An Academic Theory of Airline Industry Woes

An NBER working paper seeks to explain airline financial difficulties through changes in price sensitivity of travelers, as well as a shift in costs and preferences favoring non-stop flights over connections through hubs. A non-gated .pdf version of the paper can be found here. (Hat tip to Tyler Cowen.)

Ultimately I think it does a good job in demonstrating price sensitive consumers, and less well demonstrating changes in consumer preferences.

The paper appears to contain some factual inaccuracies — I’m a staunch critic of much so-called security regulation, but it hasn’t measurably increased baggage handling time on connecting flights. Meanwhile, the paper is correct that connection times have grown, but that’s a function of ‘de-banking’ hubs to spread labor costs evenly throughout the day rather than having peaks and then paying workers to wait around for the next bank of flights. The majors learned from low cost carriers like Airtran, shifting to a model of customers waiting on planes rather than planes waiting on customers.

The paper attributes lower costs of regional jets as a driver of point-to-point flying, and much of those lower costs attributable to labor. This is both misleading on the cost side, and misattributes the cause. Regional jets have lower absolute costs than larger jets, which does make it possible to fly point-to-point in some markets. But the per-passenger costs tend to be higher.

That’s why Independence Air, initially an all-regional jet airline hubbing at Washington-Dulles, failed. Their business model was to be a low fare carrier but found themselves operating with higher average seat mile costs than the majors.

Meanwhile, the reason that regional jets had lower labor costs was because of pilot union contracts at the major carriers — airlines tended to be permitted under their contracts to farm out regional jet flying to affiliated “express” carriers, though the extent to which they could do this was often limited in number or proportion to their mainline fleet (“scope clauses”).

There’s nothing inherently lower cost about pilots flying regional jets, it’s purely a function of labor contracts. Flying was pushed towards these jets to avoid overpriced labor contracts, many of which were being renegotiated in the bankruptcies the paper points to.

It’s also odd to posit a declining hub premium and at the same time an increasing premium for non-stop flights and greater frequency, since those two attributes are precisely the features of large airline hubs. I what’s really going on is a flattening of fares. That may only continue through the current financial crisis, as premium class travel is collapsing between major financial centers like New York, London, and Tokyo.

The idea that ‘peoples’ preferences changed’ rather than ‘people make different decisions in light of different product offers’ is an odd one, and one that the data in the paper doesn’t really seem to resolve.

Sure, consumers may exhibit higher bookings of non-stop flights at a higher price. But there are fewer connecting flights with downsized capacity. And with higher load factors, individual segments are harder to book at a cheap price as a connection and fewer backup options exist to reach a destination promptly in the case of irregular operations. So rather than assuming that consumers are somehow different than in the 90’s I’d posit it’s just as likely that consumer behavior is changing in response to industry changes.

It’s certainly true that the internet created greater transparency in pricing. And lower search costs help not just individual consumers but also business travel buyers, with internet-based booking engines able to constrain and track employee purchase decisions, placing a check on what used to be a significant principal-agent problem in business travel booking where employees of major companies had little incentive to care about booking highest-priced tickets which were frequently most beneficial to them personally.

Meanwhile, the study groups several markets and excludes several smaller markets, which tends to obscure some of the things going on. I’d have to run the relevant data myself to see what effect this has, but when the proliferation of direct flights and smaller aircraft is posited as important, cutting out even metropolitan areas with just 750,000 people may matter as does recognizing differences in markets (which the study groups). Take for example Washington-Reagan (with slot controls and distance limits, thus a proliferation of short-haul flying and a premium for the handful of permitted flights beyond 1250 miles in distance) versus Washington-Dulles and Baltimore (with its concentration of low cost and secondary carriers). During the times when the study posits airline profitability, prior to the effects they’re claiming to measure, Washington-Dulles managed to support $2400 tickets to the West Coast while full fare flying out of Baltimore was frequently in the $600 range.

As far as what’s actually driving airline problems, the hub premium decline is actually – I believe – a decline in full fare passengers rather than a function of hub and spoke models per se. Airlines tend to focus their hubs on cities that have been able to secure highest-fare passengers, with the hubs generating an effect where the largest carrier captures a disproportionately large share of that business. Hub location was crucial to airline profitability in the ’90s, and in fact about the only unprofitable ‘major’ carrier was TWA and that was explainable by their hub’s location — St. Louis which offered far fewer full fare business travelers than other major carriers’ hubs. (TWA also had the highest labor costs in spite of paying below industry average wages, with incredibly oneraous work rules.)

As prices became more transparent, major airlines were also faced with greater low-cost competition. Southwest Airlines grew into the largest domestic carrier by total passengers. JetBlue started competing on US Airways near-monopoly Northeast short-haul routes, which pushed US Airways into more longer-haul flying, adding even more major carrier competition to such routes.

New entrants ‘cherry picked’ routes that previously had been cross-subsidizing unprofitable major carrier activity. The majors found it difficult to leave unprofitable routes in part because of an attachment to sunk costs, internal incentive structures, and labor contracts.

These carriers, without the significant up-front investment in IT, also tended to have simpler fare structures which undermined the ability of major carriers competing with them to maintain tightly differentiated price segmentation through ticketing restrictions.

A combination of information-technology, price-sensitive businesses coming out of the 2001-2002 economic downturn, and the introduction of new competition seem to drive changes in the airline industry. Major carriers were ill-equipped to deal with those changes and were forced into bankruptcy reorganization. Meanwhile, it’s not clear that such organization alone will lead to sustained profitability over time. The airline industry’s ability to lose money (and yet continue to attract capital!) is truly astonishing. There’s much truth in the old saw that the quickest way to become a millionaire is to “start out with a billion dollars and invest in an airline.”

About Gary Leff

Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community InsideFlyer.com, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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