BOEING VERSUS AIRBUS:

AN ECONOMIC ANALYSIS

A Thesis submitted to the Miami University

Honors Program in partial fulfillment of the

requirements for University Honors with Distinction

By

Alan John Cook

May 2008

Oxford, Ohio

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ABSTRACT

Boeing Versus Airbus: An Economic Analysis

By: Alan J. Cook

In business there have been few rivalries as spectacular as that between Boeing and Airbus. Not only are bottom lines and stakeholder returns at stake, but also national pride and supremacy of the skies. These two immense corporations have been battling it out for over four decades. But what makes this competition between two very different foes so epic? What is it that drives these two firms to compete so vigorously? Why are they competing at all? With only two firms controlling the entire market, the industry fits the classic definition of an oligopoly – and yet we observe neither firm has undertaken collusion or moved to limit output.

This paper will present an analysis of the competitive relationship between the rival firms within the large commercial aircraft manufacturing industry1 (or more simply the commercial aircraft industry).

This paper will be divided into four main parts, each attempting to answer a pivotal question to our understanding of the nature of the competition: What does standard economic theory tell us about oligopolies? What is actually observed in the commercial aircraft industry? What factors drive the competition? What implications do these findings have?

1 There are many firms that manufacture aircraft, including Bombardier of Canada and Embraer of Brazil, however Airbus and Boeing are the only manufacturers of Large Commercial Aircraft (LCA), and as such the focus of this thesis will be on the LCA segment of the Commercial Aircraft Manufacturing industry.

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Boeing Versus Airbus: An Economic Analysis By: Alan J. Cook

Approved by:

, Advisor Dr. James Brock

, Reader Dr. Barnali Gupta

, Reader Dr. Deborah Fletcher

Accepted by:

, Director University Honors Program

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TABLE OF CONTENTS

Abstract ...... 3

I. History of Jet Travel ...... 9

II. Standard Oligopoly Theory ...... 13

Cooperative & Non‐Cooperative Oligopoly Models ...... 16

III. Commercial Aircraft Manufacturing Industry Observations ...... 18

Number of Firms ...... 18

Market Concentration and Market Share ...... 19

Firm Structures ...... 22

Barriers to Entry ...... 24

Interdependence ...... 26

Price Competition ...... 27

Non Price Competition ...... 30

Innovations ...... 33

IV. What Factors Drive the Competition? ...... 38

Instrument of National Policy ...... 39

Order Size ...... 40

Differentiated Products ...... 41

Fixed Output ...... 42

Expanding Market ...... 43

Conclusion ...... 43

V. What Implications Does This Have? ...... 45

References ...... 46

Appendix ...... 48

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I. HISTORY OF JET TRAVEL

In order to truly appreciate this analysis, it is important to cast it in the appropriate light and context. We therefore begin with a brief history of the commercial aircraft industry.

The Beginning of Flight. The Wright Brothers flew their first plane in 1903 at Kitty Hawk. This was the first instance of heavier‐than‐air powered flight that carried a human being. Airplane development progressed slowly until World War I, at which time flight was recognized for the military advantages it provided. Several small firms cropped up to supply military aircraft. In the interwar period, plane development took aircraft from being constructed mostly of wood and canvas to aluminum. The onset of World War II saw tremendous improvements in airplane design and the level of production. Germany built the first practical rocket and jet engine powered aircraft towards the end of the war. Up to this point aircraft were used almost exclusively for military purposes, but after the end of

WWII, commercial aviation began to increase in popularity. Firms that had previously produced military airframes for the war switched over production to civilian aircraft. Companies such as Lockheed

Aircraft, Douglas Aircraft, and many smaller companies produced propeller‐driven aircraft that eventually launched the age of civilian commercial jet travel.2

The Jet Age. While civilian travel was firmly in the realm of propeller‐driven airplanes, the military – specifically the newly formed United States Air Force – took interest in the potential use of jet engines to power fighters and bombers. Boeing became a leader in jet engine technology, both due to luck and better engineers. Boeing then decided to take their expertise into the civilian market by producing a commercial jetliner. At the time, other manufacturers and airline executives believed that the cost and revenue structures could not be married to produce a profitable jetliner. This all changed

2 Heppenheimer, T. A. A Brief History of Flight. New York: John Wiley & Sons, 2001.

9 with Britain’s De Havilland Comet which was popular because it could fly faster, quieter, and above the weather, providing a smoother trip. 3

Boeing’s first jetliner – the 707 – was introduced in 1958, had four engines, and went on to be commercially successful. Lockheed and Douglas then proceeded to develop their own advancements:

Douglas building the DC‐8 in 1958 and Lockheed building the turbo‐powered Electra (propellers powered by a jet turbine engine instead of pistons, a derivative of the jet engine used). Because of

Boeing’s early lead and because of strategic business decisions, the 707 went on to become the industry leader, propelling Boeing to the forefront of large commercial aircraft manufacturing.4 The 707 was followed by the 727 in 1963, the 737 in 1967, the 747 in 1968, the 757 in 1983, the 767 in 1982, the 777 in 1994, and the 787 which is currently in development.5

The Birth of Airbus. In the 1960’s the commercial aircraft industry was dominated by American firms: Boeing, McDonnell‐Douglas, and Lockheed. European producers such as Hawker Siddeley of the

United Kingdom, Aérospatiale of France, and Deutche Aerospace of Germany realized that independently they did not have the resources necessary to build a large commercial airplane (LCA) that was capable of competing against the American jetliners. They formed what initially was called the

“A300 Project” which was collaboration between the three firms to product a medium‐range wide‐body jet. The A300 Project then went on to become a formal consortium: Airbus Industrie was established under French law and officially headquartered in Toulouse, France in 1970. The member firms of the consortium would take responsibility for the design and production of specific components, and the

French partner would assemble the final aircraft – Airbus Industrie was responsible for sales, marketing,

3 McIntyre, Ian. Dogfight. Westport, Connecticut: Praeger, 1992. 4 Heppenheimer, T. A. A Brief History of Flight. New York: John Wiley & Sons, 2001. 5 Boeing Commercial Airplanes. http://www.boeing.com/commercial/products.html.

10 and technical support for airlines. The first A300 entered into service in 1974; however, the United

Kingdom withdrew from the venture before the A300 reached its first customer.

Industry Collapse. Both Douglas Aircraft and Lockheed suffered serious setbacks in the 1960’s and the 1970’s. With Airbus still in its infancy, this led to a collapse in the commercial aircraft manufacturing industry. Douglas Aircraft began development of their DC‐9 in 1963, and determined that the proto‐typing process would take too long, so it took the plane directly from paper to production. This meant that any problems with the design had to be fixed on the assembly line. The results were production delays and cost overruns. The problems were too much for the company to overcome, and Douglas was forced to merge with McDonnell Aircraft – a military contractor – in order to avoid bankruptcy. Douglas became a wholly owned subsidiary of the newly named McDonnell‐

Douglas and restarted DC‐9 production and went on to develop the DC‐10 in 1968.6

Lockheed built one and only one commercial jetliner: the L‐1011 TriStar. This plane was very similar in design and competed directly with the Douglas DC‐10 and indirectly with the Boeing 727 and

747. However, the L‐1011 had production difficulties that delayed its launch for a year. In addition,

Lockheed had made the decision to contract with only one engine provider – Rolls Royce – and midway through the development of both the L‐1011 and the new engines that were to accompany it Rolls

Royce declared bankruptcy. This further set back the L‐1011, and Lockheed lost a substantial number of orders to the DC‐10 which had been released the previous year. The market simply was not big enough to support three separate firms and the associated development costs of four separate planes.

Lockheed produced only 250 planes and stopped production in 1981.7

The Rise of Airbus. The initial success of Airbus was poor; in 1979 only 81 A300s were in service. However, the launch of the A320 in 1981 marked Airbus as a major competitor. The A320 was

6 McIntyre, Ian. Dogfight. Westport, Connecticut: Praeger, 1992. 7 Heppenheimer, T. A. A Brief History of Flight. New York: John Wiley & Sons, 2001.

11 a superior product to the Boeing 737 against which it competed, and Airbus had over 400 confirmed orders for the A320 before the first production plane flew. 8 The A320 incorporated several technological improvements over competitors at Boeing and McDonnell‐Douglas, including fly‐by‐wire control systems, glass cockpits, and cockpit commonality. The success of the A320 propelled Airbus to develop the A330 and A340 which continued to integrate technological developments. This success, coupled with the demise of Douglas and exit of Lockheed, allowed Airbus to erode Boeing’s dominate market share. By the 1990’s, Airbus had surpassed Boeing in terms of number of orders.9

Jet Travel Available to the Masses. Air travel is no longer exclusively for the business traveler or the wealthy. Low‐cost airlines such as Southwest in the United States, Ryan Air, Wizz Jet, and Easy Jet in Europe, and numerous low‐cost airlines in Asia such as Spice Jet in India or Tiger Airlines out of

Singapore all offer especially low fares. Traditional airlines are constantly driving down the operating costs, thereby lowering their air fares.10 With the expansion of low‐cost air travel to developing countries such as India, China, Malaysia and Indonesia, jet travel is truly becoming accessible to everyone. 11

8 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 9 Heppenheimer, T. A. A Brief History of Flight. New York: John Wiley & Sons, 2001. 10 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 11 McIntyre, Ian. Dogfight. Westport, Connecticut: Praeger, 1992.

