With major airline carriers such as Delta going into bankruptcy due to heavy competition from low cost carriers entering, like Jet Blue, understanding how the existing airlines respond to the threat of a new competition is important. Austan Goolsbee and Chad Syverson investigate how airlines respond to the threat of a rival (Southwest), not the actual entry. Using airline ticket data from routes Southwest ever flies any flights from, Goolsbee and Syverson find that established airlines drop prices on routes where Southwest is entering both endpoint airports before Southwest actually flies these routes. The authors infer that established airlines are trying to create brand loyalty in consumers before the impact of a new airline is felt.
The data comes from the U.S. Department of Transportation’s DB1A files that takes a 10% sample of all domestic tickets used in each quarter. The authors look particularly at any routes Southwest eventually flies during the period of 1993 to 2002. The data also includes any tickets from those routes flown by American, Continental, Delta, Northwest, TWA, United and US Airways. With almost 19,000 route-carrier quarter observations, the authors look at flight prices and other flight attributes of the selected routes before Southwest flies that direct flight, but has begun operating on both endpoints of the route.
Looking as far as three years before and after Southwest starting flying the route, the authors find that the airlines present before Southwest significantly drop flight prices on the threatened route. The prices begin dropping by 11% three to four quarters before Southwest enters the route. Prices fall 15% by one to two quarters before and by the time Southwest first flies the route, the prices offered by other carries for the same flight have fallen 26% total. Although the prices fall some after the entry, ½ to ¾ of the fare decrease occurred before entry.
Goolsbee and Syverson conjecture that the established airlines use this price drop as an entry deterrence strategy against Southwest. Although the authors mull over three ideas for what the strategy could be, they settle on a loyalty goal, where the airlines attempt to dampen the impact of the new competition by increasing passengers and their loyalty before the competition begins. Investigating the number of passengers, the authors uncover a substantial increase in passengers. The prices are not dropping due to lack of demand, but as part of a strategy. The airlines may be increasing the number of flights some, but 50-60% of the increase traffic comes from more people per plane.
To further support their theory on loyalty strategy, Goolsbee and Syverson consider frequent flier miles. Theorizing that the airlines are inducing people to fly more with lower prices, gain more frequent flier miles and thus have loyalty later, the authors expect to find more price cuts in higher fare flights (where frequent flyers(like business travelers) are more prevalent) and flights that have a higher percentage of business travelers. Although prices drop on all flights, the evidence shows that prices drop almost twice as much on the planes with more frequent fliers. This finding supports the theory that airlines are hoping that flyers with more frequent flier miles will return with their business.
Indirectly strengthening their argument on airline strategy, the authors explore and reject other reasons for possible decrease in price: a price cut on all flights or on flights in the surrounding areas. Relative to overall fare movement, the price cuts on these routes are not representative of and move independently from other flights. Considering the pricing behavior of the established airlines in nearby airports that could compete(such as Boston vs. Providence(Southwest) or Miami vs. Ft. Lauderdale(SW)), the authors find no evidence that prices in nearby airports falls when Southwest threatens a route. In fact, evidence shows that prices increase by 7.5%. In addition, the number of passengers in nearby airports falls. Goolsbee and Syverson conjecture that some passengers will switch airports to receive the lower price, but those that remain are not price sensitive and thus will be willing to pay the increased price.
With the increased usage of online airline booking and difficulty of using frequent flier miles, I wonder if this strategy used by the incumbents works. As more and more people use online resources such as Orbtiz or Travelocity instead of the traditional travel agent, the airlines have become more competitive as costumers can more easily find the lowest price. As the past few years have shown us with the bankruptcy of major incumbents like Delta, the most important issue with costumers is price. As price competition increases, airlines are making it harder for frequent flier miles to be used, with restrictions on flights, how many seats per flight are for frequent fliers, etc. The combination of price importance and the difficulty using frequent flier miles decreases the incentives of frequent flier miles. I think this strategy of creating loyalty to an airline is slowly crumbling.