2.2 Operational Characteristics
2.2.3 Marketing Features
Other often-used terms in the industry are fairly obvious in meaning.Point-to-point (or city pairing) services are those with dedicated flights directly serving origin and destination (O&D) markets.Round-robin(triangular) flights fly in one direction, first to one point, then another, and finally back to the origin. Andhubsare the centers of the hub-and-spoke route networks that airlines operate out of a few important regional cities—e.g., United uses Chicago and San Francisco as hubs, American uses Dallas- Ft. Worth, and Delta, Atlanta. Also, throughcode-sharingarrangements, flights on one line use the same airline code-designation as that of another to feed passengers into the other line’s routes. A domestically based line might, for example, share its code with an international line, to the presumed benefit of both.
increase each airline’s network spread, marketing power, and geographical reach with little extra cost and help the top 20 airlines in the world to command more than 70 % of total traffic as measured by passenger-kilometers. Yet, even so, there is not yet a single global airline.
Advertising and Reservation Systems To succeed over the long run, airlines need to be sharp on many fronts: equipment and fuel purchasing, bidding for routes, labor and government relations, safety maintenance procedures, and flight scheduling.
All other things being equal, however, none of these things matters unless cus- tomers can be convinced to fly the same route on one line instead of another. Given the competitive-monopolistic nature of most (but not all) airline route operations, advertising plays a key frontline role used both offensively and defensively. Many airlines will in the normal course of business have to allocate at least 2 % of revenues toward advertising; however, they will need to spend much more if launching a new service, entering a new market, or trying to gain share against entrenched competitors. Economists call this measure of advertising to revenues the advertising intensity ratio. More formally, it can be expressed as:
advertising intensity¼ðadvertising expenditureÞ=ðsales revenueÞ
¼kA=ðPQÞ ¼εa=εp;
whereAis advertising expenditure,kis a constant,Pis price,Qis quantity,εpis the price elasticity of demand, and εa is the advertising elasticity of demand. The notions of elasticity here are similar in concept to those discussed in Sect. 1.3 (Primary principles) and below in Sect.2.3(Economic characteristics).20
Because a reservation system is one of the first things that a prospective passenger comes into contact with, the reservation system is now as much a powerful advertising and marketing medium as it is a data bank. American Airlines most visibly demonstrated this through shrewd use of its SABRE reservation
AeroMexico, Delta, and Korean Air). Cooperation in these alliances can result in cost savings through joint purchasing and adoption of common information-technology platforms. Most nations, however, place restrictions on outright foreign ownerships. For instance, foreigners may own up to 49 % of equity and 25 % of voting rights in Unites States carrier companies. See also Doganis (2001, p. 75), Michaels (2006, 2007), Maynard (2009b), and Cameron (2012b).
One way to measure the effectiveness of such marketing in a particular market or within a network is to compare actual percent market share of revenues (or total passengers’boardings), Sr, with the percent share of scheduled service, Sss If the resulting “marketing power” ratio, MPR¼Sr/Sssis above 1.0 or moving to above 1.0, the airline’s marketing is effective. The ratio is similar to that of the same name that is used in broadcasting.
Code-sharing also provide carriers, especially on international routes, to engage price-discrimination strategies. See McCartney (2004a).
20The advertising intensity ratio is discussed further in Hanlon (1996) and in Bagwell (2003, pp. 55–62). It is based on theory, developed by Dorfman and Steiner (1954) for optimal monopoly advertising. This model shows that it makes sense to increase spending on advertising as long as the sales gain from doing this is greater than the sales to be gained if such spending were to instead be used for price reductions.
system (versus United’s APOLLO), which, in the 1980s, notably boosted share of market through the simple expedient of listing American’s scheduled flights ahead of competing flights on every reservation screen.21
21In response to many complaints about this, the CAB in 1984 ordered that vendors must offer primary terminal displays that rank flights based on fares and service factors rather than on carrier identities and that connecting flights must be listed according to objective criteria. Nevertheless, the reservation systems remained inherently biased in favor of online connections over interline connections. Until 2004, DOT rules did not permit such bias; instead it was ordered that flights be listed by schedule, yet allowing agents to install their own screen preferences. After the DOT rules expired in 2004, bias was again seen creeping into travel agency bookings sites because Travelocity, Expedia, and Orbitz began cutting special deals with airlines and hotels, paying to have flights or rooms listed ahead of those of competitors. As noted in theWall Street Journalof November 9, 2004, the result is that travel sites sometimes list hotels as sold out or unavailable when they really are not. The four global reservation distribution systems in use as of the early 2000s were SABRE, Amadeus (created by several European airlines), Galileo, and Worldspan. By 2012, Lutfhansa, Air France, Iberia, had sold interests in Amadeus, American Airlines had sold SABRE, and British Air and KLM had sold Galileo.