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II. STANDARD OLIGOPOLY THEORY

An oligopoly is an industry that is dominated by a few firms that control a significant amount of the market for that industry. The commercial aircraft manufacturing industry is dominated by only two firms – any fewer and it would be a monopoly. These two firms control the entire market; between them they have 100% market share – it is not possible for them to have more. By definition, then, the commercial aircraft manufacturing industry is a duopoly, an oligopoly with only two firms. But the analysis does not end there. The industry meets the definition of an oligopoly, but meeting the definition does not give us insight into the nature of the competition.

Ford, General Motors, and Chrysler. ExxonMobil, Valero Energy, British Petroleum, Royal

Dutch/Shell, Chevron/Texaco. American, United, Delta, Continental, Northwest. American Tobacco Co.,

Ligget & Myers, R.J. Reynolds, Philip Morris Co. If one were to poll a group of economists, the majority would agree the above‐mentioned companies all act as part of an oligopoly, in their respective industry.

But what characteristics are common across the different industries that are unique to oligopolies and can be used as indicators of an oligopolistic relationship? While we can identify several key indicators of an oligopolistic relationship between firms (listed below), it is in comparing the commercial aircraft manufacturing industry to known and prevalent oligopolies that is the crux of this analysis.

Interdependence & Collusion. When looking at the prevalent oligopolies present today we notice several key indicators that identify an industry as being dominated by an oligopoly. Arguably the most important are interdependence and collusion among the firms within that industry. Firms may choose to work together to set either output or prices; colluding firms recognize that if they work together – either implicitly or explicitly – profits can be held artificially high. However, this collusion is difficult to maintain because each firm has an incentive to ‘cheat’. We see that when a firm in an

13 oligopoly moves to gain more market share by lowering their price, the other firms in the oligopoly move to ‘punish’ the dissenting firm by their lowering prices too, and all are less profitable as a result.

Interdependence refers to strategic interaction between firms when independently making market choices. Each firm considers the actions of other market firms when making ita decisions; the profit of each firm is dependent on the strategies undertaken by the other firms. The resulting equilibrium is referred to as a Nash Equilibrium12 where no market firm can improve its situation given the choices of all other firms. Interdependence often leads to uniform pricing from firm to firm, but not necessarily the collusive price.

Barriers to Entry. Interestingly, when looking at the examples of oligopolies listed above, we note that not all of them are in industries with exceptionally high barriers to entry. It is inexpensive and technologically simple to produce cigarettes. On the other hand, the production of automobiles and the refinement of oil are industries with fairly substantial barriers to entry; it takes extremely large amounts of capital equipment to refine oil and significant investments in plants and machinery to produce automobiles. What we observe is that in every example of oligopolies there are some forms of barriers to entry, whether they are a result of the nature of the industry, as is the case with automobile manufacturing and petroleum refinement, or created artificially by participants in the oligopoly, as is the case with tobacco.

Price & Non‐Price Competition. In a general sense, firms would rather be price‐setters rather than price‐takers. The reason for this is simple: firms understand their own cost structures – if they are able to set their price, then they are able to determine their own level of profit and thus reach a profit‐ maximizing position. Therefore firms have an incentive towards avoiding price competition with other

12 Nobel laureate John Nash is credited with the development of this particular equilibrium concept in his work in game theory. For more on game theory and Nash equilibriums, see Lynne, Pepall, J. Daniel Richards and Norman George. "Industrial Organization: Contemporary Theory and Practice." South‐Western College Publishing, 1999. 223‐269

14 firms if at all possible. In order to be a price‐setter, a firm must be in a less than perfectly competitive market where the firm has some influence over price and does not face a horizontal demand curve. This can only occur when a firm has substantially enough of the market that they can affect price changes.

Within oligopolies, a price leader sets the first price, and firms in the industry subsequently set their prices. The followers have an incentive to undercut the price leader in order to gain more market share.

Non‐price competition is very similar and often serves as an escalation of price competition to the next level. To put it a different way, firms have an incentive to isolate their firm and act as a monopoly. In a duopoly, this can be achieved if firms tacitly or explicitly agree to limit their product sets so that they are able have a monopoly on individual types of planes (130‐150 seats for example).

Observing price and non‐price competition can provide significant insight into oligopolistic behavior.

Innovation. Collusion – either explicit or implicit – hampers innovation within an industry. This is because firms have an incentive not to ‘rock the boat’ and introduce change. The line of logic for colluding firms is simple: if one changes, all must change in order to compete; change costs money, which diminishes everyone’s profit. Therefore, firms that are colluding to keep profits high have an incentive to avoid innovation.13 14

Number of Firms, Market Concentration, and Firm Structure. In addition to the above five characteristics, one can gain insight by looking at the firm structures of both Airbus and Boeing, as well as by analyzing the industry in which both firms participate. All of the following models begin by assuming that firms produce only one good in an industry with little or no product differentiation – for example production of oil.

13 Loury, Glenn C. "Market Structure and Innovation." The Quarterly Journal of Economics (1979): 395‐410. 14 Reinganum, Jennifer F. "Uncertain Innovation and Presistence of Monopoly." American Economic Review (1983): 741‐748.

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COOPERATIVE & NON‐COOPERATIVE OLIGOPOLY MODELS

Economists have identified several possible oligopoly structures and developed specific models that attempt to quantify and understand the incentives that motivate firm behavior. There are many different models used to describe oligopolistic firm behavior based on the way in which firms interact.

Cartels. Sometimes called trusts, these are the organizations or affiliations of firms that actively attempt to increase their profits through collusive behavior that increases prices. Firms that are part of a cartel will formally agree to limit their output or raise their prices. The ultimate goal is for all firms to come together and make their decisions as a monopoly would. Market forces would no longer divide up market share; the member firms would agree how the market would be divided. This model is an example of a cooperative oligopoly model.

Cournot Model. Unlike a cartel, the firms in a Cournot model oligopoly act more independently.

Each firm takes into account what they believe the other firms will do when they set their output. All firms within the industry simultaneously set their output using their understanding of the strategies of all other market participants. This equilibrium is known as a Cournot Nash equilibrium. The level of output is somewhere between what a monopoly would produce and what perfect competition would produce.

Stackelberg Model. In the Stackelberg model there is a dominant, or leader firm, and a rival or follower firm. The dominant firm will set its output first based on what they predict the other firm will do. The rival firm then sets its output based on what the best response by the follower. In this oligopolistic environment, the level of output will be greater than in a simple Cournot model.

Bertrand Price‐Setting Model. In the previous models the oligopolists set output and the market forces set the price. However, in the Bertrand model the oligopolist sets prices and then lets consumers

16 determine how much of their product they wish to buy. The equilibrium in the Bertrand model is insensitive to demand since price is set only as a result of the firm’s costs. When the various oligopoly firms produce differentiated products, the goods are strategic compliments.

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III. COMMERCIAL AIRCRAFT MANUFACTURING INDUSTRY OBSERVATIONS

In order to meaningfully analyze the competitive relationship between Airbus and Boeing, it is important to look at the aforementioned factors. These factors, when looked at in conjunction with one another, can provide a picture of the competitive relationship.

NUMBER OF FIRMS

When looking at the commercial aircraft industry, there are three main segments:

1) large commercial airplanes (LCA),

2) regional jets, and

3) private jets.

Currently, only Airbus and Boeing belong to this LCA segment, with firms such as Embraer of

Brazil and Bombardier of Canada taking up positions within the Regional Jet segment in North America, and firms such as Gulfstream and LearJet round out the private jet market. There are striking differences between the LCA and regional jet segments. The LCA market is truly global, which will be discussed later, while the regional jet market remains localized generally to one hemisphere –

Bombardier and Embraer typically do not sell aircraft in Europe or Asia for example; those markets are generally served by different firms within those regions.15

This is not to say that there is not some overlap – both Boeing and Airbus also sell their LCA privately to individuals and corporations and Embraer does produce a regional jet that borders on the

LCA category – but the overlap is minimal, and there are only a handful of private owners of Boeing or

Airbus jetliners. In addition, the private jet market is minuscule in comparison to the LCA, and small compared to the regional jet market. Because of the wide difference between the LCA and regional jet

15 Heppenheimer, T. A. A Brief History of Flight. New York: John Wiley & Sons, 2001.

18 segments and because of the minimal overlap, the focus of this paper will be on the competition for the production and sale of LCA within the commercial aircraft industry.

