LOW COST AIRLINES: a FAILED BUSINESS MODEL? Kenneth

LOW COST AIRLINES: A FAILED BUSINESS MODEL?

Kenneth Button University Professor Director of the Center for Transportation, Policy, Operations, and Logistics, and Director of the Aerospace Policy Research Center School of Public Policy George Mason University (MS 3C6) Fairfax, VA 22030, USA. E-mail: [email protected]

“You fucking academic eggheads! You don't know shit. You can't deregulate this industry. You're going to wreck it. You don't know a goddamn thing!” Robert L. Crandall, CEO American Airlines, addressing a Senate lawyer in 1977

“If the Wright brothers were alive today Wilbur would have to fire Orville to reduce costs” Herb Kelleher, Former President of Southwest Airlines, 1994

INTRODUCTION

The low cost airline model (often called the “no frills” model in Europe – we tend to stick with the American vernacular) has been the subject of intense interest and study. The “Southwest effect”, basically the drop in fares that occurs when a low-fare airline begins serving an airport that had previously had no low-fare carriers, has become part of the vocabulary of air transportation. This paper looks at just how successful the low cost model is taken in it broadest context. In particular, while there have clearly been airlines pursuing the low cost approach that have largely endured and prospered, the question is whether that is because of the underlying business model, or a function of good management exercised, perhaps combined with an element of Napoleonic luck on the part of the individuals running these companies.

The importance of low cost carriers as major suppliers of air services in short-haul markets is exemplified in by Ryanair being the larger movers of air travelers within Europe, and Southwest having the same position in the United States. Low-cost airlines are also becoming significant factors in airport planning. Their requirements differ from those of 'legacy' carriers. They have thus been driving the development of secondary airports and cheaper, specialized terminals at large established airports (De Neuville, 2008; Barrett, 2004a).

To preempt our conclusions, the low cost airline model has served many carriers very well , and has had a profound impact on the airline industry throughout the world, but it has been far from a ubiquitous success. It is also a model that has many dimensions, and has tended to morph over the

years1. There are, in addition, reasons to suspect that the model as we have seen it in the past, will need to change to succeed in a dynamic market and, in the short term, to function well in the depressed macro-economic environments of 2009.

We begin by exploring the criteria against which success should be measured, and the nature of the market environment in which low cost carriers have emerged, and then move on to see how they have faired in the Spencerian (Spencer, 1874 to 1896) world of Lamarckian evolution in which they operate.

THE CONCEPT OF SUCCESS

To assess the achievement of any business model one needs criterion to set it against; essentially some form of matrix and a benchmark. Success in business can be assessed on several dimensions. In terms of the business community it may relate to profits, the standard neo-classical rent seeking criteria, but business success may also be seen in relation to market share or in terms of sales revenues (Baumol, 1962). Internally, the management of a firm may also see success is the context of performing well in a number of defined areas (Williamson, 1975), or it may more broadly ‘satisfice’ (Simon, 1959) and think in terms meeting a much wider range of objectives – sales, profits, market share, labor force retention, share price, etc. From the perspective of antitrust authorities, success is the absence of the exercise of market power, either in terms of extracting economic rents from consumers or through the enjoyment of X-inefficiency2. From a technology perspective, success is normally associated with new or innovative processes that overcome some barrier to production and thus reduces costs significantly, allowing economic development (Rostow, 1960).

From a social perspective, the issue is one of social welfare maximization that is often articulated in the transport context as meeting some standard of mobility or accessibility whichever is the political fashion of the day. The recent interest in the environment often sees industrial success as something consistent with sustainable development. Finally, I suppose in macro economic climate of 2008, success in business would be the creation or retention of jobs.

These criteria are overlaid with temporal considerations. Success, when achieved, may be long- term or transitory. The Pony Express had some successes in the mid-19th century in the United States, and may indeed be considered the forerunner of modern express delivery, but it only lasted for 19 months. One would, I think, question if it really can be considered a successful business model as we would normally think of the term. IThe business rather found a temporal niche market for a very specialized service. Other business models, such as those associated with the mass production models initiated by Fiat and subsequently developed by Henry Ford have proved to be more enduring.

Here we treat the low cost airline model as an attempt to circumvent a particular market problem; namely the historically low operating margins in the scheduled airline market. This problem, and its root cause is discussed below, but in summary since the gradual liberalization of scheduled airlines around the world there has been a singular difficulty in carriers maintaining operating margins above zero, and certainly at a level found in most other sectors of the economy. A variety

1 Southwest Airlines, for example, now carriers a significant number of interlining passengers and has a number of clearly definable hubs in its network. 2 Market power per se is not normally an issue, but rather it is whether firms abuse it.

of business models have been explored that have tried to resolve this problem, most notably that associated with hub-and-spoke operations, as well as a number of innovative practices, such as frequent flier programs, business lounges, computer reservations systems, and so on, and the low cost model has often been seen as one of the more successful.

