Economics of Airline Business: What Caused the Current Recession
Airline business in India is going through one of its most testing
times in recent memory. For the first time the industry is
experiencing a business cycle slump. In the pre liberalisation days
there was no possibility of up and downs of a business cycle. During
the post liberalisation phase the industry had been fortunate to live
through an almost unbroken period of growth with very few hiccups.
Though there were a few closures of airlines in the nineties but
these were not due to any slack in passenger demand. It would
therefore be worthwhile to study what caused the current recession;
is it due to external factors like global meltdown; or slowing down
of the Indian economy; or a collective ignorance (or ignoring) of
airline economics.
Before analysing and identifying factors responsible for the current
recession we need to outline what is meant by airline economics and
its relevance in Indian context. The exposition of theory has been
kept at a non-technical level so the basics could be followed by a
wide spectrum. Use of jargons has been deliberately avoided and only
that much of theory has been explained which is absolute essential
for our purpose.
Airline
Economics
Special characteristics
Like any other business, airline business too shares the usual
characteristics of controlling costs, negotiating with labour unions,
seeking rates that accurately reflect the various elasticities
of demand, obtaining financing, and making the kind of profits that
will keep shareholders happy and will attract capital. In addition,
they must live with certain special economic characteristics.
An Undifferentiated Product
Airline service tends to be what economists call an undifferentiated
product - that is, to many passengers the service of one airline is
rather hard to differentiate from the service of another. Modern
aircraft are very much alike, at least within any given size range.
The speed, comfort, and safety aspects of a journey are likely to be
much the same, whichever airline a passenger selects. Airlines
frequently have concentrated their advertising on desperate
attempts to differentiate their product by emphasizing steak dinners
aloft, friendly smiles, and similar minor benefits. Yet probably a
flight is chosen not by reason of favouring one airline over another
but simply by the most convenient times of departure and arrival. In
a sense, flight scheduling is a form of product differentiation, and
it would appear to be the most important one.
In the days of fare regulation, the similarity of product resulted in
airlines' tending to charge the same fare for the same service, so
that passengers usually took it for granted that they would pay the
same fare regardless of which airline they picked. However, it has
been seen that even when there is no restrictions on fares that the
airlines could charge, airlines generally charge similar fare; this
practice follows from a belief by airline management that it had to
meet the competition. Typically a fare in a market will be the lowest
fare that any one of the competing carriers wishes to charge.
It is often argued that greater product differentiation exists
than is usually realized. Various experiments with low cost service
and with flights that serve regional services are pointed out as
examples.
It is relatively easy to enter the airline business and easier still
for an existing airline to expand into a new market. Unlike, say
the railways, which must buy a right-of-way and lay miles of track
before it can make a paisa, an airline need own only the vehicle. It
does not own the "road" over which its vehicles travel
or the terminals (that is, the airports). And even the vehicle can be
leased or bought on credit, aircraft typically being sold with a
mortgage (often called an equipment trust) on them. The economic
barrier seems small indeed, compared with almost any manufacturing
industry. Here there are no factories to be built, no assembly lines
to equip. It is relatively easy for anyone to buy a plane and jump
into the business or easier still for an existing airline to move
into a new market - to the extent that remaining governmental
barriers, as in international service, will permit. All this, of
course, oversimplifies the problem. Modern aircraft are expensive,
and monthly payments on them are huge. Various taxes, charges, and
rentals must be paid for the use of airports and the airways. There
are the costs of getting any business started hiring and training
personnel, advertising one's entrance into the new market. Then there
is the question of the need to operate on a particular scale in order
to realize cost savings. On this point there is much disagreement.
Some economists will hold that the largest airline, if well managed,
will have the lowest costs. Others will point to the experience of
smaller airlines that often have been more profitable than the larger
ones. Perhaps shrewd adapting of the size of one's operations to
the peculiar economics of one's routes is of greater cost
significance than mere size alone. How easy, then, is entry? The
traditional transportation economists hold that the barriers are
slight and that the removal of entry and rate controls results in the
following:
1. | Too |
2. | Rate |
3. | "Cream-skimming" |
Tendency to Monopoly or Oligopoly
Another characteristic of airline service may seem somewhat
contradictory to the one just mentioned. It is that airlines may have
an inherent tendency toward gradual elimination of competitors, with
a resultant oligopoly, or even monopoly, in a market. This is a
controversial point, but a belief in such a tendency has been one
basis for the existence of governmental economic regulation of
the industry. Is it contradictory to say that this is a field that
competitors can enter with ease, yet at the same time a field where
only the strongest will survive? It is not contradictory if we
distinguish between the short run and the long run. It is one thing
for a small company to enter the airline business, and quite another
for it to survive. In India relaxation of entry controls that
came with deregulation has been followed by the entry of many new
small airlines but not all managing to survive.
Economists who favour deregulation argue that to the extent that
monopolistic tendencies exist, competitive forces largely
counteract them in a deregulated system. And, to the extent that such
forces fail to maintain a competitive system, the regular competition
policy that apply to other industries will come into play.
There are various other characteristics of airline service. For
instance, airlines have experienced a long-term growth rate well in
excess of that of most other industries. Another characteristic is
that the long-run tendency (at least until recent years) to larger,
faster aircraft served to make the airlines more capital- intensive
and less labour-intensive, although this trend partly gave way to a
fuel-intensive era with the dramatic increase in the price of fuel in
the 1970s. Still another characteristic has been that, as new
technology brings new models of aircraft on the market, the airlines
may go through several years of financial problems as they receive
earlier-ordered aircraft that cause their capacity to grow faster
than their traffic. (Break-in costs of crews and aircraft may add to
their woes.)
High Cash Flow
Because airlines own large fleets of expensive aircraft that
depreciate in value over time, they typically generate a substantial
positive cash flow (profits plus depreciation). Most airlines use
their cash flow to repay debt or acquire new aircraft. When profits
and cash flow decline, an airline's ability to repay debt and acquire
new aircraft is jeopardized.
Labour Intensive
Airlines also are labour intensive. Each major airline employs a
virtual army of pilots, flight attendants, mechanics, baggage
handlers, reservation agents, gate agents, security personnel, cooks,
cleaners, managers, accountants, lawyers, etc. Computers have enabled
airlines to automate many tasks, but there is no changing the fact
that they are a service business, where customers require personal
attention. Usually upto one-third of the revenue generated each day
by the airlines goes to pay its workforce.
Thin Profit Margins
The bottom line result of all of this is thin profit margins, even in
the best of times. For example airlines in the USA, through the
years, have earned a net profit between one and two percent, compared
to an average of above five percent for U.S. industry as a whole.
Airline Revenue - Where the Money
Comes From
About 75 percent of the airline industry's revenue comes from
passengers and about 15 percent from cargo shippers. The remaining 10
percent comes from other transport-related services. For the
all-cargo carriers, of course, cargo is the sole source of
transportation revenue. For the major passenger airlines, which also
carry cargo in the bellies of their planes, less than 10 percent of
revenue comes from cargo (in many cases far less).
Most of the passenger revenue (nearly 80 percent) comes from domestic
travel, while 20 percent comes from travel to and from destinations
in other countries. A significant portion of the tickets sold by
airlines is discounted (some estimate the share to be as high as 90
percent), with discounts, at times, averaging two-thirds off full
fare. Fewer than 10 percent pay full fare, most of them last-minute
business travellers. The majority of business travellers, however,
receive discounts when they travel. A relatively small group of
travellers, the frequent flyers, account for a sizeable portion of
air travel.
Airline Costs - Where the Money Goes
Approximately airline costs are as follows:
Flying Operations - essentially any cost associated with the
operation of aircraft, such as fuel and pilot salaries - 50 percent;
Maintenance - both parts and labour - 12 percent;
Aircraft and Traffic Service - basically the cost of handling
passengers, cargo and aircraft on the ground and including such
things as the salaries of baggage handlers, dispatchers and airline
gate agents - 9 percent;
Promotion/Sales - including advertising, reservations and travel
agent commissions - 6 percent;
Passenger Service - mostly inflight service and including such
things as food and flight attendant salaries - 9 percent;
Transport Related - delivery trucks and inflight sales - 4 percent;
Administrative - 5 percent;
Depreciation/Amortization - equipment and plants - 5 percent.
The above is an approximate distribution of cost the actual cost
varies from airlines to airlines and also depends on a number of
factors like, type of aircraft, type of service etc.
Break-Even Load Factors
Every airline has what is called a break-even load factor. That is
the percentage of the seats the airline has in service that it must
sell at a given yield, or price level, to cover its costs.
Since revenue and costs vary from one airline to another, so does the
break-even load factor. Escalating costs push up the break-even load
factor, while increasing prices for airline services have just the
opposite effect, pushing it lower. Overall, the break-even load
factor for the industry in recent years has been approximately 66
percent.
Airlines typically operate very close to their break-even load
factor. The sale of just one or two more seats on each flight can
mean the difference between profit and loss for an airline.
Seat Configurations
Adding seats to an aircraft increases its revenue-generating power,
without adding proportionately to its costs. However, the total
number of seats aboard an aircraft depends on the operator's
marketing strategy. If low prices are what an airline's customer’s
favour, it will seek to maximize the number of seats to keep prices
as low as possible. On the other hand, a carrier with a strong
following in the business community may opt for a large
business-class section, with fewer, larger seats, because it knows
that its business customers are willing to pay premium prices for the
added comfort and workspace. The key for most airlines is to strike
the right balance to satisfy its mix of customers and thereby
maintain profitability.
Airline and Public Interest
Objectives
Public interest objectives of airline could be classified into three
categories (A) the trade and commerce of the country; (B) the Postal
Service; and (C) the national defence. This three-way division of the
public interest into commerce, postal, and defence is useful enough,
though it by no means exhausts the goals that the public and its
government seek from airline services, even if we define the word
commerce very broadly to cover the social desirability of being able
to travel swiftly from one end of the nation to the other and the
national cohesiveness, both political and social, that derives in
part from ease of travel.
