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Economies of Scale in the Airline Industry

Discuss about the Indicators of socio-spatial transport disadvantage.

Economies of scale arises when increasing size scale of production is associated with a declining unit cost of production.  It implies a falling average cost in the long-run.  In the airline industry if economies of scale exist, implying the average cost of airline decreases with increase in the output level then the concentration in the industry is justified based on cost savings. The economies of scale can be measured with respect to size of the firms. In order to examine the presence of economies of scale in the airline industry empirical data needs to be collected on overhead cost of the concerned airline. The airlines incur both fixed and variable costs. The fixed cost of airlines includes cost of financing aircrafts, insurance fees, Tax and registration fees, aircraft accessories, salaries of the crewmember (Carlton & Perloff, 2015). The variable costs are costs that varies with the level of output. For aviation industry, the variable costs are cost of oil, fuel, fees of landing, catering, and salaries to crew paid on hourly basis, maintenance cost and others. The information regarding scale of economies implies data should be gathered on costs. The economies of scale in the airline industry arise when the company uses a single type of plane.

In the airline industry, the fixed costs are generally higher than the variable cost. Therefore, with increasing number of passengers the overhead cost reduces leading to economies of scale. The knowledge regarding the overhead cost is required to conduct empirical study on airlines. With increasing operation, the unit cost should be reduced. As the aviation industry provides services, the output or firm size cannot be measured like that of physical good (Ostrom, 2016). The operational efficiency are measured in terms of number aircraft that the company built.

Another source of economies of scale in the airline industry volume discount benefit. The big airlines often gets a better deal for dealing with range of supplier for the bulk purchase (Ambulkar, Blackhurst & Grawe, 2015). The decision regarding presence of economies of scale focus on analysis of operating cost. For this, appropriate form of cost function should be used. For example, in the absence of any economies of scale a cost function in linear form is appropriate. With presence of economies of scale form of arithmetic cost function is appropriate. The size of the airline may be measured in terms of seat-miles, ton-miles, and revenue-passengers’ miles and so on. The cost characteristics are cost of ground handling (Li, Wang & Cui, 2016). The economies of scale depend on the fact that whether marginal cost of this activity goes down with increases the volume of airlines at a particular airport.

Merger refers to the corporate strategy of joining different business organization together to become a single company. This enhances both the financial and operational strength of the merged companies (Prince & Simon, 2017). For the airline industry the strategy of merging is not a new idea. There are generally three primary motives of mergers.

Mergers in the Airline Industry

Monopoly motive: When two or more companies merged to form a single company then a strong company is formed. This enjoys a greater market power resulting from the reduced competition. The single firm may behave like a monopolist in the market.

Speculative motive: The merging of two or more companies raise the speculative power of the companies.

Business motive: The merged firms complement each other in different business operation. This increases financial strength and efficiency of operation.

Mergers in the airline industry encompasses all the three motives. The primary effect of mergers in the airline industry is on the airfares. For the airline industry, mergers between airline companies have twofold impacts on airfares working in two opposite directions. Hence, the ultimate impact of such strategy on fares remain ambiguous. Because of mergers, the intensity of competition in the industry reduces. This has the impact of significantly drive up fares. This is particularly the case in the hub airports (Goetz & Sutton, 2017). The concentration in hub airports is usually high and high entry barriers raises the market power of the dominant players. These dominant airlines enjoy a high margin between price and marginal cost. There is however positive side of mergers as well. When two or more companies merged then efficiency of the firms’ increases. Merging lead to lowering unit cost of production because of resulted economies of scale and gain from productive efficiency. Mergers among different airline companies initially reduces airfares. This is what is experienced from mergers occurred in US airline industry.

The airline industry in United States has experienced some dramatic changes in the last decade. Since 2000, all the five legacy carriers have declared bankrupt. In order to overcome the situation most airlines in US merged successfully with another airline company except American airlines. As a result of these mergers three largest legacy constitute almost 47.3 percent of domestic airline industry in US (Rupp & Tan, 2017). Additionally, the three airlines have made global alliances capturing 77.1% share in the world market. The mergers among airline companies thought of to raise airfare by reducing intensity of domestic competition. However, the positive side of mergers more than offset the impact of reduced competition. With mergers the use of low-cost carriers expands rapidly. The US airways because of mergers among airlines is able to use different aircrafts while Southwest airways uses only one type of aircraft namely Boeing 737.

