Economic Profile for the Airline Industry - Essay Example

Industry Research Airline Industry Industry Profile Martin Sharkey Western International Introduction The airline industry is of strategic importance in an increasingly globalized market place. Unlike other industries, the driving forces in this market do not depend on technological developments, but rather on developments in the legal, institutional and cultural domains (Alderighi et al, 2004, p. 2) that influence the structure of the market and impact mobility. This paper aims to create a general economic profile for the airline industry by discussing various aspects of the airline market, such as industry trends, market demand and supply and associated elasticity, the products the industry produces and associated externalities, employment relationships, and more. In the end the paper observes the influence of governmental policies on the success and failure of the airline industry. 2. Industry Deregulation The deregulation of the US airline industry preceded that in the European market by approximately 10 years (Alderighi et al, 2004, p. 2). Still, on both continents the process of deregulation and privatization induced important structural changes. Deregulation allowed many carriers to sign alliances to exploit economies of scale (Alderighi et al, 2004, p. 2); reduced price levels and expanded the number of services. It affected the industry structure and dynamics both on the supply and demand side. 3. Industry supply In the airline industry there are two types of companies - traditional carriers and low cost firms (Alderighi et al, 2004, p. 7). Traditional companies offer products with different quality - economy and business - at different prices and can provide a full range of products and services at a higher cost. Low-cost carriers offer a restricted range of services at much lower prices. This is so, because traditional full-service carriers "with hub-and-spoke systems" have a high cost business model, while low cost carriers have a low cost business model (Gillen et al, 2004). 4. Price elasticity of supply Price elasticity of supply measures how the supplied quantity responds to changes in prices (Mankiw, p. 100). In the light of the airline industry, elasticity of supply means the extent to which airline companies can adjust the number of flights for the different airline segments. Given the high maintenance costs, intensive capital structure within the industry (Skapinker, 2001), also the strict regulations and reduced flexibility in market behavior, there are not many opportunities for quick changes in airline travel supply, meaning that in the short-run supply is inelastic. Over the long-run period, though, as history has proven, the industry can adapt to changing demand. One example is the deregulation in the industry that significantly increased supply over the past 20 years (Alderighi, 2004). 5. Industry demand The process of globalization has increased mobility of goods and people (Alderighi et al, 2004, p. 3). On one hand expansion of cargo transport has significantly increased the demand for airline transport. On the other, tourist travelers increasingly enjoy the comfort of airlines. It can therefore be concluded that the airline market demand comprises of different market segments, based on consumer type, distance and location. Business travelers form the so called "strong market" (Adlerighi et al, 2004, p. 7) whereas the weak market comprises of leisure travelers. Additionally, the travel market is divided into long-haul and short-haul travel, and international, and North American long haul travel (Gillen et al, 2004). 6. Price elasticity of demand Price elasticity of demand measures the degree of responsiveness to change in prices of fares (Mankiw, p. 90). Because the airline industry demand is formed by two very different types of consumers - business and leisure - there is no single elasticity value for the airline travel demand (Gillen et al, 2004). Price elasticity of demand is also influenced by time and distance aspects. This is so, because relative fare prices change significantly over time and different types of travelers express different types of behavior for long and short distances (Gillen et al, 2004). For example, there are plenty of substitutes for air travel, such as rail travel, road or sea travel. Demand for these substitutes influences airline travel demand and price elasticity. Still, availability of alternative transportation modes significantly decreases when it comes to long-haul travel (Gillen et al, 2004). This decreases price elasticity of demand for longer flights. As regards domestic and international travel, international travel is spread over greater periods of time and the airline costs represent a smaller proportion of the overall travel costs. Therefore international travelers are likely to be less price sensitive than domestic travelers. Finally, business travelers have a less elastic demand than leisure travelers, because business travel is a necessity, whereas leisure air travel is a luxury (Mankiw, p. 90) and is more easily adapted to time and price changes (Gillen et al, 2004). One event that has affected price elasticity of demand in the airline industry was the entry of low-cost airlines. Market deregulation has allowed the entry of companies offering much cheaper airline tickets. Traditional airlines have responded by reducing fares for all available leisure and business fares (Alderighi et al, 2004) and this has lead to lower average prices within the whole industry. Lower average fares have lead to lower elasticity of demand estimates (Gillen et al, 2004). On the other hand the increase in the number of competitors in the market creates higher price elasticity of demand. 