Assignment Task
Executive Summary
This paper discusses Porter’s five forces framework and its application to the commercial airline industry in the North American region. The airline industry in the US was booming right up until the COVID-19 pandemic shocked the globe. It will take a few years for airline carriers to get back on track in terms of revenue, number of passengers carried, and number of flights being offered. Porter’s five forces framework is used to analyze the different forces that act on this industry, and which eventually affect the profit. The first force which has a significant impact on the industry is internal rivalry. In the U.S.A. there exist a few major firms that dominate more than 75 percent of the entire airline market. For this specific industry, there are barriers to entry and exit such as high fixed costs. Furthermore, these firms usually differentiate against one another based on price. The second force which is not as significant is the threat of entry. Due to there being a requirement for high initial investments and the presence of regulatory obstacles, firms that are new to this industry will most likely not try to penetrate the American market. To continue, the next force that does not significantly impact is substitutes and complements. Other than the rail network, there are no real substitutes when it comes to the airline industry.
Introduction
The purpose of this paper is to examine the airline industry using Porter’s five forces framework in the North American region. This industry is a subset of the much larger aviation industry which includes military aviation, general aviation, and commercial aviation. In the U.S.A, commercial aviation is divided into three parts based on the revenue collected by the airline. Airlines are classified as either Major, National, or Regional airlines (Sectors of Aviation, 2021). Major: Delta Airlines, American Airlines, Southwest Airlines, and United Airlines National Airlines: Atlas Air and Emory Worldwide Regional Airlines: Piedmont Airlines and SkyWest Airlines The geography of the US coupled with the absence of a high-speed passenger train network is the reason why there is a significant demand for airline travel.
The airline industry raked in about 106.5 billion dollars in revenue for the year 2021 coming from a total of 59 airlines, out of which 18 are major. Furthermore, the number of passengers for the same year sat at 926 million and this industry is expected to grow annually at a rate of 29.07 percent from 2021-2025. In terms of market distribution, American Airlines is at the top with a share of 19.3 percent, closely followed by Southwest Airlines at 17.4 percent, Delta Airlines at 15.5 percent, United Airlines at 12.4 percent, Spirit Airlines at 5.8 percent, and Alaska Airlines at 5.3 percent. The remaining 24.3 percent market share is taken by the other fifty-three US Airlines (Roger Cheng, 2021) What is interesting to note is that the overall debt accumulated sat at a staggering amount of 180 billion dollars for the year 2020 (Roger Cheng, 2021). Despite, these statistics the airline industry is considered to be a popular industry for new businesses to enter. After the COVID-19 5 pandemic, there have been many low-cost carriers that have entered the US airline industry which has led to disruptive changes being made (Kaffash & Khezrimotlagh, 2022). Before looking at Porter’s five forces it is important to understand the structure of the airline industry in the US. The airline industry in the US is oligopolistic in nature. As mentioned above, there are a few carriers that account for the majority of the industry’s market share. The major six airlines account for almost 75 percent of the entire market. The fact that a few airline firms dominate the US market shows the oligopolistic nature of the industry. In this oligopoly, these major firms have the power to set or change the prices for their tickets at different output levels.
However, the issue is when a firm decides to change the price, the competitors notice this behaviour and as a result, take their own decisions to either price cut or some other action so that they can gain a larger share of the market. This can lead to a deadlock and that is the reason why the airline firms are cautious because they are aware of how they can lose market power to either their direct competitors or to new firms entering the industry. Furthermore, the fixed costs are relatively high as this industry requires a high amount of capital investment at the start (Rubin & Joy, 2005). The Air Transport Association estimated that two-thirds of the total costs for an airline are fixed costs (Air Transport Association, 2002). Even though the major airlines have the power and ability to restrict competition, low-cost carriers have been able to create a niche and offer their services to price-sensitive customers. Surprisingly, these new entrants can break even and at times earn profit as their overhead cost is lower. The reasons for this are as follows (Rubin & Joy, 2005):
- Since the labor is not unionized, the airline takes advantage of lower pay scales.
- Utilisation of more fuel-efficient aircraft which tend to be much smaller in size.
- Turnover time is less compared to other major airlines.
The diagram below shows the impact of macroeconomic and microeconomic factors on the airline industry’s demand and supply.
As can be seen in the diagram above, due to different micro and macro factor factors, the demand has decreased from D1 to D2. Not only that, but the elasticity of demand has increased as customers are more responsive when there is a change in the price level. Demand curve D2 is flatter compared to the original demand curve D1. This shift of the demand curve has led to the price of airline tickets dropping from P1 to P2. Furthermore, the quantity of passengers that demand these airline tickets has also decreased from Q1 to Q3. As there is a change in demand, the airline industry has reduced the supply of airline tickets from supply curve S1 to S2. This was done so that the costs could be reduced and now the new equilibrium is at P3, E3 (Rubin & Joy, 2005). The purpose of this diagram was to show how price-sensitive customers are in the US.
when it comes to the airline industry. Gone are the days when customers would pay more just so that they could fly on their preferred airline. The emergence of technology and the availability of digital resources has allowed customers to have access to enough data to compare and find the cheapest possible option to travel.
