Spinning off low cost carriers--when it does make sense?ABSTRACT In the last 10 years, a number of major and flag-bearer air carriers have been spinning off low fare alternative airlines from their main operation to compete with low fare rivals. This paper examines the incentives and possible indicators of success for this strategy. Using a two-stage game model, we determine that the high fare airline company will find it profitable to create its own low fare airline when (a) the factor of cross elasticity between high fare good and low fare good is relative large and (b) the existing load factor on the high fare airline is relatively high. The model also shows that total welfare as a result of this strategy can rise under some favourable conditions. 1. INTRODUCTION "Lets face it, if you're an airline and your name doesn't begin with Southwest, you are by default a bankruptcy candidate." Jamie Baker
Jamie Baker (born August 31, 1966 in Nepean, Ontario) is a Canadian former hockey player, having played for the Quebec Nordiques, Ottawa Senators, San Jose Sharks and , an airline analyst at J.P. Morgan, to The Associated Press Associated Press: see news agency. Associated Press (AP) Cooperative news agency, the oldest and largest in the U.S. and long the largest in the world. on the restructuring going on in the airline industry. To be fair, Jet Blue Airways airways Anatomy The 'pipes'–trachea, bronchi, bronchioles–through which air passes to and from the alveoli. See Small airways. , Airtran and West Jet, the disciples of Southwest Airlines This article is about the American airline. For the former Japanese airline, see Japan Transocean Air. For the British airline, see Air Southwest. Southwest Airlines Co. , are also profitable North American airlines North American Airlines is an American airline based in New York City, USA. It operates scheduled international services from the USA to Africa and Guyana, as well as domestic and international charter services and wet lease services. Its main base is John F. . Not coincidentally co·in·ci·den·tal adj. 1. Occurring as or resulting from coincidence. 2. Happening or existing at the same time. co·in , all of these share common characteristics--they are all no-frill low cost point-to-point airlines. The Southwest airline case study is quickly filling up textbooks, journals and magazines as the new airline model for profit maximization In economics, profit maximization is the process by which a firm determines the price and output level that returns the greatest profit. There are several approaches to this problem. . The impact of Southwest on the airline industry has been estimated at $12.9 billion in savings to consumers (1). All airlines have four broad components in their profit functions; the product of yield and traffic equates to revenues and the product of unit costs and output equates to costs. Southwest Airlines has focused primarily on reducing unit costs to increase traffic through the lowest prices. There are five key elements in their strategy. First, utilize all the same aircraft (737s) to reduce training and maintenance costs. Second, use less expensive secondary airports near major centers to reduce transaction cost laden turnaround times (1) In batch processing, the time it takes to receive finished reports after submission of documents or files for processing. In an online environment, turnaround time is the same as response time. and increases productivity. Third, pay high attention to customer satisfaction to increase load factors (2). Fourth, reduce booking costs through an aggressive Internet strategy. Finally, maintain lower labor costs by more closely aligning interests between labor and management (3) (Holloway, 1997). In contrast to Southwest and its clones, a large segment of the North American North American named after North America. North American blastomycosis see North American blastomycosis. North American cattle tick see boophilusannulatus. airline industry is in financial free fall. Air Canada filed for bankruptcy on April 1st, 2003 to join Hawaiian Airlines Hawaiian Airlines is the 11th largest commercial airline in the United States. It is the largest airline based in the State of Hawai'i and is commonly referred to by the acronym "HAL". and United. American Airlines American Airlines Major U.S. airline. American was created through a merger of several smaller U.S. airlines and incorporated in 1934. It continued to buy the routes of other airlines, becoming an international carrier in the 1970s; its routes include South America, the reduced its costs by $1.6 billion on March 31st to just avoid bankruptcy. U.S. Airways just finished reducing its costs while under bankruptcy protection (4). Delta and Northwest are using the examples of American and US Airways as leverage for reducing costs. There are numerous explanations for the financial crisis facing most of the North American major and flag bearer One who is the holder or possessor of an instrument that is negotiable—for example, a check, a draft, or a note—and upon which a specific payee is not designated. carriers. There are exogenous Exogenous Describes facts outside the control of the firm. Converse of endogenous. factors reducing traffic such as health and security concerns. There are also a number of endogenous endogenous /en·dog·e·nous/ (en-doj´e-nus) produced within or caused by factors within the organism. en·dog·e·nous adj. 1. Originating or produced within an organism, tissue, or cell. factors relating to relating to relate prep → concernant