Plane Wreck: The Airline Industry in 2001-2004

Between 2001 and 2003, players in the global airline industry lost some $30 billion, more money than the industry had made since its inception. The losses were particularly severe among the big six airlines in the United States (American Airlines, United, Delta, Continental, US Airways, and Northwest). In 2002 these major airlines lost $7.4 billion and another $5.3 billion in 2003. Both US Airways and United were forced to seek Chapter 11 bankruptcy protections. Although forecasts suggest the six major airlines will break even in 2004, a return to the boom years of 1995-2000, when the airlines posted record profits, seems unlikely anytime soon.

The dramatic slump in airline profits began in early 2001 when business travel started to fall off in the wake of the rapidly deflating technology and dot-com bubble of the 1990s. Then, in the aftermath of the terrorist attacks of September 11, demand dropped through the floor. The airlines began cutting prices to try to maintain their passenger loads in the face of declining demand. However, the tactic didn't work. When one airline serving a particular route cut its prices, its competitors, desperate to cover their fixed costs, quickly followed. The result was a downward price spiral. In the fourth quarter of 2001, prices fell by 15 percent as airlines tried to induce people to fly. Despite this effort, passenger traffic fell by 19 percent, and revenue at major airlines fell by over 30 percent.

Even though demand and profits plummeted at the big six airlines, some carriers continued to make profits during 2001 - 2003, most notably the budget airline Southwest. In addition, other newer budget airlines, including AirTran and JetBlue (which was started in 2000), gained market share during this period. Indeed, between 2000 and 2003 the budget airlines in the United States expanded capacity by 44 percent even as the majors slashed their carrying capacity and parked unused planes in the desert. In 1998 the budget airlines held a 16 percent share the U.S. market, and by mid 2004 their share had risen to 29 percent.

The key to the success of the budget airlines is their business model, which gives them a 30 to 50 percent cost advantage over traditional airlines. The budget airlines all follow the same basic script: They purchase just one type of aircraft (some standardise on Boeing 737s, others on Airbus 320s). They also hire non-union labour and cross-train employees to perform multiple jobs (for example, to help meet turnaround times, the pilots might help check tickets at the gate). As a result of such flexible work rules, Southwest needs only 80 employees to support and fly an aircraft, compared to 115 at the big six airlines. The budget airlines also favour flying "point to point" rather than through hubs, and they often use cheap secondary airports rather than major hubs. They focus on large markets with large traffic volume (such as up and down the East Coast). To cut costs further, they offer no frills on the flights: no in-flight food or complementary drinks. Finally, prices are set low to fill up the seats.

In contrast, the business model of the six major air lines is based on the network or hub-and-spoke system. Under this system, the network airlines route their flights through major hubs. Often a single airline will dominate a hub (thus United dominates Chicago O'Hare airport). This system was developed because it was a way of efficiently using airline capacity when there wasn't enough demand to fill a plane flying point to point. By using a hub-and-spoke system, the major network airlines have been able to serve some 38,000 city pairs, some of which generate fewer than fifty passengers per day. But the budget airlines seem to have found a way around this constraint by focusing on a few hundred city pairs where there is sufficient demand to fill their planes and flying directly between them (point to point). The network carriers also suffer from a higher cost structure because of their legacy of an unionised workforce. In addition, their costs are pushed higher by their superior in-flight service. In good times, the network carriers can recoup their costs by charging higher prices than the discount airlines, particularly for business travellers, who pay more to book late and to fly business or first class. In the weak demand environment of the early 2000s, however, this was no longer the case.

To make matters worse for the network airlines, the budget airlines have started to enter the lucrative coast-to-coast markets. The major airlines long dominated these markets and kept fares high. However, by taking advantage of new long-range versions of their favourite aircraft, such as the Boeing 737-800, to fly these routes nonstop, budget airlines have been able to directly compete with the network airlines. JetBlue, for example, has over 50 percent of its capacity on coast-to-coast routes. To protect their turf, the network airlines have responded by adding more flights in an attempt to squeeze the budget carriers out. As a result, between June 2003 and June 2004, capacity on coast-to-coast routes increased anywhere from 14 to 100 percent. With all these extra seats to fill, airlines have had to slash fares, which have fallen by as much as 60 to 70 percent on some routes.

The major network airlines have also moved to cut their operating costs. Between 2001 and 2004, they cut their operating costs by $13.4 billion and reduced payrolls by 100,000. Yet it has not been enough to check the expansion of the budget airlines or to dose the cost advantage the discounters enjoy. To make matters worse, in 2004 prices for jet fuel soared as oil peaked at over $40 a barrel. Some of the major airlines responded by trying to raise prices, only to give up within days. Some observers have also commented that the industry's problems are exacerbated by bankruptcy laws that keep troubled airlines such as United in the industry by allowing them time to reorganise under Chapter 11 bankruptcy protection rules.

Case Discussion Questions

1. Use the competitive forces model to analyse the structure of the airline industry during 2001-2004. How well does this analysis explain the low profitability of the industry?

2. Are the budget airlines in a different strategic group than the major network airlines?

3. Compare and contrast the business models of the network and budget airlines. What are the strengths and weaknesses of each model?

4. What is required for the industry to return to profitability?

5. What must the major network airlines do to respond to the competitive threat posed by the budget airlines? Have they taken steps in this direction? Have they done enough?