Chapter 5 Is it the fault of bad industry economics

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CASE 5

The US Airline Industry in 2015

TEACHING NOTE

NOTE: There is an error on Figure 2 of the printed case: the two trend lines

have been mislabeled. The upper line shows WACC; the lower line shows ROIC.

Thus, the industry has earned a return on capital less than the cost of capital for

the entire period.

■ SYNOPSIS ■

During 2015, the US airline industry, boosted by a growing US economy and falling oil prices, experienced a

continuation in the upswing in profitability that had begun in 2012. Did this mark a new era of prosperity for

the industry, or was it simply another of the temporary upturns in profitability that would be followed by a

return to the industry’s normal state of intense price competition, low margins, weak balance sheets, and

frequent bankruptcies?

The case outlines how the strategies of the airlines attempted to moderate price competition. Mergers, frequent

flier programs, and building dominant positions at hub airports have achieved moderate success in taming

price competition.

■ TEACHING OBJECTIVES ■

I wrote this case to allow students to gain experience in applying the basic tools of industry analysis to a

sector that is both familiar and easy to analyze. After using Crown Cork and Seal as my favored case for

industry analysis, I felt the need to update to something more contemporary.

The airline industry is highly suitable for analyzing the relationship between industry structure, competition,

and profitability for several reasons:

 The industry is a disaster in terms of its financial performance. This immediately raises an interesting

question: is lousy financial performance because the airlines are badly managed (Southwest, after all,

■ POSITION IN THE COURSE ■

This case is suitable for introducing the analysis of industry and competition—in particular, for applying

Porter’s Five Forces of Competition framework. A subsequent class can then be devoted to a case that

involves a more complex industry structure or competitive dynamics.

■ ASSIGNMENT QUESTIONS ■

1. Assess the overall financial performance of the US airline industry during the past 20 years.

4. Are there any strategies used by the airlines that have been effective in moderating the forces of

competition? Are there any strategies that the airlines could use to improve industry profitability in

the future?

■ READING ■

■ CASE DISCUSSION AND ANALYSIS ■

I have taken two approaches to teaching this case:

1. An historical approach, where I follow the history of the industry since the days of regulation and ask

students about the key structural features of the industry at each stage of the industry’s development

and their implications for competition and profitability. Such a discussion would concentrate upon the

following phases of the industry’s history:

 The era of regulation. What were the main features of the industry’s regulatory structure during

 The decision to deregulate. Given the effects of deregulation on industry structure and behavior,

were the economists who supported deregulation right about the “contestable” nature of the

industry? Is this an industry where entry and exit are easy?

2. An emphasis on industry profitability following deregulation and an application of the Porter Five

Forces framework to identify the characteristics of industry structure that have produced intense price

competition and dismal industry profitability.

My preference is for the latter approach: it is more direct, more tightly focused, and allows an easier

deployment of the core Porter framework. So, let me expand upon this approach.

Industry Performance

During the three decades since deregulation, overall industry profitability has been depressingly low. Industry

net margin (net income/sales revenue) during the 1980s was between -4% and +3%, averaged 1.7%; was

Why Has Industry Performance Been So Poor?

To explain the reasons for low profitability in the US airline industry, the key is to link the strength of

competition among airlines to the industry’s structure. The organizing framework for the analysis is Porter’s

Five Forces Framework. Two approaches are possible:

Among the key points that I bring out in this analysis are:

1. Supplier power. There’s a lot of monopoly and duopoly power upstream. The unions and the airports

are effectively monopolists – the unions (especially the pilots) have used this power to keep wages

and benefits high and impose restrictive working practices that keep productivity low. The airplane

2. Industry rivalry. The main competitive force in this industry is rivalry between the airlines. We know

this is very strong – look at the frequent price wars that break out. The key to understanding this

intense rivalry is the combined effect of the different structural factors. The prime driver is excess

capacity – the airlines are always willing to compete on price in order to fill empty seats. How low

3. Entry. Much of the case over deregulation was based on arguments for “contestability” – if airlines

could enter and exit individual routes and regional/local markets easily, then the industry would

establish levels of prices and profits that would approximate to those in perfect competition. Were the

proponents of contestability correct?

Barriers to entry are not especially high – most capital equipment can be leased, and so can pilots,

crews, and ground facilities.

4. Buyer power. The biggest change during the past decade on the buyer side has been the growth of

online sales and the increased transparency of airline prices made possible by the internet. More

informed customers are also more price-sensitive customers. Hence, there are few buyers who are

5. Substitute competition. Generally weak for journeys exceeding 300 miles—but for shorter journeys

automobiles and, in a few cases (e.g. Washington-New York-Boston) rail are viable substitutes.

