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Low-cost airlines: a failed business model?
Subject:
Airlines
Sustainable development
Author:
Button, Kenneth
Pub Date:
03/22/2012
Publication:
Name: Transportation Journal Publisher: American Society of Transportation and Logistics, Inc. Audience: Academic; Trade Format: Magazine/Journal Subject: Business; Transportation industry Copyright: COPYRIGHT 2012 American Society of Transportation and Logistics, Inc. ISSN: 0041-1612
Issue:
Date: Spring, 2012 Source Volume: 51 Source Issue: 2
Topic:
Event Code: 200 Management dynamics Computer Subject: Company business management
Product:
SIC Code: 4512 Air transportation, scheduled; 4513 Air courier services; 4522 Air transportation, nonscheduled
Organization:
Company Name: Southwest Airlines Co.; Ryanair Ltd.; easyJet Airline Company Ltd.
Geographic:
Geographic Scope: United States; Ireland; United Kingdom Geographic Code: 4EUUK United Kingdom

Accession Number:
313344947
Full Text:
Abstract

The article examines the sustainability of the low-cost, or no-frills, airline business model. It looks at the background to the development of this managerial approach within the context of some prevailing business theories and considers variations on the basic low-cost airline model. It assesses, drawing from the experiences of a number of markets, whether the model in itself is likely to be enduring, or whether it is simply a transient way for some airlines to recover their full costs.

Keywords

Low-cost airlines, airline markets, airline finances, market stability

Introduction

The low-cost airline model (often called the "no-frills" model in Europe because airlines offer only basic services to their customers) has been the subject of intense interest and study. The "Southwest effect," basically the drop in fares that occurs when a low-fare airline begins serving an airport that had previously had no low-fare carriers, has become part of the vocabulary of air transportation. This article looks at just how successful the low-cost model is in its broadest context. In particular, while clearly some airlines pursuing the low-cost approach have largely endured and prospered, the question remains as to whether this is because of the underlying business model or is a function of good management exercised, perhaps, with an element of Napoleonic luck on the part of the individuals running these companies.

We begin by exploring the criteria against which success should be measured, and the nature of the market environment in which low-cost carriers have emerged, and then move on to see how they have fared in the Spencerian world (Spencer 1882-96) of Lamarckian evolution in which they operate.

The Concept of a Successful Business Model

To assess the achievement of any business model one needs criteria to set it against, essentially in some forms of matrices, and a benchmark. Success in business can be assessed on several dimensions. In terms of the business community, it may relate to profits, the standard neoclassical rent-seeking criteria, but business success may also be seen in relation to market share or sales revenues (Baumol 1962). Internally, the management of a firm may also see success in the context of how well the firm performs in a number of defined areas (Williamson 1975), or it may more broadly "satisfice" (Simon 1959) and think in terms of meeting a much wider range of objectives such as sales, profits, market share, labor-force retention, and share price. From the perspective of antitrust authorities, success is the absence of the exercise of market power, either in terms of extracting economic rents from consumers or through the enjoyment of X-inefficiency. (1) From a technology perspective, success is normally associated with new or innovative processes that overcome some barriers to production and, thus, reduce costs significantly, allowing economic development (Rostow 1960). From a social perspective, the issue is one of welfare maximization, often articulated in the transport context as meeting some standards of mobility or accessibility, whichever is the political fashion of the day. The recent interest in the environment often sees industrial success as something that may not always be consistent with "sustainable development" in the Brundtland sense (World Commission on Environment 1987). Finally, in the short term, the macroeconomic climate after 2008 has often seen success couched in terms of the creation or retention of jobs.

Here we treat the low-cost airline model as an attempt to circumvent a particular and narrow market problem, namely the historically low operating margins in the scheduled airline market. Since the advent of gradual liberalization of scheduled airlines around the world, there has been a singular difficulty in carriers maintaining operating margins above zero, and certainly at a level found in most other sectors of the economy. This problem and its root cause are discussed in more detail in the following sections. Business models that have tried to resolve this problem have been explored by airlines, most notably those associated with hub-and-spoke operations and a number of innovative practices, such as frequent-flier programs, business lounges, and computer-reservations systems (CRSs). Among these various business models, the low-cost model has often been seen as one of the more successful.

What this notion of success may not coincide with is the short-term maximization of consumer welfare. There seems little doubt that low-cost airlines have, in many markets, resulted in lower fares in the short term for travelers and a greater selection of service types. The notion of success adopted here is geared more toward long term than short term, and reflects the arbiter of enduring business success in a competitive market. It construes social welfare maximization rather than shorter-term considerations such as current share values or margins. Essentially, success here is seen as the development of a sustainable and pervasively X-efficient industry that is financially viable. Success for one or two businesses pursuing a particular approach to their activities is not axiomatically seen as a successful business model. They may have benefited from other factors that added to their success such as the quality of their management, or they may just have found a narrow market niche into which they fit for a period of time. A successful business model, in our context, has to be one that is widely and successfully adopted, provides stability in the market, and remains in use for an extended period of time. These are essentially soft criteria akin to a structure, conduct, performance approach.

