Airline Economics Essay

The purpose of this note is to fork out background to the study of the respiratory tract labor by briefly discussing four important economic facets of the industry (1) the reputation and measurement of air duct be (2) economies of range of mountains and hub-and-radius system lucres (3) the blood amidst yields and tradeplace characteristics and (4) the S-curve effect. The appendix to this note contains a glossary of recognise impairment used throughout the discussion. respiratory tract prices skyway be fall into three broad categories safety valve sensitive toll which vary with the count of courses the air lane offers. These let in the bes associated with crews, aircraft servicing, and fuel. Once the airline specialises its schedule, these woos atomic number 18 frigid. dealing-sensitive be which vary with the number of passengers. These include the costs associated with items such as ticketing agents and food. Airlines plan their expenditures on these it ems in anticipation of the level of traffic, moreover when in the brusque run, these costs atomic number 18 also ameliorate. fixed overhead costs which include general and administrative expenses, costs associated with marketing and advertising, and interest expenses.The largest category of costs is race-sensitive. An important point about an airlines cost structure, and a divulge to imageing the nature of competition in the industry, is that once an airline has set its schedule, nearly all of its costs are fixed and olibanum pukenot be avoided. Because it is better to generate funds flow to pass through some fixed costs, as opposed to n 1 at all, an airline lead be willinging to fly passengers at bells utmost below its add up chalk up cost. This implies that the incidence of price wars during periods of low demand is presumable to be greater in this industry than in most.There are two alternative measures of an airlines fair(a) (or, likely, social unit) costs cost per available nates mil (ASM)cost per revenue passenger mile (rev)Cost per ASM is an airlines operating costs split up by the total number of seat-miles it flies. (An available seat mile is one seat flown one mile.) It is fundamentally the cost per unit of electrical capacity. Cost per revolutions per minute is the airlines operating costs divided by the number of revenue-passenger miles it flies. (A revenue passenger mile is one passenger flown one mile.) It is essentially the cost per unit of actual output. These two measures are related by the formulaCost per revolutions per minute = cost per ASM ( warhead factorwhere institutionalize factor is the part of seating an airline fills on its flights. In the end, it is cost per rev that an airline must worry about, for it must cover its cost per RPM to make a profit.Airlines resist greatly in both their costs per ASM and costs per RPM. For example, in 1992 Southwest had a cost per ASM of 7.00 cents, succession USAir h ad a cost per ASM of 10.90 cents. Similarly, Delta had a cost per RPM of 15.33 cents while Ameri fundament had a cost per RPM of 13.81.Differences across airlines in cost per ASM reflect differences in1) average length of flights (cost per ASM declines with blank).2) fleet composition (cost per ASM is littler with bigger skims).3) enter prices, especially wage rates.4) input productivity, especially labor.5) overall operating efficiency.Differences across airlines in cost per RPM reflect differences in cost perASM plus differences in thin out factor. Two airlines talent endure very similar costs per ASM, unless quite different costs per RPM because of differences in lade factor. For example, in 1992 USAir and Uniteds cost per ASM differed by less than 2 cents (USAir 10.90, United 9.30), but their costs per RPM differed by nearly 5 cents (USAir 18.54, United 13.80) because of USAirs bring down overall load factor (USAir .59, United .67)Economies of Scope and Hub-and-Spoke Ne tworksEconomies of stove play an important role in establishment the structure of the U.S. airline industry. The source of economies of scope in the airline industry is the hub-and-spoke network. In hub-and-spoke network, an airline flies passengers from a set of spoke cities through a central hub, where passengers then channelize planes and fly from the hub to their outbound destinations. Thus, a passenger get goinging from, say, Omaha to Louisville on American Airlines would board an American flight from Omaha to gelt, change planes, and then fly from Chicago to Louisville.In general, economies of scope occur when a multiproduct firm can produce apt(p) quantities of products at a lower total cost than the total cost of producing these similar quantities in separate firms. If quantity can be aggregated into a common measure, this definition is equivalent to saying that a firm producing many products will ache a lower average cost than a firm producing just a a few(prenomi nal) products. In the airline industry, it makes economic sense to appreciate about individual origin-destination pairs (e.g., St. Louis to New Orleans, St. Louis to Houston, etc.) as obvious products. Viewed in this way, economies of scope would exist if an airlines cost per RPM is lower the more origin-destination pairs its serves.To understand how hub-and-spoke networks give rise to economies of scope, it is first essential to explain economies of density. Economies of density are essentially economies of photographic plate on a given pass, i.e., reductions in average cost as traffic volume on the route increases. Economies of density occur because of two factors (1) spread flight sensitive fixed costs and (2) economies of aircraft size. As an airlines traffic volumeincreases, it can fill a larger fraction of seats on a given type of aircraft and and then increase its load factor. The airlines total costs increase only slightly as it carries more passengers because traffic -sensitive costs are small in relation to flight-sensitive fixed costs.As a result, the airlines cost per RPM falls as flight-sensitive fixed costs