Application of core theory to the U.S. Airline industry

Journal of the Academy of Business and Economics, March, 2005 by Vedapuri S. Raghavan, Jayathi Raghavan

ABSTRACT

Competition in the airline industry has been fierce since the industry was deregulated in 1978. The proponents of deregulation believed that more competition would improve efficiency and reduce prices and bring overall benefits to the consumer. In this paper, a case is made based on core theory that under certain demand and cost conditions more competition can actually lead to harmful consequences for industries like the airline industry, or cause an empty core problem. Practices like monopolies, cartels, price discrimination, which are considered inefficient allocation of resources in many other industries, can actually be beneficial in the case of the airline industry in bringing about an efficient equilibrium.

Keywords: empty core, demand, cost, equilibrium, unrestricted contracting, competition, airline industry.

1. INTRODUCTION

The US Airline industry is considered highly competitive. However, despite receiving $5.0 billion in direct assistance from the U.S. government in 2001, the financial stability of the U.S. domestic airline industry remains substantially in doubt. The recent spate of bankruptcies filings, first by U.S. Airways and then by United Airlines, leads one to wonder whether competition is essentially good for the industry or will ultimately prove destructive. Clearly, the terrorist attacks of September 11, 2001 have had a serious impact on the industry. However, the industry, particularly the major carriers, was headed toward financial distress prior to the terrorist attacks (Will, 2002). For the quarter ended June 2001, the industry posted an operating loss of $70 million, as compared to an operating profit in excess of $3,000 million the prior year (Linenberg and Flemming, 2001). Various explanations, ranging from labor issues to weak business plans have been offered as reasons for the current woes of the U.S. Airline industry (Zellner, 2002).

In this paper we offer a theoretical explanation for the problems faced by the airline industry based on core theory. According to core theory, in some industries, like the airline industry, excess competition can lead to an empty core problem or lack of a stable equilibrium. The notion that competition may be destructive for the airline industry is further strengthened by what happened in the US airline industry immediately after deregulation in the 80's. At that time price-cutting in the industry was extreme, most firms in the industry were losing money even though buyers wanted the product and were willing to pay higher than prevailing prices. The cumulative losses incurred by the industry exceeded the profits previously earned since the industry's inception. Several carriers failed and ceased operations including such high profile operators as Pan American Airways and Eastern Airlines.

Specifically, core theory suggests that, under certain conditions, non-competitive practices may in fact have an efficiency-enhancing role in the sense of making both producers and consumers better off. Core theory also clarifies the notion of efficient competition and cooperation--that agents in a market may simultaneously cooperate and compete at the same time.

The paper is organized as follows. In the second section we provide a brief review of terminology and definitions for introducing Core Theory. The third section provides an applied framework so that the concepts of Core Theory are related to standard notions of market organization. In the fourth section, we identify some symptoms of an empty core and relate it to the airline industry. Section 5 looks at how the airlines have dealt with the empty core problem in the industry. Section 6 concludes with some policy implications.

2. TERMINOLOGY AND DEFINITIONS

Core Theory concepts are closely related to many standard economics concepts and are rooted in Game Theory. To keep the exposition simple, we do not discus these issues. The following definitions are necessary for understanding Core Theory. A numerical illustration and industry examples are included with the definitions.

Allocation: As individual buyers and sellers participate in a market they seek gains from their trading activities. The gains, each of the market participants receive from their individual trading activity is considered their allocation. In effect, the allocation is their pay-off for participating in the market.

Avoidable cost: The firm in the industry has the option of avoiding this cost. For example in the shipping industry the ship can decide to sail or not to sail and hence can avoid the cost associated with sailing (this decision is separate from cost of purchasing the ship). Similarly in the airline industry the aircraft may decide not to fly and can avoid fuel and other costs associated with flying (this decision is separate from the decision to acquire the aircraft).

Sunk cost: Expenditure, which cannot be recovered. The cost of purchasing a ship or an aircraft can be considered sunk cost.

Divisible vs. Indivisible demand: Divisible demand refers to situations where demand can be broken down into separate units. For example in ocean liner shipping where small packets are shipped or as in the case of airlines where each seat on the aircraft can be considered a separate unit which can be sold at different prices. Whereas in the case of indivisible demand it is not possible to divide demand into different units as in the case of bulk shipping.