Commentary: Kirthank: Boeing Airbus price war duopoly

Graphs - Kinked Demand Curve, Economies of Scale

Airbus and Boeing are duopolistic firms that produce airplanes. Airbus

and Boeing are currently in a price war, in order to gain market share past that of

the traditional 50-50/45-55 market share. Airbus is currently the number one

airplane firm, with exceptional sales on their A320neo plane. Both Boeing and

Airbus enjoy similar market share, and the consumers’ preference is generally 50-

50%.

Whether Boeing or Airbus started the price war is not clear, but their

situation can be shown in a kinked demand curve

:One firm lowers price, other reacts by making it cheaper (oligopolistic

kinked demand curve):

This does not benefit consumers as plane ticket prices will be significantly

increased, as both companies will have to make up for the lost revenue in the price

war. Both Airbus and Boeing do not benefit from this current decision in the short

run, as they are lowering their average revenue, which could harm the company

badly. However, in the long run, if one firm is able to drive the other down to a loss

(as the average revenue will be lower than average cost of building a plane leading

to less output), then that firm will be able to gain significant market share, and

potentially gain monopolistic market power. This can be applied to the game

theory. Neither firm will collude (as it would become a monopoly, which would

restrict the market). If one firm cuts the price, the other firm can either decide to

lower their price and AR to increase sales by a small amount, or keep price the

same, leading to loss of consumers.

Moreover, by earning market share past the normal 45/55, then that firm

will be in an economies of scale, coming away with high efficiency and beneficial

experience.

:Economies of Scale Graph:

By surviving a price war, either Boeing or Airbus will have maximized efficiency.

Because AR is decreasing during the price war, both firm will have to cut labor and

variable costs. They will cut workers they find not performing to maximum

efficiency. By the time the price war is over, the remaining firms will have cut down

their average variable cost down to only that which is necessary, and have a

smaller yet more efficient labor force. This allows them to survive better for future

price wars, thus making it a long run benefit. This experience allows them to

allocate their labor force more efficiently, and in preparation for future competition.

In the short run, by minimizing variable cost, it also minimizes average cost and

operating loss the firm faces during the price war.

As Boeing and Airbus are now in a price war, they cannot stop now. This

means that this is the only future action they can take that can be predicted as of

now. If they continue, I would suggest to cut down on variable costs, as while it

may not benefit workers, it will allow one or both firms to gain more maximum

efficiency at the lowest cost. This would not benefit consumers, as the AR of both

firms will decrease with the price war, leading to higher priced plane tickets to

make up for the loss. It will not benefit the government as they get less room to

intervene, as taxation is limited. Overall, this action will benefit both firms in the

long run, as one or both will gain efficiency, more experience to overcome future

competition, and lower variable costs at the end of the price war. It also allows

them to operate at the maximum efficiency at the lowest variable cost possible. In

the short run, however, it reduces AR, meaning that both companies have the

potential to operate at a loss, and more consumers will have to pay the burden that

both firms face.

Duopoly market

 is a market condition in which only two firms have dominant controlover a market,

they own all or nearly all of the market for a given product or service. Aclosely

related concept is a monopoly, a situation in which a single company dominates

themarket. A duopoly is the most basic form of oligopoly (a market dominated by a

smallnumber of companies). Boeing and Airbus have been called a duopoly for

their command ofthe large passenger airplane market; in just the same way as

Cola and Pepsi dominates thefizzy drinks markets.This case study shows a perfect

example of duopoly market detailing the intensity of thecompetition between the

two dominant companies in the Civil aviation and aircraftmanufacturing industry

(Boeing and Airbus). The paper also presents facts, figures andcomparisons of

sales and orders for both companies for the period between 1996 and 2006

(Exhibit I and II).

After Lockheed Martin pulled out of the airplane production business inthe early

1980s and McDonnell Douglas (a major American aerospace manufacturer

anddefence contractor) merged with Boeing in 1997, only Boeing and Airbus were

left tomanufacture the largest commercial airplanes

Only Two firms in the industry

The industry of airplane manufacturing is highly capital-intensive due to the great

demandfor expensive technology and the need for highly skilled expertise.

Success and survival ofaviation companies is also linked to available support and

subsidies from respectivegovernments, which gives clues as why the Civil aviation

and aircraft manufacturingindustry is mainly concentrated in the affluent United

states and Europe? And why thereare few new non-major market entrants.