What this notion of success may not coincide with is the short-term maximization of consumer welfare. There seems little doubt that low cost airlines have, in many markets, resulted in lower fares for travelers and a greater diversity of service types to choose from. The notion of success adopted here is rather more long term, and reflect long-term social welfare maximization rather than shorter-term gratifications. What is not done here is to try to quantify benefits or place any discount rate on when they are enjoyed. Essentially. Success is seen as the development of a sustainable, X- and allocatively efficient industry that is financially viable.

Successes for one for two businesses pursuing a particular approach to their business dose not axiomatically mean they have a successful business model. They may have other factors that also add to their success such as the quality of their management, or they may just have found a narrow market niche into which they fit. A successful business model, in our context, has to be one that is widely and successfully adopted, and remains in use for an extended period of time.

THE BASIS OF AIRLINE COMPETITION

Until the late 1970s airline markets throughout the world were virtually all highly regulated, often publically owned, and frequently enjoyed both direct and indirect subsidies. The changes from the late 1970s suddenly thrust airline management from a world with pretty well defined parameters into one where there was not only considerable commercial risk (the “know unknown” to quote Donald Rumsfeld), but also considerably certainty. Risk is something that management schools teach their students to handle through various forms of hedging and insurance, although sometimes they do not seem to listen to their professors, but uncertainty is more challenging. The natural business inclination is to minimize it, and this is essentially what the legacy airlines have sought to do. They have tried to minimize competition by developing fortress hubs, and to tie customers in with frequent flier programs. But this is only one of two broad strategies business may adopt.

Michael Porter (1995) in his classic book on management, Competitive Advantage, argues that to be successful in a market, a supplier must pursue one of two alternative broad business options.

First, it may try to differentiate its product and seek to gain a degree of monopoly power. In the airlines context this involved the traditional airlines that had grown under regulatory protection and, in many countries, were still state owned trying to exploit economies of scope and scale, as well as market presence, by developing extensive hub-and-spoke networks around one or two major airports that acted as consolidation and dispersal points for traffic akin to a post office sorting depot. They added to they strength by seeking to control information flows through computer reservation systems (CRSs); the first of which, Sabre, was developed by American Airlines in the United States. This allowed the airline owners of systems, through travel agents, to favor their own flights when flight options were displayed to potential customers; an effect reinforced through the halo effects associated with bonuses offered to agents who achieved high bookings for the CRS owner airline. The CRS systems, and the flow of information that it provided the airline, also allowed airlines to adjust the fares being offered customers to reflect their willingness- to-pay and thus price discriminate between those who are more or less fare sensitive. Added to this the traditional carriers formed alliances both with other major airlines but

also with feeder carriers. This created seamless services for customers and more integrated schedules of service that minimized the time required to interline at a hub airport.

The alternative highlighted by Porter was for a business to compete on the basis of cost; to develop and maintain a market share by offering its products at lower prices than its competitors (“low-cost leadership”). This has been the approach of the low cost carriers; sometimes called ‘no-frill’ carriers in Europe because they offer only basic services to their customers. They have sought to establish, and subsequently sustain, themselves by undercutting the fares offered by rival airlines. While the title ‘low cost’ airline is widely, used the business models adopted can vary quite considerably between carriers; some for example focus on secondary airports in cities whereas other serve the major hubs, some offer no on-line services whereas other do, some have frequent flier programs whereas some do not, etc. In addition, in some cases traditional airlines have operated divisions or subsidiaries that have sought to be low cost. Defining a low cost carrier is thus a little like the famed words of United States Supreme Court Justice Potter Stewart when discussing obscenity, "I shall not today attempt further to define the kinds of material I understand to be [obscene]…. But I know it when I see it”.

The low cost approach in aviation has a long history, the first successful low-cost carrier was Pacific Southwest Airlines in the United States, which pioneered the concept in 1949, and in that sense one could say the business model has worked. This however is somewhat deceptive. This is also not just because long-haul low cost carriers have never really gained a market niche, the first airline attempting no-frills transatlantic service being Laker Airways with its famous ‘Skytrain’ service between London and New York City in the late 1970s, but because numerous large carriers still survive in the market, despite many years of ‘deregulation’, that do not follow the low cost path in its traditional sense.

THE UNDERLYING ISSUE

The financial performance of the airline sector in general has hardly been stellar over the past two decades. The industry as a whole suffers from sever cyclical fluctuations in demand, and overall has operating margins well below industry as a whole (Figure 1), and even within the larger air transport chain performs poorly compared to airports, global distribution systems, airframe and aero engine manufactures, etc. (Button, 2004).