Assessing the combined impact of the different competitive forces is a matter of judgement. Rivalry among

airlines has been by far the major competitive force depressing prices and profits—this has been

reinforced by supplier power. However, the different competitive forces interact with one another in a

The relevant industry/market. As with all industry analysis, a critical issue concerns the relevant

boundaries of the industry. The US market for passenger air transport comprises a number of distinct

markets: every city pair is a separate market in terms of demand-side substitutability. Competitive

conditions differ hugely between them – some are monopolies in terms of direct flights (Washington

Other factors influencing industry profitability

Inevitably, students introduce reasons for the industry’s low profitability that have little or nothing to do with

industry structure. Two explanations are commonly offered:

1. The industry is unprofitable because costs are high. This issue typically arises in relation to fuel

costs. Certainly oil prices rose sharply after 2001 and were exceptionally high during 2007-8. But

has low profitability since 2001 been the result of high oil prices? In industries where competition

is strong, industry-wide movements in costs tend to be passed on to consumers. In the airline

business, rising fuel prices tend to result in rising fares – and they may be passed on directly in the

form of fuel surcharges.

It is interesting to compare the airline industry with the oil refining industry. In airlines fuel is the

biggest cost item; in refining crude oil is the biggest cost item. Yet in refining it is well accepted

that high or low crude prices have very little influence on refining margins. Is the situation not

identical in airlines? Well, not quite. Oil refining benefits from a highly inelastic demand for its

2. A related argument is that the industry’s profits are low because so many airlines are inefficiently

managed—if all airlines could be as cost-efficient as Southwest, they too could enjoy the kinds of

profits that Southwest makes. There’s a fallacy of aggregation here. Southwest is profitable

The Outlook for Industry Profitability, 2016-2020

What is the outlook for competition and profitability over the next five years? In mid-2015, the outlook for the

industry is more favorable than it has been for some time: the reviving economy and capacity discipline have

caused rising load factors (Figure 4), and recent mergers are reducing pressures to compete on fares (Figure 5

shows moderately rising fares). Costs are better controlled and oil prices are expected to remain low. Several

factors will be especially important in determining whether the upturn in profitability will be sustained:

 Capacity growth. The critical factor will be whether capacity growth outstrips the growth in demand.

 Industry consolidation. The mergers between United and Continental and American and US Airways

mean that there are only three legacy airlines remaining. Although there is evidence that mergers have

not reduced competition in the industry (see the section on “Mergers”), this evidence does not take

account of the recent American/US Airways merger, and Southwest. Is further consolidation likely?

Certainly mergers and acquisitions offer the potential for cost reduction; however, the attitude of

government and the competition authorities is critical. Even without major mergers, the tendency for

the airlines to build regional power bases centered on a few hubs has the potential to lessen rivalry on

many routes.

made by Bombardier, Embraer and others.

 Cost reduction. What about the benefits of continued cost-cutting by the major airlines? Cost

reduction by the “legacy” airlines is reducing the cost gap between them and the low-cost carriers.

Can the airlines improve industry profitability through the strategies they deploy?

The airlines have adjusted their strategies in many ways in an attempt to improve performance. However, the

evidence is that the companies have only limited power to counteract the harsh economics of the industry.

Strategic initiatives have included:

• Product differentiation. The tendency over time has been for airline journeys to become commodity

has been immensely successful is frequent flier schemes. These have encouraged customer loyalty

and provided incentives for alliances, as well as creating an additional revenue stream for the airlines.

Looking ahead, the experience of JetBlue and Virgin America is interesting: their differentiated

offerings combined with low prices have met with a strong consumer response. Is there also scope

for the legacy airlines to compete through improved inflight entertainment, better food and drink, and

technology-enhanced customer services?

• Capacity reduction. The financial woes of 2001–5 and 2008-9 encouraged cutbacks in schedules and

• Regional concentration. Much more successful than mergers and acquisitions at controlling

competition has been the concentration by each airline on a few major airports. Although motivated

primarily by efficiency, the hub-and-spoke system has had the effect of consolidating capacity and

routes at a few airports –sometimes creating the near-monopolization of gates and slots at some

■ KEY TAKE-AWAYS FROM THE CASE DISCUSSION ■

1. Industry structure drives competition which in turn determines industry profitability. The inability of

the US airline industry to generate profits is not because the industry has been cursed by God,

managed by idiots, or simply unlucky—it’s because of the industry’s structure.

3. The Porter Five Forces model is useful not just in explaining the past and the present; its real value to

managers is:

a) Predicting the intensity of competition and levels of profitability in the future. If we can

predict the changes in industry structure that are likely, then we can evaluate whether

4. The Porter Five Forces analysis (like most other strategy frameworks) is not an algorithm that

provides clear and precise answers. The Five Forces Framework is a means of organizing our analysis

of the many factors influencing competition and profitability in an industry. It helps us to identify the