The Effect of a Low Cost Carrier in the Airline Industry

The Effect of a Low Cost
Carrier in the Airline
Industry







By
Christine Wang
MMSS Honors Seminar
June 6, 2005



*a special thanks to my advisor Ian Savage

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Table of Contents


Abstract…………………………………………………………....p. 3
I.
Introduction………………………………………………...p. 4
II.
Deregulation………………………………………………..p. 4-6
III. Effects of Competition on Pricing Behavior…………..…...p. 7-9
A) The Threat of Entry
B) Indirect Competition
C) Competition of Airports within the same Metropolitan Area
IV. Other Factors Influencing Pricing Behavior……………….p. 10-15
A) Hubs and Market Share
B) Price Discrimination
V.
The “Southwest Effect”……………………………………p. 15-19
A) Southwest’s Success
B) The Definition
C) A Study on Southwest
VI. The Analysis…………………………………………...…..p. 19-32
A) The Origins of the Regression
B) The Data
C) The Estimating Equation
D) Descriptive Statistics and Explanation of Coefficients
E) Regression without Southwest
F) The Magnitude of Southwest’s Effect
VII. The Effect of Southwest Today……………………………p. 32-35
VIII. Conclusion…………………………………………………p. 35
Appendix: Individual Airline Analysis……..………………….…p. 36-38
Works Cited………………………………………………………p. 39








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Abstract


This paper analyzes the extent of the “Southwest Effect” on the pricing of fares in
the airline industry. First, it discusses the basic principles of pricing under competition,
large market share, and price discrimination. Next, it discusses the role of Southwest in
the airline market. The presence of a low cost carrier, such as Southwest, in a particular
city pair market has long been assumed to lower the fares in that market. This paper
analyzes the extent to which this hypothesis is true. Does the fact that Southwest Airlines
has low fares influence other competitors in that market to lower their fares as well? Or
do the lower fares of Southwest merely lower the average fare in the market? If
Southwest does influence other competitors to lower their fares, does it have more of an
impact on certain airlines? This paper will attempt to answer these questions with
statistical analysis and past literature.










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I. Introduction

In order to understand the principles of pricing in the airline industry,

knowledge of the industry and its history are essential. There are numerous aspects to
how a plane ticket is priced—how many miles the flight is traveling, when a person buys
his/her ticket, whether the origin and destination airports are hubs, etc. However, one
criteria stands out—the presence of Southwest. With revenues and profits increasing year
to year, Southwest’s success has infiltrated the news and media of the airline industry.
But, what is the cost to its competitors? The following paper will analyze the impact of
Southwest in the airline industry and what this means for the future of all carriers.
II. Deregulation

Since 1938, the U.S. Congress formally regulated air transportation through the
Civil Aeronautics Act. This Act created a board to control the entry and exit of air
carriers, to regulate fares, and to control mergers. However after World War II, an
economic and political consensus1 emerged, claiming that regulation was inefficient and
restricted the growth of the airline industry. These new findings led to the deregulation of
the airline industry in 1978.
The U.S. Domestic Airline Industry was deregulated as part of a reform
movement that has transformed the banking, telecommunications, energy, and
transportation industries in the United States.2 Deregulation was premised on the idea that
an unregulated market would approximate a perfectly competitive industry, one that had

1 Economic studies included Caves 1962, Levine 1965, Jordan 1970, Keeler 1972, and
Douglas and Miller 1974. Political support stemmed from Congressional hearings led by
Senator Edward Kennedy.
2 Goetz and Sutton; p. 238.