The problem with the airline market is that it is highly competitive, but at the same time has the peculiarities of a form of fixed costs found is a number of services industries (including professional sports and the theatre)3. These are not the fixed costs of bricks and mortar of the type Alfred Marshall (1890) wrote about a century ago, but rather commitment to offer a scheduled service. The fact that an airline has to have an aircraft (whether it owns it or leases it is immaterial) sitting at a gate at particular time, with a full crew, fuel, and other supplies on board, with ground staff committed to booking, ticketing, boarding and baggage handling for the flight, with slots to pay for at both ends of a flight, and with various services at the destination to provide is de facto a fixed cost. It matters little whether the flight has a zero load factor or a 100% load factor; these costs have to be borne. To complicate matters, the commitment to the service is made months in advance and thus costs cannot be completely known. This, however, is largely a

3 These costs may also be seen as ‘sunk’ costs in the tradition of the analysis of contestable markets developed by Baumol et al (1982). They are costs that cannot be recovered if no-one uses the flight and the resources are not easily transferrable.

matter of commercial risks and can often be insured against in a variety of ways, of which fuel hedging has attracted the most attention recently with the rapid rise in oil prices through 2007/8 and there even more rapid fall thereafter.

Europe US Global

0 05 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 20 2006 -2

-4

-6

-8

-10 Notes: (I) A lack of a bar indicates a missing observation and not a zero operating margin, (ii) Memberships of the various reporting bodies vary over time and thus the reported margins reflect the associated carriers at the time of reporting. Sources: Boeing Commercial Airplane, Association of European Airlines, and Air Transport Association of America, International Air Transport Association.

Figure 1 Airline operating margins; global, European, and United States

While the cost side of air transport is not simple, it does in many ways reflect many other industries. The challenge is the recovery of fixed costs in a competitive market environment (Button, 2003; 2005). In the extreme case of full information and atomized competition and innumerable potential customers, airfares are pushed right down to marginal costs and no contributions to fixed costs are made. This problem of an ‘empty core’ has been known to economists for well over a century (Edgeworth, 1881)4, and one reason that Coase was awarded his Nobel Prize was for his work on cost recovery in this area5.

4 The problem can be couched in terms of Alfred Kahn’s famed statement in 1977, when he was about to deregulate the US airline market, “I really don't know one plane from the other. To me they are just marginal costs with wings.” This is true but it relates to short-run costs and some thought was needed regarding the long-run costs in a competitive environment. 5 As the Nobel citation said of Coase’s work, he had explained why “traditional theory had not embodied all of the restrictions which bind the allocations of economic agents.

Perhaps more by instinct than logic, the problem of the empty core has, in the air transport case, either been directly handled by interventions by government, most notably though direct subsidies with the tax payer covering the fixed costs or by cross-subsidies through the granting of institutional monopoly powers through the granting of such things as licenses or concessions that allow airlines to charge above marginal costs. These measures have largely been abandoned because of both political capture and the degree of X-inefficiency that manifestly resulted. One practice that has remained in the United States, although not in Europe, is simply to allow airlines to right-off losses through Chapter 11 bankruptcy, despite the moral hazard issues that this entails.

Any supplier’s natural instinct in a perfectly competitive market is to try and carve out some form of monopoly power; to put some slope on the demand curve that is confronting it. Basically this means following the first approach posited by Porter, and traditional airlines have sought to distinguish their products in a wide variety of ways. In some cases, traditional airlines engaged in the international market have focused increasingly on such services that have remained protected under restrictive air service agreements, although the scope for this has shrunk as “Open Skies” policies have spread. Frequently flier programs have offered ‘bonuses’ to loyal customers, there has been market segmentation between various types of traveler, both in terms of motivation (business, leisure, visiting friends and relatives) and distance (short and long haul), their has been efforts to control terminal facilities (the “fortress hubs”), and there have been measures to offer seamless services (strategic alliances)6. These measures have generally only been of temporary use in stemming off competition. In some cases they are easily replicated (as in the case of frequent flier programs that are now ubiquitous and largely uniform), and in others have been successfully counteracted by competitors (as with ‘hub-busting’, direct services).

While many of the measures of product differentiation remain in the airline sector, their potency has seldom solved the cost recovery challenge, even, as we saw in Figure 1, when the business cycle has favored the airlines. The second approach described by Porter, lowing costs of production below competitors. Basically this entails a focus on just one element in the competitive matrix, namely fares. Of course, this does not excluded other elements, things are seldom black or white, but it is all a matter of degree. The low cost airlines seek to attract traffic from competitors in the short-term, as well as generate new traffic to cover their short run costs with the hope of forcing traditional carriers from the market in the longer term and thus enjoy some degree of monopoly power. There is some overlap in this approach with Bain’s (1949) limit pricing theory of business behavior in that the low cost carriers would not push fares back to their previous level to ensure that legacy carriers remain uncompetitive on the routes involved.

