Pricing Behavior and Non-Price Characteristics in the Airline Industry: Volume 3

Research analyzing competition and individual carriers' financial condition's influence on pricing behavior in the airline industry are presented in the first part of the book. The initial chapter by Manuel Hernandez, Anirban Sengupta, and Steven Wiggins directly tests whether competition creates a challenge for legacy carriers practicing nonlinear pricing such that passengers are charged different prices for the same flight without cost justification. The authors use transactions level data, which has the advantage of allowing an empirical examination of the effect of Southwest and other LCCs on both the level and structure of fares of legacy carriers. The analysis is performed by defining a menu of airline fare types according to restrictive ticket characteristics to then evaluate the competitive effects of both Southwest and other LCCs, including adjacent and potential competition from Southwest, on the relative pricing behavior of major carriers. Findings suggest that competition from Southwest has an important effect on both the level and fare structure of legacy carriers. In particular, direct and potential competition from Southwest both lower the fare per mile and compress the fare structure by decreasing the premia of the highest fares, including first-class tickets, over the lowest fares. Adjacent competition from Southwest and direct competition from other LCCs only seem to significantly affect the fare level.

Firms with linear pricing offer their customers the same price for each unit of a good or service. Anything else is nonlinear pricing. Nonlinear pricing in imperfect markets indicates a fundamental asymmetry in information between firms and consumers. Consumers are commonly expected to exhibit quality- or quantity-preference differences and have different reservation values for different product attributes. The firms, however, cannot observe consumers' preferences. When complete information regarding preferences is not observable, nonlinear pricing strategies with firms offering a menu or schedule of prices allow consumers to sort themselves according to their own preferences, resulting in market segmentation.

The passenger air travel market has recently been impacted by two major innovations: first, in the 1990s, the rise of “low-cost carrier” (LCC) airlines offering cheap one-way point-to-point tickets, and then, in the new millennium, the emergence and enthusiastic adoption by consumers of online Internet booking systems. It has been suggested that the transparency of Internet booking would result in only the lowest fare offerings being sustainable in the market, and the simplicity and efficiency of LCCs would mean that it would be their fares that would be the lowest.

This study traces the evolution of offered airfares on 50 busy routes on the US domestic market. Our approach differs from that in the literature in the following ways. First, we trace the lowest offered fares for specific round-trip itineraries, acknowledging both that many trips involve return travel and that the round-trip airfare is often not equal to the sum of the two one-way fares. Many previous studies (e.g., Escobari, 2009; Escobari & Gan, 2007) either looked at fare quotes for specific one-way flights or examined the lowest round-trip quote available. Second, our sample of half of the top 100 domestic routes includes itineraries from markets with varying number of competitors as well as from markets with and without the presence of low-cost carriers (LCCs). Third, we have collected fare quotes simultaneously from three leading online travel agents. Thus, our research design allows us to see whether any systematic airfare differences exist across the different online distributors of travel services.

The vertical relationships literature has considered situations where both producers and retailers have a degree of market power. On one hand, retailers may have certain freedom in deciding what price to charge to the final consumers. On the other hand, large retailers may also pressurize producers (Wal-Mart is a classic example; see also Comanor and Rey (2000) for a formal treatment of this topic). At the same time, producers may pressurize retailers via resale price maintenance. The interplay of producers' and retailers' bargaining power, in addition to the structure (both horizontal and vertical) of product and distribution markets, eventually determine the sticker price faced by an unsuspecting consumer.

Few industries may be better suited to study the effects of financial distress on managerial decision making than the airline industry. Economic recessions, natural catastrophes, and terrorist attacks are just some of the factors that frequently take a particularly heavy toll on the airline industry. Thus, coping with and overcoming financial distress is a critical aspect of airline management.

Code-sharing, a phenomenon observed in international airline markets, has emerged as an important form of alliance in the domestic U.S. airline industry. Unlike international markets where code-share agreements were often the only way for a carrier to enter into a route serving another country, the post-1980 U.S. airline industry has enjoyed de facto free entry and exit. However, the financial conditions of the mid-1990s combined with various constraints on airport and airspace capacity led domestic carriers to experiment with code-sharing.

