Diagram 5:
- Another barrier to enter are the sunk costs. These are costs that cannot be recouped (e.g. by transferring asset to the uses). Sunk costs are irrecoverable and therefore the airlines will not get the money back. Many firms do not enter because they cannot cover the costs of the exit, which is typically for the airline industry. That is why we can conclude that there is no hit and run philosophy in the passenger airline industry.
Considering the above-mentioned facts, evidence is given for imperfect contestability within the airline industry, i.e. entry is neither free nor absolute, and sunk costs occur. The level of contestability of the separate markets within the industry, however, depends on several factors such as the availability of counter and loading space at the airports.
A final factor, justifying an oligopolistic market structure, is the existence of price discrimination within the aviation industry. It occurs when a carrier sells its services at different prices to different customers in order to maximise profits, for reasons unrelated to cost differences. This phenomenon is a typical feature of oligopolistic markets, as monopolists are able to maximise profit without discriminating their prices, and as firms under monopolistic as well as perfect competition mostly act as price takers and thus cannot set their prices completely on their own.
The industry for air services can be segregated on the basis of different types of flights, namely charter and scheduled flights. Charter flights are usually viewed as relevant only to the leisure market, since they do not normally offer the service frequency, ticket flexibility or indeed higher levels of service associated with business travel, and have a particular disadvantage in not offering the facility to interline with other carriers. Therefore, some airlines even regard charter services as non-substitutes for scheduled services, particularly for time-sensitive and business travellers. Those usually stick to scheduled flights because of their high standard of service and lounge facilities, their high service frequency and their flexibility.
Finally, the previous investigation was concerned with markets as being defined by separate routes between two airports. Another distinction which helps to define different markets, however, is whether a traveller is time-sensitive or price-sensitive, as airline ticket prices and conditions usually mean a trade-off between flight flexibility and cost (Competition Commission, 2000a). These two types of market represent in general two different types of passengers – business and leisure travellers. While the former are usually categorized as time-sensitive, the latter ones are, in most cases, viewed as the price-sensitive customers.
4. Strategies in the airline industry
To understand the strategies adopted by firms, we have to be aware of the indications of our analysis of the market structure (see 4.). First of all, competition is on single routes, i.e. city pairs. The dominant market structure is oligopolistic. Therefore firms are interdependent and are left with the choice between collusion and competition. Nevertheless, some routes are only served by only one company (monopoly), while others are facing a monopolistic competition with many firms competing for market share. However, the strategies adopted are highly influenced by the contestability of the market. Not the existing competition, but the potential competition determines the firm’s behaviour.
4.1 Strategies towards each other
One of the first decisions a firm in an oligopolistic market has to make is the one between collusion and competition. In the current past we could observe the emergence of new alliances, e.g. the Star Alliance and the Oneworld Alliance (Humphreys).
These aim to increase efficiency and increase market power. Typical features of these alliances are code sharing, which allows advertising one flight through two firms, and franchising. This means that small airlines being granted the licence to operate routes under a major carrier’s code, increasing the feeder traffic to a hub and the size of the network as a whole.
The number of firms competing in one market (i.e. route) depends on the number of passengers that wish to fly that route. It is not unusual that certain routs are natural monopolies, due to low demand. In this case only one firm can operate the route profitable. However, contestability in the airline market is comparatively high, as it is easy for existing firms to enter new routes, even if that means entering a tough competition like in the case of the natural monopoly. Nevertheless, due to the fact that costs of entry and exit as well as sunk costs are reasonable low, it is only a low risk for a firm to enter that market if it thinks it can operate it more efficiently. In case of loosing the competition the firm can use the planes on other routes; its sunk costs are low. Therefore firms are forced to operate as efficient as possible in order to keep competitors out of their markets. This includes using all possible economies of scale. Therefore the use of the so-called hub-and-spoke system was chosen by many airlines in order to increase efficiency. This means that traffic is collected from feeder points and consolidated at a hub before being redistributed by further flights to other destinations. This reduces the number of flights required to serve a certain number of routes and allows the use of larger aircrafts as passengers for several destinations can be consolidated onto one flight and therefore offers economies of scale (Ferguson, 1993).
