What Happened to the Airline Industry?

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.

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 (NBER Working Paper No. 14503), 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 percent more price-sensitive; passengers displayed a strong preference for direct flights; and changes in airlines' marginal costs significantly favored direct flights. They conclude that along with the expansion of low cost carriers, these factors explain more than 80 percent of the decrease in legacy carriers' variable profits.

Changes in passenger demand accounted for almost half of the 80 percent 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 percent, while the average fare for direct flights fell by only 4 percent. During this period, the average airline fare decreased from $493 to $451, or 8.5 percent, 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 percent in 1999 to 32.9 percent 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.

The authors estimate that by 2006 the legacy airlines were transporting 4 percent more passengers with 9 percent less revenue and 19 percent less in profit than in 1996. And, despite the bankruptcies and mergers in the early 2000s and the sharp downturn that followed 9/11, the average revenue-passenger-miles divided by the available-seat-miles of a flight, known as the load factor, rose from 71.2 percent to 79.7 percent from 1999 to 2006. It reached a record high of 80.5 percent in 2007.

Channeling passengers through a hub airport allows carriers to increase the load factor. But it also requires extra fuel, both for the two extra landings and the longer distances passengers have to travel. The authors estimate that in 1999, the marginal cost of servicing a connecting passenger on a long route was $18, or about 12 percent, lower than that of servicing a direct passenger. That cost advantage disappeared in 2006, probably because fuel was more expensive. In 2006, servicing a connecting passenger cost $12 more and reported inflation-adjusted operating costs increased from 11.4 cents per available seat mile to 12.5 cents.

The authors analyze data on fares, itineraries, ticketing, flight delays, and number of passengers transported from the U.S. Department of Transportation. Their database is drawn from a 10 percent random survey of airline tickets from U.S. carriers. The authors focus on the 4,300 markets with airports located in metropolitan areas with at least 850,000 people in 2006. They caution that their model was most accurate at predicting changes in the mean, that they estimated only variable profits because they could not observe fixed costs, and that their study did not include the effects of changes in capacity, network formation, or improvements in technological efficiency.

-- Linda Gorman