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Summary Air Transport Economics for the mid-term Exam

Air Transport Economics (Universiteit van Amsterdam)

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14-02-2012 UvA Business Studies


M.J.H.Schellekens 2011/2012
Air Transport Economics Semester 2, Block I

Summary of Introduction to Air Transport Economics by Vasigh, Fleming and Tacker (2010).

Chapter 1: The Evolving Air Transport Industry

The US Deregulation Act of 1978 has led to a volatile US airline industry. Prior to deregulation, the
airline industry was relatively stable with minimal losses and healthy profits. This state of affairs was
mainly due to government regulation, virtually eliminating any meaningful competition between airlines
and certainly preventing new competitors from entering the market.
The US airline industry has been the most dominant aviation industry in the world. However, in terms of
international passengers, both the Asia-Pacific and Europe markets already surpassed the US, with the top
four international airports being located in Europe (LHR, CDG, FRA, AMS).

Domestic aviation is relatively small in Europe; therefore, European airlines survive on international
traffic. Focusing on international traffic is certainly a dominant trend in aviation, another trend within the
industry is the growth and expansion of the cargo industry. After the US Airline Deregulation Act, other
countries began to follow and deregulate their own countries. The industry took on a more cyclical nature
of a competitive industry. Furthermore, the financial condition of the airline industry is highly related to
economic growth.

The early parts of the decade following deregulation were troublesome for the airline industry. However,
the industry recovered and displayed record short-run profits in the late 1980s and again in the late 1990s.
Financial distress and competition caused airlines to be more innovative and conscious of controlling
costs. The post-deregulation profitability cycle continued into the twenty-first century with the global
aviation industry experiencing its worst downturn in history. The 9/11 terrorist attacks were the proximate
cause of the global industrys financial problems, the root cause was a slowing economy, reducing
passenger yields.

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Threats to profitability are ever-present, with fuel costs constituting the largest threat. In fact, for many
airlines, fuel costs are now higher than labor costs, and airlines have few options in dealing with them.
The ultimate question of profitability depends to a large extent to the elasticity of demand for the product
and the cost containment of the airlines management.

Airline Industry Consolidation


-Low cost carriers are capturing more of the domestic market share while legacy network carriers are
losing theirs. Mainly due to LCCs continual expansion and advantages they possess because of their low
cost structure.
-Emergence of regional carriers is another major trend in terms of market share

The industry Herfindahl-Hirschman index (HHI) is a measure of how consolidated the domestic US
market is. Historically, mergers rapidly followed after deregulation in 1978. In the ten years following
deregulation there were 51 M&As resulting in the creation of six legacy carriers from the 15 independent
carriers that had close to 80 percent US market share.

Some economists argue that less intense competition, through consolidation and coordination, can
actually benefit consumers by allowing airlines to build more efficient networks with greater economies
of scale, scope, and density.

While M&As have slowed in the US, the relatively low HHI and poor financial condition of the legacy
carriers indicates that there is till potential for additional M&As within the industry.
Few recent international mergers include:
KLM & Air France
Lufthansa & Swiss Air
Air Canadas acquisition of Canadian Airlines
Japan Airlines purchase of Japan Air System

Many M&As do not realize the envisioned benefits because one-off merger costs, such as aircraft
painting and IT harmonization, are far more costly than planned. Also difficulties arise in dealing with
labor groups, merging seniority lists, and differing corporate culture.

One of the greatest challenges a merger faces is managing multiple and powerful stakeholders (McKinsey
& Company, 2001). A merger of two mid-sized airlines could unlock synergies in excess of 7 per cent.
The principal benefit of mergers is cost rationalization. Merged airlines can:
-Increase bargaining power with suppliers;
-Spread high fixed costs over a greater network;
-Merge functions as parts inventories, back office functions, and sales functions
-Increase network harmonization

It is important to note that the level of consolidation in the at major US airports is much greater than the
level of consolidation within the airline industry in general.

Factors Affecting World Air Traffic Growth


The most important factor affecting air traffic growth is prosperity in the region, measured by GDP or
GNP.
GDP = the total market value of all final goods and services produced in a country in a given year.
Increased prosperity derives increase air travel demand in two ways:
1. Increased economic activity helps generate employment, causing an increase in business travel.
2. Economic prosperity decreases unemployment and leads to an increase in average household
income.

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Furthermore, these factors influence traffic growth:


-A decrease in the real cost of air traffic will also create air traffic growth.
-Population growth rates
-Economic liberalization promotes traffic growth
-Politics and political stability
-Terrorist attacks
-Amount of leisure time people have

The Economic Impact of the Air Transport Industry


Commercial aviation consists of two primary segments:
-Large commercial air carriers
-Regional/commuter airlines

Economic impact can be divided into three categories:


1. Direct = economic activities that would not have occurred in the absence of air transportation
2. Indirect = financial benefits that are attributed to airport/airline activities (hotels, restaurants, etc.).
3. Induced = multiplier effects of the direct and indirect impacts. Increased employment and salaries
that come from secondary spending that results from direct and indirect economic impacts
Total impact = direct impacts + indirect impacts + induced impacts

The Global Outlook for the Air Transport Industry


The global outlook for the air transport industry mirrors the global economic outlook. However, direct
correlations between GDP and air transport growth are never exact, due to a variety of issues. For
example, structural barriers within the industry can cause drastic differences between economic growth
and the growth of the air transport industry.

Chapter 2: Principles of Economics

The only way that has ever been discovered to have a lot of people cooperate together voluntarily is
through the free market. And thats why its so essential to preserving individual freedom.

Milton Friedman

Demand
Economics takes as a given that people respond to incentives in a generally predictable manner.
The law of demand states that price and quantity demanded are inversely related. A slight change in price
would lead to a change in quantity demanded because of a decision maker who is on the margin - that is,
one who is almost indifferent as to whether they rake a given flight or not.
Movement along a given air travel demand curve: a price decrease causes an increase in quantity
demanded.
Shift of an air travel market demand curve: demand increases, shifts rightward from some change
other than the price of air travel. The most common determinants of demand are:
prices of substitutes
prices of complements
seasonal factors
general preferences
product quality
random factors (terrorism, natural disasters)

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Supply
The supply of air travel, is based on production costs. Long-run supply curves can vary tremendously, but
short-run supply curves are reliably upward sloping.
Movement along a given air travel market supply curve: a price increase causes an increase in quantity
supplied.
A shift of an air travel market supply curve: supply increases, shifts the curve rightward when
production costs decrease or new entry occurs.
Movement of an air travel market supply curve by itself: supply decreases, shifts the curve leftward
when production costs increase or firms exit the market.

Equilibrium
Equilibrium price is found where supply and demand intersect. P* is the corresponding price and this
price is achieved through a process of trial and error.
Airlines differ from most businesses in that inventories perish - that is, empty seats are worthless once the
plane takes off. There is a dynamic process for reaching P*, equilibrium price, if airlines initially
overestimate demand. Average fare is too high, and few bookings are received. Airlines bring the price
down, and reduce capacity until equilibrium is reached at P*. In practice, supply and demand for air travel
tend to shift frequently.

Changes in equilibrium
Analyzing changes in equilibrium is straightforward as long as one proceeds by first deducing which
curve is shifting in which direction.
-increase in demand; demand curve shifts right; both equilibrium price and quantity increase.
-Decrease in supply; supply curve shifts left; price goes up; demand falls.
Shift of demand curve: demand increases which causes both equilibrium price and quantity to
increase.
Shift of supply curve: as supply decreases, equilibrium quantity decreases and equilibrium price
increases.
Movement of both supply and demand on the curve: as supply decreases and demand increases,
equilibrium can only be reached at a much higher price.

