During the United Airlines second quarter earnings call on Thursday morning, CEO Scott Kirby laid out his belief in how economic forces will drive up airline industry revenue. In response to a question by J.P. Morgan’s Jamie Baker, Kirby explained his belief that mean regression alone will mean higher fares.
“I think that absolutely the airline revenue to GDP ratio is going to trend back upwards.. every time capacity gets ahead of demand this ratio [declines]… demand for air travel is inelastic.”“It really is just as simple as this ratio goes down when supply exceeds demand…I am incredibly encouraged to see the rapid response that is happening..beginning mid-August.”
“I’ve been through these cycles with capacity many times in my career, this is the fastest response..I’ve ever seen.”Kirby says that airlines cutting back capacity means fares will rise (because demand will remain stable) and therefore fares will rise. Airlines will earn more money for their product. And the reason he knows it works this way is because historically airlines earn a fixed share of GDP, and currently airlines are earning a lower than average percentage of total economic activity.Six years ago Scott Kirby explained his belief that over the long term airfares earn a fixed rate of GDP, that demand for travel is unmoored to price, and that airlines only harm themselves when they discount. At the time he explained,
Airfares can rise because airline revenue as a share of GDP is lower than what it used to be.
He thinks lowering fares is self-defeating, it doesn’t bring in more sales it just lowers the revenue earned from each ticket.Later that same year he argued that airfares will eat GDP and that fares should double. Because “in the last 30 years airline revenue as a percentage or GDP has gone to about .6 from about 1.2%… we are under pricing our product by 50%.”
In what Kirby describes as ‘economics 202’ he rejects the notion that in a competitive industry price should fall towards marginal cost.
He continued to present data last year that fares should rise, because airline revenue is below historical average relative to GDP. It’s a point of faith for Kirby, that he’s stuck to for years, but it hasn’t… happened.Implicit in Kirby’s analysis is that airline product isn’t really differentiated, and sales do not spur demand. People buy travel when they want or need to travel, unaffected by price. That doesn’t seem accurate.
And it assumes that air travel isn’t replaced by other technologies. Online communication doesn’t change the overall demand for air travel, and neither do other modes of transportation. It also would only hold if growth in supply of seats matches growth in demand.
In fact, in congested areas of the country air travel growth is limited by air traffic control competence at technology implementation and hiring, and an inability for congested airports to expand.Of course, even if airline revenues revert to historical average as a percentage of GDP, if GDP falls that will be a drag on revenue. The overall health of the economy affects demand for air travel! It also means overcapacity, driving down fares as airlines compete for even a fixed pie of travel demand..