Economics: A Comprehensive Study of Competition of the European Airline Market

A Comprehensive Study of Competition of the European Airline Market: Market Competition, Market Concentration and Price Dispersion

ABSTRACT

One of the main characteristics of the airline industry is that passengers are charged relatively high prices when one carrier is in a position to control a very high portion of traffic. According to the economies of this industry, there is a very strong link between the price of tickets and the size of a carrier and its concentration. This paper seeks to identify the impact of the liberalization of the European airline industry which was mainly done to increase competition in the market to the air flight fares charged by most European airlines. The paper will explore the situation of the market and fares charged during the pre-liberalization era with the aim of analysing the effect of the competition introduced by the liberalization to the fare prices. After the liberalization there was reduced barrier to entry which resulted in increased low cost airlines (LCAs) into the market which explains the huge reduction of fare prices by up to 25% with inflation accounted for. We also find that the reduction in fare prices does not necessarily lead to low quality services which means that the liberalization was a huge step towards improved consumer welfare within the European airline markets.

Keywords: European Airline Liberalization, market concentration, market competition, price dispersion.

  1. INTRODUCTION

During the post-liberalization period, the European airline industry was heavily regulated with governments entering into bilateral agreements to fix fare prices and create monopoly and duopolistic structures which generally sheltered their national airlines from competition from new entrants. The political regulation was both in terms of operations as well as ownership, with most airlines being nationally owned and privatization of airlines being only a recent concept. Arguments for regulation were grounded on the idea that airline services fell under public utilities and any external benefits within the industry should be averted through proper regulation. It was believed that allowing free and unregulated competition within the airline industry would be detrimental to public interest which leaned towards the running of properly managed and operational airlines (Dobson, 1995).

The net effect of this was that fare prices for European airline consumers were very high. It had been established that the fare prices charged in Europe were consistently higher than those charged by US airlines for similar distances. In 1984, the Federation of European Consumers estimated that it was cheaper to take all their delegates on a trip to Washington, DC as compared to holding their conference in any part of Europe (Sampson, 1988). Based on the idea that higher fares result from the exercise of market power then high prices place consumer welfare and efficiency to a detrimental effect. Economists started questioning the benefits of the continued government regulation of airline and began advocating for freer competition (Dobson, 1995) citing many advantages associated with such a move. They argued that the effect of regulation was mainly to limit price freedom and hinder product differentiation leading to stunted growth of the industry and restricting entry to the market. The advantages that would result to consumers arising from deregulating the market and creating a competitive environment for airlines were numerous in the form of reduced fares, greater product differentiation, and innovatory pricing.

These debates eventually yielded results with several political and legal developments taking place between 1992 and 1997 leading to liberalization of the European airline industry. More specifically, measures were taken in 1992 which introduced freedom for any individual to provided airline services to the public within the European Union. This development paved way for further developments in 1997 when the freedom by an airline to provide cabotage was introduced. This meant that one state’s airline could operate in another state without any restrictions or prohibitions as long as they are both members of the European Union.

Today, following these developments, government control of airlines has greatly diminished and the introduction of free competition in the industry has opened great opportunities, redefining the rules of competition and leading to the emergence of new market segments (Yang and Ye, 2008). New airlines entered the market with reduced costs of up to 40% than those of the incumbent carriers arising largely from the use of discounted second-hand aircrafts and low non-union labour costs. This was effective in forcing incumbent carriers to find ways of minimizing their operation costs so as to remain competitive something which led to low fare prices and increased demand for air services (Chan, 2000).

This paper will provide a comprehensive analysis of the liberalization of the European airline industry and the significance of this historical move to the whole structure of the European market in terms of competition, market distribution and fair prices. We analyse the state of competition within the market before the process of liberalization began and the effect this had in the market in terms of market concentration and price dispersion. The whole process of liberalization including the players involved and market circumstances has been analysed as well as how this has affected the airline market industry. One of the main effects of the liberalization was that entry barriers were done away with which allowed more airlines to enter the market. This has led to proliferation of low-cost airlines (LCAs) in a market, which was previously oligopolistic in nature with few airlines that were sheltered from competition. The effect of the LCAs in the industry have therefore led to a major shift in the market by introducing fierce competition and  increasing market concentration both of which have had significant effects on air fares. This paper will look into the issue of LCAs and how their presence in the market have led to price dispersion bringing fare prices down for consumers whose willingness-to-buy is low.

