## THE AIRLINE DEREGULATION EVOLUTION CONTINUES

# The Southwest Effect

![](media/image1.wmf)

Prepared by:

Randall D. Bennett

James M. Craun

Office of Aviation Analysis

U.S. Department of Transportation

May 1993

**[Table of Contents]{.underline}**

#### Major Findings 3

Southwest 4

Industry Structural Changes 5

The Southwest Effect 6

The importance of new entrants 8

#### Appendix A: Charts 10

> Chart 1 10
>
> Chart 2 10
>
> Chart 3 11

##### Chart 4 11

> Chart 5 12
>
> Chart 6 12
>
> Chart 7 13
>
> Chart 8 13
>
> Chart 9 14
>
> Chart 10 14
>
> Chart 11 15
>
> Chart 12 16
>
> Chart 13 16
>
> Chart 14 17
>
> Chart 15 17
>
> Chart 16 18
>
> Chart 17 18
>
> Chart 18 19
>
> Chart 19 19
>
> Chart 20 20
>
> Chart 21 20
>
> Chart 22 21
>
> Chart 23 21

**Major Findings:**

The principal driving force behind dramatic fundamental changes that
have occurred and will occur in the U.S. airline industry over the next
few years is the dramatic growth of low-cost Southwest Airlines:

-   A return to profitability hinges on developing lower-cost services
    in short haul markets and increasing fares in longer-haul markets:

-   Other major airlines are giving up competing with Southwest\'s
    low-cost service for market share. Southwest\'s continuing expansion
    will force other airlines to bring about a major change in their
    [cost structures]{.underline} by developing new, low-cost services
    in short-haul markets.

-   The industry\'s inability to continue to charge relatively high
    fares in short-haul markets will, in turn, force a correction in the
    domestic industry\'s long-haul [pricing structure]{.underline} where
    intense competition has produced fares that appear to be low in
    relation to costs.

-   The inability for existing airlines to compete with Southwest\'s
    much lower costs creates an even greater need for the government to
    encourage low-cost, new entry, as a discipline for Southwest\'s
    pricing behavior in the future, and to replace service of other
    major airlines that are scaling back service or exiting markets
    dominated by Southwest.

**Southwest:**

Southwest Airlines, long thought of as a Dallas Love Field niche
airline, is the fastest growing, most profitable U.S. airline. Southwest
does not operate the hub-and-spoke system of service used by every other
major airline. Southwest specializes, instead, in very dense, short-haul
markets, where it can provide frequent service.

Southwest is having a profound effect on the airline industry. The
reason is its aggressive expansion and very low operating costs (Chart
1). With the exception of America West, the unit costs of the other
major airlines are 50 to 70 percent higher than Southwest\'s costs.
America West\'s unit costs are 20 percent higher. With such a cost
disadvantage, other airlines simply cannot compete with Southwest at the
low prices it can profitably charge. Southwest\'s much lower operating
costs are making it the dominant airline today in the sense that
Southwest, more than any other airline, is causing the industry to
change. Other airlines cannot compete with Southwest in the same manner
as they do each other.

Southwest\'s combination of low prices and high frequency service
virtually eliminates, as an effective competitive weapon, the use of
yield management techniques that other airlines have successfully used
on each other and traditional new entrant airlines. And other airlines\'
hubs have not protected them from Southwest. Most of its markets involve
another airline\'s hub city, sometimes two hub cities, yet Southwest
dominates market share virtually everywhere it serves. With its focus on
short-haul markets, connecting services of hub-and-spoke airlines are
not a realistic competitive alternative. And focusing on dense markets
minimizes the advantage of flow traffic hub-and-spoke airlines typically
use to discourage competition by other airlines.

Southwest is rapidly dominating dense short-haul markets throughout the
country, with the exception of the East Coast where it does not operate.
For the year ended September 30, 1992, Southwest controlled or strongly
effected price for more than 60 percent of the travelers in the most
dense markets under 500 miles (markets with 500 or more passengers per
day). The difference in price is very dramatic. The average prices for
markets Southwest does not participate in for distances of 0 - 250 miles
and 251 - 500 miles, are \$109.92 and 130.32, respectively. In Southwest
markets of similar distances, the average prices charged by all carriers
are \$56.29 and \$57.61, respectively.

