|The Jet Airplane - the Real Beginning of Today’s Airline Industry
The commercial airline industry as we know it today began on April 22, 1952. That was the day the Board of Directors of The Boeing Company authorized $15 million to develop a commercial airplane powered by a jet engine and called project 367-80. Old timers at Boeing still refer to it as the dash 80 but we know it as the 707. It was the first successful commercial jet transport and with this tool airlines were finally able to replace ships and trains as the primary mode of long distance passenger transportation in the world.
At the time Douglas Aircraft was the leading producer of commercial aircraft with a highly successful line of piston powered airplanes that started with the DC-2 in 1934, continued with the famous DC-3 (the C-47 of World War II) and climaxed in the 1950s with the DC-6 and DC-7.
Along with Lockheed Aircraft, Douglas dominated the production of commercial airplanes while Boeing was a bit player. The 707 changed all that. Douglas, as is so often the case with a market leader, was slow to appreciate the potential of this new technology and so their DC-8 came to market after the 707. Lockheed went in a different direction and developed a turbo-prop (a hybrid consisting of a propeller mounted in front of a turbo jet engine) called the Electra.
The pure jet proved to be much superior to the turbo-prop, and by having the first one in service Boeing soon came to dominate the world commercial aircraft market. Lockheed left the commercial business, and after a brief return in the 1970s left it again for good, while Douglas was merged into McDonnell Aircraft in 1967 as a way to escape bankruptcy. Thirty years later the circle was completed when, in 1997, the now McDonnell Douglas Company was acquired by Boeing.
|The Physics of Flight We have used terms such as jet and turbo-prop that need to be explained. These, of course, are the engines that are mounted on the airplane, but to explain them we need to explain an airplane, as strange as that may sound. For any airplane to operate it must deal with four forces: thrust, drag, lift and weight (gravity), with thrust being the key. Thrust is the power driving the aircraft forward, and it not only must overcome the reverse force of drag caused by the density of air (your hand held out a car window is pushed backward by this force) but must also, in conjunction with the shape of the wing, provide the aircraft with enough lift to allow it to overcome its weight and become airborne.
In flight all four forces are active all the time since an airplane operates in three dimensions and not just the two, represented by thrust and drag, we encounter in daily life on earth. (A scuba diver knows that functioning in three dimensions is very different from two - neutral buoyancy is all about balancing lift and weight, something we never have to think about on land.) In airplanes thrust is a function of the engines, and three words sum up the guiding principles of engine and airplane development: higher, farther, faster. For the rest of us the more conventional words are altitude, range, and speed.
One of the more famous airline accidents in history came on March 31, 1931 when a TWA wood and fabric Fokker tri-motor went down in Kansas killing all aboard including the legendary Notre Dame football coach Kunte Rockne. Up to that time there had been a fierce debate over whether wood or metal was the better material for building airplanes. When wood rot was found in the wing of the Rockne airplane the debate was over and all subsequent airplanes were made of metal.
From the beginning a propeller, an idea perhaps derived from a windmill, mounted in front of a piston engine that turned it was the source of thrust, and this worked very well for everything from the Wright flyer to trans-Atlantic airliners. There were, however, limits to the efficiency of a piston driven propeller. They restricted the speed of commercial aircraft to about 350 miles per hour, and the piston engine required oxygen rich air that limited the altitude at which the airplanes could fly. Finally, these engines used a considerable amount of fuel and this placed limits on range, so trans-Atlantic trips stopped at Gander, Newfoundland, and Shannon, Ireland, to refuel.
The principles of a jet turbine engine were well known. They were used in power generation and gas pipelines, but were not applied to aircraft until World War II when Germany built the ME-262 jet fighter late in the war. Following the war the British, who had also developed such an engine, built the first commercial jet named the Comet that entered service in 1952. Unfortunately, structural weaknesses led to two accidents and the aircraft was withdrawn from operation in 1954 (later improved versions operated until 1997 when the last one was retired) casting a cloud of uncertainty over the future of commercial jet power. Boeing, of course, was already developing the 707 and its first flight came just six months after the Comet was grounded.
How a Jet Engine Works
A jet engine operates by compressing the air that enters the inlet, speeding it up much more than a propeller can, and this compressed air is ignited in the turbine where the fuel adds to the mass, pressure, and speed of the gas leaving the exit nozzle. Newton’s third law says that any force produces an equal but opposite reaction, so the forward thrust comes from the speed of the exiting gas. With this greater thrusting power the three objectives of altitude, range, and speed all increased to the point that today we have aircraft capable of non-stop flight from New York to Asia at altitudes of 40,000 feet (air up there has much less oxygen to burn fuel, but this is OK since much less thrust is needed to cruise in that thinner air) at speeds of 600 miles per hour.
Going faster and higher involves supersonic flight and that brings a whole new set of problems, some environmental, that almost certainly will be solved in the future. The British/French built Concorde was the only supersonic commercial airplane in service but it was too small, probably too slow and clearly too inefficient to serve as a prototype for a commercially successful supersonic aircraft. The last Concorde was retired in 2003.
The first generation of jet engines are now not only obsolete in economic terms but illegal from a noise standpoint as environmental forces have demanded ever quieter operating standards, with the latest requirements, called Stage III, becoming effective in the U.S. at the end of 1999 and in the rest of the world three years later. These demands, along with better economics, have been met by mounting a large fan in front of the turbine inlet to move, and compress, more air than the amount that needs to be burned in the turbine. This extra air passes directly out the exhaust and the ratio of it to the air that is burned is called the bypass ratio; the higher the bypass ratio the more efficient, and quieter, are the engines.
The Airplane as a Factory:
Why, you ask, began a discussion of the airline industry by talking about airplanes? The reason is that for an airline the commercial airplane is a factory that manufacturers seats, and those seats are the inventory that an airline sells. Moreover, airplane manufacturers control the technology that makes that factory more productive, so airlines must look to them to provide the kind of equipment that allows airlines to compete successfully against other forms of transportation. This tight symbiotic relationship goes back to the very beginnings of aviation and neither party able to survive without the other. With the jet airplane airlines finally had a factory that enabled them to sweep the field and become the dominant form of passenger transportation in the world.
