INTEGRATING CASE STUDY 9 The Art of Devising Airfares

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1 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 1

2 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 filed. 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 2

3 suddenly reoffered hours before takeoff on Thursday if passenger projections based on previous flights fail to materialize, Mr. McKaige said. 3

4 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 flight 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. 4

5 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 (September 2007); and United, Continental to Combine, The Wall Street Journal (May 5, 2010), p. B1. 5