Yes Fares Will Rise, But Only if Demand Grows or Capacity Falls

Fares

I’ve heard the question from friends, media, colleagues… will fares rise because of rising oil prices? The answer is… they shouldn’t in the short term. In the long run, probably, but it remains to be seen. Why isn’t it obvious? Well, this requires understanding how airline revenue management works to really get the answer. It’s time to roll up the sleeves and dig in.

The goal of airline revenue management (RM) is to maximize revenue. That’s how it goes regardless of whether oil prices are high or low. What fares are available for sale comes from a combination of sophisticated computer algorithms, human ingenuity, competitive moves, dartboards, and everything in between. But in the end, the goal is always to maximize revenue. Costs do not matter.

For this reason, any time someone asks me, “oh man the price of oil spiked today, so will prices go up?” — my answer is always no. If the RM teams are doing their jobs, they are already getting the most out of the capacity that is for sale. If they could just jack up fares to cover costs, that means they could have raised fares before and failed to do their jobs properly.

This doesn’t apply if there is some shock to demand, but that has not happened. Demand is strong, and people want to fly. So why has oil spiked, and what changed in this chart?

We all know the answer to that. WAR. Oil spiked after the Russian invasion of Ukraine, and it has now settled back down somewhat, but it’s still high. Demand for travel to Moscow has disappeared overnight, but everywhere else there is no impact. In fact, demand seems to be at record levels. Because of that, fares aren’t going to just rise in order to cover costs.

How is it possible that costs don’t matter? Well, in RM they don’t. Costs really start to matter in the Network Planning world. They are making decisions further out about how much capacity to put in the market, and that can have an immediate impact on fares… but not for immediate travel.

I will point out it hasn’t always been this way. Airlines used to play games with fuel surcharges. They would slap on surcharges that would show up like resort fees, as a sneak attack after the fact which didn’t impact the advertised fare so it had less of an impact on consumer behavior. (They still do with award travel.) But ever since the government required that all mandatory charges get displayed in the advertised fare, they no longer had that lever. Without this mechanism, the best way to increase fares now is to restrict capacity.

It is exceedingly rare to see an airline cut back on capacity in the short term. Yes, a pandemic that stops every person from traveling is one reason to slash capacity. Airlines just basically stopped flying in March 2020, but that is a very rare event. For the most part, the fixed costs are already pretty high. Aircraft and crew schedules are set. To make changes can be a real logistical challenge. Airlines have gotten better at this during COVID, but without a major demand shock, big capacity shifts just don’t happen at the last minute.

Instead, what the Network teams are doing now is looking further out, thinking about May and into summer in particular. Those are time periods where they can make capacity decisions more easily. And why does capacity matter so much? Think back to that Econ class you were forced to take as an undergrad. Remember the part before you fell asleep where they had the two crossing lines?

Yeah, it’s that one. And I put the labels in Comic Sans to remind you that this was about as close as your Econ professor ever got to having a sense of whimsy. I know, it was bad.

But the point is that if you’re in RM, you are given the quantity and you just have to get the highest fares you can. In Network, you determine where to set the quantity. If demand increases, as it has since the depths of the pandemic, then fares go up. And if you cut capacity, fares go up since there are more people fighting for fewer seats. At the same time, if you add capacity, fares go down.

I make this all sound simple, and it’s not at all. But the basic concept is simple. That means the question is not “will fares rise?” They will rise if they can, and they’ve been doing a fair bit of that lately since demand has been so strong. The question is… what will airlines do with capacity? Capacity is the lever airlines can use to try to juice fares up if costs get too high.

The J.P. Morgan Industrials Conference was this week, and plenty of airlines talked about their plans and what they were seeing. And what they are seeing is roaring demand. The problem is that they don’t know if they can make money off that demand since oil is bouncing around like a ping pong ball. So they have to make some decisions and run with it.

Several airlines have said they’ll moderate their capacity this summer in the face of uncertain oil. Any capacity reduction will lead fares to be higher than they were at the previous level. This, of course, doesn’t mean that one flight you want will see fares change. That’s the problem with thinking about “will fares rise?” — it’s always a general trend, and when people ask if fares rise, they have specifics in mind.

So, will they rise? They sure will thanks to strong demand. But oil alone isn’t going to move the needle unless capacity drops… if it does, that means the airline wasn’t doing its job right in the first place.