The recent study has revealed a mixed impact of consolidation in the US airline industry. The official report of US government has found that competition increases at largest airport and that of the popular air route (latimes.com, 2018). While for small airport and at less popular air route the competition decreases.

The Hub and Spoke networking system have several benefits to airline companies. With Hub and Spoke networking system, there the airline companies reap the benefits of economies of density and economies of scope (Williams, 2017). In hub and spoke networking system, different spokes are connected with a central hub. Individuals having different final destination are first taken to a central hub and then are carried to respective final destination. However, with point-to-point system, each flight directly travel to the final destination. There is no central hub. Each node is directly connected another. Most airlines though now switch to the hub and spoke networking system but some drawbacks are now realized in the system. Some major drawbacks of hub and spoke networking system over point-to-point system are as follows

Hub-and-Spoke Networking System in the Airline Industry

The structure of hub and spoke networking system is like a hub and spoke of a wheel. There is a central airport called hub. Passengers first reach to the hub from their city. Different cities are connected with the central hub. After reaching the central hub, passengers are set out for the city of their destination.  As the journey split in two part, it automatically involves more times. Additionally, in order to maximize benefits the airlines scheduled several flight at the peak hour. This results in congestion in hub airport. The congestion and overcrowding leads to unnecessary delay. In the point-to-point system, on the other hand there are each node has direct connection with other (Cao, Stanley & Stanley, 2017).  Because of direct connection, this airline networking method is highly time saving. In the hub and spoke system delay in one inbound flight transmitted to the entire system and all the other outbound flights that are connected with passengers. Any disruption caused in hub like that resulted from bad weather condition affects the entire operation of flights.

The hub and spoke system is greatly advantageous for gathering more passengers in a comprehensive manner but it generally involves a higher cost of operation. In the point-to-point system, because of non-stop journey there is no need of service agents for passengers, baggage facilities, ramp, lounges and maintenance personnel. However, with hub and spoke networking system, the intervening stoppage at the hub needs additional take off. For this, airlines need to incur additional cost in the form of fees for landing and charges for additional purposes. The design of route in this system further drives up prices (Skipper et al., 2016). Only a few original destinations can be directly connected with the hub. The passenger for whom destinations are not directly connected with the hub further suffer with a higher travel time and airlines have to bear additional cost in the form of additional cost of attendant (Sugiyanto et al., 2015).

The networking structure is complex as compared to the point-to-point system. The route designing with hub and spoke system is complicated. The connection of different cities with hub involve proper designing. The point-to-point system on the other hand is made with simplest architecture as it connects the execution of hub and Spoke networking system requires greater operational efficiency (Rodrigue, Comtois & Slack, 2016). Many countries fail to operate the system successfully and still relies on point-to-point system.

In the hub and spoke system, the traffic merging implies traffic structure that consists of high peaks at a definite point of time. This is the time when airport facilities are used highly. At the busiest port additional infrastructure and capacity needs to be built to cater demand in the peak hour (Lachmann, 2016). However, during off-peak times, because of less traffic these facilities remain inefficient or idle leading to underutilization of resources.

The hub airport and other associated airlines highly depend on a selected number of airport via which they design their traffic route. These main airports represent a major share of the business. Because of limited capacity of the airports unnecessary delay, occur in the hub causing inefficiency in the system.

Conclusion

Hub and spoke networking system is a widely used networking mechanism by the airline industry to maximize its revenue. Under this system there is a central node called the hub. Other networking node are connected with this central node. Passengers are first taken from their home city to the central hub and are then sent to their respective destination from this central hub. This concept relates to the aspect of multi-plant economies of scope (Barros & Wanke, 2015). The multi-plant economies of scope depict a situation where different goods and services in an industry are send to and from other market. In case of airline industry, with a hub and spoke network airline first takes passengers from the set of spoke cities via a central hub. Once reached to the hub, passengers then change flights and set out to the destination of their choice.