Orbitz (acquired by Expedia in 2015 for $1.34 billion) and Hotwire (part of Expedia as of 2005) are discussed in Barrett (2000). Trottman and Power (2002) discuss antitrust concerns about Orbitz, which had been owned by the five largest US airlines (United, American, Delta, Northwest, and Continental). Orbitz quickly became the No. 3 online player competing against the Web sites of Expedia and Travelocity.com, which in 2015 merged when SABRE sold its interest. As of 2005, Galileo International (also a part of the Travelport unit of Cendant that was sold to Blackstone) had been the second-largest travel reservation system after SABRE. Galileo’s consumer leisure-travel site, Trip.com, is described in theWall Street Journal, April 29, 2002. As of 2014, OTAs account for an estimated 12 % of $1.2 trillion in worldwide bookings. Commissions on airline tickets may be as low as 2–3 %, with rental-car commissions somewhat higher (around 8 %), and hotels potentially the highest at up to 30 % (but usually in the range of 15–25 %). Google is leading the way toward turning browsers into bookers and thus competing with the legacy OTAs.
In 2002, Orbitz was only beginning to enter so-called “merchant” discounting in which Expedia (and also competitor Priceline.com) negotiates discount prices for large blocks of hotel rooms or vacation packages and then profits from selling at higher prices to consumers. In this “merchant”
model, margins are higher and Expedia controls the pricing. This differs from the traditional agency model, where online companies give customer reservations to the service supplier in return for a commission, and on top of which are added segment fees from global distribution systems and service fees from travelers. A brief history of Orbitz and its effect on pricing is in Hansell (2002). In 2002 SABRE sold around $80 billion of tickets and retained 2 % as revenue. See also Hansell (2003) and Deutsch (2006).
American Airlines pulled out of Orbitz in favor of its own system in late 2010 but was then ordered by the Illinois Circuit Court to return in 2011. Data from PhoCusWright shown in Esterl (2011) indicates that in 2010, US Airline booking revenue was $110 billion, with 32 % derived from airline websites, 45 % from travel agents, 16 % from online travel agencies, and 7 % from airline call centers. Travel sites like Expedia and Orbitz, and Galileo and Worldspan (owned by Travelport) get fees of $8–$10 (and often up to $12) for each roundtrip airline ticket they sell, with around $3–$5 coming from airlines and $5 from global distribution systems (GDS). This translates into around $7 billion in annual cost for the world’s airlines. In return, online travel agents (OTAs)—the largest of which include Priceline, Expedia, MakeMyTrip Limited (India), and Orbitz Worldwide—receive reservation flows and computing capability from the GDS systems.
However, around 2012, airlines and hotels began to seriously incentivize travelers to book directly on company sites (e.g., RoomKey.com for hotels), and thus circumventing the OTAs. On this, see White (2015) and also Rich and Angwin (2002),BusinessWeek(July 8, 2002), Levere (2011),
2.2 Operational Characteristics 65
Modern reservation systems can sift data banks of mind-boggling size and complexity as they keep constant track of billions of pieces of information—
everything from flight schedules, passenger names, and seat assignments to fares that change almost by the minute (and that are funneled through the Airline Tariff Publishing Co. [ATPCO], a clearinghouse for all airlines’fares that is owned jointly and funded by 30 US and foreign carriers).
