Th Unique U.s.
Airline Industry
on
airline industry, one of the most visible compo-
nents iofthe nation's infrastructure, is also one of the
most profoundly misunderstood parts of the U.S.
I y. This book provides a broad range of infor-
on a business which has long been both unusu-
petitive and singularly unprofitable. The
of this opening essay is to point out that while
there are some characteristics that the airline industry
_ with many other industries-in particular the
I~~:tivevalue of being the low-cost producer-
also several factors which combine to make
business' genuinely unique:
• industry's product generates only a very
brand loyalty. To airline customers, who
[ace enormous importance on price and schedule,
fere is very little difference between the products
f the different airlines.
• I most business, adding product features does not
te a greater supply of the product; in this in-
andbook of Airline Economics
Robert L. Crandall
Chairman and Chief Executive Officer
American Airlines, Inc.
dustry, enhancing a key product feature, the
frequency of service offered, increases both prod-
uct quality (consumer choices) and the amount of
product an airline has to sell. The importance of
schedule frequency creates a powerful incentive
for carriers to add flights, as a means of enhanc-
ing the competitive appeal of their products.
• The very nature of scheduled air transportation
dictates that supply and demand-even in the best
of times-will be severely out of balance. The need
to meet demand during peak periods, and to offer
service on the weaker segments of the airline net-
work, assure a continuing oversupply of the
industry's instantly perishable product.
• The marginal cost of selling an otherwise empty
seat is very small-on average, less than one-
fourth of the full cost-meaning there is a very low
effective floor on prices.
• The airline market is made up of thousands of ori-
gin-destination city pairs which are served by way
of a smaller but still substantial number of actually
Section 1. Executive Forum 3
4 Th1 Handbook of Airline Economics

flown routes. A route that is a primary, fully costed Moreover, when one carrier enjoys a frequency ad-
route fpr one carrier will be regarded as an inci- vantage over another, on a particular route, the com-
dental by-product by any carrier with underused petitive value of that advantage is more than
equipment not currently serving the route in ques- proportional. For example, if Carrier A has six daily
tion. I flights between two points, while Carrier B has only
• Barriers to entry into the airline industry are sur- three, the relative strength of Carrier A versus Carrier
prisingly low, as witnessed by the influx of new B is greater than two to one. The reason for this is that
carrierr in recent years. At the same time, there are Carrier A's customers-in addition to having two
extrao~dinarily high exit barriers which keep car- times as many chances to match a flight to their
riers-and the capacity they operate-in the indus- needs-will perceive the more frequent service as of-
try much longer than their financial performance fering them more flexibility to change their plans at the
would lotherwise justify. last minute.
• Computerized Reservations Systems (CRSs)-the Because airline hub-and-spoke systems provide the
industry's dominant distribution vehicle-provide most convenient service between the greatest number
airline customers, instantly, with much better com- of cities, most U'.S.carriers operate domestic route net-
parative price and service information than is works focused around one or more hubs. The fact that
available to consumers of other products. Since customers see the airlines' product-a seat on an air-
price iSIso important in consumer decisions, carri- plane-as a relatively undifferentiated commodity
ers wil~ match a competitors' lower price rather notwithstanding, each time a network-based airline
than lose business. Thus, the real-time pricing in- offers a new flight, it commits an additional city to all
formation provided by airline CRSs intensifies the others served by the hub and, thus, introduces a
the in~ustry's price competition. number of new products. Additionally, by widening
Let's 101k at each of these factors in more detail. the reach of its network, it strengthens its entire exist-
ing product line.