The industry has also been kept afloat, and enjoy a flow of investment that would not seem justified by the returns earned, by forces not always embodied in neo-classical economic models; much of the theory suggests it should have gone by now. One explanation for the flow of investment has been a possible money illusion; airlines because fares are collected well in advance of the delivery of services may be seen to be cash rich with the potential of using that money to earn a return elsewhere. There also seems to be a Los Vegas effect in the sense that while the returns for the industry as a whole may be low, some airlines do well for periods - Southwest shares, for example, earned well above the average for the United States stock market

6 In perhaps slightly less technical terms, Michael O'Leary, Ryanair's chief executive, summed up the business model rather well, Code-sharing, alliances, and connections are all about "how do we screw the poor customer for more money?"

throughout the 1990s. The actors further up the value chain – airports, airframe manufacturers and so on – simply cannot allow the airline industry to die because of the money they make by selling their goods and services to them. Finally, aero-planes present a largely irrational fascination for many people, a sort of modern equivalent to the “foamers” in the United States and the “grisers” in the United Kingdom who spend their time spotting trains, and this stimulates them to invest; it is a ‘sexy’ industry for them.7.

The general outcome of all of this is, perhaps best summed up by the American financier Warren Buffet Warren Buffett in his 2008, annual letter to Berkshire Hathaway shareholders, “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”

THE LOW COST AIRLINE MODEL

Although there is no single description of a low cost or no-frills carrier, and they vary in form (Mercer Management Consulting, 2002), there seems to be some general agreement about their basic characteristics. In very general terms, low cost carriers offer low fares by using a range of broad strategies, and not all are used by every low cost airline. These strategies both remove some elements of cost from their production functions, and reduce the levels of many of the remaining costs8. In doing this, they offer a more limited rather of services and, in some cases, charge separately for the attributes they do offer.

In sum, low cost airlines have the following broad set of features.

• First, they do not provide the range of services that legacy carriers normally offer, or at least not in the base fare. There is an effective unbundling of services; food and drinks often have to be bought on board, the free baggage allowance in small, no sky-bridges are offered to the plane, the airports served are second tier, there are no-reclining seats, and so on. • Second, they maximize the use of their factors of production. Aircraft turn around times are kept short because there is no-belly-hold cargo to unload/unload, there are no window shades to open, there are no seat-back pockets to be emptied, less congested airports are favored, planes are only cleaned once a day, there are no on-line passengers to worry about, etc. In terms of crew, these are often based at ‘home’ to service radial routes that that makes their scheduling easier, and they also often perform a number of functions in the provision of the service. • Third, they keep overheads down by using common fleets of aircraft that are cheaper to maintain and crew. • Fourthly, they seek to maximize complementary revenues from sales of refreshments and for baggage,

7 Warren Buffet considers himself a “reformed aeroholic” after losing $300 million or so in a US Air investment in the mid 1990s. Although it may seem unbelievable, many civil servants have pictures and models of planes in their offices, rather than of the passengers and cargo that they have a responsibility to move efficiently. It is a basically a non-pecuniary form of reward from policy capture. 8 Barrett (2004b) is a good explanation of how Ryanair works.

• Fifth, low cost carriers drive hard bargains with their supplies including aircraft manufacturers, because they tend to use common fleets, and airports, because they can offer significant business for otherwise under-utilized car parking and concessions. • Sixth, they only offer a single class of service that simplifies booking and passenger handling • Finally, bookings are often exclusively carried out electronically.

Simple comparisons show that the operational advantage of carriers such as Ryanair often lies in the radial short haul networks they operate with non-online services to second tier airports centered around a base airport that allows for the maximum utilization of a standardized aircraft fleet and of crew without the congestion and the repositioning costs associated with mixed distance, on-line services through a hub using a varied fleet. Other low cost carriers have variants on this, easyJet, for instance serves many of the larger airports and Air Berlin has a frequent flyer program, but all low cost carriers are aggressive in keeping costs to a minimum by charging for on-board services, having quick turn around times for their aircraft, cutting out sales commissions, and striking hard bargains with airports and other suppliers of inputs.

Essentially, a key element of the low cost business model is one of unbundling and a focus on core business. Many of the attributes of a full-service, legacy carrier can be obtained from a low cost airline (e.g. meals, extra baggage, more comprehensive insurance9, etc.), but this entails an additional price. The overall philosophy and features of low costs carriers, whether admitted or not by all, was well summed up by Michael O'Leary, Ryanair's chief executive, in BusinessWeek in 2002, when he said, “Air transport is just a glorified bus operation.”

THE IMPACT OF LOW COST CARRIERS ON THE OVERALL AIRLINE MARKET

There are numerous studies that have examined the effects of low cost airlines on the fares and the markets that they have penetrated and they almost unanimously show that the effects are low fares than those offered by incumbent airlines. These fares, however, lead to significant traffic generation to the extent that the actual traffic volume of incumbents is little affected; the impact is on their bottom line resulting from lower revenues as they must reduce fares to stay competitive. While much of the analysis has been on the domestic United States market, where a 10% ticket sample offers good fare data, the effect seem to be fairly general. In most markets, for example, where they have a significant presence there have been major structural changes with fares falling, overall demand rising, and the traditional carriers losing market share (UK Civil Aviation Authority, 2006)10.

