airline industry is categorised as a contestable market, however it is not a pure contestable market. Sunk costs do exist in the industry as well as barriers to entry that would limit the number of airlines operating in the UK. First of all, companies need to get license from the authorities and there are regulations that are needed to be obeyed especially on safety issues during operation. The availability of desired take-off and landing slots at airports is limited and at different cost depending on how busy the airport is. For example, Gatwick airport would cost lower for an airline company to land or take-off compared to Heathrow airport which is an international airport of UK.
There is a necessity for applying for and securing an air operator’s license from the UK authorities. All regulations have to be followed and this could hinder a firm to enter the airline industry if they cannot fulfil the law. When a firm enters the industry, they have to consider the retaliatory behaviour of the incumbents; the existing companies tend to be more competitive in the market by cutting down fares, expansion in flight frequency or increase in spending of marketing and advertising. This would make the new entrants difficult to compete against the existing companies since they have not achieved economies of scale, therefore their cost is still high.
One of the characteristics of a contestable market is having no sunk cost. However, for an airline industry, the companies would incur sunk cost, cost that they might not recover when leaving the market. For a new airline, they have to take account for the set-up costs which require a very high capital. Some of the examples are installing a seat reservation system, design staff uniforms and advertising in order to inform the public its presence to the market, these are also considered as fixed costs which do not vary with the passengers they have. There are operating costs incurred as well such as fuel for the aircraft, catering services and maintenance cost which normally is very high. A source stated that the flying operation costs take up the largest proportion of total costs of an airline in general that includes pilot salaries and fuel.
Passengers do not respond instantaneously to price differentials, and so incumbents can react before an entrant is able to capture the entire market. The threat of potential entrants would be less as a result to this because the existing airlines know that they can compete effectively. It can be concluded ‘hit and run’ basis is unlikely to happen as the entrants would not able to make supernormal profit. Experience has shown that existing airlines have a variety of means of deterring entry in addition to price retaliation, such as the frequent flyer programmes.
The UK airline industry has the characteristics of a contestable market, except that it has a few sunk costs that act as barriers to entry which can prevent new entrants coming into the industry.
Have any of the theoretical benefits of contestability been recognised in the UK airline industry?
The government performed the deregulation of airline industry when they decide that the industry can be more efficient in many ways when they are run by private sectors, which changed the industry into a contestable market.
In a contestable market, there would tend to be more number of companies and this would lead to competition. In theory, competition brings the price down since every airline is trying to attract passengers and try to develop loyalty to them in the future. The demand for air transport tends to be pro-cyclical, such that air traffic growth generally expands with increased economic growth but at a much faster rate or vice versa. So it explains that the income elasticity of demand is positively high – probably less for ‘no frills’ airlines. In 1978, only 275 million people took to the skies - a number that more than doubled to 600 million in 1997. It makes having a vacation to other countries more accessible for a normal household these days since the deregulation. As the standard of living of people in UK rises, the proportion of their household income spent on travelling as leisure purposes increases.
Another significant tool for an airline company to determine fares is the price elasticity of demand. The PED for a family who is willing to take a vacation outside UK tends to be elastic whereas it would inelastic for passengers who travel for business purposes. If the fare goes too high, a family can postpone their vacation to later date or travel somewhere in the UK. PED also depends on whether the flight is a short haul or long haul. Short haul flight has a higher PED because consumers have alternatives to travel by coach or train, in other words short haul flight has more substitutes. It shows that different groups of people are willing to pay different prices, and this how airlines can take advantage by raising the price for those who needs a ticket with short notice. As a result, fares change more rapidly than they did before deregulation, and passengers sitting in the same section on the same flight are often paying different prices for their seats. Airlines must maximise the revenue from each flight by offering the right mix of full fare tickets and various discount tickets.