The Basis of Airline Competition

Although there were important national differences, until the late 1970s all airline markets were virtually highly regulated, and airlines were often publically owned, frequently enjoying both direct and indirect subsidies. The changes from the late 1970s thrust airline management from a world with well-defined parameters into one not only involving considerable commercial risk (the "known unknown" to quote Donald Rumsfeld [2002], the former US Secretary of Defense), but also considerable uncertainty (Kahn 1988b). Risk is something that management schools teach students to handle through various forms of hedging and insurance, but uncertainty is more challenging. The natural business inclination is to minimize it where there is an intuition that it exists, and this is essentially what the legacy airlines have sought to do. They have sought to minimize competition by developing fortress hubs, and to tie customers in with frequent-flier programs. However, this is only one of two broad strategies business may adopt.

Michael Porter (1985) in his classic book on management, Competitive Advantage, argues that to be successful in a market, a supplier must pursue one of two alternative broad business options. First, it may try to differentiate its product to gain a degree of monopoly power. In the airline context, this business option involved traditional airlines that had grown under regulatory protection and, in many countries, were still state owned. These traditional airlines tried to exploit economies of scope and scale, as well as market presence, by developing extensive hub-and-spoke networks around one or two major airports. These airports then acted as consolidation and dispersal points for traffic akin to a post office sorting depot (Morrison and Winston 1995). They added to their strength by seeking to control information flows through CRSs that allowed the airline owners of systems, through travel agents, to favor their own flights when flight options were displayed to potential customers. Such an effect was further reinforced through the halo effects associated with bonuses offered to agents who achieved high bookings for the CRS-owner airline. The CRS system, and the flow of information that it provided, also allowed the airlines to adjust the fares offered to customers to reflect their willingness to pay and, thus, price discriminating between those who are more or less fare sensitive. In addition, the traditional carriers formed alliances with both other major airlines and feeder carriers. The alliances created seamless services for customers and more integrated schedules of service that minimized the time required to make interline connection at a hub airport.

The alternative highlighted by Porter (1985) was for a business to compete on the basis of cost, that is, to develop and maintain a market share by offering its products at lower prices than its competitors. This "low-cost leadership" business option has been the approach of the low-cost carriers. They have sought to establish, and subsequently sustain, themselves by undercutting the fares offered by rival airlines. While the title "low-cost" airline is widely used, the business models adopted can vary quite considerably between carriers. Some carriers, for example, focus on secondary airports in cities, whereas others serve the major hubs; some offer no online services, whereas others do; and some have frequent-flier programs, whereas others do not. In addition, in some cases traditional airlines have operated divisions or subsidiaries that have sought to be low cost. Defining a low-cost carrier is, thus, a little like the famed words of the US Supreme Court Justice Potter Stewart when discussing obscenity, "I shall not today attempt further to define the kinds of material I understand to be [obscene].... But I know it when I see it." (2)

The low-cost approach in aviation has a long history. The first successful low-cost carrier was Pacific Southwest Airlines in the United States, which pioneered the concept in 1949, and companies like Southwest have been in business since the early 1970 (Gittell 2005). In that sense, one could say the business model has worked. This proclamation, however, is somewhat deceptive not only because long-haul, low-cost carriers have never really gained a market niche, but also because numerous large carriers that do not follow the low-cost path still survive, despite many years of "deregulation." (3)

The Underlying Issue

The financial performance of the airline sector in general has hardly been stellar over the past two decades. The industry as a whole suffers from severe cyclical fluctuations in demand and overall has operating margins well below most other industries (as shown in figure 1). Even within the larger air transport chain, airlines perform poorly compared to other players such as airports, global distribution systems, and airframe and aero engine manufacturers (Button 2004).

[FIGURE 1 OMITTED]

The problem with the airline market is that it is highly competitive, but at the same time has the peculiarities of a form of fixed costs found in a number of service industries such as professional sports and the theatre. (4) These industries are not characterized by the fixed costs of bricks and mortar of the type Alfred Marshall (1890) wrote about a century ago, but rather by the commitment to offer a scheduled service. The fact that an airline has to have an aircraft, whether owned or leased, is immaterial; sitting at a gate at particular time, along with various services required at the origin and destination, is de facto a fixed cost. Examples of services adding to the fixed cost are pertinent to slots at both ends of a flight: a full crew, fuel, and other supplies on board, and ground staff committed to booking, ticketing, boarding, and baggage handling for the flight. It matters little whether the flight has a zero load factor or a 100 percent load factor; these costs have to be borne. To further complicate the matter, the commitment to the service is made months in advance. Thus, costs cannot be completely known, albeit this is largely a matter of commercial risks and can often be insured against in a variety of ways, of which fuel hedging has attracted the most attention (Carter, Rogers, and Simkins 2006).

