Why Don't The Airlines Just Raise Fares?

[FWAAA]

OK, so we can't raise fares. So, what can be done?
BTW, DiffyQ was my all-time hardest course. All you guys who aced calculus have my admiration.

[post="236784"][/post]​

Reduce the number of full-service seats chasing the dwindling supply of business travelers, for starters. Easiest way to do that is to shut down United Airlines and US Airways. That would help DL, NW, CO and AA more than any misguided attempt at raising fares across the board. Even at today's fares, everyone's revenue would rise as the customers of UA and US flock to the remaining survivors.

Same thing that happens when too many grocery chains or gas stations prevent any of them from really prospering. Someone needs to go out of business.

 

[mweiss]

Well, there are a few things that can be done.

One is to reduce capacity. If all airlines have roughly the same cost structures, a reduction in capacity benefits the entire industry. This worked well for the automobile industry throughout most of the latter part of the 20th century. The problem with this approach is twofold.

First of all, the legacy carriers have a longstanding history of putting too much capacity out there in the hopes of capturing additional market share. The net result has been too many seats chasing too few profitable butts.

Secondly, the cost structures of the airlines are not roughly the same. LCCs run circles around the legacies in terms of cost efficiency.

So, this means that the legacies could try to reduce costs. That's what they've sort of been trying to do. However, they cannot reduce costs sufficiently to compete effectively against the LCCs while still maintaining parts of the business that cannot or should not be jettisoned.

So, this means that the legacies should instead consider proper market segmentation. Just as there's a Neiman-Marcus, a Macy's, a Mervyn's, a Target, and a Wal-Mart, each chasing different demographics, so too could there be different demographic segmentation in the airline industry.

We now clearly see a Wal-Mart in the airline industry (Southwest), and a Target (JetBlue). Neiman-Marcus could be roughly matched up with fractional jets. Mervyn's might line up somewhat with AirTran. For a while, Midwest Express was sort of the Macy's.

The bottom line is, a mature, competitive market requires segmentation to be successful. There's room for more than one brand in each segment, but nobody is successful trying to be both Wal-Mart and Neiman-Marcus in the same brand. Even in the automobile industry, this is the case (witness Toyota creating the Lexus brand).

That's all well and good, but no single air travel market is large enough to satisfy a UA or AA, which is a real problem for them. And, even if there were a single market large enough, it's incredibly hard to change the corporate culture fast enough to target that market effectively. The larger the company, the harder it is.

OBTW, calculus was no walk in the park for me, either. Fortunately, for economics it's not nearly as complicated as it is for engineering.

 

[Bob Owens]

You guys are making the assumption that if you raise prices that same number of people will fly. If you raise prices you will get less flying and loose revenue. Southwest has always said (I guess before new LCC's came into the market) that their biggest competitor is the auto. If I can fly ISP- Baltimore cheaper than driving, I am going to fly. If I can take the train cheaper than flying I am going to take the train

[post="236709"][/post]​

Is flying competeing with the auto to Hawaii?

 

[Bob Owens]

Not true. The cost is always an inhibiting factor. We've just moved up the demand curve because the leisure fares are cheaper. It's still pretty much the same inhibiting factor.

Well obviuosly its not as inhibing as it once was.

Which elasticity?

Well, both. But in particular I was referring to leisure elasticity.
Fine. But you're not even explaining observations. You're speculating on what would happen if airfares went up, with not even empirical evidence to back it up.
JS answered that one:

Good. So this should be cake for you.

Begin Part 2
R = P(k+aP) [thanks again JS]
which means that R = kP + aP²

If you wish to find the maximum or minimum of a formula, you take the first derivative (in this case with respect to price) and set it equal to zero.

So, maximum revenue would be:
k + 2aP = 0
2aP = -k
P = -(k/2a)

Since you aced calculus, I'm sure you'll recall that this would work for any function Q, linear or not. In the case of airline demand, which is bimodal, you'd end up with two maxima and one minimum. By taking the second derivative, and testing the signs at the three points, you can determine which of the three are maxima and which is the minimum.