relating to relate prep → bezüglich +gen, mit Bezug auf +acc their comparatively high per unit costs. At this stage, the question facing the North American major and flag bearer carriers is not whether they should compete with Southwest, WestJet and other low cost carriers by reducing their costs, but how to do it and quickly. A Consumers including business travelers are buying down and this trend is permanent. The days when CFO See Chief Financial Officer. =s issued directives not to travel in executive class have been replaced by new directives to only travel with low cost carriers whenever they are available. We have to conform to Verb 1. conform to - satisfy a condition or restriction; "Does this paper meet the requirements for the degree?" fit, meet coordinate - be co-ordinated; "These activities coordinate well" this reality and transform Air Canada into a low cost carrier in its own right. We cannot product a product for $1 and sell it for 754 while our main domestic competitor can produce the same product for 504.@ B Robert Milton Robert Milton is the current Chairman, President and Chief Executive Officer of ACE Aviation Holdings Inc. (ACE), the parent company of Air Canada. , President of Air Canada, in the National Post, March 22nd, 2003. A number of broad cost cutting strategies have emerged (Holloway, 1997). Most of these strategies are directed at managing specific internal cost drivers. For example, as discussed above, a number of airlines are using a combination of threats based on exogenous factors and bankruptcy to gain significant concessions from labor, creditors and suppliers. Other airlines are reducing output and cutting back on routes. United Airlines just cut back a number of routes, as did KLM KLM Kaiserliche Marine (Enigma: Rising Tide game) KLM Koninklijke Luchtvaart Maatschappij (Royal Dutch Airlines) KLM Klub Langer Menschen (German: Tall Person Club) . Strategic alliances such as those by Northwest, Delta and Continental are being used to achieve efficiencies in ticketing and bulk purchases (Oum, Park and Zhang, 2000). Beginning in the early 1990s, a new cost management strategy, called the spin off strategy, emerged. A number of new airlines were established either within but separate from the main airline or as standalone stand·a·lone adj. Self-contained and usually independently operating: a standalone computer terminal. entities. These include Continental Lite in 1993, Shuttle by United Shuttle by United was a regional airline operated as a subsidiary of United Airlines from 1994 to 2001 along the West Coast of the United States. It provided air shuttle service between San Francisco International Airport (SFO), Los Angeles International Airport (LAX), and other in 1994, Delta Express Delta Express was a no-frills brand owned and operated by Delta Air Lines from 1996 to 2003. Delta Express was based out of Orlando International Airport, and focused on leisure routes between Florida and the northeast United States, as well as certain parts of the midwest. in 1996, and Air Canada=s Tango tango Spirited dance; also a South American ballroom dance. It evolved in the dance halls and, perhaps, the brothels of poorer districts of Buenos Aires, Arg., possibly influenced by the Cuban habanera. It was made popular in the U.S. and Zip in 2001 (6). All of these new airlines were intended to directly compete with low cost point-to-point Southwest type carriers and contribute either revenues or increased traffic to their parent companies. In theory, they would lower costs by adapting as much of the Southwest model as possible. In some point-to-point markets, the existence of these low cost spin offs would provide an effective barrier to entry, and in others; they would directly compete with Southwest and/or its followers followers see dairy herd. . This strategy is not without some obvious risks. First, there is the selection of the appropriate point-to-point markets to compete over. Second, there is a branding issue and possible confusion and alienation alienation, in property laws: see tenure. alienation In the social sciences context, the state of feeling estranged or separated from one's milieu, work, products of work, or self. among customers (7). Third, it is possible that the client base from the mainline mainline Drug slang verb To inject a drug is merely siphoned off to their upstart. Fourth, there is a shift in corporate culture required to dramatically reduce costs per unit. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke" put differently there are high switching costs. Finally, there may be problems satisfying premium passengers who are forced to use the discount service (8). The results so far indicate that this strategy is not working well in North America North America, third largest continent (1990 est. pop. 365,000,000), c.9,400,000 sq mi (24,346,000 sq km), the northern of the two continents of the Western Hemisphere. . Continental Lite stopped operating in 1996 after reporting over $100 million in losses in 1994. United Express suspended its operations in 2001 because its costs were not significantly different from the parent company. A plan to re-launch Delta Express using a different name and different cost structure was announced in 2002 (Washington Times, Nov. 16th, 2002). The practical experience of others has not daunted daunt tr.v. daunt·ed, daunt·ing, daunts To abate the courage of; discourage. See Synonyms at dismay. [Middle English daunten, from Old French danter, from Latin Air Canada and still has support among the business community (9). Is this strategy viable? (10) When or under what conditions the airline companies should practice this strategy? The objective of our paper tries to use economic model to answer these questions. The paper uses a two stage game theoretic model to generate the parameters that an optimizing Air Canada or similar major airline should consider in choosing where and how to spin off a no frill carrier to compete with a low cost alternative. Chief among these parameters are the cross elasticity of demand In economics, the cross elasticity of demand and cross price elasticity of demand measures the responsiveness of the quantity demand of a good to a change in the price of another good. in various markets and the load factor. The remainder of the paper is organized into three sections. Section 2 presents the basic model. Section 3 examines main airlines with and without concurrent production of low fare substitutes. Section 4 concludes. Several technical derivations are relegated to an Appendix. 2. BASIC MODEL We assume that there are two goods in the market; a high fare good ([X.sub.h]) and a low fare good ([X.sub.l]). In a compromise between generality gen·er·al·i·ty n. pl. gen·er·al·i·ties 1. The state or quality of being general. 2. An observation or principle having general application; a generalization. 3. and tractability, we assume that consumers possess identical quadratic quadratic, mathematical expression of the second degree in one or more unknowns (see polynomial). The general quadratic in one unknown has the form ax2+bx+c, where a, b, and c are constants and x is the variable. utility functions yielding satisfaction from consumption of a high fare good in quantity [X.sub.h] and from its substitute (the low fare good) in the amount [X.sub.l]. Then: (1) U = [X.sub.0] + u([X.sub.h], [X.sub.l] = [X.sub.0] + [[alpha].sub.h][X.sub.h] + [[alpha].sub.l][X.sub.l] - [1/2]([beta][X.sup.2.sub.h] + 2y [X.sub.h][X.sub.l] + [[beta].sub.l][X.sub.l.sup.2]) where [X.sub.0] reflects the utility derived from a competitive numeraire sector, [[beta].sub.h] >0, [[beta].sub.l] >0, y >0 and [y.sub.2] < [[beta].sub.h][[beta].sub.l] to ensure convexity Convexity A measure of the curvature in the relationship between bond prices and bond yields. Notes: Positive convexity corresponds to curvature that opens upward. Negative convexity corresponds to curvature that opens downward. . From (1) can be derived linear inverse (mathematics) inverse - Given a function, f : D -> C, a function g : C -> D is called a left inverse for f if for all d in D, g (f d) = d and a right inverse if, for all c in C, f (g c) = c and an inverse if both conditions hold. demand relations: (2) Pi = [differential]U/[differential]Xi = [alpha]i - [[beta].sub.i] - Xi - Y Xj, i, j = h, l; i [not equal to] j (3) Xi = 1/[[beta]i [beta]j - [y.sup.2]][([alpha]i - Pi)[beta]j - ([alpha]j - Pj)Y], i, j = h, l; I [not equal to] j The factor [alpha]i represents the reservation price Reservation price The price below or above which a seller or purchaser is unwilling to go. of the high fare or low fare good and we assume [alpha]h>[alpha]l. Rearranging equation (2), we obtain the direct demand functions for high fare and low fare products: In the producer side, we assume that there is one main airline company who provides one high fare good [X.sub.h] and possibly produces one low fare good [x.sub.l1] in its sub-company. Without any loss of generality, we assume that there exists one independent low fare airline company in the market who produces another low fare good, [x.sub.l2]. Therefore, the total quantity demanded of the low fare good is [X.sub.l] = [x.sub.l1] + [x.sub.l2]. The another assumption in the model is that the unit costs (per seat) of the high fare and low fare goods are constants as [c.sub.h] and [c.sub.l], [c.sub.h] >[c.sub.l] . However, unlike other industries the quantity demanded does not equal to the quantity supplied in the airline industry because load factors are usually less than one. Therefore, the total cost for either high fare or low fare good not only depends on the demand of the good but also depends on the output (11). To derive the total cost in the markets, we define the load factor [[lambda].sub.i] (i=h, l). Factor [[lambda].sub.i] is a function of the ratio of average occupied seats and capacity level in one particular [[lambda].sub.i] = f(Xi/Ki) [less than or equal to] 1, [differential][lambda]i/[differential]Xi > 0, [lambda]i (1) = 1, and i = h, l market (12), i.e. where [K.sub.i] is the capacity level in i's good market. 2.1 Two-stage Game: the Main Airline Produces Both Types of Good We frame this strategic decision as a two-stage game where the main airline also produces one low fare good. In the first stage of the game, the main airline and the low fare airlines play a Stackelberg game to set the quantities. In the second stage of the game, two low fare airline companies play a Cournot quantity setting game, given the quantity chosen by the high fare good in the first stage of the game. We start from the second stage in order to solve the game. 2.1.1 The Second Stage of the Game: Two Low Fare Airline Companies Compete in Quantity In stage two, firm i's reaction function is derived from: (4) [r.sub.li]([x.sub.lj]=argmax([P.sub.l][x.sub.li] - [c.sub.l][[X.sub.li]/[[lambda].sub.l]]) = [[[alpha].sub.l] - [[beta].sub.l]([x.sub.li] + [x.sub.lj]) - Y[X.sub.h]][x.sub.li] - [c.sub.l.sup.*][x.sub.li] i, j=1, 2; i [not equal to] j where [c.sub.l.sup.