LOW COST AIRLINES: A FAILED BUSINESS MODEL?

Kenneth Button
University Professor
Director of the Center for Transportation, Policy, Operations, and Logistics, and Director of the
Aerospace Policy Research Center
School of Public Policy
George Mason University (MS 3C6)
Fairfax, VA 22030, USA.
E-mail: kbutton@gmu.edu

“You fucking academic eggheads! You don't know shit. You can't deregulate this
industry. 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 reduce
costs”
Herb Kelleher,
Former President of Southwest Airlines, 1994

INTRODUCTION

The low cost airline model (often called the “no frills” model in Europe – we tend to stick with
the American vernacular) 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 paper looks at just how successful the low cost model is taken in it broadest
context. In particular, while there have clearly been airlines pursuing the low cost approach that
have largely endured and prospered, the question is whether that is because of the underlying
business model, or a function of good management exercised, perhaps combined with an element
of 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 is
exemplified in by Ryanair being the larger movers of air travelers within Europe, and Southwest
having the same position in the United States. Low-cost airlines are also becoming significant
factors in airport planning. Their requirements differ from those of 'legacy' carriers. They have
thus been driving the development of secondary airports and cheaper, specialized terminals at
large established airports (De Neuville, 2008; Barrett, 2004a).

To preempt our conclusions, the low cost airline model has served many carriers very well , and
has had a profound impact on the airline industry throughout the world, but it has been far from a
ubiquitous success. It is also a model that has many dimensions, and has tended to morph over the

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years1. There are, in addition, reasons to suspect that the model as we have seen it in the past, will
need to change to succeed in a dynamic market and, in the short term, to function well in the
depressed 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 how
they have faired in the Spencerian (Spencer, 1874 to 1896) world of Lamarckian evolution in
which they operate.

THE CONCEPT OF SUCCESS

To assess the achievement of any business model one needs criterion to set it against; essentially
some form of matrix 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 neo-classical
rent seeking criteria, but business success may also be seen in relation to market share or in terms
of sales revenues (Baumol, 1962). Internally, the management of a firm may also see success is
the context of performing well in a number of defined areas (Williamson, 1975), or it may more
broadly ‘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-inefficiency2. From a
technology perspective, success is normally associated with new or innovative processes that
overcome some barrier to production and thus reduces costs significantly, allowing economic
development (Rostow, 1960).

From a social perspective, the issue is one of social welfare maximization that is often articulated
in the transport context as meeting some standard of mobility or accessibility whichever is the
political fashion of the day. The recent interest in the environment often sees industrial success as
something consistent with sustainable development. Finally, I suppose in macro economic
climate 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-19th century in the United
States, and may indeed be considered the forerunner of modern express delivery, but it only
lasted for 19 months. One would, I think, question if it really can be considered a successful
business model as we would normally think of the term. IThe business rather found a temporal
niche market for a very specialized service. Other business models, such as those associated with
the mass production models initiated by Fiat and subsequently developed by Henry Ford have
proved 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, and
its root cause is discussed below, but in summary since the 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. A variety
                                                        
1
Southwest Airlines, for example, now carriers a significant number of interlining passengers and has a
number of clearly definable hubs in its network.
2
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 that
associated with hub-and-spoke operations, as well as a number of innovative practices, such as
frequent flier programs, business lounges, computer reservations systems, and so on, and 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 for travelers and a greater diversity of service types to choose from. The notion of success
adopted here is rather more long term, and reflect long-term social welfare maximization rather
than shorter-term gratifications. What is not done here is to try to quantify benefits or place any
discount rate on when they are enjoyed. Essentially. Success is seen as the development of a
sustainable, X- and allocatively efficient industry that is financially viable.

Successes for one for two businesses pursuing a particular approach to their business dose not
axiomatically mean they have a successful business model. They may have other factors that also
add to their success such as the quality of their management, or they may just have found a
narrow market niche into which they fit. A successful business model, in our context, has to be
one that is widely and successfully adopted, and remains in use for an extended period of time.