Diagram 6: hub-and-spoke vs. point to point
It is furthermore important to raise barriers to entry to reduce the contestability of the market and allow the firm to earn supernormal profits. This can be done by gaining control of ground resources like airport facilities and landing and take-off slots, to own a good computer reservation system, to develop good relations with travel agents and by political lobbyism. It also can be a barrier to entry to let all competitors know that they will face a heavy price war if they enter a certain market. Tools for this are for example ‘predatory pricing’. That means charging prices below the competitor’s average cost and, if necessary, below the own average costs. The business is thus willing to suffer short-term losses in order to drive competitors out of the business, just to raise prices again as soon as the competitor has left the market. However, there are concerns against this practice and this has let to formal complaints with the European Commission against Lufthansa in the past (Sloman 2001, see below).
For any new entrant it is important to have a strategy different from that of existing carriers and to offer a service that is in some respect more attractive to customers than those currently available. Therefore the so-called ‘no frills’ airlines (e.g. Ryan Air) tried to gain
market shares in the price-sensitive travellers segment.
Ryan Air is able to charge low prices by operating on low average costs through cost savings of various kinds, e.g. by using airports with spare capacities as bases similar to the hub-and-spoke system (e.g. Frankfurt Hahn, Germany). They charge for on board service, use online booking, keep ground times
Diagram 7: Ryan Air’s network; Base airport Frankfurt Hahn, Germany
as short as possible and they make the flight crew to assist at or fulfil also other tasks.
Furthermore through spectacular marketing campaigns (free flights) Ryan Air was able to gain attention and caused serious threats to the established airlines, which engaged in aggressive price wars in order to protect their market shares (e.g. Lufthansa).
4.2 Strategies towards customers
As we are examining the passenger airline market, market share depends on customers carried. Therefore the firms have adopted several strategies in order to bind customers to their company and extract as much of the consumers’ surplus as possible (that is the difference between the amount the customer is willing to pay and the actual price).
Therefore firms use 3rd degree price discrimination. That means they sell the same product in different market at different prices, taking advantage of the different elasticities of demand.
To be able to do this, some conditions have to be met:
- The firms must be a price setter
- The markets must be separate, resell must be impossible
- Demand elasticity must differ
As all these conditions are met, the business traveller (market Y) is charged a much higher price as he depends on flights at specific times at short notice. The Leisure traveller (market X) however is much more price-sensitive and is therefore charged a lower price, but has to make a booking far in advance. We can however not talk about pure price discrimination, as the product sold is different in some features as business travellers’ demand for some services (e.g. conditions, comfort, etc.) that also generates higher costs for the airline.
The basic service however, transport from A to B, is the same.
This market segmentation, crucial for price discrimination, is practiced to a much higher extend than just this rough segmentation between business and leisure traveller.
Diagram 8: 3rd degree price discrimination (Sloman, 2000, p. 194)
This is mirrored in the complex tariff systems most airlines uses. The use of electronically yield management systems as well as computer reservation systems (CRS) helps to further extend this market segmentation as it relates forecasted demand to seats available using historical and real time data and automatically restricts the available amount of discounted fares (Ferguson, 1993). A similar effect has the use of online booking. While customers who are willing to spend enough time searching may be able to find the cheapest possible tariff, everyone who is not willing to do so is charged a higher price.
Another important strategy towards customers is the creation of a brand loyalty. A popular strategy to do this is using frequent flyer programs (e.g. Lufthansa’s ‘Miles and More’). Offering rewards such as free flights, customers are given incentives to use the same airline again. This is especially true for business travellers who collect the miles themselves while the firm is paying the flight.
Of course marketing has also a great effect in binding customers. By advertising cheap fares and punctuality market shares can be won from competitors that fail to satisfy their customers.
A good example for this is ‘German Wing’ a German ‘no-frills’ airline that recently entered the price-sensitive market segment. With an aggressive marketing campaign advertising its lowest fare, it gained a lot of attention, even if only a small contingent was actually available at this price. But while most customers were paying a higher price, competitors are judged against this low price.