*] is the relative cost in the low fare good market which is represented as [c.sub.l]/[[lambda].l]. This relative cost captures the feature that the total costs depend on the load factor and the capacity of the plane. The first order condition for maximum profit for Equation (4) can be solved to yield: (5) [x.sub.l1] = [x.sub.l2] = [x.sub.l] = 1/3 [[beta].sub.l] ([[theta Theta A measure of the rate of decline in the value of an option due to the passage of time. Theta can also be referred to as the time decay on the value of an option. If everything is held constant, then the option will lose value as time moves closer to the maturity of the option. ].sub.l] - Y [X.sub.h]) where [[theta].sub.l] = ([alpha] - [c.sub.l.sup.*) and reflects the firm=s net absolute cost advantage. We consider later the importance of this element for the firm=s choices and market outcomes. Hence, the total low fare output is: (6) [X.sub.l] = [x.sub.l1] + [x.sub.l2] = 2/3[[beta].sub.l] ([[theta].sub.l] - y[X.sub.h]) Given this expression for [X.sub.l], we turn to the first stage of the game--the Stackelberg competition The Stackelberg leadership model is a strategic game in economics in which the leader firm moves first and then the follower firms move sequentially. It is named after the German economist Heinrich Freiherr von Stackelberg who published Marktform und Gleichgewicht between high fare and low fare products 2.1.2 The First Stage of the Game: Main Airline Company and Two Low Fare Companies Compete in Quantity Substituting the total low fare output function (6) back into (2), the indirect consumer demand functions can be re-expressed as: (7) [P.sub.h] = [[alpha.sub.h] - 2y [[theta].sub.l]/3[[beta].sub.l] - [3[[beta].sub.h][[beta].sub.l] - 2[y.sup.2]/3[[beta].sub.l]] [X.sub.h] (8) [P.sub.l] = [[alpha].sup.l] - 2[[theta].sub.l]/3 - [Y/3] [X.sub.h] The main airline's joint profit maximization task is the selection of [X.sub.h] so as to maximize: (9) [[pi].sub.h] = [P.sub.h] [X.sub.h] - [c.sub.h] [[X.sub.h]/[[lambda.sub.h]] + [P.sub.l][x.sub.l1] - [c.sub.l] [[X.sub.l1]/[[lambda].sub.l]] = ([P.sub.h] - [c.sub.h.sup.*])[X.sub.h] + ([P.sub.l] - [c.sub.l.sup.*])[x.sub.l1] Once again, the parameters [[lambda].sub.h] and [c.sub.h.sup.*] represent the load factor and the relative costs in the high fare good market. Substituting (5), (7) and (8) into (9), differentiating and solving for [X.sub.h] we obtain the Stackelberg output of the high fare product in the two-stage game, [X.sub.h.sup.s2]: (10) [x.sup.s2.sub.h] = [9[[beta].sub.l][[theta].sub.h] - 8y [[theta].sub.l]]/2(9[[beta].sub.h][[beta].sub.l] - 7[y.sup.2]) where [[theta].sub.h] = ([[alpha].sub.h] - [c.sub.h.sup.*]) is the net absolute cost advantage of high fare good production. Substituting (10) into equation (5) we obtain the Stackelberg output of the low fare production in the two-stage game, [x.sub.l.sup.s2]: (11) [X.sup.s2.sub.l] = [[theta].sub.l] / 3[[beta].sub.l] - [9[[beta].sub.l]y[[theta].sub.h] - 8 [y.sub.2][[theta].sub.l]/6(9[[beta].sub.h][[beta].sup.2.sub.l] - 7[[beta].sub.l][y.sup.2]) In this case the main airline aggregate profit is: (12) [[pi].sup.s2.sub.h] = [([theta].sub.h] - 2y [[theta].sub.l]/3[beta].sub.l] - [[3[[beta].sub.h][[beta].sub.l] - 2[y.sup.2]]/3[[beta].sub.l]][X.sup.s2.sub.h]) [X.sup.s2.sub.h] + 1/9[[beta].sub.l]([[theta].sub.l] - y[x.sup.s2.sub.h]).sup.2] 2.2 One Stage Game: The Main Airline Produces Only High Fare Good When the main airline does not pursue the spin off strategy it becomes a one-stage Stackelberg game. Retaining the assumptions from the previous section but adding the constraint that [x.sub.l1] = 0 so that [X.sub.l] = [x.sub.l2], the main airline company and low fare company now play a one-stage Stackelberg quantity-setting game. In the one-stage game, the reaction function of the low fare firm is derived from: [r.sub.l]([X.sub.h]) = argmax ([P.sub.l][X.sub.l] - [c.sub.l] [[X.sub.l]/[[lambda].sub.l]]) = ([alpha].sub.l] - [[beta].sub.l] [X.sub.l] - y[X.sub.h])[X.sub.l] - [c.sub.l] * [X.sub.l] which yields: (13) [X.sub.l] = 1/2[[beta].sub.l]([[theta].sub.l] - y[X.sub.h]) The objective of the high fare producer is to maximize: (14) [[pi].sub.h] = [P.sub.h][X.sub.h] - [c.sub.h] [[x.sub.h]/[[lambda].sub.h]] = ([[alpha].sub.h] - [[beta].sub.h] [X.sub.h] - y[X.sub.l])[X.sub.h] - [c.sub.h] * [X.sub.h] Substituting the low fare firm=s reaction function (13) into (14) we derive the main airline's single-stage Stackelberg output [X.sub.h.sup.s1] as: (15) [X.sup.s1.sub.h] = [2[[beta].sub.l][[theta].h] - y[[theta].sub.l]]/[4[[beta].sub.h][[beta].sub.l] - 2[y.sup.2]] Thus, substituting for [X.sub.h.sup.s1] into (13), the low fare firm=s output becomes: (16) [X.sup.s1.sub.l] = [(4[[beta].sub.h][[beta].sub.l] - [y.sub.2])[[theta].sub.l] - 2[[beta].sub.l]y[[theta].sub.h]]/[8[[beta].sub.h][[beta].sup.2.sub.l] - 4[[beta].sub.l] [y.sup.2]] Therefore, the main airline's Stackelberg profit in one stage game is, (17) [[pi].sup.s1].sub.h] = ([[theta].sub.h] - y[[theta].sub.l]/2[[beta].sub.l] - [2[[beta].sub.h][[beta].sub.l] - [y.sup.2]/2[[beta].sub.l]] [X.sup.s1.sub.h])[X.sup.s1.sub.h] 3. COMPARISON ANALYSIS: TO PRODUCE LOW FARE GOOD OR NOT Now, we can discuss and compare the strategic options for the main airline comany. Certainly, the airline company and social planner In welfare economics, a social planner is a decision-maker who attempts to achieve the best result for all parties involved. In neo-classical welfare economics, this means the maximization of a social welfare function. have diferent objectives in the business. The main airline company will pursue the strategy if its profit increases while social planner is looking for Looking for In the context of general equities, this describing a buy interest in which a dealer is asked to offer stock, often involving a capital commitment. Antithesis of in touch with. welfare improvement. Therefore, we conduct the following comparison analysis between two situations: produce low fare good or not from the views of profit and welfare respectively. 