While the cost side of air transport is not simple, it does in a number of ways reflect many other industries. The challenge is the recovery of fixed costs in a competitive market environment (Button 2003, 2005). In the extreme case of full information and atomized competition and innumerable potential customers, airfares are pushed right down to marginal costs and no contributions to fixed costs are made. This problem of an "empty core" has been known to economists for well over a century (Edgeworth 1881), and one reason that Coase was awarded his Nobel Prize was for his work on cost recovery in this type of market structure. (5)

Perhaps more by instinct than logic, the problem of the empty core in the air transport case has either been directly handled by government interventions, or by cross-subsidies. The former are most notably through direct subsidies with the taxpayer covering the fixed costs, while the latter are through the conceding of institutional monopoly powers with the granting of licenses or concessions that allow airlines to charge above marginal costs. These measures have largely been abandoned because of the recognition of both political capture and the degree of X-inefficiency that manifestly resulted. One practice that has remained in the United States, although not to the same extent in Europe, is simply to allow airlines to write off losses through Chapter 11 bankruptcy, despite the moral hazard issues it creates.

Any supplier's natural instinct in a perfectly competitive market is to try to carve out some form of monopoly power, so as to put some slope on the demand curve that is confronting it. This means following the first approach posited by Porter (1985) in which traditional airlines have sought to distinguish their products in a wide variety of ways. In some cases, they have engaged in the international market, focusing increasingly on services that have remained protected under restrictive air-service agreements, although the scope for this strategy has shrunk as the "Open Skies" and similar policies have spread. Frequent-flier programs have offered "bonuses" to loyal customers, and there has been market segmentation between various types of traveler, both in terms of motivation (business, leisure, visiting friends and relatives) and distance (short haul and long haul). There have also been efforts to control terminal facilities (the "fortress hubs") and measures to offer seamless services (strategic alliances). (6) However, the aforementioned approaches have generally only stemmed off competition temporarily. In some cases they are easily replicated (as in the case of frequent-flier programs that are now ubiquitous and largely uniform), and in others they have been successfully counteracted by competitors (as with "hub-busting," direct services).

While many of the measures of product differentiation remain in the airline sector, their potency has seldom solved the cost-recovery challenge, even when the business cycle has favored the airlines (as we saw in figure 1). The second approach, lowering costs of production below competitors, entails focusing on just one element in the competitive matrix, namely fares. Of course, this approach does not exclude other elements--things are seldom black or white--but it is all a matter of degree. The low-cost airlines seek to attract traffic from competitors in the short term, while generating new traffic to cover their immediate costs with the hope of forcing traditional carriers from the market in the longer term so as to allow them to enjoy some degree of monopoly power. This approach is essentially Bain's (1949) limit pricing theory of business behavior in that the low-cost carriers do not push fares back to their previous level once in a market to ensure that legacy carriers remain uncompetitive on the routes involved; they retain monopoly power without fully exploiting monopoly prices.

The industry has also been kept afloat, and enjoyed a flow of investment that would not seem justified by the returns earned, by forces not always embodied in neoclassical economic models, for much of this theory suggests it should have gone by now. One explanation for the flow of investment has been a possible money illusion. Because fares are collected well in advance of the delivery of services, airlines maybe seen to be cash rich with the potential of owners using that money to earn a return elsewhere. There also seems to be a "Las Vegas effect" in the sense that while the returns for the industry as a whole may be low, some airlines do well for periods. Southwest shares, for example, earned well above the average for the US stock market throughout the 1990s. The actors further up the value chain, such as airports and airframe manufacturers, simply cannot allow the airline industry to die because of the money they make by selling their goods and services to it and thus support it. Finally, airplanes present a largely irrational fascination for many people and this stimulates them to invest; to them it is a "sexy" industry. Warren Buffet considered himself in an interview to the Sunday Telegraph in 2002 a "reformed aeroholic" after losing $300 million or so in a USAir investment in the mid 1990s. Buffett, in his 2008 annual letter to Berkshire Hathaway shareholders, perhaps best sums up the general outcome of all of these forces.

The Low-Cost Airline Model

Although there is no single form and description of a low-cost or no-frills carrier (Mercer Management Consulting 2002), there is some agreement about its basic characteristics. In very general terms, low-cost carriers offer low fares by using a range of broad differentiation strategies. These strategies both remove some elements of cost from their production functions and reduce the levels of many of the remaining costs. (7) In doing so, they offer more limited services and, in some cases, charge separately for the attributes they do offer, which vary among low-cost airlines. (8)

Simple comparisons show that the operational advantage of low-cost carriers such as Ryanair often lies in the radial short-haul networks they operate with no online services. Such services are virtually exclusive to second-tier airports centered around a "base" airport that allows for the maximum utilization of a standardized aircraft fleet and crew without the congestion. An additional advantage is the avoidance of the repositioning costs associated with mixed distance, on-line services through a hub using a varied fleet. Other low-cost carriers have variants on the basic low-cost model. EasyJet, for example, serves many of the larger airports, whereas Air Berlin has a frequent-flier program and is joining the oneworld alliance. In spite of these variations, all low-cost carriers are aggressive in keeping costs to a minimum by charging for on-board services, having quick turnaround times for their aircrafts, cutting out sales commissions, and striking hard bargains with airports and other suppliers.

