So I have been involving in writing a mock business case on United for a class, and one of my theories for United's problem is the various disadvantages legacy airlines share. My eventual solution proposal will be to subsidize airline industry and reverse the deregulation. Airlines simply bear too much burdens that are out of their controls while provide essential services for public welfare.

I would like to share my thought with you, invite you to pick apart my theory and hear some feedbacks from the collected wisdom of FlyerTalk.

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The deregulation of US airlines industry opened up the floodgate of competition that ultimately undermined the profitability of legacy carrier. While deregulation provided some airlines such as Southwest opportunity to capture a large market share, legacy carriers became victims of their existing business model and route structure, failing new entrants that trigger price war, and an industry that favors airlines serving only limited number of cities.

Business Model

Legacy carriers such as United Airlines and American Airlines have long history of providing air travel for American people. Over time, air transportation has become similar to electricity or postal system, their services become necessities our economy depends upon. Cities large and small need air transportation and expect the comprehensive services of legacy carriers to connect people with the world. It is in this capacity United, like other legacy carriers, serves the majority of small cities where low-cost airlines such as JetBlue and Southwest are absent.

Serving small cities is not as lucrative as serving large cities. Fewer population and smaller planes go against economic of scale and are more prone to market fluctuation. Unlike large cities with diversified customer base that provides a steady and predictable revenue stream, it is difficult to maximize profit from small cities where customer bases often come from limited sources. For example, academic schedule might play a large part of seasonal demand in a small college town. Unpredictable special event might easily exceed the limited capacity to/from a small city. Both of these predictable cyclic change and unpredictable peak are threats very difficult for airlines to mitigate in small cities, due to small capacities and limited scheduled flights.

Although flights between small cities to hubs are not as profitable (see “Route Structure” below), legacy carriers continue to serve them because of the aforementioned necessity. Furthermore, even if carrying passengers from small cities to a hub is not as profitable, legacy carriers make profit on these passengers when transporting them onto their more profitable connecting flights between major destinations. In addition, several legacy carriers usually serve the same small city. When one legacy career exits the small city market, the airline loses both revenue and market share of lucrative hub-to-hub flights to competitors. In conclusion, legacy carriers are locked in to their existing business model of providing comprehensive nationwide services.

Route Structure

The fastest and cheapest way to transport passengers between a very small number of cities is to have direct flights between every city pair and fill each flight full of passengers. As the number of cities served increases, the number of flights needed for this direct route structure becomes prohibitively large. For example, 55 unique routes are required to serve 10 cities while 4960 unique routes are needed to serve 100 cities! To efficiently serve a large number of cities therefore, an airline must adopt the star-and-spoke route structure. Although the star-and-spoke structure costs more flight time, consumes more fuel, and is more vulnerable to delay, this system allows scalability and sustainability for legacy carriers such as United due to their large amount of destinations.

The star-and-spoke system however leaves room for new airlines to enter the market by serving only a few city pairs. Since these new entrants only need to operate direct flights and have the option to find the most profitable city pairs, startup airlines have both lower operating cost and higher gross margin. In responding to new entrants, legacy airlines that already operated on these routes often have to engage in a price war and become unprofitable on those routes (see “Price War” below). To make the matter worse, these new routes startups choose are often the most profitable routes that legacy carriers fly to offset their other unprofitable routes (i.e. small cities flights as mentioned in “Business Model”). By lowering the profit margin on their most profitable routes, legacy carriers continue to lose money on their unprofitable routes, and thus fall deeper into the red. Even if a price war successfully drives new entrant into bankruptcy, another new airline could start up quickly and continue to levy a toll on the legacy carriers. Each bankruptcy of a startup thus reflects the financial loss the surviving carriers have also gone through.

Price War

As mentioned before, new entrants often disrupt and bring down the existing market with their financially unsound business model by triggering a price war. SkyBus for example, like most startups, was heavily leveraged and only hoping to turn profitable after a period of time. This yearning to quickly develop market share and the ability to withstand initial loss allowed it to sell cheap tickets below cost. When consumers flocked to its $10 per flight offer, SkyBus and its competitors at existing market both lose revenue.

