case study on oligopoly airlines

Page One Economics ®

The economics of flying: how competitive are the friendly skies.

"If the Wright brothers were alive today, Wilbur would have to fire Orville to reduce costs." —Herb Kelleher, Co-Founder, Chairman Emeritus and former CEO of Southwest Airlines 1

Introduction

If you've ever traveled by plane, you know how stressful flying can be. Between the long lines and crowded flights, air travel is something most of us endure for business, family, or vacation. Several decades ago, however, the experience was quite different and even considered luxurious by some. 2 Flyers usually received complimentary meals, whereas flyers today receive complimentary peanuts or pretzels at best. Passengers also previously enjoyed more legroom and had a wider choice of seats, unlike today's crowded flights. 3 What changed? 

Luxurious to No Frills 

Prior to 1978, a government agency called the Civil Aeronautics Board regulated how much airlines charged and where they flew. 4 Because prices were regulated, airlines had to use non-price competition strategies to attract customers, including more frequent flights and higher quality meals. 5 While these amenities resulted in a more pleasant flying experience for those who could afford it, flights were rarely full since the high cost deterred potential customers. 

In the late 1970s, Alfred Kahn, an economist who chaired the Civil Aero­nautics Board, led the effort to deregulate the airline industry. He recognized that the lack of price competition prevented the market from operating efficiently because higher prices resulted in fewer people flying. 6 Kahn thought deregulation would introduce price flexibility and make tickets more affordable—benefitting consumers and filling more empty seats. 7 However, Kahn also believed that the airline industry would still need strong antitrust laws to "preserve the benefits of competition that deregulation was supposed to produce." 8

Spurred by Kahn and other advocates of deregulation, Congress developed the Airline Deregulation Act. After passing with bipartisan support, President Jimmy Carter signed the act into law on October 24, 1978. 9 Along with the freedom to choose their own routes, the law allowed airlines to set their own airfares. 10 While you might suspect that this freedom led to higher prices, the law actually checked price hikes by introducing competition in the airline industry, encouraging airlines to lower their airfares to attract customers. Existing airlines added flights and routes, and new airlines entered the market to compete for the best routes at the cheapest rates. 11 As a result, once adjusted for inflation, airfares declined by 30 percent between 1976 and 1990. 12  

Following the law of demand , as the price of airline tickets fell, consumers increased the quantity of airline tickets they demanded. By offering discounted airfares, airlines were able to fill more seats, which improved the efficiency of the industry by better utilizing available aircrafts. 13 However, one unintended consequence of the lower airfares and corresponding increase in consumer demand was a decline in the quality of the flying experience. To accommodate passengers who wanted a flying experience similar to the pre-deregulation years, airlines started offering business class seats for a premium. In addition to costing a few hundred dollars more than standard airfares, these seats include more space and inflight services. While airlines have the freedom to raise service quality and charge higher prices, consumers typically prefer lower airfares despite the lower-quality flying experience. This preference incentivizes airlines to adjust their flights to the average flyer, making business class the exception rather than the norm. 14  

Is the Airline Industry an Oligopoly?

Although a healthy level of competition is important to maintain the best services for the lowest possible prices, competition does not always ensure the stability of an industry. Airlines have high fixed costs, which are costs that do not vary with the level of output in the short run; for airlines, fixed costs include buying and maintaining aircraft fleets. Conversely, variable costs fluctuate with the level of output. For airlines, these costs include fuel and salaries. Variable costs tend to be relatively low, although they can be volatile (e.g., fuel prices). Firms with a combination of high fixed cost and relatively low variable costs often attempt to spread their fixed costs across many units of output (e.g., airline tickets). For airlines, this combination creates economic incentives to grow very large. Economists explain this combination of factors as economies of scale , and it often results in a handful of very large companies dominating an industry. 

How did this play out for airlines? After deregulation, competition pushed fares so low that, for many airlines, only variable costs were covered. Airlines won't typically lower prices below variable costs because then it would be cheaper for them to not fly at all. But keep in mind that covering only variable costs means that fixed costs haven't been accounted for. After deregulation, many airlines weren't covering the full cost of running the company. Predictably, this situation makes airlines susceptible (in the long run) to bankruptcy and mergers. Indeed, the more competitive environment caused the industry to take sustained losses between 1977 and 2009, particularly around 9/11 and at the onset of the Great Recession. As a result, the airline industry underwent a series of mergers between 2005 and 2015, decreasing from nine major airlines to just four: American, United, Delta, and Southwest. Com­bined, these airlines controlled 80 percent of the U.S. market in 2015, 15 making the U.S. airline industry arguably an oligopoly . 16 (See the boxed insert.)

Since the mergers helped bring struggling airlines out of bankruptcy, why should the oligopolistic nature of the industry cause concern? An oligopoly can introduce complications for consumers in a number of ways. For one, a smaller number of firms (less competition) means that firms can raise prices more easily without the threat of losing large numbers of customers. In addition, although new entrants have greater potential gains from entering a less-competitive market, it can be difficult to enter an oligopolistic industry because of high barriers to entry. For the airline industry, barriers to entry include high startup costs (e.g., a new Boeing 737 airplane can cost $80 to $116 million 17 ), competition for airport gates, and large economies of scale.

Low-Cost Carriers: Reintroducing Competition

Figure 1: The Rise and Fall of Airfares

SOURCE: FRED®, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CUSR0000SETG01 , accessed June 13, 2018.

