Economic of the Airline Industry - Research Paper Example

Economic Report of the Airline Industry By: December, 2008 0 Introduction Today, the business environment has increasingly become more turbulent, chaotic and challenging than ever before and to survive, it is vital that a firm understands the strategies underpinning the success of rival firms and try to emulate, or do something better than the rivals. Transaction costs economics and the new institutional economics have provided ways in which traditional economics model (On the assumptions of maximising behaviour by individuals) can be used in understanding the relationship between institutions and the reform process (Craciunesco 2006). Changes in investment activity, employment, and prices may be a recurring and frequent manifestation of economic development in a competitive and dynamic economy. Kanter (1995:71) on his work of "Mastering Change" argues that success in the present day business is not for those companies that re-engineer the way they do things, or for those fixing the past. According to Kanter (1995) such an action will not constitute an adequate response. This is so because success is based on an organisation's ability to create, rather than predict the future by developing those products that will literally transform the way the world thinks and view it self and the needs (Kanter 1995:71). This report looks at the industry environment of the airline industry, the microenvironment, and the global environment. This report draws primarily on Porter's interpretation of the literature on industrial organization economics to identify competitive forces. The central theme in the paper is that, if an airline company is to survive and prosper, its management must understand the implications that environmental forces have for strategic opportunities and threats. Focus on the paper is on the determinants of demand of air travel. The paper also looks at the nature of competition of the low airline industry. 1.1The Determinant of Demand in the Airline Industry According to Jayathi (2005), competition in the airline industry has been fierce since the industry was deregulated in 1978. Under the believe that through deregulation more competition would improve efficiency and reduce prices and bring overall benefits to the consumer. Jayathi (2005), postulates that, while practices like monopolies, cartels, price discrimination, are considered inefficient allocation of resources in other industries, it can actually be beneficial in the case of the airline industry in bringing about an efficient equilibrium (Jayathi 2005). All things being equal, the demand of air travel will be affected by a number of important change drivers. Using Porters five forces and the PESTLE framework the factors affecting the demand for air travels will be explained inline with the demand and supply graph. Figure 1 and Two According to Johnson et al (2005), in the macroeconomic environment changes in the growth rate of the economy, interest rates, currency exchange rates, and inflation rates are all major determinants of the overall level of demand. Adverse changes in any of these can threaten profitability in an industry. For example, Johnson et al. (2005) states that a fall in the interest rate will increase consumers desire to borrow , and consequently more financing options for air travel. Where interest rates are high, this will affect the airline industry negatively. From Figure one above, an increase in the prices of air fare tickets from D1 to D2 increases demand for air travels from Q1 to Q3. In addition, the PESTLE model further refers to technological factors as important change drivers in determining demand in the airline industry. In the post-World War II period, the pace of technological change has accelerated, unleashing a perennial gale of creative destruction (Johnson et al 2005). Technological change can make established products obsolescent overnight, but at the same time, it can create new products and processes. Thus technological change is both an opportunity and a threat; it is creative and destructive. To survive in such a turbulent environment, a company must be alert and perceptive. The development of other efficient transportation system is likely to affect the demand of air travel negatively. For example in recent years, increase in cruise ship transportation has reduced the number of air passengers on leisure travel. Another factor likely to affect the demand of air transport is the social environment. New social movements create both opportunities and threats. For example, the impact of the trend toward greater health consciousness has been immense. Those companies that recognize the opportunities can reap substantial gains. Porter (1985:4) contends that the Five Forces define the rules of competition in any industry and at the same time marks the bases for understanding a company's success. Porter (1985) went further and argues that, competitive strategy must grow out of a sophisticated understanding of the rules of competition that determine an industry's attractiveness. The researcher further claims that, "The ultimate aim of competitive strategy is to cope with and, ideally, to change those rules in the firm's behaviour." (1985: 4) and through their own strategy a firm can take hold of these five forces. Where available substitute such as rail and road transport are efficiently and effectively developed, then the demand of air transport will be affected negatively. However where the other means of transport are not properly developed it will be affected positively. It is evident from the five forces outline above that, changes in this microenvironment can have a direct impact on any one of the five forces in Porter's model, thereby altering the relative strength of these forces and with it, the attractiveness of an industry. Consequently, while factors such as terror attack, political instability, terror alerts will reduce the demand for air transport, in a stable environment, the demand will increase. The role of social groups such as climate change, environmental protection laws will reduce the demand for air travel. Another factor likely to determine the demand for air transport is socially responsible behaviour of air transport companies when compared to other system of transport. The practice of corporate social responsibility (CSR) is subject to much debate and criticism. Proponents argue that there is a strong business case for CSR, in that corporations benefit in multiple ways by operating with a perspective broader and longer than their own immediate, short-term profits". (Sacconi, 2004) "Critics argue that CSR distracts from the fundamental economic role of businesses; others argue that it is nothing more than superficial window-dressing; still others argue that it is an attempt to pre-empt the role of governments as a watchdog over powerful multinational corporations". (Bulkeley, 2001; Sacconi, 2004). Law (2006) defined social responsibility reporting (corporate social reporting)as the reporting of social accounting issues by a business. However, where a corporation is seen as responsible, the demand for its activities increases. The burning of fossil fuels and other human activities producing green house gases has also drawn the attention of the scientific and international community to what has become known as global warming. In the list of potential damages of global warming, the negative effect on the world's agriculture stands out as the most important. The list of these problems is inexhaustible. Kreiger, (2001), refers to the present scenario as a legal framework entitling the owner of those means to the profits they generate subject only to non-arbitrary taxation. According to Gantz (2005), world environmental problems include but are not limited to air-pollution, climate change, environmental disaster, effect of warfare, europhication, coastal pollution, mangrove destruction, skin cancer, and soil erosion (Glantz 2005, Cline 2007). 