THE BASIS OF AIRLINE COMPETITION

Until the late 1970s airline markets throughout the world were virtually all highly regulated, often
publically owned, and frequently enjoyed both direct and indirect subsidies. The changes from
the late 1970s suddenly thrust airline management from a world with pretty well defined
parameters into one where there was not only considerable commercial risk (the “know
unknown” to quote Donald Rumsfeld), but also considerably certainty. Risk is something that
management schools teach their students to handle through various forms of hedging and
insurance, although sometimes they do not seem to listen to their professors, but uncertainty is
more challenging. The natural business inclination is to minimize it, and this is essentially what
the legacy airlines have sought to do. They have tried to minimize competition by developing
fortress hubs, and to tie customers in with frequent flier programs. But this is only one of two
broad strategies business may adopt.

Michael Porter (1995) 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 and seek to gain a degree of monopoly power. In the
airlines context this involved the traditional airlines that had grown under regulatory protection
and, in many countries, were still state owned trying 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 that acted as consolidation and dispersal points for traffic akin to a post office
sorting depot. They added to they strength by seeking to control information flows through
computer reservation systems (CRSs); the first of which, Sabre, was developed by American
Airlines in the United States. This allowed the airline owners of systems, through travel agents, to
favor their own flights when flight options were displayed to potential customers; an effect
reinforced through the halo effects associated with bonuses offered to agents who achieved high
bookings for the CRS owner airline. The CRS systems, and the flow of information that it
provided the airline, also allowed airlines to adjust the fares being offered customers to reflect
their willingness- to-pay and thus price discriminate between those who are more or less fare
sensitive. Added to this the traditional carriers formed alliances both with other major airlines but

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also with feeder carriers. This created seamless services for customers and more integrated
schedules of service that minimized the time required to interline at a hub airport.

The alternative highlighted by Porter was for a business to compete on the basis of cost; to
develop and maintain a market share by offering its products at lower prices than its competitors
(“low-cost leadership”). This has been the approach of the low cost carriers; sometimes called
‘no-frill’ carriers in Europe because they offer only basic services to their customers. 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 for example focus on secondary airports in cities
whereas other serve the major hubs, some offer no on-line services whereas other do, some have
frequent flier programs whereas some do not, etc. 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 United States 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”.

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 in that
sense one could say the business model has worked. This however is somewhat deceptive. This is
also not just because long-haul low cost carriers have never really gained a market niche, the first
airline attempting no-frills transatlantic service being Laker Airways with its famous ‘Skytrain’
service between London and New York City in the late 1970s, but because numerous large
carriers still survive in the market, despite many years of ‘deregulation’, that do not follow the
low cost path in its traditional sense.

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 sever cyclical fluctuations in demand, and overall
has operating margins well below industry as a whole (Figure 1), and even within the larger air
transport chain performs poorly compared to airports, global distribution systems, airframe and
aero engine manufactures, etc. (Button, 2004).

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 is a number of services industries (including
professional sports and the theatre)3. These are not the fixed costs of bricks and mortar of the type
Alfred Marshall (1890) wrote about a century ago, but rather commitment to offer a scheduled
service. The fact that an airline has to have an aircraft (whether it owns it or leases it is
immaterial) sitting at a gate at particular time, with a full crew, fuel, and other supplies on board,
with ground staff committed to booking, ticketing, boarding and baggage handling for the flight,
with slots to pay for at both ends of a flight, and with various services at the destination to
provide is de facto a fixed cost. It matters little whether the flight has a zero load factor or a 100%
load factor; these costs have to be borne. To complicate matters, the commitment to the service is
made months in advance and thus costs cannot be completely known. This, however, is largely a
                                                        
3
These costs may also be seen as ‘sunk’ costs in the tradition of the analysis of contestable markets
developed by Baumol et al (1982). They are costs that cannot be recovered if no-one uses the flight and the
resources are not easily transferrable.

