Government Legislation And Market Structure Of Airline Industry Economics Essay

Over the past two decades the airline industry has experienced major changes that has affected the overall structure and segmentation of the market. The Low-Cost Carrier (LCC) market has stolen ground on the established market, at a substantial rate. This essay will focus on the Low-Cost Carrier (LCC) market and in particular will look at the easyJet firm based in Luton, England. The essay will asses the position that easyJet has acquired in the European airline market and the microeconomic factors that affect the firm. In addition, the essay will provide an analysis of how past, current and future prospects of the economy and how macroeconomic factors influence easyJet’s growth. Finally, based on analysis of the key discussions raised throughout the essay, a set of recommendations will be made outlining possible strategies that the firm could consider in order to prosper further.

History of easyJet

Greek entrepreneur Stelious Haji-Ioannou founded easyJet in 1995. The company was created to take advantage of the deregulation of the European Airline industry and to offer customers a low cost alternative. The company along with Ryanair pioneered the ‘no-frills’ airline. The reduction of costs lies at the core of the low-cost business model, which aims to offer lower fares, eliminating some comfort and services that were traditionally guaranteed (Malighetti, Paleari & Redondi. 2009). EasyJet was floated on the stock market in 2000. It has grown since then into a leading European Low-Cost Carrier. The company provides airline services on short-haul and medium-haul point-to-point routes, operating primarily in Europe on over 400 routes.

SECTION 1, MICROECONOMICS:

Government Legislation & Market Structure:

In the past the European airline industry was characterized by an oligopoly market structure, a form of imperfect competition in which a limited number of firms dominated the industry (Rubin & Joy, 2005). However although airlines may use oligopoly market power to restrict competition, new innovative firms can carve out a niche, which is the strategy of easyJet (Rubin & Joy, 2005)

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In order to stimulate competition, during the 1980’s the European Commission implemented the ‘open skies’ legislation. This aimed to liberalise air travel within the European Community and challenge the cartel of flag-carrying national airlines such as British Airways, Air France and Lufthansa which controlled 40% of the available passenger-kilometers on scheduled intra-European flights through bilateral agreements, regulated by the International Air Transport Association (IATA) (Ghoshal, Lefefebure, Jorgensen & Staniforth, 1988)

As easyJet’s annual report in 2001 eludes to the market environment ‘for too long, many of Europe’s airlines have considered themselves immune from the realities of their operating environment. State aid, entrenchment at Europe’s busiest airports and favourable restrictive bilateral agreements have been used to prevent proper competition from sweeping continental Europe.

According to Rubin et al., (2005) although high entry costs of aircraft acquisition and other capital requirements make entry difficult, the industry appears more contestable (e.g. imperfectly competitive but subject to potential entry if warranted by prices or profits). This paved the way for the LCC’s to enter the market, armed with completely different business models which have erode the dominant carriers market share even at large hub airports. Figure 1 shows how the UK in particular where easyJet are based have taken to the LCC idea.

Figure 1 Low Cost Carriers operating to/from major European countries by frequency in November 2005

Source: OAG MAX Online. February 2006

Competitive analysis:

The airline industry is characterised by high levels of competition, therefore the profit margins can be result in low returns. Because profit margins are very small, during a recession or a lull in demand airlines can become bankrupt within a short space of time. In order for easyJet to sustain there profit growth they rely on very quick turnarounds in order to maximize there profit.

In addition the expansion of the Internet has made the pricing of fairs more transparent to the customer and has eradicated the travel agents fee, which has brought huge cost savings for airlines. These costs have been passes onto to the passengers, which has triggered a boom in flight capacity. However, the internet has also resulted in more price comparison websites for the price sensitive customer to compare ticket prices from different airlines. Customers now do not have much loyalty towards specific airlines, as they are more concerned with finding the cheapest price for their journey. However easyJet have now become one of the leading LCC airlines in the UK as illustrated by market share in Figure 2. Figure 2 Shows the dominance of both easyJet and Ryanair that have a large market share in the UK.

Figure 2 Low Cost Carriers to/from the UK

Source: OAG MAX Online. March 2006

Major determinants of demand:

The demand for air travel is sensitive to changes in easyJet’s own prices, the price of related goods, incomes and individual taste preferences. However the degree of sensitivity is dependent on varying market conditions.

EasyJet’s own price

The low cost carriers have profoundly changed the airline industry, by increasing the demand for air travel. Alertness to ‘latent demand,’ characterized by the passenger’s willingness to pay elastic prices, which is not the attitude of the so-called ‘traditional’ passengers, is among the key factors of easyJet’s success (Pels and Rietveld, 2004).

