Ryanair - Low-Priced Airline or a Collapsed Business Model


By

Dr. Sarveshwar Pande
Assistant Professor
Amity Business School, Amity University
Lucknow

Dr. Brian Anderson
Assistant Professor
Central Queensland University
Sydney
 


Air transport is an expensive activity, and not only because it is fuel-hungry: it also demands that airlines settle series of taxes and services to the airports they fly to. These payments, originally designed to cover the operating costs of the airports, allow the infrastructures to serve as a profitable tool of development for the region. But some low-cost carriers, Ryanair in particular, managed to turn the traditional model where airports provide services and charge airlines for them into a model where airports build a business plan to attract low-cost airlines and offer conditions to retain them. Ryanair, one of Europe's first low fares airlines, is familiar with blazing a trail. Its strategy of low basic ticket prices with an increasing selection of optional extras has proved extremely successful and is already transforming how other airlines operate around the world. Ryanair's success in offering low fares to popular destinations is underpinned by operating a low cost business model. For the first time in a decade, the airline had issued profit warnings on its net-profit forecast, whereas a change of stance made the airline anxious to maintain a certain control on the bad press that had damaged its reputation so far.

This paper will follow two main axes. First, it shall analyse the successful business model of thecompany which conceptually relies on two steps: bring together the elements of success (obtain thelowest fares, lure a maximum of passengers) and maximise its revenue (make profit out of the fluxand secure the incomes thanks to advanced tax optimization). Then, in a second part, further expansion on the idea that Ryanair had entered an era of crisis by demonstrating how Ryanair's sacredtriptych is endangered and by reviewing the threats that menace the model: an overall rise of costs, anefarious social climate and a political upheaval at the European scale.Flying ahead of every other analysis attempted before, a clearunderstanding of Ryanair's business model and future is sure to be anticipated.

INTRODUCTION

"You egocentric academic eggheads! You don't know anything. You can't deregulate this
Industry. You're going to wreck it. You don't know anything about aviation finance!"

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

The low cost airline model (often called the "no frills" model) in Europe has been the subject of intense interest and study. The "Southwesteffect", basically the drop in fares that occurs when a low-fare airline begins serving an airportthat had previously had no low-fare carriers, has become part of the vocabulary of airtransportation. This paper looks at just how successful the low cost model had taken in it broadestcontext. In particular, while there have clearly been airlines pursuing the low cost approach thathave largely endured and prospered, the thought provoking question is whether that is because of the underlyingbusiness model, or a function of good management exercised, or both or, perhaps combined with an elementof Napoleonic luck on the part of the individuals managing these companies.

The importance of low cost carriers as major suppliers of air services in short-haul markets isexemplified in by Ryanair being the larger movers of air travelers within Europe, and Southwesthaving the same position in the United States. Low-cost airlines are also becoming significantfactors in airport planning. Their requirements differ from those of 'legacy' carriers. They havethus been driving the development of secondary airports and cheaper, specialized terminals atlarge established airports (De Neuville, 2008; Barrett, 2004a).To preempt our conclusions, the low cost airline model has served many carriers very well, andhas had a profound impact on the airline industry throughout the world, but it has been far from aubiquitous success. It is also a model that has many dimensions, and has tended to morph over theyears. There are, in addition, reasons to suspect that the model as we have seen it in the past, willneed to change to succeed in a dynamic market and, in the short term, to function well in thedepressed macro-economic environments of 2009.

We begin by exploring the criteria against which success should be measured, and the nature ofthe market environment in which low cost carriers have emerged, and then move on to see howthey have faired in the Spencerian (Spencer, 1874 to 1896) world of Lamarckian evolution inwhich they operate.

THE CONCEPT OF SUCCESS

To assess the achievement of any business model one needs criterion to set it against; essentiallysome form of matrix and a benchmark. Success in business can be assessed on severaldimensions. In terms of the business community it may relate to profits, the standard neo-classicalrent seeking criteria, but business success may also be seen in relation to market share or in termsof sales revenues (Baumol, 1962). Internally, the management of a firm may also see success isthe context of performing well in a number of defined areas (Williamson, 1975), or it may morebroadly '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 antitrustauthorities, success is the absence of the exercise of market power, either in terms ofextracting economic rents from consumers or through the enjoyment of X-inefficiency. From atechnology perspective, success is normally associated with new or innovative processes thatovercome some barrier to production and thus reduces costs significantly, allowing economicdevelopment (Rostow, 1960).

