ECONOMICS FOR BUSINESS STUDIES (ECO745)
Answer both case studies provided below (Total: 100 marks).
CASE STUDY 1:
AIRASIA INDIA: CLASH FOR THE INDIAN SKIES
On May 7, 2014, AirAsia’s founder received an Air Operator’s Permit (AOP) from the Indian aviation regulator — the Directorate General of Civil Aviation (DGCA). The permit — essentially a flying license for AirAsia to operate in Indian skies — brought to an end the long approval process and legal hurdles that AirAsia had to face after it announced its entry into the Indian aviation market.
AirAsia India was a joint venture partnership between Malaysian low-cost carrier (LCC) AirAsia Berhad, Tata Sons Limited and Telestra Tradeplace Private Limited. It had acquired a reputation of being the most aggressive LCC in Asia and one of the most aggressive in the world. Entry into India, with its large population, high economic growth, large and growing middle class, as well as an aspirational young and urban population, was a natural choice for AirAsia. Yet, the Indian aviation market posed its own set of challenges, including demand supply dynamics, regulatory procedures, high aeronautical charges, high fuel costs, etc. AirAsia India aimed to create a revolution in the Indian aviation market by pursuing its characteristic aggressive pricing strategies, together with extremely competitive operational targets. The founder of AirAsia had tweeted his intent regarding the same.
THE INDIAN AVIATION INDUSTRY
As journalist Paul Cuckoo noted, “The airline business is complex anywhere in the world and even more so in India. It burns cash fast, is highly regulated and produces a commodity that is worth nothing if not sold in time. Making a success of it is no small [feat].”
Developments in Indian Aviation
Civil aviation in India dated back to 1912. The first domestic air route between Karachi and Delhi was serviced by the Indian state Air Services in collaboration with Imperial Airways, United Kingdom. In 1915, the first private Indian airline, Tata Sons Ltd., started a regular airmail service between Karachi and Madras. Later it began carrying scheduled passenger traffic. In 1946, Tata Airline was renamed as Air India. Nine air transport companies operated in India in 1947, at the time of independence; this was gradually reduced to eight, with Orient Airways shifting to Pakistan.
The Government of India, together with Air India, established a joint-sector company, Air India International Ltd., headed by J.R.D. Tata, in 1948. The government nationalized the airline sector under the Air Corporations Act 1953, due to the worsening financial condition of airlines. Nationalization of the aviation sector led to the emergence of a state-led monopoly. Indian Airlines, formed through the merger of eight domestic airlines, came to enjoy a monopoly in the operation of domestic services; Air India had a virtual monopoly to operate overseas services (except some routes to neighbouring countries, which were given to Indian Airlines).
In 1986, the government opened up the sector to private players in a limited manner by allowing them to operate as air taxi operators. With economic reforms in 1991, there was a move towards greater privatization and liberalization of the aviation sector as well. In 1994, the Indian government revoked the Air Corporation Act to enable the entry of private carriers who could offer scheduled services. However, the market did not grow sufficiently large enough for all players to compete; many of the airlines went bankrupt. Only two private carriers survived the tough Indian aviation industry in the new century: Jet and Sahara.
In 2003, a landmark year in the history of the Indian aviation sector, Air Deccan, the first Indian LCC or ‘no-frill’ airline emerged as a challenge to the duopoly of Jet and Sahara as private carriers. Jet and Sahara had been following the stereotypical pricing strategies of economy and business fares. Air Deccan changed the way the Indian aviation industry operated with its different and innovative pricing strategies in the form of check fares, web fares, APEX fares, Internet auctions, special discounts, corporate plans, last-day fares, promotional fares, etc.