MARKET CONCENTRATION AND MARKET SHARE

As mentioned above, there are only two firms that share nearly 100% of the market. While there are still older planes produced by defunct Soviet firms as well as some European manufactures such as British Aerospace or France’s Aerospatiale that remain in limited commercial service, it is safe to say that nearly all LCA were produced by either Boeing or Airbus16. Therefore the market is highly concentrated and qualifies as a classic duopoly.

Within the commercial aircraft industry, there are many different methods to measure the relative market share of each firm. Generally speaking, the different methods depend upon where in the aircraft’s life‐cycle one measures: Number of jetliners produced, number of jetliners in service, or the number of jetliners ordered.

Number of jetliners produced. This measure would count all of the planes that have ever been built. This would include discontinued jetliners and jetliners that have been retired from active commercial service. This would not, however, include planes that were built as prototypes or were used as demonstrations of concept. The question then becomes, do you include the planes produced by firms that have since been acquired or merged with Boeing or Airbus? For example, does one count the planes produced by McDonnell‐Douglas as part of the jetliners produced by Boeing?

There are arguments on each side. Originally the planes were produced in competition to one another; therefore one could argue that entire jetliner product lines might never have been produced if the firms had been one from the beginning. From the other perspective, because the acquired firm is

16 Boeing has absorbed via merger McDonnell‐Douglas, and all other American firms’ planes are no longer in service; currently only Boeing and Airbus produce LCA.

19 now part of the company – they have acquired all the assets, debt, etc. from the acquired firm – then it should follow that the purchasing firm has acquired the right to count the purchased firms planes as part of their market share. In addition, it is common practice to increase your claim to market share after a merger or acquisition – Procter & Gamble would certainly increase their claim to the share of the toothpaste market if they were to acquire Colgate. In fact, antitrust action looks at the combined market share of the two firms after merger or purchase to determine whether or not to allow the combination to proceed. Due to this precedent, this analysis will include under Boeing all planes produced by acquired firms and under Airbus all planes produced by acquired firms.

In terms of the number of jetliners produced, Boeing wins a clear victory. This is in no small part because of Boeing’s early arrival into the manufacture of large commercial jetliners. In addition, the

1997 merger with McDonnell‐Douglas (McDonnell earlier merged with Douglas to form McDonnell‐

Douglas in 196717) has also helped to increase Boeing’s overall market share, since both Boeing and

Douglas were producing jetliners long before the Airbus consortium formed. If one looks more recently; since 2000, we see that Boeing’s dominance is not as clear. Since 2003, Airbus has actually held the lead in terms of the number of planes delivered per year. In 2007 Airbus and Boeing were dead even, with each producing 44718 and 44119 respectively. (See Exhibit 1, 2 & 3 for a breakdown of market share by number of jetliners produced.)

Number of Jetliners in Service. This measure would be very similar to the number of jetliners produced but it would exclude those planes that have been removed from active commercial service. It would again raise the question of whether or not to include the planes produced by firms that were eventually acquired. For the same reasons as given above, this analysis will continue to include planes

17 Prior to the merger with Douglas, McDonald never participated in the commercial aircraft manufacturing industry, having only ever produced military aircraft. 18 Boeing Commercial Airplanes http://active.boeing.com/commercial/orders/index.cfm 19 Airbus S.A.S. website http://www.airbus.com/en/corporate/orders_and_deliveries/

20 produced by acquired firms in the market share of the purchasing firm. Implicitly this measure in conjunction with the measure of jetliners produced will provide the number of jetliners retired by subtracting the former from the latter.

The useful life of a jetliner is around 25 years, thus clearly limiting the period this measure looks into history.20 The window of time that this measure looks at is from the present (2007) back approximately until 1980. Therefore this measure is most relevant in determining market share since

1980. Since Airbus did not take off until the 1980’s, the gap with Boeing began to close about this time.

Therefore Boeing is no longer the only major provider of jetliners in this measure, though Boeing still retained the lead because of the strong presence prior to 1980. There are some rather important things to notice: While the historical position of both companies is certainly important, it does not carry the same weight as current performance. Up until the late 1990’s Boeing was the clear winner. In 2000 we observe that, for the first time, Airbus was delivering more planes per year than Boeing.21

Number of Jetliners Ordered. While both of the previous measures have looked solely towards the past for measures of market share, the number of jetliners ordered can give us insight into the future. Orders should eventually equate into deliveries, and therefore should equate into future payment streams. It is for these reasons that number of orders is the most frequently cited in news reporting.

The number of orders can be broken down into three main categories: orders delivered, orders not delivered, and total orders. To which one looks depends mostly upon the motivations behind the analysis: One would look at orders delivered to gauge past performance of a jetliner’s sales; one would look at orders not yet delivered to gain insight into the future health of a jetliner and its manufacturer;

20 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 21 Boeing Commercial Airplanes http://active.boeing.com/commercial/orders/index.cfm & Airbus S.A.S. website http://www.airbus.com/en/corporate/orders_and_deliveries/

21 and one would look at the total number of orders to get the overall picture in terms of jetliner’s sales performance. Each measure provides important insight for the purpose of this paper.

In starting with total number of jetliners ordered, it becomes quite clear that the Boeing 737 has been the most successful jetliner in production, with 7,676 ordered as of the end of 2007.22 One should also note that the A320 – Airbus’ direct competitor with the Boeing 737 – and all of its derivatives have garnered less than half the number of 737 orders.23 However, when looking at the larger planes produced by each competitor, it is clear that Boeing 747 is outpacing Airbus’ A380. Boeing has built a commanding dominance with its 777 and 787 Dreamliner. Orders for each are 1,044 and 817 respectively, which significantly surpass the number of orders for the A330, Airbus’ second most successful plane behind the A320.24

Both Airbus and Boeing have seen significant growth in the number of aircraft ordered since

2000; jetliner sales have kept pace with the growth in air travel. What is interesting to note is that both firms have seen near identical growth. Airbus, however, saw Boeing surpass them in orders for 2005 and 2006, but regained the lead in 2007.25 (See Exhibits 4, 5 & 6 for a breakdown of market share by number of jetliners ordered.)

FIRM STRUCTURES

Boeing. The Boeing Company is a publicly‐traded firm registered with Securities and Exchange

Commission in the United States and listed on the New York Stock Exchange (ticker symbol BA). The firm is owned by shareholders via 1,012,261,159 outstanding shares of Boeing Stock (2006 Boeing 10‐K),

22 Boeing Commercial Airplanes http://active.boeing.com/commercial/orders/index.cfm 23 Airbus S.A.S. website http://www.airbus.com/en/corporate/orders_and_deliveries/ 24 Airbus S.A.S. website http://www.airbus.com/en/corporate/orders_and_deliveries/ 25 Boeing Commercial Airplanes http://active.boeing.com/commercial/orders/index.cfm & Airbus S.A.S. website http://www.airbus.com/en/corporate/orders_and_deliveries/

22 making it a publicly owned firm managed by a board of directors on the shareholders’ behalf.26 Boeing regularly publishes its financial information in both its SEC filings (10‐K and 10‐Q, among others) and distributes an annual report to its shareholders. These filings and reports contain extensive detailed information on Boeing’s commercial airplanes division, the entity responsible for the design, testing, and manufacture of all Boeing commercial jetliners.27

Airbus. The current structure of the firm now known as Airbus S.A.S. is extraordinarily complex and difficult to fully discern. Airbus S.A.S. was formed after the merger of DaimlerChrysler Aerospace

AG (DASA) of Germany, Aerospatiale‐Matra of France, and Aeronauticas SA (CASA) of Spain to form

European Aeronautic Defense and Space Company or EADS. As a result of the merger, EADS now holds

80% of the shares of Airbus S.A.S. The remaining 20% is owned by BAE Systems, a British firm. All four firms, DASA, Aerospatiale, CASA, and BAE, were the original founding firms of the Airbus Consortium.

EADS is a simplified joint‐stock company that has major shareholders such as SOGEADE a French state‐ owned holding company, SEPI a Spanish state‐owned holding company, and Daimler AG, with the

French government directly owning a portion of the publicly traded shares.28 Daimler is partially owned by the German government, and BAE Systems is partially owned by the British crown29. In addition,

EADS is traded on six public stock exchanges in Europe. Though the connection is not direct, Airbus

S.A.S. continues to be partially owned and controlled by the governments of four European countries.

EADS and BAE Systems each publish annual financial reports. However, Airbus S.A.S does not publicly distribute its financials. In addition, the Airbus financial information is not directly contained in either the EADS or BAE reports. It is therefore very difficult to determine Airbus’s financial status. For further clarification of Airbus’s firm structure, please refer to Exhibit 7.

