Airline Deregulation in The Airline Industry

Introduction

Airline Deregulation in The Airline Industry

The Airline Industry is characterized as an oligopoly that is an industry being dominated by few firms producing similar products — Available Seat Miles (ASM). Prior to 1978, the airlines were highly regulated by the CAB (Civil Aeronautics Board). The CAB was able to dictate ticket prices, route authorities, and barriers to entry or exit. An anti-competitive industry was promoted for decades under the CAB, in which prices were adjusted to meet the rising operating costs of the airlines. Airlines became highly inefficient under regulation and allowed costs and capacity to soar without regard to profitability.

Discussion

After numerous price increases during the early 1970s, the consumers demanded a more competitive industry — lower prices. Eventually, the consumer won, and the Airline Deregulation Act was passed in 1978. This act was designed to promote competition among carriers by increasing efficiency and lowering costs, thus, airlines were forced to charge what the market would bear, not what CAB dictated. Many airlines have prospered, yet many others have failed, during deregulation. The following report lists the key developments in the industry over the past 19 years.

Deregulation allowed existing carriers to enter and exit markets freely, charging prices according to demand. As predicted, deregulation spurred an increase in competition and lowered ticket prices on most routes. Airlines began competing in more route segments and exiting unprofitable markets, making room for regional carriers. New low-cost carriers focused on highly profitable niche markets serving point to point, O & D (Origin and Destination) traffic. In contrast, major airlines increased capacity on high demand markets and began establishing hub and spoke systems.

The first of the low-cost carriers to introduce a drastically reduced ticket price was People Express Airlines (PEX). As one of the first post-deregulation start-up airlines, it thrived in the east coast markets from its Newark hub — beginning operations in 1980. Operating a fleet of used narrowbody aircraft (B727, B737) and employing non-union workers. PEX was able to achieve very low direct operating costs per ASM. PEX was able to operate at a cost per seat mile of fewer than 6 cents, 50% less than its competition (Delta, USAir). As a result, PEX was able to offer its customers low $35 airfares and attract competing airline customers, while still earning a profit. The lucrative times for PEX, however, did not continue.

Like most airline failure scripts, it over-expanded. Attempting to expand into major airline territory and compete for head-on with well-established airlines. It was competing with too many airlines in too many markets and lost the battle. Eventually, PEX merged with failing Frontier airlines, in a flawed attempt to expand its market share westward. In actuality, this merger further weakened the carrier as both United and Continental lowered fares to compete in the western region. PEX was finally purchased in 1987 by Continental Airlines (Texas Air), and the Cinderella story had ended.

Some important lessons were learned from the PEX failure; Airline seats are commodities, and most customers will be attracted to the lowest priced seat. Customers search for the most value for the lowest price, as a result, customer service is a key to return customers. Business travelers search for the most value and are willing to pay a premium ticket price for this service. An airline must attract a sufficient amount of high yield business travelers to sustain a profit, balancing the low yield from discount tickets. The key lesson from PEX is that small niche carrier should not attempt to over-expand without adequate cash reserves — to sustain long fare wars with major carriers in certain markets.

Other more successful low-cost carriers also developed during this time, typically in the highly competitive west and the southwest region of the US. Former intra-state carrier Southwest Airlines (SWA) began operations from a small hub at Dallas, Love Field. Using a common fleet of Boeing 737’s, SWA served secondary markets and smaller downtown airports to attract customers. By using a “keep-it-simple” approach and catering towards the short-haul traveler, SWA was able to operate at very low costs and maintain profitability. Many airlines have attempted to copy the SWA formula, with marginal success.

To combat the encroachment of low-cost airlines into their own market share, major airlines developed satellite airlines. The concept to create a low-cost no-frills airline is a preemptive move to sustain market share in highly competitive markets (Southwestern, Western US). This “airline-within-an-airline” concept was developed initially by Continental Airlines to combat the threat of low-cost airlines in major markets. What developed was Cavite, a low-cost subsidiary of Continental Airlines.

By using smaller aircraft (B-737, DC-9) and lower wage employees Cavite attempted to compete with dominant carriers on the east coast (Delta, USAir). Learning no pertinent lessons from the previous failures of PEX, Cavite quickly lost market share as customers lost confidence in the safety and reliability of the airline. More recently United Airlines (UAL) initiated a low-cost spin-off airline called U-2 (Shuttle by United) to compete against low-cost carriers in the western US (SWA, Westpac, Reno). It’s initial attempt to compete for head-on with SWA was flawed and after a slight restructuring, it has found its niche — feeding the UAL hubs at Los Angeles and San Francisco. Similar to the philosophy of United’s, Delta Airlines began a low-cost airline called Delta Express in 1996 to compete with no-frills airline ValuJet in the southeast US.

