So, when we last left off, we went through the basics of market pricing. Now, Bob, I know you already know this stuff, but I want to make sure that it's clear not only to you, but also to the others who are reading this thread.
As I said before, this chapter covers why a company would stay in a market, even at a loss. You, of course, already mentioned one before. You pointed out that a company would stay in a market at a loss in order to increase market share. So why would a company do this?
Simply put, the only reason to take a loss in a market as a means of gaining market share is to remove one or more players from the market. More importantly, you have to remove the players with lower costs than your business. Why?
The only reason to take a loss today is to make it up with profits tomorrow. This means that you have to raise the unit price to a profitable level for your business.
Recall from our last chapter that the market price is determined from the entry prices and the capacity of the lowest-cost players. (I'm mixing up the entry price and cost terms here, assuming that they're synonyms; naturally, they aren't always synonymous, though for the purposes of this chapter the effects are the same even when they're not synonymous terms.) This means that the only way to raise the market price is to get one or more of the lower-cost players out of the market.
In order to remove one of the lower-cost players, you have to either drain them of cash reserves (or convince them that you will), or saturate the capacity of the market somehow in a manner that prevents the lower-cost players from serving the market.
One instance of the first model is sometimes referred to as "predatory pricing." In the airline industry, this is where the established airline substantially drops fares and increases frequency. If it's the mid-90s, and you're American and you're only up against Vanguard in a couple of markets, you have much deeper pockets than they do. You have more routes that can subsidize the loss on these markets for a much longer time than little Vanguard can sustain.
A variation on the first model applies when you're not the highest-cost player. If you're willing to sell tickets at a price below the market price, but still profitably for you, you'll force the player above you to sell at a loss. Just as above, the goal is to remove the other player. This approach only works if you can add capacity inexpensively. Interestingly enough, pretty much any airline in the US can add capacity inexpensively. In fact, the union pay structures of the airlines all but demand an expanding airline, so you'll see this approach occur often.
The second model is what led to "fortress hubbing." By saturating the gate capacity at an airport, you prevent anyone else from gaining a foothold at that same airport. Selling seats at a loss in the short term in order to gain a fortress hub in the long term is a solid investment, provided you have the cash to support establishing this stronghold.
A third reason to take a loss today is an expectation of a changing supply or demand curve in the future.
Let's hit the supply curve first. Imagine that you're serving a market at a loss today, but if you could reduce your costs by 10% you'd be making a profit at exactly the same price. If you can figure out how to cut those costs by 10%, it's worthwhile to stay in the market. It's expensive to enter a new market (which would include a market that you left). If you believe that you'll reduce your costs soon enough that you lose less in the meantime than you would by exiting and re-entering the market, then it makes sense to stay in, even at a loss.
Similarly, if you're convinced that demand will rise soon enough to offset your current loss, and that your current loss is smaller than the cost of re-entering the market, it makes sense to stay in the market in the short term.
These models drove the legacy carriers from deregulation until today. Build fortress hubs in order to generate monopoly income on a set of routes, which would subsidize more competitive routes that would be sold roughly at cost. If a newcomer arrives, smother it or acquire it quickly. It worked well for a long time.
The model was far from perfect, though. In particular, while it's true that the demand curve is highly bimodal, the upper mode is especially sensitive to the economy. I did some analysis of that sensitivity. In particular, I compared the size of the upper mode to the change in the stock market (which is a good representative for the direction of the economy; a rapidly expanding economy produces a rapidly rising stock market, whereas a contracting economy produces a flat or somewhat dropping stock market). The two tracked so well that they almost looked like a single line on a line graph...if you shifted the size of the mode slightly to the left. In other words, they tracked perfectly, but the demand for business air travel lags the economic climate slightly.
This means that if you tune your business model to take advantage of the bimodal nature of the demand curve, you'll do well when the economy is expanding, and badly when the economy is stagnant or contracting. As long as you can survive the bad times, such a business model isn't inherently bad, but it takes some really solid business and money management to do it.
Of course, one option for such a bimodal-depenent airline would be to shrink when the economy is slow, and expand when the economy is hot. However, many factors preclude this approach:
Now, somewhere out there is Bob Owens, saying "But this proves nothing about the airlines' ability to raise fares!" And he's right. But it now gives us a good jumping off point for the discussion.
Since we have a bimodal market, we have to tackle this in two parts. Let's start with the business mode, and then we'll hit up the leisure mode.
Why can't we raise business fares? Well, first of all, it isn't 1999 anymore. The business mode is much smaller than it was in 1999. As we established in the previous two chapters, the market price is based on stack ranking the entry prices and capacities, and starting at the lowest price, going down the list until we meet the capacity.
But!!!! We also established that there is a significant cost associated with capacity reduction, which tends to lower the exit price to a point below the cost of providing the service.
