Case Study 1: The Competitive Environment of the US Domestic Airline Industry in 2010

Instructor’s Manual

Abstract

The competitive landscape of the U.S. domestic airlines dramatically changed when the
industry was deregulated in 1978. While airline traffic and revenues grew exponentially, aided
by unfettered market competition and resulting efficiency, airline profitability had mostly stayed
lackluster due to cost pressures, chronic oversupply of seats, and intense price-based rivalry to
fill seats. Thirty years into deregulation, the major airlines were still searching for the Holy Grail
that would defend them against industry threats and deliver sustained profitability. This case
describes the evolution of the U.S. domestic airline industry over the years, the cost pressures
and revenue uncertainties airlines faced at the beginning of 2010, and the strategic options to
effectively deal with these issues. The options ranged from shaping the industry structure to
achieving differentiation through service offerings. The exact choices they made would
determine their survival and long-term success.

Key Word Identifiers: US Airline Industry; Competitive Environment; Industry Analysis;

Deregulation.

Learning Objectives:

a. To understand the airline industry and how industry forces evolve, jockey for position, and
create competitive pressures.
b. To build skills in the analysis of the industry environment using Porter’s five-forces
framework.
c. To recognize the choices imposed by the alternative generic strategies in a turbulent industry.

Courses, levels, and topics for which this case is intended:

This case is intended for use in a course on Strategic Management or Competitive Strategy
offered to upper level undergraduate/ MBA students. It can be positioned for discussion after the
session on ‘industry/ environmental analysis.’

Relevant texts and research methodology:

The case uses concepts and frameworks that are covered in all standard texts on strategic
management. The case has been written from published sources and relevant citations/sources of
information are extensively provided in the case in the form of end notes.

Classroom Discussion (assignment) questions & answers:

1. What important trends have shaped this industry?

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This question is meant to get the students to take an overview of the industry before going into
the more specific industry analysis. This enables the students to get into issues usually ascribed
to the ‘general or societal environment’ in a strategy course. The three broad features that can be
discussed are:

a. Deregulation. This removed the externally imposed structure and operational limitations, and
led the airlines to compete which in turn drove down prices and made air travel more affordable.
A discussion of this feature can lead to a comparison of a regulated and a de-regulated
environment.

b. Economic growth. The period of good economic growth (combined with population growth)
led to rise in incomes, making air travel accessible to the masses, and impacted demand
conditions. Similarly, the slowdown of the economy in more recent times has had a reverse
impact.

c. Airlines’ strategy choices. The choice by the airlines to be a network or a low cost carrier,
driven by their respective missions and competencies also shaped how the industry evolved over
time. This choice led to how airlines behaved and reacted to environmental changes which in
turn shaped the industry.

2. Use Porter’s framework to analyze the US domestic airline industry and assess its profit
potential.

The objective of this question is to enable the student to understand the various dimensions of an
industry environment and to apply Porter’s framework. This enables a discussion of (a) the
potential for above normal profitability in this industry, (b) how firms can find a position in the
industry, and (c) how their actions can influence the balance of the forces. The first is dealt with
in this question, while (b) and (c) are covered in the other questions.

Rivalry: High. The growing trend of concentration in the industry through mergers and code-
sharing (i.e., alliances), and a slow growing market, point to intense rivalry. There is excess
capacity. Costs are rising and squeezing profit margins. Product differentiation is low so
switching costs are low.

Bargaining power of buyers: Medium. Although buyers are not concentrated, switching costs
are low. Buyers are price sensitive and have the means, through Expedia, Priceline and other
search engines, to look for discounts. Even corporate customers are budget conscious. Yet,
buyers cannot bargain; they are merely price takers.

Power of substitutes: Low. Substitutes to air travel are not close; buses, and auto travel provide a
rough ceiling for pricing short distance travel, the kind that regional carriers attempt to serve.
Rail travel availability is highly localized; so some challenge is provided in the northeast where
the rail corridor is efficient and demand is moderately price elastic. Buyer propensity to
substitute is generally low.

