The Analysis of the Expansion of Low-Cost Airline Carriers - Research Paper Example

? The Economic Factors Explaining the Expansion of Low-Cost Airline Carriers Air Travels Demand The global financial crisis affected the demand of air travel; more so the spillover effects of this crisis resulted to deteriorating performance of the airline industry. The following factors have a positive/negative effect on the airline business; level of consumer income, level of air travel fares, tastes and/or preferences, and the prices of other modes of transport. Tastes and/or preferences in air travel market can be described by the choice of the threes types of air travel class; economy class, business class, and the luxury/leisure class (Junwook, 2011). Accessibility of alternative modes of transport that are rationally close substitutes for air transportation diminishes with distance travelled. Globalization and free movement of merchandise and people between and within regions have a positive effect on air travel demand. Business travel market consists of time sensitive passengers; therefore, these customers are price inelastic in terms of fares. If the airline firm offers high quality service to this market segment, such as frequent and reliable frights, flexibility, comfortable seats, and excellent, frequent flyer programme rewards, business class customers will be willing to pay high prices (Junwook, 2011). However, with the introduction of low cost airlines the price elasticity of this business class market has changed and they display price elasticity. In previous years, airline industry relied heavily on business travel market as a major source of profit, however, this trend has changed, and the industry has noted that a higher percentage of passengers considers price over service. Business class customers are willing to give up luxuries, food quality, flexibility or choice in return to lower prices. According to Rosario & Eddy, 2010, the economy travel market is largely determined by the costs being charged by the airlines; they are price sensitive. The first class air travel market does not generate much profit to the airline industry, as a result, many airlines are moving from three to a two-class cabin. The levels of consumer income influence the passenger’s choice of the air travel class; the choice of consumers with high levels of income will differ with those of consumers with low levels of income (Bijan, & Tom, 2008). The demand for leisure travel is influenced by the number of independent holidays and short term breaks; in this market passengers book flights, accommodation and car by themselves. According to Airport International, the changes in demand of leisure travel indicate that customers are expecting and preferring low fares. Low fares in this market segment are the main stimulus for growth in luxury travel, and passengers are willing to change destination for fabulous deals. According to Susan, 2009, the prices of air tickets are largely influenced by the fuel prices, the exchange rates, and the costs of financing airline projects. High costs of financing, unstable exchange rates, and high fuel prices lead to high air fares. Other natural calamities, such tsunami and earthquakes among others results to decline in tourism and business travels thereby, affecting the air travel demand in the affected areas (Roger, 2008). The following diagrams and tables show the effects of fuel prices on operating costs of the airline industry. Prices of air tickets are determined by the price of fuel; fuel price is influenced by the prevailing economic conditions such as the exchange rates. Industry Fuel Costs and Net Profits. Source: Industry Financial Forecast Table (IATA Economics). Fuel Impact on Operating Costs Year % of Operating Costs Average Price per Barrel of Crude Break-even Price per Barrel Total Fuel Cost 2003 14% $28.8 $23.4 $44 billion 2004 17% $38.3 $34.5 $65 billion 2005 22% $54.5 $51.8 $91 billion 2006 26% $65.1 $68.3 $117 billion 2007 28% $73.0 $82.2 $135 billion 2008 33% $99.0 $88.9 $189 billion 2009 26% $62.0 $55.4 $125 billion 2010 26% $79.4 $91.0 $139 billion 2011F 30% $112.0 $116.3 $178 billion 2012F 32% $99.0 $101.1 $198 billion Source: Industry Financial Forecast Table (IATA Economics) The above diagram shows that there has been a decline in the business travel. International air travel is the main driver of the airline industry; decline in premium seat sales has resulted to a reduction in profits; this has lead to expansion of low cost carriers. Elasticity of demand measures the responsiveness of demand of a product or service due to a change of one of the influencing factors. A higher price of air tickets results to a lower quantity of air tickets demanded ceteris paribus. In the airline industry, the price responsiveness of demand differs from one service to another and from one market to another (Laurie, 2010). Price elasticity of demand assesses the responsiveness of the demand of a product/service to changes in its price while other affecting factors are held constant (Roger, 2008). While studying the air travel demand, one should differentiate among markets for; leisure and business travel, short-haul and long-haul travel, and domestic and international long-haul travel. Accessibility of alternative modes of transport that are rationally close substitutes for air transport diminishes with distance travelled. In this case, the demand for air travel will be less elastic for long distance flights than for a short distance flights. International travel is less sensitive to variations in ticket prices as compared to domestic travel since the airfare is a smaller percentage of overall trip costs (Gust & Peter, 2008). Demand for leisure travel is more elastic as compared to business travel; there is a higher possibility that leisure travelers will postpone trips to certain destinations in response to high prices of air tickets, or may choose to shop in those locations where air tickets are affordable. Income elasticity of demand measures the responsiveness of demand to changes in levels of income (Walter, 2006). Air travel demand has a positive income elasticity of demand; the industry