Southwest Airlines

Capturing surplus
Han Yi Kim
 Southwest Airlines
• Founded in 1971 by Rollin King and Herb
Kelleher
• The third-largest airline in the world
• The United States’ most successful low-fare,
high frequency, point-to-point carrier.
• Known as a “discount airline” since 1973
- offers low fares
- no-frills service
- basis for Southwest's popularity and rapid growth
 Corporate Culture
• Tickets must be bought from the airline itself, the
phone or online
• Extra Rapid Rewards
- frequent flier program
- credits for online booking users only
• Customers are assigned to a boarding group
depending on check-in time
- find their own seats on the plane
• Colorful boarding announcements and crews that burst
out in song instead of no video entertainment
• Meal service is less than on historically full service
airlines
 Basis for profitability
• Fuel hedging
– Purchased fuel options for years in advance to
smooth out fluctuations in fuel costs
– substantially increased its hedging in 2001 in
response to projections of increased crude oil prices
– Advantaged after Sep. 11, 2001 attack, the oil shock
from Iraq War, and Hurricane Katrina
• Operated only one model of aircraft
– Boeing 737, medium range-narrow body commercial
passenger jet aircraft
– easy to replace parts and ground support equipment
 The Southwest Effect
• A trend that indicated the success and
profitability of Southwest’s business model
– less expensive than driving between two
points in the early 1970s, during the first
major energy cost crisis in the U.S.
• Basis of lean operations and high aircraft
utilization
• When a low fare carrier enters a market,
profit grows dramatically
 Fight against high speed rail
• In 1991 Texas TGV Corporation planed to connect the
“Texas Triangle” (Houston – Dallas – San Antonio) with a
privately financed high speed train system at a lower fare
rate
– The same model Southwest Airlines used 20 years
earlier to break in to the Texas market
• The original estimated cost was $5.6 billion, but the task
of securing the necessary private funds proved extremely
difficult
• Southwest Airlines created legal barriers to prohibit the
consortium from moving forward with the help of lobbyists.
• In 1994, the Texas TGV Corporation has failed and
withdrew high speed rail development
– lost $40 million to be invested
Conditions for price discrimination
• A firm must have some market power to price discriminate
– The demand curve the firm faces must be downward
sloping
• Southwest knows that it can attract more customers
at lower fare price
• The firm must have some information about the different
amounts people will pay for its product.
– Southwest must know how reservation prices or
elasticities of demand differ across consumers
• A firm must be able to prevent resale, or arbitrage.
– Customers need to present an identity card before
boarding
Third-Degree Price Discrimination
• The firm identifies different consumer groups, in
the market, each with a different demand curve.
– Southwest Airlines recognizes that any given flights
has different types of travelers
• business travelers vs. vacation travelers
• To maximize profit, the firm sets a price for each
group by equating marginal revenue and
marginal cost.
– Equivalently, by using the inverse elasticity pricing
rule (IEPR)
The Inverse Elasticity Pricing Rule
(IEPR)
• The rule stating that the difference
between the profit-maximization price and
marginal cost, expressed as a percentage
of price, is equal to minus the inverse of
the price elasticity of demand.
 Price elasticity of demand
• The percentage change in quantity demanded
(Q) that occurs in response to a percentage
change in price (P)

• Estimates of the price Elasticity of demand for Airline

Category Estimated EQ,P
Airline travel, leisure - 1.52
Airline travel, business - 1.15
*Source: Tea Hoon Oum and Jong-Say Yong, “Concepts of Price Elasticities of Transport Demand
and Recent Empirical Estimates,” Jounal of Transport Economics and Policy (May 1992):139-154
 Examples
• Using the inverse elasticity pricing rule to determine the ratio of
between tickets for business (PB) and vacation travelers (PV)
– The IEPR tells that (PB – MC)/PB = -(1/e)
• Substitute the estimated price elasticity of demand for
business travelers, e = -1.15
• solve for MC: MC = 0.13 PB
– The IEPR also tells that (PV– MC)/ PV = -(1/e)
• Substitute the estimated price elasticity of demand for
vacation travelers, e = -1.52
• solve for MC: MC = 0.342 PV
• Equate these two expressions for MC: PB /PV = 0.342/0.130 = 2.63
• Thus, Southwest Airlines will maximize profit by charging
2.63 times as much for a business travel ticket as it
charges for vacation travel ticket
– (the exact prices of the tickets will depend on the marginal cost)
 Advertising campaigns
• “Just Plane Smart”
• “The Somebody Else Up There Who
Loves You”
• “THE Low Fare Airline”
• “Symbol of Freedom”
• “Wanna get away?”
– “[ding] You are now free to move about the
country”
 Livery
• Some southwest
planes feature special
themes, rather than
the normal livery
– Shamu One/Two/Three
– California One
– Arizona One
– Lone Star One
– Triple Crown One
– Sliver One
 2005 Financial Statistics:
• Net income: $548 million
• Total passengers carried: 88.4 million
• Total RPMs: 60.2 billion
• Passenger load factor: 70.7 percent
• Total operating revenue: $7.6 billion
Southwest Airlines’ Top 10 Airports
(as of February 22, 2006)

Daily

Departur Number Nonstop Cities

Cities es of Gates Served Service Established
Las Vegas 216 21 51 1982
Phoenix 200 24 41 1982
Chicago Midway 200 29 43 1985
Baltimore/Washington 165 19 34 1993
Oakland 138 11 20 1989
Houston Hobby 134 17 28 1971
Dallas (Love Field) 120 14 14 1971
Los Angeles (LAX) 118 12 19 1982
San Diego 92 10 16 1982
Orlando 90 9 28 1996
 Incidents and Accidents
• On March 5, 2000, Southwest Airlines Flight
1455 overran a runway at the Burbank airport in
California
– Leaving 43 injured but no fatalities
– Resulted in the dismissal of the pilots
• On December 8, 2005, Southwest Airlines Flight
1248 skidded off a runway at Midway Airport in
Chicago, Illinois, in heavy snow conditions
– A young boy was killed in a car struck by the plane
after it had skidded into a street
– Several minor injuries reported from passengers
onboard the aircraft and on the ground
 Conclusion
• Southwest Airlines uses third-degree price
discrimination to fill the plane with
travelers in the most profitable way
• Depending on the price of elasticity of
demand for tickets
– Charge a higher price for business travelers
who have relatively inelastic demands
– Charge a lower price for vacation travelers
who have relatively elastic demands