3.1 The Profit Comparison Comparing the two-stage game profit [[pi].sub.h.sup.s2] with the one-stage game profit [[pi].sub.h.sup.s1] for the main airline, we find [[pi].sup.s2.sub.h] > [[pi].sup.s1.sub.h] if [X.sup.s2.sub.h] > [X.sup.s1.sub.h] or (13) (18) y > [([[phi].sup.2] + 7[[beta].sub.h][[beta].sub.l]).sup.1/2] - [phi] where [phi] = [5/2][[beta].sub.l][[[theta].sub.h]/[[theta].sub.l]] Proposition 1 The high fare airline will find it profitable to spin off a low fare alternative if the magnitude of y, the cross effect between the high fare and low fare goods is sufficiently large In mathematics, the phrase sufficiently large is used in contexts such as:
y > [([[theta].sup.2] + 7[[beta].sub.h][[beta].sub.l]).sup.1/2] - [phi] where [phi] = [5/2][[beta].sub.l][[[theta].sub.h]/[[theta].sub.l]] When the factor of cross price elasiticity is large, the high fare airline can take a larger share of the total market from its low fare rival by spinning off its own low fare airline. Assuming that the low fare spin-off The situation that arises when a parent corporation organizes a subsidiary corporation, to which it transfers a portion of its assets in exchange for all of the subsidiary's capital stock, which is subsequently transferred to the parent corporation's shareholders. produces airline seats at the same unit costs as the low fare rival, total profits for the high fare airline will increase. Proposition 1 however, is subject to a corollary corollary: see theorem. . Inequality (18) is more likely to hold when the ratio of [[theta].sub.h] /[[theta].sub.l] is relatively large; i.e. the ratio of the net absolute cost advantage of the high fare good to low fare good. Corollary 1. A main airline is more likely to spin off a low fare alternative the larger is the net absolute advantage of its high fare good relative to the net absolute advantage of low fare supply, i.e. [[theta].sub.h]/[[theta].sub.l] > 6/5 [([[beta].sub.h]/[[beta].sub.l]).sup.1/2] Proof: Let [rho] = [[beta].sub.h][[beta].sub.l] then inequality (18) becomes [([[phi].sup.2] + 7[rho]).sup.1/2] - [phi] < [[rho].sup.1/2] [??] [([[phi].sup.2] + 7[rho]).sup.1/2] < [[rho].sup.1/2] + [phi] Squairing both side of above inequality, we have 3[[rho].sup.1/2] < [phi] or [[theta].sub.h]/[[theta].sub.l] > 6/5 [([[beta].sub.h]/[[beta].sub.l]).sup.1/2] Q.E.D. Stated another way, there is an incentive for the high fare airline to create a spin off when there exist a relatively small amount of empty seats on its high fare routes. When the load factors on high fare routes is not too small, it make sense to directly compete through a low fare spin off, since a small amount of high fare profit will be sacrificed to substitution. If there are already very low load factors on high fare routes than the spin-off strategy could actually reduce total profits for the airline because the profit gain from low fare routes may not cover the profit loss from high fare routes. This suggests that the spin off strategy may only work on certain routes. This corollory represents a strategic decision rule for carrieres considering the low fare spin off strategy. In particular, this algorithm could be used in yield management systems. Yield management systems try to exploit opportunities for price discrimination by segmenting the various segmented demand curves present in an airline market. To our knowledge, these systems do not account for cross price elasticities Price elasticities The percentage change in quantity divided by a percentage change in the price. Answers the question: How much will the demand for my product decrease if I raise prices by 10%? with other carriers or total load factor in a market. Such enhancements may improve the future viability of spin-off discount carriers, by allowing them to Acherry pick@ potentially profitable markets. Such a development would be somewhat ironic since this is precisely the model that Southwest and the other discount start-ups have pursued to transform the market in the first place. 3. 2 The Welfare Comparison Total societal so·ci·e·tal adj. Of or relating to the structure, organization, or functioning of society. so·ci  e·tal·ly adv.Adj. welfare in this two good world can be represented as: (19) W = U([X.sub.h], [X.sub.l] + w - [c.sub.h] * [X.sub.h] - [c.sub.l] * [X.sub.l] where w represents a constant wage rate and is assumed constant (16). Totally differentiating the welfare function, yields: (20) dW=([differential]U/[differential][X.sub.h] - [c.sub.h.sup.*])d[X.sub.h] + ([differential]U/[differential][X.sub.h] - [c.sub.h.sup.*]) d[X.sub.l] =([P.sub.h] - [c.sub.h.sup.*])d[X.sub.h] + ([P.sub.l] - [c.sub.l.sup.*])d[X.sub.l] Suppose we start from a situation in which an airline does not spin off a low fare alternative and produces only its high fare good. The welfare change for the additional low fare is then: [MATHEMATICAL EXPRESSION A group of characters or symbols representing a quantity or an operation. See arithmetic expression. NOT REPRODUCIBLE IN ASCII ASCII or American Standard Code for Information Interchange, a set of codes used to represent letters, numbers, a few symbols, and control characters. Originally designed for teletype operations, it has found wide application in computers. ] Since [P.sub.h] - [c.sub.h.sup.