Provided that you can accurately discriminate between the two different passenger groups, you can set prices accordingly. If you cannot separate the two groups, then you must test the two price points to determine which produces higher revenue.

So right there you admit that in order to find out you have to try it first. So the unknown, whether or not they can raise prices remains just that-unknown. I say they can, so far nothing in your formula proves they cant.

Well, that'd all be fine if maximizing revenues were the goal. It's not. Maximizing profit is the goal.

Again, I'll simplify things a bit here, but I'll explain up front why we can do so. The big assumption I will make is that all costs not directly associated with adding an additional person to a flight are "fixed costs." This is true in the sense that once a schedule is set, all of the variable costs associated with schedule changes are no longer variable.

Oh really? In what reality?

And, since we're talking about setting ticket prices for a particular seat on a particular flight, schedule-related costs are now fixed.

So, with an established schedule, the marginal profit associated with a passenger can be expressed as
marginal profit = P-c,
where P is the price paid, and c is the marginal cost of carrying the additional passenger. That marginal cost includes several factors, such as the additional fuel burn caused by the additional weight, wear and tear on the aircraft interior, the marginal costs of selling the ticket and addressing any customer service issues (e.g., calls to res to change the seat), etc., etc....the list is long.

The total profit for a particular flight, assuming a single price for every ticket, can be expressed as:
profit = Q(P-c)
Now, if you had different prices, you'd have to express it more like this:
profit = Q1(P1-c) + Q2(P2-c) + Q3(P3-c)......
It makes the math more complicated, so this exercise is left up to the reader if you wish to test it out for yourself. And, yes, you could even break down different marginal costs for different passengers if you have more time on your hands.

Anyway, we'll go back to the simpler single-price model. Recall that Q=k+aP. Substitute it into the single-price profit model and you get
profit = (k+aP)(P-c) = kP-kc+aP²-acP

Take the first derivative to find the maximum, and you'll get
k-ac+2aP=0
2aP=ac-k
P=(ac-k)/2a

Again, if the demand function isn't linear, you still can do exactly the same thing.

Incidentally, a, the slope of the demand curve, represents the degree of elasticity. If a=0, demand is perfectly inelastic (i.e., quantity demanded would remain unchanged regardless of price). If a=∞ (that's infinity, in case your computer doesn't display it properly), demand is perfectly elastic (i.e., a tiny change in price would have an infinite impact in quantity demanded).

Neither of which exists.

Anyway, as before, if you have a more complex polynomial expression for the demand curve, you can find the local maxima and minima by taking the first derivative and setting it equal to zero, and you can determine if they're minima or maxima by taking the second derivative at those points and checking their signs.

Now for the next level of complexity. This is more advanced pricing.

If you want to truly maximize profits, you'd charge exactly the maximum that each person is willing to pay. This would allow you to get much more profit than with a single-price model. Your total profit function would be
profit = §(P-c)Q
where § represents the integral (it's the closest symbol I could find). Since we've already discussed Q as a function of P, I'm not going to go back into the substitution...just understand that we're integrating with respect to P, and Q is a function of P.

When setting your lower bound for the integration, you must set it to the higher of these two values:
1) Available capacity
2) The marginal cost c
in order to maximize profit. In other words, you want to either sell out a flight or be unable to sell any tickets for more than it costs you to serve that one additional passenger. The upper bound could be set to infinity, but realistically it makes no sense to set it any higher than the highest price anyone is willing to pay for the ticket.

To the degree that you approach the integration model (i.e., adding additional fares), your profits should rise.

Of course, with all that I've discussed here, the biggest assumption is that we know what the demand function looks like. At best, we have a visceral sense of what it looks like. One of the jobs of Yield Management is to ascertain as clearly as possible exactly what the demand function's shape is. If they know the shape, they can determine exactly what pricing to set.

YM has one other big job. As I said above, if you want to truly maximize profits, you'd charge exactly the maximum that each person is willing to pay. In order to do that, you have to figure out what differentiates one customer from another, so as to be able to price accurately. YM gets to figure that stuff out, too. That's how the rules for each fare code are determined.