Since deregulation, airlines have had the same pricing freedom as companies in most other industries. Over those years, the number of competing airlines soared from 39 to 95 and adjusting for inflation, airline tickets are 37% cheaper today than they were before deregulation. Airlines are operating productively efficient (producing when cost is at its minimum) that would lower the fares and in order for airlines to continue in the business they are only able to make normal profit in the long run. The diagram below shows a normal contestable market diagram and how the price and quantity supplied being determined.
It shows that an airline is producing at quantity Q where their marginal cost is the same as marginal revenue (MC=MR) which is allocative efficiency. Then the price is determined when it meets average revenue which is the demand curve. This is how an airline operates in the long run where they are only able to make normal profit.
We have seen the quality of services in the UK airline industry has improved dramatically since deregulation. With the existence of competition in the market, passengers benefit with more frequency and regularity of destination flights. It is also easier to gather information to find lowest prices from different airlines through the internet, moreover a flight can be booked as well through websites. This way is much cheaper than buying a ticket from an agent as we have to pay for the commission. Air security, as far as concerned has been tightened over the years due to the impact of the September 11 terrorist attack. As airlines are being independent from UK government and obtain economies of scale, they can afford more research and development for the general interest of their passengers. For example recently British Airways has introduced ‘flat bed’ for their first class passengers.
Finally, it can be said that the biggest effect on pricing is that of the emergence of low-cost airlines. It is these discounted fares, from the traveller's perspective, that can be said to be the most important result of airline deregulation. Flying with a low-cost airline is increasingly affordable for most Europeans. Average air fares in the low-cost airlines sector account for just 3% of the average monthly EU industrial wage. These airlines can keep their operating costs very low by the use of internet for ticket sales to reduce distribution costs. Passengers can travel without tickets, instead they receive an email containing their travel information details and confirmation number when they book online. This is then to been handed to the check-in counter for boarding pass, this is called e-ticket.
The benefits of contestable market in UK airline industry are therefore been realised, where passengers benefit from lower fares, increase in frequency of flights and better services.
Is there any evidence to suggest that the UK airline industry is an oligopolistic market?
An oligopolistic market is dominated by a few producers; each of whom has some control over the market. UK airline industry can be said an oligopolistic market as each of the airlines is providing the same services – air travel. There is a limit to a number of airlines as well due to a limited number of airports and air traffic.
Some airlines have merged with other airlines over the recent years for example a merge between Air France and KLM Royal Dutch Airlines in 2003. One of the reasons of their merge could be to obtain economies of scale and reducing their average operational costs. However the main aim would be to obtain a larger proportion of share in the market, as a result the merge has created them the third largest airline in the world and the largest in Europe, surpassing BA. This merger comes as the worldwide airline industry is suffering – both American carriers and national carriers in Europe. US airlines are still recovering after the impact of terrorism and recession.
Airlines have to take into account the likely reactions of the rivals when considering price changes which can lead to uncertainty in the market. The airlines are interdependent of price and output decisions. Therefore an airline has to compete in different ways other than price, such as promotions and discount fares. These are important to keep the airlines competitive in the market, such that they need to advertise through the media to let the consumers well aware of their latest promotion. In the end, they have to agree with a certain range of price and this made non-price competition important.
Up to now, most activity has been in terms of airline alliances. Most airlines have joined alliances, and then passengers can benefit from points by frequently travelling with the airline. This would create loyalty of passengers to the airline as when they reach a certain number of points, it could worth a flight. These arrangements allow international carriers to cooperate in terms of ticketing, frequent flier miles, priority flier clubs, joint discount fares and single check-in service. Alliances are the closest to mergers most airlines will come to merging in the future, given national interests and antitrust hurdles. Star Alliance accounted the biggest share of the world alliance with 26% which consists of big airlines such as United Airlines and Lufthansa. The British flag carrier British Airways joined the One World alliance along with American Airlines.
In these terms, the UK air transport industry was further advanced in competitive terms than the rest of Europe for most of the 1990s. Against this background, the structure of the UK airline industry has grown and changed significantly in the last ten years. This report examines the trends and underlying factors that have changed UK airlines in recent years.