The Second Largest Major Airline Economics Essay


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The first flight was discovered in the year 1903; however, flying was considered very risk and therefore, air fights were not common until 1925 when the Air Mail Act allowed postmaster to contract private airlines for mail delivery. In the same year, Air Commerce Act elevated the power of the Secretary of Commerce to establish airways, license pilots, certify aircrafts, define and enforce air traffic regulations in the U.S. this facilitated the growth of the U.S Airline industry. The first commercial airlines that followed after these policy developments included Pan American, Ford transport Service and Western Air Express. By mid 20th century, the Civil Aeronautics Act established the Civil Aeronautics Board (CAB) which served several functions including regulation of flight fares and determination of airline routes. At this susceptible age of the airline industry, the CAB regulated flight fares on the basis of average costs. In this period also, price competition in terms of adjustment of flight was irrational, and therefore competition moved along offering the best quality. Where (route) the CAB found airline service quality to be inefficient, it allowed other carriers to operate on such routes. This gave an advantage to existing carriers over new entrants.

Deregulation: Consolidation, Concentration. Globalization

It is generally held that the economic discipline played an important role in developing the conceptual grounds for the deregulation movement and in supporting the political process that led to its implementation. Two related concepts; referred to as the contestable market theory played a major role in the deregulation of the aviation industry. The first is embodied in the general Chicago School view while the second lies in the analytical formulation of a contestable markets model by Baumol, Paznar, and Willing. Both concepts were translated into the notion that the industry is naturally competitive, and thus regulation must be eliminated. Neither of the two views represents a model of deregulation, nor do they admit aspects of market processes. The Baumol, Paznar and Willing formulation is an analytic statement of the properties of possible market equilibrium under certain unique assumptions. The Chicago view has never been developed into a coherent formal model of potential competition at all. Both views play down the traditional notion of barriers to entry, economies of scale and the advantages of incumbency.

One of the major implications of both views is that market concentration should not, by itself, be a determinant of price or necessarily an indication of market failure. In general, these views provide an economic rationale in favor of expanding the laissez-faire doctrine to certain monopolistic or oligopolistic industries. Traditional perfect market theory suggests that atomistic markets tend to be efficient since super-normal profits would attract actual new entry. According to the new view, the threat of potential entry in response to supernormal pricing (and not an actual entry itself) is sufficient to discipline prices if entry and exit are relatively easy. The general metaphor used in this regard is that the threat of potential "hit and run" competition on a "city-pair" market would restrain fares. For the Chicago School, the contestable markets idea was only one building block within a comprehensive framework that supports curtailing government intervention in markets. Moreover, it tied in neatly with Stigler's industry capture concept. Since, it was argued, there are no major obstacles to entry or exit in a typical aviation market, there is no "real" public interest rationale for regulation. Rather, the airlines effectuated the regulatory process in an attempt to eliminate actual and potential entry. The contestable markets idea was embraced by politicians and regulators during the middle 1970s and early 1980s and raised to iconic status. There was general public frustration with government performance that was translated into a simple political and popular message pushing for the elimination of government regulation, in general, and in the aviation industry in particular. For Democrats, deregulation was perceived as a pro-consumer policy; for Republicans, it implied limiting the government's role in the market. There was a wide consensus that the airline industry was an ideal candidate for deregulation, that the specific rules and institutions used in regulating the aviation industry had failed, and that a major revision or reform was imminent. Interestingly, even the regulators questioned the wisdom of airline regulation. A Civil Aeronautics Board Special Staff Report publication in 1975 reflected the dominant view at the time by arguing that the industry is naturally competitive and not monopolistic and therefore, in the absence of economic regulation, it is clear that monopoly abuses would not occur. The only major opponents to deregulation were the major airlines, taking a stance that of course enhanced the notion that interest group politics and industry capture aspects were responsible for regulation to begin with and further justified its elimination. Economists during this period offered a new political message, shifting from the traditional call for the regulation of industries in the public interest to the deregulation of industry. Accordingly, in the public interest a message that was enthusiastically adopted by the public and by elected officials. The Civil Aeronautics Act of 1938, which had established the ground rules for four decades of economic regulation of the airline industry, was associated with the post-depression political view that government intervention was the remedy for failures of the free market mechanism. The 1978 Deregulation Act reflected the new view that the social cost of the cure may be greater than the costs of the failure. The post-deregulation industry was very closely monitored by economists seeking empirical proof of their hypotheses. In general, the literature may be characterized by somewhat naive enthusiasm and celebration of the success of deregulation during its first stages and until the middle 1980s. Later came surprise and perhaps some disappointment in light of the generally unexpected outcome of the experiment. Most economists and public officials did not expect the industry to evolve the way it had, despite the consensus that the current outcome was superior to government regulation. Expectations as to further concentration, along with concerns over increasing fares in the late 1990s prompted antitrust initiatives against major airlines for alleged predatory behavior and encouraged stricter stands against potential increases in major airlines' market power through takeovers and strategic alliances. Political initiatives aimed at protecting passenger rights and improving service, were launched and the industry has moved from a government-regulated cartel in the late 1970s to an antitrust-monitored oligopoly consisting of a smaller number of larger airlines. This evolutionary path may suggest that the aviation industry had inherent natural monopoly characteristics, perhaps because of significant fixed costs and other particular network characteristics. On the contrary, the widely held pre-deregulation view of economists and regulators was the absence of such characteristics in the industry, which is why the aviation industry was viewed as an ideal candidate for deregulation. It is ironic that the structure that has evolved makes the post-deregulation industry closer than ever to the traditional natural monopoly model.