26 Boeing Company. Form 10‐K. Chicago, IL: Boeing Company, 2006. 27 See for example Boeing’s 2007 Annual Report: Boeing Company. Annual Report. Chicago, IL: Boeing Company, 2007. 28 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 29 The British Crown now holds only a minority share of BAE Systems due to partial privatization.

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BARRIERS TO ENTRY

Barriers to entry exist for a number of reasons, but the end result is that there is limited entry into a market or industry because the hurdles that must be overcome are great, and therefore firms that are already part of the industry or market have an advantage and are insulated from competition from new entrants. Within the commercial aircraft industry, this is especially the case. To illustrate the point, it took a government consortium formed by three European countries that directly subsidized its creation to enter the commercial aircraft industry in 1967.30 It took the resources of three national governments to form a firm capable of competing against the two large entrenched firms at the time:

Boeing and McDonnell‐Douglas. Specifically related to the commercial aircraft industry, there are a number of barriers to entry worth discussing.

Financing. The cost to design, prototype, build, and deliver a new LCA is immense. For the

Boeing 777 the development costs were estimated to be $10‐12 billon31. The new Airbus A380 has estimated development costs of €12 billion ($16.2 billion)32. When new planes are developed, it is often the case that the firms producing them will have little idea as to how many they must produce to achieve profitability. The firms producing these planes spend years designing, prototyping, testing, and building them before they ever go into production and the first one is delivered to a customer.

Therefore financing is especially difficult given the long time horizon and the significant degree of uncertainty. In addition, these LCA development plans are notorious for going over budget. The 777

30 Thornton, David Weldon. Airbus Industrie. New York: St. Martin's Press, 1995. 31 Gates, Dominic. "Airbus 350 Muscles in on the 777." Seattle Times 31 July 2007. 32 Factbox‐Sizing up the Airbus double‐decker. 12 November 2007. 2 February 2008 .

24 was originally budgeted at only $2 billion33. The A380 was initially estimated to cost €8.8 billion ($11.9 billion) when approved by the supervisory board of Airbus34.

Engineering. Aircraft of the size produced by Boeing and Airbus require significant engineering experience and know‐how in order to successfully design, test, and produce a viable jetliner. It almost boggles the mind to comprehend what is required to design aircraft that must successfully carry 130 to

555 passengers anywhere from 250 to 10,000 miles daily year‐round without failure for 25 years while remaining economically profitable for airlines.35 The task is daunting to say the least. To put this into perspective, Boeing has only designed eight planes from scratch since they started building jetliners in

1955.36 Airbus has only designed four since 1969.37

Technology. The commercial aircraft manufacturing industry has often been compared to NASA style programs in their drive to develop and implement new and innovative technological solutions.

Commercial jetliners are behind military aircraft and space flight in terms of the volume of technological developments.38 In order for a firm to be competitive in this industry, it must keep pace with the rate of technological change. At the current stage of development, either Boeing or Airbus is capable of building a plane that will ferry passengers from point A to B. It is how quickly, efficiently, quietly, comfortably, and safely that matters. Improvements in these areas arise because of design improvements via technological change. New entrants and current competitors alike can only expect to be competitive if they are able to produce and bring to market technology that improves upon the existing jetliners.

33 Gates, Dominic. "Airbus 350 Muscles in on the 777." Seattle Times 31 July 2007. 34 Norris, Guy. Airbus A380: Superjumbo of the 21st Century. Osceola, WI: Zenith Press, 2005. 35 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 36 Boeing Commercial Airplanes. http://www.boeing.com/commercial/products.html. 37 Airbus S.A.S http://www.airbus.com/en/aircraftfamilies/ 38 McIntyre, Ian. Dogfight. Westport, Connecticut: Praeger, 1992.

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Production & Logistics. Every jetliner contains literally hundreds of thousands of parts, ranging in size from rivets to seats to overhead compartments. After designing these components, they must then be manufactured and brought together into one aircraft in one place. This is a monumental task that has brought down previous market participants. The primary reason for the collapse of Douglas

Aircraft was their inability to manage their supply chain and bring together airplanes at a reasonable cost.39 Boeing’s trouble in the late 1980’s was in large part due to then‐current leadership’s inadequate management of part procurement and logistics.40

INTERDEPENDENCE

One of the key indicators of true oligopolistic behavior in industries such as oil, tobacco, automotive manufacturing, or airlines, is interdependence among firms within the industry. This is most obvious when the firms collude to set prices and output, erect barriers to deter new entrants, or limit competition in other ways. The form of this collusion can be either explicit or implicit. In every industry mentioned, we observe explicit collusion through joint ventures and mergers or implicit collusion in setting prices or limiting technological developments. When looking at the commercial aircraft industry, there have been several joint ventures between Boeing and Airbus. Most of these have taken place surrounding the interest in developing a “super jumbo”.41 However, none of the joint ventures resulted in anything tangible. Airbus eventually went alone and developed the A380. In hindsight it appears that many of the past joint ventures were an attempt to learn of technological developments being made by the other firm.42 This example provides a direct instance of strategic behavior.

39 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 40 Lawrence, Philip K. and David W. Thornton. Deep Stall. Hampshire, England: Ashgate, 2005. 41 McIntyre, Ian. Dogfight. Westport, Connecticut: Praeger, 1992. 42 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007.

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PRICE COMPETITION

It stands to reason that within a competitive industry there will be competition based on price; in competitive industries the firms become price‐takers and not price‐setters. However, in a relatively non‐competitive industry there will be little price competition. As with most things in economics, pricing is not this black and white in the commercial aircraft manufacturing industry. While the two firms are mature and have an extensive product line, all their products do not directly compete with one another. For example, the Boeing 737 and Airbus A320 directly compete for sales, but the Boeing 747 has remained unchallenged for almost 30 years. The result is that price competition is fierce for some planes – the 737 versus the A320 – while there remained no competition for others, like the Boeing 747 for decades until the development by Airbus of the A380.43

Discounts. When a new plane is in development, the manufacturing firm sets a ‘price’ for that airliner. However, no airline ever actually pays that price. Each customer receives discounts off the sticker price, and this becomes the de facto price for purchasing that jetliner. In addition, larger orders receive additional discounts on top of the original discounts. The size of the discounts is a closely‐ guarded secret – the result is that the price any one airline pays for a plane is difficult to determine. This strategy is known as price discrimination where Boeing and Airbus are taking advantage of each airline’s different willingness‐to‐pay. The actual revenue that Airbus or Boeing receives from an order is extremely nebulous.44

Under‐pricing. The Boeing 747 for almost 30 years went unchallenged by Airbus. Until the development of the A380, Airbus had no plane that could carry 400+ passengers over distances beyond

10,000 miles. With little competition, Boeing was capable of charging a higher price than perhaps would otherwise be the case within a competitive environment. The Airbus A330 and A340 have enjoyed

43 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 44 McIntyre, Ian. Dogfight. Westport, Connecticut: Praeger, 1992.

27 significant success in Europe because of the non‐price competition that is discussed in the next section.

The Boeing 737 and the Boeing A320 are very similar planes carrying similar numbers of passengers over similar distances. Therefore the 737 and A320 directly compete for airline customers. The significant competition drives down the price of airliners offered by both firms. In the competition to get large orders, both firms have been accused of under‐pricing their 737 or A320 in order to land the deal. This is financed by the profits each firm makes on the sale of the more lucrative 747 and A330/40. Estimates place the pure profit generated on the sale of each 747 to be approximately $25 million.45

Order size. It is often the case in the commercial aircraft industry that large orders can make or break a firm, especially at the critical point where firms have invested significantly in the development of a new plane (such as the prototyping process) but have yet to realize significant sales of that plane. An example would be Douglas Aircraft’s DC‐8, which was bogged down in cost‐overruns and production delays. The Company would have become illiquid and failed a decade earlier had it not been for timely orders by Northwest Airlines and Delta Airlines. More recently, the success of the Boeing 787

Dreamliner has been in part the result of large orders from several East Asian airlines – such as Vietnam

Airlines, Quantas, and All Nippon Airways, and the Chinese government.46

It should be noted, however, that the Airbus A380 development project was kept afloat in part because of the orders for private luxury jets from wealthy individuals and heads of state such as the kings of several oil‐producing Middle East counties. In these cases, the ability to incorporate unique and extravagant luxury trump the operation economics that airlines usually face.47

Government Subsidies. Perhaps one of the most contentious issues in the competition between

Boeing and Airbus has been subsidization of each firm by their respective governments: The United

45 Sell, T. M. Wings of Power. Seattle: University of Washington Press, 2001. 46 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 47 Airbus S.A.S. Annual Review. Toulouse, France: Airbus S.A.S, 2005.

