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The airline industry has been subject of intense p

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rice competition since itwas deregulated, and the result has been a number of new carriers whichspecialize in regional service and no-frills operations. These carrierstypically purchase older aircraft and often operate outside theindustry-wide computerized reservations system. In exchange for theseinconveniences, passengers receive low fares relative to the industry as awhole. This research examines two low fare air carriers, ValuJet andSouthwest Airlines. By investigating these air carriers, we can betterunderstand the economic impacts of price versus service in the airlineindustry as a whole, as well as, the impacts on passenger and investorconfidence.

Until 1978, air transport rates were approved by thegovernment, which meant that price was not a primary competitive factor.

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Instead, airlines would compete on service and image. The airlineindustry was dominated by giants (American, United, TWA) which offerednationwide and some international service, and by regional carriers, suchas Southwest, which offered short trips between airports not served by thenationals. Deregulation of the airline industry brought about in 1978introduced a situation in which the national and regional carriers weresuddenly able to compete in an environment that resembled a free market.

Rate schedules were lifted, price fixing was eliminated and routemanagement was removed. The main factors that affected whether an airlinecould serve a particular city was whether or not that city had enoughgates for the new carrier, and whether the carrier was able to afford topurchase them. Companies such as Southwest recognized potential for lowfares, and began building a niche for themselves by offering low fareswith equivalent low levels of service. Southwest’s success gave rise to anew generation of low fare airlines, with ValuJet entering the market inthe early 1990’s. Unfortunately, ValuJet suffered a string of accidentswhich brought the future of this air carrier into question. ValuJet is alow-priced airline that offers inexpensive tickets for regional travel.

Based in Atlanta, the airline serves the Southeastern United States andcompetes with Continental Airlines as well as with other small regionalcarriers. It serves 31 cities primarily in the southeastern UnitedStates. The airline began its service with flights to Tampa and Orlandofrom Atlanta in 1993. The no-frills strategy paid off for the fledglingairline, which posted half again as many revenue passenger miles in April1996 as it did in April 1995. However, the company announced that it wasslowing the expansion of its services, voluntarily, at the same time thatit posted this impressive revenue mark (Cole & Pasztor, 1996, p. A6).

Perhaps due to overexpansion or to poor luck, Valujet experienced a seriesof mishaps in its short history. In January 1994, a DC-9 skidded off arunway in Washington which resulted in the entire airport being shut down.

In June 1995, a ValuJet flight went through an emergency evacuation afteran engine failed and shrapnel flew into the cabin. Additional incidents,including one where the landing gear collapsed after a particularlyforceful landing, led the FAA to begin an intense review of ValuJet inFebruary 1996. This review found that ValuJet was in compliance with FAAregulations, but cited concern about pilot training and aircraftmaintenance (Larson, 1996, p.30). In May 1996, Valujet flight 592 crashedin the Everglades, killing all aboard and resulting in a shutdown of thecarrier for several months. When ValuJet began flying again, it did sowith a reduced schedule, and considerable speculation about whether thecompany will be able to continue operations long-term. The company isalso involved in litigation resulting from the crash, and the long-termprospects for the company are questionable. The following chartidentifies key operating statistics for Southwest (seat miles are inmillions, cost factors are in cents) (Shammas, 1996, p. 5541P):1995 1994 1993 Revenue Passenger Miles (RPM)2,62494144 AvailableSeat Miles (ASM) 3,813 1,471 63 Load Factor 68.8 %64.0 %69.7 %Revenueper RPM13.4 13.8 13.1 Cost per ASM6.86.89.8BecauseSouthwest’sflights are generally an hour or less in length, the airline saves moneyby not having to serve meals. It has a liberal work rule arrangement withits unions, so productivity is high, and overall costs are low. Forexample, Southwest gets 672 hours per year on average from pilots versus371 for American Airlines pilots, and 60 percent more passenger miles perflight attendant (Levinson, 1993, p. 34). These figures enable thecompany to realize profits during years in which the industry as a wholewas suffering. The following chart identifies key operating statisticsfor Southwest (seat miles are in billions, cost factors are in cents)(Klein, 1996, p. 2077):1995 1994 1993 Revenue Passenger Miles(RPM) 23.33 21.6118.83 Available Seat Miles (ASM) 36.1832.1227.51Revenue per RPM 11.83 11.56 11.77 Cost per ASM7.07 7.08 7.25Inaddition, the company has a 70 percent average load factor in an industrythat averages 63 percent, and operating costs per passenger mile are 22percent less than industry average. It has one of the youngest fleets inthe industry (6.9 years compared with an industry average of 12.9 in1992), and the best on-time and baggage handling records in 1992 (Gold,1993, p. 29). Each of these factors contributes to the company’sfinancial and marketing success. Southwest’s success has come aboutbecause it is providing a product that the market wants, no-frillsregional air travel, at a price that is attractive. Despite its no-frillsorientation, the company maintains strong customer service satisfactionand high levels of customer service, encouraging repeat business. Whenthe airline enters a new market, such as Baltimore, its fares are as muchas 85 percent less than those of its higher-priced competitors, attractingpassengers quickly and forcing the competition to either match the priceor lose market share. In its target markets, Southwest has positioneditself to even compete favorably with traveling by car (Thorpe, 1996, p.