In more detail, as an example, Dresner et al. (1996) hypothesized that the effect of Southwest (and other low-fare carriers) may be greater than previously estimated because of possible spillover effects that Southwest’s service on one route has on adjacent competitive routes that involve nearby airports. They found significant effects of service on adjacent competitive routes but did not aggregate their results. Morrison (2001), taking a more macro perspective, looking at the actual, adjacent and potential competition Southwest brought to United States routes in 1998,

9 Michael O’Leary, CEO of Ryanair, for example, defines the carriers rather basic accident insurance policy thus, “We don’t fall over ourselves if they say, ‘My granny fell ill’. What part of no refund don’t you understand? You are not getting a refund so fuck off.” 10 There are about 60 airlines across Europe offering a version of the low-cost theme. Ryanair is the largest air carrier of passengers within Europe.

finds that its own passengers benefited by $3.4 billion (current prices) in low travel costs, while those on other carriers gained $9.5 billion in terms of lower fares.

Comparing the situation on either side of the Atlantic, Pitfield (2008) found that the impact of Southwest is less than that for the majority of Ryanair routes he examined, except for the start-up routes involving Stockholm and Hamburg. This seems to be because, the Italian destinations analyzed are more likely to be dominated by leisure traffic than with the exception of Las Vegas, the United States cases. Further, the number of carriers on the routes is greater in America, and the scale of traffic is considerably higher on all corridors except London–Stockholm putting more competitive pressure on the Irish airline. Finally, Ryanair, with its frequent offerings of flights at €0.01, where taxes and charges are excluded, may be a more aggressive competitor. Overall he found that Southwest, when it has significant effects, has a smaller initial impact than Ryanair but the latter establishes larger market shares as a result of its impact on competitors. It appears that United States competitors are more competitive than most of Ryanair's in terms of pricing and product differentiation.

The advent of low cost carriers has also impacted on other elements of the air service supply chain, and in particular on airports. Low cost carriers offer a no-frill service, and seek to keep their costs down by seeking low costs at airports. This has led to the development of small, second or third tier facilities as airports, and the construction of special low cost terminals at some major airports (De Neuville, 2008). This in turn has added a new dimension to the competition between airports as many seek to attract low cost carriers, but in doing so engage in a form of competition that has been alien to them in a more regulated environment (Dresner at al., 1996). The nature and extent of this competition, and which airports will succeed, depends ultimately not only in their competitive position regarding other airports, but also with the extent of monopoly power they can exercise over the airlines. Francis et al.’s (2003) case study analysis raises questions about the sustainability of relationships with airlines. The success of many low- cost carriers has been explained the rapid growth in passenger volumes at airports where they operate. Yet many low-cost airlines have failed. Given the proliferation of new low-cost carriers, and the instability of macroeconomic conditions, the ability to develop contractual arrangements reflecting the risks of failure incurred by either party becomes more difficult.

THE AIRLINE WITHIN AN AIRLINE MODEL

There is one form of low cost airline, in some ways a special case, that justifies particular, if somewhat terse treatment, that of a low cost airline embedded within a more traditional carrier.

To combat competition within their established market many legacy airlines have, at various time, established their own low cost carrier11. Institutionally the arrangements between the traditional elements of a company and its low cost off-shoot have differed, in part because of local legal stipulations but also to meet the internal constraints, such as labor agreements and slot availability, and to confront the challenges of the particular low cost carriers that were penetrating the market. They also, in some cases, had wider objectives, such as the spinning off of profitable business or to test out low cost elements that they could later adopted in their mainline operations.

11 Graf (2005) offers a useful table listing the main ventures by legacy carriers into the low cost airlines market.

These efforts at emulating the low cost model, largely that of Southwest, have proved to be unsuccessful. There has in many cases been confusion on the marketing side in terms of being able to develop separate brand images. (Morrell, 2005). Operationally, they were handicapped in the United States in particular by labor union agreements that prevented costs from being reduced significantly, and by internal management constraints that limited their operational freedom and also did not afford them financial autonomy. In effect, they were seen as part of a larger business model encompassing a range of products along the lines of the Procter and Gamble generic competitive strategy of broad differentiation. This prevented costs from falling low enough to compete with the single brand, low costs airlines.

The European experience, where there has been some physical separation of the low-cost off- shoot by, for example, making use of different airports, has been a little more successful than that of United States carriers. Transferring decentralized traffic flows to the low-cost unit and deploying the aircraft of the network carrier exclusively to hub operations as a work-sharing and positioning strategy for the business units (e.g. in the case of Germanwings and Lufthansa) has had some success.

