The impact of passenger mix on reported "hub premiums" in the U.S. airline industry

Southern Economic Journal, Oct, 2005 by Darin Lee, Maria Jose Luengo-Prado

1. Introduction

One of the most actively debated issues in the U.S. airline industry since its deregulation in 1978 has centered around the prices charged by network airlines for service to and from their hub airports. This topic, known as the "hub premium" debate, stems from the belief held by many travelers that they are being overcharged by network airlines on flights to and from their respective hubs. (1) In addition to much anecdotal evidence, numerous U.S. Government studies (e.g., U.S. Department of Transportation 1990; U.S. General Accounting Office 1990; U.S. General Accounting Office 1999) have found that average fares at concentrated hub airports tend to be higher--often substantially--than at other nonhub airports. For example, the U.S. General Accounting Office (1999) reported that average fares at one hub were 83% higher than the national average, and another recent study (U.S. Department of Transportation 2001) went so far as to refer to hubs as "pockets of pain."

The existing literature has studied and attempted to quantify the hub premium using--for the most part--one of two approaches. One set of studies (e.g., Morrison and Winston 1995; Morrison and Winston 2000) analyzes a cross section of airports and relates airport concentration to average fares. These studies improve on initial studies by the U.S. General Accounting Office (1990) and the U.S. Department of Transportation (1990) by attempting to control for factors known to impact average fares, such as average distance, the proportion of connecting passengers, and frequent flyer tickets. A second set of studies (e.g., Borenstein 1989; Evans and Kessides 1993) disaggregates data at the carrier and market level, thus controlling for structural differences between markets, and attempts to distinguish between market and airport characteristics as sources of potential pricing power. (2) In general, this latter group of studies argues that high concentration by a single airline at an airport can lead to entry barriers in the form of frequent flyer programs, travel agency commission overrides, and long-term leases on gates and airport facilities, among others, thus dampening nonstop competition and allowing the hub airline to charge supracompetitive fares. Borenstein (1989) also suggests that ownership of computer reservation systems (CRSs) serves as an entry barrier by allowing large network airlines to bias the information presented to both travelers and travel agents in favor of their own service. (3)

None of the mentioned studies, however, has directly controlled for the passenger mix (the proportion of leisure versus business travelers)--which is known to affect average fares--and thus, the estimation results in studies such as Borenstein (1989) and Evans and Kessides (1993) may suffer from omitted variable bias. Network airlines have long argued that average fares are higher in markets to and from their hubs compared to other markets within their networks because a greater proportion of passengers traveling to and from their hubs are business travelers, purchasing more flexible--and much more expensive--unrestricted tickets. Unrestricted tickets offer a number of attributes that make them both more attractive to customers as well as more costly for airlines to provide. For example, unrestricted tickets may be changed without any fees, are fully refundable, can be purchased at the last minute, and, depending on the airline and/or the traveler's frequent flyer status, may provide the traveler with a free first-class upgrade. Because unrestricted tickets can cost several times as much as restricted coach tickets, network airlines argue that even a few extra unrestricted passengers per flight can have a relatively large impact on average fares. For example, an Expedia.com search for restricted, roundtrip, nonstop coach class tickets between Boston and Los Angeles yielded fares of $281, $295, and $295 on Delta, American, and United, respectively. For unrestricted coach class tickets on the same flights, the fare was $2583.50 on the same three carriers. (4)

Most recent hub premium studies acknowledge that passenger mix may impact average fares, so it is somewhat surprising that only one study (Gordon and Jenkins 2000) has explicitly attempted to control for this factor. (5) Using proprietary data from Northwest Airlines, the authors found that after controlling for passenger mix, distance, and the number of stops, Northwest's hub passengers receive a hub discount compared to Northwest's passengers traveling throughout the rest of its network. This study, however, only focuses on Northwest Airlines, and its methodology has been subject to criticism (for example, the authors treat passengers connecting from one of Northwest's regional partners as hub-originating passengers). Thus, after more than a decade of debate, the hub premium controversy is still largely unresolved, a point echoed in a recent study by the Department of Transportation's Volpe Center: