Why Do Investors Remain Invested in Airline Business

In an earlier paper we had discussed why airlines do not make a decent return on their investment. In that paper with the help of core theory it was explained how the inherent unstable nature of airline market made it impossible for airlines to post a healthy profit consistently over a period of time. The paper, however, did not answer the next logical question that if airline was such a profit challenged business then why the investors did not get out of it at the earliest. We attempt to do this in the present paper.

Economic theory is based on the assumption that human behaviour is rational and therefore any economic decision would be based on cause and effect rationality. In reality, however, humans do not always behave rationally while making their decision. Take the case of an investors who business interest in several industry including airline. Ever since he has invested in airlines he has found that the return from airline business has abysmal compared to his other businesses. As rational investor he aught to move his investment out airlines and put it one his other existing business to maximise his gains, but he does not do so. Traditional economics would label such behaviour as irrational.

Let us take another example, a non aviation one. A year ago during IPL 1 the match between Delhi Dare Devils and Kolkata Knight Riders was abandoned due to rain without a ball being bowled. Cricket matches often get abandoned due to rain therefore was nothing unusual in the present case. In fact it was a day of inclement weather, it had been raining incessantly since morning and well before it was time for the match to start it was fair knowledge that no play would be possible as the playground, which had no drainage system worth the name was sure to be water logged. Yet, 25000 spectators turned up at the ground several hours before the scheduled start and stayed on till the scheduled time for the match to end. Traditional theory would call the behaviour of the spectators as irrational. In a rational world the spectator who already knew that no play would be possible would have been better off in spending the time in some other pursuit that had the possibility of bringing positive return rather than drenching in the rain under the open sky of the uncovered stadium. But such was the behaviour of not one or two odd spectators, 25000 people behaved in this irrational manner. Clearly there must have been some logic behind this apparent illogical behaviour. To understand such behaviour we need to go beyond traditional economics; we need to look into the psychology of sunk cost.

Psychology of Sunk Cost

Psycho economics[1], which is also known as behavioural economics, is the youngest branch of economics. It came into prominence in the 1990s although work had been going on much earlier. It received the stamp of recognition when one of the pioneers Daniel Khaneman was awarded the Nobel Prize in Economics in 2002 "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".[2] Philosophy of sunk cost is one among the many new concepts that this branch of economics has developed to explain many issues that traditional theory has not been able to explain adequately. However, before describing the philosophy we need to know what is meant by sunk cost and it relevance in decision making.

What is Sunk Cost

Sunk cost is the cost already incurred which cannot be recovered regardless of future events.

In economics and business decision-making, sunk costs are costs that cannot be recovered once they have been incurred. Sunk costs are sometimes contrasted with variable costs, which are the costs that will change due to the proposed course of action, and prospective costs which are costs that will be incurred if an action is taken.

In traditional microeconomic theory, only variable costs are relevant to a decision. Traditional economics proposes that an economic actor does not let sunk costs influence one's decisions, because doing so would not be rationally assessing a decision exclusively on its own merits. The decision-maker may make rational decisions according to their own incentives; these incentives may dictate different decisions than would be dictated by efficiency or profitability, and this is considered an incentive problem and distinct from a sunk cost problem.

Behavioral economics proposes the opposite: that sunk costs greatly affect actors' decisions, because humans are inherently loss aversive and thus normally act irrationally when making economic decisions.

For example, when we have put effort into something, we are often reluctant to pull out because of the loss that we will make, even if continued refusal to jump ship will lead to even more loss. The potential dissonance of accepting that we made a mistake acts to keep us in blind hope. It is common for people who have invested in company shares to hold on tight to them as the market slumps, in the desperate hope that the shares will rise in price again.