Essentially, a key element of the low-cost business model is one of unbundling and a focus on core business. Many of the attributes of a full-service, legacy carrier (e.g., meals, extra baggage, more comprehensive insurance) can be obtained from a low-cost airline at an additional price. (9) The overall philosophy and features of low-costs carriers, whether or not admitted by all, were well summed up by Michael O'Leary, Ryanair's chief executive officer, when he said, "air transport is just a glorified bus operation." (10)

The Impact of Low-Cost Carriers on the Overall Airline Market

Numerous studies have examined the effects of low-cost airlines on the fares and the markets they serve. This group of studies shows that the effect is lower fares than those offered by incumbent airlines, which in turn leads to significant traffic generation to the extent that the actual traffic volume of incumbents is little affected. Rather, the impact on the latter is on their bottom lines, resulting from lower revenues as they must reduce fares to stay competitive. While much of the analysis has been on the domestic US market, where a 10 percent ticket sample offers good fare data, the effect seem to be fairly general. In most markets, for example, where low-cost airlines have a significant presence, there have been major structural changes with fares falling, overall demand rising, and the traditional carriers losing market share (UK Civil Aviation Authority 2006). (11)

As a more elaborated example, Dresner, Lin, and Windle (1996) hypothesized that the effect of Southwest and other low-fare carriers may be greater than previously estimated. This is because of possible spillover effects that Southwest's service on one route has on adjacent competitive routes that involve nearby airports. They found significant effects on services on adjacent competitive routes but did not aggregate their results. Morrison (2001) took a more macro perspective and looked at the actual, adjacent, and potential competition Southwest brought to US routes in 1998. Results showed that Southwest's passengers benefited by $3.4 billion (current prices) in low travel costs, while those on other carriers gained $9.5 billion in terms of lower fares.

Comparing the situation on either side of the Atlantic, Pitfield (2008) found that the impact of Southwest in the United States has been less than that in the majority of Ryanair routes he examined, except for the start-up routes involving Stockholm and Hamburg. This finding seems to be because the Italian destinations analyzed are more likely to be dominated by leisure traffic than those studied in the United States (with the exception of Las Vegas). Further, the number of carriers on the routes is greater in America, and the scale of traffic is considerably higher on all corridors, except London-Stockholm, which has competitive pressure on the Irish airline. Finally, with its frequent offerings of flights at a unit cost of 0.01[euro] per available seat mile, taxes and charges excluded, Ryanair may be a more aggressive competitor. Overall Pitfield found that Southwest, when it has significant effects, has a smaller initial impact than Ryanair, although the latter establishes larger market shares as a result of its impact on competitors. It appears that US competitors are more competitive than most of Ryanair's in terms of pricing and product differentiation.

The advent of low-cost carriers has also affected other elements of the air-service supply chain, particularly airports. To keep their costs down, low-cost carriers often use small, second- or third-tier airports, and/or dedicated low-cost terminals at some major airports (De Neuville 2008). This practice, in turn, has added a new dimension to the competition between airports seeking to attract low-cost carriers. But, in doing so, airports engage in a form of competition that has been alien to them in a more regulated environment (Dresner, Lin, and Windle 1996). The nature and extent of this competition, and which airports succeed, depend not only on their competitive position in relation to other airports, but also on the extent of monopoly power they can exercise over the airlines. Francis, Fidato, and Humphreys' (2003) case study analysis raises questions about the sustainability of airports' relationships with airlines. The success of many lowcost carriers has been explained by the rapid growth in passenger volumes at airports where they operate. Yet many low-cost airlines have failed. Given the proliferation of new low-cost carriers and the instability of macroeconomic conditions, the ability to develop contractual arrangements that reflect the risks of failure incurred by either party becomes more difficult.

The Airline-within-an-Airline Model

To combat competition within their established markets, many legacy airlines have, at various times, established their own low-cost carriers. (12) Institutionally, the arrangements between the traditional elements of a company and its low-cost offshoot have differed for a number of reasons. The difference can stem from local legal stipulations, the airlines' internal constraints (e.g., labor agreements and slot availability), and the challenges of the particular low-cost carriers that were penetrating the market. They also, in some cases, have had wider objectives, such as to spin off profitable business or to test out low-cost elements that they could later adopted in their mainline operations.

