1. Biography for William Swan Chief Economist, Seabury-Airline Planning Group. 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 Lessons from US Deregulation William M Swan Chief Economist Boeing Commercial Airplanes, Marketing; Retired,

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

4. Economies of Airplane Size 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

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

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

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

8. 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

9. Prices, Fares, and Yields be careful what you measure

10. Route Structure Early Routes Followed Trains –Linear Multi-stop routes between big cities –Intersecting routes owned by different airlines –Fares were same $/Km everywhere Current networks are hub-focused –Gateway international hubs –Internal regional hubs –Competing airlines use different hubs

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

12. 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

13. 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

14. 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

15. 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

17. Half of Travel is in Connecting Markets

18. Connecting Share of Loads Averages about 50%

19. 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

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

21. 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

22. 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

23. Forecasters in 1990 Were Confused

24. What We Missed: New Routes

25. Minot Connects to the World

26. 18:00 Bank Gives Minot 38 Destinations Inbound Bank Outbound Bank

27. 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”

28. 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

29. 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

30. 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

31. 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

32. The LCC/HCC War HCCs have adapted –Labor rates down: wages, rules, retirement –Service quality, costs, and prices down –Higher fares in small connecting markets LCCs will migrate services –Higher quality: boarding, onboard, reliability –More connections at higher prices –More price differentiation –Higher connecting share –Higher fares in small connecting markets Who can tell which is which?

33. Cost Reductions Keep Coming

34. 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

35. 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

36. 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

37. 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”

38. William Swan: Data Troll Story Teller Economist