But such systems can do much more when used to improve predictions of passenger bookings and price and departure-time sensitivities. Airlines have come to depend on these systems to manage the yield that they derive from every flight. In the post-1978 deregulated environment,yield managementhas become an essential price-setting tool without which most airlines would likely be perennially unprofitable. Yield-management strategies are what make it possible for carriers to earn more by selling 100 seats at 100 different prices than all seats at the same price.22
Because most business travelers—accounting for around half the customer base of major US carriers—usually care more about convenient departure times than about ticket prices and they also book closer to departure time than leisure travelers, airlines can maximize yield based on forecasted booking patterns. Such patterns run pretty close to those formed for the same day of the week and time of the year as in prior years and allow operators to engage price discrimination strategies (as described in Chap.1) to the utmost.23 In other words, prices can be set just high enough to fill a flight with a maximum number of high-paying passengers.
“The Ineluctable Middleman,” about Global Distribution Systems inThe Economistof August 25, 2012, and FitzGerald (2013), and Salzman (2013). TripAdvisor was spun-off from Expedia in 2013.
22On a global basis, business and first class long-haul cabins are estimated to account for 10–15 % of all seats but for up to half of revenues for carriers such as British Airways and Lufthansa (Mouawad 2013a). According to Garvett and Hilton (2002, p. 181), an airline’s profitability is most closely related to yield management effectiveness, ownership structure (i.e., government versus private) and/or tenure of airline, and unit revenue. Stage length (i.e., an airport-to-airport segment) and customer satisfaction were also factors. Yield and load factors are not necessarily correlated with profits. And profits require both high load factors and high yields at the same time (i.e., high revenue per available seat-kilometer). Homan (1999, p. 508) suggests “that for every 1 percent decrease in yield, quantity demanded (by RPMs) increases by about 0.7 percent.
Additionally, for every 1 percent increase in real GDP, demand increases by over 0.9 percent.”
Doganis (2001, p. 283) indicates, however, that maximization of total passenger revenue per flight “is not the same as ensuring the highest load factor or the highest average yield.” And Fallows (2005) suggests that yield management has led to arrays of special fares and conditions that have made travel confusing but that kept planes full. Yet introductions of Orbitz/Travelocity type systems have begun to wreak havoc on yield management attempts and have led to the demise of high-cost operators. A new price-predictive service (farecast.com) that uses algorithms to help passengers forecast ticket price changes is discussed in Darlin (2006) and Tedeschi (2007). See also Belobaba (1998a, b) and Noyes (2014) on use of big data.
23Such price discrimination tactics for dividing business from leisure travelers include overnight stay requirements that force business travelers to pay much higher fares if they want flexibility and to be home on weekends. See McCartney (2008c) and Thompson (2013).
Frequent-Flyer Programs These major marketing tools, along with the advent of sophisticated reservation systems, came into prominence in the early 1980s. Fre- quent flyers, those making more than ten trips a year, are worthy customers who account for only 8 % of passengers but 45 % of trips flown. In offering free flights to passengers, the operators may be arguably providing a special type of quantity discount to their best customers. In the process, they also hope to build brand loyalty and, as explained in Chap.1, to shift the demand curve to the right and make it more price-inelastic (i.e., vertical). The programs have succeeded to the extent that people have been known to fly far out of the way and to spend much more time in transit than necessary just to qualify for additional mileage credits. This loyalty aspect has financial impact because it costs far more in marketing expenditures to attract new customers than to retain existing ones.24
24Although the programs have turned out to be essential in supporting a brand, McCartney (2004b) notes that the loyalty benefits have been diluted over time as the companies have joined in marketing alliances, added corporate discount contracts, and begun to tilt such programs in favor of more profitable customers who pay higher prices. Brand loyalty has done little to slow the rise of low-fare carriers. Another tactic discussed in McCartney (2006a) is to issue prepaid passes that allow customers to lock in relatively reasonable fares, while the airline transfers some of the risk of empty seats to customers, gets cash in advance, and retains the traffic. See also McCartney (2012a). Sharkey (2002) discusses the growing frequent-flyer liabilities being incurred by the major lines, noting that they have been accounting for free trips for years at rates that have typically averaged 7–8 % of the total paid miles flown. As an example, Delta had 10 million awards each representing 25,000 miles on its books at the end of 2002. The liability to cover the cost was $228 million, or around $23 per award. In 2014, United earned $2.9 billion from sales of mile equivalents to other companies.
In implementing the programs, airlines incur administrative expenses that amount to perhaps 1 % of total costs. For major carriers, this might amount to 10–13 % of total current liabilities.