The seats produced by this airplane factory are a very peculiar kind of inventory. They do not appear on the current asset section of the balance sheet, as inventory does for most companies, because it is not the physical seat that is sold but just the use of that seat on a particular flight. Each seat is used over and over, on average more than 1,000 times a year in the U.S., so it is never consumed in the normal sense. However, on every flight any seat that is not occupied represents inventory that is lost forever. Therefore, we have the apparent paradox of an airline seat perishing many times a day but never dying. As we shall see, that paradox dominates all airline economic and business strategy decisions.
Flying has forever been a dream of man. Icarus tried it with wax wings but not until the Wright brothers demonstrated powered flight at Kitty Hawk, North Carolina on December 17, 1903 did the age of flight began for mankind. Why was it so difficult to learn the skill? After all, nature has evolved flight dozens of times and in many different ways from pterosaurs to robins, and has even done it with creatures such as bees which aerodynamic theory says should not be able to fly. And we have always had the example of birds where we could study the process closely.
A contentious issue among paleobiologists today is whether birds developed flying from the ground up or from the trees down. This author is satisfied that the ground up position is most probably right (although both sides have strong arguments and the issue may never be truly resolved) and the reason is the paradox that faced man in his early attempts: you have to learn how to fly before you can fly! This seems obvious today as would be pilots learn all the aspects of flying before they are allowed to actually operate an airplane, but in the early days everything was trial and error. Working from the ground up those errors might be unpleasant but were not necessarily fatal, whereas launching from a tree or a cliff, as many men did, almost always was. The creature that became a bird faced the same dilemma.
Milestones in the Development of the Airline Industry
Beginnings of the Airline Industry
The first recorded flight with a revenue passenger took place in Germany in March 1912, while the first such flight in the U.S. was between St. Petersburg and Tampa, Florida, on New Years Day 1914. The providers of these irregular services do not warrant the name “airline” so the first scheduled daily passenger service, and thus the first airline, was established in Germany in 1919. Only sixteen years had passed since the Wright brothers showed how flight was possible but there had been rapid advancements in aeronautics since then, much of it coming as a result of the military demands of World War I. Aircraft really played a small role in that war, although they produced some of its most notable heroes, but the value of this weapon was recognized for reconnaissance as well as combat missions so considerable resources were devoted to airplane improvements.
In the U.S. the needs of a wartime economy and the availability of better airplanes led the Post Office to establish an airmail service in 1918. This was operated as an arm of the Post Office Department until 1926 when legislation converted the service to one operated by private companies under contract with the Post Office, and an air transport company owned by the Ford Motor Company performed the first contract flight. Some of the airlines operating today trace their beginnings to airmail contracts they were first awarded in the late 1920s but their dependence on the revenue from these government awards was also the initial basis for government control of the fledgling airline industry.
The trans-Atlantic solo flight from New York to Paris by Charles Lindbergh on May 20-21, 1927, still probably ranks as the most memorable event in aviation history. No one foresaw the impact this would have on the public as seventy-eight people had already made the non-stop trip across the Atlantic (none solo), and he was just competing for a $25,000 prize offered by a New York hotel man for the first non-stop trip to Paris, solo or otherwise. Lindbergh had already made a record trans-continental flight in his airplane, the Spirit of St. Louis, but at the time he was not the favorite to win the prize money. When he did, and did it solo, the public acclaim for his historic achievement translated directly into a greater appreciation of the merits of air travel. This, combined with the award of mail contracts, got the U.S. airline industry off the ground, so to speak.
Lindbergh’s first direct involvement in the airline industry (he did fly mail for one of the early carriers) was as chairman of the technical committee of Transcontinental Air Transport (TAT) formed in May 1928 and quickly known as the “Lindbergh Line”. In this role he had a major influence on TAT’s routes and aircraft, and pioneered most of the routes that are still part of that airline, which was TWA before it merged into American Airlines in 2002. Early in 1929 he became the technical advisor to Pan American, a company formed just six months earlier that had won all the foreign airmail contracts let by the Post Office up to that time. All of these contracts were in Latin America where Lindbergh was well known and liked following a goodwill tour of the region after his Atlantic crossing. Primitive facilities demanded that the routes be flown with aircraft capable of landing on water as well as land, but despite these limitations, by the end of 1930 Pan Am had over 20,000 miles of routes compared to only 250 when Lindbergh joined them.
In 1933 his work was to explore the possibilities of a route to Europe over the North Atlantic following, as nearly as possible, the “great circle” path he had used on his trip to Paris. Given that the earth is round, despite protestations from the Flat Earth Society, then the shortest distance between continents, or from one end of a continent to the other for that matter, is not a straight line but a half moon arc going well to the north even, if the trip is long enough, into the Arctic. In the southern hemisphere, of course, it’s the reverse and you go south. The Pan Am Atlantic routes followed the lines Lindbergh had explored but his similar great circle path in the Pacific, flown by he and his wife in 1931, could not be used as Russia refused to allow U.S. aircraft to refuel on its territory (sound familiar?). As a result Pan Am had to use the longer central Pacific route using Honolulu, Midway, Wake, Guam and Manila as refueling stops - all of them points made famous in World War II. Lindbergh remained a technical advisor and a Director of Pan Am until 1974, retiring just a few months before he passed away at his home in Hawaii.
From the beginning airlines were considered a form of public utility subject to government regulation and/or ownership. Moreover, in many parts of the world they are seen as an extension of national identity. These attitudes caused the business aspect of airlines to become secondary to national and public service objectives, so profit, the normal goal of any business, was not seen as a measure of how well the airline was operated. You would think that public service motives would demand the lowest possible fares, but this was seldom how it worked. Government owned airlines in particular often emphasized employment as a primary goal even if that led to artificially high fares, while for most private airlines, such as those in the U.S., regulatory decisions were often determined more by political than economic factors.
The Nature and Form of Airline Regulation
For privately owned airlines the normal regulatory process was to accept the costs as reported by the airline and then apply a uniform rate of return to obtain an approved fare level. By insulating the business from market forces inter-company competition, which still existed and could be very aggressive, took such forms as larger seats and grander food. The fact that these amenities raised the cost of doing business was not a problem because the regulatory body accepted those costs and allowed the airline to increase its fares enough to cover them and, in theory, earn a modest profit. Of course, those profits often were not achieved because political forces, not market factors, limited the size of the fare increase.