The invisible hand of Adam Smith = Voluntary trades in free enterprise often motivate behavior that
helps society, even though individuals are mainly trying to help themselves and their own family. This
principle is the underlying foundation that makes individual freedom feasible and a free enterprise system
so productive.

Price Controls
A controlled price will allocate resources, but not in accordance with supply and demand. A price lower
than equilibrium will drastically reduce quantity supplied.
The greatest irony is that government price control results in consumers typically paying more than the
market rate. This follows from the fact that there is more to life than cash; time in a manner of speaking,
is money too. Normally, consumers compete for scarce products through price, but government price
regulation precludes that. So, consumers compete instead by getting to limited supplies ahead of the
crowd - paying in terms of time instead of money.
Supply shortage = when a price point is imposed on a price below equilibrium on the new supply curve,
a supply shortage will occur.

Landing Fees and Airport Congestion


A correct price can eliminate excessive airport congestion. The demand for airport use is a downward
sloping curve; if we increase the landing fee, fewer aircraft use the airport and congestion may be
alleviated.

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Optimal congestion: every time an aircraft takes off or lands it generates both costs and benefits. As long
as a given operation creates more benefits than costs than that operation should occur.
The marginal benefit in this case is the benefit generated by the latest operation.
Marginal cost is the cost generated by the latest operation.
Individuals inherently engage in an activity as long as the marginal benefit exceeds the marginal cost. But
problems can occur if an activity generates and external cost - that is, a cost that falls on someone else.
People tend to discount, or even ignore, costs imposed on others. Thus, external costs often result in
excessive activity, generating more cost than benefit.

The marginal cost system-wide curve embodies all costs, including what an individual airline would view
as external costs. This curve is essentially a demand curve.
If the government allows the landing fee to be at a price P*, where the MC(system wide) are equal to the
MB, then an output Q* of optimality is achieved. Governments rarely set this price right and often opt for
a lower price than P*, resulting in a higher output Q, and costs exceed benefits.
Costs here include: -wasted fuel;
-higher aircraft maintenance;
-lost productivity of aircraft and employees from excessive time getting in an out of
the airport

Economics of Government
Rational political ignorance = time spent informing oneself on political policies is lost since a single
vote does not have a tangible impact. It is rational, given our preferences, to remain ignorant when the
cost of acquiring knowledge is greater than the benefit.
Governments around the world impose harmful price controls because such policies are extremely
popular with rationally ignorant voters who simply want lower prices and do not think through, the
consequences of translating impulsive wishes into uncompromising law.

Economists generally agree that private provision of most goods will be more efficient than government
production. The best consumer protection is often competition in an open market.
Mixed economy = production and resource allocation is directed through the price system of private
enterprises, but government provides some crucial services and is an active regulator in certain areas of
the private sector.
It is important for the general economy, and aviation in particular, to limit government influence and to
allow the private sector to handle the operations for which it is so well suited.

Chapter 3: The Evolving Air Transport Industry

Airline demand analysis is concerned with understanding passenger behavior. Airline supply refers to the
airlines ability and willingness to provide a specific number of seats at alternative prices in a given time
period in a given market.

Demand is the willingness to buy specific quantities of a good or a service at alternative prices in a given
time period under ceteris paribus conditions. Demand is usually asses in RPMs Revenue Passenger
Miles, or RTMs Revenue Ton Miles.
Ceteris paribus, as price increases, the quantity demanded decreases.
Demand schedule = a table showing the quantities of a good that customers are willing and able to buy at
alternative prices in a given time period. Demand is cumulative, meaning that if a customer is willing to
pay $1000,- for a ticket, this customer is also willing to pay $500,- for a ticket.

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Demand curve = graphically describes the demand schedule and the quantities of a good that customers
are willing and able to buy at alternative prices in a given time period. Demand curves are inherently
downward sloping.
Demand function = the functional relationship between the quantity demanded and factors influencing
demand.
Implicit demand function = demand function which simply states a general relationship between the
quantities demanded and the factors affecting demand. It does not state the mathematical relationships.
Explicit demand function = mathematical relationship between the quantity demanded and the various
variables impacting on demand. For instance: D = 15000 2P

A demand schedule rarely has a perfect linear form. Two other types of demand function are the semi-log
function and the log-linear demand function.
Semi-log form LnQd = 0 + 1.P
Log-linear form LnQd = 0 + 1.LnP
For the airline industry, it is usually assumed that the typical demand function takes the log-linear shape.

Determinants of Demand for Air Transportation


Major determinants affecting demand for air transportation are:
Ticket price
Competitors ticket price
Passenger income
State of the economy
Available other forms of transportation
Customer loyalty
In-flight amenities
Frequency of service
Safety
Random factors (terrorist attacks, natural disasters)
Of these factors, ticket price is the only determinant of demand that causes a movement along the demand
curve. Changes in the other determinants of demand cause a shift in the entire demand curve.

The demand for air travel also has many unique characteristics that present problems for the airline
industry. These are:
1. Constant fluctuation demand for individual flights is constantly changing and every route is
unique in its demand characteristics
2. Cyclicality refers to a long-term trend of peaks and troughs of economic activity
3. Seasonality/Peaking peaking is more a short-term event where demand spikes
4. Directional flow the increased demand of passengers in one direction for a period of time
5. Perishability the moment the plane leaves the gat, any empty seats are lost as revenue
generating products. Therefore, cose matching of demand and supply is essential.

Source of Demand
Direct demand = demand that directly satisfied a consumers need (e.g. food).
Derived demand = the demand of a product or service depends on the demand for other products or
services (people do not buy a ticket to fly but because of the demand to arrive at the destination).

Elasticity of Demand
Elasticity is the percentage change in the dependent variable (quantity demanded) resulting from a 1 per
cent change in an independent variable (factor of demand). Elasticity measures the responsiveness of one
variable to changes in another.
Elasticity = Percentage change Y / Percentage change X

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There are two types of variables in measuring elasticity:


-Endogenous variables are the variables the airline can directly control.
-Exogenous variables are the variables that are outside the companys direct control.

Price elasticity = the percentage change in the quantity demanded resulting from a 1 per cent increase in
price. Point elasticity measures the elasticity of the function at a specific value, while arc elasticity
measures the elasticity of the function over a range of values.

Point price elasticity formula:

Arc price elasticity formula:

Price elasticity is categorized into one of three groups:E > 1 (Elastic)


E < 1 (Inelastic)
E = 1 (Unitary Elastic)
The point at which the company achieves the optimal price level is the point of unitary elasticity.

Figure 3.7 Pricing decisions based on elasticity

Cross-Price elasticity = measurement of the impact of a related firms price on demand. A related firm is
either a substitute (competitor) or a complement.

Point cross-price elasticity formula:

Arc cross-price elasticity formula:

E(x,y) > 0 (substitute)


E(x,y) < 0 (complement)
E(x,y) = 0 (Independent)

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Income elasticity = the sensitivity that changes in the annual income of consumers have on the quantity
demanded for a product. GDP is the best proxy variable for income.

Point income elasticity:

Arc income elasticity:

Ey > 1 (superior good)


Ey > 0 (normal good)
Ey < 0 (inferior good)

Supply of Airline Services


One of the key reasons the airline industry has faced financial difficulties and has profit margins well
below many other industries is that it demand fluctuates constantly but its supply is relatively fixed.

Airline supply refers to airlines ability and willingness to provide a specific number of seats at
alternative prices in a givin time period and a given market.
Supply is usually expressed in available seat miles ASMs, or available ton miles ATMs.

