The emergences of Low-Cost-Airlines in India in the past six months have led to stiff competition between the regular network airlines Jet Airways, Air Sahara and Indian Airlines, leading to slashing of fares and other aggressive tactics to drive out the new entrants. This commentary will analyse why the Low-Cost-Airlines pose a threat to the key players using the economic concepts of the theory of firms.
The Low-Cost Airline concept is very fresh to the Indian market. Low Cost Carrier Air Deccan started operating in southern India since September 2003. The fares set by Air Deccan are competitively low and quite out of reach for the regular network airlines.
Assuming, the market is in equilibrium and the firms to maximise profit. The domestic aviation industry of India is an oligopoly, i.e. a market in which only a few firms share a large proportion of the industry selling differentiated or undifferentiated products and where the entry of new firms is restricted. There is a fair degree of competition amongst them to get the biggest market share due to which they face a kinked demand curve.
This will be explained by the following graph. (fig 1.1) At the market equilibrium price P, a quantity Q is demanded. (Its important to consider that the airline is not necessarily flying fully occupied. So the increase and decrease in the demand of air tickets due to the changes in price might only result in an increased or decreased occupancy rate). As price increases from P to P1 the demand decreases to x but the firm continues producing at Q (as there is the problem of indivisibility1). So there is a surplus of goods, which implies that it has lost customers who are now consuming the services of the other firms at lower prices.
However, if it reduces the price to P2 there is a shortage of goods as the demand increases to y and it produces only at Q, so now it has to shift the production to Q2 (in this case it results in a higher occupancy rate of the airline than at price P). This brings about increased revenues with the other firms losing their customers, in light of which they too lower their prices to the same level to maintain their market share.
Entry of Air Deccan into the market offering their services at a price substantially lower than that of the established firms helps it to gain customers from them. Jet and the others can not lower their prices without affecting their profits in the short run since their costs of production are quite high relative to Air Deccan.
Both the firms face the same profit maximising situation as illustrated by the following graph. Profit is maximised by both firms where marginal cost i.e. the cost of producing one extra unit of a good, is equal to marginal revenue which is the extra revenue gained by selling that extra unit of good.
Assuming, the average cost (i.e. total cost incurred per unit of output,) curve of Jet is lower than Deccan since it is an already established firm, enjoying economies of scale which exists when increasing the scale of production leads to a lower cost per unit output. It can lower its price in the short-run to start a price war. Though it will harm its profits in the short-run, the long-run effects might be the exit of Air Deccan from the industry, which means a greater market share for Jet. Moreover, there are several barriers to entry for a new firm entering the aviation industry.
However, the modus-operandi of Air Deccan is totally different unlike the other airlines and puts it at a greater advantage in case of a price war. The cost of production is very low as compared to the other airlines. Using secondary airports which charge lower fees and not offering meals on board, plus the optimum utilisation of the crew through multi-tasking helps in reducing the costs. The increased capacity of their aircrafts also increases their revenues and thus the profits.
The prospect of being able to make the same journey in less time at the same price is attracting customers towards Air Deccan from the AC first class and two tier segment of the Indian Railways, who were not able to afford a plane ride. It will result in expansion of the market and an increase in the market share of the same.
By expanding, Air Deccan will gain economies of scale which will help in lowering their average cost curve and thus being able to further slash down their prices, while maintaining the same margin of profit. This will be explained with the following graph.(fig1.3)
Assuming that Air Deccan produces at the profit maximisation point (where marginal cost is equal to marginal revenue).The shift of the average cost curve of Air Deccan from AC to AC’ might happen with attainment of economies of scale which will only materialise in the long-run. This lowers down the costs of production and the airline can further lower down its price from AR to AR’, which will attract customers from the other airlines. Thus, the airline might be able to survive a price war waged by Jet and the others while maintaining the same level of profit.
Air Deccan is right now facing stiff price war from the established airlines like Jet and Sahara, it might be able to survive it as it is not only luring the customers of the rival airlines but those of the railways as well. A large customer base enables the airline to further lower down its prices as it starts to gain economies of scale in the long-run resulting in the reduction of air fares in general. The other airlines have to revise their cost structures, increase efficiency and reduce number of employees. The consumers are sure to gain from the price war.
1 Supply is fixed in the short run. An aircraft as a factor of production is indivisible which implies that for a trip from A to B, an aircraft uses the same amount of fuel and manpower etc. whether there are ten or hundred occupied seats. Since, the aircraft has a fixed number of seats, its supply of seats for each trip is always fixed.