BA, Lufthansa and the faulty 737

What happened?

In March this year Boeing 737 Max 8 aircrafts have been grounded following two fatal crashes that killed a total of 346 people. Big similarities were found between the two crashes, resulting in investigators implicating the faulty angle of attack sensor triggering the anti-stall system. Boeing has responded by introducing quick software fixes with regulators hesitating to permit the planes to fly again. New orders for the Max 8 have halted since the grounding; however, a surprise announcement from Lufthansa and BA have indicated their interests in placing large orders for the 737 Max.

After Boeing 737 Max 8 aircrafts have been banned from a few major air spaces, Boeing has decided to ground the planes for an undefined timeframe which has now lasted over 6 months. This has led to the cancellation of thousands of flights and a great uncertainty for airlines relying on the new Boeing airplanes.

  • Norwegian has been fighting for survival since 18 of its Max 8 aircrafts have been grounded following the accidents and 92 future planes are now undeliverable. This is putting extra pressure on company’s profitability, largely a result of a dip in passenger numbers.
  • Southwest Airlines are now pulling out of Newark Airport in New York to reshuffle it’s lower capacity to more lucrative markets.

In the last months Boeing has been losing orders from its book at a high pace. Flyadeal has cancelled an order for up to 50 Max 8 planes, with many others facing the pressure from the public to switch to a rival aerospace builder. Utair and VieJet have promised to make a decision following the results of the investigations, not yet ruling out the 737 MAX option. Kenya Airways will either stick with the 737 MAX or may choose to opt for an older version of the plane. Boeing has been shedding orders at a high pace, now down 180 Max 8 planes largely because of cancellations.

Airline market structure

The aircraft manufacturing market can largely be characterised as a duopoly, the real rival to Boeing is Airbus - its European counterpart. Airbus’ counterpart to the Boeing 737 Max 8 is the A320 series planes, another popular narrow-body category jet. Airbus has its order book filled well into the next decade for this engine family. In addition, they have leveraged the unique situation in the last few months, expanding production capacity and taking away orders from Boeing customers. The situation currently looks dire for Boeing, as the safety its most popular plane (80% of order book) is under question and the bad reputation among flyers is kicking in.

What did Lufthansa and British Airways do?

Both Lufthansa and British Airways have recently indicated that they are still interested in placing a large purchase of the 737 MAX aircrafts. Lufthansa’s CEO has made a public statement that the airline has not lost its trust in Boeing and they remain confident the issue will be fixed. This came in the context of the aircraft renewal programme currently taking place at Lufthansa. Boeing on the other hand went as far as signing a letter of intent to order 200 new 737 Max planes, with agreement not yet finalised. Given the negative public reception of Boeing’s 737 Max 8 and concerned passengers cancelling bookings before the planes were grounded, these announcements may seem surprising. However, looking at it from a Game Theory and Bargaining Theory perspective, there may be an underlying logical reasoning behind BA’s and Lufthansa’s statements.

What were the airlines’ options?

As Lufthansa and BA have found themselves in a monopolistic market in the midst of placing a large order, it is forced to improve its negotiation position as alternatives in form of other planes are simply not available. Using the learnings of the bargaining theory, Lufthansa and BA have several options to improve their negotiation positions. Some of the options are to:

  1. … leverage available competition,
  2. … use private information to own advantage,
  3. … set focal points,
  4. … make use of alternatives/improve BATNA ,
  5. … make a commitment

The strongest lever in this setting for Lufthansa and BA would have been to leverage the competition and conduct a total value of ownership assessment . This could allow the company to improve its bargaining position by quantifying non-monetary aspects such as the set-up costs required to operate a new aircraft and other factors. The announcements by Lufthansa and BA combines points 4. and 5. together by making a commitment to an alternative option thereby aiming to improve their BATNA.

Nash Bargaining Solution

Real life bargaining cases can be set up and modelled using game theory. In reality each party engaged in a negotiation has a range of preferences over outcomes and interests. An agreement must be reached so that there is an inherent benefit to both parties; as such bargaining solution should be in an acceptable range for both sides. Nash Bargaining Solution (NBS) provides one possible way of evaluating a bargaining problem. In the proposed model, each party has a utility function to indicate the preferences over the negotiation outcomes. In addition to this Nash has envisioned that there exists a disagreement point, which is a monetary payoff in case no agreement is reached. The NBS answers the question at which exact point both parties would reach an agreement and the solution is proved to be unique. This is done through maximising the product of the individual payoffs over the disagreement points.