5. Consequences of the market structure
5.1. Consequences for firms
As a result of the prevailing oligopolistic market structure, the airline sector is relatively regulated in most countries. Although the market has experienced continuous deregulation and privatisation during the last years, the passenger airline firms still face certain obligations, which are mainly concerned with safety standards and environmental burdens. These restrictions have let to higher costs and prices in the sector.
Instead of competing in one single, international market, different airlines may choose to locate in particular sub-markets. Therefore some rather concentrate on cargo; others operate in air charter services or in scheduled air passenger services. (Ferguson, 1993). As already mentioned in the foregoing, a further attempt of gaining market power is by differentiating products, this happens for example by offering different, often relatively sophisticated services. For example, Air Frances advertises for its exquisite cuisine. In the last decade, where competition increased steadily, this product differentiation in terms of service has become more and more important: In order to compete with larger competitors, such as Aer Lingus and British Airways, Ryanair decided to offer “no frills” services, which implies that no free snacks or drinks are served and that there is no pre-booked seat allocation. This helped Ryanair to save cost, labour and materials. (Slack, 2001)
The repercussions of market liberalisation have enhanced competition, having led to an augmentation in efficiency and, at the same time, forced airlines to make better use of their capacities: e.g. overall occupancy of seats per aircraft has increased. A further implication of the new market conditions is the attempt of EU carriers to reduce costs, for example by reducing their number of staff or increasing labour productivity. However, they have not been successful in reducing the average labour cost per employee. They now tend to pay their staff on average slightly more in return for proportionately greater productivity increases (SMRS, 1996). It can be said that benefits for the passenger airlines are maximised when true competitors to incumbents can actually enter the markets (Caves and Higgins, 1993).
The previous years have shown that the industry and route efficiency has become particularly sensitive to actual competitive pressures (Gonenc and Nicoletti, 2000). An example for this can be seen in the fact that between 1992 and 1995 six new airlines started serving intra-EU cross border-scheduled routes. On the other hand four carriers had to leave the market between 1989 and 1992 (SMRS, 1996). Particularly in the single European aviation market, where most airline operators used to be national bearers such as BA, the impact of deregulation is well remarkable. Before privatisation these airline operators had monopoly power in their respective air spaces. But due to privatisation and deregulation in the UK and in Europe, these enterprises now are faced with much more competition (BBC 2001a).
Apart from the reduction of national “flag carrier’s” the market liberalisation also resulted in increased interlining, code sharing and alliances between the newer, often smaller firms and the incumbents. (Competition Commission, 2000a).
However, severe competitors of the “flag carriers” are low cost operators like Easy Jet and Ryanair, which try to gain market power in the short-haul market (see appendix). Long haul means flights outside the UK, Europe, the Mediterranean, Canaries and Madeira, whereas Short Haul’ means flights to the UK, Europe, the Mediterranean, Canaries and Madeira. While the big airlines try to win more premium business traffic, the cheap fares airlines fight ruthlessly for leisure traffic (BBC 2001b).
The tight competition in the sector and the exploitation of both scale and scope economies has let to the introduction of hub-and-spoke networks, which allow traffic to be collected from feeder points and consolidated at hub before being redistributed by further flights to other destinations. This implies that a few airports, such as London Heathrow, Charles de Gaulle (Paris) etc., become the focus of the operations of air carriers. Therefore it is possible to serve routes more frequently with larger aircrafts. (Gonenc and Nicoletti, 2000).
In regard to the increased competition, BA chairman Lord Marshall stresses the importance of consolidation between airlines in order to stay competitive in the global market, especially when facing the present downturn of customers. Consolidations may constitute a solution of two major concerns of most airline firms nowadays: the amount of empty seats on their planes and the cost of getting those planes into the air. As these two factors constitute fixed costs, reducing those leads to profits. Therefore Lord Marshall is convinced that cross-border merger, acquisition and joint equity venture are important for the future of airlines like BA (BBC 2001b).
Finally it is important to mention constraints and barriers of the market. Due to the market structure, access to airport slots remains one of the biggest barriers to the sector, thereby inhibiting competition on existing routes and the development of new routes. Slots are nowadays sometimes up for auction, but this kind of slot pricing may discourage operators of small aircrafts (SMRS, 1996). Furthermore the still existing capacity constraints enable incumbent airlines to maintain higher load factors and prices than otherwise, by preventing the more efficient airlines from expanding existing services or entering new routes. But these capacity regulations may also restrict the growth in capacity, and in combination with other constraints, such as restrictions on routes, a limit to the efficient operation of airlines and a raise in the cost of providing the services can arise (Doove, 2001).
