1. Biography for William Swan Chief Economist, Seabury-Airline Planning Group. Visiting Professor, Cranfield University. Retired Chief Economist for Boeing Commercial Aircraft 1996-2005 Previous to Boeing, worked at American Airlines in Operations Research and Strategic Planning and United Airlines in Research and Development. Areas of work included Yield Management, Fleet Planning, Aircraft Routing, and Crew Scheduling. Also worked for Hull Trading, a major market maker in stock index options, and on the staff at MIT’s Flight Transportation Lab. Education: Master’s, Engineer’s Degree, and Ph. D. at MIT. Bachelor of Science in Aeronautical Engineering at Princeton. (bill.swan@cyberswans.com)bill.swan@cyberswans.com © Scott Adams

2. Airline Evolution William M Swan Chief Economist Boeing Commercial Airplanes, Marketing; Retired Spring 2007

3. Structure is Destiny Structure of costs across airplane sizes Structure of fares and reservations Structure of route networks and hubs

4. The Airplanes are Amazingly Similar 707 –Prototype 707 in 1954 –Advanced 707-320 Seating 189, charter configuration Speed 600 mph nominal Altitude 36,000 ft Range: Transcontinental Wing 146 ft, length 152 ft, body width 12 ft 737 –3 rd generation family -600, -700, -800, -900 –Largest are -800/-900 Seating 189/215, charter configuration Speed 530 mph actual Altitude 35,000 ft Range: Transcontinental Wing 113ft, length 130 ft/138 ft, body width 12 ft

5. The Significant Changes Jets now come from 70-550 seats in size –100-400 seats if you want to use Boeings – 70-350 seats if you want to use 2 engines Ranges now cross the Pacific –How long will people sit? –The world is round – limits useful range

6. Big Airplanes are Cheaper per Seat Conventional Representation (Confusing)

7. Underlying Linear Relationship Well-Adjusted Presentation (Clear)

8. Big Airplanes Make You Wait (Cost with Frequency Value Included)

9. Concepts to Keep The denser the route, the cheaper the seats Not the Same as bigger airline, wider network –No indication that extensive networks are cheap Not the Same as longer flight distance –However, longer the distances are cheaper per Km Economies of Airplane Size have Persisted since jet airplanes: –MIT study in 1971 –AA/UA fleet planning 1986 –Boeing Study 2001

10. Ticket Prices Yield has declined 2-3%/year since 1971 –Representing a 1% annual decline in fares –Further decline due to change in ticket mix –Yield is “cents per kilometer” Two kinds of fares –Advance purchase, discount fares –Regular, unrestricted, full fares Low Cost Carrier (LCC) pricing –Erosion of full fare levels –Less than meets the eye

11. Prices, Fares, and Yields

12. Fare Regulation in US Why Regulate Fares? –Economies of Density Average cost per seat > Marginal cost per seat Natural monopoly – at least when network is thin –Mentality of only one (“full”) price No discount fares, airlines for premium travel only How fares were regulated (US case) –Yield (cents per km) fixed Independent of range (but longer distances are cheaper per km) Independent of market density (but denser markets are cheaper per seat) –Set to cover average costs including return on investment Consequences of regulating fares this way –Long haul was immensely profitable –Large markets were immensely profitable –Low value trips were not offered low value tickets (few discounts) –Load factor 50-55% range (today 70%+)

13. Deregulation US deregulation 1978 –End of restrictions on starting new nonstops –End of fare regulations 1977 Regulated snapshot: –Only ATL and ORD were hubs –JFK gateway for most Europe flights –Regional carriers feeding majors at hub cities –Interline (between airlines) connections –Limited 30% discount advance purchase fares –Fares proportional to distance, no “boarding” cost –Fares independent of market size, no “small” cost

14. First Response to Deregulation Airlines added new nonstop routes –Bleeding traffic off old connecting legs –Reducing head-to-head competition –Making networks thinner but with more links –Filling out hubs Prices went up in small, short markets –It took a while unlearn “long, big” paradigm –Smaller communities gained services –Hubs began to develop –Regional carriers merged with majors They were always loosing money before, anyway

15. Evolution of Routes & Networks Origin-to-Destination (O&D) flows small –Few pairs big enough for local only service Need to combine flows to build size –Get to at least 100 seats per departure –Best layout turns out to be coordinated hubs Three Stages of Hubs 1.Natural gateways, minimum spanning trees 2.Competitive hubs, banked connections 3.Continuous hubbing

17. Half of Travel is in Connecting Markets

19. Half the Trips are Connecting

20. Connecting Share of Loads Averages about 50%

21. Network Evolution: Airlines Hate To Compete Avoid head-to-head competition –Preferred airline wins big First choice on all high-fare traffic –Higher yields First choice for whatever low-fare travel is going –Full on off-peak days means higher load factor –Unstable head-to-head competition –Natural Monopoly New Routes = “get your own monopoly”