One might think in a price war, there is only one winner—the consumers. This however is not necessarily true. When airlines engage in price war, they often sacrifice quality of service and safety to cut down cost. Equipments break down more frequently which results in cancellation and delay. As the industry races to the bottom, unpleasant experiences with customer services become the norm. Furthermore, when SkyBus went bankrupt, tens of thousands of customers were stranded in airports and more lost their tickets.

Revenue Comes From Business Travelers

The primary reason SkyBus went bankrupt and abruptly ceased operations is a sobering lesson for any airline searching its market. The rising crude oil price and the economic downturn are two announced reasons for its insolvency, but in reality they correlate to the unprofitable market segment—the budget consumers.

Due to its non-existent customer service and bus-like in-flight experience, SkyBus market segment represents the lowest income air travelers, family with many children and people who care no other criteria than price. These people are in fact the most elastic consumers—travelers with the lowest marginal benefit and the highest opportunity cost. In other words, in an economic downturn, when the demand decreases, they are the first group of consumers to stop flying.

In fact, Southwest and JetBlue have established their market leadership not only for their low-cost, but their affinity with business travelers. Southwest allows its customers to change their travel plan at any time with no penalty, and provides 100% refund of all tickets in credit form. Furthermore, Southwest schedules frequent flights throughout the day to allow people missing earlier flights to catch a later one.

Economy Plus Attracts Business Travelers for United

United has enjoyed strong loyalty from business travelers from corporate and government contract, and most importantly, its Economy Plus seating. Economy Plus is not a traditional premium economy cabin found on many foreign airlines, but several rows of seats in the front of the regular economy cabin that simply have five inch extra legroom. Without any other enhancement, these rows with extra legroom reserved for United’s frequent flyers mean a lot for business travelers. From a recent survey, Economy Plus is unanimously the top reason United frequent flyers are not willing to switch airlines amidst decline in customer services. Once a frequent flyers are “spoiled” with the extra legroom, it is very hard to go back to the cramped 31 inch seat pitch on other airlines.

Price Discrimination

Airline operation carries high fixed cost, low variable cost and a limited number of seats for sale. Thus, it is in the best interest for United to fill its planes to capacity. To do so, United could charge each passenger a flat rate based on the current demand of the market (light travel season or holiday). The total revenue generated from this single fare-for-all method, however, leaves too much economic surplus for consumers. Airlines have to find a way to price discriminate passengers in order to charge the maximum price (marginal benefit) each passenger is willing to pay. This need of price discrimination is the reason for a highly complex fare structure.

Price discrimination comes in several forms for United: Cabin class, fare class, upgrade instruments and redeemable miles (RDM).

Cabin class: Tickets for premium cabins—United First and United Business—cost more than United Economy, and often carry higher profit margin. For comparison, the cheapest Economy cabin fare a two-cabin transcontinental flight from San Francisco to Newark New Jersey is roughly $410, while the cheapest fare in the United First cabin is over $1600.

Fare class: Within each cabin there exists more than one fare level. These fare levels come with different types of restriction. More restrictions apply to cheaper fares while full fare tickets carry no restriction. For example, the Y fare is a fully refundable and changeable full fare for Economy Class. Cheaper H and M fares are changeable, but not fully refundable. Much cheaper fares that most consumers usually pay for are S, T and L fares. These heavily discounted fares come with many restrictions such as requiring a Saturday night stay and advanced booking. They are also nonrefundable and non-changeable. By charging people who desire greater flexibility or business travelers who have to return home during weekend (thus the absence of a Saturday night stay) higher fee, airlines could successfully identify customers with highest marginal benefit.

Upgrade instrument and RDM: United Airlines operates an industry leading loyalty program called the Mileage Plus (more on this later). Customer accrued miles and upgrade certificates from flying and spending on United. Similar to coupon, these incentives provide customers who cannot afford premium class travel a way to sometimes receive the benefit of premium class traveling by paying a subsidized fee. For example, instead of buying the cheapest business class ticket to Asia for $4500 or the cheapest Economy class ticket for $1000, a Mileage Plus member could use 30,000 of his or her accrued miles to upgrade one way to Business Class cabin by buying a higher Economy fare for $2000 that is eligible for upgrade. (Most fare classes are not eligible for such kind of upgrade.)