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matter of commercial risks and can often be insured against in a variety of ways, of which fuel
hedging has attracted the most attention recently with the rapid rise in oil prices through 2007/8
and there even more rapid fall thereafter.

Europe US Global

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Notes: (I) A lack of a bar indicates a missing observation and not a zero operating margin, (ii) Memberships
of the various reporting bodies vary over time and thus the reported margins reflect the associated carriers
at the time of reporting.
Sources: Boeing Commercial Airplane, Association of European Airlines, and Air Transport Association of
America, International Air Transport Association.

Figure 1
Airline operating margins; global, European, and United States

While the cost side of air transport is not simple, it does in many 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)4, and one reason that Coase was awarded
his Nobel Prize was for his work on cost recovery in this area5.
                                                        
4
The 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 is true but it relates to short-run costs and some thought was needed
regarding the long-run costs in a competitive environment.
5
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.

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Perhaps more by instinct than logic, the problem of the empty core has, in the air transport case,
either been directly handled by interventions by government, most notably though direct
subsidies with the tax payer covering the fixed costs or by cross-subsidies through the granting of
institutional monopoly powers through the granting of such things as licenses or concessions that
allow airlines to charge above marginal costs. These measures have largely been abandoned
because of both political capture and the degree of X-inefficiency that manifestly resulted. One
practice that has remained in the United States, although not in Europe, is simply to allow airlines
to right-off losses through Chapter 11 bankruptcy, despite the moral hazard issues that this
entails.

Any supplier’s natural instinct in a perfectly competitive market is to try and carve out some form
of monopoly power; to put some slope on the demand curve that is confronting it. Basically this
means following the first approach posited by Porter, and traditional airlines have sought to
distinguish their products in a wide variety of ways. In some cases, traditional airlines engaged in
the international market have focused increasingly on such services that have remained protected
under restrictive air service agreements, although the scope for this has shrunk as “Open Skies”
policies have spread. Frequently flier programs have offered ‘bonuses’ to loyal customers, there
has been market segmentation between various types of traveler, both in terms of motivation
(business, leisure, visiting friends and relatives) and distance (short and long haul), their has been
efforts to control terminal facilities (the “fortress hubs”), and there have been measures to offer
seamless services (strategic alliances)6. These measures have generally only been of temporary
use in stemming off competition. 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 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, as we saw in Figure 1, when the business
cycle has favored the airlines. The second approach described by Porter, lowing costs of
production below competitors. Basically this entails a focus on just one element in the
competitive matrix, namely fares. Of course, this does not excluded 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, as well as generate new traffic to cover their short run costs
with the hope of forcing traditional carriers from the market in the longer term and thus enjoy
some degree of monopoly power. There is some overlap in this approach with Bain’s (1949) limit
pricing theory of business behavior in that the low cost carriers would not push fares back to their
previous level to ensure that legacy carriers remain uncompetitive on the routes involved.

The industry has also been kept afloat, and enjoy a flow of investment that would not seem
justified by the returns earned, by forces not always embodied in neo-classical economic models;
much of the theory suggests it should have gone by now. One explanation for the flow of
investment has been a possible money illusion; airlines because fares are collected well in
advance of the delivery of services may be seen to be cash rich with the potential of using that
money to earn a return elsewhere. There also seems to be a Los 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 United States stock market
                                                        
6
In perhaps slightly less technical terms, Michael O'Leary, Ryanair's chief executive, 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?"

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throughout the 1990s. The actors further up the value chain – airports, airframe manufacturers
and so on – simply cannot allow the airline industry to die because of the money they make by
selling their goods and services to them. Finally, aero-planes present a largely irrational
fascination for many people, a sort of modern equivalent to the “foamers” in the United States
and the “grisers” in the United Kingdom who spend their time spotting trains, and this stimulates
them to invest; it is a ‘sexy’ industry for them.7.

The general outcome of all of this is, perhaps best summed up by the American financier Warren
Buffet Warren Buffett in his 2008, annual letter to Berkshire Hathaway shareholders, “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.”

