Air Fares aren't Fair

 
 

Airline Pricing Explained

Even the airlines now agree that their present pricing no longer seems to work. But they don't seem able to come up with a better system!'

But although they agree the present system does not work, they can't come up with a better system!  Maybe you can?  Selected reader replies are featured in this column.

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Take a flight somewhere and look around you.  The chances are that the person seated next to you may have paid four times more than you, for the exact same flight.  Or maybe you were the sucker and paid four times more than he did!  Worse still, many of the people seated in first class probably paid less for their seats than you did for your uncomfortable middle seat way at the very back, next to the toilets, galleys and engines.

Is this fair?

This week we look at why the airlines have what seem to be crazy and inconsistent pricing for the same flight.  To understand this, you need to think like an airline executive and understand the problems they face.

(1)  Discrepancy between Incremental and Fixed costs

Most things that are bought and sold have a high incremental (extra) cost and a low fixed cost.  For example, most of the selling price for a car, or a can of soft drink, is represented by the incremental cost of making and distributing the extra car or the extra can of soft drink.  Only a small part of the cost goes to fixed or overhead costs (such as the administrative salaries, the cost of the machinery, etc).  But in the airline industry, the incremental costs of accepting one extra passenger onto a plane are very low, whereas the fixed costs of operating the flight (with or without any passengers at all) are very high.

No-one ever likes to discount below cost.  This limits how much of a discount you'll ever get on a car, but that same limit is not present with airline tickets, because the 'cost' of the ticket is so low.  As a rough rule of thumb, the incremental cost of accepting one more passenger is less than one tenth of the fixed costs (per person assuming a 70% full plane) that the airline needs to recover.  For example, maybe an airline needs to get $10,000 for flying a crewed plane between two cities, and maybe the plane will normally fill 100 seats - the airline needs to get an average of $100 per passenger to cover the fixed costs.  But the incremental costs of taking on one extra passenger are maybe a couple of gallons of extra jet fuel, perhaps a meal, and a small fee to the airports or baggage handling contractors - in total, maybe $5-10.

This means that if the airline can sell an otherwise unsold seat for even $20, it has made as much as $15 extra profit, even though it needs to average $100 per ticket for the first 100 seats it sells on the plane.  The temptation to discount seats that would otherwise not be sold at all is the reason why you'll see a limited number of very cheap fares.

However, the airlines are also keen to keep their average ticket price close to $100, which means that if they sell a ticket for $25, they then feel they need to sell another ticket for $175 so as to keep their average ticket price close to the $100 target.  This is a dreadful contradiction that airlines have to continually struggle with - the more they sell cheap tickets, the more they also want to sell expensive tickets!

They also are always very worried that the seat they sell at a discount might have been able to be sold at a higher price - this is the continual fear that they have.

(2)  Seats on Flights are a Perishable Product

Obviously, once the plane has taken off, the airline has lost the opportunity to make more money selling the remaining empty seats on that plane.  This means that, the closer to departure for each flight, the more desperate the airline is to sell seats that it thinks are not going to be sold.

But, there is also a contradictory force at work here - a person that needs to buy an airline ticket for urgent travel today or tomorrow is probably willing to pay just about any amount of money for the ticket, because it is very important to him to travel.  So the airline, on the one hand, wants to sell these 'last minute' tickets for very high prices to 'must travel' passengers, but also would be pleased to sell them at almost any price to people that would only travel if they see an incredible bargain fare.  This is another dreadful contradiction that the airlines have to struggle with - the closer to departure it gets, the less valuable the tickets are to them, but hopefully the more valuable the tickets are to potential additional travelers.  How to get only high priced tickets to such last minute travelers, while also offering low priced tickets to 'discretionary' last minute travelers?

(3)  Different Consumer Valuations on Tickets

People fly for different reasons.  Some people fly because they have to fly; some people fly because it is more convenient, others fly because it is cheaper, and others fly for indulgence (so as to get somewhere for a vacation).

Recognizing these different factors, the same flight can be priced at different prices to appeal to these different types of travelers.  For example, a flight between Los Angeles and San Francisco could be priced at $100 roundtrip to appeal to a bargain hunter looking for a cheap vacation, maybe $150 for people that will then fly because it is cheaper than driving, maybe $225 for people that will fly because it is more convenient than driving, and $300 (or more) to people that absolutely urgently have to get to San Francisco as quickly as possible.

But, obviously, even if a person is willing to pay $300 for this flight, if she can find a $100 fare, she would rather take it!  So here is the third problem that the airlines have - how can the accurately restrict the low fares to only the leisure travels, the mid priced fares to the people willing to pay middle prices, and make sure that the person who'll pay top dollar is not able to buy fares more cheaply?

(4)  Supply and Demand

Some flights are simply more popular than others, maybe because of time or day or day of week.  A flight at 2am is not as popular as a flight at 8am.  And a flight on Wednesday is probably not as popular as a flight on Friday.

However, the airline still needs to operate these flights (so as to keep a regular schedule or to move the plane to the next place it needs to be) so it needs to adjust pricing, flight by flight, to encourage people to fill up the less popular flights as well as the more popular flights.

The Airline Challenge

And so, airlines have to confront these all these challenges (and many more!) and somehow come up with an air fare structure that enables them to sell as many tickets as possible per flight, and at as high an average fare as possible.

The real Catch-22 is that for every discounted ticket they sell below their targeted average fare, they then feel the need to balance it with a higher ticket priced above their average fare, magnifying the spread between the cheapest and the most expensive tickets.

As consumers it is easy to say 'give us a simple fare structure that we can understand' and it is easy to complain about the huge discrepancies between fares for the exact same flights.

What would you do?  If you were in charge of setting fares, what would you do?  Remember, you want to charge as much as possible for every ticket, but you also want to sell as many tickets as possible, at any price at all, and there are a lot of people out there that will only pay bottom dollar, as well as some that will pay top dollar.

A selection of suggestions from readers can be found in this column.

Why Not Copy the 'Discount' Carriers?

Here's a surprising fact.  The average fare that the 'discount' carriers receive from their passengers is not much lower than the average fare received by the 'full fare' carriers.

For example, the 2001 annual reports for United and Southwest (to choose extreme examples at both ends of the spectrum) show that United got an average 9.8c of operating revenue per available seat mile (ASM) while Southwest got an average of 8.5c.  In other words, on average Southwest fares are only 13% less than United fares!  (The difference is even less if measuring revenue passenger miles.)

The real success of Southwest comes not from its 'low' fares (which aren't much lower than 'normal' fares) but from its low operating costs.  In 2001, United's operating cost per ASM was 12.0c, but Southwest's was only 7.5c - a massive 37.5% reduction.

The 'success' of airlines like Southwest is nothing to do with their fare policies at all, their financial success is all to do with their cost structure, not their fare structure.  Traditional airlines can't copy these carriers (which should be called 'low cost' rather than 'low fare') fares because they can't also copy their costs (much as they would desperately love to).


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Originally written 21Jun 2002, last update 15 Oct 2013
Copyright 2002 by David M Rowell.
You may freely reproduce or distribute this article for noncommercial purposes as long as you give credit to me as original writer.