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Managerial Economics, Fall 2011

Alexandra Korenkova, Alina Belashova, Artyom Antonov, Ekaterina Kolesnikova, Natalia Vazhnenko

Russian internal market of passenger air travelling

Our analysis will be focused on the Russian internal market of passenger air travelling. This means that we will concentrate on the market of flights within Russia (internal flights). Flights from Russian airports to airports in other countries will not be considered in our analysis. We will consider flights of companies, regardless of whether they are Russian or foreign. However, since most companies that organize internal flights within Russia are Russian companies, our analysis will mainly target Russian companies. Our analysis will be based only on passenger air travel. Cargo air travel will not be studied.

Costs of typical firm

Characteristics

Current situation

Future trend

Main fixed costs

In our industry, most costs are fixed. The main costs are:

  • Maintenance of the companies’ offices

  • Leasing and customs payments; interest expenses (approximately 12,5% of the total costs)

  • Fuel (approximately 25% of the total costs)

  • Airport fees (approximately 20%)

  • Technical services (approximately 15%)

  • Payroll (approximately 7,5%).

Costs, such as fuel and airport fees, depend on the number of operations (number of flights of the company). However, they are fixed because, once the flight is organized, the costs are constant, regardless of how many passengers are transported. They are the same when 1 passenger is transported and when 100 passengers are transported.

Certain other costs, primarily the costs of maintaining the offices and leasing, customs and interest payments are fixed and in the short-run do not depend neither on the number of passengers, nor on the number of flights.

The fuel is main fixed cost in the structure of fixed costs. In short-term period, probably, nothing will change, but in long-term period some changes may happen in case regulatory documents will transform the situation with monopoly of fuelling complexes and therefore the prices will go down (in theory).1

The other fixed costs are not going to change substantially.

Main variable costs

The variable costs of airlines are much less significant than the fixed costs. The variable costs (costs which depend on the number of passengers transported) are mainly the costs of providing the passengers with food and beverages. Also, a fraction of the payroll may be regarded as a variable cost. The salaries of the pilots are fixed costs, however the salaries of stewards can be to a certain extent considered to be variable. When there are few passengers, the flight can have fewer stewards to serve them with food and beverages. However, since a certain amount of stewards is required on a flight, no matter how many passengers are transported, the payroll of the stewards is only partly a variable cost.

Variable costs are not going to fluctuate much. As well, their part in the structure of all costs is very low. Some of variable costs as food and drinks are not in the structure of low-cost airlines. If Russian airline industry would resemble European more and would have low-costers than these variable costs wouldn’t exist anymore. However, these changes are possible only in long-term period.

Economy of scale (scope)

The Russian airline companies do not exploit the economies of scale to a significant extent. Very often, the airplanes are not full (on average only 73,5% of the planes’ seats are occupied and this number is growing very slowly), which means that the airlines have to set higher prices to compensate for the fixed costs of organizing a flight. International In comparison, the capacities are used to 81,8% on international flights to and from Russia and here the airlines are able to offer more competitive prices.

The airlines are able to benefit from economies of scope to a certain extent. The two main segments of customers are the economy class and the business class. Airlines can transport the passengers of these two segments jointly, in one airplane, meaning that they, thus, reduce their total costs per passenger. If this was not possible, airlines would have to organize separate flights for business class and economy class passengers and pay, for example, twice for the fuel. Also, there are some variable costs that arise from the sale of tickets (each 1 sale requires certain costs) and the check-in of passengers (the more passengers check in, the higher are the costs).

The trends for Russian volume of traffic are positive, thus, we can assume that the economies of scale will be exploited to the bigger extend, in short-term period and even more in long-term period.2

Are there minimum efficient scale (MES)?

What is the efficient growth mode?

Because most of the costs are fixed, the minimum costs are achieved when the airplane’s capacity is utilized completely. It is more difficult to determine what number of flights allows a company to achieve the minimum efficient scale (assuming that the capacities are utilized to the full extent). In our opinion, an airline company must have several flights to achieve a minimum efficient scale (in this case, the costs of leasing and interest payments and the costs of maintaining the company’s office are decreased as they are spread over a larger amount of flights). However, at some point, as the number of flights increases, the company may begin to suffer from an increase in the average costs (for example, due to increasing inefficiency of the head office).

No changes expected.

Sensitivity of costs to capacity utilization

The average costs are very sensitive to capacity utilization. As it was mentioned previously, most costs are fixed costs. So, when the capacity is utilized to a high extent, the fixed costs are spread over a large group of customers. As a result, the total costs drop significantly. The variable costs per passenger do not change significantly with an increase in the capacity utilization but this is not so important as most costs are fixed.

The structure of this industry dictates this behavior, which is not supposed to change.

Behavior of marginal cost

Marginal costs are very low. Most costs are fixed, so when 1 extra passenger is transported, the extra costs that arise are very small. Also, we think that due to the nature of the variable costs they may decrease as the number of passengers increases up to a certain point and increase after that. For example, as the number of passengers grows, the airlines may benefit from the opportunity to buy food as wholesale. However, at some point, as the airline begins to serve a lot of passengers and buy significant amounts of food, the costs may start to go up (for example, due to inefficiency of procurement or even theft of the employees responsible for this; as the company grows in size, it is increasingly more difficult to control all this).

Considering the possible changes associated with low-costers, the marginal costs may become even smaller, though they are already almost neglibible.

Exit barriers

The exit barriers are high. The functioning of an airways company requires significant initial investment, primarily in the purchase of airplanes. As a result, once a company purchased the airplanes and entered the market, it is very difficult for it to exit the market. Exiting the market would require to sell the airplanes, however when they are sold, significant sums of money may be lost (due to a difference between the selling and the purchase price). Furthermore, it will be difficult to sell these planes as other Russian companies already have the necessary amount of planes and usually buy extra airplanes from abroad. It is also very difficult to sell the airplanes abroad due to government regulations. This makes market exit unattractive for companies. Many of them may prefer to stay in the market if they don’t make significant profits or even if they make losses (hoping that they will start to make profits in the future). This increases the competition on the Russian passenger air transportation market. However, the exit barriers in the Russian market may actually be lower than the exit barriers in the market of some developed country. In Russia, the average age of an airplane is 21 years3, which means that the airplanes are quite old. Therefore, the value of these airplanes is not so high and it may be more attractive for a Russian company to close its business than it is for a US company (whose planes are newer). After all, the value of these airplanes is not so high and, in any case, the company will have to stop using them in quite a short period of time, so it is not such an unattractive option to leave the market, even if nothing can be done with the airplanes that are no longer needed.

Due to mentioned reason, with time, the exit barriers for companies which are not very successful and don’t buy new planes, will become even lower. However, generally, the exit barriers will remain high.