This type of economic regulation came rather late in the U.S. During the 1920s and early 1930s the key involvement of the government was, as we have seen, awarding contracts to carry mail, while operational standards and the control of airways were in the hands of the Commerce Department. Those mail contracts were vital to the airlines in the early years, and amounted to de facto economic regulation, because airlines could not support a business with the small number of passengers they could carry on the aircraft of the day. Therefore, losing a contract could doom an airline while mail contract rates set by the Post Office largely determined their profitability.
Few people flew, or were willing to fly, given the pioneering nature of the industry and the considerable risks involved which were due more to the primitive state of air navigation and weather forecasting than to the quality of the airplanes themselves. It took a tragedy to move the U.S. Congress to address these problems, and it happened on May 6, 1935, when a TWA Douglas DC-2 trying to reach Kansas City went down because of unexpected poor weather, a malfunctioning radio and an inadequate fuel reserve. One of the four passengers killed was Senator Bronson Cutting of New Mexico. He was one of the more respected members of the Senate at the time and his death triggered an investigation that led to the Civil Aeronautics Act of 1938. Under it a Civil Aeronautics Authority (CAA) was established to operate air traffic control and navigation facilities, including airports, while a Civil Aeronautics Board (CAB) became responsible for economic regulation over air fares and routes.
The CAA and CAB remained part of the Commerce Department until 1958 when another accident led Congress to change the system again. By the mid 1950s air travel had begun to mature into a major mode of travel, but the traffic control system had a limited amount of radar and airplanes none at all. One result was that on September 15, 1954, 300 airliners were circling New York trying to land in pea-soup weather while on June 21, 1956, delays in the same place continued for fourteen hours. No accidents happened on those occasions but on June 30, 1956, a TWA Superconstellation and United DC-7 collided over the Grand Canyon and the 128 deaths made it the worst aviation accident in U.S. history at the time. The direct result was the Federal Aviation Act that placed administration of airways and air safety in the hands of an independent Federal Aviation Administration (FAA), where it remains today, while the CAB was also made an independent agency. In 1972 the FAA was made part of the new Department of Transportation (DoT), but the CAB remained independent.
There are old pilots and there are bold pilots - but there are no old, bold pilots!
Route Regulation: Along with air fares, the key form of economic regulation was deciding what routes an airline could fly. (A major portion of the route system of the larger carriers was in place before 1938 when this regulation began, with many of them resulting from the award of mail contracts, and those routes were not changed.) Route cases could be started for a variety of reasons such as requests from a city for more service or a determination by the Civil Aeronautics Board that more service was needed. Once begun, all airlines wishing to serve the route or routes could apply for them and, in a quasi-legal proceeding, all the arguments were heard and eventually, always after a year or more, the CAB would render its decision. For the winner it was often a mixed blessing. Winning was the only way to expand the system, but many times the route won did not fit well with the rest of the network. Airlines could only hope that in future cases they would win additional routes that complemented and supported the ones just received. Clearly this was not a textbook way to build a business.
Two stories illustrate the inherent weakness of the route award process of a regulated air transport system. One involves the Trans-Pacific Case of 1969 where the objective was to authorize new service across the Pacific. This was done, but it was also the event that started Pan American World Airways down the road to eventual liquidation. Pan Am was the de facto U.S. flag carrier and as such it took passengers from gateway cities like New York and San Francisco to international destinations. By design it had almost no domestic routes so domestic airlines were willing to turn their international passengers over to Pan Am at these gateways. In the Trans-Pacific decision the CAB changed the rules. They awarded other airlines Pacific routes from inland cities such as Dallas and Chicago permitting them to avoid the gateways and avoid giving passengers to Pan Am.
Over the next several years the same thing was done in European markets. In response Pan Am, quite logically, requested domestic routes so it could compete for these inland international passengers, but all such requests were denied. Before 1969 Pan Am was a consistently profitable, often the most profitable, U.S. airline, but over the next 23 years of its life it reported profits only five times. For Pan Am deregulation came ten years too late.
The second example is more recent and it involves a route between Honolulu and Nagoya, Japan, given to America West Airlines in February 1991. (This occurred well after domestic airline service was deregulated but at the time international routes were still awarded in the same regulated way.) America West was (and is) a very small airline that had little service to Hawaii from the mainland while Nagoya was (and is) a secondary traffic point in Japan. What Nagoya needed to enable that city to develop this international route in competition with Japan Airlines was an airline with a powerful traffic base in the United States and substantial service to Honolulu. That is not what Nagoya got. Instead of American Airlines, United Air Lines or Northwest Airlines they got America West because the U.S. regulators ignored Nagoya's needs in order to implement their theory of spreading competition. The result was predictable. America West could not attract any traffic because it was not strong on either end of the route and there is a story that on one 747 flight there were just two passengers!
For this and other reasons America West entered bankruptcy in June 1991 (later it emerged and is now a successful domestic carrier) and gave up the route as part of its reorganization. Nagoya / Honolulu is now operated by Northwest. By following a vague policy of increasing competition at the expense of economic and market realities regulators have made many decisions like these and the losers were airlines, the cities seeking to build air service and, in the end, even the regulatory objective of creating more competition.
Deregulation in the United States: As a result of the shortcomings of this regulatory system, primarily its tendency to make air fares too high, the U.S. Congress in 1978 passed the Deregulation Act. This legislation has proved to be one of the most important events in the history of the airline industry. At a stroke it cut all ties of government control over fares and domestic routes and for the first time gave airlines the opportunity to operate as a true business. As could be expected, a period of substantial turmoil followed as entrepreneurs quickly moved in to start dozens of new airlines while managers of the established carriers struggled to adapt to the new environment. In the end all but one (America West) of the airlines launched in the first decade of deregulation failed. Many of them, along with most of the smaller carriers operating before deregulation, were absorbed into larger airlines as consolidation and acquiring greater market share became the dominant business objective of those years.
