Airline Industry There Are Two

Airline Industry

There are two different major classifications of airlines, legacy carriers such as American Airlines, Delta, and United with hub-and-spoke systems and newer low-cost airlines such as Southwest, JetBlue, and AirTran with point-to-point models (America's airlines, flying on empty, 2005). Armed with lower airfares, low-cost carriers have already captured around twenty percent of the market and are rapidly gaining an even greater market share (Eli). More than ever, legacy carriers need new pricing strategies to survive.

Section II of this paper describes existing business conditions that impact pricing strategies for legacy carriers such as hub-and-spoke business models, price elasticities, consumer demand, the producer price index and unemployment. Section III discusses pricing theories such as price discrimination and premium pricing through one-to-one marketing as well as corresponding pricing strategies that are likely to help legacy airlines return to profitability given the constraints identified in Section II. Section IV, synthesizes the results of all sections to summarize barriers to decreasing prices and appropriate responses.

II. Business Conditions Impacting Pricing Strategies

The ability to change prices is often dependant on a variety of internal operating considerations as well as external market conditions. This section presents those variables that appear to have the most influence on the ability of legacy airlines to change their prices. Findings indicate that this will be difficult.

A. Hub-and-Spoke Systems

Today, most legacy airlines have at least one central airport that their flights have to go through. From that hub, the spoke flights take passengers to select destinations (Bonsor). This hub-and-spoke system is in sharp contrast with point-to-point models that fly directly between two small markets. Hub-and-spoke systems are supposed to help fill seats. Each seat on the plane represents a portion of the total flight cost (Bonsor). For each seat that is filled by a passenger, an airline lowers its break-even price, which is the seat price at which an airline stops losing money and begins to show a profit on the flight. In good economic times, hubs enabled the legacy airlines to provide frequent service to many cities with short layovers, but now many travelers are no longer willing to pay the high ticket prices that make them viable (Coy and Zellner, 2002). Point-to-point systems, on the other hand, cut costs by minimizing downtime for aircraft and employees (Eli). In 2002, JetBlue operated each of its aircraft for an average of 12.9 hours per day, while legacy carriers with hub-and-spoke systems struggled to reach 10.0 hours per day. The lower labor productivity for legacy carriers arises from paying pilots and crew members having to wait in airports or hotels for their next flight.

B. Price Elasticities

The airline industry is characterized by very complex pricing dynamics, depending on travel distance, type of traveler, and domestic and international flights, to name a few of the many factors that determine the degree of price elasticity or inelasticity (Air travel demand elasticities: Concepts, issues and measurement). For long-haul international business travel, demand is not sensitive to fare changes because there are few close substitutes. On the other hand, long-haul domestic business travelers have much higher elasticities than international business travelers. Telecommunications has become more acceptable as a substitute in domestic markets due to common culture, laws, contracts, etc. Likewise, international leisure travelers have greater elasticity than do international business travelers. These consumers are more likely to either postpone their trips in response to higher fares or seek locations that are not as expensive. Currently, the dollar is weak against many international currencies, serving to make many destinations unappealing for price sensitive leisure travel.

Not surprisingly, the elasticity for short/medium-haul leisure is the highest of all travel types (Air travel demand elasticities: Concepts, issues and measurement). For this segment, alternative forms of transportation such as car, rail or bus are the most common substitutes along with not traveling at all. In contrast, elasticity for short/medium-haul business travel is moderately inelastic, being even less than the long-haul domestic business elasticity. Short/medium-haul business travelers are willing to pay higher fares to save time. Further, there are numerous short haul-trips that arise in the course of business dealings, trips that are not easily planned and that can be completed in a morning or afternoon.

Legacy airlines have long used differentiated pricing, a form of price discrimination, in order to sell air services at varying prices simultaneously to different market segments (Airline). Factors influencing the price include the days remaining until departure, the current booked load factor, the forecast of total demand by price point, competitive pricing in force, and variations by day of week of departure and by time of day.

