A-La-Carte Pricing in the Airline Industry - Graduate Student ...

gallon to 298 cents per gallon: during previous years in the decade, fuel never rose more than51.9 cents per gallon from one year to another (ATA 2009). While fuel costs historically madeup 10 to 15 percent of passenger airline operating costs, in the third quarter of 2008 that figurerose to an average of 35 percent (ATA). With fuel costs mostly fixed by exogenous prices(airlines still undertook many efforts to increase fuel efficiency and eliminate unnecessary fuelburn), air carriers faced increased pressure in order to generate additional revenues to maintainprofitable.In basic economic terms, the airline industry faced two stages of shocks—first, a demandshock resulted in decreased demand for air travel, with customers willing to buy less air travel atevery possible price. Second, the rise in oil prices generated a supply shock, with airlines willingto supply a lower quantity of air travel at every possible price. Classical microeconomic theorypredicts that a perfectly competitive market would have responded with: (a) a drop in capacityand a lower price for the demand shock and (b) a drop in capacity and a higher price for thesupply shock.Industry data display trends consistent with this theoretical interpretation. Figure 2.1shows U.S. scheduled passenger airlines‘ Available Seat Miles (ASMs) and Revenue PassengerMiles (RPMs) from 1996 to 2009. A sizable drop in capacity can be seen between 2001 and 2002,and capacity remains below trend until the mid-2000s. After leveling off in 2007, capacity againappears to fall after that year. Figure 2.2 shows domestic average airfares from 1996 to 2009.Immediately following the September 11th attacks, airfares fell considerably. This low wasfollowed by a gradual increase in fares until 2008, however, when prices rose above the pre-2001point. In 2008, fares began a dramatic decline, however, likely in response to a global economicdownturn.32