Management of all large airlines except United were strongly opposed to deregulation because it represented change to a world none of them could imagine, or were equipped by experience to deal with. Their testimony to Congress filled volumes and sometimes bordered on the hysterical as this author observed when he spent several days sitting in the Washington hearing room. The theoretical basis for deregulation was described in a 1974 book “Economic Regulation of Domestic Air Transport: Theory and Policy” by George Douglas and James Miller III and published by the Brookings Institution. The four years from that book until the passage of the Act in 1978 were easily the most contentious for the industry since the 1930s but, in the end, it was the promise of low fares for the consumer that carried the day with Congress. All economic regulation, along with the CAB, was abolished, and doing away with the CAB was the key element that calmed the worst fears of airline managers. The initial proposals had retained some degree of economic control over the airlines so were seen by the industry as just a rearrangement of the deck chairs, while full freedom was something they never expected to obtain.
For the traveling public the rewards were indeed the significantly lower fares that were promised by the Act, most noticeable in the number of very low discount fares available to leisure travelers. For the airlines, however, the 1980s were actually less profitable than the years before deregulation because carriers were still learning how to operate in the new environment. Some learned better than others.
One airline badly misread the political climate that produced deregulation and it cost them their life. Braniff International was a successful, medium-sized airline operating in the Midwest and Latin America from its base in Texas. The management became convinced that deregulation would not last and that Congress would reverse itself before long and reinstate economic control over the industry. As a result, after the bill was passed in 1978, they set out to expand into as many new markets as possible before this happened, and the next two years witnessed an orgy of new additions to the system in all parts of the country. They were wrong about the intentions of Congress but it didn’t matter because that much expansion that fast overwhelmed the resources of the company leading to massive losses beginning in 1980 followed bankruptcy in May 1982. At the time, conventional wisdom said that the public would not fly on an airline that was in bankruptcy so Braniff and the court saw no alternative except to liquidate the company. Of course, we soon found out that this conventional wisdom was wrong when Continental Airlines filed bankruptcy papers in September 1983, closed down for two days, and restarted as a low cost/low fare airline that was immediately accepted by the traveling public. So the Braniff name passed into history as the first major casualty of deregulation and became the first of four famous names, Eastern, Pan Am and TWA being the others, who failed to make the transition from a regulated to a deregulated world.
With the United States adopting an unregulated domestic airline market, our national policy became one of pressing for similar freedom for international travel between the U.S. and other countries. This pressure was not always well received, but a number of countries did sign what became known as “open skies” agreements with the U.S., while the European Union, representing the second largest air travel region in the world, made full deregulation a part of its economic policy. A number of countries in the Asia/Pacific region, as well as those in other parts of the world, are moving in the same direction.
It is important to understand that, except among the countries of the European Union, “open skies” deals with international travel between countries not domestic service within a country. Even in the United States domestic deregulation does not allow a foreign airline such as British Airways to operate a route such as Chicago / Memphis. Such service is called “cabatoge” and it is forbidden: domestic markets are still reserved for domestic airlines although pure free market advocates would do away with this limitation.
War and Terrorism – Trauma for the Airlines: Over the last fifteen years the economic fortunes of the airline industry have been dominated by the war and terrorism. The 1991 Gulf War began the period and its importance was not so much that it was a war, but that it was a war in the Middle East where both oil and terrorism are major forces. Fuel is a large airline cost item so they are very sensitive to higher oil prices, and airlines had for some time been a prime target of terrorist attacks. It was, therefore, the fear that there could be a rash of such attacks as a result of the war that led passengers throughout the world to avoid flying during and after the Gulf War and produced the first ever year-over-year decline in world airline traffic in 1991. That fear, along with the sharp rise in the cost of jet fuel in 1990 after the invasion of Kuwait, began a period when the world airlines recorded losses of $20 billion with the U.S. carriers accounting for almost $11 billion of that. In those years five of the twelve largest U.S. carriers went into bankruptcy, two others came close and two of the bankrupt companies, Eastern and Pan American, were liquidated.
Those years were followed by six of the best earnings years the industry has ever had (1995 to 2000) but, of course, it all came to an end with 9/11. Since then airlines worldwide have lost over $36 billion with the U.S. carriers recording losses of about $40 billion, some of that in the form of one time writeoffs that are not in the world numbers.
The Economic Basis of Air Transportation
The Driver behind Travel: Without travel there would be no need for airlines, so why do people travel and why do they go where they go? At the most basic level we are a restless race. Our early ancestor, Homo Erectus, traveled from Africa to Asia and several hundred thousand years later Marco Polo did the same thing from Europe. Asians crossed the Bering Strait to North America and later the Spanish conquered that new world. Americans made westward expansion the hallmark of their identity as a nation. Human beings, it seems, have an irrepressible urge to be on the go, but underneath it all is an economic driver.
Virtually all travels in human history are about gaining land, or food or wealth - in short, economics. It’s no different for air travel. But if air travel is driven by economics it is a very special kind of economics. Air travel is the alpha form of transport. It is the fastest and most expensive mode on a scale where walking is the cheapest, and slowest, way to go from point to point. This fact means that air travel is for the wealthy (using the world, not the western, standard for defining wealth) and this is why most air travel today is found in developed countries of the world. It also means that, above the subsistence level, the rate of growth in a country's economy is the key factor in determining how much air travel there will be within that country and between it and other countries.
Given this connection between air travel and wealth it should be no surprise that the airline industry in the U.S. is a relatively mature business. For a long time this country has had a high level of personal wealth, and has also had the longest time to exploit the opportunities opened up by deregulation. Total U.S. passenger revenue compared to Personal Consumption Expenditures was growing rapidly until 1980, but has declined since then. It does seem odd that this was a growth industry when it was regulated but became mature at almost the same time it was deregulated, but that is what the data says. Since deregulation traffic expanded more than three fold but because air fares declined 50% in real terms, revenue has failed to keep pace with growth in the overall economy.
Travel is an Intermediate, not End, Product: Unlike most consumer services air transportation is not an end product but an intermediate one, used only when it is necessary for someone to satisfy another personal or business need. No one gets up in the morning and says that today I am going to take an airplane ride unless they are part of that small minority that have their own airplane. In the early days of aviation many people did do that because the experience was so new and unique that flying was a thrill in itself; you didn't have to go anywhere, just fly, and barnstormers traveled throughout the country offering people that chance. Now the airplane is only another mode of transportation and that means the airplane ride is not the key activity. The desire to reach a vacation resort or a place where business can be conducted is the key and the airplane trip is just a necessary intermediate step to achieve that end.