Scholars failed to predict that industry strategic behavior in the post-deregulation era would permit the airlines to innovate and change technology, market structure, and the rules of the game the way they have. In particular, the major airlines moved to transform the industry structure from a relatively' simple, mostly linear, city-pair network structure into a complex hub-and-spoke structure. In the new structure fixed costs, sunk costs and economies of scale, scope, density, and size play a major role, together with other strategic advantage. In such a structure, strategic behavior has been a factor as never before.

In 1978, Congress passed the Deregulation Act, catching airlines generally unprepared. On the eve of deregulation the industry had exhibited heterogeneity in cost characteristics across major and non-major groups of airlines and among airlines within each group. Airlines overall differed in their fleet structures and labor contracts, two of the major elements that determine an airline's cost structure. They also differed in the structure of their route systems. Four decades of price regulation had accommodated high aircraft capacity and continually increasing labor costs by fare hikes. Route franchising policies had created somewhat unbalanced route systems. United, on the one hand, had the best-integrated and most efficient domestic system. Pan Am, on the other hand, had a monopolistic position in international markets but almost no domestic base. High fuel prices made the first generation aircraft, especially the 707s and the DC8s that were designed prior to the fuel crisis of the mid-1970s, relatively expensive to operate. These four-engine aircraft consumed more fuel and required more passengers in order to break even and were hard hit by surging oil prices, as well as by the recessionary impact on load factors. The new aircraft delivery cycle of the early 1970s provided the major airlines with a relatively high number of more efficient, high-capacity, wide body jumbo jets. These aircraft, however, required high-density, long-range markets in order to break even and therefore could be operated economically only in a few high-density markets that remained strong despite the recession. In general, the financially weaker airlines operated more of the less fuel-efficient aircraft They faced a competitive disadvantage in operating costs, as well as financial constraints to entering fleet restructuring programs with new and more expensive aircraft. Lenders were reluctant to finance aggressive fleet restructuring programs, and the public debt market assigned highly speculative investment grades to airline debt. Economic slowdown and world recession during the late 1970s, and early 1980s reduced load factors, fleet utilization, and revenues, putting the acquisition of new aircraft farther out of reach. Withdrawing service of less profitable routes, retiring older-generation aircraft, initiating labor layoffs, and renegotiating of labor contracts were the only major policy choices available to airlines at the time. The industry challenge was to adjust to a new market regime in face of a revenue collapse due to severe recession and doubled fuel prices. For most airlines, these steps implied contraction in an attempt to reduce costs. It is important to understand the specific economic conditions of that period and to appreciate their impact on the industry and by extension their implications for deregulation. The advent of deregulation coincided with a worldwide recession and an industry economic crisis. The 1973 oil crisis and recession dramatically impacted the industry. In fact, after more than a decade of an average annual world industry growth of 14%, the industry, for the first time in the jet age, fell to approximately 3% average growth during the years 1973 to 1975.