39 comments on “Yes Fares Will Rise, But Only if Demand Grows or Capacity Falls

  1. Cranky – you have the supply and demand curves backwards – demand curves slope down (buy more at a lower price) and the supply curve slopes up (produce more at a higher price).

      1. > Remember the part before you fell asleep where they had the two crossing lines?

        Apparently you fell asleep before they covered it :)

  2. I think your econ 101 curve is messed up. As price goes up, demand decreases and supply increases. Your curve has it the other way.

  3. Your curves are backwards. The issue here is that the US airline industry is seeing strong demand, but the majority of it, an overwhelming majority of it, is leisure travel, not business travel, which remains very much a small percentage of overall ticket sales. The industry is staring down high fuel prices, muted premium demand, and at some point, it will have no choice but to cut capacity as a trigger for higher fares.

    Another wave of consolidation is coming and the Federal Government, regardless of which party is the dominant one, will likely look the other way, since it won’t want to dole out billions to prop up the industry again. AS, B6, WN, will each melt into one of the big 3.

    1. Maybe for the smaller guys, but WN has $10 billion in equity and reasonably healthy profit margin even in ’20. Come on. . .

      1. WN has little growth prospects. Its network is mature. Operational integrity is iffy. They will be acquired by Delta or UA in the next 3-5 years.

        1. Personally, I think it is more likely that WN buys a bunch of wide bodies and starts routes over large bodies of water to other continents than becoming an acquisition target for UA etc.

        2. Not very likely. In the first place, the US Government is probably not going to let that happen, and see competition in the market reduced, especially with the current administration. If you were talking about a merger between one of the top 4, of which DL, UA, and WN are all part of, and one of the smaller US Regionals…… maybe, very small chance a merger would get approved. Again, it depends on how much competition in the market is eroded. JetBlue and American are now facing that pressure just on an alliance – not even a merger.
          Also, WN is not likely to think of itself as an acquisition / merger target, and will likely be a much larger, more robust airline. It would be very difficult for one of the other top-4 airlines to take on this type of acquisition.
          Your comment about growth prospects is way off – there are a huge amount of North American cities that they have not touched down in yet – Alaska, Canada, more of Mexico, the Caribbean, and Central America. And, with the 737MAX, they are able to go to S. America and Europe.
          Mature network – perhaps part of it. But, the 737MAX opens up entirely new continents / countries / destination cities for them. It would be a very exciting time to be working in WN’s network planning department!

    2. WN won’t merge with or acquire anyone – short of a flat-out depression there’s no way DOJ could sign off on a merger with a Network Three carrier – their domestic share is simply too big – and I can’t see that much benefit to a merger with AS or B6. If they were to bid for one, it’d be Alaska, since they simply don’t have the imagination to run multiple airline types in their fleet.

      An AS-B6 merger is a possibility, or one or both being acquired by another network carrier. There’d likely be some restrictions and slots taken away at DCA, LGA, and possibly JFK.

      I think the most likely outcome is further codesharing between AA, AS, and B6. Since they can’t coordinate schedules or prices without an outright antitrust exemption (unlikely), it’ll probably take the form of AA reducing capacity on routes where there’s overlap.

      1. Craig,

        I don’t think a JetBlue/American merger wouldn’t require many divestitures in New York. All it would do is what the NEA is currently doing – level the playing field among the big three in New York City. If anything, the NEA is probably preferable to a merger because it avoids major divestitures in Boston and Florida.

        If JetBlue and American decide that a full-blown merger is better (or easier to pull off) than the NEA, The only place I can see slot concessions in New York would be to Spirit/Frontier at LaGuardia (which I think is the real rationale behind Spirit’s objections). JetBlue doesn’t have many slots at Reagan National, and American’s market share, at roughly 50%, doesn’t really constitute a “fortress hub.” In the event of a merger between American and JetBlue, I’m guessing Spirit/Frontier will probably end up with JetBlue’s current slots at Reagan, with the possible exception of its beyond perimeter slot for San Juan, Puerto Rico. Spirit/Frontier would provide the most competition to Southwest and American at DCA. In the event of a merger, I think there would be some airport gate divestitures/sales in Boston (mostly to Delta) and Fort Lauderdale (to United and/or Spirit/Frontier).