One final note. The profit maximizing functions mentioned above are simplified to the case where the airline has a monopoly on the route. Naturally, for most routes, that is not the case. However, you can adjust your demand function accordingly by applying the reasonable assumption that if your competitors charge a lower price for the same fare rules, they will get those customers before you do. If you all charge the same price for the same rules, you can apply varying levels of sophistication to determine the market share breakdowns.

OK. If you managed to follow all of that, you should be able to understand why increasing prices will not necessarily translate into increasing profits, or even increasing revenues.

[post="236718"][/post]​

[/quote]

My My you sure are impressed with yourself, once again your arguement is filled with words like "provided, assume,if etc." I remember what Crandall said about guys like you, the term egghead comes to mind. There is a reason why businessmen use such info for reference only and dont actually let you run things. All your fancy formulas still do not prove anything, you may try to baffle us with BS but you still proved nothing.

By the way I did well in Economics also, but again Ill admit, that was a long time ago.

 

[UAL_TECH]

Reduce the number of full-service seats chasing the dwindling supply of business travelers, for starters. Easiest way to do that is to shut down United Airlines and US Airways. That would help DL, NW, CO and AA more than any misguided attempt at raising fares across the board. Even at today's fares, everyone's revenue would rise as the customers of UA and US flock to the remaining survivors.

Same thing that happens when too many grocery chains or gas stations prevent any of them from really prospering. Someone needs to go out of business.

[post="236797"][/post]​

And how do you propose to do that?
Every time the 'limbo stick' is lowered, do you not think it will affect everyone?
As walmart is 'out cheaping' everyone else and putting them out of business because they pay their employees in 'dirt', I guess the question will be who is the biggest 'dirt eater'. After this round of concession at USAir and the 'Lazy U', the bar will once again be lowered. With lower employee compensation and no DB plan to worry about, that will put the 'Lazy U' at a more cost competitive advantage that AA will have to match.

I recommend starting with potting soil as it has more nutrients and then work down to 'dirt' until you look forward to the taste.

B) UT

 

[UAL_TECH]

Well, there are a few things that can be done.

One is to reduce capacity. If all airlines have roughly the same cost structures, a reduction in capacity benefits the entire industry. This worked well for the automobile industry throughout most of the latter part of the 20th century. The problem with this approach is twofold.

First of all, the legacy carriers have a longstanding history of putting too much capacity out there in the hopes of capturing additional market share. The net result has been too many seats chasing too few profitable butts.

Secondly, the cost structures of the airlines are not roughly the same. LCCs run circles around the legacies in terms of cost efficiency.

So, this means that the legacies could try to reduce costs. That's what they've sort of been trying to do. However, they cannot reduce costs sufficiently to compete effectively against the LCCs while still maintaining parts of the business that cannot or should not be jettisoned.

So, this means that the legacies should instead consider proper market segmentation. Just as there's a Neiman-Marcus, a Macy's, a Mervyn's, a Target, and a Wal-Mart, each chasing different demographics, so too could there be different demographic segmentation in the airline industry.

We now clearly see a Wal-Mart in the airline industry (Southwest), and a Target (JetBlue). Neiman-Marcus could be roughly matched up with fractional jets. Mervyn's might line up somewhat with AirTran. For a while, Midwest Express was sort of the Macy's.

The bottom line is, a mature, competitive market requires segmentation to be successful. There's room for more than one brand in each segment, but nobody is successful trying to be both Wal-Mart and Neiman-Marcus in the same brand. Even in the automobile industry, this is the case (witness Toyota creating the Lexus brand).

That's all well and good, but no single air travel market is large enough to satisfy a UA or AA, which is a real problem for them. And, even if there were a single market large enough, it's incredibly hard to change the corporate culture fast enough to target that market effectively. The larger the company, the harder it is.

OBTW, calculus was no walk in the park for me, either. Fortunately, for economics it's not nearly as complicated as it is for engineering.

