How Airlines Compete Fighting it out in a City-Pair Market

William M. SwanChief Economist

Seabury Airline Planning GroupNov 200

Papers: http://www.seaburyapg.com/company/research.htmlContact: bill.swan@cyberswans.com

A Stylized GameWith Realistic Numbers

1. The Simplest Case, Airlines A & Z

2. Case 2: Airline A is Preferred

3. Peak and Off-peak days

4. Full Spill model version

5. Airline A is “Sometimes” Preferred

6. Time-of-day Games

Model the Fundamentals• Capture all relevant characteristics

– Different passengers pay high and low fares– Different passengers like different times of day– Different passengers have less or more time flexibility– Airlines block space to accommodate higher fares– Demand varies from day to day– Demand that exceeds capacity spills

• to other flights, if possible

– Airlines can be preferred, one over another– Passengers have a hierarchy of decisions

• Price; Time; Airline

– Bigger airplanes are cheaper per seat than smaller ones

Example Simple but True• Example here as simple as we could devise

– Covers all fundamentals– Uses simplest possible distributions

• Time of day• Fares paid• Airline choices• Demand variations• Choice Hierarchy

– Means and Standard Deviations are realistic• Each is a “cartoon”

– Reflects industry experience with detailed models– Based on best practices at

• AA; UA; Boeing; MIT• Other airlines that were Boeing customers• University contacts

The Simplest Case: Airlines A & Z

• Identical airlines in simplest case• Two passenger types:

1. Discount @ $100, 144 passengers demand2. Full-fare @ $300, 36 passengers demand- Average fare $140

• Each airline has– 100-seat airplane– Cost of $126/seat– Break-even at 90% load, half the market

We Pretend Airline A is Preferred

• All 180 passengers prefer airline A– Could be quality of service– Maybe Airline Z paints its planes an ugly color

• Airline A demand is all 180 passengers– Keeps all 36 full-fare– Fills to 100% load with 64 more discount– Leaves 80 discount for airline Z– Average A fare $172– Revenue per Seat $172– Cost per seat was $126– Profits: huge

Airline Z is not Preferred

• Gets only spilled demand from A

• Has 80 discount passengers on 100 seats

• Revenue per seat $80

• Cost per seat was $126

• Losses: huge

“not a good thing”

Preferred Carrier Does Not Want to Have Higher Fares

• Pretend Airline A charges 20% more– Goes back to splitting market evenly with Z– Profits now 20%– Profits when preferred were 36%

• 25% extra revenue from having all of full-fares

• 11% extra revenue from having high load factor

• Airline Z is better off when A raises prices– Returns to previous break-even condition

Major Observations

• Average fares look different in matched case:– $172 for A vs. $80 for Z

• Preferred Airline gains by matching fares– Premium share of premium traffic– Full loads, even in the off-peak– Even though discount and full-fares match Z

More Observations

• “Preferred wins” result drives quality matching between airlines

• Result is NOT high quality– Everybody knows everybody tries to match– Therefore quality is standardized, not high

• Result is arbitrary quality level– add qualities that people value beyond cost?

Variations in Demand Change Answer

• Consider 3 seasons, matched fares case1. Off peak at 2/3 of standard demand (120)2. Standard demand of 180 total, as before3. Peak day at 4/3 of standard demand (240)4. Each season 1/3 of year5. Same average demand, revenue, etc.

• Off-peak A gets 24 full-fare, 76 discount– Z gets only 20 discount

• Peak A gets 48 full-fare, 52 discount– Z gets 100 discount, still below break-even– Z is spilling 40 discounts, lost revenues

• Overall, A at $172/seat and Z at $67– Compared to $172 & $80 in simple case– Some revenue in the market is “spilled’ – all from Airline Z

Full Spill Model Case• Spill model captures normal full variations of seasonal demand

– Spill is airline industry standard model*• Spill model exercised 3 times:

– Full-fare demand against A capacity• For full-fare spill, which is zero

– Total demand against A capacity• Spill will be sum of discount and full-fare

– Total demand against A + Z capacity• Spill will be sum of A and Z spills

• K-cyclic = 0.36; C-factorA=0.7; C-factorAZ=0.7• Results

– A $11/seat below 3-season case– Z $1/seat better than 3-season case

• Qualitatively the same conclusions: A wins big; Z looses.

*See Swan, 1997

Airline A is “Sometimes” Preferred

• 2/3 of customers prefer airline A• 1/3 of customers prefer airline Z• Full spill case• Results:

– A has 85% load; $133/seat—15% above avg.– Z has 73% load; $97/seat—15% below avg.