The past several years have seen dramatic increases in oil prices, which have adversely impacted airlines, with the average price of jet fuel increasing from $1.34 per gallon between 1995 and 2005 to $2.81 per gallon between 2006 and 2009. As a partial response to these increases in costs, many airlines have introduced fees for services that were previously provided to their customers free of charge. One such charge is a fee on checked baggage, which most airlines introduced in 2008. These charges have been successful in increasing airline revenues, so successful that many airlines have increased their fees multiple times over the past two years. Baggage fees have also enabled airlines to avoid dramatic increases in their airfares, which may result in significantly fewer customers, as these additional fees generate revenues, but since they are not collected when passengers book their tickets, the cost of air travel on these airlines appears lower than it actually is. The most notable exception to this pattern of charging baggage fees is Southwest Airlines, which has launched a “Bags Fly Free” advertising campaign in an attempt to differentiate their product from that of fee charging airlines. In this chapter, we use a spatial autoregressive model to analyze what impact the increase in fuel costs, and the introduction of baggage fees have had on ticket prices. Our results suggest that increases in jet fuel prices are passed along to travelers in the form of higher ticket prices but that baggage fees actually reduce ticket prices, as airlines may substitute baggage fee revenue for ticket revenue to become more competitive on their airfare. We also find that Southwest Airlines has increased their ticket prices on routes in which they compete with fee charging firms, leveraging their “Bags Fly Free” product differentiation to increase their revenues.

In their respective market outlooks, both Boeing and Airbus forecast strong growth in intercontinental passenger traffic until 2029. However, they differ substantially with respect to their assessment of the future development of airline (and alliance) networks. These deviating projections have, in turn, massively influenced their product range. Boeing, having long predicted a major growth in intercontinental point-to-point operations – based on the so-called fragmentation (dehubbing) hypothesis – has consistently opted for the development of the B787 (Dreamliner) family of midsized, and extremely efficient, wide-body aircraft. Airbus, on the contrary, is forecasting a substantial increasing demand for hub-to-hub traffic, which according to the company, will require airlines to purchase a large number of very large aircraft (VLA), especially its Airbus 380. Though both manufacturers did not put all their money where their mouths are – Boeing has reacted to the Airbus 380 challenge with an updated derivative of its Boeing 747 flagship, the Boeing 747-8 Intercontinental, while Airbus is targeting its proposed Airbus 350 family against both the Boeing 787 and Boeing 777 – the fragmentation hypothesis remains one of the most controversial issues in the civil aviation community today. Regardless of which scenario will eventually turn out to be more realistic, either will impact tremendously on aircraft manufacturers, on the airlines' route and fleet planning decisions as well as airport operators.

With the liberalization of air transport and the enlargement of air traffic, airports face insistent requests from airlines to perform and improve both service quality and cost efficiency. As a result, airport ownership, governance, and regulations are debated and sometimes have already been changed. Airport pricing under different governance structure is a central issue in this context.

Over the past 50 years, air travel in the United States has increased from approximately 33 million passengers in 1960 to over 607 million passengers in 2007 (National Transportation Statistics, 2011, Table 1–40). This is over an 18-fold increase in air travel in the past five decades. Over that same time period, the number of airports increased modestly, from 15,161 in 1980 to 19,750 in 2009. The number of those airports serving public commercial traffic is even smaller, and has declined from 730 airports in 1980 to 559 in 2009 (National Transportation Statistics, 2011, Table 1–3). Together, these two facts point to phenomenal growth among airports (measured by the number of passenger trips).

Airport noise is an undesirable consequence of arriving and departing flights. Much research effort has focused on how such noise affects the prices of houses located nearby and consistently finds that more noise is associated with lower housing prices.¹ On the other hand, few studies have examined the determinants of airport noise.

Safety is arguably the most important “quality” attribute of commercial aviation, yet it rarely figures into overt interfirm rivalry. Usually, airlines do not even allude to their safety record vis-à-vis rivals in their advertising and press statements. Moreover, statistical analysis by independent parties usually indicates that peer airlines within the same geographic region and segment of the industry have indistinguishable safety records (Barnett, 2010).