Southwest Airlines Capturing surplus Han Yi Kim

Southwest Airlines Capturing surplus Han Yi Kim

Southwest Airlines Founded in 1971 by Rollin King and Herb Kelleher The third-largest airline in the world The United States’ most successful low-fare, high frequency, point-to-point carrier. Known as a “discount airline” since 1973 - offers low fares - no-frills service - basis for Southwest's popularity and rapid growth

Corporate Culture Tickets must be bought from the airline itself, the phone or online Extra Rapid Rewards - frequent flier program - credits for online booking users only Customers are assigned to a boarding group depending on check-in time - find their own seats on the plane Colorful boarding announcements and crews that burst out in song instead of no video entertainment Meal service is less than on historically full service airlines

Basis for profitability Fuel hedging – Purchased fuel options for years in advance to smooth out fluctuations in fuel costs – substantially increased its hedging in 2001 in response to projections of increased crude oil prices – Advantaged after Sep. 11, 2001 attack, the oil shock from Iraq War, and Hurricane Katrina Operated only one model of aircraft – Boeing 737, medium range-narrow body commercial passenger jet aircraft – easy to replace parts and ground support equipment

The Southwest Effect A trend that indicated the success and profitability of Southwest’s business model – less expensive than driving between two points in the early 1970s, during the first major energy cost crisis in the U.S. Basis of lean operations and high aircraft utilization When a low fare carrier enters a market, profit grows dramatically

Fight against high speed rail In 1991 Texas TGV Corporation planed to connect the “Texas Triangle” (Houston – Dallas – San Antonio) with a privately financed high speed train system at a lower fare rate – The same model Southwest Airlines used 20 years earlier to break in to the Texas market The original estimated cost was 5.6 billion, but the task of securing the necessary private funds proved extremely difficult Southwest Airlines created legal barriers to prohibit the consortium from moving forward with the help of lobbyists. In 1994, the Texas TGV Corporation has failed and withdrew high speed rail development – lost 40 million to be invested

Conditions for price discrimination A firm must have some market power to price discriminate – The demand curve the firm faces must be downward sloping Southwest knows that it can attract more customers at lower fare price The firm must have some information about the different amounts people will pay for its product. – Southwest must know how reservation prices or elasticities of demand differ across consumers A firm must be able to prevent resale, or arbitrage. – Customers need to present an identity card before boarding

Third-Degree Price Discrimination The firm identifies different consumer groups, in the market, each with a different demand curve. – Southwest Airlines recognizes that any given flights has different types of travelers business travelers vs. vacation travelers To maximize profit, the firm sets a price for each group by equating marginal revenue and marginal cost. – Equivalently, by using the inverse elasticity pricing rule (IEPR)

The Inverse Elasticity Pricing Rule (IEPR) The rule stating that the difference between the profit-maximization price and marginal cost, expressed as a percentage of price, is equal to minus the inverse of the price elasticity of demand.

Price elasticity of demand The percentage change in quantity demanded (Q) that occurs in response to a percentage change in price (P) Estimates of the price Elasticity of demand for Airline Category Estimated EQ,P Airline travel, leisure - 1.52 Airline travel, business - 1.15 *Source: Tea Hoon Oum and Jong-Say Yong, “Concepts of Price Elasticities of Transport Demand and Recent Empirical Estimates,” Jounal of Transport Economics and Policy (May 1992):139-154

Examples Using the inverse elasticity pricing rule to determine the ratio of between tickets for business (PB) and vacation travelers (PV) – The IEPR tells that (PB – MC)/PB -(1/e) Substitute the estimated price elasticity of demand for business travelers, e -1.15 solve for MC: MC 0.13 PB – The IEPR also tells that (PV– MC)/ PV -(1/e) Substitute the estimated price elasticity of demand for vacation travelers, e -1.52 solve for MC: MC 0.342 PV Equate these two expressions for MC: PB /PV 0.342/0.130 2.63 Thus, Southwest Airlines will maximize profit by charging 2.63 times as much for a business travel ticket as it charges for vacation travel ticket – (the exact prices of the tickets will depend on the marginal cost)

Advertising campaigns “Just Plane Smart” “The Somebody Else Up There Who Loves You” “THE Low Fare Airline” “Symbol of Freedom” “Wanna get away?” – “[ding] You are now free to move about the country”

Livery Some southwest planes feature special themes, rather than the normal livery – – – – – – Shamu One/Two/Three California One Arizona One Lone Star One Triple Crown One Sliver One

2005 Financial Statistics: Net income: 548 million Total passengers carried: 88.4 million Total RPMs: 60.2 billion Passenger load factor: 70.7 percent Total operating revenue: 7.6 billion

Southwest Airlines’ Top 10 Airports (as of February 22, 2006) Daily Cities Departur es Las Vegas 216 Phoenix Number of Gates Nonstop Cities Served Service Established 21 51 1982 200 24 41 1982 Chicago Midway 200 29 43 1985 Baltimore/Washington 165 19 34 1993 Oakland 138 11 20 1989 Houston Hobby 134 17 28 1971 Dallas (Love Field) 120 14 14 1971 Los Angeles (LAX) 118 12 19 1982 San Diego 92 10 16 1982 Orlando 90 9 28 1996

Incidents and Accidents On March 5, 2000, Southwest Airlines Flight 1455 overran a runway at the Burbank airport in California – Leaving 43 injured but no fatalities – Resulted in the dismissal of the pilots On December 8, 2005, Southwest Airlines Flight 1248 skidded off a runway at Midway Airport in Chicago, Illinois, in heavy snow conditions – A young boy was killed in a car struck by the plane after it had skidded into a street – Several minor injuries reported from passengers onboard the aircraft and on the ground

Conclusion Southwest Airlines uses third-degree price discrimination to fill the plane with travelers in the most profitable way Depending on the price of elasticity of demand for tickets – Charge a higher price for business travelers who have relatively inelastic demands – Charge a lower price for vacation travelers who have relatively elastic demands