An Empirical Analysis of Airline Network Structure: The Effect of Hub Concentration on Airline Operating Costs David M. Short Professor Michelle P. Connolly, Faculty Advisor Professor Andrew T. Sweeting, Secondary Advisor Honors thesis submitted in partial fulfillment of the requirements for Graduation with Distinction in Economics in Trinity College of Duke University Duke University Durham, North Carolina 2013 Acknowledgments First, I would like to thank my advisor, Professor Michelle Connolly, for her invaluable guidance this past year. If it were not for her help in shaping my research question, fleshing out my theoretical model, and analyzing my results, this thesis would have never become a reality. Second, I would like to express my gratitude to Carol Hamcke-Onstwedder, who volunteered through the Duke Reader Project to assist me with my honors thesis. She read through many of my drafts on short notice and helped me better organize my paper to express my points more clearly. Finally, I would like to thank Professor Andrew Sweeting, Professor Marjorie McElroy, my peers in my honors thesis seminar, and my parents for helping me obtain data sets, acting as a sounding board, and editing this paper. I could not have completed this honors paper without the involvement and assistance of all of the aforementioned people. 2 Abstract The Airline Deregulation Act of 1978 provided the impetus for domestic U.S. airlines to establish hub-and-spoke networks to improve profitability and stem financial losses. This study seeks to determine if a significant relationship exists between an airline’s Hub Concentration and its total costs (all terms defined on page 4). Previous studies in the airline industry have focused on mergers, competition, profitability, and route network structure, but no study to date has focused solely on costs and Hub Concentration. Using the microeconomic principle of cost minimization, a cost function for airlines was developed. Furthermore, panel data for sixteen domestic U.S. airlines were collected from seven reputable sources on a quarterly basis from 1995 through 2011. Then, panel data regressions using random and fixed effects were used to analyze the data. This study finds that an increase in an airline’s Hub Concentration leads to a higher cost per available seat mile, a lower cost per passenger seat mile, and lower operating expenses. Even though many airlines that currently operate a hub-and-spoke network, such as American, United, Delta, and Frontier, have filed for bankruptcy in the last decade, this study shows that a more concentrated hub-and-spoke network is an effective way of reducing costs. JEL Classification: C23; L93; R40 Keywords: Models with Panel Data; Industrial Organization; Air Transportation 3 Abbreviations and Definitions BTS – Bureau of Transportation Statistics CASM – Cost per available seat mile – the cost (in cents) of operating one aircraft seat, available for sale, flown one mile, occupied or not CPSM – Cost per passenger seat mile – the cost (in cents) of flying one passenger a distance of one mile in the air DOT – Department of Transportation Hub Concentration – the ratio of the number of flights departing from/arriving at an airline’s primary hub or focus city (listed in Appendix II) to the total number of flights operated by an airline in a given period Load Factor – the ratio of passenger seat miles to available seat miles On-Time Performance – a flight is considered delayed when it arrives 15 or more minutes after its scheduled arrival time Operating Expenses – the sum of all expenditures required to run an airline in a given period SEC – Securities and Exchange Commission 4 Table of Contents I. Introduction ………………………………………….....………………………………... Pg. 7 II. Structure of the U.S. Airline Industry ………………………………………………… Pg. 8 III. Review of Previous Airline Industry Studies …………..……..………….…………. Pg. 15 IV. Panel Data of Airline Costs ……………..……………..……...…..…………………. Pg. 17 V. Theoretical Model: A Cost Function for Airlines ……….……………….....……….. Pg. 26 VI. Empirical Model …………………………………….………………………..………. Pg. 31 VII. Analysis ………..………...………………………………………………………….... Pg. 32 VIII. Conclusions …………………....……………………………..……..………………. Pg. 39 Appendix I: Aircraft Seating Capacities ……...…………………….………………… Pg. 42 Appendix II: Primary Hubs and Focus Cities for each U.S. Airline …………....…... Pg. 43 Appendix III: Links to each U.S. Airline’s Quarterly and Annual SEC Filings ...…… Pg. 46 Appendix IV: Summary Statistics for Continuous Variables …………………….…… Pg. 48 Appendix V: Correlation Table for Continuous Variables ………………..……………Pg. 51 References ……………………………………...……………………………....………….. Pg. 52 5 List of Tables and Figures Figures Figure 1: Schematic Drawing of Airline Hub-and-Spoke Network ……………..