The Sunk Cost Effect

Traditional economics predicts that people will consider the present and future costs and benefits when determining a course of action. Past costs should not be a factor. Contrary to these predictions, people routinely consider historic, nonrecoverable costs when mak­ing decisions about the future. This behaviour is called the sunk-cost effect.4 The sunk-cost effect is an escalation of commitment and has been defined as the "greater tendency to continue an endeavour once an investment in money, time or effect has been made."

In their seminal paper[3] Hal R. Arkes and Catherine Blumer explain the concept of sunk cost philosophy with the example of a contest winner of a radio programme who has been rewarded with a ticket to a football game. Since he does not want to go to the game alone he persuades a friend to purchase a ticket. When they are about to leave for the game a terrible blizzard begins and the contest winner does not want to go. His friend insists on going to the match since he did not, ‘want to waste the money that he has already paid for the ticket.’ According to traditional theory the friend is not behaving rationally; he should go to the game only if the pleasure of watching the game is more than the agony of sitting in blinding snowstorm. After all the price of the ticket has already been paid for by the friend and his decision to go or not to go will not bring the money back to him, that money is gone; it is a sunk cost. Past investments that are irrecoverable should not be allowed to influence present decision. But, as 25000 spectators at the cricket ground on a rainy night demonstrated, people do.[4]

Something similar happens in the airline business. Individual and companies invest in airlines for a variety of reasons; since this paper is about why people remain invested and not why they invest in airline business we will not discuss the issue in too much detail. In terms of behavioural economics the broad reasons for investing in airlines can be summed as

(a) It will not happen to me: This is a syndrome that we are familiar with. Individuals routinely assume that ordinary misfortunes like road accidents, a loss in business, attack of an epidemic and so on will not happen to them. The confidence comes from two sources, first, about which one is generally unaware, is the statistical probability of such events occurring are extremely low and therefore for most part misfortunes do not strike a person too often. The second, about which the individual is well aware off, is an inherent belief in themselves that they are smarter than the rest. So, billionaires, otherwise familiar with the apocryphal story about the shortest way of becoming a millionaire is to start an airline does precisely that viz. invests in airline business. They carry with them the self-belief that they would be able to run the business much better than others ahead of them have been able to.

(b) Prior experience: It is generally true that those investing in airlines have some prior experience, say, as a pilot, a tour operator or travel agent, experience of running airlines etc. This provides them a confidence that they can do better than others.

(c) Glamour: Traditionally flying has enjoyed a very high glamour quotient primarily because it is a task that human beings can never perform. Another factor that earns respect for those manoeuvring a flying machine is the high risk factor. Mankind has always accorded great value to those who dare to put their life at risk to achieve the improbable. Airline business basks in the reflected glory of this glamour. In the pecking order of the Chamber of Commerce the owner of an airline enjoys a higher ranking than the owner of a hosiery firm though the business of the later may be earning higher profit.

After a point of time investors having made their investment confront situations that we have discussed in the earlier part of the paper. After facing several years of low profitability or outright losses when it seems that it would be best to get out of the business they walk into the fallacy of sunk cost. Having spent so much money and time on an investment it appears to the investors that all their efforts would go to waste if they wind up the airline. Their dilemma can be explained with the aid of the following diagram that contains prospect theory’s^[5] value function. The function defines the relationship between objectively defined gains and losses and subjectively

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[1] Behavioural economics and behavioural finance are closely related fields that have evolved to be a separate branch of economic and financial analysis which applies scientific research on human and social, cognitive and emotional factors to better understand economic decisions by consumers, borrowers, investors, and how they affect market prices, returns and the allocation of resources.

The field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioural models typically integrate insights from psychology with neo-classical economic theory. Behavioural Finance has become the theoretical basis for technical analysis.

Behavioural analysts are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases towards promoting self-interest.

[2] "Nobel Laureates 2002"; Nobelprize.org

[3] The Psychology of Sunk Cost, Hal R. Arkes and Catherine Blumer; Organisational Behaviour and Human Decision Process, 1985, 35, 124-140, reproduced in Judgement and Decision Making, Terry Connolly, Hal R. Arkes, Kenneth R. Hammond, p 97-113, accessed at http://books.google.com/books?id=Uo34qW1wi_YC&printsec=frontcover&source=gbs_navlinks_s. Various dates.

