Airline Industry Economics: Supply, Demand, and Policy

Introduction

The economic environment of the airline industry is a difficult one in which to operate. The industry is faced with stiff competition, high fixed costs, low product differentiation, easy availability of substitutes, and low switching costs for consumers. As a result, few airlines are able to maintain consistent profitability.

Airlines are typically highly leveraged, which makes them very sensitive to externalities. They tend to experience cyclical profitability — earning healthy profits when externalities are generally positive, and losing money when conditions turn negative.

Wage inequality is a major factor in airline operations because employees represent a high fixed cost for most carriers. In addition, employees represent the service component of an airline's operations, which is one of the few areas where an airline can truly differentiate itself.

Elasticity of Supply and Demand

Finally, monetary and fiscal policy affects the airline industry in two key ways. First, these policies help shape the broader economic environment, to which airlines are highly sensitive. Second, governments are often involved in providing direct financial support for the industry, and the degree to which a government is willing to do so plays a significant role in determining the industry's success.

Elasticity of demand in the airline industry is driven by three main factors: intense competition, low product differentiation, and ease of entry. These factors result in persistent price competition, and consumers have become conditioned to select airlines based on just a handful of criteria, with price being the most predominant.

One of the main ways in which airlines compete is through routes. The most popular routes carry the highest load factors. However, many U.S. markets are served by multiple airports — the New York City area, for example, has five. Secondary airports charge lower landing fees, enabling new competitors to challenge even the strongest routes of established airlines. Some secondary airports eventually become major hubs in their own right, such as Newark and Fort Lauderdale. The availability of secondary airports makes it easier for smaller airlines to enter the market. They may not have access to the best airports, but they have the cheapest ones, and this encourages them to compete on price.

Moreover, the industry's cost structure is heavily weighted toward fixed costs. The marginal cost of carrying an additional passenger on a given flight is very low, and each empty seat represents an opportunity cost. Airlines are therefore better off selling that seat at any price rather than leaving it unsold. This, too, exerts downward pressure on fares.¹

On the surface, the airline industry should not be easy to enter. The industry is heavily regulated, and the startup costs — both for acquiring aircraft and securing landing rights — are significant. Profitability is typically low. Yet this has not dissuaded many investors.² Aircraft are available on the secondary market for purchase or lease, which reduces capital requirements. Many airlines are started by experienced industry insiders who can navigate regulatory complexities, and a surplus of experienced staff is generally available. Furthermore, rapidly shifting growth patterns and the inflexibility of large carriers have left many markets and routes underserved, giving new entrants a ready opening. Despite substantial barriers, new airlines have entered the market with considerable frequency.

Low product differentiation intensifies price competition further. There are only a handful of commercial aircraft manufacturers in the world, making it difficult to compete on the basis of the aircraft themselves. Service is one area where airlines can attempt to differentiate, but even service quality can only go so far. Price therefore becomes the most logical competitive dimension.

The availability of substitutes is another factor driving demand elasticity, particularly in the regional sector. Personal travelers have access to many modes of transportation; the airline's key advantage is speed. Consumers expect to pay a premium for this, but most have a price threshold beyond which they are willing to accept a slower alternative. Business travelers face a similar trade-off, with the additional option of electronic communication and courier services as substitutes for travel.

Supply elasticity in the airline industry mirrors demand elasticity. The industry is cyclical: when profits are available, incentives to enter or expand increase. Airlines are often forced to capture revenues during favorable periods and then contract operations during downturns. This supply elasticity is a direct function of both demand conditions and cost levels.

High costs reduce airline margins, which are often only 1–2% — the equivalent of one or two passengers per flight. This makes airlines highly price-sensitive with respect to key inputs; a rise in any major input cost can eliminate an airline's margin entirely. One such cost is credit. Fleet expansion requires capital acquisitions typically financed with debt. When the cost of debt is low, airlines can expand supply readily; when credit is expensive, the eroded margin makes expansion unattractive. The result is a high price elasticity of supply.

Impact of Externalities

Because the airline industry is highly sensitive to the economic environment, both positive and negative externalities have a significant impact on operations.

The price of fuel is among the most important externalities. Airlines attempt to manage fuel-price risk through sophisticated hedging strategies in financial markets and through fuel surcharges passed on to passengers. Fuel is one of the largest cost items for any airline. It behaves only partially as a variable cost: while airlines have some control over the number of flights operated, the unit of sale is a seat, not a flight. Once a flight departs, each seat either generates revenue or represents a lost opportunity. To illustrate the magnitude of fuel-price risk, the industry estimated that losses in 2008 attributable to the sharp increase in fuel prices would range between $2.3 billion and $6.1 billion, depending on price movements in the latter half of the year.³

The overall state of the economy is another critical externality. In good economic times, both consumers and businesses are more willing to choose the higher-cost option of air travel for its convenience. In tighter conditions, both groups often reduce air travel. As something of a discretionary expense, air travel is frequently among the first cuts made when budgets are strained. The economic slowdown driven by rising fuel prices, for example, produced negative growth in business travel in the first half of 2008.⁴

Government policy represents yet another externality. Governments have an intense interest in the airline industry: the inherent risks of aviation — where failures can result in hundreds of deaths — drive detailed safety regulation that adds costs for carriers. While the long-term benefits of such regulation are clear, regulatory changes can raise costs significantly, and given the thin margins on which airlines operate, even modest cost increases can affect profitability.

Security regulations can also dampen demand.⁵ The airline's chief competitive advantage over substitutes is speed and convenience. The security measures enacted in response to the September 11, 2001, terrorist attacks reduced the convenience factor for travelers, which in turn suppressed demand. Given that profit margins on many flights amount to the revenue from just one or two passengers, even a minor negative impact on demand is felt keenly by the industry.

Catastrophic events more broadly represent a significant externality. The September 11th attacks had a substantial and immediate negative effect on the industry. Demand fell sharply, placing serious financial pressure on carriers, and it took several years for demand and profitability to recover.

Conclusion

The gap between executive compensation and front-line worker pay is particularly pronounced. In 2007, for example, American Airlines sought to halt wage increases for its workers in order to protect the company's hard-won financial stability, while simultaneously paying out $250 million in combined compensation to its executives.⁷ Much of this executive pay came in the form of stock options, which does not hit the bottom line in the same way as cash salaries. Nonetheless, such disparities generate significant employee skepticism and resentment, which can have downstream effects on morale, service quality, and labor relations.

The airline industry operates on razor-thin margins, making it susceptible to virtually any economic disruption. It is highly competitive despite substantial barriers to entry, and highly cyclical in its ability to generate profits. With few exceptions — Southwest Airlines being the most frequently cited — few carriers have managed externalities well over the long term. Were it not for the perceived strategic importance of aviation to the global transportation infrastructure, the industry likely would not have received the level of government support it has historically enjoyed. Yet despite the challenging economics, new competitors consistently enter the field, drawn by the prospect of capturing profits during economic upswings.