are spread over a larger traffic volume. As traffic volume on the route gets even larger, it becomes worthy to substitute larger aircraft (e.g., 300 seat Boeing 767s) for little aircraft (e.g., 150 seat Boeing 737s). A key aspect of this alternate is that the 300 seat aircraft flown a given outer space at a given load factor is less than twice as dear(p) as the 150 seat aircraft flown the same maintain at the same load factor. The reason is that stunt man the number of seats and passengers on a plane does not require doubling the number of pilots or flight attendants or the metre of fuel.Economies of scope push through from the interplay of economies of density and the properties of a hub-and-spoke network. To see how, get hold of an origin-destination pair say, capital of Indiana to Chicago with a low-pitched amount of traf fic. An airline serving only this route would use small planes, and even then, would probably enmesh with a low load factor. But at one time consider an airline serving a hub-and-spoke network, with the hub at Chicago. If this airline offered flights surrounded by capital of Indiana and Chicago, it would not only draw passengers who want to travel from Indianapolis to Chicago, but it would also draw passengers from traveling from Indianapolis to all other(a) points accessible from Chicago in the network (e.g., Los Angeles or San Francisco). An airline that includes the Indianapolis-Chicago route as incite of a larger hub-and-spoke network can do work larger aircraft at high(prenominal) load factors than an airline serving only Indianapolis-Chicago.As a result, it can benefit from economies of density to give a lower cost per RPM along the Indianapolis-Chicago route. In addition, the traffic between Indianapolis and the other spoke cities that will fly through Chicago will in crease load factors and lower costs per RPM on all of the spoke routes in the network. The overall effect an airline that serves Indianapolis-Chicago as part of a hub-and-spoke network will wealthy person lower costs per RPM than an airline that only servesIndianapolis-Chicago. This is precisely what is meant by economies of scope.Relation Between Airline Yields and Market CharacteristicsAn airlines yield is the amount of revenue it collects per revenue passenger mile. It is essentially a measure of the average airline fares, adjusting for differences in distances between different origins and destinations. Airline yields are strongly touched by the characteristics of the particular origin-destination market being served. In particular, there are two important relationships Shorter distance markets (e.g., New York-Pittsburgh) tend to have higher(prenominal) yields than nightlong distance markets (e.g., New York-Denver). Controlling for differences in the number of competitors, fli ghts between smaller markets tend to have higher yields than flights between larger markets.The reasons for relationship 1) are summarized in Figure 1. terseer distancehigher cost per RPMlower load factorhigher cost per RPMhigher yieldFigure 1Cost per ASM slackly falls as distance increases. This is because, say, doubling ride mileage does not require doubling key inputs such as fuel or labor. Thus, shorter flights have higher cost per ASM than continuing flights, and airlines must accomplish higher yields to cover these higher costs. In addition, shorter distance flights generally have lower load factors than longer distance flights, which implies a higher cost per RPM for shorter distance flights, again requiring higher yields. Why are load factors lower for shorter flights?The reasons has to do with the greater substitutionpossibilities that consumers have in short-distance markets (e.g., car of train travel are more viable options). In short distance markets, we would theref ore expect that some fraction of time-sensitive travelers (e.g., vacationers) would travel on these alternative modes, so short distance flights would have a higher ratio of time-sensitive travelers (e.g., business persons) than longer distance flights. Competitive pressures thus force airlines to offer more prevalent flight schedules in short-distance markets, which leads to lower load factors.The reason for relationship 2) has to do with the economies of density discussed earlier. Smaller markets will have lower traffic volumes, and airlines will generally operate smaller aircraft at lower load factors, increase costs per RPM and yields.The S-Curve EffectThe S-curve effect refers to a phenomenon whereby a predominate mail carriers market conduct ( get by of RPM) in a particular origin-destination market tends to be greater than the carriers share of capacity (share of ASM). Thus, for example, if United offers 70% of the seats flown between Denver and San Francisco, and Contine ntal flies the remaining 30%, then the S-curve effect says that Uniteds share of the actual traffic in this market will be greater than 70% and Continentals will be less than 30%. This translates into an S-shaped relationship between share of capacity and market share, as shown in Figure 2.The S-curve effects stems from two sources. First, an airline with a greater share of capacity in a market is likely to have greater visibility in that market, so passengers are likely to contact it first. Second, an airline with a greater capacity share is likely to have more frequent and thus more convenient departures. This, too, works to move on its share of the actual traffic.The S-curve phenomenon makes capacity an important agonistic weapon in the rivalry among airlines. An airline with the pecuniary resources to purchaseaircraft and airport gates to achieve a dominant capacity share on key routes is likely to win the fight for market share. This suggests that, in general, it will be v ery difficult for a small carrier to challenge a dominant carrier at a hub airport, unless the small carrier can achieve significant cost advantages uncorrelated to scale. The history of competition in the post-deregulation airline industry seems to bear this out.