From a social perspective, the issue is one of social welfare maximization that is often articulatedin the transport context as meeting some standard of mobility or accessibility whichever is thepolitical fashion of the day. The recent interest in the environment often sees industrial success assomething consistent with sustainable development.  The Pony Express had some successes in the mid-19th century in the UnitedStates, and may indeed be considered the forerunner of modern express delivery, but it onlylasted for 19 months. One would, I think, question if it really can be considered a successfulbusiness model as we would normally think of the term. The business rather found a temporalniche market for a very specialized service. Other business models, such as those associated withthe mass production models initiated by Fiat and subsequently developed by Henry Ford haveproved 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, andits root cause is discussed below, but in summary since the gradual liberalization of scheduledairlines around the world there has been a singular difficulty in carriers maintaining operatingmargins above zero, and certainly at a level found in most other sectors of the economy. Business models have been explored that have tried to resolve this problem, most notably thatassociated with hub-and-spoke operations, as well as a number of innovative practices, such asfrequent flier programs, business lounges, computer reservations systems, and so on, and the lowcost 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 consumerwelfare. There seems little doubt that low cost airlines have, in many markets, resulted in lowerfares for travelers and a greater diversity of service types to choose from. The notion of successadopted here is rather more long term, and reflect long-term social welfare maximization ratherthan shorter-term gratifications. What is not done here is to try to quantify benefits or place anydiscount rate on when they are enjoyed. Successes for one for two businesses pursuing a particular approach to their business dose notaxiomatically mean they have a successful business model. They may have other factors that alsoadd to their success such as the quality of their management, or they may just have found anarrow market niche into which they fit. A successful business model, in our context, has to beone 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, oftenpublically owned, and frequently enjoyed both direct and indirect subsidies. The changes fromthe late 1970s suddenly thrust airline management from a world with pretty well definedparameters into one where there was not only considerable commercial risk but also considerably certainty. Risk is something thatmanagement schools teach their students to handle through various forms of hedging andinsurance, although sometimes they do not seem to listen to their professors, but uncertainty ismore challenging. The natural business inclination is to minimize it, and this is essentially whatthe legacy airlines have sought to do. They have tried to minimize competition by developingfortress hubs, and to tie customers in with frequent flier programs. But this is only one of twobroad strategies business may adopt.

Michael Porter (1995) in his classic book on management, Competitive Advantage, argues that tobe 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 theairlines context this involved the traditional airlines that had grown under regulatory protectionand, 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 twomajor airports that acted as consolidation and dispersal points for traffic akin to a post officesorting depot. They added to their strength by seeking to control information flows throughcomputer reservation systems (CRSs); the first of which, Sabre, was developed by AmericanAirlines in the United States. This allowed the airline owners of systems, through travel agents, tofavor their own flights when flight options were displayed to potential customers; an effectreinforced through the halo effects associated with bonuses offered to agents who achieved highbookings for the CRS owner airline.

The CRS systems, and the flow of information that itprovided the airline, also allowed airlines to adjust the fares being offered customers to reflecttheir willingness- to-pay and thus price discriminate between those who are more or less faresensitive. Added to this the traditional carriers formed alliances both with other major airlines butalso with feeder carriers. This created seamless services for customers and more integratedschedules 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; todevelop 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 havesought to establish, and subsequently sustain, themselves by undercutting the fares offered byrival airlines. While the title 'low cost' airline is widely, used the business models adopted canvary quite considerably between carriers; some for example focus on secondary airports in citieswhereas other serve the major hubs, some offer no on-line services whereas other do, some havefrequent flier programs whereas some do not, etc. In addition, in some cases traditional airlineshave operated divisions or subsidiaries that have sought to be low cost.

