Market Structure Of The Airline Industry Economics Essay

Coursework title- Easy Air is a major airline competing with rivals in both short-haul and long-haul flights. Identify the market environment in which Easy Air operates and discuss possible pricing and business strategies for Easy Air in order to maximize its profits.

Easy Air is a major airline competing with other short-haul and long-haul flights which operates in an oligopoly market structure. This market structure is considered to be an imperfect competition, where a limited number of airlines dominate the industry. Easy Air is registered in the United Kingdom and according to British Air Transport Association (BATA 2009), there are 9 other passenger airlines registered in the country [1] .

As it has been stated by Hornby, W; Gammie, B and Wall, S (2001) one of the most important aspect of decision making in any business is to set the price of the good or service that the company offer. It is a rather complicated issue as this can lead to the success or failure of the business [2] . This paper will analyse the possible business and pricing strategies that Easy Air Airline can use for profit maximization.

Unlike firms operating in monopoly market structure where they have the control on the price they charge, and in perfect competition market where the firms are the price taker; in an oligopoly market structure, the firms have the power to change their price at different level of output. But because all the firms competing with each other offer same products or service, the action of one firm is noticeable by the other. When one firm changes its business or pricing strategy, not only his profit is affected but that of his competitor as well [3] . According to authors Peppers, L and Bails, D (1987), individual firm has greater degree of control if there are fewer competitors in a market [4] .

The key characteristics of the Oligopoly market are (1) an industry which is dominated by a small number of large firms, (2) firms selling either homogenous or differentiated products, and (3) the industry has high level of barriers to entry [5] .

The airline industry of most countries is dominated by only a few airlines companies, depending on the size of the population. For instance Easy Air has to compete with 9 other airlines targeting the population of the United Kingdom. All of them offer homogenous service starting from ticket booking, in flights service, flights frequencies, and similar destination around the world. But the barrier to entry in the airline industry is significant. As authors Peppers, L and Bails, D (1987) stated; “If the oligopoly is to maintain its long-term position, there must be substantial barriers to entry into the industry” [6] . There are high fix costs associated in the airline industry making it difficult for new player to enter the market. These high capital investments include the purchase of aircrafts.

Base on previous theoretical and empirical evidence, there are different business strategies that Easy Air can follow in order to maximize its profit.

Wei, W and Hansen, M (2006), carried a study to explore how airlines make decisions on the size of their aircrafts and service frequency from profit maximizing perspective in duopoly markets. They apply the game theory models to analyse the airline companies in two different markets: the short-haul and the long-haul market. The research was based on cost, market share and demand models obtained from empirical studies. By using the sensitivity analysis for the short-haul market, they found that there was a strong advantage for a leader in Stackelberg game in attracting more demand. Although demands were higher in the short-haul market; the companies were making more profit in the long-haul. This is because airlines made use of smaller aircrafts for short distance as being cost effective and also, there were high competitions. They concluded that due to increase in demand on the short haul market, and because airports cannot increase service frequency due to their size, aircraft manufacturer should therefore built larger and more cost efficient airplanes to serve the short-haul markets thus increasing its profitability.

In this aspect, Malighetti, P; Paleari, S and Redondi, R (2009) conducted an empirical analysis of Ryanair’s to know if they have changed their pricing strategy. They have created a panel dataset for Ryanair European flights over a period of two years from 2006 to 2007. They found that the company adopted a low-cost carriers pricing strategy as being one of the prominent factor in increasing the demand for short-haul destinations in Europe. As such, surprisingly this low cost carrier continued to grow excessively at an alarming rate. However, now that the company has become the dominant low cost carrier in Europe, it appears that it is reducing its dynamic price which used to be a major stimulus to encourage people to travel to touristic parts of Europe.

Giaume, S and Guillou, S (2004), has provided evidence that concentration and price discrimination are negatively related. They have fully underpinned the explanation of price discrimination that in a monopoly market, consumers are more willing to pay any amount. However, when it comes to competition, firms not only consider the price the consumers are willing to pay but also consider their choice and preferences.

On the other hand, Moyer, K (1996) studied on how British Airways used Scenario Planning to develop its business strategies in view of future uncertainty. The company was transformed from a loss making and a state owned airline in the early 1980’s to world leader in the passenger airlines industry in the 1990’s and became more customer oriented. In 1994, because of rapid changes in technology and education level, the company started to use scenario analysis to develop new strategic agenda in order to respond immediately as airline industry is highly sensitive to the economic cycle. Scenarios were reviewed on a regular basis in helping the business to sustain growth.

Because of the financial crisis in 2008 and its effect it had on the operations of British Airways, the company had to change their structure and map their long-term vision to be the world’s leading global premium airline as depicted in their annual report of 2008/2009. Moreover, due to the increase in fuel, British Airways had to cut its operation cost through the new terminal 5 at London Heathrow reducing its employees as the terminal is well equipped with the latest technologies reducing the need of manpower in certain areas. They have also as a mean to save cost made use of frequent fuel efficient aircrafts for both short and long haul flights. In order to become the airline choice for long-haul premium customer, the company has now set its objective in giving customers more satisfaction at every touch point, reducing CO2 emission, grow the presence of the company in all major cities in the world and meet the customer’s needs and improve margins through revenues streams. [7] 

As noted by Schwartz, M (1986), there are 215,396 changes in airfare every day. This resulted in Domestic airlines spending huge amount of money to monitor prices of other firms [8] . They do this because there are a large number of customers who chose a flight on the basis of the price, and in order for firms to get these customers, they have to set the lowest price possible in the market [9] .