• If Z is low-cost by 15%, can break even• This could represent new-entrant case

Cases of Increasing Realism

Airline A $/seat

Load Factor

Avg. Fare

Simple $172 100% $172

3-seasons $172 100% $172

Spilled $161 89% $181

2/3 Pref. $133 85% $157

Airline Z $/seat

Load Factor

Avg. Fare

Simple $ 80 80% $100

3-seasons $ 67 67% $100

Spilled $ 68 68% $100

2/3 Pref. $ 97 73% $133

Total A & Z $/seat Load Factor Avg. Fare

Simple $126 90% $140

3-seasons $119 83% $143

Spilled $115 79% $146

2/3 Pref. $115 79% $146

Time-of-Day Games

• What if 2/3 preferred case was because Z was at a different time of day?– 1/3 of people prefer Z’s time of day– 1/3 of people prefer A’s time of day– 1/3 of people can take either, prefer Airline A’s quality (or color)

• Ground rules: back to simple case– No peak, off-peak spill– Back to 100% maximum load factor– System overall at breakeven revenues and costs

• Simple case for clarity of exposition– Spill issues add complication without insight– Spill will merely soften differences

Simple Time-of-Day Model

Total DemandMorning Midday Evening

Only

17.5% 17.5% 17.5%

AM 15%

PM 15%

any 17.5%

Both A & Z in Morning A=36F, 64D Z=0F, 80D

Full

Fare

Morn

-ing

Mid-

Day

Even

-ing

Only 25% 25% 25%

AM 10%

PM 10%

All 5%

Dis-count

Morn

-ing

Mid-

Day

Even

-ing

Only 10% 10% 10%

AM 20%

PM 20%

All 30%

RAS=$172 RAS=$ 80

Z “Hides” in Evening A=18.9F, 81.1D Z=17.1F, 62.9D

Full

Fare

Morn

-ing

Mid-

Day

Even

-ing

Only 25% 25% 25%

AM 10%

PM 10%

All 5%

Dis-count

Morn

-ing

Mid-

Day

Even

-ing

Only 10% 10% 10%

AM 20%

PM 20%

All 30%

RAS=$138 RAS=$114

A Pursues to Midday A=22.5F, 77.5D Z=13.5F, 66.5D

Full

Fare

Morn

-ing

Mid-

Day

Even

-ing

Only 25% 25% 25%

AM 10%

PM 10%

All 5%

Dis-count

Morn

-ing

Mid-

Day

Even

-ing

Only 10% 10% 10%

AM 20%

PM 20%

All 30%

RAS=$145 RAS=$107

Demand Up 50%, A uses 200 seats A=33.7F, 166.3D Z=20.3F, 49.7D

Full

Fare

Morn

-ing

Mid-

Day

Even

-ing

Only 25% 25% 25%

AM 10%

PM 10%

All 5%

Dis-count

Morn

-ing

Mid-

Day

Even

-ing

Only 10% 10% 10%

AM 20%

PM 20%

All 30%

RAS=$134, CAS=$95 RAS=$111; CAS=$126

Larger Airplanes are Cheaper Per Seat

$50

$70

$90

$110

$130

$150

$170

$190

$210

$230

0 50 100 150 200 250 300 350 400SEATS

CA

S -

Co

st

pe

r A

va

ila

ble

Se

at Too Expensive

Declining Advantages to Scale

Reasonable Range of Sizes

Demand Up 50%, Z adds Morning A=27F, 73D Z=27F, 143D

Full

Fare

Morn

-ing

Mid-

Day

Even

-ing

Only 25% 25% 25%

AM 10%

PM 10%

All 5%

Dis-count

Morn

-ing

Mid-

Day

Even

-ing

Only 10% 10% 10%

AM 20%

PM 20%

All 30%

RAS=$154, CAS=$126 RAS=$112; CAS=$126

Demand Up 50%, A adds Morning A=40.5F, 157.4D Z=13.5F, 58.6D

Full

Fare

Morn

-ing

Mid-

Day

Even

-ing

Only 25% 25% 25%

AM 10%

PM 10%

All 5%

Dis-count

Morn

-ing

Mid-

Day

Even

-ing

Only 10% 10% 10%

AM 20%

PM 20%

All 30%

RAS=$139, CAS=$126 RAS=$ 99; CAS=$126

A adds Evening Instead A=54F, 146D Z=0F, 70D

Full

Fare

Morn

-ing

Mid-

Day

Even

-ing

Only 25% 25% 25%

AM 10%

PM 10%

All 5%

Dis-count

Morn

-ing

Mid-

Day

Even

-ing

Only 10% 10% 10%

AM 20%

PM 20%

All 30%

RAS=$154, CAS=$126 RAS=$ 70; CAS=$126

case

A

pax

F

A

Pax

D

A

Avg

Fare

A

Rev/

Seat

B

pax

F

B

Pax

D

B

Avg

Fare

B

Rev/

Seat

A in morning

B in morning36 64 $170 $170 0 80 $100 $80

A in morning

B in evening19 81 $137 $137 17 63 $142 $112

A in midday

B in evening22 78 $144 $144 14 66 $133 $105

A 200 in midday

B in evening35 165 $135 $135 21 51 $158 $114

A in midday

B morn & eve28 72 $156 $156 28 144 $133 $114

A morn & mid

B in evening42 156 $142 $141 14 60 $138 $102

A morn & eve

B in evening56 144 $156 $156 0 72 $100 $72

Summary and Conclusions• Airlines have strong incentives to match

– A preferred airline does best matching prices – A non-preferred airline does poorly unless it can match

preference.• A preferred airline gains substantial revenue

– Higher load factor in the off peak – Higher share of full-fare passengers in the peak – Gains are greater than from higher prices

• A less-preferred airline has a difficult time covering costs

• Preferred airline’s advantage is reduced by1. Spill2. Partial preference3. Time-of-day distribution