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Article Excerpt
Frequent flyer programs (FFPs) may allow airlines to exercise market power on routes that depart from airports at which they are dominant. Prior research, however, has not disentangled the effects of FFPs from other advantages that dominant airlines may possess. I exploit variation in the extent and scope of U.S. airlines' FFP partnerships with international carriers to evaluate the economic impact of enhancements to FFPs. The results indicate that enhancements to an airline's FFP are associated with increases in its demand on specifically those routes that depart from airports at which it is dominant.
1. Introduction
* Since the deregulation of the airline industry, considerable attention has been focused on the relationship between airport dominance and the competitiveness of routes departing from that airport. Airlines' reorganization of their networks from point-to-point to hub-and-spoke resulted in a significant number of airports being dominated by a single domestic airline. Although there is evidence that hubs allow airlines to achieve lower costs and offer higher frequency, there is also evidence that airlines are able to charge higher fares and capture a larger share of passengers on routes that depart from their hubs. (1) In analyzing this relationship between airport dominance and route-level market power, both academics and policymakers have argued that frequent flyer programs (FFPs) may provide dominant airlines with a competitive advantage. Because the marginal value of FFP points increases with the number of points already accumulated, FFPs give consumers an incentive to concentrate all of their flying with a single carrier. When choosing the airline with which to concentrate their points, consumers will
prefer the dominant carrier at an airport because it offers the best opportunities for earning points and redeeming rewards.
The article uses a novel empirical approach to estimate the relationship between FFPs and an airline's demand on routes that depart from airports at which it is dominant. Although existing empirical work has clearly established the existence of a "hub effect," FFPs are likely to be only one of several advantages that dominant airlines possess and therefore only one part of the estimated hub effect. Borenstein (1991) distinguishes between those advantages that result naturally from the carrier's size of operations at an airport (such as the reputation that a dominant carrier acquires) and those that result from institutions created by the carrier (such as FFPs). Although both types may insulate a dominant airline from competition, they may have different welfare implications. The natural advantages may provide some benefits to consumers--for example, through reduced search costs--that may offset the negative effects of the reduced competition that results from having a dominant carrier at the airport. On the other hand, to the extent that FFPs create little social value--and actually distort behavior by exploiting a principal-agent problem--the welfare effects of these programs are more likely to be negative. (2)
Potential policy responses to the observed lack of competition at hubs must weigh the welfare losses that result from reduced competition at hubs against the welfare benefits that result from airlines' use of hub-and-spoke networks. These include cost, frequency, and scheduling benefits, as well as any informational benefits. Selecting the appropriate response requires an understanding of what it is that allows a dominant airline to be insulated from competition. For example, if it is primarily FFPs, then an appropriate response might be a ban on airlines' use of these programs. Doing so might encourage small-scale entry into hub airports while still preserving the many benefits that result from hub-and-spoke networks.
Data limitations have made it difficult to empirically separate the effects of FFPs from the other components of the hub effect. Given this, this article attempts to use a new empirical approach to estimate the relationship between FFPs and demand. Specifically, I estimate the impact of enhancements to an airline's FFP. If FFPs provide dominant airlines with a competitive advantage on routes that depart from their hubs, then enhancements to their FFPs should provide airlines with an even greater advantage on specifically these routes. Intuitively, whereas earlier papers estimate the hub effect, this article estimates the change in the hub effect when airlines enhance their FFPs. Although the estimates cannot reveal what fraction of the hub effect results from FFPs, they can provide evidence on how the relationship between FFPs and demand varies with an airline's dominance at an airport.
The specific type of enhancement that I consider is the formation of FFP partnerships. In the mid to late 1990s, domestic airlines increasingly entered into FFP partnerships with international carriers. These partnerships allowed members of the domestic airline's program to earn and redeem the domestic airline's FFP points on flights operated by partner airlines. Although these partnerships had no direct effect on the quality of airlines' domestic flights, they significantly increased consumers' earning and redemption opportunities in a domestic airline's program. Because of regulatory and financial barriers that limit a domestic airline's ability to serve international markets, FFP partnerships can expand a domestic airline's program to include many international routes that it does not serve on its own.