Airfares rose in the wake of the mergers, particularly since some airlines were attempting to pull themselves out of bankruptcy. However, airfares began to drop several years ago (Figure 1). If oligopolies have an increased level of market power , or the power to set prices, what has caused this recent decrease in airfares? Once again, a shift in the structure of the airline industry might help explain the shift in prices. 

Figure 2: Domestic Revenue Passenger Miles

NOTE: Data are for June 2017 to July 2018. Figures on bars are rounded. Revenue passenger miles are a measure of the volume of air passenger transportation. A revenue passenger mile is equal to one paying passenger carried one mile.

SOURCE: U.S. Department of Transportation, TranStats; https://www.transtats.bts.gov/ , accessed September 28, 2018.

A number of low-cost carriers began expanding their routes in 2016, including Spirit Airlines and Frontier Airlines (Figure 2). Such carriers increase competition in the market by catering to price-sensitive fliers. The average one-way fare between Detroit and Philadelphia was over $300 prior to the expansion of Spirit Airlines; afterward, the fare decreased to roughly $183. 18 Southwest, well-known for its low-cost flights, also causes airfares to decrease when it adds routes. In fact, the phenomenon has been named the "Southwest Effect." 19  

Larger airlines such as United and American tend to attract business travelers who want to enjoy amenities not provided by low-cost carriers. "Economy class" fliers, however, comprise the majority of travelers, making it imperative for the larger airlines to consider ways to attract them. 20 Thus, low-cost carriers pressure larger airlines to offer "basic economy" fares. As a result, airfares today are much more competitive across all airlines, regardless of whether the airline has traditionally been considered "low cost." 

Conclusion 

The proliferation of low-cost flights in recent years has pushed the airline industry, which was arguably an oligopoly, toward monopolistic competition. Like the airline industry, most other industries do not fall neatly into one of the four standard market structure classifications. In fact, market structures could be thought of as a continuum from pure monopoly to perfect competition. (See the boxed insert.) Although the lines between market structures are not always clear, market structures can help explain how firms might behave based on the number of buyers and sellers. They can also help explain how the prices of goods and services are determined. 

The airline industry has undergone a number of major shifts, starting with the deregulation of the industry in 1978. The most recent shift, the expansion of low-cost flights, suggests that consumers prefer lower prices over higher-quality service. And it is possible that another structural shift could cause the airline industry to look very different from the way it looks today.

1 B.R. "Our Favourite Air Lines." Economist , December 22, 2011; https://www.economist.com/gulliver/2011/12/22/our-favourite-air-lines .

2 Collins, Mike. "Airline Deregulation and the Beleaguered Traveler." Forbes , May 5, 2015; https://www.forbes.com/sites/mikecollins/2015/05/05/airline-deregulation-and-the-beleaguered-traveler/#b3a7cad235ba . 

3 Collins (2015).

4 Gowrisankaran, Gautam. "Competition and Regulation in the Airline Industry." Federal Reserve Bank of San Francisco Economic Letter , January 18, 2002; https://www.frbsf.org/economic-research/publications/economic-letter/2002/january/competition-and-regulation-in-the-airline-industry/ .

5 Chmura, Christine. "The Effects of Airline Regulation." Foundation for Economic Education, August 1, 1984; https://fee.org/articles/the-effects-of-airline-regulation/ . 

6 Hershey, Robert D. Jr. "Alfred E. Kahn Dies at 93; Prime Mover of Airline Dereg­ulation." New York Times , December 28, 2010; https://www.nytimes.com/2010/12/29/business/29kahn.html?mtrref=www.bing.com&gwh=D6FD8AE0980CC9852CF74BAE2AF42907&gwt=pay .

7 Lang, Susan S. "Economist Alfred Kahn, 'Father of Airline Deregulation' and Former Presidential Adviser, Dies at 93." Cornell Chronicle , December 27, 2010; http://news.cornell.edu/stories/2010/12/alfred-kahn-father-airline-deregulation-dies-93 .

8 Elliott, Justin. "The American Way." ProPublica , October 11, 2016; https://www.propublica.org/article/airline-consolidation-democratic-lobbying-antitrust . 

9 Smithsonian National Air and Space Museum. "Deregulation: A Watershed Event." 2007; https://airandspace.si.edu/exhibitions/america-by-air/online/jetage/jetage08.cfm . 

10 Gowrisankaran (2002).

11 Smithsonian National Air and Space Museum (2007). 

12 Kahn, Alfred. "Airline Deregulation." Concise Encyclopedia of Economics ; http://www.econlib.org/library/Enc1/AirlineDeregulation.html , accessed September 4, 2018. 

13 Smithsonian National Air and Space Museum (2007). 

14 Russell, Karl. "Why We Feel So Squeezed When We Fly." New York Times , May 2, 2017, update; https://www.nytimes.com/interactive/2017/04/17/business/how-flying-changed.html . 

15 Mutzabaugh, Ben. "Era of Airline Merger Mania Comes to a Close with Last US Airways Flight." USA Today , October 15, 2015; https://www.usatoday.com/story/travel/flights/todayinthesky/2015/10/15/airline-mergers-american-delta-united-southwest/73972928/ . 

16 Sorkin, Andrew. "As Oil Prices Fall, Airfares Still Stay High." New York Times , March 23, 2015; https://www.nytimes.com/2015/03/24/business/dealbook/as-oil-prices-fall-air-fares-still-stay-high.html . 

17 Asick, Paul. "How Much Does a Boeing 737 Cost?" 24/7 Wall St., March 13, 2017; https://247wallst.com/aerospace-defense/2017/03/13/how-much-does-a-boeing-737-cost/ .