7. Public goods and common resources As mentioned above, the number of goods and services airlines produce has significantly increased over the years. Before deregulation, the airline industry was completely under the governmental control to serve the public interest. Deregulation, however, does not mean that the governments have let go the focus on public interest such as improved mobility and national security. Today the airline industry still produces public goods such as airline security (College of Business, 2006). Airline security is a non-rival good, meaning that it does not diminish when people use it. US airline companies pay people who are responsible for screening passengers at the airports. Additionally, it offers a non-excludable product. People at the airport cannot be prevented from using it; on the contrary, security measures apply equally to all people within the airport area of control. 8. Positive and negative externalities Next to the core products and services that are directly related to transportation, there are a number of positive and negative externalities, associated with the airline industry. On the overall, "the aviation industry creates substantial economic value" (Smyth et al, 2005). It is a US$400 billion industry that generates US$2.9 trillion of economic activity on a global scale. This measure is the most direct, money-related measure of the effect of the airline industry. There are however a number of positive externalities that cannot be measured in values. Air transport is the only worldwide transportation network, which makes it essential for businesses and tourism (Smyth et al, 2005, p. 8). In this manner airlines contribute to sustainable development, by generating economic growth, providing jobs and improving mobility on a global scale. Governments and pressure groups offer cite environmental and social costs as a justification for higher taxes for airline companies (Smyth et al, 2005, p. 8). Examples of these negative externalities are carbon monoxide emissions or noise, as measured in decibels. While these externalities do exist, they need to be viewed with two things in mind. One is the comparison between negative externalities, produced by airlines and those by other transportation methods and the overall effect on environment and society, as compared to overall benefits. Aviation makes the highest net contribution of all transportation modes in terms of passenger journeys (Smyth et al, 2005, p. 9). The second aspect is that the airline industry is investing in reducing those externalities. For example, carbon monoxide emissions have been reduced by 50%, and fuel efficiency today exceeds the efficiency of any modern compact car (Smyth et al, 2005, p. 8). 9. Wage inequality Another aspect of the airlines' economic profile are the employment relations within the industry, as reflected by wage inequality. Wage inequality in the airline industry has significantly increased after industry deregulation (Deller, 2002) between union and non-union workers. Intense competition from new "non-union low-wage" entrants forced existing companies to lower the wages of their employees as a way to stay competitive. Still, because of high industry unionization (Bratsberg et al, 2001), after deregulation the unions retained considerable bargaining power and were more effective in preserving higher wages, as compared to non-union workers. Union power influenced wage levels of similar categories of workers who differ in their employment relations. Therefore the union wage advantage or "union premium" (Bratsberg et al, 2001) increased during the years after deregulation and this lead to greater wage inequality between union and non-union workers. 10. How the government influences a deregulated industry using fiscal and monetary policies Even after privatization, because of its strategic importance, the national and private airlines have been subject strict regulations. National governments have deployed a range of general monetary and industry-related fiscal policies to influence the development of the industry. Monetary policies influence the state of economy by controlling the money supply in the economy through open-market operations, reserve requirements and discount rates (Mankiw, 2004, pp. 634, 640). Lower discount rates or lower reserve requirements are expected to increase money demand and increase bank loans. Moreover, infused liquidity after crises, such as September 11 attacks, aim to preserve the safety of the banking system (Levy, 2001). Since airlines are very capital-intensive businesses, the cost of loans and their availability is of crucial importance to the financial health of airlines. Additionally, a number of fiscal policies have been deployed that have either positively or negatively influenced the airline industry. The most obvious positive effect from the fiscal policy is visible in the countercyclical measures taken by the Fed after September 11 attacks. As a result of the attacks the airline industry faced a grave financial crisis and deep recession that resulted in layoffs of thousands of airline workers. Revenues for companies like Delta fell significantly below expectations, whereas fixed costs on leasing, fuel and people remained the same, which created negative cashflow and seriously impaired the financial stability of the companies (CNN, 2001). To counteract the negative effect of dropped demand, the government prepared a $15 billion package to compensate airline companies for their immediate losses, $5 billion in direct helps, and $10 billion in loan guarantees (CNN, 2001). Further on, laid off workers, both direct and associated workers at airports and support services, were to receive governmental assistance through extended unemployment compensations and health insurance. This all represents direct government spending that is targeted specifically at the airline industry. More general fiscal measures that affect not only airlines, but also other affected industries, consist of tax cuts and investment programs such as infrastructure investments, to make the economy grow again. Whereas tax cuts are positive for economic growth, they have a number of shortcomings (Levy, 2001) - they are relatively modest for majority of taxpayers, and there is a long phase-in that delays economic responses. Governmental