Southwest\'s increasing dominance can be illustrated in a number of
ways. In the top 100 48-state markets for the industry, which account
for about one third of domestic passengers, Southwest is the dominant
airline, with more passengers than each of the Big Three (64 percent,
110 percent and 27 percent more than American, Delta and United,
respectively), and almost as many passengers as the other five major
airlines combined. Southwest\'s average share in its own top 100 markets
is 65 percent, compared with less than 40 percent for any other airline
except Northwest (43 percent). In its own top 100 markets, Southwest is
the dominant airline in 93, has a 50 percent or greater share in 80, and
has a 67 percent or better share in 53. No other airline comes close to
these numbers in their own respective top 100 markets. And Southwest\'s
dominance is almost universally pervasive. Compared with a year earlier,
its most recent market shares are up in virtually every one of its top
100 markets, often dramatically. In several instances competitors have
dropped out. All this despite the fact that 82 of Southwest\'s top 100
markets involves another airline\'s connecting hub \-- 16 involve two
connecting hubs.

A review of how the industry pricing structure has evolved under
deregulation will help set the stage for understanding the implications
of Southwest\'s success.

**Industry Structural Changes:**

A useful benchmark for evaluating changes in the industry\'s pricing
structure is the Standard Industry Fare Level (SIFL). The SIFL, in
effect, was the lowest unrestricted coach fare in each market on July 1,
1977, and has been updated since, semiannually, to reflect changes in
operating costs.[^1]

Charts 2 through 8 reveal interesting changes in the industry\'s pricing
structure. Chart 2 shows that in 1979 average fares were very close to
the SIFL in markets of distances up to 750 miles, then gradually
declined in relation to SIFL so that in markets of longer distances
average fares were about 25 percent below the SIFL fares. Chart 3 shows
that by 1984, average prices had dropped in relation to the SIFL in
markets of all distances except between 501 to 750 miles. This reflected
the addition to the system of several new entrant airlines, including
Air Cal, America West, New York Air, People Express, Pacific Southwest,
and Southwest, which stimulated aggressive price competition.

The first dramatic change in the industry\'s pricing structure occurred
during the next four years when hubbing greatly proliferated. Chart 4
shows that in relation to the SIFL prices in short haul markets greatly
increased while prices in longer-haul markets dropped considerably. Both
changes appeared to move average prices in the right direction in
relation to pre-deregulation costs, but both perhaps overcorrected,
leaving prices in short-haul markets too high, and prices in long-haul
markets too low, in relation to costs of providing service. This fits
our understanding of the competitive effects of hubbing, where numerous
\"hubs in-between\" compete vigorously for medium- to long-haul
travelers while hubbing carriers are able to exert some measure of price
control in short-haul markets to their respective connecting hubs.

The second dramatic change in the industry\'s pricing structure had
occurred by 1991. Chart 5 shows that while prices in longer-haul markets
remained low in relation to the SIFL, actually declined a little more,
prices in short-haul markets had declined very significantly. Chart 6
illustrates the reason \-- the \"Southwest Effect.\" Industry prices,
excluding Southwest markets, did not decline in relation to the SIFL as
it existed in 1988, which means that the reasons the overall industry
average prices declined in relation to SIFL are the low fares in
Southwest markets, and by the much larger proportion of travelers
affected by Southwest\'s pricing policies. These same basic trends
continue in the most recent annual data, for the year ended September
30, 1992, shown in Charts 7 and 8.

Note that the airline industry made a profit in 1988 despite the fact
that long-haul fares had declined, relatively, because the industry had
managed to significantly increase its short-haul fares. The significant
decline in these prices clearly has been a factor in the industry\'s
financial performance in recent years. The differences between
\"Actual\" and \"Actual-WN\" lines on Charts 6 and 8 represent the fare
decreases resulting from Southwest\'s pricing policies. Had all traffic
moved at the higher prices, domestic industry revenues would have been
\$2.5 to \$3.0 billion higher in 1992.[^2]

Thus the industry\'s profitability picture has been compounded \--
long-haul prices that are perhaps too low in relation to cost because
they are so competitive, and, more recently, short-haul prices that are
too low because of very low-cost Southwest. Given these constraints, it
would appear that in order to return to profitability the other major
airlines in the industry must increase their long-haul prices, and
reduce their short-haul costs.

