Price Wars: Airline Industry Pains and Gains

How can one of the largest air carriers in Europe also be one of the worst airlines? What is this mass air passenger syndrome of voluntary and repeated self-inflicted pain?

How can a ticket price for a certain destination vary between £50 and £1000? How much do airlines gain from your fare? How much does a flight actually cost the carrier?

The airline industry often contradicts itself. It is large, it contains multitudes.

To try and overcome these mind-crunching conundrums, we’ll take a look at the history of commercial airlines. This will help us gain a better understanding of the phenomenon of low cost carriers (LCCs) which has successfully and fully transformed air travel. The love-hate syndrome affecting millions of passengers and the ticket price variations are simply a consequence.

 

Aviation Background: How did low cost carriers (LCCs) appear?

The first commercial flight

1914 - the first scheduled commercial flight took its first passenger, Abram Pheil, across Tampa Bay in Florida, USA. The 34-kilometer flight took 23 minutes and was witnessed by a cheering crowd of over 3000 enthusiasts. The ticket was auctioned off to the local businessman for $400 (equivalent to nearly $10,000 today).

Flying was a slow, dangerous and extremely expensive feat!

 

A Boeing B-314 taking off from the water.

 

The half-a-million US dollars plane

1939 - Pan American inaugurated the world's first transatlantic flight between New York and Marseilles, France.

Passengers flew on the legendary Boeing B-314 flying boat which cost $550,000 and could transport 74 travellers. Scheduled flight length was 29 hours and passengers paid $375 (equivalent to $6,800 today) for a one-way trip across the ocean.

It was the time of wicker chairs, silverware and crystal.

 

The era of mass air travel

1950s - After World War II commercial aviation grew rapidly. One in five Americans had flown on a plane.

The transatlantic route quickly became the world's number one route in terms of number of passengers and revenue. This led to fierce competition among several major international airlines, including the European Royal Dutch Airlines (KLM), Air France, and Swissair.

Two-class planes appeared. 

Prices: a round-trip New York – London cost $500, roughly equal to $5500 today.

 

Deregulation boosts competition and lowers prices

1970s - the Civil Aeronautics Board set minimum fares and issued routes. Flying was still for the well-off. A few airlines dominated the market and competition was based not on prices but on onboard service extras and food.

1978 - United States Congress passed the Airline Deregulation Act. Fares and routes were no longer under federal government control. New start-up airlines could enter the market.

Prices fell (as much as 50% within 30 years) and the number of tickets sold and seats filled increased (from 57% in the 1970s to over 80% today).

1990s - the liberalisation of the market spread around the world.

 

The Southwest Effect

The emergence of budget carriers, like Southwest Airlines, generated the following phenomenon, still occurring today:

  1. A new start up airline enters the market adding new supply. They offer prices that are dramatically lower than the fares of established major airlines (which typically enjoy near monopoly in the community).
  2. Established carriers lower their own fares to remain competitive. This affects their profitability.
  3. Demand for air transportation in the community grows for all airlines boosting revenues.

So as a result of the LCCs, we have more travellers flying on more and more planes paying cheaper and cheaper fares.

 

The Price War is on!

Today air travel is seen as commoditized and brand loyalty among customers - as rather low. Therefore, competition is price-based, not quality based.

 

Passenger numbers grow

The number of air travellers has grown from 0.3 billion in the 1970s to over 4.2 billion in 2018 (more than half the world's population last estimated at 7.7 billion).
A chart representing the number of air travellers.

Fares fall

Ticket prices are a fraction of what they used to be! Remember the $5500 ticket for the London-New York round trip in the 1950s? Round-trip prices today start at $300.

Meanwhile, Ryanair advertises international flights UK  to Spain starting from €7.89.

 

New business models emerge

In an attempt to remain competitive, some of the largest carriers have introduced the Basic economy fare. The cheaper tickets offer less flexibility - no changes, refunds or advance seat assignment.

 

Ultra low-cost carriers have also made their entry. They offer the so called ‘bare fare’ plus frills control - baggage allowance, advanced seating or refreshments are offered a la carte, each for a price.

The cost cutting/ no frills model of LCCs leaves some passengers unhappy.

No more wicker chairs or silverware. Only 76 cm of legroom, no food, no seat-back pockets, no compensation for missed connecting flights (each booking is separate). This may perhaps help explain why Ryanair appears in both ‘The largest airlines’ and ‘The worst air carriers’ rankings.