Besides significant reductions in the demand for air travel due to recession, oil prices, which constitute a major operational cost component, dramatically affected the supply side. In 1979, airline operational growth fell for the first time in aviation history toward 0%. It was under these specific economic conditions that the industry, entered deregulation, and this circumstance had many important implications. First, the economic conditions during early deregulation made major incumbent airlines different in terms of costs.

The economic difference between these two major groups and the subsequent impact on the airlines' cost structure became more significant as fuel prices increased and as new fuel -efficient aircraft were introduced into the market. The oil crisis starting in 1973 generated great cost heterogeneity within the major incumbent airlines, depending on the composition of their fleets and their particular route structures. The second important happening is that the particular economic conditions in the late 19700 and early 1980s encouraged both the entry of new low-cost startup airlines and the expansion of small incumbents. Entry of new airlines into the market is usually constrained particularly by physical factors, the most obvious of which is the availability of aircraft and airport space. Entry is also constrained by the fixed availability of air and ground crews. That is, if input markets are in equilibrium or all available stock of aircraft and or airport space is employed, new entry is constrained.

The worldwide economic conditions of the late 1970s and early 1980s created a worldwide overcapacity of aircraft at low market rates. In addition, unemployed crows and other airline personnel and gates and airport space were available and could be hired or acquired by new startup airlines for very attractive prices. These airlines were free from contracts with labor unions, and airport authorities and other pre-deregulation commitments that implied high overhead costs and structural rigidities to incumbent airlines. Unemployed crews, mechanics, and other airline personnel could be hired at cheaper rates. This economic environment lured a new group of airlines that enjoyed a different cost structure and an operational freedom not easily available to the major incumbents. New entrants, for example could use maintenance outsourcing while incumbents were tied to high-cost agreements for in-house maintenance. New entrants could also hire non-unionized labor. Entry of new discount "no frills" airlines into the market further contributed to the evolving industry heterogeneity. In this respect, a major incumbent airline faced both real and potential competition from members of its own group, incumbent airlines from a smaller regional group of airlines that enjoyed cost advantages, previously non-regulated niche airlines and new startups that took advantage of favorable input market conditions

United Airlines was the largest carrier at the time of deregulation. It was also perhaps the best-positioned major airline to take the role of the post-deregulation industry leader with its more efficient fleet mix, better-structured route network and superior cash position. Its initial policy responses to deregulation included increasing capacity and price competition on high-density routes, abandoning low-density less profitable routes, and attempting to cut in labor costs. These were the initial choices for all major airlines, but they had little effect. Fierce competition on high-density routes did not generate enough revenues and resulted in significant losses. The high-density, linear, city-pair routes that were targeted by all were quite vulnerable to competition. Negotiations with labor did not produce desirable cost cuts either. United Airlines' attempts to renegotiate its labor contracts in 1979 resulted in a two-month mechanics strike that cost the airline dearly. The impact of this strike on the industry was significant, as it transmitted very clearly the difficulty of labor cost adjustments for major incumbents. Not surprisingly, labor unions strongly opposed deregulation and exhibited strong opposition to post-deregulation contract renegotiations.

American Airlines was the second-largest major airline with the highest cost structure in its group. Most of American's aircraft were first-generation fuel-inefficient 707 and 727-100 aircraft. American's labor was unionized and very highly paid. Judging only by its cost structure and applying the wisdom of industrial organization models of the time. American might have been thought to have an extremely low chance of surviving deregulation as a major airline. Yet American is traditionally credited as the industry leader in making the strategic move to the hub-and-spoke structure, which ended up positioning it as one of the three largest airlines of the post-deregulation era. All the economic models of the period emphasized the competitive importance of cost structure. Whether in response to the threat of incumbent airlines, new entrants or potential competition, American, as a high-cost airline, felt the competition pressure perhaps more than any other major airline because of its cost structure. American seriously considered cutting costs by shrinking its size, selling aircraft, withdrawing service from less profitable routes, or even selling off part of the airline. It also thought about reformulating the airline as a non-union, low-cost airline. American achieved a certain degree of cost reduction by the pre-deregulation move of its headquarters to Dallas, the retiring of 707 aircraft, and the renegotiations of labor contracts. But these steps were not enough to combat the lower-cost competitors. Other incumbent airlines faced similar problems. Pragmatically, cutting labor costs, withdrawing from less profitable markets, and retiring aircraft were the major immediate cost-reduction policies open to the incumbents. The airlines were caught

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