Student Economic Review, Vol. 17, 2003, pp. 245-257
HOW RYANAIR HAS EXPLOITED THE ECONOMIC THEORY BEHIND
AIRLINE CONTESTABILITY AND DEREGULATION
BY SEAN BROPHY AND DOMINIC ST.GEORGE
“We [Ryanair] will become the largest airline in Europe and as such the largest airline in the world… only we can destroy ourselves” Michael O’Leary 11/2/03 Lecture at Trinity College Dublin
The European aviation industry has undergone enormous changes over the past decade through liberalisation and deregulation. Because of this, new airlines have been able to enter and grow within the European airline market. Some have been a success, others have failed. Ryanair has undoubtedly proved to be the success story of European air transport. This essay will show how Ryanair entered the market and ensured that its potential has been fully utilised. But in the process, has Ryanair managed to become the incumbent firm that now stops others from entering? Section 1 introduces the economic theory behind various markets, ranging from a natural monopoly to the idealistic perfectly competitive market. Section 2 introduces Baumol’s contestable market, and how this differs from the strict economist’s view of perfect competition. Section 3 analyses how these opposing theories fit in with the airline industry. Section 4 looks at how the role of deregulation controls this theoretical activity. Section 5 compares Ryanair with the American airline Southwest, the original low fares airline, and examines how this model has been transferred into the European market. In Section 6 the essay performs an industry level analysis of European aviation at the moment by using Porter’s five forces (threat of entry, competitive rivalry, bargaining power of suppliers and buyers and the threat of substitutes). Section 7 directly identifies with Ryanair’s key strength; its cost advantages and how airline deregulation has enabled Ryanair to transform itself from David into Goliath.
Through initially outlining the economic theory and then applying it to the European aviation market and more specifically, to Ryanair, the essay will show how they have exploited airline contestability and deregulation.
RYANAIR: CONTESTABILITY AND DEREGULATION
Perfect Competition Vs Natural Monopoly
Basic economics suggest that an economist’s ideal market structure from the point of view of efficient resource allocation is “perfect competition”. This is characterized by a large number of buyers and sellers, homogenous products, free entry and exit, and perfect knowledge on the part of the buyers and sellers about the conditions within the market. Through perfect competition the conditions of pareto optimality are fulfilled. Although theoretically ideal, most markets, in reality, do not come close to being perfectly competitive. But the concept itself is still very important to economists.
Until recently the airline industry in Europe was the opposite of this idealistic economic theory. There were minimal sellers (one airline to each country), entry from competitors was near impossible, and fares were ridiculously overpriced. Governments owned the airlines and generally ran them as they so wished. Natural monopolies, which in the past were run by the state, can be characterised by steadily decreasing average costs that allow one single large supplier to produce the quantity demanded by the market at lower costs than would be possible by a greater number of firms. But air transport is not a natural monopoly.
In this respect some industries such as railroad transportation, telecommunications and the distribution (rather than the production) of electricity have shown characteristics that might make it more cost-efficient to organize the production in a single enterprise instead of several. If the conditions for a natural monopoly exist, it might seem reasonable from an economic policy point of view for the state to intervene. This is...
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