Five categories of fares are used, each designed to steal consumer surplus from five different groups of passengers based on their demand elasticity. In contrast, low- fare competitors usually offer straightforward, pre-announced, simple prices.

C. Market Indicators

The legacy airline industry as a whole is in peril, losing forty billion dollars for the years 2001 through 2006 (Global airline industry to return to profitability in 2007: IATA, 2007). Consumer demand for legacy airline services has been during this time, making it difficult to raise prices. Reasons for subdued demand range from the effects of terrorist attacks, the downturn in the economy, the war in Iraq, the SARS epidemic in Asia, soaring fuel costs and intense competition from the entry of newer low-cost carriers such as Southwest, JetBlue, AirTran and Spirit (America's airlines, flying on empty, 2005). In the summer of 2005 things finally started looking up. Airline passenger numbers were up and planes were on average seventy-nine percent full. However, revenues per seat ("yields") were still falling, decreasing by 1.8% for the same period in 2004.

Market indicators imply even further pressure on consumer demand for legacy airlines services in the foreseeable future. The Congressional Budget Office (CBO) forecasts real Gross Domestic Product to decline from 3.7% in 2005 to 3.4% in 2006 (the budget and economic outlook: Fiscal years 2008 to 2017, 2007). Consumer spending as indicated by retail sales isn't promising. 2008 U.S. retail sales are forecast to rise at the slowest pace in six years (Wal-Mart looks to lure Super Bowl shoppers, 2008).

Producer Price Index (PPI) is an inflationary indicator published by the U.S. Bureau of Labor Statistics to evaluate wholesale price levels in the economy. The index for finished energy goods surged 18.4% in 2007 (Producer price indexes, 2007).

This is bad news for airlines because jet fuel accounts for twelve to fourteen percent of airlines' operating costs and is the industry's second-biggest expense (Chakravorty, 2005). After Delta saw its fuel costs rise 50% in 2007, the airline cut domestic flights, instituted a hiring freeze on all non-customer facing positions and is considering additional job cuts (Delta hampered by fuel costs in Q4, notes job cuts, 2007).

The CBO expects the unemployment rate to increase from 4.7% in 2007 to 4.9% in 2008 (the budget and economic outlook: Fiscal years 2008 to 2017, 2007). However, this should not have a large impact on labor costs in the airline industry. Cost cutting is difficult because employees have already made substantial wage concessions. For instance, Delta's pilots accepted a 14% wage reduction in 2006 (Judge OKs Delta pilots' pay cut, 2006).

III. Pricing Theories and Strategies

Because legacy airlines have expensive hub-and-spoke business models, weak financial performance, anemic, consumer demand and higher energy costs, it doesn't make sense for them to try to compete on price. Instead, legacy airlines need to explore price discrimination to find those customers that are willing to pay more for airline services. Given weak demand, increased competition and a flat or marginally improving economy, one-to-one marketing practices are needed to find new customers and to justify their higher prices. These techniques are the most viable way for the legacy carriers to seize market share from its competitors.

A. Price Discrimination

Price discrimination is practice of charging different buyers different prices for the same quantity and quality of products or services. Price discrimination is often referred to as yield management in the airline industry and is already one of its most important tools to maximize profits and create economic efficiencies that would otherwise be elusive (Odlyzko, 2003). According to Odlyzko,

Incentives for commercial organizations to price discriminate are growing.

Commercial organizations' ability to price discriminate is increasing.

Information an individual provides allows commercial organizations to determine buyers' willingness to pay, and thus is the basis for price discrimination.

On the Internet, airlines have access to personal data entered by the consumer (name, address, gender, email, phone, credit card numbers, travel preferences) surfing patterns and purchase history. Odlyzko asserts this type of information provides unparalleled opportunities for price discrimination. Not only can airlines rely on supply-and-demand factors to formulate different prices for the same service, they can now use their wealth of customer data to charge consumer's maximum prices.