 

Collateral damage

Competition is definitely ferocious! Fares are going down. And so are some airlines!

Survival of the fittest rules: weaker players suffer and die out in bankruptcies and mergers, which leads to market consolidation. 

 

Example: One of the USA's oldest air carriers - Northwest Airlines Corp. ceased to exist in 2010 and was merged with Delta Air Lines. US Airways merger in 2013 created American Airlines - the largest carrier in the USA and ultimately the world!

Generally, between 2005 and 2015 mergers between 9 air carriers created 4 major US Airlines controlling 84% of the US market today. How does this affect competition and prices?

 

A graphic showing the domestic market share of leading U.S. airlines.

 

North American airlines work at the greatest (net post-tax) profit margin of 5.5% in 2019, says International Air Transport Association (IATA) Annual Review. Compare this with 3.7% for Europe, 2.3% for Asia-Pacific and negative numbers for the Middle East.

 

These margins seem rather slim!

Can airlines actually afford the low fares you see in your search results? And why do prices fluctuate so much?

 

Airline economics: How does flight pricing work?

Flight operating cost or How much does a flight cost an airline?

The answer would depend on a number of factors, like destination, aircraft capacity, load factor, etc.

What is clear however is that your airfare covers plane price, maintenance and insurance,  airline operational expenses, airport costs, taxes, fuel, and staff costs.

Here’s a popular WendoverProductions video breakdown of the basic costs included in a $70 flight in the USA:

 

  • Taxes - 9% of the ticket cost cover Domestic passenger ticket tax, 8% cover 9/11 security fee, and a further 6% - a domestic flight segment tax (about 23% in total)
  • Maintenance costs - Maintenance inspection 6%, labour - 6%, parts - 3% and engine restoration - 6% (about 21% in total)
  • Takeoff and landing fees - about 19%
  • Aircraft cost and amortization - 17% of your ticket cost
  • The cost of running an airline - 14% 
  • Fuel cost - 4% of the ticket price
  • Staff costs: pilot and crew - only 2% out of your $70

 

A circular graphic representing the costs in a domestic flight.

 

The numbers however vary widely depending on the type of flight (short-haul or long-haul), type of aircraft, and even the business model of the airline.

What is clear however is how much profit airlines make per passenger on average. According to the data in the recent IATA report profit per passenger is expected to decline in 2019 to $6.12 (from $6.85 in 2018).

 

How do airlines price tickets? 

Today airfares are not actually based on seat cost (expenses, fuel and taxes) but on a strategy called Airline Revenue Management. The goal of this strategy is, of course, to maximise profits.

How does it work?

When you go online to book a flight, the price displayed on your screen is based on a wide range of factors like: past bookings, remaining capacity, average demand and probability of selling seats later. This Dynamic pricing model exists today thanks to modern technology.

The difference in prices is also related to the fact that airlines profile their passengers into two categories: leisure and business travellers.

 

Leisure travellers usually fly to holiday destinations (say the Canary Islands) and they book months in advance. Therefore, prices start high and then they fluctuate according to demand and rate of filling capacity.

 

Business travellers, on the other hand, travel to destinations like Hong Kong and they book last minute tickets so that the flight can fit their busy schedules. What is more, business travellers are less price sensitive as their employer foots the bill.

In this case, initial prices are low to fill minimum capacity and then they go steeply up in the days before departure.

 

What is interesting is that marketing staff can manually adjust these for special events like Championship finals, for example. It’s the simple rule of supply and demand. Therefore, a plane fare for a certain destination may well be priced at  £50 during the low capacity winter season and £1000 for the sports finals.

Dynamic pricing allowed full service airlines to introduce ‘basic economy fares’ to compete with LCCs by appearing at the top in search engine results like Google flights.

 

Airline economics: Budget VS Full service carriers

Low cost carriers’ strategy: How do LCCs cut costs?

At the start of 2019 the leading carrier on the US market and the world's largest low-cost carrier, Southwest Airlines, announced its 46-th consecutive year of profitability.

How do they do it?