The major determinand of supply is ticket price. Airlines are willing to supply more seats as ticket prices
increase.
-Another major determinant of supply is the price of resources, such as: fuel, maintenance, landing fees
-The next major determinant affecting supply is technology.
-Competitive factors are another important determinant of supply for air transportation.
-Random factors are the another factor affecting supply.
-The final factor affecting supply is government regulation
Besides these factors, deregulation of air transport has also significantly affected the supply curve. Since
regulation generally prohibits market forces from determining supply, an artificial cap is usually set on
supply. Therefore, when air transport deregulation occured, the artificial cap on supply was withdrawn,
and supply subsequently increased.

Characteristics of Supply for Airline Services


Two important characteristics of supply that help shape the air transportation industry are seasonality and
rigidity. An airlines supply is fairly rigid as it can be difficult for it to reduce and/or increase supply
dramatically. Ultimately, this rigidity in supply limits the airlines ability to match supply and demand
effectively.

Supply and demand equilibrium is achieved when both the supply and demand functions are written in
terms of price and set equal toe each other.

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Chapter 4: Cost and Product Analysis: The General Concepts


Costs of production in the airline industry are minimized through either the mix of inputs or the
reallocation of resources across multiple plants. Profitability can be improved by either increasing
revenues or decreasing costs. The amount of profitability is the contribution margin, or the difference
between unit revenue and unit costs.
Revenue per air seat mile RASM, and cost per air seat mile CASM, are used to calculate the
operating margin for airlines.
Cost (economic definition) = the foregone alternative use incurred in the exchange, transformation, use,
and production of goods and resources. Typically, fuel, labor, maintenance, and aircraft ownership costs
are the four largest costs for any airline.

Cost Classification
Historical costs = costs actually incurred to acquire an asset.
Current costs = the costs incurred under prevailing market conditions.
Future costs = the expected costs that may be incurred sometime in the future; these will be affected by
rate of inflation/interest.
Sunk costs = costs that have been incurred in the past and that are not recoverable.

Cost Division
The most common method of classifying costs, in economics, is by their relation to output.
Fixed costs (FC) remain fixed in the short run, regardless of level of output.
Variable costs (VC) vary directly with changes in production.
In the long run, however, all costs are assumed to be variable, since over time a company is fully able to
change fixed costs.
The airline industry tends to have high fixed costs, increasing barriers to entry. The ratio of fixed to
variable costs is called operating leverage.
Average costs is the total cost function divided by output. Because fixed costs remain constant regardless
of output, average fixed costs will decrease with increases in output, since fixed costs are spread out over
a greater range of outputs. This provides an incentive for a firm to increase output if it has a high level of
fixed costs.

Mixed cost = type of cost which exhibits characteristics of both fixed and variable costs. Mixed costs are
fixed for a certain range of output and then increase for a different range of outputs. A mixed cost appears
like a step function with various levels.
Marginal cost = the change in total costs resulting from an increase in one additional unit of output.
TC = FC + VC
ATC = AFC + AVC
MC = dTC / dQ

Explicit/Implicit costs
Explicit costs = costs represented by actual out-of-pocket expenditures.
Implicit costs = generally a non-cash expenditure, such as opportunity costs value of the next best
option.

Accounting costs generally only recognize explicit costs, not taking opportunity costs into consideration.
Economic costs include both implicit and explicit costs.

Linear cost function: TC = a + b.Q


Linear costs occur when the company experiences constant marginal costs of input charges.

Cubic cost function: TC = a + b.Q + c.Q.Q + d.Q.Q.Q


This cost function first exhibits increasing marginal returns and then diminishing returns to scale.

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The total cost curve is the variable cost curve shifted on top of the fixed cost line.The average fixed cost
curve will always slope downward at a declining rate, eventually being asymptotic with the x-axis. The
average total cost curve is u-shaped, similar to average variable costs. The marginal cost curve crosses
both the AVC and ATC curves at their minimum point and continues above them as output rises. This is
because at first, we are adding unit costs less than average causing average costs to fall. Then, as these
additional unit costs increase, they eventually become equal and then above the average causing
average costs to rise.
Cost curves provide the following rules for managerial decision making:
Marginal costs tell us where (how much) to produce
Average total cost tells us whether we should produce
Average variable cost tells us when we should cease production
The explanation for this is that as long as the revenue from the extra unit exceeds its cost, then we want to
produce more.
ATC can be multiplied by output to give total costs. As long as total revenues exceed total costs, we will,
of course, continue production.
ATC = TC / Q
TC = ATC . Q
If our total revenues do not cover our total variable costs, then we should cease production.

Quadratic cost function: TC = a + b.Q + c .Q.Q

Average cost function = total cost function divided by Q


Marginal cost function = first order derivative of total cost function
The second order derivative of the total cost function determines if the u-shape is a minimum or
maximum and at which point the marginal costs are minimized. (positive = minimum; negative =
maximum)

Economies of Scale, Scope, and Density


Economies of scale = advantages gained when average unit costs decrease with an increase in the
quantity being produced. Sources of economies of scale are:
-Lower cost and higher productivity due to the division of labor.
-Increase in labor productivity due to concentration on a fewer number of tasks and more experience on
the job (learning curve).

The reverse is diseconomies of scale, where average unit costs increase with an increase in production
quantity. Causes of diseconomies of scale are:
-Inability to efficiently coordinate material flows and manage employees due to larger facilities
-Slow decision ladder
-Workers and management becoming more segregated and communication less effective
-Inflexibility
-Capacity limitations
Companies usually will have levels of quantity where economies of scale are present and levels where
diseconomies of scale exist. This is exactly what occurs for cubic cost functions.

Economies of scope = company can reduce its unit costs by leveraging efficiencies through sharing
resources for multiple projects or production lines. Multiple projects can be more cost-efficient when they
are done together rather than individually.

Economies of density = cost-effective results are achieved through the consolidation of operations.
Airlines have found it more cost-effective to consolidate operations at a single airport rather than
operating a point-to-point service hub and spoke system.
Using a hub drastically reduced the number of flights to connect a given number of destinations.

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Number of flights required in a hub and spoke system: Flights = n 1


Number of flights required without a hub and spoke system: Flights = (n.(n 1)) / 2

Airline Industry Cost Structure


Most common metric to standardize airline costs are CASMs (costs per available seat miles). An ASM is
one aircraft seat, flown one mile, regardless of whether it is carrying a revenue passenger.
Direct operating costs (DOC) = those costs directly attributable to the airlines operations. Principal
categories of direct cost are: -fuel costs
-flight and cabin crew expenses
-direct maintenance expenditures
-other operating costs, including landing fees and capital equipment changes

Fuel costs
(Fuel price per gallon) / (ASM/Block hour)
Fuel costs = ASM x / (Gallons/Block hour)
Investment strategies such as purchasing aviation fuel at the market bearing rate and offsetting this with
investment gains from oil options, can help offset increases in the cost of fuel.
A second way airlines can adjust their fuel costs is by being more fuel efficient e.g. operating more
efficient aircraft.
Other fuel efficiency methods center on technological advances, such as the installation of blended
winglets.
More subtle fuel management strategies include n-1 taxi operations, flight planning for minimum fuel-
burn routes and altitudes, avoiding a situation where an airplane takes to much fuel on board, buying fuel
in regions where price are lower and in bulk, and redesigning hubs and schedules to reduce congestion.

Flight/cabin crew expenses


The next greatest direct operating cost for US airlines is crew expenses. Airlines have recently been able
to dramatically reduce their labor costs.
Formula for flight personnel costs is: Flight personnel costs = ASM x labor rate / (ASM / Block hour).

Maintenance costs
Airlines must cost-effectively manage their maintenance operations and staffing levels. A major
innovation in the maintenance area has been the outsourcing of maintenance activities to third-party
vendors.
Maintenance costs ASM x (Maintenance Labor and Material / Block Hour) / (ASM / Block Hour).