The term commerce includes the flow of airfreight, business travel,
tourist travel, and, indeed, the travel of anyone for any purpose.
This much is obvious. What may be less obvious is that members of the
public who may seldom, if ever, have occasion to fly have a major
stake in having adequate airline service. They include persons
connected directly or indirectly with the tourist industry, all
residents of areas heavily dependent on tourist travel, and the
owners and employees of industries whose executives depend on air
travel or whose operations may rely on airfreight. It includes the
stockholders and employees of the aircraft manufacturing industries,
since the manufacture of civil transport aircraft—that is,
aircraft specifically designed for use by airlines—depends on
airlines as customers.
The entire economies of regions where aircraft manufacturing is a
major industry (the Seattle area with respect to the Boeing Company,
for example) thus become indirectly dependent on the health and
development of airline service. And, since companies other than the
designated aircraft manufacturers for aircraft — and this
includes the engines — frequently manufacture components, the
ramifications spread. General Electric, for example, makes aircraft
engines.
The process of ramification can also be illustrated by tourist
travel. Important enough to the economies of such places as Goa and
Delhi, airline service becomes even more critical to North East,
where due its relative geographical isolation lack of air service
could effectively prevent the growth of tourism industry.
Indeed, as the airline economist Melvin Brenner has put it,
“transportation is a basic part of the economic/social/cultural
infrastructure, which affects the efficiency of all other business
activities in a community and the quality of life of its residents.”1
But we have been taking a rather commercial view of the term
commerce. The ability to travel is prized by most people. A few
clichés may demonstrate the point. We want to see the world,
or we say that travel broadens a person in one sense or another. And
few of us are immune to the romance of far-off places as an
advertising ploy. There is travel to get away from it all, whether by
fleeing to the beach or the mountains or by fleeing the quiet life
for a place of excitement. Almost anyone would like to see one’s
children have a chance to visit foreign countries as part of their
education, to experience the languages and cultures and try to
appreciate the different values of societies other than our own. And,
for at least some of us, the process of travelling itself may be an
enjoyable and rewarding experience.
The point to be emphasized here is that although this paper is
largely about economic matters, the ultimate objectives of an air
transport network go far beyond the fields of economics or business
administration and touch questions concerning the very nature of
humanity.
If the foregoing discussion seems to paint a wholly rosy picture of
what airlines do for us, let it be noted here that airline service
can be injurious as well as helpful to the public. Obvious examples
are the environmental problems of noise and air pollution in the
vicinity of airports, airline accidents, and injury to competing
industries. And it is possible that not all residents of a tourist
mecca are delighted with the air-delivered seasonal swarms of people
who crowd and overtax their facilities.
Moreover, there are those who would say that, in a world of rapidly
growing population, countries with high per capita drain on the
earth’s finite resources, such as the United States, should
seek to level off the seemingly endless rise in such consumption
activities as airline service. Travel by air in the United States
continues to increase at a rate far beyond the increase in its
population or wealth, with attendant drain on the world’s
petroleum resources and aggravation of the environmental impact of
airports.
Airline Entry And Exit Policies
Entry can mean that an existing airline institutes service in a
market or in a series of markets along a route. It may also mean that
a brand new enterprise enters the airline business; as a result of
deregulation, there have recently been many of these. Exit means an
airline’s discontinuing service in a market either by its own
decision or by governmental action.
Why does an airline wish to enter a market? There is the obvious
business reason of perceiving a profit to be made, but this can be
broken down into many elements. An airline with a strong summer
peaking in its system may desire to fly to Goa, where the peak season
is winter. Or, if it has idle capacity on weekends and holidays
because of a preponderance of business travel on its system, it may
wish to add tourist markets. An airline may have aircraft that
operate at lowest cost on long hauls and thus will be motivated to
seek new routes with widely separated major cities. In some cases an
airline may simply have too much capacity (aircraft, personnel,
terminal facilities, computerized reservations systems, and so on)
for its volume of business and may feel the solution is to enlarge
the size of its route system.
The precise nature of the existing route system can be an important
factor. How well would the additional point or route tie in with the
airline’s schedule pattern? The planning of an airline’s
schedules and the allocation of its operating personnel are extremely
complex problems, and compatibility of proposed new points or routes
with the existing pattern is critical. If the carrier already has
terminal facilities at one or more of the points along the proposed
new route, that fact will weigh in its favour. In other instances an
airline’s expansion plans will be tied to the concept of
back-up or feeder traffic.
Attention will also be given to the density of the market—that
is, to the quantity of traffic already flowing in it—and to
indicators of future growth, such as population and income trends for
the areas in question. And, of course, the number and strength of the
airlines already in each market will be a major consideration, as
will an estimate of what others may be planning to enter.
To these sound motivations perhaps we should add that, since airline
managers are human beings, there may at times be an impulse to favour
growth as inherently good, to feel pride as additional dots are
placed on the company’s map.
Economies of Scale, Scope, and
Density
Economists make a distinction among economies of scale, economies of
scope, and economies of density. An airline that expands its total
operations may realize economies of scale, but whether any major
airline is likely to realize economies by simply getting bigger is a
matter of much controversy. However, an airline adding a route
branching out from its existing network may well realize economies of
scope—that is, savings because, for example, its airport
facilities and personnel are already in place at the point of origin
and their costs can now be spread over more units of output. On the
other hand, economies of density do not come from adding a new route
but from getting better utilisation of existing services. For
example, an airline that carries 100 passengers in a single plane to
a destination as opposed to carrying 50 passengers in two aircraft to
that same destination is making use of economies of density.
Hub-and-Spoke Systems
Major airlines have increasingly emphasized the development of
so-called hub-and-spoke systems, which one authority has defined as
follows:
A hub and spoke system consists of a set of “spoke”
routes flying to and from minor markets into major “hub”
cities. The major airline, which creates the hub and spoke system,
flies some of these spokes itself. Commuters, local, or smaller
airlines whom the major airline has co-opted into the system fly
other spokes. A set of much longer and heavier regional spokes
connects major traffic hubs and are all operated by the creator of
the particular system. Indeed, the traffic potential of the regional
spokes is the reason behind the creation of the system.
Another authority offers this description of how such systems work:
The basic notion of a hub and spoke system is that flights from many
different cities converge on a single airport—the hub—at
approximately the same time, and after giving the passenger
sufficient time to make connections, all then leave the hub airport
bound for different cities. Such a convergence of flights on a hub is
often called a “connecting complex” or “connecting
bank.”2
One motive of an airline in developing hub-and-spoke systems is to
increase the average number of passengers on its flights, an obvious
critical element in earning a profit. By developing traffic along the
feeder spokes, an airline increases its traffic along its longer
hauls. Moreover, it controls the flow of the spoke traffic onto its
long-haul flights since it controls the arrival times of the feeder
flights at the hub airport. Thus, an airline with a strong hub system
protects its traffic from being diverted to another airline en route.
From the passenger’s standpoint there may be an advantage in
increasing the number of flights to and from minor points, but there
is the great disadvantage of a reduction in the number of nonstop
flights and of flights without a change of planes.
Airline Exit Policies
The reasons why an airline wishes to exit from a market are largely
the reverse of its reasons for entry. An operation may have proved
unprofitable — or less profitable than if the resources were
employed elsewhere — and future prospects do not seem bright.
Competition from other airlines may have proved severe. Perhaps
little feeder effect has occurred, or perhaps a change in the
composition of the carrier’s fleet has made a short-haul market
too expensive to service. (A sharp rise in fuel costs can exacerbate
the latter problem.) Or maybe the carrier is in weakened financial
condition and must undergo a general retrenchment.
The Costs of Airline Service
We now focus on the supply side of airline service. The supply side
concerns the elements that are put together to make an airline
service and what they cost. Principal cost categories is as follows:
Flying operations
Direct maintenance
Maintenance burden
Depreciation and
amortization
Passenger service
Aircraft servicing
Traffic servicing
Reservations and sales
Advertising and
publicity
General and administrative
Flying operations
include crew wages and fuel. Direct maintenance covers the costs of
labour and materials directly attributable to the maintenance and
repairing of aircraft, including periodic overhauls, and other flight
equipment. Maintenance burden means the overhead costs related to the
upkeep and repair of flight equipment and other property, such as the
administering of stockrooms, the keeping of maintenance records, and
the scheduling and supervising of maintenance operations. This
category could also be called “indirect maintenance costs.”
Passenger service would take in the cost of food and providing cabin
attendants. Aircraft servicing refers to routine servicing such as
washing the aircraft and cleaning the passenger cabin, but not to
mechanical servicing. It also includes landing fees. Traffic
servicing includes ticketing and baggage handling.
Reservations and sales, as well as advertising and publicity, are
self-explanatory, as are depreciation and amortization, but let us
note that the latter item includes the cost of paying off the huge
purchase price of modern aircraft. Lastly, general and administrative
costs have been defined as: “Expenses of a general corporate
nature and expenses incurred in performing activities which
contribute to more than a single operating function such as general
financial accounting activities, purchasing activities,
representation at law, and other general operational administration
not directly applicable to a particular function.”3
There are other ways to categorize airline costs. One authority would
use three categories: capacity costs, traffic-related costs, and
overhead costs. The first would include wages of flight crew and
flight attendants, fuel, maintenance, landing fees, depreciation of
aircraft, and charges for leasing aircraft. Traffic-related costs
would include ticketing, baggage handling, other terminal expenses,
passenger food, and aircraft servicing. Overhead costs would include
“the expenses of maintaining the organization, such as
personnel functions, planning, and general management.”4
Another source would use a generally similar set of three
categories, but would put aircraft depreciation and leasing costs
under “overhead.”5
Analysis Of Costs
Let us emphasize that the above sets of categories are merely
accounting systems, are ways of organizing the costs. When the time
comes to analyse airline costs, and make managerial and governmental
decisions based upon them, we find ourselves in a much more difficult
area. Not only is cost analysis inherently a complicated subject, but
it is made even more difficult by problems of terminology. There are
common costs, separable costs, constant costs, variable costs, fully
allocated costs, out-of-pocket costs, direct operating costs,
terminal costs, line-haul costs—just to mention a few. Airline
management and transportation economists do not always use cost
terminology consistently, and the classification of a cost as one
type or another may also depend on the managerial decision being
contemplated.