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numerous carriers, no significant economies of scale, and no significant barriers to entry.
But between 1983 and 1988, the airline industry experienced a massive wave of
bankruptcies, mergers, and acquisitions. Over 200 carriers left the market, leaving nine
airlines (United, American, Continental, TWA, US Air, Pan Am, Delta, Northwest, and
Eastern) to share 92 percent of domestic revenue3. Contrary to initial expectations,
deregulation actually led to a decrease in competition.
Even though deregulation created a more concentrated airline market, it has also
lowered the average airfare and has increased competition on many city-pair routes4.
Moreover, with the allowance of frequent flier plans and discounted fares, U.S. domestic
passenger levels have increased dramatically. From 1978 to 1993, the number of
domestic plane passengers grew from 256 million to 478 million, an 87 percent increase5.
In addition, the frequency in the number of flights has also increased from 5 million flight
departures in 1978 to 7.2 million in 19936. Ordinarily, such growth in demand would
imply positive financial returns; however, the period of deregulation was much less
profitable than in the years prior to deregulation. The situation was so “bleak” that the
Clinton Administration organized the National Commission to Ensure a Strong
Competitive Airline Industry in 1993.
Overall, deregulation of the United States domestic airline industry has had mixed
results. On one hand, people are flying more, average fares are lower, and the number of
flights available has increased. On the other hand, the profits of the industry have greatly

3 Goetz and Sutton; p. 240.
4 U.S. Department of Transportation 1990, U.S. General Accounting Office 1990,
National Research Council 1991.
5 U.S. Department of Transportation 1978, 1993.
6 U.S. Federal Aviation Administration 1978, 1993.

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declined and the industry has become more concentrated. Today, only one or two carriers
dominate specific airports, demonstrating a bias towards the larger airlines. With this
sudden shift in decision-making and control away from government agencies to
individual firms, there is, contrary to the initial expectations of perfect competition, a
possibility of monopolistic behavior. The typical concern with monopolistic behavior is
the fact that it often leads to an increase in price, which then implies a decrease in
consumer surplus and even welfare. However, because the average fare has actually
declined for the industry as a whole, consumer surplus7 has not been adversely affected.
Also, the effect on welfare is ambiguous8. These results can be explained because even
though monopolistic behavior might be expected with the increase in market
concentration, the airline industry is still a competitive industry in the respect that any
airline carrier is allowed to enter the market. Overall, deregulation seems to only benefit
certain groups. It benefits consumers and large airlines, but it also hurts small airlines and
the profitability of the industry as a whole.







7 Consumer surplus is defined as the difference between a consumer’s willingness to pay
(height of the demand curve) and what the consumer actually pays. Therefore, if the price
of an airline ticket decreases, this increases the difference between the demand curve and
the price and consumer surplus increases.
8 Welfare is defined as the sum of consumer surplus and the profit of the industry’s firms.
Therefore, even though consumer surplus increases, profit might decrease enough to
make welfare decrease. However, if profit does not decrease more than consumer surplus,
welfare will increase.

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III. Effects of Competition on Pricing Behavior

As a result of deregulation, competition in the airline industry is able to act as it
naturally would. In the regular model of perfect competition, the presence of competitors
lowers the price of a particular good for the industry. However, in the case of airline
tickets, the concept of “competition” is unclear since there are a number of different types
of competition. The following is a discussion of these types of competition and whether
each type does indeed lower prices like the model of competition predicts.
A) The Threat of Entry
Since deregulation, a lot has been learned about the “performance characteristics
of airline markets functioning free of government control”9. In a perfectly contestable
market, the threat of entry is said to be sufficient enough to induce competitive pricing.
However, in the studies above, results showed that the airline industry could actually
promote monopolistic behavior. The belief that the airline market conforms to the
contestable markets model has influenced the establishment of a number of policies,
including a number of airline mergers in the 1980’s who expected potential competition
to lower market power in the industry. However, interest in this subject has led to a
number of empirical studies analyzing the extent to which the threat of entry really does
influence market behavior.

One study, performed by Morrison and Winston, found that potential competitors
have a significantly smaller effect on market behavior than actual competitors10. Another
study, performed by Severin Borenstein, found that the effect of potential competitors

9 Peteraf and Reed; p. 193.
10 Morrison and Winston report an insignificant effect of potential carriers until there are
at least four potential entrants into the airline industry.

