Summer is here, and this season’s travel is in an advanced planning stage if not already underway. I used to travel from New York to Amman, Jordan, and vice versa for my annual vacation almost every year. Now I cannot do that, and I have to spend some summers in Philadelphia away from my other family. For many years I paid $950 for this annual international round trip, but now I cannot travel every year because I cannot afford the cost of the trip. In the last few years, the fares have increased by more than 40 percent. The same flight now costs $1,400.
As an economist, I thought about the reasons behind this hefty increase in fares, which really has changed what I do with a long summer vacation granted to a university professor. I came up with several fundamental reasons. The first one has to do with the oil market, which affects the price of jet fuel used to fuel airplanes. The price of West Texas Intermediate oil ranged between $60 and $70 per barrel for several years, but the price has recently accelerated and is now about $97 per barrel. The sky-high cost of jet fuel in any given flight is about 35 percent of the total operating cost of that flight in 2013, rising from 10 percent in 2001. The jet fuel cost remains around record prices of more than $3 per gallon. Obviously, the more expensive jet fuel has helped to jack up the fares. Airlines are looking for a less expensive alternative, placing their hopes on the nascent biofuel industry.
Another reason has to do with the nature of the market power inherited in an oligopoly. Students in ECON 101 know that the market structure of the airline industry is an oligopoly with a differentiated product. The oligopoly itself is known for having high market concentration in its industry, a characteristic that gives it the market power to set the price much higher than the marginal cost of each passenger on the flight. Additionally, the service or the product that the airline industry provides is highly differentiated whether in terms of the size and location of the seats, the timeliness of departures and arrivals, and the food service given on the flight. You may add to these differentiating factors the friendliness of the flight attendants. This differentiation creates passenger loyalty to specific airlines, which gives these companies more market power to increase the fares above the marginal cost per passenger.
But the most potent force behind the fare increase is the destruction of capacity that is manifested in reducing the number of flights going to the same destination. Airlines have lopped off large chunks of their operations to buttress their fares. This is more obvious in U.S. domestic capacity than in international capacity. A solid example of a significant decline in international capacity is India, which has experienced a cut in capacity every year from 2009 to 2013.
The industry cancels flights that are not well paid and transfers the passengers to other flights with more passengers to make full flights. You can see the realization of this phenomenon in full flights regardless of whether you travel in winter or summer. Here, passengers have to accept the higher prices when they look for seats on the tight space on the planes. Killing capacities by airlines means higher concentration in this industry, which translates into greater market power and prices much higher than marginal costs. You add to the culled capacity the alliance between the individual airlines. While there are some advantages to having alliances in this industry, an alliance is a coordination that amounts to a soft merger in an oligopolistic industry characterized by high concentration and market power. In many cases, mergers are anti-competitive and can lead to higher prices. The government can block anti-competitive mergers but cannot block alliances.
To have lower or more reasonable airline fares, we need a reversal in those forces that have contributed to the higher fares. We need lower oil prices, increases in capacity and looser alliances. I do not see any reversal in the near future, given the fact that the economy is growing. In fact, if the low growth in the economy accelerates into strong growth, we will see a shortage in capacity, with much higher fares than what we have now. Fasten your seat belt tightly.
Shawkwat Hammoudeh is a professor of economics at Drexel University. He can be contacted at [email protected]