To simplify the discussion, we will limit ourselves to certain types
of costs that commonly arise in airline decision making and will
relate our discussion, so far as possible, to specific kinds of
decisions.
Common versus Separable Costs
Separable costs are those that can be allocated clearly and on a
logical basis to a particular service—food and cabin attendant
wages and passenger ticketing may clearly and logically be allocated
to passenger service, while the cost of handling freight at a
terminal may clearly be allocated to cargo service. But the cost of
the crew’s wages, while obviously necessarily incurred to
transport both passengers and cargo, cannot be allocated in a clear
and logical manner between the two classes of traffic. Thus, we call
this type of cost a common cost. The common versus separable duo can
also be used for types of passenger traffic, such as allocating the
costs of free champagne to the first-class passengers. Similarly,
among different types of cargo, it is possible to have separable
costs such as the special expenses resulting from carrying unusual
cargo such as live animals.
Decisions as to the proper level of cargo rates when cargo is carried
in the cargo compartments on passenger flights involve management
deeply in the question of common costs.
Out-of-Pocket Costs, Constant Costs,
and Fully Allocated Costs
These three terms are extremely important in rate decisions.
Out-of-pocket cost is a familiar term in transportation economics; it
refers to the added cost incurred when performing an additional
service or accepting an added unit of traffic. It is the separable
cost of an individual unit. Out-of-pocket costs are sometimes also
called incremental costs and, generally speaking, are what economists
would call marginal costs.
But one cannot simply scan an airline’s accounts and designate
some costs as out-of-pocket. The use of the term depends on the
decision to be made. If an airline has a flight ready to take off and
one more passenger comes running for the gate, the out-of-pocket
costs of carrying this one additional person are almost
nothing—merely the food eaten on board and the negligible
amount of fuel consumption from the added payload. Crew wages will
not change, nor will depreciation of the aircraft, nor will the
salaries of management, just because one extra passenger is carried.
A standby fare involves this cost concept.
But if an airline is operating, say, three flights a day in a market
and decides to increase the frequency to four, such items as crew
wages, fuel and landing fees are going to be out-of-pocket costs with
respect to that decision. Moreover, if ticketing and baggage-handling
facilities are already overloaded, the added flight may result in the
airline’s having to expand these facilities, and the resulting
costs can be considered out-of-pocket with respect to that flight.
Constant costs are ordinarily defined as those costs that do not vary
with changes in the amount of traffic. Very often the term fixed cost
is used interchangeably with constant cost although, strictly
speaking, fixed costs are those that will continue to be incurred so
long as the airline goes on operating as a corporation, even if it
suspends services. In practice, decision-making personnel in
management and government will use either fixed or constant for all
costs that are not out-of-pocket with respect to the decision being
considered.
What, then, are fully allocated costs? The expression means the costs
of carrying the particular unit of traffic, including both the
out-of-pocket element and a fair share of the constant costs.
The out-of-pocket, constant, and fully allocated cost concepts find
practical application in, among other things, decisions respecting
the discount type of fare, such as holiday fare aimed at the tourist
market. Here some substantial saving is offered to a passenger who
buys a round-trip ticket where the return coupon cannot be used
until, say, two weeks after the departure flight. The airline may
concede that such a fare does not cover costs on a fully allocated
basis but will justify the fare as meeting out-of-pocket costs and
making, in addition, a small contribution to constant costs. If the
holiday fare attracts enough passengers who would not otherwise fly,
and if they can be accommodated in seats that would otherwise be
empty, the discount fare may indeed make very good sense, provided
that not too many passengers will shift from regular fares to the
discount fare.
Line-Haul versus Terminal Costs
Separating costs into line-haul and terminal is significant when
explaining why the total cost per passenger-mile drops as the length
of the trip grows. This phenomenon is called the cost taper and leads
to a rate taper. Line-haul costs are those directly related to the
mileage and time elapsing while the aircraft is actually in flight.
Certainly this would include crew wages and fuel as well as direct
maintenance costs and the wages of cabin attendants. Terminal
costs—which are also called ground costs—would include
the expense of activities at the terminal, such as aircraft and
traffic servicing, and reservations and sales. These are costs
related to the amount of traffic carried but independent of the
mileage it travels.
An airline’s costs at a terminal should be allocated equally
among the passengers serviced since the costs of processing a
passenger at an airport are about the same regardless of the length
of the passenger’s trip. The amount per passenger is then
spread over the mileage travelled by the passenger to form part of
the cost per passenger-mile for that trip. Spread over a journey of
several thousand miles, this cost contributes a smaller amount per
passenger-mile than if it were spread over a short trip. The effect
is that the total cost per passenger-mile (line-haul plus terminal)
tapers downward with the length of the trip. (Line-haul costs also
taper downward somewhat since costs such as fuel are higher for
takeoffs and landings and for slower speeds; line-haul costs per mile
are lowest when the aircraft is cruising at high speed.)
In the case of cargo, the terminal costs include the entire process
of receiving, weighing, sorting, guarding, and storing cargo, loading
the aircraft, and unloading it at the destination. Terminal costs
make up a big proportion of the total costs of cargo traffic, and
they represent a major managerial problem area.
Often the cost taper, whether for passengers or cargo, leads to a
tapering downward of the rate per mile on long hauls, although this
is only one factor in rate determination.
Direct Operating Costs and Indirect
Operating Costs
Airline management frequently uses the term direct operating cost
(often abbreviated DOCs) and typically will define them as those
elements closely related to flying the aircraft, for example, crew
wages and fuel. Indirect operating costs consist of the ground or
terminal cost just mentioned as well as overhead expenses. The
expression ground and indirect is sometimes used for these same
costs, which is perhaps closer to literal accuracy, since many of the
ground costs are directly related to the amount of traffic though not
to the actual flying of the aircraft.
Seat-Mile Costs and Other Ratios
The carrier’s accounts, beyond merely listing cost figures, are
the basis for some ratios that are of critical importance to
management. One of these is the cost per available seat-mile. The
word available is really unnecessary, and the simpler term seat-mile
is commonly used. It means a seat carried for a mile, a measure of
the physical output of the airline. The cost per seat-mile represents
to management the total cost of a unit of output in passenger
service.
The cost per revenue passenger-mile can also be computed. Usually the
term passenger-mile is used, dropping the word revenue. The only
significance of revenue is that passengers are occasionally carried
free of charge or for a token sum, such as 10 percent of the normal
fare. These are not counted when computing passenger-miles, though a
half-fare passenger such as a child is counted as one passenger.
A related ratio is the load factor, which relates the passenger-miles
to the seat-miles. An aircraft with 100 seats flying 1,000 miles
performs 100,000 seat-miles. If 55 percent of the seats are filled
with paying passengers, the passenger-miles would be 55,000, and the
load factor would be 55 percent. The term breakeven load factor is in
common use in airline economics. It means the percentage of seats
that must be occupied by paying passengers in order that the revenues
from the operation will just cover the costs.
In the case of cargo, one may compute the cost per available ton-mile
or per revenue ton-mile. A load factor may also be computed, although
with cargo there is really two load factors (or two ways of computing
a load factor). One is to calculate the relationship of the revenue
ton-miles to the available ton-miles. This reflects the traditional
manner of measuring cargo in all modes of transportation—by
weight. But the critical figure for air cargo is usually the volume
or “cube” of the cargo. On many flights the cargo space
is filled well before the weight limit of the aircraft is reached. A
load factor based on weight alone might show a cargo flight with,
say, a 70 percent load factor when the plane was completely filled.
To reflect this situation, a volume-related load factor could be
computed that relates occupied space to available space.
The Short-Haul Problem
Seat-mile costs are particularly significant in the short-haul
problem, although the problem involves both cost and demand
considerations. Not only is the cost per seat-mile higher for shorter
stage lengths, but also the demand is highly elastic (that is, highly
price-sensitive), since alternative modes of transportation are
relatively attractive over shorter distances. To attract traffic in a
short-haul market, an airline must keep its rates low, but to cover
its seat-mile costs it must keep its rates high. Every mode of
transportation has this short-haul dilemma, but in air transportation
it is acute.
There are a number of reasons why seat-mile costs are higher for
short hauls, some of which have already been mentioned in explaining
cost taper. One reason is that the cost of processing passengers and
cargo at terminals is about the same regardless of how long the
flight is. It costs as much to ticket passengers and handle their
baggage if they are going on a 100-mile trip as if they are going on
a 3,000-mile trip and, for the shorter trip, there are far fewer
miles over which to spread these terminal costs. Another factor is
that fuel consumption is heavy during takeoff and landing, and this
charge must be spread over fewer miles for the short hauls. Landing
fees payable to the airport must be similarly spread.
The short haul also results in higher crew-wage costs per seat-mile
because of the slower average speed of the aircraft. If a stage
length is only 100 or 200 miles, the aircraft may not get up to
maximum speed before it is time to slow down again.
The short-haul cost problem results today in giving small points
service only at fares that are quite high considering the length of
the trip. Thus, although a service may offer the advantage of
connecting a minor point with a larger city from whose airport there
are numerous connections throughout the country and the world, a
passenger at the small point is faced with an initial expensive short
haul. Under open market theory, of course, this is appropriate as
reflecting the true costs of the service.
It should be noted that the short-haul cost problem is not confined
to regional and commuter carriers or to small points. Major airlines
sometimes fly short stages as part of a longer route—for
example, Bhubaneshwar to Vishakhapatnam as the last leg of a flight
from Delhi — and must consider the extent to which the cost
taper runs against them when they schedule such stages.
