270-Does the Withdrawal of Capacity Help?

As industry prices fall, and companies’ fortunes decline with the resultant squeeze on their margins, some companies, especially the leaders, seek to withdraw capacity from the market. The leading companies expect the capacity withdrawal to do two things: redress the imbalance between capacity and demand; and raise prices to more attractive levels because of this better balance.  See HERE for what makes returns high.  In practice, the withdrawal of capacity often fails to achieve either of these objectives.

Whenever a leader in an industry reduces its capacity to force price increases, it must consider how competitors will respond. In many, if not most, cases low-cost competitors expand their capacity to make up for the withdrawal of capacity by the industry leaders. The end result often is even more capacity available in a marketplace and the same or lower prices available for the industry leaders.

After several quarters of improving profits, the airline industry is again slipping into hostile market conditions as rising fuel prices reduce margins and force higher prices. Higher prices limit demand growth. In response to the margin squeeze these tougher times bring to the industry, the industry leaders are restricting the growth in their capacity and, in some cases, reducing the capacity they offer in the domestic U.S. market. The problem is that several of the industry followers are not going along.  See HERE for reasons industry capacity tends to rise in most markets.

United Continental Holdings and AMR Corporation’s American Airlines have both posted losses for the most recent quarter. Both of these industry leaders plan to reduce their domestic capacity as a result. They will be reducing seats available flying into and out of selected domestic markets.

The pattern of leaders reducing capacity and followers adding it seems to be holding in the current airline industry. Southwest Airlines, JetBlue Airways and Alaska Air Group derive most of their revenues in the domestic U.S. market. Each of these companies reported profits in the most recent quarter. This profitability of the three follower airline competitors indicates that their costs are lower than are the costs of the two legacy airlines that have reported losses, United Continental and American Airlines. Southwest plans to increase its capacity by 5% to 6% in 2011. JetBlue plans to add 6% to 8% this year, while Alaska Air plans to grow its capacity by 9%.

The industry followers are able to add capacity in the face of capacity withdrawal by their larger industry-leading competitors because they have these lower costs. The lower costs enable the follower companies to make a profit while their larger competitors suffer losses. In the long run, the only way that the industry-leading competitors will be able to stop the expansion of these follower competitors will be to match or beat their lower cost structures.

22 July 2011

Update:

The four industry leaders have used their vastly superior economies of scale and pinpoint pricing to eliminate the effective threat of low-end airline competitors.

An industry leader is unlikely to be successful in raising prices by reducing its capacity unless it is able, at the same time, to discourage other competitors from adding capacity. The years 2008 to 2010 were very difficult for the domestic airline industry. The airlines were unprofitable for much of that time. The industry reduced capacity in 2009 but added it back by 2010 as demand grew again. From October 2008 until October 2009 domestic airline industry capacity, measured in available seat miles fell about 3% from 56.5 billion to 54.5 billion. Despite the majors’ reduction in capacity, the smaller discount airlines added some capacity as the majors reduced it.  Capacity utilization, measured in revenue passenger miles, fell very slightly from 44.9 billion to 44.8 billion. By October 2010, industry capacity had increased by about 4% to 56.7 billion while revenue passenger miles increased 5 ½% to 47.3 billion. 2008 saw domestic majors, nationals and large regionals lose over $18 billion. These companies reduced their losses to $2.3 billion in 2009 and returned to profitability of $1.2 billion by 2010. This period saw discount carriers gain share of the market.

That situation has greatly changed today. The top 4 airlines have preempted much of the growth of the smaller Price Leader competitors by offering some seats on most flights at very low prices. In other words, they have covered the price points low-end competitors offer. This did not take away all the revenues of low-end competitors, but it did impact their revenues and profitability. See HERE for more on industry price points.

By early 2020 the US domestic airline industry had become an oligopoly. The top 4 legacy airlines (Delta, American, Southwest and United) controlled nearly 2/3 of the total market and had good control on pricing. Low-cost carriers were having little effect on corporate pricing.  During the period from 2009 to 2021, revenue per passenger mile grew by less than 1% a year, from 14 cents to 15.6 cents. The average corporate price from 2015 to 2020 hovered around $500 per ticket. The 3 legacy airlines plus Southwest control the market with their ability to use their superior size and low costs to produce profits despite stagnant industry prices.

For the last few years, it has been difficult for the low-cost carriers to thrive in competition with the legacy airlines. They no longer have the pricing capability they once had. The low-cost carriers offer about 10% of their capacity at very low prices and then gradually raise the price as flight occupancy rises until their prices are comparable to those of the competing legacy airline. Aside from losing some of its price advantage, a low-cost carrier has difficulty entering or expanding in an airport dominated by the legacy carriers because of limited gates and take-off slots.

Over the long-term, the purpose of price in a hostile market is to discourage the production of product. Price has that objective until the industry runs short of capacity. See HERE for more perspective.

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