Prior to deregulation the Civil Aeronautics Board ‘experimented’ with the idea of price competition. That’s the story of how Southwest Airlines became the largest liquor distributor in Texas through fare segmentation. Faced for the first time with fares lower than their own, they segmented customers: matching $13 fares between Dallas and Houston offered by major competitors, while continuing to sell $26 flights to expense account business travelers who would be able to take home a bottle of booze from the flight.
More significantly, in 1977, American Airlines introduced the Super Saver fare. Initially on New York – California routes, it was expanded across their domestic route network in 1978 and the airline introduced ‘Ultimate Super Saver’ in 1985, discounting up to 70% to compete against new lower cost carriers that launched after deregulation.
The American Airlines insight was that they could beat low cost carriers at their own game through revenue management. They could be a high fare business airline and a low fare airline by offering different prices to different customers. Using restrictions such as advance purchase requirements, change penalties, and Saturday night stay requirements they made cheap fares available to price sensitive travelers and still retained their margins on business customers who booked the most convenient flights at the last minute.
This gave American a competitive advantage because they had no marginal cost to run their low fare airline — since they were already running the airline and they had empty seats. Other carriers quickly copied, of course.
In recent times Spirit Airlines, Frontier, and Allegiant have been among the most successful US airlines with the highest margins. None of them is a ‘new airline’ but their low cost business models were launched in the last 20 years.
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The low cost discount carriers eroded the major legacy carriers’ pricing model. They offered last minute cheap tickets. As a result Delta, American and United faced a conundrum: they had to match fares or lose business, but they’d erode their premium margins selling cheap fares to business travelers in the process.
Basic economy fares became the new advance purchase and Saturday stay requirement, segmenting business travelers from the most price sensitive leisure travelers. Many business travelers aren’t even shown basic economy fares through their corporate booking portals. And companies will generally pay for advance seat assignments, and in United’s case for a passenger to be able to bring a carry on bag on board.
The new tool at the disposal of major carriers in the form of segmentation was a strategy of making their inexpensive product worse, hoping customers would spend more money to avoid it. They made their lowest priced ticket closer in experience to what the ultra low cost carriers were offering.
Prior to that, of course, it made sense to buy a Delta, United, or American ticket rather than a Spirit or Frontier ticket at the same price because you got better value for your money. Basic economy erodes the product advantage over ultra low cost carriers, while restoring the ability to segment customers.
United Airlines President Scott Kirby declares that new low cost carriers cannot succeed because United will match their pricing. He says United couldn’t do that before, so new carriers are at a disadvantage and already no new carriers have been successful over the last 15 years.
Virgin America, founded in 2004, was the last startup airline in the United States that actually became a reality.
The low-cost airline model is predicated on the competition not matching prices, Kirby said, and unlike the situation over the last 30 years, United now has the capabilities with segmentation, including basic economy, to go tit-for-tat with the new entrants.
“It’s a business model they are not in control of,” Kirby said, referring to low-cost carriers.
Speaking about so-called segmentation, a slicing and dicing of an aircraft cabin seating for different prices, United can now compete in both levels, which it couldn’t do for decades until now, said Kirby. He argued that gives both price-conscious consumers and passengers who care about product more choice.
Kirby’s view seems extremely misguided.
- Airlines became successful with their low cost business models exactly in the time period that Kirby says none have succeed. The definitional issue here is that ‘new’ airlines generally came about after their predecessor attempts failed.
Spirit Airlines began as Charter One and for years was a Detroit-based airline — its transition to a low cost carrier started in 2007. The new Frontier began service in 1994 after Continental Airlines shuttered its Denver hub. It wasn’t until 2014 though that they transitioned to the Spirit low cost carrier model. Similarly, AirTran (acquired by Southwest) can be said to have been a success — but it came out of ValuJet so wasn’t really ‘new’.
- Segmentation (Basic Economy) isn’t a new tool. Airlines have been successfully segmenting customers since at least the 1985 introduction of American Airlines Ultimate Super Saver fares. Basic economy is just the latest strategy for gaining back the ability to charge different prices to different customers.
- The latest version of segmentation erodes United’s advantages. United and other airlines were already matching fares of low cost carriers. This did not begin with the introduction of Basic Economy, which hasn’t meant lower fares for customers but rather new restrictions on the existing lowest fares.
Basic economy fares mean giving customers less than before, eroding the product advantage that major airlines had over low cost rivals. It used to make all the sense in the world to choose a legacy airline over Frontier or Spirit at the same price because of the mileage program or advance seat assignments. Reduced mileage-earning, limitations on use of elite benefits, and at best only allowing customers to pay for seat assignments close to departure shrink that difference in product.
- Ultra low cost carriers have their own competitive advantages. One of the best deals in travel is Spirit’s Big Front Seat, a domestic first class seat without perks like boarding or bags. It can be as little as tens of dollars more than a standard coach ticket. Meanwhile Frontier Airlines has aggressively rolled out elite benefits that allow their top flyers to make all tickets refundable, and they’ve aggressively integrated their credit card product into the program so that every dollar spent earns an elite qualifying model.
Meanwhile both Frontier and Spirit have improved their products. Both participate in PreCheck. Spirit has even been installing inflight internet, and delivering a reliable flight operation.
The Super Saver model was a realization that airlines flying routes anyway had excess capacity and could sell those seats to price-sensitive travelers at little to no marginal cost without cannibalizing high yield sales.
The basic economy model is effectively the same thing, though in a world with less excess capacity the ability to match pricing at no cost is limited.
United can certainly declare an intention to match price, but that will begin to hurt their yields. They are the most aggressive major carrier restricting the basic economy product — only they forbid full-sized carry-on bags completely on these fares — so at the same price United not only has to compete with the product of Spirit, Frontier, or new low cost entrants they also have to compete with American, Delta, JetBlue and especially Southwest which are offering more to the customer.
Ultimately a high cost carrier needs to win by attracting premium fare traffic. United realizes this with its introduction of a new business class (despite Kirby’s attempts to erode Polaris) and premium-heavy aircraft configurations. The idea, though, that customers will always choose United over a competitor at the same price — and that United can now win the war on price because of ‘new’ tools they’ve never had before — seems entirely off base.