5.2 The consequences for consumers
Deeper discounts are only one of the benefits for consumers the deregulation of the market brought about. In addition, special offers are generally more widely published. This seems to have an influence on the customers, which increasingly avail themselves of this opportunity (SMRS, 1996). There has been a strong increase in air supply in recent years (). Through decreasing certain barriers to entry, the European horizon has been opened for small airlines (Gonenc and Nicoletti, 2000) such as Easy Jet, Ryan Air and Go. They are mainly targeting price sensitive and flexible customers flying between the UK and the European continent, nearly exclusively operating from secondary airports. As these passenger airlines are primarily selling on the internet and tickets cannot be bought on travel agencies, their low priced offers might not be available to all potentially interested people.
The increasing substitution of conventional tickets by new types such as ‘etix’ and more frequent competitive promotions also tend to increase choice and cut average prices for non-full-price fares (Competition Commission, 2000a). The aforementioned hub-and-spokes networks save costs to carriers, which can then be passed on to the consumers. Furthermore more EU-cities can be relatively easy and efficiently connected and consumers very often only have relatively short idle time between connecting flights.
Through deregulation there is often the choice of more than two main flag-carriers of the related countries ( Miert 1995).
This can lead to cheaper flights through price competition, also reflecting the interdependence of the carriers. Like that a higher proportion of our society can benefit from travelling by plane, as this becomes more affordable.
Although there has been a downward trend in the price of non-standard fares, business as well as fully flexible fares tends to rise due to increasing price discrimination ( 1998, Doove, 2001). This is because their demand is relatively inelastic and they provide the main revenue for the airlines. Nevertheless, these customers can benefit from various promotions such as frequent flyer programs and ‘two for the price of one’ deals. Often these are offered to oblige the passengers to the respective airline or alliance in the increasingly competitive environment.
Altogether, the fares are not as low as they could be. This might be due to the fact that airlines do not want to damage their fare structure for long term. They could be unable to increase fares during “better times”. Theoretically, given the oligopoly pricing, new airlines would enter the industry, as to equalize supply and demand and to match fares with costs. But things like frequent-flyer programs and the limited number of take-offs and landings per airport, mostly allocated to the existing major airlines, prevent this from happening (, 1998).
5.3 Consequences for society
In many respects the aviation market has a considerable impact on society. Yet it is relatively difficult to judge whether the effects are rather to be ranked as positive or negative. In the following the attempt is made to give an answer to this question by explaining the several factors in more detail.
Apart from recent trouble the aviation business experienced a continuous growth throughout the last decade. This fact is closely related to the liberalisation of the European markets. Especially this development made the aviation sector to a major UK industry in its own right. To get an impression of the industry’s dimensions in the British economy, it is useful to have a closer look at the following figures:
The aviation industry contributes £10.2 billion a year to UK GDP, generates and supports 380,000 direct and indirect UK jobs, exports £6.6 billion a year of services, and is responsible for investment of £2.5 billion a year in the UK (British Air Transport Association). In addition the sector contributes £2.5 billion a year to the Exchequer, thereby indirectly helping the government being able to run a higher public spending policy, which, if allocated efficiently can help to improve socially efficiency within the state. (Humphreys).
Furthermore the industry’s figures concerning productivity and growth underpin the importance of the sector to UK competitiveness: Growing four times faster than the UK economy and producing 2.5 times more output per worker than the national average, the aviation industry can be considered as a catalyst for growth in tourism and knowledge-based industries and as an attraction for direct foreign investment (British Air Transport Association).
Hence it could be argued that the passenger airline industry tends to be a Pareto improvement: There is an increase in social efficiency, where the positive development of the passenger airlines benefits part of the society without making anyone else being made worse off.