Economies of scope exists when firms engage in producing a combination of goods enjoy a cost advantage over producing only a single product.  In case of airline industry individual with different origin, pairs are considered as distinct group of product. The economies of scope is said to exists if average cost to the airline from serving distinct passengers pairs are lower than serving passengers with same with same destination (Stuck, Broekel  & Revilla Diez, 2016).. In order to understand how economies of scope arising from the hub and spoke networking system it is necessary to explain the concept the economies of density. Economies of density is associated with the concept of reduction in traffic average traffic cost with increase in traffic volume in a specific route. Economies of density arises because with increasing number of passengers the fixed cost of specific flight such as cost of flight, cabin crew, servicing and fuels cost are spread out. The variable costs of setting out a flight like ticket handling, food is small relative to the size of fixed cost. Therefore, the unit cost if serving additional passengers is very low (Wilmsmeier, Monios & Pérez-Salas, 2014). Consequently, with increase in the traffic volume it is possible for airline companies to fill more seat with passengers. The interplay of hub and spoke networking system and presence of economies of density opens economies of scope for the airline industry.

As discussed above, hub and spoke networking system offers several benefits to the airlines companies. It increases strength of the passengers without needs of increasing aircraft size. By establishing connectivity with the hub airlines can attracts more passengers it becomes possible to fill the flights in a comprehensive manner (An, Zhang & Zeng, 2015). To reap the cost advantage airlines just need to allow passengers with different destination pairs. As there is no need to increase aircraft size or scale of operation hub and spoke system is more likely to relate to economies of scope rather than economies of scale.

In economics, the economies of scale is defined as the prospect of expanding the scale of production that is associated with a corresponding decline in unit costs in long run. Firms can enjoy benefits of economies of scale in different ways (Holness, Bashar & Rochon, 2015). The sources of economies of scale is classified in the following categories

Internal/external economies of scale: The internal economies of scale is associated with the internal environment of firm. This arises along with firms’ growth itself implying that these factors are controllable. Firms can influence these aspects by their internal management decision. External economies of scale on the other hand is subject to the growth of the industry and does not depend on firms’ size (Fine, 2016). This therefore is not directly related to decision of the management . The locational benefit is an example of external economies of scale. This type of economies of scale is often known as economies of concentration as the benefits of scale arises when different firms in the same industry set up factories close to each other.

Physical/Monetary: Physical economies of scale is related with efficiency of input while monetary economies of scale is that arise from benefits of reduced unit cost with expanding production.

Level: product, plant and firm: The economies of scale arises in different forms. The cost advantages depend on several factors (Baumol & Blinder, 2015). Firms sometimes enjoy a cost benefit from production of more and more units, often from expanding the plant size and sometimes from conducting production with relatively large sized plants.

In the airline industry the both internal and external economies of scale exists. The economies of scale arise when airlines make use of a single plane. When number of passengers increases in a single aircraft then fixed costs are spread out. The advantge of airline industry is the presence of very low marginal cost. Therefore, use of single plane for carrying large number of passengers brings economies of scale. One example is Southwest Airline that uses only Boeing 737. However, the struggling US airways uses different aircrafts.

Economies of scope is said to occur when firms enjoy cost benefit from altering its operation mix. Unlike economies of scale, it is not associated with the expansion of production scale. For example, suppose the production of 100 unit of a good say X has a production cost of £100 if produced alone. However, if production of X is taken place in combination of some other good say Y then marginal cost of production may fall. The same is the case for Y. The unit production cost of Y may fall when produced in combination with X.  There can be two possible cause for this. The first is, the two products may have common processing facilities. Example may include different models of cars under in the same plant. The second one is production costs of these two goods can be complementary in nature (McKenzie & Lee,2016). This is especially the case when production of joint products or by products are considered. The economies of scope is measured by computing the extent of cost reduction in percentage terms from joint production. This is expressed in the following way

C(Q1) and C (Q2) represent the independent cost of production of Q1 and Q2 respectively. C (Q1+Q2) is the joint production cost of Q1 and Q2 together. With the presence of economies of scope joint production cost is less than the total of independent production cost, thus giving a positive value of S. A larger value of S implies greater economies of scope and vice versa.