The cost taper does not go on forever. At some point, as the haul
gets very long, it becomes necessary to reduce the passenger load in
order to squeeze the maximum mileage (within safety standards) from
the maximum fuel-carrying capacity of the aircraft. The cost per
passenger-mile begins to increase rather than decrease with the
additional length of haul. In practice, airlines seldom fly such
extended stage lengths.
A possible future development that could have a major bearing on
short-haul air service is high-speed rail passenger transit.
Proposals have been made for such service from time to time though
nothing have materialised so far from these proposals.
The Production Function And Factor
Costs
In elementary economics we talk about factors of production and break
them down into land, labour, capital, and managerial
entrepreneurship. We also consider how these factors are brought
together in certain proportions to create a particular output. An
industrialized country may put a lot of capital and a little labour
together to produce an article. A country with low-wage labour and
not much capital will use a lot of labour and little machinery to
produce the same article. The proportion of one to the other —
not the cost or wage levels as such, but the proportion of labour to
machinery to land — is called the production function.
A good way to look at the term is to take the word function in the
sense that it is used in mathematics. (What it does not refer to is a
machine “functioning” to produce something.) Suppose we
have an equation and a graph that shows the relationship of x to y;
for this we use the word function.
The production function, then, may be defined as the relationship
between the quantities of each input and the quantity of output. But
what are the inputs for an airline service? Breaking it down beyond
the usual general categories of “capital,” “labour,”
and so on, we can readily name such factors as the aircraft, the
flight crew, and the fuel. The cost of buying the aircraft, including
financing charges, and the cost of maintenance might be considered as
“capital.” Crew wages, fuel, and landing fees are also
major operational costs. There are all sorts of other costs, such as
ticketing facilities, executive expenses, and so on, but we may
simplify matters by saying that you produce air transportation of
passengers, cargo, and mail by putting together an aircraft, a flight
crew, fuel, and a landing strip at each end of the flight.
When you put this together as a production function, you find that
there is little difference between one airline and another. One
economist, Mahlon Straszheim, uses the word homogeneous to describe
this similarity. He is, of course, looking at the international
scene, where he finds that there is little difference in the
production function even when comparing airlines of countries with
widely differing levels of technological development.
As an example, let us consider a New York–London service where
American Airlines is competing with Air India. While the wage level
in India being low that typically Indian industries use much labour
in proportion to capital, Air India uses machinery that is anything
but primitive. The machinery is aircraft it has bought in the United
States. It flies the same aircraft as American on this route. It has
the same required-size flight crew as American. For each flight
between the two cities, each airline uses about the same amount of
fuel and pays the same number of operational fees, one to each
airport.
It is important to distinguish clearly between the amounts of each
factor and the price tag on each factor. If each airline uses the
same type of aircraft, the same number of flight personnel, and the
same amount of litres of fuel, and pays the same number of landing
fees, then the production function is the same, even though the cost
of a factor to one carrier may be different from the cost to the
other carrier flying between the two cities. The production function
is homogeneous for airline service, and the underlying reason seems
to be that to run an airline service at all, you simply cannot use
primitive machinery but must use a machine that represents an
extremely high level of technology and moreover is largely a
standardized product of a handful of manufacturers.
Exceptions can be found to the above in areas of the world where low
living standards may make feasible some local or regional services
using old piston aircraft. Here the input of labour is greater and
the input of capital lower. The aircraft are relatively cheap; but,
due to both the small capacity and slow speed of the plane, many more
man-hours are required to perform a given number of seat-miles than
is the case with modern jet aircraft.
But how is it possible for high-wage countries to compete with
low-wage countries in their airline services? In particular, how can
it happen that an airline of a high-wage country may have a
lower-cost operation than an airline of a low-wage country? This has
happened. There have been years in which Pan American was the example
of low-cost operations on the Atlantic. Straszheim’s answer,
derived from his own research, has to do with what he calls
“scheduling of inputs.” He finds that the skills of
management in scheduling the utilisation of aircraft, flight crews,
and other inputs tend to be more effective in the airlines with the
high-wage problems.
How many hours are the crew actually flying the plane? How
efficiently do you use your other personnel? And how many hours out
of 24 is each aircraft actually flying? With today’s expensive
aircraft, the utilisation rate is a figure over which management is
well advised to brood constantly. Depreciation charges are severe,
and they apply whether a plane is working or idle. (The presumed life
of an aircraft is about 15 to 20 years.) Good management, then, is
called on to do an expert job with the crazy-quilt pattern of
allocating aircraft and crews over its entire system.
If you get your aircraft to the end of the line and it lays over, how
long will the layover be? And how far can you crowd all this?
Management must consider what passengers want in terms of the time of
day of a departure and of an arrival. Experience shows that an
utilisation rate of 8 to 9 hours a day (that is, out of 24 hours) is
good. This will vary, of course, with the airline, the type of route,
and the type of aircraft. Time on the ground involves time spent
loading and unloading, time spent fuelling and for maintenance, but
the major time on the ground results from the fact that an airline
must please its passengers by using its fleet at the times of day
when the passengers want the service.
It should be noted that aircraft utilisation, as the term is
ordinarily used in air transportation, refers to the time that the
plane is engaged in revenue flights and does not have anything to do
with how well the capacity of the plane is being utilized by filling
it with revenue passengers. In short, aircraft utilisation and load
factor are two different ratios altogether. But there is a
relationship between them that is important in running an airline: it
can be a bad management decision to achieve high aircraft utilisation
by having numerous flights even though experiencing low load factors.
The fleet is kept busy but at the expense of scheduling beyond what
the traffic justifies. The impact on profits is clear.
While on the subject of aircraft utilisation, we might mention that
there are factors affecting it in addition to managerial skill, such
as the seasonality or other peaking tendencies on an airline’s
system, the amount of competition from other airlines, and
limitations on the discretion of management as to how many flights
they wish to schedule. The latter is particularly evident in
international operations.
Utilisation of reservations, ticketing, and baggage-handling
personnel can also be critical to cost control. Here, in addition to
managerial skill, a major factor is the extent to which an airline
serves large cities with a constant flow of traffic so that personnel
and airport facilities can be kept rather steadily busy.
Aircraft Selection As A Determinant
Of Costs
Nowhere is airline management more severely tested than in making
decisions on the types of aircraft it will have in its fleet and the
number of each type. Often commitments must be made for delivery
dates many years in the future, with all of the uncertainties that
implies, and large sums of money must be obligated. Of course,
deliveries and payments are spread over a number of yeas, but the
obligation that each airline undertakes is a massive one, made even
more critical by the sensitivity of the airline industry to economic
cycles. Commitments made by an airline in prosperous times, such as
in 2006 and 2007, can have the result that aircraft may be delivered
(and payment expected) when traffic has dropped and they are least
needed.
Beyond the cost impact of carrying the huge investment that an
airline fleet represents, there is the even greater cost
consideration of the operating efficiency of the fleet. New aircraft
offer savings on fuel and maintenance, which, over time, may well
justify their great initial cost.
Financing and Leasing Aircraft
An airline will very rarely acquire an aircraft by simply buying it
entirely with its own funds. Far more likely it will obtain financing
in the form of a secured debt comparable to a mortgage on a person’s
home, only here the aircraft is the collateral and the legal
instrument may be called an equipment trust or a conditional sales
contract. Nowadays, however, it is also very common for an airline to
lease the aircraft, perhaps by a simple rental or by a long-term
lease with a right to purchase. The legal instruments under which
these expensive aircraft are financed or leased are many and varied,
and, the complexities of this area of the law are best left to the
lawyers.
Leasing has become an increasingly popular way for airlines to add to
their fleets. Estimates as of 1995 were that about half the U.S.
scheduled airlines’ fleets were leased. Through leasing, an
airline conserves its own capital but loses the residual value of the
aircraft when it is turned back to the lessor, unless an option to
purchase has been included in the lease. Leasing may also help an
airline keep its capacity closely tailored to its traffic.
One disadvantage to leasing is its effect on the cash flow of the
airline. When an airline owns an aircraft, it allocates a portion of
its revenue to an account that covers the depreciation of that
aircraft. Then as Professors Tretheway and Oum put it, “depreciation
is an accounting charge and does not require an actual outlay of
cash.” They go on to say:
In recent years, this cash flow relationship has changed
dramatically. Whereas in 1961 three percent of aircraft were leased,
by 1988, 42 percent of aircraft were leased. With an aircraft lease,
the airline does not lay out cash up-front when the aircraft is
acquired. Instead, cash is laid out throughout the lifetime of the
aircraft. With the adoption of leasing by airlines, carriers are now
experiencing required annual cash outlays roughly equal to their cash
inflows. Because of this, when difficult times are experienced—such
as a recession or fuel crisis, carriers can experience negative cash
flows. As a result, airlines are more likely to experience
bankruptcy.
With the great expansion of aircraft leasing by airlines throughout
the world, several large companies have become major lessors with
worldwide operations. Financial institutions from around the world
participate in their ownership. Among the largest of these are AerFi
(formerly GPA Group), General Electric Capital Aviation Services, and
the International Lease Finance Corporation.
Impact Of Technological Advances On
Costs
As we have seen, advancing technology in aircraft has enabled the
airlines to achieve lower seat-mile costs as a basic trend. The small
piston aircraft of the 1930s, such as the DC-3, had very high
seat-mile costs. The advent of larger piston aircraft caused
seat-mile cost to drop, as did the arrival of turboprop planes. The
introduction of turbojets caused a major further drop, and the coming
of wide-bodied jets still another. The drop in seat-mile costs,
however, has been counteracted by the inflation the whole economy has
been experiencing.