[post="236801"][/post]​

Maybe you should have taken a few Political Science and Sociology classes. Humanity studies might give you some help also.

So, how many 'beans' are in a 1 quart jar?

UT

 

[Bob Owens]

OK, so we can't raise fares. So, what can be done?
BTW, DiffyQ was my all-time hardest course. All you guys who aced calculus have my admiration.

[post="236784"][/post]​

Dont let him get away with that. If you were having a debate and all of a sudden the other guy started speaking Greek would you turn around and say "I dont know what the hell he just said but I guess he must be right?

He went through a lot of effort there to say nothing. He didnt prove anything.

 

[mweiss]

Well obviuosly (price is) not as inhibing as it once was.

Not obvious at all. If you move along the same curve, the curve doesn't change. Only your position on it. What we can say is that, at the current leisure price point, there is a greater quantity demanded. Perhaps that's what you meant to say?

OK, so I said...

Provided that you can accurately discriminate between the two different passenger groups, you can set prices accordingly. If you cannot separate the two groups, then you must test the two price points to determine which produces higher revenue.

...to which you replied...

So right there you admit that in order to find out you have to try it first. So the unknown, whether or not they can raise prices remains just that-unknown. I say they can, so far nothing in your formula proves they cant.

You misunderstood the meaning of that sentence. It's a mathematical test, not an empirical test. You simply multiply the price and quantity at one of those local maxima, and compare it to the product of price and quantity at the other local maximum. You then price according to which one will give the greater revenue (assuming revenue is your goal, rather than profits).

Then when I said that...

...once a schedule is set, all of the variable costs associated with schedule changes are no longer variable.

...you shot back with

Oh really? In what reality?

That would be the one we live in. Yes, there's a feedback loop among the different groups, but schedules don't change daily. Within a constant schedule, the remaining marginal variable operating costs are entirely based on whether or not a ticket has been sold for a seat. If you want to talk about rescheduling, there's a whole set of models to apply there...but they're not pricing models (though they can use data obtained from previous pricing models).

Then I talked about the definition of the slope of a demand curve, alluding to the two extremes. You came back with...

Neither of which exists.

Absolute zero and infinite temperature don't exist in the real world, either. That doesn't mean that you cannot have hotter and colder temperatures, and make application of their existence.

My My you sure are impressed with yourself

Not really. You said you wanted to hear why pricing works the way it does. I explained it.

once again your arguement is filled with words like "provided, assume,if etc."

All of which I was able to explain were irrelevant to the fundamentals. The extrapolations aren't that complicated; they're just work.

I remember what Crandall said about guys like you, the term egghead comes to mind.

The funny thing is, the economic formulae I tossed out there are precisely the reason AA so dominated the 1980s.

All your fancy formulas still do not prove anything, you may try to baffle us with BS but you still proved nothing.

It was baffling? Should have been perfectly clear to someone who aced calculus.

By the way I did well in Economics also, but again Ill admit, that was a long time ago.

And it looks like you retained about as much.

 

[Wretched Wrench]

Hey, mweiss, how about stiicking to the issues and lightening up on the personal attacks and sneering?

Such only diminishes the credibility of what you say.

 

[Thomas Paine]

Wheres the beef?

 

[Bob Owens]

mweiss,Jan 7 2005, 11:49 PM]
Not obvious at all. If you move along the same curve, the curve doesn't change. Only your position on it.

But right off the bat the assumptions made were incorrect. So like I said even though your math may prove valid the outcome is not. You still have not plugged in real figures, and you will also need to provide how you determined those figures. Placement on the curve determines the optimum price right? So wrong assumptions will put us at the wrong point on the curve will it not? You have also not taken into account various other factors that not only move our position on the curve but move the curve from its position.

What we can say is that, at the current leisure price point, there is a greater quantity demanded. Perhaps that's what you meant to say?

You claimed that the price of air travel is inhibiting, my point was that air travel has come way down in price and is affordable, in fact its sometimes even cheaper, than other modes. "Greater demand" or less inhibiting and more affordable, not exactly the same, one can be the result of the other. I meant what I said.OK, so I said...
...to which you replied...
You misunderstood the meaning of that sentence.

