Research in Transportation Economics 24 (2008) 1–4

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Research in Transportation Economics

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The economics of low-cost airlines: Introduction

Kenneth Button a, *, Stephen Ison b
a
George Mason University, Fairfax, Virginia, USA
b
Loughborough University, Leicestershire, UK

a r t i c l e i n f o
In some cases, however, there are airlines that make money and
Article history: this attracts finance to the industry through a sort of ‘Las Vegas’
Available online 14 April 2009 effect – investors hope to pick the winners. In recent years, carriers
such as Southwest Airlines in the Unites States and Ryanair in
Europe have proved to be good investments. They have financially
outperformed not only most other carriers, but also the financial
markets in general. These are seen as low-cost carriers that have
Analyzing the economics of the airline industry makes one
adopted a different path to the more traditional, often termed
understand why Thomas Carlyle called economics ‘‘the dismal
‘legacy’ carriers that dominated airline markets until, and for
science’’. It is not an industry that, as a whole has performed well in
a period after, the airlines industry began to be deregulated in the
terms of its financial achievements over the past three decades or
late 1970s and early 1980s.
so. Apparently, according to Philip Delves Broughton recent
As Michael Porter in his classic study of Comparative Advantage
accounts of teaching at the Harvard Business School (Ahead of the
pointed out, in a competitive market there are two broad ways to
Curve: Two Years at Harvard Business School), it has been held up as
make abnormal returns. First, you may try to differentiate your
an example of how not to run business in the 21st Century and, in
product and seek to gain a degree of monopoly power. In the
hard numerical terms, its operating margins have been close to zero
airlines context, this involved the traditional airlines that had
since the late 1970s; the comparable figure for U.S. industry as
grown under regulatory protection and, in many countries, were
a whole over this period was, for example, being in the region of 6%.
still state owned trying to exploit economies of scope and scale, as
However, as Warren Buffett said in 2002, ‘‘[The airline business] has
well as market presence, by developing extensive hub-and-spoke
eaten up capital over the past century like almost no other business
networks around one or two major airports that acted as consoli-
because people seem to keep coming back to it and putting fresh
dation and dispersal points for traffic akin to a post office sorting
money in.’’
depot. They added to their strength by seeking to control infor-
There may be a number of reasons why the airline industry
mation flows through computer reservation systems (CRSs); the
continues to survive in this rather ‘dismal’ world. Certainly, some
first of which, Sabre, was developed by American Airlines in the
markets are less gloomy because of growth and protection of
United States. This allowed the airline owners of systems, through
markets by what amounts to government fiat. There are also other
travel agents, to favor their own flights when flight options were
elements in the larger air transportation supply chain – the air
displayed to potential customers; an effect reinforced through the
frame and aero-engine manufacturers, airports, and global distri-
halo effects associated with bonuses offered to agents who ach-
bution systems, for example – that have earned a respectable
ieved high bookings for the CRS owner airline. The CRS systems,
economic return and support the airlines because of their role as
and the flow of information that it provided the airline, also
the cash register at the end of the chain. Airlines are where the
allowed them to adjust the fares being offered customers to reflect
ultimate prices that cover the up-stream suppliers costs and profits
their willingness-to-pay and thus price discriminate between those
are recovered. In the United States, Chapter 11 bankruptcy laws
who are more or less fare sensitive. Added to this, the traditional
allow airlines to write off many of their costs but largely to remain
carriers formed alliances both with other major airlines but also
intact and to operate without the weight of high fixed costs. In
with feeder carriers. This created seamless services for customers
some parts of the world, direct subsidies are still used to support
and more integrated schedules of service that minimized the time
airlines, and in other such as the United States there are implicit
required to interchange at a hub airport.
subsidies with national carriers being given preferred treatment in
The alternative highlighted by Porter was for a business to
the carriage of government personal or for their availability at times
compete on the basis of cost; to develop and maintain a market
of potential military need.
share by offering its products at lower prices than its competitors.
This has been the approach of the low-cost carriers; sometimes
* Corresponding author. called ‘no-frill’ carriers in Europe because they offer only basic
E-mail address: kbutton@gmu.edu (K. Button). services to their customers. They have sought to establish, and