*] >0 and [P.sub.l] - [c.sub.l.sup.*] > 0, the sign of [DELTA]W is determined by d[X.sub.h] and d[X.sub.l]. As proved in the Appendix, subject to certain conditions, we have [X.sub.h.sup.s2] > [X.sub.h.sup.s1] and 2 [X.sub.l.sup.s2] > [X.sub.l.sup.s1]. Therefore, we have the following proposition (17). Proposition 2 There will be both profit and welfare improvement from the spin-off strategy when the factor of cross price elasticity between two goods is large enough, i.e. y > max {[([[phi].sup.2] + 7[[beta].sub.h][[beta].sub.l]).sup.1/2] - [phi], [([[phi].sup.2] - [304/1444][[[beta].sub.h][[beta].sub.l]).sup.1/2] + [phi]} where [phi] = [21/38][[beta].sub.l][[[theta].sub.h]/[[theta].sub.l]] Proposition 2 shows that both profit and welfare can increase by the strategy of spin off if the factor of cross price elasticity is large enough. There will always be an increase in consumer surplus from the introduction of another low fare airline, but in some circumstances the consumer gain could be smaller than then the loss in producer surplus from pursing this strategy. If the factor of cross price elasticity is relatively large, there will be a large consumer surplus increase in low fare good market and this consumer gain is greater than the profit loss in high fare good market. More importantly, under the same condition the total profit of main airline counted from both its high fare business and low fare business is larger than the situation the airle only operates high fare routes. In other words, to the extent that these spin offs acclerate airline bankruptcies, total welfare can fall. 4. CONCLUSIONS Our results suggest that any airline considering competition with a low cost carrier should closely examine the cross price elasticity of demand Price Elasticity of Demand A measure of the responsiveness of the quantity demanded of a good to a change in its price. It is calculated as: and the load factors on the high fare routes. To the extent that traffic is falling for exogenous or endogenous reasons, or cross elasticity are low, or the current high fare load factor is already low the strategy=s likelihood for success decreases. We believe that for many major and flag bearer airlines such as Air Canada, which at least one of these factors is in place and the likelihood of success of the spin off strategy seems low. We intend to estimate our models parameters to confirm this hypothesis. APPENDIX 1. Proof of Proposition 1 Let [X.sup.s2.sub.h] = [9[[beta].sub.l][[theta].sub.h] - 8y[[theta].sub.l]]/2(9[[beta].sub.h][[beta].sub.l] - 7[y.sup.2]) < [X.sup.s1.sub.h] = [2[[beta].sub.l][[theta].sub.h] - y[[theta].sub.l]]/[4[[beta].sub.h][[beta].sub.l] - 2[y.sup.2]] or (A1) 2[y.sup.2][[theta].sub.l] + 10[[beta].sub.l][[theta].sub.h]y - 14[[beta].sub.h][[beta].sub.l][[theta].sub.l] < 0 Solving (A1) for y, y > [[(100[[beta].sup.2.sub.l][[theta].sub.h] + 112[[beta].sub.h][[beta].sub.l][[theta].sup.2.sub.l]).sup.1/2] - 10[[beta].sub.l][[theta].sub.h]]/4[[theta].sub.l] = [([25/4][[beta].sup.2.sub.l][[[theta].sup.2.sub.h]/[[theta].sup.2.sub.l]] + 7[[beta].sub.h][[beta].sub.l]).sup.1/2] - [5/2][[beta].sub.l][[[theta].sub.h]/[[theta].sub.l]] In order to ensure the convexity of utility function, the following condition is kept. [y.sup.2] < [[beta].sub.l][[beta].sub.h] or y < [([[beta].sub.l][[beta].sub.h]).sup.1/2] 2. The Social Welfare Function W = U([X.sub.h], [X.sub.l], [X.sub.0]) + Y - [P.sub.h][X.sub.h] - [P.sub.l][X.sub.l] - [P.sub.0][X.sub.0] Given consumer utility functions U ([X.sub.h] , [X.sub.l] , [X.sub.0]) with [X.sub.0] a numeraire good, society=s aggregate welfare function can be written as: (A2) W = U([X.sub.h], [X.sub.l]) + Y - [P.sub.h][X.sub.h] - [P.sub.l][X.sub.l] where Y represents money income and comprises the sum of profits, [pi] and wages, w. We assume the total wage bill is constant. Then, normalizing and setting the price of the numeraire good to unity: (A3) The total profits from both high fare good and low fare good can be written as: (A4) [pi] = [P.sub.h] [X.sub.h] - [c.sub.h] * [X.sub.h] + [P.sub.l][X.sub.l] - [c.sub.l] * [X.sub.l] and, substituting (w + [pi]) for Y, the total welfare function becomes: (A5) W = U([X.sub.h], [X.sub.l]) + w - [c.sub.h] * [X.sub.h] - [c.sub.l] * [X.sub.l] 3. Proof of Proposition 2 From (11) and (16), we know d[X.sub.l] = 2[X.sub.l.sup.s2] - [X.sub.l.sup.s1], i.e. (A6) d[X.sub.l] = 2[[theta].sub.l]/3[[beta].sub.l] - [9[[beta].sub.l]y[[theta].sub.h] - 8[y.sup.2][[theta].sub.l]]/3(9[[beta].sub.h][[beta.sup.2.sub.l] - 7[[beta].sub.l][y.sup.2]) - [(4[[beta].sub.h][[beta].sup.2.sub.l] - [[beta].sub.l][y.sup.2])[[theta].sub.l] - 2[[beta].sub.l]y[[theta].sub.h]]/[8[[beta].sub.h][[beta].sup.2.sub.l] - 4[[beta].sub.l][y.sup.2]] Let d[X.sub.l] >0 in (A6), (A7) 2[[theta].sub.l]/3[[beta].sub.l] - [9[[beta].sub.l]y[[theta].sub.h] - 8[y.sup.2][[theta].sub.l]]/3(9[[beta].sub.h][[beta].sup.2.sub.l] - 7[[beta].sub.l][y.sup.2]) - [(4[[beta].sub.h][[beta].sup.2.sub.l] - [[beta].sub.l][y.sup.2])[[theta].sub.l] - 2[[beta].sub.l]y[[theta].sub.h]]/[8[[beta].sub.h][[beta].sup.2.sub.l] - 4[[beta].sub.l][y.sup.2]] > 0 Since 3(9[[beta].sub.h][[beta].sup.2.sub.l] - 7[[beta].sub.l][y.sup.2]) > 8[[beta].sub.h][[beta].sup.2.sub.l] - 4[[beta].sub.l][y.sup.2] (A7) holds if (A8) 2[[theta].sub.l]/3[[beta].sub.l] - [9[[beta].sub.l]y[[theta].sub.h] - 8[y.sup.2][[theta].sub.l]]/[8[[beta].sub.h][[beta].sup.2.sub.l] - 4[[beta].sub.l][y.sup.2]] - [(4[[beta].sub.h][[beta].sup.2.sub.l] - [[beta].sub.l][y.sup.2])[[theta].sub.l] - 