Threats of substitutes in the airline industry

The Commercial Airline Industry

October 17th, 2014

Ben Cohen

Z23106977

Global Strategy and Policy

Man 4720

Professor Harry Schwartz

Finance Major

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In this paper, a Porter’s analysis will be conducted on the commercial airline

industry. The Porter analysis is a means of measuring the intensity of the competitive

forces associated with an industry. The competitive forces consist of threat of new

entrants, rivalry among existing firms, threat of substitute products or services,

bargaining power of buyers, bargaining power of suppliers, and relative power of other

stakeholders. Each of these 6 competitive forces will be analyzed and rated high, medium

or low in strength based on their intensity.

Threat of New Entrants: Low Companies that are considering or attempting to enter the airline industry will

have extreme difficulty, as a result of the many entry barriers they will encounter. These

entry barriers are why the threat of new entrants in the commercial airline industry is

considered low. Airline companies operating in today’s industry have a large inventory of

aircrafts and offer many flight availabilities. They are able to use economies of scale to

effectively provide flexibility to travelers. The existing airline companies will capitalize

on their economies of scale as a competitive advantage and entice travelers with their

low-cost fares for the same service. This is why in the airline industry many companies

seek to gain strategic alliances with other companies. Forming strategic alliances allows

companies to add new routes and increase sales revenue, without substantially increasing

their capital investment. An example of this is the joint venture agreement between Delta

Air lines and Virgin Atlantic Airways Ltd. This agreement allowed them to form a “fully

integrated joint venture that will operate on a “metal neutral” basis with both airlines

sharing the costs and revenues, from all joint venture flights” (Delta Air Lines, 2012).

This agreement will allow these two airlines to provide a seamless network between

North America and the U.K. for their customers. These alliances have changed the

dynamic of the industry.

Another barrier to entry into this industry is the extremely high capital

requirements. It takes a large amount of initial capital to buy inventory of large

commercial aircrafts. However, it is not just the initial capital that is crucial; it is also the

steady capital needed to maintain these aircrafts. “Domestic carriers spent $11.6 billion

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last year on capital improvements. Over the past five years U.S. airlines have retired

nearly 1,300 planes” (Mayerowitz, 2014). This is substantial evidence of the financial

intensity associated with entry into this industry.

Another barrier to entry is government policy. Government policy in the past

played a much larger role, however today, it is no longer a strong barrier to entry into the

airline industry. This is the case because on October 24, 1978, the Airline Deregulation

Act was passed. “Federal controls over the entry and exit of airlines, flight schedules,

airfares and quality control of service were abolished” (Morris, 2013). Although

government policy is no longer a strong entry barrier, the difficulty new companies face

with economies of scale and capital requirements still make the threat of new entrants

low.

Rivalry among Existing Firms: High A major challenge facing the companies in the airline industry is the rivalry

among existing firms. Even though the number of competitors is low, airline companies

face intense competition. This intense competition is a direct result of the Airline

Deregulation Act in 1978. Prior to this act, “flying was absurdly expensive. There was

one simple reason why flying was absurdly expensive. That was the law” (Morris, 2013).

The deregulation of the airline industry allowed companies to adjust prices and thus make

the market more competitive and price sensitive.

Another challenge is the high amount of fixed costs airline companies face.

Companies must fly their planes on schedule, whether at full capacity or not. This is a

key factor that illustrates the competiveness of the industry. Regardless of the situation,

airline companies must find a way to entice customers to fly with them, and that often

means lowering ticket prices. “To cover its costs, an airline must have on average 65% of

its seats occupied, a share that increased since deregulation” (Rodrigue, 2014).

Companies must then sell there remaining tickets at a price that gives them no profit

simply because it’s better to redeem some money, than to lose the entire amount on an

empty seat. As a result of this, companies must formulate a strategy to increase sales, or

they will operate at a loss.

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Diversity of rivals is another factor that plays a role in the rivalry among firms.

For the most part, all airlines provide the same services and therefore it is very difficult

for companies to differentiate themselves. This lack of diversity increases competition

and ultimately drives prices down. “Over the last 10 years or so, Allegiant Travel and

Spirit Airlines have pioneered a new “ultra-low-cost-carrier” business model in the

airline industry” (Weinberg, 2014). This example clearly illustrates the intense rivalry

airline companies face and their willingness to provide low-cost fares to gain market

share.