Because of the their alternative business plan, easyJet are able to offer a reduced price to customers. The price choices and the ability of the airlines to understand the characteristics of the demand are decisive in the balance of the business model itself (Malighetti, Paleari, and Redondi, 2009)

The Internet has also increased the transparency of costs and allowed customers to compare prices instantly. There is now no loyalty, because customers will most often than not choose the cheapest ticket. No-frills airlines tend to use simplified pricing structures based on demand regulated single fares or flexible return tickets without the high- cost premium fares required by mainstream airlines for fully flexible travel (Baum, 1997). Lower fares have meant that those more frequent shorter holidays are not necessarily a more expensive option and the trend towards more flexible booking arrangements has encouraged this development (Graham, 2006).

Price of related goods:

The price of substitute goods and the consumer’s purpose of travel consistently affect the demand for easyJet’s services. There are numerous forms of substitutes that could cater for the customer’s needs such as travelling by car domestically or by train internationally. The structure of demand, which guides the optimisation choices of the carrier, is influenced by the presence of competitors, and the passengers’ opportunities to opt for a substitute service (Malighetti, Paleari, and Redondi, 2009) Therefore if Eurostar decreased their prices to travel from London to Paris then this would affect the demand for and the price customers are willing to pay to travel with easyJet.

In addition airline passengers usually travel for different purposes, either leisure, business or to visits friends and family. Typically, business travelers have lower demand elasticity, and higher willingness to pay than leisure travelers. (Alves, and Barbot, 2009)

Income

The demand for travel is also affected by the average household income. If the household income increases so does the purchase of luxury goods such as travelling abroad. On this basis a elasticity multiplier of 1.1 is used to adjust air travel price elasticity’s for short-haul flights (Deaton, 1975).

Tastes

SECTION 2: MACROECONOMICS

This section of the essay will asses how past current and future prospects of the economy has affected easyJet.

Monetary and Fiscal policy:

Monetary policies in the shape of interest rates affect the demand on the airline industry. Higher interest rates raise the retail price index by raising the cost of living. This has made borrowing from banks more expensive and coupled with the current economic climate has had a negative impact on consumer expenditure.

Therefore people have less disposable income to spend on travelling aboard.

Figure 3 Relationship between Interest rates & easyJet’s annual total profit

Source: Bank of England

As Figure 3 illustrates, between 2005 and 2007 there was a sharp increase in easyJet profits. However, because of the recent economic recession the Bank of England have responded to the current climate by reducing their interest rates from 5.5% to 2.0% to try and stimulate the economy.

EasyJet are affected by fiscal policies through the implementation of tax duties on air carriers. The government allocate these fees to fund for increased security needed since the September 11th terrorist attack and support operations at airpark facilitates. As the graph illustrates during the 2007-2008 period there was a sharp decline in profits due to the unexpected doubling of Air Passenger Duty (APD) in the UK (easyJet Plc Annual report, 2007). Although the government use fiscal policies to try and stabilise the airline industry, they ultimately decrease the already tight profit margin that easyJet operates under.

In addition the future of the airline industry seems likely that there will be more taxes levied at easyJet and the airline industry as a whole. As easyJet’s annual (2008) reports states ‘the European Union has now finalised the terms of aviation’s entry into the Emissions Trading Scheme (ETS). This will require us, from 2012, to hold carbon emission allowances to cover our CO2 emissions. ETS is a cap and trade scheme, covering many sectors, and is designed to ensure

that carbon emissions in the EU are reduced as efficiently as possible’.

Crude oil

The airline industry uses kerosene, which is now ranked as the third highest petroleum because it is widely available and can withstand a wide range of temperature fluctuation. Therefore, the price of kerosene has an obvious and direct impact on the cost of easyJet’s and the airline industry as a whole, because it is one of the major costs occurred in the business.

Figure 4 The relationship between Crude Oil and easyJet’s net profit

Source: U.S. Energy Information Administration, Independent Statistics & Analysis

Figure 4 illustrates the relationship between crude oil prices and easyJet’s total revenue. As you can see from the graph there is a direct correlation between the two values. Crude oil has been rising astronomically since 2000. EasyJet’s annual report highlighted the affect that oil is having on their profits ‘the price of oil, which constituted some 14% of our costs for the year ended 30 September 2004 (easyJet Plc Annual Report, 2004). In 2008 the price of oil was still high on the agenda of easyJet’s annual report, which stated ‘The price of fuel rose to unprecedented levels and less well positioned competitors struggled to survive resulting in capacity exiting the market’. In addition it is alarming to realise that the price of jet fuel has risen by more than 50% in the last year. This is directly affecting easyJet’s baseline profits as Table 1 demonstrates. (IATA Website, 2010)

Table 1 This week’s price of aviation jet fuel

Percentage change vs.