Witnessing the tremendous growth rates of air traffic as well as the success of LCC model, other airlines — such as Indigo, Paramount and Go Air — entered the Indian aviation market as LCCs. Others, such as Kingfisher, opted for the full-service carrier (FSC) model. A series of mergers and acquisitions took place in 2007, including the Indian Airlines/Air India merger, the Jet-Sahara deal and the Kingfisher-Deccan deal. In 2008, domestic air transport policy was revised to allow foreign equity participation. Foreign investors were allowed to invest up to 49 per cent in Indian carriers, while nonresident Indians were allowed to invest up to 100 per cent through the automatic (no government approval) route. However, no direct or indirect participation by any foreign airlines was allowed. The sector remained closed to foreign direct investment (FDI) by international carriers.
In September 2012, the FDI norms in the sector were relaxed. Foreign carriers were allowed to invest up to 49 per cent of the paid-up capital of an Indian carrier under the government approval route in scheduled air transport services. Several foreign airlines sought to enter India in response to these relaxed norms. These included Singapore Airlines Ltd., Abu-Dhabi’s Etihad Airways and Malaysia’s AirAsia Berhad. In April 2013, Etihad picked up a 24 per cent stake of US$379 million in the financially strained domestic carrier Jet Airways. It also paid $70 million to buy Jet’s airport slots at London’s Heathrow Airport and committed to invest another $150 million to buy out Jet’s frequent flyer programme. However, the deal ran into significant regulatory hurdles. In late 2013, the Tata group joined with Singapore Airlines to launch a full-service airline with an initial investment of $100 million.
A three-way joint venture, owned by the Tata group (30 per cent), AirAsia (49 per cent) and India’s Telestra Tradeplace (21 per cent) — was meant to launch a budget airline/LCC in India. It had received the approval of the Foreign Investment Promotion Board (FIPB) in April 2013. Yet, it faced keen competition from other players waiting to enter the Indian skies, as well as from domestic players. India was likely to be a major growth market in the future. AirAsia’s founder had announced that the company would revolutionize air travel in India by offering fares 35 per cent cheaper than the competition. He further announced that AirAsia would achieve an aircraft utilization rate of 16 hours and a turn-around time of 20 minutes, thereby beating competitors on operational parameters. Yet the Indian aviation market posed its own set of challenges and being ‘low cost’ was no guarantor of success. AirAsia’s first aircraft, a 180 seater A320, had already arrived in Chennai in March 2014. With the grant of the AOP, all that was required was for AirAsia to take to the Indian skies.
Performance of the Indian Aviation Industry
The Indian aviation sector witnessed high growth in terms of passengers carried. The decade from 2001/02 to 2011/12 witnessed a 373 per cent increase in the passengers carried by Indian scheduled domestic service operators and a 290 per cent increase in the passengers carried by international services. Capacity utilization in civil aviation was measured using the passenger load factor (PLF) (see Exhibit 3 for a glossary of terms). The domestic service sector’s capacity utilization as measured by the PLF increased from 55 to 75 per cent.
India was the fastest-growing aviation market and the ninth-largest civil aviation market in the world in 2013. The domestic passenger throughput was estimated to grow at an average of 12 per cent per annum, while that for international passengers grew at 8 per cent per annum over the period from 2012 to 2017. Further, it was estimated that by 2020, India would have the third-largest civil aviation market in the world, with the number of airborne passengers increasing from 140 million in 2010, to about 420 million in 2020.
Capacity versus Demand
The supply side parameter used to assess capacity growth in the aviation market was the available seat kilometres (ASK), whereas the demand side parameter used to assess the revenue generated by airlines from passenger traffic was the revenue passenger kilometres (RPK) performed. The ASK and the RPK measured the supply and the demand side of the market, respectively. While both ASK and RPK generally moved in tandem, the increase in the gap between ASK and RPK — especially after 2005/2006 — was indicative of excess capacity creation in relation to demand.
Most Indian carriers, anticipating significant growth in traffic, placed orders to augment their aircraft fleet. An estimate by KPMG indicated that airlines in India were expected to add around 370 aircrafts worth INR 1,500 billion to their fleet by 2017 .