Note that when a new type of aircraft is introduced, the savings on
seat-mile costs (to whatever extent they may not be cancelled out by
inflation) may only slowly be reflected in reduced fares. There are
various break-in costs, such as the training of personnel to fly and
service the new model. And typically the new aircraft attracts
passengers; thus, when an airline’s fleet consists of some of
the new type and some of the old, the airline will certainly not cut
its fares for flights on the new ones when they are the ones to which
the passengers are flocking. This was particularly noticeable when
jet aircraft first began to replace piston aircraft; some airlines
even imposed a jet surcharge based on superior passenger appeal,
despite the fact that the seat-mile cost was lower than on the piston
aircraft.
It appears that, at least in the immediate future, the impact of
technological advances on costs come not so much from larger or
faster aircraft but from fuel efficiency and maintenance savings.
Advances in airframe and engine technology can lengthen the periods
between both routine maintenance operations and long-term overhauls.
Other advances with a favourable impact on costs need not be confined
to the aircraft itself — improved maintenance equipment, for
example, or more efficient equipment for processing passengers,
baggage, and air cargo. The elaborate computerization of reservations
procedures is an example of a technological advance that, although
requiring a large initial investment, provides a long run saving in
labour expense as well as improved service to the passenger.
The Demand for Airline
Service
Some Demand Characteristics
There are certain characteristics of the demand for airline service
that, while not unique to airlines, are at least unusual.
Air transportation is what economists sometimes call an intermediate
good (and the demand for it a derived demand), in the sense that most
people use air transportation as a means to achieve some other
purpose. Very few passengers fly merely for the sake of flying.
Consequently, when trying to estimate passenger demand, it is
necessary to go into all the various reasons that make a destination
city attractive. Tourists flying to Goa have as their objective the
happy vacation they expect to spend there; the air trip is largely or
entirely a means to this objective. Business travellers have as their
objective the business they are going to discuss or transact at the
destination; their air trip also is largely or entirely a means to
this end.
Passengers can be divided into categories by looking at the purpose
of their trip. Typically the simplest of the divisions is into
tourist or business travel, the latter including government travel.
Another category would be visiting friends or relatives, often
classified as “VFR” traffic. And there is always a
“miscellaneous” or “other” category, which
would include someone travelling to a new job or to attend college,
for example.
For each of these groups an airline will try to work out the
elasticity of demand. Actually there are two elasticities involved:
the price elasticity of demand and the income elasticity of demand.
In economics the term elasticity of demand is assumed to refer to
price elasticity. That is, what is the sensitivity of the public to
the price of a product? As the price is lowered, how much more will
they buy? How much less as the price is raised?
But the other type of demand elasticity is particularly important to
air transportation, especially with respect to the tourist market. We
look at the level of income in a country (or in a city or in a
segment of the public) and ask how much of any increase in real
income is likely to go into air travel. Conversely, if real income
drops, what will be the proportional drop in air travel? The basic
concept here is that, as real income rises, people will spend
proportionally less on necessities such as food and shelter and
proportionally more on luxuries or semi luxuries. Economists call
this behaviour pattern Engel’s Law.
Let’s compare the average per capita income in the United
States with the average per capita income in a very poor country. If
the real income of U.S. citizens goes up, say, 10 percent in a year,
very little of this increase will be spent on food, somewhat more on
housing, and quite a bit more on luxuries such as travel. (Real
income, of course, makes allowance for inflation; if the dollar
income goes up 10 percent and prices go up 10 percent, then real
income has not gone up at all.) The reason for this disproportionate
effect on luxury purchases is that most U.S. families are in a
position where basic necessities are taken care of quite adequately,
while an airline trip to a vacation spot is something that will be
undertaken only as the budget will allow. This is fine for the
airlines in prosperous times, but it also means that airlines are
particularly vulnerable to economic recessions.
If we look, however, at people in very poor countries, an increase in
their real incomes of 10 percent will flow largely into food and
other necessities and very little into air travel. Changes in their
income levels will have little or no impact on air transportation,
and hence we say that the income elasticity of demand for airline
service is low.
What about business travel? Income elasticity of demand is less
important than with respect to tourist travel, but when a
corporation’s profits are down, it may take a closer look at
its expenditures for the travel of its executives.
To the extent that post liberalisation expansion of low cost airlines
have increased the proportion of leisure to business passengers, the
average income elasticity has risen and with it the degree of
vulnerability of airlines to recessions.
Returning now to the more familiar elasticity concept—price
elasticity of demand — we find a similar distinction between
business and tourist travel. Both have some price elasticity, but
that of the tourist is greater. If airfares rise, some business firms
will tighten up on their travel budget and may send employees by
other. But the airlines have found that the tourist market is far
more price-elastic, and this fact gives rise to the many discount
fares weighted with conditions that make them suitable to vacationers
but not to most business travel. For example, a discount may apply
only when the ticket is bought a month in advance of the flight. Or
the discount may be offered only for a round trip where the person
must be gone for at least a specified minimum time including a full
weekend. Business travel generally requires available space on short
notice, often with same or next-day return. In our next chapter we
will look at how airlines tailor fares to each segment of the market.
The price elasticity of demand for the “visiting friends and
relatives” category (as well as the “miscellaneous”
or “other” category) is as varied as the reasons for each
trip, and consequently it is hard to generalize about it.
Relative Advantage with Trip
Distance
Another important characteristic of the demand for airline service is
that the advantage of airlines over other means of travel grows with
the length of the trip. Consider a person trying to decide whether to
use the family car or go by bus, train, or plane. The longer the
trip, the stronger the inclination to choose air. Clearly this is a
factor of significance in estimating passenger demand between any two
cities.
Variability Factor
Passenger demand for any mode of transportation varies greatly by the
hour of the day, the day of the week, and in most markets by the
season of the year. Variability is the general term that describes
this built-in headache of the transportation industry.
Surveys of airline traffic show a definite seasonality; the peak
period has 20–25 percent more traffic than the lean period.
Variability by day of the week will often reflect whether a market is
dominated by business or by tourist travel. A market oriented to
business travel will have slack days on weekends, whereas one
oriented to tourist travel may show quite the opposite pattern.
However, Dempsey and Gesell show Sunday to be the peak day (26
percent above the lightest day, Tuesday) because business travellers
may be leaving that evening while leisure travellers are returning.
The most severe variability in any market is likely to occur by hour
of the day, even if we disregard the hours in the middle of the night
when traffic drops to nearly zero. There is an effect somewhat
comparable to commuter rush hours, with the hours of 5 and 8 A.M. and
around 9 P.M. being the daily peaks. In considering hourly
variability we must, of course, be aware of at least some degree of
circular causation: maybe some passengers departing at the 8 A.M.
peak are doing so only because the airline has scheduled its only
morning flight to their destination at that hour. Airlines naturally
schedule heavily at peak hours and, by so doing, may attract
passengers who would just as soon leave at a late-morning trough.
Along a similar line of reasoning, an airline that offers a night
flight special low fare will show figures that seem to indicate a
jump in passenger demand at 11 P.M. and midnight over lower apparent
demand at 8 or 9 P.M. But what is really being measured by those
figures is an increase in the quantity demanded because of the lower
price; the demand, in the economist’s sense of the word, can be
said to increase only when the increase in traffic is not related to
price.
Variability is a constant major problem of airline management in
planning the best utilisation of aircraft, flight crews, ground
personnel, and so on. They must plan around it, and on occasions they
will try to cope with it by pricing policies, such as the night
flight mentioned above and off-season fares for tourist destination.
Limited Managerial Control over
Demand Factors
Airline management has only a limited control over some of the
factors affecting passenger demand, and it has no control at all over
others. It has no control at all over people’s income levels or
over the general state of the economy, or over services and prices of
competing modes. It has only very limited control over technological
advances that result in improved speed and comfort. Looking back to
the time when the airlines changed their fleets from piston to jet
aircraft, with a great improvement in both speed and comfort, we can
say that each airline made the actual decision to purchase the new
aircraft and that the airline industry encouraged the manufacturers
to produce jet transports. But the technological development itself
was the product of factors such as defence-oriented government
financing in the US, and an individual airline had no practical
choice but to adopt the new type of aircraft once its competitors
were doing so.
An airline has only a limited say as to the prices it will charge. No
matter to what degree its rates have been freed from governmental
controls, it usually finds that as a practical business matter it
must meet the competition.
Two areas where airline management has broad control are flight
scheduling and the services aboard the flight. Flight scheduling
includes the number of flights in each market, the time of day that
each departs, the number of nonstop services, and the number of seats
that are generally available. (An airline that is stingy on the
capacity it schedules in a market is obviously the one that may not
have a seat for a prospective passenger.) For domestic services,
airlines control scheduling decisions subject only to the pressures
of competition and sometimes to limitations on airport space. For
schedule changes in international services, however, management (1)
may have to obtain prior consent of the foreign government, (2) may
be free to initiate changes subject to ex post facto challenge by the
foreign government (one of the original Bermuda principles), or (3)
may have complete discretion (the goal of U.S. policy in many current
bilateral negotiations).
As for services aboard its flight—meals, drinks, movies, and so
on — management generally has broad discretion, limited only by
competitive pressures. Even here, however, there can be some
limitations where rate regulation still exists and where a tariff
distinguishes between first class and economy fares in terms of such
amenities.
Total Demand versus Market Shares
Some of the factors we have been discussing tend to attract people to
air travel, others merely to attract to a particular airline some
people who were going to fly anyway. The total demand for airline
service was certainly affected by the quantum jump in speed and
comfort when the airlines went from piston to jet fleets. And the
general level of personal income also affects total demand for air
service. But service amenities are another matter: very few people
will decide to fly to a point merely because they can obtain food or
drink or movies en route. When an airline emphasises the service
aspects in it’s advertising, it is trying to increase its share
of the traffic by winning people away from its competitor airlines.
Flight scheduling may have either result: the existence of a flight
at a particular hour may cause people to fly rather than to drive
their own cars, but in many other instances flight scheduling will
merely win a passenger who was going to fly anyway.
Much airline advertising does little to promote air travel as such
but concentrates on winning or holding a share of the market.