Many studies have been done in regard to the liberalization of the European airline industry and the diverse effects that this has had in the market since its initialization in 1992. However, research study in regard to the effect that liberalization brought into the market in regard to lower prices to consumers who are still struggling financially has largely been ignored, most especially in Europe. Little research has been done in this regard in the US market, but there almost no research on this topic in Europe. The study therefore aims at bridging this gap by connecting the research finding of other scholars in order to draw conclusions specific to our research study. This research study will be especially helpful to consumers in understanding why some airlines have been charging different prices for the same product since liberalization. It will also be important to traditional flag carriers to help them understand how the LCAs are able to offer cheaper prices for their products as compared to those offered by them and still maintain their competitiveness in the market.

  • LITERATURE REVIEW
    • Competition during Pre-Liberalization Period

The history of airline regulation is rooted in the 1919 Paris convention, which provided that states retained the sovereign rights over their own airspace. Based on this provision, over 52 world states sat down and produced the 1944 Chicago Convention. The main role of the convention was to ensure that the governments of the concerned states controlled international and air transport markets. The idea of “open skies” which was floated by some countries such as the US was greatly opposed by the European nations. The European nations were especially supportive of the regulatory framework as they viewed it as an opportunity to rebuild their economies which had been devastated by the World War.  They therefore proposed the establishment of an international body mandated with the role of regulating capacity and airline fares on routes. In 1945, the International Air Transport Authority also known as IATA was formed. IATA was to fix fares and then submit them to member governments who would approve them making them binding on all states. This eliminated the freedom of states fixing their own fares.

The effect of these legislative and political developments is that the internal European market became heavily regulated using bilateral agreements between states up until the 1980’s. The majority of the European airlines were public owned majorly by the government. The bilateral agreements concluded between states created duopolistic market structures for these airlines by creating heavy barriers to new entry in the market. The bilateral agreements also allowed airlines to pool their resources together and share their capacity managing to eliminate competition amongst themselves on those routes. Further, these governments heavily subsidized their carriers, both directly and indirectly. This depended on the individual government. Subsidies were mainly offered to compensate an airline where the government had introduced a new public obligation, to enable them develop and run domestic services; to enable them offer airline services to economically challenged regions; to encourage an airline acquire another airline; or generally to help in covering operation costs.  There was also the use of airlines by the government to effect employment policies. It was almost impossible for new competitors to enter the market. A number of stringent laws were formulated to specifically protect these new airlines from competition. This arrangement led to inefficient allocation of resources with the airlines always incurring heavy costs that required to be subsidized by the government.

A historic criticism against the regulation of the European airline industry has been that fare prices charged by airlines to most routes were consistently high compared to the fares charged by US airlines. This has mainly been attributed to the monopolies existing in most markets, which were created through bilateral agreements by government. The liberalization movement was initiated as an effort to eliminate these monopolies and pull fare prices down to attain a more competitive environment. Another adverse outcome of the regulation is that due to lack of competition, the products offered by the existing airlines were poor in quality. Also since airlines were not keen in reducing their operation costs, there was increased inefficiency in the operation of this industry. This means that the customer was unnecessarily forced to pay extra as the increased costs of operation were distributed down to them in forms of high ticket fares, something which could have been prevented through efficiency in management brought about by healthy competition in the market (Mason, 2000). The LCAs have therefore come to ensure that what the ordinary consumer pays is fair and properly determined by operating market forces.

  • The Liberalization Process

Due to their different economic positions, the US and the European countries were basically on different ends about regulation of the airline industry. The US, whose economy had withstood the scourge of war was not afraid of competition and thus advocated for the “open air” policy during the making of the Chicago Convention in 1944 but to no success. Thus even though US continued to be adhere to the provisions of the convention for another three decades, the idea of liberalization was not lost to it (Button, 1991). However, the effects of this was only became evident during the 1970’s when the US Civil Aeronautics Board (CAB), unable to effect changes using IATA, decide to form bilateral agreements with countries in Europe on an individual basis. Even this strategy was only going to make an impact by convincing UK, the main oppose of the open air policy, and then using traffic diversion threats on other European countries in order to force bilateral agreements on them. This was a very successful move which saw the level of competition rise significantly upon the entry of new airlines. However, as between the European countries themselves, the heavy regulation continued to be the norm.

