The Economics of Airlines

Volodymyr Bilotkach

• Editore: Agenda Publishing
• Anno: 2021
• ISBN:
  9781788213844
• Edizione: 2
• Argomento: Negocios y empresa
• Categoria: Industria del transporte

The airline industry is fundamental to the workings of the global economy. Yet, ironically for an industry of such sheer scale and economic muscle, profit margins are razor thin and many airlines struggle to break even. The precarious economics of the sector were fully revealed when Covid-19 grounded flights across the world prompting many national carriers to seek government bailouts, while smaller airlines collapsed.

In this updated and expanded new edition Volodymyr Bilotkach explains the economic realities of the airline industry and the challenges that the sector now faces after the seismic impact of the Covid-19 pandemic. The impact of such a large-scale external shock on the industry is considered across each of its sectors and for each of its primary economic determinants. The book also includes new material on changes to cost structures, the pricing of add-on services, cargo, airport slot allocation and the impact of climate change.

The book remains a comprehensive introduction to the economics of airlines, how carriers compete, how they develop their business, and how demand and cost structure, coupled with the complex regulatory regime, produces the industry we see today.

Part I

DEMAND AND COST

1

DEMAND FOR AIR TRAVEL

Key concepts

When it comes to discussion of demand for just about any product or service, there is a general misunderstanding both in the media and among the general public of what this concept really is. We often read and hear statements such as “demand for air travel remains strong” or “tourism demand increased by five per cent as compared to the same month last year”. These statements are typically based on some numbers from the data. These numbers, however, do not necessarily represent demand or changes in demand. Rather, what we observe from the data are outcomes of the interplay of forces of demand, supply (the concept of supply is even more misused) and competition – all the forces I will be discussing in more detail in the subsequent chapters. As a matter of fact, an increase in the number of, say, airline passengers, could result from changes in the underlying demand relationship, changes in supply (e.g., new entry on the market, liberalization, or fierce competition), or changes in both demand and supply. The truth is that with so many moving parts in the market system economists themselves are often able to say only with a limited degree of certainty whether the resulting change in quantity and price is the outcome of a change in demand. Yet, pointing to changes in market demand as the underlying reason for whatever is observed in the data is a useful and easy to understand shortcut.

So, let us use this shortcut. Figure 1.1 presents the evolution of global passenger air travel over the last 40+ years, ending just before the Covid-19 pandemic (according to figures reported by the World Bank). We can see that while fewer than 0.5 billion people made a trip by air in 1975; the corresponding number in 2019 was nearly 4.4 billion. This represents a nearly nine-fold increase in demand for air travel. Over the same period, the world’s population had nearly doubled, increasing by over 97 per cent. The global inflation adjusted GDP is estimated to have quintupled over the same period.

Figure 1.1 Global passenger air travel, 1973–2019 (billions per year)

Source: World Bank.

To visualize the effect of the Covid-19 pandemic on the airline industry, Figure 1.2 compares the number of seats offered on flights (both domestic and international) from select countries over the period from February 2020 to January 2021. The numbers reported here are seats in the corresponding month as compared to the same month a year ago (i.e., February 2020 is compared to February 2019, and January 2021 to January 2020). We can see how the pandemic affected airline markets differently in different parts of the world – from nearly complete recovery in China to close to 50 per cent fall in Japan, USA, and Australia, to a rather dire situation in the UK.

What is demand? The formal definition in economics relates to the relationship between the price of a good and the quantity customers are willing and able to buy over a certain time period. The relevant quantity and time period are specific to the goods/services and customers in question. Market boundaries also matter. In the context of air travel, we can talk about monthly demand for business travel between London and New York; annual demand for tourist trips to the Canary Islands by residents of, say, Greater Manchester; or quarterly demand for air travel between Japan and the Republic of Korea (that is the country commonly known as South Korea, of course – there are no flights between Japan and the territory ironically calling itself the People’s Democratic Republic of Korea). We can also talk about individual demand and market demand, the latter being simply the sum of all the individual demands on the market.

Figure 1.2 Changes in seat capacity during the Covid-19 pandemic in selected countries

Note: The graph represents percentage changes in the number of seats on departing flights (domestic and international) from a given country, compared to the same month a year ago, for example, May 2020 numbers represent the percentage change relative to May 2019.

Source: OAG.