policies have not always been industry-protective. Introductions of various airline taxes have induced negative effect on the industry growth and profitability. There is a significant tax and user charge contribution that the airline industry makes for local governments (Smyth et al, 2005). Aviation taxes and charges have increased significantly between 1998 and 2003 (Smyth et al, 2005), and this has been part of the privatization process of airlines. For instance, in Germany and France taxes have increased by 14%, whereby user charges have grown by 27% and 46% respectively (Smyth et al, 2005, p. 7). Additionally, upon a proposal by Jacques Chirac, a number of countries have proposed to tax airline tickets to raise funds for development aid against world poverty (CEAG). The rationale for taxing airlines is that air transport is mostly used by people who are well-off. However, in practice this tax will affect also low-income families who represent a growing segment of airline users. The tax will directly increase the price of the tickets which will increase travel costs and reduce demand. This will affect the competitive position of airline companies that are based in developing countries where people are extremely price sensitive. 11. Conclusion The airline industry is of strategic importance to national governments and businesses and is therefore a complex mix of a competitive and regulated industry. Still, whether or not governmental intervention stimulates or impedes the development of the industry is questionable. Negative influences Governments want national airlines as a matter of pride (Skapinker, 2001). This is so, because even though deregulation released control over price levels and routes, "key inputs into the industry are allocated using non-market mechanisms" (Gowrasankaran, 2002). Governments still own and control access to airport boarding gates and runways; they limit foreign ownership and prevent industry consolidation in a capital intensive, high-cost, low-profit market (Skapinker, 2001). International routes are deregulated only to some extent through negotiated bilateral open-skies agreements (Gowrasankaran, 2002), which does not create a fully competitive market. This means that restrictions over ownership and free movement of people and goods between countries impair industry growth. High fuel prices, imposed high taxes on businesses and travelers, are other aspects of economic activities and governmental policies that affect the industry profitability in a negative way. Positive influences Since the start of deregulation in U.S. in 1979 the airline industry has grown significantly. It experienced 225% growth over this period, as compared to Canada's 80% growth in a market with much lower level of competition (Gowrasankaran, 2002). Therefore it can be concluded that deregulation, in combination with competition can spur growth in the airline industry. Free market competition has increased the volume of travel and has lowered average prices, which benefits consumers. Additionally, free markets have provided incentives for innovations spread, thereby increase efficiency (Gowrasankaran, 2002). The steep sales and earnings growth in the industry over that time period is also affected by general economic activity. On one hand the booming economy spurred demand and made this transportation mode the preferred choice particularly to high-fare business travelers (Gowrasankaran, 2002). Growing GDP per capita as an indication of the passenger's income has influenced the passengers' willingness and ability to pay for air transport (Alderighi et al, 2004) and has positively influenced price levels. Even though limited, globalization has increased people's mobility and has substantially added to growing demand for air transport. References: 1. Alderighi, M., Cento, A., Nijkamp, P, Rietveld, P. (2004) The Entry of Low-Cost Airlines Tinbergen Institute Retrieved March 31, 2006 from http://www.tinbergen.nl/discussionpapers/04074.pdf 2. Bratsberg, B. & Ragan J. (2001) "Changes in the Union Wage Premium By Industry" Retrieved April 29, 2006 from: www.frisch.uio.no/pdf/changes_ilrr.pdf 3. CEAG, Corporate Economists Advisory Group (2006) "The Airline Ticket Tax - a Business Viewpoint" Policy Statement. International Chamber of Commerce. Retrieved May 9, 2006 from: www.iccwbo.org/uploadedFiles/66%20Final.pdf 4. College of Business (2006) Public Goods and Common Resources Retrieved March 31, 2006 from http://www.business.uiuc.edu/seppala/econ102/lect10.pdf 5. Deller, S. (2002) "Income Inequality in the United States" Center for Community Economic Development, University of Wisconsin-Extension, Community Economics Newsletter No 308. Retrieved April 29, 2006 from: http://www.aae.wisc.edu/pubs/cenews/docs/ce308.txt 6. Gillen, D., Morrison, W., Stewart, Ch. (2004) Air Travel Demand Elasticities: Concepts, Issues and Measurement. Department of Finance Canada Retrieved March 31 2006 from http://www.fin.gc.ca/consultresp/Airtravel/airtravStdy_e.html 7. Gowrisankaran, G. (2002) "FRBSF Economic Letter. Competition and Regulation in the Airline Industry" Olin School of Business. Retrieved May 14 from: http://www.olin.wustl.edu/faculty/gowrisankaran/pdf_papers/airline_competition.pdf 8. Levy, M. (2001) "Economic Performance and Policy Following the Terrorist Attacks" Shadow Open Market Committee October 14-15 2001. Retrieved May 9, 2006 from: www.somc.rochester.edu/Oct01/LevyOct01.pdf 9. Mankiw, G. (2004) Principles of Economics 10. Skapinker, M. (2001) Crowded Skies Financial Times October 10 2001 Retrieved March 31, 2006 from: http://www.swlearning.com/economics/econ_news/european_airlines_1101.html 11. Smyth, M. & Pearce, B. (2005) "Aviation Taxes and Charges" IATA Economics Briefing 2, November 2005 Retrieved April 3, 2006 from www.iata.org/NR/rdonlyres/8BC719FF-D354-4F61-8997-11173687DAED/0/aviation_taxes_charges.pdf 12. CNN (2001) "America's New War: Delta Airlines Announces Layoffs" Retrieved May 9, 2006 from: http://transcripts.cnn.com/TRANSCRIPTS/0109/26/bn.01.html Read More