European airline industry

Introduction

"Air travel remains a large and growing industry. It facilitates economic growth, world trade, international investment and tourism and is therefore central to the globalization taking place in many other industries."[1] Due to these dynamics, air travel has become a necessity in the modern world and with attractive opportunities the industry is one of fierce competition that has seen many changes across the years. One segment of the industry that has seen much change is that of the European Airline Industry. "Government deregulation in the 1990s and an 'open skies' agreement with the USA in 2007"[2] has seen the two main airline sections; main international carriers such as British Airways and low cost, budget carriers like Ryanair, change their strategies to adapt to these regulations. (see appendix 1) As well as this, the tragedy of September 11th and the economies effect on oil prices has seen many airlines across Europe fall into liquidation. With such heavy competition, international aviation rules and the current state of the economy, really how attractive is the European airline industry?

Analysis

To gain a better overview of the European airline industry and its attractiveness, an external industry analysis can be performed. Many new business and even existing firms that are looking to enter a new industry perform such analysis, often to examine "the dimensions of the business environment and how they shape and influence business activity."[3] Apart from the overall conclusion of whether or not to enter the industry, such examinations can give results that affect and influence the competitive advantage of the organisation. One such model that directs great focus on this area is Michael E. Porter's 'Five Forces' analysis. Shown diagrammatically in appendix 2, the 'Five Forces' model "sets out to identify those factors which are likely to affect an organisation's competitiveness. This then helps a firm choose an appropriate strategy to enhance its competitive opportunities and to protect itself from competitive threats."[4] There are many other types of industry analysis tools and models that are regularly used, all like the 'Five Forces' model, providing an outcome that will help the business in specific areas. These models/tools include; Industry Life Cycle Analysis, Strategic Group Analysis and PEST analysis. All these types of analysis tools are useful and credible in helping to provide a greater insight into an industry but the analysis tool that is going to be used in this report on the European airline industry, is that of Porter's 'Five Forces'

Threat of New Entrants (Barriers to Entry)

In his 'Five Forces' model "Porter argued that there were seven major sources of barriers to entry."[5] All have been applied to the European airline industry below:

Economies of Scale

To compete with the strong presence of economies of scale within the European airline industry would be though for any new entrant. With most airline companies being substantially large organisations, "any new entrant has to come in on a large scale in order to achieve the low cost levels of those already present."[6] With the economy in the way it is, demand is at its most for cheaper ticket prices. Economies of scale are a fundamental aspect that most airlines within the industry rely on to drive down ticket prices. To compete on this price level, any new entrants will struggle to develop the economies of scale needed in a small duration of time. As mentioned in the introduction this industry can be split into two main airline sectors, international and budget that both use economies of scale to there advantage but in different ways. International carriers for example use the 'hub and spoke' method, Richard Lynch explains, "with the 'hub and spoke' strategy of the main international carriers, one of the main benefits come from the economies of scale that derive from full loads over long distances."[7] Within budget airlines, Ryanair for example, will use their large scale to barter and drive airport fees of smaller 'out of town' airports down through the attraction of the custom and revenue the airline will bring.

Product Differentiation

"The European airline market can be broadly divided into two main market segments - business customers and leisure/domestic customers."[8] Again relating to the large international and budget carriers, this notion of business and domestic has substantial significance on product differentiation with the industry. Taking British Airways and Ryanair again as examples, BA as a strategy compete with rival airlines on the quality of serves they offer, attracting a strong business clientele. Ryanair on the other hand with there 'budget' notion, compete with their rivals on price, often meeting the needs of leisure and domestic customers. Both of these are prime examples of product differentiation that new entrants will struggle to match on a competitive level. Another major product differentiation within the European airline industry is that of "customer loyalties which stem from past advertising, customer service, product differences, or simply being first into the industry."[9] Founded in 1974, BA is a prime example of an airline that has a strong customer loyalty and by offering loyalty schemes and rewards helps them hold this competitive advantage. As a barrier to entry, loyalty is best described by Porter as "forcing entrants to spend heavily to overcome customer loyalties."[10]

Capital Requirements

In order to start an airline in Europe large start up costs have to be encored, making capital requirements a hugely influential barer to entry. In order to compete with the customer base and loyalties expressed in the previous section, advertisement is common initial practice and vital to any new entrant to the industry. This in itself is not only a great expense but can also be seen as risky, putting further pressure on the new entrant. Capital requirements again relates to the current demand for cheaper ticket prices. With the large capital requirements needed for an airline start up, a firm could struggle to be able to offer low ticket prices if a large debt is in place. Of course capital requirements will not be an issue to any new entrant if substantial money is available to cover all start up costs, but as Porter explains, "even if capital is available on the capital markets, entry represents a risky use of that capital which should be reflected in risk premiums charged the prospective entrant."[11]