The cause of the extreme competition in prices in medium- to longer-haul
markets is that, in addition to whatever single plane service that may
be available, most also have numerous on-line connecting alternatives.
In other words, the rapid growth of the number of connecting hubs has
greatly intensified competition for most passengers in markets of 1,000
miles or more. But the industry now shows signs of responding to this by
scaling back hubbing operations. The best example of this is American,
which has announced the scaling back of operations at three of its hub
complexes. USAir also greatly reduced its operation at Dayton. These
kinds of developments will eventually reduce the level of competition on
longer-haul markets so that the carriers can increase prices to more
economic levels.

**The Southwest Effect:**

A review of Southwest\'s experience in the California Corridor, the
largest domestic market in terms of number of passengers, demonstrates
how quickly Southwest gains a dominant presence in dense markets, and
the consequences of Southwest\'s success. This is a prime example of how
Southwest is changing the industry. This shows that other major airlines
attempted to compete for market share for several years in the face of
Southwest\'s low-cost service, but that they have finally given up
trying to do that. Charts 9 through 20 illustrate price, traffic and
competitive intensity in the California Corridor, beginning in the first
quarter of 1989, or just before Southwest entered.[^3] Southwest has
entered 3 of the eight airport pairs, OAK-ONT in 89/3, OAK-BUR in 90/2,
and OAK-LAX in 91/2. Chart 9 shows that in just three and one-half years
Southwest has become the dominant carrier overall, despite not providing
any service to San Francisco, which was the dominant corridor airport in
early 1989. Southwest now carries 80 percent of all OAK to LAX area
traffic and has 42 percent of the total market, compared with
second-place United\'s 37 percent, and SFO is a United hub.

Chart 10 shows than when Southwest entered its first California Corridor
airport pair \-- OAK-ONT \-- prices declined by 60 percent and traffic
tripled. The traffic increase did not come at the expense of traffic in
other airport pairs, because when Southwest entered OAK-ONT prices in
all 8 airport pairs dropped dramatically, leading to traffic increases
in each. Note that average fares have continued to be low and traffic
has continued to increase, through the third quarter of 1992.

Chart 11 shows another remarkable response to Southwest\'s entry in the
OAK-BUR airport pair in 90/2. Prices dropped 55 percent and traffic
increased six-fold. This traffic response reflects an almost tripling of
capacity as United added service in this airport pair simultaneously
with Southwest. Note that when Southwest entered OAK-ONT, competitors in
the OAK-BUR market initially dropped price, and then quickly returned
price to its pre-Southwest level just before Southwest\'s entry in the
OAK-BUR airport pair. Subsequent to Southwest\'s entry, prices have
remained low, although they have increased a little, apparently due to
greatly increased load factors. Traffic in this airport pair has
declined as competitors have exited and Southwest has not fully replaced
their capacity.

Chart 12 illustrates the Southwest Effect in the OAK-LAX airport pair.
By the time Southwest entered in 91/2, responses to its entry in other
California Corridor airport pairs had competed price down, but
Southwest\'s entry nevertheless produced big traffic increases.

Chart 13 is important. Oakland-Long Beach is the only Oakland airport
pair not served by Southwest. After initially attempting to compete with
Southwest for market share, as Southwest entered other California
Corridor airport pairs, Alaska Airlines, the only carrier in this
airport pair, gave up when Southwest entered its third corridor airport
pair. Very clearly, Alaska Airlines decided that it would not continue
struggling for market share with Southwest at Southwest\'s price levels.
For each of the past 5 quarters Alaska Airlines has steadily increased
its price, by 60 percent from its low point, despite a loss of traffic.

Chart 14 shows that for all four Oakland- Los Angeles area airport pairs
combined (Southwest is in three of them), traffic is more than triple
the pre-Southwest entry level, and prices, despite showing some small
increases during the past year, reflecting high average load factors as
Southwest has not fully replaced the capacity of exiting airlines, are
still about 50 percent below the pre-Southwest entry level.

