The global market for civil aircraft is being led by just two manufacturers and the current situation on the market is tense. The European company Airbus keeps competing with the traditional industry leader, American concern Boeing. The intense competition between Boeing and Airbus is reflected in lower prices for the airlines and improvements in the quality of aircraft (e.g. more comfort, lower specific fuel consumption, lower levels of pollutant emissions and noise) (Deutsche Bank research, 2007). There are also new ambitious players who are ready to put an end to the era of duopoly. For example, China`s C919 is about to be tested in 2016 (IEEE, 2015). Considering, that by end of 2034, due to demographic and economic growth, tourism trends, oil prices, development of new and existing routes the world fleet will double (from 18 to 37 thousands of aircraft, according to Airbus` Global Market Forecast) and manufacturers will capitalize multi-trillion dollar profits, the competition is going to be more intense.
The firm`s profit depends on intensity of the existing rivalry among existing firms. When the firms make profits, it is likely that other firms may want to enter the market, aircraft industry not being an exemption. In case with Airbus and Boeing, the entry of new firms is time-consuming and expensive and Comac (Commercial Aircraft Corporation of China) would have to overcome quite a lot of entry barriers.
One of them is cost advantage of Airbus and Boeing, which can produce at lower marginal cost. Also, it very costly to enter airline industry: the market is small in terms of number of aircraft sold, but each aircraft is an expensive product. The relatively small number of aircraft sold goes hand in hand with a long product cycle. It takes 5-6 years from launch to first delivery. Then an aircraft has a product cycle of at least 20-25 years of production during which it may be upgraded to new technological standards (Klepper, 1990). Additionally, both Airbus and Boeing benefit from economies of scale and thus are less affected by price wars. According to Schmalendee (1998), measures of scale economies or capital requirements tend to be positively correlated with industry-level accounting profitability. In samples of US firms or business units that include many industries, market share is strongly correlated with profitability; the (estimated) coefficient of concentration is generally negative or insignificant in regressions including market share.
The associated legal factors are also problematic (subsidies, certifications, trade barriers). The main parts of the aircraft, most importantly engines, are supplied by subcontractors and developed by outside companies, which currently cooperate with Boeing and Airbus. Also, so far, Chinese aircraft makers have been unable to get even a single commercial plane certified by either the United States’ Federal Aviation Administration (FAA) or the European Aviation Safety Agency (EASA). To gain such certification, a company normally needs to include the regulators from the get-go. And without FAA or EASA certification, it will be nearly impossible for Comac to succeed in selling its aircraft abroad (Francis, 2015). Additionally, the access to resources (financial and distribution channels) of any new entrant would be quite limited. Hugh Newman, technical director at the Bank of China’s aircraft leasing company points out: “They don’t have the international customer-support network. It is something that has taken Airbus and Boeing decades to develop, and it’s not something that can be replicated in a few years.” (Francis, 2015).
Lastly, even though aircraft industry overall is definitely a growth sector, it still follows cyclical economic patterns. External factors heavily disrupt aviation market, as airlines decrease their orders in times of crisis. The global economy continued to expand during 2015 at a moderate and uneven pace, as the prolonged recovery process from the global financial crisis was still saddled with unfinished post-crisis adjustments. Global recovery was also hampered by some new challenges, including a number of unexpected shocks, such as the heightened geopolitical conflicts in various areas of the world (UN Economic Prospects, 2015). This means, that current economic conditions are not perfect for a new firm to make an entry to the aircraft industry.
Strategic trade policy
Amongst all, there are also some strategic entry barriers, which can be used by Airbus and Boeing and also the governments to deter the entry. This is an important first dimension of strategic trade policy: by appropriate actions, a government can help raise national income if it can ensure that the domestic firms gain first-mover advantages in their industry. A second dimension of strategic trade policy: it may pay for a government to help domestic firms overcome the barriers to entry created by foreign firms that have already reaped first-mover advantages. This is how Airbus managed to enter the industry: UK, German, French and Spanish governments heavily subsidised it, because they wanted to lower Europe`s dependence on US aircraft sector.
European Airbus’ and American Boeing’ planes are essentially homogeneous and two firms compete in prices. Logically, two firms behave to maximise profits assuming the rival will not change output in response. Because outputs are strategic substitutes each firm’s marginal revenue declines as the output of its rival increases. No firm has an incentive to decrease its output, but this becomes possible with government intervention. Both USA and EU see aircraft industry as strategically important and therefore protect it by using tariffs or subsidising.
From a government’s point of view, it is in the interest of a country to capture a large share of the production of profit-earning imperfectly competitive industries, because subsidising leads to lower market prices and greater home market share (as a result of lower foreign market share). In particular, when there is a significant domestic market for a good, protection of this market raises the profits of the domestic firm and lowers the profits of the foreign firm in the case where both enter; like an export subsidy, this can deter foreign entry and allow the domestic firm to capture the excess returns (Krugman, 1987).
