FAIR USE NOTICE. This document contains copyrighted material whose use has not been specifically authorized by the copyright owner. The Managerial Economics course is making this material available as part of our mission to promote critical thinking about economic issues. We believe that this constitutes a `fair use' of the copyrighted material as provided for in section 107 of the US Copyright Law. If you wish to use this copyrighted material for purposes of your own that go beyond `fair use', you must obtain permission from the copyright owner.

The Wall Street Journal Interactive Edition November 3, 1997

Airlines Rely on Technology To Manipulate Fare Structure

By SCOTT MCCARTNEY Staff Reporter of THE WALL STREET JOURNAL

The gap in the air has never been wider.

While airlines continue to woo leisure travelers with sales, they are squeezing business travelers like never before. Discounts on unrestricted fares have become as rare as in-flight dinners, and with business fares already up by 20% this year, carriers pushed through an additional 5% across-the-board increase in September. In contrast, prices for leisure tickets have actually fallen slightly, according to American Express Travel Services. "They've got you and they know it," grumbles construction executive Tony Konosky, who recently wasted a week trying to find a ticket from Houston to Bombay, India, for less than $2,500. "It's like there's a target on your chest."

Mr. Konosky isn't far off, given the advanced technology that carriers now have at their disposal to set and manipulate fares. Computers allow airlines to constantly tell each other about fare changes, tamping down the chances that any one will gain even a momentary price advantage. And an obscure mathematical science known as "yield management" empowers airlines to project almost precisely how many last-minute business travelers will show up willing to pay whatever it takes to get on a given flight.

Cheap Seats

Such tactical tools have transformed airline economics during the past year. Fare sales once were few and fleeting when traffic was strong and fares were high, as has been the case this year. But with a firmer handle on the demand for high-fare business tickets, carriers have run almost continuous leisure sales and significantly expanded the supply of cheap, advance-fare seats.

For business travelers, that has meant packed planes as well as high fares. Load factors -- the percentage of seats filled -- have run at record levels, more than 70%, and many popular flights are completely filled all the time. "Ten years ago I would have said to you we probably couldn't get load factors as high as they've been in 1997," says Robert Crandall, chairman and chief executive of American Airlines and its parent AMR Corp. This fall, American will begin phasing in a new, even more powerful yield-management system that is expected to boost its annual revenue by as much as $200 million. With surprisingly high traffic and fares in September, airlines are posting record third-quarter earnings. Unit revenues are at all-time highs, and 1997 will mark the third-consecutive year of record profits for the airline industry, a milestone reached only twice before in its regulated days. What's more, an expected record 1998 will mark the first time in aviation history of four-consecutive record years of profits.

Fewer Attacks

Airlines also have benefited from a strong economy, limited capacity increases and muted competition, particularly among low-fare start-ups. But many executives say airlines have simply learned to more effectively price their product, instead of attacking each other to gain market share.

Major carriers have grown reluctant to undercut each others' fares, knowing retaliation can be expensive. Besides, airlines have found that business travelers are more swayed by convenient schedules and frequent-flier programs than by price. Because of such factors, and heavy demand, carriers have readily endorsed each others' business-fare increases rather than trying to undermine them. "We've evolved from one of these cataclysmic, World War III industries to some equilibrium that's good for shareholders and employees and communities," says Gordon Bethune, Continental Airlines' chairman and chief executive.

Much of that pricing mastery has come from recent advances in yield management, which began as simple overbooking of flights. Before deregulation in 1978, all carriers offered the same government-set fares; discounts were rare beyond night or weekend flights. People Express introduced low fares nationwide in the early 1980s; old-line carriers, with higher costs, couldn't match without losing millions.

Bell's Formula

In response, Mr. Crandall developed the first true yield-management system. It allowed American to offer a limited number of seats on a plane at a People Express price, while still selling high-fare tickets to business travelers. Those early systems, however, lacked the computing muscle to track booking trends or to gauge the systemwide impact of seat-filling discounts offered on an individual route. Inevitably, carriers either sold too many cheap seats and left behind big-ticket customers, or held back too many business seats and flew sparsely filled airplanes.

But in 1988, Bell Laboratories patented a mathematical formula that could perform rapid calculations on fare problems with thousands of variables. That led to further advances in software, enabling yield-management gurus to use simple business computers to perform complicated fare-crunching and seat-allocating that even a Cray supercomputer couldn't handle just a few years before. By meshing massive historical databases on ridership with up-to-the-minute bookings, carriers could predict with almost pinpoint accuracy how many business customers would want seats on a particular flight. As a result, "high fares get higher and low fares get lower," says Robert Cross, whose Aeronomics Inc. sells yield-management systems to airlines.

Indeed, the resulting price spread can be staggering. Take Flight 2015, American's popular 5:30 p.m. departure from Chicago to Phoenix. Its 125 coach seats are divided among seven fare "buckets," with round-trip tickets ranging from $238 to $1,404. In the weeks before each Chicago-Phoenix flight, American's yield-management computers constantly adjust the number of seats available in each bucket, taking into account tickets sold, historical ridership patterns and connecting passengers likely to use the route as one leg of a longer trip.

If advance bookings are slim, American adds seats to low-fare buckets. Ifbusiness customers buy unrestricted fares earlier than expected, the yield-management computer takes seats out of the discount buckets and preserves them for last-minute bookings that the database predicts will still show up.

With 69 of 125 coach seats already sold four weeks before one recent departure of Flight 2015, American's computer began to limit the number of seats in lower-priced buckets. A week later, it totally shut off sales for the bottom three buckets, priced $300 or less. To a Chicago customer looking for a cheap seat, the flight was "sold out," although advance-purchase fares were still available to New York-to-Phoenix customers connecting in Chicago, because the overall fare structure for that one-stop trip was higher and because American had lots of seats available on the connecting New York-Chicago flights.