Advertising a new lowered fare very likely does more to promote air
travel than the extensive advertising of service amenities. And much
advertising — reflecting the intermediate good nature of the
product — promotes air travel by presenting mouth-watering
pictures and descriptions of tourist meccas. The latter may present
the problem that the expensive advertising by one airline may cause
people to travel to the attractive point by competing airlines or by
train, bus, or private automobile.
Fixing
Fares
Basic Ratemaking Factors
The factors that enter
into determining a rate, whether domestic or international, may be
divided into two broad concepts: the cost of service and the value of
service. The first of these is easy to define but may be hard to
arrive at in a specific case; the second is hard to define as well as
hard to quantify in a specific case. The term value of service
is, in a way, a polite way of saying that a carrier should charge
what the traffic will bear. It is a term under which transportation
economists group various demand factors. What is the value of the
service to each passenger (or to each shipper of cargo)? Is it a
service that cannot be done without and for which no reasonable
substitute can be found? If so, the value-of-service principle would
cause the carrier to price the service high, perhaps very far above
the cost of performing it. The concept can perhaps be clarified by
some examples:
1. The “value” | |
2. The value of air | |
3. There is a |
Rates are determined by a complex interaction of both cost-of-service
and value-of-service factors. As an example, let us look at the
familiar type of excursion fare, wherein a substantial discount,
often on the order of 30 or 50 percent, is granted on regular economy
class if a person buys a round trip ticket on which the return coupon
may not be used for, say, at least two weeks. Often there is an added
condition that the ticket must be purchased at a specified minimum
time, say 30 days, prior to departure. Vacation travellers often can
meet these conditions, while business travellers usually cannot. The
airline is seeking to attract additional tourist travel while
minimizing the tendency for its business travellers to take advantage
of the discount fare. However, the airline must allow for the revenue
loss from those tourists who will use the discount fare even though
they would have flown anyway even if no discount fare were on offer.
The term profit-impact test is sometimes used. It means that
the new fare must generate enough additional traffic to pay the
out-of-pocket cost of carrying that traffic, with enough revenue left
over to offset the revenue lost from those using the discount fare
that would otherwise have travelled at full coach fare. The airline
is looking at the elasticity of demand for pleasure travel (a
value-of-service consideration) as well as the out-of-pocket cost of
handling the additional traffic.
As we have seen, the out-of-pocket costs for fill-up passengers on a
flight that would otherwise have departed with those seats empty are
extremely low, being limited to the cost of food consumed and a tiny
increase in fuel consumption. But if a discount fare proves very
popular, the airline may have to run additional flights to
accommodate the additional passengers; now costs such as crew wages
and fuel become out-of-pocket costs deriving from the discounted
traffic. Under these circumstances the airline may find that the
impact of the discount fare on its profit is distinctly negative.
Many airlines have tried to cope with this latter problem by limiting
the number of discount-fare tickets they will sell on each flight;
the term capacity-controlled has come into use to describe
this practice. An elaborate, computer-facilitated practice called
yield management has become the prevailing method of the
airlines in applying the concept of capacity-controlled fares.
An airline must move cautiously when establishing a discount fare,
and its task is made more difficult by the likelihood that its
competitors will respond to its initiative by establishing similar or
identical discount fares of their own. Now the new traffic—people
who would not have flown had it not been for the discount fare—is
scattered among the competitors, and each airline may get too small a
share of it to compensate for regular traffic diverted from regular
fares to the discount fare.
Determining how deep the discount should be on any discount fare
requires a particularly close look at the shape of the demand curve.
As is well known a small reduction in fare may induce very few
passengers to travel. Discounts, therefore, may be futile if they are
in the 5 or 10 percent range; thus, such fares usually involve
dramatic cuts in the 30–50 percent range.
Another example of interaction of cost-of-service and
value-of-service factors in ratemaking is the tapering of rates with
the length of a trip. Earlier we noted that the cost per seat-mile
drops with the length of a trip, a phenomenon known as the cost
taper. Rates also tend to taper with the length of a trip but,
because of the intrusion of a value-of-service element, they often do
not taper as rapidly as costs. The intruding element is that the
desirability of air travel, in contrast with bus, train, or private
automobile travel, is greater for longer trips. The airlines, knowing
this, may not taper their rates as rapidly as the tapering cost would
justify. Thus, it can be argued that long-haul passengers under these
circumstances are paying more than their fair share and are
indirectly subsidizing the short-haul passengers, a phenomenon
described as cross-subsidization.
Still another example of the interaction of cost-of-service and
value-of-service factors is peak-load pricing. Load factors of the
airlines could be improved without serious inconvenience to
passengers if the peaks and valleys of passenger demand could be
partly smoothed out by a system of fares that would be lower on
flights that operate at times of leaner demand—whether by hour
of the day, day of the week, or season of the year.
But the airlines have developed a far
more sophisticated form of off-peak pricing, which we have already
mentioned under the term capacity-controlled fares. As one
writer remarks: “One difficulty with off-peak pricing until
recently, however, has been the fact that the timing of the peak has
varied from route to route, and even from one direction to the other
on the same route.... The wide daily variation in demand on a given
route made it difficult to find a definition of off-peak suitable for
an entire airline system.”
Thus it becomes clear that pricing occurs in both the world of cost
and the world of demand. As a result, skilled pricers will consider
cost factors as constraints and demand factors as a primary driver.
Many airline pricers make the mistake of being overly cost focused —
cost recovery becomes an objective rather than a constraint (and
costs may be ill-defined). Even more frequently pricers make the
opposite mistake of ignoring costs. They and their associates in the
sales department are often too eager to say yes.
What Caused The Recession
Airlines in India have gone through five phases of development. The
first phase was the pioneering years, which started in the
pre-independence period and lasted till the early years of post
independence era. The second phase started sometimes in the late
fifties and continued till the early nineties of the last century.
The third phase has been the shortest phase so far that started with
the repeal of the Air Corporation Act and ended in 2003. The current
phase started with the emergence of low cost airlines and is now in
the midst of a recession.
The First Phase – the
Pioneering Years
The journey of civil aviation in India began in December 1912. It
coincided with the opening of the first domestic air route between
Karachi and Delhi by the Indian state Air services in collaboration
with the imperial Airways, UK, though it was a mere extension of
London-Karachi flight of the latter airline. However, before this the
first commercial flight in India was made on February 18, 1911, when
a French pilot Monseigneur Piguet flew airmails from Allahabad to
Naini, covering a distance of about 10 km in as many minutes.
On October 15, 1932, a light single-engine Puss Moth took off from
Karachi on its flight to Mumbai (then known as Bombay) via Ahmedabad.
At the controls of the tiny plane was Mr. J.R.D. Tata, operating the
first scheduled air service in the country. He landed with his
precious load of mail on a grass strip at Juhu. Life was simple then.
There were no runways, no radio facilities in the aircraft or on the
ground. There were no pretty hostesses, no aerodrome officers and no
airport buildings. At Mumbai, Mr Nevill Vintcent took over from Mr.
Tata and flew the Puss Moth to Chennai (then known as Madras) via
Bellary. Thus was born Tata Airlines, which later became Air India.
In 1933, the first full year of its operations, Tata Airlines flew
160,000 miles, carried 155 passengers and 10.71 tonnes of mail.
The Second Phase – Public
Sector Era
At the time of independence, the number of air transport companies,
which were operating within and beyond the frontiers of the country,
carrying both air cargo and passengers, was nine. It was reduced to
eight, with Orient Airways shifting to Pakistan.
In early 1948, a joint sector company, Air India International Ltd.,
was established by the Government of India and Air India (earlier
Tata Airline) with a capital of Rs 2 crore and a fleet of three
Lockheed constellation aircraft. Its first flight took off on June 8,
1948 on the Mumbai (Bombay)-London air route. At the time of its
nationalization in 1953, it was operating four weekly services
between Mumbai-London and two weekly services between Mumbai and
Nairobi. J.R.D.Tata headed the joint venture.
The soaring prices of aviation fuel, mounting salary bills and
disproportionately large fleets took a heavy toll of the then
airlines. The financial health of companies declined despite liberal
Government patronage, particularly from 1949, and an upward trend in
air cargo and passenger traffic. The trend, however, was not in
keeping with the expectations of these airlines that had gone on an
expansion spree during the post-World War II period, acquiring
aircraft and spares.
The Government set up the Air Traffic Enquiry Committee in 1950 to
look into the problems of the airline. Though the Committee found no
justification for nationalization of airlines, it favoured their
voluntary merger. Such a merger, however, was not welcomed by the
airlines and the Government had to ultimately nationalize the sector
in 1953 and accordingly, two autonomous corporations were created on
August 1, 1953. Indian Airlines was formed with the merger of
eight domestic airlines to operate domestic services, while Air India
International was to operate the overseas services (the word
'International' was dropped in 1962. Effective March 1, 1994, the
airline was renamed Air India Limited). At the time of
nationalization, Indian Airlines inherited a fleet of 99 aircraft
consisting of various types of aircraft.
The third Phase – the
Liberalisation Era
Until a decade ago, all aspects of aviation were firmly controlled by
the Government. In the early fifties, all airlines operating in the
country were merged into either Indian Airlines or Air India and, by
virtue of the Air Corporations Act, 1953; this monopoly was
perpetuated for the next forty years. The Directorate General of
Civil Aviation controlled every aspect of flying including granting
flying licenses, pilots, certifying aircrafts for flight and issuing
all rules and procedures governing Indian airports and airspace.
Finally, the Airports Authority of India was entrusted with the
responsibility of managing all national and international airports
and administering every aspect of air transport operation through the
Air Traffic Control. While nationalization of air transport sector
solved quite a few problems during the course of time it also created
a few problems. The usual ills associated with monopoly, like rising
operating cost due to low productivity, falling standard of service
and quality of infrastructure, disregard for passenger amenities,
etc.; started to surface. With the general opening up of the economy
theses characteristics of civil aviation was rendering the sector out
of sync with the rest of the economy and therefore finally the Air
Corporation Act was repealed to end the monopoly of the public sector
and private airlines were reintroduced.