18 Maidenberg, Micah. "How Low-Cost Airlines Alter the Economics of Flying." New York Times , September 1, 2017; https://www.nytimes.com/2017/09/01/business/budget-airlines-ticket-prices.html . 

19 Tuttle, Brad. "Does the 'Southwest Effect' Still Save Fliers Money?" Money , June 13, 2014; http://time.com/money/2791479/southwest-effect-cheaper-air-fares/ .

20 Maidenberg (2017).

© 2018, Federal Reserve Bank of St. Louis. The views expressed are those of the author(s) and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Antitrust laws: Legislation that prohibits practices that restrain trade, such as price fixing and business arrangements designed to achieve monopoly power. 

Barriers to entry: Anything that prevents the entry of firms into an industry.

Economies of scale: Factors that cause a producer's average cost per unit to fall as output rises. 

Law of demand: As the price of a good or service rises, the quantity demanded of that good or service falls. Likewise, as the price of a good or service falls, the quantity demanded of that good or service rises. 

Market power: The power to set prices; in other words, the ability to raise prices without losing all customers. Firms that are monopolistically competitive, oligopolistic, or monopolistic have market power, while perfectly competitive firms do not. 

Non-price competition: Competition based on distinguishing a product by means of product differentiation, such as product quality or superior after-market service.

Oligopoly: A market structure with significant barriers to entry in which a few firms offer similar or identical products.

Unintended consequences: The unexpected and unplanned results of a decision or action.

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Lufthansa Airlines: The Microeconomic and Macroeconomic Environment of the Company and the Industry in 2020 and Its Readiness Against Crisis (Case Study)

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The objective of this work is to provide an analysis of the impact of the microeconomic and macroeconomic environment of Lufthansa Airlines and sets out the performance of the organization in relation to its main competitors from 2006 until 2019.

The airline industry represents an oligopoly market with high barriers to entry and consists of large commercial aviation companies, the top 10 of them accounting for approximately half of the global business. For the assessment of the oligopoly market of the airline industry, respective economic theories, and models are used (Besanko et al., Economics of strategy, 7th edn. Wiley, Hoboken, 2015; Hall and Hitch, Price theory and business behavior. Oxf Econ Pap 2:12–45, 1939).

To explore the company’s macroeconomic exposure, market exposures, and its cost vulnerabilities, a dedicated analysis of the top 10 airlines in the world, is taking place and analysed by the application of various economic models (Eiteman and Guthrie, The shape of the average cost curve. Am Econ Rev 42(5):832–838, 1952; Samuelson and Nordhaus, Microeconomics, 17th edn. McGraw-Hill, p 110, 2001; Begg and Ward Economics for business, 6th edn. Macgrew Hill, Maidenhead, 2020). The demand of airlines is exposed to various elasticities depending on the region and the type of the airline while the evolution of oil prices contains one of the most important factors of industry and company's profitability. Therefore, a detailed analysis of the macroeconomic impact of oil prices is performed.

Lufthansa has a small sales margin due to the high costs and is a company relatively more vulnerable and exposed to external economic shocks due to its structural business design. Because of that, it is not well equipped to withstand global economic shocks. Lufthansa needs to transform its business model in order to survive future crises by optimising its operating costs and further growing its scale.

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Begg, D., & Ward, D. (2020). Economics for business (6th ed.). Macgrew Hill.

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Besanko, D., Dranove, D., & Shanley, M. (2015). Economics of strategy (7th ed.). Wiley. ISBN 9781119042310.

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Appendix 24.1

Calculation of adjusted ROCE and cost of capital: 2019 vs. 2018

• Source: 2019 Annual Report Lufthansa Group, lufthansagroup.com
• a WACC × Average capital employed
• b (EBIT + Interest on liquidity − 25% taxes)/Average capital employed
• c (Adjusted EBIT + Interest on liquidity − 25% taxes)/Average capital employed
• d Average capital employed in 2019 including IFRS 16 right-of-use assets as of 1 January 2019

Appendix 24.2

Germany Gross domestic product (GDP). Total, Million US dollars, 2006–2019. (Source: Aggregate National Accounts, SNA 2008 (or SNA 1993): Gross domestic product. Retrieved from OECD Data. data.oecd.org )

Appendix 24.3

Investment in airport infrastructure in Germany 2004–2018 Published by Statista Research Department, May 25, 2020. (This statistic illustrates the total amount invested in airport infrastructure in Germany from 2004 to 2018, in million euros. In the period of consideration, airport infrastructure investments oscillated. In 2018, investments in this sector amounted to over 1.37 billion euros. The largest amount of investments in airport infrastructure was recorded in 2011, at a total of approximately 1.8 billion euros. Amount of money invested in airport infrastructure in Germany from 2004 to 2018 (in million euros))

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Zervas, S. (2023). Lufthansa Airlines: The Microeconomic and Macroeconomic Environment of the Company and the Industry in 2020 and Its Readiness Against Crisis (Case Study). In: Tsounis, N., Vlachvei, A. (eds) Advances in Empirical Economic Research. ICOAE 2022. Springer Proceedings in Business and Economics. Springer, Cham. https://doi.org/10.1007/978-3-031-22749-3_24

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Historical Examples of Oligopolies

• Industry Consolidation on the Rise
• Media Conglomerates
• Wireless Carriers

The Big 3 Music Labels

• Domestic Airlines
• Market Structures on a Spectrum

Frequently Asked Questions

The bottom line, the most notable oligopolies in the us.

Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master's in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem.

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An oligopoly is when a market is shared by only a small number of firms, resulting in a state of limited competition. An oligopoly is similar to a monopoly, but in a monopoly , only a single company or group owns all or nearly all of the market for a given type of product or service.

