Southwest AirlinesCapturing surplus Han Yi Kim

Southwest AirlinesFounded in 1971 by Rollin King and Herb KelleherThe third-largest airline in the worldThe 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

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

Basis for profitabilityFuel hedging Purchased fuel options for years in advance to smooth out fluctuations in fuel costssubstantially 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 KatrinaOperated only one model of aircraftBoeing 737, medium range-narrow body commercial passenger jet aircrafteasy to replace parts and ground support equipment

The Southwest EffectA 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 utilizationWhen a low fare carrier enters a market, profit grows dramatically

Fight against high speed railIn 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 marketThe original estimated cost was $5.6 billion, but the task of securing the necessary private funds proved extremely difficultSouthwest 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 developmentlost $40 million to be invested

Conditions for price discriminationA firm must have some market power to price discriminateThe demand curve the firm faces must be downward sloping Southwest knows that it can attract more customers at lower fare priceThe 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 consumersA firm must be able to prevent resale, or arbitrage. Customers need to present an identity card before boarding

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 travelersbusiness travelers vs. vacation travelersTo 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)

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.

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

ExamplesUsing 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 PBThe IEPR also tells that (PV MC)/ PV = -(1/e) Substitute the estimated price elasticity of demand for vacation travelers, e = -1.52solve for MC: MC = 0.342 PVEquate these two expressions for MC: PB /PV = 0.342/0.130 = 2.63Thus, 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)

Advertising campaignsJust Plane SmartThe Somebody Else Up There Who Loves YouTHE Low Fare AirlineSymbol of FreedomWanna get away? [ding] You are now free to move about the country

LiverySome southwest planes feature special themes, rather than the normal liveryShamu One/Two/ThreeCalifornia OneArizona OneLone Star OneTriple Crown OneSliver One

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

Southwest Airlines Top 10 Airports(as of February 22, 2006)

CitiesDaily DeparturesNumber of GatesNonstop Cities ServedService EstablishedLas Vegas21621511982Phoenix20024411982Chicago Midway20029431985Baltimore/Washington16519341993Oakland13811201989Houston Hobby13417281971Dallas (Love Field)12014141971Los Angeles (LAX)11812191982San Diego9210161982Orlando909281996

Incidents and AccidentsOn March 5, 2000, Southwest Airlines Flight 1455 overran a runway at the Burbank airport in CaliforniaLeaving 43 injured but no fatalitiesResulted in the dismissal of the pilotsOn December 8, 2005, Southwest Airlines Flight 1248 skidded off a runway at Midway Airport in Chicago, Illinois, in heavy snow conditionsA young boy was killed in a car struck by the plane after it had skidded into a streetSeveral minor injuries reported from passengers onboard the aircraft and on the ground

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