These efforts at emulating the low-cost model, largely that of Southwest, have generally proved to be unsuccessful. There has in many cases been confusion on the marketing side in terms of the ability to develop separate brand images (Morrell 2005). Operationally, they were handicapped in the United States in particular by labor union agreements that prevented costs from being reduced significantly, and by internal management constraints that limited their operational freedom and financial autonomy. In effect, they were seen as part of a larger business model, encompassing a range of products along the lines of the Procter and Gamble generic competitive strategy of broad differentiation. This fraction prevented costs from falling low enough to compete with the single-brand, low-cost airlines.

The European experience, where there has been some physical separation of the low-cost offshoot by making use of different airports (for example), has been a little more successful than that of US carriers. Transferring decentralized traffic flows to the low-cost unit, and deploying the aircraft of the network carrier exclusively to hub operations as a work-sharing and positioning strategy for the business units (e.g., in the case of Germanwings and Lufthansa), has had some success.

There is also some evidence that the low-cost-airline-within-an-airline concept has proved useful as a stopgap measure to combat the increases in market presence of low-cost carriers while a legacy carrier restructures its own core operations (Graf 2005). There is also some evidence, as with JetStar in Australia, which provides a low-cost offshoot as an almost totally independent part of the parent airline, that the concept can be successful at least for a period, although whether this outcome is strictly "an-airline-within-an-airline" becomes a moot point. In general, however, they have not proved a successful concept and do not seem to have added much to the ability of the overall scheduled airline to recover its long-run costs, or, in economic terms, to increase its stability.

Competition in Low-Cost Markets

We now turn to the stand-alone low-cost airlines and assess their contribution to the provisions of scheduled services. There is no single matrix for such an assessment, but there are a number of ways in which insights may be gleaned.

Market Financial Robustness

Figure 1 illustrates the largely poor economic performance of the scheduled airline industry going back well before low-cost carriers were a significant presence. In the United States, low-cost airlines began to make serious inroads into the market in the mid-1990s, and about five or six years later in Europe, following the enactment of the full three packages of European airline deregulation. (13) Simple examination of the Figure shows little impact on the overall performance of the sector after the incursion of low-cost airlines into the market. More recent evidence in 2008 suggests that the overall industry is no more capable of handling significant macroeconomic shocks than it has been in the past. In the context of Ryanair, for example, it laid up over 80 aircraft in the fall of 2011 because of weak demand. In sum, while Southwest now enjoys about a 25 percent share of passengers and a 15 percent of revenues in the US domestic airline market, the overall market performance has not deviated from the historic pattern of cyclical fluctuations around a zero operating margin. (14)

Survival Rates

In any competitive market, one expects a number of firms to fail and new ones to enter it. This pattern reflects shifts in demand that require overall capacity adjustments. It also reflects the fact that management, for one reason or another, is not homogeneous and Spencerian forces lead to the inefficient leaving, to be replaced by the more efficient. It is a judgment call as to how many airlines should, in a well-functioning market with firms adopting appropriate business models, be entering and leaving.

Table 1 provides some details of European low-cost airlines that were forced to exit the market between 2003 and 2010. The low-cost airlines that are now defunct were diverse and ranged from a number that hardly began operations to others that were relatively successful, but merged or were taken over (e.g., Go and Buzz). One could draw up a similar list of defunct airlines in the United States and most other countries. The simple situation is that with this level of attrition, the first-movers, Ryanair and easyJet, now account for more than 88 percent of the scheduled low-cost market in Europe. Southwest Airlines holds 50 percent of the US low-cost market. There are, in other words, successful companies, but that is not the same thing as a successful business model. Replication seems to have been challenging. Further, the successes seem to be those that entered the market first, indicating that replication of the business models is far from simple.

At the more micro level, individual low-cost airlines are often less than stable in terms of the services they provide. Where there are exceptions such as in the case of Southwest Airlines, which has tended to steadily build its network with few subsequent withdrawals, this is not always the picture. In Europe, for example, the development of services at Stansted Airport, Ryanair's main base, shows both new routes and dropped routes (see table 2). While the growth is clear, it has not been in a strictly incremental way; indeed if anything the volatility of route entry and exit has grown as low-cost carriers service have expanded.

Market Power

In markets that have significant fixed costs, either the conventional "brick and mortar" type or the fixed commitment type that we have argued are associated with the scheduled airlines services, suppliers require a degree of market power to recover their costs unless government helps. The success of a market with these technical features relies on such features. Testing for market power using such measures as Herfindahl Indices to assess market concentration is not very useful in this case, for it gives no insight into contestable forces and provides no indication of the dynamics of the marketplace. The fixed-cost element in air transport is also individual service specific, rather than route specific.