0739-8859/$ – see front matter Ó 2009 Elsevier Ltd. All rights reserved.
doi:10.1016/j.retrec.2009.01.008
2 K. Button, S. Ison / Research in Transportation Economics 24 (2008) 1–4
subsequently sustain, themselves by undercutting the fares offered
by rival airlines. While the title ‘low-cost’ airline is widely used, the
business models adopted can vary quite considerably between
carriers; some for example focus on secondary airports in cities,
whereas others serve the major hubs, some offer no on-line
services, whereas others do, some have frequent flier programs,
whereas some do not, and so on. In addition, in some cases tradi-
tional airlines have operated divisions or subsidiaries that have
sought to be low cost. Defining a low-cost carrier is thus a little like
the famed words of U.S. Supreme Court Justice Potter Stewart when
discussing obscenity, ‘‘I shall not today attempt further to define the
kinds of material I understand to be [obscene].. But I know it when
I see it’’.
In very general terms, low-cost carriers offer low fares by using
the broad strategies, and not all are used by every low-cost airline.
 First, they do not provide the range of services that legacy
carries normally offer, or at least not in the base fare. There is an
effective unbundling of services; food and drinks often have to
be bought on board, the free baggage allowance in small, no
sky-bridges are offered to the plane, the airports served are
second tier, there are no-reclining seats, and so on.
 Secondly, they maximize the use of their factors of production.
Aircraft turn around times are kept short because there is no-
belly-hold cargo to unload/unload, there are no window shades
to open, there are no seat-back pockets to be emptied, less
congested airports are favored, planes are only cleaned once
a day and there are no on-line passengers to worry about. In
terms of crew, these are often based at ‘home’ to service radial
routes that makes their scheduling easier, and they also often
perform a number of functions in the provision of the service.
 Thirdly, they keep overheads down by using common fleets of
aircraft that are cheaper to maintain and crew.
 Fourthly, they seek to maximize complementary revenues
from sales of refreshments and for baggage.
 Fifthly, low-cost carriers drive hard bargains with their
supplies including aircraft manufacturers, because they tend to
use common fleets, and airports, because they can offer
significant business for otherwise under-utilized car parking
and concessions.
 Sixthly, they only offer a single class of service that simplifies
booking and passenger handling.
 Finally, bookings are often only carried out electronically.
Not all low-cost carriers are free standing enterprises. Many
traditional carriers have over the years opted to launch their own
no-frills airlines, such as KLM’s Buzz, British Airways’ Go, Air India’s
Air-India Express and United’s Ted, but most have found it difficult
to avoid cannibalizing their core business. Exceptions to this have
been bmi’s bmibaby, germanwings that is controlled 49% by Luf-
thansa and Qantas’s Jetstar, which successfully operate alongside
their full-service counterparts.
The low-cost model is also no longer unique to the United States
and to Europe. In Brazil, for example, Gol Transportes Aéreos began
operating in 2001 and WebJet Linhas Aéreas followed in 2005. In
Canada, after a number of low-cost failures such as Air Canada’s two
low-fare subsidiaries, Tango and Zip, and Canjet, and it now has
Westjet as its primary low-cost airline. India’s first low-cost airline,
Air Deccan started service in 2003 and this has spurred the entry of
more than a dozen low-cost airlines including Jetlite, SpiceJet, GoAir
and Paramount Airways. As an outlier to many trends, after a year of
operation, in 2006, Kingfisher Airlines changed its business model
from low-cost to a ‘value airline’. Australia’s first low-cost airline was
Compass, launched in 1990 but short lived. In 2000, Virgin Blue
began low-cost operations, and in early 2007, Singapore low-cost
carrier Tiger Airways formed a subsidiary airline in Australia, Tiger
Airways Australia. In 1995, Air New Zealand established a low-fare
subsidiary, Freedom Air, but it ceased operations in March 2008.
Wholly owned Qantas subsidiary Jetconnect was set up as a low-cost
New Zealand arm of Qantas. AirAsia Berhad, which began operations
in 1996, is a low-cost airline based in Kuala Lumpur, Malaysia and
was the first airline in the region to implement fully ticket-less travel
and unassigned seats. The list goes on.
That low-cost carriers have grown in number and in importance
is beyond question and they now dominate many markets. In the
context of the United States, this has been both at the expense of
the legacy airlines, through substitution effects, but also by
reducing the overall costs of air travel they have exercised income
effects that have created new markets. The situation is very much
the same in Europe except that here there has for many years been
an established charter airline market selling capacity wholesale to
all-inclusive tour companies; something under 20% of the market
in the early 1990s compared to a maximum of 2– 3% in the United
States.
The history of low-cost carriers is generally traced back to the
British entrepreneur, Freddie Laker and to the long haul-market as
opposed to the short-haul-market now seen as the domain of low-
cost airlines. In 1966, he formed Laker Airways as a charter
operator for package holidays to Mediterranean destinations, and
then initiated a revolutionary concept of low-fare, no-reservation
flights from London to New York by launching the ‘Skytrain’
service. However, overcapacity and pricing competition from the
other transatlantic carriers forced Laker Airways into bankruptcy
in 1982.
The more recent history has its origins in Southwest Airlines,
founded in 1967, and its expansion into national domestic markets
after the enactment of the 1978 U.S. Airline Deregulation Act. The
business model was, however, a variant on the Californian intra-
state, regional carrier, Pacific Southwest Airlines’, cost cutting
approach that had begun in the 1950s. Low-cost carriers came more
slowly to Europe where, because of the small geographical size of
most countries, the vast majority of markets were international and
governed by illiberal bilateral air service agreements between
governments. The gradual relaxation of these agreements between
countries, and their phased multilateral liberalization in the late
1990s allowed airlines like Ryanair to initiate low-cost services.
The lost cost airline model is often held up as a highly successful
form of business strategy. This is largely because of the enduring
success of Southwest Airlines in the United States (which carries
more passengers than any other airline in the world and at the time
of writing it had enjoyed 69 consecutive quarters) and of the Irish
carrier, Ryanair from its creation in 1997 (its carriers more
passengers in Europe than any other airline, and has been consis-
tently profitable). The picture is not quite so simple, however, and
as can be seen in Table 1, that focuses on low-cost carriers in the
United States, there have been far more failed low-cost airlines than
successful ones. Some of the failures have seen a simple withdrawal
from the market but in other cases there have been mergers with
other airlines.
Just why some low-cost airlines have succeeded and others have
encountered failure is difficult to discover in general terms. As with
any serious activity, there is an element of chance in life; as
Napoleon said when confronted with a list of possible army
promotions, ‘‘I want none of those. Go back and find me a lucky
general.’’ It is certainly true that many low-cost carriers have been
unlucky, being established before a downturn in economic activity
or having a major accident that blemishes their reputation. On the
other hand, others were lucky in terms of attracting good and
innovative management for the types of business they were
developing, and helped in the case of Southwest by association
 K. Button, S. Ison / Research in Transportation Economics 24 (2008) 1–4 3