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States military’s indirect subsidization of Boeing, and the French, German, Spanish, and United

Kingdom’s direct subsidization of Airbus.

Because Airbus was formed as a direct result of the governmental actions of the French,

German, and United Kingdom’s legislatures, there traditionally has been a strong link between the governments of the consortium’s state‐owned firms. The majority of the subsidization came during

Airbus’s first two decades, when they were the severe underdog and did not have sales that would generate cash organically. In the past, this has been most strongly represented in direct launch aid appropriated from the tax revenue of the national governments. The entire launch cost for the A300 &

A320 came from government subsidies.48 Some of the launch financing had to be repaid at favorable interest rates, while some of the launch money would never have to be returned. To date, it is unclear if all of the loans to Airbus from the member governments have been repaid. Subsidies continue to this day: the launch of the new A380 was partially subsidized through loans that must be repaid with interest.49

Boeing was a manufacturer of military aircraft before it became a leading producer of LCA. In fact, Boeing was able to develop its first commercial jet airliner because of the technology and know‐ how it had developed in the construction of military jets. Boeing remains to this day one of the largest defense contractors for the United States military50. There is strong evidence to suggest that the profits derived from its military business helped keep the firm liquid and solvent when the LCA segment of

Boeing was doing poorly. In addition, there is strong evidence that the research and development that

48 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 49 Contrada, John Della. "Subsidy War Could Harm Boeing More Than Airbus, UB Reseracher Says." University of Buffalo Reporter 24 June 2004. 50 For a period of time Boeing actually exited the defense industry but has since re‐entered and become a major participant with the 1997 merger with McDonnell‐Douglas

29 produces new technologies and materials for military applications also find their way into Boeing’s jetliners.51 Though the subsidization may not be as direct, it is real nonetheless.

NON PRICE COMPETITION

Nationalized Airlines. Within Europe the founding governments of the Airbus consortium have historically applied significant pressure on the national airlines to buy Airbus jetliners. Several of the airlines – most notably Air France – are partially owned by European governments. Especially in the beginning, the national carriers were Airbus’ only customers.52 Outside of Europe, Air India is owned by the Indian government, Air China is owned by the Chinese state, and Singapore Airlines is owned by the

Singapore government. In addition, there has always been a strong link between the Japanese government and several Japanese airlines.53 The link between airlines and governments provides a unique opportunity for competition between Airbus and Boeing. Governments have used their influence over airline executives to encourage them to buy the planes of the firm that has a large presence in their country. If either Airbus or Boeing has a subassembly plant in a country, this creates jobs and can improve the local economy. Government policy makers see this, and then wish to encourage Airbus or Boeing to expand their operations in their country. These government officials also understand that expansion only comes if the manufacturer is doing well. Therefore in the minds of the government officials, they equate their airline purchasing Airbus or Boeing products with providing jobs and economic improvements.54

This type of non‐price competition is especially important to developing countries such as India and China, because jet travel is growing fastest in Asia. Developing countries have added pressure to create jobs and to bring in foreign direct investment. Because of China’s large geographical size and the

51 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 52 McIntyre, Ian. Dogfight. Westport, Connecticut: Praeger, 1992. 53 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 54 Sparaco, Pierre. "Transatlantic Quarrel." Aviation Week & Space Technology 6 September 2004: 26‐27.

30 level of influence over the airlines by the government, both Airbus and Boeing have been putting significant effort into sourcing sub‐assemblies from China.55 What makes this especially important in

China is the fact that jetliners are often bought by the Chinese government on behalf of the Chinese airlines and not by the airlines directly.56

Jetliner Financing. Airbus has historically had a unique advantage over Boeing that is often overlooked. This is Airbus’ ability to supply financing (through the consortium’s member governments) at attractive terms for the purchase of their aircraft. Airbus’ logic is simple: If airlines cannot get the cash, they can’t buy their planes. Therefore Airbus began to assist airlines that could not obtain financing in the global credit markets. Airbus then realized that they could use financing as an additional means of competition with Boeing to secure orders of planes. Originally the financing was done on an ad hoc basis directly involving the governments of the consortiums’ members, most often France. As time progressed and Airbus began to turn a profit as a result of their operations, they began to offer up financing – still with the assistance of member governments – to all customers.57

Boeing has had little opportunity to offer up competition for Airbus’ attractive financing. Boeing is a private firm, thus they responsibly cannot offer terms better than Airbus or what the global credit market offers and remain a viable company. Therefore Boeing has had to rely on the U.S. government’s

Import‐Export bank as a means for assisting struggling airlines to finance Boeing jetliner acquisitions.

The success of this has been hit‐or‐miss, and has resulted in more disputes with Airbus than any other issue. Boeing contended that without the financing, Airbus would not have sold many of their planes,

55 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 56 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 57 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007.

31 and that the only reason many airlines went with Airbus products over Boeing products was because of the financing, not because they offered a superior airplane.58

To date, this remains one of the most hotly debated issues regarding the competitive relationship between Airbus and Boeing. It has spawned a number of congressional hearings and investigations as well as a number of international treaties. As a result, under the US‐EU Agreement on

Trade in Large Commercial Aircraft in 1992 and World Trade Organization guidelines developed as part of Uruguay Round of the General Agreement on Tariffs and Trade in 1994, financing the sale of jetliners remains legal, though it is now highly restricted.59

Government Intervention. National pride and LCA manufacturing has intrinsically been linked since Pan American Airways began international air travel. This has continued to the current day, with national pride on the line with each new jetliner sale. The heads‐of‐state of the United States and several European nations have actively gotten involved in order to see that a deal for the sale of their respective jetliners makes it through. The President of France has been involved in numerous deals with foreign airlines. President Bush helped seal the deal with China in 2004 during a visit by the Premier of the People’s Republic of China.60

Government intervention also comes in the form of government protection for their respective firms. The United States Congress, the Department of State, and the White House have often become involved in attempts to protect Boeing from what they view as unfair competition from Airbus. France,

Germany, and the United Kingdom continuously play a role in the European jetliner sales. The result has been several trade agreements between the United States and the European Union, the latest of which is the 1992 US‐EU Agreement on Trade in Large Commercial Aircraft. There are also continuous

58 Tomlinson, Richard. "Behind the Latest Boeing‐Airbus Spat." Fortune 1 November 2004: 14. 59 Holmes, Stanley. "Finally, A Boeing‐Airbus Showdown." Business Week Online 7 October 2004. 60 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007.

32 complaints filed in the World Trade Organization on behalf of either Airbus or Boeing. The latest of there was a 2005 complaint filed by the United States against the European Union, and a cross‐ complaint filed by the EU against the United States. Each alleged that illegal subsidies had been provided to their respective jetliner manufacturer. The result was that each side was found guilty and therefore no sanctions were imposed.

INNOVATIONS

In the relatively recent commercial aircraft industry environment, one can observe the following phenomena:

1) Boeing is the dominant firm,

2) Boeing becomes flush with past success and allows Airbus to take the lead,

3) Airbus is the dominant firm, and

4) Airbus becomes flush with past success and allows Boeing to take the lead.

In the transition from 1 to 2, and from 3 to 4, one of the key factors driving the change from leader to underdog has been the technological development by the then underdog that begin to endear the innovator in the eyes of the airline executives. Of the innovations listed below, the first and second were developed as a means to erode Boeing supremacy over Airbus during 1) above. The innovations listed third, fourth, and fifth were developed as a means for Boeing to reclaim the dominant position during 3) above.

Fly‐by‐Wire Systems. The Boeing 707, 727, original 737, original 747, and the Douglas DC‐9, the

McDonnell‐Douglas MD‐8 were all built with control surfaces that were connected to the cockpit’s peddles and yoke via steel cables running throughout the plane’s fuselage and wings. When the pilot pushed a peddle in the cockpit, this applied tension to the cable attached to it, which in turn caused the flight surface to move. Such systems were complicated to design, engineer and properly calibrate. This

33 type of configuration requires that the steel cables be properly tensioned, and significant effort must be made by the airlines to maintain these complex systems operating throughout the entire plane.61 When

Airbus was preparing to build its second airplane – the A320 – it was not in a position to engineer and build such a complex system.62 This was because the wing was made by one company, the fuselage by another, the cockpit by a third, and the wing box by yet another firm – and all with little interaction between the various firms. Each used different computer‐aided drafting systems that were incompatible. To design a system that extensively ran throughout the entire plane was logistically impossible given Airbus’ structure. Therefore designers were forced to turn to another method of controlling the plane’s flight surfaces.63 “Fly‐by‐wire” was at the time in its infancy with little commercial application. Airbus saw this technology as a solution to its problem. In developing this technology, it quickly became apparent that it was simpler to design and build and did not require the airlines to perform costly maintenance and calibration.64 Airbus has included this technology in all of its jetliners. Boeing was very resistant to integrating this new technology in its designs because the new technology would require their engineers to move up a steep learning curve.65

Cockpit Commonality. In 1978 when Airbus was preparing to launch the development of a new

LCA, it had only one product, the A300. At the same period in time, Boeing had a diverse product set ranging from the 727, 737, 757, 767, and 747. How was Airbus to compete with this complete product offering with only two planes? Airbus’ answer was cockpit commonality. Each of Boeing’s planes had different cockpit configurations. This was further compounded because each derivative also had different configurations. If a pilot was certified to fly a 737, he or she could not also pilot a 757. A 747‐

61 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 62 Airbus’ first plane was built using conventional methods; this caused significant delays that nearly brought down the project. Airbus had difficulty overcoming these engineering challenges, and put the firm at a severe disadvantage when preparing to launch their second plane. 63 Thornton, David Weldon. Airbus Industrie. New York: St. Martin's Press, 1995. 64 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 65 Bernstein Research. "Commercial Aircraft Upcycle ‐ Climbing Higher with Global Demand." 2006.

