The airline industry has been subject of intense p

rice competition since itwas deregulated, and the result has been a number of new carriers which
specialize in regional service and no-frills operations. These carriers
typically purchase older aircraft and often operate outside the
industry-wide computerized reservations system. In exchange for these
inconveniences, passengers receive low fares relative to the industry as a
whole.

This research examines two low fare air carriers, ValuJet and
Southwest Airlines. By investigating these air carriers, we can better
understand the economic impacts of price versus service in the airline
industry as a whole, as well as, the impacts on passenger and investor
confidence.Until 1978, air transport rates were approved by the
government, which meant that price was not a primary competitive factor.Instead, airlines would compete on service and image.

The airline
industry was dominated by giants (American, United, TWA) which offered
nationwide and some international service, and by regional carriers, such
as Southwest, which offered short trips between airports not served by the
nationals. Deregulation of the airline industry brought about in 1978
introduced a situation in which the national and regional carriers were
suddenly able to compete in an environment that resembled a free market.Rate schedules were lifted, price fixing was eliminated and route
management was removed. The main factors that affected whether an airline
could serve a particular city was whether or not that city had enough
gates for the new carrier, and whether the carrier was able to afford to
purchase them.

Companies such as Southwest recognized potential for low
fares, and began building a niche for themselves by offering low fares
with equivalent low levels of service. Southwest's success gave rise to a
new generation of low fare airlines, with ValuJet entering the market in
the early 1990's. Unfortunately, ValuJet suffered a string of accidents
which brought the future of this air carrier into question. ValuJet is a
low-priced airline that offers inexpensive tickets for regional travel.Based in Atlanta, the airline serves the Southeastern United States and
competes with Continental Airlines as well as with other small regional
carriers. It serves 31 cities primarily in the southeastern United
States.

The airline began its service with flights to Tampa and Orlando
from Atlanta in 1993. The no-frills strategy paid off for the fledgling
airline, which posted half again as many revenue passenger miles in April
1996 as it did in April 1995. However, the company announced that it was
slowing the expansion of its services, voluntarily, at the same time that
it posted this impressive revenue mark (Cole & Pasztor, 1996, p. A6).Perhaps due to overexpansion or to poor luck, Valujet experienced a series
of mishaps in its short history.

In January 1994, a DC-9 skidded off a
runway in Washington which resulted in the entire airport being shut down.In June 1995, a ValuJet flight went through an emergency evacuation after
an engine failed and shrapnel flew into the cabin. Additional incidents,
including one where the landing gear collapsed after a particularly
forceful landing, led the FAA to begin an intense review of ValuJet in
February 1996. This review found that ValuJet was in compliance with FAA
regulations, but cited concern about pilot training and aircraft
maintenance (Larson, 1996, p.

30). In May 1996, Valujet flight 592 crashed
in the Everglades, killing all aboard and resulting in a shutdown of the
carrier for several months. When ValuJet began flying again, it did so
with a reduced schedule, and considerable speculation about whether the
company will be able to continue operations long-term. The company is
also involved in litigation resulting from the crash, and the long-term
prospects for the company are questionable. The following chart
identifies key operating statistics for Southwest (seat miles are in
millions, cost factors are in cents) (Shammas, 1996, p. 5541P):
1995 1994 1993 Revenue Passenger Miles (RPM)2,624941
44 Available
Seat Miles (ASM) 3,813 1,471 63 Load Factor 68.

8 %64.0 %69.7 %
Revenue
per RPM13.4 13.8 13.1 Cost per ASM6.

86.89.8Because
Southwest's
flights are generally an hour or less in length, the airline saves money
by not having to serve meals. It has a liberal work rule arrangement with
its unions, so productivity is high, and overall costs are low. For
example, Southwest gets 672 hours per year on average from pilots versus
371 for American Airlines pilots, and 60 percent more passenger miles per
flight attendant (Levinson, 1993, p.

34). These figures enable the
company to realize profits during years in which the industry as a whole
was suffering. The following chart identifies key operating statistics
for Southwest (seat miles are in billions, cost factors are in cents)
(Klein, 1996, p. 2077):1995 1994 1993 Revenue Passenger Miles
(RPM) 23.

33 21.6118.83 Available Seat Miles (ASM) 36.1832.

12
27.51
Revenue per RPM 11.83 11.56 11.77 Cost per ASM7.

