Economic Influences That Can Negatively

Economic Influences That Can Negatively Affect the Airline Industry in the United States

This paper covers the airline industry in the United States, with some of the lessons learned since the start of deregulation in the 1970's to today. The airline's overall economics have changed significantly, from a government-controlled oligopoly to a free-for-all in which different airlines choose different economic strategies. Government regulation still plays a key economic role by limiting the participation of foreign investors and airlines, as well as the control on 'fifth freedoms,' which will be dealt with in this paper.

It is this author's contention that the current airline industry is still in a state of disequilibrium which will be addressed through mergers and bankruptcies, and that a multi-tier service offering and consumer group segmentation will continue to drive competitors' strategies in different directions.

Elasticity of Supply and Demand

It was thought before Southwest Airlines emerged in the 1970's in Texas that there was relatively little price elasticity of demand for airline travel. Since most travel was business-related or for wealthier 'retail' clients, and fare competition was limited by government fiat (the CAB did not allow significant price competition), the amount of demand for any particular city pair or for flying overall was relatively fixed in the short-term, and grew according to demographic and general economic factors more than due to pricing.

When Southwest started its operations in Texas, it was untrammeled by the CAB, as it flew only within one state, and therefore was not subject to government pricing or route regulation. It was nevertheless strictly controlled on inspections and safety, and by the fact that investors had to be from the U.S. The incumbent powerful airlines in Texas, American and Braniff, attempted to use their powerful Washington connections to place restrictions on Southwest's tiny fleet of 3 airplanes flying from Dallas to Houston. The most notable restriction was that Southwest could not use Dallas-Fort Worth Airport (the Wright Amendment), and was forced to use the smaller, but in-town Love Field (Francisco).

Southwest was able to demonstrate that by reducing fares from $100 each way to $26 each way, traffic would move up. There was a price elasticity of demand, particularly amongst middle- and lower-class 'retail' customers, and some businesspeople as well. By cutting the going fare by ae's, Southwest was able to increase air traffic between the two cities by over 100%. Whereas other airlines competed on service, Southwest competed on price.

Subsequent moves by People Express and others demonstrated an increasing demand as prices for tickets went down. Deregulation under the Carter Administration removed price and capacity controls, and essentially made it possible for airlines to charge whatever they wished. Southwest's low costs per seat-mile allowed them to sell seats for less, pick well-travelled city pairs, and watch price-elastic demand climb (Mackinac).

A more recent study on price elasticity of demand for air travel revealed the differences between business and leisure travelers (Waters) demonstrated that the price elasticity for business travelers was 1.15, as compared with leisure travelers, whose price elasticity was 1.52. That means that a 50% drop in pricing would generate 7% more business travel, while it would generate 25% more leisure travel. Since price elasticity of demand may be on a curve, this number may not be true for such large differences, but the principle is still valid.

Positive and Negative Externalities

The government's influence dropping away in the 1970's proved a positive externality when total airline revenues and seat-miles flown is taken into account. It also lowered the overall cost of airline travel for Americans, which increased productivity.

Another significant externality is the increase in wealth in the United States and elsewhere. As people grow in real income, they travel more for business and for leisure. The advent of new, fuel-saving technologies and the ability to use 2 pilots rather than 3 or 4, as well as lower maintenance costs of jets vs. piston planes per seat-mile all contribute to a lowering of the real cost of flying (see externalities for fuel costs, below).

Significant negative externalities included a cost of fuel rising in steps which, in aggregate, exceeded the CPI by several points. Nowadays, fuel is 40% of an airline's cost, whereas it was only 25% 20 years ago. This increase in fuel costs has made it necessary for airlines to purchase more modern, fuel-efficient airplanes, placing a significant capital cost burden on airlines' strained balance sheets.

Wage Inequality

The differential in wages between countries has relatively little impact on U.S. airlines (although it can have an impact on airlines which have lower wage costs, such as Cathay Pacific or Singapore Airlines when competing with higher-cost airlines). The government's continued insistence on U.S. ownership of U.S. airlines precludes lower-wage-cost countries such as Mexico being able to enjoy 'fifth freedoms,' which would allow flying from one U.S. city to another with passengers paying for the U.S.-only segment. This means that prevailing wages are kept at a relatively high leve (Gittell)l.