The success of the satellite airline system is focused on three key concepts; safety, reliability, and customer satisfaction. The customer must believe the carrier is safe, and the airline must perform reliably, “on-time”. Both concepts eluded CaLite and led directly to its failure. Customer preference can be gained by providing more hub connection possibilities and frequent flyer miles on the parent carrier. This added value draws customers from low-cost carriers.

Another development after deregulation was the hub and spoke network system. In order to compete with small low-cost niche carriers, large major airlines needed to establish regional dominance. Hubs are strategically placed airports that serve as transfer points for connecting traffic. They also serve as the origin and destination for passengers traveling to and from the hub city. Flights arrive in banks within the same time frame, off-load passengers and transfer passengers onto flights to their final destinations. This allows the hub airline to serve many more cities and passengers (“multiplier” effect) when compared with a point to point service. It also allows the airlines to achieve higher load-factors on flights, by building up passenger loads in large banks. This system was initially developed by Delta and Eastern Airlines in Atlanta. It provides frequent air-service to travelers in the southeast region.

Hubs offer great advantages to the dominant carrier — allowing the carrier to feed regional passengers onto its domestic and international flights. This allows the carrier to realize the effects of “economies of scale” by focusing the work-force on processing these banks of flights. By offering more connecting flights into the hub, airlines gain increased market share (S-curve theory). Hubs have also created some disadvantages for a carrier — by having several banks arriving during the day at 2-3 hour intervals, cause inefficiencies from the work-force during off-peak times.

This has brought about the need for an increase in part-time employees. Another disadvantage is large banks of aircraft arriving and departing within the same hour can cause air-traffic delays. As the number of runways and airspace at the hub is limited, planes must either be delayed at the gate (gate hold, flow-control) or placed in a holding pattern awaiting landing clearance (arrival sequencing).

The keys to a successful hub airport: Hub city must support a large percentage of the total passenger traffic at the airport (Origin and Destination traffic, for both domestic and international passengers). Major commercial centers with diversified industry serve as the best hubs (Dallas, Chicago, Atlanta). The airport must be able to expand to meet increased passenger demand (large and efficient terminals) and increased air-traffic (addition runways). Increased runway separation to allow for independent approaches and landings. Hub region must have favorable weather (minimize flight delays attributed to weather). Low airport landing fees (minimize landing fee costs). As the industry continues to evolve into a stable market, trends will continue to occur that will maximize the efficiency of the airline industry. Some predicted trends:

Increase by major carriers to outsource short-haul flying (750 nm or less) to regional jet aircraft. The lower direct operating costs (DOC) attainable by flying regional jets (Canadair RJ, EMB-145) will cause large major carriers to transfer unprofitable routes to low-cost regionals. These regionals will continue to feed the hub airports from regional secondary markets. This trend has already begun by the acquisition of large numbers of regional jets by Continental, and Comair (Delta regional).

Conclusion

Increase use of small wide-body aircraft and narrow body extended range (ER) aircraft to service “thin” long distance domestic (New York – Orange County) and international routes (Denver – Frankfurt). Before the introduction of aircraft such as the Boeing 757-200ER or B767-200ER, long-distance flights dictated the use of wide-body aircraft (DC-10, B747-200) for performance reasons.  As the range of the new narrowbody aircraft increases, the possibility for long “thin” routes increases.

The US airline industry continues to expand globally as the domestic markets have begun to reach maturity. Areas for large growth include South America and the Asian markets. The industry has begun to stabilize and recover after a 4 year period of heavy losses. Airlines should take caution now to not over-expand and create excess capacity. The stage has been set for low-cost carriers and satellite airlines, and they have forever changed the industry.

 

Bibliography

Air Transportation – A management perspective (1994). Wells, Alexander T. pp.174-178.

Airline Odyssey (1995). Ott, James.

Airliners (1995). People Express — The boom and bust of deregulation’s darling. Jul./Aug. 1995. pp.19-25.

An Introduction to Airline Economics (1995). O’Connor, William. pp.33-34, 107-109.

Air Transport Association Web site: http://www.air-transport.org/handbk/index.htm

 


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