Karsten Fröhlich, University of Applied Sciences Bremen, Germany
Abstract:
This paper investigates the applicability and the implications of the economic theory of product differentiation to the airline business. While the aim is not to look for the model of product differentiation, I will try to point out what models can be used for what and under which circumstances they can be used. Thus, while keeping the industry constant I will go through different models and analyse their applicability. Focus is on passenger transport and on European carriers.
My findings are that the economic theory of product differentiation can provide explanations and reasoning for many developments that have taken place in the airline business, such as the emergence of low cost carriers (LCCs), airport choice of airlines and LCC business models that depart from the business models of LCCs like Southwest and Ryanair. Hence, it should also be possible to make predictions about the future development of the airline industry using the theory of product differentiation.
1. Introduction
For a long time in its history the airline business was a highly regulated and nationalised industry. Almost every country had its respective carrier (or flag carrier), markets were sealed off, competition was limited and effectively non-existent. International flights were regulated through restrictive cabotage rights. Each flag carrier enjoyed a comfortable monopoly position within its market. In the 1990s the European aviation market was liberalised, which was somewhat later than the liberalisation process in the US which took place in the 1980s. Liberalisation in the EU came in three packages, 1987, 1990 and 1992. The third stage was certainly the most significant, because it meant the removal of licensing restrictions, the freedom of setting prices and the introduction of unrestricted cabotage rights. What however followed was to a lesser degree the introduction of competition among flag carriers, yet more the introduction of a new business model, that of Low Cost Carriers (LCCs).
Since the rise of LCCs the airline industry has undergone profound changes. Competition had already increased through the liberalisation efforts, mainly in the US- and EU-markets, and LCCs have especially put short-haul markets under severe pressure. The issue of the correct business model has become increasingly important. Consolidation has taken place everywhere. Especially the flag carriers had to adapt their way of doing business and were in a need to cut down costs. It can also be seen that not all LCCs are the same. Some have departed from the models of LCCs of the first days, like Ryanair and Southwest, and adopted a different approach. There is an increasing and ongoing debate over what a LCC really is and what the airline industry will evolve into. Recently, even the first long-haul flight of a LCC could be seen and although it remains an open question weather this will persist and find followers, it has certainly the potential to change the shape of the industry. Economic theory can provide explanations and reasoning for the entry of LCCs and thus, it should (theoretically) also be able to provide justified predictions about the future of the airline business.
Industrial economics offers a broad set tools and (sometimes competing) theories for analysing an industry and explaining market structure. I believe that there is widespread recognition that the airline industry has an oligopolistic market structure. Taking two main subjects of oligopoly theory, price discrimination and product differentiation, it can be seen that, while the issue of price discrimination has been dealt with (Botimer and Belobaba, 1999; Giaume and Guillou, 2004; Gillen and Hazledine, 2006), the issue of product differentiation in the airline business has been neglected to some extent. In Shaw (2004, chapter 5) and Klaas and Klein (2005) the issue is dealt with, but these authors used a marketing and business orientated approach, based on the tools from strategic management. For example, the latter two authors used Porter's (1980, 1985) generic business-level strategies, which claims that differentiation and cost-leadership are generally inconsistent. Yet, Hill (1988) has provided a framework that shows that they can be consistent and even generate competitive advantage.
This text is the first page of chapter one for further reading please download the paper below.
Author: Karsten Fröhlich, University of Applied Sciences Bremen, Germany
Paper: Paper submitted for the GARS Junior Researchers’ Workshop
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