The second maintainer of high and equal wages are unions. Although Southwest and American Airlines have their own pilots' and flight attendants' unions, they adhere to a similar wage and seniority scale as the general airline industry's pilot's and flight attendant's unions. The mechanics, the other key union, are generally run by the Machinist's Union, part of the AFL-CIO, and have a different set of negotiating levers.

These unions' ability to represent professionals from the industry have allowed them to maintain relatively high pensions, wages and working conditions, despite financial troubles at certain airlines. Even though major airlines such as United and Delta have gone into bankruptcy, partly due to the unions' stranglehold on wages, they were unable to wring significant concessions on wages and pensions prior to the bankruptcy court administrator stepping in and dictating contract changes.

Southwest's pilots and flight attendants enjoy similar wage and pension benefits, but their work rules are much more liberal. That is why it is not uncommon to find a pilot or flight attendant cleaning the plane, taking tickets or performing other functions which are strictly prohibited by unions in other, more traditional airlines.

How the Economy Affects the Airlines

The airline travel market is relatively mature, as viewed by its average revenue growth over the past few years. In every mature, major industry, margins are generally lower, and the industry is more influenced by general secular economic trends in the economy. U.S. travel can be divided into three segments: price-insensitive business travelers, price-sensitive business travelers, and price-sensitive 'retail' travelers. Although there is a segment of price-insensitive retail travelers, it is relatively small and can be ignored for this analysis.

In an economic downturn, when GDP actually declines, the overall amount of dollars available in the economy shrinks. With shrinking economic activity, price-sensitive business travelers will buy fewer airline tickets because they are trying to save money. Price-insensitive business travelers will decrease their travel less, but may have fewer trips due to lower overall economic activity. Price-sensitive 'retail' travelers will decrease their travel depending on their need to travel (e.g. A death in the family or a marriage may take priority) and the prevailing costs of travel, even if declining.

The impact of an economic downturn may affect different segments of the airline industry in different ways. Price-sensitive business and 'retail' travelers may reduce some travel, but also steer some of their travel to lower-cost airlines, even at the expense of some inconvenience (desired airport not available, some amenities, such as interlining baggage, not available). Thus market share can move within the airline industry from higher-cost, higher-priced, higher-service U.S. airlines to lower-cost airlines during economic downturns.

On the other side, in an economic boom similar to the past 7 years, all airlines are flying at near-capacity load levels, and can afford to increase fares and increase income. Since the 'legacy' airlines carry a good deal more debt on their balance sheet, they have been unable to match the 'upstarts' in buying new planes and hedging fuel costs. For these reasons, their costs per seat mile relative to the 'upstarts' has remained relatively high. As a result of these high costs per seat mile, they are vulnerable in a downturn due to two factors: (1) a shift in market share to the lower-cost airlines, which can still make money and steer passengers at fares which are lower, and (2) a reduction in overall demand which, in combination with market share losses and their high leverage, can push them relatively quickly into negative cash flow.

Economic Influences which Can Affect the Industry in a Negative Way

Since most airlines carry a lot of debt on their balance sheets, shifts in interest costs can have a significant effect on their overall cost of capital, and their cash flow. Many airlines' credit ratings are too poor to be able to secure financing, so they rely on third-party leasing firms such as IFLC and General Electric (which makes aircraft engines as well as running a major financial subsidiary -- GE Financial) (Business Week). Why does GE finance poorly-rated airlines with its aircraft financing? GE benefits in three ways: (1) its lower cost of capital than the airlines means that it can charge a risk premium, and make more money on the airline debt, (2) it sells aircraft engines and, more critically, spare parts, which are the biggest long-term source of revenue for the company, and (3) the loans are well-collateralized. Even in a bankruptcy procedure, the airlines have relatively little recourse to the assets, and GE would be free to sell or lease the airlines to others. Other leasing companies, while they don't have GE's aircraft engine business, are able to lure tax-advantaged investors (offshore, those receiving tax credits, others) who also give them a lower cost of capital; their expertise in leasing and selling planes, as well as their leverage in pricing negotiations with the major airframe manufacturers gives them an advantage that an individual airline may not have.