 

 The 787 Dreamliner, developed by Boeing, is a long-range, midsized, wide-

body,twin-engine passenger airliner. As in terms of capacity, it is meant to be a

complement to777 rather than a competitor The A350 XWB (extra wide body) is

Airbus’ response toBoeing’s Dreamliner, it competes with the high end of the 787

and the low end of the 777 markets. The design for the new Airbus 350 is an

improved version of the A330, started inresponse to Boeing presentation the

Dreamliner 787

. In 2006 Airbusbegan to consider a wider body, a larger wing, more powerful

engines, a higher cruise speedand many other changes to satisfy the airlines. So,

Airbus presented the A350 XWB withentirely new design. The new A350 looks

radically different from any previous twin-aisleAirbus. The new wider Airbus A350

XWB body will enable the plane to accommodate slightlywider economy seats than

its rival. The new design maximizes usable volume by having aconstant cross-

section from door one to door four.

Adaptability to change:

 

The goal of 787 Dreamliner’s design team was to build a

revolutionary aircraft to offer a revolutionary flight. According to Boeing, the design

teamstudied commercial flight very carefully to identify how this airplane could

strengthen theaviation business. The 787 Dreamliner is designed to carry

passengers for at least 30 years.During that period, interior styles will likely to

change several times. Seats, lavatories,galleys and in-flight entertainment systems

all has been designed to easily accommodateupgrades and replacements. Design

team worked with cabin component suppliers todevelop standard mounts and

interfaces that will enable quicker and more economicalmodifications. This way,

airplane owners can expect higher lease and resale valuesthroughout the

787 Dreamliner’s lifecycle

 

Fuel efficiency:

787 Dreamliner is more fuel efficient than comparable earlier airliners, it isthe first

major airliner to use composite material for most of its construction (in addition

toadvanced aluminium alloys), making it lighter for its capabilities. Because

composites do notsuffer fatigue from repeated stress the Dreamliner can be

pressurized to the equivalent of6,000 feet of altitude.A350 airframe will be built of

weight-saving advanced materials like carbon fibre-reinforcedplastics (CFRP) and

aluminium lithium alloys, according toWide body Aircraft Parade. Thenew aircraft

will be the first Airbus product with an all-composite wing. The rear fuselageand the

tail cone will be constructed from composites, as well. Boeing intends to make

50%of its 787 Dreamliner out of hardened plastics and therefore lighter and more

fuel efficient.Airbus has been planning to build much of the A350 with aluminium

alloys.

 

Noise-Reduction:

Boeing experimented with several engine noise-reducing technologies forthe 787.

Among these are a redesigned air inlet containing sound-absorbing materials

andredesigned exhaust duct covers whose rims are tipped in a toothed pattern to

allow forquieter mixing of exhaust and outside air

.

Engine:

the new A350’s engine

s will be more advanced than those on the 787 with thrustranges between 75,000

and 95,000.The primary goal of all of this design-related function is to promote

passenger comfort,make the journey direct, simple, cost effective and comfortable.

Also for the aircraft to:

 

Limit environmental pollution

 

Produce less noise

 

More space

 

Lighter and fuel efficient

 

High lease and resale value

 

Changeable interface

.

 

that two-actor markets willeventually evolve into a one dominant technological

logic. But this is not always the case.This paper shows that in the aircraft industry,

firms are obliged to deal not only with hightechnological barriers, but also growing

financial and market barriers. In order to reducethese, a complex network of

relationships has developed over time. This network involvesboth main firms

belonging to the world oligopoly and firms capable of offering

specialisedtechnology and/or a potential broadening of the market. The result is a

worldwideproduction organisation.In regards to the commercial aircraft market,

economists predicted the duopoly market willcontinue between 2007 and 2016.

The estimated Boeing and Airbus production share is 56%and 43% respectively

and the remaining 1% is shared between Russian companies andUkraine. Despite

these predictions there are signs of

possible threats from various new entrantsto the current duopoly

. Growing international competition is emerging from markets inChina, Brazil and

Russia, also from Bombardier Aerospace which is competing for a marketshare

from Airbus and Boeing. According to economist experts, China has gained

adequateexperience and competence to challenge the duopoly and is planning to

build a wide bodyaircraft along with Russia. Both

Post-Paris Air Show and the Dubai Air Show held in 2007 hasmarked a growing

global competition in the commercial aircraft market.

