ESSA

ESSA

The turbulent airline industry


Cynthia Vu

By

May 21st, 2015


Airlines are struggling to stay in the business. Why does the airline industry find it so hard to make a profit?


Just one look at the troubles of Qantas and one can see the problems airlines have to deal with on a regular basis. Qantas has been battling for years with volatile earnings, declines in market share and industrial disputes. Through all of that, they have had to significantly restructure their operations. The airline industry as a whole struggles to be profitable, with profit margins varying between 1-3% of revenue on average. The US airline industry from 1992-2006 saw an average return on capital of 5.9%, the lowest of returns analysed from 31 select industries. It is then we ask, why is it so difficult for airlines such as Qantas to be profitable?

Since progressive deregulation of the airline industry from the 1980s, airlines have naturally become very competitive and induced new players to enter the industry. The increased competition that arises leads airlines to engage in price wars. An airline would rather underestimate demand and ‘overbook’ a flight to ensure every seat on a flight is taken as the marginal cost of having an extra passenger is low. In addition, the differing demand elasticities of market segments will cause airlines to engage in price discrimination. Leisure travellers, compared to business travellers, are more flexible with travel dates and will be more reactive to prices and change their behaviour accordingly. Consumers are also well informed to compare prices by the high level of public information on airfares which are very accessible to both airlines and consumers. These implications cause intense competition between airlines to capture these customers by lowering their fares. Indeed, the entry of new low cost airlines after deregulation in the US made it more difficult for existing airlines, called legacy carriers, to compete. Many major carriers underwent folding, merging or bankruptcy due to the intense competition. This level of pricing wars will only worsen with negative economic activity or other major event.

There are significant investment and operating costs which airlines have little control over. Many of the suppliers that airlines have to source from are controlled by monopolies or oligopolies. These markets charge higher prices than those seen under perfect competition. Investing in aircraft, for instance, is supplied primarily by Boeing and Airbus. Fuel is another cost airlines are not able to control due to few oil suppliers and inelastic demand. An airline’s profit can be very sensitive to changes in fuel prices, with fuel costs estimated to have more than doubled over the past decade, becoming almost a third of all operating expenses. In addition, rising labour costs now represent a quarter of all airline expenses. If the industry is heavily unionised, airlines will not have enough bargaining power to even consider outsourcing or adjusting their labour costs. Maintenance costs are also significant, which only accelerates as the fleet of an airline ages. After paying out all these costs, airlines end up with very low margins.

The implication is that airlines will end up accepting very low prices while operating with very high costs. This does not mean that all airline companies are unprofitable. The right conditions will help an airline make a healthy profit. Take Emirates for instance. Emirates operates with a young fleet, meaning more fuel efficiency, lower maintenance costs, and the ability to fit more into each plane (which lowers the marginal costs of each passenger). Being based in Dubai means there are low taxes, no unions to battle with, and an abundance of cheap labour from nearby countries. Emirates’ competitive advantage is also in their reputation for excellence in service which Emirates can charge high prices for.

Using government assistance can help the airline industry through investment or subsidies, including money that may be put into R&D or airports. This may be due to the positive externalities received from increased mobility, much in the same way governments invest in public infrastructure such as roads and railways. But by taking government assistance out of the picture, it is said that the airline industry as a whole has made a loss over the past 120 years. In other words, the airline industry would not be very viable if not for the government.

In the end, what consumers want is an airline industry that can keep fares low in addition to good service, but with enough profitability to avoid bankruptcy or government assistance. In reality, it might be hard to maintain this balance.

 

References

Bryan, Victoria. “Low-cost? Low Chance for Air France and Lufthansa.” Reuters. September 28, 2014. Accessed May 17, 2015. http://www.reuters.com/article/2014/09/28/airlines-lowcost-idUSL6N0RQ15F20140928.

“EasyOz.” The Economist. October 29, 2005. Accessed May 17, 2015. http://www.economist.com/node/5093506.

“Two Big US Airlines File for Bankruptcy.” The Age. September 15, 2005. Accessed May 17, 2015. http://www.theage.com.au/news/business/two-big-us-airlines-file-for-bankruptcy/2005/09/15/1126750059523.html.

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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