Flying high or falling short? markup and product differentiation in the U.S. airline industry (2002–2022)

THE airline industry has always captured the imagination, but never more so than during the current deregulatory period. To understand the sources of economic rents that are the driving forces for change in this industry, we employ an interdisciplinary analysis drawn from the economics and strategy literature. This analysis allows us to identify sources of rent that are geographically based (local monopoly sources) and others that stem from economies of scale-based advantages in providing nationwide service (oligopoly sources). We examine the economic and strategic characteristics of these diverse sources of rent and suggest some policy concerns about the emerging airline market structure. An interdisciplinary approach is taken because economic models normally assume that firms have identical factor costs and similar production opportunities. Yet much of our ability to frame the forces for change in the airline industry begins with the recognition that firms came into the deregulatory period with differing factor costs and differing locational endowments and, hence, differing production opportunities. Building on Porter'sl concept of strategic groups, we offer evidence that air carriers

Competition and Entry in Small Airline Markets

T he Collins et al. (2011) study (hereafter, CRC) examines how the competitive strategies of airlines impact the persistence of their operating earnings. The study then investigates if the persistence of earnings components, such as unit prices, costs, and productivity changes, also varies by competitive strategy. The study uses 590 observations of quarterly financial performance from 14 airline companies, over the period 1996 to 2008, to examine the impact of different competitive strategies on the persistence of profit margins and asset turnover. Two airlines’ competitive strategies are identified: network carriers and low-cost providers. The paper documents that network airlines (differentiators) have more persistent operating profit margins than low-cost carriers. Little difference is noted for total asset turnover across business models. The study also demonstrates that partitioning the change in profit margin into growth, price-recovery, and productivity components more fully explains future profit margins than current profit margin alone. The paper is a nice blend of the literatures in industrial economics and both financial and management accounting. There are two strings in the paper that are interesting to management and management accountants. One is how a firm’s competitive strategy impacts the persistence of profit margins and asset turnover ratios, which are the two key components of return on assets using the DuPont formula. The other interesting issue is the examination of how volume, price, and productivity components of profit margin changes impact earnings persistence differently across competitive strategies. As this latter part of the paper uses traditional variance analysis and productivity measures, it is particularly interesting to management accountants. Below, I discuss these two inter-related issues.

The main objective of this paper is to introduce an Allen‐type index of differentiation based on cost functions. With this index, we create an economic measure of product differentiation that quantifies differences between products. Applied research has some generally accepted economic measures, for example, the Herfindahl–Hirschman Index for market concentration, or the Gini coefficient for inequality. Product differentiation, however, does not yet have an established measure. Our objective is to fill that gap and introduce a measure that can be used in market‐related applied research such as market power, antitrust, price indexes, or market strategy. To operationalize the index, we introduce the concept of a core product and use cost functions to measure the degree of differentiation from the core product. To demonstrate the use of the index, we study the effect of product differentiation on price formation in the airline industry using an enhanced hedonic model. The model is empirically tested on 103,980 observations of quarterly US domestic airfare data between 2002 and 2016 and shows that product differentiation has a significant effect on both price and mark‐up.

The aim of this research is to analyze the implementation of Sustainable Competitive Advantage (SCA) as a strategy taken by PT Garuda Indonesia in facing the commercial flight business competition in Indonesia. This research adopted Boston Consulting Group (BCG) matrix theory and the SCA approach to identify the competitive position of Garuda among its competitors in the airline industry and to analyze the component of competitors, consisting familiarity towards its own product, familiarity towards competitors, familiarity towards the competitors’ product and the component of competition techniques comprising cost advantage, product differentiation, market focus, pioneering products and market synergy. The result of this research shows that competitive position of Garuda in the airline industry in Indonesia is in the star quadrant, possessing the growth of long run opportunities. The strategies that could be adopted were forward integration, backward integration, horizontal integration, market penetration, market development and product development. Therefore it could be concluded that the SCA concept could be adopted as the marketing strategy of Garuda. The optimal adoption of the SCA concept as the marketing strategy that possessed the sustainable competition requires mending and improvement of such strategies as market synergy, human resources development and the market extension.

Competition among European Airlines – on the Role of Product Differentiation

Reputation, search cost, and airfares

This paper investigates the role of discount travel agencies such as Priceline and Hotwire in the market segmentation of the hotel and airline industries. These agencies conceal important characteristics of the offered services, such as hotel locations or flight schedules. We explicitly model this opaque feature and show that it enables service providers to price discriminate between those customers who are sensitive to service characteristics and those who are not. Service providers can profit from such discrimination despite the fact that the opaque feature virtually erases product differentiation and thus intensifies competition. The reason is that the intensified competition for less sensitive customers enables service providers to commit to a higher price for more sensitive customers, which leads to higher profits overall. This explains why airlines or hotels are willing to lose the advantage of product differentiation and offer services through discount travel agencies.