KEY DRIVERS OF GROWTH IN THE INDIAN AVIATION INDUSTRY
Indian air penetration rates — measured by the domestic passengers carried per year as against the total population — compared extremely unfavourably with India’s global peers. Thus, while the United States and Australia registered an air penetration rate of two air trips per capita per annum, the corresponding rate for India was only 0.04 air trips per capita per annum. China, while slightly more populous, exhibited about five times higher rates of domestic travel. Clearly, as Indian gross domestic product (GDP) and per capita incomes rose and as Indians began to value time more, the Indian civil aviation industry could grow exponentially.
The key drivers of growth in the Indian aviation industry included the following:
Growth in national income: India’s national income had grown over the period from 2001/02 to 2007/08, and had reached 9.6 per cent. Various domestic and global factors had, however, caused a reduction in growth and in 2012/13, the GDP growth was at its lowest at 5 per cent. The growth rate had further decreased to 4.4 and 4.8 per cent in the first and second quarters of fiscal year 2013/14, respectively. However, this was projected to improve.
Growth of the middle class: Using the Asian Development Bank standards of a per capita consumption per day of $2 to $20, it was estimated that about 25 per cent of the Indian population (1.2 billion) belonged to the middle class. This growing middle class was likely to drive Indian consumption. A McKinsey Global Institute estimate further put the country’s middle class at 583 million by 2025, making India the world’s fifth-largest consumer market.16
Growing urbanization and shifting demographics/growth in working-age population: The 2011 census placed the urban population at 31.2 per cent, up from 17 per cent in 1951. Further, a demographic dividend resulted in more than 60 per cent of India’s population being in the working-age group. This increased economic activity, as well as business and leisure travel.
Investments in airports and related infrastructure: An important factor for the surge in air passenger traffic in India was the opening up of the airport infrastructure to private sector participation. The private sector invested to the tune of INR 300 billion in the Hyderabad and Bengaluru international airports and in the modernization of Delhi and Mumbai international airports.
Untapped market potential: India’s air traffic density (measured by linking urban per capita income with air passengers), which was 72 in 2010, as compared to 282 in China, 231 in Brazil, 1225 in Malaysia, 2896 in the United States and 530 in Sri Lanka, was very low. This indicated untapped market potential, especially given the growing young population and rising disposable income levels.
Other factors responsible for the growth in the aviation industry included growth in tourism and growing integration of India with the rest of the world, necessitating greater business travel.
INDIAN AVIATION INDUSTRY: CHALLENGES
The Indian aviation industry faced a diverse set of problems, including multiple taxes, high operating costs, lack of infrastructure, policy issues such as high sales tax on aviation fuel and airlines having to fly unviable routes to develop connectivity in the country, etc.
High airport charges: Indian airports charged some of the highest fees in the Asian and Gulf region. Indian LCCs were further disadvantaged compared to their international peers, since there were no secondary airports levying lower airport charges for such LCCs in India.
High taxes and fees: The Indian aviation sector was subject to multiple fees and taxes on inputs, which were either absent or lower in matured aviation markets. Thus, fees and taxes on inputs such as fuel, aircraft leases, airport charges, air passenger tickets, air navigation service charges, maintenance costs, fuel throughput fees, and service taxes on other items raised costs substantially. Consequently, the Indian aviation sector had larger operating losses than its other global counterparts.
Lack of adequate airport infrastructure: Inadequate airport infrastructure led to congestion at airports. This not only affected the turnaround time of the aircraft and reduced the average aircraft utilization but also added to the costs significantly in the form of fuel wastage as the aircraft often were delayed in the sky. It also led to concerns regarding air safety.
High cost of aviation turbine fuel (ATF) in India: The cost of ATF accounted for 40 to 50 per cent of the total operating cost for the Indian aviation industry. Such high costs posed a challenge to the financial health of airlines. ATF prices in India were distorted due to the multitude of cascading taxes by different government entities. In addition, ATF was also subject to a high value added tax (VAT) of 30 per cent, despite its being an input fuel (similar to coal and gas). A KPMG analysis indicated that the high ATF prices in India, which were 60 per cent higher compared to neighbouring hubs such as Dubai, Singapore and Kuala Lumpur, rendered the Indian aviation industry uncompetitive.
