Airline Economics: Introduction to the Industry and Fundamentals

The airline industry is an enormous business in terms of operating capacity and expense. This means the industry is bulletproof and brings in huge profits annually. Well, no, not really. The airline industry is fundamentally a service operation. In other words, it is a business that does not trade tangible goods, but instead trades a service for money. The industry is responsible for transferring its customers from point A to B along with their belongings. There are many facets to make the airline industry operationally profitable and the business is in no way bullet proof. When the economy is on a downturn, the industry suffers significantly.

Economically, the United States is arguably in a recession. The country has been slammed with many hardships over the past years. The price of housing has dropped, the credit realm has virtually crashed, and the price of crude oil has skyrocketed. All of the above have a negative impact on the airline industry. The daily operations of the industry require many laborers and large capital. The profit margin is relatively low when factoring in the significant amounts of required operational capital.

When considering the current economically sour factors, the price of crude oil has the most significant impact on the airline industry. Other than labor costs, the price of fuel makes up the most percentage of daily operations, which is estimated at around 16% (Airline Economics, 2008). Oil price increases begin the domino effect and lead to higher operations cost for the industry. This of course cuts into the small profit margin and forces the industry to act. Unfortunately, the actions are typically layoffs, job elimination, customer reward reduction, ticket price increases etc.

Shifts and Price Elasticity of Supply and Demand

The airline industry is considered to be a luxury expense for the average flyers budget. Consumers can substitute the luxury of arriving faster with slower alternatives such as trains, automobiles, and boats. Since the price of oil forces the industry to increase the price of a ticket, the demand to fly will naturally shift to the left. The demand to fly reduces with the increases in price.

Airlines house an elastic service in terms of both supply and demand. The demand elasticity displays that consumers respond to a price increase by flying less. A 10 % increase in price may reduce the demand to fly by 20 %. The supply elasticity displays an increase in pricing also increases the supply. When the airline industry is forced to increase prices to compensate for rapid, steep oil prices the industry ultimately takes big profit margin loss.

Positive and Negative Externalities

In order to sustain airline business consumers must purchase airline tickets. This seems like common sense and it is. The majority of people do not consider how heavy externalities affect the market. The U.S. attacks on September 11, 2001 proved how heavy tragedy’s can impact the industry. Tourists virtually stopped traveling via airliners. Tourism is a large cash flow stream for the industry along with business flyers. The business flyers will generally continue to fly regardless of price increases. The industry was affected by the non market acts of the terrorists.

Airlines pollute the air with several hundred pounds of burnt fuel per typical flight. This is a negative externality that is not factored into the market price of an airline ticket. On the contrary, a positive externality is the benefit that these large machines provide for the American population. Having the ability to cross the country in several hours is at least a phenomenon of the century. Having the ability to travel rapidly is a luxury and a positive externality of the airline industry.

Perhaps a better idea of positive and negative externalities can be provided with a scenario. A massive Earthquake erupts in Mexico. A U.S. airliner has the ability to provide assistance very rapidly. The fast response is a positive externality. The Mexican citizens will benefit from the U.S. fast response. On the contrary however the general public must suffer from the noise and pollution the airliner ejects. This noise and pollution is a negative externality of the airline flight.

In terms of externalities the industry has its share of both. The best thing to remember and understand is the fact that the industry is heavily impacted by market conditions. When the markets are stressed the airline industry is almost guaranteed to fluctuate.

Wage Inequality

Like many other market industries, the airline industry is a competitive market. This means the industry must beat out other service provider’s right? In an effort to do so the industry must maintain low ticket prices. Understanding the high overhead costs of operating an airline business it is not hard to conclude that airline businesses must cut overhead costs somewhere. Recalling that labor is the highest expense item what else is the industry to do but cut wages?

Flight attendants and pilots have often felt the pain of wage cuts. This is one reason the airline industry is very unionized. In an article published by Associated Content, David Card is said to have calculated the wage inequality of the industry.

According to David Card (Deregulation, 2008) airline wages have decreased some 10 % since the deregulation act of the 1970’s. The Deregulation Act sparked the competitive markets and helped evolve the industry into what it has become. The labor wages have no doubt sacrificed along the way. It is all about competition in the free marketplace. It seems unfortunate, but wage inequality is business. It is tough to understand sometimes, and it is tough to justify at times. The bottom line though is competition requires unfortunate business decisions.

The airline industry is considered to be an old fashioned oligopoly. The business prospers by working within a parameter based group. The “big dogs” will sustain business longer than the relatively small guys.

Monetary and Fiscal Policies

It is not logical to discuss monetary and fiscal policy without elaborating on the September 11, 2001 affects. The attacks caused a rapid shift in demand due to the fear of flying and the increased ticket prices. The U.S. government also raised the security standards adding additional cost to the industry. The September 11th security tax fee was also added to the base ticket price. This tax was an effort to sustain the new security standards. September 11, 2001 caused massive layoffs in the airline industry. This again, was a result of flight fears, and fiscal policy adding to the ticket price increases.

As frequently noted economic conditions and policy have large impacts on the airline industry. When markets are stressed, the airline industry suffers dramatically. The industry is very elastic. With such elasticity, high overhead costs, and operational costs the industry struggles to maintain adequate profit margins.

Ticket consumers are the heartbeat of the airline industry. When ticket prices rise to accommodate unexpected expense increases the industry as a whole suffers. When the government imposed the September 11th security tax the industry took another blow at the time. However, since ticket consumers have since realized that the tax increase was for the ultimate benefit of the consumer, the ticket sales have significantly picked back up.

When the U.S. is economically sound the airline industry prospers from the buying confidence and power of the consumer. Vacations pick up and the demand for flight increases. The fact that airliners depend so heavily on market conditions may assist some arguments on whether or not the industry is even stable. Overall, the industry has not been around all that long relative to other industries. The Wright Brothers begin this flight evolution in the early 1900’s.

When considering the history of the industry and how it has maintained its presence it is easy to see why the industry is relatively unstable. The flight phenomenon is really just now in the ‘teenage’ years. Postal services, military needs, and government needs really started the wide array of flight demand. The industry was under heavy regulation for many of its infant years. In 1978 the Deregulation Act came into play and initiated the next chapter of the industry.

The airline industry has been evolving for several years now and will continue to evolve. There have been many airline business launches, and many airline business failures. Once the current sour economic cycle completes, the “top dogs’ will be at the top and continuing business.