This intermediate nature of air transportation is one reason it is, in economic terms, a commodity. An analogy can be made to a bushel of wheat that is a commodity for two reasons. First, nobody wants a bushel of wheat, what they want is a loaf of bread or a cake, so, like air transportation, wheat is an intermediate material needed to achieve the desired end product. Second, every bushel of wheat is just like every other bushel, so no producer can make his different from any other. In the same manner every airplane seat is just like every other seat. There are, of course, different grades of wheat and there are first class and coach seats, but for the most part wheat is wheat and a seat is a seat.
Since neither the bushel nor the seat has any value as an end in itself, economic theory says that its price will tend to seek the lowest possible level under the supply / demand conditions that prevail. Moreover, assuming the supply is adequate, the unit profit margin to any supplier will be very small. It is possible for a gourmet food shop to charge an upscale price for its cakes and cookies but there is no such thing as an upscale price for a bushel of wheat. So it is with the airline seat. Viewing air travel this way helps us understand why we have frequent price wars in the U.S. and on some international routes, particularly when new suppliers are trying to enter the market.
Producers Seek to Control Supply of a Commodity: This commodity characteristic is the force driving the intense effort of airline management’s to gain a greater degree of control over, and even domination of, the cities and routes they serve. The only way any producer of a commodity can hope to manage its price in a way that improves profit is to control the supply. The rash of U.S. airline mergers in the 1980s and recent moves by airlines throughout the world to enter into code sharing alliances across national boundaries are driven by this desire to control the supply of a commodity product. By doing these things they expect to realize a better price, or gain more traffic at the same price, that would otherwise be possible. The establishment by U.S. carriers such as United, and Delta of no-frills, “shuttle” or “express” alternatives to their full service product in order to compete more effectively against new, low fare airlines is another example of this drive to obtain better control of markets.
It must be said, however, that while an airplane seat is a commodity it is not so perfect a commodity as wheat. Airlines do have brand names, and those names do influence consumer choice as we found out after the Valujet accident in Florida when passengers in large numbers stopped using all newly formed airlines and booked their trips on the established names. This brand preference is a factor in the marketplace and some airlines refer to its benefits as the “revenue premium” they are able to obtain because of their established brand name. Nevertheless, any such benefits are marginal and it remains true that price, particularly for leisure travel, is the top priority with most consumers.
Of course, in many respects any effort to control markets is a zero sum game because, with most competitors likely to follow the same path, none can be expected to achieve the measure of control over markets, or the amount of profitability, they seek. There is an old adage that says in the history of civilization no one has ever made money by transporting people for hire! We cannot verify this for Roman chariots but it is certainly true for stagecoaches and railroads and, despite all the improvements in business strategy, in the end it may prove to be true for airlines as well.
Producing and Distributing the Service - How the Industry Functions
Controlling Traffic with a Hub and Spoke System: When the industry was regulated building a route system could be done only by participating in all of the numerous route award proceedings that were held by the CAB. These were, as noted, quasi-legal proceedings, the results of which were almost never based on economics but on vague government policy objectives such as balancing competition. By the nature of the process all of these routes were point to point, meaning they connected one city to another, so a passenger with a complex itinerary involving several cities often had to transfer to another airline to do it. He could buy the entire ticket from the original airline and then “interline” with another airline at the connecting city. Following the 1978 Deregulation Act airlines quickly began to change their route systems to build up those regions where they were strong and eliminate routes where they were weak. The adopted strategy is called hub and spoke, and it became the basis for building a system because it enabled an airline to compete more effectively in a particular city or region of the country.
The hub strategy is based on having a large number of flights into and out of an airport, the hub, several times a day The hub process enables passengers in any city, the spokes of the system, to have one stop or two stop service several times a day to just about anywhere in the country on the same airline. The system evolved because most cities do not have enough traffic to support point to point service to any but the largest metropolitan areas, and then often with just one flight a day. By using a hub an airline can provide those cities with several daily flights to and from the hub, so passengers can connect, at the hub, with one of several daily flights going to their final destination. The passenger thus gets a much greater choice of frequencies while the airline obtains a higher load factor by consolidating passengers going to or from many cities onto one flight.
A not incidental benefit for the airline is that they gain greater control over their markets and do not have to share the revenue with others as they did when interlining was common. Much has been written about the economics of hub operations, a great deal of it negative because of the expense of operating one, but a hub has powerful attractions. One is control over most of the traffic in the region and this directly serves the objective of controlling the supply of a commodity product. Hubs are also the only feasible way to move the huge volumes of traffic going to dozens of different places. This exactly describes domestic air travel in the U.S., but in many parts of the world air travel takes place largely between a few major population / business centers where point to point operations work well, making hubs unnecessary. The advantages of a hub must be measured against the fact that hubs are more expensive than point to point for both the airline and, in terms of travel time and/or cost, for many passengers as well. This fact has limited the number of true hubs and has caused a rebirth of point to point flying in a number of markets.
Point to Point Comes Back Overcrowded hubs, the growth of traffic in many secondary cities as corporations moved activities to these areas to lower their costs, and the development of new airplane types like regional jets made point to point service more feasible than it was some years ago. Moreover, there isn’t a passenger anywhere that wouldn’t prefer a non-stop flight to one requiring one or more stops, so it has never been a question of the demand for this type of service.
An early example of this shift is found on North Atlantic routes to Europe. Through all of the 1970s and into 1980s the Boeing 747 was the airplane of choice in all international markets, and it is still the flagship of many fleets. Its very large size, however, meant it was suited only to those heavily traveled routes where a profitable load factor could be obtained, and so it tended to move traffic between such international hubs as New York and London or Paris where passengers connected to another flight to reach a different destination. The Boeing 767 entered service in 1982 as an airplane smaller than the 747 but offering the comfort of a twin aisle cabin. This aircraft enabled airlines to fly directly from many U.S. points to European cities that could not support 747 service and/or offer greater frequency to those cities that could. Today trans-Atlantic service is largely operated by 767s and other similar types. Now the same trend is developing in the Pacific, because long range Boeing 777 and Airbus A-340 were specifically designed to allow non-stop flights from all parts of the U.S. and Europe to almost anywhere in Asia without going through hubs such as Tokyo. The new Boeing 787 and Airbus A-350 continue this trend with even better economics.