Sensitivity of industry profitability to oil prices: The industry was highly sensitive to oil prices. The Centre for Asia Pacific Aviation (CAPA) carried out a study assessing the sensitivities of airline profits to higher average oil prices in April 2011. It found that LCCs could sustain profits at a modest level and perform better than full-service carriers at oil prices up to $95 to $100 per barrel, other things remaining constant. However, at oil prices above $110 per barrel, the entire industry would be impacted, since at these levels the fare differentiation between them became less significant. With the crude oil to ATF price correlation at 93 per cent, any increase in global crude prices and/or a depreciation of the rupee had a direct impact on the ATF prices. In September 2013, international oil prices, which had been trading between $105 and $115 per barrel, increased due to global developments. Indian oil companies, which supplied ATF after refining imported crude, consequently raised ATF prices steeply by 6.9 per cent. This followed two rounds of ATF price hikes that they had already carried out in July and August 2013, by 5.8 per cent and 6.3 per cent respectively.
Exchange rate volatility: The rupee had depreciated steeply against the U.S. dollar between 2008/2009 and 2012/13. With the costs of fuel, insurance and freight, maintenance, repair and overhaul (MRO) expenses and lease rentals (all calculated in dollar terms), such depreciation increased industry costs substantially. Even as late as May 1, 2014, the rupee was trading at INR 60.11 to US$1.
Policy rules: The Indian aviation industry consisted of policy regulations which contributed to its financial non-viability. These included the following:
• Fleet, equity and experience requirements: According to civil aviation requirements (CAR), domestic scheduled operators had a minimum fleet requirement of five aircraft and a minimum equity requirement ranging from INR 200 million to INR 500 million (based on the take-off mass of aircraft). Such regulatory requirements meant a restriction on the number of new market entrants as well as their size, since only firms which could raise the required capital could enter. The ‘5/20’ rule also meant that Indian carriers which did not possess the mandatory five years operational experience and 20 aircraft fleet size could not operate on international routes. Such restrictions, which were binding only on Indian (and not international) carriers, affected their competitiveness further.
• Restriction on FDI by foreign carriers: FDI by international carriers was restricted to 49 per cent. Such FDI restrictions limited the potential sources of low-cost capital, as well as expertise. It also restricted access to technology and management know-how.
• Route dispersal guidelines: Aviation routes in India were divided into three categories based on their profitability. Category I routes were the profitable routes, Category II consisted of loss-making routes and Category III comprised the remaining routes. Additionally, Category IIA routes (within Category II) consisted of routes exclusively within the North Eastern region, Jammu and Kashmir, Andaman and Nicobar and Lakshadweep. Airlines were required to deploy a minimum percentage of their capacity deployed on profitable (Category I) routes on the other routes. This ranged from 10 per cent in the case of category II and IIA to 50 per cent in the case of Category III routes. Such deployment of aircraft on unviable routes affected profitability adversely.
Lack of skilled manpower: With passengers and aircraft fleets likely to triple by 2025, there was a need for skilled manpower. According to a KPMG analysis, the total manpower requirement of airlines was estimated to rise from 62,000 in 2011, to 117,000 by 2017. This included pilots, cabin crew, aircraft engineers and technicians, ground handling staff, cargo handling staff, administrative and sales staff etc. Lack of adequate trained and skilled workforce would pose a challenge.
Slot allocation policy: The slot allocation policy within the Indian aviation sector created an artificial barrier to entry and limited competition. “A ‘slot’ allocated to a particular carrier referred to its entitlement to use the runway capacity at a particular airport on a specific date at a specific time.” Such slots were limited in supply. India followed the International Air Transport Association (IATA) global guidelines of a ‘grandfather rule’ for allocation of slots. As per the guidelines, an incumbent airline, based on utilization of the slot at least 80 per cent of the time in the preceding season, was entitled to retain a group of prime slots at airports on prime routes based on historic precedence. New entrants had no access to such pre-allotted slots; nor could they access more than 50 per cent of the pool of the available slots. With a limit on the number of free slots available to new entrants, incumbent airlines garnered substantial market share and deterred any potential entry to the market.