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Threat of entry: Medium-High. Sunk costs are relatively low; new airlines can lease aircraft, use
gates in smaller airports outside the metropolis, and enter the industry. Similarly, existing airlines
can easily move into routes and regions they are not already operating. Large scale operations are
not required. There is easy access to distribution; airlines can be listed in internet searches and
thereby reach customers. However, product differentiation and reputation/brand recognition
serve as a barrier. Intense rivalry suggests that retaliation is a possibility.

Bargaining power of suppliers: Medium. Aircraft supply industry is a duopoly and can exert
some pressure but aircraft leasing reduces that pressure. Unions are strong but are weakening due
to bankruptcies, and a surplus labor market.

Two additional forces are discussed in Strategy session # 6. One is the Relative Power of other
Stakeholders is medium in this industry, especially FAA, through enforcing safety requirements.
In addition, the case suggests that the government’s Bureau of Transportation Statistics, by
providing data on operational matters, allows for comparison across airlines and thereby keeps a
competitive pressure.

The other is the Power of Complementors. A complementor is an industry whose product works
with the product of the industry being analyzed and without which the industry’s product would
lose much of its value. Thus, it is not a competitive force, and the more complementors there are
and they are close, the greater the profit potential. This is relevant in the case of airlines, where
leisure travel/vacation resorts would be a complementor, whose force is low in times of
economic difficulty.

The forces above collectively suggest that the potential for above normal profitability in the
industry is low to medium. This industry environment puts additional pressure on airlines to
generate profits through careful strategy decisions.

3. Evaluate and compare Porter’s generic strategies as applicable in the airline industry.

Although firms are seen as being national or regional, the primary basis of competition in this
industry is increasingly city-pair portfolio rather than peer based. Firms advertise on broad
overarching themes but their pricing decisions are driven by city-pair combinations. It is also an
undifferentiated industry, with few segments based on users’ needs.

Porter’s generic strategies approach recommends that firms must choose low-cost leadership
versus differentiation in either the mass market or in niches. In the airline industry, after
deregulation, network carriers catered to the mass market with various efforts at differentiation –
competing on convenience of connections due to the hub-and-spoke system, monopoly routes in
some regions, comfort, safety, frequent-flier plans, and international alliances.

However, with ease of entry, smaller players entered the market with their point to point system
requiring the networks to compete. Prices fell also due to ease of access to information on the
part of the travelers. Thus, network carriers were also drawn to price competition yet locked into
a differentiation mode, effectively reducing margins.

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The smaller operators, who were on a focus/low-cost leadership strategy, operated with low
costs, cheap, no –frills flights, and grew organically to serve the mass market. Yet, with
continued entry, even they were challenged by newer operators, leading some of them into
attempts at differentiation. For example, the ‘Business Select’ fares in Southwest Airlines cost
more and provide preferential boarding, frequent flier miles, etc.

The networks and the smaller carriers have responded through mergers, leading to consolidation
in the industry. Southwest has acquired Air Tran, and moved into major airports, like Boston,
rather than stay with smaller away-from-the-metro airports. Another response of the firms has
been to try to be both networks and low cost regional carriers by starting separate divisions that
will be outside the networks cost structures.

To explain strategy choices, the instructor can also use the alternative formulation of strategy
choices provided by Mintzberg. In this approach, low-cost leadership is seen as differentiation
based on price, and firms try to combine different forms of differentiation, including
differentiation by image, differentiation by support, differentiation by quality and differentiation
by design. This approach seems particularly appropriate in the airlines industry where every
airline is highly sensitive to pricing, and tries to add other forms of differentiation to it.

Teaching Guidelines :

The airline travel industry is one the students are familiar with through personal experience and
thus students get easily engaged in a discussion of industry trends and how firms respond. The
instructor can begin the class with a warm-up question like, ‘what is your favorite airline and
why?’ This evokes a wide range of responses. The instructor can then guide the responses to ask
them to comment on underlying areas of differentiation based on their anecdotal experience.

The instructor can make a note of these student comments on one side of the board, by listing
them, such as, price, convenient connections, frequent-flier miles, no preference, etc. This list is
useful when discussing question 3.

Then, the instructor should direct the discussion away from personal experience with firms to the
environment by asking what general factors are affecting all firms equally. This will lead to a
discussion of Assignment Question 1, above. Then the discussion can be narrowed down to the
industry with Question 2. After completion of the industry analysis discussion, the instructor can
bring the class back to the firm level with Question 3, and use the list of student preferences
already noted on the board, and engage then in a discussion whether a differentiation strategy
based on select dimensions will be unique.

Before concluding, the instructor can ask the students to reflect on how they think differently
about the industry based on the discussion, as compared to their anecdotal flying experiences.
This establishes how certain criteria are taken for granted as minimum requirements and are not
a part of competition (such as safety) and how other features seem to dominate consumer choices
(such as prices).

Airline company cases:

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Instructors who wish to follow up on the discussion of the industry with that of a company
operating in this industry may consider one of the cases below.

Source: Textbooks
1. ‘Southwest Airlines,’ in Strategic Management in Action, Mary Coulter, Prentice Hall, NJ,
2005, pp. 321-328.
(Short case, gives a brief overview of the company and its operations. Can be combined
in same session with Industry Note.)
2. ‘American Airlines since Deregulation : A Thirty-Year Experience, 1978-2007,’ in
Strategic Management: An Integrated Approach, Charles W.L. Hill & Gareth R. Jones,
Houghton Mifflin, Boston, MA, 2008, pp. C234-C249.(Case provides a detailed
description of the company, a network carrier, its strategic moves, and company data.)
3. ‘JetBlue Airways: Challenges Ahead,’ in Strategic Management: Concepts and Cases,
Hitt, M., Ireland, D. & Hoskisson, Cengage/Southwestern, 2009, pp. 205 – 221.(Case
provides a detailed description of the company’s strategy and operations with data for
company analysis.)

Source: European Case Clearing House

1. ‘Problems at Delta Airlines,’ by Dutta, S. and Regain, S, Ref # 304-531-1

(Traces the problems faced by Delta Airlines, and the restructuring plan it instituted in
2004.)
2. ‘Delta Airlines (B): Turnaround strategy and challenges ahead,’ by Sonpal, A., M. Bhatt,
and R. Shuma, Ref # 308-018-1
(A description of the turnaround strategy followed between 2005 and 2007 and the
results.)
3. ‘Independence Air: transformation from regional carrier to a low cost carrier,’ by
Ganesan, S. & S. Kathawala, Ref: 304-619-1
(Describes the airline as a small regional carrier, and the steps initiated to become a low
cost carrier and the competitive challenges ahead.)
4. ‘Southwest Airlines 2007,’ by Box, T., Byus, K., Ref # JIACS 15-01-02
(Describes the winning strategy of the airlines as a low cost carrier, the changes that are
being made to that strategy and the implications of those changes.)

Harvard Business School Press

1. ‘Southwest Airlines: In a different world,’ by J. L. Heskett and W. Earl Sasser, Ref. #

910419-PDF-ENG, 2010.
(How the organization should deal with competition that has emulated more and more of
what the company does.)

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 2. ‘Gordon Bethune at Continental Airlines,’ by N. Nohria, A. J. Mayo and M. Benson, Ref.
# 406073-PDF-ENG. Revision dated Nov 2010.
(Describes the decline in performance by the airline, the CEO’s turnaround plan, and
results achieved).

References:

Brandenburgher, A. and Nalebuff, B. 1996. Co-opetition, New York: Doubleday.

Grant, R. M. 2010. Contemporary strategy analysis, MA: Blackwell.
Mintzberg, H. 1988. Generic strategies: Toward a comprehensive framework, Advances in
Strategic Management, 5:1-67.
Porter, M. E. 1979. How competitive forces shape strategy, Harvard Business Review, 57 (2):
137-145.