There has also been some evidence that the low airline-within-an-airline concept has proved useful is as stop-gap measure to combat the increases in market presence of low cost carriers while a legacy carriers restructures its own core operations (Graf, 2005). As a generalization, however, they have not proved a successful concept, and do not seem to have added much to the ability of the overall scheduled airline to recover its long-run costs; or, in economic terms, to increase its stability.

COMPETITION IN LOW COST MARKETS

We now turn to the stand-alone low cost airlines and assess their contribution to the provisions of scheduled services. There is no single way of doing this but there are a number of ways in which insights may be gleaned.

Market financial robustness

Figure 1 has illustrated the largely poor economic performance of the scheduled airline industry going back well before low cost carriers were a significant presence. In the United States, low cost airlines began to make serious inroads into the market in the mid-1990s, and in Europe about five or six years later following the enactment of the full Three packages of European airline deregulation.12. Simple examination of the Table shows little impact on the overall performance of the sector after the incursion of low cost airlines into the market. More recent evidence in 2008 and certainly would not suggest that the overall industry is any more capable of handling significant macro-economic shocks that it has been in the past.

In sum, while Southwest now enjoys about a 25% share of passengers in the domestic and a 15% of the revenues, however, the overall performance of the United States domestic airline market

12 In 1997 they accounted for about 2.5% of the European air seat miles offered, but this grew to over 95% by 2002. Prior to that, scheduled carriers, focusing primarily on business travelers, controlled 75% of the intra-European market. Charter airlines held the remaining 25% by selling aircraft capacity to tour operators and shuttling sun-seeking package tourists from cold Northern European countries to the beaches of Southern Europe.

has not deviated from the historic pattern of cyclical fluctuations around a zero operating margin13.

Survival rates

In any competitive market one expects a number of firms to fail, and new ones to enter it. This reflects shifts in demand that require overall capacity adjustments and the fact that management, for one reason or another, is not homogeneous and Spencearian forces lead to the inefficient leaving, to be replaced by the more efficient. It is a judgment call as to how many airlines should, in well functioning market with firms adopting appropriate business models, be entering and leaving.

Table 1 provides some details of European low cost airlines that were forced from the market between 2003 and 2005. The low cost airlines that are now defunct were diverse, and ranged from a number that hardly began operations to others that were relatively successful but merged or were taken over; e.g. Go and Buzz. One could draw up a similar list for the United States, and most other countries. The simple situation is that with this level of attrition, the first-movers, Ryanair and easyJet, now between them account for more than 88% of the scheduled low-cost market in Europe. Southwest Airlines holds 50% of the United States low-cost market. There are, in other words, successful companies, but that is not the same thing as successful business model. Replication seems to have been challenging. Further, the successes seem to be those that entered the market first, indicating that replication of the business models is far from simple.

Table 1. European low cost carriers that ceased to exist*

Aeris BuzzAway Hellas Jet Agent Dream Air Hop Air Bosnia Duo Jet Magic Air Andalucia Europe DutchBird Jetgreen Air Catalunya EastJet JetsSky Europe Air Exel EU Jet JetX Air Freedom Europe Exel Aviation Group Low Fare Jet Europe Air Fairline Austria Maersk Air Air Littoral Fly Eco Now Air Luxor Fly West Silesian Air Air Madrid Flying Finn Skynet Airlines Air Polonia Free Airways Spirit Of Balkan Air Wales Fresh Aer Swedline Express Airlib Express Germania Express V Bird BasiqAir GetJet Poland VolareWeb BerlinJet Go Fly White Eagle Bexx Air Goodjet Windjet

13 The recent operating margins for Southwest, for example, were 6.4% in 2003, 6.2% in 2004, 9.6% in 2006, 10.8% in 2006, and 8.0% in 2007.

* Most of these airlines operated for a period and then went into bankruptcy. Some such as Go Fly and BuzzAway merged with successful low cost airlines. In a few cases, the airline was registered but never offered actual services.

At the more micro level, the low cost airlines are often less than stable in terms of the services that provide individually. While with one or two exceptions, Southwest Airlines has tended to steadily build its network with few subsequent withdrawals, but this is not always the picture. In Europe, for example, Table 2 illustrates the development of services at Stansted Airport, Ryanair’s main airport, showing both new routes and dropped routes. While growth is clear, it has not been in s strictly incremental way, indeed if anything the volatility of route entry and exit has grown as low cost carriers services have expended.

Market power

In markets that have significant fixed costs, either of the conventional ‘brick and mortar type or the fixed commitment type that we have argued are associated with offer scheduled airlines services, suppliers require a degree of market power to recover their costs unless government offers help. The success of a market with these technical features relies on this. Testing for market power using such measures as Herfindahl Indices to assess market concentration is not very useful in this case; it gives no insight into contestable forces and provides no indication of the dynamics of the marketplace. The fixed cost element in air transport is also individual service specific, rather than route specific.

