What happened to the airline industry?

The U.S. airline industry went through tremendous turmoil in the beginning of this decade. There were four major bankruptcies and two major mergers, with all legacy carriers – American, United, Delta, US Airways, Continental, and Northwest – reporting a large reduction in profits.

In "Tracing the Woes: an Empirical Analysis of the Airline Industry," Steven Berry and Panle Jia present a structural model of the industry and estimate the impact of changes in demand and supply on its profitability. They find that in 2006 as compared with the late 1990s:

Air-travel demand was 8 per cent more price-sensitive.

Passengers displayed a strong preference for direct flights.

Changes in airlines' marginal costs significantly favoured direct flights.

They conclude that along with the expansion of low cost carriers, these factors explain more than 80 per cent of the decrease in legacy carriers' variable profits.

Other findings:

Changes in passenger demand accounted for almost half of the 80 per cent decline in profits.

By 2006, delays and full flights had made passengers so averse to connecting flights that adding a layover to a route could reduce the number of passengers on it by almost four-fifths.

As a result, the average fare for connecting flights dropped by an estimated 12 per cent, while the average fare for direct flights fell by only 4 per cent.

During this period, the average airline fare decreased from $493 to $451, or 8.5 per cent, in 2006 dollars.

The low cost carriers, airlines providing direct flights to a restricted number of cities, increased their share of the U.S. domestic market from 22.6 per cent in 1999 to 32.9 per cent in 2006. The legacy carriers responded by shifting capacity to the more lucrative international markets and by using smaller regional jets to provide direct flights that better matched aircraft and market size.

Source: Linda Gorman, What Happened to the Airline Industry? NBER Digest, March 2009; based upon: Steven Berry and Panle Jia, Tracing the Woes: An Empirical analysis of the Airline Industry, National Bureau of Economic Research, Working Paper No. 14503, November 2008.

For text: http://www.nber.com/digest/mar09/w14503.html

For working paper: http://papers.nber.org/papers/w14503

For more on Economic Issues: http://www.ncpa.org/sub/dpd/index.php?Article_Category=17

FMF Policy Bulletin/ 31 March 2009