2[[beta].sub.l]y[[theta].sub.h]]/[8[[beta].sub.h][[beta].sup.2.sub.l] - 4[[beta].sub.l][y.sup.2]] > 0 (A8) is hold based on the following condition: (A9) 19[[theta].sub.l][y.sup.2] - 21[[beta].sub.l][[theta].sub.h]y + 4[[beta].sub.h][[beta].sub.l] > 0 Transforming (A9), we have two ceiling for y, y > [phi] + [([[phi].sup.2] - [304/1444][[beta].sub.h] [[beta].sub.l]).sup.1/2], or y < [phi] - [([[phi].sup.2] - [304/1444] [[beta].sub.h][[beta].sub.l]).sup.1/2], where [phi] = [21/38][[beta].sub.l] [[[theta].sub.h]/[[theta].sub.l]] Combining the condition for Proposition 1, we know that dW>0 if y > max{[([[phi].sup.2] + 7[[beta].sub.h][[beta].sub.l]).sup.1/2] - [phi], [([[phi].sup.2] - [304/1444][[beta].sub.h][[beta].sub.l]).sup.1/2] + [phi]} End Notes (1.) The estimated savings--due to actual, adjacent, and potential competition from Southwest--were $12.9 billion. Southwest's low fares were directly responsible for $3.4 billion of these savings to passengers. The remaining $9.5 billion represents the effect that actual, adjacent, and potential competition from Southwest had on other carriers' fares. These savings amount to 20 per cent of the airline industry=s 1998 domestic scheduled passenger revenue and slightly more than half the fare reductions attributed to airline deregulation Airline deregulation is the process of removing entry and price restrictions on airlines affecting, in particular, the carriers permitted to serve specific routes. The term usually applies to the Airline Deregulation Act of 1978. .@ (Morrison, 2001). (2.) The precise measurement of these broad parameters varies throughout the literature but for our purposes, we will consider yield to revenue per unit of output so that it can be easily compared to cost per unit of output. It is well known that output (supply) is not equal to traffic (demand) for airlines, ie the load factor is often less than one. (3.) The Department of Transport reports that Southwest airlines have the fewest customer complaints among passengers in each of the last 10 years. (4.) US Airways, United and American represent 45% of the US airline industry. (5.) Of course, part of the strategy is to also request government assistance. Significant bailout bailout The financial rescue of a faltering business or other organization. Government guarantees for loans made to Chrysler Corporation constituted a bailout. packages to stabilize the industry and protect the public good have been supported in principle by both the US and Canadian governments. Not surprisingly, the current profitable airlines are not supportive of such proposals. A it=s a classic example of helping a failed organization@ B Clive Beddoe Clive Beddoe (born 1947) is a founding shareholder and Chairman of the Board of Directors of WestJet Airlines. As a pilot himself, it was his interest in aircraft that helped form WestJet. Clive first started flying gliders at Epsom College in England during his teenage years. , CEO (1) (Chief Executive Officer) The highest individual in command of an organization. Typically the president of the company, the CEO reports to the Chairman of the Board. West Jet as quoted in the Financial Post, March 31st, 2003. (6.) This is not strictly a North American phenomenon. There are many examples in Europe including BA Regional and Lufthansa Express launched in 1992 and throughout the world such as Freedom Air in New Zealand New Zealand (zē`lənd), island country (2005 est. pop. 4,035,000), 104,454 sq mi (270,534 sq km), in the S Pacific Ocean, over 1,000 mi (1,600 km) SE of Australia. The capital is Wellington; the largest city and leading port is Auckland. and Japan Air Charter. The latter two, in contrast to the North American experience, have been relatively profitable and both remain in operation. (7.) This point was made emphatically em·phat·ic adj. 1. Expressed or performed with emphasis: responded with an emphatic "no." 2. Forceful and definite in expression or action. 3. in an April 17th, 2003 Globe and Mail editorial/opinion by Brian Campbell This article is about the NHL player. For role-playing game designer, see Brian Campbell (game designer). Brian Wesley Campbell (born on May 23, 1979, Strathroy, Ontario) is an ice hockey defenceman who plays for the Buffalo Sabres. , A drop the multiple branding. Creating airlines within airlines, such as Air Canada's Tango, will not be successful as a strategy for addressing low-fare competitors. The Air Canada brand is enormously powerful and should be leveraged everywhere. It will work for 70 to 80 per cent of the market between the two price extremes.@ (8.) As an example of these risks, consider Tango and Zip launched by Air Canada in 2001. It was clear after flying on both services that a real effort to incorporate the no-frill culture was evident in Zip (all that was missing was the vending machines vending machine, coin-operated, automatic device for selling goods. Many vending machines are capable of making change, and some of the more sophisticated ones accept paper money or credit cards. dispensing dispensing provision of drugs or medicines as set out properly on a lawful prescription. A prescription can only be filled, the drugs supplied, by a registered pharmacist, veterinarian, dentist or member of the medical profession. food) but not on Tango which still had many of the same services and style of Air Canada. (9.) In reference to the development of Tango and Zip, A I think Robert Milton (CEO of Air Canada) is a genius. He has pursued a brilliant and innovative strategy.