Table 2. Route changes at Stansted Airport.

Year New routes Dropped routes Net change in routes

1996 6 -2 4 1997 5 -8 -3 1998 16 -3 13 1999 21 -3 18 2000 23 -8 15 2001 18 -13 5 2002 18 -13 5 2003 27 -11 16 2004 19 -13 6 2005 18 -7 11

Source: UK Civil Aviation Authority (2005)

One way that market power in offering a specific service has been looked at recently is through the use of ‘data scrapping’. This entails going to travel websites, often the airlines, and examining the pattern of fares offered for a particular flight as the time of departure approaches. In other words, collecting all the fares, F, for each day, t (or some other time division) from a date prior to the flight until the actual take-off. The airlines that practice this dynamic price discrimination essentially try to capture the rents from any flight seen under the normal demand curve (the

shaded area on left element of Figure 2) by offering fares that rise as the time of a flight departure approaches (collecting the revenue under the fare-offered-curve in the right side of the figure.). The highest fare offered will not exceed F*, nor fall below the short run marginal cost (SRMC).14

Perfect third-degree price discrimination is more of a theoretical concept than a practical reality, and so the full amount that temporal fare variations capture will not completely see all consumer surplus extracted by the airline. The extent to which a carrier can extract sufficient rent above SRMC to cover its fixed costs of a committed service also influenced by the slope of the aggregate demand curve, and ipso facto, the amount of revenue that is raised under the temporal fares offered curve in the right-hand element of the figure. Fare rise towards departure because last minute bookings are largely made by individuals with limited choices and who have less prior insights into their future travel needs (generally business travelers)15.

Figure 2. Temporal price discrimination

Much, therefore, depends on the extent and over what time period seats can be sold at prices above SRMC. A priori, one would anticipate that if the airline is a monopolist then the demand curve on the left will be relatively steep and up-turn of the fares-offered curve would come quite early and rise steadily. If there is imperfect competition (essentially other flights on the route at nearly the same time) then the ability to substitute between airlines increases and the slope of the target carriers demand curve flattens on the left and the up-turn in the fares-offered curve comes later and is less pronounced. Less revenue is thus earned and the contribution to the fixed cost of

14 The area under the fares offered curve is not identical the revenues collected with price discrimination as seem in the right side of the figure, because there is no indication of the number of seats actually sold in each period. 15 In multi-class configured cabins, there may be fare dilution as travelers trade between classes. In these cases, a distinction should be drawn in the fares paid that separates out the additional costs of offering extra space, larger luggage allowances, more extensive refreshments, a higher attendant/ passenger ration, etc. from the rent extracted for booking late. All studies using data scraping methods tend to focus only on the lowest fare for a flight, in part to avoid this issue.

the service is reduced. There may also be some fluctuations in the pattern of fares offered over time as the carrier seeks to “play games” with competitors or to gain more insights into the demand elasticitities at a particular time prior to departure. If there were perfect competition in the market for a particular service, then both the demand curve and the fares offered curve would be flat 16.

There are clear limitations to this methodology, and we just list a few. Only one class of seat (business class, coach, etc) can be looked at any one time but competition between airlines extends into mixture of classes they offer. It makes no allowance for free seats occupied by frequent flier point redeemers. For comparative purposes there is generally a need to compare similar services, but definitions of rival services is subjective – e.g. does the 8.30am flight from offered by airline Z between A to B on a particular date compete with the 9.00am flight by airline X? the 10.15am flight by airline Y? and so on. The situation becomes even more complex if the 10.15am is not provided by airline Y, but by Z; in other words flights may complete with others offered by the same airline. Perhaps, most importantly there is little feel for the actual up-take of flights when data scraping, and so the elasticity of demand, that indicates the willingness to pay and not what is being offered, is not being explicitly measured,

Empirical analysis supporting the logical basis of the temporal fares-offered curve has been fairly well established in studies of European and American air transport markets.17 Figure 3, just as an example, looks at a United States monopoly market (that between Phoenix and des Moines and served, at the time by America West Airlines), illustrates the fairly consistent rise in fares as the time of departure approaches. This general pattern of temporal price differentiation holds irrespective of whether the monopoly airline is a low cost carrier or pursues the traditional, full service business model.

Fare

1050

950

850

750

$ 650 America West 08:53-17:20

550

450

350

July Year 2005 250

16 The fundamental definition of perfect competition is that any supplier in the market is confronted by a perfectly elastic demand curve (Robinson, 1962) 17 Studies include, Barbot (2006), Button and (2007), Button et al (2007), Pels and Rietveld (2004),and Pitfield (2005a. b).

Source: Button and Vega (2006)

Figure 3. Temporal-fares-offered curves for return services from Phoenix to Des Moines: leaving August, 1st and returning August 5th, 2005.