Liberalization within Europe internal market was initially proposed by the European Competition Commission. The Commission had as early as 1972 made recommendations for the opening of competition in the industry but this move was strongly opposed by the European governments (Button, 1991). The Commission reinitiated these efforts again in 1979, this time more strongly, through the publication of the Civil Aviation Memorandum Number 1. Through the memorandum, the Commission recommended that European airlines offer cheaper fare prices; that it was necessary to establish new cross-frontier services to link the various regional centers within the European community; that there should be a clear universally accepted policy on how governments should subsidize their airlines; and that it was desirable that free access to all markets be promoted. These recommendations were positively received by transportation ministers who used them to make marginal improvements in the 1980’s. Effects of these were faintly felt in the late 1982 in terms of cheaper fares and enhanced competition.

The largest stride towards liberalization occurred in December 1986 when the British Airways, faced with increased losses from poor performance and on the blink of being swept out of the market was privatized, becoming the second privately owned airline in the whole of Europe. The new management of BA employed competitive marketing strategies that saw its load-factor in regard to the transatlantic sector expand by unto 40% (McGowan & Seabright, 1989), enabling the airline to recover its eroded equity in a little over a year.  Threatened by a legal suit over airline infringement of the then existing competition rules, European ministers entered into negotiations in 1987 to find a way of allowing flexibility in setting of fares. In December 1987, the first policy on liberalization arrived which allowed airlines to offer discount fares to the extent that was acceptable by member states. Increase on capacity shares was also allowed so long as share split between two nations did not exceed the ratio of 55% to 45% (Belaud & Renaux, 191). This was a historic development and the European ministers, confident that further developments were possible went ahead to push for more reforms.

The ultimate breakthrough on the efforts of liberalization came in 1992 in Luxembourg when the European Community came to an agreement on issues that would eventually build a more competitive environment within the European markets. These issues were based on five major areas which are:

  1. Fares; airlines were now allowed to fix their own fare prices subject to the limitations placed by Brussels which was put up to ensure airlines do not charge excessive prices and to also set a baseline in case there was free-fall that would mean airlines can only operate under losses.
  2. Routes; an airline of one country heading to a foreign destination country was allowed to take traffic of that country to a third country as long as these did not go beyond 50% of the total traffic on the flight.
  3. Flights; flights from one country and heading to a second country could stop at a third country to take or drop traffic in that country without any restrictions. Initially, such an aircraft could only stop in a third country for purposes of fuelling only and not to discharge traffic.
  4. Domestic services; airlines within the European community could now operate internal flights within any of the member states from April 1997.
  5. Licensing; new universal rules governing financial requirements and safety of new airlines desiring to enter the market were adopted to ease on the barrier to entry. As long as an airline met the requirements put in place, they could freely operate their aircrafts on any route they desired and on terms as those of incumbent airlines (Captain, 1993).

The only problem with the 1992 agreement was that it omitted prescribing any specific policy that would govern how governments subsidized their national airlines. An important provision in this regard in the 1987 agreement was that the European Commission was empowered to authorize subsidizing of airlines facing severe financial difficulties (Taneja, 1988). After 1992, however, governments put in place individual mechanisms of compensating for this limitation. Subsidy methods included  increasing ownership of government stock in an airline without necessarily increasing the capital stock; helping in the purchase of aircrafts; and control of foreign airlines by charging different landing rights and fees, as well as price of fuel.

  • Competition During the Post-Liberalization Period

Basically, since the 1944 Chicago Convention came to being, air transport markets have largely been regulated by bilateral agreements between states. This means that, for a long time, the impacts of a country’s bilateral agreements played a more important role in the market than any efforts of negotiations between airlines. However, the liberalization of aircrafts has resulted into new entrants into the market intensifying competition within the airline industry. Now the main methods through which airlines adopt in order to protect themselves from competition are infrastructural or acoustic in nature. Incumbent airlines, faced with new competition from LCAs, are forced to create their own barriers to survive in the market. Scholars have argued that apart from their own artificial barriers, some airlines, especially the incumbent ones, are still protected by natural barriers. Some of these have been said to emanate from the inherent economies associated with supply of network services. According to Oum et al. (1995) and Caves et al. (1984), the economies of scope and density place significant barriers to entry in post-liberalization period since they favour traffic concentration through hubs that help intensity geographical concentration.

Other methods used by airlines to protect themselves from competition in the post-liberalization period include predatory and aggressive pricing; frequent flier programs and passenger loyalty; control over booking processes and use of information systems; formation of alliances, mergers and cartels, etc. In modern times, for example, advanced technology has had a great impact on in the way organizations relate with consumers and potential consumers. It is now possible for consumers to gather information regarding their travel destinations, the travel companies available, and other travel alternatives that may exist using internet services. This has also led to elimination of intermediaries in regard to sales and the distribution channels in the market, eliminating the greater control they had in altering prices and influencing customer decisions. This means that, with new technologies, consumers’ power in influencing the market has been increased while at the same time reducing the effect of suppliers. Apart from that, information technologies have been important in facilitating globalization of airlines. For example, on-line positioning ensures that customers can place their reservations from any part of the world. These developments have been instrumental in the reduction of prices as many costs between the airlines and consumers have been cut and the gap between consumers and airline companies having been bridged greatly.