Brand-building effects and potentially firmer pricing structures may, arguably, provide an offset as passengers have demonstrated a degree of loyalty to one line in preference to another flying the same route at the same or at perhaps even lower prices and more convenient departure times. Also, incremental revenues from affiliated consumer merchandising partners such as hotel, car rental, credit card issuer, and telephone companies have historically paid the airlines an average of 2 cents per mile-point, although current value (see McCartney 2008a) is probably approaching 1 cent per mile-point. In all, such compensation may actually add up to more than the price of a discounted- fare ticket on the typical route flown. For example, 25,000 redemption mile-points sold to marketing partners might provide the airline with $500. McCartney (2010c) indicates that most airlines charge passengers between 2.5 and 3 cents per mile and that some add processing charges of $25.
See also Lieber (2004), Maynard and Dash (2005), McCartney (2012b), Weed (2014), and The Economist, “Funny Money,” December 24, 2005. Passengers determine the buying power of miles earned by dividing the cash price of a ticket by the miles required. On this basis, business-class upgrades might have a buying power of 4–5 cents a mile as compared to 1–1.5 cents a mile for coach seats.
By 2012, airlines had accumulated on their books an estimated 10 trillion frequent flyer miles.
According to Morrell (2007, pp. 47–48), the miles are most often accounted for using the incremental cost method, which recognizes liability for potential future costs incurred in carrying such passengers. A passenger would need to have accumulated a minimum threshold of points to be entered as an accrued liability on the balance sheet. An alternative accounting treatment is the deferred revenue method. See note 78.
2.2 Operational Characteristics 67
It would initially seem that the cumulative cost to the industry of revenues foregone has been enormous—an estimated 8–10 % of revenue-passenger miles are being provided free of charge to travelers and the number of unredeemed miles is estimated at around 10 trillion. However, many of these miles will ultimately expire unclaimed and the true liability is thus much below the undiscounted face value.
In fact, frequent-flyer programs have actually evolved into a good business because of the numerous ways that billions of dollars of revenues may now be generated by selling miles to credit card issuers, hotel chains, charities, and others who use them in turn to attract and retain their own clients. Air carriers thereby collect cash years in advance of mileage redemptions and incur little extra expense if and when such redemptions occur: A frequent-flyer ticket may be worth several hundred dollars to a passenger yet the airline’s marginal cost of giving away an otherwise empty seat might be no more than $25 per domestic round trip (which covers the extra cost of ticketing, fuel, and food).25Carriers now increasingly also tie rewards to dollars spent rather than miles traveled and have begun to auction various perks such as late seating upgrades.26
Travel Agencies With the implementation of yield management practices and deregulation, passengers in the 1980s began to face a vast array of ever-changing prices and scheduling choices. Travel agencies, long functioning both as an indirect marketing arm of the airlines (and the other modal carriers) and as product and service rationalizers, helped to turn chaos into order. The number of agencies in the United States more than doubled to 27,000 between 1975 and 1995, a period that included a large increase in demand related to airline deregulation and the Civil Aeronautics Board’s (CAB) lifting of restrictions on travel agency commissions.
Travel agencies are a primary point of contact between tourists and providers of tourism services and, because of their significantly lower information search costs, have a comparative advantage relative to tourists.
The great volume of business transacted through agencies should not be surpris- ing in view of the long history of development between airlines and these indepen- dently owned distributors who, in a plan devised by the Air Traffic Conference (ATC) of 1945, were originally required to be officially accredited. However, throughout the postwar period leading up to the early 1980s, the travel agency business was inherently fraught with various potential or actual conflicts of interest that did not begin to be addressed until the CAB voted in 1980 to eliminate fixed commissions. After that, relations between agencies and airlines were never quite as cozy, with United and then other carriers in 1997 reducing their commission rates
25However, as many as 30 % of the mileage liabilities may go unredeemed and airlines may value a mile on their books at a fraction of a cent. Also, flyer programs have increasingly evolved away from rewarding customer loyalty to instead qualifying passengers for avoidance of common inconveniences.
26In aiming to appeal to the more profitable customer segments Delta in 2014 began awarding for prices instead of miles, with passengers earning between 5 and 10 miles per dollar spent. See also Lieber (2014, 2015). On auctions,see Wall Street Journal, January 7, 2016.