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Low Cost Airline

Low Cost Airline

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Published by: skowtha on Oct 24, 2010
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10/01/2013

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LOW COST AIRLINES: A FAILED BUSINESS MODEL?
Kenneth ButtonUniversity ProfessorDirector of the Center for Transportation, Policy, Operations, and Logistics, and Director of theAerospace Policy Research CenterSchool of Public PolicyGeorge Mason University (MS 3C6)Fairfax, VA 22030, USA.E-mail:kbutton@gmu.edu 
“You fucking academic eggheads! You don't know shit. Y 
 
ou can't deregulate thisindustry. You're going to wreck it. You don't know a goddamn thing!”
Robert L. Crandall,CEO American Airlines, addressing a Senate lawyer in 1977
“If the Wright brothers were alive today Wilbur would have to fire Orville to reducecosts”
Herb Kelleher,Former President of Southwest Airlines, 1994INTRODUCTIONThe low cost airline model (often called the “no frills” model in Europe – we tend to stick withthe American vernacular) has been the subject of intense interest and study. The “Southwesteffect”, basically the drop in fares that occurs when a low-fare airline begins serving an airportthat had previously had no low-fare carriers, has become part of the vocabulary of airtransportation. This paper looks at just how successful the low cost model is taken in it broadestcontext. In particular, while there have clearly been airlines pursuing the low cost approach thathave largely endured and prospered, the question is whether that is because of the underlyingbusiness model, or a function of good management exercised, perhaps combined with an elementof Napoleonic luck on the part of the individuals running these companies.The importance of low cost carriers as major suppliers of air services in short-haul markets isexemplified in by Ryanair being the larger movers of air travelers within Europe, and Southwesthaving the same position in the United States. Low-cost airlines are also becoming significantfactors in airport planning. Their requirements differ from those of 'legacy' carriers. They havethus been driving the development of secondary airports and cheaper, specialized terminals atlarge established airports (De Neuville, 2008; Barrett, 2004a).To preempt our conclusions, the low cost airline model has served many carriers very well , andhas had a profound impact on the airline industry throughout the world, but it has been far from aubiquitous success. It is also a model that has many dimensions, and has tended to morph over the
 
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years
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. There are, in addition, reasons to suspect that the model as we have seen it in the past, willneed to change to succeed in a dynamic market and, in the short term, to function well in thedepressed macro-economic environments of 2009.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 howthey have faired in the Spencerian (Spencer, 1874 to 1896) world of Lamarckian evolution inwhich they operate.THE CONCEPT OF SUCCESSTo assess the achievement of any business model one needs criterion to set it against; essentiallysome form of matrix and a benchmark. Success in business can be assessed on severaldimensions. In terms of the business community it may relate to profits, the standard neo-classicalrent seeking criteria, but business success may also be seen in relation to market share or in termsof sales revenues (Baumol, 1962). Internally, the management of a firm may also see success isthe context of performing well in a number of defined areas (Williamson, 1975), or it may morebroadly ‘satisfice’ (Simon, 1959) and think in terms meeting a much wider range of objectives –sales, profits, market share, labor force retention, share price, etc. From the perspective of anti-trust 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
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. From atechnology perspective, success is normally associated with new or innovative processes thatovercome some barrier to production and thus reduces costs significantly, allowing economicdevelopment (Rostow, 1960).From a social perspective, the issue is one of social welfare maximization that is often articulatedin the transport context as meeting some standard of mobility or accessibility whichever is thepolitical fashion of the day. The recent interest in the environment often sees industrial success assomething consistent with sustainable development. Finally, I suppose in macro economicclimate of 2008, success in business would be the creation or retention of jobs.These criteria are overlaid with temporal considerations. Success, when achieved, may be long-term or transitory. The Pony Express had some successes in the mid-19
th
century in the UnitedStates, and may indeed be considered the forerunner of modern express delivery, but it onlylasted for 19 months. One would, I think, question if it really can be considered a successfulbusiness model as we would normally think of the term. IThe business rather found a temporalniche market for a very specialized service. Other business models, such as those associated withthe mass production models initiated by Fiat and subsequently developed by Henry Ford haveproved to be more enduring.Here we treat the low cost airline model as an attempt to circumvent a particular market problem;namely the historically low operating margins in the scheduled airline market. This problem, andits root cause is discussed below, but in summary since the gradual liberalization of scheduledairlines around the world there has been a singular difficulty in carriers maintaining operatingmargins above zero, and certainly at a level found in most other sectors of the economy. A variety
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Southwest Airlines, for example, now carriers a significant number of interlining passengers and has anumber of clearly definable hubs in its network.
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Market power per se is not normally an issue, but rather it is whether firms abuse it.
 
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of business models have been explored that have tried to resolve this problem, most notably thatassociated with hub-and-spoke operations, as well as a number of innovative practices, such asfrequent flier programs, business lounges, computer reservations systems, and so on, and the lowcost 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 consumerwelfare. There seems little doubt that low cost airlines have, in many markets, resulted in lowerfares for travelers and a greater diversity of service types to choose from. The notion of successadopted here is rather more long term, and reflect long-term social welfare maximization ratherthan shorter-term gratifications. What is not done here is to try to quantify benefits or place anydiscount rate on when they are enjoyed. Essentially. Success is seen as the development of asustainable, X- and allocatively efficient industry that is financially viable.Successes for one for two businesses pursuing a particular approach to their business dose notaxiomatically mean they have a successful business model. They may have other factors that alsoadd to their success such as the quality of their management, or they may just have found anarrow market niche into which they fit. A successful business model, in our context, has to beone that is widely and successfully adopted, and remains in use for an extended period of time.THE BASIS OF AIRLINE COMPETITIONUntil the late 1970s airline markets throughout the world were virtually all highly regulated, oftenpublically owned, and frequently enjoyed both direct and indirect subsidies. The changes fromthe late 1970s suddenly thrust airline management from a world with pretty well definedparameters into one where there was not only considerable commercial risk (the “knowunknown” to quote Donald Rumsfeld), but also considerably certainty. Risk is something thatmanagement schools teach their students to handle through various forms of hedging andinsurance, although sometimes they do not seem to listen to their professors, but uncertainty ismore challenging. The natural business inclination is to minimize it, and this is essentially whatthe legacy airlines have sought to do. They have tried to minimize competition by developingfortress hubs, and to tie customers in with frequent flier programs. But this is only one of twobroad strategies business may adopt.Michael Porter (1995) in his classic book on management,
Competitive Advantage
, argues that tobe successful in a market, a supplier must pursue one of two alternative broad business options.First, it may try to differentiate its product and seek to gain a degree of monopoly power. In theairlines context this involved the traditional airlines that had grown under regulatory protectionand, in many countries, were still state owned trying to exploit economies of scope and scale, aswell as market presence, by developing extensive hub-and-spoke networks around one or twomajor airports that acted as consolidation and dispersal points for traffic akin to a post officesorting depot. They added to they strength by seeking to control information flows throughcomputer reservation systems (CRSs); the first of which, Sabre, was developed by AmericanAirlines in the United States. This allowed the airline owners of systems, through travel agents, tofavor their own flights when flight options were displayed to potential customers; an effectreinforced through the halo effects associated with bonuses offered to agents who achieved highbookings for the CRS owner airline. The CRS systems, and the flow of information that itprovided the airline, also allowed airlines to adjust the fares being offered customers to reflecttheir willingness- to-pay and thus price discriminate between those who are more or less faresensitive. Added to this the traditional carriers formed alliances both with other major airlines but

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