Another major factor that defines the nature of competition in the post-liberalization period is the threat of substitute products. According to Aharoni (2004), the airline industry is at its maturity, able to offer standardized products that are able to determine the prices in the users’ choices. There are now low-cost carriers controlling a significant market segment in the industry by maximally utilizing their advantage on low operation costs and extending their operations to secondary airports. Through this strategy, they avoid the formation of alliances, which also means that they are able to establish their individual international market base. Even though barriers to entry still exist in these markets, these are solely based on market forces and not control by governments. This means that there is now a healthy competition in the market based on airlines strategic and efficient management. This has therefore been a big contributing to cheaper fare prices improving the economic welfare of European consumers.

  • The Effect of LCAs in the Airline Market

One of the main results of liberalization of airlines in Europe and which have had tremendous effect on the competition in the industry is the introduction of Low-cost airlines (LCAs). LCAs have greatly altered how people travel, the competition between airlines, geography of air services and even introduced economic competition between cities and regions. LCAs are able to provide global low-fare air prices by taking advantage of the liberalization of air transport, intensive cost cutting (Vasigh et al., 2008), through maximum utilization of labour and air flights (Hunter, 2006) as well taking advantage of state aids and other incentives offered by various local and regional authorities (Graham and Shaw, 2008; Barbot, 2006). Today, the LCA’s operate in diverse geographical places and serve different customers. The original idea of LCA was introduced by the US Southwest Airlines who introduced their low-cost business by creating their own intra-niche market instead of competing with incumbent airlines (Doganis, 2006). Since then, low costs have increased in number and magnitude.

In Europe, LCA model was started in 1955 by the Easyjet airline, which was directly introduced into the market as an LCA (Jones, 2007). The Ryanair, an Irish private airline founded by M. O’Leary had tried the model in 1991 only to adapt its model several years later (Creaton, 2005). Today, the number of LCAs has spread far and wide encompassing the Asian-Pacific, Maghreb, South America, Middle East and some parts of Sub- Saharan Africa (Albers et al., 2010; Macario and Reis, 2011). By 2010, it was already estimated that the number of LCAs worldwide was 94 serving 650 million passengers, which constituted 23.5% of the airline market, and operating within 21.4% of airline routes (Berster et al., 2012). In addition, the LCAs have been on a mission to conquer the main traditional inter-urban routes, conventional airports, and tourist destinations. They are also serving all segments of the market with different needs and expectations including national and international students, business travellers, and young-globe trotters (Graham and Shaw, 2008). Currently, only markets under protectionist regulations and long distances are out of reach for LCAs (Francis et al., 2007).

LCAs have been described as being the main drivers of routes development and de-concentration of networks.  For example, Dobruszkues (2009) in analysing the new West-East routes in Europe concluded that even though the low-cost market still ranks second, LCAs have facilitated the development of dynamism between the East and West Central Europe. According to Campisi et al. (2010) who concentrated on the market situation in Italy, many secondary and regional airports have been experiencing high traffic growth as a result of the low-cost airlines.  According to studies, an analysis of the competition between the LCAs and incumbent airlines shows that the expansion of low-cost airlines goes hand in hand with traditional airlines strengthening their airlines hubs. Empirical evidence has also revealed that LCAs in almost all cases, offer fares that are half those offered by incumbent carriers (Doganis, 2006).

It has been shown that since the liberalization process began and subsequently progressively implemented between the year 1987 and 1977, the incumbent carriers and non-LCA airlines were able to take advantage of the newly introduced frameworks. During that time, the low-cost businesses were still in their infancy and so it can be argued were incapable of deriving as much benefits from the freedoms as the traditional flag carriers. Even then, LCAs have been found to be the main drivers of expansion in the airline industry. In addition, during the global crisis that ended recently, only the LCAs were able to withstand the challenges with most flag carriers substantially decreasing their volumes. LCAs now make about 31% of the entire domestic market in Europe. It has also been found that LCAs have been responsible in causing the increase of intra-European flights by 70% and increasing the number of seats/km by 64% between the period of 1995 and 2012. When it comes to competition, low cost airlines hold 61% of all routes.