There is no upper limit to the number of firms in an oligopoly . However, the number must be low enough that the actions of one firm significantly influence the others. Even though companies within oligopolies are competitors, they tend to cooperate with each other—either directly or indirectly—in order to benefit as a whole. This often leads to higher prices for consumers.

Key Takeaways

• An oligopoly is when a market is shared by only a small number of firms, resulting in a state of limited competition.
• Since the 1980s, it has become more common for industries to be dominated by two or three firms as merger agreements between major players have resulted in industry consolidation.
• Currently, some of the most notable oligopolies in the U.S. are in film and television production, recorded music, wireless carriers, and airlines.

For consumers and citizens, the consolidation of private power generally means they will incur higher costs, and historically, consumer efforts have been effective over time at stopping some of the abuses of power that result from industry consolidation.

• Government policy can discourage or encourage oligopolistic behavior, and firms in mixed economies often seek government blessing for ways to limit competition.

Oligopolies in history include steel manufacturers, oil companies, railroads, tire manufacturing, grocery store chains, and wireless carriers. The conditions that enable oligopolies to exist include high entry costs in  capital expenditures , legal privilege (license to use wireless spectrum or land for railroads), and a platform that gains value with more customers (such as social media). The railroad boom in the 19th century was ripe with such conditions.

In the United States during the mid- to late-1800s, a boom of railroad construction took place, including establishing the transcontinental railroad that stretched from the East Coast to California. Railroads, being both capital and labor-intensive, presented high barriers to entry and legal status as a sort of public utility. Four of the five transcontinental railroads were built with assistance from the federal government through land grants, receiving millions of acres of public lands from Congress.  

This allowed for an oligopoly, especially as smaller competitors were acquired. For instance, in 1901, nine locomotive manufacturing companies combined in a merger to form the American Locomotive Company (ALCO).  

Industry Consolidation Is on the Rise

Throughout history, there have been oligopolies in many different industries, including steel manufacturing, oil, railroads, tire manufacturing, grocery store chains, and wireless carriers. Currently, some of the most notable oligopolies in the U.S. are in film and television production, recorded music, wireless carriers, and airlines.

Since the 1980s, it has become more common for industries to be dominated by two or three firms. Merger agreements between major players have resulted in industry consolidation.

The  concentration ratio  measures the market share of the largest firms in an industry and is used to detect an oligopoly. There is no precise upper limit to the number of firms in an oligopoly, but the number must be low enough that the actions of one firm significantly influence the others.

The economic and legal concern is that an oligopoly can block new entrants, slow innovation, and increase prices, all of which harm consumers. Firms in an oligopoly  set prices , whether collectively—in a  cartel —or under the leadership of one firm, rather than  taking prices  from the market. Profit margins are thus higher than they would be in a more competitive market.

Media Conglomerates Dominate Film and Television

Film and television production in the U.S. is dominated by the film and television production units of five media conglomerates: The Walt Disney Company, WarnerMedia, NBCUniversal, Sony, and ViacomCBS. In 2023, the box office proceeds of NBCUniversal exceeded $4.9 billion, beating out Disney's $4.82 billion, who has held the number one spot since 2015.

Previously, 21st Century Fox was included in this list of the largest film production companies, but in March 2019, all the media assets of 21st Century Fox were acquired by Disney for $71.3 billion. This acquisition made The Walt Disney Company the largest media company in the world.

Wireless Carriers Represent Highly-Concentrated Industry

The combined market share of the three major wireless carrier companies in the U.S.—T-Mobile, Verizon, and AT&T—is 99.1% as of the end of 2023. In this highly concentrated industry, certain practices that are unfriendly to the consumer have become the norm, including termination fees and sneaky overage charges.

The majority of consumers are locked in contracts with one of these three companies, and there is very little recourse for this oligopoly behavior.

Although there are niche record companies that cater to specific audiences and music styles, the music industry is dominated by three major recording labels: Sony Music Entertainment, Universal Music Group, and Warner Music Group. EMI was included in this group until Universal Music Group purchased EMI in 2012.

When Universal Music Group initially expressed interest in purchasing EMI for $1.9 billion in 2012, industry watchdog groups encouraged the government to stop the deal, claiming that the consolidation would result in the newly created music superpower disrupting pricing and raising costs for consumers. Although a congressional hearing was held and the issue was examined by both American and European regulators, the takeover was eventually approved.

Domestic Airlines Oligopoly

The airline industry in the U.S. is also arguably an oligopoly, with four major domestic airlines— American Airlines, Delta Air Lines, Southwest Airlines, and United Airlines—flying about 67% of all domestic passengers in 2023.

Prior to 1978, domestic air travel in the U.S. was managed like a public good by the Civil Aeronautics Board (CAB). They established schedules, fares, and approved new routes. With the introduction of the Airline Deregulation Act in 1978—intended to increase competition in the airline industry—the price of fares dropped, in addition an increase to the number of flights offered.

However, after extensive consolidation in the industry and the failure of many smaller airlines, prices of airline flights started to sharply rise and have continued to rise despite the sharp decline in the cost of fuel. In addition, starting in 2008, airlines have begun charging fees for services that were earlier included in the airfare.

Market Structures Exist on a Spectrum

In reality, market structures should be thought of as on a spectrum from pure monopoly to perfect competition. While these industries all exhibit oligopoly behavior, structural shifts could easily upend the existing powers in the coming decades.

Is the automobile industry an oligopoly?