consum±BehaVior-Brand loyalty When origin-departure city-pairs, time of departure,
In many' dustries, product differentiation provides airport used and type of service (nonstop versus con-
a powerful competitive advantage, as well as an effec- necting) combinations are considered, an airline can
tive barri~r to entry. Established companies with schedule its resources to offer an enormous range of
strong bra~d identification and customer loyalty stem- "products," each with different revenue-generating
ming fromiproduct differences, advertising presence, potential and different costs. Furthermore, once air-
or customer-service superiority enjoy a distinct advan- planes and facilities are in place, the economics of of-
tage over rewcomers. Yet price and schedule so fering additional capacity are often evaluated on the
heavily inf~uence the purchasing behavior of airline basis of marginal cost, which is very low as a percent-
customers that brand identification becomes a second- age of total cost.
ary issue. In most industries, increased production, by itself,
While c~stomers may have a "favorite airline," more does not enhance an individual competitor's sales po-
often than inot they are willing to switch to another tential or competitive position. However, in the airline
carrier for even small differences in departure time, or industry, the fact that more capacity represents more
a few dollars' difference in price. This is, at least in part, frequency-and thus a more desirable product-gives
because the duration of most flights is short, and there
every airline an incentive to use every airplane as in-
is a limit o~ the amount of meaningful product differ-
tensively as possible. While this strategy makes sense
entiation that can be accomplished in that time. This
ready substitutability of one airline's product for for each individual carrier, it produces a tendency to-
another's hfs a powerful influence on how each ind us- ward perpetual oversupply.
try participant behaves. While each participant's ac- Supply Does Not Equal Demand
tions make'sense within its particular framework, the
cumulativ~ result is severe price instability for the in- Oversupply is a continuing fact of life in the airline
dustry as alwhole. industry. Since carriers must schedule to accommodate
most of the demand presented at peak periods, there
Competitive Value of Schedule Frequency
is an excess of seats at all other times. Moreover, un-
The infltence of even a small difference in depar- like most industries, airlines cannot reduce the supply
ture time on customer buying behavior creates a pow- of product in response to a decrease in demand with-
erful incentive for carriers to increase frequency, even out simultaneously reducing product quality (fre-
when therr are plenty of seats available on existing quency).
flights. I For example, if an airline's demand drops 2%, the

Section 1. Erecutive Forum


drop is typically spread fairly evenly throughout the
carrier's entire system. While the airline could certainly
disconjinue 2% of its flights, doing so would reduce
the ap~eal of its product in the markets selected for re-
duction, while simultaneously weakening its network
relativk to those of its competitors. This would cause
it to forfeit significant revenue, while not addressing
the excess capacity on the other 98% of its flights.
Of course, if rubber airplanes-which could be
stretcHed or shrunk in response to demand-were
available, airlines would use them. Since they are not, .
suppl~ / demand balance theorists will find the airline
industry a source of great frustration.
High Fixed Costs Combined with
low j"iarginal Costs
Wh~lemost airlines have very high fixed costs (e.g.,
aircraft, maintenance, facilities), the marginal cost of
serving one additional customer on a given flight is
very l<i>w, consisting only of the cost of food, sales com-
mission, incremental fuel burn, and other small ex-
penses. In general, the marginal cost of an additional
passehger is less than one-fourth of the full cost.
Th~se low incremental costs, and the continuous
existence of unsold capacity, often cause carriers to
push prices downward toward the level of variable
costs. rrule a ticket sold below full cost is unprofitable,
any ticket sold at a price above variable cost will make
a contribution-albeit often a small one-toward cov-
eringrthe airline's fixed costs, while an empty seat,
naturally, makes no contribution.
Th~perishable nature of an airline seat-that is, the
fact that it cannot be kept on the shelf to be sold at a
later pate-also serves to depress prices. Every seat
that flies empty represents a revenue opportunity that
is lost forever.
These factors encourage airlines to dispose of excess
seatslat almost any price. And all too often, that is ex-
actlyr,hat airlines do, wreaking havoc as competitors
scramble to match one sale after another.
A Frragmented Market
The intense competition which characterizes the
airlure industry is complicated by the fact that differ-
ent carriers often attach wildly varying importance to
the same route. There are many circumstances in which
a particular route represents an important part of a
carriler'snetwork, produces fully allocated profits and
is regarded as part of that carrier's core business. For
a ca~rier not currently serving that ro~e, on the other
hand, it represents an incremental opportunity.