Studies have argued that the main reason why LCAs have been able to reduce their fares prices and still retain their competitiveness in the market is due to their efficiency in cost cutting. This means that they are able to greatly reduce their operations costs, which give them a competitive edge over incumbent firms. Studies have shown that when a firm’s efficiency score is high, then it is able to strongly differentiate its market prices. Due to their low prices, the LCAs have been able to attract a large number of customers who have been looking for cheaper airlines all these time. This has therefore enabled them to put up a fierce competition against the traditional flag carriers who were used to being protected from competition. The effect of the LCAs reducing their prices is that the incumbent firms have been forced to reconsider their pricing strategy, the effect of which has been greatly reduced ticket prices(Goolsbee & Syverson, 2008).

  • An Economic Perspective of Competition and Price Dispersion in the Market

In review, we use the model by Rochet and Stole (2002) which is based on the assumption that consumers are vertically and horizontally heterogeneous to further explain our hypothesis. In regard to vertical heterogeneous, this depends on what motivates a customer to travel. Most of the time, there are business travellers whose willingness-to-pay is high, t2, while on the other hand there are leisure travellers whose willingness-to-pay is low, t2 >t2. According to Robinson (1933), we can call the first segment the “strong market” while the other segment is referred to as the “weak market”. The consumer mass is then normalized to 1. This means that the weak market can be quantified as µ1 – µ, while the strong market is µ2 – 1 – µ.

The main presumption is that the two types of consumers would want to receive quality products, though the strong market segment has more interest in quality than the other segment. We therefore have µi1 – ti q1 as the utility function of a product of q1quality for consumer i. therefore, our assumption will be µi2> µi1 for i-1, 2 as well as µ22 – µ12 – µ11. In this situation, there are two models of firms which are; the traditional firms (L or R) as well as low-cost firms (S or M). These two firms have two main differences, in that the traditional firms are capable of offering commodities of two different qualities, being q1 and q2, where q1 < q2 and whose unit costs are c1 < c2. On the other hand, the low-cost firm would only be able to offer commodities of only one quality q1 whose unit cost is c0 < c1. What this means is that even though the traditional firms can offer a range of products they will incur a higher unit costs in doing so while low cost firms can only offer a number of selected products but at a lower cost.

The incumbent firms produce quality q1 products for the weak market, while also producing quality q2 products to satisfy the strong market. However, since most markets are highly interdependent, a diversion may occur where a weak market consumer may want to have a strong market product. Assuming that p1j is the price that firm j charges for quality q1, and p2j is the net utility of consumer with t2, whenever they decide to purchase q2, then their net utility is the same as when they purchase q2, thus the terms u22 – p2j>u21 – p1.The same inequality can be expressed as;

P2j – p1j< r

Where r = u22 – u22. Mussa and Rosen (1978) called this condition the incentive compatibility constraints, also known as IC.

The assumption is that consumers are horizontally heterogeneous such that some will chose to buy from firm L while others buy from firm R, S, and M.  That is to say, consumer preferences in regard to that brand are heterogeneous.  To apply this logic in regard to spatial distribution of consumers,  the assumption is that there is a uniform distribution of consumers on a unitary segment as proposed by Hotelling (1929), and that firms are situated on different spots on that line. The unitary cost (transportation) of consuming a product is presumed to be equal to σ, and differs horizontally beginning with the consumer’s ideal one. If all these issues are taken into consideration, the utility of a consumer of class i situated at x who purchases a quality i product from firm j which is situated at yj can be expressed as follows: uij – plj – r|x -yj|.

  • METHODOLOGY

In this section, we use data analysis provided by other research studies to demonstrate how fare prices in air transport have reduced as a result of the competition introduced into the market by liberalization of the industry. Particularly, we are going to look into how the incumbent airline companies have been forced to readjust their fare prices as a result of the introduction of the low-cost airlines.

Particularly, we use data analysis obtained by Obermeyer et al (2013: 31-34), Alderigi et al (2012) and the statistics provided by the European Low Fares Airlines Association (ELFAA) in their website of between July and December 2013.  In Obermeyer et al., the data collected was mainly on ticket prices on routes between major European cities and other international airports recording over a million departing passengers who were travelling to other countries within Europe in 2008 (2013:31). Air fares were recorded up to six weeks before the departure date. 1210 economy-class flights managed by 40 airlines within 137 airport pairs were generated, and tabulated into two tables, (Table A and Table B) as shown below:

Table A: This table shows the regression results obtained from that study.