One day before departure, with 130 passengers booked for the 125-seat flight, American still offered five seats at full fare because its computer database indicated 10 passengers were likely not to show up or take other flights. Flight 2015 departed full and no one was bumped.

Scalping Complaint

While carriers boast that yield management allows them to extend leisure discounts to more travelers and reserve seats for their best customers, critics
contend that it amounts to high-tech scalping. "Yield management is good for airlines, but it certainly isn't good for travelers," says Nancy Barrows, chief
operating officer of Woodside Travel Trust, a major corporate-travel agency. "It's pushed business fares artificially high."

The effects are most striking in airline hub cities, where one carrier can dictate pricing. In Denver, where UAL Corp.'s United Airlines is king, business fares are up 24% this year -- and leisure fares are down 51%. In Dallas, where American dominates, business fares are up 26%, while leisure fares are down 20%, according to American Express.

Philadelphia-to-Houston has one of the highest average fares of any U.S. route of under 1,500 miles. Business fares there are up 18% this year, according to Topaz Enterprises Inc., a Portland, Ore., airfare-auditing firm, even though US Airways Group has added two nonstop flights to compete with rival Continental, which dominates with 66% of the market.

Tanker-ship manager Kevin Coyne's company recently paid Continental $1,484 for a one-day round trip to Houston. In contrast, Philadelphia-based chemical
executive Dan Smith drove 90 minutes and made the same trip from Baltimore, where Continental competes with low-fare Southwest Airlines. "It makes no sense to me," says Mr. Smith, who paid Continental a mere $280.

Competitive pressures aren't likely to drive business fares down, thanks to Airline Tariff Publishing Co. Located in a black-glass building at Washington,
D.C.'s Dulles Airport, ATPCO is owned by a group of 24 international airlines, including the seven largest U.S. carriers.

World-Wide Posting

Every carrier sends its fare changes to ATPCO, whose centralized computer system sends a download seven times a day to computer-reservation systems used by travel agents -- and to the airlines themselves. The system was started by the industry's lobbying group, the Air Transport Association, before deregulation. Airlines contend it still is necessary to make sure fares are posted world-wide simultaneously and correctly.

ATPCO says its two mainframe computers create a perfect marketplace, akin to a gas-station owner being able to watch prices his competitor posts across the street. "The reason for our being is to allow carriers to as easily as possible manage their fares and get them into the marketplace," says Michael Ferrier, ATPCO's president.

Indeed, ATPCO insures that no pricing change goes undetected. Some airlines' internal computers suggest responses to ATPCO-announced fare changes, based on the competitors' market share and other factors. A few carriers even allow their computers to automatically change fares, though most require a human to sign off.

At Houston-based Continental, pricing experts meet three times daily to review ATPCO-reported fare changes, especially those involving Continental's major
business routes. Within minutes, a Continental response can be on its way back to ATPCO with a simple keystroke or one-page fax. "We tend to always match," fare changes, says James Compton, Continental's head of pricing.

Consumer advocates argue that ATPCO lessens pressure to lower prices because it removes competitive fears. In a 1992 crackdown, the Justice Department did bar airlines from using ATPCO to post, or "signal," proposed fare changes and then withdraw them if competitors didn't go along. Now, a fare change must be available as soon as it goes into the central computer.

Weekend Boosts

In practice, however, carriers often initiate fare boosts late in the week, then watch to see if competitors will match over the weekend, when travel agencies are closed and few business tickets are sold. If that doesn't happen, increases typically are pulled Sunday night. "That is signaling," complains Alexander Anolik, a travel lawyer who represents airlines and travel agencies. "It's better than it used to be for the consumer, but it's still signaling."

During the first weekend in September, several airlines raised business fares 5%. That Sunday night, however, United instructed ATPCO to roll back the increase in markets where it competes with Southwest Airlines, which hadn't matched the increase. When ATPCO mistakenly rolled back the increase in all United markets, major carriers like American immediately followed suit. Early Monday morning, United reinstituted the 5% increase in its non-Southwest markets. Within 24 hours, other major carriers had done the same.

"It certainly looks like they have a way of getting everybody to do the same thing," says Pitts Carr, an Atlanta attorney who sued carriers for anticompetitive pricing practices in 1992. (He negotiated a settlement with the airlines.)

Justice Department officials say the system is legal as long as fares are immediately for sale, noting that, even over a weekend, a carrier takes a risk leading a fare increase because competitors will be priced lower.

Thin Margins

Airlines argue that if they were gouging customers and colluding on prices, they would be earning more money. Despite the hefty earnings of the past three years, which are expected to total $13.9 billion by the end of 1997, airline profit margins are still relatively skinny, and credit ratings for some major carriers remain below investment-grade. In the third quarter, American posted its highest pretax profit margin ever in its history, but it was only 10.1%. "We're just now approaching the average returns for most industries in this country," says Gerard Arpey, American's chief financial officer.

Still, in an industry with a cutthroat reputation, some carriers seem downright shy about head-to-head competition. Trans World Airlines, for instance, has taken to offering discount coupons through Kroger Co. grocery stores. And some travel agents have found that airlines will give them special deals, but only over the telephone and only if they think competitors won't find out. "As long as it doesn't provoke a response, they'll do it to keep my business," says Seattle travel agent Steve Danichek, who says he recently persuaded US Airways to knock $1,400 each off the price of some Seattle-to-Baltimore tickets.

Such machinations are tough to stomach for salesman Gerald Davis. To save almost $1,000 over the cost of a direct flight from Dallas, he recently went through Washington to get to New York. "They've made it a game that gets very irritating," he says. "I feel violated every time I get on a plane."