The low cost approach in aviation has a long history, the first successful low-cost carrier wasPacific Southwest Airlines in the United States, which pioneered the concept in 1949, and in thatsense one could say the business model has worked. This however is somewhat deceptive. This isalso not just because long-haul low cost carriers have never really gained a market niche, the firstairline 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 largecarriers still survive in the market, despite many years of 'deregulation', that do not follow thelow 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 twodecades. The industry as a whole suffers from severe cyclical fluctuations in demand, and overallhas operating margins well below industry as a whole, and even within the larger airtransport chain performs poorly compared to airports, global distribution systems, airframe andaero engine manufactures, etc. (Button, 2004).The problem with the airline market is that it is highly competitive, but at the same time has thepeculiarities of a form of fixed costs found is a number of services industries (includingprofessional sports and the theatre). These are not the fixed costs of bricks and mortar of the typeAlfred Marshall (1890) wrote about a century ago, but rather commitment to offer a scheduledservice. The fact that an airline has to have an aircraft (whether it owns it or leases it isimmaterial) 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 toprovide 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 ismade months in advance and thus costs cannot be completely known. These costs may also be seen as 'sunk' costs in the tradition of the analysis of contestable marketsdeveloped by Baumol et al (1982). They are costs that cannot be recovered if no-one uses the flight and theresources are not easily transferrable.

The problem can be couched in terms of Alfred Kahn's famed statement in 1977, when he was about toderegulate the US airline market, "I really don't know one plane from the other. To me they are justmarginal costs with wings." This is true but it relates to short-run costs and some thought was neededregarding the long-run costs in a competitive environment.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 directsubsidies with the tax payer covering the fixed costs or by cross-subsidies through the granting ofinstitutional monopoly powers through the granting of such things as licenses or concessions thatallow airlines to charge above marginal costs. Onepractice that has remained in the United States, although not in Europe, is simply to allow airlinesto right-off losses through Chapter 11 bankruptcy, despite the moral hazard issues that thisentails.Any supplier's natural instinct in a perfectly competitive market is to try and carve out some formof monopoly power; to put some slope on the demand curve that is confronting it. Basically thismeans following the first approach posited by Porter, and traditional airlines have sought todistinguish their products in a wide variety of ways. In some cases, traditional airlines engaged inthe international market have focused increasingly on such services that have remained protectedunder 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, and therehas 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), there has beenefforts to control terminal facilities (the "fortress hubs"), and there have been measures to offerseamless services (strategic alliances). These measures have generally only been of temporaryuse in stemming off competition. In some cases they are easily replicated (as in the case offrequent flier programs that are now ubiquitous and largely uniform), and in others have beensuccessfully counteracted by competitors (as with 'hub-busting', direct services).

While many of the measures of product differentiation remain in the airline sector, their potencyhas seldom solved the cost recovery challenge, when the businesscycle has favored the airlines. The second approach described by Porter, lowering the costs ofproduction below competitors. Basically this entails a focus on just one element in thecompetitive matrix, namely fares. The low cost airlines seek to attract trafficfrom competitors in the short-term, as well as generate new traffic to cover their short run costswith the hope of forcing traditional carriers from the market in the longer term and thus enjoysome degree of monopoly power. There is some overlap in this approach with Bain's (1949) limitpricing theory of business behavior in that the low cost carriers would not push fares back to theirprevious 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 seemjustified 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 ofinvestment has been a possible money illusion; airlines because fares are collected well inadvance of the delivery of services may be seen to be cash rich with the potential of using thatmoney to earn a return elsewhere. There also seems to be a Los Vegas effect in the sense thatwhile 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. In perhaps slightly less technical terms, Michael O'Leary, Ryanair's chief executive, summed up thebusiness model rather well, Code-sharing, alliances, and connections are all about "how do we screw thepoor customer for more money?". The actors further up the value chain – airports, airframe manufacturersand so on – simply cannot allow the airline industry to die because of the money they make byselling their goods and services to them. Finally, aero-planes present a largely irrationalfascination for many people, a sort of modern equivalent to the "foamers" in the United Statesand the "grisers" in the United Kingdom who spend their time spotting trains, and this stimulatesthem to invest; it is a 'erogenous' industry for them.

The general outcome of all of this is, perhaps best summed up by the American financier WarrenBuffet Warren Buffett in his 2008, annual letter to Berkshire Hathaway shareholders, "The worstsort of business is one that grows rapidly, requires significant capital to engender the growth, andthen earns little or no money. Think airlines. Here a durable competitive advantage has provenelusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had beenpresent at Kitty Hawk, he would have done his successors a huge favor by shooting Orvilledown."