[4] Nearly six months after that IPL match I was talking to a group of friend of my daughter when the discussion turned to that match and I commented that how foolish it was for all those people to turn up for the match when the whole of Delhi knew that no match would be possible. At this one of her friend remarked that he was one among the ‘foolish’ people. Whereupon I asked why did he have to go, his reply was, “But Uncle, I had saved my pocket money to buy the ticket.”

[5] Daniel Kahneman, professor at Princeton University’s Department of Psychology, and Amos Tversky developed prospect theory in 1979 as a psychologically realistic alternative to expected utility theory. It allows one to describe how people make choices in situations where they have to decide between alternatives that involve risk, e.g. in financial decisions. Starting from empirical evidence, the theory describes how individuals evaluate potential losses and gains.

Prospect theory contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses. Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other in possible losses, people would choose the former - even when they achieve the same economic end result. According to prospect theory, losses have more emotional impact than an equivalent amount of gains.

Why Do Airlines Not Make Money

Seemingly since the beginning of aviation history there has been discussion and speculation on the remarkable inability of the industry to generate profits. This is even more so the case now, when a number of the world's airlines are bankrupt. The failure of aviation, or at least of airlines, to produce a reasonable rate of return on investments has been a fact pondered by many at great length but never satisfactorily understood. Somehow the industry seems to violate the most basic principles of economics and business.

Complaints about the lack of profitability in the airline industry surface during periodic downturns, but the problem has been there since the industry started. Statistics shows a long history of losses for airline industry and yet at the same a phenomenal growth in traffic. The airline industry is a complex one and the apparently contradictory statistics only underscores this fact.

Airlines Profits in Perspective

Profits by definition are surplus of income over expenditure; i.e.; the difference between revenue and expenditure. The table at Annexure 1 shows operating profits for the airlines industry from 1947 to 2007 a period long enough to qualify as the ‘long run’ of the Marshallian economics. The table throws up some interesting results. The industry made operating profits in 45 of the 61 years. From 1962 to 1979 it had a long period of uninterrupted operating profit. Though operating profit during this period remained positive they nevertheless, exhibit severe slowdowns. Besides, the magnitude of profit has been modest for most of the years. The period of losses is more frequent from 1980 onwards; since then for every three consecutive years of losses there are seven or eight consecutive years of profit. If we look more closely at the table then it would be seen that the long period of uninterrupted operating profits coincided with the period of regulation of the industry in force almost in all the countries of the world during the period. The USA, which at that time accounted for more than 50% of world traffic

deregulated its airline industry in 1978 and since then the trend in operating profit, has changed altogether. Furthermore, the period of losses coincide with periods of recession. Another thing that is not as obvious in the table but comes out quite clearly in the graph is the volatile and cyclic nature of the industry; post 1978 in particular.

The picture seen in operating profit as a percent of revenues shows disturbing trend. Since 1947 the airlines have managed to clock a return of more than 5% only on 13 occasions and have not been able to achieve double digit return even once. It may surprise many at our choice of 5% as the benchmark, after all while evaluating a project we generally use discount factor of 12%, that is an investment is considered worthwhile unless it brings in a return of

12%. To lessen the surprise let us point out that the average returns that the airlines have realized in these 61 years is 2.30%; our benchmark that is double the average is therefore reasonable. The remarkable thing is that the average does not change much with change in policy; during the regulation period it was 2.25% after deregulation it improved marginally to 2.34%. Also, to be noted here is that we are talking here of gross margin that does not include the cost of borrowings. The highest return achieved during the regulation period was 9.5% (1965, 1966) and 6.1% (1988) after deregulation.

