Airline cost changes: To what extent are they passed through to the passenger?

https://doi.org/10.1016/j.jairtraman.2015.12.013Get rights and content

Highlights

  • The pass-through of cost increases depends on the type of cost increase and market structure.

  • Aviation markets are best described as differentiated oligopolies.

  • Firm-specific cost changes are passed through by less than half.

  • Sector-wide cost changes are passed through by more than half.

  • In specific circumstances, such as limited airport capacity, pass-through may be different.

Abstract

Since the start of the Millennium airline costs have been highly volatile, mainly due to large fluctuations in jet fuel prices. An important question for airlines and regulators is whether airlines are able to pass through cost changes to their prices. Little empirical evidence on the pass-through of costs exists. In this paper, we investigate which pass-through rates are most likely. According to economic theory, the pass-through of costs depends strongly on the type of cost increase (firm-specific or sector-wide) and market conditions (monopoly, oligopoly, perfect competition). In monopolistic markets, the shape of the demand curve also matters (linear, constant elasticity, log, power function). A pass-through rate of 100% is often assumed based on the reasoning that the aviation sector is highly competitive. We analyse market concentration in all airline markets in the world, and generally find a high level of concentration. Additionally, different airlines offer different products based on a variety of factors, including service, flight frequency, legroom, bags allowed on board, flight time and transfer time. Therefore, most aviation markets can be characterised as differentiated oligopolies. As airlines choose their quantities first (flight schedules) and adapt their prices to demand (yield management), we consider the Cournot model the best choice. In such markets, firmspecific cost changes will be passed through by a rate of less than half while sector-wide cost changes are passed through by a rate of more than half. In specific situations, the pass-through rate may be different. Examples are limited airport capacity (congestion), cross-subsidization, and the extent to which there is a level playing field.

Introduction

Airline costs may change for various reasons, such as alternations in input prices, labour conditions, taxation regimes and airport charges. The main cost source for airlines are fuel costs. In 2014 fuel costs represented around 20–50% of total costs, depending on the type of airline (see Table 1). The price of jet fuel has shown great fluctuations over the past 15 years. At the start of the millennium, one barrel of jet fuel cost $33 (see Fig. 1). By the summer of 2008 prices had increased five-fold to $163. Then the financial crisis hit causing a sharp price decline; by the end of 2008 a barrel of jet fuel cost $58. The subsequent economic recovery and the improving political situation in the Middle East led to a strong recovery, with jet fuel prices averaging at around $120 per barrel between 2011 and 2014. Since 2014, prices have decreased sharply due to overcapacity in the market.

Volatility in cost levels implies risk to the airline operation, especially when higher costs cannot be passed through to the passenger. The pass-through rate is not only relevant for airlines, but also for airports, policy makers and researchers. The impacts of a policy measure, such as a charge or tax increase, depend to what extent the cost increase is passed through to the passenger. When cost increases can be passed through for 100%, they are fully borne by an airline's passengers. However, the airline itself may also be affected. A full pass-through leads to higher fares, which will – depending on the elasticity of demand – result in lower sales. Furthermore, when an airline's competitors do not raise their fares, the airline's market share, sales and profits fall. If, on the other hand, the cost increase is not passed through to the passenger, the volume of demand remains the same, but profits of the airline will be negatively affected.

There is limited empirical evidence available with respect to the pass-through of cost changes in aviation. As a result, most studies that assess the impact of cost changes assume a certain pass-through rate. These rates range between 0% and 100%, primarily due to differing assumptions regarding market structure. Studies that assume a full pass-through usually do so based on the assumption that aviation markets are perfectly competitive, whereas studies that assume a lower pass-through rate view aviation markets as oligopolies.

In this paper, we investigate which pass-through rates are most likely to occur in practice. The next section provides a brief overview of the literature with respect to the pass-through of cost changes in aviation. Section 3 describes current economic theory regarding the pass-through of cost changes. It shall become clear that the pass-through rate indeed depends on the type of market structure. In Section 4, we shall therefore analyse the prevailing market structures in the aviation industry by measuring market concentration in all worldwide aviation markets. This allows us to determine which pass-through rates are most likely to occur in practice. Section 5 describes special situations in which the pass-through rates might be different. Section 6 concludes.

Section snippets

Literature

There is extensive literature in a number of fields related to the pass-through of costs. Most of the existing empirical evidence addresses the pass-through of consumer fuel costs (e.g., Burdette and Zyren, 2002, Burdette and Zyren, 2003, Meyler, 2009), emission costs (Honkatukia et al., 2006, Sijm et al., 2006, Alexeeva-Talebi, 2010a, Alexeeva-Talebi, 2010b), exchange rates (Campa and Goldberg, 2005, Campa and González-Mínguez, 2006, Campa et al., 2005, Gust et al., 2010, Leibtag et al., 2007,

Pass-through in economic theory

According to economic theory, the pass-through rate of profit maximising firms depends on market structure (perfect competition, oligopoly or monopoly) and the type of cost change (firm-specific or sector-wide). Table 2 lists the pass-through rates for various combinations of these factors found in the literature. A similar overview is given by Jørgensen and Santos (2011). However, they focus on firms having other goals besides profit maximisation. The overview in this section is limited to

Prevailing market structures in the aviation industry

To determine which pass-through rates are most likely to occur in practice, we must determine what market structures are most prevalent in the industry. In this section, we estimate the concentration level for each aviation market in the world. Concentration levels can be measured in various ways. The most straightforward method is by counting the number of competitors in a market. Intuitively, a higher number of competitors is associated with increased competition. However, this indicator does

Slots and scarcity rents

In airports for which demand exceeds slot capacity, the right to use slots may create additional monopoly or oligopoly rents. At congested airports, prices are not determined by marginal costs of production. Rather, prices will generally be sustained at a level that clears demand at a given supply rate (Oxera, 2003). In these cases, the airline will set the price above the marginal costs, creating a rent. In turn, the airport may try to appropriate part of this rent for itself by increasing its

Conclusions

According to economic theory, the pass-through of airline cost changes strongly depends on the type of cost change (firm-specific or sector-wide) and market conditions. In monopolistic markets, most or all of a cost change may be passed through, depending on the shape of the relationship between prices and demand. In more competitive situations, sector-wide cost changes may also be passed through to a large extent, although not necessarily fully. In these competitive situations, cost changes

Acknowledgements

An earlier version of this paper was presented at the Airneth seminar ‘The pass-through of cost-increases in aviation.’ The authors would like to thank the participants of the seminar for their useful suggestions. We also extend our thanks to two anonymous reviewers for their valuable comments.

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