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Variable                       Glodd                          In T                             Alodd

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Constant                      3.1349                         6.2836                         5.6019

HHI                             2.0181                         3.3647                         3.3947

HHI                             2.1757                         3.6116                         3.6456

Flights                         0.1130                         0.2014                         0.2043

LCC                            0.3821                         0.6870                         0.6816

Tourist                         0.7624                         1.4885                         1.4924

Distance                      0.0212                         0.0464                         0.0466

Population                   0.0773                         0.1684                         0.1675

Passengers                   0.0647                         0.1224                         0.1217

Morning                      0.0258                         0.0425                         0.0343

Midday                       0.1346                         0.2175                         0.2132

Afternoon                   0.0069                         0.0392                         0.0477

AdjustedR                  0.4640                         0.4253                         0.4226

Observations                           1210

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Table B: This table represents classification of airlines according to the airline dummy regression results and in terms of whether their price dispersion is higher, lower or similar to that of Lufthansa which was used as the Base airline during the study.

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Higher Dispersion                               Similar                                     Lower Price Dispersion

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British Midland                                   Spanair                                    Brussels Airlines

Ryanair                                                TAP Portugal                          MaléV Hungarian Airlines

British             Airways                                   Luxair                                      TAROM

LOT                                                    Iberia                                       Olympic Air

SAS Scandinavian Airlines                 Niki Luftfarhrt                        Air Europa

Air Lingus                                           German Wings                        Aegean Airlines

Air Berlin                                            Cypress Airways                     Air France

Blue1                                                   Norwegian Air Shuttle            Air Malta

Flybe                                                   Air Baltic                                Finnair

Cimber Sterling                                   Bulgaria Air                            Wind Jet

EasyJet                                                Estonian Air                            KLM Royal Dutch Airlines

Travel Service                                                                                     CSA Czech Airlines

Vuelning Airlines                                                                                Blue Panorama Airlines

Alitalia

Austrian

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The mode of price distribution by airlines for every flight was calculated using indices, e.g. The Gini Coefficient factor G, as follows;

| pi – pj|                                                                   (i)

Where n represents the number of prices observed, and ṕ is the average price charged for a flight and p1,…..pn show the number of ticket prices used in the study that were charged for a particular air flight.

T                                                                                   (ii)

Aε1-ε] 1/(1-ε)         where ε ≠ 1                                        (iii)

Using different dispersion methods was seen as necessary in order to minimize the risk of getting results that are distorted as a result of applying a single index. The study therefore used the above three price dispersion methods as dependent variables for our regressions.  In measuring the intensity of the competition, it applied the Herfindahl-Hirchman Index HHI, with value close to 1 showing a high market concentration which also means that the rate of competition in the market is low.  This index was calculated using the number of flights recorded for a particular route:

HH2                                                 (iv)

In this function, frequency i indicates the number of air flights that airline i took for a given route, while k represents the number of airlines that operate on that route. Number of flights within a specific route for each airline was determined within three months using the published flight plans.  HHI was calculated at an average of 0.595 and the standard deviation was 0.208. the other alternative of computing the intensity of competition was the use of passenger flows. However, this was discouraged due to unavailability of reliable data. Also, even in cases where reliable data is available, this method is highly undesirable as it is partially price determined. The use of number of flights to measure competition intensity was preferred in order to avoid the issue of endogeneity. More information was necessary in order to act as a control against other influences on dispersion of price. Therefore, dummy variables in regard to airlines and departure time and characteristics of routes using sources such as ESPON (2007) to identify the number of people living within a certain metropolitan area, while Eurostat database was used to identify the number of passengers departing from a given airport.

Data analysis provided by the study of Alderighi et al. was also used to form our hypothesis. In that study, the two-step least square estimation method (2SLS) was used to analyze the impact of new entrants into the market on the fares charged to consumers. Table 3 below shows the results obtained in that analysis while Table 4 shows the statistics obtained from ELFAA website in regard to the market share of the various European Airlines.