We now turn our attention to net profit and net margin. Here the picture is even more dismal. In 31 out of 61 years the industry made losses. Even the profit making years are not great ones their magnitude is usually fairly low. In fact, if we add up all the losses and set it off against all the profits then the net figure comes to $17,000 million or 278 million a year. Hence the remark made in the early 1990s by former CEO of American Airlines Robert Crandall that the colossal losses made by the industry negated all the profit made since 1903.

As for net profit as percent of revenue, the best that the industry could achieve was 6.1% in 1966 apart from that only on one occasion margin has been more than 5%. The 61 year average is a miserable 0.12%.

The analysis above shows that the airlines industry has not been a profitable one. And this appears to be so almost since the beginning of the industry. The evidence points towards a very depressing state of financial health of the airlines.

Where Does the Problem Lie

The above analysis raises the issue of what causes this intriguing behaviour of the airline industry. The answer lies in the nature of the industry. One of the widely accepted theories of economics holds that unfettered competition does not work very well in certain industries commonly known as natural monopoly. Natural monopolies often result in infrastructure and capital-intensive industry; examples are water supply, electricity, public transport and the like. An utility is often created because it is the only way to ensure crucial infrastructure investments are made; if multiple firms operate they may not be able to afford to upgrade their systems overtime. Economists have for long argued that natural monopolies whose activities fall within the ambit of public utilities should be provided protection by allowing them to function as monopolies but within a regulated market.

Indeed many of the elements of the infrastructure of the airline industry are natural monopolies. For example, it would not be more efficient to have multiple air-traffic control firms competing against one another. By disallowing construction of a second airport within a radius of 150 kilometres of an existing airport, airports in India are allowed to function as natural monopoly in a limited sense. But airlines themselves are never thought of as a utility and this in our opinion is a myopic view. There are a number of reasons why airlines should be treated as a public utility. Civil aviation like other transport industries generates important external benefits. The returns from air transport are not restricted to the industry itself, but encompass wider effects on the economy at large. Airlines are often used to serve important national, social and economic objectives of the government. The national airline of a country is seen purely as a symbol pf prestige; or as a means of encouraging trade and investment; or as a way of stimulating the development of tourism; or as an important source of foreign exchange; or as a vehicle for supporting the development of a domestic aero space industry; or as a way of guaranteeing the availability of standby fleet with fully trained personnel in case of emergency. The importance that governments give to some of these nationalist and mercantile objectives may be declining over the years but they are still highly significant.

The consequence of refusal to accept airline industry, as a public utility infrastructure while granting some of its constituents the benefits of monopoly has been that on the supply side airlines have to pay monopoly price for the services consumed and on the demand side it has to live by the market determined price. Living by the market price would not have been such a bad thing had the market itself been a rational place like any other competitive marketplace. Sadly this is not the case. As the Fortune magazine once observed, ‘for all its ineffable allure, though, the airline industry is like the banana business.’[1] Airplane seats are a commodity - despite heroic attempts at product differentiation, passengers think one airline's seat is pretty much like another's - and when a plane takes off with empty seats, the commodity is spoiled. It is better by far, from an airline's point of view, to lure passengers from competitors at deep discounts than not to sell seats at all. Airlines sell a perishable product, and it's like the last banana in the store; one can either get a penny for it or one can get nothing for it, so airlines sell it for a penny.

Combine these characteristics and what do you get? Vicious, endless fare wars that in most businesses would quickly thin out the players but that in airlines have helped produce a record of chaos and wreckage rare in any industry and almost incredible in one so important to the nation's and world's economy.

The commonly accepted view so far has been that pricing madness and mammoth losses have resulted from bad policy, bad management, and bad luck - problems that have masked progress toward an eventual, conventional settling down of the industry. However, a small but growing group of industry experts believe the conventional explanation of chronic airline turmoil is wrong. The new view says the trouble isn't bad luck; it's the very nature of the business. Loosely associated with Lester Telser,[2] a prominent economist at the University of Chicago, they argue that the airline industry is an economic machine programmed for self-destruction or something close to it.