Table 1 expansion of the European Union in embracing the first tranche of

Low-cost United States airlines – operating and defunct (2007) transition economies in 2004, over 450,000 Poles moved to the
Currently operating Defunct United Kingdom in the space of two years, some permanently but
AirTran Airways Air South many more temporarily, to meet demands for skilled labor. Many
Allegiant Air America West Airlines flew, often making return trips to see family, on the emergent low-
ExpressJet ATA Airlines cost carriers such as Wizz Air and Central-wing. In 2000, there were
Frontier Airlines (Operating in bankruptcy) Eastwind Airlines five scheduled services between Poland and the United Kingdom
JetBlue Airways Hooters Air but by 2006 this had grown to 27 linking 12 Polish and 12 United
Go! Independence Air Kingdom airports with most of the expansion provided by low-cost
Southwest Airlines Kiwi International Airlines carriers.
Spirit Airlines MetroJet Whether the low-cost carrier business model has a future
Sun Country Airlines Midway Airlines depends on the ability of carriers that have adopted it to retain
USA3000 Airlines National Airlines a reasonable degree of market power as well as market share.
Virgin America Pacific Southwest Airlines Airlines, as any other industry, have to recover their full cost to be
Alaska Airlines PEOPLExpress viable. Providing a scheduled service has a de facto set of fixed costs
Horizon Air Skybus Airlines associated with it irrespective of how many passengers are carried;
Island Air SkyValue there have to be booking and payment facilities, check-in desks and
United Shuttle
attendants, a plane (leased or owned), crew, fuel, a take-off and
Song (Delta)
landing slot, baggage check-in facilities at both ends of the flight,
Southeast Airlines
and so on. These costs are recovered from a combination of airfares
Tower Air
on revenues obtained from non-flight sources such as sales of
ValuJet
Vanguard Airlines
refreshments and advertising on the plane. The airline can maxi-
Western Pacific Airlines
mize its revenues by fare differentiation, and in particular, charging
Pearl Air higher fares to those who book closer to take-off time – these are
Safe Air often business travelers that are fairly fare insensitive because they
Pan Am have to make the flight at short notice. The yield management is
possible because the airline enjoys a quasi monopoly position. If
other carriers enter the market with flights to the same destination
with the ‘‘fun’’ life-style of its senior executive, the chain-smoking, at about the same time, then it becomes difficult to charge the
Wild Turkey drinking, Herb Kelleher, and in the context of Ryanair, premium fares in the days just before take-off and the competition
by Michael O’Leary that enhanced their visibility and differentiated forces fares to remain near the marginal cost level. The result is that
them from the rest of the field. full fare recovery becomes impossible. Until now, low-cost carriers
Perhaps more important, the most successful low-cost airlines have either avoided markets already serviced by another carrier, or
enjoyed a first mover advantage that allowed them entry into the only entered those served by a legacy carrier with significantly
most attractive markets first and gave them time to develop market higher costs. As the low-cost model is more widely used, so there
image. The reaction of incumbent legacy carriers has also been will inevitably be more competition between these types of carrier
important. It has taken time for these airlines to develop effective with prospect that their margins will be eroded and financial losses
strategies to compete with low-cost rivals. While neither the incurred.
Cournot nor Bertrand concepts of incumbent inertia have been This type of excessive competition problem, in economics
particularly realistic in describing incumbent reactions, the early termed the absence of a ‘core’ in the market, has only just
low-cost carriers certainly encountered an unprepared group of attracted academic attention. For technical reasons, it is impos-
incumbents that assumed competition in deregulated markets sible to determine whether the core is empty but, there are
would be between large hub-and-spoke networks. The arrival of various indicators that may be explored. There are data issues
the ‘hub-busting’ direct services offered by low-cost airlines were when analyzing any market and this is true of all airline activities,
largely dismissed as being marginal and easily dealt with by the however ‘data scraping’, in this case the collection of secondary
legacy airlines adjusting schedules or fare structures. The difficulty web data on fares offered by airlines, has provided a fruitful
was that the low-cost carriers ate into the network integrity of the database. This would seem to offer a degree of insight suggesting
legacy airlines and gradually eroded their market shares and that competitive markets for airline services may well not be
revenues. The traditional carriers have shifted much of their ener- stable, and that continual cost cutting will not produce an equi-
gies to longer-haul, often international markets and have consoli- librium. Low-cost carriers may thus do well competing in many
dated through mergers, and less formerly by forming alliances, to markets with traditional carriers, or where they are monopolies,
protect the remainders of their networks. but encounter major revenue flow problems when they compete
The economic implications of the arrival of low-cost carriers on with each other.
a route has consistently resulted in a general lowering of fares – the The papers in this Special Edition cover a range of topics
‘Southwest effect’ so-called because of the notable influence the germane to the understanding of how low-cost carriers function
United States domestic carrier has on its markets. While analysis of and the challenges that confront those that have adopted the low-
the Southwest effect has been relatively limited in Europe, the cost model. They are research papers, and thus they in no way
richness of the database in the United States, and in particular the represent a comprehensive review and they use a variety of
availability of 10% ticket samples that provides fare data, has clearly analytical techniques. Competition between traditional and low-
shown the larger, halo type effect of low-cost carriers both on cost carriers, and more recently within the low-cost market itself,
routes where they enter and those where there is probable entry. airlines has been subject of considerable interest to economists and
The advent of reasonably cheap air services has had implications business analysts in general and not only those specializing in
for the life-styles of many. In terms of migration and labor market transportation.
mobility, the low-cost carriers have stimulated markedly new The 2008 award of the Nobel Prize in Economics to Paul Krug-
patterns of behavior. Recently in Europe, for example, after the man was partly attributed to his work on product differentiation
4 K. Button, S. Ison / Research in Transportation Economics 24 (2008) 1–4
and scale effects, and this is the essence of much of the work on
competition in the various airlines markets. David Pitfield’s study of
competition between low-cost carriers, where product differenti-
ation and scale effects (in the airline case, the ‘network economies’
largely associated with scope and density) and Bogdan Daraban and
Gary Fournier’s paper on aspects of competition between legacy
and low-cost carriers, where product differentiation and scale may
be relevant, fall into this body of analysis. The theme is taken
further by Alicja Gados and David Gillen who in their work focus on
how traditional airlines have sought to internalize the challenges of
confronting carriers with a differentiated, low cost, product by
establishing their own similar low-cost services. Product differen-
tiation and scale economies are also linked to the infrastructure
choices made; for example the types of airport served. This is the
subject of the contribution of Anming Zhang, Shinya Hanaoka,
Hajime Inamura, and Tomoki Ishikura that studies the use of
secondary airports in Asian markets.
Both Yan Du, Starr McMullen and Joe Kerkvliet, and Peter Mor-
rell in their contributions consider the question, ‘‘Where does the
low-cost carrier model go now?’’ Du et al. look at ways in which
low-cost carriers may continue to expand and to minimize risks in
their markets. Their concern is with the formation of alliances
involving low-cost carriers; a feature now ingrained in the tradi-
tional airline business model but relatively new to the low-cost
sector. Morrell, in a way goes back to the roots of the low-cost
carrier model, and the efforts of Freddie Laker, and examines the
viability of low cost, long-haul operations. The contribution of Eric
Pels in many ways crosses over the themes of the bases of
competition within airline markets and the future of low-cost
carriers, and in particular the types of networks in which they best
survive.
Finally, there is a fundamental subject that has often been
poorly addressed, or flattly ignored, in much prior work on the
low-cost airlines, namely, ‘‘How exactly does their business model
differ from that of conventional Scheduled commercial airlines?
Keith Mason and Bill Morrison consider this in their paper, seeking
to find a more consistent base upon which comparisons may be
made.