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 theirbasic characteristics. In very general terms, low cost carriers offers low fares by using a range ofbroad strategies, and not all are used by every low cost airline. These strategies both remove someelements of cost from their production functions, and reduce the levels of many of the remainingcosts. In doing this, they offer a more limited rather of services and, in some cases, chargeseparately 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 leastnot in the base fare. There is an effective unbundling of services; food and drinks often haveto be bought on board, the free baggage allowance in small, no sky-bridges are offered to theplane, 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 arekept short because there is no-belly-hold cargo to unload/unload, there are no window shadesto 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. Interms of crew, these are often based at 'home' to service radial routes that that makes theirscheduling easier, and they also often perform a number of functions in the provision of theservice.

* Third, they keep overheads down by using common fleets of aircraft that are cheaper tomaintain and crew.

* Fourthly, they seek to maximize complementary revenues from sales of refreshments and forbaggage,

Warren Buffet considers himself a "reformed aeroholic" after losing $300 million or so in a US Airinvestment in the mid 1990s. Although it may seem unbelievable, many civil servants have pictures andmodels of planes in their offices, rather than of the passengers and cargo that they have a responsibility tomove efficiently. It is a basically a non-pecuniary form of reward from policy capture.

* 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 offersignificant 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 inthe radial short haul networks they operate with non-online services to second tier airportscentered around a base airport that allows for the maximum utilization of a standardized aircraftfleet and of crew without the congestion and the repositioning costs associated with mixeddistance, on-line services through a hub using a varied fleet. Other low cost carriers have variantson this, easyJet, for instance serves many of the larger airports and Air Berlin has a frequent flyerprogram, but all low cost carriers are aggressive in keeping costs to a minimum by charging foron-board services, having quick turn around times for their aircraft, cutting out salescommissions, 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 oncore business. Many of the attributes of a full-service, legacy carrier can be obtained from a lowcost airline (e.g. meals, extra baggage, more comprehensive insurance etc.), but this entails anadditional price. The overall philosophy and features of low costs carriers, whether admitted ornot by all, was well summed up by Michael O'Leary, Ryanair's chief executive, in BusinessWeek(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 andthe markets that they have penetrated and they almost unanimously show that the effects are lowfares than those offered by incumbent airlines. These fares, however, lead to significant trafficgeneration to the extent that the actual traffic volume of incumbents is little affected; the impact ison 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% ticketsample 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 faresfalling, overall demand rising, and the traditional carriers losing market share (UK Civil AviationAuthority, 2006).

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 possiblespillover effects that Southwest's service on one route has on adjacent competitive routes thatinvolve nearby airports. They found significant effects of service on adjacent competitive routesbut did not aggregate their results. Morrison (2001), taking a more macro perspective, looking atthe actual, adjacent and potential competition Southwest brought to United States routes in 1998,Michael O'Leary, CEO of Ryanair, for example, defines the carriers rather basic accident insurance policythus, "We don't fall over ourselves if they say, 'My granny fell ill'. What part of no refund don't youunderstand? You are not getting a refund so get away.". There are about 60 airlines across Europe offering a version of the low-cost theme.

Ryanair is the largestair carrier of passengers within Europefinds that its own passengers benefited by $3.4 billion (current prices) in low travel costs, whilethose 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 ofSouthwest is less than that for the majority of Ryanair routes he examined, except for the start-uproutes involving Stockholm and Hamburg. This seems to be because, the Italian destinationsanalyzed 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, andthe scale of traffic is considerably higher on all corridors except London–Stockholm putting morecompetitive 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 hefound that Southwest, when it has significant effects, has a smaller initial impact than Ryanair butthe latter establishes larger market shares as a result of its impact on competitors. It appears thatUnited States competitors are more competitive than most of Ryanair's in terms of pricing andproduct differentiation.The advent of low cost carriers has also impacted on other elements of the air service supplychain, and in particular on airports. Low cost carriers offer a no-frill service, and seek to keeptheir 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 atsome major airports (De Neuville, 2008).

