The Economics of Airlines’ Mileage Addiction

This short Business Week piece discusses the importance of frequent flyer miles to airlines — selling billions of dollars in miles, using miles to good moribund bookings and launch new routes — and includes a couple of interesting statistics.

I’m sure I’ve mentioned in the past, though flying accounts for a plurality of mileage earning (base miles at least, not counting bonuses) it no longer accounts for a majority of mileage earning.

Credit card spend represents about 20% of earned mileage. Banks vie to issue co-branded cards because they’re influential in attracting customers, and those customers tend to be high-spending. The article mentions the customer battles between US Bank, which was the issuer of the Northwest Visa, and American Express which offers the Delta American Express. With the Delta-Northwest merger, American Express comes out on top but US Bank has developed its own proprietary points program to try to retain customers.

American Express prepurchased over half a billion dollars in miles from Delta in an earlier unsuccessful attempt by the carrier to avoid bankruptcy. And again post-bankruptcy.

Similarly, Juniper Bank (since acquired by Barclays) helped fund the America West acquisition of US Airways in exchange for the credit card concession, and entered into a significant battle with Bank of America (which had issued the US Airways card beforehand and which continued to have a contract to do so that was ultimately not renewed).

Bank of America’s volume of mileage purchases from Alaska dwarfs that carrier’s annual profit or loss at least five-fold.

United got its debtor-in-possession financing and exit financing for its bankruptcy process from the issuer of its co-branded credit card. In a very real sense, United kept flying despite its financial woes in order to support the underlying credit card business.

So the next time anyone talks about flying on free tickets, stop them. Mileage award customers are not — or at least should not be — second class customers on airlines. Airlines reap huge rewards for printing and ultimately redeeming miles, and the customers who play the mileage game are crucial to airlines’ very survival.

Unfortunately, mileage programs represent a real conundrum for airlines. They’re addicted to the revenue, but the historical model has been to redeem points for seats that would otherwise go empty — making that revenue vritually ‘free’ (the marginal cost of an award seat passenger in coach redeeming at the ‘saver’ level has historically been booked at less than $30, while a mileage program will sell the miles necessary to redeem that seat for perhaps $375 on average).

However in a world of shrinking capacity — fewer flights, meaning higher load factors even in a down economy — there are simply not as many seats that would ‘otherwise go unsold’. Programs print more miles than there are seats, and the natural result is inflation.

Miles are like a proprietary currency with no independent central bank. That’s why the classic monetarist formula applies to understanding them. MV=PQ.

M usually means money, but in this case it’s the quantity of miles.

V is velocity, the speed at which those miles are redeemed.

P is the price level, in our case the award chart or number of miles it takes to redeem for a free seat.

Q is quantity, not of goods but of a particular good — seats for free travel.

With M growing, and Q shrinking or at least not growing as quickly as M, you either have to have P rising (increases in the award chart pricing) or V slowing (people either don’t want to or can’t redeem their miles as quickly). Put another way, inflation or shortages.

In fact, you see both — as long as airlines decide how many miles to print, not tied to how many seats are available, you will get inflation in award charts. Any attempts to constrain this would be unworkable, creating more problems than they’d solve. So you should just plan around this. Redeem your miles when you can, don’t save them for some future time. As long as you earn and burn in roughly the same period you’re earning under the same chart in which you’re redeeming more or less and can adjust your expectations and decision-making on the mileage accumulation side according to a correct understanding of what it will take to secure an award.

This framework also helps to understand why airlines have a love-hat relationship with improving the technology to secure awards and with the transparency of seat availability.

While several carriers have made improvements — introduction of award seat calendars, adding partner carriers to their websites for online redemption — the progress has been mind-numbingly slow and the implementations poor.

This shouldn’t be surprising. The easier it is to redeem miles, the more the airline has to spend on those redemptions. Partner airline redemptions are more costly than redemptions on one’s own carrier. And transparency in the redemption process is as likely to lead to frustrated and disappointed customers who see just how hard it is for them to redeem.

This model also helps to understand behavior such as United’s “Starnet Blocking” — partners offer them award seats, but United refuses to let its members have those seats that are actually being offered. That’s because United is addicted to the revenue from mileage sales, but doesn’t want to spend on redeeming those miles. So they set a cap on how much they’ll spend in a quarter, completely unrelated to the revenue on the mileage accrual side. In order to make their miles attractive — and secure the revenue associated with an attractive mileage program — they need to offer enough availability to convince people that their marketing promises of free travel are real. But the more they fulfill those marketing promises in fact, holding revenue constant, the lower their net. It’s a deliciate balance, a dangerous game United is playing, and those who understand that game naturally perceive Mileage Plus miles to be less valuable than those of United’s Star Alliance partners and less valuable than many United competitors as well. United’s bet is that few people understand the game, or understand their options.

The solution — and what holds airlines in check from inflating their currencies too much — is competition.

Governments need independent central banks because they claim a monopoly on currency. United has to compete with American and Air Canada. And they all have to compete with cash back credit cards, and with hotel points. And proprietary programs like American Express Membership Rewards. That’s what keeps the inflation in check, and keeps airlines offering award seats — if they clamped down too much they’d lose customers to their competitors or to other reward products.

It’s a balance, and a game you can win, if you understand what to expect.

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 Milepoint.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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Comments

  1. Gary… you forgot about the “other” $1BN in DL miles that AMEX purchased this past year… (See Note 8, pg F-31 in their 2009 10-K)… that’s another ~50+ BN miles that can be introduced into the SkyMiles program

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