22. Networks Develop from Skeletal to Connected High growth does not persist at initial gateway hubs  Early developments build loads to use larger airplanes: Larger airplanes at this state means middle-sized Result is a thin network – few links A focus on a few major hubs or gateways In Operations Research terms, a “minimum spanning tree”  Later developments bypass initial hubs: Bypass saves the costs of connections Bypass establishes secondary hubs New competing carriers bypass hubs dominated by incumbents Large markets peak early, then fade in importance  Third stage may be non-hubbed low-cost carriers : The largest flows can sustain service without connecting feed High frequencies create good connections without hub plan

23. Skeletal Networks Develop Links to Secondary Hubs Early Skeletal Network Later Development bypasses Early Hubs

24. ORD ATL DFW DEN JFK LAX MIA SFO Regional and Gateway Hubs in US

25. Hub Concepts Hub city should be a major regional center –Connect-only hubs have not succeeded Early Gateway Hubs get Bypassed –Traffic builds early, stays flat in later years Later hubs duplicate and compete with early hubs –Many of the same cities served –Which medium cities become hubs is arbitrary –Often better-run airport or airline determines success –Also the hub that starts first stays ahead

26. Largest Routes are Not Growing as bypass flying diverts traffic

27. ORD ATL DFW DEN JFK LAX MIA SFO Many Secondary Hubs in US STL SLC CVG PHX IAH MSP DTW PIT EWR SEA

28. Competition is Rising in Regional Flying

29. Competition is Rising in Long-Haul

30. Examples of the 3 Kinds of Hubs International hubs driven by long-haul –Gateway cities –Many European hubs: CDG, LHR, AMS, FRA –Some evolving interior hubs, such as Chicago –Typically 2 banks of connections per day – one in, one out Regional hubs connecting smaller cities –Most US hubs, with at least 3 banks per day (each way) –Some European hubs, with 1 or 2 banks per day High-Density hubs without banking –Continuous connections from continuous arrivals and departures –American Airlines at Chicago and Dallas –Southwest at many of its focus cities

31. Continuous Hubs AA had 12 banks a day at DFW & ORD Revised so airplanes turn in 25 minutes Passengers connect in 40-120 minutes Higher aircraft and gate utilization Nearly the same connect times as banked AA connects 50%, and lives by it WN connects 33%, and tops up with it Ryanair connects 15%, and fights it

32. Why Secondary Hubs? Airlines Hate Competition Avoid “head-to-head” whenever possible –Preferred carrier wins big Gets first choice of premium fare demand Gets full loads during off peaks Leaves 2 nd choice carrier low yield, high peaking –Result: Lots of new routes

33. Forecasters in 1990 Were Confused

34. What We Missed: New Routes

35. Hubs Still Work Fares have per-trip part, plus small per-km Fares decline with Market Size Hubs serve Smaller Connecting Markets Hubs get premium revenues for connects Low Cost Carriers price Connections High –Tend to charge sum of local fares –Prices match Hub Carriers’ prices

36. HCC Fares Decline with Market Size

37. The Real Difference is Hubs Serve Many more Small Markets US HCCs have “given up” local markets –Nonstop markets to hub city = “local” –Used to monopolize and get premium revenues –Now required to match LCCs –Revenues no longer cover union labor costs –HCCs have given up most traffic to LCCs Hubs serve connecting markets –Share of HCC revenues in small markets high –Share of LCC revenues in small markets low –Fares in small markets higher –More small market revenues mean higher HCC fares

38. Minot Connects to the World

39. 18:00 Bank Gives Minot 38 Destinations Inbound Bank Outbound Bank

40. The One Horse in a “One-Horse Town”

41. Industry Growth is Small Markets Virtuous Circle: –Better services: More Value Faster connections (add 15% demand for online) Fewer Stops (add 15% for each lost stop) Higher frequencies (add 15% for full-day schedule) –Lower Costs: Lower Prices Higher traffic volumes mean lower costs Competitive choices eliminate monopoly pricing New “small” markets get new services –Smaller towns, secondary city airports –Grow network from “below”

42. The First Big Event Nobody Noticed (Deregulation: 1984) Peoples Express opened a low cost hub –At Newark (EWR) airport, New York City –Cheap fares, lousy service AA discovered PE –Became aware of the extent of PE connects –Responded by matching PE fares 70% off full fare (compared to 35% off for SSave) Capacity only available midweek AA clearly the preferred choice at matched fares

43. Results of Big Event PE went out of business –Due to “horrendous peaking of traffic” –No midweek loads AA found it was making more money –80% average weekly load factors (not 60%) –Filling previously empty mid-week seats –Selling tickets for half previous discount fares –Revenue Management controlling sales Paradigm shift: –Old way was set fares, get load factor Weak demand means lower load factor –New way was set load factor, sell to fill Weak demand means lower average fare

44. Results of New Fare Structure Marginal seats sold at marginal cost –Breaking “single price” mentality –Economically efficient –Allows full cost recovery from multiple prices High full fares pay cost of frequency Low controlled fares get marginal capacity Saturday stay, advance purchase discriminate

