Hubs, Spokes Hike Air Fares

<B> Hubs, Spokes Hike Air Fares</B>
<I>PART II: The Downside</I>

By Jay Campbell

When it comes to airline negotiations, corporate travel managers rarely face a more difficult proposition than dealing with a local hub carrier.

Exacerbated by the consolidation craze in the 1980s--which many blamed on the U.S. Department of Transportation's lax merger oversight--the hub and spoke system has facilitated the creation of a number of local monopolies around the country. This is a consequence clearly not intended by airline deregulation.

Bolstered by frequent flyer programs, local CRS dominance, yield management and travel agency overrides, fortress hubs give airlines so much leverage that they hardly have to negotiate at all with companies headquartered there.

One source said he knows of a $20 million account based in Minneapolis which has a lower discount from Northwest Airlines than a $2 million account on the West Coast, where Northwest is far less dominant.

With 65 percent of the seat capacity in Philadelphia, US Airways is that city's largest airline. Although Philadelphia is not as much a fortress as places like Charlotte, Cincinnati and Minneapolis, US Airways still takes a tough stance on discounting there. "To my knowledge, US Airways doesn't negotiate with anyone out of Philly," said John Strayer, vice president and corporate travel manager of Philadelphia-based CDI Corp., a $5.5 million a year air account. "They won't even come to the table to talk to us."

Discounts in all concentrated airports are lower, in fact, than in other airports. Using 1997 data provided by Portland, Ore.-based auditing firm Topaz International on nearly 200 companies of all sizes and Salomon Brothers' 1997 "Airline Competition at the Fifty Largest Airports" study, BTN determined that average corporate discounts at large airports are on average 11 percent lower at concentrated airports than at unconcentrated ones. Concentration is defined by the General Accounting Office as one airline having over 60 percent of enplanements or two having over 85 percent.

The average corporate discount at 14 concentrated airports was 13.33 percent, while at 17 unconcentrated airports it was 14.81 percent, a difference of 1.48 actual percentage points. While that might not sound like much, 1.48 percent of CDI Corp.'s $5 million air volume, for example, would represent over $80,000.

Seen in light of the travel industry's frenzy over a couple of points here or there of distribution costs, the 1.48 percent becomes even more significant. Last year's commission cuts, for example, amounted to two percentage points.

Not only are discounts lower at concentrated airports, but the fares they're taken off are higher. Rosenbluth International, which provided BTN with 1997 fare data using its Dakota system, reported that the average long-haul (more than 1,000 miles) cost per mile at the 14 concentrated airports was .429 cents, six cents per mile higher than at the 17 unconcentrated airports. That's a fare difference of 16 percent.

The hub premium was 21 percent higher for short-haul markets (0-500 mi.). At 9 concentrated airports, the average short-haul cost per mile was .816 cents; at 11 unconcentrated airports it was .676.

These numbers are even further exaggerated when comparing the five airports in the two categories (see chart).

These results are consistent with studies conducted by a number of groups over the years as airline deregulation unfolded and the hub and spoke system proliferated. The GAO in 1993 indicated that, based on 1991-92 data, passengers flying from concentrated airports paid 22 percent higher fares. The same study done in 1988 revealed a 21 percent premium.

The Association of American Geographers last year found a direct link between market power and fares: "An increase in a hub's enplanement share of 10 percent results in a 4.3 percent increase in fares at that hub," it said.

Further, it is business travelers who bear the brunt of the hub premium, according to two reports by Pablo Spiller, a professor at the University of California's Walter A. Haas School of Business. Spiller determined that while, "concentration at a hub does not eliminate competition in four-segment (connecting) markets, fares that are paid by business travelers increased by 31 percent from 1985 to 1993. The hub premium, a hub carrier's increase in fare over its non-hub competitors in markets where the two compete, increased from 15 percent in 1985 to 35 percent in 1993 for business passengers."

Service for Price?

As described in the first part of this series (<I>BTN</I>, Feb. 23), corporate travel managers and business travelers balance the price they pay with the service they get. Part of that equation is the vast increases in frequency that hubs provide for local, usually business, passengers.

Airlines argue that hubs cost more because of all the direct and nonstop service they provide. Indeed, GAO's "Airline Competition" study of competition at the nation's 49 largest airports found that at 14 concentrated airports, airline yields were 27.4 percent higher when GAO limited its analysis to fares on direct and non-stop (mostly business) flights.

But GAO also said: "Since travelers typically prefer nonstop and direct flights, some analysts believe that travelers may be willing to pay more for this kind of service. Our calculations, however, show that direct service has only a small effect on fares."