Table 3: Table 3: showing fares (in Euros) charged in monopoly and the effect after new entrants

Class of Service Fares in Monopoly Entry of Incumbent Airline Entry of an LCA Entry of both incumbent and LCA
Promotional 190 -21 -40 -59
Discounted 1 314 -37 -62 -93
Discounted 2 397 -24 -112 -112
Economy 1 509 -46 -131 -155
Economy 2 624 -33 -109 -144
Unrestricted 1 918 -122 -95 -216
Unrestricted 2 1031 -153 -88 -245
Unrestricted 3 1126 -227 -55 -235

Table 4: Showing the Market share of LCAs (e.g. Easyjet and Renair) compared to other Airlines between July and Dec 2013

Airline Country No. of Passengers No. of Flights Daily Average Load Factor
Rynair Ireland 81.4m 1,600 83.00%
EasyJet UK 61.4m 1,163 89.30%
Norwegian Norway 20.7m 423 80.00%
Volotea Spain 17.2m 335 79.60%
Wizz Air Hungary 13.5m 238 86.10%
Flybe UK 7.5m 402 59.00%
Transavia.com Netherlands 6.5m 126 90.00%
Jet2.com UK 5.6m 178 90.70%
Volotea Spain 1.4m N/A N/A
Sverigeflyg Sweden 0.8m 61 72.00%
  • Model

The regression analysis used in these studies was based on cross-sectional data. Dependent variable represented the measure of price dispersion used for every scenario (G, T, A). The level of competition is indicated by market concentration variable HHI. This model is desirable as it allows flexible relationship between market concentration and price dispersion. This specification was based on the theory presented by Dai et al. (2011), who concluded that an inverse U-shaped relationship exist between price dispersion and market competition. The following estimation equation was therefore derived:

PDMfar = β0 + α1HHI2r  + α1HHIr  + µ1Flightsr + µ2LCCr+ µ3Touristr + µ4Distancer + µ5Populationr + µ6Passengersr + y1Morningfar + y2Middayfar+ y3Afternoonfar + Airlinefar + εfar                                                                                                (v)

Here, f represents a specific flight that is operated by airline operating through route r. m represents the number of airlines studied; and ε is the error term. The other variables included in the function are characteristics of routes studied which are indicated using parameters µ, dummies for departure time, y, and dummies for airlines, . Below is a brief description of these variables:

  • Flightsr  variable measures the number of air flights operating on route r within a given period of time. In other words, this is the capacity of airlines using the given route.
  • LCCr dummy variable shows whether there is a low cost airline using route r. Its role is to show the effect of LCAs to competition.
  • Touristr dummy variable indicates whether there is any city on the route that has the potential to be a tourist destination. This is to ensure that the influence of tourists on price dispersion has been eliminated.
  • Distancer variable is continues and measures the distance between the origin airport and the destination airport, and represents the operation costs involved.
  • Populationr represents the total number of people living within the metropolitan area between the two end points of the route under scrutiny. It shows the potential market size available for an airline.
  • Passengersr represents arithmetic mean of passengers departing at the airport of origin and destination operating travelling through route r. This shows the existence of ‘hubness’ (Mantin and Koo, 2009).
  • The dummy variables representing departure time include; Morningfar, 5.00 – 9.59; Middayfar, between 10.00 – 13.59; Afternoonfar, between 14.00 – 1759; and Nightfar between 18.00 – 23.59, for every flight (f) that is operated by airline a through route r. inclusion of the various dummy variables was important in seeking to control the effects of systematic pricing for peak loads. The night flights have were omitted from the study and treated as reference category.
  • Dummy variables Airlinefar were used as controls for differences in dispersion of price by various airlines. For Lufthansa, parameter (a = 1)was set at zero. Therefore, the other coefficients of airline dummies should be interpreted in relation to Lufthansa.

During the estimation process, the log odds ratios were applied to measure the two price dispersions, i.e. the Atkinson index and Gini coefficient. These were calculated as follows:

PDMlodd = ln(PDM/ (1 – PDM))                                                         (vi)

For estimations, the ordinary least squares which have heterogeneous scedasticity consistent and standard errors were employed.

4.0 RESULTS AND DISCUSSION

The resulting adjusted levels of determination show that the transformed Gini coefficient model is the best in this kind of analysis. However, the values obtained show that there is a substantial part of price dispersion variation that the model cannot account for. The values obtained using the HHI market concentration variable show an inverse U-shaped relationship between price dispersion and the intensity of competition. These values show the correct position and are statistically instrumental in all the three model specifications. These findings tally with those of Dai et al. (2011) who was studying the same concept for the US market.

The results obtained show the necessity to evaluate the actual condition of market concentration in order to derive credible conclusions on the effects of competition to price dispersion. For example, a new entrant in a market that is highly concentrate may result to increased price dispersion while entry into a market that is not too concentrated will reduce price dispersion. Evaluation of the control variables produced the following results; the degree of price dispersion rises as more number of flights in a given route increase; when the population living within a given metropolitan area is large; if there is an LCA operating on that route; and when there is a tourist destination city within at least one of metropolitan area. When the number of passengers departing from an airport goes up, price dispersion seems to go down.