This in turn has added a new dimension to thecompetition between airports as many seek to attract low cost carriers, but in doing so engage in aform 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, dependsultimately not only in their competitive position regarding other airports, but also with the extentof monopoly power they can exercise over the airlines. Francis et al.'s (2003) case study analysisraises questions about the sustainability of relationships with airlines. The success of many lowcostcarriers has explained the rapid growth in passenger volumes at airports where theyoperate. 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 arrangementsreflecting 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, ifsomewhat 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 varioustime, established their own low cost carrier. Institutionally the arrangements between thetraditional elements of a company and its low cost off-shoot have differed, in part because oflocal legal stipulations but also to meet the internal constraints, such as labor agreements and slotavailability, and to confront the challenges of the particular low cost carriers that were penetratingthe market. They also, in some cases, had wider objectives, such as the spinning off of profitablebusiness or to test out low cost elements that they could later adopted in their mainline operations.Graf (2005) offers a useful table listing the main ventures by legacy carriers into the low cost airlinesmarket.These efforts at emulating the low cost model, largely that of Southwest, have proved to beunsuccessful. There has in many cases been confusion on the marketing side in terms of beingable to develop separate brand images. (Morrell, 2005). Operationally, they were handicapped inthe United States in particular by labor union agreements that prevented costs from being reducedsignificantly, and by internal management constraints that limited their operational freedom andalso did not afford them financial autonomy. In effect, they were seen as part of a larger businessmodel encompassing a range of products along the lines of the Procter and Gamble genericcompetitive strategy of broad differentiation. This prevented costs from falling low enough tocompete with the single brand, low costs airlines.The European experience, where there has been some physical separation of the low-cost offshootby, for example, making use of different airports, has been a little more successful than thatof United States carriers. Transferring decentralized traffic flows to the low-cost unit anddeploying the aircraft of the network carrier exclusively to hub operations as a work-sharing andpositioning strategy for the business units (e.g. in the case of Germanwings and Lufthansa) hashad some success.

There has also been some evidence that the low airline-within-an-airline concept has proveduseful is as stop-gap measure to combat the increases in market presence of low cost carrierswhile 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 theability of the overall scheduled airline to recover its long-run costs; or, in economic terms, toincrease its stability.

COMPETITION IN LOW COST MARKETS

We now turn to the stand-alone low cost airlines and assess their contribution to the provisions ofscheduled services. There is no single way of doing this but there are a number of ways in whichinsights may be gleaned.

Market financial robustness

In the United States, lowcost airlines began to make serious inroads into the market in the mid-1990s, and in Europe aboutfive or six years later following the enactment of the full Three packages of European airlinederegulation. Simple examination shows little impact on the overall performanceof the sector after the incursion of low cost airlines into the market. More recent evidence in 2008and certainly would not suggest that the overall industry is any more capable of handlingsignificant 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 market12 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 theintra-European market. Charter airlines held the remaining 25% by selling aircraft capacity to touroperators and shuttling sun-seeking package tourists from cold Northern European countries to the beachesof Southern Europe.

Survival rates

In any competitive market one expects a number of firms to fail, and new ones to enter it. Thisreflects 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 inefficientleaving, 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 andleaving.

The low cost airlines that are now defunct were diverse, and ranged froma number that hardly began operations to others that were relatively successful but merged orwere taken over; e.g. Go and Buzz. One could draw up a similar list for the United States, andmost 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-costmarket 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 enteredthe market first, indicating that replication of the business models is far from simple.Most of these low cost airlines operated for a period and then went into bankruptcy. Some such as Go Fly andBuzzAway merged with successful low cost airlines. In a few cases, the airline was registered but neveroffered actual services.At the more micro level, the low cost airlines are often less than stable in terms of the servicesthat provide individually. While with one or two exceptions, Southwest Airlines has tended tosteadily build its network with few subsequent withdrawals, but this is not always the picture. InEurope, for example, the development of services at Stansted Airport,Ryanair's main airport, showing both new routes and dropped routes. While growth is clear, it hasnot been in s strictly incremental way, indeed if anything the volatility of route entry and exit hasgrown as low cost carriers services have expended.

Market power

In markets that have significant fixed costs, either of the conventional 'brick and mortar type orthe fixed commitment type that we have argued are associated with offer scheduled airlinesservices, suppliers require a degree of market power to recover their costs unless governmentoffers help. The success of a market with these technical features relies on this. The fixed cost element in air transport is also individual servicespecific, rather than route specific.One way that market power in offering a specific service has been looked at recently is throughthe use of 'data scrapping'. This entails going to travel websites, often the airlines, and examiningthe pattern of fares offered for a particular flight as the time of departure approaches. In otherwords, collecting all the fares, F, for each day, t (or some other time division) from a date prior tothe flight until the actual take-off.