………… Pg. 10 Figure 2: Graph of Jet Fuel Prices from 1977 - 2009 …………………......…..…………… Pg. 11 Figure 3: Graph of U.S. Regional Jet Fleet Size from 1993 - 2003.…………….….……… Pg. 12 Figure 4: Diagram of Point-to-Point Airline Network ……………………….........………. Pg. 13 Figure 5: U.S. Airlines’ Net Profit Margin and World GDP Growth from 1970 - 2010…... Pg. 15 Figure 6: Graphs of 4 Key Variables from 1995 - 2011 for American and Southwest …..... Pg. 25 Figure 7: Distribution of an Airline’s Operating Costs …………………...……………….. Pg. 27 Tables Table 1: Variables Borrowed from Previous Studies ……………………………………… Pg. 17 Table 2: Analysis Variables and Respective Resources ………...…………………………. Pg. 19 Table 3: Description of Other Variables ……………………………………...……………. Pg. 23 Table 4: List of Independent Variables with Reasons for Inclusion …….………………… Pg. 28 Table 5: List of Variables Included in Regressions …………….………………………….. Pg. 34 Table 6: Regression Results ………………………………….…………………………….. Pg. 35 Table 7: Predicted and Estimated Signs of Coefficients ………………..…….…………… Pg. 37 6 I. Introduction In the last decade, six major U.S. airlines filed for Chapter 11 bankruptcy: US Airways, United Airlines, Delta Airlines, Northwest Airlines, Frontier Airlines, and American Airlines (Lee 2011). Decreased passenger demand following the tragic events of September 11, 2001, further exacerbated by the effects of the 2008 financial crisis, made it difficult for many airlines to keep their costs below their revenues. Bankruptcies are not unusual in the volatile airline industry, but six bankruptcies in ten years warrant a closer look at the airlines’ complex cost structure. Previous airline studies have focused on the revenue issue, the demand issue, and the route structure issue. Borenstein (1989) analyzed airline ticket prices and airfare markups. Brueckner (2004) determined which airline network structure is most efficient when passenger demand is low. Hussain & Sahay (2006) and Aguirregabiria & Ho (2010) examined the profitability of various airline network structures. However, no study to date has exclusively focused on airline Hub Concentration and its effects on cost structure. This study seeks to fill the gap in the analysis of the airline industry by focusing on Hub Concentration and the cost component of the profit equation. The goal of this paper is to determine whether a higher Hub Concentration actually decreases an airline’s costs. The research question being tested is: Is an airline’s Hub Concentration negatively correlated with its costs? Econometric analyses using sixty-eight quarters of data for sixteen different airlines are employed to test this hypothesis. The results reveal that a higher Hub Concentration leads to a 7 higher cost per available seat mile (CASM), a lower cost per passenger mile (CPSM), and lower operating expenses for an airline1. Further analysis is discussed in Section VII. This study is relevant to both airline companies and consumers: 1) airline companies – because one of their primary goals is to lower operating costs; and 2) consumers – because the amount they pay for an airline ticket is directly proportional to the costs the airline incurs for operating the specific route. There exists a tradeoff between cheaper fares and greater inconvenience for passengers in the airline industry. This paper cannot say anything about the welfare effects of convenience, but it can say something about the welfare effects due to cost. This study is divided into eight distinct sections. Section II describes the structure and dynamics of the U.S. airline industry, providing context for the theoretical model. Section III reviews relevant literature and analyses in the airline industry. Section IV details the data sources used and their robustness for incorporation into this model. Section V formulates the theoretical model. Section VI introduces the empirical model. Section VII discusses the regression results. Section VIII provides analysis and presents the conclusions drawn from the data. II. Structure of the U.S. Airline Industry Before delving into the question of whether or not a higher Hub Concentration actually decreases an airline’s costs, it is useful to understand how deregulation, low-cost carriers, regional jets, and economic cycles influence an airline’s costs and profitability. 1 See Abbreviations and Definitions on Page 4. 8 Deregulation The U.S. Government enacted the Airline Deregulation Act in 1978. This law was intended to stimulate competition by eliminating government control over fares, routes, and market entry. Prior to deregulation, the U.S. government forced airlines to operate flights between two small markets to ensure that individuals in rural areas had sufficient access to air travel. This resulted in many