Australian Airline Industry and the Factors Affecting Its Profitability
PART A – Case Study (40 marks; minimum word count: 1,500 words; maximum: 2,000 words)
Choose an Australian industry and analyse the most important factors affecting its profitability by using the relevant concepts and theories we have studied in Lectures 1-9. You should choose the three, four or five factors that have had the most influence on profitability. You can choose factors that are currently affecting your chosen industry, or factors that seem likely to affect the industry’s profitability in the near future. Some possibilities to consider are:
Internal rivalry and the market structure: Which market structure best describes the market (i.e. perfect competition, monopoly etc.)? Why? Things to consider here are the nature of the firms’ output (homogenous vs. heterogeneous), barriers to entry, “pricetaking” vs. “price-making,” and market concentration (a small number of large firms vs. a large number of small firms). Provide measures of industry concentration if you can. Do you have reasons to believe that the market structure is likely to change in the future? Is the struggle for market share and increased profitability reflected mainly in price competition or in non-price competition? If it is non-price competition, what form does it take?
Barriers to entry: Are there barriers to entry in your chosen industry? That is, is it difficult for new firms to enter or is there free entry? Have any significant new firms entered the industry in the recent past? Consider how brand loyalty, economies of scale, intellectual-property law (e.g. patents and copyrights), and government regulation can each contribute to barriers to entry.
Substitutes and complements: Are there important substitutes and complements (in consumption) that could affect industry profits? You can consider related products that are either currently available or might soon become available.
Bargaining power of buyers: Is the input of your chosen industry bought by few large buyers with market power or a multitude of price-taking buyers with no market power? How does that affect profits? Have producers made relationship-specific investments with their buyers?
Bargaining power of suppliers: Is the market for inputs in your chosen industry concentrated or competitive? Here, you can choose to consider the markets for labour, land, raw materials, and capital. How does the relative concentration in that market affect input costs, and how can input costs affect your chosen industry’s profits? Have the producers in your chosen industry made relationship-specific investments with their input suppliers (for example, moving their factory close to a supplier’s business)? Can the supplier exploit this situation and how would that affect profitability? Are there substitute inputs that producers in your chosen industry can turn to?
Costs: What sort of cost structures do the firms in the industry face? Do the firms face any economies/diseconomies of scale, scope, and/or learning? How are these cost structures likely to affect firms’ relative sizes or their profit-maximising decisions?
Application of Key Economic Concepts
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Application of Key Economic Concepts
Part A
Australian Airline Industry: An Introduction
The Australian airline industry is a key economic sector in the country. It contributes to the creation of employment and revenue generation through tourism and investments. In particular, it contributes to about 5% of the economy, $35-$69 billion in value-added, and about 700,000 jobs (Australian Parliament House, 2020). It comprises domestic and international travellers, with domestic travellers accounting for a significant number of overall travellers (The Department of Infrastructure, Transport, Regional Development, Communications and the Arts, n.d.). In recent years, it has experienced significant challenges following the coronavirus pandemic and the recent surge in oil prices. It has also experienced labour shortages, which continue to affect its operations. Below are several factors that impact its profitability.
COVID-19
COVID-19 has had considerable effects on the airline industry. Specifically, the COVID-19 pandemic has hurt the industry's profitability in the short run and continues to have long-term effects. In 2020 when the pandemic hit, the airline industry reported revenue of $26.94 billion, a decline of almost $20 billion from $45.98 billion in 2018 (Common Wealth of Australia, 2022). This decline in revenues affected the profitability of the airline industry. One key reason for the decrease in revenue was a reduction in the volume of passengers as the Australian government imposed travel restrictions and international border controls to curb the spread of the pandemic (Australian National Audit Office (ANAO), 2022). As the demand for air travel declined, so did the revenues generated in the industry. By the end of 2020, the operating profits of four major airports had reduced by 55%, and this decline continued into 2021 (Australian Competition and Consumer Commission (ACCC), 2021). Airline companies reported significant losses due to the pandemic.
The industry has started to recover in a post-pandemic era. According to ACCC (2023), the airline has started reporting profitability as many travel restrictions and border control measures have been eliminated. For instance, Qantas Group, one of Australia's major airlines, reported a profit of $ 1.43 billion for the years 20222-23. More passengers have started using air travel because the immediate threat of COVID-19 has been eliminated. However, in a report released by the International Air Transport Association IATA (2023), the resurgence of COVID-19 in China in 2023 poses a risk to the airline industry. In fact, some countries have started imposing travel limitations to control the spread of the virus, and Australia has introduced additional measures as well. But the Australian government relaxed those measures in March 2023, and travellers from China to Australia are not required to undergo COVID-19 testing upon arrival (Smart Traveller, 2023). The removal of such measures means that travellers will not be restricted to travelling using air, and their continued use of air travel will increase demand and generate more revenues. However, the resurgence of COVID-19 remains a threat to the airline industry, and it remains to be seen whether the demand for air travel will continue rising. The Australian airline industry cannot ignore this threat.
