Supply and Demand of Southwest Airlines

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The airline industry is subject to a somewhat unique supply-demand curve, and it results in an unorthodox approach to pricing that takes into account a wide range of variables. Airline flights are a perishable good, so the price changes in relation to time. In addition, supply is sticky, because airlines cannot simply cut and gain access to landing rights easily. They must instead make supply decisions periodically, evaluating routes and flight times in the context of market opportunity as well as opportunity cost. Fixed costs are highly variable, especially fuel costs, and this affects pricing as well. Additionally, pricing of ancillary services such as luggage, food and other items sold to passengers factors into the ticket price. Another factor is that of substitutability, especially on medium-haul routes where driving or rail constitutes a viable substitute. Lastly, the strategy of the airline must be taken into account. Southwest, for example, has positioned itself as a discount airline, and therefore seeks to undercut the legacy airlines when flying the same or similar routes.

The basic supply-demand curve can be used as a starting point for understanding Southwest's pricing. In the basic curve, the higher the price of the good, the more supply will enter the market, but the lower the demand will be. The price of the good will therefore trend around the equilibrium point (Mind Tools, 2013). As McAfee and te Velde (no date) point out, perishability plays a strong role in airline pricing formulas. This is an important factor to take into consideration.

The airline industry is in a state of monopolistic competition. In such a state, firms seek to earn short-run profits by pricing at a point where marginal revenue is above marginal cost (Pearson, 2010). This is not always possible, but it is the objective. The marginal cost in airlines is based each flight, but the pricing is based on each seat. This is an important differentiator when most models assume that marginal production and marginal sales are in equivalent units. Airlines seek to price such that at a minimum they do not lose money on a flight -- that MR = MC. This involves providing incentives for purchasing early, so that the airline can establish the viability of a given flight based on demand forecasts. The airline has some short-run supply flexibility in that occasionally it can cancel flights that have very low sales. For Southwest, this is especially true at its Love Field hub, where passengers can often be re-routed or put on a later flight. Once the demand model shows that the flight is likely to reach MR=MC, the prices can increase. When marginal revenue exceeds marginal cost, the flight will be profitable but the airline still needs to cover fixed costs. At this point, the price might remain high to maximize revenue. Intuitively, lowering the cost at this point to ensure that capacity is filled sounds like a good idea, but if consumers expect prices to drop close to flight time, they have no incentive to purchase at the high price rate. Thus, the airline cannot consistently lower prices to fill seats shortly before takeoff.

In recent years, Southwest's prices have crept upward. This trend has been attributed less to pricing strategy that to changes in the underlying fixed cost structure, including rising fuel prices and the cost effects of changes to its route networks (McCartney, 2011). This trend reflects the fact that airlines still need to charge enough to cover fixed costs. When fixed costs increase, a discount airline might maintain a handful of low-priced fares to build initial capacity on a given flight, but will leverage whatever edge it can in the demand model to maximize fixed cost coverage. Airlines have long done this, but Southwest often did not, preferring to keep costs (and profits) below maximum in order to build market share. Thus, a shift in strategy for the company has resulted in a shift in its pricing strategy. The mechanics of the strategy remain the same, but the prices themselves have changed in response to changes in the underlying business conditions.