Airline Industry: United, American, and South West Airlines Research Paper

Introduction

Airlines exist in one of the competitive economic environments since the depression of 1930s in the United States. Apart from the backwardness resulted from poor economic environment, incidents like the terrorist attack on September 9^th 2001, the outbreak of SARS in Asia, and war in the Middle East have affected the progress of the industry to large extent. Because of the decreased demand and excess capacity in the industry, most airlines have substantial net losses since the turn of the century. In fact two major airlines US Airways and United Airlines had to file bankruptcy and others like American Airlines have narrowly averted it.

The major airlines in order to face the economic challenge were in the look out for new and strategic business models. Several airlines made an attempt to start a low cost airline emulating the model of South West Airlines. In fact several airlines have tried to imitate South West and have failed miserably. The primary problem is that the major airlines had cost structures that are quite high as compared to that of South West. The market structure, competitive forces operating on the industry, governmental regulations and several other factors have their impact the growth of the industry. This paper makes an analytical review of the airline industry with a comparison of the respective positions of United, American and South West Airlines.

Market Structure of US Airline Industry

Because of the economic factors and competitive forces operating on the airline industry the industry could not sustain its profitability and the industry continues to reel under financial turmoil. This position is illustrated in the table below.

Annual Loss and Earnings.

Source: Air Transport Association of America, Inc. Economics; Annual Revenue and Earnings.

Though the industry has made some recovery in the years 2006 and 2007 the airline was industry in a bad shape till 2005 due to the interaction of various general environmental forces. As evidenced by the various problems faced by the airline industry the general environment in which the airline companies must operate especially the economic, political/legal and socio cultural dimensions has significantly affected them.

The airlines are also greatly affected by the industry environment. In fact the major negative effects of dimensions of the general environment have made the airlines industry environment more pronounced. For example the rivalry in the industry is severe as airlines compete for fewer air travelers. In turn, the airline companies have significantly affected the operations of major aircraft manufacturers like Boeing by delaying or cancelling their orders for new aircrafts. Interestingly enough although most analysts point out the airline industry as being an unattractive one there are quite a few new entrants. Learning on the success of Southwest airlines other airlines in the industry are also in the process of restructuring and are desperately trying to reduce their costs.

Porter’s Five Forces Analysis

Compared to the general environment the industry environment often has a more direct effect on the firms’ strategic competitiveness and above average returns (Hawawini et al 2003) The intensity of industry competition and an industry’s profit potential are functions of five forces of competition; the threats posed by new entrants, the power of suppliers, the power of buyers, product substitutes, and the intensity of rivalry among competitors. Research suggests that different geographic markets for the same product can have considerably different competitive conditions. (Garcia-Pont and Nohria, 2002)

The Five Forces Model determines the external competitive threats that act on the market environment of any particular industry. The model was developed by the American Management scholar Michael Porter and the model summarizes the extent to which the external forces acting on the industry to assess the intensity of competition. The Five Forces Analysis of US airline industry takes the following form:

Threat from New Entrants

This force acts when the new entrants could enter the market without difficulty and pose a competition for an existing business. The greater the ease with which new entrants enter the market the higher is the level of competition. The capital cost of entry, the scale economies, product and price differentiation, switching costs, the expected retaliation from the existing player, legislative measures and access to the distribution channels is some of the factors that influence the ease of the new entrants. The market may present the entry barriers in any one or more of the following forms:

• Economies of Scale
• Proprietary product Differences
• Brand identity
• Capital requirements
• Cost disadvantages
• Access to distribution channels
• Government policy

In the airline industry there are high entry barriers; one of the major factors is the substantial capital costs involved. But however this has not deterred new firms entering the industry. For instance Air Trans Airways and JetBlue which were late entrants to the industry have created competitive challenges for the major airlines especially in the midst of economic problems witnessed in the early 21^st century. Both firms compete in the low cost airline segment. With the demand for low cost airline increased the major high-cost airlines were made less competitive and vulnerable to these newer airlines competitive actions.