Turning to the San Francisco airport pairs (Charts 15 through 19), and
the entire California Corridor (Chart 20), we see the same picture in
the OAK-LGB airport pair. After responding strongly to Southwest\'s
entry in the first 2 corridor airport pairs, once Southwest entered its
third airport pair, OAK-LAX, carriers have either exited, or have began
to steadily, and, significantly, increase prices despite a major loss of
traffic.

The experience for the corridor overall is that average prices are down
by one third, and traffic is up by 60 percent on only 6 percent more
capacity as average load factors have risen from under 50 percent to 67
percent. Clearly, consumers are better off as a consequence of
Southwest\'s entry into the California Corridor.

But equally noteworthy, this review of the California Corridor vividly
illustrates that Southwest\'s competitors, after initially competing for
market share, have learned that they cannot economically compete for
local traffic with Southwest with the services they now provide. Eight
airlines have discontinued service in one or more of the eight airport
pairs, and the few survivors are quickly moving back toward their old
fare levels without regard to market share; [i.e.]{.underline}, they are
effectively surrendering market share, and short-haul markets, to
Southwest.

But this probably should be viewed as an interim strategy. Dense,
short-haul markets account for more than one third of domestic
passengers, and while the other major airlines cannot effectively
compete with Southwest for that traffic with their present services,
they cannot totally concede this proportion of the total domestic market
to Southwest. The other major airlines, therefore, will have to develop
low-cost alternatives for competing with Southwest, perhaps in concert
with other strategies to minimize the effect of losing local market
share to Southwest. This holds the promise of the airline industry
becoming much more efficient in short-haul markets, enabling the
industry to carry passengers in such markets profitably at greatly
reduced prices.

We know that other airlines are actively considering ways of competing
with Southwest. United has had discussions with America West to take
over some of its aircraft leases and (presumably markets) and create
joint marketing efforts. Delta has indicated that it has a plan, but has
declined to offer any information about its strategy. But the extent to
which other ongoing airlines will succeed in developing strategies for
competing with Southwest, and when they will be able to implement such
strategies, cannot be predicted. The possibility that other airlines may
not succeed in their efforts to become more competitive with Southwest,
at least to the full extent necessary, places great emphasis on the need
to encourage the development of low cost new entrant airlines.

**The importance of new entrants:**

Southwest\'s demonstrated ability to quickly dominate markets and force
out competitors may not be perceived as a problem in the near term
because Southwest offers lower prices, even as a monopolist, than other
major airlines offer even in the most competitive markets. But while
consumers continue to benefit from very low Southwest fares, in some
markets, at least, a significant part of the initial competitive benefit
is being eroded by the inability of existing airlines to effectively
compete with Southwest.

We have demonstrated this trend in the California Corridor, and industry
data show that this effect is occurring more broadly (Charts 21 through
23). While in relation to SIFL overall industry fares for the year ended
September 30, 1992, appear similar to what they were in 1991, Chart 21
shows that fares in short-haul markets are actually somewhat higher
despite Southwest\'s continuing expansion, and despite the 1992 summer
fare war, which should have affected fares in non-Southwest markets more
than the already low fares in Southwest markets. Charts 22 and 23
illustrate why.

Chart 22 shows that, like fares in the California Corridor, fares
throughout the country in Southwest markets increased significantly
faster than SIFL from 1991 to the year ended September 30, 1992. Like
the California Corridor, the increase seems to be a result of
Southwest\'s competitors increasing their prices. In virtually every
competitive market in its top 100 markets Southwest now charges
significantly lower fares, on average, than its competitors charge.
Chart 23 shows that industry fares in non-Southwest markets of up to 250
miles increased even faster in 1992. These charts suggest that
Southwest, alone, is not enough to discipline airline industry prices in
short-haul markets.

