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,
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POSITION IN THE COURSE
This case is suitable for introducing the analysis of industry and competitionin 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
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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
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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 milesbut for shorter journeys
automobiles and, in a few cases (e.g. Washington-New York-Boston) rail are viable substitutes.
.
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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 profitsthis 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
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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
managedif 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
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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
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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 20015 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
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of the many factors influencing competition and profitability in an industry. It helps us to identify the

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