Threat of Substitute Products or Services: Medium The airline industry faces potential competition from other forms of substitute

products. These substitutes consist of other forms of travel such as cars, buses, railroads,

and cruises. “For trips between 100 and 500 miles, express buses, trains, and airlines are

all vying for customers and contemplating the future of these shorter trips” (Webber,

2012). Substitute transportation methods pose serious competition threats to short

domestic flights. Driving offers the customer the most flexibility and therefore must be

taken into consideration by airline companies. Although these are legitimate alternatives

to flying, threat of substitutes is still ranked as medium because with the increased

industry competition, airlines are forced to offer consumers comparable low-cost fares. In

addition to the comparable prices, airlines offer a faster and more convenient method of

travel than any other form of transportation. More so, when it comes to long distance

trips, airlines face very few substitutes and that is why airlines will continue to be the

dominant method of transportation for longer trips.

Bargaining Power of Buyers: Medium Passengers are considered the buyers in the airline industry. In the airline

industry, alternative suppliers are plentiful. As a result, passengers have the ability to

search all the different airline rates and choose the best option. The fact that the airline

industry is pretty standardized really gives the buyer strong bargaining power. “The shift

in the airline industry over the past four decades has been towards more price sensitivity”

(The Economist, 2012). In addition, changing costs are very little. If a customer is not

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satisfied with an airline, they can easily switch to another company with no cost. There is

essentially no commitment by a passenger. Since passengers can easily find an alternative

flight, airlines don’t have much pricing power and therefore buyers bargaining power

plays a major role in the airline industry. This directly correlates with the increase in

customer demand for cheaper tickets.

Bargaining Power of Suppliers: High In the airline industry, the main suppliers are the airplane and part manufacturers. The

two main suppliers are Airbus and Boeing and between them, they have significant power

and dominance over the airline industry. “The gap in annual orders for Airbus and

Boeing has been very narrow, which is indicative of the intense competition that exists

between these two airplane manufacturers” (Trefis, 2014). The airline industry has a

limited amount of suppliers and Airbus and Boeing have high credibility and therefore

have a strong demand for their products. “Airbus has increased the average list prices of

its aircraft by 2.6 percent across the product line” (Airbus, 2014). Examples that illustrate

these two suppliers high bargaining powers are the low amount of other suppliers, high

built up switching costs and the uniqueness and superiority of their products. As a result

of this, Airbus and Boeing are able to charge a premium.

Relative Power of Other Stakeholders: Medium The airline industry faces the power of other stakeholders such as the government. The

government agency that is most relative to the airline industry is the Transportation

Security Administration. The Transportation Security Administration’s main goal is to

manage the security policies of the airline industry. “The Office of Security Policy and

Industry Engagement Commercial Aviation Airlines Branch develops new policy,

reviews existing policies to address evolving threats to commercial airlines, and provides

regulatory oversight of commercial airlines” (TSA, 2014). As a result, the TSA imposes

strict regulations for the safety of travelers. “Airline operators must adhere to rules on

security and training or face fines, suspension of operating licenses, or even face criminal

charges” (Stoltz, 2014). These penalties force airline companies to encounter additional

costs to meet these standards. This is why the power of government regulations plays a

significant role in the airline industry.

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Works Cited

"Delta and Virgin Atlantic To Form Strategic Alliance." Delta. Delta Air

Lines, 11 Dec. 2012. Web. 11 Oct. 2014.

.

Mayerowitz, Scott. "As Planes Age, Airlines Go On A Record New Jet

Shopping Spree." The Huffington Post. TheHuffingtonPost.com, 09 Jan. 2014.

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Huffington Post. TheHuffingtonPost.com, 13 Dec. 2013. Web. 11 Oct. 2014.

over-evidence_b_4399150.html>.

Rodrigue, Jean-Paul. "Operating Expenses of the Airline Industry." The

Geography of Transport Systems. N.p., 2014. Web. 11 Oct. 2014.

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Webber, Robbie. "Buses, Rail, and Airlines Compete for Short-distance Intercity Travel

SSTI." State Smart Transportation Initiative. N.p., 30 Oct. 2012. Web. 12 Oct.

2014.

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Economist, The. "Airlines Would Like To Be Legally Exempt From Telling You How

Much Your Flight Actually Costs." Business Insider. Business Insider, Inc, 31

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Trefis. "Boeing Leads Airbus In The Race For New Commercial Airplane Orders

In 2014." Forbes. Forbes Magazine, 18 Aug. 2014. Web. 12 Oct. 2014.

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Airbus. "Price Adjustment for Airbus' Modern, Fuel-efficient Aircraft Family." New

Airbus Aircraft Lists Prices for 2014. Airbus, 13 Jan. 2014. Web. 12 Oct. 2014.

airbus-aircraft-list-prices-for-2014/>.

TSA. "Commercial Airlines." Transportation Security Administration. Transportation

Security Administration, 29 Jan. 2014. Web. 12 Oct. 2014.

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Stoltz, Brenda. "Navigating TSA, DOT, and FAA Security Requirements for Airline

Operators." NATA Compliance Services Blog. N.p., 17 Apr. 2014. Web. 14 Oct.

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