Regardless of global attempts to enter the market, Boeing and Airbus will remain

the twobiggest players for the foreseeable future because they enjoy: long

experience, advancedtechnology, government support, loyal clients, network of

suppliers and resources. Buteventually the rising global companies will gain shares

in the market and transform it tooligopoly market.

History of trade dispute between Boeing and Airbus: An

overview

Until 1980, US commercial aircraft industry enjoyed a de facto

monopolistic position in the world market, despite the European-based

Airbus Industry having come to exist in 1970.2 The US dominant

position, with two US commercial aircraft manufacturers, Boeing and

McDonnell Douglas together, accounting for more than two-thirds of the

world market share, continued till as late as the mid-1990s. With Boeing

deciding to acquire McDonnell in 1996, it was expected that the position

will improve further. Surprisingly, this formidable position came to be

challenged by Airbus, which since 1981, contrary to its initial perception

of having been regarded as only a marginal competitor, was

progressively increasing its market share. By early 2000s, Airbus was

consistently garnering a larger share of new orders than Boeing, and in

2003, it even surpassed Boeing for the first time in deliveries of aircrafts

(305 deliveries by Airbus as against only 281 by Boeing).

* The author’s review of the Boeing-Airbus trade-dispute is mainly based

on the details of the case specified in Hill (2005)1

The phenomenal success of Airbus was not received well by many

in the US who attributed it to the fact that it was due mainly to the huge

subsidies it received from the government. This was followed by a chain

sequence of accusations and counter-accusations. Somehow, under an

agreement in 1992, the two sides agreed to make some allowances to

each other. The agreement allowed Airbus to receive some launch aid

from EU governments (Great Britain, Germany, France and Spain), and

Boeing to benefit from government R & D contracts. Under the

agreement, direct government subsidies were limited to 33 per cent of

the total costs of developing a new aircraft with the condition that such

subsidies had to be repaid with interest within 17 years. But the

agreement did not last long. In 1997, the agreement broke down when

the European Union decided to challenge the merger between Boeing

and McDonnell Douglas on the ground that it limited competition.

Boeing’s plea was that the merger was necessary to strengthen its

presence in the defense and space side of the aerospace business areas

where McDonnell Douglas was traditionally strong. After the two sides

listened to each other, the dispute between the two appeared to have

settled. But soon after, the Airbus executives, who had initially stated

that they had no objections to the merger, gradually started opposing

the merger again and became increasingly vocal in their

pronouncements. Trade tensions between them erupted yet again in

2004. This time, the US questioned the appropriateness of Airbus

receiving the launch aid even as it had consolidated its position in the

world market. To this the Airbus responded with the accusation that

Boeing was still benefiting from subsidies. No break-through was seen in

the dispute. To add fuel to the fire, the British government decided to

announce even a fresh dose of aid ($ 700 million) to the Airbus in mid-

2005. The US dissatisfied with these developments formally filed a

request with the WTO for establishment of a dispute resolution panel.

The EU, on its part, quickly reacted and filed a countersuit with the WTO

claiming that US aid to Boeing exceeded the terms set out in the 1992

agreement.

Main issues of contention and their merit

Looking back at the history of trade dispute between Boeing and

Airbus, I may summarize and comment upon the main grievances,

arguments and counter-arguments of this case as follows:

The most convincing grievance of Boeing (which was consistently

losing its business to Airbus) was that Airbus received huge subsidies,

between 1970 and 1990, in the form of loans at below-market interest

rates and tax breaks which together amounted to $ 25.9 billion. This

benefited Airbus in two major ways. One, its R&D became a highly

subsidized, hence, a high-voltage innovative program with extremely

favorable cost and quality implications, and thereby, a competitive edge

in the market. Two, it also provided a financial base to the Airbus which

was strong enough to enable it offer its aircrafts to its customers on

highly attractive terms of credit – credit to the extent of 80 percent of

the aircraft cost for a term of 8-10 years, at approximately 7 percent

interest rate. This was quite in contrast as compared to the credit

provisions in the case of Boeing. The US Export-Import Bank supplied

credit for purchase of Boeing and McDonnell Douglas aircrafts – 20

percent down payment, and credit against only 40 percent of the aircraft

cost, the remaining 40 percent to be financed by private banks at an

average interest rate of about 8.5 percent for a period of 10 years.