One way that market power in offering a specific service has been looked at recently is through the use of "data scraping." This approach entails going to travel websites, often the airlines', and examining the pattern of fares offered for a particular flight as the time of departure approaches. In other words, it involves collecting all the fares, F, for each day (or some other time division), t, from a date prior to the flight until the actual takeoff. The airlines that practice this dynamic price discrimination essentially try to capture the rents from any flight seen under the normal demand curve (the shaded area on the left element of figure 2) by offering fares that rise as the time of a flight departure approaches (collecting the revenue under the fare-offered curve in the right side of the figure). The highest fare offered will not exceed F* or fall below the short-run marginal cost (SRMC). (15)

[FIGURE 2 OMITTED]

Perfect third-degree price discrimination is more of a theoretical concept than a practical reality, and so the full amount that temporal fare variations capture will not completely see all consumer surplus extracted by the airline. The extent to which a carrier can extract sufficient rent above SRMC to cover its fixed costs of a committed service is also influenced by the slope of the demand curve and, ipso facto, the amount of revenue that is raised under the temporal fares-offered curve in the right-hand element of the figure. Fares rise toward departure because last-minute bookings are largely made by individuals with limited choices and fewer prior insights into their future travel needs (generally business travelers). (16)

Much, therefore, depends on the extent and time period seats to which can be sold at prices above SRMC. A priori, one would anticipate that if the airline is a monopolist, then the demand curve on the left of figure 2 will be relatively steep and up-turn of the fares-offered curve would come quite early and rise steadily. If there is imperfect competition (essentially other flights on the route at nearly the same time), then the ability to substitute between airlines increases and the slope of the target carriers demand curve flattens on the left and the up-turn in the fares-offered curve comes later and is less pronounced. Less revenue is, thus, earned and the contribution to the fixed cost of the service is reduced. There may also be some fluctuations in the pattern of fares offered over time as the carrier seeks to "play games" with competitors or to gain more insights into the demand elasticity at a particular time prior to departure. If there were perfect competition in the market for a particular service, then both the demand curve and the fares-offered curve would be flat. (17)

There are clear limitations to this methodology, and we just list a few. Only one class of seat (e.g., business class or coach) can be analyzed at any one time, but competition between airlines extends into mixture of classes they offer. It makes no allowance for free seats occupied by frequent-flier-point redeemers. For comparative purposes, there is generally a need to compare similar services, but definitions of rival services are subjective. For instance, does the 8:30 AM flight offered by airline Z between A to B on a particular date compete with the 9:00 AM flight offered by airline X, or the 10.15 AM flight by airline Y? The situation becomes even more complex if the 10:15 AM is not provided by airline Y, but by Z. In other words, flights may compete with others offered by the same airline. Perhaps most importantly, there is little feel for the actual uptake of flights when data scraping, and so the elasticity of demand that indicates the willingness-to-pay and not what is being offered is not being explicitly measured.

Empirical analysis supporting the logical basis of the temporal fares-offered curve has been fairly well established in studies of European and American air transport markets (e.g., Pels and Rietveld 2004; Barbot 2006). As an example gleaned from figure 3, a US nonstop monopoly market, served between Phoenix and Des Moines at the time by America West Airlines, illustrates the fairly consistent rise in fares as time of departure approaches. This general pattern of temporal price differentiation holds irrespective of whether the monopoly airline is a low-cost carrier or pursues the traditional, full-service business model. Of more interest in terms of whether the low-cost model is successful is what happens when two carriers offer nearly identical services, differentiated largely by a small difference in departure times. Again the pattern is consistent and has been examined in detail in other works. Figure 4 simply offers an example, again from the United States, of a duopoly situation and the volatility that arises in that the lack of a significant and consistent fare rise close to takeoff is clear. Other studies that have looked at services where there are more than two competitors show a further flattening out of the temporal fares-offered curve.

[FIGURE 3 OMITTED]

Much of the analysis using data scraping has not been concerned with the issue of the success of the low-cost model per se, but rather with its relative performance vis-a-vis the traditional full-service model. Of particular relevance to assessing the success of the low-cost business model has been attempts to look for market leadership using such techniques as Granger causality testing (Button and Vega 2007) and ARIMA time series models (Pitfield 2005a, 2005b). The findings suggest that there is little evidence of price leadership in markets where there are several suppliers, which in turn indicates the lack of any marked degree of monopoly power. Thus, even when there are both low-cost and traditional, full-service suppliers offering near-identical services in terms of departure times, there is no indication that one type of business dominates others. More importantly, in terms of the absolute success of a particular business model, there is no evidence that this flattening out, and often irregular, pattern of fares being offered diminishes when it is low-cost carriers competing with each other rather than low-cost airlines confronting legacy carriers.

[FIGURE 4 OMITTED]

That low-cost airlines have enjoyed some financial success may, thus, not be because of the business model per se, but rather the nature of the markets that they have entered. Some airlines have enjoyed a degree of economic rent, allowing full cost recovery by simply avoiding competition, and the same would seem to be true of routes served by traditional airlines on parts of their networks. Avoiding competition is hardly a novel way of approaching business and cannot really be defined as a business model in the full meaning of the term. More importantly, in terms of success, it may only be a transitory solution. Traditional carriers, for example, may respond by entering these markets to compete and thus ensure the integrity of their larger operations. But regarding short-haul market, other low-cost carriers may enter the market and thus reduce the potential for rent extraction.