        A JetBlue merger with either United or Delta would create a massive imbalance in New York unless there are major divestitures included in the transaction, which would differ somewhat based on the merger partner. But in either case, JetBlue would probably have to divest virtually all of its slots at JFK so what real advantage is there to a merger with either United or Delta? I tend to doubt that Southwest, with its largely domestic focus, would want to massively increase its presence at JFK, so I don’t see that merger occurring.

        All of the above bloviation is to opine that a merger involving any of the major airlines probably isn’t in the cards at this point. But I could be wrong. However, a merger I could see happening at some point would be between Alaska and Hawaiian. I think those two are a natural fit. The biggest issue is what to call the merged carrier.

        1. Correction to the first sentence. it should read, “I don’t think a JetBlue/American merger ***would*** require many divestitures in New York.” Not ***wouldn’t*** as I wrote. That’s what I get for rewriting the sentence.

        2. I’ve thought that a B6/AA merger has been all but inevitable for years because it was the only way for AA to become a serious player in NYC again. but now that they have the alliance I’m not so sure it’s needed, if B6 doesn’t become someone else’s acquisition target. Would it be possible for AA to purchase a “golden share” of B6, similar to what NW had done with CO back in the 90’s? If they were able to purchase a “golden share” they wouldn’t have a majority ownership stake, so there would be little to no scope issues. B6 would be happy to stay independent and secure from takeover.

          1. Two parties can agree to do virtually anything as long as what they agree to do is legal. But I don’t think anything like a golden share is necessary in the case of JetBlue and American. JetBlue is a relatively large airline (close in size to the combined Spirit and Frontier) serving important markets with a unique offering. I really don’t think it has to merge or be bought out to stay viable. The same is true of Alaska and Hawaiian (even though I wrote they’d be good merger partners). In any merger or other combination between entities, there are always ways to work out the issues that need to be worked out, including scope.

        3. @DesertGhost – I agree with all of that, except I think the Feds will probably look for a few slot divestures at DCA, either for FronSpirit or a new entrant (Avelo or Breeze), just for appearances if nothing else. If they do, the divestures will be minimal. I do think something along the lines of an expanded NEA is more likely than a merger between B6 and AA.

          I do think Alaska is going to come into play here somewhere, most likely with an expanded NEA-style partnership with AA. Right now they’re in the same space as JetBlue, strong on one coast with spokes cast to the other, while AnimalSpirit has a truly national presence.

          As for Hawaiian, an Alaska-Hawaiian merger would be interesting, to say the least. They might elect to run two brands, or come up with a a different name for the common operation (Pacific-something) and keep the Alaska and Hawaiian names for the intrastate services.

          1. Graig,

            My original comment mentioned DCA slot divestitures as a likely condition of a JetBlue/American merger. I believe they would come from JetBlue which has nine pairs at DCA (which were acquired as a result of the American/US Airways merger). A large percentage of American’s slots are of the “commuter” variety, which ULCCs can’t use (but would entail scope issues). American and JetBlue have already agreed to lease some of their DCA slots to other airlines as part of the NEA. Frontier already has three beyond perimeter slots to Denver, so JetBlue’s eight (without the San Juan slot pair) would allow Frontier/Spirit to operate 11 flights per day. I’m not sure the DOJ would award valuable DCA slots to a start-up airline when it can accomplish its ends by awarding them to established carriers.

    3. Unfortunately your comment is wrong on several fronts. Business travel has recently surpassed 70% recovery rates. Also premium demand, especially fueled by leisure travelers, is currently nearing record highs…. you might want to check you assumptions before you post

  4. And yet YQ for the 3 transatlantic joint businesses went up on 16MAR; $50.00 in economy RT, $200.00 in business RT. OK, the base fare stayed the same – but the YQ did not.

    1. You’re right JAXBA. I’ve worked in RM at a big European airline for a couple of years on the intercontinental scope. Last time the Brent Crude was trending towards $100, there was actually quite some pressure from the top on RM to see if we could ‘move the market in the right direction to cover the incurring costs’. It’s sort a game of ‘who blinks first’ between the 3 alliances. Which means that you try to increase YQ across the board on a particular scope, sometimes have cutouts for the base fare, and if the market doesn’t move along you walk back on it and wait until someone else moves.

      It’s true that such sort of thing wouldn’t work under ‘normal circumstances’ and the dynamics described in this article are at play. But when the oil price starts to exceed $80 per barrel, markets start to move, and that in a somewhat unpredictable way, since everyone is at different levels of oil hedging etc. However I’m totally unaware of what the dynamics are for the domestic U.S. market.