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100 pilot could not fly a 747‐300.66 In addition, each pilot must fly a certain number of hours each year in order to maintain his or her certification. This could be quite expensive for the less frequent 747 and

767 flights. Airbus saw an opportunity to configure their cockpits such that A300 pilots could also be certified on their new planes, which were to be smaller. Therefore pilots could fly the more frequent, shorter routes in their new A320 to maintain their certification for the A300. In addition, pilots could easily be moved between routes and plane types. For airlines, this meant increased flexibility and decreased training costs.67

Engine Configurations. Conventional wisdom had always held in LCA that four engines were needed to cross the Atlantic or Pacific oceans; in case one engine failed there would still be three engines to make the trip. Capitalizing on this wisdom, when Airbus built its A330 and A340, they built the A330 with two engines for shorter routes, and the A340 with four engines for longer international routes. Besides the engine configuration, the fuselage, cockpit, and wings were the same.68 However, four engines have one major problem: Cost. Four engines consume more fuel than an equivalent twin engine airplane. Four engines also require twice the number of spare parts and twice the maintenance.

While this wisdom held, there were not engines capable of producing the thrust required to propel a jumbo jet with only two engines. In the 1980’s and early 1990’s high‐bypass turbofan jet engines were developed that produced substantially more thrust than previous simpler turbojet engines. These new high‐bypass turbo fan engines were more reliable, consumed less fuel, and produced more thrust. Boeing, looking at the highly successful A330 and A340, was trying to find a way to gain a competitive advantage in the jumbo market. To that end, Boeing developed and released the

66 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 67 Bernstein Research. "Commercial Aircraft Upcycle ‐ Climbing Higher with Global Demand." 2006. 68 Bernstein Research. "Commercial Aircraft Upcycle ‐ Climbing Higher with Global Demand." 2006.

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777 in 1994 with only two high‐bypass turbofan engines. The 777 was significantly more fuel efficient than the A340, and the 777 then propelled Boeing back into dominance.69

Fuel Efficiency. With the price of oil continuing to rise with no end in sight, continuing pressure has been placed on the airlines in terms of their fuel costs. This in turn has become an incentive for the aircraft manufacturers to develop the most fuel efficient planes possible, with the firm capable of producing a fuel efficient plane gaining a sizable competitive advantage. For Airbus and Boeing, the path towards fuel efficiency has been one full of twists and potholes. Airbus originally had picked up the banner of fuel efficiency as a means of gaining an edge over Boeing in their early life. As Airbus matured and gained success, they became risk‐averse and unwilling to move away from the designs that had served them well in the past. Unfortunately, fuel efficiency is a relative term dependent on where one is in time; that which was considered ‘fuel efficient’ a decade ago may now be a ‘gas guzzler’ today.

During Airbus’ complacency, Boeing took up the banner of fuel efficiency, and this became a primary concern in the development of the 777. Fuel efficiency rose to prime significance in the development of the 787 Dreamliner.70 There is no doubt with crude oil prices rising above $100 a barrel that fuel efficiency will continue to be an important consideration for airline executives.

Composite Materials. Another consequence of the rise in importance of fuel efficiency is the increased use of composite materials in LCA construction. Composite materials like carbon fiber weigh less than steel or aluminum and also provide greater strength. This allows aircraft manufacturers to save substantial weight on the airframe. This directly translates into fuel savings, since less fuel is required to take off and fly. Composites also offer opportunities for new manufacturing techniques. For example, the fuselage of the new Boeing 787 Dreamliner will be one uninterrupted carbon‐fiber piece.

This will save a significant number of man hours, since thousands of rivets would be needed to attach

69 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007. 70 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007.

36 hundreds of aluminum fuselage panels together, which would have been necessary given conventional manufacturing techniques. In fact, the 787 will be constructed of over 50% composite materials, including the fuselage and wings.71 Composite materials are the newest development in jetliner manufacturing and potentially represent the largest development since the high‐bypass turbo fan jet engine. 72

Both Airbus and Boeing demonstrated an inclination towards avoiding innovation when they had dominate status. Boeing was unwilling to begin incorporating new technologies while they held near‐monopoly standing. Airbus has also shown an unwillingness to accept new risk while they have held the market share lead. Both have also shown that market share, and therefore competition, can be increased via innovation.

71 Bernstein Research. "Commercial Aircraft Upcycle ‐ Climbing Higher with Global Demand." 2006. 72 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007.

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IV. WHAT FACTORS DRIVE THE COMPETITION?

It is clear that the commercial aircraft manufacturing industry is oligopolistic. There are only two firms that make up the entire market. Airbus and Boeing’s competitive relationship is constantly characterized by instances of strategic interaction. The above analysis makes it clear that each firm considers the others actions when making decisions. Both firms take into account the competitive position of the other firm. But the question that remains is why, despite all the incentives towards collusion, do these firms compete so vigorously? For that matter, what is the unique nature of their competition that makes it particularly fierce?

All firms have incentives to maximize profits. This is just as true for both Airbus and Boeing. The commercial aircraft is an oligopoly. Therefore, they are in a unique situation to exploit opportunities that are not available to more competitive firms. Because of the extreme barriers to entry in the commercial aircraft market, the commercial aircraft industry is insulated from new entrants and additional competition. In a duopoly, firms can collude – either tacitly or explicitly – to set output, prices, or both such that they can produce at the profit‐maximizing position. This can be achieved in one of two main ways:

1) Both firms can produce similar product sets so that they can collectively limit their

output and fix prices; or

2) Sufficiently differentiate their products so that they can have a niche monopoly of

their products.

In either case the goal is to control the level of output so that they can set the price. The question then becomes, do we see either 1) or 2) above in the commercial aircraft industry? If not, what incentives or activities override the conduct we would expect?

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What becomes clear in the analysis above is that Airbus and Boeing do not behave like 1) or 2).

If competition is a spectrum, at one end are price‐setting monopolies, and at the other are perfectly competitive price‐takers (see Exhibit 8). Oligopolies are traditionally found close to the monopoly end.

In this case there are a number of factors that push the commercial aircraft industry away from monopolies and towards perfect competition.

INSTRUMENT OF NATIONAL POLICY

Because of jetliner’s intrinsic tie with high‐technology, the sheer number of employees needed to manufacture aircraft, and because of a link between aviation and national pride, commercial aircraft manufacturing has historically served as an instrument of national policy for the respective home governments.

Technology In recent decades the prestige and success of a nation has come to be linked with high‐technology. There are a number of reasons for this from the ability of nations to defend themselves with new‐and‐improved technology, to the ability to provide better quality of life through new gadgets, to the esteem that comes from being on the cutting edge. This is all exemplified in jetliners because of their close tie to military aircraft and because jetliners are often the first to commercially implements new technologies. The United States government has made it clear that they wish to promote the advancement of current technologies and the development of new technologies.

European governments have done the same. Airbus and Boeing can be held up as prime examples of how their firms are able to break into new frontiers.

Employment Commercial aircraft are large machines, often containing hundreds of thousands of parts. As such it takes an extraordinary number of employees to manufacture jetliners. Large orders for aircraft can keep citizens employed for years to come. Boeing or Airbus can then serve as a means of employment for large numbers of people if governments are able to influence or manipulate aircraft

39 sales. National governments working in cooperation with a manufacturer can ensure that the company in question has business and therefore has jobs for their citizens.

National Pride For many nations across the globe, there is pride in what their country is capable of producing: the French are proud of their wines and cheese, the Americans proud of the space program and the cutting edge technology, etc. This is also the case with jetliners – the Americans are very proud of Boeing and the French, Germans, and British are very proud of Airbus. This is not hard to understand when one thinks of the tremendous effort that must go into producing a viable jetliner. To that end, jetliners have come to symbolize engineering and technical mastery, and thus pride in the products of Boeing and Airbus. This adds an additional motive for manufacture beyond simple profit:

Prestige. One cannot underestimate the importance that prestige has played in the motivations of airline executives and jetliner manufacturers like Airbus and Boeing.

