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Southwest Airlines

Southwest Airlines. Capturing surplus Han Yi Kim. 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

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Southwest Airlines

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  1. Southwest Airlines Capturing surplus Han Yi Kim

  2. 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

  3. 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

  4. 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

  5. The Southwest Effect • A trend that indicated the success and profitability of Southwest’s 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

  6. 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

  7. 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

  8. 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)

  9. 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.

  10. 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 CategoryEstimated 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

  11. 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)

  12. 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”

  13. 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

  14. 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

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

  16. 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

  17. 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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