33-Capacity Reduction to Raise Prices

Ever since deregulation, the airline industry seems to have been in overcapacity and Hostility. Masses of low-cost carriers entered and challenged the legacy airlines. It has been a 40-year war. There have been apparently good companies come and go. Many original carriers failed and disappeared. But it appears that the war has ended. There are four major players who have survived: American, Delta, Southwest and United. Every day, Southwest, the leading low-cost carrier, looks more like the three other legacy airlines. That should not surprise us given how well the three legacies have climbed to the top of industry returns. It is an interesting story.

Posted July, 2008

Some analysts have estimated that the domestic airline industry needs to reduce its capacity by 20% in order to become profitable. This estimate sounds very high to me, as I’m sure it would to most of the flying public. If you miss a flight today, or if one should happen to be canceled on you, you are not necessarily going to get to your destination today. Airlines are flying with a high percentage of their seats filled.

But the airline industry seems to be taking this advice to heart. All of the legacy airlines have announced substantial capacity reductions to their current fleets. In addition, the legacy airlines have been shifting domestic capacity to their international routes, thereby reducing domestic capacity, over the last few years.

There is a broad belief that this reduction in capacity will enable the industry to raise prices. This is unlikely to be the case in this industry, as it has not been the case in other industries.

Over the last twenty years, we have analyzed many industries in overcapacity, like the current domestic airline industry. (See “The Real Reason Market Share Matters” in StrategyStreet.com/Tools/Perspectives) In several of those industries, the industry leaders reduced their capacity in order to support prices or get them to rise to more acceptable levels. In each case, this initiative failed.

Capacity reduction usually fails because lower cost competitors in the industry simply add capacity as the higher cost capacity withdraws. The industry leaders end up with lower market shares and the expanding followers end up with both higher market shares and better cost structures. These low-cost competitors become even more formidable opponents.

The same thing seems to be happening in the airline industry today. As the legacy carriers have reduced their domestic capacity over the last few years, the low-cost airlines have expanded to take their places. Already, Southwest Airlines has announced plans to continue growing its domestic route structure through 2009. Virgin America, a discount airline, also plans to take delivery of new aircraft over the next year. Sounds like the same old story playing out again.

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Update 2022:

The removal of capacity did little to help the large airlines. Industry prices continued to fall throughout 2008 and 2009. Industry returns were dismal and stayed that way for several years.  A leader in an industry cannot successfully remove capacity and raise prices unless it can control any potential new entrant. The airline industry could not control these new entrants and low prices continued pressuring the industry.

By 2019, the top four domestic air carriers (American Airlines, Southwest Airlines, Delta and United Airlines controlled 65% of the total domestic market. Their market power was greater than this percentage because these carriers held even higher shares of their key hubs and spokes. In recent years, these four major airlines removed unprofitable flights, filled a higher percentage of seats on planes, and slowed capacity growth to command higher airfares. Airline capacity has grown at a slower pace than ticket prices. In addition, since 2008, the airlines have charged ancillary fees for services that were formerly free.  These four major carriers finally achieved significant pricing power in their markets.

The airline industry consolidated to four major players over nearly a 40 year period of pain-and-suffering. To see how industry Hostility ends go HERE.

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Update 10/25

The 40 year war between legacy airlines and the vast group of low-cost carriers is largely over. The legacies have won the latest battle and likely the war. It took a very long time and the loss of lots of money, but the legacies control the market today. They gained this control through three long-term initiatives to spike the advantages of the low-cost carriers.

First, they destroyed the cost advantages of the low-cost carriers by developing good economies of scale. Bankruptcy, as ugly as it can be, enabled several airlines to reduce unproductive fixed costs. Afterwards they could take on competitors on a more even playing field. As in most industries, the industry leaders consolidated. Delta acquired Northwest Airlines in 2008. United Airlines combined with Continental Airlines in 2010. In 2013, American Airlines merged with USAir. Then, there were fewer legacy competitors. The legacy airlines restructured their costs with aggressive benefit/cost trade-offs and massive investments in technology. A first step in creating economies of scale. Having learned from the sad experience of many years, the legacies began to add capacity behind, not ahead of, demand to improve capacity utilization. They further improved their capacity costs ( by investing in new more cost-effective planes.

Second, they improved their product mix for superior revenues and profits. For the first time, they matched the product price points (Function benefits) of the low-cost carriers. Along the way, they expanded and maintained ancillary fees, a revenue benefit the low-cost carriers did not have. The legacies implemented these initiatives by creating several new classes of service. This took away much of the low-cost carriers’ price advantage. These moves increased the legacies’ capacity utilization, productivity and revenues.

Third, they created new Function and Price benefits to distinguish their products from the low-cost carriers. They have developed and exploited new loyalty program benefits appealing to their larger customers (a Function benefit). Because of the extent of their networks, these loyalty programs have become very attractive for frequent flyers. The legacies have complemented their Function advantages by developing real-time pricing. Substantial investment in technology enable the legacy carriers to set a detailed price, even down to the individual customer. For years, they had neither the regulatory authority nor the technological prowess to offer real-time pricing.

So, several doors have closed in the face of the low-cost carriers. Now they must struggle to redefine themselves.

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