The second carrier-needing only to recover the
marpinal costs of adding service with equipment it
already has, but which may be surplus to its needs
The Handbook of Airline Economics 5
because of, say, a recession-may choose to facilitate
its entry to the route by pricing its services at or just
above marginal cost. In this scenario, the second car-
rier will benefit from filling lots of empty seats, and
contributing-in at least a small way-to covering its
fixed costs.
The first carrier, compelled to match the newcomer's
price, will suffer significant yield erosion and will be
unable to meet its objective of full cost recovery. The
new carrier will benefit, but industry results (Carrier
A + Carrier B) will move from black into red ink.
As with decisions to add or sustain capacity, the
pricing decisions of individual carriers usually make
economic sense from the carrier's perspective. But for
the industry as a whole, these decisions contribute to
the continual price erosion which has restricted the
ability of all carriers to increase revenues to keep up
with rising costs.
low Entry Barriers/High Exit Barriers
Despite the fact that even relatively strong carriers
have been unable to earn an adequate return on their
investments, recent years have brought a steady stream
of new entrants into the industry. The barriers to en-
try into the industry are surprisingly low. For example,
in many businesses, economies of scale-whereby unit
costs decline as the volume of business increases-
force new entrants either to enter on a large scale or
suffer a substantial cost disadvantage.
In the airline industry, however, the hard times of
recent years and the failure of several major carriers
have made both aircraft and labor available to start-ups
at bargain prices. Moreover, start-ups tend to operate
selected, point-to-point route systems, rather than ex-
pensive hubs, and to forego many customer-service
features airline passengers like but will not pay for.
This, in turn, has created a reverse economy of scale,
whereby new entrants are able to enter with far lower
costs than their bigger competitors.
Start-up airlines' easy access to state-of-the-art dis-
tribution systems also gives them a leg up not avail-
able to new entrants in other industries, where
distribution channels are more limited, or can be tied
up by existing competitors. Computerized reservations
systems allow start-up airlines to have their products
displayed and sold on an equal basis with those of
market leaders.
Unfortunately, the low entry barriers into the indus-
try are coupled with high exit barriers. Entry is easy,
and is attracted by upturns in the economy, but capac-
ity does not leave the industry when results deterio-
rate. Economic, strategic, emotional and political
factors keep competitors in the airline industry even
when they are earning a low or even negative return
Chapter 1. The Unique U.S. Airline Industry
6 The r"OdbOOk 0' Airline Economics
on investm~nt.
One suc~ factor is current U.S. bankruptcy law,
which all0"1'sfailed carriers to continue to operate in-
definitely.Jllhe negative effects of U.S. bankruptcy law
are explored!more fully in the public-policy section of
this chaptd.
Another ~eason failed carriers do not abandon the
industry is that an airline is a network, and the airline's
assets are nb t worth, in liquidation, anything like the
present val1f1e
l of the cash flows generated by even an
unprofitabte network. As a result, failing airlines
struggle on, often resorting to extreme tactics-such as
initiating "fare wars" to bring in cash to cover only
direct operrting costs-which contribute to the poor
economic performance of the industry as a whole.
purChaSifg Power
The cons~ant availability of unsold inventory gives
unusually strong bargaining leverage to large purchas-
ers of air tr1vel. Corporations, tour operators and the
U.S. Goverpment are all able to negotiate deep dis-
counts, sinewairlines lose less offering the discounts
than they 10uld by permitting competitors to take the
business while the rejecting carrier flies empty seats.
Probablytthe most striking example of a large pur-
chaser usinp its clout to gain deep airline discounts is
the U.S. G~iVernment.The General Services Adminis-
tration co els airlines to bid against one another for
governme business on each individual route. Since
the weakes carrier on a route may have to abandon it
without the government's business, competition is
fierce and JI n many routes, all carriers offer fares far
below full costs. By using its leverage to act as a
monopsoni t, the U.S. Government has reduced the
industry's evenue for each of the last several years by
roughly $1 ~illion.