Other operating costs


These costs can include airport-related expenditures (landing fees, gate agents, baggage handlers), and in-
flight catering costs.
Indirect Costs = ASM x (Indirect costs / ASM)

Airline Break-Even Analysis


An important measurement of any companys cost structure is its break-even analysis. Break-even
analysis is the number of units or revenue required in order for the firms costs to be recovered.
Q(breakeven) = Fixed Costs / (Price Variable Costs)
Price Variable Costs = Contribution Margin, therefore;
Q(breakeven) = Fixed Costs / Contribution Margin

General formula for airline break-even: (RPM . RRPM) (ASM . CASM)


Load factor = RPM / ASM
Break-even load factor = CASM / RRPM

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Operating leverage
Operating leverage is a powerful metric that highlights the ratio between operating profit growth and
sales growth The degree of operating leverage is an elasticity of the overall companys financial health
with respect to sales growth.
DOL = %change in EBIT / %change in Sales

Explicit operating leverage formulas:


DOL = Q(P-V) / (Q(P-V) FC)
DOL = (S VC) / (S VC FC)
Companies with a high degree of operating leverage are much more reactive to changes in output.
Therefore, companies with a high degree of operating leverage will experience greater volatility of
operating profit than companies with smaller degrees of operating leverage.
A negative operating leverage indicates that a company is countercyclical to the industry. This scenario
indicates decreasing returns to scale, probably due to the fact that the company has grown too quickly and
is not effectively leveraging its fixed costs.

Chapter 5: Aviation Infrastructure: Operations and Ownership

One of the most unique features of the industry is the unprecedented amount of regulatory and operational
control the industry is subject to. Government agencies often regulate and control everything from the
direct ownership of airports, the control of aircraft in the air, and the certification of aircraft production on
the ground.

Early air traffic control began in the 1920s and was mainly concerned with navigation rather than control.

In the early 1930s this system was replaced by a more formal set-up that consisted of a series of light
towers, called the Transcontinental Lighted Airway.

In the mid-1930s an airline consortium established the first three centers to pool information on specific
flights so as to provide better separation.

At the end of 1930s Congress passed the Civil Aeronautics Act which transferred civil aviation
responsibilities from the Department of Commerce to a new agency called the Civil Aeronautics
Authority.

In 1940 President Roosevelt separated the Authority into two agencies, the Civil Aeronautics
Administration (CAA) and the Civil Aeronautics Board (CAB).

The Federal Aviation Agency was then created by the Federal Aviation Act of 1958 and tasked with the
old responsibilities of the CAA and the new responsibility of safety rule-making.

Finally, in 1967 the Agencys name was changed to the Federal Aviation Administration, and it was
placed under the Department of Transportation

One of the principal advantages of air travel is the speed at which an individual can arrive at its
destination. Factors that contribute to delay in the system certainly reduce industry attractiveness, and
reduce quantity of air traffic demanded.

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Fig 5.1 The short-term economic effect of air traffic delay

Delays that are imposed on the system can be thought of as externally imposed costs to both the
consumers and the producers of air travel. We can think of the costs as a parallel shift in the supply curve.
The costs created by a delay are dead-weight losses. In other words, there are no tax proceeds being
transferred to government, consumers and producer suffer a loss of wealth, but government gets nothing
out of that.

The question of who bears the greater amount of cost depends on the slopes of the demand and supply
curves. As the supply curve becomes more inelastic (slope gets higher) it becomes increasingly difficult
for producers to shift the burden of cost to the consumers.
In case of a perfectly inelastic supply, the ticket price remains the same for consumers, and the entire cost
of the delay is borne by the producers.
Supply is relatively inelastic, at least in the short- to intermediate term, in comparison with demand.
Therefore, the greater part of the cost of delay in the industry will be borne by the producers.

Fig. 5.2 The cost of delay with inelastic supply

There are other longer-term supply and demand economic effects that need consideration. On the supply
side, if the cost of delay is persistent and longer-lasting, then the value of the specialized resources
presently in use in the aviation industry will be diminished accordingly.
The long-term effect further lowers quantity and raises price. On the demand side, we can expect a shift
in demand away from air travel to alternative modes of travel where this is feasible.

The fact that the final product of the industry is under the direct control of an outside government agency
(the FAA) that does not have the same incentives or goals as the industry, especially those concerning
profitability, can lead to large external costs that are increasingly imposed on the industry.

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Institutional Problems in US Air Traffic Control
US ATC management is inherently flawed and in need of major reform, because:
-funding flows from an unpredictable revenue stream subject to the federal budget process.
-inability to attract and retain needed managers and engineers who are skilled at implementing complex
technology projects.
-Lack of both mission focus and clear accountability.
A possible solution to these problems, might be to move to a private, non-profit corporation.

Advantages of Independent Ownership


-The existence of an independence revenue stream allows access to private capital markets to fund
modernization.
-The elimination of tax funding creates an exemption from government procurement rules that have
tended to impede the acquisition of new technology.
-Independent funding also allows exemption from civil service regulations that can make it difficult to
attract, manage and maintain the appropriately skilled workforce.

All commercialized, self-supporting air navigation service providers (ANSPs) that are implemented in
various countries such as Australia, France, Germany, Switzerland, etc., belong to the Civil Air
Navigation Services Organization (CANSO).
Since commercialization of ATC, safety had either been unaffected or even improved in these countries.

Airport Ownership and Management


At present, all the airports in the US are under some type of government control. One of the byproducts of
this type of control is typically a pricing system (landing fees) that is fixed over the entire day.
Many economists would maintain that private ownership of airports would provide a better set of
incentives for the long-term viability of the industry.

Reason for privatization:


Greater efficiency of operations
Capital infusion, opening up non-traditional sources of capital
Conversion of a private airport into a tax-paying corporate entity
Private companies can readily raise funds for project without political entanglement
Companies can engage in equity financing
In essence, private airports appears to have the same regulatory incentive as government airport, since
there is no change in regulations, plus the added incentives of stricter legal liability and of a profit motive.
Also, the danger of excessively high monopoly pricing may not be as great as it first appears. In the end,
airports can only charge airlines higher fees if airlines are able to pass on those higher costs to customers.

Types of Privatization
Contracting of selected services
Long-term lease approach
Full divesture / sale of shares

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Chapter 7: International Aviation: Open Skies and Global Alliances

Open skies = the legal framework surrounding the rights granted to airlines, with its roots tracing back to
the original air transportation agreements between countries.
Global alliances deal with the arrangements that airlines have made with one another to expand their
scope on a global basis.

History of International Aviation Agreements


The first international agreement concerning air transportation occurred shortly after the end of the First
World War in Paris. Delegates from the 26 countries drew up the Convention Relating to the Regulation
of Air Navigation. This was the first time that countries had been provided with an internationally
recognized legal authority over their airspace, enabling them to allow or disallow aviation access into
their country. Neither Russia nor the US signed the Paris Convention of 1919.

On the 12th of October 1929 the Warsaw Convention was drawn up. One of the major results was the
definition of international carriage:
International carriage = Any carriage in which, according to the contract made by the parties, the place
of departure and destination, are situated either within the territories of two High Contracting Parties, or
within the territory of a single High Contracting Party, if there is an agreed stopping place within a
territory subject to the sovereignty, suzerainty, mandate or authority of another Power, even though that
Power is not a party to this Convention.
Another outcome of the Warsaw Convention concerned aircraft liability. The air carrier is liable for: any
damage sustained in the event of the death or wounding of a passenger or any other bodily injury suffered
by a passenger, if the accident which caused the damage so sustained took place on board the aircraft or
in the course of any of the operations of embarking or disembarking.