But!!!!!! This means that there is a greater capacity than the simple market equilibrium would suggest is optimal, which lowers the market price still further!
In other words, the industry analysts are absolutely correct that there is too much capacity in the industry. What they should be saying is that there is too much business mode capacity in the industry.
And, as I mentioned earlier, the business mode was shrinking somewhat, even before the economic meltdown, because the difference in pricing between the two modes finally exceeded the cost to the businesses of either disguising themselves as leisure travelers or using a non-airline means of getting the job done (fractional jets, video teleconferencing, email...).
But let's say for a moment that AA decided to raise business fares by $10 apiece. What would happen? Well, for a segment of the market, there would be no change. They'd fly AA regardless. That's a shrinking segment, since businesses have gotten much more draconian in managing their travel budgets. No, most of AA's business customers would defect to other airlines...because they have to. The effect would be somewhat muted at DFW relative to other locations, but even there AA can't be too much more expensive than their connecting counterparts.
In other words, while it's true that business demand is relatively inelastic, you still have to price within the range of your competitors when there's excess capacity. Otherwise, the decrease revenue caused by a decrease in the number of passengers would exceed the additional revenue generated by the remaining passengers.
Besides, that's not how yield management does their job anyway. If you have enough fares in a market, you produce de facto fare increases by changing the relative size of the fare buckets. (If you remind me to, we can discuss how that's essentially the way DL's new fare strategy works.)
And what about the leisure mode? Well, as I mentioned before, each dollar in a leisure fare carries much more weight than its business counterpart. Not only is it typically felt by a multiplying factor (because leisure travelers tend to run in packs
), but there is no multiplying factor in the substitute of a rental car and/or gasoline. That is, a rental car costs the same whether there's one person in it or four. And the incremental cost of gasoline to move four people around relative to only one is small.
So in the leisure market we have much greater elasticity. Raise those fares, and you wish you were raising the business fares instead!
OK, Bob...the ball's in your court.
As I said before, this chapter covers why a company would stay in a market, even at a loss. You, of course, already mentioned one before. You pointed out that a company would stay in a market at a loss in order to increase market share. So why would a company do this?
Simply put, the only reason to take a loss in a market as a means of gaining market share is to remove one or more players from the market. More importantly, you have to remove the players with lower costs than your business. Why?
The only reason to take a loss today is to make it up with profits tomorrow. This means that you have to raise the unit price to a profitable level for your business.
Recall from our last chapter that the market price is determined from the entry prices and the capacity of the lowest-cost players. (I'm mixing up the entry price and cost terms here, assuming that they're synonyms; naturally, they aren't always synonymous, though for the purposes of this chapter the effects are the same even when they're not synonymous terms.) This means that the only way to raise the market price is to get one or more of the lower-cost players out of the market.
In order to remove one of the lower-cost players, you have to either drain them of cash reserves (or convince them that you will), or saturate the capacity of the market somehow in a manner that prevents the lower-cost players from serving the market.
One instance of the first model is sometimes referred to as "predatory pricing." In the airline industry, this is where the established airline substantially drops fares and increases frequency. If it's the mid-90s, and you're American and you're only up against Vanguard in a couple of markets, you have much deeper pockets than they do. You have more routes that can subsidize the loss on these markets for a much longer time than little Vanguard can sustain.
A variation on the first model applies when you're not the highest-cost player. If you're willing to sell tickets at a price below the market price, but still profitably for you, you'll force the player above you to sell at a loss. Just as above, the goal is to remove the other player. This approach only works if you can add capacity inexpensively. Interestingly enough, pretty much any airline in the US can add capacity inexpensively. In fact, the union pay structures of the airlines all but demand an expanding airline, so you'll see this approach occur often.
The second model is what led to "fortress hubbing." By saturating the gate capacity at an airport, you prevent anyone else from gaining a foothold at that same airport. Selling seats at a loss in the short term in order to gain a fortress hub in the long term is a solid investment, provided you have the cash to support establishing this stronghold.
A third reason to take a loss today is an expectation of a changing supply or demand curve in the future.
Let's hit the supply curve first. Imagine that you're serving a market at a loss today, but if you could reduce your costs by 10% you'd be making a profit at exactly the same price. If you can figure out how to cut those costs by 10%, it's worthwhile to stay in the market. It's expensive to enter a new market (which would include a market that you left). If you believe that you'll reduce your costs soon enough that you lose less in the meantime than you would by exiting and re-entering the market, then it makes sense to stay in, even at a loss.
Similarly, if you're convinced that demand will rise soon enough to offset your current loss, and that your current loss is smaller than the cost of re-entering the market, it makes sense to stay in the market in the short term.
