155-Fewer Customers? Cut Capacity

For a year now the economy has weighed down passenger airline traffic. The industry expects a 4% reduction in passenger volume for 2009’s Thanksgiving season compared to the previous year. And, as demand has fallen, so have prices. Ticket prices this year are down 13% compared to 2008, so the industry is getting hit twice: by a fall-off in passenger seat miles flown, and by falling prices per seat mile. (See the Symptom & Implication “Demand in the industry is falling” on StrategyStreet.com.)

The airline industry thought it had an answer to this developing problem: cutting capacity. The industry has reduced capacity by 6.9% this year in the expectation that the industry could improve its efficiency and raise prices. (See “Audio Tip #116: The Withdrawal of Capacity to Raise Prices” on StrategyStreet.com.)

So, why haven’t prices risen? There are two possible answers. The first is that the industry has panicked and is offering lower prices to keep demand from falling any further than it already has. This answer is certainly in keeping with the industry’s previous practices. But there is a more subtle and more problematic answer as well, and that is that the smaller industry carriers are adding capacity faster than the industry leaders are reducing it.

Over the years we have witnessed many cases where industry leaders would reduce their capacity in order to constrain supply and force industry prices to rise. Time and again industry followers have stymied these initiatives. These followers insist on adding capacity, even as the industry leaders withdraw it. The result is the same, or more capacity, and continued low or falling prices.

To some extent, this addition of capacity by follower competitors is predictable (see “Audio Tip #106: How do we Predict Competitor Responses to our Price Moves?” on StrategyStreet.com). These smaller competitors already added capacity in the face of low industry pricing. They have even more incentive to add capacity as industry prices rise.

Posted 11/30/09

Update:

An industry leader is unlikely to be successful in raising prices by reducing its capacity unless it is able, at the same time, to discourage other competitors from adding capacity.

The years 2008 to 2010 were very difficult for the domestic airline industry. The airlines were unprofitable for much of that time. The industry reduced capacity in 2009 but added it back by 2010 as demand grew again. From October 2008 until October 2009 domestic airline industry capacity, measured in available seat miles fell about 3% from 56.5 billion to 54.5 billion. Despite the majors’ reduction in capacity, the smaller and discount airlines added some capacity as the majors reduced it.  Capacity utilization, measured in revenue passenger miles, fell very slightly from 44.9 billion to 44.8 billion. By October 2010, industry capacity had increased by about 4% to 56.7 billion while revenue passenger miles increased 5 ½% to 47.3 billion. 2008 saw domestic majors, nationals and large regionals lose over $18 billion. These companies reduced their losses to $2.3 billion in 2009 and returned to profitability of $1.2 billion by 2010. This period saw discount carriers gain share of the market.

The price the industry charged, whose purpose in a hostile market is to discourage competitive expansion, failed in its purpose and capacity continued to increase. Prices remained under pressure despite capacity cutbacks by legacy carriers. See HERE for more perspective.

8/22

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