Bargaining Power of Suppliers

Suppliers can exert bargaining power in an industry by increasing the prices for the product or by making changes in the quality of their materials. There are various determinants of the power of suppliers that act as a market force. The following are some of the determinants that affect the bargaining power of the suppliers:

• Differentiation of inputs
• Switching costs
• Presence of substitute inputs
• Supplier concentration
• Importance of supply volumes
• Total purchases in the industry
• Impact of inputs on product cost
• Threat of forward integration

Any or a combination of the above determinants can influence the market force on the product. Powerful supplier groups can squeeze the profitability of the company or industry. If a firm is unable to recover the cost increases by its suppliers by altering its cost structure then its profitability is reduced by its supplier’s action.

The airline industry is an example of an industry in which suppliers’ bargaining power is relatively low. Even though the number of suppliers is low, the demand for aircrafts is also relatively low. Boeing and Airbus are competing strongly for most orders of major aircraft (99)

Also the shift in the strategy of airline industry to short-haul flights and low costs has enhanced the fortunes of other aircrafts manufacturers who make smaller and more efficient aircrafts.

Bargaining Powers of Buyers

Business firms seek to maximize the return on their invested capital. Alternatively buyers want to buy products at the lowest possible price – being the point at which the industry earns the lowest acceptable rate of return on its invested capital. To reduce their costs, buyers bargain for higher quality, greater levels of service and lower prices. These outcomes are achieved by encouraging competitive battles among the industry’s firms.

There are certain factors which determine the strength of the force acting through the power of customers. Some of the factors are:

• Buyer concentration against firm concentration
• Buyer volume
• Switching costs
• Buyer information
• Substitute products
• Price of total purchases
• Product differences
• Brand identity
• Quality performance

The bargaining power of the consumers appear to have increased with the availability of more information though internet which acts as a shopping and distribution alternative for the consumers. One of the reasons for the increased bargaining power of consumers is that the individual buyers incur virtually no switching costs when they decide to purchase from one manufacturer rather than another.

These realities are increasingly felt in the airline industry and hence they are made to change their strategies for sustaining their market share. There is very little differentiation in air travel and the switching costs are very low.

Threat from Substitute Products

Substitute products limit the potential of an industry by placing a ceiling on the prices it can charge. The more attractive the price performance trade-off offered the greater are the limitations of the industry to improve profitability. The factors that influence the threat of the substitute products are:

• Relative price performance of substitutes
• Switching costs
• Buyer propensity to substitute products

Substitute products that have the potential to improve their performance trade-off with the industry are potential threats. Equally a firm that has a product that cannot be easily substituted either because it is unique or because it enjoys some kind of a protection is in a strong position.

The key question for the analysis of the influence of the substitute products is whether the substitute poses a threat to the organization’s product or provides a higher perceived value or benefit. Another question that needs consideration is what is the ease with which the buyers can switch to substitute?

Thus in general product substitutes present a strong threat to a firm when customers face few if any of the switching costs and when the substitute product’s price is lower or its quality and performance capabilities are equal to or greater than those of the competing product. Differentiating a product along different dimensions that customers value such as price, quality, after sales service and location reduces a substitute’s attractiveness.

As far as the airline is concerned the availability of substitute products is plenty and the travelers have at no cost switch the airline as there is no affinity or brand loyalty involved. It is the question of pricing and quality of service which determine the consumer behavior.

Extent of Competitive Rivalry

Because an industry’s firms are mutually dependent actions taken by one company usually invite competitive responses. Thus in many industries firms actively compete against one another. Competitive rivalry intensifies when a firm is challenged by a competitor’s actions or when a company recognizes an opportunity to improve its market position.

Intense rivalry is related to a number of factors like:

• Growth in the industry
• Intermittent over capacity
• Value added
• Product differences
• Brand identity
• Switching costs
• Corporate stakes
• Diversity of competitors
• Exit barriers

Considering the airline industry there is an intense competitive rivalry between competitors like United, US Airways, American and other major airline companies. Airline service has become a commodity meaning that the price variable is a primary source of competition among the industry participants. Through various marketing campaign, consumers are well award of the discounts and low costs the firms offer to induce them to use the respective airline services.