THE LOW COST AIRLINE MODEL

Although there is no single description of a low cost or no-frills carrier, and they vary in form
(Mercer Management Consulting, 2002), there seems to be some general agreement about their
basic characteristics. In very general terms, low cost carriers offer low fares by using a range of
broad strategies, and not all are used by every low cost airline. These strategies both remove some
elements of cost from their production functions, and reduce the levels of many of the remaining
costs8. In doing this, they offer a more limited rather of services and, in some cases, charge
separately for the attributes they do offer.

In sum, low cost airlines have the following broad set of features.

• First, they do not provide the range of services that legacy carriers normally offer, or at least
not in the base fare. There is an effective unbundling of services; food and drinks often have
to be bought on board, the free baggage allowance in small, no sky-bridges are offered to the
plane, the airports served are second tier, there are no-reclining seats, and so on.
• Second, they maximize the use of their factors of production. Aircraft turn around times are
kept short because there is no-belly-hold cargo to unload/unload, there are no window shades
to open, there are no seat-back pockets to be emptied, less congested airports are favored,
planes are only cleaned once a day, there are no on-line passengers to worry about, etc. In
terms of crew, these are often based at ‘home’ to service radial routes that that makes their
scheduling easier, and they also often perform a number of functions in the provision of the
service.
• Third, they keep overheads down by using common fleets of aircraft that are cheaper to
maintain and crew.
• Fourthly, they seek to maximize complementary revenues from sales of refreshments and for
baggage,

                                                        
7
Warren Buffet considers himself a “reformed aeroholic” after losing $300 million or so in a US Air
investment in the mid 1990s. Although it may seem unbelievable, many civil servants have pictures and
models of planes in their offices, rather than of the passengers and cargo that they have a responsibility to
move efficiently. It is a basically a non-pecuniary form of reward from policy capture.
8
Barrett (2004b) is a good explanation of how Ryanair works.

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• Fifth, low cost carriers drive hard bargains with their supplies including aircraft
manufacturers, because they tend to use common fleets, and airports, because they can offer
significant business for otherwise under-utilized car parking and concessions.
• Sixth, they only offer a single class of service that simplifies booking and passenger handling
• Finally, bookings are often exclusively carried out electronically.

Simple comparisons show that the operational advantage of carriers such as Ryanair often lies in
the radial short haul networks they operate with non-online services to second tier airports
centered around a base airport that allows for the maximum utilization of a standardized aircraft
fleet and of crew without the congestion and the repositioning costs associated with mixed
distance, on-line services through a hub using a varied fleet. Other low cost carriers have variants
on this, easyJet, for instance serves many of the larger airports and Air Berlin has a frequent flyer
program, but all low cost carriers are aggressive in keeping costs to a minimum by charging for
on-board services, having quick turn around times for their aircraft, cutting out sales
commissions, and striking hard bargains with airports and other suppliers of inputs.

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 can be obtained from a low
cost airline (e.g. meals, extra baggage, more comprehensive insurance9, etc.), but this entails an
additional price. The overall philosophy and features of low costs carriers, whether admitted or
not by all, was well summed up by Michael O'Leary, Ryanair's chief executive, in BusinessWeek
in 2002, when he said, “Air transport is just a glorified bus operation.”

THE IMPACT OF LOW COST CARRIERS ON THE OVERALL AIRLINE MARKET

There are numerous studies that have examined the effects of low cost airlines on the fares and
the markets that they have penetrated and they almost unanimously show that the effects are low
fares than those offered by incumbent airlines. These fares, however, lead to significant traffic
generation to the extent that the actual traffic volume of incumbents is little affected; the impact is
on their bottom line resulting from lower revenues as they must reduce fares to stay competitive.
While much of the analysis has been on the domestic United States market, where a 10% ticket
sample offers good fare data, the effect seem to be fairly general. In most markets, for example,
where they 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)10.

