Network effects for asset-heavy businesses
Every week we hear of a new incident involving ridiculous customer service by a major airline. At a time when conference attendees are inundated with talks on customer-centricity, it may seem surprising that large legacy airlines, especially in the US and in Europe, continue to exist and thrive unchallenged despite poor customer service. In many ways, the airline industry has been immune to threats from upstarts.
Like most industries, the legacy model of the airline industry did get threatened with the rise of the Internet. For one, travel agents lost their choke point over market access, allowing smaller airlines to come in without having pre-established relationships with travel agents. But smaller discount airlines, despite gaining market share and even expanding the market, have failed to pose a significant threat to legacy airlines. Less nuanced arguments point to the strength of frequent flyer programs as one of the factors enabling the continued power of legacy airlines. However, frequent flyer programs overtly favour only the premium users of an airline, and cannot be the reason for the continued success of legacy airlines.
Instead, the answer lies in strategic choices of network structure.
At a time when digital platforms leverage massive demand-side economies of scale to disrupt entire industries, the airline industry continues to resist the acts of upstarts by developing massive supply-side economies of scale. Ironically, the very network dynamics that digital platforms use to build demand-side economies of scale are also used by airline companies to build supply-side economies of scale. The scale advantages prevent emerging competitors from unseating established rivals despite offering better pricing and/or customer service.
I am not an airline industry insider, I am merely a network dynamics enthusiast and a super-frequent flier. And through this article, I propose that framework to help understand power structures in the airline industry.
The key to understanding the entrenched scale advantages of massive airline companies lies in understanding the hub and spoke model that has been developed in the airline industry. The topology of hub and spoke models is that of a decentralized network where multiple nodes which act as hubs – in this case, airports — are connected to smaller nodes through spokes.
There are several factors that make this network structure a strategic choice for airline companies.
1: The importance of super nodes
The first factor involves the importance of super nodes. These are nodes on the network that have much higher connection density and hence much higher network power. In the case of the airline industry, these are the hub airports.
First, hubbing concentrates massive market power with the hubbing airline. The hubbing airline, for example, Singapore Airlines at Singapore Changi airport, controls a large share of the flights in and out of the hub airport. this, alone, can give the airline significant power over competition to increase fares on flights originating from the hub.
Second, an airline that is dominant in this manner at the particular hub also has higher negotiating power over any future plans to bring in other airlines, and introduce new routes, at the airport. This further limits the rise of new competition at the hub airport and allows the airline near-monopolistic control of specific routes.
Finally, airport capacity does not increase all that often. As a result, this negotiation power can have lasting impact.
2: Cross-Subsidization across the network
Control over the hubs explains how large airlines exert influence over the routes that involve hubs. Predictably, smaller upstarts which fail to get control of the hub work on the routes between smaller airports.
However, scale again plays an important role over here. Legacy airlines that operate across a large network of routes are able to engage in predatory pricing on routes where the upstarts are coming up. They are able to subsidize these routes owing to their ability to capture higher prices on their main routes. Hence, control over the hubs helps these airlines dominate not just the flights involving the hubs but also flights between smaller airports. Small airlines with a smaller network are unable to price as competitively because they do not enjoy this form of cross-subsidization. Quite often, smaller airlines burn through cash and move out of the market, allowing incumbents greater control across the network.
There is a third way in which large legacy airlines exploit network structures to their advantage. While smaller airlines operate on a point to point system, larger airlines exploit the hub and spoke system to create multi-point flights.
A large airline can provide frequent flights to and from small cities by combining travelers originating from multiple sources and moving to multiple destinations on a smaller number of total flights, as long as the flights are routed through the hub. A point-to-point system would require a larger number of total flights to serve the same network of small airports. As a result, the hub and spoke system enables many more flying options and much more frequent flights than is possible through direct flights. Combined with cross-subsidisation, the economics of operating these flights is also more efficient.
In this way, the same structural factors that create demand-side economies of scale for today’s large digital platforms continued to strengthen legacy airlines by creating supply-side economies of scale for them. Rounds of consolidation in the airline industry have only strengthened these hub and spoke models, making it all the more difficult for smaller airlines to come in and compete.
It takes a network to fight a network. And smaller airlines with point-to-point network topologies are unable to sustain their fight against larger airlines with hub and spoke network topologies.
Interaction failure and multihoming costs will determine winners in the war for the next big platform