Apparently, the two competitors cannot be said to be on a level playing

field with regard to the availability of credit support to their marketing

efforts. But there is other side of this issue, as well. a little reflection on

which would tilt the scale in favour of Airbus. We will turn to it a little

later. Let us first see what the contention of Airbus was in this regard.

The main reaction of Airbus to the said objection of Boeing was

that its success was not due basically to the subsidies it received, but to

its state-of-the-art technology, and strategic production and marketing

vision. Strategically, it concentrated initially only on market segments

not served by new aircraft or not served at all. As this position of Airbus

appears to be based on facts which are of objective nature and

verifiable, the grievance of Boeing, expressed in the disguise of unequal

credit terms, is possibly the expression of disgust over its failure to

protect its market share and retain its hegemony in the market. Even

otherwise, the main issue of trade rift between the two cannot be said to

be the government aid. If Airbus received subsidies, so did Boeing, too.

If at all, the blame with regard to the subsidy controversy lies with any

one, it lies first of all with Boeing, and then with the governments, on the

two sides.

If we evaluate and compare the subsidies availed by Airbus and

Boeing, there is a major difference between Airbus subsidy and Boeing

subsidy. The Airbus subsidy has been in the form of repayable loans with

interest for aircraft development, which is legal according to the World

Trade Organization. The Boeing subsidy, on the other hand, has been for

aircraft production, which is prohibited by the WTO and which is never

required to be paid back. This fact is duly supported by a research

conducted at the Canada-United States Trade Center in the UB

Department of Geography3. If someone is to lose the case on this

ground, it is Boeing. Is Boeing ready to payback the subsidies and accept

self-financing arrangement to cover for the areas funded by subsidies?

Secondly, it is quite intriguing as to why government aid continues

to be allowed even after these giants have matured enough to be able to

find out to stand on their own strength. To me no argument (in favour of

any further continuation of aid) - employment-based, or BOP-based, or

even the one that derives its strength in the name of national pride - is

acceptable to me.

Watching this episode from heaven, Hamilton and List, would have

wondered over the wrong empirical side of the Infant Industry Argument

they put forward in support of players competing on unequal levels!

According to the infant industry argument, it makes sense to extend

temporary support to such domestic industries which are crucial to the

general wellbeing of the people of the country and which cannot

compete with its giant competitors for want of level playing field. It is a

historical fact that the world’s three market economies - USA, Germany

and Japan - all began their industrialization duly assisted by their

respective governments through various types of trade barriers. This

argument seems fine, highly plausible and convincing. Many

governments have seen merit and conviction in this argument. But there

are instances when governments, both in developed and developing

countries, have made its extensive use to defend their, otherwise

unjustifiable, anti-free-trade policies.

Protectionist measures, tariff or non-tariff, are justifiable only as a

temporary support. But experience has shown that in most countries,

the shelter behind these restrictive trade practices became mostly a

perpetual phenomenon (look at the classical case of agricultural

subsidies in India). Subsidies, beyond a particular stage, may do no good

if these fail to make the industry really competitive and self-reliant. Even

after decades of basking under the comfort of subsidies, both Boeing

and Airbus, and sadly, even their respective governments, still continue

to regard their continuation indispensable.

The following are the main arguments that have been put forward

in support of continuation of subsidies, in this case:

High development costs: The costs of developing a new

airliner are estimated to be between $ 5 billion to $ 15 billion

for various categories of aircrafts.

High break-even level: Given such enormous development

costs, a company must procure a substantial market share

to break-even. It has been estimated that the break-even in

the case of commercial aircraft industry may not be

expected before 15 years or so, given the demand and

production projections.

Volatile demand: The commercial airline business is prone to

cyclical behaviour. As experience shows, in the recent past,

many major airlines suffered from falling demand and went

bankrupt, although there were other, less important,

reasons, too.

Substantial experience curve levels: In aircraft industry, a

significant experience curve exists on the manufacturing

side. It has been estimated that the positive economies,

induced by experience and learning acquired during

sustained production tempo, produce a significant reduction

in unit cost – with doubling of accumulated output the

company enjoys a unit cost advantage to the extent of 20

percent. Conversely, it means that if a company achieves

only half of the market share required to break-even, it will

suffer a 20 percent cost disadvantage.

There can be hardly any dispute with the merit of these arguments.