Although pricing decisions are easy to implement and reverse since the competitors can easily imitate them, it allows only a temporary competitive advantage. Competing principally on the basis of price has the potential to reduce substantially the ability of the airline to operate profitably and eliminates the possibility of winning consumer loyalty. However Southwest operates at such a low cost structure which provides the company the most competitive advantage. Southwest uses the cost as a distinct competitive edge although it has other sources of differentiation that can be used as competitive advantage. The airline is praised for consistently high level of service which is an additional source of competitive edge.

Structure – Conduct – Performance (SCP) Analysis

Scherer and Ross have applied the Structure – Conduct – Performance (SCP) approach to industry analysis. The SCP approach has been found to be in favor in the United Stated for major industry analysis. While the structure of the industry forms the basis of the analysis, conduct is affected by the market structure. In market structure the number and size of the firms in the industry, their cost characteristics become the relevant elements to consider.

In addition the barriers to entry and basic conditions of demand and supply also play a dominant role in the analysis. The performance of the industry on the other hand is determined by mostly the conduct of the market participants. Factors like whether there exists a real competition among the market participants, the legal tactics they employ and the way in which they advertise and price their products determine the performance level of the players. (Mark N. Cooper, 1999)

Structure

According to economic principles when the number of firms operating in the industry is six then the industry is said to be an oligopoly and where the number of firms is fifty or more of approximately equal sizes then there is said to be a competition. Department of Justice has recognized the danger of having only six equal sized firms in its Merger Guidelines. The guidelines follow the Herfindahl-Hirschman Index (HHI) and this index measures the market share of each firm expressed as a percentage, squares it and totals the result.

Usually a market with six equal sized firms would have a HHI of 1667 and accordingly the department has declared that any market with a HHI of above 1800 to be highly concentrated. Thus the key threshold for any industry is at about the equivalent of six or fewer firms operating. Economists view the concentration at this level from a different perception in which they consider the market share of the largest four firms (4 – Firm Concentration Ratio).

Therefore in a market with six equal sixed firms the 4 – Firm Concentration Ratio would be 67%. Since under this condition the ability of the smaller number of firms controlling a large market for competing with each other will be clear this market can be regarded as oligopolistic. Hence it is necessary that there must be 50 or more firms to ensure that competition prevails in the industry. Considering the necessity to have healthy competition the Department of Justice has established a second threshold with a HHI of 1000 where the market will be defined as a moderately concentrated market which would consist of 10 equal sized firms. In this market the 4 – Firm Concentration Ratio would be 40%.

Shepherd describes this a loose oligopoly in which the leading four firms would have 40% or less of the market share and therefore there will be absolutely no chances of colluding with each other to resort to price-fixation. The Consumers Association (1996) is of the view that the concentration in the airline industry is different and according to the Association, having at least three competitors can be considered as the key threshold for the airline industry.

Based on the above discussions on market structures the airline industry in the United States can be regarded as generally highly concentrated. It is so because most routes have fewer than four carriers. National averages indicate that the HHI is around 4000 on a city-pair basis. One of the studies indicates that HHI at the airports is less than 3300 which implies the equivalent of three airlines per airport. When measured by city-pairs the HHI, was found to be over 5000 implying the concentration equivalent to two per route (Hayes and Ross, 1998). With such a high level of concentration prevalent the airfares are bound to have significant influence from the anti-competitive behavior and changes in the market structure.

Conduct

The conduct of the industry is largely influenced by the deregulation of the industry which gave rise to the phenomena of hubs and spoke networks that have raised serious public policy concern. Since the characteristics of the hubs appear to enable the airlines to muster market power. The positive side of hubs and spoke networks is that they increase efficiency. They also promote economies of scale and operating efficiencies that act as a deterrent for the competitors to enter.