Switching Costs

As portrayed by Porter, "a barrier to entry is created by the prescience of switching costs, that is, one-time costs facing the buyer of switching from one supplier's products to another's."[12] For the European airline industry the aspect of switching costs is a rather mix bag as it can be argued that costs of the main products differ between them selves. One aspect that heavily effects the switching costs is the bargaining power of the industry's suppliers, examined fully further in the report. To help examine switching costs as a barrier, it is useful to spit the products that are potentially 'switchable':

Fuel

With product differentiation being low in fuel, airlines have the choice to switch and chose between suppliers with small costs. "Aviation fuel is largely undifferentiated; one supplier is as good as another, and in most locations there are few switching costs - all suppliers offer similar products."[13]

Planes

For a new entrant buying a fleet of planes the switching costs is nonexistent due to the fact that there has been no switch. As Haberberg and Rieple explain switching costs occur only for existing airlines that maybe have to switch between the two main suppliers, "switching costs are high, since a fleet consisting solely of Boeing or Airbus aircraft is far cheaper for an airline to maintain than a mixed fleet."[14] One aspect that affects this mixed fleet costing is the ability and skills of the staff using the products, "switching costs from one supplier to the other is high because all mechanics and pilots would have to be retrained."[15]

Access to Distribution Channels

The two main distribution channels for airline tickets are through travel agents or direct through the airline itself. Throughout the years the European airline industry has witnessed several changes in the popularity between these two types of channels. As George Williams explains in his study, one of the major causes of change was the deregulation rules enforced in the 1990s. "Prior to deregulation rules the majority of passenger made their reservations direct with an airline. With the new increase in options available to them, given the freedom of carriers to operate any route, travellers increasingly turned to travel agents for information and independent advice."[16] This then created a rather large barrier to entry as airlines had to ensure travel agents sold/distributed their tickets. Larger well established airlines often used there reputation and bargaining powers to secure distribution with the agencies that smaller less established airlines could not compete with.

Although travel agents still hold a respectable percentage of distribution for airlines, increasing more customers are reverting back to the pre deregulation trend of booking direct. "In recent years direct selling has become more and more significant as traditional airlines have supplemented direct selling through sales shops and call centres with an increased emphasis on web-based business. New airlines have appeared which largely or totally ignore the travel agency industry.[17] One such example of this type of airline is Ryanair who through there website[18] offers unique promotions to customers. Apart from the method of selling the tickets, it can be argued that the airports that airlines use is also another type of distribution channel. Porter explains that a barrier to entry is created when "logical distribution channels for the product have already been served by established firms."[19] In relation to airports then this means the taking off and landing slots offered by them. Agreed by Williams, he explains that "the rights of incumbent airlines to take-off and landing slots make it extremely difficult for new entrants to establish flight schedules at attractive times of the day."[20] Ryanair again are a prime example of an entrant that overcame this barrier by instead of competing for such thing at major hubs with larger established airlines, fly to smaller rural airports where the activity they will bring allows the company to demand such services.

Cost Disadvantages Independent to Scale

One major barrier to the European airline industry that cost disadvantages independent to scale brings, is that of the number of established airlines. As Porter explains, one major effect of this is that "established firms may have cost advantages not replicable by potential entrants no matter what their size and attained economies of scale."[21] For example, airlines such as British Airways have inputted lots of money into such things as research that has allowed them to establish strategies to costs that new entrants may not have discovered. One major resolution to such problem for new entrants is to merge with already established airlines. Mergers and strategic alliances will allow airlines in this industry the opportunity to perform such things as "working together on a project, or sharing information, or even sharing productive resources."[22] This strategy has been used by many airlines, shown diagrammatically in appendix 4.

Government Policy

Due to such government acts on the industry like deregulation, government policy is now a lower barrier to entry for the European airline industry. Before deregulation was in place the government had huge powers over the industry, in forcing such rules as "new airlines were prevented from entering markets, existing companies could not simply offer flights into or out of any airport of their choice, routes could not be poached and prices for pacific routes where fixed."[23] Although such new rules have lowered their effect, the government still have sufficient inputs to the industry. Throughout a substantial amount of industries there is an increased pressure from governments on their effect on the environment. This is ever so apparent on the European airline industry, with government changing rules on such things as tax, reported by the BBC in 2007, "Air taxes will be switched from individual passengers to airline flights to encourage more efficient use of planes."[24] This of course creates the argument then that changing taxation could increase ticket prices making it "unfair to poor holidaymakers and fail to make planes more efficient."[25] As well as holding power of such policies to taxation, current and new airlines will have to co-operate with other government impacts on such things as fuel prices, regulations to customer rights and health and safety.

