Shared Costs v. Cost Externalization in the Airline Industry

airlinedigIn my blog post yesterday, I referred to a concept called cost externalisation. I define it as the ability of a firm to get other organizations and actors within its business eco-system to cover its costs of doing business that would otherwise be a shared cost between it and its business partners. I think it is a concept that is relevant in a range of industries but is especially important to network industries such as transportation.

I am struck by the emergence of the LCC segment in the airline industry and while I share the consensus held by analysts that LCCs effectively undermine the traditional carriers by changing the business model from “hub and spoke” to “point-to-point”, I will use this blog post to emphasize another feature of the LCCs i.e. they get their external stakeholders to bear a greater share gif the operational costs of an airline than their traditional competitors. In other words, they are able to push operating costs and system maintenance onto their eco-system partners (airports, ground handling, local governments, taxpayers and customers).

Take the most obvious example of this. Ryanair. The company pressurises local governments to use EU structural funds to build an airline terminal for their planes to land. It refuses to pay for jetways to bring planes to the terminal. It refuses to pay for buses to ferry passengers from the plane to the terminal building. All three tactics are an attempt to pass on the fixed cost of infrastructure onto other stakeholders. An airport needs terminal buildings; it needs to have jetways and buses for its ground services to be adequate. So effectively, Ryanair is ‘free riding’ on the investments of other actors.

While Ryanair is the most extreme case of cost externalisation, other LCCs do the same. Discouraging the use of airport check-in by charging for customers if they wish to check in at the terminal. By charging for check-in bags, they reduce the number of bags handled by the airport. The problem is that an airport needs to have these facilities in any case – but the LCCs underutilize these facilities leading to a rise in the average cost of usage for those airlines that do allow for free check-in at the terminal and for baggage allowances.

There are also indirect costs that are created by LCCs. At a mid-sized airport in Central Europe, the loss of traditional carriers and their replacement with LCCs who refuse to share the costs of airport terminal activities and assets led to a decline in revenues for the airport. The airport responded by increasing the cost of “priority” security lanes to the traditional airlines. Naturally, the traditional airlines refused to pay the extra. What did the airport do? It requires customers (elite frequent fliers) who would normally get to a priority lane to pay five euros to use it.

I’m no defender of the traditional airlines – in future blog posts I will enlarge on my criticisms but the LCC revolution is a double-edged sword. Yes, they have created travel opportunities that didn’t exist previously but they have created negative (and largely) unintended consequences for the industry.

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