ORDER SIZE

Air travel has become less expensive in recent years with low‐cost and no‐frill airlines. The result has been increased numbers of aircraft orders and also aircraft order size. Orders can be tens of millions of dollars upwards to hundreds of millions of dollars. This creates a tremendous amount of pressure to bring in that sale, especially since a large order can book the production line for months or even years at a time. Orders can also be infrequent in nature, especially surrounding the development of a new jetliner by either firm. This infrequency can exacerbate the importance of obtaining orders. In essence, so much can be at stake that an incentive towards collusion is overridden by the need to ensure the success of your plane.

The commercial aircraft industry is characterized by tremendous fixed costs, including the up‐ front costs associated with designing, proto‐typing, and manufacturing the first jetliner. These costs are difficult to determine in advance, and are not easily shed in the case of harder times. The key to stability

40 in this industry seems to be the ability to develop and maintain a significant back‐log of orders. In doing so, one ensures a continuing revenue stream far into the future; when an order is placed, a down payment is placed with the remaining balance to be paid upon delivery. In the case of Boeing, at the end of 2007 they had a back order of 3,427 aircraft and Airbus had 4,336, with 375‐475 planes being produced each year. They will not receive the majority of their payment until the deliveries are made, which means that each firm can expect a large flow of revenue for years to come.

DIFFERENTIATED PRODUCTS

Standard oligopolistic theory often assumes that firms produce only one product and that the products manufactured by each firm in the industry are homogenous. When firms are producing raw materials like copper or oil, it is simple to have a single uniform product among oligopolistic firms.

However, in the case of commercial aircraft manufacturing, the products are large and complicated; it would be very difficult for Airbus and Boeing to design and built two identical planes independently. As a result, each firm makes small decisions in a number of directions that change planes that are meant to serve the same purpose. While both planes will take you from point A to point B, each does so with little differences like seat width, entertainment options (personal screens versus one main screen for example) or air humidity during flight. Boeing planes use a yoke piloting system while Airbus planes use a joystick. These differences between jetliners invariably cause airlines to choose between one or the other; preferences for one plane over another can then develop.

In the case of the commercial aircraft manufacturing industry, a single plane will not satisfy all customers. Planes are needed to fly long‐distance routes with hundreds of passengers and short routes with only 130 passengers. In addition, the person who wants to buy a long‐distance plane will most likely also want to buy a short‐distance plane. This gives rise to different products. Each firm could choose to produce at one range of the market – for example, Boeing could choose to only produce long‐

41 distance and Airbus could choose to produce only short‐distance planes – but both firms have attempted to develop complete product sets that are capable of meeting airlines’ every need. Part of this is because of the development of commonality between planes and the utilization of economies of scale; it is cheaper for airlines to maintain one maintenance crew for Airbus planes than two maintenance crews for Airbus and Boeing planes, for example.73

FIXED OUTPUT

With many products it is very easy to vary the level of output within a firm. With jetliners it is simply not possible to turn a knob and build immense planes faster. Significant investment in plants, buildings, and equipment is needed first. This also means that firms cannot easily set their production output in advance – where is one to park dozens of completed 747s? Each plane can represent tens of millions to hundreds of millions of dollars in investment and it is difficult for any firm to carry such inventory for very long. The end result is that output is predetermined and fixed, and is known in advance by all firms in the industry. Therefore the incentive is to make sure that your firm does not have to shut down or build planes for inventory – both of which carry significant costs. In looking at this from a different perspective, Airbus and Boeing have only within the last three years seen significant growth in aircraft orders. It would take decades for capital investment to increase production by only fifty percent to pay off. Therefore the market for jetliners would have to increase substantially over a sustained period in order to justify such an investment.

73 Irwin, Douglas A. and Nina Pavcnik. "Airbus Versus Boeing Revisited: International Competition in the Aircraft Market." NBER Working Paper Series. Cambridge: National Bureau of Economic Research, December 2001.

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EXPANDING MARKET

Because of the tremendous increase in air travel, the commercial aircraft industry has seen record levels of new jetliner orders since 2005; Boeing and Airbus each saw triple the number of orders in 2005 than what they saw in 2004.74 With such expansive growth, there are many opportunities to gain market share in expanding markets like the East Asian markets discussed earlier. With the explosive growth in air travel in developing countries like China, India, and Malaysia, there are significant opportunities for increased growth in those regions. Record order sizes are being logged by each firm from airlines operating in the areas of growth – this provides the same incentives as described in the aforementioned “Order Size” section.75

CONCLUSION

The commercial aircraft manufacturing industry is characterized by relatively fixed output. This coupled with the infrequent aircraft orders, and the significant long‐run uncertainty because of extended product life‐cycle, means that the normal forces of supply and demand are distorted. Research and development of a new jetliner takes years, and it takes additional years or decades to realize the complete return on that jetliner. Costs remain nebulous for the manufacture of each individual jetliner as a result. Because of the steep learning curve associated with developing new products, there is a significant advantage to the firm that develops new planes first. This translates into an advantage for the firm that innovates first. Moreover the commercial aircraft industry is truly international in scope, and therefore strategic trade policy on the part of both the United States and the European Union plays a role in shaping the competition. Boeing and Airbus compete so vigorously because they face a

74 "Air War." Economist 25 June 2005: 12. 75 Newhouse, John. Boeing versus Airbus. New York: Alfred A Knopf, 2007.

43 marketplace where supply is relatively constant and demand is intermittent; this is made all that much worse with uncertainty.

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V. WHAT IMPLICATIONS DOES THIS HAVE?

With inflexible supply, uncertainty, and a dose of national pride (irrationality), our assumptions that predict duopolistic behavior no longer holds. The commercial aircraft manufacturing industry indicates models that predict incentives towards collusive behavior and limited output are not easily applied to all industries. The model has not failed, but merely was designed to reflect the reality represented by different industries. We must recognize and account for the differences presented by the commercial aircraft manufacturing industry.

Every industry is unique, including the commercial aircraft manufacturing industry. For many these differences are what make the field of economics interesting. If we could develop a model that was easily applied to every industry, there would be nothing left to carry our interest. The standard model provides a framework for out analysis, but the unique circumstances in each industry are what provide it spirit. The commercial aircraft manufacturing industry is an oligopoly, but what is the nature of the competition? What drives the competition? Answering these questions can become just about as much about psychology as mathematical models. The commercial aircraft industry certainly provides much to satiate our curiosity.

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47

APPENDIX

Exhibit 1: Boeing jetliner deliveries 1958 through 2007

Exhibit 2: Airbus jetliner deliveries 10974 through 2007

Exhibit 3: Chart graphing the deliveries of Airbus and Boeing 1958 through 2007

Exhibit 4: Boeing firm orders received 1955 through 2007

Exhibit 5: Airbus firm orders received 1974 through 2007

Exhibit 6: Chart graphing firm orders received by Airbus and Boeing 1955 through 2007

