article review on "trouble in the air"

This article is on the same issue of our recent DRQ, so I think it may be interesting.

Trouble in the air
Apr 17th 2008 From The Economist print edition
The merger of Delta and Northwest is driven by fear as much as hope

DARKENING economic clouds, oil at $114 a barrel, cut-throat competition and disappearing credit lines are confronting airlines with their biggest crisis since the dark days after September 11th 2001. It is a measure of the panic sweeping the industry that Delta and Northwest said this week they would push ahead with their $3.6 billion merger to create the world's biggest airline by traffic. Previously both firms had said that gaining agreement with their 11,000 unionised pilots over pay and conditions was an essential pre-condition to the deal. Yet even though Northwest's pilots remain bitterly opposed, due mainly to unresolved seniority issues, the two airlines have decided to take the risk of a potentially long-drawn-out and fractious integration of their operations because they calculate that a merger is their best chance of survival as the industry's woes deepen.
In the past few weeks, four smaller airlines in America—Aloha, Skybus, ATA and Frontier—have filed for bankruptcy. Maxjet, an all business-class transatlantic airline, went bust in December; its rival Silverjet is desperately looking for a buyer. Oasis Hong Kong, a pioneer of low-cost long-haul services, abruptly collapsed on April 9th. Alitalia may experience a similar fate unless a takeover by Air France-KLM, sabotaged by unions and Italy's newly elected prime minister, Silvio Berlusconi, can be revived. Nothing links these airlines, which span every conceivable business model in aviation, other than their inability to cope with the brutal economics of the business, especially the near-doubling of fuel prices in the past 18 months.
Delta and Northwest are not yet in such a hole, but having only recently emerged from Chapter 11 bankruptcy protection themselves, they know that time is not on their side. After a strong recovery by America's airlines in the past few years, profitability has fallen fast this year. And balance sheets are still weak, even at the big network carriers. IATA, the international organisation that represents the industry, observed last September that American carriers were “vulnerable to shocks”—and that was when oil was at $67 a barrel and the credit crunch had yet to bite. Adding to that vulnerability is the realisation by America's airlines that there is little, if any, fat left to trim if they stay as they are. The industry has reduced its workforce by 39%, cut wages by 30% and defaulted on pensions to the tune of $20 billion.
The first paragraph briefly tells us some reasons pushig the two airlines to integrate. One is that economic recession in the US that causes decrease in demand. Competition with other airlines further decreases the quantity of air tickets sold by the two airlines. Rise in oil price increases the cost for each flight. These are some vital factors for airline as we can see from the second paragraph that four smaller airlines have filed for bankrupcy. Smaller revenue minus larger cost will definitely result in a much lower profit. The two airlines are both making losses, that's why they need to merge to reduce the cost of production in order to survive during the tough time for this industry. As setting up an airline company involves very high cost, the company usually can enjoy substantial internal economic of scale. Both airlines expand their scale of production by merging, hence their total fixed cost can be spread over a larger output to achieve cost saving. Moreover, the two airlines can save through rationalisation which reduces repetition of some operation procedure and staff. As we can see from the third paragraph that the whole industry is saving wherever it can, cutting down cost is the only solution for airlines. The first paragraph also points out the main issue needs to be settled for a successful merger is "gaining agreement with their 11,000 unionised pilots over pay and conditions".

To make matters still worse, as carriers elsewhere in the world ordered around 7,000 new, fuel-efficient aircraft in recent years, those fragile balance sheets meant that American airlines sat on their hands. Delta has 117 McDonnell Douglas MD-88s with an average age of 18 years; Northwest soldiers on with more than 90 DC-9s with an average age nudging 40 years. These planes are up to 40% thirstier than their more modern counterparts, a crippling burden given the price of fuel. They are also more difficult to maintain—as last week's grounding of American Airlines' similarly elderly MD-80s highlighted.
Delta and Northwest have little scope to cut front-line staff or replace their ageing fleets any time soon—production lines at Boeing and Airbus are fully booked until 2012. But they think they can secure cost reductions of about $1 billion a year by centralising their back-office operations and cutting management jobs. They also hope to boost revenue by combining route networks and strengthening their appeal to lucrative corporate customers.
These two paragraph explains in more detail how the rise in fuel price gives extra burden to Delta and Northwest. Delta and Northwest have aircrafts with an average age of 18 and 40 years respectively. They are much more fuel consuming than the new and fuel efficient aircrafts being used in other airlines around the world. Moreover, the two firms need to spend a lot on the maintance of these old planes. These are the two main sources of their high cost of production. As they are not able to obtain new aircrafts before 2012, they intend to increase revenue by "combining route networks and strengthening their appeal to lucrative corporate customers" in the short run. I think ordering new fuel efficient aircrafts is definitely part of their long term plan to remain competitive in this industry.

Other American network carriers are watching closely. A similar tie-up between United and Continental, the second- and fourth-biggest, is under discussion, and American, the largest carrier, waits menacingly on the sidelines. Northwest's attempt to merge with Continental was blocked in 1998, but regulatory approval is more likely this time, given the lack of route overlap between Delta and Northwest. The prospect of a union-friendly Democrat in the White House next year is a further spur to getting deals done quickly.
The assumption in the industry is that consolidation will result in stronger airlines. That is probably true, but difficulties remain. As long as the barriers to new entrants remain absurdly low, intense—even suicidal—competition will persist at home. On international routes, “open skies” liberalisation is an opportunity, but the superior financial clout and modern planes of the big European network carriers, such as Air France-KLM and Lufthansa, are a threat. For hard-pressed airline managers with the urge to merge, relief is more likely to be fleeting than permanent.
The second last paragraph states some reasons for the merger is possible to be done quickly. In the last paragraph, the author points out that merger is only a "fleeting" solution for the airlines as both domestic and international competition remain fierce. The author says that "the barriers to new entrants remain absurdly low". Barriers to entry are a combination of obstacles that deter or prevent new firms from entering a market to compete with existing firms. If the barriers are low, basically a lot of new airlines can enter the market easily. This reduces the market share of the existing airlines and makes it harder for them to survive.