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Monday, May 26, 2008

Airlines and Telephone Companies

Economics 102 tells us that, in a competitive market, marginal price tends to approach marginal cost.

That is, as long as there is a single cent to be made by producing and selling an additional unit, the producer will reduce prices to sell more. But only up until the point where it is still just profitable to do so.

In most industries, there are economies of scale so costs decline as volume increases. After a certain point, for many reasons, costs no longer drop or they start to rise again. As a result the incentive to produce more declines.

There are some industries whose business models are superficially similar but where the pricing model is radically different: airlines and telephone companies come instantly to mind.

In the airline and telephone industries, the similarities are that large sums of money must be invested to be in business at all - airplanes and telephone networks are expensive - and large numbers of people must be employed for the company to be able to function at even the most minimal level.

In the telephone business, the marginal cost - for another minute of talk time - is vanishingly close to zero. For airlines, the cost of putting a passenger in an otherwise empty seat is not much more.

The major problem for these two industries is that the marginal cost of creating a unit of production (one minute of telephone talk time or one passenger flown for one mile which is the airline unit of capacity) is less than the average cost. Since price inevitably approaches marginal cost, there is now a situation where average price is less than average cost. The inevitable result is the creation of massive losses and, ultimately, a visit to the local friendly (?) bankruptcy court.

The land-line telephone companies have solved this problem by abandoning the usage pricing model and simply charging for access to the network. Mobile operators are still clinging to vestiges of "pay for use" but are close to abandoning it too. Most customers now pay a fixed monthly amount for "all you can eat" service. Since the telephone companies can calculate their costs, they can set a price that should - absent spectacular incompetence - be profitable. That works well provided that they can keep their subscribers for defecting to their competitors or to other communication methods.

The airlines have no prospect of charging for access to the network. I wouldn't pay $500 per month to fly as much as I wanted on Treetop Air. Neither would Treetop Air want to take the risk that I would fly 10,000 miles every month at a cost of around 12 cents per mile to them

So airlines are attempting to increase revenue with additional charges for checked bags, making a reservation by telephone instead of online, selling sandwiches on board etc. It makes me wonder which airline will be the first to have pay toilets on their aircraft!

These additional charges are annoying to travellers and, as a result, may not last. So truth in pricing may return - for a while.

Airlines are also cutting capacity. The idea is, following the supply-demand model that we learn in Economics 101 - that they can raise prices as seats are less available. If, however, they raise prices too much, they will generate empty seats - even with lower capacity - and the temptation to run cut rate sales just to fill the seats will become irresistible.

Filling otherwise empty seats at cut rate prices can be a profitable strategy - if only in the short term. It just doesn't last for long!

Go to Bankruptcy Court. Go directly to Bankruptcy Court. Do not Pass Go. Do not collect $200 million. (Apologies to Parker Brothers makers of the board game Monopoly (R)

Owners of telephone company stock may not make much money in the long run but they probably won't lose too much. Owners of airline stocks should remember the phrase caveat emptor (buyer beware) and consider running for the exits.

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