In general, budget airlines use the following tricks to cut costs:

 

  • Fuel hedging - Airlines sign contracts locking in the current fuel price for months ahead. This means that if the price goes up, the carriers will keep paying the lower price for the term of the contract. However, fuel hedging may have a negative effect on profitability if fuel prices go down.
  • 1-type-aircraft fleet - This helps cut maintenance costs. The airline needs to stock parts for only 1 model, pilots and staff in general are trained for this model only.
  • Smaller airports - Smaller underutilized airports have lower airport fees. Busy airports sell landing slots and these can be outrageously expensive. Back in 2016 Oman Air bought from Air France–KLM a pair of take-off and landing slots at Heathrow Airport - highly prized early morning arrival - for $75 million!
  • Short-haul flights - Short distance flights mean that a large number of flights can be fit into the schedule. Generally the less time the plane spends on the ground, the more profit it makes.
  • Direct sales - Budget airlines managed to cut out the middleman. This means that your ticket price does not include the travel agents fee as you book it through the low cost’s call center (in the early days) or the internet (today).
  • Lower salaries - According to data Ryanair spends less than 10 percent of turnover on staff costs.

 

How do Full service carriers work?

Meanwhile, the legacy airlines use the hub & spoke model. They develop a central hub (usually a large airport which attracts a large volume of passengers) and multiple spokes to various locations in the region (spokes that attract a smaller number of passengers usually use smaller aircraft).

 

Developing a hub is expensive as are landing slots at large airports. Full service carriers typically offer flexibility (upgrades, itinerary/routing and seating changes), as well as frills (meals, private lounges, wi-fi and inflight entertainment). These translate into additional costs.

 

Airline industry issues: Why do so many airlines go bust?

Recently, IATA downgraded its 2019 outlook for the global air transport industry from $35.5 billion forecast in December 2018 to a $28 billion profit. The reasons according to the International Association were slowing demand and rising costs.

Unfortunately, these two simple reasons may prove fatal for weaker airlines (they did for WOW Air, Germania and Adria Airways) or troubled travel companies, like Thomas Cook.

 "Bankruptcy" and "Law" words placed on a Scrabble game board.

 

So what are the main reasons for airline demise in general?

  • High fixed and variable costs

    Aircraft are extremely expensive which means large lease or loan payments. For example, a Boeing MAX 200 costs close to US$125M.

    This is why the first airlines were typically flagship carriers, like British Airways, for example.

    Generally, airlines have high fixed costs (expensive aircraft and maintenance) and lower variable costs (fuel and salaries). This is why they typically try to spread the costs over many airline tickets using the economy of scale principle. The more passengers you manage to get flying on the plane, the better. This model also means larger companies manage to offer lower prices (Imagine Tesco fighting a price war against your local around-the-corner grocery store).

     

    So we end up with a few very large companies that dominate the market and have the market power (to set prices). Such oligopoly conditions make it very hard for new start-up airlines to enter the market.

    However, after deregulation and the emergence of LCCs, prices fell so low that they sometimes covered only the variable costs. This means that fixed costs (such as aircraft loans) remain unaccounted for. In the long run, this leads to bankruptcies and mergers.

     

  • Unprofitable airlines continue to fly

    Why? The reason is that an airline bankruptcy means the loss of thousands of jobs as well as millions of losses for the airline’s creditors. In the case of large carriers like Indian Jet Airways, there are political reasons too.

    What makes things even worse is that suffering airlines use cut throat prices to try and fill seats, which affects stronger competitors as they lose their pricing power.

     

  • Oil price

    You are probably somewhat mystified by the constant fuss about the price of fuel!

    As already stated, a lot of airline costs are fixed. This is why changes in variable costs, like fuel, have a great effect on profitability. According to the IATA report, fuel makes up 25% of airline operating expenses. This is why it affects not simply prices but also the profitability of airlines as a whole.

    The expected average cost for 2019 is $70.00/barrel Brent, which is 27.5% higher than the $54.9/barrel Brent in 2017.

     

  • Overcapacity

     Overcapacity means there are too many airlines offering too many seats to the same destination. What is more, summer is typically high season yet the period from September onwards is rather tough for air carriers. This is why air fares in the winter are usually considerably lower following the supply and demand principle.

    Slower demand means that some of the weaker airlines cannot get enough bookings for the winter. This, naturally, affects their profitability and ultimately their chances for survival in the Fare war.

 

Three black dots divider.

EasyJet’s founder Stelios Haji-Ioannou sums it all up in the BBC documentary on LCCs: ‘Every airline, at the end of the day, goes bust because it buys one aircraft too many that flies one unprofitable route’ .