31-Pricing in today’s airline industry – Part1

Can an industry leader remove capacity in order to induce a price increase? Many people believe that they can. Here is a story where it seemed to work. It didn’t work for long. The industry leaders were unable to prevent others from stepping in where they had withdrawn. A trend we have seen in many industries.

Posted 6/26/08

I am surprised and confused by the airline industry today. All the legacy airlines have announced substantial capacity reductions, in some cases by more than 20% of capacity. For example, United Airlines plans to ground 100 of its 460 planes in the foreseeable future. Some smaller cities will lose airline service completely. The legacies’ hub and spoke system is about to have fewer spokes.

Here is what confuses me. These capacity reductions come before the airlines try a last ditch effort to simply raise the basic fares. The airlines are grounding planes that can not produce cash at today’s price levels. Fine. Makes sense if you can’t generate cash with the plane. But before doing that, why not raise prices at least to a level that gives the airline enough cash to operate the about-to-be-abandoned route? If customers won’t pay that price, then O.K., ground the planes and refund the advanced-purchased tickets. (See “Costs: The Last Consideration” in StrategyStreet.com/Tools/Perspectives)

The airlines have learned well over the last thirty years that they cannot charge premium prices and expect that customers will remain loyal. The airline industry today may be the fastest industry on earth to match prices, but I think there is an opportunity here.

An airline ticket to most locations is still a relative travel bargain. The cost per passenger mile traveled is still well below that of an automobile or rail equivalent. When faced with a choice of no service, the majority of customers would pay more.

How big is that majority? It’s big enough to be worth the attempt to raise prices to levels that the airlines consider reasonable to keep the current fleet flying. Why not try?

The answer to “why not try” is that competitors will not go along. That may not be true today. Even discounters, such as Jet Blue and Air Tran, are suffering in this marketplace. It would be worth a gamble to test their willingness to go along.

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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.  United Airlines earnings were negative in 2009 and creeped into positive territory in 2010.  The airline industry remained unattractive for the next several years. But that is over now.

By 1983, all airlines were free of domestic CAB regulation, which meant they could set their own prices and effectively compete with other carriers.  Inflation adjusted prices for flying today in 2022 are much lower than they were before deregulation. This price decline has resulted in a huge increase in airline traffic. Pre Covid, with four carriers controlling a significant percentage of the US domestic market, prices were high enough to afford the larger players in the airline industry reasonable profits.

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.

Often, industry participants and observers expect that an industry will reduce capacity in order to improve prices and margins. See WHY THAT DOESN’T WORK

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Update 10/25

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 they stuck. The fees stuck because all of the legacy carriers matched these fees. Customers really had no choice.

Base ticket prices continued to decline because low-cost carriers moved into those market segments the legacy carriers left. These low-cost carriers, especially Southwest, generally declined to add these ancillary fees. They continued to grow market share on the basis of their lower total costs.

The legacy carriers continued on with their pricing strategy of capacity restriction. Over a couple of years the legacy airlines reduced capacity by 13% market demand fell by 10%. The legacies were beginning to learn how to compete with the low-cost carriers. There is more of that story in our next blog, number 32.

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