Term Paper on "Economic Profile"

Term Paper 7 pages (2335 words) Sources: 7 Style: APA

[EXCERPT] . . . .

Economic Profile of the Airline Industry

The economic environment of the airline industry is a difficult one in which to operate. The industry is faced with stiff competition, high fixed costs, low differentiation, easy availability of substitutes and low cost of switching. As a result, few airlines are able to maintain consistent profitability.

Airlines are typically highly-leveraged. This makes them very sensitive to externalities. They tend to see cyclical profitability. In times when externalities are generally positive, they make healthy profits; in times where externalities are generally negative, most airlines will lose money.

Wage inequality is a major factor in airline operations because employees represent a high fixed cost for most airlines. In addition, they represent the service component of an airline's operations, which is one of the few areas where an airline can truly differentiate itself.

Lastly, monetary and fiscal policy impacts the airline industry in two key ways. First, these policies help to shape the economic environment. Airlines are highly sensitive to changes in the economic environment, which means that fiscal policy plays a significant role in the overall success of the industry. Another key factor is that the government is often involved in providing direct monetary support for the industry, and the degree to which a government is willing to do that will help to determine the industry's success.

Elasticity of Supply & Demand

Elasticity of demand in the airline industry is driven by three main factors - intense competition, low product differentiation and ease of entry. These factors result in price competition. Consumers have become conditioned to select airlines based on just a handful of factors, price being the most predominant.

One of the main ways in which airlines compete is through routes. The most popular routes will have the highest load factors. However, many U.S. markets are served by multiple airports (five in the New York City area, for example). The secondary airports will charge lower landing fees to the airlines. This enables new competitors to challenge even the strongest routes of established airlines by using these secondary airports to serve a given market. Some secondary airports eventually become major airports (Newark and Fort Lauderdale, to name a pair). The result of the use of secondary airports is that it allows small airlines to enter the market easily. They do not have the best airports, but they have the cheapest airports, and this encourages them to compete on the basis of price. Moreover, the industry's cost structure is heavily weighted to fixed costs. The marginal cost of carrying an additional passenger on a given flight is very low and each empty seat represents an opportunity cost. Therefore, airlines are better off selling that seat at any price than not selling it at all. This, too, exerts downward pressure on seat prices.

On the surface, the airline industry should not be easy to enter. The industry is heavily regulated. The costs of starting an airline are high, both in terms of acquiring the aircraft but also in acquiring landing rights. Moreover, the profitability is typically low. However, this has not dissuaded many investors from getting into the business. Airplanes are available on the secondary market to purchase or to lease, which lowers the costs. Many airlines are started by players with experience in the industry, who therefore have the expertise to navigate through the layers of red tape. There is a surplus of staff with airline experience on the market as well. Moreover, there is significant incentive to enter the industry because rapidly shifting growth patterns and big airline inflexibility have left many markets and routes underserved, allowing new airlines an easy way into the market. So despite substantial barriers, new airlines have been able to enter the market with some frequency.

Low product differentiation also increases price competition. There are only a handful of airline manufacturers in the world, so it is difficult to compete on the basis of the physical airplanes themselves. Service is one area where airlines can and do attempt to compete, but even service can only provide differentiation to a point. This means that price is the most logical way for airlines to compete.

Another factor that drives elasticity in the airline industry is the availability of substitutes. This is especially true of the regional airline sector. There are many modes of transportation available to personal travelers. The advantage an airline offers is speed. The consumer expects to pay a premium for this advantage but most consumers have a price threshold at which they are willing to use a slower mode of transport. Business travelers face a similar situation, except that they have even more substitutes available, in particular via electronic modes of communication and the use of courier services.

Supply elasticity in the airline industry mirrors demand elasticity. The industry is cyclical. When profits are available, the incentive to enter the industry or expand operations increases. Airlines are often faced with making their money when the opportunity presents itself, and then contracting their services when the industry enters a down cycle. This elasticity is solely based on the profits available to the industry and is a function of both demand and costs.

Costs can affect airline industry supply. High costs reduce airline's margins. Often, airline profit margins are only 1-2%, which on many flights is only a couple of passengers. This makes airlines price sensitive with regards to key inputs. A rise in the cost of a key input can eliminate an airline's margin. Therefore, upward pressures on key airline industry costs can affect supply.

One key cost is the cost of credit. For an airline to expand, it needs to increase the size of its fleet. Capital acquisitions of this nature in the airline industry are typically financed with debt. In times when the cost of debt is low, airlines are able to increase their supply easily. Conversely, airlines are unlikely to do so in times when credit is relatively expensive since the increased cost of credit erodes the available margins. Therefore airlines have high price elasticity of supply.

Impact of Externalities

Because the airline industry is highly sensitive to the economic environment, externalities both positive and negative has a significant impact on the industry.

The price of fuel is among the most important externalities. The airline industry attempts to control its impact through the use of sophisticated hedging techniques, both in the market and in the form of fuel surcharges. Fuel is one of the most significant costs for airlines. Fuel is only a variable cost to the extent that the airline can exert some control over the number of flights. The unit of sale in the industry, however, is not a flight but a seat. Once a flight leaves, each seat represents a sale opportunity either made or lost. This makes fuel costs only partially variable. To illustrate the impact of fuel prices, the airline industry has stated that losses in 2008 due to the sharp increase in fuel prices would be between $2.3 and $6.1 billion, depending on where prices go in the last six months of the year.

The overall state of the economy is another key externality in the airline industry. In good economic times, consumers and businesses alike are more apt to trade up to the higher-cost option of flying for the convenience aspect. However, in tighter economic times, both groups of consumers often decrease the amount of air travel. As a luxury item, air travel is one of the first cuts made by many consumers when faced with a slowing economy. For example, the economic slowdown caused by rising fuel prices has resulted in negative growth in business travel in the first half of this year.

The role of government is another critical externality. The government has an intense interest in the state of the industry. One on hand, the nature of the business is dangerous - failures can result in hundreds of deaths. This drives detailed safety regulations. These regulations add costs to the industry. While the long-term benefits of such regulation are obvious, changes to these regulations can raise costs, which given the thin margins on which airlines typically operate can have a significant impact on profitability.

Furthermore, security regulations can decrease demand. The airline industry's key advantage over substitutes is the speed and convenience of its service. We have seen that the security measures invoked as a response to the September 11th terrorist attacks have reduced the convenience factor for travelers, which in turn can impact demand. Remember that on many flights the profit margin amounts to just one or two passengers. Therefore any negative impact on demand, even minor, relating to increase security regulations, is felt by the industry.

Catastrophic events are another key externality for the airline industry. The September 11th terrorist attacks, for example, had a substantial negative effect on the industry. Demand decreased significantly and immediately. This put serious financial pressure on the industry, and it took several years for demand and profitability to rebound.… READ MORE

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