As was to be expected, liberalisation of air services led to
launching of several private sector airlines. East West, Damania
Airways, Air Sahara, NEPC Airways, Jet Airways, ModiLuft were some of
the prominent airlines set up during that period. Of these, only Jet
Airways survives today. The airlines that started operating showed
lots of promise in the beginning and many at that time thought that
Indian aviation was well on the way to gain maturity. Almost every
area of airline business showed improvement. Capacity increased
manifold, in 1996 the airlines collectively offered 70,000 seats,
there were visible improvement in efficiency in the matter of ground
handling, cabin crew, punctuality and on board catering.6
It is unfortunate though that what started with so much fan fare soon
began to flounder. Within a few years of their operation most of the
airlines either closed down or, as it happened in the case of
Damania, merged with other airline.
Not much material or analysis is available on the probable cause(s)
of the failure of the airlines in establishing themselves as viable
operators. However, based on our own analysis we would like to put
forward the following:
The pace at which the industry developed was too fast for the
national economy to handle. The economy was still growing at 5-6
percent per annum and personal disposable income for a large majority
of middle class (i.e.; the potential ‘flying’ class) had
not reached the critical mass at which point one could look beyond
the daily grind and seek for some luxury. The industry either did not
understand or preferred to ignore the income elasticity of demand of
its client base and ended up with an incomplete profile of the
market.
The industry created capacity that was far in excess of actual
demand. In 1996 when air traffic stood at around 27,000 to 32,000
passengers per day, the airlines together offered around 70,000
seats. It would, however, be wrong to blame the airlines for the
excess capacity. Since aircrafts come in standard sizes it is in the
nature of the airline industry to perpetually operate in environment
of demand-supply mismatch. It is one of the inflexibilities that we
have already discussed while talking about special characteristics of
airline business. It is one of the ironies of airline business that
the airlines’ have to bear the consequences of actions of which
they are not responsible; in this case the outcome associated with
over capacity.
The private sector airline underestimated the strength of the public
sector airline. The unspoken belief among the private airlines was
that in the onslaught of competition the public sector would soon
wither away. That the public sector could (and would) adapt itself to
the dictates market demands and improve its efficiency to the extent
of successfully retaining a major part of its client base was way
beyond the expectations of private airlines, thus the easy pickings
of passengers that they were hoping for never materialised.
All the airlines, including the ones that survived, failed to
demonstrate entrepreneurial courage and a boldness to experiment with
a new idea. The concept of low cost carriers (which in theory at
least, is most suited for a country like India) that was taking off
at the same period in the West was completely ignored by all the
airlines.
The country was not ready for an aviation makeover. Running an
airline does not only involve buying an aircraft and flying it also
needs the presence of supporting industry aviation finance, for
example. The airlines were operating in a void.
Most of the airlines were under capitalised. We have earlier spoken
about easy entry as on of the unique characteristics of airline
business. In Indian context entry in those were even easier than they
are now. Anybody could set up an airline with just one aircraft
provided he promised to upgrade to three aircrafts within three years
and invested a minimum of rupees one crore. As soon as Air
Corporation Act was repealed all the Air Taxi Operators of the time
converted themselves into airline companies without any adequate
homework. Business economics was the last thing on their mind, if it
was there at all. Though airlines like Damania, East West had
experienced men running the company yet nothing in the way they ran
their airline indicated they were seriously aware how capital
intensive the business was. Jet Airways was the only airline to start
operation with adequate preparation, it had equity tie up with Gulf
Air and Kuwait Airways. It is perhaps because of this tie up and
their professionalism that we see Jet’s aircraft in the skies
today. The other airline that survived was Air Sahara, which could be
ascribed to deep pockets and also the fact that they had not spread
their resources too thin.
For all the defunct airlines finance remained the single biggest
problem throughout their existence and which ultimately led to their
downfall. While Damania sold out to NEPC Airways, NEPC’s own
finance kept going from bad to worse to the extent that they kept
defaulting on paying taxes and the government had to ultimately
confiscate it licences. East West’s died along with the violent
death of its MD. ModiLuft’s partnership had to end when
Lufthansa called off the deal presumably due to non receipt of dues.
The Fourth Phase – The Era of
Growth and . . .
2003 is a watershed year for Indian aviation industry for two
significant reasons. First, with re-launch of new private sector
airline it finally signalled the end of the shock that followed from
the failure of airlines in the earlier phase. Secondly, India entered
the era of low cost airlines. Launch of low cost airline (LCA)
radically altered the nature of competition within the airline
industry, especially on short-haul routes. LCAs exploited different
operational methods, fewer service offerings (e.g. charges for
in-flight catering) and distribution efficiencies (e.g. internet-only
bookings) to lower their cost base and to lower the average fares
paid by customers. Strong competition from LCAs forced the full cost
airlines (FCAs) to respond or to fail.
India's first low-cost airline, Air Deccan started service on August
25, 2003. The airline's fares for the Delhi-Bangalore route were 30%
less than those offered by its rivals such as Indian Airlines, Air
Sahara and Jet Airways on the same route. The success of Air Deccan
spurred the entry of nearly a dozen low-cost airlines in India.
Within a few years setting up its operation Air Deccan had to face
stiff competition from other low-cost Indian carriers such as
Jetlite, SpiceJet, GoAir, IndiGo Airlines and Paramount Airways.
After a year of operation, in 2006, Kingfisher Airlines changed its
business model from low-cost to value airlines.
The LCAs made the years 2005 and 2006 the most eventful years for
Indian aviation. The two years were characterised by a rapid growth
in the size of the passenger market and a fiercely fought price war
in which the full service carriers too joined in. Fares kept plunging
beyond anybody’s expectation and as fare fell the number of air
travellers increased manifold, a significant majority of which were
first time travellers. Growth in passengers induced a growth in
number of aircrafts as well. There were several other factors as well
that contributed to the spurt in growth of the aviation sector. On
the demand side were factors like GDP growth, under penetrated
market, rising disposable income, growth in tourism. On the supply
side were factors like improved infrastructure and a more mature
market.
Unlike the past, present day Indian aviation is clearly got divided
into two categories that of full service carriers and low cost
carriers. The advent of low cost carriers resulted in making
significant changes in the nature and development of the industry. As
price competition strengthened the pressure on airlines to contain
cost increased and as a result quality of service suffered, most
noticeable in delays/cancellation of flights and poor in flight
catering.
It also had a few downside, the revenue model of LCAs was based on a
heavily discounted fare structure and an absolutely stripped down
passenger amenities. While the business model of low cost was
bringing in the passenger it also meant that margin had to
necessarily remain small, significantly this implied that even if an
airline was to earn a profit the volume of profit was likely to be
low unless the volume of passenger carried was very large. However,
increasing the number of passengers might have required increasing
the number of destinations, number of aircrafts and so on, which
would have implied added overheads and added costs. Thus the success
of LCA depended much on the skill of the airline in successfully
managing its yield, optimising its route planning and efficient
designing of its scheduling.
….. Recession
Fare Setting, Fare War and their Consequences
Though low fares resulted in higher traffic it also led to lower
yield, which combined with higher input cost put severe strain on
airlines finances. Most of the newly launched airlines were running
in losses, even the more established airlines were finding it hard to
make profit regularly. Towards the end of 2006, mounting price war,
financial losses and rapidly expanding capacity created a situation
where an imminent catastrophe of closure of several airlines looked
real enough.
If Indian aviation in 2007 has to be described in a single word then
‘consolidation’ would be the right term to use. After a
fiercely fought price war in 2006, that saw several airlines coming
dangerously close to bankruptcy and thus raising the spectre of a
repeat of the 1990s, 2007 saw saner elements prevail. Airlines
realized that the price war that they were waging could only result
in pyrrhic victory. The most significant gain of 2007 thus was return
to realistic pricing of airfare. 2007 witnessed completion of one
major merger, setting in motion of the process of merger in another
case and in a third case conclusion of a merger the process for which
had started in earlier years. Analysts expected that the impact of
these consolidations would be felt in 2008; while in the case of Air
India-Indian Airlines merger infusion of new funds was not expected,
in the case of Deccan-Kingfisher merger a significant infusion of
funds was thought to be inevitable in the light of the poor financial
health of Air Deccan.
Passenger traffic continued to grow at a healthy rate in 2007. This
prompted nearly all the airlines to place orders for buying new
aircraft, undeterred by the fact that they posted combined losses of
about Rs 2,000 crore largely on account of rising fuel costs.
While yields slid, operation costs mounted. Airline CFOs were
reported to claim that more than 80 percent of the cost had become
"uncontrollable". These included wage and fuel costs (60
percent of all expenses) and higher depreciation and interest
charges. These were taking a toll on the financial health of all
airlines.
The sub prime crisis in the US had its impact on the Indian aviation
as well. Augmenting funding from international banks became difficult
as most major lenders were grappling with the sub prime crisis
gripping the US market; they reduced their exposure towards funding
airlines.
From the brief description of developments between 2005 and 2007 in
the Indian aviation, it can be observed that the genesis of a
recession had been shown way back in 2005 and continued in the
subsequent year in the form of price war. The industry in general was
selling a severely under priced product. Airlines, including full
service carriers, were following similar business strategies. The
primary aim of airlines at the time was to gain market share. In
order to fulfil their objective of obtaining market share the
airlines went about offering discounted fare, at times, at
ridiculously low rate. For example, as recently as in late 2007 in
order to gain market share GoAir positioned its fares around 30 per
cent lower than most airlines and on a clogged sector like
Mumbai-Delhi, where a Kingfisher ticket cost Rs 2,000 as basic fare a
GoAir ticket went as low as Rs 500.