In more detail, as an example, Dresner et al. (1996) hypothesized that the effect of Southwest
(and other low-fare carriers) may be greater than previously estimated 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 of service on adjacent competitive routes
but did not aggregate their results. Morrison (2001), taking a more macro perspective, looking at
the actual, adjacent and potential competition Southwest brought to United States routes in 1998,

                                                        
9
Michael O’Leary, CEO of Ryanair, for example, defines the carriers 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 fuck off.”
10
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.

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finds that its own 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 is less than that for the majority of Ryanair routes he examined, except for the start-up
routes involving Stockholm and Hamburg. This seems to be because, the Italian destinations
analyzed are more likely to be dominated by leisure traffic than with the exception of Las Vegas,
the United States cases. 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 putting more
competitive pressure on the Irish airline. Finally, Ryanair, with its frequent offerings of flights at
€0.01, where taxes and charges are excluded, may be a more aggressive competitor. Overall he
found that Southwest, when it has significant effects, has a smaller initial impact than Ryanair but
the latter establishes larger market shares as a result of its impact on competitors. It appears that
United States competitors are more competitive than most of Ryanair's in terms of pricing and
product differentiation.

The advent of low cost carriers has also impacted on other elements of the air service supply
chain, and in particular on airports. Low cost carriers offer a no-frill service, and seek to keep
their costs down by seeking low costs at airports. This has led to the development of small,
second or third tier facilities as airports, and the construction of special low cost terminals at
some major airports (De Neuville, 2008). This in turn has added a new dimension to the
competition between airports as many seek to attract low cost carriers, but in doing so engage in a
form of competition that has been alien to them in a more regulated environment (Dresner at al.,
1996). The nature and extent of this competition, and which airports will succeed, depends
ultimately not only in their competitive position regarding other airports, but also with the extent
of monopoly power they can exercise over the airlines. Francis et al.’s (2003) case study analysis
raises questions about the sustainability of relationships with airlines. The success of many low-
cost carriers has been explained 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
reflecting the risks of failure incurred by either party becomes more difficult.

THE AIRLINE WITHIN AN AIRLINE MODEL

There is one form of low cost airline, in some ways a special case, that justifies particular, if
somewhat terse treatment, that of a low cost airline embedded within a more traditional carrier.

To combat competition within their established market many legacy airlines have, at various
time, established their own low cost carrier11. Institutionally the arrangements between the
traditional elements of a company and its low cost off-shoot have differed, in part because of
local legal stipulations but also to meet the internal constraints, such as labor agreements and slot
availability, and to confront the challenges of the particular low cost carriers that were penetrating
the market. They also, in some cases, had wider objectives, such as the spinning off of profitable
business or to test out low cost elements that they could later adopted in their mainline operations.

                                                        
11
Graf (2005) offers a useful table listing the main ventures by legacy carriers into the low cost airlines
market.

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These efforts at emulating the low cost model, largely that of Southwest, have proved to be
unsuccessful. There has in many cases been confusion on the marketing side in terms of being
able 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
also did not afford them 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 prevented costs from falling low enough to
compete with the single brand, low costs airlines.

The European experience, where there has been some physical separation of the low-cost off-
shoot by, for example, making use of different airports, has been a little more successful than that
of United States 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 has also been some evidence that the low airline-within-an-airline concept has proved
useful is as stop-gap measure to combat the increases in market presence of low cost carriers
while a legacy carriers restructures its own core operations (Graf, 2005). As a generalization,
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 way of doing this but there are a number of ways in which
insights may be gleaned.

Market financial robustness

Figure 1 has illustrated 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 in Europe about
five or six years later following the enactment of the full Three packages of European airline
deregulation.12. Simple examination of the Table 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
and certainly would not suggest that the overall industry is any more capable of handling
significant macro-economic shocks that it has been in the past.

In sum, while Southwest now enjoys about a 25% share of passengers in the domestic and a 15%
of the revenues, however, the overall performance of the United States domestic airline market

                                                        
12
In 1997 they accounted for about 2.5% of the European air seat miles offered, but this grew to over 95%
by 2002. Prior to that, scheduled carriers, focusing primarily on business travelers, controlled 75% of the
intra-European market. Charter airlines held the remaining 25% by selling aircraft capacity to tour
operators and shuttling sun-seeking package tourists from cold Northern European countries to the beaches
of Southern Europe.