The Issue of Bilateral Monopolies

Low-cost carriers have exerted an influence on airports, both by stimulating the development of basic, regional facilities, and by forcing many established airports to reassess the way they operate. Low-cost carriers seldom want the "frills" that are found at traditional airports, but instead focus on keeping costs to a minimum and in many cases forcing the airports to rely on land-side and concessionary revenues rather than air-side, takeoff, and landing fees. Ryanair, for example, has a reputation for being particularly aggressive in its negotiations with airports (Barrett 2009).

The low-cost airlines have been able to do so in the past at smaller airports because of asymmetries in the bargaining situation, particularly in Europe (Button 2010). The situation has often been in a bilateral monopoly context between a single low-cost carrier and a small airport. (18) In these cases, the outcome, except in very specific cases, is unclear and depends on the bargaining strength and information held by both parties.

When the airport is spatially constrained, the ability of the airline to choose to put its resources in other markets gives it an advantage in many cases. For the traditional carriers, their need for large hubs, of which there are few, and an integrated network involving strategic nodes puts them in a weaker position.

While there are numerous examples of low-cost airlines that are still able to enjoy the upper hand in negotiations with airports, the situation is no longer as clear-cut as in the past (Francis, Fidato, and Humphreys 2003). (19) The growth in the number of low-cost airlines, plus the fact that in many cases the transactions are increasingly about renewals of contracts at airports where a carrier has already sunk costs, has reduced the power of the carriers.

Conclusions

That the low-cost airline model was initially successful for a number of airlines is obvious. The expansion of the intrastate carrier, Air Southwest out of Texas to become Southwest Airlines in the United States, the rapid growth of Ryanair and easyJet in Europe, and the emergence of carriers such as Gol and Tiger in emerging BRIC (Brazil, Russia, India, and China) markets attest to the impact of the low-cost airline model. It is also clear that low-cost airlines have been instrumental on pushing down airfares, opening new markets, and allowing people who could not do so before to travel by air. However, success for a few firms is not the same thing as a successful long-term business model; the achievement needs to be more widespread. Also, the generation of social welfare through lowering travel costs does not establish a successful business if the full commercial costs of the system are not borne by its users, but rather by its investors.

Low-cost carriers have performed well when they have established monopoly power, but this is a transitory situation in the context of modern open-air transport markets. It is quite a legitimate tactic within a Coasian world of competition and fixed costs but, as with other strategies that have been deployed over the years, is not one that is likely to prove enduring. The low-cost airline model is, thus, successful in the same way that frequent-flier programs, fortress hubs, and the like provided success to the traditional airlines. It is, however, not a success in terms of meeting the fundamental long-term problems of providing scheduled services in a highly competitive market. One manifestation of this repercussion has been the gradual transformation of Southwest in the United States. The airline has entered more major markets, offered frequent-flier facilities, engaged in yield management, provided online service (now about a third of its traffic), and rewarded frequent fliers; all of which are not the features of a low-cost airline. Ryanair has also seen changes, albeit much less so, with limited services offered to major airports such as Madrid-Barajas and London Gatwick.

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Notes

Earlier versions of this article were presented at the German Aviation Research Society Workshop on New Issues in Airline and Airport Economics held in Hamburg in 2009, and at the Aviation Policy Research Association in Tokyo in 2011. I would like to thank attendees at these meetings, and those who subsequently responded to a mimeo version of the paper for their very helpful comments.

(1.) Market power per se is not normally an issue, but rather it is whether firms abuse it (Kahn 1988a).

(2.) In his concurring opinion in Jacobellis v. Ohio, 378 U.S. 184 (1964)

(3.) The first airline attempting no-frills transatlantic service was Laker Airways with its famous "Skytrain" service between London and New York City in the late 1970s.

(4.) These costs may also be seen as "sunk" costs in the tradition of the analysis of contestable markets developed by Baumol, Panzar, and Willig (1982). They are costs that cannot be recovered if no one uses the flight and the resources are not easily transferrable.

(5.) The "empty core" problem can be couched in terms of Alfred Kahn's famed statement in 1977, when he was about to deregulate the US airline market: "I really don't know one plane from the other. To me they are just marginal costs with wings." This statement is true, but it relates only to short-run costs, but some thought is needed regarding the long-run costs in a competitive environment. As the Nobel citation said of Coase's work, he had explained why "traditional theory had not embodied all of the restrictions which bind the allocations of economic agents."

(6.) In perhaps slightly less technical terms, Michael O'Leary, Ryanair's chief executive officer, summed up the business model rather well; code-sharing, alliances, and connections are all about "how do we screw the poor customer for more money?" "Full-Service Airlines Are 'Basket Cases,'" Bloomberg Business Week, September 12, 2002, http://www.businessweek.com/bwdaily/dnflash/sep2002/nf20020912_7642. htm.

