The Airline Industry

The Airline Industry

In 2001, commercial airlines carried nearly 450 million passengers for leisure, personal, and business travel, an increase of approximately 250% since the 1978 industry deregulation. Despite this long-term growth, the number of passengers increased only about 1.5% annually from 1997 to 2001. The airlines were buffeted by both economic and exogenous factors that coincided with particular force. In 2002 and early 2003, virtually every major carrier was under bankruptcy protection or claimed to be on the verge of bankruptcy (Brooks, 2007).

The airline industry is characterized by an oligopoly market structure, a form of imperfect competition in which a limited number of firms dominate the industry. Oligopoly firms have market power in setting or altering prices for their products by establishing various output levels. Since airlines produce similar outputs and compete with their industry rivals, any action a competing airline takes is noticed by its competitors. Consequently, rivals may react with price-cutting or other attempts to enhance market share. Thus, the airlines are interdependent, and each recognizes that its market power is vulnerable to erosion by competitors or new market entrants (Brooks, 2007).

The airline industry is faced with a double edge sword at all times. With the advent of the internet a price transparency on ticket cost has forced the airlines to adapt to the more price conscious customer who can compare all the fares and choose the cheapest one available. Yet even before the inception of the internet the airline industry was a very cyclical industry. Since its inception the airline industry has always been impacted by the elasticity of demand, externalities, and wage inequality, monetary, fiscal, and federal policies (Brooks, 2007).

The elasticity of demand is based purely on current market conditions, the customer's purpose for travel, and available substitutes. Externalities continue to influence the elasticity of demand. The September 11th tragedy has had rippling effects on the entire travel industry. The September 11th event impacted fiscal policies and it created staffing problems nationwide.

Although airlines may use oligopoly market power to restrict competition, new innovative firms can carve out a niche, which is the strategy of the low-fare regional airlines. Pre-9/11 airline industry studies illustrate that well-established hub-and-spoke route networks present a considerable, but possibly penetrable, barrier for new airlines (Walsh, 2007). Although high entry costs of aircraft acquisition and other capital requirements make entry difficult, the industry appears more contestable in the post-9/11era, as evidenced by the growth of low-fare carriers. These market entrants can erode a dominant carrier's market share, even at large hub airports. Unlike their larger competitors, several of these new market entrants are profitable and continue to experience growth (Walsh 2007).

The market power characteristics of price determination, product differentiation, economies of scale and contestability with low-cost competitors indicate that airlines are an inherently unstable industry, a problem typical of industries with high capital costs. Airlines build excess capacity during macroeconomic expansion, which becomes all too apparent during the subsequent downturn. When industry sales decline, airlines compete for a shrinking passenger base, and those with the lowest cost structures will be the most likely survivors (Walsh 2007).

Negative and positive externalities play a vital role in determining supply and demand in the airline industry. Since the airline industry is a direct product of market conditions, it is greatly affected by all externalities. Many people noticed a decline in travel after the September 11th tragedy occurred due to safety concerns. When there is a huge increase in fares that definitely interferes with the demand for travel; it causes the price of tickets to continue to rise since a clear correlation between supply and demand exists. When the economy is doing well in terms of the employment rate, and when the dollar is strong people have the tendency to travel more.

The airline industry is interpreted as being very unstable due to the immediate reaction to tragedies. Immediately following the September 11th tragedy the airline industry was affected and it affected other industries indirectly. The airline industry plays a key role in globalizing our economy and the market is strongly dependant on the airline industry. The rise and decline in fuel costs is another negative externality that affects the airline industry. Fuel costs have been on the rise for quite some time, so customers have gotten used to the change (Walsh, 2007).

In many cases external costs can affect the lifespan of many airlines. The airlines are dependent on customers to buy their tickets in order to survive the external cost of fuel, labor, and advertising. The external costs are set depending on the current condition of the market. According to FRBSF Economic Letter (2002), over the last 20 years airlines such as Pan Am, Texas Air, and TWA have gone out of business. Externalities such as tragedies (in some cases crashes) as well as over-head costs left these airlines in turmoil. Two notable airlines United and Delta went bankrupt, but they managed to climb out by making changes. Delta and United escaped bankruptcy by cutting back on employee pay, pension plans, and in-flight meal service. The rate of transaction affects the livelihood of current employees, retirees, customers, and each individual airline (Walsh, 2007).

There is no clear classification of the airline industry because it serves a broad purpose. If a customer is flying for business purposes overseas, there is no easy alternative. The classification would be based on the customer's purpose of travel. People who are flying for pleasure are not being forced, so leisure travel would be considered excludable. There are clear seating capacities on airplanes; it would rival which would classify the airline industry as a public good. When someone is forced to travel for business purposes, the travel would be considered non-excludable. It would be difficult to determine if a rival exists since there are alternatives. According to FRBSF Economic Letter (2002) there is no substantive evidence to support the airline industry of being a natural monopoly (Jerram, 1998).

There is a long history of wage inequality in the airlines industry, in the recent years there has been a decline. In order to address the growing issue nationwide of wage inequality, many states introduced a living wage ordinance which was an effort to control wage inequality. Statistics demonstrate there is a correlation between wage inequality and high turnover. Wage inequality

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