Anyone who has studied economics even at a basic level has heard about the relationship known as the law of demand – other things being equal, lower price leads to higher quantity of the good demanded, and higher price reduces the quantity demanded (technically, this law is only guaranteed to work for normal goods, but that is more information than we need). Of course, price is not the only factor that affects the quantity of goods or services customers are willing and able to buy. Other factors that are known to affect demand include customers’ income, prices of other goods/services, number of consumers on the market, consumers’ tastes and preferences, as well as some other market-or product-specific factors. For instance, in addition to the above, demand for ice-cream will depend on the weather, while demand for seaside holidays can be affected by the political climate (e.g., there are very few European tourists holidaying on the Crimean peninsula since its illegal occupation by Russia in 2014) or potential threats of terrorism (my own conversations with industry experts suggested that in the summer of 2016 demand for holidays in Turkey and parts of Greece was down due to the attempted coup in the former country and the effect of the refugee crisis in the latter).

Expected effects of the above-mentioned factors on demand are generally common sense. The more customers there are, the higher the demand, other things being equal. The effect of higher income is more tricky to gauge. Think about an average person’s “consumption” of public transportation. Eventually, as a person becomes richer, there comes the time when he/she buys a car instead of taking a bus or a train. In fact, economists make a distinction between what they call “normal” and “inferior” goods. For normal goods, demand increases as consumers’ incomes increase, while for inferior ones the relationship is the opposite. Note that the term “inferior” goods does not necessarily signify goods of lower quality – these are usually the goods for which a more convenient alternative exists, but that more convenient alternative requires higher income levels to become affordable. If you think about it, air travel in economy class can be an inferior good for some very high income levels, and using commercial airline services can itself be an inferior good for those few of us who can afford private jets.

As far as effects of prices of other goods on demand are concerned, here economists distinguish between goods that are substitutes and those that are complements. The names here are self-explanatory. If the two goods are substitutes (such as apples and oranges, or air travel and high-speed rail), an increase in the price of one leads to an increase in the demand for the other (other things equal, once again) as some customers switch from a relatively more expensive to a relatively cheaper good or service. For goods that are complements (such as golf clubs and golf balls, or personal car trips to the city centre and parking in the central business district), an increase in price of one leads to a decrease in demand for the other. For instance, an increase in the price of parking in the city centre makes commuting by car more expensive, and reduces demand for personal car trips.

Knowing only the direction of change in demand is however not enough for practical purposes. If you are running a business, you would like to know not that you will be able to sell more if you decrease your price, but how much more. Economists use a simple measure of responsiveness of demand to changes in price, income, prices of other goods, and just about any other determinant of demand that can be quantified (such as, for instance, air temperature, if we are talking about the demand for ice-cream): elasticity. This measure is a simple ratio of the percentage change in quantity of a good/service demanded and the percentage change in the respective demand determinant. For instance, own-price elasticity of demand is the ratio of the percentage change in quantity demanded over the percentage change in price of the good in question. If, then, a 10 per cent increase in price leads to consumers buying 5 per cent less of a good or service on a certain market over a certain time period, the value of own-price elasticity will be equal to -0.5. Note that own-price elasticity will be a negative number, as according to the law of demand price and quantity demanded move in opposite directions. Once you have the information about responsiveness of demand to changes in various relevant factors, you will be able to make more informed business decisions.

Determinants of demand for air travel

Now, let us move from the general to the more specific. What determines demand for air travel, and what do we know about it? Firstly, demand for travel is different from demands for many other products and services in one important way – it is derived from demand for other goods and/or services. Whatever the reason for your next trip, the trip itself is a means, not an end. Economists say that demand for travel is derived from demand for other goods or services. As a result, some characteristics of demand for air travel are determined by demand for the underlying activities, from which air travel demand is derived. For instance, demand for flights to holiday destinations from the UK tends to be higher during school holidays than during school term time, and Thanksgiving week is one of the busiest travel times in the US. Nevertheless, demand for air travel is affected by the same factors as demand for any other good or service.