In the airline industry significant economies of scope exist as discussed in the case given.  Airlines enjoy the benefits of economies of scope by carrying freight and passengers on the same plane. The airlines without increasing its size enjoys a cost advantage from a combination of production; in the airline case the distinct products are freight and passengers. In addition to those, another source of economies of scope is that derived from hub and spoke networking system. Here, just by connecting different destination cities the airlines are able to attract more passengers and enjoys several advantages.

In the airline industry, economies of scope can play an important role. In this context, the economies of scope is defined as reduction in the average production cost by the means of spreading out the cost of employing resources over a combination of two or more items. There are a variety of application for economies of scope in the concerned industry such as frequent flier program, cargo, maintenance activities and activities related to ground handling (Moulin, 2014). It is more cost effective for airline companies to carry cargo or freight and passengers together in the same flight rather than carrying them separately. The freight and passengers are viewed as distinct products for an airline company. Because of the presence of high fixed cost carrying freight and passengers, separately incur greater cost to airlines rather than carrying combination of these two. The fixed cost here spread out result in realization of economies of scope for the airline company.

An important form of economies of scope in the airline industry today arises is from hub and spoke networking system. This indicates a system where passengers first fly from one city to the central hub and from the central hub to respective final destination (Kleymann & Seristö, 2017). The resulting economies of scope brings several advantages for the airline companies. The airline is able to serve more routes as different cities are connected to the central hub. With presence of economies of scope, the airlines enjoy significant benefit without increasing number of aircraft or changing the miles flown.

The global airline industry today enjoys benefits of both economies of scale and economies of scope. This lead to significant expansion of the airline industry. Economies of scale arises because of mergers among airlines and expansion of scale of operation. Mergers by increasing operational efficiency leading to reduction in airfares. The air travel demand is generally highly elastic in nature. The low fares along with increase in average income of people stimulate the air travel demand. Today’s low fare carriers are often cheaper than railway fares and therefore attracts more passengers (Yazdi, Dutta & Steven, 2017). Being the fastest means of transportation people prefer to travel by air for different purposes like business, holiday trip and others to save time. However, the supply of aircrafts cannot be increased too rapidly in line with demand. Consequently, the busiest airports are now facing the problem of overcrowding.

The overcrowded airlines suffer from diseconomies of scale. The diseconomies of scale depict a situation where expansion of the firm size is associated with an increasing unit cost in the long run (Xiao et al., 2016). This again may arise from internal and external factors. When resulted from internal factor then it is termed as internal economies of scale. When external factors that is factors not related to firms’ size and other internal factors then it is known as external diseconomies of scale. The overcrowding effect is more likely to cause external diseconomies of scale in the busiest airports and for the airline companies.

With the adaption of Hub and Spoke system, the overcrowding problem is mostly faced in the central hub. Under this system, most of the flight trips are designed in the peak hours. Because of scheduling several flights in the same time there is a problem of overcrowding. When different airline companies scheduled flight at the same time then this further aggravates the problem. The overcrowding in effect leads to common problem like delay in scheduled flight and long ques in the airports (Gibbons & Wu, 2017). This increases dissatisfaction among the passengers. The benefits of economies of scope from hub and spoke system thus offset from the resulting diseconomies of scale for airlines,

Overcrowding not only costs the airlines in terms of raising passengers’ dissatisfaction but also leads to wastage of resources because of delays. There is wastage of fuel because of planes stack delaying. For example, £119,000 worth of fuel wastes every day in London because of flight delaying for average passengers of 55,800 (dailymail.co.uk, 2018). The waste of fuel imposes an external cost of pollution by releasing harmful carbon di oxide into the environment.

With increasing strength of passengers, the management cost increases. More crews are required to manage the crowd. With increasing number of crews, the management cost increases. Too much staffs or crewmembers results in inefficiency in airline operation and a resulted diseconomies of scale.

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