A Blog by Jonathan Low


Apr 9, 2019

How the Bizarre Economics of Airplanes Affects Boeing's 737 Crisis

The reality is that there are only two aircraft suppliers in the world. Airplanes are expensive, take a long time to build - and when airlines buy them, it is with the thought that they will be used for decades based on their passenger demand models.

So while Boeing may be hurt in the short term, this is probably not a threat to its brand - or its continued profitability: because for the airlines and the flying public, there are currently no real alternatives. JL

Joe Pinsker reports in The Atlantic:

Grounding a plane affects the supply of (not the demand for) seats. Airplane are so expensive that once an airline buys one, it wants to put it to use as much as possible.A plane takes a long time to make, a year or longer, and even buying used planes can take a while. “It’s not like they have a bunch lying around." The airplane-building industry  is a duopoly. Airbus’s order book is also not empty. The DC-6 and the Boeing 727 both went on to have “stellar” careers after early incidents. So the 737 Max just might get rebranded. One analyst who follows Boeing closely didn’t see “meaningful long-term risk” for the company.

The U.S. government ordered the grounding of Boeing’s 737 Max airplanes, following similar mandates in the preceding days by dozens of countries after a crash of one such plane in Ethiopia. The hundreds of 737 Max planes previously in service worldwide are all currently grounded.
In many other industries, when a product has a flaw, companies can rely on a range of workarounds, such as other suppliers who can rise to fill the need, or other products that can be subbed in quickly. But because of the airline industry’s peculiarities—from the importance of airlines’ in-advance flight-traffic projections to the extraordinary cost of a single plane—this temporary ban could have far-reaching, hard-to-contain effects.
The grounding will likely hurt Boeing, whose shares are down after the Ethiopian Airlines crash and whose sales might take a hit. It will likely hurt airlines, which now have fewer seats with which to shuttle customers around the country and the world. And it will likely hurt passengers, who might have to adjust their schedule and, in some cases, their spending. But most notable is the scale of it all: Depending on the duration of the grounding, it could cost all involved parties billions of dollars.
Start with Boeing. The price of the company’s stock fell more than 10 percent, which represented nearly $30 billion of the company’s market value, in the days after the crash. One of investors’ worries is that the reputation of the 737 Max—which was also involved in a crash last fall in Indonesia—is now tarnished to the point that it will hurt demand for the plane. This is no small concern: The 737 Max, a jet that costs more than $100 million, is Boeing’s all-time best-selling aircraft, and the company is lined up to sell several thousand more. If airlines cancel their orders, Boeing would stand to lose billions of dollars. (The company did not respond to an interview request.)

Volodymyr Bilotkach, an economist at Newcastle University and the author of The Economics of Airlines, says that if cancellations do materialize, Boeing likely doesn’t have a great Plan B, but neither does anyone else. The airplane-building industry, he says, is an “effective duopoly,” meaning it’s dominated by two suppliers: “There is no way Airbus”—the other half of the duopoly—“will be able to come to the rescue, as that manufacturer’s order book is also not empty.” Indeed, one analyst who follows Boeing closely told Bloomberg earlier this week that his firm didn’t see “meaningful long-term risk” for the company. (Bilotkach says it’s possible that instead of taking their business elsewhere, some airlines might opt for older Boeing-made models with safer records.)
Airlines—Boeing’s customers—are not in a great position either. The primary challenge in the industry, says Clifford Winston, an economist at the nonpartisan Brookings Institution, is how far in advance airlines have to decide how large their fleet should be at any given time. “A plane takes a long time to make,” he says—sometimes a year or longer, and even buying used planes can take a while. Airlines’ task, in essence, is to guess how many people want to go from, say, Nashville to Denver on this day next year, and then buy a bunch of elaborate, $100 million metal contraptions accordingly.
Because airlines’ fleets are assembled according to long-term projections, they might have trouble adapting quickly to events that hurt demand, such as recessions or terrorist attacks.“That’s when they lose a ton of money,” Winston says.
Grounding a certain model of plane, while it affects the supply of (not the demand for) seats, can have a similar effect. Planes are such a big investment that once an airline buys one, it wants to put it to use as much as possible, which means, Winston says, “it’s not like they have a bunch lying around” for situations like this. Basically, airlines are now stuck making the most of what they already have.
Southwest Airlines, for example, is grounding its 34 Max 8 planes, which it says accounts for fewer than 5 percent of its daily flights, and relying on “every available aircraft in our fleet” to carry out its operations. Fewer than 5 percent might seem small, but it can interfere with the delicate capacity-demand calculus that airlines perform months or years in advance. Because the duration of the grounding is unknown, it’s hard to say exactly what damage it will do, but Winston estimates that if the 737 Max planes stay out of service for months, the losses to the industry and passengers “could run in the billions of dollars.” If the grounding ends much sooner, the losses will probably be much smaller. (Southwest told me that it doesn’t comment on financial estimates outside its official earnings updates.)

Southwest isn’t the only U.S. airline with 737 Max planes. American Airlines has pulled its 24 Max 8 planes out of service, which affects about 85 flights out of the airline’s roughly 6,700 daily trips, and United has grounded 14 Max 9 planes (a similar model), which together account for some 40 flights a day.
Winston says that this shortage of capacity draws attention to another quirk of airline economics: Only American carriers are allowed to fly trips starting and ending in the U.S. He’s in favor of extending what are called “cabotage rights” to overseas airlines, one benefit of which would be that they could provide more seats in situations like this, after a surprise reduction in capacity.
Where does all this leave passengers? Winston expects to see airlines cancel some flights and perhaps raise the prices of others to compensate for the lost revenue. That means some passengers might end up spending more to get where they need to go on their preferred timeline; others might just have to be flexible on their departure time, consider another mode of transit, or not go at all.
At this point, it’s not clear how long the grounding will last, and while it is terrible publicity for Boeing, some plane manufacturers have managed to fare all right after their new aircraft has come under scrutiny. George Hoffer, a transportation economist, pointed out to me that the Douglas DC-6 and the Boeing 727 both went on to have “stellar” careers after early incidents. So the 737 Max could yet recover—it just might get rebranded. “My guess is that they will eventually … drop the Max” from its name, Hoffer said. Though the true mark of success would be for the plane’s name to go back to where it was: out of the headlines and mostly unknown to passengers.


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