Let us start with price, which is actually not a straightforward concept to define when we talk about air travel. Most people would think about price as the air fare (plus charges for add-on services, such as checked luggage, if you cannot travel with only hand luggage). Economists, however, define the concept of full price of travel differently. For an economist time is, not surprisingly, money. And travel time is therefore also money. Consequently, anything that makes a trip longer increases the cost of the trip, even if the airfare does not change. With this respect, economists define the term schedule delay as the difference between the passenger’s most preferred and the actual departure or arrival time. For instance, once for a business trip to Geneva I had to leave on a Sunday to be at my destination in time for a meeting at 9.00am on Monday (I was based in the UK then). On one hand, I have a strong preference towards spending as much time as possible on a weekend with my family; but at the same time I also prefer not arriving too late on Sunday night. Let us say that my preferred arrival time at Geneva is 9.00pm. As a non-stop flight from Newcastle to Geneva is about two hours; my preferred departure time from Newcastle is 6.00pm (which is 7.00pm Central European Time). The two reasonably priced options for that trip included a non-stop flight leaving at 8.00am (which would give me a departure and arrival schedule delay of ten hours), and a one-stop itinerary leaving at 5:30pm (only 30 minutes of departure schedule delay), but arriving at 10:30pm (which would mean 90 minutes of schedule delay on arrival).

The total price of travel is then defined as the sum of the monetary price (which includes airfare and other out-of-pocket costs) and the disutility of schedule delay. The latter is related to the flight frequency and the passengers’ value of time. While passengers’ preferred departure and arrival times will be different (business travellers might prefer a morning flight for an afternoon meeting and an evening flight for a morning meeting the following day, as an example); higher flight frequency will make it easier to find a flight closer to one’s preferred departure time. Not surprisingly, business travellers tend to have higher values of time, and are willing to pay more to save time and get more convenient flights, as compared to leisure travellers. Returning to my example of a business trip to Geneva, I ended up taking a flight on Sunday afternoon instead of Sunday morning, despite the former being about twice as expensive as the latter. Airlines operating hub-and-spoke networks emphasize high flight frequency and convenience of their services to business travellers, while point-to-point low-cost carriers tend to offer lower flight frequency, often complemented with a lower price (but not necessarily a lower total trip price, when expected schedule delay is taken into account). Interestingly, studies show that on average passengers’ willingness to pay for higher flight frequency exhibits decreasing marginal returns – the passengers are generally willing to pay a higher price premium for the second daily flight than for the third and subsequent services.

How responsive is demand for air travel to the price of travel? According to a study prepared for IATA (InterVISTAS 2007), estimates of price elasticity of air travel range from -0.4 to -2.0, depending on the market definition, area of the world, and length of trip. These numbers mean that a 10 per cent increase in price of travel will on average yield a 4–20 per cent decrease in demand for air travel. Generally speaking, demand for short-haul trips is slightly more responsive to price changes as compared to long-haul travel demand. This can be explained by the fact that on shorter-haul markets travelling by surface transport can be a viable alternative, whereas on long-haul routes surface transport is not an option. Well-developed road and rail networks in Europe can be a reason why demand for air travel in this region is more responsive to price than in other regions of the world. Demand for international air travel is less responsive to price than demand for domestic trips. Interestingly, demand on the transatlantic markets is about twice as price responsive as on the transpacific routes, while price elasticity of demand on the Europe–Asia market is somewhere in between.

Air travel is, not surprisingly, a “normal” good, in the sense of relationship between income and demand. As people become richer, they travel more. Moreover, demand for air travel grows faster than income growth. Looking at the demand elasticities from the above-mentioned IATA study, we see the values range from as low as 1.3 to as high as 2.7. This means that 10 per cent increase in disposable income leads on average to 13–27 per cent increase in the demand for air travel, other things being equal. Economists sometimes call those goods for which demand grows at a faster rate than growth in income, “luxuries”.

Interestingly, income elasticity of demand for air travel increases with the length of haul (it is the highest for the very long-haul flights). Developing economies also exhibit higher income elasticity of air travel demand as compared to developed countries. The latter fact is one of the things that makes industry experts optimistic about the future of commercial passenger aviation in the long run: as income growth has been higher in the countries with higher income elasticities of demand for air travel; economic growth can be expected to generate higher growth rates in passenger numbers globally as compared to what we could expect if developed economies were the ones growing at a faster rate.

The key substitute for air travel is surface transport, including both personal car and high-speed rail. While air travel retains the shortest travel time advantage as compared to surface transport, personal car offers effectively zero departure delay and an added convenience of mobility at the destination, while high-spe...