Demonstrate, in your own words, some factors that could determine and explain the contestability of a particular air route: Managerial & Decision Economics Case Study, NCI, Ireland

Questions

1. Demonstrate, in your own words, some factors that could determine and explain the contestability of a particular air route.
2. Demonstrate your understanding of deadweight loss in relation to the previously regulated airline industry where airlines had monopolies on routes. How has the deregulation of the aviation industry solved that and who benefits from that solution the most?
3. In a recession, do you think that the low-cost carriers are more, or less vulnerable than the traditional carriers? And in a boom? (Consider elasticities in your answer and illustrate your answers with graphs where appropriate)
4. Search for low-cost long-haul carriers and compare their prices and quality of service to that of major carriers. In your view, how are they able to compete at substantially lower prices? Do you believe this model is sustainable?

Airline Deregulation

If a market is highly contestable, the mere threat of competition may be successful in keeping prices and profits down. Of course, established firms would not like this! They would be keen to erect barriers to entry and to make exit more costly for any firm that did enter.

Governments around the world are generally in favor of increased competition and frown on the erection of entry barriers. This means that they generally prefer not to intervene if markets are competitive or highly contestable, but may attempt to regulate the prices, profits, or behavior of firms where competition or contestability is limited. Conversely, if markets have been regulated and yet are potentially competitive, many governments have then deregulated them.

A good case study of deregulation and contestability (or lack of it) is the airline industry. Here the reduction of regulations over decades has allowed low-cost airlines to build market share and challenge the large network carriers.

The USA

The airline industry in the United States has been deregulated since 1978. Prior to this, air routes were allocated by the government, with the result that many airlines operated as monopolies or shared the route with just one other airline.

Now there exists a policy of Open Skies. Initially, the consequences were dramatic, with lower fares and, over many routes, a greater choice of airlines. The Brookings Institute calculated that, in the first ten years of deregulation, the lower fares saved consumers some $100 billion.

One consequence of the increased competition was that many long-established US airlines went out of business. Even where routes continued to be operated by just one or two airlines, fares still fell if the route was contestable: if the entry and exit costs remained low.

In 1992, despite the bankruptcies, 23 new carriers were established in North America, and many routes were taken over by existing carriers. But deregulation did not make all routes more contestable. In some cases, the reverse happened. In a situation of rising costs and falling revenues, there were mergers and takeovers of vulnerable airlines.

By 2000 just seven airlines accounted for over 90 percent of American domestic air travel, compared with fifteen in 1984. With this move towards greater monopolization, some airlines managed to make their routes less contestable. The result was that airfares over the 1990s rose faster than prices in general.

A key ingredient in making routes less contestable was the development of a system of air routes radiating out from about 30 key or ‘hub’ airports. With waves of flights scheduled to arrive and depart within a short space of time, passengers can make easy connections at these hub airports.

The problem is that several of these hub airports became dominated by single airlines which, through economies of scale and the ownership or control of various airport facilities, such as boarding gates or check-in areas, could effectively keep out potential entrants.

By 2002, at 15 of the hub airports, including some of the busiest, the dominant airline had a market share in excess of 70 percent. The airlines also used measures to increase ‘customer loyalty and thereby make entry barriers higher. These measures include frequent flier rewards, deals with travel agents, and code sharing with ‘partner’ airlines.

The rise of the low-cost airlines

In the 2000s, however, the domestic US airlines market became more competitive again, thanks to the growth of low-cost carriers (LCCs), the largest being Southwest Airlines. These accounted for just 7 percent of US domestic passengers in 1990; by 2009 this had risen to 34 percent and in 2013, for the first time, LCCs had a greater market share than the network carriers. The response of the major airlines was to create their own low-cost carriers, such as Delta’s ‘Song’ in 2004 and United’s ‘Ted’ in 2004.

A danger here is that big airline may use their LCCs to undercut the prices of small new entrants to drive them out of the market. Such ‘predatory pricing’, however, is illegal and the Department of Justice investigated several cases. However, observing predatory practices is much easier than proving them.

Thus, cases have been consistently dismissed by juries, who have concluded that there was insufficient proof that the big airlines were breaking the law. This issue re-emerged in 2011 when Delta Airlines was criticized for adopting predatory practices in order to maintain a monopoly position at Minneapolis St Paul Airport.

With the rise in fuel prices in 2006–8 and lower passenger numbers from 2007, resulting from the global recession, some of these new LCCs went out of business. Delta shut its Song division in 2006 and United shut Ted in 2008. Southwest continued in its position of market dominance, with 18.0 percent of domestic passengers carried in 2015. This made it the largest carrier, ahead of Delta at 16.9 percent and United at 14.7 percent.