The competitive reaction to Southwest is affecting not just price, but
service as well, as Southwest\'s competitors scale back their service or
exit altogether. Even where competitors do not cut back their services,
when the local market involves one of their hubs they appear to be
allocating more of their capacity to passengers connecting at the hub
rather than the local passengers to and from the hub. This could be
significant because it might suggest that the hubbing carriers are
trying to carve out a middle ground which would allow them to co-exist
with low-cost airlines at their hubs; [i.e.]{.underline}, a competitive
balance somewhere between the hubbing airlines dominating dense
short-haul markets to their hubs as they have done in the past, and
yielding such markets totally to Southwest or Southwest clones, as some
now appear to be doing.

Unless and until the other major airlines succeed in developing a good
response, low-cost new entrants will be the only vehicle to (1) replace
other airlines\' lost service, (2) exert cost-related price competition
on Southwest which now seems to be fading, and (3) extend low-fare
services to other markets (along with Southwest).

Without a competitive discipline, over time Southwest\'s fares will
increase to cover cost inefficiencies that will creep in, and to extract
monopoly profits. We already see Southwest\'s prices beginning to
increase where it has forced out its competition and its load factors
have attained relatively high levels. We do not yet know whether this is
a short-term phenomenon, until Southwest can increase its capacity to
replace the capacity of exited carriers, or whether this is Southwest\'s
strategy in the absence of more effective competition. And in the San
Francisco airport pairs where Southwest does not directly operate,
traffic has fallen quickly in reaction to sharp price increases and
capacity reductions by the remaining airlines. In markets dominated by
Southwest more effective low-cost competition is needed to keep fares
low and to maintain a competitive level of service.

[APPENDIX A: CHARTS\
]{.underline}

![](media/image2.wmf)

![](media/image3.wmf)

![](media/image4.wmf)

![](media/image5.wmf)

![](media/image6.wmf)

![](media/image7.wmf){width="6.448611111111111in"
height="3.9805555555555556in"}

![](media/image8.wmf){width="6.448611111111111in"
height="3.729861111111111in"}

![](media/image9.wmf){width="6.448611111111111in"
height="3.813888888888889in"}

![](media/image10.wmf){width="6.448611111111111in"
height="3.8756944444444446in"}

![](media/image11.wmf){width="6.448611111111111in"
height="4.143055555555556in"}

![](media/image12.wmf){width="6.370833333333334in" height="4.075in"}

![](media/image13.wmf){width="6.370833333333334in"
height="3.642361111111111in"}

![](media/image14.wmf){width="6.448611111111111in" height="3.79375in"}

![](media/image15.wmf){width="6.448611111111111in"
height="3.9784722222222224in"}

![](media/image16.wmf){width="6.370833333333334in"
height="3.9784722222222224in"}

![](media/image17.wmf){width="6.370833333333334in"
height="3.8965277777777776in"}

![](media/image18.wmf){width="6.370833333333334in"
height="3.9784722222222224in"}

![](media/image19.wmf){width="6.370833333333334in"
height="3.813888888888889in"}

![](media/image20.wmf){width="6.370833333333334in"
height="3.9784722222222224in"}

![](media/image21.wmf){width="6.370833333333334in" height="3.9375in"}

![](media/image22.wmf)

![](media/image23.wmf)

![](media/image24.wmf)

[^1]: Two basic facts should be understood about the SIFL. First, since
    it was set at the unrestricted coach fare level, to the extent
    carriers offered other lower fares such as offpeak (night coach) or
    discount fares, the actual average prices charged tended to be
    lower. Second, the 1977 coach fares were \"cost related\" but not
    \"cost based,\" that is, unrestricted coach fares over 400 miles
    were set at levels 2 to 4 percent above costs and fares were set at
    levels as much as 22.5 percent below costs at the shortest distances
    and gradually increasing to the cost line at 400 miles.

[^2]: While not all traffic would move at the higher prices, revenue
    would have been substantially higher, and, costs would have been
    lower. Southwest\'s entry often causes incumbent carrier revenues to
    drop by half, despite a greater traffic volume, which, at the least,
    results in added traffic handling costs, and sometimes added
    capacity costs as well.

[^3]: The California Corridor includes San Francisco and Oakland, on the
    one hand, and Los Angeles, Burbank, Ontario, and Long Beach, on the
    other.