While n.~t every airline passenger has the clout to
negotiate t~e discounts of a large tour operator or cor-
poration, there are a number of factors that give even
the smallest customer an advantage in buying an air-
line ticket ttlat he or she does not enjoy when purchas-
ing most of er products.
First, an airline's product is typically not well dif-
ferentiated from that of its competitors. For that rea-
son, and b~cause an airline trip is a "big-ticket item,"
passengers consistently demonstrate a willingness to
choose one airline over another on the basis of rela-
tively smal differences in price or schedule.
Second, FRSs give even individual airline custom-
ers instant access to more complete price and service
informatio+ than exists in any other marketplace. The
wealth of ~formation available to all consumers inten-
sifies competition among the carriers, as any price
change is tediatelY known to travel agents-who
Section 1. EI ecutive Forum
book more than 80%of airline seats-and is almost al-
ways matched by all competitors. Few, if any, indus-
tries operate in so nearly perfect a marketplace.
The Cost Imperative
Since an airline's costs define the limit of how low
it can profitably price, and since most airline custom-
ers value low prices above all other carrier-selection
factors, the carrier with the lowest costs has a power-
ful competitive advantage. The fact that most carriers
have a very difficult time differentiating their products
from those of their competition makes this especially
true. Thus, cutting costs to the lowest possible level has
become a key strategic necessity in today's airline in-
dustry.
Unfortunately, reducing costs is easier said than
done. In addition to a carrier's high fixed costs, many
of its so-called "variable costs"-if not completely out
of the airline's control-are very difficult to manage.
Two of the biggest are jet fuel and labor.
Although an airline can maximize its efficiency by
purchasing aircraft that burn less fuel than others, fuel-
efficient airplanes often have much higher capital costs
than less-efficient aircraft. Moreover, the actual price
of fuel is contingent on factors far outside any airline's
span of control. Thus, fuel costs are only marginally
manageable.
The high level of unionization in the airline indus-
try-particularly among the more established carri-
ers-also reduces the extent to which labor costs can
truly be considered "variable." Labor typically repre-
sents the largest cost advantage start-up airlines have
over more established carriers. Moreover, despite its
reliance on high technology, the business is very labor
intensive. New entrants often outsource many func-
tions to service providers that pay their people mini-
mum market rates and provide few, if any, benefits.
Since these providers draw from a large pool of expe-
rienced people trained by carriers that have failed, new
entrants often offer service which is qualitatively in-
distinguishable from that offered by long-established
carriers.
In contrast, the older carriers, which have been ver-
tically integrated for decades, operate under the terms
of union contracts that prevent them from making
changes to match the costs of new entrants. These con-
tracts typically include extraordinarily complex work
rules that sharply reduce the carriers' ability to im-
prove labor productivity. Moreover, the work force of
the traditional carrier is much more senior than that of
a start-up airline, creating an even greater disparity in
wage rates as a 10- or 20-year airline veteran will in-
variably have achieved a far higher wage than his or
her counterpart at a start-up carrier.

Public Policy
The ~ndustry's structural problems have been exac-
erbated, since deregulation, by the implementation of
policies inconsistent with the industry's efforts to re-
shape itself from a regulated to a competitive structure.
Following deregulation, competition intensified as
carriers explored various ways to attract revenue, re-
duce C?sts and earn an economic return on their enor-
mous capital investments.
However, as the years passed, neither the Congress
nor successive Administrations created a mechanism
for the systematic evaluation of the probable conse-
quences of airline failures. Nor did the U'.S.adopt leg-
islation or policies consistent with the industry's
peculi<jlrcharacteristics and its new-found competitive
freedom. The government's preoccupation has been
with consumer benefits and job preservation.
f
As consequence of this failure, the unique inabil-
ity of airlines to exit the business and simultaneously
preserve their network value, and the inability of suc-
cessor owners to lower the labor costs of acquired air-
lines, airlines have been unable to reshape themselves
as successfully as competitors in other industries.