A comparison of the results obtained from this study with those of other studies show both similarities and deviations. For example, the positive influence of number of flights to price dispersion was also observed in the study carried out by Gaggero and Piga (2011) who concluded that these results show the impact of using price dispersion to competitively steal business from competitors. This means that airlines use greater price differentiation as a response to increased flights within a given route. However, the results obtained in regard to Populations and Passengers variables go against the observations made by Manti and Koo (2009), although the observed effect of the introduction of LCAs to competition was the same. It is therefore established that when LCAs, who are known to engage in high price differentiation, are introduced into the market, this forces the incumbent airlines to engage in low-high pricing strategies which has the effect of increasing price dispersion (Mantin and Koo, 2009). To cite the findings by Borestein and Rose (1994), as passenger groups exhibit homogeneity in their price elasticities of demand, then it is expected that price discriminations will go up. Therefore, lower price dispersion should be expected in routes with high number of leisure passengers. While Borestein and Rose used empirical evidence to support this argument, results from this research study show higher price dispersion on routes with tourist destinations.

According to past studies, a production possibility frontier has been estimated while employing parametric or non-parametric analysis. Some of the productivity studies that conducted their studies using data collected from a period comparable to the one used for this study are Assaf and Josiassen (2012) and Barbot et al. (2008). Barbot conducted a data envelopment analysis using data from 2005 in computing the total factor productivity (TFP) as well as efficiency scores. They found that LCAs operate with greater efficiency as compared to incumbent airlines. Assaf and Josiassen also confirm this position through the use of a translog distance function as well as data panel between 2001 and 2008.

The results from these two studies in regard to efficiency scores and TPF are very similar to the findings of this study with the results of dummy variables to the extent that airlines that show high efficiency scores in those productivity studies have exhibited a pattern of strongly differentiated fares, and the other way round. In particular, the two studies calculated high efficiency scores for airlines such as British Airways, Easyjet and Ryanair while at the same time calculated low efficiency scores for Finnair, Malev, Czech Airlines, Alitalia and Australian airlines. In both studies, Cyprus Airways and Iberia scored equally with Lufthansa. In regard to TAP, Air France and KLM, the studies were not adequately clear though the findings are in tandem with the airline dummy estimations from this study. The two studies however seemed to have calculated a low score for LOT while according to our study, LOT are better equipped to differentiate their fare prices more strongly as compared to Lufthansa. 

The reason why some airlines are able to differentiate their prices more strongly as compared to others is routed in the efficiency of the airline (Obermeyer et al. 2013: 33). When an airline is more efficient than its counterparts, then it is able to enjoy the cost advantage which enables it to offer low prices especially for those customers with a price elastic demand. The LCAs, which have been known to operate under relatively low costs, are therefore able to offer lower fare prices. The incumbent airlines seeking to serve consumers whose demand is elastic are also forced to lower their prices. On the other hand, since there is little incentive for an airline to lower its fare prices for customers whose demand is inelastic, this leads to increased level of price dispersion. Thus, incumbent airlines providing services to customers whose demand is inelastic such as tourists and high valued clients do not have to lower their prices which explains the different prices charged by different airlines at the airport. The study concludes by saying that the results of this study are largely heuristic in nature. To derive more reliable results, it would be necessary to conduct an econometric analysis which creates a link between efficiency and productivity with price dispersion in future research studies.

5.0 CONCLUSIONS

Most studies that have been conducted to establish the relationship between price dispersion and the degree of market competition within the airline industry have produced rather heterogeneous findings. Majority of the early studies produced a monotonic – either positive or negative – connection between competition and price dispersion. However, more recent research in the same area has shown a non-monotonic relationship between these two elements. Most of the studies are those that have been conducted within the US market. Very few researches have been conducted within the European airline market in regard to this topic. As a bridge to this gap, we have found that there the relationship between the intensity of competitions and the degree of price dispersion when it comes to economy-class flights is an inverse U-shaped one. Based on the actual degree of market concentration, increased competition into the airline industry will either raise or lower price dispersion. Therefore, the mere entry or mergers within the industry do cannot tell us what will happen to price dispersion unless we have evaluated the level of market concentration first. However, for purposes of our discussion, which sought to identify how, liberalization led to lowered fare prices, the results of this research study support our argument that entry of new competitors led to reduced fare prices. This is based on the premise that before liberalization took place, there were few airlines, thus market concentration was low. Thus, any entrants immediately after liberalization were entering into a market that was less concentrated. The results have shown that entry into a lowly concentrated market leads to reduced prices fares even from the other incumbent airlines.

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