A series of significant changes and unforeseen events during the last several years has presented the airline industry with its most significant challenges since it was deregulated 25 years ago. These challenges have come from within the industry as well as from external factors affecting the demand for air travel. Since the late 1990s, the U.S. airline industry, especially legacy airlines, has faced several internal challenges that have altered the way it operates. Foremost among these challenges is addressing declining yields brought on by price transparency and competition. The airlines’ increased use of the Internet to reduce ticket distribution costs. However, the price transparency the Internet provides has empowered consumers searching for the lowest fares and depressed fare levels. The emergence of well- capitalized low-cost airlines has also been a significant challenge. Although earlier new entrant airlines quickly disappeared, this recent group is better capitalized and offers a good overall product. Between 1998 and 2003, these low-cost airlines increased their presence in the 5,000 largest city pair markets (e.g., New York – Boston) from 32 to 46 percent and increased overall market share of passenger enplanements from 23 to 33 percent. Demand for air travel began weakening in 2000, well before the September 11th terrorist attacks. An economic downturn that began in 2000 depressed airline revenues, and the terrorist attacks of September 11th, the Iraq war, and the outbreak of Severe Acute Respiratory Syndrome (SARS) have compounded this trend. These events have contributed to a change in the demand for air travel that is likely to suppress revenues for the foreseeable future, including the inability of airlines to charge premium business fares. Although it is impossible to isolate the effect of various events, demand as measured by revenue passenger miles (RPMs), was down 6.5 percent and 11.4 percent for 2001 and 2002, respectively, from the Federal Aviation Administration’s (FAA) June of 2001 forecasts. Airlines responded very differently to the challenges of the last few years. Legacy airlines faced with mounting losses and curtailed demand for air travel sought to reduce capacity and along with it their operating expenses. Low-cost airlines, already enjoying a cost advantage over legacy airlines, used their competitive cost advantage to grow. Legacy airlines cut operating expenses by $12.7 billion between October 1, 2001, and December 31, 2003. This 14.5 percent reduction in operating expenses exceeds the percentage reduction in seat capacity of 12.6 percent during the same period. According to airline financial reports to DOT, legacy airline labor costs were reduced $5.5 billion annually, or about 16 percent during this time period (see fig. 1). Both USAirways and United signed new labor agreements while in bankruptcy, and American Airlines also achieved new agreements while on the verge of bankruptcy. Legacy airlines also achieved $2.1 billion savings from a 59 percent reduction in the commissions paid to travel agents, because those commissions were sharply reduced. Finally, legacy airlines reduced fuel costs by 18.7 percent during the period, although the recent upsurge in fuel prices has reversed these savings. The only cost category to increase for legacy airlines was transport-related expenses, which doubled during the period, an increase of $3.9 billion. Increases in transport-related expenses for legacy airlines are largely because of fees paid to regional airline partners for providing regional air service. In the aftermath of September 11th, legacy airlines shifted some of their routes over to regional airlines in an attempt to reduce seat capacity on these routes. Meanwhile, low-cost airlines used legacy airlines retrenchment as an opportunity to expand. The seven low-cost airlines increased seat capacity by 26.1 percent during the same period that legacy airlines cut capacity by 12.6 percent, but total operating costs for low-cost airlines increased by a more modest 9.8 percent, or a little more than $1 billion. Low-cost airlines’ labor costs, these airlines’ largest single cost component increased over $750 million, or 21 percent (see fig. 2). Despite their growth, low-cost airlines were able to achieve small reductions in some of their other costs, including commissions, passenger food, depreciation and amortization, and transportation related expenses. The financial performance of U.S. airlines since 2000 has followed two very different paths. Despite significant cost-saving initiatives and industry-wide traffic volumes approaching pre-September 11th levels, legacy airlines continue to lose money. Legacy airlines’ unit costs (cost to fly one seat 1 mile) have increased since 2000 while fares have declined; as a result, these airlines have yet to regain profitability. Meanwhile, low-cost airlines continue to expand market share, enjoy a greater unit cost advantage over legacy airlines than they did in 2000, and in all but one quarter have collectively earned a profit. The weak performance of the legacy airlines over the last 3 years has significantly diminished their financial condition; as a result, some of these airlines are vulnerable