Economies of Scale and Scope in Airline Industry

Raghunatha Reddy L Chanpreet Singh

Introduction

US airline was deregulated in 1978,while Europe airlines remained highly regulated. Deregulation took place because of following reasons,
a) b) c) d) e) f) g) Planes Were Only Half Full - But Airlines Couldn't Offer Discounted Fares Airlines Couldn't Add New Routes Airlines Couldn't Remove Old Routes The Airlines Were Not Profitable New Airlines Couldn't Start Up An Industry Death Cycle Lessons from Southwest and PSA

Deregulation caused various bankruptcies, mergers and intense competition.

USAir expanded in the late 80s purchasing Pacific Southwest Airlines (PSA) in 1986 and Piedmont Airlines in 1987.
Various economies of scope and scale arises because of this deregulation.

Economies of scale
Due to bankruptcies, various mergers took place which in turn resulted in airlines operating various type of airplanes. Ex : US airways was operating Boeing, Airbus and McDonnell Douglas Economies of scale arise in maintenance cost, operating cost and training cost. with different type of aircrafts.

US Airways
Maintenance cost Salary and Wages Training cost Fuel cost $ 762,157,000 $ 592,791,000 $ 55,106,000 $ 805,205,000

SouthWest Airlines
$ 216,896,000 $ 276,973,000 $ 1,287,000 $ 267,001,000

Total
Source:web.mit.edu/airlinedata

$ 2,213,230,000

$ 762,157,000

Empirical Result
US Airways
Maintainance cost/mile

SouthWest $.88

$1.69

Salary and Wages/mile

$1.31
$.30

$1.2
$.12

Training cost/mile

Fuel cost /mile

$1.79

$1.68

total cost/mile

$5.09

$3.88

Economies of scope
After deregulation economies of scope arises because the airlines were free to choose their own routes. The CAB loses control over deciding the route and fares of the airlines. Instead of aircrafts carrying only passengers they started carrying passengers and freight which resulted in lower cost per mile. Airlines switched to hub and spoke system instead of conventional point to point system which initially proved to be very effective cost reducing method, which allowed the airlines to fill the flights more comprehensively.

Advantages Of Hub And Spoke System

Increases aircraft utilization and passenger load factors

Service to more number of cities.

Centralizing operations at the hub leads to economies of scale Increase demand (frequent flights) Economies of scope.

Why Hub and Spoke system is Economies of Scope?

economies of scope occur when a firm producing many products has a lower average cost than a firm producing just a few products Omaha to Boston is a single Product. (Omaha to Chicago, Chicago to Boston) are two different Products. If average cost of offering two different products is less than cost of offering one product then we can say there is economies of scope.

Omaha

Boston
Less daily traffic Low load factor

Omaha
High daily traffic High load factor

Chicago

Boston
High daily traffic High load factor

Disadvantages Of Hub And Spoke System:

Congestion and delays at hub airports Weather problems at hub. Increase in income of people. Inherent Disadvantage: more time, more cost. Increase in the cost of slots at hubs.

After 35 years of deregulaion

Before deregulation After deregulation

Fares

around 12-15 cents/mile

around 7-10 cents/miles

Productivity

140 seats/flight

152 seats/flight

Accidents rate

.2-.5 %

.4-.7%

Accessibility

Available in 90 towns

Reached 430 towns

Source:www.econlib.org

Conclusion
Airline deregulation has worked. It would be ironic if, by misdiagnosing the present discontents, US were to return to policies of protectionism and centralized planning at the very time when countries as dissimilar as China, the Soviet Union, Chile, Australia, France, Spain, and Poland are all discovering the superiority of the free market.