Even in good times, airlines depend on a hairline balancing of supply and demand

The New York Times, "Economic Scene" , October 11, 2001

On a recent flight from Los Angeles to Dallas, the American Airlines pilot thanked the passengers profusely at the beginning and end of the trip.

The plane was packed, with only a few empty middle seats, and crew members were happy to be back to the world of crowded cabins and potential profits.

Before the Sept. 11 attacks, the airlines were struggling to overcome the effects of the economic downturn. Business travel in particular had dropped sharply. After the attacks, planes were grounded for two days, meaning the airlines kept paying their operating costs but had absolutely no revenue. Since then, fears not only of hijackings but of airport security problems and delays have discouraged passengers from flying.

All in all, it's been a very bad month for the airlines. They've laid off about 80,000 workers and dropped about a fifth of their flights. As Congress rushed to pass a bailout, giving the airlines $5 billion in grants and $10 billion in loan guarantees, the perception grew that airlines are an inherently bad business -- a "failing industry," in the words of Peter G. Fitzgerald, the Illinois Republican who was the sole Senator to vote against the bailout.

Economists who study the industry say it's simplistic to argue that the airlines are always in trouble. The industry isn't exceptionally profitable, but it does make reasonable returns.

Still, even under normal circumstances -- and these aren't normal circumstances -- the business does present definite challenges to managers.

The essential problem is matching capacity with demand, which requires making spending decisions far in advance of ticket sales. That may not sound unusual -- many businesses have to guess how much product to make -- but the problem is harder for airlines than for manufacturers. If they plan for too many passengers, they can't carry the extra seats in inventory.

"Either you sell the seat for this particular flight for this hour or you don't sell it," said Pablo Spiller, an economist at the Haas School of Business at the University of California at Berkeley. "You can't say, 'I'll keep the Thursday, Oct. 4, seat at 5 for next week.' No, it went away, that seat."

If planes fly with few passengers because an airline overestimated demand, those flights tend to lose money. For a given flight, the costs of fuel, labor and the aircraft itself are essentially fixed, regardless of how many passengers the plane is carrying. That's why the airline's "load factor," the percentage of seats filled, is such an important indicator of how well it is doing.

When the load factor drops, airlines tend to get into fare wars. Adding another passenger to a given flight costs almost nothing, so any additional revenue will help cover those fixed costs. If one airline has too much capacity, it will sharply reduce fares to fill up its planes. Competitors will drop their fares to match, lest they lose their passengers.

"It's a very competitive industry," Professor Spiller said. "It's not a fragmented industry -- you have a few large players -- but it's very competitive because in every market you have several players." The hub-and-spoke system means that most travelers can choose among several airlines. This competition means air fares behave almost like agricultural commodities, with airlines having little control over prices. (The exception is for flights starting or ending at "fortress hubs," like Delta's in Atlanta, where one airline controls a great majority of flights.)

In any new industry, managers have to learn how to deal with the particular challenges of the business. Just ask the dot-commers. Airlines aren't a new business, of course, but they operated in a completely different environment from 1938, when the federal government imposed regulation, until 1978.

"They have fundamental challenges matching capacity with demand -- both in getting that capacity and predicting what that demand will be -- and adjusting to business cycles," said Clifford Winston, an economist with the Brookings Institution. Learning how to do that after deregulation, he adds, "was going to take them a while; for 40 years, they had no practice at it and no incentive to do anything about it."

Travel demand fluctuates greatly with overall economic conditions. Since 1978, when federal price and route controls were removed, the airlines have gone through just a couple of full business cycles. "In each successive decade, they were getting better," Dr. Winston said.

After the 1981-82 recession, the airlines bounced back. But during the good times of the mid- and late-1980's, they bought far too many planes. That gave them too much capacity when the economy turned down in the early 90's, leading to fare wars and financial losses.

In the boom of the 1990's, the airlines made plenty of money. To the annoyance of passengers, they not only limited discounts but kept capacity relatively tight. That discipline not only increased profits but made adjustment easier when the downturn came. Before Sept. 11, Dr. Winston argues, "The expectation was, yes, things might slow down for them, but they were gong to come through this part of the business cycle better than they had in the past."

The attacks, however, were a completely different sort of shock. "You have not seen a reduction in demand like this ever," Professor Spiller said. "This is a cataclysm. It's like an earthquake shook a country. The country stops."

Aside from lobbying for the bailout, the airlines have responded by reducing fixed costs. Ordinarily, they wouldn't lay off employees, preferring to cut work hours, because bringing on new people when business improves is complicated and expensive. Similarly, dropping flights can alienate customers, so airlines try to avoid that step. Now, however, they have no choice. "The demand drop is so large that there is no way out," Professor Spiller said.

The attacks created a genuine, but perhaps short-term crisis, for the industry. The continuing crisis that the business is tagged with is less real. With the schedule cuts in place and Americans beginning to travel again, load factors are rising. The problem with this cyclical industry is that its fortunes always upset someone.

"When they're losing money, the airlines are crying; when they're making money, the politicians are crying," Professor Spiller said, noting that not long ago elected officials were accusing the industry of profiteering. "So it's a wonderful business."