Business Economics Assessment - Passenger Airlines

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Business Economics Assessment

Passenger Airlines


Contents

1. Table of contents………………………………………………………………..……..        2

2. Summary…………………………………………………………………………………        3

3. The market structure of the airline industry………………...…………………….        4

4. Strategies in the airline industry………………………..…………………………...        7

4.1 Strategies towards each other………………..………………………………………        7

4.2 Strategies towards customers……………………………………………………….        9

5. Consequences of the market structure……….……………………………………10

5.1 Consequences for firms…………………………..………………………..………….        10

5.2 Consequences for consumers………………………………………………………..        11

5.3 Consequences for society…………...……………………………………………..…        12

6. Regulations effecting airlines………………………………………………………..        13

7. Conclusion………………………………………………………………………………        15

8. Appendix………………………………………………………………………………...        16

9. Bibliography…………………………………………………………………………….        17


2. Summary

In the airline industry it is possible to identify separate markets. In generally it can be argued that oligopoly is the dominating market structure. The firms in the industry are interdependent and therefore individual companies’ decisions have an influence on the competitors. Furthermore barriers to entry can be observed.

In this imperfect competitive market the airline companies face the choice of adopting competing or colluding strategies towards each other. These include for instance hub-and-spoke networks and the establishment of alliances. Customers are primarily affected by the carriers’ strategies through price discrimination and product differentiation.

Although the recent deregulation and privatisation of the airline industry the passenger airlines are still faced with various restrictions tending to increase costs.

Nevertheless, the process of reducing operational costs and the exploitation of economies of scale are consequences of the market structure identifiable for the firms in the industry. The price discrimination exercised might imply either benefit or disadvantage, depending on the demand elasticity of the respective customer group. Altogether the consequences for society might be seen as positive, given benefits like an increase in UK GDP. Nonetheless harmful factors, such as negative externalities from the growth in air traffic, cannot be neglected.

Due to the oligopolistic market structure the European airline market has been subject to various restrictions aiming to increase the competition in the industry.


3. The Market Structure of the Airline Industry

According to the Competition Commission (2000a), “competition in the airline industry takes place on a number of levels and the relevant market in an examination of airline competition can vary from one case to the next”.

However, it is very common and indeed simplest to view the industry not as one single, overall market, but to divide it into a number of separate markets, each representing a route between two airports. Most of these ‘micro-markets’ show an oligopolistic market structure, i.e. “they contain only a few competing [carriers, with each having] enough market power to prevent its being a price-taker ... [Each carrier] is subject to enough inter-firm rivalry to prevent it considering the market demand curve as its own” (Lipsey, 1999, p. 176). The airlines are interdependent with one another, and each carrier’s actions impact upon the actions of other firms within the market. In most markets, air services are still provided by a few carriers, generally dominated by an incumbent flag carrier or by an airline alliance between incumbents (Gonenc and Nicoletti, 2000). There are, nevertheless, significant differences in the structure of industries under oligopoly (Sloman, 2000). The different types of oligopoly vary from collusive, including dominant firm oligopolies, to non-collusive oligopolies. The case of collusive ones is represented by the occurrence of legal alliances amongst airlines, such as the Star Alliance, Oneworld Alliance, Sky Team or North West Airlines/KLM. Those firms agree to limit competition between them. They may set output quotas, fix prices or agree not to ‘poach’ each other’s markets in order to achieve an efficient use of their capacity and, thus, to maximise their profits (Sloman, 2000). These firms’ behaviour can be characterized as a monopoly, since the participants will act as a single seller (see Diagram 1).

                                                                        Diagram 1:

Collusive oligopoly (cartel), acting as a single monopolist

  • P* is high, Q* is low

        

A special mode of such collusive oligopolies is known as the ‘dominant firm oligopoly’, with one firm producing the largest proportion of the market output and the other businesses acting as price takers and competitive firms (see Diagram 2).

        Diagram 2:

Dominant firm oligopoly (price leadership cartel), determining price PL  and output QL  for the leader, QF for the fringe and QT  for the total industry

  • leader maximises profits (MC=MR)
  • fringe firms act as price takers

 

        

The other extreme of oligopolies is represented by non-collusive ones (see Diagram 3), whose participants do not favour cooperation and agreements. Price competition, therefore, prevails in these markets. In such competing oligopolies the reactions of the rivals are the ones that shape the demand curve for each firm.

                                                                Diagram 3:

        

Non-collusive oligopoly,

facing a kinked demand curve, where any change in MC between MC1 and MC2 has no effect on price P* and output Q*

  • D is more elastic above P*

and less elastic below P*

In the aviation sector, however, there are not only different modes of oligopolies discernible, but also in some cases other market forms which are different from the oligopolistic structure, such as monopolies and monopolistically competing firms (Stavins, 2001). The case of monopoly, when there is only one firm in the industry (Sloman, 2000), is given for those routes, i.e. markets, which are operated by only one airline. Monopolistic competition, by contrast, is prevailing in those markets where there are many firms, each one producing a slightly differentiated product and thus having some control over its price.

Summarizing, all these aspects regarding the market structure of the airline industry, oligopoly can be viewed as the dominant market structure, while in some few cases tendencies towards monopoly as well as monopolistic competition can be recognized. The latter cases are due to certain external influences effecting the level of competition within the separate markets, such as the geographical locations and capacities of the airports.

Having identified a dominant oligopolistic market structure within the industry for air services, further indicators are going to be examined in the following, which justify this result.

As already mentioned, there are still only a few firms in each of the different airline markets. There were 27 in 1998 (Competition Commission, 2000b); nearly all of them were only operating a limited number of routes, i.e. usually only few carriers constitute a single market.

As another key feature of oligopolistic markets, new entrants to the aviation industry have to face several entry barriers. Such barriers are, according to Bain (1956), the existence of product differentiation and brand loyalty within the industry, economies of scale and an absolute cost advantage for the established firms as well as sunk costs for the new entrants.

  • Product differentiation is a common practice to prevent potential competitors to enter the airline market. Through the alliances in the passenger airline industry they can act like a monopolist. It is difficult to enter the market because the oligopolist and their alliance try to close the gaps in the service i.e. flight service (see Diagram 4). Through this wide range of services they are able to prevent competition in this industry.

Diagram 4:

  • A passenger airline experiences economies of scale if cost per passenger fall as the scale of production increase. In the passenger airline we have mostly fixed costs. If there are a high number of passengers that means that the average cost per passenger is low. Therefore we have economies of scale (A). If one of the passenger airlines tries to extent their capacity then they have to buy new equipment. The fix costs increase and when in the same time the number of passenger does not increase then there will be an increase of average costs per passenger. Therefore the airline is experiencing diseconomies of scale (C) (see Diagram 5).
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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 ...

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