There are four possible pricing models that can be used in an Oligopoly market structure that managers can use to maximize profit. They are (1) Sweezy, (2) Cournot, (3) Bertrand and (4) Stackelberg Oligopoly model. Based on the industry characteristics in which Easy Air operates, Sweezy Oligopoly model will be the best model to determine the price at which the company can maximize its profit.

Sweezy Oligopoly model is based on the assumption on how other firms respond to price increase and price decrease by one of the competitor. The characteristic of this industry is that there only a few firms serving a large number of customers and each firm produce differentiated products. Each firm have the assumption that their competitor will match any price decrease but not price increase. This is because the competitor thinks that if the other one will increase its price, they can gain the customers who are not willing to pay more, but if the competitors decrease their price, then they have no choice rather than to decrease their price in order not to lose their customers.

Apart from using the MR=MC rule for setting profit maximization price, Easy Air can use Price discrimination to yield even greater profit. Price discrimination is defined as the practice of charging different prices to consumers for the same good or services (Baye, M 2009). Price Discrimination is a common practice used in the airline industry. In An airline industry operates within different segment with different needs and preference. The segment is divided into First Class, Business Class and Economy Class. If for instance, business passenger who is price sensitive, and willing to buy an Economic class return ticket, he cannot do so as most of the time airline companies set the requirement that Economic class will have to stay over the week-end, thus making the business passenger pay more to return before. And in the same situation, if the business passenger wants to change the date or time of his flight, and because of high demand in the flights he want to use, airline companies might ask the business passenger to upgrade his booking to First class in order to get a seat.

Another common example of price discrimination in the airline industry is when passengers paying different prices for the same segment on the same flight. Often, passenger airlines offer discount for persons who do early booking compare to the one who buy at the last moment. This is a form of price discrimination as both passengers at the end will enjoy same service. But in this circumstance, the passenger who bought the ticket in advance cannot resell it to someone else, and if they want to cancel the booking, they will not get full refund, which in other word increase the revenue of the airline as it can sell that seat to another passenger.

There are three different types of price discrimination; first, second and third degree. The information that the manager needs to have about the customer varies for each category. In the first degree, the manager uses the price discrimination strategy to charge the customer the highest price he is willing to pay. For Easy Air, it is really difficult to use such strategy because the level of competition in the industry is high, and passengers have the ability to compare prices with other airlines before booking. The second degree is rarely common in the airline industry. This strategy is normally used in business with high fix cost, where company sell products which are deemed to be surplus at lower rates. In the airline industry this strategy does not work, because if someone cancel his booking at the last moment, the company cannot advertised that seat for sale as they know if someone will have to travel to other destinations, they have to make several arrangement in terms of holiday at work, and accommodation at the place the flight is going, and also should fulfil the entry requirement by the immigration authority in that country. So it is unrealistic to have someone waiting hours at the airport fully prepared, for the announcement when another person will cancelled his booking so that he can buy that ticket to fly to that destination.

The final type of price discrimination is the third degree strategy. This is the most common strategy used by firms, which accepts demand of their product differs systematically by consumers in different demographic groups. In this strategy the firms can increase its profit by charging different group of customer different prices [10] . For instance in Easy Air situation, the company can charge different price for each segment the company is serving. They know if a person is booking a First Class ticket, it means that he has the ability to pay. In this situation the company can absorb the entire consumer surplus from the customers, thus increasing its revenues.

Another situation where the third degree price discrimination applies for Easy Air is for customer who booked their ticket at the last moment. There are many customers who use to plan their holiday well in advance, and book their ticket earlier. This allows passenger airlines to know whether the flights are fully booked or the number of remaining seats available. Also, the revenue received from customers is like an extra cash-flow for the company well before the departure date. But for customers who booked their ticket at the last moment, it shows that they really need to travel to their destination. Because the consumer demand becomes more inelastic at that point, it would be advantageous for Easy Air to raise its price at the point where it absorbs the entire market surplus.

We will use the Sweezy Model of Oligopoly to determine the price level at which Easy Air can maximize its profit. The diagram below shows the level at which the company can chose the best price.

Since we assume that other firms operating in the same market as Easy Air will match any price increase, but not price decrease, the demand curve for Easy Air will then be ABD1 as shown in above diagram. Normally profit maximizing occur where MR=MC, and it is the maximum price a passenger will pay for that flight. The profit maximization of Easy Air if marginal cost=MC0, will be at point C, where MR2=MC0. In this case the profit maximization of output will then be Q0 and optimal price P0. The advantage of using this model to determine the price is that it tell the range at which changes in marginal cost does not affect profit maximizing level of output. On the diagram above it is the range between C and E.

In this paper we find that Easy Air operates in an Oligopoly market structure because of its characteristics. Possible business and pricing strategies were discussed into how the company can maximize its profit. To conclude we found that by using the Sweezy Oligopoly model, the company will be able to maximize its return and by applying the third price discrimination method, the company will be able to yield even higher profit.