Eventually, the Warsaw Convention was completely overhauled by he Montreal Convention of 1999,
which is the current convention governing international carriage liability. This Convention states an air
carrier has unlimited liability there is no maximum cap on the payment.

The next major international agreement was the Chicago Convention of 1944, held near the end of WWII
and hosted by Franklin D. Roosevelt. He wanted an agreement that would allow any airliner from any
country to fly to any other country with little or not restriction (open skies agreement). Few of the
delegations attending the convention backed him on his goal for open skies. Instead, the Chicago
Convention created a system of bilateral air service agreements between countries for all international
flying.

No scheduled international air service may be operated over or into the territory of a contracting state,
except with the permission or other authorization of that state, and in accordance with the terms of such
permission or authorization.
Chicago Convention, 1944
A major outcome of the CC was the creation of the International Civil Aviation Organization (ICAO)
with the objective of developing the principles and techniques of international air navigation and to
foster the planning and development of international air transport.

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Bilateral Air Service Agreements
Bilateral air service agreements controlled market access, market entry, and, in many cases, market
pricing. There are up to eight degrees of freedom that may be granted in bilateral air service agreements.
1. first freedom the right for an airline to fly over another country without landing
2. second freedom the right to make a landing for technical reasons in another country without
picking up or dropping of revenue passengers.
3. third freedom the right to carry revenue traffic from your own country to another country
4. fourth freedom the right to carry revenue traffic from the other country back to yours
5. fifth freedom enable an airline to carry revenue traffic fro their own country to another country,
and then pick up and drop off traffic from the intermediate country to a third country
6. sixth freedom allows an airline to carry traffic between two other countries by using its home
base as a transit point
7. seventh freedom allows an airline to carry revenue traffic between points in two countries on
services which lie entirely outside its own home country
8. eighth freedom allows a foreign airline to fly between two domestic points in a country
(cabotage)

The Bermuda Agreement


First bilateral air service agreement was signed between the US and UK on 11 February 1946. In 1977
this agreement was overhauled, creating the Bermuda 2 agreement.
In a bilateral agreement both countries must approve the pricing of tickets of all carriers operating
between the two countries. This double approval of tariffs is usually related to a cost plus profit
formula. The Bermuda 2 agreement also deals with other issues concerning security, airworthiness,
dispute resolutions, and customs issues; however, from both an economic and an airline standpoint, the
greatest impact of the Bermuda 2 agreement is the granting of air freedoms and route authorities.
Article 2 of the Bermuda 2 agreement grants the rights bestowed on airlines of both the UK and US.
Airlines are granted:
a) the right to fly across its territory without landing; and
b) the right to make stops in its territory for non-traffic purposes

Bilateral air service agreements, such as the Bermuda 2 agreement, place tremendous restrictions on
international travel. The general thrust of bilateral air service agreements has been to protect national
interests and provide support for national airlines. The artificial restrictions imposed by bilateral air
service agreements raise costs, create inefficiencies in the market, and allow rent-seeking behavior on the
part of favored airlines.

Open Skies Agreements


In 1992, the Netherlands and the United States signed the first open skies agreement. The general trend
in international aviation is to do away with complicated and restriction-laden bilateral agreements and
move towards open skies.
US open skies agreements generally contain eight key provisions:
1. Absence of restrictions on international route flights
2. Airline pricing should be determined by market forces
3. Clause ensuring fair and equal opportunity to compete
4. Airlines should be able to enter cooperative marketing agreements
Provisions 5-8 of the agreement contain mechanisms for dispute settlement, consultation pertaining to
unfair practices, liberal legal charter agreements, and agreements pertaining to the safe and secure
operation of flights between the two countries.
Benefits of open skies:
Airlines are able to fly more routes, leading to increased competition and lower average airfares
Carriers that are currently excluded from a market gain more than carriers that already have
extensive route rights

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Open Skies in Europe


In 1997 a single European aviation market was created. Carriers are free to fly routes throughout Europe.
National ownership has become irrelevant for intra-European flights, and this is the primary reason why
low-cost carriers such as easyJet and Ryanair have been able to expand rapidly.
Global travel from Europe is still largely dominated by each countrys respective flag carriers. This is a
result of the current bilateral agreements between individual European countries and other countries
around the world.

Open Skies in Asia


The Asia-Pacific region has not yet implemented open skies largely on account of perceived national
interests identical to those that prevented the US and Europe from liberalizing their airspace.
Probably the most ambitious economic liberalization project to occur in the Asia-Pacific region is the
multilateral open skies agreement between the ASEAN (Association of Southeast Asian Nation)
countries. All member nations would permit unlimited flights between their capital cities by December
2008 and full open skies to other cities by December 2010.

Global Airline Alliances


Although the initial global alliances started as simple code-share agreements between airlines, they have
evolved into global alliances with multiple airlines that span the globe.
Code share agreement = enables an airline to place passengers onto the flight of another carrier
1992 KLM and Northwest formed a major transatlantic alliance with a broad code-sharing agreement. In
1993 this alliance received anti trust immunity from the US Department of Transportation.

First truly global alliance was formed in 1997 between United, Lufthansa, SAS, Air Canada, and Thai
Airways. This was called the Star Alliance.
The OneWorld Alliance was founded in 1998 and comprised of American, BA, Qantas, and Cathay
Pacific; and the Skyteam Alliance, originates from 1999, originally between Delta, Air France, and
Aeromexico, later including KLM amongst others.

Benefits of Global Alliances


-The major benefit of global alliances to the airlines and consumers is an expanded and optimized route
network
-Global alliances provide a traveler with greater flight options and help make the travelling experience
more enjoyable.
-Another major benefit of global alliances is cost reduction in maintenance and operational activities as a
result of bulk purchasing and sharing of resources.
-Airports are another area in which alliances are looking to reduce costs. Alliances are seeking to host
operations all under one roof.
-Having a strong global presence also enables the alliances to obtain global corporate travel agreements
for corporations requiring global travel.
-The final benefit frequent travelers enjoy is the fact that global alliances enable travelers to accrue and
redeem miles on a variety of airlines.

Disadvantages of Global Alliances


-Cost in bringing information technology system in line with other alliance members

The awareness of international air service agreements and the push for open skies is critical to the
evolution of international aviation, while global alliances enable airlines to exploit international
opportunities.

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Chapter 12: Low-cost, Start-up Airlines: A New Paradigm

The roots of the low-cost carriers can be traced back to 1971 when founder Herb Kelleher mapped out the
route and cost structure for Southwest Airlines.

Following deregulation in the US, many new airlines entered the market, causing airfares to plummet 40
per cent in real terms between 1978 and 1997, and more than doubling the number of passengers. Despite
a huge demand for low cost travel, many low-cost carriers have failed. Predictably, the remaining low-
cost carriers have been those with the lowest cost base.

Major carriers often attempted low-cost subsidiary airlines and all failed. In Europe, KLM divested itself
of Buzz while British Airways did the same with its low-cost carrier Go. Many airlines that tried to
imitate the low-cost model never truly adopted it. They tried to establish the LCC with much of their
existing cost structure, inevitably leading to failure.

Characteristics of Low-cost Carriers


There are a number of general characteristics all LCCs exhibit:
Lower labor costs per hour of productivity
Lower ticket distribution costs
No-frills service pay as you go approach.
Common fleet type reductions in maintenance spare part inventories, flight crew training
expenses and increased operational flexibility. Airplanes configured high density/all-economy.
Origin and destination route structure since deregulation, legacy carriers adopted a hub-and-
spoke structure. Hubs are extremely expensive and one of the main cost benefits underlying the
hub is the ability to realize economies of scale. Many hubs in the US have overcapacity and this
had led to diseconomies of scale. This is the reason LCCs operate on a point-to-point structure.
Use of secondary airports congested primary airports usually mean more time on the ground
and higher airport fees, so are avoided where possible.
Increased aircraft utilization since an aircraft does not make any money on the ground, the more
an aircraft is flying the more it can carry passengers. LCCs focus on short turnarounds and flying
longer routes to accomplish maximum aircraft utilization.