In domestic markets, largely U.S. and European, regional jets opened up the same options. Airlines in all operating environments (short haul, long haul, domestic or international) have shown that they will always opt for smaller airplanes with which they can offer greater frequency in preference to larger equipment. In economic terms they are saying that the revenue and earnings benefits of smaller aircraft and higher frequency outweigh the lower unit cost advantage they could obtain by using large airplanes. The proof comes in the fact that in the years since 1988 the average size of the world fleet has declined from about 175 to 164 seats, while the U.S. fleet has shrunk to 137 seats from 168. With all these new airplane types we should expect more point to point flying in the future. Airlines will not only find it easier to obtain a profitable load factor and yield on the smaller number of seats they contain but the competitive force of passenger preference will demand it. Nevertheless, a substantial portion of both domestic and international traffic will still flow through hubs as there are many markets where they provide the most convenient and frequent service.
Southwest: the Prototype Point to Point Airline: The most famous napkin of all time is the one that Rollin King used to draw a triangle with the cities of San Antonio, Dallas and Houston at the points. He said to his lunch companion, Herb Kelleher, “Herb, let’s start an airline”. Herb’s response was “Rollin, you’re crazy -- lets do it”. Thus was born, in 1966, the idea that became Southwest Airlines, and today it is easily the most successful airline in the U.S. and perhaps in the world. When it began operations in 1971 the industry was still regulated but as Southwest served only cities in the state of Texas it was not under the economic control of the CAB. It was modeled after Pacific Southwest Airlines (now merged into USAirways), an intra-state carrier that had been operating in California since 1949.
Southwest does not run a hub-and-spoke system but rather offers point to point service with a large number of frequencies in mostly short haul markets at very low prices. The original concept, still a hallmark of the company, was to win passengers that would otherwise drive between cities that were 300 or so miles apart. It worked, in spades! Today, thanks to deregulation, Southwest covers a large portion of the U.S., and in the process they have developed several key cities that function much like hubs. Southwest, however, does not operate them with banks of flights like a conventional hub, but because there are so many flights coming and going through each one it is possible for a passenger to reach most cities in the country on Southwest, making between one and three stops to change planes.
With their low prices this also works, but perhaps the real key to their consistent profitability (they have not lost money since 1972, the second year in business) is disciplined growth. They have never added too many airplanes to the fleet too fast or tried to enter too many new markets too quickly - by contrast, the inability to control temptation in one or the other, if not both, of these areas is the chief reason almost all new, startup airlines have failed. For Southwest the result of this discipline has been substantial and steady growth.
In recent years a number of number of new airlines styled more or less on the Southwest model have emerged in the U.S., Europe and Asia. These carriers (along with Southwest) have, or will, become such a significant factor in the marketplace that they are now setting the standard for air fares in many markets and are thus a serious challenge for the established airlines. Since this so called “Low Fare” phenomenon is expected to grow rapidly, often at the expense of many of those older carriers, it is now the most significant trend shaping the future of the air transportation landscape.
Cargo : For a passenger airline cargo is a byproduct. All airlines were originally cargo companies as the only economic activity that could support regular air service was airmail contracts obtained from the government. That was then. Now an airline’s schedule is determined by passenger traffic flows, but the airplanes making most of those flights have more room in the belly than is required to carry passenger luggage, and this is available for cargo.
All of the economic characteristics described for passenger service apply to cargo: an intermediate service of a commodity nature with marginal cost pricing. However, as a byproduct cargo pricing can be even more marginal than that for passengers, and this makes it particularly difficult for those airlines that are entirely cargo carriers. That is a key reason why such cargo airlines use mostly old airplanes which are no longer economic for passenger service and are, therefore, cheap enough to be profitable in an all cargo fleet. Some products can, to some extent, escape this pricing trap because they are perishable (flowers are an example), have a time urgency (such as designer clothes), or lend themselves to serving “just in time” inventory management which many companies have adopted. However, the ultimate example of the ability of a cargo airline to charge a premium price for just in time delivery is the now ubiquitous FedEx. Started in 1971 it, along with a number of competitors, has become an indispensable part of business life throughout the world and, as is the case with the last minute business traveler, the price of the service is usually not a relevant consideration in deciding whether to use it. To state the case briefly, it may be impossible to charge premium prices for cargo or packages when they are measured by weight, but such a premium can be obtained when the standard for measurement becomes time.
Management by Engineers with Safety First: In the early days engineers dominated industry senior management. These founders of the industry were aviators, and their main interest was the airplane with the commercial aspects of carrying mail and passengers largely an excuse for being in aviation and a reason to be able to buy more airplanes. Nevertheless, that pioneering group led the industry from the beginning all the way to the jet age. Along the way they developed an acute sense of passenger service as well, but service to them largely involved such things as better seats and food because, under regulation, pricing and marketing (new routes) were in the hands of lawyers who argued cases before the CAB.
The foremost engineering concern was safety because from the earliest days the founders knew that unless air transportation was safe few would use it. Airline safety is somewhat like motherhood and the flag, no one can be against it but most of the things said about it are platitudes at best and political stump posturing at worst. Why does airline safety make such good press (it has always been a good fallback subject for a reporter looking for a story to get him on page one) and why, despite the superb safety record of the airline industry, does the public still have a real fear about safety when they fly? The answer is probably in our genes.
We evolved as a terrestrial animal that only feels secure when it’s feet are on the ground. At one time our early ancestors were arboreal and our closest genetic cousins, the chimps, are still comfortable climbing and sleeping in trees. We climb trees, mostly before the age of twelve, but few of us can claim to have no fear of the heights involved even if we are only a few feet off the ground. On the ground we feel we are in control of our destiny but off it we are not. Flying is the ultimate loss of control for the human primate species. Every fiber of our genetic makeup screams at us that this is wrong, that we cannot survive in this environment and that we must get back to land as quickly as possible.
