INTEGRATING CASE STUDY 9

The Art of Devising Airfares

Salvatore’s Managerial Economics: Principles and Worldwide Applications, 8th
International Edition

Chapter 11-2: The Art of Devising Air Fares

Introductory Comment
The following selection illustrates most of the concepts presented in this part of the text as they
are applied in the real world, and, thus, it serves as an excellent integrating case study. It
shows the importance of market structure in output and pricing decisions, price leadership,
price discrimination, and the pricing of multiple products, and how they are all interrelated to
incremental analysis in pricing as it is conducted in a major industry.

In the airline business, it is sometimes called the dark science. Fare wars, however, have put a
spot- light on how carriers use state-of-the-art computer software, complex forecasting
techniques, and a little intuition to divine how many seats and at what prices they will offer on
any given flight.
The aim of this inventory, or yield management, is to squeeze as many dollars as possible
out of each seat and mile <own. That means trying to project just how many tickets to sell at a
discount without running out of seats for the business traveler, who usually books at the last
minute and therefore pays full fare. Too many wrong projections can lead to huge losses of
revenue, or even worse. The inability of the People Express airline to manage its inventory
of seats properly, for example, was one of the major causes of its demise.
“It’s a sophisticated guessing game,” said Robert E. Martens, vice president of pricing
and production planning at American Airlines, which has the most sophisticated technology
for yield management, according to airline analysts and consultants. “You don’t sell a seat to a
guy for $69 when he is willing to pay $400.”
With the industry now adopting very low discount but nonrefundable fares, the complex
task of managing seat inventory may become easier because airlines will be better able to
predict how many people will show up for a flight. Some airlines have already seen a drop in
their no-shows, which means they can overbook less and bump fewer customers. The
nonrefundable fares could also enable carriers to sell more discount seats weeks before a flight,
rather than putting them on sale at the last minute in an effort to fill up the plane.
American’s inventory operation illustrates just how complicated the process can be. At
the airline’s corporate headquarters, 90 yield managers are linked by terminals to five IBM
mainframe computers in Tulsa, Oklahoma. The managers monitor and adjust the fare mixes
on 1,600 daily flights, as well as 528,000 future flights involving nearly 50 million passengers.
Their work is hectic: a fare’s average life span is two weeks, and industry-wide about 200,000
fares change daily.

Few Discounts on Fridays

American and the other airlines base their forecasts largely on historical profiles on each
flight. Business travelers, for example, book heavily on many Friday afternoon flights, but
often not until the day of departure. The airlines reserve blocks of seats for those frequent
fliers. Few, if any, discounts are made available. “Good luck in getting a ‘Q fare’ from New
York to Chicago on Friday afternoon,” said James J. Hartigan, president of United Airlines,
using the industry parlance for the low-priced, supersaver ticket. “It’s like winning the New
York lottery.” The same route at midday on a Wednesday, however, begs for passengers, so the

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airline might discount more than 80 percent of its seats to draw leisure travelers and others
with more flexible schedules.

Passengers Angered
Many passengers, attracted by advertisements trumpeting deep discounts but unaware
that fare allocations change from flight to flight, have expressed anger at the carriers and
travel agents when the cheap seats were unavailable. To help clear up the confusion,
Continental Airlines has run ads noting the relative demand for certain routes, thus giving
some sense of the supply of discount seats. Overbooking, too, is based on the computerized
history of flights and their no-shows and involves myriad factors that include destination,
time of day, and cost of ticket.
The airlines have used inventory management for decades, but its importance in
helping carriers enhance their revenue coincides with new software developed in the past
three or four years, analysts and airline executives said. Some of the software has been
developed in-house; other systems have been from such companies as the Unis Corporation
and the Control Data Corporation. “It’s probably the No. 1 management tool required to
compete properly in this highly competitive airline environment,” said Lee R. Howard,
executive vice president of Airline Economics, a Washington-based consulting (rm.
Effective inventory management alone can improve an airline’s revenues by 5 to 20
percent annually, analysts estimated. Mr. Martens said American’s system was worth
“hundreds of millions of dollars” a year to the airline. The airline’s total sales exceeded $6
billion last year. “The revenue implications for yield management are enormous,” said Julius
Maltudis, airline analyst at Salomon Brothers. Inventory management improves a carrier’s
load factor, or ratio of seats f i led. Every
1 percent increase in the load factor translates into $10 million in revenues for the typical
major carrier, analysts said.

