Southwest Airlines

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Southwest Airlines

• Capturing surplus
• Han Yi Kim

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Southwest Airlines

• Founded in 1971 by Rollin King and Herb Kelleher
• The third-largest airline in the world
• The United States most successful low-fare, high
  frequency, point-to-point carrier.
• Known as a discount airline since 1973
• - offers low fares
• - no-frills service
• - basis for Southwest's popularity and rapid
  growth

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Corporate Culture

• Tickets must be bought from the airline itself,
  the phone or online
• Extra Rapid Rewards
• - frequent flier program
• - credits for online booking users only
• Customers are assigned to a boarding group
  depending on check-in time
• - find their own seats on the plane
• Colorful boarding announcements and crews that
  burst out in song instead of no video
  entertainment
• Meal service is less than on historically full
  service airlines

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Basis for profitability

• Fuel hedging
• Purchased fuel options for years in advance to
  smooth out fluctuations in fuel costs
• substantially increased its hedging in 2001 in
  response to projections of increased crude oil
  prices
• Advantaged after Sep. 11, 2001 attack, the oil
  shock from Iraq War, and Hurricane Katrina
• Operated only one model of aircraft
• Boeing 737, medium range-narrow body commercial
  passenger jet aircraft
• easy to replace parts and ground support
  equipment

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The Southwest Effect

• A trend that indicated the success and
  profitability of Southwests business model
• less expensive than driving between two points in
  the early 1970s, during the first major energy
  cost crisis in the U.S.
• Basis of lean operations and high aircraft
  utilization
• When a low fare carrier enters a market, profit
  grows dramatically

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Fight against high speed rail

• In 1991 Texas TGV Corporation planed to connect
  the Texas Triangle (Houston Dallas San
  Antonio) with a privately financed high speed
  train system at a lower fare rate
• The same model Southwest Airlines used 20 years
  earlier to break in to the Texas market
• The original estimated cost was 5.6 billion, but
  the task of securing the necessary private funds
  proved extremely difficult
• Southwest Airlines created legal barriers to
  prohibit the consortium from moving forward with
  the help of lobbyists.
• In 1994, the Texas TGV Corporation has failed and
  withdrew high speed rail development
• lost 40 million to be invested

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Conditions for price discrimination

• A firm must have some market power to price
  discriminate
• The demand curve the firm faces must be downward
  sloping
• Southwest knows that it can attract more
  customers at lower fare price
• The firm must have some information about the
  different amounts people will pay for its
  product.
• Southwest must know how reservation prices or
  elasticities of demand differ across consumers
• A firm must be able to prevent resale, or
  arbitrage.
• Customers need to present an identity card before
  boarding

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Third-Degree Price Discrimination

• The firm identifies different consumer groups, in
  the market, each with a different demand curve.
• Southwest Airlines recognizes that any given
  flights has different types of travelers
• business travelers vs. vacation travelers
• To maximize profit, the firm sets a price for
  each group by equating marginal revenue and
  marginal cost.
• Equivalently, by using the inverse elasticity
  pricing rule (IEPR)

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The Inverse Elasticity Pricing Rule (IEPR)

• The rule stating that the difference between the
  profit-maximization price and marginal cost,
  expressed as a percentage of price, is equal to
  minus the inverse of the price elasticity of
  demand.

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Price elasticity of demand

• The percentage change in quantity demanded (Q)
  that occurs in response to a percentage change in
  price (P)
• Estimates of the price Elasticity of demand for
  Airline
• Category
  Estimated EQ,P
• Airline travel, leisure -
  1.52
• Airline travel, business - 1.15
• Source Tea Hoon Oum and Jong-Say Yong,
  Concepts of Price Elasticities of Transport
  Demand and Recent Empirical Estimates, Jounal of
  Transport Economics and Policy (May 1992)139-154

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Examples

• Using the inverse elasticity pricing rule to
  determine the ratio of between tickets for
  business (PB) and vacation travelers (PV)
• The IEPR tells that (PB MC)/PB -(1/e)
• Substitute the estimated price elasticity of
  demand for business travelers, e -1.15
• solve for MC MC 0.13 PB
• The IEPR also tells that (PV MC)/ PV -(1/e)
• Substitute the estimated price elasticity of
  demand for vacation travelers, e -1.52
• solve for MC MC 0.342 PV
• Equate these two expressions for MC PB /PV
  0.342/0.130 2.63
• Thus, Southwest Airlines will maximize profit by
  charging 2.63 times as much for a business travel
  ticket as it charges for vacation travel ticket
• (the exact prices of the tickets will depend on
  the marginal cost)

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Advertising campaigns

• Just Plane Smart
• The Somebody Else Up There Who Loves You
• THE Low Fare Airline
• Symbol of Freedom
• Wanna get away?
• ding You are now free to move about the
  country

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Livery

• Some southwest planes feature special themes,
  rather than the normal livery
• Shamu One/Two/Three
• California One
• Arizona One
• Lone Star One
• Triple Crown One
• Sliver One

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2005 Financial Statistics

• Net income 548 million
• Total passengers carried 88.4 million
• Total RPMs 60.2 billion
• Passenger load factor 70.7 percent
• Total operating revenue 7.6 billion

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Southwest Airlines Top 10 Airports(as of
February 22, 2006)
Cities Daily Departures Numberof Gates Nonstop CitiesServed Service Established
Las Vegas 216 21 51 1982
Phoenix 200 24 41 1982
Chicago Midway 200 29 43 1985
Baltimore/Washington 165 19 34 1993
Oakland 138 11 20 1989
Houston Hobby 134 17 28 1971
Dallas (Love Field) 120 14 14 1971
Los Angeles (LAX) 118 12 19 1982
San Diego 92 10 16 1982
Orlando 90 9 28 1996

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Incidents and Accidents

• On March 5, 2000, Southwest Airlines Flight 1455
  overran a runway at the Burbank airport in
  California
• Leaving 43 injured but no fatalities
• Resulted in the dismissal of the pilots
• On December 8, 2005, Southwest Airlines Flight
  1248 skidded off a runway at Midway Airport in
  Chicago, Illinois, in heavy snow conditions
• A young boy was killed in a car struck by the
  plane after it had skidded into a street
• Several minor injuries reported from passengers
  onboard the aircraft and on the ground

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Conclusion

• Southwest Airlines uses third-degree price
  discrimination to fill the plane with travelers
  in the most profitable way
• Depending on the price of elasticity of demand
  for tickets
• Charge a higher price for business travelers who
  have relatively inelastic demands
• Charge a lower price for vacation travelers who
  have relatively elastic demands

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