It is testimony to the reasoning power of our brain that it is able to overcome this genetic message and allow most of us to feel reasonably safe in an airplane. However, for some like John Madden the genes take over and flying is an impossible, or at best a terrifying, experience. Yet many of these same people, as well as a lot of others, have no concerns about driving a car at high speed in heavy freeway traffic, an activity that is acknowledged to be much more dangerous than flying on a commercial airplane. However, that is on land and on land our genes tell us we are in control. This fact of human nature was well understood by the airlines from the beginning so safety has always been a primary, if not the primary, concern of management.
Airline Marketing: To Whom? What is airline marketing? Remember, we are dealing with a near commodity service where brand name is much less significant than it is for other consumer products or services. The starting point is to determine to whom you will market your product and where it will be sold - that is on what routes. United Air Lines did a study showing that 6% of its customers generated 37% of its revenue! United labels these customers the “Road Warriors” and the meaning is clear - people that travel every week, spending almost all of their work time on the road. At the other end of the scale 32% of the passengers produced just 9% of revenue; these are the occasional leisure travelers for whom price is paramount. This breakdown is probably typical for most large U.S. airlines and clearly intensive marketing to the latter group would be very unrewarding. Indeed, the real question might be: why even operate the airplanes whose seats would be filled by them? Of course, the issue is not that simple as most if not all of the flights in a scheduled system must be operated to properly serve the top groups that provide most of the revenue. So the pricing and marketing issues become how to attract more of the favored groups and just enough of the others to make sure each departing flight has the highest possible load factor.
Before getting into that there is a related question, and it has to do with the size of the airplane. The imbalance between the number of passengers and the amount of revenue is a key element in holding down the average seat size because, to expand on the phenomenon described earlier, greater frequency is very valuable to the road warrior as is point to point service that bypasses hubs. Moreover, with a smaller airplane a greater percentage of the seats can be allocated to the favored groups, so it becomes both a tool to attract more passengers of this type and to increase average yield. One of the first tools developed to attract, and hold, the road warrior and other premium travel groups was the now ubiquitous frequent flier program. Launched by American Airlines in 1981 these programs are now so widespread, with mileage awards given for everything from hotels to automobile purchases, that they have lost much of the marketing power of the early years. Still, no airline can afford to be without one, and it remains true that programs at the largest carriers are more valuable than others because more destinations, particularly overseas, can be offered.
Yield Management - Keystone of the Marketing Program: Without doubt the most important marketing and pricing tool in the industry is yield management. This was developed initially in the early 1980s, and at its most elemental level it is not a system for selling seats but rather is a “don’t sell” system. That is, the essential concept of yield management is founded on the fact that usually the earlier a passenger books and pays for a trip the lower the price he/she will be able to obtain. Moreover, it is likely that most of these long lead time buyers will be traveling for personal reasons, such as vacations or family holiday visits, and thus are very interested in getting the lowest price and are willing to meet whatever restrictions may apply to use them. These passengers are part of the 59% that produce less than one quarter of the revenue. The airline wants to serve them but not at the expense of the later booking business traveler who is willing to pay a higher price and doesn’t want to, or can’t, meet the restrictions that apply to lower ones.
The yield management program must limit the number of seats sold to the early birds, this is the “don’t sell” aspect, so that inventory is available closer to the flight’s departure date to serve the premium price buyer. Of course, on the day of departure any seats that are not sold are about to become worthless so in the last hour before the flight the price again drops as those seats are offered to “stand by” passengers willing to take the risk and uncertainty that such seats will be available. On the other hand, if more seats have been sold than there are seats on the airplane, you will hear the familiar announcement by gate agents offering free tickets or a cash bonus to anyone willing to give up their seat. Yield management programs allow overbooking based on past history of the number of passengers that are likely not to show up for a flight, but in these days of record high load factors it is becoming more difficult to rely on that history. Both empty seats and overbooking are expensive for an airline, although overbooking is the only one with a direct cost, and yield management walks a fine line in trying to keep both to a minimum.
It all sounds simple, but consider that each airline has several hundred flights every day, and every one of them has a different profile of the type, and number, of passenger that normally uses them. Then multiply that daily total by up to 365 days, since some people book a year in advance, and the magnitude of a job, which can only be done with massive computer power, becomes apparent. Flights at 5:00PM on Friday have a very different volume and mix of passengers from those at 1:00PM on Tuesday, both are different if the flight is departing from a major hub or a small spoke city, and all of them are different in February than they are in August. (There is a story told by the comic Myron Cohen where the punch line is “everybody got to be somewhere”. Well, every airplane got to be somewhere all day, every day, and some of those somewhere’s produce much more traffic than others.)
The yield managers use elaborate mathematical models to assist in the determination of how many seats on each flight should be allocated to various price “buckets”, and these quantities are continuously updated as seats are sold through travel agents, company reservation systems, and on line. In the end, however, yield management is as much an art as a science, and the manager is often faced with anomalies that cause bookings on a particular flight to depart from the established profile. This requires changing the program for that flight and in making such changes the manager has to use judgment based on experience.
Over the years the cumulative effect of these judgments, and of experience with the underlying math, has refined the yield management system to the point where the airline has become much more adept at predicting traffic flows for all types of passengers. The rewards of this knowledge are that an airline is now better able to match airplane size with market needs and obtain higher load factors on all flights. In 1991 the domestic operations of the Major U.S. airlines had a load factor of 61.3%, but just six years later, in 1997, the domestic load factor was 69.6% while now it is in the 75% to 80% range. By contrast, from the beginning of the jet age until the mid 1980s the annual domestic load factor was almost always between 55% and 60%.
The ability of the industry to achieve load factors once thought to be impossible without incurring severe traffic spill is a direct result of improved yield management. As a result revenue per flight and RASM (revenue per available seat mile) increased and airlines were able to avoid a considerable amount of capital spending for additional aircraft that would have been required had loads remained in the 60% area.