However, this is not generally the case. Due to the increase in passenger airline traffic, external costs have gone up. External costs are such as pollution, noise and congestion. For example, a greater level of air pollution is one of the main social costs, together with the increased noise pollution, especially for people living close to airports. In particular the expansion of the no-frills airlines contributed remarkably to congestion and pollution. The competition has brought about congestion at major and some secondary airports. This has led to expansion and construction of new landing ‘slots’. The expansion in the construction of landing ‘slots’ will lead to pollution and also increase noise levels.
Moreover it should be taken into account that the increase in passenger air traffic happened to the detriment of other transport sectors, like rail traffic and mainly ferries.
On the whole, the consequences of the passenger airlines to society can be considered as positive: Not only concerning its considerably contribution to the British economy, but also in terms of travelling, where leisure travel has become more affordable for all members of our society, the aviation sector provides numerous social benefits. Finally it has also been discernible that the industry is trying to reduce external costs, for example by making the aircrafts less noisy, trying to reduce their rate of pollution and shifting airports to outer city sectors.
6. The regulations effecting airlines
The UK and EU Competition Policies are designed to protect consumers. They control competition to make sure that no companies are abusing their market positions by over charging consumers to make super normal profits. They also make sure a company is not monopolising the market by preventing other companies from entering. If a company is thought to be carrying out anti-competitive practices, it will be referred to the Competition Commission (in Britain) or the European Commission, who will then carry out a report into that company to see whether the allegations are correct. If they are, the company will then have to go to either the British or European Court of Justice.
The UK Competition Policy is largely based on the 1998 Competition Act that has brought it into symmetry with the EU Competition Policy. The two main articals of the EU Competition Policy are Article 85, covering all types of oligopolistic collusion that are against the interests of consumers and Article 86, covering the abuse of market power and includes mergers. The UK Competition Policy is also split into two chapters which mirror the two articles of the EU Competition Policy (Sloman, 2000: 351,352). Both policies tackle private and public barriers to competition through regulation and the construction of a broad legal framework. It has established legally binding rules and regulations in order to:
- Prevent firms from colluding by price-fixing, cartels and other collaborative strategies.
- Prevent firms from abusing positions of market dominance.
- Control the size to which firms grow through acquisition and merger.
- Restrict state aid to indigenous firms.
There are cases when it has been asked of the competition commission to investigate various sections of the aviation industry. One such resent example has been the request of the Civil Aviation Authority to conduct a report in the maximum airport charges that can set at Manchester Airport, with a similar request looking into the same issue at the major London airports. The main issues concerning charges in both cases are weather charges are single or dual till (single till the maximum airport charge is set to cover operating costs and rates of return of all the airports assets, commercial and aeronautical. Dual till airport charges are set going on aeronautical assets alone). There is the issue if quality of service should determine the rate of charges, if pricing should be determined by on- or off-peak times and whether or not there should be increased security costs. The issue of the public interest covers whether or not there has been a lack of investment by the companies, if consultation procedures are adequate and the quality of service. The findings by the commission are important as to regulate and create a fair playing field between all UK aeronautical companies. If certain companies are neglecting to follow various guidelines, which have been set, then it needs to be addressed. If the commission finds that the level of charges or care taken for public interest is unsatisfactory then guidelines have to be set. However, there has to be a level playing field and as the commission has stated there is an issue of weather the airports should be regulated as a whole of on individual bases. It is not realistic to set the same guidelines for a major airport such as Heathrow as for a smaller airport such as Stansted.
The Civil Aviation Authority (CAA) is the main regulator of competition in the aeronautical industry. The CAA is of the opinion that the UK aviation markets should be as contestable as possible. It has said to allow the market to compete at the same level as other markets. There should be as much freedom in the market as possible. Their viewpoint is that all bilateral restrictions should be lifted and that they should only be accountable for the normal completion policy. In this respect the CAA will handle any allegations of anti-competitive behaviour according to UK competition law. This means it will determine whether the airline in question is dominant within its market. If found to be dominant in its market it will then seek to determine if there has been a misuse of the dominant companies position in the market and dealt with respectively. There is need for control but any unnecessary restrictions made can only act as a set back for the industry and cause more problems and economic set backs which would hinder success in the market.