By announcing its subsidy for the domestic firm, the government can significantly change the nature of the game and increase home welfare. As the output expansion by the home firm becomes credible, the best response from the rival is to decrease output. As a result, profits shift from the foreign to domestic firm. The subsidy enables the firm to commit to a higher output and to shift profits internationally from the other firm. Despite the high cost of the subsidy, government would be better off. The additional profit is sufficient to more than cover the cost of the subsidy, leading to an overall welfare gain.
Although, there are some important points to note. When both governments subsidise, as it happens with Airbus and Boeing, the government subsidy game begins, which may lead to lower welfare for both parties, as both parties expand output driving the prices down. The solution to this would be a tax on exports, which would shift the reaction functions of both firms inwards. Also, even in a world characterized by increasing returns and imperfect competition, budget constraints still hold. A country cannot protect everything and subsidize everything. Thus interventionist policies to promote particular sectors, whether for strategic or externality reasons, must draw resources away from other sectors. This substantially raises the knowledge that a government must have to formulate interventions that do more harm than good (Krugman, 1987). When America and Europe are focusing on subsidising one sector, governments may harm another by driving the resources from them, which would in the end lead to the profit shift within the economy.
Returning to the potential new Chinese firm entry, the subsidising from the Chinese government would be esssential. It would be able to increase its market share only at the expense of Airbus and Boeing. However, if Comac produces more, Airbus and Boeing would have to produce less, otherwise, an increase in production will lead to lower prices and profits, because the demand on the market of aircraft is limited. And of course, neither Boeing nor Airbus have an incentive to start producing less. Below is the theoretical reaction function for the Comac (C) and Boeing+Airbus (BA, taken together for simplicity).
Comac would prefer to be at the point B, but rivals know, that this is not credible given its cost structure. Here governments` subsidizing can lower the cost and move Comac to the reaction function at the intersection B. However, in real life, Comac may not have enough information and will not be competitive even with subsidizing.
Disputes Between Airbus and Boeing
Since the establishment of Airbus, the US has been complaining about European government providing too much subsidies in the form of ‘Launch Aid’ or ‘Repayable Launch Investment’, which distort competition. US argue that Europe has increased its market share at the expense of US. In 1992 US has signed the Agreement on Trade in Large civil Aircraft, which was acting as a regulator of government support, and has terminated it in October 2004. The case about excessive government subsidising was taken to the WTO and it may take several more years to solve it.
The way two airline companies compete is fairly simple. Once capacity is determined, aircraft producers have limited choice over short-run output levels. They bargain with airlines in their day-to-day marketing activities over the price of aircraft. Airlines seem to make extensive use of repeated negotiations with the suppliers of an aircraft for a specific market segment. Competition takes the form of a price game at given capacity levels, where the outcome of the long-run quantity game then becomes a restriction in the short-run price game. If demand turns out to be larger than expected, firms will produce at their capacity limit and choose prices which maximize profits. For unexpectedly low demand the price game may drive prices down to marginal cost levels (Klepper, 1990).
The chance, that there will be an absolute winner in these disputes is fairly low, thus the solution of the negotiations would be to gradually reduce the amount of subsidies given by both governments, which is achievable due to continuingly high margins in the airline industry.
It is difficult to enter aircraft industry, because initial investment is expensive and it takes a long time until a new firm would become an established producer. For example, the entry of European Airbus has been made possible by heavy government`s subsidising. Even considering the government`s support, since 1970 Airbus was able to overcome the disadvantage of late entry only by 2006, when it was close to breaking even. Thus, it is possible to overcome the disadvantage of a late entry only after a long time and without heavy subsidies from Chinese government the entry will be unlikely.
Newcomers are virtually unable to compete successfully, because of considerable economies of scope and scale and enormous capital requirements. The productivity of Airbus and Boeing models has risen continually over the life cycle of an aircraft model, thus it will be difficult for Comac`s cost structure to be competitive. Because of the competition between Airbus and Boeing, the prices on the market are already quite low and it will be difficult for Comac to keep up. Moreover, cost disadvantage of later market entry still applies. Once a new firm has entered the industry, it will be quite complex to stay on top, because the product requires development and research spending as well as modern engineering expertise. Comac would also struggle with finding customers: Japanese and US airlines are mainly served by Boeing and Europe, the Near and Middle East prefer Airbus. Moreover, in the long run, Comac will have to supply a full family of aircraft in order to stay in the market. Also, current global economic recession is not the perfect time to enter the industry. The uncertainty surrounding the success or failure of developing new aircraft combined with the large amounts of capital tied up mean the existence of the entire company can be jeopardised by a single misstep (high cluster risk) (Deutsche Bank research, 2007).
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