These models drove the legacy carriers from deregulation until today. Build fortress hubs in order to generate monopoly income on a set of routes, which would subsidize more competitive routes that would be sold roughly at cost. If a newcomer arrives, smother it or acquire it quickly. It worked well for a long time.
The model was far from perfect, though. In particular, while it's true that the demand curve is highly bimodal, the upper mode is especially sensitive to the economy. I did some analysis of that sensitivity. In particular, I compared the size of the upper mode to the change in the stock market (which is a good representative for the direction of the economy; a rapidly expanding economy produces a rapidly rising stock market, whereas a contracting economy produces a flat or somewhat dropping stock market). The two tracked so well that they almost looked like a single line on a line graph...if you shifted the size of the mode slightly to the left. In other words, they tracked perfectly, but the demand for business air travel lags the economic climate slightly.
This means that if you tune your business model to take advantage of the bimodal nature of the demand curve, you'll do well when the economy is expanding, and badly when the economy is stagnant or contracting. As long as you can survive the bad times, such a business model isn't inherently bad, but it takes some really solid business and money management to do it.
Of course, one option for such a bimodal-depenent airline would be to shrink when the economy is slow, and expand when the economy is hot. However, many factors preclude this approach:
- Leases are typically long-term, and must be paid whether the item covered by the lease (e.g., gates, counter space, airplanes) are being used or not.
- Union contracts dictate that layoffs occur from the bottom up, but the employees near the bottom are typically the best value. That is, since wages rise faster than productivity, the cheapest unit of productivity is near the bottom (not at the bottom, since new hires start out particularly unproductive). This can be countered somewhat with buyouts of people at the top, but this is of limited use for a number of reasons.
- Ramping down can mean leaving one or more markets altogether, with the aforementioned re-entry costs later.
- Laying off union employees should come with laying off non-union employees as well, if for no other reason than to prevent the company from becoming too top heavy. The problem is, if the mid-level jobs ebb and flow, where each ebb coincides with a bad economy, it will be exceptionally hard to find people willing to take the job. What's the point in taking a job where you'll be laid off just when it's hardest to find another? Without the added incentive of the seniority-protected union contracts, airline management jobs would be even less appealing than their unionized counterparts.
Now, somewhere out there is Bob Owens, saying "But this proves nothing about the airlines' ability to raise fares!" And he's right. But it now gives us a good jumping off point for the discussion.
Since we have a bimodal market, we have to tackle this in two parts. Let's start with the business mode, and then we'll hit up the leisure mode.
Why can't we raise business fares? Well, first of all, it isn't 1999 anymore. The business mode is much smaller than it was in 1999. As we established in the previous two chapters, the market price is based on stack ranking the entry prices and capacities, and starting at the lowest price, going down the list until we meet the capacity.
But!!!! We also established that there is a significant cost associated with capacity reduction, which tends to lower the exit price to a point below the cost of providing the service.
But!!!!!! This means that there is a greater capacity than the simple market equilibrium would suggest is optimal, which lowers the market price still further!
In other words, the industry analysts are absolutely correct that there is too much capacity in the industry. What they should be saying is that there is too much business mode capacity in the industry.
And, as I mentioned earlier, the business mode was shrinking somewhat, even before the economic meltdown, because the difference in pricing between the two modes finally exceeded the cost to the businesses of either disguising themselves as leisure travelers or using a non-airline means of getting the job done (fractional jets, video teleconferencing, email...).
But let's say for a moment that AA decided to raise business fares by $10 apiece. What would happen? Well, for a segment of the market, there would be no change. They'd fly AA regardless. That's a shrinking segment, since businesses have gotten much more draconian in managing their travel budgets. No, most of AA's business customers would defect to other airlines...because they have to. The effect would be somewhat muted at DFW relative to other locations, but even there AA can't be too much more expensive than their connecting counterparts.
In other words, while it's true that business demand is relatively inelastic, you still have to price within the range of your competitors when there's excess capacity. Otherwise, the decrease revenue caused by a decrease in the number of passengers would exceed the additional revenue generated by the remaining passengers.
Besides, that's not how yield management does their job anyway. If you have enough fares in a market, you produce de facto fare increases by changing the relative size of the fare buckets. (If you remind me to, we can discuss how that's essentially the way DL's new fare strategy works.)
And what about the leisure mode? Well, as I mentioned before, each dollar in a leisure fare carries much more weight than its business counterpart. Not only is it typically felt by a multiplying factor (because leisure travelers tend to run in packs
), but there is no multiplying factor in the substitute of a rental car and/or gasoline. That is, a rental car costs the same whether there's one person in it or four. And the incremental cost of gasoline to move four people around relative to only one is small.So in the leisure market we have much greater elasticity. Raise those fares, and you wish you were raising the business fares instead!
OK, Bob...the ball's in your court.