The real key to this is that airlines-unlike most
other businesses-cannot economically discontinue
their activities. The network nature of airline compa-
nies_jwhich are worth the present value of the future
stream of cash flows generated by the integrated use
of airplanes, people and facilities-means that an air-
line dnnot efficiently liquidate its assets piecemeal, as
many companies do. The value of an airline's assets-
individual aircraft, buildings, ground leases, etc.-is
substantially less than the stream of cash flow which
can b, produced by using those assets in concert. More-
over, Ian unprofitable airline cannot readily be sold,
because union contracts prevent purchasers from act-
ing t9 reduce costs.
As a consequence of these realities, failed airlines
have made extensive use of U.S. bankruptcy laws,
whicf permit them to continue operating for very ex-
tended periods of time-thus preserving their network
value-while simultaneously using the protection of
the bankruptcy court to repudiate prior obligations, to
negotiate reduced aircraft lease payments, to persuade
debt holders to accept equity for debt exchanges, and
to wting labor-cost concessions from unions by per-
suadrg them that the company's bankruptcy would
make cost reductions a necessity. Absent this unique
abiliJy to use U.S. bankruptcy laws for the purpose of
sust'tining network revenues, failed airlines would
havel no choice but to recognize their losses by liqui-
dating their assets and acknowledging their failure.
The Handbookof AirlineEconomics 7
One of the most important consequences of the
bankruptcy scenario is the reality that bankrupt air-
lines, seeking to reverse their fortunes and to attract
and retain passengers, often act as price leaders, post-
ing reduced prices in the belief that even if revenues
do not match costs, they will be better off attracting
passengers at lower fares than suffering the conse-
quences of abandonment by their customers.
As the bankrupts have offered lower prices, their
competitors-recognizing that they will be financially
better off matching the lower prices than allowing traf-
fic to be diverted to their bankrupt brethren-have
matched, setting off the continuing fare wares that
have characterized the domestic industry throughout
the 1980s and early 1990s. The result has been huge
losses for the industry, creating abnormal debt-to-eq-
uity ratios and reducing the securities of most U'.S.
carriers to noninvestment grade.
By being more concerned with the preservation of
jobs than with the continuing health of the domestic
air transport industry, the U.S. Government has put the
entire industry at risk and dramatically altered the
capacity of U'.S.carriers to make the huge investments
in aircraft and facilities necessa-ry to a successful air-
line industry.
In international aviation, government policy has
been equally misguided. The United States is the
world's only deregulated airline market-in virtually
every other country, government regulation of prices,
s~"Vicefrequency and other commercial factors is rou-
tine, and one airline dominates the market. Thus, with
respect to their international competitors, U'S, airlines
are peculiarly disadvantaged in a variety of ways.
First and foremost is the propensity of the U.S. Gov-
ernment to grant foreign flag carriers unique oppor-
tunities to build network systems more powerful than
those available to U.S. airlines.
Although Pan American World Airways long domi-
nated the U.S. presence in international aviation, the
transatlantic markets, before and after Pan Am, are an
interesting example of how this phenomenon has de-
veloped. Prior to its demise, Pan Am competed in the
transatlantic market with European carriers, each of
which was supported by a strong hub in its own do-
mestic marketplace, while Pan Am was forbidden to
operate its own domestic services. Thus, on its trans-
atlantic flights, Pan Am was able to offer fewer origin-
destination city-pairs than Lufthansa, British Airways
(BA), Air France and other European carriers because
their transatlantic services were supported by connect-
ing flights to many points beyond their hubs. When it
was finally given the freedom to fly domestically in
1978,Pan Am's image as an international-only carrier
Chapter 1. The UniqueU.S.AirlineIndustry
8
I
The Handbook of Airline Economics
I
I
was so entrJnched, and its finances so ravaged, that it rier from competing in this market and creating a
was never able to establish a strong domestic presence. monopoly for BA.