The airlines that practice this dynamic price discriminationessentially try to capture the rents from any flight seen under the normal demand by offering fares that rise as the time of a flight departureapproaches. 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 consumersurplus extracted by the airline. The extent to which a carrier can extract sufficient rent aboveSRMC to cover its fixed costs of a committed service also influenced by the slope of theaggregate demand curve, and ipso facto, the amount of revenue that is raised under the temporalfares offered curve in the right-hand element of the figure. Fare rise towards departure becauselast minute bookings are largely made by individuals with limited choices and who have lessprior insights into their future travel needs (generally business travelers).

Much, therefore, depends on the extent and over what time period seats can be sold at pricesabove breakeven. A priori, one would anticipate that if the airline is a monopolist then the demandcurve on the left will be relatively steep and up-turn of the fares-offered curve would come quiteearly and rise steadily. If there is imperfect competition (essentially other flights on the route atnearly 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 comeslater and is less pronounced.

In multi-class configured cabins, there may be fare dilution as travelers trade between classes. In thesecases, a distinction should be drawn in the fares paid that separates out the additional costs of offering extraspace, 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 thelowest fare for a flight, in part to avoid this issue, the service is reduced. There may also be some fluctuations in the pattern of fares offered overtime as the carrier seeks to "play games" with competitors or to gain more insights into thedemand elasticitities at a particular time prior to departure. If there were perfect competition inthe market for a particular service, then both the demand curve and the fares offered curve wouldbe flat.

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 airlinesextends into mixture of classes they offer. It makes no allowance for free seats occupied byfrequent flier point redeemers. For comparative purposes there is generally a need to comparesimilar services, but definitions of rival services is subjective – e.g. does the 8.30am flight fromoffered by airline Z between A to B on a particular date compete with the 9.00am flight by airlineX? the 10.15am flight by airline Y? and so on. The situation becomes even more complex if the10.15am is not provided by airline Y, but by Z; in other words flights may complete with othersoffered by the same airline. Perhaps, most importantly there is little feel for the actual up-take offlights when data scraping, and so the elasticity of demand, that indicates the willingness to payand not what is being offered, is not being explicitly measured.

Empirical analysis supporting the logical basis of the temporal fares-offered curve has been fairlywell established in studies of European and American air transport markets.The fundamental definition of perfect competition is that any supplier in the market is confronted by aperfectly elastic demand curve (Robinson, 1962).  Studies include, Barbot (2006), Button and (2007), Button et al (2007), Pels and Rietveld (2004),andPitfield (2005a. b).Of more interest in terms of whether the low cost model is successful is what happens when twocarriers offer nearly identical services, differentiated largely by a small difference in departuretimes. There are several suppliers, which in turn indicates the lack of any marked degree of monopolypower. Thus even when there are both low costs and traditional, full service suppliers offeringnear identical services in terms of departure times there is no indication that one type of businessdominates others. More importantly, in terms of the absolute success of a particular businessmodel, there is no evidence that this flattening out, and often irregular, pattern of fares beingoffered diminishes when it is low costs carriers that are competing with each other rather than lowcosts airlines confronting legacy carriers.

That low cost airlines have enjoyed some financial success may thus not be because of thebusiness model per se but rather the nature of the markets that they have entered. Some suchairlines have enjoyed a degree of economic rent allowing full cost recovery by simply avoidingcompetition, and the same would seem to be true of routes served by traditional airlines on partsof their networks. Avoiding competition is hardly a novel way of approaching business andcannot 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, mayrespond by entering these markets to compete, and thus ensure the integrity of their largeroperations. But more importantly regarding short haul market, other low cost carriers may enterthe market and thus reduce the potential for rent extraction.

The issue of bilateral monopolies

Low cost carriers have exerted an influence on airports, by stimulation  of the development ofbasic, 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 ratherfocusing on keeping costs to a minimum and, in may cases, forcing the airports to rely on landside,and concessionary revenues rather than air side take-off and landing fees.