But one thing is not clear. If the two commercial aircraft companies are

expected to be competitive and profit-making in the long-run by their

respective governments, and further, if they are regarded worth

developing through subsidies and other protectionist measures, why

should the government not leave them to the total care of the private

sector; why should it assume any responsibility for itself, in this regard?

To counter this suggestion, it may be argued that the investment

involved is on an enormous scale, and for a long period, and above all, it

is exposed to the adverse effects of demand uncertainties. This

argument surely is not convincing. If at all, it implies any thing it is as

follows: Only the productive resources owned by the private sector have

an opportunity cost, so do not let them be wasted. The resources at the

command of the government are no body’s money (the tax-payer!), so

why care for their opportunity cost. Moreover, the argument that private

investors take into account only the current returns in an industry and

fail to take account of the future prospects is not consistent with investor

behaviour in advanced countries, particularly where the latter are often

observed to back projects whose returns are uncertain and lie far in the

future. (Consider, for instance, the US biotechnology industry, which

attracted hundreds of millions of dollars of capital years before it made

even a single commercial sale)4.

Reality of the situation

On the strength of these arguments, one would tend to agree with

the view of the analysts in this area that the world market for

commercial aircrafts can at the most support the presence of three

major producers. In my assessment, recognition of the oligopolistic

nature of global commercial aircraft market must be accompanied by

acknowledgement of the self-defeating outcomes of individually-

centered, non-collusive strategies adopted by firms in such industry.

This is what Boeing and Airbus has to learn from Cournot’s model in

which oligopolistic firms are portrayed behaving in an extremely naïve, if

not stupid, manner, and never learning from their past mistakes. As a

result, they finally land themselves in a collectively disadvantageous

position. In such case, respect for mutual interdependence and acting in

a coordinated way is in the interest of both. More or less, similar are the

implications of other non-collusive behavior models, for instance,

Stackleberg’s model (the leader-leader case).

Conclusion

The substance of this review of the case, in question, is that firms,

such as Boeing and Airbus, operating in an oligopolistic market

environment should not be ‘misled to be competitive’ by way of granting

legitimacy to their clamour for subsidies, direct or indirect. This is

patently unjustified. This amounts to frittering away scarce productive

resources for which policy makers owe an explanation to the tax-payers.

The sooner the two giants in the arena of global commercial aircraft

market see the writing on the wall and adjust themselves to the reality

of the market scenario and assimilate its culture of co-existence (in

terms of leadership acceptance, or market sharing, or adopting limit-

pricing behaviour so as to keep potential entrants at bay), the better it is

for them and their countries. In no way, this perception may be

construed to imply a competition-limiting approach. The fact is that in

this particular case, any attempt of acquiring a competitive edge by one

side on the other is most likely to induce a chain sequence of actions

and counter-reactions, arguments and counter-arguments. Ultimately, it

is detrimental to their own interest as well as to the interests of their

customers. Both Boeing and Airbus spend billions of dollars for buying

aircraft parts and sub-assemblies such as avionics and landing gears. So,

frequent trade war can be more deteriorating than just affecting the

airline customers. In any dispute between two parties when

insinuations and allegations replace logic, when the mediator

(like grievances-redressal mechanism of the WTO) lacks the

necessary teeth to ensure compliance of its norms and rulings,

and when even the governments lose objectivity and vision,

solutions are not easy to seek. Given, sincerity of purpose and

sagacity, the solutions are not difficult, either.

U.S should explore the options of expanding its target market to other

emerging foreign markets like Vietnam and Iran5. Current export

controls in U.S. prevent Boeing from entering these markets. They also

affect Airbus sales through re-export constraints. Airbus can lower the

U.S content by the introduction of Rolls Royce engines in place of the

manufactures Pratt and Whitney and General Electric. The two

companies should look for ways of comparative advantage by looking at

the use of cost effective and more specialized products and services

produced by other country to bring in operational efficiency through

scale economies. For example, Western Europe holds a competitive

advantage with respect to Wind Tunnel capability.

References

1. Hill, Charles W. L. (2005), International business: Competing in the

Global Market Place, Mcgraw-Hill.

2. http://ec.europa.eu/trade/issues/sectoral/industry/aircraft/

index_en.htm)

3. http:// igeographer.lib.indstate.edu/pritchard.pdf

4. Krugman, Paul R. (2003), International Economics, Pearson

Education, Inc.

5. Global Competitiveness of U. S. Advanced-Technology

Manufacturing Industries- By DIANE Publishing Company