Subsequent to Pan Am's failure, as American, As a consequence of U.S. code-sharing policy, the
United andlDelta began to fly transatlantic routings, number of aircraft actually operated by U.S. carriers
those carriefs recovered market share which had been across the Atlantic has decreased in recent years, and
lost duringl~he many years of Pan Am's and TWA's in the summer of 1995,every U.S.carrier except Ameri-
decline. UlortunatelY, when USAir and Northwest can flew fewer transatlantic flights with its own aircraft
encountere financial difficulty, the United States al- and crews than it did in 1994.
lowed BAt enter into a broad code-sharing agreement For these reasons, despite the fact that the U.S.mar-
with USAir land authorized KLM, the Dutch carrier, to ket constitutes-by itself-nearly 40% of the world's
code-share r.ith Northwest. Code-sharing is a market- total aviation demand, the U.S. Government's interna-
ing device through which the two-character airline tional policies have had the effect of reducing the prob-
designator code of one carrier is used to characterize ability that its major domestic carriers can be
the flights or another airline as the coding carrier's own, successful, long-term competitors in transatlantic mar-
misleading consumers into believing that flights on kets, and have shifted the transatlantic advantage,
connecting I airlines are really on a single carrier-a rather dramatically, to European airlines.
preferred Pfoduct. The KLM and BA actions enabled
Conclusion
these two carriers to connect their hubs in Amsterdam
and Londoh with pseudo hubs in the United States, This chapter has enumerated some of the real dif-
and to widen enormously the reach of their combined ferences between the airline industry and other busi-
real and "PFeudo" networks. nesses, and has touched on a few of the public policies
U.S. airlires, other than the partners selected by BA which, together with those unique characteristics, have
and KLM, were severely disadvantaged by the result- shaped U.S. commercial aviation in the years since
ant ability of KLM and British Airways to offer vastly deregulation.
larger numbers of origin-destination combinations on As the reader pursues this anthology, he or she will
their transatlantic services than airlines like United and no doubt identify other ways in which the airline in-
American. In response, United negotiated a code-shar- dustry is unique, and think of other ways in which
ing agreement with Germany's Lufthansa, which public policy has had perverse results. That's as it
linked Lufthansa's hub at Frankfurt with United's at should be, for this chapter is intended primarily to
Chicago, ahd Delta entered into more limited code- pique the reader's interest and to suggest that in many
sharing arrrngements with Virgin Atlantic, Swissair, respects, conventional "business solutions" to prob-
Austrian atd Sabena, the Belgian carrier. It seems in- lems of inadequate revenues, excessive costs and un-
evitable, at this point, that American-although it has satisfactory profitability are not terribly useful to
often announced its preference to compete indepen- airline managers.
dently-wir have no choicebut to enter into code-shar- In the chapters to come, you will learn more about
ing agreeIljlents with one or more major European the intricacies of a complex, often misunderstood, but
carriers. While these code-sharing agreements are fascinating business.
lauded by the U.S. Government as a means of increas-
ing compefition on transatlantic routes, their actual
effect is to reduce competition! The Philadelphia-Lon-
don route ~sa good example of how code-sharing has
reduced competition.
When t~e BA-USAir code-sharing agreement was
approved, rhe U.S. Department of Transportation for-
bade USAir to operate between Philadelphia and Lon-
don, for f~ar of potential collusion with British
Airways. Unfortunately, it overlooked the fact that of
all U.S. carriers, only USAir could potentially compete
successfull~ between London and Philadelphia, since
no other U.S. carrier has a Philadelphia hub. Even
worse, by fermitting British Airways to code-share
with USAif' the United States created a condition by
which British Airways has hubs in both Philadelphia
and Londoh-thus effectively precluding any U.S.car-

I
Section 1. Hxecutive Forum