to bankruptcy, especially if there are additional shocks to the industry. Legacy airlines, as a group, have been unsuccessful in sufficiently reducing their costs to make them more competitive with low-cost airlines. Unit cost competitiveness is key to profitability for airlines because airlines have found it extremely difficult to increase their revenues in the current environment. While legacy carriers reduced their overall operating expenses over the last three years, these cuts largely paralleled legacy airlines’ capacity reductions. Conversely, low-cost airlines have been able to reduce their unit costs through expansion. Low-cost airlines’ ability to maintain lower labor costs and lower asset-related costs accounts for the majority of the unit cost differences between low-cost airlines and legacy airlines. Wall Street analysts suggested that one of the best measure for examining airline unit cost performance is to compare airline unit cost curves. These curves relate airlines’ unit costs to the stage length (distance) flown. Figure 3 shows legacy and low-cost airline unit cost curves for 2000 and 2003 and shows that the gap between legacy and low-cost airline unit costs has widened across all distances. For example, in 2000, at a 1,000-mile stage length legacy airlines’ unit costs were 45 percent higher than low- cost airlines; by 2003, legacy airlines’ unit costs were 67 percent higher. Some of the legacy airline unit cost increase is due to the capacity purchased from regional airlines—an increase in operating expenses (the numerator) but without a corresponding increase in available seat miles (the denominator) in the unit cost calculation. However, this does not account for all or even most of the gap between legacy and low-cost airlines’ unit costs. To account for this unit cost difference between legacy and low-cost airlines, we also examined legacy and low-cost airline unit costs over time and the various cost items that comprise total operating expenses. Overall, we found that the gap in aggregated (for all stage lengths) unit costs for legacy and low-cost airlines has widened since 2000, from 2.1 cents per available seat mile to 3.8 cents at the end of 2003. Figure 4 shows this widening gap and the cost components that account for the difference. The two primary cost components that comprise the unit cost difference between legacy airlines and low-cost airlines are labor costs and asset- related costs. Legacy airlines have high labor costs owing to a highly tenured, unionized workforce, while low-cost airlines are able to keep labor costs down because of a younger and lower paid work force but also by achieving higher levels of labor productivity than legacy airlines. Legacy airlines have higher asset-related costs than low-cost airlines because legacy airlines generally have older fleets and more types of aircraft in their fleets than low-cost airlines. Legacy airlines also put their planes in the air fewer hours per day than low-cost airlines. Finally, some portion of this difference is due to legacy airlines’ purchase of regional airline capacity during the period. Other costs that currently are part of the remaining unit cost difference between legacy airlines and low-cost airlines include expenses for fuel, passenger ticketing commissions, and passenger food. Both legacy and low-cost airlines have encountered weak revenues over last several years. The internal and external factors cited earlier have depressed fares and demand for air travel. Overall, industry-wide demand has nearly returned to pre-September 11th levels, but fares have not. Unit revenue, or yield, the amount of revenue airlines collect for every mile a passenger travels, has fallen 19 percent from the first quarter of 2000 through the fourth quarter of 2003, for the airlines examined in this study. The trends are similar for both the legacy airlines and low-cost airlines; legacy yields dropped about 19 percent, and low-cost airline yields dropped about 18 percent (see Figure 5). Although nearly as many passengers are flying as before September 11th, they are paying less to do so. In addition, legacy airlines are losing market share to the low-cost airlines. Demand, as measured in the number of miles paying passengers were transported, is down over 10 percent for the legacy airlines since 2000; demand for low-cost airlines has risen nearly 40 percent. Not only are legacy airlines collecting less fare revenue from the passengers they fly, they are also flying fewer passengers than they used to. Low-cost airlines are flying more passengers at lower prices. Low-cost airlines have been able to use their relative cost advantage to remain profitable at a time when fares are down throughout the industry. As figure 6 demonstrates, legacy airlines have lost money in each of the last 3 years, for a total of $24.3 billion; low-cost airlines have made money in every year. Since 2000, the financial condition of legacy airlines has deteriorated. Both legacy airlines and low-cost airlines increased their cash balances following the events of September 11th; legacy airlines did so primarily through borrowing, while low-cost airlines increased theirs by generating profits as well as borrowing.