Low Cost Airline Carriers – Value Pricing or Inelastic Demand

It’s once again that time of year where the kids are out of school, the stress of work is weighing us down and the thought of a relaxing getaway is on our minds.  As we begin to investigate the options there are many factors we need to consider including costs, time constraints and of course destination.  Unfortunately, a large majority of us don’t live in Hawaii, next to a four star resort or a world-class golf course.  That means we have to get into a car, board a plane, find a train, ship or some other form of transportation to get to where we are going.  After you consider all of the options – even with the inconveniences of security, over crowded flights and additional fees – you may find yourself with one viable alternative – air travel.

Unless you are booking an all-inclusive trip, you will more than likely have to compare airline fares.  Here is where the fun begins.  Just recently, I needed to book a trip to Dallas and since I don’t have a corporate travel department, I had to do it myself. After a few minutes looking at availability, schedules and fares, I came to the conclusion that only two major airlines, American and Southwest, met my criteria.  When I priced out the fares, I was amazed that it was exactly the same price.  I have flown on both of these airlines many times, but I have never seen fares that were exactly the same.  I decided to check out fares for some other destinations and found them to be exactly the same, to the penny.  What was happening?  Had Southwest figured out something new?  Had they changed their strategy?  Weren’t they the airline that grew based on good service and low fares?

It looks like the end of lucrative fuel hedges has forced Southwest to raise fares in order to remain profitable.  In addition, the company may soon incorporate the lucrative fees charged by other airlines for food, ticket changes and bags.  In fact, it has been reported that airline revenue from add-ons to ticket sales jumped to almost $22 billion (up 38% from 2009) last year and continues to soar as more carriers chase extra sources of income.  So, are these fares and add-on fees here to stay?  All evidence point to yes.

So how does this all connect with pricing?  In the 1980s, American developed a yield management system that could segment customers very precisely and offer discrete pricing based on specific criteria of the traveler.  Although no longer a competitive advantage, yield management is still a staple in the industry.  Looking for new ways to be more competitive, low cost carries began to pop up everywhere.  They focused on short (less than 3 hours) flight segments, used a single type of aircraft, minimized some of the high cost perks, sold directly to the customer and offered a good level of service.  This strategy was responsible for propelling Southwest into a staging decade of growth. But when you grow to be the biggest airline for domestic flying, will you still be the low-fare leader?

It looks as though Southwest, as many other carriers have already done, may be headed down the same path.  Although they are now matching fares with other airlines, they still don’t charge for bags and that can add up to $50 in savings per customer per flight.  Is this still a large enough differentiator?  Is this really a competitive advantage, a value driver or really a result of inelastic demand?  Let’s look closer.

There are a plethora of different criteria that go into making the purchasing decision. several of which were mentioned earlier in this article.  Another key criteria is the type of traveler.  For purposes of simplicity, we will assume you are either travelling on business or pleasure. Business travelers are usually less price sensitive and aren’t impacted by the baggage fees and other add-on expenses. In fact, many of these travelers aren’t subject to these fees because of their travel status. When we carve out the business traveler, we are left with those customers who fly infrequently and may have no option except to pay fees for baggage and other services.   As always, we must look at the issue from both sides of the equation. So the real question is whether the low cost carries such as Southwest, raised prices to capture additional value they offer to their customers by not charging for bags or are the major airlines capitalizing on the inelasticity of customers once they have purchased a ticket?

The answer is both.  Southwest knows that non-business customers will shop primarily on fare.  Customers choose to fly with them because of the quality of service and price.  They have successfully integrated this strategy into their marketing campaigns such as “bags fly free”.  Despite the enormous benefits of this campaign, Southwest, and other low cost carriers, will need to develop new sustainable competitive advantages to continue to entice customers to fly with them. On the other hand, the major airlines try to set pricing in a way that doesn’t discourage travelers from booking travel.  Once a ticket is booked, the barrier to switch to another airline is high enough that travelers are stuck with a menu of add-on fees such as baggage, ticket change fees and food costs.   In the past, both of these strategies have been successful in helping airlines boost revenue – but at what cost?

The industry has undergone a tremendous amount of consolidation as airlines struggle to find ways to reduce cost, increase fares and become more profitable. Sustainable competitive advantages are shrinking and consumer power is increasing.  All of these factors are creating a flurry of change in the industry which will more than likely lead to reduced routes, increased fares and over crowded flights.  It is hard to determine what the true impact to the consumer will be but it looks like we are entering a period of a sellers market.  Bon voyage!