The argument, at its simplest, goes like this: No matter how many employees are laid off or labour concessions gained, the fixed costs of aviation - planes, fuel, facilities - are destined to remain relatively high. The marginal costs of adding passengers on a partly filled flight are negligible. So the airlines need not charge much to make that perishable seat worth selling. The result is now a days’ roughly 90% of airline passengers buy their tickets at a discount, paying on average just a third of the full fare. Thus in an industry with high fixed costs and low marginal costs, competition produces a market that never settles down. Economists say such a market has an "empty core."[3]

The essence of neo classical demand theory is built on the premise that through a process of bidding and counter bidding between the seller and the buyer the parties arrive at a price at which neither the seller makes an excess profit nor the buyer makes an excess gain. With both the buyer and the seller satisfied with the transaction the market will attain a state of equilibrium such a market guarantees that no one in the market is worse off than before and at least one person is better off than before. This is known as Pareto the position where social welfare is at the optimum. The attainment of equilibrium is made possible due to the presence of large number of buyers and sellers.

Without challenging the central proposition of the neo classical demand theory the core theory makes the additional proposition that it is not always necessary for a competitive market to attain an equilibrium price. According to core theory a market can perpetually remain in disequilibria if certain conditions are fulfilled. Telser describes these conditions using the word ‘Chaos”. According to Telser, there is chaos when "price cutting is extreme, most firms in the industry are losing money, and yet it is plain that buyers want the product and are willing to pay higher prices than those currently prevailing."[4]

If we look at the airline industry we find it meets all the requirements of a competitive market; it has large number of buyers and sellers, there is no restriction to firm’s entry or exit nor is there any restraint on price. Theoretically therefore, the industry should at some stage reach the equilibrium state yet experience shows that it never happens. The relentless pressure to sell seats and at least recover the short run marginal cost makes airlines to resort to extreme price cutting and offering seats at ridiculous fares (e.g. for Rs. 99) even when the passengers are willing to pay much higher fare, thus fulfilling Telser’’s criteria of an industry with an empty core. The chaos so created never settles down, airlines are known to sell seats even when the aircraft is on the verge of takeoff! In the process the gap between the marginal and average cost gets so large that airlines generally are not able to recover their long run average cost and thus fail to make any money.

The above discussions highlight that the unrestricted ability to contract and re-contract among buyers and sellers within an industry allows fares to be bid down to non-profitable levels. To the extent that one or more airlines have excess operating capacity, attracting additional customers by lowering price (provided such price is above marginal cost) creates additional operating profit (or reduces operating loss) for the individual airline. The important feature is the effect of excess capacity, not necessarily the cause of that excess capacity.

Another condition that must be fulfilled for an empty core to exist is the presence of avoidable cost[5]. The presence of avoidable cost lends another peculiarity to the airline industry and contributes towards the industry’s poor profitability. Once an airline has incurred the sunk cost[6] and created operating capacity the actual operation of the aircraft requires the incurrence of large avoidable cost irrespective of level of utilisation. This results in what economists call a U shaped cost curve. Once however, an airline has committed to particular fleet and schedule it cannot change output without incurring substantial adjustment cost. The airlines get caught in a no win situation – not flying saves avoidable cost but incurs adjustment cost; flying on the other hand results in higher expenditure but lower revenue.

On the supply side the cost conditions of an airline are such that cost per mile flown falls as the number of miles flown increases. However, technological constraints imply that, only reducing aircraft capacity can increase distance flown. Further, cost per passenger falls as the number of seats filled on an aircraft rises up to full capacity. Taken together this implies that marginal cost starts increasing well before the payload at maximum range is reached. The airline industry has generally operated with excess productive capacity. Further airlines tend to cut prices to short-run marginal cost in the face of excess capacity that occur due to variations in demand, which pushes prices below that required to operate an efficient set of schedules.