is cyclical, during a recession there is demand falls, whereas during an economic boom the demand rises for both leisure and business travels (Laurie, 2010). Recent studies indicate that income levels of air travel consumers affect their choice of travel class. The business travel customers are aiming to minimize their travel costs, thereby, protecting the profits of their enterprises. The airline industry has expanded the low costs carrier to cater for the demand of these prices sensitive business class customers since the trend may not be cyclical. Chart 1 below shows that elasticity values differ significantly by the travel distance, type of traveler, and international/domestic routes; this is a confirmation of distinct markets in the airline industry. This shows that demand for air transport is less elastic for business travelers than for leisure travelers, and less elastic for longer distance flights, especially international travel. Based on the studies business travel does not illustrate a consistently increasing sensitivity as distance travelled becomes shorter. Chart 1: Own-Price Elasticity of Demand. Market Segment Number of studies Number of estimates Elasticity Long-haul international business 2 16 -0.265 Long-haul international leisure 6 49 -1.04 Long-haul domestic business 2 26 -1.15 Long-haul domestic leisure 2 6 -1.104 Short-haul business 3 16 -0.7 Short-haul leisure 3 16 -1.520 More Elastic Less Elastic -2 -1.5 -1 -0.5 0 Source: Department of Finance Canada Figure 1: Total revenue = ?5 * 100,000 =?5,000,000 Price per ticket ?5 D 100 Air Tickets-Quantity Demanded (000s). If the company decides to lower the price per ticket to ?3, the degree of price elasticity of the demand curve determines the extent of the increase in demand and the change in total revenue. Figure 2 Price per ticket ?5 ?3 D 100 140 Air Tickets-Quantity Demanded (000s). Figure 3 Price per ticket ?10 ?5 D 5 6 Air Tickets-Quantity Demanded (000s). Price elasticity of demand is -0.4 (Inelastic); if the company decides to lower the price of the air ticket to increase sales, the total revenue falls. If the demand is price elastic increasing price would reduce total revenue, and reducing price would increase total revenue. If demand is price inelastic increasing price would increase total revenue, and reducing price would reduce total revenue (Walter, 2006). Figure 4 Price per ticket ?10 ?7 D 5 20 Air Tickets-Quantity Demanded (000s). Price elasticity of demand is -10 (Elastic); if the company decides to lower the price of air ticket to increase sales, the total revenue will rise. According to Tobias, 2011, lifestyle of people in different countries affects their demand of various products and/or services. The Euro zone debt crisis has adversely affected the performance of European airlines; however, in North American airlines are protecting their profits through capacity cuts. In Asia, the expansion of China’s domestic market has resulted to a significant increase in profits. Some of the African countries rely on the Europe as the major market of their exports. The demand and supply of exports and imports is partly determined by the lifestyles of individuals of different countries. In a country where demand of imports and exports is high, demand for business class tickets is also high (Peter & Cynthia, 2009). However, if the business class customers are price sensitive the demand for economy class tickets will increase. Airlines operating in countries where there is high demand of economy class tickets will tend to invest in low costs carriers (Peter & David, 2010). During and before winter some residents of countries affected travel to other countries as tourists. During this period, the demand for air travel is high, although the prices of air tickets determine the level of this demand. Families with high living lifestyles tend to prefer leisure travel as compared to those with price sensitive lifestyles (Gust & Peter, 2008). The following table shows the impact of weather on international travels in the United States. 2010 Monthly U.S Outbound Air Travel to International Regions. Month Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Total Outbound Travels 2,792,974 2,543,715 3,259,577 2,942,494 3,561,600 4,425,162 3,970,549 3,108,491 2,698,357 2,629,131 2,457,578 2,911,510 Monthly Change % 3.1 % 0.3% 6.2% -4.5% 7.7% 11.0% -5.8% -14.3% -9.7% -10.1% -12.1% -16.3% Source: Office of Travel & Tourism Industries, 2010 Analysis. References Junwook, C. (2011). Air Travel Demand and Pricing Behavior. Beijing: LAP Lambert Academic Publishing. Tobias, K. (2011). Demographic and infrastructure: National and Regional Aspects of Demographic Change. New York: Springer. Laurie, A.G. (2010). Discrete Choice Modeling and Air Travel Demand: Theory and Applications. Georgia: Ashgate Publishing Ltd. Peter, F. & David, G. (2010). Airport Competition: The European Experience. New York: Ashgate Publishing Ltd. Rosario, M. & Eddy, V. (2010). Critical Issues in Air Transport Economics And Business. New York: Routledge. Susan, F. (2009). Commercial Aviation: Airline Industry Contraction Due to Volatile Fuel Prices and Falling Demand Affects Airports, Passengers, and Federal Government Revenues. Darby: Diane Publishing. Peter, B. & Cynthia, B. (2009). The Global Airline Industry. San Francisco: John Wiley & Sons. Walter, J. W. (2006). Economics. New York: Barron’s Educational Series. Office of Travel & Tourism Industries. Outbound Travel from the U.S.: 2010 Monthly U.S Outbound Air Travel to International Regions. Bijan, V. & Tom, T. (2008). Introduction to Air Transport Economics: From Theory to Applications. Georgia: Ashgate Publishing Ltd. David, W.G., William, G.M., & Christopher S. (2008). Air Travel Demand Elasticities: Concepts, Issues, and Measurements. Waterloo, Canada: Department of Finance Canada. Gust, B. & Peter, D. (2008). Transport Economics. London: De Boeck Hoger. Roger, A.A. (2008). Economics. Sacramento, California: Cengage Learning. International Air Transport Association (IATA). Airport International (2005). Changes In Demand For Air Travel. Cranfield, Bedfordshire: Department of Air Travel at Cranfield University. Read More