Legacy Airlines: Pricing Strategies to Compete With Low-Cost Carriers

Introduction

There are two major classifications of airlines: legacy carriers such as American Airlines, Delta, and United, which operate hub-and-spoke systems, and newer low-cost airlines such as Southwest, JetBlue, and AirTran, which use 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, including 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 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.

Business Conditions Impacting Pricing Strategies

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

Hub-and-Spoke Systems

Today, most legacy airlines have at least one central airport that their flights must pass through. From that hub, spoke flights take passengers to select destinations (Bonsor). This hub-and-spoke system stands in sharp contrast with point-to-point models that fly directly between two smaller markets. Hub-and-spoke systems are designed to help fill seats. Each seat on a plane represents a portion of the total flight cost (Bonsor). For each seat filled by a passenger, an airline lowers its break-even price — 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 legacy airlines to provide frequent service to many cities with short layovers, but many travelers are no longer willing to pay the high ticket prices that make this model 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 pilots and crew members having to wait in airports or hotels between flights.

Price Elasticities

The airline industry is characterized by very complex pricing dynamics, depending on travel distance, type of traveler, and whether flights are domestic or international, among many other 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. Long-haul domestic business travelers, on the other hand, have much higher elasticities than their international counterparts. Telecommunications has become a more acceptable substitute in domestic markets due to shared culture, laws, and contracts. Similarly, international leisure travelers have greater elasticity than international business travelers, as they are more likely to postpone trips in response to higher fares or seek less expensive destinations. A weak dollar against many international currencies makes numerous destinations unappealing for price-sensitive leisure travelers.

Not surprisingly, elasticity for short- and medium-haul leisure travel is the highest of all travel types (Air travel demand elasticities: Concepts, issues and measurement). For this segment, alternative forms of transportation — car, rail, or bus — are the most common substitutes, along with not traveling at all. In contrast, elasticity for short- and medium-haul business travel is moderately inelastic, even less than for long-haul domestic business travel. Short-haul business travelers are willing to pay higher fares to save time, and many such trips arise unexpectedly in the course of business dealings, making advance planning difficult.

Legacy airlines have long used differentiated pricing — a form of price discrimination — to sell air services at varying prices simultaneously to different market segments (Airline). Factors influencing price include days remaining until departure, current booked load factor, forecast of total demand by price point, competitive pricing in force, and variations by day of the week and time of day. Five categories of fares are used, each designed to capture consumer surplus from five different groups of passengers based on their demand elasticity. In contrast, low-fare competitors typically offer straightforward, pre-announced, and simple prices.

Market Indicators

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

Market indicators suggest further pressure on consumer demand for legacy airline services in the foreseeable future. The Congressional Budget Office (CBO) forecast real Gross Domestic Product growth 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 was equally unpromising, with 2008 U.S. retail sales forecast to rise at the slowest pace in six years (Wal-Mart looks to lure Super Bowl shoppers, 2008).

The 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, as 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 began considering additional job cuts (Delta hampered by fuel costs in Q4, notes job cuts, 2007).

The CBO expected 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 was not expected to have a large impact on labor costs in the airline industry, since employees had already made substantial wage concessions. For instance, Delta's pilots accepted a 14% wage reduction in 2006 (Judge OKs Delta pilots' pay cut, 2006).

Conclusion

Legacy airlines face significant barriers to lowering prices. They therefore need a different plan for competing against lower-cost airlines that offer low fares. Theories of price discrimination and premium pricing through one-to-one marketing identify ways that legacy carriers can avoid direct price competition. Long-haul international business travelers and short- and medium-haul domestic business travelers represent the best segments to target because they are not price-sensitive. To be successful, however, airlines will have to differentiate their services from those of low-cost carriers to appeal to their target audience and understand the needs of individual consumers within market segments.

Bibliography

Airline. Retrieved from Web site: http://airline.biography.ms/

Air travel demand elasticities: Concepts, issues and measurement. Retrieved from Web site: http://www.fin.gc.ca/consultresp/Airtravel/airtravStdy_3e.html

American Airlines re-launches direct corporate booking portal CorporateAccess.com (2005, November 17). Retrieved from Web site: http://biz.yahoo.com/prnews/051117/dath051.html?.v=23

American cancels some flights on fuel costs (2005, September 30). Associated Press. Retrieved from Web site:

America's airlines, flying on empty (2005, September 6). The Economist. Retrieved from Web site: http://www.economist.com/agenda/displayStory.cfm?Story_ID=4399993

Bonsor, K. How airlines work. Retrieved from Web site: http://travel.howstuffworks.com/airline3.htm

The budget and economic outlook: Fiscal years 2008 to 2017 (2007, January). Congressional Budget Office. Retrieved from Web site: http://www.cbo.gov/ftpdoc.cfm?index=7731

Chakravorty, J. (2005, January 4). Airlines shares fall as oil prices rise. Retrieved from Web site: http://yahoo.reuters.com/financeQuoteCompanyNewsArticle.jhtml?duid=mtfh69917_2005-01-24_19-48-44_n24162794_newsml

Coy, P. and Zellner, W. (2002, August 5). Commentary: The airlines: Caught between a hub and a hard place. BusinessWeek. Retrieved from Web site: http://www.businessweek.com/magazine/content/02_31/b3794112.htm

Delta hampered by fuel costs in Q4, notes job cuts (2007, December 4). Sacramento Business Journal. Retrieved from Web site: http://sacramento.bizjournals.com/sacramento/stories/2007/12/03/daily20.html?surround=lfn

Eli, D. Legacy airlines could learn from low-cost competitors. Global Insight. Retrieved from Web site: http://www.globalinsight.com/Perspective/PerspectiveDetail857.htm

Giddens, N. (2002, August). Brand loyalty. Retrieved from Web site: http://www.extension.iastate.edu/agdm/wholefarm/html/c5-54.html

Global airline industry to return to profitability in 2007: IATA (2007, April). Retrieved from Web site: http://findarticles.com/p/articles/mi_kmafp/is_200704/ai_n18773303

Judge OKs Delta pilots' pay cut (2006, May 31). CNN. Retrieved from Web site: http://money.cnn.com/2006/05/31/news/companies/delta_pilots/index.htm

Odlyzko, A. (2003, July 27). Privacy, economics and price discrimination on the Internet. Digital Technology Center, University of Minnesota. Retrieved from Web site: http://www.dtc.umn.edu/~odlyzko/doc/privacy.economics.pdf

Peppers, D., Rogers, M., and Dorf, B. (1999, January–February). Is your company ready for one-to-one marketing? Harvard Business Review. Retrieved from Web site: http://www.wjdoll.utoledo.edu/Ideas%20for%20discussion/IsYourCompReadyforOne-to-OneMarketing.pdf

Producer price indexes (2007, December). Bureau of Labor Statistics. Retrieved from Web site: http://www.bls.gov/news.release/ppi.nr0.htm

Wal-Mart looks to lure Super Bowl shoppers (2008, January 29). MSNBC. Retrieved from Web site: http://www.msnbc.msn.com/id/22894081