Automobile manufacturing is an example of an oligopoly, with the leading auto manufacturers in the United States being Ford ( F ), GM, and Stellantis (the new iteration of Chrysler through mergers). Worldwide there remain perhaps just a dozen key automakers including Toyota, Honda, Volkswagen Group, and Renault-Nissan-Mitsubishi.

What is a homogenous oligopoly?

A homogenous, or undifferentiated oligopoly involves a small group of firms that all produce the same product, often in a standardized fashion. Oil companies, for example, all produce crude oil that is then standardized through the refining process.

What is a differentiated oligopoly?

Unlike a homogenous oligopoly, a differential one involves firms that produce close, but not perfect substitutes . For example, car companies all produce vehicles, but a luxury car is not a perfect substitute for a rugged pickup truck.

How does the prisoner's dilemma relate to oligopoly?

The prisoner's dilemma is a scenario in  decision analysis  and game theory in which two actors, acting in their own self-interests do not produce the optimal outcome. For firms in an oligopoly, the problem is that each individual firm has an incentive to undercut the others—if all firms in the oligopoly agree to jointly restrict supply and keep prices high, then each firm stands to capture substantial business from the others by breaking the agreement undercutting the others. The result is a sub-optimal outcome for all firms involved.

What is a Cournot oligopoly?

The Cournot oligopoly model is a popular model to depict conditions of imperfect competition . lt describes an industry structure in which rival firms offering identical products compete on the amount of output they produce, independently and at the same time. The idea that one firm reacts to what it believes a rival will produce forms part of the perfect competition theory.

Oligopolies exist naturally or can be supported by government forces as a means to better manage an industry. Customers can experience higher prices and inferior products because of oligopolies, but not to the extent they would through a monopoly, as oligopolies still experience competition. The majority of the industries in the U.S. have oligopolies, creating significant  barriers to entry  for those wishing to enter the marketplace.

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IndiGo Airlines: Monopolizing Indian Skies

By: Ramakrushna Panigrahi

India's airline industry was an oligopoly, with six major players in the market. IndiGo, launched in 2006, had become India's largest airline and a dominant player, after having taken advantage of…

• Length: 11 page(s)
• Publication Date: Apr 22, 2019
• Discipline: Strategy
• Product #: W19161-PDF-ENG

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India's airline industry was an oligopoly, with six major players in the market. IndiGo, launched in 2006, had become India's largest airline and a dominant player, after having taken advantage of market conditions, including a rise in per capita income that led to increased demand for air travel. However, in 2018, after a decade of consistent profitability, IndiGo was experiencing a decline in profits that was affecting its share price. The airline's management needed to consider how the company could sustain its market-leading position over the long term and even increase profits, while accepting the minimal control it and its competitors had over ticket prices, amid an atmosphere of rising costs for aviation fuel and personnel costs.

Ramakrushna Panigrahi is affiliated with International Management Institute-Bhubaneswar.

Learning Objectives

This case is intended for a postgraduate managerial economics course, but can also be used in a graduate-level business strategy course for a discussion of alternative strategic decisions in the face of fierce competition or in courses on brand management and the marketing of services. Working through the case will give students the opportunity to understand how pricing decisions are made in oligopolistic market structures and why prices remain sticky for a long period; understand the kinked demand curve model of oligopoly where costs escalate over a period of time but prices cannot be increased due to price wars among competitors; gain exposure to numerous concepts in managerial economics such as product differentiation, marginal cost and average cost, economies of scale, cross-price elasticity, and price wars under an oligopolistic market structure; understand the difference between real and nominal prices, and between real and nominal income, and their significance for consumers' purchasing power; and consider how a company can sustain profitability under oligopolistic competition with dynamic pricing models.

Apr 22, 2019

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Transportation and distribution

Ivey Publishing

W19161-PDF-ENG

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Open Access

Peer-reviewed

Research Article

Pricing strategy of multi-oligopoly airlines based on service quality

Roles Conceptualization, Supervision, Writing – review & editing

Affiliation College of Civil Aviation, Nanjing University of Aeronautics and Astronautics, Nanjing, Jiangsu, China

Roles Methodology, Validation, Writing – original draft

* E-mail: [email protected]

• Hang Zhou, 
• Shikang Zhou

• Published: June 17, 2019
• https://doi.org/10.1371/journal.pone.0216651
• Reader Comments

In recent years, with the rapid development of China's air transport industry and the change in market consumption structure, service quality has become one of the important factors affecting airline revenue. How to formulate a reasonable pricing strategy and maintain competitiveness in the fierce market competition has become an urgent problem for airlines. First, the impact factor of service quality level in the traditional pricing model is introduced and a static price competition model for multi-oligopoly airlines based on service quality is established in this paper. And then, a dynamic pricing model based on service quality of the multi-oligopoly airlines is established. The model incorporates the weight factor of service quality impact, which is used to indicate the weight of the service quality level in the process of airline dynamic pricing. The research results show that the service quality level of airlines has an indispensable influence on its development. Airlines should improve service quality as soon as possible to enhance market competitiveness and achieve sustainable development.

Citation: Zhou H, Zhou S (2019) Pricing strategy of multi-oligopoly airlines based on service quality. PLoS ONE 14(6): e0216651. https://doi.org/10.1371/journal.pone.0216651

Editor: Baogui Xin, Shandong University of Science and Technology, CHINA

Received: November 8, 2018; Accepted: April 25, 2019; Published: June 17, 2019

Copyright: © 2019 Zhou, Zhou. This is an open access article distributed under the terms of the Creative Commons Attribution License , which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited.