Crystal-Ball Gazing
As sophisticated as it is, however, yield management is still subject to variables beyond its
control. “Yield management is about 70 percent technology and 30 percent crystal-ball
gazing,” said Robert W. Cuggin, assistant vice president of marketing development at Delta
Air Lines. Bad weather or a last-minute switch to a plane of a different size can wreak havoc
with weeks of planning, he said.
At American, inventory management begins 330 days before departure. Yield
managers use the pro(les of a flight’s history to parcel out an alphabet soup of fares,
rationing full-fare seats first, then moving down the price scale. In the following weeks, the
computer alerts the managers if sales in a particular fare class pick up unexpectedly. If a
travel agent booked a large group of passengers, for example, the computer would <ag the
large order, and yield managers would restrict or expand the number of seats in that
category. Otherwise, managers begin checking all fare mixes regularly
180 days before departure, adding or subtracting seats in each according to
demand.
The process continues right up to two hours before boarding, according to American’s
director of yield management, Dennis McKaige. Airlines typically put more discount seats
on sale just before an advance purchase requirement expires, he said. Therefore, a new
batch of cheap tickets that require a 30-day advance purchase might go on sale 31 days
before departure. A cut-rate fare offered on Monday might be sold out by Wednesday, then
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suddenly reoffered hours before takeoff on Thursday if passenger projections based on
previous flights fail to materialize, Mr. McKaige said.

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 There are some instances when an airline actually gives preference to discount travelers
over customers paying full fare. American has recently developed software to increase the
yield on flights through its hubs. American gives preference to a passenger flying on a
discount fare from Austin, Texas, to London through Dallas/Fort Worth, over another
passenger paying full fare from Austin to Shreveport, Louisiana, through Dallas/Fort
Worth. The London passenger, who pays $241 each way, is worth more to the airline than
the passenger flying to Shreveport, who pays the full fare of $87 each way. For the bargain
hunter, finding a discount will increasingly depend on the season, day and time of travel, the
destination, and the length of stay.

The New Fare Cuts

Continental, a unit of Texas Air, ignited one round of rock-bottom fares with “Maxsaver
tickets,” which require a minimum two-day advance purchase and are nonrefundable. “The
spread between our highest and lowest fares is much lower than with other airlines,” said
James O’Donnel, vice president of marketing at Continental. “While our yield management
job is no less important than other airlines’, it is easier.” Mr. O’Donnel said the carrier’s system
was more automated than those used by some of its competitors.
The two-day purchase requirement has siphoned off some business travelers who would
other- wise have paid full fare. (American and several other airlines abandoned plans to raise
their lowest discount fares and increase the advance purchase requirement on the cheapest
tickets to 30 days, from 2. The airlines backed away from the change when support for the
proposal collapsed.) Airline officials said that nonrefundable tickets were here to stay. Mr.
Martens said that since the nonrefundable, Maxsaver-type fares were introduced, American’s
no-show rate had dropped “substantially below” the usual range of 12 to 15 percent.
Passengers who are willing to commit themselves to a particular flight in exchange for lower
prices allow yield managers to re(ne their operations by concentrating on the remaining coach
seats.

Concluding Remarks
Yield management (i.e., the idea of selling as many tickets as possible at high fares and selling
the rest of the seats at cut rates) is here to stay in the pricing of airline tickets and is constantly
being reviewed with the use of ever more powerful computers and software. Indeed, yield
management is considered the single most important technological improvement in airline
management in the past decade and is often credited with making the difference between pro(t
and loss for many airlines. For example, The New York Times found that on a single fli ght in
1997, the 33 passengers who held Chicago–Los Angeles tickets paid 27 different fares,
ranging from $87 to $728. In 2010, a New York–Los Angeles roundtrip ticket might cost
$287 to one flier and $2,247 to another. Yield management is now spreading also to hotels,
cruise lines, and truck rentals. The great variety and frequent changes in airfares are, however,
creating great confusion and frustration for air travelers as they are routinely unable to book
seats at the lowest advertised fares. This led to increasing complaints of false advertisement,
which the Transportation Department (the sole authority charged with regulating the airline
industry since it was deregulated in 1978) has regularly investigated. In 1998, the
Transportation Department also started to investigate the major airlines’ practices of slashing
fares to drive newcomers (i.e., start-up airlines) out or to discourage their entering the market.
This type of “predatory pricing,” illegal under U.S. antitrust laws, will be examined in Chapter
13. As more and more travelers use the Internet to shop around for the lowest airfares available,
the number of passengers paying full fare has now sharply declined, leading to tremendous
yield erosion for the regular airlines.

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Source: Eric Schmidt, “The Art of Devising Air Fares,” The New York Times (March 4, 1987), pp.
D1–D2. Reprinted by permission of the New York Times Corporation. See also “Computers as Price
Setters Complicate Travelers’ Lives,” The New York Times (January 24, 1994), p. 1; “Special Offers
by Airlines Come Under U.S. Review,” The New York Times (January 23, 1995), p. 10; “So, How
Much Did You Pay for Your Ticket?” The New York Times (April 12, 1998), sec. 4, p. 2; “Prying
Open the Open Skies,” Business Week (February 9, 1998), p. 39; “U.S. Expands Airline Investigation
of Possible Monopolization of Airports,” The Wall Street Journal (February 26, 1998), p. A3;
“Airlines Now Offer ‘Last Minute’ Fare Bargains Weeks Before Flights,” The Wall Street Journal
(March 15, 2002), p. B1; “Airline Seats Have Become a Commodity,” Financial Times (July 13,
2005), p. 5; S. Borenstein and N. L. Rose, “How Airlines Market Work,” NBER Working Paper No.
13452 (September 2007); and “United, Continental to Combine,” The Wall Street Journal (May 5,
2010), p. B1.