Read the attached case study on the airline industry. Is this a competitive industry in your opinion? Explain your answer.

US Airline Industry

The domestic US airline industry has been intensely competitive since it was

 

deregulated in 1978. After 

deregulation

, the incumbent carriers felt the most pain as newer airlines with lower cost structures entered the market to compete head-on with the established airlines. There were several bankruptcies followed by a wave of consolidation with the fittest carriers surviving and the rest being acquired or going out of business. To determine the profitability of the airline industry, the following industry analysis using Porter’s five-forces framework has been carried out. This industry analysis helps in the understanding of the size of the Potential Industry Earnings (PIE), and how much of this the different participants can extract.

Rivalry among Existing Competitors
There is intense rivalry among different airlines. In the pre-deregulation days, airlines competed mostly on things like service, meals and in-flight movies as prices were regulated by the Civil Aeronautics Board (Regulating body). After de-regulation, rivalry among competitors  has taken on the form of severe price competition, with airlines ruthlessly undercutting each other with fare promotions.

There are a number of airlines making the airline industry fairly crowded. Even though the 3-firm 

concentration ratio

 in 1992 was 50%, and the 8-firm concentration was 92%, the fact that the airlines competed on price made the industry much more competitive than the numbers might suggest.

The service the airlines sell (air transport) is pretty homogenous, and there is not much product (in this case, service) differentiation. The major differences between the services offered by different airlines include the total time spent on an airplane and the number of connections. While time-sensitive business travelers may prefer shorter, direct flights, most leisure travelers don’t see this as a big differentiator when the price is factored in.

Buyers (both business as well as leisure travelers) have low 

switching costs

 and there is very little relationship-specific investment that travelers make. Although the airlines made an effort to create customer loyalty by offering frequent flyer programs, most of the 

competitive advantage

 this provided was quickly eroded by almost all airlines offering such programs. Moreover, leisure travelers are motivated to shop around for the best price.

The airline industry is also characterized by very high 

fixed costs

. The majority of the operational costs (labor, landing fees, cost of aircraft etc.) are fixed regardless of how full the planes are, and the marginal cost of adding an extra passenger is almost negligible (just the cost of food plus an insignificant amount of extra fuel). Thus, on the margin, every extra seat sold contributes directly to the bottom line. This motivates airlines to undercut each other till price approaches marginal cost.

Intense competition also lead to excess seat capacity in several markets. This, combined with periods of declining demand because of macro-economic factors, and the high fixed costs and low marginal costs make the airline industry very price competitive. Things like access to Computer Reservation Systems and innovative pricing coupled with yield management were competitive advantages for a little while before they become a staple of being in business as an airline.

Entry into the Market

Entry into the domestic airline industry is relatively easy since there are no significant barriers to entry. Inputs such as aircraft maintenance, food service, ground services, reservations etc., could be outsourced. Airplanes could be leased, thereby defraying large initial capital investments, and rights to use gates could be leased at market rates. The main consideration for profitable entry seemed to be the ability of airlines to fill their airplanes above the breakeven point. In an industry fraught with price competition, brand identity and reputation did not have significant value either.

In the airline industry, exit costs are not very high either. Planes could be easily redeployed to other markets, or sold off, and gates and landing rights could be sub-leased to other carriers.

Substitutes

There are a number of substitutes to air travel, especially over short distances. These include taking other modes of transportation such as driving, taking the train etc., or not traveling at all. The use of technology (like WebEx, NetMeeting, video-conferencing etc.) that facilitates remote virtual collaboration is becoming a good substitute for business air travel as well.

Supplier Power

The primary inputs to the airline industry include airplanes, labor and fuel. There are only two major manufacturers (three at the time of the case – Boeing, Airbus and McDonnell Douglas) for large commercial aircraft. This, along with the relationship specific investment that the airlines make in the form of trained mechanics, existing stock of aircraft etc., is likely to give the aircraft manufacturers some supplier power. A mitigating factor for this supplier power is the lumpy nature of aircraft sales, where there are a few high-value orders placed by airlines with deliveries spanning several years. Labor such as pilots, cabin crew, ground personnel, gate agents etc. are typically unionized and have some bargaining power. Aviation fuel is a commodity and its prices are determined largely by market forces and geo-political factors.

 

Buyer Power

The power that airline customers have varies based on the options available to them and the origin-destination city pair. As the General Accounting Office report in 1989 found, fares were 27% higher in monopoly or 

duopoly

 hubs than at competitive airports. Sophisticated yield management techniques and competitive pricing have allowed airlines to extract significant consumer surplus in smaller remote markets where travelers don’t have much choice and for direct long-haul flights that are preferred by business travelers. Even though there are pockets where some airlines have pricing power, the overall airline industry in characterized by significant buyer power stemming from the intense price competition among airlines.