Profit Margins in U.S. Domestic Airline Routes
One sentence summary: Profit margins in U.S. domestic airline routes have an average of about 13.3% across routes, with a range between 2.7% and 42.9%.
The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Transport Policy.
This paper estimates profit margins in the U.S. airline industry at the domestic route level. The dynamic estimation methodology used not only is robust to any simultaneity/endogeneity bias by construction but also results in profit margin estimates that are highly consistent with actual profit data from the U.S. airline industry. Estimated annual profit margins have an average of about 13.3%, with a range between 2.7% and 42.9% across routes. A cross-route analysis further suggests that annual profit margins increase with the market share of the largest airline serving the route, whereas they decrease with airfare. Important policy suggestions follow.
Non-technical Summary
One-way airfare between Seattle, WA and Yakima, WA is about $103, while it is about $402 between New York City, NY and Monterey, CA. Although these airfares might have been determined by several market conditions, which of these routes have higher profit margins? Answering this question is important not only for this particular route but also for any other one, because consumer welfare and thus optimal policy against excessive usage of market power by airlines highly depend on the answer. Airlines also manage their fleet and determine their investment plans to expand or shrink their facilities based on this critical information; moreover, even airplane designs are achieved based on these details.
This paper estimates profit margins for individual domestic routes within the U.S. by using quarterly data between 2000 and 2017. The estimation is achieved by using implications of the well-known Lerner markup rule in a structural vector autoregression (SVAR) model. This corresponds to estimating the inverse price elasticity of demand for each route in a dynamic framework as it represents the profit margin in the Lerner markup rule. The estimation of profit margins is achieved by using the textbook definition of the inverse price elasticity of demand, which is the percentage change in airfare divided by the percentage change in the number of passengers. Since profit maximization is achieved by choosing the number of passengers according to the Lerner markup rule, in the context of the SVAR model, profit margins are estimated as the cumulative response of airfares divided by the cumulative response of passenger numbers, both following a shock on the number of passengers after controlling for changes in airline costs. Such an approach not only is robust to any simultaneity/endogeneity bias by construction (due to allowing for changes in both airfare and passenger numbers, following a structural shock) but also results in continuous profit margin estimates.
Estimation results suggest that annual profit margins have an average of about 13.3% across routes, with a range between 2.7% and 42.9%. The average estimates (across routes) are highly similar to those implied by actual profit data obtained from the U.S. domestic airline industry, supporting our results. When variation across routes is further investigated, it is shown that annual profit margins can be explained by lower airfares, lower distance or higher airline market shares.
Going back to the question asked at the beginning of this paper, it turns out that the route between Seattle, WA and Yakima, WA with an average airfare of $103 has experienced annual profit margins of about 22.1%, while the route between New York City, NY and Monterey, CA with an average airfare of $402 has experienced annual profit margins of about 9.9%. Therefore, the higher airfare (with a distance of 2,596 miles) has experienced profit margins less than half of those experienced by the lower airfare (with a distance of only 103 miles), suggesting that consumer welfare has been higher with the higher airfare (or the longer distance). This result is not specific to this particular route; it has been shown by considering all routes that doubling airfare (distance) across routes results in about 1.4% (0.9%) lower annual profit margins.
Other market characteristics have also played important roles; e.g., doubling the market share of the largest airline results in about 3.1% higher annual profit margins. It is implied regarding consumer welfare that consumers benefit more from U.S. domestic routes with higher airfares, longer distances or lower airline market shares. Regarding airline profits, it is implied that there are higher annual profit opportunities in routes with lower airfares, higher airline market shares or shorter distances.
City characteristics have also shown to be important determinants of profit margins, where cities such as Albany, GA or Atlantic City, NJ are the cities with lowest profit margins, whereas cities such as Redding, CA or Panama City, FL are those with highest profit margins, on average across routes.
Regarding consumer welfare, it is implied that consumer benefit more from U.S. domestic routes with higher airfares, longer distances or lower airline market shares. Regarding airline profits, it is implied that there are higher quarterly profit opportunities in routes with lower airfares, higher airline market shares or shorter distances.
One-way airfare between Seattle, WA and Yakima, WA is about $103, while it is about $402 between New York City, NY and Monterey, CA. Although these airfares might have been determined by several market conditions, which of these routes have higher profit margins? Answering this question is important not only for this particular route but also for any other one, because consumer welfare and thus optimal policy against excessive usage of market power by airlines highly depend on the answer. Airlines also manage their fleet and determine their investment plans to expand or shrink their facilities based on this critical information; moreover, even airplane designs are achieved based on these details.
This paper estimates profit margins for individual domestic routes within the U.S. by using quarterly data between 2000 and 2017. The estimation is achieved by using implications of the well-known Lerner markup rule in a structural vector autoregression (SVAR) model. This corresponds to estimating the inverse price elasticity of demand for each route in a dynamic framework as it represents the profit margin in the Lerner markup rule. The estimation of profit margins is achieved by using the textbook definition of the inverse price elasticity of demand, which is the percentage change in airfare divided by the percentage change in the number of passengers. Since profit maximization is achieved by choosing the number of passengers according to the Lerner markup rule, in the context of the SVAR model, profit margins are estimated as the cumulative response of airfares divided by the cumulative response of passenger numbers, both following a shock on the number of passengers after controlling for changes in airline costs. Such an approach not only is robust to any simultaneity/endogeneity bias by construction (due to allowing for changes in both airfare and passenger numbers, following a structural shock) but also results in continuous profit margin estimates.
Estimation results suggest that annual profit margins have an average of about 13.3% across routes, with a range between 2.7% and 42.9%. The average estimates (across routes) are highly similar to those implied by actual profit data obtained from the U.S. domestic airline industry, supporting our results. When variation across routes is further investigated, it is shown that annual profit margins can be explained by lower airfares, lower distance or higher airline market shares.
Going back to the question asked at the beginning of this paper, it turns out that the route between Seattle, WA and Yakima, WA with an average airfare of $103 has experienced annual profit margins of about 22.1%, while the route between New York City, NY and Monterey, CA with an average airfare of $402 has experienced annual profit margins of about 9.9%. Therefore, the higher airfare (with a distance of 2,596 miles) has experienced profit margins less than half of those experienced by the lower airfare (with a distance of only 103 miles), suggesting that consumer welfare has been higher with the higher airfare (or the longer distance). This result is not specific to this particular route; it has been shown by considering all routes that doubling airfare (distance) across routes results in about 1.4% (0.9%) lower annual profit margins.
Other market characteristics have also played important roles; e.g., doubling the market share of the largest airline results in about 3.1% higher annual profit margins. It is implied regarding consumer welfare that consumers benefit more from U.S. domestic routes with higher airfares, longer distances or lower airline market shares. Regarding airline profits, it is implied that there are higher annual profit opportunities in routes with lower airfares, higher airline market shares or shorter distances.
City characteristics have also shown to be important determinants of profit margins, where cities such as Albany, GA or Atlantic City, NJ are the cities with lowest profit margins, whereas cities such as Redding, CA or Panama City, FL are those with highest profit margins, on average across routes.
Regarding consumer welfare, it is implied that consumer benefit more from U.S. domestic routes with higher airfares, longer distances or lower airline market shares. Regarding airline profits, it is implied that there are higher quarterly profit opportunities in routes with lower airfares, higher airline market shares or shorter distances.
The corresponding academic paper by Hakan Yilmazkuday has been accepted for publication at Transport Policy.
The working paper version is available here.