Additionally, the airline industry is still dealing with the COVID-19 aftermath. According to IATA (2022), the pandemic contributed to the loss of about 20 years gain in passenger traffic within a period of about two years. The industry will take over 20 years to return to the pre-pandemic passenger traffic forecasts. These long-term effects are not unique to the global airline industry. In Australia, the number of passengers has increased significantly in the post-pandemic era, but they are nowhere close to the pre-pandemic numbers. As the AC (2023) reveals, as of January 2023, only 4.4 million passengers travelled by air, and this number accounts for about 89% of pre-pandemic air travellers. The airlines have increased their seat capacity, but the number of air travellers has not increased significantly. As Figure 2 shows, the number of domestic and international travellers dropped considerably in 2022 and has not bounced back to the pre-pandemic levels yet. As the industry recovers from the coronavirus effects, its profitability will continue to increase, but full recovery will take some years.
Internal Rivalry and Market Structure
The Australian airline industry can be described as an oligopoly. According to ACCC (2022), the industry was deregulated over 30 years ago and has mostly been a duopoly consisting of Qantas Group and Virgin. However, it now has three major firms predominantly competing on high-traffic routes after the entry of Rex. Also, in 2023, a new player, Bonza, joined the market (ACCC, 2022). These new entrants have contributed to increased competition among the firms as they all scramble to increase their market shares. As Samuelson et al. (2021) indicate, the entry of new players in the market destabilizes the profitability of the incumbent firms because of reduced market shares. As shown in Figure 2, Rex already has significant market shares, especially in the regional-to-regional category. Overall, it has a market share of 5.3%, which is expected to grow as it expands its intercity operations (ACCC, 2022).
As a result of increased competition among rival firms, Australian airline firms are always trying to offer attractive prices for air tickets. Rival airlines operating on the same route often lower their prices, albeit temporarily, to attract more customers. For example, Qantas' Jestar usually offers lower airfares when operating on the same route as Rex to remain competitive (ACCC, 2022). The airfares increase when Rex is not operating on the same route. Increased airline competition will make the industry more competitive and force airline companies to reduce airfare and revenues. Assuming the cost of production remains the same, lower revenues will translate to lower profits.
At the rate at which the new airlines are entering the Australian airline industry, the market structure is likely to shift in the future. Initially, it was dominated by two large airlines (Virgin Australia and Qantas Group), which own low-cost carriers (LCCs) brands (ACCC, 2023). However, the entry of Rex and Bonza indicates that the market might soon consist of many small airlines instead of a few large ones.
Price Elasticity of Demand
In the last year, the airfare charged by the airline industry has been significantly high. According to the ACCC (2023), the high cost of jet fuel has forced airlines to increase airfares. The increase in jet fuel prices has contributed to high production costs for the airlines. In order to maintain some level of profitability and sustain their operations, airlines have been forced to increase airfares. However, this has affected the volume of passengers as they respond to high airfares. According to the principle of price elasticity, when the demand for products and services is sensitive to the price, the demand is said to be price elastic (Samuelson et al., 2021). In the airline industry's case, the decline in the volume of passengers following the rise in airfares indicates that the demand in the industry is price elastic.
The price elasticity of demand in the airline industry can be attributed to the availability of substitutes, especially for domestic passengers. According to Samuelson et al. (2021), consumers can easily shift to close substitutes when the price of a commodity rises. The Australian airline industry is not the only industry providing transportation for domestic travellers. Substitutes include efficient public buses and trains. According to Visontay (2022), by the end of 2022, most Australians had switched to interstate train and coach travel options in response to the rising airfares. As Figure 3 reveals, the number of passengers in January 2023 declined by 7% right about the time airfares started to rise. The availability of close substitutes contributed to the price elasticity of demand in the industry.
Price elasticity affects the profitability of the industry. Samuelson et al. (2021) reveal that, generally, when the demand is price elastic, an increase in price causes a decrease in revenues due to a reduction in the quantity demanded. Therefore, it can be assumed that the price elasticity of demand in the airline indu...