The domestic US airline industry has been intensely competitive since it was deregulated in 1978. In a regulated environment, most of the cost increases were passed along to consumers under a fixed rate-of-return based pricing scheme. This allowed labor unions to acquire a lot of power and workers at the major incumbent carriers were overpaid. After deregulation, the incumbent carriers felt the most pain, and the floodgates had opened for newer more nimble carriers with lower cost structures to compete head-on with the established airlines. There were several bankruptcies followed by a wave of consolidation with the fittest carriers surviving and the rest being acquired or going out of business.
Analysis of the airline industry
To determine the profitability of the airline industry, we will do an industry analysis using Porter’s five-forces framework. This industry analysis will help us in understanding the size of the Potential Industry Earnings (PIE), and how much of this the different participants can extract.
Rivalry among competitors
There is intense rivalry among different airlines. In the pre-deregulation days, airlines competed mostly on things like service, meals and in-flight movies etc., since prices were mandated by the Civil Aeronautics Board. In the post-de-regulation era, this rivalry has taken on the form of severe price competition, with airlines ruthlessly undercutting each other with fare promotions. There are a number of airlines making the airline industry fairly crowded. Even though the 3-firm concentration in 1992 was 50%, and the 8-firm concentration was 92%, the fact that the airlines competed on price made the industry much more competitive than the numbers might suggest. The service the airlines sell (air transport) is pretty homogenous, and there is not much product (in this case, service) differentiation. The major differences between the services offered by different airlines include the total time spent on an airplane and the number of connections. While time-sensitive business travelers may prefer shorter, direct flights, most leisure travelers don’t see this as a big differentiator when the price is factored in. Buyers (both business as well as leisure travelers) have low switching costs and there is very little relationship-specific investment that travelers make. Although the airlines made an effort to create customer loyalty by offering frequent flyer programs, most of the competitive advantage this provided was quickly eroded by almost all airlines offering such programs. Moreover, leisure travelers are motivated to shop around for the best price.
Sankar Ram Sundaresan
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EWMBA 299 – Competitive Strategy
The airline industry is also characterized by very high fixed costs. The majority of the operational costs (labor, landing fees, cost of aircraft etc.) are fixed regardless of how full the planes are, and the marginal cost of adding an extra passenger is almost negligible (just the cost of food plus an insignificant amount of extra fuel). Thus, on the margin, every extra seat sold contributes directly to the bottom line. This motivates airlines to undercut each other till price approaches marginal cost. Intense competition also lead to excess seat capacity in several markets. This, combined with periods of declining demand because of macro-economic factors, and the high fixed costs and low marginal costs make the airline industry very price competitive. Things like access to Computer Reservation Systems and innovative pricing coupled with yield management were competitive advantages for a little while before they become a staple of being in business as an airline.
Entry into the domestic airline industry is relatively easy since there are no significant barriers to entry. Inputs such as aircraft maintenance, food service, ground services, reservations...