The ability to earn and redeem on international partners' flights should affect the value to consumers of earning an airline's FFP points on domestic flights through two channels. First, partnerships expand consumers' redemption opportunities in a domestic airline's FFP by increasing the set of available reward flights. Second, partnerships expand the set of flights on which consumers can earn an airline's points. This should increase the value of earning that airline's FFP points on any given domestic flight by increasing the likelihood that consumers will be able to earn enough points for an eventual reward. Because the average international flight is significantly longer than the average domestic flight, international partnerships allow consumers to reach reward thresholds and earn elite status after only a small number of trips.
By expanding earning and redemption opportunities, changes in FFP partnerships generate time-series variation in the value of earning a particular airline's FFP points. I map the changes in partnerships that occur over the sample period into changes in the actual set of flights on which consumers can earn and redeem an airline's FFP points. I then construct variables which summarize earning and redemption opportunities on an airline's FFP partners. These variables are used to identify the effects of enhancements to FFPs on an airline's demand curve on domestic routes. After estimating the effect on demand, I also investigate how enhancements to FFPs impact an airline's number of passengers and fares.
The empirical approach used here can be compared to that used in earlier work on the advantages of airport dominance. (3) Borenstein (1989) analyzes the effects of airport dominance on fares using data from the third quarter of 1987. He finds that, controlling for the overall concentration of a route and for airline and route fixed effects, increases in an airline's share of passengers on a route and at the endpoint airports allow an airline to charge higher prices. Borenstein (1991) estimates the effect of airport dominance on an airline's market share using an empirical approach that controls for airline-city-pair fixed effects. Intuitively, his strategy compares Delta's market share on round-trips between Atlanta and Boston to its market share on round-trips between Boston and Atlanta and relates this to the difference between Delta's dominance at the Atlanta and at the Boston airports. He finds that an airline with a dominant presence at an airport is able to attract a disproportionate share of consumers whose trips originate at that airport and that this effect appears to be smaller on tourist-oriented routes, suggesting that this advantage results from FFPs.
In both of these papers, however, the effects of airport dominance are being identified from differences in airlines' dominance across airports. The estimates on the airport dominance variables capture both the effects of the airline's FFP and any other advantages stemming from the airline's dominance. Because these other advantages also occur only at the dominated airport, they are not being captured even by airline-city-pair fixed effects. As a result, these papers do not allow the effects of FFPs to be isolated.
The main advantage of the empirical strategy implemented here is that changes in partnerships provide variation in the value of earning a domestic airline's FFP points but should not affect the other advantages that result from an airline's dominance at an airport. As a result, the marginal impact of enhancements to FFPs can be identified, while the other advantages of airport dominance can be carefully controlled for. Of course, airlines do choose when and with whom to form these partnerships. This raises the concern that changes in partners may be correlated with unobserved factors that also affect an airline's demand. To account for this, I exploit the fact that the effects of changes in FFP partnerships should be larger for consumers who are likely to be members of an airline's FFP. For example, consumers in Atlanta (where Delta is dominant) are likely to be members of Delta's FFP whereas consumers in Philadelphia (a US Airways hub) are likely to collect US Airways points. As a result, consumers in Atlanta should value Delta's partnership with Air France more than consumers in Philadelphia. Based on this intuition, routes that depart from airports at which an airline is not dominant are used to estimate airline-specific time effects that control for unobservable factors which may be correlated with changes in the airline's partners, but which do not differentially affect demand on routes departing from airports at which the airline is dominant.