Data Availability: Data underlying the study are available on the Figshare database ( https://figshare.com/articles/Airline_Service_Evaluation_Report_for_the_1st_Quarter_2018_pdf/8131340 ; https://figshare.com/articles/Airline_Service_Evaluation_Report_for_the_3rd_Quarter_2018_pdf/8131358 ; https://figshare.com/articles/Airline_Service_Evaluation_Report_for_the_2nd_Quarter_2018_pdf/8131364 ; https://figshare.com/articles/Airline_Service_Evaluation_Report_for_the_3rd_Quarter_2017_pdf/8131361 ; https://figshare.com/articles/Airline_Service_Evaluation_Report_for_the_4th_Quarter_2017_pdf/8131391 ).

Funding: The authors received no specific funding for this work.

Competing interests: The authors have declared that no competing interests exist.

1. Introduction

Service quality refers to the extent to which a service can meet the needs of the serviced person.

Traditionally, China’s four airlines have strong control in the air transport market. But with the rapid development of the air transport industry, some newly developing airlines have gradually carved up market share by actively seeking differentiated competitive advantages. From the perspective of operation, the basic functions provided to passengers by airlines on the same route are consistent, and the competition among these airlines is based on the air route. Especially on the main routes, 4 or more airlines on 50% of the routes are snatching marketing resources, there is fierce competition among airlines [ 1 ]. In general, the air transport market in China presents a multi-oligopolistic pattern with fierce market competition among airlines. How to maintain the advantages and enhance the competitiveness of the market has become an urgent problem that the airline needs to solve.

With the development of the economic, the consumption structure of the public is moving toward the emphasis on ‘quality’, especially in traveling. The service quality has become one of the important factors affecting the ticket revenue, and it is the best way for aviation-related enterprises to increase added value and implement differentiated development strategies [ 2 ]. The survey shows that the proportion of tourists and business passengers accounted for more than 65% in China’s air transport market. The higher the service quality of airline, the higher the satisfaction of these passengers and the higher loyalty, and the market share of the airline can be increased. In short, high-quality service has become the core competitiveness of airline to improve the revenue and achieve sustainable development [ 3 ]. So it is necessary to construct a pricing model based on service quality to study the effect of service quality on airline revenue management (RM).

2. Related researches

Before the gradual opening of air traffic rights, the method of setting the price of the ticket is uniform in the International. At this time, the research on airline revenue management was mainly based on single routes, and the focus was on overselling. Mumbower S studied factors that affect passengers' purchase of a premium class, including seat price, ticket purchase time, number of passengers, and load factor and based on the research results, made substantial suggestions for airlines to increase revenue [ 4 ]. Aguirregabiria, Victor and others based on dynamic competition theory [ 5 ], studied the influence of airlines' demand distribution, cost and policy factors on the radial aviation network in the US market.

In the study of airline ticket price strategy, some scholars try to find out the nature of market competition and propose a reasonable strategy for airlines' competitive advantage. Zhang Yahua studied the two problems of price wars and price alliances in the air transport market. Research shows that the price war is cyclical, and in the case of a market downturn, price alliances are more likely to occur [ 6 ]. Dan Zhang focused on the dynamic pricing problem between multiple alternative flights, developed the Markov pricing model, and proposed a heuristic algorithm for summarizing ideas [ 7 ]. Moreno-Izquierdo L seeks to analyze the effect that the internet has on the price strategy of low cost airlines. The study showed that the most significant factors on pricing strategies were the number of rivals, the behavior of demand and costs [ 8 ]. Xia HS constructed a duopoly competition model of airlines based on different competitive strategy and rational, controlled and analyzed the model, they provided some suggestions for the price regulation for the airline market [ 9 ]. Hu Rong, etc. built a dynamic pricing model of three oligopoly airlines. They studied the model chaos control and proposed two methods for delaying the feedback of the model [ 10 ]. Song JQ compares and analyzes the fare strategies under the competitive characteristics of different air transport markets, and combines the market characteristics of China to introduce the characteristic variables of high-speed rail competition in fare analysis [ 11 ].

Since the 1970s, scholars have conducted a lot of research on the relevant aspects of service quality and achieved fruitful results. In 2016, Etemadsajadi et al. studied the impact of pre- and in-flight airline service quality on passenger satisfaction and loyalty, reflecting the importance of airline pre-flight service quality [ 12 ]. In 2012, Yang K C et al. used a simple structural equation model to analyze the relationship between the service quality of a low-cost airline, the company's image, and the behavioral intentions of passengers. The research results show that higher service quality has a positive impact on passengers' behavior intentions and company image [ 13 ]. In 2007, Abdullah K et al. used the SERVQUAL method to evaluate the perceptions of Malaysian customers on their airline service levels. The results show that the three aspects of service empathy, reliability and tangibility are usually the most concerned by passengers [ 14 ]. Li Ling used the method of analytic hierarchy process (AHP) and GRAP to quantitatively evaluate the competitiveness of China’s the three major airlines and international famous airlines, it is concluded that China's airlines need to be upgraded in terms of operating scale, service quality and production efficiency [ 15 ]. Zhang zan adopts a game theoretical approach to examine the impact of free offering on the competition between two firms in the presence of network effects, and it is shown that when a firm’s core product has a sufficient advantage in product quality, it is better for this firm to sell the bundle but for the other to use free strategy [ 16 ].