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may be even less if there are specific carriers who dominate a certain airport11. (A
discussion of Hub Airports will be included later on). Overall, however, the airline
industry does not appear to conform well to the contestable markets model. The threat of
entry is not strong enough to induce either competitive pricing or a less concentrated
market.
B) Indirect Competition

Most of the studies mentioned earlier use a model of large city-pair markets with
multiple competitors. “Considerably less is known about market performance in smaller
markets, especially those in which there is no direct competition”12. However, a few
conclusions have been made about the presence of indirect competition in both large and
small markets.

Indirect competition is defined as the presence of carriers offering service on a
route with at least one stop and a change of planes; whereas direct competition is defined
as the presence of a carrier offering service on a route with no stops or change of planes.
In 1989, Peter Reiss and Pablo Spiller modeled entry into small airline markets with at
most one direct competitor and an unlimited number of indirect competitors13. The results
concluded that indirect competition had a significant effect on market behavior.
However, because indirect service is less desirable than a direct flight, it allows for
product differentiation between carriers and does not influence the market behavior in
exactly the same manner as a perfectly competitive market, with multiple direct
competitors, would. This is due to the fact that airline carriers are able to price

11 Borenstein, The Dominant Firm Advantage.
12 Peteraf and Reed; p. 195.
13 Reiss and Spiller, Competition and Entry in Small Airline Markets.

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discriminate towards groups that value direct service more highly than indirect service.
Direct service is not the only factor that is affected by price discrimination. Time
valuation (discussed in a later section) is another.
C) Competition of Airports within the same Metropolitan Area
Airports within the same metropolitan area pose the possibility of substitutability
(a passenger might go to another airport if it finds that its carriers offer a lower fare). In
this case, an antitrust analysis was performed which used the cross-elasticity of demand
as the criteria for judging market boundaries14. However, this analysis ignored the
presence of price discrimination and demand segmentation in the airline industry. Since
airlines are allowed to offer restricted discount fares to travelers on the same route at
different times of the day, this enables them to separate out customers by their valuation
of time. Therefore, since business travelers usually book flights that they themselves do
not pay for, we would expect that competing airports would affect the fare of an average
traveler more than that of a business traveler.
Overall, a number of factors influence competition. Some factors even influence
competition on varying levels in different areas of the airline industry. However, the
presence of perfect competition in the deregulated airline market is doubtful. There has
not only been increasing market concentration since deregulation, but also the existence
of monopolistic power in many airports. The next section analyzes other factors that may
influence the pricing behavior of air carriers.



14 Borenstein, Hubs and High Fares: Dominance and Market Power in the U.S. Airline
Industry.

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IV. Other Factors Influencing Pricing Behavior
A) Hubs and Market Share
There are a number of advantages to having airport dominance on a particular
route. The first is that airport dominance enables a carrier to attract more passengers and
raise fares on routes out of that airport because it has a “competitive advantage on routes
that include that airport”15. These competitive advantages arise in two forms. First are
those that occur naturally and second are those that result from programs instituted by
particular airlines. For example, competitive advantage of airport dominance that occurs
naturally is the ability to attract more passengers because it offers the most flights to and
from a city. On the other hand, competitive advantage that occurs through programs
includes frequent-flyer programs and reward systems for travel agents that pay bonuses
when the agent books more flights in favor of one carrier versus another16. In addition, an
airline that dominates a crowded airport may prevent competition by attaining gates and
other physical resources that other airlines need to be competitive. If numerous factors
put a potential entrant at a disadvantage, the carrier may not enter the route market at all
in an effort to avoid difficulties.
Also, using marketing devices that give an advantage to the dominant airline will
increase the number of passengers wanting to fly on that airline. One of the best
marketing devices for this purpose is the use of frequent-flyer programs. “These
programs usually give a gift, usually free travel, to a customer after he or she has

15 Borenstein, Airline Mergers; abstract.
16 Borenstein, Hubs and High Fares: Dominance and Market Power in the U.S. Airline
Industry.

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