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has not deviated from the historic pattern of cyclical fluctuations around a zero operating
margin13.

Survival rates

In any competitive market one expects a number of firms to fail, and new ones to enter it. This
reflects shifts in demand that require overall capacity adjustments and the fact that management,
for one reason or another, is not homogeneous and Spencearian 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 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 from the market
between 2003 and 2005. 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 for the United States, and
most other countries. The simple situation is that with this level of attrition, the first-movers,
Ryanair and easyJet, now between them account for more than 88% of the scheduled low-cost
market in Europe. Southwest Airlines holds 50% of the United States low-cost market. There are,
in other words, successful companies, but that is not the same thing as 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.

Table 1.
European low cost carriers that ceased to exist*

Aeris BuzzAway Hellas Jet

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

                                                        
13
The recent operating margins for Southwest, for example, were 6.4% in 2003, 6.2% in 2004, 9.6% in
2006, 10.8% in 2006, and 8.0% in 2007.

  11
 

* 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.

At the more micro level, the low cost airlines are often less than stable in terms of the services
that provide individually. While with one or two exceptions, Southwest Airlines has tended to
steadily build its network with few subsequent withdrawals, but this is not always the picture. In
Europe, for example, Table 2 illustrates the development of services at Stansted Airport,
Ryanair’s main airport, showing both new routes and dropped routes. While growth is clear, it has
not been in s strictly incremental way, indeed if anything the volatility of route entry and exit has
grown as low cost carriers services have expended.

Market power

In markets that have significant fixed costs, either of the conventional ‘brick and mortar type or
the fixed commitment type that we have argued are associated with offer scheduled airlines
services, suppliers require a degree of market power to recover their costs unless government
offers help. The success of a market with these technical features relies on this. Testing for
market power using such measures as Herfindahl Indices to assess market concentration is not
very useful in this case; 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.

Table 2.
Route changes at Stansted Airport.

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)

One way that market power in offering a specific service has been looked at recently is through
the use of ‘data scrapping’. This 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, collecting all the fares, F, for each day, t (or some other time division) from a date prior to
the flight until the actual take-off. The airlines that practice this dynamic price discrimination
essentially try to capture the rents from any flight seen under the normal demand curve (the

  12
 

shaded area on 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*, nor fall below the short run marginal cost (SRMC).14

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 also influenced by the slope of the
aggregate 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. Fare rise towards departure because
last minute bookings are largely made by individuals with limited choices and who have less
prior insights into their future travel needs (generally business travelers)15.

Figure 2.
Temporal price discrimination

Much, therefore, depends on the extent and over what time period seats 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 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
                                                        
14
The area under the fares offered curve is not identical the revenues collected with price discrimination as
seem in the right side of the figure, because there is no indication of the number of seats actually sold in
each period.
15
In multi-class 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 additional costs of offering extra
space, larger luggage allowances, more extensive refreshments, a higher attendant/ passenger ration, etc.
from the rent extracted for booking late. All studies using data scraping methods tend to focus only on the
lowest fare for a flight, in part to avoid this issue.

  13
 

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 elasticitities 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 16.

There are clear limitations to this methodology, and we just list a few. Only one class of seat
(business class, coach, etc) can be looked 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 is subjective – e.g. does the 8.30am flight from
offered by airline Z between A to B on a particular date compete with the 9.00am flight by airline
X? the 10.15am flight by airline Y? and so on. The situation becomes even more complex if the
10.15am is not provided by airline Y, but by Z; in other words flights may complete with others
offered by the same airline. Perhaps, most importantly there is little feel for the actual up-take 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.17 Figure 3, just as an
example, looks at a United States monopoly market (that between Phoenix and des Moines and
served, at the time by America West Airlines), illustrates the fairly consistent rise in fares as the
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.