Achieving lower costs, achieving greater reputation, facilitating advertising and promotion and better coordination of scheduling and baggage handling are some of the benefits resulting from the creation of hubs. On the negative side there are bound to be anti-competitive actions by sheer exploitation of market power by the incumbents of hubs. The incumbents also act to lock in customers by resorting to a number of market mechanisms like frequent flier programs, deals with travel agents for diverting the traffic, manipulation of computerized reservation systems, code sharing and segmentation of markets.

The incumbents block the entry of competitors into hubs by denying gate space and extracting excessive profits on provision of facilities. The entrants usually are made to suffer from an inability to attract adequate passengers for establishing their presence. Through these anti-competitive activities the incumbents of hubs are able to enjoy higher profits through higher prices in the hubs. Morrison and Winston (1995) have identified that the conduct of the airline industry is characterized by anti-competitive behaviors of hubbing, frequent flier programs, and manipulation of computerized reservation systems.

Performance

Generally it is observed that in a more competitive environment the prices tend to be lower and the output is at a higher level. This situation will be prevalent irrespective of how the competition is measured. At the micro level, this effect can be observed in the act of individual airlines entering into specific markets. At the macro level the changes in the generalized concentration ratios would indicate the effect of higher competition.

PEST and Macro Institutional Analysis

The industry environment can also be assessed using a PEST analysis. The US airline industry can be analyzed using this tool.

Political Considerations

The deregulation of the airline industry is the major landmark in the US which had changed the scope of the industry altogether. In the deregulated market the entry barriers has been reduced and the US airline industry witnessed the introduction of a number of new airlines in the post de-regulated environment – although most of them operated for shorter periods only. This has resulted in creating more competition among the airlines with fares dropping up to 20% creating new sources of demand. The added competition had put more pressure on the high cost full service airlines to compete with smaller low cost airlines.

At the international level groups like International Civil Aviation Organization have established worldwide standards for safety and other concerns of the industry. This had its impact on the functioning of the airline. Similarly the bilateral agreements entered into between the countries have also had their impact on the growth and performance of the airlines.

Economic Considerations

The major factor that impacts the airline industry is the financing of new aircrafts and maintaining the fleet level. Since it is highly capital intensive many of the firms have found it difficult to compete with their fleet strength. Southwest airlines with their reliance on a single aircraft model of Boeing 737 could overcome this aspect to a large extent and have proved successful. Another major financial issue is hedging against oil and fuel prices which are second to the labor cost to the firms in the industry. High level of operating and fixed costs in the case of full service airlines have prevented them from competing efficiently with the low cost airlines who are the new entrants into the industry.

Social Considerations

The changes in the life styles and income levels of the people made the airline travel more affordable when the IT companies were at their peak performance levels prior to the dot.com bubble. This had its effect on the business of the airline industry. However the airlines had to reel into losses between years 2001 and 2005 (see table above). Awareness of the customers of the discounts and lower fares through internet and print media has made competition among the airlines stiffer. New entrants offering lowest possible prices often made customers switch their loyalty among different airlines.

Technological Considerations

The inability of the major airlines to sustain their profitability has disabled them to upgrade their fleet with aircrafts having more advanced features. Most of the airlines had either delayed or cancelled their orders with the aircraft manufacturers and this affected the technological advancement of the airline industry to a large extent.

Sustenance of Competitive Advantage

In order that the firm in any industry retains its competitive advantage it is necessary that the firm has a tighter control over its resources. The sustenance of competitive advantage relies mainly on the resources and their adaptation by the firm. To obviate the better utilization of the resources it is advisable to do a Resource Based View (RBV) of the available resources and form different strategies to ensure rapid corporate growth.

Resources can be defined as “stocks of available [tangible and intangible] factors that are owned and controlled by a firm (Amit and Schoemaker, 1993) In this respect a resource can be identified as something a firm is in possession of or has access to. For instance participation in the computerized reservation systems like SABRE or APOLLO can be considered as a resource. This can be considered as a resource irrespective of the fact that they are not owned by a participating airline. According to Morecroft (1997) aircrafts, staff, reputation, employee morale and airports are some of the valuable resources in the airline industry.