No I misunderstood YOUR meaning, obviously the sentence could be interpreted differently by different people as was the case here.


That would be the one we live in. Yes, there's a feedback loop among the different groups, but schedules don't change daily.

Maybe the one YOU live in. You said that costs dont change. They do, maybe they are not a consideration in your formula but the fact is that every flight, even on the exact same trip, has a different cost.

Absolute zero and infinite temperature don't exist in the real world, either.
That doesn't mean that you cannot have hotter and colder temperatures, and make application of their existence.

Absolute zero does not exist? I guess you never took Physics. Its -459.67 degree F.
Did any one say that they wanted a lesson on yeild management? Give us your determination and a figure that shows why prices cant be raised and we can work back as far as we need to. Lets say on a flight from LGA to ORD at 7am on a Monday morning, the first week of December.

Not really. You said you wanted to hear why pricing works the way it does. I explained it.

No you said that you made a post that supports your claim that prices cant be raised, I said go ahead and repost it. So far you have simply posted basic formulas that do not take into account all the other variables and you have not provided any specific figures.

By the way isnt there a lot of talk out there by "experts" who claim that this same pricing system is broken?

It was baffling?

Did I say it was Baffling? Read it again, I said you "MAY TRY to baffle us with BS", not that you were successful at it.

Should have been perfectly clear to someone who aced calculus.
And it looks like you retained about as much.

I retained enough to see through your BS.



So far all you have done is quote formulas. Nowhere have you proven that the price of Air travel could not be raised.

Do your formulas take into account the desire of airlines to gain market share? Preditory pricing? And the fact that sometimes in this industry it pays to lose money?

With the airlines trying to line up concessionary contracts till 2012 they will have plenty of time to recoup todays losses.

 

[mweiss]

Hey, mweiss, how about stiicking to the issues and lightening up on the personal attacks and sneering?

Such only diminishes the credibility of what you say.

[post="236898"][/post]​

Point taken...*sigh* it's just that I'm beginning to feel like I'm typing to a brick wall. :unsure:

 

[mweiss]

...right off the bat the assumptions made were incorrect.

The assumptions were there to bring you to a level set understanding, not to be the q.e.d.

So like I said even though your math may prove valid the outcome is not.

Outcome? We haven't even gotten to the outcome yet. You're still arguing the validity of the underlying theory.

Placement on the curve determines the optimum price right? So wrong assumptions will put us at the wrong point on the curve will it not?

No. The shape of the curve determines the optimum price. The YM departments are constantly experimenting so as to ascertain the shape of that curve.

You have also not taken into account various other factors that not only move our position on the curve but move the curve from its position.

Because it's irrelevant to the pricing determination, insofar as the airlines have little control over the shape of the demand curve. Where the airlines have much more latitude is in the shape of the supply curve, which is why you keep hearing the drumbeat about reducing costs (though wages are hardly the only lever at the airline's disposal).

In other words, the airline must focus on improving the shape of the supply curve, and accurately ascertaining the shape of the demand curve.

You claimed that the price of air travel is inhibiting, my point was that air travel has come way down in price and is affordable, in fact its sometimes even cheaper, than other modes.

Those two statements are not mutually exclusive. Of course the price is inhibiting. If the price of airline tickets were cut by 50% tomorrow, wouldn't there be a greater quantity of seats demanded? As long as the answer to that question is "yes," price is an inhibition.

No I misunderstood YOUR meaning, obviously the sentence could be interpreted differently by different people as was the case here.

So what's the point in arguing the semantics? How about arguing the point itself, eh? :huh:

 

[mweiss]

Maybe the one YOU live in. You said that costs dont change. They do, maybe they are not a consideration in your formula but the fact is that every flight, even on the exact same trip, has a different cost.

But so what? What matters in determining the marginal passenger cost is what the specific addition of that one passenger will cost the company to serve. And, yes, there is a degree of variability there as well (e.g., how many times that passenger calls CS). So you take an average of the costs of many passengers, and you get as close as you can.