Cost Structure Comparison


In the modern competitive aviation world the most successful airlines are those with the lowest cost
structure. New generations of aircraft used by LCCs are much more fuel efficient so that fuel costs are
decreased, resulting in an overall decrease in CASM compared to some of the older types used by legacy
carriers.

In general, LCCs have been able to achieve lower operating costs. Looking at the cost structures it shows
that LCCs have financially outperformed legacy carriers since 2000. In particular, LCCs have been much
more successful in terms of operating profit and profit margin than the legacy carriers, and one of the
main reasons for this has been their lower cost structure.

LCCs also acquire a greater proportion of their revenues from passengers than from other sources. This is
largely because, unlike legacy carriers, many LCCs carry no additional cargo on their flights. LCCs spend
less of their total operating expenses on personnel than do legacy carriers. This is probably caused by
legacy carriers both having more staff on their flights and paying their employees more. Finally, LCCs
spend a greater proportion of their operating expenses on fuel and maintenance in comparison to legacy
carriers.

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Incumbent Response to Low-cost Carriers


Legacy carriers have implemented two major strategies to combat low-cost carriers: the creation of their
own LCCs and unilateral cost cutting.
-LCC creation by legacy carriers has largely failed in both North America and Europe. Part of the
problem lies in the operation never truly being low-cost, especially with regard to labor costs. The legacy
carriers were also very concerned about the new operator reducing their own core business.
-Cost-cutting has entailed legacy carriers unilaterally cutting costs of mainline services, such as on-board
food, charging for in-flight amenities (blankets, pillows, entertainment). Legacy carriers have also
attempted to reduce their cost structures by retiring older aircraft, receiving labor concessions, and
reconfiguring aircraft seating layouts. In general however, this response to LCCs has largely been
ineffective.

Future of Low-cost Carriers


The LCCs that have been successful up until now have focused solely on reducing costs and being
efficient. The future looks promising, since the line between an LCC and a legacy carrier is blurring. On
the other hand, LCCs will face tremendous competition from legacy carriers and LCCs alike. When
markets reach saturation, LCCs need to find new destinations to achieve growth. The last domain for
legacy carriers has been international flying. Legacy carriers currently do not face fierce competition
from LCCs in this domain yet, principally because of international air treaty regulations and the fact that
international flying diverges from the low-cost model.

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Air Transport Economics

Summary of Articles

Article 1: Transatlantic Airline Alliances: Competitive Issues and Regulatory Approaches


Author: United States Department of Transportation

Summary of Content

Introduction
The primary goal of this research project is to foster a common understanding of the transatlantic airline
industry among the United States Department of Transportation and European Commission staffs as a
basis upon which to build compatible regulatory approaches to competition issues in the airline sector.
The most important conclusion is the remarkable similarities between competitive structures in the airline
industries of the EU and US and similarities in the trends that continue to shape them.

The project related only to passenger transport. Research was carried out in two phases:
1. qualitative phase included meetings with EU and US carriers
2. quantitative phase was an econometric assessment of the Passenger Origin-Destination Survey
data collected by DOT.

Background
-The US airline industry was deregulated by Congress in 1978. The completion of the last provision of
the Third Package of reforms in the EU was completed only in 1997, nearly two decades after passage
of the Airline Deregulation Act.

-Following deregulation, the EU industry quickly evolved to closely resemble the U.S. in several
respects: 1. Legacy carriers in the EU achieved cost-efficiencies as they were privatized and quickly
moved to restructure their businesses by adopting a hub-and-spoke model.
2. LCCs quickly appeared in the EU, opening new markets and entering established intra-
EU markets of the legacy carriers.

-Despite differences in EU and US airline industry evolution, similar competitive dynamics have led to
remarkably similar competitive structures. Both industries are largely divided into: pre-deregulation
legacy carriers, and post-deregulation no-frills, or hybrid low-fare carriers, on the other hand.

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The development of alliances


-The largest US legacy carriers in existence today are relatively new to their European counterparts. The
European carriers, which were prohibited from access to the domestic US market, initially wanted to
protect their competitive positions restricting traffic rights for flights to and from the member states.
Ultimately, EU legacy carriers turned to code-share and marketing alliances to adjust to the changing
competitive landscape.

-Post deregulation, the legacy carrier business model on both sides of the Atlantic is predicated on a
from anywhere to everywhere consumer proposition. To meet the demands of customers, carriers must
seek commercial partners that can help them provide greater network coverage and increased service
options.

-To remain competitive, legacy carriers have two main challenges: expanding their global networks,
which are an important comparative advantage versus LCCs, and making their overall costs more
competitive with the growing LCC sector.

Existing forms of cooperation


-Reasons for cooperative arrangements for air carriers are: achieve a better network reach, seek to
minimize risk exposure, and/or share in the risk of launching new routes or creating IT projects.

-Tactical alliance agreement can be formed to address a specific deficiency in an airlines network.
Tactical alliance agreements typically involve only two carriers and cover a limited number of routes,
principal objective is providing connectivity to each carriers respective networks.

-The global alliances consist of Star Alliance, SkyTeam and oneworld. Members of the global alliances
coordinate on a multilateral basis to create the largest possible worldwide joint network. The trend
towards joining a global alliance may not necessarily represent consolidation or reduced competition in
the aviation industry. Instead, the competition analysis should distinguish between the degree of
integration within the existing global alliances and the likely competitive effects.

-To address these challenges, legacy carriers broaden and deepen their global network integration with
alliance partners. The advent of significant LCC competition on transatlantic routes would put further
pressure on legacy carriers business models. The core members of the global alliances have deepened
their cooperation by launching highly integrated JVs. Their stated goal is to become effectively
indifferent to which plane or metal carries a passenger, i.e. they seek metal neutrality in their
cooperation.

Reasons for carriers to join global alliances


-Link networks of routes and sell tickets on the flights of their commercial partners, offering travellers
access to hundreds of destination worldwide on a single virtual network
-Wider brand recognition, familiarizing customers with an individual brand through the association with
the global alliance brand.
-Improve access to feeder traffic of alliance partners particularly important for long-haul operations.
-Better address the needs of corporate customers, by covering more destinations and providing better
connections
-Possibility of jointly financing expensive and long-term projects, such as IT development projects.

Trends in global alliances


-Increased breadth in cooperation alliances recruit new members to fill white spots in their networks.
In doing this alliances balance the trade-off between, an increment in global network and increased
revenue synergies and, the risk of inefficiencies due to increased alliance size.

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-Increased depth in cooperation means establishing a JV within a global alliance. Presently there are no
plans in the public domain for the creation of a fourth global alliance.
-The current LCC model, targeted at cost minimization, appears inconsistent with the complexity of a
global alliance.

Developments in regulatory environment


-Traditionally, international air services around the world have been governed by bilateral agreements
between sovereign states, as foreseen in the Convention on International Civil Aviation signed at Chicago
on 7 December 1944.Slowly but surely, reform of the regulatory framework is occurring.

-In the US, DOT launched an initiative in 1992 to negotiate open-skies agreements that would be more
responsive to the dynamic changes in the global aviation industry. The US currently has more than 90
open-skies partners.