1.2 Demand Elasticity of Air travels For local air travel, the demand of air travels turn to be inelastic. This is because while for domestic travels there are other several efficient and faster means of transportation, with international travel the demand of air travels turn to be fairly inelastic. This is so because of the absence of an efficient and related substitute, people can only pause travel in situations such as terror alert (Jayathi 2005). Because alternative substitute such as rail, road and sea transport takes several days to arrive at the destinations, generally they are considered as poor substitute for international flights. However, for domestic flights this might be quite efficient. Using the core theory, Jayathi (2005) states that, in the airline industry, excess competition can lead to an empty core problem or lack of a stable equilibrium. The notion that competition may be destructive for the airline industry is further strengthened by what happened in the United States airline industry immediately after deregulation in the 80's. Jayathi (2005) further states that, income distribution, population policies, a lax in migration and immigration policies will increase the demand for air travels as opposed to a situation where government work to counter the situations. 2.0 How competative is the low cost airline, market Explain you answer "Porters five forces framework was originally developed as a way of assessing the attractiveness (Profit potential) of different industries. As such it can help in identifying the sources of competition in an industry or sector"1. The basis upon which this framework is built will serve in analysing competition in the low cost airlines market. Competitive Rivalry: Because the low cost airlines activities are limited within a definite range they are exposed to competition to road rail and sea transport. Competition at the low cost airline turns to be very high. The are numerous low cost airlines with each of them plying almost the same route, prices turn to be low, to back up with rail and road transport. Some flights are generally more popular than the others, for example flying at 2pm and flying at 11pm. The flights for 2pm are more popular when compared to the flights of 11pm. Each of the players in the low-cost transportation industry is key players and a new low cost airline in the industry is often welcome with price cuts. The competition is going to be fierce, with easy-jet, Ryan air, SAS currently being the market leaders in Europe. Thus any new player should pay particular attention on the four Ps, product price, promotion, and place. In the low cost airlines industry, the bargaining power of buyers are high because of numerous and other transportation means available them. Buyers can be viewed as a competitive threat when they force down prices or when they demand higher quality and better service. The ability of buyers to make demands on a company depends on their power relative to that of the company (Porter 1980). With a relatively high profit margin, in the sector to attract potential competitors or new entrants, the situation is however difficult for new entrants to enter the line of business. This is because of the huge capital requirements and negotiation involve in starting a new airline business. In the low cost airline industry, Suppliers can be viewed as a threat when they are able to force up the price the company must pay for inputs or to reduce the quality of goods supplied, how ever, because suppliers are mostly arranged in the form of a leasing contract, bargaining power goes to the buyer. According to Friends of the Earth (2003), the unit costs at individual airports will be influenced by a whole range of factors which according to FOE (2003) varies from country to country and between airports in the same country. Airports, by the nature of their activities exhibit certain economic characteristics irrespective of their cost structure. According to Ruzza, (2004, p.56) cited in EEC Note No. 10/07 significance economies of scale do follow airport operations. According to the researcher, as airports increases their traffic throughput, the cost per unit per traffic declines. However, earlier studies in the British airports showed that unit costs fall sharply as profits throughputs (EEC Note N0. 10/07). With the airline industry, while the cost of accepting an extra passenger is very low, the fixed cost of airlines turn to be high. The incremental costs of accepting one extra passenger onto a plane are very low, whereas the fixed costs of operating the flight (with or without any passengers at all) are very high. References Bulkeley, H. (2001). Governing Climate Change: The Politics and Risks Society. Transactions of the Institute of British Geographers, New Series, vol. 26, No. 4, pages 430-447. Craciunescu C., (2006). Interest and Prices: Economics, Journal of Management, and Financial Markets .2006 Vol: 1 Issue: 2 Cline, R.C., (2007). Global Warming and Agriculture: Impact Estimates by Country.. Peterson Institute for international Economics. 250 pp. ISBN paper 978-0-88132-403-7. Retrieved October 9, 2008, from Academic Index Glantz, H. .M., (2005). Creeping Environmental Problems. The Peterson Institute for International Economics Issue 23, 11-36. Retrieved October 9, 2008, from Academic Index Johnson, G. and Scholes, K., (2007). Exploring Corporate Strategy, Prentice-Hall, Europe Kanter, R. M. 1995. "Mastering Change." Pp. 71-83 in Learning Organizations: Developing Cultures for Tomorrow's Workplace, edited by Chawla and Renesch.Portland, OR: Productivity Press Krieger J. (2001). "Capitalism" The Oxford Companion to the Politics of the World, 2e., ed. Oxford University Press Inc. 2001. Oxford Reference Online. Porter, M.E. (1985). Competitive advantage: Creating and sustaining superior performance. New York, NY: Free Press. Porter, M.E. (1990). Competitive advantage of nations. New York, NY: Free Press. Sacconi, L. (2004). A Social Account for CSR as Extended Model of Corporate Governance (Part II): Compliance, Reputation and Reciprocity. Journal of Business Ethics, No. 11, pages 77-96. Read More