An Analysis of Profit Cycles in the Airline Industry

Abstract

This paper discusses the financial dynamics of the airline industry by identifying the fundamental cycle periods of profitability and their driving factors. Assuming the industry profit cycles could be modeled as an undamped second-order system, the fundamental cycle period was found to be 11.3 years for the U.S. airline industry and 10.5 years for the world airline industry. An empirical profitability model was estimated and the results revealed that such cycle period is endogenous, neither deregulation nor September 11 have significantly changed the cycle length. To analyze the causes of profit cyclicality, parametric models were developed under the hypothesis that phase lag in the system caused the profit oscillations; and two hypotheses, lag in capacity response and lag in cost adjustment were studied. Analysis of the parametric model of capacity response indicated that the system stability depends on the delay between aircraft orders and deliveries and on the aggressiveness in airplane ordering. Exaggerated capacity response was observed in the simulation as the gain in the model has lumped impacts of exogenous factors, suggesting capacity shortfall alone cannot fully explain the industry dynamics. The model also indicates reducing delay may help to mitigate system oscillations. Simulation results of the parametric model regarding cost adjustment were consistent with profit observations. Finally, a coupled model was developed to study the joint effects of capacity and cost. Simulation results indicated that the coupled model explained industry dynamics better than individual capacity or cost models, suggesting that the system behavior is driven by the joint effects of capacity response and cost adjustment.