The article's first set of results establishes that, controlling for the other advantages of airport dominance, enhancements to an airline's FFP are associated with increases in an airline's demand curve on routes that depart from airports at which it is dominant. The impact of enhancements to FFPs increases with an airline's level of dominance at an airport, with the effect on routes departing from the airline's most dominated airports (more than 60% of departing flights) more than double that effect on routes out of airports at which it has between 40% and 60% of flights. To the extent that the airports at which enhancements to FFPs affect demand are the same airports at which FFPs themselves affect demand, then the estimated pattern of coefficients clearly suggests that FFPs confer an advantage to specifically those airlines that have a very dominant position at an airport.
The article's second set of results establishes that the increase in demand following an airline's enhancement of its FFP results in a new equilibrium that is associated with fewer passengers carried and higher fares. This finding is consistent with the idea that enhancements to FFPs should have a larger impact on the willingness to pay of passengers who already have a high valuation of the airline and its FFP than they do on the willingness to pay of passengers with a low valuation. As well, the fare regressions indicate that enhancements to FFPs appear to have a larger effect on tickets at the top of the price distribution than at the bottom and a larger effect on business- and first-class tickets than coach tickets. These results provide additional evidence that I am indeed measuring an FFP effect.
The remainder of the article is organized as follows. The next section provides a brief discussion of FFPs and FFP partnerships. In Section 3, I present the empirical framework. Section 4 describes the data and variable construction. Section 5 discusses the results. A final section concludes.
2. Background: FFPs and airline alliances
* Basic facts. The first FFP was introduced by American Airlines in May 1981, three years after the deregulation of the industry. (4) Within days of the introduction of American's FFP, United Airlines introduced an almost identical program of its own. Later that year, Delta, Continental, and TWA followed suit. By 1984, membership in American's FFP was already at 2 million, and by 1992 it had reached 16 million. Today, the large U.S. FFPs (American, United, and Delta) have over 20 million members each, although many members are, of course, shared. Worldwide, there are now more than seventy different FFPs. (5)
FFPs award consumers frequent flyer points for purchased flights. The number of points awarded is typically equal to the distance of the flight but may also depend on the type of ticket purchased. Less-restricted, higher-fare tickets will often entitle the traveler to additional points. Accumulated FFP points can be redeemed for rewards, the most common of which are free tickets or free class upgrades with the airline. FFP reward schedules are structured such that a minimum number of points must be earned before any reward can be redeemed, after which the value of rewards generally increases nonlinearly with the number of points required. (6) In addition, FFPs have so-called elite programs that award "status" to consumers who fly a minimum number of miles with the airline in a given year. Most have three tiers, with qualification for each tier requiring an increasing number of miles flown. (7) Each tier entitles a traveler to an increasing amount of preferential treatment. Because the elite programs entitle a consumer to preferential treatment on all flights taken with the airline in the year of qualification (and, in some cases, flights on the airline's partners as well), they create large, discrete increases in the value of earning additional FFP points as one approaches the tier status thresholds. Together, these nonlinearities give consumers an incentive to accumulate all of their points in a single airline's FFR. (8) This is the sense in which these programs "create loyalty."
[] FFPs and market power at dominated airports. As described above, FFPs' reward schedules give consumers an incentive to accumulate all of their points in a single carrier's program. If consumers regularly fly to multiple destinations, or are uncertain about where they will need to fly, then they will prefer the FFP of the airline that serves the largest set of routes out of their home airport. In addition to maximizing their opportunities for earning points, this airline will also offer the largest selection of reward destinations. For both of these reasons, the dominant airline at an airport will offer the most attractive FFP, for consumers at that airport. (9) Once consumers become invested in that airline's FFP, any flight not taken with that airline represents forgone FFP points. To induce consumers to purchase their flights, carriers that are not dominant at the airport must offer consumers a lower price to compensate them for the forgone FFP points. By requiring competitors to offer this "extra" price reduction, the use of an FFP by the dominant airline at an airport can lower the profits of airlines which serve only a small set of routes out of that airport. This...
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