45. Southwest and LCCs New Airlines from Deregulation 19 out of 20 start-ups failed WN (Southwest) succeeded America West (hubbed) survived (+AirTran) LCCs had 20% cost advantage from labor WN had “shuttle technology” –Engineered for loading and unloading –Reliability from high frequency –Incidental connections high (30%) –Business airline: not “cheap,” Just good –Good employee relations; reasonable wages

46. The 2nd Big Event Nobody Noticed (Deregulation in 1998) Airlines were paying $3/segment booking fees –Computer reservations systems owned by AA, UA –Travel agents hooked to mainframes Agents got 8-15% booking fees Agents got bribes to sell AA, UA, DL….dominant networks Southwest refused to pay fee –Was thrown off reservations systems –Continued to sell on internet –No drop in Southwest business –No one noticed Majors’ Res systems no longer in control

47. Consequences of 2 nd Event Majors became able to reduce commissions –Travel agencies no longer had pricing power –Removed one high-cost part from trip Start ups no longer had to pay majors –Previous Res System profits greater than airline’s –Majors owned Res Systems –Majors no longer controlled cost of entry –Majors lost full information about competitor’s prices Later consequence: Competitive Pricing –Direct-to-airline bookings made prices hard to monitor –Internet intermediaries compared multiple airlines sites –Cost of information on prices greatly reduced –Now only 18 out of 20 start-ups fail = twice the successes –Majors unable to extract rents to pay pilots’ premiums

48. The LCC/HCC War Airline Industry is forever young –Birth and death process 38% of ASK service 20 years back, airline gone 28% of today’s ASKs with new airlines Index of competition flat to rising HCCs have adapted –Labor rates down: wages, rules, retirement –Service quality, costs, and prices down LCCs will migrate services –Higher quality: boarding, onboard, reliability –More connections at higher prices –More price differentiation –Higher connecting share Who can tell which is which?

49. Simple Revenue Management Pricing Profile Depends on Time

50. Cost Reductions Keep Coming

51. Two Choices: 1.Regulated Airlines Few routes, larger airplanes Focus on inelastic business demand Monopoly prices and costs Permanent Names 2.Competitive Markets Many routes, smaller airplanes Innovation, adaptation Competitive prices and costs Bankruptcies and Start-ups Biggest names still survive

52. Evolution: Part 2 Birth and Death 38% of the air travel 20 years ago –Was flown by carriers that do not exist today 28% of the air travel today –Is flown by carriers that did not exist 20 years ago Competition is greater now –By any reasonable technical measure –But only slightly greater. Almost unchanged Conclusion: A healthy industry requires –Failure of badly run airlines –Failure of most new start-up airlines –Success of some new start-up airlines Overall employment and services should grow

53. Mergers That Work When airlines serve the same airports –Their merger will be a success –Merged airline offers better connections –Better, more valuable service to customers –May eliminate some competition Mostly this is a short-haul carrier merging with a long-haul carrier

54. More Mergers that Work Failing airlines are acquired –Majority of employees retained –Majority of airplanes retained –All airports’ still served –Management employees of failing airline gone This process is good –Reduces operations in a orderly fashion –Maintains the most service and employees –Avoids losses associated with bankruptcy

55. Mergers that Seldom Work Merging airlines to expand network reach –Overlap of airports only at edges –Makes bigger airline –Does not improve many connections Most such mergers have not worked –Difficulties with employee cooperation –Little increase in value or saving in cost –Tendency to retain bad practices

56. Bankruptcy: How Airlines Fail Government airlines do not fail –They just need money, over and over Regulated airlines seldom fail –They just don’t improve services –They also may not improve costs Competitive airlines do fail –Efficiency comes from eliminating the bad ones –In the “Profit and Loss” system The losses are the important thing A loss comes when it costs more to run the airline –Than the customers are willing to value the service Bankruptcy is the way to stop doing things that are losses

57. Bankruptcy: Social Details In the US –Bankrupt means not enough money to pay wages; leases; loans; owners of airline –Owners give up all their invested money –Part of loans are given up (“haircut”) –Lease payments may be reduced Or airplanes taken away –Wages may be reduced –Airline gets smaller –BUT IT CONTINUES TO EXIST After 3 rd Bankruptcy and reorganization –Airline may stop operating

58. Bankruptcy: Social Details In Europe –Bankruptcy is more disgraceful –Airline is shut down –Airplanes and airport gates are sold –Employees all loose their jobs –Similar to 3 rd bankruptcy of US airline Stock holders loose all their money Bond holders loose almost all their money Airplanes and employees try to find new airlines

59. The Hard Problem A healthy industry means some airlines fail Failure is hard on employees Failure may reduce services How to make transition smooth –Most employees get jobs at new airline –Most airplanes are put back to use –Most services are kept operating No country has “ideal” Government Policies –Either regulate to avoid failure –Or allow messy bankruptcy Arguments about who looses how much money No incentives to make smooth transitions Be the first: Do it “better”

60. William Swan: Data Troll Story Teller Economist