(7.) Barrett (2009) has a good explanation of how Ryanair works. Some idea of the cost differentials between low-cost and traditional carriers is that the 2005-6 unit cost per available seat mile for Ryanair was 0.04 [euro], 0.059 [euro] for easyJet, 0.078 [euro] for British Airways, and 0.097 [euro] for Delta (Davy Stockbrokers 2006).

(8.) The low-cost model is also not static, but has evolved since its generally agreed introduction by Pacific Southwest Airlines (Alamdari and Fagan 2005).

(9.) Michael O'Leary, CEO of Ryanair, for example, defines the carrier's rather basic accident insurance policy thus: "We don't fall over ourselves if they say, 'My granny fell ill.' What part of no refund don't you understand? You are not getting a refund so f*** off" (cited in Griffiths 2004).

(10.) "Full-Service Airlines Are 'Basket Cases.'"

(11.) There are about 60 airlines across Europe offering a version of the low-cost theme. Ryanair is the largest air carrier of passengers within Europe.

(12.) Graf (2005) offers a useful table listing the main ventures by which legacy carriers enter into the low-cost airlines market.

(13.) In 1997 they accounted for about 2.5 percent of the European air seat miles offered, but this share grew to over 95 percent by 2002. Prior to that, scheduled carriers, focusing primarily on business travelers, controlled 75 percent of the intra-European market. Charter airlines held the remaining 25 percent by selling aircraft capacity to tour operators and shuttling sun-seeking package tourists from cold Northern European countries to the beaches of Southern Europe.

(14.) The recent operating margins for Southwest, for example, were 6.4 percent in 2003, 6.2 percent in 2004, 9.6 percent in 2006, 10.8 percent in 2006, and 8.0 percent in 2007.

(15.) The area under the fares-offered curve is not identical to the revenues collected with price discrimination as seen in the right side of the figure because there is no indication of the number of seats actually sold in each period.

(16.) In multiclass-configured cabins, there may be fare dilution as travelers trade between classes. In these cases, a distinction should be drawn in the fares paid that separates out the rent extracted for booking late from the additional costs of offering extra space, larger luggage allowances, more extensive refreshments, a higher attendant/passenger ration, and so on. All studies using data scraping methods tend to focus only on the lowest fare for a flight, in part to avoid this issue.

(17.) The fundamental definition of perfect competition is that any supplier in the market is confronted by a perfectly elastic demand curve (Robinson 1962).

(18.) Some indication of the ability of Ryanair and, albeit to a much lesser extent, easyJet to exercise power at airports can be seen by the fact that the former has on average 0.17 competitors and the latter 0.80 on a sample of 2,705 routes studied by the International Center for Competitiveness Studies in Aviation (2010).

(19.) The withdraw of a 3 [euro] passenger surcharge at Frankfurt Hahn Airport in January 2009 after threats of service transfers by Ryanair is an illustration of this negotiating power dynamic.
The worst sort of business is one that grows rapidly, requires
   significant capital to engender the growth, and then earns little
   or no money. Think airlines. Here a durable competitive advantage
   has proven elusive ever since the days of the Wright Brothers.
   Indeed, if a farsighted capitalist had been present at Kitty Hawk,
   he would have done his successors a huge favor by shooting
   Orville down.


Table 1/European Low-Cost Carriers That Ceased to Exist

Aeris              Color Air                     Hellas Jet

Agent              Direct Fly                    Hop
Air Bosnia         Dream Air                     Jet Magic
Air Andalucia      Duo                           Jetgreen
Air Polonia        Europe DutchBird              JetsSky
Air Scotland       EastJet                       JetX
Air Catalunya      EU Jet                        MyAir
Europe Air Exel    Europe Exel Aviation Group    Low Fare Jet
Air Freedom        Fairline Austria              Maersk Air
Europe Air         Flyglobespan                  Now
Air Littoral       Fly Eco                       Silesian Air
Air Luxor          Fly West                      Skynet Airlines
Air Madrid         Flying Finn                   Sterling Airlines
Air Polonia        Free Airways                  Spirit of Balkan
Air Wales          Fresh Aer                     Swedline Express
Airlib Express     Germania Express              V Bird
BasigAir           GetJet Poland                 VolareWeb
BerlinJet          GetJet                        Virgin Express
Bexx Air           Go Fly                        White Eagle
BuzzAway           Goodjet                       Windjet

Note: Most of these airlines operated for a period and then went into
bankruptcy. Some, such as Go Fly  and BuzzAway, merged with successful
low-cost airlines. In a few cases, the airline was registered,
but never offered actual services.

Table 2/Route Changes at Stansted Airport, London

Year    New Routes       Dropped Routes      Net Change in Routes

1996         6                 -2                      4
1997         5                 -8                     -3
1998        16                 -3                     13
1999        21                 -3                     18
2000        23                 -8                     15
2001        18                -13                      5
2002        18                -13                      5
2003        27                -11                     16
2004        19                -13                      6
2005        18                 -7                     11

Source: UK Civil Aviation Authority (2005)
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