The existing researches on airline revenue management (RM) pay little attention to the impact of service quality on the competition strategy, and most of the study of the pricing strategy is based on the built of duopoly or three-oligopoly model. The traditional duopoly and three-oligopoly competition models are not suitable for the current market characteristics, due to the increasingly fierce competition in the air transport market. Thus, this paper built a pricing model of multi-oligopoly airlines, and the factor of service quality is involved in this model. The influence on market demand, revenue, and competition by the service quality level is analyzed so that the more reasonable development strategy is provided for the airline to achieve sustainable development.

3. Model and methods

Before constructing the service-quality-based multi-oligopoly airlines pricing model, this paper firstly needs to set some assumptions: 1) in order to focus on the impact of service quality on airline competition strategies, this paper only considers the impact of passenger ticket price and service quality on the market demand; 2) this paper assumes that the market demand of airlines is affected not only by the service quality and ticket price but also by these two factors of their rivals. The higher of service quality level its own and the ticket price of its rivals, the lower of market demand; the higher of ticket price of its own and the service quality level of its rivals, the lower the market demand of airline, it is in keeping with public awareness; 3) in order ensure the solvability and uniqueness of the solution of the model, this paper also assumes that the demand function is continuously differentiable, bounded and the inverse function exists.

3.1 Market demand function

D i is the market demand for airline i . a i is the basic market demand, that is the original market share of airline i without considering the factors of the ticket price and service quality, and it is depended on the degree of passengers’ acceptation to such factors as air route, time and brand. e i p i represents the impact of ticket price p j of airline i on the market demand, f i s i is the effort of airline i to improve the market demand. p i is the ticket price of airline i , e i is the sensitivity coefficient of the ticket price to market demand, s i is the service quality level of airline i , f i is the sensitivity coefficient of service quality to market demand. d i p j represents the impact of the ticket price of rival airline j on market demand D i , g i s j represents the impact of service quality of rival airline j on market demand of airline i . d i is the sensitivity coefficient of ticket price p i of rival airline j to the market demand of airline i , and g i is the sensitivity coefficient of service quality s j of rival airline j to the market demand of airline i .

d i is the joint sensitivity coefficient of ticket price p j of rival airlines to the market demand of airline i , which means the oligopoly airlines excludes their own factors, the combined effect of competitors' fares on airline i ’s market demand. g i is the joint sensitivity coefficient of service quality s j of rival airlines to the market demand of airline i , which means the oligopoly airlines excludes their own factors, the combined impact of competitors' quality of service on airline i ’s market demand.

3.2 Variable cost function

Actually, the airline should focus on the variable cost, especially considering the short-term competition, which may make competition strategy by the airline be more effective. The variable cost of airline mainly includes the fare incurred by various projects such as fuel, original materials, landing service, catering, reservation and so on. Variable cost refers to a cost item that changes with a change in business volume within a certain scale. Overall, the variable costs of airline operations grow as market demand grows. In the early stage of the growth of the business, the variable cost and business volume are linear. As the business continues to grow, the variable cost and the business are usually nonlinear. The relationship between business and variable cost is rough as shown in Fig 1 .

• PPT PowerPoint slide
• PNG larger image
• TIFF original image

https://doi.org/10.1371/journal.pone.0216651.g001

C it is the variable cost of airline i at period t and C it >0, D it is the market demand of airline i at period t; θ i is the growth coefficient and θ i >0, which indicates the degree of change in variable costs as market demand grows.

3.3 Service quality-based static pricing model of multi-oligopoly airlines

In reality, a service provider can compensate for the loss of demand caused by low-level service quality level by appropriately lowering the price, or balance the market demand caused by high price by improving the service quality level, and make its own market demand. It remains stable, but it cannot guarantee that the needs of competitors in other markets will not change. Therefore, when establishing the airline's four demand models, not only must consider the impact of its own fare and service quality level, but also consider the competitor's service level and fare. This model is based on the four oligarchic airlines. The current status of competition in China's air transport market will help Chinese airlines to formulate more reasonable pricing strategies.

This paper mainly focuses on the competition between four-oligarchic airlines, and firstly constructs the service quality-based marker demand function of four-oligopoly.

3.4 Service quality-based dynamic pricing model of multi-oligopoly airlines

In the actual situation, the information in the market always changes over time, and airline is usually unable to obtain comprehensive market information due to the limited rationality of decision. The pricing strategy obtained from the static model is based on the theory of complete rational decision, which is an ideal model and leads to the incomprehensive of results. This paper further considers the pricing strategy of airline form the perspective of multi-cycle game, so as to increase the scientificity and rationality of the results. Firstly, a dynamic market demand function of oligarchic airlines is established and analyses the influence of service quality on the market competition under the consideration of time period.

The factor of service quality level influence weight is introduced in the dynamic pricing model, it can analyze the impact of service quality level influence weight on the competition cycle and the impact on the average profit of each oligarchic airline, help airlines make better decisions.

Most of the previous literature only considered fixed costs, or a single cost factor, resulting in a pricing strategy that was not reasonable enough. In actual operations, the factors affecting the operating costs of airlines are multifaceted. The dynamic pricing model takes into account the variable cost factor, making the pricing strategy more practical.

4 Experiment and Analysis

4.1 the impact of service quality level on market demand.