Exhibit 7: Airbus firm structure diagram

Exhibit 8: Competitive Spectrum diagram

Data for Exhibits 1, 3, and 4 Source: Boeing Commercial Airplanes website

http://active.boeing.com/commercial/orders/index.cfm

Data for Exhibits 2, 3, and 5 Source: Airbus S.A.S. website

http://www.airbus.com/en/corporate/orders_and_deliveries/

48

Exhibit 1 Boeing Deliveries from 1958 ‐ 2007 Total Total D & YEAR 707 717 727 737 747 757 767 777 787 Boeing DC‐8DC‐9DC‐10 MD‐11 MD‐80 MD‐90 M‐D TOTAL 1958 8 8 ‐ 8 1959 77 77 21 21 98 1960 91 91 91 91 182 1961 80 80 42 42 122 1962 68 68 22 22 90 1963 34 6 40 19 19 59 1964 38 95 133 20 20 153 1965 61 111 172 31 5 36 208 1966 83 135 218 32 69 101 319 1967 118 155 4 277 41 153 194 471 1968 111 160 105 376 102 202 304 680 1969 59 114 114 4 291 85 122 207 498 1970 19 55 37 92 203 33 51 84 287 1971 10 33 29 69 141 13 46 13 72 213 1972 4 41 22 30 97 4 32 52 88 185 1973 11 92 23 30 156 29 57 86 242 1974 21 91 55 22 189 48 47 95 284 1975 7 91 51 21 170 42 43 85 255 1976 9 61 41 27 138 50 19 69 207 1977 8 67 25 20 120 22 14 36 156 1978 13 118 40 32 203 22 18 40 243 1979 6 136 77 67 286 39 35 74 360 1980 3 131 92 73 299 18 41 5 64 363 1981 2 94 108 53 257 16 25 61 102 359 1982 8 26 95 26 2 20 177 10 11 34 55 232 1983 8 11 82 22 25 55 203 12 51 63 266 1984 8 8 67 16 18 29 146 10 44 54 200 1985 3 115 24 36 25 203 11 71 82 285 1986 4 141 35 35 27 242 17 85 102 344 1987 9 161 23 40 37 270 10 94 104 374 1988 165 24 48 53 290 10 120 130 420 1989 5 146 45 51 37 284 1 117 118 402 1990 4 174 70 77 60 385 3 139 142 527 1991 14 215 64 80 62 435 31 140 171 606 1992 5 218 61 99 63 446 42 84 126 572 1993 152 56 71 51 330 36 43 79 409 1994 1 121 40 69 41 272 17 23 40 312 1995 89 25 43 37 13 207 18 18 13 49 256 1996 76 26 42 43 32 219 15 12 25 52 271 1997 135 39 46 42 59 321 12 16 26 54 375 1998 282 53 54 47 74 510 12 8 34 54 564 1999 12 320 47 67 44 83 573 8 26 13 47 620 2000 32 282 25 45 44 55 483 4 5 9 492 2001 49 299 31 45 40 61 525 2 2 527 2002 20 223 27 29 35 47 381 ‐ 381 2003 12 173 19 14 24 39 281 ‐ 281 2004 12 202 15 11 9 36 285 ‐ 285 2005 13 212 13 2 10 40 290 ‐ 290 2006 5 302 14 12 65 398 ‐ 398 2007 330 16 12 83 441 ‐ 441 TOTAL 1,010 155 1,831 5,600 1,396 1,049 959 687 ‐ 12,687 556 976 446 200 1,191 116 3,485 16,172 Exhibit 2 Airbus Deliveries from 1974 ‐ 2007 Year A3001 A3202 A3303 A3403 A350 A380 TOTAL 1974 4 4 1975 8 8 1976 13 13 1977 15 15 1978 15 15 1979 26 26 1980 39 39 1981 38 38 1982 46 46 1983 36 36 1984 48 48 1985 42 42 1986 29 29 1987 32 32 1988 45 16 61 1989 47 58 105 1990 37 58 95 1991 44 119 163 1992 46 111 157 1993 44 71 1 22 138 1994 25 64 9 25 123 1995 19 56 30 19 124 1996 16 72 10 28 126 1997 8 127 14 33 182 1998 14 168 23 24 229 1999 8 222 44 20 294 2000 8 241 43 19 311 2001 11 257 35 22 325 2002 9 236 42 16 303 2003 8 233 31 33 305 2004 12 233 47 28 320 2005 9 289 56 24 378 2006 9 339 62 24 434 2007 367 68 11 1 447 TOTAL 810 3,337 515 348 ‐ 1 5,011

1 A300 includes all A300s and all A310, which are a derivative of the original A300 2 A320 includes all A318s, A319s, & A321s, which are derivatives of the original A320 3 The A330 & A340 have the same fuselage and wings but different numbers of engines; they are therefore the A340 is technically a derivative of the A330 but is counted separately here Exhibit 3 Deliveries 1958‐2007 800

700

600

500 s

400 Deliverie

300

200

100

0

Year

Airbus Boeing w/ Mergers Boeing w/o Mergers Exhibit 4 Boeing Firm Orders Received from 1955 to 2007 Total Total D & YEAR 707 717 727 737 747 757 767 777 787 Boeing DC‐8DC‐9DC‐10 MD‐11 MD‐80 MD‐90 M‐D TOTAL 1955 70 70 73 73 143 1956 53 53 39 39 92 1957 25 25 10 10 35 1958 31 31 10 10 41 1959 17 17 18 18 35 1960 62 80 142 4 4 146 1961 76 37 113 21 21 134 1962 17 10 27 24 24 51 1963 42 20 62 20 23 43 105 1964 71 83 154 30 33 63 217 1965 135 187 83 405 70 209 279 684 1966 101 149 35 83 368 116 159 275 643 1967 87 125 61 43 316 57 66 123 439 1968 40 66 49 22 177 36 88 63 187 364 1969 12 64 28 30 134 16 44 29 89 223 1970 13 48 21 20 102 8 34 21 63 165 1971 9 26 48 7 90 4 24 18 46 136 1972 18 119 14 18 169 28 46 74 243 1973 12 92 42 29 175 73 31 104 279 1974 16 88 47 29 180 41 13 54 234 1975 9 50 35 20 114 21 9 30 144 1976 4 113 39 14 170 35 16 51 221 1977 14 133 37 42 226 22 34 23 79 305 1978 6 125 145 76 38 49 439 41 45 27 113 552 1979 1 98 78 72 45 294 27 33 14 74 368 1980 21 68 95 49 64 11 308 6 12 14 32 340 1981 38 121 23 3 5 190 2 8 19 29 219 1982 5 11 71 14 2 2 105 48 87 135 240 1983 15 1 64 24 26 20 150 2 43 45 195 1984 131 23 2 15 171 6 117 123 294 1985 274 42 45 38 399 3 106 109 508 1986 6 212 84 13 23 338 5 11 120 136 474 1987 11 177 66 46 57 357 2 20 88 110 467 1988 312 49 148 83 592 2 44 239 285 877 1989 241 56 166 100 563 18 135 153 716 1990 11 111 122 95 52 28 419 37 50 27 114 533 1991 70 31 50 65 24 240 10 23 33 273 1992 114 23 35 21 30 223 7 10 26 43 266 1993 101 2 33 54 30 220 6 10 16 236 1994 67 16 12 17 112 4 9 13 125 1995 42 169 32 13 22 101 379 9 14 39 62 441 1996 438 56 59 43 68 664 10 17 17 44 708 1997 314 36 44 79 54 527 11 2 3 16 543 1998 41 354 15 50 38 68 566 13 24 4 41 607 1999 237 35 18 30 35 355 ‐ 355 2000 21 374 26 43 9 116 589 ‐ 589 2001 3 188 16 37 40 30 314 ‐ 314 2002 32 162 17 8 32 251 ‐ 251 2003 8 206 4 7 11 13 249 ‐ 249 2004 8 152 10 9 42 56 277 ‐ 277 2005 570 48 19 153 232 1,022 ‐ 1,022 2006 739 72 10 77 160 1,058 ‐ 1,058 2007 850 25 36 143 369 1,423 ‐ 1,423 TOTAL 1,010 155 1,831 7,676 1,521 1,049 1,011 1,044 817 16,114 556 976 446 200 1,191 116 3,485 19,599 Exhibit 5 Airbus Firm Orders Received from 1974 to 2007 Year A3001 A3202 A3303 A3403 A350 A380 TOTAL 1974 20 20 1975 16 16 1976 1 1 1977 16 16 1978 73 73 1979 127 127 1980 47 47 1981 54 54 1982 17 17 1983 7 7 1984 21 14 35 1985 53 39 92 1986 24 146 170 1987 56 58 114 1988 45 116 3 3 167 1989 87 146 107 81 421 1990 71 300 25 8 404 1991 52 18 5 26 101 1992 32 81 1 22 136 1993 9 13 1 15 38 1994 95 30 125 1995 6 81 9 10 106 1996 15 235 42 34 326 1997 7 364 64 25 460 1998 32 437 24 63 556 1999 0 408 32 36 476 2000 2 388 110 20 520 2001 61 175 52 2 85 375 2002 0 235 24 31 10 300 2003 6 155 54 35 34 284 2004 2 279 51 28 10 370 2005 7 918 64 15 87 20 1,111 2006 673 104 15 15 17 824 2007 914 198 23 290 33 1,458 TOTAL 966 6,288 970 522 392 209 9,347

1 A300 includes all A300s and all A310, which are a derivative of the original A300 2 A320 includes all A318s, A319s, & A321s, which are derivatives of the original A320 3 The A330 & A340 have the same fuselage and wings but different numbers of engines; they are therefore the A340 is technically a derivative of the A330 but is counted separately here Exhibit 6 Orders 1955‐2007 1600

1400

1200

1000

800 Orders

600

400

200

0

Year

Airbus Boeing w/ Mergers Boeing w/o Mergers Exhibit 7

DASA German DaimlerChrysler Government AeroSpace AG

SOGEADE a French Aerospatiale‐ State Holding Matra Company EADS CASA SEPI a Spanish 80% Ownership State Holding Aeronaucticas SA Company

Six Public Stock Exchanges Airbus S.A.S. Private Shareholders French Government British Crown (Minority Stake) BAE Systems

20% Ownership Private Shareholders (Majority Stake)

Exhibit 8

Monopoly

Duopoly

Oligopoly

Monopolistic Competition

Perfect Competition