The effect of intra-industry heterogeneity on hypercompetitive escalation and de-escalation in a multimarket environment is examined. The authors study two critical dimensions of intra-industry heterogeneity: strategic similarity, which captures similarity in competitive orientation, and multimarket contact, which captures the degree of overlap between rivals in the multiple markets of the industry. Theory predicts that both variables influence the intensity of rivalry and competitive disruption. The predictions in the literature about the effect of strategic similarity on the intensity of rivalry are mixed. While strategic group theory proposes that strategic similarity may lead to lower rivalry, other theories (focusing on product differentiation, the resource-based view of the firm, and hypercompetitive escalation) predict that strategic similarity may actually increase rivalry. Those diametrically opposed propositions are captured as alternative hypotheses of the effect of strategic similarity. With respect to the effect of multimarket contact on the intensity of rivalry, the existing literature on multiple point competition predicts that multimarket contact should decrease rivalry, since it provides credible threats which discourage competitive escalation. The paper performs an empirical analysis of these hypotheses with data on over 3,000 city-pair markets of the U.S. airline industry. The paper focuses on the effects of changes in strategic similarity and multimarket contact in a city-pair market on the prices charged by airlines in that market. Other important factors which influence prices, such as service attributes, market characteristics, cost positions, market structure and firm-specific advantages, are rigorously controlled. The methodology used for the empirical analysis, a panel data regression with fixed-effect intercepts, also serves to control for other sources of stable differences across airlines and city-markets. The results show that strategic similarity moderately increases the intensity of rivalry, whereas multimarket contact strongly decreases it. Interestingly, the findings suggest that the effect of strategic similarity on intensity of rivalry may be biased if the effect of multimarket contact is not explicitly accounted for. This is due to the fact that strategic similarity may capture some of the strong de-escalation effect of multimarket contact when this variable is not controlled. This finding explains and challenges prior literature which found that strategic similarity reduces rivalry. The findings have important theoretical implications. For strategic group theory, they suggest two distinct dimensions of strategic heterogeneity (strategic similarity, multimarket contact), which should not be aggregated because they have opposite effects on the intensity of rivalry. These two dimensions should be separately considered to produce more rigorous analysis of rivalry within and between strategic groups. For hypercompetition theory, the findings indicate that hypercompetition in the cost-quality arena and stronghold invasion arena may lead in the future to greater competitive restraint. If hypercompetition in the cost-quality arena leads to greater differentiation in the market positions of firms, this could de-escalate competition. In addition, if hypercompetition in the stronghold invasion arena leads firms to obtain a broader multimarket overlap with their rivals, this condition could also provide the basis for deterrence and hypercompetitive de-escalation.

The paper is based on a lecture in the Beesley Series delivered at the Institute of Directors in London, in October 2012. Initially, it points out that transport infrastructure in the UK prior to the 20th century was planned and developed largely by private interests. Today private sector initiatives are restricted largely to air and seaports, the conduits for the nation’s trade in goods and services. The state is also inclined to intervene in this 'ports sector, which creates tensions between planned solutions and the market driven imperatives of commercial interests. State planning, notionally, is anchored by a welfare economics approach to evaluation but aspects of this are controversial and the paper argues that the current approach fails to adequately capture the competitive effects of investment. It then argues that whilst the private sector has been good at adding value by product differentiation, as illustrated by the airline industry, public sector assets by contrast are much more homogeneous in attributes, output and price. But there are opportunities for introducing variety and choice into the provision of publically provided transport infrastructure by market segmentation. The approach is illustrated by novel approaches in relation to capacity constrained commuter railways and motorways.

This paper investigates the role of discount travel agencies such as Priceline and Hotwire in the market segmentation of the hotel and airline industries. These agencies conceal important characteristics of the offered services, such as hotel locations or flight schedules. We explicitly model this opaque feature and show that it enables service providers to price discriminate between those customers who are sensitive to service characteristics and those who are not. Service providers can profit from such discrimination despite the fact that the opaque feature virtually erases product differentiation and thus intensifies competition. The reason is that the intensified competition for less sensitive customers enables service providers to commit to a higher price for more sensitive customers, which leads to higher profits overall. This explains why airlines or hotels are willing to lose the advantage of product differentiation and offer services through discount travel agencies.

In 2003, amid the turmoil of the U.S. airline industry in the post-9/11 environment, the senior management of the Alaska Air Group announced a “strategic vision” entitled “Alaska 2010.” The pronouncement articulated positions with regard to cost leadership, product differentiation, and growth. This study empirically assesses the efficacy of this decision with regard to the major network carrier of the air group, Alaska Airlines. The analysis focuses on the period beginning with the announcement and ending in 2010.The implementation of such a strategic protocol is dynamic and inter-temporal in nature. Therefore, it is often difficult to assess the effectiveness of changes in strategies, particularly since such effectiveness is often a function of the confounding forces of organizational strategy and market conditions. Thus, this study utilizes the multi-period methodology of the strategic variance analysis of operating income.This methodology decomposes operating income into three components: (1) growth, (2) price recovery, and (3) productivity. This is of particular interest from a strategic planning perspective, as the price component evaluates a company’s product differentiation strategy while the productivity component evaluates whether an airline’s low cost strategy was successful because of efficiency gains.

A firm's actions in one market can change competitors' strategies in a second market by affecting its own marginal costs in that other market. Whether the action provides costs or benefits in the second market depends on (a) whether it increases or decreases marginal costs in the second market and (b) whether competitors' products are strategic substitutes or strategic complements. The latter distinction is determined by whether more "aggressive" play (e.g., lower price or higher quantity) by one firm in a market lowers or raises competing firms' marginal profitabilities in that market. Many recent results in oligopoly theory can be most easily understood in terms of strategic substitutes and complements.

What drives effective competition in the airline industry? An empirical model of city-pair market concentration

We examine the effects of entry on the pricing behavior of incumbent legacy airlines in a market where the newcomer is a rapidly expanding low-cost carrier - the Brazilian airline industry in the early 2000s. We estimate the timing and the determinants of price responses to entry allowing them to be asymmetric and controlling for product differentiation. We also propose a decomposition procedure of time fixed-effects to better control for unobserved heterogeneity in prices: by accounting for time-varying route-, city- and carrier-specific unobservables, we find that incumbents do price-respond to actual entry but not to potential entry. We provide suggestive evidence that the lack of preemptive behavior is due to the fact that financially distressed incumbents with virtually no bankruptcy protection were not able to engage in costly deterrence against a newcomer with deep pockets and committed to expansion. Our most important results uncover product differentiation effects stemming from more convenient departures during peak hours and nonstop service, which significantly softened actual price responses.