Prahalad and Hamel (1990) identify even core competence as one of the resources possessed by the firm citing the example of core competence in logistics of Wal-Mart. Stalk, Evans and Shulman (1992) supports this view point. However in some cases it may not be possible to acquire such valuable resources over strategic factor markets as observed by Barney (1986) and Grant (1991) Therefore it becomes critically important that such resources of strategic importance are accumulated within the firm so that the firm can sustain the competitive advantage. (Dierickx and Cool 1989) Since there are no clear mechanisms are available to assist the firms to acquire the necessary resources, it is for the firms to increase their ability to coordinate the growth of several tangible and intangible resources.

For the airline industry the number of cities in service results in increase in the number of potential passengers. The passengers in turn are attracted by the perceived service fare ratio of an airline as compared with that of another. As stated earlier fare is a short term phenomena which is subject to implementation and withdrawal subject to exigencies, whereas the reputation of an airline cannot be viewed from a short term perspective.

Therefore it is essential for an airline that its current and potential customers have confidence in the services of the airline and this confidence will turn itself into more number of passengers. Hence it can be deduced that passengers and reputation are the important resources for an airline and both are obviously interconnected to each other. The next important thing is the financial resources which are closely connected with the growth in the number of passengers and the aircrafts.

The resource aircraft is again dependent on the number of passengers that the airline handles and this resource leads to the more important resource of staff. New staff cannot be as productive as experienced ones and hiring of new staff lowers productivity which in turn affects the cost and profitability. The number of aircrafts and staff can therefore be considered as important resources in deciding the employee morale.

It is to be noted that both long-lasting overstraining and unchallenging positions affect the employee morale. This leads to the point that the airline should have sufficient financial resources to adequately compensate the staff to keep their morale high and hence the financial performance is important to maintain the morale of the staff. The staff morale and airport congestions are the two factors that have a strong influence on the reputation of the airline as both these factors are relevant for the service level perceived by the customers.

Since Southwest has understood the necessity to create the tangible and intangible resources the airline is able to function in an efficient manner. Some of the strengths of Southwest are; frequent reliable departures, lean, highly productive ground and gate crews, high aircraft utilization, very low fares and high reputation earned among the passengers due to almost flawless service.

Growth Scale and Scope Analysis

The scale and scope of firms operating in the airline industry ranges from a firm operating with a single airplane though high-cost full service international airlines operating a number of planes in various routes and having considerable fleet strength. The variations in the types of companies, their operating scope, and the routes they serve make the analysis of the airline industry somewhat complex. However some patterns could be witnessed over the last 5 decades of experience in operating the airline industry. The demand for air travel services can be characterized as derived demand.

There are different factors affecting the demand like business needs of cargo shipments, passenger demand both from business and leisure segments. All these factors affect the macro economic activity in the market. The patterns are found to be highly seasonal and not withstanding these patterns demand seems to be increasing over the periods. However the industry has reacted in a cyclical way (See table above) with four or five years of poor performance followed by four or five years of gradual improvements in performance. For instance since the year 1980 the industry could not even earned back the cost of capital during best of times. This is due to the fact that the profitability is generally low with 2-3% net profits after interest and tax. In the periods where there are losses the losses are very dramatic.

Consolidation has been found to be the trend with airlines forming new business combinations, alliances of groups of companies, mergers and takeovers taking place to consolidate the position of various firms operating in the industry. In the US approximately more than 200 airlines have been merged or acquired and quite a few of them have gone out of business since deregulation took place in 1978.

The future trend is focused mainly on cost reduction and improving passenger service. By reducing costs the major airlines should be able to offer low cost advantages to the customers. However the services provided by the airlines will be the main factor deciding the growth in business of the firms. An example may be found in the Southwest airlines.

Analysis of Southwest, United and American Airlines

American was one of the world’s largest passenger airlines in terms of passenger miles flown. American faced serious financial crisis as a result of the terrorist attack on September 11^th. Although the company avoided bankruptcy it found itself in a competitively disadvantageous position as against other airlines. The airline had the highest labor cost and debts in the industry.