A Global Industry learns to Compete Globally: During the 1980s consolidation in the U.S. involved mergers and this, along with the financial problems that came in the wake of the Gulf War, thinned out the industry leaving three giant air transport systems (American, Delta, and United), three other large systems (Continental, Northwest, and USAirways) and three smaller ones (Alaska, American West, and TWA) along with, of course, the ever expanding Southwest. In the breakup of Pan Am and Eastern in the early 1990s American acquired the Latin America operation of the latter, making them the largest U.S. carrier in the region. Delta acquired the European routes of Pan Am while United obtained most of the Pan Am Latin America division. Well before this, in 1986, United had purchased the Pan Am Pacific operation.
All of the economic forces and characteristics that pertain to in the domestic air travel market apply to these international routes as well, but it quickly became apparent that mergers were not a feasible way to gain a stronger international market position. For one thing U.S. law prohibits a foreign airline from owning a controlling interest in a U.S. airline, and other countries are no more eager to see a U.S. airline own one of theirs even should their law permit it. Another method had to evolve, and that was code sharing alliances which have now grown into multiple airline systems covering the entire world.
The Role of Government: Mergers or alliances between or among airlines are subject to the same governmental review and approval that apply to similar proposals in any industry under laws that govern antitrust or anti-competitive behavior. Until a few years ago this oversight for airlines was entirely in the hands of the Department of Transportation (DoT) but now the Department of Justice has the greater voice. In Europe this oversight is new as it came only with the full development of the European Union, and its powers in this area are lodged with the Economic Commission (EC). The merger of Boeing and McDonnell Douglas in 1997 encountered much stiffer resistance at the EC than it did with the U.S. Justice Department.
Although economic regulation over U.S. routes and air fares was abolished in 1978, the government remains a major factor in the industry apart from antitrust, through the FAA and DoT. All airlines must be certified as “fit”, meaning that the officers must have the experience to operate an airline and company operating systems must be adequate to maintain and operate the aircraft safely. All pilots, commercial and other, are licensed by the government, have to pass regular physical exams, and must retire from commercial flying at age 60. Maintenance personnel are also licensed, as are the maintenance facilities and every airplane part that is replaced during maintenance work. Every aircraft and its parts must have a complete paper trail that government inspectors examine more or less regularly, and most of the fines imposed on airlines are for shortcomings in the maintenance of this documentation.
Then there is the airport and airways air traffic control system - the interstate highway network of the air. Air traffic controllers are government employees and that is why, when they went on strike in 1981, President Reagan terminated two-thirds of the work force for violating the prohibition against strikes by government employees. Airlines file flight plans before departure and can modify them only upon approval of the traffic controller. There is a new concept called “free flight” that would allow aircraft the discretion to use more direct routes without staying in the rigid corridors now prescribed but in-route traffic control would still be maintained.
The most intense traffic control work comes in the terminal, or airport, area and that is where most weather or other delays occur. Delays are most frequent at major hub and large metropolitan airports and several of these, such as LaGuardia and Kennedy in New York, O’Hare in Chicago and National in Washington, have become so crowded that “slot” controls have been imposed. These controls place a limit on the number of landings and takeoffs (each one being a slot) that are permitted within a given time period and that leads to a shortage of slots relative to demand. This makes all slots at controlled airports very valuable to the airline that has them, but whether having them means owning them is a controversial issue. Some such slots have been sold, and those sales have been allowed to stand, but in a few cases the DoT has required airlines to give up such slots without compensation to make room for new airlines that otherwise could not serve the city in question in the prime traffic hours of the day.
Probably the most important government involvement, at least so far as the passenger is concerned, is the area of airline safety. The investigation of accidents, fatal or otherwise, is in the hands of the independent National Transportation Safety Board (NTSB). If they determine that some changes in airplane design or systems are needed to prevent a repeat accident their conclusions are not binding, but must be implemented by the FAA in the form of an Airworthness Directive (AD). There are several levels of urgency in these ADs from some that can be accomplished at the next regular C or D check to those that must be done immediately, with all airplanes of the type involved grounded until the work is completed. As might be expected, the NTSB and FAA are not always on the same page over these issues with the former being much more conservative than the latter. The FAA considers the economic effect of any recommendations on the airlines and/or passengers in addition to the pure safety factor. An example of one of the more prominent of these differences is that of requiring child seats as is the case in automobiles. No one questions the greater security provided by these seats, but the economic dilemma becomes clear when you realize that this means parents must buy a seat for the infant who now flies free and sits on their lap unless the adjacent seat happens to be vacant. Safety is often not an absolute black or white thing.
Then there is airplane noise. Once upon a time airports were out in the country, but urban development, and the economic power of the airport itself, caused most of them to become surrounded by homes and businesses. People don’t like noise, particularly near their homes, and people vote. Airplanes make lots of noise, and they don’t vote. The result is predictable. Political pressure led to legislation requiring airlines worldwide to reduce the noise level of their aircraft in the 1970s and again in the 1980s. This latest standard, which was met in the U.S. at the end of 1999, is called Stage III and a similar noise reduction was achieved in most of the rest of the world by the end of 2002. The effect of these regulations was to require airlines to modify existing aircraft engines with hushkits, or dispose of those aircraft and buy new equipment. Moreover, no one believes that Stage III is the end of it. Standards for a proposed Stage IV already exist and some airports in the U.S. and Europe require airplanes operating there to approach, if not reach, that Stage IV level. All these noise levels are denominated in decibels and are measured three ways: takeoff noise a certain distance from the end of the runway, landing noise at a certain distance from the beginning of the runway, and sideline noise measured a certain distance to the right and left of the runway. Each airplane type has a decibel level established for each measurement that it must be meet to conform with the requirements.
Finally, there is a regular stream of complaints in Congress, and from some consumer groups, questioning whether government shouldn’t consider some economic re-regulation of the airlines. Usually this arises because some city feels shortchanged in its air service, an airline feels it is being unfairly squeezed by one of the giants, or a consumer group feels that air fares are too high in certain markets. It isn’t that any of these groups are necessarily wrong, it’s just that no market is perfect much as we may wish it so. A vast majority of interest groups, and all of the airlines, believe that any really necessary changes can be accomplished within the current system rather than turning back the clock to a world that clearly didn’t serve the best interests of either the airlines or the traveling public. Economic re-regulation is not a realistic risk at this time, but all parties in the equation must be on constant guard to be sure it doesn’t become one.