-In Europe, the open skies judgments of 5 November 2002 of the Court of Justice of the EU laid the
foundation of liberalization of international air services at EU level. The open skies judgments meant that
member states cannot solely negotiate international air service agreements. Secondly, the judgments ruled
that Member States may not reserve benefits in such agreements to their national carriers alone.

-A major step towards US-EU liberalization was market with the first negotiations and provisional
application in March 2008 of the EU-US Air Transport Agreement. This agreement introduced new
commercial freedoms for EU and US airlines and a unique framework for regulatory cooperation in the
field of transatlantic aviation.

-The European nationality clause in the agreement provided all EU-established airlines with a right to
operate services to the US from any point in the EU, including outside their home member state. The
most immediate effect of the EU-US Air Transport Agreement was to introduce more competition in
transatlantic markets. Another result of the agreement was to formalize cooperation on competition
matters between the Commission and DOT.

-On 24 June 2010, a protocol to amend the first-stage EU-US Air Transport Agreement was signed and
entered into provisional application. Since ownership and control restrictions will remain to limit the
freedom of carriers to merge and given that alliances result in significant benefits for carriers, global
alliances and immunized JVs seem likely to continue to play an important role in transatlantic markets.

US antitrust regime for international airline alliances


-DOTs decision determining whether an application deserves an ATI is based on a rigorous two-step
analysis required by statute. First, DOT must determine whether to approve the alliance agreements.
These agreements are that the alliance: 1) must meets a serious transportation need or meet public
benefits; 2) those benefits cannot be met or achieved by reasonably available alternatives.

-If these agreements are approved, DOT undertakes a second step, in which it decides whether to grant
ATI. DOT may, however, grant ATI if: 1) the parties to such an agreement would not otherwise go
forward without it, and 2) DOT finds that the public interest requires a grant of ATI.

EU regime for alliance review


-The College of Commissioners groups together the Commissioners in charge of all EU policies,
including competition, transport, energy, and environment. As the enforcer of EU competition rules, the
Commission may initiate an alliance investigation on its own initiative if there are concerns that the
cooperation may infringe EU competition law or as a result of a complaint.

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The main EU competition rules are laid out in Articles 101 and 102 of the Treaty on the Functioning of
the European Union TFEU.

-Article 101: TFEU prohibits all agreements between undertakings and concerted practices which may
affect trade between Member States and which prevent, restrict or distort competition within the internal
market. An agreement which restricts competition escapes the prohibition under Article 101 TFEU if it
creates sufficient benefits meeting the criteria of Article 101(3) TFEU.

-Article 102: TFEU prohibits the abuse of a dominant position within the internal market or a substantial
part of it. Abuses are commonly divided into exclusionary abuses, which exclude competitors from the
market, and exploitative abuses, where the dominant company exploits its market power by, for example,
charging excessive prices.

-On 1 May 2004, there were two fundamental changes to EU competition regime. The first change was
specific to air transport, namely the Commission obtained jurisdiction as of that date to investigate air
transport services between EU and third countries in accordance with the generally applicable procedural
framework. The second change was of broader application, as Member State courts and national
competition authorities obtained the power to apply in full Article 101 TFEU.

Comparison of approaches to aviation in the EU and US


-There are a number of fundamental differences in the regulatory approaches, which manifest itself in
four areas: a) competition regime applicable to aviation
In the US the approach is one of regulatory exception. DOT and DOJ work together to assess the
competitive effects of international airline alliances. In the EU there are no sector-specific competition
rules in aviation and the same Commission department (the Directorate General for Competition) is
charged with the application of EU antitrust and merger rules.
b) mandates of the respective competition authorities
DOTs authority is limited to the transport industry while the Commission has the authority to enforce
competition rules across all industries. Furthermore, DOT has both specific competition powers and the
authority of a general regulator and policy maker in the US transport industry. The Commission is split
up regarding these competences, into the Directorate General for Competition responsible for EU
competition rules, and the Directorate General for Transport and Mobility responsible for general
transport policy.
c) tests for competition review
The legal test applied by DOT is a broader test of public interest under its statutes.
d) procedural differences
In the US, the process of reviewing and making a decision on ATI application occurs before alliances are
implemented. In the EU, after 1 May 2004 there is no possibility for carriers to notify agreements to the
Commission for approval. Carriers must themselves conduct an assessment of whether their cooperation
is in breach of EU competition rules.

Market definition
Both DOT and the Commission consider supply-and demand-side substitution important to market
definition. Demand-side substitution usually plays a determining role.

Barriers to entry
The commission and DOT have largely consistent approaches to the analysis of barriers to entry. The
main potential barriers to entry typically considered by the competition authorities are:
limited availability of airport slots at either or both ends of a city-pair
frequency advantage of the parties
strength of the parties position at their hub
All of these barriers are particularly important on hub-to-hub routes.

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Competitive assessment
The competitive assessment is likely to differ by route.

Efficiencies and consumer benefits


Under EU competition rules, the Commission conducts an analysis of possible negative competitive
effects of a transaction. DOT, on the other hand, must weigh the potential efficiencies or benefits before it
can make a grant of ATI.
-The authorities also treat out-of-market efficiencies differently. The Commission considers, as a general
rule, that negative effects and efficiencies should be weighed within one and the same relevant market.
DOT, on the other hand, views efficiencies in a broader context. DOT may consider efficiencies that are
possible not just in the relevant market, but also in other markets subject to the parties cooperation across
the network.

Primary benefits of integrated alliances

Supply Side Demand Side


-Economies of scale -Fare combinability carriers seek to maximize the
-Travellers receive more flight options and better revenue of the network; metal neutrality.
timing of itineraries -Better schedules, optimizing traffic flows
-Reduction of double marginalization -More seamless customer experience
-Frequent flyer program integration

Conclusions and next steps


Analytical approaches to airline competition matters of the Commission and DOT are already largely
compatible. Both recognize the importance of continued discussions, the importance of continuous
cooperation on remedies to avoid conflicting or unnecessarily duplicative remedies in case of parallel
reviews of the same transactions.

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Article 2: The Growth Limits of the Low-cost Carrier Model


Authors: de Wit, J., Zuidberg, J., (2012).

In the context of the route density problem, a particular hubs viability can be defined within upper and
lower boundaries. At the lower boundary, the hub O&D markets minimum size and prosperity is
required to guarantee the relatively high yield from direct air services at the hub as compensation for the
lower yield from the indirect air services provided to transfer passengers.

Low cost carriers emerged following deregulation of the US domestic market and liberalization of the
European market. Full service carriers themselves have accommodated the rise of the LCCs by
concentrating their operations on hub airports, which enabled LCCs to bypass the hubs and avoid
constraining connections.

LCCs have been able to cope with route density problems by generating new demand. An end to this
network expansion may become visible, even if costs are rigorously kept down. LCCs are seemingly once
again confronted by increasing route density problems.

The level of concentration is higher in the US LCC-market than in the EU LCC-market.

LCCs often start their services from secondary airports. LCCs try to widen their catchment areas and
increase their market shares by offering flights at lower fares. These secondary airports may also
contribute to the LCCs low cost structure, as the LCCs subsequently benefit from preferred treatment,
quick turnaround times and negligible airport charges. These secondary airports are unattractive to time-
sensitive business passengers. In the future, air services to common destinations served at these
neighboring airports will increasingly start to cannibalize each other, thus marking the end of possible
future growth.

LCCs in both the US and EU show declining average frequencies on their routes. This indicates that
unnerved, larger city pair markets seem to be hardly left, forcing LCCs to focus on thinner markets with
accordingly lower frequencies. In short, the market is becoming saturated and route density problems
become more and more predominant.

LCCs such as Ryanair must ultimately concentrate on larger airports to achieve future growth, and
consequently Ryanair will become a more direct competitor of Easyjet.