The Bargaining Power of Buyers

Customers within this industry have a large amount of buying power. "Buyer power is the extent to which and industry's customers have the power to dedicate prices, quality standards and other terms and conditions to the firms that are supplying them."[26] One major aspect that customers have a huge impact on, increasing so with the state of the economy, is the price of tickets. As mentioned previously airlines are finding it tougher and tougher to try and absorb such things as fuel costs without impacting the price of tickets. What this has seen is due to air travel being fairly undifferentiated, customers switching between airlines in accordance to ticket prices.

This effect on the industry has in fact for the budget airline section of the market, created increased business opportunities. Relating back to the theory that, "The European airline market can be broadly divided into two main market segments - business customers and leisure/domestic customers,"[27] industry research has show that business customers are recurrently switching to lower fee, budget airlines. Easyjet and Air Berlin for example have seen this and taken it as an opportunity to offer cheap flights for business purposes as Lynch illustrates, "Easyjet and Air Berlin have a deliberate policy of flying to main airports, even if the landing fees are higher. The aim is to attract business travellers, particularly those who need to save money such as small business men and entrepreneurs."[28]

Never less it can be argues though that will the increasing necessity of air travel in the modern world, airlines will always hold some form of power over its customers.

The Bargaining Power of Suppliers

The power of suppliers can be seen as crucial to the success of any business within an industry. "Suppliers can exert bargaining power over participants in an industry by threatening to raise prices or reduce the quality of purchased goods and services."[29] Much like with the switching costs between suppliers, the power they have within the European airline industry is one that can be argued from both sides. To help demonstrate this argument clearly the main supply of products has been examined below:

Fuel

Although there is no substitute to fuel and its necessity to the industry, with a wide verity of suppliers to chose from, power for this product is arguably low. As mentioned earlier suppliers of this product offer similar products, "aviation fuel is largely undifferentiated; one supplier is as good as another."[30] What this allows then is for airline companies to shop around forcing the suppliers to have to work hard to win custom. Another factor that lowers the power of suppliers of fuel is that the price of this product is directly related to the price of another, in this case, oil. With the price of oil freely available to everyone, aviation fuel suppliers are somewhat restricted on how much they then charge for their product.

This notion of fuel being linked to the price of oil in fact creates the argument that fuel suppliers do indeed have large bargaining powers. To avoid passing fuel costs to the customer in the form of ticket prices, it is vital for airlines to maintain a good relationship with its fuel supplier to ensure that supply price is maintained. Now days fuel suppliers can compete on such things as the way they offer financing on fuel, giving them greater power. Some suppliers are showing such power that in May 2008 it was reported that a 'cash up front' demand was set, "Sources within the airline industry indicate that credit is being denied to most of the leading American carriers and the practice is moving to Europe and Asia. So uncertain is the cash solvency of the industry that jet fuel suppliers insist on prepayments into special bank accounts."[31]

Planes

With only two main choices of plane manufactures, Boeing and Airbus, to choose from in the industry, the power of the suppliers is high. In industry situation like this "suppliers can be powerful if they are relatively few in numbers and their inputs are vital to the finished product." Competition between both suppliers is large, both battling to secure orders and get as many planes into the market as well as attempting to better ones product through improved technology and greater advantages to end uses.

Again though like fuel with its necessity to the industry and with just two main plane suppliers, it can still be argued that the power these suppliers have is low. Both Boeing and Airbus are subject to the economies of airline production. These suppliers "have to get a high volume of orders if they are to recover the high costs of developing new aircraft. This gives the airline companies a greater deal of power of their suppliers."[32] Selling there aircraft and securing orders then is vital to suppliers, something that can be exploited by airlines. Such example can be seen with Ryanair over Boeing, "Irish budget carrier Ryanairis threatening to cancel or defer aircraft orders from Boeing, and temporarily stem its growth, if it fails to secure a fleet-renewal agreement this year." This need for one another also irradiates the power Boeing and Airbus have in regards to passing credible threat of forward integration. It is unlikely for example that Boeing would offer flight service on top of building planes.

Airports

Another major supply other than products like planes and fuels is the services (parking, runway and air traffic control) that airports offer. This type of supply is split in two ways, large inner city airports and smaller out of town airports. Both of these types have different power over the airlines that wish to use them; larger inner city airports have huge bargaining power as these are generally popular destinations and hubs where as smaller regional airports have small power as they need the custom that an airline will bring. As mentioned in a previous section, Ryanair is a prime example of an airline that often barters with smaller airlines as it is well known that they will help increase utilisation of the airport. Both though arguably have a certain amount of power due to the fact that like planes and fuel, they are necessities to the airlines.

