Airline Industry - Increasing Competition and Alliances

American and European Airlines

Jarek GrygolecEmail: jg@econ.umn.eduWebsite: http://www.econ.umn.edu/~jg/guest.html

Why airline industry is interesting?

Flying is on the riseAirlines in the US:

620 million passengers Employ directly 1 million workersPay $18 billion in taxesEssential social, leisure and business linkAircraft maker Boeing is the biggest American exporter

Era of Regulation

Heavily restricted entry by regulatorsAirfares subject to approval by regulatorsApproval needed also for new routes

Regulatory capture inevitableIn 70s unregulated intrastate airfares in CA were 40% cheaper than airfares in comparable but regulated Eastern interstate routes

New Era of Deregulation

Deregulation of US market in 1978

“I have more faith in greed than in regulation”

Alfred Kahn, Chairman ofCivil Aeronautics Board, 1980

Free entry subject to safety rules

Survival of the Fittest?

More than 60 new interstate carriers by 1983, i.e. New York Air, Republic, Piedmont, Ozark Airlines, SouthWestMost of them went bankrupt, was acquired or merged with the incumbentsAirfares went down by 20% in the 80s, rising late in the decade however.What happened?

Using Game Theory

Fathers of modern game theory:John von Neumann Oskar Morgenstern

Everything is a game!Players → interdependent decisionsBig question: What rational players do?Answer: Equilibrium concept

1994 Nobel to Game Theorists

John F. Nash Jr.

Nash Equilibrium

Reinhard Selten

Perfect Equilibrium

John C. Harsanyi

Bayesian Equilibrium

Rules of the Game

The small entrant - “Puppy Dog”moves firstdecides to Enter or Not Enter a single route

The incumbent:operates many routesobserves entrant’s choicemoves seconddecides to Accommodate or Fight entrant

Playing the Game

Enter

Incumbent

Not Enter

Fight Accommodate

Entrant: -$1mIncumbent: $7m

Entrant: $1mIncumbent $9m

Small Entrant

Entrant: $0Incumbent: $10m

Potential PuppyDogs Observing From Sidelines

Top Dog and Puppy Dogs

A Fat Cat incumbent accommodatesThen it will face entry by many Puppy Dogs entrants to its other routesThe incumbent just turns Top Dog:

Fight any Puppy Dog Send a message: “Don’t mess up with us”

What Happened in Europe?

In the past markets dominated by national carriers, often state owned and heavily subsidized by governmentsCompare two routes in mid 90s:

Washington-New York: 216 milesLondon-Paris: 211 milesEuropean airfare 30% more expensive

LOT Polish Airlines – History

National Carrier, est. January, 1, 192968% of shares owned by state.Protected by governmentEnjoying quit life: 3.7m travelers in 2003 2nd Award in ad festival held in San Francisco in 1995 for slogan: “Poland is free. The flight very reasonable.”

Another Ad of LOT Polish Airlines

“Fly to Cracow! A place with Paris coffee shops without Parisians.”

LOT Challenged at Last

Polish market deregulated as Poland joined EU on May, 1, 2004.New low cost airlines sprang up overnightFlying for a coffee as in LOT’s ad?EasyJet’s airfare on London-Cracow route from 16 British poundPolish market is the latest part of airline deregulation adventure in Europe

New Entrants in Europe! Again?

European Union deregulated airline industry in 1997.Flood of new entrants Low – cost business modelDidn’t they learn on the mistakes of American entrants in the early 80s???As usual, some did (Ryanair, Easyjet), others did NOT (i.e. Volare)

Survival of the Fittest: Episode 2Flood of new entrants in Europe

0

150

300

450

600

750

900

1050

1995 1996 1997 1998 1999 2000 2001 2002Year

Ryanair Virgin Express EasyJet Debonair GO Buzz bmibaby

Easy Jet – LEAN and HUNGRY

Easy Jet is LEAN!!!No thrills, only web ticketsTwo types of plane to cut service costPlane is to fly not to stay in the hangar

Easy Jet is HUNGRY!!!2002: Firm order of 120 Airbus A319 aircrafts in 5 years with option for 120 in next 5 yearsPlane not full? Sell tickets for 10 Euro

Losing the Game? Change the rules

Enter

Incumbent

Not Enter

Fight Accommodate

Entrant: $1mIncumbent: $-5m

Entrant: $10mIncumbent $5m

Lean and HungryEntrant

Entrant: $0Incumbent: $10m

Top Dogs turned Fat Cats

Big incumbents were made “Fat Cats with health problems” SwissAir, Sabena went bankruptRead news for more airlines obituariesEasy Jet and Ryanair earn profits consistently

Fat Cats Face Reality

"The harsh reality is that our world has permanently changed, and we must change with it."

Gerald A. GrinsteinCEO of Delta, September 2004.

Fat Cats’ Dilemma

Beg government for subsidy?Recently Alitalia received 400m Euros in state loan guaranteesSubsidies in EU: “One time, last time”

Avoid direct duel?Focus on international routes still regulated by inter-government agreements.US-EU talks on trans-Atlantic “Open Sky”

Fat Cats’ Dilemma

Soften competition?Frequent flier programs, i.e. Miles and More, WorldPerks, etc.Italy asked competitors to increase airfare prices to match ones of ailing Alitalia

Restrict competitors’ access to airportsKeep even unused landing slotsCharge competitors higher prices for slots

Fat Cats’ Dilemma

Stronger together?Code-sharing agreementsAlliances: Star, Oneworld, SkyTeam

Real Change: Slim fast? Start a low cost airline, i.e. United’s TedLoosing fat is difficult, i.e.

KLM’s sale of Buzz to RyanairBA’s divesture of GO (now owned by Easy Jet)

The Lean and Hungry in the US

Southwest and JetblueLean and hungry look Rapid expansionConsistent profitability

AA, NWA, Delta, United on the defensiveUnited to focus on international flightsUnited’s low-cost Ted to operate within USForced cost cutting

Summary: Cheaper airfares on the way

Strategy makes a difference: Puppy Dog vs. Lean and Hungry Look

Deregulation benefits consumersIndustry shakeout:

Low cost airlines to dominate industryIncumbents have to change or exitWill business class airlines pick up?