How are Micheal Porter's Five Forces relevant to an airline business?
Michael Porter’s famous five forces are:
- 1) Supplier power
- 2) Customer power
- 3) Barriers to entry
- 4) Threat of substitutes
- 5) Industry competitiveness
1) Supplier power: Airlines have to deal with many powerful suppliers such as:
Aircraft Manufacturers: choice between Boeing and Airbus only.
Lessors: Most of the airlines in the world prefer leasing over purchasing aircraft. A number of lessors provide such services.
Engine Manufacturers: only three companies-Pratt and Whitney, General Electric and Rolls Royce- manufacture engines for large commercial jet aircraft.
Maintenance Repair Overhaul: Most of the airlines do not have MRO of their own. They need to hire the services of approved MROs in the world.
Ground Handling Agents: Airlines depend on ground handling service providers at each airport.
Cargo Handling Agents: Airlines also depend on cargo handling agents at various airports.
IT Software: Airlines need IT systems such as revenue management system and booking system etc developed various companies in the world.
Airport and Air Navigation Services Suppliers: Being Natural Monopolies they fix charges which include cost of inefficiencies. Increase in passengers related charges increases price of the ticket and resultantly decreases the demand. Increase in airlines related charges increases operating cost of airlines and accordingly decreases their bottom line.
Fuel Suppliers: Airlines have virtually no control over fuel prices. Some airlines, such as British Airways, or other mega carriers, hedge fuel but it does not always work and when the fuel prices drop unexpectedly they end up paying more than market price. Additionally Governments are entitled to impose taxes on domestic routes, such as sales tax, that airlines have no control over.
Labour: Airline Business is labour intensive. Hence cost of labour forms major part of the operating cost. It however, varies depending on whether an airline has a unionized regime or otherwise. Airlines that do not allow union activities are twice as productive and efficient as the unionized ones. Average labour cost in unionized airlines is at least twice as much non-unionized airlines. This explains why average labour cost in European and North American airlines is about 35% of the total operating cost in comparison to Asian airlines where it is almost half— about 18%. Even in Asia some airlines are unionized. These are generally Government owned airlines such as PIA and Air India. Their labour cost is twice as much as non-unionized and private airlines. Their labour productivity and efficiency is also barely half of private airlines.
Global Distributors (GDS): GDS such as Sabre, Amadeus and Travelport (Galileo, Apollo) charges are fixed for each sector. However, a limited competition does exist in the global market where the airlines could negotiate prices.
Travel agents / consolidators: Bulk auction of seats helps to fill empty seats reducing losses in lean markets; on the other hand they lower airline margins in profitable markets.
Financial Institutions: These institutions are generally weary of taking risk in investment in airlines or lending them money. This is because it is one of the riskiest businesses in the world. Losses are almost guaranteed in the first few years of the business. It is said that the quickest way to become a millionaire from a billionaire is to start an airline business.
2) Customer power:
Internet booking and price competition has given the customers an unprecedented power to window shop. Customers are hypersensitive to price. Difference in price, no matter how minute, would swing a passenger from one airline to another particularly on short haul routes.
3) Barriers to entry:
Capital Requirements: Airline business is Capital Intensive: An average airline, therefore, has to leverage upto 90% of the assets. Requirement of Working Capital is also very high. In Pakistan the minimum paid up capital limit is Rs 500 million or about US$ 5 million for a start-up airline. This amount though appears to be quite large to a potential entrepreneur or an investor but in fact it is barely enough to induct a fleet of 3-5 aircraft of the size of A-320 or Boeing 737-800 on dry lease for a period of 5 years.
Regulatory Barriers: Foreign Ownership Rules: Almost all jurisdictions in the world do not allow more than 49% foreign ownership in national airlines.
Restrictions on Operations of Foreign Registered Wet Leased Aircraft: Almost all jurisdictions in the world restrict operations of foreign registered wet leased aircraft for socioeconomic, safety and security reasons. Pakistan has, however, recently relaxed this clause in National Aviation Policy-15. The limit of maximum number of wet leased aircraft has been increased from 25% to 50% of the fleet capacity and from 90 days to 180 days. This has given the operators great flexibility to enhance capacity during high seasons and shed the same during lean seasons.
Market Access: Market Access on domestic routes is not an issue for National Airlines. Foreign airlines however are not allowed to operate on domestic routes (Cabotage). Market access to foreign international airports is a function of the parameters stipulated in bilateral Air Services Agreements. These agreements are concluded by the Governments and foreign airlines as such would usually not be entertained directly. However most of the countries including Pakistan have liberalized bilateral air services agreements with foreign countries. Allocation of desired airport slots remains an issue at the slot constrained airports. In Pakistan airports like Peshawar, Islamabad and Lahore are severely slot constrained.
Economic and Safety Authority: In Pakistan just as other jurisdictions, a start up airline has to first acquire a commercial license, which is issued by the Government based on CAA’s recommendations and Security Clearance from Security Agencies. The company itself must be registered with SECP. This process may take as many as six months on the average. Then starts the process of Air Operations Certificate (AOC) which must be completed within 365 days from the date of issuance of license. Failure to do so may result in financial penalties.
4) Threat of substitutes: This depends on the distance and geography of the route:
For Short haul routes with good rail and road infrastructure such Islamabad-Lahore, Islamabad-Peshawar, even Lahore – Peshawar and Karachi-Hyderabad; it is more economic and even convenient for the passengers to travel by road or rail rather than by air. However, routes like Peshawar-Chitral, Islamabad-Gilgit or Skardu the geographical barriers make a good case for air travel. Same is the case for many of the small airports in Baluchistan. However, this is not the case on Karachi-Islamabad, Karachi-Lahore, Karachi-Peshawar and even Karachi-Quetta routes.
5) Industry competition
Airline industry is oligopolistic where three to five airlines compete each other on prices. The capacity of an aircraft comes in bulk whereas the customers in ones and two doing window shopping. Hence filling an aircraft at the desired average price becomes a real challenge in a competitive market. Empty seats are perishable and cost almost as much as carrying revenue passengers sitting in them because of high fixed costs. Hence airlines are forced to fill the aircraft through revenue management system that works on complex algorithm computer programme continuously varying prices based on remaining seats and the time left to fill them. Airlines are therefore forced to operate close to breakeven point to survive.
An entry of a new airline in the market would upset market conditions for other competitors. Hence the dominant players in the market would let the new entrant sell below operating cost in a bid to establish its market share until it start to raise the prices. This is the time competitors in the market would pounce on it by lowering the prices in a bid to drive it out of market. The new airline having far less staying power than others would soon wind up.
Lowering the prices below operating cost by the dominant player in the market to drive out the competitor and subsequently recouping the losses after the target competitor has been driven out is called predatory pricing. It is illegal but very hard to prove even in well established jurisdictions like USA and Europe. Airblue had accused PIA for predatory pricing back in 2005. CAA and Government intervention however resolved the issue.
516 views · View Upvoters · Answer requested by Fahad Faraz
Muhammad Afsar Malik, Expert in Airline Economics
Updated Jan 21 (Accessed April 2019)
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