Even though the formulae are precise, there is inherently some error in them. The better you are in reducing that error, the better your ability to manage profits. Again, that's a big part of what YM does.

Absolute zero does not exist? I guess you never took Physics. Its -459.67 degree F.

It doesn't exist in the real world. Just like absolute elasticity doesn't exist in the real world. And just as absolute zero can be precisely defined, so can absolute elasticity.

Did any one say that they wanted a lesson on yeild management?

Um...you did.

Give us your determination and a figure that shows why prices cant be raised and we can work back as far as we need to.

Why is that even necessary? Or is it your allegation that nobody has a YM department that could figure anything out, and instead they just throw darts at a board?

By the way isnt there a lot of talk out there by "experts" who claim that this same pricing system is broken?

It is, but not broken in the way that you seem to think it is.

Do your formulas take into account the desire of airlines to gain market share? Preditory pricing? And the fact that sometimes in this industry it pays to lose money?

The desire to gain market share is fine. It's a departure from optimal pricing. Likewise with predatory pricing. However, lowering prices to gain market share has been shown not to work in nearly all instances, as the competition simply matches the pricing and nothing changes. Predatory pricing, besides being illegal, also is pretty tough to make work now, given the current financial picture.

There are few other instances where it pays to lose money as a matter of practice. Are you insinuating that the legacies are losing money on purpose?

With the airlines trying to line up concessionary contracts till 2012 they will have plenty of time to recoup todays losses.

Not if they don't change much more than those contracts.

 

[Bob Owens]

mweiss,Jan 8 2005, 06:50 PM]
The assumptions were there to bring you to a level set understanding, not to be the q.e.d.
Outcome? We haven't even gotten to the outcome yet. You're still arguing the validity of the underlying theory.

Like I said, give us your answer and we can go back from there.

No. The shape of the curve determines the optimum price. The YM departments are constantly experimenting so as to ascertain the shape of that curve.
Because it's irrelevant to the pricing determination, insofar as the airlines have little control over the shape of the demand curve.

Then why spend all that money on marketing?Isnt the sole purpose of marketing to stimluate demand?

Where the airlines have much more latitude is in the shape of the supply curve, which is why you keep hearing the drumbeat about reducing costs (though wages are hardly the only lever at the airline's disposal).

In other words, the airline must focus on improving the shape of the supply curve, and accurately ascertaining the shape of the demand curve.


Those two statements are not mutually exclusive. Of course the price is inhibiting. If the price of airline tickets were cut by 50% tomorrow, wouldn't there be a greater quantity of seats demanded? As long as the answer to that question is "yes," price is an inhibition.

I dont know, would there? Dont you agree that Air travel is an "intermediate good"? People fly to achieve some other purpose. If they cant afford to go to Disneyland they are not likely to fly there for the heck of it. Dont you agree that no matter how cheap we make airtravel there are other factors that would limit the demand?

So what's the point in arguing the semantics? How about arguing the point itself, eh?

Fine. The airlines can raise fares.

The load factors are at historic highs.

In many cases its cheaper to fly than it is to drive in travel costs alone, without even considering the value of time. Sometimes the cost of a cab to the airport or airport parking is more than the cost of the flight. Despite years of increased productivity and increased efficiency the airlines are selling tickets below the cost of providing the service. Obviously this is not a condition that is inherent to the industry because it if was it wiould no longer exist.

Price wars and massive losses while often coinciding with economic downturns also coincide with heightened competition for dominance and labor negotiations.

There is no reason to believe that demand for airtravel is declining any more than it has in other recessions nor is there any reason to believe that demand for air travel will not continue to increase in overall demand.

The airline industry is exploiting the combined events of an economic downturn, Sept 11 and a friendly administration to reset labor costs, however even with these advantages it is still neccesary to display an economic need, real or contrived, for what these companies are doing to their employees in order to prevent huge disruptions in service(and all the economic effects of such disruptions) and allow the employees to gain public support.