  5. I had a great Econ professor (clearly better than CF’s), Nancy Kimmelman. She brought French cheese to class for everyone to try.

  6. Should the last line of paragraph 7 read “to increase fares” not reduce?

      1. Happy to help! Apparently you have hundreds of editors, I mean readers, willing to lend a hand when necessary.

        While this is probably the exception that proves the rule, the inimitable Dr David Denslow, distinguished service professor of economics at the University of Florida, was one of the most entertaining professors I ever had! He enjoyed it so much and was so engaging, he taught the intro to macroeconomics course for decades despite being a tenured professor (very rare at a school the size of UF) and oft-quoted researcher and expert in Florida economics.

        1. My intro to microecon in undergrad was a very boring professor in a giant lecture hall. I hated it so much. But by the time I got to business school, I had some pretty spectacular professors for econ and it was fascinating. It’s amazing how much a bad professor can push you in the wrong direction.

  7. this is when State Run airlines in the Arab petroleum states get to (a) fill their coffers with cashh…. jet fuel at production costs and ticket prices at market rates, although they could (b) lower the prices and increase volume.. killing the competition.. what do you think will they do a) or b)

      1. If the ME3 are getting fuel at their home airports at heavily subsidized rates, I’d be curious to see the cost/benefit models that they use to determine how much “extra” fuel to carry.

        You have to assume that they are doing the math and carrying extra fuel (when max weight and fuel tank size permit) if the savings from buying less fuel away from home outweigh the costs added fuel burn from pushing that extra weight/fuel through the air.

  8. “if you’re in RM, you are given the quantity and you just have to get the highest fares you can” AKA tell the algorithm to expect more volume of demand or higher willingness to pay, guessing at where that downward-sloping curve is. RM was so much fun if only because you were purely forecasting (aka pricing) to demand, not cost. SHARES has a breakeven load factor, always thought that was hilarious since RM couldn’t do anything with capacity and there’s a fundamental tradeoff between price and demand.

  9. Another good column. Especially the “costs don’t matter to RM” part. I think that is generally true across the industry. Nevertheless, cost containment across ALL departments is key to solvency. Cost containment across the Company advantages RM, especially in a dog fight. To that extent, fare-setting can be both offensive and defensive, regardless of the vagaries of oil, geopolitics, or contagion.

    Some posters have mentioned more industry consolidation. What will trigger that is Open Skies. Everyone will be in play. The bigger the domestic network, the more attractive an airline will be under a full Open Skies scenario. Atlanta, Dallas, Chicago, Seattle and New York will be the (cash) bag drop points for the couriers from London, Amsterdam, Frankfurt, Dubai and Sydney. The undervalued sector for the buyers will be the ULCC space. The merged Frontier/Spirit has that arena nearly all to themselves with hundreds of aircraft on order and an unobstructed runway ahead. Open Skies nearly became reality a few years ago. The energy for it has not dissipated.

  10. Interesting situation in Ireland where some poorly informed politicians have started to complain that Ryanair has started to raise fares for refugees trying to escape Ukraine, via Poland. Of course MOL denied it in his usual colorful fashion, but it’s disturbing to see politicians simply jumping on the bandwagon and beating the drum – simply to gain support, without any reference to the principles outlined so well in Cranky’s column.
    Lá Fhéile Pádraig sona duit! (Happy St Patrick’s Day to all!)

  11. I think there is an overlooked game theory aspect here. It’s basic prisoner’s dilemma. When the external shock hits everyone the same it’s a lot easier to get fares increased across the entire industry than without that shock.

  12. This is obviously a question from somebody who never worked in this industry but why aren’t RM and network planning more connected? These don’t seem like disparate functions that should be so disconnected.

    1. Bill – They do work together. I mean, RM will work with Network to figure out the fare environment and set plans. In my limited experience, some teams work better together than others. I remember network having little interest in what RM said at one of my jobs, but that wasn’t the case elsewhere. It’s really a matter of how the top leadership gets them to come together. Ultimately though, they do have separate jobs. Working together makes it easier to do those jobs, but they are definitely separate departments.

      1. Thanks, very interesting. And so true, a good/bad professor can make all the difference in the world!

  13. I would expect some capacity discipline as a result of higher oil prices and pilot shortages. This will raise fares. All airlines are struggling to hire and retain pilots, especially in the regionals.

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