In case of mergers, the application of the ‘use it or lose it’ rule allowed the merged entity to retain access to all infrastructure, including slots, controlled by the airlines prior to the merger. A consolidation in the airline industry through mergers and acquisitions of incumbent carriers thus accentuated such barriers further. Airline mergers created artificial scarcity of slots and thus restricted competition. Underutilized slots, which may be open for allocation to new airlines, tended to be at odd times and not peak hours.
Pricing strategies: The Indian civil aviation sector found pricing its services to be the biggest problem. With no airline owning a significant chunk of the market, any attempt to hike prices would result in a loss of customers; at the same time, a drop in prices by one player would set into motion a ruinous price war. Again, while high prices across the industry were likely to come under the scanner of the Competition Commission of India for possible cartelization, low prices were also frowned upon as predatory pricing and anti-competitive behaviour.
In late 2010 — during the peak season of the most important Indian festival, Diwali — airfares had risen by 250 to 300 per cent and the Indian aviation ministry constituted a fare-monitoring cell for the first time to protect consumers. However, in January 2013, SpiceJet had launched a three-day mega ticket sale, when it had offered tickets at INR 2,013. The DGCA advised it not to do so and asked others not to follow. In February 2013, led by Jet Airways, other airlines (Indigo, SpiceJet and Go Air) had slashed ticket prices across 450 flights covering 57 destinations.
a) Based on your reading of the case study, what kind of market structure best describes the Indian aviation industry. State the reasons for your answer.
b) What strategies should AirAsia India pursue in such a market to ensure its survival and profitability?
c) “However, the market did not grow sufficiently large enough for all players to compete; many of the airlines went bankrupt”. Discuss this statement in the context of returns to scale.
d) In 2012, the government allowed foreign airlines to participate in India’s aviation industry. Explain what would happen to the price elasticity of demand for air travel in India and why.
e) Based on the case study, discuss the pricing model most applicable to India’s aviation industry.
f) In the section on pricing strategies, it is indicated that ‘price war’ is ruinous to the industry. Discuss what is meant by price war and the strategies that could be undertaken by the airlines to avoid it in their quest to expand market share.
CASE STUDY 2:
EDITORS' PICK|2,855 views|Mar 10, 2020,01:09pm EST
Rolling Recessions are the Likely Economic Impact of New Coronavirus And COVID-19
Bill Conerly Senior Contributor
The new coronavirus, which causes the new disease COVID-19, is the major uncertainty in the global economy, with the potential to trigger a worldwide recession. The path of the disease and its economic consequences are highly uncertain. Most likely, the world will see rolling recessions as the disease spreads to different areas, with economic recovery as the local epidemics die down.
A coronavirus forecast comes not because the future is known with high certainty, but because businesses are making decisions every day that depend on the economic outlook. The rolling recession prediction is the most likely as of today (March 10, 2020) but may change as new information emerges.
a Based on the article above, COVID-19 is a major uncertainty in the global economy. Explain ) why uncertainty in the economy is destructive for businesses.
b Businesses are making decisions every day based on the economic outlook. Uncertainty in the
) economy can hamper their decision making. Suggest two (2) ways how businesses can reduce the risk of uncertainty in decision making.
c Discuss, with appropriate examples, two (2) types of policy that the government can use to ) solve the recession in an economy.
d Using a diagram, explain the impact on Chinese Yuan as China’s exports plummeted due to
) COVID-19 epidemic. Discuss the implication of this situation on the businesses of Malaysian importers of Chinese products.
e Based on the current global economic situation due to COVID-19 pandemic, state your opinion ) regarding Malaysia’s ability to weather the economic repercussions of the pandemic.
Substantiate your opinion using relevant economic theories and concepts.