Some travel managers note that since other elements of coach service, such as meals, are equal--and especially since hub flyers often pay a penalty in terms of weaker on-time performance--extra frequencies may not make up for the premium.

Pamela Boies, travel coordinator for Duke Energy in Charlotte, said "maybe we'd be willing to have three flights a day instead of nine, if the price was adjusted accordingly." And Bill Thomas, vice president at Nations Bank, also in Charlotte, agreed that "there is a point where capacity is excessive, and we may be reaching that point."

Of course, neither of these travel managers would give up the availability of relatively frequent, nonstop service. But Charlotte air travel consumers, according to the GAO, are paying a whopping 70 percent premium over unconcentrated airports.

US Airways controlled 91.3 percent of the seats in Charlotte last year. Like Cincinnati, Charlotte is a hub not because of its local demand but rather because of its regional placement as a strategic connection point. Two-thirds of Charlotte's traffic is from connecting passengers.

Local passengers pay for the higher costs airlines incur by running hubs. For example, "Southwest's ground service people are twice as efficient without hubs," said airline analyst Morton Beyer of McLean, Va.

Research by the University of California's Institute of Transportation Studies on the airport economics of airline hubbing in 1984 described two ways network carriers make up for the increased airport costs: "One is to absorb the additional operating cost and recover it by raising the break-even load factor on the affected links (connections). This means a reduction in scheduled frequency on those links. The other strategy is to maintain the same break-even load factor by passing the cost directly to passengers in the form of increased airfares on the affected links. Passengers ultimately pay the penalty in both cases."

The hub premium paid by passengers is in part a "subsidy of the airline's operations in non-strength areas, but it does enable that city to have frequent service," said Kevin Iwamoto, chairman of the NBTA's airline committee and the new air and car supply manager at Hewlett-Packard in Palo Alto, Calif. "It's not fair, but that's business."

It is business, and corporate travel managers can be ruthless--but can a company realistically shift share to another carrier when a local major airline owns more than 90 percent of the market, or even a little less? Or can the corporate buyer offer segments in other non-strength markets in return for discounts at home? Many do, but there is a question as to whether they should have to.

Lawyers for Virgin Atlantic believe the fact that companies and travel agencies need to resort to such moves--providing traffic in competitve markets to avoid the possibility of no local discount--violates the Sherman Antitrust Act. "This practice has been attacked in other businesses," said David Tait, Virgin Atlantic's executive vice president of North America. "In pharmaceuticals, to get one drug, you don't have to buy the whole catalog."

Virgin has a pending lawsuit in New York charging that British Airways "has exploited its monopoly power at Heathrow to induce travel agents and corporate customers to enter sales agreements that foreclosed competition from Virgin." The U.S. District Court judge is in the midst of deciding whether the case should go to trial.

Meanwhile, travel managers deal with carriers that, said Thomas, "don't seem in the least bit interested in areas where there's no competition," he said. "They're not rewarding you on total purchases."

Pre- and Post-Deregulation Oligopoly

That a member of the travel industry would even use such a phrase as "areas where there's no competition" was completely unanticipated by the founders of airline deregulation, as, indeed, was the hub and spoke system itself.

"No one forsaw the hub and spoke system," said Rep. James Oberstar (D-Mich.), who was in his second term in Congress when the Airline Deregulation Act was ratified in 1978. "Now we have hub and spoke medicine."

According to a 1987 study by Frank Cassell and Frank Spencer, professors at the J.L. Kellogg Graduate School of Management at Northwestern University, the hub and spoke system was a "driving factor" behind the merger trend under the Reagan Administration.

"Airline deregulation and lack of enforcement of antitrust laws," said Cassell and Spencer, "have permitted the industry to reform into a privately controlled oligopoly that has replaced the 40-year-old government-regulated oligopoly that deregulation was designed to eliminate."

Cassell and Spencer's results were supported by the continuing consolidation that occured in the decade since their study. Ten carriers controlled 87 percent of the market in 1978. By 1995, eight carriers controlled 93 percent, said the Association of American Geographers.

Along the way, large airlines like Ozark, Piedmont and Republic disappeared as the Department of Transportation--which assumed oversight of mergers, acquisitions and consolidations from the Civil Aeronautics Board in 1984--approved every merger application that came its way, 20 in all. This occurred despite the Airline Deregulation Act's instructions that DOT avoid "unreasonable industry concentration" and "excessive market domination."

DOT's lax enforcement of this authority drew criticism from a slew of observers, even Alfred Kahn, the renowned father of airline deregulation. Now, DOT is battling criticism from the other side--the major airlines--as it attempts to correct some of the circumstances that led to the current environment, such as barriers to entry for new airlines.

Look for "Hub and Spoke Part III: The Future," in BTN's March 16 issue.