University of California
Type of paper: Thesis/Dissertation Chapter
Us Airlines 5 Forces Industry Analysis
In the airline industry, the threat of new entrants is low. High barriers to entry make it difficult for new firms to enter the industry. There is however two aspects that raise the threat and should not go unmentioned. First, a low switching cost for customers makes the entry into the market more lucrative to outside firms. Second is the lack of proprietary technology and product differentiation. Planes are either manufactured by Boing or Airbus, picking between a seat on United’s 747 and Southwest’s 747 doesn’t make much difference to the buyer. Both aspects make entry into the market appealing but as I will discuss below, entry may be easy at is more difficult than it looks and is proven by the 43 airline firms that have entered and exited the industry since 1994.
Although switching costs are low, high ticket prices influence buyers to be more brand loyal, opting to purchase from companies they recognize and trust. Furthermore, the creation of the so called “hubs” has forced regional carriers to operate out of smaller domestic airports. Cutting off access to the large distribute networks (airport gates at large international airports) has forced regional carriers to either leave operate solely out of small regional airports or pay an extremely high cost for leasing a gate. Delta’s control over Atlanta and United’s over Denver are prime examples of how national carriers dominate regions and force smaller carriers out. High capital requirements and economies of scale are also required to properly access the market, the cost of establishing one hub can costs hundreds of millions of dollars and most national carriers (Delta, United) have multiple around the country. The “Open Skies Agreement” also emphasizes the need for large economies of scale. Decreased barriers to entry into the US market will soon catch the eye of global airlines like Lufthansa and Emirates who will then look to capture a share of the US market. Lastly, barriers to entry become even more challenging when existing airlines have shown that they are willing to retaliate against new entrants.
THREAT OF SUBSTITUTE PRODUCT/SERVICE
The threat of a substitute product/service in the airlines industry is low when referring to medium and long haul flights (>500 miles) and medium when referring to short-haul flights (<500 miles – Southwest flights).There are multiple substitutes in the airline industry and consumers can choose other forms of transportation such as a car, bus, or train. There is however a cost to switch. Some means of transportation can be more costly than a plane ticket. The main cost is time. Planes are by far the fastest form of transportation available.
It is also important to take into consideration that there are two types of travelers and each has a different view towards substitutes. For the convenience, time-oriented business traveler price is irrelevant and time is the most important factor. For this type of traveler, the threat of a substitute is very low, the time to travel by car or train is much more expensive then it is to pay for a plane ticket. For the price-sensitive leisure traveler, short-haul flights could become susceptible to substitutes. Large families may opt to drive when the savings in price are viewed as more important than the savings in time.
The rivalry among existing players in the airline industry is high and very cutthroat. As shown in the Southwest Airlines case study, the industry is consolidated, exit barriers and fixed costs are high, and there is little differentiation in the product (service differentiation does exist).
Mega-mergers involving Delta/Northwest, Continental/United, and American/US Airways have consolidated the industry over the past few years and has intensified the rivalry among existing competitors. The three firms battle intensity over the convenience, time oriented business traveler, while smaller carriers like Jet Blue, Southwest, and Allegiant battle over the price-sensitive leisure traveler. Large investments in equipment and long lease agreements with airports increase barriers to exit making firms more likely to battle for market share instead of backing out of the industry altogether. The airline industry’s extremely high fixed costs (80%) make it one of the worst net operating margin performers when measured against other
industries. This high fixed costs structure increases rivalry and causes airlines to invest heavily in developing tools to maximize capacity utilization (“Load Factor”). With only two global airline manufacturers (Boing & Airbus), differentiation between products offered by competitors is very low, leaving firms to differentiate via services (booking, boarding, baggage check, and in-flight services).
POWER OF SUPPLIERS
The power of suppliers in the airline industry is moderate. The main factors contributing to a moderate power of supplier is that there are only two global suppliers (Boing & Airbus) in the airline industry. With no alternative supplier, airlines become susceptible to suppliers maximizing profits and spreading increased costs downstream. Although airplane manufacturing is a highly consolidated industry, this does not give them complete control over the airlines. Airplane manufacturers only serve two markets, commercial airlines and government contracts. For this this reason, airplane manufacturers have a vested interest in the success of airlines. If the manufacturers/suppliers begin to eat too far into the airlines profits, the airlines will fold and leave the manufacturer with no buyer. There is also little threat of forward integration from the suppliers. High capital requirements, operating with economies of scale, and access to distribution points (“Hubs”) makes it tough for suppliers to forward integrate.
POWER OF BUYERS
Buyer power in the airline industry is moderate. Price wars between competitors, low levels of differentiation in product, coupled with very low switching cost gives buyers strong influence over prices and services. Although buyers typically have a strong voice in product/service offerings, it is important to differentiate between two distinct sets of customers; customers traveling from rural areas to urban cities and travelers traveling from one urban city to another. Those traveling from city to city have many choices in the airline they wish to take thus leveraging a stronger influence on airlines. These high demand flights (for example; LA to NY or SF to NJ) are much more competitive and customers are willing to choose carriers depending on price. Travelers going from less dense rural areas to
urban cities have less options, the “hub-and-spoke” approach allows carriers to dominate a rural area with one central hub, thus eliminating competition and lowering the power a buyer has over price and services. This highlights the importance for airlines in developing a “hub-and-spokes” network to service a region, or, reinvent the wheel and continually improve “industry best practices” like Southwest did.
In conclusion, extremely high fixed operating costs (80%), high demand for capital, limited access to distribution networks (airport gates), and a fierce rivalry within the industry, drives down profit potential. The case study reading hinted towards this when it stated that the “airline industry’s extremely high fixed costs made it one of the worst net operating margin performers when measured against other industries.” Although the industry is growing as a whole and the “Open Skies Agreement” will open new markets, the industry is crippled by uncontrollable costs like the price of fuel (“17% of total operating cost at Southwest in 2004; 37% in 2012”). For all of the reasoned mentioned above, I measure the profit potential in the airlines industry to be low/very low.