Recently the pilots have demanded 50% rise in their salaries. The rise in oil prices had also impacted the revenues of American. Since the older aircrafts operated by American are less fuelfuel efficient than those of the competitors the airline lost its competitive advantage. The finances of the company were further deteriorated and the company had to ground 300 of the total 685 of the aircrafts in order to meet the requirements of FAA inspections. (Wikinvest)

For United airlines high costs are one of the important elements in judging the profitability. Wages have become the dominant factor that made the airline bungle. The descent of United from the world’s largest and highly profitable airline a few years ago to the position of bankruptcy is due to factors which are in addition to the salaries and costs. It was the case that the airline could not bring in additional revenues in addition to its inability to contain the costs.

With employees owning a majority of stakes in the company labor costs have risen even higher than those of its arch rival American during mid 1990s. The employee ownership plan has resulted in United becoming a dysfunctional business model which could not keep its passenger intact. The revenue problems of United arose mainly because of its excessive dependence on bubble spending of technology companies.

With two of its hub airports at San-Francisco and Washington- Dulles international hit hard by the dot.com bubble the company could not meet its exorbitant labor costs due to reduced traffic from then technology companies. The company was making record profits with last minute tickets earlier which avenue was totally lost due to reduced travel by high tech companies. Since the year 2000 there was a steep fall in the revenue of United up to 17% per seat per mile. The internal fights and anger of workers on the fall in the value of stock from $ 100 to nothing had made the workplace less flexible than the competitors. (David Leonhardt, 2002) Therefore the main resource of employee morale was severely which had its cascading effect on the reputation and passenger traffic.

In quite contrast to the operations of United and American, Southwest relies on customer service and organizational culture as its two major competitive advantages. The firm is using its integrated cost leadership/differentiation strategy to garner its success.

As at the end of the second quarter of 2003, for example ‘Southwest’ was the only airline to post profit in every quarter, since the 9/11 attack. The firm had not cancelled any flight or retrenched any employee during that period. The posting of a 14% profit on a 7 percent rise in sales in the second quarter of 2003 is the strong evidence for the competitive ability of Southwest. Because the fares of Southwest are as much as 20% lower than that of the competitors which was the main competitive strength of Southwest coupled with an efficient service.

Implications for Strategic Change and Recommendations

Airlines continue to implement strategic changes to combat the competitive forces operating on them in order to shape the airline industry evolution. There have been an increasing number of routes that are introduced with non-stop services with the growth in demand. In addition technology like 787 allows smaller aircrafts fly to destinations covered by longer distances. There are continued efforts on the part of the airlines to streamline the processes to ensure greater productivity and effective use of employees.

There are attempts to create new market segments to attract more customers. Several actions like removing the window shades from the aircraft to have lesser weight, removal back-packets from the seats to facilitate easy cleaning, having the tightest seating as allowed legally and keeping one mandatory lavatory on board are being taken by low cost airlines like Ryan order to meet the cost considerations. It remains to be seen what other amenities the passengers have to forego in order to fly at a competitively low cost. Another development worth mentioning is the absence of ‘hub control’ that dominated the industry for more than 15 years due to the reason that it is considered no more viable.

Larger airports like Chicago O’Hare and Dallas/Ft. Worth have increased their capacities to accommodate at least two airline hubs. In addition both the cities are provided with secondary airports to handle additional traffic. Dallas has also witnessed reduction in the hub service along with continued air port expansion which has provided space and capacity for a new entrant. Similar expansions have been undertaken in Detroit/Wayne County.

Recommendations for the firms operating in the airline industry may be focused towards increasing the passenger traffic. This is possible only by providing efficient service to the customers at the lowest cost possible. The major airlines should make it a point that they can add the frills at extra cost and offer to only those passengers who want to avail them. In this way they would be able to reduce the cost to a great extent. Commissions to the travel agencies is another area where considerable saving can be effected by offering tickets through internet or through an office servicing three or more airlines established on a cost sharing basis.

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