There have been recent cases when countries have been brought under investigation as a result of unfair compete ion practice. The European court of justice has recently ruled that Austria, Belgium, Denmark, Finland, Germany, Luxembourg, Sweden and the UK governments have acted illegally when signing bilateral air agreements called open skies deals with the US. The European commission’s main concern with such activities was that it means that other EU countries are discriminated against and European law were broken. Airlines that are not part of the agreement are unable to compete with other EU airlines, as they are unable to compete on a level playing field. The current system only allows EU airlines to fly to the US from their own countries where as US airlines can fly into any EU country from anywhere in the US. By allowing EU countries to act as a whole it is thought that it will allow greater freedom and allow EU airlines to be more competitive. Without the freedom to operate freely, EU airlines will be in danger of losing market share within the aviation industry. The UK has been one country guilty of breaching European law. There has to be a comment set of guidelines, which allow all European countries to operate fairly.
The UK market for airlines has grown by 5.7% since 1998 and now has a value of £12.9 billion. This has been mainly due to the increase of low cost airlines (appendix 1). The deregulation of European airspace has also largely aided the growth of the airlines industry in the UK. These deregulations and lower cost flights have meant the market has become more competitive and it is important that domestic bodies such as the CAA as well as the European commission allow competition to be fairly matched. If as in the case stated, certain countries airlines have greater access to the highly important transatlantic market then it will mean airlines without such open skies deals will be discriminated against. This would restrict fair competition; Airlines from any EU country have to be allowed the same opportunity to enter every aspect of the aviation market.
There are a number of other groups responsible for regulating the behaviour of airlines such as the Consumer Protection Group, the Economic Regulation Group, the Safety Regulation Group and the Directorate of Airspace Policy. These groups are mainly concerned with safety or finance issues and therefore are not meaningful for our analysis of the competitive environment the passenger airline industry.
7. Conclusions
Having identified the market structure with its implications for firms, society and governments, it is now to evaluate the current situation and make some comments on the most significant points.
As has been illustrated, the European and UK deregulation of the airline market led to a change in the market structure and the number of firms competing against one another. Privatisation resulted in an increased number of airlines not only competing against other national companies but also now competing on an international scale. The large amount of competition and the difficulty of providing the best service in such a competitive market led to many firms joining together to make alliances. At the moment there are five alliances, consisting of between two and thirteen members. As already mentioned with the introduction of the alliances, the market structure changed again. These alliances signify that the market is now an oligopoly. The majority of airlines want to join these alliances because they can benefit from reduced costs due to increased economies of scale. This can be in the form of reduced running costs; shared marketing costs, etc. The alliances obviously have numerous advantages, and especially at the present situation, where airlines have to struggle with the repercussions of the eleventh September, they become increasingly important. Alliances could be considered as a solution for current difficulties: Some commentators argue that when facing the current downturn of customer numbers such alliances or corporations are essential for carriers like BA or Lufthansa in order to stay competitive on the global market. Under these circumstances the Competition Commission might allow more mergers and corporations among airlines. Yet it has to be taken into account that the resulting market structure of the industry, with a number of companies being members of alliances, is a cause for concern as there is a possibility that there may be some cartel agreements occurring. Furthermore it is certain that companies that are not within those alliances are not reaping the benefits that the members are.
A further interesting aspect that has to be mentioned is that some of the larger firms, such as BA Plc, are not fully utilising the landing slots and airport equipment that they have. However, they are not letting any other airlines use them either. Therefore, this could be seen as preventing other companies into the market. We feel that this should be investigated, as it is obvious that the large airlines don’t need these slots but they are not letting anyone else use them.
After all it can be suggested that the Competition Commission should be aware of the potential of the market structure. All kinds of agreements and practices that prevent, restrict or distort competition, i.e. all types of oligopolistic collusion that are against the interest of consumers have to be identified and investigated. The Competition Commission needs to adopt a balanced strategy of market control, which is neither too relaxed nor too fragmented in order to retain the contestability and competitiveness of the European airline industry.
8. Appendix
Table1: Annual Gross Income (Euro) Short-Haul Pilots
Table2: European Traffic in terms of mill. Passengers (from 2002 forecast)
FSC: Full Service Carrier
LCC: Low Cost Carrier
Source: ECA (2003)
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