In order to help the airline to make a reasonable competition strategy to enhance market competitiveness and brand influence, this section mainly focuses on the relationship between the service quality level and market demand. The values of the four oligarchic airlines are assigned according to the evaluation results in the quarterly airline service evaluation report released by the Civil Aviation Passenger Service Evaluation (CAPSE). The range of service quality level is set as [ 1 , 10 ], which is divided into three grades: high, medium and low. It is called low level when the value of service quality level in the interval [ 1 , 3 ], and the interval [ 4 , 7 ] represents the intermediate level, and the interval [ 8 , 10 ] is the high level. Based on the market demand model, we analyze the market share of each airline in different service quality levels. The results can be seen in Table 1 . We set the s i with the same value in each level interval and obtain the market share.

https://doi.org/10.1371/journal.pone.0216651.t001

In order to facilitate comparison and analysis, the market share of each airline is shown in Fig 2 .

https://doi.org/10.1371/journal.pone.0216651.g002

As can be seen in Fig 2 , at the interval of low service quality level, the market demand of Hainan airline accounted for the most, and with the increase of service quality level the market shares of a downward trend. While the market share of International aviation is relatively low, and with the increase of service quality level, the proportion of market demand increases. Actually, compared to the other three oligarchic airlines, the results of service evaluation of Hainan airline according to some evaluating activities are usually relatively unsatisfied. The airfares in some air routes are relatively low and part of the routes are based on the strategy of ‘low cost and low price’ to seize the market. The International airline and Southern airline usually pay more attention to passenger satisfaction, the airfare in the same air route is always higher than of Hainan airline. In the interval of low service quality level, the Hainan airline and some other airlines with the strategy of ‘low service and low airfare’ have more competitive advantages. At the high service quality level, the market shares of International aviation and Southern airline which mainly focus on service quality are significantly higher than that of Hainan airline. At the same time, at the interval of a high level of service quality, the gap between Hainan airline and International airline in the market share is much larger than the gap than appearances at the low-level service quality interval. These fully show that the improvement of service quality can effectively enhance the market competitiveness of airlines.

4.2 The impact of service quality level on airfare

Fig 3 shows the marginal profit of each airline changes as the airfares at the low level of service quality. Fig 4 shows the marginal profit of each airline changes as the airfare at the high level of service quality.

https://doi.org/10.1371/journal.pone.0216651.g003

https://doi.org/10.1371/journal.pone.0216651.g004

The vertical coordinate is the marginal profit and the horizontal coordinate is airfare. The intersection of each line and the horizontal coordinate represents the equilibrium airfare at a certain level of service quality. When the service quality level improves, the equilibrium price increases, if airlines effectively achieve the cost control, the benefits can increase with service quality levels increase. At the low level of service quality, the gap of equilibrium airfare between Hainan airline and International aviation is relatively small. At the high level of service quality, the gap of equilibrium airfare between the four airlines significantly larger. It indicates that with the increase in people's demand for trip services, the airlines which ignores the service quality and increase profits and market share only by lowering fares will be finally phased out. The airlines that focus on service quality and improve passenger satisfaction as a business strategy can achieve sustainable development. The low-cost airlines achieve long-term development, only by changing their business philosophy that focusing on the improvement of service quality and reducing the business cost.

4.3 Dynamic analysis

https://doi.org/10.1371/journal.pone.0216651.g005

https://doi.org/10.1371/journal.pone.0216651.g006

https://doi.org/10.1371/journal.pone.0216651.g007

In summary, in the early stage of the competition, the weight of the service quality impact of the airlines in time is small, and the average profit of the airlines can also generate large fluctuations. As the weight of service quality is increased, the average profit of each airline has increased significantly. When the influence weight is increased to a certain value, and the price adjustment speed is too high, the average profit of each airline is reduced, at this time, the price adjustment speed exceeds the stable area of the system, which leads to a decrease in the profit even if the air ticket price is continuously increased. At the end of the system stability domain, even if the weight of the service quality of the airline changes greatly, the ticket price increases rapidly, and the result can only cause a slight increase in the average profit. It shows that if airlines want to achieve long-term development, they should position themselves as a development strategy to seize the market with high service quality level in the early stage of route development. Because in the later stage of market competition, the improvement of service quality level and price adjustment rate can only lead to the growth of market demand, while the effect of profit growth is not obvious.

The dynamic model proposed in this paper, not only consider the influence of airfares on the market demand, but also the impact of service quality on the competition. The time required for the system to reach equilibrium is less than the tradition pricing model that only considers the price differentiation. Therefore, the dynamic pricing based on service quality proposed is more optimized and comprehensive.

5. Conclusion

In the context of the increasingly fierce competition in China's aviation transportation market, price strategy is still the most effective and advanced method for enterprise benefits management. However, in the current research on airline price strategy, the factor of service quality is rarely considered. With the change of market consumption structure, the service quality of enterprises has gradually become an important factor for consumers to choose.

At present, the existing research on airline revenue management mainly relies on traditional price models, such as Hotelling pricing model, differentiation-based competition model and pricing model based on general demand function. Airline pricing strategy research focuses on dynamic pricing, overbooking control, market forecasting, and cabin control. However, the factors affecting these airline pricing models are not comprehensive and do not take into account the impact of increasingly important service quality levels. It is not possible to objectively and comprehensively extract the dynamic competitive characteristics of the air transport market. Therefore, these pricing models still need to be further improved and expanded.

In response to such problems, this paper considers the impact of airline service quality and competitor service quality on pricing strategy when constructing the airline pricing model, based on the profit maximization pricing goal, and introduces the airline's service. The quality feature parameter team model was revised to construct an airline pricing model based on service quality. The quantification of the quality of service factor as a decision variable is incorporated into the pricing model, making the formulation of the airline's pricing strategy more comprehensive and reasonable. The pricing model of the multi-oligopoly airline has been established, which is more complicated than the previous model and can more accurately describe the competition status of China's air transportation market. It shows that when airlines formulate price strategies, they consider the importance of their service quality level to their sustainable development, thus guiding airlines to go further in the fierce market competition.

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