Fare

1050

950

850

750

$ 650 America West 08:53-17:20

550

450

350

July Year 2005

250

                                                        
16
The fundamental definition of perfect competition is that any supplier in the market is confronted by a
perfectly elastic demand curve (Robinson, 1962)
17
Studies include, Barbot (2006), Button and (2007), Button et al (2007), Pels and Rietveld (2004),and
Pitfield (2005a. b).

  14
 

Source: Button and Vega (2006)

Figure 3.
Temporal-fares-offered curves for return services from Phoenix to Des Moines: leaving August,
1st and returning August 5th, 2005.

Of more interest in terms of whether the los 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 can be examined in detail in other works, Figure 4
simply offers another example, again from the United States, of a duopoly situation and the
volatility that arises and the lack of a significant and consistent 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.

Source: Button and Vega (2007).

Figure 4
Temporal-fares-offered curves for return services from Phoenix to Kansas City, out August, 1st
and returning August 5th, 2005

Much of the analysis using data scrapping has not been strictly concerned with the issue of the
success of the low-cost model per se, but rather with its relative performance vis-à-vis the
traditional full-service model. In this context, the data have been examined in some detail, going
beyond the simple eye-balling of graphs. Of particular relevance to assessing the success of the
low-cost business model, have been attempts to look for market leadership using such techniques
as Granger causality testing (Button et al, 2007a) and ARIMA time series models (Pitfield,

  15
 

2005a, b). 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 costs 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 costs carriers that are competing with each other rather than low
costs airlines confronting legacy carriers.

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 such
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 more importantly 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, by both stimulation the development of
basic, regional facilities and in forcing many established airports to reassess the way they operate.
Low cost carriers seldom want the “frills” that are found at traditional airports, instead rather
focusing on keeping costs to a minimum and, in may cases, forcing the airports to rely on land-
side ,and concessionary revenues rather than air side take-off and landing fees.18

The low cost airlines have been able to do this in the past at smaller airports because of
asymmetries in the bargaining situation, particularly in Europe. The situation has often been in a
bilateral monopoly context between a single low cost carriers and a small airport. In these cases
the outcome, except in very specific cases, is unclear are depends on the bargaining strength and
information held by both parties. The ability of the airline to chose to puts its resources in other
markets, whereas the airport is spatially constrained, gives it an advantage in many cases. The
traditional carriers, because of their need for large hubs, of which there are few, and an integrated
network involving strategic nodes, puts them in a less strong position.

While there are numerous examples of low cost airlines are still able to enjoy the upper hand in
negotiations with airports19, the situation is no long as clear-cut as in the past (Francis et al,
2003). The growth in the number of low cost airlines, plus the fact that in many cases the
transactions are about renewals of contracts at airports where a carrier has already sunk costs, has
reduced the power of the carriers in some cases.

CONCLUSIONS

                                                        
18
Ryanair has a reputation for being particularly aggressive in its negotiations with airports.
19
The withdraw of a €3 passenger surcharge at Frankfurt Hahn Airport in January 2009 after threats of
service transfers by Ryanair is an illustration of this.

  16
 

That the low cost airline model was successful initially for a number of airlines is obvious – the
expansion of the intra state carrier, Air Southwest out of Texas to become Southwest Airlines in
the United States, the rapid growth of Ryanair and easyJet in Europe, and emergence of carriers
such a Go and Tiger in the in emerging BRIC markets attest to this. It is also clear that low cost
airlines have been instrumental on pushing down airfares, opening new markets, and allowing
many people to travel by air who could not do so before. But success for a few firms is not the
same thing as a successful business model; its achievement more be more widespread. Also the
generation of social welfare though lowing travel costs does not establish a successful business if
the full commercial costs of the system are not borne by its users. 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 as frequent flier programs, fortress hubs and the like provided success to the
traditional airlines, but it is not a success in terms of meeting the fundamental problems of
providing scheduled services in a highly competitive market.

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