In our case, a disagreement point for Lufthansa and BA in negotiations with Airbus would be purchasing the best available aircrafts from another manufacturer – which in this case are the grounded 737 Max 8s. If in negotiations with Boeing the disagreement point (i.e. purchasing A320s) will yield a greater payoff, purchasing aircrafts from Boeing will not be an option. As such, the underlying credibility of the disagreement point needs to be evaluated. Nash then expands the NBS to address some of the constraints of the proposed model. The current solution depends solely on the utility pairs of both parties and the disagreement points. The negotiated outcome, however, can be influenced by other factors such as information structure and the players’ discount rates. It thus seems reasonable that such factors may significantly affect the negotiated outcome.

Player’s discount rates can also be interpreted as impatience that can be exploited by the other party. Boeing in general is more eager to strike a deal that the airlines and such “poverty” of inducing a greater level of impatience negatively affects the bargaining power. This is for example mirrored in international trade negotiations where more prosperous nations can strike better deals when negotiating with a poorer country. Thus the extended model of asymmetric NBS increases the bargaining power of the airlines in direct negotiations with Boeing. The model introduced above is useful for conceptual understanding and analysis of the situation, however a practical implementation is largely limited. This is due to difficulties in obtaining enough information to map out feasibility sets, utility functions and disagreements points.
As it has been shown through the NBS, airlines are weakly positioned to negotiate with Airbus using Boeing 737s as leverage. In reality the threat of purchasing the faulty airplanes can simply not be credible enough to Airbus and may only marginally improve the bargaining position of the airlines (if at all). The main question that arises in the outlined negotiation is whether the BATNA in question is in fact a credible alternative.

How credible is Lufthansa’s threat?

Credibility of BA’s and Lufthansa’s threat is under question as the 737 Max 8 grounding now continues for over six months. A verbal commitment that both airlines have issued can only be classified as partial as it can easily be revoked (while the reputation costs of future negotiations with manufacturers need to be taken into account). As such Airbus now needs to decide whether the airlines’ threat to bring Boeing into the negotiation is credible.

To understand the credibility of Lufthansa’s threat, Airbus needs to have an in-depth knowledge of the issue and be able to forecast the urgency of the potential order placement in order to receive the aircrafts on time, after the airline disposes of the old planes. Airbus has a degree of control over it, due to the backlog of current orders piling up, it may request that airlines place orders ahead of potential clarity on the 737s. In this case, by not ruling out Boeing airlines may in fact not have improved its negotiation position if Airbus believes that the threat is not credible.

Lufthansa’s and BA’s fleet mostly consists of Airbus models for short-, medium, and long-haul range. The only Boeing model that Lufthansa operates for example is the flagship 747 jumbo jet. As an airline predominantly using Airbus aircrafts, Lufthansa cannot possibly change its fleet to Boeing planes without incurring considerable costs. This commonality of planes raises the concern as to how willing Lufthansa and BA really are to place orders for the currently grounded 737 Max models. The inherent problem of high switching costs may come as one of the factors affecting the credibility of the airlines’ threat towards Airbus. As of today, all of Lufthansa’s and BA’s narrow-body fleet are from Airbus. Should the airlines make a switch to Boeing, it will have to incur a significant direct cost in the form of costly retraining of pilots and hiring new pilots with the experience of flying the 737s. There may additionally be hefty hidden indirect costs such as more costly maintenance and scheduling tasks.

Other costs less obvious costs may also need to be factored in. Looking at the passenger panic the ensued the second 737 Max plane crash, it is fair to say that an airline considering or placing orders for the Boeing narrow-body aircrafts will be losing a fair chunk of the customer base. The reputation effect of flying the Max 8s may lead to a gradual reduction in demand and need to be weighted in the decision. Other indirect costs such as the costs of rebooking fearful passengers onto different flights may also start piling up. This is in addition to possibly much larger costs arising from greater inherent risk of flying the new model in the initial stages, that may also translate into higher insurance payments.

Meanwhile Airbus has indirectly improved its bargaining position with all other customers, as deliveries planned to be released by Boeing are now delayed. This means that the bargaining power has disproportionately shifted in favour of Airbus, with the company struggling to meet an ever-increasing backlog of orders. The backlog was recently made “worse” with a newly placed bumper deal from China for 290 narrow-body A320 jets.

It is safe to assume that both Lufthansa and BA have found themselves in a lock-in position with Airbus in the narrow-body category. Considering that the threat from the airlines towards Airbus lacks credibility and the airlines do not have clear outside options, BA’s and Lufthansa’s attempt to highlight the BATNA should not improve their resulting negotiation power with Airbus.

Ayrat M
Strategy Consultant

Expert for commercial applications of game theory, industrial economics, mechanism & market design.