Jan 06 – Q11 – The Low Cost European Airline Market

(a) Explain why a low cost airline company such as Easy Jet ‘typically
generates all its profits’ in the second half of the year (line 6). (4 marks)

The demand for air travel is seasonal, with more customers wishing to fly during the
summer and Christmas periods (1). Therefore, demand at these times becomes very
price inelastic, so airlines can easily raise their fares and generate higher revenues (1).

These firms also have high fixed costs such as aircraft maintenance (1), which remain
constant throughout the year despite any surge in demand (1).

With rising revenues but fairly stable costs, profits rise rapidly during the second half of
the year.

(b) With the aid of an appropriate cost and revenue diagram, analyse the
reasons that might explain Alitalia’s ‘large financial losses’ (line 8).
(8 marks)

C/R AC2
MC

AC2
> LOSS
P* AC1
>
AC1 SNP

MR AR (4) for diagram

Q* Output

Due to increased competition in the market, some customers have left Alitalia and
gone to its new rivals (1), so revenues have fallen and the AR curve has shifted to the
left (1).

Due to the sharp rise in fuel costs, from less than $200 per tonne in 2001 to more than
$500 per tonne by the end of 2004 (fig.2), there has been an increase in total costs (1).
Hence an upward shift of the AC curve, to the point where AC > AR, thus generating
losses for Alitalia (1).
(c) Examine the extent to which the low cost airline market has achieved
economic efficiency. (8 marks)

Productive efficiency is where long-run average costs are minimised, and occurs at any
level of output where AC = MC (2). This has arguably not been achieved in the low cost
airline market as line 14 states that there is excess capacity (1).

However, falling airline prices should act as an incentive to cut costs, thus bringing the
market closer to productive efficiency. Indeed lines 15-16 state that a period of
rationalisation and consolidation is inevitable (2).

Allocative efficiency is where society gets the optimum mix of goods and services in the
highest possible quantities, at which point P = MC (2). This may have been achieved as
there is a huge choice of over 50 low-cost carriers in Europe and very low prices (1).

On the other hand, AE may not have been fully achieved, since there are still “firms
poised to enter the low-cost market”. Hence there is scope for yet greater choice and
lower prices in the future (2).

(d) Examine the ability of Easy Jet and Ryanair to survive the pressures of
‘lower air fares and increased competition’ (line 17). (10 marks)

Both Easy Jet and Ryanair benefit from economies of scale, where their higher output
gives them a lower average cost than many of the new rivals entering the market
(perhaps due to bulk purchase discounts on jet fuel) (1). This will enable both firms to
cut prices in order to defend their market shares against incoming rivals (1).

The two firms also have strong brands due to their heavy advertising expenditure. This
creates customer loyalty and makes demand for their tickets price inelastic (1). So only
a small number of their customers will defect to cheaper rivals, leaving most of the
firms’ market shares intact (1).

Finally, both firms have established route networks making it easier for passengers to
visit the more popular holiday destinations at a convenient time slot (1). Conversely,
new rivals may have to take inconvenient and longer routes, making Easy Jet and
Ryanair the more attractive option (1).

Overall, economies of scale is arguably the most significant factor. As this is the market
for low-cost airlines, price competitiveness will be more important than branding for
most consumers. However, branding is still important and perhaps the second most
important factor, as some passengers will prefer to fly with a trusted airline that has a
good safety record. The established route networks are the least significant factor, as
consumers have long been accustomed to inconvenient routes as an acceptable price to
pay for a cheap air fare (4).
(e) Assess the extent to which the European airline industry is contestable.
(10 marks)

A contestable market is one with no entry / exit barriers due to an absence of sunk costs.
This leads to ‘hit and run’ competition whenever there are supernormal profits to be
made.

The extract states that firms have exited the industry (paragraph 2). Yet despite this,
new firms are poised to enter the industry to compete for the supernormal profits being
made by the incumbents (paragraph 3). This ease of entry and exit suggests the market
is contestable, to the extent that over 50 low-cost carriers presently compete in the
industry (3).

It is also arguable that the biggest fixed cost (i.e. airplanes) need not be a sunk cost. As
there are so many new firms wishing to enter the industry, there will be a strong second
hand market in planes, so exiting firms can easily sell their planes to recover some of
their fixed costs. This also makes the market more contestable (3).

On the other hand, there are strong brands like Ryanair and Easy Jet in the industry. A
new firm wishing to compete with these brands will need to spend millions of pounds on
an advertising campaign in order to develop enough customer loyalty. These advertising
costs are irrecoverable – i.e. a sunk cost that makes the market less contestable (3).

However, perhaps branding is not so important in the low-cost airline market, where
price competitiveness is more attractive to customers than non-price factors. So long as
some level of advertising is done to communicate the new firm’s low prices – e.g. using
a cheap medium like the internet – it is arguable that marketing will not be a significant
sunk cost (2).

Furthermore, we may question whether perfect contestability itself is a desirable

attribute for the airline market. With the threat of terrorist attacks and the potential for
air accidents, safety and security are of paramount importance. Yet if supernormal
profits were always competed away, there would be a temptation to cut these costs (e.g.
by hiring fewer staff to check bags, buying cheaper airplanes, etc), leaving customers
vulnerable to fatal risks and undermining allocative efficiency (2).