Of more interest in terms of whether the los cost model is successful is what happens when two carriers offer nearly identical services, differentiated largely by a small difference in departure times. Again the pattern is consistent and can be examined in detail in other works, Figure 4 simply offers another example, again from the United States, of a duopoly situation and the volatility that arises and the lack of a significant and consistent is clear. Other studies that have looked at services where there are more than two competitors show a further flattening out of the temporal fares-offered curve.

Source: Button and Vega (2007).

Figure 4 Temporal-fares-offered curves for return services from Phoenix to Kansas City, out August, 1st and returning August 5th, 2005

Much of the analysis using data scrapping has not been strictly concerned with the issue of the success of the low-cost model per se, but rather with its relative performance vis-à-vis the traditional full-service model. In this context, the data have been examined in some detail, going beyond the simple eye-balling of graphs. Of particular relevance to assessing the success of the low-cost business model, have been attempts to look for market leadership using such techniques as Granger causality testing (Button et al, 2007a) and ARIMA time series models (Pitfield,

2005a, b). The findings suggest that there is little evidence of price leadership in markets where there are several suppliers, which in turn indicates the lack of any marked degree of monopoly power. Thus even when there are both low costs and traditional, full service suppliers offering near identical services in terms of departure times there is no indication that one type of business dominates others. More importantly, in terms of the absolute success of a particular business model, there is no evidence that this flattening out, and often irregular, pattern of fares being offered diminishes when it is low costs carriers that are competing with each other rather than low costs airlines confronting legacy carriers.

That low cost airlines have enjoyed some financial success may thus not be because of the business model per se but rather the nature of the markets that they have entered. Some such airlines have enjoyed a degree of economic rent allowing full cost recovery by simply avoiding competition, and the same would seem to be true of routes served by traditional airlines on parts of their networks. Avoiding competition is hardly a novel way of approaching business and cannot really be defined as a business model in the full meaning of the term. More importantly, in terms of success, it may only be a transitory solution. Traditional carriers, for example, may respond by entering these markets to compete, and thus ensure the integrity of their larger operations. But more importantly regarding short haul market, other low cost carriers may enter the market and thus reduce the potential for rent extraction.

The issue of bilateral monopolies

Low cost carriers have exerted an influence on airports, by both stimulation the development of basic, regional facilities and in forcing many established airports to reassess the way they operate. Low cost carriers seldom want the “frills” that are found at traditional airports, instead rather focusing on keeping costs to a minimum and, in may cases, forcing the airports to rely on land- side ,and concessionary revenues rather than air side take-off and landing fees.18

The low cost airlines have been able to do this in the past at smaller airports because of asymmetries in the bargaining situation, particularly in Europe. The situation has often been in a bilateral monopoly context between a single low cost carriers and a small airport. In these cases the outcome, except in very specific cases, is unclear are depends on the bargaining strength and information held by both parties. The ability of the airline to chose to puts its resources in other markets, whereas the airport is spatially constrained, gives it an advantage in many cases. The traditional carriers, because of their need for large hubs, of which there are few, and an integrated network involving strategic nodes, puts them in a less strong position.

While there are numerous examples of low cost airlines are still able to enjoy the upper hand in negotiations with airports19, the situation is no long as clear-cut as in the past (Francis et al, 2003). The growth in the number of low cost airlines, plus the fact that in many cases the transactions are about renewals of contracts at airports where a carrier has already sunk costs, has reduced the power of the carriers in some cases.

CONCLUSIONS

18 Ryanair has a reputation for being particularly aggressive in its negotiations with airports. 19 The withdraw of a €3 passenger surcharge at Frankfurt Hahn Airport in January 2009 after threats of service transfers by Ryanair is an illustration of this.

That the low cost airline model was successful initially for a number of airlines is obvious – the expansion of the intra state carrier, Air Southwest out of Texas to become Southwest Airlines in the United States, the rapid growth of Ryanair and easyJet in Europe, and emergence of carriers such a Go and Tiger in the in emerging BRIC markets attest to this. It is also clear that low cost airlines have been instrumental on pushing down airfares, opening new markets, and allowing many people to travel by air who could not do so before. But success for a few firms is not the same thing as a successful business model; its achievement more be more widespread. Also the generation of social welfare though lowing travel costs does not establish a successful business if the full commercial costs of the system are not borne by its users. Low cost carriers have performed well when they have established monopoly power, but this is a transitory situation in the context of modern, open air transport markets. It is quite a legitimate tactic within a Coasian world of competition and fixed costs, but as with other strategies that have been deployed over the years is not one that is likely to prove enduring. The low cost airline model is thus successful in the same way as frequent flier programs, fortress hubs and the like provided success to the traditional airlines, but it is not a success in terms of meeting the fundamental problems of providing scheduled services in a highly competitive market.

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