The Threat of Substitutes

For the European airline industry substitutes that currently stand in place are other popular public modes of transport such as Train, Car, Bus and Boat. As a generality the substitutes for air travel will never be able to compete with such factors of speed and price of a journey by plane. Like most aspects though this can be argued. Porter explains that, "identifying substitute products is a matter of searching for other products that can perform the same function as the product of the industry."[33] This theory then opens up the case that with the increase of high speed train travel, this substitute is largely becoming a competitor to air travel. Not only can train travel 'perform the same function,' in certain journeys it betters the function of air travel. One prime example of this is the new Euro Star service out of StPancras. This new service offers travel to destinations around Europe at low prices and justified journey times, competing then on both price level, avoiding long check-in procedures and the convenience of travelling to a central destination instead of suburb locations as used by Ryanair. In order to compete with this new competition, airlines have implemented new business functions to avoid customer switching such as car rentals, hotel packages and new motions to try and majorly reduce the check in times for passengers, all additionally adding competitive advantage over existing airlines.

This new threat of plane vs. train again relates to the effect of increased fuel prices. European airlines may struggle to lower their prices to compete with trains at the risk of effecting profits in relation to the cost of fuel. With overall journey time and location being addition aspects to price, budget airlines could see planes' not being filled at full capacity witch is essential. One aspect though of travel that airlines will arguable always dominate in is long haul. Applying Porter's theory of substitutes to long haul travel results in little competition.

Rivalry Among Existing Firms

Shown throughout this report, competitive rivalry is strongly present within the European airline industry. Relating back to the notion of business and domestic customers, the industry is split between competing on quality and competing on price. Before the release of prices deregulation brought to the industry, all airlines where reducing to competing on things other than price. Now budget airlines use price as there main competitive advantage, pushing out many companies from certain routes. Much like deregulation has effected rivalry in the industry, the new 'open skies' agreement also brings a whole new competitive aspect. With budget airlines now free to fly to destinations in the USA, this brings the "likelihood for much greater competition on long-haul transatlantic flights."[34] Although generally competing on only two aspects, rivalry and competition is reduced in this industry by such factors of brand awareness to airlines and the strong presence of customer loyalty, often resulting in the industry earning low rates of returns. To help counteract this, the notion expressed earlier in the report of maintaining good relationships with suppliers, will give airlines the chance of obtaining lower prices than competitors.

Industry Conclusion

Merging

"The outlook for the air travel industry is one of strong growth. Forecasts suggest that the number of passengers will double by 2010. For airlines, the future will hold many challenges. Successful airlines will be those that continue to tackle their costs and improve their products, thereby securing a strong presence in the key world aviation markets."[35]

It can be seen that strong and bold strategies are the only way forward for Europe's leading airlines.

Airlines face at least 3 major new pressures:

  1. Rapidly rising fuel costs - Difficult to recover through ticket prices
  2. More competition on existing profitable long haul routes- Through new government deregulation.
  3. Air travel's impact on world resources and environment - Consumer and government pressure to reduce the number and duration of flights.

Critical Comments

Although due to....is a justified reason for using the five forces model as an analytical tool on the airline industry, there are some criticisms to Porter's theory.

References

Bibliography

  1. http://uk.reuters.com/article/idUKTRE5AG17T20091117
  2. http://adg.stanford.edu/aa241/intro/airlineindustry.html
  3. http://business.timesonline.co.uk/tol/business/industry_sectors/transport/article4004371.ece may 2008
  4. http://books.google.co.uk/books?id=3lyGANL8TqkC&pg=PT103&lpg=PT103&dq=aviation+fuel+suppliers+switching+costs&source=bl&ots=LkJosQ8KNx&sig=ZzgYSffNePX-3Yf6FnFZd_3EnVQ&hl=en&ei=Cw4RS42HItLRjAfi8I3JAw&sa=X&oi=book_result&ct=result&resnum=1&ved=0CA8Q6AEwAA#v=onepage&q=aviation%20fuel%20suppliers%20switching%20costs&f=false
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  6. http://adg.stanford.edu/aa241/intro/airlineindustry.html
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  14. Porter, Michael E. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors. Free Press, New York.
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  22. Shaw, Stephen (2007) Airline marketing and management. Ashgate Publishing Ltd.
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  26. Porter, Michael E. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors. Free Press, New York.
  27. Sloman, J and Sutcliffe M (2004) Economics For Business, 3rd Edition, Pearson, Essex.
  28. Thompson , John L. (1993) Strategic Management: Awareness and Change. Taylor & Francis.
  29. http://news.bbc.co.uk/1/hi/england/london/7036384.stm
  30. http://news.bbc.co.uk/1/hi/uk_politics/5253444.stm
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  34. Porter, Michael E. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors. Free Press, New York.
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