A random connect system between a LCC and a hub carrier, instead of focusing solely on point-to-point
system operation, may result in more substantial feeder flows from unique LCC routes at that hub airport.
This is also the case if codesharing agreements are concluded between LCC feeders and network carriers
at major hubs, such as those that exist between WestJet and Air France-KLM. Southwest has already
taken substantial steps in the direction of hubbing. The additional transfer passenger flows partly solve
the route density problem of the point-to-point LCC.

LCC business model analyses usually focus on cost reductions and cost structure; however, there is one
LCC characteristic that clearly manifests itself in the revenue structure: ancillary revenues. By offering
unbundled low air fares, airlines can attract price-sensitive passengers to their secondary airports from
even greater distances, and can more effectively compete against the network carriers for higher yield
passengers at the major airports.

Charging for optional services leads to additional revenues, as well as some cost reductions. The main
reason why both LCCs as network carriers make greater use of a pricing strategy incorporating
unbundling of air fares, is that airlines primarily compete on their base ticket fares. These tickets fares are
compared by consumer when deciding which flight to purchase. The proliferation of add-on fees can be

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regarded as a loss leader strategy, and on the other hand as the reason why search costs substantially
increase , since the fees for the majority of optional services are only available through the airlines
websites.

The longer the route distance, the more route density becomes a constraint. Still, some of the short-haul,
low cost model advantage, such as seat density and aircraft utilization, are not transferable to long haul
operations. The relative cost advantage of a no-frills operation for long-haul flights is perhaps 20%, while
the advantage in short-haul markets is 50% or more.
Development of ancillary revenues may have a growing impact on the sustainability of long-haul, low-
cost models.

The next expansion step for LCCs, with route density ever increasing, is to more intensely tap into the
transfer markets. Route density in EU O&D markets will ultimately limit the growth perspectives for
LCCs in Europe. The indications point toward decreasing average frequencies and increasing average
route distances. The route density constraints that stem from this will likely lead to a slowdown in organic
LCC growth over the next few years, forcing LCCs to adopt other business strategies for future growth.
This can include: -shifting to primary airports
-starting hubbing activities that enable passengers to transfer to another flight
-signing codeshare agreements
-entering alliances
-acquiring other airlines

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Article 3: Temporal Configurations of European Airline Networks


Authors: de Wit, J., Burghouwt, G., (2005).

The deregulation of US domestic airline industry resulted in the reconfiguration of airline networks into
hub-and-spoke systems. Airlines in Europe already operated spatially concentrated networks long before
deregulation. This was the outcome of bilateral traffic rights designated to the national carrier. The
deregulation of the EU market stimulated a second phase of airline restructuring. European airlines
concentrated their networks by adopting or intensifying wave-system structures in their flight schedules.
Temporal concentration trends exist among European airlines with deregulation resulting in the adoption
or intensification of wave-system structures by airlines. Airline hubs with wave-system structures
generally perform better because of the increased indirect connectivity given the number of direct
connections.

The EU aviation market has gradually been deregulated in three Packages of measures in 1987, 1990,
1992. Airlines took advantage of the possibilities of a liberalized market and reorganized their networks.
A number of trunk carriers reorganized from point-to-point into hub-and-spoke networks. Direct flights
from medium-to-medium sized airports were replaced by indirect flights via a central airport or hub.

Spatial concentration and temporal configuration are the two main features of the hub-and-spoke network.
The hubbing carrier concentrates its network spatially around one or a small number of hubs. Regarding
temporal concentration, the airline operates synchronized, daily banks of flights through these hubs. The
aim is to optimize the number and quality of connections offered.

When US airlines adopted hub-and-spoke networks, spatial reorganization of networks went hand in hand
with the reorganization of airline flight schedules. European networks were already radially organized in
space before deregulation because of bilateral air service agreements (ASAs).

Temporal concentration and spatial concentration are the two main features of the hub-and-spoke
network. Spatial configuration is the level of concentration of an airline network around one or a few
central hub airports. Temporal configuration of an airline network is defined as the organization of the
airline flight schedule at an airlines station resulting in a given number and quality of indirect
connections offered through that airlines station.

A wave-system structure consists of the number of waves, the timing of the waves and the structure of the
individual waves. Three elements determine the structure of a connection wave:
1. the minimum connecting time for continental and intercontinental flights
2. the maximum connecting times
3. the maximum number of flights that can be scheduled per time period

Connections have to meet the minimum connecting times. Then, a trade-off has to be made between the
maximum allowable connecting time for the airline and the maximum number of flights that can be
scheduled in a time period.

In reality such an ideal picture is unlikely to exist, due to a number of disturbing factors:
-spokes located to close or far away, and are located off-wave
-strict scheduling may jeopardize fleet utilization
-environmental constraints may be an obstacle for airlines to fit all flights in the wave-system
-in strong O&D markets, it may be attractive to schedule a number of flights off-wave
-incoming and outgoing European banks can overlap
-airline might simply choose not to adopt a wave-system structure

The attractiveness of an indirect connection depends on:

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waiting time at the hub
routing factor
perception
fares
flights of a certain airline might be favored (loyalty program)
amenities of the hub-airport involved in the transfer

The focus in quantifying the effects of the configuration of the airlines flight schedule in terms of
indirect connectivity, is on waiting time and flight time. The ideal connection wave is the benchmark for
this analysis. Indirect connectivity is the number and quality of the indirect connections generated by the
existing flight schedule.

An actual wave-center can be identified when the waves for incoming and outgoing flights coincide
almost completely.
The weighted connectivity of an indirect connection depends on both the quality of the connection at the
hub and the quality of the indirect flight compared to the direct flight.

Recently, at smaller airports regional hub strategies have emerged. The introduction of regional jets has
facilitated the growth of these niche hubs. They can only be successful if they can serve a niche market
not covered by the major hubs.

Analyzing the sub-markets, we can divide the airline hubs roughly into four categories:
1. the all-round hubs
2. the specialized hubs
3. the European hubs
4. the directional or hourglass-hubs

More and more indirect intra-European services will be replaced by point-to-point services because of the
introduction of more efficient regional aircraft, the growth of low-cost carriers and the extension of the
high-speed rail network. On the other hand, European hubs suffer from large routing-factors because of
the short in-flight time compared to the direct flight-time and the transfer-time at the hub.

European airlines have increasingly adopted wave-system structures or intensified the existing structures.
The number of airline hubs with a wave-system structure doubled during the period of analysis.

Wave-system structures have the objective to maximize the number of connecting opportunities within a
limited time frame given the number of direct flights. Wave-system structures indeed seem to have a
positive impact on the total indirect connectivity of a hub airport.

Conclusions
After deregulation of the US market, airlines adopted hub-and-spoke networks to benefit from cost and
demand-side economies as well as to deter entry.

The networks of major EU airlines were already concentrated around a limited number of central airports
at the beginning of deregulation because of the extant system of bilateral air service agreements that
required airlines to only operate from their national home base. Consequently, spatial concentration
measures are not sufficient to analyze hub-and-spoke network operations in Europe; the temporal
configuration of airline networks also has to be analyzed.

A trend towards increasing temporal concentration is clearly detected. Wave-system structures were
implemented or intensified at the major hubs during 1990-1999. Especially the major airlines and some
niche-carriers have followed this hub-and-spoke strategy. Smaller airlines as well as new entering low-

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cost airlines are focused on )&D traffic and do not play a significant role in the market for transfer-traffic.
The increase in wave-system structures has stimulated the number of connecting opportunities at hub
airports. It has been shown that airports with wave-system structures generally offer more indirect
connections than airports without a wave-system structure, given a certain number of direct flights.

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