1-Jan-10

Index*

$/b

cts/gal

$/mt

1 week ago

1 month ago

1 year ago

Jet Fuel Price

241.7

88.4

210.5

696.7

3.7%

1.6%

50.3%

Sourced from Platts            * 100 in 2000 (87 cts/gal)

Increases in fuel prices have an obvious affect on the operation, but they also trigger economic recessions, which in turn result in a substantial decline in demand for air travel and air cargo. However, like many other industries that rely on crude oil high prices forces them to cut down their use or look for alternative resources. In order to tackle this problem easyJet have bought fleets of new airliners. ‘To offset this, we are concentrating both on operating the most fuel-efficient aircraft and reducing costs elsewhere’ (easyJet Plc Annual Report, 2004). The new aircrafts are more fuel-efficient enabling them to reduce the expenditure on fuel. In addition, when fuel prices are raised it also affects the consumer’s decision on whether to fly at all or look for substitute modes of transport.

GDP Growth:

GDP growth has historically been a key determinant of the leisure travel demand and it continues to play an important role in many forecasting models (Graham, A. 2006). EasyJet and the airline industry are affected by the overall condition of the national and international economy. When there is a healthy economy the nation’s expenditure on travel increases. However, when there is an unhealthy economy the buying habits of the consumer falls because travelers will have fewer resources available to travel for pleasure.

Figure 5 The relationship between GDP and easyJet net profit

Source: Office for National Statistics

As the graph illustrates 2002 and 2003 there was a sharp decrease in easyJet’s profit. A statement from the annual report attributes these facts to the ‘War in Iraq, economic uncertainty and the SARS epidemic all adversely affected sentiment about travel, both business and personal’ (easyJet Plc Annual Report, 2003).

However, A fundamental weakness in comparing travel growth to economic growth is that ignores the important influence that travel cost or price can play. The travel cost will determine the amount of income that needs to be spent on travel (Graham, A. 2006).

Recent reports have suggested that the UK and the rest of Europe are slowly emerging from the recent recession. This should help to contribute to easyJet reaching its projected growth forecasts.

Conclusion:

Based on the previous analysis of discussion that was raised I will now sate recommendations and describe possible strategies easyJet could consider to increase their net profit.

The current economic conditions have had an adverse affect on the airline industry as a whole. The near future may see more mergers of airlines in order to survive or heavy consolidation of their routes. The future of easyJet is heavily reliant on outside influences. However, because the easyJet company is based on a low-cost business plan coupled with the fact that population is rising, one could argue that they are in a better position to weather the storm and increase market share. In order to take advantage of the current situation easyJet need to face a number of problems.

There is no question that the price of fuel is playing a significant role in the underlining profit of the easyJet company. Both in terms of the reduced profit margin and the overall affect the price of oil can have on the overall economy, history has shown us that it can contribute to the manifestation of recessions. However because the price of oil is set externally it is out of easyJets control, therefore there is need to explore alternative avenues of curtailing the effect that oil prices has on the easyJet company.

One solution to reducing the affect that oil prices has on easyJet is by investing in more fuel efficient aircraft that reduce the amount of miles per gallon. As technology is moving forward at a unprecedented pace new airliners are becoming more aerodynamic, using lighter materials and pilots are utilising more cruise control technologies so that the consumption of fuel is used more efficiently. In addition, investing in more fuel efficient aircrafts will reduce the amount of money that will need to be paid in 2012 when the new Emissions Trading Scheme is enrolled, which is designed to ensure carbon emissions are reduced as efficiently as possible.

Another alternative method to curbing the affect oil prices is to invest in research and development of alternative fuels. Although this may initially require large investments, but if alternatives are found easyJet will be ideally placed to be one of the first airlines to take advantage of new technologies and pass the savings onto their customers.

In recent years easyJet has expanded it’s operations around Europe especially in Italy, France and Spain with nearly half of easyJet’s passengers now originating from outside the UK (easyJet Plc Annual Report, 2008). However, these expansions may have caused their operations to slip in their overall efficiency. Because of the nature of easyJet’s business plan, the company relies on very quick turnarounds at airports and highly efficient operations in order to maximise their profit margin. Therefore it would be beneficial for easyJet if they were to focus on economies of scale by making their operations more lean in order to increase profit margins.

Because customers are becoming price sensitive to airline prices, another strategy that could prove beneficial is to target the business class who will have less of a price elasticity compared to leisure travellers who do not necessarily have to use easyJet’s services. In order to appeal to the business class easyJet will need to offer more flexible and more frequent services to the major business capitals in Europe.