Europe

Until the early 1990s, the European air transport industry was highly regulated, with governments controlling routes. National routes were often licensed to the national airline and international routes to the two respective national airlines.

Since 1993, the industry has been progressively deregulated and competition has increased, with the growing availability of discount fares. Now, within the EU, airlines are free to charge whatever they like, and any EU airline can fly on any route it wants, providing it can get the slots at the airports at either end.

As in the USA, however, whilst increased competition has benefited passengers, many of the airlines have tried to make their routes less contestable by erecting entry barriers. Predatory pricing occurred, as the established airlines tried to drive out new competitors.

The proliferation of fare categories made it hard for consumers to compare prices, and established carriers’ highly publicized fares often had many restrictions, with most people having to pay considerably higher fares.

As in the USA, code sharing and airline alliances have reduced competition. Finally, at busy airports, such as Heathrow, the shortage of check-in and boarding gates, runways and airspace provided a major barrier to new entrants. Nevertheless, new low-cost airlines, such as EasyJet, Ryanair, and Flybe, provided effective competition for the established national and short-haul international carriers, which were forced to cut fares on routes where they directly competed.

British Airways went as far as re-badging their loss-making subsidiary regional airline as BA Connect in 2006, adopting a low-cost model and pledging to ‘cut one-third from standard domestic fares’. However, the company accrued further losses that year and was sold to Flybe in early 2007.

Low-cost airlines have been able to enter the market by using other airports, such as Stansted and Luton in the case of London, and various regional airports throughout Europe. Many passengers showed themselves willing to travel further at the beginning and end of their journey if the overall cost remained much lower. Ryanair has made use of smaller airports located some way from major cities.

Lower costs

How do the LCCs compete? The airline industry does not seem to be a highly contestable one. Apart from anything else, aircraft would appear to be a high-cost input. The answer lies in a variety of cost-saving opportunities. The LCCs can lease planes rather than buy them and even when they own their own planes, the aircraft are generally older and more basic, offering a standard accommodation rather than different classes.

The result is reduced exit costs, increasing contestability. In addition, by charging extra for each item of luggage, they reduce the amount they carry, thus saving fuel. LCCs also tend to pay lower wages than the major carriers. The large hub-and-spoke carriers have also found that the very nature of their operations constricts their ability to compete with the LCCs on city-to-city routes.

Not only are the hubs themselves expensive, but the movement of passengers in and out of the terminals takes longer than with smaller airports. Thus, the LCCs, with operating costs some 25 to 50 percent lower than the traditional carriers, has become a highly effective competitive force on these routes between various city pairs and have forced down prices.

Despite these successes, a period of increasing fuel prices and falling consumer demand from 2008 led some commentators to suggest that the LCCs were unlikely to survive. The past decade has certainly proved tough for some carriers, with Flybe making losses and Ryanair issuing several profits warnings in 2013.

However, others, such as EasyJet, have grown increasingly successful, while in China and South Africa there has been a number of new entrants. Then with falling fuel prices from 2014, the market environment for all carriers became more favorable again, especially low-cost carriers, for whom fuel prices are a higher percentage of their costs. It seems likely that the global airline market will remain highly contestable.

Pricing strategies

The pricing model for low-cost airline seats seems simple. As the seats get booked, so the price rises. Thus the later you leave it to book, the more expensive it will be. But, in fact, it is not as simple as this. Prices on many routes vary frequently throughout even the period of a week, with seat prices sometimes coming down as the take-off date approaches.

Flexibility in pricing makes sense for low-cost airlines because their business models depend as much on selling extras – hotels, refreshments, and car hire – as they do on selling tickets. So, what is the pricing model? The general principle of raising prices as the plane fills up still applies. This enables the airline to discriminate between passengers.

Holiday-makers and those with flexibility about when, and possibly where, to travel tend to have a relatively high price elasticity of demand. People who wish to travel at the last minute, such as business people and those facing a family emergency, tend to have a much lower price elasticity of demand and would be prepared to pay a higher, possibly much higher, price.

With relatively high fixed costs for each flight, low-cost airlines need to fill, or virtually fill, their planes if they are to make a profit. And it is not just about the direct revenue from ticket sales. Low-cost carriers also rely on the revenue from selling extras, such as onboard refreshments, hold luggage, hotels, car hire, and travel insurance. With variable costs being tiny, the pricing model is about maximizing revenue for each flight.

So, the fuller the plane, the better it is for the airline. The airlines are very experienced in estimating demand over the period from a flight coming on sale and the departure date. If they get it right, then prices will indeed rise as take-off approaches.

But sometimes they get it wrong. If, as time passes, a given flight is filling up too slowly, then it makes sense to be more flexible on prices, cutting them if necessary. Pricing may be easy in principle; but not always easy in practice!