Understanding the competitive forces at play is crucial for the US airline industry to succeed and be profitable. The issue at hand is that managers do not look at competitiveness with a broad enough lens. Instead of just focusing on the direct competitors, these airlines operating in the North American region must ensure they look at the other competitive forces that dictate profitability and competence (Porter, 2008). Michael Porter stated that profitability is defined by five forces: the bargaining power of buyers, the bargaining power of suppliers, the rivalry in the industry, substitutes, complements, and the threat of new entrants. Not only do these forces help one understand the structure of the industry but also the future of the organizations operating in that industry. The analysis of Porter’s framework allows one to obtain a holistic view of the industry and more importantly allows firms to decide on what their competitive strategy should be. Porter cleverly stated that other than direct competition, a firm must also consider the other four forces to compete strategically and get an idea about the significant trends affecting that industry (Porter, 2008). As mentioned earlier, the airline industry is one of the least profitable industries and this framework allows us to see the reasons why this is the case. First of all, there is fierce competition among the different firms that are already well established in the market. Secondly, the bargaining power that suppliers and buyers hold is immense. The only factors that are not as highly ranked as the ones mentioned above are the substitutes and the barriers to entry (Porter, 2008). Both these factors are ranked relatively low. All five forces are discussed in detail below concerning the American airline industry.
Porter’s Five Forces
Industry Rivalry
This force focuses on the number, extent, and capabilities of the competitors operating in the industry (IBISWORLD, 2020). Several determinants allow us to determine the rivalry among the existing competitors. First of all, from 2012 to 2019, the American airline industry outperformed other airline industries by registering an economic profit of forty-four billion dollars. Furthermore, half of the top ten airlines were airlines based in the North American region (Bouwer et al., 2022). Thus, the American airline industry was growing rapidly up until the start of the COVID-19 pandemic. This industry consists of a handful of major firms dominating the market along with several smaller to medium-sized firms that try to compete with these larger firms (IBISWORLD, 2020). As mentioned earlier, in this oligopolistic industry, the major airline firms are American Airlines, United Airlines, Spirit Airlines, and Alaska Airlines.
Thus, the industry rivalry force in Porter’s framework has been marked as significant or strong due to the following reasons (Rasouli, 2014):
- Several competitors competing with one another in the industry
- Fixed costs being a major component of total costs
- Lack of differentiation among airlines
- Barriers to entry and exit
Threat of New Entrants
The second force that will be discussed is the threat of new firms trying to enter the airline industry. It only makes sense for a firm to enter a new market if the profit that is being made in that industry is high enough. To continue, there should not be that many barriers to entry and exit for it to be considered an attractive opportunity for a new firm. Due to there being significant 10 barriers to entry and exit such as high capital costs, firms will think twice before entering the American airline market. To continue, for a new firm to capture a portion of the market share, it would have to have a good understanding of the regulatory framework and guidelines set for the airline industry (Nataraja & Beau , 2020). For the US market, the government organization that is responsible for regulating air travel is the US Department of Transportation (Harvard Law School Library, 2022).
Substitutes and Complements
This force deals with alternative services and/or products that provide a similar solution to customers. If there exists a product that acts as a substitute, this can act as a threat to the industry’s profit as this will create more competition (Rasouli, 2014). Firms must understand not only the service being offered by their direct competitors but also the services being offered by the indirect competitors. With respect to the airline industry in the U.S.A, there exist a few substitutes namely: rail transportation, road transportation, and sea transportation. However, due to the sheer size of the US, traveling from one coast to another via rail or road is not effective due to the amount of time it would take. Or in other words, consumers are unlikely to opt for other means of transportation if they are traveling a significant distance.
Bargaining Power of Suppliers
The profitability of an industry can be affected by the power that the supplier has. A supplier with significant bargaining power can either raise the price or change the quality of the good or service that is being provided (Porter, 1979). By doing so, a supplier can reap most of the benefits and profits (Porter, 2008). With respect to the airline industry in the US, there are two major suppliers: Airbus and Boeing. The power that these two suppliers hold is quite significant as most of the major airlines such as American Airlines, Delta Airlines, and United Airlines rely on these aircraft manufacturers to obtain their aircraft. On the other hand, Southwest Airlines relies solely on Boeing to get its fleet of Boeing 737 MAX 8 (Southwest Airlines, 2022). Globally, both these aircraft suppliers account for 99% of the aircraft orders (Nataraja & Beau , 2020). Due to being the only two suppliers, both Boeing and Airbus hold significant bargaining power over the airline carriers. If either Boeing or Airbus increases the prices of their aircraft, the airline carriers have no choice but to continue with the same supplier. This once again shows the power that a supplier can have in an industry where only a few suppliers are present (Rasouli, 2014). Even though suppliers of fuel are also essential to this specific industry, because there are numerous suppliers and considering that this product is a commodity, the suppliers do not hold as much bargaining power in this industry (Nataraja & Beau , 2020).
Bargaining Power of Buyers The power that the buyer possesses can affect the operation of an organization. Several studies have found that customer satisfaction has led to firms being able to gain a competitive advantage. By having this competitive advantage of satisfied customers, firms have been able to see increased income, a decrease in the costs required for transactions, and loyal customers purchasing the product/service again and again (Rasouli, 2014). Customers are considered a threat only when their bargaining ability could decrease prices or increase total production costs because of demand for quality products. However, in the case where buyers have significant bargaining power, can be considered a threat to the industry. This is because of the following two reasons (Rasouli, 2014):
- This power that they possess could lead to a reduction in the prices of the service
- The demand for services of top-notch quality could increase which would result in the firms spending more resources to cater to this demand.