American Airlines vs. Southwest - Term Paper Example

?American airlines vs. southwest: Which airline will prevail in the US airline market, American or Southwest or will both survive? Table of Contents Introduction 3 Economies of Scale 3 Price Elasticity of Demand 4 Conclusion 6 References 7 Introduction Airlines industry is one of the most delicate of all industries in the sense that it highly depends upon the strategies being framed by the companies. In addition, the success of an airlines company is also dependent upon that of its peers or rather rivals. Given a limited market base and a few numbers of significant players in it, there is always a scope of hard-core competition in the scenario. In most of the cases, the competition takes the form of a price war where the existing players wage a price rivalry in order to attract more customers. Since a large fraction of the costs incurred for the operation of an airline is highly variable in nature, the prevalence of a price war could always be accommodated for up to a certain extent. In fact, this is the strategy adopted by the low cost airlines like Southwest. Air tickets of Southwest Airlines are far less priced compared to their peer American Airlines. The primary competition arising between them is on account of the fact that both of them ply over the same route. This is also the reason why American Airlines is fast losing over its financial aspect compared to its counterpart, Southwest Airlines. The present paper assesses the prospects of survival of either one of the two and attempts at concluding if anyone of them will win over the other, in the long run or not. Economies of Scale Southwest is found to be continually winning over American Airlines in terms of economies of scale. American Airlines is fast losing upon its consumer base which has compelled it to operate over a lower scale compared to its low cost rival. Economies of scale imply the accrual of profit over the long run on account of an expansion in the scale of operation (Baumol & Blinder, 2011). In the adjoining diagram the situation has been depicted quite clearly. During the initial stage, the cost of operation is found to be very high, viz., C, while the quantity being produced is just Q. However, as the amount being produced expands, there is a sharp reduction in the cost of production of the commodity. The fall in the cost of production has been interpreted as long run average cost (LRAC). Actually, LRAC is a combination of a large number of short run average cost curves which too assume a similar U-shape. However, their minimum point continues to shift lower and the LRAC is the locus of the minimum points of all these short run average cost curves. Normally, a company does not continue its production operations after having reached the point of minimum long run average cost. This is the reason why the long run average cost curve is often held similar to the supply curve of the concerned producer. He will generally produce at the point where his short run average cost is lowest and thus, when the loci of all those points are obtained, it yields the long run supply curve of the organization concerned (McEachern, 2011). In the present case, the situation could be interpreted as follows. Southwest Airlines has been growing in size on account of an expansion in its customer base and its average cost of operation over the long run is being reduced simultaneously as well. However, the situation is found to be quite different for American Airlines, which although has a prospect of operating over the large scale, cannot do so on account of a reduction in its customer base. A reduction in average cost accompanied by a hike in production implies the incurrence of higher profit margins as well. This could be well evinced through the fact that during the first quarter of 2009, Southwest Airlines reaped a profit of nearly USD 5 million while its passenger base increased by approximately 12 percent. Over the same period, American Airlines incurred a huge loss and its passenger traffic expanded by a nominal 1.6 percent (CBS News, ‘Airline Leaders Worried By Fuel & Labor Costs’). Price Elasticity of Demand One of the basic reasons behind the increase in demand for air tickets of Southwest Airlines over that of American Airlines is the price elasticity of demand. Airlines are characterized by high price elasticity, on account of the presence of more than one players but a limited consumer base. This is especially the case with the high cost airlines which have an even lower consumer base compared to the lost cost ones like Southwest Airlines. Price elasticity of demand implies the rate at which demand responds due to one unit change in the price of a commodity, where the commodity in the present case is airline tickets (Depken, 4.32). Higher the price of air tickets are lower is the demand for the same and vice versa, implying the prevalence of a negative association between price and demand for the commodity. In fact, the demand for air tickets is found to move in a higher than proportionate manner compared to changes in the prices of commodities, i.e., air tickets. In the following pair of diagrams, the left hand diagram represents the situation of a low cost airline like Southwest Airways while the diagram on the right hand side represents that of a high cost airline like American Airways. Firstly in the left hand side diagram, the demand curve is found to be quite steep in nature and in contrast, the right hand side diagram is characterized by a flatter demand curve. In case of the low cost carrier, the price elasticity of demand could be considered as far less than 1 compared to the case of the high cost one that is characterized by a price elasticity of demand values at greater than 1. It could be said so because for the low cost one, a slight downfall in the demand schedule given the position of the supply schedule leads to a downfall both in price and quantity. However, the fall in price (from P0 to P1) is found to be lower than that of the reduction in quantity (Q0 to Q1). On the other hand, for the high cost carrier, a slight change in demand leads to a far more reduction in the price quotient compared to the situation of the low cost carrier. Similarly, the reduction in the quantity of the high cost carrier is far more compared to that of the low cost one. This is exactly the situation viewed for the cases of American Airways and Southwest Airways. Owing to the low price elasticity of demand, Southwest Airways could survive the brunt of an increase in the jet fuel prices while American Airways could not. When jet fuel prices rose, American Airways had no choice but to soar up the prices of their tickets that took a toll upon the quantity of their tickets being demanded. In this case, a rise in price per unit could be represented by means of an upward shift in the demand schedule of the company under consideration. When American Airways increased its ticket price to make adjustments for increase in cost of fuel, it suffered a fallback in its total passenger base. Such was the adverse impact that the company literally had to suffer a huge loss. On the other hand, the impact of the same shock upon the low cost carrier business fell rather lightly. While Southwest Airways too had to increase their price per ticket to accommodate for the increase in fuel prices, owing to a lower price elasticity of demand, the pull back pressure upon the equilibrium price was found to be lower. Thus, Southwest Airways faced a lower impact upon its price aspect compared to that of the American Airways. However, the quantity of seats being sold was also lowered. Despite this fact, the loss that Southwest was confronted by was found to be far lower compared to that faced by American Airways. Conclusion At the beginning of the paper, the question being posed was that whether American Airlines would be able to win over Southwest Airways or vice versa. After the above discussion, it might be concluded that Southwest Airways is at a position way better than that of its high cost peer. One of the most important of all factors is that Southwest Airways is fast gaining upon the market despite the fact that its inception was far later than that of the American Airlines and so is its weight in the financial contribution of the nation. However, most of the passengers are found to be inclined more towards Southwest compared to American Airways these days. One of the reasons could be that people have become far busier today than they had been even two decades back. The demand for airlines has increased naturally since people want to spend lesser and lesser time to travel distances. However, they also want to expend a lower amount for the same, especially when the distance is small. Crafts belonging to AA are characterized by a higher fixed cost compared to SW which is why it is impossible for the former to reduce their ticket price beyond a certain point. This is the very area based on which Southwest Airways is anticipated to climb higher over time. References Baumol, W. J. & Blinder, A. S. Economics: Principles and Policy. New York, USA: Cengage Learning. 2011. CBS News. Airline Leaders Worried By Fuel & Labor Costs. May 19, 2011. September 29, 2011 . Depken, C. A. Microeconomics demystified. New York, USA: McGraw-Hill. 2005. McEachern, W. A. Economics: A Contemporary Introduction. New York, USA: Cengage Learning. 2011. Read More