What’s Really Going on in Airline Pricing and Capacity?

In late June, the Department of Justice confirmed that it was investigating unnamed U.S. airlines (believed to be the four largest, American, Delta, Southwest, and United) for “possible unlawful coordination” on limiting capacity as a means of raising prices.

As someone who has worked in and near the airline industry for nearly all my career, the action is familiar. Justice has gone down this path many times, with only one modest win, settled in 1994 before a trial. Why not more success? Although the airline industry is an economics-textbook example of the relationship between supply, demand, and price, it is also one of the few consumer-facing businesses where the familiar assumption of textbook economics, “assume perfect information,” actually exists. The DOJ simply does not know how to deal with a business where 100% of price and supply (quantity) data is instantly accessible to every party, 24/7.

Thanks to the Internet, customers have instant information to every airline’s fares, rules, extras, the works. And even before that, since the mid-1970s, travel agents have had instant access to that information (which could then be passed on to consumers). Back then, with the advent of so-called computer reservations systems (CRS, now known as GDS, global distribution systems), airlines began to distribute price information to all sales channels via a carrier-owned company called ATPCO, and distributing schedule (capacity) information separately. Thus, for 40 years, American has instantly known how many total seats Delta offers in the New York-L.A. market and the range of prices (and vice-versa), and for about 20 years (with the advent of airline websites and online travel agencies) every person with Internet access could also know that fundamental information.

Airlines are being investigated and roundly criticized in the court of public opinion for being disciplined about adding supply, which in the face of flat or slow-growing demand would indeed drive down prices, just as my high-school econ teacher Mr. McCarthy explained. The reality is that it took airlines 20+ years (after deregulation allowed them to operate in a more or less open market) to figure out that unprofitable growth for its own sake, or in the name of rising market share, made no sense. Since the mid-2000s, major carriers have understood that a focus on profitability rather than market share requires a different aircraft acquisition plan. During the recent period of economic uncertainty, airlines replaced older aircraft to save on fuel and maintenance expense, but adding seat capacity when fewer people could afford to travel made no sense. The new focus yields the profits they need to give employees raises, re-pay lenders, satisfy investors, and still have capital for new aircraft and ground facilities.

Neither the Justice Department, elected officials, nor the media understand something else that troubles many observers: a persistent and distinct double standard applied to airlines. What’s okay in other sectors – in fact often applauded as astute business practice – is unacceptable in the airline industry. Let’s take an example from hotels, a related travel sector. The business is booming right now, in large measure because room supply is not growing. A recent article in The Economist described capacity restraint in the hotel sector as “a stroke of luck,” but it’s clearly more than that. The president of hotel consulting firm PKF Hospitality Research recently said, “I’ve never seen a five-year outlook that’s as healthy as what we’re looking at right now. The fundamentals are incredibly strong. In lodging, supply growth through 2014 is going to be below the historic average, and demand growth will be above average through 2015 [emphasis added].”

Gary Doernhoefer, a longtime specialist in competition law and former general counsel of the International Air Transport Association, remarked “in almost any sector, an improving economy and growth in demand that exceeds an industry’s ability to add capacity should increase per unit profitability, at least in the short term.”

And no one outside the business seems to understand that even if airlines wanted to grow, they can’t flip a switch and instantly add capacity. That’s because there are only two manufacturers of big planes (another double standard: does anyone complain about consolidation in that part of aviation?), and their order books are backlogged, driven by airline growth overseas. For example, suppose you wanted to grow by adding some proven and reliable Boeing 737s to your fleet. As of January 1, Boeing’s 737 order backlog was 4,300. In response, Boeing is ramping up 737 production from 42 per month to 52 per month by 2018, but even at that higher rate, an airline placing an order today would need to wait almost seven years for one new plane to be delivered.

Senator Charles Schumer (D-N.Y.) complained that “It’s hard to understand, with jet fuel prices dropping by 40 percent since last year, why ticket prices haven’t followed.” But the senator seems to have forgotten the billions of dollars of losses airlines sustained in the 2000s. Why would it not be okay to try to recoup those? And a double standard question: did Amtrak reduce rail fares because diesel prices declined, or did yellow New York taxis’ meters get recalibrated downward because gasoline now costs 25% less than a year ago?

Similarly, Senator Blumenthal (D-Conn.) said “Consumers are suffering rising fares and other added charges . . .” This makes for a nice press conference and subsequent headlines, but few people ever look back to the old days when a Federal entity, the Civil Aeronautics Board (CAB), controlled nearly all aspects of air commerce. Since Congress deregulated domestic airlines in 1978 and sunsetted the CAB, average airfares have declined 50% when adjusted for inflation. In lots of instances the reductions have been much larger. For example, a half-century ago, the cheapest round-trip ticket from Minneapolis/St. Paul to Dallas cost the equivalent of $834 in today’s dollars. I just checked AA.com and found plenty of MSP-DFW seats this month (summer peak) for $187, or 77% cheaper than 1965.

For years, the government and others have alleged that airlines “signal” each other. Again, in an industry with perfect information, there’s no need to do that. But it reminded me of the double standard, and “signaling” in other businesses. When I was a kid, at an intersection near our house there were gas stations on all four corners. When the guy at Shell climbed up on the ladder to change the big metal price sign up or down 2 cents a gallon, was he signaling to the Mobil dealer across the street?

Lastly, it’s worth noting that neither the DOJ nor other airlines have had much success proving allegations in the past. Although not precisely the same issue as the current investigation, the government sued American in 1999, alleging violations of antitrust law. Justice said that in response to competition from Vanguard Airlines and other LCCs, “American’s combined response of lowering prices, increasing capacity, and altering yield management constituted an unlawful, anticompetitive response.” DOJ specifically focused on four routes, between AA’s largest hub at Dallas/Fort Worth and Kansas City, Wichita, Colorado Springs, and Long Beach. A lower court saw no need for a trial and issued a summary judgment in favor of American. The government appealed to the Tenth Circuit Court of Appeals, and lost there, too. The appellate court said that the four legal “tests” the government offered to prove American’s violations were “invalid as a matter of law, fatally flawed in their application, and fundamentally unreliable.”

Earlier that decade, DOJ closely watched a suit Continental Airlines and Northwest brought against American. In 1993, a year after American introduced a simplified fare structure called Value Pricing, the two plaintiff carriers alleged that Value Pricing was a means to “1) persuade its competitors to charge higher prices; 2) limit price competition; and 3) discipline those competitors who failed to follow American’s price signals.” Sound familiar? A jury in Galveston, Texas, took less than four hours to return a verdict in American’s favor. There was no appeal.

To this longtime observer, today’s U.S. airline industry looks exactly as expected. After five decades of intrusive Federal economic regulation, since 1978 (nearly four decades) airlines, especially the three surviving older ones, have been trying to figure out how to sustain themselves in the wake of new competition with lower costs – made possible by deregulation – plus the punishing realities that affect all carriers: high fixed costs, a perishable product, time-variable demand, insufficient public (Federal) infrastructure, geopolitical vulnerability, and lots more. What are decried as “record profits” (in other businesses, earning good returns is celebrated) must be satisfying to airline people who have struggled to figure out how to achieve the stability that is taken for granted elsewhere in our market economy.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of The Eno Center for Transportation.

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