The low cost airlines have been able to do this in the past at smaller airports because ofasymmetries in the bargaining situation, particularly in Europe. The situation has often been in abilateral monopoly context between a single low cost carriers and a small airport. In these casesthe outcome, except in very specific cases, is unclear are depends on the bargaining strength andinformation held by both parties. The ability of the airline to chose to puts its resources in othermarkets, whereas the airport is spatially constrained, gives it an advantage in many cases. Thetraditional carriers, because of their need for large hubs, of which there are few, and an integratednetwork 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 innegotiations 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 thetransactions are about renewals of contracts at airports where a carrier has already sunk costs, hasreduced the power of the carriers in some cases.

CONCLUSIONS

Ryanair has a reputation for being particularly aggressive in its negotiations with airports.The withdrawal of a 3 passenger surcharge at Frankfurt Hahn Airport in January 2009 after threats ofservice transfers by Ryanair was an illustration of this.That the low cost airline model was successful initially for a number of airlines is obvious – theexpansion of the intra state carrier, Air Southwest out of Texas to become Southwest Airlines inthe United States, the rapid growth of Ryanair and easyJet in Europe, and emergence of carrierssuch a Go and Tiger in the in emerging BRIC markets attest to this.

It is also clear that low costairlines have been instrumental on pushing down airfares, opening new markets, and allowingmany people to travel by air who could not do so before. But success for a few firms is not thesame thing as a successful business model; its achievement more widespread. Also thegeneration of social welfare though lowing travel costs does not establish a successful business ifthe full commercial costs of the system are not borne by its users. Low cost carriers haveperformed well when they have established monopoly power, but this is a transitory situation inthe context of modern, open air transport markets. The low cost airline model is thus successfulin the same way as frequent flier programs, fortress hubs and the like provided success to thetraditional airlines, but it is not a success in terms of meeting the fundamental problems ofproviding scheduled services in a highly competitive market.

REFERENCES

Bain, J.S. (1949) A note on pricing in monopoly and oligopoly, American Economic Review, 39,448-64.

Barbot, C. (2006) Entry and Accommodation in Airline Markets: Easyjet Caught in theMiddle on the London-Grenoble Route, Working Paper DP 2006-02. Universidade doPorto, Faculdade de Economia.

Barrett, S.D. (2004a). How do the demands for airport services differ between full-servicecarriers and low-cost carriers? Journal of Air Transport Management, 10, 33-39.

Barrett, S.D. (200b)The sustainability of the Ryanair model, International Journal of TransportManagement, 2, 89-98

Baumol, W.J. (1962) On the theory of the expansion of the firm, American Economic Review, 52,1078-87, 1962.

Baumol, W.J., Panzar, J.C. and Willig, R.D. (1982) Contestable Markets and the Theory ofIndustry Structure, Harcourt Brace Jovanovich, New York.

Button, K.J (2003) Does the theory of the 'core' explain why airlines fail to cover their long-runcosts of capital? Journal of Air Transport Management, 9, 5-14.

Button, K.J. (2004) Wings Across Europe: Towards an Efficient European Air Transport System,Aldershot, Ashgate.

Button, K.J. (2005) The economics of cost recovery in transport, Journal of Transport Economicsand Policy, 39: 241-257.

Button, K.J. and Vega, H. (2007) The Temporal-Fares-Offered Curves in Air Transportation,Journal of the Transportation Research Forum, 46, 83-100, 2007.

Button, K.J., Costa, A. and Cruz, C. (2007) Ability to recover full costs through pricediscrimination in deregulated scheduled air transport markets, Transport Reviews, 27, 213-231.

De Neufville, R. (2008) Low-cost airports for low-cost airlines: flexible design to manage therisks, Transportation Planning and Technology, 31, 35-68.

Dresner, M., Lin, J-S C. and Windle, R. (1996) The Impact of low-cost carriers on airport androute competition, Journal of Transport Economics and Policy, 30, 309-28

Edgeworth, F.Y. (1881) Mathematical Physics , London, Kegan Paul.

Francis G. et al (2003) Airport-airline interaction: the impact of. low-cost carriers on twoEuropean airports, Journal of Air Transport Management, 9, 267-273
 


Dr. Sarveshwar Pande
Assistant Professor
Amity Business School, Amity University
Lucknow

Dr. Brian Anderson
Assistant Professor
Central Queensland University
Sydney
 

Source: E-mail February 19, 2014

          

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