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Business talk: Prices and costs in the airline industry

How are prices related to costs in the airline industry? Watch airline senior revenue manager Bill Swan share his expertise on that question.
Hi Bill. Hi Nathalie. So, Bill, today, we here to talk about the relation between cost and pricing.
For a simple company, the simplest idea is: you start a little business and you figure what it costs you to do things, and you charge people that cost and, if enough people buy your product you make money and if not enough people buy your product you go out of business. And that’s the simplest arrangement you can have. Okay, but that is not the way it is in the airline industry, right?
Not at all, and the reason is this: the airline has all of its costs fixed about ninety days out. They determine the schedule and they assigned the people to do the work shifts. And they plan to sell tickets three months before the flight takes off. Almost all of the costs are committed at that point. So there is no extra cost for passengers. So what does this mean ? What it means is if you fly around with the seats empty, –you have nobody on the airplane– you get no revenue to cover those costs. And it doesn’t cost you any more to sell a ticket to a passenger than to fly the empty seats, or very little more.
So your objective is not to have the different ticket prices cover the cost of a seat-by-seat basis or a flight-by-flight basis, but for the whole system for the whole season. So what’s happening is on each flight you’re trying to get as much revenue on that flight as you can, in hopes of that turns out to be enough revenue to pay for the flight, or for all of the flights, eventually. Okay, but how do they do that?
Well how they do that: the simplest way to think of it is that they have two kinds of prices– a high-value price that serves people have who a good value of time and an immediate need to travel quickly. And a low-value price for people just trying to get there, who want to get their economically. So they divide the ticket sales into those two kinds of ticket sales, using advance purchase requirements. But it’s very much like an umbrella manufacture that sells a black umbrella for twenty euros and the colorful ones for thirty euros, and together they pay for the plan. You see the same thing with toasters and things.
There’s a plain color and a more colorful one that does not cost anymore to make but is more valuable, is nicer, more fun for people. And they charge more for it and together it covers the total cost. But that does not really seem fair. Well it does not seem fair at the beginning, because it seems like everybody is going on the same airplane and getting there at the same time. But it works out to the best for both groups because the high-value people are paying a lot of the cost. They are about a quarter of the passengers and they pay about half the cost.
And the low-value people are getting a good deal because some of the flight cost is being paid by the high-value people. But, they still arecontributing to the total cost. If you put in an average price of a half way between, none of the discount people would fly, and that price would have to go up for the small number of high-value people to have a flight at all. So they cut it to subsidize each other that way.
The total through all the flights: peak-hour and off-peak, peak-day and off-peak, peak-season…. the total revenue hopefully covers the total cost. Okay, but how come that sometimes the lowest price is quite high and sometimes it’s quite low. That’s a good question. On Friday afternoon, everybody wants to fly, it’s very convenient time. And so they charge a high price. Airplanes almost full of high-priced tickets. And on Wednesday, at six in the morning, nobody wants to fly (although I’m going out tomorrow on that flight) and the flights are very cheap. Because you get the most revenue when you have empty seats by …. dropping the discount price to fill those seats.
So it has to do with the peak hour and the peak season, or the off-peak hours and the off-peak season. The idea is to charge exactly the right discount to fill the seats. –as high as you can get and still fill the seats–and then, if the seats are not filling, lower. Okay. But at the end of the year, what if the revenue doesn’t cover the cost ? Well, if the revenue doesn’t cover the cost, you go out of business, or at least you reduce the size of your airline. You may pull flights out and you may get out of markets. But the signal is it didn’t work out and you better plan to be smaller next year.
Okay, and on the other hand, if you make a very high profit? That’s right, you’re maximizing revenue. If it ends that way, above your costs, You are going to make a lot of money. But that doesn’t usually last for long in the airline industry, because it is very easy for somebody to move an airplane in competition to you, and if they see you are making money they will do that. So the competition limits how much you can make, fairly quickly. But if it did not limit–if you had a monopoly on the route–you could go on. Buy some more airplanes and increase the service yourself. Okay can you give us any real world example of this?
Well there is a good story: I worked for American Airlines in Dallas at a time when Southwest Airlines was flying in Dallas very much, and Southwest was an airline that was a very good discount airline–very well run and its costs were very low and they specialized in short-haul flights. Whereas American Airlines tended to specialize in longer haul. So, Southwest is very good at getting people on airplanes inexpensively and flying them at a close distances like Dallas to Houston. And American Airlines had a hub in Dallas that connected people from all over the country, mainly long haul. So we had a flight from Dallas to Houston was in competition with Southwest’s flight.
And the ticket prices for the whole flight on Southwest was only a little bit above what it cost American Airlines just to get the person on the airplane. But we kept the flight in because he wanted to feed our customers through the hub to the long haul destinations, and we met Southwest’s flight fares even though we only made a dollar or two over the cost of just putting the person on the airplane. Because we had the empty seats. But we didn’t put any extra airplanes on those routes to carry the discount customers. We only carried them in the space we were using for the long-haul connections. So that’s pretty much what happened.
It is a good example and it was a hard decision to make. Okay maybe last question what are you doing today Bill? Well I’ve gone out of the airline business and and I’ve taken up Argentine tango. I highly recommend it. It doesn’t pay as well, but it’s a lot more fun. Okay. Thank you. Thank you, Nathalie.
What about costs? Can firms ignore the production costs when pricing their products?
Let’s have a look at the airline industry to get a feel of what is going on.
In particular, can you identify why the airline pricing strategy could be to set prices that are unrelated to costs?

Join the discussion

In response to the question above, share your interpretation of Bill Swan’s explanations.

William “Bill” Swan is Chief Economist for Seabury-Airline Planning Group.
Previously and for many years, he was Chief Economist for Boeing Commercial Airplanes. He has worked for United and American Airlines in operations research and strategic planning. He holds a PhD in Transport Systems from MIT. He has been a researcher, an economist and an expert in air transport for many years. He has been one of the early revenue management developers and has followed the evolution of revenue management in air transport since the 70s.
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