The recession that began in 2008 hit the airline industry very hard as both busi
ID: 1196455 • Letter: T
Question
The recession that began in 2008 hit the airline industry very hard as both businesses and households cut back their travel plans. According to the International Air Transport Association, the industry lost $11 billion in 2008. However, by 2009, despite the fact that the economy was still extremely weak and airline traffic was still well below normal, the industry’s profitability began to rebound. And by 2010, even in the midst of continued economic weakness, the airline industry’s prospects had definitely recovered, with the industry achieving an $8.9 billion profit that year, with continued profitability in 2011. As Gary Kelly, CEO of Southwest Airlines said, “The industry is in the best position—certainly in a decade—to post profitability.”
How did the airline industry achieve such a dramatic turnaround? Simple: fly less and charge more. In 2011, fares were 14% higher than they had been the previous year, and flights were more crowded than they had been in decades, with fewer than one in five seats empty on domestic flights.
In addition to cutting back on the number of flights—particularly money-losing ones—airlines implemented more extreme variations in ticket prices based on when a flight departed and when the ticket was purchased. For example, the cheapest day to fly is Wednesday, with Friday and Saturday the most expensive days to travel. The first flight of the morning (the one that requires you to get up at 4 A.M.) is cheaper than flights departing the rest of the day. And the cheapest time to buy a ticket is Tuesday at 3 P.M. Eastern Standard Time, with tickets purchased over the weekend carrying the highest prices.
And it doesn’t stop there. As every beleaguered traveler knows, airlines have tacked on a wide variety of new fees and increased old ones—fees for food, for a blanket, for checked bags, for carry-on bags, for the right to board a flight first, for the right to choose your seat in advance, and so on. Airlines have also gotten more inventive in imposing fees that are hard for travelers to track in advance—such as claiming that fares have not risen during the holidays while imposing a “holiday surcharge.” In 2011, airlines collected more than $22.6 billion from fees for checking baggage and changing tickets, up 66% from 2010.
But the question in the minds of industry analysts is whether airlines can manage to maintain their currently high levels of profitability. In the past, as travel demand picked up, airlines increased capacity—added seats—too quickly, leading to falling airfares. “The wild card is always capacity discipline,” says William Swelbar, an airline industry researcher. “All it takes is one carrier to begin to add capacity aggressively, and then we follow and we undo all the good work that’s been done.”
1. How would you describe the price elasticity of demand for airline flights given the information in this case? Explain.
2. Using the concept of elasticity, explain why airlines would create such great variations in the price of a ticket depending on when it is purchased and the day and time the flight departs. Assume that some people are willing to spend time shopping for deals as well as fly at inconvenient times, but others are not.
3. Using the concept of elasticity, explain why airlines have imposed fees on things such as checked bags. Why might they try to hide or disguise fees?
4. Use an elasticity concept to explain under what conditions the airline industry will be able to maintain its high profitability in the future. Explain.
Explanation / Answer
(1) From given information, I infer that price elasticity of demand has an absolute value less than 1. That is, demand is inelastic.
When demand is inelastic, a rise in price lowers quantity demanded less than proportionately, and accordingly the total revenue increases, leading to higher profits (given costs are unchanged).
(2) This is an application of price discrimination. It is done to charge different price for the same service at different customer segments (with different demand conditions). Higher price is charged from a market (segment) with inelastic demand, and lower price is charged from a market (segment) with elastic demand. This increases overall revenue and profits.
(3) Even though airlines price travel & luggage of passengers as different (separate) services, passengers perceive their luggage as an inseparable part of their travel. Being inelastic, demand for air travel doesn't reduce total revenue when the total price charged for a passenger's travel (airfare + luggage charge) is higher.
(4) The conditions required to maintain future profitability will be:
(a) Demand remains inelastic and less responsive to change in price, for at least one customer segment.
(b) Re-sale of airline tickets across different customer segments is not possible, and
(c) Airlines can correctly keep estimating the elasticity of demand of different segments in future.
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