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Summary of Introduction to Air Transport Economics by Vasigh, Fleming and Tacker (2010).
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.
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.
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.
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)
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.
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.
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.
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.
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
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.
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.
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.
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.
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.
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.
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.
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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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.
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).
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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
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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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.
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.
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.
Types of Privatization
Contracting of selected services
Long-term lease approach
Full divesture / sale of shares
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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.
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)
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.
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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.
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.
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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19
Air Transport Economics
Summary of Articles
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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-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.
-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.
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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.
-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.
-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.
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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.
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.
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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.
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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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
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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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