262).Southwest’s success has not been without problem, and the companyhas again demonstrated an ability to find creative solutions to thoseproblems. For example, the company has traditionally expanded its 737fleet by adding older aircraft available at discounts (sometimes as muchas 30 percent) (Kripanlani, 1992, p. 20). Since the company’s ability toenter new markets is determined in part by the size of its fleet, andsince the company is committed to staying with homogenous fleet of 737s,it runs the risk of ending up with a large number of older aircraft thatit no longer needed (depending on the market), or that do not meet newenvironmental standards. Southwest solved this problem by beginning alease-back program in 1988. Under the program, Southwest sells some ofits older 737s, then leases them back for its own use. As of thebeginning of 1992, the company had done this with more than half of theBoeing 737-200 aircraft that it operated (Brown, 1992, p.57). Thisprogram enables the company to release aircraft that it no longer needs orthat no longer meet the stringent new environmental standards. At thesame time, the company can modify its remaining 737-200s in order to makethem compatible with noise and pollution regulations if it needs thecapacity. The company’s stock has split three times since 1990, and itsprice-earnings ratio is a healthy 13.1 percent. Its load factor is wellwithin the industry norm of 67 percent (Sanborn, 1996, p. 251), and thecompany’s commitment low fares and its safety record should help itmaintain good performance even in light of the ValuJet crash (whichbrought increased attention to all low fare carriers). The crash ofFlight 592 has brought increased scrutiny to ValuJet (and to low-farecarriers in general), and the long-term effect on ValuJet is not yetknown. The stock, which had two, two-for-one splits in 1995 and whichpeaked at more than 30 dollars per share in late 1995, has plummeted tobelow 12 dollars per share in late 1996. Investors with high tolerance ofrisk might consider the stock at this low level, and the company might bea takeover target in the future as other carriers seek its routes.

However, the company’s aging aircraft fleet would not be an asset to mostcarriers, and it is unclear whether stockholders would realize areasonable profit, even at today’s low prices. The outlook for Southwestis considerably brighter than for ValuJet. The company has one of thehighest safety records in the industry, and the company has also benefitedfrom higher ticket prices and increased passenger traffic. The recentreinstatement of the federal excise tax is not expected to have a negativeeffect on Southwest demand since it has indicated it will increase faresin only 20 percent of its markets, but this will affect profitability.

The company’s strategy is to make up the difference of lower revenue withincreased demand through its lower fares (Thorpe, 1996, p. 262). Theairline industry has become one of the most competitive segments of oureconomy. The economic realities of operation costs versus passengerdemand for cost-effective travel has forever changed the face of thetravel industry. After deregulation in 1978, the airline industry wasforced to abandon its service-oriented philosophy and consider thecompetitive pressures since they affected the various companies bottomline. Price had suddenly become the benchmark in the airline industry.

Companies such as Southwest and ValuJet recognized the potential for lowfares with commensurably low levels of service.With the changingparadigms in the airline industry comes risk, not only to the individualairlines but also the public in general. At what point do the economicpressures of making a profit for the airlines affect passenger safety? Ifthe trend toward more airline disasters continues and those accidents canbe attributed to cost-cutting measures, surely Congress will intervene.

The airline industry must be disciplined in its approach to solving theeconomic pressures, while, at the same time stay focused on safety issues.

If the airline industry is to survive and give the consumer choices,passenger confidence cannot be sacrificed for the sake of the bottom line!SourcesFederal Reserve Bank Of San Francisco:http://www.frbsf.org/publications/economics/letter/2002/el2002-01.html

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