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Chapter 2 Airline Economics

The airline industry, considered by the public as a service oriented industry, is in fact an

undifferentiated product, as identified by economist, who indicate that, to many passengers

the service of one airline is rather hard to differentiate from the service of another(OConnor,

pg. 6). For most travelers the aircraft used, the comfort and customer service experienced is

seen as approximately the same. As an undifferentiated product the airlines desperately

attempt to separate their airline product from other airlines by offering benefits others do not.

These can include such things as steak dinners aloft, baggage allowances, flexible ticketing, etc.

The ability to differentiate ones airline from others is a key to success.

Surveys have shown that ticket buyers are interested in scheduled service to their

destination (20.3%) with pricing considered second to schedules (13.8%) in reasons why

travelers chose an airline (Dempsey, Gesell, pg. 56). Pricing, which is often a significant factor in

choosing a product from a pool of undifferentiated products, is less of a variable in the airline

industry as airlines have a tendency to follow the price leader, keeping the disparage between

competing air fares relatively small. By offering more scheduled routes, while keeping fares in

check with other airlines by cutting costs and running a more efficient operation, the industry

winners can separate themselves from the rest of the pack. The dynamics of providing needed

routes, while charging profit yielding fares that are acceptable to the travelling public, enables

the airline industry the opportunity to apply the basic laws of supply and demand to its analyze

its operation and forecast its performance.

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Supply in the airline industry is often measured by load factor. Load factor is a ratio of seats

sold to the total seats available by an aircraft for passenger revenue. Since the 1950s load

factors have remained, on average, approximately 70% for US domestic carriers and 60% for

European carriers. Therefore, the supply that is available for passengers at an airline is simply

the number of seats available for the airlines scheduled routes. Airline managers attempt to

understand their market by assessing the demand for routes and the number of passengers

that will utilize them. Mangers then position fleets that complement the passenger loads that

are required to serve that route. Ideally, airlines would operate at full capacity, or 100% load

factor on every flight. However, as load factors approach full capacity, many people who

wanted to fly would be prohibited from doing so.(Dempsey, Gesell, pg.52) Boeing has

conducted a study that shows that once an airline has booked 60% of their flights capacity, 7%

of the flights will become full and unavailable for late-booking passengers. The study continues

to suggest that the higher the load factor that is experienced during normal bookings the higher

is the percentage of flights that will have to turn away passengers. Turning passengers away

loses and opportunity to develop loyal patronage as these passengers may establish such with

other carriers. Having some excess capacity may be of value so long as the profit yield per flight

remains positive.

Demand in the airline industry for passenger carriage is highly cyclical, with variations in load

factors dependent on time of day, month, year or season. The holiday seasons, for example, is

an important period for the airline industry as high load factors are anticipated and over-

capacity can result from high demand. Pricing between airlines can become a deciding factor

for passengers decisions if the variations between airline ticket prices are significant and over

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capacity experiences are problematic. Airlines typically handle issues of over capacity with

increases in frequency of scheduled flights.

American Airlines former CEO, Robert Crandall, observed that over-capacity results in more

frequency by the creation of additional flights for the airline. This in turn widens the reach of

the airline and strengthens its entire network structure by giving the traveler more products to

choose from. If each route is handled efficiently, the marginal profit yields from each flight

translates into larger increases in revenue. By increasing the number of spokes on a hub

network, airline Origin and Destination pairs more than double geometrically (Dempsey, Gesell

pg. 54). This phenomenon of the industry led American Airlines to increase its spokes from its

Dallas hub 128% in 1978-1983.

The airline that grows its network into other cities, creating new city-pairs, can enjoy the

added benefit of other carriers passengers would connect through their hub. This gives the

airline the opportunity to win new travelers through a display of better service and the

advertising of product offerings. This is demonstrated through the S-Curve effect.

The S-Curve was first identified by William Fruham in 1972. He suggested that, a carrier that

offers consumers a disproportionately larger number of flights in a market vis--vis its

competitors will enjoy an even greater disproportionate advantage in terms of both passenger

load factors and revenue. (Dempsey, Gesell pg. 54).

However, airlines have a product which is considered perishable. Once the aircraft pushes

back from the jetway, any unsold seat is lost forever. In an attempt to sell every seat on a flight

an airline will reduce its rates to attract potential customers. If this is sustained by an individual

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airline, the industry will respond by lowering their rates in order to compete. This industry

competition can result in air-fare warsthat make profitability difficult for most of the carriers

in the industry.

The airline industry is affected to a great degree by the segment of the market that is

utilizing them. Demand during peak periods can be categorized by the type of traveler utilizing

the airline. Sundays, being the peak time of the week, sees both leisure travelers as well as

business travelers, with Tuesday being the least demanded day of the week. 9am and 5pm are

the busiest times of the day for the business traveler and the weekend is usually filled with

leisure travelers. These fluctuations in demand, based on the type of traveler, allows the airline

to adjust the number of flights to destinations, such as to industrialized cities or vacation spots,

depending on the time of the week or year. Designing schedules to tailor the activity of the

customer helps the airline to increase its load factors.

The cost of running an airline is dependent on variable and fixed costs. Variable costs

fluctuate with airline activity, such as fuel, labor, etc., although variable costs are usually less

than 25% of the allocated costs of running an airline. Fixed costs, however, are the lions share

of the airlines cost. Fixed costs are typically associated with assets, such as aircraft or even pilot

training. These costs do not change unless there is a change in scale of the operation.

Airline Management Strategies, 3rd

Ed., Dempsey, Paul S., Gesell, Laurence E., Coast Aire

Publications, LLC. Chandler, AZ. 2012

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An Introduction to Airline Economics William E. OConnor 2nd

Ed. 1982 Praeger Publishers

New York

Airlines in Transition, Taneja, Nawal K., 1981 D.C. Heath and Company, Lexington,

Massachusetts

Air Transportation, 12th

Ed., Kane, Robert M., 1996 Kendall/Hunt Publishing Co, Dubuque, Iowa