97-The End of This Story is Predictable

Over the years, we have seen several industry leaders withdraw capacity from an industry in order to raise prices in the industry, especially when the leaders are confronted by low-cost Price Leader competitors. In order for this stratagem to work, the industry leaders must somehow control the expansion of low-cost competitors. That does not happen often. Nor did it happen in this industry. But the leaders in this industry did succeed in blunting the force of Price Leader competition. This blog explains how they did it.

Posted 4/20/09

For a while last year, it looked like the legacy airlines were well on their way to profitability. Business and international demands were strong and the companies had pricing power. The legacy airlines attributed much of this pricing power to their strategy of removing capacity from the marketplace. Let’s look at how that capacity removal is working out over time across the entire industry.

Recently, the Wall Street Journal’s “The Middle Seat” column conducted an analysis of some Morgan Stanley research data. The analysis evaluated changes in capacity in the industry over the recent months. They found that the legacy carriers, such as American and United, were seeing competitors grow faster than they did on overlapping routes. The faster growing competitors included jetBlue Airways and Southwest, the usual suspects. Southwest grew aggressively in Denver, while Frontier Airlines shrank capacity there. JetBlue grew in the Caribbean region as American Airlines pulled capacity from those routes. So as the legacy carriers, the industry’s Standard Leaders, reduce their capacity, the industry’s low-cost carriers, in this case Price Leaders, expand to take their places.

Why would the low-cost carriers be able to expand in a market where the industry’s legacy carriers are losing money? The answer lies in costs.

Recently, Scott McCartney, the author of “The Middle Seat” column in the Wall Street Journal’s travel section, cited another analysis from the consulting firm Oliver Wyman. Some of these conclusions were striking and scary for the legacy airlines:

• In 2003, low-cost carriers carried 26% of domestic passengers. By 2007, they carried 31%. These Price Leader airlines have been able to grow in both up and down markets.

• In the third quarter of 2008, the legacy carriers’ average revenue per seat mile was 12.46 cents, while their costs per seat mile were 14.86 cents. The airlines were losing money on each seat mile.

• The low-cost airlines fared better during the same period. Their revenue per seat mile was 10.92 cents, while their costs were just 10.87 cents. Note that the average unit cost of the legacy airlines during that period was 35% higher than the average unit cost of the low-cost carriers.

• The absolute spread between the legacy and low-cost airlines is increasing. In 2003, the low-cost airlines had a cost advantage over the legacy airlines of 2.7 cents per seat mile. By 2008, the gap was 3.8 cents. In both cases, though, the percentage gap has remained about the same.

• The reason for the growth of the low-cost carriers compared to the high-cost carriers is, in part, due to their different growth rates. (See the Symptom and Implication, “Some competitors are using growth to reduce their costs” on StrategyStreet.com.) The low-cost carriers are expanding. They are able to hire employees at the bottom of the tiered wage scales. On the other hand, legacy airlines are shrinking, so they have a harder time reducing unit costs. Many of their employees are already at the top of their wage scales.

These analyses should serve as important warnings for the legacy carriers. They are no different than U.S. Steel or Bethlehem Steel, Chrysler or General Motors. If these Standard Leader airline companies cannot achieve cost levels equivalent to those of the low-cost competitors, they will inevitably cease to exist in their current form.

Some of the legacy carriers have labor contracts coming up for renegotiation. People costs make up about 60% of the costs of legacy airlines. I hope that the representatives of these employees are reading the same studies that we are. Restrictive work rules, rather than hourly rates of cost, are the usual culprits when low cost competitors are competing with unionized Standard Leaders. These work rules spread jobs around and ease the burden of work on the unionized employee. They also open an umbrella over non-unionized or less-unionized employees in competing companies. This begs the question: What good are these work rules if the employee does not have a secure job…or any job at all?

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Update 2022:

The legacy 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. The average corporate price from 2015 to 2020 hovered around $500 per ticket. The legacy airlines control the market with their business structure of hub and spoke flights, high service, multiple price points on each flight and significant ownership of airline infrastructure. The low-cost carriers have a different business model, offering point-to-point flights with limited services and usually single aisle small jets from one manufacturer.

For the last few years, it has been difficult for the low-cost carriers to thrive in competition with the legacy airlines. 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.

The retrenchment of the airline industry, following the disastrous falloff in demand in 2020, may offer new opportunities for these low-cost carriers to expand because of the high pricing in the industry with capacity constraints.

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Update 6/26

The airline industry leaders’ ploy to remove capacity in order to raise prices seemed to work… until it didn’t. They withdrew capacity where you might expect they would. Not in the large cities and hubs where the industry’s Very Large and Large customers reside. The Small and Medium industry customers live in smaller secondary markets. The legacy carriers reduced capacity in those markets. Quickly, prices rose dramatically, sometimes more than 20%. But the good times were surely short-lived. Within a few months prices had resumed their downward trend, even in secondary markets. This price decline took place even in the face of surging fuel prices and falling demand due to the financial crisis of 2008. The removal of legacy airline capacity proved futile.

What did work to increase revenues? Ancillary fees. The legacy carriers introduced several fees for services that had once been free. Customers absolutely hated these fees. But the fees stuck. The fees stuck because all of the legacy carriers matched these fees. Customers really had no choice.

In 2026, 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. An important 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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