32-Pricing in airline industry – Part 2

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 6/30/08

How and where you raise prices is an important question. The legacy airlines are doing it badly.

The legacy airlines are nickel and diming customers by charging fees for checked bags, and so forth. The reaction of passengers is to view these changes as petty nuisances. Many will try to avoid them by simply bringing even more chattel on board.

This additional demand for overhead space makes travel even more uncomfortable for the Heart of the Market business traveler. (See the Perspective “Cutting the Right Cost” in StrategyStreet.com/Tools/Perspectives) These valuable customers will have to put up with more crowded overhead bins and delays as people drag even more luggage on to the airplane. The major effect of these new service charges is to disappoint the industry’s customers.

Normally, a company “unbundles” its product and adds additional service charges on previously “bundled” services in order to make small improvements in margins. These changes would usually improve margins by less than 10%. The airline industry needs more than that…a whole lot more. Passengers know a big price jump is inevitable. Recent customer surveys bear this out. The legacy carriers should take advantage of this customer expectation and raise prices to levels that will allow solvency, at a minimum. If that doesn’t work and it knocks out too many leisure travelers, how big is the loss?

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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.

In 2021, airline pricing continued its inexorable downward trend. In constant 2021 prices the average airline fare, starting in 1995 at $515 has fallen to $286 in 2021. A decline of 44%.  Until Covid struck, the industry had enjoyed several years of profits.  Profit margins average about 13.3% across US domestic routes. Profit margins range between 2.7% and 42.9% across routes. Profit margins increase with the market share of the largest airline serving the route.

Because virtually all airlines copied them, ancillary fees have been successful in the airline industry.  These ancillary fees cover services like checking a bag, providing extra legroom or changing a reservation.  In the early 2010s, these fees kept the entire industry in the black. More than half of the flying public dislike these fees, but the industry gives them little in the way of alternatives.   In addition, a large portion of airline ancillary fees comes from the sale of frequent flyer miles to their marketing partners.  In 2019, the 5 largest US airlines gained about $29 billion in ancillary revenue.

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.

HERE are a couple of simple rules to determine whether a company can raise its prices to increase margins or reduce them to gain share

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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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