On the demand side an airline faces seasonal and cyclical demand. Thus, matching capacity to demand in the airline industry moves it toward an empty core, or an unstable equilibrium.

Policy Implications

The study was undertaken with the objective to examine and explain why airlines do not make money. Examination of historical data on both gross and net profit established the fact that over the long run airline industry does not indeed make any money, it at best breaks even. The reasons for this intriguing state of the industry can be found in the nature or peculiarities of the industry. Since individual airlines deal with a commodity that is perishable they are always under pressure to sell their stock of available seats. Presence of excess capacity in the industry compounds the situation further. This leads to fierce price war among airlines that results in seats being sold at a price much below what the market can bear. What is worse, in their effort to maximise their short run revenue the airlines end up with fares that are below the long run average cost. Poor financial return then puts even more pressure on the airlines to maximise capacity utilisation that once again starts the cycle of under pricing and the resultant consequences.

Analysing the behaviour of the airline industry and noting its unique features economists like Telser, Button, Nyshadham, Raghavan, Pirrong, Sjostrom and others have found an explanation in the core theory. Their theory states that a competitive market through a process of coalition among its members arrives at a price that establishes equilibrium in the market, which lends stability to the market; this stability forms the core of the market. However, they also found that there are certain industries that due to their special characteristics perpetually remain unstable, i.e.; at no point the industry attains an equilibrium price. Typically firms in such industry often have to sell their products at below cost so as to survive at least in the short run; a strategy that far from solving the problem further accentuates as well as perpetuates the problem.

The issues that emerges from the above is that though the airline industry is a competitive market it does not produce an equilibrium price and therefore is inefficient and incapable of optimising social welfare. Economists have for long advocated in favour of intervention by the government where market based solution is not efficient. Thus the policy implications are the following:

1. Should the airline industry in India be treated as natural monopoly and allowed the concomitant benefits?

2. Should there be direct intervention by the government to neutralise the instability, which is inherent in the nature of the airline industry?

3. Should airlines be allowed ‘fare agreement’ in the line of Conferences in the shipping industry?

References

Antoniou, Andreas, The Status of the Core in the Airline Industry: The Case of the European Market. Managerial and Decision Economics. 19(1), 1998, 43-54

Button, Kenneth, Liberalising European Aviation: Is there an Empty Core Problem? Journal of Air Transport Economics, 30(3), 1996, 275-291.

Nyshadham, Easwar A., and Raghavan, Sunder, The Failure of Electronic Markets in the Air Cargo Industry: A Core Theory Explanation. Electronic Markets, 11(4), 2001, 246-249

Pirrong, Stephen C., An Application of Core Theory to the Analysis of Ocean Shipping Markets. Journal of Law & Economics XXXV, 1992, 89-131

Sjostrom, William, Collusion in Ocean Shipping: A test of Monopoly and Empty Core Models. Journal of Political Economy, 97(5), 1989, 1160-1179

Telser, Lester G., The Usefulness of Core Theory in Economics. Journal of Economic Perspectives, 8(2), 1994, 151-164

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[1] Why Air Travel Does’nt Work, Fortune, April 3, 1995

[2] The Usefulness of Core Theory in Economics, Lester G. Telser; Journal of Economic Perspectives, 8(2), 1994. (http://docs.google.com/fileview?id=F.c37ca0ec-e410-49bb-9afe-8b8d9696768c&hl=en; accessed on 22.02.09)

[3] See Annexure 5 for a detailed exposition

[4] Telser; opcit

[5] Avoidable cost is defined as the cost that a firm has the option to avoid. For example, in the airline industry an airline has the option not to fly an aircraft and avoid fuel and other costs associated with flying. Also see Annexure 5.

[6] Sunk cost is expenditure that cannot be recovered. For example, the cost of purchase of an aircraft. Also see Annexure 5