@ B Stanley Hart, Globe and Mail, p. B4, April 5th, 2003. (10.) Getting this strategy right is important for three reasons beyond viability. First, bankruptcy restructuring should be conducted efficiently. Second, potential buyers or investors in the bankrupt or near bankrupt airlines, need to evaluate whether these spin offs are capable of realizing profits as stand alone entities. Finally, any public resources committed to helping these airlines must be allocated to receive the highest rate of public return. (11.) The total cost of does not equal [c.sub.h] or [c.sub.l] multiplied to the total output because the empty seats will cost less than occupied seats. For example, we need not serve food and beverage F&B is a common abbreviation in the United States and Commonwealth countries, including Hong Kong. F&B is typically the widely accepted abbreviation for "Food and Beverage," which is the sector/industry that specializes in the conceptualization, the making of, and delivery of foods. for the empty seats. (12.) In order to simplify the model, we use the average occupied seats in the market to construct the load factor [[lambda].sub.i]. Therefore, [[lambda].sub.i] is an exogenous variable Exogenous variable A variable whose value is determined outside the model in which it is used. Related: Endogenous variable in the model. (13.) See Appendix for the proof. (14.) The anecdotal evidence anecdotal evidence, n information obtained from personal accounts, examples, and observations. Usually not considered scientifically valid but may indicate areas for further investigation and research. presented earlier casts some doubt on this assumption. (15.) We have the condition of [y.sup.2] < [[beta].sub.h][[beta].sub.l], to ensure convexity of the utility function (16.) See Appendix for the proof. (17.) See Appendix for the proof. REFERENCES Holloway, Stephen. Straight and Level: Practical Airline Economics. Great Yarmouth
Coordinates: Great Yarmouth, often known to locals simply as Yarmouth, is an English coastal town in the county of Norfolk. : Galliard gal·liard n. 1. A spirited dance popular in France in the 16th and 17th centuries. 2. The triple-time music for this dance. adj. Archaic Spirited; lively; gay. (Printers) Ltd., 1997. Morrison, Steven, "Actual, Adjacent, and Potential Competition: Estimating the Full Effect of Southwest Airlines", Journal of Transport Economics and Policy, 35(2) (2001): 239-56. O'Connor, William, An Introduction to Airline Economics. 6th ed. Westport, CT: Praeger Publishers, 2001. Richards, Krista, "The Effect of Southwest Airlines on U.S. Airplane airplane, aeroplane, or aircraft, heavier-than-air vehicle, mechanically driven and fitted with fixed wings that support it in flight through the dynamic action of the air. Markets", Research in Transportation Economics. 4 (1996): 33-47. Steven Berry, Michael Carnall, and Pablo Spiller, @ Airline Hubs An airline hub is an airport that an airline uses as a transfer point to get passengers to their intended destination. It is part of a hub and spoke model, where travelers moving between airports not served by direct flights change planes en route to their destinations. : Costs, Markups and the Implications of Customer Heterogeneity het·er·o·ge·ne·i·ty n. The quality or state of being heterogeneous. heterogeneity the state of being heterogeneous. ", National Bureau of Economic Research The National Bureau of Economic Research (NBER) is a "private, nonprofit, nonpartisan research organization" dedicated to studying the science and empirics of economics, especially the American economy. Working Paper, 5561 (1996): 20. Tae Hoon hoon Austral & NZ slang Noun a loutish youth who drives irresponsibly Verb to drive irresponsibly Oum, A Key Aspects of Global Strategic Alliances and the Impacts on the Future of Air Canada and other Canadian Air Carriers", Research conducted for the Canada Transportation Act Review, (2001). Tae Hoon Oum, Jong-Hun Park, and Anming Zhang, Globalization globalization Process by which the experience of everyday life, marked by the diffusion of commodities and ideas, is becoming standardized around the world. Factors that have contributed to globalization include increasingly sophisticated communications and transportation and Strategic Alliances: The Case of the Airline Industry, Netherlands: Pergamon, 2000. Williams, George, The Airline Industry and the Impact of Deregulation Deregulation The reduction or elimination of government power in a particular industry, usually enacted to create more competition within the industry. Notes: Traditional areas that have been deregulated are the telephone and airline industries. , Cambridge: University Press, 1993. Dr. Ying Kong earned his Ph.D. at Carleton University Carleton University, at Ottawa, Ont., Canada; nonsectarian; coeducational; founded 1942 as Carleton College. It achieved university status in 1957. It has faculties of arts, social sciences, science, engineering, and graduate studies, as well as the Centre for in 2000. Currently he is an assistant professor at School of Business and Economics, University College of the Cariboo, Canada. Dr. Andre Le Dressay earned his Ph.D. at Simon Fraser University Simon Fraser University, main campus at Burnaby, British Columbia, Canada; provincially supported; coeducational; chartered 1963, opened 1965. The Harbour Centre campus in downtown Vancouver opened in 1989. . Currently he is the director of Fiscal Realities Associates, Canada. |
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