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