The airlines seemed to believe that if they could garner a fair share
of the market then profit would automatically follow. This was
obviously based on an inadequate understanding of basic economics. In
a competitive market an enterprise can become a price setter if and
only if it establishes a dominant position (thumb rule - a market
share of over 50%), failing that the enterprise has to remain a price
taker. It was over optimistic for any airline to hope to reach the
dominant position in the short run in a market that had nearly a
dozen competitors. In the long run, through a process of mergers and
acquisitions as also demise of a few enterprises, the market may
reach a position of oligopoly providing the survivors the power to
dictate price and perhaps recoup the earlier losses. The problem is
the market never guarantees how long the process would take and who
would be the survivors.
In the previous section on economics of airline business we discussed
at length the intricacies of rate setting in airline business. It was
pointed out rate fixing a combination of cost of service and the
value of service. Cost of service is defined as the amount of money
needed for a utility to operate and maintain facilities, cover
capital expenses, and provide an opportunity to earn a profit. It is
obvious that airlines that were deliberately under cutting fares were
not aiming at covering even the cost of service, thus an element of
loss was inbuilt in their business strategy. Primarily the issue
boiled down to the length of time a airline was willing and
financially capable of waiting to ultimately acquire the status of a
monopolist or a oligopolist. Clearly, alongside price war the
airlines were also involved in a battle of attrition, each waiting
for the other to blink first.
As for value of service, since under pricing was the order of the day
apparently no airline was interested in realising the fare that the
traffic was willing to bear. This disinterest of airlines to charge a
fair fare had disastrous consequences as demonstrated in the
experience of Air Deccan. In a bid to attract passengers Deccan often
launched, and much fanfare, schemes like one rupee, three-rupee fare.
The airline in its publicity materials never made it clear that it
was not offering all its seats at Re. 1 and the numbers of seats
under the scheme were very limited. That the whole purpose of the
scheme was to attract eyeballs was also never clearly conceded by the
airline. Anecdotal evidence suggests that the schemes were successful
fulfilling its primary objective of creating a buzz. It was said that
usually on the opening day of the scheme would be passengers were
logging onto the airline website at the stroke of midnight to grab a
ticket. The unfortunate part was that every the schemes were on offer
those not getting a ticket far outnumbered those who got one. The
disappointments led to negative publicity for the airline as the
people were, perhaps without much justification, quick to conclude
that the airline was not offering any seat at the promised fare and
making a fool of them. Sensing the loss in trust and its negative
impact the airline ultimately had to offer many more seats than it
originally planned so that there would be a visible number of haves
than have nots.
While other airlines did not replicate Deccan’s one rupee
scheme they tried counteracting Deccan’s advantage by offering
ultra cheap fares. This strategy too had unwelcome consequences. It
resulted in airlines getting stuck in ‘sticky price point
syndrome’7.
The syndrome refers to that price of a product which even if
marginally breached leads to a severe fall in demand. For some
reason, which economists are yet not able to explain properly, the
consumer develops a preference for a particular price point of a
product. At this price point she is always willing to buy the
product, however, the moment the price goes beyond the preferred
price point (even by a small degree) she stops her purchase. The
funniest thing is that the consumer may still continue to buy the
same product but differently positioned by the company. Companies
whose products get afflicted by this syndrome find themselves in a
peculiar situation. It is not that there is no demand for the
product; it is just that at a price beyond the preferred price point
the demand dries up. The dilemma faced by the company is whether to
retain the price point or abandon it. In the case of airline the
passengers got so used to ultra cheap fares that beyond a certain
point the efforts of airlines to raise fares often led to passenger
deserting air travel and switching back to train travel. Observed
data suggests that the preferred price point happens to be Rs. 1000
i.e.; the moment the difference between air and train fare goes
beyond this point the reverse movement from air to train starts.
Thus, due to an inadequate understanding of economics of airline
business, from 2005 onwards airlines had been a perusing a fare
strategy that was tailor made for paving the way towards financial
disaster. The airlines made too literal an interpretation of demand
theory according to which when price falls demand goes up; yes it
does but provided a host of other factors also stand up. In this case
the two most important factors that the airlines missed out were
price elasticity and income elasticity. In 2007 when airlines started
the exercise of fare correction through levy of fuel surcharge,
initially the growth in passenger traffic did not suffer. After a
point continuous rise in airfares started to become a barrier for
low-cost fliers. As fuel surcharges crossed the actual fares in
several sectors, several leisure travellers and relatively new flyers
started shifting to the railways and long distance buses. Airlines
aught to not have ignored them, as this was the segment that had
fuelled rapid growth in the sector and which had prompted airlines to
add capacity.
Over Capacity
As in 1990s this time too there were far more seats on offer than
actual demand. For example, while the passenger traffic in 2006
increased at around 25%, the past year saw a capacity addition of
48%. As on the previous occasion the airlines were not altogether to
be blamed for this. Periodic over capacity is a characteristic in an
industry where capacity can only be created in
manufacturer-determined sizes. Airline shares this characteristic
with other modes of transport, notably shipping. An element of cyclic
behaviour is, in inbuilt in airline business.
In matured markets commercial aviation business cycles have a period
of 7-10 years. In this type of cycles, economic growth as a
driver of demand, the ordering and retirement of equipment, and
the entry and exit of firms in the different markets are the key
variables that influence the length and severity of the cycle.
In the period following the second round of liberalisation effect the
following dynamics could be seen as driving the industry. The first
effect was advent of a number of new airlines. These new entrants had
lower operating costs than incumbent airlines as they operated
younger fleets and their employees had low seniority and
commensurate salaries. What they lacked was network size –
a key parameter for attracting passengers. Therefore, a race began to
gain market share and utilise capacity at a disregard for short
profitability. This behaviour, although rational in the
short-term for a single player, created the illusion that even
more capacity is needed as the lowered prices boosted demand;
this was exacerbated by a growing economy. Airframe
manufacturers and, later, leasing firms were happy to oblige in
providing the capacity that was being ordered, despite the mismatch
between demand growth and the much higher capacity growth, as that
also helped them reduce their unit costs faster and compete for
market share in an oligopolistic market.
Overcapacity inevitably led to price wars and substantial losses and
even when carriers failed, their aircraft was re-circulated as
leased or sold to new entrants willing to try their chances.
Investors willing to finance these ventures facilitated this
effect.
Two other factors dictated the retention of capacity by airlines:
high midterm fixed costs and the sophisticated pricing
capability offered by revenue management systems to maximise
flight passenger revenue. The significant medium-term fixed costs
faced by airlines included the need to “hoard” or
retain highly trained employees if the airline was to remain
competitive at the next market upturn while the costs for
long-term leases, owned equipment and gate leases were also
fixed in the medium-term. The high fixed costs made the prospect
of price wars more palatable to airline managers as at least these
would ensure a source of badly needed short-term liquidity even at
the expense of profitability and long-term viability. The modern
revenue management software also provide a way of filling up the
aircraft at ever higher load factors but at prices that sometimes did
not cover the costs of the operation; the belief that the
marginal cost of a seat is zero obscured the fact that in some
cases the prices charged meant that the break-even load factor
exceeded one.
In the description above, the key factor is the repeated
mismatch between available capacity and demand in the industry
with tight capacity matched by increased demand and high returns
and vice versa. Airlines have flexibility in reducing available
capacity; depending on the time horizon of the decision maker,
schedules can be cut back in the short term and aircraft can be
parked, returned to the lessor, sold, or scrapped in the medium
and long term while airlines can go out of business. Yet,
this flexibility is limited by several factors: firstly, an
airline’s frequency and network coverage is a key
competitive advantage which is only reluctantly forfeited;
secondly, aircraft are expensive assets that do not produce if
underutilised while their lease or interest and capital payments
continue; thirdly, even when an aircraft is returned to the lessor
or sold it will return in the market sooner rather than later.
Conclusion
Rising fuel cost has generally been called responsible for the
current recession in the aviation sector. Our analysis, however,
point to other factors that were directly responsible than fuel cost.
The airline industry had been following a business strategy that
bound to lead to recession at some point of time. Though in recent
times airlines tried to ward off the inevitable by abandoning price
war and attempting to restore a more viable fare structure but their
earlier deed had reduced fares to such a low level that bringing that
up to a realistic level involved raising fares manifold which the
airline were unable to do due to elastic demand that triggered off
consumer resistance beyond a certain level of fare. Any steep
increase in fare was going to affect passenger demand seriously was
likely to jeopardise the financial position of the airlines even
further. In nutshell, by following policies that were counter
productive to profitable growth airlines had pushed themselves so far
into a corner a calamity was waiting to happen; rising fuel only
acted as a trigger.
1
Melvin Brenner, “Airline Deregulation—A Case Study in
Public Policy Failure,” Transportation Law Journal 16
(1988): 189.
2
John R. Meyer and Clinton V. Oster Jr., Deregulation and the
Future of Intercity Passenger Travel (Cambridge, Mass.: The MIT
Press, 1987), p. 56.
4
John R. Meyer and Clinton V. Oster Jr., Deregulation and the New
Airline Entrepreneurs (Cambridge, Mass.: The MIT Press, 1984),
p. 52.
5
Elizabeth E. Bailey, David R. Graham, and Daniel P. Kaplan,
Deregulating the Airlines (Cambridge, Mass.: The MIT Press,
1985), p. 48.
6
“Those were heady times indeed: beer was served as early as
6 am, there were on board fashion shows, three course lunches served
on bone china on 25 minutes flights and there was personalised
service for first class passengers.” Business Standard
Open Sky, November 2006.
7
A good example of the syndrome can be found in the market for hair
shampoos. Many years ago an enterprising company introduced sale of
shampoos in small sachets priced at 25 paise. It proved to be a
great marketing idea and its success bred many imitators. From time
to time the price of the sachet kept rising till it touched Re. 1
and there it stayed. Recently in view of rising cost due to
inflation and other factors the marketing companies made severall
attempts to raise the price and take it beyond Re. 1. To their
surprise they found that sale would plummet every time the price
crossed the one rupee lakshman rekha and be back to normal as
soon price was restored to Re. 1.
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