07 7.08 7.25
In
addition, the company has a 70 percent average load factor in an industry
that averages 63 percent, and operating costs per passenger mile are 22
percent less than industry average. It has one of the youngest fleets in
the industry (6.9 years compared with an industry average of 12.9 in
1992), and the best on-time and baggage handling records in 1992 (Gold,
1993, p.

29). Each of these factors contributes to the company's
financial and marketing success. Southwest's success has come about
because it is providing a product that the market wants, no-frills
regional air travel, at a price that is attractive. Despite its no-frills
orientation, the company maintains strong customer service satisfaction
and high levels of customer service, encouraging repeat business.

When
the airline enters a new market, such as Baltimore, its fares are as much
as 85 percent less than those of its higher-priced competitors, attracting
passengers quickly and forcing the competition to either match the price
or lose market share. In its target markets, Southwest has positioned
itself to even compete favorably with traveling by car (Thorpe, 1996, p.262).Southwest's success has not been without problem, and the company
has again demonstrated an ability to find creative solutions to those
problems. For example, the company has traditionally expanded its 737
fleet by adding older aircraft available at discounts (sometimes as much
as 30 percent) (Kripanlani, 1992, p. 20).

Since the company's ability to
enter new markets is determined in part by the size of its fleet, and
since the company is committed to staying with homogenous fleet of 737s,
it runs the risk of ending up with a large number of older aircraft that
it no longer needed (depending on the market), or that do not meet new
environmental standards. Southwest solved this problem by beginning a
lease-back program in 1988. Under the program, Southwest sells some of
its older 737s, then leases them back for its own use. As of the
beginning of 1992, the company had done this with more than half of the
Boeing 737-200 aircraft that it operated (Brown, 1992, p.57). This
program enables the company to release aircraft that it no longer needs or
that no longer meet the stringent new environmental standards.

At the
same time, the company can modify its remaining 737-200s in order to make
them compatible with noise and pollution regulations if it needs the
capacity. The company's stock has split three times since 1990, and its
price-earnings ratio is a healthy 13.1 percent. Its load factor is well
within the industry norm of 67 percent (Sanborn, 1996, p. 251), and the
company's commitment low fares and its safety record should help it
maintain good performance even in light of the ValuJet crash (which
brought increased attention to all low fare carriers).

The crash of
Flight 592 has brought increased scrutiny to ValuJet (and to low-fare
carriers in general), and the long-term effect on ValuJet is not yet
known. The stock, which had two, two-for-one splits in 1995 and which
peaked at more than 30 dollars per share in late 1995, has plummeted to
below 12 dollars per share in late 1996. Investors with high tolerance of
risk might consider the stock at this low level, and the company might be
a takeover target in the future as other carriers seek its routes.However, the company's aging aircraft fleet would not be an asset to most
carriers, and it is unclear whether stockholders would realize a
reasonable profit, even at today's low prices. The outlook for Southwest
is considerably brighter than for ValuJet. The company has one of the
highest safety records in the industry, and the company has also benefited
from higher ticket prices and increased passenger traffic.

The recent
reinstatement of the federal excise tax is not expected to have a negative
effect on Southwest demand since it has indicated it will increase fares
in only 20 percent of its markets, but this will affect profitability.The company's strategy is to make up the difference of lower revenue with
increased demand through its lower fares (Thorpe, 1996, p. 262). The
airline industry has become one of the most competitive segments of our
economy.

The economic realities of operation costs versus passenger
demand for cost-effective travel has forever changed the face of the
travel industry. After deregulation in 1978, the airline industry was
forced to abandon its service-oriented philosophy and consider the
competitive pressures since they affected the various companies bottom
line. Price had suddenly become the benchmark in the airline industry.Companies such as Southwest and ValuJet recognized the potential for low
fares with commensurably low levels of service.

With the changing
paradigms in the airline industry comes risk, not only to the individual
airlines but also the public in general. At what point do the economic
pressures of making a profit for the airlines affect passenger safety? If
the trend toward more airline disasters continues and those accidents can
be attributed to cost-cutting measures, surely Congress will intervene.The airline industry must be disciplined in its approach to solving the
economic pressures, while, at the same time stay focused on safety issues.If the airline industry is to survive and give the consumer choices,
passenger confidence cannot be sacrificed for the sake of the bottom line!
Sources
Federal Reserve Bank Of San Francisco:
http://www.frbsf.org/publications/economics/letter/2002/el2002-01.html